{"text": "A Complete Guide \nto the \nFutures mArket\nThe Wiley Trading series features books by traders who have survived the market’s \never changing temperament and have prospered—some by reinventing systems, \nothers by getting back to basics. Whether a novice trader, professional or some-\nwhere in-between, these books will provide the advice and strategies needed to \nprosper today and well into the future. For more on this series, visit our website \nat www.WileyTrading.com.\nFounded in 1807, John Wiley & Sons is the oldest independent publishing com-\npany in the United States. With offices in North America, Europe, Australia and \nAsia, Wiley is globally committed to developing and marketing print and electronic \nproducts and services for our customers’ professional and personal knowledge \nand understanding.\nA Complete Guide \nto the \nFutures mArket\nTechnical Analysis and Trading Systems, \nFundamental Analysis, Options, Spreads, and \nTrading Principles \nseCond edition\nJack d. schwager\nmark etzkorn\nCover images: Stock Chart © Adam Kazmierski/iStockphoto; Abstract Background © Olga Altunina/ iStockphoto \nCover design: Wiley\nCopyright © 2017 by Jack D. Schwager. All rights reserved.\nPublished by John Wiley & Sons, Inc., Hoboken, New Jersey.\nThe first edition of A Complete Guide to the Futures Market was published by John Wiley & Sons in 1984.\nPublished simultaneously in Canada.\nNo part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form \nor by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as \npermitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior \nwritten permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the \nCopyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-\n8600, or on the W eb at www .copyright.com. Requests to the Publisher for permission should be addressed to \nthe Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, \nfax (201) 748-6008, or online at www .wiley.com/go/permissions.\nLimit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in \npreparing this book, they make no representations or warranties with respect to the accuracy or completeness \nof the contents of this book and specifically disclaim any implied warranties of merchantability or fitness \nfor a particular purpose. No warranty may be created or extended by sales representatives or written sales \nmaterials. The advice and strategies contained herein may not be suitable for your situation. Y ou should consult \nwith a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit \nor any other commercial damages, including but not limited to special, incidental, consequential, or other \ndamages.\nFor general information on our other products and services or for technical support, please contact our \nCustomer Care Department within the United States at (800) 762-2974, outside the United States at (317) \n572-3993, or fax (317) 572-4002.\nWiley publishes in a variety of print and electronic formats and by print-on-demand. Some material included \nwith standard print versions of this book may not be included in e-books or in print-on-demand. If this book \nrefers to media such as a CD or DVD that is not included in the version you purchased, you may download this \nmaterial at http://booksupport.wiley.com. For more information about Wiley products, visit www .wiley.com.\nLibrary of Congress Cataloging-in-Publication Data:\nNames: Schwager, Jack D., 1948- author.\nTitle: A complete guide to the futures market : fundamental analysis, \n technical analysis, trading, spreads and options / Jack D. Schwager.\nDescription: Second edition. | Hoboken, New Jersey : John Wiley & Sons, Inc., \n [2017] | Series: Wiley trading series | Includes index.\nIdentifiers: LCCN 2016034802 (print) | LCCN 2016047999 (ebook) | ISBN \n 9781118853757 (pbk.) | ISBN 9781118859599 (pdf) | ISBN 9781118859544 (epub)\nSubjects: LCSH: Futures market. | Commodity exchanges. | Hedging (Finance)\nClassification: LCC HG6046 .S39 2017 (print) | LCC HG6046 (ebook) | DDC \n 332.64/52-dc23\nLC record available at https://lccn.loc.gov/2016034802\nPrinted in the United States of America.\n10 9 8 7 6 5 4 3 2 1\nIn memory of Stephen Chronowitz, my mentor and friend.\n\nvii\nContents\nAbout the Authors xv\nPArt I PrelImInArIes\nChAPter 1 For Beginners only 3\nPurpose of This Chapter 3\nThe Nature of Futures Markets 3\nDelivery 4\nContract Specifications 5\nV olume and Open Interest 9\nHedging 11\nTrading 15\nTypes of Orders 16\nCommissions and Margins 19\nTax Considerations 19\nChAPter 2 the Great Fundamental versus technical Analysis Debate 21\nPArt II ChArt AnAlysIs AnD teChnICAl InDICAtors\nChAPter 3 Charts: Forecasting tool or Folklore? 27\nChAPter 4 types of Charts 35\nBar Charts 35\nLinked Contract Series: Nearest Futures versus Continuous Futures 39\nClose-Only (“Line”) Charts 40\nviii\nContents\nPoint-and-Figure Charts 42\nCandlestick Charts 43\nChAPter 5 linking Contracts for long-term Chart Analysis: \nnearest versus Continuous Futures 45\nThe Necessity of Linked-Contract Charts 45\nMethods of Creating Linked-Contract Charts 46\nNearest versus Continuous Futures in Chart Analysis 48\nConclusion 51\nChAPter 6 trends 57\nDefining Trends by Highs and Lows 57\nTD Lines 66\nInternal Trend Lines 73\nMoving Averages 78\nChAPter 7 trading ranges 83\nTrading Ranges: Trading Considerations 83\nTrading Range Breakouts 86\nChAPter 8 support and resistance 91\nNearest Futures or Continuous Futures? 91\nTrading Ranges 92\nPrior Major Highs and Lows 94\nConcentrations of Relative Highs and Relative Lows 101\nTrend Lines, Channels, and Internal Trend Lines 106\nPrice Envelope Bands 107\nChAPter 9 Chart Patterns 109\nOne-Day Patterns 109\nContinuation Patterns 122\nT op and Bottom Formations 134\nChA", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 0}
{"text": "s 83\nTrading Range Breakouts 86\nChAPter 8 support and resistance 91\nNearest Futures or Continuous Futures? 91\nTrading Ranges 92\nPrior Major Highs and Lows 94\nConcentrations of Relative Highs and Relative Lows 101\nTrend Lines, Channels, and Internal Trend Lines 106\nPrice Envelope Bands 107\nChAPter 9 Chart Patterns 109\nOne-Day Patterns 109\nContinuation Patterns 122\nT op and Bottom Formations 134\nChAPter 10 Is Chart Analysis still Valid? 149\nChAPter 11 technical Indicators 155\nWhat Is an Indicator? 155\nThe Basic Indicator Calculations 157\nComparing Indicators 157\nMoving Average Types 165\nOscillators and Trading Signals 167\nIndicator Myths 170\nIndicator “Types” 172\nConclusion 173\nixCONTENTS\nPArt III APPlyInG ChArt AnAlysIs to trADInG\nChAPter 12 midtrend entry and Pyramiding 177\nChAPter 13 Choosing stop-loss Points 183\nChAPter 14 setting objectives and other Position exit Criteria 189\nChart-Based Objectives 189\nMeasured Move 190\nRule of Seven 194\nSupport and Resistance Levels 196\nOverbought/Oversold Indicators 198\nDeMark Sequential 199\nContrary Opinion 203\nTrailing Stops 204\nChange of Market Opinion 204\nChAPter 15 the most Important rule in Chart Analysis 205\nFailed Signals 205\nBull and Bear Traps 205\nFalse Trend Line Breakouts 211\nReturn to Spike Extremes 213\nReturn to Wide-Ranging Day Extremes 216\nCounter-to-Anticipated Breakout of Flag or Pennant 219\nOpposite Direction Breakout of Flag or Pennant Following a Normal Breakout 222\nPenetration of T op and Bottom Formations 225\nBreaking of Curvature 229\nThe Future Reliability of Failed Signals 229\nConclusion 231\nPArt IV t rADInG systems AnD PerFormAnCe meAsurement\nChAPter 16 technical trading systems: structure and Design 235\nThe Benefits of a Mechanical Trading System 236\nThree Basic Types of Systems 236\nTrend-Following Systems 237\nT en Common Problems with Standard Trend-Following Systems 244\nPossible Modifications for Basic Trend-Following Systems 247\nCountertrend Systems 254\nDiversification 256\nT en Common Problems with Trend-Following Systems Revisited 259\nx\nContents\nChAPter 17 examples of original trading systems 261\nWide-Ranging-Day System 261\nRun-Day Breakout System 268\nRun-Day Consecutive Count System 273\nConclusion 278\nChAPter 18 selecting the Best Futures Price series for system testing 279\nActual Contract Series 279\nNearest Futures 280\nConstant-Forward (“Perpetual”) Series 281\nContinuous (Spread-Adjusted) Price Series 282\nComparing the Series 285\nConclusion 287\nChAPter 19 testing and optimizing trading systems 289\nThe W ell-Chosen Example 289\nBasic Concepts and Definitions 291\nChoosing the Price Series 293\nChoosing the Time Period 293\nRealistic Assumptions 295\nOptimizing Systems 297\nThe Optimization Myth 298\nT esting versus Fitting 310\nThe Truth about Simulated Results 312\nMultimarket System T esting 313\nNegative Results 314\nT en Steps in Constructing and T esting a Trading System 315\nObservations about Trading Systems 316\nChAPter 20 how to evaluate Past Performance 319\nWhy Return Alone Is Meaningless 319\nRisk-Adjusted Return Measures 323\nVisual Performance Evaluation 335\nInvestment Insights 343\nPArt V FunDAmentAl AnAlysIs\nChAPter 21 Fourteen Popular Fallacies, or What not to Do Wrong 347\nFive Short Scenes 347\nThe Fourteen Fallacies 349\nxiCONTENTS\nChAPter 22 supply-Demand Analysis: Basic economic theory 359\nSupply and Demand Defined 359\nThe Problem of Quantifying Demand 362\nUnderstanding the Difference between Consumption and Demand 363\nThe Need to Incorporate Demand 366\nPossible Methods for Incorporating Demand 368\nWhy Traditional Fundamental Analysis Doesn’t W ork in the Gold Market 371\nChAPter 23 types of Fundamental Analysis 373\nThe “Old Hand” Approach 373\nThe Balance Table 373\nThe Analogous Season Method 374\nRegression Analysis 375\nIndex Models 376\nChAPter 24 the role of expectations 379\nUsing Prior- Y ear Estimates Rather Than Revised Statistics 379\nAdding Expectations as a Variable in the Price-Forecasting Model 380\nThe Influence of Expectations on Actual Statistics 380\nDefining New-Crop Expectations 381\nChAPter 25 Incorporating Inflation 383\nChAPter 26 seasonal Analysis 389\nThe Concept of Seasonal Trading 389\nCash versus Futures Price Seasonality 389\nThe Role of Expectations 390\nIs It Real or Is It Probability? 390\nCalculating a Seasonal Index 391\nChAPter 27 Analyzing market response 403\nEvaluating Market Response for Repetitive Events 403\nChAPter 28 Building a Forecasting model: A step-by-step Approach 413\nChAPter 29 Fundamental Analysis and trading 417\nFundamental versus T echnical Analysis: A Greater Need for Caution 417\nThree Major Pitfalls in Fundamental Analysis 418\nCombining Fundamental Analysis with T echnical Analysis and Money Management 426\nWhy Bother with Fundamentals? 427\nAre Fundamentals Instantaneously Discounted? 428\nxii\nContents\nFitting the News to Price Moves 431\nFundamental Developments: Long- T erm Implications versus Short- T erm Response 432\nSummary 435\nPArt VI Futures sPreADs AnD oPtIons\nChAPter 30 the Concepts and mechanics of spread trading 439\nIntroduction 439\nSpreads—Definition and Basic Concepts 440\nWhy Trade Spreads? 440\nTypes of Spreads 441\nThe General Rule 443\nThe General Rule—Applicability and Nonapplicability 443\nSpread Rather Than Outright—An Example 445\nThe Limited-Risk Spread 446\nThe Spread Trade—Analysis and Approach 448\nPitfalls and Points of Caution 449\nChAPter 31 Intercommodity spreads: Determining Contract ratios 453\nChAPter 32 spread trading in stock Index Futures 461\nIntramarket Stock Index Spreads 461\nIntermarket Stock Index Spreads 462\nChAPter 33 spread trading in Currency Futures 471\nIntercurrency Spreads 471\nIntracurrency Spreads 473\nChAPter 34 An Introduction to options on Futures 477\nPreliminaries 477\nFactors That Determine Option Premiums 480\nTheoretical versus Actual Option Premiums 483\nDelta (the Neutral Hedge Ratio) 484\nChAPter 35 option trading strategies 487\nComparing Trading Strategies 487\nProfit/Loss Profiles for Key Trading Strategies 489\nPArt VII PrACtICAl trADInG Gu", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 1}
{"text": "ercurrency Spreads 471\nIntracurrency Spreads 473\nChAPter 34 An Introduction to options on Futures 477\nPreliminaries 477\nFactors That Determine Option Premiums 480\nTheoretical versus Actual Option Premiums 483\nDelta (the Neutral Hedge Ratio) 484\nChAPter 35 option trading strategies 487\nComparing Trading Strategies 487\nProfit/Loss Profiles for Key Trading Strategies 489\nPArt VII PrACtICAl trADInG GuIDelInes\nChAPter 36 the Planned trading Approach 559\nStep 1: Define a Trading Philosophy 559\nStep 2: Choose Markets to Be Traded 560\nxiii\nCONTENTS\nStep 3: Specify Risk Control Plan 560\nStep 4: Establish a Planning Time Routine 563\nStep 5: Maintain a Trader’s Spreadsheet 563\nStep 6: Maintain a Trader’s Diary 565\nStep 7: Analyze Personal Trading 565\nChAPter 37 seventy-Five trading rules and market observations 567\nEntering Trades 568\nExiting Trades and Risk Control (Money Management) 569\nOther Risk-Control (Money Management) Rules 570\nHolding and Exiting Winning Trades 570\nMiscellaneous Principles and Rules 571\nMarket Patterns 572\nAnalysis and Review 573\nChAPter 38 50 market Wizard lessons 575\nAPPenDIx A Introduction to regression Analysis 589\nBasics 589\nMeaning of Best Fit 591\nA Practical Example 593\nReliability of the Regression Forecast 593\nAPPenDIx B A review of elementary statistics 597\nMeasures of Dispersion 597\nProbability Distributions 599\nReading the Normal Curve (Z) Table 604\nPopulations and Samples 606\nEstimating the Population Mean and Standard Deviation from the Sample Statistics 607\nSampling Distribution 608\nCentral Limit Theorem 609\nStandard Error of the Mean 612\nConfidence Intervals 612\nThe t- T est 614\nAPPenDIx C Checking the significance of the regression equation 619\nThe Population Regression Line 619\nBasic Assumptions of Regression Analysis 620\nT esting the Significance of the Regression Coefficients 620\nStandard Error of the Regression 627\nConfidence Interval for an Individual Forecast 627\nExtrapolation 630\nCoefficient of Determination (r2) 630\nSpurious (“Nonsense”) Correlations 634\nxiv\nContents\nAPPenDIx D the multiple regression model 637\nBasics of Multiple Regression 637\nApplying the t- T est in the Multiple Regression Model 640\nStandard Error of the Regression 641\nConfidence Intervals for an Individual Forecast 642\nR2 and Corrected R2 642\nF- T est 643\nAnalyzing a Regression Run 644\nAPPenDIx e Analyzing the regression equation 649\nOutliers 649\nThe Residual Plot 650\nAutocorrelation Defined 651\nThe Durbin-Watson Statistic as a Measure of Autocorrelation 651\nThe Implications of Autocorrelation 654\nMissing Variables and Time Trend 655\nDummy Variables 658\nMulticollinearity 663\nAddendum: Advanced T opics 666\nAPPenDIx F Practical Considerations in Applying regression Analysis 673\nDetermining the Dependent Variable 673\nSelecting the Independent Variables 675\nShould the Preforecast Period Price Be Included? 675\nChoosing the Length of the Survey Period 676\nSources of Forecast Error 677\nSimulation 678\nStepwise Regression 679\nSample Step-by-Step Regression Procedure 680\nSummary 681\nreferences and recommended readings 683\nIndex 685\nxv\nAbout the A utho RS\nJack Schwager is a co-founder and Chief Research Officer of FundSeeder, a firm that seeks to find \nundiscovered trading talent worldwide via its trader platform (FundSeeder.com), and a co-founder \nof FundSeeder Investments (FundSeederinvest.com), which seeks to connect properly regulated \ntraders with sources of investment capital. Mr. Schwager is a recognized industry expert in futures \nand hedge funds and the author of a number of widely acclaimed financial books. Previously, \nMr. Schwager was a partner in the Fortune Group (2001–2010), a London-based hedge fund advisory \nfirm. His prior experience also includes 22 years as Director of Futures research for some of Wall \nStreet’s leading firms, most recently Prudential Securities.\nMr. Schwager has written extensively on the futures industry and great traders in all financial mar-\nkets. He is perhaps best known for his best-selling series of interviews with the greatest hedge fund \nmanagers of the last three decades: Market Wizards (1989), The New Market Wizards (1992), Stock \nMarket Wizards (2001), Hedge Fund Market Wizards (2012), and The Little Book of Market Wizards (2014). \nHis other books include Market Sense and Nonsense (2012), a compendium of investment miscon-\nceptions, and the three-volume series Schwager on Futures, consisting of Fundamental Analysis (1995), \nT echnical Analysis (1996), and Managed T rading (1996). He is also the author of Getting Started in T echnical \nAnalysis (1999), part of Wiley’s popular Getting Started series.\nMr. Schwager is a frequent seminar speaker and has lectured on a range of analytical topics includ-\ning the characteristics of great traders, investment fallacies, hedge fund portfolios, managed accounts, \ntechnical analysis, and trading system evaluation. He holds a BA in Economics from Brooklyn College \n(1970) and an MA in Economics from Brown University (1971).\nMark \netzkorn is founder of FinCom Media. He was formerly Editor-in-Chief of Active T rader maga-\nzine, editor at Futures magazine, and a member of the Chicago Mercantile Exchange. He has authored, \nedited, and contributed to more than 10 books on the financial markets.\n\nPreliMinaries\nPart I\n\n3\nCha P ter 1\nIf a little knowledge is dangerous, where is the man who has so much as to be out of danger?\n—Thomas Henry Huxley\n ■ Purpose of This Chapter\nThe focus of this book is on analysis and trading. although these subjects are explored in far greater \ndepth than in most general commodity texts, the presentation in the following chapters does not \nassume any prior knowledge except for a familiarity with the basic concepts of futures markets. This \nchapter is intended to provide a sketch of the background information necessary to make this book \naccessible to the novice reader. The title of this chapter should be taken literally. Traders who are \nalready familiar with futures markets should pr", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 2}
{"text": "presentation in the following chapters does not \nassume any prior knowledge except for a familiarity with the basic concepts of futures markets. This \nchapter is intended to provide a sketch of the background information necessary to make this book \naccessible to the novice reader. The title of this chapter should be taken literally. Traders who are \nalready familiar with futures markets should proceed directly to Chapter 2.\nThe introductory discussion provided by this chapter is deliberately brief and does not purport \nto cover all background subjects. T opics such as the history of exchanges, choosing a broker, and \noperation of the clearinghouse are not covered because a familiarity with these subjects is unnecessary \nfor the analysis and trading of futures markets. \nreaders who desire a more detailed discussion of com-\nmodity market basics can refer to a wide range of introductory commodity texts.\n ■ The Nature of Futures Markets\na futures contract is a commitment to deliver or receive a standardized quantity and quality of a com-\nmodity or financial instrument at a specified future date. The price associated with this commitment \nis the trade entry level.\nFor Beginners Only\n4\nA Complete Guide to the Futures mArket\nThe essence of a futures market is in its name: Trading involves a commodity or financial \ninstrument for a future delivery date, as opposed to the present time. Thus, if a cotton farmer \nwished to make a current sale, he would sell his crop in the local cash market. However, if the \nsame farmer wanted to lock in a price for an anticipated future sale (e.g., the marketing of a still \nunharvested crop), he would have two options: He could locate an interested buyer and negotiate \na contract specifying the price and other details (quantity, quality, delivery time, location, etc.). \nalternatively, he could sell futures. some of the major advantages of the latter approach are the \nfollowing:\n 1. The futures contract is standardized; hence, the farmer does not have to find a specific buyer.\n 2. The transaction can be executed virtually instantaneously online.\n 3. The cost of the trade (commissions) is minimal compared with the cost of an individualized \nforward contract.\n 4. The farmer can offset his sale at any time between the original transaction date and the final \ntrading day of the contract. The reasons this may be desirable are discussed later in this chapter.\n 5. The futures contract is guaranteed by the exchange.\nUntil the early 1970s, futures markets were restricted to commodities (e.g., wheat, sugar, \ncopper, cattle). since that time, the futures area has expanded to incorporate additional market sec-\ntors, most significantly stock indexes, interest rates, and currencies (foreign exchange). The same \nbasic principles apply to these financial futures markets. Trading quotes represent prices for a future \nexpiration date rather than current market prices. For example, the quote for December 10-year \nT -note futures implies a specific price for a $100,000, 10-year U.\ns. Treasury note to be delivered \nin December. Financial markets have experienced spectacular growth since their introduction, and \ntoday trading volume in these contracts dwarfs that in commodities. \nnevertheless, futures markets \nare still commonly, albeit erroneously, referred to as commodity markets, and these terms are \nsynonymous.\n ■ Delivery\nshorts who maintain their positions in deliverable futures contracts after the last trading day \nare obligated to deliver the given commodity or financial instrument against the contract. similarly, \nlongs who maintain their positions after the last trading day must accept delivery. in the com-\nmodity markets, the number of open long contracts is always equal to the number of open short \ncontracts (see section V olume and Open \ninterest). Most traders have no intention of making \nor accepting delivery, and hence will offset their positions before the last trading day. (The \nlong offsets his position by entering a sell order, the short by entering a buy order.) \nit has been \nestimated that fewer than 3 percent of open contracts actually result in delivery. some futures \ncontracts (e.g., stock indexes, eurodollar) use a cash settlement process whereby outstanding long \nand short positions are offset at the prevailing price level at expiration instead of being physically \ndelivered.\n5FOr Beginners Only\n ■ Contract Specifications\nFutures contracts are traded for a wide variety of markets on a number of exchanges both in the \nUnited states and abroad. The specifications for these contracts, especially details such as daily price \nlimits, trading hours, and ticker symbols, can change over time; exchange web sites should be con-\nsulted for up-to-date information. Table 1.1 provides the following representative trading details for \nsix futures markets (\ne-mini s&P 500, 10-year T -note, euro, Brent crude oil, corn, and gold): \n 1. exchange. note that some markets are traded on more than one exchange. in some cases, \ndifferent contracts for the same commodity (or financial instrument) may even be traded on the \nsame exchange.\n 2. ticker symbol. The quote symbol is the letter code that identifies each market (e.g., es for \nthe e-mini s&P 500, C for corn, eC for the euro), combined with an alphanumeric suffix to \nrepresent the month and year.\n 3. Contract size. The specification of a uniform quantity per contract is one of the key ways in \nwhich a futures contract is standardized. By multiplying the contract size by the price, the trader \ncan determine the dollar value of a contract. For example, if corn is trading at $4.00/bushel (bu), \nthe contract value equals $20,000 ($4 × 5,000 bu per contract). \nif Brent crude oil is trading at \n$48.30, the contract value is $48,300 ($48.30 × 1,000 barrels). although there are many impor-\ntant exceptions, very roughly speaking, higher per-contract dollar values will imply a greater \npotential/risk level. (The concept of contract value", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 3}
{"text": ". For example, if corn is trading at $4.00/bushel (bu), \nthe contract value equals $20,000 ($4 × 5,000 bu per contract). \nif Brent crude oil is trading at \n$48.30, the contract value is $48,300 ($48.30 × 1,000 barrels). although there are many impor-\ntant exceptions, very roughly speaking, higher per-contract dollar values will imply a greater \npotential/risk level. (The concept of contract value has no meaning for interest rate contracts.)\n 4. Price quoted in. This row indicates the relevant unit of measure for the given market.\n 5. Minimum price fluctuation (“tick”) size and value. This row indicates the minimum \nincrement in which prices can trade, and the dollar value of that move. For example, the mini-\nmum fluctuation for the \ne-mini s&P 500 contract is 0.25 index points. Thus, you can enter an \norder to buy December e-mini s&P futures at 1,870.25 or 1,870.50, but not 1,870.30. The \nminimum fluctuation for corn is 1\n4 ¢/bu, which means you can enter an order to buy December \ncorn at $4.01 1\n2 or $4.01 3\n4 , but not $4.01 5\n8 per bushel. The tick value is obtained by multiply-\ning the minimum fluctuation by the contract size. For example, for Brent crude oil, one cent \n($0.01) per barrel × 1,000 barrels = $10. For corn, \n1\n4 50 00 12 50¢/bu ×=,$ ..\n 6. Contract months. each market is traded for specific months. For example, the e-mini s&P \n500 futures contract is traded for March, June, september, and December. Corn is traded for \nMarch, May, July, september, and December. Table 1.2 shows the letter designations for each \nmonth of the year, which are added (along with the contract year) to a market’s base ticker \nsymbol to create a contract-specific ticker symbol. For example, December 2017 \ne-mini s&P \n500 futures have a ticker symbol of esZ17, while the symbol for the March 2018 contract is \nesH18. The symbol for May 2017 corn is CK17. The last trading day for a contract typically \noccurs on a specified date in the contract month, although in some markets (such as crude oil), \nthe last trading day falls in the month preceding the contract month. For most markets, futures \nare listed for contract months at least one year forward from the current date. However, trading \nactivity is normally heavily concentrated in the nearest two contracts.\n6\nA Complete Guide to the Futures mArket\ntable 1.1 Sample Futures Contract Specifications\ne-Mini S&P 500 10-Y ear t-Note euro FX brent Crude Oil Corn Gold\nexchange CMe group CM e group/CBOT CM e group intercontinental \nexchange (iCe Futures \neurope)\nCMe group/CBOT CM e group/nyMeX\nticker Symbol es Ty eC B C gC\nContract Size $50 × s&P 500 index U.s. Treasury note with a \nface value at maturity of \n$100,000.\n125,000 euros 1,000 barrels 5,000 bushels (∼ 127 \nmetric tons)\n100 troy ounces\nPrice Quoted In\nindex points Points ($1,000) and halves of \n1/32 of a point (e.g., 126-16 \nrepresents 126 16/32 and \n126-165 represents 126 \n16.5/32).\nU.\ns. dollars per \neuro\nU.s. dollars and cents Cents per bushel U. s. dollars and cents per \ntroy ounce\nMinimum Price \nFluctuation \n(“tick”) Size \nand Value\n0.25 index points = \n$12.50\nOne-half of 1/32 of one \npoint ($15.625, rounded \nto the nearest cent per \ncontract).\n$0.00005 per \neuro increments \n($6.25/contract)\nOne cent ($0.01) per \nbarrel = $10\n1/4 cent per bushel = \n$12.50\n$0.10 per troy ounce = $10\nContract Months Mar, Jun, \nsep, Dec Mar, Jun, sep, Dec Mar, Jun, sep, Dec all months of the year Mar, May, Jul, sep, Dec The current month; the next \ntwo months; any Feb, apr, \naug, and Oct within a 23-\nmonth period; and any June \nand Dec within a 72-month \nperiod beginning with the \ncurrent month.\ntrading hours Mon–Fri, 5:00 p.m. \nprevious day to 4:15 \np.m.; trading halt \nfrom 3:15 p.m. to \n3:30 p.m.\n5:00 p.m. to 4:00 p.m., \nsun–Fri.\nsun–Fri. 5 p.m. to \n4 p.m. CT with a \n60-min. break each \nday beginning at \n4:00 p.m.\n1 a.m. to 11 p.m. \nlondon time\nsun–Fri, 7:00 p.m. \nto 7:45 a.m. CT and \nMon–Fri, 8:30 a.m. to \n1:20 p.m. CT .\nsun–Fri, 6:00 p.m. to 5:00 \np.m. (5:00 p.m. to 4:00 p.m. \nChicago time/CT) with a \n60-minute break each day \nbeginning at 5:00 p.m. (4:00 \np.m. CT).\n6\n7FOr Beginners Only\nDaily Price limit 7%, 13%, and 20% \nlimits are applied \nto the futures fixing \nprice, effective 8:30 \na.m. to 3 p.m. CT , \nMon–Fri.\n7%, 13%, and 20% limits are \napplied to the futures fixing \nprice, effective 8:30 a.m. to \n3 p.m. CT , Mon–Fri. (\nsee \nexchange for specifics.)\nn/a n/a $0.25 n/a\nSettlement type Cash settlement Deliverable Deliverable Physical delivery based \non eFP delivery, with \nan option to cash settle \nagainst the \niCe Brent \nindex price for the \nlast trading day of the \nfutures contract.\nDeliverable Deliverable\nFirst Notice Day\nn/a Final business day of the \nmonth preceding the \ncontract month.\nn/a n/a last business day of \nmonth preceding \ncontract month.\nThe last business day of the \nmonth preceding the delivery \nmonth.\nlast Notice Day n/a Final business day of the \ncontract month.\nn/a n/a The business day after \nthe last contract’s last \ntrading day.\nThe second-to-last business \nday of the delivery month.\nlast trading Day Until 8:30 a.m. on \nthe 3rd Friday of the \ncontract month.\n12:01 p.m. on the 7th \nbusiness day preceding \nthe last business day of the \ndelivery month.\n9:16 a.m. CT on \nthe second business \nday immediately \npreceding the \nthird W ed of the \ncontract month.\nThe last business day \nof the second month \npreceding the relevant \ncontract month.\nBusiness day prior to \nthe 15th calendar day of \nthe contract month.\nThe third-to-last business day \nof the delivery month.\nDeliverable \nGrade\nn/a U.s. T -notes with a remaining \nterm to maturity of 6.5 to 10 \nyears from the first day of the \ndelivery month.\nn/a n/a #2 yellow at contract \nprice, #1 yellow at \na 1.5 cent/bushel \npremium, #3 \nyellow \nat a 1.5 cent/bushel \ndiscount.\ngold delivered under this \ncontract shall assay to a \nminimum of 995 fineness.\n7\n8\nA Complete Guide to the Futures mArket\n 7. trading hours. Trading hours are listed in terms", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 4}
{"text": "es with a remaining \nterm to maturity of 6.5 to 10 \nyears from the first day of the \ndelivery month.\nn/a n/a #2 yellow at contract \nprice, #1 yellow at \na 1.5 cent/bushel \npremium, #3 \nyellow \nat a 1.5 cent/bushel \ndiscount.\ngold delivered under this \ncontract shall assay to a \nminimum of 995 fineness.\n7\n8\nA Complete Guide to the Futures mArket\n 7. trading hours. Trading hours are listed in terms of the local times for the given exchange. \n(all U.s. exchanges are currently located in either the eastern or Central time zones.)\n 8. Daily price limit. exchanges normally specify a maximum amount by which the contract \nprice can change on a given day. For example, if the December corn contract closed at $4.10 on \nthe previous day, and the daily price limit is 25¢/bu, corn cannot trade above $4.35 or below \n$3.85. \nsome markets employ formulas for increasing the daily limit after a specified number of \nconsecutive limit days.\nin cases in which free market forces would normally seek an equilibrium price outside the \nrange boundaries implied by the limit, the market will simply move to the limit and virtually \ncease to trade. For example, if after the market close the U.\ns. Department of agriculture (UsDa) \nreleases a very bullish corn crop production estimate, which hypothetically would result in an \nimmediate 30¢/bu price rise in an unrestricted market, prices will be locked limit up (25¢/bu) the \nnext day. This means that the market will open and stay at the limit, with virtually no trading tak-\ning place. The reason for the absence of trading activity is that the limit rule restriction maintains \nan artificially low price, leading to a deluge of buy orders at that price but few if any sell orders.\nin the case of a very severe surprise event (e.g., sudden major crop damage), a market \ncould move several limits in succession, although such moves are less common than in the days \nbefore near-24-hour electronic trading. \nin such situations, traders on the wrong side of the \nfence might not be able to liquidate their positions until the market trades freely. The new trader \nshould be aware of, but not be overly frightened by, this possibility, since such events of extreme \nvolatility rarely come as a complete surprise. \nin most cases, markets vulnerable to such volatile \nprice action can be identified. some examples of such markets would include commodities in \nwhich the UsDa is scheduled to release a major report, coffee or frozen concentrated orange \njuice during their respective freeze seasons, and markets that have exhibited recent extreme \ntrading volatility. For some markets, the limit on the nearby contract is removed at some point \ntable 1.2 Contract Month Designations\nMonth ticker Designation\nJanuary F\nFebruary g\nMarch H\napril J\nMay K\nJune M\nJuly n\naugust Q\nseptember U\nOctober V\nnovember X\nDecember Z\n9FOr Beginners Only\napproaching expiration (frequently first notice day—see item 10). Daily price limits can change \nfrequently, so traders should consult the exchange on which their products trade to ensure they \nare aware of current thresholds.\n 9. Settlement type. Markets are designated either as physically deliverable or cash settled. in \nTable 1.1, the e-mini s&P 500 futures are cash settled, while all the other markets can be physi-\ncally delivered.\n 10. First notice day. This is the first day on which a long can receive a delivery notice. First notice \nday presents no problem for shorts, since they are not obligated to issue a notice until after the \nlast trading day. Furthermore, in some markets, first notice day occurs after last trading day, \npresenting no problem to the long either, since all remaining longs at that point presumably \nwish to take delivery. However, in markets in which first notice day precedes last trading day, \nlongs who do not wish to take delivery should be sure to offset their positions in time to avoid \nreceiving a delivery notice. (Brokerage firms routinely supply their clients with a list of these \nimportant dates.) \nalthough longs can pass on an undesired delivery notice by liquidating their \nposition, this transaction will incur extra transaction costs and should be avoided. Last notice \nday is the final day a long can receive a delivery notice.\n 11. last trading day. This is the last day on which positions can be offset before delivery becomes \nobligatory for shorts and the acceptance of delivery obligatory for longs. as indicated previously, \nthe vast majority of traders will liquidate their positions before this day.\n 12. Deliverable grade. This is the specific quality and type of the underlying commodity or finan-\ncial instrument that is acceptable for delivery.\n ■ Volume and Open Interest\nV olume is the total number of contracts traded on a given day. V olume figures are available for each \ntraded month in a market, but most traders focus on the total volume of all traded months.\nOpen interest is the total number of outstanding long contracts, or equivalently, the total number \nof outstanding short contracts—in futures, the two are always the same. When a new contract begins \ntrading (typically about 12 to 18 months before its expiration date), its open interest is equal to zero. \nif a buy order and sell order are matched, then the open interest increases to 1. Basically, open interest \nincreases when a new buyer purchases from a new seller and decreases when an existing long sells to \nan existing short. The open interest will remain unchanged if a new buyer purchases from an existing \nlong or a new seller sells to an existing short.\nV olume and open interest are very useful as indicators of a market’s liquidity. \nnot all listed futures mar-\nkets are actively traded. some are virtually dormant, while others are borderline cases in terms of trading \nactivity. illiquid markets should be avoided, because the lack of an adequate order flow will mean that the \ntrader will often have to accept very poor trade execution prices if he wants to get in or out o", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 5}
{"text": "t are very useful as indicators of a market’s liquidity. \nnot all listed futures mar-\nkets are actively traded. some are virtually dormant, while others are borderline cases in terms of trading \nactivity. illiquid markets should be avoided, because the lack of an adequate order flow will mean that the \ntrader will often have to accept very poor trade execution prices if he wants to get in or out of a position.\ngenerally speaking, markets with open interest levels below 5,000 contracts, or average daily \nvolume levels below 1,000 contracts, should be avoided, or at least approached very cautiously. \nnew markets will usually exhibit volume and open interest figures below these levels during their \n10a COMPleTe gUiDe TO THe FUTUres MarKeT\ninitial months (and sometimes even years) of trading. By monitoring the volume and open interest \nfi gures, a trader can determine when the market’s level of liquidity is suffi cient to warrant participa-\ntion. Figure 1.1 shows February 2016 gold (top) and april 2016 gold (bottom) prices, along with \ntheir respective daily volume fi gures. February gold’s volume is negligible until november 2015, \nat which point it increases rapidly into December and maintains a high level through January (the \nFebruary contract expires in late February). Meanwhile, april gold’s volume is minimal until Janu-\nary, at which point it increases steadily and becomes the more actively traded contract in the last \ntwo days of January—even though the February gold contract is still a month from expiration at \nthat point. \n The breakdown of volume and open interest fi gures by contract month can be very useful in \ndetermining whether a specifi c month is suffi ciently liquid. For example, a trader who prefers to \ninitiate a long position in a nine-month forward futures contract rather than in more nearby con-\ntracts because of an assessment that it is relatively underpriced may be concerned whether its level \nof trading activity is suffi cient to avoid liquidity problems. in this case, the breakdown of volume and \nopen interest fi gures by contract month can help the trader decide whether it is reasonable to enter \nthe position in the more forward contract or whether it is better to restrict trading to the nearby \ncontracts. \n Traders with short-term time horizons (e.g., intraday to a few days) should limit trading to the \nmost liquid contract, which is usually the nearby contract month. \n FIGURE  1.1 V olume shift in gold Futures\nChart created using Tradestation. ©Tradestation T echnologies, inc. all rights reserved. \n\n11FOr Beginners Only\n ■ Hedging\na sell hedge is the sale of a futures contract as a temporary substitute for an anticipated future sale \nof the cash commodity.1 similarly, a buy hedge is a temporary substitute for an anticipated forward \npurchase of the cash commodity. in essence, the goal of the hedger is to lock in an approximate future \nprice in order to eliminate exposure to interim price fluctuations. The concept of hedging is perhaps \nbest explained through illustration. let’s look at several examples of hedging.\nhedging examples for a Commodity\nCotton Producer Sell Hedge The date is april 1. a cotton farmer estimates his potential \nproduction at approximately 200,000 lbs, assuming average yields. The current cash price is 95¢/\nlb—an extremely attractive price, but one the producer cannot take advantage of, since his crop will \nnot be harvested until \nnovember. December futures are trading at 85¢/lb, reflecting market expecta-\ntions for an interim price decline. The producer believes the December price may actually be overly \noptimistic. He expects that a large increase in U.\ns. production, in response to high prices, will result \nin a major price collapse by the time the new crop is harvested. given his bearish expectations, the \nproducer is eager to lock in a price on his anticipated production.\nHistorical comparisons indicate the november–December cash prices in the producer’s region \ntend to average approximately 2–4¢ below the December futures price. (The difference between cash \nand futures is called the basis. \nin this case, the november–December basis is said to be “2–4¢ under.”) \nThus, by selling December futures at the current price of 85¢/lb, the farmer can lock in an approxi-\nmate cash price of 81–83¢. Because the producer believes prices will be significantly below 80¢/lb by \nharvest time, he decides to sell three December futures contracts against the expected post-harvest \nsale of his crop. This is called a sell hedge.\nnote that three contracts represent 150,000 lbs of cotton, an amount equivalent to three-quarters \nof the producer’s anticipated crop. The farmer does not hedge his entire crop, because his eventual \noutput is still open to considerable uncertainty. \nif weather conditions are extremely poor, his yields \ncould be reduced by more than 25 percent. Consequently, to avoid the possibility of overhedging his \ncrop, an action that would leave him with a net short position, he prudently decides to sell only three \ncontracts.\nTable 1.3 illustrates two hypothetical outcomes of this hedge. \nin case 1, the producer is entirely \ncorrect in his expectations, and cash prices decline to 72¢/lb by December 1. in line with the normal \nhistorical basis relationship, December futures are simultaneously trading at 75¢/lb. The producer \nsells his cash crop at 72¢/lb, but also realizes a profit of 10¢/lb on his futures position. Thus, on the \n150,000 lbs of crop that he has hedged, his effective price is 82¢/lb. (Commissions have not been \nincluded in this or the following illustrations in order to keep exposition as simple as possible. The \nadjustment for commissions would not meaningfully alter the results.) \nas a result of hedging, the \n1 The sell hedge may also be used as a proxy for temporary inventory reduction (see example of stock portfolio \nmanager later in this section).\n12\nA Complete Guide to the Futures mArket\ntable 1.3 Cotton Producer Sell h", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 6}
{"text": "e following illustrations in order to keep exposition as simple as possible. The \nadjustment for commissions would not meaningfully alter the results.) \nas a result of hedging, the \n1 The sell hedge may also be used as a proxy for temporary inventory reduction (see example of stock portfolio \nmanager later in this section).\n12\nA Complete Guide to the Futures mArket\ntable 1.3 Cotton Producer Sell hedge\nCase 1: Severely W eakening Cash Price Case 2: relatively Firm Cash Price\napr. 1 Dec. 1 apr. 1 Dec. 1\nCash price 95¢ 72¢ Cash price 95¢ 92¢\nFutures price 85¢ 75¢ Futures price 85¢ 95¢\nresults: results:\nCash sale price: 72¢ Cash sale price: 92¢\nProfit on futures: 10¢ loss on futures: 10¢\neffective sale price: 82¢ effective sale price: 82¢\nfarmer has locked in a much better price than he would have realized had he waited until his crop \nwas harvested before taking any marketing action. in dollar terms, the producer’s income is $15,000 \nhigher than it would have been without the hedge:\n31 05 00 00 15 000×× =¢/lb lbs,$ ,\na hedge will not always be profitable. in the situation illustrated by case 2, Table 1.3, the producer’s \nprojections proved wrong as cash prices remained firm, declining a mere 3¢/lb from their lofty april \n1 levels. in this case, the farmer is able to sell his crop at a much better than expected 92¢/lb, but he \nexperiences a loss of 10¢/lb on his futures position. His effective sales price is once again 82¢/lb. Of \ncourse, in this instance, with the benefit of hindsight, the producer would have been much better off \nhad he had not hedged. \nnonetheless, note that even though he has sacrificed the opportunity for a \nwindfall profit by hedging, he still realizes his target sales price of 82¢/lb.\nThe value of hedging is that it provides the producer with a much wider range of marketing strate-\ngies. remember, if he prefers to take his chances and wait until after the harvest to market his crop, \nhe can do so. Futures widen the range of possibilities by allowing the producer to lock in any futures-\nimplied price during the interim. Thus, although he will not always make the right choice, presumably, \nover the long run, the increased marketing flexibility provided by futures should prove advantageous.\nCotton Mill Buy Hedge The date is June 1. a cotton mill has forward contracted to supply a \nfabric order for the following March. T o meet this production order, the mill will need 1 million lbs \nof cotton on hand by December.\nThe current cash price is 77¢/lb, and December futures are trading at 80¢/lb. \nassuming the same \n−3¢/lb basis established in the aforementioned cotton producer example, the December futures \nprice quote implies cash prices will be unchanged in December relative to their current levels.\nalthough the mill has plenty of time to purchase the actual cotton, it is concerned that cash prices \nwill rise significantly in the coming months. since the end-product sales price has already been nego-\ntiated, the company must lock in its input price in order to guarantee a satisfactory profit margin. \ngiven this scenario, the mill has two choices:\n 1. i ncrease its inventory sufficiently to cover its anticipated December–March requirements.\n 2. Hedge its forward requirements by buying December cotton futures.\n13FOr Beginners Only\ngiven the price structure in this example, the mill will be much better off buying futures. Why? \nBecause the purchase of futures covers the forward commitment without incurring any storage costs. \n(This is true since the December futures price implies an unchanged cash price relative to current \nlevels.) \nin contrast, the purchase of actual cotton would incur storage-related costs for the six-month \nperiod. The most important of these expenses would be borrowing costs, or lost interest, if the firm \nwas using its own funds.\nTable 1.4 illustrates two alternative outcomes for this hedge. \nin both cases, it is assumed the \nfirm purchases the actual cotton on December 1, simultaneously offsetting its long hedge position in \nfutures. \nin the first situation, cash prices increase between June and December, and the actual cash \nmarket purchase price on December 1 is 87¢/lb. However, as a result of a 10¢/lb profit on the futures \nhedge, the effective price to the firm is 77¢ (the cash price on June 1). \nin the second illustration, cash \nprices decline, and the firm’s actual purchase price is 67¢/lb. However, as a result of a 10¢/lb loss in \nfutures, the effective price is once again 77¢/lb. \nalthough in this case the mill would have been better \noff not hedging, it is still purchasing the cotton at the previously desired locked-in price.\nsince most companies will be more concerned about locking in adequate profit margins than \nabout giving up windfall profits, hedging should provide a useful tool for business management. \nFurthermore, it should be emphasized that the firm always has the option not to hedge if, for any \nreason, the price implied by futures is not considered attractive. \nin short, users of commodities who \nincorporate hedging should have an advantage over their competitors, because they have a much \nwider range of purchasing strategies.\nhedging in Financial Futures\nThe previous examples illustrate the buy-and-sell hedge for a commodity. The same basic principles \napply to the financial markets, as shown by the following examples.\na corporation expecting the need for a loan in six months and concerned about rising borrowing \ncosts in the interim could lock in an approximate fixed rate by selling short-term interest rate futures \n(e.g., eurodollars). (\nan increase in interest rates will cause the price of interest rate instruments to \ndecline.)\ntable 1.4 Cotton Mill buy hedge\nCase 1: rising Cash Price Case 2: Declining Cash Price\nJune 1 Dec. 1 June 1 Dec. 1\nCash price 77¢ 87¢ Cash price 77¢ 67¢\nFutures price 80¢ 90¢ Futures price 80¢ 70¢\nresults: results:\nCash purchase price: 87¢ Cash purchase price: 67¢\nProfit on futures: 10¢ loss on futures:", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 7}
{"text": "an increase in interest rates will cause the price of interest rate instruments to \ndecline.)\ntable 1.4 Cotton Mill buy hedge\nCase 1: rising Cash Price Case 2: Declining Cash Price\nJune 1 Dec. 1 June 1 Dec. 1\nCash price 77¢ 87¢ Cash price 77¢ 67¢\nFutures price 80¢ 90¢ Futures price 80¢ 70¢\nresults: results:\nCash purchase price: 87¢ Cash purchase price: 67¢\nProfit on futures: 10¢ loss on futures: 10¢\neffective purchase price: 77¢ effective purchase price: 77¢\n14\nA Complete Guide to the Futures mArket\na bond fund manager anticipating a cash influx in three months and an imminent decline in interest \nrates could lock in a rate of return by going long T -note futures.\na stock portfolio manager concerned about the possibility of a sharp, temporary break in stock \nprices could reduce market exposure by selling stock index futures (e-mini s&P 500, e-mini nasdaq \n100, russell 2000 index Mini). such action would be far more cost effective (i.e., would incur much \nlower commission costs) than liquidating part or all of his portfolio and reinstating the position at a \nlater date.\na U.s. company that knew it would require 10 million euros in three months to pay for an import \ntransaction could lock in the exchange rate by purchasing euro futures.\nGeneral Observations regarding hedging\n 1. i n all the preceding examples, the hedger offsets either an anticipated future transaction in the \nactual market or a current position with an equal but opposite transaction in futures. Thus, for \nthe hedger, participation in futures can reduce risks associated with price changes. \nin effect, the \ntrue speculators among producers and users of commodities (or the financial markets) are those \nwho do not hedge. For example, the farmer who does not hedge is speculating on the direction \nof prices during the interim before his crop is harvested.\n 2. s ome written discussions of hedging almost seem to imply that producers and users of \nexchange-traded commodities should automatically hedge. This is ridiculous—hedging should \nbe considered only if the futures-implied price is desirable. Otherwise, one is merely exchang-\ning the futures-implied price for the subsequent actual cash price. Over the long run, this type \nof hedging should be a break-even process in terms of trades and a net loss generator because of \ncommissions.\n 3. Hedging should be viewed as an important marketing tool, because it provides the producer \nand user with a wide range of purchase and sale strategies. Hedgers can always choose not \nto hedge, but nonhedgers eliminate the possibility of enhancing their profits through futures-\nrelated opportunities.\n 4. The hedger need not wait until the time of the actual transaction to lift the hedge. For example, \nreconsider the case of the cotton producer who sells December futures at 85¢/lb. \nif by October, \nfutures have declined to 70¢/lb, the hedger might very well decide to cover his short hedge \nposition. \nalthough at a price of 85¢/lb the farmer was eager to protect against the possibility \nof declining prices, at a price of 70¢/lb he might well prefer to take his chances. if prices were \nsubsequently to rally, the producer might decide to reinstate his hedge. in fact, sophisticated \nhedgers will often use such a trading approach in hedging. The key point is that, contrary to \nmost textbook illustrations, a hedge should be maintained only as long as the implied price \nprotection is deemed desirable.\n 5. i t is important to keep the time differential and expectations in mind when comparing a current \ncash price with the cash price implied by futures. For example, in the hedge illustrated in case \n1, Table 1.3, the futures-implied cash price is 13¢/lb below the current cash price. \nyet, despite \n15FOr Beginners Only\nthis wide discount, the hedge is still very profitable because the price differential is ultimately \nfar outweighed by the intervening price decline. Thus, the relevant question is not whether the \nfutures-implied cash price is attractive relative to the current cash price, but rather whether it is \nattractive relative to the expected future cash price.\n 6. The hedger does not precisely lock in a transaction price. His effective price will depend on \nthe basis. For example, if the cotton producer sells futures at 85¢/lb, assuming a −3¢ basis, his \neffective sales price will be 80¢/lb, rather than the anticipated 82¢/lb, if the actual basis at the \ntime of offset is −5¢. However, it should be emphasized that this basis-price uncertainty is far \nsmaller than the outright price uncertainty in an unhedged position. Furthermore, by using \nreasonably conservative basis assumptions the hedger can increase the likelihood of achieving, \nor bettering, the assumed locked-in price.\n 7. a lthough a hedger plans to buy or sell the actual commodity, it will usually be far more efficient \nto offset the futures position and use the local cash market for the actual transaction. Futures \nshould be viewed as a pricing tool, not as a vehicle for making or taking delivery.\n 8. Most standard discussions of hedging make no mention whatsoever of price forecasting. \nThis omission seems to imply that hedgers need not be concerned about the direction of \nprices. \nalthough this conclusion may be valid for some hedgers (e.g., a middleman seek-\ning to lock in a profit margin between the purchase and sales price), it is erroneous for \nmost hedgers. There is little sense in following an automatic hedging program. \nrather, \nthe hedger should evaluate the relative attractiveness of the price protection offered by \nfutures. Price forecasting would be a key element in making such an evaluation. \nin this \nrespect, it can easily be argued that price forecasting is as important to many hedgers as it \nis to speculators.\n ■ Trading\nThe trader seeks to profit by anticipating price changes. For example, if the price of December gold \nis $1,150/oz, a trader who expects the price to rise above $1,250/oz will go long. The trader has \nno i", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 8}
{"text": "asting would be a key element in making such an evaluation. \nin this \nrespect, it can easily be argued that price forecasting is as important to many hedgers as it \nis to speculators.\n ■ Trading\nThe trader seeks to profit by anticipating price changes. For example, if the price of December gold \nis $1,150/oz, a trader who expects the price to rise above $1,250/oz will go long. The trader has \nno intention of actually taking delivery of the gold in December. \nright or wrong, the trader will \noffset the position sometime before expiration. For example, if the price rises to $1,275 and the \ntrader decides to take profits, the gain on the trade will be $12,500 per contract (100 oz × $125/\noz). \nif, on the other hand, the trader’s forecast is wrong and prices decline to $1,075/oz, with the \nexpiration date drawing near, the trader has little choice but to liquidate. in this situation, the loss \nwould be equal to $7,500 per contract. note that the trader would not take delivery even given \na desire to maintain the long gold position. in this case, the trader would liquidate the December \ncontract and simultaneously go long in a more forward contract. (This type of transaction is called \na rollover and would be implemented with a spread order—defined in the next section.) Traders \nshould avoid taking delivery, since it can often result in substantial extra costs without any com-\npensating benefits.\n16\nA Complete Guide to the Futures mArket\nnovice traders should caution against the securities-based bias of trading only from the long side. \nin futures trading, there is no distinction between going short and going long. 2 since prices can go \ndown as well as up, the trader who takes only long positions will eliminate approximately half the \npotential trading opportunities. also, it should be noted that futures frequently command a premium \nto current prices; consequently, the inflation argument for a long-side bias is frequently erroneous.\nThe successful trader must employ some method for forecasting prices. The two basic analytical \napproaches are:\n 1. technical analysis. The technical analyst bases projections on non-economic data. Price data \nare by far the most important—and often only—input in technical analysis. The basic assump-\ntion of technical analysis is that prices exhibit repetitive patterns and that the recognition of \nthese patterns can be used to identify trading opportunities. T echnical analysis can also include \nother data, such as volume, open interest, and sentiment measures.\n 2. Fundamental analysis. The fundamental analyst uses economic data (e.g., production, \nconsumption, exports) to forecast prices. \nin essence, the fundamentalist seeks to uncover trad-\ning opportunities by identifying potential transitions to significantly more ample or tighter \nsupply-demand balances.\nas discussed in Chapter 2, technical and fundamental analysis are not mutually exclusive \napproaches. Many traders use both in the decision-making process or as components of automated \ntrading systems.\n ■ Types of Orders\nDay versus Good till Canceled (GtC)\nUnless specified otherwise, orders are assumed to be good only for the day of entry. if the trader wants \nthe order to remain open until canceled, he must specify that it is a good-till-canceled (gTC) order.\nMarket\nThis instruction directs the broker to execute the order upon receipt at the prevailing price level. \nMarket orders are used when the trader is more concerned with initiating or liquidating a position \nimmediately than with trying to achieve a specific execution price. Market orders ensure the trade \nwill be executed unless prices are locked in at the daily limit or the order is entered too close to the \nend of the trading session.\n2 some beginners are confused about how it is possible for a trader to sell a commodity he does not own. The \nkey to the answer lies in the fact that the trader is selling a futures contract, not the cash commodity. even though \nthe trader who stays short past the last trading day must acquire the actual commodity to fulfill his contractual \nobligation, there is no need for him to own the commodity before that time. The short sale is simply a bet that \nprices will go down before the last trading day. \nright or wrong, the trader will offset his short position before \nthe last trading day, eliminating any need for actual ownership of the commodity.\n17FOr Beginners Only\nlimit\nThe limit order, also called an or-better order, is used when the trader wants to ensure that the execu-\ntion price will be no worse than a certain level. For example, an order to buy December gold at a \n$1,150/ounce limit can only be executed at a price equal to or below $1,150.\nif the market is trading higher than that level when the brokerage receives the order, it must wait \nfor the price to decline to $1,150 before it can execute the trade. if the price fails to return to that \nlevel, the brokerage is unable to fill the order. similarly, an order to sell December gold at a $1,190/\nounce limit would indicate that the order can only be filled at a price equal to or above $1,190. limit \norders will normally provide better fills than will market orders, but the trade-off is that they may not \nbe executed. \na trader whose primary concern is to get the order filled, particularly if it is an order to \nliquidate a losing position, should not use a limit order.\nStop\na stop order is not executed until the market reaches the given price level. The indicated price on \na buy stop must always be above the market, while the indicated price on a sell stop must always be \nbelow the market.\nin effect, a stop order will always be filled at a price worse than the market price. Why then would \na trader use a stop order? There are two very important reasons: First, stop orders are used to limit \nlosses or protect open profits. For example, a trader who buys March sugar at 14.50¢/lb might place \nan order to sell March sugar at 13.50¢/lb stop, \ngTC. if the market s", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 9}
{"text": "ys be \nbelow the market.\nin effect, a stop order will always be filled at a price worse than the market price. Why then would \na trader use a stop order? There are two very important reasons: First, stop orders are used to limit \nlosses or protect open profits. For example, a trader who buys March sugar at 14.50¢/lb might place \nan order to sell March sugar at 13.50¢/lb stop, \ngTC. if the market subsequently declines to 13.50¢/lb \nor lower, the stop order becomes a market order. in this way, the trader limits his risk on the trade to \napproximately 100 points. The reason for the word approximately is that markets often move beyond \nthe stop price before the order can be executed. \nin the case of a short position, the protective stop order \nwould be placed at a higher price. For example, if the trader went short March sugar at 14.50¢/lb, an \norder might be placed to buy March sugar at 15.50¢/lb stop, \ngTC.\nsecond, a stop order may be used if a trader views the market’s ability to reach a certain level as a \nprice signal. For example, if March sugar has been trading between 12.00¢ and 15.00¢/lb for several \nmonths, a trader might believe that the ability of the market to significantly penetrate the high of this \nrange would be a sign of strength, suggesting a potential bull move. \nin this case, the trader might enter \nan order to buy March sugar at 15.50¢/lb stop. Thus, even though March sugar can be purchased \nmore cheaply at the current price, the trader prefers to use the stop order because he only wants to \nbe long if the market is able to demonstrate a specified degree of strength.\nStop-limit\na stop-limit order is a stop order in which the actual execution price is limited. For example, an \norder to “buy March 10-year T -notes at 124'16 stop, 124'24 limit, gTC” means that if March 10-year \nT -note futures advance to 124'16, the buy order is activated but cannot be executed at a price above \n124'24. \nsimilarly, an order to “sell March T -notes at 122 stop, 121'22 limit, gTC” is a sell stop that is \nactivated if the market declines to 122, but which cannot be filled at a price below 121'22. The stop \nand limit portions of the order need not necessarily be at different prices.\n18\nA Complete Guide to the Futures mArket\nStop Close-Only\na stop close-only is a stop order that is activated only if any portion of the closing price range is \nbeyond the indicated price. (This type of order is not accepted on all exchanges.)\nMarket If touched\na market-if-touched (M iT) order is similar to a limit order except that it becomes a market order \nanytime the limit price is reached. For example, given the following sequence of prices—79.40, \n79.35, 79.25, 79.20, 79.25, 79.30, 79.40, 79.50 . . .—a 79.20 M iT buy order would become a \nmarket order once 79.20 was reached, but a 79.20 limit order could be filled only at a price of \n79.20 or better. \nin this illustration, the market decline to 79.20 is so fleeting that the limit order \nmight very well not be filled, while the M iT order would be executed (probably at some price \nabove 79.20). The MiT is a hairsplitting type of order that is largely superfluous. Over the long run, \na trader will achieve equivalent results by using slightly higher buy limits (lower sell limits) instead \nof M\niT orders.\nFill or Kill\nas the name implies, a fill-or-kill (FOK) order is a limit order that must be filled immediately or \ncanceled.\nScale\na scale order is used for multicontract positions in which the trader wants to enter different contracts \nat different prices. For example, if June British pound futures are trading at 153.00, a trader who \nwants to sell 10 contracts on a possible rally to the 155.00–157.00 zone might enter a scale order to \nsell 10 June British pound contracts, one at 155.20 limit and one contract every 0.20 points higher, \nwith the last contract having a limit price of 157.00.\nOne Cancels Other\nThe one-cancels-other (OCO) order is a two-sided order in which the execution of one side cancels \nthe other. For example, a trader who is long February live cattle at 117.00, with an objective of \n125.00 and a stop point at 109.00, might enter the following order: sell 1 February cattle 125.00 \nlimit/109.00 stop, OCO, \ngTC.\nContingent\nin this type of order the execution instruction for one contract is contingent on another contract. an \nexample would be: sell October sugar at the market if March sugar trades at 13.00 or lower. (This \ntype of order is not accepted on all exchanges.)\n19FOr Beginners Only\nSpread\na spread involves the simultaneous purchase of one futures contract against the sale of another futures \ncontract, either in the same market or in a related market. in essence, a spread trader is primarily \nconcerned with the difference between prices rather than the direction of price. an example of a spread \ntrade would be: Buy 1 July cotton/sell 1 December cotton, July 200 points premium December. \nThis order would be executed if July could be bought at a price 200 points or less above the level at \nwhich December is sold. \nsuch an order would be placed if the trader expected July cotton to widen \nits premium relative to December cotton.\nnot all brokerages will accept all the order types in this section (and may offer others not listed here). \nTraders should consult with their brokerage to determine which types of orders are available to them.\n ■ Commissions and Margins\nin futures trading, commissions are typically charged on a per-contract basis. in most cases, large \ntraders will be able to negotiate a reduced commission rate. although commodity commissions are \nrelatively moderate, commission costs can prove substantial for the active trader—an important rea-\nson why position trading is preferable unless one has developed a very effective short-term trading \nmethod.\nFutures margins are basically good-faith deposits and represent only a small percentage of the con-\ntract value (roughly 5 percent with some significant variability around this level).", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 10}
{"text": "s are \nrelatively moderate, commission costs can prove substantial for the active trader—an important rea-\nson why position trading is preferable unless one has developed a very effective short-term trading \nmethod.\nFutures margins are basically good-faith deposits and represent only a small percentage of the con-\ntract value (roughly 5 percent with some significant variability around this level). Futures exchanges \nwill set minimum margin requirements for each of their contracts, but many brokerage houses will \nfrequently require higher margin deposits. \nsince the initial margin represents only a small portion of \nthe contract value, traders will be required to provide additional margin funds if the market moves \nagainst their positions. These additional margin payments are referred to as maintenance.\nMany traders tend to be overly concerned with the minimum margin rate charged by a broker-\nage house. \nif a trader is adhering to prudent money management principles, the actual margin level \nshould be all but irrelevant. as a general rule, the trader should allocate at least three to five times \nthe minimum margin requirement to each trade. Trading an account anywhere near the full margin \nallowance greatly increases the chances of experiencing a severe loss. Traders who do not maintain at \nleast several multiples of margin requirements in their accounts are clearly overtrading.\n ■ Tax Considerations\n Tax laws change over time, but for the average speculator in the United states, the essential elements \nof the futures contract tax regulations can be summarized in three basic points:\n 1. There is no holding period for futures trades (i.e., all trades are treated equally, regardless of the \nlength of time a position is held, or whether a position is long or short).\n20\nA Complete Guide to the Futures mArket\n 2. s ixty percent of futures trading gains are treated as long-term capital gains, and the remaining \n40 percent are treated as short-term capital gains. since current maximum tax rates on long- \nand short-term capital gains are 20 percent and 50 percent, respectively, this formula suggests \na maximum tax rate of 32 percent on futures trades.\n 3. g ain (loss) in a given year is calculated as the total of realized gain (loss) plus unrealized gain \n(loss) as of December 31.\n21\nChapter 2\nThe Great \nFundamental \nversus T echnical \nAnalysis Debate\nCuriously, however, the broken technician is never apologetic about his method. If anything, he \nis more enthusiastic than ever. If you commit the social error of asking him why he is broke, he \nwill tell you quite ingeniously that he made the all-too-human error of not believing his own \ncharts. T o my great embarrassment, I once choked conspicuously at the dinner table of a chartist \nfriend of mine when he made such a comment. I have since made it a rule never to eat with a \nchartist. It’s bad for digestion.\n—Burton G. Malkiel\nOne evening, while having dinner with a fundamentalist, I accidentally knocked a sharp knife \noff the edge of the table. He watched the knife twirl through the air, as it came to rest with the \npointed end sticking into his shoe. “Why didn’t you move your foot?” I exclaimed. “I was waiting \nfor it to come back up, ” he replied.\n—Ed Seykota (an avowed technician)\nF\nundamental analysis involves the use of economic data (e.g., production, consumption, disposable \nincome) to forecast prices, whereas technical analysis is based primarily (and often solely) on the \nstudy of patterns in the price data itself. Which method is better? This question is the subject of great \n22\nA Complete Guide to the Futures mArket\ndebate. Interestingly, the experts are no less divided on this matter than are novices. In a series of \nbooks in which I interviewed some of the world’s best traders,1 I was struck by the sharply divergent \nviews on this issue.\nJim Rogers was characteristic of one extreme of the spectrum. During the 1970s, Jim Rogers and \nGeorge Soros were the two principals of the Quantum Fund, perhaps the most successful Wall Street \nfund of its day. In 1980, Rogers left the fund to escape managerial responsibilities and devote all his \ntime to managing his own investments—an endeavor at which he again proved spectacularly success-\nful. (The Quantum Fund maintained its excellent performance in the ensuing years under George \nSoros’s directorship.) Over the years, Rogers has been on record with a high percentage of accurate \nmarket forecasts. As but one example, in my 1988 interview with him, Rogers correctly predicted \nboth the massive collapse in the Japanese stock market and the continued multiyear downtrend in \ngold prices. Clearly, Jim Rogers is a man whose opinion merits serious attention.\nWhen I queried Rogers about his opinion on chart reading (the classic method of technical analy-\nsis), he replied: “I haven’t met a rich technician. Excluding, of course, the technicians who sell their \nservices and make a lot of money.” \n That cynical response succinctly summarized Rogers’s views about \ntechnical analysis.\nMarty Schwartz is a trader whose opinion lies at the other extreme. At the time of our interview , \nSchwartz, an independent stock index futures trader, was considering managing outside money. In \nconjunction with this undertaking, he had just had his personal track record audited, and he allowed \nme to view the results. During the prior 10-year period, he had achieved an average return of \n25 percent—monthly! Equally impressive, during this 120-month period, he witnessed only two \nlosing months—minuscule declines of 2 percent and 3 percent. Again, here was an individual whose \nopinion on the market warranted serious respect.\nAlthough I did not mention Rogers’s comments to Schwartz, when I asked Schwartz whether \nhe had made a complete transition from fundamental to technical analysis (Schwartz had started his \nfinancial career as a stock analyst), his response almost sounded like a direct rebuttal to Jim Rogers: \n“Absolutely. I", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 11}
{"text": "cent. Again, here was an individual whose \nopinion on the market warranted serious respect.\nAlthough I did not mention Rogers’s comments to Schwartz, when I asked Schwartz whether \nhe had made a complete transition from fundamental to technical analysis (Schwartz had started his \nfinancial career as a stock analyst), his response almost sounded like a direct rebuttal to Jim Rogers: \n“Absolutely. I always laugh at people who say, ‘I’ve never met a rich technician. ’ I love that! It is such \nan arrogant, nonsensical response. I used fundamentals for nine years and got rich as a technician.”\nThere you have it. Two extraordinarily successful market participants holding polar-opposite \nviews regarding the efficacy of fundamental versus technical analysis. Whom do you believe?\nIn my own assessment, both Rogers’s and Schwartz’s viewpoints contain elements of truth. It is \npossible to succeed as a trader by being a pure fundamentalist, a pure technician, or a hybrid of the \ntwo. The two methods are certainly not mutually exclusive. In fact, many of the world’s most suc-\ncessful traders use fundamental analysis to determine the direction to trade a market and technical \nanalysis to time the entry and exit of such trades.\nOne virtually universal trait I found among successful traders was that they had gravitated to an \napproach that best fit their personality. Some traders prefer very long-term approaches, while others \n1 Market Wizards (Hoboken, NJ: John Wiley & Sons, 2012 [orig. pub. 1989]); The New Market Wizards (Hoboken, \nNJ: John Wiley & Sons, 2008); Stock Market Wizards (New Y ork, NY: HarperBusiness, 2003); and Hedge Fund \n Market Wizards (Hoboken, NJ: John Wiley & Sons, 2012).\n23THE GREAT FuNDAMENTAl vERSuS TECHNICAl ANAlYSIS DEBATE\nare inclined toward day trading; some traders feel comfortable only when following signals gener-\nated by an automated system, while others find such a mechanical method anathema; some traders \nthrive in the near-bedlam atmosphere of a trading room, while others succeed only if their decisions \nare made in the calm of a quiet office; and some traders find fundamental analysis a natural approach, \nwhile others instinctively lean to technical methods, and still others a blend of the two.\nEssentially, then, there is no universal answer to the question, which is better, fundamental analy-\nsis or technical analysis? Quite simply, it depends on the individual, who must determine his or her \nnatural approach.\nThe relative popularity of fundamental analysis versus technical analysis tends to wax and wane in \nbroad cyclical fashion. When I first became a market analyst in the 1970s, fundamental analysis was \nconsidered a solid approach, while technical analysis was regarded by most as some sort of hocus-pocus \nor black magic.\nThe situation changed, however, because the huge price trends that developed during the com-\nmodity inflation period of the 1970s were ideally suited to the trend-following techniques widely \nfavored by technical analysts. Even the simplest trend-following strategies tended to perform \nextremely well during this period, while sophisticated fundamental methodologies often proved to \nbe highly misleading. In this environment, the popularity of technical analysis grew enormously, while \nfundamental analysis declined in favor. This basic trend extended into the 1980s, as technical analysis \nbecame the primary method of choice and fundamental analysis a minority technique. By the end of \nthe 1980s, a significant majority of money managers in the futures industry (known as commodity \ntrading advisors, or CTAs) employed technical analysis exclusively or at least for the bulk of their \ntrading decisions. Thus, whereas at the beginning of the 1970s few market participants would even \nconsider technical analysis, by the late 1980s few would consider fundamental analysis.\nBy this time, however, general market behavior had become increasingly erratic, with fewer sus-\ntained trends and an increasing percentage of false price breakouts (i.e., price moves above or below \ntrading ranges that are followed by price reversals rather than price extensions). Simultaneously, the \nspectacular performance of some technical trend followers deteriorated substantially, or at the very \nleast their results exhibited periodic deep equity retracements. At the same time, it appeared that \nmany of the traders and money managers with the best performance were those who were primar-\nily fundamentally oriented, or at least relied on fundamentals as a significant input in their trading \ndecisions.\nT o summarize, there is no “right” side to the great fundamental versus technical debate: the appro-\npriate method depends on the individual. Moreover, even for individual traders, the perceived answer \nmay change dramatically, or even completely reverse, over the years. Also, combining fundamental \nanalysis with technical analysis can provide a particularly effective approach and is indeed descriptive \nof the general methodology used by some of the world’s most successful traders. The bottom line is \nthat each trader must explore both approaches and select the methodology or blend that feels the \nmost comfortable and appropriate.\nThe relative pros and cons of using fundamental and technical analysis for trading, as well \nas practical considerations about combining the two methods, are examined in greater detail in \nChapter 29.\n\nChart aNalysis aNd \nteChNiCal iNdiCators\nPart II\n\n27\nCha P ter 3\nCharts: Forecasting \ntool or Folklore?\nCommon sense is not so common.\n—V oltaire\nt\nhere is a story about a speculator whose desire to be a winner was intensified by each successive \nfailure. initially he tried basing his trading decisions on fundamental analysis. he constructed \nintricate models that provided price forecasts based on an array of supply/demand statistics. Unfor-\ntunately, his models’ predictions were invariably upset by some unexpected event, such as a drought \nor a surprise export sale", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 12}
{"text": "speculator whose desire to be a winner was intensified by each successive \nfailure. initially he tried basing his trading decisions on fundamental analysis. he constructed \nintricate models that provided price forecasts based on an array of supply/demand statistics. Unfor-\ntunately, his models’ predictions were invariably upset by some unexpected event, such as a drought \nor a surprise export sale.\nUltimately, in exasperation, he gave up on the fundamental approach and turned to chart analysis. \nhe scrutinized price charts, searching for patterns that would reveal the secrets of trading success. \nhe was the first to discover such unusual formations as shark-tooth bottoms and Grand teton tops. \nBut alas, the patterns always seemed reliable until he started basing his trades on them. When he went \nshort, top formations proved to be nothing more than pauses in towering bull markets. \nequally dis-\ntressing, steady uptrends had an uncanny tendency to reverse course abruptly soon after he went long.\n“the problem,” he reasoned, “is that chart analysis is too inexact. What i need is a computerized trad-\ning system.” so he began testing various schemes to see if any would have been profitable as a trading sys-\ntem in the past. after exhaustive research, he found that buying cattle, cocoa, and eurodollars on the first \ntuesday of months with an odd number of days and then liquidating these positions on the third thursday \nof the month would have yielded extremely profitable results during the preceding five years. inexpli-\ncably, this carefully researched pattern failed to hold once he began trading. another stroke of bad luck.\nthe speculator tried many other approaches— elliott waves, Fibonacci numbers, Gann squares, \nthe phases of the moon—but all proved equally unsuccessful. it was at this point that he heard of a \nfamous guru who lived on a remote mountain in the himalayas and who answered the questions of \nall pilgrims who sought him out. the trader boarded a plane to Nepal, hired guides, and set out on a \ntwo-month trek. Finally, completely exhausted, he reached the famous guru.\n28\nA Complete Guide to the Futures mArket\n“oh, Wise one,” he said, “i am a frustrated man. For many years i have sought the key to successful \ntrading, but everything i have tried has failed. What is the secret?”\nthe guru paused for only a moment, and, staring at his visitor intently, answered, “B lash.” he \nsaid no more.\n“Blash?” the trader did not understand the answer. it filled his mind every waking moment, but \nhe could not fathom its meaning. he repeated the story to many, until finally one listener interpreted \nthe guru’s response.\n“it’s quite simple,” he said. “Buy low and sell high.”\nthe guru’s message is apt to be disappointing to readers seeking the profound key to trading wis-\ndom. Blash does not satisfy our concept of an insight because it appears to be a matter of common \nsense. however, if, as V oltaire suggested, “Common sense is not so common,” neither is it obvious. \nFor example, consider the following question: What are the trading implications of a market reaching \nnew highs? the “common-sense” Blash theory would unambiguously indicate that subsequent trad-\ning activity should be confined to the short side.\nV ery likely, a large percentage of speculators would be comfortable with this interpretation. Per-\nhaps the appeal of the B lash approach is tied to the desire of most traders to demonstrate their \nbrilliance. after all, any fool can buy the market after a long uptrend, but it takes genius to fade the \ntrend and pick a top. in any case, few trading responses are as instinctive as the bias toward buying \nwhen prices are low and selling when prices are high.\nas a result, many speculators have a strong predilection toward favoring the short side when \na market trades in new high ground. there is only one thing wrong with this approach: it doesn’t \nwork. a plausible explanation is readily available. a market’s ability to reach and sustain new highs is \nusually evidence of powerful underlying forces that often push prices much higher. Common sense? \nCertainly. But note that the trading implications are exactly opposite to those of the “common-sense” \nB\nlash approach.\nthe key point of all of this is that many of our common-sense instincts about market behavior are \nwrong. Chart analysis provides a means of acquiring common sense in trading—a goal far more elu-\nsive than it sounds. For example, if prior to beginning trading an individual exhaustively researched \nhistorical price charts to determine the consequences of a market’s reaching new highs, he would \nhave a strong advantage in avoiding one of the common pitfalls that await the novice trader. \nsimilarly, \nother market truths can be gleaned through a careful study of historical price patterns.\nit must be acknowledged, however, that the usefulness of charts as an indicator of future price \ndirection is a fiercely contested subject. rather than list the pros and cons of this argument, we \nfound an episode of a financial markets tV series that was very popular in the 1980s and 1990s, \nwhich succinctly highlighted some of the key issues in this debate. the transcript from this program \nis presented:\nModerator: hello, i’m louis Puneyser of Wallet Street Week. tonight we will depart from our \nnormal interview format to provide a forum for a debate on the usefulness of commodity \nprice charts. Can all those wiggly lines and patterns really predict the future? \nor is shake-\nspeare’s description of life also appropriate to chart analysis: “. . . a tale told by an idiot, full of \n29\nCharts: ForeCasting tool or Folklore?\nsound and fury, signifying nothing”? our guests tonight are Faith N. trend, a renowned techni-\ncal analyst with the Wall street firm of Churnum & Burnum, and Phillip a. Coin, a professor \nat ivory tower University and the author of The Only Way to Beat the Market—Become a Broker. \nMr. Coin, you belong to a group called the random Walkers.", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 13}
{"text": "an idiot, full of \n29\nCharts: ForeCasting tool or Folklore?\nsound and fury, signifying nothing”? our guests tonight are Faith N. trend, a renowned techni-\ncal analyst with the Wall street firm of Churnum & Burnum, and Phillip a. Coin, a professor \nat ivory tower University and the author of The Only Way to Beat the Market—Become a Broker. \nMr. Coin, you belong to a group called the random Walkers. is that some sort of hiking club \nthat decides its destinations by throwing darts at a trail map? (He smiles smugly into the camera.)\nProFessor CoiN: W ell, no, Mr. Puneyser. the random Walkers are a group of economists who \nbelieve that market price movements are random. that is, one can no more devise a system \nto predict market prices than one can devise a system to predict the sequence of colors that \nwill turn up on a roulette wheel. Both events are strictly a matter of chance. Prices have no \nmemory, and what happened yesterday has nothing to do with what will happen tomorrow . \nin other words, charts can only tell you what has happened in the past; they are useless in \npredicting the future.\nMs. treNd: Professor, you overlook a very important fact: daily prices are not drawn out of a bowl, \nbut rather are the consequence of the collective activity of all market participants. human be-\nhavior may not be as predictable as the motion of planets as governed by the laws of physics, but \nneither is it totally random. \nif this is not the case, your profession—economics—is doomed to \nthe same fate as alchemy. (Professor Coin squirms uncomfortably in his seat upon this reference.) Charts \nreveal basic behavioral patterns. \ninsofar as similar interactions between buyers and sellers will \nresult in similar price patterns, the past can indeed be used as a guideline for the future.\nProFessor CoiN: if past prices can be used to predict future prices, why have a myriad of \nacademic studies concluded that tested technical rules failed to outperform a simple buy-\nand-hold policy once commissions were taken into account?\nM\ns. treNd: the rules used in those studies are generally oversimplified. the studies demonstrate \nthat those particular rules don’t work. they don’t prove that a richer synthesis of price infor-\nmation, such as chart analysis, or a more complex technical system, cannot be successfully \nexploited for making trading decisions.\nP\nroFessor CoiN: Why then are there no studies that conclusively demonstrate the viability of \nchart analysis as a forecasting tool?\nMs. treNd: your argument merely reflects the difficulties of quantifying chart theories rather \nthan the deficiencies of the chartist approach. one man’s top formation is another man’s \ncongestion area. an attempt to define anything but the simplest chart pattern mathematically \nwill be unavoidably arbitrary. the problems become even more tangled when one realizes \nthat at any given time, the chart picture may exhibit conflicting patterns. thus, in a sense, it \nis not really possible to test many chart theories objectively.\nProFessor CoiN: that’s rather convenient for you, isn’t it? if these theories can’t be rigorously \ntested, of what use are they? how do you know that trading on charts will lead to better than \na 50/50 success rate—that is, before commissions?\n30\nA Complete Guide to the Futures mArket\nMs. treNd: if you mean that blindly following every chart signal will only make your broker \nrich, i don’t disagree. however, my point is that chart analysis is an art, not a science. a \nfamiliarity with basic chart theories is only the starting point. the true usefulness of charts \ndepends on the individual trader’s ability to synthesize successfully his own experience with \nstandard concepts. in the right hands, charts can be extremely valuable in anticipating ma-\njor market trends. there are many successful traders who base their decisions primarily on \ncharts. What would you attribute their success to—a lucky streak?\nProFessor CoiN: yes. exactly that, a lucky streak. if there are enough traders, some of them \nwill be winners, whether they reach their decisions by reading charts or throwing darts at \nthe commodity price page. \nit’s not the method, just the laws of probability. even in a casino, \nsome percentage of the people are winners. you wouldn’t say that their success is due to any \ninsights or system.\nMs. treNd: all that proves is that superior performance by some chartists could be due to chance. it \ndoesn’t disprove the contention that the skillful chartist is onto something that gives him an edge.\nModerator: i sense a lot of resistance here, and i think we could use some more support. have \neither of you brought any evidence along that would tend to substantiate your positions?\nProFessor CoiN: yes! (At this point, Professor Coin pulls a thick manuscript from his briefcase and \nthrusts it into Mr. Puneyser’s hands. The moderator flips through the pages and shakes his head as he \nnotices a profusion of funny little Greek letters.)\nM\noderator: i had something a little less mathematical in mind. even educational tV is not \nready for this.\nProFessor CoiN: W ell, i also have this. (He pulls out a sheet of paper and hands it to Ms. T rend.) \nhow would you interpret this chart, Ms. trend? (He unsuccessfully attempts to suppress a smirk.)\nMs. treNd: i’ d say this looks like a chart based on a series of coin tosses. you know , heads one \nbox up, tails one box down.\nProFessor CoiN: (Whose smirk has turned into a very visible frown.) how did you know that?\nMs. treNd: lucky guess.\nProFessor CoiN: W ell, anyway, that doesn’t affect my argument. look at this chart. here’s a \ntrend. and this here—isn’t that what you people call a head-and-shoulders formation?\nModerator: speaking of head and shoulders, do either of you have an opinion on Procter & \nGamble?\nProFessor CoiN: (Continuing.) the same chart patterns you are so quick to point to on your \nprice charts also show up in obviously random series.\nMs. treNd: yes, but that line of reasoning", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 14}
{"text": "ook at this chart. here’s a \ntrend. and this here—isn’t that what you people call a head-and-shoulders formation?\nModerator: speaking of head and shoulders, do either of you have an opinion on Procter & \nGamble?\nProFessor CoiN: (Continuing.) the same chart patterns you are so quick to point to on your \nprice charts also show up in obviously random series.\nMs. treNd: yes, but that line of reasoning can lead to some odd conclusions. For instance, would \nyou agree that the fact that working economists tend to have advanced degrees is not a chance \noccurrence?\n31Charts: ForeCastiNG tool or FolKlore?\n ProFessor CoiN: of course. \n Ms. treNd: W ell then, a random sample of the population is also likely to turn up some people \nwith advanced degrees. do you then conclude that the fact that an economist has an advanced \ndegree is a coincidence? \n ProFessor CoiN: i still don’t see any diff erence between price charts and my randomly gener-\nated chart. \n Ms. treNd: y ou don’t? does this look like a randomly generated chart? (Ms. T rend holds up a July \n1980 silver chart—see Figure 3.1 .) \n ProFessor CoiN: W ell, not exactly, but . . . \n Ms. treNd: ( On the attack .) or this. ( She holds up the December 1994 coff ee chart—see Figure 3.2 .) \ni could go on. \n Moderator: ( T o Professor Coin .) Ms. trend really seems to be percolating. are there any grounds \nfor dismissing her examples? \n ProFessor CoiN: W ell, i admit those examples are pretty extreme, but they still don’t prove \nthat past prices can predict future prices. \n Moderator: Before our time reaches limit-up, so to speak, i would like to rechart our course. \ni wonder what your opinions are about fundamental analysts? \n FIGURE /uni00A03.1 July 1980 silver\nChart created using tradestation. ©tradestation t echnologies, inc. all rights reserved. \n\n32a CoMPlete GUide to the FUtUres MarKet\n FIGURE /uni00A03.2 december 1994 Coff ee\nChart created using tradestation. ©tradestation t echnologies, inc. all rights reserved. \n ProFessor CoiN: W ell, they’re better than chartists since they can at least explain price moves. \nBut i’m afraid their attempts to forecast prices are equally futile. y ou see, at any given moment, \nthe market discounts all known information, so there is no way they can project prices unless \nthey can anticipate unforeseen future developments such as droughts or export embargoes. \n Ms. treNd: W ell, fi rst i would like to address the implication that chart analysts ignore funda-\nmentals. actually we believe that the price chart provides an unambiguous and immediate \nsummary of the net impact of all fundamental and psychological factors. in contrast, accurate \nfundamental models, if they could be constructed at all, would be extremely complex. Fur-\nthermore, the fundamental data for the forecast period would have to be estimated, thereby \nmaking the price projections extremely vulnerable to error. \n Moderator: then you might say you both agree with the statement that fundamentalists end \nup with holes in their shoes. \n Ms. treNd: y es. \n ProFessor CoiN: y es. \n Moderator: W ell, on that upbeat note of agreement, we end tonight’s program. \n in a sense, the argument between the “random walkers” and the chartists can never be clearly \nresolved. it must be understood that it is impossible to prove randomness; all that one can prove is \n33\nCharts: ForeCasting tool or Folklore?\nthat a given pattern does not exist. since there is no consensus as to the precise mathematical defini-\ntion of many chart patterns, the viability of these patterns as price indicators can be neither proven \nnor disproven.\nFor example, if one wanted to test the contention that breakouts from trading ranges represent \nvalid trade signals, the first requirement would be to formulate concise definitions of a trading range \nand a breakout. \nassume that the following definitions are adopted: (1) that the trading range is a price \nband that completely encloses all daily price changes during the past six-week period and that is no \nwider than 5 percent of the median price during that period,\n1 and (2) that a breakout is a closing price \nabove or below the six-week trading range. although the validity of breakouts as trading signals could \nbe tested for these specific definitions, the definitions themselves will be challenged by many. some \nof the objections might be the following:\n 1. t he price band is too narrow .\n 2. t he price band is too wide.\n 3. t he six-week period is too long.\n 4. t he six-week period is too short.\n 5. No allowance is made for isolated days beyond the confines of the range—an event that most \nchart analysts would agree does not disturb the basic pattern.\n 6. t he direction of the trend prior to the trading range is not considered—a factor many chartists \nwould view as a critical input in interpreting the reliability of a breakout.\n 7. t he breakout should be required to exceed the boundary of the trading range by a minimum \namount (e.g., 1 percent of the price level) in order to be viewed as valid.\n 8. s everal closes above the trading range should be required to indicate a breakout.\n 9. a time lag should be used to test the validity of the breakout; for example, are prices still \nbeyond the trading range one week after the initial penetration of the range?\nthe preceding list represents only a partial itemization of the possible objections to our hypotheti-\ncal definitions of a trading range and breakout, and all of this for one of the most basic chart patterns. \nimagine the ambiguities and complications in specifically defining a pattern such as a confirmed head \nand shoulders.\nFor their part, the chartists cannot win the argument, either. although chart analysis is based on gen-\neral principles, its application depends on individual interpretation. the successful chart-oriented trader \nmight not have any doubts about the viability of chart analysis, but the “random walk” theoreticians \nwould dismiss his success as a consequence of the laws of pr", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 15}
{"text": "med head \nand shoulders.\nFor their part, the chartists cannot win the argument, either. although chart analysis is based on gen-\neral principles, its application depends on individual interpretation. the successful chart-oriented trader \nmight not have any doubts about the viability of chart analysis, but the “random walk” theoreticians \nwould dismiss his success as a consequence of the laws of probability, since even a totally random trade \nselection process would yield a percentage of winners. \nin short, the debate is not about to be concluded.\nit is also important to realize that even if conclusive tests were possible, the conflicting claims \nof the random walkers and the chartists need not necessarily be contradictory. one way of viewing \nthe situation is that markets may witness extended periods of random fluctuation, interspersed with \nshorter periods of nonrandom behavior. \nthus, even if the price series as a whole appears random, it \n1 the specification of maximum price width is deliberately intended to exclude periods of wide-swinging prices \nfrom being defined as trading ranges.\n34\nA Complete Guide to the Futures mArket\nis entirely possible that there are periods within the data that exhibit definite patterns. the goal of the \nchart analyst is to identify those periods (i.e., major trends).\nthe time has come to admit my own biases. Personal experience has convinced me that charts \nare a valuable, if not essential, trading tool. however, such perceptions do not prove anything. the \nrandom walkers would argue that my conclusions could be based on selective memory—that is, a \ntendency to remember the successes of chart analysis and forget the failures—or just pure luck. and \nthey are right. such explanations could indeed be correct.\nthe bottom line is that each trader must evaluate chart analysis independently and draw his own \nconclusions. however, it should be strongly emphasized that charts are considered to be an extremely \nvaluable trading tool by many successful traders, and therefore the new trader should be wary of \nrejecting this approach simply on the basis of intuitive skepticism. \nthe following are some of the \nprincipal potential benefits of using charts. Note that a number of these uses remain valid even if one \ntotally rejects the possibility that charts can be used to forecast prices.\n 1. Charts provide a concise price history—essential information for any trader.\n 2. Charts can provide the trader with a good sense of the market’s volatility—an important con-\nsideration in assessing risk.\n 3. Charts are a very useful tool to the fundamental analyst. long-term price charts enable the fun-\ndamentalist to isolate quickly the periods of major price moves. By determining the fundamen-\ntal conditions or events that were peculiar to those periods, the fundamentalist can identify the \nkey price-influencing factors. \nthis information can then be used to construct a price behavior \nmodel.\n 4. Charts can be used as a timing tool, even by traders who formulate their trading decisions on \nthe basis of other information (e.g., fundamentals).\n 5. Charts can be used as a money management tool by helping to define meaningful and realistic \nstop points.\n 6. Charts reflect market behavior that is subject to certain repetitive patterns. Given sufficient \nexperience, some traders will uncover an innate ability to use charts successfully as a method of \nanticipating price moves.\n 7. a n understanding of chart concepts is probably an essential prerequisite for developing profit-\nable technical trading systems.\n 8. Cynics take notice: under specific circumstances, a contrarian approach to classical chart signals \ncan lead to very profitable trading opportunities. \nthe specifics of this approach are detailed in \nChapter 15.\nin short, charts have something to offer everyone, from cynics to believers. the remaining \n chapters of Part ii review and evaluate the key concepts of classical chart theory, as well as addressing \nthe all-important question of how charts can be used as an effective trading tool.\n35\nChapter 4\nTypes of Charts\nYou don’t need a weatherman to know which way the wind blows.\n—Bob Dylan\n ■ Bar Charts\nBar charts are by far the most common type of price chart. In a daily bar chart, each day is represented \nby a vertical line that ranges from the daily low to the daily high. The day’s closing value is indicated by \na horizontal protrusion to the right of the bar, while the opening price is represented by a protrusion \nto the left of the bar. Figure 4.1 is a daily bar chart of the July 2015 soybean contract.\nThe daily (or intraday for short-term traders) bar chart is most useful for trading purposes, but \nbar charts for longer data periods provide extremely important perspective. These longer-period bar \ncharts (e.g., weekly, monthly) are entirely analogous to the daily bar chart, with each vertical line \nrepresenting the price range and final price level for the period. Figure 4.2 is a weekly bar chart for \nsoybean futures. The segment within the rectangle corresponds to the period depicted in Figure  4.1. \nFigure 4.3 is a monthly bar chart for soybean futures, and the two rectangles enclose the periods \ndepicted in Figures 4.2 and 4.1.\nThe change in time perspective can go in the other direction as well; intraday charts can provide \ngreater detail of the price action than daily charts. Figure 4.4 is a 30-minute chart of the July soybean \nfutures that covers the same time period as the last eight daily bars in Figure 4.1.\nUsed in combination, the monthly, weekly, daily, and intraday bar charts provide a telephoto-type \neffect. The monthly and weekly charts would be used to provide a broad market perspective and to \nformulate a technical opinion regarding the potential long-term trend. The daily chart—and, for \n36A COMPLETE GUIDE TO THE FUTURES MARKET\n FIGURE  4.1 Daily Bar Chart: July 2015 Soybeans \n FIGURE  4.2 W eekly Bar Chart: Soybeans (Continuous Futures)\nNote: Continuous", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 16}
{"text": "r charts provide a telephoto-type \neffect. The monthly and weekly charts would be used to provide a broad market perspective and to \nformulate a technical opinion regarding the potential long-term trend. The daily chart—and, for \n36A COMPLETE GUIDE TO THE FUTURES MARKET\n FIGURE  4.1 Daily Bar Chart: July 2015 Soybeans \n FIGURE  4.2 W eekly Bar Chart: Soybeans (Continuous Futures)\nNote: Continuous futures will be defi ned in the next section.\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n37TYPES OF CHARTS\n FIGURE  4.3 Monthly Bar Chart: Soybeans (Continuous Futures)\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE  4.4 30-Minute Bar Chart: July 2015 Soybeans\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n38A COMPLETE GUIDE TO THE FUTURES MARKET\nshorter-term traders, intraday charts—would then be employed to determine the timing of trades. If \nthe long-term technical picture is suffi ciently decisive, by the time the trader gets to the daily or intra-\nday charts, he may already have a strong market bias. For example, if a trader interprets the monthly \nand weekly charts as suggesting the likelihood that the market has witnessed a major long-term top, \nhe will only monitor the daily and intraday charts for sell signals. \n The diff erence in perspective between short-term and long-term charts can be striking. For exam-\nple, in the daily bar chart shown in Figure 4.5 , the technical picture for coff ee seemed quite bearish, \nwith prices in late October 2013 having just pushed below a period of sideways price action while in \nthe midst of a longer-term downtrend that showed no evidence of abating. The weekly futures chart \n(Figure 4.6 ), however, provided a strikingly diff erent perspective. Although this multiyear chart \nalso showed the market in an unbroken downtrend, it revealed that prices had fallen to the vicinity \nof the 2008 and 2009 lows—a signifi cant price level that had supported the market in the past, and \nwhich, in late 2013, implied the potential for a major trend reversal in that vicinity. Indeed, as the \ninset chart for the December 2014 coff ee contract shows, prices subsequently embarked on a huge \nrally from November 2013 into early October 2014. Although in late October 2013 it may not have \nbeen apparent which of these confl icting interpretations would prevail, the basic point is that longer-\nterm charts may suggest very diff erent interpretations of price patterns than those indicated by daily \ncharts. Hence, both types of charts should be examined. \n FIGURE  4.5 Daily Bar Chart Perspective: December 2013 Coff ee\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n39TYPES OF CHARTS\n FIGURE  4.6 W eekly Bar Chart Perspective: Coff ee Nearest Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n ■ Linked Contract Series: Nearest Futures versus \nContinuous Futures \n The time period covered by the typical weekly or monthly bar chart requires the use of a series of \ncontracts. Normally, these contracts are combined using the nearest futures approach: a contract is \nplotted until its expiration and then the subsequent contract is plotted until its expiration, and so on. \nTraders should be aware that a nearest futures chart may refl ect signifi cant distortions due to the price \ngaps between the expiring month and the subsequent contract. \n Figure 4.7 provides two clear examples of this type of distortion. The top chart is a live cattle \nweekly nearest futures chart; the bottom chart is a live cattle weekly continuous futures chart, which \nwill be defi ned momentarily. The nearest futures chart implies a large 7.175-cent (6 percent) one-\nweek gain in the price of cattle from the August 31 close to the September 7, 2012 close. However, \nthis price jump never really took place because the price gap represented nothing more than the expi-\nration of the lower-priced August 2012 cattle contract and the switch to the higher-priced October \n2012 cattle contract. In contrast, the continuous futures chart, which, as will be explained shortly, \nrefl ects actual price movements, showed that price had rallied only 0.45 cents from August 31 to \nSeptember 7, 2012. Almost exactly a year later the same relationship between the prices in diff erent \ncontract months produced an even more noteworthy discrepancy: While the nearest futures chart \nshowed a 3.15-cent gain from August 30 to September 6, 2013, the continuous futures chart shows \ncattle prices actually declined 1.125 cents between these dates. \n40A COMPLETE GUIDE TO THE FUTURES MARKET\n FIGURE  4.7 Distortion in Nearest Futures Chart: Cattle W eekly Nearest Futures (top) \nand Cattle W eekly Continuous Futures (bottom)\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n The fact that a nearest futures chart is vulnerable to great distortion, in the sense that price moves \ndepicted in the chart may contrast dramatically with the results realized by an actual trader (as was the \ncase in the cattle example), makes it necessary to consider an alternate linked-contract representation \nthat does not share this defect. The continuous futures chart provides such an alternative approach. \n Continuous futures is a series that links together successive contracts in such a way that price gaps \nare eliminated at rollover points. Although continuous futures will precisely refl ect price swings, past \ncontinuous levels will not match actual historical levels. (In contrast, nearest futures will accurately \nrefl ect actual historical levels, but not price swings.) The appropriate series depends on the intended \npurpose. Nearest futures should be used to indicate the actual price levels at which a market traded \nin the past. However, continuous futures should be used to illustrate the results that wo", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 17}
{"text": "tinuous levels will not match actual historical levels. (In contrast, nearest futures will accurately \nrefl ect actual historical levels, but not price swings.) The appropriate series depends on the intended \npurpose. Nearest futures should be used to indicate the actual price levels at which a market traded \nin the past. However, continuous futures should be used to illustrate the results that would have been \nrealized by a trader. Continuous futures will be discussed in greater detail in Chapters 5 and 18. \n ■ Close-Only (“Line”) Charts \n As the name implies, close-only charts ignore high and low price information and refl ect only closing \nvalues. Some price series can be depicted only in close-only chart formats because intraday data are \nnot readily available. Two examples are cash price series (Figure 4.8 ) and spreads (Figure 4.9 ), which \nrepresent the price diff erence between two contracts, in this case the July 2015 and November 2015 \nsoybean futures prices. \n41TYPES OF CHARTS\n FIGURE  4.8 Cash Price Chart: Crude Oil\n FIGURE  4.9 Spread Chart: July–November 2015 Soybeans\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n Some chart traders may prefer close-only charts even when high/low/close data are available \nbecause they feel a clearer price picture can be obtained by using only the close. In their view , \nthe inclusion of high/low data only serves to obfuscate the price chart. There is much to be said \n42A COMPLETE GUIDE TO THE FUTURES MARKET\nfor the emphasis on the closing value as the embodiment of the day’s essential price information. \nNevertheless, many important chart patterns depend on the availability of high/low data, and one \nshould think twice before ignoring this information. \n ■ Point-and-Figure Charts \n The essential characteristic of the point-and-fi gure chart is that it views all trading as a single \ncontinuous stream and hence ignores time. A point-and-fi gure chart is illustrated in Figure 4.10 . \nAs can be seen, a point-and-fi gure chart consists of a series of columns of X ’s and O ’s. Each X rep-\nresents a price move of a given magnitude called the box size. As long as prices continue to rise, \nX ’s are added to a column for each increment equal to the box size. However, if prices decline by \nan amount equal to or greater than the reversal size (usually quoted as a multiple of the box size), \na new column of O ’s is initiated and plotted in descending fashion. The number of O ’s will depend \non the magnitude of the reversal, but by defi nition must at least equal the reversal size. By conven-\ntion, the fi rst O in a column is always plotted one box below the last X in the preceding column. \nAn analogous description would apply to price declines and upside reversals. The choice of box and \nreversal size is arbitrary. \n FIGURE  4.10 Point-and-Figure Chart: December 2014 Gold\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n43TYPES OF CHARTS\n Figure 4.10 is a point-and-fi gure chart of December 2014 gold futures with a box size of $3 and a \nreversal size of three boxes, or $9. In other words, as long as a price decline of $9 or more does not \noccur, X ’s continue to be added in a single column. When a price decline of $9 or more occurs, a new \ncolumn of O ’s is begun, with the fi rst O placed one box below the last X . \n As stated previously, the point-and-fi gure chart does not refl ect time. One column may represent \none day or two months. For example, Figure 4.11 is a bar chart corresponding to the point-and-fi gure \nchart in Figure 4.10 . The period captured in the rectangle corresponds to the similarly highlighted \ncolumn in the point-and-fi gure chart. Note that this seven-day period occupies only one column on \nthe point-and-fi gure chart. \n ■ Candlestick Charts \n Candlestick charts add dimension and color to the simple bar chart. The segment of the bar that \nrepresents the range between the open and close is represented by a two-dimensional “real body,” \nwhile the extensions beyond this range to the high and low are shown as lines (called “shadows”). A \nday on which the open and close are near opposite extremes of the daily range will have a large real \nbody, whereas a day on which there is little net change between the open and close will have a small \nreal body. The color of the real body indicates whether the close was higher than the open (white—\nFigure 4.12 ) or lower than the open (black—Figure 4.13 ). Figure 4.14 shows a daily candlestick \nchart corresponding to the price action displayed in Figures 4.10 and 4.11 . \n FIGURE  4.11 Bar Chart Corresponding to Point-and-Figure Chart in Figure 4.10 : \nDecember 2014 Gold\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n44A COMPLETE GUIDE TO THE FUTURES MARKET\n FIGURE  4.12 Candlestick Chart: White Real Body \nHigh\nClose\nOpen\nLow\n FIGURE  4.13 Candlestick Chart: Black Real Body \nHigh\nOpen\nClose\nLow\n FIGURE  4.14 Candlestick Chart Corresponding to Figures 4.10 and 4.11 : December \n2014 Gold\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n45\nChapter 5\n ■ The Necessity of Linked-Contract Charts\nMany of the chart analysis patterns and techniques detailed in Chapters 6 through 9 require long-\nterm charts—often charts of multiyear duration. This is particularly true for the identification of top \nand bottom formations, as well as the determination of support and resistance levels.\nA major problem facing the chart analyst in the futures markets is that most futures contracts \nhave relatively limited life spans and even shorter periods in which these contracts have significant \ntrading activity. For many futures contracts (e.g., currencies, stock indexes) trading activity is almost \ntotally concentrated in the nearest one or two contract months. For example, in Figure 5.1, there \nwere only about two months of liquid data available for the Mar", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 18}
{"text": "hat most futures contracts \nhave relatively limited life spans and even shorter periods in which these contracts have significant \ntrading activity. For many futures contracts (e.g., currencies, stock indexes) trading activity is almost \ntotally concentrated in the nearest one or two contract months. For example, in Figure 5.1, there \nwere only about two months of liquid data available for the March 2016 Russell 2000 Index Mini \nfutures contract when it became the most liquid contract in this market as the December 2015 con -\ntract expiration approached. This market is not particularly unusual in this respect. In many futures \nmarkets, almost all trading is concentrated in the nearest contract, which will have only a few months \n(or weeks) of liquid trading history when the prior contract approaches expiration.\nLinking Contracts \nfor Long- T erm \nChart Analysis: \nNearest versus \nContinuous Futures\n46A COMPLETE GUIDE TO THE FUTURES MARKET\n The limited price data available for many futures contracts—even those that are the most actively \ntraded contracts in their respective markets—makes it virtually impossible to apply most chart analy-\nsis techniques to individual contract charts. Even in those markets in which the individual contracts \nhave a year or more of liquid data, part of a thorough chart study would still encompass analyzing \nmultiyear weekly and monthly charts. Thus, the application of chart analysis unavoidably requires \nlinking successive futures contracts into a single chart. In markets with very limited individual con-\ntract data, such linked charts will be a necessity in order to perform any meaningful chart analysis. In \nother markets, linked charts will still be required for analyzing multiyear chart patterns. \n ■ Methods of Creating Linked-Contract Charts \n Nearest Futures \n The most common approach for creating linked-contract charts is typically termed nearest futures. This \ntype of price series is constructed by taking each individual contract series until its expiration and \nthen continuing with the next contract until its expiration, and so on. \n Although, at surface glance, this approach appears to be a reasonable method for constructing \nlinked-contract charts, the problem with a nearest futures chart is that there are price gaps between \nexpiring and new contracts—and quite frequently, these gaps can be very substantial. For exam-\nple, assume the September coff ee contract expires at 132.50 cents/lb and the next nearest con-\ntract (December) closes at 138.50 cents/lb on the same day. Further assume that on the next day \n FIGURE  5.1 March 2016 Russell 2000 Mini Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n47\nLinking ContraCts for Long-term Chart anaLysis\nDecember coffee falls 5 cents/lb to 133.50—a 3.6 percent drop. A nearest futures price series will \nshow the following closing levels on these two successive days: 132.50 cents, 133.50 cents. In other \nwords, the nearest futures contract would show a one-cent (0.75 percent) gain on a day on which longs \nwould actually have experienced a huge loss. This example is by no means artificial. Such distortions—\nand indeed more extreme ones—are quite common at contract rollovers in nearest futures charts.\nThe vulnerability of nearest futures charts to distortions at contract rollover points makes it desir-\nable to derive alternative methods of constructing linked-contract price charts. One such approach \nis detailed in the next section.\nContinuous (Spread-adjusted) price Series\nThe spread-adjusted price series known as “continuous futures” is constructed by adding the cumulative dif-\nference between the old and new contracts at rollover points to the new contract series.\n1 An example should \nhelp clarify this method. Assume we are constructing a spread-adjusted continuous price series for gold \nusing the June and December contracts.\n2 If the price series begins at the start of the calendar year, initially the \nvalues in the series will be identical to the prices of the June contract expiring in that year. Assume that on the \nrollover date (which need not necessarily be the last trading day) June gold closes at $1,200 and December \ngold closes at $1,205. In this case, all subsequent prices based on the December contract would be adjusted \ndownward by $5—the difference between the December and June contracts on the rollover date.\nAssume that at the next rollover date December gold is trading at $1,350 and the subsequent June \ncontract is trading at $1,354. The December contract price of $1,350 implies that the spread-adjusted \ncontinuous price is $1,345. Thus, on this second rollover date, the June contract is trading $9 above the \nadjusted series. Consequently, all subsequent prices based on the second June contract would be adjusted \ndownward by $9. This procedure would continue, with the adjustment for each contract dependent on the \ncumulative total of the present and prior transition point price differences. The resulting price series would \nbe free of the distortions due to spread differences that exist at the rollover points between contracts.\nThe construction of a continuous futures series can be thought of as the mathematical equivalent \nof taking a nearest futures chart, cutting out each individual contract series contained in the chart, \nand pasting the ends together (assuming a continuous series employing all contracts and using the \nsame rollover dates as the nearest futures chart). Typically, as a last step, it is convenient to shift the \nscale of the entire series by the cumulative adjustment factor, a step that will set the current price \nof the series equal to the price of the current contract without changing the shape of the series. The \nconstruction of a continuous futures chart is discussed in greater detail in Chapter 18.\n1 T o avoid confusion, readers should note that some data services use the term continuous futures to refer to linking \ntogether", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 19}
{"text": "s by the cumulative adjustment factor, a step that will set the current price \nof the series equal to the price of the current contract without changing the shape of the series. The \nconstruction of a continuous futures chart is discussed in greater detail in Chapter 18.\n1 T o avoid confusion, readers should note that some data services use the term continuous futures to refer to linking \ntogether contracts of the same month (e.g., linking from March 2015 corn when it expires to March 2016 corn, \nand so on). Such charts are really only a variation of nearest futures charts—one in which only a single contract \nmonth is used—and will be as prone to wide price gaps at rollovers as nearest futures charts, if not more so. \nThese types of charts have absolutely nothing in common with the spread-adjusted continuous futures series \ndescribed in this section—that is, nothing but the name. It is unfortunate that some data services have decided \nto use this same term to describe an entirely different price series than the original meaning described here.\n2 The choice of a combination of contracts is arbitrary. One can use any combination of actively traded months \nin the given market.\n48\nA Complete Guide to the Futures mArket\nComparing the Series\nIt is important to understand that a linked futures price series can only accurately reflect either price \nlevels, as does nearest futures, or price moves, as does continuous futures, but not both—much as a \ncoin can land on either heads or tails, but not both. The adjustment process used to construct continu-\nous series means that past prices in a continuous series will not match the actual historical prices that \nprevailed at the time. However, a continuous series will accurately reflect the actual price movements \nof the market and will exactly parallel the equity fluctuations experienced by a trader who is continu-\nally long (rolling over positions on the same rollover dates used to construct the continuous series), \nwhereas a nearest futures price series can be extremely misleading in these respects.\n ■ Nearest versus Continuous Futures in Chart Analysis\nGiven the significant differences between nearest and continuous futures price series, the obvious \nquestion in the reader's mind is probably: Which series—nearest futures or continuous futures—\nwould be more appropriate for chart analysis? T o some extent, this is like asking which factor a \nconsumer should consider before purchasing a new car: price or quality. The obvious answer is \nboth—each factor provides important information about a characteristic that is not measured by the \nother. In terms of price series, considering nearest futures versus continuous futures, each series pro-\nvides information that the other doesn't. Specifically, a nearest futures price series provides accurate \ninformation about past price levels, but not price swings, whereas the exact reverse statement applies \nto a continuous futures series.\nConsider, for example, Figure 5.2. What catastrophic event caused the instantaneous 165-\ncent (24 percent) collapse in the nearest futures chart for corn from July 12 to July 15, 2013? \nAnswer: absolutely nothing. This “phantom” price move reflected nothing more than a transition \nfrom the old crop July contract to the new crop December contract. Figure 5.3, which depicts \nthe continuous futures price for the same market (and by definition eliminates price gaps at con -\ntract rollovers), shows that no such price move existed—corn was actually little changed from \nJuly 12 to July 15. Clearly, the susceptibility of nearest futures charts to distortions caused by \nwide gaps at rollovers can make it difficult to use nearest futures for chart analysis that focuses \non price swings.\nOn the other hand, the continuous futures chart achieves accuracy in depicting price swings at \nthe sacrifice of accuracy in reflecting price levels. In order to accurately show the magnitude of past \nprice swings, historical continuous futures prices can end up being very far removed from the actual \nhistorical price levels. In fact, it is not even unusual for historical continuous futures prices to be \nnegative (see Figure 5.4). Obviously, such “impossible” historical prices can have no relevance as \nguidelines to prospective support and resistance levels.\nThe fact that each type of price chart—nearest and continuous—has certain significant intrin-\nsic weaknesses argues for combining both types of charts in a more complete analysis. Often these \ntwo types of charts will provide entirely different price pictures. For example, consider the nearest \nfutures chart for lean hogs depicted in Figure 5.5. Looking at this chart, it would be tempting to \n49LINKING CONTRACTS FOR LONG- TERM CHART ANALYSIS\n FIGURE  5.2 Corn Nearest Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE  5.3 Corn Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n50A COMPLETE GUIDE TO THE FUTURES MARKET\n FIGURE  5.4 RBOB Gasoline Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE   5.5 Lean Hog Nearest Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n51LINKING CONTRACTS FOR LONG- TERM CHART ANALYSIS\n conclude that hogs were experiencing a period of severe price dislocation and volatility in 2013, \npeaking sometime in early July. Now look at Figure 5.6 , which shows the continuous version of the \nsame market. This chart shows that hog prices were in a consistent uptrend that began in April and \npeaked at the end of October. It is no exaggeration to say that, without the benefi t of the chart labels, \nit would be virtually impossible to recognize that Figures 5.5 and 5.6 depict the same market. \n ■ Conclusion \n In summary, the brevity of liquid trading periods for futures contracts in many markets makes the use \nof li", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 20}
{"text": "s that hog prices were in a consistent uptrend that began in April and \npeaked at the end of October. It is no exaggeration to say that, without the benefi t of the chart labels, \nit would be virtually impossible to recognize that Figures 5.5 and 5.6 depict the same market. \n ■ Conclusion \n In summary, the brevity of liquid trading periods for futures contracts in many markets makes the use \nof linked-contract charts essential. Continuous futures charts, which remove the distortions caused by \nprice gaps at contract rollovers, are probably the most meaningful type of longer-term chart and, on \nbalance, are far preferable to the more conventional nearest futures chart—although the latter can still \nbe a useful supplement in identifying long-term support and resistance levels. Continuous futures are even \nmore critical for testing trading systems—a topic that will be discussed in Chapter 18 . Figures 5.7 through \n 5.16 provide comparisons between long-term nearest and continuous charts for various futures mar-\nkets. Note how strikingly diff erent nearest and continuous futures charts for the same market can be. \nReaders are reminded that continuous futures charts generated in the future will show diff erent price \nscales than those shown in the following pages (although the price moves will remain the same), since \nit is assumed that the scales will be adjusted to match the prevailing current contract. \n \n FIGURE  5.6 Lean Hog Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n52A COMPLETE GUIDE TO THE FUTURES MARKET\n FIGURE 5.7 10- Y ear T -Note Nearest Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE  5.8 10- Y ear T -Note Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n53LINKING CONTRACTS FOR LONG- TERM CHART ANALYSIS\n FIGURE 5.9 Soybean Nearest Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE 5.10 Soybean Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n54A COMPLETE GUIDE TO THE FUTURES MARKET\n FIGURE 5.11 Soybean Meal Nearest Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE 5.12 Soybean Meal Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n55LINKING CONTRACTS FOR LONG- TERM CHART ANALYSIS\n30\n28\n26\n24\n22\n20\n18\n16\n14\n12\nFeb\nVIX nearest futures (VX), daily\nMarNov Oct\n2013 year\n2014 year\n2015 year\n14 15Apr MayJ un JulA ug Sep Oct No vF eb 16 FebMar Apr MayJ un JulA ug Sep Oct Nov\n FIGURE 5.13 VIX Nearest Futures\nChart created using TD Ameritrade’s thinkorswim. \n FIGURE 5.14 VIX Continuous Futures\nChart created using TD Ameritrade’s thinkorswim. \n30\n32\n34\n36\n38\n28\n26\n24\n22\n20\n18\n16\n14\n12\nFeb\nVIX continuous futures (VX), daily\nMarNov Oct\n2013 year\n2014 year\n2015 year\n14 15Apr MayJ un JulA ug Sep Oct No vF eb 16 FebMar Apr MayJ un JulA ug Sep Oct Nov\n56A COMPLETE GUIDE TO THE FUTURES MARKET\n FIGURE 5.15 Live Cattle Nearest Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE 5.16 Live Cattle Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n57\nChapter 6\nThe trend is your friend except at the end when it bends.\n—Ed Seykota\n ■ Defining Trends by Highs and Lows\nOne standard definition of an uptrend is a succession of higher highs and higher lows. For example, \nduring the May 2014–March 2015 period in Figure 6.1, each relative high (RH) is higher than the \npreceding high, and each relative low (RL) is higher than the preceding low . In essence, an uptrend \ncan be considered intact until a previous reaction low point is broken. A violation of this condition \nserves as a warning signal that the trend may be over. For example, in Figure 6.1, the late April \npenetration of the early April relative low confirmed the end of the nearly yearlong rally, after \nwhich the market entered an extended trading range (see weekly chart inset). Figure 6.2 provides \nan intraday example of an uptrend defined by successively higher highs and higher lows. It should be \nemphasized, however, that the disruption of the pattern of higher highs and higher lows (or lower \nhighs and lower lows) should be viewed as a clue, not a conclusive indicator, of a possible long-term \ntrend reversal.\nIn similar fashion, a downtrend can be defined as a succession of lower lows and lower highs (see \nFigure 6.3). A downtrend can be considered intact until a previous reaction high is exceeded.\nUptrends and downtrends are also often defined in terms of trend lines. An uptrend line is a line \nthat connects a series of higher lows (see Figures 6.4 through 6.6); a downtrend line is a line that con-\nnects a series of lower highs (see Figure 6.7). Trend lines can sometimes extend for many years. For \nexample, Figure 6.8 is a weekly chart with a trend line reflecting a multiyear uptrend in the E-mini \nNasdaq 100 futures that included the daily timeframe uptrend from Figure 6.4. Figure 6.9 illustrates \na trend line defining a 33-year uptrend in 10-year U.S. T -note futures.\nTrends\n58A COMPLETE GUIDE TO THE FUTURES MARKET\n FIGURE  6.1 Uptrend as Succession of Higher Highs and Higher Lows: Dollar \nIndex Continuous Futures\n Note: RH = relative high; RL = relative low .\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE  6.2 Uptrend as Succession of Higher Highs and Higher Lows: December \n2014 10- Y ear T -Note\n Note: RH = relative high; RL = relative low .\n Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n59TRENDS\n FIGURE  6.3 Downtrend as Succession of Lower Highs and Lower Lows: Euro \nContinuous Futures\n Note: RH = relative high; RL = relative l", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 21}
{"text": "ghts reserved. \n FIGURE  6.2 Uptrend as Succession of Higher Highs and Higher Lows: December \n2014 10- Y ear T -Note\n Note: RH = relative high; RL = relative low .\n Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n59TRENDS\n FIGURE  6.3 Downtrend as Succession of Lower Highs and Lower Lows: Euro \nContinuous Futures\n Note: RH = relative high; RL = relative low .\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE  6.4 Uptrend Line: E-Mini Nasdaq 100 Continuous Futures\n Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n60A COMPLETE GUIDE TO THE FUTURES MARKET\n FIGURE  6.5 Uptrend Line: Copper Continuous Futures\n Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE 6.6 Uptrend Line: June 2016 E-Mini Dow Futures\n Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n61TRENDS\n FIGURE 6.7 Downtrend Line: WTI Crude Oil Continuous Futures\n Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE 6.8 Uptrend Line: E-Mini Nasdaq 100 Continuous Futures\n Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n62A COMPLETE GUIDE TO THE FUTURES MARKET\n It is not uncommon for reactions against a major trend to begin near a line parallel to the trend \nline. Sets of parallel lines that enclose a trend are called trend channels. Figure 6.10 shows an uptrend \nchannel on a daily chart, while Figure 6.11 shows a downtrend channel on a weekly chart. \n FIGURE  6.9 Uptrend Line: 10- Y ear U.S. T -Note Continuous Futures\n Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE  6.10 Uptrend Channel: Soymeal Continuous Futures\n Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n63TRENDS The following rules are usually applied to trend lines and channels: \n 1. Declines approaching an uptrend line and rallies approaching a downtrend line are often good \nopportunities to initiate positions in the direction of the major trend. \n 2. The penetration of an uptrend line (particularly on a closing basis) is a sell signal; the penetra-\ntion of a downtrend line is a buy signal. Normally, a minimum percentage price move or a \nminimum number of closes beyond the trend line is required to confi rm a penetration. \n 3. The lower end of a downtrend channel and the upper end of an uptrend channel represent \npotential profi t-taking zones for short-term traders. \n Trend lines and channels are useful, but their importance is often overstated. It is easy to overesti-\nmate the reliability of trend lines when they are drawn with the benefi t of hindsight. A consideration \nthat is frequently overlooked is that trend lines often need to be redrawn as a bull or bear market is \nextended. Thus, although the penetration of a trend line will sometimes off er an early warning signal \nof a trend reversal, it is also common that such a development will merely require a redrawing of the \ntrend line. For example, Figure 6.12 shows an uptrend line connecting the November and December \n2012 lows in the Russell 2000 Mini futures. Prices remained above this line until February 2013, \nwhen prices closed below it, signaling an end to this move. Figure 6.13 extends Figure 6.12 by two \nmonths and shows that the February penetration of the original (dashed) trend line was a pullback \nthat preceded a rally to a higher high. Prices remained above the revised (solid) trend line connecting \nthe November and February lows until early April, at which point the market posted a more signifi -\ncant correction. Figure 6.14 , however, shows the larger uptrend extended for almost another year, \nprompting three additional revisions to the uptrend line, each of which was necessitated by a closing \npenetration of the preceding trend line. \n FIGURE  6.11 Downtrend Channel: Soybean Oil Continuous Futures\n Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n64A COMPLETE GUIDE TO THE FUTURES MARKET\n FIGURE  6.12 Uptrend Line: Russell 2000 Mini Continuous Futures\n Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE  6.13 Uptrend Line Redefi ned: Russell 2000 Mini Continuous Futures\n Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n65TRENDS\n Figure 6.15 provides a similar example for a downtrend. The initial downtrend line connecting \nthe December 2014 and March 2015 highs (gray dotted line) was penetrated to the upside in June, \nbut after a few weeks of sideways price action, the market resumed its decline. The revised trend line \n(thicker dashed line) connecting the December 2014 and June 2015 highs extended until November \n2015, when prices again pushed higher—enough to require a third revision to the downtrend line \n(solid line), but not enough to end the longer-term downtrend. \n FIGURE  6.14 Uptrend Line Redefi ned: Russell 2000 Mini Continuous Futures\n Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE  6.15 Downtrend Line Redefi ned: Oat Continuous Futures\n Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n66\nA Complete Guide to the Futures mArket\nThe preceding examples are meant to drive home the point that the penetration of trend lines \nis more the rule than the exception. The simple fact is that trend lines tend to be penetrated, \nsometimes repeatedly, during their evolution, which is equivalent to saying that trend lines are \nfrequently redefined as they extend. The important implications of this observation are that trend \nlines work much better in hindsight than in real time and that penetrations of trend lines often \nprove to be false signals.\n ■ TD Lines\nIn his book The New Science of T ec", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 22}
{"text": "lines tend to be penetrated, \nsometimes repeatedly, during their evolution, which is equivalent to saying that trend lines are \nfrequently redefined as they extend. The important implications of this observation are that trend \nlines work much better in hindsight than in real time and that penetrations of trend lines often \nprove to be false signals.\n ■ TD Lines\nIn his book The New Science of T echnical Analysis,1 Thomas DeMark accurately notes that the drawing \nof trend lines is a highly arbitrary process. Presented with the same chart, different people will draw \ndifferent trend lines. In fact, presented with the same chart at different times, even the same person \nmight well draw the trend line differently.\nIt is easy to see the reason for this lack of precision. A trend line is typically intended to connect \nseveral relative highs or relative lows. If there are only two such points, the trend line can be drawn \nprecisely. If, however, the trend line is intended to connect three or more points—as is frequently the \ncase—a precise line will exist in only the rare circumstance that the relationship between all the points \nis exactly linear. In most cases, the trend line that is drawn will exactly touch at most one or two of the \nrelative highs (or lows), while bisecting or missing the other such points. The trend line that provides \nthe best fit is truly in the eye of the beholder.\nDeMark recognizes that in order for a trend line to be defined precisely and unambiguously, it must \nbe based on exactly two points. DeMark also notes that, contrary to convention, trend lines should be \ndrawn from right to left because “recent price activity is more significant than historical movement.” \nThese concepts underlie his approach of drawing trend lines. DeMark’s TD methodology for defining \ntrend lines is explained by the following definitions:\n2\nRelative high. A daily high that is higher than the high on the N prior and N succeeding days, \nwhere N is a parameter value that must be defined. For example, if N = 5, the relative high is defined \nas a high that is higher than any high in the prior five days and succeeding five days. (An analogous \ndefinition could be applied for data expressed in any time interval. For example, in a 60-minute \nbar chart, the relative high would be a high that is higher than the high on the prior or succeeding \nN 60-minute bars.)\nRelative low. A daily low that is lower than the low on the N prior and N succeeding days.\nTD downtrend line. The prevailing downtrend line is defined as the line connecting the most recent \nrelative high and the most recent preceding relative high that is also higher than the most recent relative \nhigh. The latter condition is essential to assure the trend line connecting the two relative highs slopes \ndown. Figure 6.16 illustrates the prevailing TD downtrend line, assuming an N = 5 parameter value is \nused to define relative highs.\n1 Thomas DeMark, The New Science of T echnical Analysis (New Y ork, NY: John Wiley & Sons, 1994).\n2 The following definitions and terminology differ from those used by DeMark, but the implied method of identify-\ning trend lines is equivalent. I simply find the following approach clearer and more succinct than DeMark’s presen-\ntation of the same concept.\n67TRENDS\nTD uptrend line . The prevailing uptrend line is defi ned as the line connecting the most recent relative \nlow and the most recent preceding relative low that is also lower than the most recent relative low . Figure 6.17 \nillustrates the prevailing TD uptrend line, assuming an N = 8 parameter value is used to defi ne relative lows. \n By basing trend line defi nitions on the most recent relative highs and relative lows, trend lines will \nbe continually redefi ned as new relative highs and relative lows are defi ned. For example, Figure 6.18 \n FIGURE  6.16 TD Downtrend Line ( N = 5): E-Mini Nasdaq 100 Continuous Futures\n Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE  6.17 TD Uptrend Line ( N = 8): Copper Continuous Futures\n Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n68A COMPLETE GUIDE TO THE FUTURES MARKET\nshows the succession of TD uptrend lines that would be implied as new relative lows are defi ned \n( N = 10) until a trend reversal signal is received. In this chart it is assumed that a trend reversal signal \nis defi ned as three consecutive closes below the prevailing uptrend line. In similar fashion, Figure 6.19 \n FIGURE  6.18 Succession of TD Uptrend Lines ( N = 10): U.S. Dollar Index \nContinuous Futures\n Note: Lines 1–3 are successive TD uptrend lines that use N = 10 to defi ne relative lows (RL).\n Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE  6.19 Succession of TD Downtrend Lines ( N = 10): June 2015 Euro Futures\n Note: Lines 1 and 2 are successive TD downtrend lines that use N = 10 to defi ne \n relative highs (RH).\n Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n69TRENDS\n FIGURE  6.20 Succession of TD Uptrend Lines ( N = 10): August 2015 Gasoline\n Note: Lines 1–3 are successive TD uptrend lines, using N = 10 to defi ne relative \nlows (RL).\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \nillustrates TD downtrend lines that would be implied as new relative highs are defi ned ( N = 10) until \na trend reversal signal is received (again, based on three consecutive closes beyond the trend line). \n Diff erent values for N will yield very diff erent trend lines. For example, Figures 6.20 through \n 6.22 contrast the TD uptrend lines implied by three diff erent values of N for the same chart. The \nlower the value of N , the more frequently the trend line is redefi ned and the more sensitive the \nline is to penetration. For example, contrast the 21 trend lines generated by the N = 2 defi nition \nin Figure 6.22 , versus the me", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 23}
{"text": "eld very diff erent trend lines. For example, Figures 6.20 through \n 6.22 contrast the TD uptrend lines implied by three diff erent values of N for the same chart. The \nlower the value of N , the more frequently the trend line is redefi ned and the more sensitive the \nline is to penetration. For example, contrast the 21 trend lines generated by the N = 2 defi nition \nin Figure 6.22 , versus the mere three trend lines that result when an N = 10 defi nition is used in \nFigure 6.20 . \n In analogous fashion, Figures 6.23 through 6.25 contrast the TD downtrend lines implied by three \ndiff erent values of N for the same chart. Similar to Figures 6.20 through 6.22 , these charts also show \nthat when the value of N is low , the prevailing downtrend line is redefi ned frequently and tends to be \nvery sensitive. In Figure 6.23 , which shows TD lines for N = 10, there are only three downtrend \nlines. For N = 5 the number of trend lines increases to fi ve during the same period (Figure 6.24 ). \nFinally, for N = 2, 18 diff erent trend lines are generated (Figure 6.25 ). As these illustrations make \nclear, the choice of a value for N will make a tremendous diff erence in the trend lines that are gener-\nated and the resulting trading implications. \n DeMark’s basic defi nition of trend lines is equivalent to the aforementioned defi nitions with \nN = 1. Although he acknowledges that trend lines can be defi ned using higher values of N —“TD \nlines of higher magnitude,” in his terminology—his stated preference is for trend lines drawn using \nthe basic defi nition. Personally, my own preference is quite the opposite. Although it is a truism that \n70A COMPLETE GUIDE TO THE FUTURES MARKET\n FIGURE 6.21 Succession of TD Uptrend Lines (N = 5): August 2015 Gasoline\n Note: Lines 1–6 are successive TD uptrend lines, using N = 5 to defi ne relative \nlows (RL).\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE  6.22 Succession of TD Uptrend Lines ( N = 2): August 2015 Gasoline\n Note: Lines 1–21 are successive TD uptrend lines, using N = 2 to defi ne relative \nlows (RL).\n Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n71TRENDS\n FIGURE  6.23 Succession of TD Downtrend Lines ( N = 10): Gold Continuous Futures\n Note: Lines 1–3 are successive TD downtrend lines, using N = 10 to defi ne relative \nhighs (RH).\n Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE 6.24 Succession of TD Downtrend Lines (N = 5): Gold Continuous Futures\n Note: Lines 1–5 are successive TD downtrend lines, using N = 5 to defi ne relative \nhighs (RH)\n Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n72A COMPLETE GUIDE TO THE FUTURES MARKET\nusing an N = 1 defi nition for trend lines will yield earlier signals for valid trend line breakouts, the \ncritical trade-off is that such an approach will tend to provide very tight trend lines that are prone to \nfar more false breakout signals. As a general principle, I think it is far more critical to avoid bad signals \nthan to get the jump on good signals; hence, I strongly favor using higher values of N (e.g., N = 3 to \nN = 12) to defi ne trend lines. \n There is, however, no “right” or “wrong” choice for a value for N ; it is strictly a matter of subjective \npreference. The reader is encouraged to experiment drawing trend lines using diff erent values of N . \nEach trader will feel comfortable with certain values of N and uncomfortable with others. Generally \nspeaking, short-term traders will gravitate to low values of N and long-term traders to higher values. \n As a fi ne-tuning point, which becomes particularly important if trend lines are defi ned using N = 1, \nit is preferable to defi ne relative highs and relative lows based on true highs and true lows rather than \nnominal highs and lows. These terms are defi ned as: \nT rue high . The high or previous close, whichever is higher. \nT rue low. The low or previous close, whichever is lower. \n For most days, the true high will be identical to the high and the true low will be identical to \nthe low . The diff erences will occur on downside gap days (days on which the entire trading range is \nbelow the previous day’s close) and upside gap days (days on which the entire trading range is above \nthe previous day’s close). Although such gaps are much rarer (and, generally, smaller) than in the days \n FIGURE  6.25 Succession of TD Downtrend Lines ( N = 2): Gold Continuous Futures\n Note: Lines 1–18 are successive TD downtrend lines, using N = 2 to defi ne relative \nhighs (RH).\n Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n73TRENDSbefore nearly 24-hour electronic trading, they do occasionally still occur, and can thus impact the \nidentifi cation of relative highs and lows. The use of true highs and true lows yields relative highs and \nrelative lows that are more in line with our intuitive concept of what these points should represent. \n For example, in Figure 6.26 , using an N = 3 defi nition, bar A would be identifi ed as a relative low \nbased on the nominal low . This point is identifi ed as a relative low , however, only because of the upside gap \nthat occurred three days earlier; it hardly fi ts the intuitive concept of a relative low . In this case, using the \ntrue low instead of the nominal low would eliminate the low of Bar A as a relative low . \n ■ Internal Trend Lines \n Conventional trend lines are typically drawn to encompass extreme highs and lows. An argument can \nbe made, however, that extreme highs and lows are aberrations resulting from emotional excesses \nin the market, and that, as such, these points may be unrepresentative of the dominant trend in the \nmarket. An internal trend line does away with the implicit requirement of having to draw trend lines \nbased on extreme price excursions. An internal trend line is a trend line drawn", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 24}
{"text": "s. An argument can \nbe made, however, that extreme highs and lows are aberrations resulting from emotional excesses \nin the market, and that, as such, these points may be unrepresentative of the dominant trend in the \nmarket. An internal trend line does away with the implicit requirement of having to draw trend lines \nbased on extreme price excursions. An internal trend line is a trend line drawn so as to best approxi-\nmate the majority of relative highs or relative lows without any special consideration being given to \nextreme points. In a rough sense, an internal trend line can be thought of as an approximate best-fi t \nline of relative highs and relative lows. Figures 6.27 through 6.34 provide a wide range of examples of \ninternal uptrend and downtrend lines. For comparison, most of these charts also depict conventional \ntrend lines, which are shown as dashed lines. (T o avoid cluttering the charts, only one or two of the \nconventional trend lines that would have been implied in the course of a price move are shown.) \n FIGURE  6.26 Nominal Low versus True Low: Lean Hog Continuous Futures\n Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n74A COMPLETE GUIDE TO THE FUTURES MARKET\n FIGURE  6.27 Internal Trend Line versus Conventional Trend Line: Euro \nContinuous Futures\n Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE 6.28 Internal Trend Line versus Conventional Trend Line: E-Mini S&P 500 \nIndex Continuous Futures\n Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n75TRENDS\n FIGURE 6.29 Alternate Internal Trend Lines: Coff ee Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE 6.30 Internal Trend Line: Soybean Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n76A COMPLETE GUIDE TO THE FUTURES MARKET\n FIGURE 6.31 Internal Trend Line versus Conventional Trend Line: Wheat \nContinuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE 6.32 Internal Trend Line versus Conventional Trend Line: Live Cattle \nContinuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n77TRENDS\n FIGURE 6.33 Internal Trend Line versus Conventional Trend Lines: Platinum \nContinuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE  6.34 Internal Trend Line versus Conventional Trend Lines: Soybean Oil \nContinuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n78\nA Complete Guide to the Futures mArket\nOne shortcoming of internal trend lines is that they are unavoidably arbitrary, perhaps even \nmore so than conventional trend lines, which at least are anchored by the extreme highs or lows. In \nfact, there is often more than one plausible internal trend line that can be drawn on a chart—see, \nfor example, Figure 6.29. Nevertheless, in my experience, internal trend lines are far more useful \nthan conventional trend lines in defining potential support and resistance areas. An examination \nof Figures 6.27 through 6.34 will reveal the internal trend lines depicted in these charts generally \nprovided a better indication of where the market would hold in declines and stall in advances than did \nthe conventional trend lines. Of course, this sample of illustrations does not prove the superiority of \ninternal trend lines over conventional trend lines, since it is always possible to find charts that appear \nto validate virtually any contention, and such a proof is certainly not intended or implied. Rather, the \ncomparisons in these charts are intended only to give the reader a sense of how internal trend lines \nmight provide a better indication of potential support and resistance areas.\nThe fact that I personally find internal trend lines far more useful than conventional trend lines \nproves nothing—the anecdotal observation of a single individual hardly represents scientific proof. \nIn fact, given the subjective nature of internal trend lines, a scientific test of their validity would be \nvery difficult to construct. My point, however, is that internal trend lines are a concept that should \ncertainly be explored by the serious chart analyst. I am sure that by doing so many readers will also \nfind internal trend lines more effective than conventional trend lines, or at least a worthwhile addition \nto the chart analyst’s tool kit.\n ■ Moving Averages\nMoving averages provide a very simple means of smoothing a price series and making any trends more \ndiscernible. A simple moving average is defined as the average close of the past N days, ending with \nthe current day. For example, a 40-day moving average would be equal to the average of the past 40 \ncloses, including the current day. (Typically, moving averages are calculated using daily closes. How-\never, moving averages can also be based on opens, highs, lows, or an average of the daily open, high, \nlow , and close. Also, moving averages can be calculated for time intervals of data other than daily, \nin which case the “close” would refer to the final price quote in the given time interval.) The term \nmoving average refers to the fact that the set of numbers being averaged is continuously moving through \ntime. Figure 6.35 illustrates a 40-day moving average superimposed on a price series. Note that the \nmoving average clearly reflects the trend in the price series and smooths the meaningless fluctuations \nin the data. In choppy markets moving averages will tend to oscillate in a general sideways pattern, as \nillustrated in Figure 6.36.\nOne very simple method of using moving averages to define trends is based on the direction of \nchange in a moving average’s value relative to the previous day. For example, a moving average (a", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 25}
{"text": "ts the trend in the price series and smooths the meaningless fluctuations \nin the data. In choppy markets moving averages will tend to oscillate in a general sideways pattern, as \nillustrated in Figure 6.36.\nOne very simple method of using moving averages to define trends is based on the direction of \nchange in a moving average’s value relative to the previous day. For example, a moving average (and \nby implication the trend) would be considered to be rising if today’s value was higher than yesterday’s \nvalue and declining if today’s value was lower.\nNote that the basic definition of a rising moving average is equivalent to the simple condition that \ntoday’s close is higher than the close N days ago. Why? Because yesterday’s moving average is identical \n79TRENDS\n FIGURE  6.35 Moving Average (40-Day) in Trending Market: Canadian Dollar \n Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE  6.36 Moving Average (40-Day) in Sideways Market: Oat Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \nto today’s moving average with the exception that yesterday’s moving average includes the close N days \nago and does not include today’s close. Therefore, if today’s close is higher than the close of N days \nago, then today’s moving average will be higher than yesterday’s moving average. Similarly, a declin-\ning moving average is equivalent to the condition that today’s close is lower than the close N days ago. \n80A COMPLETE GUIDE TO THE FUTURES MARKET\n The smoothing properties of moving averages are achieved at the expense of introducing lags in \nthe data. By defi nition, since moving averages are based on an average of past prices, turning points in \nmoving averages will always lag the corresponding transitions in the raw price series. This character-\nistic is readily evident in both Figures 6.35 and 6.36 . \n In trending markets, moving averages can provide a very simple and eff ective method of identify-\ning trends. Figure 6.37 duplicates Figure 6.35 , denoting buy signals at points at which the moving \naverage reversed to the upside by at least 10 ticks and sell signals at points at which the moving \naverage turned down by the same minimum amount. (The reason for using a minimum threshold \nreversal to defi ne turns in the moving average is to keep trend signals from fl ipping back and forth—\n“whipsawing”—repeatedly at times when the moving average is near zero.) As Figure 6.37 shows, this \nextremely simple technique generated good trading signals. During the 24-month period shown, this \nmethod generated only seven signals. The fi rst signal (long) was exited with a small profi t in August. \nThe short position triggered at this point captured a signifi cant portion of the July 2014–March 2015 \ndecline. The April 2015 buy was exited with a small loss in June 2015, but the ensuing short trade \nwas exited profi tably in October. The subsequent buy was reversed in late November at a loss, and the \nfi nal short trade was exited with a profi t in February 2016. \n The problem is that while moving averages will do well in trending markets, in choppy, sideways \nmarkets they are apt to generate many false signals. For example, Figure 6.38 duplicates Figure 6.36 , \nindicating buy signals at points where the moving average turned up by at least 10 ticks and sell sig-\nnals at points witnessing equivalent downside reversals in the moving average. The same method that \nworked so well in Figure 6.37 —buying on upturns in the moving average and selling on downturns \nin the moving average—proves to be a disastrous strategy in this market, yielding six losses and one \nessentially break-even trade. \n FIGURE  6.37 Moving-Average-Based Signals in Trending Market: Canadian Dollar \nContinuous Futures\n Notes: Buy (B) = 10-tick rise in moving average off its low . Sell (S) = 10-tick decline in \nmoving average off its high.\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n81TRENDS\n There are many other ways of calculating a moving average besides the simple moving average \ndescribed in this section. Some of these other methods, as well as the application of moving averages \nin trading systems, are discussed in Chapter 16 . \n FIGURE  6.38 Moving-Average-Based Signals in Sideways Market: Oat Continuous \nFutures\n Notes: Buy (B) = 10-tick rise in moving average off its low . Sell (S) = 10-tick decline in \nmoving average off its high.\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n83\nChapter 7\nTrading Ranges\nThere is the plain fool, who does the wrong thing at all times everywhere, but there is the Wall \nStreet fool, who thinks he must trade all the time.\n—Edwin Lefèvre\n ■ Trading Ranges: Trading Considerations\nA trading range is a horizontal corridor that contains price fluctuations for an extended period. Gen-\nerally speaking, markets tend to spend most of their time in trading ranges. Unfortunately, however, \ntrading ranges are very difficult to trade profitably. In fact, most technical traders will probably find \nthat the best strategy they can employ for trading ranges is to minimize their participation in such \nmarkets—a procedure that is easier said than done.\nAlthough there are methodologies that can be profitable in trading ranges, the problem is that \nthese same approaches are disastrous for trending markets, and while trading ranges are easily iden-\ntifiable for the past, they are nearly impossible to predict. Also, it should be noted that most chart \npatterns (e.g., flags, pennants) are relatively meaningless if they occur within a trading range. (Chart \npatterns are discussed in Chapter 9.)\nTrading ranges can often last for years. For example, the silver market remained in a trading range \nfor much of the 1990s (see Figure 7.1). Figures 7.2, 7.3, and 7.4 show a multiyear crude oil trading \nrange represented in c", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 26}
{"text": "ould be noted that most chart \npatterns (e.g., flags, pennants) are relatively meaningless if they occur within a trading range. (Chart \npatterns are discussed in Chapter 9.)\nTrading ranges can often last for years. For example, the silver market remained in a trading range \nfor much of the 1990s (see Figure 7.1). Figures 7.2, 7.3, and 7.4 show a multiyear crude oil trading \nrange represented in continuous futures, nearest futures, and the December 2014 contract. These \nthree charts illustrate that the trading range boundaries and periods will differ depending on whether \ndepicted as continuous futures, nearest futures, or an individual contract, although there will typi-\ncally be significant overlap between these alternative representations. Trading ranges also show up in \nshorter-term charts. Figure 7.5 shows an example on a 15-minute chart of euro futures.\n84A COMPLETE GUIDE TO THE FUTURES MARKET\n FIGURE  7.1 Multiyear Trading Range: Silver Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE  7.2 Multiyear Trading Range: Crude Oil Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n85TRADING RANGES\n FIGURE  7.3 Multiyear Trading Range: Crude Oil Nearest Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE  7.4 Multiyear Trading Range: December 2014 Crude Oil Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n86A COMPLETE GUIDE TO THE FUTURES MARKET\n FIGURE  7.5 Intraday Trading Range: December 2013 Euro Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n Once a trading range is established, the upper and lower boundaries tend to defi ne support\nand resistance areas. This topic is discussed in greater detail in the next chapter. Breakouts from \ntrading ranges can provide important trading signals—an observation that is the subject of the \nnext section. \n ■ Trading Range Breakouts \n A breakout from a trading range suggests an impending price move in the direction of the breakout. \nThe signifi cance and reliability of a breakout are often enhanced by the following three factors: \n 1. Duration of the trading range. The longer the duration of a trading range, the more poten-\ntially signifi cant the eventual breakout. This point is illustrated using a weekly chart example in \nFigure 7.6 and a daily chart example in Figure 7.7 . \n 2. Narrowness of range. Breakouts from narrow ranges tend to provide particularly reliable \ntrade signals (see Figures 7.8 , 7.9 , and 7.10 ). Furthermore, such trades can be especially attrac-\ntive since the meaningful stop point implies a relatively low dollar risk. \n 3. Confi rmation of breakout. It is rather common for prices to break out from a trading \nrange by only a small amount, or for only a few days, and then fall back into the range. One \nreason for this tendency is that stop orders are frequently clustered in the region beyond a \n87TRADING RANGES\n FIGURE  7.6 Downside Breakout from Extended Trading Range: W eekly \nHeating Oil Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE  7.7 Upside Breakout from Extended Trading Range: December 2010 Coff ee \nContinuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \ntrading range. Consequently, a move slightly beyond the range can sometimes trigger a string \nof stops. Once this initial fl urry of orders is fi lled, the breakout will fail unless there are solid \nfundamental reasons and underlying buying (or overhead selling in the case of a downside \nbreakout) to sustain the trend. \n88A COMPLETE GUIDE TO THE FUTURES MARKET\n FIGURE  7.8 Downside Breakout from Narrow Trading Range: Japanese Y en \n Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE  7.9 Downside Breakout from Narrow Trading Range: Australian Dollar \nContinuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n89TRADING RANGES In view of these behavioral considerations, the reliability of a breakout from a trading range as a \nsignal for an impending trend is signifi cantly improved if prices are still beyond the range after a num-\nber of days (e.g., fi ve). Other types of confi rmation can also be used—minimum percent penetration, \na given number of thrust days (discussed in Chapter 9 ), and so on. Although waiting for a confi rma-\ntion following breakouts will lead to worse fi lls on some valid signals, it will help avoid many “false” \nsignals. The net balance of this trade-off will depend on the confi rmation condition used and must be \nevaluated by the individual trader. The key point, however, is that the trader should experiment with \ndiff erent confi rmation conditions, rather than blindly follow all breakouts. \n FIGURE  7.10 Upside Breakout from Narrow Trading Range: U.S. Dollar Index \nContinuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n91\nChapter 8\nIn a narrow market, when prices are not getting anywhere to speak of but move in a narrow \nrange, there is no sense in trying to anticipate what the next big movement is going to be—up \nor down.\n—Edwin Lefèvre\n ■ Nearest Futures or Continuous Futures?\nFor any application of technical analysis in which the accurate representation of price moves is essen-\ntial, continuous futures, as opposed to nearest futures, are the only viable choice for depicting price \nseries that extend across multiple contracts. However, in the case of support and resistance, actual \npast price levels, which are accurately represented by only the nearest futures, are also important. \nThis consideration raises the question of which type of longer-term chart—nearest or continuous", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 27}
{"text": "continuous futures, as opposed to nearest futures, are the only viable choice for depicting price \nseries that extend across multiple contracts. However, in the case of support and resistance, actual \npast price levels, which are accurately represented by only the nearest futures, are also important. \nThis consideration raises the question of which type of longer-term chart—nearest or continuous \nfutures—should be used to determine support and resistance levels. There is no correct answer. \nInsofar as the accurate measurement of prior price moves is important in determining support and \nresistance, continuous futures charts should be used. Insofar as past actual price levels are important \nin determining support and resistance, nearest futures charts should be used. Essentially, strong \narguments can be made for using both types of charts for defining support and resistance levels. \nTraders need to experiment with whether they find nearest or continuous futures charts more useful \nin identifying support and resistance levels, or, for that matter, if they find consulting both of these \ncharts the most effective method.\nSupport and \nResistance\n92A COMPLETE GUIDE TO THE FUTURES MARKET\n ■ Trading Ranges \n Once a trading range is established (at least one to two months of sideways price movement on the \ndaily time frame), prices will tend to meet resistance at the upper end of the range and support at \nthe lower end of the range. Although chart analysis is best suited as a tool to signal trend-following \ntrades, some agile traders adopt a strategy of selling rallies and buying declines in a trading range \nsituation. Generally speaking, such a trading approach is diffi cult to pull off successfully. Further-\nmore, it should be emphasized that fading minor trends within a trading range can lead to disaster \nunless losses are limited (e.g., by liquidating the position if prices penetrate the range boundary by a \nspecifi ed minimum amount, or the market trades beyond the range for a minimum number of bars, \nor both). \n After prices break out from a trading range, the interpretation of support and resistance is turned \non its head. Specifi cally, once prices witness a sustained breakout above a trading range, the upper \nboundary of that range becomes a zone of price support. The extended lines in Figures 8.1 and 8.2 \nindicate the support levels implied by the upper boundaries of the prior trading ranges. In the case \nof a sustained breakout below a trading range, the lower boundary of that range becomes a zone of \nprice resistance. The extended lines in Figures 8.3 and 8.4 indicate the resistance levels implied by the \nlower boundaries of preceding trading ranges. \n FIGURE  8.1 Support Near T op of Prior Trading Range: Euro Stoxx 50 Continuous \nFutures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n93SUPPORT AND RESISTANCE\n FIGURE  8.2 Support Near T op of Prior Trading Range: British Pound Continuous \nFutures \nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved.\n FIGURE  8.3 Resistance Near Bottom of Prior Trading Range: Palladium Nearest \nFutures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n94A COMPLETE GUIDE TO THE FUTURES MARKET\n FIGURE  8.4 Resistance Near Bottom of Prior Trading Range: Platinum Continuous \nFutures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n ■ Prior Major Highs and Lows \n Normally, resistance will be encountered in the vicinity of previous major highs and support in the \nvicinity of major lows. Figures 8.5 , 8.6 , and 8.7 illustrate both behavioral patterns. For example, in \nFigure 8.5 the late 2003 low acted as a support level for subsequent lows in 2004, 2007, and 2008, \nwhile the 2005 high provided a resistance level for the 2009 highs. In Figure 8.6 the late 2009 and \nearly 2010 highs formed near the resistance level of the 2008 high, while the late 2011 low provided \nsupport for the 2012 and 2013 lows. Subsequently, the 2014 high functioned as resistance for the \n2015 highs, while the early 2016 low formed just above the support level of the early 2015 low . \nAlthough the concept of resistance near prior peaks and support near prior lows is perhaps most \nimportant for weekly or monthly charts, such as Figures 8.5 and 8.6 , the principle also applies to \ndaily charts, such as Figure 8.7 . In this chart, the June and August 2013 highs occurred near the March \n2013 peak. \n It should be emphasized that a prior high does not imply subsequent rallies will fail at or below\nthat point, but rather that resistance can be anticipated in the general vicinity of that point. Similarly, \na prior low does not imply that subsequent declines will hold at or above that point, but rather that \nsupport can be anticipated in the general vicinity of that point. Some practitioners of technical analysis \ntreat prior highs and lows as points endowed with sacrosanct signifi cance: If a prior high was 1,078, \nthen they consider 1,078 to be major resistance, and if, for example, the market rallies to 1,085, \nthey consider resistance to be broken. This is nonsense. Support and resistance should be considered \napproximate areas, not precise points. Note that although prior major highs and lows proved highly \n95SUPPORT AND RESISTANCE\n FIGURE  8.5 Resistance at Prior High and Support at Prior Low: Euro Bund Nearest \nFutures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE  8.6 Resistance at Prior Highs and Support at Prior Lows: Cocoa Nearest \nFutures \nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved.\n\n96A COMPLETE GUIDE TO THE FUTURES MARKET\nsignifi cant as resistance and support in all three of the preceding charts, reversals mostly occurred \nbefore price reached a given level or after penetrating it by a notable amount (although usually not \nclo", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 28}
{"text": "or Highs and Support at Prior Lows: Cocoa Nearest \nFutures \nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved.\n\n96A COMPLETE GUIDE TO THE FUTURES MARKET\nsignifi cant as resistance and support in all three of the preceding charts, reversals mostly occurred \nbefore price reached a given level or after penetrating it by a notable amount (although usually not \nclosing beyond it); reversals that occur very near the precise levels of prior highs or lows are the \nexception rather than the rule. \n The penetration of a previous high can be viewed as a buy signal, and the penetration of a \nprior low can be viewed as a sell signal. Similar to the case of breakouts from trading ranges, to \nbe viewed as trading signals penetrations of highs and lows should be signifi cant in terms of price \nmagnitude, time duration, or both. Thus, for example, as should be clear from the preceding dis-\ncussion regarding Figures 8.6 and 8.7 , a one-period (one-day for daily chart, one-week for weekly \nchart, etc.) penetration of a prior high or low would not prove anything. A stronger confi rmation \nthan a mere penetration of a prior high or low should be required before assuming such an event \nrepresents a buy or sell signal. Some examples of possible confi rmation conditions include a mini-\nmum number of closes beyond the prior high or low , a minimum percent price penetration, or \nboth requirements. \n Figures 8.8 and 8.9 illustrate examples of penetrations of previous highs as buy signals, assum-\ning a confi rmation condition of three closes above the high. Similarly, Figures 8.10 and 8.11 provide \nexamples of penetrations of previous lows as sell signals, using an analogous confi rmation condition. \nIn Figure 8.9 price turned lower in late 2012 a little above the resistance level of the early 2012 high. \nIn January 2014 the market posted its third weekly close above the late 2012 high (dashed line), \n triggering a buy signal. Incidentally, this chart also provides a good example of a prior low (formed in \n2013) holding as support more than two years later. \n Following a sustained penetration of a prior high or low , the interpretation of support and resis-\ntance is turned on its head. In other words, the area of a prior high becomes support and the area of \n FIGURE  8.7 Resistance at Prior High: Cotton Nearest Futures \nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved.\n Resistance at Prior High: Cotton Nearest Futures \n\n97SUPPORT AND RESISTANCE\n FIGURE  8.8 Penetration of Previous High as Buy Signal: Russell 2000 Mini Nearest \nFutures \nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved.\n Penetration of Previous High as Buy Signal: Russell 2000 Mini Nearest \n FIGURE  8.9 Penetration of Previous High as Buy Signal: Live Cattle Nearest Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \na previous low becomes resistance. For example, in Figure 8.12 the resistance level from Figure 8.9 \nsubsequently became support in April 2014 when the market pulled back temporarily before rallying \nto new highs. In Figure 8.13 , which extends the support line of Figure 8.10 , the September 2011 \n98A COMPLETE GUIDE TO THE FUTURES MARKET\n FIGURE  8.10 Penetration of Previous Low as Sell Signal: Silver Nearest Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE  8.11 Penetration of Previous Low as Sell Signal: Mexican Peso Nearest Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \nlow provides a support area for the December 2011 and June 2012 lows. When this support level \nis subsequently penetrated in April 2013, this same level then proves to be a resistance area for the \nJune–August 2013 rebound. Figure 8.14 shows a remarkably similar pattern unfolding on the daily \nsilver chart: The late June 2013 low provided support for subsequent lows between November 2013 \n99SUPPORT AND RESISTANCE\n FIGURE  8.12 Previous Resistance Becomes Support: Live Cattle Nearest Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n Previous Resistance Becomes Support: Live Cattle Nearest Futures\nand June 2014. This support level subsequently functioned as resistance in January and May 2015 \nafter the market rallied off its late 2014 lows. In Figure 8.15 , the support level that was penetrated \nto the downside in August 2015 functioned as resistance for the October 2015 rebound as well as the \nrally that peaked in March 2016. \n FIGURE  8.13 Previous Support Becomes Resistance: Silver Nearest Futures \nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved.\n Previous Support Becomes Resistance: Silver Nearest Futures \n\n100A COMPLETE GUIDE TO THE FUTURES MARKET\n FIGURE  8.15 Previous Support Becomes Resistance: Live Cattle Nearest Futures \nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved.\n FIGURE  8.14 Previous Support Becomes Resistance: Silver Nearest Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n101\nSUPPORT AND RESISTANCE\n ■ Concentrations of Relative Highs and Relative Lows \n The previous section dealt with support and resistance at prior major highs and lows—single peaks \nand nadirs. In this section we are concerned with support and resistance at price zones with concen-\ntrations of relative highs and relative lows rather than absolute tops and bottoms. Specifi cally, there \nis often a tendency for relative highs and relative lows to be concentrated in relatively narrow zones. \nThese zones imply support regions if current prices are higher and resistance areas if current prices \nare lower. This approach is particularly useful for anticipating support and resistance areas in long-\nterm nearest futures charts, which, as the reader wil", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 29}
{"text": "and bottoms. Specifi cally, there \nis often a tendency for relative highs and relative lows to be concentrated in relatively narrow zones. \nThese zones imply support regions if current prices are higher and resistance areas if current prices \nare lower. This approach is particularly useful for anticipating support and resistance areas in long-\nterm nearest futures charts, which, as the reader will recall, accurately refl ect past price levels (in \ncontrast to continuous futures, which accurately refl ect past price swings ). Figures 8.16 through 8.21 \nprovide weekly chart examples of support or resistance occurring at prior concentrations of relative \nlows and relative highs (or relative lows alone). In Figure 8.21 , a support zone initially defi ned by \nmultiple relative highs from 2007 to 2010 subsequently functions as a resistance zone in 2013–2014 \nafter the market sells off . \n The approach of using concentrations of prior relative highs and lows to defi ne support and resis-\ntance can also be applied to daily continuous or nearest futures charts of suffi cient duration—for \nexample, two years. (The life span of most individual futures contracts is too short for this method \nto be eff ectively applied on such charts.) Figures 8.22 through 8.24 provide daily chart examples of \nsupport and resistance occurring at prior concentrations of relative highs and relative lows. Figure \n 8.24 is similar to Figure 8.21 in that a support zone transforms into a resistance zone. \n FIGURE  8.16 Support Zone Defi ned by Concentration of Prior Relative Lows and \nHighs: Swiss Franc Nearest Futures\n Note: /uni2191 = relative low; /uni2193 = relative high. \nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved.\n Support Zone Defi ned by Concentration of Prior Relative Lows and \n\n102A COMPLETE GUIDE TO THE FUTURES MARKET\n FIGURE  8.17 Support Zone Defi ned by Concentration of Prior Relative Lows and \nHighs: Gasoline Nearest Futures\n Note: /uni2191 = relative low; /uni2193 = relative high.\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE  8.18 Support Zone Defi ned by Concentration of Prior Relative Highs and \nLows: Soybean Meal Nearest Futures\n Note: /uni2191 = relative low; /uni2193 = relative high.\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n103\nSUPPORT AND RESISTANCE\n FIGURE  8.19 Support Zone Defi ned by Concentration of Prior Relative Highs and \nLows: British Pound Nearest Futures\n Note: /uni2191 = relative low; /uni2193 = relative high.\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE  8.20 Support Zone Defi ned by Concentration of Prior Relative Lows: Copper \nNearest Futures\n Note: /uni2191 = relative low .\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n104A COMPLETE GUIDE TO THE FUTURES MARKET\n FIGURE  8.21 Support and Resistance Zones Defi ned by Concentration of Prior \nRelative Highs and Lows: Australian Dollar Nearest Futures\n Note: /uni2191 = relative low; /uni2193 = relative high.\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE  8.22 Support Zone Defi ned by Concentration of Prior Relative Lows and \nHighs: Cocoa Nearest Futures\n Note: /uni2191 = relative low; /uni2193 = relative high.\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n105\nSUPPORT AND RESISTANCE\n FIGURE  8.23 Resistance Zone Defi ned by Concentration of Prior Relative Highs and \nLows: Mexican Peso Nearest Futures\n Note: /uni2191 = relative low; /uni2193 = relative high.\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE  8.24 Support and Resistance Zones Defi ned by Concentration of Prior \nRelative Highs and Lows: Sugar Nearest Futures\n Note: /uni2191 = relative low; /uni2193 = relative high.\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n106A COMPLETE GUIDE TO THE FUTURES MARKET\n Although best suited to longer-term charts, the technique of using prior concentrations of relative \nhighs and lows as support and resistance zones can also be applied to shorter-term charts. Figure 8.25 \nprovides an intraday example: a support zone defi ned by a series of prior relative highs and lows on \na 30-minute chart. \n ■ Trend Lines, Channels, and Internal Trend Lines \n The concept that trend lines, channel lines, and internal trend lines indicate areas of potential support \nand resistance was detailed in Chapter 6 . Again, as previously discussed, based on personal experi-\nence, I believe that internal trend lines are more reliable in this regard than conventional trend lines. \nHowever, the question of which type of trend line is a better indicator is a highly subjective matter, \nand some readers may well reach the opposite conclusion. In fact, there is not even a mathematically \nprecise defi nition of a trend line or an internal trend line, and how these lines are drawn will vary \nfrom individual to individual. \n FIGURE  8.25 Support Zone Defi ned by Concentration of Prior Relative Highs and \nLows: Euro Continuous Futures\n Note: /uni2191 = relative low; /uni2193 = relative high.\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n107\nSUPPORT AND RESISTANCE\n ■ Price Envelope Bands \n A price envelope band can be derived from a moving average. The upper band of the price envelope \nis defi ned as the moving average plus a given percentage of the moving average. Similarly, the lower \nband of the price envelope is defi ned as the moving average minus a given percentage of the moving \naverage. For example, if the current moving average value is 600 and the percentage value is defi ned \nas 3 percent, the upper band value would be 618 and the lower band value would be 582. By selecting \nan appropriate percent boundary", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 30}
{"text": "a given percentage of the moving average. Similarly, the lower \nband of the price envelope is defi ned as the moving average minus a given percentage of the moving \naverage. For example, if the current moving average value is 600 and the percentage value is defi ned \nas 3 percent, the upper band value would be 618 and the lower band value would be 582. By selecting \nan appropriate percent boundary for a given moving average, a trader can defi ne an envelope band \nso that it encompasses most of the price activity, with the upper boundary approximately coinciding \nwith relative highs and the lower boundary approximately coinciding with relative lows. \n Figure 8.26 illustrates a price envelope band for the Australian dollar continuous futures using \na 20-day moving average and a 2.5 percent value. The price envelope provides a good indication of \nsupport and resistance for much of the period captured in the chart, especially when the market is \nmoving sideways (e.g., February–April 2015 and September 2015–January 2016). An alternative way \nof expressing the same concept is that the price envelope indicates “overbought” and “oversold” levels. \nPrice envelope bands can also be applied to data for other than daily time intervals. For example, \nFigure 8.27 illustrates a 1.25 percent price envelope band applied to 60-minute bars of the March \n2016 E-mini S&P 500 contract. \n FIGURE  8.26 Price Envelope Band as Indication of Support and Resistance in Daily \nBar Chart: Australian Dollar Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n108A COMPLETE GUIDE TO THE FUTURES MARKET\n FIGURE  8.27 Price Envelope Band as Indication of Support and Resistance on \n60-Minute Bar Chart: March 2016 E-Mini S&P 500 Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n It should be noted, however, that the price envelope is not as eff ective a tool as it might appear to \nbe. Although it provides a reasonably good indication of when the market may be nearing a turning \npoint, prices can continue to hug one end of the price envelope during extended trends. This pattern, \nfor example, is evident at the beginning of Figure 8.26 (November–December 2014), as well as the \nmiddle of the chart (July and August–September 2015). Thus, while it is true that price excursions \nbeyond the price envelope band tend to be limited and temporary, the fact that prices are near one of \nthe boundaries of the envelope does not necessarily mean that a price turning point is imminent. On \nbalance, the price envelope provides one means of gauging potential areas of support and resistance, \nbut it is also susceptible to multiple false signals. \n109\nNever confuse brilliance with a bull market.\n—Paul Rubink\n ■ One-Day Patterns\nSpikes\nA spike high is a day whose high is sharply above the highs of the preceding and succeeding days. \nFrequently, the closing price of a spike high day will be near the lower end of the day’s trading range. \nA spike high is meaningful only if it occurs after a price advance, in which case it can often signify \nat least a temporary climax in buying pressure, and hence can be viewed as a potential relative high. \nSometimes spike highs will prove to be major tops.\nGenerally speaking, the significance of a spike high will be enhanced by the following factors:\n 1. A wide difference between the spike high and the highs of the preceding and succeeding days.\n 2. A close near the low of the day’s range.\n 3. A substantial price advance preceding the spike’s formation.\nThe more extreme each of these conditions, the greater the likelihood that a spike high will prove to \nbe an important relative high or even a major top.\nIn analogous fashion, a spike low is a day whose low is sharply below the lows of the preceding and \nsucceeding days. Frequently, the closing price on a spike low day will be near the upper end of the \nday’s trading range. A spike low is meaningful only if it occurs after a price decline, in which case it \ncan often signify at least a temporary climax in selling pressure and hence can be viewed as a potential \nrelative low . Sometimes spike lows will prove to be a major bottom.\nChart Patterns\nChapter 9\n110A COMPLETE GUIDE TO THE FUTURES MARKET\n Generally speaking, the signifi cance of a spike low will be enhanced by these three factors: \n 1. A wide diff erence between the lows of the preceding and succeeding days and the spike low . \n 2. A close near the high of the day’s range. \n 3. A substantial price decline preceding the spike’s formation. \n The more extreme each of these conditions, the greater the likelihood that a spike low will prove to \nbe an important relative low or even a major bottom. \n Figures 9.1 through 9.4 contain several examples of spike highs and spike lows on daily and \nweekly charts. The massive spike high in Figure 9.3 marked a multiyear top in the Swiss franc futures. \nFigure 9.4 contains two examples of spike lows that marked swing bottoms. \n The preceding descriptions of spike highs and lows listed three essential characteristics that \ntypify such days. However, the defi nition of these conditions was somewhat imprecise. Specifi cally, \nhow great must the diff erence be between a day’s high (low) and the highs (lows) of the preceding \nand succeeding days in order for it to qualify as a spike high (low)? How close must the close be to \nthe low (high) for a day to be considered a spike high (low)? How large must a preceding advance \n(decline) be for a day to be viewed as a possible spike high (low)? The answer to these questions is \nthat there are no precise specifi cations; in each case, the choice of a qualifying condition is a subjec-\ntive one. However, Figures 9.1 through 9.4 should provide an intuitive sense of the types of days \nthat qualify as spikes. \n FIGURE  9.1 Spike High: Cotton Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 31}
{"text": "low)? The answer to these questions is \nthat there are no precise specifi cations; in each case, the choice of a qualifying condition is a subjec-\ntive one. However, Figures 9.1 through 9.4 should provide an intuitive sense of the types of days \nthat qualify as spikes. \n FIGURE  9.1 Spike High: Cotton Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n111\nCHART PATTERNS\n FIGURE  9.2 Spike High: Copper Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE  9.3 Spike High: Swiss Franc Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n112A COMPLETE GUIDE TO THE FUTURES MARKET\n It is possible, though, to construct a mathematically precise defi nition for spike days. An example \nof such a defi nition for a spike high might be a day that fulfi lled all three of the following conditions \n(the defi nition for a spike low day would be analogous): \n 1. H t − Max( H t −1 , H t +1 ) > k · ADTR 10 , \n where H t = high on given day \n H t −1 = high on preceding day \n H t +1 = high on succeeding day \n k = multiplicative factor that must be defi ned (e.g., k = 0.75) \n ADTR 10 = average daily true range during past 10 days 1 \n 2. H t − C t > 3 · ( C t − L t ), \n where C t = close on given day \nL t = low on given day \n 3. H t > maximum high during past N days, where N = constant that must be defi ned (e.g., N = 50) \n The first of the preceding conditions assures us that the spike high will exceed the surround-\ning highs by an amount at least equal to three-quarters of the past 10-day average true range \n(assuming the value of k is defined as 0.75). The second condition assures us that the spike day’s \nclose will be in the lower quartile of its range. The third condition, which requires that the spike \nday’s high exceed the highest high during the past 50 days (assuming N = 50), guarantees that \n FIGURE  9.4 Spike Lows: British Pound Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n 1 The true range is equal to the true high minus the true low . The true high is the maximum of the current day’s \nhigh and the previous day’s close. The true low is the minimum of the current day’s low and the previous day’s \nclose.\n113\nCHART PATTERNS\nthe day was preceded by an upswing. (Generally speaking, higher values of N will require larger \nprior advances.) \n The three-part definition just provided for a spike high day is only intended to offer an \nexample of how a mathematically precise definition can be constructed. Many other definitions \nare possible. \n reversal Days \n The standard defi nition of a reversal high day is a day that makes a new high in an upmove and then \nreverses to close below the preceding day’s close. Analogously, a reversal low day is a day that makes \na new low in a decline and then reverses to close above the preceding day’s close. The following dis-\ncussion focuses on reversal high days, but mirror-image comments would apply to reversal low days. \n Similar to spike highs, a reversal high day is generally interpreted as suggesting a buying climax and \nhence a relative high. However, the condition required for a reversal high day by the standard defi ni-\ntion is a relatively weak one, meaning that reversal high days are fairly common. Hence, while many \nmarket highs are reversal days, the problem is that the majority of reversal high days are not market \nhighs. Figure 9.5 , which illustrates this point, is fairly typical. It shows the fi nal leg of the crude oil \nmarket’s historic rally to its all-time high in July 2008 and its equally impressive sell-off in the follow-\ning months. Note that although a reversal high day occurred just a few days before the July top, it had \nbeen preceded by eight other reversal days since late February, only one of which (the seventh, in late \n FIGURE  9.5 Reversal Days: WTI Crude Oil Continuous Futures\n Note: R = reversal day.\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n114A COMPLETE GUIDE TO THE FUTURES MARKET\nMay) was followed by a downswing of any signifi cance. The reversal low days that occurred from late \nJuly to December paint a similar picture: Given crude oil futures fell another $20 before bottoming \nin February 2009 (not shown), even the fi nal signal in December 2008 was extremely premature. \nFigure 9.6 depicts another example of the commonplaceness of premature reversal day signals. In this \ncase, a reversal day actually occurred at the exact peak of a major rally dating back to the beginning of \n2009. This incredible sell signal, however, was preceded by eight other reversal days, the majority of \nwhich occurred far earlier in the advance. Anyone who might have traded this market based on rever-\nsal signals would probably have thrown in the towel well before the valid signal fi nally materialized. \n In the examples just provided, at least a reversal day signal occurred at or near the actual high. \nFrequently, however, an uptrend will witness a number of reversal highs that prove to be false signals \nand then fail to register a reversal high near the actual top. It can be said that reversal high days suc-\ncessfully call 100 out of every 10 highs. In other words, reversal days provide occasional excellent \nsignals, but far more frequent false signals. \n In my opinion, the standard defi nition of reversal days is so prone to generating false signals that \nit is worthless as a trading indicator. The problem with the standard defi nition is that merely requir-\ning a close below the prior day’s close is much too weak a condition. Instead, I suggest defi ning a \nreversal high day as a day that witnesses a new high in an upmove and then reverses to close below \nthe preceding day’s low . (If desired, the condition can be made even stronger by requiring that the \nclose be below", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 32}
{"text": "ading indicator. The problem with the standard defi nition is that merely requir-\ning a close below the prior day’s close is much too weak a condition. Instead, I suggest defi ning a \nreversal high day as a day that witnesses a new high in an upmove and then reverses to close below \nthe preceding day’s low . (If desired, the condition can be made even stronger by requiring that the \nclose be below the low of the prior two days.) This more restrictive defi nition will greatly reduce \nthe number of false reversal signals, but it will also knock out some valid signals. For example, this \n FIGURE  9.6 Reversal Days: Copper Continuous Futures\n Note: R = reversal day.\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n115\nCHART PATTERNS\nrevised defi nition would have eliminated all but the fourth signal in Figure 9.5 . In Figure 9.6 the \nmore restrictive defi nition for a reversal day would have avoided all but the fourth signal and the \nninth (fi nal and valid) signal. \n A reversal day may sound somewhat similar to a spike day, but the two patterns are not equiva-\nlent. A spike day will not necessarily be a reversal day, and a reversal day will not necessarily be a \nspike day. For example, a spike high day may not close below the previous day’s low (or even below \nthe previous day’s close, as specifi ed by the standard defi nition), even if the close is at the day’s low . \nAs an example of the reverse case, a reversal high day may not signifi cantly exceed the prior day’s \nhigh, as required by the spike high defi nition, or exceed the subsequent day’s high at all, since the \nsubsequent day’s price action is not part of the reversal day defi nition. Also, it is possible that a rever-\nsal day’s close may not be near the low , a standard characteristic of a spike day, even if it is below the \nprevious day’s close. \n Occasionally, a day will be both a reversal day and a spike day. Such days are far more signifi cant \nthan days that are only reversal days. An alternative to using the more restrictive defi nition for a \nreversal day is using the standard defi nition, but requiring that the day also fulfi ll spike day conditions. \n(Although a day that met both the strong reversal day condition and the spike day conditions would \nbe most meaningful of all, such days are fairly rare.) Figure 9.7 provides an example of a day that met \nboth spike and reversal low day conditions. Figure 9.8 highlights three days: a spike and reversal high \nday that marked the high of the rally, a spike and reversal low day several days later that was followed \nby a few days of sideways price action, and a spike and reversal low day that was followed by a correc-\ntion within the prevailing downtrend. \n FIGURE  9.7 Spike and Reversal Day: July 2008 Soybeans\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n116A COMPLETE GUIDE TO THE FUTURES MARKET\n thrust Days \n An upthrust day is a day with a close above the previous day’s high, while a downthrust day is a day \nwith a close below the previous day’s low . The signifi cance of thrust days is tied to the concept that the \nclose is by far the most important price of the day. A single thrust day is not particularly meaningful, \nsince thrust days are quite common. However, a series of upthrust days (not necessarily consecutive) \nwould refl ect pronounced strength. Similarly, a series of downthrust days would refl ect pronounced \nmarket weakness. \n During bull markets upthrust days signifi cantly outnumber downthrust days—see, for example, \nthe especially bullish mid-May to early July period in Figure 9.9 . Conversely, in bear markets down-\nthrust days signifi cantly outnumber upthrust days—see the July–September period in Figure 9.10 . \nAnd, as should come as no surprise, in sideways markets, upthrust and downthrust days tend to be in \nrough balance—for example, the March to mid-April period in Figure 9.9 and the October–November \nperiod in Figure 9.10 . \n run Days \n A run day is a strongly trending day. Essentially, a run day is a more powerful version of a thrust day \n(although it is possible for a run day to fail to meet the thrust day condition). Run days are defi ned \nas follows: \n FIGURE  9.8 Spike and Reversal Days: Mexican Peso Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n117\nCHART PATTERNS\n FIGURE  9.9 Upthrust and Downthrust Days in Bull Market: E-Mini S&P 500 \nContinuous Futures\n Note: /uni2191 = upthrust day; /uni2193 = downthrust day.\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE  9.10 Upthrust and Downthrust Days in Bear Market: December 2014 Euro \n Note: /uni2191 = upthrust day; /uni2193 = downthrust day.\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n118A COMPLETE GUIDE TO THE FUTURES MARKET\nUp run day. A day that meets the following two conditions: \n 1. The true high of the run day is greater than the maximum true high of the past \nN days (e.g., N = 5). \n 2. The true low on the run day is less than the minimum true low on the \nsubsequent N days. \nDown run day. A day that meets the following two conditions: \n 1. The true low of the run day is less than the minimum true low of the past N days.\n 2. The true high on the run day is greater than the maximum true high on the \nsubsequent N days. \n As can be seen by these defi nitions, run days cannot be defi ned until N days after their occurrence. \nAlso, note that although most run days are also thrust days, it is possible for the run day conditions to \nbe met on a day that is not a thrust day. For example, it is entirely possible for a day’s low to be lower \nthan the past fi ve-day low , its high to be higher than the subsequent fi ve-day high, and its close to be \nhigher than the previous day’s low . \n Figures 9.11 and 9.12 provide examples of run days (based on a defi nition of", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 33}
{"text": "e also thrust days, it is possible for the run day conditions to \nbe met on a day that is not a thrust day. For example, it is entirely possible for a day’s low to be lower \nthan the past fi ve-day low , its high to be higher than the subsequent fi ve-day high, and its close to be \nhigher than the previous day’s low . \n Figures 9.11 and 9.12 provide examples of run days (based on a defi nition of N = 5). As these charts \nshow , run days tend to occur when a market is in a trend run—hence the name. The materialization \nof up run days, particularly in clusters, can be viewed as evidence the market is in a bullish phase (see \nFigure 9.11 ). Similarly, a predominance of down run days provides evidence the market is in a bearish \nstate (see Figure 9.12 ). In Chapter 17 , we use the concept of run days to construct trading systems. \n FIGURE  9.11 Run Days in Bull Market: Euro Stoxx 50 Continuous Futures \nNote: /uni2191 up run day; /uni2193 down run day.\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved.\n\n119\nCHART PATTERNS\nNote: Although the basic premise of thrust days and run days would apply to longer time frames, \nit does not hold on intraday charts. The closing prices of intraday bars—especially on very short time \nframes, such as one or two minutes—do not carry the same weight as the closing prices of daily and \nweekly bars, which mark the end of signifi cant trading periods. \n Wide-ranging Days \n A wide-ranging day is a day whose volatility signifi cantly exceeds the average volatility of recent trad-\ning days. Wide-ranging days are defi ned as follows: \nWide-ranging day . A day the volatility ratio (VR) is greater than k (e.g., k = 2.0). The \nVR is equal to today’s true range divided by the average true range of the past N -day \nperiod (e.g., N = 15). \n Wide-ranging days can have special signifi cance. For example, a wide-ranging day with a \nstrong close that materializes after an extended decline often signals an upside trend reversal. \nSimilarly, a wide-ranging day with a weak close that occurs after an extended advance can signal a \ndownside reversal. In Figure 9.13 , strong-closing wide-ranging days marked the reversals of two \ndownswings in euro futures. (Note that although the back-to-back wide-ranging days in July did \nnot close in the upper reaches of their respective ranges, both closed near or above the previous \ndays’ highs.) Figure 9.14 features two sets of consecutive weak-closing wide-ranging days that \n FIGURE  9.12 Run Days in Bear Market: March 2015 Sugar\n Note: /uni2191 = up run day; /uni2193 = down run day.\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n120A COMPLETE GUIDE TO THE FUTURES MARKET\n FIGURE  9.13 Wide-Ranging Up Days: Euro Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE  9.14 Wide-Ranging Down Days: Silver Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \nended rallies in silver in dramatic fashion. The weekly chart inset shows these events marked the \neff ective end of the market’s longer-term uptrend, ushering in an extended period of sideways-\nto-lower price action. \n121\nCHART PATTERNS\n Figures 9.15 and 9.16 highlight days that satisfy the previously described example of wide-ranging \nday criteria: The true range of each wide-ranging day is greater than twice the average true range of \nthe preceding 15 days. In Figure 9.15 , the fi rst of these days, a weak-closing wide-ranging day in May \n2012 marked the defi nitive end of a WTI crude oil rally following the consolidation that had formed \nnear the market highs. The second downside wide-ranging day had no special signifi cance, as it formed \nafter a large decline had already occurred. The third (strong-closing) wide-ranging day signaled a \nmajor market reversal to the upside. \n In Figure 9.16 there are four wide-ranging days, the fi rst three of which were the start of major \ntrend reversals; the fourth failed to witness any follow-through price action. However, there is an \nimportant caveat: The “wide-ranging day” in early May, which signaled a reversal near the market \ntop, did not, in fact, strictly meet the wide-ranging day criteria based on the parameters we used as \nan example (2.0 multiple and 15 days)—its true range was only 1.94 times the size of the 15-day \naverage true range. Had we instead chosen a multiple of 1.9 instead of 2.0 to defi ne wide-ranging \ndays, this day would have represented a wide-ranging day without any qualifi cation. There is noth-\ning special about the parameter values of 2.0 and 15 days chosen in our example. Moderate shifts of \nthese values up or down would still preserve the spirit of the wide-ranging day, as was indeed the case \nwith the early May wide-ranging day, which had a larger-than-normal range with a very weak close \nfollowing a major uptrend. There is a trade-off in choosing the parameter value for the multiple: The \nlower the multiple chosen to defi ne wide-ranging days, the greater the probability of capturing valid \nwide-ranging day reversal signals, but the greater the chance of identifying wide-ranging days that are \nmeaningless. In this context, it may make sense for a trader to use more than one set of parameter \nvalues to defi ne wide-ranging days to be aware of days that just miss the selected defi nition. Of course, \ndays defi ned by higher multiples would carry greater weight. \n FIGURE  9.15 Wide-Ranging Up and Down Days: October 2012 WTI Crude Oil\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n122A COMPLETE GUIDE TO THE FUTURES MARKET\n FIGURE  9.16 Wide-Ranging Up and Down Days: September 2011 Coff ee\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved.` \n Figures 9.17 and 9.18 show instances of wide-ranging bars on diff erent timeframes. The wide-\nranging week", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 34}
{"text": "Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n122A COMPLETE GUIDE TO THE FUTURES MARKET\n FIGURE  9.16 Wide-Ranging Up and Down Days: September 2011 Coff ee\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved.` \n Figures 9.17 and 9.18 show instances of wide-ranging bars on diff erent timeframes. The wide-\nranging weeks in Figure 9.17 marked the beginning of an uptrend in Japanese yen futures that \nextended into early 2012, as shown in the monthly chart inset. In Figure 9.18 the weak-closing \nwide-ranging hourly bar reversed a seven-day advance. In Chapter 17 , we will use the concept of \nwide-ranging days as the primary element in constructing a sample trading system. \n ■ Continuation Patterns \nContinuation patterns are various types of congestion phases that materialize within long-term trends. \nAs the name implies, a continuation pattern is expected to be resolved by a price swing in the same \ndirection that preceded its formation. \n triangles \n There are three basic types of triangle patterns: symmetrical (see Figures 9.19 through 9.21 ), ascend-\ning (Figures 9.22 and 9.23 ), and descending (Figures 9.24 and 9.25 ). A symmetrical triangle is usually \nfollowed by a continuation of the trend that preceded it, as in Figures 9.19 through 9.21 . Conven-\ntional chart wisdom suggests that nonsymmetrical triangles will yield to a trend in the direction of \nthe slope of the hypotenuse, as is the case in Figures 9.22 through 9.25 . However, the direction of the \nbreakout from a triangle formation is more important than the type. For example, in Figure 9.26 , \nalthough the two congestion patterns are descending triangles—and the second is preceded by a price \ndecline—both break out to the upside and are followed by rallies. \n123\nCHART PATTERNS\n FIGURE  9.17 Wide-Ranging Up W eeks: Japanese Y en Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE  9.18 Wide-Ranging Down Bar: September 2015 E-Mini Nasdaq 100 Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n124A COMPLETE GUIDE TO THE FUTURES MARKET\n FIGURE  9.19 Symmetrical Triangle: Japanese Y en Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE  9.20 Symmetrical Triangle: March 2015 DAX\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n125\nCHART PATTERNS\n FIGURE  9.21 Symmetrical Triangle: Copper Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE  9.22 Ascending Triangle: Euro Stoxx 50 Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n126A COMPLETE GUIDE TO THE FUTURES MARKET\n FIGURE  9.24 Descending Triangle: Euro Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE  9.23 Ascending Triangle: Euro Continuous Futures\n Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved.\n127\nCHART PATTERNS\n FIGURE  9.26 Descending Triangles with Upside Breakouts: 10- Y ear T -Note \nContinuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE  9.25 Descending Triangle: September 2015 E-Mini Dow\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n128A COMPLETE GUIDE TO THE FUTURES MARKET\n Flags and pennants \n Flags and pennants are narrow-band, short-duration (e.g., one to three weeks) congestion phases \nwithin trends. The formation is called a fl ag when it is enclosed by parallel lines and a pennant when \nthe lines converge. Figures 9.27 through 9.31 illustrate both types of patterns. Figure 9.29 shows \nfl ags forming on a weekly chart, while Figure 9.30 shows fl ags and pennants on an intraday chart. \n Pennants may appear to be similar to triangles, but they diff er in terms of time: the triangle has a \nlonger duration. Similarly, the diff erence between a horizontal fl ag and a trading range is a matter of \nduration. Among the many fl ags and pennants in Figure 9.27 , for example, there are two congestion \npatterns (in August–September 2011 and January–February 2012) that could be classifi ed as either \nlong fl ags or pennants or short trading ranges or triangles. Regardless of which name these patterns \nare given, their implication is the same: fl ags and pennants typically represent pauses in a major trend. \nIn other words, these patterns are usually followed by price swings in the same direction as the price \nswings that preceded their formation. \n A breakout from a fl ag or pennant can be viewed as a confi rmation the trend is continuing and a \ntrading signal in the direction of the trend. Since breakouts are usually in the direction of the main \ntrend, however, I prefer to enter positions during the formation of the fl ag or pennant, anticipating \nthe probable direction of the breakout. This approach allows for more advantageous trade entries, \nwithout a signifi cant deterioration in the percentage of correct trades, since reversals following \nbreakouts from fl ags and pennants are about as common as breakouts in the counter-to-anticipated \ndirection. Following a breakout from a fl ag or pennant, the opposite extreme of the formation can be \nused as an approximate stop-loss point. \n FIGURE  9.27 Flags and Pennants: Natural Gas Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n129\nCHART PATTERNS\n FIGURE  9.28 Flags and Pennants: March 2015 Wheat\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE  9.29 Flags and Pennants: Soymeal Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n130A", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 35}
{"text": "eated using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n129\nCHART PATTERNS\n FIGURE  9.28 Flags and Pennants: March 2015 Wheat\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE  9.29 Flags and Pennants: Soymeal Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n130A COMPLETE GUIDE TO THE FUTURES MARKET\n FIGURE  9.30 Flags and Pennants: September E-Mini Nasdaq 100\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE  9.31 Flags and Pennants: Euro Schatz Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n131\nCHART PATTERNS\n A signifi cant penetration of a fl ag or pennant in the opposite-to-anticipated direction—that is, \ncounter to the main trend—can be viewed as a signal of a potential trend reversal. For example, in \nFigure 9.31 note that after a strong rally that included pennant breakouts in the direction of the main \ntrend, downside breakouts from the two fl ags that formed in June and August–September marked \nshort-term and longer-term highs. \n Flags and pennants typically point in the opposite direction of the main trend. This characteristic \nis exhibited by the majority of fl ags and pennants illustrated in Figures 9.27 through 9.31 . The direc-\ntion in which a fl ag or pennant points, however, is not an important consideration. In my experience, \nI have not found any signifi cant diff erence in reliability between fl ags and pennants that point in the \nsame direction as the main trend as opposed to the more usual opposite slope. \n Flags or pennants that form near the top or just above a trading range can be particularly potent \nbullish signals. In the case where a fl ag or pennant forms near the top of a trading range, it indicates \nthat the market is not backing off despite having reached a major resistance area—the top of the \nrange. Such price action has bullish implications and suggests that the market is gathering strength \nfor an eventual upside breakout. In the case where the fl ag or pennant forms above the trading range, \nit indicates that prices are holding above a breakout point, thereby lending strong confi rmation to \nthe breakout. Generally speaking, the more extended the trading range, the greater the potential \nsignifi cance of a fl ag or pennant that forms near or above its top. Figures 9.32 through 9.34 provide \nexamples of fl ags or pennants that materialized near the top or above trading ranges and proved to be \nprecursors of price advances. \n FIGURE  9.32 Flag Near T op of Trading Range as Bullish Signal: U.S. Dollar Index \nContinuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n132A COMPLETE GUIDE TO THE FUTURES MARKET\n FIGURE  9.33 Flag Above T op of Trading Range as Bullish Signal: Live Cattle \n Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE  9.34 Flag Near T op of Trading Range as Bullish Signal: June 2011 Heating Oil\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n133\nCHART PATTERNS\n For similar reasons, fl ags or pennants that form near the bottom or just below trading ranges are \nparticularly bearish patterns. Figures 9.35 through 9.37 provide examples of fl ags or pennants that \nmaterialized near the bottom or below trading ranges and proved to be harbingers of price declines. \n FIGURE  9.35 Flag Near Bottom of Trading Range as Bearish Signal: October 2015 \nWTI Crude Oil\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE  9.36 Flag Near Bottom of Trading Range as Bearish Signal: Japanese Y en \nContinuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n134A COMPLETE GUIDE TO THE FUTURES MARKET\n FIGURE  9.37 Flag Near Bottom of Trading Range as Bearish Signal: Copper Continuous \nFutures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n ■ Top and Bottom Formations \n V tops and Bottoms \n The “V” formation is a turn-on-a-dime type of top (see Figure 9.38 ) or bottom (see Figure 9.39 ). \nOne problem with a V top or bottom is that it is frequently diffi cult to distinguish from a sharp \ncorrection unless accompanied by other technical indicators (e.g., prominent spike, signifi cant \nreversal day, wide gap, wide-ranging day). The V top in Figure 9.38 did contain such a clue—a \nspike day—whereas the V bottom in Figure 9.39 was unaccompanied by any other evidence of a \ntrend reversal. \n Double tops and Bottoms \n Double tops and bottoms are exactly what their names imply. Of course, the two tops (or bottoms) \nthat make up the pattern need not be exactly the same, only in the same general price vicinity. Double \ntops and bottoms that materialize after large price moves should be viewed as strong indicators of a \nmajor trend reversal. Figure 9.40 illustrates a major double top in weekly Euro Bobl futures, while \nFigure 9.41 shows a double top on the daily chart for Canadian dollar futures. (Continuous futures \nare used for most of the charts illustrating double tops and bottoms because the liquid trading period \nfor most individual contracts is usually not long enough to display the time span encompassing these \n135\nCHART PATTERNS\npatterns and the preceding and succeeding trends.) Figure 9.42 shows a major double bottom in the \nE-mini Nasdaq 100 futures. Figure 9.43 depicts a double bottom on a two-minute chart: In this case \nthe pattern preceded an explosive upmove (nearly 1 percent in less than an hour) in the June 2015 \nMini Russell 2000 futures. \n FIGURE  9.38 “V” T op: Wheat Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE  9.39 “V” Bottom: Euro Stoxx 50 Continuou", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 36}
{"text": "00 futures. Figure 9.43 depicts a double bottom on a two-minute chart: In this case \nthe pattern preceded an explosive upmove (nearly 1 percent in less than an hour) in the June 2015 \nMini Russell 2000 futures. \n FIGURE  9.38 “V” T op: Wheat Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE  9.39 “V” Bottom: Euro Stoxx 50 Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n136A COMPLETE GUIDE TO THE FUTURES MARKET\n FIGURE  9.40 Double T op: Euro Bobl W eekly Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE  9.41 Double T op: Canadian Dollar Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n137\nCHART PATTERNS\n FIGURE  9.42 Double Bottom: E-Mini Nasdaq 100 Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE  9.43 Double Bottom: June 2015 Mini Russell 2000 Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n138A COMPLETE GUIDE TO THE FUTURES MARKET\n As illustrated in Figures 9.40 through 9.43 , a double top (bottom) is considered completed when \nprices move below (above) the reaction low (high) between the two tops (bottoms) of the forma-\ntion. When the intervening reaction is relatively deep, as for example in Figure 9.44 , it is impractical \nto wait for such an “offi cial” confi rmation, and a trader may have to anticipate that the pattern has \nformed based on other evidence. For example, in Figure 9.44 , the confi rmation of the double top \ndid not occur until the market had dropped nearly 20 percent from the May 2008 high (the second \npeak of the double top). However, the pennant pattern that formed after the initial downswing from \nthat high implied the next price swing would also be down. Based on this clue, a trader could have \nreasonably concluded a double top was in place, even though the pattern had not yet been completed \naccording to the standard defi nition. T op and bottom formations with more repetitions (e.g., triple \ntop or bottom) occur rather infrequently but would be interpreted in the same fashion. Figure 9.45 \nshows a triple top in weekly DAX futures. \n head and Shoulders \n The head-and-shoulders pattern is one of the best-known chart formations. The head-and-shoulders \ntop is a three-part formation in which the middle high is above the high points on either side (see \nFigure 9.46 ). Similarly, the head-and-shoulders bottom is a three-part formation in which the mid-\ndle low is below the low point on either side (see Figures 9.47 and 9.48 ). Perhaps one of the most \ncommon mistakes made by novice chartists is the premature anticipation of the head-and-shoulders \nformation. The head-and-shoulders pattern is not considered complete until the neckline—a line \n FIGURE  9.44 Double T op: Platinum Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n139\nCHART PATTERNS\n FIGURE  9.45 Triple T op: DAX Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE  9.46 Head-and-Shoulders T op: Sugar Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \nconnecting the reaction lows or highs separating the shoulders from the head—is penetrated, as \nillustrated in these charts. Furthermore, a valid head-and-shoulders pattern is formed only after a \nmajor price move has occurred. Patterns that bear the shape of a head-and-shoulders formation but \nlack this requirement can be misleading. \n140A COMPLETE GUIDE TO THE FUTURES MARKET\n FIGURE  9.47 Head-and-Shoulders Bottom: Euro Stoxx 50 Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE  9.48 Head-and-Shoulders Bottom: November 2012 Soybeans\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n141\nCHART PATTERNS\n Figure 9.48 is noteworthy in that the “head” of the head-and-shoulders bottom consists of twin \nlows that constitute a double bottom, a pattern that would have been confi rmed when price traded \nabove the early December high (short dashed line), as discussed in the previous section. The penetra-\ntion of the head-and-shoulders neckline occurred approximately six weeks later. \n Sometimes the distinction between a head-and-shoulders pattern and a triple top (or bottom) \npattern is not clear-cut. For example, Figure 9.49 shows a major long-term top in the U.S. Dol-\nlar Index futures in which the ultimate high has slightly lower highs on either side. This formation \ncould reasonably be categorized as either pattern—regardless, its implication as a top pattern is \nthe same. \n rounding tops and Bottoms \n Rounding tops and bottoms (also called saucers ) occur somewhat infrequently, but are among the most \nreliable top and bottom formations. Figure 9.50 shows a Nikkei 225 continuous futures chart with a \nrounding top that formed at the apex of a multiyear high and was followed by a sharp sell-off . Ideally, \nthe pattern would not contain any “jags,” as this chart does (e.g., the sharply lower low in late June); \nhowever, I consider the main criterion to be whether the outer perimeter conforms to a rounding \nshape. Figure 9.51 depicts a rounding top pattern that formed a major peak in soybean continuous \nfutures in 2014. Although the late-April to early-May price dip prevented a perfect rounding top \npattern, the outer boundary of the March–May price action conformed well to a rounding pattern. \n FIGURE  9.49 Head-and-Shoulders or Triple T op? Dollar Index Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n142A COMPLETE GUIDE TO THE FUTURES MARKET\n Figure 9.5", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 37}
{"text": "hough the late-April to early-May price dip prevented a perfect rounding top \npattern, the outer boundary of the March–May price action conformed well to a rounding pattern. \n FIGURE  9.49 Head-and-Shoulders or Triple T op? Dollar Index Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n142A COMPLETE GUIDE TO THE FUTURES MARKET\n Figure 9.52 provides a textbook instance of a rounding bottom pattern in lean hog continuous futures. \nNotice that in this example the price action during the bottoming process was relatively smooth and \nmostly free of the occasional jagged moves that were present in the previous examples. This rounding bot-\ntom was followed by an explosive upmove that began in mid-February 2014. Figure 9.53 shows a briefer \nrounding bottom in the Swiss franc that marked the transition from a downturn to an uptrend. \n FIGURE  9.50 Rounding T op: Nikkei 225 Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE  9.51 Rounding T op: Soybean Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n143\nCHART PATTERNS\n FIGURE  9.52 Rounding Bottom: Lean Hog Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE  9.53 Rounding Bottom: Swiss Franc Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n triangles \n Triangles, which are among the most common continuation patterns, can be top and bottom forma-\ntions as well. Figures 9.54 through 9.57 illustrate triangle tops and bottoms. As in the case of the \ncontinuation pattern, the key consideration is the direction of the breakout from the triangle. \n144A COMPLETE GUIDE TO THE FUTURES MARKET\n FIGURE  9.54 Triangle T op: Platinum Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE  9.55 Triangle T op: Orange Juice Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n145\nCHART PATTERNS\n FIGURE  9.56 Triangle Bottom: DAX Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE  9.57 Triangle Bottom: Copper Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n146A COMPLETE GUIDE TO THE FUTURES MARKET\n The tops in Figures 9.54 and 9.55 took the form of large descending triangles. The downside \nbreakouts out of both patterns were followed by energetic sell-off s. (Notice also in Figure 9.55 the \ntwo fl ags that formed during the March–May downtrend that followed the penetration of the tri-\nangle’s lower boundary. Each would have given traders who missed the initial breakout a chance to \ncapture at least some of the downmove.) Figure 9.56 shows a triangle bottom in DAX continuous \nfutures that was followed by a major uptrend. The symmetrical triangle bottom that formed on the \ndaily copper chart in 2010 (Figure 9.57 ) is shown in the weekly inset to be part of a correction in the \nmarket’s longer-term uptrend. \n Major tops and bottoms may often be consistent with more than one type of pattern. For example, \na case could have been made for defi ning the preceding triangular tops and bottoms as head-and-\nshoulders formations with, generally speaking, similar pattern confi rmation points. \n W edge \n In a rising wedge, prices edge steadily higher in a converging pattern (see Figure 9.58 ). In instances \nwhen the successive highs form in a relative tight band, as they do here, the inability of prices to \naccelerate on the upside, despite continued probes into new high ground, suggests the existence \nof strong scale-up selling pressure. A sell signal occurs when prices break below the lower wedge \nline. Figure 9.59 provides an example of a declining wedge. W edge patterns can sometimes take an \nextremely long time to complete. The wedge in Figure 9.59 formed over the course of a year, and \neven longer-term wedges have been known to occur. \n FIGURE  9.58 Rising W edge: Euro Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n147\nCHART PATTERNS\n FIGURE  9.59 Declining W edge: Sugar Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n Spikes and reversal Days \n These one-day patterns, which often mark relative highs and relative lows, and sometimes major \npeaks and bottoms, were discussed in an earlier section of this chapter. \n\n149\nI always laugh at people who say, “I’ve never met a rich technician. ” I love that! It is such an \narrogant, nonsensical response. I used fundamentals for nine years and got rich as a technician.\n—Marty Schwartz\nM\nost traders who have never used chart analysis (and even some who have) are quite skeptical \nabout this approach. Some of the commonly raised objections include: “How can such a simple \nanalytical approach work?” “Since key chart points are hardly a secret, won’t large professional traders \nsometimes push the market enough to trigger chart stops artificially?” “Even if chart analysis worked \nbefore it was detailed in scores of websites, books, and magazines, isn’t the method too well publi-\ncized to still be effective?”\nAlthough the points raised by these questions are basically valid, a number of factors explain why \nchart analysis remains an effective trading approach:\n 1. Trading success does not depend on being right more than half the time—or, for that matter, \neven half the time—as long as losses are rigidly controlled and profitable trades are permitted \nto run their course. For example, consider a trader who in March 1991 assumed that September \n1992 eurodollars had entered another trading range (see Figure 10.1) and decided to trade in the \ndirection of any subsequent closin", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 38}
{"text": "does not depend on being right more than half the time—or, for that matter, \neven half the time—as long as losses are rigidly controlled and profitable trades are permitted \nto run their course. For example, consider a trader who in March 1991 assumed that September \n1992 eurodollars had entered another trading range (see Figure 10.1) and decided to trade in the \ndirection of any subsequent closing breakout. Figure 10.2 shows the initial trade signals and liqui-\ndation points that would have been realized as a result of this strategy. The implicit assumption is \nthat stops are placed at the midpoint of the trading range. (The relevant considerations in choos-\ning a stop point are discussed in detail in Chapter 13.) As can be seen in Figure 10.2, the first two \ntrades would have resulted in immediate losses. Figure 10.3, however, shows the third signal was \nthe real thing—a long position that would have occurred in time to benefit from a major price \nadvance that far exceeded the combined price swings on the prior two adverse trades. (Note the \nrelevant trading range is redefined— that is, widened—after each of the false breakouts.)\nIs Chart Analysis \nStill Valid?\nChapter 10\n150A COMPLETE GUIDE TO THE FUTURES MARKET\n It is noteworthy that although two out of three trades were losers, on balance the trader \nwould have realized a large net profi t. The key point is that a disciplined adherence to money \nmanagement principles is an essential ingredient in the successful application of chart analysis. \n 2. Chart analysis can be made much more eff ective by requiring confi rmation conditions for trade \nentry, rather than blindly following all technical signals. There is a natural trade-off in the choice \nof confi rmation rules: the less restrictive the conditions, the greater the number of false signals; \nthe more restrictive the conditions, the greater the potential surrendered profi t due to late \nentry. Some of the key methods that can be used to construct confi rmation conditions might \ninclude the following: time delays, minimum percent penetration, and specifi c chart patterns \n(e.g., the trade must be confi rmed by two subsequent thrust days in the direction of the signal). \n There is no such thing as a best set of confi rmation conditions. In any list of tested alterna-\ntives, the indicated best strategy will vary from market to market as well as over time. Thus, \nthe ultimate choice of confi rmation rules will depend on the trader’s analysis and experience. \nIn fact, the specifi c choice of confi rmation conditions is one of the pivotal ways in which chart \nanalysis is individualized. \n As an illustration of how confi rmation conditions might be used, consider the following set \nof rules: \n a. Wait three days after signal is received. \n b. For a buy signal, enter trade if the close is above the high since signal was received, or on \nthe fi rst subsequent day fulfi lling this condition. An analogous condition would apply to \nsell signals. \n FIGURE /uni00A010.1 Trading Range Market: September 1992 Eurodollar\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n151\nIS CHART ANALYSIS STILL VALID?\nAs can be seen in Figure 10.2 , these rules would have fi ltered out the losing March and May \nsignals while only modestly delaying the entry point for the subsequent highly profi table buy \nsignal. Of course, one could also construct examples in which the use of confi rmation condi-\ntions is detrimental to the trading results. However, the key point is that the use of confi rmation \nrules is one of the primary means of transforming classical chart concepts into a more powerful \ntrading approach. \n 3. Chart analysis is more than just the recognition and interpretation of individual patterns. One \nof the earmarks of the successful chart trader is an ability to synthesize the various components \nof the overall picture. For example, the trader who recognizes just a trading range in September \n1992 Eurodollars (see Figure 10.1 ) would treat upside and downside breakouts equivalently. \nHowever, the more experienced chartist will also consider the broader picture. For example, \nby examining the long-term weekly continuous futures chart in early 1991 (see Figure 10.4 ), \nthe analyst could have noted that the market had just formed a fl ag pattern near the top of a \nfi ve-year trading range. This extremely bullish long-term chart picture would have strongly cau-\ntioned against accepting any apparent sell signals on the daily chart. Such a more comprehensive \nchart analysis could therefore have helped the analyst avert the false sell signal in March (see \nFigure 10.2 ) and adopt a much more aggressive trading stance from the long side than would \nhave been warranted if the situation were viewed as just another trading range. \n Figures 10.5 and 10.6 illustrate a similar example in June 2012 natural gas futures. In ear-\nly 2011 a trader who decided to trade in the direction of a breakout of the October 2010–\nJanuary 2011 trading range (again, assuming a stop point in the middle of the range) would have \n FIGURE /uni00A010.2 False Breakout Signals: September 1992 Eurodollar\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n152A COMPLETE GUIDE TO THE FUTURES MARKET\n FIGURE /uni00A010.3 Winning Breakout Signal after Two False Signals: September 1992 Eurodollar\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE /uni00A010.4 Long- T erm Chart as Part of Comprehensive Analysis: Eurodollar Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n153\nIS CHART ANALYSIS STILL VALID?\nexperienced fi ve losing trades (three buys and two sells) before the August 2011 sell signal that \nwas followed by an extended downmove. The context provided by the weekly chart (Figure 10.6 ), \nhowever, suggests a trader who was aware of the longer-term downtre", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 39}
{"text": "us Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n153\nIS CHART ANALYSIS STILL VALID?\nexperienced fi ve losing trades (three buys and two sells) before the August 2011 sell signal that \nwas followed by an extended downmove. The context provided by the weekly chart (Figure 10.6 ), \nhowever, suggests a trader who was aware of the longer-term downtrend that preceded the \nconsolidation could have reasonably chosen to ignore upside breakouts and focus exclusively on \ndownside breakouts in expectation of a continuation of that trend. \n Of course, the preceding examples benefi t from hindsight. However, the point is not to \nprove the application of chart analysis would have conclusively indicated the probable continua-\ntion of a long-term bull market in eurodollar futures in early 1991 or the likely perpetuation of \nthe extended downtrend in natural gas futures in 2011, but rather to illustrate the multifaceted \nanalytical process of the experienced chart trader. It should be clear that the skill and subjectiv-\nity implied in this approach place chart analysis in the realm of an art that cannot be mimicked \nby merely following a set of textbook rules. This is a crucial point in understanding how the \nchartist approach can remain valid despite widespread publicity. \n 4. Assuming some skill in fundamental forecasting (i.e., a better than 50/50 accuracy rate), chart \nanalysis can be combined with fundamental projections to provide a more eff ective approach. Spe-\ncifi cally, if the long-term fundamental forecast indicates the probability of much higher (lower) \nprices, only bullish (bearish) chart signals would be accepted. If the fundamental projection \nwas neutral, both buy and sell signals would be accepted. Thus, the chart analyst who is also a \ncompetent fundamental analyst would have a decided edge over the majority of traders basing \ntheir trading decisions solely on chart-oriented input. \n FIGURE /uni00A010.5 False and Winning Breakout Signals: June 2012 Natural Gas Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n154A COMPLETE GUIDE TO THE FUTURES MARKET\n 5. The failure of a market to follow through in the direction of a key chart signal is a crucial item \nof information often overlooked by novice chartists. Recognizing and acting on these situations \ncan greatly enhance the eff ectiveness of the chartist approach. This subject is discussed in detail \nin Chapter 15 . \n In conclusion, the skeptics are probably correct in claiming that a Pavlovian response to chart sig-\nnals will not lead to trading success. However, this assertion in no way contradicts the contention that \na more sophisticated utilization of charts, as suggested by the cited factors, can indeed provide the \ncore of an eff ective trading plan. In any case, chart analysis remains a highly individualistic approach, \nwith success or failure critically dependent on the trader’s skill and experience. It would be unreason-\nable to expect to play the violin well without some degree of practice and innate talent. Chart analysis \nis no diff erent—the sour notes of novice practitioners notwithstanding. \n FIGURE /uni00A010.6 Long- T erm Chart as Part of Comprehensive Analysis: June 2012 W eekly Natural \nGas Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n155\nAny intelligent fool can make things bigger, more complex, and more violent. It takes a \ntouch of genius—and a lot of courage to move in the opposite direction.\n— Ernst F. Schumacher\n ■ What Is an Indicator?\nT echnical indicators are mathematical formulas based on market data—most often prices, but also \noccasionally volume and open interest. (In the equity market, other data, such as the number of \nadvancing or declining issues, are sometimes incorporated in these calculations.) The implicit goal of \nmost technical indicators is to signal potential changes in market direction that might not be apparent \nthrough direct price analysis or fundamental analysis. The implicit assumption underlying this approach \nis that indicators extract or distill useful forecasting information from market data.\nMost indicators attempt to translate price action into directional signals in one of two ways:\n 1. Comparing current price levels to past price levels to determine the prevailing direction and \nmagnitude of price change.\n 2. Using a smoothing function, such as a moving average, to filter out what are deemed to be ran-\ndom fluctuations (“noise”), thus revealing a market’s prevailing trend.\nThere are any number of ways to accomplish either of these goals, or to combine them. Consider \nthe simple case of comparing today’s closing price with the most recent 20 days of price action to \ndetermine how much price has changed and whether the close is relatively strong or weak. The fol-\nlowing are only some of the possible approaches:\n 1. Calculate the difference between the current close and the close 20 days ago.\n 2. Calculate the percentage change (ratio) of the current close and the close 20 days ago.\nT echnical Indicators\nChapter 11\n156\nA Complete Guide to the Futures mArket\n 3. Determine the current closing price’s position within the 20-day high-low range, or its position \nwithin the range of the highest and lowest closing prices of the past 20 days.\n 4. Measure how much the current closing price varies from the “typical” price of the past 20 days \nby comparing it (as either a difference or a ratio) to the average (or median) of the other closing \nprices during this period.\n 5. Alternatively, a shorter-term moving average (or median) value could be substituted for the \nclosing price in the previous calculation, in which case the indicator would become the differ-\nence between (or ratio of), say, a 3-day moving average and the 20-day moving average.\n 6. Use a statistical measurement, such as percentile rank, to determine where the current close \npla", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 40}
{"text": "uring this period.\n 5. Alternatively, a shorter-term moving average (or median) value could be substituted for the \nclosing price in the previous calculation, in which case the indicator would become the differ-\nence between (or ratio of), say, a 3-day moving average and the 20-day moving average.\n 6. Use a statistical measurement, such as percentile rank, to determine where the current close \nplaces among the 20 most recent closes, or within the 20-day range.\n 7. Rather than using the most recent closing price as the reference point, the direction and pace of \nprice changes over the past 20 days could alternatively be measured by comparing the period’s \naggregate (or average) gains to its aggregate (or average) losses. One example: Divide the sum \n(or average) of the positive close-to-close changes over the past 20 days by the sum (or average) \nof the absolute negative close-to-close changes over the past 20 days.\nAll these calculations provide some gauge of how far, and in what direction, a market has moved \nover the past 20 days. Moreover, any of the foregoing indicators could be based on values other than \n20, expanding the list of possible indicators by another dimension. If this list of possible indicators \nseems excessive (or redundant), peruse any trading website, app, or analysis platform, and you are \nlikely to be confronted by dozens—sometimes in excess of 100—technical indicators, all purport-\nedly designed to help interpret and forecast market activity. Grappling with the sheer number of \nindicators, and their often cryptic formulas and names, can be a daunting prospect for the new trader \nor analyst, who might understandably assume each of these tools has unique properties and specific \npurposes.\nThe truth, however, is that despite the wide array of indicators and the properties ascribed to \nthem by various proponents and followers, the majority of these tools are based on a handful of basic \nmathematical formulas. In fact, variations and combinations of the previously listed seven calculations \nprovide the basis for a surprisingly large percentage of the most widely referenced technical tools. \nOne critical consequence of this observation is that there is a high degree of correlation among tech-\nnical indicators, even if they might seem to be unrelated at a glance.\nRather than risking a descent down the rabbit hole of comparing the supposed applications and \nidiosyncrasies of dozens of technical indicators, the following discussion instead focuses on the basic \ntypes of calculations underlying these indicators and what they can and cannot convey about market \nbehavior. The goal is to provide the reader with a logical foundation for objectively interpreting and \nanalyzing technical indicators. In short, readers looking for answers to questions such as “What’s \nthe best technical indicator?” or “What are the best settings for indicator xyz?” or “Which indicators \nare best for trading currency (or grain, or stock index) futures?” should look elsewhere. These are, \nin fact, meaningless questions because they presuppose a degree of differentiation among indicators \nthat does not exist and assume a stability in the performance of individual indicators that is unsup-\nported by empirical evidence.\n157\nTEChnICAl InDICATORS\n ■ The Basic Indicator Calculations\nMost technical indicators incorporate one or more of the following five calculations:\n 1. A smoothing function, such as a moving average or moving median.\n 2. A comparison of the current data point to a specific past data point, as either a difference (e.g., \ntoday’s close minus the close 10 days ago) or a ratio (today’s close divided by the close 10 days ago).\n 3. A comparison of the current data point to an average (e.g., today’s close minus the average close \nof the past 10 days).\n 4. A comparison of an average to another average of a different length (e.g., the 10-day moving \naverage minus the 30-day moving average).\n 5. A comparison of the current data point to a past range (e.g., the difference between today’s \nclose and the lowest low of the past 10 days divided by the difference between the highest high \nof the past 10 days and the lowest low of the past 10 days).\nBeyond the number of price bars used (the “look-back period”), these calculations allow for a great \ndeal of variation without altering the basic characteristics of the indicator. For example, a smoothing \nfunction could take the form of a simple moving average, a weighted moving average, an exponen-\ntial moving average, or an “adaptive average” that adjusts its length according to changes in market \nvolatility. Moreover, any of these averages could be based on a bar’s closing price, high, low , open, or \nmidpoint.\n ■ Comparing Indicators\nFigures 11.1 through 11.5 illustrate the five types of indicator calculations defined in the previous sec-\ntion and highlight the relationships between them. For reference, we’ll use the following shorthand \nto identify these formulas:\nIndicator 1: M\na (moving average).\nIndicator 2: Close – Close (difference) or Close/Close (ratio).\nIndicator 3: Close – M\na (difference between close and moving average) or Close/Ma (ratio \nof close and moving average).\nIndicator 4: Ma – Ma (difference between two moving averages) or Ma/Ma (ratio of two \nmoving averages).\nIndicator 5: CS (closing strength).\nIn all cases, subscripts are used to denote the look-back period—for example, “MA 30” refers to a \n30-bar moving average, “Close – Close10” refers to the difference between the current close and the \nclose 10 bars ago, and so on.\nIn Figure 11.1, a daily price chart of WTI crude oil from August 2015 to May 2016 is overlaid with \n10- and 30-day simple moving averages (thin and thick lines, respectively). The lower portion of the \nchart contains two indicators. The first is the difference between the most recent close and the close \n158A COMPlETE GUIDE TO ThE FUTURES MARKET\n10 days earlier (Close – Close 10 ), while the second is the diff erenc", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 41}
{"text": "aily price chart of WTI crude oil from August 2015 to May 2016 is overlaid with \n10- and 30-day simple moving averages (thin and thick lines, respectively). The lower portion of the \nchart contains two indicators. The first is the difference between the most recent close and the close \n158A COMPlETE GUIDE TO ThE FUTURES MARKET\n10 days earlier (Close – Close 10 ), while the second is the diff erence between the close and the 10-day \nmoving average (Close – MA 10 ). Both calculations provide a snapshot of the price movement over the \nmost recent 10 days—how much price has moved relative to each indicator’s respective reference \nprice. For the fi rst indicator, positive values occur when the current close is above the close 10 days \nago; negative values occur when the current close is below the close 10 days ago. For the second indica-\ntor, positive or negative values refl ect closing prices above or below the 10-day average price. notice \nthat although the two indicators have minor diff erences, their fl uctuations closely mirror each other. \n The indicators in Figure 11.2 are the ratio versions of the indicators in Figure 11.1 —that is, the \nresult of dividing the current close by the close 10 days ago (Close/Close \n10 ), and dividing the cur-\nrent close by the 10-day moving average (Close/MA 10 ). note that they appear to be the same as the \nindicators in Figure 11.1 except for their scaling. In fact, the indicators in Figure 11.2 are perfectly \ncorrelated to their counterparts in Figure 11.1 . In other words, in terms of trading signal generation, \nthere is absolutely no diff erence between the two sets of indicators. \n Figure 11.3 returns to the diff erence calculations used in Figure 11.1 , except the look-back \nperiod for both is 30 days instead of 10 days. Again, the indicators appear very similar, although \neach is signifi cantly diff erent from its counterpart in Figure 11.1 because of the longer look-back \nperiod: The 30-day indicators in Figure 11.3 highlight far fewer of the shorter-term price highs and \nlows and instead trace the contour of the intermediate-term price action. For example, during the \n FIGURE  11.1 Diff erence Indicators: Close – Close vs. Close – MA\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n159\nTEChnICAl InDICATORS\n FIGURE  11.2 Ratio V ersions of Diff erence Indicators\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE  11.3 30-Day V ersions of Close – Close and Close – MA Indicators\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n160A COMPlETE GUIDE TO ThE FUTURES MARKET\nOctober–December 2015 period, both indicators are smoother and have a more pronounced down-\nward bias than their 10-day counterparts in Figure 11.1 . \n Figure 11.4 compares the Close – MA 30 indicator from Figure 11.3 with the MA 10 – MA 30 indica-\ntor, which represents the diff erence between the 10-day moving average and 30-day moving average. \nThe use of two moving averages produces an indicator that is closely related to the Close − MA \nindicator, but is smoother and a bit less timely (e.g., note the delay between the MA \n10 – MA 30 and the \nClose – MA 30 indicator in refl ecting the early-April price low). \n Finally, Figure 11.5 compares the Close/Close 10 indicator from Figure 11.2 with the CS 10 indicator, \nwhich shows where the current close falls within the range (high–low) of the most recent 10 days (e.g., \nif the close is the highest price of the most recent 10 days, the indicator reading is 1.00, or 100 percent). \n The similarities between the indicators in Figures 11.1 through 11.5 are substantial and not specifi c to \nthe time window represented in these charts. Table 11.1 shows the correlation coeffi cients \n1 for all six pair \ncombinations of the four 10-day indicator calculations (Close – Close, Close – MA, CS, and MA – MA 2 ) \n FIGURE  11.4 Price – MA vs. MA – MA Indicators\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n 1 The correlation coeffi cient, which measures the linear relationship between two data samples, ranges from \n–1.00 to +1.00, with –1.00 representing a perfect negative correlation (values moving in exact opposition) and \n+1.00 representing perfect positive correlation (values moving exactly in tandem).\n 2 The MA – MA calculations in Table 11.1 use three days for the short-term moving average and 10 days for the \nlong-term moving average.\n161\nTEChnICAl InDICATORS\n FIGURE  11.5 Close/Close vs. Closing Strength Indicators\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n table 11.1 10-Day Indicator Correlations, Crude Oil \nClose – Close vs.\nClose – Ma\nClose – Close vs.\nMa – Ma\nClose – Close \nvs. CS\nClose – Ma vs.\nMa – Ma\nClose – Ma \nvs. CS\nMa – Ma \nvs. CS\n aug. 2015–\nMay 2016 \n0.81 0.83 0.81 0.89 0.93 0.83\n May 2005–\nMay 2016 \n0.84 0.86 0.77 0.90 0.87 0.78\n during two periods: August 14, 2015 through May 5, 2016 (the period shown in Figures 11.1 through \n 11.5 ); and a much longer period, May 5, 2005 through May 5, 2016. The lowest correlation between \nany two indicators during the August 2015–May 2016 period was 0.81. The correlations for the 2005–\n2016 period were similar, with some pairs registering modestly higher correlations and other pairs \nmodestly lower correlations. Even the lowest fi gure in Table 11.1 (0.77, for the May 2005–May 2016 \nClose – Close vs. CS indicator comparison) refl ects a signifi cant level of positive correlation. \n162\nA Complete Guide to the Futures mArket\nTable 11.2 extends the same analysis to three additional markets—corn, E-mini S&P 500, and \neuro futures—and from 6 to 10 indicator-pair combinations, based on adding a sixth calculation: the \nUp/Down Average (“U/D Avg.”), which is defined as the average positive close-to-close change over \nthe past N days divided by the average (absolute) negative close-to-close", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 42}
{"text": "plete Guide to the Futures mArket\nTable 11.2 extends the same analysis to three additional markets—corn, E-mini S&P 500, and \neuro futures—and from 6 to 10 indicator-pair combinations, based on adding a sixth calculation: the \nUp/Down Average (“U/D Avg.”), which is defined as the average positive close-to-close change over \nthe past N days divided by the average (absolute) negative close-to-close change over the past N days, \nnormalized so that it fluctuates in a range from zero to 1.00.\n3 Table 11.2 also differs from Table 11.1 \nin that it is based on 20-day look-back periods (instead of 10), except for the MA – MA indicator, \nwhich uses a short-term moving average length of 10 days and a long-term moving average length \nof 30 days.\nAlthough Table 11.2 contains some readings well below the lowest correlation figure in Table 11.1 \n(mostly for pairs involving the Up/Down Average indicator), the average and median correlations \nfor the ten indicator combinations shown are still uniformly strong, ranging from a low of 0.54 \nto a high of 0.87. Table 11.3, which replicates the analysis of Table 11.2 using 60-day look-back \nperiods instead of 20 (and 20-day and 60-day moving average lengths for the MA – MA indicator), \ndemonstrates very similar results, with the average/median correlations ranging from a low of 0.49 \nto a high of 0.90.\nThe significance of the similarity between the indicator formulas discussed thus far is that they \nare the building blocks of a host of popular indicators, especially those known as momentum \nindicators, or “oscillators.” \n This group includes, but is by no means limited to, momentum, rate-\nof-change (ROC), the stochastic oscillator, the relative strength index (RSI), %R, moving average \ntable 11.2 20-Day Indicator Correlations\nClose \n– Close \nvs. Close \n– Ma\nClose \n– Close \nvs. Ma \n– Ma\nClose \n– Close \nvs. CS\nClose \n– Close \nvs. U/D \navg.\nClose – Ma \nvs. Ma \n– Ma\nClose \n– Ma \nvs. CS\nClose \n– Ma \nvs. U/D \navg.\nMa \n– Ma \nvs. CS\nMa \n– Ma \nvs. U/D \navg.\nCS vs. \nU/D \navg.\nCrude oil Aug. ’15–May ’16 0.84 0.81 0.84 0.88 0.72 0.95 0.72 0.68 0.69 0.72\nMay ’05–May ’16 0.88 0.88 0.79 0.57 0.80 0.87 0.52 0.69 0.51 0.53\nCorn Aug. ’15–May ’16 0.77 0.84 0.71 0.33 0.53 0.91 0.15 0.45 0.34 0.19\nMay ’05–May ’16 0.86 0.90 0.71 0.59 0.69 0.80 0.52 0.55 0.53 0.51\nS&p 500 Aug. ’15–May ’16 0.90 0.84 0.81 0.81 0.71 0.68 0.79 0.90 0.64 0.66\nMay ’05–May ’16 0.88 0.84 0.74 0.51 0.67 0.57 0.44 0.86 0.43 0.48\neuro Aug. ’15–May ’16 0.80 0.86 0.77 0.77 0.58 0.90 0.74 0.55 0.61 0.75\nMay ’05–May ’16 0.86 0.90 0.76 0.65 0.70 0.87 0.59 0.61 0.57 0.62\naverage: 0.85 0.86 0.77 0.64 0.68 0.82 0.56 0.66 0.54 0.56\nMedian: 0.86 0.85 0.77 0.62 0.69 0.87 0.55 0.64 0.55 0.58\n3 The formula for normalizing the indicator values between 0 and 1.00 is: 1 – {1/[1 + (UA/DA)]}, where UA is \nthe average positive close-to-close change over the past n bars and DA is the absolute value of the average nega-\ntive close-to-close change over the past n bars.\n163\nTEChnICAl InDICATORS\ntable 11.3 60-Day Indicator Correlations\nClose \n– Close \nvs. Close \n– Ma\nClose \n– Close \nvs. Ma \n– Ma\nClose \n– Close \nvs. CS\nClose \n– Close \nvs. U/D \navg\nClose \n– Ma \nvs. Ma \n– Ma\nClose \n– Ma \nvs. CS\nClose \n– Ma \nvs. U/D \navg\nMa \n– Ma \nvs. CS\nMa \n– Ma vs. \nU/D avg\nCS vs. \nU/D avg\nCrude oil Aug. ’15–May ’16 0.85 0.90 0.82 0.60 0.88 0.95 0.83 0.83 0.67 0.75\nMay ’05–May ’16 0.91 0.92 0.76 0.27 0.90 0.86 0.43 0.74 0.26 0.50\nCorn Aug. ’15–May ’16 0.23 0.05 0.42 0.53 0.56 0.90 0.07 0.46 0.22 0.22\nMay ’05–May ’16 0.87 0.85 0.76 0.68 0.84 0.82 0.61 0.66 0.59 0.58\nS&p 500 Aug. ’15–May ’16 0.62 0.13 0.57 0.22 0.82 0.96 0.70 0.81 0.77 0.66\nMay ’05–May ’16 0.64 0.18 0.60 0.24 0.83 0.88 0.44 0.70 0.40 0.41\neuro Aug. ’15–May ’16 0.80 0.74 0.78 0.79 0.70 0.93 0.90 0.60 0.73 0.85\nMay ’05–May ’16 0.85 0.86 0.78 0.62 0.84 0.88 0.59 0.72 0.53 0.64\naverage: 0.72 0.58 0.69 0.49 0.80 0.90 0.57 0.69 0.52 0.58\nMedian: 0.82 0.80 0.76 0.56 0.84 0.89 0.60 0.71 0.56 0.61\n convergence-divergence (MACD), the price (or moving average) oscillator, the commodity chan-\nnel index (CCI), and the money flow index (MFI). (Note: There is little consistency in the technical \nindicator lexicon, especially with regard to more generic indicators. T erms such as momentum, rate of \nchange, and price oscillator sometimes refer to different calculations in different sources. The names \nused here are widely applied, but may conflict with other sources. The calculations, not the names, \nare what are important.)\nFigure 11.6 compares five popular indicators: momentum, the “fast” stochastic oscillator, CCI, \nRSI, and the MFI. “Momentum” is simply the Close – Close indicator. The fast stochastic is a three-day \nmoving average of the CS indicator. (The second, thinner line in the stochastic plot in Figure 11.6 is \na three-day moving average of the primary indicator line.) The CCI divides the difference between \nprice and a moving average (similar to the Close – MA indicator) by a measure of the absolute total \nprice deviation during the look-back period. The RSI is essentially the U/D Average indicator, except \nit uses an exponential smoothing function instead of a simple moving average and is scaled from zero \nto 100 instead of zero to 1. The MFI is basically a volume-weighted version of the RSI that magnifies \nindicator readings that are accompanied by high trade volume. The precise formulas for these indica-\ntors (which are readily available online) are less important than the fact that they are all derived from \nour basic indicator calculations and are all highly correlated to each other. Table 11.4 summarizes \nthe average correlations for 20-day versions of the 10 pair combinations of these five common indica-\ntors for the same periods shown in Tables 11.2 and 11.3. As Table 11.4 clearly demonstrates, these \nfive popular indicators are all highly correlated, with correlations ranging from a low of 0.67 to a \nhigh of 0.94.\nThe takeaway from this analysis is that all technical indicators that", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 43}
{"text": "summarizes \nthe average correlations for 20-day versions of the 10 pair combinations of these five common indica-\ntors for the same periods shown in Tables 11.2 and 11.3. As Table 11.4 clearly demonstrates, these \nfive popular indicators are all highly correlated, with correlations ranging from a low of 0.67 to a \nhigh of 0.94.\nThe takeaway from this analysis is that all technical indicators that measure the magnitude and \ndirection of prices over a given time period must inevitably compare at least two price points or \n164A COMPlETE GUIDE TO ThE FUTURES MARKET\ngroups of prices, which means they must incorporate at least one of the indicator formulas we have \noutlined, or a closely related calculation. Figures 11.1 through 11.6 and Tables 11.1 through 11.4 \nsuggest the specifi c type of calculation used is far less important than the time period it surveys in \nterms of diff erentiating one indicator from another. This characteristic of indicators is starkly illus-\ntrated in Figure 11.7 , which compares three indicator calculations (top to bottom): Close – Close \n10 , \nMA 3 – MA 10 , and MA 20 – MA 100 . Although the upper and middle indicators use a diff erent type of \ncalculation, they are very similar. In contrast, the middle and lower indicators use the same type \nof calculation but are radically diff erent. The key point is that the upper and middle indicators are \nsimilar because they both track a similar trend length, while the middle and lower indicators are very \n diff erent because the time length surveyed by the lower indicator is much longer. In short, it’s the time \nlength, not the indicator, that matters. \n table 11.4 Correlations of Common Indicators, Daily Crude Oil \nMom vs. \nStoch\nMom \nvs. CCI\nMom \nvs. rSI\nMom \nvs. MFI\nStoch \nvs. CCI\nStoch \nvs. rSI\nStoch \nvs. MFI\nCCI\nvs. rSI\nCCI\nvs. MFI\nrSI\nvs. MFI\nAug. ’15–May ’16 0.81 0.77 0.87 0.82 0.94 0.87 0.68 0.86 0.69 0.82\nMay ’05–May ’16 0.78 0.71 0.84 0.82 0.93 0.87 0.72 0.83 0.67 0.81\n FIGURE  11.6 Popular Indicator Comparison\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n165\nTEChnICAl InDICATORS\n FIGURE  11.7 Indicator length vs. Calculation Type\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n ■ Moving Average Types \n Moving averages, which are incorporated in many indicators, can be calculated in diff erent ways. \nWhereas a simple moving average (SMA) weights all prices equally (i.e., a 10-day average is the sum \nof the closing prices of the past 10 days divided by 10), the weighted moving average (WMA) and \nexponential moving average (EMA) use multipliers to increase the infl uence of more recent data in \nthe calculation (see Chapter 16 for details). The logic behind weighting a moving average is based \non an implicit assumption (not necessarily true) that recent price action is more important than \nmore distant price action when attempting to forecast future price direction. The intent of weight-\ning a moving average is to reduce lag by creating an indicator that is more responsive to directional \nchanges—a seemingly logical goal, but one that can have drawbacks as well as advantages. \n Table 11.5 shows the results of testing the same basic trading system using simple, weighted, and \nexponential moving averages. The system goes long when prices close above the moving average and \ngoes short when prices close below the moving average. The system was tested on three markets: the \nE-mini S&P 500 futures (ES), WTI crude oil futures (Cl), and euro futures (EC), using daily data \nfrom January 30, 2006, through January 28, 2016. In all cases, one contract was traded per signal, and \nthe moving average length was set to 60 days. \n The results, while based on a small sample of markets, are illustrative. In each market, a diff erent \ntype of moving average produced the highest net profi t and highest profi t factor (gross profi t/ gross loss). \n166A COMPlETE GUIDE TO ThE FUTURES MARKET\nThe implication is that the search for the “best” smoothing approach is likely to be a fruitless one. \nOver time, applied across multiple markets and parameter values, a particular smoothing calculation \nis unlikely to demonstrate a meaningful advantage over another. Figure 11.8 helps illustrate why. The \ndaily crude oil prices in this chart are overlaid with 60-day simple (dashed line), weighted (thick solid \nline), and exponential (thin solid line) moving averages. In just a single roughly six-month period, \nthere are multiple instances of the varying degrees of lag among the three moving averages helping or \n FIGURE  11.8 Moving Average Comparison\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n table 11.5 Simple, W eighted, and exponential Moving average Signals \nNet profit a No. trades Win % profit Factor b \n eS \nExponential $5,440 163 23.31% 0.98\nSimple –$1,635 163 19.63% 0.92\nW eighted –$30,860 209 23.44% 0.76\nCl \nSimple $175,050 161 24.22% 1.87\nExponential $113,870 178 23.03% 1.42\nW eighted $102,010 225 20.44% 1.3\neC \nW eighted $59,763 186 24.19% 1.36\nExponential $46,350 202 21.78% 1.29\nSimple $29,325 154 21.43% 1.18\na Closed trades plus open trade profit/loss (P/l) at end of test period. \nb Reflects closed trades only. \n167\nTEChnICAl InDICATORS\nhurting performance. For example, in March 2015, the market closed above both the WMA and SMA \n(triggering long positions) before reversing to close below both averages the next day (triggering \nshort positions)—a classic example of a “whipsaw” loss that occurs in trend-following strategies dur-\ning congested or volatile market conditions. The EMA escaped this loss. \nhowever, in other instances \nof whipsaw trades evident in the chart, it was the WMA or SMA that avoided the losing trade, while \nthe other two averages did not. Also, note that after the WMA suffered a whipsaw loss in early June \nwhile the SMA did not, in late June the WMA then provided a better short entry as t", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 44}
{"text": "rategies dur-\ning congested or volatile market conditions. The EMA escaped this loss. \nhowever, in other instances \nof whipsaw trades evident in the chart, it was the WMA or SMA that avoided the losing trade, while \nthe other two averages did not. Also, note that after the WMA suffered a whipsaw loss in early June \nwhile the SMA did not, in late June the WMA then provided a better short entry as the market turned \nsharply lower. Multiply the offsetting benefits and drawbacks illustrated in this chart by similar occur-\nrences in multiple markets over many years, and it is easy to see why one smoothing approach is \nunlikely to significantly outperform another, other than by chance.\nUltimately, the look-back period will be more important than the particular smoothing tech-\nnique. Over time, the difference between using a 40-period EMA and a 40-period SMA will \nbe much less significant than the difference between using a 40-period EMA and an 80-period \nEMA. Once again, it is the time length used in the calculation rather than the calculation type \nthat matters.\n ■ Oscillators and Trading Signals\nThe most common type of indicator by far is the one commonly referred to as the momentum \nindicator or oscillator, which is a calculation designed to highlight shorter-term swing points and \nso-called overbought and oversold levels. All the basic calculations and indicators in Figures \n11.1 through 11.7 (using shorter-term look-back periods) could be placed in this category. The \npopularity of oscillators is probably driven by the desire of many traders to capture as many of a \nmarket’s twists and turns as possible. The popularity of oscillators, however, is arguably inversely \ncorrelated to their usefulness. T o see why, let’s examine a few examples of applying oscillators \nas trading tools.\nFigure 11.9 depicts the 10-year T -note futures with a 10-day fast stochastic oscillator line (i.e., \na three-day moving average of the CS calculation). The indicator’s two horizontal lines at 80 and 20 \nare default overbought and oversold levels that, according to oscillator conventional wisdom, are \nused to indicate points at which price moves are overextended and likely to correct. Thus, over -\nbought readings (above 80) signal selling opportunities, and oversold readings (below 20) signal \nbuying opportunities. Although the oscillator does seem to signal all the price turning points, it does \nso prematurely.\nThe astute reader might argue that the simplistic use of the oscillator to signal trades whenever it \nenters overbought/oversold zones may be a suboptimal application of the indicator. What if, instead, \nwe waited for the indicated reversal to be confirmed before generating a trade signal? For example, a \nbuy signal might be triggered by the following dual conditions:\n 1. The oscillator declines into oversold territory (<20), suggesting an environment potentially \nconducive to long positions.\n 2. The oscillator then rises back above the oversold threshold (>20), confirming the anticipated \ntrend reversal from down to up.\n168A COMPlETE GUIDE TO ThE FUTURES MARKET\n A trade would be signaled only after the second condition is met. An analogous set of dual condi-\ntions would apply to sell signals. Figure 11.10 is the same chart as Figure 11.9 except it illustrates \nsignals based on adding the confi rmation condition. now , the oscillator seems to perform spectacu-\nlarly well as a trading tool, generating sells near relative highs and buys near relative lows! Many \nnovice traders will see a chart such as Figure 11.10 and think they have discovered the perfect trading \nsystem. In fact, it is not uncommon for some vendors to market systems using similar approaches, \nillustrating the purported wonderful performance of their system with charts that look very much \nlike Figure 11.10 . \n So what is wrong with such a dual-condition oscillator application for generating trading signals? \nnothing, as long as you can predict that the market will stay in a trading range in the future . The \nperiod shown in Figure 11.10 (late January to mid-June 2016) represents nearly ideal conditions for \nshort-term indicators such as oscillators to track price swings: the market moved sideways and the \nprice swings were relatively similar in magnitude. In such environments oscillators can appear to be \nalmost foolproof trading tools. If, however, the same approach is applied to a trending market—and \nkeep in mind it’s impossible to know whether a trending or trading range market will prevail in the \nfuture—the results can be disastrous. Figure 11.11 shows the signals that would have resulted from \napplying the same dual-condition trade rules in a trending market. In this case, during an eight-\nmonth period when the euro futures declined approximately 16 percent, the same oscillator trig-\ngered exactly one sell signal while issuing nine buy signals, including seven consecutive losing buys \nfrom August 2014 to January 2015. \n FIGURE  11.9 Oscillator Signals: Initial Penetration\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n Oscillator Signals: Initial Penetration\n\n169\nTEChnICAl InDICATORS\n FIGURE  11.10 Oscillator Dual-Condition Signals\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE  11.11 Oscillator Signals in Trending Market\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n170\nA Complete Guide to the Futures mArket\nThe bottom line is that oscillators will work well as contrarian trading tools if we can assume the \nmarket will move in a trading range. If the market instead embarks on an extended trend, oscillator-\nbased signals can lead to huge losses. And while it is easy to identify past trading ranges for which \nan oscillator-based trading strategy will produce magnificent hypothetical results, we don’t know \nwhether a trading range or trending market will prevail in the immediate future. In other", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 45}
{"text": "e the \nmarket will move in a trading range. If the market instead embarks on an extended trend, oscillator-\nbased signals can lead to huge losses. And while it is easy to identify past trading ranges for which \nan oscillator-based trading strategy will produce magnificent hypothetical results, we don’t know \nwhether a trading range or trending market will prevail in the immediate future. In other words, we \ndon’t know whether the upcoming market environment will be conducive or adverse to the use of \noscillators. As a subjective observation, on balance, oscillators have probably harmed traders more \nthan helped them. \nhowever, if a trader fully understands their limitations, these tools could still \nprovide reasonable trading signals. For example, if a trader has good reason to expect that a trading \nrange market is more likely to prevail—and uses rigorous risk management to control losses if this \nprojection proves wrong—then an oscillator could be used as a trading tool.\n ■ Indicator Myths\nThrough repetition over decades, certain bits of “common wisdom” regarding technical indicators \nhave become entrenched in trading literature, despite the ability of traders to disprove such mislead-\ning ideas through testing. The following list is far from exhaustive, but it touches upon some of the \nmost dangerously misleading, and easily refutable, examples of such myths.\nthe Confirmation Myth\nTraders are often exhorted to consult multiple technical indicators to “confirm” a potential trade \nsignal. This advice may sound sensible, but given the high correlation among so many indicators, such \nconfirmation is often an illusion. Unless the indicators being consulted are uncorrelated—say, if they \nuse radically different look-back periods (which is usually not the case)—they are probably simply \nrepeating the same information, with any apparent variations between the indicators likely meaning-\nless. The similarities between the indicators shown in Figures 11.1 through 11.7 illustrate how easy it \nis to generate false “confirmation” from calculations that are, more or less, the same indicator.\nthe “Magic Number” Myth\nThis misconception revolves around the belief that a specific indicator parameter (typically, the look-\nback period) provides universally optimal performance or otherwise possesses special properties. \nPopular examples include the nearly ubiquitous use of a 14-day look-back period as the default setting \nfor short-term countertrend indicators and references in the financial media regarding the impor-\ntance of the penetration of a 200-day moving average. The reality is that such parameter values will be \noptimal only in isolated markets as a function of chance. The question of what values work best for a \nspecific portfolio over a specific time range can be answered only by computer testing. And even then, \nthe answer would apply only to past data and could not be presumed to be indicative of the optimal \nvalues for the future. Chapter 19, which addresses the issue of optimization, provides a more in-depth \ndiscussion of this point.\n171\nTEChnICAl InDICATORS\n the leading Indicator Myth \n Some technical tools are commonly referred to as “leading” indicators for their supposed ability to sig-\nnal a market move before the price series itself gives any indication of a change in direction. Although \nit might be fair to say that a price-based indicator could (to some eyes) highlight an aspect of price \naction with predictive properties, the inescapable fact is that an indicator can never “lead” price action \nbecause, by defi nition, it is based on historical prices. If a certain indicator reading or pattern proves \n(through testing) to have predictive value, that information must be present in the price series itself. \n the Divergence Signal Myth \n This belief is a subset of the leading indicator myth. Divergence is most commonly used to describe \nthe phenomenon of an indicator (usually one designated as a “countertrend” tool) moving in opposition \nto a price series, and thus supposedly giving advance warning of vulnerability in the prevailing price \ntrend. For example, prices might make a new high in an uptrend, while the countertrend indicator \nmakes a lower high, suggesting the new price peak has been established on weaker momentum, which \nin turn implies that a correction or reversal is imminent. Such patterns are, in fact, quite common at \nmarket turning points. Unfortunately, though, they are also quite common at other times as well, often \ngenerating one false reversal signal after another during extended market trends. Figure 11.12 , which \ndepicts crude oil prices during the market’s extended sell-off in 2014 and into early 2015, highlights \n FIGURE  11.12 Price-Indicator Divergences\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n172A COMPlETE GUIDE TO ThE FUTURES MARKET\na series of successive price lows that were accompanied by higher lows in the MA 5 – MA 20 and Close \n– Close 20 indicators. These divergences between price and the indicators began signaling the potential \nfor a signifi cant correction or reversal as soon as the trend began—approximately six months and \n$50/bl. before the market staged a modest bounce in late January 2015. The situation is even worse \nthan it looks because Figure 11.12 omits some smaller false divergences that were left unmarked to \navoid cluttering the chart. \n ■ Indicator “Types” \n Indicators are typically categorized according to whether they are intended to identify longer-term \ntrends or emphasize shorter-term price swings and countertrend moves. While it is true that smoothing \nfunctions, such as moving averages, lend themselves to trend analysis because they simplify price action, \nsuch classifi cations usually have more to do with an indicator’s look-back period than any inherent \ncharacteristic of the calculation. For example, although moving average crossovers are “classic” trend-\nfollowing signals,", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 46}
{"text": "ice swings and countertrend moves. While it is true that smoothing \nfunctions, such as moving averages, lend themselves to trend analysis because they simplify price action, \nsuch classifi cations usually have more to do with an indicator’s look-back period than any inherent \ncharacteristic of the calculation. For example, although moving average crossovers are “classic” trend-\nfollowing signals, an MA \n3 – MA 10 calculation (three-day moving average minus 10-day moving aver-\nage), which conforms to the standard moving-average crossover form, could hardly be described as \na long-term trend-following indicator (see Figure 11.13 ). By contrast, the basic C – C momentum \ncalculation, most often used to highlight short-term price swings, will nonetheless refl ect longer-term \ntrends as its look-back period increases, as evidenced by the C – C \n100 calculation shown in Figure 11.13 . \n FIGURE  11.13 length vs. Indicator Type\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n173\nTEChnICAl InDICATORS\n ■ Conclusion\nBecause they are derivatives of price, it can be argued that technical indicators—when used to gener-\nate trading signals—actually distance traders and analysts from the data they are attempting to under-\nstand. Although indicators can, perhaps, highlight certain aspects of market action that might not be \nimmediately evident by looking at a chart or a spreadsheet, they cannot create information that is not \nalready present in the market data itself.\nSimplicity is generally a virtue with regard to technical indicators. There are only so many ways to \nmeasure the direction and magnitude of price changes, and the slight differences between approaches \nare unlikely to produce meaningful differences in trading signals. The more inputs an indicator has (and \nthe more arcane those inputs are), the more likely that either it is obscuring, rather than clarifying, the \nmarket action it is intended to interpret, or it is merely a more complex version of a simpler calculation.\nPerhaps the most important insight the reader can take away from this chapter is that indicators \nthat tend to work well in nontrending conditions will unavoidably perform miserably in trending \nconditions, whereas tools designed for trends will fare poorly in trendless markets. Unfortunately, \nmarkets do not ring bells when they are switching from one phase to the other. As a result, no single \nindicator or parameter input (such as the look-back period) can be expected to perform consistently \nwell across multiple markets and time frames.\n\nAPPlyiNg ChArt \nANAlysis to trAdiNg\nPart III\n\n177\nCha P ter 12\nNobody can catch all the fluctuations.\n—Edwin lefèvre\nF\nor many reasons, you may find yourself considering whether to enter a new position after the \nmarket has already made a substantial price move. Examples include: (1) you were not previously \nfollowing the market; (2) in an effort to get a better price, you futilely waited for a price correction \nthat never developed; (3) you were previously skeptical about the sustainability of the trend, but have \nnow changed your opinion.\nFaced with such a situation, many traders will be extremely reluctant to trade the market. \nthis \nattitude can be easily explained in psychological terms. the act of entering a new position after a \ntrend is already well underway in a sense represents an admission of failure. Even if the trade is prof-\nitable, traders know their gains would have been much greater if they had acted earlier. \nthus, even \nwhen you have a strong sense of probable market direction, you might be tempted to think: “ i've \nmissed so much of the move, why bother?”\nAs an example, consider chart-oriented traders examining the coffee market in mid-February \n2014 (see Figure 12.1) after not having participated in the sharp price advance prior to that time. \nsuch traders would have noted the market had broken out above the resistance level defined by the \nJanuary 2014 and october 2013 highs, with prices remaining in new high ground for two weeks—a \nvery bullish chart configuration. in addition, prices had just formed a flag pattern after an upmove—\nprice action indicative of another imminent upswing. however, observing that prices had already \nadvanced more than 37 percent since the November 2013 low (and more than 25 percent in just \nseven days in late January and early February), traders might have been reluctant to enter a new long \nposition belatedly, reasoning the market was overextended.\nMidtrend Entry \nand Pyramiding\n178A CoMPlEtE gUidE to thE FUtUrEs MArKEt\n Figure 12.2 vividly illustrates the folly of this conclusion. incredibly, as of mid-February 2014, \ncoff ee prices had completed only about 35 percent of their ultimate advance to the March high. the \nmoral of this tale is provided by an observation in Reminiscences of a Stock Operator by Edwin lefèvre: \n“[Prices] are never too high to begin buying or too low to begin selling.” \n the key question is how one enters the market in the midst of a major trend. Actually, the goals in \nimplementing a midtrend position are the same as those for initiating any position: favorable timing \n FIGURE /uni00A012.1 Missed Price Move? (May 2014 Coff ee)\nChart created using tradestation. ©tradestation t echnologies, inc. All rights reserved. \n FIGURE /uni00A012.2 how it turned out (May 2014 Coff ee)\nChart created using tradestation. ©tradestation t echnologies, inc. All rights reserved. \n\n179\nMidtrENd ENtry ANd PyrAMidiNg\nof entry and risk control. the following are four key strategies that could be employed to achieve \nthese objectives: \n 1. Percent retracement. this approach attempts to capitalize on the natural tendency of a \nmarket to partially retrace prior price swings. generally speaking, one might initiate the \nposition anytime the market retraces a given percentage of the price swing from the last \nrelative low or relative high. A reasonable choice for this percentage would be a fi gure i", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 47}
{"text": "yed to achieve \nthese objectives: \n 1. Percent retracement. this approach attempts to capitalize on the natural tendency of a \nmarket to partially retrace prior price swings. generally speaking, one might initiate the \nposition anytime the market retraces a given percentage of the price swing from the last \nrelative low or relative high. A reasonable choice for this percentage would be a fi gure in the \n35 to 65 percent range. Figure 12.3 illustrates the entry points using this approach, assuming \na 50 percent retracement criterion. Notice two of these retracements are based on rallies \n(A–d and C–d, respectively) that are defi ned by the same relative high but diff erent rela-\ntive lows. the main advantage of this method is that it is capable of providing superior entry \npoints. however, it is also subject to a major disadvantage: frequently, the necessary retrace-\nment condition may not be fulfi lled until the trend has carried much further, or possibly even \nreversed. \n 2. reversal of minor reaction. this approach is based on waiting for a minor reaction to mate-\nrialize and then entering on the fi rst signs of a resumption of the major trend. of course, \nthe precise method would depend on how a reaction and trend resumption were defi ned. the \nchoices are virtually limitless. For illustration purposes, we will provide one possible set of \ndefi nitions. \n A “reaction” is identifi ed whenever the reaction count reaches 4. the reaction count is initially \nset to 0. in a rising market, the count would be raised to 1 any day in which the high and low were \nequal or lower than the corresponding points on the day on which the high of the move was set. \nthe count would be increased by 1 each day the high and low are equal to or lower than the high \n FIGURE /uni00A012.3 Buy signals on 50 Percent retracements (E-Mini s&P MidCap 400 \nContinuous Futures)\nChart created using tradestation. ©tradestation t echnologies, inc. All rights reserved. \n180A CoMPlEtE gUidE to thE FUtUrEs MArKEt\nand low of the most recent day on which the count was increased. the count would be reset to 0 \nanytime the market moved to new highs. Analogous conditions would apply to a declining market. \n the resumption of the major trend would be indicated whenever the thrust count reached 3. \nthe thrust count would initially be set to 0 and would begin being monitored after a reaction \nwas defi ned. in the case of a reaction in a rising market, the thrust count would increase by 1 \non each upthrust day and would be reset to 0 anytime the reaction low was penetrated. (thrust \ndays were defi ned in Chapter 9.) once a signal was received, the reaction low could be used as \na stop-loss reference point. For example, the position might be liquidated anytime the market \nclosed below the reaction low . once again, an analogous set of conditions could be used for \ndefi ning a resumption of the trend in a declining market. \n Figure 12.4 illustrates the reversal of minor reaction approach using the specifi c defi nitions \njust detailed. the points at which reactions are defi ned are denoted by the symbol RD, with the \nnumbers prior to these points indicating the reaction count values. Buy signals are indicated at \nthe points at which the thrust count equals 3, with the letters prior to these points indicating \nthe thrust count values. For any given entry point, stop-loss liquidation would be signaled by a \nclose below the most recent stop level, which in this case is the lowest relative low between the \nidentifi cation of the reaction and the completion of the thrust count. \n 3. Continuation pattern and trading range breakouts. the use of continuation pat-\nterns and trading ranges for entry signals was discussed in Chapter 9 . since to some extent \nchart patterns are in the eye of the beholder, this approach will reflect a degree of subjec-\ntivity. Figure 12.5 offers one interpretation of continuation patterns (implicit assumption: \n FIGURE /uni00A012.4 reversal of Minor reaction (Australian dollar Continuous Futures)\nChart created using tradestation. ©tradestation t echnologies, inc. All rights reserved. \n\n181\nMidtrENd ENtry ANd PyrAMidiNg\nat least five trading days are required to form a continuation pattern), and the correspond-\ning sell points reflect closes below these consolidations. it should be noted, however, that \nonce a trend is considered established, it is not absolutely necessary to wait for penetra-\ntions of continuation patterns as confirmation of trade entry signals. By definition, these \npatterns are expected to be resolved by price swings in the same direction as the price \nmoves that preceded their formation. thus, for example, in a downtrend, short positions \ncould be established within consolidation patterns based on an expectation of an eventual \ndownside breakout. the high prices in the patterns depicted in Figure 12.5 could be used \nas reference points for the placement of protective stops (as marked on the chart) follow-\ning the downside breakouts of these patterns. \n 4. reaction to long-term moving average. Price retracements to a moving average of the \nprice series can be viewed as signals that the reaction to the main trend is near an end. specifi -\ncally, if a trader believed that an uptrend was in place, long positions could be entered anytime \nprices declined to below a specifi ed moving average. similarly, if a downtrend were believed \nto be in eff ect, short positions could be initiated on rallies above the moving average. Figure \n 12.6 , which superimposes a 40-day moving average over continuous E-mini s&P 500 futures, \nprovides an illustration of this approach. For example, traders who were bullish on the stock \nmarket during the period depicted and looking to enter on a correction could have used price \npullbacks below the 40-day moving average as entry signals for long positions. the arrows in \nFigure 12.6 indicate potential buy entry levels based on this approach. \n FIGURE/uni00A012.5 Continuation", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 48}
{"text": "futures, \nprovides an illustration of this approach. For example, traders who were bullish on the stock \nmarket during the period depicted and looking to enter on a correction could have used price \npullbacks below the 40-day moving average as entry signals for long positions. the arrows in \nFigure 12.6 indicate potential buy entry levels based on this approach. \n FIGURE/uni00A012.5 Continuation Pattern Breakouts as Entry signals (February Wti Crude oil)\nChart created using tradestation. ©tradestation t echnologies, inc. All rights reserved. \n\n182A CoMPlEtE gUidE to thE FUtUrEs MArKEt\n FIGURE /uni00A012.6 reaction to long- t erm Moving Average (E-Mini s&P 500 Futures)\n Note: /uni2191 = buy entry signal based on a reaction to below the 40-day moving average. \nChart created using tradestation. ©tradestation t echnologies, inc. All rights reserved. \n Chapter 16 illustrates how crossovers of moving averages can be used as trend-reversal signals. in the \napplication just described, we have used moving average crossover points to signal countertrend trade \nentry signals. there is no contradiction. When moving average crossovers are employed for generat-\ning trend reversal signals, typically, two moving averages are used so that the smoothing of both data \nseries will reduce false trend-reversal signals. in the method just detailed, we deliberately defi ned \ncrossover points based on the price series itself, which is more sensitive than a moving average since \nit contains no smoothing of the data, and one moving average. in other words, we would use more \nsensitive defi nitions of moving average crossovers for countertrend applications than we would for \ntrend-identifi cation applications. \n it should be noted that the problem of midtrend entry is identical to the problem of pyramiding , \nwhich is the implementation of additional units to an existing position. Both transactions involve \nimplementing a position after the market has already witnessed a substantial move in a given direc-\ntion. Consequently, the strategies discussed in this chapter for a midtrend entry could also be applied \nto the timing of pyramid positions. \n A few additional guidelines are necessary for pyramiding. First, one should not add to any existing \nposition unless the last unit placed shows a profi t. second, one should not add to an existing position \nif the intended stop point would imply a net loss for the entire position. third, pyramid units should \nbe no greater than the base (initial) position size. \n183\nIt was the same with all. They would not take a small loss at first but had held on, \nin the hope of a recovery that would “let them out even. ” And prices had sunk and \nsunk until the loss was so great that it seemed only proper to hold on, if need be a year, \nfor sooner or later prices must come back. But the break “shook them out, ” and prices just \nwent so much lower because so many people had to sell, whether they would or not.\n—Edwin Lefèvre\nT\nhe success of chart-oriented trading is critically dependent on the effective control of losses. \nA precise stop-loss liquidation point should be determined before initiating a trade. The most \ndisciplined approach would be to enter a good-till-canceled (GTC) stop order at the same time \nthe trade is implemented. However, if the trader knows he can trust himself, he could predeter-\nmine the stop point and then enter a day order at any time this price is within the permissible \ndaily limit.\nHow should stop points be determined? A basic principle is that the position should be liquidated \nat or before the point at which price movement causes a transition in the technical picture. For exam-\nple, assume a trader decides to sell September natural gas after the mid-October downside breakout \nhas remained intact for five days (see Figure 13.1). In this case, the protective buy stop should be \nplaced no higher than the upper boundary of the July–October trading range, since the realization of \nsuch a price would totally transform the chart picture. Some of the technical reference points com-\nmonly used for placing protective stops include:\n 1. Trend lines. A sell stop can be placed below an uptrend line; a buy stop can be placed above \na downtrend line. One advantage of this approach is that the penetration of a trend line will \nChoosing \nStop-Loss Points\nChap T er 13\n184A COMPLETE GUIDE TO THE FUTURES MARKET\nusually be one of the fi rst technical signals in a trend reversal. Thus, this type of stop point \nwill strongly limit the magnitude of the loss or the surrendered open profi t. However, this \nattribute comes at a steep price: trend line penetrations are prone to false signals. As dis-\ncussed in Chapter 6 , it is common for trend lines to be redefi ned in the course of a bull or \nbear market. \n 2. Trading range. As illustrated in the preceding natural gas example, the opposite side of a \ntrading range can be used as a stop point. Frequently, the stop can be placed closer (particu-\nlarly in the case of broader trading ranges) because if the breakout is a valid signal, prices \nshould not retreat too deeply into the range. Thus, the stop might be placed somewhere in \nthe zone between the midpoint and the more distant boundary of the range. The near end of \nthe trading range, however, would not be a meaningful stop point. In fact, retracements to \nthis area are so common that many traders prefer to wait for such a reaction before initiating \na position. (The advisability of this delayed entry strategy following breakouts is a matter of \npersonal choice. In many instances it will provide better fi lls, but it will also cause the trader \nto miss some major moves.) \n 3. Flags and pennants. After a breakout in one direction of a fl ag or pennant formation, the \nreturn to the opposite end (or some point beyond) can be used as a signal of a price reversal, and \nby implication a point for placing stops. For example, in Figure 13.2 the downside penetration \nof a fl ag pattern in m", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 49}
{"text": "rovide better fi lls, but it will also cause the trader \nto miss some major moves.) \n 3. Flags and pennants. After a breakout in one direction of a fl ag or pennant formation, the \nreturn to the opposite end (or some point beyond) can be used as a signal of a price reversal, and \nby implication a point for placing stops. For example, in Figure 13.2 the downside penetration \nof a fl ag pattern in mid-August was quickly followed by a rebound above the same formation. \nThis price action proved to be a precursor of a signifi cant price advance. \n FIGURE /uni00A013.1 Stop Placement Following Trading Range Breakout: September \n2015 Natural Gas\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n185\nCHOOSING STOP-LOSS POINTS \n 4. Wide-ranging days. Similar to fl ags and pennants, after a breakout in one direction, the \nreturn to the opposite end can be used as a signal of a price reversal, and hence a point for plac-\ning stops. For example, in Figure 13.3 note how the return of prices back above the true high of \nthe wide-ranging down day that formed in mid-March (after initially trading below this pattern) \nled to a strong rally. \n 5. relative highs and relative lows. If the implied risk is not too great, the most recent relative \nhigh or relative low can be used as a stop point. \n1 For example, assume a trader initiated a long \nposition in December corn in response to the breakout above resistance in June (see Figure 13.4 ). \nIn this case, the sell stop could be placed below either the May low or the June low . \n Sometimes the risk implied by even the closest technically signifi cant points may be excessive. In \nthis case, the trader may decide to use a money stop— that is, a protective stop-loss point with no tech-\nnical signifi cance that is determined by the desired dollar risk level. For example, consider the plight \nof a trader in July 2008 who after the swift, steep (nearly $18/barrel) price break during the week \nending July 18 is convinced the crude oil market has put in a major top (see Figure 13.5 ). The closest \n 1 The specifi c defi nition of a relative low or relative high is somewhat arbitrary. (The following description is in \nterms of the relative low , but analogous commentary would apply to the relative high.) The general defi nition of \na relative low is a day whose low is below the lows of the preceding and succeeding N days. The specifi c defi nition \nof a relative low will depend on the choice of N . A reasonable range for N is 5 to 15.\n FIGURE /uni00A013.2 Stop Placement Following Flag Pattern Breakout: December 2010 RBOB \nGasoline\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n186A COMPLETE GUIDE TO THE FUTURES MARKET\n FIGURE /uni00A013.3 Stop Placement Following Wide-Ranging Day Breakout: June 2012 10- Y ear T -Note\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE /uni00A013.4 Stop Placement at Relative Lows: December 2012 Corn\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n187\nCHOOSING STOP-LOSS POINTS \n FIGURE /uni00A013.5 Example of Market Where Money Stop Is Appropriate: December \n2008 WTI Crude Oil\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \nmeaningful stop point—the contract high (which is the nearest relative high)—would imply a risk \nof $17,850 per contract (assuming entry at the July 18 closing price)! Although risk can sometimes \nbe reduced if the trader waits for a reaction before entering the market, such a retracement may not \noccur until the market moves substantially lower. Thus, in a situation in which the nearest meaningful \nstop point implies a very large risk, a market order accompanied by a money stop may represent the \nmost viable trading approach. \n Stops should be used not only to limit losses but also to protect profi ts. In the case of a long posi-\ntion, the stop should be raised intermittently as the market rises. Similarly, in a declining market, the \nstop should be lowered as the market declines. This type of stop is called a trailing stop. \n Figure 13.6 illustrates the use of a trailing stop. Assume a trader implements a long position on \nthe breakout above the upper boundary of the trading range, with a stop-loss liquidation plan keyed \nto relative lows. Specifi cally, the trader plans to liquidate the long position following a close below the \nmost recent relative low with the reference point being revised each time the market moves to new \nhigh ground. (Of course, the stop condition may often be more restrictive. For example, the trader \nmight require a specifi ed number of closes below a previous low , or a minimum penetration of that \nlow to activate the stop.) The initial stop-loss point would be a close below Stop 1, which is set at a \nlevel in the lower half of the trading range—a point that represents less risk than a stop at the more \ndistant March 2009 relative low . Following the early June 2009 advance to new highs, the stop-loss \nreference point would be raised to the May low (Stop 2). Similarly, the stop reference points would \nbe raised successively to the levels indicated by Stops 3 to 11. The position would have been stopped \nout on the decline below Stop 11 in March 2010. \n188A COMPLETE GUIDE TO THE FUTURES MARKET\n As a general rule, stops should be changed only to reduce risk. Some traders who can’t stand the \nthought of getting stopped out at the bottom of a move (top if short) may be diligent in placing a GTC \nstop order upon initiating the position, but then cancel the order when the market gets within range. \nThis type of order has been derisively, albeit appropriately, referred to as a CIC (cancel if close) order. \nRevising the stop to allow greater risk defeats the entire purpose of the stop. \n FIGURE /uni00A013.6 Trailing Stop: E-Mini Nasdaq 100 Continuous Futures\nChart created using TradeStation.", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 50}
{"text": "stop order upon initiating the position, but then cancel the order when the market gets within range. \nThis type of order has been derisively, albeit appropriately, referred to as a CIC (cancel if close) order. \nRevising the stop to allow greater risk defeats the entire purpose of the stop. \n FIGURE /uni00A013.6 Trailing Stop: E-Mini Nasdaq 100 Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n189\nIt never was my thinking that made the big money for me. It was always my sitting. \nGot that? My sitting tight! It is no trick at all to be right on the market.\n—Edwin Lefèvre\nA \ntrade is like the army—getting in is a lot easier than getting out. Provided the trader is adhering \nto money management principles, a losing trade presents little ambiguity; that is, liquidation \nwould be indicated by a predetermined stop point. However, the profitable trade presents a problem \n(albeit a desirable one). How should the trader decide when to take profits? Myriad solutions have \nbeen proposed to this dilemma. The following sections explore some of the primary approaches.\n ■ Chart-Based Objectives\nMany chart patterns are believed to provide clues regarding the magnitude of the potential price \nmove. For example, conventional chart wisdom suggests that once prices penetrate the neckline of \na head-and-shoulders formation, the ensuing price move will at least equal the distance from the top \n(or bottom) of the head to the neckline. As another example, many point-and-figure chartists claim \nthat the number of columns that compose a trading range provides an indication of the potential num-\nber of boxes in a subsequent trend. (See discussion in Chapter 4 for an explanation of point-and-figure \ncharting.) Generally speaking, chart patterns are probably considerably less reliable as indicators of \nprice objectives than as trade signals.\nSetting Objectives \nand Other Position \nExit Criteria\nChapter 14\n190A COMPLETE GUidE TO THE FUTUrES MArKET\n ■ Measured Move \n This method is the essence of simplicity. The underlying premise is that markets will move in approxi-\nmately equal-size price swings. Thus, if a market rallies 30 cents and then reacts, the implication is \nthat the rally from the reaction low will approximate 30 cents. Although the measured move concept \nis so simple that it strains credibility, the approach off ers reasonable guidelines more frequently than \none might expect. When two or more of these objectives nearly coincide, it tends to enhance the reli-\nability of the price area as an important objective zone. \n Since price swings often span several contracts, it is useful to apply the measured move technique \nto longer-term price charts that link several contracts. Generally speaking, continuous futures charts \nare more appropriate than nearest futures charts for measured move analysis because, as was noted \nin Chapter 4 and further detailed in Chapter 5 , continuous futures accurately refl ect price swings, \nwhereas nearest futures do not. \n in Figure 14.1 , the measured move objective that was fulfi lled in july 2012 was the result of \nadding the amount of the december 2011–May 2012 rally (404.75¢) to the early june 2012 low of \n667.25¢. Figure 14.2 shows two measured moves on a weekly chart. The fi rst measured move target \nat 0.2711 (MM1), which was very close to the March 2015 relative low , was derived by subtract-\ning the june–december 2014 decline of 0.0752 from the january 2015 high of 0.3462. The second \nmeasured move objective at 0.2297 (MM2), which was fairly close to the September 2015 low , \nwas obtained by subtracting the january–March 2015 decline of 0.0818 from the late April high of \n FIGURE  14.1 Measured Move: Soybean Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, inc. All rights reserved. \n\n191\nSETTiNG ObjECTivES ANd OTHEr POSiTiON ExiT CriTEriA\n0.3115. Figure 14.3 shows four measured move targets, three of which (MM1, MM3, and MM4) \nimplied targets very near swing point highs. \n Figure 14.4 illustrates a series of reasonably accurate measured move targets in frozen orange \njuice futures from mid-2012 to late 2013. Price didn’t reach three of the targets (MM2, MM6, and \nMM9, represented by dashed lines), but missed only MM2 by a notable margin. Of the other six \ntargets, all but MM4 represented quite advantageous exit points. Also, note that MM3 and MM5 \nsignaled exit points at around the same level, reinforcing the target objective in that price vicinity. \n Figure 14.5 provides another example of successive reasonably accurate measured move targets over \na roughly two-year period. Note that the same price point can serve as the terminus of two diff erent \nprice swings (see October 2014 high with stacked 8 and 4), which can lead to two diff erent measured \nmove objectives based on that point (MM4 and MM8). This chart also provides an example of coincident \nmeasured move objectives: MM6, which is a projection based on the january–March 2014 upswing off \nthe May low , occurred one tick away from MM8, which was the result of adding the june–October 2013 \nrally to the November low . MM4 and MM5 also signaled exits at approximately the same price level. \n As Figures 14.4 and 14.5 illustrate, when there is more than one relevant price swing for deriv-\ning a measured move objective, there will be more than one measured move objective for the same \nprojected low or high. When two or more of these objectives nearly coincide, it tends to enhance \nthe reliability of the projected price area as an important target zone. Figure 14.6 provides a perfect \nexample of two coinciding measured move price targets. The measured move objectives implied by \nthe july 2014–March 2015 decline (MM5) and the May–October 2015 decline (MM6) coincided just \nabove the actual market bottom formed in january 2016. \n FIGURE  14.2 Measured Moves: brazilian real Continuous Futures\nChart created using TradeStation. ©Trad", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 51}
{"text": "rtant target zone. Figure 14.6 provides a perfect \nexample of two coinciding measured move price targets. The measured move objectives implied by \nthe july 2014–March 2015 decline (MM5) and the May–October 2015 decline (MM6) coincided just \nabove the actual market bottom formed in january 2016. \n FIGURE  14.2 Measured Moves: brazilian real Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, inc. All rights reserved. \n\n192A COMPLETE GUidE TO THE FUTUrES MArKET\n FIGURE  14.3 Measured Moves: Soymeal Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, inc. All rights reserved. \n FIGURE  14.4 Measured Moves: Orange juice Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, inc. All rights reserved. \n\n193\nSETTiNG ObjECTivES ANd OTHEr POSiTiON ExiT CriTEriA\n FIGURE  14.5 Concentration of Measured Move Targets: Cocoa Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, inc. All rights reserved. \n FIGURE  14.6 Concentration of Measured Move Targets: Canadian dollar Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, inc. All rights reserved. \n\n194A COMPLETE GUidE TO THE FUTUrES MArKET\n ■ Rule of Seven \n This method of setting objectives is an interesting and easy-to-use approach detailed in T echniques of a \nProfessional Commodity Chart Analyst by Arthur Sklarew (Windsor books, 1980). The rule of seven refers \nto a common set of multipliers used to determine objectives, which are derived by dividing 7 by 5, 4, 3, \nand 2, respectively. Thus, the multipliers are: 7 ÷ 5 = 1.4, 7 ÷ 4 = 1.75, 7 ÷ 3 = 2.33, and \n7 ÷ 2 = 3.5. The products of each of these multipliers and the magnitude of the fi rst price swing in \na bull market are added to the low to obtain a set of price objectives. in a bear market, the products \nare subtracted from the high. \n Sklarew suggests using the latter three multipliers (1.75, 2.33, and 3.5) for fi nding objectives in bull \nmarkets and the fi rst three multipliers (1.4, 1.75, and 2.33) for deriving objectives in a bear market. \nin addition, he indicates objectives based on the lower multipliers are more meaningful if the reference \nprice move (the price swing multiplied by the multipliers) is of extended duration (i.e., several months) \nand objectives based on the higher multipliers are more signifi cant if a short-term price swing is used in \nthe calculations. Of course, there will be some degree of subjectivity in this approach, since the percep-\ntion of what constitutes the fi rst price swing in a trend could vary from trader to trader. \n The rule of seven is illustrated in Figure 14.7 . (Note that this is the same chart that was used as \nFigure 14.3 to illustrate measured move objectives. readers may fi nd it instructive to compare the \n FIGURE  14.7 rule of Seven: Soymeal Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, inc. All rights reserved. \n\n195\nSETTiNG ObjECTivES ANd OTHEr POSiTiON ExiT CriTEriA\nimplications of these two approaches.) The fi rst wave of the bull market that began in April 2013 \nwas 94.30 points, measured from the April low to the june high. Following Sklarew’s guidelines, \nbecause this is a bull market, we skip the fi rst objective and use the second through fourth objec-\ntives, obtained using the multipliers 1.75, 2.33, and 3.5. The April 11 low , which is used to cal-\nculate all the objectives, was 123.90. The second objective is 288.90 [123.90 + (1.75 × 94.30)]. \nThe third objective is 343.60 [123.90 + (2.33 × 94.30)]. The fourth objective is 454 [123.90 + \n(3.5 × 94.30)]. Note that objective 2 was just below the december 2013 relative high of 294.80, \nwhile objective 3 was just below the February 27 relative high of 346.10. The market failed to \nreach objective 4. \n Figure 14.8 (which repeats Figure 14.6 ) illustrates the rule of seven for an extended bear market \nin Canadian dollar continuous futures. The chart intentionally shows two sets of objectives based \non using diff erent lows (A and b) to defi ne the initial leg of the downtrend. in both cases, the Sep-\ntember 2012 high was used as the initial high reference price. The fi rst wave of this bear market \nusing low A in March 2013 was 0.0674 points, while using low b in March 2014 the fi rst wave was \n0.1407 points. Following Sklarew’s guidelines, since this is a bear market, we use the fi rst through \nthird objectives (obtained using the multipliers 1.4, 1.75, and 2.33). The products of these three \nmultipliers and the two initial price swings are subtracted from the high of the move to obtain the \ntwo sets of downside objectives. Of the three objectives that referenced low A, only Objective 2 was \n FIGURE  14.8 rule of Seven: Canadian dollar Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, inc. All rights reserved. \n\n196A COMPLETE GUidE TO THE FUTUrES MArKET\nfairly close to a relative low (during the january–March 2014 consolidation). Among the objectives \nusing low b, Objective 2 was just below the March 2015 relative low , while Objective 3 was just \nabove the january 2016 low . \n ■ Support and Resistance Levels \n Points near support levels provide a reasonable choice for setting initial objectives on short positions. \nFor example, the indicated objective zone in Figure 14.9 is based on support anticipated in the area \nof two prior relative lows. Similarly, prices near resistance levels can be used for setting initial objec-\ntives on long positions. For example, the indicated objective in Figure 14.10 is based on resistance \nimplied by the two previous highs in late 2009 and early 2010. in Figure 14.11 , an upside objective \nfor british pound prices after the early 2009 bottom was implied by the late 2005 relative low , a level \nthat continued to function as a ceiling for prices over the next several years (a case of former support \nbecoming resistance, as discussed in Chap", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 52}
{"text": "tive in Figure 14.10 is based on resistance \nimplied by the two previous highs in late 2009 and early 2010. in Figure 14.11 , an upside objective \nfor british pound prices after the early 2009 bottom was implied by the late 2005 relative low , a level \nthat continued to function as a ceiling for prices over the next several years (a case of former support \nbecoming resistance, as discussed in Chapter 8 ). \n Generally speaking, support and resistance levels usually represent only temporary rather than \nmajor objectives. Consequently, in using this approach, it is advisable to seek to reenter the position \nat a better price if a reaction does develop. \n FIGURE  14.9 downside Objective at Support Zone: Australian dollar Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, inc. All rights reserved. \n\n197\nSETTiNG ObjECTivES ANd OTHEr POSiTiON ExiT CriTEriA\n FIGURE  14.10 Upside Objective at resistance Level: Cocoa Nearest Futures\nChart created using TradeStation. ©TradeStation T echnologies, inc. All rights reserved. \n FIGURE  14.11 Upside Objective at Former Support Turned resistance: british Pound Nearest Futures\nChart created using TradeStation. ©TradeStation T echnologies, inc. All rights reserved. \n\n198A COMPLETE GUidE TO THE FUTUrES MArKET\n ■ Overbought/Oversold Indicators \n Overbought/oversold indicators are technical measures intended to refl ect when prices have risen or \nfallen too sharply and are thus vulnerable to a reaction. Figure 14.12 illustrates the relative strength \nindex (rSi), which provides an example of an overbought/oversold indicator. \n1 The rSi has a range \nof values between 0 and 100. based on the standard interpretation, levels above 70 suggest an over-\nbought condition, while levels below 30 suggest an oversold condition. \n The choice of specifi c overbought/oversold boundaries is a subjective one. For example, instead \nof 70 and 30, one might use 75 and 25, or 80 and 20. The more extreme the selected threshold lev-\nels, the closer the overbought/oversold signals will be to market turning points, but the greater the \nnumber of such points that will be missed. \n The buy (up) arrows in Figure 14.12 denote points at which the rSi crosses below 30—that \nis, reaches an oversold condition that can be viewed as a signal to liquidate short positions. The sell \n(down) arrows denote points at which the rSi crosses above 70—that is, reaches an overbought con-\ndition that can be viewed as a signal to liquidate long positions. \n Although the overbought/oversold signals in Figure 14.12 provide some reasonably good position \nliquidation signals in the latter half of the chart (mid-April 2015 forward), the signals before that \n FIGURE  14.12 relative Strength index in Trend and Trading range Conditions: U.S. dollar index \nContinuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, inc. All rights reserved. \n 1 The rSi was originally introduced in j. W elles Wilder, jr., New Concepts in T echnical T rading Systems (Winston-\nSalem, NC: Hunter Publishing, 1978).\n199\nSETTiNG ObjECTivES ANd OTHEr POSiTiON ExiT CriTEriA\npoint—when the market was in a strong uptrend—were almost all terrible. The 27 percent rally off \nthe july 2014 low that ultimately extended into March 2015 generated 10 overbought signals, four \nof which occurred in rapid succession in the first two months of the rally. Only the final two signals \nduring this period, in late \njanuary and early March 2015, could be considered relatively timely. This \nexample hints at both the benefits and drawbacks of using overbought/oversold indicators as liquida-\ntion signals. The approach will usually work well when the market is in a trading range, but will fail \nmiserably during strong trending phases.\nThe derivation and interpretation of various technical indicators are discussed in detail in \nChapter 11.\n ■ DeMark Sequential\nAs discussed in Chapter 11, all the popular overbought/oversold indicators (e.g., rSi, moving aver-\nage convergence-divergence [MACd], stochastic) are very highly correlated with each other. T om \ndeMark’s sequential, which is intended to signal points where the market is fully extended and vul-\nnerable to a major trend reversal, represents a completely different and original overbought/oversold \nindicator. The sequential methodology falls within the domain of pattern recognition. The sequential \nis fully described in a 48-page chapter in T om \ndeMark’s book The New Science of T echnical Analysis (john \nWiley & Sons, 1994). The following brief summary of the technique is intended to give a general \nsense of the approach. \nreaders interested in a fully detailed explanation of the sequential, which \nincludes several additional qualifying conditions and a discussion of various alternative trade entry \nand exit rules, are referred to \ndeMark’s text.\nThe fulfillment of the sequential buy condition involves three basic stages:\n 1. Setup. The setup requires nine or more consecutive closes that are lower than the correspond-\ning closes four trading days earlier.\n 2. Intersection. This condition requires that the high of any day on or after the eighth day of the \nsetup exceed the low of any day three or more trading days earlier. Essentially, this is a minimal \nqualifying condition that ensures that the buy setup will not be deemed complete in a “waterfall” \nprice slide.\n 3. Countdown. The countdown stage begins once the previous two conditions have been ful-\nfilled. Starting from 0, the countdown increases by one on each day with a close lower than the \nlow two days earlier. A sequential buy signal is generated once the countdown reaches 13. \nin \ncontrast to the setup stage, countdown days do not need to be consecutive. The countdown is \ncanceled if any of the following three conditions arise:\na.\n There is a close that exceeds the highest intraday high during the setup stage.\nb. A sell setup occurs (i.e., nine consecutive closes above the corresponding closes four d", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 53}
{"text": ". A sequential buy signal is generated once the countdown reaches 13. \nin \ncontrast to the setup stage, countdown days do not need to be consecutive. The countdown is \ncanceled if any of the following three conditions arise:\na.\n There is a close that exceeds the highest intraday high during the setup stage.\nb. A sell setup occurs (i.e., nine consecutive closes above the corresponding closes four days \nearlier).\nc. Another buy setup occurs before the buy countdown is complete. in this situation, the new \nbuy setup takes precedence, and the countdown restarts from 0 once the intersection condi-\ntion is met.\n200\nA Complete Guide to the Futures mArket\nThe fulfillment of the sequential sell conditions are analogous:\n 1. Setup. The setup requires nine or more consecutive closes that are higher than the correspond-\ning closes four trading day earlier.\n 2. Intersection. This condition requires that the low of any day on or after the eighth day of the \nsetup is lower than the high of any day three or more trading days earlier. Essentially, this is a \nminimal qualifying condition that ensures that the sell setup will not be deemed complete in a \n“runaway” rally.\n 3. Countdown. The countdown stage begins once the previous two conditions have been ful-\nfilled. Starting from 0, the countdown increases by one on each day with a close higher than the \nhigh two days earlier. A sequential sell signal is generated once the countdown reaches 13. \nin \ncontrast to the setup stage, countdown days do not need to be consecutive. The countdown is \ncanceled if any of the following three conditions arise:\na.\n There is a close that is below the lowest intraday low during the setup stage.\nb. A buy setup occurs (i.e., nine consecutive closes below the corresponding closes four days \nearlier).\nc. Another sell setup occurs before the sell countdown is complete. in this situation, the new \nsell setup takes precedence, and the countdown restarts from 0 once the intersection condi-\ntion is met.\nFigures 14.13 through 14.17 provide illustrations of markets that fulfilled the complete sequential \nprocess. \nin each case, the setup, intersection, and countdown stages are marked on the charts; the \nfinal bar of the setup stage is highlighted with a boldfaced 9, while the final bar of the countdown \nphase is marked with a boldfaced 13. The preceding description will be clearer if read in conjunction \nwith an examination of these charts.\nFigure 14.13 provides an illustration of a sequential sell signal in \njune 2016 10-year T -note futures. \nNote that in this case, the first day of the countdown stage (which occurred three days after the end \nof the setup stage) also fulfilled the intersection requirement (a bar with a low below the high of a day \nthree or more days earlier). The countdown phase completed on February 11, the day that marked the \nhighest high and close of the upmove. Figure 14.14, which shows the \njune 2016 gold contract, pro-\nvides an example of a sequential buy. As was the case in Figure 14.13, the first day of the countdown \nstage also marked the fulfillment of the intersection requirement. The completion of the countdown \nstage coincided with the mid-\ndecember 2015 low .\nFigure 14.15 provides another example of a sequential buy, this time in the May 2016 soybean \ncontract. in this case the intersection requirement occurred on the eighth bar of the setup phase, \nwhile the countdown phase didn’t begin until nine days after the end of the setup phase. The count-\ndown completed in early March 2016, the day with the lowest low of the move and one day after the \nlowest close. (Note: Figures 14.14 and 14.15 reflect day-session-only data.)\nThe sequential rules can also be applied to bar charts for time periods other than daily. Figure 14.16 \nillustrates a sequential sell on a monthly copper continuous futures chart. Here, the end of the setup \nstage, the beginning of the countdown stage, and the fulfillment of the intersection requirement all \noccur on the same bar (month). The market peaked at month 11 of the countdown phase, but the real \n201\nSETTiNG ObjECTivES ANd OTHEr POSiTiON ExiT CriTEriA\n FIGURE  14.13 deMark Sequential: june 2016 10- Y ear T -Note Continuous Futures\n Source for sequential signals: deMark Analytics ( www .demark.com ) \nChart created using TradeStation. ©TradeStation T echnologies, inc. All rights reserved. \n deMark Sequential: june 2016 10- Y ear T -Note Continuous Futures\n FIGURE  14.14 deMark Sequential: june 2016 Gold\n Source for sequential signals: Copyright 2016, deMark for CQG, www .demark.com \nChart from CQG, inc. © 2017 All rights reserved worldwide. Signal from demark Analytics. \nCountdown begins/\nIntersection fulfilled\nSetup complete Countdown complete\n12000\n11800\n11600\n11400\n11200\n11000\n10800\n10600\n10400\n10200\n01\nFeb\n04 11 19 25\n2016\n2801 07 14 21\nDec\n02 26 09 16 23\nNov\n13\n9\n12\n1110\n98\n6\n7\n54\n32\n187\n65\n4\n3\n2\n1\nJune 2016 gold (GCM16), daily (day-session)\n202A COMPLETE GUidE TO THE FUTUrES MArKET\nCountdown begins\nSetup complete Countdown complete\n9400\n9300\n9200\n9100\n9000\n8900\n8800\n8700\n8600\n8400\n8500\n11\nApr\n14 21 28 01\nMar\n0708 16 22 01\nFeb\n0421 28 11 19 0125\n2016\nIntersection\nfulfilled\n32\n1\n13\n9\n1211109\n8\n6\n7 1\n5\n4\n3\n2\n1\n8\n76\n54\nMay 2016 soybeans (SK16), daily (day-session)\n FIGURE  14.15 deMark Sequential: May 2016 Soybeans\n Source for sequential signals: Copyright 2016, deMark for CQG, www .demark.com \nChart from CQG, inc. © 2017 All rights reserved worldwide. Signal from demark Analytics. \nCopper continuous futures (HG), monthly\nSetup complete/\nCountdown begins\nCountdown complete\n47500\n42500\n45000\n37500\n35000\n30000\n40000\n32500\n27500\n25000\n22500\n20000\n17500\n15000\n2016\nJanJ ul JanJ ul JanJ ul JanJ ul JanJ ul JanJ ul JanJ ul Jan\n12500\n20152012 2013 201420112009 20 10\nIntersection fulfilled\n3\n21\n13\n9\n12\n11109\n8\n6\n7\n5\n4\n32\n1\n876\n54\n FIGURE  14.16 deMark Sequential: Copper Continuous Futures\n Source for sequential signals: Copyright 2016, deMark for CQG, www .demark.com \nChart from CQG,", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 54}
{"text": "500\n45000\n37500\n35000\n30000\n40000\n32500\n27500\n25000\n22500\n20000\n17500\n15000\n2016\nJanJ ul JanJ ul JanJ ul JanJ ul JanJ ul JanJ ul JanJ ul Jan\n12500\n20152012 2013 201420112009 20 10\nIntersection fulfilled\n3\n21\n13\n9\n12\n11109\n8\n6\n7\n5\n4\n32\n1\n876\n54\n FIGURE  14.16 deMark Sequential: Copper Continuous Futures\n Source for sequential signals: Copyright 2016, deMark for CQG, www .demark.com \nChart from CQG, inc. © 2017 All rights reserved worldwide. Signal from demark Analytics. \n203\nSETTiNG ObjECTivES ANd OTHEr POSiTiON ExiT CriTEriA\n FIGURE  14.17 deMark Sequential: june 2016 E-Mini Nasdaq 100\n Source for sequential signals: Copyright 2016, deMark for CQG, www .demark.com \nChart from CQG, inc. © 2017 All rights reserved worldwide. Signal from demark Analytics. \nreversal did not occur until after the completion of countdown six months later. Figure 14.17 shows \ncompleted sequential sell and buy setups on an intraday chart (15-minute bars). The sell setup com-\npleted during a consolidation near the top of the rally, while the buy setup completed a bit above the \nlow of the subsequent decline, but right at the start of the fi rst extended rally after the low . \n The preceding examples were obviously selected with hindsight to illustrate the methodology. Of \ncourse, in real-life trading, the accuracy of the deMark sequential approach will not approach the \nuniformly near-perfect signals provided by the previous set of examples. if it did, all anyone would \nneed to do would be to trade all sequential signals and retire a multimillionaire. Nevertheless, these \nexamples should demonstrate that sequential can be a very powerful tool, with the capability of pro-\nviding extraordinary timing signals. Sequential also has the advantage of being inversely correlated to \ntrend-following approaches that typically dominate the technical tool bag. For these reasons, many \ntraders might fi nd deMark’s sequential a very useful addition to their overall trading methodology. \n ■ Contrary Opinion \n The theory of contrary opinion suggests that whenever a large majority of speculators are bullish, \nthose who want to be long are already long. Consequently, there will be a paucity of potential new \nbuyers, and the market will be vulnerable to a downside reaction. An analogous interpretation would \napply when the majority of traders are bearish. Contrary opinion measures are based on either surveys \n204\nA Complete Guide to the Futures mArket\nof market advisory recommendations or surveys of traders and implicitly assume these opinions rep-\nresent a reasonable proxy for overall market sentiment. The overbought and oversold thresholds in \ncontrary opinion indexes will vary with the source.\nAlthough contrary opinion is undoubtedly a sound theoretical concept, the Achilles’ heel of this \napproach is the difficulty of measuring market sentiment accurately. Contrary opinion measures pro-\nvided by existing services have frequently signaled major turning points. On the other hand, it is also \nnot unusual for a contrary opinion index to stay high while the market continues to climb, or to stay \nlow as the market continues to slide. On balance, this method provides useful information as long as \nit is not used as the sole trading guideline.\n ■ Trailing Stops\nThe use of trailing stops may be among the least glamorous, but most sensible, methods of determin-\ning a trade exit point. Although one will never sell the high or buy the low using this method, the \napproach comes closest to the ideal of permitting a profitable trade to run its course. Trailing stops \nwere detailed in Chapter 13.\n ■ Change of Market Opinion\nThis method of exiting trades represents another approach with very little flash, but lots of common \nsense. \nin this case, the trader sets no predetermined objectives at all, but rather maintains the position \nuntil her market opinion changes to at least neutral.\n205\nChapter 15\nThe Most Important \nRule in Chart Analysis\nThe market is like a flu virus—as soon as you think you have it pegged, it mutates into \nsomething else.\n—Wayne H. Wagner\n ■ Failed Signals\nA failed signal is among the most reliable of all chart signals. When a market fails to follow through \nin the direction of a chart signal, it very strongly suggests the possibility of a significant move in the \nopposite direction. For example, in Figure 15.1 note how the market abruptly reversed course after \nbreaking out above the high of the July–August 2013 consolidation in WTI crude oil. If the upside \npenetration signal were valid, the market should not have retreated back to the lower portion of the \nconsolidation and certainly not below its lower boundary. The fact that such a retracement occurs \nalmost immediately following the breakout strongly suggests a “bull trap.” Such price action is con-\nsistent with the market’s rising just enough to activate stop orders lying beyond the boundary of the \nrange, but uncovering no additional buying support after the breakout—an indication of a very weak \nunderlying technical picture. In effect, the immediate failure of the apparent buy signal can be viewed \nas a strong indication the market should be sold.\nNow that we have established the critical importance of failed signals, the following sections detail \nvarious types of failed signals, along with guidelines as to their interpretation and trading implications.\n ■ Bull and Bear Traps\nBull and bear traps are major breakouts that are soon followed by abrupt, sharp price reversals, in stark \ncontrast to the price follow-through that is expected to follow breakouts. In my experience, this type \nof counter-to-anticipated price action is among the most reliable indicators of major tops and bottoms.\n206A CoMPleTe GuIDe To THe FuTuReS MARKeT\n An example of a bull trap was provided in the previous section (Figure 15.1 ). Another instance of \na bull trap was the June 2015 peak in RBoB gasoline (see Figure 15.2 ). After rallying from January to \nMay 2015, the market consolidated fo", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 55}
{"text": ", this type \nof counter-to-anticipated price action is among the most reliable indicators of major tops and bottoms.\n206A CoMPleTe GuIDe To THe FuTuReS MARKeT\n An example of a bull trap was provided in the previous section (Figure 15.1 ). Another instance of \na bull trap was the June 2015 peak in RBoB gasoline (see Figure 15.2 ). After rallying from January to \nMay 2015, the market consolidated for roughly one month before breaking out to new highs in mid-\nJune. However, the market quickly reversed back into the trading range, and by mid-July prices had \nbroken below the range’s lower boundary, setting the stage for a multimonth downtrend. \n Analogous to the bull trap, in the case of a bear trap, the market falls just enough to trigger resting \nstops below the low end of a trading range, but fails to uncover any additional selling pressure after \nthe breakout—an indication of substantial underlying strength. In eff ect, the immediate failure of a \nsell signal can be viewed as a signal the market should be bought. \n Figure 15.3 shows a bear trap that marked the 2014 low in u.S. Dollar Index futures. In May the \nmarket broke below the lower boundary of a long-standing trading range but reversed two days later \nto close back above that threshold. This price action proved to be the beginning of the market’s largest \nrally in more than a decade. \n Figure 15.4 provides another example of a bear trap. Corn prices, which had been trending lower \nsince late summer 2012, entered a trading range in November–December 2013. The market broke \nbelow the downside of the range in early January 2014, falling more than 2 percent over the next two \ndays before reversing sharply and returning to the midpoint of the range. May corn futures subse-\nquently surged approximately 25 percent over the next three months. \n FIGURE  15.1 Bull Trap: WTI Crude oil Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n207\nTHe MoST IMPoRTANT Rule IN CHART ANAlySIS\n FIGURE  15.2 Bull Trap: RBoB Gasoline Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE  15.3 Bear Trap: u.S. Dollar Index Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n208A CoMPleTe GuIDe To THe FuTuReS MARKeT\n FIGURE  15.4 Bear Trap: May 2014 Corn Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n How much of a pullback is required to indicate a bull or bear trap has occurred? The following are \nseveral possible confi rmation conditions: \nInitial price confi rmation. A price retracement to the midpoint of the consolidation that \npreceded the breakout. \nStrong price confi rmation. A price retracement to the more distant boundary (lower for bull \ntrap; upper for bear trap) of the consolidation that preceded the breakout. \ntime confi rmation. The failure of the market to return to the extreme price witnessed follow-\ning the breakout within a specifi ed amount of time (e.g., four weeks). \n The trade-off between initial and strong price confi rmations is that the former will provide better \nentry levels in trading bull and bear traps, whereas the latter will provide more reliable signals. The \ntime confi rmation condition can be used on its own or in conjunction with the two price confi rma-\ntion conditions. Figures 15.5 through 15.8 repeat Figures 15.1 through 15.4 , adding each of the \nthree confi rmation conditions (using four weeks for the time confi rmation condition). Note the time \nconfi rmation can occur before both price confi rmation conditions, after both price confi rmation \nconditions (as is the case in Figures 15.6 and 15.8 ), or between the price confi rmations (Figures 15.5 \nand 15.7 ). \n209\nTHe MoST IMPoRTANT Rule IN CHART ANAlySIS\n FIGURE  15.5 Bull Trap Confi rmation Conditions: WTI Crude oil Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE  15.6 Bull Trap Confi rmation Conditions: RBoB Gasoline Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n210A CoMPleTe GuIDe To THe FuTuReS MARKeT\n FIGURE  15.7 Bear Trap Confi rmation Conditions: u.S. Dollar Index Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE  15.8 Bear Trap Confi rmation Conditions: May 2014 Corn Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n211\nTHe MoST IMPoRTANT Rule IN CHART ANAlySIS\nA bull trap signal would be invalidated if the market returned to the breakout high. Similarly, \na bear trap signal would be invalidated if the market returned to the breakout low . More sensitive \n conditions could be used to invalidate bull or bear trap signals once the market has moved sufficiently \nin the direction of the signal or a specified amount of time has elapsed. An example of such a condition \nwould be the return of prices to the opposite boundary of a consolidation once a strong price confir-\nmation signal was received (e.g., in the case of a bull trap, a return to the top of the consolidation after \nprices broke to below the low end of the consolidation). An example of a more sensitive combined \nprice/time invalidation signal would be the return of prices to the median of a consolidation (i.e., \nthe initial price confirmation point for bull and bear trap signals) at any time four or more weeks after \na strong price confirmation was received. The more sensitive the selected invalidation condition, the \nsmaller the loss on an incorrect call of a bull or bear trap, but the greater the chance that a correct \ntrade will be abandoned prematurely.\nIf the selected invalidation condition does not occur, a trade implemented on a bull or bear trap \nsignal would be held until a price objective or other trade liquidation condition was met or until the", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 56}
{"text": "more sensitive the selected invalidation condition, the \nsmaller the loss on an incorrect call of a bull or bear trap, but the greater the chance that a correct \ntrade will be abandoned prematurely.\nIf the selected invalidation condition does not occur, a trade implemented on a bull or bear trap \nsignal would be held until a price objective or other trade liquidation condition was met or until there \nwas evidence of an opposite direction trend reversal.\n ■ False Trend Line Breakouts\nAs discussed in Chapter 6, trend lines are particularly prone to false breakouts. Such false break-\nouts can be used as signals for trading in the direction opposite to the breakout. In fact, in my \nopinion, false trend line breakout signals are considerably more reliable than conventional trend \nline breakout signals. In the case of a downtrend, a false trend line breakout would be confirmed \nif the market closed below the trend line a specified number of times (e.g., two, three) follow-\ning an upside breakout. Similarly, in the case of an uptrend, a false trend line breakout would \nbe confirmed if the market closed above the trend line a specified number of times following a \ndownside breakout.\nFigure 15.9 provides an example of a false breakout of an uptrend line in 10-year T -note \nfutures. The September downside breakout of the uptrend line was soon followed by a break \nabove the line. The indicated failure signal is based on an assumed requirement of two closes \nabove the line for confirmation. Figure 15.10 provides a similar example in the \ne-mini Nasdaq \n100 futures.\nIt is quite possible for a chart to yield multiple successive false trend breakout signals in the \nprocess of a trend line being redefined. In Figure 15.11 the initial upside penetration of the prevail -\ning downtrend line occurred in mid-March. Prices quickly retreated back below the line, with the \nindicated failure signal assumed to be triggered by the second close below the line. Another false \nbreakout occurred about a month later based on the redefined trend line using the March relative \nhigh. Prices retreated below this downtrend line several days later, yielding another false trend \nbreakout signal. \n212A CoMPleTe GuIDe To THe FuTuReS MARKeT\n FIGURE  15.10 False Breakout of uptrend line: e-Mini Nasdaq Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE  15.9 False Breakout of uptrend line: 10- y ear T -Note Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n213\nTHe MoST IMPoRTANT Rule IN CHART ANAlySIS\n FIGURE  15.11 Multiple False Breakouts of Downtrend lines: euro Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n ■ Return to Spike Extremes \n As was detailed in Chapter 9 , price spikes frequently occur at important price reversals. Conse-\nquently, the return of prices to a prior spike extreme can be viewed as transforming the original spike \ninto a failed signal. The more extreme the spike (i.e., the greater the magnitude by which the spike \nhigh or low exceeds the highs or lows on the prior and subsequent days), the more signifi cant its pen-\netration. The signifi cance of such failed signals is also enhanced if at least several weeks, and preferably \nseveral months, have elapsed since the original spike. \n In Figure 15.12 , the January 2016 return to both the August and october 2015 spike highs was \nfollowed by a sharp rally well above the prior spike highs. In Figure 15.13, the october 2010 penetra-\ntion of the early 2008 spike high was followed by a sharp rally. Figures 15.14 and 15.15 provide two \nillustrations of downside penetrations of spike lows being followed by steep sell-off s. \n214A CoMPleTe GuIDe To THe FuTuReS MARKeT\n FIGURE  15.12 Penetration of Spike Highs: 30- y ear T -Bond Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE  15.13 Penetration of Spike High: Cotton Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n215\nTHe MoST IMPoRTANT Rule IN CHART ANAlySIS\n FIGURE  15.14 Penetration of Spike Highs: Soybean oil Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE  15.15 Penetration of Spike low: Australian Dollar Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n216A CoMPleTe GuIDe To THe FuTuReS MARKeT\n FIGURE  15.16 Spike Penetration Signals Negated: 5- y ear T -Note Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n Generally speaking, a close beyond the opposite extreme of the spike can be viewed as negat-\ning the failed signal. For example, in Figure 15.16 the price briefl y exceeded the August spike high, \nforming a second spike high in early october, but then immediately retreated, falling below the low \nof the August spike day—a failed failed signal, so to speak. This pattern repeated itself in early 2016 \nwhen the market penetrated the october spike, rallied for about a week (forming a spike high in the \nprocess), but then reversed to close below the low of the october spike day in early March. \n ■ Return to Wide-Ranging Day Extremes \n As explained in Chapter 9 , wide-ranging days (WRDs) with particularly strong or weak closes tend to \nlead to price extensions in the same direction. Consequently, a close above the high price of a downside \nWRD or below the low price of an upside WRD can be viewed as confi rming such days as failed signals. \n In Figure 15.17 the WRD that formed in mid-April 2015 is penetrated to the downside about 10 \nweeks later, leading to a signifi cant decline. In Figure 15.18 a huge WRD formed in early July 2013 \nin the vicinity of the May swing high. Three days later, the uptrend was reversed by", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 57}
{"text": "of a downside \nWRD or below the low price of an upside WRD can be viewed as confi rming such days as failed signals. \n In Figure 15.17 the WRD that formed in mid-April 2015 is penetrated to the downside about 10 \nweeks later, leading to a signifi cant decline. In Figure 15.18 a huge WRD formed in early July 2013 \nin the vicinity of the May swing high. Three days later, the uptrend was reversed by a downside WRD, \nwhich was followed three days later by a close below the low of the fi rst WRD, confi rming a failed \nsignal and leading to an extended market slide. \n Figure 15.19 shows an example of an up-closing WRD in late April that was reversed by a down-\nclosing WRD 12 days later. A closing penetration of the April WRD occurred four days later and was \nfollowed by a large, sustained downtrend. Figure 15.20 shows a massive down-closing WRD that was \neclipsed to the upside a little more than a month later and followed by a strong rally to new high ground. \n217\nTHe MoST IMPoRTANT Rule IN CHART ANAlySIS\n FIGURE  15.17 Penetration of upside Wide-Ranging Day: Canadian Dollar Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE  15.18 Penetration of upside Wide-Ranging Day: u.S. Dollar Index Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n218A CoMPleTe GuIDe To THe FuTuReS MARKeT\n FIGURE  15.19 Penetration of upside Wide-Ranging Day: Copper Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE  15.20 Penetration of Downside Wide-Ranging Day: Bund Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n219\nTHe MoST IMPoRTANT Rule IN CHART ANAlySIS\n ■ Counter-to-Anticipated Breakout of Flag or Pennant \n As was explained in Chapter 9 , typically, fl ag or pennant consolidations tend to be followed by price \nswings in the same direction as the price swings that preceded their formation. Therefore, if a fl ag or \npennant formation is followed by a breakout in the opposite direction of the preceding price swing, it \nwould qualify the pattern as a failed signal. \n In Figure 15.21 , just as would have been implied by the chart interpretation guidelines presented in \nChapter 9 , the fl ag formations that evolved during the 2014 downtrend in soybean prices were generally \nfollowed by downswings. The one exception, however, was the fl ag that formed in late September and \nearly october. In this instance, the fl ag was followed by an upside breakout. This counter-to-anticipated \nprice action was followed by a rally of more than 13 percent to the mid-November high. Figures 15.22 , \n 15.23 , and 15.24 provide three examples where counter-to-anticipated downside breakouts of fl ag pat-\nterns signaled major trend reversals. Note that Figure 15.24 is, in fact, the same reversal depicted in \nFigure 15.19 , which focused on the downside penetration of the strong-closing WRD that immediately \npreceded the fl ag. In Figure 15.25 heating oil prices rallied more than 33 percent in one month after the \ncounter-to-anticipated upside breakout of the fl ag that formed in early 2015. \n A counter-to-anticipated breakout does not need to be followed by an immediate extension of \nthe price move in order to be a valid confi rmation of a failed signal. How much of a retracement can \nbe allowed before the interpretation of a failed signal is abandoned? one reasonable approach is to \n FIGURE  15.21 Counter-to-Anticipated Breakout of Flag Pattern: Soybean Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n220A CoMPleTe GuIDe To THe FuTuReS MARKeT\n FIGURE  15.22 Counter-to-Anticipated Breakout of Flag Pattern: Canadian Dollar Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE  15.23 Counter-to-Anticipated Breakout of Flag Pattern: orange Juice Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n221\nTHe MoST IMPoRTANT Rule IN CHART ANAlySIS\n FIGURE  15.24 Counter-to-Anticipated Breakout of Flag Pattern: Copper Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE  15.25 Counter-to-Anticipated Breakout of Flag Pattern: Heating oil Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n222A CoMPleTe GuIDe To THe FuTuReS MARKeT\n FIGURE  15.26 Counter-to-Anticipated Flag Breakout and opposite Direction Flag Breakout \nFollowing Normal Breakout: Cocoa Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n consider the confi rmation of a failed signal in force as long as prices do not close beyond the oppo-\nsite end of the relevant fl ag or pennant. The retracement in Figure 15.21 provides a good example: \nafter the breakout above the top of the September–october fl ag, prices pulled back but held at the \napproximate midpoint of the fl ag before pushing higher, thereby leaving the failed signal intact. \n Figure 15.26 highlights two fl ag patterns. The fi rst formed in July when prices were rallying and \nwas followed by a sharp sell-off after a counter-to-anticipated breakout to the downside. The second \nfl ag occurred in September when the market was rebounding. The market initially broke out of this \nfl ag in the expected direction—to the upside—but after a few days prices dropped back into the fl ag’s \nrange and, eventually, penetrated the bottom of the fl ag, confi rming a failed signal pattern. The mar-\nket subsequently dropped more than 5 percent over the next two weeks. This type of reversal after a \nnormal breakout is the subject of the next section. \n ■ Opposite Direction Breakout of Flag or Pennant Following \na Normal Breakout \n In some cases", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 58}
{"text": "few days prices dropped back into the fl ag’s \nrange and, eventually, penetrated the bottom of the fl ag, confi rming a failed signal pattern. The mar-\nket subsequently dropped more than 5 percent over the next two weeks. This type of reversal after a \nnormal breakout is the subject of the next section. \n ■ Opposite Direction Breakout of Flag or Pennant Following \na Normal Breakout \n In some cases, fl ags and pennants are followed by breakouts in the anticipated direction, but prices \nthen reverse to close beyond the opposite extreme of the fl ag or pennant, as was the case with the \nSeptember 2015 pattern in Figure 15.26 . This combined price action provides another example of \n223\nTHe MoST IMPoRTANT Rule IN CHART ANAlySIS\n FIGURE  15.27 opposite Direction Breakout of Flag Following Normal Breakout: Platinum \nContinuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \na failed signal, since the anticipated breakout of the fl ag or pennant is followed by a price reversal \ninstead of a price follow-through. Note that a close beyond the opposite end of the fl ag or pennant \nis required to confi rm a failed signal, rather than a mere intraday penetration. Although this more \nrestrictive condition will yield slightly less timely confi rmations of failed signals in cases when such a \nconclusion proves valid, it will reduce the number of inaccurate calls of failed signals. \n In Figure 15.27 the fl ag consolidation that formed in January–February 2013 after an upswing off \nsupport near the November–December lows was followed by an upside breakout, as might have been \nanticipated. Instead of witnessing a further sustained advance, however, prices moved higher for only \ntwo days, and less than two weeks later the market had retreated to below the low end of the fl ag \nconsolidation. This price action qualifi ed the earlier upside breakout above the fl ag pattern as a failed \nsignal. (Note this type of signal could also be termed a bull or bear trap if it occurs at a major high \nor low .) In April a counter-to-anticipated upside breakout of a pennant formation was followed by a \nsharp bounce and consolidation before the market dropped to new lows in June. \n In Figure 15.28 the fl ag that formed during an upswing in natural gas prices was also followed by \nan upside breakout and then a retreat below the low end of the fl ag. In this instance, the market pushed \nback into the fl ag’s range several days later but did not reach the pattern’s upper boundary, leaving the \nfailed signal confi rmation intact. \n Figure 15.29 illustrates a fl ag pattern that formed during an extended downtrend in sugar futures. \nThe market fi rst broke out of the fl ag in the anticipated direction but reversed in a few days after \n224A CoMPleTe GuIDe To THe FuTuReS MARKeT\n FIGURE  15.28 opposite Direction Breakout of Flag Following Normal Breakout: April 2016 Natural Gas\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE  15.29 opposite Direction Breakout of Flag Following Normal Breakout: Sugar \n Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n225\nTHe MoST IMPoRTANT Rule IN CHART ANAlySIS\n FIGURE  15.30 opposite Direction Breakout of Flag Following Normal Breakout: euro Continuous \nFutures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \nforming a spike low . The subsequent upside penetration of the fl ag confi rmed the failed signal. After \na partial pullback toward the middle of this upward-sloping fl ag, prices staged a huge upmove. Note \nthis failed signal is also a perfect example of a bear trap bottom. \n In Figure 15.30 an expected downside breakout of the fl ag was followed by an upswing above its \nupper boundary, confi rming a failed fl ag signal that was followed by a brisk rally. \n ■ Penetration of Top and Bottom Formations \n The penetration of patterns that are normally associated with major tops and bottoms represents \nanother important type of failed signal. For example, Figure 15.31 illustrates the double top \nthat formed in u.S. 30-year T -bond futures in late 2010 and the penetration of this top several \nmonths later. The monthly chart inset shows the extent of the market’s subsequent rally. Pen-\netrations of double tops and double bottoms can be significant failure signals even if the top or \nbottom formation is not confirmed. For example, Figure 15.32 shows the downside penetration \nof an unconfirmed double bottom—that is, prices did not exceed the pattern’s october 2013 \nintermediate high. Nonetheless, penetration of the pattern’s July 2013 and January 2014 lows \nrepresented the violation of an important support level, as evidenced by the continued sell-off \nthat followed. \n226A CoMPleTe GuIDe To THe FuTuReS MARKeT\n FIGURE  15.31 Penetration of Double T op: 30- y ear u.S. T -Bond Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE  15.32 Penetration of Double Bottom: Australian Dollar Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n227\nTHe MoST IMPoRTANT Rule IN CHART ANAlySIS\n Penetrations of double-top and double-bottom patterns provide good signals but are rela-\ntively rare. Failed signals involving head-and-shoulders patterns are more common and often \nprovide excellent trading indicators. Although the choice of what condition constitutes a confi r-\nmation of a failed head-and-shoulders pattern is somewhat arbitrary, I would use the criterion of \nprices exceeding the most recent shoulder. For example, in Figure 15.33 the rebound above the \nshoulder that peaked at the beginning of November 2012 would represent a confi rmation of a \nfailed head-and-shoulders top pattern. Sometimes prices will fi rst dip back after penetrating the \nshoulder, even when a substantial advance ultimately", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 59}
{"text": "attern is somewhat arbitrary, I would use the criterion of \nprices exceeding the most recent shoulder. For example, in Figure 15.33 the rebound above the \nshoulder that peaked at the beginning of November 2012 would represent a confi rmation of a \nfailed head-and-shoulders top pattern. Sometimes prices will fi rst dip back after penetrating the \nshoulder, even when a substantial advance ultimately ensues, as is the case in Figure 15.34 , which \nshows a long-term example on a weekly chart of the e-mini S&P 500 futures. As long as prices \ndon’t close below the relative low formed between the head and right shoulder, the failed signal \nwould remain intact. Figure 15.35 provides another example of a strong rally following a failed \nhead-and-shoulders top. \n Figure 15.36 illustrates a failed head-and-shoulders bottom pattern. In analogous fashion to the \nhead-and-shoulders top case, the downside penetration of the more recent shoulder is used as the \nconfi rmation condition of a failed signal. \n The trader may often benefi t by waiting for a retracement before implementing a position based \non the confi rmation of a failed head-and-shoulders pattern, as illustrated by Figure 15.34 . The trade-\noff is that such a strategy will result in missing very profi table trades in those cases where there is no \nretracement or only a very modest retracement (e.g., Figures 15.35 and 15.36 ). \n FIGURE  15.33 Failed Head-and-Shoulders T op Pattern: Soymeal Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n228A CoMPleTe GuIDe To THe FuTuReS MARKeT\n FIGURE  15.34 Failed Head-and-Shoulders T op Pattern: e-Mini S&P 500 Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE  15.35 Failed Head-and-Shoulders T op Pattern: Nikkei 225 Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n229\nTHe MoST IMPoRTANT Rule IN CHART ANAlySIS\n ■ Breaking of Curvature \n As was discussed in Chapter 9 , rounding patterns often provide very reliable trading signals. In this \nsense, the breaking of a curved price pattern can be viewed as transforming the pattern into a failed \nsignal. Figure 15.37 actually contains two examples where the breaking of the curvature of what had \nbeen an apparent rounding-top pattern represented a bullish signal. In Figure 15.38 , the breaking of \nthe curvature of an apparent rounding-bottom pattern led to a steep decline in corn prices in 2014. \nNote the downthrust in January 2014 (the low of the curved pattern) was the bear trap illustrated in \nFigures 15.4 and 15.8 . So, in eff ect, this chart illustrates two successive failure patterns, the fi rst sig-\nnaling a near-two-month rebound, and the second the subsequent reversal into a major downtrend. \n ■ The Future Reliability of Failed Signals \n There is an inverse relationship between the popularity of an indicator and its effi ciency. For example, \ndecades ago, when technical analysis was used by fewer market practitioners, chart breakouts (price \nmoves above or below prior trading ranges) tended to work relatively well, providing many excellent \nsignals without an abundance of false signals. In my observation, as technical analysis became increasingly \npopular and breakouts a commonly used tool, the effi ciency of this pattern seemed to deteriorate. In \nfact, it now seems that price reversals following breakouts may more often be the rule than the exception. \n FIGURE  15.36 Failed Head-and-Shoulders Bottom Pattern: Sugar Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n230A CoMPleTe GuIDe To THe FuTuReS MARKeT\n FIGURE  15.37 Breaking of Curvature: e-Mini Nasdaq 100 Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE  15.38 Breaking of Curvature: Corn Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n231\nTHe MoST IMPoRTANT Rule IN CHART ANAlySIS\nAs stated earlier, I find failed signals considerably more reliable than conventional chart patterns. \nAlthough the concept of failed signals is certainly not new , I don’t believe its usage is widely empha-\nsized. If the use of failed signals were to become significantly more widespread, however, their long-\nterm reliability could be adversely affected.\nAs a final comment, it should be emphasized that the concept of failed signals in this chapter has \nbeen presented in the context of conventional chart analysis as it exists today. In the future—particu-\nlarly the distant future—what passes for popular chart interpretation may well change. The concept \nof failed signals, however, can be made dynamic by pegging it to the conventional wisdom. In other \nwords, if a new chart pattern became popular as a technical signal in the future (e.g., in the way \nbreakouts are widely used today), a failure of the pattern could be viewed as more significant than the \npattern itself. In this more general sense, the concept of failed signals could prove timeless.\n ■ Conclusion\nThe novice trader will ignore a failed signal, riding a position into a large loss while hoping for the \nbest. More experienced traders, having learned the importance of money management, will exit \nquickly once it is apparent they have made a bad trade. However, the truly skilled trader will be able \nto do a 180-degree turn, reversing a position at a loss if market behavior (e.g., confirmation of a failed \nsignal) points to such a course of action. In other words, it takes great discipline to capitalize on failed \nsignals, but such flexibility is essential to the effective synthesis of chart analysis and trading.\n\nTraDing SySTeMS \nanD PerforMance \nMeaSureMenT\nPart IV\n\n235\nCha P ter 16\nThere are only two types of trend-following systems: fast and slow.\n—Jim orcutt\nB\ne forewarned. if you are expe", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 60}
{"text": "led \nsignal) points to such a course of action. In other words, it takes great discipline to capitalize on failed \nsignals, but such flexibility is essential to the effective synthesis of chart analysis and trading.\n\nTraDing SySTeMS \nanD PerforMance \nMeaSureMenT\nPart IV\n\n235\nCha P ter 16\nThere are only two types of trend-following systems: fast and slow.\n—Jim orcutt\nB\ne forewarned. if you are expecting to find the blueprint for a heretofore secret trading system \nthat consistently makes 100 percent plus per year in real-life trading with minimal risk, you’ll \nhave to look elsewhere. for one thing, i have not yet discovered such a “sure thing” money machine. \nBut, in a sense, that is beside the point. Quite frankly, i have always been somewhat puzzled by \nadvertisements for books or computer software promising to reveal the secrets of systems that \nmake 100 percent, 200 percent, and more! Why are they selling such valuable information for $99, \nor even $2,999?\nThe primary goal of this chapter is to provide readers with the background knowledge necessary \nto develop their own trading systems. The discussion focuses on the following five areas:\n 1. a n overview of some basic trend-following systems\n 2. The key weaknesses of these systems\n 3. g uidelines for transforming “generic” systems into more powerful systems\n 4. c ountertrend systems\n 5. Diversification as a means of improving performance\nchapter 17 provides additional examples of trading systems, using original systems as illustra-\ntions. The essential issues of appropriate data selection, system testing procedures, and performance \nmeasurement are discussed in \nchapters 18, 19, and 20.\nT echnical \nTrading Systems: \nStructure and Design\n236\nA Complete Guide to the Futures mArket\n ■ The Benefits of a Mechanical Trading System\nis paper trading easier than real trading? Most speculators would answer yes, even though both tasks \nrequire an equivalent decision process. This difference is explained by a single factor: emotion. over-\ntrading, premature liquidation of good positions because of rumors, jumping the gun on market entry \nto get a better price, riding a losing position—these are but a few of the negative manifestations of \nemotion in actual trading. Perhaps the greatest value of a mechanical system is that it eliminates emo-\ntion from trading. \nin so doing, it allows the speculator to avoid many of the common errors that often \nimpede trading performance. furthermore, removing the implied need for constant decision making \nsubstantially reduces trading-related stress and anxiety.\nanother benefit of a mechanical system is that it ensures a consistent approach—that is, the trader \nfollows all signals indicated by a common set of conditions. This is important, since even profitable \ntrading strategies can lose money if applied selectively. T o illustrate this point, consider the example \nof a market advisory whose recommendations yield a net profit over the long run (after allowances for \ncommissions and poor executions). Will the advisory’s subscribers make money if they only imple-\nment trades in line with its recommendations? \nnot necessarily. Some people will pick and choose \ntrades, invariably missing some of the biggest winners. others will stop following the recommenda-\ntions after the advisor has a losing streak, and as a result may miss a string of profitable trades. The \npoint is that a good trading strategy is not sufficient; success also depends on consistency.\na third advantage of mechanical trading systems is they normally provide the trader with a method \nfor controlling risk. Money management is an essential ingredient of trading success. Without a plan \nfor limiting losses, a single bad trade can lead to disaster. \nany properly constructed mechanical system \nwill either contain explicit stop-loss rules or specify conditions for reversing a position given a sufficient \nadverse price move. \nas a result, following signals generated by a mechanical trading system will nor-\nmally prevent the possibility of huge losses on individual trades (except in extreme circumstances when \none is unable to liquidate a position because the market is in the midst of a string of locked-limit moves). \nThus, the speculator using a mechanical system may end up losing money due to the cumulative effect \nof a number of negative trades, but at least his account will not be decimated by one or two bad trades.\nof course, money management does not necessarily require the use of a trading system. risk control \ncan also be achieved by initiating a good-till-canceled stop order whenever a new position is taken, or by \npredetermining the exit point upon entering a trade and sticking to that decision. However, many trad-\ners lack sufficient discipline and will be tempted to give the market just a little more time once too often.\n ■ Three Basic Types of Systems\nThe categories used to classify trading systems are completely arbitrary. The following three-division \nclassification is intended to emphasize a subjective interpretation of the key conceptual differences in \npossible trading approaches:\ntrend-following. a trend-following system waits for a specified price move and then initiates \na position in the same direction based on the implicit assumption that the trend will continue.\nCountertrend. a countertrend system waits for a significant price move and then initiates a \nposition in the opposite direction on the assumption that the market is due for a correction.\n237\nTechnical Trading SySTemS: STrucTure and deSign\nPattern recognition. in a sense, all systems can be classified as pattern recognition systems. \nafter all, the conditions that signal a trend or a countertrend trade are a type of pattern (e.g., \nclose beyond the 20-day high or low). However, the implication here is that the chosen patterns \nare not based primarily on directional moves, as is the case in trend-following and counter-\ntrend systems. \nfor example, a pattern-recognition syste", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 61}
{"text": "ms can be classified as pattern recognition systems. \nafter all, the conditions that signal a trend or a countertrend trade are a type of pattern (e.g., \nclose beyond the 20-day high or low). However, the implication here is that the chosen patterns \nare not based primarily on directional moves, as is the case in trend-following and counter-\ntrend systems. \nfor example, a pattern-recognition system might generate signals on the basis \nof “spike days” (see chapter 9). in this case, the key consideration is the pattern itself (e.g., \nspike) rather than the extent of any preceding price move. of course, this example is overly \nsimplistic. in practice, the patterns used for determining trading signals will be more complex, \nand several patterns may be incorporated into a single system.\nSystems of this type may sometimes employ probability models in making trading decisions. \nin this case the researcher would try to identify patterns that appeared to act as precursors of \nprice advances or declines in the past. an underlying assumption in this approach is that such \npast behavioral patterns can be used to estimate current probabilities for rising or declining \nmarkets given certain specified conditions. This chapter does not elaborate on this approach of \ntrading system design since it lies beyond the scope of the overall discussion.\nit should be emphasized that the lines dividing the preceding categories are not always clear-cut. \nas modifications are incorporated, a system of one type may begin to more closely approximate the \nbehavioral pattern of a different system category.\n ■ Trend-Following Systems\nBy definition, trend-following systems never sell near the high or buy near the low , because a meaningful \nopposite price move is required to signal a trade. Thus, in using this type of system, the trader will always \nmiss the first part of a price move and may surrender a significant portion of profits before an opposite \nsignal is received (assuming the system is always in the market). There is a basic trade-off involved in \nthe choice of the sensitivity, or speed, of a trend-following system. \na sensitive system, which responds \nquickly to signs of a trend reversal, will tend to maximize profits on valid signals, but it will also gener-\nate far more false signals. a nonsensitive, or slow , system will reflect the reverse set of characteristics.\nMany traders become obsessed with trying to catch every market wiggle. Such a predilection leads \nthem toward faster and faster trend-following systems. although in some markets fast systems con-\nsistently outperform slow systems, in most markets the reverse is true, as the minimization of losing \ntrades and commission costs in slow systems more than offsets the reduced profits in the good trades. \nThis observation is only intended as a cautionary note against the natural tendency toward seeking \nout more sensitive systems. However, in all cases, the choice between fast and slow systems must be \ndetermined on the basis of empirical observation and the trader’s subjective preferences.\nThere is a wide variety of possible approaches in constructing a trend-following system. \nin this \nchapter we focus on two of the most basic methods: moving average systems and breakout systems.\nMoving average Systems\nThe moving average for a given day is equal to the average of that day’s closing price and the closing \nprices on the preceding N − 1 days, where N is equal to the number of days in the moving average. \n238\nA Complete Guide to the Futures mArket\nfor example, in a 10-day moving average, the appropriate value for a given day would be the average \nof the 10 closing prices culminating with that day. The term moving average refers to the fact that the \nset of numbers being averaged is continuously moving through time.\nBecause the moving average is based on past prices, in a rising market the moving average will be \nbelow the price, while in a declining market the moving average will be above the price. Thus, when \na price trend reverses from up to down, prices must cross the moving average from above. Similarly, \nwhen the trend reverses from down to up, prices must cross the moving average from below . \nin the \nmost basic type of moving average system, these crossover points are viewed as trade signals: a buy \nsignal is indicated when prices cross the moving average from below; a sell signal is indicated when \nprices cross the moving average from above. The crossover should be determined based on closing \nprices. Table 16.1 illustrates the calculation of a 10-day simple moving average and indicates the cor-\nresponding crossover signal points.\ntable 16.1 Calculating a Moving average\nDay Closing Price 10-Day Moving average Crossover Signal\n1 80.50\n2 81.00\n3 81.90\n4 81.40\n5 83.10\n6 82.60\n7 82.20\n8 83.10\n9 84.40\n10 85.20 82.54\n11 84.60 82.95\n12 83.90 83.24\n13 84.40 83.49\n14 85.20 83.87\n15 86.10 84.17\n16 85.40 84.45\n17 84.10 84.64 Sell\n18 83.50 84.68\n19 83.90 84.63\n20 83.10 84.42\n21 82.50 84.21\n22 81.90 84.01\n23 81.20 83.69\n24 81.60 83.33\n25 82.20 82.94\n26 82.80 82.68 Buy\n27 83.40 82.61\n28 83.80 82.64\n29 83.90 82.64\n30 83.50 82.68\n239\nTecHnicaL TraDing SySTeMS: STrucTure anD DeSign\n figure 16.1 shows the June 2015 WTi crude oil contract with a 35-day moving average. The non-\ncircled buy and sell signals on the chart are based on the simple moving average system just described. \n(for now ignore the circled signals; they are explained later.) note that although the system catches \nthe major downtrend, it also generates several false signals. of course, this problem can be mitigated \nby increasing the length of the moving average, but the tendency toward excessive false signals is a \ncharacteristic of the simple moving average system. The reason for this is that temporary, sharp price \nfl uctuations, suffi cient to trigger trade signals, are commonplace events in futures markets. \n one school of thought suggests the problem with the simple moving average system is th", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 62}
{"text": "itigated \nby increasing the length of the moving average, but the tendency toward excessive false signals is a \ncharacteristic of the simple moving average system. The reason for this is that temporary, sharp price \nfl uctuations, suffi cient to trigger trade signals, are commonplace events in futures markets. \n one school of thought suggests the problem with the simple moving average system is that it \nweights all days equally, whereas more recent days are more important and hence should be weighted \nmore heavily. Many diff erent weighting schemes have been proposed for constructing moving aver-\nages. Two of the most common weighting approaches are the linearly weighted moving average (LWMa) \nand the exponentially weighted moving average (eWMa). \n1 \n The LWMa assigns the oldest price in the moving average a weight of 1, the second oldest price \na weight of 2, and so on. The weight of the most recent price would be equal to the number of days \n FIGURE  16.1 June 2015 WTi crude oil and 35-Day Moving average\n Note: /uni2191 = buy signal: prices cross moving average from below and close above line; /uni2193 = sell \nsignal: prices cross moving average from above and close below line; = buy signal not \neliminated by fi lter; = sell signal not eliminated by fi lter. \nchart created using TradeStation. ©TradeStation T echnologies, inc. all rights reserved. \n 1 The following two sources were used as reference for the remainder of this section: (1) Perry Kaufman, T rading \nSystems and Methods (Hoboken, nJ: John Wiley & Sons, 2013), and (2) T echnical Analysis of Stocks & Commodities, \nbonus issue 1995, sidebar, page 66.\n240\nA Complete Guide to the Futures mArket\nin the moving average. The LWMa is equal to the sum of the weighted prices divided by the sum of \nthe weights:\nLWMA =\nPt\nt\nt\nt\nn\nt\nn\n⋅\n=\n=\n∑\n∑\n1\n1\nwhere t = time indicator (oldest day = 1, second oldest = 2, etc.)\nPt = price at time t\nn = number of days in moving average\nfor example, for a 10-day LWM a, the price of 10 days ago would be multiplied by 1, the \nprice of 9 days ago by 2, and so on through the most recent price, which would be multiplied by \n10. The sum of these weighted prices would then be divided by 55 (the sum of 1 through 10) to \nobtain the LWM\na.\nThe eWMa is calculated as the sum of the current price multiplied by a smoothing constant between \n0 and 1, denoted by the symbol a, and the previous day’s eWMa multiplied by 1 − a:\nEWMA EWMAtt taP a=+ − −()1 1\nThis linked calculation wherein each day’s value of the eWMa is based on the previous day’s value \nmeans that all prior prices will have some weight, but the weight of each day drops exponentially the \nfurther back in time it is. The weight of any individual day would be:\naa k()1 −\nwhere k = number of days prior to current day (for current day, k = 0 and term reduces to a).\nSince a is a value between 0 and 1, the weight of each given day drops sharply moving back in time. \nfor example, if a = 0.1, yesterday’s price would have a weight of 0.09, the price two days ago would \nhave a weight of 0.081, the price 10 days ago would have a weight of 0.035, and the price 30 days ago \nwould have a weight of 0.004.\nan eWMa with a smoothing constant, a, corresponds roughly to a simple moving average of \nlength n, where a and n are related by the following formula:\nan=+21/( )\nor\nna a=−() / 2\nThus, for example, an eWMa with a smoothing constant equal to 0.1 would correspond roughly \nto a 19-day simple moving average. as another example, a 40-day simple moving average would cor-\nrespond roughly to an eWMa with a smoothing constant equal to 0.04878.\n241\nTecHnicaL TraDing SySTeMS: STrucTure anD DeSign\n in my view , there is no strong empirical evidence to support the idea that linearly or exponentially \nweighted moving averages provide a substantive and consistent improvement over simple moving \naverages. Sometimes weighted moving averages will do better; sometimes simple moving averages \nwill do better. (See chapter 11 for an illustration of this point.) The question of which method will \nyield better results will be entirely dependent on the markets and time periods selected, with no rea-\nson to assume that past relative superiority will be indicative of the probable future pattern. in short, \nexperimentation with diff erent weighted moving averages probably does not represent a particularly \nfruitful path for trying to improve the simple moving average system. \n a far more meaningful improvement is provided by the crossover moving average approach. in this \nsystem, trade signals are based on the interaction of two moving averages, as opposed to the interaction \nbetween a single moving average and price. The trading rules are very similar to those of the simple \nmoving average system: a buy signal is generated when the shorter moving average crosses above the \nlonger moving average; a sell signal is generated when the shorter moving average crosses below the lon-\nger moving average. (in a sense, the simple moving average system can be thought of as a special case of \nthe crossover moving average system, in which the short-term moving average is equal to 1.) Because \ntrade signals for the crossover system are based upon two smoothed series (as opposed to one smoothed \nseries and price), the number of false signals is substantially reduced. figures 16.2 , 16.3 , and 16.4 \ncompare trade signals generated by a simple 12-day moving average system, a simple 48-day moving \naverage system, and the crossover system based on these two averages. generally speaking, the crossover \nmoving average system is far superior to the simple moving average. (However, it should be noted that \n FIGURE  16.2 e-Mini nasdaq 100 continuous futures with 12-Day Moving average\n Note: /uni2191 = buy signal: prices cross moving average from below and close above line; /uni2193 = sell \nsignal: prices cross moving average from above and close below line. \nchart created using TradeStation. ©TradeStation T echnologies, inc.", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 63}
{"text": "r superior to the simple moving average. (However, it should be noted that \n FIGURE  16.2 e-Mini nasdaq 100 continuous futures with 12-Day Moving average\n Note: /uni2191 = buy signal: prices cross moving average from below and close above line; /uni2193 = sell \nsignal: prices cross moving average from above and close below line. \nchart created using TradeStation. ©TradeStation T echnologies, inc. all rights reserved. \n\n242a coMPLeTe guiDe To THe fuTureS MarKeT\n FIGURE  16.3 e-Mini nasdaq 100 continuous futures with 48-Day Moving average\n Note: /uni2191 = buy signal: prices cross moving average from below and close above line; /uni2193 = sell \nsignal: prices cross moving average from above and close below line. \nchart created using TradeStation. ©TradeStation T echnologies, inc. all rights reserved. \n FIGURE  16.4 e-Mini nasdaq 100 continuous futures with Moving average crossover\n Note: /uni2191 = buy signal: short-term moving average (12-day) crosses long-term moving average \n(48-day) from below; /uni2193 = sell signal: short-term moving average crosses long-term moving \naverage from above. \nchart created using TradeStation. ©TradeStation T echnologies, inc. all rights reserved. \n\n243\nTecHnicaL TraDing SySTeMS: STrucTure anD DeSign\nby including some of the trend-following-system modifi cations discussed in a later section, even the \nsimple moving average system can provide the core for a viable trading approach.) The weaknesses of \nthe crossover moving average system and possible improvements are discussed later. \n breakout Systems \n The basic concept underlying breakout systems is very simple: the ability of a market to move to a \nnew high or low indicates the potential for a continued trend in the direction of the breakout. The \nfollowing set of rules provides an example of a simple breakout system: \n 1. cover short and go long if today’s close exceeds the prior N -day high. \n 2. cover long and go short if today’s close is below the prior N -day low . \n The value chosen for N will defi ne the sensitivity of the system. if a short-duration period is used \nfor comparison to the current price (e.g., N = 7), the system will indicate trend reversals fairly \nquickly, but will also generate many false signals. in contrast, the choice of a longer-duration period \n(e.g., N = 40) will reduce false signals, but at the cost of slower entry. \n figure 16.5 compares the trade signals generated by the preceding simple breakout system in silver \ncontinuous futures using N = 7 and N = 40. The following three observations, which are evidenced in \nfigure 16.5 , are also valid as generalizations describing the trade-off s between fast and slow breakout \nsystems: \n 1. a fast system will provide an earlier signal of a major trend transition (e.g., the october 2012 \nsell signal). \n FIGURE  16.5 Breakout System Signals, fast versus Slow Systems: Silver continuous futures\n Note: B, S = signals for N = 7; , = signals for N = 40. \nchart created using TradeStation. ©TradeStation T echnologies, inc. all rights reserved. \n\n244\nA Complete Guide to the Futures mArket\n 2. a fast system will generate far more false signals.\n 3. The loss per trade in the slower system will be greater than the loss for the corresponding trade \nin the faster system. in some cases, a fast system might even realize a small profit on a minor \ntrend that results in a loss in a slower system. for example, the N = 40 system’s august buy \nsignal that was liquidated in november resulted in a net loss of approximately $2.54 (exclud-\ning commissions). The corresponding buy signal for the N = 7 version—triggered in July and \nexited in September—resulted in a net gain of around $2.46.\nas indicated by the preceding illustration, fast and slow systems will each work better under dif-\nferent circumstances. in the case of the chosen illustration, on balance, the slow system was much \nmore successful. of course, one could just as easily have chosen an example in which the reverse \nobservation was true. However, empirical evidence suggests that, in most markets, slower systems \ntend to work better. \nin any case, the choice between a fast and a slow system must be based on up-\nto-date empirical testing.\nThe previous example of a breakout system was based on the current day’s close and prior period’s \nhigh and low . it should be noted that these choices were arbitrary. other alternative combinations \nmight include current day’s high or low versus prior period’s high or low; current day’s close versus \nprior period’s high close or low close; and current day’s high or low versus prior period’s high close \nor low close. \nalthough the choice of the condition that defines a breakout will affect the results, the \ndifferences between the variations just given (for the same value of N) will be largely random and not \noverwhelming. Thus, while each of these definitions might be tested, it probably makes more sense to \nfocus research efforts on more meaningful modifications of the basic system.\nThe pitfalls of breakout-type systems are basically the same as those of moving average systems and \nare detailed in the following section.\n ■ Ten Common Problems with Standard \nTrend-Following Systems\n 1. too many similar systems. Many different trend-following systems will generate similar \nsignals. Thus, it is not unusual for a number of trend-following systems to signal a trade during \nthe same one- to five-day period. Because many speculators and futures funds base their deci-\nsions on basic trend-following systems, their common action can result in a flood of similar \norders. \nunder such circumstances, traders using these systems may find their market and stop \norders filled well beyond the intended price, if there is a paucity of offsetting orders.\n 2. Whipsaws. Trend-following systems will signal all major trends; the problem is that they \nwill also generate many false signals. \na major frustration experienced by traders using trend-\nfollowing systems is that markets wil", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 64}
{"text": "er such circumstances, traders using these systems may find their market and stop \norders filled well beyond the intended price, if there is a paucity of offsetting orders.\n 2. Whipsaws. Trend-following systems will signal all major trends; the problem is that they \nwill also generate many false signals. \na major frustration experienced by traders using trend-\nfollowing systems is that markets will frequently move far enough to trigger a signal and then \nreverse direction. This unpleasant event can even occur several times in succession; hence, the \nterm whipsaw. \nfor example, figure 16.6, which indicates the trade signals generated by a break-\nout system (close beyond prior N-day high-low) for N = 10, provides a vivid illustration of the \ndark side of trend-following systems.\n245\nTecHnicaL TraDing SySTeMS: STrucTure anD DeSign 3. Failure to exploit major price moves. Basic trend-following systems always assume an \nequal-unit-size position. as a result, given an extended trend, the best such a system can do \nis to indicate a one-unit position in the direction of the trend. for example, in figure 16.7 a \nbreakout system with N = 40 would signal a long position in December 2012 and remain long \nthroughout the entire uptrend until february 2014. although this outcome is hardly unfavor-\nable, profi tability could be enhanced if the trend-following system were able to take advantage \nof such extended trends by generating signals indicating increases in the base position size. \n 4. Nonsensitive (slow) systems can surrender a large percentage of profi ts. although slow \nvariations of trend-following systems may often work best, one disturbing feature of such systems \nis that they may sometimes surrender a large portion of open profi ts. in figure 16.8 , for example, a \nbreakout system with N = 40 catches a major portion of the october–December 2014 price advance \nin silver, but then surrenders more than the entire gain before an opposite signal occurs. The June buy \nsignal is initially profi table, but then realizes a much larger loss by the time a sell signal is received. \n 5. Cannot make money in trading range markets. The best any trend-following system can \ndo during a period of sideways price action is to break even—that is, generate no new trade sig-\nnals. in most cases, however, trading range markets will be characterized by whipsaw losses. This \nis a particularly signifi cant consideration since sideways price action represents the predominant \nstate of most markets. \n 6. temporary large losses. even an excellent trend-following system may witness transitory peri-\nods of sharp equity retracement. Such events can be distressing to the trader who enjoys a profi t \ncushion, but they can be disastrous to the trader who has just begun following the system’s signals. \n FIGURE  16.6 Breakout Signals in Trading range Market: october 2015 natural gas futures\n Note: B = buy signal: close above prior 10-day high; S = sell signal: close below 10-day low . \nchart created using TradeStation. ©TradeStation T echnologies, inc. all rights reserved. \n\n246a coMPLeTe guiDe To THe fuTureS MarKeT\n FIGURE  16.7 failure of System to exploit Major Price Move: russell 2000 Mini futures\nchart created using TradeStation. ©TradeStation T echnologies, inc. all rights reserved. \n FIGURE  16.8 Surrender of Profi ts by nonsensitive System: Silver continuous futures\n Note: B = buy signal: close above prior 40-day high; S = sell signal: close below 40-day low . \nchart created using TradeStation. ©TradeStation T echnologies, inc. all rights reserved. \n\n247\nTechnical Trading SySTemS: STrucTure and deSign\n 7. extreme volatility in best-performing systems. in some cases, the trader may find that \nthe most profitable trend-following systems are also subject to particularly sharp retracements, \nthereby implying an unacceptable level of risk.\n 8. System works well in testing but then bombs. This scenario is perhaps the most common \ntale of woe among traders who have used mechanical trading systems.\n 9. Parameter shift.2 frequently, the trader may perform an exhaustive search to find the best \nvariation of a system based on past data (e.g., the optimum value of N in a breakout system), \nonly to find that the same variation performs poorly (relative to other variations) in the ensuing \nperiod.\n 10. Slippage. another common experience: the system generates profits on paper, but simultaneously \nloses money in actual trading. Slippage is discussed in chapter 19.\n ■ Possible Modifications for Basic \nTrend-Following Systems\neven simple systems, such as moving average or breakout systems, will probably prove profitable if \ntraded consistently over a broad range of markets for a sufficient length of time (e.g., three to five \nyears or longer). However, the simplicity of these systems is a vice as well as a virtue. in essence, \nthe rules of these systems are perhaps too simple to adequately account for the wide variety of pos-\nsible market situations. \neven if net profitable over the long run, simple trend-following systems will \ntypically leave the trader exposed to periodic sharp losses. in fact, the natural proclivity of many, if \nnot most, users of such systems to abandon the approach during a losing period will lead them to \nexperience a net loss even if the system proves profitable over the longer run.\nin this section, we discuss some of the primary ways to modify basic trend-following systems in \nan effort to improve their performance. for simplicity, most of the examples will use the previously \ndescribed simple breakout system. However, the same types of modifications could also be applied to \nother basic trend-following systems (e.g., crossover moving average).\nConfirmation Conditions\nan important modification that can be made to a basic trend-following system is the requirement for \nadditional conditions to be met before a signal is accepted. if these conditions are not realized before \nan opposite direction signal is received", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 65}
{"text": "the same types of modifications could also be applied to \nother basic trend-following systems (e.g., crossover moving average).\nConfirmation Conditions\nan important modification that can be made to a basic trend-following system is the requirement for \nadditional conditions to be met before a signal is accepted. if these conditions are not realized before \nan opposite direction signal is received, no trade occurs. confirmation rules are designed specifi-\ncally to deal with the nemesis of trend-following systems: false signals. The idea is that valid signals \nwill fulfill the confirmation conditions, while false signals generally will not. The range of possible \n2 The meaning of the term parameter as it is used in trading systems is detailed in chapter 19.\n248a coMPLeTe guiDe To THe fuTureS MarKeT\nchoices for confi rmation conditions is limited only by the imagination of the system designer. Here \nare three examples: \n 1. Penetration. a trade signal is accepted only if the market moves a specifi ed minimum amount \nbeyond a given reference level (e.g., signal price). This confi rming price move can be measured \nin either nominal or percentage terms. figure 16.9 compares the trade signals generated by a \nstandard breakout system with N = 12 and the corresponding system with a confi rmation rule \nrequiring a close that exceeds the prior N -day high or low by at least 3 percent. \n3 note that in \nthis example, although the confi rmation rule results in moderately worse entry levels for valid \nsignals, it eliminates fi ve of six losing buy signals. (The sell signals following the nonconfi rmed \nbuy signals are also eliminated, since the system is already short at these points.) \n 2. time delay. in this approach, a specifi ed time delay is required, at the end of which the signal is \nreevaluated. for example, a confi rmation rule may specify that a trade signal is taken if the mar-\nket closes beyond the signal price (higher for a buy, lower for a sell) at any time six or more days \nbeyond the original signal date. figure 16.10 compares the signals generated by a basic breakout \nsystem with N = 12, and the corresponding system with the six-day time delay confi rmation \ncondition. again, the confi rmation rule eliminates fi ve of the six losing buy signals. \n 3 Because figure 16.9 depicts a continuous futures series, percentage price changes would be equal to the \nprice changes shown on this chart divided by the corresponding nearest futures price, which is not shown. \nrecall from chapter 5 that continuous futures accurately refl ect price swings but not price levels. conse-\nquently, continuous futures cannot be used as the divisor to calculate percentage changes.\n FIGURE  16.9 Penetration as confi rmation condition: coff ee continuous futures\n Note: B, S = signals for breakout system with N = 12; , = signals for breakout system \nwith N = 12 and 3 percent closing penetration confi rmation. \nchart created using TradeStation. ©TradeStation T echnologies, inc. all rights reserved. \n\n249\nTecHnicaL TraDing SySTeMS: STrucTure anD DeSign\n 3. Pattern. This is a catch-all term for a wide variety of confi rmation rules. in this approach, a \nspecifi ed pattern is required to validate the basic system signal. for example, the confi rmation \nrule might require three subsequent thrust days beyond the signal price. 4 figure 16.11 com-\npares the signals generated by the basic breakout system, with N = 12 and the signals based upon \nthe corresponding system using the three-thrust-day validation condition. The thrust-day count \nat confi rmed signals is indicated by the numbers on the chart. Here, too, the confi rmation rule \neliminates fi ve of six losing buy signals. \n The design of trading systems is a matter of constant trade-off s. The advantage of confi rmation \nconditions is that they will greatly reduce whipsaw losses. However, it should be noted that confi rma-\ntion rules also have an undesirable side eff ect—they will delay entry on valid signals, thereby reducing \ngains on profi table trades. for example, in figures 16.9 through 16.11 , note that the confi rmation \nrules result in worse entry prices for all the valid trade signals. The confi rmation condition will be \nbenefi cial as long as reduced profi ts due to delayed entry are more than off set by avoided losses. a sys-\ntem that includes confi rmation conditions will not always outperform its basic system counterpart, \nbut if properly designed it will perform signifi cantly better over the long run. \n 4 a thrust day, which was originally defi ned in chapter 9 , is a day with a close above the previous day’s high or \nbelow the previous day’s low .\n FIGURE  16.10 Time Delay as a confi rmation condition: coff ee continuous futures\n Note: B, S = signals for breakout system with N = 12; , = signals for breakout system with \n N = 12 and six-day time delay confi rmation. \nchart created using TradeStation. ©TradeStation T echnologies, inc. all rights reserved. \n\n250a coMPLeTe guiDe To THe fuTureS MarKeT\n Filter \n The purpose of a fi lter is to eliminate those trades that are deemed to have a lower probability of suc-\ncess. for example, the technical system might be combined with a fundamental model that classifi es \nthe market as bullish, bearish, or neutral. T echnical signals would then be accepted only if they were \nin agreement with the fundamental model’s market designation. in cases of disagreement, a neutral \nposition would be indicated. in most cases, however, the fi lter condition(s) will also be technical in \nnature. for example, if one could derive a set of rules that had some accuracy in defi ning the pres-\nence of a trading range market, signals that were received when a trading range market was indicated \nwould not be accepted. in essence, in developing a fi lter, the system designer is trying to fi nd a com-\nmon denominator applicable to the majority of losing trades. \n W e will use the frequently unsatisfactory simple moving average system t", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 66}
{"text": "of rules that had some accuracy in defi ning the pres-\nence of a trading range market, signals that were received when a trading range market was indicated \nwould not be accepted. in essence, in developing a fi lter, the system designer is trying to fi nd a com-\nmon denominator applicable to the majority of losing trades. \n W e will use the frequently unsatisfactory simple moving average system to provide a specifi c \nexample of a fi lter condition. The noncircled signals in figure 16.1 illustrate the typical tendency of \nthe simple moving average system to generate many false signals—even in trending markets. These \nwhipsaw trades can be substantially reduced by applying a fi lter rule that requires trade signals to be \nconsistent with the trend of the moving average. for example, price crossing the moving average from \nbelow and closing above the moving average would be accepted as a buy signal only if the moving \naverage was up relative to the previous day’s level. This fi lter condition makes intuitive sense because \nit adheres to the basic technical concept of trading with the major trend. \n FIGURE  16.11 example of a Pattern confi rmation condition: coff ee continuous futures\n Note: B, S = signals for breakout system with N = 12; , = signals for breakout system with \n N = 12 and three-thrust-day confi rmation. \nchart created using TradeStation. ©TradeStation T echnologies, inc. all rights reserved. \n\n251\nTechnical Trading SySTemS: STrucTure and deSign\nTwo points should be clarified regarding the application of this rule:\n 1. a rejected signal could be activated later if the moving average subsequently turned in the direc-\ntion of the signal before an opposite-direction crossover of the price and moving average.\n 2. Signals that occur after rejected signals are ignored because the net position is already consistent \nwith the implied trade. This observation is true because the simple moving average system is \nalways in the market.\nThe circled signals in \nfigure 16.1 indicate the trades that would have been accepted if the filter \nrule just described were applied. (in both instances these trades occurred after delays, as previously \ndescribed, rather than upon immediate penetration of the moving average.) as can be seen, the rule \nsubstantially reduces the number of false signals. although in some cases the application of the filter \ncondition results in adversely delayed trade entries (for example, the July sell signal), on balance the \nbenefits clearly outweigh the disadvantages. \nof course, a single illustration doesn’t prove anything. \nHowever, the implication of figure 16.1 does have a more general applicability. Most empirical testing \nwould reveal that, more often than not, the inclusion of the type of filter rule depicted in figure 16.1 \ntends to improve performance.\nin fact, a crossover between price and the moving average that is opposite to the direction of the \nmoving average trend can often provide a good signal to add to rather than reverse the original position. \nfor example, in figure 16.1 the March and May 2014 downside penetrations of the moving average \ncould be viewed as buy rather than sell signals because the moving average trend was still up in those \ninstances. The rationale behind this interpretation is that in a trending market, reactions often carry to \nthe vicinity of a moving average before prices resume their longer-term trend (see \nchapter 12). Thus, \nin effect, such rejected signals could actually provide the basis for a method of pyramiding.\nit should be noted that, in a sense, the confirmation conditions detailed in the previous section \nrepresent one type of filter, insofar as signals that fulfill a subsequent set of conditions are accepted, \nwhile those that do not are eliminated. However, the distinction here is that a filter implies a set \nof screening rules applied at the time the base system signal is received. \nin other words, the sorting \nprocedure occurs without any dependency on subsequent developments (although, to be perfectly \naccurate, subsequent developments could still permit a delayed acceptance of a rejected signal). \ncon-\nsequently, as we have defined the terms, a system can include both a filter and a confirmation rule. in \nsuch a system, only signals that were accepted based on the filter definition and subsequently validated \nby the confirmation rule(s) would actually result in trades.\nMarket Characteristic adjustments\none criticism of simple trend-following systems is that they treat all markets alike. for example, in a \nbreakout system, with N = 20, both highly volatile and very quiet markets will require the same condi-\ntions for a buy signal—a 20-day high. Market characteristic adjustments seek to compensate for the fact \nthat a system’s optimum parameter value settings will depend on market conditions. \nfor example, in \nthe case of a breakout system, instead of using a constant value for N, the relevant value for N might be \ncontingent on the market’s volatility classification. as a specific illustration, the average two-day price \n252\nA Complete Guide to the Futures mArket\nrange during the past 50-day period might be used to place the market into one of five volatility \nclassifications.5 The value of N used to generate signals on any given day would then depend on the \nprevailing volatility classification.\nV olatility appears to be the most logical choice for classifying market states, although other cri-\nteria could also be tested (e.g., fundamentally based conditions, average volume level). in essence, \nthis type of modification seeks to transform a basic trend-following system from a static to a dynamic \ntrading method.\nDifferentiation between buy and Sell Signals\nBasic trend-following systems typically assume analogous conditions for buy and sell signals (e.g., buy \non close above 20-day high, sell on close below 20-day low). However, there is no reason to make this \nassumption automatically. \nit can be argued that bul", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 67}
{"text": "seeks to transform a basic trend-following system from a static to a dynamic \ntrading method.\nDifferentiation between buy and Sell Signals\nBasic trend-following systems typically assume analogous conditions for buy and sell signals (e.g., buy \non close above 20-day high, sell on close below 20-day low). However, there is no reason to make this \nassumption automatically. \nit can be argued that bull and bear markets behave differently. for example, \na survey of a broad spectrum of historical price data would reveal that price breaks from major tops \ntend to be more rapid than price rallies from major bottoms.\n6 This observation suggests a rationale \nfor using more sensitive conditions to generate sell signals than those used to generate buy signals. \nHowever, the system designer using such an approach should be particularly sensitive to the danger \nof overfitting the system—a pitfall discussed in detail in \nchapter 19.\nPyramiding\none inherent weakness in basic trend-following systems is that they automatically assume a constant \nunit position size for all market conditions. it would seem desirable to allow for the possibility of \nlarger position sizes in the case of major trends, which are almost entirely responsible for the success \nof any trend-following system. \none reasonable approach for adding units to a base position in a major \ntrend is to wait for a specified reaction and then initiate the additional unit(s) on evidence of a resump-\ntion of the trend. Such an approach seeks to optimize the timing of pyramid units, as well as to provide \nexit rules that reasonably limit the potential losses that could be incurred by such added positions. \nan \n5 a two-day price range is used as a volatility measure instead of a one-day range since the latter can easily yield \na distorted image of true market volatility. for example, on a limit day, the one-day range would equal zero, in \nextreme contrast to the fact that limit days reflect highly volatile conditions. of course, many other measures \ncould be used to define volatility.\n6 The reverse statement would apply to short-term interest rate markets, which are quoted in terms of the \ninstrument price, a value that varies inversely with the interest rate level. in the interest rate markets, interest \nrates rather than instrument prices are analogous to prices in standard markets. for example, there is no upper \nlimit to a commodity’s price or interest rates, but the downside for both of these items is theoretically limited. as \nanother example, commodity markets tend to be more volatile when prices are high, while short-term interest \nrate markets tend to be more volatile when interest rates are high (instrument prices are low). The situation for \nlong-term (i.e., bond) markets is ambiguous since although interest rates can fall no lower than approximately \nzero, the pricing mathematics underlying these instruments result in an accelerated price advance (for equal \ninterest rate changes) as interest rates fall.\n253\nTechnical Trading SySTemS: STrucTure and deSign\nexample of this type of approach was detailed in chapter 12. another example of a possible pyramid \nstrategy would be provided by the following set of rules:\nBuy Case\n 1. a reaction is defined when the net position is long and the market closes below the prior 10-day \nl ow.\n 2. o nce a reaction is defined, an additional long position is initiated on any subsequent 10-day high \nif the following conditions are met:\na. The pyramid signal price is above the price at which the most recent long position was \ninitiated.\nb.\n The net position size is less than three units. (This condition implies that there is a limit of \ntwo pyramid units.)\nSell Case\n 1. a reaction is defined when the net position is short and the market closes above the prior 10-day \nhigh.\n 2. o nce a reaction is defined, an additional short position is initiated on any subsequent 10-day low \nif the following conditions are met:\na.\n The pyramid signal price is below the price at which the most recent short position was \ninitiated.\nb.\n The net position size is less than three units. (This condition implies that there is a limit of \ntwo pyramid units.)\nfigure 16.12 illustrates the addition of this pyramid plan to a breakout system with N = 40 \napplied to the 2012–2013 gold market. ( for now , ignore the “stop level” signals; they are explained \nshortly.)\nrisk control becomes especially important if a pyramiding component is added to a system. gen-\nerally speaking, it is usually advisable to use a more sensitive condition for liquidating a pyramid posi-\ntion than the condition required to generate an opposite signal. The following is one example of a set \nof stop rules that might be employed in a system that uses pyramiding. Liquidate all pyramid positions \nwhenever either condition is fulfilled:\n 1. a n opposite trend-following signal is received.\n 2. The market closes above (below) the high (low) price since the most recently defined reaction \nthat was followed by a pyramid sell (buy). \nfigure 16.12 illustrates the stop levels implied by this \nrule in the case of the 2012–2013 gold market.\ntrade exit\nThe existence of a trade exit rule in a system (e.g., a stop rule) would permit the liquidation of a \nposition prior to receiving an opposite trend-following signal. Such a rule would serve to limit losses \n254a coMPLeTe guiDe To THe fuTureS MarKeT\non losing trades as well as limit the amount of open profi ts surrendered on winning trades. although \nthese are highly desirable goals, the trade-off implied by using a trade exit rule is relatively severe. if a \ntrade exit rule is used, rules must be specifi ed for reentering the position; otherwise, the system will \nbe vulnerable to missing major trends. \n The danger in using a trade exit rule is that it may result in the premature liquidation of a good \ntrade. although the reentry rule will serve as a backstop, the combination of an activated trade exit \nrule and a subsequent reentry", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 68}
{"text": "ively severe. if a \ntrade exit rule is used, rules must be specifi ed for reentering the position; otherwise, the system will \nbe vulnerable to missing major trends. \n The danger in using a trade exit rule is that it may result in the premature liquidation of a good \ntrade. although the reentry rule will serve as a backstop, the combination of an activated trade exit \nrule and a subsequent reentry is a whipsaw loss. Thus, it will not be at all uncommon for the addition \nof a trade exit rule (and implied reentry rule) to have a negative impact on performance. neverthe-\nless, although it is not easy, for some systems it will be possible to structure trade exit rules that \nimprove performance on balance. (in terms of return, and usually in terms of return/risk measures \nas well, if a trade exit rule helps performance, the use of the trade exit rule as a reversal signal—as \nopposed to just a liquidation signal—will help performance even more.) Trade exit rules can also be \nmade dynamic. for example, the trade exit condition can be made increasingly sensitive as a price \nmove becomes more extended in either magnitude or duration. \n ■ Countertrend Systems \n General Considerations regarding Countertrend Systems \n countertrend systems often appeal to many traders because their ultimate goal is to buy low and sell \nhigh. unfortunately, the diffi culty of achieving this goal is inversely proportional to its desirability. \n FIGURE  16.12 Pyramid Signals: gold continuous futures\n Note: S = base position sell signal; = pyramid sell signal; rD = reaction defi ned. \nchart created using TradeStation. ©TradeStation T echnologies, inc. all rights reserved. \n\n255\nTechnical Trading SySTemS: STrucTure and deSign\na critical distinction to keep in mind is that whereas a trend-following system is basically self- \ncorrecting, a countertrend system implies unlimited losses. Therefore, it is essential to include some \nstop-loss conditions in any countertrend system (unless it is traded simultaneously with trend-following \nsystems). otherwise, the system could end up being long for the duration of a major downtrend or \nshort for the duration of a major uptrend. (Stop-loss conditions are optional for most trend-following \nsystems, since an opposite signal will usually be received before the loss on a position becomes \nextreme.\n7)\none important advantage of using a countertrend system is that it provides the opportunity for \nexcellent diversification with simultaneously employed trend-following systems. in this regard, it \nshould be noted that a countertrend system might be desirable even if it was a modest net loser, the \nreason being that if the countertrend system was inversely correlated to a simultaneously traded \ntrend-following system, trading both systems might imply less risk than trading the trend-following \nsystem alone. Therefore, it is entirely possible that the two systems combined might yield a higher \npercent return (at the same risk level), even if the countertrend system alone lost money.\ntypes of Countertrend Systems\nThe following are some types of approaches that can be used to try to construct a countertrend \nsystem:\nFading minimum move. This is perhaps the most straightforward countertrend approach. \na \nsell signal is indicated each time the market rallies by a certain minimum amount above the low \npoint since the last countertrend buy signal. Similarly, a buy signal is indicated whenever the \nmarket declines by a minimum amount below the high point since the last countertrend sell \nsignal. The magnitude of the price move required to generate a trade signal can be expressed \nin either nominal or percentage terms. \nfigure 16.13 illustrates the trade signals that would be \ngenerated by this type of countertrend system for a 7.5 percent threshold level in the January–\nSeptember 2015 natural gas market. \nit is no accident this chart depicts the same market that \nwas previously used in this chapter to illustrate whipsaw losses for a sensitive trend-following \nsystem (see \nfigure 16.6). countertrend systems will tend to work best under those types of \nmarket conditions in which trend-following systems fare poorly.\nFading minimum move with confirmation delay. This is similar to the preceding counter-\ntrend system, with the exception that some minimum indication of a trend reversal is required \nbefore the countertrend trade is initiated. \nfor example, a one-thrust-day confirmation might \nbe required to validate countertrend signals based on fading a given percent price move.\nOscillators. a countertrend system could use oscillators to generate trade signals. However, as \ndiscussed in chapters 11 and 12, although using oscillators to signal countertrend trades may \nwork well in a trading-range market, in a trending market such an approach can be disastrous.\n7 Stop-loss rules, however, might be mandatory for an extremely nonsensitive trend-following system—for \nexample, a breakout system with N = 150.\n256a coMPLeTe guiDe To THe fuTureS MarKeT\nContrary opinion. a countertrend system might use contrary opinion as an input in timing \ntrades. for example, once the contrary opinion rose above a specifi ed level, a short position \nwould be indicated contingent on confi rmation by a very sensitive technical indicator. (con-\ntrary opinion was discussed in chapter 14 .) \n ■ Diversifi cation \n The standard interpretation attached to the term diversifi cation is that trading is spread across a broad \nrange of markets. although this is the single most important type of diversifi cation, assuming the \navailability of suffi cient funds, there are two additional levels of possible diversifi cation. first, each \nmarket can be traded with several systems. Second, several variations of each system can be used. for \nexample, if two contracts of cocoa are being traded using the breakout system, each contract can be \ntraded using a diff erent value of N (i.e., the number of days whose high or low must be penetrated \nto trigger", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 69}
{"text": "nt funds, there are two additional levels of possible diversifi cation. first, each \nmarket can be traded with several systems. Second, several variations of each system can be used. for \nexample, if two contracts of cocoa are being traded using the breakout system, each contract can be \ntraded using a diff erent value of N (i.e., the number of days whose high or low must be penetrated \nto trigger a signal). \n in the following discussion, the term single market system variation (SMSV) will refer to the concept \nof a specifi c variation of a given system traded in a single market. Thus, the simple breakout system, \nwith N = 20, traded in the cocoa market would be an example of an SMSV . in the simplest case in \n FIGURE  16.13 countertrend Signals: october 2015 natural gas futures\n Note: Percentages are calculated as price changes in continuous futures divided by corresponding \nnearest futures price levels. B = buy signal: 7.5% decline from prior high; S = sell signal: 7.5% \nadvance from prior low . \nchart created using TradeStation. ©TradeStation T echnologies, inc. all rights reserved. \n\n257\nTechnical Trading SySTemS: STrucTure and deSign\nwhich a single system is used for all markets, and a single system variation is used in each market, \nthere would be only one SMSV for each market traded. This simplified case represents the typical \napplication of trading systems and employs only the standard diversification across markets. However, \nif sufficient funds are available, additional benefits can be obtained by also diversifying across different \nsystems and different variations of each system.\nThere are three important benefits to diversification:\n 1. Dampened equity retracements. Different SMSVs will not witness their losses at precisely \nthe same periods. Thus, by trading a wide variety of SMSVs, the trader can achieve a smoother \nequity curve. This observation implies that trading 10 SMSVs with equivalent profit/risk char-\nacteristics could provide lower risk at the same return level than trading 10 units of a single \nSMSV . \nor, alternatively, by trading larger size, 10 SMSVs with equivalent profit/risk character-\nistics could provide higher return at the same risk level than trading 10 units of a single SMSV . \nup to a point, diversification would be beneficial even if the portfolio included SMSVs with \npoorer expected performance. a key consideration would be a given SMSV’s correlation with \nthe other SMSVs in the portfolio.\n 2. ensured participation in major trends. Typically, only a few of the actively traded futures \nmarkets will witness substantial price trends in any given year. Because the majority of trades in \nmost trend-following systems will lose money,\n8 it is essential that the trader participate in the \nlarge-profit trades—that is, major trends. This is a key reason for the importance of diversifica-\ntion across markets.\n 3. bad luck insurance. futures systems trading, like baseball, is a game of inches. given the \nright combination of circumstances, even a minute difference in the price movement on a sin-\ngle day could have an extraordinary impact on the profitability of a specific SMSV .\n T o illustrate \nthis point, we consider a breakout system (N = 20) with a confirmation rule requiring a single \nthrust day that penetrates the previous day’s high or low by a minimum amount. in system \na this amount is 0.05 cents; in system B it is 0.10 cents. This is the only difference between \nthe two systems.\nfigure 16.14 compares these two systems for the December 1981 coffee market and represents \nthe most striking instance i have ever encountered of the sensitivity of system performance to minute \nchanges in system values. The basic system buy signal (i.e., close above the 20-day high) was received \non July 16. This buy was confirmed by system \na on July 17 as the close was 0.09 cents above the \nprevious day’s high (point a1). System B, however, which required a 0.10-cent penetration, did not \nconfirm the signal until the following day (point B1).\nThe buy signal for system a would have been executed at approximately $0.97 (point a2). \nHowever, due to the ensuing string of limit moves, the buy signal for system B could not be \nfilled until prices surpassed $1.22 (point B2). Thus, during this short interim, system \na gained \n8 Such systems can still be profitable because the average gain significantly exceeds the average loss.\n258a coMPLeTe guiDe To THe fuTureS MarKeT\n25¢/lb ($9,375 per contract), while system B, which was unable to reverse its short position, \nlost a similar amount. The failure of the market to close 0.01 cent higher on a given day (a price \nmove equivalent to less than $4) resulted in an incredible $18,750 per contract diff erence in the \nperformance of the two nearly identical system variations! it should be emphasized this example \nrefl ects the randomness in commodity price movements rather than the instability of the tested \nsystem. any system, other than a day trading system, could refl ect the same degree of instability, \nsince the performance diff erence was due to just a single trade in which the signals were separated \nby only one day. \n This example should explain how it is possible for a trader to lose money in a given market \nusing a system that generally performs well—he may just have chosen a specifi c variation that \ndoes much worse than most other variations (even very similar ones). By trading several varia-\ntions of a system, the speculator could mitigate the impact of such isolated, abnormally poor \nresults. \n9 of course, in so doing, the trader would also eliminate the possibility of gains far exceed-\ning the average performance of the system. on balance, however, this prospect represents a desir-\nable trade-off , since it is assumed that the basic trading goal is consistent performance rather than \nwindfall profi ts. \n FIGURE  16.14 System Trading: a game of inches (December 1981 coff ee)\nchart created using TradeStation. ©TradeStation T ec", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 70}
{"text": "d also eliminate the possibility of gains far exceed-\ning the average performance of the system. on balance, however, this prospect represents a desir-\nable trade-off , since it is assumed that the basic trading goal is consistent performance rather than \nwindfall profi ts. \n FIGURE  16.14 System Trading: a game of inches (December 1981 coff ee)\nchart created using TradeStation. ©TradeStation T echnologies, inc. all rights reserved. \n 9 in the preceding example, system a and system B were deliberately chosen to be nearly identical in order to \nmake the point about the potential impact of chance in its strongest possible form. However, in practice, the \ntrader should choose system variations that are substantially more diff erentiated.\n259\nTechnical Trading SySTemS: STrucTure and deSign\n ■ Ten Common Problems with Trend-Following Systems \nRevisited\nW e are now ready to consider possible solutions to the previously enumerated problems with stan-\ndard trend-following systems. The problems and the possible solutions are summarized in Table 16.2.\ntable 16.2 Problems with Standard trend-Following Systems and Possible Solutions\nProblems with Standard trend-\nFollowing Systems Possible Solutions\n1. T oo many similar systems 1a. Try to construct original systems in order to avoid the \nproblem of “trading with the crowd.”\n1b. if trading more than one contract, spread out entry.\n2. Whipsaws 2a. employ confirmation conditions.\n2b. Develop filter rules.\n2c. employ diversification.\n3. failure to exploit major price moves 3. add pyramiding component.\n4. nonsensitive (slow) systems can \nsurrender a large percentage of profits.\n4. employ trade exit rules.\n5. cannot make money in trading-range \nmarkets\n5. Trade trend-following systems in conjunction with \ncountertrend systems.\n6. T emporary large losses 6a. if funds permit, trade more than one system in each market.\n6b. When beginning to trade a system, trade more lightly if \nentering positions at a point after the signal has been received.\n7. extreme volatility in best-performing \nsystems\n7. By employing diversification, the trader can allocate some \nfunds to a high-profit-potential system that is too risky to \ntrade on its own.\n8. System works well in testing but then \nbombs.\n8. The danger of such a development can be reduced if systems \nare properly tested. This subject is discussed in detail in \nchapter 19.\n9. Parameter shift 9a. if funds permit, diversify by trading several variations of each \nsystem.\n9b. experiment with systems that incorporate market \ncharacteristic adjustments.\n10. Slippage 10. use realistic assumptions (discussed in chapter 19).\n\n261\nNothing works at all times in all kinds of markets.\n—Adam Smith\nT\nhe previous chapter provided two examples of generic trading systems—moving averages and \nbreakouts. This chapter details several original trading systems that are based on some of the pat-\nterns introduced in Chapter 9. Although the systems detailed here represent fully automated trading \nstrategies, the primary goal of this chapter is not to offer specific trading systems, but rather to give read-\ners a feel for how technical concepts can be utilized to construct a mechanical trading approach. Study-\ning these examples should provide readers with ideas as to how to design their own trading systems.\n ■ Wide-Ranging-Day System\nBasic Concept\nA wide-ranging day, which was introduced in Chapter 9, is a day with a much wider true range 1 \nthan recent trading sessions. The high volatility inherent in wide-ranging days gives these days special \nsignificance. Typically, the market will tend to extend in the direction of the initial price move beyond \nExamples \nof Original \nTrading Systems\nChapter 17\n1 The true range is equal to the true high minus the true low. The true high is the maximum of the current day’s high \nand the previous day’s close. The true low is the minimum of the current day’s low and the previous day’s close. \n262\nA Complete Guide to the Futures mArket\nthe boundaries of the wide-ranging day. However, situations in which the market originally penetrates \none side of the wide-ranging day and then reverses to penetrate the other side also have significance.\nThe wide-ranging-day system defines trading ranges based on wide-ranging days. Signals are generated \nwhen prices close above or below these trading ranges. In the simplest case, the trading range is defined \nas the wide-ranging day itself. However, we make the system more general by defining the trading range \nas the price range encompassing all the true highs and true lows during the period extending from N1 \ndays before the wide-ranging day to N2 days after, where N1 and N2 are parameter values that must be \ndefined. For example, if both N1 and N2 equal 0, the trading range would be defined by the wide-ranging \nday itself (i.e., the range between the true high and true low of the wide-ranging day). If N1 = 2 and \nN2 = 4, the trading range would be defined as the range between the highest true high and lowest true \nlow in the interval beginning two days before the wide-ranging day and ending four days after it.\nDefinitions\nWide-ranging day. A day on which the volatility ratio (VR) is greater than k (e.g., k = 2). The \nVR is equal to today’s true range divided by the average true range of the past N-day period \n(e.g., N = 10).\nprice trigger range (ptr). The range defined by the highest true high and lowest true low in \nthe interval between N1 days before the most recent wide-ranging day to N2 days after. Note \nthat the PTR cannot be defined until N2 days after a wide-ranging day. (If N2 = 0, the PTR \nwould be defined as of the close of the wide-ranging day itself.) The PTR will be redefined each \ntime there is a new wide-ranging day (i.e., N2 days after such an event).\ntrading Signals\nBuy case. On a close above the high of the PTR, reverse from short to long.\nSell case. On a close below the low of the PTR, reverse from long to short.\nDaily Checklist\nT o generate trading sign", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 71}
{"text": "f N2 = 0, the PTR \nwould be defined as of the close of the wide-ranging day itself.) The PTR will be redefined each \ntime there is a new wide-ranging day (i.e., N2 days after such an event).\ntrading Signals\nBuy case. On a close above the high of the PTR, reverse from short to long.\nSell case. On a close below the low of the PTR, reverse from long to short.\nDaily Checklist\nT o generate trading signals, perform the following steps each day:\n 1. If short and today’s close is above the high of the PTR, liquidate short and go long.\n 2. If long and today’s close is below the low of the PTR, liquidate long and go short.\n 3. Check whether exactly N2 days have elapsed since the most recent wide-ranging day. If this \ncondition is met, redefine the PTR.\nThe order of these steps is very important. Note that the check for new trading signals precedes \nthe check whether the PTR should be redefined. Thus, if the day a new PTR is defined also signals a \ntrade based on the prevailing PTR going into that day, a signal would be generated. If step 3 preceded \nsteps 1 and 2, trade signals could get delayed each time a signal occurred on the day a new PTR is \ndefined (N2 days after the most recent wide-ranging day, which would be the wide-ranging day itself \nwhen N2 = 0). For example, assume the system is long, N2 = 0, and the close on a new wide-ranging \nday is below the low of the preceding wide-ranging day. According to the listed step order, the new \nwide-ranging day would signal a reversal from long to short. If steps 1 and 2 followed step 3, no signal \n263\nExAMPlES OF ORIgINAl TRADINg SySTEMS\nwould occur, since the PTR would be redefined, and the market would have to close below the new \nwide-ranging day to trigger a signal.\nSystem parameters\nN1. The number of days prior to the wide-ranging day included in the PTR period.\nN2. The number of days after the wide-ranging day included in the PTR period.\nk. The value the volatility ratio (VR) must exceed in order to define a wide-ranging day.\nNote: N, the number of past days used to calculate the VR, is assumed to be fixed (e.g., N = 10).\nparameter Set List\nTable 17.1 provides a sample parameter set list. Readers can use this list as is or adjust it as desired. \nThe subject of testing multiple parameter sets and deciding which one to use in actual trading is \naddressed in Chapter 19.\ntaBLe 17.1 parameter Set List\nk N1 N2\n1. 1.6 0 0\n2. 1.6 2 0\n3. 1.6 4 0\n4. 1.6 0 2\n5. 1.6 2 2\n6. 1.6 4 2\n7. 1.6 0 4\n8. 1.6 2 4\n9. 1.6 4 4\n10. 2.0 0 0\n11. 2.0 2 0\n12. 2.0 4 0\n13. 2.0 0 2\n14. 2.0 2 2\n15. 2.0 4 2\n16. 2.0 0 4\n17. 2.0 2 4\n18. 2.0 4 4\n19. 2.4 0 0\n20. 2.4 2 0\n21. 2.4 4 0\n22. 2.4 0 2\n23. 2.4 2 2\n24. 2.4 4 2\n25. 2.4 0 4\n26. 2.4 2 4\n27. 2.4 4 4\n264A COMPlETE gUIDE TO THE FUTURES MARKET\n FIGURE  17.1 Wide-Ranging Day System, Chart 1: Copper Continuous Futures\n Note: Thicker bars are wide-ranging days. B, S = buy and sell signals for N 1 = 0 and \n N 2 = 0; , = buy and sell signals for N 1 = 2 and N 2 = 4. \nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n an Illustrated example \n T o illustrate how the system works, Figures 17.1 through 17.5 superimpose trading signals on copper \ncharts spanning late October 2013 to November 2015, a period the weekly chart inset in Figure 17.1 \nshows consisted mostly of a choppy, longer-term price descent, interspersed with short-term uptrends \nin mid-2014 and early 2015. Note these charts are continuous futures to coincide with the price series \nused to generate signals. As will be fully detailed in the next two chapters, continuous futures are usu-\nally the most suitable price series to use in trading systems. T o help provide continuity between charts, \neach chart overlaps one to two months of the preceding chart. \n Two types of signals are indicated on the accompanying charts: \n 1. The noncircled signals are generated by the system when both N 1 and N 2 are set to zero. In \nother words, the PTR is defi ned by the true high and true low of the wide-ranging day. \n 2. The circled signals are generated by the system when N 1 = 2 and N 2 = 4. (In other words, the \nPTR is defi ned by the true price range encompassing the interval beginning two days before the \nwide-ranging day and ending four days after it.) \n Occasionally, both sets of parameter values will yield identical signals. In most cases, however, the \nsecond system version will trigger signals later or not at all. (The reverse can never occur, since the \nPTR based on N 1 = 2 and N 2 = 4 must be at least as wide as the PTR based on N 1 = 0 and N 2 = 0. \nTherefore any penetration of the former PTR must also be a penetration of the latter PTR, but not \nvice versa.) \n265\nExAMPlES OF ORIgINAl TRADINg SySTEMS\n FIGURE  17.3 Wide-Ranging Day System, Chart 3: Copper Continuous Futures\n Note: Thicker bars are wide-ranging days. B, S = buy and sell signals for N 1 = 0 and \nN 2 = 0; , = buy and sell signals for N 1 = 2 and N 2 = 4. \nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE  17.2 Wide-Ranging Day System, Chart 2: Copper Continuous Futures\n Note: Thicker bars are wide-ranging days. B, S = buy and sell signals for N 1 = 0 and \n N 2 = 0; , = buy and sell signals for N 1 = 2 and N 2 = 4. \nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n266A COMPlETE gUIDE TO THE FUTURES MARKET\n FIGURE  17.4 Wide-Ranging Day System, Chart 4: Copper Continuous Futures\n Note: Thicker bars are wide-ranging days. B, S = buy and sell signals for N 1 = 0 and \n N 2 = 0; , = buy and sell signals for N 1 = 2 and N 2 = 4. \nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE  17.5 Wide-Ranging Day System, Chart 5: Copper Continuous Futures\n Note: Thicker bars are wide-ranging days. B, S = buy and sell signals for N 1 = 0 and \n N 2 = 0; , = buy and sell signals for N 1 = 2 and N 2 = 4. \nChart created using TradeStation. ©TradeStation T echnologies", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 72}
{"text": "for N 1 = 2 and N 2 = 4. \nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE  17.5 Wide-Ranging Day System, Chart 5: Copper Continuous Futures\n Note: Thicker bars are wide-ranging days. B, S = buy and sell signals for N 1 = 0 and \n N 2 = 0; , = buy and sell signals for N 1 = 2 and N 2 = 4. \nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n267\nExAMPlES OF ORIgINAl TRADINg SySTEMS\nFirst, we examine the trading signals generated for the system version when both N1 and N2 equal \nzero (the noncircled signals). Therefore, for now , ignore the circled signals, which are based on the \nparameter set consisting of N1 = 2 and N2 = 4. W e will subsequently examine the instances in which \nthe two parameter sets yield different signals.\nThe first signal occurs in December 2013 when a close above the high of the December 4 wide-\nranging day triggers a buy (Figure 17.1). The system then reverses to short modestly higher in January \n2014 when the market closes below the low of the wide-ranging day formed in late December. The \nJanuary short position profits from the ensuing downtrend and remains intact until late April when \nthe market closes above the high of the second wide-ranging day that formed in March, triggering a \nbuy signal.\nThe April 2014 long position remains intact for several months, capturing a portion of the ensuing \nuptrend, until it is reversed in early August when the market closes below the low of the early July \nwide-ranging day (Figure 17.2). The early August short position is short-lived and results in the first \nlosing trade when a subsequent market bounce forms a wide-ranging day that is exceeded by a closing \nprice two days later, triggering a buy signal. This August buy signal proves to be a whipsaw trade as the \nsystem reverses back to short in September 2014 (Figure 17.3).\nThe next buy signal materializes near the same level in late October 2014 when the market closes \nabove the true high of the October wide-ranging day. This buy signal proves to be another whipsaw \nloss as the market immediately turns lower and eventually closes below the same October wide-\nranging day, triggering a sell signal in November. Note, as is the case here, a single wide-ranging day \ncan trigger multiple trades (in opposite directions) in the absence of intervening wide-ranging days. \nThe November sell signal yields a small profit before leading to a third successive losing buy signal in \nDecember 2014. The January 2015 sell signal is exited at a profit in February 2015 when the market \ncloses above the high of the second wide-ranging day formed in January (Figure 17.4). Additional \ntrades are shown in Figures 17.4 and 17.5.\nNext we examine how the signals generated by the second parameter set (N 1 = 2, N 2 = 4; \ncircled on charts) differ from those that result from the first parameter set (N 1 = 0, N 2 = 0). \nOne pattern the reader will notice is that whenever both parameter sets had signals in the same \ncycle—a signal in the same direction before the first parameter set triggered an opposite signal—\nthe delay caused by using the second parameter set almost invariably resulted in a less favorable \nentry level. In most cases the differences in entry levels were moderate (e.g., the signals shown \nin Figure 17.1). In some instances, however, the difference in entry levels was quite substantial. \nFor example, in Figure 17.2, the second parameter set went long in late June, more than two \nmonths after the first parameter set, because prices needed to close not just above the high of the \nMarch 11 wide-ranging day, but above the high of the two days preceding that day. Occasionally, \nboth parameter sets may trigger signals on the same day (e.g., the September 2015 buy in Figure \n17.5), but there are no instances where the second parameter set has a better entry. The poorer \nentry levels generated by the second parameter set are no accident, since the wider PTRs defined \nby the nonzero N 1 and N 2 values will always result in equal or higher buy signals and equal or \nlower sell signals.\n268\nA Complete Guide to the Futures mArket\nThe reader might well wonder why one would ever want to use nonzero values for N1 and N2, \nsince the resulting delayed entries are invariably equal to or worse than entries based on keeping \nN1 and N2 equal to zero. The answer lies in the fact that the broader PTRs that result from nonzero \nN1 and N2 values will tend to filter out some losing signals—a characteristic that can have a major \nimpact on the system’s profitability. For example, following the August 2014 sell signal, the second \nparameter set avoids the three successive losing buy signals generated by the first parameter set \n(Figure 17.3). As a result, the second parameter set generates a substantial profit during this period \nwhile the series of trades generated by the first parameter set results in a net loss, despite the pre-\nvailing major downtrend.\nOn balance, in the market example illustrated in Figures 17.1 through 17.5, the benefit of filtering \nout some losing trades far outweighs the cumulative negative impact of the worse entries that result \nfrom using nonzero values for N1 and N2: For the entire period, the second parameter set generates \na cumulative profit of $0.488 per pound ($12,200 per contract) versus a cumulative loss of –$0.379 \nper pound (–$9,475 per contract) for the first parameter set.\nAlthough in some cases parameter sets with more sensitive entry conditions will experience the \nbetter performance, the outcome in our example is more typical. \ngenerally speaking, the parameter \nsets with more restrictive entry conditions will do better, as the benefit of reducing whipsaw trades \noutweighs the disadvantage of worse entries. Ironically, human nature will lead most traders, espe-\ncially novices, to choose more sensitive parameter sets because they will be attracted by the better \nentries and smaller surrender", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 73}
{"text": "our example is more typical. \ngenerally speaking, the parameter \nsets with more restrictive entry conditions will do better, as the benefit of reducing whipsaw trades \noutweighs the disadvantage of worse entries. Ironically, human nature will lead most traders, espe-\ncially novices, to choose more sensitive parameter sets because they will be attracted by the better \nentries and smaller surrender of open profits on individual trades offered by these sets, failing to fully \nappreciate the cumulative impact of reduced bad trades—a trait characteristic of more restrictive \nparameter sets.\nIt should be emphasized the selected example was intended to illustrate the mechanics of the wide-\nranging day system across varied market conditions, not to put the system in the best light. Therefore, \nthis example deliberately contained both intervals of strong wins as well as whipsaw losses. Note that \nI could easily have made the system look much more impressive by selecting a market and time period \nwith much smoother trends. Such cherry-picked illustrations are all too common in trading books, \narticles, web sites, and—especially—advertisements. W e return to this subject in the discussion of \n“the well-chosen example” in Chapter 19.\n ■ Run-Day Breakout System\nBasic Concept\nUp and down run days were defined in Chapter 9. As was explained, run days tend to occur in strongly \ntrending markets. In this system, buy reversal signals are generated when the market closes above the \nmaximum true high of a specified number of prior down run days. Similarly, sell reversal signals are \ngenerated when the market closes below the minimum true low of a specified number of prior up run \ndays. The idea is that the ability of the market to close opposite the extreme point defined by one or \nmore such strongly trending days implies a trend reversal has occurred.\n269\nExAMPlES OF ORIgINAl TRADINg SySTEMS\ntrading Signals\nBuy case. Reverse to long whenever both of the following two conditions are met:\n 1. The close is above the maximum true high of the most recent N2 down run days. (Note: Only \nthe run day true highs are considered, not the true highs on the interim days.)\n 2. The most recent run day is an up run day. (Without this second condition, in some cases, the \nfirst condition in the sell case would result in an automatic reversal back to a short position.)\nSell case. Reverse to short whenever both of the following two conditions are met:\n 1. The close is below the minimum true low of the most recent N2 up run days. (Note: Only the \nrun day true lows are considered, not the true lows on the interim days.)\n 2. The most recent run day is a down run day. (Without this second condition, in some cases, the \nfirst condition in the buy case would result in an automatic reversal back to a long position.)\nDaily Checklist\nT o generate trading signals, perform the following three steps each day:\n 1. Check whether the trading day N1 days prior to the current day can be defined as an up or a \ndown run day.\n2 (Recall that a run day cannot be defined until the close N1 days after the run \nday.) Keep track of all run days and their true highs and true lows.\n 2. If short, check whether today’s close is above the maximum true high of the past N2 down run \ndays. If it is, check whether the most recent run day was an up run day. If it was, reverse from \nshort to long.\n 3. If long, check whether today’s close is below the minimum true low of the past N2 up run days. \nIf it is, check whether the most recent run day was a down run day. If it was, reverse from long \nto short.\nparameters\nN1. The parameter used to define run days. For example, if N = 3, a day would be defined as an up \nrun day if its true high was greater than the maximum true high of the prior three days and its \ntrue low was less than the minimum true low of the following three days.\nN2. The number of prior down run days used to compute the maximum true high that must be \nexceeded by a close for a buy signal. (Also, the number of prior up run days used to compute \nthe minimum true low that must be penetrated by a close for a sell signal.)\n2 Although uncommon, a day can be both an up run day and down run day. This unusual situation will occur if a \nday’s true high is greater than the true highs during the prior and subsequent N1 days, and its true low is lower \nthan the true lows during the prior and subsequent N1 days. Days that fulfill both the up and down run day defini-\ntions are not considered run days.\n270\nA Complete Guide to the Futures mArket\nparameter Set List\nTable 17.2 provides a sample parameter set list. Readers can use this list as is or adjust it as desired.\nan Illustrated example\nT o illustrate the mechanics of the run-day breakout system, Figures 17.6 through 17.9 show the buy \nand sell signals generated by the system for the parameter set N1 = 5 and N2 = 4 in the WTI crude \noil market. Down run days are denoted by downward-pointing arrows and up run days by upward-\npointing arrows.\nA close below the minimum true low of the four most recent up run days triggers a sell signal \nin January 2014 (Figure 17.6). Note the second condition for a sell signal—that is, the most recent \nrun day is a down run day—was fulfilled on the day of the signal. Had the signal occurred one day \nearlier, no trade would have been taken because the December 31, 2013, down run day (the first in \nthe string of four) would not yet have been confirmed, and the most recent run day would have been \nthe December 19 up run day. (Remember that each run day marked with an arrow can be confirmed \nonly after five days have passed.)\nA buy signal occurs in February 2014 when the market closes above the true high of the December \n31 down run day (the maximum true high of that string of four down run days). The second condition \nis also met as the most recent run day is an up run day.\nThe market drifts higher into June (note the predominance of up run days versus down run days) \nand then begins", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 74}
{"text": "nly after five days have passed.)\nA buy signal occurs in February 2014 when the market closes above the true high of the December \n31 down run day (the maximum true high of that string of four down run days). The second condition \nis also met as the most recent run day is an up run day.\nThe market drifts higher into June (note the predominance of up run days versus down run days) \nand then begins to sag into July (Figure 17.7). The system next goes short in July when the market \ncloses below the minimum true low of the prior four up run days. The system stays short through the \nentire ensuing downtrend, which is characterized by a tremendous predominance of down run days, \neventually reversing nearly nine months later (in April 2015) on the close above the true high of the \ncluster of down run days in March (Figure 17.8). The system holds this position through June as the \nmarket moves sideways to slightly higher. The downturn in July generates a flurry of down run days, \nand the system turns short on July 22 with a close below the March 25 low (Figure 17.9). Note that \ntaBLe 17.2 parameter Set List\nN1 N2\n1. 3 2\n2. 3 3\n3. 3 4\n4. 3 5\n5. 5 2\n6. 5 3\n7. 5 4\n8. 7 2\n9. 7 3\n10. 7 4\n271\nExAMPlES OF ORIgINAl TRADINg SySTEMS\n FIGURE  17.7 Run-Day Breakout System ( N 1 = 5; N 2 = 4), Chart 2: WTI Crude Oil \nContinuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE  17.6 Run-Day Breakout System ( N 1 = 5; N 2 = 4), Chart 1: WTI Crude Oil \nContinuous Futures\n Note: The direction of the arrows indicates the direction of the run day. \nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n272A COMPlETE gUIDE TO THE FUTURES MARKET\n FIGURE  17.8 Run-Day Breakout System ( N 1 = 5; N 2 = 4), Chart 3: WTI Crude Oil \nContinuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE  17.9 Run-Day Breakout System ( N 1 = 5, N 2 = 4), Chart 4: WTI Crude Oil \nContinuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n273\nExAMPlES OF ORIgINAl TRADINg SySTEMS\nalthough the sharp rebound in late August is large enough to rally the market above the maximum \ntrue high of the four most recent down run days, there is no buy signal because there is no interven-\ning up run day.\nOverall, the system successfully exploits the major downtrend (July 2014 to August 2015) that \noccurs during the two-year survey period, capturing about half of the total profit that would be realized \nby a hypothetical trader who goes short at the high of the two-year period and covers the position at \nthe low of the period. Readers, however, are cautioned against generalizing the system’s performance \nbased on this single market/single parameter set example. In most cases, the system will not attain the \nlevel of performance exhibited in this illustration.\n ■ Run-Day Consecutive Count System\nBasic Concept\nThis system also uses run days as the key input in generating trading signals. In this system, reversal \nsignals occur whenever there are a specified number of up run days without any intervening down \nrun days, or vice versa.\nDefinitions\nThe system uses the following definitions:\nBuy count. The buy count is activated whenever a sell signal is received. The count starts at \nzero and increases by one whenever a new up run day is defined. The count is reset to zero \nwhenever there is a down run day. In effect, the buy count represents the number of up run \ndays that occur without any intervening down run days. The buy count is closed when a buy \nsignal is received.\nSell count. The sell count is activated whenever a buy signal is received. The count starts at \nzero and increases by one whenever a new down run day is defined. The count is reset to zero \nwhenever there is an up run day. In effect, the sell count represents the number of down run \ndays that occur without any intervening up run days. The sell count is closed when a sell signal \nis received.\ntrading Signals\nBuy case. Reverse to long whenever the buy count reaches N2. Keep in mind that the fulfill-\nment of this condition will not be known until N1 days after the N2th consecutive up run day. \n(Consecutive here means that there are no intervening down run days, not that the up run days \noccur on consecutive days.)\n274\nA Complete Guide to the Futures mArket\nSell case. Reverse to short whenever the sell count reaches N2. Keep in mind that the fulfill-\nment of this condition will not be known until N1 days after the N2th consecutive down run day. \n(Consecutive here means that there are no intervening up run days, not that the down run days \noccur on consecutive days.)\nDaily Checklist\nT o generate trading signals, perform the following three steps each day:\n 1. Check whether the trading day N1 days prior to the current day can be defined as an up or a \ndown run day. (Recall that a run day cannot be defined until the close N1 days after the run day.) \nIf the day is an up run day, increase the buy count by one if the buy count is active (i.e., if the \ncurrent position is short); otherwise, reset the sell count to zero. (Either the buy or sell count is \nalways active, depending on whether the current position is short or long.) If the day is defined \nas a down run day, increase the sell count by one if the sell count is active (i.e., if current posi-\ntion is long); otherwise, reset the buy count to zero.\n 2. If the buy count is active, check whether it is equal to N2 after step 1. If it is, cover short, go \nlong, close buy count, and activate sell count.\n 3. If the sell count is active, check whether it is equal to N2 after step 1. If it is, cover long, go \nshort, close sell count, and activate buy count.\nparameters\nN1. The parameter used to define run days.\nN2. The number of consecutive run days required for a signal.\nparameter Set List\nTable 17.3 provides a sample parameter set list. Readers can use th", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 75}
{"text": ", close buy count, and activate sell count.\n 3. If the sell count is active, check whether it is equal to N2 after step 1. If it is, cover long, go \nshort, close sell count, and activate buy count.\nparameters\nN1. The parameter used to define run days.\nN2. The number of consecutive run days required for a signal.\nparameter Set List\nTable 17.3 provides a sample parameter set list. Readers can use this list as is or adjust it as desired.\ntaBLe 17.3 parameter Set List\nN1 N2\n1. 3 1\n2. 3 2\n3. 3 3\n4. 3 4\n5. 5 1\n6. 5 2\n7. 5 3\n8. 7 1\n9. 7 2\n10. 7 3\n275\nExAMPlES OF ORIgINAl TRADINg SySTEMS\n an Illustrated example \n Figures 17.10 through 17.14 illustrate the signals generated by the run day consecutive count system \nfor N 1 = 5 and N 2 = 3. In other words, the system reverses from long to short whenever there are \nthree consecutive down run days and from short to long whenever there are three consecutive up \nrun days. (Consecutive here means that there are no intervening run days in the opposite direction; \nnot consecutive days.) Keep in mind that the actual trade signal will not be received until the fi fth close after \nthe third consecutive run day, since a run day is not defi ned until N1 days after its occurrence (N1 = 5 in this \nexample). \n The fi rst signal in Figure 17.10 —a buy in December 2013—occurs during a brief trading range \nand is reversed by a sell signal that occurs near the January 2014 low—a good example of how even \nprofi table systems can generate terrible individual trade signals. The three consecutive up run days \nthat start off February trigger a long position on February 12 (fi ve days after the third up run day). \nFigure 17.11 shows this position remains intact until June 12, when the system reverses to short. \nNote that although the signal occurs on the fi fth consecutive down run day in the sequence, it is \nthe fact that this day is fi ve days after the third consecutive down run day that triggers the trade. \nThe downtrend that begins in June witnesses 18 down run days with no intervening up run days. In \ncontrast, the preceding February–May uptrend contained 12 up run days and only one down run day. \n The system reverses to the upside at the start of November 2014 (Figure 17.12 ), one week into a \ntwo-and-a-half-month trading range. The three consecutive down run days, which lead to the down-\nside breakout of this range, turn the system short in January 2015. The next signal is the worst trade \nin the survey period, as the system reverses to long in February, shortly before the March 2 relative \n FIGURE  17.10 Run-Day Consecutive Count System, Chart 1: Soybean Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n276A COMPlETE gUIDE TO THE FUTURES MARKET\n FIGURE  17.11 Run-Day Consecutive Count System, Chart 2: Soybean Continuous \nFutures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE  17.12 Run-Day Consecutive Count System, Chart 3: Soybean Continuous \nFutures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n277\nExAMPlES OF ORIgINAl TRADINg SySTEMS\n FIGURE  17.13 Run-Day Consecutive Count System, Chart 4: Soybean Continuous \nFutures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE  17.14 Run-Day Consecutive Count System, Chart 5: Soybean Continuous \nFutures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n278\nA Complete Guide to the Futures mArket\nhigh (Figure 17.13). The system does not generate a sell signal until late May, just before a relative \nlow . Fortunately, the system reverses back to long two weeks later in June 2015 just before a sharp, \nbut short-lived, rally (Figure 17.14). The subsequent downside reversal is equally abrupt, and the \nsystem surrenders most of its profit on the long position by the time the next sell signal is gener-\nated in July. The final two signals occur in October and November 2015 within a relatively narrow \nconsolidation phase.\nIt should be noted that our intention was to select a realistic market illustration of the system and \nnot to cherrypick an example in which the system performed particularly well, as is typical in most \nbooks on trading. The foregoing example provided a market with both favorable (two 4-month trends) \nand unfavorable (a more than yearlong wide-swing trading range) price environments. On balance, the \nsystem was net profitable (a cumulative gain of 76.25 cents per bushel, or $3,812.50 per contract) as \nthe profits during the two trending periods outweighed the losses during the extended trading range \nperiod.\n ■ Conclusion\nIn this chapter we have introduced some original trading systems. Although they are viable as \ndescribed, readers may wish to experiment with modifications that use the concepts of these systems \nas the core of more complex approaches. The ultimate goal of this chapter was not to present specific \ntrading systems, but rather to illustrate how basic chart concepts can be transformed into trading \nsystems. The number of possible systems that can be constructed from the technical patterns and \nconcepts already discussed in this volume are limited only by the imagination of the reader.\n279\nChapter 18\nGarbage in, garbage out.\n—Anonymous\nS\nystem traders wishing to test their ideas on futures prices have always faced a major obstacle: the \ntransitory life span of futures contracts. In contrast to the equities market, where a given stock is \nrepresented by a single price series spanning the entire test period, in futures each market is repre\nsented by a string of expiring contracts. Proposed solutions to this problem have been the subject of \nmany articles and a great deal of discussion. In the process, substantial confusion has been generated, \nas evidenced by the use of identical terms to describe different types of price series. Even worse, so \nmuch misinforma", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 76}
{"text": "series spanning the entire test period, in futures each market is repre\nsented by a string of expiring contracts. Proposed solutions to this problem have been the subject of \nmany articles and a great deal of discussion. In the process, substantial confusion has been generated, \nas evidenced by the use of identical terms to describe different types of price series. Even worse, so \nmuch misinformation has been provided on this subject that many market participants now believe \nthe equivalent of “the earth is flat” theory.\nThere are four basic types of price series that can be used. The definition, advantages, and dis\nadvantages of each are discussed in turn.\n ■ Actual Contract Series\nAt a surface glance, the best route might seem to be simply to use the actual contract series. How\never, there are two major problems with this approach. First, if you are testing a system over a \nmeaningful length of time, each market simulation will require a large number of individual price \nSelecting the Best \nFutures Price Series \nfor System T esting\n280\nA Complete Guide to the Futures mArket\nseries. For example, a 15year test run for a typical market would require using approximately 60 to \n90 individual contract price series. Moreover, using the individual contract series requires an algo\nrithm for determining what action to take at the rollover points. As an example of the type of problem \nthat may be encountered, it is entirely possible for a given system to be long in the old contract and \nshort in the new contract or vice versa. These problems are hardly insurmountable, but they make the \nuse of individual contract series a somewhat unwieldy approach.\nThe awkwardness involved in using a multitude of individual contracts is not, however, the main \nproblem. The primary drawback in using individual contract series is that the period of meaningful \nliquidity in most contracts is very short—much shorter than the already limited contract life spans. \nT o see the scope of this problem, examine a cross section of futures price charts depicting the price \naction in the one\nyear period prior to expiration. In many markets, contracts don’t achieve meaning\nful liquidity until the final five or six months of trading, and sometimes even less. This problem was \nillustrated in Chapter 5. The limited time span of liquid trading in individual contracts means that any \ntechnical system or method that requires looking back at more than about six months of data—as \nwould be true for a whole spectrum of longer\nterm approaches—cannot be applied to individual \ncontract series. Thus, with the exception of shortterm system traders, the use of individual contract \nseries is not a viable alternative. It’s not merely a matter of the approach being difficult but, rather, its \nbeing impossible because the necessary data simply do not exist.\n ■ Nearest Futures\nThe problems in using individual contract series as just described has led to the construction of vari\nous linked price series. The most common approach is almost universally known as nearest futures. \nThis price series is constructed by taking each individual contract series until its expiration and then \ncontinuing with the next contract until its expiration, and so on. This approach may be useful for \nconstructing long\nterm price charts for purposes of chart analysis, but it is worthless for providing a \nseries that can be used in the computer testing of trading systems.\nThe problem in using a nearest futures series is that there are price gaps between expiring and new \ncontracts—and quite frequently these gaps can be very substantial. For example, assume the July corn \ncontract expires at $4 and that the next nearest contract (September) closes at $3.50 on the same day. \nAssume that on the next day September corn moves from $3.50 to $3.62. A nearest futures price series \nwill show the following closing levels on these two successive days: $4, $3.62. In other words, the near\nest futures contract would imply a 38\ncent loss on a day on which longs would have enjoyed (or shorts \nwould have suffered) a price gain of 12 cents. This example is by no means artificial. In fact, it would \nbe easy to find a plethora of similarly extreme situations in actual price histories. Moreover, even if the \ntypical distortion at rollover is considerably less extreme, the point is that there is virtually always some \ndistortion, and the cumulative effect of these errors would destroy the validity of any computer test.\nFortunately, few traders are naive enough to use the nearest futures type of price series for computer \ntesting. The two alternative linked price series described in the next sections have become the approaches \nemployed by most traders wishing to use a single price series for each market in computer testing.\n281\nSElECTINg THE BEST FuTurES PrICE SErIES For SySTEM TESTINg\n ■ Constant-Forward (“Perpetual”) Series\nThe constantforward (also known as “perpetual”) price series consists of quotes for prices a constant \namount of time forward. The interbank currency market offers actual examples of constantforward \nprice series. For example, the threemonth forward price series for the euro represents the quote for \nthe euro three months forward from each given day in the series. This is in contrast to the standard \nu.S. futures contract, which specifies a fixed expiration date.\nA constant forward series can be constructed from futures price data through interpola\ntion. For example, if we were calculating a 90 day constant forward (or perpetual) series and \nthe 90day forward date fell exactly one third of the way between the expirations of the nearest \ntwo contracts, the constant forward price would be calculated as the sum of two thirds of the \nnearest contract price and one third of the subsequent contract price. As we moved forward in \ntime, the nearer contract would be weighted less, and the weighting of the subsequent contract \nwould increase proportionately. Eventually, the neares", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 77}
{"text": "ne third of the way between the expirations of the nearest \ntwo contracts, the constant forward price would be calculated as the sum of two thirds of the \nnearest contract price and one third of the subsequent contract price. As we moved forward in \ntime, the nearer contract would be weighted less, and the weighting of the subsequent contract \nwould increase proportionately. Eventually, the nearest contract would expire and drop out of \nthe calculation, and the constant\nforward price would be based on an interpolation between the \nsubsequent two contracts.\nAs a more detailed example, assume you want to generate a 100day forward price series based on \neuro futures, which are traded in March, June, September, and December contracts. T o illustrate the \nmethod for deriving the 100\nday constantforward price, assume the current date is January 20. In \nthis case, the date 100 days forward is April 30. This date falls between the March and June contracts. \nAssume the last trading dates for these two contracts are March 14 and June 13, respectively. Thus, \nApril 30 is 47 days after the last trading day for the March contract and 44 days before the last trad\ning day for the June contract. T o calculate the 100\nday forward price for January 20, an average price \nwould be calculated using the quotes for March and June euro futures on January 20, weighting each \nquote in inverse proportion to its distance from the 100\nday forward date (April 30). Thus, if on Janu\nary 20 the closing price of March futures is 130.04 and the closing price of June futures is 130.77, the \nclosing price for the 100\nday forward series would be:\n44\n91 1300 4 130 77 130 42(. )( .) .+=47\n91\nNote that the general formula for the weighting factor used for each contract price is:\nW CF\nCC W FC\nCC1\n2\n21\n2\n1\n21\n= −\n− = −\n−\nwhere C1 = number of days until the nearby contract expiration\n C2 = number of days until the forward contract expiration\n F = number of days until forward quote date\n W1 = weighting for nearby contract price quote\n W2 = weighting for forward contract price quote\n282\nA Complete Guide to the Futures mArket\nSo, for example, the weightings of the March and June quotes that would be used to derive a \n100day forward quote on March 2 would be as follows:\nWeighting for March quot e\nWeighting for \n = −\n− =1031 00\n103 12\n3\n91\nJJune quote = −\n− =100 12\n103 12\n88\n91\nAs we move forward in time, the nearer contract is weighted less and less, but the weighting for \nthe subsequent contract increases proportionately. When the number of days remaining until the \nexpiration of the forward contract equals the constant forward time (100 days in this example), the \nquote for the constant forward series would simply be equal to the quote for the forward contract \n(June). Subsequent price quotes would then be based on a weighted average of the June and Septem\nber prices. In this manner, one continuous price series could be derived.\nThe constant\nforward price series eliminates the problem of huge price gaps at rollover points and \nis certainly a significant improvement over a nearest futures price series. However, this type of series \nstill has major drawbacks. T o begin, it must be stressed that one cannot literally trade a constant\n\nforward series, since the series does not correspond to any real contract. An even more serious \ndeficiency of the constant\nforward series is that it fails to reflect the effect of the evaporation of time \nthat exists in actual futures contracts. This deficiency can lead to major distortions—particularly in \ncarrying\ncharge markets.\nT o illustrate this point, consider a hypothetical situation in which spot gold prices remain stable at \napproximately $1,200/ounce for a oneyear period, while forward futures maintain a constant pre\nmium of 1 percent per twomonth spread. given these assumptions, futures would experience a steady \ndowntrend, declining $73.82/ounce1 ($7,382 per contract) over the oneyear period (the equivalent \nof the cumulative carryingcharge premiums). Note, however, the constantforward series would com\npletely fail to reflect this bear trend because it would register an approximate constant price. For \nexample, a two\nmonth constantforward series would remain stable at approximately $1,212/ounce \n(1.01 × $1,200 = $1,212). Thus, the price pattern of a constant forward series can easily deviate \nsubstantially from the pattern exhibited by the actual traded contracts—a highly undesirable feature.\n ■ Continuous (Spread-Adjusted) Price Series\nThe spreadadjusted futures series, commonly known as continuous futures, is constructed to elimi\nnate the distortions caused by the price gaps between consecutive futures contracts at their transi\ntion points. In effect, the continuous futures price will precisely reflect the fluctuations of a futures \nposition that is continuously rolled over to the subsequent contract N days before the last trading \nday, where N is a parameter that needs to be defined. If constructing their own continuous futures \ndata series, traders should select a value of N that corresponds to their actual trading practices. \n1 This is true since, given the assumptions, the oneyear forward futures price would be approximately $1,273.82 \n(1.016 × $1,200 = $1,273.82) and would decline to the spot price ($1,200) by expiration.\n283\nSElECTINg THE BEST FuTurES PrICE SErIES For SySTEM TESTINg\nFor example, if a trader normally rolls a position over to a new contract approximately 20 days before \nthe last trading day, N would be defined as 20. The scale of the continuous futures series is adjusted so \nthe current price corresponds to a currently traded futures contract.\nTable 18.1 illustrates the construction of a continuous futures price for the soybean market. For \nsimplicity, this example uses only two contract months, July and November; however, a continuous \nprice could be formed using any number of traded contract months. For example, the continuous futures \nprice could be constructed using", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 78}
{"text": "e current price corresponds to a currently traded futures contract.\nTable 18.1 illustrates the construction of a continuous futures price for the soybean market. For \nsimplicity, this example uses only two contract months, July and November; however, a continuous \nprice could be formed using any number of traded contract months. For example, the continuous futures \nprice could be constructed using the January, March, May, July, August, September, and November \nsoybean contracts.\ntable 18.1 Construction of a Continuous Futures price Using July and November Soybeans \n(cents/bushel)*\nDate Contract actual price\nSpread at rollover \n(Nearby Forward)\nCumulative \nadjustment \nFactor\nUnadjusted \nContinuous Futures \n(Col. 3 + Col. 5)\nContinuous \nFutures price \n(Col. 6 – 772.5)\n6/27/12 Jul 12 1,471 1,471 698.5\n6/28/12 Jul 12 1,466 1,466 693.5\n6/29/12 Jul 12 1,512.75 1,512.75 740.25\n7/2/12 Nov 12 1,438 85 85 1,523 750.5\n7/3/12 Nov 12 1,474.75 85 1,559.75 787.25\n***\n10/30/12 Nov 12 1,533.75 85 1,618.75 846.25\n10/31/12 Nov 12 1,547 85 1,632 859.5\n11/1/12 Jul 13 1,474 86.25 171.25 1,645.25 872.75\n11/2/12 Jul 13 1,454 171.25 1,625.25 852.75\n***\n6/27/13 Jul 13 1,548.5 171.25 1,719.75 947.25\n6/28/13 Jul 13 1,564.5 171.25 1,735.75 963.25\n7/1/13 Nov 13 1,243.25 312.5 483.75 1,727 954.5\n7/2/13 Nov 13 1,242.5 483.75 1,726.25 953.75\n***\n10/30/13 Nov 13 1,287.5 483.75 1,771.25 998.75\n10/31/13 Nov 13 1,280.25 483.75 1,764 991.5\n11/1/13 Jul 14 1,224.5 45.5 529.25 1,753.75 981.25\n11/4/13 Jul 14 1,227.75 529.25 1,757 984.5\n***\n6/27/14 Jul 14 1,432 529.25 1,961.25 1,188.75\n6/30/14 Jul 14 1,400.5 529.25 1,929.75 1,157.25\n7/1/14 Nov 14 1,147.5 243.25 772.5 1,920 1,147.5\n7/2/14 Nov 14 1,141.5 772.5 1,914 1,141.5\n*Assumes rollover on last day of the month preceding the contract month.\n284\nA Complete Guide to the Futures mArket\nFor the moment, ignore the last column in Table 18.1 and focus instead on the unadjusted con\ntinuous futures price (column 6). At the start of the period, the actual price and the unadjusted \ncontinuous futures price are identical. At the first rollover point, the forward contract (November \n2012) is trading at an 85\ncent discount to the nearby contract (July 2012). All subsequent prices of \nthe November 2012 contract are then adjusted upward by this amount (the addition of a positive \nnearby/forward spread), yielding the unadjusted continuous futures prices shown in column 6. At \nthe next rollover point, the forward contract (July 2013) is trading at an 86.25\ncent discount to the \nnearby contract (November 2012). As a result, all subsequent actual prices of the July 2013 contract \nmust now be adjusted by the cumulative adjustment factor—the total of all rollover gaps up to that \npoint (171.25 cents)—in order to avoid any artificial price gaps at the rollover point. This cumulative \nadjustment factor is indicated in column 5. The unadjusted continuous futures price is obtained by \nadding the cumulative adjustment factor to the actual price.\nThe preceding process is continued until the current date is reached. At this point, the final cumu\nlative adjustment factor is subtracted from all the unadjusted continuous futures prices (column 6), \na step that sets the current price of the series equal to the price of the current contract (November \n2014 in our example) without changing the shape of the series. This continuous futures price is indi\ncated in column 7 of Table 18.1. Note that although actual prices seem to imply a net price decline of \n329.50 cents during the surveyed period, the continuous futures price indicates a 443\ncent increase—\nthe actual price change that would have been realized by a constant long futures position.\nIn effect, the construction of the continuous series can be thought of as the mathematical equiva\nlent of taking a nearest futures chart, cutting out each individual contract series contained in the \nchart, and pasting the ends together (assuming a continuous series employing all contracts and using \nthe same rollover dates as the nearest futures chart).\nIn some markets, the spreads between nearby and forward contracts will range from premiums to \ndiscounts (e.g., cattle). However, in other markets, the spread differences will be unidirectional. For \nexample, in the gold market, the forward month always trades at a premium to the nearby month.\n2 In \nthese types of markets, the spreadadjusted continuous price series can become increasingly disparate \nfrom actual prices.\nIt should be noted that when nearby premiums at contract rollovers tend to swamp nearby dis \ncounts, it is entirely possible for the series to eventually include negative prices for some past periods \nas cumulative adjustments mount, as illustrated in the soybean continuous futures chart in Figure 18.1. \nThe price gain that would have been realized by a continuously held futures position during this period \n2 The reason for this behavioral pattern in gold spreads is related to the fact that world gold inventories exceed \nannual usage by many multiples, perhaps even by as much as a hundredfold. Consequently, there can never ac\ntually be a “shortage” of gold—and a shortage of nearby supplies is the only reason why a storable commodity \nwould reflect a premium for the nearby contract. (Typically, for storable commodities, the fact that the forward \ncontracts embed carrying costs will result in these contracts trading at a premium to more nearby months.) \ngold prices fluctuate in response to shifting perceptions of gold’s value among buyers and sellers. Even when \ngold prices are at extremely lofty levels, it does not imply any actual shortage, but rather an upward shift in the \nmarket’s perception of gold’s value. Supplies of virtually any level are still available—at some price. This is not \ntrue for most commodities, in which there is a definite relevant limit in total supplies.\n285\nSElECTINg THE BEST FuTurES PrICE SErIES For SySTEM TESTINg\nfar exceeded the net price gain implied by nearest futures, and the su", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 79}
{"text": "ply any actual shortage, but rather an upward shift in the \nmarket’s perception of gold’s value. Supplies of virtually any level are still available—at some price. This is not \ntrue for most commodities, in which there is a definite relevant limit in total supplies.\n285\nSElECTINg THE BEST FuTurES PrICE SErIES For SySTEM TESTINg\nfar exceeded the net price gain implied by nearest futures, and the subtraction of the cumulative adjust\nment factor from the most recent (2015) prices would result in negative prices for the majority of the \ntime before 2009. Such an outcome is unavoidable if the continuous futures price series is to refl ect the \nnet gain in a continually held long position and if the series is shifted by the constant factor necessary to \nset the current continuous futures price equal to the current contract actual price. \n Although the fact that a continuous futures price series could include negative prices may sound \ndisconcerting, it does not present any problems in using the series for testing systems. The reason \nfor this is that in measuring the profi ts or losses of trades, it is critical that the price series employed \naccurately refl ects price changes, not price levels. However, it also will often be useful to generate the \nactual prices that correspond to the continuous futures prices in order to facilitate such applications \nas checking trading signals against actual contract charts. \n It should also be noted that the transition between contracts need not occur on the last trading \nday, as is the conventional assumption in the nearest futures price series. In fact, because physically \ndelivered contracts are particularly vulnerable to distortions in their fi nal weeks of trading due to \ntechnical concerns regarding delivery, it probably makes sense to avoid these prices in constructing a \ncontinuous series. It follows, then, that one should use a rollover date before the last trading day (e.g., \n20 days prior to the last trading day). \n ■ Comparing the Series \n It is important to understand that a linked futures price series can only accurately refl ect either price \n levels, as do nearest futures, or price moves , as do continuous futures, but not both—much as a coin \ncan land on either heads or tails but not both. The adjustment process used to construct continuous \n FIGURE  18.1 “Negative” Prices in a Continuous Futures Chart: Soybean Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n286\nA Complete Guide to the Futures mArket\nseries means that past prices in a continuous series will not match the actual historical prices that \nprevailed at the time. However, the essential point is that the continuous series is the only linked \nfutures series that will exactly reflect price swings and hence equity fluctuations in an actual trading \naccount. Consequently, it is the only linked series that can be used to generate accurate simulations in \ncomputer testing of trading systems.\nThe preceding point is absolutely critical! Mathematics is not a matter of opinion. There is one \nright answer and there are many wrong answers. The simple fact is that if a continuous futures price \nseries is defined so that rollovers occur on days consistent with rollovers in actual trading, results \nimplied by using this series will precisely match results in actual trading (assuming, of course, accu\nrate commission and slippage cost estimates). In other words, the continuous series will exactly paral\nlel the fluctuations of a constantly held (i.e., rolled over) long position. All other types of linked series \nwill not match actual market price movements.\nT o illustrate this statement, we compare the implications of various price series using the sideways \ngold market example cited earlier in this chapter (i.e., gold hovering near $1,200 and a forward/\nnearby contract premium equal to 1 percent per two\nmonth spread). A trader buying a oneyear for\nward futures contract would therefore pay approximately $1,273.82 (1.016 × $1,200 = $1,273.82). \nThe spot price would reflect a sideways pattern near $1,200. As previously seen, a 60day constant\nforward price would reflect a sideways pattern near $1,212 (1.01 × $1,200). A nearest futures \nprice series would exhibit a general sideways pattern, characterized by extended minor downtrends \n(reflecting the gradual evaporation of the carrying charge time premium as each nearby contract \napproached expiration), interspersed with upward gaps at rollovers between expiring and subsequent \nfutures contracts.\nThus the spot, constant\nforward, and nearest futures price series would all suggest that a long \nposition would have resulted in a breakeven trade for the year. In reality, however, the buyer of the \nfutures contract pays $1,273.82 for a contract that eventually expires at $1,200. Thus, from a trading \nor real\nworld viewpoint, the market actually witnesses a downtrend. The continuous futures price is \nthe only price series that reflects the market decline—and real dollar loss—a trader would actually \nhave experienced.\nI have often seen comments or articles by industry “experts” arguing for the use of constant\n\nforward (perpetual) series instead of continuous series in order to avoid distortions. This argument \nhas it exactly backwards. Whether these proponents of constant\nforward series adopt their stance \nbecause of naïveté or self interest (i.e., they are vendors of constant forwardtype data), they are \nsimply wrong. This is not a matter of opinion. If you have any doubts, try matching up fluctuations \nin an actual trading account with those that would be implied by constant\nforwardtype price series. \nyou will soon be a believer.\nAre there any drawbacks to the continuous futures time series? of course. It may be the best \nsolution to the linked series problem, but it is not a perfect answer. A perfect alternative simply \ndoes not exist. \none potential drawback, which is a consequence of the fact t", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 80}
{"text": "an actual trading account with those that would be implied by constant\nforwardtype price series. \nyou will soon be a believer.\nAre there any drawbacks to the continuous futures time series? of course. It may be the best \nsolution to the linked series problem, but it is not a perfect answer. A perfect alternative simply \ndoes not exist. \none potential drawback, which is a consequence of the fact that continuous futures \naccurately reflect only price swings, not price levels, is that continuous futures cannot be used for any \ntype of percentage calculations. This situation, however, can be easily remedied. If a system requires \nthe calculation of a percentage change figure, use continuous futures to calculate the nominal price \n287\nSElECTINg THE BEST FuTurES PrICE SErIES For SySTEM TESTINg\nchange and nearest futures for the divisor. Also, there is some unavoidable arbitrariness involved in \nconstructing a continuous series, since one must decide which contracts to use and on what dates \nthe rollovers should occur. However, this issue is not really a problem since these choices should \nmerely mirror the contracts and rollover dates used in actual trading. Moreover, there is arbitrariness \ninvolved in the use of any of the price series discussed. Finally, in some markets, the contracts being \nlinked together may have very different past price patterns (as is often the case in livestock markets). \nHowever, this problem would exist in any kind of linked series.\n ■ Conclusion\nFor the purpose of computer testing of trading systems, there are only two types of valid price \nseries: (1) individual contract series and (2) continuous futures series. Individual contract series are \na viable approach only if the methodologies employed do not require looking back more than four or \nfive months in time (a restriction that rules out a vast number of technical approaches). In addition, \nthe use of individual contract series is far clumsier. Thus, for most purposes, the continuous futures \nprice series provides the best alternative. As long as one avoids using continuous prices for percent\nage calculations, this type of price series will yield accurate results (i.e., results that parallel actual \ntrading) as well as provide the efficiency of a single series per market. Again, I would strongly caution \ndata users to avoid being misled by those who argue for the use of constant\nforwardtype series in \ncomputer testing applications. If your goal is a price series that will accurately reflect futures trading, \nthe constant\nforward series will create distortions rather than avoid them.\nover the years more—but not all—data vendors and systemtesting platforms have embraced the \ncontinuous futures series described here as the default data type for long term analysis and system \ntesting. Traders should nonetheless confirm with the vendor that longterm futures data series link\ning different contracts are indeed constructed using the continuous futures (i.e., spread adjusted) \nmethodology. Traders should also be cognizant of the contracts and rollover dates used by the vendor \nso that they can match their contract selection and rollover dates accordingly. V endors should be able \nto provide a clear explanation of the methodology they employ for constructing long\nterm (i.e., \nlinkedcontract) futures data series.\n\n289\nChapter 19\nEvery decade has its characteristic folly, but the basic cause is the same: people persist \nin believing that what has happened in the recent past will go on happening into the \nindefinite future, even while the ground is shifting under their feet.\n—George J. Church\n ■ The Well-Chosen Example1\nY ou’ve plunked down your $895 to attend the 10th annual “Secret of the Millionaires” futures \ntrading seminar. At that price, you figure the speakers will be revealing some very valuable \ninformation.\nThe current speaker is explaining the Super-Razzle-Dazzle (SRD) commodity trading system. \nThe slide on the huge screen reveals a price chart with “B” and “S” symbols representing buy and sell \npoints. The slide is impressive: All of the buys seem to be lower than the sells.\nThis point is brought home even more dramatically in the next slide, which reveals the equity \nstream that would have been realized trading this system—a near-perfect uptrend. Not only that but \nthe system is also very easy to keep up.\nAs the speaker says, “All it takes is 10 minutes a day and a knowledge of simple arithmetic.”\nY ou never realized making money in futures could be so simple. Y ou could kick yourself for not \nhaving attended the first through ninth annual seminars.\nT esting and \nOptimizing \nTrading Systems\n1 The following section is adapted from an article that first appeared in Futures magazine in September 1984.\n290\nA Complete Guide to the Futures mArket\nOnce you get home, you select 10 diversified markets and begin trading the SRD system. Each \nday you plot your equity. As the months go by, you notice a strange development. Although the equity \nin your account exhibits a very steady trend, just as the seminar example did, there is one small \ndifference: The trend on your equity chart is down. What went wrong?\nThe fact is you can find a favorable illustration for almost any trading system. The mistake is in extrap-\nolating probable future performance on the basis of an isolated and well-chosen example from the past.\nA true-life example may help illustrate this point. Back in 1983, when I had been working on \ntrading systems for only a couple of years, I read an article in a trade magazine that presented the \nfollowing very simple trading system:\n 1. If the six-day moving average is higher than the previous day’s corresponding value, cover short \nand go long.\n 2. If the six-day moving average is lower than the previous day’s corresponding value, cover long \nand go short.\nThe article used the Swiss franc in 1980 as an illustration. Without going into the details, suffice it \nto say that applying this system to the Swiss fr", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 81}
{"text": "e trading system:\n 1. If the six-day moving average is higher than the previous day’s corresponding value, cover short \nand go long.\n 2. If the six-day moving average is lower than the previous day’s corresponding value, cover long \nand go short.\nThe article used the Swiss franc in 1980 as an illustration. Without going into the details, suffice it \nto say that applying this system to the Swiss franc in 1980 would have resulted in a profit of $17,235 \nper contract after transaction costs. Even allowing for a conservative fund allocation of $6,000 per \ncontract, this implied an annual gain of 287 percent! Not bad for a system that can be summarized in \ntwo sentences. It is easy to see how traders, presented with such an example, might eagerly abandon \ntheir other trading approaches for this apparent money machine.\nI couldn’t believe such a simple system could do so well. So I decided to test the system over a \nbroader period—1976 to mid-1983\n2—and a wide group of markets.\nBeginning with the Swiss franc, I found that the total profit during this period was $20,473. In \nother words, excluding 1980, the system made only $3,238 during the remaining 6½ years. Thus, \nassuming that you allocated $6,000 to trade this approach, the average annual percent return for \nthose years was a meager 8 percent—quite a comedown from 287 percent in 1980.\nBut wait. It gets worse. Much worse.\nWhen I applied the system to a group of 25 markets from 1976 through mid-1983, the system \nlost money in 19 of the 25 markets. In 13 of the markets—more than half of the total survey—the \nloss exceeded $22,500, or $3,000 per year, per contract! In five markets, the loss exceeded $45,000, \nequivalent to $6,000 per year, per contract! Also, it should be noted that, even in the markets where \nthe system was profitable, its performance was well below gains exhibited for these markets during \nthe same period by most other trend-following systems.\nThere was no question about it. This was truly a bad system. Y et if you looked only at the well-\nchosen example, you might think you had stumbled upon the trading system Jesse Livermore used in \nhis good years. Talk about a gap between perception and reality.\nThis system witnessed such large, broadly based losses that you may well wonder why fading the \nsignals of such a system might not provide an attractive trading strategy. The reason is that most of the \n2 The start date was chosen to avoid the distortion of the extreme trends witnessed by many commodity markets \nduring 1973–1975. The end date merely reflected the date on which I tested this particular system.\n291\nTESTING AND OPTIMIzING TRADING SYSTEMS\nlosses are the result of the system being so sensitive that it generates large transaction costs. (Trans-\naction costs include commission costs plus slippage. The concept of slippage is discussed later in this \nchapter.) This sensitivity of the system occasionally is beneficial, as was the case for the Swiss franc in \n1980. However, on balance, it is the system’s major weakness.\nLosses due to transaction costs would not be realized as gains by fading the system. Moreover, \ndoing the opposite of all signals would generate equivalent transaction costs. Thus, once transac-\ntion costs are incorporated, the apparent attractiveness of a contrarian approach to using the system \nevaporates.\nBecause the related episode and the system testing it inspired occurred many years ago, some \nreaders might justifiably wonder whether the system has been a viable strategy in more recent years. \nT o answer this question, we tested the same system on a portfolio of 31 U.S. futures contracts for the \n10 years ending November 30, 2015, and produced similar results: Only 12 of the 31 markets gener-\nated a net gross profit—that is, a profit before accounting for commissions or slippage. Incorporating \na $25 commission and slippage assessment reduced the number of profitable markets to nine, and the \ntotal losses of the unprofitable markets outweighed the profits of the winning markets by a factor of \nmore than 4 to 1, with a total cumulative loss of −$940,612 for the entire 10-year period (assuming \na trade size of one contract per market).\nThe moral is simple: Don’t draw any conclusions about a system (or indicator) on the basis of \nisolated examples. The only way you can determine if a system has any value is by testing it (without \nbenefit of hindsight) over an extended time period for a broad range of markets.\n ■ Basic Concepts and Definitions\nA trading system is a set of rules that can be used to generate trade signals. A parameter is a value that \ncan be freely assigned in a trading system in order to vary the timing of signals. For example, in the \nbasic breakout system, N (the number of prior days whose high or low must be exceeded to indicate \na signal) is a parameter. Although the operation of the rules in the system will be identical whether \nN = 7 or N = 40, the timing of the signals will be vastly different. (For an example, see Figure 16.5 \nin Chapter 16.)\nMost trading systems will have more than one parameter. For example, in the crossover moving \naverage system there are two parameters: the length of the short-term moving average and the length \nof the long-term moving average. Any combination of parameter values is called a parameter set. For \nexample, in a crossover moving average system, moving averages of 10 and 40 would represent a \nspecific parameter set. Any other combination of moving average values would represent another \nparameter set. In systems with only one parameter (e.g., breakout), the parameter set would consist \nof only one element.\n3\n3 Note that the terms parameter set and system variation (the latter was used in Chapter 16) refer to identical con-\ncepts. The introduction of the term parameter set was merely deferred until this chapter because doing so allowed \nfor a more logically ordered presentation of the material.\n292\nA Complete Guide to the Futures mArket\nMost “gener", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 82}
{"text": "he parameter set would consist \nof only one element.\n3\n3 Note that the terms parameter set and system variation (the latter was used in Chapter 16) refer to identical con-\ncepts. The introduction of the term parameter set was merely deferred until this chapter because doing so allowed \nfor a more logically ordered presentation of the material.\n292\nA Complete Guide to the Futures mArket\nMost “generic” systems are limited to one or two parameters. However, the design of more \ncreative and flexible systems, or the addition of modifications to basic systems, will usually imply the \nneed for three or more parameters. For example, adding a confirmation time delay rule to the cross-\nover moving average system would imply a third parameter: the number of days in the time delay.\nAs a general principle, it is wise to use the simplest form of a system (i.e., the least number of \nparameters) that does not imply any substantial deterioration in performance relative to the more \ncomplex versions. However, one should not drop parameters that are deemed important simply to \nreduce the number of implied parameter sets. In this case, a more reasonable approach would be \nto limit the number of parameter sets actually tested.\nIt should be noted that even for a simple one- or two-parameter-set system, it is not necessary to \ntest all possible combinations. For example, in a simple breakout system in which one wishes to test the \nperformance for values of N = 1 to N = 100, it is not necessary to test each integer in this range. A more \nefficient approach would be to first test the system using spaced values for N (e.g., 10, 20, 30, . . . , 100), \nand then, if desired, the trader could focus on any areas that appeared to be of particular interest. For \nexample, if the system exhibited particularly favorable performance for the parameter values N = 40 \nand N = 50, the trader might want to also test some other values of N in this narrower range. Such an \nadditional step, however, is probably unnecessary, since, as is discussed later in this chapter, performance \ndifferences in parameter set values—particularly values in such close proximity—are probably a matter \nof chance and lack any significance.\nAs a more practical real-life example, assume we wish to test a crossover moving average system \nthat includes a time-delay confirmation rule. If we were interested in the performance of the system \nfor parameter values 1 to 50 for the shorter-term moving average, 2 to 100 for the longer-term mov-\ning average, and 1 to 20 for the time delay, there would be a total of 74,500 parameter sets.\n4 Note \nthat we cannot reduce the number of parameters without severely damaging the basic structure of the \nsystem. However, we can test a far more limited number of parameter sets and still produce a very \ngood approximation of the system’s overall performance. Specifically, we might use increments of 10 \nfor the shorter-term moving average (10, 20, 30, 40, and 50), increments of 20 for the longer-term \nmoving average (20, 40, 60, 80, and 100), and three selected values for the time delay (e.g., 5, 10, and \n20). This approach would limit the number of parameter sets to be tested to 57.\n5 Once these param-\neter sets are tested, the results would be analyzed, and a moderate number of additional parameter \nsets might be tested as suggested by this evaluation. For example, if a time delay of 5—the smallest \nvalue tested—seemed to work best for most favorably performing parameter sets, it would also be \nreasonable to test smaller values for the time delay.\nConceptually, it might be useful to define four types of parameters:\nContinuous parameter. A continuous parameter can assume any value within a given range. \nA percentage price penetration would be an example of a continuous parameter. Because a \n4 T o avoid double counting, each “short-term” moving average can only be combined with a “long-term” moving \naverage for a longer period. Thus, the total number of combinations is given by (99 + 98 + 97 + … + 50) \n(20) = 74,500.\n5 (5 + 4 + 4 + 3 + 3)(3) = 57.\n293\nTESTING AND OPTIMIzING TRADING SYSTEMS\ncontinuous parameter can assume an infinite number of values, it is necessary to specify some \ninterval spacing in testing such a parameter. For example, a percent penetration parameter \nmight be tested over a range of 0.05 percent to 0.50 percent, at intervals of 0.05 (i.e., 0.05, \n0.10, . . . , 0.50). It is reasonable to expect performance results to change only moderately for \nan incremental change in the parameter value (assuming a sufficiently long test period).\nDiscrete parameter. A discrete parameter can assume only integer values. For example, the \nnumber of days in a breakout system is a discrete parameter. Although one can test a discrete \nparameter for every integer value within the specified range, such detail is often unnecessary, \nand wider spacing is frequently employed. As with continuous parameters, it is reasonable to \nexpect performance results to change only moderately for a small change in the parameter value.\nCode parameter. A code parameter is used to represent a definitional classification. Thus, there \nis no significance to the cardinal value of a code parameter. For example, assume we wish to \ntest a simple breakout system using three different definitions of a breakout (buy case): close \nabove previous N-day high, high above previous N-day high, and close above previous N-day high \nclose. W e could test each of these systems separately, but it might be more efficient to use a \nparameter to specify the intended definition. Thus, a parameter value of 0 would indicate the \nfirst definition, a value of 1 the second definition, and a value of 2 the third definition. Note \nthat there are only three possible values for this parameter, and that there is no significance to \nincremental changes in parameter values.\nFixed or nonoptimized parameter. Normally, any type of parameter will be allowed to assume \ndifferent values in", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 83}
{"text": "hus, a parameter value of 0 would indicate the \nfirst definition, a value of 1 the second definition, and a value of 2 the third definition. Note \nthat there are only three possible values for this parameter, and that there is no significance to \nincremental changes in parameter values.\nFixed or nonoptimized parameter. Normally, any type of parameter will be allowed to assume \ndifferent values in testing a system. However, in systems with a large number of parameters, it \nmay be necessary to fix some parameter values in order to avoid an excessive number of parame-\nter sets. Such parameters are called nonoptimized parameters. For example, in a nonsensitive (slow) \ntrend-following system, we might wish to include a backup stop rule to prevent catastrophic \nlosses. By definition, in this situation, the stop rule would be activated on only a few occasions. \nConsequently, any parameters implicit in the stop rule could be fixed, since variation in these \nparameter values would not greatly affect the results.\n ■ Choosing the Price Series\nThe first step in testing a system in a given market is choosing the appropriate price series. The issues \nrelated to this selection were fully detailed in Chapter 18. Generally speaking, a continuous futures series \nis the preferred choice, although actual contract data could be used for short-term trading systems.\n ■ Choosing the Time Period\nGenerally speaking, the longer the test period, the more reliable the results. If the time period is too \nshort, the test will not reflect the system’s performance for a reasonable range of market situations. \nFor example, a test of a trend-following system on the Canadian dollar market that used only the three \n294A COMPLETE GUIDE TO THE FUTURES MARKET\nyears of data from roughly October 2012 to October 2015—a period dominated by a sustained bear \nmarket (see Figure 19.1 )—would yield highly misleading results in terms of the system’s probable \nlong-term performance, as evidenced by the monthly chart inset, which shows the market’s price \naction dating back to 2004. Although testing over only the recent past is almost always undesirable, \nlonger periods are not always necessarily better for testing than shorter ones. In some markets, if too \nlong a period is used for testing a system, the earlier years in the survey period might be extremely \nunrepresentative of current market conditions. \n Although it is impossible to provide a decisive answer as to the optimum number of years to be \nused in testing, 10 to 20 years is a reasonable range. For short-term trading systems (average duration \nof trades equal to a few weeks or less), a shorter test period (e.g., 5 to 10 years) would probably be \nsuffi cient. Trading system test results based on time periods signifi cantly shorter than these guidelines \nshould be suspect. In fact, it is rather incredible that some published studies on trading systems are \nbased on test periods of two years or less. \n Trading systems that use intraday data do not need to be tested over as long a time period as is \nthe case for daily data because any time period will contain far more data points. For example, in the \ncase of fi ve-minute bars, a stock-index futures contract—just during the stock market’s cash trading \nsession—will generate the equivalent of a year’s worth of daily price bars (252) in a little more than \nthree days. A year’s worth of this fi ve-minute data would contain approximately as many price bars \nas 78 years of daily data. \n However, the far greater amount of data inherent in intraday data does not mean the test period \ncan be reduced proportionally—not even close. The governing principle will always be to select \n FIGURE  19.1 Major Trending Phase as Unrepresentative Price Sample: Canadian Dollar \nContinuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n295\nTESTING AND OPTIMIzING TRADING SYSTEMS\nenough data to expose the system to a wide range of market conditions. A trader testing a system \nbased on five-minute bars should run the test on far more than 30 days of data, even though this \ndata contains more bars than 10 years of daily price bars, since the larger-scale market conditions \ncan often be relatively static over such brief time periods. For example, the intraday price action \nduring a very strong 30-day trending period will likely differ dramatically from the typical intraday \nprice action during a 30-day trading range. The necessity that any meaningful system test span bull, \nbear, and sideways markets means that even intraday systems will need to be tested over a period \nof at least several years, if not more. In fact, given the current speed of computer processing, if \nthe data are available, there is no compelling reason to run intraday systems tests for significantly \nshorter periods than daily systems. Sure, such tests will include dramatically more data, but that \nis a good thing.\nIdeally, one should test a system using a longer time period (e.g., 15 years) and then evaluate the \nresults for the period as a whole and various shorter time intervals (e.g., individual years). Such an \napproach is important in determining the system’s degree of time stability—the relative performance \nconsistency from one period to the next. Time stability is important because it enhances confidence \nregarding a system’s potential for maintaining consistently favorable performance in the future. Most \npeople would be quite hesitant about using a system that generated significant net profits over a \n15-year period due to three spectacularly performing years but then witnessed losses or near break-\neven results in the remaining 12 years—and rightly so. In contrast, a system that registered moderate \nnet gains during the 15-year period and was profitable in 14 of the 15 years would undoubtedly be \nviewed as more attractive by most traders.\n ■ Realistic Assumptions\nSystem traders often discover that their actual results are subs", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 84}
{"text": "cularly performing years but then witnessed losses or near break-\neven results in the remaining 12 years—and rightly so. In contrast, a system that registered moderate \nnet gains during the 15-year period and was profitable in 14 of the 15 years would undoubtedly be \nviewed as more attractive by most traders.\n ■ Realistic Assumptions\nSystem traders often discover that their actual results are substantially worse than the paper trad-\ning results implied by the system. In fact, this situation is so common that it even has its own name: \nslippage. Assuming that the divergence in the results is not due to errors in the program, slippage is \nbasically a consequence of a failure to use realistic assumptions in testing the system. Basically, there \nare two types of such faulty assumptions:\n 1. transaction costs. Most traders don’t realize that merely adjusting for actual commission \ncosts in testing a system is not a sufficiently rigid assumption. The reason for this is that commis-\nsions account for only a portion—and usually a minor portion—of transaction costs. Another \nless tangible, but no less real, cost is the difference between the theoretical execution price and \nthe actual fill price. For example, if one is testing a system assuming order entry on the close, \nthe use of the midpoint of the closing range might not be a realistic assumption. For some \nreason, buys near the upper end of the closing range and sells near the lower end of the clos-\ning range seem to be far more common than their reverse counterparts. There are two ways of \naddressing this problem. First, use the worst possible fill price (e.g., high of the closing range \nfor buys). Second, use a transaction cost per trade assumption much greater than the actual \n296A COMPLETE GUIDE TO THE FUTURES MARKET\nhistorical commission costs (e.g., $25 per side, per trade). The latter approach is preferable \nbecause it is more general. For example, how would one decide the worst possible fi ll price for \nan intraday stop order? \n 2. limit days. Unless it is programmed otherwise, an automated trading system will indicate \nexecutions on the receipt of each signal. However, in the real world, things are not quite so \nsimple. Occasionally, execution will not be possible because the market is locked at the daily \npermissible limit. Or even if execution is possible, it could occur at a much worse level than \nthe intended price because the market gaps far beyond the signal trigger price. Although \nnearly continuous trading hours have made these events less common than in decades past, \nthey still occur, especially in less liquid markets. If one assumes execution in such a situ-\nation, the paper results may dramatically overstate actual performance. Figure 19.2 illus-\ntrates the diff erence even a single locked-limit day can have on trade results. September \n2011 corn futures closed limit down at 648 cents on June 30. A trader who wanted—\nor worse, needed—to sell on this close but did not receive a fi ll would have had to wait \nfor the next session to execute the trade. The market opened 41.25 cents lower the next \nday, representing a $2,062.50 loss per contract, assuming the trade was fi lled exactly at the \nopening price. \n The potential systems trader may discover that seemingly attractive trading systems disintegrate \nonce realistic assumptions are employed. This characteristic is particularly true for very active sys-\ntems, which generate very large transaction costs. However, it is far better to make this discovery in \nthe analytical testing stage than in actual trading. \n FIGURE  19.2 Wide Gap between Signal Price and Actual Entry: Impact of Limit Days \n(September 2011 Corn)\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n297\nTESTING AND OPTIMIzING TRADING SYSTEMS\n ■ Optimizing Systems\nOptimization refers to the process of finding the best-performing parameter set(s) for a given system \napplied to a specific market. The underlying premise of optimization is that parameter sets that worked \nbest in the past have a greater probability of superior performance in the future. (The question of \nwhether this assumption is valid is addressed in the next section.)\nA basic question that must be considered in optimization is what criteria should be used for defin-\ning best performance. Frequently, best performance is simply interpreted as largest equity gain. \nHowever, such a definition is incomplete. Ideally, four factors should be considered in performance \ncomparisons:\n 1. percent return. Return measured relative to funds needed to trade the system. The impor-\ntance of using percent return rather than nominal gain is detailed in Chapter 20.\n 2. risk measure. In addition to percent gain, it is also important to employ some measure of \nequity fluctuations (e.g., variability in rate of gain, retracements in equity). Besides the obvious \npsychological reasons for wishing to avoid parameter sets and systems with high volatility, a \nrisk measure is particularly significant because one might pick an unfavorable starting date for \ntrading the system. Chapter 20 discusses several performance measures that incorporate both \npercent return and risk.\n 3. parameter stability. It is not sufficient to find a parameter set that performs well. It is also \nnecessary to ascertain the parameter set does not reflect a fluke in the system. In other words, \nwe wish to determine that similar parameter sets also exhibit favorable performance. In fact, the \ngoal of optimization should be to find broad regions of good performance rather than the single \nbest-performing parameter set.\nFor example, if in testing a simple breakout system one found that the parameter set \nN = 7 exhibited the best percent return/risk characteristics but that performance dropped off \nvery sharply for parameter sets N < 5 and N > 9, while all sets in the range N = 25 to N = 54 \nperformed relatively well, it would make much more sense to choose a param", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 85}
{"text": "r than the single \nbest-performing parameter set.\nFor example, if in testing a simple breakout system one found that the parameter set \nN = 7 exhibited the best percent return/risk characteristics but that performance dropped off \nvery sharply for parameter sets N < 5 and N > 9, while all sets in the range N = 25 to N = 54 \nperformed relatively well, it would make much more sense to choose a parameter set from the \nlatter range. Why? Because the exceptional performance of the set N = 7 appears to be a pecu-\nliarity of the historical price data, which is not likely to be repeated. The fact that surrounding \nparameter sets performed poorly suggests that there is no basis for confidence in trading the \nparameter set N = 7. In contrast, the broad range of performance stability for sets in the region \nN = 25 to N = 54 suggests that a set drawn from the center of this range would have a better \nprospect for success.\n 4. time stability. As detailed in a previous section, it is important to ascertain that favorable \nperformance for the period as a whole is truly representative of the total period rather than a \nreflection of a few isolated intervals of extraordinary performance.\nFor comparisons involving different parameter sets for the same system, the preceding factors tend \nto be highly correlated. Generally, the parameter sets with the best gains will also be the sets that \nexhibit the smallest equity retracements. Consequently, for the optimization of a single system, the \nuse of a basic return/risk measure (e.g., the Sharpe ratio or the gain-to-pain ratio) will usually yield \n298\nA Complete Guide to the Futures mArket\nsimilar results to a complex performance evaluation that incorporates multiple performance mea-\nsures. Thus, although the multifactor performance evaluation is theoretically preferable, it is often not \nessential. However, if one is comparing parameter sets from completely different systems, the explicit \nconsideration of risk, parameter stability, and time stability is more important.\nThe foregoing represents a theoretical discussion of optimization concepts and procedures, and \nimplicitly assumes that optimization enhances a system’s future performance. As discussed in the next \nsection, however, the viability of optimization is open to serious question.\n ■ The Optimization Myth\nIt is ironic that optimization receives so much attention while its underlying premise is rarely considered. \nIn other words, do the better performing parameter sets of the past continue to exhibit above-average \nperformance in the future?\nAs an empirical test of the validity of optimization we examine the historical rankings of a range of \nparameter set values for a breakout system: reverse from short to long if today’s close is higher than \nthe highest close during the past N days; reverse from long to short if today’s close is lower than the \nlowest close during the past N days. Nine values of N for this system were tested: 20, 30, 40, 50, 60, \n70, 80, 90, and 100.\nTables 19.1 to 19.10 compare the profit/loss rankings of these parameter sets in 10 markets for \nthree 2-year test periods (2009–2010, 2011–2012, and 2013–2014), with parameter sets listed in \nthe order of their performance during the respective prior eight-year periods. (All markets were \ntraded with one contract per signal.) In other words, the top-performing parameter set of the prior \neight-year period (2001–2008, 2003–2010, or 2005–2012) is listed first, the second-best parameter \nset of the prior period is listed second, and so on. For example, if the top number in a column is 6, it \nmeans that the best-performing parameter set for that market in the prior eight-year period was the \nsixth-ranked parameter set (out of nine) during the given test period.\ntable 19.1 breakout System (10-Y ear t-Notes): Comparison of parameter Set rankings in two-Y ear test \nperiods vs. rankings in prior eight-Y ear periods\nparameter Set rank \nprior eight-Y ear period\nrank of Same parameter \nSet in 2009–2010\nrank of Same parameter \nSet in 2011–2012\nrank of Same parameter \nSet in 2013–2014\n1 9 9 7\n2 8 6 5\n3 7 7 3\n4 2 8 1\n5 5 4 4\n6 6 5 6\n7 1 3 2\n8 3 1 9\n9 4 2 8\n299\nTESTING AND OPTIMIzING TRADING SYSTEMS\ntable 19.2 breakout System (euro): Comparison of parameter Set rankings in two-Y ear test periods vs. \nrankings in prior eight-Y ear periods\nparameter Set rank \nprior eight-Y ear period\nrank of Same parameter \nSet in 2009–2010\nrank of Same parameter \nSet in 2011–2012\nrank of Same parameter \nSet in 2013–2014\n1 4 2 1\n2 9 1 7\n3 5 4 2\n4 6 5 5\n5 7 6 8\n6 3 3 3\n7 8 7 9\n8 2 8 6\n9 1 9 4\ntable 19.3 breakout System (Japanese Y en): Comparison of parameter Set rankings in two-Y ear test \nperiods vs. rankings in prior eight-Y ear periods\nparameter Set rank \nprior eight-Y ear period\nrank of Same parameter \nSet in 2009–2010\nrank of Same parameter \nSet in 2011–2012\nrank of Same parameter \nSet in 2013–2014\n1 9 5 4\n2 2 3 1\n3 8 7 6\n4 1 6 2\n5 3 1 7\n6 4 4 8\n7 7 9 9\n8 6 2 5\n9 5 8 3\ntable 19.4 breakout System (Gold): Comparison of parameter Set rankings in two-Y ear test periods \nvs. rankings in prior eight-Y ear periods\nparameter Set rank \nprior eight-Y ear period\nrank of Same parameter \nSet in 2009–2010\nrank of Same parameter \nSet in 2011–2012\nrank of Same parameter \nSet in 2013–2014\n1 7 2 2\n2 3 4 3\n3 4 5 4\n4 9 1 9\n5 6 6 1\n6 8 9 7\n7 1 8 5\n8 2 7 6\n9 5 3 8\n300\nA Complete Guide to the Futures mArket\ntable 19.5 breakout System (Natural Gas): Comparison of parameter Set rankings in two-Y ear test \nperiods vs. rankings in prior eight-Y ear periods\nparameter Set rank \nprior eight-Y ear period\nrank of Same parameter \nSet in 2009–2010\nrank of Same parameter \nSet in 2011–2012\nrank of Same parameter \nSet in 2013–2014\n1 8 3 1\n2 4 5 4\n3 5 1 2\n4 1 6 3\n5 6 8 9\n6 2 9 5\n7 9 4 8\n8 7 7 6\n9 3 2 7\ntable 19.6 breakout System (WtI Crude Oil): Comparison of parameter Set rankings in two-Y ear test \nperiods vs. rankings in prior eight-Y ear periods\nparameter Set rank \nprior eight-Y ear period\nrank o", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 86}
{"text": "iod\nrank of Same parameter \nSet in 2009–2010\nrank of Same parameter \nSet in 2011–2012\nrank of Same parameter \nSet in 2013–2014\n1 8 3 1\n2 4 5 4\n3 5 1 2\n4 1 6 3\n5 6 8 9\n6 2 9 5\n7 9 4 8\n8 7 7 6\n9 3 2 7\ntable 19.6 breakout System (WtI Crude Oil): Comparison of parameter Set rankings in two-Y ear test \nperiods vs. rankings in prior eight-Y ear periods\nparameter Set rank \nprior eight-Y ear period\nrank of Same parameter \nSet in 2009–2010\nrank of Same parameter \nSet in 2011–2012\nrank of Same parameter \nSet in 2013–2014\n1 3 6 1\n2 2 7 6\n3 7 9 8\n4 4 1 2\n5 5 3 5\n6 1 5 4\n7 9 8 9\n8 6 2 3\n9 8 4 7\ntable 19.7 breakout System (Corn): Comparison of parameter Set rankings in two-Y ear test periods \nvs. rankings in prior eight-Y ear periods\nparameter Set rank \nprior eight-Y ear period\nrank of Same parameter \nSet in 2009–2010\nrank of Same parameter \nSet in 2011–2012\nrank of Same parameter \nSet in 2013–2014\n1 3 7 3\n2 4 1 7\n3 2 3 5\n4 1 8 8\n5 9 4 1\n6 5 9 6\n7 6 2 2\n8 8 5 4\n9 7 6 9\n301\nTESTING AND OPTIMIzING TRADING SYSTEMS\ntable 19.8 breakout System (Soybeans): Comparison of parameter Set rankings in two-Y ear test \nperiods vs. rankings in prior eight-Y ear periods\nparameter Set rank \nprior eight-Y ear period\nrank of Same parameter \nSet in 2009–2010\nrank of Same parameter \nSet in 2011–2012\nrank of Same parameter \nSet in 2013–2014\n1 6 4 5\n2 3 5 3\n3 4 7 1\n4 1 2 4\n5 2 3 2\n6 8 1 7\n7 7 6 6\n8 9 8 8\n9 5 9 9\ntable 19.9 breakout System (Coffee): Comparison of parameter Set rankings in two-Y ear test periods \nvs. rankings in prior eight-Y ear periods\nparameter Set rank \nprior eight-Y ear period\nrank of Same parameter \nSet in 2009–2010\nrank of Same parameter \nSet in 2011–2012\nrank of Same parameter \nSet in 2013–2014\n1 3 1 9\n2 8 2 1\n3 1 6 6\n4 7 8 3\n5 9 9 2\n6 2 5 4\n7 6 7 8\n8 5 4 7\n9 4 3 5\ntable 19.10 breakout System (e-Mini Nasdaq 100): Comparison of parameter Set rankings in two-Y ear \ntest periods vs. rankings in prior eight-Y ear periods\nparameter Set rank \nprior eight-Y ear period\nrank of Same parameter \nSet in 2009–2010\nrank of Same parameter \nSet in 2011–2012\nrank of Same parameter \nSet in 2013–2014\n1 5 3 9\n2 7 1 7\n3 4 2 8\n4 2 8 4\n5 6 6 6\n6 9 5 1\n7 3 9 2\n8 8 4 5\n9 1 7 3\n302\nA Complete Guide to the Futures mArket\nAs a visual aid to help see if there is any consistency between past and future performance, the \ntwo top-performing parameter sets in each test period are denoted by circles and the two bottom \nparameter sets by squares. If the basic premise of optimization were valid—that is, that the best-\nperforming parameter sets of the past were likely to be the best-performing parameter sets in the \nfuture—then Tables 19.1 through 19.10 should reflect a pattern of circles consistently near column \ntops and squares consistently near column bottoms. However, this is not the case. Both circles and \nsquares are sometimes near column tops, sometimes near column bottoms, and sometimes near \ncolumn midpoints. The apparent randomness in the vertical placement of the circles and squares in \nTables 19.1 through 19.10 implies the correlation between past and future performance is highly \ntenuous.\nTable 19.11 further highlights the weakness of the relationship between past and future per-\nformance. In addition to showing the average rank of the best-performing parameter sets from the \neight-year sample periods in the subsequent two-year test periods (second column), Table 19.11 \nalso shows how often the best- and worst-performing sets in a prior eight-year period repeated \ntheir positions in the subsequent two-year period versus completely reversing their rank order. \nNote the initially best- and worst-performing parameter sets repeated in subsequent two-year \nperiods a total of eight times, which is only one time more than the number of times the best set \nbecame the worst set or the worst set became the best set. Also notice that the best-performing \nparameter set became the worst-performing set one more time (5) than the best-performing set \nrepeated as the top set.\nThis instability in the values of the best-performing parameter sets from period to period \nmeans gauging a system’s performance by the best past parameter sets will grossly overstate the \nsystem’s performance potential. T o illustrate this point, Tables 19.12 through 19.15 compare \nthe performance of the best parameter set in each test period versus the average of all param-\neter sets and the performance of the parameter sets that had the best and worst results in the \ntable 19.11 Stability of best- and W orst-performing parameter Sets\nMarket\navg. rank of best \nparameter Set\nbest parameter \nSet repeated\nW orst parameter \nSet repeated\nbest Set becomes \nW orst Set\nW orst Set becomes \nbest Set\n10-yr. T -note 4.70 0 0 2 0\nEuro 4.30 1 1 0 1\nJapanese yen 4.77 0 0 1 0\nGold 4.27 0 0 0 0\nNatural gas 5.10 1 0 0 0\nWTI crude oil 5.13 1 0 0 0\nCorn 6.00 0 1 0 0\nSoybeans 5.43 0 2 0 0\nCoffee 5.30 1 0 1 0\nE-mini Nasdaq 100 4.70 0 0 1 1\ntotal 4 4 5 2\n303\nTESTING AND OPTIMIzING TRADING SYSTEMS\nprior period. In this example, based on the all-market totals, selecting the worst parameter \nset in the prior period would have outperformed a strategy of picking the best past parameter \nset in one of the three test periods (see Table 19.12), as well as the three-period total (see \nTable 19.15). The penultimate column of these tables marks the instances the worst-performing \nparameter set in a prior eight-year period outperformed the prior best-performing set in the \nsubsequent two-year period. The final column shows how often the average parameter set per-\nformance in the subsequent two-year period outperformed the best-performing set of the prior \neight-year period.\ntable 19.12 profit/loss ($) Comparisons for 2009–2010 test period: actual best parameter Set vs. \nperiod average and best and W orst parameter Sets in prior period\nMarket\nbest parameter \nSet in period\nbest parameter Set \nin prior period\nW orst parameter \nSet in prior period\navg. of all \nparameter Sets\nW orst prior \n> best prior\navg", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 87}
{"text": "performed the best-performing set of the prior \neight-year period.\ntable 19.12 profit/loss ($) Comparisons for 2009–2010 test period: actual best parameter Set vs. \nperiod average and best and W orst parameter Sets in prior period\nMarket\nbest parameter \nSet in period\nbest parameter Set \nin prior period\nW orst parameter \nSet in prior period\navg. of all \nparameter Sets\nW orst prior \n> best prior\navg. > \nbest prior\n10-yr. T -note $7,453 –$7,188 $2,391 $253 X X\nEuro $47,575 $18,963 $47,575 $22,511 X X\nJapanese yen $5,438 –$23,825 –$9,638 –$8,967 X X\nGold $50,740 $7,420 $19,020 $25,084 X X\nNatural gas $46,960 –$7,360 $34,120 $16,522 X X\nWTI crude oil –$11,670 –$26,030 –$45,150 –$33,041\nCorn $8,875 $6,913 –$338 $3,188\nSoybeans $34,188 $11,875 $22,350 $16,944 X X\nCoffee $25,650 $12,075 $11,963 $6,713\nE-Mini Nasdaq 100 $12,330 $4,820 $12,330 $5,417 X X\ntotal $227,538 –$2,338 $94,623 $54,625 7 7\ntable 19.13 profit/loss ($) Comparisons for 2011–2012 test period: actual best parameter Set vs. \nperiod average and best and W orst parameter Sets in prior period\nMarket\nbest parameter \nSet in period\nbest parameter Set \nin prior period\nW orst parameter \nSet in prior period\navg. of all \nparameter Sets\nW orst prior \n> best prior\navg. > \nbest prior\n10-yr. T -note $13,172 –$3,750 $9,234 $3,516 X X\nEuro $10,900 $10,900 –$11,550 $1,938\nJapanese yen –$1,538 –$7,963 –$12,913 –$8,157\nGold $16,310 $7,300 $3,170 –$5,672\nNatural gas $16,050 $2,590 $10,930 –$712 X\nWTI crude oil $12,330 –$30,950 –$11,920 –$19,537 X X\nCorn –$963 –$8,563 –$8,538 –$9,138 X\nSoybeans $24,013 –$3,113 –$16,413 –$2,590 X\nCoffee $48,563 $48,563 $20,963 $8,308\nE-Mini Nasdaq 100 $1,540 –$7,630 –$20,870 –$13,506\ntotal $140,377 $7,385 –$37,906 –$45,550 4 3\n304\nA Complete Guide to the Futures mArket\ntable 19.14 profit/loss ($) Comparisons for 2013–2014 test period: actual best parameter Set vs. \nperiod average and best and W orst parameter Sets in prior period\nMarket\nbest parameter \nSet in period\nbest parameter Set \nin prior period\nW orst parameter \nSet in prior period\navg. of all \nparameter Sets\nW orst prior \n> best prior\navg. > \nbest prior\n10-yr. T -note $2,922 –$2,328 –$3,359 –$1,557 X\nEuro $19,963 $19,963 $5,013 $2,568\nJapanese yen $39,713 $38,138 $39,713 $27,339 X\nGold $25,840 $21,160 –$4,340 $11,042\nNatural gas $6,250 $6,250 –$1,590 –$2,077\nWTI crude oil $39,060 $39,060 $18,070 $23,379\nCorn $9,750 $3,675 –$1,150 $2,661\nSoybeans $8,663 $488 –$12,863 $1,211 X\nCoffee $28,313 –$9,113 $2,963 $7,677 X X\nE-Mini Nasdaq 100 $29,640 –$8,780 $16,505 $10,635 X X\ntotal $210,112 $108,512 $58,961 $82,878 3 4\ntable 19.15 profit/loss ($) Comparisons for three test periods Combined: actual best parameter Sets \nvs. period averages and best and W orst parameter Sets in prior periods\nMarket\nbest parameter \nSet in period \ntotal\nbest parameter \nSet in prior \nperiod total\nW orst parameter \nSet in prior \nperiod total\navg. of all \nparameter Sets \ntotal\nW orst prior \n> best prior\navg. > \nbest prior\n10-yr. T -note $23,547 –$13,266 $8,266 $2,212 X X\nEuro $78,438 $49,825 $41,038 $27,017\nJapanese yen $43,613 $6,350 $17,163 $10,215 X X\nGold $92,890 $35,880 $17,850 $30,454\nNatural gas $69,260 $1,480 $43,460 $13,733 X X\nWTI crude oil $39,720 –$17,920 –$39,000 –$29,199\nCorn $17,663 $2,025 –$10,025 –$3,289\nSoybeans $66,863 $9,250 –$6,925 $15,565 X\nCoffee $102,525 $51,525 $35,888 $22,698\nE-Mini Nasdaq 100 $43,510 –$11,590 $7,965 $2,546 X X\ntotal $578,027 $113,559 $115,678 $91,953 4 5\nOur example used a very small list of only nine parameter sets. Many system developers run opti-\nmizations across hundreds or even thousands of parameter sets. Imagine the degree of performance \noverstatement that would occur by representing a system’s performance by the best parameter sets \nin these cases!\nFor comparison, Tables 19.16 through 19.19 show the same information as Tables 19.12 through \n19.15 except they reflect tests of the same system conducted 20 years earlier on a slightly different \n305\nTESTING AND OPTIMIzING TRADING SYSTEMS\nportfolio (30-year U.S. T -bonds, Deutsche marks, Japanese yen, gold, silver, heating oil, corn, \nsoybeans, live cattle, and sugar). In this case, the three 8-year sample periods were 1981–1988, \n1983–1990, and 1985–1992 and the three 2-year test periods were 1989–1990, 1991–1992, and \n1993–1994.\ntable 19.16 profit/loss ($) Comparisons for 1989–1990 test period: actual best parameter Set vs. \nperiod average and best and W orst parameter Sets in prior period\nMarket\nbest parameter \nSet in period\nbest parameter Set \nin prior period\nW orst parameter \nSet in prior period\navg. of all \nparameter Sets\nW orst prior \n> best prior\navg. > \nbest prior\nT -bond 6,670 −9,090 1,420 −2,180 X X\nDeutsche mark 7,780 3,020 6,340 5,390 X X\nJapanese yen 11,840 9,240 8,420 8,130\nGold 3,390 1,700 −320 1,080\nSilver 5,850 5,330 1,630 3,050\nHeating oil 7,650 1,760 6,430 3,380 X X\nCorn 1,640 −2,190 −2,730 −590 X\nSoybeans 4,970 −7,160 4,740 −740 X X\nCattle 2,090 850 −3,290 −20\nSugar 4,240 4,170 −5,560 −840\ntotal 56,120 7,630 17,080 16,030 4 5\ntable 19.17 profit/loss ($) Comparisons for 1991–1992 test period: actual best parameter Set vs. \nperiod average and best and W orst parameter Sets in prior period\nMarket\nbest parameter \nSet in period\nbest parameter Set \nin prior period\nW orst parameter \nSet in prior period\navg. of all \nparameter Sets\nW orst prior \n> best prior\navg. > \nbest prior\nT -bond 3,710 −1,820 −2,920 −420 X\nDeutsche mark 9,180 1,680 9,180 4,770 X X\nJapanese yen 3,340 −240 −3,620 −1,670\nGold 1,370 90 1,370 −1,050 X\nSilver −720 −1,890 −1,780 −1,640 X X\nHeating oil 5,510 −980 4,290 1,540 X X\nCorn 560 −480 340 −440 X X\nSoybeans −2,420 −6,090 −3,190 −4,650 X X\nCattle 1,380 −160 1,380 −340 X\nSugar 810 −1,690 −1,850 −1,410 X\ntotal 22,700 −11,570 3,200 −5,010 7 7\n306\nA Complete Guide to the Futures mArket\ntable 19.18 profit/loss ($) Comparisons for 1993–1994 test period: actual best parameter Set vs. \nperiod average and best and W orst parameter Sets in prior period\nMarket\nbest parameter", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 88}
{"text": "X\nCorn 560 −480 340 −440 X X\nSoybeans −2,420 −6,090 −3,190 −4,650 X X\nCattle 1,380 −160 1,380 −340 X\nSugar 810 −1,690 −1,850 −1,410 X\ntotal 22,700 −11,570 3,200 −5,010 7 7\n306\nA Complete Guide to the Futures mArket\ntable 19.18 profit/loss ($) Comparisons for 1993–1994 test period: actual best parameter Set vs. \nperiod average and best and W orst parameter Sets in prior period\nMarket\nbest parameter \nSet in period\nbest parameter Set \nin prior period\nW orst parameter \nSet in prior period\navg. of all \nparameter Sets\nW orst prior \n> best prior\navg. > \nbest prior\nT -bond 11,600 3,500 7,910 7,180 X X\nDeutsche mark 6,210 −3,660 −1,410 −3,300 X X\nJapanese yen 3,620 2,460 −3,060 260\nGold 490 −1,900 −930 −1,460 X X\nSilver 1,600 −3,650 −790 −2,690 X X\nHeating oil 2,200 2,200 −890 −1,700\nCorn 1,910 1,910 −1,030 640\nSoybeans 2,120 1,570 −2,060 −240\nCattle 1,600 950 1,600 500 X\nSugar 880 570 −240 −550\ntotal 32,230 3,950 −900 −1,360 5 4\ntable 19.19 profit/loss ($) Comparisons for three test periods Combined: actual best parameter Sets \nvs. period averages and best and W orst parameter Sets in prior periods\nMarket\nbest parameter \nSets in test \nperiods total\nbest parameter \nSets in prior \nperiods total\nW orst parameter \nSets in Prior \nperiods total\nperiod \nparameter Set \naverages total\nW orst prior \n> best prior\navg. > \nbest prior\nT -bond 21,980 −7,410 6,410 3,950 X X\nDeutsche mark 23,170 1,040 14,110 6,860 X X\nJapanese yen 18,800 11,460 1,740 6,720\nGold 5,250 −110 120 −1,430 X\nSilver 6,730 −210 −940 −1,280\nHeating oil 15,360 2,980 9,830 3,220 X X\nCorn 4,110 −760 −3,420 −390 X\nSoybeans 4,670 −11,680 −510 −5,330 X X\nCattle 5,070 1,640 −310 140\nSugar 5,930 3,060 −7,650 −2,800\ntotal 111,070 10 19,380 9,660 5 5\nBased on the combined three-period, all-market totals from this second set of tests, selecting the \nworst parameter set in the prior period actually would have outperformed a strategy of picking the \nbest past parameter set in two of the three test periods, as well as the three-period total!\nThis observation is not intended to imply that the prior-period worst-performing parameter set is \nlikely to outperform the prior-period best-performing set. If similar empirical tests were conducted \nfor other systems, the prior-period best-performing parameter set would probably outperform the \nprior-period worst-performing set more often than the other way around (although the types of results \nwitnessed in our example are far from uncommon). The key point, however, is that invariably, as was the \n307\nTESTING AND OPTIMIzING TRADING SYSTEMS\ncase in Tables 19.12 through 19.15 and 19.16 through 19.19, the prior-period best-performing parame-\nter sets would fall far short of the actual best-performing parameter sets for the given periods and would \noften fail to provide any statistically significant improvement over the average of all parameter sets.\nAlthough optimization seemed to have little, if any, value when applied market by market, optimiza-\ntion does appear to be a bit more useful if applied to a portfolio. In other words, instead of picking the \nbest past parameter set for each market, the best past single parameter set applied across all markets is \nselected. Table 19.20 shows the two-year test period parameter set rankings for a portfolio consisting \nof the 10 markets that provided the results for Tables 19.16 through 19.19.\n6 The one striking correla-\ntion between past and future performance is that the worst parameter set in the prior eight-year period \nis also the worst parameter set in the subsequent two-year period in all three test intervals!\nAlthough the worst past parameter set also seems likely to be the worst future parameter set, \nother past ranking placements seem to imply little predictive value. The average ranking for all three \ntest periods of the remaining eight prior-period ranking placements (i.e., all rankings excluding the \nworst one) is 4.5. While the average test period ranking of the best parameter set in the prior eight-\nyear period (3.3) is somewhat better than this average, the fourth-ranked parameter set in the prior \nperiod has by far the best average ranking in the future test periods (2.3). Also note that the second-\nbest prior-period parameter set has an average test period rank almost identical to the corresponding \naverage for the second worst prior-period parameter set (4.7 vs. 5.0).\nT o gain some insight as to why the worst prior-period ranking seems to be such an excellent \npredictor of future performance (namely, continued poor performance for that parameter set), while \nother ranking placements seem to have little predictive value, we examine performance rankings based \non parameter set value. Table 19.21 indicates parameter set rankings in each of the three tests periods \nbased on parameter set values (as opposed to prior-period rankings as was the case in Table 19.20). The \nparameter set values are listed in ascending order.\n6 In this case the portfolio consisted of one contract in each market, with the exception of corn, which was traded \nwith two contracts because of its low volatility.\ntable 19.20 breakout System (portfolio): Comparison of parameter Set rankings in two-Y ear test \nperiods vs. rankings in prior eight-Y ear periods\nparameter Set rank \nprior eight-Y ear period\nrank of Same parameter \nSet in 1989–1990\nrank of Same parameter \nSet in 1991–1992\nrank of Same parameter \nSet in 1993–1994 avg. rank\n1 1 7 2 3.3\n2 5 1 8 4.7\n3 3 6 4 4.3\n4 2 4 1 2.3\n5 4 8 6 6.0\n6 6 3 7 5.3\n7 7 5 3 5.0\n8 8 2 5 5.0\n9 9 9 9 9.0\n308\nA Complete Guide to the Futures mArket\ntable 19.21 breakout System (portfolio): Comparison of parameter Set rankings in two-Y ear test \nperiods based on N-Values\nparameter Set N-Value\nrank of parameter Set \nin 1989–1990\nrank of parameter Set \nin 1991–1992\nrank of parameter Set \nin 1993–1994 avg. rank\n20 9 9 9 9.0\n30 8 2 5 5.0\n40 7 5 3 5.0\n50 6 3 1 3.3\n60 4 6 6 5.3\n70 5 7 8 6.7\n80 1 1 2 1.3\n90 2 4 4 3.3\n100 3 8 7 6.0\nTable 19.21 reveals that the worst-p", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 89}
{"text": "out System (portfolio): Comparison of parameter Set rankings in two-Y ear test \nperiods based on N-Values\nparameter Set N-Value\nrank of parameter Set \nin 1989–1990\nrank of parameter Set \nin 1991–1992\nrank of parameter Set \nin 1993–1994 avg. rank\n20 9 9 9 9.0\n30 8 2 5 5.0\n40 7 5 3 5.0\n50 6 3 1 3.3\n60 4 6 6 5.3\n70 5 7 8 6.7\n80 1 1 2 1.3\n90 2 4 4 3.3\n100 3 8 7 6.0\nTable 19.21 reveals that the worst-performing parameter set in each of the test periods was actually \nthe same parameter set! (Since Table 19.20 indicated the test period worst parameter set was the same \nas the prior-period worst parameter set in all three cases, the implication is that this same parameter \nset was also the worst-performing parameter set in all three prior eight-year periods.) This consistently \nworst-performing parameter set is at one extreme end of the parameter set range tested: N = 20.\nAlthough N = 20—the most sensitive parameter set value tested—is consistently the worst per-\nformer (when applied across a portfolio), the other values tested (N = 30 to N = 100) show no \nconsistent pattern. It is true that the parameter set N = 80 was by far the best-performing set with \nan incredible average rank of 1.3. However, the average rankings of the two surrounding N-values \n(6.7 and 3.3) suggest that the stellar performance of N = 80 was probably a statistical fluke. As was \nexplained earlier in this chapter, a lack of parameter stability suggests that the past superior perfor-\nmance of a parameter set probably reflects a peculiarity in the historical data tested rather than a \npattern that is likely to be repeated in the future.\nTables 19.22 and 19.23 show analogous portfolio optimization statistics for the portfolios in the \nmore recent test periods that were reviewed in Tables 19.12 through 19.15. Note in Table 19.23 that \nthe same N = 20 parameter set once again exhibited inferior performance, registering as the worst-\nperforming set in two of the three periods.\nIt is instructive to review the observations revealed by the foregoing optimization experiments:\n ■ Optimization appeared to have no value whatsoever when applied on a market-by-market basis.\n ■ When applied to a portfolio, however, optimization in the earlier (1981–1994) example appeared \nuseful in predicting the parameter set most likely to witness inferior future performance, although \nit still showed no reliable pattern in predicting the parameter set most likely to witness superior \nfuture performance.\n ■ Upon closer examination it appeared this pattern of consistent inferior performance was not \nso much a consequence of the prior-period ranking as the parameter value. In other words, the \n309\nTESTING AND OPTIMIzING TRADING SYSTEMS\nparameter set range tested began at a value that was clearly suboptimal for the given system: N = 20. \nThis same parameter value remained suboptimal, on average, in the more recent test period as well. \nAlthough not indicated in the parameter set ranking tables, lower values of N would have shown \neven worse performance—in fact, strikingly worse—as the value of N was decreased.\nThese observations, which are consistent with the results of other similar empirical tests I have \nconducted in the past, suggest the following five key conclusions regarding optimization:7\ntable 19.22 breakout System (portfolio): Comparison of parameter Set rankings in two-Y ear test \nperiods vs. rankings in prior eight-Y ear periods (2000–2014)\nparameter Set rank \nprior eight-Y ear period\nparameter Set rank \nin 2009–2010\nparameter Set rank \nin 2011–2012\nparameter Set rank \nin 2013–2014 average rank\n1 9 1 1 3.7\n2 2 7 5 4.7\n3 3 2 3 2.7\n4 7 3 9 6.3\n5 6 4 4 4.7\n6 8 5 8 7.0\n7 4 8 2 4.7\n8 5 6 7 6.0\n9 1 9 6 5.3\ntable 19.23 breakout System (portfolio): Comparison of parameter Set rankings in two-Y ear test \nperiods based on N-Values (2000–2014)\nparameter Set \nN-Value\nrank of parameter Set \nin 2009–2010\nrank of parameter Set \nin 2011–2012\nrank of parameter Set \nin 2013–2014 average rank\n20 9 3 9 7.0\n30 7 5 8 6.7\n40 6 8 7 7.0\n50 8 9 6 7.7\n60 5 6 2 4.3\n70 3 7 3 4.3\n80 4 4 4 4.0\n90 1 2 5 2.7\n100 2 1 1 1.3\n7 Although a single empirical experiment cannot be used to draw broad generalizations, I am willing to do so here \nbecause the results of the optimization test just described are fairly typical of many similar tests I have conducted \nin the past. In this sense, the optimization tests detailed in the text are not intended as a proof of the severe limita-\ntions of optimization, but rather as illustrations of this point.\n310\nA Complete Guide to the Futures mArket\n 1. Any system—repeat, any system—can be made to be very profitable through optimization \n(i.e., over its past performance). If you ever find a system that can’t be optimized to show \ngood profits in the past, congratulations, you have just discovered a money machine (by \ndoing the opposite, unless transaction costs are exorbitant). Therefore, a wonderful past \nperformance for a system that has been optimized may be nice to look at, but it doesn’t mean \nvery much.\n 2. Optimization will always, repeat always, overstate the potential future performance of a \nsystem—usually by a wide margin (say, three trailer trucks’ worth). Therefore, optimized \nresults should never, repeat never, be used to evaluate a system’s merit.\n 3. For many if not most systems, optimization will improve future performance only marginally, if \nat all.\n 4. If optimization has any value, it is usually in defining the broad boundaries for the ranges from \nwhich parameter set values in the system should be chosen. Fine-tuning of optimization is at \nbest a waste of time and at worst self-delusion.\n 5. In view of the preceding items, sophisticated and complex optimization procedures are a waste \nof time. The simplest optimization procedure will provide as much meaningful information \n(assuming that there is any meaningful information to be derived).\nIn summary, contrary to widespread belief, there is some reasonable question as to wheth", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 90}
{"text": "is at \nbest a waste of time and at worst self-delusion.\n 5. In view of the preceding items, sophisticated and complex optimization procedures are a waste \nof time. The simplest optimization procedure will provide as much meaningful information \n(assuming that there is any meaningful information to be derived).\nIn summary, contrary to widespread belief, there is some reasonable question as to whether opti-\nmization will yield meaningfully better results over the long run than randomly picking the param-\neter sets to be traded. Lest there be any confusion, let me explicitly state that this statement is not \nintended to imply that optimization is never of any value. First, as indicated previously, optimization \ncan be useful in defining the suboptimal extreme ranges that should be excluded from the selection \nof parameter set values (e.g., N ≤ 20 in our breakout system example). Also, it is possible that, for \nsome systems, optimization may provide some edge in parameter set selection, even after suboptimal \nextreme ranges are excluded. However, I do mean to imply that the degree of improvement provided \nby optimization is far less than generally perceived and that traders would probably save a lot of \nmoney by first proving any assumptions they are making about optimization rather than taking such \nassumptions on blind faith.\n ■ Testing versus Fitting\nPerhaps the most critical error made by users of futures trading systems is the assumption the per-\nformance of the optimized parameter sets during the test period provides an approximation of the \npotential performance of those sets in the future. As was demonstrated in the previous section, such \nassumptions will lead to grossly overstated evaluations of a system’s true potential. It must be under-\nstood that futures market price fluctuations are subject to a great deal of randomness. Thus, the “ugly \ntruth” is that the question of which parameter sets will perform best during any given period is largely \na matter of chance. The laws of probability indicate that if enough parameter sets are tested, even a \nmeaningless trading system will yield some sets with favorable past performance. Evaluating a system \nbased on the optimized parameter sets (i.e., the best-performing sets during the survey period) \n311\nTESTING AND OPTIMIzING TRADING SYSTEMS\nwould be best described as fitting the system to past results rather than testing the system. If optimiza-\ntion can’t be used to gauge performance, how then do you evaluate a system? The following sections \ndescribe two meaningful approaches.\nblind Simulation\nIn the blind simulation approach the system is optimized using data for a time period that deliber-\nately excludes the most recent years. The performance of the system is then tested using the selected \nparameter sets for subsequent years. Ideally, this process should be repeated several times.\nNote that the error of fitting results is avoided because the parameter sets used to measure per-\nformance in any given period are selected entirely on the basis of prior rather than concurrent data. \nIn a sense, this testing approach mimics real life (i.e., one must decide which parameter sets to trade \non the basis of past data).\nThe optimization tests of the previous section used this type of procedure, stepping through time \nin two-year intervals. Specifically, system results for the 2001–2008 period were used to select the \nbest-performing parameter sets, which were then tested for the 2009–2010 period. Next, the system \nresults for the 2003–2010 period were used to select the best-performing parameter sets, which were \nthen tested for the 2011–2012 period. Finally, the system results for the 2005–2012 period were \nused to select the best-performing parameter sets, which were then tested for the 2013–2014 period.\nThe essential point is that simulation and optimization periods should not be allowed to overlap. \nSimulations that are run over the same period as the optimization are worthless.\naverage parameter Set performance\nFinding the average parameter set performance requires defining a complete list of all parameter \nsets you wish to test before running any simulations. Simulations are then run for all the parameter \nsets selected, and the average of all sets tested is used as an indication of the system’s potential per-\nformance. This approach is valid because you could always throw a dart to pick a parameter from a \nbroad range of parameter set values. If you throw enough darts, the net result will be the average. The \nimportant point is that this average should be calculated across all parameter sets, not just those sets \nthat prove profitable. Note that the trader might still choose to trade the optimized parameter sets \nfor the future (instead of randomly selected ones), but the evaluation of the system’s performance \nshould be based on the average of all sets tested (which is equivalent to a random selection process).\nThe blind simulation approach probably comes closest to duplicating real-life trading circumstances. \nHowever, the average parameter set performance is probably as conservative and has the advantage of \nrequiring far less calculation. Both approaches represent valid procedures for testing a system.\nOne important caveat: In the advertised claims for given systems, the term simulated results is often \nused loosely as a euphemism for optimized results (instead of implying the results are based on a blind \nsimulation process). If this is the case, the weight attached to the results should equal the amount of \nmoney invested in the system: zero. The commonplace misuse and distortion of simulated results is \nexamined in detail in the next section.\n312\nA Complete Guide to the Futures mArket\n ■ The Truth about Simulated Results\nAlthough the value of optimization in improving a system’s future performance is open to debate, \nthere is absolutely no question the use of optimized results will greatly distort the implied future \nperformance o", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 91}
{"text": "ro. The commonplace misuse and distortion of simulated results is \nexamined in detail in the next section.\n312\nA Complete Guide to the Futures mArket\n ■ The Truth about Simulated Results\nAlthough the value of optimization in improving a system’s future performance is open to debate, \nthere is absolutely no question the use of optimized results will greatly distort the implied future \nperformance of a system. As was demonstrated earlier in this chapter, there is very little, if any, \ncorrelation between the best-performing parameters in a system for one period and the best-\nperforming parameters in a subsequent period. Hence, assuming that the performance implied by \nthe best-performing parameters could have been achieved in the past is totally unrealistic.\nAfter years of experience, my attitude toward simulated results is summarized by what I call \nSchwager’s simulations corollary to Gresham’s law of money. As readers may recall from Economics \n101, Gresham’s proposition was that “bad money drives out good.” Gresham’s contention was that \nif two types of money were in circulation (e.g., gold and silver) at some arbitrarily defined ratio \n(e.g., 16:1), the bad money (i.e., the money overvalued at the fixed rate of exchange) would drive \nout the good. Thus, if gold were worth more than 16 ounces of silver, a 16:1 ratio would result in \nsilver driving gold out of circulation (as people would tend to hoard it).\nMy corollary is “bad simulations drive out good.” The term bad means simulations derived based \non highly tenuous assumptions, not bad in terms of indicated performance. On the contrary, truly \n“bad” simulations will show eye-popping results.\nI frequently see ads hawking systems that supposedly make 200 percent, 400 percent, or even \n600 percent a year. Let’s be conservative—and I use the term loosely—and assume a return of only \n100 percent per year. At this level of return, $100,000 would grow to over $1 billion in just over 13 \nyears! How can such claims possibly be true, then? The answer is they can’t. The point is that, given \nenough hindsight, it is possible to construct virtually any type of past-performance results. If anyone \ntried to sell a system or a trading program based on truly realistic simulations, the results would \nappear laughably puny relative to the normal promotional fare. It is in this sense that I believe that \nbad (unrealistic) simulations drive out good (realistic) simulations.\nHow are simulated results distorted? Let us count the ways:\n 1. the well-chosen example (revisited). In constructing a well-chosen example, the system \npromoter selects the best market, in the best time period, using the best parameter set. Assum-\ning a system is tested on 25 markets for 15 years and uses 100 parameter set variations, there \nwould be a total of 37,500 (25 × 15 × 100) one-year results. It would be difficult to construct \na system in which not one of these 37,500 possible outcomes showed superlative results. For \nexample, if you tossed a group of 10 coins 37,500 times, don’t you think you would get 10 out \nof 10 heads sometimes? Absolutely. In fact, you would get 10 out of 10 heads on the average of \none out of 1,024 times.\n 2. Kitchen sink approach. By using hindsight to add parameters and create additional system \nrules that conveniently take care of past losing periods, it is possible to generate virtually any \nlevel of past performance.\n 3. Ignoring risk. Advertised system results frequently calculate return as a percent of margin \nor as a percent of an unrealistically low multiple of margin. This return measurement approach \n313\nTESTING AND OPTIMIzING TRADING SYSTEMS\nalone can multiply the implied returns severalfold. Of course, the risk would increase commen-\nsurately, but the ads don’t provide those details.\n 4. Overlooking losing trades. It is hardly uncommon for charts in system websites or adver-\ntisements to indicate buy and sell signals at the points at which some specified rules were met, \nbut fail to indicate other points on the same chart where the same conditions were met and the \nresulting trades were losers.\n 5. Optimize, optimize, optimize. Optimization (i.e., selecting the best-performing param-\neter sets for the past) can tremendously magnify the past performance of a system. Virtually any \nsystem ever conceived by man would look great if the results were based on the best parameter \nset (i.e., the parameter set that had the best past performance) for each market. The more \nparameter sets tested, the wider the selection of past results, and the greater the potential simu-\nlated return.\n 6. Unrealistic transaction costs. Frequently, simulated results only include commissions but \nnot slippage (the difference between the assumed entry level and the actual fill that would be \nrealized by using a market or stop order). For short-term systems (e.g., those using intraday \ndata), ignoring slippage can make a system that would wipe out an account in real life look like \na money machine.\n 7. Fabrication. Even though it is remarkably easy to construct system rules with great perfor-\nmance for the past, some promoters don’t even bother doing this much. For example, one \ninfamous individual for years repeatedly promoted $299 systems that were outright frauds.\nThe preceding is not intended to indict all system promoters or those using simulated results. \nCertainly, there are many individuals who construct simulated results in appropriately rigorous \nfashion. However, the sad truth is that the extraordinary misuse of simulations over many years has \nmade simulated results virtually worthless. Advertised simulated results are very much like restaurant \nreviews written by the proprietors—you would hardly expect to ever see a bad review . I can assure \nyou that you will never see any simulated results for a system that show the system long the S&P as of \nthe close of October 16, 1987, September 10, 2001, or March 5, 2010. Can simulated results ever be \nused?\n Y es,", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 92}
{"text": "s virtually worthless. Advertised simulated results are very much like restaurant \nreviews written by the proprietors—you would hardly expect to ever see a bad review . I can assure \nyou that you will never see any simulated results for a system that show the system long the S&P as of \nthe close of October 16, 1987, September 10, 2001, or March 5, 2010. Can simulated results ever be \nused?\n Y es, if you are the system developer and you know what you’re doing (e.g., use the simulation \nmethods detailed in the previous section), or, equivalently, if you have absolute faith in the integrity \nand competence of the system developer.\n ■ Multimarket System Testing\nAlthough it is probably unrealistic to expect any single system to work in all markets, generally \nspeaking, a good system should demonstrate profitability in a large majority of actively traded \nmarkets (e.g., 85 percent or more). There are, of course, some important exceptions. A system \nemploying fundamental input would, by definition, be applicable to only a single market. In addition, \nthe behavior of some markets is so atypical (e.g., stock indexes) that systems designed for trading such \nmarkets might well perform poorly over the broad range of markets.\n314\nA Complete Guide to the Futures mArket\nIn testing a system for a multimarket portfolio, it is necessary to predetermine the relative \nnumber of contracts to be traded in each market. This problem is frequently handled by simply \nassuming the system will trade one contract in each market. However, this is a rather naive \napproach, for two reasons. First, some markets are far more volatile than other markets. For \nexample, a portfolio that included one contract of coffee and one contract of corn would be far \nmore dependent on the trading results in coffee. Second, it may be desirable to downgrade the \nrelative weightings of some markets because they are highly correlated with other markets (e.g., \n10-year T -notes and 30-year T -bonds).\n8\nIn any case, the percentage allocation of available funds to each market should be determined prior \nto testing a system. These relative weightings can then be used to establish the number of contracts \nto be traded in each market.\n ■ Negative Results\nOne should not overlook the potential value of negative results. Analyzing the conditions under which \na system performs poorly can sometimes reveal important weaknesses in the system that have been \noverlooked and thus provide clues as to how the system can be improved. Of course, the fact that \nthe implied rule changes improve results in the poorly performing case does not prove anything. \nHowever, the validity of any suggested rule changes would be confirmed if such revisions generally \ntended to improve the results for other parameter sets and markets as well. The potential value of \nnegative results as a source of ideas for how a system can be improved cannot be overstated. The con-\ncept that disorder is a catalyst for thought is a general truth that was perfectly expressed by the late \nnovelist John Gardner: “In a perfect world, there would be no need for thought. W e think because \nsomething goes wrong.”\nThe idea of learning from poor results is basically applicable to a system that works in most mar-\nkets and for most parameter sets but performs badly in isolated cases. However, systems that exhibit \ndisappointing results over a broad range of markets and parameter sets are likely to be lost causes, \nunless the results are spectacularly poor. In the latter case, a system that exactly reverses the trade \nsignals of the original system might be attractive. For example, if tests of a new trend-following \nsystem reveal that the system consistently loses money in most markets, the implication is that one \nmight have accidently stumbled upon an effective countertrend system. Such discoveries may be \ndifficult on the ego, but they should not be ignored.\nOf course, the fact that a system exhibits stable poor performance does not imply that the \nreverse system would perform favorably, since transaction costs may account for a significant por -\ntion of losses. Thus, the reverse system might also perform badly once these costs are taken into \naccount, as was the case for the aforementioned well-chosen example described at the start of \n8 For purposes of future trading (as opposed to historical testing), historical performance might be a third \nrelevant factor in determining contract weightings. However, this factor cannot be included as an input in the \ntesting procedure because it would bias the results.\n315\nTESTING AND OPTIMIzING TRADING SYSTEMS\nthis chapter. As another example, at surface glance, reversing the signals generated by a system that \nloses an average of $3,000 per year may appear to be an attractive strategy. If, however, two-thirds \nof the loss can be attributed to transaction costs, fading the signals of this system will result in a loss \nof $1,000 per year, assuming a continuation of the same performance. (The preceding assumptions \nimply that transaction costs equal $2,000 per year and that the trades lose $1,000 per year net of \nthese costs. Thus, reversing the signals would imply a $l,000-per-year gain on the trades, but the \n$2,000-per year transaction costs would imply a net loss of $1,000 per year.) Moral: If you are going \nto design a bad system, it should be truly terrible if it is to be of value.\n ■ Ten Steps in Constructing and Testing a Trading System\n 1. Obtain all data needed for testing. Again, with the exception of short-term trading systems, \nwhich may be able to use actual contract data, the use of continuous futures (not to be confused \nwith nearest futures or perpetual prices) is highly recommended.\n 2. Define the system concept.\n 3. Program rules to generate trades in accordance with this concept.\n 4. Select a small subset of markets and a subset of years for these markets.\n 5. Generate system trading signals for this subset of markets and time for a given par", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 93}
{"text": "al contract data, the use of continuous futures (not to be confused \nwith nearest futures or perpetual prices) is highly recommended.\n 2. Define the system concept.\n 3. Program rules to generate trades in accordance with this concept.\n 4. Select a small subset of markets and a subset of years for these markets.\n 5. Generate system trading signals for this subset of markets and time for a given parameter set.\n 6. Check to see that the system is doing what was intended. Almost invariably, a careful check will \nreveal some inconsistencies due to either or both of the following reasons:\na.\n There are errors in the program.\nb. Rules in program do not anticipate some circumstances, or they create unforeseen \nrepercussions.\nSome examples of the latter might include the system failing to generate a signal, given an \nevent at which a signal is intended; system generating a signal when no signal is intended; system \nrules inadvertently creating a situation in which no new signals can be generated or in which a \nposition is held indefinitely. In essence, these types of situations arise because there will often \nbe some missed nuances.\nThe system rules need to be modified to correct both programming errors as well as \nunforeseen inconsistencies. It should be emphasized that corrections of the latter type are only \nconcerned with making the system operate consistently with the intended concept and should \nbe made without any regard as to whether the changes help or hurt performance in the sample cases used \nin the developmental process.\n 7. After making necessary corrections, repeat step 6. Pay particular attention to changes in the \nindicated signals versus those from previous runs for two reasons:\na.\n T o check whether the program changes achieved the desired fix.\nb. T o make sure the changes did not have unintended effects.\n 8. Once the system is working as intended, and all rules and contingencies have been fully defined, \nand only after such a point, test the system on the entire defined parameter set list across the full \ndatabase. Be sure the intended trading portfolio has been defined before this test is run.\n316\nA Complete Guide to the Futures mArket\n 9. As detailed earlier in this chapter, evaluate performance based on the average of all parameter \nsets tested or a blind simulation process. (The former involves far less work.)\n 10. Compare these results with the results of a generic system (e.g., breakout, crossover moving \naverage) for the corresponding portfolio and test period. The return/risk of the system should \nbe measurably better than that of the generic system if it is to be deemed to have any real value.\nThe preceding steps represent a rigorous procedure that is designed to avoid generating results \nthat are upwardly biased by hindsight. As such, expect most system ideas to fail the test of merit \nin step 10. Designing a system with a truly superior performance is more difficult than most \npeople think.\n ■ Observations about Trading Systems\n 1. In trend-following systems, the basic method used to identify trends (e.g., breakout, crossover \nmoving average) may well be the least important component of the system. In a sense, this \ncontention is merely a restatement of Jim Orcutt’s observation that “There are only two types \nof trend-following systems: fast and slow .” Thus, in designing trend-following systems, it may \nmake more sense to concentrate on modifications (e.g., filters and confirmation rules to reduce \nbad trades, market characteristic adjustments, pyramiding rules, stop rules) than on trying to \ndiscover a better method for defining trends.\n 2. Complexity for its own sake is no virtue. Use the simplest form of a system that does not imply \na meaningful sacrifice in performance relative to more complex versions.\n 3. The well-publicized and very valid reason for trading a broad range of markets is risk control \nthrough diversification. However, there is a very important additional reason for trading as \nmany markets as possible: insurance against missing any of the sporadic giant price moves in the \nfutures markets. The importance of catching all such major trends cannot be overstressed—it \ncan make the difference between mediocre performance and great performance. The 2008–\n2011 gold market and the 2007–2009 and 2014–2016 crude oil markets are three spectacular \nexamples of markets that were critical to portfolio performance.\n 4. If trading funds are sufficient, diversification should be extended to systems as well as markets. \nTrading several systems rather than a single system could help smooth overall performance. \nIdeally, the greatest degree of diversification would be achieved if the mix of systems included \ncountertrend and pattern-recognition systems as well as trend-following systems. (However, \nthis goal may be difficult to achieve because countertrend and pattern-recognition systems are \ngenerally significantly harder to design than trend-following systems.)\n 5. If sufficient funds are available, it is better to trade a number of diversified parameter sets than \nto trade a single optimized set.\n 6. Generally speaking, the value of parameter optimization is far overstated.\n 7. The previous observation strongly suggests that optimized results should never be used for \nevaluating the relative performance of a system. Two meaningful methods for testing systems \nwere discussed in the text.\n317\nTESTING AND OPTIMIzING TRADING SYSTEMS\n 8. So-called simulated results are frequently optimized results (i.e., derived with the benefi t of hindsight) \nand, as such, virtually meaningless. This caveat is particularly pertinent in regard to promotions for \ntrading systems, which invariably use very well-chosen examples. \n 9. An analysis of the results of successful systems will almost invariably reveal the presence of many \nmarkets with one or more years of very large profi ts, but few instances of very large single-year \nlosses. The implication is that a key reason for the s", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 94}
{"text": "ngless. This caveat is particularly pertinent in regard to promotions for \ntrading systems, which invariably use very well-chosen examples. \n 9. An analysis of the results of successful systems will almost invariably reveal the presence of many \nmarkets with one or more years of very large profi ts, but few instances of very large single-year \nlosses. The implication is that a key reason for the success of these systems is that their rules \nadhere to the critical, albeit clichéd principle of letting profi ts run and cutting losses short. \n 10. A market should not be avoided because its volatility increases sharply. In fact, the most volatile \nmarkets are often the most profi table. \n 11. Isolating negative results for a system that performs well on balance can provide valuable clues \nas to how the system can be improved. \n 12. A frequently overlooked fact is that trading results may often refl ect more information about the \nmarket than the system. For example, in Figure 19.3 , the fact that a trend-following system that \nwas short in mid-January 2015 would have witnessed the transformation of a large open profi t \ninto a large loss before the system provided a liquidation or reversal signal would not necessarily \nrefl ect inadequate risk control. Virtually any trend-following system would have experienced \nthe same fate. \n This example illustrates how the value of a system cannot be judged in a vacuum. In some \ncases, poor performance may refl ect nothing more than the fact that market conditions would \nhave resulted in poor results for the vast majority of systems. Similarly, favorable results may \nalso refl ect the conditions of the market rather than any degree of superiority in the tested \n FIGURE  19.3 Trading Results Refl ect Market, Not System: Short Swiss Franc Continuous \nFutures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n318\nA Complete Guide to the Futures mArket\nsystem. These considerations suggest that a meaningful assessment of a new system’s perfor-\nmance should include a comparison to a benchmark (e.g., the corresponding performance of \nstandard systems, such as a crossover moving average or a simple breakout, during the same \nperiod for the same markets).\n 13. Use continuous futures prices for testing systems.\n 14. Use only a small portion of the database (i.e., some markets for only a segment of the full time \nperiod) for developing and debugging a system.\n 15. Use charts with superimposed signal annotations as an aid to debugging systems.\n 16. In checking the accuracy and completeness of the signals generated by a system, make changes \ndictated by deviations from the intended operation of the system (due to oversights related to \nthe full implications of the rules employed or unforeseen situations) with complete disregard \nfor whether such changes increase or decrease profits in the sample tests.\n319\n ■ Why Return Alone Is Meaningless\nY ou are looking for a London hotel room on the Internet. Y ou find the same hotel room at two differ-\nent sites (both including taxes) at two different prices:\n ■ Site A: 300\n ■ Site B: 250\nWhich is the better deal? The answer may seem obvious, but it’s not. On one occasion, when I \nposed this question to a conference audience, one attendee shouted the response, “It depends whether \nthey both include breakfast.” “That would have to be a very expensive breakfast,” I answered. But at \nleast he had the right idea. The question I posed contained incomplete information. I didn’t specify \nwhat currency the prices were quoted in. What if the 300 price was in dollars and the 250 price was \nin pounds (let’s say when the pound was at $1.40)? Changes everything, doesn’t it?\n“W ell,” you are probably thinking, “no rational person will ignore the currency denomination in \ncomparing two prices, so what’s the point?” \n The point is that investors make this type of error all the \ntime when selecting investments by focusing only on returns. Comparing returns without risk is as \nmeaningless as comparing international hotel prices without the currency denomination. Risk is the \ndenomination of return.\nHow to Evaluate \nPast Performance*\nChapter 20\n* This chapter is adapted from Jack D. Schwager, Market Sense and Nonsense: How the Markets Really Work (and How \nThey Don’t) (Hoboken, NJ: John Wiley & Sons, 2012).\n320\nA Complete Guide to the Futures mArket\nConsider the two managers in Table 20.1. Assuming the two managers are considered qualitatively \nequivalent, which is the better-performing manager? 1 Many investors would opt for Manager B, \nreasoning, “I am willing to accept the higher risk to get the higher return potential.” But is this \nreasoning rational? In Table 20.2 we add a third investment alternative—leveraging an investment \nwith Manager A at 300 percent.\n2 The leveraged investment with Manager A now has both a higher \nreturn and lower risk than Manager B. So even risk-seeking investors should prefer Manager A, \nusing a leverage factor that raises return to the desired level.\nOne can picture risk as a hole—the deeper the hole, the greater the risk—and return as a pile of \nsand. Leverage is the shovel that, if desired, allows transferring some of the sand from the risk hole \nto the return pile, thereby increasing return in exchange for accepting greater risk—a trade-off that \nmay be preferred if the risk level is lower than desired. Continuing the analogy, by using negative \nleverage (i.e., holding more cash), it is also possible to transfer sand from the return pile to the risk \nhole, thereby reducing risk in exchange for accepting lower return. In this sense, risk and return are \nentirely interchangeable through leverage (that is, through varying exposure).\ntable 20.1 a Comparison of two Managers\nreturn risk (Standard Deviation) return/risk ratio\nManager A 10% 5 2:1\nManager B 25% 25 1:1\ntable 20.2 a Comparison of two Managers revisited\nreturn risk (Standard Deviation) return/risk ratio\nManager A 10", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 95}
{"text": "in exchange for accepting lower return. In this sense, risk and return are \nentirely interchangeable through leverage (that is, through varying exposure).\ntable 20.1 a Comparison of two Managers\nreturn risk (Standard Deviation) return/risk ratio\nManager A 10% 5 2:1\nManager B 25% 25 1:1\ntable 20.2 a Comparison of two Managers revisited\nreturn risk (Standard Deviation) return/risk ratio\nManager A 10% 5 2:1\nManager B 25% 25 1:1\nManager A 3× 30% 15 2:1\n2 For strategies that use margin (e.g., futures, foreign exchange, options), managers need only a small percent-\nage of the nominal investment to meet margin requirements. In these instances, investors can often use notional \nfunding—that is, funding an account with a smaller amount of cash than the nominal level. For example, an \ninvestor might notionally fund an account with $300,000 cash to be traded as a $900,000 investment, implicitly \nleveraging the cash investment 300 percent vis-à-vis an investment that is not notionally funded. T echnically \nspeaking, although notional funding increases the exposure per dollar invested, it does not actually imply leverage, \nsince there is no borrowing involved. Our example assumes notional funding. Nevertheless, in the ensuing discus-\nsion, we use the term leverage to indicate increased exposure (even if there is no borrowing involved). For strate-\ngies that must be fully funded, the leveraged portion of returns would have to be reduced by borrowing costs.\n1 Although this chapter is written from the perspective of an investor comparing investments with two different \nmanagers, exactly analogous comments would apply to a trader comparing two different systems or two differ-\nent trading strategies.\n \n321\nHOW TO EVALUATE PAST PERFORMANCE\n As a practical example to illustrate this concept, in Figure 20.1 we compare two actual manag-\ners. Assuming we consider past performance indicative of potential future performance—at least in a \nrelative sense—which manager provides a better investment? It would appear the answer is indetermi-\nnate: Manager C clearly achieves a superior return, but Manager D displays considerably lower risk, as \nevidenced by much smaller equity drawdowns throughout the track record. The seeming inability to \ndetermine which manager exhibits better performance is true only in a superfi cial sense, however. In \nFigure 20.2 , we again compare Managers C and D, but this time we assume the exposure to Manager \nD is doubled. \n3 Now it is clear that Manager D is superior in terms of both return and risk, achieving a \nsignifi cantly higher ending net asset value (NAV) and still doing so with visibly lower equity drawdowns \n(despite the doubling of exposure). Even though Manager C ended up with a higher return in Figure \n 20.1 , investors could have achieved an even higher return with a 2× investment in Manager D while still \nmaintaining less risk. The lesson is that return is a faulty gauge; it is the return/risk ratio that matters. \n 3 Managers C and D are commodity trading advisors (CTAs) who trade futures, so increased exposure could \nhave been achieved through notional funding (i.e., without leverage through borrowing). The returns depicted \nin Figure 20.1 were adjusted to remove interest income, so that doubling exposure (whether through notional \nfunding or through borrowed leverage) would multiply all the returns by a near-exact factor of 2.0. (If returns \nincluded interest income, then doubling the exposure would not fully double the returns because there would be \nno interest income on the additional exposure.)\n FIGURE  20.1 Two Paths to Return \nApril\nJanuary\n4,000\n2,000\n3,000\n1,000\nJuly\nOctober\nApril\nJanuary\nJuly\nOctober\nApril\nJanuary\nJuly\nOctober\nApril\nJanuary\nJuly\nOctober\nApril\nJanuary\nJanuary\nJuly\nOctober\nApril\nJanuary\nJuly\nOctober\nApril\nJanuary\nJuly\nOctober\nManager C\nManager D\nApril\nJanuary\nJuly\nOctober\n322A COMPLETE GUIDE TO THE FUTURES MARKET\n What if leverage is not available as a tool? For example, what if investors have a choice between \nManagers C and D in Figure 20.1 but there are practical impediments to increasing the exposure of \nManager D? Now return and risk are inextricably bundled, and investors must choose between the \nhigher-return/higher-risk profi le of Manager C and the lower-return/lower-risk profi le of Manager \nD. It might seem that risk-tolerant investors would always be better off with Manager C. Such inves-\ntors might say, “I don’t care if Manager C is riskier, as long as the end return is higher.” The fl aw in this \npremise is that investors who start with Manager C at the wrong time—and that is easy to do—may \nactually experience signifi cant losses rather than gains, even if they maintain the investment, and espe-\ncially if they don’t. The more volatile the path of returns, the more likely investors will abandon the \ninvestment during one of the equity plunges and, as a result, never realize the higher return. After all, \ninvestors in real time do not know the investment will eventually recover. Thus, even though Manager \nC ends up ahead of Manager D, many investors will never survive the ride to see the eventual suc-\ncessful outcome (and even those who do may have initiated their investment on an upside excursion, \nreducing or even eliminating their net return). The greater the volatility, the larger the percentage of \ninvestors who will close out their investments at a loss. \n Clearly, there is a need to use risk-adjusted returns rather than returns alone to make valid perfor-\nmance comparisons. In the next section we consider some alternative risk-adjusted return measures. \nApril\nJanuary\n4,000\n5,000\n6,000\n7,000\n8,000\n2,000\n3,000\n1,000\nJuly\nOctober\nApril\nJanuary\nJuly\nOctober\nApril\nJanuary\nJuly\nOctober\nApril\nJanuary\nJuly\nOctober\nApril\nJanuary\nJanuary\nJuly\nOctober\nApril\nJanuary\nJuly\nOctober\nApril\nJanuary\nJuly\nOctober\nManager C\nManager D 2×\nApril\nJanuary\nJuly\nOctober\n FIGURE  20.2 Doubling the Exposure of the Lower-Risk Manager \n323\nHow to EvaluatE Past", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 96}
{"text": "return measures. \nApril\nJanuary\n4,000\n5,000\n6,000\n7,000\n8,000\n2,000\n3,000\n1,000\nJuly\nOctober\nApril\nJanuary\nJuly\nOctober\nApril\nJanuary\nJuly\nOctober\nApril\nJanuary\nJuly\nOctober\nApril\nJanuary\nJanuary\nJuly\nOctober\nApril\nJanuary\nJuly\nOctober\nApril\nJanuary\nJuly\nOctober\nManager C\nManager D 2×\nApril\nJanuary\nJuly\nOctober\n FIGURE  20.2 Doubling the Exposure of the Lower-Risk Manager \n323\nHow to EvaluatE Past PErformancE\n ■ Risk-Adjusted Return Measures\nSharpe ratio\nThe Sharpe ratio is the most widely used risk-adjusted return measure. The Sharpe ratio is defined \nas the average excess return divided by the standard deviation. Excess return is the return above the \nrisk-free return (e.g., the Treasury bill rate). For example, if the average return is 8 percent per year \nand the T -bill rate is 3 percent, the excess return would be 5 percent. (It should be noted that during \ncertain periods, such as the years following the 2008 financial crisis, zero, or near-zero, interest rates \ncan effectively eliminate the expectation of a meaningful “risk-free” return. For reference, the \n average \nthree-month T -bill rate from 2009 through 2015 was only 0.08 percent. In contrast, from 2002 to 2008 \nthe average three-month T -bill rate was 2.58 percent, and during 1995–2001 it was 5.03 percent.) The \nstandard deviation is a measure of the variability of return. In essence, the Sharpe ratio is the average \nexcess return normalized by the volatility of returns:\nSR AR RF\nSD= −\nwhere SR = Sharpe ratio\nAR = average return (used as proxy for expected return)\nRF = risk-free interest rate (e.g., Treasury bill return)\nSD = standard deviation\nThe standard deviation is calculated as follows:\nSD\nXX\nN\niI\nN\n=\n−\n−\n∑ () 2\n1\nwhere X = mean\nXi = individual returns\nN = number of returns\nAssuming monthly data is used to calculate the Sharpe ratio, as is most common, the Sharpe ratio \nwould be annualized by multiplying by the square root of 12. Note that the return is an arithmetic \naverage return, not the compounded return.\nThere are two basic problems with the Sharpe ratio:\n 1. the return measure is based on average rather than compounded return. The \nreturn an investor realizes is the compounded return, not the average return. The more volatile \nthe return series, the more the average return will deviate from the actual (i.e., compounded) \nreturn. For example, a two-year period with a 50 percent gain in one year and a 50 percent \nloss in the other would represent a zero percent average return, but the investor would actually \nrealize a 25 percent loss (150% × 50% = 75%). The average annual compounded return of \n–13.4 percent, however, would reflect the reality (86.6% × 86.6% = 75%).\n324A COMPLETE GUIDE TO THE FUTURES MARKET\n 2. the Sharpe ratio does not distinguish between upside and downside volatility.\nThe risk measure inherent in the Sharpe ratio—the standard deviation—does not refl ect the \nway most investors perceive risk. Investors care about loss, not volatility. They are averse to \ndownside volatility, but actually like upside volatility. I have yet to meet any investors who \ncomplained because their managers made too much money in a month. The standard deviation, \nand by inference the Sharpe ratio, however, makes no distinction between upside and downside \nvolatility. This characteristic of the Sharpe ratio can result in rankings that would contradict \nmost investors’ perceptions and preferences. \n4 \n Figure 20.3 compares two hypothetical managers that have identical returns over the period \ndepicted, but very diff erent return profi les. Which manager appears riskier? Decide on an answer \nbefore reading on. \n 4 T o be fair, in some cases, high upside volatility can be indicative of a greater potential for downside volatility, and \nin these instances the Sharpe ratio will be an appropriate measure. The Sharpe ratio, however, will be particularly \nmisleading in evaluating strategies that are designed to achieve sporadic large gains while strictly controlling \ndownside risk (that is, “right-skewed” strategies).\n FIGURE  20.3 Which Manager Is Riskier? \nFebruary\nApril\nJune\nAugust\nOctober\nDecember\nFebruary\nApril\nJune\nAugust\nOctober\nDecember\nFebruary\nApril\nJune\nAugust\nOctober\nDecember\nFebruary\nApril\nJune\nAugust\nOctober\nDecember\nFebruary\nApril\nJune\nAugust\nOctober\nDecember\nDecember\nFebruary\nApril\nJune\nAugust\nOctober\nDecember\n2,000\n1,800\n1,600\n1,400\n1,200\n2,400\n2,200\n1,000\n800\nManager A\nManager B\n325\nHow to EvaluatE Past PErformancE\nMost likely you chose Manager A as being riskier. Manager A has three drawdown episodes in \nexcess of 20 percent, with the largest being 28 percent. In contrast, Manager B’s worst peak-to-valley \ndecline is a rather moderate 11 percent. Y et the standard deviation—the risk component of the Sharpe \nratio—is 30 percent higher for Manager B. As a result, even though both Managers A and B have equal \ncumulative returns and Manager A has much larger equity retracements, Manager A also has a signifi-\ncantly higher Sharpe ratio: 0.71 versus 0.58 (assuming a 2 percent risk-free rate). Why does this occur? \nBecause Manager B has a number of very large gain months, and it is these months that strongly push \nup Manager B’s standard deviation, thereby reducing the Sharpe ratio. Although most investors would \nclearly prefer the return profile of Manager B, the Sharpe ratio decisively indicates the reverse ranking.\nThe potential for a mismatch between Sharpe ratio rankings and investor preferences has led to \nthe creation of other return/risk measures that seek to address the flaws of the Sharpe ratio. Before \nwe review some of these alternative measures, we first consider the question: What are the implica-\ntions of a negative Sharpe ratio?\nAlthough it is commonplace to see negative Sharpe ratios reported for managers whose returns \nare less than the risk-free return, negative Sharpe ratios are absolutely meaningless. When the Sharpe \nratio is positive, greater volatility (as measured by the standard deviation), a", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 97}
{"text": "me of these alternative measures, we first consider the question: What are the implica-\ntions of a negative Sharpe ratio?\nAlthough it is commonplace to see negative Sharpe ratios reported for managers whose returns \nare less than the risk-free return, negative Sharpe ratios are absolutely meaningless. When the Sharpe \nratio is positive, greater volatility (as measured by the standard deviation), a negative characteristic, \nwill reduce the Sharpe ratio, as it logically should. When the Sharpe ratio is negative, however, greater \nvolatility will actually increase its value—that is, the division of a negative return by a larger number \nwill make it less negative. Comparisons involving negative Sharpe ratios can lead to absurd results. \nTable 20.3 provides an example. Manager B has a negative excess return twice the size of Manager \nA’s (–10 percent versus –5 percent) and four times the volatility of Manager A. Even though Manager \nB is much worse than Manager A in terms of both return and volatility, Manager B has a higher (less \nnegative) Sharpe ratio. This preposterous result is a direct consequence of higher volatility resulting \nin higher (less negative) Sharpe ratios when the Sharpe ratio is in negative territory. What should be \ndone with negative Sharpe ratios? Ignore them.\n5 They are always worthless and frequently misleading.\nSortino ratio\nThe Sortino ratio addresses both of the Sharpe ratio’s previously cited problems. First, it uses the \ncompounded return, which is representative of the actual realized return over any period of time, 5 What if some value must be used, as in an application such as ranking a list of managers based on the ratio? In \nthis case, a dual rank criterion makes much more sense: ranking managers based on the Sharpe ratio when excess \nreturns are positive and on excess returns when Sharpe ratios are negative.\ntable 20.3 a Comparison of two Managers with Negative Sharpe ratios\naverage annual \nreturn\nrisk-Free \nreturn excess return\nannualized Standard \nDeviation Sharpe ratio\nManager A –3% 2% –5% 5 –1.0\nManager B –8% 2% –10% 20 –0.5\n326\nA Complete Guide to the Futures mArket\ninstead of the arithmetic return. Second, and most important, the Sortino ratio focuses on defining \nrisk in terms of downside deviation, considering only deviations below a specified minimum accept-\nable return (MAR) instead of a standard deviation (used in the Sharpe ratio), which includes all devia-\ntions, upside as well as downside. Specifically, the Sortino ratio is defined as the compounded return \nin excess of the MAR divided by the downside deviation, as follows:\nSR ACRM AR\nDD= −\nwhere SR = Sortino ratio\nACR = annual compounded return\nMAR = minimum acceptable return (e.g., zero, risk-free, average)\nDD = downside deviation\nwhere DD is defined as:\nDD\nXM AR\nN\nii\nN\n=\n−∑ (min (, ))0 2\nwhere Xi = individual returns\nMAR = minimum acceptable return (e.g., zero, risk-free, average)\nN = number of data values\nFor example, if we define MAR = 0, then DD calculations will include only deviations for months \nwith negative returns (the other months will equal zero).\nThe MAR in the Sortino ratio can be set to any level, but one of the following three definitions is \nnormally used for the MAR:\n 1. Zero. Deviations are calculated for all negative returns.\n 2. risk-free return. Deviations are calculated for all returns below the risk-free return.\n 3. average return. Deviations are calculated for all returns below the average of the series being \nanalyzed. This formulation is closest to the standard deviation, but considers deviations for only \nthe lower half of returns.\nFrequently, the fact that a manager has a higher Sortino ratio than Sharpe ratio is cited as evidence \nthat returns are positively skewed—that is, there is a tendency for larger deviations on the upside \nthan on the downside. This type of comparison is incorrect. The Sortino and Sharpe ratios cannot be \ncompared, and as formulated, the Sortino ratio will invariably be higher, even for managers whose \nworst losses tend to be larger than their best gains. The reason for the upward bias in the Sortino \nratio is that it calculates deviations for only a portion of returns—those returns below the MAR—\nbut uses a divisor based on the number of all returns to calculate the downside deviation. Because \nit distinguishes between upside and downside deviations, the Sortino ratio probably comes closer to \nreflecting investor preferences than does the Sharpe ratio and, in this sense, may be a better tool for \n327\nHow to EvaluatE Past PErformancE\ncomparing managers. But the Sortino ratio should be compared only with other Sortino ratios and \nnever with Sharpe ratios.\nSymmetric Downside-risk Sharpe ratio\nThe symmetric downside-risk (SDR) Sharpe ratio, which was introduced by William T . Ziemba,6 is \nsimilar in intent and construction to the Sortino ratio, but makes a critical adjustment to remove the \ninherent upward bias in the Sortino ratio vis-à-vis the Sharpe ratio. The SDR Sharpe ratio is defined \nas the compounded return minus the risk-free return divided by the downside deviation. The down-\nside deviation is calculated similarly to the downside deviation in the Sortino ratio with one critical \nexception: a multiplier of 2.0 is used to compensate for the fact that only returns below a specified \nbenchmark contribute to the deviation calculation.\n7 The benchmark used for calculating the down-\nside deviation can be set to any level, but the same three choices listed for the MAR in the Sortino \nratio would apply here as well: zero, risk-free return, and average return. (In his article, Ziemba uses \nzero as the benchmark value.) Unlike the Sortino ratio, the SDR Sharpe ratio (with the benchmark \nset to the average) can be directly compared with the Sharpe ratio.\n8\nSDRSR ACRR F\nDD\n= −\n×2\nwhere SDRSR = symmetric downside-risk Sharpe ratio\nACR = annual compounded return\nRF = risk-free interest rate (e.g., T -bill return)\nDD = downside deviation\n6 Willia", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 98}
{"text": "rage return. (In his article, Ziemba uses \nzero as the benchmark value.) Unlike the Sortino ratio, the SDR Sharpe ratio (with the benchmark \nset to the average) can be directly compared with the Sharpe ratio.\n8\nSDRSR ACRR F\nDD\n= −\n×2\nwhere SDRSR = symmetric downside-risk Sharpe ratio\nACR = annual compounded return\nRF = risk-free interest rate (e.g., T -bill return)\nDD = downside deviation\n6 William T . Ziemba, “The Symmetric Downside-Risk Sharpe Ratio,” Journal of Portfolio Management (Fall 2005): \n108–121.\n7 Ziemba used the term benchmark instead of MAR in defining downside deviation. If the median were used as \nthe benchmark, only half the returns would be used to calculate the downside deviation, and a multiplier of 2.0 \nwould then provide an exact compensating adjustment. For other choices for the benchmark (e.g., zero, risk-\nfree return, average), the number of points below the benchmark would not necessarily be exactly half, and a \nmultiplier of 2.0 would provide an approximate adjustment.\n8 T o be perfectly precise, there would be a tendency for the SDR Sharpe ratio to be slightly lower for a symmetric \ndistribution of returns because the SDR Sharpe ratio uses the compounded return rather than the arithmetic \nreturn used in the Sharpe ratio, and the arithmetic return will always be equal to or higher than the compounded \nreturn. If, however, zero or the risk-free return is used as the benchmark in the downside deviation calculation, \nassuming the manager’s average return is greater than the risk-free return, there would be a tendency for the \nSDR Sharpe ratio to be higher than the Sharpe ratio for a symmetric distribution of returns for two reasons: \n1.\n There will be fewer than half the returns below the benchmark, so the multiplication by 2.0 will not fully \ncompensate.\n2.\n Downside deviations from the risk-free return (and especially zero) would be smaller than deviations from \nthe average.\nThese two factors would cause the downside deviation to be smaller than the standard deviation, implying a \nhigher SDR Sharpe ratio than Sharpe ratio.\n328\nA Complete Guide to the Futures mArket\nwhere DD is defined as:\nDD\nXX\nN\nii\nN\n=\n−\n−\n∑ (min (, ))0\n1\n2\nwhere Xi = individual returns\nX = benchmark return (e.g., mean, zero, risk-free)\nSince the SDR Sharpe ratio includes only the downside deviation, multiplying by the square root \nof 2 (a consequence of doubling the squared deviations) is equivalent to assuming the upside deviation \nis equal (i.e., symmetric) to the downside deviation. This proxy replacement of the upside deviation is \nwhat makes it possible to compare SDR Sharpe ratio values with Sharpe ratio values.\nThe SDR Sharpe ratio (with any of the standard choices for a benchmark value) is preferable to \nthe Sharpe ratio because it accounts for the very significant difference between the risk implications \nof downside deviations versus upside deviations as viewed from the perspective of the investor. The \nSDR Sharpe ratio is also preferable to the Sortino ratio because it is an almost identical calculation,\n9 \nbut with the important advantage of being directly comparable with the widely used Sharpe ratio. \nAlso, by comparing a manager’s SDR Sharpe ratio versus the Sharpe ratio, an investor can get a sense \nof whether the manager’s returns are positively or negatively skewed.\nGain-to-pain ratio\nThe gain-to-pain ratio (GPR) is the sum of all monthly returns divided by the absolute value of the \nsum of all monthly losses.\n10 This performance measure indicates the ratio of cumulative net gain to \nthe cumulative loss realized to achieve that gain. For example, a GPR of 1.0 would imply that, on \naverage, an investor has to experience an amount of monthly losses equal to the net amount gained. \nThe GPR penalizes all losses in proportion to their size, and upside volatility is beneficial since it \nimpacts only the return portion of the ratio.\n9 Besides the essential introduction of the 2.0 multiplier term, which allows unbiased comparisons between the \nSDR Sharpe ratio and the Sharpe ratio, the only difference between the SDR Sharpe ratio and the Sortino ratio \nis that it subtracts the risk-free return from the compounded return instead of the MAR (which may or may not \nbe the risk-free return).\n10 The gain-to-pain ratio (GPR) is a performance statistic I have been using for many years. I am not aware of any \nprior use of this statistic, although the term is sometimes used as a generic reference for return/risk measures \nor a return/drawdown measure. The GPR is similar to the profit factor, which is a commonly used statistic in \nevaluating trading systems. The profit factor is defined as the sum of all profitable trades divided by the absolute \nvalue of the sum of all losing trades. The profit factor is applied to trades, whereas the GPR is applied to interval \n(e.g., monthly) returns. Algebraically, it can easily be shown that if the profit factor calculation were applied to \nmonthly returns, the profit factor would equal GPR + 1 and would provide the same performance ordering as \nthe GPR. For quantitatively oriented readers familiar with the omega function, note that the omega function \nevaluated at zero is also equal to GPR + 1.\n329\nHow to EvaluatE Past PErformancE\nGPR\nX\nX\nii\nN\nii\nN= =∑\n∑\n1\n0|m in(, )|\nwhere Xi = individual returns\nA key difference between the GPR and measures such as the Sharpe ratio, the SDR Sharpe ratio, \nand the Sortino ratio is that the GPR will be indifferent between five 2 percent losses and one \n10 percent loss, whereas the other ratios discussed so far will be impacted far more by the single \nlarger loss. This difference results because the standard deviation and downside deviation calcula-\ntions used for the other ratios involve squaring the deviation between the reference return level \n(e.g., average, zero, risk-free) and the loss. For example, if the reference return is zero percent, \nthe squared deviation for one 10 percent loss would be five times greater than the squ", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 99}
{"text": "the single \nlarger loss. This difference results because the standard deviation and downside deviation calcula-\ntions used for the other ratios involve squaring the deviation between the reference return level \n(e.g., average, zero, risk-free) and the loss. For example, if the reference return is zero percent, \nthe squared deviation for one 10 percent loss would be five times greater than the squared devia-\ntion for five 2 percent losses (10\n2 = 100; 5 × 2 2 = 20). In the GPR calculation, by contrast, both \ncases will add 10 percent to the denominator. If an investor is indifferent as to whether a given \nmagnitude of loss is experienced over multiple months or in a single month, then the GPR would \nbe a more appropriate measure than the SDR Sharpe ratio and Sortino ratio. However, an investor \nwho considers a single larger loss worse than multiple losses totaling the same amount would have \nthe opposite preference.\nAlthough the GPR would typically be applied to monthly data, it can also be calculated for other \ntime intervals. If daily data are available, the GPR can provide a statistically very significant measure \nbecause of the large amount of sample data. The longer the time frame, the higher the GPR because \nmany of the losses visible on a shorter time interval will be smoothed out over a longer period. In my \nexperience, on average, daily GPR values tend to be about one-sixth as large as the monthly GPR for the \nsame manager, although the ratio between daily and monthly GPR values can range widely. For monthly \ndata, roughly speaking, GPRs greater than 1.0 are good and those above 1.5 are very good. For daily \ndata, the corresponding numbers would be approximately 0.17 and 0.25.\nOne advantage of the GPR over the other ratios is that rankings remain consistent even for nega-\ntive returns—that is, a smaller negative GPR is always better than a larger negative GPR (a relation-\nship that is not necessarily true for the other ratios). A GPR of zero means that the sum of all wins is \nequal to the sum of all losses. The theoretical minimum GPR value is –1.0 and would occur if there \nwere no winning months. The closer the GPR is to –1.0, the smaller the ratio of the sum of all wins \nto the sum of all losses.\n11\ntail ratio\nAn important question for the investor is whether a manager’s extreme returns tend to be larger \non the upside or the downside. Managers with frequent small gains and occasional large losses \n(negatively skewed managers) are more risky and less desirable than managers with frequent small \n11 The ratio of the sum of wins to the sum of losses is equal to GPR + 1. So, for example, a GPR of −0.25 would \nimply that the ratio of the sum of wins to the sum of losses is 0.75.\n330\nA Complete Guide to the Futures mArket\nlosses and occasional large gains (positively skewed managers). Although there is a statistic that mea-\nsures skewness—the degree to which a return distribution has longer tails (extreme events) on the \nright (positive) or left (negative) side than the symmetric normal distribution—it is difficult to attach \nintuitive meaning to specific values (beyond the value of the sign).\nThe tail ratio measures the tendency for extreme returns to be skewed to the positive or negative \nside in a statistic whose value is intuitively clear.\nTR\nX\nN\nX\nN\npp\npT\npT\nppT\np\npT\n=\n=\n=\n<\n=−\n=\n>−∑\n∑\n0\n100\n100\n100\nwhere Xp = return at percentile p\n T = threshold percentile to calculate numerator of tail ratio (Implicit assumption: Lower \npercentile rankings represent higher return. For example, the top 10% of returns \nwould be all returns less than T, where T = 10.)\n Np<T = number of returns below percentile\n Np>100−T = number of returns above percentile 100−T\nThe tail ratio requires one parameter input: the upper and lower percentile threshold used to \ncalculate the statistic. If the threshold is set to 10, for example, the tail ratio would be equal to the \naverage of all returns in the top decile of returns divided by the absolute value of the average of all \nreturns in the bottom decile of returns. (Note: If the average of bottom decile returns is positive, the \ntail ratio would have no meaning and cannot be calculated.) If returns were normally distributed, the \ntail ratio would equal 1.0. A ratio significantly less than 1.0 would indicate a tendency for the largest \nlosses to be of greater magnitude than the largest gains, while a ratio significantly greater than 1.0 \nwould indicate the reverse tendency. For example, if the tail ratio was equal to 0.5, it would imply \nthat the magnitude of the average loss in the bottom decile was twice as large as the average gain in \nthe top decile—a reading indicative of a potentially very risky manager.\nMar and Calmar ratios\nThe MAR ratio is the annualized compounded return divided by the maximum drawdown.\nMAR ACR\nNAV\nNAV\nj\ni\n=\n− \n\n\n\n\n1m in\nwhere ACR = annual compounded return (expressed in decimal form)\nNAV = net asset value\nj > i\n331\nHow to EvaluatE Past PErformancE\nThe Calmar ratio is exactly the same except the calculation is specifically restricted to the past \nthree years of data. Although these ratios are useful in that they are based on a past worst-case situa-\ntion, the fact that the risk measure divisor is based on only a single event impedes their statistical sig-\nnificance. Also, if applied over entire track records, the MAR will be strongly biased against managers \nwith longer records, because the longer the record, the greater the potential maximum drawdown. \n(This bias does not exist in the Calmar ratio because, by definition, it is based on only the past three \nyears of data.) Manager comparisons should be limited to common time periods, a restriction that is \nespecially critical when using the MAR ratio.\nreturn retracement ratio\nThe return retracement ratio (RRR) is similar to the MAR and Calmar ratios in that it is a measure \nof the average annual compounded return divided by a retracement measure. The key difference, \nhowever", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 100}
{"text": "d on only the past three \nyears of data.) Manager comparisons should be limited to common time periods, a restriction that is \nespecially critical when using the MAR ratio.\nreturn retracement ratio\nThe return retracement ratio (RRR) is similar to the MAR and Calmar ratios in that it is a measure \nof the average annual compounded return divided by a retracement measure. The key difference, \nhowever, is that instead of being based on a single retracement (the maximum retracement), the RRR \ndivides return by the average maximum retracement (AMR), which is based on a maximum retrace-\nment calculation for each month. The maximum retracement for each month is equal to the greater \nof the following two numbers:\n 1. The largest possible cumulative loss that could have been experienced by any existing investor in \nthat month (the percentage decline from the prior peak NAV to the current month-end NAV).\n 2. The largest loss that could have been experienced by any new investor starting at the end of that \nmonth (the percentage decline from the current month-end NAV to the subsequent lowest NAV).\nRRR ACRR F\nAMR= −\nwhere ACR = annual compounded return\nRF = risk-free return\nAMR = average maximum retracement = MRi/N\nwhere N = number of months\nMRi = max(MRPNHi, MRSNLi)\nwhere MRPNHi is the maximum retracement from prior NAV high, and is defined as:\nMRPN HP NH NA VP NHii ii=−() /\nwhere PNHi = prior NAV high (prior to month i)\nNAVi = NAV at end of month i\nMRSNLi is the maximum retracement to a subsequent NAV low , and is defined as:\nMRSN LN AV SN LN AVii ii=−() /\nwhere SNLi is the subsequent NAV low (subsequent to month i).\n332\nA Complete Guide to the Futures mArket\nThe reason for using both metrics to determine a maximum retracement for each month is \nthat each of the two conditions would be biased to show small retracement levels during a seg-\nment of the track record. The first condition would invariably show small retracements for the \nearly months in the track record because there would not have been an opportunity for any large \nretracements to develop. Similarly, the second condition would inevitably show small retrace-\nments during the latter months of the track record for analogous reasons. By using the maximum \nof both conditions, we assure a true worst-case number for each month. The average maximum \nretracement is the average of all these monthly maximum retracements. The return retracement \nratio is statistically far more meaningful than the MAR and Calmar ratios because it is based on \nmultiple data points (one for each month) as opposed to a single statistic (the maximum drawdown \nin the entire record).\nComparing the risk-adjusted return performance Measures\nTable 20.4 compares Managers A and B shown in Figure 20.3 in terms of each of the risk-adjusted \nreturn performance measures we discussed. Interestingly, the Sharpe ratio, which is by far the \nmost widely used return/risk measure, leads to exactly the opposite conclusion indicated by all \nthe other measures. Whereas the Sharpe ratio implies that Manager A is significantly superior in \nreturn/risk terms, all the other performance measures rank Manager B higher—many by wide \nmargins. Recall that both Managers A and B had identical cumulative returns, so the only differ-\nence between the two was the riskiness implied by their return paths. The Sharpe ratio, which uses \nthe standard deviation as its risk metric, judged Manager B as being riskier because of higher vola-\ntility, as measured across all months. Most of Manager B’s volatility, however, was on the upside—a \ntable 20.4 a Comparison of risk-adjusted return Measures\nManager a Manager b b as percent of a\nSharpe ratio 0.71 0.58 82%\nSortino ratio (zero) 1.27 1.44 113%\nSortino ratio (risk-free) 1.03 1.15 112%\nSortino ratio (average) 0.87 0.94 107%\nSDR Sharpe ratio (zero) 0.75 0.85 113%\nSDR Sharpe ratio (risk-free) 0.73 0.81 112%\nSDR Sharpe ratio (average) 0.62 0.66 107%\nGain-to-pain ratio (GPR) 0.70 0.71 101%\nTail ratio (10%) 1.13 2.86 253%\nTail ratio (5%) 1.10 2.72 247%\nMAR ratio 0.41 1.09 265%\nCalmar ratio 0.33 1.70 515%\nReturn retracement ratio (RRR) 0.77 1.67 218%\n333\nHow to EvaluatE Past PErformancE\ncharacteristic most investors would consider an attribute, not a fault. Although Manager A had \nlower volatility overall, the downside volatility was significantly greater than Manager B’s—a char-\nacteristic that is consistent with most investors’ intuitive sense of greater risk. The Sharpe ratio \ndoes not distinguish between downside and upside volatility, while the other risk-adjusted return \nmeasures do.\nAlthough all the risk-adjusted return measures besides the Sharpe ratio penalize only downside \nvolatility, they do so in different ways that have different implications:\n ■ Sortino ratio and SD r Sharpe ratio. These ratios penalize returns below a specified level \n(e.g., zero) with the weight assigned to downside deviations increasing more than proportionately \nas their magnitude increases. Thus, one larger downside deviation will reduce the ratio more than \nmultiple smaller deviations that sum to the same amount. These ratios are unaffected by the order \nof losing months. Two widely separated losses of 10 percent will have the same effect as two con-\nsecutive 10 percent losses, even though the latter results in a larger equity retracement.\n ■ Gpr. The GPR penalizes downside deviations in direct proportion to their magnitude. In contrast \nto the Sortino and SDR Sharpe ratios, one large deviation will have exactly the same effect as \nmultiple smaller deviations that sum to the same amount. This difference explains why Managers \nA and B are nearly equivalent based on the GPR, but Manager A is significantly worse based on \nthe Sortino and SDR Sharpe ratios: Manager A has both larger and fewer losses, but the sum of \nthe losses is nearly the same for both managers. The GPR is similar to the Sortino and SDR Sharpe \nratios in terms of being indifferent to the order of losses; that is, it d", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 101}
{"text": "is difference explains why Managers \nA and B are nearly equivalent based on the GPR, but Manager A is significantly worse based on \nthe Sortino and SDR Sharpe ratios: Manager A has both larger and fewer losses, but the sum of \nthe losses is nearly the same for both managers. The GPR is similar to the Sortino and SDR Sharpe \nratios in terms of being indifferent to the order of losses; that is, it does not penalize for consecu-\ntive or proximate losses.\n ■ tail ratio. The tail ratio focuses specifically on the most extreme gains and losses. The tail ratio \nwill be very effective in highlighting managers whose worst losses tend to be larger than their best \ngains. In terms of the tail ratio, Manager B, who achieves occasional very large gains but whose \nworst losses are only moderate, is dramatically better than Manager A, who exhibits the reverse \npattern.\n ■ Mar and Calmar ratios. In contrast to all the foregoing performance measures, these ratios \nare heavily influenced by the order of returns. A concentration of losses will have a much greater \nimpact than the same losses dispersed throughout the track record. Both of these measures, how-\never, focus on only the single worst equity drawdown. Therefore losses that occur outside the \ninterim defined by the largest peak-to-valley equity drawdown will not have any impact on these \nratios. Because the maximum drawdown for Manager A is much greater than for Manager B, these \nratios show a dramatic difference between the two managers.\n ■ return retracement ratio (rrr). The RRR is the only return/risk measure that both penal-\nizes all downside deviations and also penalizes consecutive or proximate losses. In contrast to the \nMAR and Calmar ratios, which reflect only those losses that define the maximum drawdown, the \nRRR calculation incorporates all losses.\nTable 20.5 summarizes and compares the properties of the different risk-adjusted return measures.\n334\nA Complete Guide to the Futures mArket\nWhich return/risk Measure Is best?\nT o some extent, the choice of which return/risk measures to use depends on the performance mea-\nsure properties favored by the individual investor. The major advantages and disadvantages of these \nperformance measures can be summarized as follows:\n ■ Sharpe ratio. Although the Sharpe ratio is the most widely used risk-adjusted metric, it provides \nrankings that are least consistent with most people’s intuitive sense of risk because it penalizes \nupside gains.\n ■ Sortino ratio. This ratio corrects the main deficiency of the Sharpe ratio by focusing on down-\nside risk instead of total volatility as the measure of risk. In addition, the Sortino ratio uses a com-\npounded return, which matches actual return over the entire period, whereas the Sharpe ratio \nuses an arithmetic average return, which does not. One disadvantage of the Sortino ratio is that \nit is not directly comparable with the Sharpe ratio because its calculation is biased to delivering \nhigher values.\n ■ SDr Sharpe ratio. This ratio provides the same fix as the Sortino ratio, and it has the advan-\ntage of an additional adjustment that allows for direct comparisons of its values with Sharpe \nratio values. Similar to the Sortino ratio, the SDR Sharpe ratio also uses the compounded return \ninstead of the arithmetic average return. Since the SDR Sharpe ratio will provide nearly identical \nrankings as the Sortino ratio and has the advantage of allowing for comparisons with the Sharpe \nratio for the same manager, it seems the better choice for any investor. Using both ratios would \nbe redundant.\n ■ Gain-to-pain ratio (Gpr). Similar to the Sortino and SDR Sharpe ratios, the GPR penalizes a \nmanager only for losses (zero percent is also a common choice for minimum acceptable return or \nbenchmark in the Sortino and SDR Sharpe ratios). The GPR weights losses proportionately to their \ntable 20.5 properties of risk-adjusted performance Measures\nproperty Sharpe ratio\nSDr Sharpe \nratio\nSortino \nratio G pr tail ratio\nMar and \nCalmar rrr\nIs impacted by upside volatility X\nIs impacted only by downside \nvolatility\nX X X X X X\nReflects all downside volatility X X X X X\nGives more than proportionate \nweight to large losses\nX X X X\nIs impacted by proximity of losses X X\nFocuses on extreme returns only X\nRankings remain consistent for net \nnegative returns\nX X\n335\nHow to EvaluatE Past PErformancE\nmagnitude, whereas the Sortino and SDR Sharpe ratios magnify the weight of larger losses. \nInvestors who view one 10 percent monthly loss the same as five 2 percent losses might prefer \nthe GPR, whereas investors who consider the single 10 percent monthly loss to be worse might \nprefer the SDR Sharpe ratio.\n ■ tail ratio. Since, by definition, the tail ratio considers only a small percentage of all returns \n(20 percent or less), it is not intended as a stand-alone risk-adjusted return measure. Its focus \non extreme returns, however, makes it a very useful supplemental metric to one of the other \nmeasures.\n ■ Mar and Calmar ratios. These ratios will penalize for losses that occur with sufficient proximity \nto be part of the same drawdown. The other ratios (with the exception of the RRR) are unaffected \nby the sequence of returns. The drawback of these ratios is that the risk is defined by only a single \nevent (the maximum drawdown), impeding their statistical significance and representativeness.\n ■ return retracement ratio ( rrr). This ratio is both based on downside deviations and im-\npacted by proximate losses. Its big advantage vis-à-vis the MAR and Calmar ratios is that it reflects \nall retracements, with the risk number based on all monthly numbers, rather than just a single \nevent and single statistic: the maximum drawdown. Although the MAR and Calmar ratios might \nstill be consulted as supplemental measures reflecting a worst-case situation, the RRR is prefer-\nable as a return/drawdown ratio.\n ■ Visual Performance Evaluation\nMany people will find that the performance charts in this", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 102}
{"text": "ements, with the risk number based on all monthly numbers, rather than just a single \nevent and single statistic: the maximum drawdown. Although the MAR and Calmar ratios might \nstill be consulted as supplemental measures reflecting a worst-case situation, the RRR is prefer-\nable as a return/drawdown ratio.\n ■ Visual Performance Evaluation\nMany people will find that the performance charts in this section provide a better intuitive sense of \nrelative performance (in both return and risk terms) than do performance statistics.\nNet asset Value (NaV) Charts\nAn NAV chart, such as was illustrated in Figure 20.3, provides an extremely useful way of evaluating \na track record. The NAV chart depicts the compounded growth of $1,000 over time. For example, \nan NAV of 2,000 implies that the original investment has doubled from its starting level as of the \nindicated time. The NAV chart can offer a good intuitive sense of past performance in terms of both \nreturn and risk. In fact, if an investor were to examine only a single performance gauge, the NAV \nchart would probably be the most informative.\nThe way we visually perceive conventionally scaled NAV charts that depict longer-term periods, \nhowever, may result in misleading inferences. Consider Figure 20.4, and answer the following three \nquestions before reading on:\n 1. Was return higher in the first half of the track record or the second?\n 2. Was the manager riskier during the first half of the track record or the second?\n 3. Was the return/risk performance better during the first half of the track record or the second?\n336A COMPLETE GUIDE TO THE FUTURES MARKET\n If you picked the fi rst half as the answer to any of these three questions, you are wrong. If you \npicked the second half for any answer, you are also wrong. The two halves are exactly the same. In fact, \nall four quarters of the track record are the same. Figure 20.4 was created by copying the returns of \nManager A in Figure 20.3 and pasting the sequence three times to the end to create an extended NAV \nthat repeats the same return pattern, displaying it four times in all. Looking at Figure 20.4 , however, it \nseems as if both the return and the volatility are increasing sharply over time. They are not. The illusion \nis an artifact of depicting NAV charts on a conventional arithmetic scale. On an arithmetic scale, an \nNAV decline of 1,000 when the NAV is at 16,000 looks the same as an NAV decline of 1,000 when the \nNAV is 2,000. The two declines, however, are radically diff erent: a modest 6 percent decline in the fi rst \ninstance and a huge 50 percent drop in the second. The distortion on an arithmetic scale chart will get \nmagnifi ed when the NAV range is wide, which is frequently a serious problem for long-term charts. \n The ideal way to depict an NAV chart is on a logarithmic scale. On a log scale chart, the increments \nfor a fi xed amount of movement (e.g., 1,000) become proportionately smaller as the level increases, \nand as a result, equal percentage price moves will appear as equal size moves on the vertical scale. \nFigure 20.5 depicts the same NAV as Figure 20.4 , but on a log scale. The self-replicating nature of the \nchart is now evident as equal percentage changes now look identical wherever they appear. The moral is \nthat a log scale is always the correct way to represent an NAV chart and is especially critical when there \nis a wide NAV range (more likely on long-term charts). A log scale was used for Figures 20.1 and 20.2 \nearlier in this chapter to allow for an accurate representation of relative volatility across time. \n FIGURE  20.4 How Has Performance Changed over Time? \n20,000\n18,000\n16,000\n14,000\n12,000\n10,000\n8,000\n6,000\n4,000\n2,000\nDecember\nJune\nDecember\nJune\nDecember\nJune\nDecember\nJune\nDecember\nJune\nDecember\nJune\nDecember\nJune\nDecember\nJune\nDecember\nJune\nDecember\nJune\nDecember\nJune\nDecember\nJune\nDecember\nJune\nDecember\nJune\nDecember\nJune\nDecember\nJune\nDecember\nJune\nDecember\nJune\nDecember\nJune\nDecember\nJune\nDecember\nJune\nDecember\nJune\nDecember\nJune\nDecember\nDecember\nJune\n0\n337\nHOW TO EVALUATE PAST PERFORMANCE\n rolling Window return Charts \n The rolling window return chart shows the return for the specifi ed time length ending in each month. \nFor example, a 12-month rolling window return chart would show the 12-month return ending in \neach month (beginning with the 12th month of the track record). The rolling window return chart \nprovides a clear visual summary of the results of investing with a manager for a specifi ed length of \ntime and answers such questions as: What would have been the range of outcomes with a manager \nfor investments held for 12 months? 24 months? What was the worst loss for investments held for \n12 months? 24 months? \n For any December, the rolling 12-month return would be the same as the annual return. The \nimportant diff erence is that the rolling window return chart would show the analogous returns for \nall the other months as well. There is only a one-out-of-12 chance that December will be the worst \n12-month return for the year. By showing all 12-month returns ending in any month, the rolling win-\ndow chart will encompass worst-case events likely to be missed by annual returns and will provide \na much more representative performance picture for one-year holding periods. The rolling window \nreturn chart can be calculated for other time intervals as well (e.g., 24 months, 36 months). \n T o illustrate the use of the rolling window return chart as a graphic analysis tool, we compare \nthe two managers shown in Figure 20.6 , who diff er only moderately in terms of return (Manager \nE’s annual compounded return is 1.3 percent higher), but diff er widely in terms of the stability of \nreturns. As shown in Figure 20.7 , Manager E’s 12-month returns range enormously from a severe \n FIGURE  20.5 Log Scale: Equal Percentage Price Moves Appear Equal \n20,000\n10,000\n5,000\n4,000\n3,000\n2,000\n1,000\n500\nDecember\nJune\nDecember\nJune\nDecember\nJune\nDecember\nJune\nD", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 103}
{"text": "in terms of return (Manager \nE’s annual compounded return is 1.3 percent higher), but diff er widely in terms of the stability of \nreturns. As shown in Figure 20.7 , Manager E’s 12-month returns range enormously from a severe \n FIGURE  20.5 Log Scale: Equal Percentage Price Moves Appear Equal \n20,000\n10,000\n5,000\n4,000\n3,000\n2,000\n1,000\n500\nDecember\nJune\nDecember\nJune\nDecember\nJune\nDecember\nJune\nDecember\nJune\nDecember\nJune\nDecember\nJune\nDecember\nJune\nDecember\nJune\nDecember\nJune\nDecember\nJune\nDecember\nJune\nDecember\nJune\nDecember\nJune\nDecember\nJune\nDecember\nJune\nDecember\nJune\nDecember\nJune\nDecember\nJune\nDecember\nJune\nDecember\nJune\nDecember\nJune\nDecember\nJune\nDecember\nDecember\nJune\n338A COMPLETE GUIDE TO THE FUTURES MARKET\n FIGURE  20.6 Small Diff erence in Return; Wide Diff erence in Stability of Return \nMarch\nDecember\n2,000\n3,000\n4,000\n1,000\n500\nJune\nSeptember\nDecember\nMarch\nJune\nSeptember\nDecember\nMarch\nJune\nSeptember\nDecember\nMarch\nJune\nSeptember\nDecember\nMarch\nJune\nSeptember\nDecember\nMarch\nJune\nSeptember\nDecember\nMarch\nJune\nSeptember\nDecember\nSeptember\nDecember\nMarch\nJune\nManager F\nManager E\n FIGURE  20.7 12-Month Rolling Return: Manager E \nMarch\nDecember\n–60%\n–40%\n–20%\n20%\n40%\n60%\n80%\n100%\n120%\n140%\n160%\n0%\nJune\nSeptember\nDecember\nMarch\nJune\nSeptember\nDecember\nMarch\nJune\nSeptember\nDecember\nMarch\nJune\nSeptember\nDecember\nMarch\nJune\nSeptember\nDecember\nMarch\nJune\nSeptember\nDecember\nSeptember\nDecember\nMarch\nJune\n339\nHOW TO EVALUATE PAST PERFORMANCE\nloss of 49 percent to a spectacular gain of 142 percent. In contrast, manager F’s 12-month returns \nare contained in a far more moderate range of –10 percent to +29 percent (see Figure 20.8 ). \nInvestors who were patient enough to stay with Manager F for at least 12 months would have \nexperienced only a handful of investment initiation months that would have resulted in a net loss. \nSuch patience, however, would not have provided any solace to investors with Manager E, who \nwould have witnessed more than one-quarter of all 12-month holding periods resulting in net \nlosses exceeding 15 percent, with several in excess of 40 percent. Even investors who committed \nto a 24-month holding period with Manager E would still have been subject to nearly one-fi fth \nof all intervals with losses in excess of 15 percent (see Figure 20.9 ). In contrast, the worst-case \noutcome for investors with Manager F for a 24-month holding period would have been a positive \nreturn of 4 percent (see Figure 20.10 ). \n Investors can use the rolling window return chart to assess the potential frequency and magnitude \nof worst-case outcomes as an aid in selecting investments consistent with their holding period toler-\nance for a losing investment. For example, an investor who is unwilling to maintain a losing invest-\nment for more than 12 months should avoid managers who have a meaningful percentage of negative \n12-month returns, regardless of how favorable all the other performance statistics may be. \n Rolling charts can also be used to depict other statistics besides return. For example, a rolling \nchart of annualized volatility (using daily data and a window of several months) can be used as a tool \nto monitor both managers and portfolios for early evidence of a possible increase in risk. \n FIGURE  20.8 12-Month Rolling Return: Manager F \nMarch\nDecember\n40%\n–20%\n–10%\n20%\n30%\n10%\n0%\nJune\nSeptember\nDecember\nMarch\nJune\nSeptember\nDecember\nMarch\nJune\nSeptember\nDecember\nMarch\nJune\nSeptember\nDecember\nMarch\nJune\nSeptember\nDecember\nMarch\nJune\nSeptember\nDecember\nSeptember\nDecember\nMarch\nJune\n340A COMPLETE GUIDE TO THE FUTURES MARKET\n FIGURE  20.9 24-Month Rolling Return: Manager E \nDecember\nFebruary\nApril\nJune\nAugust\nOctober\nDecember\nFebruary\nApril\nJune\nAugust\nOctober\nDecember\nFebruary\nApril\nJune\nAugust\nOctober\nDecember\nFebruary\nApril\nJune\nAugust\nOctober\nDecember\nFebruary\nApril\nJune\nAugust\nOctober\nDecember\nFebruary\nApril\nJune\nAugust\nOctober\n300%\n280%\n260%\n240%\n220%\n200%\n180%\n160%\n140%\n120%\n100%\n80%\n60%\n40%\n20%\n–20%\n–40%\n–60%\n0%\nDecember\n FIGURE  20.10 24-Month Rolling Return: Manager F \n35%\n20%\n25%\n30%\n10%\n5%\n0%\n15%\nDecember\nFebruary\nApril\nJune\nAugust\nOctober\nDecember\nFebruary\nApril\nJune\nAugust\nOctober\nDecember\nFebruary\nApril\nJune\nAugust\nOctober\nDecember\nFebruary\nApril\nJune\nAugust\nOctober\nDecember\nFebruary\nApril\nJune\nAugust\nOctober\nDecember\nFebruary\nApril\nJune\nAugust\nOctober\nDecember\n341\nHOW TO EVALUATE PAST PERFORMANCE\n Underwater Curve and 2DUC Charts \n The underwater chart shows the worst possible cumulative percentage loss any investor could have \nexperienced as of the end of each month—an assumption that implies an investment started at the \nprior NAV peak. The low point in the NAV chart is the maximum retracement (the risk measure \nused in the MAR and Calmar ratios). The underwater chart, however, provides far more informa-\ntion because it shows not only the worst possible loss for the entire track record (the maximum \nretracement), but the worst possible loss as of the end of every other month in the track record as \nwell. Figure 20.11 illustrates the underwater chart for the same two managers with widely disparate \nstability of returns depicted in Figure 20.6 . The diff erence between the two could hardly be starker. \nManager F’s retracements are very shallow and relatively short-lived (a rise to the 0 percent level \nindicates a new NAV high); Manager E’s retracements are both deep and protracted. The underwater \nchart provides an excellent visual representation of an investment’s relative risk in a way that is very \nconsistent with the way most investors perceive risk. \n One shortcoming of the underwater curve is that it will understate risk for months in the \nearly portion of the track record because there is an insuffi cient look-back period for a prior NAV \npeak. For these earlier months, there is no way of assessing a true worst-case loss representa-\ntion, because a prior track record of suffi cient length simply does not exist. Also, the underwater \ncurve is constructed", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 104}
{"text": "ming of the underwater curve is that it will understate risk for months in the \nearly portion of the track record because there is an insuffi cient look-back period for a prior NAV \npeak. For these earlier months, there is no way of assessing a true worst-case loss representa-\ntion, because a prior track record of suffi cient length simply does not exist. Also, the underwater \ncurve is constructed from the perspective of the worst cumulative loss that could have been \n FIGURE  20.11 Underwater Curve: Manager E vs. Manager F \n0%\n−10%\n−20%\n−30%\n−40%\nManager E\nManager F\n−50%\n−60%\nJanuary\nApril\nJuly\nOctober\nJanuary\nApril\nJuly\nOctober\nJanuary\nApril\nJuly\nOctober\nJanuary\nApril\nJuly\nOctober\nJanuary\nApril\nJuly\nOctober\nJanuary\nApril\nJuly\nOctober\nJanuary\nApril\nJuly\nOctober\nJanuary\nApril\nJuly\nOctober\n342A COMPLETE GUIDE TO THE FUTURES MARKET\nexperienced by an existing investor. Arguably, the worst loss suff ered by new investors may be an \neven more relevant measure. One solution to these inadequacies in the underwater curve calcula-\ntion is to also consider the worst loss that could have been experienced by any investor starting \nin each month, assuming the investment was exited at the subsequent lowest NAV point. W e can \nthen create a two-direction underwater curve (2DUC) that for each month would show the maxi-\nmum of the following two losses: \n 1. The cumulative loss of an existing investor starting at the prior NAV peak. \n 2. The cumulative loss of an investor starting that month-end and liquidating at the subsequent \nNAV low. \n The average of all the points in the 2DUC chart would, in fact, be the risk measure used in the \nreturn retracement ratio (the average maximum retracement). The underwater excursions for Man-\nager E become signifi cantly more extreme in the 2DUC chart (Figure 20.12 ), widening from an \naverage monthly value of 21 percent to 30 percent (the AMR). The underwater curve for Manager F \nremains subdued in the 2DUC chart with a still very low average value of 3 percent. The 2DUC chart \nimplies that the average worst-case scenario for investors with Manager E is 10 times worse than with \nManager F; that is a lot of extra risk for a 1.3 percent diff erence in the average annual compounded \nreturn. Based on performance, it would be diffi cult to justify choosing Manager E over Manager F, \neven for the most risk-tolerant investor. \n FIGURE  20.12 2DUC: Manager E vs. Manager F \n 2DUC: Manager E vs. Manager F\n0%\n−10%\n−20%\n−30%\n−40%\nManager E\nManager F\n−50%\n−60%\nJanuary\nApril\nJuly\nOctober\nJanuary\nApril\nJuly\nOctober\nJanuary\nApril\nJuly\nOctober\nJanuary\nApril\nJuly\nOctober\nJanuary\nApril\nJuly\nOctober\nJanuary\nApril\nJuly\nOctober\nJanuary\nApril\nJuly\nOctober\nJanuary\nApril\nJuly\nOctober\n343\nHow to EvaluatE Past PErformancE\n ■ Investment Insights\nMany investors place too much emphasis on return. Since return can always be improved by increas-\ning exposure (i.e., taking on greater risk), the return/risk ratio is a far more meaningful performance \nmeasure. An investment with higher return/risk and lower return than an alternative investment with \nthe reverse characteristics can be brought up to the same higher return level with lower risk by using \nleverage.\nThe Sharpe ratio is by far the most widely used return/risk metric. The Sharpe ratio, however, \npenalizes upside volatility the same as downside volatility, which is not consistent with the way most \ninvestors view risk. Other return/risk measures detailed in this chapter, which focus on losses as \nthe proxy for risk, more closely reflect the way most investors perceive risk. Investors can use Table \n20.5, which summarizes the properties of different return/risk measures, to select the performance \nmeasures that best fit their criteria.\nReturn/risk statistics can be supplemented with the performance charts detailed in this chapter, \nwhich provide a tremendous amount of information in an intuitive and accessible format and should \nbe at the core of any performance analysis. I recommend using the following performance charts in \nany manager or fund evaluation:\n ■ An NAV chart\n ■ Both 12-month and 24-month rolling window return charts\n ■ A 2DUC chart\n■ ■ ■\nNote: Some of the statistics and chart analytics described in this chapter are my own invention and \nhence not yet available on any existing software. Many of these statistics and analytical charts can be \naccessed for free on FundSeeder.com.\n\nFuNdaMeNtal aNalysis\nPart V\n\nFourteen Popular \nFallacies, or What \nNot to \ndo Wrong\nCha P ter 21\n347\nThe fault, dear trader, is not in the fundamentals, but in ourselves.\n(With apologies to shakespeare)\n ■ Five Short Scenes\nScene 1\nthe u.s. treasury announces a new plan to sell stockpiled gold. Not surprisingly, the market opens \nwith near-limit losses the following day. you reason that the new gold sales will sharply increase sup-\nply and that, therefore, the market still offers a good selling opportunity, even given the decline. you \nare somewhat concerned about expectations for continued increasing inflation and dollar weakness \nbut decide the gold sale will dominate market action over the near term.\nafter going short, the market hovers for two days and then, as you expected, breaks sharply. One \nweek later, your trade is substantially in the plus column and convinced that you have caught a new \nbear market in its infancy, you resolve to hold the position as a long-term trade. \nthe next week, \nhowever, the market begins to rally inexplicably, and your profits evaporate. Paradoxically, despite \nan absence of any meaningful bullish news, the rally continues and prices even surpass the levels they \nwere at before the \nu.s. treasury announcement. your losses continue to grow , and finally you bail out, \npromising yourself, “that’s the last time i trade on fundamentals.”\n348\nA Complete Guide to the Futures mArket\nScene 2\nyou’ve done your homework and feel confident the u.s. department of agriculture’s 50-state Hogs \nand Pigs report, which will be released in", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 105}
{"text": "rices even surpass the levels they \nwere at before the \nu.s. treasury announcement. your losses continue to grow , and finally you bail out, \npromising yourself, “that’s the last time i trade on fundamentals.”\n348\nA Complete Guide to the Futures mArket\nScene 2\nyou’ve done your homework and feel confident the u.s. department of agriculture’s 50-state Hogs \nand Pigs report, which will be released in the afternoon, will reflect a large expansion in hog produc-\ntion. you anticipate that hog numbers will be up at least 7 percent over the year-ago level. Hog prices \nhave already sold off sharply in recent weeks, but you reason that a report in line with your expecta-\ntions will push prices still lower.\nalthough you are quite familiar with the dangers of riding a position into a major report, this is \none time you cannot resist. at the report release time, eyes glued to your computer screen and your \nheart pounding, you read the critical figure. a smile crosses your face as you see the number. “i knew \nit!” you shout triumphantly. the report shows hog numbers up 8 percent.\nthe next day the market opens limit down, and you begin to calculate what your profits will be \nafter three limit-down days—a conservative assumption. But before you can even finish calculating \nyour profits, a strange thing happens: \nthe market begins to rally. By the end of the session, hog prices \nare actually 100 points higher! the uptrend continues in subsequent trading sessions, and one week \nlater you liquidate your position with a sizable loss. you feel cheated. you were right in your expecta-\ntions: the report was bearish, wasn’t it?\nScene 3\nyou’ve been long corn for three weeks and it’s been one of your best trades ever. the market has \nmoved steadily and sharply higher with export rumors flying in all directions. that evening on the \nnews, the lead story is the official announcement of an additional large grain sale to Japan. daydream-\ning, you wonder if this is the trade you will retire on.\nNext morning you call your broker. “Corn is due 8 to 10 cents a bushel higher,” he says. Not as \ngood as you thought, but it will do. However, by the time corn is ready to open, the call has dropped \nto unchanged, and the market actually opens 2 cents lower. \nseveral days later, corn has fallen more \nthan 40 cents, and your profits have virtually evaporated.\nScene 4\nCattle futures have rallied to near all-time record highs. you are well aware that cattle supplies are \ndown and expected to remain low , but upon closer examination, you have discovered that supplies \nwere lower in a number of other past situations when prices were lower. \nyou reason the current rally \nis overdone and go short.\nWhen cattle rallies an additional 10¢/lb, you figure the market is an even better short, and add to \nyour position. Prices are still moving higher when you finally throw in the towel on the trade.\nScene 5\nyou have read that sugar prices are below costs of production, a factor that seems to suggest that \nprices have overdone the down side. you go long. Not only does the price fail to rise, but it actually \n349\nFOurteeN POPular FallaCies, Or WHat NOt tO dO WrONg\ncontinues to slide steadily lower. you can’t understand why producers continue to sell sugar at a loss. \nyou are both confused and frustrated at the seemingly logic-defying market price action as your losses \ncontinue to mount.\n■ ■ ■\nthese five scenes appear to provide proof that fundamental analysis just does not work. at least, that \nis the conclusion a great many futures traders have drawn from such experiences.\nthe simple truth, however, is that much that passes for fundamental analysis is either incomplete \nor incorrect—and frequently both. the trader who ignores fundamentals completely is almost cer-\ntainly better off than the trader who uses fundamentals incorrectly. However, this in no way alters the \nfact that good fundamental analysis is a useful, and even powerful, tool.\nBefore turning to how to do things right, it is essential to first cover what not to do wrong. W e \nbegin by exploring 14 common fallacies in fundamental analysis. incidentally, these fallacies do not \nrepresent mistakes made solely by the novice trader. in fact, virtually all these errors have been \nrepeated numerous times in the most respected financial news outlets and in myriad commodity \nresearch publications. \nthere is no significance to the order of the list.\n ■ The Fourteen Fallacies\n1. Viewing Fundamentals in a Vacuum\n“the fundamentals are bearish” is often thought to be synonymous with an abundant supply situation. \nsuch an interpretation might seem plausible, but it can lead to inaccurate conclusions.\nFor example, assume the sugar market is trading at 30¢/lb. and in transition from tightness to \nsurplus. given this scenario, the fundamentals can indeed be termed “bearish,” and an expectation of \nlower prices would be reasonable. assume that prices begin to move lower. are the fundamentals still \nbearish at 25¢? V ery likely. at 20¢? Maybe. at 15¢? at 10¢? at 5¢? the point is that at some price \nlevel, the fundamentals are no longer bearish, no matter how large the projected supply.\nin fact, it is entirely possible that the fundamentals could be bullish in a surplus situation if prices \nhave overdone the downside—a situation that is far from infrequent. thus, fundamentals are not \nbullish or bearish in themselves; they are only bullish or bearish relative to price. the failure of many \nanalysts to realize or acknowledge this fact is the reason why the fundamentals are so often termed \nbullish at market tops and bearish at market bottoms.\n2. Viewing Old Information as New\nFinancial news outlets frequently report old information and new information in much the same \nmanner. For example, a story with the headline “W orld Cotton Production Projected to \nrise 10 \nPercent” may sound very bearish. However, what the story is not likely to indicate is that this may be \nthe fourth or fifth such estimate rele", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 106}
{"text": "s and bearish at market bottoms.\n2. Viewing Old Information as New\nFinancial news outlets frequently report old information and new information in much the same \nmanner. For example, a story with the headline “W orld Cotton Production Projected to \nrise 10 \nPercent” may sound very bearish. However, what the story is not likely to indicate is that this may be \nthe fourth or fifth such estimate released. V ery likely, the previous month’s estimate also projected \n350\nA Complete Guide to the Futures mArket\nan approximate 10 percent increase in world production. For that matter, the previous month’s esti-\nmate might have forecast a 12 percent increase, and the current estimate actually represents a price-\nconstructive development. \nthe main point to keep in mind is that much information that sounds new \nis actually old news, long discounted by the market.\n3. One-Y ear Comparisons\nthe use of one-year comparisons is fairly widespread, probably because it offers a simple means of \ninstant analysis. this approach is overly simplistic, however, and should be avoided. For example, \nconsider the following market commentary: “the december Hogs & Pigs report indicates that large \npork supplies are around the corner. Market hogs on all farms are up 10 percent. the projected 10 \npercent increase in hog slaughter should push prices lower. . . .” although this type of analysis could \nbe right on target in some situations, it will be susceptible to error if used consistently.\nsharp-eyed readers may already be citing fallacy number 1—that is, large supplies do not neces-\nsarily imply lower prices, since the market may already be discounting such a development. How-\never, some additional potential errors pertain specifically to the one-year comparison. First, just \nbecause the \ndecember report indicated a 10 percent increase in hog numbers does not mean it \nimplies large supplies. Perhaps hog numbers were extremely low the previous year. second, the rela-\ntionship between hog slaughter and market hogs can vary significantly. it is possible that the preceding \nyear the ratio of slaughter to market hogs was abnormally high. in this case, a 10 percent increase in \nmarket hogs would imply a smaller increase in slaughter. although one-year comparisons can be used \nsparingly for illustrative purposes, they should never represent the sole basis of fundamental analysis.\n4. Using Fundamentals for timing\nif this list of fallacies were ordered on the basis of frequency of occurrence, this item would be a \nstrong contender for the number 1 spot. Fundamental analysis is a method for gauging what price \nis right under given statistical conditions and can be used in constructing annual, quarterly, and in \nsome instances monthly price projections. However, it is ludicrous to attempt to boil supply-demand \nstatistics down to the point at which they provide an instantaneous price signal, which is exactly what \nsome traders do when they rely on fundamentals for timing.\ntrading on the basis of market websites, newspaper articles, and newswire stories, falls into this \ncategory. it is no surprise that speculators who base their trades on such items are usually spectacu-\nlarly unsuccessful. the only major exception are those traders who use this type of information in a \ncontrary way, such as viewing the failure of the market to rally after the release of a bullish newswire \nstory as a signal to go short.\nthe fundamental researcher must also guard against the natural instinct of wanting to take a \nmarket position right after completing an analysis that indicates either an underpriced or overpriced \nsituation. \nthe market is not aware of the timing of a researcher’s personal price discovery. even if the \nanalysis is correct, the right time may be three weeks or even three months off. in short, for purposes \nof timing, even the fundamental analyst should use some form of technical input.\n351\nFOurteeN POPular FallaCies, Or WHat NOt tO dO WrONg\n5. Lack of Perspective\nassume the following scenario: scanning the financial pages one day, you notice the following \nheadline: “government Officials estimate 10,000 Head of Cattle Killed in recent Midwest Winter \nstorm.” does such a large production loss suggest a major buying opportunity? Wait a minute. What \nlarge production loss? ten thousand cattle might sound like a very big number if you were to picture \nthem on your front lawn, but viewed in terms of a total u.s. cattle population of about 90 million \nhead (and many times that globally), the loss does not even equal the proverbial drop in the bucket.\nthis example is based on supply, but cases involving domestic consumption or exports could be \nillustrated just as easily. in each instance, the same question should be asked: How important is the \nevent (e.g., production loss, new export sales) in terms of the total picture?\n6. Ignoring relevant time Considerations\ntrue or false: Higher grain prices imply higher meat prices. No cheating—think before reading on.\nactually, this is not a fair question, because the answer depends on the time frame. Most peo-\nple would probably answer true, since rising grain prices do suggest increased costs of production \nfor feedlot operators, a development that would lead to reduced meat production and higher meat \nprices. (Cost of production is itself a primary source of misconception and is discussed separately.) \nHowever, this reasoning is true only for the very long run (2½ years plus).\nOver the short to intermediate term—the time frame that is really of primary concern to futures \n traders—the effect might be exactly the opposite. if high grain prices are effective in influencing cattle \nfeeders to reduce production, the preliminary impact will be increased marketings and lower prices as a \nresult of breeding herd liquidation. Higher grain prices might reduce the weight to which cattle are fed, but \nthis effect is relatively minor. \nincreased feeding costs would only imply a shift in the flow of supp", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 107}
{"text": "e exactly the opposite. if high grain prices are effective in influencing cattle \nfeeders to reduce production, the preliminary impact will be increased marketings and lower prices as a \nresult of breeding herd liquidation. Higher grain prices might reduce the weight to which cattle are fed, but \nthis effect is relatively minor. \nincreased feeding costs would only imply a shift in the flow of supply (since \ncattle gain weight more slowly on grass) rather than a change in total actual supplies over the longer run.\nin the world of economics, the cause-and-effect relationship is not necessarily instantaneous. in \nsome cases, an event will trigger a very quick price response; in other instances, such as the cattle \nsituation, the effect will not occur for many years.\n7. assuming that Prices Cannot Decline Significantly \nBelow the Cost of Production\nNo matter how many times this old saw is disproved by actual events, it never seems to be laid to rest. the \ncost of production is not—repeat, not—a price-supporting factor, especially for nonstorable commodities.\nOnce a commodity is produced, the market does not care about the cost of production. Prices \nwill be determined on the basis of existing supply and demand. if prices fall to the cost of production \nand there is still a surplus, prices will continue to decline until an equilibrium price level is reached.\nWhy should producers sell a commodity below the cost of production? the fact is they don’t have \nmuch choice. agricultural markets are highly competitive, with literally thousands of sellers. Conse-\nquently, any individual is powerless to pass on production costs to the marketplace. instead, individu-\nals must accept the price that the market will bear. after all, a low price is better than no price.\n352\nA Complete Guide to the Futures mArket\nOf course, an unprofitable situation will lead to production cutbacks, but this will not happen \novernight. the minimum time lag might be one year, but in many instances, it will take several years \nbefore prices below the cost of production actually result in reduced output. in this sense, fallacy \nnumber 7 is a corollary of fallacy number 6—ignoring relevant time considerations. Many commod-\nity markets have witnessed periods in which prices have fallen and stayed below cost of production \nfor years at a time. Keep this empirical reality in mind the next time you read a recommendation to \npurchase a commodity because it is at or below the cost of production.\n8. Improper Inferences\nFallacy number 8 might be best explained by citing some examples. First, cattle-on-feed numbers \ndo not necessarily provide an indication of potential future slaughter. \nreason: cattle on feed do not \ninclude grass-fed cattle. as long as grass-fed cattle account for a stable percentage of total slaughter, \nthere is no problem. But if the percentage varies widely over time (as has tended to be the case), the \nstraightforward use of cattle-on-feed numbers to predict slaughter can lead to a totally erroneous con-\nclusion. \nif, for instance, high feed prices influence a shift toward increased grass feeding of cattle, the \ntotal number of cattle could be higher, even if the cattle-on-feed figure shows a significant reduction.\nMuch market analysis and commentary naively ignores the preceding complication in projecting \ncattle slaughter. How bad is this error? table 21.1 shows the relationship between percentage changes \nin cattle on feed and total slaughter. there is a great deal of variability between the two sets of figures. \nin fact, from 1995 through 2014 there were 34 quarters when the deviation in percentage changes \nbetween cattle on feed and total slaughter exceeded 5 percent and seven quarters with deviations \ngreater than 10 percent! \nit is not an overstatement to say that one can achieve far more accurate \nslaughter projections using the naive assumption that slaughter in any given quarter will equal the \ncorresponding previous year’s level. \nthis is a clear example of no information being far preferable to \nincorrectly used information.\ntaBLe 21.1 Percentage Changes in Cattle on Feed Numbers V ersus Percentage Changes in Slaughter\nQuarter\nCattle on Feed as Percentage \nof Previous Y ear\nCattle Slaughter as Percentage \nof Previous Y ear\nDiscrepancy between two \nPercentagesa\nJan-2015 94.48% 100.98% 6.50%\nOct-2014 91.17% 99.49% 8.31%\nJul-2014 91.72% 97.61% 5.89%\napr-2014 94.14% 99.53% 5.39%\nJan-2014 94.77% 94.79% 0.02%\nOct-2013 97.01% 92.31% –4.70%\nJul-2013 99.85% 96.81% –3.05%\napr-2013 100.19% 95.01% –5.18%\nJan-2013 96.95% 94.37% –2.58%\nOct-2012 98.66% 97.40% –1.26%\nJul-2012 95.37% 102.66% 7.28%\napr-2012 96.18% 102.00% 5.82%\n353\nFOurteeN POPular FallaCies, Or WHat NOt tO dO WrONg\nQuarter\nCattle on Feed as Percentage \nof Previous Y ear\nCattle Slaughter as Percentage \nof Previous Y ear\nDiscrepancy between two \nPercentagesa\nJan-2012 96.53% 103.02% 6.49%\nOct-2011 97.00% 104.86% 7.85%\nJul-2011 99.84% 103.74% 3.90%\napr-2011 99.54% 104.92% 5.39%\nJan-2011 101.85% 104.83% 2.99%\nOct-2010 105.02% 102.91% –2.10%\nJul-2010 102.74% 103.26% 0.52%\napr-2010 100.89% 96.46% –4.42%\nJan-2010 102.36% 97.99% –4.37%\nOct-2009 100.78% 100.57% –0.22%\nJul-2009 96.14% 94.73% –1.41%\napr-2009 94.99% 95.53% 0.54%\nJan-2009 96.44% 92.90% –3.53%\nOct-2008 95.30% 94.97% –0.33%\nJul-2008 101.84% 95.88% –5.96%\napr-2008 102.58% 100.34% –2.24%\nJan-2008 101.42% 101.03% –0.39%\nOct-2007 103.22% 96.33% –6.89%\nJul-2007 99.60% 98.76% –0.84%\napr-2007 100.25% 98.58% –1.67%\nJan-2007 103.97% 101.44% –2.53%\nOct-2006 103.73% 108.61% 4.89%\nJul-2006 102.94% 104.60% 1.66%\napr-2006 106.22% 108.64% 2.41%\nJan-2006 103.25% 104.47% 1.22%\nOct-2005 100.45% 99.81% –0.64%\nJul-2005 101.69% 102.57% 0.88%\napr-2005 97.22% 100.99% 3.77%\nJan-2005 96.43% 100.41% 3.98%\nOct-2004 98.28% 102.73% 4.45%\nJul-2004 87.31% 101.96% 14.65%\napr-2004 90.09% 100.33% 10.24%\nJan-2004 94.33% 105.58% 11.26%\nOct-2003 91.22% 98.05% 6.83%\nJul-2003 103.14% 94.62% –8.51%\napr-2003 103.37% 92.45% –10.92%\nJan-2003 99.", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 108}
{"text": "6.22% 108.64% 2.41%\nJan-2006 103.25% 104.47% 1.22%\nOct-2005 100.45% 99.81% –0.64%\nJul-2005 101.69% 102.57% 0.88%\napr-2005 97.22% 100.99% 3.77%\nJan-2005 96.43% 100.41% 3.98%\nOct-2004 98.28% 102.73% 4.45%\nJul-2004 87.31% 101.96% 14.65%\napr-2004 90.09% 100.33% 10.24%\nJan-2004 94.33% 105.58% 11.26%\nOct-2003 91.22% 98.05% 6.83%\nJul-2003 103.14% 94.62% –8.51%\napr-2003 103.37% 92.45% –10.92%\nJan-2003 99.29% 91.60% –7.70%\nOct-2002 100.62% 93.63% –6.99%\ntaBLe 21.1 (Continued)\n(Continued)\n354\nA Complete Guide to the Futures mArket\nQuarter\nCattle on Feed as Percentage \nof Previous Y ear\nCattle Slaughter as Percentage \nof Previous Y ear\nDiscrepancy between two \nPercentagesa\nJul-2002 103.08% 95.24% –7.84%\napr-2002 101.37% 100.47% –0.90%\nJan-2002 98.93% 98.03% –0.91%\nOct-2001 100.65% 100.99% 0.34%\nJul-2001 97.13% 105.89% 8.76%\napr-2001 98.22% 102.87% 4.65%\nJan-2001 94.41% 102.81% 8.40%\nOct-2000 98.64% 107.20% 8.56%\nJul-2000 99.18% 108.61% 9.43%\napr-2000 100.26% 107.58% 7.33%\nJan-2000 103.09% 107.57% 4.48%\nOct-1999 102.15% 104.96% 2.81%\nJul-1999 102.89% 104.30% 1.41%\napr-1999 102.03% 102.63% 0.60%\nJan-1999 100.62% 95.63% –4.99%\nOct-1998 98.42% 97.83% –0.59%\nJul-1998 97.99% 102.27% 4.28%\napr-1998 96.69% 97.27% 0.58%\nJan-1998 97.54% 105.65% 8.11%\nOct-1997 99.57% 112.69% 13.12%\nJul-1997 101.46% 114.26% 12.80%\napr-1997 97.00% 105.90% 8.90%\nJan-1997 99.19% 102.05% 2.86%\nOct-1996 100.12% 96.94% –3.17%\nJul-1996 98.32% 85.05% –13.27%\napr-1996 105.91% 99.50% –6.42%\nJan-1996 106.58% 107.92% 1.34%\nOct-1995 103.04% 101.63% –1.41%\nJul-1995 105.14% 106.00% 0.85%\napr-1995 105.48% 100.17% –5.31%\nJan-1995 103.14% 94.61% –8.53%\navg. (abs) 4.73%\nMed. (abs) 4.40%\nMax. (abs) 14.65%\nMin. (abs) 0.02%\nQtrs. w/ abs discrepancy ≥ 5% 34\nQtrs. w/ abs discrepancy ≥ 10% 7\naColumn 2 minus column 3 percentages.\ntaBLe 21.1 (Continued)\n355\nFOurteeN POPular FallaCies, Or WHat NOt tO dO WrONg\nanother example of an improper inference is provided by the projection of production from \nacreage figures. a given percentage change in acreage does not necessarily imply a similar change \nin production (even assuming equivalent yields). For most crops, the distribution of production is a \ncritically important variable. For example, average cotton yields in some states, such as California, are \napproximately three times as high as average yields in other states, such as \ntexas. although consider-\nably more time consuming, production projections should be based on a breakdown of acreage by \narea (region or state) rather than on a total acreage figure.\n9. Comparing Nominal Price Levels\nit is inaccurate to compare current prices with the actual recorded prices of previous years. in draw-\ning comparisons with past seasons, it is necessary to adjust historical prices for inflation. even though \nu.s. inflation has been subdued since the mid-1980s, over broad periods of time, even low inflation \ncan have a significant cumulative effect. Moreover, in the future, higher inflation levels could recur, \nmaking this factor a critical consideration.\nas an example, assume that an exhaustive survey of the statistical data for commodity x in past \nyears indicates that 1997 and 2003 were very similar to the current season in terms of overall funda-\nmentals. \ndoes this observation imply that current-season prices will be about in line with the price \nlevels of 1997 and 2003? Of course not. in real dollar terms, the prices may be roughly equivalent, \nbut because of the impact of inflation, current nominal prices are likely to be higher.\ninflation cannot be considered in a vacuum, however. For example, a protracted downshift in \ndemand for most physical commodities (resulting from reduced inventory requirements) begin-\nning around 1980 provided a counterbalancing force to inflation. Because demand is very difficult \nto quantify—as will be discussed in detail in Chapter 22—the net effect is that inflation-adjusted \nforecasts can be biased to the high side. \nin other words, ironically, in some cases it is possible that a \nnaive analyst who ignores both demand shifts and inflation adjustments may derive a more accurate \nforecast than the analyst who adjusts for inflation. \nsuch accidental accuracy is likely to be a temporary \nphenomenon. the correct procedure would be to incorporate inflation adjustments in the model and \nthen infer and include demand shifts in the model as well.\n10. Ignoring expectations\nMarkets often place greater emphasis on expectations for the following year (or season) than on pre-\nvailing fundamentals. \nthis pattern is especially true in transitional periods when the supply situation \nis moving from surplus to tightness, or vice versa.\nthe 1990 wheat market provided an excellent example. in the 1989–1990 season, the winter \nwheat crop proved very disappointing because of below-average yields. as a result, carryover stocks \n(measured as a percent of utilization) fell to their lowest level in 15 years. Moreover, winter wheat \nseedings for the 1990 crop increased only slightly, thereby seeming to suggest the extension of a tight \nsupply situation into the new season.\ndespite the apparent bullish scenario, wheat prices moved steadily and sharply lower from the \nvery beginning of 1990. this price slide cannot be explained in terms of prevailing fundamentals, \nbut only in terms of expectations. as the year progressed, it became increasingly evident that the \n356\nA Complete Guide to the Futures mArket\n1990–1991 hard red winter wheat crop would result in extremely good yields. as it turned out, the \nyield of the 1990–1991 winter wheat crop increased by an imposing 16 percent over the previous \nseason’s level, and the percentage of planted acreage harvested rose from 75 percent to 88 percent. \nas a result of excellent yields and sharply lower acreage abandonment, 1990–1991 winter wheat \nproduction increased by a huge 39 percent, despite the fact that planted acreage was only marginally \nhigher, and carryover stocks returned to comfortable levels.\nalthough t", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 109}
{"text": "16 percent over the previous \nseason’s level, and the percentage of planted acreage harvested rose from 75 percent to 88 percent. \nas a result of excellent yields and sharply lower acreage abandonment, 1990–1991 winter wheat \nproduction increased by a huge 39 percent, despite the fact that planted acreage was only marginally \nhigher, and carryover stocks returned to comfortable levels.\nalthough the fundamental transition just described was reflected by data available after mid-spring \n1990, during early 1990 such changes would have fallen into the category of expectations. thus, price \naction in the wheat market during the first half of 1990 provided a classic example of expectations \ndominating prevailing fundamentals.\n11. Ignoring Seasonal Considerations\nalmost every commodity exhibits one or more seasonal patterns. ignoring seasonal factors can \neasily lead to the misinterpretation of fundamental data. For example, a 5 percent increase in hog \nslaughter during the fourth quarter relative to the third-quarter level would actually be indicative \nof a trend toward reduced production—not expanded production. \nthe explanation behind this \napparent paradoxical statement lies in the fact that hog production is highly seasonal. Producers \nbreed hogs so that the largest pig crop is born during the spring and the smallest in winter. Because \nit takes approximately six months for hogs to reach market weight, slaughter tends to be heaviest \nduring the fall and lightest during the summer. \nthus, it is essential to adjust for the seasonal pro-\nduction pattern in drawing slaughter comparisons between the current period and the preceding \nmonth or quarter.\nComparisons of production and consumption figures with the corresponding figures of previous \nyears obviously do not require any consideration of seasonal factors. However, if comparisons of fun-\ndamental data involve different time periods during the year, it is essential to examine historical data \ncarefully for possible seasonal behavior and to make any necessary adjustments.\n12. expecting Prices to Conform to target Levels in \nWorld trade agreements\nthe history of commodities is replete with examples of world trade agreements that totally failed to \nachieve their stated goals. trade agreements typically attempt to support prices through export controls \nand stockpiling plans. although these provisions provide some underlying support to the market and occa-\nsionally even spark temporary rallies, they are usually not sufficiently restrictive to maintain prices signifi-\ncantly above equilibrium levels for any extended period of time. \nthe international sugar agreement and \nthe international Cocoa agreement are two examples of world trade agreements that ultimately failed to \nsupport prices above the lower end of their respective stated target ranges (in the years when these agree-\nments attempted to support prices; they no longer even attempt to do so). Perhaps the most effective \nprice-supporting organization has been the Organization of the Petroleum \nexporting Countries (OPeC), \nbut even the oil cartel has frequently seen prices fall below their target level—often by a wide margin.\nit should be noted that world trade agreements are even more impotent in terms of restraining a \nprice advance. in the case in which prices approach the upper end of a target range, the most powerful \n357\nFOurteeN POPular FallaCies, Or WHat NOt tO dO WrONg\naction that any agreement could take would be the elimination of all restrictions—in other words, a \nreturn to a free market.\n13. Drawing Conclusions on the Basis of Insufficient Data\nsometimes it is virtually impossible to construct a fundamental forecasting model for a market \nbecause of a lack of sufficient comparative historical data. a perfect case in point was provided in the \naugust 1972 issue of Commodities magazine (now called Modern T rader), which ran a detailed study of \nfundamentals in the cotton market. the article ultimately came to the valid conclusion that only two \nseasons since 1953 could truly be termed free markets. as the article explained, during the 1950s and \n1960s, government programs had maintained cotton prices above the levels that would have been \nrealized had prices been determined by the interaction of supply and demand. \nso far, so good.\nthe proper and very worthwhile conclusion would have been that existing data were insufficient to \npermit the use of fundamentals in forecasting prices. after all, how can you interpret the price impli-\ncations of a projected statistical balance if there are only two previous years to use as a comparison?\nunfortunately, the author went on to sketch an entire set of price forecasting conclusions on the \nbasis of admittedly very limited relevant information. Quoting the first item, “Final stock levels under \n3½ million bales imply a very tight supply situation and suggest a likelihood of a price rise well above \n30¢ in such seasons.”\nalthough this statement certainly proved true, by implication it severely understated the upside \npotential in the cotton market. Only a little more than one year after the article was published, cotton \nprices reached an all-time peak of 99¢/lb. \nincidentally, i was the author of that article.\n14. Confusing the Concepts of Demand and Consumption\ndemand is probably one of the two most misused words in futures literature and analysis (parameter \nbeing the other; see Chapter 19). the confusion between demand and consumption is not a matter of \nsemantics; the two terms represent very different concepts, and their frequent interchangeable use \nleads to many major analytical errors. \nan adequate explanation of this statement requires a diversion \ninto a short review of basic supply-demand theory, which is the subject of the next chapter.\nat this point, it might be instructive to return to the five scenes depicted at the beginning of this \nchapter to try to determine which of the 14 fallacies were responsible for the incorrect", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 110}
{"text": "geable use \nleads to many major analytical errors. \nan adequate explanation of this statement requires a diversion \ninto a short review of basic supply-demand theory, which is the subject of the next chapter.\nat this point, it might be instructive to return to the five scenes depicted at the beginning of this \nchapter to try to determine which of the 14 fallacies were responsible for the incorrect trading con-\nclusions. Note that each scene reflects two or more fallacies. \nthe answers can be found in table 21.2.\ntaBLe 21.2 Fallacies Committed in the Five Scenes\nScene Fallaciesa\n1 4, 5, 10\n2 1, 3, 4\n3 2, 4\n4 9, 10\n5 7\nathe inclusion of additional items is not necessarily incorrect. Other fallacies might \nalso be applicable (e.g., fallacy number 1 in any of the scenes), but are not listed \nbecause the text provides insufficient information to make such a determination.\n\n359There are in the fields of economics no consistent relations, and consequently, no measurement \nis possible.\n—Ludwig Edler von Mises\n ■ Supply and Demand Defined\nSupply curves slope upward, meaning more is offered to the market at higher prices (Figure 22.1). 1 \nAssuming that the time unit shown on the horizontal axis in Figure 22.1 equals one season, the sup-\nply that can be offered to the market will be limited to total production plus stocks, regardless of the \nprice. At high prices, however, producers will be willing to hold smaller inventories and therefore \noffer greater quantities to the market. Conversely, at lower prices, producers will prefer to store \nSupply-Demand \nAnalysis: Basic \nEconomic Theory\nChapter 22\n1 The supply and demand curves in this section are drawn as straight lines for simplicity of exposition. It also \nseemed desirable to avoid the unnecessary digression of discussing the factors that determine the precise shapes \nof these curves. Although the straight-line assumption may often be adequate within normal boundaries, supply \nand demand curves will not be linear over the entire price range. For example, as prices rise and the quantity \nconsumed declines, it will usually take greater and greater increases in price to induce a given further reduction \nin the amount consumed. As another example, over the short run, at some point the supply curve must begin to \nrise asymptotically, since the supply offered to the market cannot exceed the existing total supply (i.e., stocks \nplus current production).\n360A COMPLETE GUIDE TO THE FUTURES MARKET\n FIGURE  22.1 Supply Curve \nQuantity (per unit time)\nPrice\nlarger quantities rather than marketing their goods at prevailing depressed levels. The slope of the \nsupply curve will refl ect this tradeoff between the options of sale and storage. 2 \n For perishable (e.g., eggs, potatoes 3 ) or nonstorable (e.g., cattle, hogs) commodities, supply is \napproximately fi xed and can be represented by a vertical line (Figure 22.2 ). For example, if a supply \ncurve is drawn for the hog market for a time unit of one-half year, the amount off ered to the market \nduring that period will be relatively independent of market prices. Low prices will not reduce the \nquantity supplied, because once hogs reach market weight, with the exception of temporary delays, \nproducers have little choice but to bring those hogs to market, regardless of the price. However, since \nthere is a lag of nearly one year between producers’ breeding decisions and the time that resulting \n 2 For longer time units (e.g., 10 years), the supply curve will also refl ect the potential for an expansion in pro-\nduction beyond current levels. For example, high prices may encourage shifts in acreage to the high-priced com-\nmodity and increased usage of fertilizer in new crops. From the vantage point of futures trading, however, it is \nmost useful to limit the discussion of supply and demand to short time units (i.e., season or fraction of a season).\n 3 These commodities are no longer traded as futures markets, but provide perfect illustrations of perishable goods.\n FIGURE  22.2 Fixed Supply \nQuantity (per unit time)\nPrice\n361\nSUPPLY -DEMAND ANALYSIS: BASIC ECONOMIC THEORY\noff spring reach market weight, high prices cannot induce an increase in the quantity supplied. In fact, \nif anything, the supply curve in such a market exhibits a perverse behavior; that is, high prices will \nreduce the quantity supplied. The reason is that high prices will infl uence producers to withhold hogs \nfrom the market for breeding, thereby reducing current supplies. However, for simplicity’s sake, we \nwill assume a vertical supply curve in the case of perishable or nonstorable commodities. \nDemand can be defi ned as a schedule of the various quantities of a commodity that will be con-\nsumed at each price level. In a sense, demand is a barometer of consumer buying pressure. Demand \ncurves slope downward, meaning more will be demanded at lower prices (Figure 22.3 ). \nElasticity of demand can be defi ned as the percentage increase in the amount demanded divided by \nthe percentage decrease in price. If the demand for a commodity is inelastic, it means that a relatively \nlarge percentage change in price will only induce a small percentage change in the amount demanded. \nFigure 22.4 presents illustrations of elastic and inelastic demand curves. \n4 \n The elasticity of demand is primarily determined by two basic factors: \n 1. availability of substitutes. The elasticity of demand will vary directly with the availability \nof substitutes. For example, the demand for salt is highly inelastic, but the demand for a given \nbrand of salt is very elastic. \n 2. percentage of total income spent on the good. The elasticity of demand will vary directly \nwith the percentage of expenditures allocated to a good. For example, the demand for automobiles \nis far more elastic than the demand for salt, even though there are no close substitutes for either item. \n Generally speaking, the demand curves for most commodities tend to be inelastic; that is, a \ngiven pe", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 111}
{"text": ". percentage of total income spent on the good. The elasticity of demand will vary directly \nwith the percentage of expenditures allocated to a good. For example, the demand for automobiles \nis far more elastic than the demand for salt, even though there are no close substitutes for either item. \n Generally speaking, the demand curves for most commodities tend to be inelastic; that is, a \ngiven percentage change in price will induce a smaller opposite percentage change in the amount \ndemanded. This is a signifi cant consideration, since prices of goods with inelastic demand curves are \nmore subject to wide price swings in times of shortage. \n FIGURE  22.3 Demand Curve \nQuantity (per unit time)\nPrice\n 4 Elasticity is not constant along each demand curve. Elasticity is a concept that relates to a given point, not to \nthe entire curve. As we move rightward along a line or demand curve (in both the elastic and inelastic cases), the \nelasticity of demand will decrease, since any given change in price will represent a larger percentage change, and \nwill infl uence the same absolute, but smaller percentage, change in the quantity demanded. In other words, as \ncan be verifi ed in Figure 22.4 , rightward movement along the demand curve will increase the denominator and \ndecrease the numerator of the elasticity of demand.\n362A COMPLETE GUIDE TO THE FUTURES MARKET\n FIGURE  22.4 Elasticity of Demand \nQuantity (per unit time)\nPrice\nELASTIC\nINELASTIC\nA\nB\nOC D\nQuantity (per unit time)\nCD= OD\nAB\nOB\nPrice\nA\nB\nOC D\n ■ The Problem of Quantifying Demand \n As all students of Economics 101 know , price is determined by the intersection of the supply and \ndemand curves (Figure 22.5 ). However, there is one major problem in using supply-demand analysis \nto project prices: Demand is not readily quantifi able—that is, there is no way of determining how \nmuch will be consumed at any given price level. Whereas in most cases supply can be either approxi-\nmately fi xed as in the case of perishable and nonstorable commodities, or at least roughly estimated \nusing production and stock statistics, \n5 demand is entirely intangible. It is hardly feasible to query all \n 5 The precious metal markets provide an important exception. See the section, Why Traditional Fundamental \nAnalysis Doesn’t W ork in the Gold Market, at the end of this chapter.\n363\nSUPPLY -DEMAND ANALYSIS: BASIC ECONOMIC THEORY\n FIGURE  22.5 Equilibrium \nQuantity (per unit time)\nPrice\nSupply\nDemand\nP\nOQ\npotential consumers as to the amount of a good they would purchase at various price levels. Even if a \nsampling procedure were used—presumably an impractical and prohibitively expensive approach for \nthe analyst—there is no reason to assume that consumers could even describe their demand curves. \n The only theoretically acceptable means of quantifying demand is to infer demand curves through \na detailed analysis of historical consumption and price data. Although this is an easy task if demand \nis relatively stable, unfortunately, it is either diffi cult or impossible if demand is subject to frequent \nwide shifts. \n ■ Understanding the Difference between Consumption \nand Demand \n Perhaps the most commonly employed solution to the problem of quantifying demand is the use of \nconsumption as a proxy for demand. This approach, however, has one major drawback: It is totally \nincorrect. The synonymous use of consumption and demand represents a confusion of two entirely \ndiff erent concepts. Consumption is the amount of a good used and is determined by price, which in \nturn is determined by supply and demand factors. Demand refers to the amount of a good that will be \nused at any given price level and, along with supply, determines price. \n An increase in demand means that more will be consumed at any given price level (Figure 22.6 ). \nFactors that might aff ect demand include disposable income, consumer tastes, and the price of substi-\ntute goods but, by defi nition, not price. For most commodities, a rise in disposable income will result \nin an increase in demand; that is, at each given price, more will be consumed than before. A price \ndecline will lead to increased consumption, showing movement along the same demand curve, but it \ndoes not imply anything about demand. In other words, all else being equal, the same amount will be \nconsumed at each given price level unless there is a change in demand. \n364A COMPLETE GUIDE TO THE FUTURES MARKET\n FIGURE  22.6 Increase in Demand \nQuantity (per unit time)\nPrice\n Figure 22.7 summarizes the relationship between demand and consumption. Consumption (i.e., \nthe amount consumed) is directly dependent on price, where price is determined by the interaction \nof supply and demand. The key point to keep in mind: Consumption is a consequence of price, not a \ndeterminant of price. Thus the concept that consumption mirrors demand is totally erroneous; con-\nsumption is determined by both supply and demand. \n FIGURE  22.7 Supply-Demand Interaction \nProduction\nStock levels\nMarketing policy\n(the percentage\nof total supply\nwhich will be\noffered at each\ngiven price)*\nCunsumer tastes\nLevel of\ndisposable income\nInflation\n*For perishable of nonstorable commodities, such as hogs\nand cattle, the entire amount will be offered during the\nseason, regardless of price level. In this case, supply for the\nseason is fixed, that is, equal to total production.\nPopulation size\nPrice of substitute\ngoods\nMeans influences\nSupply\nDemand\nPrice Consumption\n365\nSUPPLY -DEMAND ANALYSIS: BASIC ECONOMIC THEORY\n In fact, for perishable and nonstorable commodities, consumption primarily refl ects supply, not \ndemand. For example, assume that pork consumption has increased sharply. Does this mean that pork \ndemand has suddenly improved dramatically? Absolutely not. The consumption increase is merely the \nresult of increased hog slaughter. Recalling that the supply curve for hogs (and therefore pork) can be \napproximated by a vertical line, Figure 22.8 demonstrates", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 112}
{"text": "ption primarily refl ects supply, not \ndemand. For example, assume that pork consumption has increased sharply. Does this mean that pork \ndemand has suddenly improved dramatically? Absolutely not. The consumption increase is merely the \nresult of increased hog slaughter. Recalling that the supply curve for hogs (and therefore pork) can be \napproximated by a vertical line, Figure 22.8 demonstrates the consumption level will be determined \nby supply and will be the same, no matter which demand curve prevails. Thus, an increase in con-\nsumption would merely refl ect an increase, or rightward shift, in supply—a bearish development—\nand not an increase in demand, which would be a bullish development. \n It is entirely possible for a demand increase and a consumption decrease to occur simultaneously. \nFigure 22.9 illustrates how this is possible for both the variable supply and fi xed supply cases. At the \n FIGURE  22.8 Consumption Refl ects Supply (in Fixed Supply Case) \nQuantity (per unit time)\nOQ\nSupply\nDemand\ncurves\nPrice\n FIGURE  22.9 Higher Demand, Lower Consumption: Variable Supply (a) and Fixed Supply (b) \nQuantity (per unit time)\n(a)\nQuantity (per unit time)\n(b)\nOO BA BA\n1\n1 1\n1\n2\n2\n2\n2\nPrice\nPrice\n366\nA Complete Guide to the Futures mArket\nstart, in period 1, the equilibrium consumption level is at point A. Although demand increases in \nperiod 2, the equilibrium consumption level declines to B as a result of the decline in supply.\nEven the U.S. Department of Agriculture (USDA), one of the nation’s leading employers of econ-\nomists, has misused the term demand. The popularly termed supply-demand reports are in reality sup-\nply-disappearance reports (with disappearance defined as total domestic consumption plus exports).\nQuite frequently, when the USDA changes its estimates for items that are sometimes discussed \nunder the label of “demand” (domestic consumption, exports),\n6 the revision reflects a change in sup-\nply, not demand. For example, if the projected carryover for a commodity is already at estimated \nminimum pipeline requirements, a reduced production forecast will mean that the USDA has to \nlower either the domestic consumption estimate, the export estimate, or both. Otherwise, the USDA \nmight find itself in the absurd position of projecting a near-zero or even negative carryover. However, \nthe key point is that such revisions do not imply that demand has been reduced—a bearish conclu-\nsion—but rather that high prices will ration scarce supplies, thereby resulting in reduced usage.\n ■ The Need to Incorporate Demand\nBecause of the difficulties involved in quantifying demand, there is often a temptation to concentrate \nsolely on supply factors in constructing a fundamental price-forecasting model. This can be a grave \nerror, because a demand shift can often be the dominant force in a major price move. The 1980–1982 \ncopper market provided a classic example of the dangers of ignoring demand. T o focus in on this \nexample, we will examine a 21-year segment of the copper market (1973–1993) that contains three \nmajor bull-bear price cycles, with the bear phase of the middle cycle containing the 1980–1982 mar-\nket that is the center of our attention.\nConsider the following copper price-forecasting model:\nPf S\nC= \n \n\nwhere P = average deflated copper price during the period\n S = copper stock level (U.S. plus foreign refined copper stocks)\n C = copper consumption level during the period (annualized refined copper deliveries, \nUnited States plus foreign)\nf( ) is read as “is a function of,” which basically means “is dependent on.”\nAt surface glance, this model seems reasonably plausible. In essence, the model implies that prices \nwill be low when copper stocks are large relative to the usage level and high in the reverse case. This \nmodel certainly seems logical enough. Figure 22.10, which illustrates the relationship between cop-\nper prices and the stock/consumption ratio during a 21-year segment (1973–1993) that is centered \nnear the 1980–1982 bear market that we wish to focus on, appears to confirm this expected market \n behavior. The strong inverse correlation between the stock/consumption ratio and copper prices is \n6 USDA report tables, however, correctly label these items as components of “disappearance.”\n367\nSUPPLY -DEMAND ANALYSIS: BASIC ECONOMIC THEORY\n FIGURE  22.10 Average Monthly Copper Nearest Futures Price vs. Copper Stock/Consumption Ratio \nJan-73\n20\n40\n60\n80\n¢/Lb.\nRatio\n100\n120\n140\n160\n180\n0\n4\n10\n15\n20\n25\n30\n35\n40\nJul-73\nJan-74\nJul-74\nJan-75\nJul-75\nJan-76\nJul-76\nJan-77\nJul-77\nJan-78\nJul-78\nJan-79\nJul-79\nJan-80\nJul-80\nJan-81\nJul-81\nJan-82\nJul-82\nJan-83\nJul-83\nJan-84\nJul-84\nJan-85\nJul-85\nJan-86\nJul-86\nJan-87\nJul-87\nJan-88\nJul-88\nJan-89\nJul-89\nJan-90\nJul-90\nJan-91\nJul-91\nJan-92\nJul-92\nJan-93\nJul-93\nPrice\nbroadly evident across the entire period shown. However, note the seemingly puzzling 1980 to mid-\n1982 price behavior. During this period, prices plunged dramatically despite a slide in the stock/\nconsumption ratio to a major low . How can this counter-to-expected price action be explained? \n There is no mystery. Although the stock/consumption ratio is an important price-infl uencing \nfactor, it only refl ects supply. The apparent paradoxical behavior from 1980 to mid-1982 is explained \nby the fact that the model does not incorporate demand. During this period, the anticipation and \nultimate realization of a severe recession combined with high real interest rates (interest rate minus \ninfl ation rate) drastically reduced the inventories users wished to hold at each given price level. In \nother words, there was a sharp downward shift in the demand curve. This crucial fundamental devel-\nopment simply could not be refl ected by the model just described. \n The moral is that it is always necessary to take demand into account. The next section discusses \nseveral methods for incorporating demand in the price-forecasting model. But even when this type of \nanalysis is not poss", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 113}
{"text": "e level. In \nother words, there was a sharp downward shift in the demand curve. This crucial fundamental devel-\nopment simply could not be refl ected by the model just described. \n The moral is that it is always necessary to take demand into account. The next section discusses \nseveral methods for incorporating demand in the price-forecasting model. But even when this type of \nanalysis is not possible, demand must still be considered. If demand is not part of the model because \nof the inherent diffi culties in quantifying demand, then the analysis should be divided into two steps: \n 1. Model projection \n 2. Informal evaluation of the potential impact of demand factors \n368\nA Complete Guide to the Futures mArket\n ■ Possible Methods for Incorporating Demand\nHow can the problem of nonquantifiable demand be circumvented? The answer depends on the mar-\nket. The following types of markets permit various solutions to the problem of quantifying demand:\nStable Demand\nFor some markets, the supposition that demand is stable is a reasonable simplifying assumption. In \neffect, in this type of market, fundamental price forecasts can be based strictly on supply statistics.\nGrowth pattern in Demand Change\nFor other markets, although demand changes from year to year, the pattern of change can be described \nby a simplified assumption (e.g., demand increases by 3 percent annually). For markets of this type, \ndemand can be represented by an index that changes in a manner consistent with the assumed growth \npattern for demand.\nIdentification of Demand-Influencing Variables\nFor some markets, although changes in demand cannot be described by any consistent growth pat-\ntern, the factors that affect demand can be identified. For example, beef demand increases in some \nyears and decreases in others. Nevertheless, it can easily be demonstrated that these shifts are depen-\ndent on other identifiable factors, such as availability of competitive meat supplies. In such cases, one \ncan bypass the problem of precisely specifying the demand curve by directly formulating a price-\n \nforecasting model that uses supply statistics and the factors determining demand as inputs. An exam-\nple of such a model is given by the following equation:\nQCPf CS HS BS T= (, ,, )\nwhere QCP = average quarterly cattle price\n CS = quarterly cattle slaughter\n HS = quarterly hog slaughter\n BS = quarterly broiler slaughter\n T = time trend\nIn the preceding example, CS represents a supply variable, while HS, BS, and T represent variables \nthat affect demand. Trend affects demand through inflation (more will be demanded at each nominal \nprice level because of inflation) and possible other factors that have a trending characteristic.\nAs another example, in attempting to forecast copper prices, one of the ways we could incorpo-\nrate the demand effect would be by focusing on the level of activity in the key copper-using indus-\ntries. \n Figure 22.11 illustrates the relationship between copper prices and an index of new housing \nfor the same 21-year period that was surveyed in Figure 22.10. Figure 22.12 illustrates the rela-\ntionship between copper prices and domestic auto sales during the same period. Note how the \n369\nSUPPLY -DEMAND ANALYSIS: BASIC ECONOMIC THEORY\n FIGURE  22.11 Average Monthly Copper Nearest Futures Price vs. Index of New \nPrivate Housing \nJan-73\n20\n40\n60\n80\n¢/Lb.\nIndex\n100\n120\n140\n160\n180\n40\n60\n80\n100\n120\n140\n160\n180\n200\nJul-73\nJan-74\nJul-74\nJan-75\nJul-75\nJan-76\nJul-76\nJan-77\nJul-77\nJan-78\nJul-78\nJan-79\nJul-79\nJan-80\nJul-80\nJan-81\nJul-81\nJan-82\nJul-82\nJan-83\nJul-83\nJan-84\nJul-84\nJan-85\nJul-85\nJan-86\nJul-86\nJan-87\nJul-87\nJan-88\nJul-88\nJan-89\nJul-89\nJan-90\nJul-90\nJan-91\nJul-91\nJan-92\nJul-92\nJan-93\nJul-93\nPrice\nIndex\n FIGURE  22.12 Average Monthly Copper Nearest Futures Price vs. Annualized Seasonally \nAdjusted Auto Sales \nJan-73\nJul-73\nJan-74\nJul-74\nJan-75\nJul-75\nJan-76\nJul-76\nJan-77\nJul-77\nJan-78\nJul-78\nJan-79\nJul-79\nJan-80\nJul-80\nJan-81\nJul-81\nJan-82\nJul-82\nJan-83\nJul-83\nJan-84\nJul-84\nJan-85\nJul-85\nJan-86\nJul-86\nJan-87\nJul-87\nJan-88\nJul-88\nJan-89\nJul-89\nJan-90\nJul-90\nJan-91\nJul-91\nJan-92\nJul-92\nJan-93\n4\n5\n6\n7\n8\n9\n10\nPrice\n11\n12\n20\n40\n60\n80\n100\n¢/Ld.\n120\n140\n160\n180\nMillion\nSales\n370A COMPLETE GUIDE TO THE FUTURES MARKET\n FIGURE  22.13 Consumption as Proxy for Inelastic Demand \nQuantity (per unit time)\nPrice\nS1\nS1\nS2\nS2\nD1\nD2\nD3\nD4\nD1\nD2\nD3\nD4\ndeclines in housing starts and automobile sales preceded downturns in copper prices, including the \n1980 to mid-1982 decline. Recall from the previous section that the imposing 1980 to mid-1982 \nbear market seemed somewhat puzzling when viewed solely relative to the stock/consumption ratio. \nFigure 22.11 and 22.12 illustrate how this seeming paradox can be resolved once demand factors are \nconsidered. Of course, the specifi c demand factors included would change over time. For example, \nour copper illustration focused on the 1973–1993 time segment. In a current copper price model, \nindicators of emerging market demand would be far more critical than they were then. \n highly Inelastic Demand (and Supply elastic relative to Demand) \n Although conceptually incorrect, practically speaking, for markets of this type it is possible to use \nconsumption as a proxy for demand. Since by defi nition in these markets consumption in a given \nyear will not vary widely, regardless of price level, one can assume the prevailing consumption level \nroughly refl ects the demand level. For example, Figure 22.13 illustrates a series of inelastic demand \ncurves and two diff erent supply curves. Note how the quantity consumed at the equilibrium price \nlevel is primarily dependent on the prevailing demand curve. Hence, consumption can serve as a \nproxy indicator for the unknown demand curve. \n371\nSupply -DemanD analySiS: BaSic economic Theory\nAn example of this approach is provided by the following model:\nDASP f IS P\nC= +\n \n\nwhere DASP = deflated average annual sugar price\n IS = initial stocks\n P = production\n C = c", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 114}
{"text": "the equilibrium price \nlevel is primarily dependent on the prevailing demand curve. Hence, consumption can serve as a \nproxy indicator for the unknown demand curve. \n371\nSupply -DemanD analySiS: BaSic economic Theory\nAn example of this approach is provided by the following model:\nDASP f IS P\nC= +\n \n\nwhere DASP = deflated average annual sugar price\n IS = initial stocks\n P = production\n C = consumption\nNote that initial stocks plus production is a proxy for supply, and consumption is a proxy for demand.\n ■ Why Traditional Fundamental Analysis Doesn’t \nWork in the Gold Market\nUnfortunately, the approaches we have enumerated for dealing with the elusiveness of demand do \nnot encompass all cases. For some markets, not only is demand highly erratic, it is also difficult or \nnearly impossible to define a stable relationship that describes the precise dependence of demand on \nother variables.\nGold is a perfect example of such a market. Gold demand is basically dependent on the market’s \npsychological perception of the value of gold, which in turn is dependent on a myriad of interrelated \nvariables, including relative inflation rates, world interest rates, currency fluctuations, trade balance \nfigures, OPEC actions, and political turmoil. The problem of specifying gold demand is further com-\nplicated by the fact that the relative importance of any of these factors in influencing gold demand \nis subject to considerable variation. For example, during some periods, currency fluctuations may \nbecome the pivotal price-influencing factor, while at other times developments in this area exert only \na minor price impact.\nIn the case of gold, even the supply side of the equation cannot be readily approximated. Similar \nto demand, supply is subject to wide, erratic shifts that are also dependent on market psychology. This \ninstability of the supply curve is primarily attributable to shifts in dishoarding rather than to changes \nin commercial supply.\nThe combination of highly erratic, intangible supply and demand curves makes the gold market a \nfundamental analyst’s nightmare. Some analysts attempt to construct a fundamental model for gold \nby focusing on such statistics as mine production and industrial usage. This approach represents true \nfolly, since these figures are equal to only a minuscule fraction of total gold supply. Gold prices are \ndependent on the psychological considerations detailed earlier, and there is no way to avoid this fact.\nIn effect, for a market such as gold, the traditional fundamental approach just does not work. \nConstructing an econometric model to predict gold prices is like trying to write a computer program \nthat will predict a photographer’s next picture on the basis of her past shots—the answer may be \nsomewhat better than a blind guess but is hardly worth the effort.\n\n373\nChapter 23\nTypes of \nFundamental Analysis\nWhen you can measure what you are speaking about, and express it in numbers, you know \nsomething about it; but when you cannot measure it, when you cannot express it in numbers, \nyour knowledge is of a meager and unsatisfactory kind: it may be the beginnings of knowledge, \nbut you have scarcely, in your thoughts, advanced to the stage of science.\n—William Thomson, Lord Kelvin\n ■ The “Old Hand” Approach\nThe “old hand” approach refers to the analytical method used by analysts whose familiarity with \nthe market is so finely honed that they have developed a virtual sixth sense with respect to its price \nfluctuations. By talking to a variety of commercial participants, they get a feel for market tone. They \nare also well tuned in to the flow of market news and are constantly assessing the market’s behavior \nin response to this information. This is strictly a nonscientific approach, with the individual acting \nas the computer. It is not intrinsically inferior to more sophisticated approaches; its value is strictly \ndependent on the skills and intuition of the practitioner. In fact, it is hardly unusual for some analysts \nof this school to consistently outperform their econometrically oriented counterparts. This approach \nis strictly individualistic, however, and by definition can only be acquired by personal experience.\n ■ The Balance Table\nThe balance table summarizes the key components of current-season supply and disappearance, along \nwith prior-season comparisons. The balance between supply and disappearance will indicate a season-\nending carryover; it is the relative magnitude of this figure that is considered the primary price-\ndetermining statistic. Table 23.1 illustrates a U.S. Department of Agriculture (USDA) balance table \n374\nA Complete Guide to the Futures mArket\ntable 23.1 U.S. Wheat Supply/Disappearance balance, June–May Crop Y ear (million bushels)\n1988–1989 1989–1990 1990–1991 1991–1992 1992–1993 1993–1994 a\nBeginning stocks 1,261 702 536 366 472 529\nImports 23 23 37 41 70 75\nProduction 1,812 2,037 2,736 1,981 2,459 2,493\ntotal supply 3,096 2,762 3,309 2,888 3,001 3,097\nFood use 726 749 786 789 829 845\nSeed use 103 100 90 94 93 94\nFeed/Residual 146 143 500 254 196 325\nT otal domestic use 975 992 1,376 1,137 1,118 1,264\nExports 1,419 1,233 1,068 1,280 1,354 1,125\ntotal disappearance 2,394 2,225 2,444 2,416 2,472 2,389\nending stocks 702 536 866 472 529 708\nEnding stocks as % of \ntotal use 29 24 35 20 21 30\naProjected.\nSource: USDA.\nfor the wheat market. The analyst who relies heavily on the balance table will focus on possible shifts \nin the various components of supply and disappearance in an effort to anticipate the probable direc-\ntion of price change.\nThe balance table is a valuable aid that succinctly summarizes the key market statistics. By itself, \nhowever, the balance table is insufficient in answering the critical question of what price is right \nunder the given conditions. In fact, the analyst who uses only the balance-table approach to forecast \nprices will be guilty of fallacy number 1 detailed in Chapter 21 (i.e., viewing fundamentals in", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 115}
{"text": "e balance table is a valuable aid that succinctly summarizes the key market statistics. By itself, \nhowever, the balance table is insufficient in answering the critical question of what price is right \nunder the given conditions. In fact, the analyst who uses only the balance-table approach to forecast \nprices will be guilty of fallacy number 1 detailed in Chapter 21 (i.e., viewing fundamentals in a \nvacuum).\n ■ The Analogous Season Method\nIn the analogous season method, the analyst finds past seasons that shared the same fundamental charac-\nteristics of a current season and then uses the price profiles of those analogous seasons as a “road map” \nin projecting current season price swings. For example, if in the current season production is up, \nusage is down, and the ending stocks/usage ratio is down, the analyst might find all past seasons that \nalso exhibited these conditions. Next, the analyst would identify key price turning points in the analo-\ngous seasons (e.g., harvest low , postharvest high, winter low , crop-scare high). The timing and relative \nmagnitude of price swings between these key turning points would then be calculated for each past \nanalogous season. Finally, price swing ranges and turning point time windows would be projected for \nthe current season, based on the assumption that the current season price patterns would be at least \nroughly similar to the price action of prior analogous seasons.\n375\nTyPES oF FUNDAMENTAL ANALySIS\n ■ Regression Analysis\nHow can you determine which fundamental factors are most important in determining price levels? \nEven assuming you can make a reasonable conjecture as to what are the key fundamental factors \ninfluencing prices, how can you translate the current levels of these factors into a price forecast? \nSay, for example, you are trying to forecast hog futures prices. \nyou assume that hog prices will be \ninversely correlated with hog slaughter levels and also inversely correlated with competitive meat \nsupplies (e.g., broiler slaughter, cattle slaughter). \nyou also assume that for any combination of supply \nlevels for these various meats, prices will be higher in the current year than in past years because of \nthe influence of inflation. Even if all these assumptions are correct, how can you determine the price \nimplications for any given combination of the various meat supplies?\nSimply comparing current supply levels to past year levels will not yield any price forecast. For \nexample, what are the price implications of hog slaughter being 3 percent lower than in some prior \nyear while broiler slaughter and cattle slaughter are each 2 percent higher? How does one reconcile \nthe multiple comparisons of the current year to each of the past years examined? How much differ-\nence does a given time separation make when drawing comparisons between different years? All of \nthese questions seem impossible to answer by simply comparing current and past data.\nRegression analysis provides a statistical procedure that can be used to translate fundamental data \ninto price projections. The assumptions we just made regarding the plausible key influences on hog \nprices could be formalized into the following equation:\nPa bH bB bC bT=+ ++ +12 34\nwhere P = average price\n H = hog slaughter\n B = broiler slaughter\n C = cattle slaughter\n T = time trend\nThe values of a, b1, b2, b3, and b4 are determined by the regression analysis procedure (explained \nin the appendices). Given projections for hog slaughter, broiler slaughter, and cattle slaughter, we can \nplug those values and the time trend value for the current year into the preceding equation and obtain \na precise price forecast.\nEven if you are not mathematically inclined, think twice before dismissing the regression-analysis \napproach. Regression analysis embeds a number of important attributes:\n 1. Regression analysis makes it possible to combine multiple fundamental inputs, compared across \nmultiple years, to derive a price forecast.\n 2. Regression analysis can be used to test the relative significance of each of the price-influencing \nvariables (called independent variables) as well as the forecasting equation as a whole.\n 3. Regression analysis provides an efficient learning tool for understanding the interrelationships \nbetween various fundamental factors and price.\n376\nA Complete Guide to the Futures mArket\nRegression analysis is probably the single most useful analytical tool in fundamental analysis. \nAppendices A through F provide an in-depth discussion of regression analysis.\n ■ Index Models\nSometimes we may wish to construct a fundamental model that uses scores of explanatory variables as \nindicators of a market’s price. For example, we might postulate that bond prices are inversely related \nto a variety of inflation indicators (e.g., gold prices, S&P Goldman Sachs Commodity Index, con-\nsumer price index), economic indicators (e.g., employment, industrial production, housing starts), \nand monetary indicators (e.g., yield spread). Given the wide range of such indicators, and allowing \nthat each indicator can be used with multiple time lags (as the relationship between bond rates and \nan indicator will frequently not be contemporaneous), it is easy to see how the number of possible \nexplanatory variables could reach 50 or even higher.\nRegression analysis cannot handle situations that involve large numbers of explanatory (inde-\npendent) variables. Typically, a regression equation will employ five or fewer independent variables. \nThere are two primary reasons why regression analysis cannot be applied to cases involving a multi-\ntude of variables:\n 1. If large numbers of independent variables are used, there is a great danger of overfitting (i.e., \nderiving a model that is tailored to fit past data but will be useless as a tool for projecting future \nprices or price trends).\n 2. When large numbers of independent variables are employed it is virtually inevitable that a num-\nber of such variables wil", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 116}
{"text": "ases involving a multi-\ntude of variables:\n 1. If large numbers of independent variables are used, there is a great danger of overfitting (i.e., \nderiving a model that is tailored to fit past data but will be useless as a tool for projecting future \nprices or price trends).\n 2. When large numbers of independent variables are employed it is virtually inevitable that a num-\nber of such variables will be closely related to each other. High correlations among independent \nvariables in a regression model will result in a statistical problem called multicollinearity, which \ndestroys the reliability of the derived forecasting equation. (This problem is discussed in greater \ndetail in Appendix E.)\none method of handling a large number of explanatory variables is to combine them all in an \nindex model. The following step-by-step approach illustrates one possible procedure:\n 1. Assign each indicator a value of +1 if its current status is considered bullish for the price of the \ngiven market and a value of −1 if it is considered bearish. (How such a determination is made \nwill be discussed momentarily.)\n 2. Add all the assigned indicator values to obtain an index value.\n 3. Normalize the index by multiplying by 100 divided by number of indicators. This step will yield \nan index with a theoretical range of −100 (if all the indicators are bearish) to +100 (if all the \nindicators are bullish). For example, if there are 50 indicators, and 30 are bullish and 20 bearish, \nthe preceding procedure would yield a normalized index value of +20. \nof course, an equal split \nbetween bullish and bearish indicators would yield an index value of 0, as is intuitively desirable.\nThis procedure sounds simple enough. The key question, however, is: how does one determine if \na current indicator value is bullish or bearish? Deciding on some value as the division line between \n377\nTyPES oF FUNDAMENTAL ANALySIS\n bullish and bearish values is highly undesirable for two key reasons: (1) many variables trend over \ntime; and (2) due to structural changes over time, the definition of “high” and “low” will tend to shift \nfor many, if not most, variables. Hence, it is far more practical to categorize a variable as bullish or \nbearish based on its direction of movement (i.e., trend) rather than its level. Trend categorization, \nhowever, falls more within the realm of technical analysis than fundamental analysis. Indeed, some of \nthe very basic tools of technical analysis (e.g., crossover moving average) can be applied to defining \nthe assigned indicator values in an index model of the type described in this section. For example, if \nusing a crossover moving average to define the trend direction of the indicators, an indicator would \nbe assigned a value of +1 if the short-term moving average was greater than the long-term moving \naverage, and a value of −1 in the reverse case.\n\n379\nChapter 24\nThe Role \nof Expectations\nWhat we anticipate seldom occurs; what we least expect generally happens.\n—Benjamin Disraeli\n ■ Using Prior-Year Estimates Rather Than Revised Statistics\nHistorical data are based on final revised estimates rather than the estimates that were available at the \ntime. For example, the historical levels of U.S. corn production are revised throughout the season with \nthe final revision occurring after the end of the season. These final revised estimates for each season \n(the actual levels) can differ substantially from the crop estimates that prevailed during each season (the \nexpected levels). Similarly, historical corn consumption and export levels (the actual levels based on final \nrevised estimates) can be very different from the expected levels that prevailed during each season.\nTypically, fundamental models would use actual historical data as inputs. But is this default approach \nthe best procedure? A strong argument can be made that the data levels expected at the time are more \nrelevant to explaining price behavior than actual data levels that only became known after the price \nforecast period in question. Thus, it may be possible to build a more accurate model using past estimates \nrather than actual statistics as the price-explanatory variables. For example, if we are trying to construct \na model to explain and predict September–November corn prices, we might well find that the past \nproduction and usage estimates released during the September–November period are more helpful than \nthe actual supply statistics in explaining the year-to-year historical variation in September–November \nprices. Such price behavior would merely reflect that what the market thought was true in the past \nwas more important in determining prices than what was actually true (as defined by the final revised \nestimates)—a reasonable outcome given that market participants have no way of determining actual \nstatistics and must rely on prevailing estimates for their marketing, purchasing, and trading decisions.\nThe key point is that using past expected data rather than actual statistics might be theoretically \nsounder and may well yield better price-forecasting models. Of course, using past expected statistics in \n380\nA Complete Guide to the Futures mArket\na model will require considerably more work in terms of data gathering, which may explain why such \ndata are far less frequently used than the final revised numbers. As is true for most of life’s endeavors, \ncreating a better product (price-forecasting model in this case) requires more effort. There are no \nshortcuts in doing things right.\n ■ Adding Expectations as a Variable \nin the Price-Forecasting Model\nThus far, we have discussed the choice between using anticipated versus actual data for explaining \npast price variation. Regardless of which is used, one can also consider adding a variable to represent \nexpectations for a key statistic in a following season. T o clarify this distinction, we list the four possible \nvariations in the extent to which expectations are incorporated in a mo", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 117}
{"text": "ting Model\nThus far, we have discussed the choice between using anticipated versus actual data for explaining \npast price variation. Regardless of which is used, one can also consider adding a variable to represent \nexpectations for a key statistic in a following season. T o clarify this distinction, we list the four possible \nvariations in the extent to which expectations are incorporated in a model:\n 1. Price is a function of concurrent-season actual statistics (no use of expectations).\n 2. Price is a function of estimates for concurrent-season statistics (expectations used for concurrent-\nseason data).\n 3. Price is a function of concurrent-season actual statistics and expectations for the following sea-\nson (expectations used for following-season data).\n 4. Price is a function of concurrent-season estimates and expectations for the following season \n(expectations used for both concurrent- and following-season data).\nThe expectations for a coming season can often exert a more pronounced price impact than \ndo prevailing fundamentals. This observation is especially true during the latter half of a season—a \ntime at which the fundamentals for the given season are usually well defined and not subject to large \nvariation. In fact, frequently, when there is a dichotomy between the implications of old-crop funda-\nmentals and new-crop expectations, the latter tend to dominate the price picture.\nWhy should expectations for a coming season affect current-season prices? Expectations influence \ncurrent selling and buying psychology. For example, if supplies are burdensome and a shift toward \nsupply tightness is anticipated, sellers will have an incentive to hold back the commodity and will \noffer less to the market at each given price level (the supply curve will shift upward in response to \nreduced supply). At the same time, buyers will attempt to build inventories and therefore will pur-\nchase increased quantities at any given price level (the demand curve will shift upward). These two \neffects reinforce each other, and the net result will be higher prices in the current season.\n ■ The Influence of Expectations on Actual Statistics\nIronically, bullish new-crop expectations can actually cause current-season fundamentals to appear \nmore bearish. The following cause-and-effect diagram illustrates this point:\nBullish expectations forn ew crop pr iced uringo ld-c rops eason\no\n→↑ →\nlld-crop consumpt iona nd export so ld-c rops tock s↓→ ↑\n381\nTHE ROlE OF ExPEcTATIONS \nAs a result of this string of events, seasons that experience bullish new-crop expectations are likely \nto appear inexplicably overpriced based on old-crop fundamentals—another reason why new-crop \nexpectations should be incorporated in the price-forecasting model wherever possible.\n ■ Defining New-Crop Expectations\nOn the supply side, new-crop expectations can be based on planting intentions and subsequently on \nacreage estimates. In using these estimates to define expectations, one usually assumes a trend yield \n(the yield implied by a regression-derived best-fit line of past yields) or an average yield (e.g., five-\nyear average for each state or region) if there is no pronounced trend. Such neutral projections would \nthen be adjusted upward in the case of very favorable growing weather, or downward if conditions \nwere adverse.\nOn the usage side, expectations are defined by the historical behavior pattern. For example, if \nin recent years consumption changes for a given commodity have tended to range from −2 percent \nto +4 percent, as a function of the direction and magnitude of price change, in the absence of any \nadditional information, one might use a 1 percent consumption increase as a representative figure for \nexpected new-crop consumption.\nHistorical expectation statistics can be generated in a similar manner or by surveying past com-\nmentaries in U.S. Department of Agriculture situation reports, trade reports, and industry market \nreports. Unfortunately, there is some unavoidable arbitrariness in the latter approach, since the expec-\ntation figures depend on the sources chosen and on the weights assigned to each source. However, this \nambiguity is not a critical drawback, since at any given time, new-crop projections by various sources \ntend to cluster in the same general area.\n\n383Nothing so weakens government as persistent inflation.\n—John Kenneth Galbraith\nI\nn designing price-forecasting models, it is essential to keep in mind that the measure of prices—the \ndollar—is itself a variable. Thus, using nominal prices to compare widely separated years makes as \nmuch sense as comparing the dollar price of a commodity in one season to the euro price in another \nseason. It is safe to say that any model that does not adjust for inflation is critically flawed.\nFigures 25.1 through 25.4 illustrate the difference between nominal and inflation-adjusted prices \nin different futures markets from 1995 to 2015. These charts illustrate that adjusting for the effect of \ninflation can alter the relationship between past highs and lows, as well as the relative magnitudes of \nprior past moves. For example, in Figure 25.1, the 2004 highs in lumber nearest futures were above \nthe 1996 and 1999 highs in nominal terms (solid line), but lower than these previous peaks on an \ninflation-adjusted basis (dashed line). In Figure 25.2, in March 2004 soybean nearest futures eclipsed \ntheir March 1997 high on a nominal basis, but the inflation-adjusted series made a lower high in \nMarch 2004.\nFigure 25.3 compares nominal and inflation-adjusted copper nearest futures. Successively higher \nhighs in 2007 and 2008 in the nominal series were slightly lower highs in the deflated series. Also \nnote that although nominal prices were substantially higher at the end of the period than at the start, \ninflation-adjusted prices were near unchanged for period as a whole.\nFinally, in Figure 25.4, the nominal price graph reflects a strong uptrend in live cattle prices dur-\nin", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 118}
{"text": "Successively higher \nhighs in 2007 and 2008 in the nominal series were slightly lower highs in the deflated series. Also \nnote that although nominal prices were substantially higher at the end of the period than at the start, \ninflation-adjusted prices were near unchanged for period as a whole.\nFinally, in Figure 25.4, the nominal price graph reflects a strong uptrend in live cattle prices dur-\ning 1995 through 2011 (the sharp correction in 2008 notwithstanding), while the inflation-adjusted \nIncorporating \nInflation\nChapter 25\n384A CoMPlETE GUIDE To THE FUTUrES MArKET\n FIGURE /uni00A025.1 lumber: Nearest Futures, Nominal vs. Defl ated by PPI*\n *Monthly closing prices defl ated by PPI indexed to June 2005 = 100. \n FIGURE /uni00A025.2 Soybeans: Nearest Futures, Nominal vs. Defl ated by PPI* \n *Monthly closing prices defl ated by PPI indexed to June 2005 = 100. \n385\nINCorPorATING INFlATIoN\n FIGURE /uni00A025.3 Copper: Nearest Futures, Nominal vs. Defl ated by PPI*\n*Monthly closing prices defl ated by PPI indexed to June 2005 = 100. \n FIGURE /uni00A025.4 live Cattle: Monthly Nearest Futures, Nominal V ersus Defl ated by PPI*\n*Monthly closing prices defl ated by PPI indexed to June 2005 = 100. \n386\nA Complete Guide to the Futures mArket\nprice series moved essentially sideways during the same period, with little net change for the period \nas a whole. In other words, the entire rise in nominal prices during this 17-year period was nothing \nmore than the inflation effect.\nSome of the ways inflation can be incorporated into the price-forecasting model include the fol-\nlowing:\n 1. A representative inflation index is chosen, such as the producer price index (PPI), consumer \nprice index (CPI), or the gross domestic product (GDP) deflator, and each historical price is \ndivided by the contemporaneous index value, yielding a deflated price series. (Actually, the \nreported index value is divided by 100, since the index figures are quoted as a percent of a \nbase of 100.) The inflation-adjusted price series in Figure 25.1 through 25.4 were deflated in \nthis manner, using monthly PPI data with June 2005 as the base month (i.e., June 2005 PPI = \n100). Table 25.1 applies this method to corn futures price data. A price forecast derived using \nthis approach would be translated into current dollar terms by multiplying the projection by an \nestimate of the inflation index for the forecast period.\n 2. Alternately, all historical prices can be transformed into current dollar equivalents by mul-\ntiplying each past price by the ratio of the estimated inflation index for the forecast period \nto the index value during the given past period. Table 25.2 illustrates this approach for a \nSeptember–November 2015 forecast period, based on the assumption that PPI numbers are \navailable only through August 2015. The table estimates the average September–November \n2015 PPI by assuming the year-to-year percentage PPI change for this period will be the \nsame as the known year-to-year percentage change in the June–August 2015 average PPI. \n(The estimated 7.5 percent decrease in PPI using this approach compared with an actual \ndecrease of 7.3 percent.)\nNote that even when the PPI estimate used for the forecast period proves somewhat out of \nline, the distortion to the price analysis will be limited for two reasons. First, any reasonable \ninflation estimate will almost invariably be within a few percentage points of the actual figure \nand usually much closer. Second, all past prices will be overstated or understated equivalently \n(in percentage terms), thereby maintaining their relative relationship and leaving any price-\nexplanatory model virtually unaffected. In any case, the forecast error attributable to an inac-\ncurate inflation projection would be minuscule compared with the distortion that would result \nfrom the use of nominal rather than inflation-adjusted prices.\n 3. The inflation influence can be incorporated through its impact on the demand curve. Inflation \nimplies an upward shift in the demand curve. All else being equal, the amount consumed at each \ngiven price level will increase over time, since each nominal price level represents a lower real \nprice. However, because of the previously discussed problems in quantifying demand curves, \nthis method represents more of a theoretical concept than a practical approach.\nThe actual method used to adjust for inflation is of secondary importance. The key point is \nthat inflation is a critical input that should be incorporated in any fundamental price-forecasting \nmodel.\n387\nINCorPorATING INFlATIoN\ntable 25.1 Corn Monthly Nearest Futures prices: Nominal and Deflated\nY ear avg. Dec Futures price, Sep–Nov avg. Sep–Nov ppIa Inflation-adjusted avg. price\n1995 325.00 81.21 400.20\n1996 277.83 83.04 334.57\n1997 269.67 82.78 325.77\n1998 215.58 80.23 268.70\n1999 198.42 82.96 239.18\n2000 204.17 87.51 233.31\n2001 209.42 84.99 246.41\n2002 246.42 86.11 286.17\n2003 237.50 90.02 263.83\n2004 200.17 97.02 206.32\n2005 196.42 106.31 184.76\n2006 320.08 106.33 301.03\n2007 377.67 113.89 331.61\n2008 412.83 121.00 341.19\n2009 370.92 113.78 325.99\n2010 535.92 120.80 443.63\n2011 613.58 130.96 468.54\n2012 753.33 131.71 571.95\n2013 428.33 131.26 326.33\n2014 357.75 131.93 271.17\nareported index values would be divided by 100.0, since reported figures are quoted as a percentage of June 2005 base = 100.0.\nIronically, in the post-1979 period there were some instances when naïve price-forecasting mod-\nels that totally ignored the effect of inflation may actually have provided more accurate projections \nthan models incorporating this important factor. This apparent paradox can be explained by the \nextraordinarily high real interest rates (nominal rates minus inflation) witnessed in 1979–1980, \nwhich triggered a permanent change in inventory psychology. The high cost of holding commod -\nity inventories provided a strong incentive to reduce inventories all along the pipeline (from raw \nproduct to retail). In ef", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 119}
{"text": "ncorporating this important factor. This apparent paradox can be explained by the \nextraordinarily high real interest rates (nominal rates minus inflation) witnessed in 1979–1980, \nwhich triggered a permanent change in inventory psychology. The high cost of holding commod -\nity inventories provided a strong incentive to reduce inventories all along the pipeline (from raw \nproduct to retail). In effect, this widespread decision to hold lower inventories represented a classic \nexample of a downshift in the demand curve. \nonce set in motion by the shock of the high inflation/\nhigh interest rate environment of 1979–1980, and abetted by technological advances and new inven-\ntory theories (e.g., “just-in-time”), inventory demand continued to contract even when inflation and \ninterest rates fell sharply. The resulting sustained downshift in demand tended to counterbalance the \ninfluence of inflation.\nThe preceding discussion certainly is not intended to imply that inflation can be safely ignored, \nbut rather that major shifts in the demand for commodities, which can run counter to the inflation \n388\nA Complete Guide to the Futures mArket\neffect, as was the case for the pronounced downward shift in demand evident in the 1980s and early \n1990s, must also be incorporated. Some examples of ways the latter factor can be included (assuming \na regression model) are the addition of a trend variable\n1 and the use of a dummy variable to segment \nthe data by different periods. (Dummy variables are discussed in Appendix E.)\n1 Note that a trend variable need not increase for the entire period used in the analysis, but can be assumed to \nlevel off if the trending variable (the downward shift in demand in our example) is assumed to dissipate at some \npoint.\ntable 25.2 average September–November price of December Corn Futures: Nominal and estimated \n2015 Dollar equivalent terms\nY ear\navg. Dec Futures \nprice, Sep–Nov\navg. Sep– \nNov ppIa\nestimated avg. \nSep–Nov 2015 ppI\nMultiplier to Convert \npast Season prices into \n2015 terms\nDec Futures avg. \nSep–Nov price in \n2015 $ terms\n1995 325.00 81.31 120.16 1.478 480.35\n1996 277.83 83.24 120.16 1.444 401.19\n1997 269.67 82.63 120.16 1.454 392.10\n1998 215.58 80.02 120.16 1.502 323.80\n1999 198.42 82.91 120.16 1.449 287.51\n2000 204.17 87.84 120.16 1.368 279.30\n2001 209.42 83.86 120.16 1.433 300.10\n2002 246.42 86.24 120.16 1.393 343.26\n2003 237.50 90.24 120.16 1.332 316.35\n2004 200.17 97.56 120.16 1.232 246.61\n2005 196.42 106.48 120.16 1.128 221.56\n2006 320.08 106.37 120.16 1.130 361.69\n2007 377.67 114.99 120.16 1.045 394.67\n2008 412.83 115.38 120.16 1.041 429.76\n2009 370.92 114.65 120.16 1.048 388.72\n2010 535.92 121.84 120.16 0.986 528.42\n2011 613.58 130.11 120.16 0.923 566.33\n2012 753.33 131.09 120.16 0.917 690.80\n2013 428.33 130.85 120.16 0.918 393.21\n2014 357.75 129.90 120.16 0.925 330.92\naPPI indexed to June 2005 = 100.\n389\nChapter 26\nThe freeze may come in winter, but the seasonal rally comes in fall.\n—Jack D. Schwager\n ■ The Concept of Seasonal Trading\nVarious markets exhibit seasonal tendencies. Sometimes these seasonal patterns can be attributed \nto obvious fundamental causes, such as harvest selling or buying in front of potential freeze danger \nperiods for some agricultural markets. Financial markets can also exhibit seasonal patterns tied to \nfundamental causes (e.g., Treasury refundings, year-end book squaring). Sometimes, however, sea-\nsonal patterns will not be associated with any apparent fundamental factors.\nThe concept of utilizing seasonal patterns in making trading decisions is based on the assumption \nthat seasonal influences will cause biases in the movements of market prices. Of course, such correla-\ntions will be far from perfect. It is hardly uncommon for markets to move opposite to their normal \nseasonal trends. The key question is whether, on balance, there is enough positive correlation between \nfuture price movements and past seasonal patterns for such information to be useful. Because (as will \nbe detailed later) apparent seasonal patterns would be expected to appear even in random series, it is \ndifficult to determine to what extent seasonal price patterns reflect true biases as opposed to random \noccurrences. Hence, there is an unavoidable degree of subjectivity in deciding how much weight to \ngive past seasonal patterns. A reasonable approach is to use seasonal analysis as a supplement to fun-\ndamental and technical analysis in making trading decisions, but never as a sole input.\n ■ Cash versus Futures Price Seasonality\nIt is important to understand that seasonal patterns in futures and cash prices may not be equivalent. \nFor example, even if cash prices move lower for a given crop during harvest time with great con-\nsistency, it doesn’t mean this pattern will provide a trading opportunity. It is entirely possible the \nSeasonal Analysis\n390\nA Complete Guide to the Futures mArket\nfutures market will discount harvest-time weakness in the cash market, thereby eliminating any profit \nopportunity. Because we are concerned with trading futures, not the cash commodities or financial \ninstruments, the key question is whether a seasonal pattern exists in futures. Therefore, futures data \nshould be used for all seasonality calculations.\n ■ The Role of Expectations\nBecause markets tend to discount expected events, such as changes in the seasons, true seasonal \npatterns often differ radically from conventional beliefs regarding such patterns. For example, it is \nwidely believed that markets that are vulnerable to severe cold weather, such as heating oil, frozen \nconcentrated orange juice, and coffee, exhibit strength during the winter. (For coffee, the relevant \nwinter period is June through August.) However, these markets often exhibit seasonal strength prior \nto the advent of winter and tend to decline with the onset of winter.\n ■ Is It Real or Is It Probability?\nEven if a market exhibits a seemingly pronounced seasonal pattern, this does not mean a t", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 120}
{"text": "concentrated orange juice, and coffee, exhibit strength during the winter. (For coffee, the relevant \nwinter period is June through August.) However, these markets often exhibit seasonal strength prior \nto the advent of winter and tend to decline with the onset of winter.\n ■ Is It Real or Is It Probability?\nEven if a market exhibits a seemingly pronounced seasonal pattern, this does not mean a true seasonal \npattern exists. If enough markets are examined for enough periods of time, the emergence of some \napparent seasonal patterns will be a virtual certainty even if all the examined price series are random. In \nother words, past seasonal patterns could simply be due to normal probability and not suggest any \npotential bias for future price behavior.\nT o illustrate how patterns can occur—in fact, are likely to occur—even if the distribution of price \nmovements is random, we can use coin tosses to represent up or down price changes: heads repre-\nsents a week with a net price gain; tails a week with a net price loss. Assume we flip a coin 10 times \nto represent the price movement in a given market in each of the past 10 years. W e then repeat this \n10-flip trial for a total of 52 times (one corresponding to each week in the year).\nAlthough an equal number of heads and tails (i.e., an equal number of years of up and down price \nmovement) will be the most common event, more than 75 percent of the trials will yield an unequal num-\nber of heads and tails (an unequal number of up and down years). In fact, some of these trials will result in \na highly unbalanced number of heads and tails. It can be shown through probability theory that in 52 trials \n(weeks) there is a better than 75 percent chance of getting one or more 10-flip trials with at least 9 out \nof 10 heads or tails (one or more weeks with at least 9 out of 10 years of up or down price movements).\nIf the preceding process of 52 ten-flip trials is repeated a total of 25 times (to represent 25 dif-\nferent markets), then the probability of getting one or more 10-flip trials with at least 9 of 10 heads \nor tails is a virtual certainty (99.999999998 percent). In fact, there is a better than 99 percent prob-\nability there will be more than 15 ten-flip trials with at least 9 out of 10 heads or tails. T o state this \nin market equivalent terms, even if the distribution of up and down price movements is random in \nall markets, in a group of 25 markets, there is a better than 99 percent chance of finding more than \n15 instances in which a market moved higher (or lower) in at least 9 out of the past 10 years during a \n391\nSEASONAl ANAlySIS\ngiven week. Thus, it is important to understand that a certain number of apparent seasonal patterns \nare inevitable even if the distribution of price movements is random.\n ■ Calculating a Seasonal Index\nThere are many methods for calculating a seasonal index. This section examines two basic approaches.\naverage percentage Method\nThe average percentage method is by far the simplest way to calculate a seasonal index. This method \ninvolves the following steps:\n 1. Calculate an annual average for each year or season.\n 2. Express each data item (daily, weekly, or monthly value) as a percentage of the corresponding \nannual average. Either daily, weekly, or monthly data can be used in constructing seasonal indi-\nces. A daily or weekly seasonal index is obviously preferable to a monthly index, particularly \nfor trading purposes, but it also requires far more data manipulation. This section uses monthly \nindices solely for simplicity of illustration.\n 3. Average the percentage values for each period (month, week, or day). The resulting figures are \nthe seasonal index.\nT o illustrate this method, we will calculate the seasonal index for heating oil. Table 26.1 lists the \naverage monthly prices for the 1996–2015 December heating oil contracts (which expire in Novem-\nber). Note the first column of data (November) is listed for later use and is not included in calculating \nthe annual average. The final column in Table 26.1 indicates the 12-month average for each contract. \nTable 26.2 expresses each monthly price as a percentage of the annual average. These percentage \n figures are then averaged for each month to yield a seasonal index at the bottom of the table.\nIn calculating a seasonal index, it is wise to check for any extreme years that might distort the \nresults. The question of what constitutes an extreme year can only be answered subjectively. With \nregard to the heating oil market from 1996 through 2015, one year stands out: 2008. As Table 26.1 \nshows, the December 2008 heating oil contract traversed an extraordinarily wide range. It is usually \nbest to exclude such uncharacteristic years when calculating a seasonal index, unless some adjustment \nscheme is used to modify their exaggerated influence. However, there are no concrete rules, and the \nultimate decision must depend on the judgment of the researcher.\nAlthough a sense of the seasonal pattern can be gained by examining the seasonal index at the bot-\ntom of Table 26.2, a graphic presentation is far more convenient and informative. Figure 26.1 shows the \nseasonal index, both with and without the inclusion of 2008. In this case, the extreme year does not have \na significant impact on the basic seasonal pattern. As is readily apparent, there is a seasonal tendency for \nprices to reach relative highs around September\n –October and to bottom around December–January.\nIt is important to note the average percentage method does not remove any trend from the data. \nThus, what appears to be a seasonal pattern might partially reflect a long-term trend in prices. In fact, \n392\ntable 26.1 December heating Oil Contract: average Monthly prices\nY ear of Contract \nexpiration Nova Dec Jan Feb Mar apr May Jun Jul aug Sep Oct Nov Dec–Nov avg\n1996 0.507 0.515 0.510 0.509 0.527 0.543 0.538 0.543 0.572 0.601 0.672 0.711 0.701 0.579\n1997 0.587 0.591 0.610 0.586 0.584 0.574 0.591 0.574", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 121}
{"text": "ppears to be a seasonal pattern might partially reflect a long-term trend in prices. In fact, \n392\ntable 26.1 December heating Oil Contract: average Monthly prices\nY ear of Contract \nexpiration Nova Dec Jan Feb Mar apr May Jun Jul aug Sep Oct Nov Dec–Nov avg\n1996 0.507 0.515 0.510 0.509 0.527 0.543 0.538 0.543 0.572 0.601 0.672 0.711 0.701 0.579\n1997 0.587 0.591 0.610 0.586 0.584 0.574 0.591 0.574 0.567 0.573 0.575 0.600 0.564 0.582\n1998 0.572 0.553 0.528 0.514 0.495 0.500 0.489 0.458 0.435 0.398 0.417 0.416 0.358 0.463\n1999 0.444 0.418 0.411 0.386 0.427 0.469 0.466 0.475 0.535 0.570 0.609 0.589 0.641 0.500\n2000 0.563 0.570 0.601 0.651 0.686 0.647 0.720 0.794 0.794 0.877 0.977 1.016 1.004 0.778\n2001 0.771 0.725 0.722 0.750 0.734 0.754 0.803 0.789 0.733 0.760 0.739 0.643 0.568 0.727\n2002 0.600 0.596 0.597 0.596 0.665 0.702 0.707 0.685 0.709 0.735 0.787 0.778 0.720 0.690\n2003 0.669 0.702 0.748 0.805 0.779 0.722 0.738 0.781 0.808 0.841 0.780 0.842 0.841 0.782\n2004 0.760 0.785 0.828 0.841 0.899 0.916 1.018 1.036 1.120 1.219 1.272 1.491 1.402 1.069\n2005 1.282 1.189 1.225 1.324 1.533 1.622 1.498 1.655 1.789 1.956 2.047 1.992 1.716 1.629\n2006 1.807 1.857 1.934 1.959 1.949 2.128 2.135 2.171 2.239 2.177 1.916 1.729 1.725 1.993\n2007 1.940 1.943 1.788 1.861 1.947 2.004 2.011 2.072 2.156 2.065 2.192 2.352 2.604 2.083\n2008 2.445 2.477 2.531 2.624 2.897 3.115 3.634 3.902 3.917 3.383 3.001 2.438 1.926 2.987\n2009 2.140 1.695 1.710 1.481 1.528 1.575 1.685 1.961 1.810 1.951 1.818 1.963 1.985 1.763\n2010 2.261 2.213 2.209 2.118 2.231 2.378 2.234 2.162 2.090 2.140 2.163 2.279 2.343 2.213\n2011 2.441 2.521 2.700 2.984 3.115 3.299 3.123 3.027 3.076 2.987 2.937 2.904 3.059 2.978\n2012 2.971 2.919 3.000 3.160 3.276 3.214 2.988 2.657 2.811 3.019 3.139 3.122 3.014 3.027\n2013 2.966 2.974 3.015 3.065 2.977 2.912 2.875 2.911 2.983 3.073 3.047 2.982 2.950 2.980\n2014 2.904 2.963 2.915 2.921 2.937 2.917 2.921 2.986 2.952 2.879 2.763 2.558 2.374 2.840\n2015 2.375 2.073 1.813 1.903 1.897 1.922 2.015 1.959 1.791 1.583 1.613 1.547 1.452 1.797\naNovember of year preceding the contract year. This column is needed to calculate Table 26.3.\n393\ntable 26.2 December heating Oil Contract: Monthly price as a percentage of the December–November average\nY ear of Contract \nexpiration Dec Jan Feb Mar apr May Jun Jul aug Sep Oct Nov\n1996 88.98 88.23 88.03 91.14 93.87 92.90 93.92 98.87 103.79 116.20 122.85 121.21\n1997 101.58 104.71 100.63 100.21 98.54 101.46 98.50 97.29 98.46 98.71 103.09 96.82\n1998 119.36 113.98 111.00 106.75 107.83 105.46 98.76 93.94 85.97 89.97 89.80 77.18\n1999 83.77 82.32 77.32 85.38 93.79 93.27 95.04 107.05 114.11 121.92 117.81 128.22\n2000 73.26 77.23 83.67 88.15 83.09 92.53 102.08 102.05 112.71 125.60 130.58 129.07\n2001 99.76 99.44 103.16 101.02 103.82 110.46 108.63 100.83 104.54 101.72 88.50 78.11\n2002 86.40 86.59 86.45 96.42 101.80 102.44 99.28 102.74 106.53 114.13 112.80 104.43\n2003 89.80 95.63 102.86 99.60 92.25 94.41 99.82 103.24 107.49 99.76 107.59 107.56\n2004 73.41 77.43 78.72 84.08 85.72 95.26 96.92 104.80 114.03 119.00 139.49 131.12\n2005 72.99 75.22 81.29 94.12 99.56 91.94 101.64 109.82 120.06 125.69 122.28 105.39\n2006 93.16 97.01 98.28 97.76 106.75 107.12 108.92 112.35 109.23 96.14 86.73 86.54\n2007 93.28 85.82 89.37 93.47 96.21 96.54 99.48 103.50 99.13 105.23 112.94 125.01\n2008 82.92 84.73 87.84 96.98 104.28 121.65 130.65 131.13 113.26 100.47 81.63 64.47\n2009 96.14 96.95 83.98 86.64 89.31 95.56 111.19 102.64 110.63 103.11 111.31 112.57\n2010 100.00 99.80 95.71 100.82 107.42 100.93 97.69 94.44 96.68 97.71 102.96 105.84\n2011 84.67 90.67 100.21 104.60 110.78 104.88 101.66 103.31 100.33 98.62 97.54 102.73\n2012 96.44 99.13 104.41 108.23 106.17 98.74 87.79 92.87 99.76 103.71 103.16 99.58\n2013 99.77 101.17 102.83 99.89 97.72 96.47 97.68 100.08 103.11 102.25 100.05 98.98\n2014 104.33 102.61 102.82 103.38 102.69 102.83 105.12 103.91 101.36 97.29 90.06 83.59\n2015 115.31 100.86 105.88 105.53 106.95 112.14 108.97 99.66 88.07 89.77 86.08 80.77\naverages:\nall Y ears 92.77 92.98 94.22 97.21 99.43 100.85 102.19 103.23 104.46 105.35 105.36 101.96\nexcl. 2008 93.28 93.41 94.56 97.22 99.17 99.75 100.69 101.76 104.00 105.61 106.61 103.93\n394A COMPlETE GUIDE TO THE FUTURES MARKET\nfor data exhibiting a strong trend, the eff ect of the trend will often totally swamp any true seasonal \npattern. (By this we mean the seasonal pattern that remains after the trend has been removed from \nthe data.) An unadjusted seasonal index, such as the average percentage method, is relevant because \nit more directly refl ects the past results of implementing a position on a given date and exiting it on \nanother given date. However, because secular trends may change, it can be argued that the detrended \nseasonal index might be more relevant in refl ecting seasonal patterns. The next section describes one \nmethod for deriving a detrended seasonal index. \n link relative Method \n The link relative method involves the following steps: \n 1. Express each data value as a percentage of the previous month’s value. \n 2. Average these percentage values for each month. \n 3. Set the fi rst month’s value at 100.0 and reexpress all the other monthly averages as relative \npercentages of the fi rst month’s value. \n 4. Adjust the resulting values for trend. \n 5. Multiply each of these values by the appropriate common factor so that the average monthly \nseasonal index value equals 100.0. \n These steps will be clearer if we work through an example. Table 26.3 indicates each month’s \nprice as a percentage of the previous month’s price. (These fi gures are derived from Table 26.1 .) The \nmonthly averages for all these percentages are listed at the bottom of the table. \n FIGURE  26.1 December Heating Oil Contract Seasonal Index: Average Percentage \nMethod \n December Heating Oil Contract Seasonal Index: Average Percentage \n\n395\ntable 26.3 December heating Oil Contract: Monthly average price as a percentage of the previous Month’s price\nY ear of Contract \nexpiration Dec Jan Feb Ma", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 122}
{"text": "e \nmonthly averages for all these percentages are listed at the bottom of the table. \n FIGURE  26.1 December Heating Oil Contract Seasonal Index: Average Percentage \nMethod \n December Heating Oil Contract Seasonal Index: Average Percentage \n\n395\ntable 26.3 December heating Oil Contract: Monthly average price as a percentage of the previous Month’s price\nY ear of Contract \nexpiration Dec Jan Feb Mar apr May Jun Jul aug Sep Oct Nov\n1996 101.51 99.16 99.77 103.53 103.00 98.97 101.10 105.26 104.98 111.95 105.73 98.66\n1997 100.70 103.09 96.10 99.58 98.33 102.96 97.08 98.78 101.20 100.25 104.44 93.92\n1998 96.74 95.50 97.39 96.17 101.01 97.80 93.65 95.11 91.52 104.65 99.82 85.94\n1999 94.23 98.27 93.93 110.42 109.85 99.45 101.90 112.64 106.59 106.84 96.63 108.84\n2000 101.21 105.43 108.33 105.35 94.26 111.37 110.31 99.97 110.45 111.43 103.97 98.84\n2001 93.95 99.68 103.74 97.93 102.77 106.39 98.35 92.82 103.68 97.30 87.01 88.26\n2002 99.38 100.23 99.83 111.53 105.59 100.63 96.91 103.49 103.68 107.13 98.84 92.58\n2003 104.99 106.50 107.56 96.82 92.62 102.34 105.74 103.43 104.12 92.80 107.85 99.97\n2004 103.24 105.47 101.67 106.81 101.95 111.13 101.74 108.14 108.81 104.36 117.22 94.00\n2005 92.72 103.06 108.07 115.79 105.77 92.35 110.54 108.05 109.33 104.69 97.29 86.18\n2006 102.77 104.13 101.31 99.48 109.20 100.34 101.69 103.15 97.22 88.02 90.21 99.78\n2007 100.16 92.01 104.13 104.58 102.94 100.34 103.05 104.04 95.78 106.15 107.33 110.69\n2008 101.31 102.18 103.67 110.41 107.52 116.65 107.40 100.37 86.38 88.71 81.24 78.98\n2009 79.23 100.84 86.63 103.16 103.08 106.99 116.36 92.31 107.78 93.21 107.95 101.13\n2010 97.90 99.80 95.91 105.33 106.55 93.96 96.79 96.67 102.38 101.06 105.38 102.79\n2011 103.30 107.09 110.52 104.38 105.91 94.67 96.93 101.62 97.11 98.29 98.91 105.32\n2012 98.24 102.79 105.32 103.66 98.10 92.99 88.92 105.79 107.41 103.97 99.47 96.52\n2013 100.26 101.40 101.64 97.14 97.84 98.72 101.25 102.46 103.03 99.17 97.85 98.93\n2014 102.05 98.35 100.21 100.54 99.33 100.13 102.23 98.85 97.55 95.98 92.57 92.82\n2015 87.27 87.46 104.98 99.67 101.34 104.85 97.18 91.46 88.37 101.93 95.88 93.84\naverage 98.06 100.62 101.54 103.61 102.35 101.65 101.46 101.22 101.37 100.89 99.78 96.40\n396\nA Complete Guide to the Futures mArket\nAs the next step, in Table 26.4 we express each month’s value relative to the first month \n(December), which is set at 100.0. Thus, since the average ratio of January to December prices \nis 100.62 percent from Table 26.3, its value is set to 100.62 (i.e., 100.62 percent of 100.0). \nSimilarly, since the average ratio of February to January prices is 101.54 percent, the February \nvalue would be set to 101.54 percent of 100.62 or 102.17. The value for March would be \n103.61 percent of 102.17, or 105.86, and so on. Note that the entry for the second value of \nDecember is equal to 98.06 percent of the November value (98.06 is the average December \nvalue from Table 26.3).\nThe higher value for the second December entry reflects the trend in the data. T o remove this \ntrend, we must find the constant factor that will increase to 109.10 (the ratio of the second Decem-\nber value to the first) when multiplied by itself 12 times. In other words, we want to find a constant \nmonthly growth factor X. This can be expressed as X\n12 = 109.10. The derivation of this value requires \nthe use of logarithms (readers unfamiliar with logarithms can skip to the immediately following \ndescription of an alternative approach for detrending the data):\nX\nX\nX\nX\n12 10 91\n12 1 091\n11 21 091\n00 031\n=\n=\n=\n=\n(. )\nlogl og(. )\nlogl og(. )\nlog.\n/\n552\n00 03152 10 07284antilogo\nfr ounded to1.0073.. ,=\nIn other words, (1.0073)12 = 1.091.\nW e assume a constant growth trend. The first month’s (December) value will still equal 100.0; the \nsecond month’s value will be divided by 1.0073; the third month’s value will be divided by (1.0073)2; \nthe fourth by (1.0073) 3, and so on. These calculations are illustrated in Table 26.5. The final month \n(the second December entry) will be divided by (1.0073)12, thereby transforming its value to 100.0. \nSince both December values are equal after the adjustment of the data by the constant growth factor, \nthe trend has been removed from the data.\nalternative approach\nThe following steps, which do not require the use of logarithms, can be used to derive a reasonably \ngood approximation of the last column in Table 26.5.\ntable 26.4 December heating Oil Contract 1996–2015: Monthly average price as a percentage of the \nprior December average price\nDec Jan Feb Mar apr May Jun Jul aug Sep Oct Nov Dec\n100 100.62 102.17 105.86 108.35 110.14 111.74 113.10 114.65 115.67 115.42 111.26 109.10\n397\nSEASONAl ANAlySIS\n 1. Find the difference between the two December values in Table 26.4 (9.10).\n 2. Multiply this difference by 1/12 and subtract the product from the second month’s (January) \nvalue (100.62 − 0.76 = 99.86).\n 3. Multiply the difference found in step 1 by 2/12 and subtract the product from the third month’s \nvalue. Multiply the difference found in step 1 by 3/12 and subtract the product from the fourth \nmonth’s value. Continue this progression for the remaining months. Using this method, the \nadjusted values would be:\nDec Jan Feb Mar apr May Jun Jul aug Sep Oct Nov\n100 99.86 100.65 103.59 105.32 106.35 107.19 107.79 108.58 108.85 107.84 102.92\nThese approximated figures are very close to the precise adjusted values shown in Table 26.5.\nFor the sake of uniformity, it is desirable that the average of the monthly seasonal index values \nequal 100, or equivalently, that the sum of the monthly index values equal 1200. Table 26.5 shows the \nsum of the index values in this case is more than 1200, which makes it necessary to adjust the figures \nby a multiplier:\nMultiplier == 1200\n1256 71 09 549. .\nDividing each of the values in Table 26.5 by 0.9549 produces the seasonal index values in Table 26.6, \nwhich are plotted in Figure 26.2. The average percentage method and link relative method indices are \ncompared in Fi", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 123}
{"text": "Table 26.5 shows the \nsum of the index values in this case is more than 1200, which makes it necessary to adjust the figures \nby a multiplier:\nMultiplier == 1200\n1256 71 09 549. .\nDividing each of the values in Table 26.5 by 0.9549 produces the seasonal index values in Table 26.6, \nwhich are plotted in Figure 26.2. The average percentage method and link relative method indices are \ncompared in Figure 26.3. Note there is a great deal of similarity between the two methods. The basic \ntable 26.5 trend adjustment for Monthly Index Values\nMonth Values from table 26.4 trend-adjustment Divisor\ntrend-adj. Divisor \nNumerical equivalent adjusted Value\nDec 100 100\nJan 100.62 (1.007284)1 1.007284 99.89\nFeb 102.17 (1.007284)2 1.014621 100.69\nMar 105.86 (1.007284)3 1.022012 103.58\nApr 108.35 (1.007284)4 1.029456 105.25\nMay 110.14 (1.007284)5 1.036954 106.21\nJun 111.74 (1.007284)6 1.044508 106.98\nJul 113.10 (1.007284)7 1.052116 107.50\nAug 114.65 (1.007284)8 1.059779 108.18\nSep 115.67 (1.007284)9 1.067499 108.36\nOct 115.42 (1.007284)10 1.075275 107.34\nNov 111.26 (1.007284)11 1.083107 102.73\ntotal 1256.71\n398A COMPlETE GUIDE TO THE FUTURES MARKET\n table 26.6 Seasonal Index for December heating Oil Contract Using the link relative Method \n Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov \n95.49 95.38 96.15 98.91 100.50 101.42 102.15 102.65 103.30 103.47 102.50 98.09\n FIGURE  26.2 December Heating Oil Contract Seasonal Index: link Relative Method \n December Heating Oil Contract Seasonal Index: link Relative Method \n FIGURE  26.3 December Heating Oil Seasonal Index: Comparison of Average Percentage \nMethod and link Relative Method \n December Heating Oil Seasonal Index: Comparison of Average Percentage \n\n399\nSEASONAl ANAlySIS\ndiff erence is that the average percentage method index refl ects the long-term trend, whereas the link \nrelative method does not. Both approaches indicate a relative low in the December–January period \nand a relative high in September. \n Figures 26.4 through 26.9 Illustrate the seasonal graphs for specifi c contract months in several \nfutures markets, both unadjusted (average percentage method) and detrended (link relative method), \n FIGURE  26.4 December WTI Crude Oil Seasonal Index: Comparison of Average \nPercentage Method and link Relative Method \n FIGURE  26.5 December E-Mini S&P 500 Seasonal Index: Comparison of Average \nPercentage Method and link Relative Method \n December E-Mini S&P 500 Seasonal Index: Comparison of Average \n\n400A COMPlETE GUIDE TO THE FUTURES MARKET\n FIGURE  26.6 December Gold Seasonal Index: Comparison of Average Percentage \nMethod and link Relative Method \n FIGURE  26.7 September Coff ee Seasonal Index: Comparison of Average Percentage \nMethod and link Relative Method \n\n401\nSEASONAl ANAlySIS\n FIGURE  26.8 November Frozen Concentrated Orange Juice Seasonal Index: \nComparison of Average Percentage Method and link Relative Method \n November Frozen Concentrated Orange Juice Seasonal Index: \n FIGURE  26.9 December Corn Seasonal Index: Comparison of Average Percentage \nMethod and link Relative Method \n December Corn Seasonal Index: Comparison of Average Percentage \nbased on data from 1996 through 2015 (with the exception of the E-mini S&P 500 in Figure 26.6 , \nwhich used data from 1998 through 2015). \n It should be stressed that seasonal patterns should never be used as the sole basis for making trad-\ning decisions, as they are only one infl uence and can easily be swamped by fundamental and technical \nforces impacting the market. \n\n403\nChapter 27\nMarkets are never wrong—opinions often are.\n—Jesse Livermore\n ■ Evaluating Market Response for Repetitive Events\nA market’s response to key fundamental developments can provide important clues about the prob-\nable future price direction. When these developments are repetitive, such as the release of key eco-\nnomic numbers or U.S. Department of Agriculture (USDA) reports, a systematic approach can be \nused to analyze the implications of market response. The general analytic procedure would involve \nthe following steps:\n 1. Identify the event to be studied (e.g., the Treasury market’s response to the monthly employ-\nment report).\n 2. Construct a table comparing the market’s immediate reaction to a report’s release to subse-\nquent price trends.\n 3. Search for consistent patterns.\nThere is no single correct format for analyzing market response. The objective of this chapter is to \nillustrate the analysis process rather than to provide specific market-response models for trading the \nmarkets. The observed responses in the following examples are moderate and there is not enough data \nto rule out that the results could simply be due to chance. The reader can apply a similar methodology \nfor analyzing market reaction for other situations that may be of interest.\nAnalyzing Market \nResponse\n404\nA Complete Guide to the Futures mArket\nexample a: t-Note Futures response to Monthly \nU.S. employment report\nThe U.S. employment situation report released by the Bureau of Labor Statistics is the most closely \nwatched monthly economic release, capable of triggering volatile moves in a wide range of markets. \nLet’s say our goal is to check whether the direction (and magnitude) of the price move in U.S. Trea-\nsury futures on the day the monthly employment report is released is indicative of the price action \nin subsequent weeks. In other words, we want to check the hypothesis that a “bullish” or “bearish” \nmarket response to the employment report is an indicator of probable near-term price direction. W e \nmight proceed as follows:\n 1. Determine the threshold to determine a bullish or bearish initial response to the employment report.\n 2. Measure the market’s price action in the N days following employment report days that satisfy \nthis criterion.\nTable 27.1 shows how the U.S. 10-year- T -note futures traded in the first 10 trading days (two \nweeks) after the monthly employment report between 2006 and 2015 based on whether the move \nfrom the cl", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 124}
{"text": "reshold to determine a bullish or bearish initial response to the employment report.\n 2. Measure the market’s price action in the N days following employment report days that satisfy \nthis criterion.\nTable 27.1 shows how the U.S. 10-year- T -note futures traded in the first 10 trading days (two \nweeks) after the monthly employment report between 2006 and 2015 based on whether the move \nfrom the close of the day prior to the report to the report day’s close was bullish or bearish. In this \ncase, a bullish initial response was defined as a closing gain (measured from the previous day’s close) \nof 0.50 points (16/32) or more on the day of the employment report, while a bearish initial response \nwas defined as a 0.50-point or larger decline. (This nominal amount was selected solely for illustra-\ntion purposes and has no special significance.)\nTwenty-six employment report days fulfilled the bullish criteria from 2006 through 2015 (top half \nof table), while 33 fulfilled the bearish criteria (bottom half of table). Table 27.1 shows the cumula-\ntive average and median gains from the close of the employment report day to the closes of the next \n10 days. For comparison, the table also includes the average price changes for all 1- to 10-day periods \nduring the 10-year analysis window . The table also shows the percentage of times the T -note futures \ncontract closed higher than the employment report day close after bullish and bearish initial responses \nto the report, along with the percentage of higher closes for all 1- to 10-day periods. For example, \non the first day after bullish initial reactions to the employment report, 10-year T -note futures closed, \non average, –0.054 points lower (–0.039 points median), compared to an average 0.021-point one-\nday gain for all days. The market closed higher 42.31 percent of the time one day after initial bullish \nresponses, compared to 51.93 percent for all days.\nBecause it is often easier to digest such data visually, Figure 27.1 graphs the results for the bullish \ninitial responses, while Figure 27.2 graphs the results for the bearish initial responses. Surprisingly, \nthe analysis suggests that, if anything, there was a tendency for T -note price action in the near-term \nperiod following employment reports to move in the opposite direction of the market’s initial \nresponse. Specifically, there seems to be a notable tendency for contrarian price action in the two \ndays following a bullish initial response to the unemployment report (after which trading was mixed), \nwhile the price action was more consistently bullish after an initial bearish response. Figure 27.1 \nshows that after two days T -notes closed below the close of the employment report day 73 percent of \nthe time, with an average decline of 0.205 points (around 6/32nds). This observation suggests that \nthose seeking to enter a position in the direction of the market’s bullish response to the report might \n405\nAnALyzIng MARkeT ReSPonSe\n taBLe 27.1 10-Y ear t -Note Futures response to Monthly employment report: Cumulative Change as of \nIndicated Day (2006–2015) \nBullish\n26 instances Day 1 Day 2 Day 3 Day 4 Day 5 Day 6 Day 7 Day 8 Day 9 Day 10 \nMedian post-report \nChange \n-0.039 -0.172 0.016 0.164 0.211 0.063 0.117 0.344 -0.055 0.117\naverage post-report \nChange \n-0.054 -0.205 -0.035 -0.030 0.119 0.214 0.093 0.189 0.082 0.111\naverage Change \nall Days \n0.021 0.042 0.063 0.084 0.105 0.126 0.147 0.168 0.188 0.208\nhigher Close than \nreport Day (% times) \n42.31% 26.92% 50.00% 53.85% 65.38% 53.85% 53.85% 53.85% 46.15% 57.69%\nall Days higher Close \n(%times) \n51.93% 53.85% 55.09% 55.24% 54.94% 55.04% 56.09% 57.14% 56.79% 56.79%\nBearish \n33 instances Day 1 Day 2 Day 3 Day 4 Day 5 Day 6 Day 7 Day 8 Day 9 Day 10 \nMedian post-report \nChange \n0.031 0.219 0.141 0.328 0.484 0.422 0.406 0.609 0.313 0.484\naverage post-report \nChange \n0.081 0.285 0.306 0.401 0.474 0.605 0.707 0.649 0.622 0.603\naverage Change \nall Days \n0.021 0.042 0.063 0.084 0.105 0.126 0.147 0.168 0.188 0.208\nhigher Close than \nreport Day (% times) \n51.52% 57.58% 57.58% 63.64% 63.64% 72.73% 69.70% 66.67% 72.73% 63.64%\nall Days higher Close \n(%times) \n51.93% 53.85% 55.09% 55.24% 54.94% 55.04% 56.09% 57.14% 56.79% 56.79%\n FIGURE  27.1 \n 10- y ear T -note after Bullish Initial Response to Jobs Report (Cumulative) \n0.35\n75%\n50%\n25%\n0%\nPost-report average\nPost-report higher close\n12 34 56 78 91 0\nAll days higher close\nAll days average\nPost-report median\n0.15\n−0.05Gain/loss from report day close\n% higher closes\nDay\n−0.25\n406A CoMPLeTe gUIDe To THe FUTUReS MARkeT\nbe better off waiting a couple of days before entering a position. In contrast, Figure 27.2 highlights the \nmarket’s tendency to move higher after bearish initial responses. It should be noted that the period \nsurveyed was one that witnessed a long-term uptrend. Therefore, the appropriate comparison is to \nthe corresponding changes for all days. \n Figures 27.3 and 27.4 present a slightly diff erent perspective of the performance of 10-year T -note \nfutures after bullish and bearish initial responses to the monthly employment report. Instead of show-\ning the cumulative performance from the close of the employment report day, these charts show each \nday’s gain or loss. Figure 27.3 highlights the negative average returns in the fi rst two days after bull-\nish initial responses, while Figure 27.4 shows a tendency for higher prices in the fi rst two days after \nbearish report responses. \n In examining historical patterns (e.g., market response, seasonal tendencies), it is usually impos-\nsible to say whether apparent proclivities refl ect true market biases (or ineffi ciencies) or whether \nsuch results are strictly a function of chance. even clearly random events with a 50 percent expected \noutcome will sometimes deviate signifi cantly from 50 percent simply by chance. For example, if you \nfl ipped 10 coins 1,000 times, approximately 17 percent of the time you would get seven or more \nheads. getting seve", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 125}
{"text": "pparent proclivities refl ect true market biases (or ineffi ciencies) or whether \nsuch results are strictly a function of chance. even clearly random events with a 50 percent expected \noutcome will sometimes deviate signifi cantly from 50 percent simply by chance. For example, if you \nfl ipped 10 coins 1,000 times, approximately 17 percent of the time you would get seven or more \nheads. getting seven or more heads on any individual toss of 10 coins certainly wouldn’t imply the \ncoins have a tendency to land on heads. Two factors should be considered in trying to assess whether \na past pattern might be meaningful rather than due to chance: \n 1. Number of observations. The greater the number of observations, the more likely a past \npattern might be signifi cant. \n 2. theoretical explanation. If there is a logical reason why a past pattern might have occurred, \nit enhances the potential signifi cance of the observed tendency. \n0.85\n0.65\n0.45\n0.25\n0.05\n75%\n50%\n25%\n0%\nPost-report average\nPost-report higher close\n12 34 56 78 91 0\nAll days higher close\nAll days average\nPost-report median\nGain/loss from report day close\n% higher closes\nDay\n FIGURE  27.2 10- y ear T -note after Bearish Initial Response to Jobs Report (Cumulative) \n407\nAnALyzIng MARkeT ReSPonSe\n FIGURE  27.3 10- y ear T -note after Bullish Initial Response to Jobs Report (Daily) \n0.20\n75%\n50%\n25%\n0%\nPost-report average\nPost-report higher close\n12 34 56 78 91 0\nAll days higher close\nPost-report median\n0.10\n0.00\nGain/loss from prev. day\n% higher closes\nDay\n−0.10\n FIGURE  27.4 10- y ear T -note after Bearish Initial Response to Jobs Report (Daily) \n0.25\n0.20\n50%\n25%\n0%\nPost-report average\nPost-report higher close\n12 34 56 78 91 0\nAll days higher close\nPost-report median\n0.15\n0.10\n0.05\n0.00\n−0.05Gain/loss from prev. day\n% higher closes\nDay\n408A CoMPLeTe gUIDe To THe FUTUReS MARkeT\n FIGURE  27.5 e-Mini S&P Change 500 after Bullish Initial Response to Jobs Report \n(Cumulative) \n20\n50%\n25%\n0%\nPost-report average\nPost-report higher close\n1 23456789 10\nAll days higher close\nPost-report median\nAll days average\n15\n10\n5\n0\n−5 Gain/loss from report day close\n% higher closes\nDay\n example B: Stock Index Futures response to employment reports \n Stock index futures also are prone to volatile moves in response to monthly employment reports. \nFigures 27.5 and 27.6 show the results of an analysis of the e-mini S&P 500 futures contract’s \nperformance in the fi rst 10 trading days following bullish and bearish initial responses to employment \nreports from 2006 through 2015. In this case, however, bullish and bearish are defi ned not by the price \nchange on the report day, but rather the location of the closing price within the report day’s range: \n 1. A close within the upper 25 percent of the day’s range is defi ned as a bullish initial response. \n 2. A close in the bottom 25 percent of the day’s range is defi ned as a bearish initial response. \n of the 120 employment reports from 2006 through 2015, 42 satisfi ed the bullish response criteria, \nwhile 26 satisfi ed the bearish response criteria. Figure 27.5 shows the e-mini S&P’s average and \nmedian cumulative gain/loss from the close of bullish response report days to the closes of the next \n10 consecutive days, while Figure 27.6 provides an analogous chart for bearish response days. The \nmost noticeable pattern is the tendency for follow-through weakness in the week following bearish \nresponse days (Figure 27.6 ). The chart for bullish response days (Figure 27.5 ) is fairly inconclusive. \n Table 27.2 shows the results of a related analysis. In this case, an initial bullish reaction was defi ned \nas a close 1.35 percent or more above the previous day’s close and a bearish reaction as a close \n1.35 percent or more below the previous day’s close. Initial responses between these thresholds were \nclassifi ed as neutral. These initial responses were then compared to the subsequent moves from the \nreport day’s close to the close of the day immediately preceding the next month’s employment report \n(approximately 20 days, but ranging from 18 to 25 days for any given month). In this example, the \ncumulative price changes after bullish and neutral initial reactions were similar (and positive), while the \n409\nAnALyzIng MARkeT ReSPonSe\n FIGURE  27.6 e-Mini S&P 500 Change after Bearish Initial Response to Jobs Report \n(Cumulative) \n50%\n75%\n25%\n0%\nPost-report average\nPost-report higher close\n123456789 10\nAll days higher close\nPost-report median\nAll days average\n10\n5\n0\n−5\n−10Gain/loss from report day close\n% higher closes\nDay\n taBLe 27.2 e-Mini S&p 500 Cumulative Change in Month Following Intitial \nresponse to employment report, 2006–2015 \n Bullish Initial \nresponse \n Bearish Initial \nresponse \n Neutral Initial \nresponse \n average 5.54 –16.05 7.88\n Median 18.13 –8.75 14.25\n % higher Close 64.29% 35.71% 65.91%\nperformance after bearish initial responses tended to be negative. Because there was a decisive uptrend \nin place during the survey period, there is a bias toward getting bullish price behavior following any \ndefi ned event—a tendency refl ected by the bullish result following neutral response days. Therefore, \nthe bullish price action following bullish response days may be more a matter of refl ecting the prevailing \nlong-term trend than any meaningful pattern, particularly since the price responses following bullish \nand neutral response days were similar. The negative price action following bearish response days, how-\never, seems potentially more signifi cant since it runs counter to the prevailing long-term trend. Still, \neven here, there is the caveat that the results are based on a small number of observations. \n Isolated events \n expectations are the key to evaluating market response for any single event. In other words, the failure \nof a market to respond to a fundamental development as decisively as might have been anticipated \ncould provide an important signal regarding the market’s inherent strength or", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 126}
{"text": "ll, \neven here, there is the caveat that the results are based on a small number of observations. \n Isolated events \n expectations are the key to evaluating market response for any single event. In other words, the failure \nof a market to respond to a fundamental development as decisively as might have been anticipated \ncould provide an important signal regarding the market’s inherent strength or weakness. \n410A CoMPLeTe gUIDe To THe FUTUReS MARkeT\n A classic example of this principle was the counter-to-anticipated response of the gold market dur-\ning the 1991 gulf War. As the United States’ January 17 deadline for starting air strikes approached \nwithout any concessions from Iraq, gold prices fi rmed. The start of the air war during nighttime \nhours in the United States saw gold surge to a three-month high of $410/oz. in the overnight mar-\nket. But this rally abruptly fi zzled, and gold prices began to sink rapidly. By the time the gold market \nopened in the United States the next morning, prices were actually $28/oz. lower than the previ-\nous evening’s close. This extremely weak price action in response to an event that could have been \nexpected to rally prices—even allowing for what proved to be the market’s correct anticipation for a \nquick U.S. victory—suggested that gold prices were vulnerable to further erosion. As can be seen in \nFigure 27.7 , prices did indeed continue to slide in the ensuing months, falling to new contract lows. \n The basic principle is that a price response to an important event that is radically diff erent from \nwhat might normally have been anticipated may provide an important clue as to the market’s probable \nnear-term direction. \n Limitations of Market response analysis \n The following are some of the ambiguities that arise in conducting market response analysis: \n 1. In any type of market response analysis, the answers we obtain are dependent on the param-\neters used in the analysis. For example, the various thresholds used to defi ne bullish and bearish \nresponse days in this chapter were representative values selected to illustrate the analysis \nprocess; they were not the result of any attempt to fi nd optimal defi nitions of what constitutes \nstrong (bullish) or weak (bearish) reactions. The choice of analysis parameters, which will often \n FIGURE  27.7 April 1991 gold\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n411\nAnALyzIng MARkeT ReSPonSe\nbe subjective, can have a large impact on the results—a reality that provides a strong argument \nfor analyzing a range of parameters.\n 2. When dealing with market events that occur relatively infrequently, there is the problem of \ndetermining the significance of results based on samples that might be too small (or spread out \nacross too long and varied an analysis period) to be considered statistically valid. For example, \nsome of the examples in this chapter were based on only 13 or 14 observations.\n 3. Response patterns may shift over time. A market’s response to a particular report or event \nmight be consistent for an extended period during one type of economic environment or mar-\nket regime, but that tendency could diminish or disappear if conditions change—for example, \nin the change from a rising interest rate environment to a declining rate environment.\nIn view of the foregoing limitations, market response patterns should be viewed as one potential \nindicator of near-term market direction, which could be combined with other analysis to support a \ntrading opinion, as opposed to being used as a stand-alone market signal.\n\n413\nChapter 28\nBuilding a Forecasting \nModel: A Step-by-\nStep Approach\nEconomics as a positive science is a body of tentatively accepted generalizations about economic \nphenomena that can be used to predict the consequences of changes in circumstances.\n—Milton Friedman\nB\necause of the heterogeneous nature of commodity markets, there is no such thing as a standard \nfundamental model. Among the key substantive characteristics that differentiate markets are de-\ngree of storability, availability of substitutes, importance of imports and exports, types of government \nintervention, and sensitivity to general economic conditions. Consequently, in contrast to technical \nanalysis, in which a specific system or methodology can often be applied to a broad spectrum of mar-\nkets, the fundamental approach requires a separate analysis for each market.\nThe time-consuming nature of fundamental analysis makes it virtually impossible to cover a large \nnumber of markets adequately using this approach. Thus, as a practical matter, a trader wishing to \nemploy fundamental inputs in trading decisions must resort to one of the following alternatives:\n 1. Restrict fundamental analysis to a superficial examination of the key statistics in a broad range \nof markets.\n 2. Employ in-depth fundamental analysis for only a few markets and trade all other markets based \non technical input only.\n 3. Rely on published fundamental analysis.\nThe first alternative is usually a poor compromise. Market knowledge based on a cursory exami-\nnation of fundamentals is often worse than total ignorance. In fact, next to poor money management, \n414\nA Complete Guide to the Futures mArket\nperhaps the most common reason that nonprofessional traders lose money in commodities is that \nthey base their trading decisions on superficial fundamental information (e.g., market blogs, online \nforums, brokers' two-sentence market summaries). The analytic approach outlined in this chapter \nimplicitly assumes alternative 2. It is a good idea to start by analyzing and following only one or two \nmarkets fundamentally, expanding this list only after all research ideas on previously chosen markets \nhave been investigated. The third alternative is a reasonable supplement to individual research, as long \nas one is selective. Unfortunately, a significant portion of published research is analytically unsound. \nHowever,", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 127}
{"text": "e 2. It is a good idea to start by analyzing and following only one or two \nmarkets fundamentally, expanding this list only after all research ideas on previously chosen markets \nhave been investigated. The third alternative is a reasonable supplement to individual research, as long \nas one is selective. Unfortunately, a significant portion of published research is analytically unsound. \nHowever, if you have fully grasped the concepts of this section, you should have no difficulty in evalu-\nating the analytic merit of available published research.\nOnce a market has been selected for fundamental study, the following step-by-step approach can \nbe employed:\n 1. read background material. The first step in any analysis must be a familiarization with the \ngiven market. Before beginning, an analyst must have a good idea of the key fundamentals that \naffect the market, as well as the primary sources of statistical information.\n 2. Gather statistics. Once you have a good understanding of the basic mechanics of a market, \nlist all the statistics that might be relevant in formulating a price analysis. The U.S. Department \nof Agriculture (USDA), which publishes a wide variety of reports on domestic and foreign agri-\ncultural products, is an excellent source of information. Another major source of statistics is the \nCRB Commodity \n Yearbook, which contains extensive data for the complete range of commodity \nmarkets. For many markets, special statistical sources will have to be consulted. The familiariza-\ntion process described in step 1 should provide the information regarding the primary statistical \nsources for a given market.\n 3. adjust price data for inflation. This adjustment is an essential step in fundamental price \nforecasting. As a caveat, though, if there is a prevailing downward-shifting trend in demand \n(a circumstance that will offset inflation), then unadjusted prices could yield more accurate \nforecasts.\n 4. Construct a model. Select one or more of the approaches discussed in Chapter 23 and \nattempt to construct a price-explanatory model. Regression analysis, which is perhaps the most \npowerful and efficient of these approaches, is covered comprehensively in the Appendices.\n 5. Modify model. After identifying which past years, or seasons, failed to fit the general pattern, \ntry to determine the factors that were responsible for the aberrant behavior. Attempt to incor-\nporate these factors into the general model. In some cases, highly unusual price action in a past \nyear might reflect the impact of isolated events (e.g., price controls, export embargoes, forced \nliquidation by huge speculators) that are not relevant to the current market. In such situations, \nit is often preferable to delete the abnormal year from the model. It should be emphasized, how-\never, that the expedient deletion of a year simply because it does not fit the pattern constitutes \nimproper methodology. The practical decision-making process in the deletion of years from a \nmodel is discussed in much greater detail in Appendix E.\n 6. Incorporate expectations. Check to see whether expectation-based statistics improve the \nmodel.\n415\nBuilding a Forecasting Model: a step-By -step approach\n 7. estimate the independent variables. The independent variables are the factors used to \nexplain and forecast prices in the model. These inputs must be estimated for the forecast period. \nFor example, the coming season's corn crop, which would obviously be a key input in any corn \nprice-forecasting model, could be estimated on the basis of planting intentions, historical yields, \nand weather conditions to date.\n 8. Forecast a price range. Allowing for a plausible range of values for each of the independent \nvariables, use the model to forecast a price range for the upcoming period.\n 9. evaluate the potential impact of government regulations. Consider whether existing \ngovernment programs or international agreements are likely to interfere with the normal free \nmarket mechanism.\n 10. examine seasonal patterns. Using the methods discussed in Chapter 26, determine whether \nthere are any pronounced seasonal patterns for the given market. Furthermore, it is essential \nto check whether recent price action has violated normal seasonal patterns, since such behavior \nmight reflect underlying weakness or strength.\n 11. Search for market response patterns. As detailed in Chapter 27, a market response to \nkey fundamental information (e.g., major government reports) might provide important clues \nregarding the impending price direction.\n 12. assess the trade opportunity. Compare the potential price range implied by the forego-\ning analytic steps with the prevailing price level. A trading opportunity is only indicated if the \ncurrent price is outside the projected range. (This step will not be applicable for analytical \napproaches designed to forecast the direction of the market rather than the price level.)\n 13. time trade entry. Some elements of the fundamental approach, such as seasonal analysis and \nmarket response patterns, and some fundamental methods, such as index models, might pro-\nvide timing clues. Generally speaking, however, the timing of a trade entry should be based on \ntechnical input (e.g., chart analysis, technical model). Otherwise, the timing of fundamentally \noriented trades is apt to be based on the date on which the analysis is completed—a ludicrous \nproposition. Furthermore, it should be emphasized that even if the fundamental analysis is cor-\nrect, prices can always get more out of line before the trend is reversed. The practical aspects of \ncombining fundamental analysis and trading are the subject of Chapter 29.\n\n417\nChapter 29\nFundamental \nAnalysis and Trading\nAll our knowledge brings us nearer to our ignorance.\n—T . S. Eliot\n ■ Fundamental versus Technical Analysis: \nA Greater Need for Caution\nVirtually every market student who has ever relied on fundamental analysis as the basis of a market \nopinion can recall instanc", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 128}
{"text": "aspects of \ncombining fundamental analysis and trading are the subject of Chapter 29.\n\n417\nChapter 29\nFundamental \nAnalysis and Trading\nAll our knowledge brings us nearer to our ignorance.\n—T . S. Eliot\n ■ Fundamental versus Technical Analysis: \nA Greater Need for Caution\nVirtually every market student who has ever relied on fundamental analysis as the basis of a market \nopinion can recall instances in which his conclusions proved dead wrong. The same, of course, can be \nsaid for the technical analyst. However, there is a critical distinction between them. If the technical \nanalyst’s methodology leads to erroneous projections, the same analytic tools will eventually point \nto an opposite conclusion. In effect, technical analysis is a self-correcting approach. In contrast, the \nfundamental analyst treads on far more dangerous ground. If the fundamental analyst’s assessment \nindicates wheat prices should be $7.00 when the market price is $6.00, by definition, he would be \neven more bullish if prices were to decline to $5.50—assuming the key economic statistics have \nremained unchanged.\nTherein lies the great danger in using fundamental analysis: The more inaccurate the projection, \nthe more adamant practitioners are apt to become regarding the current attractiveness of market \npositions in line with their original prognostications. Thus, traders who base their decisions strictly \non fundamental considerations might find themselves pyramiding positions in those situations they \nare most incorrect—a blueprint for disaster. In other words, there is a real danger that a sole or near-\nexclusive reliance on fundamentals will sooner or later transform an error into a major trading loss.\n418\nA Complete Guide to the Futures mArket\nIn fact, this very experience has caused many fundamentalists to renounce their former analytic \nbeliefs. One is reminded of Mark Twain’s observation: “The cat that sits down on a hot stove lid will \nnever sit down on a hot stove lid again . . . [nor on] a cold one.” The problem lies not in the validity \nof fundamental analysis as a valuable analytic tool, but rather in the failure to recognize the limitations \nof this approach. This chapter focuses on these limitations.\n ■ Three Major Pitfalls in Fundamental Analysis\nEven fundamental analysts who do everything right will eventually find themselves reaching the \nwrong conclusion. There are three possible reasons this could occur:\n1. \nthe unexpected development. In this case, the model is right, but the assumptions are \nwrong. The 1972–1973 cotton market provides a classic historical example of such a development. \nBefore that time, the United States did not export any cotton to China. This situation changed dra-\nmatically during the 1972–1973 season, when the United States exported more than one-half million \nbales, or approximately 11 percent of its total shipments, to the People’s Republic of China (PRC). \nTable 29.1 shows exports to the PRC further expanded in the 1973–1974 season. The sudden emer-\ngence of the PRC as a major importer of U.S. cotton was one of the key factors behind the historic \n1972–1973 bull market in cotton.\nW eather often plays the role of the unexpected development in agricultural markets. Figure 29.1 \ndepicts the price impact of the 1989 freeze on the frozen concentrated orange juice (FCOJ) market. \nFigure 29.2 illustrates the price impact of the 2012 drought on the corn market. Although such devel-\nopments in the weather are hardly extraordinary, they cannot be anticipated, since allowing for their \npossible occurrence would lead to inflated price projections in most other years.\nAn example of an impossible-to-predict sequence of events causing a major market reaction was \nthe March 2011 Japanese earthquake, which triggered a tsunami that caused core meltdowns in three \nof the Fukushima Daiichi nuclear reactors. (Although the possibility that a tsunami could result in a \nmajor accident was anticipated by some, the timing of such a tsunami was, of course, unpredictable.) \nFigure 29.3 shows this disaster resulted in a 20 percent plunge in the Nikkei index futures over the \ncourse of four days.\ntable 29.1 early 1970s Shift in U.S. Cotton exports to the people’s republic of China (1,000 bales)\nSeason exports to prC total exports exports to prC as percentage of total\n1971–1972 0 3,385 0\n1972–1973 585 5,311 11.0\n1973–1974 898 6,123 14.7\n1974–1975 307 3,926 7.8\n1975–1976 9 3,311 0.2\n1976–1977 0 4,784 0\n419\nFUNDAMENTAl ANAlySIS AND TRADINg\n FIGURE  29.1 March 1990 FCOJ\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE  29.2 September 2012 Corn\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n420A COMPlETE gUIDE TO THE FUTURES MARKET\n FIGURE  29.3 Nikkei 225 Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n Iraq’s August 1990 invasion of Kuwait is another example of how an unanticipated event can dra-\nmatically alter the supply-demand balance and trigger a huge price shift. As depicted in Figure 29.4 , \nthis event was followed by a huge advance in crude oil prices, as the market’s perceptions about avail-\nable oil supplies shifted in response to interrupted Kuwaiti output, the embargo against Iraqi crude, \nand fears that the confl ict would extend to threaten critical Saudi Arabian supplies. \n Figure 29.5 shows the dramatic impact of the unexpected decision by Switzerland’s central bank \nto remove a price cap on the Swiss franc that had been in place for approximately three years. This \nshock event caused an almost immediate 25 percent leap in the Swiss franc’s value on January 15, \n2015. Although this price surge was largely reversed over the subsequent two months, the sudden \nmarket move had a devastating impact on currency traders with short positions in the Swiss franc. \n Surprises in government reports, which can trigger sharp price reactions, are a c", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 129}
{"text": "tely three years. This \nshock event caused an almost immediate 25 percent leap in the Swiss franc’s value on January 15, \n2015. Although this price surge was largely reversed over the subsequent two months, the sudden \nmarket move had a devastating impact on currency traders with short positions in the Swiss franc. \n Surprises in government reports, which can trigger sharp price reactions, are a common source \nof unexpected developments. However, because the release dates of these reports are known, as \nare the reports that are apt to cause large price moves (typically, the initial planting and production \nestimates in agricultural markets), the resulting price moves are not completely unexpected in the \nway an unscheduled event might be (e.g., freeze, nuclear accident, invasion). Sometimes, however, a \nreport that does not typically trigger a major price impact may do so. One such instance was the U.S. \nDepartment of Agriculture’s (USDA) quarterly corn stocks report released on March 28, 2013. Dur-\ning what was perceived to be an exceptionally tight corn market (as a result of the drought referenced \nby Figure 29.2 ), the report indicated corn stocks were nearly 8 percent (387 million bushels) higher \nthan previously estimated. In response, corn futures dropped more than 5 percent the next trading \nday, and more than 8 percent the day after that (see Figure 29.6 ). \n421\nFUNDAMENTAl ANAlySIS AND TRADINg\n FIGURE  29.4 December 1990 WTI Crude Oil\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE  29.5 Swiss Franc Continuous Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n422A COMPlETE gUIDE TO THE FUTURES MARKET\n FIGURE  29.6 May 2013 Corn\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n 2. the missing variable. Quite often, a market whose price behavior has been adequately \ndescribed by a set of variables for an extended period of time will suddenly be dramatically aff ected \nby an entirely new factor. The 1972–1973 infl ationary boom, and its associated hoarding psychology, \nprovides an excellent example of a missing key factor. During this period, price behavior in diff erent \nmarkets became far more interdependent, and a wide variety of markets far exceeded the price levels \nsuggested by their intrinsic fundamentals. Any fundamental analysis of a specifi c market that failed to \ntake into account the potential price impact of the overall bullish wave would have yielded sharply \nunderstated price projections. \n The 1981–1982 period provided an almost exact opposite example of a missing key variable. In \nthis instance, failure to take into account the pronounced impact of simultaneous defl ation and high \nreal interest rates on inventory psychology would have resulted in overstated price forecasts for virtu-\nally any commodity market. \n It is tempting to think that pivotal events such as the two aforementioned major shifts in com-\nmodity demand curves were so readily apparent they would have been quickly incorporated into any \nfundamental model. Such major transitions, however, tend to be far more conspicuous in retrospect \nthan at the time of their occurrence. Often by the time such structural changes become evident, \nprices have already witnessed a major move. \n 3. poor timing. Even if fundamental analysis is accurate and the assumptions are correct, a mar-\nket can still move counter to the fundamental price projection over the short term—or even the \nintermediate term. In other words, generally speaking, fundamental models do not provide reliable \ntiming information. \n423\nFUNDAMENTAl ANAlySIS AND TRADINg\n FIGURE  29.7 Case-Shiller National Home Price Index, Infl ation Adjusted\nSource: www .econ.yale.edu/~shiller/data.htm. Data refl ect December values for each calendar year.\n Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n The 2008 fi nancial meltdown and the subsequent great Recession provide an excellent illustra-\ntion of the disconnect between changes in the fundamentals and the timing of price moves. There \nwere many reasons for the 2008 fi nancial crisis but certainly chief among them was the bursting of \nthe housing bubble that had seen housing prices far exceed historical norms. For more than a century \nsince the starting year of the Case-Shiller Home Price Index, the infl ation-adjusted index level fl uctu-\nated in a range of approximately 65 to 130. At the peak of the 2003–2006 housing bubble, the index \nhad nearly doubled its long-term median level (see Figure 29.7 ). \n The extremes of the housing bubble were fueled by excesses in subprime mortgage lending: loans \nwere made to borrowers with poor credit, requiring little or no money down, and in its later phases no \nverifi cation of income or assets. An insatiable demand for mortgages to bundle into mortgage-backed \nsecurities (MBSs) incentivized mortgage lenders to write as many mortgages as possible. These lenders \nwere unconcerned about whether borrowers could pay back the loans because they passed on the owner-\nship of mortgages to other fi nancial institutions for use in securitizations. The competition among mort-\ngage lenders to fi nd new borrowers seemed like a race to issue the poorest quality mortgages possible. \n The S&P Case-Shiller Home Price Index peaked in the spring of 2006 (see Figure 29.8 ). \nAt the same time, the rate of delinquencies on subprime adjusted rate mortgages (ARMs) rose \nsteadily throughout 2006 and accelerated in 2007 (see Figure 29.9 ). Despite these ominous \ndevelopments, U.S. stock prices continued to move higher, ultimately extending to new record \nlevels, as shown in Figures 29.8 and 29.9 . In fact, the extension of the equity bull market after \nthe peak in housing prices in mid-2006 occurred in the face of a more than doubling of sub-\n424A COMPlETE gUIDE TO THE FUTURES MARKET\n FIGURE  29.8 The S&P/Case-Shil", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 130}
{"text": "ee Figure 29.9 ). Despite these ominous \ndevelopments, U.S. stock prices continued to move higher, ultimately extending to new record \nlevels, as shown in Figures 29.8 and 29.9 . In fact, the extension of the equity bull market after \nthe peak in housing prices in mid-2006 occurred in the face of a more than doubling of sub-\n424A COMPlETE gUIDE TO THE FUTURES MARKET\n FIGURE  29.8 The S&P/Case-Shiller Home Price Index (20-City Composite, Seasonally \nAdjusted) vs. S&P 500 Index Median Monthly Price\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE  29.9 Subprime Arm T otal Delinquencies vs. S&P 500 Median Monthly Price\nSource: OTS (delinquency data)\n Chart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n425\nFUNDAMENTAl ANAlySIS AND TRADINg\nprime delinquencies—a fundamental development that not only had very negative implications \nfor housing prices and the economy, but also seriously imperiled the literally trillions of dol -\nlars of subprime MBS that had been issued. All these factors were bearish for the stock market. \nNonetheless, it was not until 18 months after housing prices had peaked and a similar interim \nof sharply rising delinquencies on subprime mortgages that the stock market finally topped out \nin October 2007.\nAssume a fundamental analyst came to the conclusion the prevailing bull market in equities during \nthe mid-2000s was critically dependent on an ongoing housing bubble, which could not be sustained, \nand whose inevitable reversal would lead to a stock market collapse—a prognostication that would \nultimately prove spectacularly correct. Further assume this analyst interpreted the reversal in the \nCase-Shiller Home Price Index in mid-2006 and the concurrent emerging uptrend in subprime mort-\ngage delinquencies as early evidence that the housing bubble was unraveling—another correct assess-\nment. Now consider the outcome if the analyst acted on this market assessment by implementing a \nshort position in stock index futures in September 2006—the month after subprime delinquencies \nreached a new multiyear high. A short S&P position initiated at the median price in September 2006 \nwould have been exposed to a 20 percent rise in the index before the stock market ultimately peaked \nin October 2007. Although the stock market subsequently collapsed, it is highly unlikely the analyst \ncould have survived such a large adverse price move before giving up and liquidating the position at \na large loss.\nThe point is not that fundamentally oriented traders should adamantly hold on to positions if they \nhave a strong conviction in their market analysis—a mental attitude that would be almost certain to \nresult in financial ruin, as it would take only one wrong forecast to lead to a devastating loss. Rather, \nthe point is that even accurate fundamental analysis can lead to poor trading results if fundamentals are \nused for timing.\nCrude oil prices in 1985 offer another classic example of a market that continued to extend its \nprior trend after an important fundamental change, only to witness a belated major reversal many \nmonths later. In March 1985 the Saudis announced they would no longer be the Organization of the \nPetroleum Exporting Countries’ (OPEC) “swing supplier” (i.e., the producer that adjusted its output \nto keep supply and demand in balance). Their decision to abandon their price-supportive role had \nbearish implications. The Saudis implemented this policy by introducing netback crude oil pricing \nduring the summer of 1985, or guaranteeing buyers of Saudi oil a profit margin. In essence, the Sau-\ndis were pricing their oil at whatever price was necessary to move all their production. Despite this \nominous action, prices still continued to climb (see Figure 29.10). Prices did not collapse until OPEC \nofficially decided to “pursue market share” at their December 1985 meeting, six months after the de \nfacto implementation of such a policy by Saudi Arabia.\nA fundamental analyst who decided in the summer of 1985 that the world oil market was vulner-\nable to a collapse would have been absolutely right—eventually. In the interim, any short positions \nimplemented on this analysis would have been subject to a protracted, large loss. Thus, poor timing \nof trade entry based on the timing of fundamental events could have transformed a potential windfall \ntrade into a major loss. The simple fact is that the timing of price moves is often out of sync with the \ntiming of fundamental developments.\n426A COMPlETE gUIDE TO THE FUTURES MARKET\n FIGURE  29.10 March 1986 WTI Crude Oil Futures\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n ■ Combining Fundamental Analysis with Technical \nAnalysis and Money Management \n As a result of the three pitfalls in fundamental analysis, a buy-and-hold or sell-and-hold trading strat-\negy will eventually prove disastrous for virtually any fundamental analyst. Even assuming a price-\nforecasting model always managed to include all key variables, a fundamental analyst would still \nbe vulnerable to large trading losses as a result of unexpected developments and poor timing. The \nobservations in the previous section suggest the following important trading rule: \nrUle: Never hold a fundamental opinion with complete rigidity. \n Clearly, fundamental analysis alone is insuffi cient for making trading decisions. The two missing \ningredients are technical analysis and money management. These various inputs can be combined in \nthe following manner. Fundamental analysis is used as the initial step in the decision-making process \nin order to determine whether the market is underpriced, overpriced, or in line. \nrUle: View fundamental analysis as a tool for gauging whether the market is out of line. \n Once a fundamental indication is obtained, technical factors are checked for possible confi rma-\ntion. This technical input can be in the form of charts", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 131}
{"text": "ental analysis is used as the initial step in the decision-making process \nin order to determine whether the market is underpriced, overpriced, or in line. \nrUle: View fundamental analysis as a tool for gauging whether the market is out of line. \n Once a fundamental indication is obtained, technical factors are checked for possible confi rma-\ntion. This technical input can be in the form of charts or a mechanical system. The main point is that \nit is necessary to check whether the fundamentally suggested trade appears reasonable in terms of \nmarket action. For example, if fundamentals suggest the market is overpriced at a time when prices \n427\nFUNDAMENTAl ANAlySIS AND TRADINg\nare in an unbroken uptrend, it would usually be best to delay the implementation of any short posi-\ntion. However, such a fundamental projection might still provide the motivation for initiating shorts \non the first signs the market is faltering.\nOccasionally, it is reasonable to implement a fundamental trade counter to the prevailing price \ntrend if the market is approaching a major resistance area. For example, assume corn prices are cur-\nrently $6/bushel and in a virtually unbroken uptrend, while fundamental analysis suggests an equi-\nlibrium price level of only $5. If the market is approaching a major resistance area (e.g., a previous \nhigh, or the low end of a prior trading range), one might use fundamental analysis as the justification \nfor anticipating a top. However, the trade should only be considered if the trader chooses a predeter-\nmined exit point.\nThis point introduces the third major element in making trading decisions: money management. \nOf course, the control of losses is essential even when the trading implications of fundamental and \ntechnical analysis are in full agreement. However, money management is particularly critical when \none is anticipating a market turn.\nrUle: An effective trading approach should combine fundamental analysis with technical analysis \nand money management.\n ■ Why Bother with Fundamentals?\nAt this point, the reader might well ask: If fundamental input must be used in conjunction with tech-\nnical analysis, why should the trader even bother with fundamental analysis in the first place? There \nare several answers to this question:\n 1. Fundamental analysis provides an extra dimension of information not available to the purely tech-\nnical trader. Knowing why a market is acting the way it is can be invaluable in trading decisions. \nFor example, a rally in a declining market might be attributable to a news item that does not \nmeaningfully alter a bearish fundamental outlook, or it might reflect that the market is oversold \nrelative to the fundamentals. T echnical analysts cannot distinguish between these two situations—\nthey must treat all similar patterns alike, regardless of the underlying causes. The fundamental \nanalyst, however, can use an awareness of existing market conditions and potential developments \nas an aid in assessing whether a rally is likely to be the beginning of a new bull market or a bull \ntrap. Of course, such value judgments will not always be accurate, but this consideration is not a \nproblem. For fundamental input to be of value, it is only necessary that profits (or reduced losses) \ntied to correct decisions exceed the losses (or reduced gains) resulting from incorrect decisions.\n 2. Fundamentals might sometimes portend a major price move well in advance of any technical \nsignals. The trader who is aware of such a potential transition could have an important advantage \nover traders who are only following technical signals.\n 3. A knowledge of fundamentals would permit a trader to adopt a more aggressive stance when \nthe fundamentals suggest the potential for a major move. The strictly technical trader, however, \nwould have to treat all trading signals the same.\n428\nA Complete Guide to the Futures mArket\n 4. An understanding of the underlying fundamentals can provide the incentive to stay with a win-\nning trade.\n 5. The way in which a market responds to fundamental news can be used as a trading tool, even by \nthe technical trader.\n ■ Are Fundamentals Instantaneously Discounted?\nOne aspect of the efficient market hypothesis, a popular theory subscribed to by many economists, \ncan be paraphrased as follows: At any given time, the market discounts all known information. Of \ncourse, if this premise were true, all market analysts—and readers of this book as well—would \nbe suffering from mass delusion. However, there are more compelling reasons for contesting this \nhypothesis. One reason is the fundamental information responsible for a major price transition is \nfrequently available well before the price trend actually develops. Another reason is that price moves \noften reflect a reaction to a preceding price swing that had carried the market well beyond funda -\nmentally sustainable equilibrium levels. In both cases, dramatic price moves may materialize in the \napparent absence of any significant concurrent change in the basic fundamentals. In fact, in the case \nin which a market has sharply overshot its equilibrium level, it is not unusual for prices to respond \nin the opposite direction one would anticipate for certain fundamental news (e.g., a rally following \na bearish news item).\nThe aforementioned types of price behavior are inexplicable only if one assumes the market dis-\ncounts all known information at any given time. However, a far more plausible view of market behav-\nior is that prices sometimes lag or anticipate the levels implied by existing information.\nCopper during 2002 through 2006 provides a good example of a market in which price moves \noccurred well after the fundamental changes responsible for those moves. In 2002, copper invento-\nries reached enormous levels. Not surprisingly, the copper market languished at low prices. Inven-\ntories then embarked upon a long decline, but prices failed to respond for more than a year (see \nFigure 29.11). Beg", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 132}
{"text": "per during 2002 through 2006 provides a good example of a market in which price moves \noccurred well after the fundamental changes responsible for those moves. In 2002, copper invento-\nries reached enormous levels. Not surprisingly, the copper market languished at low prices. Inven-\ntories then embarked upon a long decline, but prices failed to respond for more than a year (see \nFigure 29.11). Beginning in late 2003, prices finally adjusted upward to a higher plateau, as invento-\nries continued to slide. Prices then continued to move sideways at this higher level for about one year \n(early 2004 to early 2005), even though inventories fell still further. This sideways drift was followed \nby an explosive rally, which saw prices nearly triple in just over one year’s time. Ironically, this enor-\nmous price advance occurred at a time when inventories had actually begun to increase moderately. \nA fundamental analyst who correctly anticipated both the peak and low in copper inventories and \ntraded based on the timing of shifting fundamentals could well have fared poorly.\nPrice responses followed major changes in the fundamentals (inventory levels) with long lags. \nThe market in 2006 traded at dramatically higher price levels on the same fundamentals as it did in \nearly 2005. These long lags between changes in fundamentals and price adjustments contradict the \nimmediate price adjustments implied by the efficient market hypothesis. The more plausible explana-\ntion is that the shift in market psychology from complacency regarding ample supply availability to \nheightened sensitivity over supply shortages occurred gradually over time rather than as an immediate \nresponse to changing fundamentals.\n429\nFUNDAMENTAl ANAlySIS AND TRADINg\n FIGURE  29.11 lME Copper Inventories vs. lME Copper Prices\nCQg, Inc. © \n979030\n24232\n950000\n900000\n850000\n800000\n750000\n700000\n650000\n600000\n550000\n550000\n450000\n400000\n350000\n300000\n250000\n200000\n150000\n100000\n2002\nJan Jul\n50000\n411425\n2003\nJan Jul\n2004\nJan Jul\n2005\nJan\n2006\nJanJul\n7170\n8500\n8000\n7500\n7000\n6500\n6000\n5500\n5000\n4500\n4000\n3500\n3000\n2500\n2000\n1500\n2002\nJan Jul\n2003\nJan Jul\n2004\nJan Jul\n2005\nJan\n2006\nJanJul\nO= 411425 Line\nE= −2375\nL= 411425\nI= 411425\nH= 411425\n430A COMPlETE gUIDE TO THE FUTURES MARKET\n FIGURE  29.12 March 1986 Corn\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n The 1985–1986 corn market provides another excellent illustration of the nonsynchronous rela-\ntionship between fundamental information and price movements. Corn prices rose steadily from \nSeptember through December 1985 (see Figure 29.12 ), despite repeated increases in the production \nestimate and reductions in the total usage projection, which resulted in a consistent expansion in the \nforecasted ending stock/usage ratio (see Table 29.2 ). This price action would be completely inexpli-\ncable if one assumed that prices always responded instantaneously to new fundamental information, \na popular academic premise that is subject to frequent empirical contradiction in the real world. \nRather, it makes far more sense to view the subsequent price collapse in January/February 1986 as a \nbelated response to the steady deterioration in the fundamental picture in late 1985. \n table 29.2 Corn: USDa Supply/Disappearance estimates During 1985–1986 Season (million bushels) \nMonth production total Use ending Stocks Stock/Use ratio (%)\nAugust 1985 8,266 7,145 2,364 33.1\nSeptember 1985 8,469 7,070 2,717 38.4\nOctober 1985 8,603 7,070 2,851 40.3\nNovember 1985 8,717 7,045 3,052 43.3\nDecember 1985 8,717 7,045 3,052 43.3\nJanuary 1986 8,717 7,045 3,052 43.3\nFebruary 1986 8,865 6,845 3,403 49.7\n431\nFUNDAMENTAl ANAlySIS AND TRADINg\n ■ Fitting the News to Price Moves\nAlthough day-to-day price moves often reflect ongoing adjustments to background fundamentals \nand shifting expectations rather than reactions to concurrent events, the media will usually seek to \nfit the news to market price movements. If the market is up sharply on a given day, some economic \nnews will be found to explain the price strength. Similarly, if the market breaks precipitously, it’s a \nsafe bet that some bearish fundamental explanation will be found. This tailoring of news to fit the \nprice action can sometimes reach absurd lengths, as exemplified by the following two excerpts. \nThe first selection is from an article with the headline, “Strong Economic Reports \ngive a lift to \nthe Dollar”:\nThe dollar closed mostly higher yesterday after what currency traders saw as stronger-\nthan-expected economic reports. “There was good reaction to surprisingly strong num-\nbers,” said . . . “The biggest one was retail sales.” . . . The Commerce Department reported \nthat retail sales rose three-tenths of 1 percent in November, after remaining unchanged in \nOctober. A fall in new weekly claims for unemployment also helped the dollar.\nThe next quotation comes from a story with the headline, “\nlong- T erm Rates Fall on Reports”:\n. . . bond prices benefited from a Commerce Department report that showed the \nChristmas buying season got off to a slow start in November. . . . At first blush, the \nnumbers seemed to suggest that consumer activity had begun to pick up. But analysts \nsaid the increase was tainted because of the downward revisions in sales figures for Sep-\ntember and October. “The revisions showed that consumers are still struggling,” said . . .\nBoth of these stories come from the same newspaper, on the same day, on facing pages!\nOf course, major unexpected developments will have an immediate market impact when they \nbecome known, but for the most part, the efficient market hypothesis assumption that prices instan-\ntaneously adjust to fundamental news has it exactly backwards. It is far more accurate to say the \nfinancial news will instantaneously adjust to price changes. Whether the market is up or down on a \ngiven day, financial reporters have to find an explanation for the price move. Therefore, an", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 133}
{"text": "n they \nbecome known, but for the most part, the efficient market hypothesis assumption that prices instan-\ntaneously adjust to fundamental news has it exactly backwards. It is far more accurate to say the \nfinancial news will instantaneously adjust to price changes. Whether the market is up or down on a \ngiven day, financial reporters have to find an explanation for the price move. Therefore, an explana-\ntion will be drawn from the coincident news developments on that day, whether they are pertinent \nor not. This routine process can lead to the comical situation of the same development being used \nas both a bullish and bearish explanation on days where the market traverses widely between up and \ndown or vice versa.\nAugust 26, 2011, was a perfect example. On that day, the market sold off in the morning, and then \nrallied sharply into the afternoon. The key focus of market attention was a speech by Federal Reserve \nChairman Ben Bernanke. The following two headlines announced stock market news stories issued by \nthe same newswire service on the same day:\nWall Street Slides after Bernanke Comments\nWall Street Bounces as Bernanke Keeps Hopes Alive\n432\nA Complete Guide to the Futures mArket\nThe first story read, “Major indexes fell more than 1 percent after Federal Reserve Chairman \nBen Bernanke said the U.S. economic recovery was much less robust than hoped but stopped short \nof signaling further action to boost growth.” The second story saw things a bit differently: “Bernanke \nraised hope the Fed could consider further stimulus measures for the economy at an extended policy \nmeeting in September.”\nNow , you could believe the same event was bearish before it was bullish. It seems considerably \nmore plausible, though, to believe that the interpretation of the event was altered to fit the market \nprice action. I can assure you that if the market had failed to rebound, there would not have been any \nstories about how the market ignored Bernanke’s constructive comments. The market action deter-\nmines the interpretation of the news, not the other way around.\nQuite frequently prices move higher on the same longer-term fundamentals that have been known \nfor some time or in reaction to a prior decline that took prices too low based on the underlying funda-\nmentals. But while these types of longer-term underlying factors are what really move prices, rather \nthan the often minor or irrelevant developments that are coincident on the same day, they apparently \ndo not make acceptable news copy. When was the last time you saw a financial page headline that \nread, “Market Rallies Sharply because Bullish Fundamentals Unchanged” or “Market Plunges as Prices \nCorrect Recent Speculative Mania”?\n ■ Fundamental Developments: Long-Term Implications \nversus Short-Term Response\nIn interpreting new developments, it is necessary to make a distinction between the long term and \nthe short term. The long-term interpretation is fairly straightforward: All else being equal, a bullish \nnews item suggests higher prices. However, the short-term interpretation of new developments is \nentirely different: The essential consideration is how the market responds to the news. In this regard, \nas summarized by the following rule, the significant occurrence is a divergence between fundamental \nnews and subsequent price action.\nrUle: A bullish fundamental development that is followed by a decline or that prompts a rally \nwell below expectations should be viewed as a bearish signal. A bearish fundamental development \nthat is followed by a rally or that prompts a significantly smaller-than-anticipated decline should \nbe viewed as a bullish signal.\nBy no means is this rule sufficient by itself to allow trading decisions. But in conjunction with \nother market information, such as background fundamentals and the technical picture, an awareness \nof this rule should help improve a trader’s performance.\nSome examples of interpreting market response were provided in Chapter 27. Still, another \nexample might help clarify this approach in using fundamental developments as a trading tool. The \ntime was December 24, 1980, and the cotton market finished the holiday-shortened week just below \ncontract highs and only a few cents below record highs. Despite the pronounced price advance over \nthe previous six-month period, the fundamental picture still appeared bullish because supply and \n433\nFUNDAMENTAl ANAlySIS AND TRADINg\nusage trends suggested the potential for the lowest ending carryover since the early 1950s. The weekly \nexport report released after the close indicated a huge net sales fi gure in excess of one-half million \nbales. This export fi gure confi rmed rumors of potential large sales to China and virtually assured a \nvery low season ending carryover. \n On the basis of her analysis, Stephanie Statistics had been long for some time. After the release of the \nstrikingly bullish December 24 export fi gure, Stephanie had to virtually restrain herself from calculating \nthe potential increase in her open equity as a result of this latest news item. Monday morning the market \nopened with near limit gains. “Not bad,” she thought, but the fact that the market did not open locked \nlimit-up was disconcerting. As the day progressed, prices began to ease and warning bells went off in her \nmind. Something was wrong—the market was not really acting right, given the export news. On the \nbasis of this input, Stephanie liquidated one-third of her position that day, one-third the next day, and the \nremaining third one week later. This scaled liquidation refl ected her reluctance to give up a long position \nin the cotton market, given what she still perceived to be an extremely bullish fundamental outlook. \n Stephanie’s fundamental view of the market at that time could not have been more off target. \nAs subsequent events would prove, that Monday was the top of the market (see Figure 29.13 ) and \nthe start of a yearlong slide—the impending extremely low carry", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 134}
{"text": "her reluctance to give up a long position \nin the cotton market, given what she still perceived to be an extremely bullish fundamental outlook. \n Stephanie’s fundamental view of the market at that time could not have been more off target. \nAs subsequent events would prove, that Monday was the top of the market (see Figure 29.13 ) and \nthe start of a yearlong slide—the impending extremely low carryover notwithstanding. Eventually, \nthe fundamental explanations for the market’s weakness became evident: high interest rates, a deep \nrecession, and expectations for a large new crop. However, by that time, prices had already moved \nsubstantially lower (albeit a large portion of the bear move still remained to be realized). The crucial \npoint is that a contrarian interpretation of a bullish news item provided a long liquidation signal at the \n FIGURE  29.13 July 1981 Cotton\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n434A COMPlETE gUIDE TO THE FUTURES MARKET\nmarket top and prevented an incorrect fundamental market evaluation from transforming a profi table \nposition into a large loss. \n The preceding story was not a recreation based on artifi cial hindsight. The events described are \ntrue, only the names have been changed to protect the guilty. \n A large price move in response to a seemingly neutral event can also be signifi cant. The FCOJ \nmarket’s response to the October 1993 Crop Production report, which was initially interpreted as \n“neutral,” provides an excellent example. This situation and its implications are nicely described from a \ntrader’s perspective in the following excerpt of an interview of Russell Sands that appeared in Commodity \nT raders Consumers Report : \n y esterday there was a crop report. They were expecting between 165 and 180 million \nboxes of orange juice. The number came out at 172—right in the middle. The early \ncall this morning was unchanged to slightly lower. A few minutes before the open they \nchanged the call to 300 lower. The market opened 700 lower. Now it’s down 900. \n I have no idea what the fundamentals are. I read the crop report yesterday after-\nnoon, and I thought it would be a quiet day. Maybe the estimates were wrong. Maybe \nsomebody didn’t believe the estimates. I have no clue as to why this happened. All I \nknow is there was a neutral report, there was a close-to-unchanged call, but all of a \nsudden the market is sharply lower and I didn’t get out. All the fundamental knowl-\nedge in the world is not going to save me. I’m scrambling to get out and cut my losses. \n As readers can ascertain in Figure 29.14 , getting out of longs even 900 points lower on the day \nin question looked awfully good a few days or a few weeks later. The preceding quotation, which \n FIGURE  29.14 November 1993 FCOJ\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n435\nFUNDAMENTAl ANAlySIS AND TRADINg\napparently was recorded at the moment of the market event being described, provides a good real-\nlife illustration of how market response to fundamental news can be utilized as an aid in making \ntrading decisions.\n ■ Summary\nAn awareness of the potential limitations of fundamental analysis is essential to its successful appli-\ncation. Perhaps the key point to keep in mind is that fundamental analysis is primarily a tool for \nforecasting intermediate or long-term price swings and should not be used as a timing indicator. The \nonly exception to this basic premise is that a counter-to-anticipated market response to fundamental \ninformation could be viewed as a contrarian trading signal (e.g., a bullish fundamental development \nwould have bearish near-term implications if it failed to elicit the anticipated positive price response).\n\nFutures spreAds \nAnd OptiOns\nPart VI\n\n439\nCha P ter 30\nThere was a one-lot trader named Fred,\nwho tried to reduce risk with a spread.\nBut the spread was his demise—\nHe overdid position size,\ntrading not 1 but 10 instead.\n ■ Introduction\ndespite widespread publicity and extensive information, spreads still remain an often misunderstood \nand relatively little-used trading vehicle. there is nothing inordinately complicated about spread trad-\ning; many traders simply lack the familiarity with the concepts involved. ironically, it is usually the \nnovice trader, for whom spreads can be a particularly useful trading vehicle, who shuns them as an \nesoteric operation confined to the “pros.” Furthermore, even experienced traders often exhibit a bias \nagainst trading spreads, preferring to trade in outright positions because of their greater potential. \nthese traders fail to realize that, at times, spreads may offer a more attractive reward/risk ratio than \noutright positions. in other words, at a given time, X number of spreads may offer equal potential to \na one-contract outright position but imply a smaller risk. (Of course, such a judgment will always \nbe subjective.)\nthe Concepts \nand Mechanics of \nspread trading\n440\nA Complete Guide to the Futures mArket\n ■ Spreads—Definition and Basic Concepts\nA spread trade involves the simultaneous purchase of one futures contract against the sale of another \nfutures contract either in the same market or in a related market. normally, the spread trader will \ninitiate a position when he considers the price difference between two futures contracts to be out of \nline rather than when he believes the absolute price level to be too high or too low . \nin essence, the \nspread trader is more concerned with the difference between prices than the direction of price. For \nexample, if a trader buys October cattle and sells February cattle, it would not make any difference to \nhim whether October rose by 500 points and February by only 400 points or October fell by 400 and \nFebruary fell by 500. \nin either case, October would have gained 100 points relative to February, and \nthe trader’s profit would be completely independent of the overall market dir", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 135}
{"text": "of price. For \nexample, if a trader buys October cattle and sells February cattle, it would not make any difference to \nhim whether October rose by 500 points and February by only 400 points or October fell by 400 and \nFebruary fell by 500. \nin either case, October would have gained 100 points relative to February, and \nthe trader’s profit would be completely independent of the overall market direction.\nHowever, this is not to say the spread trader will initiate a trade without having some definitive \nbias as to the future outright market direction. in fact, very often the direction of the market will \ndetermine the movement of the spread. in some instances, however, a spread trader may enter a posi-\ntion when he has absolutely no bias regarding future market direction but views a given price differ-\nence as being so extreme that he believes the trade will work, or at worst allow only a modest loss, \nregardless of market direction. W e will elaborate on the questions of when and how market direction \nwill affect spreads in later sections.\n ■ Why Trade Spreads?\nthe following are some advantages to not exclusively restricting one’s trading to outright positions:\n 1. In highly volatile markets, the minimum outright commitment of one contract \nmay offer excessive risk to small traders. \nin such markets, one-day price swings in excess \nof $1,500 per contract are not uncommon, and holding a one-contract position may well be \novertrading for many traders. \nironically, it is usually these highly volatile markets that provide \nthe best potential trading opportunities. spreads offer a great flexibility in reducing risk to \na desirable and manageable level, since a spread trade usually presents only a fraction of the \nrisk involved in an outright position.\n1 For example, assume a given spread is judged to involve \napproximately one-fifth the risk of an outright position. in such a case, traders for whom a one-\ncontract outright position involves excessive risk may instead choose to initiate a one-, two-, \nthree-, or four-contract spread position, depending on their desired risk level and objectives.\n 2. there are times when spreads may offer better reward/risk ratios than outright \npositions. Of course, the determination of a reward/risk ratio is a subjective matter. never-\ntheless, given a trader’s market bias, in a given situation spreads may sometimes offer a better \nmeans of approaching the market.\n1 For some markets, reduced-size contracts are available on one or more exchanges.\n441\ntHe COnCepts And MeCHAniCs OF spreAd trAding \n 3. Spreads often offer some protection against sudden extreme losses due to dra-\nmatic events that may spark a string of limit-up or limit-down moves counter to \none’s position (e.g., freeze, large export deal). \nsuch situations are not all that infrequent, \nand traders can sometimes lose multiples of the maximum loss they intended to allow (i.e., as \nreflected by a protective stop) before they can even liquidate their positions. \nin contrast, during \na time of successive limit moves, the value of a spread might not even change as both months \nmay move the limit. Of course, eventually the spread will also react, but when it does, the \nmarket may well be past its frenzied panic stage, and the move may be gradual and moderate \ncompared with the drastic price change of the outright position.\n 4. a knowledge and understanding of spreads can also be a valuable aid in trading \noutright positions. For example, a failure of the near months to gain sufficiently during a \nrally (in those commodities in which a gain can theoretically be expected) may signal the trader \nto be wary of an upward move as a possible technical surge vulnerable to retracement. \nin other \nwords, the spread action may suggest that no real tightness exists. this scenario is merely one \nexample of how close observation of spreads can offer valuable insights into outright market \ndirection. \nnaturally, at times, the inferences drawn from spread movements may be mislead-\ning, but overall they are likely to be a valuable aid to the trader. A second way an understanding \nof spreads can aid an outright-position trader is by helping identify the best contract month in \nwhich to initiate a position. \nthe trader with knowledge of spreads should have a distinct advan-\ntage in picking the month that offers the best potential versus risk. Over the long run, this factor \nalone could significantly improve trading performance.\n 5. trading opportunities may sometimes exist for spreads at a time when none is \nperceived for the outright commodity itself.\n ■ Types of Spreads\nthere are three basic types of spreads:\n 1. the intramarket (or interdelivery) spread is the most common type of spread and con-\nsists of buying one month and selling another month in the same commodity. An example of an \nintramarket spread would be long \ndecember corn/short March corn. the intramarket spread \nis by far the most widely used type of spread and will be the focus of this chapter’s discussion.\nthe intercrop spread is a special case of the intramarket spread involving two different \ncrop years (e.g., long an old crop month and short a new crop month). the intercrop spread \nrequires special consideration and extra caution. intercrop spreads can often be highly volatile, \nand price moves in opposite directions by new and old crop months are not particularly uncom-\nmon. \nthe intercrop spread may often be subject to price ranges and patterns that distinctly \nseparate it from the intracrop spread (i.e., standard intramarket spread).\n 2. the intercommodity spread consists of a long position in one commodity and a short \nposition in a related commodity. in this type of spread the trader feels the price of a given \n442\nA Complete Guide to the Futures mArket\ncommodity is too high or low relative to a closely related commodity. some examples of this \ntype of spread include long december cattle/short december hogs and long July wheat/short \nJuly corn.", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 136}
{"text": "y spread consists of a long position in one commodity and a short \nposition in a related commodity. in this type of spread the trader feels the price of a given \n442\nA Complete Guide to the Futures mArket\ncommodity is too high or low relative to a closely related commodity. some examples of this \ntype of spread include long december cattle/short december hogs and long July wheat/short \nJuly corn. The source/product spread, which involves a commodity and its by-product(s)—for \nexample, soybeans versus soybean meal and/or soybean oil—is a specific type of intercommod-\nity spread that is sometimes classified separately.\nusually, an intercommodity spread will involve the same month in each commodity, but \nthis need not always be the case. ideally, traders should choose the month they consider the \nstrongest in the market they are buying and the month they consider the weakest in the market \nthey are selling. Obviously, these will not always be the same month. For example, assume the \nfollowing price configuration:\nDecember February april\nCattle 120.00 116.00 118.00\nHogs 84.00 81.00 81.00\ngiven this price structure, a trader might decide the premium of cattle to hogs is too small \nand will likely increase. this trading bias would dictate the initiation of a long cattle/short hog \nspread. However, the trader may also believe February cattle is underpriced relative to other \ncattle months and that december hogs are overpriced relative to the other hog contracts. in \nsuch a case, it would make more sense for the trader to be long February cattle/short decem-\nber hogs rather than long december cattle/short december hogs or long February cattle/short \nFebruary hogs.\nOne important factor to keep in mind when trading intercommodity spreads is that contract \nsizes may differ for each commodity. For example, the contract size for euro futures is 125,000 \nunits, whereas the contract size for British pound futures is 62,500 units. \nthus, a euro/British \npound spread consisting of one long contract could vary even if the price difference between \nthe two markets remained unchanged. \nthe difference in price levels is another important fac-\ntor relevant to contract ratios for intercommodity spreads. the criteria and methodology for \ndetermining appropriate contract ratios for intercommodity spreads are discussed in the next \nchapter.\n 3. the intermarket spread. this spread involves buying a commodity at one exchange and sell-\ning the same commodity at another exchange, which will often be another country. An example \nof this type of spread would be long \nnew Y ork March cocoa/short London March cocoa. trans-\nportation, grades deliverable, distribution of supply (total and deliverable) relative to location, \nand historical and seasonal basis relationships are the primary considerations in this type of \nspread. \nin the case of intermarket spreads involving different countries, currency fluctuations \nbecome a major consideration. intermarket spread trading is often referred to as arbitrage. As \na rule, the intermarket spread requires a greater degree of sophistication and comprehensive \nfamiliarity with the commodity in question than other types of spreads.\n443\ntHe COnCepts And MeCHAniCs OF spreAd trAding \n ■ The General Rule\nFor many commodities, the intramarket spread can often, but not always, be used as a proxy for an \noutright long or short position. As a general rule, near months will gain ground relative to distant \nmonths in a bull market and lose ground in a bear market. \nthe reason for this behavior is that a bull \nmarket usually reflects a current tight supply situation and often will place a premium on more imme-\ndiately available supplies. \nin a bear market, however, supplies are usually burdensome, and distant \nmonths will have more value because they implicitly reflect the cost involved in storing the com-\nmodity for a period of time. \nthus, if a trader expects a major bull move, he can often buy a nearby \nmonth and sell a more distant month. if he is correct in his analysis of the market and a bull move \ndoes materialize, the nearby contract will likely gain on the distant contract, resulting in a success-\nful trade. \nit is critical to keep in mind that this general rule is just that, and is meant only as a rough \nguideline. there are a number of commodities for which this rule does not apply, and even in those \ncommodities where it does apply, there are important exceptions. W e will elaborate on the question \nof applicability in the next section.\nAt this point the question might legitimately be posed, “\nif the success of a given spread trade is \ncontingent upon forecasting the direction of the market, wouldn’t the trader be better off with an \noutright position?” Admittedly, the potential of an outright position will almost invariably be consid-\nerably greater. But the point to be kept in mind is that an outright position also entails a correspond-\ningly greater risk. \nsometimes the outright position will offer a better reward/risk ratio; at other \ntimes the spread will offer a more attractive trade. A determination of which is the better approach \nwill depend upon absolute price levels, prevailing price differences, and the trader’s subjective views \nof the risk and potential involved in each approach.\n ■ The General Rule—Applicability and Nonapplicability\nCommodities to Which the General rule Can Be applied\nCommodities to which the general rule applies with some regularity include corn, wheat, oats, \nsoybeans, soybean meal, soybean oil, lumber, sugar, cocoa, cotton, orange juice, copper, and heating \noil. (\nthe general rule will also usually apply to interest rate markets.) Although the general rule will \nusually hold in these markets, there are still important exceptions, some of which include:\n 1. At a given point in time the premium of a nearby month may already be excessively wide, and \nconsequently a general price rise in the market may fail to widen the spread further.\n 2. s ince hig", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 137}
{"text": "ng \noil. (\nthe general rule will also usually apply to interest rate markets.) Although the general rule will \nusually hold in these markets, there are still important exceptions, some of which include:\n 1. At a given point in time the premium of a nearby month may already be excessively wide, and \nconsequently a general price rise in the market may fail to widen the spread further.\n 2. s ince higher prices also increase carrying costs (see section entitled “the Limited-risk spread”), \nit is theoretically possible for a price increase to widen the discount of nearby months in a \nsurplus market. Although such a spread response to higher prices is atypical, its probability of \noccurrence will increase in a high-interest-rate environment.\n444\nA Complete Guide to the Futures mArket\n 3. s preads involving a spot month near expiration can move independently of, or contrary to, the \ndirection implied by the general rule. the reason is that the price of an expiring position is criti-\ncally dependent upon various technical considerations involving the delivery situation, and wide \ndistortions are common.\n 4. A bull move that is primarily technical in nature may fail to influence a widening of the nearby \npremiums since no real near-term tightness exists. (\nsuch a price advance will usually only be \ntemporary in nature.)\n 5. g overnment intervention (e.g., export controls, price controls, etc.), or even the expectation \nof government action, can completely distort normal spread relationships.\ntherefore, it is important that when initiating spreads in these commodities, the trader keep in \nmind not only the likely overall market direction, but also the relative magnitude of existing spread \ndifferences and other related factors.\nCommodities Conforming to the Inverse of the General rule\nsome commodities, such as gold and silver, conform to the exact inverse of the general rule: in a ris-\ning market distant months gain relative to more nearby contracts, and in a declining market they lose \nrelative to the nearby positions. In fact, in these markets, a long forward/short nearby spread is often a good \nproxy for an outright long position, and the reverse spread can be a substitute position for an outright short. \nin \neach of these markets nearby months almost invariably trade at a discount, which tends to widen in \nbull markets and narrow in bear markets.\nthe reason for the tendency of near months in gold and silver to move to a wider discount in a \nbull market derives from the large worldwide stock levels of these metals. generally speaking, price \nfluctuations in gold and silver do not reflect near-term tightness or surplus, but rather the market’s \nchanging perception of their value. \nin a bull market, the premium of the back months will increase \nbecause higher prices imply increased carrying charges (i.e., interest costs will increase as the total \nvalue of the contract increases). Because the forward months implicitly contain the cost of carrying \nthe commodity, their premium will tend to widen when these costs increase. Although the preced-\ning represents the usual pattern, there have been a few isolated exceptions due to technical factors.\nCommodities Bearing Little or No relationship to the General rule\nCommodities in which there is little correlation between general price direction and spread differ-\nences usually fall into the category of nonstorable commodities (cattle and live hogs). W e will exam-\nine the case of live cattle to illustrate why this there is no consistent correlation between price and \nspread direction in nonstorable markets.\nLive cattle, by definition, is a completely nonstorable commodity. When feedlot cattle reach mar-\nket weight, they must be marketed; unlike most other commodities, they obviously cannot be placed \nin storage to await better prices. (\nto be perfectly accurate, cattle feeders have a small measure of \nflexibility, in that they can market an animal before it reaches optimum weight or hold it for a while \nafter. However, economic considerations will place strong limits on the extent of such marketing \n445\ntHe COnCepts And MeCHAniCs OF spreAd trAding \nshifts.) As a consequence of the intrinsic nature of this commodity, different months in live cattle are, \nin a sense, different commodities. June live cattle is a very different commodity from december live \ncattle. the price of each will be dependent on the market’s perception of the supply-demand picture \nthat it expects to prevail at each given time period. it is not unusual for a key cattle on feed report to \ncarry bullish implications for near months and bearish connotations for distant months, or vice versa. \nin such a case, the futures market can often react by moving in opposite directions for the near and \ndistant contracts. the key point is that in a bullish (bearish) situation, the market will sometimes view \nthe near-term supply/demand balance as being more bullish (bearish) and sometimes it will view the \ndistant situation as being more bullish (bearish). A similar behavioral pattern prevails in hogs. \nthus, \nthe general rule would not apply in these types of markets.\nin these markets, rather than being concerned about the overall price direction, the spread trader \nis primarily concerned with how he thinks the market will perceive the fundamental situation in dif-\nferent time periods. For example, at a given point in time, June cattle and \ndecember cattle may be \ntrading at approximately equal levels. if the trader believes that marketings will become heavy in the \nmonths preceding the June expiration, placing pressure on that contract, and further believes the \nmarket psychology will view the situation as temporary, expecting prices to improve toward year-\nend, he would initiate a long \ndecember/short June cattle spread. note that if he is correct in the \ndevelopment of near-term pressure but the market expects even more pronounced weakness as time \ngoes on, the trade will not work even if his e", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 138}
{"text": "lacing pressure on that contract, and further believes the \nmarket psychology will view the situation as temporary, expecting prices to improve toward year-\nend, he would initiate a long \ndecember/short June cattle spread. note that if he is correct in the \ndevelopment of near-term pressure but the market expects even more pronounced weakness as time \ngoes on, the trade will not work even if his expectations for improved prices toward year-end also \nprove accurate. One must always remember that a spread’s life span is limited to the expiration of the \nnearer month, and substantiation of the spread idea after that point will be of no benefit to the trader. \nthus, the trader is critically concerned, not only with the fundamentals themselves, but also with the \nmarket’s perception of the fundamentals, which may or may not be the same.\n ■ Spread Rather Than Outright—An Example\nFrequently, the volatility of a given market may be so extreme that even a one-contract position may \nrepresent excessive risk for some traders. \nin such instances, spreads offer the trader an alternative \napproach to the market. For example, in early 2014, coffee futures surged dramatically, gaining more \nthan 75 percent from late January to early March, with average daily price volatility more than tri-\npling during that period. \nprices swung wildly for the next several months—pushing to a higher high \nin April, giving back more than half of the rally in the sell-off to the July low , and then rallying to yet \nanother new high in October (see Figure 30.1). At that juncture, assume a low-risk trader believed \nthat prevailing nearest futures prices near $2.22 in mid-October 2014 were unsustainable, but based \non the market’s volatility (which was still around three times what it had been early in the year) and his \nmoney management rules felt he could not assume the risk of an outright position. \nsuch a trader could \ninstead have entered a bear spread (e.g., short July 2015 coffee/long december 2015 coffee) and \nprofited handsomely from the subsequent price slide. Figure 30.1 illustrates the close correspondence \nbetween the spread and the market. \nthe fact that an outright position would have garnered a much \nlarger profit is an irrelevant consideration, since the trader’s risk limitations would have prevented him \nfrom participating in the bear move altogether had his market view been confined to outright trades.\n446A COMpLete guide tO tHe Futures MArKet\n ■ The Limited-Risk Spread \n the limited-risk spread is a type of intracommodity spread involving the buying of a near month \n(relatively speaking) and the selling of a more distant month in a storable commodity in which the \nprocess of taking delivery, storing, and redelivering at a later date does not require reinspection or \ninvolve major transportation or storage complications. this defi nition would exclude such commodi-\nties as live cattle, which by defi nition are nonstorable, and sugar, which involves major complications \nin taking delivery and storing. Commodities that fall into the limited-risk category include corn, \nwheat, oats, soybeans, soybean oil, copper, cotton, orange juice, cocoa, and lumber. \n2 \n in a commodity fulfi lling the above specifi cations, the maximum premium that a more distant \nmonth can command over a nearby contract is roughly equal to the cost of taking delivery, holding \nthe commodity for the length of time between the two expirations, and then redelivering. the cost \nfor this entire operation is referred to as full carry. the term limited risk will be used only when the \nnearby month is at a discount. For example, assuming full carry in the October/december cotton \n FIGURE  30.1 July and december 2015 Coff ee Futures vs. July/december 2015 Coff ee spread\nChart created using tradestation. ©tradestation t echnologies, inc. All rights reserved. \n 2 Although precious metals can easily be received in delivery, stored, and redelivered, they are not listed here \nbecause spreads in precious metals are almost entirely determined by carrying charges. thus, the only motivation \nfor implementing an intramarket precious metals spread is an expectation for a change in carrying charges. in \ncontrast, the purpose of a limited-risk spread is to profi t from an expected narrowing of the spread relative to \nthe level implied by carrying charges (which are assumed to remain constant).\n447\ntHe COnCepts And MeCHAniCs OF spreAd trAding \nspread is equal to 200 points, a long October/short december spread initiated at October 100 points \nunder might be termed a limited-risk spread. However, the same long October/short december \ncotton spread would not be termed limited risk if, for example, October were at a 300-point pre-\nmium. nevertheless, it should be noted that even in this latter case, the maximum risk would still be \ndefined—namely, 500 points—and in this respect the spread would still differ from spreads involving \nthe selling of the nearby contract, or spreads in markets that do not fulfill the limited-risk specifica-\ntions detailed above.\nthe best way to understand why it is unlikely for the premium of a distant month to exceed car-\nrying costs is to assume the existence of a situation where this is indeed the case. in such an instance, \na trader who bought a nearby month and sold a more distant month would have an opportunity for \nspeculative gain and, at worst, would have the option of taking delivery, storing, and redelivering at \na likely profit (since we assumed a situation in which the premium of the distant month exceeded \ncarrying charges). \nsounds too good to be true? Of course, and for this reason differences beyond full \ncarry are quite rare unless there are technical problems in the delivery process. in fact, it is usually \nunlikely for a spread difference to even approach full carry since, as it does, the opportunity exists for \na speculative trade that has very limited risk but, theoretically, no limit on upside potential. \nin othe", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 139}
{"text": "nds too good to be true? Of course, and for this reason differences beyond full \ncarry are quite rare unless there are technical problems in the delivery process. in fact, it is usually \nunlikely for a spread difference to even approach full carry since, as it does, the opportunity exists for \na speculative trade that has very limited risk but, theoretically, no limit on upside potential. \nin other \nwords, as spreads approach full carry, some traders will initiate long nearby/short forward spreads \nwith the idea that there is always the possibility of gain, but, at worst, the loss will be minimal. For \nthis reason, spreads will usually never reach full carry.\nAt a surface glance, limited-risk spreads seem to be highly attractive trades, and indeed they often \nare. However, it should be emphasized that just because a spread is relatively near full carry does not neces-\nsarily mean it is an attractive trade. V ery often, such spreads will move still closer to full carry, resulting \nin a loss, or trade sluggishly in a narrow range, tying up capital that could be used elsewhere. How-\never, if the trader has reason to believe the nearby month should gain on the distant, the fact that the \nspread has a limited risk (the difference between full carry and the current spread differential) makes \nthe trade particularly attractive.\nthe components of carrying costs include interest, storage, insurance, and commission. W e will \nnot digress into the area of calculating carrying charges. ( such information can be obtained either \nthrough the exchanges themselves or through commodity brokers or analysts specializing in the given \ncommodity.) However, we would emphasize that the various components of carrying charges are \nvariable rather than fixed, and consequently carrying charges can fluctuate quite widely over time. \ninterest \ncosts are usually the main component of carrying charges and are dependent on interest rates and \nprice levels, both of which are sometimes highly volatile. \nit is critical to keep changes in carrying costs \nin mind when making historical comparisons.\nCan a trader ever lose more money in a limited-risk spread than the amount implied by the differ-\nence between full carry and the spread differential at which the trade was initiated? the answer is that \nalthough such an occurrence is unlikely, it is possible. For one thing, as we indicated above, carrying \ncharges are variable, and it is possible for the theoretical maximum loss of a spread trade to increase \nas a result of fluctuations in carrying costs. For example, a trader might enter a long October/short \ndecember cotton spread at 100 points October under, at a time when full carry approximates 200 \npoints—implying a maximum risk of 100 points. However, in ensuing months, it is possible higher \n448\nA Complete Guide to the Futures mArket\nprices and rising interest rates could cause full carry to move beyond 200 points, increasing the trad-\ner’s risk correspondingly. in such an instance, it is theoretically possible for the given spread to move \nsignificantly beyond the point the trader considered the maximum risk point. Although such an event \ncan occur, it should be emphasized that it is rather unusual, since in a limited-risk spread increased \ncarrying costs due to sharply higher price levels will usually imply larger gains for the nearby months. \nAs for interest rates, changes substantial enough to influence marked changes in carrying costs will \nusually take time to develop.\nAnother example of a limited-risk spread that might contain hidden risk is the case in which \nthe government imposes price ceilings on nearby contracts but not on the more distant contracts. \nAlthough highly unusual, this situation has happened before and represents a possible risk that the \nspread trader should consider in the unlikely event that the prevailing political environment is condu-\ncive to the enactment of price controls.\nAlso, for short intervals of time, spread differences may well exceed full carry due to the absence \nof price limits on the nearby contract. For a number of commodities, price limits on the nearby \ncontract are removed at some point before its expiration (e.g., first notice day, first trading day of \nthe expiring month, etc.). Consequently, in a sharply declining market, the nearby month can move \nto a discount exceeding full carry as the forward month is contained by price limits. Although this \nsituation will usually correct itself within a few days, in the interim, it can generate a substantial mar-\ngin call for the spread trader. \nit is important that spread traders holding their positions beyond the \nremoval of price limits on the nearby contract are sufficiently capitalized to easily handle such possible \ntemporary spread aberrations.\nAs a final word, it should be emphasized that although there is a theoretical limit on the premium that \na distant month can command over a nearby contract in carrying-charge markets, there is no similar limit on the \npremium that a nearby position can command. \nnearby premiums are usually indicative of a tight current \nsupply situation, and there is no way of determining an upper limit to the premium the market will \nplace on more immediately available supplies.\n ■ The Spread Trade—Analysis and Approach\nStep 1: Straightforward historical Comparison\nA logical starting point is a survey of the price action of the given spread during recent years. Histori-\ncal spread charts, if available, are ideal for this purpose. if charts (or historical price data that can be \ndownloaded into a spreadsheet) are unavailable, the trader should, if possible, scan historical price \ndata, checking the difference of the given spread on a biweekly or monthly basis for at least the past \n5 to 10 years. \nthis can prove to be a time-consuming endeavor, but a spread trade initiated without \nany concept of historical patterns is, in a sense, a shot in the dark. Although spreads can deviate \nwidely from historic", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 140}
{"text": "are unavailable, the trader should, if possible, scan historical price \ndata, checking the difference of the given spread on a biweekly or monthly basis for at least the past \n5 to 10 years. \nthis can prove to be a time-consuming endeavor, but a spread trade initiated without \nany concept of historical patterns is, in a sense, a shot in the dark. Although spreads can deviate \nwidely from historical patterns, it is still important to know the normal range of a spread, as well as \nits “average” level.\n449\ntHe COnCepts And MeCHAniCs OF spreAd trAding \nStep 2: Isolation of Similar Periods\nAs a rule, spreads will tend to act similarly in similar situations. thus, the next step would be a refine-\nment of step 1 by means of isolating roughly similar periods. For example, in a high-priced year, we \nmight be interested in considering the spread action only in other past bull seasons, or we can cut the \nline still sharper and consider only bull seasons that were demand oriented or only those that were \nsupply oriented. An examination of the spread’s behavior during different fundamental conditions in \npast years will usually reveal the relative comparative importance of similar and dissimilar seasons.\nStep 3: analysis of Spread Seasonality\nthis step is a further refinement of step 1. sometimes a spread will tend to display a distinct seasonal \npattern. For example, a given spread may tend to widen or narrow during a specific period. Knowledge \nof such a seasonality can be critically important in deciding whether or not to initiate a given spread. \nFor example, if in nine of the past 10 seasons the near month of a given spread lost ground to the distant \nmonth during the March–June period, one should think twice about initiating a bull spread in March.\nStep 4: analysis and Implications of relevant Fundamentals\nthis step would require the formulation of a concept of market direction (in commodities where \napplicable), or equivalent appropriate analysis in those commodities where it is not. this approach is \nfully detailed in the sections entitled “the general rule” and “the general rule—Applicability and \nnonapplicability.”\nStep 5: Chart analysis\nA key step before initiating a spread trade should be the examination of a current chart of the spread \n(or the use of some other technical input). As in outright positions, charts are an invaluable informa-\ntional tool and a critical aid to timing.\n ■ Pitfalls and Points of Caution\n ■ do not automatically assume a spread is necessarily a low-risk trade. in some instances, a spread \nmay even involve greater risk than an outright position. specifically, in the case of intercommodity \nspreads, intercrop spreads, and spreads involving nonstorable commodities, the two legs of the \nspread can sometimes move in opposite directions.\n ■ Be careful not to overtrade a spread because of its lower risks or margin. A 5- to 10-contract \nspread position gone astray can often prove more costly than a bad one-contract outright trade. \nOvertrading is a very common error in spread trading.\n450\nA Complete Guide to the Futures mArket\n ■ As a general rule, traders should avoid trading spreads in markets in which they are unfamiliar \nwith the fundamentals.\n ■ Check the open interest of the months involved to ensure adequate liquidity, especially in spreads \ninvolving distant back months. A lack of liquidity can significantly increase the loss when getting \nout of a spread that has gone awry. At times, of course, a given spread may be sufficiently attrac-\ntive despite its less-than-desirable liquidity. \nnevertheless, even in such a case, it is important that \ntraders be aware of the extra risk involved.\n ■ place a spread order on a spread basis rather than as two separate outright orders. some traders \nplace their spread orders one leg at a time in the hopes of initiating their position at a better price \nthan the prevailing market level. \nsuch an approach is inadvisable not only because it will often \nbackfire, but also because it will increase commission costs.\n ■ When the two months of the spread are very close in price, extra care should be taken to specify \nclearly which month is the premium month in the order.\n ■ do not assume that current price quotations accurately reflect actual spread differences. time lags \nin the buying and selling of different contracts, as well as a momentary concentration of orders in \na given contract month, can often result in outright price quotations implying totally unrepresen-\ntative spread values.\n ■ do not liquidate spreads one leg at a time. Failing to liquidate the entire spread position at one \ntime is another common and costly error, which has caused many a good spread trade to end in \na loss.\n ■ Avoid spreads involving soon-to-expire contracts. expiring contracts, aside from usually being \nfree of any price limits, are subject to extremely wide and erratic price moves dependent on \ntechnical delivery conditions.\n ■ do not assume the applicability of prior seasons’ carrying charges before initiating a limited-risk \nspread. Wide price swings and sharply fluctuating interest costs can radically alter carrying costs.\n ■ try to keep informed of any changes in contract specifications, since such changes can substan-\ntially alter the behavior of a spread.\n ■ properly implemented intercommodity and intermarket spreads often require an unequal num-\nber of contracts in each market. the methodology for determining the proper contract ratio be-\ntween different markets is discussed in the next chapter.\n ■ do not use spreads to protect an outright position that has gone sour—that is, do not initiate an \nopposite direction position in another contract as an alternative to liquidating a losing position. \nin most cases such a move amounts to little more than fooling oneself and often can exacerbate \nthe loss.\n451\ntHe COnCepts And MeCHAniCs OF spreAd trAding \n ■ Because it is especially easy to procrastinate in liquidating a losing spread position, the", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 141}
{"text": "that has gone sour—that is, do not initiate an \nopposite direction position in another contract as an alternative to liquidating a losing position. \nin most cases such a move amounts to little more than fooling oneself and often can exacerbate \nthe loss.\n451\ntHe COnCepts And MeCHAniCs OF spreAd trAding \n ■ Because it is especially easy to procrastinate in liquidating a losing spread position, the spread \ntrader needs to be particularly vigilant in adhering to risk management principals. it is advisable \nthat the spread trader determine a mental stop point (usually on the basis of closing values) prior \nto entering a spread and rigidly stick to liquidating the spread position if this mental stop point is \nreached.\n ■ Avoid excessively low-risk spreads because transaction costs (slippage as well as commission) will \nrepresent a significant percentage of the profit potential, reducing the odds of a net winning out-\ncome. \nin short, the odds are stacked against the very-low-risk spread trader.\n ■ As a corollary to the prior item, a trader should choose the most widely spaced intramarket \nspread consistent with the desired risk level. \ngenerally speaking, the wider the time duration in \nan intramarket spread, the greater the volatility of the spread. this observation is as true for mar-\nkets conforming to the general rule as for markets unrelated or inversely related to the general \nrule. \ntraders implementing a greater-than-one-unit intramarket spread position should be sure to \nchoose the widest liquid spread consistent with the trading strategy. For example, it usually would \nmake little sense to implement a two-unit March/May corn spread, since a one-unit March/July \ncorn spread would offer a very similar potential/risk trade at half the transaction cost.\n\n453\n. . . many more people see than weigh.\n—Philip Dormar Stanhope, Earl of Chesterfield\nB\ny definition, the intention of the spread trader is to implement a position that will reflect changes \nin the price difference between contracts rather than changes in outright price levels. T o achieve \nsuch a trade, the two legs of a spread must be equally weighted. As an obvious example, long 2 \nDecember corn/short 1 March corn is a spread in name only. Such a position would be far more \ndependent on fluctuations in the price level of corn than on changes in the price difference between \nDecember and March.\nThe meaning of equally weighted, however, is by no means obvious. Many traders simply assume \nthat a balanced spread position implies an equal number of contracts long and short. Such an assump-\ntion is usually valid for most intramarket spreads (although an exception will be discussed later in this \nchapter). However, for many intermarket and intercommodity\n1 spreads, the automatic presumption \nof an equal number of contracts long and short can lead to severe distortions.\nConsider the example of a trader who anticipates that demand for lower quality Robusta coffee \nbeans (London contract) will decline relative to higher quality Arabica beans (New Y ork contract) and \nIntercommodity \nSpreads: Determining \nContract Ratios\nChapter 31\n1 The distinction between intermarket and intercommodity spreads was defined in Chapter 30. An intermarket \nspread involves buying and selling the same commodity at two different exchanges (e.g., New Y ork vs. London \ncocoa); the intercommodity spread involves buying and selling two different but related markets (e.g., wheat vs. \ncorn, cattle vs. hogs).\n454\nA Complete Guide to the Futures mArket\nattempts to capitalize on this forecast by initiating a 5-contract long New Y ork coffee/short London \ncoffee spread. Assume the projection is correct, and London coffee prices decline from $0.80/lb to \n$0.65/lb, while New Y ork coffee prices simultaneously decline from $1.41/lb to $1.31/lb. At sur-\nface glance, it might appear this trade is successful, since the trader is short London coffee (which has \ndeclined by $0.15/lb) and long New Y ork coffee (which has lost only $0.10/lb). However, the trade \nactually loses money (even excluding commissions). The explanation lies in the fact that the contract \nsizes for the New Y ork and London coffee contracts are different: The size of the New Y ork coffee \ncontract is 37,500 lb, while the size of the London coffee contract is 10 metric tonnes, or 22,043 lb. \n(Note: In practice, the London coffee contract is quoted in dollars/tonne; the calculations in this sec-\ntion reflect a conversion into $/pound for easier comparison with the New Y ork coffee contract.) \nBecause of this disparity, an equal contract position really implies a larger commitment in New Y ork \ncoffee. Consequently, such a spread position is biased toward gaining in bull coffee markets (assuming \nthe long position is in New Y ork coffee) and losing in bear markets. The long New Y ork/short London \nspread position in our example actually loses $2,218 plus commissions, despite the larger decline in \nLondon coffee prices:\nProfit/los so f co ntractso f units per c ontrac tg ain/loss=× ×## per un it\nProfit/loss in long New York coffee positio n5 37 5000=× ×−,( $. .) $,10/lb1 8 750=−\nProfit/loss in short London coffee position = 52 20 43×× +,( $001 5/lb 16 532.) $,=+\nNet profit/l oss in sprea d2 218=− $,\nThe difference in contract size between the two markets could have been offset by adjusting the \ncontract ratio of the spread to equalize the long and short positions in terms of units (lb). The gen-\neral procedure would be to place U1/U2 contracts of the smaller-unit market (i.e., London coffee) \nagainst each contract of the larger-unit contract (i.e., New Y ork coffee). (U1 and U2 represent the \nnumber of units per contract in the respective markets—U1 = 37,500 lb and U2 = 22,043 lb.) Thus, \nin the New Y ork coffee/London coffee spread, each New Y ork coffee contract would be offset by \n1.7 (37,500/22,043) London coffee contracts, implying a minimum equal-unit spread of five London \ncoffee versus three New Y ork cof", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 142}
{"text": "larger-unit contract (i.e., New Y ork coffee). (U1 and U2 represent the \nnumber of units per contract in the respective markets—U1 = 37,500 lb and U2 = 22,043 lb.) Thus, \nin the New Y ork coffee/London coffee spread, each New Y ork coffee contract would be offset by \n1.7 (37,500/22,043) London coffee contracts, implying a minimum equal-unit spread of five London \ncoffee versus three New Y ork coffee (rounding down the theoretical 5.1-contract London coffee posi-\ntion to 5 contracts.) This unit-equalized spread would have been profitable in the above example:\nProfit/los so f co ntractso f units per c ontrac tg ain/loss=× ×## per un it\nProfit/loss in long New York coffee positio n3 37 5000=× ×−,( $. .) $,10/lb1 1 250=−\nProfit/loss in short London coffee position 52 20 43 0=× ×+,( $. 115/lb +1 6 532)$ ,=\nNet profit/l oss in sprea d+ 5 282= $,\nThe unit-size adjustment, however, is not the end of our story. It can be argued that even the \nequalized-unit New Y ork coffee/London coffee spread is still unbalanced, since there is another signifi-\ncant difference between the two markets: London coffee prices are lower than New Y ork coffee prices. \nThis observation raises the question of whether it is more important to neutralize the spread against \nequal price moves or equal-percentage price moves. The rationale for the latter approach is that, all \nelse being equal, the magnitude of price changes is likely to be greater in the higher-priced market.\n455\nIntercommodIty SpreadS: determInIng contract ratIoS\nThe fact that percentage price change is a more meaningful measure than absolute price change is \nperhaps best illustrated by considering the extreme example of the gold/silver spread. The equal-unit \napproach, which neutralizes the spread against equal-dollar price changes in both markets, would \nimply the rather ludicrous spread position of 50 gold contracts versus 1 silver contract. (The contract \nsize of silver is 5,000 oz; the contract size of gold is 100 oz.) Obviously, such a position would be \nalmost entirely dependent upon changes in the price of gold rather than any movement in the gold/\nsilver spread. The disparity is due to the fact that since gold is far higher priced than silver (by a ratio \nof 32-101:1 based on the past 30-year range), its price swings will also be far greater. For example, if \ngold is trading at $1,400/oz and silver at $20/oz, a $2 increase in silver prices is likely to be accom-\npanied by far more than a $2 increase in gold prices. Clearly, the relevant criterion in the gold/silver \nspread is that the position should be indifferent to equal percentage price changes rather than equal \nabsolute price changes. Although less obvious, the same principle would also appear preferable, even \nfor intercommodity or intermarket spreads between more closely priced markets (e.g., New Y ork \ncoffee/London coffee).\nThus we adopt the definition that a balanced spread is a spread that is indifferent to equal percentage \nprice changes in both markets. It can be demonstrated this condition will be fulfilled if the spread is \ninitiated so the dollar values of the long and short positions are equal.\n2 An equal-dollar-value spread \n2 If the spread is implemented so that dollar values are equal, then:\nNU PN UPtt11 10 22 20,,== =\nwhere N1 = number of contracts in market 1\n N2 = number of contracts in market 2\n U1 = number of units per contract in market 1\n U2 = number of units per contract in market 2\n P1,t=0 = price of market 1 at spread initiation\n P2,t=0 = price of market 2 at spread initiation\nAn equal-percentage price change implies that both prices change by the same factor k. Thus,\nPk PP kPtt tt11 10 21 20,, ,,== ==== and\nwhere Pl,t = 1 = price of market 1 after equal-percentage price move\n P2,t = 1 = price of market 2 after equal-percentage price move\nAnd the equity changes (in absolute terms) are:\nEquity change in market 1 positio n =− ===NU kP PN UPtt11 10 10 11 1|| ,, ,t t\ntt\nk\nNU kP P\n=\n==\n−\n=−\n0\n22 20 20\n1 |\n| ,,\n|\nEquity change in market 2 positio n| || ,=− =NU Pkt22 20 1 |\nSince, by definition, an equal-dollar-value spread at initiation implies that N1U1P1,t = 0 = N2U2P2,t = 0, the equity \nchanges in the positions are equal.\nIt should be noted that the equal-dollar-value spread only assures that equal-percentage price changes will \nnot affect the spread if the percentage price changes are measured relative to the initiation price levels. However, \nequal-percentage price changes from subsequent price levels will normally result in different absolute dollar \nchanges in the long and short positions (since the position values are not necessarily equal at any post-initiation \npoints of reference).\n456\nA Complete Guide to the Futures mArket\ncan be achieved by using a contract ratio that is inversely proportional to the contract value (CV) ratio. \nThis can be expressed as follows (see footnote 2 for symbol definitions):\nN\nN\nCV\nCV\nUP\nUP\nt\nt\n2\n1\n1\n2\n11 0\n22 0\n== =\n=\n,\n,\nor, NN CV\nCV21\n1\n2\n= \n\n\n\n\n\nFor example, if New Y ork coffee is trading at $1.41/lb and London coffee at $.80/lb, the equal-dollar-\nvalue spread would indicate a contract ratio of 1 New Y ork coffee/3 London coffee:\nNN CV\nCV N UP\nUP\nt\nt\n21\n1\n2\n1\n11 0\n22 0\n= \n\n\n\n\n =\n\n\n\n\n\n\n=\n=\n,\n,\nIf New York coffee contractN1 1= ,\nN2 =× ×=37 5001 41/22 0430 80 3 London contracts,$ ., $.\nThus, in an equal-dollar-value spread position, 3 New Y ork coffee contracts would be balanced by 9 \n(not 5) London contracts.\nIt may help clarify matters to compare the just-defined equal-dollar-value approach to the \nequal-unit approach for the case of the New Y ork coffee/London coffee spread. Although the equal-\nunit spread is indifferent to equal absolute price changes, it will be affected by equal-percentage \nprice changes (unless, of course, the price levels in both markets are equal, in which case the two \napproaches are equivalent). For example, given initiation price levels of New Y ork coffee = $1.41/lb \nand London coff", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 143}
{"text": "for the case of the New Y ork coffee/London coffee spread. Although the equal-\nunit spread is indifferent to equal absolute price changes, it will be affected by equal-percentage \nprice changes (unless, of course, the price levels in both markets are equal, in which case the two \napproaches are equivalent). For example, given initiation price levels of New Y ork coffee = $1.41/lb \nand London coffee = $.80/lb, consider the effect of a 25 percent price decline on a long 3 New Y ork/\nshort 5 London coffee (equal unit) spread:\nProfit/loss in long New York coffee positio n3 37 5000=× ×−,( $. .) $,3525 39 656=−\nProfit/loss in short London coffee position 52 20 43 0=× ×−,( $. 220 +2 20 43)$ ,=\nProfit/loss in sprea d1 7 613=− $,\nThe equal-dollar-value spread, however, would be approximately unchanged:\nProfit/loss in long New York coffee positio n3 37 5000=× ×−,( $. .) $,3525 39 656=−\nProfit/loss in short London coffee position 92 20 43 0=× ×+,( $. 220 +3 96 77)$ ,=\n Profit/loss in sprea d+ 21= $\nReturning to our original example, if the trader anticipating price weakness in London coffee rela-\ntive to New Y ork coffee had used the equal-dollar-value approach (assuming a 3-contract position for \nNew Y ork coffee), the results would have been as follows:\nProfit/loss in long New York coffee positio n3 37 5000=× ×−,( $. .) $,10 11 250=−\nProfit/loss in short London coffee position 92 20 43 +0=× ×,( $. 115 29 758) $,=+\nProfit/loss in sprea d+ 18 508= $,\n457\nINTERCOMMODITY SPREADS: DETERMINING CONTRACT RATIOS\n Thus, while the naive placement of an equal contract spread actually results in a $2,218 loss \ndespite the validity of the trade concept, the more appropriate equal-dollar-value approach results in \na $18,508 gain. This example emphasizes the critical importance of determining appropriate contract \nratios in intercommodity and intermarket spreads. \n An essential point to note is that if intercommodity and intermarket spreads are traded using an \nequal-dollar-value approach—as they should be—the price diff erence between the markets is no \nlonger the relevant subject of analysis. Rather, such an approach is most closely related to the price \nratio between the two markets. This fact means that chart analysis and the defi nition of historical \nranges should be based on the price ratio, not the price diff erence. Figures 31.1 , 31.2 , and 31.3 illus-\ntrate this point. Figure 31.1 depicts the September 2013 wheat/September 2013 corn spread in the \nstandard form as a price diff erence. Figure 31.2 illustrates the price ratio of September 2013 wheat \nto September 2013 corn during the same period. Finally, Figure 31.3 plots the equity fl uctuations of \nthe approximate equal-dollar-value spread: 3 wheat versus 4 corn. Note how much more closely the \nequal dollar position is paralleled by the ratio than by the price diff erence. \n3 \n 3 The equal-dollar-value spread would be precisely related to the price ratio only if the contract ratios in the \nspread were continuously adjusted to refl ect changes in the price ratio. (An analogous complication does not \nexist in equal-unit spreads, since the contract weightings are determined independent of price levels.) However, \nunless price levels change drastically during the holding period of the spread, the absence of theoretical readjust-\nments in contract ratios will make little practical diff erence. In other words, equity fl uctuations in the equal-\ndollar-value spread will normally closely track the movements of the price ratio.\n FIGURE /uni00A031.1 September 2013 Wheat Minus September 2013 Corn\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n\n458A COMPLETE GUIDE TO THE FUTURES MARKET\n FIGURE /uni00A031.2 Price Ratio of September 2013 Wheat to September 2013 Corn\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \n FIGURE /uni00A031.3 3 September 2013 Wheat Minus 4 September 2013 Corn \n459\nINTERCOMMODITY SPREADS: DETERMINING CONTRACT RATIOS\n In the preceding example, because wheat is a larger contract than corn (in dollar-value terms), \na long 1 wheat/short 1 corn spread would be biased in the direction of the general price trend of \ngrains. For example, during November 2012–August 2013, a period of declining grain prices (see \nFigure 31.4 ), the equal contract spread seems to suggest that wheat prices weakened signifi cantly \nrelative to corn prices (see Figure 31.1 ). In reality, as indicated by Figures 31.2 and 31.3 , the \nwheat/corn relationship during this period was best characterized by a trading range. T o illustrate \nthe trading implications of the spread ratio, consider a long wheat/short corn spread initiated at the \nlate-November 2012 relative high and liquidated at the August 2013 peak. This trade would have \nresulted in a near breakeven trade if the spread were implemented on an equal-dollar-value basis \n(see Figure 31.2 or 31.3 ), but a signifi cant loss if an equal contract criterion were used instead (see \nFigure 31.1 ). \n It should now be clear why the standard assumption of an equal contract position is usually valid \nfor intramarket spreads. In these spreads, contract sizes are identical, while price levels are normally \nclose. Thus, the equal-dollar-value approach suggests a contract ratio very close to 1:1. \n If, however, two contracts in an intramarket spread are trading at signifi cantly diff erent price \n levels, the argument for using the equal-dollar-value approach (as opposed to equal contract positions) \nwould be analogous to the intercommodity and intermarket case. Wide price diff erences between \ncontracts in an intramarket spread can occur in extreme bull markets that place a large premium on \n FIGURE /uni00A031.4 September 2013 Wheat and September 2013 Corn \n\n460\nA Complete Guide to the Futures mArket\nnearby supplies (i.e., in markets conforming to the “general rule” defined in Chapter 30). Intercrop \nspreads (which are a subset of intramarket spre", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 144}
{"text": "case. Wide price diff erences between \ncontracts in an intramarket spread can occur in extreme bull markets that place a large premium on \n FIGURE /uni00A031.4 September 2013 Wheat and September 2013 Corn \n\n460\nA Complete Guide to the Futures mArket\nnearby supplies (i.e., in markets conforming to the “general rule” defined in Chapter 30). Intercrop \nspreads (which are a subset of intramarket spreads) can also exhibit wide price differences. In these \ncases, the greater dollar volatility implicit in the higher-priced month suggests that the spread be initi-\nated with a larger number of contracts in the lower-priced month.\nIt should be noted that the concept of equal dollar value is meaningless for interest rate futures. \nFor example, a $1 million eurodollar contract is certainly not 10 times as large as a $100,000 T -bond \ncontract. In fact, because of its much longer maturity, and, hence, much greater volatility, the T -bond \ncontract is a substantially “larger” contract by any reasonable definition.\n461\nThe stock market is but a mirror which . . . provides an image of the underlying or \nfundamental economic situation.\n—John Kenneth Galbraith\n ■ Intramarket Stock Index Spreads\nSpreads in carrying charge markets, such as gold, provide a good starting point for developing a theo-\nretical behavioral model for spreads in stock index futures. As is the case for gold, there can never \nbe any near-term shortage in stock indexes, which means spreads will be entirely determined by \ncarrying charges. As was explained in Chapter 30, gold spreads are largely determined by short-term \ninterest rates. For example, since a trader could accept delivery of gold on an expiring contract and \nredeliver it against a subsequent contract, the price spread between the two months would primarily \nreflect financing costs and, hence, short-term rates. If the premium of the forward contract were sig-\nnificantly above the level implied by short-term rates, the arbitrageur could lock in a risk-free profit \nby performing a cash-and-carry operation. And if the premium were significantly lower, an arbitra-\ngeur could lock in a risk-free profit by implementing a short nearby/long forward spread, borrowing \ngold to deliver against the nearby contract and accepting delivery at the expiration of the forward \ncontract. These arbitrage forces will tend to keep the intramarket spreads within a reasonably well-\ndefined band for any given combination of short-term interest rates and gold prices.\nThe same arguments could be duplicated substituting a stock index for gold. In a broad sense this \nis true, but there is one critical difference between stock index spreads and gold spreads: Stocks pay \nSpread Trading in \nStock Index Futures\nChapter 32\n462\nA Complete Guide to the Futures mArket\ndividends. Thus, the interest rate cost of holding a stock position is offset (partially, or more than \ntotally) by dividend income. The presence of dividends is easily incorporated into the framework of \ncalculating a theoretical spread level. The spread would be in equilibrium if, based on current prices, \ninterest rates, and dividends, there would be no difference between holding the actual equities in \nthe index for the interim between the two spread months versus buying the forward index futures \ncontract. Holding equities would incur an interest rate cost that does not exist in holding futures, but \nwould also accrue the dividend yield the holder of futures does not receive. The theoretical spread \nlevel (P\n2 − P1) at the expiration of P 1 at which these two alternative means of holding a long equity \nposition—equity and stock index futures—would imply an equivalent outcome can be expressed \nsymbolically as follows:\nPP P t id21 1 360−= \n \n −()\nwhere P1 = price of nearby (expiring) futures contract\n P2 = price of forward futures contract\n t = number of days between expiration of nearby contract and expiration of forward contract\n i = short-term interest rate level at time of P1 expiration\n d = annualized dividend yield (%)\nAs is evident from this equation, if short-term interest rates exceed dividend yields, forward \nfutures will trade at a premium to nearby contracts. Conversely, if the dividend yield exceeds short-\nterm interest rates, forward futures will trade at a discount.\nSince the dividend yield is not subject to sharp changes in the short run, for any given index \n(price) level, intramarket stock index spreads would primarily reflect expected future short-term \nrates (similar to gold spreads). If short-term interest rates exhibit low volatility, as characterized by \nthe near-zero interest rate environment that prevailed in the years following the 2008 financial crisis, \nstock index spreads will tend to trade in relatively narrow range—a consequence of both major \ndrivers of stock index spreads (interest rates and dividend yield) being stable.\n ■ Intermarket Stock Index Spreads\nAs is the case with intercommodity and intermarket spreads trading at disparate price levels, stock \nindex spreads should be traded as ratios rather than differences—an approach that will make the \nspread position indifferent to equal percentage price changes in both markets (indexes). As a reminder, \nto trade a ratio, the trader should implement each leg of the spread in approximately equal contract \nvalue positions, which, as was shown in Chapter 31, can be achieved by using a contract ratio that is \ninversely proportional to the contract value ratio.\nFor example, if the E-mini Nasdaq 100 futures contract, which has a contract value of 20 times the \nindex, is trading at 4,300 (a contract value of $86,000), and the Russell 2000 Mini futures contract, \n463\nSPREAd TRAdING IN SToCK INdEx FuTuRES\nwhich has a contract value of 100 times the index, is trading at 1,150 (a contract value of $115,000), \nthe contract value ratio (CVR) of Nasdaq to Russell futures would be equal to:\nCVR2 04 ,300 /1 00 1,150 07 478=× ×=() () .\nTherefore, the contract ratio would be", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 145}
{"text": "trading at 4,300 (a contract value of $86,000), and the Russell 2000 Mini futures contract, \n463\nSPREAd TRAdING IN SToCK INdEx FuTuRES\nwhich has a contract value of 100 times the index, is trading at 1,150 (a contract value of $115,000), \nthe contract value ratio (CVR) of Nasdaq to Russell futures would be equal to:\nCVR2 04 ,300 /1 00 1,150 07 478=× ×=() () .\nTherefore, the contract ratio would be equal to the inverse of the contract value ratio: \n1/0.7478 = 1.337. Thus, for example, a spread with 3 long (short) Russell contracts would be bal-\nanced by 4 Nasdaq short (long) contracts: 3 × 1.337 = 4.01.\nBecause some stock indexes are inherently more volatile than other indexes—for example, smaller-\ncap indexes tend to be more volatile than larger-cap indexes—some traders may wish to make an \nadditional adjustment to the contract ratio to neutralize volatility differences. If this were done, the \ncontract ratio defined by the inverse of the contract value ratio would be further adjusted by multiply-\ning by the inverse of some volatility measure ratio. \none good candidate for such a volatility measure is \nthe average true range (ATR), which was defined in Chapter 17. As an illustration, if in the aforemen-\ntioned example of the Nasdaq 100/Russell 2000 ratio, the prevailing ATR of the Nasdaq 100 is 0.8 \ntimes the ATR of the Russell 2000, then the Nasdaq/Russell 2000 contract ratio of 1.337 would be \nfurther adjusted by multiplying by the inverse of the ATR ratio (1 / 0.8 = 1.25), yielding a contract \nratio of 1.671 instead of 1.337. If this additional adjustment is made, then a spread with 3 long (short) \nRussell contracts would be balanced by 5 short (long) Nasdaq contracts: 3 × 1.671= 5.01.\nIt is up traders to decide whether they wish to further adjust the contract ratio for volatility. For the \nremainder of this chapter, we assume the more straightforward case of contract ratios being adjusted \nonly for contract value differences (i.e., without any additional adjustment for volatility differences).\nThe four most actively traded stock index futures contracts are the E-mini S&P 500, E-mini \nNasdaq 100, E-mini \ndow , and the Russell 2000 Mini. There are six possible spread pairs for these \nfour markets:\n ■ E-mini S&P 500 / E-mini dow\n ■ E-mini S&P 500 / E-mini Nasdaq 100\n ■ E-mini S&P 500 / Russell 2000 Mini\n ■ E-mini Nasdaq 100 / E-mini dow\n ■ E-mini Nasdaq 100 / Russell 2000 Mini\n ■ E-mini dow / Russell 2000 Mini\nTraders who believe a certain group of stocks will perform better or worse than another group \ncan express this view through stock index spreads. For example, a trader who expected large-cap \nstocks to outperform small-cap stocks could initiate long E-mini S&P 500/short Russell 2000 Mini \nspreads or long E-mini \ndow/short Russell 2000 Mini spreads. A trader expecting relative outperfor-\nmance by small-cap spreads would place the reverse spreads. As another example, a trader expecting \nrelative outperformance by technology stocks might consider spreads that are long the tech-heavy \nNasdaq 100 index and short another index, such as long E-mini Nasdaq 100/short E-mini S&P 500 \n464A CoMPLETE GuIdE To THE FuTuRES MARKET\nspreads. Again, to trade these types of spreads as price ratios, the spreads would be implemented so \nthe contract values of each side are approximately equal, a condition that will be achieved when the \ncontract ratio between the indexes is equal to the inverse of the contract value ratio. \n Figures 32.1 through 32.6 illustrate the contract value ratios for these six spread pairs during \n2002–2015. In some cases, such as the S&P 500/dow spread, the contract value ratio does not vary \nmuch. As can be seen in Figure 32.1 , the contract value ratio for this pair ranged by a factor of only \nabout 1.2 from low to high over the entire period. For other index pairs, however, the contract value \nratio ranged widely. For example, Figure 32.4 shows that during the same period, the high Nasdaq/\ndow contract value ratio was nearly 2.5 times the low ratio. Since the contract ratio required to keep \nthe trade neutral to equal percentage price changes in both markets is equal to the inverse of the \nprevailing contract value ratio, the appropriate contract ratio for these spreads can range widely over \ntime. For example, for the aforementioned Nasdaq 100/dow ratio, a three-contract dow position \nwould have been balanced by a seven-contract Nasdaq position when the contract value ratio was at \nits low versus only a three-contract position (rounding up) when the ratio was at its high. \n Figures 32.7 through 32.12 illustrate the price ratios for the six stock index pairs during the same \nperiod, along with an overlay of one of the indexes to facilitate visually checking of the relationships \nbetween the index price ratio and the overall stock market direction. Note that the price ratios \nin Figures 32.7 through 32.12 are identical in pattern to the contract value ratios in Figures 32.1 \nthrough 32.6 , which is a consequence of the contract value ratio being equal to the price ratio times \na constant—the constant being equal to the ratio of the multipliers for the indexes. \n FIGURE  32.1 Contract Value Ratio: S&P 500/dow E-Mini Futures \n\n465\nSPREAd TRAdING IN SToCK INdEx FuTuRES\n FIGURE  32.2 Contract Value Ratio: S&P 500/Nasdaq 100 E-Mini Futures \n FIGURE  32.3 Contract Value Ratio: S&P 500/Russell 2000 Mini Futures \n\n466A CoMPLETE GuIdE To THE FuTuRES MARKET\n FIGURE  32.4 Contract Value Ratio: Nasdaq 100/dow E-Mini Futures \n FIGURE  32.5 Contract Value Ratio: Nasdaq 100/Russell 2000 Mini Futures \n467\nSPREAd TRAdING IN SToCK INdEx FuTuRES\n FIGURE  32.6 Contract Value Ratio: dow/Russell 2000 Mini Futures \n FIGURE  32.7 S&P 500/dow E-Mini Futures Ratio vs. S&P \n\n468A CoMPLETE GuIdE To THE FuTuRES MARKET\n FIGURE  32.8 S&P 500/Nasdaq 100 E-Mini Futures Ratio vs. S&P \n FIGURE  32.9 S&P 500/Russell 2000 Mini Futures Ratio vs. S&P \n469\nSPREAd TRAdING IN SToCK INdEx FuTuRES\n FIGURE  32.10 Nasdaq", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 146}
{"text": "s \n467\nSPREAd TRAdING IN SToCK INdEx FuTuRES\n FIGURE  32.6 Contract Value Ratio: dow/Russell 2000 Mini Futures \n FIGURE  32.7 S&P 500/dow E-Mini Futures Ratio vs. S&P \n\n468A CoMPLETE GuIdE To THE FuTuRES MARKET\n FIGURE  32.8 S&P 500/Nasdaq 100 E-Mini Futures Ratio vs. S&P \n FIGURE  32.9 S&P 500/Russell 2000 Mini Futures Ratio vs. S&P \n469\nSPREAd TRAdING IN SToCK INdEx FuTuRES\n FIGURE  32.10 Nasdaq 100/dow E-Mini Futures Ratio vs. dow \n FIGURE  32.11 Nasdaq 100/Russell 2000 Mini Futures Ratio vs. Russell 2000 \n470A CoMPLETE GuIdE To THE FuTuRES MARKET\n FIGURE  32.12 dow/Russell 2000 Mini Futures Ratio vs. Russell 2000 \n Generally speaking, at least during the 14-year period depicted in these charts, Figures 32.7 \nthrough 32.12 refl ect a tendency for larger-cap indexes to lose ground to smaller-cap indexes dur-\ning market uptrends and to outperform (i.e., decline less) during market downtrends. For example, \nFigure 32.12 compares the index ratio of the largest cap of the four indexes (dow) to the smallest cap \nof the four indexes (Russell 2000) with the Russell 2000 index. on balance, there is a clear inverse \ncorrelation between the index ratio and the market direction. As another example, in Figure 32.7 , in \nwhich both indexes in the spread are large-cap, but in which the smaller-cap of the two (S&P) is in the \nnumerator of the ratio, the ratio is clearly positively correlated with the market direction. Another \ninteresting aspect of Figure 32.7 is that there appears to be some tendency for the S&P/dow ratio to \nlead major trend reversals in the outright market. \n471\nSpread Trading in \nCurrency Futures\nLenin was certainly right. There is no subtler, no surer means of overturning the existing basis of \nsociety than to debauch the currency. The process engages all the hidden forces of economic law on \nthe side of destruction, and does it in a manner which not one man in a million is able to diagnose.\n—John Maynard Keynes\n ■ Intercurrency Spreads\nConceptually, intercurrency spreads are identical to outright currency trades. After all, a net long or short \ncurrency futures position is also a spread in that it implies an opposite position in the dollar. For example, \na net long Japanese yen (JY) position means that one is long the JY versus the U.S. dollar (USD). If the JY \nstrengthens against the USD, the long JY position will gain. If the JY strengthens against the Swiss franc \n(SF) and euro but remains unchanged against the USD, the long JY position will also remain unchanged.\nIn an intercurrency spread, the implied counterposing short in the USD is replaced by another \ncurrency. For example, in a long JY/short euro spread, the position will gain when the JY strengthens \nrelative to the euro, but will be unaffected by fluctuations of the JY relative to the dollar. The long \nJY/short euro spread is merely the combination of a long JY/short USD and a long USD short euro \nposition, in which the opposite USD positions offset each other. (T o be precise, the implied USD posi-\ntions will only be completely offset if the dollar values of the JY and euro positions are exactly equal.)\nThere are two possible reasons for implementing an intercurrency spread:\n 1. The trader believes currency 1 will gain against the USD, while currency 2 will lose against the USD. In \nthis case, a long currency 1/short currency 2 spread is best thought of as two separate outright trades.\n 2. The trader believes that one foreign currency will gain on another, but has no strong opinion \nregarding the movement of either currency against the USD. In this case, the intercurrency spread \nis analogous to an outright currency trade, with the implied short or long in the USD replaced by \nanother currency. If, however, the two currencies are far more closely related to each other than to \nthe USD, the connotation normally attributed to a spread might be at least partially appropriate.\nChapter 33\n472\nA Complete Guide to the Futures mArket\nIf an intercurrency spread is motivated by the second of these factors, the position should be \n balanced in terms of equal dollar values. (This may not always be possible for the small trader.) \nOtherwise, equity losses can occur, even if the exchange rate between the two currencies remains \nunchanged.\nFor example, consider a long 4 December SF/short 4 December euro spread position imple-\nmented when the December SF = $1.000 and the December euro = $1.250. At the trade initiation, \nthe exchange rate between the SF and euro is 1 euro = 1.25 SF. If the SF rises to $1.100 and the \neuro climbs to $1.375, the exchange rate between the SF and euro is unchanged: 1 euro = 1.25 SF. \nHowever, the spread position will have lost $12,500:\nEquity change numbe ro fc ontrac ts number of unitsp er contra ct ga=× × iin/loss peru nit\nEquity change in long SF 41 25 000 01 0= 50 000=× ×,$ .$ ,\nEquity change in short euro 4 125 000 01 25 62 500=× ×− =−,$ .$ ,\nNetp rofit/loss 12 500=− $,\nThe reason the spread loses money even though the SF/euro exchange rate remains unchanged \nis that the original position was unweighted. At the initiation prices, the spread represented a long \nSF position of $500,000 but a short euro position of $625,000. Thus, the spread position was biased \ntoward gaining if the dollar weakened against both currencies and losing if the dollar strengthened. If, \nhowever, the spread were balanced in terms of equal dollar values, the equity of the position would \nhave been unchanged. For example, if the initial spread position were long 5 December SF/short 4 \nDecember euro (a position in which the dollar value of each side = $625,000), the aforementioned \nprice shift would not have resulted in an equity change:\nEquity change in long SF 51 25 000 01 06 25 00=× ×=,$ .$ ,\nEquity change in short euro 4 125 000 01 25 62 500=× ×− =−,( $. )$ ,\nNetprofit/loss 0=\nThe general formula for determining the equal-dollar-value spread ratio (number of contracts of \ncurrency 1 per contract of currency 2) is:\nEqual-", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 147}
{"text": "alue of each side = $625,000), the aforementioned \nprice shift would not have resulted in an equity change:\nEquity change in long SF 51 25 000 01 06 25 00=× ×=,$ .$ ,\nEquity change in short euro 4 125 000 01 25 62 500=× ×− =−,( $. )$ ,\nNetprofit/loss 0=\nThe general formula for determining the equal-dollar-value spread ratio (number of contracts of \ncurrency 1 per contract of currency 2) is:\nEqual-dollar-spread rati o\nnumbe ro f units per\ncontra ct of currenc= yy2\npriceo f\ncurrenc y2\nnumbe ro f units per\ncontra ct of currenc y1\n() ()\n(() ()\npriceo f\ncurrenc y1\nFor example, if currency 1, the British pound (BP) = $1.50, and currency 2, the euro = $1.20, \nand the BP futures contract consists of 62,500 units, while the euro futures contract consists of \n125,000 units, the implied spread ratio would be:\n(, )($ .)\n(, )($ .) .125 0001 20\n62 5001 50 16=\n473\nSPreAD TrADINg IN CUrreNCY FUTUreS\nThus, the equal dollar value spread would consist of 1.6 BP contracts per euro contract, or 8 BP to \n5 euro.\nequity fluctuations in an equal-dollar-value intercurrency spread position will mirror the price \nratio (or exchange rate) between currencies. It should be emphasized that price ratios (as opposed to \nprice spreads) are the only meaningful means of representing intercurrency spreads. For example, if \nthe BP = $1.50 and SF = $1.00, an increase of $0.50 in both the currencies will leave the price spread \nbetween the BP and SF unchanged, even though it would drastically alter the relative values of the two \ncurrencies: a decline of the BP vis-à-vis the SF from 1.5 SF to 1.33 SF.\n ■ Intracurrency Spreads\nAn intracurrency spread—the price difference between two futures contracts for the same currency—\ndirectly reflects the implied forward interest rate differential between dollar-denominated accounts \nand accounts denominated in the given currency. For example, the June/December euro spread \nindicates the expected relationship between six-month eurodollar and euro rates in June.\n1\nT o demonstrate the connection between intracurrency spreads and interest rate differentials, we \ncompare the alternatives of investing in dollar-denominated versus euro-denominated accounts:\nS = spot exchange rate ($/euro)\nF = current forward exchange rate for date at end of investment period ($/euro)\nr\n1 = simple rate of return on dollar-denominated account for investment period (nonannualized)\nr2 = simple rate of return on euro-denominated account for investment period (nonannualized)\nalternative a:\nInvest in Dollar-Denominated account\nalternative B:\nInvest in euro-Denominated account\n1. Invest $1 in dollar-denominated account. 1. Convert $1 to euro at spot.\n2. Funds at end of period = $1 (1 + r1) exchange rate is S, which yields 1/S euro. (By definition, if S equals dollars \nper euro, 1/S = euro per dollar.)\n2. Invest 1/S euro in euro-denominated account at r\n2.\n3. Lock in forward exchange rate by selling the anticipated euro proceeds \nat end of investment period at current forward rate F.2\n4. Funds at end of period = 1/S (1 + r2) euro.\n5. Converted to dollars at rate F, funds at end of period = $F/S (1 + r2) \n(since F = dollars per euro).\n1 The eurocurrency rates are interest rates on time deposits for funds outside the country of issue and hence free \nof government controls. For example, interest rates on dollar-denominated deposits in London are eurodollar \nrates, while rates on sterling-denominated deposits in Frankfurt are eurosterling rates. The quoted eurocurrency \nrates represent the rates on transactions between major international banks.\n2 A short forward position can be established in one of two ways: (1) selling futures that are available for forward \ndates at three-month intervals; and (2) initiating a long spot/short forward position in the foreign exchange (FX) \nswap market and simultaneously selling spot.\n474\nA Complete Guide to the Futures mArket\nIf the proceeds of the two above alternatives are to be equivalent, then:\n11 12+= +r F\nS r()\nThus, at this equilibrium level, given values for S, r1, and r2, F would be automatically determined. \nFor example, if S = $0.80/euro, r 1 = 2 percent per six-month period (4.04 percent annualized), \nand r2 = 1 percent per six-month period (2.01 percent annualized), at equilibrium, the six-month \nforward rate would be:\nF Sr\nr= +\n+ ==()\n()\n.( .)\n(. ) .1\n1\n0810 2\n10 1 08 07921\n2\nAt forward rate of F = 0.80792, both alternatives will yield $1.02. This result is obvious for the \ndollar-denominated account; for the euro-denominated account:\n$/ () $. (. )\n. $.FS r1 0 80792 10 1\n08 0 10 22+= =\nConsider what would happen if the forward exchange rate F were greater than the equilibrium \nlevel (i.e., greater than $0.80792/euro in the above example). For instance, using an assumed value \nof F = $0.82/euro, the proceeds of Alternative B would be:\n$. (. )\n. $.08 21 01\n08 0 10 3525=\nThus, if F = $0.82/euro, arbitrageurs could borrow dollars at r1 convert the dollars into euro, invest \nthe euro at r2, and hedge the anticipated six-month forward euro proceeds at $0.82/euro. In doing so, \nthey would pay $1.02 for the dollar loan, but would earn $1.03525, thereby netting a risk-free profit of \n$0.01525 per dollar borrowed. If such a wonderful opportunity existed (and it will soon be clear why \nit could not), all arbitrageurs who were awake and could add would rush to implement the above set of \ntransactions. This activity by arbitrageurs would impact both the spot and forward exchange rates. In the \nspot market, the concentration of conversions of dollars into euros would cause the euro to gain against \nthe dollar, and hence the spot rate S would rise. Similarly, in the forward market, heavy sales of euro \nagainst the dollar would cause the euro to weaken against the dollar and hence the forward rate F would \nfall.\n3 These market forces would narrow the gap between the forward and spot rates until:\nF\nS\nr\nr= +\n+\n1\n1\n1\n2\n3 In the futures market, such sales would occur directly. In the cash FX ma", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 148}
{"text": "t \nthe dollar, and hence the spot rate S would rise. Similarly, in the forward market, heavy sales of euro \nagainst the dollar would cause the euro to weaken against the dollar and hence the forward rate F would \nfall.\n3 These market forces would narrow the gap between the forward and spot rates until:\nF\nS\nr\nr= +\n+\n1\n1\n1\n2\n3 In the futures market, such sales would occur directly. In the cash FX market, downward pressure on the implied \nforward rate would manifest itself through the initiation of long spot/short forward swaps (spreads).\n475\nSPreAD TrADINg IN CUrreNCY FUTUreS\nOf course, the market forces just described would come into play well before the forward/spot \nratio increased to 0.82/0.80 = 1.025. The intervention of arbitrageurs will assure the six-month \nforward/spot ratio would not rise significantly above 1 + r 1/1 + r2 = 1.0099. A similar argument \ncould be used to demonstrate that arbitrage intervention would keep the forward/spot ratio from \ndeclining significantly below 1.0099. In short, arbitrage activity will assure that the forward/spot \nratio will be approximately defined by the above equation. This relationship is commonly referred to \nas the interest rate parity theorem.\nSince currency futures must converge with spot exchange rates at expiration, the price spread \nbetween a forward futures contract and a nearby expiring contract must reflect the prevailing interest \nrate ratio (between the eurodollar rate and the given eurocurrency rate).\n4 Hence, a spread between \ntwo forward futures contracts can be interpreted as reflecting the market’s expectation for the inter-\nest rate ratio at the time of the nearby contract expiration. Specifically, if P\n1 = price of the more \nnearby futures expiring at t1 and P2 = price of the forward futures contract expiring at time t 2, then \nP2/P1 will equal the expected interest rate ratio (expressed as 1+r1/1+r2) for term rates of duration \nt2 − t1 at time t1. It should be stressed that the forward interest rate ratio implied by spreads in futures \nwill usually differ from the prevailing interest rate ratio.\nIf the market expects the eurodollar rate to be greater than the foreign eurocurrency rate, forward \nfutures for that currency will trade at a premium to more nearby futures—the wider the expected \ndifferential, the wider the spread. Conversely, if the foreign eurocurrency rate is expected to be \ngreater than the eurodollar rate, forward futures will trade at a discount to nearby futures.\nThe above relationships suggest that intracurrency spreads can be used to trade expectations \nregarding future interest rate differentials between different currencies. If a trader expected eurodol-\nlar rates to gain (move up more or down less) on a foreign eurocurrency rate (relative to the expected \ninterest rate ratio implied by the intracurrency futures spread), this expectation could be expressed \nas a long forward/short nearby spread in that currency. Conversely, if the trader expected the foreign \neurocurrency rate to gain on the eurodollar rate, the implied trade would be a long nearby/short \nforward intracurrency spread.\nAs a technical point, a 1:1 spread ratio would fluctuate even if the implied forward interest rate \nratio were unchanged. For example, if P\n2 = $0.81/euro and P1 = $0.80/euro, a 10-percent increase \nin both rates would result in a 810-point price gain in the forward contract and only a 800-point gain \nin the nearby contract, even though the implied forward interest rate ratio would be unchanged (since \nan equal percentage change in each month would leave F/S unchanged). In order for the spread posi-\ntion to be unaffected by equal percentage price changes in both contracts, a development that would \nnot affect the implied forward interest rate ratio, the spread would have to be implemented so that the \ndollar value of the long and short positions were equal. This parity will be achieved when the contract \nratio is equal to the inverse of the price ratio. For example, given the above case of P\n2 = $0.81 and \n4 All references to interest rate ratios in this section should be understood to mean (1 + r1)/(l + r2) where r1 \nand r2 are the nonannualized rates of return for the time interim between S and F. Thus, in the above example, \nthe interest rate ratio for the six-month period given annualized rates of 4.04 percent and 2.01 percent is equal \nto 1.02/1.01 = 1.0099. The reader should be careful not to misconstrue the intended definition of interest rate \nratio with a literal interpretation, which in the above example would suggest a figure of 0.02/0.01 = 2.\n476\nA Complete Guide to the Futures mArket\nP1 = $0.80, an 80-contract forward/81-contract nearby spread would not be affected by equal price \nchanges (e.g., a 10-percent price increase would cause a total 64,800-point change in both legs of the \nspread). As can be seen in this example, a balanced spread will only be possible for extremely large \npositions. This fact, however, does not present a problem, since the distortion is sufficiently small so \nthat a 1:1 contract ratio spread serves as a reasonable approximation.\nIntracurrency spreads can also be combined to trade expectations regarding two foreign euro-\ncurrency rates. In this case, the trader would implement a long nearby/short forward spread in the \ncurrency with the expected relative rate gain, and a long forward/short nearby spread in the other \ncurrency. For example, assume that in February the June/December euro spread implies that the \nJune six-month eurodollar rate will be 1 percent above the euro rate, while the June/December JY \nspread implies that the June eurodollar rate will be 2 percent above the euroyen rate. In combina-\ntion, these spreads imply that the June euro rate will be higher than the June euroyen rate. If a trader \nexpected euroyen rates to be higher than euro rates in June, the following combined spread positions \nwould be implied: long June JY/short December JY plus long December euro/sho", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 149}
{"text": "une/December JY \nspread implies that the June eurodollar rate will be 2 percent above the euroyen rate. In combina-\ntion, these spreads imply that the June euro rate will be higher than the June euroyen rate. If a trader \nexpected euroyen rates to be higher than euro rates in June, the following combined spread positions \nwould be implied: long June JY/short December JY plus long December euro/short June euro.\nT o summarize, intracurrency spreads can be used to trade interest rate differentials in the follow-\ning manner:\nexpectation Indicated trade\neurodollar rate will gain on given eurocurrency rate \n(relative to rate ratio implied by spread).\nLong forward/short nearby\nspread in given currency\neurodollar rate will lose on given eurocurrency rate \n(relative to rate ratio implied by spread).\nLong nearby/short forward\nspread in given currency\neurocurrency rate 1 will gain on eurocurrency rate 2 \n(relative to rate ratio implied by spreads in both markets).\nLong nearby/short forward spread in market 1 and long \nforward/short nearby spread in market 2\n477\nA put might more properly be called a stick. For the whole point of a put—its purpose, if you \nwill—is that it gives its owner the right to force 100 shares of some godforsaken stock onto \nsomeone else at a price at which he would very likely rather not take it. So what you are really \ndoing is sticking it to him.\n—Andrew T obias\nGetting By on $100,000 a Year (and Other Sad T ales)\n ■ Preliminaries\nThere are two basic types of options: calls and puts. The purchase of a call option on futures1 provides \nthe buyer with the right, but not the obligation, to purchase the underlying futures contract at a speci-\nfied price, called the strike or exercise price, at any time up to and including the expiration date. 2 A put \noption provides the buyer with the right, but not the obligation, to sell the underlying futures contract \nat the strike price at any time prior to expiration. (Note, therefore, that buying a put is a bearish trade, \nwhile selling a put is a bullish trade.) The price of an option is called the premium, and is quoted in \nAn Introduction to \nOptions on Futures\nChapter 34\n1 Chapters 34 and 35 deal specifically with options on futures contracts. However, generally speaking, analogous \nconcepts would apply to options on cash (physical) goods or instruments (e.g., bullion versus gold futures). \nSome of the advantages of basing an option contract on futures as opposed to the cash asset are discussed in the \nnext section.\n2 For some markets, the expiration date on the option and the underlying futures contract will be the same; for other \nmarkets, the expiration date on the option will be a specified date prior to the expiration of the futures contract.\n478\nA Complete Guide to the Futures mArket either dollars (or cents) per unit or points. Table 34.1 illustrates how to calculate the dollar value of \na premium. As a specific example, a trader who buys a $1,000 August gold call at a premium of $50 \npays $50/oz ($5,000 per contract) for the right to buy an August gold futures contract at $1,000 \n(regardless of how high its price may rise) at any time up to the expiration date of the August option.\nBecause options are traded for both puts and calls and a number of strike prices for each futures \ncontract, the total number of different options traded in a market will far exceed the number of \nfutures contracts—often by a factor of 10 to 1 or more. This broad variety of listed options provides \nthe trader with myriad alternative trading strategies.\nLike their underlying futures contracts, options are exchange-traded, standardized contracts. \nConsequently, option positions can be offset prior to expiration simply by entering an order opposite \nto the position held. For example, the holder of a call could liquidate his position by entering an order \nto sell a call with the same expiration date and strike price.\nThe buyer of a call seeks to profit from an anticipated price rise by locking in a specific purchase \nprice. His maximum possible loss will be equal to the dollar amount of the premium paid for the \noption. This maximum loss would occur on an option held until expiration if the strike price were \nabove the prevailing futures price. For example, if August gold futures were trading at $990 upon the \nexpiration of the August option, a $1,000 call would be worthless because futures could be purchased \nmore cheaply at the existing market price.\n3 If the futures were trading above the strike price at expira-\ntion, then the option would have some value and hence would be exercised. However, if the difference \ntable 34.1 Determining the Dollar Value of Option premiums\nContracts Quoted on an Index\nOption premium (in points) × $ value per point = $ value of the option premium\nExamples:\nE-mini S&P 500 options\n8.50 (option premium) × $50 per point = $425 (option premium $ value)\nU.S. dollar index options\n2.30 (option premium) × $1,000 per point = $2,300 (option premium $ value)\nContracts Quoted in Dollars\nOption premium (in dollars or \ncents per unit)\n× No. of units in futures contract = $ value of the option premium\nExamples:\nGold options\n$42 (option premium) × 100 (ounces in futures contract) = $4,200 (option premium $ value)\nWTI crude oil options\n$1.24 (option premium) × 1,000 (barrels in futures contract) = $1,240 (option premium $ value)\n3 However, it should be noted that even in this case, the call buyer could have recouped part of the premium if \nhe had sold the option prior to expiration. This is true since the option will maintain some value (i.e., premium \ngreater than zero) as long as there is some possibility of the futures price rising above the strike price prior to \nthe expiration of the option.\n479\nAN INTrOduCTION TO OPTIONS ON FuTureS\nbetween the futures price and the strike price were less than the premium paid for the option, the \nnet result of the trade would still be a loss. In order for the call buyer to realize a net profit, th", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 150}
{"text": "premium \ngreater than zero) as long as there is some possibility of the futures price rising above the strike price prior to \nthe expiration of the option.\n479\nAN INTrOduCTION TO OPTIONS ON FuTureS\nbetween the futures price and the strike price were less than the premium paid for the option, the \nnet result of the trade would still be a loss. In order for the call buyer to realize a net profit, the dif-\nference between the futures price and the strike price would have to exceed the premium at the time \nthe call was purchased (after adjusting for commission cost). The higher the futures price, the greater \nthe resulting profit. Of course, if the futures reach the desired objective, or the call buyer changes his \nmarket opinion, he could sell his call prior to expiration.\n4\nThe buyer of a put seeks to profit from an anticipated price decline by locking in a sales price. \nSimilar to the call buyer, his maximum possible loss is limited to the dollar amount of the premium \npaid for the option. In the case of a put held until expiration, the trade would show a net profit if the \nstrike price exceeded the futures price by an amount greater than the premium of the put at purchase \n(after adjusting for commission cost).\nWhile the buyer of a call or put has limited risk and unlimited potential gain,\n5 the reverse is true \nfor the seller. The option seller (“writer”) receives the dollar value of the premium in return for \nundertaking the obligation to assume an opposite position at the strike price if an option is exercised. \nFor example, if a call is exercised, the seller must assume a short position in futures at the strike \nprice (since by exercising the call, the buyer assumes a long position at that price). \nupon exercise, \nthe exchange’s clearinghouse will establish these opposite futures positions at the strike price. After \nexercise, the call buyer and seller can either maintain or liquidate their respective futures positions.\nThe seller of a call seeks to profit from an anticipated sideways to modestly declining market. In \nsuch a situation, the premium earned by selling a call will provide the most attractive trading oppor-\ntunity. However, if the trader expected a large price decline, he would usually be better off going \nshort futures or buying a put—trades with open-ended profit potential. In a similar fashion, the seller \nof a put seeks to profit from an anticipated sideways to modestly rising market.\nSome novices have trouble understanding why a trader would not always prefer the buy side of an \noption (call or put, depending on his market opinion), since such a trade has unlimited potential and \nlimited risk. Such confusion reflects the failure to take probability into account. Although the option \nseller’s theoretical risk is unlimited, the price levels that have the greatest probability of occurring \n(i.e., prices in the vicinity of the market price at the time the option trade occurs) would result in a net \ngain to the option seller. \nroughly speaking, the option buyer accepts a large probability of a small loss \nin return for a small probability of a large gain, whereas the option seller accepts a small probability \nof a large loss in exchange for a large probability of a small gain. In an efficient market, neither the \nconsistent option buyer nor the consistent option seller should have any advantage over the long run.\n6\n4 even if the call is held until the expiration date, it will usually still be easier to offset the position in the options \nmarket rather than exercising the call.\n5 T echnically speaking, the gains on a put would be limited, since prices cannot fall below zero; but for practical \npurposes, it is entirely reasonable to speak of the maximum possible gain on a long put position as being unlimited.\n6 T o be precise, this statement is not intended to imply that the consistent option buyer and consistent option seller \nwould both have the same expected outcome (zero excluding transactions costs). Theoretically, on average, it is rea-\nsonable to expect the market to price options so there is some advantage to the seller to compensate option sellers for \nproviding price insurance—that is, assuming the highly undesirable exposure to a large, open-ended loss. So, in effect, \noption sellers would have a more attractive return profile and a less attractive risk profile than option buyers, and it \nis in this sense that the market will, on average, price options so that there is no net advantage to the buyer or seller.\n480\nA Complete Guide to the Futures mArket\n ■ Factors That Determine Option Premiums\nAn option’s premium consists of two components:\nPremiu mi ntri nsic v aluet imev alue=+\nThe intrinsic value of a call option is the amount by which the current futures price is above the strike \nprice. The intrinsic value of a put option is the amount by which the current futures price is below the \nstrike price. In effect, the intrinsic value is that part of the premium that could be realized if the option were \nexercised and the futures contract offset at the current market price. For example, if July crude oil futures \nwere trading at $74.60, a call option with a strike price of $70 would have an intrinsic value of $4.60. The \nintrinsic value serves as a floor price for an option. Why? Because if the premium were less than the intrinsic \nvalue, a trader could buy and exercise the option, and immediately offset the resulting futures position, \nthereby realizing a net gain (assuming this profit would at least cover the transaction costs).\nOptions that have intrinsic value (i.e., calls with strike prices below the current futures price and \nputs with strike prices above the current futures price) are said to be in-the-money. Options with no \nintrinsic value are called out-of-the-money options. An option whose strike price equals the futures \nprice is called an at-the-money option. The term at-the-money is also often used less restrictively to refer \nto the specific option wh", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 151}
{"text": "lls with strike prices below the current futures price and \nputs with strike prices above the current futures price) are said to be in-the-money. Options with no \nintrinsic value are called out-of-the-money options. An option whose strike price equals the futures \nprice is called an at-the-money option. The term at-the-money is also often used less restrictively to refer \nto the specific option whose strike price is closest to the futures price.\nAn out-of-the-money option, which by definition has an intrinsic value of zero, nonetheless retains \nsome value because of the possibility the futures price will move beyond the strike price prior to the expi-\nration date. An in-the-money option will have a value greater than the intrinsic value because a position in \nthe option will be preferred to a position in the underlying futures contract. \nreason: Both the option and \nthe futures contract will gain equally in the event of favorable price movement, but the option’s maximum \nloss is limited. The portion of the premium that exceeds the intrinsic value is called the time value.\nIt should be emphasized that because the time value is almost always greater than zero, one should \navoid exercising an option before the expiration date. Almost invariably, the trader who wants to \noffset his option position will realize a better return by selling the option, a transaction that will yield \nthe intrinsic value plus some time value, as opposed to exercising the option, an action that will yield \nonly the intrinsic value.\nThe time value depends on four quantifiable factors\n7:\n 1. the relationship between the strike price and the current futures price. As illus-\ntrated in Figure 34.1, the time value will decline as an option moves more deeply in-the-money \nor out-of-the-money. \ndeeply out-of-the-money options will have little time value, since it is \nunlikely the futures will move to (or beyond) the strike price prior to expiration. deeply in-\nthe-money options have little time value because these options offer very similar positions to \nthe underlying futures contracts—both will gain and lose equivalent amounts for all but an \nextreme adverse price move. In other words, for a deeply in-the-money option, the fact that the \n7 Theoretically, the time value will also be influenced by price expectations, which are a non-quantifiable factor.\n481\nAN INTrOduCTION TO OPTIONS ON FuTureS\nrisk is limited is not worth very much, because the strike price is so far away from the prevailing \nfutures price. As Figure 34.1 shows, the time value will be at a maximum at the strike price. \n 2. time remaining until expiration. The more time remaining until expiration, the greater \nthe time value of the option. This is true because a longer life span increases the probability \nof the intrinsic value increasing by any specifi ed amount prior to expiration. In other words, \nthe more time until expiration, the greater the probable price range of futures. Figure 34.2 \nillustrates the standard theoretical assumption regarding the relationship between time value \nand time remaining until expiration for an at-the-money option. Specifi cally, the time value is \n FIGURE  34.1 Theoretical Option Premium Curve \n Source: Chicago Board of Trade, Marketing department. \nCall Option\nStrike price\nIntrinsic value\nT -bond futures price130\n132\n134\n136\n138\n140\nTime value premium\n8\n6\n4\n2 Option premium\nStrike price\nIntrinsic\nvalue\nT-bond futures price\n124\n126\n128\n130\n8\n6\n4\n2 Option premium\nPut Option\nTime value premium\n FIGURE  34.2 Time Value decay \n Source: Options on Comex Gold Futures, published by Commodity \nexchange, Inc. (COMeX), 1982. \nTime value decay\n94 10\nTime remaining until expiration (months)\nTime value premium\n482\nA Complete Guide to the Futures mArket\ntable 34.2 Option prices as a Function of V olatility in \ne-Mini S&p 500 Futures pricesa\nannualized V olatility put or Call premium\n10 22.88 ($1,144)\n20 45.75 ($2,288)\n30 68.62 ($3,431)\n40 91.46 ($4,573)\n50 114.29 ($5,715)\na At-the-money options at a strike price of 2000 with 30 days to expiration.\n8 James Bowe, Option Strategies T rading Handbook (New Y ork, NY: Coffee, Sugar, and Cocoa exchange, 1983).\nassumed to be a function of the square root of time. (This relationship is a consequence of the \ntypical assumption regarding the shape of the probability curve for prices of the underlying \nfutures contract.) Thus, an option with nine months until expiration would have 1.5 times the \ntime value of a four-month option with the same strike price \n(; ;. )93 42 32 15== ÷= \nand three times the time value of a one-month option (; ;)93 11 31 3== ÷= .\n 3. V olatility. Time value will vary directly with the estimated volatility of the underlying futures \ncontract for the remaining lifespan of the option. This relationship is the result of the fact that \ngreater volatility raises the probability the intrinsic value will increase by any specified amount \nprior to expiration. In other words, the greater the volatility, the larger the probable range of \nfutures prices. As Table 34.2 shows, volatility has a strong impact on theoretical option pre-\nmium values.\nAlthough volatility is an extremely important factor in determining option premium values, \nit should be stressed that the future volatility of the underlying futures contract is never pre-\ncisely known until after the fact. (In contrast, the time remaining until expiration and the rela -\ntionship between the current price of futures and the strike price can be exactly specified at any \njuncture.) Thus, volatility must always be estimated on the basis of historical volatility data. As \nwill be explained, this factor is crucial in explaining the deviation between theoretical and actual \npremium values.\n 4. Interest rates. The effect of interest rates on option premiums is considerably smaller than \nany of the above three factors. The specific nature of the relationship between interest rates and \npremiums was succinctly summarized by James Bowe", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 152}
{"text": "of historical volatility data. As \nwill be explained, this factor is crucial in explaining the deviation between theoretical and actual \npremium values.\n 4. Interest rates. The effect of interest rates on option premiums is considerably smaller than \nany of the above three factors. The specific nature of the relationship between interest rates and \npremiums was succinctly summarized by James Bowe\n8:\nThe effect of interest rates is complicated because changes in rates affect not only the \nunderlying value of the option, but the futures price as well. Taking it in steps, a buyer \nof any given option must pay the premium up front, and of course the seller receives \nthe money. If interest rates go up and everything else stays constant, the opportunity \ncost to the option buyer of giving up the use of his money increases, and so he is will-\ning to bid less. Conversely, the seller of options can make more on the premiums by \n483\nAN INTrOduCTION TO OPTIONS ON FuTureS\ninvesting the cash received and so is willing to accept less; the value of the options fall. \nHowever, in futures markets, part of the value of distant contracts in a carry market \nreflects the interest costs associated with owning the commodity. An increase in the \ninterest rate might cause the futures price to increase, leading to the value of existing \ncalls going up. The net effect on calls is ambiguous, but puts should decline in value \nwith increasing interest rates, as the effects are reinforcing.\n ■ Theoretical versus Actual Option Premiums\nThere is a variety of mathematical models available that will indicate the theoretical “fair value” for an \noption, given specific information regarding the four factors detailed in the previous section. Theoret-\nical values will approximate, but by no means coincide with, actual premiums. \ndoes the existence of \nsuch a discrepancy necessarily imply that the option is mispriced? definitely not. The model-implied \npremium will differ from the actual premium for two reasons:\n 1. The model’s assumption regarding the mathematical relationship between option prices (premi-\nums) and the factors that affect option prices may not accurately describe market behavior. This \nis always true because, to some extent, even the best option-pricing models are only theoretical \napproximations of true market behavior.\n 2. The volatility figure used by an option-pricing model will normally differ somewhat from the \nmarket’s expectation of future volatility. This is a critical point that requires further elaboration.\nrecall that although volatility is a crucial input in any option pricing formula, its value can \nonly be estimated. The theoretical “fair value” of an option will depend on the specific choice of a \nvolatility figure. Some of the factors that will influence the value of the volatility estimate are the \nlength of the prior period used to estimate volatility, the time interval in which volatility is mea-\nsured, the weighting scheme (if any) used on the historical volatility data, and adjustments (if any) \nto reflect relevant influences (e.g., the recent trend in volatility). It should be clear that any specific \nvolatility estimate will implicitly reflect a number of unavoidably arbitrary decisions. \ndifferent \nassumptions regarding the best procedure for estimating future volatility from past volatility will \nyield different theoretical premium values. Thus, there is no such thing as a single, well-defined fair \nvalue for an option.\nAll that any option pricing model can tell you is what the value of the option should be given \nthe specific assumptions regarding expected volatility and the form of the mathematical relationship \nbetween option prices and the key factors affecting them. If a given mathematical model provides a \nclose approximation of market behavior, a discrepancy between the theoretical value and the actual \npremium means the market expectation for volatility, called the implied volatility, differs from the \nhistorically based volatility estimate used in the model. The question of whether the volatility assump-\ntions of a specific pricing model provide more accurate estimates of actual volatility than the implied \nvolatility figures (i.e., the future volatility suggested by actual premiums) can only be answered \nempirically. A bias toward buying “underpriced” options (relative to the theoretical model fair value) \n484\nA Complete Guide to the Futures mArket\nand selling “overpriced” options would be justified only if empirical evidence supported the conten-\ntion that, on balance, the model’s volatility assumptions proved to be better than implied volatility in \npredicting actual volatility levels.\nIf a model’s volatility estimates were demonstrated to be superior to implied volatility estimates, \nit would suggest, from a strict probability standpoint, a bullish trader would be better off selling puts \nthan buying calls if options were overpriced (based on the fair value figures indicated by the model), \nand buying calls rather than selling puts if options were underpriced. Similarly, a bearish trader would \nbe better off selling calls than buying puts if options were overpriced, and buying puts rather than \nselling calls if options were underpriced. The best strategy for any individual trader, however, would \ndepend on the specific profile of his price expectations (i.e., the probabilities the trader assigns to \nvarious price outcomes).\n ■ Delta (the Neutral Hedge Ratio)\nDelta, also called the neutral hedge ratio, is the expected change in the option price given a one-unit \nchange in the price of the underlying futures contract. For example, if the delta of an August gold \ncall option is 0.25, it means that a $1 change in the price of August futures can be expected to result \nin a $0.25 change in the option premium. Thus, the delta value for a given option can be used to \ndetermine the number of options that would be equivalent in risk to a single futures contract for small \nchanges", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 153}
{"text": "ice of the underlying futures contract. For example, if the delta of an August gold \ncall option is 0.25, it means that a $1 change in the price of August futures can be expected to result \nin a $0.25 change in the option premium. Thus, the delta value for a given option can be used to \ndetermine the number of options that would be equivalent in risk to a single futures contract for small \nchanges in price. It should be stressed that delta will change rapidly as prices change. Thus, the delta \nvalue cannot be used to compare the relative risk of options versus futures for large price changes.\nTable 34.3 illustrates the estimated delta values for out-of-the-money, at-the-money, and in-the-\nmoney call options for a range of times to expiration. Where did these values come from? They are \nderived from the same mathematical models used to determine a theoretical value for an option pre-\nmium given the relationship between the strike price and the current price of futures, time remaining \ntable 34.3 Change in the premium of an e-Mini S&p 500 Call Option for 20.00 ($1000) Move in the \nUnderlying Futures Contracta\nIncrease in the 2000 call option premium if the futures price rises:\nFrom 1900 to 1920 From 2000 to 2020 From 2100 to 2120\nTime to expiration $ Delta $ Delta $ Delta\n1 week $10 0.01 $500 0.5 $1,000 1\n1 month $120 0.12 $510 0.51 $870 0.87\n3 months $260 0.26 $510 0.51 $750 0.75\n6 months $330 0.33 $520 0.52 $690 0.69\n12 months $390 0.39 $520 0.52 $650 0.65\naAssumed volatility: 15 percent; assumed interest rate: 2 percent per year.\nSource: CMe Group (www .cmegroup.com).\n485\nAN INTrOduCTION TO OPTIONS ON FuTureS\nuntil expiration, estimated volatility, and interest rates. For any given set of values for these factors, \ndelta will equal the absolute difference between the option premium indicated by the model and the \nmodel-indicated premium if the futures price changes by one point. Table 34.3 illustrates a number \nof important observations regarding theoretical delta values:\n 1. Delta values for out-of-the-money options are low. This relationship is a result of the \nfact that there is a high probability that any given price increase\n9 will not make any actual differ-\nence to the value of the option at expiration (i.e., the option will probably expire worthless).\n 2. Delta values for in-the-money options are relatively high, but less than one. In-\nthe-money options have high deltas because there is a high probability that a one-point change \nin the futures price will mean a one-point change in the option value at expiration. However, \nsince this probability must always be equal to less than one, the delta value will also always be \nequal to less than one.\n 3. Delta values for at-the-money options will be near 0.50. Since there is a 50/50 chance \nthat an at-the-money option will expire in-the-money, there will be an approximately 50/50 \nchance that a one-point increase in the price of futures will result in a one-point increase in the \noption value at expiration.\n 4. Delta values for out-of-the-money options will increase as time to expiration \nincreases. A longer time to expiration will increase the probability that a price increase in \nfutures will make a difference in the option value at expiration, since there is more time for \nfutures to reach the strike price.\n 5. Delta values for in-the-money options will decrease as time to expiration \nincreases. A longer time to expiration will increase the probability that a change in the futures \nprice will not make any difference to the option value at expiration since there is more time for \nfutures to fall back to the strike price by the time the option expires.\n 6. Delta values for at-the-money options are not substantially affected by time to \nmaturity until near expiration. This behavioral pattern is true because the probability that \nan at-the-money option will expire in-the-money remains close to 50/50 until the option is \nnear expiration.\n9 This section implicitly assumes that the option is a call. If the option is a put, read “price decrease” for all refer-\nences to “price increase.”\n\n487\nBrokers are fond of pointing out to possible buyers of options that they are a splendid thing to \nbuy, and pointing out to sellers that they are a splendid thing to sell. They believe implicitly in \nthis paradox. Thus the buyer does well, the seller does well, and it is not necessary to stress the \npoint that the broker does well enough. Many examples can be cited showing all three of them \nemerging from their adventures with a profit. One wonders why the problem of unemployment \ncannot be solved by having the unemployed buy and sell each other options, instead of mooning \naround on those park benches.\n—Fred Schwed\nWhere Are the Customers’ Yachts?\n ■ Comparing Trading Strategies\nThe existence of options greatly expands the range of possible trading strategies. For example, in the \nabsence of an option market, a trader who is bullish can either go long or initiate a bull spread (in those \nmarkets in which spread movements correspond to price direction). However, if option-related trad-\ning approaches are included, the bullish trader can consider numerous alternative strategies including: \nlong out-of-the-money calls, long in-the-money calls, long at-the-money calls, short out-of-the-money \nputs, short in-the-money puts, short at-the-money puts, “synthetic” long positions, combined positions \nin futures and options, and a variety of bullish option spreads. Frequently, one of these option-related \nstrategies will offer significantly better profit potential for a given level of risk than an outright futures \nposition. Thus, the trader who considers both option-based strategies and outright positions should \nhave a decided advantage over the trader who restricts his trades to only futures.\nOption Trading \nStrategies\nChapter 35\n488\nA Complete Guide to the Futures mArket\nThere is no single best trading approach. The optimal trading strategy in any given situat", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 154}
{"text": "iven level of risk than an outright futures \nposition. Thus, the trader who considers both option-based strategies and outright positions should \nhave a decided advantage over the trader who restricts his trades to only futures.\nOption Trading \nStrategies\nChapter 35\n488\nA Complete Guide to the Futures mArket\nThere is no single best trading approach. The optimal trading strategy in any given situation will \ndepend on the prevailing option premium levels and the specific nature of the expected price sce-\nnario. How does one decide on the best strategy? This chapter will attempt to answer this critical \nquestion in two steps. First, we will examine the general profit/loss characteristics (profiles) of a \nwide range of alternative trading strategies. Second, we will consider how price expectations can be \ncombined with these profit/loss profiles to determine the best trading approach.\nThe profit/loss profile is a diagram indicating the profit or loss implied by a position (vertical axis) \nfor a range of market prices (horizontal axis). The profit/loss profile provides an ideal means of \nunderstanding and comparing different trading strategies. The following points should be noted \nregarding the profit/loss profiles detailed in the next section:\n 1. All illustrations are based on a single option series, for a single market, on a single date: the \nAugust 2015 gold options on April 13, 2015. This common denominator makes it easy to com-\npare the implications of different trading strategies. The choice of April 13, 2015, was not arbi-\ntrary. On that date, the closing price of August futures (1,200.20) was almost exactly equal to \none of the option strike prices ($1,200/oz), thereby providing a nearly precise at-the-money \noption—a factor that greatly facilitates the illustration of theoretical differences among out-of-\nthe-money, in-the-money, and at-the-money options. The specific closing values for the option \npremiums on that date were as follows ($/oz):\nStrike price august Calls august puts\n1,050 155.2 5.1\n1,100 110.1 10.1\n1,150 70.1 19.9\n1,200 38.8 38.7\n1,250 19.2 68.7\n1,300 9.1 108.7\n1,350 4.5 154.1\nOption pricing data in this chapter courtesy of OptionVue (www .optionvue.com).\nThe reader should refer to these quotes when examining each of the profit/loss profiles in \nthe next section.\n 2. In order to avoid unnecessarily cluttering the illustrations, the profit/loss profiles do not include \ntransaction costs and interest income effects, both of which are very minor. (Note the assump-\ntion that transaction costs equal zero imply that commission costs equal zero and that positions \ncan be implemented at the quoted levels—in this case, the market close.)\n 3. The profit/loss profiles reflect the situation at the time of the option expiration. This assumption \nsimplifies the exposition, since the value of an option can be precisely determined at that point \nin time. At prior times, the value of the option will depend on the various factors discussed in \nthe previous chapter (e.g., time until expiration, volatility, etc.). Allowing for an evaluation of \neach option strategy at interim time stages would introduce a level of complexity that would \nplace the discussion beyond the scope of this book. However, the key point to keep in mind \n489\nOPTION TrAdINg STrATegIeS\nis that the profit/loss profile for strategies that include a net long options position will shift \nupward as the time reference point is further removed from the expiration date. The reason is \nthat at expiration, options have only intrinsic value; at points prior to expiration, options also \nhave time value. Thus, prior to expiration, the holder of an option could liquidate his position at \na price above its intrinsic value—the liquidation value assumed in the profit/loss profile. Simi-\nlarly, the profit/loss profile would be shifted downward for the option writer (seller) at points \nin time prior to expiration. This is true since at such earlier junctures, the option writer would \nhave to pay not only the intrinsic value but also the time value if he wanted to cover his position.\n 4. It is important to keep in mind that a single option is equivalent to a smaller position size than a \nsingle futures contract (see section entitled “\ndelta—the Neutral Hedge ratio” in the previous \nchapter). Similarly, an out-of-the-money option is equivalent to a smaller position size than an \nin-the-money option. Thus, the trader should also consider the profit/loss profiles consisting \nof various multiples of each strategy. In any case, the preference of one strategy over another \nshould be based entirely on the relationship between reward and risk rather than on the absolute \nprofit (loss) levels. In other words, strategy preferences should be totally independent of posi-\ntion size.\n 5. Trading strategies are evaluated strictly from the perspective of the speculator. Hedging applica-\ntions of option trading are discussed separately at the end of this chapter.\n ■ Profit/Loss Profiles for Key Trading Strategies\nStrategy 1: Long Futures\nexAMPle. Buy August gold futures at $1,200. (See Table 35.1 and Figure 35.1.)\nComment. The simple long position in futures does not require much explanation and is included \nprimarily for purposes of comparison to other less familiar trading strategies. As every trader knows, \nthe long futures position is appropriate when one expects a significant price advance. However, as will \ntabLe 35.1 profit/Loss Calculations: Long Futures\nFutures price at expiration ($/oz) Futures price Change ($/oz) profit/Loss on position\n1,000 –200 –$20,000\n1,050 –150 –$15,000\n1,100 –100 –$10,000\n1,150 –50 –$5,000\n1,200 0 $0\n1,250 50 $5,000\n1,300 100 $10,000\n1,350 150 $15,000\n1,400 200 $20,000\n490A COMPleTe gUIde TO THe FUTUreS MArKeT\nbe illustrated later in this section, for any given price scenario, some option-based strategy will often \nprovide a more attractive trade in terms of reward/risk characteristics. \n Strategy 2: Short Futures \nex", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 155}
{"text": "$20,000\n1,050 –150 –$15,000\n1,100 –100 –$10,000\n1,150 –50 –$5,000\n1,200 0 $0\n1,250 50 $5,000\n1,300 100 $10,000\n1,350 150 $15,000\n1,400 200 $20,000\n490A COMPleTe gUIde TO THe FUTUreS MArKeT\nbe illustrated later in this section, for any given price scenario, some option-based strategy will often \nprovide a more attractive trade in terms of reward/risk characteristics. \n Strategy 2: Short Futures \nexAMPle . Sell August gold futures at $1,200. (See Table 35.2 and Figure 35.2 .) \n tabLe 35.2 profit/Loss Calculations: Short Futures \nFutures price at expiration ($/oz) Futures price Change ($/oz) profit/Loss on position\n1,000 200 $20,000\n1,050 150 $15,000\n1,100 100 $10,000\n1,150 50 $5,000\n1,200 0 $0\n1,250 –50 –$5,000\n1,300 –100 –$10,000\n1,350 –150 –$15,000\n1,400 –200 –$20,000\n FIGURE  35.1 Profi t/loss Profi le: long Futures \nPrice of August gold futures at option expiration ($/oz)\nProfit/loss at expiration ($)\n1,000\n20,000\n15,000\n10,000\n5,000\n−5,000\n−10,000\n−15,000\n−20,000\n0\n1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400\n491\nOPTION TrAdINg STrATegIeS\nComment. Once again, this strategy requires little explanation and is included primarily for com-\nparison to other strategies. As any trader knows, the short futures position is appropriate when one \nis expecting a signifi cant price decline. However, as will be seen later in this chapter, for any given \nexpected price scenario, some option-based strategy will often off er a more attractive trading oppor-\ntunity in terms of reward/risk characteristics. \n Strategy 3a: Long Call (at-the-Money) \nexAMPle . Buy August $1,200 gold futures call at a premium of $38.80/oz ($3,880), with August gold \nfutures trading at $1,200/oz. (See Table 35.3 a and Figure 35.3 a.) \nComment. The long call is a bullish strategy in which maximum risk is limited to the premium paid \nfor the option, while maximum gain is theoretically unlimited. However, the probability of a loss is \ngreater than the probability of a gain, since the futures price must rise by an amount exceeding the \noption premium (as of the option expiration) in order for the call buyer to realize a profi t. Two spe-\ncifi c characteristics of the at-the-money option are the following: \n 1. The maximum loss will only be realized if futures are trading at or below their current level at \nthe time of the option expiration. \n 2. For small price changes, each $1 change in the futures price will result in approximately a $0.50 \nchange in the option price. (At-the-money options near expiration, which will change by a \ngreater amount, are an exception.) Thus, for small price changes, a net long futures position is \nequivalent to approximately two call options in terms of risk. \n FIGURE  35.2 Profi t/loss Profi le: Short Futures \nPrice of August gold futures at option expiration ($/oz)\n1,000 1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400\nProfit/loss at expiration ($)\n20,000\n15,000\n10,000\n5,000\n−5,000\n−10,000\n−15,000\n−20,000\n0\n492A COMPleTe gUIde TO THe FUTUreS MArKeT\n tabLe 35.3a profit/Loss Calculations: Long Call (at-the-Money) \n(1) (2) (3) (4) (5)\nFutures price at \nexpiration ($/oz)\npremium of august \n$1,200 Call at \nInitiation ($/oz)\n$ amount of \npremium paid\nCall Value at \nexpiration\nprofit/Loss of \nposition [(4) – (3)]\n1,000 38.8 $3,880 $0 –$3,880\n1,050 38.8 $3,880 $0 –$3,880\n1,100 38.8 $3,880 $0 –$3,880\n1,150 38.8 $3,880 $0 –$3,880\n1,200 38.8 $3,880 $0 –$3,880\n1,250 38.8 $3,880 $5,000 $1,120\n1,300 38.8 $3,880 $10,000 $6,120\n1,350 38.8 $3,880 $15,000 $11,120\n1,400 38.8 $3,880 $20,000 $16,120\n FIGURE  35.3a Profi t/loss Profi le: long Call (At-the-Money) \nPrice of August gold futures at option expiration ($/oz)\nFutures at time of position\ninitiation and strike price\nBreakeven price = $1,238.80\nProfit/loss at expiration ($)\n1,000\n15,000\n17,500\n12,500\n10,000\n7 ,500\n2,500\n0\n−2,500\n−5,000\n5,000\n1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400\n493\nOPTION TrAdINg STrATegIeS\nStrategy 3b: Long Call (Out-of-the-Money)\nexAMPle. Buy August $1,300 gold futures call at a premium of $9.10/oz ($910), with August gold \nfutures trading at $1,200/oz. (See Table 35.3b and Figure 35.3b.)\nComment. The buyer of an out-of-the-money call reduces his maximum risk in exchange for accept-\ning a smaller probability that the trade will realize a profit. By definition, the strike price of an out-of-\nthe-money call is above the current level of futures. In order for the out-of-the-money call position \nto realize a profit, the futures price (as of the time of the option expiration) must exceed the strike \nprice by an amount greater than the premium ($9.10/oz in this example). Note that in the out-of-\nthe-money call position, price increases that leave futures below the option strike price will still result \nin a maximum loss on the option. The long out-of-the-money call might be a particularly appropriate \nposition for the trader expecting a large price advance, but also concerned about the possibility of a \nlarge price decline.\nIt should be emphasized that the futures price need not necessarily reach the strike price in order \nfor the out-of-the-money call to be profitable. If the market rises quickly, the call will increase in \nvalue and hence can be resold at a profit. (However, this characteristic will not necessarily hold true \nfor slow price advances, since the depressant effect of the passage of time on the option premium \ncould more than offset the supportive effect of the increased price level of futures.)\nFor small price changes, the out-of-the-money call will change by less than a factor of one-half for \neach dollar change in the futures price. Thus, for small price changes, each long futures position will \nbe equivalent to several long out-of-the-money calls in terms of risk.\ntabLe 35.3b profit/Loss Calculations: Long Call (Out-of-the-Money)\n(1) (2) (3) (4) (5)\nFutures price at \nexpiration ($/oz)\npremium of august \n$1,300 Call at \nInitiation ($/oz)\n$ amount of \npremium paid\nCall Value at \nexpiration\nprofit/Loss on \nposition [(4) –", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 156}
{"text": "rice. Thus, for small price changes, each long futures position will \nbe equivalent to several long out-of-the-money calls in terms of risk.\ntabLe 35.3b profit/Loss Calculations: Long Call (Out-of-the-Money)\n(1) (2) (3) (4) (5)\nFutures price at \nexpiration ($/oz)\npremium of august \n$1,300 Call at \nInitiation ($/oz)\n$ amount of \npremium paid\nCall Value at \nexpiration\nprofit/Loss on \nposition [(4) – (3)]\n1,000 9.1 $910 $0 –$910\n1,050 9.1 $910 $0 –$910\n1,100 9.1 $910 $0 –$910\n1,150 9.1 $910 $0 –$910\n1,200 9.1 $910 $0 –$910\n1,250 9.1 $910 $0 –$910\n1,300 9.1 $910 $0 –$910\n1,350 9.1 $910 $5,000 $4,090\n1,400 9.1 $910 $10,000 $9,090\n494A COMPleTe gUIde TO THe FUTUreS MArKeT\n FIGURE  35.3b Profi t/loss Profi le: long Call (Out-of-the-Money) \nPrice of August gold futures at option expiration ($/oz)\nFutures price at time\nof position initiation Strike price\nBreakeven price\n= $1,309.10\nProfit/loss at expiration ($)\n1,000\n10,000\n5,000\n7 ,500\n2,500\n−2,500\n0\n1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400\n Strategy 3c: Long Call (In-the-Money) \nexample . Buy August $1,100 gold futures call at a premium of $110.10 /oz ($11,010), with August \ngold futures trading at $1,200/oz. (See Table 35.3 c and Figure 35.3 c.) \nComment. In many respects, a long in-the-money call position is very similar to a long futures posi-\ntion. The three main diff erences between these two trading strategies are: \n 1. The long futures position will gain slightly more in the event of a price rise—an amount equal \nto the time value portion of the premium paid for the option ($1,010 in the above example). \n 2. For moderate price declines, the long futures position will lose slightly less. (Once again, the \ndiff erence will be equal to the time value portion of the premium paid for the option.) \n 3. In the event of a large price decline, the loss on the in-the-money long call position would be lim-\nited to the total option premium paid, while the loss on the long futures position will be unlimited. \n In a sense, the long in-the-money call position can be thought of as a long futures position with a \nbuilt-in stop. This characteristic is an especially important consideration for speculators who typically \nemploy protective stop-loss orders on their positions—a prudent trading approach. A trader using a \nprotective sell stop on a long position faces the frustrating possibility of the market declining suffi ciently \nto activate his stop and subsequently rebounding. The long in-the-money call position off ers the spec-\nulator an alternative method of limiting risk that does not present this danger. Of course, this benefi t \ndoes not come without a cost; as mentioned above, the buyer of an in-the-money call will gain slightly \nless than the outright futures trader if the market advances, and will lose slightly more if the market \ndeclines moderately. However, if the trader is anticipating volatile market conditions, he might very \n495\nOPTION TrAdINg STrATegIeS\nwell prefer a long in-the-money call position to a long futures position combined with a protective \nsell stop order. In any case, the key point is that the trader who routinely compares the strategies \nof buying an in-the-money call versus going long futures with a protective sell stop should enjoy an \nadvantage over those traders who never consider the option-based alternative. \n FIGURE  35.3c Profi t/loss Profi le: long Call (In-the-Money) \nPrice of August gold futures at option expiration ($/oz)\nFutures price at\ntime of position\ninitiationStrike price\nBreakeven price = $1210.10\nProfit/loss at expiration ($)\n1,000\n10,000\n−10,000\n−15,000\n5,000\n−5,000\n0\n15,000\n20,000\n1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400\n tabLe 35.3c profit/Loss Calculations: Long Call (In-the-Money) \n(1) (2) (3) (4) (5)\nFutures price at \nexpiration ($/oz)\npremium of august $1,100 \nCall at Initiation ($/oz)\n$ amount of \npremium paid\nCall Value at \nexpiration\nprofit/Loss on \nposition [(4) – (3)]\n1,000 110.1 $11,010 $0 –$11,010\n1,050 110.1 $11,010 $0 –$11,010\n1,100 110.1 $11,010 $0 –$11,010\n1,150 110.1 $11,010 $5,000 –$6,010\n1,200 110.1 $11,010 $10,000 –$1,010\n1,250 110.1 $11,010 $15,000 $3,990\n1,300 110.1 $11,010 $20,000 $8,990\n1,350 110.1 $11,010 $25,000 $13,990\n1,400 110.1 $11,010 $30,000 $18,990\n496\nA Complete Guide to the Futures mArket\nTable 35.3d summarizes the profit/loss implications of various long call positions for a range of \nprice assumptions. Note that as calls move deeper in-the-money, their profit and loss characteristics \nincreasingly resemble a long futures position. The very deep in-the-money $1,050 call provides \nan interesting apparent paradox: The profit/loss characteristics of this option are nearly the same \nas those of a long futures position for all prices above $1,050, but the option has the advantage of \nlimited risk for lower prices. How can this be? Why wouldn’t all traders prefer the long $1,050 \ncall to the long futures position and, therefore, bid up its price so that its premium also reflected \nmore time value? (The indicated premium of $15,520 for the $1,050 call consists almost entirely \nof intrinsic value.)\nThere are two plausible explanations to this apparent paradox. First, the option price reflects \nthe market’s assessment that there is a very low probability of gold prices moving to this deep in-\nthe-money strike price, and therefore the market places a low value on the time premium. In other \nwords, the market places a low value on the loss protection provided by an option with a strike price \nso far below the market. Second, the $1,050 call represents a fairly illiquid option position, and the \nquoted price does not reflect the bid/ask spread. No doubt, a potential buyer of the call would have \nhad to pay a higher price than the quoted premium in order to assure an execution.\ntabLe 35.3d profit/Loss Matrix for Long Calls with Different Strike prices\nDollar amount of premiums paid\n$1,050 $1,100 $1,150 $1,200 $1,250 $1,300 $1,350\nCall Call a Call Call a Call Call a", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 157}
{"text": "tion position, and the \nquoted price does not reflect the bid/ask spread. No doubt, a potential buyer of the call would have \nhad to pay a higher price than the quoted premium in order to assure an execution.\ntabLe 35.3d profit/Loss Matrix for Long Calls with Different Strike prices\nDollar amount of premiums paid\n$1,050 $1,100 $1,150 $1,200 $1,250 $1,300 $1,350\nCall Call a Call Call a Call Call a Call\n$15,520 $11,010 $7,010 $3,880 $1,920 $910 $450\nposition profit/Loss at expiration\nFutures price at \nexpiration ($/oz)\nLong \nFutures \nat $1,200\nIn-the-Money at-the-Money Out-of-the-Money\n$1,050\nCall\n$1,100\nCalla\n$1,150\nCall\n$1,200\nCalla\n$1,250\nCall\n$1,300\nCalla\n$1,350\nCall\n1,000 –$20,000 –$15,520 –$11,010 –$7,010 –$3,880 –$1,920 –$910 –$450\n1,050 –$15,000 –$15,520 –$11,010 –$7,010 –$3,880 –$1,920 –$910 –$450\n1,100 –$10,000 –$10,520 –$11,010 –$7,010 –$3,880 –$1,920 –$910 –$450\n1,150 –$5,000 –$5,520 –$6,010 –$7,010 –$3,880 –$1,920 –$910 –$450\n1,200 $0 –$520 –$1,010 –$2,010 –$3,880 –$1,920 –$910 –$450\n1,250 $5,000 $4,480 $3,990 $2,990 $1,120 –$1,920 –$910 –$450\n1,300 $10,000 $9,480 $8,990 $7,990 $6,120 $3,080 –$910 –$450\n1,350 $15,000 $14,480 $13,990 $12,990 $11,120 $8,080 $4,090 –$450\n1,400 $20,000 $19,480 $18,990 $17,990 $16,120 $13,080 $9,090 $4,550\naThese calls are compared in Figure 35.3d.\n497\nOPTION TrAdINg STrATegIeS\n Figure 35.3 d compares the three types of long call positions to a long futures position. It should be \nnoted that in terms of absolute price changes, the long futures position represents the largest position \nsize, while the out-of-the-money call represents the smallest position size. Figure 35.3 d suggests the \nfollowing important observations: \n 1. As previously mentioned, the in-the-money call is very similar to an outright long futures \nposition. \n 2. The out-of-the-money call will lose the least in a declining market, but will also gain the least in \na rising market. \n 3. The at-the-money call will lose the most in a steady market and will be the middle-of-the-road \nperformer (relative to the other two types of calls) in advancing and declining markets. \n Again, it should be emphasized that these comparisons are based upon single-unit positions that \nmay diff er substantially in terms of their implied position size (as suggested by their respective delta \nvalues). A comparison that involved equivalent position size levels for each strategy (i.e., equal delta \nvalues for each position) would yield diff erent observations. This point is discussed in greater detail in \nthe section entitled “Multiunit Strategies.” \n FIGURE  35.3d Profi t/loss Profi le: long Futures and long Call Comparisons (In-the-Money, \nAt-the-Money, and Out-of-the-Money)\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \nPrice of August gold futures at option expiration ($/oz)\nFutures price at time of position initiation\nLong futures\nAt-the-money call\n(strike price = $1,200)\nOut-of-the-money\ncall (strike price = $1,300)\nIn-the-money call\n(strike price = $1,100)\nProfit/loss at expiration ($)\n1,000\n10,000\n−10,000\n−15,000\n5,000\n−5,000\n0\n15,000\n20,000\n1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400\n498A COMPleTe gUIde TO THe FUTUreS MArKeT\n Strategy 4a: Short Call (at-the-Money) \nexample . Sell August $1,200 gold futures call at a premium of $38.80 /oz ($3,880), with August gold \nfutures trading at $1,200/oz. (See Table 35.4 a and Figure 35.4 a.) \n tabLe 35.4a profit/Loss Calculations-Short Call (at-the-Money) \n(1) (2) (3) (4) (5)\nFutures price at \nexpiration ($/oz)\npremium of august \n$1,200 Call at \nInitiation ($/oz)\n$ amount of \npremium received\nCall Value at \nexpiration\nprofit/Loss on \nposition [(3) – (4)]\n1,000 38.8 $3,880 $0 $3,880\n1,050 38.8 $3,880 $0 $3,880\n1,100 38.8 $3,880 $0 $3,880\n1,150 38.8 $3,880 $0 $3,880\n1,200 38.8 $3,880 $0 $3,880\n1,250 38.8 $3,880 $5,000 –$1,120\n1,300 38.8 $3,880 $10,000 –$6,120\n1,350 38.8 $3,880 $15,000 –$11,120\n1,400 38.8 $3,880 $20,000 –$16,120\n FIGURE  35.4a Profi t/loss Profi le: Short Call (At-the-Money)\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \nPrice of August gold futures at option expiration ($/oz)\nFutures price at time\nof position initiation\nand strike price Breakeven price\n= $1,238.80\nProfit/loss at expiration ($)\n1,000\n5,000\n2,500\n−5,000\n−2,500\n0\n−10,000\n−7,500\n−17,500\n−15,000\n−12,500\n1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400\n499\nOPTION TrAdINg STrATegIeS\nComment. The short call is a bearish position with a maximum potential gain equal to the premium \nreceived for selling the call and unlimited risk. However, in return for assuming this unattractive \nmaximum reward/maximum risk relationship, the seller of a call enjoys a greater probability of \nrealizing a profit than a loss. Note the short at-the-money call position will result in a gain as long as \nthe futures price at the time of the option expiration does not exceed the futures price at the time \nof the option initiation by an amount greater than the premium level ($38.80/oz in our example). \nHowever, the maximum possible profit (i.e., the premium received on the option) will only be real-\nized if the futures price at the time of the option expiration is below the prevailing market price at the \ntime the option was sold (i.e., the strike price). The short call position is appropriate if the trader is \nmodestly bearish and views the probability of a large price rise as being very low . If, however, the trader \nanticipated a large price decline, he would probably be better off buying a put or going short futures.\nStrategy 4b: Short Call (Out-of-the-Money)\nexample. Sell August $1,300 gold futures call at a premium of $9.10/oz ($910), with August gold \nfutures trading at $1,200/oz. (See Table 35.4b and Figure 35.4b.)\nComment. The seller of an out-of-the-money call is willing to accept a smaller maximum gain (i.e., \npremium) in exchange for increasing the probability of a gain on the trade. The seller of an out-of-\nthe-", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 158}
{"text": ": Short Call (Out-of-the-Money)\nexample. Sell August $1,300 gold futures call at a premium of $9.10/oz ($910), with August gold \nfutures trading at $1,200/oz. (See Table 35.4b and Figure 35.4b.)\nComment. The seller of an out-of-the-money call is willing to accept a smaller maximum gain (i.e., \npremium) in exchange for increasing the probability of a gain on the trade. The seller of an out-of-\nthe-money call will retain the full premium received as long as the futures price does not rise by an \namount greater than the difference between the strike price and the futures price at the time of the \noption sale. The trade will be profitable as long as the futures price at the time of the option expiration \nis not above the strike price by more than the option premium ($9.10/oz in this example). The short \nout-of-the-money call represents a less bearish posture than the short at-the-money call position. \nWhereas the short at-the-money call position reflects an expectation that prices will either decline \nor increase only slightly, the short out-of-the-money call merely reflects an expectation that prices \nwill not rise sharply.\ntabLe 35.4b profit/Loss Calculations: Short Call (Out-of-the-Money)\n(1) (2) (3) (4) (5)\nFutures price at \nexpiration ($/oz)\npremium of august $1,300 \nCall at Initiation ($/oz)\n$ amount of \npremium received\nValue of Call \nat expiration\nprofit/Loss on \nposition [(3) – (4)]\n1,000 9.1 $910 $0 $910\n1,050 9.1 $910 $0 $910\n1,100 9.1 $910 $0 $910\n1,150 9.1 $910 $0 $910\n1,200 9.1 $910 $0 $910\n1,250 9.1 $910 $0 $910\n1,300 9.1 $910 $0 $910\n1,350 9.1 $910 $5,000 –$4,090\n1,400 9.1 $910 $10,000 –$9,090\n500A COMPleTe gUIde TO THe FUTUreS MArKeT\n Strategy 4c: Short Call (In-the-Money) \nexample . Sell August $1,100 gold futures call at a premium of $110.10 /oz ($11,010), with August \ngold futures trading at $1,200/oz. (See Table 35.4 c and Figure 35.4 c.) \n FIGURE  35.4b Profi t/loss Profi le: Short Call (Out-of-the-Money)\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \nPrice of August gold futures at option expiration ($/oz)\nFutures price at time\nof position initiation Strike price\nBreakeven price\n= $1,309.10\nProfit/loss at expiration ($)\n1,000\n2,500\n−5,000\n−2,500\n0\n−10,000\n−7,500\n1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400\n tabLe 35.4c profit/Loss Calculations: Short Call (In-the-Money) \n(1) (2) (3) (4) (5)\nFutures price at \nexpiration ($/oz)\npremium of august $1,100 \nCall at Initiation ($/oz)\nDollar amount of \npremium received\nValue of Call \nat expiration\nprofit/Loss on \nposition [(3) – (4)]\n1,000 110.1 $11,010 $0 $11,010\n1,050 110.1 $11,010 $0 $11,010\n1,100 110.1 $11,010 $0 $11,010\n1,150 110.1 $11,010 $5,000 $6,010\n1,200 110.1 $11,010 $10,000 $1,010\n1,250 110.1 $11,010 $15,000 –$3,990\n1,300 110.1 $11,010 $20,000 –$8,990\n1,350 110.1 $11,010 $25,000 –$13,990\n1,400 110.1 $11,010 $30,000 –$18,990\n501\nOPTION TrAdINg STrATegIeS\nComment. For most of the probable price range, the profi t/loss characteristics of the short in-the-\nmoney call are fairly similar to those of the outright short futures position. There are three basic dif-\nferences between these two positions: \n 1. The short in-the-money call will lose modestly less than the short futures position in \nan advancing market because the loss will be partially off set by the premium received for \nthe call. \n 2. The short in-the-money call will gain modestly more than the short futures position in a mod-\nerately declining market. \n 3. In a very sharply declining market, the profi t potential on a short futures position is open-ended, \nwhereas the maximum gain in the short in-the-money call position is limited to the total pre-\nmium received for the call. \n In eff ect, the seller of an in-the-money call chooses to lock in modestly better results for the prob-\nable price range in exchange for surrendering the opportunity for windfall profi ts in the event of a \nprice collapse. generally speaking, a trader should only choose a short in-the-money call over a short \nfutures position if he believes that the probability of a sharp price decline is extremely small. \n Table 35.4 d summarizes the profi t/loss results for various short call positions for a range of \nprice assumptions. As can be seen, as calls move more deeply in-the-money, they begin to resemble \n FIGURE  35.4c Profi t/loss Profi le: Short Call (In-the-Money)\nChart created using TradeStation. ©TradeStation T echnologies, Inc. All rights reserved. \nPrice of August gold futures at option expiration ($/oz)\nFutures price at\ntime of position\ninitiation\nStrike price\nBreakeven price\n= $1210.10\nProfit/loss at expiration ($)\n1,000\n10,000\n15,000\n−10,000\n5,000\n−5,000\n0\n−20,000\n−15,000\n1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400\n502\nA Complete Guide to the Futures mArket\na short futures position more closely. (Sellers of deep in-the-money calls should be aware that longs \nmay choose to exercise such options well before expiration. early exercise can occur if the poten-\ntial interest income on the premium is greater than the theoretical time value of the option for a \nzero interest rate assumption.) Short positions in deep out-of-the-money calls will prove profitable \nfor the vast range of prices, but the maximum gain is small and the theoretical maximum loss is \nunlimited.\nFigure 35.4d compares each type of short call to a short futures position. The short at-the-money \ncall position will be the most profitable strategy under stable market conditions and the middle-of-\nthe-road strategy (relative to the other two types of calls) in rising and declining markets. The short \nout-of-the-money call will lose the least in a rising market, but it will also be the least profitable \nstrategy if prices decline. The short in-the-money call is the type of call that has the greatest potential \nand risk and, as mentioned above, there is a strong resemblance between this strategy and an outright \nshort position in futures.\nIt should be emphasized that the com", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 159}
{"text": "markets. The short \nout-of-the-money call will lose the least in a rising market, but it will also be the least profitable \nstrategy if prices decline. The short in-the-money call is the type of call that has the greatest potential \nand risk and, as mentioned above, there is a strong resemblance between this strategy and an outright \nshort position in futures.\nIt should be emphasized that the comparisons in Figure 35.4d are based upon single-unit positions. \nHowever, as previously explained, these alternative strategies do not represent equivalent position \nsizes. Comparisons based on positions weighted equally in terms of some risk measure (e.g., equal \ndelta values) would yield different empirical conclusions.\ntabLe 35.4d profit/Loss Matrix for Short Calls with Different Strike prices\nDollar amount of premium received\n$1,050 $1,100 $1,150 $1,200 $1,250 $1,300 $1,350\nCall Call Call Call Call Call Call\n$15,520 $11,010 $7,010 $3,880 $1,920 $910 $450\nposition profit/Loss at expiration\nFutures price at \nexpiration ($/oz)\nShort Futures \nat $1,200\nIn-the-Money \nat-the-\nMoney Out-of-the Money\n$1,050 Call $1,100 Call a $1,150 Call $1,200 Call a $1,250 Call $1,300 Call a $500 Call\n1,000 $20,000 $15,520 $11,010 $7,010 $3,880 $1,920 $910 $450\n1,050 $15,000 $15,520 $11,010 $7,010 $3,880 $1,920 $910 $450\n1,100 $10,000 $10,520 $11,010 $7,010 $3,880 $1,920 $910 $450\n1,150 $5,000 $5,520 $6,010 $7,010 $3,880 $1,920 $910 $450\n1,200 $0 $520 $1,010 $2,010 $3,880 $1,920 $910 $450\n1,250 –$5,000 –$4,480 –$3,990 –$2,990 –$1,120 $1,920 $910 $450\n1,300 –$10,000 –$9,480 –$8,990 –$7,990 –$6,120 –$3,080 $910 $450\n1,350 –$15,000 –$14,480 –$13,990 –$12,990 –$11,120 –$8,080 –$4,090 $450\n1,400 –$20,000 –$19,480 –$18,990 –$17,990 –$16,120 –$13,080 –$9,090 –$4,550\naThese calls are compared in Figure 35.4d.\n503\nOPTION TrAdINg STrATegIeS\n Strategy 5a: Long put (at-the-Money) \nexample . Buy August $1,200 gold futures put at a premium of $38.70/oz ($3,870), with August gold \nfutures trading at $1,200/oz. (See Table 35.5 a and Figure 35.5 a.) \n FIGURE  35.4d Profi t/loss Profi le: Short Futures and Short Call Comparisons (In-the-Money, \nAt-the-Money, and Out-of-the-Money) \nPrice of August gold futures at option expiration ($/oz)\nFutures price at time\nof position initiation\nShort futures\nAt-the-money call\n(strike price = $1,200)\nOut-of-the-money call\n(strike price = $1,300)\nIn-the-money call\n(strike price = $1,100)\nProfit/loss at expiration ($)\n1,000\n10,000\n15,000\n−10,000\n5,000\n−5,000\n0\n−15,000\n−20,000\n1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400\n tabLe 35.5a profit/Loss Calculations: Long put (at-the-Money) \n(1) (2) (3) (4) (5)\nFutures price at \nexpiration ($/oz)\npremium of august $1,200 \nput at Initiation ($/oz)\n$ amount of \npremium paid\nput Value at \nexpiration\nprofit/Loss on \nposition [(4) – (3)]\n1,000 38.7 $3,870 $20,000 $16,130\n1,050 38.7 $3,870 $15,000 $11,130\n1,100 38.7 $3,870 $10,000 $6,130\n1,150 38.7 $3,870 $5,000 $1,130\n1,200 38.7 $3,870 $0 –$3,870\n1,250 38.7 $3,870 $0 –$3,870\n1,300 38.7 $3,870 $0 –$3,870\n1,350 38.7 $3,870 $0 –$3,870\n1,400 38.7 $3,870 $0 –$3,870\n504A COMPleTe gUIde TO THe FUTUreS MArKeT\nComment. The long put is a bearish strategy in which maximum risk is limited to the premium paid \nfor the option, while maximum gain is theoretically unlimited. However, the probability of a loss is \ngreater than the probability of a gain, since the futures price must decline by an amount exceeding \nthe option premium (as of the option expiration) in order for the put buyer to realize a profi t. Two \nspecifi c characteristics of the at-the-money option are: \n 1. The maximum loss will be realized only if futures are trading at or above their current level at \nthe time of the option expiration. \n 2. For small price changes, each $1 change in the futures price will result in approximately a $0.50 \nchange in the option price (except for options near expiration). Thus, for small price changes, a \nnet short futures position is equivalent to approximately 2 put options in terms of risk. \n Strategy 5 b: Long put (Out-of-the-Money) \nexample . Buy August $1,100 gold futures put at a premium of $10.10 /oz ($1,010). (The current \nprice of August gold futures is $1,200/oz.) (See Table 35.5 b and Figure 35.5 b.) \nComment. The buyer of an out-of-the-money put reduces his maximum risk in exchange for accept-\ning a smaller probability that the trade will realize a profi t. By defi nition, the strike price of an out-of-\nthe-money put is below the current level of futures. In order for the out-of-the-money put position \nPrice of August gold futures at option expiration ($/oz)\nFutures price at time\nof position initiation\nand strike price\nBreakeven price = $1,161.30\nProfit/loss at expiration ($)\n1,000\n10,000\n7,500\n−5,000\n5,000\n−2,500\n2,500\n0\n17,500\n15,000\n12,500\n1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400\n FIGURE  35.5a Profi t/loss Profi le: long Put (At-the-Money) \n505\nOPTION TrAdINg STrATegIeS\nto realize a profi t, the futures price (as of the time of the option expiration) must penetrate the strike \nprice by an amount greater than the premium ($10.10/oz in the above example). Note that in the \nout-of-the-money put position, price decreases that leave futures above the option strike price will \nstill result in a maximum loss on the option. The long out-of-the-money put might be a particularly \nappropriate position for the trader expecting a large price decline, but also concerned about the pos-\nsibility of a large price rise. \n tabLe 35.5b profit/Loss Calculations: Long put (Out-of-the-Money) \n(1) (2) (3) (4) (5)\nFutures price at \nexpiration ($/oz)\npremium of august $1,100 \nput at Initiation ($/oz)\n$ amount of \npremium paid\nValue of put \nat expiration\nprofit/Loss on \nposition [(4) – (3)]\n1,000 10.1 $1,010 $10,000 $8,990\n1,050 10.1 $1,010 $5,000 $3,990\n1,100 10.1 $1,010 $0 –$1,010\n1,150 10.1 $1,010 $0 –$1,010\n1,200 10.1 $1,010 $0 –$1,010\n1,250 10.1 $1,010 $0 –$1,010\n1,300 10.1 $1,010 $0 –$1,010\n1,350 10.1 $1,010 $0 –$1,010\n1,40", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 160}
{"text": "iration ($/oz)\npremium of august $1,100 \nput at Initiation ($/oz)\n$ amount of \npremium paid\nValue of put \nat expiration\nprofit/Loss on \nposition [(4) – (3)]\n1,000 10.1 $1,010 $10,000 $8,990\n1,050 10.1 $1,010 $5,000 $3,990\n1,100 10.1 $1,010 $0 –$1,010\n1,150 10.1 $1,010 $0 –$1,010\n1,200 10.1 $1,010 $0 –$1,010\n1,250 10.1 $1,010 $0 –$1,010\n1,300 10.1 $1,010 $0 –$1,010\n1,350 10.1 $1,010 $0 –$1,010\n1,400 10.1 $1,010 $0 –$1,010\nPrice of August gold futures at option expiration\nFutures price at time\nof position initiation\nBreakeven\nprice\n= $1,089.90\nProfit/loss at expiration ($)\n1,000\n7,500\n10,000\n5,000\n−2,500\n2,500\n0\n1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400\nStrike price\n FIGURE  35.5b Profi t/loss Profi le: long Put (Out-of-the-Money) \n506\nA Complete Guide to the Futures mArket\nIt should be emphasized that the futures price need not necessarily reach the strike price in order \nfor the out-of-the-money put to be profitable. If the market declines quickly, the put will increase in \nvalue, and hence can be resold at a profit. (However, this behavior will not necessarily hold for slow \nprice declines, since the depressant effect of the passage of time on the option premium could well \nmore than offset the supportive effect of the decreased price level of futures.)\nFor small price changes, the out-of-the-money put will change by less than a factor of one-half for \neach dollar change in the futures price. Thus, for small price changes, each short futures position will \nbe equivalent to several short out-of-the-money puts in terms of risk.\nStrategy 5c: Long put (In-the-Money)\nexample. Buy August $1,300 gold futures put at a premium of $108.70/oz ($10,870), with August \ngold futures trading at $1,200/oz. (See Table 35.5c and Figure 35.5c.)\nComment. In many respects, a long in-the-money put option is very similar to a short futures posi-\ntion. The three main differences between these two trading strategies are:\n 1. The short futures position will gain slightly more in the event of a price decline—an amount \nequal to the time value portion of the premium paid for the option ($870 in this example).\n 2. For moderate price advances, the short futures position will lose slightly less. (Once again, the \ndifference will be equal to the time value portion of the premium paid for the option.)\n 3. In the event of a large price advance, the loss on the in-the-money long put position would be \nlimited to the total option premium paid, while the loss on the short futures position would be \nunlimited.\ntabLe 35.5c profit/Loss Calculations: Long put (In-the-Money)\n(1) (2) (3) (4) (5)\nFutures price at \nexpiration ($/oz)\npremium of august $1,300 \nput at Initiation ($/oz)\nDollar amount \nof premium paid\nValue of put \nat expiration\nprofit/Loss on \nposition [(3) – (4)]\n1,000 108.7 $10,870 $30,000 $19,130\n1,050 108.7 $10,870 $25,000 $14,130\n1,100 108.7 $10,870 $20,000 $9,130\n1,150 108.7 $10,870 $15,000 $4,130\n1,200 108.7 $10,870 $10,000 –$870\n1,250 108.7 $10,870 $5,000 –$5,870\n1,300 108.7 $10,870 $0 –$10,870\n1,350 108.7 $10,870 $0 –$10,870\n1,400 108.7 $10,870 $0 –$10,870\n507\nOPTION TrAdINg STrATegIeS\n In a sense, the long in-the-money put position can be thought of as a short futures position with \na built-in stop. This characteristic is an especially important consideration for speculators who \ntypically employ protective stop loss orders on their positions—a prudent trading approach. A \ntrader using a protective buy stop on a short position faces the frustrating possibility of the market \nadvancing suffi ciently to activate his stop and subsequently breaking. The long in-the-money put \nposition off ers the speculator an alternative method of limiting risk that does not present this \ndanger. Of course, this benefi t does not come without a cost: as mentioned earlier, the buyer of an \nin-the-money put will gain slightly less than the outright short futures trader if the market declines \nand lose slightly more if the market advances moderately. However, if the trader is anticipating \nvolatile market conditions, he might very well prefer a long in-the-money put position to a short \nfutures position combined with a protective buy stop order. In any case, the key point is that the \ntrader who routinely compares the strategies of buying an in-the-money put versus going short \nfutures with a protective buy stop should enjoy an advantage over those traders who never consider \nthe option-based alternative. \n Table 35.5 d summarizes the profi t/loss implications of various long put positions for a range of \nprice assumptions. Note that as puts move deeper in-the-money, their profi t and loss characteristics \nincreasingly resemble a short futures position. \n FIGURE  35.5c Profi t/loss Profi le: long Put (In-the-Money) \nPrice of August gold futures at option expiration ($/oz)\nFutures\nprice at time\nof position\ninitiation\nStrike price\nBreakeven price\n= $1,191.30\nProfit/loss at expiration ($)\n1,000\n10,000\n−10,000\n−15,000\n5,000\n−5,000\n0\n15,000\n20,000\n1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400\n508\nA Complete Guide to the Futures mArket\ntabLe 35.5d profit/Loss Matrix for Long puts with Different Strike prices\nDollar amount of premium paid\n$1,350 \nput\n$1,300 \nput\n$1,250 \nput\n$1,200 \nput\n$1,150 \nput\n$1,100 \nput\n$1,050 \nput\n$15,410 $10,870 $6,870 $3,870 $1,990 $1,010 $510\nposition profit/Loss at expiration\nFutures price at \nexpiration ($/oz)\nShort Futures \nat $1,200\nIn-the-Money at-the-Money Out-of-the-Money\n$1,350 \nput\n$1,300 \nputa\n$1,250 \nput\n$1,200 \nputa\n$1,150 \nput\n$1,100 \nputa\n$1,050 \nput\n1,000 $20,000 $19,590 $19,130 $18,130 $16,130 $13,010 $8,990 $4,490\n1,050 $15,000 $14,590 $14,130 $13,130 $11,130 $8,010 $3,990 –$510\n1,100 $10,000 $9,590 $9,130 $8,130 $6,130 $3,010 –$1,010 –$510\n1,150 $5,000 $4,590 $4,130 $3,130 $1,130 –$1,990 –$1,010 –$510\n1,200 $0 –$410 –$870 –$1,870 –$3,870 –$1,990 –$1,010 –$510\n1,250 –$5,000 –$5,410 –$5,870 –$6,870 –$3,870 –$1,990 –$1,010 –$510\n1,300 –$10,000 –$10,410 –$10,870 –$6,870 –$3,870 –$1,990 –$1,", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 161}
{"text": "3,010 $8,990 $4,490\n1,050 $15,000 $14,590 $14,130 $13,130 $11,130 $8,010 $3,990 –$510\n1,100 $10,000 $9,590 $9,130 $8,130 $6,130 $3,010 –$1,010 –$510\n1,150 $5,000 $4,590 $4,130 $3,130 $1,130 –$1,990 –$1,010 –$510\n1,200 $0 –$410 –$870 –$1,870 –$3,870 –$1,990 –$1,010 –$510\n1,250 –$5,000 –$5,410 –$5,870 –$6,870 –$3,870 –$1,990 –$1,010 –$510\n1,300 –$10,000 –$10,410 –$10,870 –$6,870 –$3,870 –$1,990 –$1,010 –$510\n1,350 –$15,000 –$15,410 –$10,870 –$6,870 –$3,870 –$1,990 –$1,010 –$510\n1,400 –$20,000 –$15,410 –$10,870 –$6,870 –$3,870 –$1,990 –$1,010 –$510\naThese puts are compared in Figure 35.5d.\nFigure 35.5d compares the three types of long put positions to a short futures position. It should \nbe noted that in terms of absolute price changes, the short futures position represents the largest \nposition size, while the out-of-the-money put represents the smallest position size. Figure 35.5d sug-\ngests the following important observations:\n 1. As previously mentioned, the in-the-money put is very similar to an outright short futures \nposition.\n 2. The out-of-the-money put will lose the least in a rising market, but will also gain the least in a \ndeclining market.\n 3. The at-the-money put will lose the most in a steady market and will be the middle-of-\nthe-road performer (relative to the other two types of puts) in declining and advancing \nmarkets.\nAgain, it should be emphasized that these comparisons are based on single-unit positions that \nmay differ substantially in terms of their implied position size (as suggested by their respective delta \nvalues). A comparison that involved equivalent position size levels for each strategy (i.e., equal delta \nvalues for each position) would yield different observations.\n509\nOPTION TrAdINg STrATegIeS\nexample . Sell August $1,200 gold futures put at a premium of $38.70/oz ($3,870), with August gold \nfutures trading at $1,200/oz. (See Table 35.6 a and Figure 35.6 a.) \nPrice of August gold futures at option expiration ($/oz)\nFutures price at time\nof position initiation\nShort futures\nAt-the-money put\n(strike price = $1,200)\nOut-of-the-money put\n(strike price = $1,100)\nIn-the-money\nput (strike price = $1,300)\nPrice/loss at expiration ($)\n1,000\n10,000\n−10,000\n−15,000\n5,000\n−5,000\n0\n15,000\n20,000\n1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400\n FIGURE  35.5d Profi t/loss Profi le: Short Futures and long Put Comparisons (In-the-Money, \nAt-the-Money, and Out-of-the-Money) \n tabLe 35.6a profit/Loss Calculations: Short put (at-the-Money) \n(1) (2) (3) (4) (5)\n Futures price at \nexpiration ($/oz) \n premium of august $1,200 \nput at Initiation ($/oz) \n $ amount of \npremium received \n put Value at \nexpiration \n profit/Loss on \nposition [(3) – (4)] \n1,000 38.7 $3,870 $20,000 –$16,130\n1,050 38.7 $3,870 $15,000 –$11,130\n1,100 38.7 $3,870 $10,000 –$6,130\n1,150 38.7 $3,870 $5,000 –$1,130\n1,200 38.7 $3,870 $0 $3,870\n1,250 38.7 $3,870 $0 $3,870\n1,300 38.7 $3,870 $0 $3,870\n1,350 38.7 $3,870 $0 $3,870\n1,400 38.7 $3,870 $0 $3,870\n510A COMPleTe gUIde TO THe FUTUreS MArKeT\nComment. The short put is a bullish position with a maximum potential gain equal to the premium \nreceived for selling the put and unlimited risk. However, in return for assuming this unattractive \nmaximum reward/maximum risk relationship, the seller of a put enjoys a greater probability of real-\nizing a profi t than a loss. Note that the short at-the-money put position will result in a gain as long as \nthe futures price at the time of the option expiration is not below the futures price at the time of the \noption initiation by an amount greater than the premium level ($38.70/oz in our example). However, \nthe maximum possible profi t (i.e., the premium received on the option) will only be realized if the \nfutures price at the time of the option expiration is above the prevailing market price at the time the \noption was sold (i.e., the strike price). The short put position is appropriate if the trader is modestly\nbullish and views the probability of a large price decline as being very low . If, however, the trader \nanticipated a large price advance, he would probably be better off buying a call or going long futures. \n Strategy 6b: Short put (Out-of-the-Money) \nexample . Sell August $1,100 gold futures put at a premium of $10.10 /oz ($1,010), with August gold \nfutures trading at $1,200/oz. (See Table 35.6 b and Figure 35.6 b .) \nComment. The seller of an out-of-the-money put is willing to accept a smaller maximum gain (i.e., \npremium) in exchange for increasing the probability of gain on the trade. The seller of an out-of-the-\nmoney put will retain the full premium received as long as the futures price does not decline by an \n FIGURE  35.6a Profi t/loss Profi le: Short Put (At-the-Money) \nPrice of August gold futures at option expiration ($/oz)\nFutures price at time\nof position initiation\nand strike price\nBreakeven price\n= $1,161.30\nProfit/loss at expiration ($)\n1,000\n−10,000\n−12,500\n5,000\n2,500\n−2,500\n−5,000\n−7,500\n0\n−15,000\n−17,500\n1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400\n511\nOPTION TrAdINg STrATegIeS\namount greater than the diff erence between the futures price at the time of the option sale and the \nstrike price. The trade will be profi table as long as the futures price at the time of the option expira-\ntion is not below the strike price by more than the option premium ($10.10/oz in this example). \nThe short out-of-the-money put represents a less bullish posture than the short at-the-money put \n tabLe 35.6b profit/Loss Calculations: Short put (Out-of-the-Money) \n(1) (2) (3) (4) (5)\n Futures price at \nexpiration ($/oz) \n premium of august $1,100 \nput at Initiation ($/oz) \n Dollar amount of \npremium received \n Value of put \nat expiration \n profit/Loss on \nposition [(3) – (4)] \n1,000 10.1 $1,010 $10,000 –$8,990\n1,050 10.1 $1,010 $5,000 –$3,990\n1,100 10.1 $1,010 $0 $1,010\n1,150 10.1 $1,010 $0 $1,010\n1,200 10.1 $1,010 $0 $1,010\n1,250 10.1 $1,010 $0 $1,010\n1,300 10.1 $1,010 $0 $1,010\n1,350 10.1 $1,010 $0 $1,010\n1,40", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 162}
{"text": "premium of august $1,100 \nput at Initiation ($/oz) \n Dollar amount of \npremium received \n Value of put \nat expiration \n profit/Loss on \nposition [(3) – (4)] \n1,000 10.1 $1,010 $10,000 –$8,990\n1,050 10.1 $1,010 $5,000 –$3,990\n1,100 10.1 $1,010 $0 $1,010\n1,150 10.1 $1,010 $0 $1,010\n1,200 10.1 $1,010 $0 $1,010\n1,250 10.1 $1,010 $0 $1,010\n1,300 10.1 $1,010 $0 $1,010\n1,350 10.1 $1,010 $0 $1,010\n1,400 10.1 $1,010 $0 $1,010\nPrice of August gold futures at option expiration ($/oz)\nFutures price at time\nof position initiation\nBreakeven price\n= $1,089.90\nProfit/loss at expiration ($)\n1,000\n−10,000\n2,500\n−2,500\n−5,000\n−7,500\n0\n1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400\nStrike price\n FIGURE  35.6b Profi t/loss Profi le: Short Put (Out-of-the-Money) \n512\nA Complete Guide to the Futures mArket\nposition. Whereas the short at-the-money put position reflects an expectation that prices will either \nrise or decline only slightly, the short out-of-the-money put merely reflects an expectation that prices \nwill not decline sharply.\nStrategy 6c: Short put (In-the-Money)\nexample. Sell August $1,300 gold futures put at a premium of $108.70/oz ($10,870), with August \ngold futures trading at $1,200/oz. (See Table 35.6c and Figure 35.6c.)\nComment. For most of the probable price range, the profit/loss characteristics of the short in-the-\nmoney put are fairly similar to those of the outright long futures position. There are three basic dif-\nferences between these two positions:\n 1. The short in-the-money put will lose modestly less than the long futures position in a \ndeclining market because the loss will be partially offset by the premium received for \nthe put.\n 2. The short in-the-money put will gain modestly more than the long futures position in a moder-\nately advancing market.\n 3. In a very sharply advancing market, the profit potential on a long futures position is open-ended, \nwhereas the maximum gain in the short in-the-money put position is limited to the total pre-\nmium received for the put.\nIn effect, the seller of an in-the-money put chooses to lock in modestly better results for the \nprobable price range in exchange for surrendering the opportunity for windfall profits in the \nevent of a price explosion. \ngenerally speaking, a trader should only choose a short in-the-money \nput over a long futures position if he believes that the probability of a sharp price advance is \nextremely small.\ntabLe 35.6c profit/Loss Calculations: Short put (In-the-Money)\n(1) (2) (3) (4) (5)\nFutures price at \nexpiration ($/oz)\npremium of august $1,300 \nput at Initiation ($/oz)\nDollar amount of \npremium received\nput Value at \nexpiration\nprofit/Loss on \nposition [(3) – (4)]\n1,000 108.7 $10,870 $30,000 –$19,130\n1,050 108.7 $10,870 $25,000 –$14,130\n1,100 108.7 $10,870 $20,000 –$9,130\n1,150 108.7 $10,870 $15,000 –$4,130\n1,200 108.7 $10,870 $10,000 $870\n1,250 108.7 $10,870 $5,000 $5,870\n1,300 108.7 $10,870 $0 $10,870\n1,350 108.7 $10,870 $0 $10,870\n1,400 108.7 $10,870 $0 $10,870\n513\nOPTION TrAdINg STrATegIeS\n Table 35.6 d summarizes the profi t/loss results for various short put positions for a range of price \nassumptions. As can be seen, as puts move more deeply in the money, they begin to more closely \nresemble a long futures position. (As previously explained in the case of calls, sellers of deep in-the-\nmoney options should be cognizant of the real possibility of early exercise.) Short positions in deep \nout-of-the-money puts will prove profi table for the vast range of prices, but the maximum gain is \nsmall and the theoretical maximum loss is unlimited. \n Figure 35.6 d compares each type of short put to a long futures position. The short at-the-money \nput position will be the most profi table strategy under stable market conditions and the middle-of-\nthe-road strategy (relative to the other two types of puts) in declining and rising markets. The short \nout-of-the-money put will lose the least in a declining market, but it will also be the least profi table \nstrategy if prices advance. The short in-the-money put is the type of put that has the greatest potential \nand risk and, as mentioned above, there is a strong resemblance between this strategy and an outright \nlong position in futures. \n It should be emphasized that the comparisons in Figure 35.6 d are based upon single-unit positions. \nHowever, as previously explained, these alternative strategies do not represent equivalent position \nsizes. Comparisons based on positions weighted equally in terms of some risk measure (e.g., equal \ndelta values) would yield diff erent empirical conclusions. \n FIGURE  35.6c Profi t/loss Profi le: Short Put (In-the-Money) \nPrice of August gold futures at option expiration ($/oz)\nFutures price\nat time of\nposition initiation\nBreakeven price\n=$1,191.30\nProfit/loss at expiration ($)\n1,000\n10,000\n15,000\n−10,000\n5,000\n−5,000\n−15,000\n−20,000\n0\n1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400\nStrike price\n514A COMPleTe gUIde TO THe FUTUreS MArKeT\n tabLe 35.6d profit/Loss Matrix for Short puts with Different Strike prices \nDollar amount of premium received\n$1,350\nput\n$1,300\nput\n$1,250\nput\n$1,200\nput\n$1,150\nput\n$1,100\nput\n$1,050\nput\n$15,410 $10,870 $6,870 $3,870 $1,990 $1,010 $510\nposition profit/Loss at expiration\nFutures price at \nexpiration ($/oz)\nLong \nFutures \nat $1,200\nIn-the-\nMoney\nat-the-\nMoney\nOut-of-\nthe-Money\n$1,350\nput\n$1,300\nput a \n$1,250\nput\n$1,200\nput a \n$1,150\nput\n$1,100\nput a \n$1,050\nput\n1,000 –$20,000 –$19,590 –$19,130 –$18,130 –$16,130 –$13,010 –$8,990 –$4,490\n1,050 –$15,000 –$14,590 –$14,130 –$13,130 –$11,130 –$8,010 –$3,990 $510\n1,100 –$10,000 –$9,590 –$9,130 –$8,130 –$6,130 –$3,010 $1,010 $510\n1,150 –$5,000 –$4,590 –$4,130 –$3,130 –$1,130 $1,990 $1,010 $510\n1,200 $0 $410 $870 $1,870 $3,870 $1,990 $1,010 $510\n1,250 $5,000 $5,410 $5,870 $6,870 $3,870 $1,990 $1,010 $510\n1,300 $10,000 $10,410 $10,870 $6,870 $3,870 $1,990 $1,010 $510\n1,350 $15,000 $15,410 $10,870 $6,870 $3,870 $1,990 $1,010 $510\n1,400 $20,000 $15,410 $10,870 $6,8", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 163}
{"text": "0 –$10,000 –$9,590 –$9,130 –$8,130 –$6,130 –$3,010 $1,010 $510\n1,150 –$5,000 –$4,590 –$4,130 –$3,130 –$1,130 $1,990 $1,010 $510\n1,200 $0 $410 $870 $1,870 $3,870 $1,990 $1,010 $510\n1,250 $5,000 $5,410 $5,870 $6,870 $3,870 $1,990 $1,010 $510\n1,300 $10,000 $10,410 $10,870 $6,870 $3,870 $1,990 $1,010 $510\n1,350 $15,000 $15,410 $10,870 $6,870 $3,870 $1,990 $1,010 $510\n1,400 $20,000 $15,410 $10,870 $6,870 $3,870 $1,990 $1,010 $510\n a These puts are compared in Figure 35.6 d. \nPrice of August gold futures at option expiration ($/oz)\nFutures price at time\nof position initiation\nLong futures\nAt-the-money put\n(strike price = $1,200) \nOut-of-the money\nput (strike price\n= $1,100)\nIn-the-money put\n(strike price = $1,300)\nProfit/loss at expiration ($)\n1,000\n10,000\n15,000\n−10,000\n5,000\n−5,000\n0\n−15,000\n−20,000\n1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400\n FIGURE  35.6d Profi t/loss Profi le: long Futures and Short Put Comparisons (In-the-Money, \nAt-the-Money, and Out-of-the-Money) \n515\nOPTION TrAdINg STrATegIeS\nStrategy 7: Long Straddle (Long Call + Long put)\nexample. Buy August $1,200 gold futures call at a premium of $38.80/oz ($3,880) and simultane-\nously buy an August $1,200 gold futures put at a premium of $38.70/oz ($3,870). (See Table 35.7 \nand Figure 35.7.)\nComment. The long straddle position is a volatility bet. The buyer of a straddle does not have \nany opinion regarding the probable price direction; he merely believes that option premiums \nare underpriced relative to the potential market volatility. Andrew T obias once offered a some -\nwhat more cynical perspective of this type of trade\n1: “Indeed, if you haven’t any idea of which \nway the [market] is headed but feel it is headed someplace, you can buy both a put and a call \non it. That’s called a straddle and involves enough commissions to keep your broker smiling \nall week.”\nAs can be seen in Figure 35.7, the long straddle position will be unprofitable for a wide price \nrange centered at the current price. Since this region represents the range of the most probable price \noutcomes, the long straddle position has a large probability of loss. In return for accepting a large \nprobability of loss, the buyer of a straddle enjoys unlimited profit potential in the event of either a \nlarge price rise or a large price decline. The maximum loss on a long straddle position is equal to the \ntotal premium paid for both the long call and long put and will only be experienced if the expiration \nprice is equal to the futures price at the time the options were purchased. (Implicit assumption: both \nthe call and put are at-the-money options.)\ntabLe 35.7 profit/Loss Calculations: Long Straddle (Long Call + Long put)\n(1) (2) (3) (4) (5) (6) (7)\nFutures price \nat expiration \n($/oz)\npremium of august \n$1,200 Call at \nInitiation ($/oz)\npremium of august \n$1,200 put at \nInitiation ($/oz)\n$ amount of \ntotal premium \npaid\nCall Value at \nexpiration\nput Value at \nexpiration\nprofit/Loss on \nposition \n[(5) + (6) – (4)]\n1,000 38.8 38.7 $7,750 $0 $20,000 $12,250\n1,050 38.8 38.7 $7,750 $0 $15,000 $7,250\n1,100 38.8 38.7 $7,750 $0 $10,000 $2,250\n1,150 38.8 38.7 $7,750 $0 $5,000 –$2,750\n1,200 38.8 38.7 $7,750 $0 $0 –$7,750\n1,250 38.8 38.7 $7,750 $5,000 $0 –$2,750\n1,300 38.8 38.7 $7,750 $10,000 $0 $2,250\n1,350 38.8 38.7 $7,750 $15,000 $0 $7,250\n1,400 38.8 38.7 $7,750 $20,000 $0 $12,250\n1 Andrew T obias, Getting By on $100,000 a Year (and Other Sad T ales) (New Y ork, NY: Simon & Schuster, 1980).\n516A COMPleTe gUIde TO THe FUTUreS MArKeT\n Strategy 8: Short Straddle (Short Call + Short put) \nexample . Sell August $1,200 gold futures call at a premium of $38.80/oz ($3,880 ) and simultane-\nously sell an August $1,200 put at a premium of $38.70/oz ($3,870). (See Table 35.8 and Figure 35.8 .) \nPrice of August gold futures at option expiration ($/oz)\nFutures price at time\nof position initiation\nand call and put\nstrike prices\nBreakeven price\n= $1,122.50\nBreakeven price\n= 1,277.50\nProfit/loss at expiration ($)\n1,000\n5,000\n10,000\n15,000\n–10,000\n–5,000\n0\n1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400\n FIGURE  35.7 Profi t/loss Profi le: long Straddle (long Call + long Put) \n tabLe 35.8 profit/Loss Calculations: Short Straddle (Short Call + Short put) \n(1) (2) (3) (4) (5) (6) (7)\nFutures price \nat expiration \n($/oz)\npremium of august \n$1,200 Call at \nInitiation ($/oz)\npremium of august \n$1,200 put at \nInitiation ($/oz)\n$ amount of \ntotal premium \nreceived\nCall Value at \nexpiration\nput Value at \nexpiration\nprofit/Loss on \nposition \n[(4) – (5) – (6)]\n1,000 38.8 38.7 $7,750 $0 $20,000 –$12,250\n1,050 38.8 38.7 $7,750 $0 $15,000 –$7,250\n1,100 38.8 38.7 $7,750 $0 $10,000 –$2,250\n1,150 38.8 38.7 $7,750 $0 $5,000 $2,750\n1,200 38.8 38.7 $7,750 $0 $0 $7,750\n1,250 38.8 38.7 $7,750 $5,000 $0 $2,750\n1,300 38.8 38.7 $7,750 $10,000 $0 –$2,250\n1,350 38.8 38.7 $7,750 $15,000 $0 –$7,250\n1,400 38.8 38.7 $7,750 $20,000 $0 –$12,250\n517\nOPTION TrAdINg STrATegIeSComment. The short straddle position will be profi table over a wide range of prices. The best outcome \nfor a seller of a straddle is a totally unchanged market. In this circumstance, the seller will realize his \nmaximum profi t, which is equal to the total premium received for the sale of the call and put. The short \nstraddle position will remain profi table as long as prices do not rise or decline by more than the combined \ntotal premium of the two options. The seller of the straddle enjoys a large probability of a profi table trade, \nin exchange for accepting unlimited risk in the event of either a very sharp price advance or decline. \n This strategy is appropriate if the speculator expects prices to trade within a moderate range, but \nhas no opinion regarding the probable market direction. A trader anticipating nonvolatile market con-\nditions, but also having a price-directional bias, would be better off selling either calls or puts rather \nthan a straddle. For example, a trader expecting low volatility and modestly declining prices should \nsel", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 164}
{"text": "appropriate if the speculator expects prices to trade within a moderate range, but \nhas no opinion regarding the probable market direction. A trader anticipating nonvolatile market con-\nditions, but also having a price-directional bias, would be better off selling either calls or puts rather \nthan a straddle. For example, a trader expecting low volatility and modestly declining prices should \nsell 2 calls instead of selling a straddle. \n Strategy 9: bullish “texas Option hedge” (Long Futures + Long Call) 2\nexample . Buy August gold futures at $1,200 and simultaneously buy an August $1,200 gold futures \ncall at a premium of $38.80 /oz ($3,880). (See Table 35.9 and Figure 35.9 .) \n FIGURE  35.8 Profi t/loss Profi le: Short Straddle (Short Call + Short Put) \n Profi t/loss Profi le: Short Straddle (Short Call + Short Put) \nPrice of August gold futures at option expiration ($/oz)\nBreakeven price\n= $1,122.50\nBreakeven price\n= 1,277.50\nProfit/loss at expiration ($)\n1,000\n5,000\n10,000\n–10,000\n–15,000\n–5,000\n0\n1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400\nFutures price at time\nof position initiation\nand call and put\nstrike prices\n 2 By defi nition, a hedge implies a futures position opposite to an existing or anticipated actual position. In com-\nmodity trading, T exas hedge is a facetious reference to so-called “hedgers” who implement a futures position in the \nsame direction as their cash position. The classic example of a T exas hedge would be a cattle feeder who goes long \ncattle futures. Whereas normal hedging reduces risk, the T exas hedge increases risk. There are many option strate-\ngies that combine off setting positions in options and futures. This strategy is unusual in that it combines reinforcing \npositions in futures and options. Consequently, the term T exas option hedge seems to provide an appropriate label.\n518A COMPleTe gUIde TO THe FUTUreS MArKeT\n tabLe 35.9 profit/Loss Calculations: bullish “texas Option hedge” (Long Futures + Long Call) \n(1) (2) (3) (4) (5) (6)\nFutures price at \nexpiration ($/oz)\npremium of august \n$1,200 Call at \nInitiation ($/oz)\n$ amount of \npremium paid\nprofit/Loss on Long \nFutures position\nCall Value at \nexpiration\nprofit/Loss on \nposition [(4)+(5)–(3)]\n1,000 38.8 $3,880 –$20,000 $0 –$23,880\n1,050 38.8 $3,880 –$15,000 $0 –$18,880\n1,100 38.8 $3,880 –$10,000 $0 –$13,880\n1,150 38.8 $3,880 –$5,000 $0 –$8,880\n1,200 38.8 $3,880 $0 $0 –$3,880\n1,250 38.8 $3,880 $5,000 $5,000 $6,120\n1,300 38.8 $3,880 $10,000 $10,000 $16,120\n1,350 38.8 $3,880 $15,000 $15,000 $26,120\n1,400 38.8 $3,880 $20,000 $20,000 $36,120\n FIGURE  35.9 Profi t/loss Profi le: Bullish “T exas Option Hedge” (long Futures + long Call) \nPrice of August gold futures at option expiration ($/oz)\nFutures price at time of position\ninitiation and strike price\nBreakeven price = $1,219.40\nProfit/loss at expiration ($)\n1,000\n37,500\n50,000\n25,000\n−25,000\n−37,500\n12,500\n−12,500\n0\n1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400\nLong 2 futures\nLong futures + long call\n519\nOPTION TrAdINg STrATegIeS\nComment. This strategy provides an interesting alternative method of pyramiding—that is, increas-\ning the size of a winning position. For example, a trader who is already long a futures contract at a \nprofit and believes the market is heading higher may wish to increase his position without doubling \nhis risk in the event of a price reaction—as would be the case if he bought a second futures contract. \nSuch a speculator could choose instead to supplement his long position with the purchase of a call, \nthereby limiting the magnitude of his loss in the event of a price retracement, in exchange for real-\nizing a moderately lower profit if prices continued to rise.\nFigure 35.9 compares the alternative strategies of buying two futures versus buying a futures con-\ntract and a call. (For simplicity of exposition, the diagram assumes that both the futures contract and \nthe call are purchased at the same time.) As can be seen, the long two futures position will always do \nmoderately better in a rising market (by an amount equal to the premium paid for the call), but will \nlose more in the event of a significant price decline. The difference in losses between the two strate-\ngies will widen as larger price declines are considered.\nStrategy 10: bearish “texas Option hedge” (Short Futures + \nLong put)\nexample. Sell August gold futures at $1,200 and simultaneously buy an August $1,200 gold put at a \npremium of $38.70/oz ($3,870). (See Table 35.10 and Figure 35.10.)\nComment. This strategy is perhaps most useful as an alternative means of increasing a short position. \nAs illustrated in Figure 35.10, the combination of a short futures contract and a long put will gain \nmoderately less than 2 short futures contracts in a declining market, but will lose a more limited \namount in a rising market.\ntabLe 35.10 profit/Loss Calculations: bearish “texas Option hedge” (Short Futures + Long put)\n(1) (2) (3) (4) (5) (6)\nFutures price at \nexpiration ($/oz)\npremium of august $1200 \nput at Initiation ($/oz)\n$ amount of \npremium paid\nprofit/Loss on Short \nFutures position\nput Value at \nexpiration\nprofit/Loss on position \n[(4) + (5) – (3)]\n1,000 38.7 $3,870 $20,000 $20,000 $36,130\n1,050 38.7 $3,870 $15,000 $15,000 $26,130\n1,100 38.7 $3,870 $10,000 $10,000 $16,130\n1,150 38.7 $3,870 $5,000 $5,000 $6,130\n1,200 38.7 $3,870 $0 $0 –$3,870\n1,250 38.7 $3,870 –$5,000 $0 –$8,870\n1,300 38.7 $3,870 –$10,000 $0 –$13,870\n1,350 38.7 $3,870 –$15,000 $0 –$18,870\n1,400 38.7 $3,870 –$20,000 $0 –$23,870\n520A COMPleTe gUIde TO THe FUTUreS MArKeT\n Strategy 11a: Option-protected Long Futures (Long Futures + Long \nat-the-Money put) \nexample . Buy August gold futures at $1,200/oz and simultaneously buy an August $1200 gold put at \na premium of $38.70/oz ($3,870). (See Table 35.11 a and Figure 35.11 a.) \nComment. A frequently recommended strategy is that the trader implementing (or holding) a long \nfutures position can consider buying a put to protect his downside risk. The", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 165}
{"text": "Long Futures (Long Futures + Long \nat-the-Money put) \nexample . Buy August gold futures at $1,200/oz and simultaneously buy an August $1200 gold put at \na premium of $38.70/oz ($3,870). (See Table 35.11 a and Figure 35.11 a.) \nComment. A frequently recommended strategy is that the trader implementing (or holding) a long \nfutures position can consider buying a put to protect his downside risk. The basic idea is that if the \nmarket declines, the losses in the long futures position will be off set dollar for dollar by the long put \nposition. Although this premise is true, it should be stressed that such a combined position represents \nnothing more than a proxy for a long call. The reader can verify the virtually identical nature of these \ntwo alternative strategies by comparing Figure 35.11 a to Figure 35.3 a. If prices increase, the long \nfutures position will gain, while the option will expire worthless. On the other hand, if prices decline, \nthe loss in the combined position will equal the premium paid for the put. In fact, if the call and put \npremiums are equal, a long futures plus long put position will be precisely equivalent to a long call. \n In most cases, the trader who fi nds the profi t/loss profi le of this strategy attractive would be better \noff buying a call, because the transaction costs are likely to be lower. However, if the trader already \nholds a long futures position, buying a put may be a reasonable alternative to liquidating this position \nand buying a call. \nPrice of August gold futures at option expiration ($/oz)\nFutures price at\ntime of position\ninitiation and\nstrike price\nBreakeven price = $1,180.65\nProfit/loss at expiration ($)\n1,000\n37,500\n50,000\n25,000\n−25,000\n−37,500\n12,500\n−12,500\n0\n1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400\nShort 2 futures\nShort futures + long put\n FIGURE  35.10 Profi t/loss Profi le: Bearish “T exas Option Hedge” (Short Futures + long Put) \n521\nOPTION TrAdINg STrATegIeS\n tabLe 35.11a profit/Loss Calculations: Option-protected Long Futures—Long Futures + Long at-the-\nMoney put (Similar to Long at-the-Money Call) \n(1) (2) (3) (4) (5) (6)\nFutures price at \nexpiration ($/oz)\npremium of august $1,200 \nput at Initiation ($/oz)\n$ amount of \npremium paid\nprofit/Loss on Long \nFutures position\nput Value at \nexpiration\nprofit/Loss on position \n[(4) + (5) – (3)]\n1,000 38.7 $3,870 –$20,000 $20,000 –$3,870\n1,050 38.7 $3,870 –$15,000 $15,000 –$3,870\n1,100 38.7 $3,870 –$10,000 $10,000 –$3,870\n1,150 38.7 $3,870 –$5,000 $5,000 –$3,870\n1,200 38.7 $3,870 $0 $0 –$3,870\n1,250 38.7 $3,870 $5,000 $0 $1,130\n1,300 38.7 $3,870 $10,000 $0 $6,130\n1,350 38.7 $3,870 $15,000 $0 $11,130\n1,400 38.7 $3,870 $20,000 $0 $16,130\n FIGURE  35.11a Profi t/loss Profi le: Option-Protected long Futures—long Futures + long \nat-the-Money Put (Similar to long At-the-Money Call) \nPrice of August gold futures at option expiration ($/oz)\nFutures at time of\nposition initiation\nand strike price\nBreakeven price = $1,238.70\nProfit/loss at expiration ($)\n1,000\n10,000\n7,500\n12,500\n15,000\n17,500\n5,000\n−5,000\n−2,500\n2,500\n0\n1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400\n522A COMPleTe gUIde TO THe FUTUreS MArKeT\n Strategy 11b: Option-protected Long Futures (Long Futures + Long \nOut-of-the-Money put) \nexample . Buy August gold futures at $1,200/oz and simultaneously buy an August $1,100 gold \nfutures put at a premium of $10.10/oz ($1,010). (See Table 35.11 b and Figure 35.11 b.) \n tabLe 35.11b profit/Loss Calculations: Option-protected Long Futures—Long Futures + Long Out-of-\nthe-Money put (Similar to Long In-the-Money Call) \n(1) (2) (3) (4) (5) (6)\nFutures price at \nexpiration ($/oz)\npremium of august $1,100 \nput at Initiation ($/oz)\n$ amount of \npremium paid\nprofit/Loss on Long \nFutures position\nput Value at \nexpiration\nprofit/Loss on position \n[(4) + (5) – (3)]\n1,000 10.1 $1,010 –$20,000 $10,000 –$11,010\n1,050 10.1 $1,010 –$15,000 $5,000 –$11,010\n1,100 10.1 $1,010 –$10,000 $0 –$11,010\n1,150 10.1 $1,010 –$5,000 $0 –$6,010\n1,200 10.1 $1,010 $0 $0 –$1,010\n1,250 10.1 $1,010 $5,000 $0 $3,990\n1,300 10.1 $1,010 $10,000 $0 $8,990\n1,350 10.1 $1,010 $15,000 $0 $13,990\n1,400 10.1 $1,010 $20,000 $0 $18,990\n FIGURE  35.11b Profi t/loss Profi le: Option-Protected long Futures—long Futures + long \nOut-of-the-Money Put (Similar to long In-the-Money Call) \nPrice of August gold futures at option expiration ($/oz)\nFutures price at time\nof position initiation\nBreakeven price = $1,210.10\nProfit/loss at expiration ($)\n1,000\n10,000\n15,000\n20,000\n5,000\n−5,000\n−10,000\n−15,000\n0\n1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400\nStrike price\n523\nOPTION TrAdINg STrATegIeS\nComment. As can be verified by comparing Figure 35.11b to Figure 35.3c, this strategy is virtually \nequivalent to buying an in-the-money call. Supplementing a long futures position with the purchase \nof an out-of-the-money put will result in slightly poorer results if the market advances, or declines \nmoderately, but will limit the magnitude of losses in the event of a sharp price decline. Thus, much \nlike the long in-the-money call position, this strategy can be viewed as a long position with a built-\nin stop.\nIn most cases, it will make more sense for the trader to simply buy an in-the-money call since \nthe transaction cost will be lower. However, if a speculator is already long futures, the purchase of \nan out-of-the-money put might present a viable alternative to liquidating this position and buying an \nin-the-money call.\nStrategy 12a: Option-protected Short Futures (Short Futures + Long \nat-the-Money Call)\nexample. Sell August gold futures at $1,200/oz and simultaneously buy an August $1,200 gold call \nat a premium of $38.80/oz ($3,880). (See Table 35.12a and Figure 35.12a.)\nComment. A frequently recommended strategy is that the trader implementing (or holding) a short \nfutures position can consider buying a call to protect his upside risk. The basic idea is that if the mar-\nket advances, the losses in the short futures position will be offset dol", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 166}
{"text": "d simultaneously buy an August $1,200 gold call \nat a premium of $38.80/oz ($3,880). (See Table 35.12a and Figure 35.12a.)\nComment. A frequently recommended strategy is that the trader implementing (or holding) a short \nfutures position can consider buying a call to protect his upside risk. The basic idea is that if the mar-\nket advances, the losses in the short futures position will be offset dollar for dollar by the long call \nposition. Although this premise is true, it should be stressed that such a combined position represents \nnothing more than a proxy for a long put. The reader can verify the virtually identical nature of these \ntwo alternative strategies by comparing Figure 35.12a to Figure 35.5a. If prices decline, the short \nfutures position will gain, while the option will expire worthless. And if prices advance, the loss in the \ncombined position will equal the premium paid for the call. In fact, if the put and call premiums are \nequal, a short futures plus long call position will be precisely equivalent to a long put.\ntabLe 35.12a profit/Loss Calculations: Option-protected Short Futures—Short Futures + Long at-the-\nMoney Call (Similar to Long at-the-Money put)\n(1) (2) (3) (4) (5) (6)\nFutures price at \nexpiration ($/oz)\npremium of august $1,200 \nCall at Initiation ($/oz)\n$ amount of \npremium paid\nprofit/Loss on Short \nFutures position\nCall Value at \nexpiration\nprofit/Loss on position \n[(4)+ (5) – (3)]\n1,000 38.8 $3,880 $20,000 $0 $16,120\n1,050 38.8 $3,880 $15,000 $0 $11,120\n1,100 38.8 $3,880 $10,000 $0 $6,120\n1,150 38.8 $3,880 $5,000 $0 $1,120\n1,200 38.8 $3,880 $0 $0 –$3,880\n1,250 38.8 $3,880 –$5,000 $5,000 –$3,880\n1,300 38.8 $3,880 –$10,000 $10,000 –$3,880\n1,350 38.8 $3,880 –$15,000 $15,000 –$3,880\n1,400 38.8 $3,880 –$20,000 $20,000 –$3,880\n524A COMPleTe gUIde TO THe FUTUreS MArKeT\n In most cases, the trader who fi nds the profi t/loss profi le of this strategy attractive would be better \noff buying a put, because the transaction costs are likely to be lower. However, if the trader already \nholds a short futures position, buying a call may be a reasonable alternative to liquidating this position \nand buying a put. \n Strategy 12b: Option-protected Short Futures (Short Futures + Long \nOut-of-the-Money Call) \nexample . Sell August gold futures at $1,200/oz and simultaneously buy an August $1,300 gold \nfutures call at a premium of $9.10/oz ($910). (See Table 35.12 b and Figure 35.12 b.) \nComment. As can be verifi ed by comparing Figure 35.12 b to Figure 35.5 c, this strategy is virtually \nequivalent to buying an in-the-money put. Supplementing a short futures position with the purchase \nof an out-of-the-money call will result in slightly poorer results if the market declines or advances \nmoderately, but will limit the magnitude of losses in the event of a sharp price advance. Thus, much \nas with the long in-the-money put position, this strategy can be viewed as a short position with a \nbuilt-in stop. \nPrice of August gold futures at option expiration ($/oz)\nFutures price at time\nof position initiation\nand strike priceBreakeven price = $1,161.20\nProfit/loss at expiration ($)\n1,000\n10,000\n17,500\n15,000\n12,500\n7,500\n5,000\n2,500\n−5,000\n−2,500\n0\n1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400\n FIGURE  35.12a Profi t/loss Profi le: Option-Protected Short Futures—Short Futures + long \nAt-the-Money Call (Similar to long At-the-Money Put) \n525\nOPTION TrAdINg STrATegIeS\n In most cases, it will make more sense for the trader simply to buy an in-the-money put since the \ntransaction costs will be lower. However, if a speculator is already short futures, the purchase of an \nout-of-the-money call might present a viable alternative to liquidating this position and buying an \nin-the-money put. \n tabLe 35.12b profit/Loss Calculations: Option-protected Short Futures—Short Futures + Long Out-\nof-the-Money Call (Similar to Long In-the-Money put) \n(1) (2) (3) (4) (5) (6)\nFutures price at \nexpiration ($/oz)\npremium of august $1,300 \nCall at Initiation ($/oz)\n$ amount of \npremium paid\nprofit/Loss on Short \nFutures position\nCall Value at \nexpiration\nprofit/Loss on position \n[(4) + (5) – (3)]\n1,000 9.1 $910 $20,000 $0 $19,090\n1,050 9.1 $910 $15,000 $0 $14,090\n1,100 9.1 $910 $10,000 $0 $9,090\n1,150 9.1 $910 $5,000 $0 $4,090\n1,200 9.1 $910 $0 $0 –$910\n1,250 9.1 $910 –$5,000 $0 –$5,910\n1,300 9.1 $910 –$10,000 $0 –$10,910\n1,350 9.1 $910 –$15,000 $5,000 –$10,910\n1,400 9.1 $910 –$20,000 $10,000 –$10,910\n FIGURE  35.12b Profi t/loss Profi le: Option-Protected Short Futures—Short Futures + long \nOut-of-the-Money Call (Similar to long In-the-Money Put) \nPrice of August gold futures at option expiration ($/oz)\nFutures price at time\nof position initiation\nBreakeven price = $1,190.90\nProfit/loss at expiration ($)\n1,000\n10,000\n15,000\n20,000\n5,000\n−5,000\n−10,000\n−15,000\n0\n1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400\nStrike price\n526\nA Complete Guide to the Futures mArket\nStrategy 13: Covered Call Write (Long Futures + Short Call)\nexample. Buy August gold futures at $1,200/oz and simultaneously sell an August $1,200 gold \nfutures call at a premium of $38.80/oz ($3,880). (See Table 35.13 and Figure 35.13.)\nComment. There has been a lot of nonsense written about covered call writing. In fact, even \nthe term is misleading. The implication is that covered call writing—the sale of calls against long \npositions—is somehow a more conservative strategy than naked call writing—the sale of calls without \nany offsetting long futures position. This assumption is absolutely false. Although naked call writing \nimplies unlimited risk, the same statement applies to covered call writing. As can be seen in Figure \n35.13, the covered call writer merely exchanges unlimited risk in the event of a market advance (as is \nthe case for the naked call writer) for unlimited risk in the event of a market decline. In fact, the reader \ncan verify that this strategy is virtually equivalent to a “naked” short put position (see Strategy 35.6a).\nOne", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 167}
{"text": "same statement applies to covered call writing. As can be seen in Figure \n35.13, the covered call writer merely exchanges unlimited risk in the event of a market advance (as is \nthe case for the naked call writer) for unlimited risk in the event of a market decline. In fact, the reader \ncan verify that this strategy is virtually equivalent to a “naked” short put position (see Strategy 35.6a).\nOne frequently mentioned motivation for covered call writing is that it allows the holder of a long \nposition to realize a better sales price. For example, if the market is trading at $1,200 and the holder \nof a long futures contract sells an at-the-money call at a premium of $38.80/oz instead of liquidating \nhis position, he can realize an effective sales price of $1,238.80 if prices move higher (the $1,200 \nstrike price plus the premium received for the sale of the call). And, if prices move down by no more \nthan $38.80/oz by option expiration, he will realize an effective sales price of at least $1,200. Pre-\nsented in this light, this strategy appears to be a “heads you win, tails you win” proposition. However, \nthere is no free lunch. The catch is that if prices decline by more than $38.80, the trader will realize a \nlower sales price than if he had simply liquidated the futures position. And, if prices rise substantially \nhigher, the trader will fail to participate fully in the move as he would have if he had maintained his \nlong position.\nThe essential point is that although many motivations are suggested for covered call writing, the \ntrader should keep in mind that this strategy is entirely equivalent to selling puts.\ntabLe 35.13 profit/Loss Calculations: Covered Call Write—Long Futures + Short Call (Similar to \nShort put)\n(1) (2) (3) (4) (5) (6)\nFutures price \nat expiration \n($/oz)\npremium of \naugust $1,200 Call \nat Initiation ($/oz)\n$ amount of \npremium received\nprofit/Loss on Long \nFutures position\nCall Value at \nexpiration\nprofit/Loss on position \n[(3) + (4) – (5)]\n1,000 38.8 $3,880 –$20,000 $0 –$16,120\n1,050 38.8 $3,880 –$15,000 $0 –$11,120\n1,100 38.8 $3,880 –$10,000 $0 –$6,120\n1,150 38.8 $3,880 –$5,000 $0 –$1,120\n1,200 38.8 $3,880 $0 $0 $3,880\n1,250 38.8 $3,880 $5,000 $5,000 $3,880\n1,300 38.8 $3,880 $10,000 $10,000 $3,880\n1,350 38.8 $3,880 $15,000 $15,000 $3,880\n1,400 38.8 $3,880 $20,000 $20,000 $3,880\n527\nOPTION TrAdINg STrATegIeS\n Strategy 14: Covered put Write (Short Futures + Short put) \nexample . Sell August futures at $1,200 and simultaneously sell an August $1,200 gold futures put at \na premium of $38.70/oz ($3,870). (See Table 35.14 and Figure 35.14 .) \n FIGURE  35.13 Profi t/loss Profi le: Covered Call Write—long Futures + Short Call (Similar to \nShort Put) \n Profi t/loss Profi le: Covered Call Write—long Futures + Short Call (Similar to \nPrice of August gold futures at option expiration ($/oz)\nProfit/loss at expiration ($)\n1,000\n5,000\n2,500\n0\n−2,500\n−7 ,500\n−10,000\n−12,500\n−15,000\n−5,000\n1,050 1,100 1,150 1,200 1,250\nFutures price at time\nof position initiation\nand strike price\n Breakeven price\n= $1,161 .20\n1,300 1,350 1,400\n−17 ,500\n tabLe 35.14 profit/Loss Calculations: Covered put Write—Short Futures + Short put (Similar to \nShort Call) \n(1) (2) (3) (4) (5) (6)\nFutures price \nat expiration \n($/oz)\npremium of \naugust $1,200 put \nat Initiation ($/oz)\n$ amount of \npremium received\nprofit/Loss on Short \nFutures position\nput Value at \nexpiration\nprofit/Loss on position \n[(3) + (4) – (5)]\n1,000 38.7 $3,870 $20,000 $20,000 $3,870\n1,050 38.7 $3,870 $15,000 $15,000 $3,870\n1,100 38.7 $3,870 $10,000 $10,000 $3,870\n1,150 38.7 $3,870 $5,000 $5,000 $3,870\n1,200 38.7 $3,870 $0 $0 $3,870\n1,250 38.7 $3,870 –$5,000 $0 –$1,130\n1,300 38.7 $3,870 –$10,000 $0 –$6,130\n1,350 38.7 $3,870 –$15,000 $0 –$11,130\n1,400 38.7 $3,870 –$20,000 $0 –$16,130\n528A COMPleTe gUIde TO THe FUTUreS MArKeT\nComment. Comments analogous to those made for Strategy 13 would apply here. The sale of a put \nagainst a short futures position is equivalent to the sale of a call. The reader can verify this by compar-\ning Figure 35.14 to Figure 35.4 a. The two strategies would be precisely equivalent (ignoring transac-\ntion cost diff erences) if the put and call premiums were equal. \n Strategy 15: Synthetic Long Futures (Long Call + Short put) \nexample . Buy an August $1,150 gold futures call at a premium of $70.10/oz ($7,010) and simultane-\nously sell an August $1,150 gold futures put at a premium of $19.90/oz ($1,990). (See Table 35.15 \nand Figure 35.15 .) \nComment. A synthetic long futures position can be created by combining a long call and a short put \nfor the same expiration date and the same strike price. For example, as illustrated in Table 35.15 and Figure \n 35.15 , the combined position of a long August $1,150 call and a short August $1,150 put is virtually \nidentical to a long August futures position. The reason for this equivalence is tied to the fact that the \ndiff erence between the premium paid for the call and the premium received for the put is approxi-\nmately equal to the intrinsic value of the call. each $1 increase in price will raise the intrinsic value of \nthe call by an equivalent amount and each $1 decrease in price will reduce the intrinsic value of the \n FIGURE  35.14 Profi t/loss Profi le: Covered Put Write—Short Futures + Short Put (Similar \nto Short Call) \nPrice of August gold futures at option expiration ($/oz)\n1,000 1,050 1,100 1,150 1,200 1,250\nFutures price at time\nof position initiation\nand strike price Breakeven price\n= $1,238.70\n1,300 1,350 1,400\nProfit/loss at expiration ($)\n5,000\n2,500\n0\n−2,500\n−7 ,500\n−10,000\n−12,500\n−17 ,500\n−15,000\n−5,000\n529\nOPTION TrAdINg STrATegIeS\n tabLe 35.15 profit/Loss Calculations: Synthetic Long Futures (Long Call + Short put) \n(1) (2) (3) (4) (5) (6) (7) (8)\nFutures price \nat expiration \n($/oz)\npremium of \naugust $1,150 \nCall at Initiation \n($/oz)\n$ amount \nof premium \npaid\npremium of \naugust $1,150 \nput at Initiation \n($/oz)\n$ amount \nof premium \nreceived\nCall", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 168}
{"text": "500\n−10,000\n−12,500\n−17 ,500\n−15,000\n−5,000\n529\nOPTION TrAdINg STrATegIeS\n tabLe 35.15 profit/Loss Calculations: Synthetic Long Futures (Long Call + Short put) \n(1) (2) (3) (4) (5) (6) (7) (8)\nFutures price \nat expiration \n($/oz)\npremium of \naugust $1,150 \nCall at Initiation \n($/oz)\n$ amount \nof premium \npaid\npremium of \naugust $1,150 \nput at Initiation \n($/oz)\n$ amount \nof premium \nreceived\nCall Value \nat \nexpiration\nput Value \nat \nexpiration\nprofit/Loss on \nposition \n[(5) − (3) + (6) − (7)]\n1,000 70.1 $7,010 19.9 $1,990 $0 $15,000 −$20,020\n1,050 70.1 $7,010 19.9 $1,990 $0 $10,000 −$15,020\n1,100 70.1 $7,010 19.9 $1,990 $0 $5,000 −$10,020\n1,150 70.1 $7,010 19.9 $1,990 $0 $0 −$5,020\n1,200 70.1 $7,010 19.9 $1,990 $5,000 $0 −$20\n1,250 70.1 $7,010 19.9 $1,990 $10,000 $0 $4,980\n1,300 70.1 $7,010 19.9 $1,990 $15,000 $0 $9,980\n1,350 70.1 $7,010 19.9 $1,990 $20,000 $0 $14,980\n1,400 70.1 $7,010 19.9 $1,990 $25,000 $0 $19,980\n FIGURE  35.15 Profi t/loss Profi le: Synthetic long Futures (long Call + Short Put) \nPrice of August gold futures at option expiration ($/oz)\nProfit/loss at expiration ($)\n1,000\n20,000\n15,000\n10,000\n5,000\n−5,000\n−10,000\n−15,000\n−20,000\n0\n1,050 1,100 1,150 1,200 1,250\nFutures price at time\nof position initiation\nBreakeven price\n= $1,200.20\n1,300 1,350 1,400\n530\nA Complete Guide to the Futures mArket\ncall (or if prices decline below $1,150, increase the value of the put) by an equivalent amount. Thus, \nas long as the expiration date and strike price of the two options are identical, a long call/short put \nposition acts just like a long futures contract.\nThe futures equivalent price implied by a synthetic position is given by the following formula:\nSynthetic futures pos itio n prices trike pricec all prem ium=+ − −put premi um\nIt should be noted there will be one synthetic futures position price corresponding to each strike \nprice for which options are traded for the given futures contract.\nIn this example, the synthetic long position is the same price as a long futures contract. (Synthetic \nfutures position price = $1,150 + $70.10 − $19.90 = $1,200.20.) Thus, ignoring transaction costs \nand interest income effects, buying the August $1,150 call and simultaneously selling the August \n$1,150 put would be equivalent to buying an August futures contract. Of course, the trader consider-\ning this strategy as an alternative to an outright long futures position must incorporate transaction \ncosts and interest income effects into the calculation. In this example, the true cost of the synthetic \nfutures position would be raised vis-à-vis a long futures contract as a result of the following three \nfactors:\n 1. Because the synthetic futures position involves two trades, in a less liquid market, it is reason-\nable to assume the execution costs will also be greater. In other words, the option-based strategy \nwill require the trader to give up more points (relative to quoted levels) in order to execute the \ntrade.\n 2. The synthetic futures position will involve greater commission costs.\n 3. The dollar premium paid for the call ($7,010) exceeds the dollar premium received for the put \n($1,990). Thus, the synthetic futures position will involve an interest income loss on the differ-\nence between these two premium payments ($5,020). This factor, however, would be offset by \nthe margin requirements on a long futures position.\nOnce the above differences are accounted for, the apparent relative advantage a synthetic futures \nposition will sometimes seemingly offer will largely, if not totally, disappear. Nonetheless, insofar as \nsome market inefficiencies may exist, the synthetic long futures position will sometimes offer a slight \nadvantage over the direct purchase of a futures contract. In fact, the existence of such discrepancies \nwould raise the possibility of pure arbitrage trades.\n3 For example, if the price implied by the synthetic \nlong futures position was less than the futures price, even after accounting for transaction costs and \ninterest income effects, the arbitrageur could lock in a profit by buying the call, selling the put, and \nselling futures. Such a trade is called a reverse conversion. Alternately, if after adjusting for transaction \ncosts and interest income effects, the implied price of the synthetic long futures position were greater \nthan the futures price, the arbitrageur could lock in a profit by buying futures, selling the call, and \nbuying the put. Such a trade is called a conversion.\n3 Pure arbitrage implies a risk-free trade in which the arbitrageur is able to lock in a small profit by exploiting \ntemporary price distortions between two related markets.\n531\nOPTION TrAdINg STrATegIeS\nIt should be obvious that such risk-free profit opportunities will be limited in terms of \nboth duration and magnitude. generally speaking, conversion and reverse conversion arbitrage \nwill normally only be feasible for professional arbitrageurs who enjoy much lower transac-\ntion costs (commissions plus execution costs) than the general public. The activity of these \narbitrageurs will tend to keep synthetic futures position prices about in line with actual futures \nprices.\nStrategy 16: Synthetic Short Futures (Long put + Short Call)\nexample. Buy an August $1,300 gold futures put at a premium of $108.70/oz ($10,870) and simul-\ntaneously sell an August $1,300 gold futures call at a premium of $9.10/oz ($910). (See Table 35.16 \nand Figure 35.16.)\nComment. As follows directly from the discussion of the previous strategy, a synthetic short futures \nposition can be created by combining a long put and a short call with the same expiration date and the same \nstrike price. In this example, the synthetic futures position based upon the $1,300 strike price options \nis $0.40 higher priced than the underlying futures contract. (Synthetic futures position = $1,300 \n+ $9.10 − $108.70 = $1,200.40.) However, for reasons similar to those discussed in the previous \nstrategy, much of the advantage of an impl", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 169}
{"text": "short call with the same expiration date and the same \nstrike price. In this example, the synthetic futures position based upon the $1,300 strike price options \nis $0.40 higher priced than the underlying futures contract. (Synthetic futures position = $1,300 \n+ $9.10 − $108.70 = $1,200.40.) However, for reasons similar to those discussed in the previous \nstrategy, much of the advantage of an implied synthetic futures position price versus the actual futures \nprice typically disappears once transaction costs and interest income effects are incorporated into the \nevaluation. An arbitrage employing the synthetic short futures position is called a conversion and was \ndetailed in the previous strategy.\ntabLe 35.16 profit/Loss Calculations: Synthetic Short Futures (Long put + Short Call)\n(1) (2) (3) (4) (5) (6) (7) (8)\nFutures \nprice at \nexpiration \n($/oz)\npremium of \naugust $1,300 \nCall at Initiation \n($/oz)\nDollar \namount of \npremium \nreceived\npremium of \naugust $1,300 \nput at Initiation \n($/oz)\nDollar \namount of \npremium \npaid\nValue of \nCall at \nexpiration\nValue of \nput at \nexpiration\nprofit/Loss on \nposition \n[(3) − (5) + (7) − (6)]\n1,000 9.1 $910 108.7 $10,870 $0 $30,000 $20,040\n1,050 9.1 $910 108.7 $10,870 $0 $25,000 $15,040\n1,100 9.1 $910 108.7 $10,870 $0 $20,000 $10,040\n1,150 9.1 $910 108.7 $10,870 $0 $15,000 $5,040\n1,200 9.1 $910 108.7 $10,870 $0 $10,000 $40\n1,250 9.1 $910 108.7 $10,870 $0 $5,000 –$4,960\n1,300 9.1 $910 108.7 $10,870 $0 $0 –$9,960\n1,350 9.1 $910 108.7 $10,870 $5,000 $0 –$14,960\n1,400 9.1 $910 108.7 $10,870 $10,000 $0 –$19,960\n532A COMPleTe gUIde TO THe FUTUreS MArKeT\n Strategy 17: the ratio Call Write (Long Futures + Short 2 Calls) \nexample . Buy August gold futures at $1,200 and simultaneously sell two August $1,200 gold futures \ncalls at a premium of $38.80/ oz. ($7,760). (See Table 35.17 and Figure 35.17 .) \n FIGURE  35.16 Profi t/loss Profi le: Synthetic Short Futures (long Put + Short Call). \nFutures price at time\nof position initiation\nBreakeven price\n= $1,210.40\nPrice of August gold futures at option expiration ($/oz)\nProfit/loss at expiration ($)\n1,000\n20,000\n15,000\n10,000\n5,000\n−5,000\n−10,000\n−15,000\n−20,000\n0\n1,050 1,100 1,150 1,200 1,250 1,300 1,350 1,400\n tabLe 35.17 profit/Loss Calculations: ratio Call Write—Long Futures + Short 2 Calls (Similar to \nShort Straddle) \n(1) (2) (3) (4) (5) (6)\nFutures price \nat expiration \n($/oz)\npremium of \naugust $1,200 Call \nat Initiation ($/oz)\n$ amount of \ntotal premium \nreceived\nprofit/Loss on \nLong Futures \nposition\nValue of 2 Calls \nat expiration\nprofit/Loss on position \n[(3) + (4) − (5)]\n1,000 38.8 $7,760 –$20,000 $0 –$12,240\n1,050 38.8 $7,760 –$15,000 $0 –$7,240\n1,100 38.8 $7,760 –$10,000 $0 –$2,240\n1,150 38.8 $7,760 –$5,000 $0 $2,760\n1,200 38.8 $7,760 $0 $0 $7,760\n1,250 38.8 $7,760 $5,000 $10,000 $2,760\n1,300 38.8 $7,760 $10,000 $20,000 –$2,240\n1,350 38.8 $7,760 $15,000 $30,000 –$7,240\n1,400 38.8 $7,760 $20,000 $40,000 –$12,240\n533\nOPTION TrAdINg STrATegIeS\nPrice of August gold futures at option expiration ($/oz)\nProfit/loss at expiration ($)\n1,000\n10,000\n5,000\n−5,000\n−10,000\n0\n1,050 1,100 1,150 1,200 1,250\nBreakeven price\n= $1,122.40\nBreakeven price\n= $1,277 .60\n1,300 1,350 1,400\n−15,000\nFutures price at time\nof position initiation\n FIGURE  35.17 Profi t/loss Profi le: ratio Call Write—long Futures + Short 2 Calls (Similar to \nShort Straddle) \nComment. The combination of 1 long futures contract and 2 short at-the-money calls is a balanced \nposition in terms of delta values. In other words, at any given point in time, the gain or loss in the \nlong futures contract due to small price changes (i.e., price changes in the vicinity of the strike price) \nwill be approximately off set by an opposite change in the call position. (Over time, however, a mar-\nket characterized by small price changes will result in the long futures position gaining on the short \ncall position due to the evaporation of the time value of the options.) The maximum profi t in this \nstrategy will be equal to the premium received for the 2 calls and will occur when prices are exactly \nunchanged. This strategy will show a net profi t for a wide range of prices centered at the prevailing \nprice level at the time the position was initiated. However, the position will imply unlimited risk in \nthe event of very sharp price increases or declines. \n The profi t/loss profi le for this strategy should look familiar—it is virtually identical to the short \nstraddle position (see Strategy 35.8). The virtual equivalence of this strategy to the short straddle \nposition follows directly from the previously discussed structure of a synthetic futures position:\nRatio call wr itel ong f utures short calls\n=+ 2\n However, from the synthetic futures position relationship, we know that:\n Long f utures long call short put ≈+ \n534\nA Complete Guide to the Futures mArket\nThus:\nRatio call writ el ong c all short put short c alls or\nRati\n ≈+ + 2,\noo call wr ite short put short call≈+\nThe right-hand term of this last equation is, in fact, the definition of a short straddle. In similar \nfashion, it can be demonstrated that a short put write (short futures + short 2 puts) would also yield \na profit/loss profile nearly identical to the short straddle position.\nStrategy 18: bull Call Money Spread (Long Call with Lower Strike \nprice/Short Call with higher Strike price)\nexample. Buy an August $1,250 gold futures call at a premium of $19.20/oz ($1,920) and \nsimultaneously sell an August $1,300 call at a premium of $9.10 ($910). (See Table 35.18 and \nFigure 35.18.)\nComment. This type of spread position is also called a debit spread because the amount of premium \npaid for the long call is greater than the amount of the premium received for the short call. The maxi-\nmum risk in this type of trade is equal to the difference between these two premiums. The maximum \npossible gain in this spread will be equal to the difference between the two strike prices minus the \nnet difference between th", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 170}
{"text": "position is also called a debit spread because the amount of premium \npaid for the long call is greater than the amount of the premium received for the short call. The maxi-\nmum risk in this type of trade is equal to the difference between these two premiums. The maximum \npossible gain in this spread will be equal to the difference between the two strike prices minus the \nnet difference between the two premiums. The maximum loss will occur if prices fail to rise at least \nbeyond the lowest strike price. The maximum gain will be realized if prices rise above the higher \nstrike price. Note that although the maximum profit exceeds the maximum risk by a factor of nearly \n4 to 1, the probability of a loss is significantly greater than the probability of a gain. This condition is \ntrue since prices must rise $60.10/oz before the strategy proves profitable.\ntabLe 35.18 profit/Loss Calculations: bull Call Money Spread (Long Call with Lower Strike price/\nShort Call with higher Strike price)\n(1) (2) (3) (4) (5) (6) (7) (8)\nFutures price \nat expiration \n($/oz)\npremium of \naugust $1,250 \nCall ($/oz)\n$ amount \nof premium \npaid\npremium of \naugust $1,300 \nCall ($/oz)\nDollar amount \nof premium \nreceived\n$1,250 Call \nValue at \nexpiration\n$1,300 Call \nValue at \nexpiration\nprofit/Loss on \nposition \n[(5) − (3) + (6) − (7)]\n1,000 19.2 $1,920 9.1 $910 $0 $0 -$1,010\n1,050 19.2 $1,920 9.1 $910 $0 $0 -$1,010\n1,100 19.2 $1,920 9.1 $910 $0 $0 -$1,010\n1,150 19.2 $1,920 9.1 $910 $0 $0 -$1,010\n1,200 19.2 $1,920 9.1 $910 $0 $0 -$1,010\n1,250 19.2 $1,920 9.1 $910 $0 $0 -$1,010\n1,300 19.2 $1,920 9.1 $910 $5,000 $0 $3,990\n1,350 19.2 $1,920 9.1 $910 $10,000 $5,000 $3,990\n1,400 19.2 $1,920 9.1 $910 $15,000 $10,000 $3,990\n535\nOPTION TrAdINg STrATegIeS\n This strategy can perhaps be best understood by comparing it to the long call position (e.g., long \nAugust $1,250 gold futures call). In eff ect, the spread trader reduces the premium cost for the long \ncall position by the amount of premium received for the sale of the more deeply out-of-the-money \ncall. This reduction in the net premium cost of the trade comes at the expense of sacrifi cing the pos-\nsibility of unlimited gain in the event of a large price rise. As can be seen in Figure 35.18 , in contrast \nto the outright long call position, price gains beyond the higher strike price will cease to aff ect the \nprofi tability of the trade. \n Strategy 19a: bear Call Money Spread (Short Call with Lower Strike \nprice/Long Call with higher Strike price)—Case 1 \nexample . Buy August $1,150 gold futures call at a premium of $70.10/oz ($7,010) and simultane-\nously sell an August $1,100 gold futures call at a premium of $110.10/oz ($11,010), with August \ngold futures trading at $1,200/oz. (See Table 35.19 a and Figure 35.19 a.) \nComment. This type of spread is called a credit spread, since the amount of premium received for \nthe short call position exceeds the premium paid for the long call position. The maximum possible \ngain on the trade is equal to the net diff erence between the two premiums. The maximum possible \nloss is equal to the diff erence between the two strike prices minus the diff erence between the two \npremiums. The maximum gain would be realized if prices declined to the lower strike price. The \nmaximum loss would occur if prices failed to decline to at least the higher strike price. Although \n FIGURE  35.18 Profi t/loss Profi le: Bull Call Money Spread (long Call with lower Strike Price/\nShort Call with Higher Strike Price) \nPrice of August gold futures at option expiration ($/oz)\nProfit/loss at expiration ($)\n1,000\n3,750\n5,000\n2,500\n0\n−1,250\n1,250\n1,050 1,100 1,150 1,200 1,250\nBreakeven price\n= $1,260.10\n1,300 1,350 1,400\n−2,500\nFutures price at time\nof position initiation\n536A COMPleTe gUIde TO THe FUTUreS MArKeT\n tabLe 35.19a profit/Loss Calculations: bear Call Money Spread (Short Call with Lower Strike price/\nLong Call with higher Strike price); Case 1—both Calls In-the-Money \n(1) (2) (3) (4) (5) (6) (7) (8)\nFutures price \nat expiration \n($/oz)\npremium of \naugust $1,150 \nCall ($/oz)\n$ amount \nof premium \npaid\npremium of \naugust $1,100 \nCall ($/oz)\n$ amount \nof premium \nreceived\n$1,150 Call \nValue at \nexpiration\n$1,100 Call \nValue at \nexpiration\n profit/Loss on \nposition \n [(5) − (3) + (6) − (7)] \n1,000 70.1 $7,010 110.1 $11,010 $0 $0 $4,000\n1,050 70.1 $7,010 110.1 $11,010 $0 $0 $4,000\n1,100 70.1 $7,010 110.1 $11,010 $0 $0 $4,000\n1,150 70.1 $7,010 110.1 $11,010 $0 $5,000 –$1,000\n1,200 70.1 $7,010 110.1 $11,010 $5,000 $10,000 –$1,000\n1,250 70.1 $7,010 110.1 $11,010 $10,000 $15,000 –$1,000\n1,300 70.1 $7,010 110.1 $11,010 $15,000 $20,000 –$1,000\n1,350 70.1 $7,010 110.1 $11,010 $20,000 $25,000 –$1,000\n1,400 70.1 $7,010 110.1 $11,010 $25,000 $30,000 –$1,000\nPrice of August gold futures at option expiration ($/oz)\nProfit/loss at expiration ($)\n1,000\n3,750\n5,000\n2,500\n0\n−1,250\n1,250\n1,050 1,100 1,150 1,200 1,250\nBreakeven price = $1,140\n1,300 1,350 1,400\nFutures price at time\nof position initiation\n FIGURE  35.19a Profi t/loss Profi le: Bear Call Money Spread (Short Call with lower Strike \nPrice/long Call with Higher Strike Price); Case 1—Both Calls In-the-Money \n537\nOPTION TrAdINg STrATegIeS\nin the above example the maximum gain exceeds the maximum risk by a factor of 4 to 1, there is \na greater probability of a net loss on the trade, since prices must decline by $60/oz before a profit \nis realized.\nIn this type of spread, the trader achieves a bearish position at a fairly low premium cost at the \nexpense of sacrificing the potential for unlimited gains in the event of a very sharp price decline. This \nstrategy might be appropriate for the trader expecting a price decline but viewing the possibility of a \nvery large price slide as being very low .\nStrategy 19b: bear Call Money Spread (Short Call with Lower Strike \nprice/Long Call with higher Strike price)—Case 2\nexample. Buy an August $1,300 gold futures call at a premium of $9.10/oz ($9.10) and simultane-\nously sell a", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 171}
{"text": "sharp price decline. This \nstrategy might be appropriate for the trader expecting a price decline but viewing the possibility of a \nvery large price slide as being very low .\nStrategy 19b: bear Call Money Spread (Short Call with Lower Strike \nprice/Long Call with higher Strike price)—Case 2\nexample. Buy an August $1,300 gold futures call at a premium of $9.10/oz ($9.10) and simultane-\nously sell an August $1,200 gold futures call at a premium of $38.80/oz ($3,880), with August gold \nfutures trading at $1,200/oz. (See Table 35.19b and Figure 35.19b.)\nComment. In contrast to the previous strategy, which involved two in-the-money calls, this illustra-\ntion is based on a spread consisting of a short at-the-money call and a long out-of-the-money call. \nIn a sense, this type of trade can be thought of as a short at-the-money call position with built-in \nstop-loss protection. (The long out-of-the-money call will serve to limit the risk in the short at-the-\nmoney call position.) This risk limitation is achieved at the expense of a reduction in the net premium \nreceived by the seller of the at-the-money call (by an amount equal to the premium paid for the out-\nof-the-money call). This trade-off between risk exposure and the amount of net premium received \nis illustrated in Figure 35.19b, which compares the outright short at-the-money call position to the \nabove spread strategy.\ntabLe 35.19b profit/Loss Calculations: bear Call Money Spread (Short Call with Lower Strike price/Long \nCall with higher Strike price); Case 2—Short at-the-Money Call/Long Out-of-the-Money \nCall\n(1) (2) (3) (4) (5) (6) (7) (8)\nFutures price \nat expiration \n($/oz)\npremium of \naugust $1,300 \nCall ($/oz)\n$ amount \nof premium \npaid\npremium of \naugust $1,200 \nCall ($/oz)\n$ amount \nof premium \nreceived\nValue of \n$1,300 Call at \nexpiration\nValue of \n$1,200 Call at \nexpiration\nprofit/Loss on \nposition \n[(5) − (3) + (6) − (7)]\n1,000 9.1 $910 38.8 $3,880 $0 $0 $2,970\n1,050 9.1 $910 38.8 $3,880 $0 $0 $2,970\n1,100 9.1 $910 38.8 $3,880 $0 $0 $2,970\n1,150 9.1 $910 38.8 $3,880 $0 $0 $2,970\n1,200 9.1 $910 38.8 $3,880 $0 $0 $2,970\n1,250 9.1 $910 38.8 $3,880 $0 $5,000 –$2,030\n1,300 9.1 $910 38.8 $3,880 $0 $10,000 –$7,030\n1,350 9.1 $910 38.8 $3,880 $5,000 $15,000 –$7,030\n1,400 9.1 $910 38.8 $3,880 $10,000 $20,000 –$7,030\n538A COMPleTe gUIde TO THe FUTUreS MArKeT\n Strategy 20a: bull put Money Spread (Long put with Lower Strike \nprice/Short put with higher Strike price)—Case 1 \nexample . Buy an August $1,250 gold futures put at a premium of $68.70/oz ($6,870) and simulta-\nneously sell an August $1,300 put at a premium of $108.70/oz ($10,870), with August gold futures \ntrading at $1,200/oz. (See Table 35.20 a and Figure 35.20 a.) \nComment. This is a net credit bull spread that uses puts instead of calls. The maximum gain in this \nstrategy is equal to the diff erence between the premium received for the short put and the premium \npaid for the long put. The maximum loss is equal to the diff erence between the strike prices minus \nthe diff erence between the premiums. The maximum gain will be achieved if prices rise to the higher \nstrike price, while the maximum loss will occur if prices fail to rise at least to the lower strike price. \nThe profi t/loss profi le of this trade is very similar to the profi le of the net debit bull call money \nspread illustrated in Figure 35.18 . \nPrice of August gold futures at option expiration ($/oz)\nProfit/loss at expiration ($)\n1,000\n5,000\n2,500\n0\n−2,500\n−5,000\n−7 ,500\n−10,000\n−12,500\n−17 ,500\n1,050 1,100 1,150 1,200 1,250\nBear call money spread\nShort at-the-money\ncall\nBreakeven price on\nspread = $1,229.70\nBreakeven price on\nshort call = $1,238.80\n1,300 1,350 1,400\n−15,000\nFutures price at time\nof position initiation\n FIGURE  35.19b Profi t/loss Profi le: Bear Call Money Spread (Short Call with lower Strike \nPrice/long Call with Higher Strike Price); Case 2—Short At-the-Money Call/long Out-of-the-\nMoney Call with Comparison to Short At-the-Money Call \n539\nOPTION TrAdINg STrATegIeS\n tabLe 35.20a profit/Loss Calculations: bull put Money Spread (Long put with Lower Strike price/\nShort put with higher Strike price); Case 1—both puts In-the-Money \n(1) (2) (3) (4) (5) (6) (7) (8)\nFutures price \nat expiration \n($/oz)\npremium of \naugust $1,250 \nput ($/oz)\n$ amount \nof premium \npaid\npremium of \naugust $1,300 \nput ($/oz)\n$ amount \nof premium \nreceived\n$1,250 put \nValue at \nexpiration\n$1,300 put \nValue at \nexpiration\nprofit/Loss on \nposition\n[(5) − (3) + (6) −(7)]\n1,000 68.7 $6,870 108.7 $10,870 $25,000 $30,000 –$1,000\n1,050 68.7 $6,870 108.7 $10,870 $20,000 $25,000 –$1,000\n1,100 68.7 $6,870 108.7 $10,870 $15,000 $20,000 –$1,000\n1,150 68.7 $6,870 108.7 $10,870 $10,000 $15,000 –$1,000\n1,200 68.7 $6,870 108.7 $10,870 $5,000 $10,000 –$1,000\n1,250 68.7 $6,870 108.7 $10,870 $0 $5,000 –$1,000\n1,300 68.7 $6,870 108.7 $10,870 $0 $0 $4,000\n1,350 68.7 $6,870 108.7 $10,870 $0 $0 $4,000\n1,400 68.7 $6,870 108.7 $10,870 $0 $0 $4,000\n FIGURE  35.20a \n Profi t/loss Profi le: Bull Put Money Spread (long Put with lower Strike Price/\nShort Put with Higher Strike Price); Case 1—Both Puts In-the-Money \nPrice of August gold futures at option expiration ($/oz)\nProfit/loss at expiration ($)\n1,000\n3,750\n5,000\n2,500\n0\n1,250\n1,050 1,100 1,150 1,200 1,250\nBreakeven price\n= $1,260\n1,300 1,350 1,400\n−1,250\nFutures price at time\nof position initiation\n540\nA Complete Guide to the Futures mArket\nStrategy 20b: bull put Money Spread (Long put with Lower Strike \nprice/Short put with higher Strike price)—Case 2\nexample. Buy an August $1,100 gold futures put at a premium of $10.10/oz ($1,010) and simul-\ntaneously sell an August $1,200 put at a premium of $38.70/oz ($3,870), with August gold futures \ntrading at $1,200/oz. (See Table 35.20b and Figure 35.20b.)\nComment. In contrast to Case 1, which involved two in-the-money puts, this strategy is based on \na long out-of-the-money put versus a short at-the-money put spread. In a sense, this strategy can \nbe viewed", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 172}
{"text": "ium of $10.10/oz ($1,010) and simul-\ntaneously sell an August $1,200 put at a premium of $38.70/oz ($3,870), with August gold futures \ntrading at $1,200/oz. (See Table 35.20b and Figure 35.20b.)\nComment. In contrast to Case 1, which involved two in-the-money puts, this strategy is based on \na long out-of-the-money put versus a short at-the-money put spread. In a sense, this strategy can \nbe viewed as a short at-the-money put position with a built-in stop. (The purchase of the out-of-\nthe-money put serves to limit the maximum possible loss in the event of a large price decline.) This \nrisk limitation is achieved at the expense of a reduction in the net premium received. This trade-off \nbetween risk exposure and the amount of premium received is illustrated in Figure 35.20b, which \ncompares the outright short at-the-money put position to this spread strategy.\nStrategy 21: bear put Money Spread (Short put with Lower Strike \nprice/Long put with higher Strike price)\nexample. Sell an August $1,100 gold futures put at a premium of $10.10/oz ($1,010) and simul-\ntaneously buy an August $1,150 put at a premium of $19.90/oz ($1,990), with August gold futures \ntrading at $1,200/oz. (See Table 35.21 and Figure 35.21.)\nComment. This is a debit bear spread using puts instead of calls. The maximum risk is equal to the \ndifference between the premium paid for the long put and the premium received for the short put. The \nmaximum gain equals the difference between the two strike prices minus the difference between \nthe premiums. The maximum loss will occur if prices fail to decline to at least the higher strike price. \nThe maximum gain will be achieved if prices decline to the lower strike price. The profit/loss profile of \nthis spread is approximately equivalent to the profile of the bear call money spread (see Figure 35.19a).\ntabLe 35.20b profit/Loss Calculations: bull put Money Spread (Long put with Lower Strike price/Short put \nwith higher Strike price); Case 2—Long Out-of-the-Money put/Short at-the-Money put\n(1) (2) (3) (4) (5) (6) (7) (8)\nFutures price \nat expiration \n($/oz)\npremium of \naugust $1,100 \nput ($/oz)\nDollar \namount of \npremium paid\npremium of \naugust $1,200 \nput ($/oz)\nDollar amount \nof premium \nreceived\nValue of \n$1,100 put at \nexpiration\nValue of \n$1,200 put at \nexpiration\nprofit/Loss on \nposition \n[(5) − (3) + (6) − (7)]\n1,000 10.1 $1,010 38.7 $3,870 $10,000 $20,000 –$7,140\n1,050 10.1 $1,010 38.7 $3,870 $5,000 $15,000 –$7,140\n1,100 10.1 $1,010 38.7 $3,870 $0 $10,000 –$7,140\n1,150 10.1 $1,010 38.7 $3,870 $0 $5,000 –$2,140\n1,200 10.1 $1,010 38.7 $3,870 $0 $0 $2,860\n1,250 10.1 $1,010 38.7 $3,870 $0 $0 $2,860\n1,300 10.1 $1,010 38.7 $3,870 $0 $0 $2,860\n1,350 10.1 $1,010 38.7 $3,870 $0 $0 $2,860\n1,400 10.1 $1,010 38.7 $3,870 $0 $0 $2,860\n541\nOPTION TrAdINg STrATegIeS FIGURE  35.20b Profi t/loss Profi le: Bull Put Money Spread (long Put with lower Strike Price/\nShort Put with Higher Strike Price); Case 2—long Out-of-the-Money Put/Short At-the-Money \nPut with Comparison to Short At-the-Money Put \nPrice of August gold futures at option expiration ($/oz)\nProfit/loss at expiration ($)\n1,000\n5,000\n2,500\n0\n−2,500\n−5,000\n−7 ,500\n−10,000\n−12,500\n−15,000\n1,050 1,100 1,150 1,200 1,250\nBull put money spread\nShort at-the-money\nput\nBreakeven price on spread = $1,171.40\nBreakeven price on short put $1,161.30\n1,300 1,350 1,400\n−17 ,500\nFutures price at time\nof position initiation\n tabLe 35.21 profit/Loss Calculations: bear put Money Spread (Short put with Lower Strike price/Long \nput with higher Strike price) \n(1) (2) (3) (4) (5) (6) (7)\nFutures price \nat expiration \n($/oz)\npremium of \naugust $1,150 \nput ($/oz)\n$ amount \nof premium \npaid\npremium of \naugust $1,100 \nput ($/oz)\n$ amount \nof premium \nreceived\nValue of \n$1,150 \nput\nValue of \n$1,100 \nput\nprofit/Loss on position \n[(5) − (3) + (6) − (7)]\n1,000 19.9 $1,990 10.1 $1,010 $15,000 $10,000 $4,020\n1,050 19.9 $1,990 10.1 $1,010 $10,000 $5,000 $4,020\n1,100 19.9 $1,990 10.1 $1,010 $5,000 $0 $4,020\n1,150 19.9 $1,990 10.1 $1,010 $0 $0 –$980\n1,200 19.9 $1,990 10.1 $1,010 $0 $0 –$980\n1,250 19.9 $1,990 10.1 $1,010 $0 $0 –$980\n1,300 19.9 $1,990 10.1 $1,010 $0 $0 –$980\n1,350 19.9 $1,990 10.1 $1,010 $0 $0 –$980\n1,400 19.9 $1,990 10.1 $1,010 $0 $0 –$980\n542A COMPleTe gUIde TO THe FUTUreS MArKeT\n Other Spread Strategies \n Money spreads represent only one class of option spreads. A complete discussion of option spread \nstrategies would require a substantial extension of this section—a degree of detail beyond the scope \nof this presentation. The following are examples of some other types of spreads. \ntime spread. A time spread is a spread between two calls or two puts with the same strike price, \nbut a diff erent expiration date. An example of a time spread would be: long 1 August $1,300 \ngold futures call/short 1 december $1,300 gold futures call. Time spreads are more complex \nthan the other strategies discussed in this section, because the profi t/loss profi le at the time \nof expiration cannot be precisely predetermined, but rather must be estimated on the basis of \ntheoretical valuation models. \nDiagonal spread. This is a spread between two calls or two puts that diff er in terms of both the \nstrike price and the expiration date. An example of a diagonal spread would be: long 1 August \n$1,200 gold futures call/short 1 december $1,250 gold futures call. In eff ect, this type of \nspread combines the money spread and the time spread into one trade. \nbutterfl y spread. This is a three-legged spread in which the options have the same expiration \ndate but diff er in strike prices. A butterfl y spread using calls consists of two short calls at a given \nstrike price, one long call at a higher strike price, and one long call at a lower strike price. \n The list of types of option spreads can be significantly extended, but the above examples \nshould be sufficient to give the reader some idea of the potential range of complexity of spread \nPrice of August gold futures at option", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 173}
{"text": ". A butterfl y spread using calls consists of two short calls at a given \nstrike price, one long call at a higher strike price, and one long call at a lower strike price. \n The list of types of option spreads can be significantly extended, but the above examples \nshould be sufficient to give the reader some idea of the potential range of complexity of spread \nPrice of August gold futures at option expiration ($/oz)\nProfit/loss at expiration ($)\n1,000\n3,750\n5,000\n2,500\n0\n−1,250\n−2,500\n1,250\n1,050 1,100 1,150 1,200 1,250\nBreakeven price\n= $1,140.20\n1,300 1,350 1,400\nFutures price at time\nof position initiation\n FIGURE  35.21 Profi t/loss Profi le; Bear Put Money Spread (Short Put with lower Strike Price/\nlong Put with Higher Strike Price) \n543\nOPTION TrAdINg STrATegIeS\nstrategies. One critical point that must be emphasized regarding option spreads is that these \nstrategies are normally subject to a major disadvantage: the transaction costs (commissions plus \ncumulative bid/asked spreads) for these trades are relatively large compared to the profit poten-\ntial. This consideration means that the option spread trader must be right a large percentage of \nthe time if he is to come out ahead of the game. The importance of this point cannot be overem -\nphasized. In short, as a generalization, other option strategies will usually offer better trading \nopportunities.\nMultiunit Strategies\nThe profit/loss profile can also be used to analyze multiple-unit option strategies. In fact, multiple-\nunit option positions may often provide the more appropriate strategy for purposes of comparison. \nFor example, as previously detailed, a long futures position is more volatile than a long or short call \nposition. In fact, for small price changes, each $1 change in a futures price will only result in approxi-\nmately a $0.50 change in the call price (the delta value for an at-the-money call is approximately \nequal to 0.5). As a result, in considering the alternatives of buying futures and buying calls, it probably \nmakes more sense to compare the long futures position to two long calls (see Table 35.22) as opposed \nto one long call.\nFigure 35.22 compares the strategies of long futures versus long two calls, which at the time of \ninitiation are approximately equivalent in terms of delta values. Note this comparison indicates that \nthe long futures position is preferable if prices change only moderately, but that the long two-call \nposition will gain more if prices rise sharply, and lose less if prices decline sharply. In contrast, the \ncomparison between long futures and a long one-call position would indicate that futures provide \nthe better strategy in the event of a price advance of any magnitude (see Figure 35.3d). For most \npurposes, the comparison employing two long calls will be more meaningful because it comes much \ncloser to matching the risk level implicit in the long futures position.\ntabLe 35.22 profit/Loss Calculations: Long two at-the-Money Calls\n(1) (2) (3) (4) (5)\nFutures price at \nexpiration ($/oz)\npremium of august \n$1,200 Call ($/oz)\n$ amount of total \npremium paid\nValue of 2 Calls \nat expiration\nprofit/Loss on \nposition [(4) − (3)]\n1,000 38.8 $7,760 $0 –$7,760\n1,050 38.8 $7,760 $0 –$7,760\n1,100 38.8 $7,760 $0 –$7,760\n1,150 38.8 $7,760 $0 –$7,760\n1,200 38.8 $7,760 $0 –$7,760\n1,250 38.8 $7,760 $10,000 $2,240\n1,300 38.8 $7,760 $20,000 $12,240\n1,350 38.8 $7,760 $30,000 $22,240\n1,400 38.8 $7,760 $40,000 $32,240\n544A COMPleTe gUIde TO THe FUTUreS MArKeT\n Choosing an Optimal Strategy \n It the previous sections we examined a wide range of alternative trading strategies. Now what? How \ndoes a trader decide which of these alternatives provides the best trading opportunity? This ques-\ntion can be answered only if probability is incorporated into the analysis. The selection of an optimal \noption strategy will depend entirely on the trader’s price and volatility expectations. Insofar as these \nexpectations will diff er from trader to trader, the optimal option strategy will also vary, and the \nsuccess of the selected option strategy will depend on the accuracy of the trader’s expectations. In \norder to select an optimal option strategy, the trader needs to translate his price expectations into \nprobabilities. \n The basic approach requires the trader to assign estimated probability levels for the entire range \nof feasible price intervals. Figure 35.23 illustrates six diff erent types of probability distributions for \nAugust gold futures. These distributions can be thought of as representing six diff erent hypothetical \nexpectations. (The charts in Figure 35.23 implicitly assume that the current price of August gold \nfutures is $1,200.) Several important points should be made regarding these probability distributions: \n 1. The indicated probability distributions only represent approximations of traders’ price expec-\ntations. In reality, any reasonable probability distribution would be represented by a smooth \ncurve. The stair-step charts in Figure 35.23 are only intended as crude models that greatly sim-\nplify calculations. (The use of smooth probability distributions would require integral calculus \nin the evaluation process.) \nPrice of August gold futures at option expiration ($/oz)\nProfit/loss at expiration ($)\n1,000\n25,000\n12,500\n−12,500\n−25,000\n0\n1,050 1,100 1,150 1,200 1,250\nBreakeven price on long\n2 calls = $1,238.80\nLong futures\nLong 2 calls\n1,300 1,350 1,400\n37 ,500\n+37 ,500\nFutures price at time\nof position initiation\n FIGURE  35.22 Profi t/loss Profi le: Two long Calls vs. long Futures \n545\nOPTION TrAdINg STrATegIeS\n 2. The sum of all the probabilities is equal to 1.0. \n 3. The stair-step type of graph used in Figure 35.23 implicitly assumes an equal probability for \neach price in the interval. \n 4. The high and low intervals in each diagram are intended as summary descriptions for all \nprices beyond the internal border of that interval. For example, in expected Probability \ndistribution 1, the assu", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 174}
{"text": "TrATegIeS\n 2. The sum of all the probabilities is equal to 1.0. \n 3. The stair-step type of graph used in Figure 35.23 implicitly assumes an equal probability for \neach price in the interval. \n 4. The high and low intervals in each diagram are intended as summary descriptions for all \nprices beyond the internal border of that interval. For example, in expected Probability \ndistribution 1, the assumption of a 5 percent probability of a price between $1,050 and \n$1,099.90 (with all prices in that range having an equal probability of occurrence) and a zero \nprobability of a lower price is equivalent to the more realistic assumption of a 5 percent prob-\nability of a price below $1,100, with the probability-weighted average of such prices equal to \n$1,075. \n FIGURE  35.23 Probability of Futures Price within given range of Option expiration for Various \nexpected Probability distributions (Arrow Indicates Current Price of Futures) \n.02\n.04\n.06\n.08\n.10\n.12\n.14\n.16\n.18\n.20\nExpected probability distribution 3\n975\n.02\n.04\n.06\n.08\n.10\n.12\n.14\n.16\n.18\n.20\n1,025\n1,075\n1,125\n1,175\n1,225\nExpected probability distribution 1\n1,275\n1,325\n1,375\n1,425\n975\n1,025\n1,075\n1,125\n1,175\n1,225\n1,275\n1,325\n1,375\n1,425\n975\n1,025\n1,075\n1,125\n1,175\n1,225\n1,275\n1,325\n1,375\n1,425\n975\n1,025\n1,075\n1,125\n1,175\n1,225\n1,275\n1,325\n1,375\n1,425\n975\n1,025\n1,075\n1,125\n1,175\n1,225\n1,275\n1,325\n1,375\n1,425\n975\n1,025\n1,075\n1,125\n1,175\n1,225\n1,275\n1,325\n1,375\n1,425\n.02\n.04\n.06\n.08\n.10\n.12\n.14\n.16\n.18\n.20\nExpected probability distribution 5\n.02\n.04\n.06\n.08\n.10\n.12\n.14\n.16\n.18\n.20\nExpected probability distribution 4\n.02\n.04\n.06\n.08\n.10\n.12\n.14\n.16\n.18\n.20\nExpected probability distribution 2\n.02\n.04\n.06\n.08\n.10\n.12\n.14\n.16\n.18\n.20\nExpected probability distribution 6\n546\nA Complete Guide to the Futures mArket\n 5. The probability distributions in Figure 35.23 represent sample hypothetical illustrations \nof personal price expectations. The indicated optimal strategy in any given situation will \ndepend upon the specific shape of the expected price distribution, an input that will differ from \ntrader to trader.\nThe general nature of the price expectations implied by each of the distributions in Figure 35.23 \ncan be summarized as follows:\nExpected Probability Distribution 1. Higher prices and low volatility. This interpretation follows from \nthe fact that there is a greater probability of higher prices and that the probabilities are heavily \nweighted toward intervals close to the current price level.\nExpected Probability Distribution 2. Higher prices and high volatility. This distribution reflects the \nsame 60/40 probability bias toward higher prices as was the case for \ndistribution 1, but the \nassumed probability of a substantially higher or lower price is much greater.\nExpected Probability Distribution 3. lower prices and low volatility. This distribution is the bearish \ncounterpart of distribution 1.\nExpected Probability Distribution 4. lower prices and high volatility. This distribution is the bearish \ncounterpart of distribution 2.\nExpected Probability Distribution 5. Neutral price assumptions and low volatility. This distribution is \nsymmetrical in terms of higher and lower prices, and probability levels are heavily weighted \ntoward prices near the current level.\nExpected Probability Distribution 6. Neutral price assumptions and high volatility. This distribution is \nalso symmetrical in terms of high and low prices, but substantially higher and lower prices have \na much greater probability of occurrence than in \ndistribution 5.\nFigure 35.24 combines expected Probability distribution 1 with three alternative bullish strat-\negies. (Since it is assumed that there is a greater probability of higher prices, there is no need to \nconsider bearish or neutral trading strategies.) Insofar as the assumed probability distribution is \nvery heavily weighted toward prices near the current level, the short put position appears to offer \nthe best strategy. Figure 35.25 combines the same three alternative bullish strategies with the bull -\nish/volatile price scenario suggested by \nexpected Probability distribution 2. In this case, the long \ncall position appears to be the optimal strategy, since it is by far the best performer for large price \nadvances and declines—price outcomes that account for a significant portion of the overall prob -\nability distribution.\nIn analogous fashion, Figure 35.26 suggests the preferability of the short call position given \nthe bearish/nonvolatile price scenario assumption, while Figure 35.27 suggests that the long put \nposition is the optimal strategy given the bearish/volatile price scenario. Finally, two alternative \nneutral strategies are compared in Figures 35.28 and 35.29 for two neutral price distributions \nthat differ in terms of assumed volatility. The short straddle appears to offer the better strategy in \nthe low volatility distribution assumption, while the reverse conclusion is suggested in the volatile \nprice case.\n547\nOPTION TrAdINg STrATegIeS\n FIGURE  35.24 “Bullish/Nonvolatile” expected Probability distribution and Profi t/loss \nProfi les for Three Alternative Bullish Strategies \nPrice of August gold futures at option expiration ($/oz)\nProfit/loss at expiration ($)\n1,000\n25,000\n12,500\n−12,500\n−25,000\n0\n1,050 1,100 1,150 1,200 1,250\nLong futures\nShort 2 puts\nLong 2 calls\n.20\n.18\n.16\n.14\n.12\n.10\nProbability\n.08\n.06\n.04\n.02\n1,300 1,350 1,400\n FIGURE  35.25 “Bullish/V olatile” expected Probability distribution and Profi t/loss Profi les \nfor Three Alternative Bullish Strategies \nPrice of August gold futures at option expiration ($/oz)\nProfit/loss at expiration ($)\n1,000\n25,000\n12,500\n−12,500\n−25,000\n0\n1,050 1,100 1,150 1,200 1,250\nLong futures\nShort 2 puts\nLong 2 calls\n.20\n.18\n.16\n.14\n.12\n.10\nProbability\n.08\n.06\n.04\n.02\n1,300 1,350 1,400\n548A COMPleTe gUIde TO THe FUTUreS MArKeT\n FIGURE  35.26 “Bearish/Nonvolatile” expected Probability distribution and Profi t/loss \nProfi les for Three Alternative Bearish Strateg", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 175}
{"text": "iration ($/oz)\nProfit/loss at expiration ($)\n1,000\n25,000\n12,500\n−12,500\n−25,000\n0\n1,050 1,100 1,150 1,200 1,250\nLong futures\nShort 2 puts\nLong 2 calls\n.20\n.18\n.16\n.14\n.12\n.10\nProbability\n.08\n.06\n.04\n.02\n1,300 1,350 1,400\n548A COMPleTe gUIde TO THe FUTUreS MArKeT\n FIGURE  35.26 “Bearish/Nonvolatile” expected Probability distribution and Profi t/loss \nProfi les for Three Alternative Bearish Strategies \n “Bearish/Nonvolatile” expected Probability distribution and Profi t/loss \nPrice of August gold futures at option expiration ($/oz)\nProfit/loss at expiration ($)\n1,000\n25,000\n12,500\n−12,500\n−25,000\n0\n1,050 1,100 1,150 1,200 1,250\nShort futures\nShort 2 calls\nLong 2 puts\n.20\n.18\n.16\n.14\n.12\n.10\nProbability\n.08\n.06\n.04\n.02\n1,300 1,350 1,400\n FIGURE  35.27 “Bearish/V olatile” expected Probability distribution and Profi t/loss Profi les \nfor Three Alternative Bearish Strategies \nPrice of August gold futures at option expiration ($/oz)\nProfit/loss at expiration ($)\n1,000\n25,000\n12,500\n−12,500\n−25,000\n0\n1,050 1,100 1,150 1,200 1,250\n.20\n.18\n.16\n.14\n.12\n.10\nProbability\n.08\n.06\n.04\n.02\n1,300 1,350 1,400\nShort futures\nShort 2 calls\nLong 2 puts\n549\nOPTION TrAdINg STrATegIeS\n FIGURE  35.28 “Neutral/Nonvolatile” expected Probability distribution and Profi t/loss \nProfi les for Two Alternative Neutral Strategies \n “Neutral/Nonvolatile” expected Probability distribution and Profi t/loss \nPrice of August gold futures at option expiration ($/oz)\nProfit/loss at expiration ($)\n1,000\n10,000\n5,000\n−5,000\n−10,000\n0\n1,050 1,100 1,150 1,200 1,250\n.20\n.18\n.16\n.14\n.12\n.10\nProbability\n.08\n.06\n.04\n.02\n1,300 1,350 1,400\nLong straddle\nShort straddle\n FIGURE  35.29 “Neutral/V olatile” expected Probability distribution and Profi t/loss Profi les \nfor Two Alternative Neutral Strategies \nPrice of August gold futures at option expiration ($/oz)\nProfit/loss at expiration ($)\n1,000\n10,000\n5,000\n−5,000\n−10,000\n−15,000\n0\n1,050 1,100 1,150 1,200 1,250\n.20\n.18\n.16\n.14\n.12\n.10\nProbability\n.08\n.06\n.04\n.02\n1,300 1,350 1,400\nLong straddle\nShort straddle\n550\nA Complete Guide to the Futures mArket\nOne problem with the graphic approach described thus far is that it may not always be visually \nclear which is the best strategy for the given price distribution assumption. Obviously, a more precise \nmethod of determining the optimal trading strategy would be desirable. Intuitively, it might appear \nthat expected gain would provide such a relative measure. \nexpected gain is the expected gain (or loss) \non a trade and can be expressed as follows:\nExpected g ain =\n=\n∑ () ()PXii\ni\nn\n1\nwhere Pi = probability of price interval i\n Xt = average gain (or loss) of interval i\n n = number of intervals\nUnfortunately, expected gain has a major defect as a relative measure: it is dependent upon posi-\ntion size. The expected gain of any strategy that has a positive expected gain could always be improved \nby trading a multiple of the position. Thus, in comparing alternative strategies with positive expected \ngains, the indicated optimal strategy would vary depending on the assumed position sizes. Such arbi-\ntrariness in a relative measure is obviously unacceptable.\nThe use of expected gain as a relative measure can lead to some ludicrous conclusions. For exam-\nple, a strategy that had a 50 percent probability of a $1,000 gain and a 50 percent probability of a \n$900 loss would be judged better than an alternative strategy with a 50 percent chance of a $100 gain \nand a 50 percent chance of a $10 loss (an expected gain of $50 vs. an expected gain of $45). Obvi-\nously, virtually any trader would prefer the second strategy, despite its lower expected gain.\nThe dependency of expected gain on position size actually reflects a more fundamental flaw in this \nmeasure: expected gain does not incorporate a measure of risk. A measure that included risk would \nnot be dependent upon position size, since doubling the position would not only double the expected \ngain, but would also double the risk. One such possible measure is the probability-weighted profit/\nloss ratio (PWP\nlr), which can be defined as follows:\nPWPLR\nPG\nPL\nii\ni\nm\njj\nj\nn=− =\n=\n∑\n∑\n() ()\n() ()\n1\n1\nwhere Pi = probability of interval i, where i represents an interval with a net gain at the average \nprice of the interval\n Pj = probability of interval j, where j represents an interval with a net loss at the average \nprice of the interval\n Gi = indicated gain at the average price of the interval\n Lj = indicated loss at the average price of the interval\n m = number of intervals with net gain at average price of interval\n n = number of intervals with net loss at average price of interval\n551\nOPTION TrAdINg STrATegIeS\nAn implicit assumption in the formulation of the probability-weighted profit/loss ratio is that each \nprice in a given interval has an equal probability of occurrence.4\nNote that the PWPlr will be totally unaffected by position size. This is true because increasing the \nposition will affect the numerator and denominator of the PWPlr equally, thereby leaving the ratio \nunchanged. Tables 35.23 through 35.28 evaluate the strategies graphically analyzed in Figure 35.24 \nthrough 35.29. The conclusions are equivalent, but the advantage of this method is that it yields pre-\ncise, unambiguous results. T o select an optimal strategy, the trader would merely define his estimate \nof the probability distribution for prices and then calculate the PWP\nlrs for each alternative trading \napproach.\n4 It is worth noting that the probability-weighted profit/loss ratio will yield the same ordering of strategies as \nthe ratio of the expected gain to the expected loss on losing trades, where the expected loss on losing trades is \ndefined as: () ()PLjj\nj\nn\n=\n∑\n1\n. This can be demonstrated as follows: \nExpected g ain\nExpected gain\nExpe\n=−\n==\n∑∑() () () ()PG PLii\ni\nm\njj\nj\nn\n11\nccted loss on losing trade s =−\n=\n=\n=\n∑\n∑\n() ()\n() ()\nPG\nPL\nP\nii\ni\nm\njj\nj\nn\n1\n1\n1\nW WPLR − 1\ntabLe 35.23 probability-W eighted profit/Loss ratio Comparis", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 176}
{"text": "e expected gain to the expected loss on losing trades, where the expected loss on losing trades is \ndefined as: () ()PLjj\nj\nn\n=\n∑\n1\n. This can be demonstrated as follows: \nExpected g ain\nExpected gain\nExpe\n=−\n==\n∑∑() () () ()PG PLii\ni\nm\njj\nj\nn\n11\nccted loss on losing trade s =−\n=\n=\n=\n∑\n∑\n() ()\n() ()\nPG\nPL\nP\nii\ni\nm\njj\nj\nn\n1\n1\n1\nW WPLR − 1\ntabLe 35.23 probability-W eighted profit/Loss ratio Comparisons for “bullish/Nonvolatile” expected \nprobability Distribution\nLong Futures Long Call Short put\nprice range \n($/oz)\naverage \nprice \n($/oz)\nassumed \nprobability\nGain/Loss at \naverage \nprice ($)\nprobability-\nW eighted \nGain/Loss ($)\nGain/Loss \nat average \nprice ($)\nprobability-\nW eighted \nGain/Loss ($)\nGain/Loss \nat average \nprice ($)\nprobability-\nW eighted \nGain/Loss ($)\n1,050–1,099.9 1,075 0.05 –12,500 –625 –3,880 –194 –8,630 –431.5\n1,100–1,149.9 1,125 0.15 –7,500 –1,125 –3,880 –582 –3,630 –544.5\n1,150–1,199.9 1,175 0.2 –2,500 –500 –3,880 –776 1,370 274\n1,200–1,249.9 1,225 0.2 2,500 500 –1,380 –276 3,870 774\n1,250–1,299.9 1,275 0.2 7,500 1,500 3,620 724 3,870 774\n1,300–1,349.9 1,325 0.15 12,500 1,875 8,620 1,293 3,870 580.5\n1,350–1,399.9 1,375 0.05 17,500 875 13,620 681 3,870 193.5\nProbability-weighted profit/loss ratio:4,750/2,250 = 2.11 2,698/1,828 = 1.48 2,596/976 = 2.66\n552\nA Complete Guide to the Futures mArket\ntabLe 35.24 probability-W eighted profit/Loss ratio Comparisons for “bullish/V olatile” expected \nprobability Distribution\nLong Futures Long Call Short put\nprice range \n($/oz)\naverage \nprice \n($/oz)\nassumed \nprobability\nGain/Loss \nat average \nprice ($)\nprobability-\nW eighted \nGain/Loss ($)\nGain/Loss \nat average \nprice ($)\nprobability-\nW eighted \nGain/Loss ($)\nGain/Loss \nat average \nprice ($)\nprobability-\nW eighted \nGain/Loss ($)\n950–999.9 975 0.04 –22,500 –900 –3,880 –155 –18,630 –745.2\n1,000–1,049.9 1,025 0.06 –17,500 –1,050 –3,880 –233 –13,630 –817.8\n1,050–1,099.9 1,075 0.08 –12,500 –1,000 –3,880 –310 –8,630 –690.4\n1,100–1,149.9 1,125 0.1 –7,500 –750 –3,880 –388 –3,630 –363\n1,150–1,199.9 1,175 0.12 –2,500 –300 –3,880 –466 1,370 164.4\n1,200–1,249.9 1,225 0.18 2,500 450 –1,380 –248 3,870 696.6\n1,250–1,299.9 1,275 0.14 7,500 1,050 3,620 507 3,870 541.8\n1,300–1,349.9 1,325 0.12 12,500 1,500 8,620 1,034 3,870 464.4\n1,350–1,399.9 1,375 0.1 17,500 1,750 13,620 1,362 3,870 387\n1,400–1,449.9 1,425 0.06 22,500 1,350 18,620 1,117 3,870 232.2\nProbability-weighted profit/loss ratio:6,100/4,000 = 1.53 4,020/1,800 = 2.23 2,486/2,616 = 0.95\ntabLe 35.25 probability-W eighted profit/Loss ratio Comparisons for “bearish/Nonvolatile” expected \nprobability Distribution\nShort Futures Short Call Long put\nprice range \n($/oz)\naverage \nprice \n($/oz)\nassumed \nprobability\nGain/Loss \nat average \nprice ($)\nprobability-\nW eighted \nGain/Loss ($)\nGain/Loss \nat average \nprice ($)\nprobability-\nW eighted \nGain/Loss ($)\nGain/Loss \nat average \nprice ($)\nprobability-\nW eighted \nGain/Loss ($)\n1,000–1,049.9 1,025 0.05 17,500 875 3,880 194 13,630 681.5\n1,050–1,099.9 1,075 0.15 12,500 1,875 3,880 582 8,630 1,294.5\n1,100–1,149.9 1,125 0.2 7,500 1,500 3,880 776 3,630 726\n1,150–1,199.9 1,175 0.2 2,500 500 3,880 776 –1,370 –274\n1,200–1,249.9 1,225 0.2 –2,500 –500 1,380 276 –3,870 –774\n1,250–1,299.9 1,275 0.15 –7,500 –1,125 –3,620 –543 –3,870 –580.5\n1,300–1,349.9 1,325 0.05 –12,500 –625 –8,620 –431 –3,870 –193.5\nProbability-weighted profit/loss ratio: 4,750/2,250 = 2.11 2,604/974 = 2.67 2,702/1,822 = 1.48\n553\nOPTION TrAdINg STrATegIeS\ntabLe 35.26 probability-W eighted profit/Loss ratio Comparisons for “bearish/V olatile” expected \nprobability Distribution\nShort Futures Short Call Long put\nprice range \n($/oz)\naverage \nprice \n($/oz)\nassumed \nprobability\nGain/Loss \nat average \nprice ($)\nprobability-\nW eighted \nGain/Loss ($)\nGain/Loss \nat average \nprice ($)\nprobability-\nW eighted \nGain/Loss ($)\nGain/Loss \nat \naverage \nprice ($)\nprobability-\nW eighted \nGain/Loss ($)\n950–999.9 975 0.06 22,500 1,350 3,880 233 18,630 1,117.8\n1,000–1,049.9 1,025 0.1 17,500 1,750 3,880 388 13,630 1,363\n1,050–1,099.9 1,075 0.12 12,500 1,500 3,880 466 8,630 1,035.6\n1,100–1,149.9 1,125 0.14 7,500 1,050 3,880 543 3,630 508.2\n1,150–1,199.9 1,175 0.18 2,500 450 3,880 698 –1,370 –246.6\n1,200–1,249.9 1,225 0.12 –2,500 –300 1,380 166 –3,870 –464.4\n1,250–1,299.9 1,275 0.1 –7,500 –750 –3,620 –362 –3,870 –387\n1,300–1,349.9 1,325 0.08 –12,500 –1,000 –8,620 –690 –3,870 –309.6\n1,350–1,399.9 1,375 0.06 –17,500 –1,050 –13,620 –817 –3,870 –232.2\n1,400–1,449.9 1,425 0.04 –22,500 –900 –18,620 –745 –3,870 –154.8\nProbability-weighted profit/loss ratio: 6,100/4,000 = 1.53 2,494/2,614 = 0.95 4,025/1,795 = 2.24\ntabLe 35.27 probability-W eighted profit/Loss ratio Comparisons for “Neutral/Nonvolatile” expected \nprobability Distribution\nLong Straddle Short Straddle\nprice range \n($/oz)\naverage \nprice ($/oz)\nassumed \nprobability\nGain/Loss at \naverage price ($)\nprobability- \nW eighted \nGain/Loss ($)\nGain/Loss at \naverage price ($)\nprobability- \nW eighted \nGain/Loss ($)\n1,000–1,049.9 1,025 0.05 9750 488 –9,750 –488\n1,050–1,099.9 1,075 0.1 4,750 475 –4,750 –475\n1,100–1,149.9 1,125 0.15 –250 –38 250 38\n1,150–1,199.9 1,175 0.2 –5,250 –1,050 5,250 1,050\n1,200–1,249.9 1,225 0.2 –5,250 –1,050 5,250 1,050\n1,250–1,299.9 1,275 0.15 –250 –38 250 38\n1,300–1,349.9 1,325 0.1 4,750 475 –4,750 –475\n1,350–1,399.9 1,375 0.05 9,750 488 –9,750 –488\nProbability-weighted profit/loss ratio: 1,925/2,175 = 0.89 2,175/1,925 = 1.13\n554\nA Complete Guide to the Futures mArket\nhedging applications\nThe entire discussion in this chapter has been approached from the vantage point of the speculator. \nHowever, option-based strategies can also be employed by the hedger. T o illustrate how options can be \nused by the hedger, we compare five basic alternative strategies for the gold jeweler who anticipates a \nrequirement for 100 ounces of gold in August. The assumed date in this illustration is April 13, 2015, \na day on which the relevant price quotes were as follows: spot gold = $1,198.90, August gold futures \n= $1,200,", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 177}
{"text": "ategies can also be employed by the hedger. T o illustrate how options can be \nused by the hedger, we compare five basic alternative strategies for the gold jeweler who anticipates a \nrequirement for 100 ounces of gold in August. The assumed date in this illustration is April 13, 2015, \na day on which the relevant price quotes were as follows: spot gold = $1,198.90, August gold futures \n= $1,200, August $1,200 gold call premium = $38.80, August $1,200 gold put premium = $38.70. \nThe five purchasing alternatives are:\n5\n 1. Wait until time of requirement. In this approach, the jeweler simply waits until August \nbefore purchasing the gold. In effect, the jeweler gambles on the interim price movement of \ngold. If gold prices decline, he will be better off. However, if gold prices rise, his purchase price \nwill increase. If the jeweler has forward-contracted for his products, he may need to lock in his \nraw material purchase costs in order to guarantee a satisfactory profit margin. Consequently, the \nprice risk inherent in this approach may be unacceptable.\ntabLe 35.28 probability-W eighted profit/Loss ratio Comparisons for “Neutral/V olatile” expected \nprobability Distribution\nLong Straddle Short Straddle\nprice range \n($/oz)\naverage \nprice ($/oz)\nassumed \nprobability\nGain/Loss at \naverage price ($)\nprobability- \nW eighted \nGain/Loss ($)\nGain/Loss at \naverage price ($)\nprobability- \nW eighted \nGain/Loss ($)\n950–999.9 975 0.05 14,750 738 –14,750 –738\n1,000–1,049.9 1,025 0.08 9,750 780 –9,750 –780\n1,050–1,099.9 1,075 0.1 4,750 475 –4,750 –475\n1,100–1,149.9 1,125 0.12 –250 –30 250 30\n1,150–1,199.9 1,175 0.15 –5,250 –788 5,250 788\n1,200–1,249.9 1,225 0.15 –5,250 –788 5,250 788\n1,250–1,299.9 1,275 0.12 –250 –30 250 30\n1,300–1,349.9 1,325 0.1 4,750 475 –4,750 –475\n1,350–1,399.9 1,375 0.08 9,750 780 –9,750 –780\n1,400–1,449.9 1,425 0.05 14,750 738 –14,750 –738\nProbability-weighted profit/loss ratio: 3,985/1,635 = 2.44 1,635/3,985 = 0.41\n5 There is no intention to imply that the following list of alternative hedging strategies is all-inclusive. Many other \noption-based strategies are also possible. For example, the jeweler could buy a call and sell a put at the same \nstrike price—a strategy similar to buying a futures contract (see Strategy 15).\n555\nOPTION TrAdINg STrATegIeS\n 2. buy spot gold. The jeweler can buy spot gold and store it until August. In this case, he locks \nin a purchase price of $1,198.90/oz plus carrying costs (interest, storage, and insurance). This \napproach eliminates price risk, but also removes the potential of benefiting from any possible \nprice decline.\n 3. buy gold futures. The jeweler can purchase one contract of August gold futures, thereby \nlocking in a price of $1,200/oz. The higher price of gold futures vis-à-vis spot gold reflects the \nfact that futures embed carrying costs. Insofar as the price spread between futures and spot gold \nwill be closely related to the magnitude of carrying costs, the advantages and disadvantages of \nthis approach will be very similar to those discussed in the above strategy.\n 4. buy an at-the-money call. Instead of purchasing spot gold or gold futures, the jeweler could \ninstead buy an August $1,200 gold futures call at a premium of $38.80/oz. The disadvantage of \nthis approach is that if prices advance the jeweler locks in a higher purchase price: $1,238.80/\noz. However, by purchasing the call, the jeweler retains the potential for a substantially lower \npurchase price in the event of a sharp interim price decline. Thus, if, for example, spot prices \ndeclined to $1,050/oz by the time of the option expiration, the jeweler’s purchase price would \nbe reduced to $1,088.80/oz (the spot gold price plus the option premium).\n6 In effect, the pur-\nchase of the call can be viewed as a form of price risk insurance, with the cost of this insurance \nequal to the “premium.”\n7\n 5. buy an out-of-the-money call. As an example, the jeweler could purchase an August \n$1,300 gold futures call at a premium of $9.10/oz. In this case, the jeweler forgoes protection \nagainst moderate price advances in exchange for reducing the premium costs. Thus, the jeweler \nassures he will have to pay no more than $1,309.10/oz. The cost of this price protection is $910 \nas opposed to the $3,880 premium for the at-the-money call. In a sense, the purchase of the \nout-of-the-money call can be thought of as a price risk insurance policy with a “deductible.” As \nin the case of purchasing an at-the-money call, the jeweler would retain the potential of benefit-\ning from any interim price decline.\nAs should be clear from the above discussion, options meaningfully expand the range of choices \nopen to the hedger. As was the case for speculative applications, the choice of an optimal strategy will \ndepend on the trader’s (hedger’s) individual expectations and preferences. It should be stressed that \nthis section is only intended as an introduction to the concept of using options for hedging. A compre-\nhensive review of hedging strategies would require a far more extensive discussion.\n6 T echnically speaking, since gold futures options expire before the start of the contract month, the effective \npurchase price would be raised by the amount of carrying costs for the remaining weeks until August.\n7 The use of futures for hedging is also often described as “insurance.” However, in this context, the term is \nmisapplied. In standard application, the term insurance implies protection against a catastrophic event for a cost \nthat is small relative to the potential loss that is being insured. In using futures for hedging, the potential cost is \nequivalent to the loss protection. For example, if the jeweler buys gold futures, he will protect himself against \na $10,000 increase in purchase cost if prices increase by $100/oz, but he will also realize a $10,000 loss on \nhis hedge if prices decline by $100/oz. In this sense, the use of the call for hedging comes much closer to the \nstandard concept of", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 178}
{"text": "ures for hedging, the potential cost is \nequivalent to the loss protection. For example, if the jeweler buys gold futures, he will protect himself against \na $10,000 increase in purchase cost if prices increase by $100/oz, but he will also realize a $10,000 loss on \nhis hedge if prices decline by $100/oz. In this sense, the use of the call for hedging comes much closer to the \nstandard concept of insurance: the magnitude of the potential loss being insured is much greater than the cost \nof the insurance.\n\nPractical tradiNg \nguideliNes\nPart VII \n\n559\nCha P ter 36\nIf making money is a slow process, losing it is quickly done.\n—ihara saikaku\ni\nf the amount of money you risk in futures trading represents a minuscule fraction of your net \nworth, and your major motivation for speculation is entertainment, the shoot-from-the-hip ap-\nproach might be fine. However, if your major objective in futures trading is to make money, an \norganized trading plan is essential. \nthis assertion is not just a platitude. search out successful futures \nspeculators, and you will no doubt find that they all use a well-defined, disciplined trading approach.\nthe following seven steps provide general guidelines for constructing an organized trading plan.\n ■ Step 1: Define a Trading Philosophy\nHow do you plan to make your trading decisions? if your answer is something vague like, “When my \nfriend gets a hot tip from his broker,” “When i get a trade idea from reading a blog,” or “On market \nfeel while watching the trading screen,” you’re not ready to begin trading. a meaningful strategy \nwould be based on either chart analysis, technical trading systems, fundamental analysis, or some \ncombination of these approaches. \nthe same method will not necessarily be used in all markets. For \nexample, in some markets a trader might use a synthesis of fundamental and chart analyses to make \ntrading decisions, while in other markets decisions may be based on chart analysis only.\nthe more specific the trading strategy, the better. For example, a trader who plans to base his trades \non chart analysis should be able to specify the types of patterns that would signal trades, as well as other \ndetails, such as confirmation rules. Of course, the most specific trading strategy would be one based on \na mechanical trading system; however, such a fully automated approach may not appeal to all traders.\nthe Planned trading \napproach\n560\nA Complete Guide to the Futures mArket\n ■ Step 2: Choose Markets to Be Traded\nafter deciding how to pick trades, you must choose which markets to follow . For most traders, con-\nstraints on time and available funds will significantly limit the number of markets that can be moni-\ntored and traded. three factors might be considered in selecting markets.\nSuitability to trading approach\ntraders should choose those markets that appear to have the best potential for satisfactory perfor-\nmance, given their planned approach. Of course, such a determination can be made only on the basis \nof either past trading experience or historical testing of a specific trading strategy.\nDiversification\nthe multiple benefits of diversification were fully discussed in chapter 16. However, the essential \npoint here is that diversification provides one of the most effective means of reducing risk. diversi-\nfication can be enhanced by choosing markets that are not closely related. For example, if you knew \nthat you wanted to trade gold, then silver and platinum would be poor choices for additional markets, \nunless your available funds were sufficient to permit you to trade many other markets as well.\nV olatility\na trader with limited funds should avoid extremely volatile markets, since the inclusion of such \nmarkets in a portfolio will severely limit the total number of markets that can be traded. (V olatility \nhere refers to dollar volatility per contract. \nconsequently, high volatility could imply relatively large \nprice swings, large-size contracts, or both.) unless your approach is better suited to a given volatile \nmarket, you will be better off trading a wider variety of less volatile markets (diversification again).\n ■ Step 3: Specify Risk Control Plan1\nthe rigid control of losses is perhaps the most critical prerequisite for successful trading. a risk con-\ntrol plan should include the following elements.\nMaximum risk per trade\ntraders can substantially increase their probability of long-term success by restricting the percent-\nage of total funds allocated to any given trade.2 the maximum risk on any trade should be limited to \n1 risk control is typically referred to as “money management,” although i believe the former represents the more \ndescriptive label.\n2 the implicit assumption here is that the trader’s expected net profit per trade (eNPPt) is positive. if a trader’s \neNPPt is negative, the laws of probability will assure failure if he trades long enough. such a situation would be \nanalogous to the roulette player whose expected gain per bet is negative.\n561\ntHe PlaNNed tradiNg aPPrOacH\n2 percent of total equity and, ideally, 1 percent or less. For smaller accounts, adhering to such a guide-\nline will require restricting trading to less volatile markets, mini contracts, and spreads. speculators \nwho find that they must risk 3 percent or more of their equity on individual trades should seriously \nreconsider their financial suitability for futures trading.\nthe maximum risk per trade can be used to determine the number of contracts that can be initi-\nated in any given trade. For example, if the maximum risk per trade is 1 percent of equity, and the \ntrader’s account size is $200,000, a crude oil trade that required a stop point $1/barrel below the \nmarket would imply a maximum position size of two contracts. (\nthe crude oil contract represents \n1,000 barrels, so each $1 move equates to $1,000 per contract.)\nStop-Loss Strategy\nKnow where you’re going to get out before you get in. the importance of this rule cannot be over-\nemphas", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 179}
{"text": "ity, and the \ntrader’s account size is $200,000, a crude oil trade that required a stop point $1/barrel below the \nmarket would imply a maximum position size of two contracts. (\nthe crude oil contract represents \n1,000 barrels, so each $1 move equates to $1,000 per contract.)\nStop-Loss Strategy\nKnow where you’re going to get out before you get in. the importance of this rule cannot be over-\nemphasized. Without a predetermined exit point, you can find yourself vulnerable to procrastinating \nin the liquidation of a losing position. \nat the wrong time, one such lapse of trading discipline could \nliterally knock you out of the game.\nideally, you should place a good-till-canceled (gtc) stop order when entering a trade. However, \nif you are fairly certain you can trust yourself, a mental stop point can be determined at trade entry, \nand thereafter adjusted only to reduce risk. For a more detailed discussion of stop-order placement \nstrategies, see \nchapter 13.\nit should be noted that a system trader does not necessarily need to employ stop-loss rules in \norder to achieve risk control. For example, if a trading system automatically reverses the position \ngiven a sufficient trend reversal, the system will inherently perform the major function of a stop-loss \nrule—the prevention of catastrophic losses on individual trades—without such a rule being explicit. \nOf course, large cumulative losses can still occur over many trades, but the same vulnerability would \nalso apply if stops were used.\nDiversification\nBecause different markets will experience adverse moves at different times, trading multiple markets \nwill reduce risk. \nas a very simple example, assume you have a $100,000 account and you are using \na system that experiences average drawdowns of $5,000 in both gold and euro futures. if you traded \ntwo contracts of either market, the average drawdown would be equal to 10 percent ($10,000 ÷ \n$100,000), whereas if you traded one contract of each, the average drawdown would invariably be less \n(possibly even less than for one contract of a single market if the markets were inversely correlated). \nin \nfact, the average drawdown could reach 10 percent (assuming average drawdowns remain at $5,000 \nfor each market) only if the drawdowns in the two markets proved to be exactly synchronized, which \nis exceedingly unlikely. Of course, the risk-reduction benefit of diversification would increase if more \nunrelated markets were added to the portfolio. \nalso, as noted in chapter 16, the concept of diversi-\nfication applies not only to trading multiple markets but also multiple systems (or approaches) and \nmultiple system variations (i.e., parameter sets) for each market, assuming equity is sufficient to do so.\n562\nA Complete Guide to the Futures mArket\nalthough our focus in this section is risk control, it should be noted that diversification can also \nincrease return by allowing the trader to increase the average exposure in each market without increas-\ning overall risk. in fact, the addition of markets with a lower average return than other markets in an \nexisting portfolio can actually increase the return of the portfolio if the risk reduction gained by diversifica-\ntion is greater than the decline in return and the trader adjusts exposure accordingly. two other benefits \nof diversification—ensuring participation in major trends and “bad luck insurance”—were discussed in \nchapter 16.\nreduce Leverage for Correlated Markets\nalthough adding markets to a portfolio allows a trader to increase leverage, it is important to make \nadjustments for highly correlated markets. For example, a currency portfolio, consisting of the eight most \nactive currency futures contracts (euro, Japanese yen, British pound, \naustralian dollar, canadian dollar, \nu.s. dollar index, Mexican peso, swiss franc), would be subject to much greater risk than a more broadly \ndiversified eight-market portfolio because of the very strong correlations between some of these markets. \nconsequently, the exposure level (as measured by the margin-to-equity ratio or other risk metric) of such \nan all-currency portfolio should be adjusted downward vis-à-vis a more diversified eight-market portfolio \nwith equivalent individual market volatilities.\nMarket V olatility adjustments\nthe number of contracts traded in each market for any given equity size should be adjusted to account \nfor volatility differences. there are two aspects of this rule. First, fewer contracts would be traded in \nmore volatile markets. second, even for a single market, the number of contracts would vary in con-\njunction with fluctuations in volatility. Of course, since contracts can’t be traded in fractions, traders \nwith small accounts will be unable to make such volatility adjustments, which is one reason why small \naccounts will be subject to greater risk. (Other reasons include the unavoidability of the maximum \nrisk per trade exceeding desired levels and an inability to diversify sufficiently.)\nadjusting Position Size to equity Changes\nPosition size should also be adjusted in accordance with major fluctuations in equity. For example, if \na trader’s position size in the corn market was equal to four contracts when the account equity was at \n$200,000, then a $50,000 decline in the account equity should result in the corn position size being \nreduced to three contracts. (Of course, if equity rose instead, the position size should be increased.)\nLosing Period adjustments (Discretionary traders Only)\nWhen a trader’s confidence is shaken because of an ongoing losing streak, it is often a good idea to \ntemporarily cut back position size or even take a complete trading break until confidence returns. \nin this way, the trader can keep a losing phase from steamrolling into a disastrous retracement. this \nadvice would not apply to a system trader, however, since for most viable systems, a losing period \n563\ntHe PlaNNed tradiNg aPPrOacH\nenhances the potential for favorable performance in", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 180}
{"text": "od idea to \ntemporarily cut back position size or even take a complete trading break until confidence returns. \nin this way, the trader can keep a losing phase from steamrolling into a disastrous retracement. this \nadvice would not apply to a system trader, however, since for most viable systems, a losing period \n563\ntHe PlaNNed tradiNg aPPrOacH\nenhances the potential for favorable performance in the ensuing period. Or to put it another way, \nconfidence and frame of mind are critical to the performance of a discretionary trader but are not \nrelevant to the performance of a system.\n ■ Step 4: Establish a Planning Time Routine\nit is important to set aside some time each evening for reviewing markets and updating trading \nstrategies. in most cases, once the trader has established a specific routine, 30–60 minutes should be \nsufficient (less if only a few markets are being traded). the primary tasks performed during this time \nwould be:\n 1. Update trading systems or review charts. at least one of these should be employed as an \naid in making trading decisions. in those markets in which fundamental analysis is employed, \nthe trader will also have to reevaluate the fundamental picture periodically after the release of \nimportant new information (e.g., government crop report).\n 2. Plan new trades. determine whether any new trades are indicated for the next day, which \ncould be defined as either including or excluding the preceding night session. if new trades are \nindicated, decide on a specific entry plan. (this step applies to discretionary trading only, since \nany systematic approach should include a specific trade entry approach.) in some cases, a trad-\ning decision may be contingent on an evaluation of market behavior on the following day. For \nexample, assume a trader is bearish on corn, and a modestly bullish crop report is received after \nthe close. \nsuch a trader might decide to go short if the market is trading lower on the day at any \npoint within one hour of the close.\n 3. Update exit points for existing positions. the trader should review the stops and objec-\ntives on existing positions to see whether any revisions appear desirable in light of the current \nday’s price action. \nin the case of stops, such changes should be made only to reduce trade risk.\n ■ Step 5: Maintain a Trader’s Spreadsheet\nthe planning routine discussed in the previous section implies some systematic form of record keep-\ning. Figure 36.1 provides one sample of a format that might be used for a trader’s spreadsheet.\nthe first four columns simply identify the trade. column 5 would be used to indicate the intended \nstop point at time of entry. revisions of this stop would be entered in column 6. the reason for main-\ntaining the initial stop point as a separate item is that this information may be useful in any subsequent \ntrade analysis. For example, traders may wish to check whether their initial stops tend to be too wide \nor too close.\ncolumns 7 through 10 provide a summary of the implied risk on open positions. By adding these \nentries for all open positions, a trader can assess current total exposure—information critical in con-\ntrolling risk and determining whether new positions can be initiated. \n564a cOMPlete guide tO tHe Futures MarKet\n the use of objectives (columns 11 and 12) is a matter of individual preference. although in some \ncases the use of objectives will permit a better exit price, in other circumstances objectives will result \nin the premature liquidation of a trade. consequently, some traders may prefer to forgo the use of \nobjectives, allowing the timing of liquidation to be determined by either a trailing stop or a change \nof opinion. \n liquidation information is contained in columns 13 through 15. the reason for maintaining the \nexit date is that it can be used to calculate the duration of the trade, information that may be useful in \ntrade analysis. column 15 would indicate the profi t or loss on the trade after deducting commissions. \n columns 16 and 17 provide room for capsule comments regarding the reasons for entering the \ntrade (made at that time) and a hindsight evaluation of the trade. (Of course, entries for these two \ncolumns would require much greater space than shown in Figure 36.1 .) the observations noted in \nthese two columns can be particularly helpful in detecting any patterns in successes and failures. Fur-\nthermore, a more extensive description of the trade would be contained in a trader’s diary, which is \ndiscussed in the next section. \n the novice will usually benefi t from a period of paper trading before plunging into actual trading. \nthe trader’s spreadsheet is ideally suited to this purpose, since it would not only provide an indication of \npotential trading success, but it would also get the new trader into the habit of approaching speculation \nin a systematic and disciplined fashion. thus, when the transition is made to actual trading, the decision \nprocess will have become routine. Of course, the diffi culty of trading decisions will increase dramati-\ncally once real money is at stake, but at least new traders who have established a routine of maintaining a \ntrader’s spreadsheet will have a decisive advantage over their typically ill-prepared counterparts. \n FIGURE  36.1 sample Page from a trader’s spreadsheet \n(1)\nTrade\nEntry\nDate\nLong\nor\nShort\nEntry\nPrice\nExit\nDate\nExit\nPriceC omment\nReasons\nfor\nEntering\nTrade\nNet\nProfit\nor\nLossUnits Mar ketI nitialC urrent\nStops\nCumulative\nImplied Risk\n(2)( 3) (4)( 5) (6)( 7) (8)( 9) (10) (11) (12) (13) (14) (15) (16) (17)\nInitialC urrent\nAs Percentage\nof Equity\nInitialC urrent\nObjective\nInitialC urrent\n565\ntHe PlaNNed tradiNg aPPrOacH\n ■ Step 6: Maintain a Trader’s Diary\nthe trader’s diary should contain the following basic information for each trade:\n 1. reasons for trade. it is important that the reasons for the trade are entered at the time the trade \nis taken so that this summary provides an accurate description of the o", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 181}
{"text": "rrent\nAs Percentage\nof Equity\nInitialC urrent\nObjective\nInitialC urrent\n565\ntHe PlaNNed tradiNg aPPrOacH\n ■ Step 6: Maintain a Trader’s Diary\nthe trader’s diary should contain the following basic information for each trade:\n 1. reasons for trade. it is important that the reasons for the trade are entered at the time the trade \nis taken so that this summary provides an accurate description of the original trade rationale, \nunbiased by hindsight and trade outcome. Over time, this information can help traders deter-\nmine whether any of their trading strategies are particularly prone to success or failure.\n 2. trade exit comments. trade exit is as important as trade entry. Here, the trader would note \nboth good and bad decisions made in exiting trades. For example, if a close stop was used on the \ntrade, did it result in getting stopped out of a good trade, or did it reduce the loss on what would \nhave been a losing trade even with a wider stop? \nas another example, if a trailing stop was used, \ndid it result in premature exit or did it avoid a larger surrender of open profits? comments in \nthis section can help the trader determine whether the exit strategies employed are benefiting \nor hurting performance.\n 3. Lessons. a trader should itemize the mistakes or correct decisions made in the course of the \ntrade. the mere act of keeping such a written record can greatly help a trader to both rein-\nforce good trading habits and avoid repeating past mistakes—particularly if repeated errors \nare denoted in bold or in capital letters. \nthe trader’s diary should be reviewed periodically to \nhelp reinforce these observations. after a while, the lessons will sink in. speaking from personal \nexperience, this approach can be instrumental in eradicating frequently repeated mistakes.\nit may also be very useful to augment the written diary with charts illustrating trade entry and \nexit points.\n ■ Step 7: Analyze Personal Trading\ntraders must not only analyze the markets, but also their own past trades in order to isolate the \nstrengths and weaknesses of their approach. Besides the trader’s diary, two useful tools in such an \nanalysis are analysis of segmented trades and the equity chart.\nanalysis of Segmented trades\nthe idea behind segmenting trades into different categories is to help identify any patterns of sub-\nstantially above- or below-average performance. For example, a trader who makes decisions based on \nchart patterns could segment trades by the type of chart pattern that signaled the trade. \nthis exercise \ncould potentially reveal that some patterns provide much more reliable signals than others, allowing \nthe trader to make appropriate strategy adjustments.\nas another example, by breaking down trades into buys and sells, a trader might discover a predilec-\ntion toward taking long side trades, even though past short trades have a higher average profit. such a \ncombined observation would obviously imply the desirability of correcting a bias toward the long side.\n566\nA Complete Guide to the Futures mArket\nas a third example, after breaking down performance results by market, a trader might discover \na tendency to consistently lose money in a specific market. such evidence might suggest the trader \ncould improve overall performance by not trading this market. segmenting trading results by market \ncan be an extremely important exercise, since many traders have a poor intuitive sense of their rela-\ntive degree of success in various markets. the cessation of trading in poorer performing markets need \nnot be permanent. the trader could attempt to identify the reasons for the disappointing results in \nthese markets and then research and test possible trading adjustments.\nas a fourth example, a trader who combines day trading and position trading might find it par-\nticularly instructive to compare the net results of each category. My suspicion is that if such analysis \nwere performed by all traders to whom the exercise is relevant, the population of day traders would \nshrink by 50 percent overnight.\nOf course, there are many other criteria that can be used to segment trades. \ntwo other examples \nof relevant comparisons are fundamentally versus technically oriented trades, and trades that were \nin agreement with the position of a given trading system versus those that were not. \nin each case, \nthe trader would be searching for patterns of success or failure. the process of analyzing segmented \ntrades can be greatly simplified by utilizing the previously described trader’s spreadsheet.\nequity Chart\nthe equity chart is a close-only type of chart in which the indicated value for each day represents \nthe account equity (including the equity on open positions). the primary purpose of such a chart is \nto alert the trader when there is a precipitous deterioration of performance. For example, if after an \nextended, steady climb, the account equity experiences a sudden, steep decline, a trader might well \nbe advised to lighten positions and take time to reassess the situation. \nsuch an abrupt shift in per-\nformance might reflect a transformation of market conditions, a current vulnerability in the trader’s \napproach, or a recent predilection toward poor trading decisions. \na determination of the actual cause \nis not essential, since any of these factors could be viewed as strong cautionary signals to reduce risk \nexposure. \nin short, the equity chart can be an important tool in mitigating equity retracements.\ntraders can create equity charts for their accounts, as well as access other performance charts and \nstatistics, cost-free at fundseeder.com.3\n3 For the sake of full disclosure, i have a financial interest in Fundseeder.\n567\nLive long enough and you will eventually be wrong about everything.\n—Russell Baker\nF\new things are easier to ignore than trading advice. Many of the most critical trading rules have \nbeen so widely circulated that they have lost their ability to provoke any thought in the new trader. \nTh", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 182}
{"text": "cost-free at fundseeder.com.3\n3 For the sake of full disclosure, i have a financial interest in Fundseeder.\n567\nLive long enough and you will eventually be wrong about everything.\n—Russell Baker\nF\new things are easier to ignore than trading advice. Many of the most critical trading rules have \nbeen so widely circulated that they have lost their ability to provoke any thought in the new trader. \nThus, valid market insights are often dismissed as obvious clichés.\nConsider the rule “Cut your losses short”—perhaps the single most important trading maxim. \nLives there a speculator who has not heard this advice? Y et there is certainly no shortage of specula-\ntors who have ignored this rule. Not surprisingly, there is also no shortage of speculators whose \naccounts were virtually obliterated by one or two losing trades.\nThe truth is that most speculators will ignore advice until they have “rediscovered the wheel” \nthrough their own trading experience. Moreover, most traders will repeat a mistake many times before \nthe lesson finally sinks in. Thus, I have no illusions that the advice presented in this and the next chapter \nwill spare the reader from committing basic trading errors. However, it is hoped that several readings \nof these chapters (particularly following periods of negative trading results) will at least help some \nnovice traders reduce the number of times these mistakes are repeated—hardly a trivial achievement.\nThe observations in this chapter are based on personal experience. Thus, the following list of rules \nshould be viewed in their proper perspective: empirically based opinions as opposed to proven facts. \nOverall, there will be substantial overlap with other published expositions of trading guidelines. This \nis hardly surprising, since a wide range of rules (many of them mundane) are based on such sound \nSeventy-Five Trading \nRules and Market \nObservations\nChapter 37\n568\nA Complete Guide to the Futures mArket\nprinciples that they are almost universally accepted as trading truths. For example, I have never met \na successful trader who did not believe that risk control was essential to profitable trading. However, \nsome of the rules listed below reflect a subjective view that is contradicted by other writers (e.g., \nusing market orders instead of limit orders). In the final analysis, traders must discover their own \ntrading truths. It is hoped that the following list will help speed the process.\n ■ Entering Trades\n 1. Differentiate between major position trades and short-term trades. Focus on major position \ntrades, since these are usually far more critical to trading success. The average risk allocated \nto short-term trades (as implied by number of contracts in position and stop point) should be \nsignificantly smaller. A mistake made by many traders is that they become so involved in trying \nto catch the minor market swings (generating lots of commissions and slippage in the process) \nthat they miss the major price moves.\n 2. If you believe a major trading opportunity exists, don’t be greedy in trying to get a slightly bet-\nter entry price. The lost profit potential of one missed price move can offset the savings from 50 \nslightly better execution prices.\n 3. Entry into any major position should be planned and carefully thought out—never an intraday \nimpulse.\n 4. Find a chart pattern that says the timing is right—now. Don’t initiate a trade without such a \nconfirming pattern. (Of course, this rule applies only to traders who base their trading decisions \non charts.)\n 5. Place orders determined by daily analysis. If the market is not close to the desired entry level, \neither enter a good-till-canceled (GTC) order at the appropriate price or record the trade idea \nand review it each day until the trade is entered or the trade idea is no longer deemed attractive. \nFailure to adhere to this rule can result in missing good trades. One common occurrence is that \na trade idea is recalled once the market has moved beyond the intended entry, and it is then dif-\nficult to do the same trade at a worse price.\n 6. When looking for a major reversal in a trend, it is usually wiser to wait for some pattern that \nsuggests that the timing is right rather than fading the trend at projected objectives and support/\nresistance points. This rule is particularly important in the case of a market in which the trend \nhas carried prices to long-term highs/lows (e.g., highs/lows beyond a prior 100-day range). \nRemember, in most cases of an extended trend, the market will not form V-type reversals. \nInstead prices will normally pull back to test highs and lows—often a number of times. Thus, \nwaiting for a top or bottom to form can prevent getting chopped to pieces during the topping \nor bottoming process—not to mention the losses that can occur if you are highly premature in \npicking the top or bottom. Even if the market does form a major V top or V bottom, subsequent \nconsolidations (e.g., flags) can allow favorable reward/risk entries.\n 7. If you have an immediate instinctive impression when looking at a chart (particularly, if you are \nnot conscious about which market you are looking at), go with that feeling.\n569\nSEVENTY-FIVE TRADING RuLES AND MARkET OBSERVATIONS\n 8. Don’t let the fact that you missed the first major portion of a new trend keep you from trading \nwith that trend (as long as you can define a reasonable stop-loss point).\n 9. Don’t take positions counter to recent price failure patterns (e.g., a long position after a bull \ntrap or a short position after a bear trap), even if there are many other reasons for the trade.\n 10. Don’t trade counter to the first wide-ranging day (i.e., day with a range far exceeding the recent \naverage range) of a price move. For example, if you are waiting to enter a trade on a correction, \nand the correction then forms on a wide-ranging day, don’t enter the trade.\n 11. In most cases, use market orders rather than limit orders. This rule is especially importa", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 183}
{"text": "r reasons for the trade.\n 10. Don’t trade counter to the first wide-ranging day (i.e., day with a range far exceeding the recent \naverage range) of a price move. For example, if you are waiting to enter a trade on a correction, \nand the correction then forms on a wide-ranging day, don’t enter the trade.\n 11. In most cases, use market orders rather than limit orders. This rule is especially important when \nliquidating a losing position or entering a perceived major trading opportunity—\n situations \nin which traders are apt to be greatly concerned about the market getting away from them. \nAlthough limit orders will provide slightly better fills for a large majority of trades, this benefit \nwill usually be more than offset by the substantially poorer fills, or missed profit potential, in \nthose cases in which the initial limit order is not filled.\n 12. Never double up near the original trade entry point after having been ahead. Often, the fact that \nthe market has completely retraced is a negative sign for the trade. Even if the trade is still good, \ndoubling up in this manner will jeopardize holding power due to overtrading.\n ■ Exiting Trades and Risk Control (Money Management)\n 13. Decide on a specific protective stop point at the time of trade entry.\n 14. Exit any trade as newly developing patterns or market action are contrary to trade—even if stop \npoint has not been reached. Ask yourself, “If I had to have a position in this market, which way \nwould it be?” If the answer is not the position you hold, get out! In fact, if contradictory indica-\ntions are strong enough, reverse the position.\n 15. Always get out immediately once the original premise for a trade is violated.\n 16. If you are dramatically wrong the first day trade is on, abandon trade immediately.\n 17. In the event of a major breakout counter to the position held, either liquidate immediately or \nuse a very close stop.\n 18. If a given market suddenly trades far in excess of its recent volatility in a direction opposite to \nthe position held, liquidate your position immediately. For example, if a market that has been \ntrading in approximate 50-point daily ranges opens 100 to 150 points higher, cover immediately \nif you are short.\n 19. If you sell into resistance or buy into support, and the market then consolidates instead of \nreversing, get out.\n 20. For analysts and market advisors: If your gut feeling is that a recent recommendation or written \nreport is wrong, reverse your opinion.\n 21. If you’re unable to watch markets for a period of time (e.g., when traveling), either liquidate \nall positions or be sure to have GTC stop orders on all open positions. (Also, in such situations, \nlimit orders can be used to ensure getting into the market on planned buys at lower prices or \nplanned sells at higher prices.)\n570\nA Complete Guide to the Futures mArket\n 22. Do not get complacent about an open position. Always know where you are getting out even if \nthe point is far removed from the current price. Also, an evolving pattern contrary to the trade \nmay suggest the desirability of an earlier-than-intended exit.\n 23. Fight the desire to immediately get back into the market following a stopped-out trade. Getting \nback in will usually supplement the original loss with additional losses. The only reason to \nget back in on a stopped out trade is if the timing seems appropriate based on evolving price \npatterns—that is, only if it meets all the conditions and justifications of any new trade.\n ■ Other Risk-Control (Money Management) Rules\n 24. When trading is going badly: (a) reduce position size (keep in mind that positions in strongly \ncorrelated markets are similar to one larger position); (b) use tight stop-loss points; (c) slow up \nin taking new trades.\n 25. When trading is going badly, reduce risk exposure by liquidating losing trades, not winning \ntrades. This observation was memorably related by Edwin Lefèvre in Reminiscences of a Stock \nOperator: “I did precisely the wrong thing. The cotton showed me a loss and I kept it. The wheat \nshowed me a profit and I sold it out. Of all the speculative blunders there are few greater than \ntrying to average a losing game. Always sell what shows you a loss and keep what shows you a \nprofit.”\n 26. Be extremely careful not to change trading patterns after making a profit:\na.\n Do not initiate any trades that would have been deemed too risky at the start of the trading \nprogram.\nb.\n Do not suddenly increase the number of contracts in a typical trade. (However, a gradual \nincrease as equity grows is O\nk.)\n 27. Treat small positions with the same common sense as large positions. Never say, “It’s only one \nor two contracts.”\n 28. Avoid holding very large positions into major reports or the release of important government \nstatistics.\n 29. Apply the same money management principles to spreads as to outright positions. It is easy to \nbe lulled into thinking that spreads move gradually enough so that it is not necessary to worry \nabout stop-loss protection.\n 30. Don’t buy options without planning at what outright price the trade is to be liquidated.\n ■ Holding and Exiting Winning Trades\n 31. Do not take small, quick profits in major position trades. In particular, if you are dramatically \nright on a trade, never, never take profits on the first day.\n 32. Don’t be too hasty to get out of a trade with a wide-ranging day in your direction. The wide-\nranging day, however, can be used to reset stop to closer point.\n571\nSEVENTY-FIVE TRADING RuLES AND MARkET OBSERVATIONS\n 33. Try to use trailing stops, supplemented by developing market action, instead of objectives as a \nmeans of getting out of profitable trades. using objectives will often work against fully realizing \nthe potential of major trends. Remember, you need the occasional big winners to offset losers.\n 34. The preceding rule notwithstanding, it is still useful to set an initial objective at the time \nof trade entry to allow the application of the", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 184}
{"text": "by developing market action, instead of objectives as a \nmeans of getting out of profitable trades. using objectives will often work against fully realizing \nthe potential of major trends. Remember, you need the occasional big winners to offset losers.\n 34. The preceding rule notwithstanding, it is still useful to set an initial objective at the time \nof trade entry to allow the application of the following rule: If a very large portion of an \nobjective is realized very quickly (e.g., 50 to 60 percent in one week or 75 to 80 percent \nin two or three weeks), take partial profits, with the idea of reinstating liquidated contracts \non a reaction. The idea is that it is O\nk to take a quick, sizable profit. Although this rule may \noften result in missing the remainder of the move on the liquidated portion of the position, \nholding the entire position, in such a case, can frequently lead to nervous liquidation on the \nfirst market correction.\n 35. If an objective is reached, but you still like the trade, stay with it using a trailing stop. This rule is \nimportant in order to be able to ride a major trend. Remember, patience is not only important \nin waiting for the right trades, but also in staying with trades that are working. The failure to \nadequately profit from correct trades is a key profit-limiting factor.\n 36. One partial exception to the previous rule is that if you are heavily positioned and equity is surg-\ning straight up, consider taking scale-up profits. Corollary rule: When things look too good to be \ntrue—watch out! If everything is going right, it is probably a good time to begin taking scale-up \n(scale-down) profits and using close trailing stops on a portion of your positions.\n 37. If taking profits on a trade that is believed to still have long-term potential (but is presumably \nvulnerable to a near-term correction), have a game plan for reentering the position. If the mar-\nket doesn’t retrace sufficiently to allow for reentry, be cognizant of patterns that can be used for \ntiming a reentry. Don’t let the fact that the reentry point would be worse than the exit point \nkeep you from getting back into a trade in which the perception of both the long-term trend \nand current timing suggest reentering. The inability to enter at a worse price can often lead to \nmissing major portions of large trends.\n 38. If trading multiple contracts, avoid the emotional trap of wanting to be 100 percent right. For \nexample, if tempted to take profits on a trade that is still acting well, try to keep at least a partial \nposition for the duration of the move—until the market forms a convincing reversal pattern or \nreaches a meaningful stop-loss point.\n ■ Miscellaneous Principles and Rules\n 39. Always pay more attention to market action and evolving patterns than to objectives and \nsupport/resistance areas. The latter can often cause you to reverse a correct market bias very \nprematurely.\n 40. Whenever you feel action should be taken either entering or exiting a position—act, don’t \nprocrastinate.\n 41. Never go counter to your own opinion of the long-term trend of the market. In other words, \ndon’t try to dance between the raindrops.\n572\nA Complete Guide to the Futures mArket\n 42. Winning trades tend to be ahead right from the start. Along the same line of thought, Peter \nBrandt, a successful trader with four decades of experience advises: “Never take a losing trade \nhome on a Friday.”\n 43. Correct timing of entry and exit (e.g., timing entry on a reliable pattern, getting out immedi-\nately on the first sign of trade failure), can often keep a loss small even if the trade is dead wrong.\n 44. Intraday decisions are usually wrong. Most traders would be better off keeping their screens \nturned off during the day and reviewing markets once daily after the close of the main trading \nsession.\n 45. Be sure to check markets before the close on Friday. Often, the situation is clearer at the end of \nthe week. In such cases, a better entry or exit can usually be obtained on Friday near the close \nthan on the following Monday opening. This rule is particularly important if you are holding a \nsignificant position.\n 46. Act on market dreams (that are recalled unambiguously). Such dreams are often right because \nthey represent your subconscious market knowledge attempting to break through the barri-\ners established by the conscious mind (e.g., “How can I buy here when I could have gone long \n$2,000 lower last week?”)\n 47. Y ou are never immune to bad trading habits—the best you can do is to keep them latent. As \nsoon as you get lazy or sloppy, they will return.\n ■ Market Patterns\n 48. If the market sets new historical highs and holds, the odds strongly favor a move very far beyond \nthe old highs. Selling a market at new record highs is probably one the amateur trader’s worst \nmistakes.\n 49. Narrow market consolidations near the upper end of broader trading ranges are bullish pat-\nterns. Similarly, narrow consolidations near the low end of trading ranges are bearish.\n 50. Play the breakout from an extended, narrow range with a stop against the other side of the \nrange.\n 51. Breakouts from trading ranges that hold 1 to 2 weeks, or longer, are among the most reliable \ntechnical indicators of impending trends.\n 52. A common and particularly useful form of the above rule is: Flags or pennants forming right \nabove or below prior extended and broad trading ranges tend to be fairly reliable continuation \npatterns.\n 53. If the market breaks out to a new high or low and then pulls back to form a flag or pennant in \nthe pre-breakout trading range, assume that a top or bottom is in place. A position can be taken \nusing a protective stop beyond the flag or pennant consolidation.\n 54. A breakout from a trading range followed by a pullback deep into the range (e.g., three-quarters \nof the way back into the range or more) is yet another significant bull- or bear-trap formation.\n 55. If an apparent V bottom is followed by a nearb", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 185}
{"text": "t trading range, assume that a top or bottom is in place. A position can be taken \nusing a protective stop beyond the flag or pennant consolidation.\n 54. A breakout from a trading range followed by a pullback deep into the range (e.g., three-quarters \nof the way back into the range or more) is yet another significant bull- or bear-trap formation.\n 55. If an apparent V bottom is followed by a nearby congestion pattern, it may represent a bot-\ntom pattern. However, if this consolidation is then broken on the downside and the V bottom \n573\nSEVENTY-FIVE TRADING RuLES AND MARkET OBSERVATIONS\nis approached, the market action can be read as a sign of an impending move to new lows. In \nthe latter case, short positions could be implemented using protective stops near the top of the \nconsolidation. Analogous comments would apply to V tops followed by nearby consolidations.\n 56. V tops and V bottoms followed by multimonth consolidations that form in close proximity to \nthe reversal point tend to be major top or bottom formations.\n 57. Tight flag and pennant consolidations tend to be reliable continuation patterns and allow entry \ninto an existing trend, with a reasonably close, yet meaningful, stop point.\n 58. If a tight flag or pennant consolidation leads to a breakout in the wrong direction (i.e., a reversal \ninstead of a continuation), expect the move to continue in the direction of the breakout.\n 59. Curved consolidations tend to suggest an accelerated move in the direction of the curve.\n 60. The breaking of a short-term curved consolidation, in the direction opposite of the curve path-\nway, tends to be a good trend-reversal signal.\n 61. A wide-ranging day that closes counter to the main trend can often provide a reliable early signal \nof a trend change—particularly if it also triggers a reversal signal (e.g., complete penetration of \nprior consolidation).\n 62. Near-vertical, large price moves over a period of 2 to 4 days (coming off of a relative high or \nlow) tend to be extended in the following weeks.\n 63. Spikes are good short-term reversal signals. The extreme of the spike can be used as a stop point.\n 64. In spike situations, look at chart both ways—with and without spike. For example, if a flag is \nevident when a spike is removed, a penetration of that flag is a meaningful signal.\n 65. The ability of a market to hold relatively firm when other correlated markets are under signifi-\ncant pressure can be viewed as a sign of intrinsic strength. Similarly, a market acting weak when \ncorrelated markets are strong can be viewed as a bearish sign.\n 66. If a market trades consistently higher for most of the daily trading session, anticipate a close in \nthe same direction.\n 67. Two successive flags with little separation can be viewed as a probable continuation pattern.\n 68. View a curved bottom, followed by a shallower, same-direction curved consolidation near the \ntop of this pattern, as a bullish formation (cup-and-handle). A similar pattern would apply to \nmarket tops.\n 69. A failed signal is more reliable than the original signal. Go the other way, using the high (low) \nbefore the failure signal as a stop. Some examples of such failure patterns are rule numbers 53, \n54, 58, and 60.\n 70. The failure of a market to follow through on significant bullish or bearish news (e.g., a major \nu.S. Department of Agriculture report) is often a harbinger of an imminent trend reversal. Pay \nparticular attention to such a development if you have an existing position.\n ■ Analysis and Review\n 71. Review charts every day—especially if you are too busy.\n 72. Periodically review long-term charts (e.g., every 2 to 4 weeks).\n574\nA Complete Guide to the Futures mArket\n 73. Religiously maintain a trader’s diary, including a chart for each trade taken and noting the fol-\nlowing: reasons for trade; intended stop and objective (if any); follow-up at a later point indi -\ncating how the trade turned out; observations and lessons (mistakes, things done right, or \nnoteworthy patterns); and net profit/loss. It is important that the trade sheet be filled out \nwhen a trade is entered so that the reasons for the trade accurately reflect your actual thinking \nrather than a reconstruction.\n 74. Maintain a patterns chart book whenever you notice a market pattern that is interesting and you \nwant to note how you think it will turn out, or you want to record how that pattern is eventually \nresolved (in the case where you don’t have any bias concerning the correct interpretation). Be \nsure to follow each chart up at a later date to see the actual outcome. Over time, this process \nmay improve skills in chart interpretation by providing some statistical evidence of the forecast-\ning reliability of various chart patterns (as recognized in real time).\n 75. Review and update trading rules, trader’s diary, and patterns chart book on a regular schedule \n(e.g., three-month rotation for the three items). Of course, any of these items can be reviewed \nmore frequently, whenever it is felt such a review would be useful.\n575\nThere is no such thing as being right or beating the market. If you make money, it is because \nyou understood the same thing the market did. If you lose money, it is simply because \nyou got it wrong. There is no other way of looking at it.\n—Musawer Mansoor Ijaz\nT\nhe methods employed by exceptional traders are extraordinarily diverse. Some are pure funda-\nmentalists; others employ only technical analysis; and still others combine the two methodologies. \nSome traders consider two days to be long term, while others consider two months to be short term. \nY et despite the wide gamut of styles, I have found that certain principles hold true for a broad spec-\ntrum of successful traders. This chapter contains a list of 50 observations regarding success in trading \ndrawn from the lessons I learned and insights I developed in the process of interviewing great traders \nover several decades—an endeavor chronicled in four Market Wizards b", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 186}
{"text": "o be short term. \nY et despite the wide gamut of styles, I have found that certain principles hold true for a broad spec-\ntrum of successful traders. This chapter contains a list of 50 observations regarding success in trading \ndrawn from the lessons I learned and insights I developed in the process of interviewing great traders \nover several decades—an endeavor chronicled in four Market Wizards books.\n 1. First things first. First, be sure that you really want to trade. It is common for people who \nthink they want to trade to discover that they really don’t.\n 2. Examine your motives. Think about why you really want to trade. If you want to trade for \nthe excitement, you might be better off riding a roller coaster or taking up hang gliding. If you \nare drawn to trading because you think it is an easy way to make a lot of money, the markets are \nlikely to disabuse you of that assumption.\n50 Market Wizard \nLessons*\nChapt E r 38\n* This chapter is adapted from the following two sources: Jack Schwager, The New Market Wizards (New Y ork, NY: \nHarper Business, 1989), pp. 461–478; © 1989 by Harper Collins Publishers. Used with permission. Jack Schwa-\nger, Hedge Fund Market Wizards (New Y ork, NY: John Wiley & Sons, 2012), pp. 489–499; © 2012 by John Wiley \n& Sons Publishers. Used with permission.\n576\nA Complete Guide to the Futures mArket\n 3. there is no holy grail in trading. Many traders mistakenly believe there is some single \nsolution to defining market behavior. Not only did the methods used by highly successful traders \nI interviewed vary widely, they were sometimes polar opposites of each other.\n 4. Match the trading method to your personality. Trading success is not about finding the \none true method but rather about finding the one method that is right for you. It is critical to \nchoose a method that is consistent with your own personality and comfort level. If you can’t \nstand to give back significant profits, then a long-term trend-following approach—even a very \ngood one—will be a disaster, because you will never be able to follow it. If you don’t want to \nwatch the quote screen all day (or can’t), don’t try a day-trading method. If you can’t stand \nthe emotional strain of making trading decisions, then try to develop a mechanical system for \ntrading the markets. The importance of finding an approach that fits you cannot be overempha-\nsized. Randy McKay, who met success as both an on-the-floor and off-the-floor trader, asserted: \n“Virtually every successful trader I know ultimately ended up with a trading style suited to his \npersonality.”\nIncidentally, the mismatch of trading style and personality is one of the key reasons why pur-\nchased trading systems rarely make profits for those who buy them, even if the system is a good \none. Why? Because every system will have periods of poor performance. And if you are trading \nsomeone else’s system, particularly a “black box” system where you have no idea why signals are \nbeing generated, you will likely abandon it the first time it does poorly.\n 5. It is absolutely necessary to have an edge. Y ou can’t win without an edge, even with the \nworld’s greatest discipline and money management skills. If you could, then it would be possible \nto win at roulette (over the long run) using perfect discipline and risk control. Of course, that \nis an impossible task because of the laws of probability. If you don’t have an edge, all that money \nmanagement and discipline will do for you is to guarantee that you will bleed to death gradually. \nIncidentally, if you don’t know what your edge is, you don’t have one.\n 6. Derive a method. T o have an edge, you must have a method. The type of method is irrelevant. \nSome of the supertraders are pure fundamentalists; some are pure technicians; and some are \nhybrids. Even within each group, there are tremendous variations. For example, within the \ngroup of technicians, there are tape readers (or their modern-day equivalent—screen watch-\ners), chartists, mechanical system traders, Elliott Wave analysts, Gann analysts, and so on. The \ntype of method is not important, but having one is critical—and, of course, the method must \nhave an edge.\n 7. Developing a method is hard work. Shortcuts rarely lead to trading success. Developing \nyour own approach requires research, observation, and thought. Expect the process to take lots \nof time and hard work. Expect many dead ends and multiple failures before you find a successful \ntrading approach that is right for you. Remember that you are playing against tens of thousands \nof professionals. Why should you be any better? If it were that easy, there would be a lot more \nmillionaire traders.\n 8. Skill versus hard work. Is trading success dependent on innate skills, or is hard work suf-\nficient? There is no question in my mind that many of the supertraders have a special talent \nfor trading. Marathon running provides an appropriate analogy. Virtually anyone can run a \n577\n50 Market Wizard Lessons\nmarathon, given sufficient commitment and hard work. Y et, regardless of the effort and desire, \nonly a small fraction of the population will ever be able to run a 2:12 marathon (or 2:25 for \nwomen). Similarly, anyone can learn to play a musical instrument. But again, regardless of work \nand dedication, only a handful of individuals possess the natural talent to become concert solo-\nists. The general rule is that exceptional performance requires both natural talent and hard work \nto realize its potential. If the innate skill is lacking, hard work may provide proficiency, but not \nexcellence.\nIn my opinion, the same principles apply to trading. Virtually anyone can become a net prof-\nitable trader, but only a few have the inborn talent to become supertraders. For this reason, it \nmay be possible to teach trading success, but only up to a point. Be realistic in your goals.\n 9. Good trading should be effortless. Wait a minute. Didn’t I just list hard work as an \ningredient to successful tra", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 187}
{"text": "my opinion, the same principles apply to trading. Virtually anyone can become a net prof-\nitable trader, but only a few have the inborn talent to become supertraders. For this reason, it \nmay be possible to teach trading success, but only up to a point. Be realistic in your goals.\n 9. Good trading should be effortless. Wait a minute. Didn’t I just list hard work as an \ningredient to successful trading? How can good trading require hard work and yet be effortless?\nThere is no contradiction. Hard work refers to the preparatory process—the research and \nobservation necessary to become a good trader—not to the trading itself. In this respect, hard \nwork is associated with such qualities as vision, creativity, persistence, drive, desire, and com-\nmitment. Hard work certainly does not mean that the process of trading itself should be filled \nwith exertion. It certainly does not imply struggling with or fighting against the markets. On the \ncontrary, the more effortless and natural the trading process, the better the chances for success. \nOne trader quoting Zen and the Art of Archery made the following analogy: “In trading, just as in \narchery, whenever there is effort, force, straining, struggling, or trying, it’s wrong. Y ou’re out of \nsync; you’re out of harmony with the market. The perfect trade is one that requires no effort.”\nVisualize a world-class distance runner, clicking off mile after mile at a five-minute pace. \nNow picture an out-of-shape, 250-pound couch potato trying to run a mile at a 10-minute pace. \nThe professional runner glides along gracefully—almost effortlessly—despite the long distance \nand fast pace. The out-of-shape runner, however, is likely to struggle, huffing and puffing like a \nYugo going up a 1 percent grade. Who is putting in more work and effort? Who is more success-\nful? Of course, the world-class runner puts in his hard working during training, and this prior \neffort and commitment are essential to his success.\n 10. trade within your comfort zone. If a position is too large you will be prone to exit good \ntrades on inconsequential corrections because fear will dominate the decision process.\n 11. Money management and risk control. Almost all the great traders I interviewed felt that \nmoney management was even more important than the trading method. Many potentially suc-\ncessful systems or trading approaches have led to disaster because the trader applying the strat-\negy lacked a method of controlling risk. Y ou don’t have to be a mathematician or an expert \nin portfolio theory to manage risk. Risk control can be as easy as the following four-step \napproach: \n1.\n Never risk more than 1 to 2 percent of your capital on any trade. (Risking less than 1 percent \nper trade is even better if this restriction can be met while still being consistent with your \nmethodology.)\n2.\n Predetermine your exit point before you get into a trade. Many of the traders I interviewed \ncited exactly this rule.\n578\nA Complete Guide to the Futures mArket\n3. Start with a deliberately small trading stake that you can afford to lose without it causing \nany significant financial or emotional impact. If this equity is lost, stop trading. Once you \nfeel confident and ready to start trading again, begin with another small stake. By rigorously \nlimiting the worst case in this manner, you will never be knocked out of the game because \nof one disastrous trading experience, as happens to so many novice traders.\n4.\n If you are in an equity drawdown and feel you are out of sync with the markets or your trad-\ning confidence is shaky, take a breather, analyze what went wrong, and wait until you feel \nconfident and have a high-probability idea before you begin trading again. For traders with \nlarge accounts, trading very small is a reasonable alternative to a complete trading hiatus. \nThe strategy of cutting trading size down sharply during losing streaks is one mentioned by \nmany of the traders I interviewed.\n 12. the trading plan. Trying to win in the markets without a trading plan is like trying to build \na house without blueprints—costly (and avoidable) mistakes are virtually inevitable. A trading \nplan simply requires combining a personal trading method with specific money management \nand trade entry rules. Robert Krausz, a hypnotist who made a specialty of working with traders, \nconsidered the absence of a trading plan the root of all the principal difficulties traders encoun-\nter in the markets. Richard Driehaus, a very successful mutual fund manager I interviewed, \nstresses that a trading plan should reflect a personal core philosophy. He explains that without \na core philosophy, you are not going to be able to hold on to your positions or stick with your \ntrading plan during really difficult times.\n 13. Don’t confuse the concepts of winning and losing trades with good and bad \ntrades. A good trade can lose money, and a bad trade can make money. Even the best trading \nprocess will lose a certain percentage of the time. There is no way of knowing a priori which \nindividual trade will make money. As long as a trade adheres to a process with a positive edge, \nit is a good trade, regardless of whether it wins or loses, because if similar trades are repeated \nmultiple times, they will come out ahead. Conversely, a trade that is taken as a gamble is a bad \ntrade, regardless of whether it wins or loses, because over time such trades will lose money.\n 14. Discipline. Discipline was probably the most frequent word used by the exceptional traders \nthat I interviewed. Often, it was mentioned in an almost apologetic tone: “I know you’ve heard \nthis a million times before, but believe me, it’s really important.”\nThere are two basic reasons why discipline is critical. First, it is a prerequisite for maintain-\ning effective risk control. Second, you need discipline to apply your method without second-\nguessing and choosing which trades to take. I guarantee that you will almost always pick the \nwrong ones. Why?", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 188}
{"text": "tone: “I know you’ve heard \nthis a million times before, but believe me, it’s really important.”\nThere are two basic reasons why discipline is critical. First, it is a prerequisite for maintain-\ning effective risk control. Second, you need discipline to apply your method without second-\nguessing and choosing which trades to take. I guarantee that you will almost always pick the \nwrong ones. Why? Because you will tend to pick the comfortable trades, and as Bill Eckhardt, \na mathematician turned successful commodity trading advisor (CTA), explained, “What feels \ngood is often the wrong thing to do.”\n 15. Understand that you are responsible. Whether you win or lose, you are responsible for \nyour own results. Even if you lost on your broker’s tip, an advisory service recommendation, or \na bad signal from the system you bought, you are responsible because you made the decision to \nlisten and act. I have never met a successful trader who blamed others for his losses.\n579\n50 Market Wizard Lessons\n 16. the need for independence. Y ou need to do your own thinking. Don’t get caught up in mass \nhysteria. Ed Seykota, a futures trader who multiplied the equity in his accounts a thousandfold \nover an 18-year period, pointed out that by the time a story is making the cover of national \nperiodicals, the trend is probably near an end.\nIndependence also means making your own trading decisions. Never listen to other opin-\nions. Even if it occasionally helps on a trade or two, listening to others invariably seems to end \nup costing you money—not to mention confusing your own market view . As Michael Marcus, \na spectacularly successful futures trader, stated in Market Wizards, “Y ou need to follow your own \nlight. If you combine two traders, you will get the worst of each.”\nA related personal anecdote concerns another trader I interviewed in Market Wizards. \nAlthough he could trade better than I if he were blindfolded and placed in a trunk at the bottom \nof a pool, he still was interested in my view of the markets. One day he called and asked, “What \ndo you think of the yen?”\nThe yen was one of the few markets about which I had a strong opinion at the time. It had \nformed a particular chart pattern that made me very bearish. “I think the yen is going straight \ndown, and I’m short,” I replied.\nHe proceeded to give me 51 reasons why the yen was oversold and due for a rally. After he \nhung up, I thought: “I’m leaving on a business trip tomorrow . My trading has not been going \nvery well during the last few weeks. The short yen trade is one of the only positions in my ac-\ncount. Do I really want to fade one of the world’s best traders given these considerations?” I \ndecided to close out the trade.\nBy the time I returned from my trip several days later, the yen had fallen 150 points. As luck \nwould have it, that afternoon the same trader called. When the conversation rolled around to \nthe yen, I couldn’t resist asking, “By the way, are you still long the yen?”\n“Oh no,” he replied, “I’m short.”\nThe point is not that this trader was trying to mislead me. On the contrary, he firmly \nbelieved each market opinion at the time he expressed it. However, he was a very short-\nterm trader and his timing was good enough so that he probably made money on both sides \nof the trade. In contrast, I ended up with nothing, even though I had the original move \npegged exactly right. The moral is that even advice from a much better trader can lead to \ndetrimental results.\n 17. Confidence. An unwavering confidence in their ability to continue to win in the markets, was \na nearly universal characteristic among the traders I interviewed. Dr. Van Tharp, a psychologist \nwho has done a great deal of research on traders and was interviewed in Market Wizards, claims \nthat one of the basic traits of winning traders is that they believe “they’ve won the game before \nthey start.”\nThe trader who has confidence will have the courage to make the right decisions and the \nstrength not to panic. There is a passage in Mark Twain’s Life on the Mississippi that I find remark-\nably apropos, even though it has nothing to do with trading. In it, the protagonist—an appren-\ntice steamboat river pilot—is tricked by his mentor and the crew into panicking in a stretch of \n580\nA Complete Guide to the Futures mArket\nriver he knows to be the easiest in the entire run. The following exchange then ensues with his \nmentor:\n“Didn’t you know there was no bottom in that crossing?”\n“Y es sir, I did.”\n“V ery well then, you shouldn’t have allowed me or anybody else to shake your confi-\ndence in that knowledge. Try to remember that. And another thing, when you get into \na dangerous place, don’t turn coward. That isn’t going to help matters any.”\n 18. Losing is part of the game. The great traders fully realize that losing is an intrinsic element \nin the game of trading. This attitude seems linked to confidence. Because exceptional traders are \nconfident that they will win over the long run, individual losing trades no longer seem horrible; \nthey simply appear inevitable—which is what they are. As Linda Raschke, a futures trader with a \nhigh ratio of winning to losing trades, explained, “It never bothered me to lose because I always \nknew I would make it right back.”\nThere is no more certain recipe for losing than having a fear of losing. If you can’t stand tak-\ning losses, you will either end up taking large losses or missing great trading opportunities—ei-\nther flaw is sufficient to sink any chance for success.\n 19. Lack of confidence and time-outs. Trade only when you feel confident and optimistic. I \nhave often heard traders say: “I just can’t seem to do anything right.” Or “I bet I get stopped out \nright near the low again.” If you find yourself thinking in such negative terms, it is a sure sign \nthat it is time to take a break from trading. Get back into trading slowly. Think of trading as a \ncold ocean. T est the water before plunging in.\n 20. the urge to seek advice.", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 189}
{"text": "nt and optimistic. I \nhave often heard traders say: “I just can’t seem to do anything right.” Or “I bet I get stopped out \nright near the low again.” If you find yourself thinking in such negative terms, it is a sure sign \nthat it is time to take a break from trading. Get back into trading slowly. Think of trading as a \ncold ocean. T est the water before plunging in.\n 20. the urge to seek advice. The urge to seek advice betrays a lack of confidence. As Linda \nRaschke said, “If you ever find yourself tempted to seek out someone else’s opinion on a trade, \nthat’s usually a sure sign that you should get out of your position.”\n 21. the virtue of patience. Waiting for the right opportunity increases the probability of suc-\ncess. Y ou don’t always have to be in the market. As Edwin Lefèvre put it in his classic Reminis-\ncences of a Stock Operator, “There is the plain fool who does the wrong thing at all times anywhere, \nbut there is the Wall Street fool who thinks he must trade all the time.”\nOne of the more colorful descriptions of patience in trading was offered by well-known \ninvestor Jim Rogers in Market Wizards: “I just wait until there is money lying in the corner, and \nall I have to do is go over there and pick it up.” In other words, until he is so sure of a trade that \nit seems as easy as picking money off the floor, he does nothing.\nMark W einstein, who was interviewed in Market Wizards, provided the following apt analogy: \n“Although the cheetah is the fastest animal in the world and can catch any animal on the plains, it \nwill wait until it is absolutely sure it can catch its prey. It may hide in the bush for a week, waiting \nfor just the right moment. It will wait for a baby antelope, and not just any baby antelope, but \npreferably one that is also sick or lame. Only then, when there is no chance it can lose its prey, \ndoes it attack. That, to me, is the epitome of professional trading.”\n 22. the importance of sitting. Patience is important not only in waiting for the right trades, but \nalso in staying with trades that are working. The failure to adequately profit from correct trades \nis a key profit-limiting factor. Quoting again from Lefèvre in Reminiscences, “It never was my \n581\n50 Market Wizard Lessons\nthinking that made big money for me. It was always my sitting. Got that? My sitting tight!” Bill \nEckhardt offered a particularly memorable comment on this subject: “One common adage . . . \nthat is completely wrongheaded is: Y ou can’t go broke taking profits. That’s precisely how many \ntraders do go broke. While amateurs go broke by taking large losses, professionals go broke by \ntaking small profits.”\n 23. Developing a low-risk idea. One of the exercises Dr. Van Tharp uses in his seminars is \nhaving the participants take the time to write down their ideas on low-risk trades. The merit \nof a low-risk idea is that it combines two essential elements: patience (because only a small \nportion of ideas will qualify) and risk control (inherent in the definition). Taking the time to \nthink through low-risk strategies is a useful exercise for all traders. The specific ideas will vary \ngreatly from trader to trader, depending on the markets traded and methodologies used. At the \nseminar I attended, the participants came up with a long list of descriptions of low-risk ideas. As \none example: a trade in which the market movement required to provide convincing proof that \nyou are wrong is small. Although it had nothing to do with trading, my personal favorite of the \nlow-risk ideas mentioned was: “Open a doughnut shop next door to a police station.”\n 24. the importance of varying bet size. All traders who win consistently over the long run \nhave an edge. However, that edge may vary significantly from trade to trade. It can be mathemat-\nically demonstrated that in any wager game with varying probabilities, winnings are maximized \nby adjusting the bet size in accordance with the perceived chance for a successful outcome. \nOptimal blackjack betting strategy provides a perfect illustration of this concept.\nIf the trader has some idea as to which trades have a greater edge—say, for example, based \non a higher confidence level (assuming that it is a reliable indicator)—then it makes sense to be \nmore aggressive in these situations. As Stanley Druckenmiller, one of the most consistently prof-\nitable hedge fund managers ever, expressed it, “The way to build [superior] long-term returns \nis through preservation of capital and home runs. . . . When you have tremendous conviction \non a trade, you have to go for the jugular. It takes courage to be a pig.” For a number of Market \nWizards, keen judgment as to when to really step on the accelerator and the courage to do so \nhave been instrumental to their achieving exceptional (as opposed to merely good) returns.\nSome of the traders I interviewed mentioned that they varied their trading size in accordance \nwith how they were doing. For example, McKay indicated that it was not uncommon for him \nto vary his position size by as much as a factor of one hundred to one. He finds this approach \nhelps him reduce risk during losing periods while enhancing profits during the winning periods.\n 25. Scaling in and out of trades. Y ou don’t have to get in or out of a position all at once. Scaling \nin and out of positions provides the flexibility of fine-tuning trades and broadens the set of alter-\nnative choices. Most traders sacrifice this flexibility without a second thought because of the \ninnate human desire to be completely right. (By definition, a scaling approach means that some \nportions of a trade will be entered or exited at worse prices than other portions.) Some traders \nalso noted that scaling out enabled them to stay with at least a portion of long-term winning \ntrades much longer than would otherwise have been the case.\n 26. trading around a position can be beneficial. Most traders tend to view trading as a \ntwo-step process: a decision when to enter and", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 190}
{"text": "that some \nportions of a trade will be entered or exited at worse prices than other portions.) Some traders \nalso noted that scaling out enabled them to stay with at least a portion of long-term winning \ntrades much longer than would otherwise have been the case.\n 26. trading around a position can be beneficial. Most traders tend to view trading as a \ntwo-step process: a decision when to enter and a decision when to exit. It may be better to \n582\nA Complete Guide to the Futures mArket\nview trading as a dynamic rather than static process between entry and exit points. The basic \nidea is that as a trade moves in the intended direction, the position exposure would be gradually \nreduced. The larger the move and the closer the market gets to a target objective, the more the \nposition would be decreased. After reducing exposure in this manner, the position would be \nreinstated on a market correction. Any time the market retraced to a correction reentry point, \na net profit would be generated that otherwise would not have been realized. The choppier the \nmarket, the more excess profits trading around the position will generate. Even a trade in which \nthe market fails to move in the intended direction, on balance, could still be net profitable as a \nresult of gains generated by lightening the total position on favorable trend moves and reinstat-\ning liquidated portions of the position on corrections. This strategy will also reduce the chances \nof being knocked out of a favorable position on a market correction, because if the position has \nalready been reduced, the correction will have less impact and may even be desired to rein-\nstate the liquidated portion of the position. The only time this strategy will have a net adverse \nimpact is if the market keeps going in the intended direction without ever retracing to correc-\ntion reentry levels. This negative outcome, however, simply means that the original trade was \nprofitable, but the total profits are smaller than they would have been otherwise. In a nutshell, \ntrading around a position will generate extra profits and increase the chances of staying with a \ngood trade the at expense of sometimes giving up a portion of profits when the market moves \nsmoothly in the intended direction.\n 27. Being right is more important than being a genius. I think one reason why so many \npeople try to pick tops and bottoms is that they want to prove to the world how smart they are. \nThink about winning rather than being a hero. Forget trying to judge trading success by how \nclose you can come to picking major tops and bottoms, but rather by how well you can pick \nindividual trades with favorable return/risk characteristics. Go for consistency on a trade-to-\ntrade basis, not perfect trades.\n 28. Don’t worry about looking stupid. Last week, you told everyone at the office, “My analy-\nsis has just given me a great buy signal in the S&P . \n The market is going to a new high.” Now \nas you examine the market action since then, something appears to be wrong. Instead of rally -\ning, the market is breaking down. Y our gut tells you that the market is vulnerable. Whether you \nrealize it or not, your announced prognostications are going to color your objectivity. Why? \nBecause you don’t want to look stupid after telling the world that the market was going to a \nnew high. Consequently, you are likely to view the market’s action in the most favorable light \npossible. “The market isn’t breaking down, it’s just a pullback to knock out the weak longs.” As \na result of this type of rationalization, you end up holding a losing position far too long. There \nis an easy solution to this problem: Don’t talk about your position.\nWhat if your job requires talking about your market opinions (as mine once did)? Here the \nrule is: Whenever you start worrying about contradicting your previous opinion, view that \nconcern as reinforcement to reverse your market stance. As a personal example, in early 1991, \nI came to the conclusion that the dollar had formed a major bottom. I specifically remember \none talk in which an audience member asked me about my outlook for currencies. I responded \nby boldly predicting that the dollar would head higher for years. Several months later, when the \n583\n50 Market Wizard Lessons\ndollar surrendered the entire gain it had realized following the news of the August 1991 Soviet \ncoup before the coup’s failure was confirmed, I sensed that something was wrong. I recalled my \nmany predictions over the preceding months in which I had stated that the dollar would go up \nfor years. The discomfort and embarrassment I felt about these previous forecasts told me it was \ntime to change my opinion.\nIn my earlier years in the business, I invariably tried to rationalize my original market opin-\nion in such situations. I was burned enough times so that I eventually learned a lesson. In the \npreceding example, the abandonment of my original projection was fortunate because the dol-\nlar collapsed in the ensuing months.\n 29. Sometimes action is more important than prudence. Waiting for a price correction to \nenter the market may sound prudent, but it is often the wrong thing to do. When your analysis, \nmethodology, or gut tells you to get into a trade at the market instead of waiting for a correction—\ndo so. Caution against the influence of knowing that you could have gotten in at a better price in \nrecent sessions, particularly in those situations when the market witnesses a sudden, large move \n(often due to an important surprise news item). These types of trades often work because they \nare so hard to do.\n 30. Catching part of the move is just fine. Just because you missed the first major portion \nof a new trend, don’t let that keep you from trading with that trend (as long as you can define \na reasonable stop-loss point). McKay commented that the easiest part of a trend is the middle \nportion, which implies always missing part of the trend prior to entry.\n 31. Don’t try to be", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 191}
{"text": "are so hard to do.\n 30. Catching part of the move is just fine. Just because you missed the first major portion \nof a new trend, don’t let that keep you from trading with that trend (as long as you can define \na reasonable stop-loss point). McKay commented that the easiest part of a trend is the middle \nportion, which implies always missing part of the trend prior to entry.\n 31. Don’t try to be 100 percent right. Almost every trader has had the experience of the mar-\nket moving against the position sufficiently to raise significant concern regarding the potential \nadditional loss, while still believing the position is correct. Staying in the trade risks an uncom-\nfortably large loss, but liquidating the trade risks abandoning a good position at nearly the worst \npossible point. In such circumstances, instead of making an all-or-nothing decision, traders can \nchoose to liquidate part of the position. Taking a partial loss is much easier than liquidating the \nentire position and will avoid the possibility of riding the entire position for a large loss. It will \nalso preserve the potential for a partial recovery if the market turns around.\n 32. Maximize gains, not the number of wins. Eckhardt explains that human nature does not \noperate to maximize gain but rather the chance of a gain. The problem with this is that it implies \na lack of focus on the magnitudes of gains (and losses)—a flaw that leads to nonoptimal per-\nformance results. Eckhardt bluntly concludes: “The success rate of trades is the least important \nperformance statistic and may even be inversely related to performance.” Jeff\n Yass, a very suc-\ncessful options trader, echoes a similar theme: “The basic concept that applies to both poker and \noption trading is that the primary object is not winning the most hands, but rather maximizing \nyour gains.”\n 33. Learn to be disloyal. Loyalty may be a virtue in family, friends, and pets, but it is a fatal flaw \nfor a trader. Never have loyalty to a position. The novice trader will have lots of loyalty to his \noriginal position. He will ignore signs that he is on the wrong side of the market, riding his \ntrade into a large loss while hoping for the best. The more experienced trader, having learned \nthe importance of money management, will exit quickly once it is apparent he has made a bad \n584\nA Complete Guide to the Futures mArket\ntrade. However, the truly skilled trader will be able to do a 180-degree turn, reversing his posi-\ntion at a loss if market behavior points to such a course of action. Druckenmiller made the awful \nerror of reversing his stock position from short to long on the very day before the October 19, \n1987, crash. His ability to quickly recognize his error and, more important, to unhesitatingly \nact on that realization by reversing back to short at a large loss helped transform a potentially \ndisastrous month into a net profitable one.\n 34. pull out partial profits. Pull a portion of winnings out of the market to prevent trading \ndiscipline from deteriorating into complacency. It is far too easy to rationalize overtrading and \nprocrastination in liquidating losing trades by saying, “It’s only profits.” Profits withdrawn from \nan account are much more likely to be viewed as real money.\n 35. hope is a four-letter word. Hope is a dirty word for a trader, not only in regards to pro-\ncrastinating in a losing position, hoping the market will come back, but also in terms of hoping \nfor a reaction that will allow for a better entry in a missed trade. If such trades are good, the \nhoped-for reaction will not materialize until it is too late. Often, the only way to enter such \ntrades is to do so as soon as a reasonable stop-loss point can be identified.\n 36. Don’t do the comfortable thing. Eckhardt offers the rather provocative proposition that \nthe human tendency to select comfortable choices will lead most people to experience worse \nthan random results. In effect, he is saying that natural human traits lead to such poor trad-\ning decisions that most people would be better off flipping coins or throwing darts. Some of \nthe examples Eckhardt cites of the comfortable choices people tend to make that run counter \nto sound trading principles include gambling with losses, locking in sure winners, selling on \nstrength and buying on weakness, and designing (or buying) trading systems that have been \noverfitted to past price behavior. The implied message to the trader is: do what is right, not what \nfeels comfortable.\n 37. Y ou can’t win if you have to win. There is an old Wall Street adage: “Scared money never \nwins.” The reason is quite simple: If you are risking money you can’t afford to lose, all the emo-\ntional pitfalls of trading will be magnified. Early in his career, when the bankruptcy of a key \nfinancial backer threatened the survival of his fledgling investment firm, Druckenmiller “bet the \nranch” on one trade, in a last-ditch effort to save his firm. Even though he came within one week \nof picking the absolute bottom in the T -bill market, he still lost all his money. The need to win \nfosters trading errors (e.g., excessive leverage and a lack of planning in the example just cited). \nThe market seldom tolerates the carelessness associated with trades born of desperation.\n 38. the road to success is paved with mistakes. Learning from mistakes is essential to \nimprovement and ultimate success. Each mistake, if recognized and acted on, provides an oppor-\ntunity for improving a trading approach. Most traders would benefit by writing down each mis-\ntake, the important lesson, and the intended change in the trading process. Such a trading log can \nbe periodically reviewed for reinforcement. Trading mistakes cannot be avoided, but repeating \nthe same mistakes can be, and doing so is often the difference between success and failure.\n 39. think twice when the market lets you off the hook easily. Don’t be too eager to get out \nof a position you have been worried about if the mar", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 192}
{"text": "he intended change in the trading process. Such a trading log can \nbe periodically reviewed for reinforcement. Trading mistakes cannot be avoided, but repeating \nthe same mistakes can be, and doing so is often the difference between success and failure.\n 39. think twice when the market lets you off the hook easily. Don’t be too eager to get out \nof a position you have been worried about if the market allows you to exit at a much better price \nthan anticipated. If you had been worried about an adverse overnight (or over-the-weekend) \n585\n50 Market Wizard Lessons\nprice move because of a news event or a technical price failure on the previous close, it is likely \nthat many other traders shared this concern. The fact that the market does not follow through \nmuch on these fears strongly suggests that there must be some very powerful underlying forces \nin favor of the direction of the original position. This concept, which was first proposed in Mar-\nket Wizards by Marty Schwartz, who compiled an astounding track record trading stock index \nfutures, was illustrated by the manner in which Lipschutz, a large-scale currency trader, exited \nthe one trade he admitted had scared him. In that instance, on Friday afternoon, a time when the \ncurrency markets are particularly thin (after Europe’s close), Lipschutz found himself with an \nenormous short dollar position in the midst of a strongly rallying market. He had to wait over \nthe weekend for the T okyo opening on Sunday evening to find sufficient liquidity to exit his posi-\ntion. When the dollar opened weaker than expected in T okyo, he didn’t just dump his position \nin relief; rather, his trader’s instincts told him to delay liquidation—a decision that resulted in a \nfar better exit price.\n 40. a mind is a terrible thing to close. Open-mindedness seems to be a common trait among \nthose who excel at trading. For example, Gil Blake, a mutual fund timer who has made incred-\nibly consistent profits, actually fell into a trading career by attempting to demonstrate to a \ncolleague that prices were random. When he realized he was wrong, he became a trader. In the \nwords of Driehaus, “The mind is like a parachute—it’s only good when it’s open.”\n 41. the markets are an expensive place to look for excitement. Excitement has a lot to \ndo with the image of trading, but nothing to do with success in trading (except in an inverse \nsense). In Market Wizards, Larry Hite, the founder of Mint Management, one of the largest CTA \nfirms, described his conversation with a friend who couldn’t understand his absolute adherence \nto a computerized trading system. His friend asked, “Larry, how can you trade the way you do? \nIsn’t it boring?” Larry replied, “I don’t trade for excitement; I trade to win.”\n 42. Beware of trades born of euphoria. Take caution against placing impulsive trades influ-\nenced by being caught up in market hysteria. Excessive euphoria in the market should be seen \nas a cautionary flag of a potential impending reversal.\n 43. If you are on the right side of euphoria or panic, lighten up. Parabolic price moves \ntend to end abruptly and sharply. If you are fortunate enough to be on the right side of the mar-\nket in which the price move turns near vertical, consider scaling out of the position while the \ntrend is still moving in your direction. If you would be petrified to be on the other side of the \nmarket, that is probably a good sign that you should be lightening your position.\n 44. the calm state of a trader. If there is an emotional state associated with successful trading, \nit is the antithesis of excitement. Based on his observations, Charles Faulkner, a neuro-linguistic \nprogramming (NLP) practitioner who works with traders, stated that exceptional traders are \nable to remain calm and detached regardless of what the markets are doing. He describes Peter \nSteidlmayer’s (a successful futures trader who is best known as the inventor of the Market Pro-\nfile trading technique) response to a position that is going against him as being typified by the \nthought, “Hmmm, look at that.”\n 45. Identify and eliminate stress. Stress in trading is a sign that something is wrong. If you feel \nstress, think about the cause, and then act to eliminate the problem. For example, let’s say you \n586\nA Complete Guide to the Futures mArket\ndetermine that the greatest source of stress is indecision in getting out of a losing position. One \nway to solve this problem is simply to enter a protective stop order every time you put in a \nposition.\nI will give you a personal example. When I was a research director, one of the elements of my \njob was providing trading recommendations to brokers in my company. This task is very similar \nto trading, and, having done both, I believe it’s actually more difficult than trading. At one point, \nafter years of net profitable recommendations, I hit a bad streak. I just couldn’t do anything \nright. When I was right about the direction of the market, my buy recommendation was just a \nbit too low (or my sell price too high). When I got in and the direction was right, I got stopped \nout—frequently within a few ticks of the extreme of the reaction.\nI responded by developing a range of computerized trading programs and technical indica-\ntors, thereby widely diversifying the trading advice I provided to the firm. I still made my day-\nto-day subjective calls on the market, but everything was no longer riding on the accuracy of \nthese recommendations. By widely diversifying the trading-related advice and information, and \ntransferring much of this load to mechanical approaches, I was able to greatly diminish a source \nof personal stress—and improve the quality of the research product in the process.\n 46. pay attention to intuition. As I see it, intuition is simply experience that resides in the \nsubconscious mind. The objectivity of the market analysis done by the conscious mind can be \ncompromised by all sorts of extraneous considerations (e.g., one’", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 193}
{"text": "hanical approaches, I was able to greatly diminish a source \nof personal stress—and improve the quality of the research product in the process.\n 46. pay attention to intuition. As I see it, intuition is simply experience that resides in the \nsubconscious mind. The objectivity of the market analysis done by the conscious mind can be \ncompromised by all sorts of extraneous considerations (e.g., one’s current market position, a \nresistance to change a previous forecast). The subconscious, however, is not inhibited by such \nconstraints. Unfortunately, we can’t readily tap into our subconscious thoughts. However, when \nthey come through as intuition, the trader needs to pay attention. As the Zen-quoting trader \nmentioned earlier expressed it, “The trick is to differentiate between what you want to happen \nand what you know will happen.”\n 47. Life’s mission and love of the endeavor. In talking to the traders interviewed in Market \nWizards, I had the definite sense that many of them felt that trading was what they were meant to \ndo—in essence, their mission in life. In this context, Charles Faulkner quoted NLP cofounder \nJohn Grinder’s description of mission: “What do you love so much that you would pay to do it?” \nThroughout my interviews, I was struck by the exuberance and love the Market Wizards had \nfor trading. Many used gamelike analogies to describe trading. This type of love for the endeavor \nmay indeed be an essential element for success.\n 48. the elements of achievement. Faulkner has a list of six key steps to achievement based on \nGary Faris’s study of successfully rehabilitated athletes, which appears to apply equally well to \nthe goal of achieving trading success. These strategies include the following:\n1.\n Using both “T oward” and “Away From” motivation;\n2. Having a goal of full capability plus, with anything less being unacceptable;\n3. Breaking down potentially overwhelming goals into chunks, with satisfaction garnered from \nthe completion of each individual step;\n4.\n Keeping full concentration on the present moment—that is, the single task at hand rather \nthan the long-term goal;\n587\n50 Market Wizard Lessons\n5. Being personally involved in achieving goals (as opposed to depending on others); and\n6. Making self-to-self comparisons to measure progress.\n 49. prices are nonrandom = the markets can be beat. In reference to academicians who \nbelieve market prices are random, Monroe Trout, a commodity trading advisor with one of \nthe best risk/return records in the industry, says, “That’s probably why they’re professors and \nwhy I’m making money doing what I’m doing.”\n The debate over whether prices are random is \nnot yet over. However, my experience in interviewing scores of great traders left me with little \ndoubt that the random walk theory is wrong. It is not the magnitude of the winnings registered \nby the Market Wizards, but the consistency of these winnings in some cases, that underpin my \nbelief. As a particularly compelling example, in his first fund, Edward Thorp, a mathematician \nbest known for his best-selling book Beat the Dealer, compiled a track record of 227 winning \nmonths and only 3 losing months (all under 1 percent)—an extraordinary 98.7 winning per-\ncentage. The odds of getting such a result by chance (as would be the case if the markets were \nrandom) are less than 1 out of 10\n63. T o put this probability in context, the odds of randomly \nselecting a specific atom in the earth would be about a trillion times better. Certainly, winning \nat the markets is not easy—and, in fact, it is getting more difficult as professionals account for a \nconstantly growing proportion of the activity—but it can be done!\n 50. Keep trading in perspective. There is more to life than trading.\n\n589\nIntroduction to \nRegression Analysis\nTheory helps us bear our ignorance of fact.\n—George Santayana\n ■ Basics\nRegression analysis is concerned with describing and evaluating the relationship between a given \n variable and one or more other variables. For example, we might be interested in describing the \nrelationship between the pig crop (number of pigs born during a given period) and the hog slaughter \nlevel in the following six-month period.\n1 The relationship between these variables is illustrated in \nFigure A.1. Each point in Figure A.1 represents a single observation or year. The location of a point \nalong the horizontal axis is determined by the December–May pig crop, while its placement along \nthe vertical axis is determined by the June–November hog slaughter level. Note that there is a clear \nAppendix A \n1 Readers may notice that a predominant number of the examples in the Appendices will be drawn from the hog \nmarket. There are three basic reasons for this: (1) Such comparisons will illustrate the advantages of regression \nanalysis in terms of preciseness, efficiency, flexibility, and ease of application. (2) The exposition will be clearer \nif a limited number of markets are used to provide illustrative examples. (3) Because hogs are nonstorable, the \nhog market can be represented adequately by simple fundamental models. In any event, it should be stressed that \nchosen examples are merely intended as vehicles to illustrate the general concepts and techniques of regression \nanalysis, and not as a description of the methodology for analyzing any specific market. Consequently, the illus-\ntrations should be as relevant to the reader interested in applying regression analysis to the interest rate markets \nas to the reader whose primary focus is the livestock sector.\n590APPENDIX A\nrelationship between these two variables: large hog slaughter levels correspond to large pig crop \nlevels. In this example, hog slaughter is the dependent variable in that hog slaughter depends on the pig \ncrop, but not vice versa, and the pig crop is the independent , or explanatory , variable. The primary goal \nof regression analysis is to defi ne a mathematical relationship between the dependent variable and the", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 194}
{"text": "these two variables: large hog slaughter levels correspond to large pig crop \nlevels. In this example, hog slaughter is the dependent variable in that hog slaughter depends on the pig \ncrop, but not vice versa, and the pig crop is the independent , or explanatory , variable. The primary goal \nof regression analysis is to defi ne a mathematical relationship between the dependent variable and the \nindependent variable(s). \n Perhaps the most basic underlying assumption in the standard regression analysis approach is that \nthe relationship between the dependent and independent variables is linear. In the case in which there \nis only one explanatory variable, the regression equation will be a straight line and can be expressed as\nYa bX=+\n where a and b are constants determined by the regression procedure. 2 The values derived for a and \nb by the regression procedure are termed the regression coeffi cients ( a is sometimes simply referred to \nas the constant term ). By convention, Y is the variable that we are trying to explain or predict—the \ndependent variable—while X is the explanatory or independent variable. \n 2 T o be precise, a and b are parameters. A parameter can be thought of as a hybrid between a variable and a \n constant. If the focus is on the variation of the equation as a whole, then a and b are variables. Given the equa-\ntion, Y = a + bX , each set of values for a and b will defi ne a diff erent line. However, if we are concerned with the \nrelationship between the variables X and Y , given a specifi c set of values for a and b , as is the case in regression \nanalysis, then a and b can be termed constants.\n FIGURE  A.1 June–November Hog Slaughter vs. December–May Pig Crop (Thousands) \n44\n46\n48\n50\n52\n54\n56\n58\n60\n47 49 51 53 55 57 59\nJun-Nov hog slaughter\nDec-May pig crop\n’96\n’01\n’97\n’95\n’00\n’03 ’02\n’04 ’05\n’07\n’08 ’12\n’09\n’11\n’13’10\n’14’98\n’06\n’99\n591\nINTRoDuCTIoN To REGRESSIoN ANAlySIS\n The constants a and b in the regression equation have special meanings. Constant b is the amount \nvariable Y (e.g., hog slaughter) will change given a one-unit change in variable X (e.g., pig crop). For \nexample, in the simple linear equation Y = 1 + 2 X each unit change in X will result in a two-unit \nchange in Y . Note this relationship will hold regardless of the level of X . In fact, the constancy of the \nchange in Y given a fi xed change in X is a basic characteristic of a linear equation. Constant a is called \nthe Y intercept because it is the value of Y at which the line crosses the Y axis—that is, the value of Y\nwhen X equals zero. (See Figure A.2 for a graphic depiction of the preceding points.) \n Given a set of data points such as those illustrated in Figure A.1 , regression analysis will seek to fi nd \nthe values of a and b in the regression equation that result in the line that best fi ts the observed points. \n ■ Meaning of Best Fit \n using Figure A.1 as an example, how would we defi ne the best-fi t line to the scatter of points? Intui-\ntively, it seems that we would want to pick the line that minimizes the deviations from the individual \npoints to the line. The deviation of any single point or observation can be defi ned as the diff erence \n FIGURE  A.2 Meaning of a and b for Straight line \nY\nY = 1 + 2X\nb = 2\nb = 2\na = 1\n1\n1\nX\n20\n15\n10\n10\n5\n}\n5\n592APPENDIX A\nbetween Y i , the observed value, and ˆYi , the Y value predicted by the line for the same value of X . The \ndeviation of a single point is thus equal to YYii − ˆ (see Figure A.3 ). \n These deviations are also called residuals. W e cannot derive a summary deviation fi gure for a group \nof points by adding all the individual deviations. Why? Because deviations above and below the line \nwill tend to cancel each other out. Thus, the sum of the residuals can be small even if the line fi ts the \ndata points poorly. In fact, if the deviations below the line are greater than the deviations above the \nline, the sum of the residuals will be negative—an absurd value for a measure of total deviation. How \nwould one interpret a negative total deviation? In other words, the sum of the residuals does not off er \na criterion for determining best fi t. \n one possible solution is to fi nd the line that minimizes the sum of the absolute deviations, that is, \nthe sum of the residuals measured without regard to sign. Another possible approach would be to \nsquare each of the deviations before adding them, thereby assuring that they will all be positive, and \nthen to fi nd the line that minimizes the sum of these squared deviations \n3 : \n()YYii\ni\nn\n−\n=\n∑ ˆ 2\n1\n This least-squares approach represents the method employed by regression analysis, and is preferable \nto the sum of the absolute deviations for several reasons: \n 1. Theoretically, the least-squares approach will yield the best estimates. 4 \n 2. The least-squares method will place greater weight on large errors as a result of the squaring \noperation in its computation. This approach is usually advantageous, since it is desirable to avoid \nlarge deviations. \n 3 The symbol /uni03A3 means “the sum of.” The superscript n indicates the number of observations, and the subscript\n i = 1 indicates the observation number at which the summation begins. In other words, in this term, all the \nsquared deviations are summed, and there are a total of n observations.\n 4 The least-squares estimates will be both unbiased and effi cient. These terms are defi ned in Appendix C.\n FIGURE  A.3 Deviation for a Single observation \nYi − Y\n^\ni = deviation\nY\n^\ni\nYi \n593\nINTRoDuCTIoN To REGRESSIoN ANAlySIS\n 3. The sum of the absolute deviations is computationally far more unwieldy than the sum of the \nsquared deviations.\n 4. The least-squares approach permits many useful tests of the reliability of the equation.\nIt can be demonstrated by straightforward calculus proofs the values of a and b that minimize the \nsum of the squared deviations are:\nb\nnX YX Y\nnX X\na\nY\nii ii\ni\nn\ni\nn\ni\nn\nii\ni\nn\ni\nn\ni\n=\n⋅− ⋅\n− \n\n\n\n\n\n=\n= ==\n==\n∑ ∑ ∑", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 195}
{"text": "viations is computationally far more unwieldy than the sum of the \nsquared deviations.\n 4. The least-squares approach permits many useful tests of the reliability of the equation.\nIt can be demonstrated by straightforward calculus proofs the values of a and b that minimize the \nsum of the squared deviations are:\nb\nnX YX Y\nnX X\na\nY\nii ii\ni\nn\ni\nn\ni\nn\nii\ni\nn\ni\nn\ni\n=\n⋅− ⋅\n− \n\n\n\n\n\n=\n= ==\n==\n∑ ∑ ∑\n∑ ∑\n1 11\n2\n1\n2\n1\n \nii\nn\ni\ni\nn\nn b\nX\nn Yb X==\n∑∑\n−= −11 \nwhere n = number of observations\nY = mean of Yi, and\nX = mean of Xi\n ■ A Practical Example\nAs a practical example, we will find the best-fit line using the least-squares approach for the set of \nobservations in Figure A.1. Table A.1 summarizes the necessary computations. The resulting best-fit \nline is illustrated in Figure A.4. T o obtain a specific forecast, we would merely plug the estimated pig \ncrop value into the regression equation. For example, if the December–May pig crop estimate were \n51 million, the forecast for hog slaughter in the subsequent June–November period would be 50.51 \nmillion (–3.6279 + (1.0615 * 51)).\n ■ Reliability of the Regression Forecast\nIt is essential to understand that, by itself, a point price projection derived from a regression equation \nis of little use. \none must first consider how well the model describes the data and the expected vari-\nability of forecasts based upon the regression equation. W e can get an intuitive answer to this question \nby examining how closely the observations fall to the fitted regression line (Figure A.4).\nBut we should be able to assess a model’s accuracy more precisely. Simply examining a scatter \nchart leaves many unanswered questions. How close do the observations have to be to the regression \nline for the model to be judged satisfactory? How do we check whether a model provides an undis-\ntorted representation of the real world? How closely can we expect the model’s forecasts to anticipate \nactual results?\n594\nAppendix A\nTAble A.1 Computation of least-Squares best-Fit line\nY ear\npig Crop\n(dec–May, millions)\nXi\nHog Slaughter\n(Jun–nov, millions)\nYi Xi2 XiYi\n1995 50.077 48.294 2,507.71 2,418.40\n1996 47.888 45.453 2,293.26 2,176.64\n1997 48.394 46.201 2,341.98 2,235.85\n1998 52.469 50.929 2,753.00 2,672.20\n1999 51.519 51.111 2,654.21 2,633.20\n2000 50.087 49.689 2,508.71 2,488.76\n2001 49.472 49.169 2,447.48 2,432.50\n2002 50.858 50.709 2,586.54 2,578.94\n2003 50.029 50.758 2,502.90 2,539.38\n2004 50.737 52.265 2,574.24 2,651.76\n2005 51.33 52.333 2,634.77 2,686.23\n2006 52.242 53.150 2,729.23 2,776.68\n2007 54.266 55.569 2,944.80 3,015.52\n2008 57.019 57.648 3,251.17 3,287.05\n2009 57.564 57.391 3,313.61 3,303.68\n2010 56.326 55.681 3,172.62 3,136.26\n2011 57.118 56.264 3,262.47 3,213.69\n2012 57.818 57.478 3,342.92 3,323.23\n2013 57.02 55.914 3,251.28 3,188.23\n2014 53.821 52.418 2,896.70 2,821.17\n∑Xi = 1,056.05 ∑Yi = 1,048.42 ∑Xi2 = 55,969.58 ∑XiYi = 55,579.37\nb = (20 * 55,579.37) – (1,056.05 * 1,048.42) / (20 * 55,969.58) – (55,969.58)2 = 1.0615 \na = (1,048.42/20) – 1.0615 * (1,056.05/20) = –3.6279 \nYi = −3.6279 + 1.0615Xi\nAnother problem with the graphic analysis depicted in Figure A.4 is that it just isn’t feasible for \nregression equations that include two or more explanatory variables—a situation that is the rule \nrather than the exception.\nThese considerations lead us to one of the primary benefits of regression analysis: The approach \npermits a wide variety of scientific tests of a model’s adequacy. Such tests are essential to the success-\nful application of regression analysis. An understanding of these tests, as opposed to a mere cookbook \napplication, requires a synopsis of some key statistical concepts. Appendix B provides an abridged \ncrash course in elementary statistics. W e will return to regression analysis in Appendix C.\n595\nINTRoDuCTIoN To REGRESSIoN ANAlySIS FIGURE  A.4 Best-Fit line for June–November Hog Slaughter vs. December–May Pig Crop \n44\n46\n48\n50\n52\n54\n56\n58\n60\n47 49 51 53 55 57 59\nJun-Nov hog slaughter\nDec-May pig crop\n’96\n’01\n’97\n’95\n’00\n’03 ’02\n’04 ’05\n’07\n’08 ’12\n’09\n’11\n’13’10\n’14’98\n’06\n’99\nY = −3.6279+ 1 .0615X\n\n597\nA Review of \nElementary Statistics\nThe theory of probabilities is at bottom nothing but common sense reduced to Calculus.\n—Pierre Simon de Laplace\n ■ Measures of Dispersion\nFor any data series there are two basic types of descriptive statistics: (1) some measure of central tendency \n(e.g., arithmetic mean, median, mode, geometric mean, harmonic mean); and (2) a measure of dispersion. \nThe intuitive meaning of dispersion is quite clear. For example, consider the following two sets of numbers:\n A. 30, 53, 3, 22, 16, 104, 71, 41\n B. 42, 40, 42, 46, 39, 45, 42, 44\nAlthough both series have the same arithmetic mean, it is clear that series A would have a high \ndispersion measure and series B a low dispersion measure. The concept of dispersion is extremely \nimportant in forecasting. For example, if we were told there was a ninth number in each of the series \nthat was not listed, we would be far more certain about our guess being close to the mark in series B \nthan in series A. Thus, it is extremely desirable to have a measure that describes the dispersion of a set \nof numbers, much as the mean describes the central tendency of a set of numbers.\nThe basic question is: How do we measure dispersion? In a sense, we have already answered this \nquestion. Deriving a dispersion measure for a set of numbers is entirely analogous to the computation \nof a single deviation measure for a group of points from a line. In the case of a set of numbers, the \ndeviations would be measured relative to some central point. For theoretical reasons, the arithmetic \nmean is the most desirable measure of central tendency. T o derive a single deviation measure for a set \nof numbers, we cannot simply add the individual deviations, because they will tend to cancel each other \nout. Once again, two possible solutions are the sum of the absolute deviations or the sum of the squared \nd", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 196}
{"text": "measured relative to some central point. For theoretical reasons, the arithmetic \nmean is the most desirable measure of central tendency. T o derive a single deviation measure for a set \nof numbers, we cannot simply add the individual deviations, because they will tend to cancel each other \nout. Once again, two possible solutions are the sum of the absolute deviations or the sum of the squared \ndeviations. The latter measure is far more convenient to use and is preferable for theoretical reasons.\nAppendix B \n598\nAppendix B\nHowever, the sum of the squared deviations is not a representative measure of dispersion since it \nis dependent on how many numbers are in the series. For example, if series B contained 1,000 sets \nof the indicated string of numbers, the sum of the squared deviations for the series would be greater \nthan the corresponding figure for series A. This measure is therefore quite misleading because series \nA would still reflect greater dispersion by any intuitive definition of that term. This problem is solved \nsimply by dividing the sum of the squared deviations by the number of items in the series. The result-\ning measure is called the variance, which can be expressed as:\nVariance ==\n−\n=\n∑\nσ2\n2\n1\n()XX\nN\ni\ni\nN\nwhere X = mean\nXi = individual data values\nN = number of observations\nNote the variance is not stated in the same units as the original data series. For example, if the units of \nthe original set of numbers were tons, the variance would be expressed in tons squared.\nThe dispersion measure can be expressed in the same units as the original data series by simply \ntaking the square root of the variance. This computation also makes intuitive sense since it reverses \nthe original squaring process applied to the individual terms. The resulting figure is called the standard \ndeviation and can be expressed as:\nStandard deviation ==\n−\n=\n∑\nσ\n()XX\nN\ni\ni\nN\n2\n1\nIn a rough sense, the standard deviation is a type of average deviation (of the individual data points \nfrom the mean), in which the data points that are further from the mean have greater than propor-\ntionate impact on the calculation. (This greater weight is the result of the squaring \n process.)1\n1 These definitions for the variance and standard deviation are applicable when the entire set of data elements \nis known, in which case the set of numbers is called the population. However, in actual practice, available sets of \nnumbers will often represent samples from a population. In fact, this assumption appears to be implied for series \nA and B. For reasons that will be explained later, the variance and standard deviation calculations for a sample \nare slightly different. Specifically, for samples, the variance and standard deviation would be expressed as follows:\nVariance sample\nStandard deviatio ns amp\n ()\n()\n(\n==\n−\n−\n=\n∑\ns\nXX\nn\ni\ni\nn\n2\n2\n1\n1\nlle )\n()\n==\n−\n−\n=\n∑\ns\nXX\nn\ni\ni\nn\n2\n1\n1\nwhere n = number of observations in the sample.\n599\nA REvIEw OF ELEMENTARy STATISTIcS\nTABle B.1 Standard deviation Computations\nSeries A: 30, 53, 3, 22, 16, 104, 71, 41 Series B: 42, 40, 42, 46, 39, 45, 42, 44\nXi XXi − ()XXi − 2 Xi XXi − ()XXi − 2\n30 −12.5 156.25 42 −0.5 0.25\n53 +10.5 110.25 40 −2.5 6.25\n3 −39.5 1,560.25 42 −0.5 0.25\n22 −20.5 420.25 46 +3.5 12.25\n16 −26.5 702.25 39 −3.5 12.25\n104 +61.5 3,782.25 45 +2.5 6.25\n71 +28.5 812.25 42 −0.5 0.25\n41 −1.5 2.25 44 +1.5 2.25\nXi\ni\nn\n=\n=\n∑ 340\n1\nXXi\ni\nN\n−() =\n=\n∑\n2\n1\n7 546 00,. Xi\ni\nN\n=\n=\n∑ 340\n1 \nXXi\ni\nN\n−() =\n=\n∑\n2\n1\n40 00.\nX\nX\nN\ni\n==∑ 42 5 . X\nX\nN\ni\n==∑ 42 5 .\nVariance ==\n−()\n===\n∑\nσ2\n2\n1 7 546\n8 943 25\nXX\nN\ni\ni\nN\n, . Variance ==\n−()\n===\n∑\nσ2\n2\n1 40\n8 5\nXX\nN\ni\ni\nN\nStandard deviation ==\n−()\n==\n∑\nσ\nXX\nN\ni\ni\nn 2\n1 30 712. Standard deviation ==\n−()\n==\n∑\nσ\nXX\nN\ni\ni\nn 2\n1 2 236.\nNote: These computations apply to a population. For samples, the computation would be slightly different (see footnote 1).\nThe greater the standard deviation, the greater the degree of variability in a set of numbers. T o \nget a better sense of this statistic, Table B.1 calculates the standard deviation for series A and B. It is \nessential to have a clear understanding of the standard deviation before proceeding, since this term \nwill play a pivotal role in defining the normal distribution and in probability testing.\n ■ Probability Distributions\nA random variable is a variable with a value that depends on a statistical experiment in which each out-\ncome (or range of outcomes) has a specific probability of occurrence. For example, if trading decisions \nwere based on the toss of a coin, the number of winning trades, excluding commissions, in 10 trades \nwould be a random variable. A probability distribution indicates the probability associated with different \nvalues of a random variable. Figure B.1 indicates the probabilities for different numbers of gains in \n10 trades if trading decisions are based on chance. The highest probability of 0.246 is associated with \nfive gains in 10 trades. The probability of alternative events decreases as the number of gains moves \n600APPENDIX B\naway from fi ve. The probability of 10 out of 10 winning trades is only 0.001. (By defi nition, the sum \nof all the probabilities equals 1.0.) \n This example of a probability distribution was based on a discrete variable, which is a variable that \ncan take on only certain fi xed values—for example, we can have six winning trades or seven winning \ntrades, but not 6.3 winning trades. Frequently, we will be concerned with random variables that are \ncontinuous, which are variables that can assume any value. An example of a continuous variable would \nbe the reaction time of drivers in stepping on the brake when a stop sign is fl ashed on a screen in a \nsimulation test. For continuous variables, the probability of each event (e.g., probability of the reac-\ntion time being exactly 0.41237 second) is not meaningful or even defi nable. Instead, the relevant \nconsideration is the probability of events in a certain range (e.g., the probability of a reaction tim", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 197}
{"text": "ion time of drivers in stepping on the brake when a stop sign is fl ashed on a screen in a \nsimulation test. For continuous variables, the probability of each event (e.g., probability of the reac-\ntion time being exactly 0.41237 second) is not meaningful or even defi nable. Instead, the relevant \nconsideration is the probability of events in a certain range (e.g., the probability of a reaction time \nbetween 0.4 and 0.5 seconds). \n A continuous distribution describes the probability associated with a continuous random variable. \nThe total area under a continuous distribution curve will equal 1.0 (100 percent) since there is \n100 percent probability an event will take on some value, and the sum of all the probabilities of mutu-\nally exclusive events cannot exceed 100 percent. \n2 A continuous distribution is characterized by the \n2 Mutually exclusive means that only one event can occur at a time. For example, in the reaction time test, only one \ntime value can be associated with any given test.\n FIGURE  B.1 Probability Distribution for Number of winning Trades \nin 10 Trades If Decision Based on chance \n.25\n.20\n.15\n.10\n.05 Probability\n012345\nNumber of wins in 10 trades (excluding commissions)\n6789 10\n601\nA REvIEw OF ELEMENTARy STATISTIcS\nfact that the area between any two given values is equal to the probability the random variable will fall \nin the interval between these two values. For example, in Figure B .2 the total area under the curve \nwould be equal to 1.0, and the shaded area would indicate the probability of the continuous variable \nhaving a value between X \n1 and X 2 . If the shaded area represented 20 percent of the total area under \nthe curve, the probability of the continuous variable falling in a range between X 1 and X 2 would be \n20 percent. \n Figure B .2 represents the familiar bell-shaped normal distribution curve. Empirically, the normal \ndistribution has been shown to serve as a good approximation of the probability distribution for an \nextremely wide range of random variables. For example, it can be demonstrated that as the number \nof trades in Figure B .1 increases, the distribution will begin to approach a normal distribution. For \na large number of trades (e.g., 1,000), the probability distribution would be almost exactly repre-\nsented by a normal distribution. Probabilities for continuous random variables such as reaction time \nfrequently will also be well described by the normal distribution. \n Figure B .3 shows how the probability of an event falling within a fi xed interval increases as the \ninterval moves closer to the mean. The probability of an event occurring in the range X \n1 − X 2 (i.e., \nthe area under the curve between X 1 and X 2 ) is greater than the probability of an event in the range \n FIGURE  B.2 continuous Probability Distribution \nX1 X2\n FIGURE  B.3 Fixed Interval Probability Increases with Proximity \nto Mean \nX1XX 2 X3 X4 X5\n602\nAppendix B\nX3−X4. Note the probability of an event occurring in a range distant from the mean is near zero, even \nif it is a very broad range. For example, in Figure B.3, the probability of the variable having a value \nbetween X5 and infinity is near zero.\nThe formula for the normal distribution is:\nYe XX= −− []1\n2\n12\n2\nσπ\nσ(/ )( )/\nThis seemingly intimidating formula is not as frightening as it might initially appear. Like any other \nequation describing a relationship between X and Y, it tells us the value of Y given a value for X. The \nkey point to realize about this equation is the precise relationship between X and Y will be determined \nentirely by the mean of \nXX() and the variance of X (σ).3 All the other values in the formula are con-\nstants (π = 3.1416, e = 2.7183). Thus, once X and σ are determined, the normal distribution for a \nparticular set of numbers is completely defined. Note the value of Y will reach a maximum when X \nequals\nX , at which point the formula reduces to\nY = 1\n2σπ\nAt any other value of X, the value of the term\n1\n2\n2\nXX−\n\n\nσ\nwill be greater than 0, resulting in a lower value of Y. The further any given value X is from X, the larger \nthis term and the lower the value of Y.4\nBecause the normal distribution will differ for any given set of values for X and σ, it is desirable to \nchoose a given set of values upon which to base a standard table of probability values. For simplicity, \nthis table is based on X = 0 and σ = 1. T o be able to use this standard table, we have to transform the \nnumbers in a series into Z values, where\nZ XX\ni\ni\nx\n= −\nσ\n3 X and σ are parameters. As explained in footnote 2 in Appendix A, a parameter can be thought of as a hybrid \nbetween a variable and a constant. In this instance, X and σ will assume different values for different distribu-\ntions of X (i.e., different sets of numbers); however, for any given distribution (set of numbers), X and σ will \nbe fixed (i.e., constants).\n4 e−k is equivalent to l/e k, therefore the larger 12 2/[ () ]XX− /σ gets, the smaller the value of e XX−−() [( )]12 2// σ , \nhence the smaller the value of Y.\n603\nA REvIEw OF ELEMENTARy STATISTIcS\nand Xi is a given value in a set of numbers. 5 The numerator of this term is the distance of the given \nnumber from the mean; the denominator is the standard deviation of the set of numbers. Thus, the \nZ value is simply the distance of a given value from the mean in terms of standard deviations. For \nexample, if the mean of a set of numbers is 10, and the standard deviation is 2, the Z value for a \n5 The fact that the distribution of Z values will always have a mean equal to zero ()Z = 0 and a standard deviation \nequal to 1 (σz = 1) given that any set of X values is easy to demonstrate:\nZ XX Z\nXX\nN\nXX\nN\ni\nX\ni\nXi\nN\nX\ni\ni\nN\ni\nN\n= − =\n−\n\n\n\n\n\n=\n−\n\n\n\n\n\n= ==\n∑ ∑ ∑\nσ\nσ σ1 11\n1\nKeeping in mind that XX Ni\ni\nN\n= \n\n\n\n\n\n=\n∑\n1\n/.\nZ N NX NX\nX\n=− () =1 0σ\nThe standard deviation of Z (σz) can be expressed as\nσz\ni\ni\nN\nZZ\nN=\n−()\n=\n∑\n2\n1\nBut we have just proved that Z = 0, so\nσ σ\nσ\nσ σ\nZ\ni\ni\nN\ni", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 198}
{"text": "ation \nequal to 1 (σz = 1) given that any set of X values is easy to demonstrate:\nZ XX Z\nXX\nN\nXX\nN\ni\nX\ni\nXi\nN\nX\ni\ni\nN\ni\nN\n= − =\n−\n\n\n\n\n\n=\n−\n\n\n\n\n\n= ==\n∑ ∑ ∑\nσ\nσ σ1 11\n1\nKeeping in mind that XX Ni\ni\nN\n= \n\n\n\n\n\n=\n∑\n1\n/.\nZ N NX NX\nX\n=− () =1 0σ\nThe standard deviation of Z (σz) can be expressed as\nσz\ni\ni\nN\nZZ\nN=\n−()\n=\n∑\n2\n1\nBut we have just proved that Z = 0, so\nσ σ\nσ\nσ σ\nZ\ni\ni\nN\ni\nXi\nn\nx\ni\ni\nN\nZ\nN\nXX\nN\nXX\nN==\n−\n\n\n\n\n\n=⋅\n−()\n=\n= = =\n∑ ∑ ∑\n2\n1\n2\n1\n2\n2\n11\n1\n \nZ\nX X\ni\ni\nN\nXX\nN\n−()\n=\n∑\n2\n1\nSince\nXX\nN\ni\ni\nN\n−()\n=\n∑\n2\n1\nis the definition for σx,\nσ σ σZ\nX\nX=⋅ =1 1\n604\nAppendix B\nnumber X = 6 would be −2 (i.e., X is 2 standard deviations removed from the mean). This standard-\nized distance of a number from its mean will allow us to gauge the probabilities of a given value being \nhigher or lower than a given number.\n ■ Reading the Normal Curve (Z) Table\nRemember, a Z value indicates how many standard deviations a given observation lies above or below its \nmean, with the sign indicating whether the number is above or below the mean. Table B.2 lists the prob-\nabilities corresponding to different Z values. These numbers represent the probabilities of an observa-\ntion of a normally distributed random variable falling in the range between zero and the given Z value. \nFor example, there is a .4332 (43.32 percent) probability the Z value will be between zero and +1.5. \nT o determine the probability of a Z value being less than a given number, simply add .50 (the probability \nof a value below the mean) to the probability listed in Table B.2. Thus, the probability of a Z value less \nthan 1.5 = .9332. The probability of a Z value greater than 1.5 would be .0668 (i.e., 1 − .9332). T o \nfind the probability of a Z value being more than +1.5 or less than −1.5 (in other words, more than \n1.5 standard deviations removed from the mean), we would merely double this figure and get .1336.\nFrom Table B.2, we can verify that for a normal distribution there is a .6826 probability that an \nobservation will fall within one standard deviation of the mean, a .9554 probability that it will be \nwithin two standard deviations, and a .9974 probability that it will be within three standard deviations.\nAn example may help clarify some of these ideas. AB\nc is a brokerage house that has a long-running \nprogram to train new brokers. In addition to interviews, the firm administers a test to decide which \ncandidates will be accepted into the program. After testing thousands of candidates over the years \nthey have found the scores are approximately normally distributed, with a mean of 70 and a standard \ndeviation of 10. Given these facts, try the following questions:\n 1. w hat is the probability a new applicant taking the test will get a score above 92 (assuming we \nare not given any additional information about the person)?\n 2. w hat is the probability the applicant will get a score between 50 and 80?\nGive it a try before reading on.\nAnswers\n 1. Z XX= −\nσ\nZ = − =92 70\n10 22.\nchecking Table B.2, we see that the probability value corresponding to Z = 2.2 is .4861. Thus, \nthere is a .9861 probability that a candidate will score 92 or less, or equivalently, a .0139 (1.39 per-\ncent) probability that the score will be higher.\n605\nA REvIEw OF ELEMENTARy STATISTIcS\nTABle B.2 Areas under the normal Curve\nAn entry in the table is the proportion under the entire curve that is between z = 0 and a positive value of z. Areas for \nnegative values of z are obtained by symmetry.\nSecond decimal place of Z\nz .00 .01 .02 .03 .04 .05 .06 .07 .08 .09\n0.0 .0000 .0040 .0080 .0120 .0160 .0199 .0239 .0279 .0319 .0359\n0.1 .0398 .0438 .0478 .0517 .0557 .0596 .0636 .0675 .0714 .0753\n0.2 .0793 .0832 .0871 .0910 .0948 .0987 .1026 .0164 .1103 .1141\n0.3 .1179 .1217 .1255 .1293 .1331 .1368 .1406 .1443 .1480 .1517\n0.4 .1554 .1591 .1628 .1664 .1700 .1736 .1772 .1808 .1844 .1879\n0.5 .1915 .1950 .1985 .2019 .2054 .2088 .2123 .2157 .2190 .2224\n0.6 .2257 .2291 .2324 .2357 .2389 .2422 .2454 .2486 .2517 .2549\n0.7 .2580 .2611 .2642 .2673 .2703 .2734 .2764 .2794 .2823 .2852\n0.8 .2881 .2910 .2939 .2967 .2995 .3023 .3051 .3078 .3106 .3133\n0.9 .3159 .3186 .3212 .3238 .3264 .3289 .3315 .3340 .3365 .3389\n1.0 .3413 .3438 .3461 .3485 .3508 .3531 .3554 .3577 .3599 .3621\n1.1 .3643 .3665 .3686 .3708 .3729 .3749 .3770 .3790 .3810 .3830\n1.2 .3849 .3869 .3888 .3907 .3925 .3944 .3962 .3980 .3997 .4015\n1.3 .4032 .4049 .4066 .4082 .4099 .4115 .4131 .4147 .4162 .4177\n1.4 .4192 .4207 .4222 .4236 .4251 .4265 .4279 .4292 .4306 .4319\n1.5 .4332 .4345 .4357 .4370 .4382 .4394 .4406 .4418 .4429 .4441\n1.6 .4452 .4463 .4474 .4484 .4495 .4505 .4515 .4525 .4535 .4545\n1.7 .4554 .4564 .4573 .4582 .4591 .4599 .4608 .4616 .4625 .4633\n1.8 .4641 .4649 .4656 .4664 .4671 .4678 .4686 .4693 .4699 .4706\n1.9 .4713 .4719 .4726 .4732 .4738 .4744 .4750 .4756 .4761 .4767\n2.0 .4772 .4778 .4783 .4788 .4793 .4798 .4803 .4808 .4812 .4817\n2.1 .4821 .4826 .4830 .4834 .4838 .4842 .4846 .4850 .4854 .4857\n2.2 .4861 .4864 .4868 .4871 .4875 .4878 .4881 .4884 .4887 .4890\n2.3 .4893 .4896 .4898 .4901 .4904 .4906 .4909 .4911 .4913 .4916\n2.4 .4918 .4920 .4922 .4925 .4927 .4929 .4931 .4932 .4934 .4936\n2.5 .4938 .4940 .4941 .4943 .4945 .4946 .4948 .4949 .4951 .4952\n2.6 .4953 .4955 .4956 .4957 .4959 .4960 .4961 .4962 .4963 .4964\n2.7 .4965 .4966 .4967 .4968 .4969 .4970 .4971 .4972 .4973 .4974\n2.8 .4974 .4975 .4976 .4977 .4977 .4978 .4979 .4979 .4980 .4981\n2.9 .4981 .4982 .4982 .4983 .4984 .4984 .4985 .4985 .4986 .4986\n3.0 .4987 .4987 .4987 .4988 .4988 .4989 .4989 .4989 .4990 .4990\nSource: Donald J. Koosis, Business Statistics (New york, Ny: John wiley & Sons, 1997). copyright © 1997 by John wiley & Sons; reprinted by \npermission.\n606\nAppendix B\n 2. This question is not as easy. It would be incorrect to proceed as follows:\nZ = − =80 50\n10 30.\nwhy? Because Z values must be measured relative to the mean. So the solution requires two steps: \nFirst, the probability of getting a score between 70 and 80 must be calculated. Thi", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 199}
{"text": "New york, Ny: John wiley & Sons, 1997). copyright © 1997 by John wiley & Sons; reprinted by \npermission.\n606\nAppendix B\n 2. This question is not as easy. It would be incorrect to proceed as follows:\nZ = − =80 50\n10 30.\nwhy? Because Z values must be measured relative to the mean. So the solution requires two steps: \nFirst, the probability of getting a score between 70 and 80 must be calculated. This can be done as \nfollows:\nZ = − =80 70\n10 10.\nchecking Table B.2, we find that this probability equals .3413. Next, to calculate the probability \nof a score between 50 and 70, we proceed as follows:\nZ = − =−50 70\n10 20.\nThis corresponds to a probability of .4772. Thus, the probability of a score between 50 and 80 is the \nsum of these two values:\n.3413 + .4772 = .8185 (81.85 percent)\n ■ Populations and Samples\nIf a data set contains all possible observations, it is called a population. If it consists of only a portion \nof these observations, it is called a sample. whether a data set represents a population or a sample \ndepends on the intended use. For example, if we are interested in the average income of all the \nemployed people in Manhattan, the population would consist of all workers in Manhattan, and a \nsample would be only a portion of those workers. However, if we wish to estimate the average income \nof all U.S. workers, all workers in Manhattan would be a sample.\nIntuitively, it should be clear that all workers in Manhattan would not be a very good sample of \nall U.S. workers. The problem in this case is that the sample is not representative of the population. \nIn order for a sample to be representative of a population, it must be a random sample. A random sam-\npling process is one in which each sample that can be drawn from the population has an equal chance \nof being selected. Samples that are not random will be biased, and a sampling approach that is not \nrandom will yield biased estimates. The mean of sample means that are biased will deviate from the \npopulation mean. Ironically, for a biased sample, the larger the sample size, the more certain its mean \nwill deviate from the population mean.\nIn standard terminology, when a measure refers to the population, it is called a parameter.\n6 A measure \nthat refers to a sample is called a statistic. Thus, the standard deviation for a population (σ) is a param-\neter, and the standard deviation of a sample (s) is a statistic.\n6 The meaning of the term parameter when used in this context should not be confused with the distinction among \nparameters, variables, and constants explained in footnote 2 of Appendix A.\n607\nA REvIEw OF ELEMENTARy STATISTIcS\n ■ Estimating the Population Mean and Standard \nDeviation from the Sample Statistics\nAlthough the intention of probability testing is to draw inferences about a population, it is usually \nimpractical to collect data for the entire population. In fact, it is frequently impossible, since some \npopulations are infinite. For example, the number of heads in 10 tosses of a coin is an infinite \npopulation, since there is no limit to how many times this event can be repeated. In practice, most \napplications of probability testing, including those in regression analysis, are based on samples rather \nthan on populations.\nThus far, we have avoided the troublesome fact that the population mean and standard devia-\ntion are usually not known. \nwe must now turn to the question of how the population mean and \nstandard deviation can be estimated from a sample. It can be demonstrated that the mean of a \nrandom sample is an unbiased estimate of the population mean, even if the population does not \nshow a normal distribution. This is equivalent to saying that, on average, the mean of randomly \nselected samples will equal the population mean. The sample standard deviation, however, is not \nan unbiased estimate of the population standard deviation, since it tends to slightly underesti-\nmate the population parameter. It has been proved that an unbiased estimate of the population \nvariance (once again, variance is the square of the standard deviation) is given by the following \nequation\n7:\ns XX\nn\n2\n2\n1= −()\n−\n∑\nTaking the square root to translate this variance into a standard deviation, we get\ns XX\nn= −()\n−\n∑\n2\n1\nThis formula is almost identical to the population standard deviation. The only difference is the \nuse of the divisor n − l instead of N.8 For large samples, the difference between the formulas will be \nnearly negligible.\nFinally, although the sample mean is an unbiased estimate of the population mean, this does not \nsuggest the sample mean is necessarily close to the population mean. Thus, in addition to the point \nestimate provided by the sample mean, it would be highly desirable to determine a probable range for \nthe population mean. But before we consider how such a range might be determined, we must first \ngrasp the concept of a sampling distribution.\n7 when a standard deviation refers to a sample rather than a population, it is designated by an s instead of σ.\n8 The quantity n − 1 is called the number of degrees of freedom. we will define this term later.\n608\nAppendix B\n ■ Sampling Distribution\nFast Fred is a relatively active day trader. Being meticulous—but old-fashioned—at the end of \nevery trading day he records the details of each of his trades in a notebook because he feels doing \nso helps him better absorb the lessons of his successes and failures in the markets. He eventually \nrealizes that he should have kept his entries in an Excel spreadsheet so he could make calcula-\ntions on his performance, but being a creature of habit, he continues to enter his trades in his \nnotebook.\nFast Fred varies the number of contracts per trade based on the volatility of the market. He does \nall his trades using market orders. Recently, he has noticed that his average slippage per trade has \nincreased significantly. (Slippage is the difference between the actual execution price and the market \nprice at the time of tra", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 200}
{"text": "creature of habit, he continues to enter his trades in his \nnotebook.\nFast Fred varies the number of contracts per trade based on the volatility of the market. He does \nall his trades using market orders. Recently, he has noticed that his average slippage per trade has \nincreased significantly. (Slippage is the difference between the actual execution price and the market \nprice at the time of trade entry.) Being concerned that his trading approach may no longer be viable, \nFast Fred begins monitoring his slippage and notices that it is running around $75 per trade, which \nhe believes is roughly $50 higher than it has averaged in the past. He reasons that if his average net \nprofit (profit after gross commission and slippage) is not at least $60 per trade, it is probably not \nworthwhile continuing to trade. Unfortunately, he has never bothered to compile summary statistics \nfrom his many trades. The thought of going through all his trade records, which he estimates at more \nthan 3,000 for the past year alone, seems worse than just taking his chances. Instead, he decides to \ndraw a sample.\nKnowing a little about statistics, Fred creates a random sample of 30 trade entries and calculates \nthe average net profit per trade of this sample is $85 and the standard deviation of the sample is $100. \nHe believes a 95 percent probability of an expected gain of at least $60 per trade is necessary to justify \nhis continued trading activity. (An implicit assumption is that the past mean gain can be used as an \nestimate of his future expected gain per trade.) Given this information, is Fred’s day trading method \nstill viable? Unfortunately, we are not quite ready to answer this question without some additional \ntheoretical background.\nwe will eventually return to Fred’s dilemma, but first let us consider what might happen if Fred \ntook another random sample of all his trades (including those selected for the first sample).9 The mean \nnet profit per trade of this sample would be different. If he repeated this process many times, Fred \nwould generate list of different means, each corresponding to a different sample. However, it should be \napparent these sample means would be much less spread out (i.e., have a smaller standard deviation) \nthan the individual observations in a single sample. As will be detailed shortly, the standard deviation of \nobservations within a sample and the standard deviation of sample means are related in a specific way.\nIn Figure B.4, hypothetical sample means for the net profit per trade are grouped by class \n(ranges of $10), with the y axis indicating the frequency of occurrences in each class. If the \n9 The assumption that trades that were picked for a prior sample can be picked again is important. Remember, \nthe definition of a random sample is that each sample must have an equal chance of being selected. If the trade \nentries are not replaced, all possible samples that included any of the original trades will no longer be able to be \npicked—violating the random sample assumption. If the population is very large, the absence of replacement \nwill not be significant, since combinations involving the selected sample will account for only a minute fraction \nof all possible combinations.\n609\nA REvIEw OF ELEMENTARy STATISTIcS\nnumber of samples was repeated infinitely, and the class sizes were reduced correspondingly, \nFigure B .4 would approach a continuous curve known as a sampling distribution. The key point \nto realize is that the sampling distribution is a probability distribution curve related to sample \nstatistics (e.g., sample means). Looking at Figure B .4 , we might guess the sampling distribu-\ntion would be similar to a normal distribution. In fact, if the sample size (i.e., standard size of \neach sample, not number of samples) is large enough, the sampling distribution will precisely \napproach a normal distribution. \n ■ Central Limit Theorem \n The preceding illustration leads us to the central limit theorem, one of the most important concepts in \nstatistical testing. The central limit theorem can be paraphrased as follows: The distribution of sample \nmeans from a population will approach a normal distribution as the sample size increases even if the \npopulation is not normally distributed. \n FIGURE  B.4 Sampling Distribution of Mean \n7\n6\n5\n4\n3\n2\n1\nFrequency (number of samples with mean in indicated profit range)\n35−45 45−55 55−65 65−75 75−85\nX\nAverage net profit per trade of sample\n_85−95 95−105105−115115−125125−135\n610APPENDIX B\n.10\n.20Probability\n2 1 3456789 10\n FIGURE  B.5 Probability Distribution for Spinning wheel \n7\n6\n5\n4\n3\n2\n1\nFrequency (number of samples with mean in specified range)\n5.8−6.2\n6.3−6.7\n6.8−7 .2\n7 .3−7.7\n7.8−8.2\n5.3−5.7\n4.8−5.2\n4.3−4.7\n3.3−3.7\n2.8−3.2\n FIGURE  B.6 Sampling Distribution of Mean for Spinning wheel Trials \n T o illustrate the central limit theorem, consider the probability distribution for the number that \nturns up when spinning a wheel numbered 1 through 10. The probability distribution for this ran-\ndom variable is depicted in Figure B .5 . Assuming an honest wheel, each number has an equal 0.10 \nprobability of turning up. This illustration is obviously well removed from a normal probability \n611\nA REvIEw OF ELEMENTARy STATISTIcS\ndistribution. Table B.3 summarizes the means of 30 samples of 10 spins each. 10 These samples are \ngrouped by class in Figure B.6. Note the sample means roughly approximate a normal distribution, \neven though the parent population bears no resemblance to a normal distribution. Our sample size of \n10 was fairly small. If a larger sample size had been used, the approximation of a normal distribution \nwould have been better.\n10 These numbers were constructed using a random numbers table, an approach precisely equivalent to the \nexample given.\nTABle B.3 30 Samples on Spinning Wheel (N = 10)\nSample number numbers on Wheel (10 spins) Mean ()X\n1 8 10 5 6 6 2 4 6 8 10 6.5\n2 5 7 1 1 4 3 8 9 5 3 4.5\n3 8 5 4 10 7 5 5 4", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 201}
{"text": ". If a larger sample size had been used, the approximation of a normal distribution \nwould have been better.\n10 These numbers were constructed using a random numbers table, an approach precisely equivalent to the \nexample given.\nTABle B.3 30 Samples on Spinning Wheel (N = 10)\nSample number numbers on Wheel (10 spins) Mean ()X\n1 8 10 5 6 6 2 4 6 8 10 6.5\n2 5 7 1 1 4 3 8 9 5 3 4.5\n3 8 5 4 10 7 5 5 4 10 10 6.8\n4 3 1 8 5 7 1 6 5 9 10 5.5\n5 1 9 10 9 3 2 6 5 2 10 5.7\n6 9 1 6 2 1 3 5 7 3 1 3.8\n7 4 6 6 10 8 4 4 9 5 2 5.8\n8 4 10 10 2 4 5 6 3 8 1 5.3\n9 8 7 8 10 6 6 10 3 1 9 6.8\n10 7 4 9 8 6 9 7 6 8 10 7.4\n11 7 9 2 10 3 7 10 5 10 9 7.2\n12 6 4 1 3 8 8 1 1 10 7 4.9\n13 5 7 2 7 9 6 4 8 8 9 6.5\n14 1 2 6 10 3 5 10 9 1 4 5.1\n15 7 4 10 6 8 2 4 5 4 3 5.3\n16 5 3 1 10 3 10 7 4 7 5 5.5\n17 6 2 4 8 8 5 8 5 4 8 5.8\n18 6 3 9 2 4 9 9 6 1 10 5.9\n19 2 5 3 6 9 3 4 6 6 9 5.3\n20 6 2 1 8 6 1 5 2 9 7 4.7\n21 4 4 5 7 8 7 5 10 8 6 6.4\n22 2 9 10 6 9 1 4 5 3 5 5.4\n23 5 4 7 1 10 1 4 7 3 3 4.5\n24 9 4 5 2 6 9 6 4 2 2 4.9\n25 4 5 8 5 7 6 8 5 9 7 6.4\n26 8 2 1 2 8 6 8 7 1 6 4.9\n27 7 8 7 6 6 5 1 7 9 6 6.2\n28 9 7 7 5 9 4 3 3 2 1 4.9\n29 2 3 5 7 9 1 6 1 8 9 5.1\n30 4 3 2 9 2 1 8 4 1 6 4.0\n612\nAppendix B\nBefore moving on, bear in mind the examples involving repeated samplings were intended only \nas illustrations to elucidate the concepts of sampling distributions and the central limit theorem. \nIn practice, however, we would always select only a single sample. Accuracy could be improved by \nsimply increasing the size of this single sample.\n ■ Standard Error of the Mean\nThe standard deviation of sample means is usually smaller than the standard deviation of any given \nsample. The standard deviation of sample means is called the standard error of the mean and is repre-\nsented by the symbol: \nσX. (Standard error is a frequently used statistical term and can be interpreted \nas the standard deviation of the sampling distribution of the given statistic. In this case, the given \nstatistic is the mean. Other types of standard error related to regression analysis are considered in \nAppendix \nc.) Given a distribution with a standard deviation σ, it can be proved that a random sample \nof size n has the following standard error of the mean:11\nσ σ\nx\nn\n=\nOf course, we usually will not know the value of σ and will have to use s as an unbiased estimate of \nσ. (Recall that the two are very similar for all but very small samples.) Thus, in practice we would use\nσx\ns\nn\n=\nFor example, if the standard deviation of the sample (s) is 20 and the sample size is 25, then σx \nwould equal 4. The larger the sample, the smaller σx . However, note that the accuracy of the sample \nincreases much more slowly than the sample size. For instance, a 25-fold increase in the sample size \nwould reduce \nσx only by a factor of 5.\n ■ Confidence Intervals\nRecall that assuming a data set is normally distributed, the probability of an observation falling within \na given range can be determined from Table B.2. For example, the ±Z values that include 95 percent \nof observations are ±1.96, since 2.5 percent of the distribution lies above +1.96 and 2.5 percent \nbelow −1.96. (Table B.2 indicates that .4750 of the area lies between Z = 0 and Z = +1.96; so, given \n11 This formula applies to infinite populations or samples in which the sample size is relatively small compared \nwith the population. Although we will not be concerned with such cases, the precise formula when the sample \nsize represents a significant percent of the population is\n(/ )( )/()σ nN nN−− 1\nwhere n = sample size and N = population size.\n613\nA REvIEw OF ELEMENTARy STATISTIcS\nthe symmetry of the normal distribution, 95 percent of observations could be expected to fall within \nthe range of −1.96 to +1.96.)\nThe formula for the Z value was formerly stated as\nZ XX= −\nσ\nIn the case of a distribution of sample means (which the central limit theorem assures us will \napproximate a normal distribution), we have\nZ X\nx\n= −µ\nσ\nwhere X = sample mean\nm = population mean\nσx = standard error of the mean (i.e., the standard deviation of sample means)\nFrom the previous section, we know that σx can be approximated by sn . Thus,\nZ X\nsn\n= −µ\nor\nµ= −⋅XZ s\nn\nIf we were interested in the area that enclosed 95 percent of sample means, Z = ±1.96, the previ-\nous formula could be expressed as\nµ\nµ\n=±\n−⋅ << +⋅\nX s\nn\nX s\nn\nX s\nn\n19 6\n19 61 96\n.\n..\nThis calculation can be interpreted as follows. In repeated samplings the true population mean \ncould be expected to lie between Xs n−⋅19 6 . and Xs n+⋅19 6 . 95 percent of the time. \nSuch a range is called a confidence interval.\nThe confidence interval can be used to test hypotheses about the population mean.12 The standard \napproach involves testing the null hypothesis, which states there is no difference between the sample \nmean and the hypothesized population mean. Typically, we want to reject the null hypothesis, or, \nequivalently, demonstrate the sample mean is different from the hypothesized population mean at \n12 This discussion refers to population and sample means. However, it applies more generally to any sample \nstatistic used to test an hypothesis about the population parameter.\n614\nAppendix B\nsome specified level of significance. The most commonly used level of significance is 0.05 (5 percent), \nwhich means that the sample mean lies outside the 95 percent confidence interval of the hypothesized \npopulation mean.\n13 A statistical rejection of the null hypothesis demonstrates, with a probability at \nthe stated level, that the sample could not have been drawn from a parent population with the hypoth-\nesized mean.\nSometimes, however, it is more critical to minimize the chance of rejecting the null hypothesis \nwhen in fact it is true (i.e., accepting that the sample mean is statistically different from the hypoth-\nesized population mean when it is not).\n14 In such a case we might use a 0.01 level of significance. Of \ncourse, there is a tradeoff, because the lower the value for the level of significan", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 202}
{"text": "d mean.\nSometimes, however, it is more critical to minimize the chance of rejecting the null hypothesis \nwhen in fact it is true (i.e., accepting that the sample mean is statistically different from the hypoth-\nesized population mean when it is not).\n14 In such a case we might use a 0.01 level of significance. Of \ncourse, there is a tradeoff, because the lower the value for the level of significance (the more stringent \nthe test), the wider (less specific) the confidence interval.\n ■ The t-Test\nThe Z-test is appropriate when the sampling distribution is normal, a condition that can be assumed \ntrue when the sample size is large. 15 However, for small samples the sampling distribution is better \napproximated by the t-distribution, and hence the t-test is more accurate. The t distribution is very \nsimilar to the normal distribution for all but very small samples. As the sample size increases, the nor-\nmal and t distributions become increasingly similar. For example, at a 0.05 level of significance for a \none-tailed test, the t value is 10 percent greater than the Z value for a sample of 10, 3 percent greater \nfor a sample of 30, and 1 percent greater for a sample of 100. For an infinite sample, the normal and \nt distributions will be identical.\nSimilar to the standardized normal distribution, the t distribution is symmetrical, with a mean \nequal to zero and a standard deviation equal to 1. The formula for the t value of a sample statistic (e.g., \nmean) is totally analogous to the Z value:\nt X\nsn\n= −µ\n13 This statement assumes that there is no a priori reason for assuming a value above or below the hypothesized \nmean. Such a situation is referred to as a two-tailed test. If, however, there is reason to believe that the sample \nmean would be above the null hypothesis population mean, the relevant question would be whether the \nsample mean was significantly higher than the population mean, not whether it was significantly different from \nthe population mean. Such a situation is called a one-tailed test. The 0.05 significance level for a one-tailed test \nwould correspond to the probability that a value was outside the 90 percent confidence interval. The distinc-\ntion between one-tailed and two-tailed tests is discussed in greater detail in subsequent sections.\n14 An incorrect decision of this type is called a type 1 error. The probability of making a type 1 error is indicated by \nthe level of significance. Accepting the null hypothesis when it is false is called a type 2 error. It should be stressed \nthat the acceptance of the null hypothesis does not prove it is true, but only indicates that the null hypothesis \ncould not be rejected at the stated level of significance. Thus, the acceptance of the null hypothesis does not \nprove that the sample was drawn from a population with the hypothesized mean, but rather that the sample and \nhypothesized population means are not statistically different at the specified level of significance.\n15 The meaning of large depends on the distribution of the underlying population. Roughly speaking, 30 is usually \nsufficiently large.\n615\nA REvIEw OF ELEMENTARy STATISTIcS\nThe t-test uses the t distribution for probability testing and is entirely analogous to the Z-test.16\nThe specific t distribution will depend on the degrees of freedom (df )—the number of observations \n(sample size) minus the number of constraints. For example, in tests of the sampling distribution of \nthe mean, df = n − 1. There is one constraint, since given the mean, only n − 1 terms can be freely \nassigned. T o see this, assume we have 10 observations with a mean of 50. If the sum of the first nine \nitems equals 400, the value of the last term must be 100. Thus we say there are only n − 1 df. In a two-\nvariable regression line, there are two parameters: a and b. Once these are fixed, only n − 2 terms \ncan be assigned freely. Thus, t-tests of regression coefficients in the two-variable model are based on \nn − 2 degrees of freedom.\nThe application of the t-test is almost totally analogous to the Z-test. The only difference between \nthe two is that the specific value used in the t-test depends on the degrees of freedom. Table B.4 \nprovides a list of t values. The appropriate row is determined by the number of degrees of freedom, \nand the column by the desired level of significance in testing. Given the great similarity between the \nZ-test and the t-test, it would probably be redundant to provide a detailed description of the use of \nTable B.4. However, to check that you understand how to use this table, try the following questions:\n 1. If you are testing the hypothesis that the population mean is not significantly greater than the null \nhypothesis, what value must t exceed to reject this hypothesis at a 0.05 level of significance (i.e., \nto conclude that the true population mean is significantly greater than the null hypothesis)? The \nsample size is 20.\n 2. If you are testing the hypothesis that the population mean is not significantly different from the \nnull hypothesis, what value must t exceed in order to reject this hypothesis at the 0.05 level of \nsignificance (i.e., to conclude that the true population mean is significantly different from the \nnull hypothesis)? Once again, the sample size is 20.\n 3. a. Given a four-unit sample with a mean equal to 40 and a standard deviation equal to 10, what \nis the 95 percent confidence interval for the population mean?\nb.\n Now try it for a sample size equal to 30.\nAnswers\n 1. 1.729. For df = 19, Table B.4 indicates that there is only a 5 percent probability that this level \nwill be exceeded. This type of test is called a one-tailed test.\n 2. 2.093. A 5 percent probability of being significantly different from the null hypothesis is equiva-\nlent to determining the t values that will define the boundaries for the upper and lower 2.5 per-\ncent of the distribution. This is an example of a two-tailed test.\n16 The astute reader may well wonder why we bother d", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 203}
{"text": "t this level \nwill be exceeded. This type of test is called a one-tailed test.\n 2. 2.093. A 5 percent probability of being significantly different from the null hypothesis is equiva-\nlent to determining the t values that will define the boundaries for the upper and lower 2.5 per-\ncent of the distribution. This is an example of a two-tailed test.\n16 The astute reader may well wonder why we bother describing the Z-test in the first place, since the t-test would \nbe more accurate for samples. The reason is that the mathematics underlying the t distribution assume that the \npopulation of the data series is normally distributed. This is a much stronger assumption than was necessary for \nthe application of the Z-test, which only required that the sampling distribution be normal—a condition that \nthe central limit theorem guaranteed would be approximately fulfilled for a sufficiently large sample. Thus, the \nZ-test provides the justification for probability testing of non-normally distributed populations. This is a critical \nfact, since the assumption of a normally distributed population is often not warranted.\n616\nAppendix B\nTABle B.4 Student’s t distribution\nThe first column lists the number of degrees of freedom (k). The headings of the other columns give probabilities (P) for t to \nexceed the entry value. Use symmetry for negative t values.\np\ndf .10 .05 .025 .01 .005\n1 3.078 6.314 12.706 31.821 63.657\n2 1.886 2.920 4.303 6.965 9.925\n3 1.638 2.353 3.182 4.541 5.841\n4 1.533 2.132 2.776 3.747 4.604\n5 1.476 2.015 2.571 3.365 4.032\n6 1.440 1.943 2.447 3.143 3.707\n7 1.415 1.895 2.365 2.998 3.499\n8 1.397 1.860 2.306 2.896 3.355\n9 1.383 1.833 2.262 2.821 3.250\n10 1.372 1.812 2.228 2.764 3.169\n11 1.363 1.796 2.201 2.718 3.106\n12 1.356 1.782 2.179 2.681 3.055\n13 1.350 1.771 2.160 2.650 3.012\n14 1.345 1.761 2.145 2.624 2.977\n15 1.341 1.753 2.131 2.602 2.947\n16 1.337 1.746 2.120 2.583 2.921\n17 1.333 1.740 2.110 2.567 2.898\n18 1.330 1.734 2.101 2.552 2.878\n19 1.328 1.729 2.093 2.539 2.861\n20 1.325 1.725 2.086 2.528 2.845\n21 1.323 1.721 2.080 2.518 2.831\n22 1.321 1.717 2.074 2.508 2.819\n23 1.319 1.714 2.069 2.500 2.807\n24 1.318 1.711 2.064 2.492 2.797\n25 1.316 1.708 2.060 2.485 2.787\n26 1.315 1.706 2.056 2.479 2.779\n27 1.314 1.703 2.052 2.473 2.771\n28 1.313 1.701 2.048 2.467 2.763\n29 1.311 1.699 2.045 2.462 2.756\n30 1.310 1.697 2.042 2.457 2.750\n40 1.303 1.684 2.021 2.423 2.704\n60 1.296 1.671 2.000 2.390 2.660\n120 1.289 1.658 1.980 2.358 2.617\n∞ 1.282 1.645 1.960 2.326 2.576\nSource: Donald J. Koosis, Business Statistics (New york, Ny: John wiley & Sons, 1997). copyright © 1997 by John wiley & Sons; reprinted by \npermission.\n617\nA REvIEw OF ELEMENTARy STATISTIcS\n 3. a. Xt s\nn\nXt s\nn\n⋅⋅ << +⋅µ\n40 3 182 10\n4\n40 31 82 10\n4\n−⋅ << +⋅.. µ\n24.09 < μ < 55.91\nb. 40 2 045 10\n30\n40 20 45 10\n30\n−⋅ << +⋅.. µ\n36.27 < μ < 43.73\nNote how dramatically the larger sample size increases the precision of the estimated confidence \ninterval at the same probability level.\nThe choice of whether to employ a one-tailed or two-tailed test is not always clear-cut. Normally, \na two-tailed test is used when we do not have any preconceived conclusion about the sample. In this \ncase, the probability test for significance must allow for variation in either direction of the statistic \nbeing estimated (e.g., population mean). However, sometimes there are strong reasons to believe the \nsample statistic will be above or below the hypothesized population value—the only question being \nwhether the difference will be significant. This type of situation will often apply in testing the signifi-\ncance of regression coefficients, as will be detailed in Appendix \nc.\nIt is finally time to return to our beleaguered day trader. we now see the solution to Fred’s \ndilemma is fairly straightforward. you might wish to return to the section, “Sampling Distribution,” to \ntry to determine the correct decision before reading on.\nGiven the previously stated assumptions, the confidence interval for the expected net profit per \ntrade would be\n$. $ $. $85 16 99 100\n30\n−⋅ << ⋅expected net pro fit per trad e8 5+16 99 1100\n30\n53 98$. $.<<expected net pro fit per trad e1 16 02\nThus, it is not possible to say that there is a 95 percent probability the expected net profit per \ntrade is greater than $60.\nA few comments are in order. First, a one-tailed test is used because Fred is only concerned about \ntesting the statistical significance of the expected net profit per trade being greater than $60 rather than \nthe statistical significance of it being different from $60. Second, it should be stressed the confidence \ninterval merely failed to demonstrate with a 95 percent or higher probability that the population \nexpected net profit per trade was more than $60; it in no way proved that this figure was less than \n$60. Such a proof would have required a sample mean of $28.97 (or less), which would have implied \na confidence interval of −$2.05 to $59.99. Third, if Fred had chosen a less-restrictive probability \nrequirement, such as 90 percent, the confidence interval would have been\n$. $ $. $85 13 11 100\n30\n85 13 11−⋅ << +⋅expected net profit per trad e 1100\n30\n61 06 1089 4$. $.<<expected net profit per trad e\nimplying the opposite decision.\n618\nAppendix B\nThe arbitrariness of the preceding example might seem unsettling. However, it should be empha-\nsized the tester is free to choose the criterion that is deemed most important. If Fred is very con-\ncerned about continuing to trade when in fact such a decision would be unwarranted by the true \npopulation expected net profit per trade (type 1 error), he would choose a low (restrictive) value for \nthe level of significance for testing. If he was less concerned about this type of error, he would use a \nhigher value for the level of significance. In fact, if Fred’s primary concern was to avoid terminating \nhis trading when the true expected net profit per trade was actually more than $60, he might continue \nto trade even if the sa", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 204}
{"text": "(type 1 error), he would choose a low (restrictive) value for \nthe level of significance for testing. If he was less concerned about this type of error, he would use a \nhigher value for the level of significance. In fact, if Fred’s primary concern was to avoid terminating \nhis trading when the true expected net profit per trade was actually more than $60, he might continue \nto trade even if the sample mean was less than $60, constructing a confidence interval to test whether \nthe sample mean was significantly below the hypothesized $60 population mean.\n619\nChecking the \nSignificance of the \nRegression Equation\nAppendix C \nFactual evidence can never “prove” a hypothesis; it can only fail to disprove it, which is what \nwe generally mean when we say, somewhat inexactly, that the hypothesis is “confirmed” by \nexperience.\n—Milton Friedman\n ■ The Population Regression Line\nIn Appendix A we discussed the derivation of a regression line on the basis of empirical data. While it \nwas premature to raise the subject then, the fitted line provided by the regression formula is actually \na sample of the true population line, which is not known. For example, the regression line relating \nhog slaughter to the pig crop was a sample of the true relationship between the two variables. The \nfitted line is a sample because it represents only one realization of an entire series of possible regres-\nsion lines. The actual regression line realized will depend on measurement error in the data and the \nunknown influence of variables not included in the model.\nThe population or true regression model can be expressed as\nYa Xeii =+ + β\nwhere e is a randomly distributed error or disturbance term.\n620\nAppendix C\nEven if we knew the true population regression line, the actual observed values Yi would still \ndeviate from the predicted level by an amount equal to the error term e. The key reason for this is \nthat a regression equation is a highly simplified model for the behavior of the dependent variable. In \nreality, the number of hogs slaughtered will depend on many more variables than just the pig crop—\nfor example, the distribution of pigs born during the period, weather conditions, feed prices, and hog \nprices. Although the magnitude of the disturbance term can be reduced by including other relevant \nvariables in the regression model (this anticipates multiple regression, discussed in Appendix D), it is \nimpossible to introduce enough variables to eliminate these deviations completely.\n1\nIn addition, even if all relevant variables were included in the model, observations would still \ndeviate from the regression line due to measurement errors. This is not a trivial consideration, since \ndata items that can be precisely measured (e.g., temperature) are by far the exception. Most data can \nonly be estimated from samples (e.g., pig crop, hog slaughter).\n ■ Basic Assumptions of Regression Analysis\nAppendix A explained that a basic assumption of regression analysis is that the relationship between \nthe dependent variable Y and the independent variable X is linear. Several other key assumptions are \nrelated to the error terms:\n 1. The mean value of the error terms equals zero.\n 2. The error terms have a constant variance equal to σ2.\n 3. The error terms are independent random variables. This assumption has two important implications:\na.\n The error terms are uncorrelated.\nb. The error terms and the independent variable X are uncorrelated.\n 4. The error terms are normally distributed.\nThese assumptions underlie the various tests used to assess a regression model’s reliability.\n ■ Testing the Significance of the Regression Coefficients\nThe empirically derived values of a and b will not equal the population values of α and β except by \nchance (Figure C.1). It can be shown, however, that a is an unbiased estimate of α and b is an unbiased \nestimator of β.\n2 Actually, it can be demonstrated that a and b are not only unbiased estimators, but \n1 Even if all such variables were known and could be precisely determined—two extraordinarily unlikely \nassumptions—the regression computation would still limit the number of variables that could be introduced, \nsince each additional variable would reduce the degrees of freedom by 1. The significance of the regression \nequation is reduced as the degrees of freedom decline, and the equation becomes totally trivial when the number \nof variables is equal to the number of observations.\n2 An unbiased estimator is one that on the average will equal the population parameter. In other words, the mean \nof the sampling distribution for an unbiased estimator will be equal to the population parameter value.\n621\nCHECKING THE SIGNIFICANCE OF THE REGRESSION EQUATION\nthat they are the “best linear unbiased estimators” (BLUE). This means that a and b will have the low-\nest variance (i.e., are the most “effi cient”) among all possible unbiased linear estimators of α and β. \n Although b provides an unbiased point estimate for the population regression coeffi cient β , we \nwould like to know the variability of this estimate. In other words, we are interested in the standard \nerror of b . Recall from Appendix B that the standard error is the standard deviation of a sampling \ndistribution of a statistic. In this case, the relevant statistic is the regression coeffi cient b . \n A diagram can help clarify this point. Figure C.2 shows a distribution with a mean equal to β —the \npopulation regression coeffi cient. Figure C.2 illustrates the distribution that will be formed by the \nestimated values of b if an infi nite number of samples were drawn. In other words, Figure C.2 is a \nsampling distribution of b . The standard deviation of this distribution is called the standard error of b . \n In Appendix B we indicated that the t value for a sample mean could be expressed as\nt X\nsn\n= −µ\n FIGURE  C.1 Fitted vs. True Regression Line \nY = a + bX (fitted regression line)\nY = /uni03B1 + /uni03B2X (unknown true regression line)", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 205}
{"text": "of samples were drawn. In other words, Figure C.2 is a \nsampling distribution of b . The standard deviation of this distribution is called the standard error of b . \n In Appendix B we indicated that the t value for a sample mean could be expressed as\nt X\nsn\n= −µ\n FIGURE  C.1 Fitted vs. True Regression Line \nY = a + bX (fitted regression line)\nY = /uni03B1 + /uni03B2X (unknown true regression line)\nY\nX\n FIGURE  C.2 Sampling Distribution of Regression Coeffi cient \nProbability of b\nE(b) = /uni03B2\nb\n622\nAppendix C\nThe only difference now is that we are trying to make judgments about the population regression \ncoefficient β from the sample coefficient b, rather than making decisions about the population mean \nμ from the sample mean X. In general terms, the t value could be expressed as\nt = −sample statistic populati on paramete r\nstandard error se(. ..) of sample st atisti c\nIn other words, in all applications, the t values indicate the number of standard deviations between \nthe sample statistic and the hypothesized population parameter. A large t value (approximately 2 or \nmore) will indicate there is only a small probability the hypothesized population parameter could \nbe correct. The higher the t value, the less likely the sample came from a parent population with the \nhypothesized parameter value. In the case of the regression coefficient, the preceding general formula \nfor the t value could be expressed as follows\n3:\nt b\nb= −β\nse.. ()\nFrequently, we will be interested in testing the hypothesis that β = 0. The reason? In the absence \nof any information, the best estimate for a variable is the mean, or equivalently, the regression line\nYa bX=+\nwhere aY=\nb = 0\nIf, however, the independent variable has some explanatory power, then a regression line with \na nonzero slope would offer a better fit to the observations (Y i). Thus, a key question to be con-\nsidered in any regression analysis is whether the regression coefficient b is significantly different \nfrom zero.\nIn order to answer this question, we test the assumption that the population regression coefficient \nβ = 0. In this case the t value reduces to\nt b\nb= se.. ()\nThus, the t value is the regression coefficient divided by the standard error of the regression coef-\nficient. In other words, the t value indicates how many standard deviations the regression coefficient \nis from the population coefficient if our hypothesis that β = 0 were true. If the t value is high (e.g., an \n3 Strictly speaking, the distribution of b is not generally normal except in the limit of a large number of observa-\ntions. Although this implies that the use of the t distribution for calculating confidence intervals is imprecise, \nfrom a practical standpoint, the t distribution will yield satisfactory results because the exact boundaries of the \nconfidence interval are not critically dependent on the actual distribution of b.\n623\nCHECKING THE SIGNIFICANCE OF THE REGRESSION EQUATION\nabsolute value approximately greater than 2.0),4 it suggests that the population regression coefficient \nis not equal to zero.\nIn order to apply the preceding formula, we need to know the value of s.e.(b). Given the previously \ndetailed assumptions of regression analysis, it can be demonstrated that\nse.. ()b s\nXXi\ni\nn=\n−()\n=\n∑\n2\n2\n1\nwhere s2 is an unbiased estimator of the population variance σ2. (σ2 is the variance of the error \nterms, or equivalently, the variance of the observations from the unknown population regression \nline.5) Since the true regression line is not known, σ 2 must be estimated. It can be proved that s 2 is \nan unbiased estimator of σ2 where6\ns\nYY\nn\nYa bX\nn\nii\ni\nn\nii\ni\nn\n2\n2\n1\n2\n1\n22=\n−()\n− =\n−+()\n−\n==\n∑∑ ˆ\nwhere Yi = the individual observations\nˆYi = fitted values (i.e., values implied by regression line) at Xi (the values of the independent \nvariable corresponding to the observations Yi)\nAssuming that we are testing the hypothesis b = 0, we can now express the regression coefficient \nt value:\nt b\nb\nb\ns\nXX\nb\nXX\nYY\nn\ni\ni\nn\ni\ni\nn\nii\ni\nn\n==\n−()\n=\n−()\n−()\n−=\n=\n=∑\n∑\n∑\nse.. () ()\n2\n1\n2\n1\n2\n1\n2\nˆ\n4 For example, if there are 5 degrees of freedom, a t value of 2.0 would imply that a coefficient at least as much \ngreater than 0 than the one measured would occur only 5 percent of the time, if the true population regression \ncoefficient were equal to 0 (Table B.4). If there are 60 degrees of freedom, such an event would occur only 2.5 \npercent of the time. These figures assume that a one-tailed test is employed. (See discussion at end of this section.)\n5 Note that error terms refer to the differences between the observed values (Yi) and the true population regres-\nsion line (not the fitted regression line). T erminology note: The term error or disturbance describes the difference \nbetween an observation and the true population regression line (which is usually not known), while the term \nresidual or deviation refers to the difference between an observation and the fitted regression line. This theoretical \ndistinction is obscured by the rather commonplace use of error terms to refer to the residuals (the deviations \nbetween the observations and the fitted regression line).\n6 The reason for dividing by n − 2 is that 2 degrees of freedom are lost because of the constraints imposed by \nfitting a and b. In other words, for any given set of values for a and b, once n − 2 observations are specified, the \nremaining 2 observations can no longer be freely assigned. In general, the number of degrees of freedom will \nequal the number of observations minus the total number of parameters (see footnote 2 in Appendix A).\n624APPENDIX C\n Note the following three facts: \n 1. The sign of the t value will depend upon the regression coeffi cient. If X and Y are inversely corre-\nlated, the regression coeffi cient and t will be negative. The sign of the t value is insignifi cant. W e are \nonly concerned with the absolute value of t in testing the signifi cance of the regression coeffi cient b. \n 2.", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 206}
{"text": "note 2 in Appendix A).\n624APPENDIX C\n Note the following three facts: \n 1. The sign of the t value will depend upon the regression coeffi cient. If X and Y are inversely corre-\nlated, the regression coeffi cient and t will be negative. The sign of the t value is insignifi cant. W e are \nonly concerned with the absolute value of t in testing the signifi cance of the regression coeffi cient b. \n 2. As seems intuitively desirable, the s term in the previous equation will ensure that the t value \nwill decline as the sum of the squared deviations increases. \n 3. The narrower the range of X values for the observations, the lower the t value, since \n XXi\ni\nn\n−()\n=\n∑\n2\n1\n \nwill be smaller, hence the less reliable the regression coeffi cient estimate. This concept is illustrated \nin Figure C.3 . Note that when the observations correspond to a small range of the independent vari-\nable (Figure C.3 a), the infl uence of the deviations can easily swamp the eff ect of the slope, and the \nestimated regression line will not be very reliable. Conversely, when the observations correspond \nto a wide range of X values (Figure C.3 b) the estimated regression line will be far more reliable. \n FIGURE  C.3 Eff ect of Range of X t on Reliability of the Regression Coeffi cient\n Source: T . H. W onnacott and R. J. W onnacott. Econometrics, John Wiley & Sons, New Y ork, 1980. \nCopyright © 1980 by John Wiley & Sons; reprinted by permission. \nY = a + bX\n(estimated regression)\n(b)\nY = /uni03B1 + /uni03B2X\n(unknown true regression)Y\nX\nY = a + bX\n(estimated regression)\n(a)\nY = /uni03B1 + /uni03B2X\n(unknown true regression)\nY\nX\n625\nCHECKING THE SIGNIFICANCE OF THE REGRESSION EQUATION\nIn testing the significance of the regression coefficient b, it is often more appropriate to use a one-\ntailed test. The reason for this is that the direction of the relationship between the dependent and \nexplanatory variable(s) is usually known a priori. In such cases it is more relevant to test whether \nthe coefficient value is significantly greater than or less than zero rather than whether it is significantly \ndifferent from zero. For example, we know that a larger pig crop will result in higher hog slaughter. \nThe only relevant question is if the relationship is statistically significant. Thus, the appropriate ques-\ntion is not whether b is significantly different from zero, but whether it is significantly greater than \nzero, since we do not entertain the possibility that a larger pig crop will result in lower hog slaughter. \nIf, however, we wanted to test whether there was a relationship between the dependent variable and \nthe independent variable, without any bias about the direction of the relationship, a two-tailed test \nwould be used.\nThe t-test can also be applied to the constant or intercept term, a. In this case, the t value to test \nthe hypothesis that the population regression line intercept is equal to zero would be\nt a\na\na\ns n\nX\nXXi\ni\nn\n==\n+\n−()\n=\n∑\nse.. () 1 2\n2\n1\nIn practice, there is usually little reason to be overly concerned about the significance of the con-\nstant term, and t-tests of the constant term can be omitted without any great loss.\nAs an example of how the t-test might be applied, consider the regression equation\nY =−1 1094 6 8276.. X\nderived in Appendix A. Table C.1 illustrates how to compute the t value for the regression coef-\nficient b. Although it will not be necessary to compute the t value in practice, since the availability \nof a standard computer regression program is presumed, it is important to have a feel for the com-\nputations that underlie the key regression statistics. Checking the t value derived in Table C.1, we \nfind that it far exceeds 1.734—the t value at a 0.05 level of significance for a one-tailed test with \n18df (see Table B.4). W e conclude the December–May pig crop is indeed significant in explaining \nthe June–November slaughter.\nThe conclusion that the regression coefficient in the previous example is statistically significant \nmight seem somewhat trivial. After all, the same conclusion would seem to be intuitively obvious by \nexamining the scatter chart for the observations (see Figure A.4). In fact, as a generalization, unless \none demonstrates an extraordinarily poor sense of intuition in choosing the independent variable \nin a simple regression, that is, a regression equation with only one explanatory variable, the t-test will \nusually prove significant. However, the t-test becomes critically important in evaluating a multiple \nregression model—a regression equation with two or more explanatory variables. In this case, a simple \ngraphic depiction of the regression fit is no longer possible, and the significance of additional variables \nis often not intuitively apparent. The t-test is one of the most important statistical tests in regression \nanalysis and will be considered further in the multiple regression case.\n626\nAppendix C\nFitted regression line (from Table A.1): Y = –3.6279 + 1.0615X\nt b\nb\nbX X\nYY\nn\ni\ni\nn\nii\ni\nn\n==\n⋅− ()\n−()\n−\n==\n=\n∑\n∑\nse.. ()\n..\n2\n1\n2\n1\n2\n1 06152 07 073\n24ˆ . .\n.\n311\n18\n13 144=\n(b) Computing r2\nNote: Ignore this section of the table until reaching the appropriate section later in this appendix.\nr\nYY\nYY\nii\ni\nn\ni\ni\nn\n2\n2\n1\n2\n1\n11 24 311\n2576 3 09 056=−\n−()\n−()\n=− ==\n=\n∑\n∑\nˆ\n.\n. .\nTAble C.1 (a) Computing the t-Value for the Regression Coefficient \nY ear\nJun–nov Hog \nSlaughter Yi\ndec–May pig \nCrop Xi XXi − () 2XXi −\nFitted \nValue \nˆYi\nResidual \nYYii − ˆ () 2YYii − ˆ YYi − ()YYi − ˆ\n1995 50.077 48.2936 –2.726 7.429 49.529 –1.235 1.526 –4.128 17.037\n1996 47.888 45.4527 –4.915 24.154 47.205 –1.753 3.071 –6.968 48.559\n1997 48.394 46.2009 –4.409 19.437 47.742 –1.541 2.376 –6.220 38.692\n1998 52.469 50.9291 –0.334 0.111 52.068 –1.139 1.297 –1.492 2.226\n1999 51.519 51.1112 –1.284 1.648 51.060 0.052 0.003 –1.310 1.716\n2000 50.087 49.6888 –2.716 7.375 49.539 0.149 0.022 –2.732 7.466\n2001 49.472 49.1693 –3.331 11.094 48.887 0.283 0.080 –3.252 10.575\n2002 50.858 50.7086", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 207}
{"text": "7 –4.915 24.154 47.205 –1.753 3.071 –6.968 48.559\n1997 48.394 46.2009 –4.409 19.437 47.742 –1.541 2.376 –6.220 38.692\n1998 52.469 50.9291 –0.334 0.111 52.068 –1.139 1.297 –1.492 2.226\n1999 51.519 51.1112 –1.284 1.648 51.060 0.052 0.003 –1.310 1.716\n2000 50.087 49.6888 –2.716 7.375 49.539 0.149 0.022 –2.732 7.466\n2001 49.472 49.1693 –3.331 11.094 48.887 0.283 0.080 –3.252 10.575\n2002 50.858 50.7086 –1.945 3.782 50.358 0.351 0.123 –1.713 2.933\n2003 50.029 50.7581 –2.774 7.693 49.478 1.280 1.639 –1.663 2.766\n2004 50.737 52.2648 –2.066 4.267 50.229 2.035 4.143 –0.156 0.024\n2005 51.33 52.3326 –1.473 2.169 50.859 1.474 2.172 –0.089 0.008\n2006 52.242 53.1504 –0.561 0.314 51.827 1.323 1.751 0.729 0.532\n2007 54.266 55.5693 1.463 2.141 53.975 1.594 2.540 3.148 9.911\n2008 57.019 57.6483 4.216 17.777 56.898 0.751 0.563 5.227 27.323\n2009 57.564 57.3914 4.761 22.670 57.476 –0.085 0.007 4.970 24.703\n2010 56.326 55.6805 3.523 12.414 56.162 –0.482 0.232 3.259 10.623\n2011 57.118 56.2641 4.315 18.622 57.003 –0.739 0.546 3.843 14.768\n2012 57.818 57.4775 5.015 25.153 57.746 –0.268 0.072 5.056 25.567\n2013 57.02 55.9142 4.217 17.786 56.899 –0.985 0.969 3.493 12.201\n2014 53.821 52.4176 1.018 1.037 53.503 –1.085 1.178 –0.004 0.000\n∑Y\ni = 1,056.05 ∑X i = 1,048.42 ∑ (X i − X)2 = 207.073 ∑ (Yi − Yi)2 = 24.311 ∑ (Yi − Y)2 = 257.630\nY = 52.803 X = 52.421\n627\nCHECKING THE SIGNIFICANCE OF THE REGRESSION EQUATION\n ■ Standard Error of the Regression\nThe standard error of the regression (SER) is the standard deviation of the residuals, or equivalently, the \nstandard deviation of the observations from the fitted regression line:7\nSER =\n−()\n−\n=\n∑ YY\nn\nii\ni\nn\nˆ 2\n1\n2\nThis formula should look familiar. The SER was previously denoted by an s and appeared in the \ncalculation of the standard error of the regression coefficient, s.e.(b). The name standard error of the \nregression merely highlights the fact that this figure is a measure of dispersion for the entire equation. \nNote that the wider the scatter of points from the regression line, the larger the SER.\nIt should be emphasized that the SER can only be interpreted relative to the range of the dependent \nvariable. For example, in price-forecasting equations, an SER figure of 10¢ would be indicative of an \nexcellent fit if the given price series ranged between $6 and $12, and an extremely poor fit if the price \nrange were $0.30 to $0.60. For this reason, as long as the mean of the dependent variable \nY is greater \nthan the range between the high and low values, it may be useful to consider the percent (%SER) \nwhere\n8\n%SER SER= Y\nIn effect, the %SER is a dispersion measure normalized by the magnitude of the underlying data. \nWhen comparing different equations with the same dependent variable, over the same time interval, the \n%SER will yield the same conclusions as the SER, with the advantage of being stated in terms that are \nintuitively more meaningful.\n9\n ■ Confidence Interval for an Individual Forecast\nAssume that we used our regression equation to forecast a future value of the dependent variable \nY, given a specific value of the independent variable X. What forecast range would have a 95 per-\ncent probability of containing the true value of Y? (Implicit assumption: The estimated value for the \n7 The SER is also often referred to as the standard error of the estimate (SEE), or simply as the standard \nerror (SE).\n8 If Y is less than the range, the %SER could be very misleading. For example, if the dependent variable included \nvalues that were both positive and negative, its mean could be close to 0. In this case, the %SER could approach \ninfinity.\n9 Caution should be exercised in drawing any conclusions from comparisons that involve equations with different \ndependent variables, since the %SER would be sensitive to the dependent variable chosen. For an example of \nwhy this is undesirable, see the discussion in the section “Coefficient of Determination (r\n2).”\n628\nAppendix C\n independent variable is either known or precisely projected; that is, there is no forecast error involved \nin the X value.) In answering this question, we note that even if all the regression assumptions are \nfulfilled, there are three sources of potential error:\n 1. error of the mean. The true population regression line is unknown and is estimated from the \nobservations. The resulting fitted line passes through (, )XY , while the population line passes \nthrough (, )XY X , where in general, YX, the unknown population mean at X, will not equal the \nsample mean Y . As indicated in Figure C.4a, this type of error will result in all forecasts (i.e., \nprojections of Y for any value of X) being too high or low by the difference between the value \nof Y and YX. (Figure C.4a depicts the case of a positive error of the mean; a symmetric image \nwould apply for a negative error.)\n 2. error of the slope. There will also be some difference between the true regression coefficient \nβ and the fitted line slope b. Figure C.4b illustrates the combined effect of this source of error \nand the error of the mean for the forecasted value \nˆY f at X f . Note that the error of the slope \nwill be zero at X since the fitted regression must pass through (, )XY , but will increase steadily \nas X values are further removed from X. (The illustration in Figure C.4b depicts the case of a \npositive error of the mean and an estimated regression coefficient that is too high; a symmetric \nimage would apply for the reverse case.)\n 3. Random error. For reasons previously explained, even if the true population line were pre-\ncisely known, there would still be error terms. The confidence interval for the population line \nis illustrated in Figure C.4c. Note that the interval is independent of the value of X.\nThe forecast error for any individual prediction would reflect the combined effect of all three \nof the influences just discussed (Figure C.4d). The shape of the confidence interval depicted in \nFigure C.4d is a consequence of the fact tha", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 208}
{"text": "d still be error terms. The confidence interval for the population line \nis illustrated in Figure C.4c. Note that the interval is independent of the value of X.\nThe forecast error for any individual prediction would reflect the combined effect of all three \nof the influences just discussed (Figure C.4d). The shape of the confidence interval depicted in \nFigure C.4d is a consequence of the fact that, although the error of the mean and the random error \ncomponents will be equal for all values of X, the error of the slope increases for values further \nremoved from \nX. If the independent variable value for the forecast period is denoted by Xf, the stan-\ndard error for the forecasted value of Yf is given by\nse.. ()ˆYs n\nXX\nXX\nf\nf\ni\ni\nn=+ +\n−()\n−()\n=\n∑\n1 1\n2\n2\n1\nNote that when Xf, equals X, and n is large, this term reduces to approximately s—the standard \ndeviation of the residuals. (Once again, s is more commonly called the standard error of the regres-\nsion.) Also note that the further X\nf is from X, the larger the s.e. ()Y fˆ\nThe confidence interval for Yf would be\nˆ .. ( ˆ ) ˆ .. ( ˆ )Yt YY Yt Yff ff f−< <+ ⋅∑ se se\n629\nCHECKING THE SIGNIFICANCE OF THE REGRESSION EQUATION\nFitted regression line\nError of the mean\nUnknown population line\nY\n(a)\nXX\nX\nY\nYX\nFitted regression line\nError of the mean\nLine parallel to unknown population line\nUnknown\npopulation\nline\nY\n(b)\nXX\nY\nYf\nXf\n95% confidence interval\nif population line known\nPopulation line\nY\n(c)\nXXf\n95% confidence interval for\nindividual forecast at X = Xf\nY\n(d)\nXXf\nError of the\nslope\nFitted regression line\n95% confidence interval\nfor individual forecast at\nmean of X\n FIGURE  C.4 Confi dence Interval for an Individual Forecast \nwhere t = t value at the specifi ed level of signifi cance for the given number of degrees of freedom. At \nXX= , this interval would reduce to\nˆˆYt s n YY ts nff f−⋅ +< <+ ⋅+1 1 1 1\n630\nAppendix C\n ■ Extrapolation\nExtrapolation refers to predictions beyond the range of observations, that is, forecasts for Yf where Xf \nis greater than or less than any observed value Xi. As should be apparent from the preceding formula \nfor s.e. (Yf), predictions in the extrapolated range will be particularly subject to uncertainty, since s.e. \n( ˆY f ) increases as the X value moves farther away from X. However, there is an even more important \nreason why extrapolation-based forecasts should be viewed with great skepticism. Basically, it is never \nsafe to assume that the relationship between the dependent and independent variables exhibited in the \nobserved range would continue to hold in the extrapolated range. For example, consider a market in \nwhich there is a rough inverse linear relationship between price and the final stock/consumption ratio \nduring the observation period. This relationship would likely break down in a record shortage situa-\ntion, since prices frequently begin to rise at an accelerated rate once an expected shortage reaches a \ncritically low level.\nWhat should be done in the case in which the expected value for the explanatory variable falls \nbeyond the observed range? Many professional analysts faced with such a dilemma will apprehen-\nsively extrapolate and hope for the best (probably because of implicit pressure to provide forecasts, \nwhether the necessary data exists or not). Such hopes are often misplaced. This does not mean to \nimply that the analyst must resign herself to a yearlong hibernation before she ventures any market \nforecast—few firms are that enlightened. Rather, the intended point is that in such a situation, the \nanalyst must rely almost totally on her intuitive fundamental sense of the market and technical \nanalysis to generate forecasts, rather than naively continuing to use a formal fundamental model that \nis no longer relevant.\n ■ Coefficient of Determination (r2)\nIf the regression model were unavailable or, equivalently, if the independent variable were useless in \nexplaining the dependent variable Y, the best forecast for a value of Y would be its mean \nY . W e define \nthe difference between an individual observation and the mean, YYi − , as the total deviation. Now \nif X is of any use in explaining Y , the deviations between the observed points and the fitted regres-\nsion line should tend to be smaller than the total deviation. For any given observation Yi, the portion \nof the total deviation explained by the regression equation would equal the fitted value minus the \nmean, \nˆYYi − . The portion that remains unexplained will equal the observed value minus the fitted \nvalue YYii − ˆ . The relationship among the explained, unexplained, and total deviations is illustrated in \nFigure C.5. For any given observation, this relationship can be expressed as follows:\nTotal deviatio n= explained deviatio n+ unexplai ned devi ation\nfoor forf orYY Y\nYY YY YY\nii i\nii ii−() =− () −()+ˆˆ\nIf we are interested in deriving a relationship between total variation, a measure of the deviation of \nall points, and explained and unexplained variation, we cannot simply sum the terms, because opposite \n631\nCHECKING THE SIGNIFICANCE OF THE REGRESSION EQUATION\ndeviations will off set each other, yielding a tautological relationship. 10 Thus, we square both sides of \nthe equation before summing. This step is analogous to the approach used to get around the same \nproblem in trying to fi nd the best-fi t line:\n \nYY YY YY\nYY YY\ni\ni\nn\nii i\ni\nn\nii i\n−() =− () +−() \n\n=−\n() +− ()\n==\n∑∑\n2\n1\n2\n1\n22\nˆˆ\nˆˆ −−− () −()\n===\n∑∑∑ 2\n111\nYY YYii i\ni\nn\ni\nn\ni\nn\nˆˆ\n \n Given the previously stated assumption that the independent variable X and the error terms are \nuncorrelated, it can be algebraically demonstrated that\n20\n1\nYY YYii i\ni\nn\n−() −() =\n=\n∑\n 10 YY YY YY\nYY Y\ni\ni\nn\ni\ni\nn\nii\ni\nn\ni\ni\nn\ni\ni\nn\n−() =− () +− ()\n=− +\n== =\n==\n∑∑ ∑\n∑∑\n11 1\n11\nˆˆ\nˆ\n \n− −\n=− () =−\n=\n==\n==\n∑∑\n∑∑\nˆY\nYY Yn Y\ni\ni\nn\ni\nn\ni\ni\nn\ni\ni\nn\n11\n11\n00\n FIGURE  C.5 Explained, Unexplained, and T otal Deviation \nTotal deviation (Yi − Y)\nY = a + bXY\nX\nExplained deviation (Yi", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 209}
{"text": "he error terms are \nuncorrelated, it can be algebraically demonstrated that\n20\n1\nYY YYii i\ni\nn\n−() −() =\n=\n∑\n 10 YY YY YY\nYY Y\ni\ni\nn\ni\ni\nn\nii\ni\nn\ni\ni\nn\ni\ni\nn\n−() =− () +− ()\n=− +\n== =\n==\n∑∑ ∑\n∑∑\n11 1\n11\nˆˆ\nˆ\n \n− −\n=− () =−\n=\n==\n==\n∑∑\n∑∑\nˆY\nYY Yn Y\ni\ni\nn\ni\nn\ni\ni\nn\ni\ni\nn\n11\n11\n00\n FIGURE  C.5 Explained, Unexplained, and T otal Deviation \nTotal deviation (Yi − Y)\nY = a + bXY\nX\nExplained deviation (Yi − Y)\nUnexplained deviation\n(Yi − Yi)\nY = Y\n632\nAppendix C\nThus, we have\nTotal variatio ne xplai ned vari ation unexplai ned vari ation=+\nYii i\ni\nn\nii\ni\nn\ni\nn\nYY YY Y−() =− () +− ()\n===\n∑∑∑\n2 2\n1\n2\n11\nˆˆ\nwhere variation is defined as the sum of the squared deviations.\nDividing both sides by YYi\ni\nn\n−()\n=\n∑\n2\n1\n1\n1\n2\n1\n2\n1\n2\n1\n2\n1\n=\n−()\n−()\n+\n−()\n−()\n=\n=\n=\n=\n=\n∑\n∑\n∑\n∑\nˆˆYY\nYY\nYY\nYY\ni\ni\nn\ni\ni\nn\nii\ni\nn\ni\ni\nn\nexp plained vari ation\ntotal variatio n\nunexplai ned vari ation\ntot+ aal vari ation\nW e define r2 as the\nExplai ned vari ation\nTotal variatio n =\n−()\n−()\n=\n=\n∑ ˆYY\nYY\ni\ni\nn\ni\ni\n2\n1\n2\n1\nn n\n∑\nor equivalently,\nr\nYYii\ni\nn\n2\n2\n111=− =−\n−()\n=\n∑unexplai ned vari ation\ntotal variatio n\nˆ\nYYYi\ni\nn\n−()\n=\n∑\n2\n1\nThe second form is more convenient because the analysis of the regression equation focuses on the \nunexplained variation (residuals). Note that 0 ≤ r2 ≤ 1. If X does not explain any of the variation in Y, \nthen r2 = 0. If X explains all of the variation in Y (i.e., all the observations fall precisely on the fitted \nline), r2 = 1. The r2 calculation is an extremely useful summary statistic because of the significance of \nwhat it measures—the percentage of variation explained by the regression equation—and the intui-\ntive clarity with which the r2 figure can be interpreted. Table C.1b illustrates the calculation of r2 for \nthe regression line derived in Table A.1.\nThe statistic r 2 is extremely useful in comparing alternative models, as long as they all have \nthe same dependent variable, that is, they differ only in the explanatory variables. However, when \n633\nCHECKING THE SIGNIFICANCE OF THE REGRESSION EQUATION\n regression equations have different dependent variables, inferences based on r 2 can prove very mis-\nleading. For example, consider the following two models:\nModel I:\nModel II:\nPa bP r\nPa bX r\ntt\nt\n=+ =\n=+ =\n−1\n2\n2\n09 8\n05 0\n,.\n,.∆\nwhere Pt = closing price on day t\nPt−1 = closing price on day t − 1\nΔPt = Pt − Pt−1\nX = an explanatory variable known on day t − 1 and used to predict price changes\nDespite the fact that Model I has a much higher r2, Model II represents the better forecasting equation. \nIf the survey period is sufficiently long, an equation such as Model I will merely tell us that the price on a \ngiven day will be almost equal to the preceding day’s price. (In such an equation, b is likely to be very close \nto 1.0.) The reason for the high r2 value is that although prices for the entire period may range widely, \nprices on adjacent days must be closely correlated (at most, they can be separated by the daily price \nlimit). Model I, however, is totally useless in forecasting the next day’s price. In contrast, the independent \nvariable in Model II explains 50 percent of the price change on a given day and might be an extremely \nimportant aid in day trading. This illustration is intended to highlight the potential folly of making value \njudgments about regression equations with different dependent variables.\n11\n11 An even more extreme example is possible. If we used hogs not slaughtered (HNS) instead of hog slaughter \n(HS) as the dependent variable regressed against the pig crop (PC), where HNS = PC − HS, the sum of the \nsquared residuals and hence SER would be exactly the same, but r 2 would be different. Why? Because r2 would \nbe affected by the dependent variable chosen\nr\nYYii\ni\nn\n2\n2\n111=− =−\n−()\n=\n∑unexplained variatio n\ntotal variatio n\nˆ\nYYYi\ni\nn\n−()\n=\n∑\n2\n1\nIn this example,\nYYii\ni\nn\n−()\n=\n∑ ˆ 2\n1\nwill be the same whether HS or HNS is the dependent variable, but\nYYi\ni\nn\n−()\n=\n∑\n2\n1\nwill be different, hence r2 will be different.\n634APPENDIX C\n ■ Spurious (“Nonsense”) Correlations \n It is important to understand that cause and eff ect in the regression procedure are in the eyes of the \nbeholder. The r 2 value derived in Table C.1 b merely tells us that there is a strong correlation between \nhog slaughter and the preceding pig crop. The way we interpret the cause and eff ect of this statistic \nemanates only from our theoretical understanding of the underlying process. In this particular exam-\nple, it is quite obvious the pig crop in one period aff ects slaughter in the next period rather than vice \nversa. However, if enshrouded in ignorance, we set out to prove the level of hog slaughter determines \nthe number of pigs born in the preceding period, the resulting equation would yield the identical r \n2\nvalue. Thus, r 2 only refl ects the degree of correlation between two variables; it in no way proves a \ncause-and-eff ect relationship. \n The potential folly of drawing cause-and-eff ect inferences from an r 2 fi gure is demonstrated by \nFigure C.6 . Note what appears to be a striking relationship between the number of hedge funds \nand U.S. wine consumption. In fact, the r \n2 value between the number of hedge funds and U.S. wine \nconsumption during the period depicted is a remarkably high 0.99! What conclusions are we to draw \nfrom this chart? \n ■ Increased wine consumption encourages people to invest in hedge funds. \n ■ Hedge funds drive people to drink. \n ■ The hedge fund industry should promote wine consumption. \n4,000\n4,500\n5,000\n5,500\n6,000\n6,500\n7,000\n7,500\n8,000\n8,500\n9,000\n650600550500450\nNumber of Hedge Funds\nWine Consumption (Mil. Gal.)\n95\n96\n97\n98\n99\n00\n0201\n03\n04\nr2 0.99\n FIGURE  C.6 Number of Hedge Funds vs. U.S. Wine Consumption \n635\nCHECKING THE SIGNIFICANCE OF THE REGRESSION EQUATION\n ■ Wine growers should promote hedge fund investing.\n ■ All of the above.\n ■ None of the above.\nActually, the striking correlation between wine consumption and the number of hedge funds i", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 210}
{"text": "00450\nNumber of Hedge Funds\nWine Consumption (Mil. Gal.)\n95\n96\n97\n98\n99\n00\n0201\n03\n04\nr2 0.99\n FIGURE  C.6 Number of Hedge Funds vs. U.S. Wine Consumption \n635\nCHECKING THE SIGNIFICANCE OF THE REGRESSION EQUATION\n ■ Wine growers should promote hedge fund investing.\n ■ All of the above.\n ■ None of the above.\nActually, the striking correlation between wine consumption and the number of hedge funds is \nvery easily explained. Both variables were affected by a common third variable during the period \ndepicted: time. In other words, both the number of hedge funds and wine consumption witnessed \npronounced growth trends during this time period. The apparent relationship arises from the fact \nthat these trends were simultaneous. This type of coincident linear relationship is called “spurious” or \n“nonsense” correlation. Actually, the correlation is real enough; only the interpretation of cause and \neffect is nonsense.\n\n637\nThe Multiple \nRegression Model\nAppendix d\nIn our description of nature the purpose is not to disclose the real essence of the \nphenomena but only to track down, so far as it is possible, relations between \nthe manifold aspects of our experience.\n—Niels Bohr\n ■ Basics of Multiple Regression\nIn practice, it is rarely possible to explain the behavior of a dependent variable adequately with only \none explanatory variable. For example, hog slaughter alone will provide only a rough indication of hog \nprices. A more satisfactory model would also incorporate other independent variables, such as broiler \nslaughter. The multiple regression equation is a straightforward extension of simple regression and describes \nthe linear relationship between the dependent variable and two or more independent variables.\nThe meaning of linear, which might not be intuitively obvious beyond the two-dimensional case, \nis that all the variables are of the first degree and are combined only by addition or subtraction. For \nexample, in terms of Z as a function of X and Y, Z = 2X + Y + 3 is a linear equation, while Z = X\n2 + 2y2 \n+ 4, Z = XY, and Z = log X + log Y are nonlinear equations. A basic characteristic of a linear equation \nis that a one-unit change in an independent variable will result in a constant magnitude change in the \ndependent variable, regardless of the independent variable value. In other words, in a linear equation, \nthe slope in each dimension is constant. When there are only two variables, as is the case in simple \nregression, the linear equation can be depicted by a straight line. When there are three variables, the \nlinear equation can be represented by a plane in three-dimensional space. Linear equations involving \nmore than three variables can no longer be simply represented in three-dimensional Euclidean space.\n638\nAppendix d\nAs in the simple regression case, regression analysis is only appropriate if the relationship between \nthe variables is approximately linear. This is not as strict a limitation as it may sound, since many non-\nlinear equations can be transformed into linear equations.\nThe general form of the multiple regression equation is\nYX XX ekk=+ +… +αβ ββ11 22\nThe preceding equation represents the unknown population or true regression. The general form \nof the fitted regression is\nYa bX bX bXkk=+ +…11 22\nwhere a, b1, b2, . . . , bk are chosen so as to minimize the sum of the squared residuals. A regression \ncoefficient bi can be interpreted as follows: If all other independent variables are held constant, a \none-unit change in X i will cause the dependent variable Y to change by b i. A residual can still be \ninterpreted as the difference between an observed value of the dependent variable (Yi) and the fitted \nvalue (Yi). Regardless of how many variables there are in the equation, the residuals still represent a \nsingle-dimensional difference.\nThese concepts can perhaps be clarified by considering a practical example. Assume that we have \nderived a regression equation relating hog prices to hog slaughter and broiler slaughter:\nYa bX bX=+ +11 12 2\nwhere Y = deflated hog prices\nX1 = hog slaughter\nX2 = broiler slaughter\nThis relationship is depicted in Figure D.1. Each combination of values for X 1 and X 2 will fix a \nlocation in the (X1, X2) plane. The regression equation will indicate the value of Y (the height of the y \naxis) at that point. In other words, the regression equation defines the price level that corresponds to \nany combination of hog and broiler slaughter.\nFor any given value of X\n2 (broiler slaughter), increases in hog slaughter will reduce Y (hog prices) \nat a constant rate. Similarly, for any given value of X 1 (hog slaughter), increases in broiler slaughter \nwill reduce Y. Thus, as can be seen, the highest prices will occur when hog slaughter and broiler \nslaughter are low , and the lowest prices when these explanatory variables are high.\nEach observation will represent a combination of values for X1 and X2 and the corresponding value \nof Y during the given period. Of course, the actual observed Y i values, which are indicated by solid \ndots in Figure D.1, will rarely fall exactly on the plane. The vertical distance between any point and \nthe plane (i.e., the difference between the actual hog price and the price predicted by the regression \nplane) is the residual and is indicated by an arrow . As in the simple regression case, the residual is \nmeasured along a single axis (y). The regression procedure will specify the values for a, b\n1, and b2, \nwhich will minimize the sum of the squares of these residuals.\n639\nTHE MULTIPLE REGRESSION MODEL\n W e deliberately avoid indicating the computational formulas for deriving the regression coef-\nfi cients, or for that matter, any of the statistics for the multiple regression case. The reason for this is \nthat multiple regression computations are far too cumbersome to be reasonably considered without \nthe aid of a computer. The assumptions underlying multiple regression are completely analogous to \nthose detailed fo", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 211}
{"text": "id indicating the computational formulas for deriving the regression coef-\nfi cients, or for that matter, any of the statistics for the multiple regression case. The reason for this is \nthat multiple regression computations are far too cumbersome to be reasonably considered without \nthe aid of a computer. The assumptions underlying multiple regression are completely analogous to \nthose detailed for the simple regression model. In the multiple regression case, there is one additional \nassumption: that there is no linear relationship among any two or more independent variables. If this \nassumption is not met, it will lead to a problem called multicollinearity . \n FIGURE  D.1 Scatter of Observed Points About the Regression Plane \nX1 = hog slaughter\nY = a + b1X1 + b2X2\nX2 = broiler slaughter\nY = deflated hog price\n640\nAppendix d\n ■ Applying the t-Test in the Multiple Regression Model\nThe t values in the multiple regression output can be used to evaluate the significance of the regres-\nsion coefficients. The t values from any standard computer regression analysis assume the hypothesis \nbeing tested is that the regression coefficient equals zero. In this case, the t value for bi is provided by\nt b\nb\ni\ni\n= se.. ()\nThis relationship can be expressed as follows:\nT-STA T COEFF\nST ER=\nwhere T -STAT = t value for given regression coefficient\nCOEFF1 = value of given regression coefficient\nST ER = standard error of given regression coefficient (not to be confused with the standard \nerror of the regression, SER, which is described in the next section)\nFrequently, these statistics will be listed in three adjacent columns with each row providing sta-\ntistics for the constant term or specified regression coefficient. The interpretation of the t statistic \nis identical to the simple regression case. The t value indicates the number of standard deviations \nbetween the indicated coefficient value and the true population coefficient if the latter were actually \nequal to zero. The higher the t value, the more significant the regression coefficient. T o use the t table \n(Table B.4), one would check the row corresponding to n−k degrees of freedom (df ) where n equals \nthe total number of observations and k equals the number of variables in the equation. Roughly speak-\ning, t values above 2.0 are clearly significant and indicate that the given independent variable should \nbe retained in the model. It should be noted that the t value does not definitively prove significance; \nrather it establishes significance at a specific probability level. The higher the t value, the more unlikely \na regression coefficient would be assumed to be significant when it is not.\nWhat if the t statistic is less than the t value at the 0.05 level of significance (e.g., less than 1.812 \nfor a one-tailed test with 10 df)?\n2 Here there is no clear-cut answer. The choice depends on the priori-\nties of the analyst. If she is more concerned about retaining an insignificant variable in the model, she \nmight lean to dropping any variable whose regression coefficient is not significant at the 0.05 level. \nOn the other hand, if she is more concerned about deleting a meaningful variable, she would retain \nthe variable unless the t value was very low .\nA reasonable criterion is that any theoretically meaningful variable with a t value greater than \n1.0 should usually be retained,\n3 although it should be noted that many analysts prefer to use a cutoff \n1 Frequently also called VALUE.\n2 It is assumed that the regression coefficient has the anticipated sign (e.g., negative for hog slaughter in an equa-\ntion in which hog prices are the dependent variable). Situations in which the sign is opposite to expectations are \ndiscussed later in this appendix.\n3 There is a special meaning to t values > 1.0. It has been demonstrated that if explanatory variables are retained \nif their t-value > 1.0 and deleted otherwise, the “Corrected R2” (which is discussed later) will be maximized.\n641\nTHE MULTIPLE REGRESSION MODEL\nlevel of 2.0. The key words are theoretically meaningful. A low t value does not contradict the assumed \nrelationship between the dependent and explanatory variable. Remember, a t value below the level of \nstatistical significance does not indicate that the independent variable is not meaningful in explaining \nthe dependent variable. It only means that its significance has not been demonstrated at the desired \nprobability level. As long as the variable has the anticipated sign, the results are still consistent with \ntheoretical expectations, albeit the relationship is not as strong as would be desired. Furthermore, \neven a t value of 1.0 would still be significant at the 0.20 level (i.e., 80 percent probability) for any \nregression equation in which df \n > 2. Variables with t values below 1.0 should usually be dropped.\nThere is one exception to the decision process just detailed. Occasionally, the analyst might try \nincluding all the independent variables she believes should significantly affect the dependent variable, \nonly to find that the resulting regression equation is disappointing. At this point, in desperation she \nmight try a variety of independent variables in the hopes that perhaps one or more of these are signifi-\ncantly related to the dependent variable. Such a method could be termed a “shotgun” or “kitchen sink” \napproach and is not recommended unless all theoretically plausible variables have been exhausted. In \nany event, in this case one should apply stricter requirements for retaining a variable. First, a two-\ntailed rather than one-tailed test should be used (see section “T esting the Significance of the Regres-\nsion Coefficients” in Appendix C). Second, variables with t values below the 0.05 level of significance \nshould be rejected. In fact, one can argue that a more restrictive significance level should be adopted \n(e.g., 0.01), since the probability of accepting a meaningless variable increases with the number of \nvariables t", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 212}
{"text": "d test should be used (see section “T esting the Significance of the Regres-\nsion Coefficients” in Appendix C). Second, variables with t values below the 0.05 level of significance \nshould be rejected. In fact, one can argue that a more restrictive significance level should be adopted \n(e.g., 0.01), since the probability of accepting a meaningless variable increases with the number of \nvariables tested.\nThus far, we have assumed that a theoretically chosen variable has the correct sign. However, in \nequations with many variables, a coefficient with the wrong sign is not uncommon. Such an occur-\nrence usually indicates the presence of multicollinearity—a linear dependence between two or more \nexplanatory variables. (A discussion of how to handle such variables is presented in the section on \nmulticollinearity in Appendix E.) At this point, suffice it to say that the t values of such variables are \nusually irrelevant.\n ■ Standard Error of the Regression\nThe standard error of the regression (SER) is a measure of the unexplained variation. The definition of \nthe SER is almost totally analogous to the simple regression case. The only difference is that the sum \nof the squared residuals is divided by the appropriate degrees of freedom, instead of n−2. Thus, for \nthe more general multiple regression case, the SER could be expressed as\nSER =\n−()\n−\n=\n∑ YY\nnk\nii\ni\nn\nˆ 2\n1\nwhere k = number of parameters in equation (which is equal to the number of independent vari-\nables plus 1, assuming there is a constant term in the equation). Note in the simple regression case \nthat k = 2.\n642\nAppendix d\nAs in the simple regression case, the % SER is equal to the SER divided by Y . Where appropriate \n(see Appendix C), the % SER may be more convenient to use, because it is stated in a form that is \nintuitively meaningful.\n ■ Confidence Intervals for an Individual Forecast\nIn the multiple regression case, the calculation of a confidence interval for an individual forecast is \nsomewhat complicated. As a simplification, the confidence interval can be calculated for the situation \nin which all of the independent variables are equal to their means. In this specialized case, the formula \nfor the confidence interval would be analogous to the simple regression case in which \nXX= :\nˆˆYt s n YY t nff f−⋅ +< <+ ⋅+1 1 1 1\nwhere s = SER\nt = t value at specified level of significance for the given degrees of freedom\nThis represents a minimum confidence interval, and the further removed the independent vari-\nables are from their respective means, the wider the actual confidence interval.\n ■ R2 and Corrected R2\nThe term R2 is the multiple regression counterpart of r2 and is defined in exactly the same way. Thus, \nthe entire discussion related to r2 in Appendix C applies here as well and need not be duplicated.\nIn the multiple regression case, it is important to realize that the addition of another independent \nvariable can only increase R2. Remember that R2 is the ratio of explained variation to total variation. \nThe introduction of a new variable will not affect total variation, and it can only increase explained \nvariation. Even the introduction of a totally irrelevant variable will probably result in a small increase \nin explained variation. For example, it is a safe bet that adding a variable for the number of ducks in \nBelgium would increase the R\n2 of a regression equation for forecasting U.S. interest rates.\nThe point that the addition of a meaningless explanatory variable will raise R 2 is more than an \nesthetic consideration. Recall that each additional variable will decrease the degrees of freedom by \n1, thereby reducing the significance of the equation on the basis of other measures such as the t-test \nand SER, all else being equal. For this reason, it is desirable to modify the R\n2 measure so that it is \npenalized for the addition of irrelevant variables. This alternative measure is called the Corrected R 2 \n(CR2), or sometimes the Adjusted R2. The problem with R2 is that it is based on variation, which does \nnot account for the number of degrees of freedom. The CR2 avoids this defect, because it is based on \nvariance. The variance is simply the variation divided by the number of degrees of freedom. It will be \nrecalled that R\n2 can be defined as4\nR2 1=− unexplai ned vari ation\ntotal variatio n\n4 The formulas for R2 and r2 are identical.\n643\nTHE MULTIPLE REGRESSION MODEL\nW e now define CR2 as\nCR2 1=− unexplai ned vari ance\ntotal variance\nwhere\nVariance variatio n= df\nThus,\nCR\nYY\nnk\nYY\nn\ni\ni\nn\ni\nn\n2\n1\n2\n1\n1\n2\n1\n1\n1\n=−\n−\n−\n−\n−\n=\n=\n∑\n∑\n()\n()\n\nThe numerator of the ratio term is based on n observations, but there are k constraints in find-\ning the regression line used to calculate Y i. Thus df = n − k. The denominator is also based on n \nobservations, but there is only one constraint, Y ; thus df = n − 1. The preceding equation can be \nrewritten as\nCR R n\nnk\n22 11 1=− −⋅ −\n−()\nAs is readily apparent in this form of the equation, when n is large relative to k, the CR2 will almost \nequal R2.\nTypical regression runs will provide the CR2 (corrected R square or adjusted R square) along with \nR2 (R square). As a general rule, the CR2 is a more useful measure for comparing different regression \nequations for the same dependent variable.\n ■ F-Test\nWhereas the t distribution is used to test the significance of the individual regression coefficients, the \nF distribution is used to test the significance of the regression equation as a whole. In other words, \nthe F statistic tests the hypothesis that none of the regression coefficients is significant. The F statistic \ncan be expressed as\nF = explained variance\nunexplai ned vari ance\n644\nAppendix d\nNote that the F value is based on variance, not variation. Once again, variance = variation + df.\nF\nYY\nk\nYY\nnk\nYY\nYY\ni\ni\nn\nii\ni\nn\ni\ni\nn\nii\ni\n=\n−()\n−\n−()\n−\n=\n−()\n−()\n=\n=\n=\n∑\n∑\n∑\n2\n1\n2\n1\n2\n1\n2\n1\nˆ\nˆ\nˆ\n= =\n∑\n⋅ −\n−\n1\n1n\nnk\nk\nThe degrees of freedom for the explained variance = k − 1, since k v", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 213}
{"text": "significant. The F statistic \ncan be expressed as\nF = explained variance\nunexplai ned vari ance\n644\nAppendix d\nNote that the F value is based on variance, not variation. Once again, variance = variation + df.\nF\nYY\nk\nYY\nnk\nYY\nYY\ni\ni\nn\nii\ni\nn\ni\ni\nn\nii\ni\n=\n−()\n−\n−()\n−\n=\n−()\n−()\n=\n=\n=\n∑\n∑\n∑\n2\n1\n2\n1\n2\n1\n2\n1\nˆ\nˆ\nˆ\n= =\n∑\n⋅ −\n−\n1\n1n\nnk\nk\nThe degrees of freedom for the explained variance = k − 1, since k values are employed in \ndefining the regression line used to calculate ˆYi, but one df is lost because of the constraint imposed \nby Y . As for the unexplained variance, there are n observations, but k constraints are imposed in \nfinding the regression line upon which Y i is based. Recalling the alternative definitions for R 2, we \ncan re-express F as5\nF R\nR\nnk\nk= − ⋅ −\n−\n2\n211\nThe appropriate degrees of freedom will be specified in the notation for the F statistic. For \nexample, F (2/8) = 23.5 indicates an F value for a regression equation in which k − 1 = 2 and \nn − k = 8. T o check for significance, the F statistic is compared to the listed values in the F table \nfor the corresponding number of degrees of freedom. For example, checking Table D.1, it can \nbe determined that at the 0.01 level of significance, F (2/8) = 8.65; thus, a value of 23.5 would \nbe significant.\nIn practice, the F-test is not particularly critical, since it will almost invariably prove significant. \nThis should not be surprising, because the F-test checks whether all the regression coefficients com-\nbined have any predictive value—a very weak criterion. In any case, for comparisons of regression \nequations with the same dependent variable, higher F values would indicate a better model (assuming \nnone of the regression assumptions are violated). However, similar information could be gathered by \ncomparing CR\n2 values.\n ■ Analyzing a Regression Run\nTable D.2 presents the results for a sample regression run. At this juncture, most of Table D.2 should \nbe comprehensible. However, it may be helpful to interpret the key statistics of this table.\n 1. The regression equation is Y = 49.06899 − 1.07049 (X1) + 0.35775 (X2). T o get a point fore-\ncast for Y, one would merely plug in the estimated values of X1 and X2. For example, if X1 = 20 \n5 \nˆYY RY Yii\ni\nn\ni\nn\n−() =⋅ −()\n==\n∑∑\n2 2 2\n11\n and YY RY Yii i\ni\nn\ni\nn\n−() =− −\n==\n∑∑ ˆ () ()\n2 22\n11\n1\n645\nTHE MULTIPLE REGRESSION MODEL\nTAble d.1 F distribution\nValues of Fn1,n2,α on the F(n1,n2,α)-distribution\npr{F(n1,n2)-variable ≥ Fn1,n2,α} = α = 0.01\n0\n/uni03B1 = .01\n/uni03B1 = .01\nFn1, n2, /uni03B1\nF(n1, n2)-distribution\nn1 (numerator df )\nn2 (denominator df ) 1 2 4 6 8 10 12 24 ∞\n[tn2,.005]2 Values of Fn1,n2,α\n1 4,052 5,000 5,625 5,859 5,982 6,056 6,106 6,235 6,366\n2 98.50 99.00 99.25 99.33 99.37 99.40 99.42 99.46 99.50\n3 34.12 30.82 28.71 27.91 27.49 27.23 27.05 26.60 26.13\n4 21.20 18.00 15.98 15.21 14.80 14.55 14.37 13.93 13.46\n5 16.26 13.27 11.39 10.67 10.29 10.05 9.89 9.47 9.02\n6 13.75 10.92 9.15 8.47 8.10 7.87 7.72 7.31 6.88\n7 12.25 9.55 7.85 7.19 6.84 6.62 6.47 6.07 5.65\n8 11.26 8.65 7.01 6.37 6.03 5.81 5.67 5.28 4.86\n9 10.56 8.02 6.42 5.80 5.47 5.26 5.11 4.73 4.31\n10 10.04 7.56 5.99 5.39 5.06 4.85 4.71 4.33 3.91\n11 9.65 7.21 5.67 5.07 4.74 4.54 4.40 4.02 3.60\n12 9.33 6.93 5.41 4.82 4.50 4.30 4.16 3.78 3.36\n13 9.07 6.70 5.21 4.62 4.30 4.10 3.96 3.59 3.17\n14 8.86 6.51 5.04 4.46 4.14 3.94 3.80 3.43 3.00\n15 8.68 6.36 4.89 4.32 4.00 3.80 3.67 3.29 2.87\n20 8.10 5.85 4.43 3.87 3.56 3.37 3.23 2.86 2.42\n25 7.77 5.57 4.18 3.63 3.32 3.13 2.99 2.62 2.17\n30 7.56 5.39 4.02 3.47 3.17 2.98 2.84 2.47 2.01\n40 7.31 5.18 3.83 3.29 2.99 2.80 2.66 2.29 1.80\n60 7.08 4.98 3.65 3.12 2.82 2.63 2.50 2.12 1.60\n120 6.85 4.79 3.48 2.96 2.66 2.47 2.34 1.95 1.38\n∞ 6.63 4.61 3.32 2.80 2.51 2.32 2.18 1.79 1.00\nSource: Abridged from Table 18 of Pearson and Hartley, Biometrika T ables for Statisticians, Third Edition, V olume 1, 1976, with kind permission of \nthe Biometrika Trustees (http://biomet.oxfordjournals.org).\nThe diagram, and this presentation of the table, are taken from Table 4b of S. R. Searle, Linear Models (New Y ork, NY: John Wiley & Sons, \n1997). Copyright © 1997 by John Wiley & Sons; reprinted by permission.\n646\nAppendix d\nTAble d.2 Sample Regression Run Results\nVariable Coefficient Standard error T-Stat Mean\nCONSTANT 49.06899 9.67267 5.07 41.16071 (dependent variable)\nX1 −1.07049 0.23464 −4.56 21.00714\nX2 0.35775 0.13400 2.67 40.75357\nObservation Actual Fitted Residual % deviation\n1 35.90000 35.25925 0.64075 1.82\n2 52.70000 54.54910 −1.84910 −3.39\n3 46.30000 50.74680 −4.44680 −8.76\n4 34.20000 36.98609 −2.78609 −7.53\n5 51.30000 46.15574 5.14426 11.15\n6 44.20000 44.02220 0.17780 0.40\n7 33.90000 29.70675 4.19325 14.12\n8 31.30000 30.54304 0.75696 2.48\n9 31.70000 32.74207 −1.04207 −3.18\n10 29.90000 31.58795 −1.68795 −5.34\n11 51.10000 49.76981 1.33019 2.67\n12 56.10000 51.62468 4.47532 8.67\n13 43.90000 45.56465 −1.66465 −3.65\n14 33.7500 36.99187 −3.24187 −8.76\nY = CONSTANT + C1 · X1 + C2 · X2\nRSQ = 0.8953 SER = 3.2338 F(2,11) = 47.0\nRSQC = 0.8762 % SER = 7.86 DW = 1.69\nand X2 = 40, the predicted Y value would be 41.969. In practice, it will be more convenient to \nuse mnemonic symbols for the variables instead of Y, X1, and X2.\n 2. R2 = 0.8953, which means that X1 and X2 explain 89.53 percent of the total variation in Y. The \nCR2, which is adjusted downward for lost degrees of freedom, is 0.8762.\n 3. SER = 3.2338. This would be a key figure of merit in comparisons with alternative models. The \nSER could also be used to construct a crude confidence interval for an individual forecast based \non the assumption that all the independent variable values are equal to their respective means. \nThis confidence interval would be\n6\nˆˆYt s n YY ts nff f−⋅ +< <+ ⋅+1 1 1 1\n6 See the section, “Confidence Intervals for an Individual Forecast.”\n647\nTHE MULTIPLE REGRESSION MODEL\nwhere s = SER = 3.23\nn = 14\nt = 2.201 (t value for two-sided test at 0.05 level of significance for 11 df )\nˆ .( .) (. ) ˆ .( .) .)\nˆ .\n(YY Y\nY\nff", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 214}
{"text": "all the independent variable values are equal to their respective means. \nThis confidence interval would be\n6\nˆˆYt s n YY ts nff f−⋅ +< <+ ⋅+1 1 1 1\n6 See the section, “Confidence Intervals for an Individual Forecast.”\n647\nTHE MULTIPLE REGRESSION MODEL\nwhere s = SER = 3.23\nn = 14\nt = 2.201 (t value for two-sided test at 0.05 level of significance for 11 df )\nˆ .( .) (. ) ˆ .( .) .)\nˆ .\n(YY Y\nY\nff f\nf\n−< <\n−\n22 01 32 31 03512 2013 23 10 351\n73 5\n+\n888 7 3588<<YYff ˆ . +\nUsing the point estimate for Y f of 41.969 derived in 1, the 95 percent confidence interval \nwould be\n34 610 49 328.. <<Y f\nThis would mean a 95 percent probability the actual value will fall in the stated range if the \nforecast is based on independent variables equal to their respective means. Of course, this will \nnever be the case. Consequently, the actual confidence interval will always be wider. Neverthe-\nless, given this understanding, the simplified confidence interval provides at least a rough sense \nof the potential variability of the forecast.\n 4. The %SER SER=÷ Y . The %SER provides a figure that is intuitively meaningful and can be \nused instead of the SER if all model comparisons involve the same dependent variable.\n 5. The F value for 2 df in the numerator and 11 df in the denominator = 47.0, which is well above \nthe listed F value of 7.21 at the 0.01 significance level. Again, the F test will almost invariably \nverify that the equation is significant.\n 6. DW stands for Durbin-Watson, a measure discussed in Appendix E..\n 7. The t statistic is equal to the coefficient values divided by the respective standard error. In this \nexample, all the coefficients are significant (t value at the 0.05 level of significance for a one-\ntailed test with 11 df is 1.796).\n 8. The Actual column in Table D.2 lists the actual observations of Y, and the Fitted (also called \nPredicted) column lists the corresponding values indicated by the regression equation. The dif-\nference between these two figures for each observation is listed in the Residual column. The \nPercent Deviation column is equal to the residual divided by the fitted value. (In some cases, the \nresiduals are normalized by dividing the residuals by the SER—that is, expressing residuals in \nstandard deviation units. Residuals normalized in this manner are termed standardized residuals \nor standard residuals and are discussed in Appendix E.)\nThus far, we have only discussed the meaning of the overall summary statistics for the regression \nequation. As will be detailed in Appendix E, the individual residual values also contain extremely \nimportant information and should be carefully analyzed.\n\n649\nAnalyzing the \nRegression Equation\nAppendix e\nIt is a test of true theories not only to account for but to predict phenomena.\n—William Whewell\n ■ Outliers\nAn outlier is an observation with a large residual—that is, a large deviation between the observed \nvalue and fitted value. Outliers reflect one of the following conditions:\n 1. An error in collecting or manipulating the data for the given point.\n 2. The existence of a significant extraneous causal factor that only affected the outlier(s).\n 3. The omission of an important explanatory variable from the equation.\n 4. A structural flaw in the model.\nThe presence of outliers indicates a deficiency in the model. After verifying that an outlier is not \nthe result of error, one should try to identify possible factors responsible for the aberrant behavior. \nIf the outlier can be explained by a missing variable that affected all observations, then this variable \nshould be included in the equation. If, however, the outlier was a consequence of an isolated event that \nis not expected to reoccur, then it should be viewed as an unrepresentative point, and the regression \nshould be rerun with the outlier deleted. This recalculation is important, since the method of least \nsquares used to derive the regression coefficients will give greater weight to outliers. Thus, one or \ntwo such points could seriously distort the regression equation fit. However, unless the isolated causes \nof the outlier have been identified, one should avoid the temptation of deleting such points simply \nbecause it will improve the regression fit.\n650\nAppendix e\n ■ The Residual Plot\nThe scatter diagram, such as the one depicted in Figure A.4, is of limited use in detecting outliers, \nsince it can only be applied in the simple regression case. The residual plot provides a graphic tech-\nnique for detecting outliers that is as easy to apply in multiple regression as it is in simple regression. \nIn constructing residual plots, it is more convenient to use standardized residuals rather than the \nactual residuals, which vary widely from case to case. The standardized residual for the ith observation \nis defined as\nsr YY\nsi\nii= − ˆ\nwhere\ns\nYY\nnk\nii\ni\nn\n==\n−()\n−\n=\n∑\nSER\nˆ 2\n1\nwhere n = number of observations\n k = number of parameters (which is equal to the number of independent variables plus 1, \nassuming there is a constant term in the equation)\nIn effect, the standardized residual can be thought of as indicating how many standard deviations a \nresidual is from the assumed residual mean of zero. If the regression assumptions are valid, the stan-\ndardized residuals should be randomly distributed and fall primarily in a range between +2 and −2. \nOne great advantage of using standardized residuals is that the interpretation of a residual plot is the \nsame for all types of data. There are three basic types of residual plots:\n 1. sri versus the fitted Y values ()Y iˆ .\n 2. sri versus the independent variables (in multiple regression, there can be one such plot for each \nindependent variable).\n 3. sri versus time (i.e., the sri values are plotted in time order).\nThe preceding plots are available on some computer packages. However, even when they are not, \nthey can easily be constructed from the printout of residual values. Since virtually all applications of \nregression analysis", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 215}
{"text": "e independent variables (in multiple regression, there can be one such plot for each \nindependent variable).\n 3. sri versus time (i.e., the sri values are plotted in time order).\nThe preceding plots are available on some computer packages. However, even when they are not, \nthey can easily be constructed from the printout of residual values. Since virtually all applications of \nregression analysis in forecasting futures involve time series data, the third type of residual plot will \nnormally be the most useful.\nFigure E.1 provides an example of a residual plot plotted against time. As is readily visible, 2011 \nand 2014 are outliers. Also note the predominance of negative residuals in the remaining years—a \nconsequence of the two positive outliers pulling up the regression line. (Remember, the least-squares \nprocedure will tend to place greater weight on outliers.)\nOne essential attribute of the residual plot is that it can be applied just as easily when a model con-\ntains three or more variables, a situation in which a scatter diagram cannot be constructed. Perhaps \neven more importantly, the residual plot can be used to check for autocorrelation. Before turning to \nthis critical application of the residual plot, it is first necessary to discuss autocorrelation and the most \ncommonly used method for its detection, the Durbin-Watson (DW) statistic.\n651\nANALYZING THE REGRESSION EQUATION\n FIGURE  E.1 Standardized Residuals Plotted Against Time \n2000\n+2.5\n+2.0\n+1 .5\n+1 .0\n+0.5\n0\n−0.5\n−1 .0\n−1 .5\n−2.0\n2001\n2002\n2003\n2004\n2005\n2006\n2007\n2008\n2009\n2010\n2011\n2012\n2013\n2014\n ■ Autocorrelation Defi ned \n Autocorrelation refers to the situation in which the error terms are correlated. The existence \nof autocorrelation indicates that there is a pattern in the data that has not yet been captured \nby the explanatory variables. For this reason, the presence of autocorrelation suggests that the \nmodel is still inadequate. Furthermore, it should be recalled that one of the basic assumptions \nunderlying the statistics of regression analysis is that the error terms are randomly distributed. \nIf autocorrelation exists, then the standard error of the coefficients and the SER may all be \nseverely understated. Thus, the normal tests of significance may yield a very distorted picture \nof the equation’s precision. \n ■ The Durbin-Watson Statistic as a Measure of Autocorrelation \n Autocorrelation refers to a linear dependency in the error terms. In the simplest case, the error \nterms are correlated to the error terms of the preceding period. This type of condition is called fi rst-\norder autocorrelation and is refl ected by the DW statistic, which is a standard measure included in the \nregression summary printout. \n652\nAppendix e\nAlthough ideally a test for autocorrelation would be based on the population error terms, these \nare unavailable. The DW test is based on the residuals (denoted here by êt) and defined as:\nDW\nee\ne\ntt\nt\nn\nt\nt\nn=\n−() −\n=\n=\n∑\n∑\nˆˆ\nˆ\n1\n2\n2\n2\n2\nwhere êt = residual value in time period t\n êt−1 = residual value in time period immediately preceding period t\nThe following approximate relationship, however, is more useful for an intuitive explanation of \nthe Durbin-Watson statistic:\nDW r≈−21()\nwhere\nr\nee\ne\ntt\nt\nn\nt\nt\nn=\n⋅ −\n=\n=\n∑\n∑\nˆˆ\nˆ\n1\n2\n2\n2\nIf there is no first-order autocorrelation, the positive values for the product ˆˆeett ⋅ −1 will tend to \noffset the negative values, and ˆˆeett ⋅∑ −1 should approximate zero. In this case, r will approach zero \nand DW will approach 2. If adjacent residuals are positively correlated, then ˆˆeett ⋅ − 1 and ˆˆeett ⋅∑ −1 \nwill tend to be positive. The greater the correlation between adjacent residuals, the more positive \nˆˆeett ⋅∑ −1 will be. In the extreme, ˆˆeett ⋅∑ −1 will approach ˆet\n2∑ , causing r to approach 1 and DW to \napproach 0. Similarly, if the adjacent residuals are negatively correlated (i.e., positive residuals tend-\ning to follow negative residuals), ˆˆeett ⋅∑ −1 will be negative. If the negative correlation is extreme, \nˆˆeett ⋅∑ −1 will approach −∑ ˆet\n2, causing r to approach −1 and DW to approach 4. In summary, the \nDW has a possible range between 0 and 4. Values near 2 indicate no first-order autocorrelation, values \nsignificantly below 2 indicate positive autocorrelation, and values significantly above 2 indicate nega-\ntive autocorrelation.\nTable E.1 contains a list of DW values that can be used to test for autocorrelation at the 0.05 level \nof significance. The appropriate values will depend on the number of observations, n, and the number \nof independent variables in the regression equation, k. Note that unlike the other tests discussed so \nfar, there are two values listed for each category. In a test for positive autocorrelation, the interpreta-\ntion would be as follows (for negative autocorrelation use 4 − DW instead of DW):\n 1. DW < dL Positive autocorrelation exists\n 2. DW > dU No positive autocorrelation exists\n 3. dL < DW < dU T est is inconclusive\n653\nANALYZING THE REGRESSION EQUATION\nTAble e.1 The distribution of durbin-Watson d 5 percent Significance points of dl and du\nk = 1 k = 2 k = 3 k = 4 k = 5\nn d L dU dL dU dL dU dL dU dL dU\n15 1.08 1.36 0.95 1.54 0.82 1.75 0.69 1.97 0.56 2.21\n16 1.10 1.37 0.98 1.54 0.86 1.73 0.74 1.93 0.62 2.15\n17 1.13 1.38 1.02 1.54 0.90 1.71 0.78 1.90 0.67 2.10\n18 1.16 1.39 1.05 1.53 0.93 1.69 0.82 1.87 0.71 2.06\n19 1.18 1.40 1.08 1.53 0.97 1.68 0.86 1.85 0.75 2.02\n20 1.20 1.41 1.10 1.54 1.00 1.68 0.90 1.83 0.79 1.99\n21 1.22 1.42 1.13 1.54 1.03 1.67 0.93 1.81 0.83 1.96\n22 1.24 1.43 1.15 1.54 1.05 1.66 0.96 1.80 0.86 1.94\n23 1.26 1.44 1.17 1.54 1.08 1.66 0.99 1.79 0.90 1.92\n24 1.27 1.45 1.19 1.55 1.10 1.66 1.01 1.78 0.93 1.90\n25 1.29 1.45 1.21 1.55 1.12 1.66 1.04 1.77 0.95 1.89\n26 1.30 1.46 1.22 1.55 1.14 1.65 1.06 1.76 0.98 1.88\n27 1.32 1.47 1.24 1.56 1.16 1.65 1.08 1.76 1.01 1.86\n28 1.33 1.48 1.26 1.56 1.18 1.65 1.10 1.75 1.03 1.85\n29 1.34 1.48 1.27 1.56 1.20 1.65 1.12 1.74 1.05 1.84\n30 1.35 1.49 1.28", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 216}
{"text": "0.86 1.94\n23 1.26 1.44 1.17 1.54 1.08 1.66 0.99 1.79 0.90 1.92\n24 1.27 1.45 1.19 1.55 1.10 1.66 1.01 1.78 0.93 1.90\n25 1.29 1.45 1.21 1.55 1.12 1.66 1.04 1.77 0.95 1.89\n26 1.30 1.46 1.22 1.55 1.14 1.65 1.06 1.76 0.98 1.88\n27 1.32 1.47 1.24 1.56 1.16 1.65 1.08 1.76 1.01 1.86\n28 1.33 1.48 1.26 1.56 1.18 1.65 1.10 1.75 1.03 1.85\n29 1.34 1.48 1.27 1.56 1.20 1.65 1.12 1.74 1.05 1.84\n30 1.35 1.49 1.28 1.57 1.21 1.65 1.14 1.74 1.07 1.83\n31 1.36 1.50 1.30 1.57 1.23 1.65 1.16 1.74 1.09 1.83\n32 1.37 1.50 1.31 1.57 1.24 1.65 1.18 1.73 1.11 1.82\n33 1.38 1.51 1.32 1.58 1.26 1.65 1.19 1.73 1.13 1.81\n34 1.39 1.51 1.33 1.58 1.27 1.65 1.21 1.73 1.15 1.81\n35 1.40 1.52 1.34 1.58 1.28 1.65 1.22 1.73 1.16 1.80\n36 1.41 1.52 1.35 1.59 1.29 1.65 1.24 1.73 1.18 1.80\n37 1.42 1.53 1.36 1.59 1.31 1.66 1.25 1.72 1.19 1.80\n38 1.43 1.54 1.37 1.59 1.32 1.66 1.26 1.72 1.21 1.79\n39 1.43 1.54 1.38 1.60 1.33 1.66 1.27 1.72 1.22 1.79\n40 1.44 1.54 1.39 1.60 1.34 1.66 1.29 1.72 1.23 1.79\n45 1.48 1.57 1.43 1.62 1.38 1.67 1.34 1.72 1.29 1.78\n50 1.50 1.59 1.46 1.63 1.42 1.67 1.38 1.72 1.34 1.77\n55 1.53 1.60 1.49 1.64 1.45 1.68 1.41 1.72 1.38 1.77\n60 1.55 1.62 1.51 1.65 1.48 1.69 1.44 1.73 1.41 1.77\n65 1.57 1.63 1.54 1.66 1.50 1.70 1.47 1.73 1.44 1.77\n70 1.58 1.64 1.55 1.67 1.52 1.70 1.49 1.74 1.46 1.77\n75 1.60 1.65 1.57 1.68 1.54 1.71 1.51 1.74 1.49 1.77\n80 1.61 1.66 1.59 1.69 1.56 1.72 1.53 1.74 1.51 1.77\n85 1.62 1.67 1.60 1.70 1.57 1.72 1.55 1.75 1.52 1.77\n90 1.63 1.68 1.61 1.70 1.59 1.73 1.57 1.75 1.54 1.78\n95 1.64 1.69 1.62 1.71 1.60 1.73 1.58 1.75 1.56 1.78\n100 1.65 1.69 1.63 1.72 1.61 1.74 1.59 1.76 1.57 1.78\nNote: DW values below dL indicate that positive autocorrelation exists; values above dU indicate that no positive autocorrelation exists. DW values \nbetween dL and dU are inconclusive. T o test for negative correlation use 4 − DW instead of DW.\nSource: S. Chatterjee and B. Price, Regression Analysis by Example, 3rd ed. (New Y ork, NY: John Wiley & Sons, 1999). Copyright © 1999 by John \nWiley & Sons; reprinted with permission.\n654\nAppendix e\nFor example, assume we are testing a regression equation with 18 observations and three vari-\nables. Positive autocorrelation would be indicated if DW < 0.93, no autocorrelation if DW > 1.69, and \nthe test would be inconclusive if 0.93 < DW < 1.69. The test for negative autocorrelation would be \nanalogous, using 4 − DW instead of DW.\nA routine check of summary statistics for a regression equation should include the DW . A par-\nticularly low or high DW would indicate a definite need for further analysis and model modification. \nHowever, it should be emphasized that even a perfect DW value (2.0) does not guarantee that auto-\ncorrelation does not exist. The DW only tests for first-order autocorrelation. If the interrelationship \nbetween the error terms is more complex, the DW might not pick it up. For this reason, it is also advis-\nable to check a residual plot for autocorrelation. Furthermore, as will be illustrated in subsequent sec-\ntions, the residual plot can also be used to provide important clues for improving the regression model.\n ■ The Implications of Autocorrelation\nThe presence of a pattern in the residuals suggests a potential inadequacy in the regression equation. \nSpecifically, autocorrelation may reflect one of the two following flaws:\n 1. The omission of significant explanatory variables in the regression equation.\n 2. The use of the linear regression method to describe a nonlinear relationship between the depen-\ndent and independent variables.\nIf the autocorrelation is due to one of these factors, it is clear why autocorrelation is undesirable. \nThese conditions indicate that a better model can be constructed, either by adding variables to the \nequation or by trying different functional relationships. However, even when this is not the case, an \nequation that exhibits autocorrelation is still undesirable, because the violation of the assumption that \nthe error terms are randomly distributed will lead to distortions.\n1 For this reason, as a last resort, \ntransformations designed to remove the autocorrelation should be considered.\nT o summarize, the DW and residual plot should be checked for autocorrelation. If residuals are \nfound to be correlated, the following steps should be taken:\n 1. Try to find any significant variables that may have been omitted from the equation.\n 2. If all feasible variables have been tried and autocorrelation still exists, experiment to see whether \nalternative functional forms (other than the linear form assumed in the regression procedure) \nare more appropriate.\n 3. If both of the preceding steps are unsuccessful, transformations to remove autocorrelation \nmight be tried.\n1 If autocorrelation exists, the standard regression approach, which is called ordinary least squares (OLS), will still \nyield unbiased estimates (i.e., estimates that on average will equal the population parameters). However, the \nestimates will no longer be efficient (i.e., they will not be the minimum variance estimates). Even worse, the \nstandard error estimates of the regression coefficients and the equation as a whole may be severely understated. \nConsequently, the true confidence interval may be much wider than suggested, and the regression equation may \nbe too imprecise to be used for forecasting.\n655\nANALYZING THE REGRESSION EQUATION\n The fi rst of these steps will be illustrated by an example in the next section. Methods to address \nthe second two steps are discussed in the addendum to this appendix. \n ■ Missing Variables and Time Trend \n A pattern in the residual plot (or the presence of autocorrelation) can be viewed as an indica-\ntion that signifi cant explanatory variables are missing from the equation. For example, Figure E.2 \nshows the residual plot for the simple regression model of the average December hog futures price \n during July–November as a function of per capita June–November hog slaughter. Note the obvious \n nonrandom distribution of the residu", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 217}
{"text": "(or the presence of autocorrelation) can be viewed as an indica-\ntion that signifi cant explanatory variables are missing from the equation. For example, Figure E.2 \nshows the residual plot for the simple regression model of the average December hog futures price \n during July–November as a function of per capita June–November hog slaughter. Note the obvious \n nonrandom distribution of the residuals: There seems to be a defi nite trending pattern in the residu-\nals with large negative values predominating in the earlier years and large positive values predomi-\nnating in the later years. \n Given this strong trending pattern in the residuals, we add a time trend as one of the explanatory \nvariables. A time trend is simply a set of successive integers. Normally, the fi rst observation would be \nassigned a value of 1, the second a value of 2, and so on. However, since the regression model is linear, \nany set of consecutive integers would serve equally well. \n It is not surprising that the fi tted values of the original equation tend to be too high in the earlier \nyears and too low in the later years since our model used nominal rather than defl ated prices. The \nreader may well wonder why we didn’t fi rst change the model by using defl ated prices instead of \nadding a time trend. In fact, this alternative approach is entirley reasonable as the fi rst change to try, \n FIGURE  E.2 Standardized Residuals for Average Price of December Hog Futures \n(July–November) vs. June–November Hog Slaughter \n Standardized Residuals for Average Price of December Hog Futures \n−2.0\n−1.5\n−1.0\n−0.5\n0.0\n0.5\n1.0\n1.5\n2.0\n2.5\n3.0\n1968\n1970\n1972\n1974\n1976\n1978\n1980\n1982\n1984\n1986\n1988\n1990\n1992\n1994\n1996\n1998\n2000\n2002\n2004\n2006\n2008\n2010\n2012\n2014\n656\nAppendix e\nand we did run this model (not shown), but the results were substantially inferior to the model that \nadded a time trend.\nTable E.2 compares the summary statistics of this two-independent-variable regression equation \nwith those of the original one-independent-variable model. Note the dramatic improvement in all the \nsummary statistics and the significance of the time trend as reflected by its t statistic. In fact, the time \ntrend is statistically even more significant in explaining hog prices than hog slaughter! In addition, \nthe strong trend evident in the residual plot for the original simple regression (Figure E.2) has been \neliminated in the residual plot for the new equation (Figure E.3). Although the trend in the residuals \nhas been eliminated, Figure E.3 still exhibits a non-random pattern. Specifically, the residuals now \nconform to a broad “U” pattern, with positive residuals predominating in the early and late years and \nnegative residuals predominating in the middle years. The existence of this pattern suggests other \nsignificant variables are still missing from the equation.\nNext we add per capita broiler slaughter to the model, since poultry is an important competi-\ntive meat to pork. Table E.3 compares the key statistics for this new equation (Model 3) with the \n corresponding values for the first two models. As can be seen, the addition of poultry slaughter \n provides a large improvement in all the key statistics. For example, the corrected R2 jumps from \n0.66 in Model 2 to 0.82 in Model 3. Moreover, not only is the t statistic for broiler slaughter highly \nsignificant but the addition of this variable also increases the t statistics for the other explanantory \nvariables (hog slaughter and trend). The addition of broiler slaughter to the equation also eliminates \nthe pattern in the residuals. As can be seen in Figure E.4, which shows the residual plot corresponding \nto Model 3, the scatter of residuals now seems random.\nAchieving a random residual plot doesn’t necessarily mean the model is complete. It may well \nbe possible to further improve the model by adding other variables. Model 4 in Table E.3 illustrates \nTAble e.2 Regression Summary Statistics for Hog-price-Forecasting Models\nStatistic\nModel 1: Hog price vs. per Capita \nHog Slaughter\nModel 2: Hog price vs. per Capita \nHog Slaughter and Trend\nR2 0.21 0.66\nCR2 0.20 0.64\nSER 13.95 9.30\n%SER 27.2 18.16\nF 11.72 40.62\nt-stat (constant) 5.19 4.57\nt-stat (hog slaughter) –3.42 –3.12\nt-stat (trend) NA 7.41\nt-stat (broiler slaughter) NA NA\nt-stat (cattle slaughter) NA NA\n657\nANALYZING THE REGRESSION EQUATION\n FIGURE  E.3 Standardized Residuals for Average Price of December Hog Futures \n(July– November) vs. June–November Hog Slaughter, and Trend \n−3.0\n−2.5\n−2.0\n−1.5\n−1.0\n−0.5\n0.0\n0.5\n1.0\n1.5\n2.0\n2.5\n1968\n1970\n1972\n1974\n1976\n1978\n1980\n1982\n1984\n1986\n1988\n1990\n1992\n1994\n1996\n1998\n2000\n2002\n2004\n2006\n2008\n2010\n2012\n2014\n TAble e.3 Regression Summary Statistics for Hog-price-Forecasting Models \nStatistic\nModel 1: Hog \nprice vs. per Capita \nHog Slaughter\nModel 2: Hog \nprice vs. per Capita \nHog Slaughter and \nTrend\nModel 3: Hog price \nvs. per Capita Hog \nSlaughter, broiler \nSlaughter, and Trend\nModel 4: Hog price vs. \nper Capita Hog Slaughter, \nbroiler Slaughter, Cattle \nSlaughter, and Trend\nR 2 0.21 0.66 0.84 0.85\nCR 2 0.20 0.64 0.82 0.84\nSER 13.95 9.30 6.53 6.24\n%SER 27.2 18.16 12.76 12.18\nF 11.72 40.62 69.51 58.40\nt -stat (constant) 5.19 4.57 8.45 6.02\nt -stat (hog slaughter) –3.42 –3.12 –4.39 –5.11\nt -stat (trend) NA 7.41 10.29 5.88\nt -stat (broiler slaughter) NA NA –6.64 –7.23\nt -stat (cattle slaughter) NA NA NA –2.22\n658APPENDIX E\n FIGURE  E.4 Standardized Residuals for Average Price of December Hog Futures \n(July– November) vs. June–November Hog Slaughter, Broiler Slaughter, and Trend \n−3.0\n−2.0\n−1.0\n0.0\n1.0\n2.0\n3.0\n1968\n1970\n1972\n1974\n1976\n1978\n1980\n1982\n1984\n1986\n1988\n1990\n1992\n1994\n1996\n1998\n2000\n2002\n2004\n2006\n2008\n2010\n2012\n2014\none such attempt: adding per capita cattle slaughter to the model on the premise that beef is another \ncompetitive meat to pork. The t statistic for cattle slaughter is statistically signifi cant and adding this \nvariable modestly increases the corrected R 2 and low", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 218}
{"text": "0\n1.0\n2.0\n3.0\n1968\n1970\n1972\n1974\n1976\n1978\n1980\n1982\n1984\n1986\n1988\n1990\n1992\n1994\n1996\n1998\n2000\n2002\n2004\n2006\n2008\n2010\n2012\n2014\none such attempt: adding per capita cattle slaughter to the model on the premise that beef is another \ncompetitive meat to pork. The t statistic for cattle slaughter is statistically signifi cant and adding this \nvariable modestly increases the corrected R 2 and lowers the SER. \n ■ Dummy Variables \n In Appendix A we derived a regression equation for forecasting June–November hog slaughter from \nthe prior December–May pig crop. Consider what happens when we attempt to make the equation \nmore general by forecasting hog slaughter during a six-month period from the pig crop of the previ-\nous six-month period. In this case, half the observations are those of the original equation, while the \nother half relate December–May slaughter to the June–November pig crop. Figure E.5 illustrates \nthe residual plot for this equation. W e have used two diff erent symbols to distinguish between the \nresiduals for June–November slaughter and the residuals for December–May slaughter. Note the \nstriking pattern of the predominance of positive residuals for June–November slaughter and nega-\ntive residuals for December–May slaughter. As Figure E.5 dramatically indicates, our equation is \nmissing some important information: the seasonal period of the slaughter forecast. Clearly, we want \nour equation to distinguish between the two periods. In other words, it is necessary to include a \nseasonal indicator. \n659\nANALYZING THE REGRESSION EQUATION\n A simple method for handling such a situation would be to add a dummy variable to the equation, \nwhich has a value of 1 for one season and a value of 0 for the other season. The regression equation \nadding a dummy variable could be written as\n HS ab PC cS=+ + \nwhere HS = hog slaughter \nPC = pig crop \nS = dummy variable, which equals 0 during December–May and 1 during June–November \n The dummy variable can be thought of as a switch that is set to off (0) during the base period \n(December–May) and on (1) during June–November. The dummy variable will have the eff ect of \nshifting the intercept by an amount c for the June–November observations. Note that this adjustment \nwill be exactly equivalent to fi nding two separate equations with the same slope, one for each period. \nThat is, HS = a + bPC + cS for all periods is equivalent to:\n HS ab PC\nHS ab PC\n=+\n=+\n1\n2\nforD ecember-Ma ys laughte r\nforJ une-November s slaughte r \nwhere a 2 = a 1 + c \n FIGURE  E.5 Standardized Residuals for Hog Slaughter vs. Previous Six-Month Pig Crop \n−2.0\n−1.5\n−1.0\n−0.5\n0.0\n0.5\n1.0\n1.5\n2.0\n2.5\n1994\n1996\n1998\n2000\n2002\n2004\n2006\n2008\n2010\n2012\n2014\n2016\nDecember-May HS\nJune-November HS\n660\nAppendix e\nTypically, most users of regression analysis will only employ a dummy variable to shift the inter-\ncept, while the slope is assumed to remain constant from period to period. However, in most instances \nthere is no reason to impose an a priori restriction that the slopes be equal in different periods. Rather, \nit seems preferable to begin by using dummy variables for both the intercept and the slopes.\n2 Once \nthis full version of dummy variables is run, we can check the t statistics to see which of the dummy \nvariables are significant and then choose the appropriate model accordingly. Thus, in our example, \nwe would begin with:\nHS ab PC cS dS PC=+ ++ ⋅⋅\nwhere S = 0 during December–May\n S = 1 during June–November\nThe form of the equation used will depend on which of the dummy variables proves significant. \nSome examples:\n 1. If neither c or d is significant, we would use:\nHS ab PC=+\n 2. If only c is significant, we would use:\nHS ab PC cS=+ +\n 3. If both c and d are significant, we would use the full-version equation:\nHS ab PC cS dS PC=+ ++ ⋅⋅\n2 There are two important exceptions: (1) When one of the periods contains only a few observations, the slope \nestimate for this period might be unreliable, and it would be better to pool the data in terms of assuming a \ncommon slope coefficient for all observations. For example, consider an annual price-forecasting model with \n15 observations, three of which coincided with a government program that distorted normal market behavior. \nIn this case, we would definitely only use the dummy variable for the constant term (with the aforementioned \nthree years having a dummy variable value equal to 1), thereby implicitly imposing the restriction of a common \nslope. The reason for this is that a slope estimate based on only three observations would not be very reliable. This \nexample illustrates one of the advantages of using dummy variables, as opposed to separate equations for each \nset of observations. (2) When the number of all possible dummy variables is large compared with the number of \nobservations, it may be desirable to conserve degrees of freedom by limiting the number of dummy variables.\n661\nANALYZING THE REGRESSION EQUATION\nNote that in this last case, when both c and d are significant, the resulting equation is equivalent to \nthe following two separate equations for each period:3\nHS = a + bPC for December–May\nHS = (a + c) + (b + d)PC for June–November\nWhy, then, do we not just run separate equations for each period? There are several reasons:\n 1. By pooling the data, we increase the number of degrees of freedom and add to the statistical \nreliability of the equation.\n 2. W e do not know beforehand which, if any, of the dummy variables will be significant. The \nsingle-equation approach will allow us to eliminate the dummy variables that appear insignifi-\ncant, thereby providing a better model. In contrast, the two-equation approach is equivalent to \nautomatically assuming that all the dummy variables are significant.\n 3. In terms of the various tasks of checking alternative models, testing for significance, and fore-\ncasting, it is more convenient to have a single equation that is applicable to all periods than a \nseparate equation", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 219}
{"text": "pear insignifi-\ncant, thereby providing a better model. In contrast, the two-equation approach is equivalent to \nautomatically assuming that all the dummy variables are significant.\n 3. In terms of the various tasks of checking alternative models, testing for significance, and fore-\ncasting, it is more convenient to have a single equation that is applicable to all periods than a \nseparate equation for each period.\n 4. As mentioned in footnote 2, there are times when it is definitely preferable to impose slope \nrestrictions—an approach that requires the use of dummy variables.\nSince in our example of hog slaughter versus the prior six-month pig crop the dummy variable for \nthe slope is statistically significant, we use the full form of the equation:\nHS ab PC cS dS PC=+ ++ ⋅⋅\nFigure E.6 shows the residual plot for the regression equation that adds dummy variables for the \nslope and intercept. Note that the positive bias for June–November residuals and the negative bias for \nDecember–May residuals has been eliminated.\nThe failure to include dummy variables when they are appropriate will bias the regression coef-\nficient estimates. In Figure E.7 we provide a hypothetical example where the points associated with \ntwo different periods are best described by best-fit lines with different constant terms. Note how the \nslope of a single regression equation line without inclusion of dummy variables is biased by the failure \nto distinguish between the two periods.\nAlthough our example involved only two periods (one period other than the base period), the \ndummy variable approach can be extended to more period divisions. For example, if we were using \na quarterly model, there would be one dummy variable for each quarter other than the base quarter.\nYa bX cS cS cS dS Xe SX fS X=+ ++ ++ ⋅⋅ +⋅ ⋅+ ⋅⋅11 22 33 12 3\n3 Although the intercept and slopes will be identical in the one- and two-equation versions, there is a minor \ntechnical difference between the two models. The single equation implicitly assumes a common variance for \nall periods, while the two-equation version allows for different variances in each period. This difference could \ntheoretically affect the various tests of significance.\n662APPENDIX E\n FIGURE  E.6 Standardized Residuals for Hog Slaughter vs. Previous Six-Month Pig Crop after \nIncluding Dummy Variables \n-2.0\n-1.5\n-1.0\n-0.5\n0.0\n0.5\n1.0\n1.5\n2.0\n2.5\n1994\n1996\n1998\n2000\n2002\n2004\n2006\n2008\n2010\n2012\n2014\n2016\nDecember-May HS\nJune-November HS\n FIGURE  E.7 Bias in Regression Line Due to Omission of Dummy Variables \nFitted line without use of\ndummy variables\nTwo equations implied by equation that\nincludes a dummy variable for constant term\n663\nANALYZING THE REGRESSION EQUATION\nwhere S1 = dummy variable for the first quarter\n S2 = dummy variable for the second quarter\n S3 = dummy variable for the third quarter\nNote that the number of dummy variables is always equal to one less than the number of periods, \nsince the base period conditions, assumed to be the fourth quarter in our example, are captured by \nthe original constant and regression coefficient.4\nIf there are two independent variables, the full-version equation would be\nYa bX bX cS cS cS dS X\ndS Xe SX e\n=+ ++ ++ +⋅ ⋅\n⋅⋅ +⋅ ⋅++\n11 22 11 22 33 11 1\n21 21 21 2 ⋅⋅ ⋅+ ⋅⋅ +⋅ ⋅SX fS Xf SX22 13 12 32\nNote that:\nb values are regression coefficients for regular independent variables.\nc values are regression coefficients for dummy constants.\nd values are regression coefficients for dummy slope for the first period (S\n1).\ne values are regression coefficients for dummy slope for the second period (S2).\nf values are regression coefficients for dummy slope for the third period (S3).\nAs should be quite apparent, when the number of periods is increased, the number of dummy \nvariables increases like rabbits. Since the researcher might wish to avoid beginning with an equa-\ntion that contains a large number of dummy variables, she might prefer to only include constant \ndummy variable terms in the starting equation and then experiment with the addition of selected \nslope dummy variable terms if she believes that her initial equation needs improvement.\n ■ Multicollinearity\nThe reader may recall that the extension to the multiple regression model required the addi-\ntional assumption that the independent variables be linearly independent. Multicollinearity is a \nterm used to describe the presence of significant correlation between two or more independent \nvariables.\nT o see why multicollinearity is a problem, consider a hog-slaughter-forecasting model that includes \nboth the pig crop during the prior six-month period and the number of market hogs at the start \nof the period as explanatory variables. In this case, the independent variables would be extremely \nhighly correlated, that is, large market hog figures would coincide with large pig-crop numbers. As \nillustrated in Figure E.8, a three-dimensional representation is really unnecessary for this model, as \n4 In fact, including a dummy variable for the base period would actually result in perfect multicollinearity—a \ntotally undesirable situation (see next section).\n664APPENDIX E demonstrated by the proximity of the points to a straight line. Actually, either the X 1, Y plane or the \nX 2, Y plane alone would have been adequate. The fi rst plane would be a two-dimensional representa-\ntion of the relationship between hog slaughter and the pig crop, and the second, a two-dimensional \nrepresentation of the relationship between hog slaughter and market hogs. In eff ect, the inclusion of \nboth the pig crop and market hogs forces the use of a three-dimensional model to represent a relation-\nship that can be adequately described by two dimensions. \n The problem lies not in the fact that multicollinearity implies the inclusion of superfl uous \ninformation, but rather that this redundancy can severely aff ect the regression equation’s reli-\nability. Multicollinearity is a perfect example of the phrase “more is les", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 220}
{"text": "hogs forces the use of a three-dimensional model to represent a relation-\nship that can be adequately described by two dimensions. \n The problem lies not in the fact that multicollinearity implies the inclusion of superfl uous \ninformation, but rather that this redundancy can severely aff ect the regression equation’s reli-\nability. Multicollinearity is a perfect example of the phrase “more is less.” As can be seen in Figure \n E.8 , when multicollinearity is present, there may be very divergent planes that closely approxi-\nmate the fi t of points. For any given set of observations, the regression procedure will choose one \nplane that best fi ts the observations. However, the real problem in multicollinearity lies in the \nfact that if the observations were only slightly altered, a totally diff erent plane might be chosen \nas the best fi t. Thus, if multicollinearity exists, the regression coeffi cients are no longer reliable \nindicators of how the dependent variable will change when each of the independent variables is \nchanged (while all the other independent variables are held constant). This fact will be refl ected \nby high standard errors, and hence low t statistics, for the regression coeffi cients of highly cor-\nrelated explanatory variables. \n FIGURE  E.8 Multicollinearity\n Source: Adapted from T . H. W onnacott and R. J. W onnacott, Econometrics , John Wiley & Sons, \nNew Y ork, 1980.\nY = hog slaughter\nX1 = pig crop\nX2 = market hogs\n665\nANALYZING THE REGRESSION EQUATION\nWhat about the reliability of the equation in forecasting? If the values of the independent variables \nfor the forecast period lie in the neighborhood of past observations, then the multicollinear model can \nstill provide adequate forecasts. This situation describes the preceding example, since presumably the \npig crop and market hogs will continue to remain highly correlated. In other circumstances, however, \nif the two correlated independent variables cease to be correlated in the future, then the forecast \nprovided by the multicollinear equation could be distorted because the model is only valid for points \nin the neighborhood of past observations. At other locations, there is no historical evidence to provide \nany clues regarding the expected relationship between the variables. In geometric terms, all planes \npassing through a line provide accurate forecasts in the vicinity of the line, but drastically different \nprojections at points removed from the line (Figure E.8).\nT o summarize, there are two major drawbacks to a multicollinear equation:\n 1. The regression coefficients lose their meaning (i.e., are no longer statistically reliable).\n 2. If the equation is used for forecasts in which the independent variables do not lie in the neigh-\nborhood of past observations, the projection could be severely distorted.\nClearly, then, it is always desirable to avoid multicollinearity. The presence of multicollinearity can \nbe detected in a number of ways:\n 1. Check the regression coefficients. The regression coefficients of an equation can provide a \nnumber of clues indicating that multicollinearity is present:\na.\n Low t statistics for coefficients that were expected to be highly significant.\nb. In more extreme cases, a regression coefficient sign that may actually be counter to theoreti-\ncal expectations.\nc.\n Large changes in the coefficient values when variables are added or deleted from the equation.\nd. Large changes in coefficient values when data points are added or deleted from the equation.\nAny of these patterns would suggest that the independent variables should be examined for signs \nof correlation.\n 2. Compare the independent variables. Sometimes common sense will dictate when the \nindependent variables are likely to be correlated. By being aware of the problem, one can often \navoid multicollinearity by carefully selecting the independent variables. For example, if the \nresearcher thought that gross national product (GNP) and disposable income might help explain \nthe variation of the dependent variable, she would use either one, or try both successively, but \nshe would not include them in the same equation simultaneously. Beyond intuition, one can \ncheck for correlation between the independent variables statistically. High absolute values of \nthe correlation coefficients\n5 between any two independent variables would indicate a potential \n5 The correlation coefficient, denoted by the symbol r, reflects the degree of relationship between two variables \nand can range between −1 and +1. Values close to +1 indicate a strong positive relationship, while values close to \n−1 indicate a strong inverse relationship. If r is close to 0, it means that there is little, if any, correlation between \nthe two variables. The square of the correlation coefficient is equal to the r\n2 of the simple regression equation in \nwhich one of the variables is a dependent variable and the other an independent variable.\n666\nAppendix e\nmulticollinearity problem. The correlation matrix—an output feature in some software pack-\nages—offers a summary array of all the paired correlation values.\nWhat should be done if multicollinearity is discovered in an equation? One solution is simply to \ndelete one of the correlated independent variables.\n ■ Addendum: Advanced Topics\nTransformations to Achieve linearity6\nPerhaps the most basic assumption in a regression analysis is that the relationship between the \ndependent and independent variables is approximately linear. If, in fact, the relationship is deci-\nsively nonlinear, the error terms might appear to be correlated. For example, consider what hap -\npens when we try to fit a regression line to the scatter points in Figure E.9a. Forcing these points \ninto a linear fit would result in the residual pattern illustrated in Figure E.9b, in which the residuals \nwould tend to be positive at high and low values of the independent variable X and negative in the \nmiddle range of values. (In Figure E.9b, the sta", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 221}
{"text": "rrelated. For example, consider what hap -\npens when we try to fit a regression line to the scatter points in Figure E.9a. Forcing these points \ninto a linear fit would result in the residual pattern illustrated in Figure E.9b, in which the residuals \nwould tend to be positive at high and low values of the independent variable X and negative in the \nmiddle range of values. (In Figure E.9b, the standardized residuals are plotted against the indepen-\ndent variable not time.)\nFortunately, many nonlinear relationships can be transformed into linear equations. For example, \nthe scatter of points in Figure E.9a suggests a hyperbolic function, or an equation of the general form\nYa b\nXc=+ +\nThis can be transformed into a linear relationship by setting\nX Xc′= +\n1\nthen\nYa bX=+ ′\nIn this form, the equation can be solved in straightforward fashion using ordinary least squares \n(OLS), the standard regression procedure. T o get a specific forecast for Y, one would merely plug in \nthe value 1/(X + c) for X′. For example, if a = 2, b = 16, c = 4, and X = 4, the forecast for Y is 4.\n6 Although still involving nothing more mathematically complex than algebra, the remainder of this appendix \ncovers material that is somewhat more advanced. \n667\nANALYZING THE REGRESSION EQUATION\n FIGURE  E.9 Distortion in Applying Linear Regression to Nonlinear Function \nY\nX\n0\n(a) (b)\nStandardized residuals\nX\n Many other types of functions can be transformed into linear equations. Let us consider a few \nmore examples: \n 1. Y = a + b 1 X + b 2 X 2 + b 3 X 3 \n Let X 1 = X ; X 2 = X 2; X 3 = X 3; then \n Y = a + b 1 X 1 + b 2 X 2 + b 3 X 3 \n This is a linear equation and OLS can be applied. Note that although the independent vari-\nables are related, the relationship is nonlinear, so that the regression assumption regarding linear \nindependence among the explanatory variables is not violated. \n 2. Y = ae bX \n Taking the natural logarithm of both sides: \n ln lnYa bX=+ \n Let Y ′ = ln Y ; a ′ = ln a ; then \n Ya bX′= ′+ \n This is a linear equation and OLS can be applied. Note that in this case, plugging a value for \n X into the derived regression equation will yield a forecast for ln Y . T o get a forecast for Y , it \nwould be necessary to fi nd the antilog value. Figure E.10 illustrates the shapes of the function \n Y = ae bX for diff erent values of b. \n668APPENDIX E\n FIGURE  E.10 Y = ae bX \n Source: S. Chatterjee and B. Price, Regression Analysis by Example, 3rd ed. (New Y ork, NY: John Wiley \n& Sons 1999). Copyright © 1999 by John Wiley & Sons; reprinted with permission. \n(b > 0)\n1/b\n(a)\nx\ny\nae\n0\n(b < 0)\n1/|b|\n(b)\nx\ny\na/e\n0\n 3. Ya Xb=⋅\n Taking logs of both sides: \nlogl og logYa bX=+\n Let Y ′ = log Y ; a ′ = log a ; X ′ = log X ; then \nYa bX′= ′+ ′\n This is a linear equation and OLS can be applied. Here we would plug the value for log X , not \nX , into the regression equation to get a forecast of log Y . T o get a forecast for Y , it would then \nbe necessary to fi nd the antilog value. Figure E.11 illustrates the shape of the function Y = aX b\nfor diff erent values of a and b . \n If a residual plot still refl ects autocorrelation after all feasible variables have been tried, the pos-\nsibility of nonlinearity should be considered. In the simple regression case, a scatter diagram can \nbe constructed in order to check whether a linear assumption is warranted or whether another \nfunctional form is more appropriate, just as Figure E.9 a suggested the equation form Y = a + b/ ( X + \nc ). In a multiple regression, if nonlinearity is expected for one of the independent variables, a regres-\nsion could be run using only the other independent variables. The residuals of this equation would \nthen be plotted against the unused independent variable. The presence of any nonlinearity would be \napparent in the resulting scatter diagram. \n669\nANALYZING THE REGRESSION EQUATION\n FIGURE  E.11 Y = aX b \n Source: S. Chatterjee and B. Price, Regression Analysis by Example , 3rd ed. (New Y ork, NY: \nJohn Wiley & Sons, 1999). Copyright © 1999 by John Wiley & Sons; reprinted with permission. \n(a, b, x all > 0)\nx\na\n1\n0\nb > 1\n(a)\nb = 1\n0 < b < 1\ny\n(a, x > 0, b < 0)\nx\na\n1\n0\n(b)\n−1 < b < 0\nb = −1\nb < −1\ny\n Transformation to Remove Autocorrelation \n The simplest assumption one can make about autocorrelation is that a current period’s error \nterm will be equal to the previous period’s error term plus a random disturbance. This can be \nexpressed as\nee\ntt t=+ −1 υ ,\nwhere υ t = a random disturbance term. \n Since Y t = α + βX t + e t and Y t −1 = α + βX t −1 + e t −1 , then\nYY XXtt tt t−= −+−−11 βυ()\n Let YY Ytt t\n* =− −1 and XX Xtt t\n* =− −1 ; then\n YXtt t\n** =+βυ \n For a k -variable multiple regression equation, these steps would yield\n YX XXtt tk kt t\n** **=+ ++ +ββ βυ11 22  \n Since by defi nition υ t is randomly distributed, OLS can now be applied to this equation. \n670\nAppendix e\nThe preceding method, which is perhaps the most commonly used transformation for removing \nautocorrelation, is known as first differences. In effect, the first difference regression equation states that \nthe change in Y will be linearly dependent on the change in X. Equations of this type will tend to have \nmuch lower R2 values. This is only to be expected, since forecasting the change from one period to the \nnext is much more difficult than forecasting the level. Once again, consider the following daytrading \nprice-forecasting model:\nPa bPtt =+ −1\nwhere Pt = closing price on day t\n Pt − 1 = closing price on day t − 1\nSuch an equation would have an extremely high R2 since it would give us a close approximation of \nthe price level for a given day. However, it would be useless in forecasting the change in price from \nday to day. The model\nPa bXtt\n** =+\nwhere PP Ptt t\n* =− −1\nXX Xtt t\n* =− −1\nin which Xt is some explanatory variable the value of which is known before day t, would be far pref-\nerable, even if its R2 value were low (e.g., R2 = 0.30).\nThe first difference approach is easy to", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 222}
{"text": "ose approximation of \nthe price level for a given day. However, it would be useless in forecasting the change in price from \nday to day. The model\nPa bXtt\n** =+\nwhere PP Ptt t\n* =− −1\nXX Xtt t\n* =− −1\nin which Xt is some explanatory variable the value of which is known before day t, would be far pref-\nerable, even if its R2 value were low (e.g., R2 = 0.30).\nThe first difference approach is easy to use, but it does involve an extreme simplifying assumption \nregarding the nature of the autocorrelation. A more realistic assumption would be\neett t=+ −ρυ 1\nwhere | ρ | < 1. Note that the larger the value of ρ, the more the error term in a given period will \nbe dependent upon the previous period’s error term. A generalized transformation is analogous to \nthe first difference transformation:\nYX e\nYX e\ntt t\ntt t\n=+ +\n=+ +−− −\nαβ\nαβ\n \n 11 1\nIf we multiply the equation for Yt − 1 by ρ\nρρ αρ βρYX ett t−− −=+ +11 1\n Thus, Yt − ρYt − 1 = α(1 − ρ) + β(Xt − ρXt − 1) + υt.\nLet YY Ytt t\n* =− −ρ 1 and XX Xtt t\n* =− −ρ 1.\nThen YXtt t\n** ()=− ++αρ βυ1 .\n671\nANALYZING THE REGRESSION EQUATION\nFor a k-variable equation, these steps would yield\nYX XXtt kk tt\n** **()=− ++ ++ +αρ ββ βυ1 11 22 \nSince by definition υ t is randomly distributed, OLS can once again be used. The only problem \nwith this procedure is that we do not know the value of ρ. W e very briefly describe two approaches \nfor estimating ρ.\n 1. The Hildreth-lu procedure. This procedure specifies a set of spaced values for ρ. If positive \nautocorrelation is assumed, these values might be 0, 0.1, 0.2, 0.3, 0.4, 0.5, 0.6, 0.7, 0.8, 0.9, \n1.0. A regression is then run for the transformed equation:\nYX XXtt tk kt\n** **()=− ++ ++αρ ββ β1 11 22 \nusing each of the specified values. The procedure will select the equation that results in the low-\nest SER. If desired, the process can be repeated using a closer spacing of ρ values in the vicinity \nof the ρ selected in the initial step.\n 2. The Cochrane-Orcutt procedure. This iterative procedure estimates a ρ value from the \nresiduals of the original equation, and a regression is then run on the transformed equation \nusing this estimate of ρ. If the resulting equation still indicates autocorrelation, the process is \nrepeated using the residuals of the new equation.\n ■ Heteroscedasticity\nOne of the assumptions that justifies the use of ordinary least squares (OLS) is that the error terms \nare homoscedastistic, that is, they have an approximate constant variance. When this condition is not \nmet, the problem is called heteroscedasticity. Figure E.12 illustrates a case of heteroscedasticity. Note \nthat the relationship between the dependent and independent variables becomes increasingly variable \nas X increases, resulting in higher absolute residual values at higher values of X. The wider variability \nbetween the dependent and independent variables in a given region will make the resulting regression \nequation less reliable.\nWeighted least squares (WLS) is a method used to circumvent this problem. For the relationship \ndepicted in Figure E.12, the WLS approach would give greater weight to the observations for lower \nvalues of X, since these offer a more precise indication of the location of the true regression line. \nRather than describe the WLS procedure, suffice it to say that there is a simpler approach using a \ntransformation that achieves exactly equivalent results. This transformation assumes that the standard \ndeviation of the error terms is proportional to the independent variable. Specifically,\nσii kX=\n672APPENDIX E\nwhere σ i = standard deviation of the error terms ( e i ). Starting with the standard regression equation\nYX eii i=+ +αβ\nwe divide by X i ,\n \nY\nX\na\nX\ne\nX\ni\nii\ni\ni\n=+ + β \n The standard deviation of e i / X i . is equal to the standard deviation of e i divided by X i . Since the \nstandard deviation of e i is σ i , which equals kX i , the standard deviation of e i /X i = k , a constant. Thus, \nthis transformation removes the heteroscedasticity of the original equation. Now if we let\n ′= ′ = ′ = ′ = ′ =Y Y\nX X X e e\nXi\ni\ni\ni\ni\ni\ni\n1 αβ βα and \nthen\n ′= ′+ ′′ + ′YX eii iαβ \n This equation can be solved by using OLS, yielding\n′=+ ′Ya bXii\nwhere a is an estimator of β in the original equation and b is an estimator of α in the original equation. \n FIGURE  E.12 Heteroscedasticity \nY\nX\n0\n(a) (b)\nStandardized residuals\nX\n673\nAppendix F\nI remember the rage I used to feel when a prediction went awry. I could have shouted at the \nsubjects of my experiments, “Behave, damn you, behave as you ought!” Eventually I realized \nthat the subjects were always right. It was I who was wrong. I had made a bad prediction.\n—Burrhus Frederic Skinner\n ■ Determining the Dependent Variable\nThe title of this section might sound trivial. After all, the dependent variable is what we wish to fore-\ncast. However, in a price-forecasting equation, the selection of a dependent variable is by no means \nobvious. The following choices must be made:\n 1. Should the price be stated in nominal or deflated terms?\n 2. Should the price be based on cash or futures?\nPractical \nConsiderations \nin Applying \nRegression Analysis\n674\nAppendix F\n 3. If the price is based on futures, should it be based on a nearest futures price series or a single \ncontract?\n 4. Should the price represent the entire season or only a specified segment of the season?\nThe answer to question 1 would typically be deflated prices, unless a trend variable is included in \nthe equation, in which case nominal prices may be a better choice. If, however, the equation does not \ninclude a trend variable, then the use of nominal prices implicitly assumes that equivalent fundamental \nconditions in two widely spaced years should result in approximately equal price levels. Obviously, this \nassumption is wrong. All else being equal, inflation will result in considerably higher prices in the more \nrecent year. The subject of adjusting prices for inflation is covered in greater detail in Cha", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 223}
{"text": "nd variable, then the use of nominal prices implicitly assumes that equivalent fundamental \nconditions in two widely spaced years should result in approximately equal price levels. Obviously, this \nassumption is wrong. All else being equal, inflation will result in considerably higher prices in the more \nrecent year. The subject of adjusting prices for inflation is covered in greater detail in Chapter 25.\nThe answers to questions 2 and 3 depend primarily on the particular price you wish to forecast. \nAlthough this consideration is also a factor in answering question 4, the choice of the time period \nshould depend more heavily on the fundamental characteristics of the market. Of course, if the initial \nchoice is inappropriate, the misjudgment will become apparent in analyzing the regression results. \nHowever, by giving some thought to the intrinsic market fundamentals before selecting the forecast \nperiod, it is possible to minimize unnecessary trial and error in the regression-analysis process.\nFor example, in most agricultural markets, the statistical balance for a given season will have a far \ngreater impact on price levels during the first half of the season than on price levels during the second half. \nThis typical market behavioral pattern reflects the fact that by the second half of the season, the prevail-\ning fundamental situation is well-defined and frequently largely discounted. More often than not, major \nprice shifts during the latter part of a season reflect developments affecting new crop expectations (e.g., \ndrought and freeze). Consequently, for a fundamental model that does not include new crop expecta-\ntions as an explanatory variable, it would generally make more sense to select a price forecast period that \napproximates the first half of the season rather than the full season. This approach does not mean that we \nignore the other six months. Rather, the implication is that it will be necessary to develop other models \nto forecast prices in those months. For example, the latter months of a season might be grouped with \nthe early months of the following season in a model that employed new-crop statistics to forecast prices.\nIn some markets, intrinsic fundamental considerations will not dictate a specific observation \nperiod. In such cases, the choice will involve only the time frame of the individual observations (e.g., \nannual, semiannual, quarterly, monthly).\n1 Here a general rule might apply: start with the longest \nperiod (i.e., annual or semiannual), and if the regression model is satisfactory, work toward a shorter \nperiod. Although the shortest time frame projection is most useful for trading purposes, the difficulty \nof forecasting is inversely proportional to the length of the time period. Also, the shorter the time \nframe, the more likely the problem of autocorrelation. For example, in a monthly model there is a \nhigh probability that a high positive residual in one month will be followed by a positive residual in \nthe next month. Thus, for monthly and even quarterly models, transformations to remove autocor-\nrelation may be necessary (e.g., first differences).\n1 The choice of the length of the period must also be made for markets in which the structure of the model \ndepends on the forecast period. For example, a model based solely on old-crop statistics (i.e., a model that does \nnot incorporate new-crop expectations) could use a six-month forecast period (coinciding with the first half of \nthe season) or it could be applied to two separate three-month periods.\n675\nPRACTICAL CONSIDERATIONS IN APPLYING REGRESSION ANALYSIS\n ■ Selecting the Independent Variables\nGeneral Considerations\nThere is more to selecting the independent variables than choosing the factors that intuitively appear \nto be good candidates for explanatory variables. Perhaps the pivotal question to be considered is \nwhether the regression equation is intended for explaining or forecasting the dependent variable. \nSometimes, a regression equation is only intended as an explanatory model. For example, a wheat \nproducer might be interested in determining the relationship between yield and the quantity of fertil-\nizer applied. In this case, his goal is not to forecast yield, a projection that will also depend heavily on \nother factors, such as weather conditions, but to understand the implications of various management \nchoices. Furthermore, he need not worry about estimating the independent variable (quantity of \nfertilizer), since it is entirely under his control.\nIn contrast, most applications of regression analysis in the futures markets will be concerned with \nforecasting. If an equation is intended primarily for prediction, it is critical to choose explanatory \nvariables that can be determined with relative reliability. For example, if we were to construct a cop-\nper price-forecasting model in which the concurrent gross domestic product (GDP) was an impor-\ntant input, the equation would be useless if GDP levels were no more predictable than copper prices, \neven if R\n2 = 1.00. Thus, in selecting independent variables, the researcher should keep in mind the \nprecision with which these variables can be estimated before the forecast period.\nIf they prove statistically significant, lagged variables are the ideal choice for explanatory variables. \nA lagged variable is one whose value is determined during a period before the period for the corre-\nsponding dependent variable. For example, the average GDP during the prior six months would be a \nlagged variable. Thus, even if the lagged value of GDP were substantially less significant in explaining \ncopper prices than the concurrent value, it might still be a preferable choice.\nUnfortunately, the analyst will rarely be lucky enough to construct a regression equation that uses \nonly lagged variables. Concurrent variables that can be forecast with reasonable accuracy provide an \nacceptable alternative. In fact, some variables, such as population, can be f", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 224}
{"text": "ntially less significant in explaining \ncopper prices than the concurrent value, it might still be a preferable choice.\nUnfortunately, the analyst will rarely be lucky enough to construct a regression equation that uses \nonly lagged variables. Concurrent variables that can be forecast with reasonable accuracy provide an \nacceptable alternative. In fact, some variables, such as population, can be forecast with such accuracy \nthat they are similar to lagged variables. Other variables can be projected within a reasonable range. For \nexample, in the hog model, hog slaughter is much easier to project than hog prices, since it depends on \nlagged variables (e.g., prior pig crop, market hogs at start of period). In short, the essential question to \nconsider is whether the values for a potential explanatory variable are known before the forecast period \nor are at least substantially easier to project than the values for the dependent variable.\nAnother criterion in selecting the independent variables is that they should not be correlated, \nin order to avoid the problem of multicollinearity. If several correlated variables seem to be good \nchoices for explanatory variables, they should be tested individually.\n ■ Should the Preforecast Period Price Be Included?\nAn important question to be decided in a price-forecasting equation is whether to include the pre-\nforecast period (PFP) price as an explanatory variable. One reason for including the PFP price is that \n676\nAppendix F\nit is usually an important factor. For example, consider the following two situations in which the PFP \nprice was not taken into account by the model:\nSituation A Projected average price for forecast period = 60¢;\nprice on day before forecast period = 40¢.\nSituation B Projected average price for forecast period = 60¢;\nprice on day before forecast period = 80¢.\nW ould it be reasonable to expect the same price level in both cases? Definitely not! Some textbook \ntheories notwithstanding, in the real world, prices do not adjust instantaneously to changing funda-\nmentals. In situation A, a major uptrend would be required for prices merely to reach the forecasted \nequilibrium level. Such an advance will not occur overnight. Furthermore, it is not sufficient for \nprices to reach 60¢ in order to achieve the projected 60¢ average. Prices would have to go far beyond \n.60¢ in order to make up for all the days of sub-60¢ prices during the early part of the period. Simi-\nlarly, in situation B, prices would have to go far below 60¢ to achieve a 60¢ average. In practice, prices \nmay well reach 60¢ in both situations A and B, but the average price is likely to be well below 60¢ in \nsituation A and well above 60¢ in situation B.\nThe preceding example illustrates that the PFP price may often be an important explanatory \nvariable. Then why not always include it in the model? Ironically, the answer is that it may sometimes \nbe too good in explaining price behavior. In other words, if the PFP price swamps the effect of the \nother independent variables, the price projection will primarily reflect current price levels. Thus, if \nthe PFP price accounts for a large percentage of the R\n2, the model may be good at explaining prices, \nbut will be ineffective at predicting price changes, which after all is the primary goal in price projec-\ntion. However, in some cases, the other independent variables may explain a major portion of total \nvariation, even when the PFP price is included. In these situations, including the PFP price may help \neliminate a significant portion of the unexplained variation that would exist if it were omitted, while \nstill yielding a model that is capable of predicting price changes.\nThe decision of whether to include the PFP price as an independent variable must be made empir-\nically on a case-by-case basis. A reasonable procedure would be to use a stepwise regression approach \n(see the section titled “Stepwise Regression” in this appendix) both with and without including the \nPFP price on the list of independent variables. Although the model that includes the PFP price will \nalways exhibit better summary statistics, it should only be chosen if the effect of the PFP price is sig-\nnificant without being overwhelming.\n ■ Choosing the Length of the Survey Period\nIdeally, it is desirable to use the longest feasible survey period, since more data points will increase the \naccuracy of the regression statistics. However, in the real world, there is a tradeoff between the length \nof the survey period and the relevance of the earliest data points to current conditions. For example, \nit would be ludicrous to include data before 1973 in a fundamental forecasting model for currency \nrates, since exchange rates were fixed before that point.\n677\nPRACTICAL CONSIDERATIONS IN APPLYING REGRESSION ANALYSIS\nAs the preceding example illustrates, fundamental considerations will often limit the number of \nobservations that can be included without distorting the model. Basically, the longest survey period \nconsistent with current market conditions should be used. Scatter diagrams for the dependent vari-\nable plotted against each of the explanatory variables may be helpful in making this decision. It will \noften be necessary to run several regressions for periods of different lengths in order to decide on the \noptimum number of observations to be included. Occasionally, it may be possible to include earlier \nnonrepresentative years through the use of dummy variables.\n ■ Sources of Forecast Error\nIn order to build the best model as well as understand its potential limitations, it is important to be \naware of the potential sources of forecast error. These include:\n1. Random errors for true population regression. Any regression equation is only a simpli-\nfication that cannot include all possible influences on the dependent variable. Thus, even if we knew the \ntrue population regression equation, which we never do, and the explanatory variables were precisely", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 225}
{"text": "limitations, it is important to be \naware of the potential sources of forecast error. These include:\n1. Random errors for true population regression. Any regression equation is only a simpli-\nfication that cannot include all possible influences on the dependent variable. Thus, even if we knew the \ntrue population regression equation, which we never do, and the explanatory variables were precisely \ndetermined, this source of error would still exist. In other words, this type of error can never be avoided.\n2. Random errors in the estimated regression coefficients. Since the data used to run a \nregression represents only a sample from the population, the estimated regression coefficients will \ndeviate from the true population values.\n3. Regression equation may be misspecified. The regression model may not represent the \ntrue underlying model because of the following reasons:\na. Omission of significant variables;\nb. True model is nonlinear or wrong functional form is assumed in a linear transformation;\nc. Error terms are autocorrelated\n2.\n4. errors in independent variable values. Often, the independent variables must themselves \nbe projected, thereby introducing another tier of potential forecasting error. Sometimes, unexpected \nevents (e.g., droughts, freezes, export embargoes) can result in the actual values of the explanatory \nvariables deviating sharply from the estimated levels. In these situations, the regression projections \ncan prove wide of the mark, even when the model would have provided an accurate forecast if the \ninput had been correct.\n5. \ndata errors. Lagged variable data and the data used to forecast the independent variables may \nbe inaccurate because of sampling or compilation errors.\n6. Structural changes. Structural change accounts for perhaps the most serious vulnerability \nof the regression forecast. Regression analysis is a static approach to a dynamic process; that is, the \nstructure and behavior of a market are constantly changing. Thus, even if a model offers a good rep-\nresentation of the past, it may fail to describe a market adequately in the future. Any major structural \nchange in a market can lead to large forecast errors.\n2 Of course, conditions 3(a) and 3(b) could also result in autocorrelation; the implication here is autocorrelation \nthat exists without the presence of 3(a) and 3(b).\n678\nAppendix F\nAs an example, consider the plight of the unfortunate fundamental analyst using historical regres-\nsions to forecast prices for the 1981–1982 period, when the unprecedented combination of severe \nrecession and high interest rates resulted in a dramatic downward shift in demand for many com-\nmodities. As a result, prices in a broad spectrum of markets declined to well below the levels that \nmight have been anticipated on the basis of fundamental models that worked well in prior years, but \ndid not include these effects. As a more recent example, the late 2008 financial crisis had such a huge \ndepressant impact on commodity prices across the board that virtually any viable fundamental model \nfor any commodity market would have been likely to yield price forecasts for the late 2008, early \n2009 period that were far too high.\nThe preceding examples illustrated structural changes simultaneously affecting a broad range of \nmarkets. A structural change can also be confined to a single market. One example of such a change \nwas the dramatic shift in corn usage for ethanol production. Corn use for fuel went from one-tenth \nthe feed-use level before 2000 to greater than feed usage by 2010.\nIt is important to realize the standard error measures in regression analysis only account for the \nfirst two sources of error just listed. Perhaps even more sobering is the fact that with the exception of \na misspecified equation (3), all these sources or error are beyond the control of the analyst. However, \nthe potential variability attributable to errors in estimating the independent variables (4) can at least \nbe defined by allowing for a range of possibilities. For example, in addition to generating a price fore-\ncast based on a set of best estimates for the explanatory variables, projections can also be derived for \nsets of bearish and bullish assumptions. In this way, it is at least possible to gauge the potential impact \nof inaccurate estimates for the independent variables. Furthermore, some solace can be drawn from \nthe fact that the various types of errors listed here are not necessarily cumulative; that is, they may \npartly offset each other.\nAs a final word, it should be emphasized that this list of potential errors is not intended to discour-\nage the potential user of regression analysis, but rather to instill a sense of realism in interpreting \nregression results.\n ■ Simulation\nAs the previous section demonstrated, comparisons between the fitted values of the regression equation \nand actual observations may severely understate potential forecasting errors. The process of determining \nhow forecasts based on the given model would have compared with reality is called simulation, which is an \nextremely useful technique for testing a model under near real-life conditions. Simulation should only be \nundertaken once the choice of a model has been finalized, or at least reduced to a small number of pos-\nsibilities. Ideally, the simulation period should be long enough to include a variety of conditions (e.g., at \nleast one bull, one bear, and one neutral market in a price-forecasting equation).\nFor example, assume it is 2015 and we have decided the past 20 years of data are relevant to the \ncurrent market structure. Given the constraint that each forecast must be based on at least 10 years of \ndata, a 10-year simulation of a calendar-year forecast could be constructed as follows:\n 1. Using only data available on January 1, 2005, derive a regression equation for the same model \nfor 1995 through 2004.\n679\nPRACTICAL CONSIDERATIONS IN APPLYING REGRESSION ANALYSIS\n 2. Using only data a", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 226}
{"text": "e \ncurrent market structure. Given the constraint that each forecast must be based on at least 10 years of \ndata, a 10-year simulation of a calendar-year forecast could be constructed as follows:\n 1. Using only data available on January 1, 2005, derive a regression equation for the same model \nfor 1995 through 2004.\n679\nPRACTICAL CONSIDERATIONS IN APPLYING REGRESSION ANALYSIS\n 2. Using only data available on January 1, 2005, estimate the independent variables.\n 3. Plug these values into the 1995–2004 regression equation to obtain a forecast for 2005.\n 4. Repeat an analogous procedure for each subsequent year (2006–2014).\n 5. Compare simulations to actual values and calculate the root mean square (defined later in this \nsection).\nFor a quarterly model, the simulation procedure would be analogous. However, with a quarterly \nmodel, very little would be lost by revising the regression equation only once every four times (each \nyear) in order to reduce the amount of computation.\nIt may be instructive to compare the differences between the simulation forecasts and actual values \nwith the residuals of the current regression equation. Of course, the former will almost invariably \nbe higher, since simulation results are based on forecasts, while the regression equation is a best fit \nof past values.\nA measure that may be useful in comparing the simulation results of different models is the root \nmean square (RMS):\nrms =\n−()\n=\n∑ YY\nN\nt\nF\nt\nA\nt\nN 2\n1\nwhere\nYt\nF = forecasted value of Y for period t\nYt\nA = actual value of Y for period t\nN = number of simulated observations\nNote that the RMS calculation is analogous to the formula for the standard error of the regres-\nsion (SER) (except for the number of degrees of freedom) and reflects the same underlying \nmeaning.\n ■ Stepwise Regression\nIdeally, having selected a list of explanatory variables, regression equations would be generated for \neach possible equation form. For example, given a dependent variable Y and three independent vari-\nables X\n1, X2, and X3 there would be eight possible equations:\n 1. Y vs. X1, X2, and X3 (all independent variables included)\n 2. Y vs. X1, X2\n 3. Y vs. X1, X3\n 4. Y vs. X2, X3\n 5. Y vs. X1\n 6. Y vs. X2\n 7. Y vs. X3\n 8. YY= (no independent variables included)\n680\nAppendix F\nSuch a procedure, however, is not very efficient. The total number of possible equations doubles \nwith the addition of each independent variable (e.g., 16 for four variables, 32 for five).\nStepwise regression is a highly useful and efficient procedure for isolating and providing summary \nresults for the most statistically interesting equations. There are two basic types of stepwise regression:\n 1. Forward selection. The program selects the single independent variable that provides the \nhighest r2 value to form the first equation. Explanatory variables are then added one at a time \nto form subsequent equations, with the choice depending on which variable will result in the \nhighest R\n2 equation. The program terminates with an equation that includes all of the specified \nexplanatory variables.\n 2. Backward elimination. The program begins by listing the equation that includes all the speci-\nfied independent variables. The program then deletes the variable with the lowest t value to form \nthe second equation. Subsequent equations are formed by continuing to delete variables, one at a \ntime, with the elimination decision dependent on which remaining variable has the lowest t value.\nThe two methods will not necessarily yield the same subset of equations. Overall, the backward \nelimination process is preferable, particularly if the PFP price is one of the explanatory variables. In \nthe forward selection process, the PFP price will usually be chosen first, since it is likely to explain \nmore variation in the dependent variable than any other single variable. However, once more explana-\ntory variables are added, the significance of the PFP price may drop sharply, as other variables in \ncombination explain a portion of the variation originally attributed to the PFP price. Thus, in the \nbackward elimination process, at some stage the PFP price might have a lower t value than any of the \nremaining variables.\nAlthough the PFP price is effective as an explanatory variable, its inclusion may yield equations \nthat are less useful for forecasting purposes. With the forward selection process, there is a higher \nprobability that all of the chosen equations will include the PFP price, since the first variable chosen \nremains in all subsequent equations.\nOnce the stepwise regression results have been analyzed, detail should be generated for the equa-\ntions that appear to be the most promising.\n3 Minimum detail would include a listing of actual observa-\ntions, predicted values, and residuals. Residual plots should also be constructed for these equations \nand modification implemented as suggested by these plots.\n ■ Sample Step-by-Step Regression Procedure\nThere is no single right order in which to perform the various elements of regression analysis. The \nfollowing order merely represents one suggested sequence:\n 1. Determine the dependent variable.\n 2. List all possible choices for explanatory variables.\n3 The summary statistics would not be the only criteria for making this choice. For example, an equation that did \nnot include the PFP price as a dependent variable might be preferable to one that did if the summary statistics \nwere only modestly less favorable.\n681\nPRACTICAL CONSIDERATIONS IN APPLYING REGRESSION ANALYSIS\n 3. Choose a subset of these (usually no more than five), taking care to avoid selecting correlated \nindependent variables. Scatter diagrams can be used as an aid in this selection process.\n 4. Choose the length of the survey period. Scatter diagrams can also be used as an aid in this step.\n 5. Apply a stepwise regression program to the selected variables.\n 6. Analyze the results by examining the various key statistics: t values, SER, CR2, F, and DW. If t", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 227}
{"text": "aking care to avoid selecting correlated \nindependent variables. Scatter diagrams can be used as an aid in this selection process.\n 4. Choose the length of the survey period. Scatter diagrams can also be used as an aid in this step.\n 5. Apply a stepwise regression program to the selected variables.\n 6. Analyze the results by examining the various key statistics: t values, SER, CR2, F, and DW. If there \nis any evidence of multicollinearity, check out this possibility and rerun stepwise regression \nwith a different set of variables if necessary.\n 7. Generate detail and construct residual plots for the most promising equations in the stepwise \nregression run.\n 8. Check residual plots for outliers. Decide whether outliers should be deleted.\n 9. Check residual plots for autocorrelation.\n 10. If outliers or autocorrelation exist, try to correct through the addition of variables or transfor-\nmations to achieve linearity.\n 11. If autocorrelation is still a problem, try a transformation to eliminate autocorrelation (e.g., first \ndifferences).\n 12. Check the correlation matrix or R 2 values for various combinations of equations based on the \nexplanatory variables in order to verify that multicollinearity is not a problem.\n 13. Repeat steps 3–12 for other selections of explanatory variables.\n 14. Optional: After narrowing the number of possible models to three or less, generate simulations.\n ■ Summary\nRegression analysis is an extremely efficient and powerful tool; it is a virtual necessity for fundamen-\ntal analysis. The foregoing appendices were intended to provide the necessary background to inter-\npret and analyze the results available on standard regression software packages. Regression analysis \nprovides the means for precisely answering the question: What is the approximate equilibrium level, \ngiven the specified conditions and assumptions? The italicized qualification is essential. There is a danger \nof viewing regression results with great rigidity because of the scientific manner in which they are \nderived. This would be a mistake. As explained in the section “Sources of Forecast Error,” a variety of \nfactors are capable of causing the regression projection to be inaccurate. Therefore, the trader must \nalways be open to the possibility the regression forecast might be wrong. However, given such a sense \nof realistic awareness, fundamental regression models can provide valuable insight into a market’s \ncurrent state and its potential future direction.\n\n683\nREFERENCES AND RECOMMENDED READINGS\nW onnacott, R. J., and T . H. W onnacott. Econometrics (New Y ork, NY: John Wiley & Sons, 1980). This is an \nextraordinarily lucid treatment of an abstruse subject and is an excellent choice for readers interested in \na more in-depth understanding of regression analysis. One of the outstanding features of this book is that \nit is divided into two separate parts, which cover essentially the same material but on different levels of \ndifficulty. As a result, Part I, which provides a comprehensive and insightful overview of the key concepts of \nregression analysis, is fully accessible to a reader with only limited mathematical background.\nChatterjee, Samprit, and Ali S. Hadi. Regression Analysis by Example, 5th edition (New Delhi: Wiley India, 2012). \nThis may be the best book available on the practical application of regression analysis. As promised in the \ntitle, the essential concepts are demonstrated by example. Perhaps the book’s best feature is its thorough \nexposition of the use and interpretation of residual plots, an extremely effective yet easy-to-apply method \nfor analyzing regression results.\nPindyck, R. S., and D. L. Rubinfeld. Econometric Models and Econometric Forecasts, 4th edition (New Y ork, NY: \nMcGraw-Hill/Irwin, 1997). The first of the three sections in this book covers single-equation regression \nanalysis. (The other two sections are Multi-Equation Simulation Models and Time Series Models.) This book \noffers a clear exposition of theoretical concepts, as well as many useful insights into the practical application \nof regression analysis. Readers with limited mathematical background will find the presentation more \ndifficult than Part I of W onnacott and W onnacott.\nMakridakis, S., and S. C. Wheelwright. Forecasting Methods and Applications, 3rd edition (New Y ork, NY: John \nWiley & Sons, 1997). This text provides a broad overview of forecasting techniques, with regression \nanalysis accounting for one of six sections. The presentation is aimed at an audience interested in practical \napplications rather than theory. This book is clearly written, covers a wide range of topics, and provides a \nplethora of examples to illustrate the discussion.\nFreund, J. E., and F. J. Williams. Elementary Business Statistics: The Modern Approach, 6th sub edition (Upper Saddle \nRiver, NJ: Prentice Hall College Div ., 1992). This book provides a good general overview of elementary \nstatistics for the nonmathematical reader. The text is clearly written and replete with examples.\nKimble, G. A. How to Use (and Misuse) Statistics (Englewood Cliffs, NJ: Prentice-Hall, 1978). This introduction \nto elementary statistics is written with style and a sense of humor. Although it may be hard to believe, this is \none statistics book that can actually be read for entertainment value alone.\n\n685\nAchievement, elements of, 586–587\nAcreage figures, 355\nAction, taking, 583\nActual contract series, 279–280\nAdjusted R\n2, 642\nAdjusted rate mortgages (ARMs), 423, 424\nAdvice, seeking, 580\nAgricultural markets. See also U.S. Department of \nAgriculture (USDA)\nacreage figures, 355\ncattle (see Cattle)\ncorn (see Corn)\ncotton (see Cotton)\ngrain prices and, 351\nhogs (see Hog production)\nproduction costs and, 351\nseasonal considerations and, 356\nwheat (see Wheat market)\nAMR. See Average maximum retracement (AMR)\nAnalogous season method, 374\nAnalysis of regression equation:\nautocorrelation and (see Autocorrelation)\ndummy variables and, 659–", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 228}
{"text": "Agriculture (USDA)\nacreage figures, 355\ncattle (see Cattle)\ncorn (see Corn)\ncotton (see Cotton)\ngrain prices and, 351\nhogs (see Hog production)\nproduction costs and, 351\nseasonal considerations and, 356\nwheat (see Wheat market)\nAMR. See Average maximum retracement (AMR)\nAnalogous season method, 374\nAnalysis of regression equation:\nautocorrelation and (see Autocorrelation)\ndummy variables and, 659–663\nDurbin-Watson statistic, as measure of \nautocorrelation, 652–654\nheteroscedasticity and, 672–673\nmissing variables, time trend and, 655–658\nmulticollinearity and, 663–666\noutliers and, 649–673\nresidual plot, 650–651\ntopics, advanced, 666–671\na priori restriction, 660\nArbitrage, pure, 530\nARMs. See Adjusted rate mortgages (ARMs)\nAt-of-the-money call, buying, 555\nAt-of-the-money options\ndefinition of, 480\ndelta values and, 485\nATR. See Average true range (ATR)\nAutocorrelation:\ndefinition of, 651\nDurbin-Watson statistic as measure of, 652–654\nimplications of, 654–655\ntransformations to remove, 670–671\nAvailability of substitutes, 361\nAverage maximum retracement (AMR), 331\nAverage parameter set performance, 311\nAverage percentage method, seasonal index, \n391–394\nAverage return, 323, 326\nAverage true range (ATR), 262, 463\nBackward elimination, stepwise regression, 682\nBad luck insurance, 257\nBalanced spread, 455\nBalance table, 373–374\nBar charts, 35–39\nBear call money spread, 535–538\ncase 1: short call with lower strike price/long call \nwith higher strike price, 535–536\ncase 2: short call with lower strike price/long call \nwith higher strike price, 537–538\nIndex\n686\nIndex\nBullishness:\nbullish put trade, 477\nfundamentals and, 349\nmarket response analysis and, 404, 405\nBullish T exas option hedge, 517–519\nBull market:\nflags, pennants and, 131–132\nintramarket spreads and, 460\nrun days in, 118\nspread trades and, 443\nthrust days and, 116, 117\nBull put money spread:\ncase 1: long put with lower strike price/short put \nwith higher strike price, 538–539\ncase 2: long put with lower strike price/short put \nwith higher strike \nprice, 540\n“Bull trap”:\nabout, 205–211\nconfirmation conditions, 208, 209\nButterfly spread, 542\nBuy and sell signals, trend-following systems and, \n252\nBuy hedge, cotton mill, 12–13\nCall options, 477\nCalmar ratio, 331\nCalmness, 585\nCancel if close order. See CIC (cancel if close) order.\nCandlestick charts, 43–44\n“real body,” 43, 44\n“shadows,” 43\nCarrying-charge markets, 282\nCarrying charges, limited-risk spread and, 446, \n447–448\nCarryover stocks, 355, 432–433\nCase-Shiller Home Price Index, 423, 424\nCash settlement process, 4\nCash versus futures price seasonality, 389–390\nCattle:\ncattle-on-feed numbers, 352–354\nfutures, 348, 385\ninflation and, 385\nproduction loss, 351\nspread trades and, 444–445\nCentral limit theorem, 609–612\nChange of market opinion, 204\nBearishness:\nbearish put trade, 477\nfundamentals and, 349\nmarket response analysis and, 404, 406\nBearish T exas option hedge, 519–520\nBear market:\nof 1980-1982, 366–367\nflags, pennants and, 133–134\nrun days in, 118, 119\nspread trades and, 443\nthrust days and, 116\n“Bear trap”:\nabout, 205–211\nconfirmation conditions, 208, 210\nBeat the Dealer, 587\nBell-shaped curve, 601\nBenchmark, 327\nBernanke, Ben, 431–432\nBest fit, regression analysis and, 591–593\ndeviations, 591–592\nleast-squares approach, 592–593, 594\n“Best linear unbiased estimators” (BLUE), 621\nBet size, variation in, 581\n“Black box” system, 576\nBlind simulation approach, system optimization, 311\nBLASH approach, 27–28\nBLUE. See “Best linear unbiased estimators” (BLUE)\nBottom formations. See T op and bottom formations\nBowe, James, 482–483\nBox size, 42\nBreakout(s), 86–89\nconfirmation of, 86\ncontinuation patterns and, 180–181\ncounter-to-anticipated, flag or pennant, 219–222\ndefinition of, 33\ndownside, 87, 88\nfalse signals for, 151, 153\nfalse trend-line, 211–213\nflags, pennants and, 128\nopposite direction breakout of flag or pennant \nfollowing normal, 222–225\nupside, 87, 89\nwinning signals for, 152, 153\nBreakout systems, 243–244\nBritish pound (BP), intercurrency spreads and, \n472–473\nBull call money spread, 534–535\n687\nIndex\nComfortable choices, trading principles \nand, 584\nComfort zone, trading within, 577\nCommissions, 19\nCommodities:\nbearing little or no relationship to general rule, \n444–445\nconforming to inverse of general rule, 444\ndemand curves and, 361\ngeneral spread trade rule and, 443–444\nintercommodity spread and, 441–442\nnonstorable, 351, 360, 444\nperishable, 360, 364\nCommodities, 357\nCommodity T raders Consumers Report, 434\nCommodity trading advisors (CTAs), 23, 578\nComparing indicators, 157–165\ndifference indicators, 158, 159\nindicator correlations, 161–162, 163\npopular comparisons, 164\nComparisons:\nnominal price levels, 355\none-year, 350\ntwo managers, 320–322\nCompounded return, 323\nComputer testing of trading systems. See T esting/\noptimizing trading systems\nConfidence, 579–580\nConfidence interval(s), 612–614\nfor an individual forecast, 627–629\nmultiple regression model and, 642\nConfirmation conditions, 247–250\nbull or bear trap, 208\npattern, 249, 250\npenetration as, 248\ntime delay and, 248–249\nConfirmation myth, 170\nCongestion phases. See Continuation patterns\nConsistency, 582\nConstant-forward (“perpetual”) series, 281–282\nConsumer price index (CPI), 383\nConsumption:\ndefinition of, 363\ndemand and, 357, 363–366\nprice and, 364\nas proxy for inelastic demand, 370\nContingent order, 18\nChart(s):\nBLASH approach, 27–28\nequity, 566\nlinked-contract (see Linked-contract charts)\nRandom Walkers and, 29–34\ntypes of (see Chart types)\nChart analysis, 149–154\nconfirmation conditions and, 150\nfalse breakout signals, 151, 153\nlong-term chart, 152, 154\nmost important rules in, 205–231\nspread trades and, 449\ntrading range and, 150\nwinning breakout signals, 152, 153\nChart-based objectives, 189\nChart patterns, 109–147\ncontinuation patterns, 123–134\nflags and pennants (see Flags and pennants)\nhead and shoulders, 138–141\none-day patterns (see One-day patterns)\nreversal days, 113–116, 147\nrounding", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 229}
{"text": "breakout signals, 151, 153\nlong-term chart, 152, 154\nmost important rules in, 205–231\nspread trades and, 449\ntrading range and, 150\nwinning breakout signals, 152, 153\nChart-based objectives, 189\nChart patterns, 109–147\ncontinuation patterns, 123–134\nflags and pennants (see Flags and pennants)\nhead and shoulders, 138–141\none-day patterns (see One-day patterns)\nreversal days, 113–116, 147\nrounding tops and bottoms, 141–143\nrun days, 116, 118–119\nspikes (see Spikes)\nthrust days, 116, 117\nT op and bottom formations (see T op and bottom \nformations)\nTriangles (see Triangles)\nwedge, 146–147\nwide-ranging days (see Wide-ranging days)\nChart types, 35–44\nbar charts, 35–39\ncandlestick charts, 43–44\nclose-only (“line”) charts, 40–42\nlinked contract series: nearest futures versus \ncontinuous futures, 39–40\npoint-and-figure charts, 42–43\nCIC (cancel if close) order, 188\nClose-only (“line”) charts, 40–42\nCME/COMEX contract, 459\nCochrane-Orcutt procedure, 671\nCode parameter, 293\nCoefficient of determination (r\n2), 630–633\nCoffee:\nintercommodity spreads and, 453–454, 456\nseasonal index and, 400\nspread trade example, 445–446\n688\nIndex\nCountertrend systems, 254–256\ncontrary opinion, 256\ndefinition of, 236\nfading minimum move, 255\nfading minimum move with confirmation delay, 255\ngeneral considerations, 254–255\noscillators, 255\ntypes of, 255–256\nCountertrend trade entry signals, 182\nCovered call write, 526–527\nCovered put write, 527–528\nCPI. See Consumer price index (CPI)\nCR\n2 (corrected R2), 642–643\nCRB Commodity Yearbook, 414\nCredit spread, 535\nCrop reports, 434\nCrop years, intercrop spread and, 441\nCrossover points, moving averages and, 182\nCrude oil market. See also WTI crude oil\nmoney stop and, 185\npoor timing and, 425\nseasonal index and, 399\nCTAs. See Commodity trading advisors (CTAs)\nCurrency futures, 471–476\nintercurrency spreads, 471–473\nintracurrency spreads, 473–476\nCurvature, breaking of, 229, 230\nDaily price limit, 8–9\nData errors, 679\nData insufficiency, conclusions and, 357\nData vendors, futures price series selection and, 287\nDay versus good-till-canceled (GTC) order, 16\nDegrees of freedom (df), 615, 640, 644\nDeliverable grade, 9\nDelivery, 4\nDelta (neutral hedge ratio), 484–485\nDemand:\nconsumption and, 357, 363–366\ndefinition of, 359–362, 363\nelasticity of, 361–362\nhighly inelastic, 370–371\nincorporation of (see Incorporation of demand)\nincrease in, 364\ninflation and, 355\nprice and, 362–363\nquantifying, 362–363\nstable, 368\nContinuation patterns, 123–134\nflags and pennants (see Flags and pennants)\ntrading range breakouts and, 180–181\ntriangles (see Triangles)\nContinuous (spread-adjusted) price series, \n282–285\nContinuous distribution, 600–601\nContinuous futures. See also Nearest vs. continuous \nfutures\nprice gaps and, 282\nrule of seven and, 194–196\nContinuous futures charts:\ncreation of, 47\nmeasured moves and, 190–193\nnearest futures vs., 39–40\nContinuous parameter, 292–293\nContract months, 5, 8\nContract rollovers. See Rollover dates\nContract size, 5\nContract specifications:\nabout, 5–9\nsample, 6–7\nContrary opinion, 203–204, 256\nConversion, 530\nCopper:\ninflation and, 385\nprice-forecasting model, 366–367\nprice moves and, 428, 429\nCorn:\nethanol production and, 680\nintercommodity spreads and, 457–459\nmajor resistance area and, 427\nprice movements and, 430\nproduction, 348\nseasonal index and, 401\nunexpected developments and, 419, \n420, 421\nCorrected R\n2 (CR2), 642–643\nCorrelation coefficient (r), independent variables \nand, 665–666\nCorrelation matrix, 666\nCosts. See also Carrying charges\nproduction, price declines and, 351–352\ntransaction, 295–296, 313\nCotton:\ncarryover and, 432–433\nunexpected developments and, 418\nyields, 355\n689\nIndex\nDummy variables, 659–663\nDurbin-Watson statistic, as measure of \nautocorrelation, 652–654\nEckardt, Bill, 578, 584\nEdge, having an, 576\nEfficient market hypothesis, 428, 431\nElasticity of demand, 361–362\nElementary statistics, 597–618\ncentral limit theorem, 609–612\nconfidence intervals, 612–614\nmeasures of dispersion, 597–599\nnormal curve (Z) table, reading, 604–606\npopulation mean, 607\npopulations and samples, 606\nprobability distributions, 599–604\nsampling distribution, 608–609\nstandard deviation, 599, 607\nt-test, 614–618\nE-Mini Dow:\ndescending triangle, 127\nfutures, uptrend line, 60\nintermarket stock index spreads, 461–470\nE-Mini Nasdaq 100:\ndouble bottom, 135, 137\ndowntrend lines and, 67\nflags and pennants, 130\nintermarket stock index spreads, 461–470\nuptrend lines and, 59, 61\nwide-ranging down bar, 123\nE-Mini S&P 500:\nintermarket stock index spreads, 461–470\nmarket response analysis and, 408, 409\noptions on futures and, 482, 484\nprice envelope bands and, 107, 108\nseasonal index and, 399\ntrend lines and, 74\nupthrust/downthrust days and, 117\nEmployment report:\nstock index futures response to, 408–409\nT -Note futures response to monthly, 404–407\nENPPT . See Expected net profit per trade (ENPPT)\nEqual-dollar-spread ratio, 472\nEqual-dollar-value spread, 455–460\nEqually weighted term, 453\nEquilibrium, 363, 365\nEquity change, intercurrency spreads and, 472–473\nEquity chart, 566\nDemand curve, 359, 361\nDemand-influencing variables, 368–370\nDeMark, Thomas, 66, 69, 199\nDeMark sequential, 199–203\nDependent variable, determining, 675–676\nDetrended seasonal index, 394\nDeviation:\ndefinition of, 623\ntotal, 630–631\nDiagonal spread, 542\nDiary, maintaining trader’s, 565\nDifference indicators:\nClose – Close vs. Close – MA, 158\nratio versions, 159\nDiscipline, 578\nDiscrete parameter, 293\nDiscrete variable, 600\nDiscretionary traders, losing period adjustments, \n562–563\nDisloyalty/loyalty, 583–584\nDispersion, measures of, 597–599\nDisturbance, definition of, 623\nDiversification:\nplanned trading approach and, 560, 561–562\ntrend-following systems and, \n256–258\nDividends, 462\nDollar:\nequal-dollar-value spread, 455–460\nintercurrency spreads and, 471\nprice, 383\nDollar value, option premiums and, \n477–478\nDouble top, penetration of, 227–229\ncurvature, breaking of, 229\nDouble tops and bottoms:", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 230}
{"text": "–584\nDispersion, measures of, 597–599\nDisturbance, definition of, 623\nDiversification:\nplanned trading approach and, 560, 561–562\ntrend-following systems and, \n256–258\nDividends, 462\nDollar:\nequal-dollar-value spread, 455–460\nintercurrency spreads and, 471\nprice, 383\nDollar value, option premiums and, \n477–478\nDouble top, penetration of, 227–229\ncurvature, breaking of, 229\nDouble tops and bottoms:\ndouble bottom, 137–138\ndouble top, 136\ntriple top, 129\nDown run day, 118, 268\nDownthrust day, 116\nDowntrend channels, 62, 63\nDowntrend lines:\ndefinition of, 57\nexamples of, 59, 61, 65\nfalse breakout signals, 211, 213\nDriehaus, Richard, 578, 585\nDruckenmiller, Stanley, 581, 584\n690\nIndex\nexpectations, ignoring, 355–356\nimproper influences, 352–355\nlack of perspective, 351\nnominal price levels, comparing, 355\none-year comparisons, 350\nprice declines/cost of production, 351–352\nprices, target levels and, 356–357\nrelative time considerations, ignoring, 351\nseasonal considerations, ignoring, 356\nshort scenes and, 347–349\nusing fundamentals for timing, 350\nviewing fundamentals in a vacuum, 349\nviewing old information as new , 349–350\nFalse trend-line breakouts, 211–213\nFaulkner, Charles, 585, 586\nFill-or-kill (FOK) order, 18\nFilter, trend-following systems and, 250–251\nFinancial crisis of 2008, 323, 423, 680\nFirst notice day, 9\nFixed or nonoptimized parameter, 293\nFlags and pennants:\nbearish signal, 133–134\nbreakout from, 128\nbullish signal, 131–132\ncounter-to-anticipated breakout of, 219–222\nE-mini Nasdaq 100, 130\nEuro Schatz continuous futures, 130\nmain trend and, 131\nnatural gas continuous futures, 128\nopposite direction breakout of, following normal \nbreakout, 222–225\nsoybean continuous futures, 129\nstop-loss points and, 184–185\nwheat, 129\nFCOJ. See Frozen concentrated orange juice (FCOJ)\nFOK. See Fill-or-kill (FOK) order\nForecast error, regression analysis and, \n679–680\nForecasting model, building, 413–415\nForward selection, stepwise regression, 682\nFourteen fallacies. See Fallacies\nFree markets, 357\nFrozen concentrated orange juice (FCOJ):\ncrop reports and, 434\nseasonal index and, 401\nunexpected developments and, 418, 419\nF-test, 643–644\nFull carry, 446–447, 448\nEquity retracements, dampened, 257\nError, definition of, 623\nError of the mean, 628\nError of the slope, 628\nEthanol production, 680\nEuphoria, 585\nEurocurrency rates, 473\nEvents, pivotal, 422\nExcess return, definition of, 323\nExchange, 5\nExercise price, 477\nExit points, planning time routine and, 563\nExpectations:\nignoring, 355–356\nnew-crop, 381\nrole of (see Role of expectations)\nseasonal analysis and, 390\nExpected gain, 550, 551\nExpected net profit per trade (ENPPT), 560\nExpiration date, 477\nExplained variation, 630\nExponentially weighted moving average (EWMA), \n239–240\nExponential moving average (EMA), 165–167\nExposure, leverage and, 322\nExtrapolation, 630\nFabrication, 313\nFading minimum move, 255\nwith confirmation delay, 255\nFailed signals:\nabout, 205, 206\nbull and bear traps, 205–211\ncurvature, breaking of, 229\nfalse trend-line breakouts, 211–213\nflag or pennant, counter to anticipated breakout, \n219–222\nflag or pennant, opposite direction breakout \nfollowing normal breakout, 222–225\nfuture reliability of, 229–231\nspike extremes, return to, 213–216\ntop and bottom formations, penetration \nof, 225–229\nwide-ranging day extremes, return \nto, 216–218\nFallacies, 347–357\ndata insufficiency, conclusions and, 357\ndemand/consumption, confusion of concepts, 357\n691\nIndex\nGeneric trading systems:\nbreakouts (see Breakout systems)\nmoving averages and, 237–243\nGold:\nfundamental analysis and, 347, 371\nfutures (see Gold futures)\nintramarket stock index spreads and, 461\nmarket response analysis and, 410\nprices, 284\nseasonal index and, 400\nspot, buying, 555\nGold futures:\nbuying, 555\nvolume shift in, 10\nGold/silver spread, 454\nGood-till-canceled (GTC) orders. See GTC orders\nGovernment regulations, potential impact \nof, 415\nGovernment reports, unexpected developments \nand, 420\nGPR (gain-to-pain ratio), 328–329\nGrain prices, 351\nGreat Recession, 423\nGresham’s law of money, 312\nGrinder, John, 586\nGross domestic product (GDP):\ndeflator, 383\nindependent variables and, 677\nGTC orders:\nabout, 16\norder placement and, 568\nstop-loss points and, 183, 188\ntrade exit and, 569\nHard work, skill versus, 576–577\nHead and shoulders:\nabout, 138–141\nfailed top pattern, 227–229\nHeating oil:\nalternative approach, 396–397\naverage percentage method, 391, 392–394, \n398\nlink relative method, 394–396, 398\nHedge, definition of, 517\nHedge ratio, neutral (delta), 484–485\nHedging, 11–13\napplications, 554–555\nbuy hedge, 12–13\nFundamental analysis:\nabout, 16\nanalogous season method, 374\nbalance table, 373–374\ndanger in using, 417\ndiscounting and, 428–430\nexpectations, role of, 379–381\nfallacies. see Fallacies\nforecasting model, building, 413–415\ngold market and, 371\nindex models, 376–377\ninflation, incorporation of, 383–388\nlong-term implications versus short-term \nresponse, 432–435\nmarket response analysis (see Market response \nanalysis)\nmoney management and, 426–427\n“old hand” approach, 373\npitfalls in, 418–426\nreasons to use, 427–428\nregression analysis, 374–375\nseasonal analysis and, 389–401\nspread trades and, 449\nsupply-demand analysis, 359–371\ntechnical analysis and, 21–24, 417–418, 426–427\ntrading and, 417–435\ntypes of, 373–377\nFundSeeder.com, 343\nFutures markets, nature of, 3–4\nFutures price series selection, 279–288\nactual contract series, 279–280\ncomparing the series, 285–287\nconstant-forward (“perpetual”) series, 281–282\ncontinuous (spread-adjusted) price series, 282–285\nnearest futures, 280\nGain(s):\nexpected, 550, 551\nmaximization of, 583\nGain-to-pain ratio (GPR), 328–329\nGardner, John, 314\nGDP . See Gross domestic product (GDP)\nGeneral rule, spreads, 443–445\nabout, 443\napplicability and nonapplicability, 443–444\ncommodities bearing little or no relationship to, \n444–445\ncommodities conforming to inverse of, 444\n692\nIndex\nIntercurrency spreads, 471–473\nequity change and, 47", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 231}
{"text": "ures, 280\nGain(s):\nexpected, 550, 551\nmaximization of, 583\nGain-to-pain ratio (GPR), 328–329\nGardner, John, 314\nGDP . See Gross domestic product (GDP)\nGeneral rule, spreads, 443–445\nabout, 443\napplicability and nonapplicability, 443–444\ncommodities bearing little or no relationship to, \n444–445\ncommodities conforming to inverse of, 444\n692\nIndex\nIntercurrency spreads, 471–473\nequity change and, 472–473\nreasons for implementing, 471–472\nInterest rate differentials, intracurrency spreads and, \n473, 476\nInterest rate parity theorem, 475\nInterest rate ratios, intracurrency spreads \nand, 475\nInterest rates:\noption premiums and, 482–483\nrecession and, 367\nIntermarket spreads, 442, 453, 462–470\nInternal trend lines, 73–78\nalternate, 75\nversus conventional, 74, 76–77\nsupport and resistance and, 106\nInternational Cocoa Agreement, 356\nInternational Sugar Agreement, 356\nIn-the-money options:\ndefinition of, 480\ndelta values and, 485\nIntracurrency spreads, 473–476\ninterest rate differentials and, 473, 476\ninterest rate ratios and, 475\nIntramarket (or interdelivery) spread, 441\nIntramarket stock index spreads, 461–462\nIntrinsic value, of options, 489\nIntuition, 586\nInvestment insights, 343\nJapanese stock market, 22\nJapanese yen (JY), intercurrency spreads and, 471\nJobs report. See Employment report\nKitchen sink approach, 312\nKuwait, 1990 invasion of, 420\nLast notice day, 9\nLast trading day, 9\nLeading Indicator myth, 171–172\nLeast-squares approach, 592–593, 594\nLefèvre, Edwin, 178, 570, 580–581\nLessons, trader’s diary and, 565\nLeverage:\nnegative, 320\nrisk and, 320\nthrough borrowing. see Notional funding\nLimit days, automatic trading systems and, 296\nfinancial markets and, 13–14\ngeneral observations on, 13–15\nsell hedge, 11–12\nHeteroscedasticity, 672–673\nHidden risk, 320\nHildreth-Lu procedure, 671\nHite, Larry, 585\nHog production:\nfundamentals and, 348, 350, 356\nregression analysis and, 374, 589–591\nregression equation and, 633\nsupply-demand analysis and, 360, 365\nHope, as four-letter word, 584\nHousing market:\nCase-Shiller Home Price Index, 423\nhousing bubble, 2003-2006, 423, 425\nImplied volatility, 483–484\nIncorporation of demand:\ndemand change, growth pattern in, 368\ndemand-influencing variables, identification of, \n368–370\nhighly inelastic demand (and supply elastic \nrelative to demand), 370–371\nmethods for, 367–371\nneed for, 366–367\nstable demand, 368\nIndependence, 579\nIndependent variables:\nforecasting model, building, 415\nmulticollinearity and, 665\nregression analysis and, 677, 679\nIndex models, 376–377\nIndividual contract series, 279–280\nInflation:\nadjustments, 355\nprice data for, 414\nprice-forecasting models and, 383–388\nInflationary boom, 422\nInflation indexes, 383\nInformation, viewing old as new , 349–350\nIntelligence, 582–583\nIntercommodity spreads, 441–442. See also Limited-\nrisk spread\nabout, 441–442\ncontract ratios and, 453–460\nIntercrop spreads, 441, 460\nHedging (continued)\n693\nIndex\nMarket(s):\nagricultural, 351\nbear (see Bear market)\nbull (see Bull market)\ncorrelated, leverage reduction and, 562\nexcitement and, 585\nexiting position and, 584–585\nfree, 357\nhousing (see Housing market)\nnonrandom prices and, 587\nplanned trading approach and, 560\ntrading results and, 317\nMarket characteristic adjustments, trend-following \nsystems and, 251–252\nMarket direction, 449\nMarket hysteria, 585\nMarket-if-touched (MIT) order, 18\nMarket observations. See Rules, trading\nMarket opinion:\nappearances and, 582–583\nchange of, 204\nMarket order, 16\nMarket patterns, trading rules and, 572–573\nMarket Profile trading technique, 585\nMarket psychology, shift in, 429\nMarket response analysis, 403–411\nisolated events and, 409–410\nlimitations of, 410–411\nrepetitive events and, 403–410\nstock index futures response to employment \nreports, 408–409\nT -Note futures response to monthly U.S. \nemployment report, 404–407\nMarket Sense and Nonsense: How the Markets Really Work, \n319\nMarket statistics, balance table and, 373–374\nMarket wizard lessons, 575–587\nMarket Wizards books, 575, 579, 580, 581, 585, 586\nMAR ratio, 330, 335\nMBSs. See Mortgage-backed securities (MBSs)\nMcKay, Randy, 576, 581, 583\nMeasured moves (MM), 190–193\nMeasures of dispersion, 597–599\nMechanical systems. See T echnical trading systems\nMetals. See Copper; Gold market\nMethod:\ndetermination of, 576\ndevelopment of, 576\nLimited-risk spread, 446–448\nLimit order, 17\n“Line” (close-only) charts, 40–42\nLinearity, transformations to achieve, 666–669\nLinearly weighted moving average (LWMA), \n239–240\nLinked-contract charts, 45–56\ncomparing the series, 48\ncontinuous (spread-adjusted) price series, 47\ncreation of, methods for, 46–48\nnearest futures, 46–47\nnearest vs. continuous futures, 39–40, 48–51, \n52–56\nnecessity of, 45–46\nLinked contract series: nearest futures versus \ncontinuous futures, 39–40\nLink relative method, seasonal index, 394–396\nLiquidation information, 564\nLive cattle. See Cattle\nLivestock markets, 287. See also Cattle; Hog \nproduction\nLong call (at-the-money) trading strategy, 491–492\nLong call (out-of-the-money) trading strategy, \n493–494\nLong futures trading strategy, 489–490\nLong put (at-the-money), 503–504\nLong put (in-the-money), 506–508\nLong put (out-of-the-money), 504–506\nLong straddle, 515–516\nLong-term implications versus short-term response, \n432–435\nLong-term moving average, reaction to, 181–182\nLook-back period, 173\nLosing period adjustments, planned trading \napproach and, 562–563\nLosing trades, overlooking, 313\nLosses:\npartial, taking, 583\ntemporary large, 245\nLoyalty/disloyalty, 583–584\nLumber, inflation and, 384\n“Magic number” myth, 170\nManagers:\ncomparison of two, 320–322\nnegative Sharpe ratios and, 325\nMAR. See Minimum acceptable return (MAR)\nMargins, 19\n694\nIndex\ntrending market and, 79, 80\ntypes of, 165–167\nMulticollinearity, 663–666\nindependent variables and, 665\nmultiple regression and, 639\nregression coefficients and, 665\nMultimarket system testing, 313–314\nMultiple regression equation, 637\nMultiple regression model, 637–647\nbasics o", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 232}
{"text": "omparison of two, 320–322\nnegative Sharpe ratios and, 325\nMAR. See Minimum acceptable return (MAR)\nMargins, 19\n694\nIndex\ntrending market and, 79, 80\ntypes of, 165–167\nMulticollinearity, 663–666\nindependent variables and, 665\nmultiple regression and, 639\nregression coefficients and, 665\nMultimarket system testing, 313–314\nMultiple regression equation, 637\nMultiple regression model, 637–647\nbasics of, 637–639\nconfidence intervals for individual forecast, 642\ndefinition of, 625\nF-test, 643–644\nregression run, analyzing, 644–647\nR\n2 and corrected R2, 642–643\nstandard error of the regression and, 641–642\nt-test application in, 640–641\nMultiple-unit option strategies, 543\nMutually exclusive, 600\nNatural disasters, 418\nN AV. See Net asset value (NAV)\nNAV charts, 335–336\nNearest futures chart, 39–40\nNearest vs. continuous futures:\nchart analysis and, 48–51\nfutures price series selection and, 280\nlinked contract series, 39–40\nmeasured moves and, 190\nsupport and resistance, 91\nNegative leverage, 320\nNet asset value (NAV), 321, 331\nNet asset value (NAV) charts, 335–336\nNeuro-linguistic programming (NLP), 585\nNew-crop expectations, 381\nNew Science of T echnical Analysis, The, 199\nNikkei index futures, unexpected developments \nand, 418, 420\nNLP . See Neuro-linguistic programming (NLP)\nNominal price levels, comparing, 355\nNonoptimized parameters, 293\nNonsensitive (slow) systems, 245, 246\nNonstorable commodities, 351, 360\nNormal curve (Z) table, reading, 604–606\nNormal distribution, 599\nNormal distribution curve, 601\nNotional funding, 320, 321\nMidtrend entry, 177–182\ncontinuation pattern and trading range breakouts, \n180–181\ngoals and, 178–179\npercent retracement, 178\nreaction to long-term moving average, 181–182\nMinimum acceptable return (MAR), 326\nMinimum price fluctuation, 5\nMinor reaction, reversal of, 179–180\nMint Management, 585\nMissing variable, 421\nMission, 586\nMistakes, trading, 584\nMIT (market if touched) order, 18\nMM (measured moves), 190–193\nModels, equations and, 593\nModern T rader, 357\nModifications, trend-following systems, 247–254\nbuy and sell signals, differentiation between, 252\nconfirmation conditions, 247–250\nfilter, 250–251\nmarket characteristic adjustments, 251–252\npyramiding, 252–253, 254\ntrade exit, 253, 254\nMomentum, 163\nMomentum indicator, 167\nMoney management:\nfundamental analysis, technical analysis and, \n426–427\nrisk control and, 560, 577–578\nrules, other, 570\ntrade exit and, 569\nMoney stop, stop loss points and, 185, 187\nMortgage-backed securities (MBSs), 423, 425\nMortgage lending, subprime, 423\nMoving average convergence-divergence (MACD), 199\nMoving averages, 78–81, 157–165\ncalculation of, 238\ncrossovers of, 182\ndefinition of, 78, 238\nexponentially weighted moving average \n(EWMA), 239–240\nlinearly weighted moving average (LWMA), \n239–240\nlong-term, reaction to, 181–182\nsideways market and, 79, 81\ntechnical trading systems for, 237–243\n695\nIndex\nOption trading strategies, 487–555\ncomparing, 487–489\nhedging applications and, 554–555\nmultiunit strategies, 543–544\noptimal, choosing, 544–554\nprofit/loss profiles (see Profit/loss profile)\nspread strategies, other, 542–543\nOrders, types of, 16–19\nOrdinary least squares (OLS), 654\nOrganization of the Petroleum Exporting Countries \n(OPEC), 356, 425\nOriginal trading systems, 261–278\nrun-day breakout system, 268–273\nrun-day consecutive count system, 273–278\nwide-ranging-day system (see Wide-ranging-day \nsystem)\nOscillators, 167–170, 255\nOut-of-the-money call, buying, 555\nOut-of-the-money options:\ndefinition of, 480\ndelta values and, 485\nOutright positions, spread tables and, 440, 441\nOverbought/oversold indicators, 198–199\nParabolic price moves, 585\nParameter(s):\ndefinition of, 291, 606\ntypes of, 292–293\nParameter set:\naverage performance, 311\ndefinition of, 291\nParameter shift, trend-following systems \nand, 247\nParameter stability, optimizing systems \nand, 297\nPast performance, evaluation, 319–341\ninvestment insights, 343\nreturn alone, 319–322\nrisk-adjusted return measures, 323–335\nvisual (see Visual performance evaluation)\nPatience, virtue of, 580–581\nPattern(s). See also Chart patterns; Continuation \npatterns; One-day patterns\nmarket, 572–573\nseasonal, 415\nPattern recognition systems, definition of, 237\nPenetration of top and bottom formations, 225–229\nObservations, market. See Rules, trading\nOCO (one-cancels-other) order, 18\nOil. See Crude oil market; Heating oil; WTI \ncrude oil\n“Old hand” approach, 373\nOLS (Ordinary least squares), 654\nOne-cancels-other (OCO) order, 18\nOne-day patterns:\nabout, 109–123\nspikes, 109–113\nOne-tailed test, 614, 617\nOne-year comparisons, 350\nOPEC. See Organization of the Petroleum Exporting \nCountries’ (OPEC)\nOpen interest, volume and, 9–10\nOpen-mindedness, 585\nOptimization:\ndefinition of, 297\npast performance and, 313\nOptimization myth, 298–310\nOptimizing systems, 297–298\nOption(s):\nfair value of, theoretical, 483\nqualities of, 489\nOption premium curve, theoretical, 481\nOption premiums, 480–483\ncomponents of, 480\ninterest rates and, 482–483\nintrinsic value and, 480\nstrike price and current futures price, 480–481\ntheoretical versus actual, 483–484\ntime remaining until expiration, \n481–482\ntime value and, 480–483\nvolatility and, 482\nOption-protected long futures:\nlong futures + long at-the-money put, 520–521\nlong futures + long out-of-the-money put, \n522–523\nOption-protected short futures:\nshort futures + long at-the-money call, 523–524\nshort futures + long out-of-the-money call, \n524–525\nOptions on futures, 477–485\nabout, 477–479\ndelta and (neutral hedge ratio), 484–485\noption premiums and (see Option premiums)\n696\nIndex\nPreforecast period (PFP) price, 677–678\nPremium(s):\ndefinition of, 477\ndollar value of option, 477–478\nPrice(s):\nconsumption and, 364\ndollar price, 383\ngrain, 351\nnonrandom, 587\npreforecast period (PFP) price, 677–678\nstrike or exercise, 477\nsupply, demand and\nswings (see Price swings)\ntarget levels and, 356–357\nPrice changes, price series and, 285\nPrice envelope bands, 107–108\nPrice", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 233}
{"text": "ms)\n696\nIndex\nPreforecast period (PFP) price, 677–678\nPremium(s):\ndefinition of, 477\ndollar value of option, 477–478\nPrice(s):\nconsumption and, 364\ndollar price, 383\ngrain, 351\nnonrandom, 587\npreforecast period (PFP) price, 677–678\nstrike or exercise, 477\nsupply, demand and\nswings (see Price swings)\ntarget levels and, 356–357\nPrice changes, price series and, 285\nPrice envelope bands, 107–108\nPrice-forecasting models:\nadding expectations as variable in, 380\ndemand and, 366–367\ninflation and, 383\nPrice-indicator divergences, 171–172\nPrice levels:\nnearest futures and, 91, 101\nnearest futures price series and, 48\nnominal, comparing, 355\nprice series and, 285\nPrice movements:\ndramatic, 428\nfitting news to, 431–432\nlinked series and, 286\nparabolic, 585\ntrend-following systems and, 245, 246\nPrice oscillator, 163\nPrice quoted in, 5\nPrice reversals, 229\nPrice seasonality, cash versus futures, 389–390\nPrice-supporting organizations, 356\nPrice swings:\nnearest futures and, 101\nnearest futures price series and, 48\nPrice trigger range (PTR), 262\nProbability:\ndistributions, 599–604\nheads and tails coin tosses, 390\nreal versus, 390–391\nProbability-weighted profit/loss ratio (PWPLR), \n550–551\nProducer price index (PPI), 383\nPennants. See Flags and pennants\nPeople’s Republic of China (PRC), 418\nPercent retracement, reversal of minor reaction, \n179–180\nPercent return, optimizing systems and, 297\nPerformance evaluation, visual. See Visual \nperformance evaluation\nPerishable commodities, 360\n“Perpetual” (constant-forward) series, 281–282\nPersonality, trading method and, 576\nPersonal trading, analysis of, 565–566\nPerspective:\nkeeping, 587\nlack of, 351\nPetroleum. See Crude oil market; Heating oil; \nOrganization of the Petroleum Exporting \nCountries’ (OPEC); WTI crude oil\nPhilosophy, trading, 559, 578\nPivotal events, 422\nPlanned trading approach, 559–566\nmarkets to be traded, 560\npersonal trading, analysis of, 565–566\nplanning time routine and, 563\nrisk control plan (see Risk control plan)\ntrader’s diary, maintaining, 565\ntrader’s spreadsheet, maintaining, 563–564\ntrading philosophy and, 559\nPoint-and-figure charts, 42–43\nPopulation, definition of, 598\nPopulation mean, estimation of, 607\nPopulation regression line, 619–620\nPopulations and samples, 606\nPosition, trading around, 581–582\nPosition exit criteria, 189–204\nchange of market opinion, 204\nchart-based objectives, 189\ncontrary opinion, 203–204\nDeMark sequential, 199–203\nmeasured moves, 190–193\noverbought/oversold indicators, 198–199\nrule of seven, 194–196\nsupport and resistance levels, 196–197\ntrailing stops, 204\nPPI. See Producer price index (PPI)\nPRC. See People’s Republic of China (PRC)\nPrecious metals market. See also Gold market\ncarrying charges and, 446\ndemand and, 362\n697\nIndex\nPrudence, 583\nPTR. See Price trigger range (PTR)\nPure arbitrage, 530\nPWPLR. See Probability-weighted profit/loss ratio \n(PWPLR)\nPyramiding:\nmidtrend entry and, 182\nrejected signals and, 251\ntrend-following systems and, 252–253\nQuantum Fund, 22\nRandom error, 628, 679\nRandom sample, definition of, 608\nRandom variable, 599\nRandom Walkers, 29–34\nRate of change, 163\nRatio call write, 532–534\nReaction count, 179–180\nRecession, severe, 367. See also Great Recession\nRegression analysis, 589–595, 675–683\nabout, 374–375, 589–591\nassumptions of, basic, 620\nbest fit, meaning of, 591–593\ndependent variable, determining, 675–676\nexample, practical, 593\nforecast error and, 679–680\nindependent variables, selecting, 677\nleast-squares approach, 592–593, 594\npractical considerations in applying, 675–683\npreforecast period (PFP) price and, 677–678\nregression forecast, reliability of, 593–595\nsimulation, 680–681\nstep-by-step procedure, sample, 682–683\nstepwise regression, 681–682\nsurvey period length and, 678–679\nRegression coefficients:\ncomputing t-value for, 626\nmulticollinearity and, 665\nsampling distribution of, 621\ntesting significance of, 620–626\nRegression equation, 619–635\nanalyzing (see Analysis of regression equation)\ncoefficient of determination R\n2, 630–633\nconfidence interval for an individual forecast, \n627–629\nextrapolation, 630\nmisspecification and, 679\nProduction costs, price declines and, 351–352\nProfit(s):\npartial, pulling out, 584\nslow systems and, 245, 246\nwinning trades and, 570–571\nProfit/loss matrix, short puts with different strike \nprices, 514\nProfit/loss profile:\nalternative bearish strategies, three, 548\nalternative bullish strategies, three, 547\nalternative neutral strategies, two, 549\nbear call money spread, 536, 538\nbearish “T exas option hedge,” 520\nbear put money spread, 539, 542\nbull call money spread, 535\nbullish “T exas option hedge,” 518\nbull put money spread, 541\ncovered call write, 527\ncovered put write, 528\ndefinition of, 488\nkey option trading strategies and, 489–542\nkey trading strategies and, 489–542\nlong call (at-the-money), 492, 495\nlong call (out-of-the-money), 494\nlong futures, 490\nlong futures and long call comparisons, 497\nlong futures and short put comparisons, 514\nlong put (at-the-money), 504\nlong put (in-the-money), 507\nlong put (out-of-the-money), 505\nlong straddle, 516\noption-protected long futures, 521, 522\noption-protected short futures, 524, 525\nratio call write, 533\nshort call (at-the-money), 498\nshort call (in-the-money), 501\nshort call (out-of-the-money), 500\nshort futures, 491\nshort futures and long put comparisons, 509\nshort futures and short call comparisons, 503\nshort put (at-the-money), 510\nshort put (in-the-money), 513\nshort put (out-of-the-money), 511\nshort straddle, 517\nsynthetic long futures, 529\nsynthetic short futures, 532\ntrading strategies and, 488–489\ntwo long calls vs. long futures, 544\n698\nIndex\nRisk-adjusted return measures, 323–335\nadvantages/disadvantages of, 334–335\nCalmar ratio, 331\ncomparison of, 332–334\ngain-to-pain ratio (GPR), 328–329, \n334–335\nMAR ratio, 330, 335\nproperties of, 334\nreturn retracement ratio (RRR), 331–332, 335\nSDR Sharpe ratio, 334\nSharpe ratio, 323–325, 332, 334, 343\nSortino ratio, 325–327, 334\ns", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 234}
{"text": "tegies and, 488–489\ntwo long calls vs. long futures, 544\n698\nIndex\nRisk-adjusted return measures, 323–335\nadvantages/disadvantages of, 334–335\nCalmar ratio, 331\ncomparison of, 332–334\ngain-to-pain ratio (GPR), 328–329, \n334–335\nMAR ratio, 330, 335\nproperties of, 334\nreturn retracement ratio (RRR), 331–332, 335\nSDR Sharpe ratio, 334\nSharpe ratio, 323–325, 332, 334, 343\nSortino ratio, 325–327, 334\nsymmetric downside-risk (SDR) Sharpe ratio, \n327–328\ntail ratio, 329–330, 335\nRisk control:\nmoney management rules, other, 570\ntrade exit and, 569–570\nRisk control plan, 560–562\ncorrelated markets, leverage reduction \nand, 562\nequity size, position changes and, 562\nlosing period adjustments, 562–563\nmarket volatility adjustments, 562\nrisk per trade, maximum, 560–561\nstop-loss strategy, 561\n“Risk-free” return, 323, 326\nRMS. See Root mean square (RMS)\nRogers, Jim, 22\nRole of expectations, 379–381\nactual statistics, influence on, 381\nadding expectations as variable, 380\nprior year estimates and, 379–380\nRolling window return charts, 337–340\n12-month returns, 337, 338–339\n24-month returns, 339, 340\nRollover, 15\nRollover dates:\ncontinuous series and, 48, 51\nnearest futures charts and, 47\nRoot mean square (RMS), 681\nRounding tops and bottoms:\nbreaking of curvature and, 229, 230\nchart patterns and, 141–143\nRSI, 199\nR\n2 (coefficient of determination), 630–633\nR2 and corrected R2, 642–643\nRule of seven, 193–196\npopulation regression line, 619–620\nregression analysis and, 620\nregression coefficients, testing significance of, \n620–626\nspurious (“nonsense”) correlations, 634–635\nstandard error of the regression (SER), 627\nRelative highs and relative lows:\ndefinitions of, 66\nstop-loss points and, 185, 186\nRelative strength index (RSI), 198\nReminiscences of a Stock Operator, 178, 570, \n580–581\nResidual, definition of, 623\nResidual plot, 650–651\nResiduals, 592\nResistance. See Support and resistance\nResponsibility, 578–579\nResults, negative, 314–315\nRetracement criterion, percent retracement, 178\nReturn(s). See also Minimum acceptable return \n(MAR)\naverage, 323\ncompounded, 323\nreturn alone, meaninglessness of, 319–322\nrisk-adjusted return measures, 319–322\n“risk-free,” 323\nrolling, 337–340\nsmall difference in, 338\nstability of, 338\nReturn retracement ratio (RRR), 335\nReturn/risk statistics, performance charts \nand, 343\nReturn to spike extremes, 213–216\nReturn to wide-ranging day extremes, 216–218\nReversal days, 113–116\ndefinition of, 114–115\nspike reversal days, 115–116\nspikes and, 147\nReversal of minor reaction, 179–180\nReversal size, 42\nReverse conversion, 530\nRisk:\nhidden, 320\nignoring, 312–313\nleverage and, 320\nlow-risk idea, 581\nscared money, 584\nRegression equation (continued)\n699\nIndex\ndetrended, 394\nlink relative method, 394–396, 398\nSeasonal patterns, forecasting model, 415\nSecuritizations, 423\nSEE. See Standard error of the estimate (SEE)\nSegmented trades, analysis of, 565–566\nSell hedge, cotton producer, 11–12\nSell signals, trend-following systems and, 252\nSER. See Standard error of the regression (SER)\nSeries selection. See Futures price series selection\nSettlement type, 9\nSharpe ratio, 323–325, 334, 343. See also Symmetric \ndownside-risk (SDR) Sharpe ratio\nShort call (at-the-money) trading strategy, \n498–499\nShort call (in-the-money) trading strategy, 500–502\nShort call (out-of-the-money) trading strategy, \n499–500\nShort futures trading strategy, 490–491\nShort put (at-the-money), 509–510\nShort put (in-the-money), 512–513\nShort put (out-of-the-money), 510–512\nShort straddle, 516–517\nShort-term response versus long-term implications, \n432–435\nSideways market, moving averages and, 79, 81\nSignal price, limit days and, 296\nSignals, failed, 205, 206\nSimple moving average (SMA), 165–167\nSimple regression, 625\nSimulated results, 312–313\nfabrication, 313\nkitchen sink approach, 312\nlosing trades, overlooking, 313\noptimization and, 317\nrisk, ignoring, 312–313\nterminology and, 311\ntransaction costs, 313\nwell-chosen example, 312\nSimulation, blind, 311\nSingle market system variation (SMSV), 256–257\nSkill, hard work versus, 576–577\nSklarew , Arthur, 194\nSlippage:\nautomatic trading systems and, 295\nsampling distribution and, 608\ntransaction costs and, 291\ntrend-following systems and, 247\nRules, trading, 567–574\nanalysis and review of, 573–574\nmarket patterns and, 572–573\nmiscellaneous, 571–572\nrisk control (money management), 569–570\ntrade entry, 568–569\ntrade exit, 569–570\nwinning trades, holding/exiting, 570–571\nRun-day breakout system, 268–273\nbasic concept, 268\ndaily checklist, 269\nillustrated example, 270–273\nparameters, 269\nparameter set list, 270\ntrading signals, 269\nRun-day consecutive count system, 273–278\nbasic concept, 273\ndaily checklist, 274\ndefinitions, 273\nillustrated example, 275–278\nparameters, 274\nparameter set list, 274\ntrading signals, 273–274\nRun days, 116, 118–119, 268\nRussell 2000 Mini, intermarket stock index spreads, \n461–470\nSamples, populations and, 598, 606\nSampling distribution, 608–609\nSands, Russell, 434\nSaucers. See Rounding tops and bottoms\nSaudi Arabia, 425\nScale order, 18\nSchwager, Jack, 319\nSchwartz, Marty, 22, 585\nSDR Sharpe ratio, 327–328, 334\nSE. See Standard error (SE)\nSeasonal analysis, 389–401\ncash versus futures price seasonality, \n389–390\nexpectations, role of, 390\nreal or probability, 390–391\nseasonal index (see Seasonal index)\nseasonal trading, 389\nSeasonal considerations, ignoring, 356\nSeasonal index, 391–401\nalternative approach, 396–401\naverage percentage method, 391–394\n700\nIndex\nstock index futures and (see Stock index futures)\ntime, 542\ntypes of, 441–442\nSpread seasonality, 449\nSpreadsheet, maintaining traders, ’ 563–564\nStability:\nof return, 338\ntime (see Time stability)\nStandard deviation:\ncalculation of, 323, 599\nestimation of, 607\nStandard error (SE), 612, 627\nStandard error of the estimate (SEE), 627\nStandard error of the mean, 612\nStandard error of the regression (SER):\nabout, 627\nmultiple regression model and, 641–642\nsimulation and, 681\nStandardized residu", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 235}
{"text": "y, 449\nSpreadsheet, maintaining traders, ’ 563–564\nStability:\nof return, 338\ntime (see Time stability)\nStandard deviation:\ncalculation of, 323, 599\nestimation of, 607\nStandard error (SE), 612, 627\nStandard error of the estimate (SEE), 627\nStandard error of the mean, 612\nStandard error of the regression (SER):\nabout, 627\nmultiple regression model and, 641–642\nsimulation and, 681\nStandardized residuals, regression run analysis and, \n647\nStatistic, definition of, 606\nStatistics:\nelementary (see Elementary statistics)\nforecasting model, building, 414\ninfluence of expectations on actual, 381\nusing prior-year estimates rather than revised, \n379–380\nSteidlmayer, Peter, 585\nStepwise regression, 681–682\nStochastic indicator, 199\nStock index futures:\ndividends and, 462\nintermarket stock index spreads, 462–470\nintramarket stock index spreads, 461–462\nmost actively traded contracts, 463\nresponse to employment reports, 408–409\nspread pairs, 463\nspread trading in, 461–470\nStock market collapse, 425\nStop, trailing. See Trailing stop\nStop close only, 18\nStop-limit order, 17\nStop-loss points, 183–188\nflags and pennants and, 184–185\nmoney stop and, 185, 187\nrelative highs and relative lows, 185, 186\nrelative lows and, 185, 186\nselecting, 183–188\nSMSV . See Single market system variation (SMSV)\nSoros, George, 22\nSource/product spread, 442\nSoybeans, inflation and, 384\nSpike(s), 109–113\ndefinition of, 112–113\nreversal days and, 147\n“spike days,” 237\nSpike days. See Spike(s)\nSpike extremes, return to, 213–216\nSpike highs:\npenetration of, 214–215\nqualifying conditions and, 110–111\nsignificance of, 109\nspike extremes and, 213–216\nSpike lows:\npenetration of, 215\nprice declines, 109\nsignificance of, 110\nSpike penetration signals negated, 216\nSpike reversal days, 115–116\nSpot gold, 555\nSpread-adjusted (continuous) price series, 282–285\nSpread order, 15, 19\nSpreads:\nabout, 439–440\nanalysis and approach, 448–449\nbalanced, 455\nbutterfly, 542\nchart analysis and, 449\ncredit, 535\ncurrency futures and (see Currency futures)\ndefinition of, 440\ndiagonal, 542\nequal-dollar-value spread, 455–460\nfundamentals and, 449\ngeneral rule (see General rule, spreads)\nhistorical comparison and, 448\nintercommodity (see Intercommodity spreads)\nintercrop, 441, 460\nintermarket, 442, 453\nintramarket (or interdelivery), 441\nlimited-risk, 446–448\npitfalls and points of caution, 449–451\nrather than outright - example, 445–446\nreason for trading, 440–441\nseasonality and, 449\nsimilar periods, isolation of, 449\n701\nIndex\nrelative low , 66\nTD downtrend line, 66, 67, 68–69, 71–72\nTD uptrend line, 67–68, 69–70\ntrue high and true low , 72–73\nT echnical analysis:\nabout, 16\nfundamental analysis and, 21–24, 417–418, \n426–427\nmoney management and, 426–427\nT echnical indicators, 155–171\nabout, 155–156\ncalculations, basic, 157\ncomparing indicators (see Comparing indicators)\nmoving average types, 165–167\nmyths about, 170–172\noscillators, 167–170\ntrading signals, 167–170\n“types,” 173\nT echnical trading systems, 233–259\nbenefits of, 236\ncountertrend systems (see Countertrend systems)\npattern recognition systems (see Pattern \nrecognition systems)\ntrend-following systems (see Trend-following \nsystems)\ntypes of, overview , 236–237\nT echniques of a Professional Commodity Chart Analyst, \n194\nT esting/optimizing trading systems, 289–318, \n291–293\nassumptions, realistic, 295–296\nconcepts and definitions, 291\ncontinuous futures and, 51\nexample, well-chosen, 289–291, 314–315\nmultimarket system testing, 313–314\nnegative results, 314–315\noptimizing myth, 298–310\noptimizing systems, 297–298\nprice series and, 287\nprice series selection, 293\nsimulated results, truth about, 312–313\nsteps in constructing/testing system, 315–316\ntesting versus fitting, 310–311\ntime period selection, 293–295\ntrading systems, observations, 316–318\nT exas option hedge:\nbearish, 519–520\nbullish, 517–519\ntrading ranges and, 184\ntrailing stop and, 187–188\ntrend lines and, 183–184\nwide-ranging days and, 185, 186\nStop-loss strategy, planned trading approach and, \n561\nStop order, 17\nStrategies. See Option trading strategies\nStress, 585–586\nStrike price, 477\nSubprime mortgage lending, 423–425\nSubstitutes, availability of, 361\nSugar prices, 348–349\nSupply:\nconsumption and, 365\ndefinition of, 359–362\nelastic relative to demand (highly inelastic \ndemand and), 370–371\nfixed, 360\nprice and, 362–363\nSupply curve, 359, 360–361\nSupply-demand interaction, 364\nSupply-demand reports, 366\nSupport and resistance, 91–108\nlevels, 196–197\nnearest or continuous futures, 91\nprice envelope bands and, 107–108\nprior major highs and lows, 94–100\nresistance zone, 104, 105\nsupport zone, 101–104, 105–106\ntrading ranges, 92–94\ntrend lines/channels and, 106\nSwiss franc, unexpected developments and, 420, \n421\nSymmetric downside-risk (SDR) Sharpe ratio, \n327–328\nSynthetic long futures, 528–531\nSynthetic short futures, 531–532\nSystem-testing platforms, price series and, 287\nSystem variation, 291\nTail ratio, 329–330, 335\nTautological relationship, 631\nTax considerations, 19–20\nT -bill rates, 323\nTD lines, 66–73\ndefinitions and, 66–67, 72\nrelative high, 66\n702\nIndex\nTrading method, personality and, 576\nTrading philosophy, 559\nTrading plan, 578\nTrading range(s), 83–89, 92–94\nbreakouts from, 86–89, 180–181\ndefinition of, 33\nintraday, 86\nmulti-year, 83–85\nstop-loss points and, 184\ntrading considerations, 83–86\ntrend-following systems and, 245\nTrading rules, 567–574\nTrading signals, 167–170\nTrading system(s):\ndefinition of, 291\nprice series and, 287\nupdating, 563\nTrailing stop, 187–188\nprofitable trades and, 571\nstop-loss points and, 187–188\ntrade exit point and, 204\nTransaction costs, 295–296, 313\nTrend(s), 57–81\ndowntrend lines, 65\ninternal trend lines (see Internal \ntrend lines)\nmiddle portion of, 583\nmoving averages (see Moving averages)\nnews coverage and, 579\nparticipation in major, 257\nTD lines (see TD lines)\nuptrend lines, 63–65\n“whipsawing” signals, 80\nTrend channels:\ndefinition of, 62\nrules applied to, 63\nsupport and resistance a", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 236}
{"text": "e exit point and, 204\nTransaction costs, 295–296, 313\nTrend(s), 57–81\ndowntrend lines, 65\ninternal trend lines (see Internal \ntrend lines)\nmiddle portion of, 583\nmoving averages (see Moving averages)\nnews coverage and, 579\nparticipation in major, 257\nTD lines (see TD lines)\nuptrend lines, 63–65\n“whipsawing” signals, 80\nTrend channels:\ndefinition of, 62\nrules applied to, 63\nsupport and resistance and, 106\nTrend-following systems, 237–244\nbreakout systems, 243–244\ncommon problems with, 244–247, 259\ncountertrend systems, 254–256\ndefinition of, 236\ndiversification, 256–258\nmodifications for (see Modifications, trend-\nfollowing systems)\nmoving average systems, 237–243\nThorp, Edward, 587\nThrust count, 180\nThrust days, 89, 116, 117\nTicker symbol, 5\n“Tick” size and value, 5\nTime considerations, ignoring relative, 351\nTime-outs, 580\nTime spread, 542\nTime stability:\nautomatic trading systems and, 295\noptimizing systems and, 297\nTime value, of options, 489\nTime value decay, 481\nTiming:\npoor, 422\nusing fundamentals for, 350, 425\nT -Note:\nfutures response to monthly U.S. employment \nreport, 404–407\nmarket response analysis and, 406, 407\nT op and bottom formations:\ndouble tops and bottoms, 134, 136–138\npenetration of, 225–229\nV tops and bottoms, 134\nT otal variation, 630\nTrade(s):\nentering, 568–569\nexiting, risk control and, 569–570\nnew , planning, 563\nreason for, 565\nscaling in and out of, 581\nsegmented, analysis of, 565–566\nwinning (see Winning trades)\nTrade entry:\npoor timing and, 422–425\ntiming of, 415\nTrade exit comments, 565\nTrade opportunity, forecasting model and, 415\nTrader’s diary, maintaining, 565\nTrader’s spreadsheet, maintaining, 563–564\nTrading:\nabout, 15–16\naround a position, 581–582\nfundamental analysis and, 417–435\nseasonal, 389\nTrading hours, 8\n703\nIndex\nVariable(s):\ndependent, determining, 675–676\ndiscrete, 600\ndummy, 659–663\nindependent, 415, 665, 677\nlagged, 677\nmissing, 421, 655–658\nrandom, 599\nVariance, 607\nVariation:\ndegrees of freedom and, 642\nR\n2 and, 642–643\ntotal, 630\nVisual performance evaluation, 335–342\n2DUC charts, 341–342\nnet asset value (NAV) charts, 335–336\nrolling window return charts, 337–340\nunderwater curve, 341–342\nV olatility:\nimplied, 483–484\nmarket adjustments, 562\noption premiums and, 482, 483\nplanned trading approach and, 560\nSharpe ratio and, 324\nspread trades and, 440\nV olatility ratio (VR):\ntrend-following systems and, 247\nwide-ranging days and, 119\nV olume, open interest and, 9–10\nV tops and bottoms, 134, 135\nWallet Street Week, 29–32\nW edge, 146–147\nW eighted least squares (WLS), 672\nW eighted moving average (WMA), 165–167\nW einstein, Mark, 580\nWheat market:\nbalance table, 373–374\ncrop expectations, 355–356\nintercommodity spreads and, 457–459\nWhipsaws:\ntrend-following systems and, 244\ntrend signals, 80\nWide-ranging days:\ndefinition, 262\nstop-loss points and, 185, 186\nTrending phase, price sample and, 294\nTrend lines, 106, 183–184. See also Internal trend \nlines\nbreakouts, false, 211–213\nrules applied to, 63\nstop-loss points and, 183–184\nTriangles, 123–127, 143–146\nascending, 125–126\ndescending, 126–127\nnonsymmetrical, 123\nsymmetrical, 123, 124–125\ntriangle bottom, 145\ntriangle top, 144\nTriple top, 129\nTrue range:\ndefinitions, 262\nwide-ranging day and, 261\nt-test:\nabout, 614–618\nmultiple regression model and, 640–641\n2DUC charts, 341–342\nTwo-tailed test, 614, 617\nType 1 error, 614\nType 2 error, 614\nUnderwater curve, 341–342\nUnexpected developments, 418\nUnexplained variation, 630\nUp run day, 118, 268\nUpthrust day, 116\nUptrend:\ndefinition of, 57\nexamples of, 58\nUptrend channel, 62\nUptrend lines, 63–65\nexamples of, 59, 60, 62\nfalse breakout signals, 211, 212\nU.S. Department of Agriculture (USDA):\nbalance table, 373–374\nconsumption, demand and, 366\nforecasting model, building, 414\nunexpected developments and, 420\nU.S. dollar (USD). See Dollar\nU.S. employment report, T -Note futures response to \nmonthly, 404–407\nU.S. Treasury, fundamentals and, 347\n704\nIndex\ngains and, 583\nholding/exiting, 570–571\nlosing and, concepts of, 578, 580\nneeding to win, 584\nWizard lessons, market, 575–587\nWLS. See W eighted least squares (WLS)\nW orld trade agreements, 356–357\nWRDs. See Wide-ranging days (WRDs)\nWTI crude oil. See also Crude oil market\npoor timing and, 426\nunexpected developments and, \n420, 421\nZero return, 326\nZiemba, William T ., 327\nZ-test, 614, 615\nWide-ranging days (WRDs), 119–121\ndown bar, 123\ndown days, 120\nextremes, return to, 216–218\nstop-loss points and, 185, 186\nup and down days, 121–122\nup days, 120\nup weeks, 122\nWide-ranging-day system, 261–268\nbasic concept, 261–262\ndaily checklist, 262–263\nillustrated example, 264–268\nparameter set list, 263\nsystem parameters, 263\ntrading signals, 262\nWinning trades:\nWILEY END USER LICENSE\nAGREEMENT\nGo to www.wiley.com/go/eula to access Wiley’s ebook\nEULA.", "source": "eBooks\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf", "doc_id": "c41989b733c502606c74e860d425ee430105ce9211cb1735379c25ca3da5b948", "chunk_index": 237}
{"text": "The \nInTellI genT \nOpTIOn \nInves TOr\nThis page intentionally left blank \nThe \nInTellI genT \nOpTIOn \nInves TOr\nApplying Value Investing to the \nWorld of Options\nerik Kobayashi-solomon\nnew Y ork Chicago s an Francisco Athens l ondon Madrid Mexico City \nMilan n ew Delhi s ingapore s ydney Toronto\nCopyright © 2015 by Erik Kobayashi-Solomon. All rights reserved. Except as permitted under the \nUnited States Copyright Act of 1976, no part of this publication may be reproduced or distributed \nin any form or by any means, or stored in a database or retrieval system, without the prior written \npermission of the publisher.\nISBN: 978-0-07-183366-0\nMHID: 0-07-183366-8\nThe material in this eBook also appears in the print version of this title: ISBN: 978-0-07-183365-3,\nMHID: 0-07-183365-X.\neBook conversion by codeMantra\nVersion 1.0\nAll trademarks are trademarks of their respective owners. Rather than put a trademark symbol after \nevery occurrence of a trademarked name, we use names in an editorial fashion only, and to the benefit \nof the trademark owner, with no intention of infringement of the trademark. Where such designations \nappear in this book, they have been printed with initial caps.\nMcGraw-Hill Education eBooks are available at special quantity discounts to use as premiums and \nsales promotions or for use in corporate training programs. To contact a representative, please visit the \nContact Us page at www.mhprofessional.com.\nTERMS OF USE\nThis is a copyrighted work and McGraw-Hill Education and its licensors reserve all rights in and to the \nwork. Use of this work is subject to these terms. Except as permitted under the Copyright Act of 1976 \nand the right to store and retrieve one copy of the work, you may not decompile, disassemble, reverse \nengineer, reproduce, modify, create derivative works based upon, transmit, distribute, disseminate, \nsell, publish or sublicense the work or any part of it without McGraw-Hill Education’s prior consent. \nYou may use the work for your own noncommercial and personal use; any other use of the work is \nstrictly prohibited. Your right to use the work may be terminated if you fail to comply with these terms.\nTHE WORK IS PROVIDED “AS IS.” McGRAW-HILL EDUCATION AND ITS \nLICENSORS MAKE NO GUARANTEES OR WARRANTIES AS TO THE ACCURACY , \nADEQUACY OR COMPLETENESS OF OR RESULTS TO BE OBTAINED FROM USING THE WORK, \nINCLUDING ANY INFORMATION THAT CAN BE ACCESSED THROUGH THE WORK VIA \nHYPERLINK OR OTHERWISE, AND EXPRESSLY DISCLAIM ANY WARRANTY , \nEXPRESS OR IMPLIED, INCLUDING BUT NOT LIMITED TO IMPLIED WARRANTIES OF \nMERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE. McGraw-Hill Education \nand its licensors do not warrant or guarantee that the functions contained in the work will meet your \nrequirements or that its operation will be uninterrupted or error free. Neither McGraw-Hill \nEducation nor its licensors shall be liable to you or anyone else for any inaccuracy, error or omission, \nregardless of cause, in the work or for any damages resulting therefrom. McGraw-Hill Education has no \nresponsibility for the content of any information accessed through the work. Under no circumstanc -\nes shall McGraw-Hill Education and/or its licensors be liable for any indirect, incidental, special, \npunitive, consequential or similar damages that result from the use of or inability to use the work, even \nif any of them has been advised of the possibility of such damages. This limitation of liability shall \napply to any claim or cause whatsoever whether such claim or cause arises in contract, tort or \notherwise.\nTo Fred Solomon\n(1930–2013)\nTo my family and my “tribe”\nThis page intentionally left blank \nvii\nContents\nAcknowledgments xi\nIntroduction xiii\nPart I: options for the Intelligent Investor 1\nChapter 1: Option Fundamentals 3\nCharacteristics and history 4\nDirectionality 9\nFlexibility 20\nChapter 2: The Black-scholes-Merton Model 29\nThe BsM’s Main Job is to predict stock prices 30\nThe BsM is lousy at Its Main Job 39\nChapter 3: The Intelligent Investor’s guide to Option pricing 49\nhow Option prices are Determined 50\nTime value versus Intrinsic value 56\nhow Changing Market Conditions Affect Option prices 59\nPart II: A sound Intellectual Framework for Assessing Value 75\nChapter 4: The golden rule of valuation 77\nThe value of an Asset 78\nCash Flows generated on Behalf of Owners 80\nThe Company’s economic life 82\nTime value of Money: summing Up Cash Flows Over Time 87\nChapter 5: The Four Drivers of value 91\nBird’s eye view of the valuation process 91\nA Detailed look at the Drivers of value 97\nviii  •   Contents\nChapter 6: Understanding and Overcoming Investing pitfalls 113\nBehavioral Biases 114\nstructural Impediments 131\nPart III: Intelligent option Investing 141\nChapter 7: Finding Mispriced Options 143\nMaking sense of Option Quotes 144\nDelta: The Most Useful of the greeks 151\nComparing an Intelligent valuation range with a BsM range 155\nChapter 8: Understanding and Managing leverage 163\nInvestment leverage 164\nsimple Ways of Measuring Option Investment leverage 169\nUnderstanding leverage’s effects on a portfolio 174\nManaging leverage 183\nChapter 9: gaining exposure 187\nlong Call 189\nlong put 201\nstrangle 205\nstraddle 208\nChapter 10: Accepting exposure 211\nshort put 212\nshort Call (Call spread) 220\nshort straddle/short strangle 230\nChapter 11: Mixing exposure 233\nlong Diagonal 235\nshort Diagonal 238\nCovered Call 240\nprotective puts 248\nCollar 258\nChapter 12: risk and the Intelligent Option Investor 263\nMarket risk 263\nvaluation risk 265\nIntelligent Option Investing 267\nAppendix A: Choose Y our Battles Wisely 269\nWhere the BsM Works Best 269\nWhere the BsM Works Worst 273\nAppendix B: The Many Faces of leverage 282\nOperational leverage 282\nFinancial leverage 285\nAppendix C: p ut-Call parity 287\nDividend Arbitrage and put-Call parity 288\nNotes 295\nIndex 305\nContents    • ix\nThis page intentionally left blank \nxi\nACknowledgments\nMany thanks to all the people who have been part of the process du", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 0}
{"text": "tles Wisely 269\nWhere the BsM Works Best 269\nWhere the BsM Works Worst 273\nAppendix B: The Many Faces of leverage 282\nOperational leverage 282\nFinancial leverage 285\nAppendix C: p ut-Call parity 287\nDividend Arbitrage and put-Call parity 288\nNotes 295\nIndex 305\nContents    • ix\nThis page intentionally left blank \nxi\nACknowledgments\nMany thanks to all the people who have been part of the process during \nthe writing of this book. I am indebted to three people in particular, \nMr. Brent Farler, Mr. Ben louviere, and Mr. neil Kozarsky, who have gra-\nciously offered their time, help, and business expertise in bringing this pro-\nject to fruition. Certainly this book would be much different and of not \nnearly the quality without Brent’s guidance, thorough reading, and insight-\nful, helpful suggestions, starting with the very first draft in late 2012. \nIn the literary world, I cannot say enough good things about Mr. sam \nFleishman, of l iterary Arts r epresentatives, and Mr. Knox h uston and \nMs. Daina penikas, my editors at Mcgraw-hill, all of whom have allowed \nthis work to move from conception to completion and whose advice and \nsupport have made all the hard work worthwhile.\nIn the investment-management world, I am indebted to Mr. steve \nsilverman, owner and portfolio manager of Ironbound Capital Manage-\nment, who taught me important lessons about the business of investing and \nabout how to critically assess the value of a company, and to Mr. Deepinder \nBhatia, Founding partner of Bayard Asset Management llC, a true expert \nin the art and science of equity research and analysis.\nIn addition, I thank Mr. rafael garcia, of the International Financial \nCorporation; Mr. Joe Miramonti, of Fedora Investment p artners; \nMr. Franco Dal pont, of Batalha Capital Management; and Mr. paul neff, \nof the Federal reserve Bank of Chicago, for the excellent discussions about \nvaluation, option theory, and bringing the touchstone of valuation into the \nrealm of option investments.\nWhen I began work on this book, I did not realize just what an \nenormous process it would be. Truly, without the help and support of \nall the people mentioned here and all my friends and family around \nthe world, I would have had a much more difficult time completing \nthis work.\nxii  •   Acknowledgments\nxiii\nIntroduCtIon\nYou have a tremendous advantage over algorithmic trading models, \ninvestment bank trading desks, hedge funds, and anyone who appears on or \npays attention to cable business news shows. This book is written to show \nwhere that advantage lies and how to exploit it to make confident and suc-\ncessful investment choices. In doing so, it explains how options work and \nwhat they can tell you about the market’s estimation of the value of stocks. \neven if, after reading it, you decide to stick with straight stock in-\nvesting and never make an option transaction, understanding how options \nwork will give you a tremendous advantage as an investor. The reason for \nthis is simple: by understanding options, you can understand what the rest \nof the market is expecting the future price of a stock to be. Understanding \nwhat future stock prices are implied by the market is like playing cards with \nan opponent who always leaves his or her hand face up on the table. Y ou \ncan look at the cards you are dealt, compare them with your opponent’s, \nand play the round only when you are sure that you have the winning hand.\nBy incorporating options into your portfolio, you will enjoy an even \ngreater advantage because of a peculiarity about how option prices are \ndetermined. Option prices are set by market participants making trans-\nactions, but those market participants all base their sale and purchase \ndecisions on the same statistical models. These models are like sausage \ngrinders. They contain no intelligence or insight but rather take in a few \nsimple inputs, grind them up in a mechanical way, and spit out an option \nprice of a specific form. \nAn option model does not, for instance, care about the operational \ndetails of a company. This oversight can lead to situations that seem to be \ntoo good to be true. For instance, I have seen a case in which an investor \ncould commit to buy a strong, profitable company for less than the amount \nof cash it held—in effect, allowing the investor to pay $0.90 to receive a \ndollar plus a share of the company’s future profits! Although it is true that \nthese kinds of opportunities do not come along every day, they do indeed \ncome along for patient, insightful investors.\nThis example lies at the heart of intelligent option investing, the es-\nsence of which can be expressed as a three-step process:\n1. Understanding the value of a stock\n2. Comparing that intelligently estimated value with the mechani-\ncally derived one implied by the option market\n3. Tilting the risk-reward balance in one’s favor by investing in the \nbest opportunities using a combination of stocks and options\nThe goal of this book is to provide you with the knowledge you need to be \nan intelligent option investor from the standpoint of these three steps. \nThere is a lot of information contained within this book but also a lot \nof information left out. This is not meant to be an encyclopedia of option \nequations, a handbook of colorfully named option strategies, or a treatise on \nfinancial statement analysis. Unlike academic books covering options, such \nas hull’s excellent book,\n1 not a single integration symbol or mathematical \nproof is found between this book’s covers. Understanding how options are \npriced is an important step in being an intelligent option investor; doing dif-\nferential partial equations or working out mathematical proofs is not. \nUnlike option books written for professional practitioners, such as \nnatenberg’s book,2 you will not find explanations about complex strategies \nor graphs about how “the greeks”3 vary under different conditions. Floor \ntraders need to know these things, but intelligent option investors—those \nm", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 1}
{"text": "gent option investor; doing dif-\nferential partial equations or working out mathematical proofs is not. \nUnlike option books written for professional practitioners, such as \nnatenberg’s book,2 you will not find explanations about complex strategies \nor graphs about how “the greeks”3 vary under different conditions. Floor \ntraders need to know these things, but intelligent option investors—those \nmaking considered long-term investments in the financial outcomes of \ncompanies—have very different motivations, resources, and time horizons \nfrom floor traders. Intelligent option investors, it turns out, do better not \neven worrying about the great majority of things that floor traders must \nconsider every day.\nUnlike how-to books about day trading options, this book does not \nhave one word to say about chart patterns, market timing, get-rich-quick \nschemes, or any of the many other delusions popular among people who \nxiv  •   Introduction\nIntroduction    • xv\nwill soon be paupers. Making good decisions is a vital part of being an \nintelligent option investor; frenetic, haphazard, and unconsidered trading \nis most certainly not.\nUnlike books about securities analysis, you will not find detailed dis-\ncussions about every line item on a financial statement. Understanding \nhow a company creates value for its owners and how to measure that value \nis an important step in being an intelligent option investor; being able to \nrattle off information about arcane accounting conventions is not.\nTo paraphrase Warren Buffett,\n4 this book aims to provide you with \na sound intellectual framework for assessing the value of a company and \nmaking rational, fact-based decisions about how to invest in them with the \nhelp of the options market.\nThe book is split into three parts:\n• part I provides an explanation of what options are, how they are \npriced, and what they can tell you about what the market thinks the \nfuture price of a stock will be. This part corresponds to the second \nstep of intelligent option investing listed earlier.\n• part II sets forth a model for determining the value of a company \nbased on only a handful of drivers. It also discusses some of the \nbehavioral and structural pitfalls that can and do affect investors’ \nemotions and how to avoid them to become a better, more rational \ninvestor. This part corresponds to the first step of intelligent option \ninvesting listed earlier. \n• part III turns theory into practice—showing how to read the nec-\nessary information on an option pricing screen; teaching how \nto measure and manage leverage in a portfolio containing cash, \nstocks, and options; and going into detail about the handful of op-\ntion strategies that an intelligent option investor needs to know to \ngenerate income, boost growth, and protect gains in an equity port-\nfolio. This part corresponds to the final step of intelligent option \ninvesting listed earlier.\nno part of this book assumes any prior knowledge about options or \nstock valuation. That said, it is not some sort of “Options for Beginners” or \n“My First Book of valuation” treatment either. \nInvesting beginners will learn all the skills—soup to nuts—they need \nto successfully and confidently invest in the stock and options market. peo-\nple who have some experience in options and who may have used covered \ncalls, protective puts, and the like will find out how to greatly improve their \nresults from these investments and how to use options in other ways as \nwell. professional money managers and analysts will develop a thorough \nunderstanding of how to effectively incorporate option investments into \ntheir portfolio strategies and may in fact be encouraged to consider ques-\ntions about valuation and behavioral biases in a new light as well.\nThe approach used here to teach about valuation and options is \nunique, simple without being simpleminded, and extremely effective in \ncommunicating these complex topics in a memorable, vivid way. r ead-\ners used to seeing option books littered with hockey-stick diagrams and \npartial differential equations may have some unlearning to do, but no mat-\nter your starting point—whether you are a novice investor or a seasoned \nhedge fund manager—by the end of this book, I believe that you will look \nat equity investing in a new light.\nxvi  •   Introduction\n1\nPart I\nOptiOns FOr the \nintelligent invest Or\nDon’t believe anything you have heard or read about options.\nIf you listen to media stories, you will learn that options are modern \nfinancial innovations so complex that only someone with an advanced \ndegree in mathematics can properly understand them. \nEvery contention in the preceding sentence is wrong.\nIf you listen to the pundits and traders blabbing on the cable business \nchannels, you will think that you will never be successful using options \nunless you understand what “put backspreads, ” “iron condors, ” and count- \nless other colorfully named option strategies are. Y ou will also learn that \noptions are short-term trading tools and that you’ll have to be a razor-sharp \n“technical analyst” who can “read charts” and jump in and out of positions \na few times a week (if not a few times a day) to do well.\nEvery contention in the preceding paragraph is so wrong that believing \nthem is liable to send you to the poor house.\nThe truth is that options are simple, directional instruments that \nwe understand perfectly well from countless encounters with them in \nour daily lives. They are the second-oldest financial instrument known to \nhumanity—in a quite literal sense, modern economic life would not be \npossible without them. Options are instruments that not only can be used \nbut should be used in long-term strategies; they most definitely should be \ntraded in and out of as infrequently as possible.\n2  •   The Intelligent Option Investor\nThe first part of this book will give you a good understanding of \nwhat options are, how their prices are determined, and how those prices \nfluctuate based on changes in", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 2}
{"text": "without them. Options are instruments that not only can be used \nbut should be used in long-term strategies; they most definitely should be \ntraded in and out of as infrequently as possible.\n2  •   The Intelligent Option Investor\nThe first part of this book will give you a good understanding of \nwhat options are, how their prices are determined, and how those prices \nfluctuate based on changes in market conditions.\nThere is a good reason to develop a solid understanding of this \ntheoretical background: the framework the option market uses to determine \nthe price of options is based on provably faulty premises that, while \n“approximately right” in certain circumstances, are laughably wrong in \nother circumstances. The faults can be exploited by intelligent, patient inves-\ntors who understand which circumstances to avoid and which to seek out.\nWithout understanding the framework the market uses to value \noptions and where that framework breaks down, there is no way to exploit \nthe faults. Part I of this book, in a nutshell, is designed to give you an \nunderstanding of the framework the market uses to value options.\nThis book makes extensive use of diagrams to explain option theory, \npricing, and investment strategies. Those readers of the printed copy of this \nbook are encouraged to visit the Intelligent Option Investor website (www \n.IntelligentOptionInvestor.com) to see the full-color versions of the type of \nillustrations listed here. Doing so will allow you to visualize options even \nmore effectively in the distinctive intelligent option investing way.\n3\nChapter 1\nOptiOn Fundamentals\nThis chapter introduces what an option is and how to visualize options in \nan intelligent way while hinting at the great flexibility and power a sensible \nuse of options gives an investor. It is split into three sections:\n1. Option Overview: Characteristics, everyday options, and a brief \noption history.\n2. Option Directionality: An investigation of similarities and differ -\nences between stocks and options. This section also contains an \nintroduction to the unique way that this book visualizes options \nand to the inescapable jargon used in the options world and a bit \nof intelligent option investor–specific jargon as well.\n3. Option Flexibility: An explanation of why options are much more \ninvestor-friendly than stocks, as well as examples of the handful of \nstrategies an intelligent option investor uses most often.\nEven those of you who know something about options should at the \nvery least read the last section. Y ou will find that the intelligent option \ninvestor makes very close to zero use of the typical hockey-stick diagrams \nshown in other books. Instead, this book uses the concept of a range of \nexposure. The rest of the book—discussing option pricing, corporate \nvaluation, and option strategies—builds on this range-of-exposure concept, \nso skipping it is likely to lead to confusion later.\nThis chapter is an important first step in being an intelligent option \ninvestor. Someone who knows how options work does not qualify as be-\ning an intelligent option investor, but certainly, one cannot become an \n4  •   The Intelligent Option Investor\nintelligent option investor without understanding these basic facts. The \nconcepts discussed here will be covered in greater detail and depth later in \nthis book. For now, it is enough to get a sense for what options are, how to \nthink about them, and why they might be useful investment tools.\nCharacteristics and History\nBy the end of this section, you should know the four key characteristics \nof options, be able to name a few options that are common in our daily \nlives, and understand a bit about the long history of options as a financial \nproduct and how modern option markets operate.\nJargon introduced in this section is as follows:\nBlack-Scholes-Merton model (BSM)\nListed look-alike\nCentral counterparty\nCharacteristics of Options\nRather than giving a definition for options, I’ll list the four most important \ncharacteristics that all options share and provide a few common examples. \nOnce you understand the basic characteristics of options, have seen a few \nexamples, and have spent some time thinking about them, you will start to \nsee elements of optionality in nearly every situation in life.\nAn option\n1. Is a contractual right\n2. Is in force for a specified time \n3. Allows an investor to profit from the change in value of another \nasset\n4. Has value as long as it is still in force\nThis definition is broad enough that it applies to all sorts of options—\nthose traded on a public exchange such as the Chicago Board Options \nExchange and those familiar to us in our daily lives. \nOption Fundamentals   • 5\nOptions in Daily Life\nThe type of option with which people living in developed economies are \nmost familiar is an insurance contract. Let’s say that you want to fully insure \nyour $30,000 car. Y ou sign a contract (option characteristic number 1) \nwith your insurance company that covers you for a specified amount of time \n(option characteristic number 2)—let’s say one year. If during the coverage \nperiod your car is totaled, your insurance company buys your wreck of a \ncar (worth $0 or close to it) for $30,000—allowing you to buy an identical \ncar. When this happens, you as the car owner (or investor in a real asset) \nrealize a profit of $30,000 over the market value of your destroyed car \n(option characteristic number 3). Obviously, the insurance company is \nbound to uphold its promise to indemnify you from loss for the entire term \nof the contract; the fact that you have a right to sell a worthless car to your \ninsurance company for the price you paid for it implies that the insurance \nhas value during its entire term (option characteristic number 4). \nAnother type of option, while perhaps not as widely used by everyday \nfolks, is easily recognizable. Imagine that you are a struggling author who \nhas just penned your first novel. The novel was not a great seller, bu", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 3}
{"text": "right to sell a worthless car to your \ninsurance company for the price you paid for it implies that the insurance \nhas value during its entire term (option characteristic number 4). \nAnother type of option, while perhaps not as widely used by everyday \nfolks, is easily recognizable. Imagine that you are a struggling author who \nhas just penned your first novel. The novel was not a great seller, but one day \nyou get a call from a movie producer offering you $50,000 for the right to \ndraft a screenplay based on your work. This payment will grant the producer \nexclusive right (option characteristic number 1) to turn the novel into a \nmovie, as well as the right to all proceeds from a potential future movie \nfor a specific period of time (option characteristic number 2)—let’s say \n10 years. After that period is up, you as the author are free to renegotiate an-\nother contract. As a struggling artist working in an unfulfilling day job, you \nhappily agree to the deal. Three weeks later, a popular daytime talk show \nhost features your novel on her show, and suddenly, you have a New York \nTimes bestseller on your hands. The value of your literary work has gone \nfrom slight to great in a single week. Now the movie producer hires the \nCohen brothers to adapt your film to the screen and hires George Clooney, \nMatt Damon, and Julia Roberts to star in the movie. When it is released, \nthe film breaks records at the box office. How much does the producer pay \nto you? Nothing. The producer had a contractual right to profit from the \nscreenplay based on your work. When the producer bought this right, your \nliterary work was not worth much; suddenly, it is worth a great deal, and \n6  •   The Intelligent Option Investor\nthe producer owns the upside potential from the increase in value of your \nstory (option characteristic number 3). Again, it is obvious that the right \nto the literary work has value for the entire term of the contract (option \ncharacteristic number 4).\nKeep these characteristics in mind, and we will go on to look at how \nthese defining elements are expressed in financial markets later in this \nchapter. Now that you have an idea of what an option looks like, let’s turn \nbriefly to a short history of these financial instruments.\nA Brief History of Options\nMany people believe that options are a new financial invention, but in \nfact, they have been in use for more than two millennia—one of the first \nhistorically attested uses of options was by a pre-Socratic philosopher \nnamed Miletus, who lived in ancient Greece. Miletus the philosopher was \naccused of being useless by his fellow citizens because he spent his time \nconsidering philosophical matters (which at the time included a study of \nnatural phenomena as well) rather than putting his nose to the grindstone \nand weaving fishing nets or some such thing.\nMiletus told them that his knowledge was in fact not useless and that \nhe could apply it to something people cared about, but he simply chose not \nto. As proof of his contention, when his studies related to weather revealed \nto him that the area would enjoy a bumper crop of olives in the upcoming \nseason, he went around to the owners of all the olive presses and paid them \na fee to reserve the presses (i.e., he entered into a contractual agreement—\noption characteristic number 1) through harvest time (i.e., the contract \nhad a prespecified life—option characteristic number 2). \nIndeed, Miletus’s prediction was correct, and the following season \nyielded a bumper crop of olives. The price of olives must have fallen because \nof the huge surge of supply, and demand for olive presses skyrocketed \n(because turning the olive fruit into oil allowed the produce to be stored \nlonger). Because Miletus had cornered the olive press market, he was able \nto generate huge profits, turning the low-value olives into high-value oil \n(i.e., he profited from the change in value of an underlying asset—option \ncharacteristic number 3). His rights to the olive presses ended after the har-\nvest but not before he had become very wealthy thanks to his philosophical \nOption Fundamentals   • 7\nstudies (i.e., his contractual rights had value through expiration—option \ncharacteristic number 4).\nThis is only one example of an ancient option transaction (a few thou-\nsand years before the first primitive common stock came into existence), \nbut as long as there has been insurance, option contracts have been a well-\nunderstood and widely used financial instrument. Can you imagine how \nlittle cross-border trade would occur if sellers and buyers could not shift the \nrisk of transporting goods to a third party such as an insurance company? \nHow many ships would have set out for the Spice Islands during the Age of \nExploration, for instance? Indeed, it is hard to imagine what trade would \nlook like today if buyers and sellers did not have some way to mitigate the \nrisks associated with uncertain investments.\nFor hundreds of years, options existed as private contracts specifying \nrights to an economic exposure of a certain quantity of a certain good over \na given time period. Frequently, these contracts were sealed between the \nproducers and sellers of a commodity product and wholesale buyers of \nthat commodity. Both sides had an existing exposure to the commodity \n(the producer wanted to sell the commodity, and the wholesaler wanted to \nbuy it), and both sides wanted to insure themselves against interim price \nmovements in the underlying commodity.\nBut there was a problem with this system. Let’s say that you were a \nRenaissance merchant who wanted to insure your shipment of spice from \nIndia to Europe, and so you entered into an agreement with an insurer. The \ninsurer asked you to pay a certain amount of premium up front in return \nfor guaranteeing the value of your cargo. Y our shipment leaves Goa but is \nlost off Madagascar, and all your investment capital goes down with the \nship to the bottom of the Indian Ocean. However, when", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 4}
{"text": "ho wanted to insure your shipment of spice from \nIndia to Europe, and so you entered into an agreement with an insurer. The \ninsurer asked you to pay a certain amount of premium up front in return \nfor guaranteeing the value of your cargo. Y our shipment leaves Goa but is \nlost off Madagascar, and all your investment capital goes down with the \nship to the bottom of the Indian Ocean. However, when you try to find \nyour option counterparty—your insurer—it seems that he has absconded \nwith your premium money and is living a life of pleasure and song in \nanother country. In the parlance of modern financial markets, your option \ninvestment failed because of counterparty risk. \nPrivate contracts still exist today in commodity markets as well as \nthe stock market (the listed look-alike option market—private contracts \nspecifying the right to upside and downside exposure to single stocks, \nexchange-traded funds, and baskets is one example that institutional \ninvestors use heavily). However, private contracts still bring with them a \n8  •   The Intelligent Option Investor\nrisk of default by one’s counterparty, so they are usually only entered into \nafter both parties have fully assessed the creditworthiness of the other. \nObviously, individual investors—who might simply want to speculate on \nthe value of an underlying stock or exchange-traded fund (ETF)—cannot \nspend the time doing a credit check on every counterparty with whom \nthey might do business.\n1 Without a way to make sure that both parties are \nfinancially able to keep up their half of the option bargain, public option \nmarkets simply could not exist.\nThe modern solution to this quandary is that of the central counter -\nparty. This is an organization that standardizes the terms of the option con-\ntracts transacted and ensures the financial fulfillment of the participating \ncounterparties. Central counterparties are associated with securities \nexchanges and regulate the parties with which they deal. They set rules \nregarding collateral that must be placed in escrow before a transaction \ncan be made and request additional funds if market price changes cause \na counterparty’s account to become undercollateralized. In the United \nStates, the central counterparty for options transactions is the Options \nClearing Corporation (OCC). The OCC is an offshoot of the oldest option \nexchange, the Chicago Board Option Exchange (CBOE).\nIn the early 1970s, the CBOE itself began as an offshoot of a large \nfutures exchange—the Chicago Mercantile Exchange—and subsequently \nstarted the process of standardizing option contracts (i.e., specifying the \nexact per-contract quantity and quality of the underlying good and the \nexpiration date of the contract) and building the other infrastructure and \nregulatory framework necessary to create and manage a public market. \nAlthough market infrastructure and mechanics are very important for \nthe brokers and other professional participants in the options market, \nmost aspects are not terribly important from an investor’s point of view \n(the things that are—such as margin—will be discussed in detail later in \nthis book). The one thing an investor must know is simply that the option \nmarket is transparent, well regulated, and secure. Those of you who have a \nbit of extra time and want to learn more about market mechanics should \ntake a look through the information on the CBOE’s and OCC’s websites.\nListing of option contracts on the CBOE meant that investors needed \nto have a sense for what a fair price for an option was. Three academics, \nFischer Black, Myron Scholes, and Robert Merton, were responsible for \nOption Fundamentals   • 9\ndeveloping and refining an option pricing model known as the Black-\nScholes or Black-Scholes-Merton model, which I will hereafter abbreviate \nas the BSM.\nThe BSM is a testament to human ingenuity and theoretical elegance, \nand even though new methods and refinements have been developed \nsince its introduction, the underlying assumptions for new option pricing \nmethods are the same as the BSM. In fact, throughout this book, when you \nsee “BSM, ” think “any statistically based algorithm for determining option \np r i c e s .”\nThe point of all this background information is that options are not \nonly not new-fangled financial instruments but in fact have a long and \nproud history that is deeply intertwined with the development of modern \neconomies themselves. Those of you interested in a much more thorough \ncoverage of the history of options would do well to read the book, Against \nthe Gods: The Remarkable History of Risk, by Peter Bernstein (New Y ork: \nWiley, 1998).\nNow that you have a good sense of what options are and how they are \nused in everyday life, let’s now turn to the single most important thing for a \nfundamental investor to appreciate about these financial instruments: their \ninherent ability to exploit directionality.\nDirectionality\nThe key takeaway from this section is evident from the title. In addition to \ndemonstrating the directional power inherent in options, this section also \nintroduces the graphic tools that I will use throughout the rest of this book \nto show the risk and reward inherent in any investment—whether it is an \ninvestment in a stock or an option.\nFor those of you who are not well versed in options yet, this is the \nsection in which I explain most of the jargon that you simply cannot escape \nwhen transacting in options. However, even readers who are familiar with \noptions should at least skim through this explanation. Doing so will likely \nincrease your appreciation for the characteristics of options that make \nthem such powerful investment tools and also will introduce you to this \nnovel way of visualizing them.\n10  •   The Intelligent Option Investor\nJargon introduced in this section is as follows:\nCall option Moneyness\nPut option In the money (ITM)\nRange of exposure At the money (ATM)\nStrike price Out of the money (OTM)\nGain exposure Premium\nAccept exposur", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 5}
{"text": "for the characteristics of options that make \nthem such powerful investment tools and also will introduce you to this \nnovel way of visualizing them.\n10  •   The Intelligent Option Investor\nJargon introduced in this section is as follows:\nCall option Moneyness\nPut option In the money (ITM)\nRange of exposure At the money (ATM)\nStrike price Out of the money (OTM)\nGain exposure Premium\nAccept exposure American style\nCanceling exposure European style\nExercise (an option)\nVisual Representation of a Stock\nVisually, a good stock investment looks like this: \n5/18/2012\n-\n20\n40\n60\n80\n100\n120\n140\n160\n180\n200\n5/20/2013 249 499\nDate/Day Count\nStock Price\n749 999\nFuture Stock Price\nLast Stock Price\nY ou can make a lot of mistakes when investing, but as long as you are right \nabout the ultimate direction a stock will take and act accordingly, all those \nmistakes will be dwarfed by the success of your position.\nGood investing, then, is essentially a process of recognizing and \nexploiting the directionality of mispriced stocks. Usually, investors get \nexposure to a stock’s directionality by buying, or going long, that stock. This \nis what the investor’s risk and reward profile looks like when he or she buys \nthe stock:\nOption Fundamentals   • 11\n5/18/2012\n-\n20\n40\n60\n80\n100\n120\n140\n160\n180\n200\n5/20/2013 249 499\nDate/Day Count\nStock Price\n749 999\nGREEN\nRED\nAs soon as the “Buy” button is pushed, the investor gains expo-\nsure to the upside potential of the stock—this is the shaded region la-\nbeled “green” in the figure. However, at the same time, the investor \nalso must accept exposure to downside risk—this is the shaded region \nlabeled “red. ”\nAnyone who has invested in stocks has a visceral understanding of \nstock directionality. We all know the joy of being right as our investment \nsoars into the green and we’ve all felt the sting as an investment we own \nfalls into the red. We also know that to the extent that we want to gain \nexposure to the upside potential of a stock, we must necessarily simultane-\nously accept its downside risk.\nOptions, like stocks, are directional instruments that come in two \ntypes. These two types can be defined in directional terms:\nCall option A security that allows an investor exposure to a stock’s \nupside potential (remember, “Call up”)\nPut option A security that allows an investor exposure to a stock’s \ndownside potential (remember, “Put down”)\nThe fact that options split the directionality of stocks in half—up and \ndown—is a great advantage to an investor that we will investigate more in \na moment. \nRight now, let’s take a look at each of these directional instruments—\ncall options and put options—one by one.\n12  •   The Intelligent Option Investor\nVisual Representation of Call Options\nIn a similar way that we created a diagram of the risk-reward profile of owner-\nship in a common stock, a nice way of understanding how options work is to \nlook at a visual representation. The following diagram represents a call option.\nThere are a few things to note about this representation:\n5/18/2012\n-\n20\n40\n60\n80\n100\n120\n140\n160\n180\n200\n5/20/2013 249 499\nDate/Day Count\nStock Price\n749 999\nGREEN\n1. The shaded area (green) represents the price and time range over \nwhich the investor has economic exposure—I term this the range \nof exposure. Because we are talking about call options, and because \ncall options deal with the upside potential of a stock, you see that \nthe range of exposure lies higher than the present stock price \n(remember, “Call up”). \n2. True to one of the defining characteristics of an option mentioned \nearlier, our range of exposure is limited by time; the option pictured \nin the preceding figure expires 500 days in the future, after which \nwe have no economic exposure to the stock’s upside potential. \n3. The present stock price is $50 per share, but our upside exposure only \nbegins at $60 per share. The price at which economic exposure begins \nis called the strike price of an option. In this case, the strike price is \n$60 per share, but we could have picked a strike price at the market price \nof the stock, further above the market price of the stock (e.g., a strike \nprice of $75), or even below the market price of the stock. We will inves-\ntigate optimal strike prices for certain option strategies later in this book.\nOption Fundamentals   • 13\n4. The arrow at the top of the shaded region in the figure indicates \nthat our exposure extends infinitely upward. If, for some reason, \nthis stock suddenly jumped not from $50 to $60 per share but \nfrom $50 to $1,234 per share, we would have profitable exposure \nto all that upside.\n5. Clearly, the diagram showing a purchased call option looks a great deal \nlike the top of the diagram for a purchased stock. Look back at the top \nof the stock purchase figure and compare it with the preceding figure: \nthe inherent directionality of options should be completely obvious.\nAny time you see a green region on diagrams like this, you should \ntake it to mean that an investor has the potential to realize a gain on the \ninvestment and that the investor has gained exposure. Any time an option \ninvestor gains exposure, he or she must pay up front for that potential gain. \nThe money one pays up front for an option is called premium (just like the \nfee you pay for insurance coverage).\nIn the preceding diagram, then, we have gained exposure to a range \nof the stock’s upside potential by buying a call option (also known as a long \ncall). If the stock moves into this range before or at option expiration, we \nhave the right to buy the stock at our $60 strike price (this is termed exer -\ncising an option) or simply sell the option in the option market. It is almost \nalways the wrong thing to exercise an option for reasons we discuss shortly.\n2\nIf, instead, the stock is trading below our strike price at expiration, the \noption is obviously worthless—we owned the right to an upside scenario \nthat did not materialize, so our ownership right is worth nothing", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 6}
{"text": "ice (this is termed exer -\ncising an option) or simply sell the option in the option market. It is almost \nalways the wrong thing to exercise an option for reasons we discuss shortly.\n2\nIf, instead, the stock is trading below our strike price at expiration, the \noption is obviously worthless—we owned the right to an upside scenario \nthat did not materialize, so our ownership right is worth nothing.\nIt turns out that there is special jargon that is used to describe the \nrelationship between the stock price and the range of option exposure:\nJargon Situation\nIn the money (ITM) Stock price is within the option’s range of exposure\nOut of the money (OTM) Stock price is outside the option’s range of exposure\nAt the money (ATM) Stock price is just at the border of the option’s range of \nexposure\nEach of these situations is said to describe the moneyness of the option. \nGraphically, moneyness can be represented by the following diagram:\n14  •   The Intelligent Option Investor\n5/18/2012\n-\n20\n40\n60\n80\n100\n120\n140\n160\n180\n200\n5/20/2013 249 499\nITM\nATM\nOTM\nDate/Day Count\nStock Price\n749 999\nGREEN\nAs we will discuss in greater detail later, not only can an investor use \noptions to gain exposure to a stock, but the investor also can choose to accept \nexposure to it. Accepting exposure means running the risk of a financial loss if \nthe stock moves into an option’s range of exposure. If we were to accept expo-\nsure to the stock’s upside potential, we would graphically represent it like this:\n5/18/2012\n-\n20\n40\n60\n80\n100\n120\n140\n160\n180\n200\n5/20/2013 249 499\nDate/Day Count\nStock Price\n749 999\nRED\nAny time you see a shaded region labeled “red” on diagrams like this, you \nshould take it to mean that the investor has accepted the risk of realizing a loss \non the investment and should say that the investor has accepted exposure. Any \ntime an option investor accepts exposure, he or she gets to receive premium \nup front in return for accepting the risk. In the preceding example, the investor \nhas accepted upside exposure by selling a call option (a.k.a. a short call).\nOption Fundamentals   • 15\nIn this sold call example, we again see the shaded area representing \nthe exposure range. We also see that the exposure is limited to 500 days \nand that it starts at the $60 strike price. The big difference we see between \nthis diagram and the one before it is that when we gained upside exposure \nby buying a call, we had potentially profitable exposure infinitely upward; \nin the case of a short call, we are accepting the possibility of an infinite \nloss. Needless to say, the decision to accept such risk should not be taken \nlightly. We will discuss in what circumstances an investor might want to \naccept this type of risk and what techniques might be used to manage that \nrisk later in this book. For right now, think of this diagram as part of an \nexplanation of how options work, not why someone might want to use this \nparticular strategy.\nLet’s go back to the example of a long call because it’s easier for \nmost people to think of call options this way. Recall that you must pay a \npremium if you want to gain exposure to a stock’s directional potential. In \nthe diagrams, you will mark the amount of premium you have to pay as a \nstraight line, as can be seen here:\n5/18/2012\n-\n20\n40\n60\n80\n100\n120\n140\n160\n180\n200\n5/20/2013 249\nBreakeven Line: $62.50\n499\nDate/Day Count\nStock Price\n749 999\nGREEN\nI have labeled the straight line the “Breakeven line” for now and have as-\nsumed that the option’s premium totals $2.50. \nY ou can think of the breakeven line as a hurdle the stock must cross \nby expiration time. If, at expiration, the stock is trading for $61, you have \nthe right to purchase the shares for $60. Y ou make a $1 profit on this trans-\naction, which partially offsets the original $2.50 cost of the option.\n16  •   The Intelligent Option Investor\nIt is important to note that a stock does not have to cross this line for \nyour option investment to be profitable. We will discuss this dynamic in \nChapter 2 when we learn more about the time value of options.\nVisual Representation of Put Options\nNow that you understand the conventions we use for our diagrams, let’s \nthink about how we might represent the other type of option, dealing with \ndownside exposure—the put. First, let’s assume that we want to gain expo-\nsure to the downside potential of a stock. Graphically, we would represent \nthis in the following way:\n5/18/2012\n-\n20\n40\n60\n80\n100\n120\n140\n160\n180\n200\n5/20/2013 249 499\nDate/Day Count\nStock Price\n749 999\nGREEN\nFirst, notice that, in contrast to the diagram of the call option, the \ndirectional exposure of a put option is bounded on the downside by $0, \nso we do not draw an arrow indicating infinite exposure. This is the same \ndownside exposure of a stock because a stock cannot fall below zero dollars \nper share.\nIn this diagram, the time range for the put option is the same 500 days \nas for our call option, but the price range at which we have exposure starts \nat a strike price of $50—the current market price of the stock—making this \nan at-the-money (ATM) put. If you think about moneyness in terms of a \nrange of exposure, the difference between out of the money (OTM) and in \nthe money (ITM) becomes easy and sensible. Here are examples of differ-\nent moneyness cases for put options:\nOption Fundamentals   • 17\n5/18/2012\n-\n20\n40\n60\n80\n100\n120\n140\n160\n180\n200\n5/20/2013 249 499\nDate/Day Count\nStock Price\n749 999\nOTM\nATM\nITMGREEN\nWe are assuming that this put option costs $5, leading to a breakeven \nline of $45. This breakeven line is like an upside-down hurdle in that we \nwould like the stock to finish below $45; if it expires below $50 but above \n$45, again, we will be able to profit from the exercise, but this profit will not \nbe great enough to cover the cost of the option. \n5/18/2012\n-\n20\n40\n60\n80\n100\n120\n140\n160\n180\n200\n5/20/2013 249 499\nDate/Day Count\nStock Price\n749 999\nBreakeven Line: $45.00\nGREEN\nObviously, if we can gain", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 7}
{"text": "an upside-down hurdle in that we \nwould like the stock to finish below $45; if it expires below $50 but above \n$45, again, we will be able to profit from the exercise, but this profit will not \nbe great enough to cover the cost of the option. \n5/18/2012\n-\n20\n40\n60\n80\n100\n120\n140\n160\n180\n200\n5/20/2013 249 499\nDate/Day Count\nStock Price\n749 999\nBreakeven Line: $45.00\nGREEN\nObviously, if we can gain downside exposure to a stock, we must be \nable to accept it as well. We can accept downside exposure by selling a put; \nthis book represents a sold put graphically like this:\n18  •   The Intelligent Option Investor\n5/18/2012\n-\n20\n40\n60\n80\n100\n120\n140\n160\n180\n200\n5/20/2013 249 499\nDate/Day Count\nStock Price\n749 999\nBreakeven Line: $45.00\nRED\nIn this diagram, we are receiving a $5 premium payment in return for \naccepting exposure to the stock’s downside. As such, as long as the stock \nexpires above $45, we will realize a profit on this investment.\nVisual Representation of Options Canceling Exposure\nLet’s take a look again at our visual representation of the risk and reward \nof a stock:\n5/18/2012\n-\n20\n40\n60\n80\n100\n120\n140\n160\n180\n200\n5/20/2013 249 499\nDate/Day Count\nStock Price\n749 999\nGREEN\nRED\nWe bought this stock at $50 per share and will experience an unreal-\nized gain if the stock goes up and an unrealized loss if it goes down. What \nmight happen if we were to simultaneously buy a put, expiring in 365 days \nand struck at $50, on the same stock?\nBecause we are purchasing a put, we know that we are gaining expo-\nsure to the downside. Any time we gain exposure, we shade the exposure \nOption Fundamentals   • 19\nin green. Let’s overlay this gain of downside exposure on the preceding \nrisk-return diagram and see what we get.\n5/18/2012\n-\n20\n40\n60\n80\n100\n120\n140\n160\n180\n200\n5/20/2013 249 499\nDate/Day Count\nStock Price\n749 999\nGREEN\nRED\nThe region representing the downside exposure we gained by buy-\ning the put perfectly overlaps part of the region representing the downside \nexposure we accepted when we bought the stock. When there is a region \nsuch as this, where we are simultaneously gaining and accepting exposure, \nthe two exposures cancel out, creating no economic exposure whatsoever.\nFrom here on out, to show a canceling of economic exposure, we will \nshade the region in gray, like the following:\n5/18/2012\n-\n20\n40\n60\n80\n100\n120\n140\n160\n180\n200\n5/20/2013 249 499\nDate/Day Count\nStock Price\n749 999\nGREEN\nREDGRAY\n20  •   The Intelligent Option Investor\nAny time a gain of exposure overlaps another gain of exposure, \nthe potential gain from an investment if the stock price moves into that \nregion rises. We will not represent this in the diagrams of this book, \nbut you can think of overlapping gains as deeper and deeper shades of \ngreen (when gaining exposure) and deeper and deeper shades of red \n(when accepting it).\nNow that you understand how to graphically represent gaining and \naccepting exposure to both upside and downside directionality and how to \nrepresent situations when opposing exposures overlap, we can move onto \nthe next section, which introduces the great flexibility options grant to an \ninvestor and discusses how that flexibility can be used as a force of either \ngood or evil.\nFlexibility\nAgain, the main takeaway of this section should be obvious from the title. \nHere we will see the only two choices stock investors have with regard to \nrisk and return, and we will contrast that with the great flexibility an option \ninvestor has. We will also discuss the concept of an effective buy price and \nan effective sell price—two bits of intelligent option investor jargon. Last, \nwe will look at a typical option strategy that might be recommended by \nan option “guru” and note that these types of strategies actually are at \ncross-purposes with the directional nature of options that makes them so \npowerful in the first place.\nJargon introduced in this chapter is as follows:\nEffective buy price (EBP) Covered call\nEffective sell price (ESP) Long strangle\nLeg\nStocks Give Investors Few Choices\nA stock investor only has two choices when it comes to investing: going \nlong or going short. Using our visualization technique, those two choices \nlook like this:\nOption Fundamentals   • 21\n-\n20\n40\n60\n80\n100\n120\n140\n160\n180\n200\n-\n20\n40\n60\n80\n100\n120\n140\n160\n180\n200\nGREEN\nGREEN\nRED\nRED\nGoing long a stock (i.e., buying \na stock).\n Going short a stock (i.e., short \nselling a stock).\nIf you want to gain exposure to a stock’s upside potential by going \nlong (left-hand diagram), you also must simultaneously accept exposure to \nthe stock’s downside risk. Similarly, if you want to gain exposure to a stock’s \ndownside potential by going short (right-hand diagram), you also must ac-\ncept exposure to the stock’s upside risk. \nIn contrast, option investors are completely unrestrained in their \nability to choose what directionality to accept or gain. An option investor \ncould, for example, very easily decide to establish exposure to the direc-\ntionality of a stock in the following way:\n5/18/2012\n-\n20\n40\n60\n80\n100\n120\n140\n160\n180\n200\n5/20/2013 249 499\nDate/Day Count\nStock Price\n749 999\nGREEN\nGREEN\nGRAY\nGRAY\nGREEN\nRED\nRED\nRED\nWhy an investor would want to do something like this is completely beyond \nme, but the point is that options are flexible enough to allow this type of a \ncrazy structure to be built.\n22  •   The Intelligent Option Investor\nThe beautiful thing about this flexibility is that an intelligent option in-\nvestor can pick and choose what exposure he or she wants to gain or accept in \norder to tailor his or her risk-return profile to an underlying stock. By tailoring \nyour risk-return profile, you can increase growth, boost income, and insure \nyour portfolio from downside shocks. Let’s take a look at a few examples.\nOptions Give Investors Many Choices\nBuying a Call for Growth\n-\n50\n100\n150\n200\nBE = $55\nGREEN\nAbove an investor is bullish on the prospects of the stock and is using a call op-\ntion to gain exposure to a", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 8}
{"text": "profile to an underlying stock. By tailoring \nyour risk-return profile, you can increase growth, boost income, and insure \nyour portfolio from downside shocks. Let’s take a look at a few examples.\nOptions Give Investors Many Choices\nBuying a Call for Growth\n-\n50\n100\n150\n200\nBE = $55\nGREEN\nAbove an investor is bullish on the prospects of the stock and is using a call op-\ntion to gain exposure to a stock’s upside potential above $50 per share. Rather \nthan accepting exposure to the stock’s entire downside potential (maximum \nof a $50 loss) as he or she would have by buying the stock outright, the call-\noption investor would pay an upfront premium of, in this case, $5.\nSelling a Put for Income\n50\n100\n150\n200\n-\nBE = $45\nRED\nOption Fundamentals   • 23\nHere an investor is bullish on the prospects of the stock, so he or she doesn’t \nmind accepting exposure to the stock’s downside risk below $50. In return for \naccepting this risk, the option investor receives a premium—let’s say $5. This \n$5 is income to the investor—kind of like a do-it-yourself dividend payment.\nBy the way, as you will discover later in this book, this is also the risk-\nreturn profile of a covered call.\nBuying a Put for Protection\n50\n100\n150\n200\n-\nGREEN\nREDGRAY\nAbove an investor wants to enjoy exposure to the stock’s upside potential \nwhile limiting his or her losses in case of a market fall. By buying a put \noption struck a few dollars under the market price of the stock, the investor \ncancels out the downside exposure he or she accepted when buying the \nstock. With this protective put overlay in place, any loss on the stock will be \ncompensated for through a gain on the put contract. The investor can use \nthese gains to buy more of the stock at a lower price or to buy another put \ncontract as protection when the first contract expires.\nTailoring Exposure with Puts and Calls\n-\n20\n40\n60\n80\n100\n120\n140\n160\n180\n200\nBE = $60.50\nGREEN\nRED\n24  •   The Intelligent Option Investor\nHere an investor is bullish on the prospects of the stock and is tailor -\ning where to gain and accept exposure by selling a short-term put and \nsimultaneously buying a longer-term call. By doing this, the investor \nbasically subsidizes the purchase of the call option with the sale of the \nput option, thereby reducing the level the stock needs to exceed on the \nupside before one breaks even. In this case, we’re assuming that the call \noption costs $1.50 and the put option trades for $1.00. The cash inflow \nfrom the put option partially offsets the cash outflow from the call op-\ntion, so the total breakeven amount is just the call’s $60 strike price plus \nthe net of $0.50.\nEffective Buy Price/Effective Sell Price\nOne thing that I hope you realized while looking at each of the preceding \ndiagrams is how similar each of them looks to a particular part of our long \nand short stock diagrams:\nBuying a stock.\n-\n20\n40\n60\n80\n100\n120\n140\n160\n180\n200\n-\n20\n40\n60\n80\n100\n120\n140\n160\n180\n200\nRED\nGREEN\nGREEN\nRED\nShort selling a stock.\nFor example, doesn’t the diagram labeled “Buying a call for growth” \nin the preceding section look just like the top part of the buying stock \ndiagram? \nOption Fundamentals   • 25\nIn fact, many of the option strategies I will introduce in this book \nsimply represent a carving up of the risk-reward profile of a long or short \nstock position and isolating one piece of it. To make it more clear and easy \nto remember the rules for breaking even on different strategies, I will actu-\nally use a different nomenclature from breakeven.\nIf a diagram has one or both of the elements of the risk-return profile \nof buying a stock, I will call the breakeven line the effective buy price and \nabbreviate it EBP. For example, if we sell a put option, we accept downside \nrisk in the same way that we do when we buy a stock: \n5/18/2012\n-\n20\n40\n60\n80\n100\n120\n140\n160\n180\n200\n5/20/2013 249 499\nDate/Day Count\nStock Price\n749 999\nEBP = $45\nRED\nBasically, what we are saying when we accept downside risk is that \nwe are willing to buy the stock if it goes below the strike price. In return \nfor accepting this risk, we are paid $5 in premium, and this cash inflow \neffectively lowers the buying price at which we own the stock. If, when the \noption expires, the stock is trading at $47, we can think of the situation \nnot as “being $3 less than the strike price” but rather as “being $2 over the \nb u y p r i c e .”\nConversely, if a diagram has one or both of the elements of the risk-\nreturn profile of short selling a stock, I will call the breakeven line the \neffective sell price and abbreviate it ESP. For example, if we buy a put option \nanticipating a fall in the stock, we would represent it graphically like this:\n26  •   The Intelligent Option Investor\n5/18/2012\n-\n20\n40\n60\n80\n100\n120\n140\n160\n180\n200\n5/20/2013 249 499\nDate/Day Count\nStock Price\n749 999\nESP = $45\nGREEN\nWhen a short seller sells a stock, he or she gets immediate profit exposure \nto the stock’s downside potential. The seller is selling at $50 and hopes to make \na profit by buying the shares back later at a lower price—let’s say $35. When we \nget profit exposure to a stock’s downside potential using options, we are getting \nthe same exposure as if we sold the stock at $50, except that we do not have to \nworry about losing our shirts if the stock moves up instead of down. In order to \nget this peace of mind, though, we must spend $5 in premium. This means that \nif we hold the position to expiration, we will only realize a net profit if the stock \nis trading at the $50 mark less the money we have already paid to buy that ex-\nposure—$5 in this case. As such, we are effectively selling the stock short at $45.\nThere are some option strategies that end up not looking like one of \nthe two stock positions—the flexibility of options allows an investor to do \nthings a stock investor cannot. For example, here is the graphic representa-\ntion of a strategy commonly called a long strangle:\n5/18/2012\n-\n20\n40\n60\n80\n100\n120\n140\n1", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 9}
{"text": "x-\nposure—$5 in this case. As such, we are effectively selling the stock short at $45.\nThere are some option strategies that end up not looking like one of \nthe two stock positions—the flexibility of options allows an investor to do \nthings a stock investor cannot. For example, here is the graphic representa-\ntion of a strategy commonly called a long strangle:\n5/18/2012\n-\n20\n40\n60\n80\n100\n120\n140\n160\n180\n200\n5/20/2013 249 499\nDate/Day Count\nStock Price\n749 999\nBE 1 = $80.75\nBE 2 = $19.25\nGREEN\nGREEN\nOption Fundamentals   • 27\nHere we have a stock trading at $50 per share, and we have bought \none put option and one call option. The put option is struck at $20 and \nis trading for $0.35. The call option is struck at $80 and is trading for \n$0.40. Note that the top part of the diagram looks like the top part of the \nlong-stock diagram and that the bottom part looks like the bottom part \nof the short-stock diagram. Because a stock investor cannot be simulta-\nneously long and short the same stock, we cannot use such terminology \nas effective buy or effective sell price. In this case, we use breakeven and \nabbreviate it BE.\nThis option strategy illustrates one way in which options are much \nmore flexible than stocks because it allows us to profit if the stock moves \nup (into the call’s range of exposure) or down (into the put’s range of \nexposure). If the stock moves up quickly, the call option will be in the \nmoney, but the put option will be far, far, far out of the money . Thus, if \nwe are ITM on the call, the premium paid on the puts probably will end \nup a total loss, and vice versa. For this reason, we calculate both break-\neven prices as the sum of both legs of our option structure (where a leg \nis defined as a single option in a multioption strategy). As long as the leg \nthat winds up ITM is ITM enough to cover the cost of the other leg, we \nwill make a profit on this investment. The only way we can fail to make a \nprofit is if the stock does not move one way or another enough before the \noptions expire.\nFlexibility without Directionality Is a Sucker’s Game\nDespite this great flexibility in determining what directional invest-\nments one wishes to make, as I mentioned earlier, option market mak-\ners and floor traders generally attempt to mostly (in the case of floor \ntraders) or wholly (in the case of market makers) insulate themselves \nagainst large moves in the underlying stock or figure out how to lim-\nit the cost of the exposure they are gaining and do so to such an ex-\ntent that they severely curtail their ability to profit from large moves. \nI do not want to belabor the point, but I do want to leave you with one \ngraphic illustration of a “typical” complex option strategy sometimes \ncalled a condor :\n28  •   The Intelligent Option Investor\n5/18/2012\n-\n20\n40\n60\n80\n100\n120\n140\n160\n180\n200\n5/20/2013 249 499\nDate/Day Count\nStock Price\n749 999\nBE 1\nBE 2\nRED\nRED\nThere are a few important things to notice. First, notice how much shorter \nthe time frame is—we have moved from a 500-day time exposure to a two-week \nexposure. In general, a floor trader has no idea of what the long-term value of a \nstock should be, so he or she tries to protect himself or herself from large moves \nby limiting his or her time exposure as much as possible. Second, look at how \nlittle price exposure the trader is accepting! He or she is attempting to control his \nor her price risk by making several simultaneous option trades (which, by the \nway, puts the trader in a worse position in terms of breakeven points) that end up \ncanceling out most of his or her risk exposure to underlying moves of the stock.\nWith this position, the trader is speculating that over the next short \ntime period, this stock’s market price will remain close to $50 per share; \nwhat basis the trader has for this belief is beyond me. In my mind, winning \nthis sort of bet is no better than going to Atlantic City and betting that the \nmarble on the roulette wheel will land on red—completely random and \nwith only about a 50 percent chance of success.\n3\nIt is amazing to me that, after reading books, subscribing to newslet-\nters, and listening to TV pundits advocating positions such as this, inves-\ntors continue to have any interest in option investing whatsoever!\nWith the preceding explanation, you have a good foundation in the \nconcept of options, their inherent directionality, and their peerless flex-\nibility. We will revisit these themes again in Part III of this book when we \ninvestigate the specifics of how to set up specific option investments.\nHowever, before we do that, any option investor must have a good \nsense of how options are priced in the open market. We cover the topic of \noption pricing in Chapter 2.\n29\nChapter 2\nThe black-scholes-\nmerTon model\nAs you can tell from Chapter 1, options are in fact simple financial instru-\nments that allow investors to split the financial exposure to a stock into upside \nand downside ranges and then allow investors to gain or accept that expo-\nsure with great flexibility. Although the concept of an option is simple, trying \nto figure out what a fair price is for an option’s range of exposure is trickier. The \nfirst part of this chapter details how options are priced according to the Black-\nScholes-Merton model (BSM)—the mathematical option pricing model \nmentioned in Chapter 1—and how these prices predict future stock prices.\nMany facets of the BSM have been identified by the market at large \nas incorrect, and you will see in Part III of this book that when the rubber \nof theory meets the road of practice, it is the rubber of theory that gets \ndeformed. The second half of this chapter gives a step-by-step refutation \nto the principles underlying the BSM. Intelligent investors should be very, \nvery happy that the BSM is such a poor tool for pricing options and pre-\ndicting future stock prices. It is the BSM’s shortcomings and the general \nmarket’s unwillingness or inability to spot its structural defici", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 10}
{"text": "is the rubber of theory that gets \ndeformed. The second half of this chapter gives a step-by-step refutation \nto the principles underlying the BSM. Intelligent investors should be very, \nvery happy that the BSM is such a poor tool for pricing options and pre-\ndicting future stock prices. It is the BSM’s shortcomings and the general \nmarket’s unwillingness or inability to spot its structural deficiencies that \nallow us the opportunity to increase our wealth.\nMost books that discuss option pricing models require the reader to have \na high level of mathematical sophistication. I have interviewed candidates with \nmaster’s degrees in financial engineering who indeed had a very high level \nof mathematical competence and sophistication yet could not translate that \nsophistication into the simple images that you will see over the next few pages.\n30  •   The Intelligent Option Investor\nThis chapter is vital to someone aspiring to be an intelligent options \ninvestor. Contrary to what you might imagine, option pricing is in itself \nsomething that intelligent option investors seldom worry about. Much \nmore important to an intelligent option investor is what option prices im-\nply about the future price of a stock and in what circumstances option \nprices are likely to imply the wrong stock prices. In terms of our intelligent \noption investing process, we need two pieces of information:\n1. A range of future prices determined mechanically by the option \nmarket according to the BSM\n2. A rationally determined valuation range generated through an \ninsightful valuation analysis\nThis chapter gives the theoretical background necessary to derive the \nformer.\nThe BSM’s Main Job is to Predict Stock Prices\nBy the end of this section, you should have a big-picture sense of how the \nBSM prices options that is put in terms of an everyday example. Y ou will also \nunderstand the assumptions underlying the BSM and how, when combined, \nthese assumptions provide a prediction of the likely future value of a stock.\nJargon introduced in this section includes the following:\nStock price efficiency Forward price (stock)\nLognormal distribution Efficient market hypothesis (EMH)\nNormal distribution BSM cone\nDrift\nThe Big Picture\nBefore we delve into the theory of option pricing, let me give you a general \nidea of the theory of option prices. Imagine that you and your spouse or \nsignificant other have reservations at a nice restaurant. The reservation time \nis coming up quickly, and you are still at home. The restaurant is extremely \nhard to get reservations for, and if you are not there at your reservation time, \nThe Black-Scholes-Merton Model   • 31\nyour seats are given to someone else. Now let’s assume that in the midst \nof the relationship stress you are likely feeling at the moment, you decide \nto lighten the mood by betting with your spouse or significant other as to \nwhether you will be able to make it to the restaurant in time for your seating.\nIf you were a statistician attempting to lighten the mood of the \nevening, before you placed your bet, you would have attempted to factor in \nanswers to the following questions to figure out how likely or unlikely you \nwould be to make it on time:\n1. How long do you have until your reservation time?\n2. How far away is the restaurant?\n3. How many stop signs/stoplights are there, and how heavy is traffic?\n4. What is the speed limit on the streets?\n5. Does your car have enough gasoline to get to the restaurant?\nLet’s say that your reservation time is 6 p.m. and it is now 5:35 p.m . \nY ou realize that you will not be able to calculate an exact arrival time be -\ncause there are some unknown factors—especially how heavy traffic is and \nhow often you’ll have to stop at stoplights. Instead of trying to pick a point \nestimate of your arrival time, you decide to calculate the upper and lower \nbounds of a range of time over which you may arrive.\nAfter assessing the input factors, let’s say that your estimated arrival \ntime range looks something like this:\nModerate traffic\nNo traffic\nHeavy traffic\n12\n6 5\n4\n39\n10\n11\n8\n7\n2\n1\nIn other words, you think that your best chance of arrival is the 15-minute \nrange between 5:50 and 6:05 p.m. If traffic is light, you’ll make it toward the \nbeginning of that interval; if traffic is heavy, you’ll make it toward the end \nof that interval or may not make it at all. How willing would you be to bet \non making it on time? How much would be a fair amount to bet?\n32  •   The Intelligent Option Investor\nThis example illustrates precisely the process on which the BSM and \nall other statistically based option pricing formulas work. The BSM has a \nfixed number of inputs regarding the underlying asset and the contract itself. \nInputting these variables into the BSM generates a range of likely future values \nfor the price of the underlying security and for the statistical probability of the \nsecurity reaching each price. The statistical probability of the security reach-\ning a certain price (that certain price being a strike price at which we are inter-\nested in buying or selling an option) is directly tied to the value of the option.\nNow that you have a feel for the BSM on a conceptual dining-\nreservation level, let’s dig into a specific stock-related example.\nStep-by-Step Method for Predicting Future Stock \nPrice Ranges—BSM-Style\nIn order to understand the process by which the BSM generates stock price \npredictions, we should first look at the assumptions underlying the model. \nWe will investigate the assumptions, their tested veracity, and their impli-\ncations in Chapter 3, but first let us just accept at face value what Messrs. \nBlack, Scholes, and Merton take as axiomatic.\nAccording to the BSM,\n• Securities markets are “efficient” in that market prices perfectly \nreflect all publicly available information about the securities. This \nimplies that the current market price of a stock represents its fair \nvalue. New information regarding the securities is equally likely", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 11}
{"text": "ut first let us just accept at face value what Messrs. \nBlack, Scholes, and Merton take as axiomatic.\nAccording to the BSM,\n• Securities markets are “efficient” in that market prices perfectly \nreflect all publicly available information about the securities. This \nimplies that the current market price of a stock represents its fair \nvalue. New information regarding the securities is equally likely to \nbe positive as negative; as such, asset prices are as likely to move up \nas they are to move down.\n• Stock prices drift upward over time. This drift cannot exceed the \nrisk-free rate of return or arbitrage opportunities will be available.\n• Asset price movements are random and their percentage returns \nfollow a normal (Gaussian) distribution.\n• There are no restrictions on short selling, and all hedgers can bor -\nrow at the risk-free rate. There are no transaction costs or taxes. \nTrading never closes (24/7), and stock prices are mathematically \ncontinuous (i.e., they never gap up or down), arbitrage opportuni-\nties cannot persist, and you can trade infinitely small increments of \nshares at infinitely small increments of prices.\nThe Black-Scholes-Merton Model  • 33\nOkay, even if the last assumption is a little hard to swallow, the first \nthree sound plausible, especially if you have read something about the \nefficient market hypothesis (EMH). Suffice it to say that these assumptions \nexpress the “orthodox” opinion held by financial economists. Most finan-\ncial economists would say that these assumptions describe correctly, in \nbroad-brush terms, how markets work. They acknowledge that there may \nbe some exceptions and market frictions that skew things a bit in the real \nworld but that on the whole the assumptions are true.\nLet us now use these assumptions to build a picture of the future \nstock price range predicted by the BSM.\nStart with an Underlying Asset\nFirst, imagine that we have a stock that is trading at exactly $50 right now \nafter having fluctuated a bit in the past.\nAdvanced Building Corp. (ABC)\n5/18/2012 5/20/2013 249 499 749 999\n100\n90\n80\n70\n60\n50\n40\n30\n20\nDate/Day Count\nStock Price\nI am just showing one year of historical trading data and three years \nof calendar days into the future. Let’s assume that we want to use the BSM \nto predict the likely price of this asset, Advanced Building Corp. (ABC), \nthree years in the future.\nThe BSM’s first assumption—that markets are efficient and stock \nprices are perfect reflections of the worth of the corporation—means that if \n34  •   The Intelligent Option Investor\nthere is no additional information about this company, the best prediction \nof its future price is simply its present price. In graphic terms, we would \nrepresent this first step in the following way:\nAdvanced Building Corp. (ABC)\n5/18/2012 5/20/2013 249 499 749 999\n100\n90\n80\n70\n60\n50\n40\n30\n20\nDate/Day Count\nStock Price\nHere the dotted straight line represents a prediction of the future \nprice of the stock at any point in time. However, to the extent that the world \nsimply cannot stop spinning, news never stops flowing. Some of this news \nlikely will have an impact on the economic value of the firm, but as stated \nearlier, according to the EMH, the incoming information is random and is \njust as likely to be positive for valuation as it is to be negative. \nThe first step of the BSM prediction is pretty raw. Stated simply, at \nthis point in the process, the BSM predicts that the future price of the stock \nmost likely will be the present price of the stock, with a possible range of \nvalues around that expected price randomly fluctuating from $0 to infinity. \nTo refine this decidedly unhelpful range, the BSM must incorporate \nits second axiom into its prediction methodology. \nCalculate the Forward Price of the Stock\nLooking at a long-range chart of stock markets, one fact sticks out: mar -\nkets tend to rise over the long term. Although this is obvious to even a \nThe Black-Scholes-Merton Model  • 35\ncasual observer, the fact that markets tend to rise is contradictory to our \nfirst principal—that stocks are as likely to go up as they are to go down.\nIndeed, if stocks in general did not go up, people would not think to \ninvest in them as long as there were other investment choices such as risk-\nfree bonds available. Thus the theorists modified their first assumption \nslightly, saying that stock prices are just as likely to go up as they are to \ngo down over a very short period of time; over longer time periods, they \nwould have to drift upward. The amount of this drift is set to the risk-free \nrate via a wonderfully elegant argument involving the no-arbitrage condi-\ntion in the fourth assumption listed earlier.\nIncreasing the present price of the stock into the future at the risk-\nfree rate generates what is known as the forward price of the stock. Here is \nwhat the forward price of our asset looks.\nAdvanced Building Corp. (ABC)\n5/18/2012 5/20/2013 249 499 749 999\n100\n90\n80\n70\n60\n50\n40\n30\n20\nDate/Day Count\nStock Price\nHere we see the stock being subject to risk-free drift—moving up \nsteadily to $52 at the end of three years—this is the forward price. In terms \nof the BSM’s prediction of the future stock price, this forward price line \nrepresents its most likely value.\nThe only slight modification to this calculation of forward price \ninvolves dividend-paying stocks. For dividend-paying stocks, the expected \n36  •   The Intelligent Option Investor\ndividend serves as a downward drift that cancels out some of the upward \ndrift of the risk-free rate. Simplistically, if the risk-free rate is 3 percent \nper year and the company has a dividend yield of 1 percent per year, the \nupward-drift term will be 2 percent (= 3 percent − 1 percent).\nAdd a Range around the Forward Price\nNow even an academic would look at the preceding diagram and have his \nor her doubts that the model regarding whether the future price of this \nasset will ever be proven correct. This is when the academic will start to", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 12}
{"text": "ercent \nper year and the company has a dividend yield of 1 percent per year, the \nupward-drift term will be 2 percent (= 3 percent − 1 percent).\nAdd a Range around the Forward Price\nNow even an academic would look at the preceding diagram and have his \nor her doubts that the model regarding whether the future price of this \nasset will ever be proven correct. This is when the academic will start to \nbackpedal and remind us of the first axiom by saying, “Markets are effi-\ncient, but stock prices fluctuate based on new data coming into the market. \nBecause good news is as likely to come into the market as bad news, stock \nprices should fluctuate up and down in equal probability. ” Because they \nare fluctuating randomly, our prediction should be a statistical one based \non a range.\nTo make the predictive range more usable than our earlier condition \n(i.e., a predicted stock price between $0 and infinity), we must take a look \nat the next axiom—the percentage return of stocks follows a normal (also \ncalled Gaussian) distribution. A normal distribution is simply a bell curve, \nwith which most people are very familiar in the context of IQ scores and \nother natural phenomena. A bell curve is perfectly symmetrical—the most \ncommonly found value (e.g., an IQ of 100) is the value at the tallest point \nof the curve, and there are approximately as many instances of profound \ngenius as there are of profound mental disability.\nNote that the BSM assumes that percentage returns are normally dis-\ntributed. In our graphs, we are showing price rather than percentage return \non the vertical axis, so we will have to translate a percentage return into a \nprice. Translating a percentage return into a price gives us a distribution \nthat is skewed to the right called a lognormal distribution.\nThinking about stock prices for a moment, it becomes obvious that it \nis likely that stock prices will follow a skewed distribution simply because \nthe price cannot fall any further than $0 per share but has no upward \nbound. For further evidence that this skewed distribution is correct, \ntake a look at what happens to the prices of two stocks, both of which \nstart initially at $50, but one of which decreases by 10 percent for three \nThe Black-Scholes-Merton Model  • 37\nconsecutive days and the other which increases by 10 percent for three \nconsecutive days.\nLosing Stock Winning Stock\nOriginal price $50.00 Original price $50.00\nPrice after falling 10% $45.00 Price after rising 10% $55.00\nPrice after falling \nanother 10%\n$40.50 Price after rising \nanother 10%\n$60.50\nPrice after falling \nanother 10%\n$36.45 Price after rising \nanother 10%\n$66.55\nFinal difference \nfrom $50\n$13.55 Final difference \nfrom $50\n$16.55\nNotice that even though both have changed by the same percentage \neach day, the stock that has increased has done so more than the losing stock \nhas decreased. This experiment shows that if we assume a normal distribu-\ntion of returns, we should wind up with a distribution that is skewed toward \nhigher prices. Mathematically, this distribution is called the lognormal curve.\nIf we use the forward price as a base and then draw a cone \nrepresenting the lognormal distribution around it, we end up with the \nfollowing diagram:\nAdvanced Building Corp. (ABC)\n5/18/2012 5/20/2013 249 499 749 999\n100\n90\n80\n70\n60\n50\n40\n30\n20\nDate/Day Count\nStock Price\n38  •   The Intelligent Option Investor\nThis diagram shows that the most likely future price projected by the \nBSM still lies along the straight dotted line, and the most likely range lies \nbetween the solid lines of the curve. In this diagram, note that even though \nthe skew is subtle, the lower bound is closer to the forward price of the \nstock than is the upper bound. This confirms that the BSM’s predictive \nmodel is consistent with its third assumption. It also gives us a much more \nsensible prediction of the future price of this stock than when we started \nout. We will term this graph the BSM cone.\nAccording to the BSM, if you want to know the price at which a stock \nwill trade at any point in the future, you can look within the bounds of \nthe BSM cone. The prices within this cone are more likely to be near the \nforward price line and less likely to be near the lines of the cone itself. In \na phrase, the BSM tells an investor, “If you want to know what the future \nprice of a stock will be, look within the cone. ”\nWith the refinements we have made, we can say that our best guess \nfor the value of this stock in three years will be $52, and the range of \nvalues between which the stock will most plausibly fall will be anywhere \nfrom around $37 to just over $70. One thing to note is that the cone as \nI have drawn it here does not, in fact, show the outline of the entire log-\nnormal price distribution for the stock but rather just the most plausible \nrange. \nAlso, as mentioned earlier, the likelihood of the stock price reaching \neach of the prices along the vertical axis is not equal. The most likely future \nvalue according to the BSM is the forward price. Most likely means, in the \nstatistical sense, that there is a 50-50 chance that the stock will be above or \nbelow that line. \nAs one moves up the vertical (price) axis from the forward price \nline, the likelihood that the stock price will be above that point is pro-\ngressively lower. By the time you reach the upper line of the cone, the \nchance that the stock price will be higher than that is only around 16 \npercent. Conversely, as you move down the vertical axis from the for -\nward price line, the likelihood that the stock price will be below that \npoint is progressively lower. By the time you reach the lower line of the \ncone, the chance that the stock price will fall lower than that is again \naround 16 percent.\nThe Black-Scholes-Merton Model  • 39\nStock has ~16% chance\nof rising above this line\n50% chance of stock being\nabove or below this price\nStock has ~16% chance of\nfalling below this line\n5/18/2012 5/20/2013 249 499 749 999\n9", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 13}
{"text": "ow that \npoint is progressively lower. By the time you reach the lower line of the \ncone, the chance that the stock price will fall lower than that is again \naround 16 percent.\nThe Black-Scholes-Merton Model  • 39\nStock has ~16% chance\nof rising above this line\n50% chance of stock being\nabove or below this price\nStock has ~16% chance of\nfalling below this line\n5/18/2012 5/20/2013 249 499 749 999\n90\n100\n80\n70\n60\n50\n40\n30\n20\nAdvanced Building Corp. (ABC)\nDate/Day Count\nStock Price\nBecause the BSM assumes that stock returns are lognormally distrib-\nuted, and because the properties of the lognormal curve are very well un-\nderstood by mathematicians, every single point on the vertical price axis \nis associated with a distinct probability. In other words, with just the few \nsimple inputs we have discussed, the BSM mechanically churns out pre-\ndictions of future stock prices by associating a future stock price with a \ntheoretically derived probability.\nNow that we know what the theory says and have created a predic-\ntion of the future price of a stock based on the theory, let’s look at key areas \nwhere the BSM breaks down. \nThe BSM is Lousy at Its Main Job\nBy the end of this section, you will have a good understanding why the \nBSM—although a testament to human ingenuity and logical reasoning—is \ndeeply flawed as a model to predict asset prices in general and stock prices \nspecifically. \n40  •   The Intelligent Option Investor\nJargon that will be introduced in this section is as follows:\nLeptokurtic\nFat-tailed\nCritiques of the Base Assumptions of the BSM\nBefore we head into the critique section, let us remind ourselves of the \nbase assumptions of the BSM. When I introduced these assumptions ear -\nlier, I suggested that you should just accept them at face value, but this time \naround, let’s look at the assumptions with a more critical eye.\n• Securities markets are efficient in that market prices perfectly reflect all \npublicly available information about the securities. This implies that the \ncurrent market price of a stock represents its fair value. New information \nregarding the securities is equally likely to be positive as negative; as \nsuch, asset prices are as likely to move up as they are to move down.\n• Stock prices drift upward over time. This drift cannot exceed the \nrisk-free rate of return, or arbitrage opportunities will be available.\n• Asset price percentage returns follow a normal (Gaussian) distribution.\n• There are no restrictions on short selling, and all hedgers can bor -\nrow at the risk-free rate. There are no transaction costs or taxes. \nTrading never closes (24/7), and stock prices are mathematically \ncontinuous (i.e., they never gap up or down), arbitrage opportuni-\nties cannot persist, and you can trade infinitely small increments of \nshares at infinitely small increments of prices.\nAlthough the language is formal and filled with jargon, you need not be in-\ntimidated by the special terminology but should simply look at the assumptions \nfrom a commonsense perspective. Doing so, you will see how ridiculous each \nof these assumptions appears. Indeed, each one of them has either been proven \nwrong through experimental evidence (i.e., the first three assumptions) or is \nplainly false (the fourth assumption). Let’s look at each assumption one by one.\nMarkets Are Efficient\nThe first two assumptions spring from a theory in financial economics \ncalled the efficient market hypothesis (EMH), which is strongly associated \nThe Black-Scholes-Merton Model  • 41\nwith the University of Chicago and which, more or less, still holds truck \nwith many theorists to this day. Stock prices, under this theory, move in ac-\ncordance with the random-walk principal—having a 50-50 chance of going \nup or down in a short time period because they are bought and sold on the \nbasis of new information coming into the market, and this new informa-\ntion can be either good or bad.\nThe EMH proposes that there are different levels of efficiency in fi-\nnancial markets. The weakest form of efficiency holds that one cannot gen-\nerate returns that are disproportionate to risk in a market simply by having \naccess to information related to historical prices of the market (i.e., refut-\ning so-called technical analysis). The strongest form of efficiency holds that \neven an investor with inside information about a company cannot generate \nreturns that are disproportionate to the risk they assume by investing (this \nform is usually rejected even by supporters of the EMH).\nIn short, the EMH says that investors, in aggregate, dispassionately \nassess all available facts regarding the economic environment and \nrationally and methodically incorporate their well-informed expectations \nabout likely future outcomes into their decisions to buy or sell a given \nstock. They always act in such a way as to maximize their utility in a ra-\ntional, considered way.\nNow, before running to your favorite search engine to look for aca-\ndemic papers refuting or defending the EMH, just step back and ask one sim-\nple question: Does this model of human behavior seem right to you? How \nmany people on the road with you during rush hour or attending a sporting \nevent or going holiday shopping seem to make calculated, rational, and well-\nconsidered decisions? When it comes to something dealing with money and \ninvesting, how many people do you know who act in the way just described? \nNo matter what mathematical proof may or may not support the EMH, as a \nmodel of human behavior, the EMH simply does not ring true—to us at least.\nAside from the fundamental criticism that the EMH does not pre-\nsent a model of human behavior that seems, well, human, there have been \nempirical refutations of the EMH from almost its conception. Studies \nshowing that stocks with low price-to-book ratios, price-to-sales ratios, \nand price-to-earnings ratios outperform those with high ratios have been \nwell documented, and the effects mentioned seem to persist. One of my \nprofes", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 14}
{"text": "ism that the EMH does not pre-\nsent a model of human behavior that seems, well, human, there have been \nempirical refutations of the EMH from almost its conception. Studies \nshowing that stocks with low price-to-book ratios, price-to-sales ratios, \nand price-to-earnings ratios outperform those with high ratios have been \nwell documented, and the effects mentioned seem to persist. One of my \nprofessors in business school, Graeme Rankine, helped to discover the \n42  •   The Intelligent Option Investor\nso-called stock-split effect—the fact that stocks that split (i.e., the owners \nwere simply told that for every share they previously owned, they now owned \nmultiple shares, a change that should not have any effect whatsoever on the \nvalue of the firm) performed better after the split than those that did not \nsplit. More recently, Andrew Lo and Craig MacKinlay have demonstrated \nthat financial markets are not efficient on even a weak basis but that they \nhave some sort of a long-term price “memory” and seem to act more like \nan organic system than a mechanical one.\nLater in this book we will discuss behavioral factors that affect invest-\ning, and in fact, several prominent behavioral economics theorists (Daniel \nKahneman and Robert Shiller) have won Nobel prizes in economics as a \nresult of their groundbreaking work in this field. In essence, what behav-\nioral economics points out is that when given questions that test decision-\nmaking ability and process, most people—even highly trained people—do \nnot make decisions in a way described by the tenants of the EMH. In fact, \neconomists have found that experimentally, human decision makers are \nswayed by all sorts of issues that someone subscribing to the EMH would \nfind irrational. Human decision makers do not, it turns out, act as perfectly \nrational economic animals as the EMH posits but rather are swayed by \nemotion, illusion, and ingrained prejudice that cause their decisions to \nbe made in consistently flawed ways. Obviously, the experimental evi-\ndence that behavioral economics researchers have highlighted regarding \nhow economic actors make decisions casts doubt on the basic premises of \nthe EMH.\nIndeed, proponents of EMH would argue (do argue in the case of \nEugene Fama, a Nobel prize–winning economist at the University of \nChicago and one of the intellectual godfathers of the EMH) that asset price \nbubbles cannot occur. If markets are efficient, they incorporate all avail-\nable information regarding the likely future outcome of stocks and other \nfinancial assets in their present prices—meaning that even when prices are \nvery high, as they were during the Internet boom and the mortgage finance \nboom, market participants’ expectations are “rational. ” Fama has famously \nsaid, “I don’t even know what a ‘bubble’ is. ”\nThis type of pedagogical rigidity in the face of clear evidence of \nthe existence of bubbles and crashes, and in fact the enormous human \ncosts that the bursting of bubbles bring about (e.g., in the wake of the \nThe Black-Scholes-Merton Model  • 43\nbursting of the mortgage finance bubble), has soured many laypeople on \nthe philosophical underpinnings of the EMH, even if they have never \nheard the term specifically mentioned. Academic responses to the ten-\nants of the EMH from economists such as Nobel prize–winner Rob-\nert Shiller and Australian Steven Keen have been gaining strength and \nacceptance in recent years, whereas only a few years ago they would have \nbeen considered apostate and would have been ridiculed by “respectable” \northodox economists.\nWhatever the arguments both for and against the EMH, if you are \nreading this book, you implicitly must hold the belief that stock markets \nare inefficient because by reading this book, you must be trying to “beat” \nthe markets—an act that the EMH maintains is impossible. Although it is a \npretty blunt tool for someone trying to accurately describe the complexity \nof markets, the one thing the EMH does have to recommend it is that if you \nhold to its assumptions, the mathematics describing asset prices is made \nmuch easier, and this ease leads to the ability to develop a pricing model \nsuch as the BSM. \nIn fact, although one of my favorite indoor sports is making fun of \nEMH assumptions, I do not disagree that, especially over short time frames \nand especially for certain types of assets, the EMH assumptions hold up \npretty well and that the BSM is useful in describing likely price ranges. \nI discuss when the BSM is more useful and correct in Appendix A because \nin those instances an intelligent investor has a small chance of success. \nIt goes without saying that intelligent investors choose not to invest in \nsituations in which there is a small chance of success!\nA good theory must be simple, but it also must be provably correct \nunder all conditions. While the EMH is certainly simple, I maintain that it \ncannot be considered a good theory because it does not explain phenom-\nena in financial markets correctly in all (most?) circumstances. This means \nthat the first pillar on which the BSM is built is, for the purposes of intel-\nligent investors, wrong.\nStock Returns Are Normally Distributed\nA picture is worth a thousand words. Here is a picture of a normal \ndistribution probability curve:\n44  •   The Intelligent Option Investor\n-3σ 0\nx\n.1359\n.0214\nGaussian or\n“normal”\ndistribution\nfg(x)\n.00135 .3413 .3413 .1359\n.0214\n.00135\n-2σ 2σ 3σ-σ σ\nThe numbers near the horizontal axis show the percent of cases in \neach region (e.g., between the 0 and σ, you see the number 0.3413—this \nmeans that for a normally distributed quantity such as IQ, you would ex-\npect 34.13 percent of cases to lie in that region), and the regions are marked \noff into numbers of standard deviations [denoted by the lowercase Greek \nletter sigma (σ)].\nNow that you’ve seen a normal curve, let’s take a look at daily returns \nfor the Standard & Poor’s 500 Index (S&P 500) over the past 50 years:\n-21% -19% -17% -15% -13", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 15}
{"text": "for a normally distributed quantity such as IQ, you would ex-\npect 34.13 percent of cases to lie in that region), and the regions are marked \noff into numbers of standard deviations [denoted by the lowercase Greek \nletter sigma (σ)].\nNow that you’ve seen a normal curve, let’s take a look at daily returns \nfor the Standard & Poor’s 500 Index (S&P 500) over the past 50 years:\n-21% -19% -17% -15% -13% -11% -9%- 7% -5%- 3% -1%3 %1% 5% 7% 9% 11%\n0\n100\n200\n300\n400\n500\n900\n800\n700\n600\nS&P Returns\nFrequency\nS&P 500 Daily Returns\nThe Black-Scholes-Merton Model  • 45\nThere is a very easily recognizable difference between this curve and \nthe preceding one—namely that this one looks much pointier than the \nother. However, a more profound difference can be seen by looking at the \ncases out near the –21 percent mark and the +11 percent mark. If the S&P \n500’s actual returns were normally distributed, these points simply would \nnot exist—not for another billion years or so. The huge fall (a 20-standard-\ndeviation event) might be expected to happen in financial markets every \nfew billion years if in fact daily returns were normally distributed. Instead, \nthey seem to happen about once every 70 years or so. \nThese observations should provide good anecdotal evidence that the \nassumption of normally distributed returns is unfounded. Indeed, empir-\nical evidence has shown that stock market returns are what are termed \nstrongly leptokurtic (a.k.a. fat-tailed) to the extent that it is not helpful to \nthink of them as normal at all. The two characteristics of leptokurtic distri-\nbutions are that (1) they are pointy and (2) they contain a relatively large \nproportion of extreme tail values. Some theorists think that the best way to \nunderstand stock returns is actually to conceive of them as multiple over -\nlapping (and non-Gaussian) distributions. Whatever statistical distribu-\ntion stock returns follow, it is certainly not Gaussian.\nOption traders, in fact, took markets to be normally distributed \nuntil the great crash of 1987. After that time, the practitioner response \nto the obvious leptokurtic nature of stock price returns—charging a \nmuch higher than theoretically justified price for far out-of-the money \n(OTM) puts and far in-the-money (ITM) calls—came into being, and the \nvolatility smile, a feature we will discuss in detail in Part III of the book, \ncame into existence. This means that the second pillar on which the BSM \nis built is wrong.\nStock Prices Drift Upward at the Risk-Free Rate\nOn average, the compound annual growth of the stock market since \n1926 has been on the order of 10 percent. The average annual compound \ngrowth of U.S. government Treasury bonds (our risk-free benchmark) \nhas been on the order of 5 percent. Therefore, just comparing these \naverages, it would seem that stocks drift upward at roughly twice the \nrisk-free rate.\n46  •   The Intelligent Option Investor\nAverages can be misleading, however, so in the following graph I have \nplotted the five-year rolling compound annual growth rate for both the \nS&P 500 and T-bonds:\n35%\n30%\n25%\n20%\n15%\n10%\n5%\n0%\n-5%\n-10%\n-15%1932 1937 1942 1947 1952 1957 1962 1967 1972 1977 1982 1987 1992 1997 2002 2007\nStocks 5-year CAGR T-Bonds 5-year CAGR\nY ou can see that there are some significant outliers in the Great \nDepression area of the graph, but in general, stock returns are much higher \nthan those of risk-free instruments on this rolling basis as well. In fact, \nif you asked me to guess what any randomly selected rolling five-year \ncompound annual growth rate (CAGR) for stocks was going to be, I would \nprobably pick a number like 13 percent and figure that I would at least be in \nthe ballpark 80 percent of the time. Certainly, by looking at the preceding \ngraph, you can tell that there is no reasonable basis to believe that stocks \nshould increase anywhere around the rate of risk-free securities! As such, \nwe can discard the third pillar of the BSM.\nNo Taxes, No Trading Restrictions, and All Market Participants \nCan Borrow at the Risk-Free Rate, Etc.\nNo comment, other than to say, “Ha!” With no pillars left, the edifice of the \nBSM crumbles in on itself after even just a cursory look.\nThe Black-Scholes-Merton Model  • 47\nThe fact that the theoretical basis of option pricing is provably wrong \nis very good news for intelligent investors. The essence of intelligent option \ninvesting involves comparing the mechanically determined and unreason-\nable range of stock price predictions made by the BSM with an intelligent \nand rational valuation range made by a human investor. Because the BSM \nis using such ridiculous assumptions, it implies that intelligent, rational \ninvestors will have a big investing advantage. Indeed, I believe that they do.\nNow that we have seen how the BSM forecasts future price ranges for \nstocks and why the predictions made by the BSM are usually wrong, let us \nnow turn to an explanation of how the stock price predictions made by the \nBSM tie into the option prices we see on an option exchange such as the \nChicago Board Option Exchange (CBOE).\nThis page intentionally left blank \n49\nChapter 3\nThe InTellIgenT \nInvesTor’s guIde To \nopTIon prIcIng\nBy the end of this chapter, you should understand how changes in the follow-\ning Black-Scholes-Merton model (BSM) drivers affect the price of an option:\n1. Moneyness\n2. Forward volatility\n3. Time to expiration\n4. Interest rates and dividend yields\nY ou will also learn about the three measures of volatility—forward, im-\nplied, and statistical. Y ou will also understand what drivers affect option \nprices the most and how simultaneous changes to more than one variable \nmay work for or against an option investment position.\nIn this chapter and throughout this book in general, we will not try to \nfigure out a precise value for any options but just learn to realize when an op-\ntion is clearly too expensive or too cheap vis-à-vis our rational expectations \nfor a fair value of the underlying stock.", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 16}
{"text": "ices the most and how simultaneous changes to more than one variable \nmay work for or against an option investment position.\nIn this chapter and throughout this book in general, we will not try to \nfigure out a precise value for any options but just learn to realize when an op-\ntion is clearly too expensive or too cheap vis-à-vis our rational expectations \nfor a fair value of the underlying stock. As such, we will discuss pricing in \ngeneral terms; for example, “This option will be much more expensive than \nthat one. ” This generality frees us from the computational difficulties that \ncome about when one tries to calculate too precise a price for a given op-\ntion. The BSM is designed to give a precise answer, but for investing, simply \nknowing that the price of some security is significantly different from what \nit should be is enough to give one an investing edge.\n50  •   The Intelligent Option Investor\nIn terms of how this chapter fits in with the goal of being an \nintelligent option investor, it is in this chapter that we start overlaying \nthe range of exposure introduced in Chapter 1 with the implied stock \nprice range given by the BSM cone that was introduced in Chapter 2. \nThis perspective will allow us to get a sense of how expensive it will \nbe to gain exposure to a given range or, conversely, to see how much \nwe are likely to be able to generate in revenue by accepting exposure \nto that range. Understanding the value of a given range of exposure as \nperceived by the marketplace will allow us to determine what option \nstrategy will be best to use after we determine our own intelligent \nvaluation range for a stock.\nJargon introduced in this chapter is as follows:\nStrike–stock price ratio Volatility (Vol) \nTime value Forward volatility\nIntrinsic value Implied volatility\nTenor Statistical volatility\nTime decay Historical volatility\nHow Option Prices are Determined\nIn Chapter 1, we saw what options looked like from the perspective of \nranges of exposure. One of the takeaways of that chapter was how flexible \noptions are in comparison with stocks. Thinking about it a moment, it is \nclear that the flexibility of options must be a valuable thing. What would \nit be worth to you to only gain upside to a stock without having to worry \nabout losing capital as a result of a stock price decline? \nThe BSM, the principles of which we discussed in detail in Chapter 2, \nwas intended to answer this question precisely—“What is the fair value of \nan option?” Let us think about option prices in the same sort of probabilis-\ntic sense that we now know the BSM is using.\nFirst, let’s assume that we want to gain exposure to the upside poten-\ntial of a $50 stock by buying a call option with a strike price of $70 and a \ntime to expiration of 365 days. Here is the risk-return profile of this option \nposition merged with the image of the BSM cone:\nThe Intelligent Investor’s Guide to Option Pricing  •  51\n5/18/2012\n20\n30\n40\n50\n60\n70\n80\n90\n100\n5/20/2013 249 499 999749\nAdvanced Building Corp. (ABC)\nDate/Day Count\nStock Price\nGREEN\nNotice that because this call option is struck at $70, the upside po-\ntential we have gained lies completely outside the cone of values the BSM \nsees as reasonably likely. This option, according to the BSM, is something \nlike the bet that a seven-year-old might make with another seven-year-\nold: “If you can [insert practically impossible action here], I’ll pay you a \nzillion dollars. ” The action is so risky or impossible that in order to entice \nhis or her classmate to take the bet, the darer must offer a phenomenal \nreturn.\nOff the playground and into the world of high finance, the way to \noffer someone a phenomenal return is to set the price of a risky asset very \nlow. Following this logic, we can guess that the price for this option should \nbe very low. In fact, we can quantify this “very low” a bit more by thinking \nabout the probabilities surrounding this call option investment.\nRemembering back to the contention in Chapter 2 that the lines of \nthe BSM cone represent around a 16 percent probability of occurrence, \nwe can see that the range of exposure lies outside this, so the chance of \nthe stock making it into this range is lower than 16 percent. Let’s say that \nthe range of exposure sits at just the 5 percent probability level. What this \nmeans is that if you can find 20 identical investments like this and invest in \nall of them, only one will pay off (1/20 = 5 percent). \n52  •   The Intelligent Option Investor\nThus, if you thought that you would win $1 for each successful invest-\nment you made, you might only be willing to pay $0.04 to play the game. In \nthis case, you would be wagering $0.04 twenty times in the hope of making \n$1 once—paying $0.80 total to net $0.20 for a (probabilistic) 25 percent \nreturn.\nNow how much would you be willing to bet if the perceived chance \nof success was not 1 in 20 but rather 1 in 5? With options, we can increase \nthe chance of success simply by altering the range of exposure. Let’s try this \nnow by moving the strike price down to $60:\n5/18/2012 5/20/2013 249 499 749\n20\n30\n40\n50\n60\n70\n80\n90\n100\n999\nAdvanced Building Corp. (ABC)\nDate/Day Count\nStock Price\nGREEN\nAfter moving the strike price down, one corner of the range of \nexposure we have gained falls within the BSM probability cone. This option \nwill be significantly more expensive than the $70 strike option because the \nperceived probability of the stock moving into this range is material.\nIf we say that the chance of this call option paying its owner $1 is \n1 in 5 rather than 1 in 20 (the range of exposure is within the 16 percent \nline, so we’re estimating it as a 20 percent chance—1 in 5, in other words), \nwe should be willing to pay more to make this investment. If we expected \nto win $1 for every five tries, we should be willing to spend $0.16 per bet. \nHere we would again expect to pay $0.80 in total to net $0.20, and again \nour expected percentage return would be 25 percent. \nThe I", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 17}
{"text": "of exposure is within the 16 percent \nline, so we’re estimating it as a 20 percent chance—1 in 5, in other words), \nwe should be willing to pay more to make this investment. If we expected \nto win $1 for every five tries, we should be willing to spend $0.16 per bet. \nHere we would again expect to pay $0.80 in total to net $0.20, and again \nour expected percentage return would be 25 percent. \nThe Intelligent Investor’s Guide to Option Pricing  •  53\nNotice that by moving the strike down from an expected 5 percent chance \nof success to an expected 20 percent chance of success, we have agreed that we \nwould pay four times the amount to play. What would happen if we lowered the \nstrike to $50 so that the exposure range started at the present price of the stock? \nObviously, this at-the-money (ATM) option would be more expensive still:\n5/18/2012\n30\n20\n40\n50\n60\n70\n80\n90\n100\n5/20/2013 249 499 749 999\nAdvanced Building Corp. (ABC)\nDate/Day Count\nStock Price\nGREEN\nThe range of upside exposure we have gained with this option is not only \nwell within the BSM probability cone, but in fact it lies across the dotted line in-\ndicating the “most likely” future stock value as predicted by the BSM. In other \nwords, this option has a bit better than a 50 percent chance of paying off, so it \nshould be proportionally more expensive than either of our previous options.\nThe payouts and probabilities I provided earlier are completely made \nup in order to show the principles underlying the probabilistic pricing of \noption contracts. However, by looking at an option pricing screen, it is very \neasy to extrapolate annualized prices associated with each of the probabil-\nity levels I mentioned—5, 20, and 50 percent.\nThe following table lists the relative market prices of call options cor-\nresponding to each of the preceding diagrams.\n1 The table also shows the \ncalculation of the call price as a percentage of the present price of the stock \n($50) as well as the strike–stock price ratio , which shows how far above or \nbelow the present stock price a given strike price is.\n54  •   The Intelligent Option Investor\nStrike Price Strike–Stock Price Ratio Call Price\nCall Price as a Percent \nof Stock Price\n70 140% $0.25 0.5\n60 120% $1.15 2.3\n50 100% $4.15 8.3\nNotice that each time we lowered the strike price in successive \nexamples, we lowered the ratio of the strike price to the stock price. This \nrelationship (sometimes abbreviated as K/S, where K stands for strike price \nand S stands for stock price) and the change in option prices associated \nwith it are easy for stock investors to understand because of the obvious tie \nto directionality. This is precisely the reason why we have used changes in \nthe strike–stock price ratio as a vehicle to explain option pricing. There are \nother variables that can cause option prices to change, and we will discuss \nthese in a later section.\nI will not make such a long-winded explanation, but, of course, \nput options are priced in just the same way. In other words, this put \noption,\n5/18/2012\n-\n10\n20\n30\n40\n50\n60\n70\n80\n90\n100\n5/20/2013 249 499 749 999\nAdvanced Building Corp. (ABC)\nDate/Day Count\nStock Price\nGREEN\nThe Intelligent Investor’s Guide to Option Pricing  •  55\nwould be more expensive than the following put option, which looks like \nthis:\n5/18/2012 5/20/2013 249 499 749 999\n-\n10\n20\n30\n40\n50\n60\n70\n80\n90\n100\nAdvanced Building Corp. (ABC)\nDate/Day Count\nStock Price\nGREEN\nThe former would be more expensive than the latter simply because the \nrange of exposure for the first lies further within the BSM cone of prob-\nability than the latter.\nWe can extrapolate these lessons regarding calls and puts to come \nup with a generalized rule about comparing the prices of two or more op-\ntions. Options will be more expensive in proportion to the total range of \nexposure that lies within the BSM cone. Graphically, we can represent this \nrule as follows:\nThis call option will be much less \nexpensive…\nGREEN\nGREEN\nthan this call option.\n56  •   The Intelligent Option Investor\nThis is so because the area of the range of exposure for the option on \nthe left that is bounded by the BSM probability cone is much smaller than \nthe range of exposure for the option on the right that is bounded by the \nsame BSM probability cone.\nTime Value versus Intrinsic Value\nOne thing that I hope you will have noticed is that so far we have talked \nabout options that are either out of the money (OTM) or at the money \n(ATM). In-the-money (ITM) options—options whose range of exposure \nalready contains the present stock price—may be bought and sold in just \nthe same way as ATM and OTM options, and the pricing principle is ex-\nactly the same. That is, an ITM option is priced in proportion to how much \nof its range of exposure is contained within the BSM probability cone.\nHowever, if we think about the case of an OTM call option, we realize \nthat the price we are paying to gain access to the stock’s upside potential \nis based completely on potentiality. Contrast this case with the case of an \nITM call option, where an investor is paying not only for potential upside \nexposure but also for actual upside as well. \nIt makes sense that when we think about pricing for an ITM call option, \nwe divide the total option price into one portion that represents the poten-\ntial for future upside and another portion that represents the actual upside. \nThese two portions are known by the terms time value and intrinsic value, \nrespectively. It is easier to understand this concept if we look at a specific \nexample, so let’s consider the case of purchasing a call option struck at $40 \nand having it expire in one year for a stock presently trading at $50 per share. \nWe know that a call option deals with the upside potential of a stock \nand that buying a call option allows an investor to gain exposure to that up-\nside potential. As such, if we buy a call option struck at $40, we have access \nto all the upside potential over that $40 mark. Because t", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 18}
{"text": "ng a call option struck at $40 \nand having it expire in one year for a stock presently trading at $50 per share. \nWe know that a call option deals with the upside potential of a stock \nand that buying a call option allows an investor to gain exposure to that up-\nside potential. As such, if we buy a call option struck at $40, we have access \nto all the upside potential over that $40 mark. Because the stock is trading \nat $50 right now, we are buying two bits of upside: the actual bit and the \npotential bit. The actual upside we are buying is $10 worth (= $50 − $40) \nand is termed the intrinsic value of the option. \nA simple way to think of intrinsic value that is valid for both call options \nand put options is the amount by which an option is ITM. However, the option’s \ncost will be greater than only the intrinsic value as long as there is still time \nThe Intelligent Investor’s Guide to Option Pricing  •  57\nbefore the option expires. The reason for this is that although the intrinsic value \nrepresents the actual upside of the stock’s price over the option strike price, \nthere is still the possibility that the stock price will move further upward in the \nfuture. This possibility for the stock to move further upward is the potential bit \nmentioned earlier. Formally, this is called the time value of an option.\nLet us say that our one-year call option struck at $40 on a $50 stock \ncosts $11.20. Here is the breakdown of this example’s option price into in-\ntrinsic and time value:\n $10.00 Intrinsic value: the amount by which the option is ITM\n+ $1.20 Time value: represents the future upside potential of the stock\n= $11.20 Overall option price\nRecall that earlier in this book I mentioned that it is almost always a mis-\ntake to exercise a call option when it is ITM. The reason that it is almost always \na mistake is the existence of time value. If we exercised the preceding option, \nwe would generate a gain of exactly the amount of intrinsic value—$10. How-\never, if instead we sold the preceding option, we would generate a gain totaling \nboth the intrinsic value and the time value—$11.20 in this example—and then \nwe could use that gain to purchase the stock in the open market if we wanted.\nOur way of representing the purchase of an ITM call option from a \nrisk-reward perspective is as follows:\nAdvanced Building Corp. (ABC)\n5/18/2012 5/20/2013 249 499 749\nEBP = $51.25\n999\n100\n90\n80\n70\n60\n50\n40\n30\n20\nDate/Day Count\nStock Price\nGREEN\nORANGE\n58  •   The Intelligent Option Investor\nUsually, our convention is to shade a gain of exposure in green, but \nin the case of an ITM option, we will represent the range of exposure with \nintrinsic value in orange. This will remind us that if the stock falls from its \npresent price of $50, we stand to lose the intrinsic value for which we have \nalready paid. \nNotice also that our (two-tone) range of exposure completely over -\nlaps with the BSM probability cone. Recalling that each upper and lower \nline of the cone represents about a 16 percent chance of going higher or \nlower, respectively, we can tell that according to the option market, this \nstock has a little better than an 84 percent chance of trading for $40 or \nabove in one year’s time.\n2 \nAgain, the pricing used in this example is made up, but if we take a \nlook at option prices in the market today and redo our earlier table to in-\nclude this ITM option, we will get the following:\nStrike Price ($)\nStrike–Stock \nPrice Ratio (%) Call Price ($)\nCall Price as a Percent \nof Stock Price\n70 140 $0.25 0.5\n60 120 $1.15 2.3\n50 100 $4.15 8.3\n40 80 10.85 21.7\nAgain, it might seem confounding that anyone would want to use the \nITM strategy as part of their investment plan. After all, you end up paying \nmuch more and being exposed to losses if the stock price drops. I ask you \nto suspend your disbelief until we go into more detail regarding option \ninvestment strategies in Part III of this book. For now, the important points \nare (1) to understand the difference between time and intrinsic value, \n(2) to see how ITM options are priced, and (3) to understand our convention \nfor diagramming ITM options.\nFrom these diagrams and examples it is clear that moving the range \nof exposure further and further into the BSM probability cone will increase \nthe price of the option. However, this is not the only case in which options \nwill change price. Every moment that time passes, changes can occur to \nThe Intelligent Investor’s Guide to Option Pricing  •  59\nthe size of the BSM’s probability cone itself. When the cone changes size, \nthe range-of-exposure area within the cone also changes. Let’s explore this \nconcept more.\nHow Changing Market Conditions \nAffect Option Prices\nAt the beginning of Chapter 2, I started with an intuitive example related \nto a friendly bet on whether a couple would make it to a restaurant in time \nfor a dinner reservation. Let’s go back to that example now and see how the \ninputs translate into the case of stock options.\nDinner Reservation Example Stock Option Equivalent\nHow long before seating time Tenor 3 of the option\nDistance between home and restaurant Difference between strike price and \npresent market price (i.e., strike–stock \nprice ratio)\nAmount of traffic/likelihood of getting caught \nat a stoplight\nHow much the stock returns are \nthought likely to vary up and down \nAverage traveling speed Stock market drift\nGas expenditure Dividend payout\nLooking at these inputs, it is clear that the only input that is not known \nwith certainty when we start for the restaurant is the amount of traffic/\nnumber of stoplights measure.\nSimilarly, when the BSM is figuring a range of future stock prices, \nthe one input factor that is unknowable and that must be estimated is \nhow much the stock will vary over the time of the option contract. It is \nno surprise, then, that expectations regarding this variable become the \nsingle most important factor for determining the price of an option and \nthe factor that people talk", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 19}
{"text": "hts measure.\nSimilarly, when the BSM is figuring a range of future stock prices, \nthe one input factor that is unknowable and that must be estimated is \nhow much the stock will vary over the time of the option contract. It is \nno surprise, then, that expectations regarding this variable become the \nsingle most important factor for determining the price of an option and \nthe factor that people talk most about when they talk about options—\nvolatility (vol). \nThis factor is properly known as forward volatility and is formally \ndefined as the expected one-standard-deviation fluctuation up and \ndown around the forward stock price. If this definition sounds familiar, \n60  •   The Intelligent Option Investor\nit is because it is also the definition of the BSM cone. To the extent that \nexpectations are not directly observable, forward volatility can only be \nguessed at.\nThe option market’s best guess for the forward volatility, as expressed \nthrough the option prices themselves, is known as implied volatility. We \nwill discuss implied volatility in more detail in the next section and will \nsee how to build a BSM cone using option market prices and the forward \nvolatility they imply in Part III.\nThe one other measure of volatility that is sometimes mentioned is sta-\ntistical volatility (a.k.a. historical volatility). This is a purely descriptive statis-\ntic that measures the amount the stock price actually fluctuated in the past. \nBecause it is simply a backward-looking statistic, it does not directly affect \noption pricing. Although the effect of statistical volatility on option prices \nis not direct, it can have an indirect effect, thanks to a behavioral bias called \nanchoring. Volatility is a hard concept to understand, let alone a quantity to \nattempt to predict. Rather than attempt to predict what forward volatility \nshould be, most market participants simply look at the recent past statistical \nvolatility and tack on some cushion to come to what they think is a reason-\nable value for implied volatility. In other words, they mentally anchor on the \nstatistical volatility and use that anchor as an aid to decide what forward vola-\ntility should be. The amount of cushion people use to pad statistical volatility \ndiffers for different types of stocks, but usually we can figure that the market’s \nimplied volatility will be about 10 percentage points higher than statistical \nvolatility. It is important to realize that this is a completely boneheaded way \nof figuring what forward volatility will be (so don’t emulate it yourself), but \npeople do boneheaded things in the financial markets all the time.\nHowever people come to an idea of what forward volatility is rea-\nsonable for a given option, it is certain that changing perceptions about \nvolatility are one of the main drivers of option prices in the market. To \nunderstand how this works, let’s take a look at what happens to the BSM \ncone as our view of forward volatility changes. \nChanging Volatility Assumptions\nLet’s say that we are analyzing an option that expires in two years, with a \nstrike price of $70. Further assume that the market is expecting a forward \nThe Intelligent Investor’s Guide to Option Pricing  •  61\nvolatility of 20 percent per year for this stock. Visually, our assumptions \nyield the following:\nAdvanced Building Corp. (ABC)\n5/18/2012 5/20/2013 249 499 749 999\n100\n90\n80\n70\n60\n50\n40\n30\n20\nDate/Day Count\nStock Price\nGREEN\nA forward volatility of 20 percent per year suggests that after \nthree years, the most likely range for the stock’s price according to the \nBSM will be around $41 on the low side to around $82 on the high \nside. Furthermore, we can tell from our investigations in Chapter 2 that \nthis option will be worth something, but probably not much—about the \nsame as or maybe a little more than the one-year, $60 strike call option \nwe saw in Chapter 2.\n4\nNow let’s increase our assumption for volatility over the life of the \ncontract to 40 percent per year. Increasing the volatility means that the \nBSM probability cone becomes wider at each point. In simple terms, what \nwe are saying is that it is likely for there to be many more large swings in \nprice over the term of the option, so the range of the possible outcomes \nis wider.\nHere is what the graph looks like if we double our assumptions \nregarding implied volatility from 20 to 40 percent:\n62  •   The Intelligent Option Investor\nAdvanced Building Corp. (ABC)\n5/18/2012 5/20/2013 249 499 749 999\n100\n110\n120\n130\n90\n80\n70\n60\n50\n40\n20\n30\n10\n-\nDate/Day Count\nStock Price\nGREEN\nCompared with the preceding diagram, look how far into the exposure \nrange the new BSM probability cone extends! Under an assumption of \n40 percent per year forward volatility, the most likely price range for the \nstock as calculated by the BSM is around $30 to nearly $120.\nLooking at the range of exposure contained within the new BSM \nprobability cone, we can tell that the likelihood of the stock being at $70 or \ngreater in two years is much higher than it was when we assumed a forward \nvolatility of 20 percent. Because the area of the range of exposure contained \nwithin the new BSM cone is much greater, we can be sure that the option \nwill be much more expensive now.\nLet’s now take a look at the opposite case—volatility is assumed to be \nhalf that of our original 20 percent per year assumption:\nAdvanced Building Corp. (ABC)\n5/18/2012 5/20/2013 249 499 749 999\n80\n70\n60\n50\n40\n30\n20\n10\n-\nDate/Day Count\nStock Price\nGREEN\nThe Intelligent Investor’s Guide to Option Pricing  •  63\nWith this change in assumptions, we can see that the most likely \nrange for the stock’s price three years in the future is between about $50 and \nabout $70. As such, the chance of the stock price hitting $70 in two years \nmoves from somewhat likely (20 percent volatility in the first example) to \nvery likely (40 percent volatility in the second example) to very unlikely \n(10 percent volatility in the third example) in the eyes of the B", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 20}
{"text": "see that the most likely \nrange for the stock’s price three years in the future is between about $50 and \nabout $70. As such, the chance of the stock price hitting $70 in two years \nmoves from somewhat likely (20 percent volatility in the first example) to \nvery likely (40 percent volatility in the second example) to very unlikely \n(10 percent volatility in the third example) in the eyes of the BSM. This \ncharacterization of “very unlikely” is seen clearly by the fact that the BSM \nprobability cone contains not one whit of the call option’s exposure range.\nIn each of these cases, we have drawn the graphs by first picking an \nassumed volatility rate and then checking the worth of an option at a cer -\ntain strike price. In actuality, option market participants operate in reverse \norder to this. In other words, they observe the price of an option being \ntransacted in the marketplace and then use that price and the BSM model \nto mathematically back out the percentage volatility implied by the option \nprice. This is what is meant by the term implied volatility and is the process \nby which option prices themselves display the best guesses of the option \nmarket’s participants regarding forward volatility. \nIndeed, many short-term option speculators are not interested in the \nrange of stock prices implied by the BSM at all but rather the dramatic change in \nprice of the option that comes about with a change in the width of the volatility \ncone. For example, a trader who saw the diagram representing 10 percent annu-\nalized forward volatility earlier might assume that the company should be trad-\ning at 20 percent volatility and would buy options hoping that the price of the \noptions will increase as the implied volatility on the contracts return to normal.\nThis type of market participant talks about buying and selling volatility as if \nimplied volatility were a commodity in its own right. In this style of option trad-\ning, investors assume that option contracts for a specific stock or index should \nalways trade at roughly the same levels of implied volatility.\n5 When implied vola-\ntilities change from the normal range—either by increasing or decreasing—an \noption investor in this vein sells or buys options, respectively. Notice that this \nstyle of option transaction completely ignores not only the ultimate value of the \nunderlying company but also the very price of the underlying stock. \nIt is precisely this type of strategy that gives rise to the complex short-\nterm option trading strategies we mentioned in Chapter 1—the ones that are \nset up in such a way as to shield the investor transacting options from any of \nthe directionality inherent in options. Our take on this kind of trading is that \n64  •   The Intelligent Option Investor\nalthough it is indeed possible to make money using these types of strategies, \nbecause multiple options must be transacted at one time (in order to control \ndirectional risk), and because in the course of one year many similar trades \nwill need to be made, after you pay the transaction costs and assuming that \nyou will not be able to consistently win these bets, the returns you stand to \nmake using these strategies are low when one accounts for the risk undertaken.\nOf course, because this style of option trading benefits brokers by \nallowing them to profit from the bid-ask spread and from a fee on each \ntransaction, they tend to encourage clients to trade in this way. What is \ngood for the goose is most definitely not good for the gander in the case of \nbrokers and investors, so, in general, strategies that will benefit the investor \nrelatively more than they benefit the investor’s broker—like the intelligent \noption investing we will discuss in Part III—are greatly preferable.\nThe two drivers that have the most profound day-to-day impact \non option prices are the ones we have already discussed: a change in the \nstrike–stock price ratio and a change in forward volatility expectations. \nHowever, over the life of a contract, the most consistent driver of option \nvalue change is time to expiration. We discuss this factor next.\nChanging Time-to-Expiration Assumptions\nTo see why time to expiration is important to option pricing, let us leave \nour volatility assumptions fixed at 20 percent per year and assume that we \nare buying a call option struck at $60 and expiring in two years. First, let’s \nlook at our base diagram—two years to expiration:\nAdvanced Building Corp. (ABC)\n5/18/2012 5/20/2013 249 499 749 999\n100\n90\n80\n70\n60\n50\n40\n30\n20\nDate/Day Count\nStock Price\nGREEN\nThe Intelligent Investor’s Guide to Option Pricing  •  65\nIt is clear from the large area of the exposure range bordered by the \nBSM probability cone that this option will be fairly expensive.\nLet’s now look at an option struck at the same price on the same un-\nderlying equity but with only one year until expiration:\nAdvanced Building Corp. (ABC)\n5/18/2012 5/20/2013 249 499 749 999\n100\n90\n80\n70\n60\n50\n40\n30\n20\nDate/Day Count\nStock Price\nGREEN\nConsistent with our expectations, shortening the time to expiration \nto 365 days from 730 days does indeed change the likelihood as calculated \nby the BSM of a call option going above $60 from quite likely to just barely \nlikely. Again, this can be confirmed visually by noting the much smaller \narea of the exposure range bounded by the BSM probability cone in the \ncase of the one-year option versus the two-year one.\nIndeed, even without drawing two diagrams, we can see that the \nchance of this stock rising above $60 decreases the fewer days until expira-\ntion simply because the outline of the BSM probability cone cuts diagonal-\nly through the exposure range. As the cone’s outline gets closer to the edge \nof the exposure range and finally falls below it, the perceived chance falls \nto 16 percent and then lower. We would expect, just by virtue of the cone’s \nshape, that options would lose value with the passage of time.\nThis effect has a special name in the options world", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 21}
{"text": "e outline of the BSM probability cone cuts diagonal-\nly through the exposure range. As the cone’s outline gets closer to the edge \nof the exposure range and finally falls below it, the perceived chance falls \nto 16 percent and then lower. We would expect, just by virtue of the cone’s \nshape, that options would lose value with the passage of time.\nThis effect has a special name in the options world—time decay. Time \ndecay means that even if neither a stock’s price nor its volatility change very \nmuch over the duration of an option contract, the value of that option will \n66  •   The Intelligent Option Investor\nstill fall slowly. Time decay is governed by the shape of the BSM cone and \nthe degree to which an option’s range of exposure is contained within the \nBSM cone. The two basic rules to remember are:\n1. Time decay is slowest when more than three months are left \nbefore expiration and becomes faster the closer one moves toward \nexpiration.\n2. Time decay is slowest for ITM options and becomes faster the \ncloser to OTM the option is.\nVisually, we can understand the first rule—that time decay increases \nas the option nears expiration—by observing the following:\nSlope is shallow here...\nBut steep here...\nThe steepness of the slope of the curve at the two different points \nshows the relative speed of time decay. Because the slope is steeper the less \ntime there is on the contract, time decay is faster at this point as well.\nVisually, we can understand the second rule—that OTM options lose \nvalue faster than ITM ones—by observing the following:\nTime BT ime A Time BT ime A\nGREEN\nGREEN\nORANGE\nOTM option ITM option\nThe Intelligent Investor’s Guide to Option Pricing  •  67\nAt time A for the OTM option, we see that there is a bit of the range of \nexposure contained within the cone; however, after some time has passed \nand we are at time B, none of the range of exposure is contained within \nthe BSM cone. In contrast, at times A and B for the ITM option, the entire \nrange of exposure is contained within the BSM cone. Granted, the area of \nthe range of exposure is not as great at time B as it was at time A, but still, \nwhat there is of the area is completely contained within the cone.\nTheoretically, time decay is a constant thing, but sometimes actual \nmarket pricing does not conform well to theory, especially for thinly traded \noptions. For example, you might not see any change in the price of an option \nfor a few days and then see the quoted price suddenly fall by a nickel even \nthough the stock price has not changed much. This is a function of the way \nprices are quoted—often moving in 5-cent increments rather than in 1-cent \nincrements—and lack of “interest” in the option as measured by liquidity.\nChanging Other Assumptions\nThe other input assumptions for the BSM (stock market drift and dividend \nyield) have very small effects on the range of predicted future outcomes in \nwhat I would call “normal” economic circumstances. The reason for this is \nthat these assumptions do not change the width of the BSM cone but rather \nchange the tilt of the forward stock price line.\nRemember that the effect of raising interest rates by a few points is \nsimply to tilt the forward stock price line up by a few degrees; increasing \nyour dividend assumptions has the opposite effect. As long as interest rates \nand dividend yields stay within typical limits, you hardly see a difference in \npredicted ranges (or option prices) on the basis of a change in these variables. \nSimultaneous Changes in Variables\nIn all the preceding examples, we have held all variables but one constant \nand seen how the option price changes with a change in the one “free” \nvariable. The thing that takes some time to get used to when one is first \ndealing with options is that, in fact, the variables don’t all hold still when \nanother variable changes. The two biggest determinants of option price \nare, as we’ve seen, the strike–stock price ratio and the forward volatility \n68  •   The Intelligent Option Investor\nassumption. Because these are the two biggest determinants, let’s take a \nlook at some common examples in which a change in one offsets or exac-\nerbates a change in the other. \nFollowing are a few examples of how interactions between the variables \nsometimes appear. For each of these examples, I am assuming a shorter \ninvestment time horizon than I usually do because most people who get hurt \nby some adverse combination of variables exacerbate their pain by trading \nshort-term contracts, where the effect of time value is particularly severe.\nFalling Volatility Offsets Accurate Directional Prediction\nLet’s say that we are expecting Advanced Building Corp. to announce that it \nwill release a new product and that we believe that this product announcement \nwill generate a significant short-term boost in the stock price. We think that \nthe $50 stock price could pop up to $55, so we buy some short-dated calls \nstruck at $55, figuring that if the price does pop, we can sell the calls struck at \n$55 for a handsome profit. Here’s a diagram of what we are doing:\n20\n25\n30\n35\n40Stock Price\n45\n50\n55\n60\nAdvanced Building Corp. (ABC)\n65\nGREEN\nAs you should be able to tell by this diagram, this call option should \nbe pretty cheap—there is a little corner of the call option’s range of expo-\nsure within the BSM cone, but not much.\nThe Intelligent Investor’s Guide to Option Pricing  •  69\nNow let’s say that our analysis is absolutely right. Just after we buy the \ncall options, the company makes its announcement, and the shares pop up \nby 5 percent. This changes the strike–stock price ratio from 1.05 to 1.00. \nAll things being held equal, this should increase the price of the option \nbecause there would be a larger portion of the range of exposure contained \nwithin the BSM cone.\nHowever, as the stock price moves up, let’s assume that not everything \nremains constant but that, instead, implied volatility falls. This does hap-\npen all the time in actuality; t", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 22}
{"text": "e strike–stock price ratio from 1.05 to 1.00. \nAll things being held equal, this should increase the price of the option \nbecause there would be a larger portion of the range of exposure contained \nwithin the BSM cone.\nHowever, as the stock price moves up, let’s assume that not everything \nremains constant but that, instead, implied volatility falls. This does hap-\npen all the time in actuality; the option market is full of bright, insightful \npeople, and as they recognize that the uncertainty surrounding a product \nannouncement or whatever is growing, they bid up the price of the options \nto try to profit in case of a swift stock price move.\nIn the preceding diagram, we’ve assumed an implied volatility of 35 \npercent per year. Let’s say that the volatility falls dramatically to 15 percent \nper year and see what happens to our diagram:\n20\n25\n30\n35\n40Stock Price\n45\n50\n55\n60\nAdvanced Building Corp. (ABC)\n65\nStock price jumps\nImplied volatility drops\nGREEN\nThe stock price moves up rapidly, but as you can see, the BSM cone shrinks \nas the market reassesses the uncertainty of the stock’s price range in the \nshort term. The tightening of the BSM cone is so drastic that it more than \noffsets the rapid price change of the underlying stock, so now the option is \nactually worth less! \n70  •   The Intelligent Option Investor\nWe, of course, know that it is worth less because after the announce-\nment, there is only the smallest sliver of the call’s range of exposure con-\ntained within the BSM cone. \nVolatility Rise Fails to Offset Inaccurate Directional Prediction\nLet’s say that we are bullish on the Antelope Bicycle Co. (ABC) and, noting \nthat the volatility looks “cheap, ” buy call options on the shares. In this case, \nan investor would be expecting to make money on both the stock price and \nthe implied volatility increasing—a situation that would indeed create an \namplification of investor profits.\nWe buy a 10 percent OTM call on ABC that expires in 60 days when \nthe stock is trading for $50.\n20\n25\n30\n35\n40Stock Price 45\n50\n55\nAntelope Bicycle Corp. (ABC)\n60\nGREEN\nThe next morning, while checking our e-mail and stock alerts, we find \nthat ABC has been using a metal alloy in its crankshafts that spontaneously \ncombusts after a certain number of cranks. This process has led to severe \nburn injuries to some of ABC’s riders, and the possibility of a class-action \nlawsuit is high. The market opens, and ABC’s shares crash by 10 percent. At \nthe same time, the volatility on the options skyrocket from 15 to 35 percent \nThe Intelligent Investor’s Guide to Option Pricing  •  71\nbecause of the added uncertainty surrounding product liability claims. \nHere is what the situation looks like now:\n20\n25\n30\n35\n40Stock Price 45\n50\n55\nAntelope Bicycle Corp. (ABC)\n60\nGREEN\nThis time we were right that ABC’s implied volatility looked too cheap, but \nbecause we were directionally wrong, our correct volatility prediction does us \nno good financially. The stock has fallen heavily, and even with a large increase \nin the implied volatility, our option is likely worth less than it was when we \nbought it. Also, because the option is now further OTM than it originally was, \ntime decay is more pronounced. Thus, to the extent that the stock price stays at \nthe new $45 level, our option’s value will slip away quickly with each passing day.\nRise in Volatility Amplifies Accurate Directional Prediction\nThese examples have shown cases in which changes in option pricing \nvariables work to the investor’s disadvantage, but it turns out that changes \ncan indeed work to an investor’s advantage as well. For instance, let’s say \nthat we find a company—Agricultural Boron Co. (ABC)—that we think, \nbecause of its patented method of producing agricultural boron com-\npounds, is relatively undervalued. We decide to buy 10 percent OTM calls \non it. Implied volatility is sitting at around 25 percent, but our option is far \nenough OTM that it is not very expensive.\n72  •   The Intelligent Option Investor\n20\n30\n40Stock Price\n50\n60\n70\nAgricultural Boron Co.\n80\nGREEN\nThe morning after we buy these call options, chemical giant \nDuPont (DD) announces that it is initiating a hostile takeover and of-\nfering shareholders of ABC a 20 percent premium to the present mar -\nket price—$60 per share. DuPont’s statement mentions that it wants to \ngain exclusive access to ABC’s boron processing technology. The market \nimmediately thinks of German chemical giant BASF and believes BASF \nwill make a higher counteroffer so as to keep ABC’s revolutionary boron \nprocessing technology out of DuPont’s hands. Because there is uncer -\ntainty surrounding the possibility of a counterbid and perhaps even the \nuncertainty that DuPont’s offer will not be accepted, forward volatility on \nthe contracts increases. The net result is this\n6:\n20\n30\n40Stock Price\n50\n60\n70\nAgricultural Boron Co. (ABC)\n80\nGREEN\nThe Intelligent Investor’s Guide to Option Pricing  •  73\nWith this happy news story, our call options went from nearly \nworthless to worth quite a bit—the increase in volatility amplified the \nrising stock price and allowed us to profit from changes to two drivers of \noption pricing.\nThere is an important follow-up to this happy story that is well worth \nkeeping in the back of your mind when you are thinking about investing \nin possible takeover targets using options. That is, our BSM cone widened \na great deal when the announcement was made because the market be-\nlieved that there might be a higher counteroffer or that the deal would fall \nthrough. If instead the announcement from DuPont was that it had made \na friendly approach to the ABC board of directors and that its offer had \nalready been accepted, uncertainty surrounding the future of ABC would \nfall to zero (i.e., the market would know that barring any antitrust con-\ncerns, DuPont would close on this deal when it said it would). In this case, \nimplied volatility would simply fall away, and the call option’s value would \nbe", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 23}
{"text": "was that it had made \na friendly approach to the ABC board of directors and that its offer had \nalready been accepted, uncertainty surrounding the future of ABC would \nfall to zero (i.e., the market would know that barring any antitrust con-\ncerns, DuPont would close on this deal when it said it would). In this case, \nimplied volatility would simply fall away, and the call option’s value would \nbecome the intrinsic value (in other words, there is no potential or time \nvalue left in the option). The situation would look like this:\n20\n30\n40 Stock Price\n50\n60\n70\nAgricultural Boron Co. (ABC)\n80\nGREEN\nWe would still make $5 worth of intrinsic value on an invested base \nthat must have been very small (let’s say $0.50 or so), but were the situation \nto remain uncertain, we would make much more.\n74  •   The Intelligent Option Investor\nY ou now have a good understanding of how options work and how \nthey are priced from a theoretical perspective. Although it is clear from \nChapter 2 that the BSM has its faults, it is undeniable that in certain times \nand under certain conditions, it works well. Please see Appendix A for a \nbrief discussion of the situations in which the BSM is fairly good at pricing \noptions—intelligent option investors will want to avoid these—and when \nit is poor—cases that present the most attractive chances for intelligent in-\nvestors.\nNow that you have a good idea of how options work and are priced, \nlet’s turn to how we can do a better job of predicting valuation ranges than \nthe BSM does. This is the subject of Part II.\n75\nPart II\nA sound intellectuAl \nfrAmework for \nAssessing vAlue\nAfter reading Part I, you should have a very good theoretical grasp on \nhow options work and how option prices predict the future prices of stocks. \nThis takes us partway to the goal of becoming intelligent option investors. \nThe next step is to understand how to make intelligent, rational es-\ntimates of the value of a company. It makes no sense at all for a person to \ninvest his or her own capital buying or selling an option if he or she does not \nhave a good understanding of the value of the underlying stock.\nThe problem for most investors—both professional and individual—\nis that they are confused about how to estimate the value of a stock. As such, \neven those who understand how the Black-Scholes-Merton model (BSM) \npredicts future stock prices are not confident that they can do any better. \nThere is a good reason for the confusion among both professional and \nprivate investors: they are not taught to pay attention to the right things. \nIndividual investors, by and large, do not receive training in the basic tools \nof valuation analysis—discounted cash flows and how economic transac-\ntions are represented in a set of financial statements. Professional investors \nare exquisitely trained in these tools but too often spend time spinning \ntheir wheels considering immaterial details simply because that is what \nthey have been trained to do and because their compensation usually relies \non short- rather than long-term performance. They have all the tools in the \nworld but are taught to apply them to answering the wrong questions.\n76  •   The Intelligent Option Investor\nPart II of this book sets forth a commonsense approach to determining \nthe value of a company. It aims to provide individual investors with the \ntools they need and to offer both individual and professional investors a \nframework that allows them to focus their attention on the most important \nthings and ignore the rest.\nChapter 4 discusses what I call the golden rule of valuation. Chapter 5 \nlooks at the only four things that can affect the long-term value of a stock \nand offers a way to estimate the value a company will create over its entire \neconomic life. Chapter 6 investigates the behavioral biases and structural \nimpediments working against us in our investment decisions and offers \ntools to avoid them.\nIn general, I have written these chapters to present the valuation \nframework from a conceptual perspective and have thus left out many de-\ntails regarding financial statement line items and the like. These details are \nimportant, however, and it is unrealistic to think that you could translate \ntheory into practice without knowing them. For this reason, I have provid-\ned a detailed valuation example on the Intelligent Option Investor website, \ncomplete with descriptions of all the financial statements I analyzed and \nexplanations of the thought processes I used when doing the analysis.\n77\nChapter 4\nthe golden rule of \nv AluAtion\nCommit the following definition to memory:\nThe value of an asset is the sum of the cash flows it creates on \nbehalf of its owners over its economic life.\nContrary to popular opinion, valuation is easy. One does not need a master’s \ndegree in accounting or to be an expert in financial statement analysis to com-\npetently value a company and estimate a fair value range for a stock. The only \nthing a person needs is to internalize the preceding sentence and understand \nthe handful of factors that affect the cash flows of a firm over time. \nThis chapter focuses on developing a theoretical framework using the \ngolden rule of valuation—which you have already memorized—and looks \nat each part of that simple definition phrase by phrase, with each phrase a \ndifferent section of the chapter. The sections are as follows:\n1. The Value of an Asset: Here we offer a specific definition for an as-\nset and discuss the distinction between value and price.\n2. Cash Flows Generated on Behalf of the Owners: Specifies which \ncash flows we will measure when valuing an asset.\n3. The Company’s Economic Life: Breaks the life of the firm into \nthree stages to help make the valuation process easier and more \ntransparent. \nFor those new to the subject of valuation, I present an additional \nsection that provides overviews of specific topics such as time value of \n78  •   The Intelligent Option Investor\nmoney and discount rates, but", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 24}
{"text": "ows we will measure when valuing an asset.\n3. The Company’s Economic Life: Breaks the life of the firm into \nthree stages to help make the valuation process easier and more \ntransparent. \nFor those new to the subject of valuation, I present an additional \nsection that provides overviews of specific topics such as time value of \n78  •   The Intelligent Option Investor\nmoney and discount rates, but even being unacquainted with these terms \nright now will not be a handicap. \nBusiness is essentially a collection of very simple transactions—pro-\nducing, selling, and investing excess profits. In my experience, one of the \nbiggest investing mistakes occurs when people forget to think about busi-\nness in terms of these simple transactions. \nHaving a firm grasp of valuation is an essential part of being an in-\ntelligent option investor. The biggest drawback of the BSM is its initial as-\nsumption that all stock prices represent the true values of the stocks in \nquestion. It follows that the best opportunity for investors comes when a \nstock’s present price is far from its true intrinsic value. In order to assess \nhow attractive an investment opportunity is, we must have a good under-\nstanding of the source of value for a firm and the factors that contribute to \nit. These are the topics of this chapter and the next. \nIn terms of our intelligent option investing process, we need two \npieces of information:\n1. A range of future prices determined mechanically by the option \nmarket according to the BSM\n2. A rationally determined valuation range generated through an in-\nsightful valuation analysis\nThis chapter and the next give the theoretical background necessary to de-\nrive the latter. \nJargon to be introduced in this chapter is as follows:\nAsset Structural constraints\nDemand-side constraints Supply-side constraints\nOwners’ cash profit (OCP) Expansionary cash flow\nFree cash flow to owner(s) (FCFO) Working capital\nThe Value of an Asset \nThe meaning of asset , in financial terms, is different from the vernacular \nmeaning of “something I’ d be upset about if it broke or was stolen. ” In \nfinancial terms, an asset is anything that can be owned that (1) was created \nThe Golden Rule of Valuation    • 79\nthrough an expenditure and (2) has the capacity to generate revenues \nand/or to increase profits. Thinking about assets from the perspective of \nrevenue creation and profit growth, it is clear that things such as family cars \nare usually not assets but are rather convenience items.\nA collection of assets is also an asset—if you own a taxi cab, you own \nan asset; if you own a taxi-cab company, you also own an asset. Modern \ncorporations are extremely complex, frequently with multiple business \nlines and operations in multiple states and countries and with assets com-\nprised of machinery, land, and intellectual property. However, even though \ncorporations are complex, they are still assets in the sense that they are a \ncollection of discrete assets themselves.\nAn asset is created through an expenditure, so it follows that all assets \nhave a price; this price may be greater or less than the asset’s value. The distinc-\ntion between the price of an asset and its value lies at the heart of what is known \nas value investing, so it is an important one to grasp. As an example, let’s say that \nyou would like to start a suburban taxi service, and frame the difference be-\ntween price and value of the main asset you need to start this business: a car. In \norder for your business to be successful, the car you buy should be roomy, reli-\nable, and attractive to customers. Y ou do some research and decide to buy one \nof the two following cars—both of which fit your above-stated requirements:\n1. 2013 Bentley Mulsanne: Manufacturer’s suggested retail price \n(MSRP) of $300,000\n2. 2013 Toyota Camry: MSRP of $28,000\nThe choice between the two cars for a typical taxi business is simple. \nThe price of the Mulsanne is clearly too high. It is hard to imagine that \nthe cash flows that would accrue to the owner of a Mulsanne taxi service \nwould ever be enough to cover the cost of the car itself. In this case, the \nasset’s value as a cab is much less than its price. In the parlance of modern \nfinancial theorists, a company paying the price of a Mulsanne for a car to \nstart a suburban taxi service is “destroying shareholder value. ”\nObviously, it is not necessary to do complex calculations to see that \nvalue would be destroyed in this case with the purchase of the Bentley. We \ncannot be sure of what the value of a suburban taxi service is without some \nmore information, but we can pretty easily guess that the cash generated \nfrom such a service would not be enough to pay off the price of the Mulsanne.\n80  •   The Intelligent Option Investor\nWhether the purchase of the Camry is a good idea or not is a bit more \ncomplicated. However, our conception of value for the service should not \nchange, so our decision to invest will be driven completely by the relation-\nship of the price of the Camry to our best idea for the value it can create. If \nthe likely value of the car is higher than its price, it’s an investment worth \nconsidering; if the likely value of the car is less than its price (as was the \ncase in the Mulsanne), it is folly to do anything but walk away. If the likely \nvalue is much, much higher than the price, to the extent that it would pro-\nvide you much more wealth than you might generate with another simi-\nlarly sized, similarly risky investment, it would be irrational not to make \nthe investment.\nAll of this—determination of the value and considerations \nsurrounding investment—should seem very sensible to you. Indeed, it is \nonly common sense. The problem is that when it comes to the investment \nprocess, many investors—professional and amateur alike—throw this \ncommon sense to the wind and start getting confused by what other people \nare saying about chart patterns and multiples and potential demand for a \ncompany’s nascent pro", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 25}
{"text": "and considerations \nsurrounding investment—should seem very sensible to you. Indeed, it is \nonly common sense. The problem is that when it comes to the investment \nprocess, many investors—professional and amateur alike—throw this \ncommon sense to the wind and start getting confused by what other people \nare saying about chart patterns and multiples and potential demand for a \ncompany’s nascent product line. \nI will talk about where this confusion might come from in Chapter 6. \nNow that we have an understanding of what an asset is—something \nthat can be owned, that is created through expenditures, and has the capac-\nity to generate revenue or increase profits—let’s investigate the next phrase \nin our golden rule: “cash flows generated on behalf of owners. ”\nCash Flows Generated on Behalf of Owners\nOur taxi-cab entrepreneur buys the Camry—an act that, in the parlance of \nfinanciers, is called a capital expense—and opens the taxi service. In order \nto receive revenues, she will have to do a few things:\n• Advertise\n• Pay herself a salary\n• Spend money to maintain the taxi in good working condition (gas, \noil changes, etc.)\n• Spend money on such things as insurance, licensing, mobile phone \nservice, and banking and professional fees\nThe Golden Rule of Valuation    • 81\nLet’s assume that the owner runs the business for an entire year, and \nshe leaves what is left over after paying the preceding expenses in her bank \naccount. At the end of the year, the owner is sitting on excess profits of \n$5,000. Y ou might be tempted to say that this amount is the cash flow gen-\nerated on behalf of the owner, but let’s think about it more carefully for a \nmoment. \nThe owner is a good businessperson, so she realizes that the Camry is \nnot going to last forever. At some point, the owner will need to buy another \none, so she wants to set some money aside for a down payment—let’s say \nshe sets aside $1,000.\nNow the owner has $4,000 that is not spoken for—perhaps this is the \namount of the total cash flow generated on behalf of the owner. It could be. \nThe owner might simply be interested in running the business at the pre-\nsent level and may be content with the $4,000 in cash or so that she figures \nshe can generate in excess of expenses every year. If so, the owner might \npay herself a special “bonus” and use the $4,000 to go on a cruise.\nHowever, let’s say that the owner has an idea that she can schedule \nmore efficiently if she uses an online ordering system that is tied into her \naccounting system. She thinks this online ordering system will allow her to \nschedule a few more fares a week just from improved order efficiency and \nwill also save her a few hours a month 10-keying data into her accounting \nsystem. In other words, she believes that if she invests in the system, she will \nbe able to increase the rate of growth of both revenues (through more fares \nper week) and profits (from the reduced time expended on bookkeeping). \nThe online ordering system and related equipment cost $2,000.\nIf the owner does not spend the $2,000, she can be pretty confident \nthat her business will keep buzzing along and will generate about $4,000 \nin cash flow for her the next year. If she spends the $2,000, she figures that \nshe will be able to generate $4,500 next year—the extra $500 representing \na nice return on her investment of 25 percent (= $500/$2,000). This extra \nreturn is at risk—it could be that the investment in the computerized \nsystem will not pay off, in which case the $2,000 she spent will simply \nbe a waste—but if successful, the expenditure will pay for itself in just a \nfew years.\nIf the taxi owner decides to spend the money on the new system, she \nends up with $2,000 free and clear in her bank account. This money—the \n82  •   The Intelligent Option Investor\nmoney that is left over after paying all her daily expenses, setting aside \nmoney for the maintenance of her business, and purchasing an asset de-\nsigned to help her business expand—is the amount that we will term cash \nflows generated on behalf of the owner.\nWe have developed some terms to use in this book to describe each \nstep of the process of generating cash flows on behalf of an owner. These are:\n1. Owners’ Cash Profit (OCP): Cash available to owners after all nec-\nessary direct costs of the business have been paid and after money \nis spent or set aside to maintain the business as a going concern \n(e.g., gas, insurance, maintenance, and setting aside funds for the \nnext taxi).\n2. Expansionary Cash Flows: Any money invested to try to generate \nmore revenues or increase profit in the future. Expansionary cash \nflows are an investment, so are not guaranteed of being successful \n(e.g., online ordering system).\n3. Free Cash Flow to Owners (FCFO): Any OCP left over after \nexpansionary cash flows are made. \nFree cash flow to owners is the quantity that we will measure and \nproject to get an estimate of the value of a company. \nFrom these descriptions, you can certainly identify the OCP , ex-\npansionary cash flows, and FCFO for our taxi entrepreneur. To analyze a \npublic company, we need to associate these concepts with particular line \nitems on a financial statement. On my website, I have a detailed valuation \nexample (of enterprise software giant, Oracle) that shows what specific line \nitems to estimate each of the quantities mentioned here. \nNow that we have a good understanding of what cash flows we are \nlooking at in order to value a company, let’s investigate the phrase over the \ncompany’s economic life.\nThe Company’s Economic Life\nThe economic life of a company involves the firm struggling to generate \ncash flow subject to various constraints that change as the company \ngrows older. When a company is young, like our taxi company, the main \nThe Golden Rule of Valuation    • 83\nconstraint it is likely to face is a supply-side one. Our taxi company has only \none car and one driver. Assuming that the average ride for a customer lasts \n15 minutes, the", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 26}
{"text": "ompany involves the firm struggling to generate \ncash flow subject to various constraints that change as the company \ngrows older. When a company is young, like our taxi company, the main \nThe Golden Rule of Valuation    • 83\nconstraint it is likely to face is a supply-side one. Our taxi company has only \none car and one driver. Assuming that the average ride for a customer lasts \n15 minutes, the taxi company would be hard pressed to service more than \nabout 40 customers a day or 240 customers a week (assuming a 10-hour \nwork day and a 6-day work week). Because the taxi’s capital resource base \nis small—one car—no matter how many potential customers may exist, \nthe volume of service that may be provided is also small. This is a classic \nexample of supply-side constraints.\nMoney and credit are like oxygen to a fire for supply-constrained \ncompanies. Given extra money—whether generated through operations, \nborrowed from a bank, or raised by selling shares to other part owners—\nour taxi company will be able to buy more cars and hire more drivers. If we \nthink about these expenditures as investments, this is clearly an investor’s \ndream because virtually any investment made is guaranteed to have good \nresults. \n“There is enough customer demand for 10 taxis in this town. We have \nthree taxis and some money to invest. Let’s buy another taxi. ” This is not a \ndifficult or intellectually draining analytical process!\nAs long as the company has access to capital\n1 and is producing some-\nthing consumers want, the percentage growth rates of its revenues year \nover year during this stage of the business’s economic life can be phenom-\nenal; after all, if you own one cab and simply buy two others to serve a cab-\nstarved region, your revenues are likely to show a year-over-year growth \nrate of somewhere around 200 percent.\nFCFO during this time may, in fact, be negative—a company can \nfund itself through debt and actually pay more on expansionary projects \nthan it receives in profits—but this does not mean that the business is bad, \nmerely that it is facing supply-side constraints and trying to expand its \ncapital base to meet the size of the market’s demand.\nWe see this type of rapid growth in public companies all the time. \nRailroads in the 1800s, automobile companies in the 1900s, and Internet \nfirms in the late 1990s all showed incredible revenue growth as customer \ndemand swelled for products and services based on the latest technological \nadvances.\nIf the taxi owner can navigate the process of raising money, eventu-\nally, she will have built up her capital base to match the size of the market \n84  •   The Intelligent Option Investor\nopportunity. It is at this point that a company begins operating subject to \ndemand-side constraints—constraints arising from the vagaries of competi-\ntion and consumer choice.\nWhen faced with demand-side constraints, the taxi cab owner is no \nlonger concerned with finding new investment money to expand her capi-\ntal base but rather with finding ways to keep her cash flows growing even \nthough her capital base is sufficient to meet current customer demand. Dur-\ning this part of the company’s economic life, investment decisions become \nmore difficult. One possible investment choice is to spend money on systems \nor processes to make the operation more efficient. This will not affect top-line \n(i.e., revenue) growth but likely will increase the flow of cash to the owner \nby allowing for a higher proportion of revenues to be converted into profits.\nOther investment possibilities for our demand-constrained taxi \nentrepreneur include opening an operation in another geographic area—\nmaybe in the form of a joint venture (JV) with another entrepreneur in the \nnew region who understands the local economy well—buying a rival taxi \ncompany, or indeed branching out to start some other business under the \ntaxi company’s umbrella.\nIn terms of our original example to illustrate FCFO, in this period, for \na single car in her fleet, our taxi owner may be receiving the same $5,000 in \nprofits, setting aside the same $1,000 for a replacement vehicle, paying the \ndriver a $500 profit-sharing bonus, spending $700 for an improved lighting \nand security system for the lot in which she parks her fleet of cars, and \nsquirreling away the rest in case the opportunity to buy the taxi company \nacross town presents itself. The company may look as though it is generat-\ning $2,800 in FCFO (= $5,000 − $1,000 − $500 − $700), but in fact, in the \nowner’s mind, that $2,800 may just be temporarily available. If a good, large \ninvestment opportunity presents itself, what had looked like free cash flow \nfrom years past might get used all at once in a major investment program.\nTo find examples of companies in this stage of development, one only \nneeds to open the business section of the local newspaper. General Motors’ \nJVs with Chinese carmakers to get a toehold in the burgeoning China \nmarket, Procter & Gamble buying Gillette Razors to boost its personal-\ncare product lines, and Google stepping out of its turf of Internet search-\nbased advertising to buy Motorola Mobility Systems and manufacturing \nmobile phones are all cases in point.\nThe Golden Rule of Valuation    • 85\nThe growth of the taxi company’s cash flows will depend on how good \nthe potential investment opportunities are and how skillful the company’s \nmanagement is at exploiting those opportunities. If the opportunities are \ngood and management is skillful, growth rates will continue to be high. \nThey will certainly not be as high as during the “shooting fish in a barrel” \ninvestment environment when the company was supply constrained, but \nthey will be higher than the growth rates of most of the companies in the \nlarger economy.\nAt some point, however, good investment opportunities will become \nfewer and farther between. The taxi-cab company has bought up most of \nits regional competitors and is now constrained by the local regulator’s \nrules a", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 27}
{"text": "g fish in a barrel” \ninvestment environment when the company was supply constrained, but \nthey will be higher than the growth rates of most of the companies in the \nlarger economy.\nAt some point, however, good investment opportunities will become \nfewer and farther between. The taxi-cab company has bought up most of \nits regional competitors and is now constrained by the local regulator’s \nrules against monopoly power and anticompetitive practices. The JV in a \nneighboring region did well, so our taxi owner bought out her partner and \nhas expanded that business as far as it will go as well. She dallied with set-\nting up a craft beer brewery (figuring that tipsy customers would be more \nlikely to hire taxis) but abandoned that when it seemed like it was more \ntrouble than it was worth. \nIn fact, the taxi owner noticed that in general, as her business grew \nlarger, her investment opportunities seemed to generate less and less mar-\nginal improvement in cash flow to her. As with the case of the brewery, \nsometimes the extra money flowing in was simply not worth the time and \nhassle of running the new business.\nSo it goes in listed companies as well. Eventually, all the low-hanging \ninvestment fruit is picked and in placed in the company’s basket, and get-\nting that next apple requires more energy than it is worth. Looking at long \ndata series of companies’ profit growth, you can clearly see the downward \ntrend over time as the investment opportunities become less and less com-\npelling. Part of the problem for listed firms is not only the availability of \ngood investment opportunities but also the fact that they have grown so \nlarge that it takes not only a compelling investment but also a compelling \ninvestment that is enormous in size to really move the needle. This is col-\nloquially known as the law of large numbers .\n2 Stated simply, this rule says \nthat if you are really big, it is hard to grow really fast.\nNow what?\nThe taxi cab company has been operating under an environment \nof demand constraints for some time, and the company—through \n86  •   The Intelligent Option Investor\nacquisitions, expansion, and the like—has expanded as far as it can into \nits local economy. From here on, as long as no one invents a teleportation \ndevice (which would fairly quickly make taxis obsolete), its growth will \ndepend on structural constraints —factors such as population growth, \ngeneral economic conditions, and inflation.\nIf our taxi cab owner is smart, when faced with structural constraints, \nshe will stop looking to invest the excess profits her company is generating \nevery year and instead start paying herself a bonus (which she should in-\nvest wisely by buying a copy of this book, of course). In the world of listed \ncompanies, this bonus is termed a dividend.\nThere is, in fact, a structural speed limit for public companies as \nwell—the rate of growth of the economy at large. And when a company is \nconsistently growing at or near this structural rate, it is time for sharehold-\ners to demand to be paid dividends.\nIn the old days, before globalization, the rate of growth of the econ-\nomy at large meant the growth rate of one’s domestic economy. However, \nmore and more, reduced trade barriers and cheap transportation cost have \nmeant that the limiting growth rate is closer to that of the global economy. \nThere are investing cases in which a company can potentially grow very \nquickly overseas, but for large, well-established firms (i.e, “Blue Chip” \ncompanies), usually their overseas exposure is much smaller or much less \nprofitable than their domestic exposure, so the maximum growth rate ends \nup being pretty close to the domestic rate.\nThinking about this progression from start to finish, you can see that \ngrowth rates vary broadly in three stages—a startup stage (during which \nthe firm faces supply constraints), an investment phase (during which the \nfirm faces demand constraints), and a terminal phase (during which the \nfirm faces structural constraints). It is important to realize that companies \ncan sometimes jump between these growth stages, even though it is fairly \nrare.\n3 \nThroughout the life of a company, the firm is a machine generating \nprofits and cash flows on behalf of its owners. I have said that the value of a \ncompany is the sum of the cash flows created by that company on behalf of \nits owners over its economic life. We only have one more tiny bit to inves-\ntigate to have a complete understanding of this definition: how to sum up \ncash flows that are generated over time.\nThe Golden Rule of Valuation    • 87\nTime Value of Money: Summing Up Cash Flows Over Time\nIt turns out that summing up cash flows is not as easy as simply adding \none year’s cash flows to the next because the value of cash flows depends \non when they are received. Have a hard time believing this? Look at this \nexample: assume that you get stranded in the middle of the Mojave Desert \nand have to walk through the intense summer sun to find help at the next \ntown. Y ou stumble into a convenience store, suffering from acute dehy-\ndration—shaking, nauseous, and with an intense headache—but soon you \nrealize that you have lost your wallet on the trek into town. The shopkeeper \noffers to loan you $5 now to buy drinks, but you will have to pay him $20 \nwhen you return with your wallet.\nOf course, under the circumstances, your need is so great for the $5 \nworth of liquid now that you are glad to part with $20 a few hours later. \nIn a sense, the difference between the two amounts is sort of an exchange \nrate between two different time periods. If you go to England, it takes \none U.S. dollar to equal 0.66 of a British pound (let’s assume). In the case of \nthe Mojave convenience store, it takes 20 future dollars to equal 5 dollars \nright now.\nThis is the basic idea behind the time value of money. I will not go into \ndetail behind this concept here (because it is discussed in detail in various \nonline and print sources), but th", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 28}
{"text": "me periods. If you go to England, it takes \none U.S. dollar to equal 0.66 of a British pound (let’s assume). In the case of \nthe Mojave convenience store, it takes 20 future dollars to equal 5 dollars \nright now.\nThis is the basic idea behind the time value of money. I will not go into \ndetail behind this concept here (because it is discussed in detail in various \nonline and print sources), but the main point is the one I made earlier: cash \nflows from different periods cannot be directly summed. \nThe main assumption behind modern finance is that cash flows that \noccur later are always worth proportionally less than cash flows that occur \nsooner. The formula to translate a future cash flow (CF) into its present \nvalue (PV) is\nPV = CF × e\n−rt\nwhere r is what is called the discount rate, e is the exponential function, and \nt is the time before the future cash flow is set to occur.\nWhen one raises an exponent to a negative power, the result is a num-\nber smaller than one. This is just the mathematical translation of the phrase \n“a dollar today is worth more than a dollar tomorrow. ”\n4\nAssuming we can forecast a future cash flow, the next most impor -\ntant question we should ask is what we should use for the discount rate. \n88  •   The Intelligent Option Investor\nAccording to the orthodox view of finance [embodied in something called \nthe capital asset pricing model (CAPM), which is an idea closely related to \nthe efficient market hypothesis (EMH)], there is a statistical formula that \nshould generate the proper discount rate for any publicly traded asset by \nplugging in a few numbers. I will not go into detail as to why, but suffice it \nto say that I believe that the CAPM model’s discount rate should be ignored \nby anyone who believes that stocks can be mispriced in the marketplace.\nAbandoning orthodoxy, I advocate use of a 10 percent discount rate \nfor most U.S. large- or medium-cap investments and about 12 percent for \nU.S. small- and microcap investments. The reason for this is that the market \nas a whole has generated compounded returns for the last century or so of \naround 10 percent per year. If you restrict yourself to the small-cap stock \nuniverse, that number increases to around 12 percent. By using 10 and \n12 percent as fixed discount rates, the question I am answering is this: “If I \nexpect this company to perform about as well as its peers, what is my best \nguess for what its peers will return?”\n5 Using these set numbers allows you to \nmeasure different stocks according to a common yardstick, thereby taking \nout one source of error that one can make a mistake on in a valuation.\nFor now, let’s just see what happens to a nominal payment of \n$100 per year when discounted at 10 and 12 percent. In the following \ngraph, I have assumed that a payment of $100 is made at the end of the next \n100 years. I discounted each of these payments at the discount rate listed and \nthen kept the running sum of those discounted payments. Here is the graph:\n1,200\n1,000\n800\n600\n400\n200\n0\n048 12 16 20 24 28 32 36 40 44 48 52 56 60\nYears\n64 68 72 76 80 84 88 92 96 100\n10% Discount Rate 12% Discount Rate\nThe Golden Rule of Valuation    • 89\nThe interesting thing to note is how much the value is in the first \n30 years or less of cash flows. At the 12 percent discount rate, the sum of \nthe present value of all future cash flows trends toward around $506; at the \n10 percent discount rate, the value levels off at $1,051. The points at which \neach of the curves level off represent the total value of the respective stream \nof cash flows. Using a 12 percent discount rate, the sum of the first 13 years \nof cash flows already exceeds 95 percent of the total $506 value—in other \nwords, by year 14, it is almost the same as if you stop counting. At a 10 \npercent discount rate, it takes until year 29 to reach this point.\nThinking about this graph from a practical standpoint, it makes per-\nfect sense. What if you loaned $100 to someone and he or she promised to \nrepay you in 75 years. What value would you put on that promise of repay-\nment? Nothing or next to nothing, I wager. \nAt a 10 percent discount rate, a promise to pay $100 in 75 years, using \nthe preceding formula, is worth about $0.06; at a 12 percent discount rate, \nthat promise is worth about $0.00001. These figures can surely be consid-\nered “next to nothing” and “nothing, ” respectively.\nLook at the golden rule of valuation again:\nThe value of an asset is the sum of the cash flows it creates on \nbehalf of its owners over its economic life.\nAfter the preceding discussion, its meaning now should be perfectly clear.\nAnd now that you have a good grasp of the golden rule, let’s take a \nlook at the only four factors that can affect the value of a firm—I call them \nthe drivers of value—and how we can analyze them to get a picture of what \nthe company is worth.\nThis page intentionally left blank \n91\nChapter 5\nthe four Drivers of value\nIn my experience, most people who analyze investments spend far too \nmuch time getting distracted by trivialities. These trivialities end up pull-\ning them off course, confusing them, and creating valuation rationales that \nare so complex as to become gothic. Getting carried away with unimpor -\ntant minutiae also contributes to the difficulties people have in making \ninvesting decisions—whether to invest in the first place and whether to \ndecrease, increase, or close an investment.\nThis chapter introduces a process to estimate the value of a compa-\nny—based on the golden rule of valuation —by singling out and analyzing \nonly a handful of drivers. It seems counterintuitive, but you will see later in \nthis book that less information actually counts for more in many circum-\nstances, especially when valuing a company’s stock. This chapter works \nhand in hand with Chapter 4 in teaching the skills of an intelligent option \ninvestor. Chapter 4 outlined how value accrues to the owner of a company. \nThis chapter looks at the specific factors t", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 29}
{"text": "ers. It seems counterintuitive, but you will see later in \nthis book that less information actually counts for more in many circum-\nstances, especially when valuing a company’s stock. This chapter works \nhand in hand with Chapter 4 in teaching the skills of an intelligent option \ninvestor. Chapter 4 outlined how value accrues to the owner of a company. \nThis chapter looks at the specific factors that allow that value to accrue.\nJargon introduced in this chapter is as follows:\nExplicit forecast stage Structural growth stage\nInvestment stage\nBird’s Eye View of the Valuation Process\nBefore looking at each of the drivers in turn, let’s first get an idea of the goal \nwe are trying to reach from a high level. Our golden rule of valuation ties \nthe value of a company to the cash flows it creates over time. Cash flows are \n92  •   The Intelligent Option Investor\ncreated through the process we saw in the example of the taxi company in \nChapter 4: revenues come in, present costs are paid, likely future costs are \nsaved up for, and some investments may be undertaken to expand the busi-\nness. Any cash that is left over after this process can be paid to the owners.\nThis is a pretty simple model, so it should not be hard to create a fairly \naccurate picture of how an individual company operates and how it is likely \nto operate in the future. All we need to understand is:\n1. How revenues are likely to change \n2. How efficiently a company is translating those revenues into profits \n3. What proportion of the profits the company is investing in the \ngrowth of the business and how effective those investments are\nIndeed, this picture also describes all the typical drivers of value for a \ncompany. There is one more driver, that I call “Balance Sheet Effects” and \nwill describe in detail later in this chapter, but it is only applicable in a very \nfew companies, so most of the time all you have to consider are the preced-\ning three. In tabular format, the drivers are as follows:\nDriver Description\nRevenue growth How fast sales will likely increase\nProfitability How efficient the firm is in converting \nrevenues to profits\nInvestment level and efficacy Proportion of profits that must be invested \nto allow profits to grow in the future\nBalance-sheet effects The effect of hidden assets or liabilities \non future cash flows\nThis seems like an easy enough task—just figure out three or maybe four \nthings, and you are set—until you remember that you must make this analysis \nfor the entire economic life of the firm. “How can I know what the revenues of \nthis company are going to be 50 years in the future? What will its profitability \nbe then? How should I know what kinds of investments it will be making?”\nIndeed, having to forecast revenue growth and profitability 50, 75, or \n100 years into the future for a company is an impossible task, and an inves-\ntor would be foolish to even try (although in my consulting work I have \nseen financial models extending 50 years into the future).\nThe Four Drivers of Value  •  93\nHappily, the task of an intelligent investor can be made easier by \ndoing three things:\n1. Breaking up the economic life of a company into discrete stages \nand using shortcuts to make assumptions about what will happen \nin each stage\n2. Recalling that based on the time value of money, future cash flows \nhave increasingly shrinking present values\n3. Focusing not on forecasting a single, exact number for each of the \ndrivers but rather on developing a sensible best- and worst-case \nscenario for each one\nLet’s first look at shortcut number one: breaking up the economic \nlife of a company into stages. It is not rocket science—the stages are short, \nmedium, and long term. In the short term (0–3 or 5 years, let’s say), we \nhave a pretty easy time of thinking about how revenues, profitability, and \ninvestment levels are likely to change, so we can model the cash flows in \nthis stage explicitly. For this reason, I call this the explicit forecast stage.\nIn the medium term (from the end of the short-term period to a point \nin time 5 or 10 years in the future for most companies), we would have a \nmuch more difficult time of forecasting explicit cash flows, so we dodge \nthe difficulty by using a shortcut. We can see what investments are avail-\nable to the company at present—whether the firm is supply- or demand-\nconstrained—and what the company’s track record has been regarding the \noutcomes of its past investments. Based on this analysis, we can say, “Con-\nsidering the investment environment and management’s skill in investing \nin the past, this firm’s cash flows should be able to grow at an average rate \nof x percent during this period. ” Because this medium-term stage relies on \nthe success of present investments, I call this the investment stage . Note, \nthough, that mature companies—those that are already constrained by \nstructural factors—will not, by definition, be able to grow any faster than \nthe economy, no matter what investments they make. As such, for a mature \nfirm in a mature industry, the investment stage usually does not have to be \nconsidered. The one case where it does is when a mature firm continues to \ninvest in value-destructive projects. In this case, rather than factoring in \nabove-normal growth, we should factor in below-normal growth because \nthe owner’s cash profit is eaten up by poor investments.\n1\n94  •   The Intelligent Option Investor\nIn the long term (anything after the investment valuation stage), \nwe know that a company will become constrained by structural factors \nand will, on average, only be able to grow as fast as the economy at large. \nBecause of the structural constraints on growth, I call this the structural \ngrowth stage.\nPulling all these stages together in graphic format is instructive, and \non careful inspection, we can also see something important about the \nsecond shortcut regarding the time value of money:\n1,600\n1,400\n1,200\n1,000\n800\n600\n400\n200\n05 10 15 20 25 30\nYears in th", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 30}
{"text": "ble to grow as fast as the economy at large. \nBecause of the structural constraints on growth, I call this the structural \ngrowth stage.\nPulling all these stages together in graphic format is instructive, and \non careful inspection, we can also see something important about the \nsecond shortcut regarding the time value of money:\n1,600\n1,400\n1,200\n1,000\n800\n600\n400\n200\n05 10 15 20 25 30\nYears in the Future\nCash Flows\n35 40 45 50\n-\nNominal Cash Flow Cumulative DCF\nThis diagram shows the nominal amount of cash flow generated by the \ncompany over a period of 50 years—represented by the solid line—overlain \nby its discounted value—represented by the dashed line. The explicit fore-\ncast stage is from zero to five years, the investment stage picks up after that \nand lasts five years, and the structural growth stage begins after that. Y ou \nwill notice that the dashed line starts to level off at a figure of around $1,200. \nThe point at which that line levels off represents the total discounted value \nof those cash flows and, by extension, the value of this firm.\nThe explicit forecast stage assumes that cash-flow growth will vary up \nand down because of various competitive pressures that we have forecast \nbased on our understanding of the business environment. In this diagram, \nThe Four Drivers of Value  •  95\nthe value of the discounted cash flows generated during the explicit fore-\ncast stage makes up 39 percent of the total value of the firm.\nDuring the investment stage, we have assumed that the company’s \ninvestments will be very successful and allow the firm to generate a growth \nin cash flows of 15 percent per year (suggesting that this is a company with a \nlarge number of high-quality investment possibilities). An assumption of a \nconstant-percentage rate of growth implies that the resulting line will be an \nexponential curve, and indeed, we can see that exponential curve between \nthe 5- and 10-year marks. In this example—assuming this quick 15 percent \nper year rate of growth—the sum of discounted cash flows generated during \nthe investment stage makes up 23 percent of the total value of the firm.\nThe structural growth stage—covering years 11 onto forever—assumes \nthat investment opportunities will dry up for the firm as it hits structurally \nbased demand constraints and that cash flows from that point forward will \ngrow at 5 percent per year. We are again assuming a constant-percentage \ngrowth per year that again will generate an exponential curve—this is the \nsolid line starting after year 5 and continuing upward through year 50. Note, \nthough, that the slope of the solid line during the structural growth stage is \nsubtly shallower than the slope of the solid line during the investment stage. \nThis subtle change of slope represents a pretty big slowdown from an average \ngrowth rate of 15 percent per year to only 5 percent per year. All in all, the \ndiscounted cash flows generated during the structural growth stage make up \nthe remaining 38 percent of total value of this example firm.\nNote how small a percentage of overall value cash flows generated \nduring the explicit forecast stage represents—only 39 percent of the total. \nThis obviously implies that more than three-fifths of the value of this stock is \nbased on the cash flows generated in the investment and structural growth \nstages. The sadly amusing fact about almost all the target prices published \nby sell-side research companies (such as the big brokerage houses), the \nfair-value estimates published by third-party research companies, and the \ninvestment valuations used by buy-side companies (such as hedge and \nmutual funds) is that they are generated by analysts who spend the vast \nmajority of their analytical energy on estimating only the explicit stage of \nthe forecast—which proportionally makes up the least amount of value of a \ngoing concern—and only a tiny sliver of their time and energy on the most \nimportant, weightiest component of the forecast—future growth rates.\n96  •   The Intelligent Option Investor\nThe best thing that we as intelligent investors can do is to understand \nthe effect of medium- and long-term growth rates on the value of compa-\nnies (this makes us less susceptible to being swayed by short-term, nonma-\nterial developments such as the delayed launch of a product line or the like) \nand to attempt to rationally analyze the amount of cash flows likely to be \ngenerated along all three of the stages.\nThe final shortcut we use to improve the quality of our valuations is \nto not make the mistake of false precision and try to forecast one “right” \nnumber for each of the valuation drivers but rather to develop an idea of \nwhat the best- and worst-case scenarios are for each of the drivers. There \nare some very compelling benefits to taking this tact that I will discuss in \ngreater detail in Chapter 6 on behavioral biases and later when we talk \nabout finding option investments in Chapter 7. In the end, what we should \nbe looking to develop is a series of ranges for our drivers in the first two \nstages\n2 that looks something like this:\nExplicit Forecast Stage\nBest Case Worst Case\nRevenues 8% 5%\nProfits 18% 12 % \nInvestment Level 30% of OCP 45% of OCP\nInvestment Stage\nBest Case Worst Case Duration\nGrowth of cash flows 15% 8% 10 years\nOne last thing to note is that although the number of drivers we need \nto consider and forecast is few, we really need to understand what makes \neach of these drivers vary. In Chapter 6, I will address the idea of anchoring \nmore, but in short, it is the assumption that the next number in a series will \nbe close to the last number in that series. This assumption is not necessarily \ntrue and can, in fact, be dangerously false. For instance, just because a firm \nhas expanded revenues at an average annual percentage rate of 37 percent \nover the past few years does not mean that the next yearly increase needs \nto be 35, 30, or 25 percent or even positive.\n3\nThe Four Drivers of Value  •  97", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 31}
{"text": "ies will \nbe close to the last number in that series. This assumption is not necessarily \ntrue and can, in fact, be dangerously false. For instance, just because a firm \nhas expanded revenues at an average annual percentage rate of 37 percent \nover the past few years does not mean that the next yearly increase needs \nto be 35, 30, or 25 percent or even positive.\n3\nThe Four Drivers of Value  •  97\nSo making projections for each of the drivers should never be just a pro-\ncess of simply extrapolating past results. Making projections for each driver \nmeans really understanding what factors are influencing that driver and how \nthose factors are likely to change in the future. Although this process of under-\nstanding the underlying factors and projecting driver values into the future is \nnot as difficult or complex as neurosurgery or designing a manned spacecraft \nto Mars, it does require some creativity, insight, thought, and patience.\nFor an actual, specific example of a valuation done using this \nmethodology, please see the detailed valuation example of Oracle posted \non the Intelligent Option Investor (IOI) website www.IntelligentOptionInvestor \n.com. A general explanation of the valuation drivers, along with a few high-\nlevel examples, follows.\nA Detailed Look at the Drivers of Value\nNow that we have an idea of where we are going in our valuation process, \nlet us take a look at each of the valuation drivers one by one.\nRevenue Growth\nRevenue growth is the first determinant of value for a company—if rev-\nenues are not coming in, it is obvious that cash will not flow to the com-\npany’s owners. Organic revenue growth (i.e., that which does not come \nfrom acquiring another company) can come from\n1. Increased volume of sales (selling more stuff)\n2. Increased value of sales (selling stuff for more)\nAt the heart of understanding a company’s revenues and forecasting \nthe future growth rate of its revenues is understanding what the company \nis selling and to whom it is selling its product(s). The business model for \na company such as Bentley that is selling $300,000 Mulsannes that we re-\njected for our taxi-cab company in Chapter 4 is going to be very different \nfrom that of the $30,000 Camry-selling Toyota. \nToyota has very little ability to raise prices—that is, to sell its stuff for \nmore money—so it must sell more stuff. Bentley, on the other hand, has \nenormous pricing power—its customers are more sensitive to the image \n98  •   The Intelligent Option Investor\nthat the possession of a Bentley conveys to them than they are to the mon-\netary cost of possession—and one of the ways Bentley maintains that pric-\ning power is by restricting its production—selling less stuff, in other words. \nUnderstanding the interplay between selling more stuff and selling stuff for \nmore is essential to understanding the first driver of value to a firm.\nSome people—experienced analysts included—tend to look at rev-\nenues as year-over-year percent changes and simply extrapolate the recent \npercentage growth into the future. This is a big mistake and can be a very \nexpensive one. Companies that are at the transition between the supply-\nconstrained early growth period and the demand-constrained investment-\nbased growth period can sometimes see some very rapid slowdowns in \nrevenue growth from one year to the next. If you are trying to value a com-\npany as though its revenue stream will continue forever (or for a long time) \nor as though it were a supply-constrained startup—which is basically what \npeople do when they extrapolate recent growth rate numbers too far into \nthe future—you will estimate the value of the company as being too great. \nLikewise, when a company whose business tends to move with the business \ncycle—like a steel producer—is in a cyclic trough, and you assume that its \nbusiness is going to keep growing at low rates or even shrinking far into \nthe future, you will generate too low an estimate for the value of the firm.\nRather than extrapolating, really understanding the dynamics of the \nbusiness is crucial. Most Wall Street analysts spend proportionally less of their \ntime trying to figure out revenues than they do profit. In contrast, I usually \nsuggest that people try to spend more time getting a very firm grasp of how \na firm generates revenues. Who is buying the company’s products or services \nand why are they buying those products or services rather than another’s? \nAre customers using credit to buy the company’s products or services? And if \nso, how tenuous is that line of credit? How many of the company’s products \nmight people need or want and how often would they be willing to buy them? \nThese are all essential questions to answer, and once you have a good idea \nabout them, you will have gone a long way to understanding the value of the \ncompany in which you are considering taking an ownership stake.\nProfit generation, while undeniably an important factor, is for most \ncompanies, an almost mechanical process that is largely dependent upon \nthe amount of revenues flowing into the firm. I will discuss why most of \nthe market focuses so much on profitability in the next section, but readers \nThe Four Drivers of Value  •  99\nwho are interested in seeing what parts of a financial statement I believe are \nthe most important to dig into when analyzing revenues, please consult the \nvaluation example on the IOI website. \nProfitability\nThink back to our taxi-cab example in Chapter 4. After the first year of op-\neration, our transportation entrepreneur had $5,000 in her bank account. \nShe was planning to set $1,000 aside for a down payment on a new taxi in \na few years’ time, after her present car had used up its economic life; this \nwould give her a total of $4,000 that she could decide how to spend—either \non a Caribbean cruise or on a new computerized ordering system.\nIn this example, profitability means this $4,000 amount that we are \ncalling owner’s cash profit.\nAs I mentioned earlier, most sell", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 32}
{"text": "$1,000 aside for a down payment on a new taxi in \na few years’ time, after her present car had used up its economic life; this \nwould give her a total of $4,000 that she could decide how to spend—either \non a Caribbean cruise or on a new computerized ordering system.\nIn this example, profitability means this $4,000 amount that we are \ncalling owner’s cash profit.\nAs I mentioned earlier, most sell-side analysts and market specula-\ntors spend their time trying to forecast profitability. Usually, the profitabil-\nity they are trying to predict is an accounting line item such as earnings per \nshare (EPS), earnings before interest and taxes (EBIT), or earnings before \ninterest, taxes, depreciation, and amortization (EBITDA). The reason for \nthis is simple: most sell-side analysts’ target prices (and more than a few \nbuy-side investment strategies) are generated by multiplying one of these \nquantities by some market multiple. For example, an analyst might say that \nthe target price of ABC = 7.8 × EBITDA = $27.50 per share.\nThere are three main reasons why using multiples analysis to value a \ncompany should be used with circumspection. \nFirst and foremost, there is no law of nature saying that a stock price has \nto be a certain multiple of some financial statement line item. Just because \nother companies in a given industry are trading between 7.5 and 8.5 times \nEBITDA doesn’t mean that they can’t trade for higher or lower, nor does it \nmean that another company has to trade within that range either. \nSecond, the financial statement quantities mentioned (EPS, EBIT, \nand EBITDA) can all vary fairly substantially because of various account-\ning technicalities and other measures that do not have a material impact on \nthe firm’s long-term value. \nLast but not least, multiples imply future profitability growth rates, \nbut simultaneously make these implied growth rates much less meaningful. \n100  •   The Intelligent Option Investor\nTo illustrate this point, consider the following question: Which of the fol-\nlowing predictions seems more transparent and testable? \n1. I forecast this company’s medium-term cash flows will grow at an \naverage of 10 percent per year for five years followed by GDP-like \ngrowth afterward.\n2. I forecast this company is worth 23.5 times next year’s EPS estimates. \nClearly, the former is preferable, since by specifying the growth rates, \nyou are forced to think of how that growth might be achieved. The latter \ngives no hint of growth rates, so in effect detaches the value of the company \nfrom the operational details of the firm.\nThere are a few reasons why Wall Street analysts love to publish \nmultiples-based target prices that I will discuss in Chapter 6 when I introduce \nstructural impediments. For the time being, just realize that what is good for \nan investment banker or equity sales trader is rarely good for an investor.\nDiscounting the efficacy and transparency of market multiples-based \nvaluation is not the same as saying that profitability is not important—of \ncourse it is. However, profitability is, to a surprisingly large extent, gov-\nerned by structural factors and profit margins tend to be quite similar be-\ntween companies in the same industry. For many companies, this makes \nestimating best- and worst-case profit margins fairly easy. \nFor example, the grocery business is one in which a supermarket buys \nan item at a low price and sells it at a higher price. Because the items it sells \nare basically identical to the items sold at competitors’ stores, and because \nthere are numerous competitors serving essentially the same customer base \nin the same area, it is impossible for the supermarket to raise its prices very \nmuch or for very long before customers start switching to another store. \nBecause of these industry dynamics, the range over which grocery chain \nprofitability varies is quite narrow. We can see an illustration of this in the \nfollowing table of three large-capitalization pure-play grocery stores:\nCompany (Ticker) Market Cap Avg. 3-year OCP Margin\nKroger (KR) $23.9 B 1.5%\nWhole Foods Mkt (WFM) $14.1 B 4.9%\nSafeway (SWY) $7.9 B 1.4%\nData courtesy of YCharts.com\nThe Four Drivers of Value  •  101\nHere we see that even the fancy Whole Foods Market, which, in terms \nof grocery stores operates on a sell-stuff-for-more model, is still generat-\ning OCP margins (i.e., OCP divided by revenues) of less than 5 percent. \nKroger and Safeway—two supermarkets operating on a sell-more-stuff \nmodel—have virtually identical profit margins.\nOf course, not all businesses are as stable and predictable as grocery \nstores. There are four effects that can alter the profitability of a company: \noperational leverage, demand changes, environmental factors, and \nefficiency increases.\nThe single most important factor affecting the ability to predict \nprofitability at a firm is something called operating leverage. I describe this \nfactor in Appendix B and go into detail about how to estimate the effects of \noperating leverage in the example valuation posted on the Intelligent Option \nInvestor website. The takeaway from this material is that for companies with a \nhigh degree of operating leverage, the amount of revenues coming in will huge-\nly influence profitability. This dependence of profits on revenues provides a \nprospective investor in a company with high operational leverage more reason \nto understand the demand environment and how a firm generates revenues.\nOf course, if there are changes in the demand environment that cause \nconsumers’ preferences to change away from the product a company is \nproviding and toward another that it is not (e.g., consumers preferring \nelectronic tablets made by Apple over PCs made by Dell), or changes in \nthe supply environment that causes a company’s capital base to be too large \n(e.g., American car companies’ factories having too much capacity after the \nU.S. car market saturated in the early 1980s), profit margins are not likely to \nsettle int", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 33}
{"text": "mpany is \nproviding and toward another that it is not (e.g., consumers preferring \nelectronic tablets made by Apple over PCs made by Dell), or changes in \nthe supply environment that causes a company’s capital base to be too large \n(e.g., American car companies’ factories having too much capacity after the \nU.S. car market saturated in the early 1980s), profit margins are not likely to \nsettle into an historical range but may materially increase (e.g., Apple, after \nthe release of iPads, iPhones, and so on) or decrease (e.g., Dell, after Apple’s \nrelease of iPads, iPhones, and so on). Being able to correctly forecast this \ntype of secular shift is difficult, but can be extremely profitable.\nIn addition to these factors, there can be rapid drops and rises in \nprofitability caused by changes in the economic environment. These might \nbe company-specific events, such as a natural disaster destroying a supply \nof inventory, or economy-wide conditions, such as loose monetary policy \nencouraging consumers to use debt to make more purchases. While these \nkind of factors can have a large short-term effect on profitability, averaged \nover a longer time frame of a few years, most businesses’ profit margins end \nup returning to a fairly dependable range.\n102  •   The Intelligent Option Investor\nAnother case in which the normal profit range of a company may \nchange is through improvements in productivity. And although improve-\nments to productivity can take a long time to play out, they can be ex-\ntremely important. The reason for this is that even if a company is in a \nstage in which revenues do not grow very quickly, if profit margins are in-\ncreasing, profit that can flow to the owner(s) will grow at a faster rate than \nrevenues. Y ou can see this very clearly in the following table:\nYear 0 1 2 3 4 5 6 7 8 9 10\nRevenues \n($)\n1,234 1,271 1,309 1,348 1,389 1,431 1,473 1,518 1,563 1,610 1,658\nRevenue \ngrowth (%)\n— 3 3 3 3 3 3 3 3 3 3\nOCP ($) \n4 432 445 497 485 514 544 560 637 625 708 746\nOCP \nmargin (%)\n35 35 38 36 37 38 38 42 40 44 45\nOCP \ngrowth \nrate (%)\n— 3 12 –2 6 6 3 14 –2 13 5\nEven though revenues grew by a constant 3 percent per year over this \ntime, OCP margin (owner’s cash profit/revenues) increased from 35 to \n45 percent, and the compound annual growth in OCP was nearly twice \nthat of revenue growth—at 6 percent.\nThinking back to the earlier discussion of the life cycle of a company, \nrecall that the rate at which a company’s cash flows grew was a very important \ndeterminant of the value of the firm. The dynamic of a company with a rela-\ntively slow-growing revenue line and an increasing profit margin is common. \nA typical scenario is that a company whose revenues have been increasing \nquickly may be more focused on meeting demand by any means possible rath-\ner than in the most efficient way. As revenue growth slows, attention starts to \nturn to increasing the efficiency of the production processes. As that efficiency \nincreases, so does the profit margin. As the profit margin increases, as long as \nthe revenue line has some positive growth, profit growth will be even faster. \nThis dynamic is worth keeping in mind when analyzing companies \nand in the next section, where I discuss the next driver of company value—\ninvestment level and efficacy.\nThe Four Drivers of Value  •  103\nInvesting Level and Efficacy\nAfter our taxi company owner generated profits, she had to figure out if she \nwas going to invest those profits or spend them, and if she invested them, \nshe had to figure out what investment project was best. Listed companies \nalso face the same process and choices. Managers are responsible for in-\nvesting owners’ cash profits with the aim of generating greater profits in \nthe future or for returning owners’ cash profits to the owners via dividends. \nBecause modern companies are so large and have so many shareholders, \nmost owners not only do not take an active role in shaping the investments of \ntheir company, but they also don’t even realize that the investment process is \ntaking place.\n5 In this environment, there are unfortunately many instances in \nwhich the owners’ cash profits are invested badly or otherwise squandered on \nwasteful projects. Ford paying top dollar to buy a decrepit Jaguar springs to \nmind, as does Time Warner’s miserable purchase of AOL at the very peak of the \ntech bubble. But these egregious examples are certainly just the tip of the ice-\nberg. Companies routinely make implicit capital spending decisions by refus-\ning to close down an underperforming or obsolete business, thereby robbing \nowners of cash flows that should have been theirs and instead filling the wallets \nof consultants and employees.\n6 Or the managers, realizing that their mature \ncore business throws off an enormous amount of cash, decide to spend some \nof that cash on acquisitions of dubious economic benefit to the owners.\n7 Luck-\nily, managers can always find an investment banker or two who are ready to \ntalk about the numerous “synergies” that will no doubt someday come to pass, \nand too often boards and shareholders blithely accept the decisions and, once \nmade, do not demand an accounting of owner benefits as a result of the union. \nUsing an intelligent option investing framework, however, these here-\ntofore hidden investment programs and their success or failure can be seen \nmuch more clearly. First, we must see how much of the owners’ cash profits \nfor the company were spent on investing projects and forecast the amount that \nwill likely be invested in the future. The online valuation example provides an \nactual look at precisely what financial line items go into this calculation. Right \nnow, it is enough to frame the term investments as any cash outflows on capital \nprojects that the company is making over and above the cash outflows neces-\nsary to maintain the business as a going concern. Recall that in Chapter 4, I \ncalled this spending expansionary cash flows because they are designed", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 34}
{"text": "vides an \nactual look at precisely what financial line items go into this calculation. Right \nnow, it is enough to frame the term investments as any cash outflows on capital \nprojects that the company is making over and above the cash outflows neces-\nsary to maintain the business as a going concern. Recall that in Chapter 4, I \ncalled this spending expansionary cash flows because they are designed to \ngenerate faster profit growth in the future. \n104  •   The Intelligent Option Investor\nThe phrase faster profit growth should prompt the question, “Faster \nthan what?” It is at this point that we think back to the discussion of the \nlife cycle of a company. After a company has cleared its supply-side con-\nstraints, and after it has done all it can to increase profits in an environment \nof demand-side constraints, it bumps up against structural constraints . \nStructural constraints represent the long-run “speed limit” for the growth \nof a firm. Because there is a speed limit for a firm in the long run, it is \nlogical that during the investment stage of a company’s life we compare the \ninvestment-boosted growth with that structural speed limit.\nThe ultimate structural speed limit, as discussed earlier, is the nomi-\nnal growth in U.S. gross domestic product (GDP). In this case, nominal \nmeans the GDP growth that includes the effect of inflation as well as the \nincrease in economic activity. A graph of this nominal increase in GDP \nfrom the postwar period follows:\n3/1/1947\n100\n1,000\n10,000\nNominal U.S. GDP (Billions of USD)\nMarch 1997–September 2013\nU.S. GDP (Logarithmic Scale)\n3/1/1957 3/1/1967 3/1/1977 3/1/1987 3/1/1997 3/1/2007\nNote that I have displayed this on a logarithmic axis to show how \nconsistent growth has been. The line representing U.S. nominal GDP \nswings above or below the straight trend line but seems to swing back \ntoward the line eventually. \nThe Four Drivers of Value  •  105\nOver this very long period, the nominal GDP growth in the United \nStates averaged just over 6 percent per year. If the investment projects \nof a company are generally successful, the company will be able to \ndependably grow its profits at a rate faster than this 6 percent (or so) \nbenchmark. The length of time it will be able to grow faster than this \nbenchmark will depend on various factors related to the competitive-\nness of the industry, the demand environment, and the investing skill \nof its managers.\nSeeing whether or not investments have been successful over time is \na simple matter of comparing OCP growth with nominal GDP . Let’s look at \na few actual examples. Here is a graph of my calculation of Walmart’s OCP \nand OCP margin over the last 13 years:\n2000 2005 2010\n0.00%\n0.50%\n1.00%\n1.50%\n2.00%\n2.50%\n3.00%\n3.50%\n4.00%\n4.50%\n5.00%20,000\n18,000\n16,000\n14,000\n12,000\n10,000\n8,000\n6,000\n4,000\n2,000\n-\nEstimated Owners’ Cash Profit and OCP Margin for Walmart\nTotal Estimated OCP (LH) OCP Margin (RH)\nAs one might expect with such a large, mature firm, OCP margin \n(shown on the right-hand axis) is very steady—barely breaking from the \n3.5 to 4.5 percent range over the last 10 years. At the same time, its to-\ntal OCP (shown on the left-hand axis) grew nicely as a result of increases \nin revenues. Over the last seven years, Walmart has spent an average of \naround 2 percent of its revenues on expansionary projects, implying that \n106  •   The Intelligent Option Investor\ncash flow left for shareholders amounted to about $0.02 (≈ $0.045 – $0.02) \non every dollar, on average. How efficacious were these investments?\nIn the graph below, any point above the “0 ppt” horizontal axis \nindicates that Walmart’s year-over-year OCP growth has exceeded the \nU.S. GDP by that amount, and vice versa. The year-over-year OCP growth \nstatistics are fairly noisy, bouncing back and forth above and below growth \nin GDP; however, looking at a five-year compound annual growth rate \n(CAGR) tells the same story as the linear trend line on the chart: Walmart’s \ngrowth has slowed significantly and now looks to be close to that of the \neconomy at large on average. The rise in Walmart’s fiscal 2010 result (which \ncorresponds with calendar year 2009) is more a function of the company’s \nrevenues remaining resilient despite a U.S. recession than its growth out-\npacing a growing U.S. economy.\n40 ppt\n30 ppt\n20 ppt\n10 ppt\n0 ppt\n-10 ppt\n-20 ppt\n-30 ppt\n2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013\nGrowth in Walmart’s OCP Over (Below) Nominal GDP\nReal Growth in OCP Linear (Real Growth in OCP)\nTo the credit of Walmart’s management, the company has spent in-\ncreasingly smaller proportions of revenues on expansionary projects over \nthe last few years, perhaps in recognition that its expansionary projects \nwere bringing in less bang for the buck over time.\nIn contrast, let’s take a look at a firm whose investments seem to \nbe adding considerable value—Oracle. First, let’s take a look at its OCP \nmargin:\nThe Four Drivers of Value  •  107\n35%\n40%\n30%\n25%\n20%\n15%\n10%\n5%\n0%\nEstimated OCP Margin for Oracle\n2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013\nOther than the disastrous year of the tech bust in 2001, the company’s \nOCP margin has held fairly steadily in the 30 percent range, but recently \nit has started to move toward the 35 percent level. Over the last five years, \nthe company’s expansionary spending has averaged around 15 percent of \nrevenues per year, mainly through acquisitions. Because the expansionary \nspending is governed by its acquisitions, its investments are not uniform, \nand looking at the 2005–2008 period, the company was spending roughly \nhalf its revenues on expansion. Over this time period, how has Oracle’s \nOCP growth been vis-à-vis GDP? Let’s take a look: \n50 ppt\n60 ppt\n40 ppt\n30 ppt\n20 ppt\n10 ppt\n0 ppt\n-10 ppt\n-20 ppt\nGrowth in Oracle’s OCP Above (Below) Nominal GDP\n2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013\nReal Growth in OCP Linear (Real Growth in OCP)\n108  •   The Intelligen", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 35}
{"text": "he company was spending roughly \nhalf its revenues on expansion. Over this time period, how has Oracle’s \nOCP growth been vis-à-vis GDP? Let’s take a look: \n50 ppt\n60 ppt\n40 ppt\n30 ppt\n20 ppt\n10 ppt\n0 ppt\n-10 ppt\n-20 ppt\nGrowth in Oracle’s OCP Above (Below) Nominal GDP\n2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013\nReal Growth in OCP Linear (Real Growth in OCP)\n108  •   The Intelligent Option Investor\nIn contrast with Walmart, through this lens, we see that Oracle’s \ninvestments have generally allowed its OCP to grow at a much faster \nrate than the economy at large (2010 was the year Oracle acquired Sun \nMicrosystems, and the OCP that year is an artifact of that acquisition— \nI believe that its OCP that year was actually higher than stated here).\nThe beauty of this way of looking at companies is that the hidden or \nimplicit investments a company is making will show up in this as well. I \nbelieve that, like many large companies, Walmart is finding that it must \nspend money on expansion because it is investing ineffectually through its \ninternal business processes. One percent of revenues worth of expansionary \ncash flows per year—roughly 25 percent of owners’ cash profits—is be-\ning spent so that the company can basically keep up with growth of the \neconomy at large.\nThis discussion deals with investment efficacy. Investments—\nespecially in the corporate environment, where one company completely \ntakes control of another and must integrate the acquiree into its own \nbusiness systems and culture—take time for results to be visible. As such, \nit is easy to see why the table at the start of this section showed investment \nefficacy affecting the medium-term results of the company—its growth \nrates in particular.\nUnderstanding the interaction among these three drivers—revenue \ngrowth, profitability, and investing efficacy—allows an investor to take the \nbiggest step toward valuing a stock. Occasionally, though, one must take \nwhat I call balance-sheet effects into consideration.\nBalance-Sheet Effects\nLet’s think back to our taxi-cab service. Let’s say that our owner decided \nthat after the first year, the investment prospects for her firm were so good \nthat she would buy two new cars. She thought that she could save money \nby buying two low-mileage, off-lease cars rather than new ones.\nBefore putting the cars into service, she cleans each of the cars \nthoroughly. While cleaning out the trunk of the first car, she finds a \ntightly wrapped brown paper package. Curious, she opens the package \nto find a pound of illegal drugs. She calls the police, who come to \nThe Four Drivers of Value  •  109\ninvestigate. After looking over the situation, the police impound the \ncar, telling our taxi entrepreneur that they had no estimate for when it \nwould be returned.\nThe value of our taxi-cab company suddenly drops. Without the \nuse of the car, there is no way for it to generate revenues. However, while \nrevenues are not coming in, the company is still incurring costs (financing \nand insurance costs, in particular), so the new car is actually lowering the \ncash flow available to the owner. In the parlance of accounting experts, the \ncompany has experienced a nonoperational contingency that has resulted \nin a devaluation of one of its assets. This is a value-destroying balance-\nsheet effect.\nThe taxi company owner, upset with the turn of events and her bad luck \nin picking automobiles, grumbles as she gets back to work cleaning out the \nsecond car. Cleaning between the back seats, she finds a valid lottery ticket \nthat was forgotten by the previous owner. Expecting a couple bucks worth \nof winnings, she checks the number and is more than overjoyed to find that \nshe is holding the winning ticket for a $500,000 prize! The disappointment \nfrom the police impounding her other car melts away as she realizes this \nlittle slip of paper represents 125 years’ worth (+$500,000/$4,000) of her \ncompany’s first-year OCP . This is one heck of a positive balance-sheet \neffect.\nThe base assumption we make when we analyze a company is that all \nthe assets on the balance sheet are operating assets—that they are being \nfully exploited to generate cash flows on behalf of owner(s). However, this \nis sometimes not a valid assumption to make. Sometimes the true value of \nassets can be hidden and remain hidden for some time. \nOn the hidden-asset side, one of the biggest jobs of the class of \ninstitutional investors known as activist investors is to dig into the operating \ndetails of a company to find assets that the company is not fully using or \nis using so badly that the company is not able to create maximum cash \nflows. Usually, the activist investor is looking to throw out the current \nmanagement team and replace it with people he or she thinks can better \nuse the assets. This is termed a hostile takeover , but it is important to \nremember that the term hostile is only valid from the perspective of the \ntarget’s management team. An insightful activist investor with patience, \n110  •   The Intelligent Option Investor\nforesight, and enough board seats to push through a change can be an \nenormous boon to investors in the company.\nIn the same way that there are hidden assets, there also can be \nhidden liabilities. Enron’s complex transactions with its “special-\npurpose vehicles” are a vivid example of how dangerous hidden liabilities \ncan be. Enron managers found ways to effectively channel financial \ntransactions and obligations that they did not want on Enron’s own \nbooks (namely, losses and liabilities) onto the books of off-shore entities. \nEven though the off-shore entities were established and controlled by \nEnron’s management, they were not consolidated into Enron’s own \nfinancial statements, so the transactions and obligations effectively \ndisappeared from most investors’ view. Several investor groups started \nputting two and two together and realized that the answer was less than \nfour. Eventually, when the spec", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 36}
{"text": "shore entities. \nEven though the off-shore entities were established and controlled by \nEnron’s management, they were not consolidated into Enron’s own \nfinancial statements, so the transactions and obligations effectively \ndisappeared from most investors’ view. Several investor groups started \nputting two and two together and realized that the answer was less than \nfour. Eventually, when the special-purpose vehicles became known by \nthe investment community, it was obvious that there was much less \nequity for investors to own than they had thought previously, and the \nstock price plummeted. \nWhereas hidden assets can be thought of as a winning lottery ticket \nstuck in between the seats of a used car, an old colleague of mine in the \nhedge fund world used to call hidden liabilities “snakes sleeping in a \nbasket. ” Usually, it takes some time and familiarity with a company or \nindustry to understand where these lottery tickets or snakes may reside, \nbut most companies have them to a greater or lesser extent. Mostly, these \nhidden items are not material to valuation and thus can be ignored, but \nwhen they are not material, they can be truly powerful influences on \nvaluation.\nIt is impossible to explain precisely where to look for these hidden \nitems, but there are a few places one can typically start looking:\nLottery Tickets\n1. Real estate carried at historical cost\n2. Intellectual property (e.g., patents, copyrighted material, etc.)\n3. Government connections (not as important in developed markets \nbut could be vitally important in certain emerging markets)\n4. Overfunded pensions\nThe Four Drivers of Value  •  111\nSnakes\n1. Latent product/accident liability claims (e.g., asbestos, pollution \nremediation, etc.)\n2. Manager malfeasance (e.g., price fixing, Foreign Corrupt Practices \nAct noncompliance, etc.)\n3. Underfunded pensions\n4. Off-balance-sheet corruption\n5. Fraud\nIt’s usually hard to find these, but if you do, you should try to make an \nassumption about the best- and worst-case financial impacts of these items \nand simply tack that onto whatever cash-flow projections you have made.\nTying It All Together\nThroughout our analysis of a company’s valuation drivers, our focus as \ninvestors should always be to estimate the free cash flow to owners that a \nfirm will likely generate. \nIn the short-term, FCFO is driven by how fast revenues are growing, \nhow efficiently the company is converting those revenues to profits, and \nhow much of the profits the firm is spending on expansionary projects. \nIn the medium-term, FCFO is driven by how effective the investments \nthe firm made in the preceding period are likely to be. \nIn the long-term FCFO is driven by structural constraints because a \nfirm cannot grow faster than the economy at large. \nEach driver has both best- and worst-case projections, so pooling all \nthe best-case projections into a best-case FCFO scenario and all the worst-\ncase projections into a worst-case FCFO scenario gives us an idea of the \nmost and least cash flow that the firm will generate for us in the future \n(you can see an example of this on the Intelligent Option Investor website). \nDiscounting those FCFO scenarios generates a present value range for the \ncompany. If we can find any balance-sheet effects, we add or deduct those \neffects from the value found from discounting the FCFO scenarios. This is \nthe final valuation range of the company that we can compare to the market \nprice of the stock. When the valuation range of a company and the price of \na stock differ by a great amount, we have an opportunity to invest profitably.\n112  •   The Intelligent Option Investor\nAdvanced Building Corp. (ABC)\n5/18/2012 5/20/2013 249 499 749 999\nWorst Case, 45\nBest Case, 70\n80\n60\n40\n20\n-\nDate/Day Count\nStock Price\nThese are the general principles of intelligent investing, but again, the \nreader is invited to work through the detailed valuation example on the IOI \nwebsite to help bring these general principles to life.\nThe preceding chapter on understanding the golden rule of valuation \nand this chapter on recognizing the valuation drivers are a great step to-\nward building what Warren Buffett called a “sound framework for making \n[investment] decisions. ” \nThe one thing that I hope you have realized while reading this and the \npreceding chapter is what a simple and commonsense process valuation is. \nIt is worth asking why—if rational valuation is such a simple process—do \npeople generally have such a very difficult time investing and run into so \nmany pitfalls.\nTo understand this, I now turn to an explanation of the behavioral \nbiases and structural impediments that trip investors up and make sugges-\ntions on how to avoid them.\n113\nChapter 6\nunderstanding \nand overcoming \ninvesting pitfalls\nYou have seen that valuation is not a difficult thing. It requires \nunderstanding of a few key relationships, but it is basically a straightforward \nprocess most of the time.\nWhy then, do so many investors have such a hard time doing it well?\nThe main reason, I am sorry to say, is our nature as human beings and \nthe weaknesses of our nature. This chapter discusses two facets of that—be-\nhavioral biases and structural impediments. The first facet—behavioral bi-\nases—involves how we as human beings try to figure out complex things and \nget caught in the process of doing so. The second facet—structural impedi-\nments—speaks about how we investors tend to buy—lock, stock, and bar-\nrel—into a game designed only for us to lose, whereas the winners’ kids go to \n$50,000-a-year prep schools followed by a four-year tour of the Ivy Leagues.\nThere is hope. Don’t despair. The first step to not falling for these \npitfalls is simply to understand that they exist. \nObviously, being an intelligent option investor means investing \nintelligently, minimizing—as much as possible—the effects of irrational and \nemotional decision making. This chapter is designed to help you do just that. \nJargon introduced in this chapter", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 37}
{"text": "our of the Ivy Leagues.\nThere is hope. Don’t despair. The first step to not falling for these \npitfalls is simply to understand that they exist. \nObviously, being an intelligent option investor means investing \nintelligently, minimizing—as much as possible—the effects of irrational and \nemotional decision making. This chapter is designed to help you do just that. \nJargon introduced in this chapter is as follows:\nX-system Risk neutral\nRisk seeking Risk averse\nC-seeking Prospect theory\n114  •   The Intelligent Option Investor\nBehavioral Biases\nHuman intelligence evolved in an environment that is very different from \nthe one in which we live today. Gone is the necessity to hunt and gather, \nprotect ourselves from predators, and fashion our own shelter. In con-\ntrast, in our modern lives, we are safe from most environmental factors \nbut are instead confronted with massive amounts of data. Groundbreak-\ning photographer Rick Smolan, in his book, The Human Face of Big Data \n(Sausalito, CA: Against All Odds Productions, 2012), contends that a mod-\nern person processes more information in a single day than the typical \nsixteenth-century person processed in an entire lifetime. I am not sure if \nthere is a scientific way of proving such a contention, but it does seem at \nleast plausible.\nIn terms of investing, the mismatch between how our mental processes \nhave evolved and the tasks that we expect them to carry out becomes an \nissue because, by and large, we are still using mental strategies that served \nour Stone Age ancestors well but that serve us investing denizens of the \n“Information Age” much less well.\nThe study of human bias in economic decision making is a big topic—\ncalled behavioral economics or behavioral finance—and it is not possible to \ncover it fully here. I will give a few examples here and suggest how you might \nwork to counteract theses biases in your intelligent investing, but you are \nencouraged to study up on these issues themselves. It is a fascinating topic, \nand the more you learn, the more you will realize how much behavioral \nbiases affect everyone’s decision-making processes.\nHere I will discuss three issues:\n1. Love of symmetry\n2. Confidence and overconfidence\n3. Humans’ kinky perception of risk\nLove of Symmetry\nHere is the chart of an asset that has had a smart 8.3 percent return in just \n50 trading days. Is this thing likely to keep going up from here or fall back \ndown after its relatively rapid rise?\nUnderstanding and Overcoming Investing Pitfalls •  115\n38.50\n38.00\n37.50\n37.00\n36.50\n36.00\n35.50\n35.00\n34.50\n34.00\n33.50\n16 11 16 21 26 31 36 41 46 51\nTrading Days\nPrice per Share\nY ou would be correct if you answered, “Neither of the above. ” This is a \nchart I created using the random-number-generator function in Excel. Be-\ncause Excel recalculates the values on the sheet any time a change is made, \nI could not get the next value in this series—the series changed as soon as \nI asked Excel to calculate the next day’s return.\nI have presented similar series to various groups, including groups \nof traders. It is fascinating to hear the predictions regarding this series and \nthe reasoning behind the predictions. Usually, the crowd settles on an an-\nswer that is acceptable to most people (e.g., “It will probably go higher, but \nI’ d set a stop loss at $37.25 and aggressively buy if it goes down to $35.50”).\n1\nWhy do so many people see patterns where no patterns exist? Why \ndo so many people put their faith in so-called technical analysis (which \nis neither technical nor analysis) even though they are just as likely to be \nsuccessful consulting a Magic 8 Ball for investment advice?\nTo understand this, we need to realize that there are two separate \nhuman mental processes for analyzing and solving problems: X-system and \nC-system. \nThe X-system is in control of refleXive thought processes, and these \nprocesses take place in some very primitive areas of the brain. This system \n116  •   The Intelligent Option Investor\nis extremely good at perceiving patterns and symmetry and can operate \nvery quickly to solve common problems. It is also capable of multitask-\ning. The C-system is in control of refleCtive thought processes, and these \nprocesses take place in parts of the brain associated with higher reasoning. \nThis system works slowly to solve complex problems about which we have \nlimited experience. Its ability to multitask is limited.\nFor an illustration of these two systems, consider this problem: you \nare walking in a house and are confronted with the following object:\nY our X-system recognizes this object as a door, quickly retrieves information \nabout how to use objects of this type from your memory, and directs you \nUnderstanding and Overcoming Investing Pitfalls •  117\nto rotate the metal handle downward to open the door and move into the \nnext room. Y ou can solve this problem extremely quickly, with no conscious \nthought, even while you are doing something else, like speaking with a friend.\nNow let’s say that when you grab the handle and rotate it, rather than \nthe door opening, the handle comes off in your hand. What do you do? Y our \nmind automatically switches from X-system mode to C-system mode, and \nyou begin to solve the problem of the closed door in a logical, systematic way. \nY ou would stop talking to your friend, push the door to see if it will open with-\nout the latch, bend down to take a look at the handle mechanism, and so on.\nThroughout the process of attempting to solve this problem, you \nmay switch back and forth between X-system and C-system processing, \nusing your C-system as the controller and the X-system to check on prior \nsolutions to similar problems you may have faced.\nWith this example, you likely have a good intuitive feel for the char-\nacteristics of the X- and C-systems, but for completeness’s sake, here is a \ngrid describing them:\nX-System C-System\nReflexive Reflective\nGood for recognizing symmetry and \npatterns and for solving commonly", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 38}
{"text": "ng your C-system as the controller and the X-system to check on prior \nsolutions to similar problems you may have faced.\nWith this example, you likely have a good intuitive feel for the char-\nacteristics of the X- and C-systems, but for completeness’s sake, here is a \ngrid describing them:\nX-System C-System\nReflexive Reflective\nGood for recognizing symmetry and \npatterns and for solving commonly \nexperienced problems\nGood for analyzing complex, multistep \nproblems outside previous experience\nOperates quickly Operates slowly\nSeparate processes do not interfere with \none another, allowing for multitasking \nSeparate processes do interfere with one \nanother, making multitasking difficult \nor impossible\nUses amygdala, basal ganglia, and \ntemporal cortex—the areas of the brain \nassociated with “fight or flight,” reward \ntraining, identification of objects, and \nbehavior\nUses anterior cingulate cortex, prefrontal \ncortex, medial temporal lobe, including \nthe hippocampus—the areas of the \nbrain associated with higher-order \nfunctions such as planning and control\nDidactic style: analogy Didactic style: mathematical proof\nPsychologically comfortable and easy Psychologically uncomfortable and difficult\nThe X-system is more psychologically comfortable to us (or to most of us) \nbecause it is the part of the brain we as a species have been using during most of \nour evolutionary history. The pattern-recognition portion of our brain is highly \n118  •   The Intelligent Option Investor\ndeveloped—so much so that even though computers such as Deep Blue can go \ntoe to toe with chess grand masters, no computer has yet been designed that \nwould be able to recognize a fork that is rotated 30 percent off center or a series \nof random items placed in front of it. Even the greatest computer “mind” can-\nnot carry out a pattern-recognition task that is simple even for human infants.\nIn investing, humans tend to lean on this X-system pattern recognition \nand try to use shortcuts to analysis based on it. We have mental models for cer-\ntain kinds of companies, certain kinds of information, and certain situations, \nand we attempt to escape uncomfortable, analytical C-system processing by \nallowing our X-system to match current conditions with those mental models. \nWhen presented with a stimulus (e.g., bad quarterly earnings numbers), \nour tendency is to reflexively react rather than to analyze the information. \nThis tendency is made more visceral because the X-system that is processing \nthis stimulus is tied into the “fight or flight” response. We would rather act \nfirst, even if acting proves to be a detriment rather than a benefit.\nThis is a phenomenally difficult—I think impossible—bias to complete-\nly overcome. Although this bias can be extremely detrimental to us and our \ninvesting process, our highly developed X-system is also incredibly useful to \nus in our daily lives—allowing us to navigate the difficult problems present-\ned by doors, car operation, and so on. I discuss how to recognize and work \naround X-system biases, how to use the X-system when it is useful to do so, \nand how to frame investment decisions using C-system processes in the valu-\nation example of Oracle that can be found on the Intelligent Option Investor \nwebsite. For now, let’s look at another behavioral bias—overconfidence.\nConfidence and Overconfidence\nScientific research has shown that humans do not feel comfortable with \nC-system-style analysis and tend to doubt the results of these processes. As men-\ntioned earlier, C-system processes do not seem intuitive and certainly do not jibe \nwith the satisfying off-the-hip decision making that seems to be prized culturally.\nIn what may seem like a counterintuitive reaction to this feeling of \ndiscomfort with C-system processes, you often find analysts and investors \nattempting to collect every scrap and shred of detail regarding a company’s \noperations before making an investment decision. This phenomenon may \nhave something to do not only with a certain discomfort with C-system \nUnderstanding and Overcoming Investing Pitfalls •  119\nprocesses but also with a natural human discomfort with the unknown. All \ninvestments are made in an environment of uncertainty, and uncertainty \nis an unsettling psychological state for humans to find themselves in. \nTo ameliorate the discomfort from uncertainty, people have a tendency \nto attempt to gain control of the uncontrollable by not leaving any stone \nunturned in their analyses.\nThis may seem sensible, but in fact, studies have shown that more \ninformation does not help you to make better decisions—just the opposite, \nin fact. The first study showing this bias was done by a psychologist at the \nUniversity of Oregon named Paul Slovic, who studied the accuracy and con-\nfidence of professional horserace handicappers.\n2 Similar studies have been \nperformed on other groups—medical doctors and stock brokers among \nthem—and the results from subsequent studies have been very similar.\nProfessor Slovic gave professional handicappers varying amounts of in-\nformation about horses running in a series of races and then asked them to \nmake a prediction about the first-place finisher in each race. The handicappers \nwere then asked to assess the confidence they had in their predictions. Slovic \nhad the actual race results and compared the professionals’ confidence with \ntheir actual accuracy. The results can be represented graphically as follows:\n30%\n20%\n10%\n0%\n51 02 04 0\nNumber of Items of Information\nAccuracy vs. Confidence of Professional Handicappers\nConfidence and Accuracy\n(Accuracy measured by correct first-place selections)\nAccuracyC onfidence\n120  •   The Intelligent Option Investor\nThis is an incredible graph. The horizontal line represents the accuracy \nof the expert predictions. The dotted line represents the confidence of the \nexperts depending on the amount of information they had.\nThe fact that the predictive efficacy line remains horizontal and the \nconfidenc", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 39}
{"text": "curacy measured by correct first-place selections)\nAccuracyC onfidence\n120  •   The Intelligent Option Investor\nThis is an incredible graph. The horizontal line represents the accuracy \nof the expert predictions. The dotted line represents the confidence of the \nexperts depending on the amount of information they had.\nThe fact that the predictive efficacy line remains horizontal and the \nconfidence line increases so sharply indicates an interesting and, think-\ning about it, frightening facet of human behavior. Namely, even though \nthe predictions made by the experts who had the most data were no \nmore accurate in reality than those of their colleagues who had limit-\ned data, the ones with access to more and more data became more and \nmore confident, to the extent that they were massively overconfident. \nAccuracy remains just under 20 percent, but confidence goes up to \n30 percent—a 10 percentage point difference in perception (confidence) \nversus reality (accuracy)!\nThis behavioral bias has two large negative effects on investors. First \nis a tendency to spend too much time looking at too many nonmaterial \nminutiae until finally one cannot come to a decision regarding whether or \nnot to invest—or, as it is colloquially known, analysis paralysis. \nI think of the attempt to gather a huge amount of increasingly detailed \ninformation about an investment prospect as a sort of cosmic bargaining. \nThe analyst or investor who spends hundreds of hours looking at very de-\ntailed information not material to the valuation is doing something akin to \nmaking a burnt offering of old. The analyst or investor is, in some sense, \nmaking a prayer to the market gods: “I will sacrifice a lot of time and \nmental effort learning about this company. Please reward me with positive \nreturns this year. ” \nIn the attempt to bargain with the great unseen hand of the mar -\nket, an analyst spends more and more time collecting increasingly less and \nless important information about the potential investment until the cost \nof collecting the extra information greatly outweighs the benefit of having \ngathered it. The big problem with very detailed analyses is that the closer \none looks at a given problem, the more involved that problem becomes. \nEvery fact has some supporting details, and each supporting detail has a \nfew scenarios that may be associated with it. To do a really thorough job, \nyou must look at each scenario in turn. Ah! But these scenarios turn out to \nbe interrelated, so you must think about not only first-order changes in the \nscenarios but also secondary and tertiary ones as well. Soon the analyst or \nUnderstanding and Overcoming Investing Pitfalls •  121\ninvestor’s spreadsheet model winds up being 45 tabs deep, and it still seems \nlike there is more work that needs to be done before a decision can be \nmade (“Where were those numbers regarding the depreciation of fixed as-\nsets at the Malaysian subbranch?! How can I invest if I don’t know that?!”). \nAt this point, the analysis has become thoroughly paralyzed, and frequently \nthe investor will decide (after putting in all that hard work) just to drop \nthe whole thing because he or she “can’t get his or her head around” the \nvaluation.\nAnother cost to gathering a great amount of detailed information is \nmore subtle but no less dangerous. Let’s say that the analyst has worked \nthrough all those secondary and tertiary scenarios and decides that the \nfirm in question is undervalued. The company is trading for $X and is \nworth “$Y at a minimum. ” What is the analyst’s confidence level in that \n$Y valuation? If the scientific studies I mentioned earlier hold true, the \nanalyst is 50 percent more confident than the position warrants. This is an \nunhealthy dose of overconfidence.\nThe investor hits the “Buy” button and hopes for the best. However, \nafter a few quarters, some of the operational metrics at the firm begin to \nfalter. The Capex project that was forecast to take 5 percent of sales in year \none ends up taking closer to 9 percent. Sales are a bit lower than expected, \nand costs are a bit higher. But the investor has thought about all these pos-\nsibilities and is still very confident in the valuation; these discrepancies \nare thus looked at like anomalies that will soon be corrected with another \nquarter or two of results. The situation can drag on for an extended time \nuntil suddenly the investor is confronted with the possibility that the firm \nis running out of cash, its new product line has failed, or whatever. The in-\nvestor, once so confident, now has to face the unpleasant task of realizing a \nloss (why he or she may not want to realize a loss is discussed in the section \n“Humans’ Kinky Perception of Risk” later).\n“Love is blind. ” Unfortunately, overconfidence in an investment opin-\nion can make one just as blind as love.\nI believe that two facets of intelligent option investing can help to \nameliorate these biases. First, recall that there are at most four—and most \noften only three—drivers determining company valuation. While you are \nreading about a company and analyzing its value, it is wise to constantly \nask yourself two questions:\n122  •   The Intelligent Option Investor\n1. Is what I’m analyzing related to one of the drivers of company value?\n2. Is what I’m analyzing material to the valuation?\nSure, there is some sort of satisfaction in knowing everything there \nis to know about coal-processing technology or oil reservoir structure and \nengineering, but recognize that this satisfaction is purely personal and is \nnot going to make a bit of difference to the valuation. Understanding these \nkinds of technical details might help a tiny bit in understanding competi-\ntive dynamics in an industry, but the cost of learning them almost always \nexceeds the benefit from the knowledge. For any technical points you are \ntrying to learn about as a layperson, there are likely two armies of engi-\nneers, specifically trained in that field, arguing with one", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 40}
{"text": "ce to the valuation. Understanding these \nkinds of technical details might help a tiny bit in understanding competi-\ntive dynamics in an industry, but the cost of learning them almost always \nexceeds the benefit from the knowledge. For any technical points you are \ntrying to learn about as a layperson, there are likely two armies of engi-\nneers, specifically trained in that field, arguing with one another about \nwhatever point you are learning about. No matter how large your band-\nwidth is, it is not likely that you will be able to make a more informed deci-\nsion than those people. And if the final result is, “Company A will likely \nbe able to produce coal at a slightly cheaper cost than Company B because \nof the geology where Company A has its mines, ” this is a fact that can be \nreasonably ensured by a few minutes on Wikipedia rather than by checking \nout books from the local university’s engineering library.\nSecond, the online valuation example shows how you can create \nrational valuation ranges for a company, and I believe that those ranges \ncan be very helpful. Estimating valuation ranges rather than tying them-\nselves to point estimates of a specific stock value can help investors to re-\nmain more objective about information coming in and more observant of \nchanging conditions. For example, if an investor sees one group of valua-\ntion ranges clustered near $30 and one group clustered near $50, the inves-\ntor can objectively assess operational data coming in over time and decide \nwhich set of projected economic results the actual results will match. The \ninvestor may have thought the economic results underlying the $50 cluster \nwere more likely, but as time goes on, he or she may see that the results \nleading to the $30 cluster are closer to the truth. In this case, the investor \ncan be confident and happy about making accurate projections (because \nthe investor projected both the $30 level and the $50 level), even if he or \nshe is not particularly pleased with the investment outcome. This may be \nthe psychological slack required to combat the last behavioral bias we will \ndiscuss—humans’ kinky perception of risk.\nUnderstanding and Overcoming Investing Pitfalls •  123\nHumans’ Kinky Perception of Risk\nTake a look at the following questions: First question: you have a choice \nbetween playing two games with the following monetary payoffs. Which \ngame would you play?\n• Game 1: 75 percent chance of winning $6,000 and a 25 percent \nchance of winning $0\n• Game 2: 100 percent certainty of winning $4,000\nMake a note of your choice. Second question: you have a choice between \nplaying two games with the following monetary payoffs. Which game \nwould you play?\n• Game 3: 75 percent chance of losing $6,000 and a 25 percent chance \nof losing $0.\n• Game 4: 100 percent certainty of losing $4,000\nWhat was your answer to this question?\nMathematically, you should choose to play games 1 and 4—these \nare the rational choices. Most people irrationally would choose to play \ngames 2 and 3. The expected payout of game 1 = 75 percent × $6,000 + \n0 = $4,500. As such, game 1’s outcome generates a higher expected payoff \nthan game 2. If you chose game 2 in this instance, it would indicate that \nyou are risk averse.\nReversing the conditions of the games to generate losses instead of \nprofits, you can see that game 3 yields an expected loss ($4,500) that is \ngreater than the expected loss of game 4 ($4,000). If you chose to play \ngame 3 over game 4, this would indicate that you are risk seeking rather \nthan risk averse.\nPsychologists Amos Tversky and Daniel Kahnemann—two research-\ners who began the systematic study of behavioral biases—found that peo-\nple tend to be risk averse with respect to gains and risk seeking with respect \nto losses and have coined the term prospect theory to describe this ten-\ndency.\n3 To understand risk aversion and risk seeking, let’s look at a simple \nbetting example.\nY ou offer a test subject a choice of either receiving a certain payment \nof a certain amount or receiving an amount based on the result of a fair \n124  •   The Intelligent Option Investor\nbet such as a coin toss. If the coin comes up heads, the subject wins $100; \nif it comes up tails, the subject walks away with no payment. The expected \npayoff from the fair bet from a mathematical perspective is\n$100 × 50% + $0 × 50% = $50\nEconomists describe risk preferences for individuals on the basis of \nthe fixed payment the individual would accept in order not to subject the \npayout to a risky outcome. The three risk preferences are\n• Risk neutral\n• Risk averse\n• Risk seeking\nThe risk-neutral investor is completely rational. The mathematical expected \npayoff is $50, so the risk-neutral approach is not to accept any guaranteed \npayment other than $50 in lieu of making the bet. If you were to diagram \nthe value the rational risk-neutral investor would assign to the expected \nvalue of a risky outcome (using what economists call a utility curve ), you \nwould get the following:\n0\n0\nExpected Value of a Risky Outcome\nRisk-Neutral Utility Function\nValue Placed on a Safe Outcome\nBecause $50 is not a great deal of money to some people, they can and \ndo remain risk neutral at this monetary level. Increase the potential payout \nUnderstanding and Overcoming Investing Pitfalls •  125\nto $1 million, and I guarantee that people will most happily demonstrate \nrisk aversion.\nRisk aversion is demonstrated by someone who would be willing to \naccept a guaranteed amount of less than the mathematically calculated ex-\npected payout in order to avoid putting the total payout at risk. For exam-\nple, if you would prefer to accept a sure $45 instead of a 50 percent chance \nof winning $100, you are risk averse. The utility curve for a risk-averse \ninvestor would be represented like this:\n0\n0\nExpected Value of a Risky Outcome\nRisk-Averse Utility Function\nValue Placed on a Safe Outcome\nMost mentally healthy people with relatively low blood-alcohol levels \nare ri", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 41}
{"text": "otal payout at risk. For exam-\nple, if you would prefer to accept a sure $45 instead of a 50 percent chance \nof winning $100, you are risk averse. The utility curve for a risk-averse \ninvestor would be represented like this:\n0\n0\nExpected Value of a Risky Outcome\nRisk-Averse Utility Function\nValue Placed on a Safe Outcome\nMost mentally healthy people with relatively low blood-alcohol levels \nare risk averse to a greater or lesser extent. As the amount in question \nbecomes material (however the person in question defines materiality), the \ntendency toward risk aversion becomes much stronger. \nRisk-seeking behavior is seen in gambling addicts and people with \nhigh enough blood-alcohol levels that they should not be operating \nheavy machinery. It is, of course, the converse of risk aversion: a risk \nseeker requires a higher guaranteed payment than the mathematically \nexpected payout in order to forgo the bet. For instance, a risk seeker \nwould not want to stop betting unless he or she was offered $60 or more \nfor an expected-value bet of $50. The utility curve for a risk-seeking \ninvestor looks like this:\n126  •   The Intelligent Option Investor\n0\n0\nExpected Value of a Risky Outcome\nRisk-Seeking Utility Function\nValue Placed on a Safe Outcome\nRisk seeking may seem implausible for anyone whose problems are not the \nfeature of a daytime psychology talk show, but as you will see, each and \nevery person reading this now likely displays risk seeking many times in \nan investing career.\nIf you read an Economics 101 textbook, you will learn that peo-\nple are either risk neutral (professional economists always try hard to \nshow that they are risk neutral because they generally pride themselves \non being rational), risk averse, or risk seeking. In fact, we all display \neach of these profiles at different times depending on the situation. \nThe unfortunate fact, discovered by Tversky and Kahnemann, is that \nhumans tend to display the least helpful of each profile in different \nsituations.\nWhen we are winning, we tend to be risk averse. We have made \n20 percent on an investment in a short time, and our tendency is to “take \nour money off the table” and realize our gains. The thing we fail to realize \nwhen we feel the pride and satisfaction of hitting the “Sell” button is that at \nthe moment we close the position, our money is again sitting idle, and we \nare faced with the prospect of having to find another risky investment to \nreplace the one we just closed.\nConversely, when we are losing, we tend to be risk seeking. For \nexample, let’s say that we have lost 60 percent on an investment. Is our \nnatural tendency to sell that position? No. Because the value of our stake \nUnderstanding and Overcoming Investing Pitfalls •  127\nhas fallen so much, we sense that any small movement up will be a big \nimprovement to the present situation. We “let it ride” and hope for a lucky \nbreak. This is the action of someone who realizes that he or she has little \nto lose (because so much is lost already) and everything to gain—which, \nof course, is the very definition of desperation (and the day-to-day modus \noperandi of many hedge fund employees).\nThis variable risk profile is depicted by the following graph. The top-\nright quadrant shows a risk-averse profile—one would rather cap one’s \ngains than let them ride. The bottom-left quadrant shows a risk-seeking \nprofile—one would rather bet than realize one’s losses.\nProspect theory utility curve\nx\nU(x)\nNote how the curve in the upper right-hand quadrant looks like \nthe risk-averse utility curve and that everything in the lower left-hand \nquadrant looks like the risk-seeking utility curve. This is an astounding \ngraph, but perhaps an actual, visceral example would carry an even larger \nimpact.\nThink of the fellow who got in on the Google initial public offering, \nbuying at $85 per share. A few months later, after more than doubling his \nmoney, he happily sells at just above $200 and again puts his capital at risk \nin another investment—starting over from square one in terms of making \nan investment decision.\n128  •   The Intelligent Option Investor\n250\nGoogle (GOOG) Closing Price\nA\n200\n150\n100\n50\n0\n8/19/2004 9/19/2004 11/19/2004 12/19/2004 1/19/200510/19/2004\nThis investor’s thought at point A: “I am an investing genius! I just \nmade a 100 percent return in a couple months—time to take my money off \nthe table. ” However, after selling the shares and feeling the sense of relief \nthat he had reduced his risk exposure to Google, he eventually grows dis-\nmayed about being hasty in realizing his gain:\n800\nGoogle (GOOG) Closing Price\nB\nC\nD\nE\nF\nA\n700\n600\n500\n400\n300\n200\n100\n0\n8/19/2004 2/19/2005 2/19/20068 /19/20068 /19/20078/19/2005 2/19/2007\nUnderstanding and Overcoming Investing Pitfalls •  129\nThe investor’s reasoning may have gone like this:\nA Original sale realizing profits\nB “I did the right thing.”\nC “I left a little on the table, but it’ll come back soon, and I’ll buy some more then.”\nD “Should I short Google?!”\nE “Aaaaaaaaaaaargh!”\nF Second purchase\nFinally, after his mail carrier comments that she is retiring early after \nselling her Google position for $675 per share and a person at the country \nclub buys a new Lexus using his Google sale proceeds, our kinked utility \ncurve investor does the thing that social creatures tend to do when faced \nwith uncertainty and remorse—follow the herd. He is happy that his limit \norder to buy at $695 is filled at midday and happier still that he made a gain \nof 3 percent after buying the shares. \nOur hapless investor’s bad sense of timing is good for us because his \npurchase of Google shares at the local 2007 market peak and ownership \nthrough the fall allow us to simultaneously follow the psychological pain \nhe suffered on the stock chart and the utility function curve:\n800\nGoogle (GOOG) Closing Price\nB\nC\nA\n700\n600\n500\n400\n300\n200\n100\n0\n11/1/2007 2/1/2008 5/1/2008 8/1/2008 11/1/2008\n130  •   The Intelligent Option Investor\nThus an inve", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 42}
{"text": "od for us because his \npurchase of Google shares at the local 2007 market peak and ownership \nthrough the fall allow us to simultaneously follow the psychological pain \nhe suffered on the stock chart and the utility function curve:\n800\nGoogle (GOOG) Closing Price\nB\nC\nA\n700\n600\n500\n400\n300\n200\n100\n0\n11/1/2007 2/1/2008 5/1/2008 8/1/2008 11/1/2008\n130  •   The Intelligent Option Investor\nThus an investor in Google at $695 feels pain extremely quickly when \nthe value of the position drops slightly to the $620 per share level, let’s say; \nthis is indicated at position A in the diagram. However, as the price continues \nto decline (let’s say to the $450 per share level indicated by position B ), \nhuman decision makers have a tendency to say something like, “If only I \ncould get $475 for my shares, I’ d sell right now. ” If and when the shares do in-\ndeed reach $475, the curvature of the line in this quadrant implies that now \nthe investor will require yet a higher guaranteed price (e.g., $525 per share) \nbefore he closes the bet. At some point, which may be one representing a \nsignificant loss of principal, the investor is largely inured to the prospect \nof further losses, and if the stock price goes far enough down, the investor \nis no longer tempted to bet on a small rise in price. This is the point that \npeople usually sell—just as the $50 stock they bought is trading for $1.50 \non the Pink Sheets!\nThis psychological effect is dreadfully difficult to overcome—\nperhaps impossible. However, again, I believe that the most important \nfirst step is having a rational, educated estimate of the fair value range of \na company and understanding the drivers that go into the values making \nup that range.\nLet’s say that you bought a stock for $30 after having determined a \nlow-end valuation of $39 and the high-end valuation around $50. Now a \nquarterly earnings announcement reports good numbers—data suggesting \nthat the valuation cluster around $50 is closer to correct—and the stock \nadvances by 10 percent—to $33.\nUnder these conditions, you are less likely to excitedly take your \nprofits after the 10 percent up day because you know that the stock still \nhas about 50 percent to go before it gets to your best-case valuation range. \nAgain, understanding the drivers of valuation and having an appreciation \nfor (and humility in the face of) the uncertainty involved in any projection \nof future conditions (as reflected by a valuation range) constitute the best \nway I have found to combat the deep-seated bias related to the kinks in our \nperception of risk.\nNow we’ll look briefly at structural impediments to rational investing \nbefore pulling together all the lessons learned so far to see how to invest \nintelligently using options.\nUnderstanding and Overcoming Investing Pitfalls •  131\nStructural Impediments \nWe know that we have an enemy living inside of us in the form of the behav-\nioral biases discussed earlier. If this weren’t bad enough, we are attempting to \ninvest intelligently in an environment not conducive to intelligence. In other \nwords, not only must we battle an enemy within, but enemies without as well. \nThe enemies without are comprised of the forces arrayed against us—\nthe owners of capital attempting to invest intelligently. These forces are part \nof the very structure that has developed to trade, manage, custody, ana-\nlyze, and report on securities that is such an integral part of the investing \nprocess. They consist of the many explicit messages we as investors receive \nevery week telling us that we should “trade like a pro” and the implicit mes-\nsages that we don’t know what we are doing so we should put our faith in \nthis expert or the next if we hope to be successful. \nAt the heart of these structural issues is the distinction between prin-\ncipals and agents.\nPrincipals versus Agents\nY ou cannot talk about structural impediments without making the distinc-\ntion between principals and agents. Principals are the owners of capital \nwho invest in risky projects or assets with the expectation of generating a \npositive return. Principals can be like you and me—individuals with finite \nlives—or can be legal entities such as endowments or companies—which \nare theoretically perpetual actors. Agents, on the other hand, are the inter-\nmediaries who act on behalf of principals in return for salaries and who are \npaid for out of the capital of principals.\nAny time a person is compensated for doing something, his or her \nown interests are on the line. When our own interests are on the line, we \nlook for opportunities to protect and advance them. Unless a great deal of \nthought is put into how investment performance is measured and assessed \nand how compensation is awarded to agents as a result of that performance, \nin the process of advancing their own agendas, agents actually may end \nup working at cross-purposes to their principals. This tension between \nagents—who must work within the constraints of their industry to keep \n132  •   The Intelligent Option Investor\ntheir jobs and advance their careers—and principals—who by and large \nare simply looking to save enough money to live comfortably in retirement \nand pass something on to their descendants—lies at the root of what I term \nstructural impediments.\nTo investigate these structural impediments, we first need to figure \nout who is playing this investment game and what the rules are. To do this, \nI’ll introduce the teams: the buy side and the sell side—both of which are \nagents—and the principals. With this knowledge, we can better avoid the \nstructural pitfalls established by the agents largely for their own benefit.\nThe Buy Side\nThe buy side consists of agents hired by principals to invest and manage \nthe principals’ capital on their behalf. The most well-known buy-side play-\ners are mutual funds and hedge funds, but insurance companies, pension \nfunds, and endowments also fit into this category. I tend to think of hedge \nfunds and mutual funds", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 43}
{"text": "itfalls established by the agents largely for their own benefit.\nThe Buy Side\nThe buy side consists of agents hired by principals to invest and manage \nthe principals’ capital on their behalf. The most well-known buy-side play-\ners are mutual funds and hedge funds, but insurance companies, pension \nfunds, and endowments also fit into this category. I tend to think of hedge \nfunds and mutual funds as being different in approach from the others, so \nwe’ll look at these two groups separately.\nPerhaps the attitude of mutual and large hedge fund players can best \nbe summed up by the words of a professional money manager, who once \ntold me, “Erik, no one ever got fired for not making money; they got fired \nfor losing money. ” Most people unfamiliar with the money-management \nindustry think that performance is paramount for the managers. In fact, \ninvestment performance is only a slightly inconvenient means to an end \nfor money managers. For the owner of a hedge or mutual fund, the real \nname of the game is assets under management (AUM). AUM is the total \namount of money a fund manages on behalf of its clients, and it is the main \nsource of wealth for the owners of a fund. Mutual funds charge a load that \nrepresents a percentage of money clients leave with them to manage but are \nnot usually directly rewarded for the performance of the fund. In the case of \nmutual funds, AUM is all important, and investment performance is merely \na marketing tool. If fund A can generate good enough performance to stand \nprominently in the pack of other funds (i.e., “x percent of our funds beat \ntheir Lipper averages”), and rating companies such as Morningstar give the \nfund a positive rating, present customers of fund A are less likely to take \ntheir money to another fund, and customers of lower-performing funds \nUnderstanding and Overcoming Investing Pitfalls •  133\nwill move their money to be managed by fund A. Of course, at the annual \nbonus time, fund employees are compensated in rough proportion to the \nperformance of their investment recommendations, so there is an incentive \nfor analysts and portfolio managers to perform well. However, if an analyst \nis interested in keeping his or her revenue stream coming in in the form of \nsalary, the analyst quickly learns that the best route is usually the safest one.\nThis leads to a phenomenon known as closet indexing , where an in-\nvestment fund’s portfolio is so diversified that it effectively takes on a risk-\nreturn profile equivalent to the index (or whatever benchmark the fund is \nusing to measure relative performance). A 2011 study by Martijn Cremers \nand colleagues concluded the following (italics added by author):\nIn this paper we examine the prevalence of explicit and implicit \n(closet) indexing in equity mutual fund management across 30 \ncountries. We find that although little explicit indexing exists \nas a proportion of assets under management [N.B.: There are \nfew low-load index funds in proportion to “actively managed” \nfunds] in almost all countries, a large amount of closet indexing \nexists. That is, equity fund managers in many countries choose \nportfolios that track their stated benchmark closely.\nOr, to put it simply, whether an investor puts money into an active \nfund or an index fund, the investor mainly just gets the performance of \nthe index. In addition, bonuses and salary increases are apportioned out \non an annual basis, meaning that the natural investing time horizon for \nan analyst or money manager is only one year. Almost everyone in the \nindustry feels a sense of excitement and relief at the beginning of a new \nyear because they know they are starting out with a fresh slate. Clearly, the \nagents—the employees and owners of the funds—are not acting in the best \ninterests of the principals (because they are charging fees but not provid-\ning much or any benefit), and the agents’ investing time horizons are not, \nby and large, aligned with the investing time horizons of the principals \n(agents start again with a fresh slate every year whereas principals worry \nonly about the value of their investment assets at some point in time, like \ncollege admission or retirement).\nThe same sort of dynamic occurs in the hedge fund industry, al-\nthough with a bit of a twist. Large hedge funds usually are set up in a \n134  •   The Intelligent Option Investor\n“2-and-20” arrangement, where 2 percent of a client’s money every year \ngoes immediately to the manager (this is the load in a mutual fund), and \n20 percent of profits (or profits over some benchmark) are apportioned out \non a periodic basis. The owners of these prominent funds usually set up \ntheir businesses in such a way as to receive all the moneys based on AUM \nand leave the lion’s share of the risky, performance-based payout to the \nportfolio managers and analysts hired to manage the money. The owners \nof large hedge funds, in other words, have compensation structures that are \nvery similar to those of the owners of large mutual funds and so are con-\ncerned mainly with clients not moving their money to other hedge funds. \nFor the owners of these funds, performance is, in a sense, just a necessary \nevil to their goal of generating wealth by safekeeping the wealth of others. \nThe owners of small hedge funds and the managers/analysts of all \nhedge funds lead a much more tenuous existence. This business is extremely \ncompetitive, and the continuation of these agents’ salary- and bonus-gen-\nerated revenue streams is extremely sensitive to recent performance. Small \nhedge fund owners are beholden to hedge funds of funds (HFoF)—another \nintermediary that funnels principals’ capital to different hedge funds in re-\nturn for a fee—and their money is extremely “fast. ” If a small fund manager \ndoes not outperform the appropriate benchmark in a given quarter or can-\nnot convince the HFoF that performance lagged in the last quarter for some \nreason that will reverse itself in spades in the next quarter, it i", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 44}
{"text": "ds of funds (HFoF)—another \nintermediary that funnels principals’ capital to different hedge funds in re-\nturn for a fee—and their money is extremely “fast. ” If a small fund manager \ndoes not outperform the appropriate benchmark in a given quarter or can-\nnot convince the HFoF that performance lagged in the last quarter for some \nreason that will reverse itself in spades in the next quarter, it is very likely \nthat the HFoF will pull its money from the fund. Similarly, a portfolio man-\nager working for a large fund must, at least on an annual basis, prove to the \nhedge fund owner that his or her performance has been good enough or will \nsoon be good enough to deserve a continued allotment of the clients’ capital.\nStrangely enough, as more and more hedge funds flood the market, \nsoaking up opportunities to generate alpha (excess returns), hedge funds \nhave come to display returns that are highly correlated with the underly-\ning index. A recent research report published by Morgan Stanley told this \ntale in figures—the correlation between the Standard and Poor’s 500 Index \n(S&P 500) and an index of hedge funds reached around 90 percent in mid-\n2013.\n4 This does not mean that an individual hedge fund will engage in \ncloset indexing as a mutual fund might, but it does mean that if you invest \nyour money in multiple hedge funds to try to generate better performance, \nyour returns will start looking a lot like the returns of the index at large.\nUnderstanding and Overcoming Investing Pitfalls •  135\nTurning now to the next buy-side group—insurance companies, \npension funds, and endowments—we see a different business model and \ndifferent motivations for employees. In general, these buy-side businesses \nhave much less pressure to generate superlative returns and exist as a sort \nof appendage of another primary business. Life insurance companies \ninvest their clients’ money but generally promise very limited returns—\nstructuring agreements with clients in such a way as to ensure that if their \ninvestment decisions are at least minimally competent, they will be able to \nfulfill their promises to clients. As such, investments tend to be a default se-\nlection of blue chip equities and high-quality bonds. In this environment, \nthe portfolio manager is not measured so much on his or her investment \nprowess but rather on his or her ability to allocate to bonds and stocks in \na sensible enough proportion to be able to satisfy the insurance company’s \nobligations to its clients when they come due. The real risk to the insurance \ncompany is not collecting enough fees or promising its clients too much. \nThe investment horizon for these funds is something like 10 to 20 years. \nPension funds are much the same in terms of investment philosophy—\nif a portfolio manager allocates assets sensibly between high-grade corporate \nbonds and blue chip stocks, his or her career is basically safe. It is rare to find \nprivate sector entities now that even offer pensions to their employees and \ntougher still to think of examples of pensions that are adequately or overfunded \n(meaning that they have enough funds to meet their future obligations). Again, \nthe investment horizon for these entities is a long 10 to 20 years.\nUntil rather recently, university endowments were very similar to in-\nsurance or pension funds, but they naturally have much longer investment \ntime horizons because the money is usually not promised to any specific \npurpose in some limited time frame. Endowments usually allocate to a \nwider range of asset classes—including hedge funds, private equity funds, \nreal estate, and so on—and several gifted portfolio managers at Harvard \nand Y ale have done this to enormous effect on behalf of their schools in \nrecent years. However, in general, asset selection or allocation risks are low \nfor managers in this environment. Rather, the risks are much more related \nto the ability of managers to satisfy their schools’ boards of governors that \nthey are managing the school assets with propriety and foresight.\nOne undeniable fact to all buy-side firms is that as the entity grows \nlarger, it becomes harder and harder to invest in anything but very large \n136  •   The Intelligent Option Investor\nand liquid stocks. Even if you have a small cap position that increases by \n100 percent in a single year, if your investment base is so large that the win-\nning position’s size is only 0.005 percent of the total AUM at the beginning \nof the year, it only represents 0.01 percent of the portfolio at the end of the \nyear—hardly moving the needle in terms of excess performance.\nTo summarize the players in tabular format:\nPlayer Clients Are . . . Time Horizon Risk\nInvestment \nParadigm\nHedge funds Demanding, \nfast money\n3 months to \n1 year\nOwner: Losing \nclients\nManagers: Not \nmaking risky \nenough bets\nAnything that pro-\nvides alpha\nMutual funds Docile and \nuninformed\n1 year Breaking from the \nherd and see-\ning AUM drop\nCloset indexing\nInsurance \ncompanies \nand pension \nfunds\nLargely \nunaware \nof their \ninvestments\n10 to 20 years Not charging \nclients enough \n(insurance); not \nretiring before \nthe pension is \ndiscontinued/\ndefaulted on \n(pensions)\nAAA bonds and blue \nchip stocks—risk \naversion\nEndowments Not born yet 10 years to \n100 years\nLosing \nconfidence \nof board of \ngovernors\nWide asset-class \nlevel allocation \nwith long-term \nperspective\nLook back at this table. As a principal owner of capital, is there any-\nthing listed in the risk column that speaks to the risk of investing that you \nyourself have experienced or feel is most pressing to you?\nThe Sell Side\nThe sell side consists of companies whose job it is to connect principals \n(through their agents) who have capital with the financial markets. \nUnderstanding and Overcoming Investing Pitfalls •  137\nBroker-dealers are the sell-side counterparties for institutional investors, \nwhereas stock brokers and online brokers are the counterparties for indi-\nvidual ones.\nThe operative p", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 45}
{"text": "o you?\nThe Sell Side\nThe sell side consists of companies whose job it is to connect principals \n(through their agents) who have capital with the financial markets. \nUnderstanding and Overcoming Investing Pitfalls •  137\nBroker-dealers are the sell-side counterparties for institutional investors, \nwhereas stock brokers and online brokers are the counterparties for indi-\nvidual ones.\nThe operative principle for this business is best summed up in the old \nadage, “Bears make money, and Bulls make money. Pigs get slaughtered. ” \nIn other words, sell-siders do not care if the market goes up or down be-\ncause their revenues depend only on investors accessing the market. The \nonly way to lose this game is to get too greedy and take a risk position in a \nsecurity that subsequently loses value.\n5 \nSell-side players basically make money in proportion to how often \ntheir clients come to the market. As such, the sell side has a vested interest \nin getting its clients to trade as often as possible. Sell-side research groups \nhire very smart graduates from top universities and industry insiders \nwho basically act as marketing arms for the firms’ sales and trading desks. \nThe more short-term “catalysts” the research group can find that might \nprompt a client to make a stock purchase or sale, the better for them. \nResearch groups’ bonuses are determined in large part by feedback from \nthe sales and trading desk. Because the sales and trading team only makes \nmoney if a client trades, research that advocates long holding periods and \ninfrequent trading is certainly not welcome, no matter how efficacious it \nmight be.\nThe main duty of the people on the sales desks is to prompt clients \nto make a trading decision and to trade with them (rather than another \nbank), so salespeople spend a good bit of time making cold calls to hedge \nfund traders to give them some market “color” and point out opportunities \nto make short-term trades.\nThe End Result\nThe buy and sell sides interact with one another in such a way as to create \nan investing environment that values short-termism and dependence on \nlarge-capitalization stocks. The problem is that individual investors get \nwrapped up in these machinations and end up trying to act like agents \nwhen they are in fact principals. Agents, as we have seen, get paid a salary \nand bonus on the basis of various short-term factors that are, at best, neutral \nand, at worst, damaging to the interests of principals. Buy-side agents, as \n138  •   The Intelligent Option Investor\nwe have seen, are either relatively disinterested in investment performance \n(e.g., insurance companies and pension funds) or are interested only in \nrelative outperformance over a very short time frame (e.g., hedge funds \nand mutual funds). Sell-side agents make money in proportion to trading \nvolume and frequency, so they are happy to facilitate the enormous trade \nin a blue chip securities on behalf of a pension fund or the hundreds or \nthousands of individual trades in a day on behalf of an aggressive active \nhedge fund.\nNone of these agents are considering the economic value that may be \ncreated by the company in which they are investing, and in the attempt to \nmaximize their own compensation, they are happy to ignore the long-term \nview in favor of a trade that will work within 90 days. Individual investors \nread sell-side research, and because the research analysts are so intelligent \nand well informed about various minutiae of a given company or industry, \nthey think that the analysts’ recommendations will help them in the long \nterm. Business news channels offer a constant stream of pundits from both \nbuy and sell sides pontificating about things that matter to them—short-\nterm opportunities to generate a small advantage for the quarter—and that \nindividual investors wrongly assume should be important to them as well.\nAn experienced technical analyst can find an investment opportu-\nnity in any chart pattern. A sell-side investment banker can always talk \nabout why one company looks cheap in comparison with another in the \nsame industry based on some ratio analysis that has a shelf life of about \ntwo weeks. Discount brokerages are happy to supply individual investors \nwith sophisticated software and data packages that are “free” as long as the \ninvestors make a certain number of trades per month, and they encourage \ntheir clients to “trade like a pro. ”\nThe end result of these structural factors is that individual investors \nget caught in a mental trap that if they are doing anything different from \nwhat they see their highly paid agents doing, they must be doing some-\nthing wrong. This is reinforced by one behavioral bias I mentioned in pass-\ning earlier—herding—the human tendency to try to find safety in following \nthe lead of others rather than risk independent action. \nIn general, any information or strategy that does not hone in on the \nlong-term economic value of a company should be considered by intel-\nligent investors to be a red herring and ignored. No individual investor is \nUnderstanding and Overcoming Investing Pitfalls •  139\nbeing compensated with respect to short-term or relative performance, so \ninformation that is purported to give them advantages in this realm should \nbe taken with a grain of salt.\nNow that you have a good idea of the theory behind options from \nPart I and the theory of how to assess rational valuation ranges for a stock \nwithout falling into behavioral or structural traps from Part II, let’s apply \nthis knowledge to the practical task of investing. Part III discusses how to \napply the principles of intelligent stock valuation to option investing and \nshows how to tilt the balance of risk and reward in our favor.\nThis page intentionally left blank \n141\nPart III \nIntellIgent OptIOn \nInvestIng\nNow that you understand how options work and how to value companies, \nit is time to move from the theoretical to the practical to see how to apply \nthis knowledge to investing", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 46}
{"text": "to \napply the principles of intelligent stock valuation to option investing and \nshows how to tilt the balance of risk and reward in our favor.\nThis page intentionally left blank \n141\nPart III \nIntellIgent OptIOn \nInvestIng\nNow that you understand how options work and how to value companies, \nit is time to move from the theoretical to the practical to see how to apply \nthis knowledge to investing in the market. With Part III of this book, we \nmake the transition from theoretical to practical, and by the time you finish \nthis part, you will be an intelligent option investor.\nTo invest in options, you must know how to transact them; this is the \nsubject of Chapter 7. In it, you will see how to interpret an option pricing \nscreen and to break down the information there so that you can under -\nstand what the option market is predicting for the future price of a stock. I \nalso talk about the only one of the Greeks that an intelligent option investor \nneeds to understand well—delta.\nChapter 8 deals with a subject that is essential for option investors—\nleverage. Not all option strategies are levered ones, but many are. As such, \nwithout understanding what leverage is, how it can be measured and used, \nand how it can be safely and sanely incorporated into a portfolio, you can-\nnot be said to truly understand options.\nChapters 9–11 deal with specific strategies to gain, accept, and mix \nexposure. In these chapters I offer specific advice about what strike prices \nare most effective to select and what tenors, what to do when the expected \noutcomes of an investment materially change, and how to incorporate \neach strategy into your portfolio. Chapter 11 also gives guidance on so-\ncalled option overlay strategies, where a position in a stock is overlain by \nan option to modify the stock’s risk-reward profile (e.g., protective puts for \nhedging and covered calls for generating income).\n142  •   The Intelligent Option Investor\nUnlike some books, this book includes only a handful of strategies, \nand most of those are very simple ones. I shun complex positions for two \nreasons. First, as you will see, transacting in options can be very expensive. \nThe more complex an option strategy is, the less attractive the potential \nreturns become. Second, the more complex a strategy is, the less the inher-\nent directionality of options can be used to an investor’s advantage. \nSimple strategies are best. If you understand these simple strategies \nwell, you can start modifying them yourself to meet specific investing sce-\nnarios when and if the need arises. Perhaps by using these simple strategies \nyou will not be able to chat with the local investment club option guru \nabout the “gamma on an iron condor, ” but that will be his or her loss and \nnot yours.\nChapter 12 looks at what it means to invest intelligently while under-\nstanding the two forms of risk you assume by selecting stocks in which to \ninvest: market risk and valuation risk.\n143\nChapter 7\nFIndIng MIsprIced \nOptIOns\nAll our option-related discussions so far have been theoretical. Now it \nis time to delve into the practical to see how options work in the market. \nAfter finishing this chapter, you should understand\n1. How to read an option chain pricing screen\n2. Option-specific pricing features such as a wide bid-ask spread, \nvolatility smile, bid and ask volatility, and limited liquidity/ \navailability\n3. What delta is and why it is important to intelligent option investors\n4. How to compare what the option market implies about future \nstock prices to an intelligently determined range\nIn terms of where this chapter fits into our goal of becoming intelligent \noption investors, obviously, even if you have a perfect understanding of \noption and valuation theory, if you do not understand the practical steps \nyou must take to find actual investment opportunities in the real world, all \nthe theory will do you no good.\nNew jargon introduced in this chapter includes the following:\nClosing price Bid implied volatility\nSettlement price Ask implied volatility\nContract size Volatility smile\nRound-tripping Greeks\nBid-ask spread Delta\n144  •   The Intelligent Option Investor\nMaking Sense of Option Quotes\nLet’s start our practical discussion by taking a look at an actual option \npricing screen. These screens can seem intimidating at first, but by the end \nof this chapter, they will be quite sensible.\nLast\n0.86 -0.23\n-0.14\n-0.04\n-0.17\n-0.14\n-0.06\n-0.13\n-0.12\n-0.07\n-0.09\n-0.14\n-0.06\n-0.20\n-0.26\n-0.10\n+0.01\n0.91 0.94 21.672% 24.733% 0.8387\n0.4313\n0.0631\n0.0000\n0.0000\n0.0000\n0.9580\n0.9598\n0.9620\n0.7053\n0.4743\n0.2461\n0.0357\n0.0392\n0.0482\n21.722%\n22.988%\n62.849%\n72.188%\n81.286%\n201.771%\n192.670%\n175.779%\n20.098%\n18.997%\n18.491%\n25.587%\n29.201%\n35.855%\n55.427%\n123.903%\n64.054%\n23.311%\n22.407%\n21.813%\n21.147%\n22.144%\n23.409%\n54.689%\n66.920%\n35.642%\n23.656%\n23.072%\n22.553%\n21.460%\n21.374%\n21.581%\n32.597%\n24.854%\n23.426%\n20.380%\n19.627%\nN/A\nN/A\nN/A\nN/A\nN/A\nN/A\nN/A\nN/A\nN/A\nN/A\nN/A\nN/A\nN/A\nN/A\n0.26\n0.04\n0.02\n0.02\n0.02\n13.30\n12.40\n11.35\n1.19\n0.58\n0.22\n0.01\n0.01\n0.02\n11.90\n12.35\n10.10\n1.68\n1.10\n0.67\n0.05\n0.03\n0.02\n0.24\n0.02\n10.35\n9.30\n8.40\n1.17 19.408%\n18.405%\n17.721%\n0.56\n0.20\n11.75\n10.70\n9.50\n1.65\n1.08\n0.65\n0.04\n0.01\n0.01\n11.55 12.30\n12.00\n10.00\n2.48\n1.93\n1.48\n0.41\n0.29\n0.21\n12.20\n3.60\n1.75\n10.05\n9.85\n2.44\n1.91\n1.45\n0.39\n0.27\n0.18\n12.10\n3.50\n1.70\n0.00\n0.23\n0.02\nC0.00\nC0.00\nC0.00\n0.09\n0.45\n1.15\nC4.99\nC5.99\nC6.99\nC4.99\nC5.99\nC6.99\nC12.01\nC11.01\nC10.01\n1.16\n0.54\n0.22\nC0.00\nC0.00\nC0.00\nC0.00\nC0.00\nC0.00\n0.33\n0.76\n1.40\nC5.03\nC6.00\nC6.99\nC0.00\nC0.01\nC0.03\n0.84\n1.23\n1.88\nC12.02\nC11.03\nC10.04\n1.65\n1.06\n0.66\nC0.06\n0.03\n0.02\nC12.05\nC11.07\nC10.10\nC2.58\n1.93\n12.10\n3.40\n1.69\n0.68\n4.25\nC7.27\n1.42\n0.38\nC0.30\nC0.22\nC0.11\nC0.15\nC0.19\n1.80\n2.27\n2.73\nC5.57\nC6.43\nC7.35\nChng Bid AskA skImpl.I mpl.Bid Vol. Vol. Delta JUL 26 ´13\n31\n32\n33\n37\n38\n39\n20\n21\n22\n31\n32\n33\n37\n38\n39\nDescription\nCall\nLast Chng Bid AskA skImpl.I mpl.Bid Vol. Vol. Delta\nPut\n0.9897\n0.9869\n0.9834\n0.6325\n0.4997\n0.3606\n0.0463\n0.0266\n0.0", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 47}
{"text": "5\n1.06\n0.66\nC0.06\n0.03\n0.02\nC12.05\nC11.07\nC10.10\nC2.58\n1.93\n12.10\n3.40\n1.69\n0.68\n4.25\nC7.27\n1.42\n0.38\nC0.30\nC0.22\nC0.11\nC0.15\nC0.19\n1.80\n2.27\n2.73\nC5.57\nC6.43\nC7.35\nChng Bid AskA skImpl.I mpl.Bid Vol. Vol. Delta JUL 26 ´13\n31\n32\n33\n37\n38\n39\n20\n21\n22\n31\n32\n33\n37\n38\n39\nDescription\nCall\nLast Chng Bid AskA skImpl.I mpl.Bid Vol. Vol. Delta\nPut\n0.9897\n0.9869\n0.9834\n0.6325\n0.4997\n0.3606\n0.0463\n0.0266\n0.0155\n0.9712\n0.9628\n0.9535\n0.5890\n0.5118\n0.4324\n0.1664\n0.1258\n0.0923\n0.9064\n0.5354\n0.3336\n+0.01\n+0.10\n+0.11\n0.07 0.09 22.812%2 4.853% -0.1613\n-0.5689\n-0.9373\n-1.0000\n-1.0000\n-1.0000\n22.469%\n24.612%\n85.803%\n203.970%\n267.488%\n20.456%\n19.851%\nN/A\nN/A\nN/A\n0.42\n1.20\n5.25\n7.25\n8.90\n0.39\n1.17\n4.90\n4.85\n5.40\n+0.02\n+0.09\n+0.14\n-0.0420\n-0.0402\n-0.0380\n-0.2948\n-0.5261\n-0.7545\n-0.9652\n-0.9616\n-0.9524\n77.739%\n70.681%\n63.514%\n20.303%\n19.170%\n19.011%\n41.423%\n61.602%\n52.378%\nN/A\nN/A\nN/A\nN/A\nN/A\nN/A\n0.02\n0.02\n0.02\n0.34\n0.73\n1.38\n5.30\n6.55\n7.30\n0.33\n0.71\n1.35\n4.95\n19.958%\n18.577%\n17.954%\n4.65\n6.70\n22.720%\n22.019%\n21.378%\n20.455%\n19.050%\n21.354%\n0.000%\n23.193%\n22.845%\n22.218%\n21.148%\n20.913%\n20.899%\n+0.07\n+0.05\n+0.16\n+0.09\n+0.12\n+0.04\n50.831%\n48.233%\n46.993%\n23.384%\n22.672%\n22.106%\n36.111%\n30.947%\n44.342%\nN/A\nN/A\nN/A\nN/A\n0.02\n0.03\n0.05\n0.82\n1.25\n1.82\n5.55\n6.30\n7.55\n0.01\n0.80\n1.23\n1.79\n4.95\n6.15\n6.85\n-0.0103\n-0.0131\n-0.0166\n-0.3679\n-0.5008\n-0.6402\n-0.9558\n-0.9757\n-0.9871\n22.989%\n22.284%\n21.453%\n17.134%\n37.572%\n38.919%\n37.587%\n35.246%\n23.914%\n23.485%\n22.925%\n22.967%\n26.265%\n28.715%\n0.11 0.13\n0.17\n0.19\n1.78\n2.25\n2.80\n5.80\n6.85\n7.85\n0.13\n0.17\n1.75\n2.22\n2.76\n5.70\n6.50\n7.40\n-0.0318\n-0.0406\n-0.0503\n-0.4120\n-0.4879\n-0.5665\n-0.8294\n-0.8690\n-0.9025\n34.172%\n23.567%\n23.145%\n22.479%\n21.404%\n19.420%\n18.411%\n37.790%\n35.385%\n30.523%\n24.198%\n23.081%\n0.00\n+0.09\n33.497%\n26.033%\n24.745%\n0.68\n4.25\n7.40\n0.66\n4.15\n7.30\n-0.0906\n-0.4520\n-0.6521\n33.203%\n25.378%\n24.054%\nAUG 16 ´13\n20\n21\n22\n31\n32\n33\n37\n38\n39\nSEP 20 ´13\n20\n21\n22\n31\n32\n33\n37\n38\n39\n20\n32\n37\nJAN 17 ´14\nJAN 16 ´15\nI pulled this screen—showing the prices for options on Oracle (ORCL)—\non the weekend of July 20–21, 2013, when the market was closed. The last \ntrade of Oracle’s stock on Friday, July 19, was at $31.86, down $0.15 from the \nThursday’s close. Y our brokerage screen may look different from this one, but \nyou should be able to pull back all the data columns shown here. I have limited \nthe data I’m pulling back on this screen in order to increase its readability. \nMore strikes were available, as well as more expiration dates. The expirations \nshown here are 1 week and 26, 60, 180, and 544 days in the future—the \n544-day expiry being the longest tenor available on the listed market.\nLet’s first take a look at how the screen itself is set up without paying \nattention to the numbers listed.\nFinding Mispriced Options    • 145\nCalls are on the left, puts on the right.\nStrike prices\nand expirations\nare listed here.\nYou can tell the stock was down on this day because most of the call\noptions are showing losses and all the put options are showing gains.\nAll the strikes for\neach selected expiry\nare listed grouped\ntogether.\nThis query was set up\nto pull back three\nstrikes at the three\nmoneyness regions\n(20–22, 29–31, 37–39).\nThe 1-week options\nand the LEAPS did\nnot have strikes at\neach of the prices I\nrequested.\nNow that you can see what the general setup is, let’s drill down and \nlook at only the calls for one expiration to see what each column means.\nLast\nC12.02 11.75\n10.70\n9.50\n1.65\n1.08\n0.65\n0.04\n0.01\n0.01 0.02\n0.03\n0.05\n0.67\n1.10\n1.68\n10.10\n12.35\n11.90 N/A\nN/A\nN/A\n22.720%\n55.427% 20\nSEP 20 ´13\n21\n22\n31\n32\n33\n37\n38\n39\n0.9869\n0.9834\n0.6325\n0.4997\n0.3606\n0.0463\n0.0266\n0.0155\n123.903%\n64.054%\n23.311%\n22.407%\n21.813%\n21.147%\n22.144%\n23.409%\n22.019%\n21.378%\n20.455%\n19.050%\n21.354%\nC11.03\nC10.04\n1.65\n1.06\n-0.13\n-0.12\n-0.07\n0.00\n+0.01\n0.66\nC0.06\n0.03\n0.02\nChnq Bid AskA skImpl.I mpl.Bid Vol. Vol. Delta Description\nCall\n0.9897\nRed\n(loss) Green\n(gain)\n146  •   The Intelligent Option Investor\nLast\nThis is the last price at which the associated contract traded. Notice that \nthe last price associated with the far in-the-money (ITM) strikes ($20, $21, \n$22) and one of the far out-of-the-money (OTM) strikes ($37) have the \nletter “C” in front of them. This is just my broker’s way of showing that the \ncontract did not trade during that day’s trading session and that the last \nprice listed was the closing price of the previous day. Closing prices are not \nnecessarily market prices. At the end of the day, if a contract has not traded, \nthe exchange will give an indicative closing price (or settlement price ) for \nthat day. The Oracle options expiring on August 16, 2013, and struck at \n$20 may not have traded for six months or more, with the exchange simply \n“marking” a closing price every day.\nOne important fact to understand about option prices is that they \nare quoted in per-share terms but must be transacted in contracts that rep-\nresent control of multiple shares. The number of shares controlled by one \ncontract is called the contract size . In the U.S. market, one standard con-\ntract represents control over 100 shares. Sometimes the number of shares \ncontrolled by a single contract differs (in the case of a company that was \nacquired through the exchange of shares), but these are not usually avail-\nable to be traded. In general, one is safe remembering that the contract size \nis 100 shares.\nY ou cannot break a contract into smaller pieces or buy just part of a \ncontract—transacting in options means you must do so with indivisible \ncontracts, with each contract controlling 100 shares. Period. As such, every \nprice you see on the preceding screenshot, if you were to transact in one of \nthose options, would cost you 100 times the amount shown. For example, \nthe last price for the $31-strike option was $1.65. The investor who bought \nthat contract paid $165 for it (plus fees, taxes, and commissions, which are \nnot included in the posted price). In the rest of this book, when I make \ncalculations re", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 48}
{"text": "very \nprice you see on the preceding screenshot, if you were to transact in one of \nthose options, would cost you 100 times the amount shown. For example, \nthe last price for the $31-strike option was $1.65. The investor who bought \nthat contract paid $165 for it (plus fees, taxes, and commissions, which are \nnot included in the posted price). In the rest of this book, when I make \ncalculations regarding money spent on a certain transaction, you will al-\nways see me multiply by 100.\nChange\nThis is the change from the previous day’s closing price. My broker shows \nchange only for contracts that were actively traded that day. It looks like \nFinding Mispriced Options    • 147\nthe near at-the-money (ATM) strikes were the most active because of the \ntwo far OTM options that traded; one’s price didn’t change at all, and the \nother went up by 1 cent. On a day in which the underlying stock fell, these \ncalls theoretically should have fallen in price as well (because the K/S ratio, \nthe ratio of strike price to stock price, was getting slightly larger). This just \nshows that sometimes there is a disconnect between theory and practice \nwhen it comes to options. \nTo understand what is probably happening, we should understand \nsomething about market makers. Market makers are employees at bro-\nker-dealers who are responsible for ensuring a liquid, orderly securi-\nties market. In return for agreeing to provide a minimum liquidity of \n10 contracts per strike price, market makers get the opportunity to earn \nthe bid-ask spread every time a trade is made (I will talk about bid-ask \nspreads later). However, once a market maker posts a given price, he or \nshe is guaranteeing a trade at that price. If, in this case (because we’re \ndealing with OTM call options), some unexpected positive news comes \nout that will create a huge rise in the stock price once it filters into the \nmarket and an observant, quick investor sees it before the market maker \nrealizes it, the investor can get a really good price on those far OTM call \noptions (i.e., the investor could buy a far OTM call option for 1 cent and \nsell it for 50 cents when the market maker realizes what has happened. \nTo provide a little slack that prevents the market maker from losing too \nmuch money if this happens, market makers usually post prices for far \nOTM options or options on relatively illiquid stocks that are a bit unrea-\nsonable—at a level where a smart investor would not trade with him or \nher at that price. If someone trades at that price, fine—the market maker \nhas committed to provide liquidity, but the agreement does not stipulate \nthat the liquidity must be provided at a reasonable price. For this reason, \nfrequently you will see prices on far OTM options that do not follow the \ntheoretical “rules” of options.\nBid-Ask\nFor a stock investor, the difference between a bid price and an ask price \nis inconsequential. For option investors, though, it is a factor that must \nbe taken into consideration for reasons that I will detail in subsequent \n148  •   The Intelligent Option Investor\nparagraphs. The easiest way to think of the bid-ask spread is to think in \nterms of buying a new car. If you buy a new car, you pay, let’s say, $20,000. \nThis is the ask price. Y ou grab the keys, drive around the block, and \nreturn to the showroom offering to sell the car back to the dealership. The \ndealership buys it for $18,000. This is the bid price. The bid-ask spread is \n$2,000 in this example.\nBid-ask spreads are proportionally much larger for options than \nthey are for stocks. For example, the options I’ve highlighted here are on \na very large, important, and very liquid stock. The bid-ask spread on the \n$32-strike call option (which you will learn in the next section is exactly \nATM) is $0.02 on a midprice of $1.09. This works out to a percentage bid-\nask spread of 1.8 percent. Compare this with the bid-ask spread on Ora-\ncle’s stock itself, which was $0.01 on a midprice of $31.855—a percentage \nspread of 0.03 percent.\nFor smaller, less-liquid stocks, the percentage bid-ask spread is even \nlarger. For instance, here is the option chain for Mueller Water (MW A):\n2.5\n5\n7.5\n10\nLast\nC5.30\nC2.80\n0.55\nC0.00\nChange Bid AskI mpl. Bid Vol. Impl. Ask Vol. Impl. Bid Vol. Impl. Ask Vol.Delta\n2.5\n5\n7.5\n10\n2.5\n5\n7.5\n10\n12.5\nDescriptionCall\nLast Change BidA sk Delta\nPut\nC0.00\nC0.00\nC0.25\nC2.25\nC0.00\nC0.00\nC0.55\nC2.35\nC0.00\nC0.10\nC0.85\nC2.55\nC4.80\n5.20 5.50 N/A 340.099% 0.9978\n0.9978\n0.7330\n0.1316\n0.9347\n0.8524\n0.6103\n0.1516\n0.9933\n0.9190\n0.6070\n0.2566\n0.1024\n142.171%\n46.039%\n76.652%\nN/A\nN/A\n2.95\n0.55\n0.10\n0.20\n0.10 N/A\nN/A\nN/A\n0.10\n0.30\n2.35\n40.733%\nN/A\nN/A\nN/A\nN/A\n36.550%\n38.181%\n35.520%\n35.509%\n35.664%\n2.10\n0.50\n0.05\n0.10\n0.60\n2.402.30\n0.05\n0.15\n0.15\n0.85\n2.60\n4.90\n0.70\n2.45\n4.60\n2.70\n0.500.00\n5.20 5.50\n3.00\n0.90\n0.20\n2.80\n0.80\n0.10\n5.505.10\n3.102.85\n1.151.05\n0.400.30\n0.200.05\n39.708%\nN/A\nN/A\n36.722%\nN/A\n38.754%\n38.318%\n39.127%\n36.347%\n36.336%\n292.169% 0.0000\n-0.0000\n-0.2778\n-0.8663\n-0.0616\n-0.1447\n-0.3886\n-0.8447\n-0.0018\n-0.0787\n-0.3890\n-0.7375\n-0.8913\n128.711%\n53.108%\n88.008%\n117.369%\n60.675%\n42.433%\n44.802%\n110.810%\n50.757%\n42.074%\n43.947%\n49.401%\n163.282%\n75.219%\n42.610%\n45.215%\n122.894%\n64.543%\n42.697%\n44.728%\n50.218%\nC5.30\nC2.80\nC0.85\nC0.10\nC5.30\nC1.10\nC0.35\nC0.10\n3.00 +0.15\nAUG 16 ´13\nNOV 15 ´13\nFEB 21 ´14\nLooking at the closest to ATM call options for the November expiration—\nthe ones struck at $7.50 and circled in the screenshot—you can see that \nthe bid-ask spread is $0.10 on a midprice of $0.85. This works out to 11.8 \npercent.\nBecause the bid-ask spread is so very large on option contracts, \nround-tripping\n1 an option contract creates a large hurdle that the returns \nof the security must get over before the investor makes any money. In the \ncase of Mueller Water, the options one buys would have to change in price \nby 11.8 percent before the investor starts making any money at all. It is for \nthis reason that I consider day trading in options and/or using c", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 49}
{"text": "large on option contracts, \nround-tripping\n1 an option contract creates a large hurdle that the returns \nof the security must get over before the investor makes any money. In the \ncase of Mueller Water, the options one buys would have to change in price \nby 11.8 percent before the investor starts making any money at all. It is for \nthis reason that I consider day trading in options and/or using complex \nFinding Mispriced Options    • 149\nstrategies involving the simultaneous purchase and sale of multiple con-\ntracts to be a poor investment strategy.\nImplied Bid Volatility/Implied Ask Volatility\nBecause the price is so different between the bid and the ask, the range of fu-\nture stock prices implied by the option prices can be thought of as different \ndepending on whether you are buying or selling contracts. Employing the \ngraphic conventions we used earlier in this book, this effect is represented \nas follows:\nImplied price range implied\nby ask price volatility of 23.4%\nImplied price range implied\nby bid price volatility of 21.4%\n6/21/201612/24/20156/27/201512/29/20147/2/20141/3/20147/7/20131/8/20131/12/2012\nOracle (ORCL)\nPrice per Share\n60\n50\n40\n30\n20\n10\n-\nBecause Oracle is such a big, liquid company, the difference between \nthe stock prices implied by the different bid-ask implied volatilities is not \nlarge, but it can be substantial for smaller, less liquid companies. Looking \nat the ask implied volatility column, you will notice the huge difference \nbetween the far ITM options’ implied volatilities and those for ATM and \nOTM options. The data in the preceding diagram are incomplete, but \nif you were to graph all the implied volatility data, you would get the \nfollowing:\n150  •   The Intelligent Option Investor\n18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39\nStrike Price\nOracle (ORCL) Implied Volatility\nImplied Volatility (Percent)\n160\n180\n140\n100\n120\n80\n40\n60\n20\n0\nThinking about what volatility means with regard to future stock \nprices—namely, that it is a prediction of a range of likely values—it does not \nmake sense that options struck at different prices would predict such radi-\ncally different stock price ranges. What the market is saying, in effect, is that it \nexpects different things about the likely future range of stock prices depending \non what option is selected. Clearly, this does not make much sense.\nThis “nonsensical” effect is actually proof that practitioners \nunderstand that the Black-Scholes-Merton model’s (BSM’s) assumptions \nare not correct and specifically that sudden downward jumps in a stock \nprice can and do occur more often than would be predicted if returns fol-\nlowed a normal distribution. This effect does occur and even has a name—\nthe volatility smile . Although this effect is extremely noticeable when \ngraphed in this way, it is not particularly important for the intelligent op-\ntion investing strategies about which I will speak. Probably the most im-\nportant thing to realize is that the pricing on far OTM and far ITM options \nis a little more informal and approximate than for ATM options, so if you \nare thinking about transacting in OTM or ITM options, it is worth looking \nfor the best deal available. For example, notice that in the preceding dia-\ngram, the $21-strike implied volatility is actually notably higher than the \nFinding Mispriced Options    • 151\n$20-strike volatility. If you were interested in buying an ITM call option, \nyou would pay less time value for the $20-strike than for the $21-strike op-\ntions—essentially the same investment. I will talk more about the volatility \nsmile in the next section when discussing delta.\nIn a similar way, sometimes the implied volatility for puts is different \nfrom the implied volatility for calls struck at the same price. Again, this is \none of the market frictions that arises in option markets. This effect also \nhas investing implications that I will discuss in the chapters detailing dif-\nferent option investing strategies.\nThe last column in this price display is delta , a measure that is so \nimportant that it deserves its own section—to which we turn now.\nDelta: The Most Useful of the Greeks\nSomeone attempting to find out something about options will almost \ncertainly hear about how the Greeks are so important. In fact, I think that \nthey are so unimportant that I will barely discuss them in this book. If you \nunderstand how options are priced—and after reading Part I, you do—the \nGreeks are mostly common sense. \nDelta, though, is important enough for intelligent option investors \nto understand with a bit more detail. Delta is the one number that gives \nthe probability of a stock being above (for calls) or below (for puts) a given \nstrike price at a specific point in time.\nDeltas for calls always carry a positive sign, whereas deltas for puts are \nalways negative, so, for instance, a call option on a given stock whose delta is \nexactly 0.50 will have a put delta of −0.50. The call delta of 0.50 means that there \nis a 50 percent chance that the stock will expire above that strike, and the put \ndelta of −0.50 means that there is a 50 percent chance that the stock will expire \nbelow that strike. In fact, this strike demonstrates the technical definition of \nATM—it is the most likely future price of the stock according to the BSM.\nThe reason that delta is so important is that it allows you one way \nof creating the BSM probability cones that you will need to find option \ninvestment opportunities. Recall that the straight dotted line in our BSM \ncone diagrams meant the statistically most likely future price for the stock. \nThe statistically most likely future price for a stock—assuming that stocks \n152  •   The Intelligent Option Investor\nmove randomly, which the BSM does—is the price level at which there is \nan equal chance of the actual future stock price to be above or below. In \nother words, the 50-delta mark represents the forward price of a stock in \nour BSM cones.\nRecall now also that", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 50}
{"text": "re price for the stock. \nThe statistically most likely future price for a stock—assuming that stocks \n152  •   The Intelligent Option Investor\nmove randomly, which the BSM does—is the price level at which there is \nan equal chance of the actual future stock price to be above or below. In \nother words, the 50-delta mark represents the forward price of a stock in \nour BSM cones.\nRecall now also that each line demarcating the cone represents roughly a \n16 percent probability of the stock reaching that price at a particular time in the \nfuture. This means that if we find the call strike prices that have deltas closest to \n0.16 and 0.84 (= 1.00 − 0.16) or the put strike prices that have deltas closest to \n−0.84 and −0.16 for each expiration, we can sketch out the BSM cone at points \nin the future (the data I used to derive this graph are listed in tabular format at \nthe end of this section).\n6/21/201612/24/20156/27/201512/29/20147/2/20141/3/20147/7/20131/8/20137/12/2012\nDate\nOracle (ORCL)\nPrice per Share\n45\n40\n35\n30\n25\n20\n5\n10\n15\n-\nObviously, the bottom range looks completely distended compared \nwith the nice, smooth BSM cone shown in earlier chapters. This dis-\ntension is simply another way of viewing the volatility smile. Like the \nvolatility smile, the distended BSM cone represents an attempt by partici-\npants in the options market to make the BSM more usable in real situa-\ntions, where stocks really can and do fall heavily even though the efficient \nmarket hypothesis (EMH) says that they should not. The shape is saying, \nFinding Mispriced Options    • 153\n“We think that these prices far below the current price are much more \nlikely than they would be assuming normal percentage returns. ” (Or, in a \nphrase, “We’re scared!”)\nIf we compare the delta-derived “cone” with a theoretically derived \nBSM cone, here is what we would see:\nOracle (ORCL)\nDate\nPrice per Share\n60\n50\n40\n30\n20\n10\n-\n6/21/201612/24/20156/27/201512/29/20147/2/20141/3/20147/7/20131/8/20137/12/2012\nOf course, we did not need the BSM cone to tell us that the points \nassociated with the downside strikes look too low. But it is interesting to see \nthat the upside and most likely values are fairly close to what the BSM projects. \nNote also that the downside point on the farthest expiration is nearly \nfairly priced according to the BSM, contrary to the shorter-tenor options. \nThis effect could be because no one is trading the far ITM call long-term \nequity anticipation securities (LEAPS), so the market maker has simply \nposted his or her bid and ask prices using the BSM as a base. In the market, \nthis is what usually happens—participants start out with a mechanically \ngenerated price (i.e., using the BSM or some other computational option \npricing model) and make adjustments based on what feels right, what \narbitrage opportunities are available, and so on.\n154  •   The Intelligent Option Investor\nOne important thing to note is that although we are using the delta \nfigure to get an idea of the probability that the market is assigning to a certain \nstock price outcome, we are also using deltas for options that nearly no one \never trades. Most option volume is centered around the 50-delta mark and a \n10 to 20 percentage point band around it (i.e., from 30- to 40-delta to 60- to \n70-delta). It is doubtful to me that these thinly traded options contain much \nreal information about market projections of future stock prices.\nAnother problem with using the deltas to get an idea about market \nprojections is that we are limited in the length of time we can project out \nto only the number of strikes available. For this example, I chose an impor-\ntant tech company with a very liquid stock, so it has plenty of expirations \nand many strikes available so that we can get a granular look at deltas. \nHowever, what if we were looking at Mueller Water’s option chain and try-\ning to figure out what the market is saying?\n2.5\n5\n7.5\n10\nLast\nC5.30\nC2.80\n0.55\nC0.00\nChange Bid Ask Impl. Bid Vol. Impl. Ask Vol. Delta AUG 16 ´13\n2.5\n5\n7.5\n10\nNOV 15 ´13\n2.5\n5\n7.5\n10\n12.5\nFEB 21 ´14\nDescriptionCall\n5.20 5.50 N/A 340.099% 0.9978\n0.9978\n0.7330\n0.1316\n0.9347\n0.8524\n0.6103\n0.1516\n0.9933\n0.9190\n0.6070\n0.2566\n0.1024\n142.171%\n46.039%\n76.652%\nN/A\nN/A\n2.95\n0.55\n0.10\n2.70\n0.500.00\n5.20 5.50\n3.00\n0.90\n0.20\n2.80\n0.80\n0.10\n5.505.10\n3.102.85\n1.151.05\n0.400.30\n0.200.05\n39.708%\nN/A\nN/A\n36.722%\nN/A\n38.754%\n38.318%\n39.127%\n36.347%\n36.336%\n163.282%\n75.219%\n42.610%\n45.215%\n122.894%\n64.543%\n42.697%\n44.728%\n50.218%\nC5.30\nC2.80\nC0.85\nC0.10\nC5.30\nC1.10\nC0.35\nC0.10\n3.00 +0.15\nHere you can see that we only have three expirations: 26, 117, and \n215 days from when these data were taken. In addition, there are hardly \nany strikes that are reasonably close to our crucial 84-delta, 50-delta, and \n16-delta strikes, which means that we have to do a lot of extrapolation to \ntry to figure out where the market’s idea of the BSM cone lies.\nTo get a better picture of what the market is saying, I recommend \nlooking at options that are the most heavily traded and assuming that the \nimplied volatility on these strikes gives true information about the mar -\nket’s assumptions about the future price range of a stock. Using the im-\nplied volatility on heavily traded contracts as the true forward volatility \nexpected by the market allows us to create a theoretical BSM cone that we \nFinding Mispriced Options    • 155\ncan extend indefinitely into the future and that is probably a lot closer to \nrepresenting actual market expectations for the forward volatility (and, by \nextension, the range of future prices for a stock). Once we have this BSM \ncone—with its high-low ranges spelled out for us—we can compare it with \nthe best- and worst-case valuations we derived as part of the company \nanalysis process.\nLet’s look at this process in the next section, where I spell out, step by \nstep, how to compare an intelligent valuation range with that implied by \nthe option market.\nNote: Data used for Oracle graphing exampl", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 51}
{"text": "k). Once we have this BSM \ncone—with its high-low ranges spelled out for us—we can compare it with \nthe best- and worst-case valuations we derived as part of the company \nanalysis process.\nLet’s look at this process in the next section, where I spell out, step by \nstep, how to compare an intelligent valuation range with that implied by \nthe option market.\nNote: Data used for Oracle graphing example:\nExpiration Date Lower Middle Upper\n7/25/2013 29.10 31.86 32.75\n8/16/2013 22.00 32.00 33.50\n9/20/2013 19.00 32.00 35.00\n12/20/2013 20.00 32.50 37.00\n1/17/2014 19.00 32.50 37.20\n1/16/2015 23.00 32.30 42.00\nHere I have eyeballed (and sometimes done a quick extrapolation) to try \nto get the price that is closest to the 84-delta, 50-delta, and 16-delta marks, \nrespectively. Of course, you could calculate these more carefully and get \nexact numbers, but the point of this is to get a general idea of how likely the \nmarket thinks a particular future stock price is going to be.\nComparing an Intelligent Valuation \nRange with a BSM Range\nThe point of this book is to teach you how to be an intelligent option investor \nand not how to do stochastic calculus or how to program a computer to \ncalculate the BSM. As such, I’m not going to explain how to mathematically \nderive the BSM cone. Instead, on my website I have an application that will \nallow you to plug in a few numbers and create a graphic representation of a \nBSM cone and carry out the comparison process described in this section. \nThe only thing you need to know is what numbers to plug into this web \napplication! \n156  •   The Intelligent Option Investor\nI’ll break the process into three steps:\n1. Create a BSM cone.\n2. Overlay your rational valuation range on the BSM cone.\n3. Look for discrepancies.\nCreate a BSM Cone\nThe heart of a BSM cone is the forward volatility number. As we have seen, \nas forward volatility increases, the range of future stock prices projected by \nthe BSM (and expected by the market) also increases. However, after hav-\ning looked at the market pricing of options, we also know that a multitude \nof volatility numbers is available. Which one should we look at? Each strike \nprice has its own implied volatility number. What strike price’s volatility \nshould we use? There are also multiple tenors. What tenor options should \nwe look at? Should we look at implied volatility at the bid price? At the ask \nprice? Perhaps we should take the “kitchen sink” approach and just average \nall the implied volatilities listed!\nThe answer is, in fact, easy if you use some simplifying assumptions \nto pick a single volatility number. I am not an academic, so I don’t neces-\nsarily care if these simplifying assumptions are congruent with theory. \nAlso, I am not an arbitrageur, so I don’t much care about very precise \nnumbers, and this attitude also lends itself well to the use of simplifying \nassumptions. All we have to make sure of is that the simplifying as-\nsumptions don’t distort our perception to the degree that we make bad \neconomic choices.\nHere are the assumptions that we will make:\n1. The implied volatility on a contract one or two months from expi-\nration that is ATM or at least within the 40- to 60-delta band and \nthat is the most heavily traded will contain the market’s best idea \nof the true forward volatility of the stock. \n2. If a big announcement is scheduled for the near future, implied \nvolatility numbers may be skewed, so their information might \nnot be reliable. In this case, try to find a heavily traded near ATM \nstrike at an expiry after the announcement will be made. If the \nannouncement will be made in about four months or more, just try \nFinding Mispriced Options    • 157\nto eyeball the ATM volatility for the one- and two-month contracts.\n3. If there is a large bid-ask spread, the relevant forward volatility \nto use is equal to the implied volatility we want to transact. In \nother words, use the ask implied volatility if you are thinking \nabout gaining exposure and the bid implied volatility if you are \nthinking about accepting exposure (the online application shows \ncones for both the bid implied volatility and the ask implied \nvolatility).\nBasically, these rules are just saying, “If you want to know what the \noption market is expecting the future price range of a stock to be, find a \nnice, liquid near ATM strike’s implied volatility and use that. ” Most op-\ntion trading is done in a tight band around the present ATM mark and for \nexpirations from zero to three months out. By looking at the most heavily \ntraded implied volatility numbers, we are using the market’s price-discov-\nery function to the fullest. Big announcements sometimes can throw off \nthe true volatility picture, which is why we try to avoid gathering infor -\nmation from options in these cases (e.g., legal decisions, Food and Drug \nAdministration trial decisions, particularly impactful quarterly earnings \nannouncements, and so on). \nIf I was looking at Oracle, I would probably choose the $32-strike \noptions expiring in September. These are the 50-delta options with \n61 days to expiration, and there is not much of a difference between \ncalls and puts or between the bid and ask. The August expiration op-\ntions look a bit suspicious to me considering that their implied volatility \nis a couple of percentage points below that of the others. It probably \ndoesn’t make a big difference which you use, though. We are trying to \nfind opportunities that are severely mispriced, not trying to split hairs \nof a couple of percentage points. All things considered, I would prob-\nably use a number somewhere around 22 percent for Oracle’s forward \nvolatility.\nC12.02 11.75 N/A 55.427% 0.9897 C0.00 0.02 N/A 50.831%- 0.01032011.90\nC11.03 10.70 N/A 123.903% 0.9869 C0.01 0.03 N/A 48.233%- 0.01312112.35\nC10.04 9.50 N/A 64.054% 0.9834 C0.03 0.05 37.572% 46.993%- 0.01660.012210.10\nC0.06 0.04 20.455% 21.147% 0.0463 C5.03 5.55 N/A 36.111%- 0.95584.95370.05\n1.65 1.65 22.720% 23.311% 0.6325 0.8", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 52}
{"text": "a number somewhere around 22 percent for Oracle’s forward \nvolatility.\nC12.02 11.75 N/A 55.427% 0.9897 C0.00 0.02 N/A 50.831%- 0.01032011.90\nC11.03 10.70 N/A 123.903% 0.9869 C0.01 0.03 N/A 48.233%- 0.01312112.35\nC10.04 9.50 N/A 64.054% 0.9834 C0.03 0.05 37.572% 46.993%- 0.01660.012210.10\nC0.06 0.04 20.455% 21.147% 0.0463 C5.03 5.55 N/A 36.111%- 0.95584.95370.05\n1.65 1.65 22.720% 23.311% 0.6325 0.84 +0.07 0.82 22.989% 23.384%- 0.36790.80311.68-0.13\n1.06 1.08 22.019% 22.407% 0.4997 1.23 +0.05 1.25 22.284% 22.672%- 0.50081.23321.10-0.12\n0.66 0.65 21.378% 21.813% 0.3606 1.88 +0.16 1.82 21.453% 22.106%- 0.64021.79330.67-0.07\n0.02 0.01 21.354% 23.409% 0.0155 C6.99 7.55 N/A 44.342%- 0.98716.85390.02+0.01\n0.03 0.01 19.050% 22.144% 0.0266 C6.00 6.30 17.134% 30.947%- 0.97576.15380.030.00\nSEP 20 ´13\n158  •   The Intelligent Option Investor\nFor Mueller Water, it’s a little trickier:\n2.5\n5\n7.5\n10\nLast\nC5.30\nC2.80\n0.55\nC0.00\nChange BidA sk Delta AUG 16 ´13\n2.5\n5\n7.5\n10\nNOV 15 ´13\n2.5\n5\n7.5\n10\n12.5\nFEB 21 ´14\nDescriptionCall\nLast Change BidA sk Impl. Bid Vol. Impl. Ask Vol.Impl. Bid Vol. Impl. Ask Vol. Delta\nPut\nC0.00\nC0.00\nC0.25\nC2.25\nC0.00\nC0.00\nC0.55\nC2.35\nC0.00\nC0.10\nC0.85\nC2.55\nC4.80\n5.20 5.50N /A 340.099% 0.9978\n0.9978\n0.7330\n0.1316\n0.9347\n0.8524\n0.6103\n0.1516\n0.9933\n0.9190\n0.6070\n0.2566\n0.1024\n142.171%\n46.039%\n76.652%\nN/A\nN/A\n2.95\n0.55\n0.10\n0.20\n0.10 N/A\nN/A\nN/A\n0.10\n0.30\n2.35\n40.733%\nN/A\nN/A\nN/A\nN/A\n36.550%\n38.181%\n35.520%\n35.509%\n35.664%\n2.10\n0.50\n0.05\n0.10\n0.60\n2.402.30\n0.05\n0.15\n0.15\n0.85\n2.60\n4.90\n2.70\n0.500.00\n5.20 5.50\n3.00\n0.90\n0.20\n2.80\n0.80\n0.10\n5.505.10\n3.102.85\n1.151.05\n0.400.30\n0.200.05\n39.708%\nN/A\nN/A\n36.722%\nN/A\n38.754%\n38.318%\n39.127%\n36.347%\n36.336%\n292.169% 0.0000\n-0.0000\n-0.2778\n-0.8663\n-0.0616\n-0.1447\n-0.3886\n-0.8447\n-0.0018\n-0.0787\n-0.3890\n-0.7375\n-0.8913\n128.711%\n53.108%\n88.008%\n117.369%\n60.675%\n42.433%\n44.802%\n110.810%\n50.757%\n42.074%\n43.947%\n49.401%\n163.282%\n75.219%\n42.610%\n45.215%\n122.894%\n64.543%\n42.697%\n44.728%\n50.218%\nC5.30\nC2.80\nC0.85\nC0.10\nC5.30\nC1.10\nC0.35\nC0.10\n3.00 +0.15\n0.70\n2.45\n4.60\nIn the end, I would probably end up picking the implied volatility \nassociated with the options struck at $7.50 and expiring in August 2013 \n(26 days until expiration). I was torn between these and the same strike \nexpiring in November, but the August options are at least being actively \ntraded, and the percentage bid-ask spread on the call side is lower for them \nthan for the November options. Note, though, that the August 2013 put \noptions are so far OTM that the bid-ask spread is very wide. In this case, \nI would probably look closer at the call options’ implied volatilities. In the \nend, I would have a bid volatility of around 39 percent and an ask volatility \nof around 46 percent. Because the bid-ask spread is large, I would probably \nwant to see a cone for both the bid and ask.\nPlugging in the 22.0/22.5 for Oracle,\n2 I would come up with this cone:\nDate\nOracle (ORCL)\nPrice per Share\n60\n40\n50\n30\n10\n20\n-\n6/21/201612/24/20156/27/201512/29/20147/2/20141/3/20147/7/20131/8/20137/12/2012\nFinding Mispriced Options    • 159\nPlugging in the 39/46 for Mueller Water, I would get the following:\n6/21/201612/24/20156/27/201512/29/20147/2/20141/3/20147/7/20131/8/20137/12/2012\nDate\nMueller Water (MWA)\nPrice per Share\n25\n20\n15\n5\n10\n-\nY ou can see with Mueller Water just how big a 7 percentage point dif-\nference can be for the bid and ask implied volatilities in terms of projected \noutcomes. The 39 percent bid implied volatility generates an upper range \nat just around $15; the 46 percent ask implied volatility generates an upper \nrange that is 20 percent or so higher than that!\nOverlay an Intelligent Valuation Range on the BSM Cone\nThis is simple and exactly the same for a big company or a small one, \nso I’ll just keep going with the Oracle example. After having done a full \nvaluation as shown in the exam valuation of Oracle on the IOI website, \nyou’ve got a best-case valuation, a worst-case valuation, and probably \nan idea about what a likely valuation is. Y ou simply draw those numbers \nonto a chart like this:\n160  •   The Intelligent Option Investor\n6/21/201612/24/20156/27/201512/29/20147/2/20141/3/20147/7/20131/8/20137/12/2012\nDate\nOracle (ORCL)\nPrice per Share\n60\nBest Case\nLikely Case\nWorst Case\n40\n50\n30\n10\n20\n-\n$52\n$43\n$30\nOnce this step is done, we are ready to go onto the next and final step.\nLook for Discrepancies\nThe last step is also easy. Because options split a stock’s returns into upside \nand downside exposure, we need to take a look at both the upside and \ndownside to see where our projections differ from those of the market.\n6/21/201612/24/20156/27/201512/29/20147/2/20141/3/20147/7/20131/8/20137/12/2012\nDate\nOracle (ORCL)\nPrice per Share\n60\nBest Case\nLikely Case\nWorst Case\n40\n50\n30\n10\n20\nDownside\nUpside\n-\n$52\n$43\n$30\nA\nB\nFinding Mispriced Options    • 161\nOn the upside, we can see that our likely case valuation is $43 per share, \nwhereas the BSM’s most likely value is a bit less than $35—a difference of \nmore than 20 percent. This is the area on the graph labeled “ A. ” The BSM \nprices options based on the likelihood of the stock hitting a certain price \nlevel. The BSM considers the $43 price level to be relatively unlikely, whereas \nI consider it relatively likely. As such, I believe that options that allow me to \ngain exposure to the upside potential of Oracle—call options—are underval-\nued. In keeping with the age-old rule of investing to buy low, I will want to \ngain exposure to Oracle’s upside by buying low-priced call options.\nOn the downside, I notice that there is a fairly large discrepancy \nbetween my worst-case valuation ($30) and the lower leg of the BSM cone \n(approximately $24)—this is the region of the graph labeled “B, ” and the \nseparation between the two values is again (just by chance) about 20 percent. \nThe BSM is pricing options granting exposure to the downside—put \noptions—struck at $24 as if they were fairly likely to occur; something that \nis fairly like", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 53}
{"text": "e discrepancy \nbetween my worst-case valuation ($30) and the lower leg of the BSM cone \n(approximately $24)—this is the region of the graph labeled “B, ” and the \nseparation between the two values is again (just by chance) about 20 percent. \nThe BSM is pricing options granting exposure to the downside—put \noptions—struck at $24 as if they were fairly likely to occur; something that \nis fairly likely to occur will be priced expensively by the BSM. My analysis, \non the other hand, makes me think that the BSM’s valuation outcome is \nvery unlikely. The discrepancy implies that I believe the put options to be \novervalued—the BSM sees a $24 valuation as likely, with expensive options, \nwhereas I see it as unlikely, with nearly valueless options. In this case, we \nshould consider the other half of the age-old investing maxim and sell high.\nIn a graphic representation, this strategy might look like this:\n6/21/201612/24/20156/27/201512/29/20147/2/20141/3/20147/7/20131/8/20137/12/2012\nDate\nOracle (ORCL)\nPrice per Share\n60\nBest Case\nLikely Case\nWorst Case\n40\n50\n30\n10\n20\nDownside\nUpside\n-\n$52\n$43\n$30\nGREEN\nRED\n162  •   The Intelligent Option Investor\nWhy would I select such a short-term put option to sell? Why would \nI pick an OTM call option to buy? These are the kinds of questions I will \ncover in Chapters 9–11, which look at the specifics of different option \nstrategies.\nBefore we look at strategies, though, an option investor cannot be \nsaid to be intelligent without understanding what leverage is and how to \nuse it safely and effectively in a portfolio. We turn to this in Chapter 8.\n163\nChapter 8\nUnderstanding and \nmanaging Leverage\nIn the media, the word leverage seems like it usually occurs alongside such \nwords as dangerous, speculative, or even irresponsible, so most people have \ninternalized the message that leverage is morally wrong; options—levered \ninstruments that they are—are, by extension, viewed as morally wrong as \nwell. In fact, nearly everyone uses leverage every day of their lives without \nincident and presumably without incurring a moral stain. In my opinion, \nit is not leverage that is the problem but rather an ignorance of how lever-\nage works, coupled with overleverage and the inherent human belief that \ndisasters only happen to someone else, that is the problem. \nLeverage is a powerful tool, but like all powerful tools, if used recklessly \nand without understanding, it can bring its user to unpleasant outcomes. \nCertainly a discussion of gaining and accepting exposure using option con-\ntracts would be incomplete without a good explanation of leverage.\nI like to think of leverage coming in three flavors: operational, financial, \nand investment—the first two of which I mentioned in an earlier chapter and \ngo into more detail in Appendix B. This chapter delves specifically into in-\nvestment leverage, but to the extent that investment leverage is similar to the \nother forms of leverage, referring to Appendix B to learn about those forms \nwill help deepen your understanding of investment leverage. In this chapter, \nI first define investment leverage, discuss how it can be gained by using either \ndebt or options, look at common ways to measure it, and introduce a unique \nmethod of measuring and managing leverage in an investment portfolio.\nLeverage is not something to be taken lightly. Many very highly \ntrained, well-educated, and well-capitalized investors have gone bankrupt \n164  •   The Intelligent Option Investor\nbecause of their lack of appreciation for the fact that the sword of lever -\nage cuts both ways. Certainly an option investor cannot be considered an \nintelligent investor without having an understanding and a deep sense \nof respect for the simultaneous power and danger that leverage conveys.\nNew jargon introduced in this chapter includes the following:\nLambda\nNotional exposure\nInvestment Leverage\nCommit the following definition to memory:\nInvestment leverage is the boosting of investment returns calcu-\nlated as a percentage by altering the amount of one’s own capital \nat risk in a single investment.\nInvestment leverage is inextricably linked to borrowing money—this \nis what I mean by the phrase “altering the amount of one’s own capital at \nrisk. ” In this way, it is very similar to financial leverage. In fact, in my mind, \nthe difference between financial and investment leverage is that a company \nuses financial leverage to fund projects that will produce goods or provide \nservices, whereas in the case of investing leverage, it is used not to produce \ngoods or services but to amplify the effects of a speculative position.\nFrequently people think of investing leverage as simply borrowing \nmoney to invest. However, as I mentioned earlier, you can invest in options \nfor a lifetime and never explicitly borrow money in the process. I believe \nthat the preceding definition is broad enough to handle both the case of \ninvestment leverage generated through explicit borrowing and the case of \nleverage generated by options.\nLet’s take a look at a few example investments—unlevered, levered \nusing debt, and levered using options.\nUnlevered Investment\nLet’s say that you buy a stock for exactly $50 per share, expecting that its intrinsic \nvalue is closer to $85 per share. Over the next year, the stock increases by $5, \nor 10 percent in value. Y our unrealized percentage gain on this investment is \nUnderstanding and Managing Leverage    • 165\nobviously 10 percent. If instead the stock declines to $45 per share over that \nyear, you would be sitting on an unrealized percentage loss of 10 percent.\nOf course, this is very straightforward. Let’s now look at the purchase \nof a share of common stock using borrowed capital.\nLevered Investment Using Debt\nLet’s say that to buy a $50 share, you borrow $45 from a bank at an inter -\nest rate of 5 percent per year, put in $5 of your own cash, and buy that \nsame share of stock. Again, let’s assume that the stock increases in value by \n$5 over one", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 54}
{"text": "cent.\nOf course, this is very straightforward. Let’s now look at the purchase \nof a share of common stock using borrowed capital.\nLevered Investment Using Debt\nLet’s say that to buy a $50 share, you borrow $45 from a bank at an inter -\nest rate of 5 percent per year, put in $5 of your own cash, and buy that \nsame share of stock. Again, let’s assume that the stock increases in value by \n$5 over one year, closing at $55 per share. At the end of the year, you sell the \nstock and pay back the bank loan with interest (a total of $47.25). Doing so, \nyou realize gross proceeds of $7.75 on an original investment of $5 of your \nown capital, which equates to $2.75 in gross profits and implies a percent-\nage investment return of 55 percent.\nThere are three important things to note by comparing the levered \nand unlevered examples:\n1. The percentage return is much higher for the levered investment \n(55 versus 10 percent) because you have reduced the amount of \nyour own capital at risk much more than you have reduced the \ndollar return in the numerator.\n2. The actual dollar amount gained is lower in the levered example \n($2.75 versus $10). If your investment mandate would have been \n“Generate at least $10 worth of investment returns, ” a single unit \nof the levered investment would have failed to meet this mandate. \n3. Obviously, the underlying asset and its returns are the same in both \nlevered and unlevered scenarios—we are changing our profit expo-\nsure to the underlying, not altering its volatility or other behavior. \nTo fully understand leverage’s effects, however, we should also con-\nsider the loss scenario. Again, let’s assume that we borrow $45 and spend \n$5 of our own money to buy the $50 per share stock. We wake the next \nmorning to news that the company has discovered accounting irregulari-\nties in an important foreign subsidiary that has caused it to misstate reve-\nnues and profits for the last three years. The shares suddenly fall 10 percent \non the news. The unrealized loss is $5—the 10 percent fall in stock value \nhas wiped out 100 percent of our investment capital. \n166  •   The Intelligent Option Investor\nAnd herein lies the painful lesson learned by many a soul in the \nfinancial markets: leverage cuts both ways. The profits happily roll in dur-\ning the good times, but the losses inexorably crash down during bad times.\nLevered Investment Using Options\nDiscussing option-based investing leverage is much easier if we focus on \nthe perspective of gaining exposure. Because most people are more com-\nfortable thinking about the long side of investing, let’s look at an example \nof gaining upside exposure on a company.\nLet’s assume we see a $50 per share stock that we believe is worth $85 (in \nthis example, I am assuming that we only have a point estimate of the intrinsic \nvalue of the company so as to simplify the following diagram—normally, it is \nmuch more helpful to think about fair value ranges, as explained in Part II of \nthis book and demonstrate in the online example). We are willing to buy the \nshare all the way up to a price of $68 (implying a 25 percent return if bought \nat $68 and sold at $85) and can get call options struck at $65 per share for only \n$1.50. Graphically, this prospective investment looks like this:\nFair Value Estimate\n5/18/2012 5/20/2013 249 499 749 999\n-\n10\n20\n30\n40\n50\n60\n70\n80\n90\nEBP = $66.50\nDate/Day Count\nAdvanced Building Corp. (ABC)\nStock Price\nGREEN\nUnderstanding and Managing Leverage    • 167\nIn two years, you are obligated to pay your counterparty $65 if you \nwant to hold the stock, but the decision as to whether to take possession \nof the stock in return for payment is solely at your discretion. In essence, \nthen, you can look at buying a call option as a conditional borrowing of \nfunds sometime in the future. Buying the call option, you are saying, “I \nmay want to borrow $65 two years from now. I will pay you some interest \nup front now, and if I decide to borrow the $65 in two years, I’ll pay you \nthat principal then. ”\nIn graphic terms, we can think about this transaction like this:\n5/18/2012 5/20/2013 249 499 749 999\n-\n10\n20\n30\n40\n50\n60\n70\n80\n90\n$1.50 “prepaid interest”\nContingent loan, the future repayment\nof principal is made solely at the\ninvestor’s own discretion.\nFair Value Estimate\nAdvanced Building Corp. (ABC)\nDate/Day Count\nStock Price\nGREEN\nIf the stock does indeed hit the $85 mark just at the time our option \nexpires, we will have realized a gross profit of $20 (= $85 − $65) on an \ninvestment of $1.50, for a percentage return of 1,233 percent! Obviously, \nthe call option works very much like a loan in terms of altering the \ninvestor’s capital at risk and boosting subsequent investment returns. \nHowever, although the leverage looks very similar, there are two impor -\ntant differences:\n168  •   The Intelligent Option Investor\n1. As shown and mentioned earlier, when using an option, payment \non the principal amount of $65 in this case is conditional and com-\npletely discretionary. For an option, the interest payment is made \nup front and is a sunk cost.\n2. Because repayment is discretionary in the case of an option, you \ndo not have any financial risk over and above the prepayment of \ninterest in the form of an option premium. Repayment of a con-\nventional loan is mandatory, so you have a large financial risk if \nyou cannot repay the principal at maturity in this case.\nRegarding the first difference, not only is the loan conditional \nand discretionary, the loan also has value and can be transferred to \nanother for a profit. What I mean is this: if the stock rises quickly, the \nvalue of that option in the open market will increase, and rather than \nholding the “loan” to maturity, you can simply sell it with your profits \noffsetting the original cost of the prepaid interest plus giving you a \nnice profit. \nRegarding the second difference, consider this: if you are using bor -\nrowed money to invest and your stock drops heavily, the broker will mak", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 55}
{"text": "stock rises quickly, the \nvalue of that option in the open market will increase, and rather than \nholding the “loan” to maturity, you can simply sell it with your profits \noffsetting the original cost of the prepaid interest plus giving you a \nnice profit. \nRegarding the second difference, consider this: if you are using bor -\nrowed money to invest and your stock drops heavily, the broker will make \na margin call (i.e., ask you to deposit more capital into the account), and \nif you cannot make the margin call, the broker will liquidate the position \n(most brokers shoot first and ask questions later, simply closing out the \nposition and selling other assets to cover the loss at the first sign margin \nrequirements will not be met). If this happens, you can be 100 percent \ncorrect on your valuation long term but still fail to benefit economically \nbecause the position has been forcibly closed. In the case of options, the \nunderlying stock can lose 20 percent in a single day, and the owner of a \ncall option will never receive a margin call. The flip side of this benefit \nis that although you are not at risk of losing a position to a margin call, \noption ownership does not guarantee that you will receive an economic \nreward either. \nFor example, if the option mentioned in the preceding example ex-\npires in two years when the stock is trading at $64.99 and the stock has paid \n$2.10 in dividends over the previous two years, the option holder ends up \nwith neither the stock nor the dividend check.\nUnderstanding and Managing Leverage    • 169\nSimple Ways of Measuring Option \nInvestment Leverage\nThere are several single-point, easily calculable numbers to measure \noption-based investment leverage. There are uses for these simple measures \nof leverage, but unfortunately, for reasons I will discuss, the simple num-\nbers are not enough to help an investor intelligently manage a portfolio \ncontaining option positions. \nThe two simple measures are lambda and notional exposure. Both are \nexplained in the following sections.\nLambda\nThe standard measure investors use to determine the leverage in an option \nposition is one called lambda . Lambda—sometimes known as percent \ndelta—is a derivative of the delta\n1 factor we discussed in Chapter 7 and is \nfound using the following equation:\n= ×Lambda deltas tock price\noptionprice\nLet’s look at an actual example. The other day, I bought a deep in-\nthe-money (ITM) long-tenor call option struck at $20 when the stock \nwas trading at $30.50. The delta of the option at that time was 0.8707, \nand the price was $11. The leverage in my option position was calculated \nas follows:\n= × = × =Lambda deltas tock price\noptionprice\n0.87 30.50\n11 2.40\n \nWhat this figure of 2.4 is telling us is that when I bought that option, if the \nprice of the underlying moved by 1 percent, the value of my position would \nmove by about 2.4 percent. This is not a hard and fast number—a change in \nprice of either the stock or the option (as a result of a change in volatility or \ntime value or whatever) will change the delta, and the lambda will change \nbased on those things. \n170  •   The Intelligent Option Investor\nBecause investment leverage comes about by changing the amount \nof your own capital that is at risk vis-à-vis the total size of the investment, \nyou can imagine that moneyness has a large influence on lambda. Let’s \ntake a look at how investment leverage changes for in-the-money (ITM), \nat-the-money (ATM), and out-of-the-money (OTM) options. The stock \nunderlying the following options was trading at $31.25 when these data \nwere taken, so I’m showing the $29 and $32 strikes as ATM: \nStrike Price K /S Ratio Call Price Delta Lambda\n15.00 0.48 17.30 0.91 1.64\n20.00 0.64 11.50 0.92 2.50 ITM\n21.00 0.67 11.30 0.86 2.38\n22.00 0.70 9.60 0.89 2.90\n… \n…\n…\n…\n…\n29.00 0.93 3.40 0.68 6.25\n30.00 0.96 2.74 0.61 6.96 ATM\n31.00 0.99 2.16 0.54 7.81\n…\n…\n…\n…\n…\n39.00 1.25 0.18 0.09 15.63\n40.00 1.28 0.13 0.06 14.42 OTM\n41.00 1.31 0.09 0.05 17.36\nWhen an option is deep ITM, as in the case of the $20-strike call, we \nare making a significant expenditure of our own capital compared with \nthe size of the investment. Buying a call option struck at $20, we are—\nas explained in the preceding section—effectively borrowing an amount \nequal to the $20 strike price. In addition to this, we are spending $11.50 in \npremium. Of this amount, $11.25 is intrinsic value, and $0.25 is time value. \nWe can look at the time value portion as the prepaid interest we discussed \nin the preceding section, and we can even calculate the interest rate im-\nplied by this price (this option had 189 days left before expiration, implying \nan annual interest charge of 2.4 percent, for example). This prepaid interest \ncan be offset partially or fully by profit realized on the position, but it can \nnever be recaptured so must be considered a sunk cost. Time value always \ndecays independent of the price changes of the underlying, so although an \nUnderstanding and Managing Leverage    • 171\nupward movement in the stock will offset the money spent on time value, \nthe amount spent on time value is never recoverable.\nThe remaining $11.25 of the premium paid for a $20-strike call op-\ntion is intrinsic value . Buying intrinsic value means that we are exposing \nour own capital to the risk of an unrealized loss if the stock falls below \n$31.25. Lambda is directly related to the amount of capital we are exposing \nto an unrealized loss versus the size of the “loan” from the option, so be-\ncause we are risking $11.25 of our own capital and borrowing $20 with the \noption (a high capital-to-loan proportion), our investment leverage meas-\nured by lambda is a relatively low 2.50.\nNow direct your attention to a far OTM call option—the one struck \nat $39. If we invest in the $39-strike option, we are again effectively \ntaking out a $39 contingent loan to buy the shares. Again, we take the \ntime-value portion of the option’s price—in this case the entire premi-\num", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 56}
{"text": "ption (a high capital-to-loan proportion), our investment leverage meas-\nured by lambda is a relatively low 2.50.\nNow direct your attention to a far OTM call option—the one struck \nat $39. If we invest in the $39-strike option, we are again effectively \ntaking out a $39 contingent loan to buy the shares. Again, we take the \ntime-value portion of the option’s price—in this case the entire premi-\num of $1.28—to be the prepaid interest (an implied annualized rate of \n6.3 percent) and note that we are exposing none of our own capital to \nthe risk of an unrealized loss. Because we are subjecting none of our \nown capital in this investment and taking out a large loan, our invest-\nment leverage soars to a very high value of 15.63. This implies that a \n1 percentage point move in the underlying stock will boost our invest-\nment return by over 15 percent!\nObviously, these calculations tell us that our investment returns are \ngoing to be much more volatile for small changes in the underlying’s price \nwhen buying far OTM options than when buying far ITM options. This is \nfine information for someone interested in more speculative strategies—if \na speculator has the sense that a stock will rise quickly, he or she could, \nrather than buying the stock, buy OTM options, and if the stock went up \nfast enough and soon enough offset any drop of implied volatility and time \ndecay, he or she would pocket a nice, highly levered profit.\nHowever, there are several factors that limit the usefulness of lambda. \nFirst, because delta is not a constant, the leverage factor does not stay put \nas the stock moves around. For someone who intends to hold a position for \na longer time, then, lambda provides little information regarding how the \nposition will perform over their investment horizon. \nIn addition, reading the preceding descriptions of lambda, it is ob-\nvious that this measure deals exclusively with the percentage change in \n172  •   The Intelligent Option Investor\nthe option’s value. Although everyone (especially fly-by-night investment \nnewsletter editors) likes to tout their percentage returns, we know from \nour earlier investigations of leverage that percentage returns are only part \nof the story of successful investing. Let’s see why using the three invest-\nments I mentioned earlier—an ITM call struck at $20, an OTM call struck \nat $39, and a long stock position at $31. \nI believe that there is a good chance that this stock is worth north of \n$40—in the $43 range, to be precise (my worst-case valuation was $30, and \nmy best-case valuation was in the mid-$50 range). If I am right, and if this \nstock hits the $43 mark just as my options expire,\n2 what do I stand to gain \nfrom each of these investments?\nLet’s take a look. \nSpent Gross Profit Net Profit Percent Profit\n$39-strike call 0.18 4.00 3.82 2,122\n$20-strike call 11.50 23.00 11.50 100\nShares 31.25 43.00 11.75 38\nThis table means that in the case of the $20-strike call, we spent \n$11.50 to win gross proceeds of $23.00 (= $43 − $20) and a profit net of \ninvestment of $11.50. Netting $11.50 on an $11.50 investment generates a \npercentage profit of 100 percent.\nLooking at this chart, the first thing you are liable to notice is the \n“Percent Profit” column. That 2,122 percent return looks like something \nyou might see advertised on an option tout service, doesn’t it? Y es, that \npercentage return is wonderful, until you realize that the absolute value \nof your dollar winnings will not allow you to buy a latte at Starbuck’s. \nLikewise, the 100 percent return on the $20-strike options looks heads and \nshoulders better than the measly 38 percent on the shares, until you again \nrealize that the latter is still giving you more money by a quarter.\nRecall the definition of leverage as a way of “boosting investment re-\nturns calculated as a percentage, ” and recall that in my previous discussion \nof financial leverage, I mentioned that the absolute dollar value is always \nhighest in the unlevered case. The fact is that many people get excited about \nstratospheric percentage returns, but stratospheric percentage returns only \nUnderstanding and Managing Leverage    • 173\nmatter if a significant chunk of your portfolio is exposed to those returns!\nLambda is a good measure to show how sensitive percentage returns are to \na move in the stock price, but it is useless when trying to understand what \nthe portfolio effects of those returns will be on an absolute basis.\nNotional Exposure\nLook back at the preceding table. Let’s say that we wanted to make \nlambda more useful in understanding portfolio effects by seeing how \nmany contracts we would need to buy to match the absolute return of \nthe underlying stock. Because our expected dollar return of one of the \n$39-strike calls only makes up about a third of the absolute return of the \nstraight stock investment ($3.82 / $11.75 = 32.5% ≈ 1/3), it follows that if \nwe wanted to make the same dollar return by investing in these call options \nthat we expect to make by buying the shares, we would have to buy three \nof the call options for every share we wanted to buy. Recalling that op-\ntions are transacted in contract sizes of 100 shares, we know that if we were \nwilling to buy 100 shares of Oracle’s stock, we would have to buy options \nimplying control over 300 shares to generate the same absolute profit for \nour portfolio.\nI call this implied control figure notional exposure. Continuing with \nthe $39-strike example, we can see that the measure of our leverage on the \nbasis of notional exposure is 3:1. The value of the notional exposure is cal-\nculated by multiplying it by the strike; in this case, the notional exposure \nof 300 shares multiplied by the strike price of $39 gives a notional value \nfor the contracts of $11,700. This value is called the notional amount of the \noption position. \nSome people calculate a leverage figure by dividing the notional amount \nby the total cost of the options. In our example, we would pay $18 p", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 57}
{"text": "is cal-\nculated by multiplying it by the strike; in this case, the notional exposure \nof 300 shares multiplied by the strike price of $39 gives a notional value \nfor the contracts of $11,700. This value is called the notional amount of the \noption position. \nSome people calculate a leverage figure by dividing the notional amount \nby the total cost of the options. In our example, we would pay $18 per con-\ntract for three contracts, so leverage measured in this way would work out to \nbe 217 (= $11,700 ÷ $54). I actually do not believe this last measure of lever-\nage to be very helpful, but notional control will become important when we \ntalk about the leverage of short-call spreads later in this chapter.\nThese simple methods of measuring leverage have their place in ana-\nlyzing option investment strategies, but in order to really master leverage, \nyou must understand leverage in the context of portfolio management.\n174  •   The Intelligent Option Investor\nUnderstanding Leverage’s Effects on a Portfolio\nLooking at leverage from a lambda or notional control perspective gives \nsome limited information about leverage, but I believe that the best way \nto think about option-based investment leverage is to think about the ef-\nfect of leverage on an actual portfolio allocation basis. This gives a richer, \nmore nuanced view of how leverage stands to help or hurt our portfolio \nand allows us more insight into how we can intelligently structure a mixed \noption-stock portfolio.\nLet’s start our discussion of leverage in a portfolio context by thinking \nabout how to select investments into a portfolio. We will assume that we \nhave $100 in cash and want to use some or all of that cash to invest in risky \nsecurities. Cash is riskless (other than inflation risk, but let’s ignore that \nfor a moment), so the risk we take on in the portfolio will be dampened \nby keeping cash, and the returns we will win from the portfolio will be \nsimilarly dampened.\nWe have a limited amount of capital and want to allocate that capital \nto risky investments in proportion to two factors:\n1. The amount we think we can gain from the investment\n2. Our conviction in the investment, which is a measure of our per -\nception of the riskiness of the investment\nWe might see a potential investment that would allow us to reap a profit \nof $9 for every $1 invested (i.e., we would gain a great deal), but if our \nconviction in that investment is low (i.e., we think the chance of winning \n$9 for every $1 invested is very low), we would likely not allocate much of \nour portfolio to it.\nIn constructing a portfolio, most people set a limit on the proportion \nof their portfolio they want to allocate to any one investment. I personally \nfavor more concentrated positions, but let’s say that you paid better atten-\ntion to your finance professor in school than I did and figure that you want \nto limit your risk exposure to any one security to a maximum of $5 of your \n$100 portfolio. \nAn unlevered portfolio means that each $5 allocation would be made \nby spending $5 of your own capital. Y ou would know that if the value of \nthe underlying security decreases by $2.50, the value of the allocation will \nUnderstanding and Managing Leverage    • 175\nalso fall to $2.50. If, instead, the value of the underlying security increases \nby $2.50, the value of that allocation will rise to $7.50.\nIn a levered portfolio, each $5 allocation uses some proportion of \ncapital that is not yours—borrowed in the case of a margin loan and con-\ntingently borrowed in the case of an option. This means that for every \n$1 increase or decrease in the value of the underlying security, the lev-\nered allocation increases or decreases by more than $1. Leverage, in this \ncontext, represents the rate at which the value of the allocation increases \nor decreases for every one-unit change in the value of the underlying \nsecurity.\nWhen thinking about the risk of leverage, we must treat different types \nof losses differently. A realized loss represents a permanent loss of capital—a \nsunk cost for which future returns can offset but never undo. An unrealized \nloss may affect your psychology but not your wealth (unless you need to \nrealize the loss to generate cash flow for something else—I talk about this \nin Chapter 11 when I address hedging). For this reason, when we measure \nhow much leverage we have when the underlying security declines, we will \nmeasure it on the basis of how close we are to suffering a realized loss rather \nthan on the basis of the unrealized value of the loss. Leverage on the profit \nside will be handled the same way: we will treat our fair value estimate as the \nprice at which we will realize a gain. Because the current market price of a \nsecurity may not sit exactly between our fair value estimate and the point at \nwhich we suffer a realized loss, our upside and downside leverage may be \ndifferent.\nLet’s see how this comes together with an actual example. For this ex-\nample, I looked at the price of Intel’s (INTC) shares and options when the \nformer were trading at $22.99. Let’s say that we want to commit 5 percent \nof our portfolio value to an investment in Intel, which we believe is worth \n$30 per share. For every $100,000 in our portfolio, this would mean buying \n217 shares. This purchase would cost us $4,988.83 (neglecting taxes and \nfees, of course) and would leave us with $11.17 of cash in reserve. After we \nmade the buy, the stock price would fluctuate, and depending on what its \nprice was at the end of 540 days [I’m using as an investment horizon the \ndays to expiration of the longest-tenor long-term equity anticipation secu-\nrities (LEAPS)], the allocation’s profit and loss profile would be represented \ngraphically like this:\n176  •   The Intelligent Option Investor\n02468 10 12 14 16 18 20 22 24\nStock Price\nUnlevered Investment (Full Allocation)\nGain (Loss) on Allocation\n26 28 30 32 34 36 38 40 42 44 46 48 50(6,000)\n(4,000)\n(2,000)\n-\n2,000\n4,000\n6,000\n8,000\nU", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 58}
{"text": "on of the longest-tenor long-term equity anticipation secu-\nrities (LEAPS)], the allocation’s profit and loss profile would be represented \ngraphically like this:\n176  •   The Intelligent Option Investor\n02468 10 12 14 16 18 20 22 24\nStock Price\nUnlevered Investment (Full Allocation)\nGain (Loss) on Allocation\n26 28 30 32 34 36 38 40 42 44 46 48 50(6,000)\n(4,000)\n(2,000)\n-\n2,000\n4,000\n6,000\n8,000\nUnrealized Gain\nUnrealized Loss\nCash Value\nNet Gain (Loss) - Unlevered\nRealized Loss\nHere the future stock price is listed from 0 to 50 on the horizontal axis, \nand the net profit or loss to this position is listed on the vertical axis. Obvious-\nly, any gain or loss would be unrealized unless Intel’s stock price went to zero, \nat which point the total position would only be worth whatever spare cash we \nhad. The black profit and loss line is straight—the position will lose or gain on \na one-for-one basis with the price of the stock, so our leverage is 1.0.\nNow that we have a sense of what the graph for a straight stock \nposition looks like, let’s take a look at a few different option positions. \nWhen I drew the data for this example, the following 540-day expiration \ncall options were available:\nStrike Price Ask Price Delta\n15 8.00 0.79\n22 2.63 0.52\n25 1.43 0.35\nLet’s start with the ITM option and construct a simple-minded posi-\ntion that attempts to buy as many of these option contracts as possible with \nthe $5,000 we have reserved for this investment. We will pay $8 per share \nUnderstanding and Managing Leverage    • 177\nor $800 per contract, which would allow us to buy six contracts in all for \n$4,800. There is only $0.01 worth of time value (= $15.00 + $8.00 − $22.99) \non these options because they are so far ITM. This means that we are pay-\ning $1 per contract worth of time value that is never recoverable, so we \nshall treat it as a realized loss. If we were to graph our potential profit and \nloss profile using this option, assuming that we are analyzing the position \njust as the 540-day options expire, we would get the following\n3:\nNet Gain (Loss) - Levered\n0246810 12 14 16 18 20 22 24\nStock Price\nLevered Strategy Overview\nGain (Loss) on Allocation\n26 28 30 32 34 36 38 40 42 44 46 48 50(10,000)\n(5,000)\n-\n5,000\n10,000\nUnrealized Gain\nUnrealized Loss\nCash Value\nRealized Loss\n15,000\n20,000\nThe most obvious differences from the diagram of the unlevered po-\nsition are (1) that the net gain/loss line is kinked at the strike price and \n(2) that we will realize a total loss of invested capital—$4,800 in all—if \nIntel’s stock price closes at $15 or below. The kinked line demonstrates the \nmeaning of the first point made earlier regarding option-based investment \nleverage—an asymmetrical return profile for profits and losses. Note that \nthis kinked line is just the hockey-stick representation of option profit and \nloss at expiration that one sees in every book about options except this \none. Although I don’t believe that hockey-stick diagrams are terribly useful \nfor understanding individual option transactions, at a portfolio level, they \ndo represent the effect of leverage very well. This black line represents a \n178  •   The Intelligent Option Investor\nlevered position, and its slope is much steeper than that of an equivalent \nline showing net profit and loss on an unlevered position. A comparison of \nthe two net profit lines on the same graph shows this clearly:\n02468 10 12 14 16 18 20 22 24\nStock Price\nProfit and Loss Profile for Levered and Unlevered Investments\nGain (Loss) on Allocation\n26 28 30 32 34 36 38 40 42 44 46 48 50\n(10,000)\n(5,000)\n-\n5,000\n10,000\n15,000\n20,000\nNet Gain (Loss) - Unlevered\nNet Gain (Loss) - Levered\nLooking at this diagram, you will notice the following things about \nthe risk and return characteristics of the two positions:\nInvestment Maximum Loss Price\nNet Profit at Fair \nValue Estimate\nStock $0 $1,472\nOption $15 (2.8 × stock loss) $4,200 (3.0 × stock profit)\nThe leverage on the stock loss and the leverage on the stock profit are \nnearly equal in this instance because the point at which we realize a loss \n($15) is just about the same distance below the market price as our pre-\nsumed fair value ($30) is above. The leverage to loss is calculated as\n=Loss leverage realized loss as ap ercent of allocation\npercents tock declinet or ealizedl oss\nUnderstanding and Managing Leverage    • 179\nIn this example, we suffer a realized loss of 96 percent (= $4,800 ÷ \n$5,000) if the stock falls 35 percent, so the equation becomes\n= − =− ×Lossleverage 96%\n35% 2.8\n \n(By convention, I’ll always write the loss leverage as a negative.) This \nequation just means that it takes a drop of 35 percent to realize a loss on \n96 percent of the allocation.\nThe profit leverage is simply a ratio of the levered portfolio’s net profit \nto the unlevered portfolio’s net profit at the fair value estimate. For this \nexample, we have\n== ×Profitleverage $4,200\n$1,472 3.0\n \nLet’s do the same exercise for the ATM and OTM options and see \nwhat fully levered portfolios with each of these options would look like \nfrom a risk-return perspective. If we bought as many $22-strike options as \na $5,000 position size would allow (19 contracts in all), our profit and loss \ngraph and table would look like this:\n02468 10 12 14 16 18 20 22 24\nStock Price\nLevered Strategy Overview\nGain (Loss) on Allocation\n26 28 30 32 34 36 38 40 42 44 46 48 50(20,000)\n-\n40,000\n60,000\n80,000\n100,000\n20,000\nUnrealized Gain\nUnrealized Loss\nCash Value\nNet Gain (Loss) - Levered\nRealized Loss\n180  •   The Intelligent Option Investor\nInstrument Maximum-Loss Price Net Profit at Fair Value Estimate\nStock $0 $1,472\nOption $22 (23.2 × stock loss) $10,203 (6.9 × stock profit)\nThis is quite a handsome potential profit—6.9 times higher than we \ncould earn using a straight stock position—but at an enormous risk. Each \n$1 drop in the stock price equates to a $23.20 drop in the value of the posi-\ntion. Note that the realized loss shows a step up from $22 to", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 59}
{"text": "s Price Net Profit at Fair Value Estimate\nStock $0 $1,472\nOption $22 (23.2 × stock loss) $10,203 (6.9 × stock profit)\nThis is quite a handsome potential profit—6.9 times higher than we \ncould earn using a straight stock position—but at an enormous risk. Each \n$1 drop in the stock price equates to a $23.20 drop in the value of the posi-\ntion. Note that the realized loss shows a step up from $22 to $23. This just \nshows that above the strike price, our only realized loss is the money we \nspent on time value.\nThe last example is that of the fully levered OTM call options. Here is \nthe table illustrating this case:\nInstrument Maximum-Loss Price Net Profit at Fair Value Estimate\nStock $0 $1,472\nOption $25 (IRL 5 percent) $12,495 (8.5 × stock profit)\nThere is no intrinsic value to this option, so the entire cost of \nthe option is treated as an immediate realized loss (IRL) from inception. \nThe “IRL 5 percent” notation means that there is an immediate realized \nloss of 5 percent of the total portfolio. The maximum net loss is again at \nthe strike price of $25. The leverage factor at our fair value estimate price \nis 8.5, but again this leverage comes at the price of having to realize a \n5 percent loss on your portfolio—500 basis points of performance—and \nthere is no certainty that you will have enough or any profits to offset this \nrealized loss.\nOf course, investing choices are not as black and white as what I have \npresented here. If you want to commit 5 percent of your portfolio to a \nstraight stock idea, you have to spend 5 percent of your portfolio value on \nstock, but this is not true for options. For example, I might choose to spend \n2.5 percent of my portfolio’s worth on ATM calls (nine contracts in this ex-\nample), considering the position in terms of a 5 percent stock investment, \nand then leave the rest as cash reserve. Here is what this investment would \nlook like from a leverage perspective:\nUnderstanding and Managing Leverage    • 181\n02468 10 12 14 16 18 20 22 24\nStock Price\nLevered Strategy Overview\nGain (Loss) on Allocation\n26 28 30 32 34 36 38 40 42 44 46 48 50(5,000)\n-\n15,000\n10,000\n20,000\n25,000\n30,000\n5,000\nUnrealized Gain\nUnrealized Loss\nCash Value\nNet Gain (Loss) - Levered\nRealized Loss\nInstrument Maximum-Loss Price Net Profit at Fair Value Estimate\nStock $0 $1,472\nOption $22 (11 × stock loss) $4,833 (5.1 × stock profit)\nThe 11 times loss figure was calculated in the following way: there is a \ntotal of 47.3 percent of my allocation to this investment that is lost if the price \nof the stock goes down by 4.3 percent, so −47.3 percent/4.3 percent = −11.0. \nObviously, this policy of keeping some cash in reserve represents a sensible ap-\nproach to portfolio management when leverage is used. An investor in straight \nstock who makes 20 investments that do not hit his or her expected fair value \nwithin the investment horizon might have a few bad years of performance, but \nan investor who uses maximum option leverage and allocates 5 percent to 20 \nideas will end up bankrupt if these don’t work out by expiration time!\nSimilar to setting a cash reserve, you also might decide to make an \ninvestment that combines cash, stock, and options. For example, I might \nbuy 100 shares of Intel, three ITM option contracts, and leave the rest of \nmy 5 percent allocation in cash. Here is what that profit and loss profile \nwould look like:\n182  •   The Intelligent Option Investor\n0 24681 01 21 41 61 82 02 22 4\nStock Price\nLevered Strategy Overview\nGain (Loss) on Allocation\n26 28 30 32 34 36 38 40 42 44 46 48 50(6,000)\n(4,000)\n(2,000)\n-\n4,000\n2,000\n6,000\n10,000\n12,000\n8,000 Unrealized Gain\nUnrealized Loss\nCash Value\nNet Gain (Loss) - Levered\nRealized Loss\nInstrument Maximum-Loss Price Net Profit at Fair Value Estimate\nStock $0 $1,472\nOption $15 (1.8 × stock loss) $3,803 (2.6 × stock profit)\nThree $800 option contracts represent $2,400 of capital or 48 percent of \nthis allocation’s capital. Thus 48 percent of the capital was lost with a 34.8 per-\ncent move downward in the stock, generating a −1.4 times value for the options \nplus we add another −0.4 times value to represent the loss on the small stock \nallocation; together these generate the −1.8 times figure you see on the loss side. \nOf course, if the option loss is realized, we still own 100 shares, so the maximum \nloss will not be felt until the shares hit $0, as shown in the preceding diagram.\nFor the remainder of this book I will describe leverage positions us-\ning the two following terms: loss leverage and profit leverage . I will write \nthese in the following way: \n− X.x\nY.y\nwhere the first number will be the loss leverage ratio, and the second \nnumber will be the profit leverage ratio based on the preceding rules that \nUnderstanding and Managing Leverage    • 183\nI’ve used for calculation. All OTM options will be marked with an IRL fol-\nlowed by the percentage of the total portfolio used in the option purchase \n(not the percentage of the individual allocation but the total percentage \namount of your investment capital). On my website, you’ll find an online \nleverage tool that allows you to calculate these numbers yourself.\nManaging Leverage\nA realized loss is, to me, serious business. There are times when an inves-\ntor must take a realized loss—specifically when his or her view of the fair \nvalue or fair value range of a company changes materially enough that an \ninvestment position becomes unattractive. However, if you find yourself \ntaking realized losses because of material changes in valuation too often, \nyou should either figure out where you are going wrong in the valuation \nprocess or just put your money into a low-load mutual fund and spend \nyour time doing something more productive.\nThe point is that taking a realized loss is not something you have to do \ntoo often if you are a good investor, and hopefully, when those losses are taken, \nthey are small. As such, I believe that there are two ways to successfully manage \nleverage. Fir", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 60}
{"text": "are going wrong in the valuation \nprocess or just put your money into a low-load mutual fund and spend \nyour time doing something more productive.\nThe point is that taking a realized loss is not something you have to do \ntoo often if you are a good investor, and hopefully, when those losses are taken, \nthey are small. As such, I believe that there are two ways to successfully manage \nleverage. First is to use leverage sparingly by investing in combinations of ITM \noptions and stocks. ITM option prices mainly represent intrinsic value, and be-\ncause the time-value component is that which represents a realized loss right out \nof the gate, buying ITM options means that you are minimizing realized losses.\nThe second method for managing leverage when you cannot resist \ntaking a higher leverage position is spending as little as possible of your \ninvestment capital on it. This means that when you see that there is a com-\npany that has a material chance of being worth a lot more or a lot less than \nit is traded for at present but that material chance is still much less likely \nthan other valuation scenarios, you should invest your capital in the idea \nsparingly. By making smaller investments with higher leverage, you will \nnot realize a loss on too much of your capital at one time, and if you are \nright at least some of the time on these low-probability, high-potential-\nreward bets, you will come out ahead in the end.\nOf course, you also can use a combination of these two methods. For \nexample, I have found it helpful to take the main part of a position using a \n184  •   The Intelligent Option Investor\ncombination of stock and ITM call options but also perhaps buying a few \nOTM call options as well. As the investment ages and more data about the \ncompany’s operations come in, if this information leads me to be more \nbullish about the prospects of the stock, I may again increase my leverage \nusing OTM call options—especially when I see implied volatility trading at \na particularly low level or if the stock price itself is depressed because of a \ngenerally weak market. \nI used to be of the opinion that if you are confident in your valuation \nand your valuation implies a big enough unlevered return, it is irrational \nnot to get exposure to that investment with as much leverage as possible. \nA few large and painful losses of capital have convinced me that where-\nas levering up on high-conviction investments is theoretically a rational \ninvestment regime, practically, it is a sucker’s game that is more likely to \ndeplete your investment capital than it is to allow you to hit home runs.\nY ounger investors, who still have a long investing career ahead of \nthem and plenty of time to make up for mistakes early on, probably can \nfeel more comfortable using more leverage, but as you grow closer to the \ntime when you need to use your investments (e.g., paying for retirement, \nkids’ college expenses, or whatever), using lower leverage is better.\nLooking back at the preceding tables, one row in one table in particular \nshould stand out to you. This is the last row of the last table, where the leverage is \n−1.8/2.6. To me, this is a very attractive leverage ratio because of the asymmetry \nin the risk-reward balance. This position is levered, but the leverage is lopsided \nin the investor’s favor, so the investor stands to win more than he or she loses. \nThis asymmetry is the key to successful investing—not only from a \nleverage standpoint but also from an economic standpoint as well. I believe \nan intelligent, valuation-centric method for investing in companies such as \nthe ones outlined in this book that allow investors an edge up by allowing \nthem to identify cases in which the valuation simply does not line up with \nthe market price. This in itself presents an asymmetrical profit opportunity, \nand the real job of an intelligent investor is to find as large an asymmetry \nas possible and courageously invest in that company. If you can also tailor \nyour leverage such that your payout is asymmetrical in your favor as well, \nthis only adds potential for outsized returns, in my opinion.\nThe other reason that the −1.8/2.6 leverage ratio investment interests \nme is because of the similarity it has to the portfolio of Warren Buffett’s \nUnderstanding and Managing Leverage    • 185\nBerkshire Hathaway (BRK.A). In a recent academic paper written by re-\nsearchers at AQR Capital titled, “Buffett’s Alpha, ”4 the researchers found \nthat a significant proportion of Buffett’s legendary returns can be attributed \nto finding firms that have low valuation risk and investing in them using a \nleverage ratio of roughly 1.8. The leverage comes from the float from his in-\nsurance companies (the monies paid in premium by clients over and above \nthat required to pay out claims). As individual investors, we do not have a \ncaptive insurance company from which we can receive continual float, but \nby buying options and using leverage prudently, it is possible to invest in a \nmanner similar to a master investor.\nIn this section, we have only discussed leverage considerations when \nwe gain exposure by buying options. There is a good reason to ignore the \ncase where we are accepting exposure by selling options that we will dis-\ncuss when we talk about margining in Chapter 10. We now continue with \nchapters on gaining, accepting, and mixing exposure. In these chapters, we \nwill use all of what we have learned about option pricing, valuation, and \nleverage to discuss practical option investment strategies.\nThis page intentionally left blank \n187\nChapter 9\nGaininG ExposurE\nThis chapter is designed as an encyclopedic listing of the main strategies \nfor gaining exposure (i.e., buying options) that an intelligent option inves-\ntor should understand. Gaining exposure seems easy in the beginning be-\ncause it is straightforward—simply pay your premium up front, then if the \nstock moves into your option’s range of exposure by expiration time, you \nwin.", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 61}
{"text": "9\nGaininG ExposurE\nThis chapter is designed as an encyclopedic listing of the main strategies \nfor gaining exposure (i.e., buying options) that an intelligent option inves-\ntor should understand. Gaining exposure seems easy in the beginning be-\ncause it is straightforward—simply pay your premium up front, then if the \nstock moves into your option’s range of exposure by expiration time, you \nwin. However, the more you use these strategies in investing exposure, the \nmore nuances arise.\nWhat tenor should I choose? What strike price should I choose? \nShould I exercise early if my option is in the money (ITM)? How much \ncapital should I commit to a given trade? If the stock price goes in the \nopposite direction from my option’s range of exposure, should I close \nmy option position? All these questions are examples of why gaining \nexposure by buying options is not as straightforward a process as it \nmay seem at first and are all the types of questions I will cover in the \nfollowing pages.\nGaining exposure means buying options, and the one thing that an \noption buyer must never lose sight of is that time is always working against \nhim or her. Options expire. If your options expire out of the money (OTM), \nthe capital you spent on premiums on those options is a realized loss. No \nmatter how confident you are about your valuation call, you should al-\nways keep this immutable truth of option buying in mind. Indeed, there \nare ways to reduce the risk of this happening or to manage a portfolio in \n188  •   The Intelligent Option Investor\nsuch a way that such a loss of capital becomes just a cost of doing business \nthat will be made up for in another investment down the line.\nFor each of the strategies mentioned in this chapter, I present \na stylized graphic representing the Black-Scholes-Merton model \n(BSM) cone and the option’s range of exposure plus best- and worst-\ncase valuation scenarios. These are two of the required inputs for an \nintelligent option investing strategy—an intelligently determined valu-\nation range and the mechanically determined BSM forecast range. I will \nalso provide a summary of the relative pricing of upside and downside \nexposure vis-à-vis an intelligent valuation range (e.g., “Upside expo-\nsure is undervalued”), the steps taken to execute the strategy, and its \npotential risks and return.\nAfter this summary section, I provide textual discussions of tenor se-\nlection, strike price selection, portfolio management (i.e., rolling, exercise, \netc.), and any miscellaneous items of interest to note. Understanding the \nstrategies well and knowing how to use the tools at your disposal to tilt \nthe balance of risk and reward in your favor are the hallmark and pinnacle \nof intelligent option investing. Intelligent option investors gain exposure \nwhen the market underestimates the likelihood of a valuation that the in-\nvestor believes is a rational outcome. In graphic terms, this means that ei-\nther one or both of the investor’s best- and worst-case valuation scenarios \nlie outside the BSM cone.\nSimple (one-option) strategies to gain exposure include\n• Long calls\n• Long puts\nComplex (multioption) strategies to gain exposure include\n• Long strangles\n• Long straddles\nJargon introduced in this chapter includes the following:\nRoll\nRatio(ing)\nGaining Exposure • 189\nLong Call\nGREEN\nDownside: Fairly priced\nUpside: Undervalued\nExecute: Buy a call option\nRisk: Amount equal to premium paid\nReward: Unlimited less amount of premium paid\nThe Gist\nAn investor uses this strategy when he or she believes that there is a material \nchance that the value of a company is much higher than the present market price. \nThe investor must pay a premium to initiate the position, and the proportion of \nthe premium that represents time value should be recognized as a realized loss \nbecause it cannot be recovered. If the stock fails to move into the area of exposure \nbefore option expiration, there will be no profit to offset this realized loss.\nIn economic terms, this transaction allows an investor to go long an \nundervalued company without accepting an uncertain risk of loss if the \nstock falls. Instead of the uncertain risk of loss, one must pay the fixed pre-\nmium. This strategy obeys the same rules of leverage as discussed earlier \nin this book, with in-the-money (ITM) call options offering less leverage \nbut being much more forgiving regarding timing than are at-the-money \n(ATM) or especially out-of-the-money (OTM) options. \n190  •   The Intelligent Option Investor\nT enor Selection\nIn general, the rule for gaining exposure is to buy as long a tenor as is \navailable. If a stock moves up faster than you expected, the option will still \nhave time value left on it, and you can sell it to recoup the extra money you \nspent to buy the longer-tenor option. In addition, long-tenor options are \nusually proportionally less expensive than shorter-tenor ones. Y ou can see \nthis through the following table. These ask prices are for call options on \nGoogle (GOOG) struck at whatever price was closest to the 50-delta mark \nfor every tenor available.\nDays to Expiration Ask Price Marginal Price/Day Delta\n3 6.00 2.00 52\n10 10.30 0.61 52\n17 12.90 0.37 52\n24 15.50 0.37 52\n31 17.70 0.31 52\n59 22.40 0.17 49\n87 34.40 0.43 50\n150 42.60 0.13 50\n178 47.30 0.17 50\n241 56.00 0.14 50\n542 86.40 0.10 50\nThe “Marginal Price/Day” column is simply the extra that you pay to get \nthe extra days on the contract. For example, the contract with three days left is \n$6.00. For seven more days of exposure, you pay a total of $4.30 extra, which \nworks out to a per-day rate of $0.61. We see blips in the marginal price per \nday field as we go from 59 to 87 to 150 days, but these are just artifacts of data \navailability; the closest strikes did not have the same delta for each expiration.\nThe preceding chart, it turns out, is just the inverse of the rule we \nalready learned in Chapter 3: “time value slips away fastest as we get closer \nto expiration. ”", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 62}
{"text": "a per-day rate of $0.61. We see blips in the marginal price per \nday field as we go from 59 to 87 to 150 days, but these are just artifacts of data \navailability; the closest strikes did not have the same delta for each expiration.\nThe preceding chart, it turns out, is just the inverse of the rule we \nalready learned in Chapter 3: “time value slips away fastest as we get closer \nto expiration. ” If time value slips away more quickly nearer expiration, it \nmust mean that the time value nearer expiration is proportionally worth \nmore than the time value further away from expiration. The preceding \ntable simply illustrates this fact.\nGaining Exposure • 191\nValue investors generally like bargains and to buy in bulk, so we \nshould also buy our option time value “in bulk” by buying the longest \ntenor available and getting the lowest per-day price for it. It follows that if \nlong-term equity anticipation securities (LEAPS) are available on a stock, \nit is usually best to buy one of those. LEAPS are wonderful tools because, \naside from the pricing of time value illustrated in the preceding table, if \nyou find a stock that has undervalued upside potential, you can win from \ntwo separate effects:\n1. The option market prices options as if underlying stocks were ef-\nficiently priced when they may not be (e.g., the market thinks that \nthe stock is worth $50 when it’s worth $70). This discrepancy gives \nrise to the classic value-investor opportunity.\n2. As long as interest rates are low, the drift term understates the ac-\ntual, probable drift of the stock market of around 10 percent per \nyear. This effect tends to work for the benefit of a long-tenor call \noption whether or not the pricing discrepancy is as profound as \noriginally thought.\nThere are a couple of special cases in which this “buy the longest \ntenor possible” rule of thumb should not be used. First, if you believe \nthat a company may be acquired, it is best to spend as little on time value \nas possible. I will discuss this case again when I discuss selecting strike \nprices, but when a company agrees to be acquired by another (and the \nmarket does not think there will be another offer and regulatory approv-\nals will go through), the time value of an option drops suddenly because \nthe expected life of the stock as an independent entity has been short-\nened by the acquiring company. This situation can get complicated for \nstock-based acquisitions (i.e., those that use stocks as the currency of \nacquisition either partly or completely) because owners of the acquiree’s \noptions receive a stake in the acquirer’s options with strike price adjusted \nin proportion to the acquisition terms. In this case, the time value on \nyour acquiree options would not disappear after the acquisition but be \ntransferred to the acquirer’s company’s options. The real point is that it \nis impossible, as far as I know, to guess whether an acquisition will be \nmade in cash or in shares, so the rule of thumb to buy as little time value \nas possible still holds.\n192  •   The Intelligent Option Investor\nIn general, attempting to profit from potential mergers is dif-\nficult using options because you have to get both the timing of the \nsuspected transaction and the acquisition price correct. I will discuss \na possible solution to this situation in the next section about picking \nstrike prices.\nThe second case in which it is not necessary to buy as long a tenor as \npossible is when you are trading in expectation of a particular company \nannouncement. In general, this game of anticipating stock price move-\nments is a hard one to win and one that value investors usually steer clear \nof, but if you are sure that some announcement scheduled for a particular \nday or week is likely to occur but do not want to make a long-term invest-\nment on the company, you can buy a shorter-tenor option that obviously \nmust include the anticipated announcement date. It is probably not a bad \nidea to build in a little cushion between your expiration and the anticipated \ndate of the announcement because sometimes announcements are pushed \nback and rescheduled.\nStrike Price Selection \nFrom the discussion regarding leverage in the preceding section, it is \nclear that selecting strike prices has a lot to do with selecting what level \nof leverage you have on any given bet. Ultimately, then, strike selec-\ntion—the management of leverage, in other words—is intimately tied \nto your own risk profile and the degree to which you are risk averse or \nrisk seeking.\nMy approach, which I will talk more about in the following section \non portfolio management, may be too conservative for others, but I put it \nforward as one alternative among many that I have found over time to be \nsensible. Any investment has risk to the extent that there is never perfect \ncertainty regarding a company’s valuation. Some companies have a fairly \ntight valuation range—meaning that the confluence of their revenue stream, \nprofit stream, and investment efficacy does not vary a great deal from best to \nworst case. Other companies’ valuation ranges are wide, with a few clumps \nof valuation scenarios far apart or with just one or two outlying valuation \nscenarios that, although not the most likely, are still materially probable.\nGaining Exposure • 193\nOn the rare occasion in which we find a company that has a valuation \nrange that is far different from the present market price (either tight \nor wide), I would rather commit more capital to the idea, and for me, \ncommitting more capital to a single idea means using less leverage. In other \nwords, I would prefer to buy an ITM call and lever at a reasonable rate (e.g., \nthe −1.8 × /2.6 × level we saw in the Intel example earlier). Graphically, my \napproach would look like this:\nAdvanced Building Corp. (ABC)\n110\n100\n90\n80\n70\n60\n50\n40\n30\n20\n5/18/2012 5/20/2013 249 499 749 999\nDate/Day Count\nStock Price\nGREEN\nORANGE\nHere I have bought a deep ITM call option LEAPS that gives me lev-\nerage of a", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 63}
{"text": ", I would prefer to buy an ITM call and lever at a reasonable rate (e.g., \nthe −1.8 × /2.6 × level we saw in the Intel example earlier). Graphically, my \napproach would look like this:\nAdvanced Building Corp. (ABC)\n110\n100\n90\n80\n70\n60\n50\n40\n30\n20\n5/18/2012 5/20/2013 249 499 749 999\nDate/Day Count\nStock Price\nGREEN\nORANGE\nHere I have bought a deep ITM call option LEAPS that gives me lev-\nerage of about −1.5/2.0. I have maximized my tenor and minimized my \nleverage ratio with the ITM call. This structure will allow me to profit as \nlong as the stock goes up by the time my option expires, even if the stock \nprice does not hit a certain OTM strike price.\nIn the more common situation, in which we find a company that is \nprobably about fairly valued in most scenarios but that has an outlying \nvaluation scenario or two that doesn’t seem to be priced in properly by \nthe market, I will commit less capital to the idea but use more leverage. \nGraphically, my approach would look more like this:\n194  •   The Intelligent Option Investor\nAdvanced Building Corp. (ABC)\n100\n90\n80\n70\n60\n50\n40\n30\n20\n5/18/2012 5/20/2013 249 499 749 999\nDate/Day Count\nStock Price\nGREEN\nHere I have again maximized my tenor by buying LEAPS, but this \ntime I increase my leverage to something like an “IRL/10.0” level in case \nthe stars align and the stock price sales to my outlier valuation. \nSome people would say that the IIM approach is absolutely the op-\nposite of a rational one. If you are—the counterargument goes—confident \nin your valuation range, you should try to get as much leverage on that idea \nas possible; buying an ITM option is stupid because you are not using the \nleverage of options to their fullest potential. This counterargument has its \npoint, but I find that there is just too much uncertainty in the markets to be \ntoo bold with the use of leverage. \nOptions are time-dependent instruments, and if your option expires \nworthless, you have realized a loss on whatever time value you original-\nly spent on it. Economies, now deeply intertwined all over the globe, are \nphenomenally complex things, so it is the height of hubris to claim that \nI can perfectly know what the future value of a firm is and how long it will \ntake for the market price to reflect that value. In addition, I as a human \ndecision maker am analyzing the world and investments through a con-\ngenital filter based on behavioral biases.\nRetaining my humility in light of the enormous complexity of the \nmarketplace and my ingrained human failings and expressing this humility \nGaining Exposure • 195\nby using relatively less leverage when I want to commit a significant amount \nof capital to an idea constitute, I have found, given my risk tolerance and \nexperience, the best path for me for a general investment.\nIn contrast, we all have special investment loves or wild hares or \nwhatever, and sometimes we must express ourselves with a commitment \nof capital. For example, “If XYZ really can pull it off and come up with a \ncure for AIDS, its stock will soar. ” In instances such as these, I would rather \ncommit less capital and express my doubt in the outcome with a smaller \nbut more highly levered bet. If, on average, my investment wild hares come \ntrue every once in a while and, when they do, the options I’ve bought on \nthem pay off big enough to more than cover my realized losses on all those \nthat did not, I am net further ahead in the end.\nThese rules of thumb are my own for general investments. In the spe-\ncial situation of investing in a possible takeover target, there are a few extra \nconsiderations. A company is likely to be acquired in one of two situations: \n(1) it is a sound business with customers, product lines, or geographic \nexposure that another company wants, or (2) it is a bad business, either \nbecause of management incompetence, a secular decline in the business, or \nsomething else, but it has some valuable asset(s) such as intellectual prop-\nerty that a company might want to have.\nIf you think that a company of the first sort may be acquired, I be-\nlieve that it is best to buy ITM call options to attempt to minimize the time \nvalue spent on the investment (you could also sell puts, and I will discuss \nthis approach in Chapter 10). In this case, you want to minimize the time \nvalue spent because you know that the time value you buy will drain away \nwhen a takeover is announced and accepted. By buying an ITM contract, \nyou are mainly buying intrinsic value, so you lose little time value if and \nwhen the takeover goes through. If you think that a company of the second \nsort (a bad company in decline) may be acquired, I believe that it is best to \nminimize the time value spent on the investment by not buying a lot of call \ncontracts and by buying them OTM. In this case, you want to minimize the \ntime value spent using OTM options by limiting the number of contracts \nbought because you do not want to get stuck losing too much capital if \nand when the bad company’s stock loses value while you are holding the \noptions. Typical buyout premiums are in the 30 percent range, so buy-\ning call options 20 percent OTM or so should generate a decent profit if \n196  •   The Intelligent Option Investor\nthe company is taken out. Just keep in mind that the buyout premium is \n30 percent over the last price, not 30 percent over the price at which you \ndecided to make your investment. If you buy 20 percent OTM call options \nand the stock decreases by 10 percent before a 30 percent premium buyout \nis announced, you will end up with nothing, as shown in the following \ntimeline:\n$12-Strike Options Bought When the Stock Is Trading for $10\n• Stock falls to $9.\n• Buyout is announced at 30 percent above last price—$11.70.\n• 12-strike call owner’s profit = $0.\nHowever, there is absolutely no assurance that an acguirer will pay some-\nthing for a prospective acguiree. Depending on how keen the acquirer is to get \nits hands on the assets of the target, it may actually allow", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 64}
{"text": "line:\n$12-Strike Options Bought When the Stock Is Trading for $10\n• Stock falls to $9.\n• Buyout is announced at 30 percent above last price—$11.70.\n• 12-strike call owner’s profit = $0.\nHowever, there is absolutely no assurance that an acguirer will pay some-\nthing for a prospective acguiree. Depending on how keen the acquirer is to get \nits hands on the assets of the target, it may actually allow the target company \nto go bankrupt and then buy its assets at $0.30 on the dollar or whatever. It is \nprecisely this uncertainty that makes it unwise to commit too much capital to \nan idea involving a bad company—even if you think it may be taken out.\nPortfolio Management\nI like to think of intelligent option investing as a meal. In our investment \nmeal, the underlying instrument—the stock—should, in most cases, form \nthe main course. \nPeople have different ideas about diversification in a securities portfolio \nand about the maximum percentage of a portfolio that should be allocated to \na specific idea. Clearly, most people are more comfortable allocating a greater \npercentage of their portfolio to higher-confidence ideas, but this is normal-\nly framed in terms of relative levels (i.e., for some people, a high-conviction \nidea will make up 5 percent of their portfolio and a lower-conviction one \n2.5 percent; for others, a high-conviction idea will make up 20 percent of their \nportfolio and a lower-conviction one 5 percent). Rather than addressing what \nsize of investment meal is best to eat, let’s think about the meal’s composition.\nConsidering the underlying stock as the main course, I consider the \nleverage as sauces and side dishes. ITM options positions are the main \nGaining Exposure • 197\nsauce to make the main course more interesting and flavorful. Y ou can \nlayer ITM options onto the stock to increase leverage to a level with which \nyou feel comfortable. This does not have to be Buffett’s 1.8:1 leverage of \ncourse. Levering more lightly will provide less of a kick when a company \nperforms according to your best-case scenario, but also carries less risk \nof a severe loss if the company’s performance is mediocre or worse. OTM \noption positions (and “long diagonals” to be discussed in Chapter 11) can \nbe thought of as a spicy side dish to the main meal. They can be added \nopportunistically (when and if the firm in which you are investing has a \nbad quarter and its stock price drops for temporary reasons involving sen-\ntiment rather than substance) for extra flavor. OTM options can also be \nused as a snack to be nibbled on between proper meals. Snack, in this case, \nmeans a smaller sized position in firms that have a small but real upside \npotential but a greater chance that it is fairly valued as is, or in a company \nin which you don’t have the conviction in its ability to create much value \nfor you, the owner. \nAnother consideration regarding the appropriate level of investment \nleverage one should apply to a given position is how much operational \nand financial leverage (both are discussed in detail in Appendix B) a firm \nhas. A firm that is highly levered will have a much wider valuation range \nand will be much more likely to be affected by macroeconomic considera-\ntions that are out of the control of the management team and inscrutable \nto the investor. In these cases, I think the best response is to adjust one’s \ninvestment leverage according to the principles of “margin of safety” and \ncontrarianism. \nBy creating a valuation range, rather than thinking only of a single point-\nestimate for the value of the firm, we have unwittingly allowed ourselves to \nbecome very skillful at picking appropriate margins of safety. For example, I \nrecently looked at the value of a company whose stock was trading for around \n$16 per share. The company had very high operational and financial lever-\nage, so my valuation range was also very large—from around $6 per share \nworst case to around $37 per share best case with a most likely value of around \n$25 per share. The margin of safety is 36 percent (= ($25 − $16)/ $25). \nWhile some might think this is a reasonable margin of safety to take a bold, \nconcentrated position, I elected instead to take a small, unlevered one because \nto me, the $9 margin of safety for this stock is still not wide enough. The best \n198  •   The Intelligent Option Investor\ntime to take a larger position and to use more leverage is when the market is \npricing a stock as if it were almost certain that a company will face a worst-case \nfuture when you consider this worst-case scenario to be relatively unlikely. In \nthis illustration, if the stock price were to fall by 50 percent—to the $8 per share \nlevel—while my assessment of the value of the company remained unchanged \n(worst, likely, and best case of $6, $25, and $37, respectively), I would think I \nhad the margin of safety necessary to commit a larger proportion of my portfo-\nlio to the investment and add more investment leverage. With the stock sitting \nat $8 per share, my risk ($8 − $6 = $2) is low and unlikely to be realized while \nmy potential return is large and much closer to being assured. With the stock’s \npresent price of $16 per share, my risk ($16 − $6 = $10) is large and when bad-\ncase scenarios are factored in along with the worst-case scenario, more likely \nto occur.\nThinking of margins of safety from this perspective, it is obvious that \none should not frame them in terms of arbitrary levels (e.g., “I have a rule \nto only buy stocks that are 30% or lower than my fair value estimate. ”), but \nrather in terms informed by an intelligent valuation range. In this example, \na 36 percent margin of safety is sufficient for me to commit a small \nproportion of my portfolio to an unlevered investment, but not to go “all \nin. ” For a concentrated, levered position in this investment, I would need a \nmargin of safety approaching 76 percent (= ($25 − $6)/$25) and at least over \n60 percent (= ($25 - $10)/$25).\nWhen might such a", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 65}
{"text": "n intelligent valuation range. In this example, \na 36 percent margin of safety is sufficient for me to commit a small \nproportion of my portfolio to an unlevered investment, but not to go “all \nin. ” For a concentrated, levered position in this investment, I would need a \nmargin of safety approaching 76 percent (= ($25 − $6)/$25) and at least over \n60 percent (= ($25 - $10)/$25).\nWhen might such a large margin of safety present itself? Just when \nthe market has lost all hope and is pricing in disaster for the company. \nThis is where the contrarianism comes into play. The best time to make \na levered investment in a company with high levels of operational lever -\nage is when the rest of the market is mainly concerned about the possible \nnegative effects of that operational leverage. For example, during a reces-\nsion, consumer demand drops and idle time at factories increases. This \nhas a quick and often very negative effect on profitability for companies \nthat own the idle factories, and if conditions are bad enough or look to \nhave no near-term (i.e., within about six months) resolution, the price of \nthose companies’ stocks can plummet. Market prices often fall so low as to \nimply, from a valuation perspective, that the factories are likely to remain \nidled forever. In these cases, I believe that not using investment leverage in \nthis case may carry with it more real risk than using investment leverage \nGaining Exposure • 199\n(see my discussion of risk in Chapter 12 after reading the paragraphs below \nabout financial leverage).\nIn boom times, just the opposite is true. Factories are nearing full \ncapacity and demand is strong. Most of the market is thinking only of the \nextra percentage points of profit that can be squeezed out of the opera-\ntions when continuing strong demand pushes factory capacity even higher. \nAs every contrarian knows, this is precisely the wrong time to fall in love \nwith the stock of an operationally levered company; it is also precisely the \nwrong time to use investment leverage to gain exposure to the stock of an \noperationally levered company.\nFinancial leverage is more dangerous and requires a much more care-\nful consideration of valuation scenarios, especially if the economy is in or is \ngoing into recession. In recessions, consumer demand for products slows, \nbut banks’ and bondholders’ demand for interest and principal payments \ncontinues unabated. If demand is so low that a company is not generating \nenough cash flow to pay interest on its debt, or if it can pay interest on its \ndebt but does not have enough cash on hand to pay an entire principal pay-\nment (and banks refuse to finance that payment), the equity of the com-\npany will be worth nothing. As Buffett has so eloquently wrote in the 2010 \nannual letter to Berkshire Hathaway shareholders, “[A]ny series of positive \nnumbers, however impressive the numbers may be, evaporates when mul-\ntiplied by a single zero. ” It doesn’t matter how great a given business may \nbe during boom times; if its equity value falls to zero during bad times, the \nowner of the company’s stock will lose his or her entire investment.\nOne sad fact of life is that in many cases, companies with great op-\nerational leverage (e.g., those that own factories) have funded this leverage \nthrough the issuance of debt—hereby layering financial leverage onto oper-\national leverage. Because financial leverage represents such a severe risk to \nequity investors during bust times, and because it is devilishly hard to know \nwhen the next bust time might come, I personally think that using less in-\nvestment leverage on companies fitting this profile is generally prudent.\nLet us assume that you have decided on the composition of an investment \nmeal and dug in using your chosen allocation size and leverage level. How do \nyou know when to stop “eating” and close all or part of your position? Or con-\nversely, what should you do when you realize that the meal is more delicious \nthan you had originally imagined? These are natural questions to ask. \n200  •   The Intelligent Option Investor\nAfter you enter a position and some time passes, it becomes clearer \nwhat valuation scenario the company is tending toward. In some cases, \na bit of information will come out that is critical to your valuation of the \ncompany on which other market participants may not be focused. Obvi-\nously, if a bit of information comes out that has a big, positive or negative \nimpact on your assessment of the company’s value, you should adjust your \nposition size accordingly. If you believe the impact is positive, it makes \nsense to build to a position by increasing your shares owned and/or by \nadding “spice” to that meal by adjusting your target leverage level. If the \nimpact is negative, it makes sense to start by reducing leverage (or you \ncan think of it as increasing the proportion of cash supporting a particular \nposition), even if this reduction means realizing a loss. If the impact of the \nnews is so negative that the investment is no longer attractive from a risk-\nreward perspective, I believe that it should be closed and the lumps taken \nsooner rather than later. Considering what we know about prospect theory, \nthis is psychologically a difficult thing to do, but in my experience, waiting \nto close a position in which you no longer have confidence seldom does \nyou any good.\nObviously, the risk/reward equation of an investment is also influ-\nenced by a stock’s market price. If the market price starts scraping against \nthe upper edge of your valuation range, again, it is time to reduce leverage \nand/or close the position.\nIf your options are in danger of expiring before a stock has reached \nyour fair value estimate, you may roll your position by selling your option \nposition and using the proceeds to buy another option position at a more \ndistant tenor. At this time, you must again think about your target leverage \nand adjust the strikes of your options accordingly. If th", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 66}
{"text": "reduce leverage \nand/or close the position.\nIf your options are in danger of expiring before a stock has reached \nyour fair value estimate, you may roll your position by selling your option \nposition and using the proceeds to buy another option position at a more \ndistant tenor. At this time, you must again think about your target leverage \nand adjust the strikes of your options accordingly. If the price of the stock \nhas decreased over the life of the option contract, this will mean that you \nrealize a loss, which is not an easy thing to do psychologically, but consid-\nering the limitations imposed by time for all option investments, this is an \nunavoidable situation in this case.\nOne of the reasons I dislike investing in non-LEAPS call options is \nthat rolling means that not only do we have to pay another set of bro-\nker and exchange fees, but we also must pay both sides of the bid-ask \nspread. Keeping in mind how wide the bid-ask spread can be with options \nand what an enormous drag this can be on returns, you should carefully \nGaining Exposure • 201\nconsider whether the prospective returns justify entering a long call posi-\ntion that will likely have to be rolled multiple times before the stock hits \nyour fair value estimate.\nBy the way, it goes without saying that to the extent that an option \nyou want to roll has a significant amount of time value on it, it is better \nto roll before time decay starts to become extreme. This usually occurs at \naround three months before expiration. It turns out that option liquidity \nincreases in the last three months before expiration, and rolling is made \neasier with the greater liquidity.\nHaving discussed gaining bullish exposure with this section about \nlong calls, let’s now turn to gaining bearish exposure in the following sec-\ntion on long puts.\nLong Put\nGREEN\nDownside: Undervalued\nUpside: Fairly priced\nExecute: Buy a put option\nRisk: Amount of premium paid\nReward: Amount equal to strike price—premium\nThe Gist\nAn investor uses this strategy when he or she believes that it is very likely \nthat the value of a company is much lower than the present market price. \nThe investor must pay a premium to initiate the position, and the propor-\ntion of the premium that represents time value should be recognized as a \n202  •   The Intelligent Option Investor\nrealized loss because it cannot be recovered. If the stock fails to move into \nthe area of exposure before option expiration, there will be no profit to \noffset this realized loss.\nIn economic terms, this transaction allows an investor to sell short \nan overvalued company without accepting an uncertain risk of loss if the \nstock rises. Instead of the uncertain risk of loss, the investor must pay the \nfixed premium. This strategy obeys the same rules of leverage as discussed \nearlier in this book, with ITM put options offering less leverage but a great-\ner cushion before realizing a loss than do ATM or OTM put options.\nT enor Selection\nShorting stocks, which is what you are doing when you buy put op-\ntions, is hard work, not for the faint of heart. There are a couple of \nreasons for this:\n1. Markets generally go up, and for better or worse, a rising tide usu-\nally does lift all boats.\n2. Even when a company is overvalued, it is hard to know what cata-\nlyst will make that fact obvious to the rest of the market and when.\nIn the words of Jim Chanos, head of the largest short-selling hedge fund \nin the world, the market is a “giant positive reinforcement machine. ”\n1 \nIt is psychologically difficult to hold a bearish position when it seems \nlike the whole world disagrees with you. All these difficulties in taking \nbearish positions are amplified by options because options are levered \ninstruments, and losses feel all the more acute when they occur on a \nlevered position.\nMy rule for gaining bullish exposure is to pick the longest-tenor op-\ntion possible. I made the point that by buying LEAPS, you can enjoy a \nlikely upward drift that exceeds the drift assumed by option pricing. When \nbuying puts, you are on the opposite side of this drift factor (i.e., the “ris-\ning tide lifts all boats” factor), and every day that the stock does not fall is \nanother day of time value that has decayed without you enjoying a profit. \nOn the other hand, if you decide not to spend as much on time value and \nbuy a shorter-tenor put option, unless the market realizes that the stock is \nGaining Exposure • 203\novervalued and it drops before the shorter option expires, you must pay the \nentire bid-ask spread and the broker and exchange fees again when you roll \nyour put option.\nThe moral of the story is that when selecting tenors for puts, you need \nto balance the existence of upward market drift (which lends weight to the \nargument for choosing shorter tenors) with bid-ask spreads and other fees \n(which lends weight to the argument for longer tenors). If you can iden-\ntify a catalyst, you can plan the tenor of the option investment based on \nthe expected catalyst. However, it’s unfortunate but mysteriously true that \nbearish catalysts have a tendency to be ignored by the market’s “happy ma-\nchine” until the instant when suddenly they are not and the shares collapse. \nThe key for a short seller is to be in the game when the market realizes the \nstock’s overvaluation.\nStrike Price Selection\nWhen it comes to strike prices, short sellers find themselves fighting drift \nin much the same way as they did when selecting tenors. A short seller with \na position in stocks can be successful if the shares he or she is short go up \nless than other stocks in the market. The short exposure acts as a hedge to \nthe portfolio as a whole, and if it loses less money than the rest of the port-\nfolio gains, it can be thought of as a successful investment.\nHowever, the definition for success is different for buyers of a put \noption, who must not only see their bearish bets not go up by much but \nrather must see their bearish bets fall if they are to enjo", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 67}
{"text": "ks in the market. The short exposure acts as a hedge to \nthe portfolio as a whole, and if it loses less money than the rest of the port-\nfolio gains, it can be thought of as a successful investment.\nHowever, the definition for success is different for buyers of a put \noption, who must not only see their bearish bets not go up by much but \nrather must see their bearish bets fall if they are to enjoy a profit. If the \ninvestor wanting bearish exposure decides to gain it by buying OTM puts, \nhe or she must—as we learned in the section about leverage—accept a \nrealized loss as soon as the put is purchased. If, on the other hand, the \ninvestor wants to minimize the realized loss accepted up front, he or she \nmust accept that he or she is in a levered bearish position so that every \n1 percent move to the upside for the stock generates a loss larger than 1 \npercent for the position.\nThere is another bearish strategy that you can use by accepting \nexposure that I will discuss in the next section, but for investors who are \ngaining bearish exposure, there is no way to work around the dilemma of \nthe option-based short seller just mentioned.\n204  •   The Intelligent Option Investor\nPortfolio Management\nThere is certainly no way around the tradeoff between OTM and ITM \nrisk—the rules of leverage are immutable whether in a bullish or a bear -\nish investment—but there are some ways of framing the investment that \nwill allow intelligent investors to feel more comfortable with making \nthese types of bearish bets. First, I believe that losses associated with a \nbearish position are treated differently within our own minds than those \nassociated with bullish positions. The reason for this might be the fact \nthat if you decide to proactively invest in the market, you must buy se-\ncurities, but you need not sell shares short. The fact that you are losing \nwhen you are engaged in an act that you perceive as unnecessary just \nadds to a sense of regret and self-doubt that is necessarily part of the \ninvesting process.\nIn addition, investors seem to be able to accept underperform-\ning bullish investments in a portfolio context (e.g., “XYZ is losing, but \nit’s only 5 percent of my holdings, and the rest of my portfolio is up, so \nit’s okay”) but look at underperforming bearish investments as if they \nwere the only investments they held (e.g., “I’m losing 5 percent on that \ndamned short. Why did I ever short that stock in the first place?”). In gen-\neral, people have a hard time looking at investments in a portfolio con-\ntext (I will discuss this more when I talk about hedging in Chapter 11), \nbut this problem seems to be orders of magnitude worse in the case of a \nbearish position.\nMy solution to this dilemma—perhaps not the best or most rational \nfrom a performance standpoint but most manageable to me from a psy-\nchological one—is to buy OTM puts with much smaller position sizes than \nI might for bullish bets with the same conviction level. This means that I \nhave smaller, more highly levered positions. The reason this works for me \nis that once I spend the premium on the put option, I consider the money \ngone—a sunk cost—and do not even bother to look at the mark-to-market \nvalue of the option after that unless there is a large drop in the stock price. \nSomehow this acknowledgment of a realized loss up front is easier to han-\ndle psychologically than watching my ITM put position suffer unrealized \nlosses of 1.5 times the rise of the stock every day.\nThis strategy may well be proof that I simply am not a natural-born \nshort seller, and you are encouraged, now that you understand the issues \nGaining Exposure • 205\ninvolved, to devise a method for gaining bearish exposure that fits your own \nrisk profile. \nStrangle\nGREEN\nGREEN\nDownside: Undervalued\nUpside: Undervalued\nExecute: Buy an OTM call option simultaneously with buying an \nOTM put option\nRisk: Amount of premium paid\nReward: Unlimited on upside, limited to strike less total (two-leg) \npremium on the downside\nThe Gist\nThe strangle is used when the market is undervaluing the likelihood that a \nstock’s value is significantly above or below the present market price. It is a \nmore speculative position and, because both legs are OTM, a highly lever-\naged one. It can sometimes be useful for companies such as smaller drug \ncompanies whose value hinges on the success or failure of a particular drug \nor for companies that have a material chance of bankruptcy but if they can \n206  •   The Intelligent Option Investor\navoid this extreme downside are worth much more than they are presently \ntrading at.\nThe entire premium paid must be treated as a realized loss because \nit can never be recovered. If the stock fails to move into one of the areas \nof exposure before option expiration, there will be no profit to offset this \nrealized loss.\nThere is no reason why you have to buy puts and calls in equal num-\nbers. If you believe that both upside and downside scenarios are materially \npossible but believe that the downside scenario is more plausible, you can \nbuy more puts than calls. This is called ratioing a position. \nT enor Selection\nBecause the strangle is a combination of two strategies we have already \ndiscussed, the considerations regarding tenor are the same as for each of \nthe components—that is, using the drift advantage in long-term equity an-\nticipating securities (LEAPS) and buying them or the longest-tenor calls \navailable and balancing the fight against drift and the cost of rolling and \nbuying perhaps shorter-tenor puts.\nStrike Price Selection\nA strangle is slightly different in nature from its two components—long \ncalls and long puts. A strangle is an option investor’s way of expressing \nthe belief that the market in general has underestimated the intrinsic \nuncertainty in the valuation of a firm. Options are directional instru-\nments, but a strangle is a strategy that acknowledges that the investor \nhas no clear idea of which direction a stock will move but", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 68}
{"text": "ifferent in nature from its two components—long \ncalls and long puts. A strangle is an option investor’s way of expressing \nthe belief that the market in general has underestimated the intrinsic \nuncertainty in the valuation of a firm. Options are directional instru-\nments, but a strangle is a strategy that acknowledges that the investor \nhas no clear idea of which direction a stock will move but only that \nits future value under different scenarios is different from its present \nmarket price.\nBecause both purchased options are OTM ones, this implies, in my \nmind, a more speculative investment and one that lends itself to taking \nprofit on it before expiration. Nonetheless, my conservatism forces me to \nselect strike prices that would allow a profit on the entire position if the \nstock price is at one of the two strikes at expiration. Because I am buying \nexposure to both the upside and the downside, I always like to make sure \nGaining Exposure • 207\nthat if the option expires when the stock price is at either edge of my valu-\nation range, it is far enough in-the-money to pay me back for both legs of \nthe investment (plus an attractive return).\nPortfolio Management\nAs mentioned earlier, this is naturally a more speculative style of option \ninvestment, and it may well be more beneficial to close the successful leg of \nthe strategy before expiration than to hold the position to expiration. Com-\npared with the next strategy presented here (the straddle), the strangle ac-\ntually generates worse returns if held to expiration, so if you are happy with \nyour returns midway through the investment, you should close the posi-\ntion rather than waiting for expiration. The exception to this rule is that if \nnews comes out that convinces you that the value of the firm is materially \nhigher or lower than what you had originally forecast and uncertainty in \nthe other direction has been removed, you should assess the possibility of \nmaking a more substantial investment in the company.\nOne common problem with investors—even experienced and sophis-\nticated ones—is that they check the past price history of a stock and decide \nwhether the stock has “more room” to move in a particular direction. The \nmost important two things to know when considering an investment are its \nvalue and the uncertainty surrounding that value. Whether the stock was \ncheaper three years ago or much more expensive does not matter—these are \nbackward-looking measures, and you cannot invest with a rear-view mirror.\nOne final note regarding this strategy is what to do with the unused \nleg. If the stock moves up strongly and you take profits on the call, what \nshould you do with the put, in other words. Unfortunately, the unused leg is \nalmost always worthless, and often it will cost more than it’s worth to close \nit. I usually keep this leg open because you never know what may happen, \nand perhaps before it expires, you will be able to close it at a better price.\nThis is a speculative strategy—a bit of spice or an after-dinner mint \nin the meal of investing. Don’t expect to get rich using it (if you do get rich \nusing it, it means that you were lucky because you would have had to have \nused a lot of leverage in the process), but you may be pleasantly surprised \nwith the boost you get from these every once in a while.\nLet’s now turn briefly to a related strategy—the straddle.\n208  •   The Intelligent Option Investor\nStraddle\nGREEN\nDownside: Undervalued\nUpside: Undervalued\nExecute: Simultaneously buy an ATM put and an ATM call\nRisk: Amount of premium paid\nReward: Unlimited?\nThe Gist\nI include the straddle here for completeness sake. I have not included a \nlot of the fancier multioption strategies in this book because I have found \nthem to be more expensive than they are worth, especially for someone \nwith a definite directional view on a security. However, the straddle is re-\nferred to commonly and is deceptively attractive, so I include it here to \nwarn investors against its use, if for no other reason.\nThe straddle shares many similarities with the strangle, of course, but \nstraddles are enormously expensive because you are paying for every pos-\nsible price the stock will move to over the term of the options. For example, \nI just looked up option prices for BlackBerry (BBRY), whose stock was \ntrading at $9.00. For the 86 days to expiry, $9-strike calls (delta = 0.56) and \n$9-strike puts (delta = –0.44) were priced at $1.03 and $1.13, respectively. \nGaining Exposure • 209\nThe total premium of $2.16 represents 24 percent of the stock’s price, which \nmeans that if the implied volatility (around 60 percent) remains constant, \nthe stock would have to move 24 percent before an investor even breaks \neven. It is true that during sudden downward stock price moves, implied \nvolatility usually rises, so it might take a little less of a stock price move-\nment to the downside to break even. However, during sudden upside \nmoves, implied volatility often drops, which would make it more difficult \nto break even to the upside.\nDespite this expense, a straddle will still give an investor a lower \nbreakeven point than a strangle on the same stock if held to expiration. \nThe key is that a strangle will almost always generate a higher profit than \na straddle if it is closed before expiration simply because the initial cost of \nthe strangle is lower and the relative leverage of each of its legs is higher. \nThis is yet another reason to consider closing a strangle early if and when \nyou are pleased with the profits made. \nIf you do not know whether a stock will move up or down, the best \nyou can hope for is to make a speculative bet on the company. When you \nmake speculative bets, it is best to reduce the amount spent on it or you will \nwhittle down all your capital on what amounts to a roulette wheel. Reduc-\ning the amount spent on a single bet is the reason an intelligent investor \nshould stay away from straddles.\nWith all the main strategies for gaining e", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 69}
{"text": "up or down, the best \nyou can hope for is to make a speculative bet on the company. When you \nmake speculative bets, it is best to reduce the amount spent on it or you will \nwhittle down all your capital on what amounts to a roulette wheel. Reduc-\ning the amount spent on a single bet is the reason an intelligent investor \nshould stay away from straddles.\nWith all the main strategies for gaining exposure covered, let’s now \nturn to accepting exposure by selling options.\nThis page intentionally left blank \n211\nChapter 10\nAccepting exposure\nBrokerages and exchanges treat the acceptance of exposure by counter -\nparties in a very different way from counterparties who want to gain expo-\nsure. There is a good reason for this: although an investor gaining exposure \nhas an option to transact in the future, his or her counterparty—an investor \naccepting exposure—has a commitment to transact in the future at the sole \ndiscretion of the option buyer. If the investor accepting exposure does not \nhave the financial wherewithal to carry out the committed transaction, the \nbroker or exchange is on the hook for the liability.\n1\nFor example, an investor selling a put option struck at $50 per share \nis committing to buy the stock in question for $50 a share at some point \nin the future—this is the essence of accepting exposure. If, however, \nthe investor does not have enough money to buy the stock at $50 at \nsome point in the future, the investor’s commitment to buy the shares is \neconomically worthless.\nTo guard against this eventuality, brokers require exposure-accepting \ninvestors to post a security deposit called margin that will fully cover the fi-\nnancial obligation to which the investor is committing. In the preceding ex-\nample, for instance, the investor would have to keep $5,000 (= $50 per share × \n100 shares/contract) in reserve and would not be able to spend those reserved \nfunds for stock or option purchases until the contract has expired worthless.\nBecause of this margin requirement, it turns out that one of our strat-\negies for accepting leverage—short puts—always carries with it a loss lev-\nerage of –1.0—exactly the same as the loss leverage of a stock. Think about \nit this way: what difference is there between using $50 to buy a stock and \n212  •   The Intelligent Option Investor\nsetting $50 aside in an escrow account you can’t touch and promising that \nyou will buy the stock with the escrow funds in the future if requested to \ndo so? From a risk perspective, “very little” is the answer. \nShort calls are more complicated, but I will discuss the leverage car -\nried by them using elements of the structure I set forth in Chapter 8. In the \nfollowing overviews, I add one new line item to the tables that details the \nmargin requirements of the positions.\nIntelligent option investors accept exposure when the market over -\nestimates the likelihood of a valuation that the investor believes is not a \nrational outcome. In graphic terms, this means that either one or both of \nthe investor’s best- and worst-case valuation scenarios lie well within the \nBlack-Scholes-Merton model (BSM) cone.\nSimple (one-option) strategies to accept exposure include \n1. Short put\n2. Short call (call spread)\nComplex (multioption) strategies to accept exposure include the following:\n1. Short straddle\n2. Short strangle\nJargon introduced in this chapter includes the following:\nMargin Put-call parity\nEarly exercise Cover (a position)\nWriting (an option)\nShort Put\nRED\nAccepting Exposure   • 213\nDownside: Overvalued\nUpside: Fairly valued\nExecute: Sell a put contract\nRisk: Strike price minus premium received [same as stock inves-\ntor at the effective buy price (EBP)]\nReward: Limited to premium received\nMargin: Notional amount of position\nThe Gist\nThe market is pricing in a relatively high probability that the stock price \nwill fall. An investor, from a longer investment time frame perspective, \nbelieves that the value of the stock is likely worth at least the present mar-\nket value and perhaps more. The investor agrees to accept the downside \nrisk perceived by the market and, in return, receives a premium for doing \nso. The premium cannot be fully realized unless the option expires out- \nof-the money (OTM). If the option expires in-the-money (ITM), the \ninvestor pays an amount equal to the strike price for the stock but can \npartially offset the cost of the stock by the premium received. The inves-\ntor thus promises to buy the stock in question at a price of the strike \nprice of the option less the premium received—what I call the effective \nbuy price.\nI think of the short-put strategy as being very similar to buying cor -\nporate bonds and believe that the two investment strategies share many \nsimilarities. A bond investor is essentially looking to receive a specific \nmonetary return (in the form of interest) in exchange for accepting \nthe risk of the business failing. The only time a bond investor owns a \ncompany’s assets is after the value of the firm’s equity drops to zero, and \nthe assets revert to the control of the creditors. Similarly, a short-put in-\nvestor is looking to receive a specific monetary return (in the form of an \noption premium) in exchange for accepting the risk that the company’s \nstock will decrease in value. The only time a short-put investor owns a \ncompany’s shares is after the market value of the shares expires below the \npreagreed strike price.\nBecause the strategies are conceptually similar, I usually think of short-\nput exposure in similar terms and compare the “yield” I am generating \n214  •   The Intelligent Option Investor\nfrom a portfolio of short puts with the yield I might generate from a cor -\nporate bond portfolio. With this consideration, and keeping in mind that \nthese investments are unlevered, 2 the name of the game is to generate as \nhigh a percentage return as possible over the investing time horizon while \nminimizing the amount of real downside risk you are accepting.\nT enor Selectio", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 70}
{"text": "gent Option Investor\nfrom a portfolio of short puts with the yield I might generate from a cor -\nporate bond portfolio. With this consideration, and keeping in mind that \nthese investments are unlevered, 2 the name of the game is to generate as \nhigh a percentage return as possible over the investing time horizon while \nminimizing the amount of real downside risk you are accepting.\nT enor Selection\nTo maximize percentage return, in general, it is better to sell options with \nrelatively short-term expirations (usually tenors of from three to nine \nmonths before expiration). This is just the other side of the coin of the \nrule to buy long-tenor options: the longer the time to expiration, the less \ntime value there is on a per-day basis. The rule to sell shorter-tenor options \nimplies that you will make a higher absolute return by chaining together \ntwo back-to-back 6-month short puts than you would by selling a single \n12-month option at the beginning of the period.\nDuring normal market conditions, selling shorter-tenor options is \nthe best tactical choice, but during large market downdrafts, when there \nis terror in the marketplace and implied volatilities increase enormously \nfor options on all companies, you might be able to make more by sell-\ning a longer-tenor option than by chaining together a series of shorter-\ntenor ones (because, presumably, the implied volatilities of options will \ndrop as the market stabilizes, and this drop means that you will make \nless money on subsequent put sales). At these times of extreme market \nstress, there are situations where you can find short-put opportunities \non long-tenor options that defy economic logic and should be invested \nin opportunistically. \nFor example, during the terrible market drops in 2009, I found a \ncompany whose slightly ITM put long-term equity anticipation securities \n(LEAPS) were trading at such a high price that the effective buy price of \nthe stock was less than the amount of cash the firm had on its balance \nsheet. Obviously, for a firm producing positive cash flows, the stock should \nnot trade at less than the value of cash presently on the balance sheet! I ef-\nfectively got the chance to buy a firm with $6 of cash on the balance sheet \nand the near certainty of generating about $2 more over the economic life \nof the options for $5.50. The opportunity to buy $6–$8 worth of cash for \nAccepting Exposure   • 215\n$5.50 does not come along very often, so you should take advantage of it \nwhen you see it.\nOf course, the absolute value of premium you will receive by writing \n(jargon that means selling an option) a short-term put is less than the ab-\nsolute value of the premium you will receive by writing a long-term one.\n3 \nAs such, an investor must balance the effective buy price of the stock (the \nstrike price of the option less the amount of premium to be received) in \nwhich he or she is investing in the short-put strategy with the percentage \nreturn he or she will receive if the put expires OTM.\nI will talk more about effective buy price in the next section, but keep \nin mind that we would like to generate the highest percentage return pos-\nsible and that this usually means choosing shorter-tenor options.\nStrike Price Selection\nIn general, the best policy is to sell options at as close to the 50-delta [at-\nthe-money (ATM)] mark as one can because that is where time value for \nany option is at its absolute maximum. Our expectation is that the option’s \ntime value will be worthless at expiration, and if that is indeed the case, \nwe will be selling time value at its maximum and “closing” our time value \nposition at zero—its minimum. In this way, we are obeying (in reverse \norder) the old investing maxim “Buy low, sell high. ” Selling ATM puts \nmeans that our effective buy price will be the strike price at which we sold \nless the amount of the premium we received. It goes without saying that \nan intelligent investor would not agree to accept the downside exposure \nto a stock if he or she were not prepared to buy the stock at the effective \nbuy price.\nSome people want to sell OTM puts, thereby making the effective buy \nprice much lower than the present market price. This is an understandable \nimpulse, but simply attempting to minimize the effective buy price means \nthat you must ignore the other element of a successful short put strategy: \nmaximizing the return generated. There are times when you might like to \nsell puts on a company but only at a lower strike price. Rather than accept-\ning a lower return for accepting that risk, I find that the best strategy is \nsimply to wait awhile until the markets make a hiccup and knock down the \nprice of the stock to your desired strike price.\n216  •   The Intelligent Option Investor\nPortfolio Management\nAs we have discussed, the best percentage returns on short-put investments \ncome from the sale of short-tenor ATM options. I find that each quarter there \nare excellent opportunities to find a fairly constant stream of this type of short-\nterm bet that, when strung together in a portfolio, can generate annualized \nreturns in the high-single-digit to low-teens percentage range. This level of \nreturns—twice or more the yield recently found on a high-quality corporate \nbond portfolio and closer to the bond yield on highly speculative small com-\npanies with low credit ratings—is possible by investing in strong, high-quality \nblue chip stocks. In my mind, it is difficult to allocate much money to corpo-\nrate bonds when this type of alternative is available.\nSome investors prefer to sell puts on stocks that are not very vola-\ntile or that have had a significant run-up in price,\n4 but if you think about \nhow options are priced, it is clear that finding stocks that the market \nperceives as more volatile will allow you to generate higher returns. Y ou \ncan confirm this by looking at the diagrams of a short-put investment \ngiven two different volatility scenarios. First, a diagram in which implied \nv", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 71}
{"text": "hat are not very vola-\ntile or that have had a significant run-up in price,\n4 but if you think about \nhow options are priced, it is clear that finding stocks that the market \nperceives as more volatile will allow you to generate higher returns. Y ou \ncan confirm this by looking at the diagrams of a short-put investment \ngiven two different volatility scenarios. First, a diagram in which implied \nvolatility is low:\nAdvanced Building Corp. (ABC)\n80\n70\n60\n50\n40\n30\n20\n5/18/2012 5/20/2013 249 499 749 999\nDate/Day Count\nStock Price\nRED\nAccepting Exposure   • 217\nNow a diagram when implied volatility is higher:\nRED\nAdvanced Building Corp. (ABC)\n80\n70\n60\n50\n40\n30\n20\n5/18/2012 5/20/2013 249 499 749 999\nDate/Day Count\nStock Price\nObviously, there is much more of the put option’s range of exposure \nbounded by the BSM cone in the second, high-volatility scenario, and this \nmeans that the price received for accepting the same downside risk will be \nsubstantially higher when implied volatility is elevated.\nThe key to setting up a successful allocation of short puts is to find \ncompanies that have relatively low downside valuation risk but that also \nhave a significant amount of perceived price risk (as seen by the market)—\neven if this risk is only temporary in nature. Quarterly earnings seasons are \nnearly custom made for this purpose. Sell-side analysts (and the market \nin general) mainly use multiples of reported earnings to generate a target \nprice for a stock. As such, a small shortfall in reported earnings as a result \nof a transitory and/or nonmaterial accounting technicality can cause sell-\nside analysts and other market participants to bring down their short-term \ntarget price estimates sharply and can cause stock prices to drop sharply \nas well.\n5\nThese times, when a high-quality company drops sharply as a re-\nsult of perceived risk by other investors, are a wonderful time to replen-\nish a portfolio of short puts. If you time the tenors well, your short-put \n218  •   The Intelligent Option Investor\ninvestment will be expiring just about the time another short-put invest-\nment is becoming attractive, so you can use the margin that has until re-\ncently been used to support the first position to support the new one.\nObviously, this strategy only works when markets are generally trend-\ning upward or at least sideways over the investment horizon of your short \nputs. If the market is falling, short-put positions expire ITM, so you are left \nwith a position in the underlying stocks. For an option trader (i.e., a short-\nterm speculator), being put a stock is a nightmare because he or she has \nno concept of the underlying value of the firm. However, for an intelligent \noption investor, being put a stock simply means the opportunity to receive \na dividend and enjoy capital appreciation in a strong stock with very little \ndownside valuation risk.\nThe biggest problem arises when an investor sells a put and then re-\nvises down his or her lowest-case valuation scenario at a later time. For in-\nstance, the preceding diagram shows a worst-case scenario of $55 per share. \nWhat if new material information became known to you that changed your \nlower valuation range to $45 per share just as the market price for the stock \ndropped, as in the following diagram?\nAdvanced Building Corp. (ABC)\n80\n70\n60\n50 EBP = $47.50\nOvervaluation of\ndownside exposure\n40\n30\n20\n5/18/2012 5/20/2013 249 499 749 999\nDate/Day Count\nStock Price\nRED\nAccepting Exposure   • 219\nLooking at this diagram closely, you should be able to see several \nthings:\n1. The investor who is short this put certainly has a notable unrealized \nloss on his or her position. Y ou can tell this because the put the \ninvestor sold is now much more valuable than at the time of \nthe original sale (more of the range of exposure is carved out by \nthe BSM cone now). When you sell something at one price and the \nvalue of that thing goes up in the future, you suffer an opportunity \nloss on your original sale.\n2. With the drop in price and the cut in fair value, the downside ex-\nposure on this stock still looks overvalued.\n3. If the company were to perform so that its share price eventually \nhit the new, reduced best-case valuation mark, the original short-\nput position would generate a profit—albeit a smaller profit than \nthe one originally envisioned.\nAt this point, there are a couple of choices open to the investor:\n1. Convert the unrealized loss on the short-put position to a realized \none by buying $50-strike puts to close the position (a.k.a. cover the \nposition).\n2. Leave the position open and manage it in the same way that the \ninvestor would manage a struggling stock position.\nIt is rarely a sound idea to close a short put immediately after the re-\nlease of information that drives down the stock price (the first choice above, \nin other words). At these times, investors are generally panicked, and this \npanic will cause the price of the option you buy to cover to be more expen-\nsive than justified. Waiting a few days or weeks for the fear to drain out of \nthe option prices (i.e., for the BSM cone to narrow) and for the stock price \nto stabilize some will usually allow you to close the option position at a more \nfavorable price. There is one exception to this rule: if your new valuation \nsuggests a fair value at or below the present market price, it is better to close \nthe position immediately and realize those losses. If you do not close the \nposition, you are simply gambling (as opposed to investing) because you no \nlonger have a better than even chance of making money on the investment.\n220  •   The Intelligent Option Investor\nThe decision to leave the position open must depend on what other \npotential investments you are able to make and how the stock position that \nwill likely be put to you at expiration of the option contract stacks up on a \nrelative basis. For instance, let’s assume that you had received a premium \nof $2.50 for writing the puts struck at $50", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 72}
{"text": "n the investment.\n220  •   The Intelligent Option Investor\nThe decision to leave the position open must depend on what other \npotential investments you are able to make and how the stock position that \nwill likely be put to you at expiration of the option contract stacks up on a \nrelative basis. For instance, let’s assume that you had received a premium \nof $2.50 for writing the puts struck at $50. This gives you an effective buy \nprice of $47.50. The stock is now trading at $43 per share, so you can think \nof your position as an unlevered, unrealized loss of $4.50, or a little under \n10 percent of your EBP . Y our new worst-case valuation is $55 per share, \nwhich implies a gain of about 15 percent on your EBP; your new best-case \nvaluation is $65 per share, which implies a gain of 37 percent.\nHow do these numbers compare with other investments in your port-\nfolio? How much spare capacity does your portfolio have for additional \ninvestments? (That is, do you have enough spare cash to increase the size \nof this investment by selling more puts at the new market price or buying \nshares of stock? And if so, would your portfolio be weighted too heavily on a \nsingle industry or sector?) By answering these questions and understanding \nhow this presently losing investment compares with other existing or poten-\ntial investments should govern your portfolio management of the position.\nAn investor cannot change the price at which he or she transacted \nin a security. The best he or she can do is to develop a rational view of the \nvalue of a security and judge that security by its relative merit versus other \npossible investments. Whether you ever make an option transaction, this \nis a good rule to keep in mind.\nLet us now take a look at short calls and short-call spreads—the \nstrategy used for accepting upside exposure.\nShort Call (Call Spread)\nRED\nAccepting Exposure   • 221\nDownside: Fairly valued\nUpside: Overvalued\nExecute: Sell a call contract (short call); sell a call contract while \nsimultaneously buying a call contract at a higher strike \nprice (short-call spread)\nRisk: Unlimited for short call; difference between strike prices \nand premium received (short-call spread)\nReward: Limited to the amount of premium received\nMargin: Variable for a short call; dollar amount equal to the differ-\nence between strike prices for a short-call spread\nThe Gist\nThe market overestimates the likelihood that the value of a firm is above its pre-\nsent market price. An investor accepts the overvalued upside exposure in return \nfor a fixed payment of premium. The full amount of the premium will only flow \nthrough to the investor if the price of the stock falls and the option expires OTM.\nThere are two variations of this investment—the short call and the \nshort-call spread. This book touches on the former but mainly addresses \nthe latter. A short call opens up the investor to potentially unlimited capital \nlosses (because stocks theoretically do not have an upper bound for their \nprice), and a broker will not allow you to invest using this strategy except \nfor the following conditions:\n1. Y ou are a hedge fund manager and have the ability to borrow \nstocks through your broker and sell them short.\n2. Y ou are short calls not on a stock but on a diversified index (such \nas the Dow Jones Industrial Index or the Standard and Poor’s 500 \nIndex) through an exchange-traded fund (ETF) or a futures con-\ntract and hold a diversified stock portfolio.\nFor investors fitting the first condition, short calls are margined in the \nsame way as the rest of your short portfolio. That is, you must deposit initial \nmargin on the initiation of the investment, and if the stock price goes up, you \nmust pay in variance margin to support the position. Obviously, as the stock \nprice falls, this margin account is settled in your favor. For investors fitting the \nsecond condition, when you originally sell the call option, your broker should \n222  •   The Intelligent Option Investor\nindicate on your statements that a certain proportion of your account effec-\ntively will be treated as margin. This means that you stand to receive the eco-\nnomic benefit from your diversified portfolio of securities but will not be able \nto liquidate all of it. If the market climbs higher, a larger proportion of your \nportfolio will be considered as margin; if it falls lower, a smaller proportion \nof your portfolio will be considered as margin. Basically, a proportion of any \ngains from your diversified stock portfolio will be reapportioned to serve as \ncollateral for your short call when the market is rising, and a proportion of any \nlosses from your diversified stock portfolio will be offset by a freeing of margin \nrelated to your profits on the short call when the market is falling.\nMost brokers restrict the ability of individual investors to write un-\ncovered calls on individual stocks, so the rest of this discussion will cover \nthe short-call spread strategy for individual stocks.\nT enor Selection\nTenors for short-call spreads should be fairly short under the same reason-\ning as that for short puts—one receives more time value per day for short-\ner-tenor options. Look for calls in the three- to nine-month tenor range. \nThe tenor of the purchased call (at the higher strike price) should be the \nsame as the tenor of the sold calls (at the lower strike price). Theoretically, \nthe bought calls could be longer, but it is hard to think of a valuation justifi-\ncation for such a structure. By buying a longer-tenor call for the upside leg \nof the investment, you are expressing an investment opinion that the stock \nwill likely rise over the long term—this exactly contradicts the purpose of \nthis strategy: expressing a bearish investment opinion.\nStrike Price Selection\nTheoretically, you can choose any two strike prices, sell the call at the lower \nprice, and buy the call at the higher price and execute this investment. If you \nsold an ITM call, you would receive premium t", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 73}
{"text": "n investment opinion that the stock \nwill likely rise over the long term—this exactly contradicts the purpose of \nthis strategy: expressing a bearish investment opinion.\nStrike Price Selection\nTheoretically, you can choose any two strike prices, sell the call at the lower \nprice, and buy the call at the higher price and execute this investment. If you \nsold an ITM call, you would receive premium that consists of both time and \nintrinsic value. If the stock fell by expiration, you would realize all the wasted \ntime value plus the difference between the intrinsic value at initiation and the \nintrinsic value at expiration.\nDespite the theory, however, in practice, the lower strike option is usually \nsold ATM or OTM because of the threat of assignment. Assignment is the pro-\ncess the exchange goes through when investors choose to exercise the option \nAccepting Exposure   • 223\nthey own rather than trade them away for a profit. Recall from Chapter 2 \nthat experienced option investors do not do this most of the time; they \nknow that because of the existence of time value, it is usually more beneficial \nfor them to sell their option in the market and use the proceeds to buy the stock \nif they want to hold the underlying. Inexperienced investors, however, often are \nnot conscious of the time-value nuance and sometimes elect to exercise their \noption. In this case, the exchange randomly pairs the option holders who wish \nto exercise with an option seller who has promised to sell at that exercise price.\nThere is one case in which a sophisticated investor might chose to \nexercise an ITM call option early, related to a principle in option pricing \ncalled put-call parity. This rule, which was used to price options before \nadvent of the BSM, simply states that a certain relationship must exist be-\ntween the price of a put at one strike price, the price of a call at that same \nstrike price, and the market price of the underlying stock. Put-call parity \nis discussed in Appendix C. In this appendix, you can learn what the exact \nput-call parity rule is (it is ridiculously simple) and then see how it can be \nused to determine when it is best to exercise early in case you are long a \ncall and when your short-call (spread) position is in danger of early exercise \nbecause of a trading strategy known as dividend arbitrage.\nThe assignment process is random, but obviously, the more contracts \nyou sell, the better the chance is that you will be assigned on some part or all \nof your sold contracts. Even if you hold until expiration, there is still a chance \nthat you may be assigned to fulfill a contract that was exercised on settlement.\nClearly, from the standpoint of option sale efficiency, an ATM call is the \nmost sensible to sell for the same reason that a short put also was most efficient \nATM. As such, the discussion that follows assumes that you are selling the \nATM strike and buying back a higher strike to cover.\nIn a call-spread strategy, the capital you have at risk is the difference be-\ntween the two strike prices—this is the amount that must be deposited into \nmargin. Depending on which strike price you use to cover, the net premium \nreceived differs because the cost of the covering call is cheaper the further \nOTM you cover. As the covering call becomes more and more OTM, the ratio \nof premium received to capital at risk changes. Put in these terms, it seems \nthat the short-call spread is a levered strategy because leverage has to do with \naltering the capital at risk in order to change the percentage return. This con-\ntrasts with the short-call spread’s mirror strategy on the put side—short puts—\nin that the short-put strategy is unlevered. \n224  •   The Intelligent Option Investor\nFor instance, here are data from ATM and OTM call options on IBM \n(IBM) expiring in 80 days. I took these data when IBM’s shares were trad-\ning at $196.80 per share.\nSell a Call at 195\nCover at ($) Net Premium Received ($) Percent Return Capital at Risk ($)\n200 2.40 48 5\n205 4.26 43 10\n210 5.47 36 15\n215 6.17 31 20\n220 6.51 26 25\n225 6.70 22 30\n230 6.91 20 35\n235 6.90 17 40\n240 6.96 15 45\nIn this table, net premium received was calculated by selling at the $195 \nstrike’s bid price and buying at each of the listed strike price’s ask prices. Percent \nreturn is the proportion of net premium received as a percentage of the capital \nat risk—the width of the spread. This table clearly shows that accepting expo-\nsure with a call spread is a levered strategy. The potential return on a percent-\nage basis can be raised simply by lowering the amount of capital at risk.\nHowever, although accepting exposure with a call spread is un-\ndeniably levered from this perspective, there is one large difference: un-\nlike the leverage discussed earlier in this book for a purchase of call op-\ntions—in which your returns were potentially unlimited—the short-call \nspread investor receives premium up front that represents the maximum \nreturn possible on the investment. As such, in the sense of the investor’s \npotential gains being limited, the short-call spread position appears to be \nan unlevered investment.\nConsidering the dual nature of a short-call spread, it is most help-\nful to think about managing these positions using a two-step process with \nboth tactical and strategic aspects. We will investigate the tactical aspect \nof leverage in the remainder of this section and the strategic aspect in the \nportfolio management section.\nAccepting Exposure   • 225\nTactically, once an investor has decided to accept exposure to a stock’s \nupside potential using a call spread, he or she has a relatively limited choice \nof investments. Let’s assume that we sell the ATM strike; in the IBM ex-\nample shown earlier, there is a choice of nine strike prices at which we \ncan cover. The highest dollar amount of premium we can receive—what I \nwill call the maximum return—is received by covering at the most distant \nstrike. Every strike between the ATM and the most dis", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 74}
{"text": "all spread, he or she has a relatively limited choice \nof investments. Let’s assume that we sell the ATM strike; in the IBM ex-\nample shown earlier, there is a choice of nine strike prices at which we \ncan cover. The highest dollar amount of premium we can receive—what I \nwill call the maximum return—is received by covering at the most distant \nstrike. Every strike between the ATM and the most distant strike will at \nmost generate some percentage of this maximum return.\nNow let’s look at the risk side. Let’s say that we sell the $195-strike call \nand cover using the $210-strike call. Now assume that some bit of good \nnews about IBM comes out, and the stock suddenly moves to exactly $210. \nIf the option expires when IBM is trading at $210, we will have lost the \nentire amount of margin we posted to support this investment—$15 in all. \nThis $15 loss will be offset by the amount of premium we received from \nselling the call spread—$5.47 in the IBM example—generating a net loss of \n$9.53 (= $5.47 − $15). Compare this with the loss that we would suffer if we \nhad covered using the most distant call strike. In this case, we would have \nreceived $6.96 in premium, so if the option expires when IBM is trading at \nthe same $210 level as earlier, our net loss would be $8.04 (= $6.96 − $15). \nBecause our maximum return is generated with the widest spread, it fol-\nlows that our minimum loss for the stock going to any intermediate strike \nprice also will be generated with the widest spread.\nAt the same time, if we always select the widest spread, we face an \nentirely different problem. That is, the widest spread exposes us to the great-\nest potential loss. If the stock goes only to $210, it is true that the widest \nspread will generate a smaller loss than the $195–$210 spread. However, in \nthe extreme, if the stock moves up strongly to $240, we would lose the $45 \ngross amount supporting the margin account and a net amount of $38.04 \n(= $45 – $6.96). Contrast this with a net loss of $9.53 for the $195–$210 \nspread. Put simply, if the stock moves up only a bit, we will do better with \nthe wider spread; if it moves up a lot, it is better to choose a narrower \nspread. \nIn short, when thinking about call spreads, we must balance our \namount of total exposure against the exposure we would have for an inter-\nmediate outcome against the total amount of premium we are receiving. If \nwe are too protective and initiate the smallest spread possible, our chance \n226  •   The Intelligent Option Investor\nof losing the entire margin amount is higher, but the margin amount lost \nis smaller. On the other hand, if we attempt to maximize our winnings \nand initiate the widest spread possible, our total exposure is greatest, even \nthough the chance of losing all of it is lower.\nPlotting these three variables on a graph, here is what we get:\n200 (11%)\n0%\n20%\n40%\n60%\n80%\n106% 102%\n94%89%\n100%\n120%\n140%\n160%\n180%\n200%\n205 (22%) 210 (33%) 215 (44%) 220 (56%) 225 (67%) 230 (78%) 235 (89%) 240 (100%)\nStrike (% of Total Exposure)\nRisk & Return of Call Spreads vs. Maximum Spread\nRisk Comparison Return Comparison\nHere, on the horizontal axis, we have the value of the covering strike and \nthe size of the corresponding spread as a percentage of the widest spread. \nThis shows how much proportional capital is at risk (e.g., at the $215-strike, \nwe are risking a total of $20 of margin; $20 is 44 percent of total exposure \nof $45 if we covered at the $240-strike level). The top line shows how much \ngreater the loss would be if we used that strike to cover rather than the \nmaximum strike and the option expired at that strike price (e.g., if we cover \nat the $215-strike and the option expires when the stock is trading at $215, \nour loss would be 6 percent greater than the loss we would suffer if we \ncovered at the $240-strike). The bottom line shows the premium we will \nrealize as income if the stock price declines as a percentage of the total pre-\nmium possible if we covered at the maximum strike price. Here are the val-\nues from the graph in tabular format so that you can see the numbers used:\nStrike \nPrice\nDollar \nSpread\nPercent of \nMaximum \nSpread (a)\nBid \nPrice\nAsk \nPrice\nCovering at Strike\nCovering at Maximum \nStrike\nDifference\nRisk \nComparison \n(%) (b)\nReturn \nComparison \n(%) (c)\nPotential \nGain\nWorst-Case \n(Loss)\nPotential \nGain\nWorst-Case \nGain (Loss)\n195 — — 7.05 7.10 — — — — — — —\n200 5 11 4.55 4.65 2.40 (2.60) 6.96 1.96 (3.55) N.C. 34\n205 10 22 2.75 2.79 4.26 (5.74) 6.96 (3.04) 2.29 189 61\n210 15 33 1.54 1.58 5.47 (9.53) 6.96 (8.04) 0.87 119 79\n215 20 44 0.84 0.88 6.17 (13.83) 6.96 (13.04) 0.53 106 89\n220 25 56 0.38 0.54 6.51 (18.49) 6.96 (18.04) 0.39 102 94\n225 30 67 0.12 0.35 6.70 (23.30) 6.96 (23.04) 0.30 101 96\n230 35 78 0.11 0.14 6.91 (28.09) 6.96 (28.04) 0.25 100 99\n235 40 89 0.03 0.15 6.90 (33.10) 6.96 (33.04) 0.21 100 99\n240 45 100 0.02 0.09 6.96 (38.04) 6.96 (38.04) 0.18 100 100\n227\n228  •   The Intelligent Option Investor\nWith a table like this, you can balance, on the one hand, the degree \nyou are reducing your overall exposure in a worst-case scenario (by look-\ning at column a) against how much risk you are taking on for a bad-case \n(intermediary upward move of the stock) scenario (by looking at column \nb) against how much less premium you stand to earn if the stock does go \ndown as expected (by looking at column c). \nThere are no hard and fast rules for which is the correct covering strike to \nselect—that will depend on your confidence in the valuation and timing, your \nrisk profile, and the position size—but looking at the table, I tend to be drawn \nto the $215 and $220 strikes. With both of those strikes, you are reducing your \nworst-case exposure by about half, increasing your bad-case exposure just \nmarginally, and taking only a small haircut on the premium you are receiving.\n6\nNow that we have an idea of how to think about the potential risk and \nreturn on a per-contract basis, let’s turn to leverage in the s", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 75}
{"text": "he table, I tend to be drawn \nto the $215 and $220 strikes. With both of those strikes, you are reducing your \nworst-case exposure by about half, increasing your bad-case exposure just \nmarginally, and taking only a small haircut on the premium you are receiving.\n6\nNow that we have an idea of how to think about the potential risk and \nreturn on a per-contract basis, let’s turn to leverage in the strategic sense—\nfiguring out how much capital to commit to a given bearish idea.\nPortfolio Management\nWhen we thought about leverage from a call buyer’s perspective, we \nthought about how large of an allocation we wanted to make to the idea \nitself and changed our leverage within that allocation to modify the profits \nwe stood to make. Let’s do this again with IBM—again assuming that we are \nwilling to allocate 5 percent of our portfolio to an investment in the view \nthat this company’s stock price will not go higher. At a price of $196.80, a \n5 percent allocation would mean controlling a little more than 25 shares for \nevery $100,000 of portfolio value.\n7 Because options have a contract size of \n100 shares, an unlevered 5 percent allocation to this investment would \nrequire a portfolio size of $400,000.\nThe equation to calculate the leverage ratio on the basis of notional \nexposure is\n× =Notional valueo fo ne contract\nDollarv alue of allocation number of contractsl everager atio\nSo, for instance, if we had a $100,000 portfolio of which we were willing to \ncommit 5 percent to this short-call spread on IBM, our position would have a \nleverage ratio of\nAccepting Exposure   • 229\n×= ≈$19,500\n$5,000 13 .9 4: 1leverage\nSelling the $195/$220 call spread will generate $651 worth of pre-\nmium income and put at risk $2,500 worth of capital. Nothing can change \nthese two numbers—in this sense, the short-call spread has no leverage. \nThe 4:1 leverage figure merely means that the percentage return will ap-\npear nearly four times as large on a given allocation as a 1:1 allocation \nwould appear. The following table—assuming the sale of one contract of \nthe $195/$220 call spread—shows this in detail:\nWinning Case Losing Case\nPremium \nReceived \n($)\nTarget \nAllocation \n($) Leverage\nStock \nMove ($)\nPercent \nReturn on \nAllocation\nStock \nMove \n($)\nDollar \nReturn\nPercent \nReturn on \nAllocation\n651 20,000 1:1 –2 3.3 +25 –1,849 –9.2\n651 10,000 2:1 –2 6.5 +25 –1,849 –18.5\n651 5,000 4:1 –2 13.0 +25 –1,849 –37.0\nNote: The dollar return in the losing case is calculated as the loss of the $2,500 of margin \nper contract less than the premium received of $651.\nNotice that the premium received never changes, nor does the worst-\ncase return. Only the perception of the loss changes with the size of our \ntarget allocation.\nNow that we have a sense of how to calculate what strategic leverage \nwe are using, let’s think about how to size the position and about how much \nrisk we are willing to take. When we are selling a call or call spread, we are \ncommitting to sell a stock at the strike price. If we were actually selling the \nstock at that price rather than committing to do so, where would we put \nour stop loss—in other words, when would we close the position, assuming \nthat our valuation or our timing was not correct?\nLet’s say that for this stock, if the price rose to $250, you would be \nwilling to admit that you were wrong and would realize a loss of $55 per share, \nor $5,500 per hundred shares. This figure—the $5,500 per hundred shares \nyou would be willing to lose in an unlevered short stock position—can be \nused as a guide to select the size of your levered short-call spread.\n230  •   The Intelligent Option Investor\nIn this case, you might choose to sell a single $195–$240 call spread, in \nwhich case your maximum exposure would be $4,500 [= 1 × (240 – 195) × 100] \nat the widest spread. This investment would have a leverage ratio of approxi-\nmately 1:1. Alternatively, you could choose to sell two $195–$220 spreads, in \nwhich case your maximum exposure would be $5,000 [= 2 × (220 − 195) × \n100], with a leverage ratio of approximately 2:1. Which choice you select will \ndepend on your assessment of the valuation of the stock, your risk tolerance, \nand the composition of your portfolio (i.e., how much of your portfolio is al-\nlocated to the tech sector, in this example of an investment in IBM). Because \nthe monetary returns from a short-call or call-spread strategy are fixed and \nthe potential for losses are rather high, I prefer to execute bearish investments \nusing the long-put strategy discussed in the “Gaining Exposure” section.\nWith this explanation of the short-call spread complete, we have all the \nbuilding blocks necessary to understand all the other strategies mentioned \nin this book. Let’s now turn to two nonrecommended complex strategies \nfor accepting exposure—the short straddle and the short strangle—both of \nwhich are included not because they are good strategies but rather for the \nsake of completeness.\nShort Straddle/Short Strangle\nShort Straddle\nRED\nDownside: Overvalued\nUpside: Overvalued\nExecute: Sell an ATM put; simultaneously sell an ATM call spread\nAccepting Exposure   • 231\nRisk: Amount equal to upper strike price minus premium received\nReward: Limited to premium received\nMargin: Dollar amount equal to upper strike price\nShort Strangle\nRED\nRED\nDownside: Overvalued\nUpside: Overvalued\nExecute: Sell an OTM put; simultaneously sell an OTM call spread\nRisk: Call-spread leg: Amount equal to difference between \nstrikes and premium received. Put leg: Amount equal to \nstrike price minus premium received. Total exposure is \nthe sum of both legs.\nReward: Limited to premium received\nMargin: Call-spread leg: Amount equal to difference between \nstrikes. Put leg: Amount equal to strike price. Total mar -\ngin is the sum of both legs.\nThe Gist\nIn my opinion, these are short-term trades rather than investments. Even \nthough a short put uses a short-tenor option, the perspective of the inves-\ntor is that he or she is buying s", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 76}
{"text": "the sum of both legs.\nReward: Limited to premium received\nMargin: Call-spread leg: Amount equal to difference between \nstrikes. Put leg: Amount equal to strike price. Total mar -\ngin is the sum of both legs.\nThe Gist\nIn my opinion, these are short-term trades rather than investments. Even \nthough a short put uses a short-tenor option, the perspective of the inves-\ntor is that he or she is buying shares. These strategies are a way to express \nthe belief that the underlying stock price will not move over a short time. \nIn my experience, there is simply no way to develop a rational view of how \na single stock will move over a short time frame. In the short term, markets \n232  •   The Intelligent Option Investor\nfluctuate based on animal spirits, fads, and various other insanities. Why \nsubject yourself to the torture of trying to figure out these insanities and \nprofit from them when there are easier, more intelligent ways of doing so? \nOf the two strategies, the short straddle is preferable because it yields \nthe greatest amount of premium. Use this strategy at your own peril, \nhowever.\nLet’s turn now to a discussion of how to mix exposure—simultane-\nously gaining and accepting exposure and overlaying options on stock po-\nsitions.\n233\nChapter 11\nMixing ExposurE\nMixing exposure uses combinations of gaining and accepting exposure, \nemploying strategies that we already discussed to create what amounts to \nsort of a short-term synthetic position in a stock (either long or short). \nThese strategies, nicknamed “diagonals” can be extremely attractive and \nextremely financially rewarding in cases where stocks are significantly mis-\npriced (in which case, exposure to one direction is overvalued, whereas the \nother is extremely undervalued). \nFrequently, using one of these strategies, an investor can enter a po-\nsition in a levered out-of-the-money (OTM) option for what, over time, \nbecomes zero cost (or can even net a cash inflow) and zero downside expo-\nsure. This is possible because the investor uses the sale of one shorter-tenor \nat-the-money (ATM) option to subsidize the purchase of another longer-\ntenor OTM one. Once the sold option expires, another can be sold again, \nand whatever profit is realized from that sale goes to further subsidize the \nposition.\nThis strategy works well because of a couple of rules of option pricing \nthat we have already discussed:\n1. ATM options are more expensive than OTM options of the same \ntenor.\n2. Short-tenor options are worth less than long-tenor options, but \nthe value per day is higher for the short-tenor options.\n234  •   The Intelligent Option Investor\nI provide actual market examples of these strategies in this chapter and will \npoint out the effect of both these points in those examples.\nBecause these strategies are a mix of exposures, it makes sense \nthat they are just complex (i.e., multioption) positions. I will discuss the \nfollowing:\n1. Long diagonal\n2. Short diagonal\nNote that the nomenclature I use here is a bit different from what others \nin the market may use. What I term a diagonal in this book is what others \nmight call a “spit-strike synthetic stock. ” Since Bernie Madoff ’s infamous \n“split-strike conversion” fraud, this term doesn’t have a very good ring to \nit. For other market participants, a diagonal means simultaneously buying \nand selling options of the same type (i.e calls or puts). In this book, it means \nselling an option of one kind and buying the other kind.\nI will also talk about what is known in the options world as overlays. One \nof the most useful things about options is the way that they can be grafted or \noverlain onto an existing common stock position in a way that alters the port-\nfolio’s overall risk-reward profile. The strategies I will review here are as follows:\n1. Covered calls\n2. Protective puts\n3. Collars\nThese strategies are popular but often misunderstood ways to alter your \nportfolio’s risk-reward profile.\nComing this far in this book, you already have a good understand-\ning about how options work, so the concepts presented here will not be \ndifficult, but I will discuss some nuances that will help you to evaluate \ninvestment choices and make sound decisions regarding the use of these \nstrategies. I will refer to strike selection and tenor selection in the following \npages, but for these, along with “The Gist” section, I’ll include an “Execu-\ntion” section and a “Common Pitfalls” section.\nCovered calls are an easy strategy to understand once you understand \nshort puts, so I will discuss those first. Protective puts share a lot of simi-\nlarities with in-the-money (ITM) call options, and I will discuss those next. \nMixing Exposure  •  235\nCollars are just a combination of the other two overlay strategies and so are \neasiest left to the end.\nLong Diagonal\nGREEN\nRED\nDownside: Overvalued\nUpside: Undervalued\nExecute: Sell an ATM put option (short put) and simultaneously \nbuy an OTM call option (long call)\nRisk: Sum of put’s strike price and net premium paid for call\nReward: Unlimited\nMargin: Amount equal to put’s strike price\nThe Gist\nOther than the blank space in the middle of the diagram and the disparity \nbetween the lengths of the tenors, the preceding diagram looks very much like \nthe risk-return profile diagram for a long stock—accepting downside exposure \nin return for gaining upside exposure. As you can see from the diagram, the \nrange of exposure for the short put lies well within the Black-Scholes-Merton \nmodel (BSM) cone, but the range of exposure for the long call is well outside \nthe cone. It is often possible to find short-put–long-call combinations that al-\nlow for an immediate net credit when setting up this investment.\n236  •   The Intelligent Option Investor\nBecause we must fully margin a short-put investment, that leg of \nthe long diagonal carries with it a loss leverage ratio of –1.0. However, the \nOTM call leg represents an immediate realized loss coupled with a very \nhigh lambda value for gains.", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 77}
{"text": "find short-put–long-call combinations that al-\nlow for an immediate net credit when setting up this investment.\n236  •   The Intelligent Option Investor\nBecause we must fully margin a short-put investment, that leg of \nthe long diagonal carries with it a loss leverage ratio of –1.0. However, the \nOTM call leg represents an immediate realized loss coupled with a very \nhigh lambda value for gains. As such, if the put option expires ITM, the \nlong diagonal is simply a levered strategy; if the put option expires OTM, \nthe investment is a very highly levered one because the unlevered put \nceases to influence the leverage equation. Another short put may be written \nafter the previous short put expires; this further subsidizes the cost of the \ncalls and so greatly increases the leverage on the strategy.\nIf the stock moves quickly toward the upper valuation range, this \nstructure becomes extremely profitable on an unrealized basis. If the put \noption expires ITM, the investor is left with a levered long investment in \nthe stock in addition to the long position in the OTM. As in any other \ncomplex structure, the investment may be ratioed—for instance, by buying \none call for every two puts sold or vice versa.\nStrike Price Selection\nThe put should be sold ATM or close to ATM in order to maximize the time \nvalue sold, as explained earlier in the short-put summary. The call strike may be \nbought at any level depending on the investor’s appetite for leverage but is usu-\nally purchased OTM. The following table shows the net debit or credit associated \nwith the long diagonal between the ATM put ($55 strike price, delta of –0.42, \npriced at the bid price) with an expiration of 79 days and each call strike (at the \nask price) listed, all of which are long-term equity anticipated securities (LEAPS) \nhaving expirations in 534 days. The lambda figure for the OTM calls is also given \nto provide an idea of the comparative leverage of each call option. For this exam-\nple, I am using JP Morgan Chase (JPM) when its stock was trading for $56.25.\nStrike Delta (Debit) Credit Call Lambda (%)\n57.50 0.43 (2.52) 5.6\n60.00 0.37 (1.57) 6.1\n62.50 0.31 (0.76) 6.7\n65.00 0.26 (0.25) 7.0\n70.00 0.16 0.78 8.4\n75.00 0.10 1.28 9.5\n80.00 0.06 1.56 10.5\nMixing Exposure  •  237\nHere we can see that for a long diagonal using 79-day ATM puts \nand 594-day LEAPS that are OTM by just over 15 percent, we are \npaying a net of only $25 per contract for notional control of 100 \nshares. On a per-contract basis, at the following settlement prices, \nwe would generate the following profits (or losses, in the case of the \nfirst row):\nSettlement Price ($) Dollar Profit per Contract\nPercentage Return on Original \nInvestment (%)\n65 0 –100\n66 100 300\n67 200 700\n68 300 1,100\n69 400 1,500\n70 500 1,900\n71 600 2,300\n72 700 2,700\n73 800 3,100\n74 900 3,500\n75 1,000 3,900\nIf the stock price moves up very quickly, it might be more beneficial \nto close the position or some portion of the position before expiration. Let’s \nsay that my upper-range estimate for this stock was $75. From the preced-\ning table, I can see that my profit per contract if the stock settles at my fair \nvalue range is $1,000. If there is enough time value on a contract when \nthe stock is trading in the upper $60 range to generate a realized profit of \n$1,000, I am likely to take at least some profits at that time rather than wait-\ning for the calls to expire.\nIn Chapter 9, I discussed portfolio composition and likened the use \nof leverage as a side dish to a main course. This is an excellent side dish that \ncan be entered into when we see a chance to supplement the main meal of \na long stock–ITM call option position with a bit more spice. Let’s now turn \nto its bearish mirror—the short diagonal.\n238  •   The Intelligent Option Investor\nShort Diagonal\nRED\nGREEN\nDownside: Undervalued\nUpside: Overvalued\nExecute: Sell an ATM call option while buying one to cover at a \nhigher price (short-call spread) and simultaneously buy \nan OTM put option (long put)\nRisk: Sum of put’s strike price and net premium paid for call\nReward: Amount equal to the put’s strike price minus any net \npremium paid for it \nMargin: Amount equal to spread between call options\nThe Gist\nThe diagram for a short diagonal is just the inverse of the long diagonal and, of \ncourse, looks very similar to the risk-return profile diagram for a short stock—\naccepting upside exposure in return for gaining downside exposure. The gist \nof this strategy is simply the short-exposure equivalent to the long diagonal, so \nthe comments about the long diagonal are applicable to this strategy as well. \nThe one difference is that because you must spend money to cover the short \ncall on the upside, the subsidy that the option sale leg provides to the option \npurchase leg is less than in the case of the long diagonal. Also, of course, a stock \nprice cannot turn negative, so your profit upside is capped at an amount equal \nto the effective sell price. This investment also may be ratioed (e.g., by using \none short-call spread to subsidize two long puts).\nMixing Exposure  •  239\nStrike Price Selection\nStrike price selection for a short diagonal is more difficult because there \nare three strikes to price this time. Looking at the current pricing for a \ncall spread with the short call struck at $55, I get the following selection of \ncredits:\nUpper Call Strike ($)\nCall Spread \nNet Credit ($)\nPercent Total \nRisk Percent Total Return\n57.50 1.27 17 49\n60.00 2.14 33 83\n62.50 2.44 50 94\n65.00 2.51 67 97\n70.00 2.59 100 100\nLooking at this, let’s say we decide to go with the $55.00/$62.50 call \nspread. Doing so, we would receive a net credit of $2.44. Now selecting the \nput to purchase is a matter of figuring out the leverage of the position with \nwhich you are comfortable.\nStrike ($) Delta (Debit) Credit ($) Put Lambda (%)\n20.00 –0.02 2.20 –4.5\n23.00 –0.02 2.11 –4.6\n25.00 –0.03 2.05 –4.6\n28.00 –0.04 1.91 –4.8\n30.00 –0.05 1.78 –4.8\n33.00 –0.07 1.57 –4.8\n35.00", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 78}
{"text": "with the $55.00/$62.50 call \nspread. Doing so, we would receive a net credit of $2.44. Now selecting the \nput to purchase is a matter of figuring out the leverage of the position with \nwhich you are comfortable.\nStrike ($) Delta (Debit) Credit ($) Put Lambda (%)\n20.00 –0.02 2.20 –4.5\n23.00 –0.02 2.11 –4.6\n25.00 –0.03 2.05 –4.6\n28.00 –0.04 1.91 –4.8\n30.00 –0.05 1.78 –4.8\n33.00 –0.07 1.57 –4.8\n35.00 –0.09 1.38 –4.8\n38.00 –0.12 0.99 –4.8\n40.00 –0.15 0.67 –4.7\n42.00 –0.17 0.30 –4.7\n45.00 –0.23 (0.43) –4.5\n47.00 –0.26 (1.01) –4.4\n50.00 –0.33 (1.91) –4.4\n52.50 –0.39 (3.11) –4.0\n240  •   The Intelligent Option Investor\nNotice that there is much less leverage on the long-put side than on \nthe long-call side. This is a function of the volatility smile and the abnor -\nmally high pricing on the far OTM put side. It turns out that the $20-strike \nputs have an implied volatility of 43.3 percent compared to an ATM im-\nplied volatility of 22.0 percent.\nObviously, the lower level of leverage will make closing before expira-\ntion less attractive, so it is important to select a put strike price between the \npresent market price and your worst-case fair value estimate. In this way, \nif the option does expire when the stock is at that level, you will at least be \nable to realize the profit of the intrinsic value.\nWith these explanations of the primary mixed-exposure strategies, \nnow let’s turn to overlays—where an option position is added to a stock \nposition to alter the risk-return characteristics of the investor’s portfolio.\nCovered Call\nContingent Upside Exposure\nContingent Downside Exposure\nLIGHT GREEN\nRED\nLIGHT RED\nDownside: Overvalued\nUpside: Fairly valued or undervalued\nMixing Exposure  •  241\nExecute: Buy common stock and simultaneously sell a call option\nRisk: Strike price minus premium received\nReward: Limited to premium and, as long as the shares are not called, \nthe dividends received during the tenor of the option\nMargin: None as long as stock and option positions are evenly \nmatched—long stock position serves as collateral for the \nsold call\nThe Gist\nIf you look just as far as the option tenor lasts on the preceding diagram, \nyou will see that the risk-return profile is identical to that of a short put. As \nevidence, please compare the following two diagrams:\nWe have sold\naway the upside\nexposure so are\nleft with only\nthe acceptance\nof downside\nexposure here.\nRED\nCovered call\n242  •   The Intelligent Option Investor\nWe accepted\ndownside\nexposure when\nwe sold this\nput, so have no\nexposure to the\nupside here.\nRED\nThe top of the “Covered call” diagram is grayed out because we have \nsold away the upside exposure to the stock by selling the call option, and \nwe are left only with the acceptance of the stock’s downside exposure. The \npictures are slightly different, but the economic impact is the same.\nThe other difference you will notice is that after the option expires, in the \ncase of the covered call, we have represented the graphic as though there is some \nresidual exposure. This is represented in this way because if the option expires \nITM, you will have to deliver your stock to the counterparty who bought your \ncall options. As such, your future exposure to the stock is contingent on another \ninvestor’s actions and the price movement of the stock. This is an important point \nto keep in mind, and I will discuss it more in the “Common Pitfalls” section.\nExecution\nBecause this strategy is identical from a risk-reward perspective to short \nputs, the execution details should be the same as well. Indeed, covered \ncalls should—like short puts—be executed ATM to get the most time value \npossible and preferably should be done on a stock that has had a recent fall \nand whose implied volatility has spiked. However, these theoretical points \nShort put\nMixing Exposure  •  243\nignore the fact that most people simply want to generate a bit of extra in-\ncome out of the holdings they already have and so are psychologically re-\nsistant to both selling ATM (because this makes it more likely for their \nshares to be called away) and selling at a time when the stock price sud-\ndenly drop (because they want to reap the benefit of the shares recovering).\nAlthough I understand these sentiments, it is important to realize \nthat options are financial instruments and not magical ones. It would be \nnice if we could simply find an investment tool that we could bolt onto \nour present stock holdings that would increase the dividend a nice amount \nbut that wouldn’t put us at risk of having to deliver our beloved stocks to a \ncomplete stranger; unfortunately, this is not the case for options.\nFor example, let’s say that you own stock in a company that is paying out \na very nice dividend yield of 5 percent at present prices. This is a mature firm \nthat has tons of cash flow but few opportunities for growth, so management \nhas made the welcome choice to return cash to shareholders. The stock is trad-\ning at $50 per share, but because the dividend is attractive to you, you are loathe \nto part with the stock. As such, you would prefer to write the covered call at a \n$55 or even a $60 strike price. A quick look at the BSM cone tells us why you \nshould not be expecting a big boost in yield from selling the covered calls:\n80\nSold call\nrange of\nexposure\n70\n60\n50\n40\n30\n20\n5/18/2012 5/20/2013 249 499 749 999\nCash Flows R Us, Inc. (CASH)\nDate/Day Count\nStock Price\nGREEN\nLIGHT GREENGRAY\nLIGHT REDRED\n244  •   The Intelligent Option Investor\nClearly, the range of exposure for the $55-strike call is well above the \nBSM cone. The BSM cone is pointing downward because the dividend rate \nis 5 percent—higher than the risk-free rate. This means that BSM drift will \nbe lower. In addition, because this is an old, mature, steady-eddy kind of \ncompany, the expected forward volatility is low. Basically, this is a perfect \nstorm for a low option price.\nMy suggestion is to either write calls on stocks you don’t mind de-\nlivering to someone else—stocks", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 79}
{"text": "ng downward because the dividend rate \nis 5 percent—higher than the risk-free rate. This means that BSM drift will \nbe lower. In addition, because this is an old, mature, steady-eddy kind of \ncompany, the expected forward volatility is low. Basically, this is a perfect \nstorm for a low option price.\nMy suggestion is to either write calls on stocks you don’t mind de-\nlivering to someone else—stocks for which you are very confident in the \nvaluation range and are now at or above the upper bound—or simply to \nlook for a portfolio of short-put/covered-call investments and treat it like \na high-yield bond portfolio, as I described in Chapter 10 when explaining \nshort puts. It goes without saying that if you think that a stock has a lot of \nunappreciated upside potential, it’s not a good idea to sell that exposure \naway!\nOne other note about execution: as I have said, short puts and cov-\nered calls are the same thing, but a good many investors do not realize this \nfact or their brokerages prevent them from placing any trade other than a \ncovered call. This leads to a situation in which there is a tremendous sup-\nply of calls. Any time there is a lot of supply, the price goes down, and you \nwill indeed find covered calls on some companies paying a lot less than \nthe equivalent short put. Because you will be accepting the same downside \nexposure, it is better to get paid more for it, so my advice is to write the put \nrather than the covered call in such situations.\nTo calculate returns for covered calls, I carry out the following steps:\n1. Assume that you buy the underlying stock at the market price.\n2. Deduct the money you will receive from the call sale as well as \nany projected dividends—these are the two elements of your cash \ninflow—from the market price of the stock. The resulting figure is \nyour effective buy price (EBP).\n3. Divide your total cash inflow by the EBP .\nI always include the projected dividend payment as long as I am writ-\ning a short-tenor covered call and there are no issues with the company \nthat would prevent it from paying the dividend. Owners of record have a \nright to receive dividends, even after they have written a covered call on the \nMixing Exposure  •  245\nstock, so it makes sense to count the dividend inflow as one element that \nreduces your EBP . In formula form, this turns out to be\n−−Coveredc allr eturn= premiumr eceivedf romc all+ projectedd ividends\nstockp rice premiumf romc allp rojected dividends\nFor a short put, you have no right to receive the dividend, so I find the \nreturn using the following formula:\n−Shortp ut return= premiumr eceivedf roms hort put\nstrikepricep remium from shortp ut\nCommon Pitfalls\nTaking Profit\nOne mistake I hear people make all the time is saying that they are going \nto “take profit” using a covered call. Writing a covered call is taking profit \nin the sense that you no longer enjoy capital gains from the stock’s appre-\nciation, but it is certainly not taking profit in the sense of being immune \nto falls in the market price of the stock. The call premium you receive will \ncushion a stock price drop, but it will certainly not shield you from it. If \nyou want to take profits on a successful stock trade, hit the “Sell” button.\nLocking in a Loss\nA person sent me an e-mail telling me that she had bought a stock at $17, \nsold covered calls on it when it got to $20 (in order to “take profits”), and \nnow that the stock was trading for $11, she wanted to know how she could \n“repair” her position using options. Unfortunately, options are not magical \ntools and cannot make up for a prior decision to buy a stock at $17 and ride \nit down to $11.\nIf you are in such a position, don’t panic. It will be tempting to write \na new call at the lower ATM price ($11 in this example) because the cash \ninflow from that covered call will be the most. Don’t do it. By writing a \ncovered call at the lower price, you are—if the shares are called away—\nlocking in a realized loss on the position. Y ou can see this clearly if you list \neach transaction in the example separately.\n246  •   The Intelligent Option Investor\nNo. Buy/Sell Instrument\nPrice of \nInstrument\nEffective \nBuy (Sell) \nPrice of \nStock Note\n1 Buy Stock $17/share $17/share Original purchase\n2 Sell Call option $1/share $16/share Selling a covered call \nto take profits when \nstock reaches $20/\nshare leaves the \ninvestor with down-\nside exposure and $1 \nin premium income.\n3 Sell Call option $0.75 ($11.75/\nshare)\nStock falls to $11, and \ninvestor sells another \ncovered call to \ngenerate income to \nameliorate the loss.\nIn transaction 1, the investor buys the shares for $17. In transaction 2, \nwhen the stock hits $20 per share, the investor sells a covered call and receives \n$1 in premium. This reduces the effective buy price to $16 per share and \nmeans that the investor will have to deliver the shares if the stock is trad-\ning at $20 or above at expiration. When the stock instead falls to $11, the \ninvestor—wanting to cushion the pain of the loss—sells another ATM cov-\nered call for $0.75. This covered call commits the investor to sell the shares \nfor $11.75. No matter how you look at it, buying at $16 per share and sell-\ning at $11.75 per share is not a recipe for investing success.\nThe first step in such a situation as this—when the price of a stock \non which you have accepted downside exposure falls—is to look back \nto your valuation. If the value of the firm has indeed dropped because \nof some material negative news and the position no longer makes sense \nfrom an economic perspective, just sell the shares and take the lumps. \nIf, however, the stock price has dropped but the valuation still makes \nfor a compelling investment, stay in the position; if the investment is \nMixing Exposure  •  247\ncompelling enough, this is the time to figure out a clever way to get more \nexposure to it. \nY ou can write calls as long as they are at least at the same strike \nprice as your previous purchase price or EBP; th", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 80}
{"text": "nd take the lumps. \nIf, however, the stock price has dropped but the valuation still makes \nfor a compelling investment, stay in the position; if the investment is \nMixing Exposure  •  247\ncompelling enough, this is the time to figure out a clever way to get more \nexposure to it. \nY ou can write calls as long as they are at least at the same strike \nprice as your previous purchase price or EBP; this just means that you \nare buying at $16 and agreeing to sell at at least $16, in other words. Also \nkeep in mind that any dividend payment you receive you can also think \nof as a reduction of your EBP—that cash inflow is offsetting the cost of \nthe shares. Factoring in dividends and the (very small) cash inflow as-\nsociated with writing far OTM calls will, as long as you are right about \nthe valuation, eventually reduce your EBP enough so that you can make \na profit on the investment.\nOver-/Underexposure\nOptions are transacted in contract sizes of 100 shares. If you hold a number \nof shares that is not evenly divisible by 100, you must decide whether you \nare going to sell the next number down of contracts or the next number \nup. For example, let’s say that you own 250 shares of ABC. Y ou can either \nchoose to sell two call contracts (in which case you will not be receiving \nyield on 50 of your shares) or sell three call contracts (in which case you \nwill be effectively shorting 50 shares). My preference is to sell fewer con-\ntracts controlling fewer shares than I hold, and in fact, your broker may or \nmay not insist that you do so as well. If not, it is an unpleasant feeling to get \na call from a broker saying that you have a margin call on a position that \nyou didn’t know you had.\nGetting Assigned\nIf you write covered calls, you live with the risk that you will have to deliver \nyour beloved shares to a stranger. Y ou can deliver your shares and use the \nproceeds from that sale (the broker will deposit an amount equal to the \nstrike price times the contract multiplier into your account, and you get \nto keep the premium you originally received) to buy the shares again, but \nthere is no way around delivering the shares if assigned.\n248  •   The Intelligent Option Investor\nNow that you understand covered calls, let’s turn to protective \nputs.\nProtective Puts\nLIGHT GREEN\nRED\nGRAY\nDownside: Irrelevant\nUpside: Undervalued\nExecute: Buy common stock and simultaneously buy a put op-\ntion (the diagram shows the purchase of an OTM put \noption)\nRisk: Purchase price of stock minus strike price of put option \nminus premium paid\nReward: Unlimited, less premium paid for put option, which can-\nnot be recovered\nMargin: None because this is a purchase of an option\nThe Gist\nIf you look just as far as the option tenor lasts in the preceding diagram, \nyou will see that the risk-return profile is identical to that of a short put. As \nevidence, please compare the following two diagrams:\nMixing Exposure  •  249\nGREEN\nRED\nGRAY\nGREEN\nORANGE\nProtective put\nITM call\n250  •   The Intelligent Option Investor\nThe graphic conventions are a little different, but both diagrams show \nthe acceptance of a narrow band of downside exposure offset by a bound-\nless gain of upside exposure. The area below the protective put’s strike price \nshows that economic exposure has been neutralized, and the area below \nthe ITM call shows no economic exposure. The pictures are slightly differ-\nent, but the economic impact is the same.\nThe objective of a protective put is obvious—allow yourself the \neconomic benefits from gaining upside exposure while shielding yourself \nfrom the economic harm of accepting downside exposure. The problem is \nthat this protection comes at a price. I will provide more infromation about \nthis in the next section.\nExecution\nEveryone understands the concept of protective puts—it’s just like the \nhome insurance you buy every year to insure your property against dam-\nage. If you buy an OTM protective put (let’s say one struck at 90 percent of \nthe current market price of the stock), the exposed amount from the stock \nprice down to the put strike can be thought of as your “deductible” on your \nhome insurance policy. The premium you pay for your put option can be \nthought of as the “premium” you pay on your home insurance policy.\nOkay—let’s go shopping for stock insurance. Apple (AAPL) is trad-\ning for $452.53 today, so I’ll price both ATM and OTM put insurance for \nthese shares with an expiration of 261 days in the future. I’ll also annualize \nthat rate.\nStrike ($) “Deductible” ($) “Premium” ($)\nPremium as \nPercent of \nStock Price\nAnnualized \nPremium (%)\n450 2.53 40.95 9.1 12.9\n405 47.53 20.70 4.6 6.5\n360 92.53 8.80 1.9 2.7\nNow, given these rates and assuming that you are insuring a $500,000 \nhouse, the following table shows what equivalent deductibles, annual \npremiums, and total liability to a home owner would be for deductibles \nequivalent to the strike prices I’ve picked for Apple: \nMixing Exposure  •  251\nEquivalent \nAAPL Strike ($) Deductible ($) Annual Premium ($)\nTotal Liability to Home \nOwner ($)\n450 2,795 64,500 67,295\n405 52,516 32,500 85,016\n360 102,236 13,500 115,736\nI know that I would not be insuring my house at these rates and under \nthose conditions! In light of these prices, the first thing you must consider \nis whether protecting a particular asset from unrealized price declines is \nworth the huge realized losses you must take to buy put premium. Buying \nATM put protection on AAPL is setting up a 12.9 percent hurdle rate that \nthe stock must surpass in one year just for you to start making a profit on \nthe position, and 13 percent per year is quite a hurdle rate!\nIf there is some reason why you believe that you need to pay for insurance, \na better option—cheaper from a realized loss perspective—would be to sell \nthe shares and use part of the proceeds to buy call options as an option-based \nreplacement for the stock position. This approach has a few benefits:\n1. The risk-reward profile is exactly the sa", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 81}
{"text": "tion, and 13 percent per year is quite a hurdle rate!\nIf there is some reason why you believe that you need to pay for insurance, \na better option—cheaper from a realized loss perspective—would be to sell \nthe shares and use part of the proceeds to buy call options as an option-based \nreplacement for the stock position. This approach has a few benefits:\n1. The risk-reward profile is exactly the same between the two \nstructures.\n2. Any ATM or ITM call will be more lightly levered than any OTM \nput, meaning a lower realized loss on initiation.\n3. For dividend-paying stocks, call owners do not have the right to \nreceive dividends, but the amount of the projected dividend is de-\nducted from the premium (as part of the drift calculation shown \nin the section on covered calls). As such, although not being paid \ndividends over time, you are getting what amounts to a one-time \nupfront dividend payment.\n4. If you do not like the thought of leverage in your portfolio, you can \nself-margin the position (i.e., keep enough cash in reserve such that \nyou are not “borrowing” any money through the call purchase).\nI do not hedge individual positions, but I do like the ITM call op-\ntion as an alternative for people who feel the need to do so. For hedg-\ning of a general portfolio, rather than hedging of a particular holding in \na portfolio, options on sector or index exchange-traded funds (ETFs) are \nmore reasonably priced. Here are the ask prices for put options on the SPX \n252  •   The Intelligent Option Investor\nETF [tracking the Standard and Poor’s 500 Index (S&P 500), which closed \nat 1,685.73 when these data were retrieved] expiring in about 10 months:\nStrike/Stock ($) Ask Price ($) Premium as Percent of Stock Price\n0.99 106.60 6.3\n0.89 50.90 3.0\n0.80 25.80 1.5\nThis is still a hefty chunk of change to pay for protection on an index but \nmuch less than the price of protection on individual stocks.\n1\nCommon Pitfalls\nHedge Timing\nAssume that you had talked to me a year ago and decided to take my ad-\nvice and avoid buying protective puts on single-name options. Instead, you \ntook a protective put position on the S&P 500. Good for you. \nSetting aside for a moment how much of your portfolio to hedge, let’s \ntake a look at what happened since you bought the downside protection:\nS&P 500\n1,800\n1,700\n1,600\n1,500\n1,400\n1,300\n1,200\n1,100\n1,000\n8/1/20129/1/201210/1/201211/1/201212/1/20121/1/20132/1/20133/1/20134/1/20135/1/20136/1/20137/1/2013\nGREEN\nMixing Exposure  •  253\nWhen you bought the protection, the index was trading at 1,375, so \nyou bought one-year puts about 5 percent OTM at $1,300. If the market \nhad fallen heavily or even moderately during the first five months of the \ncontract, your puts would have served you very well. However, now the \nputs are not 5 percent OTM anymore but 23 percent OTM, and it would \ntake another Lehman shock for the market to make it down to your put \nstrike.\nKeeping in mind that buying longer-tenor options gives you a better \nannualized cost than shorter-tenor options, you should be leery of entering \ninto a hedging strategy such as the one pictured here:\nS&P 500\n1,800\n1,700\n1,600\n1,500\n1,400\n1,300\n1,200\n1,100\n1,000\n8/1/20129/1/201210/1/201211/1/201212/1/20121/1/20132/1/20133/1/20134/1/20135/1/20136/1/20137/1/2013\nGREEN\nBuying short-tenor puts helps in terms of providing nearer to \nATM protection, but the cost is higher, and it gets irritating to keep \nbuying expensive options and never benefiting from them (funny—\nno one ever says this about home insurance). Although there are no \nperfect solutions to this quandary, I believe the following approach \nhas merit:\n254  •   The Intelligent Option Investor\nS&P 500\n1,800\n1,700\n1,600\n1,500\n1,400\n1,300\n1,200\n1,100\n1,000\n8/1/20129/1/201210/1/201211/1/201212/1/20121/1/20132/1/20133/1/20134/1/20135/1/20136/1/20137/1/2013\nGREEN GREENLIGHT GREEN\nLIGHT GREEN\nLIGHT GREEN\nHere I bought fewer long-term put contracts at the outset and then add-\ned put contracts at higher strikes opportunistically as time passed. I have left \nmyself somewhat more exposed at certain times, and my protection doesn’t all \npick up at a single strike price, so the insurance coverage is spotty, but I have \nlikely reduced my hedging cost a great deal while still having a potential source \nof investible cash on hand in the form of options with time value on them.\nThe Unhappy Case of a Successful Hedge\nMarkets are down across the board. Y our brokerage screen is awash in red. \nThe only bright spot is the two or three lines of your screen showing your \nS&P 500 puts, which are strongly positive. Y ou bought your protection \nwhen the market was going up, so it was very cheap to purchase. Now, with \nthe market in a terror, the implied volatilities have shot up, and you are sit-\nting on a huge positive unrealized value.\nNow what?\nThe psychological urge to keep that hedge on will be strong. Such a po-\nsition is safe after all, and with the rest of the world falling apart, it feels nice to \nhave somewhere safe to go. What should you do with this unrealized profit?\nMixing Exposure  •  255\nStep one is always assessing the value of securities in your portfolio \nand securities that might be on your watch list. Does the news driving the \nmarkets down have a material effect on the value of any of your holdings? \nCertainly, if the market believes that the economy is going into a recession, \nthe next few years’ worth of revenue growth and profits may be those that \nyou projected for your explicit-period worst-case scenarios, but that will \nlikely be offset by faster medium-term growth as the economy bounces \nback. Think about the valuations you have for your holdings objectively and \nwith as little passion as possible. It’s better not to have your brokerage screen \nor a price chart of the financial markets or whatever up while you do this.\nAre there securities whose present prices are significantly different from \nyour worst-case valuation range? Do the prices imply an unlevered retur", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 82}
{"text": "economy bounces \nback. Think about the valuations you have for your holdings objectively and \nwith as little passion as possible. It’s better not to have your brokerage screen \nor a price chart of the financial markets or whatever up while you do this.\nAre there securities whose present prices are significantly different from \nyour worst-case valuation range? Do the prices imply an unlevered return of 30, \n40, or 50 percent or more? Is there a stock that has been on your watch list for a \nlong time but until now has never been at a price at which you wanted to buy it?\nThis is where you must resist the urge to take the safe path and close the \nhedge and then turn around the cash and increase your position size on your \nbest investments or on investments that you have always wanted to make but \nhaven’t had the chance. This will be a hard thing to do psychologically. The \nworld is telling you to run and hide. This is the time to remember the maxim, \n“Be bold when others are scared and scared when others are bold. ” Times of \nstress are those that set great investors apart from the rest of the crowd.\nNot Having a Plan\nFinally, we get to the question of how to size our hedge. If we look at the in-\ndicative prices for S&P 500 puts shown earlier, we can see that if we choose \nto hedge the entire amount of our portfolio, we set up at least a 6 percent-\nage point drag on our portfolio every 10 months or so, and that is a lot of \npotentially dead weight to be carrying around.\nIn daily life, I believe that people are prone to overinsure (e.g., \nextended warrantees for consumer electronic items and so on), and this \nis a good habit to keep away from in investing. Risk is not a temporary \nunrealized loss caused by market panic. Usually risk is not the inability to \ninvest more capital when you want to invest more capital (unless by not \ninvesting it you will have a shortfall in capital in the future). Risk is usually \nnot any of the things TV pundits talk about as being risk.\n256  •   The Intelligent Option Investor\nI will discuss risk in greater detail in Chapter 12, but a sensible defini-\ntion of risk is not having the capital resources to pay for something when \nyou need to pay for it. In this sense, risk can be talked about in terms of \nliquidity—a short-term lack of spending power—and solvency—a funda-\nmental lack of capital assets. For example, let’s say that you have commit-\nted to pay a restaurant and entertainers the remainder of their $50,000 fee \nfor your son’s bar mitzvah or your daughter’s wedding, and you only have \n$20,000 in net worth. Y ou are in a position of risk because of problems of \nsolvency but not necessarily liquidity (i.e., you could borrow the money to \npay for these things). However, if you have a net worth of $3 million—all of \nit unrealized gains on real estate holdings—and you have the same $50,000 \nbill to pay, you may be in a position of risk because of problems in liquidity \nbut not solvency.\nRisk that stems from issues of liquidity usually can be controlled \nthrough intelligent asset allocation. For example, the millionaire father in \nthe preceding bar mitzvah/wedding example can realize $50,000 worth \nof his unrealized investment gains to meet his immediate cash need. A \n79-year-old with 85 percent of her net worth of $2.5 million invested in \ntech sector initial public offerings (IPOs) or companies in the Chinese in-\nfrastructure supply chain can ameliorate her risk of not being able to pay \nfor necessary healthcare and living expenses by shifting more of her assets \ninto bonds and CDs. Usually, in cases such as this—which, I believe, make \nup the majority of cases people are trying to “hedge”—there are much \nbetter ways of controlling risk than buying puts on the S&P 500 or the \nRussell 2000! \nHowever, there is a more subtle instance of risk—not maximizing re-\nturns on one’s invested capital and, because of this, not having the capital \nadequacy to meet unforeseen cash-flow needs in the future. This instance \nof risk deals with solvency, rather than liquidity.\nThis type of risk cannot be ameliorated through a defensive strategy \nbut must be controlled through an offensive one. Setting aside savings, in-\nvesting those savings wisely and consistently in good times, and having the \ncourage to invest when it is hardest to do so (i.e., when the market is crash-\ning) are all elements of this risk-control strategy. Put options can only help \nwith the third case here—investing when it is hardest to do so—but they \ncannot help without the put owner’s input of personal courage.\nMixing Exposure  •  257\nThis topic brings us back to the last section—investing the proceeds \nin a successful hedge in undervalued assets. I believe that portfolio hedges \nshould be set up with a particular cost and investing goal in mind. For \nexample, “I am willing to allocate as much as 1 percentage point of my \ninvestment performance this year to have an extra 5 percent of cash on \nhand to invest in case the market drops by 10 to 20 percent. ” This is the \nrough outline of a hedging plan. It specifies the maximum you are will-\ning to spend and a target for how much cash you want in case of a certain \nmarket downdraft.\nThis plan does not mean that you always have to spend 1 percent \nof your net worth on hedges. There are times when it is more sensible to \nspend more on hedges—because of building macroeconomic uncertainty \nor whatever—and other times when it is more sensible to spend less—when \nthe economy is just coming out of a recession for instance.\nAlso note that the plan specifies a cash level. If you are not fully in-\nvested in your securities portfolio, you are already hedged to the degree \nthat your cash assets are not subject to direct security price risk (cash is \nsubject to inflation risk, but this is another topic). The cash you have on \nreserve will allow you to purchase if and when the market falls. As such, \nI don’t believe that people holding a significant allocation of cash shou", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 83}
{"text": "you are not fully in-\nvested in your securities portfolio, you are already hedged to the degree \nthat your cash assets are not subject to direct security price risk (cash is \nsubject to inflation risk, but this is another topic). The cash you have on \nreserve will allow you to purchase if and when the market falls. As such, \nI don’t believe that people holding a significant allocation of cash should \nthink about hedging per se. Y ou may believe that the market is ready to fall, \nin which case, you can make a bearish bet on the level of the index using a \nlong put, a short-call spread, or a short diagonal, but this is a proactive in-\nvestment that expresses your opinion about the level of the market vis-à-vis \nthe state of the economy.\nWhat it does not specify is what you will spend the cash on. This is \nwhere an understanding of the value of the companies in your portfolio \nor on your watch list comes into play. If you had an extra 5 percent (or \n$50,000 or however you want to think about it) in cash, in what securities \nwould you invest? Of course, the answer will change depending on the \nprice of the securities vis-à-vis what you know to be a sensible valuation \nrange because the expected returns on the investments will change with \nthe market price. \nSo this is the last step in a sensible hedging plan—having an idea of \nwhat companies you would want to invest in were you to have the extra \ncapital and if you could be reasonably assured of a good return. Having a \n258  •   The Intelligent Option Investor\nplan like this in place will allow you to size and time your hedges appropri-\nately and will help you to make the most out of whatever temporary crisis \nmight come your way.\n2\nNow that you have a good understanding of protective puts and \nhedging, let’s turn to the last overlay strategy—the collar.\nCollar\nContingent Exposure\nContingent Exposure\nContingent Exposure\nGREEN\nLIGHT GREEN\nLIGHT ORANGE\nLIGHT RED\nORANGE\nRED\nDownside: Irrelevant\nUpside: Undervalued\nExecute: Sell a call option on a stock or index that you own and on \nwhich you have a gain, and use the proceeds from the call \nsale to buy an OTM put \nRisk: Flexible, depending on selection of strikes\nReward: Limited to level of sold call strike\nMargin: None because the long position in the hedged security \nserves as collateral for the sold call option, and the OTM \nput option is purchased, so it does not require margining\nMixing Exposure  •  259\nThe Gist\nThis structure is really much simpler and has a much more straightfor -\nward investment purpose than it may seem when you look at the preceding \ndiagram. When people talk about “taking profits” using a covered call, the \ncollar is actually the strategy they should be using.\nImagine that you bought a stock some time ago and have a nice \nunrealized gain on it. The stock is about where you think its likely fair \nvalue is, but you do not want to sell it for whatever reason (e.g., it is \npaying a nice dividend or you bought it less than a year ago and do not \nwant to be taxed on short-term capital gains or whatever). Although you \ndo not want to sell it, you would like to protect yourself from downside \nexposure.\nY ou can do this cheaply using a collar. The collar is a covered call, \nwhich we have already discussed, whose income subsidizes the purchase of \na protective put at some level that will allow you to keep some of the unre-\nalized gains on your securities position. The band labeled “Orange” on the \ndiagram shows an unrealized gain (or, conversely, a potential unrealized \nloss). If you buy a put that is within this orange band or above, you will be \nguaranteed of making at least some realized profit on your original stock \nor index investment. Depending on how much you receive for the covered \ncall and what strike you select for the protective put, this collar may rep-\nresent completely “free” downside protection or you might even be able to \nrealize a net credit.\nExecution\nThe execution of this strategy depends a great deal on personal prefer -\nence and on the individual investor’s situation. For example, an investor \ncan sell a short-tenor covered call and use those proceeds to buy a longer-\ntenor protective put. He or she can sell the covered call ATM and buy a \nprotective put that is close to ATM; this means the maximum and mini-\nmum potential return on the previous security purchase is in a fairly tight \nband. Conversely, the investor might sell an OTM covered call and buy \na protective put that is also OTM. This would lock in a wider range of \nguaranteed profits over the life of the option.\n260  •   The Intelligent Option Investor\nI show a couple of examples below that give you the flavor of the \npossibilities of the collar strategy. With these examples, you can experi-\nment yourself with a structure that fits your particular needs. Look on \nmy website for a collar scenario calculator that will allow you to visualize \nthe collar and understand the payoff structure given different conditions. \nFor these examples, I am assuming that I bought Qualcomm stock at \n$55 per share. Qualcomm is now trading for $64.71—an unrealized gain \nof 17.7 percent.\nCollar 1: 169 Days to Expiration\nStrike Price ($) Bid (Ask) Price ($)\nSold call 65.00 3.40\nPurchased put 60.00 (2.14)\nNet credit $1.26\nThis collar yields the following best- and worst-case effective sell prices \n(ESPs) and corresponding returns (assuming a $55 buy price):\nESP ($) Return (%)\nBest case 66.26 20.5\nWorst case 61.26 11.4\nHere we sold the $65-strike calls for $3.40 and used those proceeds to \nbuy the $60-strike put options at $2.14. This gave us a net credit of $1.26, \nwhich we simply add to both strike prices to calculate our ESP . We add the \nnet credit to the call strike because if the stock moves above the call strike, \nwe will end up delivering the stock at the strike price while still keeping the \nnet credit. We add the net credit to the put strike because if the stock closes \nbelow the put strike, we have the right to", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 84}
{"text": "This gave us a net credit of $1.26, \nwhich we simply add to both strike prices to calculate our ESP . We add the \nnet credit to the call strike because if the stock moves above the call strike, \nwe will end up delivering the stock at the strike price while still keeping the \nnet credit. We add the net credit to the put strike because if the stock closes \nbelow the put strike, we have the right to sell the shares at the strike price \nand still keep the net credit. The return numbers are calculated on the basis \nof a $55 purchase price and the ESPs listed. Thus, by setting up this collar in \nMixing Exposure  •  261\nthis way, we have locked in a worst possible gain of 11.4 percent and a best \npossible gain of 20.5 percent for the next five and a half months.\nLet’s look at another collar with a different profit and loss profile:\nCollar 2: 78 Days to Expiration\nStrike Price ($) Bid (Ask) Price ($)\nSold call 70 0.52\nPurchased put 62.50 (1.55)\nNet debit (1.03)\nThis collar yields the following best- and worst-case ESPs and corresponding \nreturns (assuming a $55 buy price):\nESP ($) Return (%)\nBest case 68.97 25.4\nWorst case 61.47 11.8\nThis shows a shorter-tenor collar—about two and a half months be-\nfore expiration—that allows for more room for capital gains. This might be \nthe strategy of a hedge fund manager who is long the stock and uncertain \nabout the next quarterly earnings report. For his or her own business rea-\nsons, the manager does not want to show an unrealized loss in case Qual-\ncomm’s report is not good, but he or she also doesn’t want to restrict the \npotential capital gains much either.\nCalculating the ESPs and the returns in the same way as described \nhere, we get a guaranteed profit range from around 12 to over 25 percent. \nOne thing to note as well is that the protection is provided by a put, and \na put option can be sold any time before expiry to generate a cash inflow \nfrom time value. Let’s say then that when Qualcomm reports its quarterly \nearnings, the stock price drops to $61—a mild drop that the hedge fund \nmanager considers a positive sign. Now that the manager is less worried \nabout the downside exposure, he or she can sell the put for a profit. \n262  •   The Intelligent Option Investor\nThe cash inflow from selling the put for a profit may even change the net \ndebit on the collar to a net credit, or the manager can use some of the cash \nflow to buy back the sold call option if he or she is worried about the upside \nbeing limited. \nThese are just two examples, but they show the kind of flexibility that \nmakes collars very useful investing instruments. With this chapter com-\nplete, you have all the tools required to be an intelligent option investor. \nLet’s finish with an important discussion—an investigation of risk and in-\ntelligent option investing. This is the topic of Chapter 12.\n263\nChapter 12\nRisk and the intelligent \nOptiOn investOR\nThe preceding 11 chapters have given you a great deal of information about \nthe mechanics of option investing and stock valuation. In this last chapter, \nlet’s look at a subject that I have mentioned throughout this book—risk—\nand see how an intelligent option investor conceives of it. \nThere are many forms of risk—some of which we discussed earlier \n(e.g., the career risk of an investment business agent, solvency risk of a \nretiree looking to maintain a good quality of life, and liquidity risk of a \nparent needing to make a big payment for a child’s wedding). The two risks \nI discuss here are those that are most applicable to an owner of capital \nmaking potentially levered investments in complex, uncertain assets such \nas stocks. These two risks are market risk and valuation risk.\nMarket Risk\nMarket risk is unavoidable for anyone investing capital. Markets fluctuate, and \nin the short term, these fluctuations often have little to do with the long-term \nvalue of a given stock. Short term, it must be noted, is also relative. In words \nattributed to John Maynard Keynes, but which is more likely an anonymous \naphorism, “The market can remain irrational longer than you can remain sol-\nvent. ” Indeed, it is this observation and my own painful experience of the truth \nof it that has brought me to my appreciation for in-the-money (ITM) options \nas a way to preserve my capital and cushion the blow of timing uncertainty.\n\n264  •   The Intelligent Option Investor\nMarket risk is a factor that investors in levered instruments must \nalways keep in mind. Even an ITM call long-term equity anticipated \nsecurity (LEAPS) in the summer of 2007 might have become a short-tenor \nout-of-the-money (OTM) call by the fall of 2008 after the Lehman shock \nbecause of the sharp decline in stock prices in the interim. Unexpected \nthings can and do happen. A portfolio constructed oblivious to this fact is \na dangerous thing.\nAs long as market fluctuations only cause unrealized losses, market \nrisk is manageable. But if a levered loss must be realized, either because of \nan option expiration or in order to fund another position, it has the poten-\ntial to materially reduce your available investment capital. Y ou cannot ma-\nterially reduce your investment capital too many times before running out.\nA Lehman shock is a worst-case scenario, and some investors live \ntheir entire lives without experiencing such severe and material market \nrisk. In most cases, rather than representing a material threat, market risk \nrepresents a wonderful opportunity to an intelligent investor.\nMost human decision makers in the market are looking at either \ntechnical indicators—which are short term by nature—or some sort of \nmultiple value (e.g., price-to-something ratio). These kinds of measures are \nwonderful for brokers because they encourage brokerage clients to make \nfrequent trades and thus pay the brokerages frequent fees. \nThe reaction of short-term traders is also wonderful for intelligent \ninvestors. This is so because a market reaction that might look sensible or \nrational to som", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 85}
{"text": "by nature—or some sort of \nmultiple value (e.g., price-to-something ratio). These kinds of measures are \nwonderful for brokers because they encourage brokerage clients to make \nfrequent trades and thus pay the brokerages frequent fees. \nThe reaction of short-term traders is also wonderful for intelligent \ninvestors. This is so because a market reaction that might look sensible or \nrational to someone with an investment time horizon measured in days or \nmonths will often look completely ridiculous to an investor with a longer-\nterm perspective. For example, let’s say that a company announces that its \nearnings will be lower next quarter because of a delay in the release of a \nnew product. Investors who are estimating a short-term value for the stock \nbased on an earnings multiple will sell the stock when they see that earn-\nings will likely fall. Technical traders see that the stock has broken through \nsome line of “resistance” or that one moving average has crossed another \nmoving average, so they sell it as well. Perhaps an algorithmic trading \nengine recognizes the sharp drop and places a series of sell orders that are \ncovered almost as soon as they are filled. In the meantime, someone who \nhas held the stock for a while and has a gain on it gets protective of this gain \nand decides to buy a put option to protect his or her gains.\n\nRisk and the Intelligent Option Investor   • 265\nFor an intelligent option investor who has a long-term worst-case \nvaluation that is now 20 percent higher than the market price, there is a \nwonderful opportunity to sell a put and receive a fat premium (with the \npossibility of owning the stock at an attractive discount to the likely fair \nvalue), sell a put and use the proceeds to buy an OTM call LEAPS, or sim-\nply buy the stock to open a position.\nIndeed, this strategy is perfectly in keeping with the dictum, “Be fear-\nful when others are greedy and greedy when others are fearful. ” This strat-\negy is also perfectly reasonable but obviously rests on the ability of the \ninvestor to accurately estimate the actual intrinsic value of a stock. This \nbrings us to the next form of risk—valuation risk.\nValuation Risk\nAlthough valuation is not a difficult process, it is one that necessarily in-\ncludes unknowable elements. In our own best- and worst-case valuation \nmethodology, we have allowed for these unknowns by focusing on plausi-\nble ranges rather than precise point estimates. Of course, our best- or worst-\ncase estimates might be wrong. This could be due to our misunderstanding \nof the economic dynamics of the business in which we have invested or \nmay even come about because of the way we originally framed the problem. \nThinking back to how we defined our ranges, recall that we were focusing \non one-standard-deviation probabilities—in other words, scenarios that \nmight plausibly be expected to materialize two times out of three. Obvi-\nously, even if we understand the dynamics of the business very well, one \ntime out of three, our valuation process will generate a fair value range that \nis, in fact, materially different from the actual intrinsic value of the stock.\nIn contrast to market risk, which most often is a nonmaterial and tem-\nporary issue, misestimating the fair value of a stock represents a material \nrisk to capital, whether our valuation range is too low or too high. If we esti-\nmate a valuation range that is too low, we are likely to end up not allocating \nenough capital to the investment or using inappropriately light leverage. \nThis means that we will have missed the opportunity to generate as much \nreturn on this investment as we may have. If we estimate a valuation range \nthat is too high, we are likely to end up allocating too much capital to the \n\n266  •   The Intelligent Option Investor\ninvestment or using inappropriately high leverage. In the best case, we allo-\ncate too much capital to an idea that generates low returns when we might \nhave allocated it to a higher-return investment. In the worst case, we suffer \na loss of capital when the market price falls and we realize that our original \nestimates were overly optimistic.\nOne of the best ways to protect against valuation risk is to invest in \nonly the most compelling, most clearly mispriced securities. A friend who \nworked for years advising companies on mergers and acquisitions has a \nwonderful way of visualizing valuation risk that I have found particularly \nhelpful.\n1 In his conception, a company’s stock price can be represented \nby layers. At the bottom layer is the value of the company’s net assets if they \nwere all sold today. The next layer assumes that, for instance, the company \nwill cease to exist as a going concern after 10 years and will sell its net \nassets then. The next layer assumes that, for instance, the company exists \nperpetually as a going concern, but its free cash flow to owner(s) (FCFO) \ndoesn’t grow again. On and on, each layer represents a more aggressive \nassumption about the growth of its cash flows until we are assuming, for \ninstance, that the company’s FCFO will grow at an average of 50 percent \nper year for the next 15 years and then 6 percent for every year after that in \nperpetuity. We can visualize this in the following graphic:\nValue of cash flows growing at 50 percent per year for 15 years and \nthen at 6 percent per year after that—$52 per share.\nValue of cash flows growing at 20 percent per year for 15 years and \nthen at 6 percent per year after that—$27/share.\nValue of cash flows not growing but continuing on into \nperpetuity—$9 per share.\nValue of cash flows not growing and lasting 20 years—$7 per \nshare.\nMarket value of hard assets—$2 to $4 per share.\n\nRisk and the Intelligent Option Investor   • 267\nLet’s assume that the present market value of the shares is $16 per \nshare. This share price assumes a growth in FCFO of 8 percent per year for \nthe next 5 years and 5 percent per year in perpetuity after that—roughly \nequal to what we consider our", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 86}
{"text": "lows not growing and lasting 20 years—$7 per \nshare.\nMarket value of hard assets—$2 to $4 per share.\n\nRisk and the Intelligent Option Investor   • 267\nLet’s assume that the present market value of the shares is $16 per \nshare. This share price assumes a growth in FCFO of 8 percent per year for \nthe next 5 years and 5 percent per year in perpetuity after that—roughly \nequal to what we consider our most likely operational performance \nscenario. We see the possibility of faster growth but realize that this faster \ngrowth is unlikely—the valuation layer associated with this faster growth \nis the $18 to $20 level. We also see the possibility of a slowdown, and the \nvaluation layer associated with this worst-case growth rate is the $11 to \n$13 level.\nNow let’s assume that because of some market shock, the price of the \nshares falls to the $10 range. At the same time, let’s assume that the likely \neconomic scenario, even after the stock price fall, is still the same as before—\nmost likely around $16 per share; the best case is $20 per share, and the worst \ncase is $11 per share. Let’s also say that you can sell a put option, struck at \n$10, for $1 per share—giving you an effective buy price of $9 per share.\nIn this instance, the valuation risk is indeed small as long as we are \ncorrect about the relative levels of our valuation layers. Certainly, in this \ntype of scenario, it is easier to commit capital to your investment idea than \nit would be, say, to sell puts struck at $16 for $0.75 per share!\nThinking of stock prices in this way, it is clear that when the market \nprice of a stock is within a valuation layer that implies unrealistic economic \nassumptions, you will more than likely be able to use a combination of \nstocks and options to tilt the balance of risk and reward in your own \nfavor—the very definition of intelligent option investing.\nIntelligent Option Investing\nIn my experience, most stocks are mostly fairly priced most of the time. \nThere may be scenarios at one tail or the other that might be inappropriately \npriced by the option market (and, by extension, by the stock market), but \nby and large, it is difficult to find profoundly mispriced assets—an asset \nwhose market price is significantly different from its most likely valuation \nlayer.\nOpportunities tend to be most compelling when the short-term pic-\nture is the most uncertain. Short-term uncertainties make investing boldly \n\n268  •   The Intelligent Option Investor\na psychologically difficult process, but indeed, it is those times that make \nthe difference between a successful investor and an investor who nurtures \nmany regrets.\nIn the end, an intelligent option investor is not one who has a much \nbetter knowledge of some sector, industry, or even company. It is not the \ninvestor who takes the biggest risks in the hope of realizing the biggest \nreturn. It is not the investor who attempts always to be the investing \n“hero” and make the most complex, theoretically beautiful, laboriously \nresearched argument to justify an investment. Rather, the intelligent op-\ntion investor is the one who has a sound, repeatable process for estimat-\ning the value of stocks, an understanding of the pitfalls that can limit an \ninvestor’s potential, and a firm understanding of the tools that can be \nused to invest. It is the investor who understands the limits to his or her \nown expertise but who also understands that market risk does not equal \nvaluation risk and has the courage to act boldly when the two deviate \nthe most.\nIn short, the intelligent option investor is you.\n\n269\nAppendix A\nChoose Your Battles \nWiselY\nI discuss specific option investment strategies in great detail in Part III \nof this book. However, after reading Chapters 2 and 3, you should have a \ngood understanding of how options are priced, so it is a good time to see \nin what circumstances the Black-Scholes-Merton model (BSM) works best \nand where it works worst. An intelligent investor looks to avoid the condi-\ntions where the BSM works best like the plague and seek out the conditions \nwhere it works worst because those cases offer the best opportunities to tilt \nthe risk-reward balance in the investor’s favor.\nJargon introduced in this appendix includes\nFront month\nFungible\nIdiosyncratic assets\nWhere the BSM Works Best\nThe following are the situations in which the BSM works best and are the \nconditions you should most avoid:\n1. Short investment time horizons\n2. Fungible investment assets\n270  •   The Intelligent Option Investor\nShort Investment Time Horizons\nWhen the scholars developing the BSM were researching financial \nmarkets for the purpose of developing their model, the longest-tenor \noptions had expirations only a few months distant. Most market partic-\nipants tended to trade in the front-month contracts (i.e., the contracts \nthat will expire first), as is still mainly the case. Indeed, thinking back \nto our preceding discussion about price randomness, over short time \nhorizons, it is very difficult to prove that asset price movements are not \nrandom.\nAs such, the BSM is almost custom designed to handle short time \nhorizons well.\nPerhaps not unsurprisingly, agents\n1 are happy to encourage clients to \ntrade options with short tenors because\n1. It gives them more opportunities per year to receive fees and com-\nmissions from their clients. \n2. They are mainly interested in reliably generating income on the \nbasis of the bid-ask spread, and bid-ask spreads differ on the basis \nof liquidity, not time to expiration. \n3. Shorter time frames offer fewer chances for unexpected price \nmovements in the underlying that the market makers have a hard \ntime hedging.\nIn essence, a good option market maker is akin to a used car sales-\nman. He knows that he can buy at a low price and sell at a high one, so his \nmain interest is in getting as many customers to transact as possible. With \nthis perspective, the market maker is happy to use the BSM, which seems \nto give reasonable enough", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 87}
{"text": "movements in the underlying that the market makers have a hard \ntime hedging.\nIn essence, a good option market maker is akin to a used car sales-\nman. He knows that he can buy at a low price and sell at a high one, so his \nmain interest is in getting as many customers to transact as possible. With \nthis perspective, the market maker is happy to use the BSM, which seems \nto give reasonable enough option valuations over the time period about \nwhich he most cares.\nIn the case of short-term option valuations, the theory describes \nreality accurately enough, and structural forces (such as wide bid-ask \nspreads) make it hard to exploit mispricings if and when they occur. \nTo see an example of this, let’s take a look at what the BSM assumes is \na reasonable range of prices for a company with assumed 20 percent \nvolatility over a period of 30 days.\nAppendix A: Choose Your Battles Wisely   • 271\n10\n-\n20\n30\n40\n50\n60\n70\nThe range of prices implied over the next 30 days goes from around \n$47 per share to around $53 per share. If we translate what the BSM con-\nsiders the reasonable range into percentage terms, it works out to a loss \nor gain of around 6 percent. Just thinking about this in terms of one’s \npersonal experience for a moment, this is actually not a bad guess for a \nrange for a large-capitalization firm (the forward volatility assumption of \n20 percent is consistent with a large-cap firm’s “typical” implied volatility). \nI certainly would have no confidence in trying to guess the upper and \nlower stock price boundaries any better than the BSM on such a short \ntime frame. \nIt is funny, then, that most investors insist on speculating in options \non a short-term basis—usually at tenors of a month or shorter. Again, these \nseem like the kinds of bets you might get betting on red at a roulette wheel \nin Vegas. Sure, it makes one feel like James Bond the 50 percent of the time \nthat the marble falls on red, but anyone who is the least bit thoughtful \nwould, after a time, step back and wonder how far ahead he or she is getting \nby playing such a game.\n2\n272  •   The Intelligent Option Investor\nIt is important to realize that the fact that options are usually \nefficiently priced in the short term does not prevent us from transacting \nin short-tenor options. In fact, some strategies discussed in Part III are \nactually more attractive when an investor uses shorter-tenor options or \ncombines short- and long-tenor options into a single strategy.\nHopefully, the distinction between avoiding short-tenor option \nstrategies and making long-term investments in short-tenor options is \nclear after reading through Part III.\nFungible Underlying Assets\nAgain, returning for a moment to the foundation of the BSM, the scholars built \ntheir mathematical models by studying short-term agricultural commodity \nmarkets. A commodity is, by definition, a fungible or interchangeable asset; \none bushel of corn of a certain quality rating is completely indistinguishable \nfrom any other bushel of corn of the same quality rating.\nStocks, on the other hand, are idiosyncratic assets. They are intangible \nmarkers of value for incredibly complex systems called companies, no two \nof which is exactly alike (e.g., GM and Ford—the pair that illustrates the \nidea of “paired” investments in many people’s minds—are both American \ncar companies, but as operating entities, they have some significant differ-\nences. For example, GM has a much larger presence in China and has a \ndifferent capital and governance structure since going bankrupt than Ford, \nwhich avoided bankruptcy during the mortgage crisis).\nThe academics who built the BSM were not hesitant to apply a model \nthat would value idiosyncratic assets such as stocks because they had as-\nsumed from the start that financial markets are efficient—meaning that \nevery idiosyncratic feature for a given stock was already fully “priced in” \nby the market. This allowed them to overlook the complexity of individual \ncompanies and treat them as interchangeable, homogeneous entities.\nThe BSM, then, did not value idiosyncratic, multidimensional \ncompanies; rather, it valued single-dimensional entities that the scholars \nassumed had already been “standardized” or commoditized in some sense \nby the communal wisdom of the markets. Y ou will see in the next sec-\ntion that the broad, implicit assumption by option market participants \nthat markets are efficient actually brings about the greatest opportunity \nAppendix A: Choose Your Battles Wisely   • 273\nto derive low-risk profits for intelligent investors. The point I make here \nis simply how difficult it is to invest in options on commodities or in fact \nany asset that you cannot analyze using fundamental valuation techniques.\nFor investors who simply cannot resist making commodity investments, \nI offer the following case study: I personally believe that climate change will \nmake it harder for the world to feed its burgeoning population. Among \nexchange-traded funds (ETFs), futures, and options, it is very easy these days \nto express an investment opinion on such a belief, and I have done just that—\nput my money where my mouth is. While I have made such investments, \nI must admit that I have absolutely no basis for my valuation of the agricul-\ntural commodities in question and have no way to know if I have received my \nbullish exposure to these commodities at a reasonable or unreasonable price.\nSuch speculative investments satisfy some psychological need, but they are \nnot investments in the strict “intelligent investor” sense because it is very hard to \nrationally calculate a fair value for the asset. Should these types of investments \nnot be made, then? A strict adherent to rational investment principles might \nsay, “No, they should not be. ” However, considering the irrational ways people \nfind to spend money, it would seem that we have been somehow hardwired to \ndo things in a way that an economist would not consider totally rational. Rather \nth", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 88}
{"text": "tionally calculate a fair value for the asset. Should these types of investments \nnot be made, then? A strict adherent to rational investment principles might \nsay, “No, they should not be. ” However, considering the irrational ways people \nfind to spend money, it would seem that we have been somehow hardwired to \ndo things in a way that an economist would not consider totally rational. Rather \nthan fight that primitive urge, I prefer to give into it—but only with very small \nparts of my portfolio. This strategy is akin to taking only $50 to the casino floor \nand promising that once that money is gone, you won’t spend any more. \nY ou may have a gut feeling about the price of oil, the level of interest \nrates, the price of cotton, or whatever. Do yourself a favor, and if you chose \nto make a financial bet on the basis of your hunch, do as I do and make \nit a small one. While a small investment means different things to differ -\nent people, a good way to judge is to imagine the capital being completely \ngone. If you have heart palpitations at that thought, keep cutting the pro-\nspective investment in half until you feel better.\nWhere the BSM Works Worst\nNow that we know where not to look for intelligent option investments, \nlet’s look at conditions in which the BSM works worst—these are the best \nplaces for us to tilt the balance of risk and return in our favor.\n274  •   The Intelligent Option Investor\n1. Grossly mispriced assets\n2. Bimodal outcomes\n3. Long investment time horizons\nGrossly Mispriced Assets\nThe main assumption of the BSM is that there are no grossly mispriced as-\nsets. I believe that this contention is wrong on the basis of behavioral and \nstructural factors that are covered briefly in Part II of this book but would \nrequire another book to fully cover. \nJust imagine, though, that, for some reason, a stock is dramatically \nundervalued. For right now, I will not discuss why this situation could \ncome about, but let’s say that rather than being worth $50 per share, \na company is worth, best case, closer to $110 per share and, worst case, \n$70 per share. Let’s further say that we had some sort of a hazy crystal \nball that would give us a very high degree of certainty that these best- and \nworst-case values represent the real future range of values.\nHere is what a diagram of that situation would look like:\n5/18/2012\n10\n20\n30\n40\n50\n60\n70\n80\n90\n100\n110\n120\n5/20/2013 249 499 749 999\nDate/Day Count\nAdvanced Building Corp. (ABC)\nStock Price\nBest Case, 110\nWorst Case, 70\n-\nNow look at the following diagrams of a put and a call option and, \nbased on what you know about the way the BSM prices options, think \nabout the answers to the following questions.\nAppendix A: Choose Your Battles Wisely   • 275\n5/18/2012\n10\n20\n30\n40\n50\n60\n70\n80\n90\n100\n110\n120\n5/20/2013 249 499 749 999\nDate/Day Count\nAdvanced Building Corp. (ABC)\nStock Price\n-\nGREEN\nPut option\nIf someone were worried about this stock’s downside potential below $50, \nwhat would likely be the price that investor would pay to buy this put option?\na. Almost nothing\nb. A little\nc. A good bit\n5/18/2012\n10\n20\n30\n40\n50\n60\n70\n80\n90\n100\n110\n120\n5/20/2013 249 499 749 999\nDate/Day Count\nAdvanced Building Corp. (ABC)\nStock Price\n-\nRED\nCall option\n276  •   The Intelligent Option Investor\nIf someone wanted to make extra income by selling calls to accept expo-\nsure to the stock’s upside, what price would they likely charge for someone \nwanting to buy this call option?\na. Almost nothing\nb. A little\nc. A good bit\nObviously, the correct answer to the put option question is c. This option \nwould be pretty expensive because its range of exposure overlaps with so \nmuch of the BSM cone. Conversely, the answer to the call option question \nis a. This option would be really cheap because its range of exposure is well \nabove the BSM cone.\nRemember, though, that we have our crystal ball, and we know \nthat this stock will likely be somewhere between $70 and $110 per share \nin a few years. With this confidence, wouldn’t it make sense to take the \nopposite side of both the preceding trades? Doing so would look like \nthis:\n5/18/2012\n10\n20\n30\n40\n50\n60\n70\n80\n90\n100\n110\n120\n5/20/2013 249 499 749 999\nDate/Day Count\nAdvanced Building Corp. (ABC)\nStock Price\nBest Case, 110\nWorst Case, 70\n-\nGREEN\nRED\nIn this investment, which I explain in detail in Chapter 11, we are \nreceiving a good bit of money by selling an expensive put and paying \nAppendix A: Choose Your Battles Wisely   • 277\nvery little money to buy a cheap call. It may happen that the money we \nreceive for selling the put actually may be greater than the money we \npay for the call, so we actually get paid a net fee when we make this \ntransaction!\nWe can sell the put confidently because we know that our worst-case \nvaluation is $70 per share; as long as we are confident in our valuation—a \ntopic covered in Part II of this book—we need not worry about the price \ndeclining. We do not mind spending money on the call because we think \nthat the chance is very good that at expiration or before the call will be \nworth much, much more than we paid for it.\nTruly, the realization that the BSM is pricing options on inefficiently \npriced stocks as if they were efficiently priced is the most profound and \ncompelling source of profits for intelligent investors. Furthermore, finding \ngrossly mispriced stocks and exploiting the mispricing using options rep-\nresents the most compelling method for tilting the risk-reward equation in \nour direction.\nThe wonderful thing about investing is that it does not require you to \nswing at all the pitches. Individual investors have a great advantage in that \nthey may swing at only the pitches they know they can hit. The process of \nintelligent investing is simply one of finding the right pitches, and intel-\nligent option investing simply uses an extremely powerful bat to hit that \nsweet pitch.\nBimodal Outcomes\nSome companies are speculative by nature—for instance, a drug company \ndoing cance", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 89}
{"text": "itches. Individual investors have a great advantage in that \nthey may swing at only the pitches they know they can hit. The process of \nintelligent investing is simply one of finding the right pitches, and intel-\nligent option investing simply uses an extremely powerful bat to hit that \nsweet pitch.\nBimodal Outcomes\nSome companies are speculative by nature—for instance, a drug company \ndoing cancer research. The company has nothing but some intangible as-\nsets (the ideas of the scientists working there) and a great deal of costs \n(the salaries going to those scientists, the payments going to patent attor -\nneys, and the considerable costs of paying for clinical trials). If the research \nproves fruitful, the company’s value is great—let’s say $500 per share. If \nthe clinical trials show low efficacy or dangerous side effects, however, the \ncompany’s worth goes to virtually nil. What’s more, it may take years before \nit is clear which of these alternatives is true.\n278  •   The Intelligent Option Investor\nGiven what you know about the BSM, does this seem like the kind of \nsituation conducive to accurate option pricing? This example certainly does \nnot sound like the pricing scenario of a short-term agricultural commodity, \nafter all. If this hypothetical drug company’s stock price was sitting at $50 per \nshare, what is the value of the upper range the option market might be \npricing in? Let’s assume that this stock is trading with a forward volatility of \n100 percent per year (on the day I am writing this, there are only four stocks \nwith options trading at a price that implies a forward volatility of greater than \n100 percent). What price range does this 100 percent per year volatility imply, \nand can we design an option structure that would allow us to profit from a big \nmove in either direction? Here is a diagram of this situation:\n5/18/2012\n-\n500\n50\n100\n150\n200\n250\n300\n350\n400\n450\n5/20/2013 249 499\nDate/Day Count\nAdvanced Biotechnology Co. (ABC)\nStock Price\n749 999\nGREEN\nGREEN\nIndeed, even boosting volatility assumptions to a very high level, \nit seems that we can still afford to gain exposure to both the upside and \ndownside of this stock at a very reasonable price. Y ou can see from the pre-\nceding diagram that both regions of exposure on the put side and the call \nside are outside the BSM cone, meaning that they will be relatively cheap. \nThe options market is trying to boost the price of the options enough so \nthat the calls and puts are fairly priced, but for various reasons (including \nbehavioral biases), most of the time it fails miserably. \nAppendix A: Choose Your Battles Wisely   • 279\nLong Investment Time Horizons\nThis is simply a corollary to the rule that the BSM is generally good at \npricing short-time-horizon investments. The BSM is built on the prem-\nise that stocks will only rise by as much as the risk-free rate. If you ask a \nfinance professor or a market maker, he or she will be able to give you an \nelegant and logically consistent reason why this must be so.\nHowever, as you saw in Chapter 3, this situation has never been so—\nthe return on stocks is sometimes negative but often much more positive \nthan risk-free bonds. If we average the returns out, stocks still generate \nreturns that are heads and shoulders above bonds.\nOver short time horizons, the difference simply isn’t material. For in-\nstance, let’s say that we assume that a given stock should generate around \n10 percent compound annual returns over the next three to five years com-\npared with a 5 percent assumption for the risk-free rate. If we are looking at \nvery short time horizons—such as 60 days—and assume that our stock will \ngrow at exactly that 10 percent rate over that short time, then we should \ncompare our expectations with those of the option market. Here is the dia-\ngram we would get:\nAdvanced Building Corp. (ABC)\n30\n20\n40\n50\n60\n70\n60 days\n80Stock Price\n280  •   The Intelligent Option Investor\nClearly, there is not much of a difference between the BSM expected \nvalue (shown by the dotted line) and the dot representing a 10 percent \nupward drift in the stock. However, if we extend this analysis out for three \nyears, look what happens:\n5/18/2012 5/20/2013 249 499\nDate/Day Count\nAdvanced Building Corp. (ABC)\n749 999\n20\n30\n40\n50\n60\n70Stock Price\n80\nWith the longer time horizon, our assumed stock price is significantly \nhigher than what the BSM calculates as its expected price. If we take “assumed \nfuture stock price” to mean the price at which we think there is an equal chance \nthat the true stock price will be above or below that mark, we can see that the \ndifference, marked by the double-headed arrow in the preceding diagram, is the \nadvantage we have over the option market.\n3 This advantage again means that \ndownside exposure will be overvalued and upside exposure will be undervalued.\nHow, you may ask, can this discrepancy persist? Shouldn’t someone \nfigure out that these options are priced wrong and take advantage of an \narbitrage opportunity? The two reasons why these types of opportunities \ntend to persist are\n1. Most people active in the option market are trading on a very \nshort-term basis. Long-term equity anticipated securities \n(LEAPS)—options with tenors of a year or more—do exist, but \nAppendix A: Choose Your Battles Wisely   • 281\ngenerally the volumes are light because the people in the option \nmarkets generally are not willing to wait longer than 60 days for \ntheir “investment” to work out. Because the time to expiration for \nmost option contracts is so short, the difference between the BSM’s \nexpected price based on a 5 percent risk-free rate and an expected \nprice based on a 10 percent equity return is small, so no one real-\nizes that it’s there (as seen on the first diagram).\n2. The market makers are generally able to hedge out what little ex-\nposure they have to the price appreciation of LEAPS. They don’t \ncare about the price of the underlying security, only about the size \nof the", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 90}
{"text": "expected price based on a 5 percent risk-free rate and an expected \nprice based on a 10 percent equity return is small, so no one real-\nizes that it’s there (as seen on the first diagram).\n2. The market makers are generally able to hedge out what little ex-\nposure they have to the price appreciation of LEAPS. They don’t \ncare about the price of the underlying security, only about the size \nof the bid-ask spread, and they always price the bid-ask spread on \nLEAPS in as advantageous a way as they can. Also, the career of an \nequity option trader on the desk of a broker-dealer can change a \ngreat deal in a single year. As discussed in Part II, market makers \nare not incentivized in such a way that they would ever care what \nhappened over the life of a LEAPS.\nCongratulations. After reading Part I of this book and this appendix, \nyou have a better understanding of the implications of option investing \nfor fundamental investors than most people working on Wall Street. \nThere are many more nuances to options that I discuss in Part III of this \nbook—especially regarding leverage and the sensitivity of options to input \nchanges—but for now, simply understanding how the BSM works puts you \nat a great advantage over other market participants.\n282\nAppendix B\nTHe MAny FAceS OF \nLeverAGe\nAn intelligent option investor must understand investing leverage in \norder to make sense of option investing strategies. Investing leverage is, \nhowever, not the only form of leverage, and to have a well-rounded and \nwell-educated view of investing leverage, you should understand the other \nforms as well. In addition, when assessing the value of companies, it is im-\nportant to understand leverage because leverage often is the root cause of \nrapid changes in profitability during times of changing consumer demand \nsuch as inflection points in the business cycle.\nOperational Leverage\nOperational leverage is the acceptance of fixed operating costs in order to \nmake a higher per-unit profit, such as when a company decides to build a \nfactory rather than contracting for its products to be made by a third party. \nWhen a company spends cash to build a factory, that expenditure is not \ntreated as an immediate cost on the income statement. Rather, the cost \nof the new factory is spread over future periods as the noncash expense \nknown as depreciation.\n1\nLet us take a look at two companies, both of which produce the same \nitems, but one of which outsources production to a third party (Unlevered \nCo.) and the other of which has built a factory to manufacture its products \nAppendix B: The Many Faces of Leverage  • 283\n(Levered Co.). In reality, there are methods used by companies to front-\nload depreciation expenses in order to minimize taxable income for new \nprojects, but let’s assume that Levered Co. is using what is called straight-\nline depreciation so that the charge is identical each quarter.\nUnlevered Co. Levered Co.\nRevenues 100.0 100.0\nFixed depreciation expense 0.0 −65.0\nVariable operating expenses −85.0 −15.0\nOperating profit 15.0 20.0\nPretax profit 15.0 20.0\nTax −4.5 −6.0\nNet profit 10.5 14.0\nAs you can see here, Levered Co. ’s profits are a bit better than those \nof Unlevered Co. because the former is not paying a supplier and can \nproduce the items at a lower cost. Note also that both companies have \nvariable costs. For Unlevered Co., these variable costs include the costs \nof the items it has produced by the third party plus whatever salaries it \nhas to pay to salespeople and administrative staff; for Levered Co., vari-\nable costs include the costs of raw materials plus the cost of any salaries \npaid to production, sales, and administrative staff. This is our base case—\nrepresenting midcycle economic conditions (i.e., not boom or not bust).\nNow let’s look at the two companies during a trough in the business \ncycle—or bust conditions.\nUnlevered Co. Levered Co.\nRevenues 70.0 70.0\nFixed depreciation expense 0.0 −65.0\nVariable operating expenses −59.5 −10.5\nOperating profit 10.5 −5.5\nPretax profit 10.5 −5.5\nTax −3.2 +1.6\nNet profit 7.3 −3.9\n284  •   The Intelligent Option Investor\nCosts at Unlevered Co. decrease proportionally to the decrease in \nrevenues, so the operating profit margin is the same in its case. However, \nfor Levered Co., even though the variable costs decrease proportionally to \nthe decrease in revenues, the cost of depreciation stays fixed, causing a loss \nthat is only slightly ameliorated through a small tax benefit.\nThus, obviously, in business-cycle trough conditions, profitability is \nhurt through the assumption of operational leverage. Let’s take a look at \nwhat happens to both companies in peak conditions.\n2\nUnlevered Co. Levered Co.\nRevenues 130.0 130.0\nFixed depreciation expense 0.0 −65.0\nVariable operating expenses −110.5 −19.5\nOperating profit 19.5 45.5\nPretax profit 19.5 45.5\nTax −5.9 −13.6\nNet profit 13.6 31.9\nObviously, having the operational leverage during peak times is a \nwonderful thing. After the fixed-cost hurdle of depreciation is cleared, each \nextra widget produced allows the company to generate profits that are gov-\nerned solely by variable costs. Unlevered Co. is in a better position when \nthere is a downturn, but its profitability falls behind Levered Co. ’s more and \nmore the better economic conditions are.\nWhen thinking about the valuation of companies, we must remember \nwhat a large effect operational leverage can have on operations. Financial \nmarkets usually underestimate the effects of operational leverage both \nwhen the business cycle is at its peak and when it is at its trough. At the \npeak, analysts are wont to extrapolate high margins out forever and ignore \nthe possibility that the sword of leverage swings both ways. At the trough, \nanalysts are overly pessimistic and forget that a small improvement in de-\nmand can have a very large impact on financial results. \nOperational leverage is neither good nor bad—it is merely a strategic busi-\nness choice that has differe", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 91}
{"text": "h. At the \npeak, analysts are wont to extrapolate high margins out forever and ignore \nthe possibility that the sword of leverage swings both ways. At the trough, \nanalysts are overly pessimistic and forget that a small improvement in de-\nmand can have a very large impact on financial results. \nOperational leverage is neither good nor bad—it is merely a strategic busi-\nness choice that has different implications during different parts of the business \ncycle and under different revenue conditions. An intelligent investor under-\nstands this fact and is happy to invest when the rest of the market has forgotten it.\nFinancial Leverage\nFinancial leverage involves the acceptance of fixed financial costs such \nas a loan or a lease contract to fund a business. Considering the expense \nof building factories, usually operational and financial leverage occur \nsimultaneously, but to understand financial leverage itself, let’s look at two \ncompanies that, other than the amount of debt on their balance sheets, are \nexactly the same in terms of revenues and profit margin. Our base case \nshows that the unlevered company will generate a higher absolute profit \nbecause it does not have the fixed financing costs.\nUnlevered Co. Levered Co.\nRevenues 100.0 100.0\nOperating expenses −80.0 −80.0\nOperating profit 20.0 20.0\nInterest expense 0.0 −15.0\nPretax profit 20.0 5.0\nTax −6.0 −1.5\nNet profit 14.0 3.5\nNow let’s increase revenues for both companies by 50 percent and see \nwhat happens.\nUnlevered Co. Levered Co.\nRevenues 150.0 150.0\nOperating expenses −120.0 −120.0\nOperating profit 30.0 30.0\nInterest expense 0.0 −15.0\nPretax profit 30.0 15.0\nTax −9.0 −4.5\nNet profit 21.0 11.5\nThe absolute profit is still higher for the unlevered company, but the \npercentage change from the first case to the second shows a big difference. \nThe unlevered company’s profits increased by 50 percent (from 14.0 to \n21.0) with a 50 percent rise in revenues. However, the levered company’s \nprofits increased by a whopping 229 percent (from 3.5 to 11.5) with the \nsame 50 percent rise in revenues. \nAppendix B: The Many Faces of Leverage  • 285\n286  •   The Intelligent Option Investor\nHere we see an example of a defining characteristic of financial and \ninvestment leverage; that is, these sorts of leverage affect percentage calcu-\nlations, but in absolute terms, unlevered transactions always generate more \nfor a fixed level of exposure. We explore this concept in great detail when \nwe discuss investment leverage in Chapter 8.\nTo see the dangerous side of leverage’s double-edged sword, let’s look \nat a case where revenues drop 50 percent from the original baseline.\nUnlevered Co. Levered Co.\nRevenues 50.0 50.0\nOperating expenses −40.0 −40.0\nOperating profit 10.0 10.0\nInterest expense 0.0 −15.0\nPretax profit 10.0 −5.0\nTax −3.0 +1.5\nNet profit 7.0 −3.5\nHere we see that even with the tax benefit for the levered company, \nit is still running at a loss because of the fixed financial costs, whereas the \nunlevered company is still realizing a gain. In a worst-case scenario, fixed \nfinancial costs can exceed the cash coming into the business, leading to \ndebt default and, depending on the situation, bankruptcy.\nThinking about the best and worst cases from an investment perspec-\ntive for a moment, you can see why some equity investors actually prefer a \nhighly levered firm: the higher the leverage, the greater is the incremental \nprofit for equity holders when times are good. For a levered company that \nis in transition from bad to good—whether due to an upturn in economic \nconditions during a business cycle or a company-specific issue such as the \nintroduction of a new product line boosting a flagging legacy business—\na small improvement in business conditions creates a big improvement \nin profits available to shareholders. The flip side is that when business \nconditions turn downward—a transition from good to bad—a levered \ncompany’s fall from profitability to loss is sudden, and its stock price fall \ncan be even worse. The fact is that just in the case of operational lever -\nage, financial leverage is not good or bad—it is simply a strategic business \nchoice that has different implications in different situations. \n287\nAppendix c\nPUT-cALL PArITy\nBefore the Black-Scholes-Merton model (BSM), there was no way to \ndirectly calculate the value of an option, but there was a way to triangulate \nput and call prices as long as one had three pieces of data:\n1. The stock’s price\n2. The risk-free rate\n3. The price of a call option to figure the fair price of the put, and vice \nversa\nIn other words, if you know the price of either the put or a call, as long \nas you know the stock price and the risk-free rate, you can work out the \nprice of the other option. These four prices are all related by a specific rule \ntermed put-call parity.\nPut-call parity is only applicable to European options, so it is not ter-\nribly important to stock option investors most of the time. The one time it \nbecomes useful is when thinking about whether to exercise early in order \nto receive a stock dividend—and that discussion is a bit more technical. I’ll \ndelve into those technical details in a moment, but first, let’s look at the big \npicture. Using the intelligent option investor’s graphic format employed in \nthis book, the big picture is laughably trivial.\nDirect your attention to the following diagrams. What is the differ -\nence between the two?\n288  •   The Intelligent Option Investor\n-\n20\n5/18/2012 5/20/2013\n40\n60\n80\n100\n120Stock Price\n140\n160\n180\n200\n-\n20\n5/18/2012 5/20/2013\n40\n60\n80\n100\n120Stock Price\n140\n160\n180\n200\nGREENGREEN\nREDRED\nIf you say, “Nothing, ” you are practically right but technically \nwrong. The image on the left is actually the risk-reward profile of a pur -\nchased call option struck at $50 paired with a sold put option struck at \n$50. The image on the right is the risk-reward profile of a stock trading \nat $50 per share.\nThis simple comparison is the essence of", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 92}
{"text": "120Stock Price\n140\n160\n180\n200\nGREENGREEN\nREDRED\nIf you say, “Nothing, ” you are practically right but technically \nwrong. The image on the left is actually the risk-reward profile of a pur -\nchased call option struck at $50 paired with a sold put option struck at \n$50. The image on the right is the risk-reward profile of a stock trading \nat $50 per share.\nThis simple comparison is the essence of put-call parity. The parity \npart of put-call parity just means that accepting downside exposure by sell-\ning a put while gaining upside exposure by buying a call is basically the \nsame thing as accepting downside exposure and gaining upside exposure \nby buying a stock.\nWhat did I say? It is laughably trivial. Now let’s delve into the details \nof how the put-call parity relationship can be used to help decide whether \nto exercise a call option or not (or whether the call option you sold is likely \nto be exercised or not).\nDividend Arbitrage and Put-call Parity\nAny time you see the word arbitrage , the first thing that should jump to \nmind is “small differences. ” Arbitrage is the science of observing small dif-\nferences between two prices that should be the same (e.g., the price of IBM \nAppendix C: Put-Call Parity   • 289\ntraded on the New Y ork Stock Exchange and the price of IBM traded in \nPhiladelphia) but are not. An arbitrageur, once he or she spots the small \ndifference, sells the more expensive thing and buys the less expensive one \nand makes a profit without accepting any risk. \nBecause we are going to investigate dividend arbitrage, even a big-\npicture guy like me has to get down in the weeds because the differences we \nare going to try to spot are small ones. The weeds into which we are wading \nare mathematical ones, I’m afraid, but never fear—we’ll use nothing more \nthan a little algebra. We’ll use these variables in our discussion:\nK = strike price\nC\nK = call option struck at K\nPK = put option struck at K\nInt = interest on a risk-free instrument \nDiv = dividend payment\nS = stock price\nBecause we are talking about arbitrage, it makes sense that we are \ngoing to look at two things, the value of which should be the same. We \nare going to take a detailed look at the preceding image, which means that \nwe are going to compare a position composed of options with a position \ncomposed of stock.\nLet’s say that the stock at which we were looking to build a position is \ntrading at $50 per share and that options on this stock expire in exactly one \nyear. Further, let’s say that this stock is expected to yield $0.25 in dividends \nand that the company will pay these dividends the same day that the op-\ntions expire.\nLet’s compare the two positions in the same way as we did in the \npreceding big-picture image. As we saw in that image, a long call and a \nshort put are the same as a stock. Mathematically, we would express this \nas follows:\nC\nK − PK = SK\nAlthough this is simple and we agreed that it’s about right, it is not \ntechnically so.\nThe preceding equation is not technically right because we know that \na stock is an unlevered instrument and that options are levered ones. In the \n290  •   The Intelligent Option Investor\npreceding equation, we can see that the left side of the equation is levered \n(because it contains only options, and options are levered instruments), \nand the right side is unlevered. Obviously, then, the two cannot be exactly \nthe same.\nWe can fix this problem by delevering the left side of the preceding \nequation. Any time we sell a put option, we have to place cash in a mar -\ngin account with our broker. Recall that a short put that is fully margined \nis an unlevered instrument, so margining the short put should delever \nthe entire option position. Let’s add a margin account to the left side and \nput $K in it:\nC\nK − PK + K = S\nThis equation simply says that if you sell a put struck at K and put $K \nworth of margin behind it while buying a call option, you’ll have the same \nrisk, return, and leverage profile as if you bought a stock—just as in our \nbig-picture diagram.\nBut this is not quite right if one is dealing with small differences. \nFirst, let’s say that you talk your broker into funding the margin ac-\ncount using a risk-free bond fund that will pay some fixed amount of \ninterest over the next year. To fund the margin account, you tell your \nbroker you will buy enough of the bond account that one year from \nnow, when the put expires, the margin account’s value will be exactly \nthe same as the strike price. In this way, even by placing an amount less \nthan the strike price in your margin account originally, you will be able \nto fulfill the commitment to buy the stock at the strike price if the put \nexpires in the money (ITM). The amount that will be placed in margin \noriginally will be the strike price less the amount of interest you will \nreceive from the risk-free bond. In mathematical terms, the preceding \nequation becomes \nC\nK − PK + (K – Int) = S\nNow all is right with the world. For a non-dividend-paying stock, this fully \nexpresses the technical definition of put-call parity.\nHowever, because we are talking about dividend arbitrage, we have to \nthink about how to adjust our equation to include dividends. We know that \na call option on a dividend-paying stock is worth less because the dividend \nAppendix C: Put-Call Parity   • 291\nacts as a “negative drift” term in the BSM. When a dividend is paid, theory \nsays that the stock price should drop by the amount of the dividend. Be-\ncause a drop in price is bad for the holder of a call option, the price of a call \noption is cheaper by the amount of the expected dividend.\nThus, for a dividend-paying stock, to establish an option-based position \nthat has exactly the same characteristics as a stock portfolio, we have to keep \nthe expected amount of the dividend in our margin account.\n1 This money \nplaced into the option position will make up for the dividend that will be \npaid to the stock holder. Here is how this would look i", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 93}
{"text": "by the amount of the expected dividend.\nThus, for a dividend-paying stock, to establish an option-based position \nthat has exactly the same characteristics as a stock portfolio, we have to keep \nthe expected amount of the dividend in our margin account.\n1 This money \nplaced into the option position will make up for the dividend that will be \npaid to the stock holder. Here is how this would look in our equation:\nC\nK − PK + (K − Int) + Div = S\nWith the dividend payment included, our equation is complete.\nNow it is time for some algebra. Let’s rearrange the preceding equa-\ntion to see what the call option should be worth:\nCK = PK + Int − Div + (S − K)\nTaking a look at this, do you notice last term (S – K )? A stock’s price \nminus the strike price of a call is the intrinsic value. And we know that \nthe value of a call option consists of intrinsic value and time value. This \nmeans that\n/dncurlybracketleft/dncurlybracketmid/horizcurlybracketext/horizcurlybracketext/dncurlybracketright/horizcurlybracketext/horizcurlybracketext/dncurlybracketleft/dncurlybracketmid/dncurlybracketright=+ −−CP SKKK IntD iv + ()\nTime valueI ntrinsic value\nSo now let’s say that time passes and at the end of the year, the stock \nis trading at $70—deep ITM for our $50-strike call option. On the day \nbefore expiration, the time value will be very close to zero as long as the op-\ntion is deep ITM. Building on the preceding equation, we can put the rule \nabout the time value of a deep ITM option in the following mathematical \nequation:\nP\nK + Int − Div ≈ 0\nIf the time value ever falls below 0, the value of the call would trade for less \nthan the intrinsic value. Of course, no one would want to hold an option \nthat has negative time value. In mathematical terms, that scenario would \nlook like this:\nP\nK + Int − Div < 0\n292  •   The Intelligent Option Investor\nFrom this equation, it follows that if\nPK + Int < Div\nyour call option has a negative implied time value, and you should sell the \noption in order to collect the dividend. \nThis is what is meant by dividend arbitrage . But it is hard to get the \nflavor for this without seeing a real-life example of it. The following table \nshows the closing prices for Oracle’s stock and options on January 9, 2014, \nwhen they closed at $37.72. The options had an expiration of 373 days in \nthe future—as close as I could find to one year—the one-year risk-free rate \nwas 0.14 percent, and the company was expected to pay $0.24 worth of \ndividends before the options expired.\nCalls Puts\nBid Ask Delta Strike Bid Ask Delta\n19.55 19.85 0.94 18 0.08 0.13 −0.02\n17.60 17.80 0.94 20 0.13 0.15 −0.03\n14.65 14.85 0.92 23 0.25 0.28 −0.05\n12.75 12.95 0.91 25 0.36 0.39 −0.07\n10.00 10.25 0.86 28 0.66 0.69 −0.12\n8.30 8.60 0.81 30 0.97 1.00 −0.17\n6.70 6.95 0.76 32 1.40 1.43 −0.23\n4.70 4.80 0.65 35 2.33 2.37 −0.34\n3.55 3.65 0.56 37 3.15 3.25 −0.43\n2.22 2.26 0.42 40 4.80 4.90 −0.57\n1.55 1.59 0.33 42 6.15 6.25 −0.65\n0.87 0.90 0.22 45 8.25 8.65 −0.75\n0.31 0.34 0.10 50 12.65 13.05 −0.87\nIn the theoretical option portfolio, we are short a put, so its value to \nus is the amount we would have to pay if we tried to flatten the position by \nbuying it back—the ask price. Conversely, we are long a call, so its value to \nus is the price we could sell it for—the bid price.\nLet’s use these data to figure out which calls we might want to exercise \nearly if a dividend payment was coming up.\nAppendix C: Put-Call Parity   • 293\nStrike Call\nPut\n(a)\nInterest2\n(b)\nPut + Interest\n(a + b) Dividend P + I − D Notes\n18 19.55 0.13 0.03 0.16 0.24 (0.08) P + I < D, \narbitrage\n20 17.60 0.15 0.03 0.18 0.24 (0.06) P + I < D, \narbitrage\n23 14.65 0.28 0.03 0.31 0.24 0.07 No arbitrage\n25 12.75 0.39 0.04 0.43 0.24 0.19 No arbitrage\n28 10.00 0.69 0.04 0.73 0.24 0.49 No arbitrage\n30 8.30 1.00 0.04 1.04 0.24 0.80 No arbitrage\n32 6.70 1.43 0.05 1.48 0.24 1.24 No arbitrage\n35 4.70 2.37 0.05 2.42 0.24 2.18 No arbitrage\n37 3.55 3.25 0.05 3.30 0.24 3.06 No arbitrage\n40 2.22 4.90 0.06 4.96 0.24 4.72 No arbitrage\n42 1.55 6.25 0.06 6.31 0.24 6.07 No arbitrage\n45 0.87 8.65 0.06 8.71 0.24 8.47 No arbitrage\n50 0.31 13.05 0.07 13.12 0.24 12.88 No arbitrage\nThere are only two strikes that might be arbitraged for the \ndividends—the two furthest ITM call options. In order to realize the \narbitrage opportunity, you would wait until the day before the ex-dividend \ndate, exercise the stock option, receive the dividend, and, if you didn’t want \nto keep holding the stock, sell it and realize the profit.\nThis page intentionally left blank \n295\nNotes\nIntroduction\n1. Options, Futures, and Other Derivatives by John C. Hull (New Y ork: \nPrentice Hall, Eighth Edition, February 12, 2011), is considered the \nBible of the academic study of options.\n2. Option Volatility and Pricing by Sheldon Natenberg (New Y ork: \nMcGraw-Hill, Updated and Expanded Edition, August 1, 1994), is \nconsidered the Bible of professional option traders.\n3. The Greeks are measures of option sensitivity used by traders to man-\nage risk in portfolios of options. They are named after the Greek \nsymbols used in the Black-Scholes-Merton option pricing model.\n4. “To invest successfully over a lifetime does not require a stratospheric \nIQ, unusual business insights, or inside information. What’s needed \nis a sound intellectual framework for making decisions and the abil-\nity to keep emotions from corroding that framework. ” Preface to The \nIntelligent Investor by Benjamin Graham (New Y ork: Collins Business, \nRevised Edition, February 21, 2006). \nChapter 1\n1. In other words, if all option contracts were specific and customized, \nevery time you wanted to trade an option contract as an individual in-\nvestor, you would have to first find a counterparty to take the other side \nof the trade and then do due diligence on the counterparty to make \nsure that he or she would be able to fulfill his or her side of the bargain. \nIt is hard to imagine small individual investors being very interested in \nthe logistical hea", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 94}
{"text": "customized, \nevery time you wanted to trade an option contract as an individual in-\nvestor, you would have to first find a counterparty to take the other side \nof the trade and then do due diligence on the counterparty to make \nsure that he or she would be able to fulfill his or her side of the bargain. \nIt is hard to imagine small individual investors being very interested in \nthe logistical headaches that this process would entail!\n296 •   N o t e s\n2. One more bit of essential but confusing jargon when investing in \noptions is related to exercise. There are actually two styles of exercise; \none can be exercised at any time before expiration—these are termed \nAmerican style—and the other can only be exercised at expiration—\ntermed European style. Confusingly, these styles have nothing to do \nabout the home country of a given stock or even on what exchange \nthey are traded. American-style exercise is normal for all single-stock \noptions, whereas European-style exercise is normal for index futures. \nBecause this book deals almost solely with single-stock options (i.e., \noptions on IBM or GOOG, etc.), I will not make a big deal out of this \ndistinction. There is one case related to dividend-paying stocks where \nAmerican-style exercise is beneficial. This is discussed in Appendix C. \nMost times, exercise style is not a terribly important thing.\n3. Just like going to Atlantic City, even though the nominal odds for rou-\nlette are 50:50, you end up losing money in the long run because you \nhave to pay—the house at Atlantic City or the broker on Wall Street—\njust to play the game.\nChapter 3\n1. We adjusted and annualized the prices of actual option contracts so \nthat they would correspond to the probability levels we mentioned \nearlier. It would be almost impossible to find a stock trading at exactly \n$50 and with the option market predicting exactly the range of future \nprice that we have shown in the diagrams. This table is provided simply \nto give you an idea of what one might pay for call options of different \nmoneyness in the open market.\n2. Eighty-four percent because the bottom line marks the price at which \nthere is only a 16 percent chance that the stock will go any lower. If \nthere is a 16 percent chance that the stock will be lower than $40 in \none year’s time, this must mean that there is an 84 percent chance \nthat the stock will be higher than $40 in one year’s time. We write \n“a little better than 84 percent chance” because you’ll notice that the \nstock price corresponding to the bottom line of the cone is around \n$42—a little higher than the strike price. The $40 mark might corre-\nspond to a chance of, let’s say, 13 percent that the stock will be lower; \nNotes  • 297\nthis would, in turn, imply an 87 percent chance of being higher than \n$40 in a year.\n3. Tenor is just a specialty word used for options and bonds to mean the \nremaining time before expiration/maturity. We will see later that op-\ntion tenors usually range from one month to one year and that special \nlong-term options have tenors of several years.\n4. We’re not doing any advanced math to figure this out. We’re just eye-\nballing the area of the exposure range within the cone in this diagram \nand recalling that the area within the cone of the $60 strike, one-year \noption was about the same.\n5. In other words, in this style of trading, people are anchoring on recent \nimplied volatilities—rather than on recent statistical volatilities—to \npredict future implied volatilities.\n6. Note that even though this option is now ITM, we did not pay for any \nintrinsic value when we bought the option. As such, we are shading the \nentire range of exposure in green.\nChapter 4\n1. The “capital” we have discussed so far is strategic capital. There is an-\nother form of tactical capital that is vital to companies, termed working \ncapital. Working capital consists of the short-term assets essential for \nrunning a business (e.g., inventory and accounts receivables) less the \nshort-term liabilities accrued during the course of running the busi-\nness (e.g., accounts payable). Working capital is tactical in the sense \nthat it is needed for day-to-day operation of the business. A company \nmay have the most wonderful productive assets in the world, but if it \ndoes not have the money to buy the inventory of raw materials that will \nallow it to produce its widgets, it will not be able to generate revenues \nbecause it will not be able to produce anything.\n2. The law of large numbers is actually a law of statistics, but when most \npeople in the investing world use this phrase, it is the colloquial version \nto which they are referring. \n3. Apple Computer, for instance, was a specialized maker of computers \nmainly used by designers and artists in the late 1990s. Through some \n298 •   N o t e s\ninspired leadership and a large capital infusion from Microsoft to keep \nit afloat in its darkest days, Apple Computer changed its name to just \nApple and began producing handheld music devices, smartphones, and \nother media appliances (including computers). By the late 1990s, Apple \nwas facing severe structural constraints. The market in which it com-\npeted—the market for personal computers—had been commoditized, \nand prices did nothing but go down. It was clinging to a niche market \nof a few educational institutions and creative professionals—not a very \nrobust or quickly growing market. However, the company was able to \nreinvent itself as a media technology company and media content pro-\nvider using its investments and know-how in personal computing as a \nbase. Doing so, Apple jumped from a mature company into a virtual \nstartup and once again became a supply-constrained company in a \nvery short period of time. This is a rare twist, but not unheard of.\n4. Don’t waste your time remembering this formula unless you already \nknow it. Y ou can always look up the exact equation when you need to use \nit. Just remember, “ A dollar today is worth more than a dollar tomorr", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 95}
{"text": "Apple jumped from a mature company into a virtual \nstartup and once again became a supply-constrained company in a \nvery short period of time. This is a rare twist, but not unheard of.\n4. Don’t waste your time remembering this formula unless you already \nknow it. Y ou can always look up the exact equation when you need to use \nit. Just remember, “ A dollar today is worth more than a dollar tomorrow. ”\n5. If you are curious about the CAPM or any of the other related aca-\ndemic methods for determining discount rates, you have no further \nto go than your local library or various sources online. The CAPM is \none of the pillars of modern finance, and there are plenty of resources \nto learn about it. In the end, though, the “proper” discount rate you \nwill calculate will not be far off from these values. There are plenty \nof more important things on which to concentrate in a valuation, so \nmy suggestion is to spend time on those and save learning about the \nCAPM.\nChapter 5\n1. Note that, even though it may feel like it from a shareholder perspective, \nthe period during which a company is making poor investments and \ngenerating substructural profit growth will only last for a limited time. \nSooner or later, an activist investor or another company will acquire all \nor part of the capital stock of the underperforming company and run \nthe enterprise in a more rational way.\nNotes  • 299\n2. For the structural stage, I usually only use one scenario. When I start-\ned in the business of valuation, I used 6 percent growth of cash flows \nin perpetuity. Recently, convinced by PIMCO’s argument that we are \nentering an extended “new normal” period, I tend to use 5 percent \ninstead.\n3. For instance, a company may have only six very large and important \ncustomers, each of which it picked up in subsequent years. If it loses \none of those customers, rather than +35 percent revenue growth over \nthe next year, the revenue may decline by 20 percent. Or even if the \ncompany does not lose a customer, if it does not gain another, its \nrevenue growth may be trivial—3 percent, let’s say.\n4. Please see the online materials for the specific formulas used for OCP \nand FCFO.\n5. A person with a 100-share stake in Exxon—an investment worth just \nunder $10,000—has a proportional stake of 0.000006 percent in the \ncompany. No wonder investors usually do not have a strong sense of \nbeing an owner of the companies in which they are invested.\n6. In a counterexample, IBM’s management should be commended for \nselling off the dying, undifferentiated PC business to Lenovo and rea-\nligning the tech giant as primarily a provider of software and services.\n7. Networking behemoth Cisco Systems’ (CSCO) purchase of Pure \nDigital (a company that made Flip video cameras) springs immedi-\nately to mind.\nChapter 6\n1. The fact that a consensus of opinion is reached is an interesting social be-\nhavioral bias called herding. This bias, one that I will not go into great de-\ntail about here, is the tendency for people to be influenced by the actions \nor opinions of others when making a decision as a member of a group.\n2. Paul Slovic, “Behavioral Problems of Adhering to a Decision Policy, ” \npaper presented at the Institute for Quantitative Research in Finance, \nNapa, CA, May 1, 1973.\n3. This research report was quoted and summarized on the following site: \nhttp://www.valuewalk.com/2013/07/hedge-fund-alpha-negative/.\n300 •   N o t e s\n4. The original academic paper discussing prospect theory was published \nin Econometrica, Volume 47, Number 2, in March 1979 under the title: \n“Prospect Theory: An Analysis of Decision Under Risk. ”\n5. Over the years, the paradigm for broker-dealers has changed, so some \nof what is written here is a bit dated. Broker-dealers have one part of \nits business dedicated to increasing customer “flow” as is described \nhere. Over the last 20 years or so, however, they have additionally \nbegun to capitalize what amounts to in-house hedge funds, called \n“proprietary trading desks” or “prop traders. ” While the prop traders \nare working on behalf of corporations that were historically known as \nbroker-dealers (e.g., Goldman Sachs, Morgan Stanley), they are in fact \nbuy-side institutions. In the interest of clarity in this chapter, I treat \nbroker-dealers as purely sell-side entities even though they in fact have \nelements of both buy- and sell-sides.\nChapter 7\n1. Round-tripping means buying a security and selling it later.\n2. This bit of shorthand just means a bid volatility of 22.0 and an ask \nvolatility of 22.5.\nChapter 8\n1. This is one of the reasons why I called delta the most useful of the \nGreeks.\n2. When I pulled these data, I pulled the 189-day options, so my chance \nof this stock hitting that high a price in this short time period is slim, \nbut the point I am making here about percentage versus absolute re-\nturns still holds true.\n3. A tool to calculate all the downside and upside leverage figures shown \nin this chapter is available on the intelligent option investor website.\n4. “Buffett’s Alpha, ” Andrea Frazzini, David Kabiller, and Lasse H. Ped-\nersen, 2012, National Bureau of Economic Research, NBER Working \nPaper No. 19681.\nNotes  • 301\nChapter 9\n1. Yale Alumni Magazine, “The Fraud Detective, ” September/October \n2013 Issue, http://www.yalealumnimagazine.com/articles/3737.\nChapter 10\n1. This is, in fact, the crux of why U.S. taxpayers all got the opportunity \nto own a piece of AIG. One of the subsidiaries of AIG made \ncommitments to carry out transactions that, with the collapse of the \nmortgage bubble, it had no ability to do. In this case, it was not a bro-\nker or exchange that had to bear the exposure to AIG’s failure—the \ncontracts AIG were trading were over-the-counter and thus not regu-\nlated by an exchange—it was the financial system at large and U.S. \ntaxpayers in particular.\n2. The fact that this strategy is unlevered means that percentage returns \nprovide an accurate representation of the absolute wealth gene", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 96}
{"text": ". In this case, it was not a bro-\nker or exchange that had to bear the exposure to AIG’s failure—the \ncontracts AIG were trading were over-the-counter and thus not regu-\nlated by an exchange—it was the financial system at large and U.S. \ntaxpayers in particular.\n2. The fact that this strategy is unlevered means that percentage returns \nprovide an accurate representation of the absolute wealth generated \nwith the strategy. As we saw earlier, levered investments can show very \nhigh percentage returns, whereas absolute returns are not as great. This \nis not the case for short puts.\n3. Writing an option means selling an option.\n4. This is especially true for people investing in covered calls—a strategy \nI will discuss in Chapter 11 and that has the same risk-return profile as \nthe short-put strategy.\n5. Of course, there are other reasons for increased volatility during \nearnings seasons, and some of the volatility reflects issues that are ma-\nterial to valuation. In my opinion, though, the vast majority of infor -\nmation given at these times is helpful for understanding only a few \nmonths’ worth of prospective business results and, as such, should not \ncause a material change in an intelligent investor’s perception of long-\nrun company value.\n6. I am speaking here about the most attractive calls from a math-\nematical perspective, not a valuation one. I have not valued IBM \nand am most definitely not making an investment recommenda-\ntion here. I used IBM because it is a liquid option with a good \n302 •   N o t e s\nmany OTM strikes, not because I believe it’s a bearish investment \nopportunity.\n7. $100,000 × 5% = $5,000; $5,000/$196.80 per share = 25.4 shares.\nChapter 11\n1. This is due to a statistical property known as dispersion . Dispersion—\nthe fact that prices on many things do not usually move in lockstep \nwith one another—is the root of all diversification strategies.\n2. This assumes that crises are only temporary. Of course, structural or \nsecular downturns are a different matter, and the whole process of \ninvesting must be done in a different way. In particular, conceptions of \nsensible terminal growth rates become vital during these times.\nChapter 12\n1. I am indebted to Brent Farler for this image, which I think is really \nbrilliant.\nAppendix A\n1. Refer to the discussion of investing agents and principals in Chapter 6. \n2. It is only the nominal odds that are 50:50 anyway. The player always \nhas to pay the house (and if you’re James Bond, you must tip the dealer \na cool million dollars), just as an investor must pay the broker. As such, \nthe net odds are always against the owner of capital.\n3. Remember that the dotted line in the BSM cone shows that 50:50 \n“expected” value. Because our expected value dot is much higher, this \nmeans that we are assigning a higher probability of that price occurring \nthan is the option market as a whole.\nNotes  • 303\nAppendix B\n1. The idea behind this process is to match the timing of the costs of \nequipment with revenues from the items produced with that equip-\nment. This is a key principle of accountancy called matching.\n2. The problem is that troughs, by definition, follow peaks. Usually, just \nlike the timing of large acquisitions, companies decide to spend huge \namounts to build new production capacity at just about the same time \nthat economic conditions peak, and the factories come online just as \nthe economy is starting to sputter and fail.\nAppendix C\n1. A penny saved is a penny earned. We can think of the option being \ncheaper by the amount of the dividend, so we will place the amount \nthat we save on the call option in savings.\n2. This is calculated using the following equation:\nInterest = strike × r × percent of 1 year\nIn the case of the $18 strike, interest = 18 × 0.14% × (373 days/365 days \nper year) = $0.03.\nThis page intentionally left blank \n305\nA\nAbsolute dollar value of returns, \n172–173\nAccuracy, confidence vs., 119–121\nAcquisitions (see Mergers and \nacquisitions)\nActivist investors, 110\nAgainst the Gods (Peter Bernstein), 9\nAgents:\nbuy-side, 132–136\ndefined, 131\ninvestment strategies of, 137–138\nprincipals vs., 131–132\nsell-side, 136–137\nAIG, 301n1\nAllocation:\nand leverage in portfolios, \n174–183\nand liquidity risk, 256\nand portfolio management with \nshort-call spreads, 228–229\nAlpha, 134\nAmerican-style options, 296n2 \n(Chapter 1)\nAnalysis paralysis, 120\nAnchoring, 60, 97\nAnnouncements:\nand creating BSM cones, 156, 157\nmarket conditions following, 68–69, \n72–73\ntenor and trading in expectation \nof, 192\nAOL, 103\nApple Computer, 101, 250–251, \n297–298n3\nArbitrage:\ndefined, 288–289\ndividend, 223, 288–293\nAsk price, 147\nAsset allocation, liquidity risk \nand, 256\nAssets:\ndefined, 78–79\nfungible, 272–273\nin golden rule of valuation, 77\nhidden, 110, 111\nidiosyncratic, 272\ninterchangeable, 272–273\nmispriced, 274–277\noperating, 110\nprice vs. value of, 79–80\nunderlying, 33–34, 272–273\nAssets under management (AUM), 132\nAssignment:\nwith covered calls, 247–248\ndefined, 222–223\nAssumptions:\nBSM model, 32–33, 40–47, 78, 150\ndividend yield, 67\nwith forward volatility number, \n156–157\ntime-to-expiration, 64–67\nvolatility, 60–64\nAt-the-money (ATM) options:\nBSM cone for, 53\ncollars, 259\ncovered calls, 242–243, 245, 246\ndefined, 13, 16, 17\nlong calls, 189\nlong diagonals, 235–237\nIndex\n306  •   Index\nAt-the-money (ATM) options: (continued)\nlong straddles, 208–209\nOTM options vs., 233–234\nprotective puts, 250–251, 253\nshort diagonals, 238, 240\nshort puts, 215, 216\nshort straddles, 230\nshort-call spreads, 222–225\nAUM (assets under management), 132\nB\nBalance-sheet effects, 92, 108–111\nBehavior, efficient market hypothesis \nas model for, 41–42\nBehavioral biases, 114–130\noverconfidence, 118–122\npattern recognition, 114–118\nperception of risk, 123–130\nBehavioral economics, 42, 114\nBentley, 97–98\nBerkshire Hathaway, 185\nBernstein, Peter, 9\nBiases, behavioral (see Behavioral \nbiases)\nBid price, 147\nBid-ask spreads, 147–149\nBimodal outcomes, companies with, \n277", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 97}
{"text": "effects, 92, 108–111\nBehavior, efficient market hypothesis \nas model for, 41–42\nBehavioral biases, 114–130\noverconfidence, 118–122\npattern recognition, 114–118\nperception of risk, 123–130\nBehavioral economics, 42, 114\nBentley, 97–98\nBerkshire Hathaway, 185\nBernstein, Peter, 9\nBiases, behavioral (see Behavioral \nbiases)\nBid price, 147\nBid-ask spreads, 147–149\nBimodal outcomes, companies with, \n277–278\nBlack, Fischer, 8–9\nBlackBerry, 208–209\nBlack-Scholes-Merton (BSM) model, 9\nassumptions of, 32–33, 40–47, 78, 150\nconditions favoring, 269–273\nconditions not favoring, 273–281\nincorrect facets of, 29\npredicting future stock prices from, \n32–39\nranges of exposure and price \npredictions from, 50–56\ntheory of, 32\n(See also BSM cone)\nBonds, investing in short puts vs., \n213–214\nBooms, leverage during, 199\nBreakeven line, 25\nfor call options, 15, 16\nfor long strangle, 26–27\nfor put options, 17, 18\n(See also Effective buy price [EBP])\nBroker-dealers, 137, 299–300n5\nBrokers, benefits of short-term trading \nfor, 64\nBSM cone:\nfor call options, 50–55\nfor collars, 258\nfor covered calls, 240–244\ncreating, 156–160\ndefined, 38–39\ndelta-derived, 151–155\ndiscrepancies between valuation and, \n160–162\nfor ITM options, 57–58\nfor long calls, 189\nfor long diagonals, 235\nfor long puts, 201\nfor long strangles, 205\noverlaying valuation range on, 160\nfor protective puts, 248, 249\nfor put options, 54–55\nfor short diagonals, 238\nfor short puts, 212, 216, 217\nfor short straddles, 230\nfor short strangles, 231\nfor short-call spreads, 220\nwith simultaneous changes in variables, \n68–74\nand time-to-expiration assumptions, \n64–67\nand volatility assumptions, \n60–64\nBSM model (see Black-Scholes-Merton \n(BSM) model)\nBubbles, 42–43\nBuffett, Warren, xv, 184–185\nBuying options (see Exposure-gaining \nstrategies)\nBuy-side structural impediments, \n132–136\nIndex   • 307\nC\nCAGR (compound annual growth \nrate), 46\nCall options (calls):\nBSM cone for, 50–55\nbuying, for growth, 22\ncovered, 240–248\ndefined, 11\ndelta for, 151\ndividend arbitrage with, 292–293\nleverage with, 167–168\non quotes, 145\nshort, 14, 221\ntailoring exposure with, 24\nvisual representation of, 12–16\nand volatility, 68–74\n(See also Covered calls; Long calls; \nShort-call spreads)\nCapital:\ninvestment, 183–184\nstrategic vs. working, 297n1 \n(Chapter 4)\nCapital asset pricing model (CAPM), \n88, 298n4\nCapital expense, 80\nCareer risk, 263\nCash, hedge size and, 257\nCash flows:\non behalf of owners, 80–82\nexpansionary, 82, 104–108 \nin golden rule of valuation, 77\npresent value of future, 87–89\nsumming, from different time periods, \n87–89\n(See also Free cash flow to owners \n[FCFO])\n“Catalysts, ” 137\nCBOE (see Chicago Board Options \nExchange)\nCentral counterparties, 8\nChange (option quotes), 146–147\nChanos, Jim, 202\nChicago Board Options Exchange \n(CBOE), 4, 8, 47\nChicago Mercantile Exchange, 8\nChina, joint ventures in, 84\nCisco Systems, 299n6 (Chapter 5)\nCloset indexing, 133\nClosing prices:\nchange in, 146–147\ndefined, 146\nCollars, 258–262\nCommitment, counterparties’ , 211\nCommodities, options on, 6–7\nCompanies:\nwith bimodal outcomes, \n277–278\ndrivers of value for (see Value \ndrivers)\neconomic life of, 82–86, 93–94\neconomic value of, 137–139\noperational details of, xiii–xiv, \n110–111\nComplex investment strategies, 142\nCompound annual growth rate \n(CAGR), 46\nCondors, 27–28\nConfidence, accuracy vs., 119–121\nContingent loans, call options as, \n167–168\nContract size, 146\nCounterparties:\ncentral, 8\ncommitments of, 211\nfor options contracts, 295n1 \n(Chapter 1)\nCounterparty risk, 7–8\nCovered calls, 23, 240–248, \n301n4\nabout, 241–242\nBSM cone, 240–244\nexecution of, 242–245\npitfalls with, 245–248\nwith protective puts, 259–262\nCovering positions, 219, 228\nCremers, Martijn, 133\nC-system, 115–118\nCustomer “flow, ” 299n5 (Chapter 6)\n308  •   Index\nd\nDebt, investment leverage from, 165–166\nDell, 101\nDelta, 151–155, 300n1 (Chapter 8)\nDemand-side constraints, 84–86\nDepreciation, 282–284\nDiagonals, 233\nlong, 235–237\nshort, 238–240\nDirectionality of options, 9–20\ncalls, 12–16\nand exposure, 18–20\nimportance of, 27–28\nputs, 16–18\nand stock, 10–11\nvolatility and predications about, \n68–74\nDiscount rate, 87–89, 298n5\nDispersion, 302n1 (Chapter 11)\nDistribution of returns:\nfat-tailed, 45\nleptokurtic, 45\nlognormal, 36–37\nnormal, 32, 36, 40, 43–45\nDividend arbitrage, 223, 288–293\nDividend yield, 67\nDividend-paying stocks, prices of, \n35–36\nDividends, 86\nDownturns, short puts during, 214–215\nDrift:\nassumptions about, 32, 35–36\neffects of, 67\nand long calls, 202–203\nand long puts, 191\nand long strangles, 206\nDrivers of value (see Value drivers)\ne\nEarly exercise, 223\nEarnings before interest, taxes, \ndepreciation, and amortization \n(EBITDA), 99\nEarnings before interest and taxes \n(EBIT), 99\nEarnings per share (EPS), 99\nEarnings seasons:\nand tenor of short puts, 217–218\nvolatility in, 301n5\nEBIT (earnings before interest and \ntaxes), 99\nEBITDA (earnings before interest, \ntaxes, depreciation, and \namortization), 99\nEBP (see Effective buy price)\nEconomic environment, profitability \nand, 101\nEconomic life of companies:\nand golden rule of valuation, \n82–86\nimproving valuations by \nunderstanding, 93–94\nEconomic value of companies, \n137–139\nEffective buy price (EBP), 24–25, \n213, 244\nEffective sell price (ESP), 25–26\nEfficacy (see Investing level and \nefficacy)\nEfficient market hypothesis (EMH), \n33, 34, 40–43\nEndowments, 135, 136\nEnron, 110\nEPS (earnings per share), 99\nESP (effective sell price), 25–26\nEuropean-style options, 296n2 \n(Chapter 1)\nExchange-traded funds (ETFs), \noptions on, 251–252\nExecution of option overlay strategies:\ncollars, 259–262\ncovered calls, 242–245\nprotective puts, 250–252\nExercising options, 13, \n296n2 (Chapter 1)\nExpansionary cash flows, 82, 104–108\nIndex   • 309\nExpiration of options, 187\nExplicit forecast stage, 93–96\nExposure:\naccepting, 14, 18–20\ncanceling out, 18–20\ngaining, 13, 18–20\nnotional, 173\ntailoring level of, 24\n(See also Ranges of exposure)\nExposure-accepting strategies, \n211–2", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 98}
{"text": "tegies:\ncollars, 259–262\ncovered calls, 242–245\nprotective puts, 250–252\nExercising options, 13, \n296n2 (Chapter 1)\nExpansionary cash flows, 82, 104–108\nIndex   • 309\nExpiration of options, 187\nExplicit forecast stage, 93–96\nExposure:\naccepting, 14, 18–20\ncanceling out, 18–20\ngaining, 13, 18–20\nnotional, 173\ntailoring level of, 24\n(See also Ranges of exposure)\nExposure-accepting strategies, \n211–232\nmargin requirements for, 211–212\nshort call, 220–230\nshort put, 212–220\nshort straddle, 230–232\nshort strangle, 231–232\nExposure-gaining strategies, 187–209\nand expiration of options, 187\nlong call, 189–201\nlong put, 201–205\nstraddle, 208–209\nstrangle, 205–207\nExposure-mixing strategies, 233–262\ncollar, 258–262\ncovered call, 240–248\nlong diagonal, 235–237\nand OTM vs. ATM options, 233–234\nprotective put, 248–258\nshort diagonal, 238–240\nExxon, 299n4 (Chapter 5)\nF\nFalse precision, 93, 96–97\nFama, Eugene, 42\nFat-tailed distribution, 45\nFCFO (see Free cash flow to owners)\n“Fight or flight” response, 118\nFinancial crises, 302n2 (Chapter 11)\nFinancial leverage:\ndefined, 285–286\ninvestment vs., 164\nand level of investment leverage, \n197–199\nFinancial statements, xv\nFlexibility (with option investing), 20–28\nFloat, 185\nFord, 103, 272\nForward prices:\nadding ranges to, 36–39\ncalculating, 34–36\ndefined, 35–36\nranges of exposure and, 50–56\nForward volatility:\nchoosing forward volatility number, \n156–160\ndefined, 59–61\nand strike–stock price ratio, 67–74\nFree cash flow to owners (FCFO):\ndefined, 82\nand drivers of value, 111–112\nin joint ventures, 84\nand supply-side constraints, 83\nFront-month contracts, 270\nFungible assets, 272–273\nG\nGains, levered vs. unlevered, 165\nGaussian distribution (see Normal \ndistribution)\nGDP (gross domestic product), \n104–108\nGillette Razors, 84\nGM, 272\nGoals, for hedges, 257\n“Going long, ” 10, 21\n“Going short, ” 21\nGolden rule of valuation, 77–89\ncash flows generated on behalf of \nowners in, 80–82\nand definition of assets, 78–80\nand drivers of value, 91–92\nand economic life of company, 82–86\nand summing cash flows from \ndifferent time periods, 87–89\nGoogle, 84, 127–130, 190\n“Greeks, ” xiv, 295n3\n310  •   Index\nGross domestic product (GDP), 104–108\nGrowth:\nbuying call options for, 22\nnominal GDP , 104–108\nrevenue, 92, 97–99\nstructural growth stage, 94, 95\nH\nHedge funds, 132–134, 136\nHedge funds of funds (HFoF), 134\nHedges:\nreinvesting profit from, 254–255\nsize of, 255–258\ntiming of, 252–254\nHedging:\nplanning for, 255–258\nfor portfolios, 251–252\nHerding, 138, 299n1\nHFoF (hedge funds of funds), 134\nHistorical volatility, 60\nHostile takeovers, 110\nThe Human Face of Big Data (Rick \nSmolan), 114\nI\nIBM, 224–230, 299n5 (Chapter 5), \n301n6\nIdiosyncratic assets, 272\nImmediate realized loss (IRL), 180, 183\nImplied volatility:\nbid/ask, 149–151\nchanging assumptions about, 60–64\nand short puts, 216–217\nIncome, selling put options for, 23\nIndexing, closet, 133\nInsurance, 5, 250\nInsurance companies, 135, 136\nIntel, 175\nInterchangeable assets, 272–273\nInterest:\ncalculating, 303n2\noptions and payment on, 168\nprepaid, 170\nInterest rates, 67\nIn-the-money (ITM) options:\ncalls vs. puts, 27\ncovered calls, 242\ndefined, 13, 16, 17\ninvestment leverage for, 170–172\nlevered strategy with, 176–180\nlong calls, 189, 193–197\nlong diagonals, 236\nlong puts, 204\nmanaging leverage with, 183–184\nand market risk, 263–264\npricing of, 56–59, 150\nprotective puts, 249–251\nshort puts, 213–215\nshort-call spread, 222, 223\ntime decay for, 66–67\nIntrinsic value, 56–59, 171\nInvesting level and efficacy, 92, \n103–108\nInvestment capital, leverage and, \n183–184\nInvestment leverage, 163–185\nfrom debt, 165–166\ndefined, 164\nmanaging, 183–185\nmargin of safety for, 197–199\nmeasuring, 169–173\nfrom options, 166–168\nand portfolio management, \n196–197\nin portfolios, 174–183\nunlevered investments, 164–165\nInvestment phase (investment stage), \n86, 93–96\nInvestors:\nactivist, 110\nrisk-averse, 123, 125–127\nrisk-neutral, 124–126\nrisk-seeking, 123, 125–127\nIRL (immediate realized loss), \n180, 183\nITM (see In-the-money options)\nIndex   • 311\nJ\nJaguar, 103\nJoint ventures (JVs), 84–85\nJP Morgan Chase, 236–237\nK\nKahneman, Daniel, 42, 123, 126\nKeen, Steven, 43\nKeynes, John Maynard, 263\nKroger, 100\nK/S (see Strike–stock price ratio)\nL\nLambda, 169–173\nLarge numbers, law of, 85, 297n2 \n(Chapter 4)\nLast (option quotes), 146\nLEAPS (see Long-term equity \nanticipated securities)\nLegs (option structure), 27\nLehman Brothers, 264\nLenovo, 299n5 (Chapter 5)\nLeptokurtic distribution, 45\nLeverage, 163, 282–286\nfinancial, 164, 197–199, 285–286\noperating (operational), 101, \n197–199, 282–284\n(See also Investment leverage)\nLeverage ratio, 228–229\nLevered investments, portfolios with, \n176–183\nLiabilities, hidden, 110–111\nLife insurance companies, 135\nLiquidity risk, 256, 263\nListed look-alike option market, 6\nLiterary work, options on, 5–6\nLo, Andrew, 42\nLoad, 132, 134\nLoans, call options as, \n167–168\nLognormal curve, 37\nLognormal distribution, \n36–37\nLong calls, 13, 189–201\nabout, 189\nBSM cone, 189\nin long diagonals, 235–237\nportfolio management with, \n196–201\nstrike price for, 192–196\ntenor for, 190–192\nLong diagonals, 235–237\nLong puts, 201–205\nabout, 201–202\nBSM cone, 201\nportfolio management with, \n204–205\nin short diagonals, 238–240\nstrike price for, 203\ntenor for, 202–203\nLong straddles, 208–209\nLong strangles, 26–27, 205–207, 209\nLong-term equity anticipated \nsecurities (LEAPS), 153, 191, \n280–281\nLoss leverage:\nconventions for, 182–183\nformula, 178–179\nwith short puts, 211–212\nLosses:\nwith levered vs. unlevered \ninstruments, 165–166\nlocking in, 245–247\non range of exposure, 15\nunrealized, 175–176\n(See also Realized losses)\nM\nMacKinlay, Craig, 42\nMargin calls, 168\nMargin of safety, 197–199\nMargin requirements, 211–212\nMarket conditions, 59–74\nassumptions about drift and \ndividend yield, 67\nsimultaneous changes in, 67–74\n312  •   Index\nMarket conditions (continued)\ntime-to-expiration assumptions, 64–67\nand types of volatility, 59–60\nvolatility assumptions, 6", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 99}
{"text": "exposure, 15\nunrealized, 175–176\n(See also Realized losses)\nM\nMacKinlay, Craig, 42\nMargin calls, 168\nMargin of safety, 197–199\nMargin requirements, 211–212\nMarket conditions, 59–74\nassumptions about drift and \ndividend yield, 67\nsimultaneous changes in, 67–74\n312  •   Index\nMarket conditions (continued)\ntime-to-expiration assumptions, 64–67\nand types of volatility, 59–60\nvolatility assumptions, 60–64\nMarket efficiency, 32–34, 40–43\nMarket makers, 147, 281\nMarket risk, 263–265\nMatching, 302n1 (Appendix B)\nMaximum return, 225\nMergers and acquisitions:\nstrike prices selection and, 195–196\ntenor and, 191–192\nMerton, Robert, 8–9\nMiletus, 6–7\nMispriced assets, 274–277\nMispriced options, 143–162\ndeltas of, 151–155\nreading option quotes, 144–151\nand valuation risk, 266\nand valuation vs. BSM range, 155–162\nMoneyness of options:\ncalls, 13–14\nputs, 16–17\nMorningstar, 132\nMost likely (term), 38\nMotorola Mobility Systems, 84\nMueller Water, 148–149, 154, 158–160\nMultiples-based valuation, 99–100\nMutual funds, 132–133, 136\nn\nNominal GDP growth:\nowners’ cash profit vs., 104–108\nas structural constraint, 104\nNormal distribution, 32, 36, 40, 43–45\nNotional amount of position, 173\nNotional exposure, 173\nO\nOCC (Options Clearing \nCorporation), 8\nOCP (see Owners’ cash profit)\nOperating assets, 110\nOperating leverage (operational \nleverage):\ndefined, 282–284\nand level of investment leverage, \n197–199\nand profitability, 101\nOperational details of companies, \nxiii–xiv, 110–111\nOption investing:\nchoices in, 22–24\nconditions favoring BSM, 269–273\nconditions not favoring BSM, 273–281\nflexibility in, 20–28\nlong-term strategies, 1\nmisconceptions about, 1\nrisk in, 268\nshortcuts for valuation in, 93–97\nstock vs., 21–22\nstrategies for, 142 (See also specific \ntypes of strategies)\nstructural impediments in, 131–139\nthree-step process, xiv\nvaluation in, 75\nOption pricing, 29–47, 49–74\nand base assumptions of BSM, 40–47\nmarket conditions in, 59–74\npredicting future stock prices from, \n32–39\nand ranges of exposure, 50–56\ntheory of, 30–32\ntime vs. intrinsic value in, 56–59\nOption pricing models:\nbase assumptions of, 40–47\nhistory of, 8–9\noperational details of companies in, \nxiii–xiv\npredicting future stock prices with, \n32–39\nranges of exposure and price \npredictions from, 50–56\n(See also Black-Scholes-Merton \n[BSM] model)\nOption quotes, 144–151\nIndex   • 313\nOptionality, 4\nOptions, 3–28\nbuying (see Exposure-gaining \nstrategies)\ncharacteristics of, 4\ndefined, 4\ndirectionality of, 9–20\nexamples of, 5–6\nexpiration of, 187\nhistory of, 6–9\ninvestment leverage from, 166–168\nmisconceptions about, 1\nmispriced, 143–162\n(See also specific types)\nOptions Clearing Corporation (OCC), 8\nOptions contracts:\ncounterparties for, 295n1 (Chapter 1)\nexamples of, 5–6\nfront-month, 270\nprivate, 6–8\nOracle, 107–108, 144, 146, 148–153, \n155, 157, 159–162\nOrganic revenue growth, 97\nOut-of-the-money (OTM) options:\nATM options vs., 233–234\ncall vs. put, 27\ncollars, 258–262\ndefined, 13, 16, 17\ninvestment leverage for, 171–172\nlevered strategy with, 180, 181\nlong calls, 193, 195–197\nlong diagonals, 235–237\nlong puts, 203, 204\nlong strangles, 205–207\nand market makers, 147\npricing of, 150\nprotective puts, 248, 250–253\nrealized losses and, 187\nrising volatility and, 70–74\nshort diagonals, 238–240\nshort puts, 213, 215\nshort strangles, 231\nshort-call spreads, 221–224\ntime decay for, 66–67\nunrealized losses, 187\nOverconfidence, 118–122\nOverexposure, 247\nOverlays, 23, 234\nOwners:\ncash flows generated on behalf of, \n80–82\nfree cash flow to (see Free cash flow \nto owners (FCFO))\nOwners’ cash profit (OCP):\ndefined, 82\nnominal GDP growth vs., 104–108\nprofitability as, 99–102\nP\nParity, 288\nPattern recognition, 114–118\nPeaks (business-cycle):\noperational leverage in, 284\nand troughs, 302–303n2\nPension funds, 135, 136\nPercent delta, 169–173\nPercent profit, 172–173\nPercentage return, 229\nPortfolio management:\nfor long calls, 196–201\nfor long puts, 204–205\nfor long strangles, 207\nfor short puts, 216–220\nfor short-call spreads, 228–230\nPortfolios:\nhedging, 251–252\ninvestment leverage in, 174–183\nPrecision, false, 93, 96–97\nPremium, 13\nPrepaid interest, 170\nPresent value of future cash flows, 87–89\nPricing power, 98\nPrincipal (financial), 168\nPrincipals, agents vs., 131–132\nProblem solving, X- vs. C-system, \n115–118\n314  •   Index\nProcter & Gamble, 84\nProductivity, 102\nProfit:\nfrom covered calls, 245\nfrom hedging, 254–255\nowners’ cash, 82\npercent, 172–173\nProfit leverage, 179–180, 182–183\nProfitability:\nand financial leverage, 285–286\nand operational leverage, \n283–284\nas value driver, 92, 99–102\nProprietary trading desks (prop \ntraders), 300n5\nProspect theory, 123–127\nProtective puts, 248–258\nabout, 248–250\nBSM cone, 248, 249\nwith covered calls, 259–262\nexecution of, 250–252\npitfalls with, 252–258\nPure Digital, 299n6 (Chapter 5)\nPut options (puts):\nBSM cone for, 54–55\nbuying, for protection, 23\ndefined, 11\ndelta for, 151\non quotes, 145\nselling, for income, 23\ntailoring exposure with, 24\nvisual representation of, 16–18\n(See also Long puts; Protective puts; \nShort puts)\nPut-call parity, 223, 287–293\ndefined, 287–288\nand dividend arbitrage, 288–293\nfor non-dividend-paying stock, \n289–290\nQ\nQualcomm, 260–262\nQuotes, option, 144–151\nR\nRandom-walk principal, 41\nRanges of exposure, 3\nfor call options, 12–13, 15\nfor ITM options, 58–59\nand option pricing, 50–56\nRankine, Graeme, 41–42\nRatioing, 206, 238\nRealized losses:\nand buying puts, 203\nimmediate, 180, 183\nmanaging leverage to minimize, \n183–185\nand option buying, 187–188\nunrealized vs., 175–176\nRecessions, leverage during, 198, 199\nReflective thought processes, 116–118\nReflexive thought processes, 116–118\nReturn(s):\nabsolute dollar value of, 172–173\nfor covered calls, 244–245\nmaximum, 225\npercentage, 229\nfor short puts, 245\n(See also Distribution of returns)\nRevenue growth, 92, 97–99\nRisk, 263–268\ncareer, 263\ncounterparty, 7–8\nliquidity, 256, 263\nmarket, 263–265\nin option investing, 267–268\nperception of, 123–130\nand size", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 100}
{"text": "9\nReflective thought processes, 116–118\nReflexive thought processes, 116–118\nReturn(s):\nabsolute dollar value of, 172–173\nfor covered calls, 244–245\nmaximum, 225\npercentage, 229\nfor short puts, 245\n(See also Distribution of returns)\nRevenue growth, 92, 97–99\nRisk, 263–268\ncareer, 263\ncounterparty, 7–8\nliquidity, 256, 263\nmarket, 263–265\nin option investing, 267–268\nperception of, 123–130\nand size of hedges, 255–256\nsolvency, 256, 263\nvaluation, 265–267\nRisk-averse investors, 123, 125–127\nRisk-free rate:\nborrowing at, 32, 40, 46\nBSM model assumption about, 32, \n35–36, 40, 45–46\nRisk-neutral investors, 124–126\nRisk-seeking investors, 123, 125–127\nIndex   • 315\nRolling, 200–201\nRound-tripping, 148–149, 300n1 \n(Chapter 7)\nS\nSafeway, 100\nSchiller, Robert, 43\nScholes, Myron, 8–9\nSecular downturns, 302n2 (Chapter 11)\nSecular shifts, profitability and, \n101–102\nSell-side structural impediments, \n136–137\nSettlement prices, 146\nShiller, Robert, 42\nShort calls, 14, 221\nShort diagonal, 238–240\nShort puts, 211–220\nabout, 213–214\nBSM cone, 212\ncovered calls and, 241–244\nin long diagonals, 235–237\nloss leverage with, 211–212\nportfolio management with, 216–220\nprotective puts vs., 248–250\nreturns for, 245\nstrike price for, 215\ntenor for, 214–215\nShort straddles, 230–232\nShort strangles, 231–232\nShort-call spreads, 220–230\nabout, 221–222\nBSM cone, 220\nportfolio management with, \n228–230\nin short diagonals, 238–240\nstrike price for, 222–228\ntenor for, 222\nShort-term trading strategies:\nimplied volatility in, 63–64\nintelligent investing vs., 267–268\nand market risk, 264–265\nSlovic, Paul, 119\nSmolan, Rick, 114\nSolvency risk, 256, 263\nS&P 500 (see Standard & Poor’s 500 \nIndex)\nSpecial-purpose vehicles, 110\nSpreads:\nbid-ask, 147–149\nshort-call (see Short-call spreads)\nSPX ETF , 251–252\nStandard & Poor’s 500 Index (S&P \n500):\ncorrelation of hedge funds and, 134\ndistribution of returns, 44–46\nprotective puts on, 252–254\nStartup stage, 86\nStatistical volatility, 60\nStock investing, xiii\nchoices in, 20–22\nvisual representation of, 10–11\nStock prices:\nBSM model assumption about, 32, \n34–35, 40–47\ndirectional predictions of, 68–74\nof dividend-paying stocks, 35–36\npredicting, with BSM model, 32–39\n(See also Forward prices; strike–\nstock price ratio [K/S])\nStock-split effect, 42\nStop loss, 229\nStraddles:\nlong, 208–209\nshort, 230–232\nStraight-line depreciation, 283\nStrangles:\nlong, 26–27, 205–207, 209\nshort, 231–232\nStrategic capital, 297n1 (Chapter 4)\nStrike prices:\nand BSM cone, 52–54\ndefined, 12\nlong call, 192–196\nlong diagonal, 236–237\nlong put, 203\n316  •   Index\nStrike prices: (continued )\nlong strangle, 206–207\nshort diagonal, 239–240\nshort put, 215\nshort-call spread, 222–228\nStrike–stock price ratio (K/S):\nand change in closing price, \n146–147\ndefined, 53–54\nand forward volatility, 67–74\nStructural constraints, 86, 104\nStructural downturns, 302n2 \n(Chapter 11)\nStructural growth stage, 94, 95\nStructural impediments, 131–139\nbuy-side, 132–136\nand investment strategies, \n137–139\nprincipals vs. agents, 131–132\nsell-side, 136–137\nSun Microsystems, 108\nSupply-side constraints, 83\nSymmetry, bias associated with, \n114–118\nT\n“Taking profit” with covered calls, 245\nTaxes, BSM model assumption about, \n32, 40, 46\nTechnical analysis, 115\nTenor, 297n3 (Chapter 3)\ndefined, 59\nfor long calls, 190–192\nfor long puts, 202–203\nfor long strangles, 206\nfor protective puts, 252–254\nfor short puts, 214–215\nfor short-call spreads, 222\nTerminal phase, 86\nTime decay, 65–67\nTime horizons:\nlong, 279–281\nshort, 270–272\nTime value:\nintrinsic vs., 56–59\nof money, 87, 93–95\nTime Warner, 103\nTime-to-expiration assumptions, \n64–67\nToyota, 97\nTrading restrictions, 32, 40, 46\nTroughs (business-cycle):\noperational leverage in, 283–284\nand peaks, 302–303n2\nTversky, Amos, 123, 126\n“2-and-20” arrangements, 134\nU\nUncertainty, 118–119\nUnderexposure, 247\nUnderlying assets:\nfungible, 272–273\nand future stock price, 33–34\nUniversity of Chicago, 41\nUnlevered investments:\nlevered vs., 164–165\nin portfolios, 175–176, 178\nUnrealized losses, 175–176\nUnrealized profit, 254–255\nUnused leg, long strangle, 207\nU.S. Treasury bonds, 45–46\nUtility curves, 124–126\nV\nValuation:\ngolden rule of, 77–89\nmultiples-based, 99–100\nshortcuts for, 93–97\nvalue drivers in, 91–97\nValuation range:\nBSM cone vs., 160–162\ncreating, 122\nand margins of safety, 197–199\noverlaying BSM cone with, 160\nand strike price selection, 192–194\nValuation risk, 265–267\nIndex   • 317\nValue:\nof companies, 137–139\nintrinsic, 56–59, 171\ntime, 56–59, 87, 93–95\nValue drivers, 91–112\nbalance-sheet effects, 108–111\ninvesting level and efficacy, 103–108\nprofitability, 99–103\nrevenue growth, 97–99\nin valuation process, 91–97\nValue investing, 79\nVolatility (vol.):\namplifying directional predictions \nwith, 71–74\nchanging assumptions about, 60–64\nin earnings season, 301n5\nfailing to offset directional \npredictions with, 70–71\nhistorical, 60\noffsetting directional predictions \nwith, 68–70\nstatistical, 60\ntypes of, 59–60\n(See also Forward volatility; Implied \nvolatility)\nVolatility smile, 45, 150, 152\nW\nWalmart, 105–108\nWhole Foods Market, 100, 101\nWorking capital, 297n1 \n(Chapter 4)\nWriting options, 215, 301n3\nx\nX-system, 115–118\nThis page intentionally left blank \nABOUT THE AUTHOR \nerik Kobayashi-Solomon, a veteran from the investment banking and \nhedge fund world, is the founder and principal of IOI, LLC a financial \nconsultancy for individual and institutional investors. In addition to \npublishing an institutional investor-focused subscription product, Erik \nruns option and investment “boot camps” and consults on risk control, \noption strategies, and stock valuations for individual and institutional \ninvestors. \nBefore starting IOI, Erik worked for Morningstar in its stock research \ndepartment for over six years. At Morningstar, he first managed a team of \nsemiconductor industry analysts before becoming the coeditor and driv-\ning force of Morningstar’s OptionInvestor newsletter and serving as the \ncompany’s Mar", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 101}
{"text": "control, \noption strategies, and stock valuations for individual and institutional \ninvestors. \nBefore starting IOI, Erik worked for Morningstar in its stock research \ndepartment for over six years. At Morningstar, he first managed a team of \nsemiconductor industry analysts before becoming the coeditor and driv-\ning force of Morningstar’s OptionInvestor newsletter and serving as the \ncompany’s Market Strategist. \nIn addition to coauthoring a guide to fundamental investing and \noption strategies used in the Morningstar Investor Training Options \nCourse and popular weekly articles about using options as a tool for in-\nvestment portfolios, Erik was the host of several popular webinars such as \n“Covered Calls A to Z” and “Hedging 101. ” His video lecture about avoid-\ning behavioral and structural pitfalls called “Making Better Investment \nDecisions” was so popular that he was invited to be the featured speaker at \nseveral investment conferences throughout the United States. In addition, \nhe represented Morningstar on television and radio, was interviewed by \nmagazines and newspapers from Dallas to Tokyo to New Delhi, and was \na frequent guest contributor to other Morningstar/Ibbotson publications.\nErik started his career in the world of finance at Morgan Stanley \nJapan, where he ultimately headed Morgan’s listed derivatives operations \nin Tokyo. After returning to the United States, Erik founded a small hedge \nfund based on his original research in the field of Behavioral Finance and \nlater became the Risk Manager for a larger investment fund. There, he de-\nsigned option hedges for the fund’s $800 million global equity portfolio \nand advised the portfolio manager on quantitative investment strategies \nand Japanese stock market investments.\nErik, the son of a NASA scientist father and a concert violin-\nist mother, graduated Magna Cum Laude and Phi Beta Kappa from the \nUniversity of Texas at Austin, where he majored in Asian Studies and \nJapanese. After working in Japan for several years as a teacher, translator, \nand television actor, he won a full-ride scholarship to study business at \nthe number one ranked school for international business in the United \nStates—Thunderbird—in Glendale, Arizona. There, he worked as a research \nassistant to Dr. Anant Sundaram (Finance, presently at Dartmouth) from \nwhom he gained a love for finance and economics, Dr. Graeme Rankine \n(Accounting) who introduced him to Behavioral Finance, and Dr. Charles \nNeilson (Marketing) who taught him the importance of strategic thinking. \nErik graduated Summa Cum Laude and was selected as the outstanding \nstudent of his graduating class.\nErik lives in Chicago, Illinois with his family and enjoys long distance \nrunning and reading. In his spare time, he volunteers at the local Japanese \nschool to teach children Kendo—the Japanese art of swordsmanship.", "source": "eBooks\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options\\Erik Kobayashi-Solomon - The Intelligent Option Investor- Applying Value Investing to the World of Options.pdf", "doc_id": "9efde802c22b9167d882e1c5ef844de3f4acf48955a91059268f6ddf8d07f8b1", "chunk_index": 102}
{"text": "NUIF \nNEW YORK INSTITUTE OF FINANCE \nNEW YORK • TORONTO • SYDNEY • TOKYO • SINGAPORE \nNEW YORK INSTITUTE OF FINANCE \nNYIF and New York Institute of Finance ar; trademarks of Executive Tax Reports, Inc., \nused under license by Penguin Putnam Inc. \nThis publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with \nthe understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or \nother expert assistance is required, the services of a competent professional person should be sought. \n-From a Declaratlon of Principles jointly adapted by a Committee of the American Bar Association and a Committee of Publishers \nand Associations. \nCopyright © 2002 by Penguin Putnam Inc, \nPrentice Hall® is a registered trademark of Pearson Education, Inc. \nAll rights reserved. No part of this book may be reproduced in any form or by any means, without per\nmission in writing from the publisher. \nLibrary of Congress Cataloging-in-Publication Data \nMcMillan, L. G. (Lawrence G.) \nOptions as a strategic investment/ Lawrence G. McMillan. - 4th ed. \np.cm. \nIncludes index. \nISBN 0-7352-0197-8 (cloth) \n1. Options (Finance) I. Title. \nHG6042.M35 2001 \n332.63'228-dc21 \nAssociate Publisher: Ellen Schneid Coleman \nProduction Editor: Mariann Hutlak \nInterior Design/Formatting: Inkwell Publishing Services \nPrinted in the United States of America \n10 9 8 7 6 5 4 3 \nISBN 0-7352-0197-8 \n00-053319 \nMost NYIF and New York Institute of Finance books are available at special quantity discounts for \nbulk purchases for sales promotions, premiums, fund-raising, or educational use. Special books, or \nbook excerpts, can also be created to fit specific needs. \nFor details, write: Special Markets, Penguin Putnam Inc., 375 Hudson Street, New York, New York \n10014. \nContents \nPreface .......................................................... xv \nPart I \nBASIC PROPERTIES OF STOCK OPTIONS \nChapter 1 \nDefinitions ................................................. 3 \nElementary Definitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 \nFactors Influencing the Price of an Option .... ........................... 9 \nExercise and Assignment: The Mechanics ............................... 15 \nThe Option Markets . ............................................... 22 \nOption Symbology . ................................................ 23 \nDetails of Option Trading ........................................... 27 \nOrder Entry . ..................................................... 32 \nProfits and Profit Graphs ........................................... 34 \nPart II \nCALL OPTION STRATEGIES \nChapter2 \nCovered Call Writing . ....................................... 39 \nThe Importance of Covered Call Writing ............................... 39 \nCovered Writing Philosophy ......................................... 42 \nThe Total Return Concept of Covered Writing ........................... 45 \nComputing Return-on Investment ..................................... 47 \niii \niv Contents \nExecution of the Covered Write Order ................................. 56 \nSelecting a Covered Writing Position . .................................. 58 \nWriting against Stock Already Owned . ................................. 62 \nDiversifying Return and Protection in a Covered Write .................... 66 \nFollow-Up Action ........ .......................................... 70 \nSpecial Writing Situations ........................................... 87 \nCovered Call Writing Summary ...................................... 93 \nChapter3 \nCall Buying . ............................................... 95 \nWhy Buy? ....................................................... 95 \nRisk and Reward for the Call Buyer ................................... 97 \nWhich Option to Buy? .............. ............................... 101 \nAdvanced Selection Criteria ........................................ 103 \nFollow-Up Action ............... .................................. 107 \nA Further Comment on Spreads ..................................... 117 \nChapter4 \nOther Call Buying Strategies ................................ 118 \nThe Protected Short Sale (or Synthetic Put) ............................ 118 \nFollow-Up Action . ................................................ 122 \nThe Reverse Hedge (Simulated Straddle) ...... ......................... 123 \nFollow-Up Action ...... ........................................... 126 \nAltering the Ratio of Long Calls to Short Stock . ......................... 128 \nSummary . ...................................................... 131 \nChapter 5 \nNaked Call Writing ........................................ 132 \nThe Uncovered (Naked) Call Option .... .............................. 133 \nInvestment Required ............ .................................. 135 \nThe Philosophy of Selling Naked Options .............................. 137 \nRisk and Reward ................................................. 138 \nSummary ....................................................... 144 \nChapter 6 \nRatio Call Writing ......................................... 146 \nThe Ratio Write .................................................. 146 \nInvestment Required .... ..................... _ ..................... 150 \nContents V \nSelection Criteria . ................................................ 151 \nThe Variable Ratio Write . .......................................... 155 \nFollow-Up Action . ................................................ 158 \nAn Introduction to Call Spread Strategies .. ............................ 168 \nChapter7 \nBull Spreads .............................................. 172 \nDegrees of Aggressiveness .......................................... 175 \nRanking Bull Spreads ............................................. 176 \nFollow-Up Action . ................................................ 179 \nOther Uses of Bul", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 0}
{"text": ".... 158 \nAn Introduction to Call Spread Strategies .. ............................ 168 \nChapter7 \nBull Spreads .............................................. 172 \nDegrees of Aggressiveness .......................................... 175 \nRanking Bull Spreads ............................................. 176 \nFollow-Up Action . ................................................ 179 \nOther Uses of Bull Spreads ......................................... 180 \nSummary .... ................................................... 185 \nChapter 8 \nBear Spreads Using Call Options ............................ 186 \nThe Bear Spread ................................................. 186 \nSelecting a Bear Spread ... ......................................... 189 \nFollow-Up Action . ................................................ 190 \nSummary ......... .............................................. 190 \nChapter9 \nCalendar Spreads .......................................... 191 \nThe Neutral Calendar Spread ..... .................................. 192 \nFollow-Up Action . ................................................ 194 \nThe Bullish Calendar Spread ... ..................................... 196 \nFollow-Up Action ........ ......................................... 197 \nUsing All Three Expiration Series .................................... 198 \nSummary . ...................................................... 199 \nChapter 10 \nThe Butterfly Spread ....................................... 200 \nSelecting the Spread . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203 \nFollow-Up Action ... .............................................. 206 \nSummary ....................................................... 209 \nChapter 11 \nRatio Call Spreads ......................................... 210 \nDiffering Philosophies ............................................. 213 \nvi Contents \nFollow-Up Action ..... ............................................ 217 \nSumniary ....................................................... 221 \nChapter 12 \nCombining Calendar and Ratio Spreads ...................... 222 \nRatio Calendar Spread ............................................ 222 \nChoosing the Spread .............................................. 225 \nFollow-Up Action ... .............................................. 226 \nDelta-Neutral Calendar Spreads ....... .............................. 227 \nFollow-Up Action ... .............................................. 229 \nChapter 13 \nReverse Spreads ........................................... 230 \nReverse Calendar Spread . .......................................... 230 \nReverse Ratio Spread (Backspread) . .................................. 232 \nChapter 14 \nDiagonalizing a Spread . .................................... 236 \nThe Diagonal Bull Spread .......................................... 236 \nOwning a Call for \"Free\" ............ ............................... 239 \nDiagonal Backspreads ............................................. 240 \nCall Option Sumniary ............................................. 241 \nPart III \nPUT OPTION STRATEGIES \nChapter 15 \nPut Option Basics . ....................................... ~ \" 245 \nPut Strategies. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 245 \nPricing Put Options ............................................... 247 \nThe Effect of Dividends on Put Option Premiums ........................ 248 \nExercise and Assignment ........................................... 250 \nConversion . ..................................................... 253 \nChapter 16 \nPut Option Buying . ........................................ 256 \nPut Buying versus Short Sale .. ...................................... 256 \nSelecting Which Put to Buy . ........................................ 258 \nContents vii \nRanking Prospective Put Purchases ................................... 261 \nFollow-Up Action . ................................................ 262 \nLoss-Limiting Actions ............................................. 267 \nEquivalent Positions .. ............................................. 270 \nChapter 17 \nPut Buying in Conjunction with Common Stock Ownership ..... 271 \nWhich Put to Buy ................................................ 273 \nTax Considerations ............................................... 275 \nPut Buying As Protection for _the Covered Call Writer .................... 275 \nNo-Cost Collars . ................................................. 278 \nChapter18 \nBuying Puts in Conjunction with Call Purchases ............... 281 \nStraddle Buying . ................................................. 282 \nSelecting a Straddle Buy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 285 \nFollow-Up Action . ................................................ 285 \nBuying a Strangle ................................................ 288 \nChapter 19 \nThe Sale of a Put ..................................... : .... 292 \nThe Uncovered Put Sale . ........................................... 292 \nFollow-Up Action .......... ....................................... 295 \nEvaluating a Naked Put Write . ...................................... 296 \nBuying Stock below Its Market Price . ................................. 299 \nThe Covered Put Sale ............................................. 300 \nRatio Put Writing . ................................................ 300 \nChapter 20 \nThe Sale of a Straddle ...................................... 302 \nThe Covered Straddle Write ........................................ 302 \nThe Uncovered Straddle Write ...................................... 305 \nSelecting a Straddle Write .......................................... 307 \nFollow-Up Action ....... .......................................... 308 \nEquivalent Stock Position Follow-Up . ................................. 312 \nStarting Out with the Protection in Place ..............................", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 1}
{"text": "....................... 302 \nThe Uncovered Straddle Write ...................................... 305 \nSelecting a Straddle Write .......................................... 307 \nFollow-Up Action ....... .......................................... 308 \nEquivalent Stock Position Follow-Up . ................................. 312 \nStarting Out with the Protection in Place .............................. 313 \nStrangle (Combination) Writing ..................................... 315 \nFurther Comments on Uncovered Straddle and Strangle Writing . ........... 318 \nviii Contents \nChapter21 \nSynthetic Stock Positions Created by Puts and Calls ............ 321 \nSynthetic Long Stock . ............................................. 321 \nSynthetic Short Sale . .............................................. 323 \nSplitting the Strikes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 325 \nSummary ....................................................... 328 \nChapter22 \nBasic Put Spreads . ......................................... 329 \nBear Spread . .................................................... 329 \nBull Spread ..................................................... 332 \nCalendar Spread ................................................. 333 \nChapter 23 \nSpreads Combining Calls and Puts . .......................... 336 \nThe Butterfly Spread . ............................................. 336 \nCombining an Option Purchase and a Spread . .......................... 339 \nA Simple Follow-Up Action for Bull or Bear Spreads ..................... 342 \nThree Useful but Complex Strategies . ................................. 345 \nSelecting the Spreads . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 353 \nSummary ........................................................ 356 \nChapter 24 \nRatio Spreads Using Puts ................................... 358 \nThe Ratio Put Spread . ............................................. 358 \nUsing Deltas . .................................................... 361 \nThe Ratio Put Calendar Spread . ..................................... 361 \nA Logical Extension (The Ratio Calendar Combination) .... ............... 364 \nPut Option Summary . ............................................. 366 \nChapter 25 \nLEAPS ................................................... 367 \nThe Basics ...................................................... 368 \nPricing LEAPS . .................................................. 369 \nComparing LEAPS and Short-Term Options ............................ 374 \nLEAPS Strategies . ................................................ 375 \nSpeculative Option Buying with LEAPS ............................... 382 \nSelling LEAPS ................................................... 390 \nContents ix \nSpreads Using LEAPS ............................................. 403 \nSum111ary ....................................................... 409 \nPartIV \nADDITIONAL CONSIDERATIONS \nChapter 26 \nBuying Options and Treasury Bills ........................... 413 \nHow the Treasury Bill/Option Strategy Operates ......................... 413 \nSum111ary ....................................................... 421 \nChapter 27 \nArbitrage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 422 \nBasic Put and Call Arbitrage (\"Discounting\") . .......................... 423 \nDividend Arbitrage ............................................... 425 \nConversions and Reversals . ......................................... 428 \nMore on Carrying Costs ............................................ 430 \nBack to Conversions and Reversals ................................... 431 \nRisks in Conversions and Reversals ................................... 433 \nSum111ary of Conversion Arbitrage ................................... 437 \nThe \"Interest Play\" .... ............................................ 438 \nThe Box Spread .................................................. 439 \nVariations on Equivalence Arbitrage .................................. 443 \nThe Effects of Arbitrage . ........................................... 444 \nRisk Arbitrage Using Options ....................................... 445 \nPairs Trading .................................................... 454 \nFacilitation (Block Positioning) ...................................... 455 \nChapter 28 \nMathematical Applications . ................................. 456 \nThe Black-Scholes Model . .......................................... 456 \nExpected Return ................................................. 466 \nApplying the Calculations to Strategy Decisions ......................... 472 \nFacilitation or Institutional Block Positioning ........................... 482 \nAiding in Follow-Up Action . ........................................ 485 \nImplementation .................................................. 488 \nSum111ary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 489 \nX Contents \nPartV \nINDEX OPTIONS AND FUTURES \nChapter 29 \nIntroduction to Index Option Products and Futures . ............ 493 \nIndices ............................................ : ............ 493 \nCash-Based Options .............................................. 500 \nFutures ........................................................ 506 \nOptions on Index Futures .......................................... 512 \nStandard Options Strategies Using Index Options ........... ............. 516 \nPut-Call Ratio ................................................... 520 \nSummary ....................................................... 523 \nChapter30 \nStock Index Hedging Strategies . ............................. 531 \nMarket Baskets .................................................. 531 \nProgram Trading ................................................. 537 \nIndex Arbitrage .................................................. 547 \nFollow-Up", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 2}
{"text": "...................... 520 \nSummary ....................................................... 523 \nChapter30 \nStock Index Hedging Strategies . ............................. 531 \nMarket Baskets .................................................. 531 \nProgram Trading ................................................. 537 \nIndex Arbitrage .................................................. 547 \nFollow-Up Strategies . ............................................. 557 \nMarket Basket Risk ............................................... 560 \nImpact on the Stock Market . ........................................ 561 \nSimulating an Index . .............................................. 566 \nTrading the Tracking Error .... ..................................... 574 \nSummary ....................................................... 577 \nChapter31 \nIndex Spreading ........................................... 579 \nInter-Index Spreading .. ........................................... 579 \nSummary ....................................................... 588 \nChapter32 \nStructured Products ........................................ 589 \nPart I: \"Riskless\" Ownership of a Stock or Index ........................ 590 \nThe \"Structure\" of a Structured Product . .............................. 590 \nCash Value . ..................................................... 593 \nThe Cost of the Imbedded Call Option ................................ 594 \nPrice Behavior Prior to Maturity . .................................... 595 \nSIS ............................................................ 596 \nContents xi \nComputing the Value of the Imhedded Call When the Underlying \nIs Trading at a Discount ......................................... 602 \nThe Adjustment Factor ............................................ 602 \nOther Constructs ................................................. 607 \nOption Strategies Involving Structured Products ........................ 613 \nLists of Structured Products ........................................ 618 \nPart II: Products Designed to Provide \"Income\" ......................... 618 \nPERCS ......................................................... 618 \nCall Feature . .................................................... 620 \nA PERCS Is a Covered Call Write .................................... 622 \nPrice Behavior . .................................................. 623 \nPERCS Strategies ................................................ 625 \nPERCS Summary ................................................ 636 \nOther Structured Products ......................................... 637 \nStructured Product Summary ....................................... 640 \nChapter33 \nMathematical Considerations for Index Products ............... 641 \nArbitrage ....................................................... 641 \nMathematical Applications ......................................... 644 \nChapter34 \nFutures and Futures Options ................................ 652 \nFutures Contracts ................................................ 653 \nOptions on Futures ............................................... 660 \nFutures Option Trading Strategies .. .................................. 674 \nCommonplace Mispricing Strategies .................................. 683 \nSummary . ...................................................... 695 \nChapter 35 \nFutures Option Strategies for Futures Spreads ................. 696 \nFutures Spreads . ................................................. 696 \nUsing Futures Options in Futures Spreads ............................. 704 \nSummary ....................................................... 720 \nxii Contents \nPart VI \nMEASURING AND TRADING VOLATILITY \nChapter36 \nThe Basics of Volatility Trading . ............................. 727 \nDefinitions of Volatility ............................................ 728 \nAnother Approach: GARCH ........................................ 731 \nMoving Averages ................................................. 732 \nImplied Volatility . ................................................ 732 \nThe Volatility of Volatility .......................................... 734 \nVolatility Trading . ................................................ 743 \nWhy Does Volatility Reach Extremes? . ................................ 744 \nSummary ....................................................... 7 48 \nChapter37 \nHow Volatility Affects Popular Strategies ..................... 749 \nVega ........................................................... 749 \nImplied Volatility and Delta ........................................ 753 \nEffects on Neutrality .... .......................................... 755 \nPosition Vega .................................................... 757 \nOutright Option Purchases and Sales ................................. 757 \nTime Value Premium is a Misnomer .................................. 762 \nVolatility and the Put Option . ....................................... 765 \nStraddle or Strangle Buying and Selling ............................... 766 \nCall Bull Spreads . ................................................ 767 \nVertical Put Spreads .............................................. 775 \nPut Bear Spreads . ................................................ 777 \nCalendar Spreads ................................................ 778 \nRatio Spreads and Backspreads . ..................................... 780 \nSummary ....................................................... 782 \nChapter38 \nThe Distribution of Stock Prices ............................. 783 \nMisconceptions about Volatility ...................................... 783 \nVolatility Buyer's Rule! ............................................ 787 \nThe Distribution of Stock Prices ..................................... 789 \nWhat This Means for Option Traders ................................. 795 \nStock Price Distribution Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 796 \nContents xiii \nThe Pricing of Options .", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 3}
{"text": "..................... 783 \nVolatility Buyer's Rule! ............................................ 787 \nThe Distribution of Stock Prices ..................................... 789 \nWhat This Means for Option Traders ................................. 795 \nStock Price Distribution Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 796 \nContents xiii \nThe Pricing of Options . ............................................ 798 \nThe Probability of Stock Price Movement .............................. 798 \nEX'f)ected Return ................................................. 809 \nSummary . ...................................................... 810 \nChapter39 \nVolatility Trading Techniques ............................... 812 \nTwo Ways Volatility Predictions Can Be Wrong ......................... 813 \nTrading the Volatility Prediction ..................................... 814 \nTrading the Volatility Skew ......................................... 837 \nVolatility Trading Summary ............ ............................. 844 \nChapter40 \nAdvanced Concepts ........................................ 846 \nNeutrality ...................................................... 846 \nThe \"Greeks\" .................................................... 848 \nStrategy Considerations: Using the \"Greeks\" . ........................... 866 \nAdvanced Mathematical Concepts . ................................... 901 \nSummary ....................................................... 907 \nChapter41 \nTaxes . .................................................... 908 \nHistory .. ....................................................... 908 \nBasic Tax Treatment . .............................................. 910 \nExercise and Assignment ........................................... 913 \nSpecial Tax Problems .............................................. 922 \nSummary ....................................................... 925 \nTax Planning Strategies for Equity Options . ............................ 925 \nSummary ....................................................... ·930 \nChapter42 \nThe Best Strategy? ......................................... 932 \nGeneral Concepts: Market Attitude and Equivalent Positions ............... 932 \nWhat Is Best for Me Might Not Be Best for You ......................... 934 \nMathematical Ranking . ............................................ 936 \nSummary ....................................................... 937 \nPostscript . ................................................ 938 \nxiv \nAppendix A \nPart VII \nAPPENDICES \nContents \nStrategy Summary ......................................... 943 \nAppendixB \nEquivalent Positions ....................................... 945 \nAppendixC \nFormulae ................................................. 947 \nAppendixD \nGraphs ................................................... 957 \nAppendix E \nQualified Covered Calls .................................... 961 \nGlossary . ....................................................... 963 \nIndex .......................................................... 983 \nPreface \nWhen the listed option market originated in April 1973, a new world of investment \nstrategies was opened to the investing public. The standardization of option terms \nand the formation of a liquid secondary market created new investment vehicles that, \nadapted properly, can enhance almost every investment philosophy, from the con\nservative to the speculative. This book is about those option strategies -which ones \nwork in which situations and why they work. \nSome of these strategies are traditionally considered to be complex, but with \nthe proper knowledge of their underlying principles, most investors can understand \nthem. While this book contains all the basic definitions concerning options, little time \nor space is spent on the most elementary definitions. For example, the reader should \nbe familiar with what a call option is, what the CBOE is, and how to find and read \noption quotes in a newspaper. In essence, everything is contained here for the novice \nto build on, but the bulk of the discussion is above the beginner level. The reader \nshould also be somewhat familiar with technical analysis, understanding at least the \nterms support and resistance. \nCertain strategies can be, and have been, the topic of whole books - call buy\ning, for example. While some of the strategies discussed in this book receive a more \nthorough treatment than others, this is by no means a book about only one or two \nstrategies. Current literature on stock options generally does not treat covered call \nwriting in a great deal of detail. But because it is one of the most widely used option \nstrategies by the investing public, call writing is the subject of one of the most in\ndepth discussions presented here. The material presented herein on call and put \nbuying is not particularly lengthy, although much of it is of an advanced nature -\nespecially the parts regarding buying volatility and should be useful even to sophis\nticated traders. In discussing each strategy, particular emphasis is placed on showing \nwhy one would want to implement the strategy in the first place and on demonstrat-\nxv \nxviii Preface \nare made for using the computer as a tool in follow-up action, including an example \nprintout of an advanced follow-up analysis. \nTHIRD EDITION \nThere were originally six new chapters in the third edition. There were new chapters \non LEAPS, CAPS, and PERCS, since they were new option or option-related prod\nucts at that time. \nLEAPS are merely long-term options. However, as such, they require a little \ndifferent viewpoint than regular short-term options. For example, short-term inter\nest rates have a much more profound influence on a longer-term option than on a \nshort-term one. Strategies are presented for using LEAPS as a substitute for stock \nownership, as well as for using LEAPS in standard strategies. \nPERCS are actually a type of preferred stock, with a redemption feature bu", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 4}
{"text": "uire a little \ndifferent viewpoint than regular short-term options. For example, short-term inter\nest rates have a much more profound influence on a longer-term option than on a \nshort-term one. Strategies are presented for using LEAPS as a substitute for stock \nownership, as well as for using LEAPS in standard strategies. \nPERCS are actually a type of preferred stock, with a redemption feature built \nin. They also pay significantly larger dividends than the ordinary common stock. The \nredemption feature makes a PERCS exactly like a covered call option write. As such, \nseveral strategies apply to PERCS that would also apply to covered writers. \nMoreover, suggestions are given for hedging PERCS. Subsequently, the PERCS \nchapter was enveloped into a larger chapter in the fourth edition. \nThe chapters on futures and other non-equity options that were written for the \nsecond edition were deleted and replaced by two entirely new chapters on futures \noptions. Strategists should familiarize themselves with futures options, for many prof\nit opportunities exist in this area. Thus, even though futures trading may be unfamil\niar to many customers and brokers who are equity traders, it behooves the serious \nstrategist to acquire a knowledge of futures options. A chapter on futures concentrates \non definitions, pricing, and strategies that are unique to futures options; another chap\nter centers on the use of futures options in spreading strategies. These spreading \nstrategies are different from the ones described in the first part of the book, although \nthe calendar spread looks similar, but is really not. Futures traders and strategists \nspend a great deal of time looking at futures spreads, and the option strategies pre\nsented in this chapter are designed to help make that type of trading more profitable. \nA new chapter dealing with advanced mathematical concepts was added near \nthe end of the book. As option trading matured and the computer became more of \nan integral way of life in monitoring and evaluating positions, more advanced tech\nniques were used to monitor risk. This chapter describes the six major measures of \nrisk of an option position or portfolio. The application of these measures to initialize \npositions that are doubly or triply neutral is discussed. Moreover, the use of the com\nputer to predict the results and \"shape\" of a position at points in the future is \ndescribed. \nPreface xix \nThere were substantial revisions to the chapters on index options as well. Part \nof the revisions are due to the fact that these were relatively new products at the time \nof the writing of the second edition; as a result, many changes were made to the prod\nucts - delisting of some index options and introduction of others. Also, after the crash \nof 1987, the use of index products changed somewhat (with introduction of circuit \nbreakers, for example). \nFOURTH EDITION \nOnce again, in the ever-changing world of options and derivatives, some new \nimportant products have been introduced and some new concepts in trading have \ncome to the forefront. Meanwhile, others have been delisted or fallen out of favor. \nThere are five new chapters in the fourth edition, four of which deal with the most \nimportant approach to option trading today - volatility trading. \nThe chapter on CAPS was deleted, since CAPS were delisted by the option \nexchanges. Moreover, the chapter on PERCS was incorporated into a much larger \nand more comprehensive chapter on another relatively new trading vehicle - struc\ntured products. Structured products encompass a fairly wide range of securities -\nmany of which are listed on the major stock exchanges. These versatile products \nallow for many attractive, derivative-based applications - including index funds that \nhave limited downside risk, for example. Many astute investors buy structured prod\nucts for their retirements accounts. \nVolatility trading has become one of the most sophisticated approaches to \noption trading. The four new chapters actually comprise a new Part 6 - Measuring \nAnd Trading Volatility. This new part of the book goes in-depth into why one should \ntrade volatility (it's easier to predict volatility than it is to predict stock prices), how \nvolatility affects common option strategies - sometimes in ways that are not initially \nobvious to the average option trader, how stock prices are distributed ( which is one \nof the reasons why volatility trading \"works\"), and how to construct and monitor a \nvolatility trade. A number of relatively new techniques regarding measuring and pre\ndicting volatility are presented in these chapters. Personally, I think that volatility \nbuying of stock options is the most useful strategy, in general, for traders of all levels \n- from beginners through experts. If constructed properly, the strategy not only has \na high probability of success, but it also requires only a modest amount of work to \nmonitor the position after it has been established. This means that a volatility buyer \ncan have a \"life\" outside of watching a screen with dancing numbers on it all day. \nMoreover, most of the previous chapters were expanded to include the latest \ntechniques and developments. For example, in Chapter 1 (Definitions), the entire \narea of option symbology has been expanded, because of the wild movements of \nxx Preface \nstocks in the past few years. Also, the margin rules were changed in 2000, and those \nchanges are noted throughout the book. \nThose chapters dealing with the sale of options - particularly naked options -\nhave been expanded to include more discussion of the way that stocks behave and \nhow that presents problems and opportunities for the option writer. For example, in \nthe chapter on Reverse Spreads, the reverse calendar spread is described in detail \nbecause - in a high-volatility environment - the strategy becomes much more viable. \nAnother strategy that receives expanded treatment is the \"collar\" - the purchase \nof a put and simultaneous", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 5}
{"text": "on of the way that stocks behave and \nhow that presents problems and opportunities for the option writer. For example, in \nthe chapter on Reverse Spreads, the reverse calendar spread is described in detail \nbecause - in a high-volatility environment - the strategy becomes much more viable. \nAnother strategy that receives expanded treatment is the \"collar\" - the purchase \nof a put and simultaneous sale of a call against an underlying instrument. In fact, a \nsimilar strategy can be used - with a slight adjustment - by the outright buyer of an \noption (see the chapter on Spreads Combining Puts and Calls). \nI am certain that many readers of this book expect to learn what the \"best\" \noption strategy is. While there is a chapter discussing this subject, there is no defin\nitively \"best\" strategy. The optimum strategy for one investor may not be best for \nanother. Option professionals who have the time to monitor positions closely may be \nable to utilize an array of strategies that could not possibly be operated diligently by \na public customer employed in another full-time occupation. Moreover, one's partic\nular investment philosophy must play an important part in determining which strat\negy is best for him. Those willing to accept little or no risk other than that of owning \nstock may prefer covered call writing. More speculative strategists may feel that low\ncost, high-profit-potential situations suit them best. \nEvery investor must read the Options Clearing Corporation Prospectus before \ntrading in listed options. Options may not be suitable for every investor. There are \nrisks involved in any investment, and certain option strategies may involve large risks. \nThe reader must determine whether his or her financial situation and investment \nobjectives are compatible with the strategies described. The only way an investor can \nreasonably make a decision on his or her own to trade options is to attemptto acquire \na knowledge of the subject. \nSeveral years ago, I wrote that \"the option market shows every sign of becom\ning a stronger force in the investment world. Those who understand it will be able to \nbenefit the most.\" Nothing has happened in the interim to change the truth of that \nstatement, and in fact, it could probably be even more forcefully stated today. For \nexample, the Federal Reserve Board now often makes decisions with an eye to how \nderivatives will affect the markets. That shows just how important derivatives have \nbecome. The purpose of this book is to provide the reader with that understanding \nof options. \nI would like to express my appreciation to several people who helped make this \nbook possible: to Ron Dilks and Howard Whitman, who brought me into the bro-\nPreface xxi \nkerage business; to Art Kaufman, whose broad experience in options helped to crys\ntallize many of these strategies; to Peter Kopple for his help in reviewing the chap\nter on arbitrage; to Shelley Kaufman for his help on the third and fourth editions in \ndesigning the graphs and in the massive task of proofreading and editing; to Ben \nRussell and Fred Dahl for their suggestions on format and layout of the initial book; \nand to Jim Dalton (then president of the CBOE) for recommending a little-known \noption strategist when the New York Institute of Finance asked him, in 1977, if he \nhad any suggestions for an author for a new book on options. Special thanks go to \nBruce Nemirow for his invaluable assistance, especially for reading and critiquing the \noriginal manuscript. Most of all, I am grateful to my wife, Janet, who typed the orig\ninal manuscript, and to Karen and Glenn, our children, all of whom graciously with\nstood the countless hours of interrupted family life that were necessary in order to \ncomplete this work. \nLAWRENCE G. MCMILLAN \n\nI \nPART I \n--·····-·····u·-a•-s·•···i~ Prop· ertie····s··· · \n............... ~. . ..... ····••· . : ;· ...... .. . . /\"•. ··•··· .. \n·····•o·· ·· i:. ····s·····t·· ··o·c··k··•· •• .. O····· ·:·p·· · ··t···1·.·o···· ··:n.··. ·. ·::.·.s· ···· ,-\" ~,~, ,:1,-,,, o ,,,,- V ,. •• '' ,,' '' \"' ,,,., ,,,, ,,,,, \" ''' • ,•,- ~t•\" ,,,, . . . \n~··\"·\" '•''\"~ .,. ,_,,,, \nINTRODUCTION \nEach chapter in this book presents information in a logically sequential fashion. \nMany chapters build on the information presented in preceding chapters. One \nshould therefore be able to proceed from beginning to end without constantly refer\nring to the glossary or index. However, the reader who is using the text as a refer\nence - perhaps scanning one of the later chapters - many find that terms are being \nencountered that have been defined in an earlier chapter. In this case, the extensive \nglossary at the back of the book should prove useful. The index may provide aid as \nwell, since some subjects are described, in varying levels of complexity, in more than \none place in the book. For example, call buying is discussed initially in Chapter 3; \nand mathematical applications, as they apply to call purchases, are described in \nChapter 28. The latter chapters address more complex topics than do the early \nchapters. \n2 \nCHAPTER 1 \nDefinitions \nThe successful implementation of various investment strategies necessitates a sound \nworking knowledge of the fundamentals of options and option trading. The option \nstrategist must be familiar with a wide range of the basic aspects of stock options \nhow the price of an option behaves under certain conditions or how the markets \nfunction. A thorough understanding of the rudiments and of the strategies helps the \ninvestor who is not familiar with options to decide not only whether a strategy seems \ndesirable, but also - and more important - whether it is suitable. Determining suit\nability is nothing new to stock market investors, for stocks themselves are not suitable \nfor every investor. For example, if the investor's primary objectives are income and \nsafety of principal, then bonds, rather than stocks, would be more suitable. The need \nto assess the suitability of", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 6}
{"text": "hether a strategy seems \ndesirable, but also - and more important - whether it is suitable. Determining suit\nability is nothing new to stock market investors, for stocks themselves are not suitable \nfor every investor. For example, if the investor's primary objectives are income and \nsafety of principal, then bonds, rather than stocks, would be more suitable. The need \nto assess the suitability of options is especially important: Option buyers can lose their \nentire investment in a short time, and uncovered option writers may be subjected to \nlarge financial risks. Despite follow-up methods designed to limit risk, the individual \ninvestor must decide whether option trading is suitable for his or her financial situa\ntion and investment objective. \nELEMENTARY DEFINITIONS \nA stock option is the right to buy or sell a particular stock at a certain price for a lim\nited period of time. The stock in question is called the underlying security. A call \noption gives the owner ( or holder) the right to buy the underlying security, while a \nput option gives the holder the right to sell the underlying security. The price at \nwhich the stock may be bought or sold is the exercise price, also called the striking \nprice. (In the listed options market, \"exercise price\" and \"striking price\" are synony\nmous.) A stock option affords this right to buy or sell for only a limited period of time; \n3 \n4 Part I: Basic Properties of Stodc Options \nthus, each option has an expiration date. Throughout the book, the term \"options\" is \nalways understood to mean listed options, that is, options traded on national option \nexchanges where a secondary market exists. Unless specifically mentioned, over-the\ncounter options are not included in any discussion. \nDESCRIBING OPTIONS \nFour specifications uniquely describe any option contract: \n1. the type (put or call), \n2. the underlying stock name, \n3. the expiration date, and \n4. the striking price. \nAs an example, an option referred to as an \"XYZ July 50 call\" is an option to buy (a \ncall) 100 shares (normally) of the underlying XYZ stock for $50 per share. The option \nexpires in July. The price of a listed option is quo!_ed on a per-share basis, regardless \nof how many shares of stock can be bought with the option. Thus, if the price of the \nXYZ July 50 call is quoted at $5, buying the option would ordinarily cost $500 ($5 x \n100 shares), plus commissions. \nTHE VALUE OF OPTIONS \nAn option is a \"wasting\" asset; that is, it has only an initial value that declines (or \n\"wastes\" away) as time passes. It may even expire worthless, or the holder may have \nto exercise it in order to recover some value before expiration. Of course, the holder \nmay sell the option in the listed option market before expiration. \nAn option is also a security by itself, but it is a derivative security. The option is \nirrevocably linked to the underlying stock; its price fluctuates as the price of the \nunderlying stock rises or falls. Splits and stock dividends in the underlying stock \naffect the terms of listed options, although cash dividends do not. The holder of a call \ndoes not receive any cash dividends paid by the underlying stock. \nSTANDARDIZATION \nThe listed option exchanges have standardized the terms of option contracts. The \nterms of an option constitute the collective name that includes all of the four descrip\ntive specifications. While the type (put or call) and the underlying stock are self-evi\ndent and essentially standardized, the striking price and expiration date require more \nexplanation. \nChapter 1: Definitions s \nStriking Price. Striking prices are generally spaced 5 points apart for stocks, \nalthough for more expensive stocks, the striking prices may be 10 points apart. \nA $35 stock might, for example, have options with striking prices, or \"strikes,\" of \n30, 35, and 40, while a $255 stock might have one at 250 and one at 260. \nMoreover, some stocks have striking prices that are 2½ points apart - generally \nthose selling for less than $35 per share. That is, a $17 stock might have strikes \nat 15, 17½, and 20. \nThese striking price guidelines are not ironclad, however. Exchange officials \nmay alter the intervals to improve depth and liquidity, perhaps spacing the strikes 5 \npoints apart on a nonvolatile stock even if it is selling for more than $100. For exam\nple, if a $155 stock were very active, and possibly not volatile, then there might well \nbe a strike at 155, in addition to those at 150 and 160. \nExpiration Dates. Options have expiration dates in one of three fixed cycles: \nL the January/April/July/October cycle, \n2. the February/May/August/November cycle, or \n3. the March/June/September/December cycle. \nIn addition, the two nearest months have listed options as well. However, at any given \ntime, the longest-term expiration dates are normally no farther away than 9 months. \nLonger-term options, called LEAPS, are available on some stocks (see Chapter 25). \nHence, in any cycle, options may expire in 3 of the 4 major months (series) plus the \nnear-term months. For example, on February 1 of any year, XYZ options may expire \nin February, March, April, July, and October - not in January. The February option \n( the closest series) is the short- or near-term option; and the October, the far- or long\nterm option. If there were LEAPS options on this stock, they would expire in January \nof the following year and in January of the year after that. \nThe exact date of expiration is fixed within each month. The last trading day for \nan option is the third Friday in the expiration month. Although the option actually \ndoes not expire until the following day (the Saturday following), a public customer \nmust invoke the right to buy or sell stock by notifying his broker by 5:30 P.M., New \nYork time, on the last day of trading. \nTHE OPTION ITSELF: OTHER DEFINITIONS \nClasses and Series. A class of options refers to all put and call contracts on the \nsame underlying security. For instance, all IBM op", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 7}
{"text": "option actually \ndoes not expire until the following day (the Saturday following), a public customer \nmust invoke the right to buy or sell stock by notifying his broker by 5:30 P.M., New \nYork time, on the last day of trading. \nTHE OPTION ITSELF: OTHER DEFINITIONS \nClasses and Series. A class of options refers to all put and call contracts on the \nsame underlying security. For instance, all IBM options - all the puts and calls at \nvarious strikes and expiration months - form one class. A series, a subset of a class, \n6 Part I: Basic Properties of Stock Options \nconsists of all contracts of the same class (IBM, for example) having the same expi\nration date and striking price. \nOpening and Closing Transactions. An opening transaction is the ini\ntial transaction, either a buy or a sell. For example, an opening buy transaction \ncreates or increases a long position in the customer's account. A closing trans\naction reduces the customer's position. Opening buys are often followed by clos\ning sales; correspondingly, opening sells often precede closing buy trades. \nOpen Interest. The option exchanges keep track of the number of opening \nand closing transactions in each option series. This is called the open interest. \nEach opening transaction adds to the open interest and each closing transaction \ndecreases the open interest. The open interest is expressed in number of option \ncontracts, so that one order to buy 5 calls opening would increase the open \ninterest by 5. Note that the open interest does not differentiate between buyers \nand sellers - there is no way to tell if there is a preponderance of either one. \nWhile the magnitude of the open interest is not an extremely important piece of \ndata for the investor, it is useful in determining the liquidity of the option in \nquestion. If there is a large open interest, then there should be little problem in \nmaking fairly large trades. However, if the open interest is small - only a few \nhundred contracts outstanding - then there might not be a reasonable second\nary market in that option series. \nThe Holder and Writer. Anyone who buys an option as the initial transac\ntion - that is, buys opening - is called the holder. On the other hand, the \ninvestor who sells an option as the initial transaction - an opening sale - is called \nthe writer of the option. Commonly, the writer ( or seller) of an option is referred \nto as being short the option contract. The term \"writer\" dates back to the over\nthe-counter days, when a direct link existed between buyers and sellers of \noptions; at that time, the seller was the writer of a new contract to buy stock. In \nthe listed option market, however, the issuer of all options is the Options \nClearing Corporation, and contracts are standardized. This important difference \nmakes it possible to break the direct link between the buyer and seller, paving \nthe way for the formation of the secondary markets that now exist. \nExercise and Assignment. An option owner ( or holder) who invokes the \nright to buy or sell is said to exercise the option. Call option holders exercise to \nbuy stock; put holders exercise to sell. The holder of most stock options may \nexercise the option at any time after taking possession of it, up until 8:00 P.M. on \nO,apter 1: Definitions 7 \nthe last trading day; the holder does not have to wait until the expiration date \nitself before exercising. (Note: Some options, called \"European\" exercise \noptions, can be exercised only on their expiration date and not before - but they \nare generally not stock options.) These exercise notices are irrevocable; once \ngenerated, they cannot be recalled. In practical terms, they are processed only \nonce a day, after the market closes. Whenever a holder exercises an option, \nsomewhere a writer is assigned the obligation to fulfill the terms of the option \ncontract: Thus, if a call holder exercises the right to buy, a call writer is assigned \nthe obligation to sell; conversely, if a put holder exercises the right to sell, a put \nwriter is assigned the obligation to buy. A more detailed description of the exer\ncise and assignment of call options follows later in this chapter; put option exer\ncise and assignment are discussed later in the book. \nRELATIONSHIP OF THE OPTION PRICE AND STOCK PRICE \nIn- and Out-of-the-Money. Certain terms describe the relationship between \nthe stock price and the option's striking price. A call option is said to be out-of-the\nmoney if the stock is selling below the striking price of the option. A call option is in\nthe-money if the stock price is above the striking price of the option. (Put options \nwork in a converse manner, which is described later.) \nExample: XYZ stock is trading at $47 per share. The XYZ July 50 call option is out\nof-the-money, just like the XYZ October 50 call and the XYZ July 60 call. However, \nthe XYZ July 45 call, XYZ October 40, and XYZ January 35 are in-the-money. \nThe intrinsic value of an in-the-money call is the amount by which the stock \nprice exceeds the striking price. If the call is out-of-the-money, its intrinsic value is \nzero. The price that an option sells for is commonly referred to as the premium. The \npremium is distinctly different from the time value premium ( called time premium, \nfor short), which is the amount by which the option premium itself exceeds its intrin\nsic value. The time value premium is quickly computed by the following formula for \nan in-the-money call option: \nCall time value premium = Call option price + Striking price - Stock price \nExample: XYZ is trading at 48, and XYZ July 45 call is at 4. The premium - the total \nprice - of the option is 4. With XYZ at 48 and the striking price of the option at 45, \nthe in-the-money amount (or intrinsic value) is 3 points (48-45), and the time value \nisl(4-3). \n8 Part I: Basic Properties ol Stoclc Options \nIf the call is out-of-the-money, then the premium and the time value premium \nare the same. \nExample: With XYZ at 48 and an XYZ July 50", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 8}
{"text": "is at 4. The premium - the total \nprice - of the option is 4. With XYZ at 48 and the striking price of the option at 45, \nthe in-the-money amount (or intrinsic value) is 3 points (48-45), and the time value \nisl(4-3). \n8 Part I: Basic Properties ol Stoclc Options \nIf the call is out-of-the-money, then the premium and the time value premium \nare the same. \nExample: With XYZ at 48 and an XYZ July 50 call selling at 2, both the premium and \nthe time value premium of the call are 2 points. The call has no intrinsic value by \nitself with the stock price below the striking price. \nAn option normally has the largest amount of time value premium when the \nstock price is equal to the striking price. As an option becomes deeply in- or out-of\nthe-money, the time value premium shrinks substantially. Table 1-1 illustrates this \neffect. Note that the time value premium increases as the stock nears the striking \nprice (50) and then decreases as it draws away from 50. \nParity. An option is said to be trading at parity with the underlying security if \nit is trading for its intrinsic value. Thus, if XYZ is 48 and the xyz July 45 call is \nselling for 3, the call is at parity. A common practice of particular interest to \noption writers ( as shall be seen later) is to refer to the price of an option by relat\ning how close it is to parity with the common stock. Thus, the XY2 July 45 call \nis said to be a half-point over parity in any of the cases shown in Table 1-2. \nTABLE 1-1. \nChanges in time value premium. \nXYZ Stock XYZ Jul 50 Intrinsic Time Value \nPrice Call Price Value Premium \n40 1/2 0 ¼ \n43 1 0 1 \n35 2 0 2 \n47 4 0 3 \n➔50 5 0 5 \n53 7 3 4 \n55 8 5 3 \n57 9 7 2 \n60 101/2 10 ¼ \n70 191/2 20 -1/20 \nasimplistically, a deeply in-the-money call may actually trade at a discount from intrinsic value, \nbecause call buyers are more interested in less expensive calls that might return better percentage \nprofits on an upward move in the stock. This phenomenon is discussed in more detail when arbitrage \ntechniques are examined. \nCl,apter 1: Definitions 9 \nTABLE 1-2. \nComparison of XYZ stock and call prices. \nXYZ July 45 XYZ Stock Over \nStriking Price + Coll Price Price Parity \n(45 + 45 1/2) 1/2 \n(45 + 21/2 47 ) 1/2 \n(45 + 51/2 50 ) ½ \n(45 + 151/2 60 ) 1/2 \nFACTORS INFLUENCING THE PRICE OF AN OPTION \nAn option's price is the result of properties of both the underlying stock and the terms \nof the option. The major quantifiable factors influencing the price of an option are \nthe: \n1.. price of the underlying stock, \n2. striking price of the option itself, \n3. time remaining until expiration of the option, \n4. volatility of the underlying stock, \n5. current risk-free interest rate (such as for 90-day Treasury bills), and \n6. dividend rate of the underlying stock. \nThe first four items are the major determinants of an option's price, while the latter \ntwo are generally less important, although the dividend rate can be influential in the \ncase of high-yield stock. \nTHE FOUR MAJOR DETERMINANTS \nProbably the most important influence on the option's price is the stock price, \nbecause if the stock price is far above or far below the striking price, the other fac\ntors have little influence. Its dominance is obvious on the day that an option expires. \nOn that day, only the stock price and the striking price of the option determine the \noption's value; the other four factors have no bearing at all. At this time, an option is \nworth only its intrinsic value. \nExample: On the expiration day in July, with no time remaining, an XYZ July 50 call \nhas the value shown in Table 1-3; each value depends on the stock price at the time. \n10 Part I: Basic Properties of Stock Options \nTABLE 1-3. \nXYZ option's values on the expiration day. \nXYZ July 50 Coll \n(Intrinsic) Value \nXYZ Stock Price ot Expiration \n40 \n45 \n48 \n50 \n52 \n55 \n60 \n0 \n0 \n0 \n0 \n2 \n5 \n10 \nThe Call Option Price Curve. The call option price curve is a curve that \nplots the prices of an option against various stock prices. Figure 1-1 shows the \naxes needed to graph such a curve. The vertical axis is called Option Price. The \nhorizontal axis is for Stock Price. This figure is a graph of the intrinsic value. \nWhen the option is either out-of-the-money or equal to the stock price, the \nintrinsic value is zero. Once the stock price passes the striking price, it reflects \nthe increase of intrinsic value as the stock price goes up. Since a call is usually \nworth at least its intrinsic value at any time, the graph thus represents the min\nimum price that a call may be worth. \nFIGURE 1-1. \nThe value of an option at expiration, its intrinsic value. \n~ \nit \nC: \n.Q \n15.. \n0 The intrinsic value line \nbends at the \nst~iking ~ \npnce. ~ \nStock Price \nChapter 1: Definitions 11 \nWhen a call has time remaining to its expiration date, its total price consists of \nits intrinsic value plus its time value premium. The resultant call option price curve \ntakes the form of an inverted arch that stretches along the stock price axis. If one \nplots the data from Table 1-4 on the grid supplied in Figure 1-2, the curve assumes \ntwo characteristics: \n1. The time value premium ( the shaded area) is greatest when the stock price and \nthe striking price are the same. \n2. When the stock price is far above or far below the striking price (near the ends \nof the curve), the option sells for nearly its intrinsic value. As a result, the curve \nnearly touches the intrinsic value line at either end. [Figure 1-2 thus shows both \nthe intrinsic value and the option price curve.] \nThis curve, however, shows only how one might expect the XYZ July 50 call \nprices to behave with 6 months remaining until expiration. As the time to expiration \ngrows shorter, the arched line drops lower and lower, until, on the final day in the life \nof the option, it merges completely with the intrinsic value line. In other words, the \ncall is worth only its intrinsic value at expiration. Examine Figure 1-3, which depicts \nthree separate XYZ calls.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 9}
{"text": "e XYZ July 50 call \nprices to behave with 6 months remaining until expiration. As the time to expiration \ngrows shorter, the arched line drops lower and lower, until, on the final day in the life \nof the option, it merges completely with the intrinsic value line. In other words, the \ncall is worth only its intrinsic value at expiration. Examine Figure 1-3, which depicts \nthree separate XYZ calls. At any given stock price (a fixed point on the stock price \nscale), the longest-term call sells for the highest price and the nearest-term call sells \nfor the lowest price. At the striking price, the actual differences in the three option \nprices are the greatest. Near either end of the scale, the three curves are much clos\ner together, indicating that the actual price differences from one option to another \nare small. For a given stock price, therefore, option prices decrease as the expiration \ndate approaches. \nTABLE 1-4. \nThe prices of a hypothetical July 50 call with 6 months of time \nremaining, plotted in Figure 1-2. \nXYZ Stock Price \n(Horizontal Axis) \n40 \n45 \n48 \n➔SO \n52 \n55 \n60 \nXYZ July 50 \nCall Price \n(Vertical Axis) \n2 \n3 \n4 \n5 \n61/2 \n11 \nIntrinsic \nValue \n0 \n0 \n0 \n0 \n2 \n5 \n10 \nTime Value \nPremium \n(Shading) \n2 \n3 \n4 \n3 \n11/2 \n1 \n12 Part I: Basic Properties of Stock Options \nExample: On January 1st, XYZ is selling at 48. An XYZ July 50 call will sell for more \nthan an April 50 call, which in turn will sell for more than a January 50 call. \nFIGURE 1-2. \nSix-month July call option (see Table 1 ·4). \n.g \na. \nC \n0 \na \n11 \n10 \n9 \n8 \n7 \n6 \n5 \nGreatest \nValue for \nTime Value \nPremium \n0 4 ----------------------\n3 \n2 \n0 \nFIGURE 1-3. \n40 45 \nrepresents the option's \ntime value premium. \n--------L---------50\\ 55 60 \nStock Price Intrinsic value \nremains at zero \nuntil striking price \nis passed. \nPrice Curves for the 3-, 6·, and 9-month call options. \n/ \nIntrinsic Value \n9-Month Curve \nStriking Price \nStock Price \nAs expiration date draws \ncloser, the lower curve \nmerges with the intrinsic \nvalue line. The option \nprice then equals its \nintrinsic value. \nChapter 1: Definitions 13 \nThis statement is true no matter what the stock price is. The only reservation is \nthat with the stock deeply in- or out-of-the-money, the actual difference between the \nJanuary, April, and July calls will be smaller than with XYZ stock selling at the strik\ning price of 50. \nTime Value Premium Decay. In Figure 1-3, notice that the price of the 9-\nmonth call is not three times that of the 3-month call. Note next that the curve \nin Figure 1-4 for the decay of time value premium is not straight; that is, the rate \nof decay of an option is not linear. An option's time value premium decays much \nmore rapidly in the last few weeks of its life ( that is, in the weeks immediately \npreceding expiration) than it does in the first few weeks of its existence. The rate \nof decay is actually related to the square root of the time remaining. Thus, a 3-\nmonth option decays (loses time value premium) at twice the rate of a 9-month \noption, since the square root of 9 is 3. Similarly, a 2-month option decays at \ntwice the rate of a 4-month option (-..f4 = 2). \nThis graphic simplification should not lead one to believe that a 9-month option \nnecessarily sells for twice the price of a 3-month option, because the other factors \nalso influence the actual price relationship between the two calls. Of those other fac\ntors, the volatility of the underlying stock is particularly influential. More volatile \nunderlying stocks have higher option prices. This relationship is logical, because if a \nFIGURE 1-4. \nTime value premium decay, assuming the stock price remains con\nstant. \n9 4 \nTime Remaining Until Expiration \n(Months) \n0 \n14 Part I: Basic Properties ol Stodc Options \nstock has the ability to move a relatively large distance upward, buyers of the calls are \nwilling to pay higher prices for the calls - and sellers demand them as well. For exam\nple, if AT&T and Xerox sell for the same price (as they have been known to do), the \nXerox calls would be more highly priced than the AT&T calls because Xerox is a more \nvolatile stock than AT&T. \nThe interplay of the four major variables - stock price, striking price, time, and \nvolatility can be quite complex. While a rising stock price (for example) is directing \nthe price of a call upward, decreasing time may be simultaneously driving the price \nin the opposite direction. Thus, the purchaser of an out-of-the-money call may wind \nup with a loss even after a rise in price by the underlying stock, because time has \neroded the call value. \nTHE TWO MINOR DETERMINANTS \nThe Risk-Free Interest Rate. This rate is generally construed as the current \nrate of 90-day Treasury bills. Higher interest rates imply slightly higher option pre\nmiums, while lower rates imply lower premiums. Although members of the financial \ncommunity disagree as to the extent that interest rates actually affect option price, \nthey remain a factor in most mathematical models used for pricing options. (These \nmodels are covered much later in this book.) \nThe Cash Dividend Rate of the Underlying Stock. Though not clas\nsified as a major determinant in option prices, this rate can be especially impor\ntant to the writer (seller) of an option. If the underlying stock pays no dividends \nat all, then a call option's worth is strictly a function of the other five items. \nDividends, however, tend to lower call option premiums: The larger the dividend \nof the underlying common stock, the lower the price of its call options. One of \nthe most influential factors in keeping option premiums low on high-yielding \nstock is the yield itself. \nExample: XYZ is a relatively low-priced stock with low volatility selling for $25 per \nshare. It pays a large annual dividend of $2 per share in four quarterly payments of \n$.50 each. What is a fair price of an XYZ call with striking price 25? \nA prospective buyer of XYZ options is determined to figure out a fair price", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 10}
{"text": "rs in keeping option premiums low on high-yielding \nstock is the yield itself. \nExample: XYZ is a relatively low-priced stock with low volatility selling for $25 per \nshare. It pays a large annual dividend of $2 per share in four quarterly payments of \n$.50 each. What is a fair price of an XYZ call with striking price 25? \nA prospective buyer of XYZ options is determined to figure out a fair price. In \nsix months XYZ will pay $1 per share in dividends, and the stock price will thus be \nreduced by $1 per share when it goes ex-dividend over that time period. In that case, \nif XYZ's price remains unchanged except for the ex-dividend reductions, it will then \nbe $24. Moreover, since XYZ is a nonvolatile stock, it may not readily climb back to \n25 after the ex-dividend reductions. Therefore, the call buyer makes a low bid - even \nChapter I: Definitions 15 \nfor a 6-month call - because the underlying stock's price will be reduced by the ex\ndividend reduction, and the call holder does not receive the cash dividends. \nThis particular call buyer calculated the value of the XYZ July 25 call in terms \nof what it was worth with the stock discounted to 24 - not at 25. He knew for certain \nthat the stock was going to lose 1 point of value over the next 6 months, provided the \ndividend rate of XYZ stock did not change. In actual practice, option buyers tend to \ndiscount the upcoming dividends of the stock when they bid for the calls. However, \nnot all dividends are discounted fully; usually the nearest dividend is discounted \nmore heavily than are dividends to be paid at a later date. The less-volatile stocks with \nthe higher dividend payout rates have lower call prices than volatile stocks with low \npayouts. In fact, in certain cases, an impending large dividend payment can substan\ntially increase the probability of an exercise of the call in advance of expiration. (This \nphenomenon is discussed more fully in the following section.) In any case, to one \ndegree or another, dividends exert an important influence on the price of some calls. \nOTHER INFLUENCES \nThese six factors, major and minor, are only the quantifiable influences on the price \nof an option. In practice, nonquantitative market dynamics - investor sentiment -\ncan play various roles as well. In a bullish market, call premiums often expand \nbecause of increased demand. In bearish markets, call premiums may shrink due to \nincreased supply or diminished demand. These influences, however, are normally \nshort-lived and generally come into play only in dynamic market periods when emo\ntions are running high. \nEXERCISE AND ASSIGNMENT: THE MECHANICS \nThe holder of an option can exercise his right at any time during the life of an option: \nCall option holders exercise to buy stock, while put option holders exercise to sell \nstock. In the event that an option is exercised, the writer of an option with the same \nterms is assigned an obligation to fulfill the terms of the option contract. \nEXERCISING THE OPTION \nThe actual mechanics of exercise and assignment are fairly simple, due to the role of \nthe Options Clearing Corporation (OCC). As the issuer of all listed option contracts, \nit controls all listed option exercises and assignments. Its activities are best explained \nby an example. \n16 Part I: Bask Properties ol Stock Options \nExample: The holder of an XYZ January 45 call option wishes to exercise his right to \nbuy XYZ stock at $45 per share. He instructs his broker to do so. The broker then \nnotifies the administrative section of the brokerage firm that handles such matters. \nThe firm then notifies the OCC that they wish to exercise one contract of the XYZ \nJanuary 45 call series. \nNow the OCC takes over the handling. OCC records indicate which member \n(brokerage) firms are short or which have written and not yet covered XYZ Jan 45 \ncalls. The OCC selects, at random, a member firm that is short at least one XYZ Jan \n45 call, and it notifies the short firm that it has been assigned. That firm must then \ndeliver 100 shares of XYZ at $45 per share to the firm that exercised the option. The \nassigned firm, in tum, selects one of its customers who is short the XYZ January 45 \ncall. This selection for the assignment may be either: \n1. at random, \n2. on a first-in/first-out basis, or \n3. on any other basis that is fair, equitable, and approved by the appropriate \nexchange. \nThe selection of the customer who is short the XYZ January 45 completes the \nexercise/assignment process. (If one is an option writer, he should obviously deter\nmine exactly how his brokerage firm assigns its option contracts.) \nHONORING THE ASSIGNMENT \nThe assigned customer must deliver the stock - he has no other choice. It is too late \nto try buying the option back in the option market. He must, without fail, deliver 100 \nshares of XYZ stock at $45 per share. The assigned writer does, however, have a \nchoice as to how to fulfill the assignment. If he happens to be already long 100 shares \nof XYZ in his account, he merely delivers that 100 shares as fulfillment of the assign\nment notice. Alternatively, he can go into the stock market and buy XYZ at the cur\nrent market price - presumably something higher than $45 - and then deliver the \nnewly purchased stock as fulfillment. A third alternative is merely to notify his bro\nkerage firm that he wishes to go short XYZ stock and to ask them to deliver the 100 \nshares of XYZ at 45 out of his short account. At times, borrowing stock to go short \nmay not be possible, so this third alternative is not always available on every stock. \nMargin Requirements. If the assigned writer purchases stock to fulfill a \ncontract, reduced margin requirements generally apply to the transaction, so \nthat he would not have to fully margin the purchased stock merely for the pur\npose of delivery. Generally, the customer only has to pay a day-trade margin of \nOapter 1: Definitions 17 \nthe difference between the current price of XYZ and the delivery price of $45", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 11}
{"text": "ents. If the assigned writer purchases stock to fulfill a \ncontract, reduced margin requirements generally apply to the transaction, so \nthat he would not have to fully margin the purchased stock merely for the pur\npose of delivery. Generally, the customer only has to pay a day-trade margin of \nOapter 1: Definitions 17 \nthe difference between the current price of XYZ and the delivery price of $45 \nper share. If he goes short to honor the assignment, then he has to fully margin \nthe short sale at the current rate for stock sold short on a margin basis. \nAFTER EXERCISING THE OPTION \nThe OCC and the customer exercising the option are not concerned with the actual \nmethod in which the delivery is handled by the assigned customer. They want only to \nensure that the 100 shares of XYZ at 45 are, in fact, delivered. The holder who exer\ncised the call can keep the stock in his account if he wants to, but he has to margin it \nfully or pay cash in a cash account. On the other hand, he may want to sell the stock \nimmediately in the open market, presumably at a higher price than 45. If he has an \nestablished margin account, he may sell right away without putting out any money. If \nhe exercises in a cash account, however, the stock must be paid for in full - even if it \nis subsequently sold on the same day. Alternatively, he may use the delivered stock to \ncover a short sale in his own account if he happens to be short XYZ stock. \nCOMMISSIONS \nBoth the buyer of the stock via the exercise and the seller of the stock via the assign\nment are charged a full stock commission on 100 shares, unless a special agreement \nexists between the customer and the brokerage firm. Generally, option holders incur \nhigher commission costs through assignment than they do selling the option in the \nsecondary market. So the public customer who holds an option is better off selling the \noption in the secondary market than exercising the call. \nExample: XYZ is $55 per share. A public customer owns the XYZ January 45 call \noption. He realizes that exercising the call, buying XYZ at 45, and then immediately \nselling it at 55 in the stock market would net a profit of 10 points - or $1,000. \nHowever, the combined stock commissions on both the purchase at 45 and the sale \nat 55 might easily exceed $100. The net gain would actually be only $900. \nOn the other hand, the XYZ January 45 call is worth (and it would normally sell \nfor) at least 10 points in the listed options market. The commission for selling one call \nat a price of 10 is roughly $30. The customer therefore decides to sell his XYZ \nJanuary 45 call in the option market. He receives $1,000 (10 points) for the call and \npays only $30 in commissions - for a net of $970. The benefit of his decision is obvi\nous. \nOf course, sometimes a customer wants to own XYZ stock at $45 per share, \ndespite the stock commissions. Perhaps the stock is an attractive addition that will \n18 Part I: Basic Properties of Stock Options \nbring greater potential to a portfolio. Or if the customer is already short the XYZ \nstock, he is going to have to buy 100 shares and pay the commissions sooner or later \nin any case; so exercising the call at the lower stock price of 45 may be more desir\nable than buying at the current price of 55. \nANTICIPATING ASSIGNMENT \nThe writer of a call often prefers to buy the option back in the secondary market, \nrather than fulfill the obligation via a stock transaction. It should be strJssed again that \nonce the writer receives an assignment notice, it is too late to attempt to buy back \n(cover) the call. The writer must buy before assignment, or live up to the terms upon \nassignment. The writer who is aware of the circumstances that generally cause the \nholders to exercise can anticipate assignment with a fair amount of certainty. In antic\nipation of the assignment, the writer can then close the contract in the secondary mar\nket. As long as the writer covers the position at any time during a trading day, he can\nnot be assigned on that option. Assignment notices are determined on open positions \nas of the close of trading each day. The crucial question then becomes, \"How can the \nwriter anticipate assignment?\" Several circumstances signal assignments: \n1. a call that is in-the-money at expiration, \n2. an option trading at a discount prior to expiration, or \n3. the underlying stock paying a large dividend and about to go ex-dividend. \nAutomatic Exercise. Assignment is all but certain if the option is in-the\nmoney at expiration. Should the stock close even a half-point above the striking \nprice on the last day of trading, the holder will exercise to take advantage of the \nhalf-point rather than let the option expire. Assignment is nearly inevitable even \nif a call is only a few cents in-the-money at expiration. In fact, even if the call \ntrades in-the-money at any time during the last trading day, assignment may be \nforthcoming. Even if a holder forgets that he owns an option and fails to exer\ncise, the OCC automatically exercises any call that is ¾-point in-the-money at \nexpiration, unless the individual brokerage firm whose customer is long the call \ngives specific instructions not to exercise. This automatic exercise mechanism \nensures that no investor throws away money through carelessness. \nExample: XYZ closes at 51 on the third Friday of January (the last day of trading for \nthe January option series). Since options don't expire until Saturday, the next day, the \nOCC and all brokerage firms have the opportunity to review their records to issue \nassignments and exercises and to see if any options could have been profitably exer-\nGapter 1: Definitions 19 \ncised but were not. If XYZ closed at 51 and a customer who owned a January 45 call \noption failed to either sell or exercise it, it is automatically exercised. Since it is worth \n$600, this customer stands to receive a substantial amount of money back, even after \nstock commissions. \nIn the case of an XYZ January 5", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 12}
{"text": "nd to see if any options could have been profitably exer-\nGapter 1: Definitions 19 \ncised but were not. If XYZ closed at 51 and a customer who owned a January 45 call \noption failed to either sell or exercise it, it is automatically exercised. Since it is worth \n$600, this customer stands to receive a substantial amount of money back, even after \nstock commissions. \nIn the case of an XYZ January 50 call option, the automatic exercise procedure \nis not as clear-cut with the stock at 51. Though the OCC wants to exercise the call \nautomatically, it cannot identify a specific owner. It knows only that one or more XYZ \nJanuary calls are still open on the long side. When the OCC checks with the broker\nage firm, it may find that the firm does not wish to have the XYZ January 50 call exer\ncised automatically, because the customer would lose money on the exercise after \nincurring stock commissions. Yet the OCC must attempt to automatically exercise \nany in-the-money calls, because the holder may have overlooked a long position. \nWhen the public customer sells a call in the secondary market on the last day of \ntrading, the buyer on the other side of the trade is very likely a market-maker. Thus, \nwhen trading stops, much of the open interest in in-the-money calls held long \nbelongs to market-makers. Since they can profitably exercise even for an eighth of a \npoint, they do so. Hence, the writer may receive an assignment notice even if the \nstock has been only slightly above the strike price on the last trading day before expi\nration. \nAny writer who wishes to avoid an assignment notice should always buy back ( or \ncover) the option if it appears the stock will be above the strike at expiration. The \nprobabilities of assignment are extremely high if the option expires in-the-money. \nEarly Exercise Due to Discount. When options are exercised prior to \nexpiration, this is called early, or premature, exercise. The writer can usually \nexpect an early exercise when the call is trading at or below parity. A parity or \ndiscount situation in advance of expiration may mean that an early exercise is \nforthcoming, even if the discount is slight. A writer who does not want to deliv\ner stock should buy back the option prior to expiration if the option is apparently \ngoing to trade at a discount to parity. The reason is that arbitrageurs (floor \ntraders or member firm traders who pay only minimal commissions) can take \nadvantage of discount situations. (Arbitrage is discussed in more detail later in \nthe text; it is mentioned here to show why early exercise often occurs in a dis\ncount situation.) \nExample: XYZ is bid at $50 per share, and an XYZ January 40 call option is offered \nat a discount price of 9.80. The call is actually \"worth\" 10 points. The arbitrageur can \ntake advantage of this situation through the following actions, all on the same day: \n20 Part I: Basic Properties ol Stoclc Options \n1. Buy the January 40 call at 9.80. \n2. Sell short XYZ common stock at 50. \n3. Exercise the call to buy XYZ at 40. \nThe arbitrageur makes 10 points from the short sale of XYZ (steps 2 and 3), from \nwhich he deducts the 9.80 points he paid for the call. Thus, his total gain is 20 cents \n- the amount of the discount. Since he pays only a minimal commission, this trans-\naction results in a net profit. ' \nAlso, if the writer can expect assignment when the option has no time value pre\nmium left in it, then conversely the option will usually not be called if time premium \nis left in it. \nExample: Prior to the expiration date, XYZ is trading at 50½, and the January 50 call \nis trading at 1. The call is not necessarily in imminent danger of being called, since it \nstill has half a point of time premium left. \nTime value Call Striking Stock \n= + premium price price price \n= 1 + 50 50½ \n= ½ \nEarly Exercise Due to Dividends on the Underlying Stock. Some\ntimes the market conditions create a discount situation, and sometimes a large \ndividend gives rise to a discount. Since the stock price is almost invariably \nreduced by the amount of the dividend, the option price is also most likely \nreduced after the ex-dividend. Since the holder of a listed option does not receive \nthe dividend, he may decide to sell the option in the secondary market before the \nex-date in anticipation of the drop in price. If enough calls are sold because of \nthe impending ex-dividend reduction, the option may come to parity or even to a \ndiscount. Once again, the arbitrageurs may move in to take advantage of the sit\nuation by buying these calls and exercising them. \nIf assigned prior to the ex-date, the writer does not receive the dividend for he \nno longer owns the stock on the ex-date. Furthermore, if he receives an assignment \nnotice on the ex-date, he must deliver the stock with the dividend. It is therefore very \nimportant for the writer to watch for discount situations on the day prior to the ex\ndate. \n0.,,,,, I: Definitions 21 \nA word of caution: Do not conclude from this discussion that a call will be exer\ncised for the dividend if the dividend is larger than the remaining time premium. It \nwon't. An example will show why. \nEmmple: XYZ stock, at 50, is going to pay a $1 dividend with the ex-date set for the \nnext day. An XYZ January 40 call is selling at 10¼; it has a quarter-point of time pre\nmium. (TVP = 10¼ + 40 - 50 = ¼). The same type of arbitrage will not work \nSuppose that the arbitrageur buys the call at 10¼ and exercises it: He now owns the \nstock for the ex-date, and he plans to sell the stock immediately at the opening on the \nex-date, the next day. On the ex-date, XYZ opens at 49, because it goes ex-dividend \nby $1. The arbitrageur's transactions thus consist of: \n1. Buy the XYZ January 40 call at 10¼. \n2. Exercise the call the same day to buy XYZ at 40. \n3. On the ex-date, sell XYZ at 49 and collect the $1 dividend. \nHe makes 9 points on the stock (steps 2 and 3), and he receives a 1-point dividend, \nfor a total cash inflow of 10 point", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 13}
{"text": "day. On the ex-date, XYZ opens at 49, because it goes ex-dividend \nby $1. The arbitrageur's transactions thus consist of: \n1. Buy the XYZ January 40 call at 10¼. \n2. Exercise the call the same day to buy XYZ at 40. \n3. On the ex-date, sell XYZ at 49 and collect the $1 dividend. \nHe makes 9 points on the stock (steps 2 and 3), and he receives a 1-point dividend, \nfor a total cash inflow of 10 points. However, he loses 10¼ points paying for the call. \nThe overall transaction is a loser and the arbitrageur would thus not attempt it. \nA dividend payment that exceeds the time premium in the call, therefore, does \nnot imply that the writer will be assigned. \nMore of a possibility, but a much less certain one, is that the arbitrageur may \nattempt a \"risk arbitrage\" in such a situation. Risk arbitrage is arbitrage in which the \narbitrageur runs the risk of a loss in order to try for a profit. The arbitrageur may sus\npect that the stock will not be discounted the full ex-dividend amount or that the \ncall's time premium will increase after the ex-date. In either case (or both), he might \nmake a profit: If the stock opens down only 60 cents or if the option premium \nexpands by 40 cents, the arbitrageur could profit on the opening. In general, howev\ner, arbitrageurs do not like to take risks and therefore avoid this type of situation. So \nthe probability of assignment as the result of a dividend payment on the underlying \nstock is small, unless the call trades at parity or at a discount. \nOf course, the anticipation of an early exercise assumes rational behavior on the \npart of the call holder. If time premium is left in the call, the holder is always better \noff financially to sell that call in the secondary market rather than to exercise it. \nHowever, the terms of the call contract give a call holder the right to go ahead and \nexercise it anyway - even if exercise is not the profitable thing to do. In such a case, \na writer would receive an assignment notice quite unexpectedly. Financially unsound \nearly exercises do happen, though not often, and an option writer must realize that, \n22 Part I: Basic Properties of Stock Options \nin a very small percentage of cases, he could be assigned under very illogical cir\ncumstances. \nTHE OPTION MARKETS \nThe trader of stocks does not have to become very familiar with the details of the way \nthe stock market works in order to make money. Stocks don't expire, nor Cal} an \ninvestor be pulled out of his investment unexpectedly. However, the option trader is \nrequired to do more homework regarding the operation of the option markets. In \nfact, the option strategist who does not know the details of the working of the option \nmarkets will likely find that he or she eventually loses some money due to ignorance. \nMARKET-MAKERS \nIn at least one respect, stock and listed option markets are similar. Stock markets use \nspecialists to do two things: First, they are required to make a market in a stock by \nbuying and selling from their own inventory, when public orders to buy or sell the \nstock are absent. Second, they keep the public book of orders, consisting of limit \norders to buy and sell, as well as stop orders placed by the public. When listed option \ntrading began, the Chicago Board Options Exchange (CBOE) introduced a similar \nmethod of trading, the market-maker and the board broker system. The CBOE \nassigns several market-makers to each optionable stock to provide bids and offers to \nbuy and sell options in the absence of public orders. Market-makers cannot handle \npublic orders; they buy and sell for their own accounts only. A separate person, the \nboard broker, keeps the book of limit orders. The board broker, who cannot do any \ntrading, opens the book for traders to see how many orders to buy and sell are placed \nnearest to the current market (consisting of the highest bid and lowest offer). (The \nspecialist on the stock exchange keeps a more closed book; he is not required to for\nmally disclose the sizes and prices of the public orders.) \nIn theory, the CBOE system is more efficient than the stock exchange system. \nWith several market-makers competing to create the market in a particular security, \nthe market should be a more efficient one than a single specialist can provide. Also, \nthe somewhat open book of public orders should provide a more orderly market. In \npractice, whether the CBOE has a more efficient market is usually a subject for heat\ned discussion. The strategist need not be concerned with the question. \nThe American Stock Exchange uses specialists for its option trading, but it also \nhas floor traders who function similarly to market-makers. The regional option \nexchanges use combinations of the two systems; some use market-makers, while oth\ners use specialists. \nCl,apter 1: Definitions 23 \nOPTION SYMBOLOGY \nIt is probably a good idea for an option trader to understand how option symbols are \ncreated and used, for it may prove to be useful information. If one has a sophisticat\ned option quoting and pricing system, the quote vendor will usually provide the \ntranslation between option symbols and their meanings. The free option quote sec\ntion on the CBOE's Web site, www.cboe.com, can be useful for that purpose as well. \nEven with those aids, it is important that an option trader understand the concepts \nsurrounding option symbology. \nTHE OPTION BASE SYMBOL \nThe basic option symbol consists of three parts: \nOption symbol = Base symbol + Expiration month code + Striking price code \nThe base symbol is never more than three characters in length. In its simplest form, \nthe base symbol is the same as the stock symbol. That works well for stocks with three \nor fewer letters in their symbol, such as General Electric (GE) or IBM (IBM), but \nwhat about NASDAQ stocks? For NASDAQ stocks, the OCC makes up a three-let\nter symbol that is used to denote options on the stock. A few examples are: \nStock \nCisco \nMicrosoft \nQualcomm \nStock Symbol \ncsco \nMSFT \nQCOM \nOp", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 14}
{"text": "t form, \nthe base symbol is the same as the stock symbol. That works well for stocks with three \nor fewer letters in their symbol, such as General Electric (GE) or IBM (IBM), but \nwhat about NASDAQ stocks? For NASDAQ stocks, the OCC makes up a three-let\nter symbol that is used to denote options on the stock. A few examples are: \nStock \nCisco \nMicrosoft \nQualcomm \nStock Symbol \ncsco \nMSFT \nQCOM \nOption Base Symbol \nCYQ \nMSQ \nQAQ \nIn the three examples, there is a letter \"Q\" in each of the option base symbols. \nHowever, that is not always the case. The option base symbol assigned by the OCC \nfor a NASDAQ stock may contain any three letters (or, rarely, only two letters). \nTHE EXPIRATION MONTH CODE \nThe next part of an option symbol is the expiration month code, which is a one-char\nacter symbol. The symbology that has been created actually uses the expiration \nmonth code for two purposes: (1) to identify the expiration month of the option, and \n(2) to designate whether the option is a call or a put. \nThe concept is generally rather simple. For call options, the letter A stands for \nJanuary, B for February, and so forth, up through L for December. For put options, \nthe letter M stands for January, N for February, and so forth, up through X for \nDecember. The letters Y and Z are not used for expiration month codes. \n24 Part I: Basic Properties ol Stock Options \nTHE STRIKING PRICE CODE \nThis is also a one-character symbol, designed to identify the striking price of the \noption. Things can get ve:iy complicated where striking price codes are concerned, \nbut simplistically the designations are that the letter A stands for 5, B stands for 10, \non up to S for 95 and T for 100. If the stock being quoted is more expensive - say, \ntrading at $150 per share - then it is possible that A will stand for 105, B for 110, S \nfor 195 and T for 200 (although, as will be shown later, a more complicated approach \nmight have to be used in cases such as these). It should be noted that the exchanges \n- who designate the striking price codes and their numerical meaning - do not have • \nto adhere to any of the generalized conventions described here. They usually adhere \nto as many of them as they can, in order to keep things somewhat standardized, but \nthey can use the letters in any way they want. Typically, they would only use any strik\ning price code letter outside of its conventional designation after a stock has split or \nperhaps paid a special dividend of some sort. \nBefore getting into the more complicated option symbol constructions, let's \nlook at a few simple, straightforward examples: \nStock Stock Symbol Description Option Symbol \nIBM IBM IBM July 125 call IBMGE \nCisco csco Cisco April 75 put CYQPO \nFord Motor F Ford March 40 call FCH \nGeneral Motors GM GM December 65 put GMXM \nIn each option symbol, the last two characters are the expiration month code and the \nstriking price code. Preceding them is the option base symbol. For the IBM July 125, \nthe option symbol is quite straightforward. IBM is the option base symbol (as well as \nthe stock symbol), G stands for July, and E for 125, in this case. \nFor the Cisco April 75 put, the option base symbol is CYQ (this was given in the \nprevious table, but if one didn't know what the base symbol was, you would have to \nlook it up on the Internet or call a broker). The expiration month code in this case is \nP, because P stands for an April put option. Finally, the striking price code is 0, which \nstands for 75. \nThe Ford March 40 call and the GM December 65 put are similar to the oth\ners, except that the stock symbols only require one and two characters, respectively, \nso the option symbol is thus a shorter symbol as well - first using the stock symbol, \nthen the standard character for the expiration month, followed by the standard char\nacter for the striking price. \nChapter 1: Definitions 25 \nMORE STRIKING PRICE CODES \nThe letters A through T cannot handle all of the possible striking price codes. Recall \nthat many stocks, especially lower-priced ones, have striking prices that are spaced \n2½ points apart. In those cases, a special letter designation is usually used for the \nstriking price codes: \nStriking Price Code \nu \nV \nw \nX \ny \nz \nPossible Meanings \n7.5 or 37.5 or 67.5 or 97.5 or even 127.5! \n12.5 or 42.5 or 72.5 or 102.5 or 132.5 \n17.5 or 47.5 or 77.5 or 107.5 or 137.5 \n22.5 or 52.5 or 82.5 or 112.5 or 142.5 \n27.5 or 57.5 or 87.5 or 117.5 or 147.5 \n32.5 or 62.5 or 92.5 or 122.5 or 152.5 \nTypically, only the first or second meaning is used for these letters. The higher-priced \nones only occur after a very expensive stock splits 2-for-l (say, a stock that had a strike \nprice of 155 and split 2-for-l, creating a strike. price of 155 divided by 2, or 77.50). \nWRAPS \nNote that any striking price code can have only one meaning. Thus, if the letter A is \nbeing used to designate a strike price of 5, and the underlying stock has a tremen\ndous rally to over $100 per share, then the letter A cannot also be used to designate \nthe strike price of 105. Something else must be done. In the early years of option \ntrading, there was no need for wrap symbols, but in recent - more volatile - times, \nstocks have risen 100 points during the life of an option. \nFor example, if XYZ was originally trading at 10, there might be a 9-month, XYZ \nDecember 10 call. Its symbol would be XYZLB. If, in the course of the next few \nmonths, XYZ traded up to nearly 110 while the December 10 call was still in exis\ntence, the exchange would want to trade an XYZ December 110 call. But a new let\nter would have to be designated for any new strikes (A already stands for 5, so it can\nnot stand for 105; B already stands for 10, so it cannot stand for 110, etc.). There \naren't enough letters in the alphabet to handle this, so the exchange creates an addi\ntional option base symbol, called a wrap symbol. \nIn this case, the exchange might say that the option base symbol XYA is now \ngoing to be used to desi", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 15}
{"text": "have to be designated for any new strikes (A already stands for 5, so it can\nnot stand for 105; B already stands for 10, so it cannot stand for 110, etc.). There \naren't enough letters in the alphabet to handle this, so the exchange creates an addi\ntional option base symbol, called a wrap symbol. \nIn this case, the exchange might say that the option base symbol XYA is now \ngoing to be used to designate strike prices of 105 and higher ( up to 200) for the com\nmon stock whose symbol is XYZ. Having done that, the letter A can be used for 105, \nB for 110, etc. \n26 \nOption \nXYZ December 10 call \nXYZ December 110 call \nPart I: Basic Properties ol Stock Options \nSymbol \nXYZLB \nXYALB (wrap symbol is XYA) \nNote that the wrap symbol now allows the usage of Bin its standard interpretati<,n \nonce again. \nThis process can be extended. Suppose that, by some miracle, this stock rose to \n205 prior to the December expiration. Things like this happened to Yahoo (YHOO), \nAmazon (AMZN), Qualcomm (QCOM), and others during the 1990s. If that hap\npened, the exchange would now create another wrap symbol and use it to designate \nstrike prices from 205 to 300. Suppose XYZ traded up to 210, and the exchange then \nsaid that YYA would now be the wrap symbol for the higher strikes. In that case, these \nsymbols would exist: \nOption \nXYZ December 10 call \nXYZ December 110 call \nXYZ December 210 call \nSymbol \nXYZLB \nXYALB (wrap symbol is XYA) \nYYALB (wrap symbol is YYA) \nNote that there doesn't have to be any particular relationship between the wrap sym\nbols and the stock itself; any three-character designation could be used. \nLEAPS SYMBOLS \nA LEAPS option is one that is very long-term, expiring one or more years hence. \nConsequently, the expiration month codes encounter a problem with LEAPS similar \nto the one seen for striking price codes where wraps are concerned. The letter A \nstands for January as an expiration month code. However, if there is a LEAPS option \non this same stock, and that LEAPS option expires in January of the next year, the \nletter A cannot be used to designate the expiration month of the LEAPS option, since \nit is already being used for the \"standard\" option. Consequently, LEAPS options have \na different base option symbol than the \"standard\" base option symbol. \nExample: The current year is 2001. The OCC might have designated that, for IBM, \nLEAPS options expiring in the year 2002 will have the option base symbol VBM, and \nthose expiring in the year 2003 will have the option base symbol WBM. Thus, the fol\nlowing symbols would be used to describe the designated options: \nChapter 1: Definitions \nOption Description \nIBM January 125 call (expiring in 2001) \nIBM January 125 call (expiring in 2002) \nIBM January 125 call (expiring in 2003) \nIBM January 125 put (expiring in 2003) \n27 \nOption Symbol \nIBMAE \nVBMAE \nWBMAE \nWBMME \nNote that the last line shows a LEAPS put option symbol. The letter M stands for a \nJanuary put option - the standard usage for the expiration month code. \nSTOCK SPLITS \nStock splits often wreak havoc on option symbols, as the exchanges are forced to use \nthe standard characters in nonstandard ways in order to accommodate all the addi\ntional strikes that are created when a stock splits. The actual discussion of stock splits \nand the resultant option symbology is deferred to the next section. \nSYMBOLOGY SUMMARY \nThe exchanges do a good job of making symbol information available. Each exchange \nhas a Web site where memos detailing the changes required by LEAPS, wraps, and \nsplits are available for viewing. \nThe OCC and the exchanges have been forced to create multiple option base \nsymbols for a single stock in order to accommodate the various strike price and expi\nration month situations - to avoid duplication of the standardized character used for \nthe strike or expiration month. This is unwieldy and confusing for option traders and \nfor data vendors as well. In some rare cases, mistakes are made, and there can briefly \nbe two designations for the same option symbol. The only way to eliminate this con\nfusion would be to use a longer, more descriptive option symbol that included the \nexpiration year and the striking price as numerical values, much as is done with \nfutures options. It is the member firms themselves and some of the quote vendors \nwho object to the transformation to this less confusing system, because they would \nhave to recode their software and alter their databases. \nDETAILS OF OPTION TRADING \nThe facts that the strategist should be concerned with are included in this section. \nThey are not presented in any particular order of importance, and this list is not nec\nessarily complete. Many more details are given in the discussion of specific strategies \nthroughout this text. \n28 Part I: Basic Properties of Stock Options \n1. Options expire on the Saturday following the third Friday of the expiration \nrrwnth, although the third Friday is the last day of trading. In general, however, \nwaiting past 3:30 P.M. on the last day to place orders to buy or sell the expiring \noptions is not advisable. In the \"crush\" of orders during the final minutes of trad- • \ning, even a market order may not have enough time to be executed. \n2. Option trades have a one-day settlement cycle. The trade settles on the next busi\nness day after the trade. Purchases must be paid for in full, and the credits from \nsales \"hit\" the account on the settlement day. Some brokerage firms require set\ntlement on the same day as the trade, when the trade occurs on the last trading \nday of an expiration series. \n3. Options are opened for trading in rotation. When the underlying stock opens for \ntrading on any exchange, regional or national, the options on that stock then go \ninto opening rotation on the corresponding option exchange. The rotation system \nalso applies if the underlying stock halts trading and then reopens during a trad\ning day; options on that stock .reopen via a rotation. \nIn the rotation itself,", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 16}
{"text": "ns are opened for trading in rotation. When the underlying stock opens for \ntrading on any exchange, regional or national, the options on that stock then go \ninto opening rotation on the corresponding option exchange. The rotation system \nalso applies if the underlying stock halts trading and then reopens during a trad\ning day; options on that stock .reopen via a rotation. \nIn the rotation itself, interested parties make bids and offers for each particular \noption series one at a time - the XYZ January 45 call, the XYZ January 50 call, \nand so on - until all the puts and calls at various expiration dates and striking \nprices have been opened. Trades do not necessarily have to take place in each \nseries, just bids and offers. Orders such as spreads, which involve more than one \noption, are not executed during a rotation. \nWhile the rotation is taking place, it is possible that the underlying stock could \nmake a substantial move. This can result in option prices that seem unrealistic \nwhen viewed from the perspective of each option's opening. Consequently, the \nopening price of an option can be a somewhat suspicious statistic, since none of \nthem open at exactly the same time. \nAlso, it should be noted that most option traders do not trade during rotation, so \na market order may receive a very poor price. Hence, if one is considering trad\ning during rotation, a limit order should be used. ( Order entry is discussed in \nmore detail in a later section of this chapter.) \n4. When the underlying stock splits or pays a stock dividend, the terms of its options \nare adjusted. Such an adjustment may result in fractional striking prices and in \noptions for other than 100 shares per contract. No adjustments in terms are made \nfor cash dividends. The actual details of splits, stock dividends, and rights offer\nings, along with their effects on the option terms, are always published by the \noption exchange that trades those options. Notices are sent to all member firms, \nwho then make that information available to their brokers for distribution to \nclients. In actual practice, the option strategist should ascertain from the broker \n28 Part I: Bask Properties of Stock Options \nl. Options expire on the Saturday following the third Friday of the expiration \nrrwnth, although the third Friday is the last day of trading. In general, however, \nwaiting past 3:30 P.M. on the last day to place orders to buy or sell the expiring \noptions is not advisable. In the \"crush\" of orders during the final minutes of trad- , \ning, even a market order may not have enough time to be executed. \n2. Option trades have a one-day settlement cycle. The trade settles on the next busi\nness day after the trade. Purchases must be paid for in full, and the credits from \nsales \"hit\" the account on the settlement day. Some brokerage firms require set\ntlement on the same day as the trade, when the trade occurs on the last trading \nday of an expiration series. \n3. Options are opened for trading in rotation. When the underlying stock opens for \ntrading on any exchange, regional or national, the options on that stock then go \ninto opening rotation on the corresponding option exchange. The rotation system \nalso applies if the underlying stock halts trading and then reopens during a trad\ning day; options on that stock reopen via a rotation. \nIn the rotation itself, interested parties make bids and offers for each particular \noption series one at a time - the XYZ January 45 call, the XYZ January 50 call, \nand so on - until all the puts and calls at various expiration dates and striking \nprices have been opened. Trades do not necessarily have to take place in each \nseries, just bids and offers. Orders such as spreads, which involve more than one \noption, are not executed during a rotation. \nWhile the rotation is taking place, it is possible that the underlying stock could \nmake a substantial move. This can result in option prices that seem unrealistic \nwhen viewed from the perspective of each option's opening. Consequently, the \nopening price of an option can be a somewhat suspicious statistic, since none of \nthem open at exactly the same time. \nAlso, it should be noted that most option traders do not trade during rotation, so \na market order may receive a very poor price. Hence, if one is considering trad\ning during rotation, a limit order should be used. ( Order entry is discussed in \nmore detail in a later section of this chapter.) \n4. When the underlying stock splits or pays a stock dividend, the terms of its options \nare adjusted. Such an adjustment may result in fractional striking prices and in \noptions for other than 100 shares per contract. No adjustments in terms are made \nfor cash dividends. The actual details of splits, stock dividends, and rights offer\nings, along with their effects on the option terms, are always published by the \noption exchange that trades those options. Notices are sent to all member firms, \nwho then make that information available to their brokers for distribution to \nclients. In actual practice, the option strategist should ascertain from the broker \n28 Part I: Basic Properties ol Stock Options \n1. Options expire on the Saturday following the third Friday of the expiration \nmonth, although the third Friday is the last day of trading. In general, however, \nwaiting past 3:30 P.M. on the last day to place orders to buy or sell the expiring \noptions is not advisable. In the \"crush\" of orders during the final minutes of trad- , \ning, even a market order may not have enough time to be executed. \n2. Option trades have a one-day settlement cycle. The trade settles on the next busi\nness day after the trade. Purchases must be paid for in full, and the credits from \nsales \"hit\" the account on the settlement day. Some brokerage firms require set\ntlement on the same day as the trade, when the trade occurs on the last trading \nday of an expiration series. \n3. Options are opened for trading in rotation. When the underlying st", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 17}
{"text": "ay settlement cycle. The trade settles on the next busi\nness day after the trade. Purchases must be paid for in full, and the credits from \nsales \"hit\" the account on the settlement day. Some brokerage firms require set\ntlement on the same day as the trade, when the trade occurs on the last trading \nday of an expiration series. \n3. Options are opened for trading in rotation. When the underlying stock opens for \ntrading on any exchange, regional or national, the options on that stock then go \ninto opening rotation on the corresponding option exchange. The rotation system \nalso applies if the underlying stock halts trading and then reopens during a trad\ning day; options on that stock reopen via a rotation. \nIn the rotation itself, interested parties make bids and offers for each particular \noption series one at a time - the XYZ January 45 call, the XYZ January 50 call, \nand so on - until all the puts and calls at various expiration dates and striking \nprices have been opened. Trades do not necessarily have to take place in each \nseries, just bids and offers. Orders such as spreads, which involve more than one \noption, are not executed during a rotation. \nWhile the rotation is taking place, it is possible that the underlying stock could \nmake a substantial move. This can result in option prices that seem unrealistic \nwhen viewed from the perspective of each option's opening. Consequently, the \nopening price of an option can be a somewhat suspicious statistic, since none of \nthem open at exactly the same time. \nAlso, it should be noted that most option traders do not trade during rotation, so \na market order may receive a very poor price. Hence, if one is considering trad\ning during rotation, a limit order should be used. ( Order entry is discussed in \nmore detail in a later section of this chapter.) \n4. When the underlying stock splits or pays a stock dividend, the terms of its options \nare adjusted. Such an adjustment may result in fractional striking prices and in \noptions for other than 100 shares per contract. No adjustments in terms are made \nfor cash dividends. The actual details of splits, stock dividends, and rights offer\nings, along with their effects on the option terms, are always published by the \noption exchange that trades those options. Notices are sent to all member firms, \nwho then make that information available to their brokers for distribution to \nclients. In actual practice, the option strategist should ascertain from the broker \na.,,., 1: Definitions 29 \nthe specific terms of the new option series, in case the broker has overlooked the \ninformation sent. \nE«ample 1: XYZ is a $50 stock with option striking prices of 45, 50, and 60 for the \nJanuary, April, and July series. It declares a 2-for-l stock split. Usually, in a 2-for-l \nsplit situation, the number of outstanding option contracts is doubled and the strik\ning prices are halved. The owner of 5 XYZ January 60 calls becomes the owner of 10 \nXYZ January 30 calls. Each call is still for 100 shares of the underlying stock. \nIf fractional striking prices arise, the exchange also publishes the quote symbol \nthat is to be used to find the price of the new option. The XYZ July 45 call has a sym\nbol ofXYZGI: G stands for July and I is for 45. After the 2-for-l split, one July 45 call \nbecomes 2 July 22½ calls. The strike of 22½ is assigned a letter. The exchanges usu\nally attempt to stay with the standard symbols as much as possible, meaning that X \nwould be designated for 22½. Hence, the symbol for the XYZ July 22½ call would be \nXYZGX. \nAfter the split, XYZ has options with strikes of 22½, 25, and 30. In some cases, \nthe option exchange officials may introduce another strike if they feel such a strike is \nnecessary; in this example, they might introduce a striking price of 20. \nE«ample 2: UVW Corp. is now trading at 40 with strikes of 35, 40, and 45 for the \nJanuary, April, and July series. UVW declares a 2½ percent stock dividend. The con\ntractually standardized 100 shares is adjusted up to 102, and the striking prices are \nreduced by 2 percent (rounded to the nearest eighth). Thus, the \"old\" 35 strike \nbecomes a \"new\" strike of 343/s: 1.02 divided into 35 equals 34.314, which is 343/s \nwhen rounded to the nearest eighth. The \"old\" 40 strike becomes a \"new\" strike of \n39¼, and the \"old\" 45 strike becomes 441/s. Since these new strikes are all fraction\nal, they are given special symbols - probably U, V, and W. Thus, the \"old\" symbol \nUVWDH (UVW April 40) becomes the \"new\" symbol UVWDV (UVW April 39¼). \nAfter the split, the exchange usually opens for trading new strikes of 35, 40, and \n45 - each for 100 shares of the underlying stock. For a while, there are six striking \nprices for UVW options. As time passes, the fractional strikes are eliminated as they \nexpire. Since they are not reintroduced, they eventually disappear as long as UVW \ndoes not issue further stock dividends. \nExample 3: WWW Corp. (symbol WWW) is trading at $120 per share, with strike \nprices of ll0, ll5, 120, 125, and 130. WWW declares a 3-for-l split. In this case, the \nstrike prices would be divided by 3 (and rounded to the nearest eighth); the number \nof contracts in every account would be tripled; and each option would still be an \noption on 100 shares of WWW stock. The general rule of thumb is that when a split \nresults in round lots (2-for-l, 3-for-l, 4-for-l, etc.), the number of option contracts is \n30 Part I: Basic Properties ol Stock Options \nincreased and the strike price is decreased, and each option still represents 100 \nshares of the underlying stock. \nIn this case, the strikes listed above (110 through 130) would be adjusted to• \nbecome new strikes: 36.625, 38.375, 40, 41.625, and 43.375. The 40 strike would be \nassigned the standard strike price symbol of the letter H. However, the others would \nneed to be designated by the exchange, so U might stand for 38.375, V for 41.625, \nand so forth. \nExample 4: When a split does not result in a ro", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 18}
{"text": "ck. \nIn this case, the strikes listed above (110 through 130) would be adjusted to• \nbecome new strikes: 36.625, 38.375, 40, 41.625, and 43.375. The 40 strike would be \nassigned the standard strike price symbol of the letter H. However, the others would \nneed to be designated by the exchange, so U might stand for 38.375, V for 41.625, \nand so forth. \nExample 4: When a split does not result in a round lot, a different adjustment must \nbe used for the options. Suppose that AAA Corp. (symbol: AAA) is trading at $60 per \nshare and declares a 3-for-2 split. In this case, each option's strike will be multiplied \nby two-thirds (to reflect the 3-for-2 split), but the number of contracts held in an \naccount will remain the same and each option will be an option on 150 shares of AAA \nstock. \nSuppose that there were strikes of 55, 60, and 65 preceding this split. After the \nsplit, AAA common itself would be trading at $40 per share, reflecting the post-split \n3-for-2 adjustment from its previous price of 60. There would be new options with \nstrikes of 36.625, 40, and 43.375 (these had been the pre-split strikes of 55, 60, and \n65). \nSince each of these options would be for 150 shares of the underlying stock, the \nexchange creates a new option base symbol for these options, because they no longer \nrepresent 100 shares of AAA common. Suppose the exchange says that the post-split, \n150-share option contracts will henceforth use the option symbol AAX. \nAfter the split, the exchange will then list \"normal\" 100-share options on AAA, \nperhaps with strike prices of 35, 40, and 45. This creates a situation that can some\ntimes be confusing for traders and can lead to problems. There will actually be two \noptions with striking prices of 40 - one for 100 shares and the other for 150 shares. \nSuppose the July contract is being considered. The option with symbol AAAGH is a \nJuly 40 option on 100 shares of AAA Corp., while the option with symbol AAXGH is \na July 40 option on 150 shares of AAA Corp. Since option prices are quoted on a per\nshare basis, they will have nearly identical price quotes on any quote system (see item \n5). If one is not careful, you might trade the wrong one, thereby incurring a risk that \nyou did not intend to take. \nFor example, suppose that you sell, as an opening transaction, the AAXGH July \n40 call at a price of 3. Furthermore, suppose that you did not realize that you were \nselling the 150-share option; this was a mistake, but you don't yet realize it. A couple \nof days later, you see that this option is now selling at 13 - a loss of 10 points. You \nmight think that you had just lost $1,000, but upon examining your brokerage state\nment (or confirms, or day trading sheet), you suddenly see that the loss is $1,500 on \n0.,,,, 1: Definitions 31 \nthat contract! Quite a difference, especially if multiple contracts are involved. This \ncould come as a shock if you thought you were hedged (perhaps you bought 100 \nshares of AAA common when you sold this call), only to find out later that you didn't \nhave a correctly hedged position in place after all. \nEven more severe problems can arise if this stock splits again during the life \nof this option. Sometimes the options will be adjusted so that they represent a non\nstandard number of shares, such as the 150-share options involved here; and after \nmultiple splits, the exchange may even apply a multiplier to the option, rather than \nadjusting its strike price repeatedly. This type of thing wouldn't happen on the first \nstock split, but it might occur on subsequent stock splits, spaced closely together \nover the life of an option. In such a case, the dollar value of the option moves much \nfaster than one would expect from looking at a quote of the contract. \nSo you must be sure that you are trading the exact contract you intend to, and \nnot relying on the fact that the striking price is correct and the option price quote \nseems to be in line. One must verify that the option being bought or sold is exactly \nthe one intended. In general, it is a good idea, after a split or similar adjustment, to \nestablish opening positions solely with the standard contracts and to leave the split\nadjusted contracts alone. \n5. All options are quoted on a per-share basis, regardless of how many shares of \nstock the option involves. Normally the quote assumes 100 shares of the under\nlying stock. However, in a case like the UVW options just described, a quote of 3 \nfor the UVW April 39¼ means a dollar price of $306 ($3 x 102). \n6. Changes in the price of the underlying stock can also bring about new striking \nprices. XYZ is a $47 stock with striking prices of 45 and 50. If the price of XYZ \nstock falls to $40, the striking prices of 45 and 50 do not give option traders \nenough opportunities in XYZ. So the exchange might introduce a new striking \nprice of 40. In practice, a new series is generally opened when the stock trades \nat the lowest (or highest) existing strike in any series. For example, if XYZ is \nfalling, as soon as it traded at or below 45, the striking price of 40 may be intro\nduced. The officials of the option exchange that trades XYZ options make the \ndecision as to the exact day when the strike begins trading. \nPOSITION LIMIT AND EXERCISE LIMIT \n1. An investor or a group of investors cannot be long or short more than a set limit \nof contracts in one stock on the same side of the market. The actual limit varies \naccording to the trading activity in the underlying stock. The most heavily trad\ned stocks with a large number of shares outstanding have position limits of 75,000 \n32 Part I: Basic Properties ol Stock Options \ncontracts. Smaller stocks have position limits of 60,000, 31,000, 22,500, or 13,500 \ncontracts. These limits can be expected to increase over time, if stocks' capital\nizations continue to increase. The exchange on which the option is listed makes \navailable a list of the position limits on each of its optionable stocks. So, if one \nwere long", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 19}
{"text": "f 75,000 \n32 Part I: Basic Properties ol Stock Options \ncontracts. Smaller stocks have position limits of 60,000, 31,000, 22,500, or 13,500 \ncontracts. These limits can be expected to increase over time, if stocks' capital\nizations continue to increase. The exchange on which the option is listed makes \navailable a list of the position limits on each of its optionable stocks. So, if one \nwere long the limit of XYZ call options, he cannot at the same time be short any \nXYZ put options. Long calls and short puts are on the same side of the market; \nthat is, both are bullish positions. Similarly, long puts and short calls are both on \nthe bearish side of the market. While these position limits generally exceed by far \nany position that an individual investor normally attains, the limits apply to \"relat\ned\" accounts. For instance, a money manager or investment advisor who is man\naging many accounts cannot exceed the limit when all the accounts' positions are \ncombined. \n8. The numher of contracts that can be exercised in a particular period of time ( usu\nally 5 business days) is also limited to the same arrwunt as the position limit. This \nexercise limit prevents an investor or group from \"cornering\" a stock by repeat\nedly buying calls one day and exercising them the next, day after day. Option \nexchanges set exact limits, which are subject to change. \nORDER ENTRY \nOrder Information \nOf the various types of orders, each specifies: \n1. whether the transaction is a buy or sell, \n2. the option to be bought or sold, \n3. whether the trade is opening or closing a position, \n4. whether the transaction is a spread (discussed later), and \n5. the desired price. \nTYPES OF ORDERS \nMany types of orders are acceptable for trading options, but not all are acceptable on \nall exchanges that trade options. Since regulations change, information regarding \nwhich order is valid for a given exchange is best supplied by the broker to the cus\ntomer. The following orders are acceptable on all option exchanges: \nMarket Order. This is a simple order to buy or sell the option at the best pos\nsible price as soon as the order gets to the exchange floor. \nCl,apter 1: Definitions 33 \nMarket Not Held Order. The customer who uses this type of order is giv\ning the floor broker discretion in executing the order. The floor broker is not \nheld responsible for the final outcome. For example, if a floor broker has a \"mar\nket not held\" order to buy, and he feels that the stock will \"downtick\" (decline \nin price) or that there is a surplus of sellers in the crowd, he may often hold off \non the execution of the buy order, figuring that the price will decline shortly and \nthat the order can then be executed at a more favorable price. In essence, the \ncustomer is giving the floor broker the right to use some judgment regarding the \nexecution of the order. If the floor broker has an opinion and that opinion is cor\nrect, the customer will probably receive a better price than if he had used a reg\nular market order. If the broker's opinion is wrong, however, the price of the \nexecution may be worse than a regular market order. \nLimit Order. The limit order is an order to buy or to sell at a specified price \n- the limit. It may be executed at a better price than the limit - a lower one for \nbuyers and a higher one for sellers. However, if the limit is never reached, the \norder may never be executed. \nSometimes a limit order may specify a discretionary margin for the floor broker. \nIn other words, the order may read \"Buy at 5 with dime discretion.\" This instruction \nenables the floor broker to execute the order at 5.10 if he feels that the market will \nnever reach 5. Under no circumstances, however, can the order be executed at a \nprice higher than 5.10. Other orders may or may not be accepted·on some option \nexchanges. \nStop Order. This order is not always valid on all option exchanges. A stop \norder becomes a market order when the security trades at or through the price \nspecified on the order. Buy stop orders are placed above the current market \nprice, and sell stop orders are entered below the current market price. Such \norders are used to either limit loss or protect a profit. For example, if a holder's \noption is selling for 3, a sell stop order for 2 is activated if the market drops \ndown below the 2 level, whereupon the floor broker would execute the order as \nsoon as possible. The customer, however, is not guaranteed that the trade will be \nexactly at 2. \nStop-Limit Order. This order becomes a limit order when the specified price \nis reached. Whereas the stop order has to be executed as soon as the stop price \nis reached, the stop-limit may or may not be filled, depending on market behav\nior. For instance, if the option is trading at 3 while a stop-limit order is placed \nat a price of 2, the floor broker may not be able to get a trade exactly at 2. If the \n34 Part I: Basic Properties of Stock Options \noption continues to decline through 2 - 1.90, 1.80, 1.70, and so on - without ~ \never regaining the 2 level, then the broker's hands are tied. He may not execute \nwhat is now a limit order unless the call trades at 2. \nGood-Until-Canceled Order. A limit, stop, or stop-limit order may be des\nignated \"good until canceled.\" If the conditions for the order execution do not \noccur, the order remains valid for 6 months without renewal by the customer. \nCustomers using an on-line broker will not be able to enter \"market not held\" \norders, and may not be able to use stop orders or good-until-canceled orders either, \ndepending on the brokerage firm. \nPROFITS AND PROFIT GRAPHS \nA visual presentation of the profit potential of any position is important to the over\nall understanding and evaluation of it. In option trading, the many multi-security \npositions especially warrant strict analysis: stock versus options (as in covered or ratio \nwriting) or options versus options (as in spreads). Some strategists prefer a table list\ning the outcomes of a p", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 20}
{"text": "OFITS AND PROFIT GRAPHS \nA visual presentation of the profit potential of any position is important to the over\nall understanding and evaluation of it. In option trading, the many multi-security \npositions especially warrant strict analysis: stock versus options (as in covered or ratio \nwriting) or options versus options (as in spreads). Some strategists prefer a table list\ning the outcomes of a particular strategy for the stock at various prices; others think \nthe strategy is more clearly demonstrated by a graph. In the rest of the text, both a \ntable and a graph will be presented for each new strategy discussed. \nExample: A customer wishes to evaluate the purchase of a call option. The potential \nprofits or losses of a purchase of an XYZ July 50 call at 4 can be arrayed in either a \ntable or a graph of outcomes at expiration. Both Table 1-5 and Figure 1-5 depict the \nsame information; the graph is merely the line representing the column marked \n\"Profit or Loss\" in the table. The vertical axis represents dollars of profit or loss, and \nthe horizontal axis shows the stock price at expiration. In this case, the dollars of prof\nit and the stock price are at the expiration date. Often, the strategist wants to deter\nmine what the potential profits and losses will be before expiration, rather than at the \nexpiration date itself. Tables and graphs lend themselves well to the necessary analy\nsis, as will be seen in detail in various places later on. \nIn practice, such an example is too simple to require a table or a graph - cer\ntainly not both - to evaluate the potential profits and losses of a simple call purchase \nheld to expiration. However, as more complex strategies are discussed, these tools \nbecome ever more useful for quickly determining such things as when a position \nmakes money and when it loses, or how fast one's risk increases at certain stock \nprices. \nCl,opter 1: Definitions \nTABLE 1-5. \nPotential profits and losses for an XYZ call purchase. \nXYZ Price at Call Price at Profit or \nExpiration Expiration Loss \n40 $ 0 -$ 400 \n45 0 - 400 \n50 0 - 400 \n55 5 + 100 \n60 10 + 600 \n70 20 + 1,600 \nFIGURE 1-5. \nGraph of potential profits for an XYZ call purchase. \nC \n.Q \n~ ·a \nX \nw \n1il \n(J) \n(J) \n$0 0 ..J \n5 \n-e a. \n-$400 \nStock Price at Expiration \n35 \n\nfli\\R'E II \nCall Option · \n.. Strategies \nINTRODUCTION \nThe average person dealing in option trading utilizes primarily one of two option \nstrategies - call buying or covered call writing. These strategies are, at face value, \nsimple, and they are therefore the ones most often tried. There are many more \nstrategies involving the use of call options, many of which will be described later in \nthis Part. However, Chapters 2 and 3 deal with the fundamental call option strate\ngies. \nBoth covered call writing and call buying are relatively simple strategies, but, \nlike any investment, they can be employed with differing levels of skill and complex\nity. The discussions to follow begin by describing the basics of each strategy and then \ndiscuss each in depth. \n38 \nCHAPl'ER 2 \nCovered Call Writing \nCovered call writing is the name given to the strategy by which one sells a call option \nwhile simultaneously owning the obligated number of shares of underlying stock. \nThe writer should be mildly bullish, or at least neutral, toward the underlying stock. \nBy writing a call option against stock, one always decreases the risk of owning the \nstock. It may even be possible to profit from a covered write if the stock declines \nsomewhat. However, the covered call writer does limit his profit potential and there\nfore may not fully participate in a strong upward move in the price of the underlying \nstock. Use of this strategy is becoming so common that the strategist must under\nstand it thoroughly. It is therefore discussed at length. \nTHE IMPORTANCE OF COVERED CALL WRITING \nCOVERED CALL WRITING FOR DOWNSIDE PROTECTION \nExample: An investor owns 100 shares of XYZ common stock, which is currently sell\ning at $48 per share. If this investor sells an XYZ July 50 call option while still hold\ning his stock, he establishes a covered write. Suppose the investor receives $300 from \nthe sale of the July 50 call. If XYZ is below 50 at July expiration, the call option that \nwas sold expires worthless and the investor earns the $300 that he originally received \nfor writing the call. Thus, he receives $300, or 3 points, of downside protection. That \nis, he can afford to have the XYZ stock drop by 3 points and still break even on the \ntotal transaction. At that time he can write another call option if he so desires. \nNote that if the underlying stock should fall by more than 3 points, there will be \na loss on the overall position. Thus, the risk in the covered writing strategy material\nizes if the stock falls by a distance greater than the call option premium that was orig\ninally taken in. \n39 \n40 Part II: Call Option Strategies \nTHE BENEFITS OF AN INCREASE IN STOCK PRICE \nIf XYZ increases in price moderately, the trader may be able to have the best of both \nworlds. \nExample: If XYZ is at or just below 50 at July expiration, the call still expires worth\nless, and the investor makes the $300 from the option in addition to having a small \nprofit from his stock purchase. Again, he still owns the stock. \nShould XYZ increase in price by expiration to levels above 50, the covered \nwriter has a choice of alternatives. As one alternative, he could do nothing, in which \ncase the option would be assigned and his stock would be called away at the striking \nprice of 50. In that case, his profits would be equal to the $300 received from selling \nthe call plus the profit on the increase of his stock from the purchase price of 48 to \nthe sale price of 50. In this case, however, he would no longer own the stock. If as \nanother alternative he desires to retain his stock ownership, he can elect to buy back \n( or cover) the written call in the open market. This decision might involve taking a \nl", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 21}
{"text": "would be equal to the $300 received from selling \nthe call plus the profit on the increase of his stock from the purchase price of 48 to \nthe sale price of 50. In this case, however, he would no longer own the stock. If as \nanother alternative he desires to retain his stock ownership, he can elect to buy back \n( or cover) the written call in the open market. This decision might involve taking a \nloss on the option part of the covered writing transaction, but he would have a cor\nrespondingly larger profit, albeit unrealized, from his stock purchase. Using some \nspecific numbers, one can see how this second alternative works out. \nExample: XYZ rises to a price of 60 by July expiration. The call option then sells near \nits intrinsic value of 10. If the investor covers the call at 10, he loses $700 on the \noption portion of his covered write. (Recall that he originally received $300 from the \nsale of the option, and now he is buying it back for $1,000.) However, he relieves the \nobligation to sell his stock at 50 ( the striking price) by buying back the call, so he has \nan unrealized gain of 12 points in the stock, which was purchased at 48. His total \nprofit, including both realized and unrealized gains, is $500. \nThis profit is exactly the same as he would have made if he had let his stock be \ncalled from him. If called, he would keep the $300 from the sale of the call, and he \nwould make 2 points ( $200) from buying the stock at 48 and selling it, via exercise, at \n50. This profit, again, is a total of $500. The major difference between the two cases \nis that the investor no longer owns his stock after letting it be called away, whereas \nhe retains stock ownership if he buys back the written call. Which of the two alter\nnatives is the better one in a given situation is not always clear. \nNo matter how high the stock climbs in price, the profit from a covered write is \nlimited because the writer has obligated himself to sell stock at the striking price. The \ncovered writer still profits when the stock climbs, but possibly not by as much as he \nmight have had he not written the call. On the other hand, he is receiving $300 of \nimmediate cash inflow, because the writer may take the premium immediately and \nGapter 2: Covered Call Writing 41 \ndo with it as he pleases. That income can represent a substantial increase in the \nincome currently provided by the dividends on the underlying stock, or it can act to \noffset part of the loss in case the stock declines. \nFor readers who prefer formulae, the profit potential and break-even point of a \ncovered write can be summarized as follows: \nMaximum profit potential = Strike price Stock price + Call price \nDownside break-even point = Stock price - Call price \nQUANTIFICATION OF THE COVERED WRITE \nTable 2-1 and Figure 2-1 depict the profit graph for the example involving the XYZ \ncovered write of the July 50 call. The table makes the assumption that the call is \nbought back at parity. If the stock is called away, the same total profit of $500 results; \nbut the price involved on the stock sale is always 50, and the option profit is always \n$300. \nSeveral conclusions can be drawn. The break-even point is 45 (zero total prof\nit) with risk below 45; the maximum profit attainable is $500 if the position is held \nuntil expiration; and the profit if the stock price is unchanged is $300, that is, the cov\nered writer makes $300 even if his stock goes absolutely nowhere. \nThe profit graph for a covered write always has the shape shown in Figure 2-1. \nNote that the maximum profit always occurs at all stock prices equal to or greater \nthan the striking price, if the position is held until expiration. However, there is \ndownside risk. If the stock declines in price by too great an amount, the option pre\nmium cannot possibly compensate for the entire loss. Downside protective strategies, \nwhich are discussed later, attempt to deal with the limitation of this downside risk. \nTABLE 2-1. \nThe XYZ July 50 call. \nXYZ Price Stock July 50 Call Call Total \nat Expiration Profit at Expiration Profit Profit \n40 -$ 800 0 +$300 -$500 \n45 - 300 0 + 300 0 \n48 0 0 + 300 + 300 \n50 + 200 0 + 300 + 500 \n55 + 700 5 - 200 + 500 \n60 + 1,200 10 - 700 + 500 \n42 \nFIGURE 2-1. \nXYZ covered write. \nC +$500 \n0 \ne ·a. \ni.ti \ncii en $0 en 0 \n...J \n0 \n~ a. \nPart II: Call Option Strategies \nMaximum Profit Range \n50 55 60 \n\"-. Downside Risk \nStock Price at Expiration \nCOVERED WRITING PHILOSOPHY \nThe primary objective of covered writing, for most investors, is increased income \nthrough stock ownership. An ever-increasing number of private and institutional \ninvestors are writing call options against the stocks that they own. The facts that the \noption premium acts as a partial compensation for a decline in price by the underly\ning stock, and that the premium represents an increase in income to the stockhold\ner, are evident. The strategy of owning the stock and writing the call will outperform \noutright stock ownership if the stock falls, remains the same, or even rises slightly. In \nfact, the only time that the outright owner of the stock will outperform a covered \nwriter is if the stock increases in price by a relatively substantial amount during the \nlife of the call. Moreover, if one consistently writes call options against his stock, his \nportfolio will show less variability of results from quarter to quarter. The total posi\ntion - long stock and short option - has less volatility than the stock alone, so on a \nquarter-by-quarter basis, results will be closer to average than they would be with \nnormal stock ownership. This is an attractive feature, especially for portfolio man\nagers. \nHowever, one should not assume that covered writing will outperform stock \nownership. Stocks sometimes tend to make most of their gains in large spurts. A cov\nered writer will not participate in moves such as that. The long-term gains that are \nquoted for holding stocks include periods of large gains and sometimes pe", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 22}
{"text": "ck ownership. This is an attractive feature, especially for portfolio man\nagers. \nHowever, one should not assume that covered writing will outperform stock \nownership. Stocks sometimes tend to make most of their gains in large spurts. A cov\nered writer will not participate in moves such as that. The long-term gains that are \nquoted for holding stocks include periods of large gains and sometimes periods of \nlarge losses as well. The covered writer will not participate in the largest of those \ngains, since his profit potential is limited. \nChapter 2: Covered Call Writing 43 \nPHYSICAL LOCATION Of THE STOCK \nBefore getting more involved in the details of covered writing strategy, it may be use\nful to review exactly what stock holdings may be written against. Recall that this dis\ncussion applies to listed options. If one has deposited stock with his broker in either \na cash or a margin account, he may write an option for each 100 shares that he owns \nwithout any additional requirement. However, it is possible to write covered options \nwithout actually depositing stock with a brokerage firm. There are several ways in \nwhich to do this, all involving the deposit of stock with a bank. \nOnce the stock is deposited with the bank, the investor may have the bank issue \nan escrow receipt or letter of guarantee to the brokerage firm at which the investor \ndoes his option business. The bank must be an \"approved\" bank in order for the bro\nkerage firm to accept a letter of guarantee, and not all firms accept letters of guaran\ntee. These items cost money, and as a new receipt or letter is required for each new \noption written, the costs may become prohibitive to the customer if only 100 or 200 \nshares of stock are involved. The cost of an escrow receipt can range from as low as \n$15 to upward of $40, depending on the bank involved. \nThere is another alternative open to the customer who wishes to write options \nwithout depositing his stock at the brokerage firin. He may deposit his stock with a \nbank that is a member of the Depository Trust Corporation (DTC). The DTC guar\nantees the Options Clearing Corporation that it will, in fact, deliver stock should an \nassignment notice be given to the call writer. This is the most convenient method for \nthe investor to use, and is the one used by most of the institutional covered writing \ninvestors. There is usually no additional charge for this service by the bank to insti\ntutional accounts. However, since only a limited number of banks are members of \nDTC, and these banks are generally the larger banks located in metropolitan centers, \nit may be somewhat difficult for many individual investors to take advantage of the \nDTC opportunity. \nTYPES Of COVERED WRITES \nWhile all covered writes involve selling a call against stock that is owned, different \nterms are used to describe various categories of covered writing. The two broadest \nterms, under which all covered writes can be classified, are the out-of the-rrwney cov\nered write and the in-the-rrwney covered write. These refer, obviously, to whether the \noption itself was in-the-money or out-of-the-money when the write was first estab\nlished. Sometimes one may see covered writes classified by the nature of the stock \ninvolved (low-priced covered write, high-yield covered write, etc;), but these are only \nsubcases of the two broad categories. \n44 Part II: Call Option Strategies. \nIn general, out-of-the-money covered writes offer higher potential rewards but \nhave less risk protection than do in-the-money covered writes. One can establish an \naggressive or defensive covered writing position, depending on how far the call \noption is in- or out-of-the-money when the write is established. In-the-money writes \nare more defensive covered writing positions. \nSome examples may help to illustrate how one covered write can be consider\nably more conservative, from a strategy viewpoint, than another. \nExample: XYZ common stock is selling at 45 and two options are being considered \nfor writing: an XYZ July 40 selling for 8, and an XYZ July 50 selling for 1. Table 2-2 \ndepicts the profitability of utilizing the July 40 or the July 50 for the covered writing. \nThe in-the-money covered write of the July 40 affords 8 points, or nearly 18% pro\ntection down to a price of 37 (the break-even point) at expiration. The out-of-the\nmoney covered write of the July 50 offers only 1 point of downside protection at expi\nration. Hence, the in-the-rrwney covered write offers greater downside protection \nthan does the out-of-the-rrwney covered write. This statement is true in general - not \nmerely for this example. \nIn the balance of the financial world, it is normally true that investment posi\ntions offering less risk also have lower reward potential. The covered writing exam\nple just given is no exception. The in-the-money covered write of the July 40 has a \nmaximum potential profit of $300 at any point above 40 at the time of expiration. \nHowever, the out-of-the-money covered write of the July 50 has a maximum poten\ntial profit of $600 at any point above 50 at expiration. The maximum potential profit \nof an out-of-the-rrwney covered write is generally greater than that of an in-the\nrrwney write. \nTABLE 2-2. \nProfit or loss of the July 40 and July 50 calls. \nIn-the-Money Write Out-of-the-Money Write \nof July 40 of July SO \nStock of Total Stock at Total \nExpiration Profit Expiration Profit \n35 -$200 35 -$900 \n37 0 40 - 400 \n40 + 300 44 0 \n45 + 300 45 + 100 \n50 + 300 50 + 600 \n60 + 300 60 + 600 \nCl,apter 2: Covered Call Writing 45 \nTo make a true comparison between the two covered writes, one must look at \nwhat happens with the stock between 40 and 50 at expiration. The in-the-money \nwrite attains its maximum profit anywhere within that range. Even a 5-point decline \nby the underlying stock at expiration would still leave the in-the-money writer with \nhis maximum profit. However, realizing the maximum profit potential with an out-of \nthe-money cover", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 23}
{"text": "between the two covered writes, one must look at \nwhat happens with the stock between 40 and 50 at expiration. The in-the-money \nwrite attains its maximum profit anywhere within that range. Even a 5-point decline \nby the underlying stock at expiration would still leave the in-the-money writer with \nhis maximum profit. However, realizing the maximum profit potential with an out-of \nthe-money covered write always requires a rise in price by the underlying stock. This \nfurther illustrates the more conservative nature of the in-the-money write. It should \nbe noted that in-the-money writes, although having a smaller profit potential, can still \nbe attractive on a percentage return basis, especially if the write is done in a margin \naccount. \nOne can construct a more aggressive position by writing an out-of-the-money \ncall. One's outlook for the underlying stock should be bullish in that case. If one is \nneutral or moderately bearish on the stock, an in-the-money covered write is more \nappropriate. If one is truly bearish on a stock he owns, he should sell the stock instead \nof establishing a covered write. \nTHE TOTAL RETURN CONCEPT \nOF COVERED WRITING \nWhen one writes an out-of-the-money option, the overall position tends to reflect \nmore of the result of the stock price movement and less of the benefits of writing the \ncall. Since the premium on an out-of-the-money call is relatively small, the total posi\ntion will be quite susceptible to loss if the stock declines. If the stock rises, the posi\ntion will make money regardless of the result in the option at expiration. On the other \nhand, an in-the-money write is more of a \"total\" position - taking advantage of the \nbenefit of the relatively large option premium. If the stock declines, the position can \nstill make a profit; in fact, it can even make the maximum profit. Of course, an in\nthe-money write will also make money if the stock rises in price, but the profit is not \ngenerally as great in percentage terms as is that of an out-of-the-money write. \nThose who believe in the total return concept of covered writing consider both \ndownside protection and maximum potential return as important factors and are \nwilling to have the stock called away, if necessary, to meet their objectives. When \npremiums are moderate or small, only in-the-money writes satisfy the total return \nphilosophy. \nSome covered writers prefer never to lose their stock through exercise, and as \na result will often write options quite far out-of-the-money to minimize the chances \nof being called by expiration. These writers receive little downside protection and, to \nmake money, must depend almost entirely on the results of the stock itself. Such a \n46 Part II: Call Option Strategies \nphilosophy is more like being a stockholder and trading options against one's stock \nposition than actually operating a covered writing strategy. In fact, some covered \nwriters will attempt to buy back written options for quick profits if such profits mate\nrialize during the life of the covered write. This, too, is a stock ownership philosophy, \nnot a covered writing strategy. The total return concept represents the true strategy \nin covered writing, whereby one views the entire position as a single entity and is not \npredominantly concerned with the results of his stock ownership. \nTHE CONSERVATIVE COVERED WRITE \nCovered writing is generally accepted to be a conservative strategy. This is because \nthe covered writer always has less risk than a stockholder, provided that he holds the \ncovered write until expiration of the written call. If the underlying stock declines, the \ncovered writer will always offset part of his loss by the amount of the option premi\num received, no matter how small. \nAs was demonstrated in previous sections, however, some covered writes are \nclearly more conservative than others. Not all option writers agree on what is meant \nby a conservative covered write. Some believe that it involves writing an option \n(probably out-of-the-money) on a conservative stock, generally one with high yield \nand low volatility. It is true that the stock itself in such a position is conservative, but \nthe position is more aptly termed a covered write on a conservative stock. This is dis\ntinctly different from a conservative covered write. \nA true conservative covered write is one in which the total position is conserva\ntive - offering reduced risk and a good probability of making a profit. An in-the-money \nwiite, even on a stock that itself is not conservative, can become a conservative total \nposition when the option itself is properly chosen. Clearly, an investor cannot write \ncalls that are too deeply in-the-money. If he did, he would get large amounts of down\nside protection, but his returns would be severely limited. If all that one desired was \nmaximum protection of his money at a nominal rate of profit, he could leave the \nmoney in a bank. Instead, the conservative covered writer strives to make a potential\nly acceptable return while still receiving an above-average amount of protection. \nExample: Again assume XYZ common stock is selling at 45 and an XYZ July 40 call \nis selling at 8. A covered write of the XYZ July 40 would require, in a cash account, \nan investment of $3,700 - $4,500 to purchase 100 shares of XYZ, less the $800 \nreceived in option premiums. The write has a maximum profit potential of $300. The \npotential return from this position is therefore $300/$3, 700, just over 8% for the peri\nod during which the write must be held. Since it is most likely that the option has 9 \nmonths of life or less, this return would be well in excess of 10% on a per annum \nChapter 2: Covered Call Writing 47 \nbasis. If the write were done in a margin account, the return would be considerably \nhigher. \nNote that we have ignored dividends paid by the underlying stock and commis\nsion charges, factors that are discussed in detail in the next section. Also, one should \nbe aware that if he is l", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 24}
{"text": "ths of life or less, this return would be well in excess of 10% on a per annum \nChapter 2: Covered Call Writing 47 \nbasis. If the write were done in a margin account, the return would be considerably \nhigher. \nNote that we have ignored dividends paid by the underlying stock and commis\nsion charges, factors that are discussed in detail in the next section. Also, one should \nbe aware that if he is looking at an annualized return from a covered write, there is \nno guarantee that such a return could actually be obtained. All that is certain is that \nthe writer could make 8% in 9 months. There is no guarantee that 9 months from \nnow, when the call expires, there will be an equivalent position to establish that will \nextend the same return for the remainder of the annualization period. Annual returns \nshould be used only for comparative purposes between covered writes. \nThe writer has a position that has an annualized return (for comparative pur\nposes) of over 10% and 8 points of downside protection. Thus, the total position is an \ninvestment that will not lose money unless XYZ common stock falls by more than 8 \npoints, or about 18%; and is an investment that could return the equivalent of 10% \nannually should XYZ common stock rise, remain the same, or fall by 5 points (to 40). \nThis is a conservative position. Even if XYZ itself is not a conservative stock, the \naction of writing this option has made the total position a conservative one. The only \nfactor that might detract from the conservative nature of the total position would be \nif XYZ were so volatile that it could easily fall more than 8 points in 9 months. \nIn a strategic sense, the total position described above is better and more con\nservative than one in which a writer buys a conservative stock -yielding perhaps 6 or \n7% - and writes an out-of-the-money call for a minimal premium. If this conserva\ntive stock were to fall in price, the writer would be in danger of being in a loss situa\ntion, because here the option is not providing anything more than the most minimal \ndownside protection. As was described earlier, a high-yielding, low-volatility stock \nwill not have much time premium in its in-the-money options, so that one cannot \neffectively establish an in-the-money write on such a \"conservative\" stock. \nCOMPUTING RETURN ON INVESTMENT \nNow that the reader has some general feeling for covered call writing, it is time to \ndiscuss the specifics of computing return on investment. One should always know \nexactly what his potential returns are, including all costs, when he establishes a cov\nered writing position. Once the procedure for computing returns is clear, one can \nmore logically decide which covered writes are the most attractive. \nThere are three basic elements of a covered write that should be computed \nbefore entering into the position. The first is the return if exercised. This is the return \non investment that one would achieve if the stock were called away. For an out-of-the-\n48 Part II: Call Option Strategies \nmoney covered write, it is necessary for the stock to rise in price in order for the return \nif exercised to be achieved. However, for an in-the-money covered write, the return if \nexercised would be attained even if the stock were unchanged in price at option expi\nration. Thus, it is often advantageous to compute the return if unchanged - that is, the \nreturn that would be realized if the underlying stock were unchanged when the option \nexpired. One can more fairly compare out-of-the-money and in-the-money covered \nwrites by using the return if unchanged, since no assumption is made concerning stock \nprice movement. The third important statistic that the covered writer should consid\ner is the exact downside break-even point after all costs are included. Once this down\nside break-even point is known, one can readily compute the percentage of downside \nprotection that he would receive from selling the call. \nExample 1: An investor is considering the following covered write of a 6-month call: \nBuy 500 XYZ common at 43, sell 5 XYZ July 45 calls at 3. One must first compute the \nnet investment required (Table 2-3). In a cash account, this investment consists of \npaying for the stock in full, less the net proceeds from the sale of the options. Note \nthat this net investment figure includes all commissions necessary to establish the \nposition. (The commissions used here are approximations, as they vary from firm to \nfirm.) Of course, if the investor withdraws the option premium, as he is free to do, \nhis net investment will consist of the stock cost plus commissions. Once the neces\nsary investment is known, the writer can compute the return if exercised. Table 2-4 \nillustrates the computation. One first computes the profit if exercised and then \ndivides that quantity by the net investment to obtain the return if exercised. Note \nthat dividends are included in this computation; it is assumed that XYZ stock will pay \n$500 in dividends on the 500 shares during the life of the call. Moreover, all com\nmissions are included as well - the net investment includes the original stock pur\nchase and option sale commissions, and the stock sale commission is explicitly listed. \nFor the return computed here to be realized, XYZ stock would have to rise in \nprice from its current price of 43 to any price above 45 by expiration. As noted ear\nlier, it may be more useful to know what return could be made by the writer if the \nstock did not move anywhere at all. Table 2-5 illustrates the method of computing the \nTABLE 2-3. \nNet investment required-cash account. \nStock cost (500 shares at 43) \nPlus stock purchase commissions \nLess option premiums received \nPlus option sale commissions \nNet cash investment \n+ \n$21,500 \n320 \n1,500 \n+ 60 \n$20,380 \nOapter 2: Covered Call Writing \nTABLE 2-4. \nReturn if exercised-cash account. \nStock sale proceeds (500 shares at 45) \nLess stock sale commissions \nPlus dividends earned until expiration \nLess net inve", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 25}
{"text": "ash account. \nStock cost (500 shares at 43) \nPlus stock purchase commissions \nLess option premiums received \nPlus option sale commissions \nNet cash investment \n+ \n$21,500 \n320 \n1,500 \n+ 60 \n$20,380 \nOapter 2: Covered Call Writing \nTABLE 2-4. \nReturn if exercised-cash account. \nStock sale proceeds (500 shares at 45) \nLess stock sale commissions \nPlus dividends earned until expiration \nLess net investment \nNet profit if exercised \nReturn if exercised $2,290 = 11 2o/c \n$20,380 . \n0 \nTABLE 2-5. \nReturn if unchanged-cash account. \nUnchanged stock value (500 shares at 43) \nPlus dividends \nLess net investment \nProfit if unchanged \nReturn if unchanged $1,620 = 7.9'¼ \n$20,380 ° \n+ \n$22,500 \n330 \n500 \n- 20,380 \n$ 2,290 \n$21,500 \n+ 500 \n- 20,380 \n$ 1,620 \n49 \nreturn if unchanged - also called the static return and sometimes incorrectly referred \nto as the \"expected return.\" Again, one first calculates the profit and then calculates \nthe return by dividing the profit by the net investment. An important point should be \nmade here: There is no stock sale commission included in Table 2-5. This is the most \ncommon way of calculating the return if unchanged; it is done this way because in a \nmajority of cases, one would continue to hold the stock if it were unchanged and \nwould write another call option against the same stock. Recall again, though, that if \nthe written call is in-the-rrwney, the return if unchanged is the same as the return if \nexercised. Stock sale commissions must therefore be included in that case. \nOnce the necessary returns have been computed and the writer has a feeling for \nhow much money he could make in the covered write, he next computes the exact \ndownside break-even point to determine what kind of downside protection the writ\nten call provides (Table 2-6). The total return concept of covered writing necessitates \nviewing both potential income and downside protection as important criteria for \nselecting a writing position. If the stock were held to expiration and the $500 in div\nidends received, the writer would break even at a price of 39.8. Again, a stock sale \ncommission is not generally included in the break-even point computation, because \n50 Part II: Call Option Strategies \nthe written call would expire totally worthless and the writer might then write anoth\ner call on the same stock. Later, we discuss the subject of continuing to write against \nstocks already owned. It will be seen that in many cases, it is advantageous to con\ntinue to hold a stock and write against it again, rather than to sell it and establish a \ncovered write in a new stock. \nTABLE 2-6. \nDownside break-even point-cash account. \nNet investment \nLess dividends \nTotal stock cost to expiration \nDivide by shares held \nBreak-even price \n$20,380 \n500 \n$19,880 \n+ 500 \n39.8 \nNext, we translate the break-even price into percent downside protection \n(Table 2-7), which is a convenient way of comparing the levels of downside protec\ntion among variously priced stocks. We will see later that it is actually better to com\npare the downside protection with the volatility of the underlying stock. However, \nsince percent downside protection is a common and widely accepted method that is \nmore readily calculated, it is necessary to be familiar with it as well. \nBefore moving on to discuss what kinds of returns one should attempt to strive \nfor in which situati_ons, the same example will be worked through again for a covered \nwrite in a margin account. The use of margin will provide higher potential returns, \nsince the net investment will be smaller. However, the margin interest charge \nincurred on the debit balance (the amount of money borrowed from the brokerage \nfirm) will cause the break-even point to be higher, thus slightly reducing the amount \nof downside protection available from writing the call. Again, all commissions to \nestablish the position are included in the net investment computation. \nTABLE 2-7. \nPercent downside protection-cash account. \nInitial stock price \nLess break-even price \nPoints of protection \nDivide by original stock price \nEquals percent downside protection \n43 \n-39.8 \n3.2 \n+43 \n7.4% \nClrapter 2: Covered Call Writing 51 \nExample 2: Recall that the net investment for the cash write was $20,380. A \nmargin covered write requires less than half of the investment of a cash write when \nthe margin rate (set by the Federal Reserve) is 50%. In a margin account, if one \ndesires to remove the premium from the account, he may do so immediately provid\ned that he has enough reserve equity in the account to cover the purchase of the \nstock. If he does so, his net investment would be equal to the debit balance calcula\ntion shown on the right in Table 2-8. \nTABLE 2-8. \nNet investment required-margin account. \nStock cost $21,500 \nPlus stock commissions + 320 Debit balance calculation: \nNet stock cost $21,820 Net stock cost $21,820 \nTimes margin rate X 50% Less equity - 10,910 \nEquity required $10,910 Debit balance $10,910 \nLess premiums received 1,500 (at 50% margin) \nPlus option commissions + 60 \nNet margin investment $ 9,470 \nTables 2-9 to 2-12 illustrate the computation of returns from writing on margin. \nIf one has already computed the cash returns, he can use method 2 most easily. \nMethod 1 involves no prior profit calculations. \nTABLE 2-9. \nReturn if exercised-margin account. \nMethod 1 Method 2 \nStock sale proceeds \nLess stock commission \nPlus dividends \n$22,500 Net profit if exercised-cash $2,290 \n+ \nLess margin interest charges \n330 \n500 \n(10% on $10,910 for 6 months) - 545 \nLess debit balance \nLess net margin investment \nNet profit-margin \n- 10,910 \n- 9 470 \n$ 1,745 \nLess margin interest charges -\nNet profit if exercised\nmargin \n$1,745 Return if exercised = $9 ,470 = 18.4% \n545 \n$1,745 \n52 \nTABLE 2-10. \nReturn if unchanged-margin account. \nMethod 1 \nUnchanged stock value (500 \nshares at 43) \nPlus dividends \nLess margin interest charges \n(10% on $10,910 debit for \n6 months) \nLess debit balance \nLess ne", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 26}
{"text": "investment \nNet profit-margin \n- 10,910 \n- 9 470 \n$ 1,745 \nLess margin interest charges -\nNet profit if exercised\nmargin \n$1,745 Return if exercised = $9 ,470 = 18.4% \n545 \n$1,745 \n52 \nTABLE 2-10. \nReturn if unchanged-margin account. \nMethod 1 \nUnchanged stock value (500 \nshares at 43) \nPlus dividends \nLess margin interest charges \n(10% on $10,910 debit for \n6 months) \nLess debit balance \nLess net investment (margin) \nNet profit if unchanged\nmargin \n$21,500 \n+ 500 \n545 \n10,910 \n- 9 470 \n$ 1,075 \nPart II: Call Option Strategies \nMethod 2 \nProfit if unchanged-cash \nLess margin interest charges -\nNet profit if unchanged\nmargin \n$1,620 \n545 \n$1,075 \nReturn if unchanged = $ l ,075 = 11 .4% \n$9,470 \nTABLE 2-11. \nBreak-even point-margin write. \nNet margin investment \nPlus debit balance \nLess dividends \nPlus margin interest charges \nTotal stock cost to expiration \nDivide by shares held \nBreak-even point-margin \nTABLE 2-12. \nPercent downside protection-margin write. \nInitial stock price \nLess break-even price-margin \nPoints of protection \nDivide by original stock price \nEquals percent downside protection-margin \n$ 9,470 \n+ 10,910 \n500 \n+ 545 \n$20,425 \n+ 500 \n40.9 \n43 \n-40.9 \n2.1 \n+43 \n4.9% \nThe return if exercised is 18.4% for the covered write using margin. In Example \n1 the return if exercised for a cash write was computed as 11.2%. Thus, the return if \nexercised from a margin write is considerably higher. In fact, unless a fairly deep in\nthe-money write is being considered, the return on margin will always be higher than \nCl,apter 2: Covered Call Writing 53 \nthe return from cash. The farther out-of-the-money that the written call is, the big\nger the discrepancy between cash and margin returns will be when the return if exer\ncised is computed. \nAs with the computation for return if exercised for a write on margin, the return \nif unchanged calculation is similar for cash and margin also. The only difference is the \nsubtraction of the margin interest charges from the profit. The return if unchanged is \nalso higher for a margin write, provided that there is enough option premium to com\npensate for the margin interest charges. The return if unchanged in the cash example \nwas 7.9% versus 11.4% for the margin write. In general, the farther from the strike in \neither direction - out-of-the-money or in-the-money - the less the return if \nunchanged on margin will exceed the cash return if unchanged. In fact, for deeply out\nof-the-money or deeply in-the-money calls, the return if unchanged will be higher on \ncash than on margin. Table 2-11 shows that the break-even point on margin, 40.9, is \nhigher than the break-even point from a cash write, 39.8, because of the margin inter\nest charges. Again, the percent downside protection can be computed as shown in \nTable 2-12. Obviously, since the break-even point on margin is higher than that on \ncash, there is less percent downside protection in a margin covered write. \nOne other point should be made regarding a covered write on margin: The bro\nkerage firm will loan you only half of the strike price amount as a maximum. Thus, it \nis not possible, for example, to buy a stock at 20, sell a deeply in-the-money call struck \nat 10 points, and trade for free. In that case, the brokerage firm would loan you only \n5 - half the amount of the strike. \nEven so, it is still possible to create a covered call write on margin that has little or \neven zero margin .requirement. For example, suppose a stock is selling at 38 and that a \nlong-term LEAPS option struck at 40 is selling for 19. Then the margin requirement is \nzero! This does not mean you're getting something for free, however. True, your invest\nment is zero, but your risk is still 19 points. Also, your broker would ask for some sort of \nminimum margin to begin with and would of course ask for maintenance margin if the \nunderlying stock should fall in price. Moreover, you would be paying margin interest all \nduring the life of this long-term LEAPS option position. Leverage can be a good thing or \na bad thing, and this strategy has a great deal of leverage. So be careful if you utilize it. \nCOMPOUND INTEREST \nThe astute reader will have noticed that our computations of margin interest have \nbeen overly simplistic; the compounding effect of interest rates has been ignored. \nThat is, since interest charges are normally applied to an account monthly, the \ninvestor will be paying interest in the later stages of a covered writing position not \nonly on the original debit, but on all previous monthly interest charges. This effect is \ndescribed in detail in a later chapter on arbitrage techniques. Briefly stated, rather \n54 Part II: Call Option Strategies \nthan computing the interest charge as the debit times the interest rate multiplied by \nthe time to expiration, one should technically use: \nMargin interest charges = Debit [(l + r/ -1] \nwhere r is the interest rate per month and t the number of months to expiration. (It \nwould be incorrect to use days to expiration, since brokerage firms compute interest \nmonthly, not daily.) \nIn Example 2 of the preceding section, the debit was $10,910, the time was 6 \nmonths, and the annual interest rate was 10%. Using this more complex formula, the \nmargin interest charges would be $557, as opposed to the $545 charge computed \nwith the simpler formula. Thus, the difference is usually small, in terms of percent\nage, and it is therefore comrrwn practice to use the simpler method. \nSIZE OF THE POSITION \nSo far it has been assumed that the writer was purchasing 500 shares of XYZ and sell\ning 5 calls. This requires a relatively considerable investment for one position for the \nindividual investor. However, one should be aware that buying too few shares for cov\nered writing purposes can lower returns considerably. \nExample: If an investor were to buy 100 shares of XYZ at 43 and sell l July 45 call \nfor 3, his return if exercised would drop from the 11.2% return (cash) that was com\nputed earlier", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 27}
{"text": "This requires a relatively considerable investment for one position for the \nindividual investor. However, one should be aware that buying too few shares for cov\nered writing purposes can lower returns considerably. \nExample: If an investor were to buy 100 shares of XYZ at 43 and sell l July 45 call \nfor 3, his return if exercised would drop from the 11.2% return (cash) that was com\nputed earlier to a return of9.9% in a cash account. Table 2-13 verifies this statement. \nSince commissions are less, on a per-share basis, when one buys more stock and \nsells more calls, the returns will naturally be higher with a 500- or 1,000-share posi\ntion than with a 100- or 200-share position. This difference can be rather dramatic, as \nTables 2-14 and 2-15 point out. Several interesting and worthwhile conclusions can be \ndrawn from these tables. The first and most obvious conclusion is that the rrwre shares \nTABLE 2-13. \nCash investment vs. return. \nNet Investment-Cash ( l 00 shares) \nStock cost $4,300 \nPlus commissions + 85 \nLess option premium 300 \nPlus option commissions + 25 \nNet investment $4,110 \nReturn If Exercised-Cash ( l 00 shares) \nStock sale price \nStock commissions \nPlus dividend \nLess net investment \nNet profit if exercised \n$4,500 \n85 \n+ 100 \n- 4 110 \n$ 405 \nReturn if exercised = $4 05 = 9. 9% \n$4,110 \nCl,apter 2: Covered Call Writing 55 \none writes against, the higher his returns and the lower his break-even point will be. \nThis is true for both cash and margin and is a direct result of the way commissions are \nfigured: Larger trades involve smaller percentage commission charges. While the per\ncentage returns increase as the number of shares increases for both cash and margin \ncovered writing, the increase is much more dramatic in the case of margin. Note that \nin Table 2-14, which depicts cash transactions, the return from writing against 100 \nshares is 9.9% and increases to 12. 7% if 2,000 shares are written against. This is an \nincrease, but not a particularly dramatic one. However, in Table 2-15, the return if \nexercised more than doubles (21.6 vs. 10.4) and the return if unchanged nearly triples \n(13.0 vs. 4.4) when the 100-share write is compared to the 2,000-share write. This \neffect is more dramatic for margin writes due to two factors - the lower investment \nrequired and the more burdensome effect of margin interest charges on the profits of \nsmaller positions. This effect is so dramatic that a 100-share write in a cash account in \nour example actually offers a higher return if unchanged than does the margin write \n- 7.1 % vs. 4.4%. This implies that one should carefully compute his potential returns \nif he is writing against a small number of shares on margin. \nTABLE 2-14. \nCash covered writes (costs included). \nShares Written Against \n100 200 300 400 500 1,000 2,000 \nReturn if exercised (%) 9.9 10.0 10.4 10.8 11.2 12.1 12.7 \nRe~rn if unchanged(%) 7.1 7.2 7.5 7.7 7.9 8.4 8.7 \nBreak-even point 40.1 40.0 39.9 39.9 39.8 39.6 39.5 \nTABLE 2-15. \nMargin covered writes (costs included). \nShares Written Against \n100 200 300 400 500 1,000 2,000 \nReturn if exercised (%) 10.4 15.8 16.6 17.4 18.4 20.4 21.6 \nReturn if unchanged (%) 4.4 9.8 10.3 10.8 11.4 12.3 13.0 \nBreak-even point 41.2 41.1 41.0 41.0 40.9 40.7 40.6 \nWHAT A DIFFERENCE A DIME MAKES \nAnother aspect of covered writing that can be important as far as potential returns \nare concerned is, of course, the prices of the stock and option involved in the write. \n56 Part II: Call Option Strategies \nIt may seem insignificant that one has to pay an extra few cents for the stock or pos\nsibly receives a dime or 20 cents less for the call, but even a relatively small fraction \ncan alter the potential returns by a surprising amount. This is especially true for in\nthe-money writes, although any write will be affected. Let us use the previous 500-\nshare covered writing example, again including all costs. \nAs before, the results are more dramatic for the margin write than for the cash \nwrite. In neither case does the break-even point change by much. However, the \npotential returns are altered significantly. Notice that if one pays an extra dime for \nthe stock and receives a dime less for the call - the far right-hand column in Table \n2-16 - he may greatly negate the effect of writing against a larger number of shares. \nFrom Table 2-16, one can see that writing against 300 shares at those prices (43 for \nthe stock and 3 for the call) is approximately the same return as writing against 500 \nshares if the stock costs 431/s and the option brings in 27/s. \nTable 2-16 should clearly demonstrate that entering a covered writing order at \nthe market may not be a prudent thing to do, especially if one's calculations for the \npotential returns are based on last sales or on closing prices in the newspaper. In the \nnext section, we discuss in depth the proper procedure for entering a covered writ\ning order. \nTABLE 2-16. \nEffect of stock and option prices on writing returns. \nBuy Stock at 43 Buy Stock at 43.10 \nSell Call at 3 Sell Call at 3 \nReturn if exercised 11.2% cash 10.9% cash \n18.4% margin 17.7% margin \nReturn if unchanged 7.9% cash 7.6% cash \n11 .4% margin 10.7% margin \nBreak-even point 39.8 cash 39.9 cash \n40.9 margin 41.0 margin \nEXECUTION OF THE COVERED WRITE ORDER \nBuy Stock at 43. I 0 \nSell Call at 2.90 \n10.6% cash \n16. 9% margin \n7.3% cash \n9.9% margin \n40.0 cash \n41.1 margin \nWhen establishing a covered writing position, the question often arises: Which \nshould be done first - buy the stock or sell the option? The correct answer is that nei\nther should be done first! In fact, a simultaneous transaction of buying the stock and \nselling the option is the only way of assuring that both sides of the covered write are \nestablished at desired price levels. \nCl,apter 2: Covered Call Writing 57 \nIf one \"legs\" into the position - that is, buys the stock first and then attempts to \nsell the option, or vice versa - he is subjecting himself to a risk.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 28}
{"text": "uld be done first! In fact, a simultaneous transaction of buying the stock and \nselling the option is the only way of assuring that both sides of the covered write are \nestablished at desired price levels. \nCl,apter 2: Covered Call Writing 57 \nIf one \"legs\" into the position - that is, buys the stock first and then attempts to \nsell the option, or vice versa - he is subjecting himself to a risk. \nExample: An investor wants to buy XYZ at 43 and sell the July 45 call at 3. Ifhe first \nsells the option at 3 and then tries to buy the stock, he may find that he has to pay \nmore than 43 for the stock. On the other hand, if he tries to buy the stock first and \nthen sell the option, he may find that the option price has moved down. In either case \nthe writer will be accepting a lower return on his covered write. Table 2-16 demon\nstrated how one's returns might be affected ifhe has to give up an eighth by \"legging\" \ninto the position. \nESTABLISHING A NET POSITION \nWhat the covered writer really wants to do is ensure that his net price is obtained. If \nhe wants to buy stock at 43 and sell an option at 3, he is attempting to establish the \nposition at 40 net. He normally would not mind paying 43.10 for the stock if he can \nsell the call at 3.10, thereby still obtaining 40 net. \nA \"net\" covered writing order must be placed with a brokerage firm because it \nis essential for the person actually executing the order to have full access to both the \nstock exchange and the option exchange. This is also referred to as a contingent \norder. Most major brokerage firms offer this service to their clients, although some \nplace a minimum number of shares on the order. That is, one must write against at \nleast 500 or 1,000 shares in order to avail himself of the service. There are, however, \nbrokerage firms that will take net orders even for 100-share covered writes. Since the \nchances of giving away a dime are relatively great if one attempts to execute his own \norder by placing separate orders on two exchanges - stock and option - he should \navail himself of the broker's service. Moreover, if his orders are for a small number of \nshares, he should deal with a broker who will take net orders for small positions. \nThe reader must understand that there is no guarantee that a net order will be \nfilled. The net order is always a \"not held\" order, meaning that the customer is not \nguaranteed an execution even if it appears that the order could be filled at prevailing \nmarket bids and offers. Of course, the broker will attempt to fill the order if it can \nreasonably be accomplished, since that is his livelihood. However, if the net order is \nslightly away from current market prices, the broker may have to \"leg\" into the posi\ntion to fill the order. The risk in this is the broker's responsibility, not the customer's. \nTherefore, the broker may elect not to take the risk and to report \"nothing done\" -\nthe order is not filled. \nIf one buys stock at 43 and sells the call at 3, is the return really the same as buy\ning the stock at 43.10 and selling the call at 3.10? The answer is, yes, the returns are \n58 Part II: Call Option Strategies \nvery similar when the prices differ by small amounts. This can be seen without the \nuse of a table. If one pays a dime more for the stock, his investment increases by $10 \nper 100 shares, or $50 total on a 500-share transaction. However, the fact that he has \nreceived an extra dime for the call means that the investment is reduced by $62.50. \nThus, there is no effect on the net investment except for commissions. The commis\nsion on 500 shares at 43.10 may be slightly higher than the commission for 500 shares \nat 43. Similarly, the commission on 5 calls at 3.10 may be slightly higher than that on \n5 calls at 3. Even so, the increase in commissions would be so small that it would not \naffect the return by more than one-tenth of 1 %. \nTo carry this concept to extremes may prove somewhat misleading. If one were \nto buy stock at 40½ and sell the call at ½, he would still be receiving 40 net, but sev\neral aspects would have changed considerably. The return if exercised remains amaz\ningly constant, but the return if unchanged and the percentage downside protection \nare reduced dramatically. If one were to buy stock at 48 and sell the call at 8 - again \nfor 40 net - he would improve the return if unchanged and the percentage downside \nprotection. In reality, when one places a \"net\" order with a brokerage firm, he nor\nmally gets an execution with prices quite close to the ones at the time the order was \nfirst entered. It would be a rare case, indeed, when either upside or downside \nextremes such as those mentioned here would occur in the same trading day. \nSELECTING A COVERED WRITING POSITION \nThe preceding sections, in describing types of covered writes and how to compute \nreturns and break-even points, have laid the groundwork for the ultimate decision \nthat every covered writer must make: choosing which stock to buy and which option \nto write. This is not necessarily an easy task, because there are large numbers of \nstocks, striking prices, and expiration dates to choose from. \nSince the primary objective of covered writing for most investors is increased \nincome through stock ownership, the return on investment is an important consider\nation in determining which write to choose. However, the decision must not be made \non the basis of return alone. More volatile stocks will offer higher returns, but they \nmay also involve more risk because of their ability to fall in price quickly. Thus, the \namount of downside protection is the other important objective of covered writing. \nFinally, the quality and technical or fundamental outlook of the underlying stock \nitself are of importance as well. The following section will help to quantify how these \nfactors should be viewed by the covered writer. \nChapter 2: Covered Call Writing \nPROJECTED RETURNS \n59 \nThe return that one strives for is somewhat a matt", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 29}
{"text": "ownside protection is the other important objective of covered writing. \nFinally, the quality and technical or fundamental outlook of the underlying stock \nitself are of importance as well. The following section will help to quantify how these \nfactors should be viewed by the covered writer. \nChapter 2: Covered Call Writing \nPROJECTED RETURNS \n59 \nThe return that one strives for is somewhat a matter of personal preference. In gen\neral, the annualized return if unchanged should be used as the comparative measure \nbetween various covered writes. In using this return as the measuring criterion, one \ndoes not make any assumptions about the stock moving up in price in order to attain \nthe potential return. A general rule used in deciding what is a minimally acceptable \nreturn is to consider a covered writing position only when the return if unchanged is \nat least 1 % per month. That is, a 3-month write would have to offer a return of at \nleast 3% and a 6-month write would have to have a return if unchanged of at least \n6%. During periods of expanded option premiums, there may be so many writes that \nsatisfy this criterion that one would want to raise his sights somewhat, say to 1 ½% or \n2% per month. Also, one must feel personally comfortable that his minimum return \ncriterion - whether it be 1 % per month or 2% per month - is large enough to com\npensate for the risks he is taking. That is, the downside risk of owning stock, should \nit fall far enough to outdistance the premium received, should be adequately com\npensated for by the potential return. It should be pointed out that 1 % per month is \nnot a return to be taken lightly, especially if there is a reasonable assurance that it can \nbe attained. However, if less risky investments, such as bonds, were yielding 12% \nannually, the covered writer must set his sights higher. \nNormally, the returns from various covered writing situations are compared by \nannualizing the returns. One should not, however, be deluded into believing that he \ncan always attain the projected annual return. A 6-month write that offers a 6% \nreturn annualizes to 12%. But if one establishes such a position, all that he can \nachieve is 6% in 6 months. One does not really know for sure that 6 months from now \nthere will be another position available that will provide 6% over the next 6 months. \nThe deeper that the written option is in-the-money, the higher the probability \nthat the return if unchanged will actually be attained. In an in-the-money situation, \nrecall that the return if unchanged is the same as the return if exercised. Both would \nbe attained unless the stock fell below the striking price by expiration. Thus, for an in\nthe-money write, the projected return is attained if the stock rises, remains unchanged, \nor even falls slightly by the time the option expires. Higher potential returns are avail\nable for out-of-the-money writes if the stock rises. However, should the stock remain \nthe same or decline in price, the out-of-the-money write will generally underperform \nthe in-the-money write. This is why the return if unchanged is a good comparison. \nDOWNSIDE PROTECTION \nDownside protection is more difficult to quantify than projected returns are. As men\ntioned earlier, the percentage of downside protection is often used as a measure. This \n60 Part II: Call Option Strategies \nis somewhat misleading, however, since the more volatile stocks will always offer a \nlarge percentage of downside protection (their premiums are higher). The difficulty \narises in trying to decide if 10% protection on a volatile stock is better than or worse \nthan, say, 6% protection on a less volatile stock. There are mathematical ways to \nquantify this, but because of the relatively advanced nature of the computations \ninvolved, they are not discussed until later in the text, in Chapter 28 on mathemati\ncal applications. \nRather than go into involved mathematical calculations, many covered writers \nuse the percentage of downside protection and will only consider writes that offer a \ncertain minimum level of protection, say 10%. Although this is not exact, it does \nstrive to ensure that one has minimal downside protection in a covered write, as well \nas an acceptable return. A standard figure that is often used is the 10% level of pro\ntection. Alternatively, one may also require that the write be a certain percent in-the\nmoney, say 5%. This is just another way of arriving at the same concept. \nTHE IMPORTANCE OF STRATEGY \nIn a conservative option writing strategy, one should be looking for minimum returns \nif unchanged of 1 % per month, with downside protection of at least 10%, as general \nguidelines. Employing such criteria automatically forces one to write in-the-money \noptions in line with the total return concept. The overall position constructed by \nusing such guidelines as these will be a relatively conservative position - regardless \nof the volatility of the underlying stock - since the levels of protection will be large \nbut a reasonable return can still be attained. There is a danger, however, in using \nfixed guidelines, because market conditions change. In the early days of listed \noptions, premiums were so large that virtually every at- or in-the-money covered \nwrite satisfied the foregoing criteria. However, now one should work with a ranked \nlist of covered writing positions, or perhaps two lists. A daily computer ranking of \neither or both of the following categories would help establish the most attractive \ntypes of conservative covered writes. One list would rank, by annualized return, the \nwrites that afford, as a minimum, the desired downside protection level, say 10%. \nThe other list would rank, by percentage downside protection, all the writes that \nmeet at least the minimum acceptable return if unchanged, say 12%. If premium lev\nels shrink and the lists become quite small on a daily basis, one might consider \nexpanding the criteria to view more potential situations. On", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 30}
{"text": "rn, the \nwrites that afford, as a minimum, the desired downside protection level, say 10%. \nThe other list would rank, by percentage downside protection, all the writes that \nmeet at least the minimum acceptable return if unchanged, say 12%. If premium lev\nels shrink and the lists become quite small on a daily basis, one might consider \nexpanding the criteria to view more potential situations. On the other hand, if pre\nmiums expand dramatically, one might consider using more restrictive criteria, to \nreduce the number of potential writing candidates. \nA different group of covered writers may favor a more aggressive strategy of out\nof-the-money writes. There is some mathematical basis to believe, in the long rnn, that \nChapter 2: Covered Call Writing 61 \nrrwderately out-of the-rrwney covered writes will peiform better than in-the-rrwney \nwrites. In falling or static markets, any covered writer, even the more aggressive one, \nwill outperform the stockowner who does not write calls. The out-of-the-money cov\nered writer has more risk in such a market than the in-the-money writer does. But in \na rising market, the out-of-the-money covered writer will not limit his returns as much \nas the in-the-money writer will. As stated earlier, the out-of-the-money writer's per\nformance will more closely follow the performance of the underlying stock; that is, it \nwill be more volatile on a quarter-by-quarter basis. \nThere is merit in either philosophy. The in-the-money writes appeal to those \ninvestors looking to earn a relatively consistent, moderate rate of return. This is the \ntotal return concept. These investors are generally concerned with preservation of \ncapital, thus striving for the greater levels of downside protection available from in\nthe-money writes. On the other hand, some investors prefer to strive for higher \npotential returns through writing out-of-the-money calls. These more aggressive \ninvestors are willing to accept more downside risk in their covered writing positions \nin exchange for the possibility of higher returns should the underlying stock rise in \nprice. These investors often rely on a bullish research opinion on a stock in order to \nselect out-of-the-money writes. \nAlthough the type of covered writing strategy pursued is a matter of personal \nphilosophy, it would seem that the benefits of in-the-money strategy- more consis\ntent returns and lessened risk than stock ownership will normally provide - would \nlead the portfolio manager or less aggressive investor toward this strategy. If the \ninvestor is interested in achieving higher returns, some of the strategies to be pre\nsented later in the book may be able to provide higher returns with less risk than can \nout-of-the-money covered writing. \nThe final important consideration in selecting a covered write is the underlying \nstock itself. One does not necessarily have to be bullish on the underlying stock to \ntake a covered writing position. As long as one does not foresee a potential decline in \nthe underlying stock, he can feel free to establish the covered writing position. It is \ngenerally best if one is neutral or slightly bullish on the underlying stock. If one is \nbearish, he should not take a covered writing position on that stock, regardless of the \nlevels of protection that can be obtained. An even broader statement is that one \nshould not establish a covered write on a stock that he does not want to own. Some \nindividual investors may have qualms about buying stock they feel is too volatile for \nthem. Impartially, if the return and protection are adequate, the characteristics of the \ntotal position are different from those of the underlying stock. However, it is still true \nthat one should not invest in positions that he considers too risky for his portfolio, nor \nshould one establish a covered write just because he likes a particular stock. If the \n62 Part II: Call Option Strategies \npotential return is unchanged or levels of downside protection do not meet one's cri\nteria, the write should not be established. \nThe covered writing strategist strives for a balance between acceptable returns \nand downside protection. He rejects situations that do not meet his criteria in either \ncategory and rejects stocks on which he is bearish. The resulting situations will prob\nably fulfill the objectives of a conservative covered writing program: increased income, \nprotection, and less variability of results on a less volatile investment portfolio. \nWRITING AGAINST STOCK ALREADY OWNED \nEstablishing covered writing positions against stock that has previously been pur\nchased involves other factors. It is often the case that an investor owns stock that \nhas listed options trading, but feels that the returns from writing are too low in \ncomparison to other covered writes that simultaneously exist in the marketplace. \nThis opinion may be valid, but often arises from the fact that the investor has seen \na computer-generated list showing returns on his stock as being low in comparison \nto similarly priced stocks. One should note that such lists generally assume that \nstock is bought in order to establish the covered write; the returns are usually not \ncomputed and published for writing against stock already held. It may be the case \nthat the commission costs for selling one stock and investing in another may alter \nthe returns so substantially that one would be better off to write against the shares \nof stock initially held. \nExample: An investor owns XYZ stock and is comparing it against AAA stock for \nwriting purposes. If AAA is more volatile than XYZ, the current prices might appear \nas follows: \nStock \nXYZ: 50 \nAAA:50 \nOct 50 Coll \n4 \n6 \nTable 2-17 summarizes the computation of the return if exercised as one might \nsee it listed on a daily or weekly summary of available covered writing returns. \nAssume that 500 shares are being written against, that XYZ will pay 50 cents per \nshare in dividends while AAA pays none during the life of", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 31}
{"text": "than XYZ, the current prices might appear \nas follows: \nStock \nXYZ: 50 \nAAA:50 \nOct 50 Coll \n4 \n6 \nTable 2-17 summarizes the computation of the return if exercised as one might \nsee it listed on a daily or weekly summary of available covered writing returns. \nAssume that 500 shares are being written against, that XYZ will pay 50 cents per \nshare in dividends while AAA pays none during the life of the call, and that the \nOctober 50 is a 6-month call. \nWithout going into as much detail, the other significant aspects of these two \nwrites are: \nChapter 2: Covered Call Writing \nReturn if exercised - margin \nDownside break-even point cash \nDownside break-even point - margin \nXYZ \n7.9% \n46.3 \n47.6 \n63 \nAAA \n16.2% \n44.9 \n46.1 \nSeeing these calculations, the XYZ stockholder may feel that it is not advisable to \nwrite against his stock, or he may even be tempted to sell XYZ and buy AAA in order \nto establish a covered write. Either of these actions could be a mistake. \nFirst, he should compute what his returns would be, at current prices, from \nwriting against the XYZ he already owns. Since the stock is already held, no stock buy \ncommissions would be involved. This would reduce the net investment shown below \nby the stock purchase commissions, or $345, giving a total net investment (cash) of \n$23,077. In theory, the stockholder does not really make an investment per se; after \nall, he already owns the stock. However, for the purposes of computing returns, an \ninvestment figure is necessary. This reduction in the net investment will increase his \nprofit by the same amount - $345 - thus, bringing the profit up to $1,828. \nConsequently, the return if exercised (cash) wpuld be 7.9% on XYZ stock already \nheld. On margin, the return would increase to 11.3% after eliminating purchase com\nmissions. This return, assumed to be for a 6-month period, is well in excess of 1 % per \nTABLE 2-17. \nSummary of covered writing returns, XYZ and AAA. \nXYZ AAA \nBuy 500 shares at 50 $25,000 $25,000 \nPlus stock commissions + 345 + 345 \nLess option premiums received - 2,000 - 3,000 \nPlus option sale commissions + 77 + 91 \nNet investment-cash $23,422 $22,436 \nSell 500 shares at 50 $25,000 $25,000 \nLess stock sale commissions 345 345 \nDividend received + 250 0 \nLess net investment - 23,422 - 22,436 \nNet profit $ 1,483 $ 2,219 \nReturn if exercised-cash 6.3% 9.9% \n' 64 Part II: Call Option Strategies \nmonth, the level nominally used for acceptable covered writes. Thus, the investor \nwho already owns stock may inadvertently be overlooking a potentially attractive cov\nered write because he has not computed the returns excluding the stock purchase \ncommission on his current stock holding. \nIt could conceivably be an even more extreme oversight for the investor to \nswitch from XYZ to AAA for writing purposes. The investor may consider making this \nswitch because he thinks that he could substantially increase his return, from 6.3% to \n9.9% for the 6-month period, as shown in Table 2-17 comparing the two writes. \nHowever, the returns are not truly comparable because the investor already \nowns XYZ. To make the switch, he would first have to spend $345 in stock commis\nsions to sell his XYZ, thereby reducing his profits on AAA by $345. Referring again to \nthe preceding detailed breakdown of the return if exercised, the profit on AAA would \nthen decline to $1,874 on the investment of $22,436, a return if exercised (cash) of \n8.4%. On margin, the comparable return from switching stocks would drop to 14.8%. \nThe real comparison in returns from writing against these two stocks should be \nmade in the following manner. The return from writing against XYZ that is already \nheld should be compared with the return from writing against AAA after switching \nfromXYZ: \nReturn if exercised - cash \nReturn if exercised - margin \nXYZ Already Held \n7.9% \n11.3% \nSwitch from XYZ to AAA \n8.4% \n14.8% \nEach investor must decide for himself whether it is worth this much smaller \nincrease in return to switch to a more volatile stock that pays a smaller dividend. He \ncan, of course, only make this decision by making the true comparison shown imme\ndiately above as opposed to the first comparison, which assumed that both stocks had \nto be purchased in order to establish the covered write. \nThe same logic applies in situations in which an investor has been doing cov\nered writing. If he owns stock on which an option has expired, he will have to decide \nwhether to write against the same stock again or to sell the stock and buy a new stock \nfor covered writing purposes. Generally, the investor should write against the stock \nalready held. This justifies the method of computation of return if unchanged for out\nof-the-money writes and also the computation of downside break-even points in \nwhich a stock sale commission was not charged. That is, the writer would not nor\nmally sell his stock after an option has expired worthless, but would instead write \nanother option against the same stock. It is thus acceptable to make these computa\ntions without including a stock sales commission. \nChapter 2: Covered Call Writing \nA WORD OF CAUTION \n65 \nThe stockholder who owns stock from a previous purchase and later contemplates \nwriting calls against that stock must be aware of his situation. He must realize and \naccept the fact that he might lose his stock via assignment. If he is determined to \nretain ownership of the stock, he may have to buy back the written option at a loss \nshould the underlying stock increase in price. In essence, he is limiting the stock's \nupside potential. If a stockholder is going to be frustrated and disappointed when he \nis not fully participating during a rally in his stock, he should not write a call in the \nfirst place. Perhaps he could utilize the incremental return concept of covered writ\ning, a topic covered later in this chapter. \nAs stressed earlier, a covered writing strategy involves viewing the stock and \noption as a total position. It is n", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 32}
{"text": "stockholder is going to be frustrated and disappointed when he \nis not fully participating during a rally in his stock, he should not write a call in the \nfirst place. Perhaps he could utilize the incremental return concept of covered writ\ning, a topic covered later in this chapter. \nAs stressed earlier, a covered writing strategy involves viewing the stock and \noption as a total position. It is not a strategy wherein the investor is a stockholder who \nalso trades options against his stock position. If the stockholder is selling the calls \nbecause he thinks the stock is going to decline in price and the call trade itself will be \nprofitable, he may be putting himself in a tenuous position. Thinking this way, he will \nprobably be satisfied only if he makes a profit on the call trade, regardless of the \nunrealized result in the underlying stock. This sort of philosophy is contrary to a cov\nered writing strategy philosophy. Such an investor - he is really becoming a trader \nshould carefully review his motives for writing the call and anticipate his reaction if \nthe stock rises substantially in price after the call has been written. \nIn essence, writing calls against stock that you have no intention of selling is \ntantamount to writing naked calls! If one is going to be extremely frustrated, perhaps \neven experiencing sleepless nights, if his stock rises above the strike price of the call \nthat he has written, then he is experiencing trials and tribulations much as the writer \nof a naked call would if the same stock move occurred. This is an unacceptable level \nof emotional worry for a true covered writing strategist. \nThink about it. If you have some very low-cost-basis stock that you don't really \nwant to sell, and then you sell covered calls against that stock, what do you wish will \nhappen? Most certainly you wish that the options will expire worthless (i.e., that the \nstock won't get called away) - exactly what a naked writer wishes for. \nThe problems can be compounded if the stock rises, and one then decides to \nroll these calls. Rather than spend a small debit to close out a losing position, an \ninvestor may attempt to roll to more distant expiration months and higher strike \nprices in order to keep bringing in credits. Eventually, he runs out of room as the \nlower strikes disappear, and he has to either sell some stock or pay a big debit to buy \nback the written calls. So, if the underlying stock continues to run higher, the writer \nsuffers emotional devastation as he attempts to \"fight the market.\" There have been \nsome classic cases of Murphy's law whereby people have covered the calls at a big \n66 Part II: Call Option Strategies \ndebit rather than let their \"untouchable\" stock be called away, just before the stock \nitself or the stock market collapsed. \nOne should be very cautious about writing covered calls against stocks that he \ndoesn't intend to sell. If one feels that he cannot sell his stock, for whatever reason -\ntax considerations, emotional ties, etc. - he really should not sell covered calls against \nit. Perhaps buying a protective put ( discussed in a later chapter) would be a better \nstrategy for such a stockholder. \nDIVERSIFYING RETURN AND PROTECTION \nIN A COVERED WRITE \nFUNDAMENTAL DIVERSIFICATION TECHNIQUES \nQuite clearly, the covered writing strategist would like to have as much of a combina\ntion of high potential returns and adequate downside protection as he can obtain. \nWriting an out-of-the-money call will offer higher returns if exercised, but it usually \naffords only a modest amount of downside protection. On the other hand, writing an \nin-the-money call will provide more downside cushion but offers a lower return if \nexercised. For some strategists, this diversification is realized in practice by writing \nout-of-the-money calls on some stocks and in-the-moneys on other stocks. There is no \nguarantee that writing in this manner on a list of diversified stocks will produce supe\nrior results. One is still forced to pick the stocks that he expects will perform better \n(for out-of-the-money writing), and that is difficult to do. Moreover, the individual \ninvestor may not have enough funds available to diversify into many such situations. \nThere is, however, another alternative to obtaining diversification of both returns and \ndownside protection in a covered writing situation. \nThe writer may often do best by writing half of his position against in-the-rrwn\neys and half against out-of the-rrwneys on the same stock. This is especially attractive \nfor a stock whose out-of-the-money calls do not appear to provide enough downside \nprotection, and at the same time, whose in-the-money calls do not provide quite \nenough return. By writing both options, the writer may be able to acquire the return \nand protection diversification that he is seeking. \nExample: The following prices exist for 6-month calls: \nXYZ common stock, 42; \nXYZ April 40 call, 4; and \nXYZ April 45 call, 2. \nChapter 2: Covered Call Writing 67 \nThe writer wishing to establish a covered write against XYZ common stock may like \nthe protection afforded by the April 40 call, but may not find the return particularly \nattractive. He may be able to improve his return by writing April 45's against part of \nhis position. Assume the writer is considering buying 1,000 shares of XYZ. Table 2-18 \ncompares the attributes of writing the out-of-the-money (April 45) only, or of writing \nonly the in-the-money (April 40), or of writing 5 of each. The table is based on a cash \ncovered write, but returns and protection would be similar for a margin write. \nCommissions are included in the figures. \nIt is easily seen that the \"combined\" write - half of the position against the April \n40's and the other half against the April 45's - offers the best balance of return and \nprotection. The in-the-money call, by itself, provides over 10% downside protection, \nbut the 5% return if exercised is less than 1 % per month. Thus, one migh", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 33}
{"text": "lar for a margin write. \nCommissions are included in the figures. \nIt is easily seen that the \"combined\" write - half of the position against the April \n40's and the other half against the April 45's - offers the best balance of return and \nprotection. The in-the-money call, by itself, provides over 10% downside protection, \nbut the 5% return if exercised is less than 1 % per month. Thus, one might not want \nto write April 40's against his entire position, because the potential return is small. At \nthe same time, the April 45's, if written against the entire stock position, would pro\nvide for an attractive return if exercised (over 2% per month) but offer only 5% down\nside protection. The combined write, which has the better features of both options, \noffers over 8% return if exercised (11h% per month) and affords over 8% downside \nprotection. By writing both calls, the writer has potentially solved the problems inher\nent in writing entirely out-of-the-moneys or entirely in-the-moneys. The \"combined\" \nwrite frees the covered writer from having to initially take a bearish (in-the-money \nwrite) or bullish (out-of-the-money write) posture on the stock ifhe does not want to. \nThis is often necessary on a low-volatility stock trading between striking prices. \nTABLE 2-18. \nAttributes of various writes. \nBuy 1,000 XYZ and sell \nReturn if exercised \nRe~rn if unchanged \nPercent protection \nIn-the-Money \nWrite \n10 April 40's \n5.1% \n5.1% \n10.5% \nOut-of-the-Money \nWrite \nl O April 45's \n12.2% \n6.0% \n5.7% \nWrite \nBoth Calls \n5 April 40's and \n5 April 45's \n8.4% \n5.4% \n8.1% \nFor those who prefer a graphic representation, the profit graph shown in Figure \n2-2 compares the combined write of both calls with either the in-the-money write or \nthe out-of-the-money write (dashed lines). It can be observed that all three choices \nare equal if XYZ is near 42 at expiration; all three lines intersect there. \n68 Part II: Call Option Strategies \nFIGURE 2-2. \nComparison: combined write vs. in-the-money write and out-of-the\nmoney write. \nOut-of-the-Money Write \n, \n.-------► ,,, Combined Write , \n/ In-the-Money Write \n-----------➔ \nStock Price at Expiration \nSince this technique can be useful in providing diversification between protec\ntion and return, not only for an individual position but for a large part of a portfolio, \nit may be useful to see exactly how to compute the potential returns and break-even \npoints. Tables 2-19 and 2-20 calculate the return if exercised and the return if \nunchanged using the prices from the previous example. Assume XYZ will pay $1 per \nshare in dividends before April expiration. \nNote that the profit calculations are similar to those described in earlier sec\ntions, except that now there are two prices for stock sales since there are two options \ninvolved. In the \"return if exercised\" section, half of the stock is sold at 45 and half is \nsold at 40. The \"return if unchanged\" calculation is somewhat more complicated now, \nTABLE 2-19. \nNet investment-cash account. \nBuy 1,000 XYZ at 42 \nPlus stock commissions \nLess options premiums: \nSell 5 April 40's at 4 \nSell 5 April 45's at 2 \nPlus total option commissions \nNet investment \n+ \n$42,000 \n460 \n- 2,000 \n1,000 \n+ 140 \n$39,600 \nChapter 2: Covered Call Writing \nTABLE 2-20. \nNet return-cash account. \nReturn If Exercised \nSell 500 XYZ at 45 $22,500 \nSell 500 XYZ at 40 20,000 \nLess total stock sale \ncommissions 560 \nPlus dividends ($1 /share) + 1,000 \nLess net investment - 39,600 \nNet profit if exercised $ 3,340 \nReturn if exercised = 3,340 = 8_4% \n(cash) 39,600 \n69 \nReturn If Unchanged \nUnchanged stock value (500 \nshares at 42) $21,000 \nSell 500 at 40 + 20,000 \nCommissions on sale at 40 280 \nPlus dividends ($1 /share) . + 1,000 \nLess net investment - 39,600 \nNet profit if unchanged $ 2, 120 \nReturn if unchanged = 2, 120 = 5 _4% \n(cash) 39,600 \nbecause half of the stock will be called away if it remains unchanged (the in-the\nmoney portion) whereas the other half will not. This is consistent with the method of \ncalculating the return if unchanged that was introduced previously. \nThe break-even point is calculated as before. The \"total stock cost to expiration\" \nwould be the net investment of $39,600 less the $1,000 received in dividends. This is \na total of $38,600. On a per-share basis, then, the break-even point of 38.6 is 8.1 % \nbelow the current stock price of 42. Thus, the amount of percentage downside pro\ntection is 8.1 %. \nThe foregoing calculations clearly demonstrate that the returns on the \"com\nbined\" write are not exactly the averages of the in-the-money and out-of-the-money \nreturns, because of the different commission calculations at various stock prices. \nHowever, if one is working with a computer-generated list and does not want to both\ner to calculate exactly the return on the combined write, he can arrive at a relatively \nclose approximation by averaging the returns for the in-the-money write and the out\nof-the-money write. \nOTHER DIVERSIFICATION TECHNIQUES \nHolders of large positions in a particular stock may want even more diversification \nthan can be provided by writing against two different striking prices. Institutions, \npension funds, and large individual stockholders may fall into this category. It is often \nadvisable for such large stockholders to diversify their writing over time as well as \nover at least two striking prices. By diversifying over time - for example, writing one-\n70 Part II: Call Option Strategies \nthird of the position against near-term calls, one-third against middle-term calls, and \nthe remaining third against long-term calls - one can gain several benefits. First, all \nof one's positions need not be adjusted at the same time. This includes either having \nthe stock called away or buying back one written call and selling another. Moreover, \none is not subject only to the level of option premiums that exist at the time one \nseries of calls expires. For example, if one writes only 9-month calls and then", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 34}
{"text": "t long-term calls - one can gain several benefits. First, all \nof one's positions need not be adjusted at the same time. This includes either having \nthe stock called away or buying back one written call and selling another. Moreover, \none is not subject only to the level of option premiums that exist at the time one \nseries of calls expires. For example, if one writes only 9-month calls and then rolls \nthem over when they expire, he may unnecessarily be subjecting himself to the \npotential of lower returns. If option premium levels happen to be low when it is time \nfor this 9-month call writer to sell more calls, he will be establishing a less-than-opti\nmum write for up to 9 months. By spreading his writing out over time, he would, at \nworst, be subjecting only one-third of his holding to the low-premium write. \nHopefully, premiums would expand before the next eXpiration 3 months later, and he \nwould then be getting a relatively better premium on the next third of his portfolio. \nThere is an important aside here: The individual or relatively small investor who \nowns only enough stock to write one series of options should generally not write the \nlongest-term calls for this very reason. He may not be obtaining a particularly attrac\ntive level of premiums, but may feel he is forced to retain the position until expira\ntion. Thus, he could be in a relatively poor write for as long as 9 months. Finally, this \ntype of diversification may also lead to having calls at various striking prices as· the \nmarket fluctuates cyclically. All of one's stock is not necessarily committed at one \nprice if this diversification technique is employed. \nThis concludes the discussion of how to establish a covered writing position \nagainst stock. Covered writes against other types of securities are described later. \nFOLLOW-UP ACTION \nEstablishing a covered write, or any option position for that matter, is only part of the \nstrategist's job. Once the position has been taken, it must be monitored closely so that \nadjustments may be made should the stock drop too far in price. Moreover, even if \nthe stock remains relatively unchanged, adjustments will need to be made as the writ\nten call approaches expiration. \nSome writers take no follow-up action at all, preferring to let a stock be called \naway if it rises above the striking price at the expiration of the option, or preferring \nto let the original expire worthless if the stock is below the strike. These are not \nalways optimum actions; there may be much more decision making involved. \nFollow-up action can be divided into three general categories: \nChapter 2: Covered Call Writing 71 \n1. protective action to take if the stock drops, \n2. aggressive action to take when the stock rises, or \n3. action to avoid assignment if the time premium disappears from an in-the-money \ncall. \nThere may be times when one decides to close the entire position before expiration \nor to let the stock be called away. These cases are discussed as well. \nPROTECTIVE ACTION IF THE UNDERLYING STOCK DECLINES IN PRICE \nThe covered writer who does not take protective action in the face of a relatively sub\nstantial drop in price by the underlying stock may be risking the possibility of large \nlosses. Since covered writing is a strategy with limited profit potential, one should \nalso take care to limit losses. Otherwise, one losing position can negate several win\nning positions. The simplest form of follow-up action in a decline is to merely close \nout the position. This might be done if the stock declines by a certain percentage, or \nif the stock falls below a technical support level. Unfortunately, this method of defen\nsive action may prove to be an inferior one. The investor will often do better to con\ntinue to sell more time value in the form of additional option premiums. \nFollow-up action is generally taken by buying back the call that was originally \nwritten and then writing another call, with a different striking price and/or expiration \ndate, in its place. Any adjustment of this sort is referred to as a rolling action. When \nthe underlying stock drops in price, one generally buys back the original call - pre\nsumably at a profit since the underlying stock has declined - and then sells a call with \na lower striking price. This is known as rolling down, since the new option has a lower \nstriking price. \nExample: The covered writing position described as \"buy XYZ at 51, sell the XYZ \nJanuary 50 call at 6\" would have a maximum profit potential at expiration of 5 points. \nDownside protection is 6 points down to a stock price of 45 at expiration. These fig\nures do not include commissions, but for the purposes of an elementary example, the \ncommissions will be ignored. \nIf the stock begins to decline in price, taking perhaps two months to fall to 45, \nthe following option prices might exist: \nXYZ common, 45; \nXYZ January 50 call, l; and \nXYZ January 45 call, 4. \n72 Part II: Call Option Strategies \n• \nThe covered writer of the January 50 would, at this time, have a small unrealized loss \nof one point in his overall position: His loss on the common stock is 6 points, but he \nhas a 5-point gain in the January 50 call. (This demonstrates that prior to expiration, \na loss occurs at the \"break-even\" point.) If the stock should continue to fall from \nthese levels, he could have a larger loss at expiration. The call, selling for one point, \nonly affords one more point of downside protection. If a further stock price drop is \nanticipated, additional downside protection can be obtained by rolling down. In this \nexample, if one were to buy back the January 50 call at 1 and sell the January 45 at \n4, he would be rolling down. This would increase his protection by another three \npoints - the credit generated by buying the 50 call at 1 and selling the 45 call at 4. \nHence, his downside break-even point would be 42 after rolling down. \nMoreover, if the stock were to remain unchanged - that is, if XYZ were exact", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 35}
{"text": "ample, if one were to buy back the January 50 call at 1 and sell the January 45 at \n4, he would be rolling down. This would increase his protection by another three \npoints - the credit generated by buying the 50 call at 1 and selling the 45 call at 4. \nHence, his downside break-even point would be 42 after rolling down. \nMoreover, if the stock were to remain unchanged - that is, if XYZ were exactly \n45 at January expiration - the writer would make an additional $300. If he had not \nrolled down, the most additional income that he could make, if XYZ remained \nunchanged, would be the remaining $100 from the January 50 call. So rolling down \ngives more downside protection against a further drop in stock price and may also \nproduce additional income if the stock price stabilizes. \nIn order to more exactly evaluate the overall effect that was obtained by rolling \ndown in this example, one can either compute a profit table (Table 2-21) or draw a \nnet profit graph (Figure 2-3) that compares the original covered write with the \nrolled-down position. \nNote that the rolled-down position has a smaller maximum profit potential than \nthe original position did. This is because, by rolling down to a January 45 call, the \nwriter limits his profits anywhere above 45 at expiration. He has committed himself \nto sell stock 5 points lower than the original position, which utilized a January 50 call \nand thus had limited profits above 50. Rolling down generally reduces the maximum \nTABLE 2·21. \nProfit table. \nXYZ Price at Profit from Profit from \nExpiration January 50 Write Rolled Position \n40 -$500 -200 \n42 - 300 0 \n45 0 +300 \n48 + 300 +300 \n50 + 500 +300 \n60 + 500 +300 \nChapter 2: Covered Call Writing \nFIGURE 2-3. \nComparison: original covered write vs. rolled-down write. \n+$500 \nc: +$300 \n0 \n~ \n]-\niii \nen en \n0 ...J \n5 \n-e a. \n$0 \nOriginal Write \nRolled-Down Write \n50 \nStock Price at Expiration \n73 \nprofit potential of the covered write. Limiting the maximum profit may be a second\nary consideration, however, when a stock is breaking downward. Additional downside \nprotection is often a more pressing criterion in that case. \nAnywhere below 45 at expiration, the rolled-down position does $300 better \nthan the original position, because of the $300 credit generated from rolling down. \nIn fact, the rolled-down position will outperform the original position even if the \nstock rallies back to, but not above, a price of 48. At 48 at expiration, the two posi\ntions are equal, both producing a $300 profit. If the stock should reverse direction \nand rally back above 48 by expiration, the writer would have been better off not to \nhave rolled down. All these facts are clear from Table 2-21 and Figure 2-3. \nConsequently, the only case in which it does not pay to roll down is the one in \nwhich the stock experiences a reversal - a rise in price after the initial drop. The \nselection of where to roll down is important, because rolling down too early or at an \ninappropriate price could limit the returns. Technical support levels of the stock are \noften useful in selecting prices at which to roll down. If one rolls down after techni\ncal support has been broken, the chances of being caught in a stock-price-reversal \nsituation would normally be reduced. \nThe above example is rather simplistic; in actual practice, more complicated sit\nuations may arise, such as a sudden and fairly steep decline in price by the underly\ning stock. This may present the writer with what is called a locked-in loss. This means, \nsimply, that there is no option to which the writer can roll down that will provide him \n74 Part II: Call Option Strategies \nwith enough premium to realize any profit if the stock were then called away at expi\nration. These situations arise more commonly on lower-priced stocks, where the \nstriking prices are relatively far apart in percentage terms. Out-of-the-money writes \nare more susceptible to this problem than are in-the-money writes. Although it is not \nemotionally satisfying to be in an investment position that cannot produce a profit -\nat least for a limited period of time - it may still be beneficial to roll down to protect \nas much of the stock price decline as possible. \nExample: For the covered write described as \"buy XYZ at 20, sell the January 20 call \nat 2,\" the stock unexpectedly drops very quickly to 16, and the following prices exist: \nXYZ common, 16; \nXYZ January 20 call,½; and \nXYZ January 15 call, 2½. \nThe covered writer is faced with a difficult choice. He currently has an unrealized \nloss of 2½ points - a 4-point losson the stock which is partially offset by a 1 ½-point \ngain on the January 20 call. This represents a fairly substantial percentage loss on his \ninvestment in a short period of time. He could do nothing, hoping for the stock to \nrecover its loss. Unfortunately, this may prove to be wishful thinking. \nIf he considers rolling down, he will not be excited by what he sees. Suppose \nthat the writer wants to roll down from the January 20 to the January 15. He would \nthus buy the January 20 at ½ and sell the January 15 at 2½, for a net credit of 2 \npoints. By rolling down, he is obligating himself to sell his stock at 15, the striking \nprice of the January 15 call. Suppose XYZ were above 15 in January and were called \naway. How would the writer do? He would lose 5 points on his stock, since he origi\nnally bought it at 20 and is selling it at 15. This 5-point loss is substantially offset by \nhis option profits, which amount to 4 points: 1 ½ points of profit on the January 20, \nsold at 2 and bought back at ½, plus the 2½ points received from the sale of the \nJanuary 15. However, his net result is a 1-point loss, since he lost 5 points on the stock \nand made only 4 points on the options. Moreover, this 1-point loss is the best that he \ncan hope for! This is true because, as has been demonstrated several times, a covered \nwriting position makes its maximum profit anywhere above the striking price. Thus", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 36}
{"text": ", plus the 2½ points received from the sale of the \nJanuary 15. However, his net result is a 1-point loss, since he lost 5 points on the stock \nand made only 4 points on the options. Moreover, this 1-point loss is the best that he \ncan hope for! This is true because, as has been demonstrated several times, a covered \nwriting position makes its maximum profit anywhere above the striking price. Thus, \nby rolling down to the 15 strike, he has limited the position severely, to the extent of \n\"locking in a loss.\" \nEven considering what has been shown about this loss, it is still correct for this \nwriter to roll down to the January 15. Once the stock has fallen to 16, there is noth\ning anybody can do about the unrealized losses. However, if the writer rolls down, he \ncan prevent the losses from accumulating at a faster rate. In fact, he will do better by \nChapter 2: Covered Call Writing 75 \nrolling down if the stock drops further, remains unchanged, or even rises slightly. \nTable 2-22 and Figure 2-4 compare the original write with the rolled-down position. \nIt is clear from the figure that the rolled-down position is locked into a loss. However, \nthe rolled-down position still outperforms the original position unless the stock ral\nlies back above 17 by expiration. Thus, if the stock continues to fall, if it remains \nunchanged, or even if it rallies less than 1 point, the rolled-down position actually \noutperforms the original write. It is for this reason that the writer is taking the most \nlogical action by rolling down, even though to do so locks in a loss. \nTABLE 2-22. \nProfits of original write and rolled position. \nStock Price at Profit from \nExpiration January 20 Write \n10 -$800 \n15 - 300 \n18 0 \n20 + 200 \n25 + 200 \nFIGURE 2-4. \nComparison: original write vs. \n11\nlocked-in loss.\" \nc: +$200 Original Write \n~ \nt \n«i \n~ \no -$100 \n~ a.. \n15 20 \nStock Price at Expiration \nProfit from \nRolled Position \n-$600 \n- 100 \n- 100 \n- 100 \n- 100 \n76 Part II: Call Option Strategies \nTechnical analysis may be able to provide a little help for the writer faced with \nthe dilemma of rolling down to lock in a loss or else holding onto a position that has \nno further downside protection. IfXYZ has broken a support level or important trend \nline, it is added evidence for rolling down. In our example, it is difficult to imagine \nthe case in which a $20 stocksuddenly drops to become a $16 stock without sub\nstantial harm to its technical picture. Nevertheless, if the charts should show that \nthere is support at 15½ or 16, it may be worth the writer's while to wait and see if \nthat support level can hold before rolling down. \nPerhaps the best way to avoid having to lock in losses would be to establish posi\ntions that are less likely to become such a problem. In-the-money covered writes on \nhigher-priced stocks that have a moderate amount of volatility will rarely force the \nwriter to lock in a loss by rolling down. Of course, any stock, should it fall far enough \nand fast enough, could force the writer to lock in a loss if he has to roll down two or \nthr..ee times in a fairly short time span. However, the higher-priced stock has striking \nprices that are much closer together (in percentages); it thus presents the writer with \nthe opportunity to utilize a new option with a lower striking price much sooner in the \ndecline of the stock. Also, higher volatility should help in generating large enough \npremiums that substantial portions of the stock's decline can be hedged by rolling \ndown. Conversely, low-priced stocks, especially nonvolatile ones, often present the \nmost severe problems for the covered writer when they decline in price. \nA related point concerning order entry can be inserted here. When one simul\ntaneously buys one call and sells another, he is executing a spread. Spreads in gener\nal are discussed at length later. However, the covered writer should be aware that \nwhenever he rolls his position, the order can be placed as a spread order. This will \nnormally help the writer to obtain a better price execution. \nAN ALTERNATIVE METHOD OF ROLLING DOWN \nThere is another alternative that the covered writer can use to attempt to gain some \nadditional downside protection without necessarily having to lock in a loss. Basically, \nthe writer rolls down only part of his covered writing position. \nExample: One thousand shares of XYZ were bought at 20 and 10 January 20 calls \nwere sold at 2 points each. As before, the stock falls to 16, with the following prices: \nXYZ January 20 call, ½; and XYZ January 15 call, 2½. As was demonstrated in the last \nsection, if the writer were to roll all 10 calls down from the January 20 to the January \n15, he would be locking in a loss. Although there may be some justification for this \naction, the writer would naturally rather not have to place himself in such a position. \nOne can attempt to achieve some balance between added downside protection \nand upward profit potential by rolling down only part of the calls. In this example, \nChapter 2: Covered Call Writing 77 \nthe writer would buy back only 5 of the January 20's and sell 5 January 15 calls. He \nwould then have this position: \nlong 1,000 XYZ at 20; \nshort 5 XYZ January 20's at 2; \nshort 5 XYZ January 15's at 2½; and \nrealized gain, $750 from 5 January 20's. \nThis strategy is generally referred to a partial roll-down, in which only a portion of \nthe original calls is rolled, as opposed to the more conventional complete roll-down. \nAnalyzing the partially rolled position makes it clear that the writer no longer locks \nin a loss. \nIfXYZ rallies back above 20, the writer would, at expiration, sell 500 XYZ at 20 \n(breaking even) and 500 at 15 (losing $2,500 on this portion). He would make $1,000 \nfrom the five January 20's held until expiration, plus $1,250 from the five January 15's, \nplus the $750 of realized gain from the January 20's that were rolled down. This \namounts to $3,000 worth of option profits and $2,500 worth of stock lo", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 37}
{"text": "ies back above 20, the writer would, at expiration, sell 500 XYZ at 20 \n(breaking even) and 500 at 15 (losing $2,500 on this portion). He would make $1,000 \nfrom the five January 20's held until expiration, plus $1,250 from the five January 15's, \nplus the $750 of realized gain from the January 20's that were rolled down. This \namounts to $3,000 worth of option profits and $2,500 worth of stock losses, or an \noverall net gain of $500, less commissions. Thus, the partial roll-down offers the \nwriter a chance to make some profit if the stock rebounds. Obviously, the partial roll\ndown will not provide as much downside protection as the complete roll-down does, \nbut it does give more protection than not rolling down at all. To see this, compare the \nresults given in Table 2-23 if XYZ is at 15 at expiration. \nTABLE 2-23. \nStock at 15 at expiration. \nStrategy \nOriginal position \nPartial roll-down \nComplete roll-down \nStock Loss \n-$5,000 \n- 5,000 \n- 5,000 \nOption \nProfit Total Loss \n+$2,000 -$3,000 \n+ 3,000 - 2,000 \n+ 4,000 - 1,000 \nIn summary, the covered writer who would like to roll down, but who does not \nwant to lock in a loss or who feels the stock may rebound somewhat before expira\ntion, should consider rolling down only part of his position. If the stock should con\ntinue to drop, making it evident that there is little hope of a strong rebound back to \nthe original strike, the rest of the position can then be rolled down as well. \n78 Part II: Call Option Strategies \nUTILIZING DIFFERENT EXPIRATION SERIES WHEN ROLLING DOWN \nIn the examples thus far, the same expiration month has been used whenever rolling\ndown action was taken. In actual practice, the writer may often want to use a more \ndistant expiration month when rolling down and, in some cases, he may even want to \nuse a nearer expiration month. \nThe advantage of rolling down into a more distant expiration series is that more \nactual points of protection are received. This is a common action to take when the \nunderlying stock has become somewhat worrisome on a technical or fundamental \nbasis. However, since rolling down reduces the maximum profit potential - a fact that \nhas been demonstrated several times - every roll-down should not be made to a more \ndistant expiration series. By utilizing a longer-term call when rolling down, one is \nreducing his maximum profit potential for a longer period of time. Thus, the longer\nterm·call should be used only if the writer has grown concerned over the stock's capa\nbility to hold current price levels. The partial roll-down strategy is particularly \namenable to rolling down to a longer-term call since, by rolling down only part of the \nposition, one has already left the door open for profits if the stock should rebound. \nTherefore, he can feel free to avail himself of the maximum protection possible in the \npart of his position that is rolled down. \nThe writer who must roll down to lock in a loss, possibly because of circum\nstances beyond his control, such as a sudden fall in the price of the underlying stock, \nmay actually want to roll down to a near-term option. This allows him to make back \nthe available time premium in the short-term call in the least time possible. \nExample: A writer buys XYZ at 19 and sells a 6-month call for 2 points. Shortly there\nafter, however, bad news appears concerning the common stock and XYZ falls quick\nly to 14. At that time, the following prices exist for the calls with the striking price 15: \nXYZ common, 14: \nnear-term call, l; \nmiddle-term call, 1 ½; and \nfar-term call, 2. \nIf the writer rolls down into any of these three calls, he will be locking in a loss. \nTherefore, the best strategy may be to roll down into the near-term call, planning to \ncapture one point of time premium in 3 months. In this way, he will be beginning to \nwork himself out of the loss situation by availing himself of the most potential time \npremium decay in the shortest period of time. When the near-term call expires \n3 months from now, he can reassess the situation to decide if he wants to write \nChapter 2: Covered Call Writing 79 \nanother near-term call to continue taking in short-term premiums, or perhaps write \na long-term call at that time. \nWhen rolling down into the near-term call, one is attempting to return to a \npotentially profitable situation in the shortest period of time. By writing short-term \ncalls one or two times, the writer will eventually be able to reduce his stock cost near\ner to 15 in the shortest time period. Once his stock cost approaches 15, he can then \nwrite a long-term call with striking price 15 and return again to a potentially prof\nitable situation. He will no longer be locked into a loss. \nACTION TO TAKE IF THE STOCK RISES \nA more pleasant situation for the covered writer to encounter is the one in which the \nunderlying stock rises in price after the covered writing position has been estab\nlished. There are generally several choices available if this happens. The writer may \ndecide to do nothing and to let his stock be called away, thereby making the return \nthat he had hoped for when he established the position. On the other hand, if the \nunderlying stock rises fairly quickly and the written call comes to parity, the writer \nmay either close the position early or roll the call up. Each case is discussed. \nExample: Someone establishes a covered writing position by buying a stock at 50 and \nselling a 6-month call for 6 points. His maximum profit potential is 6 points anywhere \nabove 50 at expiration, and his downside break-even point is 44. Furthermore, sup\npose that the stock experiences a substantial rally and that it climbs to a price of 60 \nin a short period of time. With the stock at 60, the July 50 might be selling for 11 \npoints and a July 60 might sell for as much as 7 points. Thus, the writer may consid\ner buying back the call that was originally written and rolling up to the call with a \nhigher striking price. Table 2-24 summarizes the situation.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 38}
{"text": "at the stock experiences a substantial rally and that it climbs to a price of 60 \nin a short period of time. With the stock at 60, the July 50 might be selling for 11 \npoints and a July 60 might sell for as much as 7 points. Thus, the writer may consid\ner buying back the call that was originally written and rolling up to the call with a \nhigher striking price. Table 2-24 summarizes the situation. \nTABLE 2·24. \nComparison of original and current prices. \nOriginal Position Current Prices \nBuy XYZ at 50 XYZ common 60 \nSell XYZ July 50 call at 6 XYZ July 50 11 \nXYZ Jul 60 7 \nIf the writer were to roll-up - that is, buy back the July 50 and sell the July 60 \n- he would be increasing his profit potential. If XYZ were above 60 in July and were \ncalled away, he would make his option credits - 6 points from the July 50 plus 7 \n80 Part II: Call Option Strategies \npoints from the July 60 - less the 11 points he paid to buy back the July 50. Thus, his \noption profits would amount to 2 points, which, added to the stock profit of 10 points, \nincreases his maximum profit potential to 12 points anywhere above 60 at July expi\nration. \nTo increase his profit potential by such a large amount, the covered writer has \ngiven up some of his downside protection. The downside break-even point is always \nraised by the anwunt of the debit required to roll up. The debit required to roll up in \nthis example is 4 points - buy the July 50 at 11 and sell the July 60 at 7. Thus, the \nbreak-even point is increased from the original 44 level to 48 after rolling up. There \nis another method of calculating the new profit potential and break-even point. In \nessence, the writer has raised his net stock cost to 55 by taking the realized 5-point \nloss on the July 50 call. Hence, he is essentially in a covered write whereby he has \nbought stock at 55 and has sold a July 60 call for 7. When expressed in this manner, \nit may be easier to see that the break-even point is 48 and the maximum profit poten\ntial, above 60, is 12 points. \nNote that when one rolls up, there is a debit incurred. That is, the investor must \ndeposit additional cash into the covered writing position. This was not the case in \nrolling down, because credits were generated. Debits are considered by many \ninvestors to be a seriously negative aspect of rolling up, and they therefore prefer \nnever to roll up for debits. Although the debit required to roll up may not be a neg\native aspect to every investor, it does translate directly into the fact that the break\neven point is raised and the writer is subjecting himself to a potential loss if the stock \nshould pull back. It is often advantageous to roll to a more distant expiration when \nrolling up. This will reduce the debit required. \nThe rolled-up position has a break-even point of 48. Thus, if XYZ falls back to \n48, the writer who rolled up will be left with no profit. However, if he had not rolled \nup, he would have made 4 points with XYZ at 48 at expiration in the original position. \nA further comparison can be made between the original position and the rolled-up \nposition. The two are equal at July expiration at a stock price of 54; both have a prof\nit of 6 points with XYZ at 54 at July expiration. Thus, although it may appear attrac\ntive to roll up, one should determine the point at which the rolled-up position and \nthe original position will be equal at expiration. If the writer believes XYZ could be \nsubject to a 10% correction by expiration from 60 to 54 - certainly not out of the \nquestion for any stock - he should stay with his original position. \nFigure 2-5 compares the original position with the rolled-up position. Note that \nthe break-even point has moved up from 44 to 48; the maximum profit potential has \nincreased from 6 points to 12 points; and at expiration the two writes are equal, at 54. \nIn summary, it can be said that rolling up increases one's profit potential but also \nexposes one to risk of loss if a stock price reversal should occur. Therefore, an ele-\nChapter 2: Covered Call Writing \nFIGURE 2-5. \nComparison: original write vs. rolled-up position. \n+$1,200 \nRolled-Up Write \n+$600 Original Write \n54 60 \nStock Price at Expiration \n81 \nment of risk is introduced as well as the possibility of increased rewards. Generally, \nit is not advisable to roll up if at least a 10% correction in the stock price cannot be \nwithstood. One's initial goals for the covered write were set when the position was \nestablished. If the stock advances and these goals are being met, the writer should be \nvery cautious about risking that profit. \nA SERIOUS BUT ALL-TOO-COMMON MISTAKE \nWhen an investor is overly intent on keeping his stock from being called away (per\nhaps he is writing calls against stock that he really has no intention of selling), then \nhe will normally roll up and/or forward to a more distant expiration month whenev\ner the stock rises to the strike of the written call. Most of these rolls incur a debit. If \nthe stock is particularly strong, or if there is a strong bull market, these rolls for deb\nits begin to weigh heavily on the psychology of the covered writer. Eventually, he \nwears down emotionally and makes a mistake. He typically takes one of two roads: \n(1) He buys back all of the calls for a (large) debit, leaving the entire stock holding \nexposed to downside movements after it has risen dramatically in price and after he \n82 Part II: Call Option Strategies \nhas amassed a fairly large series of debits from previous rolls; or (2) he begins to sell \nsome out-of-the-money naked puts to bring in credits to reduce the cost of continu\nally rolling the calls up for debits. This latter action is even worse, because the entire \nposition is now leveraged tremendously, and a sharp drop in the stock price may \ncause horrendous losses - perhaps enough to wipe out the entire account. As fate \nwould have it, these mistakes are usually made when the stock is near a top in price. \nAny price decline after such", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 39}
{"text": "o reduce the cost of continu\nally rolling the calls up for debits. This latter action is even worse, because the entire \nposition is now leveraged tremendously, and a sharp drop in the stock price may \ncause horrendous losses - perhaps enough to wipe out the entire account. As fate \nwould have it, these mistakes are usually made when the stock is near a top in price. \nAny price decline after such a dramatic rise is usually a sharp and painful one. \nThe best way to avoid this type of potentially serious mistake is to allow the \nstock to be called away at some point. Then, using the funds that are released, either \nestablish a new position in another stock or perhaps even utilize another strategy for \na while. If that is not feasible, at least avoid making a radical change in strategy after \nthe stock has had a particularly strong rise. Leveraging the position through naked \nput sales on top of rolling the calls up for debits should expressly be avoided. \nThe discussion to this point has been directed at rolling up before expiration. At \nor near expiration, when the time value premium has disappeared from the written \ncall, one may have no choice but to write the next-higher striking price if he wants to \nretain his stock. This is discussed when we analyze action to take at or near expiration. \nIf the underlying stock rises, one's choices are not necessarily limited to rolling \nup or doing nothing. As the stock increases in price, the written call will lose its time \npremium and may begin to trade near parity. The writer may decide to close the posi\ntion himself - perhaps well in advance of expiration - by buying back the written call \nand selling the stock out, hopefully near parity. \nExample: A customer originally bought XYZ at 25 and sold the 6-month July 25 for \n3 points - a net of 22. Now, three months later, XYZ has risen to 33 and the call is \ntrading at 8 (parity) because it is so deeply in-the-money. At this point, the writer may \nwant to sell the stock at 33 and buy back the call at 8, thereby realizing an effective \nnet of 25 for the covered write, which is his maximum profit potential. This is cer\ntainly preferable to remaining in the position for three more months with no more \nprofit potential available. The advantage of closing a parity covered write early is that \none is realizing the maximum return in a shorter period than anticipated. He is there\nby increasing his annualized return on the position. Although it is generally to the \ncash writer's advantage (margin writers read on) to take such action, there are a few \nadditional costs involved that he would not experience if he held the position until \nthe call expired. First, the commission for the option purchase (buy-back) is an addi\ntional expense. Second, he will be selling his stock at a higher price than the striking \nprice, so he may pay a slightly higher commission on that trade as well. If there is a \ndividend left until expiration, he will not be receiving that dividend if he closes the \nChapter 2: Covered Call Writing 83 \nwrite early. Of course, if the trade was done in a margin account, the writer will be \nreducing the margin interest that he had planned to pay in the position, because the \ndebit will be erased earlier. In most cases, the increased commissions are very small \nand the lost dividend is not significant compared to the increase in annualized return \nthat one can achieve by closing the position early. However, this is not always true, \nand one should be aware of exactly what his costs are for closing the position early. \nObviously, getting out of a covered writing position can be as difficult as estab\nlishing it. Therefore, one should place the order to close the position with his bro\nkerage firm's option desk, to be executed as a \"net\" order. The same traders who facil\nitate establishing covered writing positions at net prices will also facilitate getting out \nof the positions. One would normally place the order by saying that he wanted to sell \nhis stock and buy the option \"at parity\" or, in the example, at \"25 net.\" Just as it is \noften necessary to be in contact with both the option and stock exchanges to estab\nlish a position, so is it necessary to maintain the same contacts to renwve a position \nat parity. \nACTION TO TAKE AT OR NEAR EXPIRATION \nAs expiration nears and the time value premium disappears from a written call, the \ncovered writer may often want to roll forward, that is, buy back the currently written \ncall and sell a longer-term call with the same striking price. For an in-the-money call, \nthe optimum time to roll forward is generally when the time value premium has com\npletely disappeared from the call. For an out-of-the-money call, the correct time to \nmove into the more distant option series is when the return offered by the near-term \noption is less than the return offered by the longer-term call. \nThe in-the-money case is quite simple to analyze. As long as there is time pre\nmium left in the call, there is little risk of assignment, and therefore the writer is \nearning time premium by remaining with the original call. However, when the option \nbegins to trade at parity or a discount, there arises a significant probability of exer\ncise by arbitrageurs. It is at this time that the writer should roll the in-the-money call \nforward. For example, if XYZ were offered at 51 and the July 50 call were bid at 1, \nthe writer should be rolling forward into the October 50 or January 50 call. \nThe out-of-the-money case is a little more difficult to handle, but a relatively \nstraightforward analysis can be applied to facilitate the writer's decision. One can \ncompute the return per day remaining in the written call and compare it to the net \nreturn per day from the longer-term call. If the longer-term call has a higher return, \none should roll forward. \n84 Part II: Call Option Strategies \nExample: An investor previously entered a covered writing situation in which he \nwrote five January 30 c", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 40}
{"text": "can be applied to facilitate the writer's decision. One can \ncompute the return per day remaining in the written call and compare it to the net \nreturn per day from the longer-term call. If the longer-term call has a higher return, \none should roll forward. \n84 Part II: Call Option Strategies \nExample: An investor previously entered a covered writing situation in which he \nwrote five January 30 calls against 500 XYZ common. The following prices exist cur\nrently, l month before expiration: \nXYZ common, 29¼; \nJanuary 30 call,¼; and \nApril 30 call, 2¼. \nThe writer can only make ¼ a point more of time premium on this covered write for \nthe time remaining until expiration. It is possible that his money could be put to bet\nter use by rolling forward to the April 30 call. Commissions for rolling forward must \nbe subtracted from the April 30's premium to present a true comparison. \nBy remaining in the January 30, the writer could make, at most, $250 for the 30 \ndays remaining until January expiration. This is a return of $8.33 per day. The com\nmissions for rolling forward would be approximately $100, including both the buy\nback and the new sale. Since the current time premium in the April 30 call is $250 \nper option, this would mean that the writer would stand to make 5 times $250 less \nthe $100 in commissions during the 120-day period until April expiration; $1,150 \ndivided by 120 days is $9.58 per day. Thus, the per-day return is higher from the April \n30 than from the January 30, after commissions are included. The writer should roll \nforward to the April 30 at this time. \nRolling forward, since it involves a positive cash flow ( that is, it is a credit trans\naction) simultaneously increases the writer's maximum profit potential and lowers the \nbreak-even point. In the example above, the credit for rolling forward is 2 points, so \nthe break-even point will be lowered by 2 points and the maximum profit potential \nis also increased by the 2-point credit. \nA simple calculator can provide one with the return-per-day calculation neces\nsary to make the decision concerning rolling forward. The preceding analysis is only \ndirectly applicable to rolling forward at the same striking price. Rolling-up or rolling\ndown decisions at expiration, since they involve different striking prices, cannot be \nbased solely on the differential returns in time premium values offered by the options \nin question. \nIn the earlier discussion concerning rolling up, it was mentioned that at or near \nexpiration, one may have no choice but to write the next higher striking price if he \nwants to retain his stock. This does not necessarily involve a debit transaction, how\never. If the stock is volatile enough, one might even be able to roll up for even money \nor a slight credit at expiration. Should this occur, it would be a desirable situation and \nshould always be taken advantage of. \nCbapter 2: Covered Ca# Writing \nExample: The following prices exist at January expiration: \nXYZ, 50; \nXYZ January 45 call, 5; and \nXYZ July 50 call, 7. \n85 \nIn this case, if one had originally written the January 45 call, he could now roll up to \nthe July 50 at expiration for a credit of 2 points. This action is quite prudent, since \nthe break-even point and the maximum profit potential are enhanced. The break\neven point is lowered by the 2 points of credit received from rolling up. The maxi\nmum profit potential is increased substantially - by 7 points - since the striking price \nis raised by 5 points and an additional 2 points of credit are taken in from the roll up. \nConsequently, whenever one can roll up for a credit, a situation that would normally \narise only on more volatile stocks, he should do so. \nAnother choice that may occur at or near expiration is that of rolling down. The \ncase may arise whereby one has allowed a written call to expire worthless with the \nstock more than a small distance below the striking price. The writer is then faced \nwith the decision of either writing a small-premium out-of-the-money call or a larg\ner-premium in-the-money call. Again, an example may prove to be useful. \nExample: Just after the January 25 call has expired worthless, \nXYZ is at 22, \nXYZ July 25 call at ¾, and \nXYZ July 20 call at 3½. \nIf the investor were now to write the July 25 call, he would be receiving only¾ of a \npoint of downside protection. However, his maximum profit potential would be quite \nlarge if XYZ could rally to 25 by expiration. On the other hand, the July 20 at 3½ is \nan attractive write that affords substantial downside protection, and its 1 ½ points of \ntime value premium are twice that offered by the July 25 call. In a purely analytic \nsense, one should not base his decision on what his performance has been to date, \nbut that is a difficult axiom to apply in practice. If this investor owns XYZ at a high\ner price, he will almost surely opt for the July 25 call. If, however, he owns XYZ at \napproximately the same price, he will have no qualms about writing the July 20 call. \nThere is no absolute rule that can be applied to all such situations, but one is usual\nly better off writing the call that provides the best balance between return and down\nside protection at all times. Only if one is bullish on the underlying stock should he \nwrite the July 25 call. \n86 Part II: Call Option Strategies \nAVOIDING THE UNCOVERED POSITION \nThere is a margin rule that the covered writer must be aware of if he is considering \ntaking any sort of follow-up action on the day that the written call ceases trading. If \nanother call is sold on that day, even though the written call is obviously going to \nexpire worthless, the writer will be considered uncovered for margin purposes over \nthe weekend and will be obligated to put forth the collateral for an uncovered option. \nThis is usually not what the writer intends to do; being aware of this rule will elimi\nnate unwanted margin calls. Furthermore, uncovered options may be considered \nunsuitable for", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 41}
{"text": "n though the written call is obviously going to \nexpire worthless, the writer will be considered uncovered for margin purposes over \nthe weekend and will be obligated to put forth the collateral for an uncovered option. \nThis is usually not what the writer intends to do; being aware of this rule will elimi\nnate unwanted margin calls. Furthermore, uncovered options may be considered \nunsuitable for many covered writers. \nExample: A customer owns XYZ and has January 20 calls outstanding on the last day \nof trading of the January series (the third Friday of January; the calls actually do not \nexpire until the following day, Saturday). IfXYZ is at 15 on the last day of trading, the \nJanuary 20 call will almost certainly expire worthless. However, should the writer \ndecide to sell a longer-term call on that day without buying back the January 20, he \nwill be considered uncovered over the weekend. Thus, if one plans to wait for an \noption to expire totally worthless before writing another call, he must wait until the \nMonday after expiration before writing again, assuming that he wants to remain cov\nered. The writer should also realize that it is possible for some sort of news item to \nbe announced between the end of trading in an option series and the actual expira\ntion of the series. Thus, call holders might exercise because they believe the stock will \njump sufficiently in price to make the exercise profitable. This has happened in the \npast, two of the most notable cases being IBM in January 1975 and Carrier Corp. in \nSeptember 1978. \nWHEN TO LET STOCK BE CALLED AWAY \nAnother alternative that is open to the writer as the written call approaches expira\ntion is to let the stock be called away if it is above the striking price. In many cases, \nit is to the advantage of the writer to keep rolling options forward for credits, there\nby retaining his stock ownership. However, in certain cases, it may be advisable to \nallow the stock to be called away. It should be emphasized that the writer often has \na definite choice in this matter, since he can generally tell when the call is about to \nbe exercised - when the time value premium disappears. \nThe reason that it is normally desirable to roll forward is that, over time, the \ncovered writer will realize a higher return by rolling instead of being called. The \noption commissions for rolling forward every three or six months are smaller than the \ncommissions for buying and selling the underlying stock every three or six months, \nand therefore the eventual return will be higher. However, if an inferior return has \nCl,opter 2: Covered Call Writing 87 \nto be accepted or the break-even point will be raised significantly by rolling forward, \none must consider the alternative of letting the stock be called away. \nExample: A covered write is established by buying XYZ at 49 and selling an April 50 \ncall for 3 points. The original break-even point was thus 46. Near expiration, suppose \nXYZ has risen to 56 and the April 50 is trading at 6. If the investor wants to roll for\nward, now is the time to do so, because the call is at parity. However, he notes that \nthe choices are somewhat limited. Suppose the following prices exist with XYZ at 56: \nXYZ October 50 call, 7; and XYZ October 60 call, 2. It seems apparent that the pre\nmium levels have declined since the original writing position was established, but \nthat is an occurrence beyond the control of the writer, who must work in the current \nmarket environment. \nIf the writer attempts to roll forward to the October 50, he could make at most \n1 additional point of profit until October (the time premium in the call). This repre\nsents an extremely low rate of return, and the writer should reject this alternative \nsince there are surely better returns available in covered writes on other securities. \nOn the other hand, if the writer tries to roll up and forward, it will cost 4 points \nto do so - 6 points to buy back the April 50 less 2 points received for the October 60. \nThis debit transaction means that his break-even point would move up from the orig\ninal level of 46 to a new level of 50. If the common declines below 54, he would be \neating into profits already at hand, since the October 60 provides only 2 points of pro\ntection from the current stock price of 56. If the writer is not confidently bullish on \nthe outlook for XYZ, he should not roll up and forward. \nAt this point, the writer has exhausted his alternatives for rolling. His remaining \nchoice is to let the stock be called away and to use the proceeds to establish a cov\nered write in a new stock, one that offers a more attractive rate of return with rea\nsonable downside protection. This choice of allowing the stock to be called away is \ngenerally the wisest strategy if both of the following criteria are met: \n1. Rolling forward offers only a minimal return. \n2. Rolling up and forward significantly raises the break-even point and leaves the \nposition relatively unprotected should the stock drop in price. \nSPECIAL WRITING SITUATIONS \nOur discussions have pertained directly to writing against common stock. However, \none may also write covered call options against convertible securities, warrants, or \nLEAPS. In addition, a different type of covered writing strategy - the incremental \n88 Part II: Call Option Strategies \nreturn concept - is described that has great appeal to large stockholders, both indi\nviduals and institutions. \nCOVERED WRITING AGAINST A CONVERTIBLE SECURITY \nIt may be more advantageous to buy a security that is convertible into common stock \nthan to buy the stock itself, for covered call writing purposes. Convertible bonds and \nconvertible preferred stocks are securities commonly used for this purpose. One \nadvantage of using the convertible security is that it often has a higher yield than does \nthe common stock itself. \nBefore describing the covered write, it may be beneficial to review the basics of \nconvertible securities. Suppose XYZ", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 42}
{"text": "to buy the stock itself, for covered call writing purposes. Convertible bonds and \nconvertible preferred stocks are securities commonly used for this purpose. One \nadvantage of using the convertible security is that it often has a higher yield than does \nthe common stock itself. \nBefore describing the covered write, it may be beneficial to review the basics of \nconvertible securities. Suppose XYZ common stock has an XYZ convertible Preferred \nA stock that is convertible into 1.5 shares of common. The number of shares of com\nmon that the convertible security converts into is an important piece of information \nthat the writer must know. It can be found in a Standard & Poor's Stock Guide (or \nBond Guide, in the case of convertible bonds). \nThe writer also needs to determine how many shares of the convertible securi\nty must be owned in order to equal 100 shares of the common stock. This is quickly \ndetermined by dividing 100 by the conversion ratio - 1.5 in our XYZ example. Since \n100 divided by 1.5 equals 66.666, one must own 67 shares of XYZ cv Pfd A to cover \nthe sale of one XYZ option for 100 shares of common. Note that neither the market \nprices of XYZ common nor the convertible security are necessary for this computa\ntion. \nWhen using a convertible bond, the conversion information is usually stated in \na form such as, \"converts into 50 shares at a price of 20.\" The price is irrelevant. What \nis important is the number of shares that the bond converts into - 50 in this case. \nThus, if one were using these bonds for covered writing of one call, he would need \ntwo (2,000) bonds to own the equivalent of 100 shares of stock. \nOnce one knows how much of the convertible security must be purchased, he \ncan use the actual prices of the securities, and their yields, to determine whether a \ncovered write against the common or the convertible is more attractive. \nExample: The following information is known: \nXYZ common, 50; \nXYZ CV Pfd A, 80; \nXYZ July 50 call, 5; \nXYZ dividend, 1.00 per share annually; and \nXYZ cv Pfd A dividend, 5.00 per share annually. \nChapter 2: Covered CaH Writing 89 \nNote that, in either case, the same call - the July 50 -would be written. The use of \nthe convertible as the underlying security does not alter the choice of which option to \nuse. To make the comparison of returns easier, commissions are ignored in the cal\nculations given in Table 2-25. In reality, the commissions for the stock purchase, \neither common or preferred, would be very similar. Thus, from a numerical point of \nview, it appears to be more advantageous to write against the convertible than against \nthe common. \nTABLE 2-25. \nComparison of common and convertible writes. \nWrite against Common Write against Convertible \nBuy underlying security $5,000(100 XYZ) $5,360 (67 XYZ CV Pfd A) \nSell one July 50 call 500 - 500 \nNet cash investment $4,500 $4,860 \nPremium collected $ 500 $ 500 \nDividends until July 50 250 \nMaximum profit potential $ 550 $ 750 \nReturn (profit divided by \ninvestment) 12.2% 15.4% \nWhen writing against a convertible security, additional considerations should be \nlooked at. The first is the premium of the convertible security. In the example, with \nXYZ selling at 50, the XYZ cv Pfd A has a true value of 1.5 times 50, or $75 per share. \nHowever, it is selling at 80, which represents a premium of 5 points above its com\nputed value of 75. Normally, one would not want to buy a convertible security if the \npremium is too large. In this example, the premium appears quite reasonable. Any \nconvertible premium greater than 15% above computed value might be considered \nto be too large. \nAnother consideration when writing against convertible securities is the han\ndling of assignment. If the writer is assigned, he may either (1) convert his preferred \nstock into common and deliver that, or (2) sell the preferred in the market and use \nthe proceeds to buy 100 shares of common stock in the market for delivery against \nthe assignment notice. The second choice is usually preferable if the convertible \nsecurity has any premium at all, since converting the preferred into common causes \nthe loss of any premium in the convertible, as well as the loss of accrued interest in \nthe case of a convertible bond. \n90 Part II: Call Option Strategies \nThe writer should also be aware of whether or not the convertible is catlable \nand, if so, what the exact terms are. Once the convertible has been called by the com\npany, it will no longer trade in relation to the underlying stock, but will instead trade \nat the call price. Thus, if the stock should climb sharply, the writer could be incur\nring losses on his written option without any corresponding benefit from his con\nvertible security. Consequently, if the convertible is called, the entire position should \nnormally be closed immediately by selling the convertible and buying the option \nback. \nOther aspects of covered writing, such as rolling down or forward, do not \nchange even if the option is written against a convertible security. One would take \naction based on the relationship of the option price and the common stock price, as \nusual. \nWRITING AGAINST WARRANTS \nIt is also possible to write covered call options against warrants. Again, one must own \nenough warrants to convert into 100 shares of the underlying stock; generally, this \nwould be 100 warrants. The transaction must be a cash transaction, the warrants \nmust be paid for in full, and they have no loan value. Technically, listed warrants may \nbe marginable, but many brokerage houses still require payment in full. There may \nbe an additional investment requirement. Warrants also have an exercise price. If the \nexercise price of the warrant is higher than the striking price of the call, the covered \nwriter must also deposit the difference between the two as part of his investment. \nThe advantage of using warrants is that, if they are deeply in-the-money, they \nmay provide the cash covered writer with a higher r", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 43}
{"text": "re may \nbe an additional investment requirement. Warrants also have an exercise price. If the \nexercise price of the warrant is higher than the striking price of the call, the covered \nwriter must also deposit the difference between the two as part of his investment. \nThe advantage of using warrants is that, if they are deeply in-the-money, they \nmay provide the cash covered writer with a higher return, since less of an investment \nis involved. \nExample: XYZ is at 50 and there are XYZ warrants to buy the common at 25. Since \nthe warrant is so deeply in-the-money, it will be selling for approximately $25 per \nwarrant. XYZ pays no dividend. Thus, if the writer were considering a covered write \nof the XYZ July 50, he might choose to use the warrant instead of the common, since \nhis investment, per 100 shares of common, would only be $2,500 instead of the \n$5,000 required to buy 100 XYZ. The potential profit would be the same in either \ncase because no dividend is involved. \nEven if the stock does pay a dividend (warrants themselves have no dividend), \nthe writer may still be able to earn a higher return by writing against the warrant than \nagainst the common because of the smaller investment involved. This would depend, \nof course, on the exact size of the dividend and on how deeply the warrant is in-the\nmoney. \nCbapter 2: Covered Call Writing 91 \nCovered writing against warrants is not a frequent practice because of the small \nnumber of warrants on optionable stocks and the problems inherent in checking \navailable returns. However, in certain circumstances, the writer may actually gain a \ndecided advantage by writing against a deep in-the-money warrant. It is often not \nadvisable to write against a warrant that is at- or out-of-the-money, since it can \ndecline by a large percentage if the underlying stock drops in price, producing a high\nrisk position. Also, the writer's investment may increase in this case if he rolls down \nto an option with a striking price lower than the warrant's exercise price. \nWRITING AGAINST LEAPS \nA form of covered call writing can be constructed by buying LEAPS call options and \nselling shorter-term out-of-the-money calls against them. This strategy is much like \nwriting calls against warrants. This strategy is discussed in more detail in Chapter 25 \non LEAPS, under the subject of diagonal spreads. \nPERCS \nThe PERCS (Preferred Equity Redemption Cumulative Stock) is a form of covered \nwriting. It is discussed in Chapter 32. \nTHE INCREMENTAL RETURN CONCEPT OF COVERED WRITING \nThe incremental return concept of covered call writing is a way in which the covered \nwriter can earn the full value of stock appreciation between todays stock price and a \ntarget sale price, which may be substantially higher. At the same time, the writer can \nearn an incremental, positive return from writing options. \nMany institutional investors are somewhat apprehensive about covered call \nwriting because of the upside limit that is placed on profit potential. If a call is writ\nten against a stock that subsequently declines in price, most institutional managers \nwould not view this as an unfavorable situation, since they would be outperforming \nall managers who owned the stock and who did not write a call. However, if the stock \nrises substantially after the call is written, many institutional managers do not like \nhaving their profits limited by the written call. This strategy is not only for institu\ntional money managers, although one should have a relatively substantial holding in \nan underlying stock to attempt the strategy - at least 500 shares and preferably 1,000 \nshares or more. The incremental return concept can be used by anyone who is plan\nning to hold his stock, even if it should temporarily decline in price, until it reaches a \npredetermined, higher price at which he is willing to sell the stock. \n92 Part II: Call Option Strategies \nThe basic strategy involves, as an initial step, selecting the target price at which \nthe writer is willing to sell his stock. \nExample: A customer owns 1,000 shares of XYZ, which is currently at 60, and is will\ning to sell the stock at 80. In the meantime, he would like to realize a positive cash \nflow from writing options against his stock. This positive cash flow does not neces\nsarily result in a realized option gain until the stock is called away. Most likely, with \nthe stock at 60, there would not be options available with a striking price of 80, so one \ncould not write 10 July 80's, for example. This would not be an optimum strategy \neven if the July 80's existed, for the investor would be receiving so little in option pre\nmiums - perhaps 10 cents per call - that writing might not be worthwhile. The incre\nmental return strategy allows this investor to achieve his objectives regardless of the \nexistence of options with a higher striking price. \nThe foundation of the incremental return strategy is to write against only a part \nof the entire stock holding initially, and to write these calls at the striking price near\nest the current stock price. Then, should the stock move up to the next higher strik\ning price, one rolls up for a credit by adding to the number of calls written. Rolling \nfor a credit is mandatory and is the key to the strategy. Eventually, the stock reaches \nthe target price and the stock is called away, the investor sells all his stock at the tar\nget price, and in addition earns the total credits from all the option transactions. \nExample: XYZ is 60, the investor owns 1,000 shares, and his target price is 80. One \nmight begin by selling three of the longest-term calls at 60 for 7 points apiece. Table \n2-26 shows how a poor case - one in which the stock climbs directly to the target \nprice - might work. As Table 2-26 shows, if XYZ rose to 70 in one month, the three \noriginal calls would be bought back and enough calls at 70 would be sold to produce \na credit - 5 XYZ October 70's. If the stock continued upward to 80 in another mont", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 44}
{"text": "three of the longest-term calls at 60 for 7 points apiece. Table \n2-26 shows how a poor case - one in which the stock climbs directly to the target \nprice - might work. As Table 2-26 shows, if XYZ rose to 70 in one month, the three \noriginal calls would be bought back and enough calls at 70 would be sold to produce \na credit - 5 XYZ October 70's. If the stock continued upward to 80 in another month, \nthe 5 calls would be bought back and the entire position - 10 calls - would be writ\nten against the target price. \nIf XYZ remains above 80, the stock will be called away and all 1,000 shares will \nbe sold at the target price of 80. In addition, the investor will earn all the option cred\nits generated along the way. These amount to $2,800. Thus, the writer obtained the \nfull appreciation of his stock to the target price plus an incremental, positive return \nfrom option writing. \nIn a flat market, the strategy is relatively easy to monitor. If a written call loses \nits time value premium and therefore might be subject to assignment, the writer can \nroll forward to a more distant expiration series, keeping the quantity of written calls \nconstant. This transaction would generate additional credits as well. \nC1,,,pter 2: Covered Call Writing \nTABLE 2-26. \nTwo months of incremental return strategy. \nDay 1 : XYZ = 60 \nSell 3 XYZ October 60's at 7 \nOne month later: XYZ = 70 \nBuy back the 3 XYZ Oct 60's at 11 and \nsell 5 XYZ Oct 70's at 7 \nTwo months later: XYZ = 80 \nBuy back the 5 Oct 70's at 11 and \nsell 10 XYZ Oct 80's at 6 \nCOVERED CALL WRITING SUMMARY \n93 \n+$2, 100 credit \n-$3,300 debit \n+$3,500 credit \n-$5 ,500 debit \n+$6.000 credit \n+$2,800 credit \nThis concludes the chapter on covered call writing. The strategy will be referred to \nlater, when compared with other strategies. Here is a brief summary of the more \nimportant points that were discussed. \nCovered call writing is a viable strategy because it reduces the risk of stock own\nership and will make one's portfolio less volatile to short-term market movements. It \nshould be understood, however, that covered call writing may underperform stock \nownership in general because of the fact that stocks can rise great distances, while a \ncovered write has limited upside profit potential. The choice of which call to write \ncan make for a more aggressive or more conservative write. Writing in-the-money \ncalls is strategically more conservative than writing out-of-the-money calls, because \nof the larger amount of downside protection received. The total return concept of \ncovered call writing attempts to achieve the maximum balance between income from \nall sources - option premiums, stock ownership, and dividend income - and down\nside protection. This balance is usually realized by writing calls when the stock is near \nthe striking price, either slightly in- or slightly out-of-the-money. \nThe writer should compute various returns before entering into the position: \nthe return if exercised, the return if the stock is unchanged at expiration, and the \nbreak-even point. To truly compare various writes, returns should be annualized, and \nall commissions and dividends should be included in the calculations. Returns will be \nincreased by taking larger positions in the underlying stock - 500 or 1,000 shares. \nAlso, by utilizing a brokerage firm's capability to produce \"net\" executions, buying the \nstock and selling the call at a specified net price differential, one will receive better \nexecutions and realize higher returns in the long run. \n92 Part II: Call Option Strategies \nThe basic strategy involves, as an initial step, selecting the target price at which \nthe writer is willing to sell his stock \nExample: A customer owns 1,000 shares ofXYZ, which is currently at 60, and is will\ning to sell the stock at 80. In the meantime, he would like to realize a positive cash \nflow from writing options against his stock This positive cash flow does not neces\nsarily result in a realized option gain until the stock is called away. Most likely, with \nthe stock at 60, there would not be options available with a striking price of 80, so one \ncould not write 10 July 80's, for example. This would not be an optimum strategy \neven if the July 80's existed, for the investor would be receiving so little in option pre\nmiums - perhaps 10 cents per call - that writing might not be worthwhile. The incre\nmental return strategy allows this investor to achieve his objectives regardless of the \nexistence of options with a higher striking price. \nThe foundation of the incremental return strategy is to write against only a part \nof the entire stock holding initially, and to write these calls at the striking price near\nest the current stock price. Then, should the stock move up to the next higher strik\ning price, one rolls up for a credit by adding to the number of calls written. Rolling \nfor a credit is mandatory and is the key to the strategy. Eventually, the stock reaches \nthe target price and the stock is called away, the investor sells all his stock at the tar\nget price, and in addition earns the total credits from all the option transactions. \nExample: XYZ is 60, the investor owns 1,000 shares, and his target price is 80. One \nmight begin by selling three of the longest-term calls at 60 for 7 points apiece. Table \n2-26 shows how a poor case - one in which the stock climbs directly to the target \nprice - might work. As Table 2-26 shows, if XYZ rose to 70 in one month, the three \noriginal calls would be bought back and enough calls at 70 would be sold to produce \na credit - 5 XYZ October 70's. If the stock continued upward to 80 in another month, \nthe 5 calls would be bought back and the entire position - 10 calls - would be writ\nten against the target price. \nIfXYZ remains above 80, the stock will be called away and all 1,000 shares will \nbe sold at the target price of 80. In addition, the investor will earn all the option cred\nits generated along the way. These amount to $2,800. Thu", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 45}
{"text": ". If the stock continued upward to 80 in another month, \nthe 5 calls would be bought back and the entire position - 10 calls - would be writ\nten against the target price. \nIfXYZ remains above 80, the stock will be called away and all 1,000 shares will \nbe sold at the target price of 80. In addition, the investor will earn all the option cred\nits generated along the way. These amount to $2,800. Thus, the writer obtained the \nfull appreciation of his stock to the target price plus an incremental, positive return \nfrom option writing. \nIn a flat market, the strategy is relatively easy to monitor. If a written call loses \nits time value premium and therefore might be subject to assignment, the writer can \nroll f01ward to a more distant expiration series, keeping the quantity of written calls \nconstant. This transaction would generate additional credits as well. \nO.,,er 2: Covered Call Writing \nTABLE 2-26. \nTwo months of incremental return strategy. \nDoy 1 : XYZ = 60 \nSell 3 XYZ October 60's at 7 \nOne month later: XYZ = 70 \nBuy back the 3 XYZ Oct 60's at 11 and \nsell 5 XYZ Oct 70's at 7 \nTwa months later: XYZ = 80 \nBuy back the 5 Oct 70's at 11 and \nsell 10 XYZ Oct 80's at 6 \nCOVERED CALL WRITING SUMMARY \n93 \n+$2, 100 credit \n-$3 ,300 debit \n+$3,500 credit \n-$5 ,500 debit \n+$6,000 credit \n+$2,800 credit \nThis concludes the chapter on covered call writing. The strategy will be referred to \nlater, when compared with other strategies. Here is a brief summary of the more \nimportant points that were discussed. \nCovered call writing is a viable strategy because it reduces the risk of stock own\nership and will make one's portfolio less volatile to short-term market movements. It \nshould be understood, however, that covered call writing may underperform stock \nownership in general because of the fact that stocks can rise great distances, while a \ncovered write has limited upside profit potential. The choice of which call to write \ncan make for a more aggressive or more conservative write. Writing in-the-money \ncalls is strategically more conservative than writing out-of-the-money calls, because \nof the larger amount of downside protection received. The total return concept of \ncovered call writing attempts to achieve the maximum balance between income from \nall sources - option premiums, stock ownership, and dividend income - and down\nside protection. This balance is usually realized by writing calls when the stock is near \nthe striking price, either slightly in- or slightly out-of-the-money. \nThe writer should compute various returns before entering into the position: \nthe return if exercised, the return if the stock is unchanged at expiration, and the \nbreak-even point. To truly compare various writes, returns should be annualized, and \nall commissions and dividends should be included in the calculations. Returns will be \nincreased by taking larger positions in the underlying stock - 500 or 1,000 shares. \nAlso, by utilizing a brokerage firm's capability to produce \"net\" executions, buying the \nstock and selling the call at a specified net price differential, one will receive better \nexecutions and realize higher returns in the long run. \n94 Part II: Call Option Strategies \nThe selection of which call to write should be made on a comparison of avail\nable returns and downside protection. One can sometimes write part of his position \nout-of-the-money and the other part in-the-money to force a balance between return \nand protection that might not otherwise exist. Finally, one should not write against an \nunderlying stock if he is bearish on the stock. The writer should be slightly bullish, or \nat least neutral, on the underlying stock. \nFollow-up action can be as important as the selection of the initial position \nitself. By rolling down if the underlying stock drops, the investor can add downside \nprotection and current income. If one is unwilling to limit his upside potential too \nseverely, he may consider rolling down only part of his call writing position. As the \nwritten call expires, the writer should roll forward into a more distant expiration \nmonth if the stock is relatively close to the original striking price. Higher consistent \nreturns are achieved in this manner, because one is not spending additional stock \ncommissions by letting the stock be called away. An aggressive follow-up action can \nalso be taken when the underlying stock rises in price: The writer can roll up to a \nhigher striking price. This action increases the maximum profit potential but also \nexposes the position to loss if the stock should subsequently decline. One would want \nto take no follow-up action and let his stock be called if it is above the striking price \nand if there are better returns available elsewhere in other securities. \nCovered call writing can also be done against convertible securities - bonds or \npreferred stocks. These convertibles sometimes offer higher dividend yields and \ntherefore increase the overall return from covered writing. Also, the use of warrants \nor LEAPS in place of the underlying stock may be advantageous in certain circum\nstances, because the net investment is lowered while the profit potential remains the \nsame. Therefore, the overall return could be higher. \nFinally, the larger individual stockholder or institutional investor who wants to \nachieve a certain price for his stock holdings should operate his covered writing strat\negy under the incremental return concept. This will allow him to realize the full prof\nit potential of his underlying stock, up to the target sale price, and to earn additional \npositive income from option writing. \nCall Buying \nThe success of a call buying strategy depends primarily on one's ability to select \nstocks that will go up and to time the selection reasonably well. Thus, call buying is \nnot a strategy in the same sense of the word as most of the other strategies discussed \nin this text. Most other strategies are designed to remove some of the exactne", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 46}
{"text": "dditional \npositive income from option writing. \nCall Buying \nThe success of a call buying strategy depends primarily on one's ability to select \nstocks that will go up and to time the selection reasonably well. Thus, call buying is \nnot a strategy in the same sense of the word as most of the other strategies discussed \nin this text. Most other strategies are designed to remove some of the exactness of \nstock picking, allowing one to be neutral or at least to have some room for error and \nstill make a profit. Techniques of call buying are important, though, because it is nec\nessary to understand the long side of calls in order to understand more complex \nstrategies correctly. \nCall buying is the simplest form of option investment, and therefore is the most \nfrequently used option \"strategy\" by the public investor. The following section out\nlines the basic facts that one needs to know to implement an intelligent call buying \nprogram. \nWHY BUY? \nThe main attraction in buying calls is that they provide the speculator with a great \ndeal of leverage. One could potentially realize large percentage profits from only a \nmodest rise in price by the underlying stock. Moreover, even though they may be \nlarge percentagewise, the risks cannot exceed a fixed dollar amount - the price orig\ninally paid for the call. Calls must be paid for in full; they have no margin value and \ndo not constitute equity for margin purposes. Note: The preceding statements \nregarding payment for an option in full do not necessarily apply to LEAPS options, \nwhich were declared marginable in 1999. The following simple example illustrates \nhow a call purchase might work. \n95 \n96 Part II: Call Option Strategies \nExample: Assume that XYZ is at 48 and the 6-month call, the July 50, is selling for \n3. Thus, with an investment of $300, the call buyer may participate, for 6 months, in \na move upward in the price ofXYZ common. IfXYZ should rise in price by 10 points \n(just over 20%), the July 50 call will be worth at least $800 and the call buyer would \nhave a 167% profit on a move in the stock of just over 20%. This is the leverage that \nattracts speculators to call buying. At expiration, if XYZ is below 50, the buyer's loss \nis total, but is limited to his initial $300 investment, even if XYZ declines in price sub\nstantially. Although this risk is equal to 100% of his initial investment, it is still small \ndollarwise. One should nornwlly not invest more than 15% of his risk capital in call \nbuying, because of the relatively large percentage risks involved. \nSome investors participate in call buying on a limited basis to add some upside \npotential to their portfolios while keeping the risk to a fixed amount. For example, if \nan investor normally only purchased low-volatility, conservative stocks because he \nwanted to limit his downside risk, he might consider putting a small percentage of his \ncash into calls on more volatile stocks. In this manner, he could \"trade\" higher-risk \nstocks than he might normally do. If these volatile stocks increase in price, the \ninvestor will profit handsomely. However, if they decline substantially - as well they \nmight, being volatile - the investor has limited his dollar risk by owning the calls \nrather than the stock. \nAnother reason some investors buy calls is to be able to buy stock at a reason\nable price without missing a market. \nExample: With XYZ at 75, this investor might buy a call on XYZ at 80. He would like \nto own XYZ at 80 if it can prove itself capable of rallying and be in-the-money at expi\nration. He would exercise the call in that case. On the other hand, if XYZ declines in \nprice instead, he has not tied up money in the stock and can lose only an amount \nequal to the call premium that he paid, an amount that is generally much less than \nthe price of the stock itself. \nAnother approach to call buying is sometimes utilized, also by an investor who \ndoes not want to \"miss the market.\" Suppose an investor knows that, in the near \nfuture, he will have an amount of money large enough to purchase a particular stock; \nperhaps he is closing the sale of his house or a certificate of deposit is maturing. \nHowever, he would like to buy the stock now, for he feels a rally is imminent. He \nmight buy calls at the present time if he had a small amount of cash available. The \ncall purchases would require an investment much smaller than the stock purchase. \nThen, when he receives the cash that he knew was forthcoming, he could exercise the \ncalls and buy the stock. In this way, he might have participated in a rally by the stock \nbefore he actually had the money available to pay for the stock in full. \nCl,opter 3: Call Buying 97 \nRISK AND REWARD FOR THE CALL BUYER \nThe most important fact for the call buyer to realize is that he will normally win only \nif the stock rises in price. All the worthwhile analysis in the world spent in selecting \nwhich call to buy will not produce profits if the underlying stock declines. However, \nthis fact should not dissuade one from making reasonable analyses in his call buying \nselections. Too often, the call buyer feels that a stock will move up, and is correct in \nthat part of his projection, but still loses money on his call purchase because he failed \nto analyze the risk and rewards involved with the various calls available for purchase \nat the time. He bought the wrong call on the right stock. \nSince the best ally that the call buyer has is upward movement in the underly\ning stock, the selection of the underlying stock is the most important choice the call \nbuyer has to make. Since timing is so important when buying calls, the technical fac\ntors of stock selection probably outweigh the fundamentals; even if positive funda\nmentals do exist, one does not know how long it will take in order for them to be \nreflected in the price of the stock. One must be bullish on the underlying stock in \norder to consider buying calls on that stock. Once the stock selection has b", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 47}
{"text": "make. Since timing is so important when buying calls, the technical fac\ntors of stock selection probably outweigh the fundamentals; even if positive funda\nmentals do exist, one does not know how long it will take in order for them to be \nreflected in the price of the stock. One must be bullish on the underlying stock in \norder to consider buying calls on that stock. Once the stock selection has been made, \nonly then can the call buyer begin to consider other factors, such as which striking \nprice to use and which expiration to buy. The call buyer may have another ally, but \nnot one that he can normally predict: If the stock on which he owns a call becomes \nmore volatile, the call's price will rise to reflect that change. \nThe purchase of an out-of-the-money call generally offers both larger potential \nrisk and larger potential reward than does the purchase of an in-the-money call. \nMany call buyers tend to select the out-of-the-money call merely because it is cheap\ner in price. Absolute dollar price should in no way be a deciding factor for the call \nbuyer. If one's funds are so limited that he can only afford to buy the cheapest calls, \nhe should not be speculating in this strategy. If the underlying stock increases in price \nsubstantially, the out-of-the-money call will naturally provide the largest rewards. \nHowever, if the stock advances only moderately in price, the in-the-money call may \nactually perform better. \nExample: XYZ is at 65 and the July 60 sells for 7 while the July 70 sells for 3. If the \nstock moves up to 68 relatively slowly, the buyer of the July 70 - the out-of-the\nmoney call - may actually experience a loss, even if the call has not yet expired. \nHowever, the holder of the in-the-money July 60 will definitely have a profit because \nthe call will sell for at least 8 points, its intrinsic value. The point is that, percentage\nwise, an in-the-rrwney call will offer better rewards for a rrwdest stock gain, and an \nout-ofthe-rrwney call is better for larger stock gains. \n98 Part II: Call Option Strategies \nWhen risk is considered, the in-the-money call clearly has less probability of \nrisk. In the prior example, the in-the-money call buyer would not lose his entire \ninvestment unless XYZ fell by at least 5 points. However, the buyer of the out-of-the\nmoney July 70 would lose all of his investment unless the stock advanced by more \nthan 5 points by expiration. Obviously, the probability that the in-the-money call will \nexpire worthless is much smaller than that for the out-of-the-money call. \nThe time remaining to expiration is also relevant to the call buyer. If the stock \nis fairly close to the striking price, the near-term call will most closely follow the price \nmovement of the underlying stock, so it has the greatest rewards and also the great\nest risks. The far-term call, because it has a large amount of time remaining, offers \nthe least risk and least percentage reward. The intermediate-temi call offers a mod\nerate amount of each, and is therefore often the most attractive one to buy. Many \ntimes an investor will buy the longer-term call because it only costs a point or a point \nand a half more than the intermediate-term call. He feels that the extra price is a bar\ngain to pay for three extra months of time. This line of thought may prove somewhat \nmisleading, however, because most call buyers don't hold calls for more than 60 or 90 \ndays. Thus, even though it looks attractive to pay the extra point for the long-term \ncall, it may prove to be an unnecessary expense if, as is usually the case, one will be \nselling the call in two or three months. \nCERTAINTY OF TIMING \nThe certainty with which one expects the underlying stock to advance may also help \nto play a part in his selection of which call to buy. If one is fairly sure that the under\nlying stock is about to rise immediately, he should strive for more reward and not be \nas concerned about risk. This would mean buying short-term, slightly out-of-the\nmoney calls. Of course, this is only a general rule; one would not normally buy an out\nof-the-money call that has only one week remaining until expiration, in any case. At \nthe opposite end of the spectrum, if one is very uncertain about his timing, he should \nbuy the longest-term call, to moderate his risk in case his timing is wrong by a wide \nmargin. This situation could easily result, for example, if one feels that a positive fun\ndamental aspect concerning the company will assert itself and cause the stock to \nincrease in price at an unknown time in the future. Since the buyer does not know \nwhether this positive fundamental will come to light in the next month or six months \nfrom now, he should buy the longer-term call to allow room for error in timing. \nIn many cases, one is not intending to hold the purchased call for any signifi\ncant period of time; he is just looking to capitalize on a quick, short-term movement \nby the underlying stock. In this case, he would want to buy a relatively short-term in\nthe-money call. Although such a call may be more ex-pensive than an out-of-the-\nCl,apter 3: Call Buying 99 \nmoney call on the same underlying stock, it will most surely move up on any increase \nin price by the underlying stock. Thus, the short-term trader would profit. \nTHE DELTA \nThe reader should by now be familiar with basic facts concerning call options: The \ntime premium is highest when the stock is at the striking price of the call; it is lowest \ndeep in- or out-of-the-money; option prices do not decay at a linear rate -the time pre\nmium disappears more rapidly as the option approaches expiration. As a further means \nof review, the option pricing curve introduced in Chapter 1 is reprinted here. Notice \nthat all the facts listed above can be observed from Figure 3-1. The curves are much \nnearer the \"intrinsic value\" line at the ends than they are in the middle, implying that \nthe time value premium is greatest when the stock is at the strike, and is least wh", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 48}
{"text": "the option approaches expiration. As a further means \nof review, the option pricing curve introduced in Chapter 1 is reprinted here. Notice \nthat all the facts listed above can be observed from Figure 3-1. The curves are much \nnearer the \"intrinsic value\" line at the ends than they are in the middle, implying that \nthe time value premium is greatest when the stock is at the strike, and is least when \nthe stock moves away from the strike either into- or out-of-the-money. Furthermore, \nthe fact that the curve for the 3-month option lies only about halfway between the \nintrinsic value line and the curve of the 9-month option implies that the rate of decay \nof an at- or near-the-money option is not linear. The reader may also want to refer back \nto the graph of time value premium decay in Chapter 1 (Figure 1-4). \nThere is another property of call options that the buyer should be familiar with, \nthe delta of the option (also called the hedge ratio). Simply stated, the delta of an \noption is the arrwunt by which the call will increase or decrease in price if the under\nlying stock moves by 1 point. \nFIGURE 3-1. \nOption pricing curve; 3-, 6-, and 9-month calls. \nQ) \n0 \n~ \nC: \n0 \na \n0 \n9-Month Curve \n6-Month Curve \n3-Month Curve \n/ \nIntrinsic Value \nStriking Price \nStock Price \nAs expiration date draws \ncloser, the lower curve \nmerges with the intrinsic \nvalue line. The option \nprice then equals its \nintrinsic value. \n100 Part II: Call Option Strategies \nExample: The delta of a call option is close to 1 when the underlying stock is well \nabove the striking price of the call. If XYZ were 60 and the XYZ July 50 call were \n101/s, the call would change in price by nearly 1 point ifXYZ moved by 1 point, either \nup or down. A deeply out-of-the-money call has a delta of nearly zero. If XYZ were \n40, the July 50 call might be selling at¼ of a point. The call would change very little \nin price if XYZ moved by one point, to either 41 or 39. When the stock is at the strik\ning price, the delta is usually between one-half of a point and five-eighths of a point. \nVery long-term calls may have even larger at-the-money deltas. Thus, if XYZ were 50 \nand the XYZ July 50 call were 5, the call might increase to 5½ if XYZ rose to 51 or \ndecrease to 4½ if XYZ dropped to 49. \nActually, the delta changes each time the underlying stock changes even frac\ntionally in price; it is an exact mathematical derivation that is presented in a later \nchapter. This is most easily seen by the fact that a deep in-the-money option has a \ndelta of 1. However, if the stock should undergo a series of I-point drops down to the \nstriking price, the delta will be more like½, certainly not 1 any longer. In reality, the \ndelta changed instantaneously all during the price decline by the stock. For those \nwho are geometrically inclined, the preceding option price curve is useful in deter\nmining a graphic representation of the delta. The delta is the slope of the tangent line \nto the price curve. Notice that a deeply in-the-money option lies to the upper right \nside of the curve, very nearly on the intrinsic value line, which has a slope of 1 above \nthe strike. Similarly, a deeply out-of-the-money call lies to the left on the price curve, \nagain near the intrinsic value line, which has a slope of zero below the strike. \nSince it is more common to relate the option's price change to a full point \nchange in the underlying stock (rather than to deal in \"instantaneous\" price changes), \nthe concepts of up delta and down delta arise. That is, if the underlying stock moves \nup by 1 full point, a call with a delta of .50 might increase by 5/s. However, should the \nstock fall by one full point, the call might decrease by only 3/s. There is a different net \nprice change in the call when the stock moves up by 1 full point as opposed to when \nit falls by a point. The up delta is observed to be 5/s while the down delta is 3/s. In the \ntrue mathematical sense, there is only one delta and it measures \"instantaneous\" \nprice change. The concepts of up delta and down delta are practical, rather than the\noretical, concepts that merely illustrate the fact that the true delta changes whenev\ner the stock price changes, even by as little as 1 point. In the following examples and \nin later chapters, only one delta is referred to. \nThe delta is an important piece of information for the call buyer because it can \ntell him how much of an increase or decrease he can expect for short-term moves by \nthe underlying stock. This piece of information may help the buyer decide which call \nto buy. \nChapter 3: Call Buying 101 \nExample: If XYZ is 4 7½ and the call buyer expects a quick, but possibly limited, rise \nin price in the underlying stock, should he buy the 45 call or the 50 call? The delta \nmay help him decide. He has the following information: \nXYZ: 471/2 XYZ July 45 call: price = 31/2, \nXYZ July 50 call: price = 1, \ndelta = 5/a \ndelta = 1/4 \nIt will make matters easier to make a slightly incorrect, but simplifying, assumption \nthat the deltas remain constant over the short term. Which call is the better buy if \nthe buyer expects the stock to quickly rise to 49? This would represent a 1 ½-point \nincrease in XYZ, which would translate into a 15/16 increase in the July 45 (l½ times \n5/s) or a 3/s increase in the July 50 (1 ½ times ¼). Consequently, the July 45, if it \nincreased in price by 15/16, would appreciate by 27%. The July 50, if it increased by \n3/a, would appreciate by over 37%. Thus, the July 50 appears to be the better buy in \nthis simple example. Commissions should, of course, be included when making an \nanalysis for actual investment. \nThe investor does not have to bother with computing deltas for himself. Any \ngood call-buying data service will supply the information, and some brokerage hous\nes provide this information free of charge. \nMore advanced applications of deltas are described in many of the succeeding \nchapters, as they apply to a variety of strategies", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 49}
{"text": "urse, be included when making an \nanalysis for actual investment. \nThe investor does not have to bother with computing deltas for himself. Any \ngood call-buying data service will supply the information, and some brokerage hous\nes provide this information free of charge. \nMore advanced applications of deltas are described in many of the succeeding \nchapters, as they apply to a variety of strategies. \nWHICH OPTION TO BUY? \nThere are various trading strategies, some short-term, some long-term (even buy and \nhold). If one decides to use an option to implement a trading strategy, the time hori\nzon of the strategy itself often dictates the general category of option that should be \nbought - in-the-money versus out-of-the-money, near-term versus long-term, etc. \nThis statement is true whether one is referring to stock, index, or futures options. \nThe general rule is this: The shorter-term the strategy, the higher the delta should be \nof the instrument being used to trade the strategy. \nDAY TRADING \nFor example, day trading has become a popular endeavor. Statistics have been pro\nduced that indicate that most day traders lose money. In fact, there are profitable day \ntraders; it simply requires more and harder work than many are willing to invest. \nMany day traders have attempted to use options in their strategies. These day traders \n102 Part II: Call Option Strategies \napparently are attracted by the leverage available from options, but they often lose \nmoney via option trading as well. \nWhat many of these option-oriented day traders fail to realize is that, for day\ntrading purposes, the instrument with the highest possible delta should be used. That \ninstrument is the underlying, for it has a delta of 1.0. Day trading is hard enough \nwithout complicating it by trying to use options. So of you're day trading Microsoft \n(MSFT), trade the stock, not an option. \nWhat makes options difficult in such a short-term situation is their relatively \nwide bid-asked spread, as compared to that of the underlying instrument itself. Also, \na day trader is looking to capture only a small part of the underlying's daily move; an \nat-the-money or out-of-the-money option just won't respond well enough to those \nmovements. That is, if the delta is too low, there just isn't enough room for the option \nday trader to make money. \nIf a day trader insists on using options, a short-term, in-the-money should be \nbought, for it has the largest delta available - preferably something approaching .90 \nor higher. This option will respond quickly to small movements by the underlying. \nSHORT-TERM TRADING \nSuppose one employs a strategy whereby he expects to hold the underlying for \napproximately a week or two. In this case, just as with day trading, a high delta is \ndesirable. However, now that the holding period is more than a day, it may be appro\npriate to buy an option as opposed to merely trading the underlying, because the \noption lessens the risk of a surprisingly large downside move. Still, it is the short\nterm, in-the-money option that should be bought, for it has the largest delta, and will \nthus respond most closely to the movement in the underlying stock. Such an option \nhas a very high delta, usually in excess of .80. Part of the reason that the high-delta \noptions make sense in such situations is that one is fairly certain of the timing of day \ntrading or very short-term trading systems. When the system being used for selection \nof which stock to trade has a high degree of timing accuracy, then the high-delta \noption is called for. \nINTERMEDIATE-TERM TRADING \nAs the time horizon of one's trading strategy lengthens, it is appropriate to use an \noption with a lesser delta. This generally means that the timing of the selection \nprocess is less exact. One might be using a trading system based, for ernmple, on sen\ntiment, which is generally not an exact timing indicator, but rather one that indicates \na general trend change at major turning points. The timing of the forthcoming move \nGapter 3: Call Buying 103 \nis not exact, because it often takes time for an extreme change in sentiment to reflect \nitself in a change of direction by the underlying. \nHence, for a strategy such as this, one would want to use an option with a small\ner delta. The investor would limit his risk by using such an option, knowing that large \nmoves are possible since the position is going to be held for several weeks or perhaps \neven a couple of months or more. Therefore, an at-the-money option can be used in \nsuch situations. \nI.ONG-TERM TRADING \nIf one's strategy is even longer-term, an option with a lower delta can be considered. \nSuch strategies would generally have only vague timing qualities, such as selecting a \nstock to buy based on the general fundamental outlook for the company. In the \nextreme, it would even apply to \"buy and hold\" strategies. \nGenerally, buying out-of-the-money options is not recommended; but for very \nlong-term strategies, one might consider something slightly out-of-the-money, or at \nleast a fairly long-term at-the-money option. In either case, that option will have a \nlower delta as compared to the options that have been recommended for the other \nstrategies mentioned above. Alternatively, LEAPS options might be appropriate for \nstock strategies of this type. \nADVANCED SELECTION CRITERIA \nThe criteria presented previously represented elementary techniques for selecting \nwhich call to buy. In actual practice, one is not usually bullish on just one stock at a \ntime. In fact, the investor would like to have a list of the \"best\" calls to buy at any \ngiven time. Then, using some method of stock selection, either technical or funda\nmental, he can select three or four calls that appear to offer the best rewards. This \nlist should be ranked in order of the best potential rewards available, but the con\nstruction of the list itself is important. \nCall option rankings for buying purposes must be based on the volatilities of the", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 50}
{"text": "alls to buy at any \ngiven time. Then, using some method of stock selection, either technical or funda\nmental, he can select three or four calls that appear to offer the best rewards. This \nlist should be ranked in order of the best potential rewards available, but the con\nstruction of the list itself is important. \nCall option rankings for buying purposes must be based on the volatilities of the \nunderlying stocks. This is not easy to do mathematically, and as a result many pub\nlished rankings of calls are based strictly on percentage change in the underlying \nstock. Such a list is quite misleading and can lead one to the wrong conclusions. \nExample: There are two stocks with listed calls: NVS, which is not volatile, and VVS, \nwhich is quite volatile. Since a call on the volatile stock will be higher-priced than a \ncall on the nonvolatile stock, the following prices might exist: \n104 Part II: Call Option Strategies \nNVS: 40 VVS: 40 \nNVS July 40 call: 2 VVS July 40 call: 4 \nIf these two calls are ranked for buying purposes, based strictly on a percentage \nchange in the underlying stock, the NVS call will appear to be the better buy. For \nexample, one might see a list such as \"best call buys if the underlying stock advances \nby 10%.\" In this example, if each stock advanced 10% by expiration, both NVS and \nWS would be at 44. Thus, the NVS July 40 would be worth 4, having doubled in \nprice, for a 100% potential profit. Meanwhile, the WS July 40 would be worth 4 also, \nfor a 0% profit to the call buyer. This analysis would lead one to believe that the NVS \nJuly 40 is the better buy. Such a conclusion may be wrong, because an incorrect \nassumption was made in the ranking of the potentials of the two stocks. It is not right \nto assume that both stocks have the same probability of moving 10% by expiration. \nCertainly, the volatile stock has a much better chance of advancing by 10% ( or more) \nthan the nonvolatile stock does. Any ranking based on equal percentage changes in \nthe underlying stock, without regard for their volatilities, is useless and should be \navoided. \nThe correct method of comparing these two July 40 calls is to utilize the actual \nvolatilities of the underlying stocks. Suppose that it is known that the volatile stock, \nWS, could expect to move 15% in the time to July expiration. The nonvolatile stock, \nNVS, however, could only expect a move of 5% in the same period. Using this infor\nmation, the call buyer can arrive at the conclusion that WS July 40 is the better call \nto buy: \nStock Price in July \nVVS: 46 (up 15%) \nNVS: 42 (up 5%) \nColl Price \nVVS July 40: 6 (up 50%) \nNVS July 40: 2 (unchanged) \nBy assuming that each stock can rise in accordance with its volatility, we can see that \nthe WS July 40 has the better reward potential, despite the fact that it was twice as \nexpensive to begin with. This method of analysis is much more realistic. \nOne more refinement needs to be made in this ranking process. Since most call \npurchases are made for holding periods of from 30 to 90 days, it is not correct to \nassume that the calls will be held to expiration. That is, even if one buys a 6-month \ncall, he will normally liquidate it, to take profits or cut losses, in 1 to 3 months. The \ncall buyer's list should thus be based on how the call will peiform if held for a realis\ntic time period, such as 90 days. \nChapter 3: Call Buying 105 \nSuppose the volatile stock in our example, WS, has the potential to rise by 12% \nin 90 days, while the less volatile stock, NVS, has the potential of rising only 4% in 90 \ndays. In 90 days, the July 40 calls will not be at parity, because there will be some time \nremaining until July expiration. Thus, it is necessary to attempt to predict what their \nprices will be at the end of the 90-day holding period. Assume that the following \nprices are accurate estimates of what the July 40 calls will be selling for in 90 days, if \nthe underlying stocks advance in relation to their volatilities: \nStock Price in 90 Days \nVVS: 44.8 (up 12%) \nNVS: 41 .6 (up 4%) \nColl Price \nVVS July 40: 6 (up 50%) \nNVS July 40: 21/2 (up 25%) \nWith some time remaining in the calls, they would both have time value premium at \nthe end of 90 days. The bigger time premium would be in the WS call, since the \nunderlying stock is more volatile. Under this method of analysis, the WS call is still \nthe better one to buy. \nThe correct method of ranking potential reward situations for call buyers is as \nfollows: \n1. Assume each underlying stock can advance in accordance with its volatility over \na fixed period (30, 60, or 90 days). \n2. Estimate the call prices after the advance. \n3. Rank all potential call purchases by highest percentage reward opportunity for \naggressive purchases. \n4. Assume each stock can decline in accordance with its volatility. \n5. Estimate the call prices after the decline. \n6. Rank all purchases by reward/risk ratio ( the percentage gain from item 2 divided \nby the percentage loss from item 5). \nThe list from item 3 will generate more aggressive purchases because it incorporates \npotential rewards only. The list from item 6 would be a less speculative one. This \nmethod of analysis automatically incorporates the criteria set forth earlier, such as \nbuying short-term out-of-the-money calls for aggressive purchases and buying \nlonger-term in-the-money calls for a more conservative purchase. The delta is also a \nfunction of the volatility and is essentially incorporated by steps 1 and 4. \nIt is virtually impossible to perform this sort of analysis without a computer. The \ncall buyer can generally obtain such a list from a brokerage firm or from a data serv\nice. For those individuals who have access to a computer and would like to generate \n106 Part II: Call Option Strategies \nsuch an analysis for themselves, the details of computing a stock's volatility and pre\ndicting the call prices are provided in Chapter 28 on mathematical techniques. \nOVERPRICED OR UNDERPRICED CALLS \nForm", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 51}
{"text": "an generally obtain such a list from a brokerage firm or from a data serv\nice. For those individuals who have access to a computer and would like to generate \n106 Part II: Call Option Strategies \nsuch an analysis for themselves, the details of computing a stock's volatility and pre\ndicting the call prices are provided in Chapter 28 on mathematical techniques. \nOVERPRICED OR UNDERPRICED CALLS \nFormulae exist that are capable of predicting what a call should be selling for, based \non the relationship of the stock price and the striking price, the time remaining to \nexpiration, and the volatility of the underlying stock. These are useful, for example, \nin performing the second step in the foregoing analysis, estimating the call price after \nan advance in the underlying stock. In reality, a call's actual price may deviate some\nwhat from the price computed by the formula. If the call is actually selling for more \nthan the \"fair\" ( computed) price, the call is said to be overvalued. An undervalued \ncall is one that is actually trading at a price that is less than the \"fair\" price. \nIf the calls are truly overpriced, there may be a strategy that can help reduce \ntheir cost while still preserving upside profit potential. This strategy, however, \nrequires the addition of a put spread to the call purchase, so it is beyond the scope \nof the subject matter at the current time. It is described in Chapter 23 on spreads \ncombining calls and puts. \nGenerally, the amount by which a call is overvalued or undervalued may be only \na small fraction of a point, such as 10 or 20 cents. In theory, the call buyer who pur\nchases an undervalued call has gained a slight advantage in that the call should return \nto its \"fair\" value. However, in practice, this information is most useful only to mar\nket-makers or firm traders who pay little or no commissions for trading options. The \ngeneral public cannot benefit directly from the knowledge that such a small discrep\nancy exists, because of commission costs. \nOne should not base his call buying decisions merely on the fact that a call is \nunderpriced. It is small solace to the call buyer to find that he bought a \"cheap\" call \nthat subsequently declined in price. The method of ranking calls for purchase that \nhas been described does, in fact, give some slight benefit to underpriced calls. \nHowever, under the recommended method of analysis, a call will not automatically \nappear as an attractive purchase just because it is slightly undervalued. \nTIME VALUE PREMIUM IS A MISNOMER \nThis is a topic that will be mentioned several times throughout the book, most \nnotably in conjunction with volatility trading. It is introduced here because even the \ninexperienced option trader must understand that the portion of an option's price \nthat is not intrinsic value - the part that we routinely call \"time value premium\" - is \nreally composed of much more than just time value. Yes, time will eventually wear \nChpter 3: Call Buying 107 \naway that portion of the option's price as expiration approaches. However, when an \noption has a considerable amount of time remaining until its expiration, the more \nimportant component of the option value is really volatility. If traders expect the \nunderlying stock to be volatile, the option will be expensive; if they expect the oppo\nsite, the option will be cheap. This expensiveness and cheapness is reflected in the \nportion of the option that is not intrinsic value. For example, a six-month option will \nnot decay much in one day's time, but a quick change in volatility expectations by \noption traders can heavily affect the price of the option, especially one with a good \ndeal of time remaining. So an option buyer should carefully assess his purchases, not \njust view them as something that will waste away. With careful analysis, option buy\ners can do very well, if they consider what can happen during the life of the option, \nand not merely what will happen at expiration. \nCALL BUYERS' FRUSTRATIONS \nDespite one's best efforts, it may often seem that one does not make much money \nwhen a fairly volatile stock makes a quick move of 3 or 4 points. The reasons for this \nare somewhat more complex than can be addressed at this time, although they relate \nstrongly to delta, time decay, and the volatility of the underlying stock. They are dis\ncussed in Chapter 36, 'The Basics of Volatility Trading.\" If one plans to conduct a \nserious call buying strategy, he should read that chapter before embarking on a pro\ngram of extensive call buying. \nFOLLOW-UP ACTION \nThe simplest follow-up action that the call buyer can implement when the underly\ning stock drops is to sell his call and cut his losses. There is often a natural tendency \nto hold out hope that the stock can rally back to or above the striking price. Most of \nthe time, the buyer does best by cutting his losses in situations in which the stock is \nperforming poorly. He might use a \"mental\" stop price or could actually place a sell \nstop order, depending on the rules of the exchange where the call is traded. In gen\neral, stop orders for options result in poor executions, so using a \"mental\" stop is bet\nter. That is, one should base his exit point on the technical pattern of the underlying \nstock itself. If it should break down below support, for example, then the option \nholder should place a market (not held) order to sell his call option. \nIf the stock should rise, the buyer should be willing to take profits as well. Most \nbuyers will quite readily take a profit if, for example, a call that was bought for 5 \npoints had advanced to be worth 10 points. However, the same investor is often \n108 Part II: Call Option Strategies \nreluctant to sell a call at 2 that he had previously bought for 1 point, because \"I've \nonly made a point.\" The similarity is clear - both cases resulted in approximately a \n100% profit - and the investor should be as willing to accept the one as he is the \nother. This is not to imply that", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 52}
{"text": "ad advanced to be worth 10 points. However, the same investor is often \n108 Part II: Call Option Strategies \nreluctant to sell a call at 2 that he had previously bought for 1 point, because \"I've \nonly made a point.\" The similarity is clear - both cases resulted in approximately a \n100% profit - and the investor should be as willing to accept the one as he is the \nother. This is not to imply that all calls that are bought at 1 should be sold when and \nif they get to 2, but the same factors that induce one to sell the 10-point call after \ndoubling his money should apply to the 2-point call as well. \nIn fact, taking partial profits after a call holding has increased in value is often \na wise plan. For example, if someone bought a number of calls at a price of 3, and \nthey later were worth 5, it might behoove the call holder to sell one-third to one-half \nof his position at 5, thereby taking a partial profit. Having done that, it is often easi\ner to let the profits run on the balance, and letting profits run is generally one of the \nkeys to successful trading. \nIt is rarely to the call buyer's benefit to exercise the call if he has to pay com\nmissions. When one exercises a call, he pays a stock commission to buy the stock at \nthe striking price. Then when the stock is sold, a stock sale commission must also be \npaid. Since option commissions are much smaller, dollarwise, than stock commis\nsions, the call holder will usually realize more net dollars by selling the call in the \noption market than by exercising it. \nLOCKING IN PROFITS \nWhen the call buyer is fortunate enough to see the underlying stock advance rela\ntively quickly, he can implement a number of strategies to enhance his position. \nThese strategies are often useful to the call buyer who has an unrealized profit but is \ntorn between taking the profit or holding on in an attempt to generate more profits \nif the underlying stock should continue to rise. \nExample: A call buyer bought an XYZ October 50 call for 3 points when the stock \nwas at 48. Then the stock rises to 58. The buyer might consider selling his October \n50 (which would probably be worth about 9 points) or possibly taking one of several \nactions, some of which might involve the October 60 call, which may be selling for 3 \npoints. Table 3-1 summarizes the situation. At this point, the call buyer might take \none of four basic actions: \n1. Liquidate the position by selling the long call for a profit. \n2. Sell the October 50 that he is currently long and use part of the proceeds to pur\nchase October 60's. \n3. Create a spread by selling the October 60 call against his long October 50. \n4. Do nothing and remain long the October 50 call. \nGapter 3: Call Buying \nTABLE 3-1. \nPresent situation on XYZ October calls. \nOriginal Trade \nXYZ common: 48 \nBought XYZ October 50 at 3 \n109 \nCurrent Prices \nXYZ Common: 58 \nXYZ October 50: 9 \nXYZ October 60: 3 \nEach of these actions would produce different levels of risk and reward from \nthis point forward. If the holder sells the October 50 call, he makes a 6-point profit, \nless commissions, and terminates the position. He can realize no further appreciation \nfrom the call, nor can he lose any of his current profits; he has realized a 6-point gain. \nThis is the least aggressive tactic of the four: If the underlying stock continues to \nadvance and rises above 63, any of the other three strategies will outperform the \ncomplete liquidation of the call. However, if the underlying stock should instead \ndecline below 50 by expiration, this action would have provided the most profit of the \nfour strategies. \nThe other simple tactic, the fourth one listed, is to do nothing. If the call is then \nheld to expiration, this tactic would be the riskiest of the four: It is the only one that \ncould produce a loss at expiration if XYZ fell back below 50. However, if the under\nlying stock continues to rise in price, more profits would accrue on the call. Every call \nbuyer realizes the ramifications of these two tactics - liquidating or doing nothing \nand is generally looking for an alternative that might allow him to reduce some of his \nrisk without cutting off his profit potential completely. The remaining two tactics are \ngeared to this purpose: limiting the total risk while providing the opportunity for fur\nther profits of an amount greater than those that could be realized by liquidating. \nThe strategy in which the holder sells the call that he is currently holding, the \nOctober 50, and uses part of the proceeds to buy the call at the next higher strike is \ncalled rolling up. In this example, he could sell the October 50 at 9, pocket his initial \n3-point investment, and use the remaining proceeds to buy two October 60 calls at 3 \npoints each. Thus, it is sometimes possible for the speculator to recoup his entire \noriginal investment and still increase the number of calls outstanding by rolling up. \nOnce this has been done, the October 60 calls will represent pure profits, whatever \ntheir price. The buyer who \"rolls up\" in this rrwnner is essentially speculating with \nsomeone else's money. He has put his own money back in his pocket and is using \naccrued profits to attempt to realize further gains. At expiration, this tactic would \nperform best if XYZ increased by a substantial amount. This tactic turns out to be the \n110 Part II: Call Option Strategies \nworst of the four at expiration if XYZ remains near its current price, staying above 53 \nbut not rising above 63 in this example. \nThe other alternative, the third one listed, is to continue to hold the October 50 \ncall but to sell the October 60 call against it. This would create what is known as a bull \nspread, and the tactic can be used only by traders who have a margin account and can \nmeet their firm's minimum equity requirement for spreading (generally $2,000). This \nspread position has no risk, for the long side of the spread - the October 50 cost 3 \npoints, and the short side of the spread - the Oc", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 53}
{"text": "call but to sell the October 60 call against it. This would create what is known as a bull \nspread, and the tactic can be used only by traders who have a margin account and can \nmeet their firm's minimum equity requirement for spreading (generally $2,000). This \nspread position has no risk, for the long side of the spread - the October 50 cost 3 \npoints, and the short side of the spread - the October 60 - brought in 3 points via its \nsale. Even if the underlying stock drops below 50 by expiration and all the calls expire \nworthless, the trader cannot lose anything except commissions. On the other hand, the \nmaximum potential of this spread is 10 points, the difference between the striking \nprices of 50 and 60. This maximum potential would be realized if XYZ were anywhere \nabove 60 at expiration, for at that time the October 50 call would be worth 10 points \nmore than the October 60 call, regardless of how far above 60 the underlying stock \nhad risen. This strategy will be the best peiformer of the four if XYZ remains relative\nly unchanged, above the lower strike but not much above the higher strike by expira\ntion. It is interesting to note that this tactic is never the worst peiforrner of the four \ntactics, no matter where the stock is at expiration. For example, if XYZ drops below \n50, this strategy has no risk and is therefore better than the \"do nothing\" strategy. If \nXYZ rises substantially, this spread produces a profit of 10 points, which is better than \nthe 6 points of profit offered by the \"liquidate\" strategy. \nThere is no definite answer as to which of the four tactics is the best one to \napply in a given situation. However, if a call can be sold against the currently long call \nto produce a bull spread that has little or no risk, it may often be an attractive thing \nto do. It can never tum out to be the worst decision, and it would produce the largest \nprofits if XYZ does not rise substantially or fall substantially from its current levels. \nTables 3-2 and 3-3 summarize the four alternative tactics, when a call holder has an \nunrealized profit. The four tactics, again, are: \n1. \"Do nothing\" - continue to hold the currently long call. \n2. \"Liquidate\" - sell the long call to take profits and do not reinvest. \n3. \"Roll up\" - sell the long call, pocket the original investment, and use the remain\ning proceeds to purchase as many out-of-the-money calls as possible. \n4. \"Spread\" - create a bull spread by selling the out-of-the-money call against the \ncurrently profitable long call, preferably taking in at least the original cost of the \nlong call. \nCl,apter 3: Call Buying 111 \nTABLE 3-2. \nComparison of the four alternative strategies. \nIf the underlying stock then. . . The best tactic was. . . And the worst tactic was ... \ncontinues to rise dramatic\nally ... \n\"roll up\" \nrises moderately above the do nothing \nnext strike ... \nremains relatively unchanged . .. spread \nfalls back below the original liquidate \nstrike ... \nTABLE 3-3. \nResults at expiration. \nXYZ Price at \"Roll-up\" \"Do Nothing\" \nExpiration Profit Profit \n50 or below $ 0 -$ 300(W) \n53 0(W) 0(W) \n56 0(W) + 300 \n60 0(W) + 700 \n63 + 600(W) + 1,000(B) \n67 + 1,400(B) + 1,400(B) \n70 + 2,000(B) + 1,700 \nliquidate \nliquidate or \"roll up\" \n\"roll up\" \ndo nothing \n\"Spread\" \nProfit \n$ 0 \n+ 300 \n+ 600(B) \n+ 1,000(B) \n+ 1,000(B) \n+ 1,000 \n+ 1,000 \nLiquidating \nProfit \n+$600(B) \n+ 600(B) \n+ 600(B) \n+ 600 \n+ 600(W) \n+ 600(W) \n+ 600(W) \nNote that each of the four tactics proves to be the best tactic in one case or another, \nbut that the spread tactic is never the worst one. Tables 3-2 and 3-3 represent the \nresults from holding until expiration. For those who prefer to see the actual numbers \ninvolved in making these comparisons between the four tactics, Table 3-3 summa\nrizes the potential profits and losses of each of the four tactics using the prices from \nthe example above. 'W\" indicates that the tactic is the worst one at that price, and \n\"B\" indicates that it is the best one. \nThere are, of course, modifications that an investor might make to any of these \ntactics. For example, he might decide to sell out half of his long call position, recov\nering a major part of his original cost, and continue to hold the remainder of the long \ncalls. This still leaves room for further appreciation. \n112 Part II: Call Option Strategies \nDEFENSIVE ACTION \nTwo follow-up strategies are sometimes employed by the call buyer when the under\nlying stock declines in price. Both involve spread strategies; that is, being long and \nshort two different calls on the same underlying stock simultaneously. Spreads are \ndiscussed in detail in later chapters. This discussion of spreads applies only to their \nuse by the call buyer. \n·\"Rolling Down.\" If an option holder owns an option at a currently unreal\nized loss, it may be possible to greatly increase the chances of making a limited \nprofit on a relatively small rebound in the stock price. In certain cases, the \ninvestor may be able to implement such a strategy at little or no increase in risk. \nMany call buyers have encountered a situation such as this: An XYZ October 35 \ncall was originally bought for 3 points in hopes of a quick rise in the stock price. \nHowever, because of downward movements in the stock- to 32, say- the call is now \nat 1 ½ with October expiration nearer. If the call buyer still expects a mild rally in the \nstock before expiration, he might either hold the call or possibly \"average down\" (buy \nmore calls at I½). In either case he will need a rally to nearly 38 by expiration in \norder to break even. Since this would necessitate at least a 15% upward move by the \nstock before expiration, it cannot be considered very likely. Instead, the buyer should \nconsider implementing the following strategy, which will be explained through the \nuse of an example. \nExample: The investor is long the October 35 call at this time: \nXYZ, 32; \nXYZ October 35 call, 1 ½; and \nXYZ October 30 call, 3. \nOne could sell t", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 54}
{"text": "ce this would necessitate at least a 15% upward move by the \nstock before expiration, it cannot be considered very likely. Instead, the buyer should \nconsider implementing the following strategy, which will be explained through the \nuse of an example. \nExample: The investor is long the October 35 call at this time: \nXYZ, 32; \nXYZ October 35 call, 1 ½; and \nXYZ October 30 call, 3. \nOne could sell two October 35's and, at the same time, buy one October 30 for no \nadditional investment before commissions. That is, the sale of 2 October 35's at $150 \neach would bring in $300, exactly the cost, before commissions, of buying the \nOctober 30 call. This is the key to implementing the roll-down strategy: that one be \nable to buy the lower strike call and sell two of the higher strike calls for nearly even \nmoney. \nNote that the investor is now short the call that he previously owned, the \nOctober 35. Where he previously owned one October 35, he has now sold two of \nthem. He is also now long one October 30 call. Thus, his position is: \n0.,,., 3: Call Buying \nlong 1 XYZ October 30 call, \n1hort 1 XYZ October 35 call. \n113 \nThis is technically known as a bull spread, but the terminology is not important. \nTable 3-4 summarizes the transactions that the buyer has made to acquire this \nspread. The trader now \"owns\" the spread at a cost of $300, plus commissions. By \nmaking this trade, he has lowered his break-even point significantly without increas\ning his risk. However, the maximum profit potential has also been limited; he can no \nlonger capitalize on a strong rebound by the underlying stock. \nIn order to see that the break-even point has been lowered, consider what the \nresults are~ is at 33 at October expiration. The October 30 call would be worth \n3 points and the October 35 would expire worthless with XYZ at 33. Thus, the \nOctober 30 call could be sold to bring in $300 at that time, and there would not be \nany expense to buy back the October 35. Consequently, the spread could be liqui\ndated for $300, exactly the amount for which it was \"bought.\" The spread then breaks \neven at 33 at expiration. If the call buyer had not rolled down, his break-even point \nwould be 38 at expiration, for he paid 3 points for the original October 35 call and he \nwould thus need XYZ to be at 38 in order to be able to liquidate the call for 3 points. \nClearly, the stock has a better chance of recovering to 33 than to 38. Thus, the call \nbuyer significantly lowers his break-even point by utilizing this strategy. \nLowering the break-even point is not the investor's only concern. He must also \nbe aware of what has happened to his profit and loss opportunities. The risk remains \nessentially the same the $300 in debits, plus commissions, that has been paid out. \nThe risk has actually increased slightly, by the amount of the commissions spent in \n\"rolling down.\" However, the stock price at which this maximum loss would be real\nized has been lowered. With the original long call, the October 35, the buyer would \nlose the entire $300 investment anywhere below 35 at October expiration. The \nTABLE 3-4. \nTransactions in bull spread. \nOriginal trade \nLater trade \nNet position \nTrade \nBuy 1 October 35 call at 3 \nSell 2 October 35 calls at 1 1/2 \nBuy 1 October 30 call at 3 \nLong 1 October 30 call \nShort 1 October 35 call \nCost before Commissions \n$300 debit \n$300 credit \n$300 debit \n$300 debit \n114 Part II: Call Option Strategies \nspread strategy, however, would result in a total loss of $300 only if XYZ were below \n30 at October expiration. With XYZ above 30 in October, the long side of the spread \ncould be liquidated for some value, thereby avoiding a total loss. The investor has \nreduced the chance of realizing the maximum loss, since the stock price at which that \nloss would occur has been lowered by 5 points. \nAs with most investments, the improvement of risk exposure - lowering the \nbreak-even point and lowering the maximum loss price - necessitates that some \npotential reward be sacrificed. In the original long call position (the October 35), the \nmaximum profit potential was unlimited. In the new position, the potential profit is \nlimited to 2 points if XYZ should rally back to, or anywhere above, 35 by October \nexpiration. To see this, assume XYZ is 35 at expiration. Then the long October 30 call \nwould be worth 5 points, while the October 35 would expire worthless. Thus, the \nspread could be liquidated for 5 points, a 2-point profit over the 3 points paid for the \nspread. This is the limit of profit for the spread, however, since if XYZ is above 35 at \nexpiration, any further profits in the long October 30 call would be offset by a corre\nsponding loss on the short October 35 call. Thus, if XYZ were to rally heavily by expi\nration, the \"rolled down\" position would not realize as large a profit as the original \nlong call position would have realized. \nTable 3-5 and Figure 3-2 summarize the original and new positions. Note that \nthe new position is better for stock prices between 30 and 40. Below 30, the two posi\ntions are equal, except for the additional commissions spent. If the stock should rally \nback above 40, the original position would have worked out better. The new position \nis an improvement, provided that XYZ does not rally back above 40 by expiration. \nThe chances that XYZ could rally 8 points, or 25%, from 32 to 40 would have to be \nconsidered relatively remote. Rolling the long call down into the spread would thus \nappear to be the correct thing to do in this case. \nThis example is particularly attractive, because no additional money was \nrequired to establish the spread. In many cases, however, one may find that the long \ncall cannot be rolled into the spread at even money. Some debit may be required. \nThis fact should not necessarily preclude making the change, since a small addition\nal investment may still significantly increase the chance of breaking even or making \na profit on a rebound. \nExample: The follow", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 55}
{"text": "itional money was \nrequired to establish the spread. In many cases, however, one may find that the long \ncall cannot be rolled into the spread at even money. Some debit may be required. \nThis fact should not necessarily preclude making the change, since a small addition\nal investment may still significantly increase the chance of breaking even or making \na profit on a rebound. \nExample: The following prices now exist, rather than the ones used earlier. Only the \nOctober 30 call price has been altered: \nXYZ, 32; \nXYZ October 35 call, 1 ½; and \nXYZ October 30 call, 4. \nO.,ter 3: Call Buying \nTABLE 3-5. \nOriginal and spread positions compared. \nStock Price Long Call \nat Expiration Result \n25 -$300 \n30 - 300 \n33 - 300 \n35 - 300 \n38 0 \n40 + 200 \n45 + 700 \nFIGURE 3-2. \nCompanion: original call purchase vs. spread. \n§ \n~ +$200 \n·5.. \n~ \nal \ntJ) \n.3 \n0 \n:1: \ne \nc.. -$300 \nStock Price at Expiration \nSpread \nResult \n-$300 \n- 300 \n0 \n+ 200 \n+ 200 \n+ 200 \n+ 200 \n115 \nWith these prices, a 1-point debit would be required to roll down. That is, selling 2 \nOctober 35 calls would bring in $300 ($150 each), but the cost of buying the October \n30 call is $400. Thus, the transaction would have to be done at a cost of $100, plus \ncommissions. With these prices, the break-even point after rolling down would be 34, \nstill well below the original break-even price of 38. The risk has now been increased \nby the additional 1 point spent to roll down. If XYZ should drop below 30 at October \nexpiration, the investor would have a total loss of 4 points plus commissions. The \nmaximum loss with the original long October 35 call was limited to 3 points plus a \nsmaller amount of commissions. Finally, the maximum amount of money that the \n116 Part II: Call Option Strategies \nspread could make is now $100, less commissions. The alternative in this example is \nnot nearly as attractive as the previous one, but it might still be worthwhile for the \ncall buyer to invoke such a spread if he feels that XYZ has limited rally potential up \nto October expiration. \nOne should not automatically discard the use of this strategy merely because a \ndebit is required to convert the long call to a spread. Note that to \"average down\" by \nbuying an additional October 35 call at 1 ½ would require an additional investment \nof $150. This is more than the $100 required to convert into the spread position in \nthe immediately preceding example. The break-even point on the position that was \n\"averaged down\" would be over 37 at expiration, whereas the break-even point on the \nspread is 34. Admittedly, the averaged-down position has much more profit potential \nthan the spread does, but the conversion to the spread is less expensive than \"aver\naging down\" and also provides a lower break-even price. \nIn summary, then, if the call buyer finds himself with an unrealized loss because \nthe stock has declined, and yet is unwilling to sell, he may be able to improve his \nchances of breaking even by \"rolling down\" into a spread. That is, he would sell 2 of \nthe calls that he is currently long - the one that he owns plus another one - and \nsimultaneously buy one call at the next lower striking price. If this transaction of sell\ning 2 calls and buying 1 call can be done for approximately even money, it could def\ninitely be to the buyer's benefit to implement this strategy, because the break-even \npoint would be lowered considerably and the buyer would have a much better \nchance of getting out even or making a small profit should the underlying stock have \na small rebound. \nCreating a Calendar Spread. A different type of defensive spread strategy \nis sometimes used by the call buyer who finds that the underlying stock has declined. \nIn this strategy, the holder of an intermediate- or long-term call sells a near-term call, \nwith the same striking price as the call he already owns. This creates what is known \nas a calendar spread. The idea behind doing this is that if the short-term call expires \nworthless, the overall cost of the long call will be reduced to the buyer. Then, if the \nstock should rally, the call buyer has a better chance of making a profit. \nExample: Suppose that an investor bought an XYZ October 35 call for 3 points some\ntime in April. By June the stock has fallen to 32, and it appears that the stock might \nremain depressed for a while longer. The holder of the October 35 call might con\nsider selling a July 35 call, perhaps for a price of 1 point. Should XYZ remain below \n35 until July expiration, the short call would expire worthless, earning a small, 1-point \nprofit. The investor would still own the October 35 call and would then hope for a \nrally by XYZ before October in order to make profits on that call. Even if XYZ does \nChpter 3: Call Buying 117 \nnot rally by October, he has decreased his overall loss by the amount received for the \nsale of the July 35 call. \nThis strategy is not as attractive to use as the previous one. If XYZ should rally \nbefore July expiration, the investor might find himself with two losing positions. For \nexample, suppose that XYZ rallied back to 36 in the next week. His short call that he \nsold for 1 point would be selling for something more than that, so he would have an \nunrealized loss on the short July 35. In addition, the October 35 would probably not \nhave appreciated back to its original price of 3, and he would therefore have an unre\nalized loss on that side of the spread as well. \nConsequently, this strategy should be used with great caution, for if the under\nlying stock rallies quickly before the near-term expiration, the spread could be at a \nloss on both sides. Note that in the former spread strategy, this could not happen. \nEven if XYZ rallied quickly, some profit would be made on the rebound. \nA FURTHER COMMENT ON SPREADS \nAnyone not familiar with the margin requirements for spreads, under both the \nexchange margin rules and the rules of the brokerage firm he is dealing with, should \nnot attempt to uti", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 56}
{"text": "ion, the spread could be at a \nloss on both sides. Note that in the former spread strategy, this could not happen. \nEven if XYZ rallied quickly, some profit would be made on the rebound. \nA FURTHER COMMENT ON SPREADS \nAnyone not familiar with the margin requirements for spreads, under both the \nexchange margin rules and the rules of the brokerage firm he is dealing with, should \nnot attempt to utilize a spread transaction. Later chapters on spreads outline the \nmore common requirements for spread transactions. In general, one must have a \nmargin account to establish a spread and must have a minimum amount of equity in \nthe account. Thus, the call buyer who operates in a cash account cannot necessarily \nuse these spread strategies. To do so might incur a margin call and possible restric\ntion of one's trading account. Therefore, check on specific requirements before uti\nlizing a spread strategy. Do not assume that a long call can automatically be \"rolled\" \ninto any sort of spread. \nOther Call Buying Strategies \nIn this chapter, two additional strategies that utilize the purchase of call options are \ndescribed. Both of these strategies involve buying calls against the short sale of the \nunderlying stock. When listed puts are traded on the underlying stock, these strate\ngies are often less effective than when they are implemented with the use of put \noptions. However, the concept is important, and sometimes these strategies are more \nviable in markets where calls are ve:iy liquid but puts are not. These strategies are \ngenerally known as \"synthetic\" strategies. \nTHE PROTECTED SHORT SALE (OR SYNTHETIC PUT) \nPurchasing a call at the same time that one is short the underlying stock is a means \nof limiting the risk of the short sale to a fixed amount. Since the risk is theoretically \nunlimited in a short sale, many investors are reluctant to use the strategy. Even for \nthose investors who do sell stock short, it can be rather upsetting if the stock rises in \nprice. One may be forced into an emotional - and perhaps incorrect - decision to \ncover the short sale in order to relieve the psychological pressure. By owning a call \nat the same time he is short, the investor limits the risk to a fixed and generally small \namount. \nExample: An investor sells XYZ short at 40 and simultaneously purchases an XYZ \nJuly 40 call for 3 points. If XYZ falls in price, the short seller will make his profit on \nthe short sale, less the 3 points paid for the call, which will expire worthless. Thus, by \nbuying the call for protection, a small amount of profit potential is sacrificed. \nHowever, the advantage of owning the call is demonstrated when the results are \nexamined for a stock rise. IfXYZ should rise to any price above 40 by July expiration, \n118 \nCl,apter 4: Other Call Buying Strategies 119 \nthe short seller can cover his short by exercising the long call and buying stock at 40. \nThus, the maximum risk that the short seller can incur in this example is the 3 points \npaid for the call. Table 4-1 and Figure 4-1 depict the results at expiration from uti\nlizing this strategy. Commissions are not included. Note that the break-even point is \n37 in this example. That is, if the stock drops 3 points, the protected short sale posi\ntion will break even because of the 3-point loss on the call. The short seller who did \nnot spend the extra money for the long call would, of course, have a 3-point profit at \n37. To the upside, however, the protected short sale outperforms a regular short sale \nif the stock climbs anywhere above 43. At 43, both types of short sales have $300 loss\nes. But above that level, the loss would continue to grow for a regular short sale, while \nit is fixed for the short seller who also bought a call. In either case, the short seller's \nrisk is increased slightly by the fact that he is obligated to pay out the dividends on \nthe underlying stock, if any are declared. \nA simple formula is available for determining the maximum amount of risk \nwhen one protects a short sale by buying a call option: \nRisk = Striking price of purchased call + Call price - Stock price \nDepending on how much risk the short seller is willing to absorb, he might want to \nbuy an out-of-the-money call as protection rather than an at-the-money call, as was \nshown in the example above. A smaller dollar amount is spent for the protection \nwhen one buys an out-of-the-money call, so that the short seller does not give away \nas much of his profit potential. However, his risk is larger because the call does not \nstart its protective qualities until the stock goes above the striking price. \nExample: With XYZ at 40, the short seller of XYZ buys the July 45 call at ½ for pro\ntection. His maximum possible loss, if XYZ is above 45 at July expiration, would be \nTABLE 4-1. \nResults at expiration-protected short sale. \nXYZ Price at Profit Call Price at Profit Total \nExpiration on XYZ Expiration on Call Profit \n20 +$2,000 0 -$ 300 +$1,700 \n30 + 1,000 0 - 300 + 700 \n37 + 300 0 - 300 0 \n40 0 0 - 300 300 \n50 - 1,000 10 + 700 300 \n60 - 2,000 20 + 1,700 300 \n120 \nFIGURE 4-1. \nProtected short sale. \nC: \n0 .:; \n~ \n'a.. X \nUJ \n1o +$0 en en \n0 \n...J \n0 \n-e \n0.-$300 \n40' \n', \nStock Price at Expiration \n' \nPart II: Call Option Strategies \n43 \n', ', ' ', ' ', \nShort ', \n' Sale 'll \n5½ points - the five points between the current stock price of 40 and the striking \nprice of 45, plus the amount paid for the call. On the other hand, if XYZ declines, the \nprotected short seller will make nearly as much as the short seller who did not pro\ntect, since he only spent ½ point for the long call. \nIf one buys an in-the-nwney call as protection for the short sale, his risk will be \nquite minimal. However, his profit potential will be severely limited. As an example, \nwith XYZ at 40, if one had purchased a July 35 call at 5½, his risk would be limited \nto½ point anywhere above 35 at July expiration. Unfortunately, he would not realize \nany profit on the position until t", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 57}
{"text": "nt for the long call. \nIf one buys an in-the-nwney call as protection for the short sale, his risk will be \nquite minimal. However, his profit potential will be severely limited. As an example, \nwith XYZ at 40, if one had purchased a July 35 call at 5½, his risk would be limited \nto½ point anywhere above 35 at July expiration. Unfortunately, he would not realize \nany profit on the position until the stock went below 34½, a drop of 5½ points. This \nis too much protection, for it limits the profit so severely that there is only a small \nhope of making a profit. \nGenerally, it is best to buy a call that is at-the-nwney or only slightly out-of the\nmoney as the protection for the short sale. It is not of much use to buy a deeply out\nof-the-money call as protection, since it does very little to moderate risk unless the \nstock climbs quite dramatically. Normally, one would cover a short sale before it went \nheavily against him. Thus, the money spent for such a deeply out-of-the-money call \nis wasted. However, if one wants to give a short sale plenty of room to \"work\" and \nCl,opter 4: Other Call Buying Strategies 121 \nfeels ve:ry certain that his bearish view of the stock is the correct view, he might then \nbuy a fairly deep out-of-the-money call just as disaster protection, in case the stock \nsuddenly bolted upward in price (if it received a takeover bid, for example). \nMARGIN REQUIREMENTS \nThe newest margin rules now allow one to receive favorable margin treatment when \na short sale of stock is protected by a long call option. The margin required is the \nlower of (1) 10% of the call's striking price plus any out-of-the-money amount, or (2) \n30% of the current short stock's market value. The position will be marked to market \ndaily, and most brokers will require that the short sale be margined at \"normal\" rates \nif the stock is below the strike price. \nExample: Suppose the following prices exist: \nXYZ Common stock: 47 \nOct 40 call: 8 \nOct 50 call: 3 \nOct 60 call: 1 \nSuppose that one is considering a short sale of 100 shares of XYZ at 47 and the \npurchase of one of the calls as protection. Here are the margin requirements for the \nvarious strike prices. (Note that the option price, per se, is not part of the margin \nrequirement, but all options must be paid for in full, initially). \nPosition \nShort XYZ, long Oct 40 call \nShort XYZ, long Oct 50 call \nShort XYZ, long Oct 60 call \nl 0% strike + out-of-the-money \n400 + 0 = 400* \n500 + 300 = 800* \n600 + 1,300 = 1,900 \n30% stock price \n1,410 \n1,410 \n1,41 0* \n*Since the margin requirement is the lower of the two figures, the items marked with an asterisk in \nthis table are the margin requirements. \nAgain, remember that the long call would have to be paid for in full, and that most \nbrokers impose a maintenance requirement of at least the value of the short sale itself \nas long as the stock is below the strike price of the long call, in addition to the above \nrequirements. \n122 Part II: Call Option Strategies \nFOLLOW-UP ACTION \nThere is little that the protected short seller needs to perform in the way of follow\nup action in this strategy, other than closing out the position. If the underlying stock \nmoves down quickly and it appears that it might rebound, the short sale could be cov\nered without selling the long call. In this manner, one could potentially profit on the \ncall side as well if the stock came back above the original striking price. If the under\nlying stock rises in price, a similar strategy of taking off only the profitable call side \nof the transaction is not recommended. That is, if XYZ climbed from 40 to 50 and the \nJuly 40 call also rose from 3 to 10, it is not advisable to take the 7-point profit in the \ncall, hoping for a drop in the stock price. The reason for this is that one is entering \ninto a highly risk-oriented situation by removing his protection when the call is in\nthe-money. Thus, when the stock drops, it is all right - perhaps even desirable - to \ntake the profit, because there is little or no additional risk if the stock continues to \ndrop. However, when the stock rises, it is not an equivalent situation. In that case, if \nthe short seller sells his call for a profit and the stock subsequently rises even further, \nlarge losses could result. \nIt may often be advisable to close the position if the call is at or near parity, \nin-the-money, by exercising the call. In most strategies, the option holder has no \nadvantage in exercising the call because of the large dollar difference between \nstock commissions and option commissions. However, in the protected short sale \nstrategy, the short seller is eventually going to have to cover the short stock in any \ncase and incur the stock commission by so doing. It may be to his advantage to \nexercise the call and buy his stock at the striking price, thereby buying stock at a \nlower price and perhaps paying a slightly lower commission amount. \nExample: XYZ rises to 50 from the original short sale price of 40, and the XYZ July \n40 call is selling at 10 somewhere close to expiration. The position could be liquidat\ned by either (1) buying the stock back at 50 and selling the call at 10, or (2) exercis\ning the call to buy stock at 40. In the first case, one would pay a stock commission at \na price of $50 per share plus an option commission on a $10 option. In the second \ncase, the only commission would be a stock commission at the price of $40 per share. \nSince both actions accomplish the same end result - closing the position entirely for \n40 points plus commissions - clearly the second choice is less costly and therefore \nmore desirable. Of course, if the call has time value premium in it of an amount \ngreater than the commission savings, the first alternative should be used. \nOrapter 4: Other Call Buying Strategies 123 \nTHE REVERSE HEDGE (SIMULATED STRADDLE) \nThere is another strategy involving the purchase of long calls against the short sale of \nstock. In this strategy, one purchases c", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 58}
{"text": "less costly and therefore \nmore desirable. Of course, if the call has time value premium in it of an amount \ngreater than the commission savings, the first alternative should be used. \nOrapter 4: Other Call Buying Strategies 123 \nTHE REVERSE HEDGE (SIMULATED STRADDLE) \nThere is another strategy involving the purchase of long calls against the short sale of \nstock. In this strategy, one purchases calls on more shares than he has sold short. The \nstrategist can profit if the underlying stock rises far enough or falls far enough dur\ning the life of the calls. This strategy is generally referred to as a reverse hedge or sim\nulated straddle. On stocks for which listed puts are traded, this strategy is outmoded; \nthe same results can be better achieved by buying a straddle (a call and a put). \nHence, the name \"simulated straddle\" is applied to the reverse hedge strategy. \nThis strategy has limited loss potential, usually amounting to a moderate per\ncentage of the initial investment, and theoretically unlimited profit potential. When \nproperly selected (selection criteria are described in great detail in Chapter 36, \nwhich deals with volatility trading), the percentage of success can be quite high in \nstraddle or synthetic straddle buying. These features make this an attractive strategy, \nespecially when call premiums are low in comparison to the volatility of underlying \nstock. \nExample: XYZ is at 40 and an investor believes that the stock has the potential to \nmove by a relatively large distance, but he is not sure of the direction the stock will \ntake. This investor could short XYZ at 40 and buy 2 XYZ July 40 calls at 3 each to set \nup a reverse hedge. If XYZ moves up by a large distance, he will incur a loss on his \nshort stock, but the fact that he owns two calls means that the call profits will outdis\ntance the stock loss. If, on the other hand, XYZ drops far enough, the short sale prof\nit will be larger than the loss on the calls, which is limited to 6 points. Table 4-2 and \nFigure 4-2 show the possible outcomes for various stock prices at July expiration. If \nXYZ falls, the stock profits on the short sale will accumulate, but the loss on the two \ncalls is limited to $600 (3 points each) so that, below 34, the reverse hedge can make \never-increasing profits. To the upside, even though the short sale is incurring losses, \nthe call profits grow faster because there are two long calls. For example, at 60 at \nexpiration, there will be a 20-point ($2,000) loss on the short stock, but each XYZ July \n40 call will be worth 20 points with the stock at 60. Thus, the two calls are worth \n$4,000, representing a profit of $3,400 over the initial cost of $600 for the calls. \nTable 4-2 and Figure 4-2 illustrate another important point: The maximum loss \nwould occur if the stock were exactly at the striking price at expiration of the calls. This \nmaximum loss would occur if XYZ were at 40 at expiration and would amount to $600. \nIn actual practice, since the short seller must pay out any dividends paid by the under\nlying stock, the risk in this strategy is increased by the amount of such dividends. \n124 \nTABLE 4-2. \nReverse hedge at July expiration. \nXYZ Price at Stock \nExpiration Profit \n20 +$2,000 \n25 + 1,500 \n30 + 1,000 \n34 + 600 \n40 0 \n46 600 \n50 - 1,000 \n55 - 1,500 \n60 - 2,000 \nFIGURE 4-2. \nReverse hedge {simulated straddle). \nC: \n0 \n~ \n! \nco \n(/) \n(/) \n.3 \n~-$600 \ne a. \nProfit on \n2 Calls \n-$ 600 \n600 \n600 \n600 \n600 \n+ 600 \n+ 1,400 \n+ 2,400 \n+ 3,400 \nStock Price at Expiration \nPart II: Call Option Strategies \nTotal \nProfit \n+$ l ,400 \n+ 900 \n+ 400 \n0 \n600 \n0 \n+ 400 \n+ 900 \n+ 1,400 \nThe net margin required for this strategy is 50% of the underlying stock plus \nthe full purchase price of the calls. In the example above, this would be an initial \ninvestment of $2,000 (50% of the stock price) plus $600 for the calls, or $2,600 total \nplus commissions. The short sale is marked to market, so the collateral requirement \nwould grow if the stock rose. Since the maximum risk, before commissions, is $600, \nthis means that the net percentage risk in this transaction is $600/$2,600, about 23%. \nCl,opter 4: Other Call Buying Strategies 125 \nThis is a relatively small percentage risk in a position that could have very large prof\nits. There is also very little chance that the entire maximum loss would ever be real\nized since it occurs only at one specific stock price. One should not be deluded into \nthinking that this strategy is a sure money-maker. In general, stocks do not move very \nfar in a 3- or 6-month period. With careful selection, though, one can often find sit\nuations in which the stock will be able to move far enough to reach the break-even \npoints. Even when losses are taken, they are counterbalanced by the fact that signif\nicant gains can be realized when the stock moves by a great distance. \nIt is obvious from the information above that profits are made if the stock moves \nfar enough in either direction. In fact, one can determine exactly the prices beyond \nwhich the stock would have to move by expiration in order for profits to result. These \nprices are 34 and 46 in the foregoing example. The downside break-even point is 34 \nand the upside break-:even point is 46. These break-even points can easily be com\nputed. First, the maximum risk is computed. Then the break-even points are deter\nmined. \nMaximum risk = Striking price + 2 x Call price - Stock price \nUpside break-even point = Striking price + Maximum risk \nDownside break-even point = Striking price - Maximum risk \nIn the preceding example, the striking price was 40, the stock price was also 40, \nand the call price was 3. Thus, the maximum risk = 40 + 2 x 3 - 40 = 6. This con\nfirms that the maximum risk in the position is 6 points, or $600. The upside break\neven point is then 40 + 6, or 46, and the downside break-even point is 40 - 6, or 34. \nThese also agree with Table 4-2 and Figure 4-2. \nBefore expiration, profits can be made even closer to th", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 59}
{"text": "price was 40, the stock price was also 40, \nand the call price was 3. Thus, the maximum risk = 40 + 2 x 3 - 40 = 6. This con\nfirms that the maximum risk in the position is 6 points, or $600. The upside break\neven point is then 40 + 6, or 46, and the downside break-even point is 40 - 6, or 34. \nThese also agree with Table 4-2 and Figure 4-2. \nBefore expiration, profits can be made even closer to the striking price, because \nthere will be some time value premium left in the purchased calls. \nExample: IfXYZ moved to 45 in one month, each call might be worth 6. If this hap\npened, the investor would have a 5-point loss on the stock, but would also have a 3-\npoint gain on each of the two options, for a net overall gain of 1 point, or $100. Before \nexpiration, the break-even point is clearly somewhere below 46, because the position \nis at a profit at 45. \nIdeally, one would like to find relatively underpriced calls on a fairly volatile \nstock in order to implement this strategy most effectively. These situations, while not \nprevalent, can be found. Normally, call premiums quite accurately reflect the volatil\nity of the underlying stock. Still, this strategy can be quite viable, because nearly \nevery stock, regardless of its volatility, occasionally experiences a straight-line, fairly \nlarge move. It is during these times that the investor can profit from this strategy. \n126 Part II: Call Option Strategies \nGenerally, the underlying stock selected for the reverse hedge should be \nvolatile. Even though option premiums are larger on these stocks, they can still be \noutdistanced by a straight-line move in a volatile situation. Another advantage of uti\nlizing volatile stocks is that they generally pay little or no dividends. This is desirable \nfor the reverse hedge, because the short seller will not be required to pay out as \nmuch. \nThe technical pattern of the underlying stock can also be useful when selecting \nthe position. One generally would like to have little or no technical support and \nresistance within the loss area. This pattern would facilitate the stock's ability to make \na fairly quick move either up or down. It is sometimes possible to find a stock that is \nin a wide trading range, frequently swinging from one side of the range to the other. \nIf a reverse hedge can be set up that has its loss area well within this trading range, \nthe position may also be attractive. \nExample: The XYZ stock in the previous example is trading in the range 30 to 50, \nperhaps swinging to one end and then the other rather frequently. Now the reverse \nhedge example position, which would make profits above 46 or below 34, would \nappear more attractive. \nFOLLOW-UP ACTION \nSince the reverse hedge has a built-in limited loss feature, it is not necessary to take \nany follow-up action to avoid losses. The investor could quite easily put the position \non and take no action at all until expiration. This is often the best method of follow\nup action in this strategy. \nAnother follow-up strategy can be applied, although it has some disadvantages \nassociated with it. This follow-up strategy is sometimes known as trading against the \nstraddle. When the stock moves far enough in either direction, the profit on that side \ncan be taken. Then, if the stock swings back in the opposite direction, a profit can \nalso be made on the other side. Two examples \\vill show how this type of follow-up \nstrategy works. \nExample 1: The XYZ stock in the previous example quickly moves down to 32. At \nthat time, an 8-point profit could be taken on the short sale. This would leave two \nlong calls. Even if they expired worthless, a 6-point loss is all that would be incurred \non the calls. Thus, the entire strategy would still have produced a profit of 2 points. \nHowever, if the stock should rally above 40, profits could be made on the calls as well. \nA slight variation would be to sell one of the calls at the same time the stock profit is \ntaken. This would result in a slightly larger realized profit; but if the stock rallied back \nCl,apter 4: Other Call Buying Strategies 127 \nabove 40, the resulting profits there would be smaller because the investor would be \nlong only one call instead of two. \nExample 2: XYZ has moved up to a price at which the calls are each worth 8 points. \nOne of the calls could then be sold, realizing a 5-point profit. The resulting position \nwould be short 100 shares of stock and long one call, a protected short sale. The pro\ntected short sale has a limited risk, above 40, of 3 points (the stock was sold short at \n40 and the call was purchased for 3 points). Even if XYZ remains above 40 and the \nmaximum 3-point loss has to be taken, the overall reverse hedge would still have \nmade a profit of 2 points because of the 5-point profit taken on the one call. \nConversely, if XYZ drops below 40, the protected short sale position could add to the \nprofits already taken on the call. \nThere is a variation of this upside protective action. \nExample 3: Instead of selling the one call, one could instead short an additional 100 \nshares of stock at 48. If this was done, the overall position would be short 200 shares \nof stock (100 at 40 and the other 100 at 48) and long two calls - again a protected \nshort sale. If XYZ remained above 40, there would again be an overall gain of 2 \npoints. To see this, suppose that XYZ was above 40 at expiration and the two calls \nwere exercised to buy 200 shares of stock at 40. This would result in an 8-point prof\nit on the 100 shares sold short at 48, and no gain or loss on the 100 shares sold short \nat 40. The initial call cost of 6 points would be lost. Thus, the overall position would \nprofit by 2 points. This means of follow-up action to the upside is more costly in com\nmissions, but would provide bigger profits if XYZ fell back below 40, because there \nare 200 shares of XYZ short. \nIn theory, if any of the foregoing types of follow-up action were taken and the \nunderlying stock did indeed revers", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 60}
{"text": "The initial call cost of 6 points would be lost. Thus, the overall position would \nprofit by 2 points. This means of follow-up action to the upside is more costly in com\nmissions, but would provide bigger profits if XYZ fell back below 40, because there \nare 200 shares of XYZ short. \nIn theory, if any of the foregoing types of follow-up action were taken and the \nunderlying stock did indeed reverse direction and cross back through the striking \nprice, the original position could again be established. Suppose that, after covering \nthe short stock at 32, XYZ rallied back to 40. Then XYZ could be sold short again, \nreestablishing the original position. If the stock moved outside the break-even points \nagain, further follow-up action could be taken. This process could theoretically be \nrepeated a number of times. If the stock continued to whipsaw back and forth in a \ntrading range, the repeated follow-up actions could produce potentially large profits \non a small net change in the stock price. In actual practice, it is unlikely that one \nwould be fortunate enough to find a stock that moved that far that quickly. \nThe disadvantage of applying these follow-up strategies is obvious: One can \nnever make a large profit if he continually cuts his profits off at a small, limited \n128 Part II: Call Option Strategies \namount . .. When XYZ falls to 32, the stock can be covered to ensure an overall profit \nof 2 points on the transaction. However, if XYZ continued to fall to 20, the investor \nwho took no follow-up action would make 14 points while the one who did take fol\nlow-up action would make only 2 points. Recall that it was stated earlier that there is \na high probability of realizing limited losses in the reverse hedge strategy, but that \nthis is balanced by the potentially large profits available in the remaining cases. If one \ntakes follow-up action and cuts off these potentially large profits, he is operating at a \ndistinct disadvantage unless he is an extremely adept trader. \nProponents of using the follow-up strategy often counter with the argument \nthat it is frustrating to see the stock fall to 32 and then return back to nearly 40 again. \nIf no follow-up action were taken, the unrealized profit would have dissolved into a \nloss when the stock rallied. This is true as far as it goes, but it is not an effective \nenough argument to counterbalance the negative effects of cutting off one's profits. \nALTERING THE RATIO OF LONG CALLS \nTO SHORT STOCK \nAnother aspect of this strategy should be discussed. One does not have to buy exact\nly two calls against 100 shares of short stock. More bullish positions could be con\nstructed by buying three or four calls against 100 shares short. More bearish positions \ncould be constructed by buying three calls and shorting 200 shares of stock. One \nmight adopt a ratio other than 2:1, because he is more bullish or bearish. He also \nmight use a different ratio if the stock is between two striking prices, but he still \nwants to create a position that has break-even points spaced equidistant from the cur\nrent stock price. A few examples will illustrate these points. \nExample: XYZ is at 40 and the investor is slightly bullish on the stock but still wants \nto employ the reverse hedge strategy, because he feels there is a chance the stock \ncould drop sharply. He might then short 100 shares of XYZ at 40 and buy 3 July 40 \ncalls for 3 points apiece. Since he paid 9 points for the calls, his maximum risk is that \n9 points if XYZ were to be at 40 at expiration. This means his downside break-even \nprice is 31, for at 31 he would have a 9-point profit on the short sale to offset the 9-\npoint loss on the calls. To the upside, his break-even is now 44½. IfXYZ were at 44½ \nand the calls at 4½ each at expiration, he would lose 4½ points on the short sale, but \nwould make l ½ on each of the three calls, for a total call profit of 4½. \nA more bearish investor might short 200 XYZ at 40 and buy 3 July 40 calls at 3. \nHis break-even points would be 35½ on the downside and 49 on the upside, and his \nmaximum risk would be 9 points. There is a general formula that one can always \nCbapter 4: Other Call Buying Strategies 129 \napply to calculate the maximum risk and the break-even points, regardless of the \nratios involved. \nMaximum risk= (Striking price Stock price) x Round lots shorted \n+ Number of calls bought x Call price \nU .d b ak S .ki . Maximum risk psi e re -even = tn ng pnce + ( b f all b h Num er o c s oug t -\nNumber of round lots short) \nD .d b k St .ki . Maximum risk owns1 e rea -even = n ng pnce - b f d l h Num er o roun ots s ort \nTo verify this, use the numbers from the example in which 100 XYZ were shorted at \n40 and three July 40 calls were purchased for 3 each. \nMaximum risk= (40-40) x 1 + 3 x 3 = 9 \nUpside break-even = 40 + 9/(3 - 1) = 40 + 4¼ = 44¼ \nDownside break-even= 40- 9/1 = 31 · \nIt was stated earlier that one might use an adjusted ratio in order to space the break\neven points evenly around the current stock price. \nExample: Suppose XYZ is at 38 and the XYZ July 40 call is at 2. If one wanted to set \nup a reverse hedge that would profit if XYZ moved either up or down by the same \ndistance, he could not use the 2:1 ratio. The 2:1 ratio would have break-even points \nof 34 and 46. Thus, the stock would start out much closer to the downside break-even \npoint - only 4 points away - than to the upside break-even point, which is 8 points \naway. By altering the ratio, the investor can set up a reverse hedge that is more neu\ntral on the underlying stock. Suppose that the investor shorted 100 shares of XYZ at \n38 and bought three July 40 calls at 2 each. Then his break-even points would be 32 \non the downside and 44 on the upside. This is a more neutral situation, with the \ndownside break-even point being 6 points below the current stock price and the \nupside break-even point being 6 points away. The formulae above can be used to ver\nify that, in fact, the break-evens are", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 61}
{"text": "shorted 100 shares of XYZ at \n38 and bought three July 40 calls at 2 each. Then his break-even points would be 32 \non the downside and 44 on the upside. This is a more neutral situation, with the \ndownside break-even point being 6 points below the current stock price and the \nupside break-even point being 6 points away. The formulae above can be used to ver\nify that, in fact, the break-evens are 32 and 44. Note that the 3: 1 ratio has a maximum \nrisk of 8 points, while the 2:1 ratio only had 6 points maximum risk. \nA final adjustment that can be applied to this strategy is to short the stock and \nbuy two calls, but with the calls having different striking prices. If XYZ were at 37¼ to \nstart with, one would have to use a ratio other than 2:1 to set up a position with break\neven points spaced equidistant from the current stock price. When these higher ratios \nare used, the maximum risk is increased and the investor has to adopt a bullish or bear\nish stance. One may be able to create a position with equidistant break-even points and \na smaller maximum risk by utilizing two different striking prices. \n130 \nExample: The following prices exist: \nXYZ, 37½; \nXYZ July 40 call, 2; and \nXYZ July 35 call, 4. \nPart II: Call Option Strategies \nIf one were to short 100 XYZ at 37½ and to buy one July 40 call for 2 and one July \n35 call for 4, he would have a position that is similar to a reverse hedge except that \nthe maximum risk would be realized anywhere between 35 and 40 at expiration. \nAlthough this risk is over a much wider range than in the normal reverse hedge, it is \nnow much smaller in dimension. Table 4-3 and Figure 4-3 show the results from this \ntype of position at expiration. The maximum loss is 3½ points ($350), which is a \nsmaller amount than could be realized using any ratio strictly with the July 35 or the \nJuly 40 call. However, this maximum loss is realizable over the entire range, 35 to 40. \nAgain, large potential profits are available if the stock moves far enough either to the \nupside or to the downside. \nThis form of the strategy should only be used when the stock is nearly centered \nbetween two strikes and the strategist wants a neutral positioning of the break-even \npoints. Similar types of follow-up action to those described earlier can be applied to \nthis form of the reverse hedge strategy as well. \nTABLE 4-3. \nReverse hedge using two strikes. \nXYZ Price at Stock July 40 Coll July 35 Coll Total \nExpiration Profit Profit Profit Profit \n25 +$1,250 -$200 -$ 400 +$ 650 \n30 + 750 - 200 400 + 150 \n31 1/2 + 600 - 200 400 0 \n35 + 250 - 200 400 350 \n371/2 0 - 200 150 350 \n40 - 250 - 200 + 100 350 \n431/2 - 600 + 150 + 450 0 \n45 - 750 + 300 + 600 + 150 \n50 - 1,250 + 800 + 1,100 + 650 \nGapter 4: Other Call Buying Strategies 131 \nFIGURE 4-3. \nReverse hedge using two strikes (simulated combination purchase). \nC: \n~ ·5. \nin \n~ \nl/l \n.3 \n0 \ni.l::-$350 \ne a. \nSUMMARY \n40 \nStock Price at Expiration \nThe strategies described in this chapter would not normally be used if the underly\ning stock has listed put options. However, if no puts exist, or the puts are very illiq\nuid, and the strategist feels that a volatile stock could move a relatively large distance \nin either direction during the life of a call option, he should consider using one of the \nforms of the reverse hedge strategy - shorting a quantity of stock and buying calls on \nmore shares than he is short. If the desired movement does develop, potentially large \nprofits could result. In any case, the loss is limited to a fixed amount, generally \naround 20 to 30% of the initial investment. Although it is possible to take follow-up \naction to lock in small profits and attempt to gain on a reversal by the stock, it is wiser \nto let the position run its course to capitalize on those occasions when the profits \nbecome large. Normally a 2:1 ratio (long 2 calls, short 100 shares of stock) is used in \nthis strategy, but this ratio can be adjusted if the investor wants to be more bullish or \nmore bearish. If the stock is initially between two striking prices, a neutral profit \nrange can be set up by shorting the stock and buying calls at both the next higher \nstrike and the next lower strike. \nCHAPTER 5 \nNaked Call Writing \nThe next two chapters will concentrate on various aspects of writing uncovered call \noptions. These strategies have risk ofloss if the underlying stock should rise in price, \nbut they offer profits if the underlying stock declines in price. This chapter on \nnaked, or uncovered, call writing - demonstrates some of the risks and rewards \ninherent in this aggressive strategy. Novice option traders often think that selling \nnaked options is the \"best\" way to make money, because of time decay. In addition, \nthey often assume that market-makers and other professionals sell a lot of naked \noptions. In reality, neither is true. Yes, options do eventually lose their premium if \nheld all the way until expiration. However, when an option has a good deal of life \nremaining, its excess value above intrinsic value what we call \"time value premium\" \n- is, in reality, heavily influenced by the volatility estimate of the stock. This is called \nimplied volatility and is discussed at length later in the book. For now, though, it is \nsufficient to understand that a lot can go wrong when one writes a naked option, \nbefore it eventually expires. As to professionals selling a lot of naked options, the fact \nis that most market-makers and other full-time option traders attempt to reduce their \nexposure to large stock price movements if possible. Hence, they may sell some \noptions naked, but they generally try to hedge them by buying other options or by \nbuying the underlying stock. \nMany novice option traders hold these misconceptions, probably because there \nis a general belief that most options expire worthless. Occasionally, one will even hear \nor see a statement to this effect in the mainstream media, but it is not true that most \noptions expir", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 62}
{"text": "y may sell some \noptions naked, but they generally try to hedge them by buying other options or by \nbuying the underlying stock. \nMany novice option traders hold these misconceptions, probably because there \nis a general belief that most options expire worthless. Occasionally, one will even hear \nor see a statement to this effect in the mainstream media, but it is not true that most \noptions expire worthless. In fact, studies conducted by McMillan Analysis Corp. in \nboth bull and bear months indicate that about 65% to 70% of all options have some \nvalue (at least half a point) when they expire. This is not to say that all option buyers \nmake money, either, but it does serve to show that many more options do not expire \nworthless than do. \n132 \nQapter 5: Naked Call Writing 133 \nTHE UNCOVERED (NAKED) CALL OPTION \nWhen one sells a call option without owning the underlying stock or any equivalent \nsecurity (convertible stock or bond or another call option), he is considered to have \nwritten an uncovered call option. This strategy has limited profit potential and theo\nretically unlimited loss. For this reason, this strategy is unsuitable for some investors. \nThis fact is not particularly attractive, but since there is no actual cash investment \nrequired to write a naked call ( the position can be financed with collateral loan value \nof marginable securities), the strategy can be operated as an adjunct to many other \ninvestment strategies. \nA simple example will outline the basic profit and loss potential from naked \nwriting. \nExample: XYZ is selling at 50 and a July 50 call is selling for 5. If one were to sell the \nJuly 50 call naked - that is, without owning XYZ stock, or any security convertible into \nXYZ, or another call option on XYZ - he could make, at most, 5 points of profit. This \nprofit would accrue if XYZ were at or anywhere below 50 at July expiration, as the \ncall would then expire worthless. If XYZ were to rise, however, the naked writer \ncould potentially lose large sums of money. Should the stock climb to 100, say, the \ncall would be at a price of 50. If the writer then covered (bought back) the call for a \nprice of 50, he would have a loss of 45 points on the transaction. In theory, this loss \nis unlimited, although in practice the loss is limited by time. The stock cannot rise an \ninfinite amount during the life of the call. Clearly, defensive strategies are important \nin this approach, as one would never want to let a loss run as far as the one here. \nTable 5-1 and Figure 5-1 (solid line) depict the results of this position at July expira\ntion. Note that the break-even point in this example is 55. That is, if XYZ rose 10%, \nor 5 points, at expiration, the naked writer would break even. He could buy the call \nback at parity, 5 points, which is exactly what he sold it for. There is some room for \nerror to the upside. A naked write will not necessarily lose money if the stock moves \nup. It will only lose if the stock advances by more than the amount of the time value \npremium that was in the call when it was originally written. \nNaked writing is not the same as a short sale of the underlying stock. While both \nstrategies have large potential risk, the short sale has much higher reward potential, \nbut the naked write will do better if the underlying stock remains relatively \nunchanged. It is possible for the naked writer to make money in situations when the \nshort seller would have lost money. Using the example above, suppose one investor \nhad written the July 50 call naked for 5 points while another investor sold the stock \nshort at 50. If XYZ were at 52 at expiration, the naked writer could buy the call back \nat parity, 2 points, for a 3-point profit. The short seller would have a 2-point loss. \n134 \nTABLE 5-1. \nPosition at July expiration. \nXYZ Price at Call Price at \nExpiration Expiration \n30 0 \n40 0 \n50 0 \n55 5 \n60 10 \n70 20 \n80 30 \nFIGURE 5-1. \nUncovered (naked) call write. \n+$500 \nC \n0 \n~ ·15.. \nX \nw \ncu \n(/J \n~ ...I \n0 \nlt, \n.... ...... \n\", Naked Write \n45 SO', \n.... .. .... .. .. Short Sale ,, \n.. .. \nStock Price at Expiration \n.. \nPart II: Call Option Strategies \nProfit on \nNaked Write \n+$ 500 \n+ 500 \n+ 500 \n0 \n500 \n- 1,500 \n- 2,500 \n.. .... .. \n~ \nMoreover, the short seller pays out the dividends on the underlying stock, whereas \nthe naked call writer does not. The naked call will expire, of course, but the short sale \ndoes not. This is a situation in which the naked write outperforms the short sale. \nHowever, ifXYZ were to fall sharply- to 20, say- the naked writer could only make \n5 points while the short seller would make 30 points. The dashed line in Figure 5-1 \nshows how the short sale of XYZ at 50 would compare with the naked write of the \nJuly 50 call. Notice that the two strategies are equal at 45 at expiration; they both \nCl,apter 5: Naked Call Writing 135 \nmake a 5-point profit there. Above 45, the naked write does better; it has larger prof\nits and smaller losses. Below 45, the short sale does better, and the farther the stock \nfalls, the better the short sale becomes in comparison. As will be seen later, one can \nmore closely simulate a short sale by writing an in-the-money naked call. \nINVESTMENT REQUIRED \nThe margin requirements for writing a naked call are 20% of the stock price plus the \ncall premium, less the amount by which the stock is below the striking price. If the \nstock is below the striking price, the differential is subtracted from the requirement. \nHowever, a minimum of 10% of the stock price is required for each call, even if the \nC-'Omputation results in a smaller number. Table 5-2 gives four examples of how the ini\ntial margin requirement would be computed for four different stock prices. The 20% \ncollateral figure is the minimum exchange requirement and may vary somewhat among \ndifferent brokerage houses. The call premium may be applied against the requirement. \nIn the first line of Table 5-2, if the XYZ July 50 call were selling for 7", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 63}
{"text": "sults in a smaller number. Table 5-2 gives four examples of how the ini\ntial margin requirement would be computed for four different stock prices. The 20% \ncollateral figure is the minimum exchange requirement and may vary somewhat among \ndifferent brokerage houses. The call premium may be applied against the requirement. \nIn the first line of Table 5-2, if the XYZ July 50 call were selling for 7 points, the $700 \ncall premium could be applied against the $1,800 margin requirement, reducing the \nactual amount that the investor would have to put up as collateral to $1,100. \nTABLE 5-2. \nInitial collateral requirements for four stock prices. \nColl \nWritten \nXYZ July 50 \nXYZ July 50 \nXYZ July 50 \nXYZ July 50 \nStock Price When \nColl Written \n55 \n50 \n46 \n40 \n*Requirement cannot be less than 10%. \nColl \nPrice \n$700 \n400 \n200 \n100 \n20% of \nStock Price \n$1,100 \n1,000 \n920 \n800 \nOut-of-the\nMoney \nDifferential \n$ 0 \n0 \n400 \n- 1,000 \nTotal Margin \nRequirement \n$1,800 \n1,400 \n720 \n400* \nIn addition to the basic requirements, a brokerage firm may require that for a \ncustomer to participate in uncovered writing, he have a minimum equity in his \naccount. This equity requirement may range from as low as $2,000 to as high as \n$100,000. Since naked call writing is a high-risk strategy, some brokerage firms \nrequire that the customer be able to show both financial wherewithal and option \n136 Part II: Call Option Strategies \ntrading experience before the account can be approved for naked call writing. In \naddition, some brokers require that a maintenance requirement be applied against \neach option written naked. This requirement, sometimes called a kicker, is usually \nless than $250 per call and is generally used by the broker to ensure that, should the \ncustomer fail to respond to an assignment notice against his naked call, the commis\nsion costs for buying and selling the underlying stock would be defrayed. \nNaked Option Positions Are Marked to the Market Daily. This \nmeans that the collateral requirement for the position is recomputed daily, just as in \nthe short sale of stock. The same margin formula that was described above is applied \nand, if the stock has risen far enough, the customer will be required to deposit addi\ntional collateral or close the position. The need for such a mark to market is obvious. \nIf the underlying stock should rise, the brokerage firm must ensure that the customer \nhas enough collateral to cover the eventuality of buying the stock in the open market \nand selling it at the striking price if an assignment notice should be received against \nthe naked call. The mark to market works to the customer's favor if the stock falls in \nprice. Excess collateral is then released back into the customer's margin account, and \nmay be used for other purposes. \nIt is important to realize that, in order to write a naked call, collateral is all that \nis required. No cash need be \"invested\" if one owns securities with sufficient collat\neral loan value. \nExample: An investor owns 100 shares of a stock selling at $60 per share. This stock \nis worth $6,000. If the loan rate on stock is 50% of $6,000, this investor has a collat\neral loan value equal to 50% of $6,000, or $3,000. This investor could write any of the \nnaked calls in Table 5-2 without adding cash or securities to his account. Moreover, \nhe would have satisfied a minimum equity requirement of at least $6,000, since his \nstock is equity. \nThis aspect of naked call writing - using collateral value to finance the writing \n- is attractive to many investors, since one is able to write calls and bring in premi\nums without disturbing his existing portfolio. Of course, if the stock underlying the \nnaked call should rise too far in price, additional collateral may be called for by the \nbroker because of the mark to market. Moreover, there is risk whether cash or col\nlateral is used. If one buys in a naked call at a loss, he will then be spending cash, cre\nating a debit in his account. \nRegardless of how one finances a naked option position, it is generally a good \nidea to allow enough collateral so that the stock can move all the way to the point at \nwhich one would cover the option or take follow-up action. For example, suppose a \n136 Part II: Call Option Strategies \ntrading experience before the account can be approved for naked call writing. In \naddition, some brokers require that a maintenance requirement be applied against \neach option written naked. This requirement, sometimes called a kicker, is usually \nless than $250 per call and is generally used by the broker to ensure that, should the \ncustomer fail to respond to an assignment notice against his naked call, the commis\nsion costs for buying and selling the underlying stock would be defrayed. \nNaked Option Positions Are Marked to the Market Daily. This \nmeans that the collateral requirement for the position is recomputed daily, just as in \nthe short sale of stock. The same margin formula that was described above is applied \nand, if the stock has risen far enough, the customer will be required to deposit addi\ntional collateral or close the position. The need for such a mark to market is obvious. \nIf the underlying stock should rise, the brokerage firm must ensure that the customer \nhas enough collateral to cover the eventuality of buying the stock in the open market \nand selling it at the striking price if an assignment notice should be received against \nthe naked call. The mark to market works to the customer's favor if the stock falls in \nprice. Excess collateral is then released back into the customer's margin account, and \nmay be used for other purposes. \nIt is important to realize that, in order to write a naked call, collateral is all that \nis required. No cash need be \"invested\" if one owns securities with sufficient collat\neral loan value. \nExample: An investor owns 100 shares of a stock selling at $60 per share. This stock \nis worth $6,000. If the loan rate on stock is 50% of $6,0", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 64}
{"text": "ustomer's margin account, and \nmay be used for other purposes. \nIt is important to realize that, in order to write a naked call, collateral is all that \nis required. No cash need be \"invested\" if one owns securities with sufficient collat\neral loan value. \nExample: An investor owns 100 shares of a stock selling at $60 per share. This stock \nis worth $6,000. If the loan rate on stock is 50% of $6,000, this investor has a collat\neral loan value equal to 50% of $6,000, or $3,000. This investor could write any of the \nnaked calls in Table 5-2 without adding cash or securities to his account. Moreover, \nhe would have satisfied a minimum equity requirement of at least $6,000, since his \nstock is equity. \nThis aspect of naked call writing - using collateral value to finance the writing \n- is attractive to many investors, since one is able to write calls and bring in premi\nums without disturbing his existing portfolio. Of course, if the stock underlying the \nnaked call should rise too far in price, additional collateral may be called for by the \nbroker because of the mark to market. Moreover, there is risk whether cash or col\nlateral is used. If one buys in a naked call at a loss, he will then be spending cash, cre\nating a debit in his account. \nRegardless of how one finances a naked option position, it is generally a good \nidea to allow enough collateral so that the stock can move all the way to the point at \nwhich one would cover the option or take follow-up action. For example, suppose a \n136 Part II: Call Option Strategies \ntrading experience before the account can be approved for naked call writing. In \naddition, some brokers require that a maintenance requirement be applied against \neach option written naked. This requirement, sometimes called a kicker, is usually \nless than $250 per call and is generally used by the broker to ensure that, should the \ncustomer fail to respond to an assignment notice against his naked call, the commis\nsion costs for buying and selling the underlying stock would be defrayed. \nNaked Option Positions Are Marked to the Market Daily. This \nmeans that the collateral requirement for the position is recomputed daily, just as in \nthe short sale of stock. The same margin formula that was described above is applied \nand, if the stock has risen far enough, the customer will be required to deposit addi\ntional collateral or close the position. The need for such a mark to market is obvious. \nIf the underlying stock should rise, the brokerage firm must ensure that the customer \nhas enough collateral to cover the eventuality of buying the stock in the open market \nand selling it at the striking price if an assignment notice should be received against \nthe naked call. The mark to market works to the customer's favor if the stock falls in \nprice. Excess collateral is then released back into the customer's margin account, and \nmay be used for other purposes. \nIt is important to realize that, in order to write a naked call, collateral is all that \nis required. No cash need be \"invested\" if one owns securities with sufficient collat\neral loan value. \nExample: An investor owns 100 shares of a stock selling at $60 per share. This stock \nis worth $6,000. If the loan rate on stock is 50% of $6,000, this investor has a collat\neral loan value equal to 50% of $6,000, or $3,000. This investor could write any of the \nnaked calls in Table 5-2 without adding cash or securities to his account. Moreover, \nhe would have satisfied a minimum equity requirement of at least $6,000, since his \nstock is equity. \nThis aspect of naked call writing - using collateral value to finance the writing \n- is attractive to many investors, since one is able to write calls and bring in premi\nums without disturbing his existing portfolio. Of course, if the stock underlying the \nnaked call should rise too far in price, additional collateral may be called for by the \nbroker because of the mark to market. Moreover, there is risk whether cash or col\nlateral is used. If one buys in a naked call at a loss, he will then be spending cash, cre\nating a debit in his account. \nRegardless of how one finances a naked option position, it is generally a good \nidea to allow enough collateral so that the stock can move all the way to the point at \nwhich one would cover the option or take follow-up action. For example, suppose a \nGapter 5: Naked Call Writing 137 \nstock is trading at 50 and one sells an April 60 call naked, figuring that he will cover \nthe call if the stock rises to 60 ( that is, if the option becomes an in-the-money option). \nHe should set aside enough collateral to margin the position as if the stock were at \n60 (even though the actual margin requirement will be smaller than that). If he \nallows that extra collateral, then he will never be forced into a margin call at a stock \nprice prior to (that is, below) where he wanted to take follow-up action. Simply stat\ned, let the market take you out of a position, not a margin call. \nTHE PHILOSOPHY OF SELLING NAKED OPTIONS \nThe first and foremost question one must address when thinking about selling naked \noptions (or any strategy, for that matter) is: \"Can I psychologically handle the thought \nof naked options in my account?\" Notice that the question does not have anything to \ndo with whether one has enough collateral or margin to sell calls (although that, too, \nis important) nor does it ask how much money he will make. First, one must decide \nif he can be comfortable with the risk of the strategy. Selling naked options means \nthat there is theoretically unlimited risk if the underlying instrument should make a \nlarge, sudden, adverse move. It is one's attitude regarding that fact alone that deter\nmines whether he should consider selling naked options. If one feels that he won't be \nable to sleep at night, then he should not sell naked options, regardless of any profit \nprojections that might seem attractive. \nIf one feels that the psychological suitability aspect is", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 65}
{"text": "underlying instrument should make a \nlarge, sudden, adverse move. It is one's attitude regarding that fact alone that deter\nmines whether he should consider selling naked options. If one feels that he won't be \nable to sleep at night, then he should not sell naked options, regardless of any profit \nprojections that might seem attractive. \nIf one feels that the psychological suitability aspect is not a roadblock, then he \ncan consider whether he has the financial wherewithal to write naked options. On the \nsurface, naked option margin requirements are not large (although in equity and \nindex options, they are larger than they were prior to the crash of 1987). \nIn general, one would prefer to let the naked options expire worthless, if at all \npossible, without disturbing them, unless the underlying instrument makes a signifi\ncant adverse move. So, out-of-the-money options are the usual choice for naked sell\ning. Then, in order to reduce ( or almost eliminate) the chance of a margin call, one \nshould set aside the margin requirement as if the underlying had already rrwved to \nthe strike price of the option sold. By allowing margin as if the underlying were \nalready at the strike, one will almost never experience a margin call before the under\nlying price trades up to the strike price, at which time it is best to close the position \nor to roll the call to another strike. \nThus, for naked equity call options, allow as collateral 20% of the highest naked \nstrike price. In this author's opinion, the biggest mistake a trader can make is to ini\ntiate trades because of margin or taxes. Thus, by allowing the \"maximum\" margin, \none can make trading decisions based on what's happening in the market, as opposed \nto reacting to a margin call from his broker. \n138 Part II: Call Option Strategies \n\"Suitability\" also means not risking nwre nwney than one can afford to lose. If \none allows the \"maximum\" margin, then he won't be risking a large portion of his \nequity unless he is unable to cover when the underlying trades through the strike \nprice of his naked option. Gaps in trading prices would be the culprits that could pre\nvent one from covering. Gaps are common in stocks, less common in futures, and \nalmost nonexistent in indices. Hence, index options are the options of choice when it \ncomes to naked writing. Index options are discussed later in the book. \nFinally, there is one more \"rule\" that a naked option writer must follow: \nSomeone has to be watching the position at all times. Disasters could occur if one \nwere to go on vacation and not pay attention to his naked options. Usually, one's bro\nker can watch the position, even if the trader has to call him from his vacation site. \nIn sum, then, to write naked options, one needs to be prepared psychological\nly, have sufficient funds, be willing to accept the risk, be able to monitor the position \nevery day, sell options whose implied volatility is extremely high, and cover any naked \noptions that become in-the-money options. \nRISK AND REWARD \nOne can adjust the apparent risks and rewards from naked call writing by his selec\ntion of an in-the-money or out-of-the-money call. Writing an out-of-the-money call \nnaked, especially one quite deeply out-of-the-money, offers a high probability of \nachieving a small profit. Writing an in-the-money call naked has the most profit \npotential, but it also has higher risks. \nExample: XYZ is selling at 40 and the July 50 is selling for½. This call could be sold \nnaked. The probability that XYZ could rise to 50 by expiration has to be considered \nsmall, especially if there is not a large amount of time remaining in the life of the call. \nIn fact, the stock could rise 25%, or 10 points, by expiration to a price of 50, and the \ncall would still expire worthless. Thus, this naked writer has a good chance of realiz\ning a $50 profit, less commissions. There could, of course, be substantial risk in terms \nof potential profit versus potential loss if the stock rises substantially in price by expi\nration. Still, this apparent possibility of achieving additional limited income with a \nhigh probability of success has led many investors to use the collateral value of their \nportfolios to sell deeply out-of-the-money naked calls. \nFor those employing this technique, a favored position is to have a stock at or \njust about 15 and then sell the near-term option with striking price 20 naked. This \noption would sell for one-eighth or one-quarter, perhaps, although at times there \nmight not be any bid at all. At this price, the stock would have to rally nearly one-\nC.,,er 5: Naked Call Writing 139 \nthird, or 33%, for the writer to lose money. Although there are not usually many \noptionable stocks selling at or just above $10 per share, these same out-of-the-money \nwriters would also be attracted to selling a call with a striking price 15 when the stock \nis at 10, because a 50% upward move by the stock would be required for a loss to be \nrealized. \nThis strategy of selling deeply out-of-the-money calls has its apparent attraction \nin that the writer is assured of a profit unless the underlying stock can rally rather \nsubstantially before the call expires. The danger in this strategy is that one or two \nlosses, perhaps amounting to only a couple of points each, could wipe out many peri\nods of profits. The stock market does occasionally rally heavily in a short period, as \nwitnessed repeatedly throughout history. Thus, the writer who is adopting this strat\negy cannot regard it as a sure thing and certainly cannot afford to establish the writes \nand forget them. Close monitoring is required in case the market begins to rally, and \nby no means should losses be allowed to accumulate. \nThe opposite end of the spectrum in naked call writing is the writing of fairly \ndeeply in-the-money calls. Since an in-the-money call would not have much time \nvalue premium in it, this writer does not have much leeway to the upside. If the \nstock rallies at a", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 66}
{"text": "nd forget them. Close monitoring is required in case the market begins to rally, and \nby no means should losses be allowed to accumulate. \nThe opposite end of the spectrum in naked call writing is the writing of fairly \ndeeply in-the-money calls. Since an in-the-money call would not have much time \nvalue premium in it, this writer does not have much leeway to the upside. If the \nstock rallies at all, the writer of the deeply in-the-money naked call will normally \nexperience a loss. However, should the stock drop in price, this writer will make \nlarger dollar profits than will the writer of the out-of-the-money call. The sale of the \ndeeply in-the-money call simulates the profits that a short seller could make, at least \nuntil the stock drops close to the striking price, since the delta of a deeply in-the\nmoney call is close to 1. \nExample: XYZ is selling at 60 and the July 50 call is selling for 10½. IfXYZ rises, the \nnaked writer will lose money, because there is only ½ of a point of time value pre\nmium in the call. If XYZ falls, the writer will make profits on a point-for-point basis \nuntil the stock falls much closer to 50. That is, if XYZ dropped from 60 to 57, the call \nprice would fall by almost 3 points as well. Thus, for quick declines by the stock, the \ndeeply in-the-money write can provide profits nearly equal to those that the short \nseller could accumulate. Notice that if XYZ falls all the way to 50, the profits on the \nwritten call will be large, but will be accumulating at a slower rate as the time value \npremium builds up with the stock near the striking price. \nIf one is looking to trade a stock on the short side for just a few points of nwve\nment, he might use a deeply in-the-nwney naked write instead of shorting the stock. \nHis investment will be smaller - 20% of the stock price for the write as compared to \n50% of the stock price for the short sale - and his return will thus be larger. (The \nrequirement for the in-the-money amount is offset by applying the call's premium.) \n140 Part II: Call Option Strategies \nThe writer should take great caution in ascertaining that the call does have some time \npremium in it. He does not want to receive an assignment notice on the written call. \nIt is easiest to find time premium in the more distant expiration series, so the writer \nwould normally be safest from assignment by writing the longest-term deep in-the\nmoney call if he wants to make a bearish trade in the stock. \nExample: An investor thinks that XYZ could fall 3 or 4 points from its current price \nof 60 in a quick downward move, and wants to capitalize on that move by writing a \nnaked call. If the April 40 were the near-term call, he might have the choice of sell\ning the April 40 at 20, the July 40 at 20¼, or the October 40 at 20½. Since all three \ncalls will drop nearly point for point with the stock in a move to 56 or 57, he should \nwrite the October 40, as it has the least risk of being assigned. A trader utilizing this \nstrategy should limit his losses in much the same way a short seller would, by cover\ning if the stock rallies, perhaps breaking through overhead technical resistance. \nROLLING FOR CREDITS \nMost writers of naked calls prefer to use one of the two strategies described above. \nThe strategy of writing at-the-money calls, when the stock price is initially close to the \nstriking price of the written call, is not widely utilized. This is because the writer who \nwants to limit risk will write an out-of-the-money call, whereas the writer who wants \nto make larger, quick trading profits will write an in-the-money call. There is, how\never, a strategy that is designed to utilize the at-the-money call. This strategy offers a \nhigh degree of eventual success, although there may be an accumulation of losses \nbefore the success point is reached. It is a strategy that requires large collateral back\ning, and is therefore only for the largest investors. We call this strategy \"rolling for \ncredits.\" The strategy is described here in full, although it can, at times, resemble a \nMartingale strategy; that is, one that requires \"doubling up\" to succeed, and one that \ncan produce ruin if certain physical limits are reached. The classic Martingale strat\negy is this: Begin by betting one unit; if you lose, double your bet; if you win that bet, \nyou'll have netted a profit of one unit (you lost one, but won two); if you lost the sec\nond bet, double your bet again. No matter how many times you lose, keep doubling \nyour bet each time. When you eventually win, you will profit by the amount of your \noriginal bet (one unit). Unfortunately, such a strategy cannot be employed in real life. \nFor example, in a gambling casino, after enough losses, one would bump up against \nthe table limit and would no longer be able to double his bet. Consequently, the strat\negy would be ruined just when it was at its worst point. While \"rolling for credits\" \ndoesn't exactly call for one to double the number of written calls each time, it does \nrequire that one keep increasing his risk exposure in order to profit by the amount of \nthat original credit sold. In general, Martingale strategies should be avoided. \nCl,apter 5: Naked Call Writing 141 \nIn essence, the writer who is rollingf or credits sells the most time premium that \nhe can at any point in time. This would generally be the longest-term, at-the-money \ncall. If the stock declines, the writer makes the time premium that he sold. However, \nif the stock rises in price, the writer rolls up for a credit. That is, when the stock \nreaches the next higher striking price, the writer buys back the calls that were origi\nnally sold and sells enough long-term calls at the higher strike to generate a credit. \nIn this way, no debits are incurred, although a realized loss is taken on the rolling up. \nIf the stock persists and rises to the next striking price, the process is repeated. \nEventually, the stock will stop rising - they always do - and the last set of w", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 67}
{"text": "g price, the writer buys back the calls that were origi\nnally sold and sells enough long-term calls at the higher strike to generate a credit. \nIn this way, no debits are incurred, although a realized loss is taken on the rolling up. \nIf the stock persists and rises to the next striking price, the process is repeated. \nEventually, the stock will stop rising - they always do - and the last set of written \noptions will expire worthless. At that time, the writer would make an overall profit \nconsisting of an amount equal to all the credits that he had taken in so far. In reality, \nmost of that credit will simply be the initial credit received. The \"rolls\" are done for \neven money or a small credit. In essence, the increased risk generated by continual\nly rolling up is all geared toward eventually capturing that initial credit. The similar\nity to the Martingale strategy is strongest in this regard: One continually increases his \nrisk, knowing that when he eventually wins (i.e., the last set of options expires worth\nless), he profits by the amount of his original \"bet.\" \nThere are really only two requirements for success in this strategy. The first is \nthat the underlying stock eventually fall back, that it does not rise indefinitely. This is \nhardly a requirement; it is axiomatic that all stocks will eventually undergo a correc\ntion, so this is a simple requirement to satisfy. The second requirement is that the \ninvestor have enough collateral backing to stay with the strategy even if the stock runs \nup heavily against him. \nThis is a much harder requirement to satisfy, and may in fact tum out to be \nnearly impossible to satisfy. If the stock were to experience a straight-line upward \nmove, the number of calls written might grow so substantially that they would \nrequire an unrealistically large amount of collateral (margin). At a minimum, this \nstrategy is applicable only for the largest investors. For such well-collateralized \ninvestors, this strategy can be thought of as a way to add income to a portfolio. That \nis, a large stock portfolio's equity may be used to finance this strategy through its loan \nvalue. There would be no margin interest charges, because all transactions are cred\nit transactions. (No debits are created, as long as the Martingale \"limits\" are not \nreached.) The securities portfolio would not have to be touched unless the strategy \nwere terminated before the last set of calls expired worthless. \nThis is where the danger comes in: If the stock upon which the calls are written \nrises so fast that one completely uses up all of his collateral value to finance the naked \ncalls, and then one is required to roll again, the strategy could result in large losses. \nFor a while, one could simply continue to roll the same number of calls up for deb\nits, but eventually those debits would mount in size if the stock persisted in rising. At \n142 Part II: Call Option Strategies \nthis point, even if the stock did finally decline enough for the last set of calls to expire \nworthless, the overall strategy might still have been operated at a loss. \nExample: The basic strategy in the case of rising stock is shown in Table 5-3. Note \nthat each transaction is a credit and that all ( except the last) involve taking a realized \nloss. \nThis example assumes that the stock rose so quickly that a longer-term call was \nnever available to roll into. That is, the October calls were always utilized. If there \nwere a longer-term call available (the January series, for example), the writer should \nroll up and out as well. In this way, larger credits could be generated. The number of \ncalls written increased from 5 to 15 and the collateral required as backing for the \nwriting of the naked calls also increased heavily. Recall that the collateral require\nment is equal to 20% of the stock price plus the call premium, less the amount by \nwhich the call is out-of-the-money. The premium may be used against the collateral \nrequirements. Using the stock and call prices of the example above, the investment \nis computed in Table 5-4. While the number of written calls has tripled from 5 to 15, \nthe collateral requirement has more than quadrupled from $5,000 to $21,000. This is \nwhy the investor must have ample collateral backing to utilize this strategy. The gen\neral philosophy of the large investors who do apply this strategy is that they hope to \neventually make a profit and, since they are using the collateral value of large securi\nty positions already held, they are not investing any more money. The strategy does \nnot really \"cost\" these investors anything. All profits represent additional income and \ndo not in any way disturb the underlying security portfolio. Unfortunately, losses \ntaken due to aborting the strategy could seriously affect the portfolio. This is why the \ninvestor must have sufficient collateral to carry through to completion. \nThe sophisticated strategist who implements this strategy will generally do \nmore rolling than that discussed in the simple example above. First, if the stock \ndrops, the calls will be rolled down to the next strike - for a credit - in order to con\nstantly be selling the most time premium, which is always found in the longest-term \nat-the-money call. Furthermore, the strategist may want to roll out to a more distant \nexpiration series whenever the opportunity presents itself. This rolling out, or for\nward, action is only taken when the stock is relatively unchanged from the initial \nprice and there is no need to roll up or down. \nThis strategy seems ve:ry attractive as long as one has enough collateral backing. \nShould one use up all of his available collateral, the strategy could collapse, causing \nsubstantial losses. It may not necessarily generate large rates of return in rising mar\nkets, but in stable or declining markets the generation of additional income can be \nquite substantial. Since the investor is not putting up any additional cash but is uti-\nCl,apter 5: Naked", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 68}
{"text": "has enough collateral backing. \nShould one use up all of his available collateral, the strategy could collapse, causing \nsubstantial losses. It may not necessarily generate large rates of return in rising mar\nkets, but in stable or declining markets the generation of additional income can be \nquite substantial. Since the investor is not putting up any additional cash but is uti-\nCl,apter 5: Naked Call Writing \nTABLE 5-3. \nRolling for credits when stock is rising. \nInitially: XYZ = 50 \nSell 5 XYZ October 50's at 7 \nlater: XYZ rises to 60 \nBuy 5 XYZ October 50's at 11 and \nsell 8 XYZ October 60's at 7 \nLater: XYZ rises further to 70 \nBuy 8 XYZ October 60's at 11 and \nsell 15 XYZ October 70's at 6 \nFinally: XYZ falls and the October 70's expire worthless \nTABLE 5-4. \nIncrease in collateral requirement. \nInitially: XYZ = 50 \nSell 5 XYZ October 50's at 7 \n($3,500 net credit) \nLater: . XYZ = 60 \nSell 8 XYZ October 60's at 7 \nBuy 5 October 50's at 11 \n($3,600 net credit to date) \nLater: XYZ = 70 \nSell 15 XYZ October 70's at 6 \nBuy 8 XYZ October 60' s at 1 1 \n($3,800 net credit to date) \n143 \n+$3,500 credit \n- 5,500 debit \n+ 5,600 credit \n- 8,800 debit \n+ 9,000 credit \nNet gain = +$3,800 \n$ 5,000 collateral required \n$ 9,600 collateral required \n$21,000 collateral required \nlizing the collateral power of his present securities, his \"investment\" is actually zero. \nAny profits represent additional income. The investor must be aware of one other \nfactor that can upset the strategy. If a stock should rise so far as to require the num\nber of calls to exceed the position limits set by the OCC, the strategy is ruined. In the \nexample above, XYZ would probably have to rise to about a price of over 200, with\nout a correction, before the sale of\"' 1,000 calls would be required. If the strategist \noriginally started with too many naked calls, he could potentially exceed the limit in \na short time period. Rather than attempting to sell too many calls initially in any one \n\"Position limits are higher now. \n144 Part II: Call Option Strategies \nsecurity, the strategist should diversify several moderately sized positions throughout \na variety of underlying stocks. If he does this, he will probably never have to exceed \nthe position limit of contracts short in any one security. \nEven with as many precautions as one might take, there is no guarantee that \none would have the collateral available to withstand a gain of 1000% or more, such \nas is occasionally seen with high-flying tech stocks or new IPOs. One would probably \nbe best served, if he really wants to operate this strategy, to stick with stocks that are \nwell capitalized (some of the biggest in the industry), so that they are less suscepti\nble to such violent upside moves. Even then, though, there is no guarantee that one \nwill not run out of collateral in a sharply rising market, because it is impossible to esti\nmate with complete certainty just how far any one stock might advance in a particu\nlar period of time. \nTIME VALUE PREMIUM IS A MISNOMER \nOnce again, the topic of time value premium is discussed, as it was in Chapter 3. \nMany novice option traders think that if they sell an out-of-the-money option \n(whether covered or naked), all they have to do is sit back and wait to collect the pre\nmium as time wears it away. However, a lot of things can happen between the time \nan option is sold and its expiration date. The stock can move a great deal, or implied \nvolatility can skyrocket. Both are bad for the option seller and both completely coun\nteract any benefit that time decay might be imparting. The option seller must con\nsider what might happen during the life of the option, and not simply view it as a \nstrategy to hold the option until expiration. Naked call writers, especially, should \noperate with that thought in mind, but so should covered call writers, even though \nmost don't. What the covered writer gives away is the upside; and if he constantly \nsells options without regard to the possibilities of volatility or stock price increases, \nhe will be doing himself a disservice. \nSo, while it is still proper to refer to the part of an option's price that is not \nintrinsic value as \"time value premium,\" the knowledgeable option trader under\nstands that it is also more heavily influenced by volatility and stock price movement \nthan by time. \nSUMMARY \nIn a majority of cases, naked call writing is applied as a deeply out-of-the-money \nstrategy in which the investor uses the collateral value of his security holdings to par\nticipate in a strategy that offers a large probability of making a very limited profit. It \nis a poor strategy, because one loss may wipe out many profits. The trader who \nOapter 5: Naked Call Wdting 145 \ndesires an alternative to a short sale may use the sale of an in-the-money naked call \nin order to attempt to make a quick profit on a smaller investment than the short sell\ner would have to make. Both of these strategies could entail large risk if one does not \nhave sufficient capital backing. \nAn alternative strategy, but one that is available only to very large investors, is \nto sell at-the-money calls naked, rolling up and forward for credits if the underlying \nstock rises in price. This strategy, however, can become disastrous if it takes on \nMartingale-like qualities during a rocketing rise by the underlying stock. \nRatio Call Writing \nTwo basic types of call writing have been described in previous chapters: covered call \nwriting, in which one owns the underlying stock and sells a call; and naked call writ\ning. Ratio writing is a combination of these two types of positions. \nTHE RATIO WRITE \nSimply stated, ratio call writing is the strategy in which one owns a certain number \nof shares of the underlying stock and sells calls against more shares than he owns. \nThus, there is a ratio of calls written to stock owned. The most common ratio is the \n2:1 ratio, whereby one owns 100 shares of the underlying stock and sells 2 calls. Note", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 69}
{"text": "ation of these two types of positions. \nTHE RATIO WRITE \nSimply stated, ratio call writing is the strategy in which one owns a certain number \nof shares of the underlying stock and sells calls against more shares than he owns. \nThus, there is a ratio of calls written to stock owned. The most common ratio is the \n2:1 ratio, whereby one owns 100 shares of the underlying stock and sells 2 calls. Note \nthat this type of position involves writing a number of naked call options as well as a \nnumber of covered options. This resulting position has both downside risk, as does a \ncovered write, and unlimited upside risk, as does a naked write. The ratio write gen\nerally wilI provide much larger profits than either covered writing or naked writing if \nthe underlying stock remains relatively unchanged during the life of the calls. \nHowever, the ratio write has two-sided risk, a quality absent from either covered or \nnaked writing. \nGenerally, when an investor establishes a ratio write, he attempts to be neutral \nin outlook regarding the underlying stock. This means that he writes the calls with \nstriking prices closest to the current stock price. \nExample: A ratio write is established by buying 100 shares of XYZ at 49 and selling \ntwo XYZ October 50 calls at 6 points each. If XYZ should decline in price and be \nanywhere below 50 at October expiration, the calls will expire worthless and the \nwriter will make 12 points from the sale of the calls. Thus, even if XYZ drops 12 \npoints to a price of 37, the ratio writer will break even. The stock loss of 12 points \n146 \nOtapter 6: Ratio Call Writing 147 \nwould be offset by a 12-point gain on the calls. As with any strategy in which calls are \nsold, the maximum profit occurs at the striking price of the written calls at expiration. \nIn this example, if XYZ were at 50 at expiration, the calls would still expire worthless \nfor a 12-point gain and the writer would have a 1-point profit on his stock, which has \nmoved up from 49 to 50, for a total gain of 13 points. This position therefore has \nample downside protection and a relatively large potential profit. Should XYZ rise \nabove 50 by expiration, the profit will decrease and eventually become a loss if the \nstock rises too far. To see this, suppose XYZ is at 63 at October expiration. The calls \nwill be at 13 points each, representing a 7-point loss on each call, because they were \noriginally sold for 6 points apiece. However, there would be a 14-poirit gain on the \nstock, which has risen from 49 to 63. The overall net is a break-even situation at 63 -\na 14-point gain on the stock offset by 14 points ofloss on the options (7 points each). \nTable 6-1 and Figure 6-1 summarize the profit and loss potential of this example at \nOctober expiration. The shape of the graph resembles a roof with its peak located at \nthe striking price of the written calls, or 50. It is obvious that the position has both \nlarge upside risk above 63 and large downside risk below 37. Therefore, it is imper\native that the ratio writer plan to take follow-up action if the stock should move out\nside these prices. Follow-up action is discussed later. If the stock remains within the \nrange 37 to 63, some profit will result before commission charges. This range \nbetween the downside break-even point and the upside break-even point is called the \nprofit range. \nThis example represents essentially a neutral position, because the ratio writer \nwill make some profit unless the stock falls by more than 12 points or rises by more \nthan 14 points before the expiration of the calls in October. This is frequently an \nattractive type of strategy to adopt because, normally, stocks do not move very far in \nTABLE 6-1. \nProfit and loss at October expiration. \nXYZ Price at Stock Call Profit Total \nExpiration Profit Price on Calls Profit \n30 -$1,900 0 +$1,200 -$ 700 \n37 - 1,200 0 + 1,200 0 \n45 400 0 + 1,200 + 800 \n50 + 100 0 + 1,200 + 1,300 \n55 + 600 5 + 200 + 800 \n63 + 1,400 13 - 1,400 0 \n70 + 2,100 20 - 2,800 - 700 \n148 \nFIGURE 6-1. \nRatio write (2: 1 ). \n+$1,300 \nC \n0 \ne ·5. \nX \nLU \nal \nrn rn \n.3 \n0 \n-e a. \nPart II: Call Option Strategies \nStock Price at Expiration \na 3- or 6-month time period. Consequently, this strategy has a rather high probabili\nty of making a limited profit. The profit in this example would, of course, be reduced \nby commission costs and margin interest charges if the stock is bought on margin. \nBefore discussing the specifics of ratio writing, such as investment required, \nselection criteria, and follow-up action, it may be beneficial to counter two fairly \ncommon objections to this strategy. The first objection, although not heard as fre\nquently today as when listed options first began trading, is \"Why bother to buy 100 \nshares of stock and sell 2 calls? You will be naked one call. Why not just sell one \nnaked call?\" The ratio writing strategy and the naked writing strategy have very little \nin common except that both have upside risk. The profit graph for naked writing \n(Figure 5-1) bears no resemblance to the roof-shaped profit graph for a ratio write \n(Figure 6-1). Clearly, the two strategies are quite different in profit potential and in \nmany other respects as well. \nThe second objection to ratio writing for the conservative investor is slightly \nmore valid. The conservative investor may not feel comfortable with a position that \nhas risk if the underlying stock moves up in price. This can be a psychological detri\nment to ratio writing: When stock prices are rising and everyone who owns stocks is \nhappy and making profits, the ratio writer is in danger of losing money. However, in \na purely strategic sense, one should be willing to assume some upside risk in \nexchange for larger profits if the underlying stock does not rise heavily in price. The \nChapter 6: Ratio Call Writing 149 \ncovered writer has upside protection all the way to infinity; that is, he has no upside \nrisk at all. This cannot be the mathematically optimum situ", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 70}
{"text": "riter is in danger of losing money. However, in \na purely strategic sense, one should be willing to assume some upside risk in \nexchange for larger profits if the underlying stock does not rise heavily in price. The \nChapter 6: Ratio Call Writing 149 \ncovered writer has upside protection all the way to infinity; that is, he has no upside \nrisk at all. This cannot be the mathematically optimum situation, because stocks \nnever rise to infinity. Rather, the ratio writer is engaged in a strategy that makes its \nprofits in a price range more in line with the way stocks actually behave. In fact, if \none were to try to set up the optimum strategy, he would want it to make its most \nprofits in line with the most probable outcomes for a stock's movement. Ratio writ\ning is such a strategy. \nFigure 6-2 shows a simple probability curve for a stock's movement. It is most \nlikely that a stock will remain relatively unchanged and there is very little chance that \nit will rise or fall a great distance. Now compare the results of the ratio writing strat\negy with the graph of probable stock outcomes. Notice that the ratio write and the \nprobability curve have their \"peaks\" in the same area; that is, the ratio write makes \nits profits in the range of most likely stock prices, because there is only a small chance \nthat any stock will increase or decrease by a large amount in a fixed period of time. \nThe large losses are at the edges of the graph, where the probability curve gets very \nlow, approaching zero probability. It should be noted that these graphs show the prof\nit and probability at expiration. Prior to expiration, the break-even points are closer \nto the original purchase price of the stock because there will still be some time value \npremium remaining on the options that were sold. \nFIGURE 6-2. \nStock price probability curve overlaid on profit graph of ratio \nwrite. \n+$1,300 Probability \nCurve \nStock Price \n150 Part II: Call Option Strategies \nINVESTMENT REQUIRED \nThe ratio writer has a combination of covered writes and naked writes. The margin \nrequirements for each of these strategies have been described previously, and the \nrequirements for a ratio writing strategy are the sum of the requirements for a naked \nwrite and a covered write. Ratio writing is normally done in a margin account, \nalthough one could technically keep the stock in a cash account. \nExample: Ignoring commissions, the investment required can be computed as fol\nlows: Buy 100 XYZ at 49 on 50% margin and sell 2 XYZ October 50 calls at 6 points \neach (Table 6-2). The commissions for buying the stock and selling the calls would be \nadded to these requirements. A shorter formula (Table 6-3) is actually more desirable \nto use. It is merely a combination of the investment requirements listed in Table 6-2. \nIn addition to the basic requirement, there may be minimum equity require\nments and maintenance requirements, since naked calls are involved. As these vary \nfrom one brokerage firm to another, it is best for the ratio writer to check with his \nbroker to determine the equity and maintenance requirements. Again, since naked \ncalls are involved in ratio writing, there will be a mark to market of the position. If \nthe stock should rise in price, the investor will have to put up more collateral. \nIt is conceivable that the ratio writer would want to stay with his original posi\ntion as long as the stock did not penetrate the upside break-even point of 63. \nTABLE 6-2. \nInvestment required. \nCovered writing portion (buy 100 XYZ and sell 1 call) \n50% of stock price \nLess premium received \nRequirement for covered portion \nNaked writing portion (sell 1 XYZ call) \n20% of stock price \nLess out-of-the-money amount \nPlus call premium \nLess premium received \nRequirement for naked portion \nTotal requirement for ratio write \n$2,450 \n600 \n$1,850 \n$ 980 \n100 \n+ 600 \n600 \n$ 880 \n$2,730 \nCl,apter 6: Ratio Call Writing \nTABLE 6-3. \nInitial investment required for a ratio write. \n70% of stock cost (XYZ = 49) \nPlus naked call premiums \nLess total premiums received \nPlus or minus striking price differential \non naked calls \n$3,430 \n+ 600 \n- 1,200 \n100 \n151 \nTotal requirement $2,730 (plus commissions) \nTABLE 6-4. \nCollateral required with stock at upside break-even point of 63. \nCovered writing requirement $1,850 (see Table 6-2) \n20% of stock price (XYZ = 63) 1,260 \nPlus call premium \nLess initial call premium received \nTotal requirement with XYZ at 63 \n1,400 \n600 \n$3,910 \nTherefore, he should allow for enough collateral to cover the eventuality of a move \nto 63. Assuming the October 50 call is at 14 in this case, he would need $3,910 (see \nTable 6-4). This is the requirement that the ratio writer should be concerned with, \nnot the initial collateral requirement, and he should therefore plan to invest $3,910 \nin this position, not $2,730 ( the initial requirement). Obviously, he only has to put up \n$2,730, but from a strategic point of view, he should allow $3,910 for the position. If \nthe ratio writer does this with all his positions, he would not receive a margin call \neven if all the stocks in his portfolio climbed to their upside break-even points. \nSELECTION CRITERIA \nTo decide whether a ratio write is a desirable position, the writer must first determine \nthe break-even points of the position. Once the break-even points are known, the \nwriter can then decide if the position has a wide enough profit range to allow for \ndefensive action if it should become necessary. One simple way to determine if the \nprofit range is wide enough is to require that the next higher and lower striking prices \nbe within the profit range. \n152 Part II: Call Option Strategies \nExample: The writer is buying 100 XYZ at 49 and selling 2 October 50 calls at 6 \npoints apiece. It was seen, by inspection, that the break-even points in the position \nare 37 on the downside and 63 on the upside. A mathematical formula allows one to \nquickly compute the break-even points for a 2:1 ratio", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 71}
{"text": "er and lower striking prices \nbe within the profit range. \n152 Part II: Call Option Strategies \nExample: The writer is buying 100 XYZ at 49 and selling 2 October 50 calls at 6 \npoints apiece. It was seen, by inspection, that the break-even points in the position \nare 37 on the downside and 63 on the upside. A mathematical formula allows one to \nquickly compute the break-even points for a 2:1 ratio write. \nPoints of maximum profit = Strike price - Stock price + 2 x Call price \nDownside break-even point = Strike price - Points of maximum profit \n= Stock price - 2 x Call price \nUpside break-even point = Strike price + Points of maximum profit \nIn this example, the points of maximum profit are 50 - 49 + 2 x 6, or 13. Thus, \nthe downside break-even point would be 37 (50 - 13) and the upside break-even \npoint would be 63 (50 + 13). These numbers agree with the figures determined ear\nlier by analyzing the position. \nThis profit range is quite clearly wide enough to allow for defensive action \nshould the underlying stock rise to the next highest strikes of 55 or 60, or fall to the \nnext two lower strikes, at 45 and 40. In practice, a ratio write is not automatically a \ngood position merely because the profit range extends far enough. Theoretically, \none would want the profit range to be wide in relation to the volatility of the under\nlying stock. If the range is wide in relation to the volatility and the break-even \npoints encompass the next higher and lower striking prices, a desirable position is \navailable. Volatile stocks are the best candidates for ratio writing, since their pre\nmiums will more easily satisfy both these conditions. A nonvolatile stock may, at \ntimes, have relatively large premiums in its calls, but the resulting profit range may \nstill not be wide enough numerically to ensure that follow-up action could be taken. \nSpecific measures for determining volatility may be obtained from many data serv\nices and brokerage firms. Moreover, methods of computing volatility are present\ned later in the chapter on mathematical applications, and probabilities are further \naddressed in the chapters on volatility trading. \nTechnical support and resistance levels are also important in establishing the \nposition. If both support and resistance lie within the profit range, there is a better \nchance that the stock will remain within the range. A position should not necessarily \nbe rejected if there is not support and resistance within the profit range, but the \nwriter is then subjecting himself to a possible undeterred move by the stock in one \ndirection or the other. \nThe ratio writer is generally a neutral strategist. He tries to take in the most \ntime premium that he can to earn the premium erosion while the stock remains rel\natively unchanged. If one is more bullish on a particular stock, he can set up a 2:1 \nratio write with out-of~the-money calls. This allows more room to the upside than to \nthe downside, and therefore makes the position slightly more bullish. Conversely, if \nCl,apter 6: Ratio Call Writing 153 \none is more bearish on the underlying stock, he can write in-the-money calls in a 2:1 \nratio. \nThere is another way to produce a slightly more bullish or bearish ratio write. \nThis is to change the ratio of calls written to stock purchased. This method is also \nused to construct a neutral profit range when the stock is not close to a striking price. \nExample: An investor is slightly bearishly inclined in his outlook for the underlying \nstock, so he might write more than two calls for each 100 shares of stock purchased. \nHis position might be to buy 100 XYZ at 49 and sell 3 XYZ October 50 calls at 6 points \neach. This position breaks even at 31 on the downside, because if the stock dropped \nby 18 points at expiration, the call profits would amount to 18 points and would pro\nduce a break-even situation. To the upside, the break-even point lies at 59½ for the \nstock at expiration. Each call would be worth 9½ at expiration with the stock at 59½, \nand each call would thus lose 3½ points, for a total loss of 10½ points on the three \ncalls. However, XYZ would have risen from 49 to 59½ - a 10½-point gain - therefore \nproducing a break-even situation. Again, a formula is available to aid in determining \nthe break-even point for any ratio. \nMaximum profit= (Striking price - Stock price) x Round lots \npurchased+ Number of calls written x Call price \nD •d b ak Striking Maximum profit owns1 e re -even = - ------~~----price Number of round lots purchased \nU .d b ak Striking Maximum profit psi e re -even = + price ( Calls written - Round lots purchased) \nNote that in the case of a 2:1 ratio write, where the number of round lots purchased \nequals 1 and the number of calls written equals 2, these formulae reduce to the ones \ngiven earlier for the more common 2:1 ratio write. To verify that the formulae above \nare correct, insert the numbers from the most recent example. \nExample: Three XYZ October 50 calls at a price of 6 were sold against the purchase \nof 100 XYZ at 49. The number of round lots purchased is 1. \nMaximum profit = (50 - 49) x 1 + 3 x 6 = 19 \nDownside break-even= 50-19/1 = 31 \nUpside break-even= 50 + 19/(3 1) = 59½ \nIn the 2:1 ratio writing example given earlier, the break-even points were 37 and 63. \nThe 3:1 write has lower break-even points of 31 and 59½, reflecting the more bear\nish posture on the underlying stock. \n154 Part II: Call Option Strategies \nA more bullish write is constructed by buying 200 shares of the underlying stock \nand writing three calls. To quickly verify that this ratio (3:2) is more bullish, again use \n49 for the stock price and 6 for the call price, and now assume that two round lots \nwere purchased. \nMaximum profit= (50-49) x 2 + 3 x 6 = 20 \nDownside break-even = 50 - 20/2 = 40 \nUpside break-even= 50 + 20/(3 - 2) = 70 \nThus, this ratio of 3 calls against 200 shares of stock has break-even points of 40 and \n70, reflecting a more bullish posture on the underlyin", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 72}
{"text": "(3:2) is more bullish, again use \n49 for the stock price and 6 for the call price, and now assume that two round lots \nwere purchased. \nMaximum profit= (50-49) x 2 + 3 x 6 = 20 \nDownside break-even = 50 - 20/2 = 40 \nUpside break-even= 50 + 20/(3 - 2) = 70 \nThus, this ratio of 3 calls against 200 shares of stock has break-even points of 40 and \n70, reflecting a more bullish posture on the underlying stock. \nA 2: 1 ratio may not necessarily be neutral. There is, in fact, a mathematically \ncorrect way of determining exactly what a neutral ratio should be. The neutral ratio \nis determined by dividing the delta of the written call into 1. Assume that the delta of \nthe XYZ October 50 call in the previous example is .60. Then the neutral ratio is \n1.0/.60, or 5 to 3. This means that one might buy 300 shares and sell 5 calls. Using \nthe formulae above, the details of this position can be observed: \nMaximum profit= (50 -49) x 3 + 5 x 6 = 33 \nDownside break-even = 50 - 33/3 = 39 \nUpside break-even = 50 + 33/(5 --3) = 66½ \nAccording to the mathematics of the situation, then, this would be a neutral position \ninitially. It is often the case that a 5:3 ratio is approximately neutral for an at-the\nmoney call. \nBy now, the reader should have recognized a similarity between the ratio writ\ning strategy and the reverse hedge (or simulated straddle) strategy presented in \nChapter 4. The two strategies are the reverse of each other; in fact, this is how the \nreverse hedge strategy acquired its name. The ratio write has a profit graph that looks \nlike a roof, while the reverse hedge has a profit graph that looks like a trough - the \nroof upside down. In one strategy the investor buys stock and sells calls, while the \nother strategy is just the opposite - the investor shorts stock and buys calls. Which \none is better? The answer depends on whether the calls are \"cheap\" or \"expensive.\" \nEven though ratio writing has limited profits and potentially large losses, the strate\ngy will result in a profit in a large majority of cases, if held to expiration. However, \none may be forced to make adjustments to stock moves that occur prior to expiration. \nThe reverse hedge strategy, with its limited losses and potentially large profits, pro\nvides profits only on large stock moves - a less frequent event. Thus, in stable mar\nkets, the ratio writing strategy is generally superior. However, in times of depressed \noption premiums, the reverse hedge strategy gains a distinct advantage. If calls are \nChapter 6: Ratio Call Writing 155 \nunderpriced, the advantage lies with the buyer of calls, and that situation is inherent \nin the reverse hedge strategy. \nThe summaries stated in the above paragraph are rather simplistic ones, refer\nring mostly to what one can expect from the strategies if they are held until expira\ntion, without adjustment. In actual trading situations, it is much more likely that one \nwould have to make adjustments to the ratio write along the way, thus disturbing or \nperhaps even eliminating the profit range. Such travails do not befall the reverse \nhedge (simulated straddle buy). Consequently, when one takes into consideration the \nstock movements that can take place prior to expiration, the ratio write loses some of \nits attractiveness and the reverse hedge gains some. \nTHE VARIABLE RATIO WRITE \nIn ratio writing, one generally likes to establish the position when the stock is trading \nrelatively close to the striking price of the written calls. However, it is sometimes the \ncase that the stock is nearly exactly between two striking prices and neither the in\nthe-money nor the out-of-the-money call offers a neutral profit range. If this is the \ncase, and one still wants to be in a 2:1 ratio of calls written to stock owned, he can \nsometimes write one in-the-money call and one out-of-the-money call against each \n100 shares of common. This strategy, often termed a variable ratio write or trape\nzoidal hedge, serves to establish a more neutral profit range. \nExample: Given the following prices: XYZ common, 65; XYZ October 60 call, 8; and \nXYZ October 70 call, 3. \nIf one were to establish a 2:1 ratio write with only the October 60's, he would \nhave a somewhat bearish position. His profit range would be 49 to 71 at expiration. \nSince the stock is already at 65, this means that he would be allowing room for 16 \npoints of downside movement and only 6 points on the upside. This is certainly not \nneutral. On the other hand, if he were to attempt to utilize only the October 70 calls \nin his ratio write, he would have a bullish position. This profit range for the October \n70 ratio write would be 59 to 81 at expiration. In this case, the stock at 65 is too close \nto the downside break-even point in comparison to its distance from the upside \nbreak-even point. \nA more neutral position can be established by buying 100 XYZ and selling one \nOctober 60 and one October 70. This position has a profit range that is centered \nabout the current stock price. Moreover, the new position has both an upside and a \ndownside risk, as does a more normal ratio write. However, now the maximum prof\nit can be obtained anywhere between the two strikes at expiration. To see this, note \n156 Part II: Call Option Strategies \nthat if XYZ is anywhere between 60 and 70 at expiration, the stock will be called away \nat 60 against the sale of the October 60 call, and the October 70 call will expire worth\nless. It makes no difference whether the stock is at 61 or at 69; the same result will \noccur. Table 6-5 and Figure 6-3 depict the results from this variable hedge at expira\ntion. In the table, it is assumed that the option is bought back at parity to close the \nposition, but if the stock were called away, the results would be the same. \nNote that the shape of Figure 6-3 is something like a trapezoid. This is the \nsource of the name \"trapezoidal hedge,\" although the strategy is more commonly \nknown as a variable hedge or variable ratio write. The reader s", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 73}
{"text": "ge at expira\ntion. In the table, it is assumed that the option is bought back at parity to close the \nposition, but if the stock were called away, the results would be the same. \nNote that the shape of Figure 6-3 is something like a trapezoid. This is the \nsource of the name \"trapezoidal hedge,\" although the strategy is more commonly \nknown as a variable hedge or variable ratio write. The reader should observe that the \nmaximum profit is indeed obtained if the stock is anywhere between the two strikes \nat eiqJiration. The maximum profit potential in this position, $600, is smaller than the \nmaximum profit potential available from writing only the October 60's or only the \nOctober 70's. However, there is a vastly greater probability of realizing the maximum \nprofit in a variable ratio write than there is of realizing the maximum profit in a nor\nmal ratio write. \nThe break-even points for a variable ratio write can be computed most quickly \nby first computing the maximum profit potential, which is equal to the time value \nthat the writer takes in. The break-even points are then computed directly by sub\ntracting the points of maximum profit from the lower striking price to get the down\nside break-even point and adding the points of maximum profit to the upper striking \nprice to arrive at the upside break-even point. This is a similar procedure to that fol\nlowed for a normal ratio write: \nTABLE 6-5. \nResults at expiration of variable hedge. \nXYZ Price at XYZ October 60 October 70 Total \nExpiration Profit Profit Profit Profit \n45 -$2,000 +$ 800 +$ 300 -$900 \n50 - 1,500 + 800 + 300 - 400 \n54 - 1,100 + 800 + 300 0 \n60 500 + 800 + 300 + 600 \n65 0 + 300 + 300 + 600 \n70 + 500 - 200 + 300 + 600 \n76 + 1,100 - 800 300 0 \n80 + 1,500 -$1,200 700 - 400 \n85 + 2,000 -1,700 - 1,200 - 900 \nGopter 6: Ratio Call Writing \nFIGURE 6-3. \nVariable ratio write (trapezoidal hedge). \n+$600 \nC: \ni $ \nal \n\"' \"' .3 \n5 \n;t: \ne \n0. \n$0 \nStock Price at Expiration \nPoints of maximum profit = Total option premiums + Lower \nstriking price - Stock price \nDownside break-even point = Lower striking price - Points of \nmaximum profit \nUpside break-even point = Higher striking price + Points of \nmaximum profit \n157 \nSubstituting the numbers from the example above will help to verify the formula. \nThe total points of option premium brought in were 11 (8 for the October 60 and 3 \nfor the October 70). The stock price was 65, and the striking prices involved were 60 \nand 70. \nPoints of maximum profit = 11 + 60 - 65 = 6 \nDownside break-even point= 60- 6 = 54 \nUpside break-even point= 70 + 6 = 76 \nThus, the break-even points as computed by the formula agree with Table 6-5 and \nFigure 6-3. Nate that the formula applies only if the stock is initially between the two \nstriking prices and the ratio is 2:1. If the stock is above both striking prices, the for\nmula is not correct. However, the writer should not be attempting to establish a vari\nable ratio write with two in-the-money calls. \n158 Part II: Call Option Strategies \nFOLLOW-UP ACTION \nAside from closing the position completely, there are three reasonable approaches to \nfollow-up action in a ratio writing situation. The first, and most popular, is to roll the \nwritten calls up if the stock rises too far, or to roll down if the stock drops too far. A \nsecond method uses the delta of the written calls. The third follow-up method is to \nutilize stops on the underlying stock to alter the ratio of the position as the stock \nmoves either up or down. In addition to these types of defensive follow-up action, the \ninvestor must also have a plan in mind for taking profits as the written calls approach \nexpiration. These types of follow-up action are discussed separately. \nROLLING UP OR DOWN AS A DEFENSIVE ACTION \nThe reader should already be familiar with the definition of a rolling action: The cur\nrently written calls are bought back and calls at a different striking price are written. \nThe ratio writer can use rolling actions to his advantage to readjust his position if the \nunderlying stock moves to the edges of his profit range. \nThe reason one of the selection criteria for a ratio write was the availability of \nboth the next higher and next lower striking prices was to facilitate the rolling actions \nthat might become necessary as a follow-up measure. Since an option has its great\nest time premium when the stock price and the striking price are the same, one \nwould normally want to roll exactly at a striking price. \nExample: A ratio writer bought 100 XYZ at 49 and sold two October 50 calls at 6 \npoints each. Subsequently, the stock drops in price and the following prices exist: \nXYZ, 40; XYZ October 50, l; and XYZ October 40, 4. \nOne would roll down to the October 40 calls by buying back the 2 October \n50's that he is short and selling 2 October 40's. In so doing, he would reestablish a \nsomewhat neutral position. His profit on the buy-back of the October 50 calls \nwould be 5 points each - they were originally sold for 6 - and he would realize a \n10-point gain on the two calls. This 10-point gain effectively reduces his stock cost \nfrom 49 to 39, so that he now has the equivalent of the following position: long 100 \nXYZ at 39 and short 2 XYZ October 40 calls at 4. This adjusted ratio write has a \nprofit range of 31 to 49 and is thus a new, neutral position with the stock currently \nat 40. The investor is now in a position to make profits if XYZ remains near this \nlevel, or to take further defensive action if the stock experiences a relatively large \nchange in price again. \nDefensive action to the upside - rolling up -works in much the same manner. \nChapter 6: Ratio Call Writing 159 \nExample: The initial position again consists of buying 100 XYZ at 49 and selling two \nOctober 50 calls at 6. If XYZ then rose to 60, the following prices might exist: XYZ, \n60; XYZ October 50, 11; and XYZ October 60, 6. \nThe ratio writer could thus roll this position up to reestablish a neutral profit \nrange. If", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 74}
{"text": "pside - rolling up -works in much the same manner. \nChapter 6: Ratio Call Writing 159 \nExample: The initial position again consists of buying 100 XYZ at 49 and selling two \nOctober 50 calls at 6. If XYZ then rose to 60, the following prices might exist: XYZ, \n60; XYZ October 50, 11; and XYZ October 60, 6. \nThe ratio writer could thus roll this position up to reestablish a neutral profit \nrange. If he bought back the two October 50 calls, he would take a 5-point loss on \neach one for a net loss on the calls of 10 points. This would effectively raise his stock \ncost by 10 points, to a price of 59. The rolled-up position would then be long 100 XYZ \nat 59 and short 2 October 60 calls at 6. This new, neutral position has a profit range \nof 47 to 73 at October expiration. \nIn both of the examples above, the writer could have closed out the ratio write \nat a very small profit of about 1 point before commissions. This would not be advis\nable, because of the relatively large stock commissions, unless he expects the stock to \ncontinue to move dramatically. Either rolling up or rolling down gives the writer a \nfairly wide new profit range to work with, and he could easily expect to make more \nthan 1 point of profit if the underlying stock stabilizes at all. \nHaving to take rolling defensive action immediately after the position is estab\nlished is the most detrimental case. If the stock moves very quickly after having set \nup the position, there will not be much time for time value premium erosion in the \nwritten calls, and this will make for smaller profit ranges after the roll is done. It may \nbe useful to use technical support and resistance levels as keys for when to take \nrolling action if these levels are near the break-even points and/or striking prices. \nIt should be noted that this method of defensive action - rolling at or near strik\ning prices - automatically means that one is buying back little or no time premium \nand is selling the greatest amount of time premium currently available. That is, if the \nstock rises, the call's premium will consist mostly of intrinsic value and very little of \ntime premium value, since it is substantially in-the-money. Thus, the writer who rolls \nup by buying back this in-the-money call is buying back mostly intrinsic value and is \nselling a call at the next strike. This newly sold call consists mostly of time value. By \ncontinually buying back \"real\" or intrinsic value and by selling \"thin air\" or time value, \nthe writer is taking the optimum neutral action at any given time. \nIf a stock undergoes a dramatic move in one direction or the other, the ratio \nwriter will not be able to keep pace with the dramatic movement by remaining in the \nsame ratio. \nExample: If XYZ was originally at 49, but then undergoes a fairly straight-line move \nto 80 or 90, the ratio writer who maintains a 2:1 ratio will find himself in a deplorable \nsituation. He will have accumulated rather substantial losses on the calls and will not \nbe able to compensate for these losses by the gain in the underlying stock. A similar \n160 Part II: Call Option Strategies \nsituation could arise to the downside. If:X'YZ were to plunge from 49 to 20, the ratio \nwriter would make a good deal of profit from the calls by rolling down, but may still \nhave a larger loss in the stock itself than the call profits can compensate for. \nMany ratio writers who are large enough to diversify their positions into a num\nber of stocks will continue to maintain 2:1 ratios on all their positions and will simply \nclose out a position that has gotten out of hand by running dramatically to the upside \nor to the downside. These traders believe that the chances of such a dramatic move \noccurring are small, and that they will take the infrequent losses in such cases in \norder to be basically neutral on the other stocks in their portfolios. \nThere is, however, a way to combat this sort of dramatic move. This is done by \naltering the ratio of the covered write as the stock moves either up or down. For \nexample, as the underlying stock moves up dramatically in price, the ratio writer can \ndecrease the number of calls outstanding against his long stock each time he rolls. \nEventually, the ratio might decrease as far as 1:1, which is nothing more than a cov\nered writing situation. As long as the stock continues to move in the same upward \ndirection, the ratio writer who is decreasing his ratio of calls outstanding will be giv\ning more and more weight to the stock gains in the ratio write and less and less weight \nto the call losses. It is interesting to note that this decreasing ratio effect can also be \nproduced by buying extra shares of stock at each new striking price as the stock \nmoves up, and simultaneously keeping the number of outstanding calls written con\nstant. In either case, the ratio of calls outstanding to stock owned is reduced. \nWhen the stock moves down dramatically, a similar action can be taken to \nincrease the number of calls written to stock owned. Normally, as the stock falls, one \nwould sell out some of his long stock and roll the calls down. Eventually, after the \nstock falls far enough, he would be in a naked writing position. The idea is the same \nhere: As the stock falls, more weight is given to the call profits and less weight is given \nto the stock losses that are accumulating. \nThis sort of strategy is more oriented to extremely large investors or to firm \ntraders, market-makers, and the like. Commissions will be exorbitant if frequent rolls \nare to be made, and only those investors who pay very small commissions or who have \nsuch a large holding that their commissions are quite small on a percentage basis will \nbe able to profit substantially from such a strategy. \nADJUSTING WITH THE DELTA \nThe delta of the written calls can be used to determine the correct ratio to be used in \nthis ratio-adjusting defensive strategy. The basic idea is to use the call's delta to \nremain as neutral as possible at", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 75}
{"text": "missions or who have \nsuch a large holding that their commissions are quite small on a percentage basis will \nbe able to profit substantially from such a strategy. \nADJUSTING WITH THE DELTA \nThe delta of the written calls can be used to determine the correct ratio to be used in \nthis ratio-adjusting defensive strategy. The basic idea is to use the call's delta to \nremain as neutral as possible at all times. \nCl,apter 6: Ratio Call Writing 161 \nExample: An investor initially sets up a neutral 5:3 ratio of XYZ October 50 calls to \nXYZ stock, as was determined previously. The stock is at 49 and the delta is .60. \nFurthermore, suppose the stock rises to 57 and the call now has a delta of .80. The \nneutral ratio would currently be 1/.80 ( = 1.20) or 5:4. The ratio writer could thus buy \nanother 100 shares of the underlying stock. \nAlternatively, he might buy in one of the short calls. In this particular example, \nbuying in one call would produce a 4:3 ratio, which is not absolutely correct. If he \nhad had a larger position initially, it would be easier to adjust to fractional ratios. \nWhen the stock declines, it is necessary to increase the ratio. This can be accom\nplished by either selling more calls or selling out some of the long stock. In theory, \nthese adjustments could be made constantly to keep the position neutral. In practice, \none would allow for a few points of movement by the underlying stock before adjust\ning. If the underlying stock rises too far, it may be logical for the neutral strategist to \nadjust by rolling up. Similarly, he would roll down if the stock fell to or below the next \nlower strike. The neutral ratio in that case is determined by using the delta of the \noption into which he is rolling. \nExample: With XYZ at 57, an investor is contemplating rolling up to the October 60's \nfrom his present position of long 300 shares and short 5 XYZ October 50's. If the \nOctober 60 has a delta of .40, the neutral ratio for the October 60's is 2.5:l (1 + .40). \nSince he is already long 300 shares of stock, he should now be short 7.5 calls (3 x 2.5). \nObviously, he would sell 7 or 8, probably depending on his short-term outlook for the \nstock. \nIf one prefers to adopt an even more sophisticated approach, he can make \nadjustments between striking prices by altering his stock position, and can make \nadjustments by rolling up or down if the stock reaches a new striking price. For those \nwho prefer formulae, the following ones summarize this information: \n1. When establishing a new position or when rolling up or down, at the next strike: \nN b f all t 11 Round lots held long um er o c s o se = \nDelta of call to be sold \nNote: When establishing a new position, one must first decide how many shares \nof the underlying stock he can buy before utilizing the formula; 1,000 \nshares would be a workable amount. \n2. When adjusting between strikes by buying or selling stock: \n162 Part II: Call Option Strategies \nNumber of \nround lots = Current delta x Number of short calls - Round lots held long \nto buy \nNote: If a negative number results, stock should be sold, not bought. \nThese formulae can be verified by using the numbers from the examples above. For \nexample, when the delta of the October 50 was .80 with the stock at 57, it was seen \nthat buying 100 shares of stock would reestablish a neutral ratio. \nNumber of round lots to buy= .80 x 5 3 = 4- 3 = 1 \nAlso, if the position was to be rolled up to the October 60 (delta = .40), it was seen \nthat 7.5 October 60's would theoretically be sold: \nNumber of calls to sell = __l_ = 7.5 .40 \nThere is a more general approach to this problem, one that can be applied to \nany strategy, no matter how complicated. It involves computing whether the position \nis net short or net long. The net position is reduced to an equivalent number of shares \nof common stock and is commonly called the \"equivalent stock position\" (ESP). Here \nis a simple formula for the equivalent stock position of any option position: \nESP = Option quantity x Delta x Shares per option \nExample: Suppose that one is long 10 XYZ July 50 calls, which currently have a delta \nof .45. The option is an option on 100 shares of XYZ. Thus, the ESP can be computed: \nESP = 10 x .45 x 100 = 450 shares \nThis is merely saying that owning 10 of these options is equivalent to owning 450 \nshares of the underlying common stock, XYZ. The reader should already understand \nthis, in that an option with a delta of .45 would appreciate by .45 points if the com\nmon stock moved up 1 dollar. Thus, 10 options would appreciate by 4.5 points, or \n$450. Obviously, 450 shares of common stock would also appreciate by $450 if they \nmoved up by one point. \nNote that there are some options - those that result from a stock split- that are \nfor more than 100 shares. The inclusion of the term \"shares per option\" in the for\nmula accounts for the fact that such options are equivalent to a different amount of \nstock than most options. \nThe ESP of an entire option and stock position can be computed, even if sev\neral different options are included in the position. The advantage of this simple cal-\nChapter 6: Ratio Call Writing 163 \nculation is that an entire, possibly complex option position can be reduced to one \nnumber. The ESP shows how the position will behave for short-term market move\nments. \nLook again at the previous example of a ratio write. The position was long 300 \nshares and short 5 options with a current delta of .80 after the stock had risen to 57. \nThe ESP of the 5 October 50's is short 400 shares (5 x .80 x 100 shares per option). \nThe position is also long 300 shares of stock, so the total ESP of this ratio write is \nshort 100 shares. \nThis figure gives the strategist a measure of perspective on his position. He now \nknows that he has a position that is the equivalent of being short 100 shares of XYZ. \nPerhaps he is bearish on XYZ and therefore decides to do nothing. That would be \nfine; at least he knows that his positio", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 76}
{"text": "The position is also long 300 shares of stock, so the total ESP of this ratio write is \nshort 100 shares. \nThis figure gives the strategist a measure of perspective on his position. He now \nknows that he has a position that is the equivalent of being short 100 shares of XYZ. \nPerhaps he is bearish on XYZ and therefore decides to do nothing. That would be \nfine; at least he knows that his position is short. \nNormally, however, the strategist would want to adjust his position. Again \nreturning to the previous example, he has several choices in reducing the ESP back \nto neutral. An ESP of O is considered to be a perfectly neutral position. Obviously, \none could buy 100 shares of XYZ to reduce the 100-share delta short. Or, given that \nthe delta of the October 50 call is .80, he could buy in 1.25 of these short calls (obvi\nously he could only buy l; fractional options cannot be purchased). \nLater chapters include more discussions and examples using the ESP. It is a \nvital concept that no strategist who is operating positions involving multiple options \nshould be without. The only requirement for calculating it is to know the delta of the \noptions in one's position. Those are easily obtainable from one's broker or from a \nnumber of computer services, software programs, or Web sites. \nFor investors who do not have the funds or are not in a position to utilize such \na ratio adjusting strategy, there is a less time-consuming method of taking defensive \naction in a ratio write. \nUSING STOP ORDERS AS A DEFENSIVE STRATEGY \nA ratio writer can use buy or sell stops on his stock position in order to automatical\nly and unemotionally adjust the ratio of his position. This type of defensive strategy \nis not an aggressive one and will provide some profits unless a whipsaw occurs in the \nunderlying stock. \nAs an example of how the use of stop orders can aid the ratio writer, let us again \nassume that the same basic position was established by buying XYZ at 49 and selling \ntwo October 50 calls at 6 points each. This produces a profit range of 37 to 63 at expi\nration. If the stock begins to move up too far or to fall too far, the ratio writer can \nadjust the ratio of calls short to stock long automatically, through the use of stop \norders on his stock. \n164 Part II: Call Option Strategies \nExample: An investor places a \"good until canceled\" stop order to buy 100 shares of \nXYZ at 57 at the same time that he establishes the original position. If XYZ should \nget to 57, the stop would be set off and he would then own 200 shares ofXYZ and be \nshort 2 calls. That is, he would have a 200-share covered write of XYZ October 50 \ncalls. \nTo see how such an action affects his overall profit picture, note that his average \nstock cost is now 53; he paid 49 for the first 100 shares and paid 57 for the second 100 \nshares bought via the stop order. Since he sold the calls at 6 each, he essentially has a \ncovered write in which he bought stock at 53 and sold calls for 6 points. This does not \nrepresent a lot of profit potential, but it will ensure some profit unless the stock falls \nback below the new break-even point. This new break-even point is 47 - the stock \ncost, 53, less the 6 points received for the call. He will realize the maximum profit \npotential from the covered write as long as the stock remains above 50 until expira\ntion. Since the stock is already at 57, the probabilities are relatively strong that it will \nremain above 50, and even stronger that it will remain above 47, until the expiration \ndate. If the buy stop order was placed just above a technical resistance area, this prob\nability is even better. \nHence, the use of a buy stop order on the upside allows the ratio writer to auto\nmatically convert the ratio write into a covered write if the stock moves up too far. \nOnce the stop goes off, he has a position that will make some profit as long as the \nstock does not experience a fairly substantial price reversal. \nDownside protective action using a sell stop order works in a similar manner. \nExample: The investor placed a \"good until canceled\" sell stop for 100 shares of \nstock after establishing the original position. If this sell stop were placed at 41, for \nexample, the position would become a naked call writer's position if the stock fell to \n41. At that time, the 100 shares of stock that he owned would be sold, at an 8-point \nloss, but he would have the capability of making 12 points from the sale of his two \ncalls as long as the stock remained below 50 until expiration. In fact, his break-even \npoint after converting into the naked write would actually be 52 at expiration, since \nat that price, the calls could be bought back for 2 points each, or 8 points total prof\nit, to offset the 8-point loss on the stock. This action limits his profit potential, but \nwill allow him to make some profit as long as the stock does not experience a strong \nprice reversal and climb back above 52 by expiration. \nThere are several advantages for inexperienced ratio writers to using this \nmethod of protection. First, the implementation of the protective strategies - buying \nan extra 100 shares of stock if the stock moves up, or selling out the 100 shares that \nare long if the stock moves down - is unemotional if the stop orders are placed at the \nChapter 6: Ratio Call Writing 165 \nsame time that the original position is established. This prevents the writer from \nattempting to impose his own market judgment in the heat of battle. That is, if XYZ \nhas moved up to 57, the writer who has not placed a buy stop order may be tempted \nto wait just a little longer, hoping for the stock to fall in price. If the stop orders are \nplaced as soon as the position is established, a great deal of emotion is removed. \nSecond, this strategy will produce some profit - assuming that the stops are proper\nly placed as long as the stock does not whipsaw or experience a price reversal and \ngo back through the striking price in the other directi", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 77}
{"text": "to wait just a little longer, hoping for the stock to fall in price. If the stop orders are \nplaced as soon as the position is established, a great deal of emotion is removed. \nSecond, this strategy will produce some profit - assuming that the stops are proper\nly placed as long as the stock does not whipsaw or experience a price reversal and \ngo back through the striking price in the other direction. Most follow-up actions in \nany writing strategy, whether they involve rolling actions or the use of stops, are sub\nject to losses if the stock whipsaws back and forth. \nThe disadvantage to using this type of protective action is that the writer may \nbe tying up relatively large amounts of capital in order to make only a small profit \nafter the stop order is set off. However, in a diversified portfolio, only a small per\ncentage of the stocks may go through their stop points, thereby still allowing the ratio \nwriter plenty of profit potential on his other positions. \nOnce either the buy stop or the sell stop is set off, the writer still needs to watch \nthe position. His first action after one stop is touched should be to cancel the other \nstop order, because the stops are good orders until they are canceled. From that time \non, the writer need do nothing if the stock does not experience a price reversal. In \nfact, he would just as soon have the stock experience a greater move in the same \ndirection to minimize the chances of a price reversal. \nIf a price reversal does occur, the most conservative action is to close out the \nposition just after the stock crosses back through the striking price. This will normal\nly result in a small loss, but, again, it should happen in only a relatively small number \nof his positions. Recall that .in a limited profit strategy such as ratio writing, it is \nimportant to limit losses as well. If the stock does indeed whipsaw and the position is \nclosed, the writer will still have most of his original equity and can then reestablish a \nnew position in another underlying stock. \nPlacement of Stops. The writer would ideally like to place his stops at \nprices that allow a reasonable rate of return to be made, while also having the \nstops far enough away from the original striking price to reduce the chances of \na whipsaw occurring. It is a fairly simple matter to calculate the returns that \ncould be made, after commissions are included, if one or the other of the stops \ngoes off. Dividends should be included as well, since they will accrue to the \nwriter. If the writer is willing to accept returns as low as 5% annually for those \npositions that go through their stop points, he will be able to place his stops far\nther from the original striking price. If he feels that he needs a higher return \nwhen the stops go off, the stops must be placed closer in. As with any stock or \n166 Part II: Call Option Strategies \noption investment, the writer who operates in large size will experience less of a \ncommission charge, percentagewise. That is, the writer who is buying 500 shares \nof stock and selling 10 calls to start with will be able to place his stop points far\nther out than the writer who is buying 100 shares of stock and selling 2 calls. \nTechnical analysis can be helpful in selecting the stop points as well. If there is \nresistance overhead, the buy stop should be placed above that resistance. Similarly, if \nthere is support, the sell stop should be placed beneath the support point. Later, \nwhen straddles are discussed, it will be seen that this type of strategy can be operat\ned at less of a net commission charge, since the purchase and sale of stock will not be \ninvolved. \nCLOSING OUT THE WRITE \nThe methods of follow-up action discussed above deal ,vith the eventuality of pre\nventing losses. However, if all goes well, the ratio write will begin to accrue profits as \nthe stock remains relatively close to the original striking price. To retain these paper \nprofits that have accrued, it is necessary to move the protective action points closer \ntogether. \nExample: XYZ is at 51 after some time has passed, and the calls are at 3 points each. \nThe writer would, at this time, have an unrealized profit of $800 - $200 from the \nstock purchase at 49, and $300 each on the two calls, which were originally sold at 6 \npoints each. Recall that the maximum potential profit from the position, ifXYZ were \nexactly at 50 at expiration, is $1,300. The writer would like to adjust the protective \npoints so that nearly all of the $800 paper profit might be retained while still allow\ning for the profit to grow to the $1,300 maximum. \nAt expiration, $800 profit would be realized ifXYZ were at 45 or at 55. This can \nbe verified by referring again to Table 6-1 and Figure 6-1. The 45 to 55 range is now \nthe area that the writer must be concerned with. The original profit range of 39 to 61 \nhas become meaningless, since the position has performed well to this point in time. \nIf the writer is using the rolling method of protection, he would roll forward to the \nnext expiration series if the stock were to reach 45 or 55. If he is using the stop-out \nmethod of protection, he could either close the position at 45 or 55 or he could roll \nto the next expiration series and readjust his stop points. The neutral strategist using \ndeltas would determine the number of calls to roll forward to by using the delta of \nthe longer-term call. \nBy moving the protective action points closer together, the ratio writer can then \nadjust his position while he still has a profit; he is attempting to \"lock in\" his profit. \nAs even more time passes and expiration draws nearer, it may be possible to move \nChapter 6: Ratio Call Writing 167 \nthe protective points even closer together. Thus, as the position continues to improve \nover time, the writer should be constantly \"telescoping\" his action points and finally \nroll out to the next expiration series. This is generally the more prudent move, \nbecause the commissions to sell sto", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 78}
{"text": "re time passes and expiration draws nearer, it may be possible to move \nChapter 6: Ratio Call Writing 167 \nthe protective points even closer together. Thus, as the position continues to improve \nover time, the writer should be constantly \"telescoping\" his action points and finally \nroll out to the next expiration series. This is generally the more prudent move, \nbecause the commissions to sell stock to close the position and then buy another \nstock to establish yet another position may prove to be prohibitive. In summary, then, \nas a ratio write nears expiration, the writer should be concerned with an ever-nar\nrowing range within which his profits can grow but outside of which his profits could \ndissipate if he does not take action. \nCOMMENTS ON DELTA-NEUTRAL TRADING \nSince the concept of delta-neutral positions was introduced in this chapter, this is \nan appropriate time to discuss them in a general way. Essentially, a delta-neutral \nposition is a hedged position in which at least two securities are used - two or more \ndifferent options, or at least one option plus the underlying. The deltas of the two \nsecurities offset each other so that the position starts out with an \"equivalent stock \nposition\" (ESP) of 0. Another term for ESP is \"position delta.\" Thus, in theory, \nthere is no price risk to begin with; the position is neutral with respect to price \nmovement of the underlying. That definition lasts for about a nanosecond. \nAs soon as time passes, or the stock moves, or implied volatility changes, the \ndeltas change and therefore the position is no longer delta-neutral. Many people \nseem to have the feeling that a delta-neutral position is somehow one in which it is \neasy to make money without predicting the price direction of the underlying. That is \nnot true. \nDelta-neutral trading is not \"easy\": Either (1) one assumes some price risk as \nsoon as the stock begins to move, or (2) one keeps constantly adjusting his deltas to \nkeep them neutral. Method 2 is not feasible for public traders because of commis\nsions. It is even difficult for market-makers, who pay no commissions. Most public \npractitioners of delta-neutral trading establish a neutral position, but then refrain \nfrom adjusting it too often. \nA common mistake that novice traders make with delta-neutral trading is to \nshort options in a neutral manner, figuring that they have little exposure to price \nchange because the position is delta-neutral. However, a sizeable move by the under\nlying (which often happens in a short period of time) ruins the neutrality of the posi\ntion and inevitably costs the trader a lot of money. A simple example: If one sells a \nnaked straddle (i.e., he sells a naked put and a naked call with both having the same \nstriking price) with the stock initially just below the strike price, that's a delta-ne~tral \n168 Part II: Call Option Strategies \nposition. However, the position has naked options on both sides, and therefore has \ntremendous liability. \nIn practice, professionals watch more than just the delta; they also watch other \nmeasures of the risk of a position. Even then, price and volatility changes can cause \nproblems. Advanced risk concepts are addressed more fully in the chapter on \nAdvanced Concepts. \nSUMMARY \nRatio writing is a viable, neutral strategy that can be employed with differing levels \nof sophistication. The initial ratio of short calls to long stock can be selected simplis\ntically by comparing one's opinion for the underlying stock with projected break-even \npoints from the position. In a more sophisticated manner, the delta of the written \ncalls can be used to determine the ratio. \nSince the strategy has potentially large losses either to the upside or the down\nside, follow-up action is mandatory. This action can be taken by simple methods such \nas rolling up or down in a constant ratio, or by placing stop orders on the underlying \nstock. A more sophisticated technique involves using the delta of the option to either \nadjust the stock position or roll to another call. By using the delta, a theoretically neu\ntral position can be maintained at all times. \nRatio writing is a relatively sophisticated strategy that involves selling naked \ncalls. It is therefore not suitable for all investors. Its attractiveness lies in the fact that \nvast quantities of time value premium are sold and the strategy is profitable for the \nmost probable price outcomes of the underlying stock. It has a relatively large prob\nability of making a limited profit, if the position can be held until expiration without \nfrequent adjustment. \nAN INTRODUCTION TO CALL SPREAD STRATEGIES \nA spread is a transaction in which one simultaneously buys one option and sells \nanother option, with different terms, on the same underlying security. In a call \nspread, the options are all calls. The basic idea behind spreading is that the strategist \nis using the sale of one call to reduce the risk of buying another call. The short call in \na spread is considered covered, for margin purposes, only if the long call has an expi\nration date equal to or longer than the short call. Before delving into the individual \ntypes of spreads, it may be beneficial to cover some general facts that pertain to most \nspread situations. \nChapter 6: Ratio Call Writing 169 \nAll spreads fall into three broad categories: vertical, horizontal, or diagonal. A \nvertical spread is one in which the calls involved have the same expiration date but \ndifferent striking prices. An example might be to buy the XYZ October 30 and sell \nthe October 35 simultaneously. A horizontal spread is one in which the calls have the \nsame striking price but different expiration dates. This is a horizontal spread: Sell the \nXYZ January 35 and buy the XYZ April 35. A diagonal spread is any combination of \nvertical and horizontal and may involve calls that have different expiration dates as \nwell as different striking prices. These three names that classify the spreads can be \nrela", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 79}
{"text": "ontal spread is one in which the calls have the \nsame striking price but different expiration dates. This is a horizontal spread: Sell the \nXYZ January 35 and buy the XYZ April 35. A diagonal spread is any combination of \nvertical and horizontal and may involve calls that have different expiration dates as \nwell as different striking prices. These three names that classify the spreads can be \nrelated to the way option prices are listed in any newspaper summary of closing \noption prices. A vertical spread involves two options from the same column in a news\npaper listing. Newspaper columns run vertically. A horizontal spread involves two \ncalls whose prices are listed in the same row in a newspaper listing; rows are hori\nzontal. This relationship to the listing format in newspapers is not important, but it is \nan easy way to remember what vertical spreads and horizontal spreads are. There are \nmany types of vertical and horizontal spreads, and several of them are discussed in \ndetail in later chapters. \nSPREAD ORDER \nThe term \"spread\" designates not only a type of strategy, but a type of order as well. \nAll spread transactions in which both sides of the spread are opening (initial) trans\nactions must be done in a margin account. This means that the customer must gen\nerally maintain a minimum equity in the account, normally $2,000. Some brokerage \nhouses may also have a maintenance requirement, or \"kicker.\" \nIt is possible to transact a spread in a cash account, but one of the sides must be \na closing transaction. In fact, many of the follow-up actions taken in the covered writ\ning strategy are actually spread transactions. Suppose a covered writer is currently \nshort one XYZ April call against 100 shares of the underlying stock. If he wants to roll \nforward to the July 35 call, he will be buying back the April 35 and selling the July 35 \nsimultaneously. This is a spread transaction, technically, since one call is being bought \nand the other is being sold. However, in this transaction, the buy side is a closing \ntransaction and the sell side is an opening transaction. This type of spread could be \ndone in a cash account. Whenever a covered writer is rolling - up, down, or fmward \nhe should place the order as a spread order to facilitate a better price execution. \nThe spreads discussed in the following chapters are predominantly spread \nstrategies, ones in which both sides of the spread are opening transactions. These are \ndesigned to have their own profit and risk potentials, and are not merely follow-up \nactions to some previously discussed strategy. \n170 Part II: Call Option Strategies \nWhen a spread order is entered, the options being bought and sold must be \nspecified. Two other items must be specified as well: the price at which the spread is \nto be executed, and whether that price is a credit or a debit. If the total price of the \nspread results in a cash inflow to the spread strategist, the spread is a credit spread. \nThis merely means that the sell side of the spread brings in a higher price than is paid \nfor the buy side of the spread. If the reverse is true - that is, there is a cash outflow \nfrom the spread transaction - the spread is said to be a debit spread. This means that \nthe buy side of the spread costs more than is received from the sell side. It is also \ncommon to refer to the purchased side of the spread as the long side and to refer to \nthe written side of the spread as the short side. \nThe price at which a certain spread can be executed is generally not the differ\nence between the last sale prices of the two options involved in the spread. \nExample: An investor wants to buy an XYZ October 30 and simultaneously sell an \nXYZ October 35 call. If the last sale price of the October 30 was 4 points and the last \nsale price of the October 35 was 2 points, it does not necessarily mean that the spread \ncould be done for a 2-point debit (the difference in the last sale prices). In fact, the \nonly way to detennine the market price for a spread transaction is to know what the \nbid and asked prices of the options involved are. Suppose the following quotes are \navailable on these two calls: \nOctober 30 call \nOctober 35 call \nBid \n37/s \nF/s \nAsked \n41/s \n2 \nLost Sole \n4 \n2 \nSince the spread in question involves buying the October 30 call and selling the \nOctober 35, the spreader will, at market, have to pay 41/s for the October 30 ( the asked \nor offering quote) and will receive only F/s (the bid quote) for the October 35. This \nresults in a debit of 2¼ points, significantly more than the 2-point difference in the \nlast sale prices. Of course, one is free to specify any price he wants for any type of \ntransaction. One might enter this spread order at a 21/s-point debit and could have a \nreasonable chance of having the order filled if the floor broker can do better than the \nbid side on the October 35 or better than the offering side on the October 30. \nThe point to be learned here is that one cannot assume that last sale prices are \nindicative of the price at which a spread transaction can be executed. This makes \ncomputer analysis of spread transactions via closing price data somewhat difficult. \nSome computer data services offer (generally at a higher cost) closing bid and asked \nprices as well as closing sale prices. If a strategist is forced to operate with closing \nO,apter 6: Ratio Call Writing 171 \nprices only, however, he should attempt to build some screens into his output to allow \nfor the fact that last sale prices might not be indicative of the price at which the \nspread can be executed. One simple method for screening is to look only at relative\nly liquid options - that is, those that have traded a substantial number of contracts \nduring the previous trading day. If an option is experiencing a great deal of trading \nactivity, there is a much better chance that the current quote is \"tight,\" meaning that \nthe bid and offering prices are quite close to the last sale price.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 80}
{"text": "xecuted. One simple method for screening is to look only at relative\nly liquid options - that is, those that have traded a substantial number of contracts \nduring the previous trading day. If an option is experiencing a great deal of trading \nactivity, there is a much better chance that the current quote is \"tight,\" meaning that \nthe bid and offering prices are quite close to the last sale price. \nIn the early days of listed options, it was somewhat common practice to \"leg\" \ninto a spread. That is, the strategist would place separate buy and sell orders for the \ntwo transactions comprising his spread. As the listed markets have developed, adding \ndepth and liquidity, it is generally a poor idea to leg into a spread. If the floor broker \nhandling the transaction knows the entire transaction, he has a much better chance \nof \"splitting a quote,\" buying on the bid, or selling on the offering. Splitting a quote \nmerely means executing at a price that is between the current bid and asked prices. \nFor example, if the bid is 37/s and the offering is 41/s, a transaction at a price of 4 \nwould be \"splitting the quote.\" \nThe public customer must be aware that spread transactions may involve sub\nstantially higher commission costs, because there are twice as many calls involved in \nany one transaction. Some brokers offer slightly lower rates for spread transactions, \nbut these are not nearly as low as spreads in commodity trading, for example. \nCHAPTER 7 \nBull Spreads \nThe bull spread is one of the most popular forms of spreading. In this type of spread, \none buys a call at a certain striking price and sells a call at a higher striking price. \nGenerally, both options have the same expiration date. This is a vertical spread. A bull \nspread tends to be profitable if the underlying stock rrwves up in price; hence, it is a \nbullish position. The spread has both limited profit potential and limited risk. \nAlthough both can be substantial percentagewise, the risk can never exceed the net \ninvestment. In fact, a bull spread requires a smaller dollar investment and therefore \nhas a smaller maximum dollar loss potential than does an outright call purchase of a \nsimilar call. \nExample: The following prices exist: \nXYZ common, 32; \nXYZ October 30 call, 3; and \nXYZ October 35 call, 1. \nA bull spread would be established by buying the October 30 call and simultaneous\nly selling the October 35 call. Assume that this could be done at the indicated 2-point \ndebit. A call bull spread is always a debit transaction, since the call with the lower \nstriking price must always trade for more than a call with a higher price, if both have \nthe same expiration date. Table 7-1 and Figure 7-1 depict the results of this transac\ntion at expiration. The indicated call profits or losses would be realized if the calls \nwere liquidated at parity at expiration. Note that the spread has a maximum profit \nand this profit is realized if the stock is anywhere above the higher striking price at \nexpiration. The maxipmm loss is realized if the stock is anywhere below the lower \nstrike at expiration, and is equal to the net investment, 2 points in this example. \n172 \nChapter 7: Bull Spreads 173 \nMoreover, there is a break-even point that always lies between the two striking prices \nat expiration. In this example, the break-even point is 32. All bull spreads have prof\nit graphs with the same shape as the one shown in Figure 7-1 when the expiration \ndates are the same for both calls. \nThe investor who establishes this position is bullish on the underlying stock, but \nis generally looking for a way to hedge himself. If he were rampantly bullish, he \nTABLE 7-1. \nResults at expiration of bull spread. \nXYZ Price of \nExpiration \n25 \n30 \n32 \n35 \n40 \n45 \nFIGURE 7-1. \nBull spread. \nc: +$300 \n.Q \n~ \n-~ \nw \nOctober 30 \nProfit \n-$ 300 \n- 300 \n100 \n+ 200 \n+ 700 \n+ 1,200 \nOctober 35 \nProfit \n+$100 \n+ 100 \n+ 100 \n+ 100 \n- 400 \n- 900 \n,, \n,,,' \n;ff \n,,,' \n,,' \niii \n~ \n,,,,' \n$01---------'----J...__.... _ ___. _____ _ \n30 3:?,,' 35 \n0 ::: -$200 \ne 0..-$300 \n, , \n..------,,,,,' \nCall Purchase \n•-----------,' \nStock Price at Expiration \nTotal \nProfit \n-$200 \n- 200 \n0 \n+ 300 \n+ 300 \n+ 300 \n174 Part II: Call Option Strategies \nwould merely buy the October 30 call outright. However, the sale of the October 35 \ncall against the purchase of the October 30 allows him to take a position that will out\nperform the outright purchase of the October 30, dollarwise, as long as the stock does \nnot rise above 36 by expiration. This fact is demonstrated by the dashed line in Figure \n7-1. \nTherefore, the strategist establishing the bull spread is bullish, but not overly so. \nTo verify that this comparison is correct, note that if one bought the October 30 call \noutright for 3 points, he would have a 3-point profit at expiration if XYZ were at 36. \nBoth strategies have a 3-point profit at 36 at expiration. Below 36, the bull spread \ndoes better because the sale of the October 35 call brings in the extra point of pre\nmium. Above 36 at expiration, the outright purchase outperforms the bull spread, \nbecause there is no limit on the profits that can occur in an outright purchase situa\ntion. \nThe net investment required for a bull spread is the net debit plus commissions. \nSince. the spread must be transacted in a margin account, there will generally be a \nminimum equity requirement imposed by the brokerage firm. In addition, there may \nbe a maintenance requirement by some brokers. Suppose that one was establishing \n10 spreads at the prices given in the example above. His investment, before com\nmissions, would be $2,000 ($200 per spread), plus commissions. It is a simple matter \nto compute the break-even point and the maximum profit potential of a call bull \nspread: \nBreak-even point= Lower striking price+ Net debit of spread \nMaximum profit _ Higher striking _ Lower striking _ Net debit \npotential - price price of spread \nIn the example above, the net debit was 2 points. Therefore,", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 81}
{"text": "com\nmissions, would be $2,000 ($200 per spread), plus commissions. It is a simple matter \nto compute the break-even point and the maximum profit potential of a call bull \nspread: \nBreak-even point= Lower striking price+ Net debit of spread \nMaximum profit _ Higher striking _ Lower striking _ Net debit \npotential - price price of spread \nIn the example above, the net debit was 2 points. Therefore, the break-even \npoint would be 30 + 2, or 32. The maximum profit potential would be 35 - 30 - 2, or \n3 points. These figures agree with Table 7-1 and Figure 7-1. Commissions may rep\nresent a significant percentage of the profit and net investment, and should therefore \nbe calculated before establishing the position. If these commissions are included in \nthe net debit to establish the spread, they conveniently fit into the preceding formu\nlae. Commission charges can be reduced percentagewise by spreading a larger quan\ntity of calls. For this reason, it is generally advisable to spread at least 5 options at a \ntime. \nChapter 7: Bull Spreads 175 \nDEGREES OF AGGRESSIVENESS \nAGGRESSIVE BULL SPREAD \nDepending on how the bull spread is constructed, it may be an extremely aggressive \nor more conservative position. The most commonly used bull spread is of the aggres\nsive type; the stock is generally well below the higher striking price when the spread \nis established. This aggressive bull spread generally has the ability to generate sub\nstantial percentage returns if the underlying stock should rise in price far enough by \nexpiration. Aggressive bull spreads are most attractive when the underlying common \nstock is relatively close to the lower striking price at the time the spread is established. \nA bull spread established under these conditions will generally be a low-cost spread \nwith substantial profit potential, even after commissions are included. \nEXTREMELY AGGRESSIVE BULL SPREAD \nAn extremely aggressive type of bull spread is the \"out-of-the-money\" spread. In such \na spread, both calls are out-of-the-money when the spread is established. These \nspreads are extremely inexpensive to establish and have large potential profits if the \nstock should climb to the higher striking price by expiration. However, they are usu\nally quite deceptive in nature. The underlying stock has only a relatively remote \nchance of advancing such a great deal by expiration, and the spreader could realize a \n100% loss of his investment even if the underlying stock advances moderately, since \nboth calls are out-of-the-money. This spread is akin to buying a deeply out-of-the\nmoney call as an outright speculation. It is not recommended that such a strategy be \npursued with more than a very small percentage of one's speculative funds. \nLEAST AGGRESSIVE BULL SPREAD \nAnother type of bull spread can be found occasionally - the \"in-the-money\" spread. \nIn this situation, both calls are in-the-money. This is a much less aggressive position, \nsince it offers a large probability of realizing the maximum profit potential, although \nthat profit potential will be substantially smaller than the profit potentials offered by \nthe more aggressive bull spreads. \nExample: XYZ is at 37 some time before expiration, and the October 30 call is at 7 \nwhile the October 35 call is at 4. Both calls are in-the-money and the spread would \ncost 3 points (debit) to establish. The maximum profit potential is 2 points, but it \nwould be realized as long as XYZ were above 35 at expiration. That is, XYZ could fall \nby 2 points and the spreader would still make his maximum profit. This is certainly a \nmore conservative position than the aggressive spread described above. The com-\n176 Part II: Call Option Strategies \nmission costs in this spread would be substantially larger than those in the spreads \nabove, which involve less expensive options initially, and they should therefore be fig\nured into one's profit calculations before entering into the spread transaction. Since \nthis stock would have to decline 7 points to fall below 30 and cause a loss of the entire \ninvestment, it would have to be considered a rather low-probability event. This fact \nadds to the less aggressive nature of this type of spread. \nRANKING BULL SPREADS \nTo accurately compare the risk and reward potentials of the many bull spreads that \nare available in a given day, one has to use a computer to perform the mass calcula\ntions. It is possible to use a strictly arithmetic method of ranking bull spreads, but \nsuch a list will not be as accurate as the correct method of analysis. In reality, it is \nnecessary to incorporate the volatility of the underlying stock, and possibly the \nexpected return from the spread as well, into one's calculations. The concept of \nexpected return is described in detail in Chapter 28, where a bull spread is used as \nan example. \nThe exact method for using volatility and predicting an option's price after an \nupward movement are presented later. Many data services offer such information. \nHowever, if the reader wants to attempt a simpler method of analysis, the following \none may suffice. In any ranking of bull spreads, it is important not to rank the spreads \nby their maximum potential profits at expiration. Such a ranking will always give the \nmost weight to deeply out-of-the-money spreads, which can rarely achieve their max\nimum profit potential. It would be better to screen out any spreads whose maximum \nprofit prices are too far away from the current stock price. A simple method of allow\ning for a stock's movement might be to assume that the stock could, at expiration, \nadvance by an amount equal to twice the time value premium in an at-the-money \ncall. Since more volatile stocks have options with greater time value premium, this is \na simple attempt to incorporate volatility into the analysis. Also, since longer-term \noptions have more time value premium than do short-term options, this will allow for \nlarger movements during a longer time period. Percentage ret", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 82}
{"text": "advance by an amount equal to twice the time value premium in an at-the-money \ncall. Since more volatile stocks have options with greater time value premium, this is \na simple attempt to incorporate volatility into the analysis. Also, since longer-term \noptions have more time value premium than do short-term options, this will allow for \nlarger movements during a longer time period. Percentage returns should include \ncommission costs. This simple analysis is not completely correct, but it may prove \nuseful to those traders looking for a simple arithmetic method of analysis that can be \ncomputed quickly. \nFURTHER CONSIDERATIONS \nThe bull spreads described in previous examples utilize the same expiration date for \nboth the short call and the long call. It is sometimes useful to buy a call with a longer \nChapter 7: Bull Spreads 177 \ntime to maturity than the short call has. Such a position is known as a diagonal bull \nspread and is discussed in a later chapter. \nExperienced traders often tum to bull spreads when options are expensive. The \nsale of the option at the higher strike partially mitigates the cost of buying an expen\nsive option at the lower strike. However, one should not always use the bull spread \napproach just because the options have a lot of time value premium, for he would be \ngiving up a lot of upside profit potential in order to have a hedged position. \nWith most types of spreads, it is necessary for some time to pass for the spread \nto become significantly profitable, even if the underlying stock moves in favor of the \nspreader. For this reason, bull spreads are not for traders unless the options involved \nare very short-term in nature. If a speculator is bullishly oriented for a short-term \nupward move in an underlying stock, it is generally better for him to buy a call out\nright than to establish a bull spread. Since the spread differential changes mainly as \na function of time, small movements in price by the underlying stock will not cause \nmuch of a short-term change in the price of the spread. However, the bull spread has \na distinct advantage over the purchase of a call if the underlying stock advances mod\nerately by expiration. \nIn the previous example, a bull spread was established by buying the XYZ \nOctober 30 call for 3 points and simultaneously selling the October 35 call for 1 point. \nThis spread can be compared to the outright purchase of the XYZ October 30 alone. \nThere is a short-term advantage in using the outright purchase. \nExample: The underlying stock jumps from 32 to 35 in one day's time. The October \n30 would be selling for approximately 5½ points if that happened, and the outright \npurchaser would be ahead by 2½ points, less one option commission. The long side \nof the bull spread would do as well, of course, since it utilizes the same option, but \nthe short side, the October 35, would probably be selling for about 2½ points. Thus, \nthe bull spread would be worth 3 points in total (5½ points on the long side, less 2½ \npoints loss on the short side). This represents a 1-point profit to the spreader, less two \noption commissions, since the spread was initially established at a debit of 2 points. \nClearly, then, for the shortest time period one day - the outright purchase outper\nforms the bull spread on a quick rise. \nFor a slightly longer time period, such as 30 days, the outright purchase still has \nthe advantage if the underlying stock moves up quickly. Even if the stock should \nadvance above 35 in 30 days, the bull spread will still have time premium in it and \nthus will not yet have reached its maximum spread potential of 5 points. Recall that \nthe maximum potential of a bull spread is always equal to the difference between the \nstriking prices. Clearly, the outright purchaser will do very well if the underlying \nstock should advance that far in 30 days' time. When risk is considered, however, it \n178 Part II: Call Option Strategies \nmust be pointed out that the bull spread has fewer dollars at risk and, if the under\nlying stock should drop rather than rise, the bull spread will often have a smaller loss \nthan the outright call purchase would. \nThe longer it takes for the underlying stock to advance, the more the advantage \nswings to the spread. Suppose XYZ does not get to 35 until expiration. In this case, \nthe October 30 call would be worth 5 points and the October 35 call would be worth\nless. The outright purchase of the October 30 call would make a 2-point profit less \none commission, but the spread would now have a 3-point profit, less two commis\nsions. Even with the increased commissions, the spreader will make more of a prof\nit, both dollarwise and percentagewise. \nMany traders are disappointed with the low profits available from a bull spread \nwhen the stock rises almost immediately after the position is established. One way to \npartially off set the problem with the spread not widening out right away is to use a \ngreater distance between the two strikes. When the distance is great, the spread has \nroom to widen out, even though it won't reach its maximum profit potential right \naway. Still, since the strikes are \"far apart,\" there is more room for the spread to \nwiden even if the underlying stock rises immediately. \nThe conclusion that can be drawn from these examples is that, in general, the \noutright purchase is a better strategy if one is looking for a quick rise by the under\nlying stock. Overall, the bull spread is a less aggressive strategy than the outright pur\nchase of a call. The spread will not produce as much of a profit on a short-term move, \nor on a sustained, large upward move. It will, however, outperform the outright pur\nchase of a call if the stock advances slowly and moderately by expiration. Also, the \nspread always involves fewer actual dollars of risk, because it requires a smaller debit \nto establish initially. Table 7-2 summarizes which strategy has the upper hand for var\nious stock movements over differing time per", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 83}
{"text": "m move, \nor on a sustained, large upward move. It will, however, outperform the outright pur\nchase of a call if the stock advances slowly and moderately by expiration. Also, the \nspread always involves fewer actual dollars of risk, because it requires a smaller debit \nto establish initially. Table 7-2 summarizes which strategy has the upper hand for var\nious stock movements over differing time periods. \nTABLE 7-2. \nBull spread and outright purchase compared. \nIf the underlying stock ... \nRemains \nRelatively Advonces Advances \nDeclines Unchanged Moderately Substantially \nin ... \n1 week Bull spread Bull spread Outright purchase Outright purchase \n1 month Bull spread Bull spread Outright purchase Outright purchase \nAt expiration Bull spread Bull spread Bull spread Outright purchase \nChapter 7: Bull Spreads \nFOLLOW-UP ACTION \n179 \nSince the strategy has both limited profit and limited risk, it is not mandatory for the \nspreader to take any follow-up action prior to expiration. If the underlying stock \nadvances substantially, the spreader should watch the time value premium in the \nshort call closely in order to close the spread if it appears that there is a possibility of \nassignment. This possibility would increase substantially if the time value premium \ndisappeared from the short call. If the stock falls, the trader may want to close the \nspread in order to limit his losses even further. \nWhen the spread is closed, the order should also be entered as a spread trans\naction. If the underlying stock has moved up in price, the order to liquidate would \nbe a credit spread involving two closing transactions. The maximum credit that can \nbe recovered from a bull spread is an amount equal to the difference between the \nstriking prices. In the previous example, if XYZ were above 35 at expiration, one \nmight enter an order to liquidate the spread as follows: Buy the October 35 (it is \ncommon practice to specify the buy side of a spread first when placing an order); \nsell the October 30 at a 5-point credit. In reality, because of the difference between \nbids and offers, it is quite difficult to obtain the entire 5-point credit even if expira\ntion is quite near. Generally, one might ask for a 4¼ or 47/s credit. It is possible to \nclose the spread via exercise, although this method is normally advisable only for \ntraders who pay little or no commissions. If the short side of a spread is assigned, \nthe spreader may satisfy the assignment notice by exercising the long side of his \nspread. There is no margin required to do so, but there are stock commissions \ninvolved. Since these stock commissions to a public customer would be substantial\nly larger than the option commissions involved in closing the spread by liquidating \nthe options, it is recommended that the public customer attempt to liquidate rather \nthan exercise. \nA minor point should be made here. Since the amount of commissions paid to \nliquidate the spread would be larger if higher call prices are involved, the actual net \nmaximum profit point for a bull spread is for the stock to be exactly at the higher \nstriking price at expiration. If the stock exceeds the higher striking price by a great \ndeal, the gross profit will be the same (it was demonstrated earlier that this gross \nprofit is the same anywhere above the higher strike at expiration), but the net profit \nwill be slightly smaller, since the investor will pay more in commissions to liquidate \nthe spread. \nSome spreaders prefer to buy back the short call if the underlying stock drops \nin price, in order to lock in the profit on the short side. They will then hold the long \ncall in hopes of a rise in price by the underlying stock, in order to make the long side \nof the spread profitable as well. This amounts to \"legging\" out of the spread, although \n180 Part II: Call Option Strategies \nthe overall increase in risk is small - the amount paid to repurchase the short call. If \nhe attempts to \"leg\" out of the spread in such a manner, the spreader should not \nattempt to buy back the short call at too high a price. If it can be repurchased at 1/s \nor 1/16, the spreader will be giving away virtually nothing by buying back the short call. \nHowever, he should not be quick to repurchase it if it still has much more value than \nthat, unless he is closing out the entire spread. At no time should one attempt to \"leg\" \nout after a stock price increase, taking the profit on the long side and hoping for a \nstock price decline to make the short side profitable as well. The risk is too great. \nMany traders find themselves in the somewhat perplexing situation of having \nseen the underlying make a large, quick move, only to find that their spread has not \nwidened out much. They often try to figure out a way to perhaps lock in some gains \nin case the underlying subsequently drops in price, but they want to be able to wait \naround for the spread to widen out more toward its maximum profit potential. There \nreally isn't any hedge that can accomplish all of these things. The only position that \ncan lock in the profits in a call bull spread is to purchase the accompanying put bear \nspread. This strategy is discussed in Chapter 23, Spreads Combining Calls and Puts. \nOTHER USES OF BULL SPREADS \nSuperficially, the bull spread is one of the simplest forms of spreading. However, it \ncan be an extremely useful tool in a wide variety of situations. Two such situations \nwere described in Chapter 3. If the outright purchaser of a call finds himself with an \nunrealized loss, he may be able to substantially improve his chances of getting out \neven by \"rolling down\" into a bull spread. If, however, he has an unrealized profit, he \nmay be able to sell a call at the next higher strike, creating a bull spread, in an attempt \nto lock in some of his profit. \nIn a somewhat similar manner, a common stockholder who is faced with an \nunrealized loss may be able to utilize a bull spread to lower the price at which he \ncan break even.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 84}
{"text": "getting out \neven by \"rolling down\" into a bull spread. If, however, he has an unrealized profit, he \nmay be able to sell a call at the next higher strike, creating a bull spread, in an attempt \nto lock in some of his profit. \nIn a somewhat similar manner, a common stockholder who is faced with an \nunrealized loss may be able to utilize a bull spread to lower the price at which he \ncan break even. He may often have a significantly better chance of breaking even or \nmaking a profit by using options. The following example illustrates the stockholder's \nstrategy. \nExample: An investor buys 100 shares of XYZ at 48, and later finds himself with an \nunrealized loss with the stock at 42. A 6-point rally in the stock would be necessary \nin order to break even. However, if XYZ has listed options trading, he may be able to \nsignificantly reduce his break-even price. The prices are: \nChapter 7: Bull Spreads \nXYZ common, 42; \nXYZ October 40, 4; and \nXYZ October 45, 2. \n181 \nThe stock owner could enhance his overall position by buying one October 40 call \nand selling two October 45 calls. Note that no extra money, except commissions, is \nrequired for this transaction, because the credit received from selling two October \n45's is $400 and is equal to the cost of buying the October 40 call. However, mainte\nnance and equity requirements still apply, because a spread has been established. \nThe resulting position does not have an uncovered, or naked, option in it. One \nof the October 45 calls that was sold is covered by the underlying stock itself. The \nother is part of a bull spread with the October 40 call. It is not particularly important \nthat the resulting position is a combination of both a bull spread and a covered write. \nWhat is important is the profit characteristic of this new total position. \nIf XYZ should continue to decline in price and be below 40 at October expira\ntion, all the calls will expire worthless, and the resulting loss to the stock owner will \nbe the same (except for the option commissions spent) as if he had merely held onto \nhis stock without having done any option trading. \nSince both a covered write and a bull spread are strategies with limited profit \npotential, this new position obviously must have a limited profit. If XYZ is anywhere \nabove 45 at October expiration, the maximum profit will be realized. To determine \nthe size of the maximum profit, assume that XYZ is at exactly 45 at expiration. In that \ncase, the two short October 45's would expire worthless and the long October 40 call \nwould be worth 5 points. The option trades would have resulted in a $400 profit on \nthe short side ($200 from each October 45 call) plus a $100 profit on the long side, \nfor a total profit of $500 from the option trades. Since the stock was originally bought \nat 48 in this example, the stock portion of the position is a $300 loss with XYZ at 45 \nat expiration. The overall profit of the position is thus $500 less $300, or $200. \nFor stock prices between 40 and 45 at expiration, the results are shown in \nTable 7-3 and Figure 7-2. Figure 7-2 depicts the two columns from the table labeled \n\"Profit on Stock\" and \"Total Profit,\" so that one can visualize how the new total posi\ntion compares with the original stockholder's profit. Several points should be noted \nfrom either the graph or the table. First, the break-even point is lowered from 48 to \n44. The new total position breaks even at 44, so that only a 2-point rally by the stock \nby expiration is necessary in order to break even. The two strategies are equal at 50 \nat expiration. That is, the stock would have to rally more than 8 points, from 42 to \n50, by expiration for the original stockholder's position to outperform the new posi-\n182 Part II: Call Option Strategies \nTABLE 7-3. \nLowering the break-even price on common stock. \nXYZ Price at Profit on Profit on Short Profit on long Total \nExpiration Stock October 45's October 40 Profit \n35 -$1,300 +$400 -$400 -$1,300 \n38 - 1,000 + 400 - 400 - 1,000 \n40 800 + 400 - 400 800 \n42 600 + 400 - 200 400 \n43 500 + 400 - 100 200 \n44 400 + 400 0 0 \n45 300 + 400 + 100 + 200 \n48 0 - 200 + 400 + 200 \n50 + 200 - 600 + 600 + 200 \ntion. Below 40, the two strategies produce the same result. Finally, between 40 and \n50, the new position outperforms the original stockholder's position. \nIn summary, then, the stockholder stands to gain much and gives away very lit\ntle by adding the indicated options to his stock position. If the stock stabilizes at all -\nanywhere between 40 and 50 in the example above - the new position would be an \nimprovement. Moreover, the investor can break even or make profits on a small rally. \nIf the stock continues to drop heavily, nothing additional will be lost except for option \ncommissions. Only if the stock rallies very sharply will the stock position outperform \nthe total position. \nThis strategy- combining a covered write and a bull spread - is sometimes used \nas an initial ( opening) trade as well. That is, an investor who is considering buying \nXYZ at 42 might decide to buy the October 40 and sell two October 45's (for even \nmoney) at the outset. The resulting position would not be inferior to the outright pur\nchase of XYZ stock, in terms of profit potential, unless XYZ rose above 46 by October \nexpiration. \nBull spreads may also be used as a \"substitute\" for covered writing. Recall from \nChapter 2 that writing against warrants can be useful because of the smaller invest\nment required, especially if the warrant was in-the-money and was not selling at \nmuch of a premium. The same thinking applies to call options. If there is an in-the\nmoney call with little or no time premium remaining in it, its purchase may be used \nas a substitute for buying the stock itself Of course, the call will expire, whereas the \nstock will not; but the profit potential of owning a deeply in-the-money call can be \nChapter 7: Bull Spreads \nFIGURE 7-2. \nLowering the break-even price on common stock. \nC:", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 85}
{"text": "g applies to call options. If there is an in-the\nmoney call with little or no time premium remaining in it, its purchase may be used \nas a substitute for buying the stock itself Of course, the call will expire, whereas the \nstock will not; but the profit potential of owning a deeply in-the-money call can be \nChapter 7: Bull Spreads \nFIGURE 7-2. \nLowering the break-even price on common stock. \nC: \n0 \nI +$200 \niii \n(/) \n$0 (/) \n.:l \n0 \ni5 \ne \nQ. \n-$800 \n40 \nProfit with Options \n, \n,,,' , , \n,,,' \n50 \nStock Price at Expiration \n183 \n;f ,, \nvery similar to owning the stock. Since such a call costs less to purchase than the stock \nitself would, the buyer is getting essentially the same profit or loss potential with a \nsmaller investment. It is natural, then, to think that one might write another call -\none closer to the money- against the deeply in-the-money purchased call. This posi\ntion would have profit characteristics much like a covered write, since the long call \n\"simulates\" the purchase of stock This position really is, of course, a bull spread, in \nwhich the purchased call is well in-the-money and the written call is closer to the \nmoney. Clearly, one would not want to put all of his money into such a strategy and \nforsake covered writing, since, with bull spreads, he could be entirely wiped out in a \nmoderate market decline. In a covered writing strategy, one still owns the stocks even \nafter a severe market decline. However, one may achieve something of a compromise \nby investing a much smaller amount of money in bull spreads than he might have \ninvested in covered writes. He can still retain the same profit potential. The balance \nof the investor's funds could then be placed in interest-bearing securities. \n184 \nExample: The following prices exist: \nXYZ common, 49; \nXYZ April 50 call, 3; and \nXYZ April 35 call, 14. \nPart II: Call Option Strategies \nSince the deeply in-the-money call has no time premium, its purchase will perform \nmuch like the purchase of the stock until April expiration. Table 7-4 summarizes the \nprofit potential from the covered write or the bull spread. The profit potentials are \nthe same from a cash covered write or the bull spread. Both would yield a $400 prof\nit before commissions if XYZ were above 50 at April expiration. However, since the \nbull spread requires a much smaller investment, the spreader could put $3,500 into \ninterest-bearing securities. This interest could be considered the equivalent of \nreceiving the dividends on the stock. In any case, the spreader can lose only $1,100, \neven if the stock declines substantially. The covered writer could have a larger unre\nalized loss than that if XYZ were below 35 at expiration. Also, in the bull spread sit\nuation, the writer can \"roll down\" the April 50 call if the stock declines in price, just \nas he might do in a covered writing situation. \nTABLE 7-4. \nResults for covered write and bull spread compared. \nMaximum profit potential \n(stock over 50 in April) \nBreak-even point \nInvestment \nCovered Write: \nBuy XYZ and Sell \nApril 50 Coll \n$ 400 \n46 \n$4,600 \nBull Spread: \nBuy XYZ April 35 Call and \nSell April 50 Coll \n$ 400 \n46 \n$1,100 \nThus, the bull spread offers the same dollar rewards, the same break-even \npoint, smaller commission costs, less potential risk, and interest income from the \nfixed-income portion of the investment. While it is not always possible to find a \ndeeply in-the-money call to use as a \"substitute\" for buying the stock, when one does \nexist, the strategist should consider using the bull spread instead of the covered write. \nChapter 7: Bull Spreads \nSUMMARY \n185 \nThe bull spread is one of the simplest and most popular forms of spreading. It will \ngenerally perform best in a moderately bullish environment. A bull spread will not \nwiden out to its maximum profit potential right away, though; so for short-term \ntrades, the outright purchase of a call is a better choice. The bull spread can also be \napplied for more sophisticated purposes in a far wider range of situations than mere\nly wanting to attempt to capitalize on a moderate advance by the underlying stock. \nBoth call buyers and stock buyers may be able to use bull spreads to \"roll down\" and \nproduce lower break-even points for their positions. The covered writer may also be \nable to use bull spreads as a substitute for covered writes in certain situations in \nwhich a deeply in-the-money call exists. \nBear Spreads \nUsing Call Options \nOptions are versatile investment vehicles. For every type of bullish position that can \nbe established, there is normally a corresponding bearish type of strategy. For every \nneutral strategy, there is an aggressive strategy for the investor with an opposite opin\nion. One such case has already been explored in some detail; the straddle buy or \nreverse hedge strategy is the opposite side of the spectrum. For many of the strate\ngies to be described from this point on, there is a corresponding strategy designed for \nthe strategist with the opposite point of view. In this vein, a bear spread is the oppo\nsite of a bull spread. \nTHE BEAR SPREAD \nIn a call bear spread, one buys a call at a certain striking price and sells a call at a \nlower striking price. This is a vertical spread, as was the bull spread. The bear spread \ntends to be profitable if the underlying stock declines in price. Llke the bull spread, \nit has limited profit and loss potential. However, unlike the bull spread, the bear \nspread is a credit spread when the spread is set up with call options. Since one is sell\ning the call with the lower strike, and a call at a lower strike always trades at a high\ner price than a call at a higher strike with the same expiration, the bear spread must \nbe a credit position. It should be pointed out that most bearish strategies that can be \nestablished with call options may be more advantageously constructed using put \noptions. Many of these same strategies are therefore discussed again in Part III. \n186 \nChap", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 86}
{"text": "d a call at a lower strike always trades at a high\ner price than a call at a higher strike with the same expiration, the bear spread must \nbe a credit position. It should be pointed out that most bearish strategies that can be \nestablished with call options may be more advantageously constructed using put \noptions. Many of these same strategies are therefore discussed again in Part III. \n186 \nChapter 8: Bear Spreads Using Call Options 187 \nExample: An investor is bearish on XYZ. Using the same prices that were used for \nthe examples in Chapter 7, an example of a bear spread can be constructed for: \nXYZ common, 32; \nXYZ October 30 call, 3; and \nXYZ October 35 call, 1. \nA bear spread would be established by buying the October 35 call and selling the \nOctober 30 call. This would be done for a 2-point credit, before commissions. In a \nbear spread situation, the strategist is hoping that the stock will drop in price and that \nboth options will expire worthless. If this happens, he will not have to pay anything \nto close his spread; he will profit by the entire amount of the original credit taken in. \nIn this example, then, the maximum profit potential is 2 points, since that is the \namount of the initial credit. This profit would be realized if XYZ were anywhere \nbelow 30 at expiration, because both options would expire worthless in that case. \nIf the spread expands in price, rather than contracts, the bear spreader will be \nlosing money. This expansion would occur in a rising market. The maximum amount \nthat this spread could expand to is 5 points - the difference between the striking \nprices. Hence, the most that the bear spreader would have to pay to buy back this \nspread would be 5 points, resulting in a maximum potential loss of 3 points. This loss \nwould be realized if XYZ were anywhere above 35 at October expiration. Table 8-1 \nand Figure 8-1 depict the actual profit and loss potential of this example at expiration \n(commissions are not included). The astute reader will note that the figures in the \ntable are exactly the reverse of those shown for the bull spread example in Chapter \n7. Also, the profit graph of the bear spread looks like a bull spread profit graph that \nhas been turned upside down. All bear spreads have a profit graph with the same \nshape at expiration as the graph shown in Figure 8-1. \nTABLE 8-1. \nBear spread. \nXYZ Price at October 30 October 35 Total \nExpiration Profit Profit Profit \n25 +$300 -$100 +$200 \n30 + 300 - 100 + 200 \n32 + 100 - 100 0 \n35 - 200 - 100 - 300 \n40 - 700 + 400 - 300 \n188 \nFIGURE 8-1. \nBear spread • \n. § +$200 \n\"it! -~ \nw \nCJ) 30 ig \n..J \n0 \n:!: \ne a. -$300 \nPart II: Call Option Strategies \nStock Price at Expiration \nThe break-even point, maximum profit potential, and investment required are \nall quite simple computations for a bear spread. \nMaximum profit potential== Net credit received \nBreak-even point== Lower striking price + Amount of credit \nMaximum Collateral investment = = risk required \nDifference in \nstriking prices \nCredit + Commissions received \nIn the example above, the net credit received from the sale of the October 30 \ncall at 3 and the purchase of the October 35 call at 1 was two points. This is the max\nimum profit potential. The break-even point is then easily computed as the lower \nstriking price, 30, plus the amount of the credit, 2, or 32. The risk is equal to the \ninvestment. It is the difference between the striking prices - 5 points - less the net \ncredit received - 2 points - for a total investment of 3 points plus commissions. Since \nthis spread involves a call that is not \"covered\" by a long call with a striking price \nequal to or lower than that of the short call, some brokerage firms may require a \nhigher maintenance requirement per spread than would be required for a bull \nspread. Again, since a spread must be done in a margin account, most brokerage \nfirms require that a minimum amount of equity be in the account as well. \nSince this is a credit spread, the investor does not really \"spend\" any dollars to \nestablish the spread. The investment is really a reduction in the buying power of the \ncustomer's margin account, but it does not actually require dollars to be spent when \nthe transaction is initiated. \nChapter 8: Bear Spreads Using Call Options \nSELECTING A BEAR SPREAD \n189 \nDepending on where the underlying stock is trading with respect to the two striking \nprices, the bear spread may be very aggressive, with a high profit potential, or it may \nbe less aggressive, with a low profit potential. If a large credit is initially taken in, \nthere is obviously the potential for a good deal of profit. However, for the spread to \ntake in a large credit, the underlying stock must be well above the lower striking \nprice. This means that a relatively substantial downward move would be necessary in \norder for the maximum profit potential to be realized. Thus, a large credit bear \nspread is usually an aggressive position; the spreader needs a substantial move by the \nunderlying stock in order to make his maximum profit. The probabilities of this \noccurring cannot be considered large. \nA less aggressive type of bear spread is one in which the underlying stock is \nactually below the lower striking price when the spread is established. The credit \nreceived from establishing a bear spread in such a situation would be small, but the \nspreader would realize his maximum profit even if the underlying stock remained \nunchanged or actually rose slightly in price by expiration. \nExample: XYZ is trading at a price of 25. The October 30 call might be sold for 1 ½ \npoints and the October 35 call bought for½ point with the stock at 29. While the net \ncredit, and hence the maximum profit potential, is a small dollar amount, 1 point, it \nwill be realized even if XYZ rises slightly by expiration, as long as it does not rise \nabove 30. \nIt is not always clear which type of spread is better, the large credit bear spread \nor the small credit bear s", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 87}
{"text": "be sold for 1 ½ \npoints and the October 35 call bought for½ point with the stock at 29. While the net \ncredit, and hence the maximum profit potential, is a small dollar amount, 1 point, it \nwill be realized even if XYZ rises slightly by expiration, as long as it does not rise \nabove 30. \nIt is not always clear which type of spread is better, the large credit bear spread \nor the small credit bear spread. One has a small probability of making a large profit \nand the other has a much larger probability of making a much smaller profit. In gen\neral, bear spreads established when the underlying stock is closer to the lower strik\ning price will be the best ones. To see this, note that if a bear spread is initiated when \nthe stock is at the higher striking price, the spreader is selling a call that has mostly \nintrinsic value and little time value premium (since it is in-the-money), and is buying \na call that is nearly all time value. This is just the opposite of what the option strate\ngist should be attempting to do. The basic philosophy of option strategy is to sell time \nvalue and buy intrinsic value. For this reason, the large credit bear spread is not an \noptimum strategy. It will be interesting to observe later that bear spreads with puts \nare more attractive when the underlying stock is at the higher striking price! \nA bear spread will not collapse right away, even if the underlying stock drops in \nprice. This is somewhat similar to the effect that was observed with the call bull \nspreads in Chapter 7. They, too, do not accelerate to their maximum profit potential \nright away. Of course, as time winds down and expiration approaches, then the spread \n190 Part II: Call Option Strategies \nwill approach its maximum profit potential. This is important to understand because, \nif one is expecting a quick move down by the underlying stock, he might need to use \na call bear spread in which the lower strike is actually somewhat deeply in-the\nmoney, while the upper strike is out-of-the-money. In this case, the in-the-money call \nwill decline in value as the stock moves down, even if that downward move happens \nimmediately. Meanwhile, the out-of-the-money long call protects against a disastrous \nupside breakout by the stock. This type of bear spread is really akin to selling a deep \nin-the-money call for its raw downside profit potential and buying an out-of-the\nmoney call merely as disaster insurance. \nFOLLOW-UP ACTION \nFollow-up strategies are not difficult, in general, for bear spreads. The major thing \nthat the strategist must be aware of is impending assignment of the short call. If the \nshort side of the spread is in-the-money and has no time premium remaining, the \nspread should be closed regardless of how much time remains until expiration. This \ndisappearance of time value premium could be caused either by the stock being \nsignificantly above the striking price of the stock call, or by an impending dividend \npayment. In either case, the spread should be closed to avoid assignment and the \nresultant large commission costs on stock transactions. Note that the large credit \nbear spread (one established with the stock well above the lower striking price) is \ndangerous from the viewpoint of early assignment, since the time value premium \nin the call will be small to begin with. \nSUMMARY \nThe call bear spread is a bearishly oriented strategy. Since the spread is a credit \nspread, requiring only a reduction in buying power but no actual layout of cash to \nestablish, it is a moderately popular strategy. The bear spread using calls may not be \nthe optimum type of bearish spread that is available; a bear spread using put options \nmaybe. \nCalendar Spreads \nA calendar spread, also frequently called a time spread, involves the sale of one \noption and the simultaneous purchase of a more distant option, both with the same \nstriking price. In the broad definition, the calendar spread is a horizontal spread. The \nneutral philosophy for using calendar spreads is that time will erode the value of the \nnear-term option at a faster rate than it will the far-term option. If this happens, the \nspread will widen and a profit may result at near-term expiration. With call options, \none may construct a more aggressive, bullish calendar spread. Both types of spreads \nare discussed. \nExample: The following prices exist sometime in late January: \nXYZ:50 \nApril 50 Call \n(3-month call) \n5 \nJuly 50 Call \n(6-month call) \n8 \nOctober 50 Call \n(9-month call) \n10 \nIf one sells the April 50 call and buys the July 50 at the same time, he will pay a debit \nof 3 points - the difference in the call prices plus commissions. That is, his invest\nment is the net debit of the spread plus commissions. Furthermore, suppose that in 3 \nmonths, at April expiration, XYZ is unchanged at 50. Then the 3-month call should \nbe worth 5 points, and the 6-month call should be worth 8 points, as they were pre\nviously, all other factors being equal. \nXYZ:50 \nApril 50 Call \n(Expiring) \n0 \nJuly 50 Call \n(3-month call) \n5 \nOctober 50 Call \n(6-month call) \n8 \n191 \n192 Part II: Call Option Strategies \nThe spread between the April 50 and the July 50 has now widened to 5 points. Since \nthe spread cost 3 points originally, this widening effect has produced a 2-point prof\nit. The spread could be closed at this time in order to realize the profit, or the spread\ner may decide to continue to hold the July 50 call that he is long. By continuing to \nhold the July 50 call, he is risking the profits that have accrued to date, but he could \nprofit handsomely if the underlying stock rises in price over the next 3 months, \nbefore July expiration. \nIt is not necessary for the underlying stock to be exactly at the striking price of \nthe options at near-term expiration for a profit to result. In fact, some profit can be \nmade in a range that extends both below and above the striking price. The risk in this \ntype of position is that the stock will drop a great deal or rise a g", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 88}
{"text": "ock rises in price over the next 3 months, \nbefore July expiration. \nIt is not necessary for the underlying stock to be exactly at the striking price of \nthe options at near-term expiration for a profit to result. In fact, some profit can be \nmade in a range that extends both below and above the striking price. The risk in this \ntype of position is that the stock will drop a great deal or rise a great deal, in which \ncase the spread between the two options will shrink and the spreader will lose money. \nSince the spread between two calls at the same strike cannot shrink to less than zero, \nhowever, the risk is limited to the amount of the original debit spent to establish the \nspread, plus commissions. \nTHE NEUTRAL CALENDAR SPREAD \nAs mentioned earlier, the calendar spreader can either have a neutral outlook on the \nstock or he can construct the spread for an aggressively bullish outlook. The neutral \noutlook is described first. The calendar spread that is established when the underly\ning stock is at or near the striking price of the options used is a neutral spread. The \nstrategist is interested in selling time and not in predicting the direction of the under\nlying stock. If the stock is relatively unchanged when the near-term option expires, \nthe neutral spread will make a profit. In a neutral spread, one should initially have \nthe intent of closing the spread by the time the near-tenn option expires. \nLet us again tum to our example calendar spread described earlier in order to \nmore accurately demonstrate the potential risks and rewards from that spread when \nthe near-term, April, call expires. To do this, it is necessary to estimate the price of the \nJuly 50 call at that time. Notice that, with XYZ at 50 at expiration, the results agree \nwith the less detailed example presented earlier. The graph shown in Figure 9-1 is the \n\"total profit\" from Table 9-1. The graph is a curved rather than straight line, since the \nJuly 50 call still has time premium. There is a slightly bullish bias to this graph: The \nprofit range extends slightly farther above the striking price than it does below the \nstriking price. This is due to the fact that the spread is a call spread. If puts had been \nused, the profit range would have a bearish bias. The total width of the profit range is \na function of the volatility of the underlying stock, since that will determine the price \nChapter 9: Calendar Spreads \nFIGURE 9-1. \nCalendar spread at near-term expiration. \nC: \ni +$200 \n$ \n1i:i \n~ \n0 \n~ o. -$300 \nStock Price at Expiration \nTABLE 9-1. \nEstimated profit or losses at April expiration. \nXYZ Stock April 50 April 50 July 50 \nPrice Price Profit Price \n40 0 +$500 1/2 \n45 0 + 500 21/2 \n48 0 + 500 4 \n50 0 + 500 5 \n52 2 + 300 6 \n55 5 0 8 \n60 10 - 500 l 01/2 \n193 \nJuly 50 Total \nProfit Profit \n-$750 -$250 \n- 550 - 50 \n- 400 + 100 \n- 300 + 200 \n- 200 + 100 \n0 0 \n+ 250 - 250 \nof the remaining long call at expiration, as well as a function of the time remaining to \nnear-term expiration. \nTable 9-1 and Figure 9-1 clearly depict several of the more significant aspects \nof the calendar spread. There is a range within which the spread is profitable at near\nterm expiration. That range would appear to be about 46 to 55 in the example. \nOutside that range, losses can occur, but they are limited to the amount of the initial \ndebit. Notice in the example that the stock would have to be well below 40 or well \n194 Part II: Call Option Strategies \nabove 60 for the maximum loss to occur. Even if the stock is at 40 or 60, there is some \ntime premium left in the longer-term option, and the loss is not quite as large as the \nmaximum possible loss of $300. \nThis type of calendar spread has limited profits and relatively large commission \ncosts. It is generally best to establish such a spread 8 to 12 weeks before the near\nterm option expires. If this is done, one is capitalizing on the maximum rate of decay \nof the near-term option with respect to the longer-term option. That is, when a call \nhas less than 8 weeks of life, the rate of decay of its time value premium increases \nsubstantially with respect to the longer-term options on the same stock. \nTHE EFFECT OF VOLATILITY \nThe implied volatility of the options (and hence the actual volatility of the underly\ning stock) will have an effect on the calendar spread. As volatility increases, the \nspread widens; as volatility contracts, the spread shrinks. This is important to know. \nIn effect, buying a calendar spread is an antivolatility strategy: One wants the under\nlying to remain somewhat unchanged. Sometimes, calendar spreads look especially \nattractive when the underlying stock is volatile. However, this can be misleading for \ntwo reasons. First of all, since the stock is volatile, there is a greater chance that it will \nmove outside of the profit area. Second, if the stock does stabilize and trades in a \nrange near the striking price, the spread will lose value because of the decrease in \nvolatility. That loss may be greater than the gain from time decay! \nFOLLOW-UP ACTION \nIdeally, the spreader would like to have the stock be just below the striking price \nwhen the near-term call expires. If this happens, he can close the spread with only \none commission cost, that of selling out the long call. If the calls are in-the-money at \nthe expiration date, he will, of course, have to pay two commissions to close the \nspread. As with all spread positions, the order to close the spread should be placed \nas a single order. \"Legging\" out of a spread is highly risky and is not recommended. \nPrior to expiration, the spreader should close the spread if the near-term short \ncall is trading at parity. He does this to avoid assignment. Being called out of spread \nposition is devastating from the viewpoint of the stock commissions involved for the \npublic customer. The near-term call would not normally be trading at parity until \nquite close to the last day of trading, unless the stock has undergone a", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 89}
{"text": "iration, the spreader should close the spread if the near-term short \ncall is trading at parity. He does this to avoid assignment. Being called out of spread \nposition is devastating from the viewpoint of the stock commissions involved for the \npublic customer. The near-term call would not normally be trading at parity until \nquite close to the last day of trading, unless the stock has undergone a substantial rise \nin price. \nIn the case of an early downside breakout by the underlying stock, the spread\ner has several choices. He could immediately close the spread and take a small loss \nChapter 9: Calendar Spreads 195 \non the position. Another choice is to leave the spread alone until the near-term call \nexpires and then to hope for a partial recovery from the stock in order to be able to \nrecover some value from the long side of the spread. Such a holding action is often \nbetter than the immediate close-out, because the expense of buying back the short \ncall can be quite large percentagewise. A riskier downside defensive action is to sell \nout the long call if the stock begins to break down heavily. In this way, the spreader \nrecovers something from the long side of his spread immediately, and then looks for \nthe stock to remain depressed so that the short side of the spread will expire worth\nless. This action requires that one have enough collateral available to margin the \nresulting naked call, often an amount substantially in excess of the original debit paid \nfor the spread. Moreover, if the underlying stock should reverse direction and rally \nback to or above the striking price, the short side of the spread is naked and could \nproduce substantial losses. The risk assumed by such a follow-up violates the initial \nneutral premise of the spread, and should therefore be avoided. Of these three types \nof downside defensive action, the easiest and rrwst conservative one is to do nothing \nat all, letting the short call expire worthless and then hoping for a recovery by the \nunderlying stock. If this tack is taken, the risk remains fixed at the original debit paid \nfor the spread, and occasionally a rally may produce large profits on the long call. \nAlthough this rally is a nonfrequent event, it generally costs the spreader very little \nto allow himself the opportunity to take advantage of such a rally if it should occur. \nIn fact, the strategist can employ a slight modification of this sort of action, even \nif the spread is not at a large loss. If the underlying stock is moderately below the \nstriking price at near-term expiration, the short option will expire worthless and the \nspreader will be left holding the long option. He could sell the long side immediate\nly and perhaps take a small gain or loss. However, it is often a reasonable strategy to \nsell out a portion of the long side - recovering all or a substantial portion of the ini\ntial investment - and hold the remainder. If the stock rises, the remaining long posi\ntion may appreciate substantially. Although this sort of action deviates from the true \nnature of the time spread, it is not overly risky. \nAn early breakout to the upside by the underlying stock is generally handled in \nmuch the same way as a downside breakout. Doing nothing is often the best course \nof action. If the underlying stock rallies shortly after the spread is established, the \nspread will shrink by a small amount, but not substantially, because both options will \nhold premium in a rally. If the spreader were to rush in to close the position, he \nwould be paying commissions on two rather expensive options. He will usually do \nbetter to wait and give himself as much of a chance for a reversal as possible. In fact, \neven at near-term expiration, there will normally be some time premium left in the \nlong option so that the maximum loss would not have to be realized. A highly risk\noriented upside defensive action is to cover the short call on a technical breakout and \n196 Part II: Call Option Strategies \ncontinue to hold the long call. This can become disastrous if the breakout fails and \nthe stock drops, possibly resulting in losses far in excess of the original debit. \nTherefore, this action cannot be considered anything but extremely aggressive and \nillogical for the neutral strategist. \nIf a breakout does not occur, the spreader will normally be making unrealized \nprofits as time passes. Should this be the case, he may want to set some mental stop\nout points for himself. For example, if the underlying stock is quite close to the strik\ning price with only two weeks to go, there will be some more profit potential left in \nthe spread, but the spreader should be ready to close the position quickly if the stock \nbegins to get too far away from the striking price. In this manner, he can leave room \nfor more profits to accrue, but he is also attempting to protect the profits that have \nalready built up. This is somewhat similar to the action that the ratio writer takes \nwhen he narrows the range of his action points as more and more time passes. \nTHE BULLISH CALENDAR SPREAD \nA less neutral and more bullish type of calendar spread is preferred by the more \naggressive investor. In a bullish calendar spread, one sells the near-term call and buys \na longer-term call, but he does this when the underlying stock is some distance below \nthe striking price of the calls. This type of position has the attractive features of low \ndollar investment and large potential profits. Of course, there is risk involved as well. \nExample: One might set up a bullish calendar spread in the following manner: \nXYZ common, 45; \nsell the XYZ April 50 for l; and \nbuy the XYZ July 50 for 1 ½. \nThis investor ideally wants two things to happen. First, he would like the near\nterm call to expire worthless. That is why the bullish calendar spread is established \nwith out-of-the-money calls: to increase the chances of the short call expiring worth\nless. If this happens, the investor will then own the long", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 90}
{"text": "anner: \nXYZ common, 45; \nsell the XYZ April 50 for l; and \nbuy the XYZ July 50 for 1 ½. \nThis investor ideally wants two things to happen. First, he would like the near\nterm call to expire worthless. That is why the bullish calendar spread is established \nwith out-of-the-money calls: to increase the chances of the short call expiring worth\nless. If this happens, the investor will then own the longer-term call at a net cost of \nhis original debit. In this example, his original debit was only ½ of a point to create \nthe spread. If the April 50 call expires worthless, the investor will own the July 50 call \nat a net cost of ½ point, plus commissions. \nThe investor now needs a second criterion to be fulfilled: The stock must rise in \nprice by the time the July 50 call expires. In this example, even if XYZ were to rally \nto only 52 between April and July, the July 50 call could be sold for at least 2 points. \nThis represents a substantial percentage gain, because the cost of the call has been \nChapter 9: Calendar Spreads 197 \nreduced to ¼ point. Thus, there is the potential for large profits in bullish calendar \nspreads if the underlying stock rallies above the striking price before the longer-term \ncall expires, provided that the short-term call has already expired worthless. \nWhat chance does the investor have that both ideal conditions will occur? There \nis a reasonably good chance that the written call will expire worthless, since it is a \nshort-term call and the stock is below the striking price to start with. If the stock falls, \nor even rises a little - up to, but not above, the striking price the first condition will \nhave been met. It is the second condition, a rally above the striking price by the \nunderlying stock before the longer-term expiration date, that normally presents the \nbiggest problem. The chances of this happening are usually small, but the rewards \ncan be large when it does happen. Thus, this strategy offers a small probability of \nmaking a large profit. In fact, one large profit can easily offset several losses, because \nthe losses are small, dollarwise. Even if the stock remains depressed and the July 50 \ncall in the example expires worthless, the loss is limited to the initial debit of¼ point. \nOf course, this loss represents 100% of the initial investment, so one cannot put all \nhis money into bullish calendar spreads. \nThis strategy is a reasonable way to speculate, provided that the spreader \nadheres to the following criteria when establishing the spread: \n1. Select underlying stocks that are volatile enough to move above the striking price \nwithin the allotted time. Bullish calendar spreads may appear to be very \"cheap\" \non nonvolatile stocks that are well below the striking price. But if a large stock \nmove, say 20%, is required in only a few months, the spread is not worthwhile for \na nonvolatile stock. \n2. Do not use options more than one striking price above the current market. For \nexample, if XYZ were 26, use the 30 strike, not the 35 strike, since the chances \nof a rally to 30 are many times greater than the chances of a rally to 35. \n3. Do not invest a large percentage of available trading capital in bullish calendar \nspreads. Since these are such low-cost spreads, one should be able to follow this \nrule easily and still diversify into several positions. \nFOLLOW-UP ACTION \nIf the underlying stock should rally before the near-term call expires, the bullish cal\nendar spreader must never consider \"legging\" out of the spread, or consider cover\ning the short call at a loss and attempting to ride the long call. Either action could \nturn the initial small, limited loss into a disastrous loss. Since the strategy hinges on \n198 Part II: Call Option Strategies \nthe fact that all the losses will be small and the infrequent large profits will be able \nto overcome these small losses, one should do nothing to jeopardize the strategy and \npossibly generate a large loss. \nThe only reasonable sort of follow-up action that the bullish calendar spreader \ncan take in advance of expiration is to close the spread if the underlying stock has \nmoved up in price and the spread has widened to become profitable. This might \noccur if the stock moves up to the striking price after some time has passed. In the \nexample above, if XYZ moved up to 50 with a month or so of life left in the April 50 \ncall, the call might be selling for I½ while the July 50 call might be selling for 3 \npoints. Thus, the spread could be closed at I½ points, representing a I-point gain \nover the initial debit of 1/2 point. Two commissions would have to be paid to close \nthe spread, of course, but there would still be a net profit in the spread. \nUSING ALL THREE EXPIRATION SERIES \nIn either the neutral calendar spread or the bullish calendar spread, the investor has \nthree choices of which months to use. He could sell the nearest-term call and buy the \nintermediate-term call. This is usually the most common way to set up these spreads. \nHowever, there is no rule that prevents him from selling the intermediate-term and \nbuying the longest-term, or possibly selling the near-term and buying the long-term. \nAny of these situations would still be calendar spreads. \nSome proponents of calendar spreads prefer initially to sell the near-term and \nbuy the long-term call. Then, if the near-term call expires worthless, they have an \nopportunity to sell the intermediate-term call if they so desire. \nExample: An investor establishes a calendar spread by selling the April 50 call and \nbuying the October 50 call. The April call would have less than 3 months remaining \nand the October call would be the long-term call. At April expiration, if XYZ is below \n50, the April call will expire worthless. At that time, the July 50 call could be sold \nagainst the October 50 that is held long, thereby creating another calendar spread \nwith no additional commission cost on the long side. \nThe advantage of this type of strategy is that", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 91}
{"text": "uld have less than 3 months remaining \nand the October call would be the long-term call. At April expiration, if XYZ is below \n50, the April call will expire worthless. At that time, the July 50 call could be sold \nagainst the October 50 that is held long, thereby creating another calendar spread \nwith no additional commission cost on the long side. \nThe advantage of this type of strategy is that it is possible for the two sales (April \n50 and July 50 in this example) to actually bring in more credits than were spent for \nthe one purchase (October 50). Thus, the spreader might be able to create a position \nin which he has a guaranteed profit. That is, if the sum of his transactions is actually \na credit, he cannot lose money in the spread (provided that he does not attempt to \n\"leg\" out of the spread). The disadvantage of using the long-term call in the calendar \nspread is that the initial debit is larger, and therefore more dollars are initially at risk. \nChapter 9: Calendar Spreads 199 \nIf the underlying stock moves substantially up or down in the first 3 months, the \nspreader could realize a larger dollar loss with the October/ April spread because his \nloss will approach the initial debit. \nThe remaining combination of the expiration series is to initially buy the \nlongest-term call and sell the intermediate-term call against it. This combination will \ngenerally require the smallest initial debit, but there is not much profit potential in \nthe spread until the intermediate-term expiration date draws near. Thus, there is a \nlot of time for the underlying stock to move some distance away from the initial strik\ning price. For this reason, this is generally an inferior approach to calendar spread\ning. \nSUMMARY \nCalendar spreading is a low-dollar-cost strategy that is a nonaggressive approach, pro\nvided that the spreader does not invest a large percentage of his trading capital in the \nstrategy, and provided that he does not attempt to \"leg\" into or out of the spreads. \nThe neutral calendar spread is one in which the strategist is mainly selling time; he \nis attempting to capitalize on the known fact that the near-term call will lose time pre\nmium more rapidly than will a longer-term call. A more aggressive approach is the \nbullish calendar spread, in which the speculator is essentially trying to reduce the net \ncost of a longer-term call by the amount of credits taken in from the sale of a nearer\nterm call. This bullish strategy requires that the near-term call expire worthless and \nthen that the underlying stock rise in price. In either strategy, the most common \napproach is to sell the nearest-term call and buy the intermediate-term call. \nHowever, it may sometimes prove advantageous to sell the near-term and buy the \nlongest-term initially, with the intention of letting the near-term expire and then pos\nsibly writing against the longer-term call a second time. \n. CHAPTER 10 \nThe Butterfly Spread \nThe recipient of one of the more exotic names given to spread positions, the butter\nfly spread is a neutral position that is a combination of both a bull spread and a bear \nspread. This spread is for the neutral strategist, one who thinks the underlying stock \nwill not experience much of a net rise or decline by expiration. It generally requires \nonly a small investment and has limited risk. Although profits are limited as well, they \nare larger than the potential risk. For this reason, the butterfly spread is a viable strat\negy. However, it is costly in terms of commissions. In this chapter, the strategy is \nexplained using only calls. The strategy can also be implemented using a combination \nof puts and calls, or with puts only, as will be demonstrated later. \nThere are three striking prices involved in a butterfiy spread. Using only calls, \nthe butterfly spread consists of buying one call at the lowest striking price, selling two \ncalls at the middle striking price, and buying one call at the highest striking price. The \nfollowing example will demonstrate how the butterfly spread works. \nExample: A butterfly spread is established by buying a July 50 call for 12, selling 2 \nJuly 60 calls for 6 each, and buying a July 70 call for 3. The spread requires a rela\ntively low debit of $300 (Table 10-1), although there are four option commissions \ninvolved and these may represent a substantial percentage of the net investment. As \nusual, the maximum amount of profit is realized at the striking price of the written \ncalls. With most types of spreads, this is a useful fact to remember, for it can aid in \nquick computation of the potential of the spread. In this example, if the stock were \nat the striking price of the written options at expiration (60), the two July 60's that are \nshort would expire worthless for a $1,200 gain. The long July 70 call would expire \nworthless for a $300 loss, and the long July 50 call would be worth 10 points, for a \n$200 loss on that call. The sum of the gains and losses would thus be a $700 gain, less \ncommissions. This is the maximum profit potential of the spread. \n200 \nChapter 10: The Butterfly Spread \nTABLE 10-1. \nButterfly spread example. \nCurrent prices: \nXYZ common: \nXYZ July 50 call: \nXYZ July 60 call: \nXYZ July 70 call: \nButterfly spread: \nBuy 1 July 50 call \nSell 2 July 60 calls \nBuy 1 July 70 call \nNet debit \n60 \n12 \n6 \n3 \n$1 ,200 debit \n$1,200 credit \n$300 debit \n$300 (plus commissions) \n201 \nThe risk is limited in a butterfly spread, both to the upside and to the downside, \nand is equal to the amount of the net debit required to establish the spread. In the \nexample above, the risk is limited to $300 plus commissions. \nTable 10-2 and Figure 10-1 depict the results of this butterfly spread at various \nprices at expiration. The profit graph resembles that of a ratio write, except that the \nloss is limited on both the upside and the downside. There is a profit range within \nwhich the butterfly spread makes money - 53 to 67 in the example, before commis\nsions", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 92}
{"text": "le above, the risk is limited to $300 plus commissions. \nTable 10-2 and Figure 10-1 depict the results of this butterfly spread at various \nprices at expiration. The profit graph resembles that of a ratio write, except that the \nloss is limited on both the upside and the downside. There is a profit range within \nwhich the butterfly spread makes money - 53 to 67 in the example, before commis\nsions are included. Outside this profit range, losses will occur at expiration, but these \nlosses are limited to the amount of the original debit plus commissions. \nIn accordance with more lenient margin requirements passed in 2000, the \ninvestment required for a butterfly spread is equal to the net debit expended, which \nis the risk in the spread. When the options expire in the same month and the strik\ning prices are evenly spaced (the spacing is 10 points in this example), the following \nformulae can be used to quickly compute the important details of the butterfly \nspread: \nNet investment= Net debit of the spread \nMaximum profit = Distance between strikes - Net debit \nDownside break-even= Lowest strike+ Net debit \nUpside break-even= Highest strike - Net debit \nIn the example, the distance between strikes is 10 points, the net debit is 3 \npoints (before commissions), the lowest strike used is 50, and the highest strike is 70. \nThese formulae would then yield the following results for this example spread. \n202 Part II: Call Option Strategies \nNet investment= 3 points= $300 \nMaximum profit =10-3 = $700 \nDownside break-even= 50 + 3 = 53 \nFIGURE 10-1. \nButterfly spread. \n+$700 \nUpside break-even = 70 - 3 = 67 \n$0 ___ .....__ _____ _._ __ --' __ _,_ ____ _ \n70 \n0 \n:E -$300----\nJ: \nStock Price at Expiration \nTABLE 10-2. \nResults of butterfly spread at expiration. \nXYZ Price at July 50 July 60 July 70 \nExpiration Profit Profit Profit \n40 -$1,200 +$1,200 -$300 \n50 - 1,200 + 1,200 - 300 \n53 900 + 1,200 - 300 \n56 600 + 1,200 - 300 \n60 200 + 1,200 - 300 \n64 + 200 + 400 - 300 \n67 + 500 200 - 300 \n70 + 800 800 - 300 \n80 + 1,800 - 2,800 + 700 \nTotal \nProfit \n-$300 \n- 300 \n0 \n+ 300 \n+ 700 \n+ 300 \n0 \n- 300 \n- 300 \nChapter 10: The Butterfly Spread 203 \nNote that all of these answers agree with the results that were previously obtained by \nanalyzing the example spread in detail. \nIn this example, the maximum profit potential is $700, the maximum risk is \n$300, and the investment required is also $300, commissions excluded. In percent\nage terms, this means that the butterfly spread has a loss limited to about 100% of \ncapital invested and could make profits of nearly 133% in this case. These represent \nan attractive risk/reward relationship. This is, however, just an example, and two fac\ntors that exist in the actual marketplace may greatly affect these numbers. First, com\nmissions are large; it is possible that eight commissions might have to be paid to \nestablish and liquidate the spread. Second, depending on the level of premiums to \nbe found in the market at any point in time, it may not be possible to establish a \nspread for a debit as low as 3 points when the strikes are 10 points apart. \nSELECTING THE SPREAD \nIdeally, one would want to establish a butterfly spread at as small of a debit as pos\nsible in order to limit his risk to a small amount, although that risk is still equal to \n100% of the dollars invested in the spread. One would also like to have the stock be \nnear the middle striking price to begin with, because he will then be in his maximum \nprofit area if the stock remains relatively unchanged. Unfortunately, it is difficult to \nsatisfy both conditions simultaneously. \nThe smallest-debit butterfly spreads are those in which the stock is some dis\ntance away from the middle striking price. To see this, note that if the stock were \nwell above the middle strike and all the options were at parity, the net debit would \nbe zero. Although no one would attempt to establish a butterfly spread with parity \noptions because of the risk of early assignment, it may be somewhat useful to try to \nobtain a small debit by taking an opinion on the underlying stock. For example, if \nthe stock is close to the higher striking price, the debit would be small normally, but \nthe investor would have to be somewhat bearish on the underlying stock in order to \nmaximize his profit; that is, the stock would have to decline in price from the upper \nstriking price to the middle striking price for the maximum profit to be realized. An \nanalogous situation exists when the underlying stock is originally close to the lower \nstriking price. The investor could establish the spread for a small debit in this case \nalso, but he would now have to be somewhat bullish on the underlying stock in order \nto attempt to realize his maximum profit. \nExample: XYZ is at 70. One may be able to establish a low-debit butterfly spread \nwith the 50's, 60's, and 70's if the following prices exist: \n204 \nXYZ common, 70; \nXYZ July 50, 20; \nXYZ July 60, 12; and \nXYZ July 70, 5. \nPart II: Call Option Strategies \nThe butterfly spread would require a debit of only $100 plus commissions to estab\nlish, because the cost of the calls at the higher and lower strike is 25 points, and a 24-\npoint credit would be obtained by selling two calls at the middle strike. This is indeed \na low-cost butterfly spread, but the stock will have to move down in price for much \nof a profit to be realized. The maximum profit of $900 less commissions would be \nrealized at 60 at expiration. The strategist would have to be bearish on XYZ to want \nto establish such a spread. \nWithout the aid of an example, the reader should be able to determine that if \nXYZ were originally at 50, a low-cost butterfly spread could be established by buying \nthe 50, selling two 60's, and buying a 70. In this case, however, the investor would \nhave to be bullish on the stock, because he would want it to move up to 60 by expi\nration in order for the maximum profit to be realized. \nIn general, then, if the butterfl", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 93}
{"text": "ample, the reader should be able to determine that if \nXYZ were originally at 50, a low-cost butterfly spread could be established by buying \nthe 50, selling two 60's, and buying a 70. In this case, however, the investor would \nhave to be bullish on the stock, because he would want it to move up to 60 by expi\nration in order for the maximum profit to be realized. \nIn general, then, if the butterfly spread is to be established at an extremely low \ndebit, the spreader will have to make a decision as to whether he wants to be bullish \nor bearish on the underlying stock. Many strategists prefer to remain as neutral as \npossible on the underlying stock at all times in any strategy. This philosophy would \nlead to slightly higher debits, such as the $300 debit in the example at the beginning \nof this chapter, but would theoretically have a better chance of making money \nbecause there would be a profit if the stock remained relatively unchanged, the most \nprobable occurrence. \nIn either philosophy, there are other considerations for the butterfly spread. \nThe best butterfly spreads are generally found on the more expensive and/or more \nvolatile stocks that have striking prices spaced 10 or 20 points apart. In these situa\ntions, the maximum profit is large enough to overcome the weight of the commission \ncosts involved in the butterfly spread. When one establishes butterfly spreads on \nlower-priced stocks whose striking prices are only 5 points apart, he is normally put\nting himself at a disadvantage unless the debit is extremely small. One exception to \nthis rule is that attractive situations are often found on higher-priced stocks with \nstriking prices 5 points apart (50, 55, and 60, for example). They do exist from time \nto time. \nIn analyzing butterfly spreads, one commonly works with closing prices. It was \nmentioned earlier that using closing prices for analysis can prove somewhat mislead\ning, since the actual execution will have to be done at bid and asked prices, and these \nChapter 10: The Butterfly Spread 205 \nmay differ somewhat from closing prices. Normally, this difference is small, but since \nthere are three different calls involved in a butterfly spread, the difference could be \nsubstantial. Therefore, it is usually necessary to check the appropriate bid and asked \nprice for each call before entering the spread, in order to be able to place a reason\nable debit on the order. As with other types of spreads, the butterfly spread order can \nbe placed as one order. \nBefore moving on to discuss follow-up action, it may be worthwhile to describe \na tactic for stocks with 5 points between striking prices. For example, the butterfly \nspreader might work with strikes of 45, 50, and 60. If he sets up the usual type of but\nterfly spread, he would end up with a position that has too much risk near 60 and very \nlittle or none at all near 45. If this is what he wants, fine; but if he wants to remain \nneutral, the standard type of butterfly spread will have to be modified slightly. \nExample: The following prices exist: \nXYZ common, 50; \nJuly 45 call, 7; \nJuly 50 call, 5; and \nJuly 60 call, 2. \nThe normal type of butterfly spread- buying one 45, selling two 50's, and buying one \n60 - can actually be done for a credit of 1 point. However, the profitability is no \nlonger symmetric about the middle striking price. In this example, the investor can\nnot lose to the downside because, even if the stock collapses and all the calls expire \nworthless, he will still make his I-point credit. However, to the upside, there is risk: \nIf XYZ is anywhere above 60 at expiration, the risk is 4 points. This is no longer a neu\ntral position. The fact that the lower strike is only 5 points from the middle strike \nwhile the higher strike is 10 points away has made this a somewhat bearish position. \nIf the spreader wants to be neutral and still use these striking prices, he will have to \nput on two bull spreads and only one bear spread. That is, he should: \nBuy 2 July 45's: \nSell 3 July 50's: \nBuy 1 July 60: \n$1,400 debit \n$1,500 credit \n$200 debit \nThis position now has a net debit of $100 but has a better balance of risk at either \nend. If XYZ drops and is below 45 at expiration, the spreader will lose his $100 ini\ntial debit. But now, if XYZ is at or above 60 at expiration, he will lose $100 in that \nrange also. Thus, by establishing two bull spreads with a 5-point difference between \n206 Part II: Call Option Strategies \nstrikes versus one bear spread with a IO-point difference between strikes, the risk has \nbeen balanced at both ends. When one uses strike prices that are not evenly spaced \napart, his margin requirement increases substantially. In such a case, one has to mar\ngin the individual component spreads separately. Therefore, in this example, he \nwould have to pay for the two bull spreads ( $200 each, for a total of $400) and then \nmargin the additional call bear spread ($700: the $1,000 difference in the strikes, less \nthe $300 credit taken in for that portion of the spread). Hence, in this example, the \nmargin requirement would be $1,100, even though the risk is only $100. Technically, \nof that $1,100 requirement, the spread trader pays out only $100 in cash (the actual \ndebit of the spread), and the rest of the requirement can be satisfied with excess \nequity in his account. \nThe same analysis obviously applies whenever 5-point striking price intervals \nexist. There are numerous combinations that could be worked out for lower-priced \nstocks by merely skipping over a striking price ( using the 25's, 30's, and 40's, for exam\nple). Although there are not normally many stocks trading over $100 per share, the \nsame analysis is applicable using 130's, 140's, and 160's, for example. \nFOLLOW-UP ACTION \nSince the butterfly spread has limited risk by its construction, there is usually little \nthat the spreader has to do in the way of follow-up action other than avoiding early \nexercise or possibly dosing out the positi", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 94}
{"text": "r exam\nple). Although there are not normally many stocks trading over $100 per share, the \nsame analysis is applicable using 130's, 140's, and 160's, for example. \nFOLLOW-UP ACTION \nSince the butterfly spread has limited risk by its construction, there is usually little \nthat the spreader has to do in the way of follow-up action other than avoiding early \nexercise or possibly dosing out the position early to take profits or limit losses even \nfurther. The only part of the spread that is subject to assignment is the call at the mid\ndle strike. If this call trades at or near parity, in-the-money, the spread should be \nclosed. This may happen before expiration if the underlying stock is about to go ex\ndividend. It should be noted that accepting assignment will not increase the risk of \nthe spread (because any short calls assigned would still be protected by the remain\ning long calls). However, the margin requirement would change substantially, since \none would now have a synthetic put (long calls, short stock) in place. Plus, there may \nbe more onerous commissions for trading stock. Therefore, it is usually wise to avoid \nassignment in a butterfly spread, or in any spread, for that matter. \nIf the stock is near the middle strike after a reasonable amount of time has \npassed, an unrealized profit will begin to accrue to the spreader. If one feels that the \nunderlying stock is about to move away from the middle striking price and thereby \njeopardize these profits, it may be advantageous to close the spread to take the avail\nable profit. Be certain to include commission costs when determining if an unreal\nized profit exists. As a general rule of thumb, if one is doing 10 spreads at a time, he \nChapter 10: Tire Butterfly Spread 207 \ncan estimate that the commission cost for each option is about 1/s point. That is, if one \nhas 10 butterfly spreads and the spread is currently at 6 points, he could figure that \nhe would net about 5½ points after commissions to close the spread. This 1/s estimate \nis only valid if the spreader has at least 10 options at each strike involved in a spread. \nNormally, one would not close the spread early to limit losses, since these loss\nes are limited to the original net debit in any case. However, if the original debit was \nlarge and the stock is beginning to break out above the higher strike or to break down \nbelow the lower strike, the spreader may want to close the spread to limit losses even \nfurther. \nIt has been repeatedly stated that one should not attempt to ''leg\" out of a \nspread because of the risk that is incurred if one is wrong. However, there is a \nmethod of legging out of a butterfly spread that is acceptable and may even be pru\ndent. Since the spread consists of both a bull spread and a bear spread, it may often \nbe the case that the stock experiences a relatively substantial move in one direction \nor the other during the life of the butterfly spread, and that the bull spread portion \nor the bear spread portion could be closed out near their maximum profit potentials. \nIf this situation arises, the spreader may want to take advantage of it in order to be \nable to profit more if the underlying stock reverses direction and comes back into the \nprofit range. \nExampk: This strategy can be explained by using the initial example from this chap\nter and then assuming that the stock falls from 60 to 45. Recall that this spread was \ninitially established with a 3-point debit and a maximum profit potential of 7 points. \nThe profit range was 53 to 67 at July expiration. However, a rather unpleasant situa\ntion has occurred: The stock has fallen quickly and is below the profit range. If the \nspreader does nothing and keeps the spread on, he will lose 3 points at most if the \nstock remains below 50 until July expiration. However, by increasing his risk slightly, \nhe may be able to improve his position. Notice in Table 10-3 that the bear spread por\ntion of the overall spread - short July 60, long July 70 - has very nearly reached its \nmaximum potential. The bear spread could be bought back for ½ point total (pay 1 \npoint to buy back the July 60 and receive½ point from selling out the July 70). Thus, \nthe spreader could convert the butterfly spread to a bull spread by spending ½ point. \nWhat would such an action do to his overall position? First, his risk would be \nincreased by the ½ point spent to close the bear spread. That is, if XYZ continues to \nremain below 50 until July expiration, he would now lose 3½ rather than 3 points, \nplus commissions in either case. He has, however, potentially helped his chances of \nrealizing something close to the maximum profit available from the original butterfly \nspread. \n208 Part II: Call Option Strategies \nTABLE 10-3. \nInitial spread and current prices. \nInitial Spread Current Prices \nXYZ common: 60 XYZ common: 45 \nJuly 50 call: 12 July 50 call: 2 \nJuly 60 call: 6 July 60 call: 1 \nJuly 70 call: 3 July 70 call: 1/2 \nAfter buying back the bear spread, he is left with the following bull spread: \nLong July 50 call _ N t d b·t 3u, . t \nh l all e e 1 ,2 pom s S ort Ju y 60 c \nHe has a bull spread at the total cost paid to date - 3½ points. From the earlier dis\ncussion of bull spreads, the reader should know that the break-even point for this \nposition is 53½ at expiration, and it could make a 6½ point profit if XYZ is anywhere \nover 60 at July expiration. Hence, the break-even point for the position was raised \nfrom 53 to 53½ by the expense of the ½ point to buy back the bear spread. However, \nif the stock should rally back above 60, the strategist will be making a profit nearly \nequal to the original maximum profit that he was aiming for (7 points). Moreover, this \nprofit is now available anywhere over 60, not just exactly at 60 as it was in the origi\nnal position. Although the chances of such a rally cannot be considered great, it does \nnot cost the spreader much to restructure himself into a position with a much broad\ner maximum p", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 95}
{"text": "ategist will be making a profit nearly \nequal to the original maximum profit that he was aiming for (7 points). Moreover, this \nprofit is now available anywhere over 60, not just exactly at 60 as it was in the origi\nnal position. Although the chances of such a rally cannot be considered great, it does \nnot cost the spreader much to restructure himself into a position with a much broad\ner maximum profit area. \nA similar situation is available if the underlying stock moves up in price. In that \ncase, the bull spread may be able to be removed at nearly its maximum profit poten\ntial, thereby leaving a bear spread. Again, suppose that the same initial spread was \nestablished but that XYZ has risen to 75. When the underlying stock advances sub\nstantially, the bull spread portion of the butterfly spread may expand to near its max\nimum potential. Since the strikes are 10 points apart in this bull spread, the widest it \ncan grow to is 10 points. At the prices shown in Table 10-4, the bull spread - long \nJuly 50 and short July 60 - has grown to 9½ points. Thus, the bull spread position \ncould be removed within ½ point of its maximum profit potential and the original \nbutterfly spread would become a bear spread. Note that the closing of the bull spread \nportion generates a 9½ point credit: The July 50 is sold at 25½ and the July 60 is \nbought back at 16. The original butterfly spread was established at a 3-point debit, so \nthe net position is the remaining position: \nChapter 10: The BatterRy Spread 209 \nLong July 70 call . \nShort July 60 call - Net credit 6½ points \nThis bear spread has a maximum profit potential of 6½ points anywhere below 60 at \nJuly expiration. The maximum risk is 3½ points anywhere above 70 at expiration. \nThus, the original butterfly spread was again converted into a position such that a \nstock price reversal to any price below 60 could produce something close to the max\nimum profit. Moreover, the risk was only increased by an additional ½ point. \nTABLE 10-4. \nInitial spread and new current prices. \nI nitiol Spread \nXYZ common: 60 \nXYZ July 50 call: 12 \nJuly 60 call: 6 \nJuly 70 call: 3 \nSUMMARY \nCurrent Prices \nXYZ common: \nJuly 50 call: \nJuly 60 call: \nJuly 70 call: \n75 \n251/2 \n16 \n7 \nThe butterfly spread is a viable, low-cost strategy with both limited profit potential \nand limited risk. It is actually a combination of a bull spread and a bear spread, and \ninvolves using three striking prices. The risk is limited should the underlying stock \nfall below the lowest strike or rise above the highest strike. The maximum profit is \nobtained at the middle strike. One can keep his initial debits to a minimum by ini\ntially assuming a bullish or bearish posture on the underlying stock. If he would \nrather remain neutral, he will normally have to pay a slightly larger debit to establish \nthe spread, but may have a better chance of making money. If the underlying stock \nexperiences a large move in one direction or the other prior to expiration, the spread\ner may want to close the profitable side of his butterfly spread near its maximum \nprofit potential in order to be able to capitalize on a stock price reversal, should one \noccur. \nRatio Call Spreads \nA ratio call spread is a neutral strategy in which one buys a number of calls at a lower \nstrike and sells more calls at a higher strike. It is somewhat similar to a ratio write in \nconcept, although the spread has less downside risk and normally requires a smaller \ninvestment than does a ratio write. The ratio spread and ratio write are similar in that \nboth involve uncovered calls, and both have profit ranges within which a profit can \nbe made at expiration. Other comparisons are demonstrated throughout the chapter. \nExample: The following prices exist: \nXYZ common, 44; \nXYZ April 40 call, 5; and \nXYZ April 45 call, 3. \nA 2:1 ratio call spread could be established by buying one April 40 call and simulta\nneously selling two April 45's. This spread would be done for a credit of 1 point - the \nsale of the two April 45's bringing in 6 points and the purchase of the April 40 cost\ning 5 points. This spread can be entered as one spread order, specifying the net cred\nit or debit for the position. In this case, the spread would be entered at a net credit \nof 1 point. \nRatio spreads, unlike ratio writes, have a relatively small, limited downside risk. \nIn fact, if the spread is established at an initial credit, there is no downside risk at all. \nIn a ratio spread, the profit or loss at expiration is constant below the lower striking \nprice, because both options would be worthless in that area. In the example above, if \nXYZ is below 40 at April expiration, all the options would expire worthless and the \nspreader would have made a profit of his initial I-point credit, less commissions. This \nI-point gain would occur anywhere below 40 at expiration; it is a constant. \n210 \nChapter 11: Ratio Call Spreads 211 \nThe maximum profit at expiration for a ratio spread occurs if the stock is exact\nly at the striking price of the written options. This is true for nearly all types of strate\ngies involving written options. In the example, if XYZ were at 45 at April expiration, \nthe April 45 calls would expire worthless for a gain of $600 on the two of them, and \nthe April 40 call would be worth 5 points, resulting in no gain or loss on that call. \nThus, the total profit would be $600 less commissions. \nThe greatest risk in a ratio call spread lies to the upside, where the loss may the\noretically be unlimited. The upside break-even point in this example is 51, as shown \nin Table 11-1. The table and Figure 11-1 illustrate the statements made in the pre\nceding paragraphs. \nIn a 2:1 ratio spread, two calls are sold for each one purchased. The maximum \nprofit amount and the upside break-even point can easily be computed by using the \nfollowing formulae: \nPoints of maximum profit = Initial credit + Difference between strikes or \n= Difference between strikes - Initial", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 96}
{"text": "in Table 11-1. The table and Figure 11-1 illustrate the statements made in the pre\nceding paragraphs. \nIn a 2:1 ratio spread, two calls are sold for each one purchased. The maximum \nprofit amount and the upside break-even point can easily be computed by using the \nfollowing formulae: \nPoints of maximum profit = Initial credit + Difference between strikes or \n= Difference between strikes - Initial debit \nUpside break-even point= Higher strike price+ Points of maximum profit \nIn the preceding example, the initial credit was 1 point, so the points of maxi\nmum profit = 1 + 5 = 6, or $600. The upside break-even point is then 45 + 6, or 51. \nThis agrees with the results determined earlier. Note that if the spread is established \nat a debit rather than a credit, the debit is subtracted from the striking price differ\nential to determine the points of maximum profit. \nMany neutral investors prefer ratio spreads over ratio writes for two reasons: \nTABLE 11-1. \nRatio call spread. \nXYZ Price of April 40 Coll April 45 Coll Total \nExpiration Profits Profits Profits \n35 -$ 500 +$ 600 +$100 \n40 - 500 + 600 + 100 \n42 - 300 + 600 + 300 \n45 0 + 600 + 600 \n48 + 300 0 + 300 \n51 + 600 - 600 0 \n55 +1,000 -1,400 - 400 \n60 + 1,500 -2,400 - 900 \n212 Part II: Call Option Strategies \nFIGURE 11 • 1. \nRatio call spread (2: 1 ). \nStock Price at Expiration \n1. The downside risk or gain is predetermined in the ratio spread at expiration, and \ntherefore the position does not require much monitoring on the downside. \n2. The margin investment required for a ratio spread is normally smaller than that \nrequired for a ratio write, since on the long side one is buying a call rather than \nbuying the common stock itself. \nFor margin purposes, a ratio spread is really the combination of a bull spread \nand a naked call write. There is no margin requirement for a bull spread other than \nthe net debit to establish the bull spread. The net investment for the ratio spread is \nthus equal to the collateral required for the naked calls in the spread plus or minus \nthe net debit or credit of the spread. In the example above, there is one naked call. \nThe requirement for the naked call is 20% of the stock price plus the call premium, \nless the out-of-the-money amount. So the requirement in the example would be 20% \nof 44, or $880, plus the call premium of $300, less the one point that the stock is \nbelow the striking price - a $1,080 requirement for the naked call. Since the spread \nwas established at a credit of one point, this credit can also be applied against the ini\ntial requirement, thereby reducing that requirement to $980. Since there is a naked \ncall in this spread, there will be a mark to market if the stock moves up. Just as was \nrecommended for the ratio write, it is recommended that the ratio spreader allow at \nleast enough collateral to reach the upside break-even point. Since the upside break\neven point is 51 in this example, the spreader should allow 20% of 51, or $1,020, plus \nChapter 11: Ratio Call Spreads 213 \nthe 6 points that the call would be worth less the 1-point initial net credit - a total of \n$1,520 for this spread ($1,020 + $600 - $100). \nDIFFERING PHILOSOPHIES \nFor many strategies, there is more than one philosophy of how to implement the \nstrategy. Ratio spreads are no exception, with three philosophies being predominant. \nOne philosophy holds that ratio spreading is quite similar to ratio writing - that one \nshould be looking for opportunities to purchase an in-the-money call with little or no \ntime premium in it so that the ratio spread simulates the profit opportunities from \nthe ratio write as closely as possible with a smaller investment. The ratio spreads \nestablished under this philosophy may have rather large debits if the purchased call \nis substantially in-the-money. Another philosophy of ratio spreading is that spreads \nshould be established for credits so that there is no chance of losing money on the \ndownside. Both philosophies have merit and both are described. A third philosophy, \ncalled the \"delta spread,\" is more concerned with neutrality, regardless of the initial \ndebit or credit. It is also described. \nRATIO SPREAD AS RATIO WRITE \nThere are several spread strategies similar to strategies that involve common stock. In \nthis case, the ratio spread is similar to the ratio write. Whenever such a similarity \nexists, it may be possible for the strategist to buy an in-the-money call with little or no \ntime premium as a substitute for buying the common stock. This was seen earlier in \nthe covered call writing strategy, where it was shown that the purchase of in-the\nmoney calls or warrants might be a viable substitute for the purchase of stock. If one \nis able to buy an in-the-rrwney call as a substitute for the stock, he will not affect his \nprofit potential substantially. When comparing a ratio spread to a ratio write, the max\nimum profit potential and the profit range are reduced by the time value premium \npaid for the long call. If this call is at parity (the time value premium is thus zero), the \nratio spread and the ratio write have exactly the same profit potential. Moreover, the \nnet investment is reduced and there is less downside risk should the stock fall in price \nbelow the striking price of the purchased call. The spread also involves smaller com\nmission costs than does the ratio write, which involves a stock purchase. The ratio \nwriter does receive stock dividends, if any are paid, whereas the spreader does not. \nExample: XYZ is at 50, and an XYZ July 40 call is selling for 11 while an XYZ July 50 \ncall is selling for 5. Table 11-2 compares the important points between the ratio write \nand the ratio spread. \n214 \nTABLE 11-2. \nRatio write and ratio spread compared. \nProfit range \nMaximum profit \nDownside risk \nUpside risk \nInitial investment \nRatio Write: \nBuy XYZ of 50 and \nSell 2 July SO's at 5 \n40 to 60 \n10 points \n40 points \n40 points \n$3,000 \nPart II: Call Option Strategies \nRatio", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 97}
{"text": "ly 50 \ncall is selling for 5. Table 11-2 compares the important points between the ratio write \nand the ratio spread. \n214 \nTABLE 11-2. \nRatio write and ratio spread compared. \nProfit range \nMaximum profit \nDownside risk \nUpside risk \nInitial investment \nRatio Write: \nBuy XYZ of 50 and \nSell 2 July SO's at 5 \n40 to 60 \n10 points \n40 points \n40 points \n$3,000 \nPart II: Call Option Strategies \nRatio Spread: \nBuy 1 July 40 of 11 and \nSell 2 July SO's at 5 \n41 to 59 \n9 points \n1 point \nUnlimited \n$1,600 \nIn Chapter 6, it was pointed out that ratio writing was one of the better strate\ngies from a probability of profit viewpoint. That is, the profit potential conforms well \nto the expected movement of the underlying stock. The same statement holds true \nfor ratio spreads as substitutes for ratio writes. In fact, the ratio spread may often be \na better position than the ratio write itself, when the long call can be purchased with \nlittle or no time value premium in it. \nRATIO SPREAD FOR CREDITS \nThe second philosophy of ratio spreads is to establish them only for credits. \nStrategists who follow this philosophy generally want a second criterion fulfilled also: \nthat the underlying stock be below the striking price of the written calls when the \nspread is established. In fact, the farther the stock is below the strike, the more \nattractive the spread would be. This type of ratio spread has no downside risk \nbecause, even if the stock collapses, the spreader will still make a profit equal to the \ninitial credit received. This application of the ratio spread strategy is actually a sub\ncase of the application discussed above. That is, it may be possible both to buy a long \ncall for little or no time premium, thereby simulating a ratio write, and also to be able \nto set up the position for a credit. \nSince the underlying stock is generally below the maximum profit point when \none establishes a ratio spread for a credit, this is actually a mildly bullish position. \nThe investor would want the stock to move up slightly in order for his maximum prof\nit potential to be realized. Of course, the position does have unlimited upside risk, so \nit is not an overly bullish strategy. \nChapter 11: Ratio Call Spreads 215 \nThese two philosophies are not mutually exclusive. The strategist who uses ratio \nspreads without regard for whether they are debit or credit spreads will generally \nhave a broader array of spreads to choose from and will also be able to assume a more \nneutral posture on the stock. The spreader who insists on generating credits only will \nbe forced to establish spreads on which his return will be slightly smaller if the under\nlying stock remains relatively unchanged. However, he will not have to worry about \ndownside defensive action, since he has no risk to the downside. The third philoso\nphy, the \"delta spread,\" is described after the next section, in which the uses of ratios \nother than 2: 1 are described. \nALTERING THE RATIO \nUnder either of the two philosophies discussed above, the strategist may find that a \n3:1 ratio or a 3:2 ratio better suits his purposes than the 2:1 ratio. It is not common \nto write in a ratio of greater than 4: 1 because of the large increase in upside risk at \nsuch high ratios. The higher the ratio that is used, the higher will be the credits of \nthe spread. This means that the profits to the downside will be greater if the stock \ncollapses. The lower the ratio that is used, the higher the upside break-even point will \nbe, thereby reducing upside risk. \nExample: If the same prices are used as in the initial example in this chapter, it will \nbe possible to demonstrate these facts using three different ratios (Table 11-3): \nXYZ common, 44; \nXYZ April 40 call, 5; and \nXYZ April 45 call, 3. \nTABLE 11-3. \nComparison of three ratios. \nPrice of spread \n(downside risk) \nUpside break-even \nDownside break-even \nMaximum profit \n3:2 Ratio: \nBuy 2 April 40's \nSell 3 April 45's \n1 debit \n54 \n401/2 \n9 \n2:1 Ratio: 3:1 Ratio: \nBy 1 April 40 Buy 1 April 40 \nSell 2 April 45's Sell 3 April 45's \n1 credit 4 credit \n51 49½ \nNone None \n6 9 \n216 Part II: Call Option Strategies \nIn Chapter 6 on ratio writing, it was seen that it was possible to alter the ratio \nto adjust the position to one's outlook for the underlying stock The altering of the \nratio in a ratio spread accomplishes the same objective. In fact, as will be pointed out \nlater in the chapter, the ratio may be adjusted continuously to achieve what is con\nsidered to be a \"neutral spread.\" A similar tactic, using the option's delta, was \ndescribed for ratio writes. \nThe following formulae allow one to determine the maximum profit potential \nand upside break~even point for any ratio: \nPoints of maximum = Net credit+ Number oflong calls x \nprofit Difference in striking prices or \n= Number of long calls X Difference in \nstriking prices - Net debit \nUpside break-even = Points of maximum profit ff h t \"ki . \npoint Number of naked calls + ig er s n ng pnce \nThese formulae can easily be verified by checking the numbers in Table 11-3. \nTHE \"DELTA SPREAD\" \nThe third philosophy of ratio spreading is a more sophisticated approach that is often \nreferred to as the delta spread, because the deltas of the options are used to estab\nlish and monitor the spread. Recall that the delta of a call option is the amount by \nwhich the option is expected to increase in price if the underlying stock should rise \nby one point. Delta spreads are neutral spreads in that one uses the deltas of the two \ncalls to set up a position that is initially neutral. \nExample: The deltas of the two calls that appeared in the previous examples were \n.80 and .50 for the April 40 and April 45, respectively. If one were to buy 5 of the \nApril 40's and simultaneously sell 8 of the April 45's, he would have a delta-neutral \nspread. That is, if XYZ moved up by one point, the 5 April 40 calls would appreciate \nby .80 point each, for a net gain of 4 points. Similarly, the 8 April", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 98}
{"text": "e deltas of the two calls that appeared in the previous examples were \n.80 and .50 for the April 40 and April 45, respectively. If one were to buy 5 of the \nApril 40's and simultaneously sell 8 of the April 45's, he would have a delta-neutral \nspread. That is, if XYZ moved up by one point, the 5 April 40 calls would appreciate \nby .80 point each, for a net gain of 4 points. Similarly, the 8 April 45 calls that he is \nshort would each appreciate by .50 point for a net loss of 4 points on the short side. \nThus, the spread is initially neutral - the long side and the short side will offset each \nother. The idea of setting up this type of neutral spread is to be able to capture the \ntime value premium decay in the preponderance of short calls without subjecting the \nspread to an inordinate amount of market risk. The actual credit or debit of the \nspread is not a determining factor. \nChapter 11: Ratio Call Spreads 217 \nIt is a fairly simple matter to determine the correct ratio to use in the delta \nspread: Merely divide the delta of the purchased call by the delta of the written call. \nIn the example, this implies that the neutral ratio is .80 divided by .50, or 1.6:1. \nObviously, one cannot sell 1.6 calls, so it is common practice to express that ratio as \n16:10. Thus, the neutral spread would consist of buying 10 April 40's and selling 16 \nApril 45's. This is the same as an 8:5 ratio. Notice that this calculation does not \ninclude anything about debits or credits involved in the spread. In this example, an \n8:5 ratio would involve a small debit of one point (5 April 40's cost 25 points and 8 \nApril 45's bring in 24 points). Generally, reasonably selected delta spreads involve \nsmall debits. \nCertain selection criteria can be offered to help the spreader eliminate some of \nthe myriad possibilities of delta spreads on a day-to-day basis. First, one does not \nwant the ratio of the spread to be too large. An absolute limit, such as 4:1, can be \nplaced on all spread candidates. Also, if one eliminates any options selling for less \nthan ½ point as candidates for the short side of the spread, the higher ratios will be \neliminated. Second, one does not want the ratio to be too small. If the delta-neutral \nratio is less than 1.2:1 (6:5), the spread should probably be rejected. Finally, if one is \nconcerned with downside risk, he might want to limit the total debit outlay. This \nmight be done with a simple parameter, such as not paying a debit of more than 1 \npoint per long option. Thus, in a spread involving 10 long calls, the total debit must \nbe 10 points or less. These screens are easily applied, especially with the aid of a com\nputer analysis. One merely uses the deltas to determine the neutral ratio. Then, if it \nis too small or too large, or if it requires the outlay of too large a debit, the spread is \nrejected from consideration. If not, it is a potential candidate for investment. \nFOLLOW-UP ACTION \nDepending on the initial credit or debit of the spread, it may not be necessary to take \nany downside defensive action at all. If the initial debit was large, the writer may roll \ndown the written calls as in a ratio write. \nExample: An investor has established the ratio write by buying an XYZ July 40 call \nand selling two July 60 calls with the stock near 60. He might have done this because \nthe July 40 was selling at parity. If the underlying stock declines, this spreader could \nroll down to the 50's and then to the 45's, in the same manner as he would with a ratio \nwrite. On the other hand, if the spread was initially set up with contiguous striking \nprices, the lower strike being just below the higher strike, no rolling-down action \nwould be necessary. \n218 Part II: Call Option Strategies \nREDUCING THE RATIO \nUpside fallow-up action does not normally consist of rolling up as it does in a ratio \nwrite. Rather, one should usually buy some more long calls to reduce the ratio in the \nspread. Eventually, he would want to reduce the spread to 1:1, or a normal bull \nspread. An example may help to illustrate this concept. \nExample: In the initial example, one April 40 call was bought and two April 45's were \nsold, for a net credit of one point. Assume that the spreader is going to buy one more \nApril 40 as a means of upside defensive action if he has to. When and if he buys this \nsecond long call, his total position will be a normal bull spread - long 2 April 40's and \nshort 2 April 45's. The liquidating value of this bull spread would be 10 points if XYZ \nwere above 45 at April expiration, since each of the two bull spreads would widen to \nits maximum potential (5 points) with the stock above 45 in April. The ratio spread\ner originally brought in a one-point credit for the 2:1 spread. If he were later to pay \n11 points to buy the additional long April 40 call, his total outlay would have been 10 \npoints. This would represent a break-even situation at April expiration if XYZ were \nabove 45 at that time, since it was just shown that the spread could be liquidated for \n10 points in that case. So the ratio spreader could wait to take defensive action until \nthe April call was selling for 11 points. This is a dynamic type of follow-up action, one \nthat is dependent on the options' price, not the stock price per se. \nThis outlay of 11 points for the April 40 would leave a break-even situation as \nlong as the stock did not reverse and fall in price below 45 after the call was bought. \nThe spreader may decide that he would rather leave some room for upside profit \nrather than merely trying to break even if the stock rallies too far. He might thus \ndecide to buy the additional long call at 9 or 10 points rather than waiting for it to get \nto 11. Of course, this might increase the chances of a whipsaw occurring, but it would \nleave some room for upside profits if the stock continues to rise. \nWhere ratios other than 2:1 are involved initially, the same thinking can be \napplied. In fact, the purchase of the ad", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 99}
{"text": "k rallies too far. He might thus \ndecide to buy the additional long call at 9 or 10 points rather than waiting for it to get \nto 11. Of course, this might increase the chances of a whipsaw occurring, but it would \nleave some room for upside profits if the stock continues to rise. \nWhere ratios other than 2:1 are involved initially, the same thinking can be \napplied. In fact, the purchase of the additional long calls might take place in a two\nstep process. \nExample: If the spread was initially long 5 calls and short 10 calls, the spreader \nwould not necessarily have to wait until the April 40's were selling at 11 and then buy \nall 5 needed to make the spread a normal bull spread. He might decide to buy 2 or \n3 at a lower price, thereby reducing his ratio somewhat. Then, if the stock rallied \neven further, he could buy the needed long calls. By buying a few at a cheaper price, \nthe spreader gives himself the leeway to wait considerably longer to the upside. In \nessence, all 5 additional long calls in this spread would have to be bought at an aver\nage price of 11 or lower in order for the spread to break even. However, if the first 2 \nChapter 11: Ratio Call Spreads 219 \nof them are bought for 8 points, the spreader would not have to buy the remaining 3 \nuntil they were selling around 13. Thus, he could wait longer to the upside before \nreducing the spread ratio to 1:1 (a bull spread). A formula can be applied to deter\nmine the price one would have to pay for the additional long calls, to convert the ratio \nspread into a bull spread. If the calls are bought, such a bull spread would break even \nwith the stock above the higher striking price at expiration: \nBreak-even cost of Number of short calls x Difference in strikes -Total debit to date \nlong calls - Number of naked calls \nIn the simple 2: 1 example, the number of short calls was 2, the difference in the \nstrikes was 5, the total debit was minus one (-1) (since it was actually a 1.:.point cred\nit), and the number of naked calls is 1. Thus, the break-even cost of the additional \nlong call is [2 x 5- (-1)(1)]/l = 11. As another verification of the formula, consider \nthe 10:5 spread at the same prices. The initial credit of this spread would be 5 points, \nand the break-even cost of the five additional long calls is 11 points each. Assume that \nthe spreader bought two additional April 40's for 8 points each (16 debit). This would \nmake the total debit to date of the spread equal to 11 points, and reduce the number \nof naked calls to 3. The break-even cost of the remaining 3 long calls that would need \nto be purchased if the stock continued to rally would be (10 x 5 - 11)/3 = 13. This \nagrees with the observation made earlier. This formula can be used before actual fol\nlow-up action is implemented. For example, in the 10:5 spread, if the April 40's were \n. selling for 8, the spreader might ask: \"To what would I raise the purchase price of the \nremaining long calls if I buy 2 April 40's for 8 right now?\" By using the formula, he \ncould easily see that the answer would be 13. \nADJUSTING WITH THE DELTA \nThe theoretically-oriented spreader can use the delta-neutral ratio to monitor his \nspreads as well as to establish them. If the underlying stock moves up in price too far \nor down in price too far, the delta-neutral ratio of the spread will change. The spread\ner can then readjust his spread to a neutral status by buying some additional long calls \non an upside movement by the stock, or by selling some additional short calls on a \ndownward movement by the stock Either action will serve to make the spread delta\nneutral again. The public customer who is employing the delta-neutral adjustment \nmethod of follow-up action should be careful not to overadjust, because the com\nmission costs would become prohibitive. A more detailed description of the use of \ndeltas as a means of follow-up action is contained in Chapter 28 on mathematical \napplications, under the heading \"Facilitation or Institutional Block Positioning.\" The \ngeneral concept, however, is the same as that shown earlier for ratio writing. \n220 Part II: Call Option Strategies \nExample: Early in this chapter, when selection criteria were described, a neutral \nratio was determined to be 16:10, with XYZ at 44. Suppose, after establishing the \nspread, that the common rallied to 4 7. One could use the current deltas to adjust. \nThis information is summarized in Table 11-4. The current neutral ratio is approxi\nmately 14:10. Thus, two of the short April 45's could be bought closing. In practice, \none usually decreases his ratio by adding to the long side. Consequently, one would \nbuy two April 40's, decreasing his overall ratio to 16:12, which is 1.33 and is close to \nthe actual neutral ratio of 1.38. The position would therefore be delta-neutral once \nmore. \nAn alternative way of looking at this is to use the equivalent stock position \n(ESP), which, for any option, is the multiple of the quantity times the delta times the \nshares per option. The last three lines of Table 11-4 show the ESP for each call and \nfor the position as a whole. Initially, the position has an ESP of 0, indicating that it is \nperfectly delta-neutral. In the current situation, however, the position is delta short \n140 shares. Thus, one could adjust the position to be delta-neutral by buying 140 \nshares of XYZ. If he wanted to use the options rather than the stock, he could buy \ntwo April 45's, which would add a delta long of 130 ESP (2 x .65 x 100), leaving the \nposition delta short 10 shares, which is very near neutral. As pointed out in the above \nparagraph, the spreader probably should buy the call with the most intrinsic value -\nthe April 40. Each one of these has an ESP of 90 (1 x .9 x 100). Thus, if one were \nbought, the position would be delta short 50 shares; if two were bought, the total \nposition would be delta long 40 shares. It would be a matter of individual preference \nwhether the spreader wanted to be long or s", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 100}
{"text": "ut in the above \nparagraph, the spreader probably should buy the call with the most intrinsic value -\nthe April 40. Each one of these has an ESP of 90 (1 x .9 x 100). Thus, if one were \nbought, the position would be delta short 50 shares; if two were bought, the total \nposition would be delta long 40 shares. It would be a matter of individual preference \nwhether the spreader wanted to be long or short the \"odd lot\" of 40 or 50 shares, \nrespectively. \nTABLE 11-4. \nOriginal and current prices and deltas. \nXYZ common \nApril 40 call \nApril 45 call \nApril 40 delta \nApril 45 delta \nNeutral ratio \nApril 40 ESP \nApril 45 ESP \nTotal ESP \nOriginal Situation \n44 \n5 \n3 \n.80 \n.50 \n16:10 (.80/.50) \n800 long (l Ox .8 x 100) \n800 shrt ( 16 x .5 x l 00) \n0 (neutral) \nCurrent Situation \n47 \n8 \n5 \n.90 \n.65 \n14:10 (.90/.65 = 1.38) \n900 long (10 x .9 x 100) \nl ,040 shrt ( 16 x .65 x l 00) \n140 shrt \nChapter 11: Ratio Call Spreads 221 \nThe ESP method is merely a confirmation of the other method. Either one \nworks well. The spreader should become familiar with the ESP method because, in \na position with many different options, it reduces the exposure of the entire position \nto a single number. \nTAKING PROFITS \nIn addition to defensive action, the spreader may find that he can close the spread \nearly to take a profit or to limit losses. If enough time has passed and the underlying \nstock is close to the maximum profit point - the higher striking price - the spreader \nmay want to consider closing the spread and taking his profit. Similarly, if the under\nlying stock is somewhere between the two strikes as expiration draws near, the writer \nwill normally find himself with a profit as the long call retains some intrinsic value \nand the short calls are nearly worthless. If at this time one feels that there is little to \ngain (a price decline might wipe out the long call value), he should close the spread \nand take his profit. \nSUMMARY \nRatio spreads can be an attractive strategy, similar in some ways to ratio writing. Both \nstrategies offer a large probability of making a limited profit. The ratio spread has \nlimited downside risk, or possibly no downside risk at all. In addition, if the long \ncall(s) in the spread can be bought with little or no time value premium in them, the \nratio spread becomes a superior strategy to the ratio write. One can adjust the ratio \nused to reflect his opinion of the underlying stock or to make a neutral profit range \nif desired. The ratio adjustment can be accomplished by using the deltas of the \noptions. In a broad sense, this is one of the more attractive forms of spreading, since \nthe strategist is buying mostly intrinsic value and is selling a relatively large amount \nof time value. \nCotnbining Calendar \nand Ratio Spreads \nThe previous chapters on spreading introduced the basic types of spreads. The sim\nplest forms of bull spreads, bear spreads, or calendar spreads can often be combined \nto produce a position with a more attractive potential. The butterfly spread, which is \na combination of a bull spread and a bear spread, is an example of such a combina\ntion. The next three chapters are devoted to describing other combinations of \nspreads, wherein the strategist not only mixes basic strategies ..:... bull, bear, and calen\ndar - but uses varying expiration dates as well. Although they may seem overly com\nplicated at first glance, these combinations are often employed by professionals in the \nfield. \nRATIO CALENDAR SPREAD \nThe ratio cdendar spread is a combination of the techniques used in the calendar \nand ratio spreads. Recall that one philosophy of the calendar spread strategy was to \nsell the near-term call and buy a longer-term call, with both being out-of-the-money. \nThis is a bullish calendar spread. If the underlying stock never advances, the spread\ner loses the entire amount of the relatively small debit that he paid for the spread. \nHowever, if the stock advances after the near-term call expires worthless, large prof\nits are possible. It was stated that this bullish calendar spread philosophy had a small \nprobability of attaining large profits, and that the few profits could easily exceed the \npreponderance of small losses. \nThe ratio calendar spread is an attempt to raise the probabilities while allowing \nfor large potential profits. In the ratio calendar spread, one sells a number of near-\n222 \nChapter 12: Combining Calendar and Ratio Spreads 223 \nterm calls while buyingfewer of the intermediate-term or long-term calls. Since more \ncalls are being sold than are being bought, naked options are involved. It is often pos\nsible to set up a ratio calendar spread for a credit, meaning that if the underlying \nstock never rallies above the strike, the strategist will still make money. However, \nsince naked calls are involved, the collateral requirements for participating in this \nstrategy may be large. \nExample: As in the bullish calendar spreads described in Chapter 9, the prices are: \nXYZ common, 45; \nXYZ April 50 call, l; and \nXYZ July 50 call, l½. \nIn the bullish calendar spread strategy, one July 50 is bought for each April 50 sold. \nThis means that the spread is established for a debit of½ point and that the invest\nment is $50 per spread, plus commissions. The strategist using the ratio calendar \n/ spread has essentially the same philosophy as the bullish calendar spreader: The \nstock will remain below 50 until April expiration and may then rally. The ratio calen\ndar spread might be set up as follows: \nBuy 1 XYZ July 50 call at l½ \nSell 2 XYZ April 50 calls at 1 each \nNet \nl½ debit \n2 credit \n½ credit \nAlthough there is no cash involved in setting up the ratio spread since it is done for \na credit, there is a collateral requirement for the naked April 50 call. \nIf the stock remains below 50 until April expiration, the long call - the July 50 \n- will be owned free. After that, no matter what happens to the underlying stock, the \nspread cannot lose money. In fact, if the u", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 101}
{"text": "bit \n2 credit \n½ credit \nAlthough there is no cash involved in setting up the ratio spread since it is done for \na credit, there is a collateral requirement for the naked April 50 call. \nIf the stock remains below 50 until April expiration, the long call - the July 50 \n- will be owned free. After that, no matter what happens to the underlying stock, the \nspread cannot lose money. In fact, if the underlying stock advances dramatically after \nnear-term expiration, large profits will accrue as the July 50 call increases in value. Of \ncourse, this is entirely dependent on the near-term call expiring worthless. If the \nunderlying stock should rally above 50 before the April calls expire, the ratio calen\ndar spread is in danger of losing a large amount of money because of the naked calls, \nand defensive action must be taken. Follow-up actions are described later. \nThe collateral required for the ratio calendar spread is equal to the amount of \ncollateral required for the naked calls less the credit taken in for the spread. Since \nnaked calls will be marked to market as the stock moves up, it is always best to allow \nenough collateral to get to a defensive action point. In the example above, suppose \nthat one felt he would definitely be taking defensive action if the stock rallied to 53 \n224 Part II: Call Option Strategies \nbefore April expiration. He should then figure his collateral requirement as if the \nstock were at 53, regardless of what the collateral requirement is at the current time. \nThis is a prudent tactic whenever naked options are involved, since the strategist will \nnever be forced into an unwanted close-out before his defensive action point is \nreached. The collateral required for this example would then be as follows, assuming \nthe call is trading at 3½: \n20% of 53 \nCall premium \nLess initial credit \nTotal collateral to set aside \n$1,060 \n+ 350 \n-___fill \n$1,360 \nThe strategist is not really \"investing\" anything in this strategy, because his require\nment is in the form of collateral, not cash. That is, his current portfolio assets need \nnot be disturbed to set up this spread, although losses would, of course, create deb\nits in the account. Many naked option strategies are similar in this respect, and the \nstrategist may earn additional money from the collateral value of his portfolio with\nout disturbing the portfolio itself. However, he should take care to operate such \nstrategies in a conservative manner, since any income earned is \"free,\" but losses may \nforce him to disturb his portfolio. In light of this fact, it is always difficult to compute \nreturns on investment in a strategy that requires only collateral to operate. One can, \nof course, compute the return on the maximum collateral required during the life of \nthe position. The large investor participating in such a strategy should be satisfied \nwith any sort of positive return. \nReturning to the example above, the strategist would make his $50 credit, less \ncommissions, if the underlying stock remained below 50 until July expiration. It is not \npossible to determine the results to the upside so definitively. If the April 50 calls \nexpire worthless and then the stock rallies, the potential profits are limited only by \ntime. The case in which the stock rallies before April expiration is of the most con\ncern. If the stock rallies immediately, the spread will undoubtedly show a loss. If the \nstock rallies to 50 more slowly, but still before April expiration, it is possible that the \nspread will not have changed much. Using the same example, suppose that XYZ ral\nlies to 50 with only a few weeks of life remaining in the April 50 calls. Then the April \n50 calls might be selling at l ½ while the July 50 call might be selling at 3. The ratio \nspread could be closed for even money at that point; the cost of buying back the 2 \nApril 50's would equal the credit received from selling the one July 50. He would thus \nmake½ point, less commissions, on the entire spread transaction. Finally, at the expi\nration date of the April 50 calls, one can estimate where he would break even. \nSuppose one estimated that the July 50 call would be selling for 5½ points if XYZ \nwere at 53 at April expiration. Since the April 50 calls would be selling for 3 at that \nChapter 12: Combining Calendar and Ratio Spreads 225 \ntime (they would be at parity), there would be a debit of½ point to close the ratio \nspread. The two April 50 calls would be bought for 6 points and the July 50 call sold \nfor 5½ - a ½ debit. The entire spread transaction would thus have broken even, less \ncommissions, at 53 at April expiration, since the spread was put on for a ½ credit and \nwas taken off for a ½ debit. The risk to the upside depends clearly, then, on how \nquickly the stock rallies above 50 before April expiration. \nCHOOSING THE SPREAD \nSome of the same criteria used in setting up a bullish calendar spread apply here as \nwell. Select a stock that is volatile enough to move above the striking price in the \nallotted time - after the near-term expires, but before the long call expires. Do not \nuse calls that are so far out-of-the-money that it would be virtually impossible for the \nstock to reach the striking price. Always set up the spread for a credit, commissions \nincluded. This will assure that a profit will be made even if the stock goes nowhere. \nHowever, if the credit has to be generated by using an extremely large ratio - greater \nthan 3 short calls to every long one - one should probably reject that choice, since \nthe potential losses in an immediate rally would be large. \nThe upside break-even point prior to April expiration should be determined \nusing a pricing model. Such a model, or the output from one, can generally be \nobtained from a data service or from some brokerage firms. It is useful to the strate\ngist to know exactly how much room he has to the upside if the stock begins to rally. \nThis will allow him to take defensive action in the form of closing", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 102}
{"text": "e. \nThe upside break-even point prior to April expiration should be determined \nusing a pricing model. Such a model, or the output from one, can generally be \nobtained from a data service or from some brokerage firms. It is useful to the strate\ngist to know exactly how much room he has to the upside if the stock begins to rally. \nThis will allow him to take defensive action in the form of closing out the spread \nbefore his break-even point is reached. Since a pricing model can estimate a call \nprice for any length of time, the strategist can compute his break-even points at \nApril expiration, 1 month before April expiration, 6 weeks before, and so on. When \nthe long option in a spread expires at a different time from the short option, the \nbreak-even point is dynamic. That is, it changes with time. Table 12-1 shows how \nthis information might be accumulated for the example spread used above. Since \nthis example spread was established for a ½-point credit with the stock at 45, the \nbreak-even points would be at stock prices where the spread could be removed for \na ½-point debit. Suppose the spread was initiated with 95 days remaining until April \nexpiration. In each line of the table, the cost for buying 2 April 50's is ½ point more \nthan the price of the July 50. That is, there would be a ½-point debit involved in \nclosing the spread at those prices. Notice that the break-even price increases as time \npasses. Initially, the spread would show a loss if the stock moved up at all. This is to \nbe expected, since an immediate move would not allow for any erosion in the time \nvalue premium of the near-term calls. As more and more time passes, time weighs \n226 Part II: Call Option Strategies \nmore heavily on the near-term April calls than on the longer-term July call. Once the \nstrategist has this information, he might then look at a chart of the underlying stock. \nIf there is resistance for XYZ below 53, his eventual break-even point at April expi\nration, he could then feel more confident about this spread. \nFOLLOW-UP ACTION \nThe main purpose of defensive action in this strategy is to limit losses if the stock \nshould rally before April e:xJ)iration. The strategist should be quick to close out the \nspread before any serious losses accrue. The long call quite adequately compen\nsates for the losses on the short calls up to a certain point, a fact demonstrated in \nTable 12-1. However, the stock cannot be allowed to run. A rule of thumb that is \noften useful is to close the spread if the stock breaks out above technical resistance \nor if it breaks above the eventual break-even point at expiration. In the example \nabove, the strategist would close the spread if, at any time, XYZ rose above 53 \n(before April expiration, of course). \nIf a significant amount of time has passed, the strategist might act even more \nquickly in closing the spread. As was shown earlier, if the stock rallies to 50 with only \na few weeks of time remaining, the spread may actually be at a slight profit at that \ntime. It is often the best course of action to take the small profit, if the stock rises \nabove the striking price. \nTABLE 12-1. \nBreak-even points changing over time. \nEstimated Estimated \nDays Remaining until Break-Even Point April 50 July 50 \nApril Expiration (Stock Price) Price Price \n90 45 11/2 \n60 48 Jl/2 21/2 \n30 51 21/2 4 1/2 \n0 53 3 51/2 \nTHE PROBABILITIES ARE GOOD \nThis is a strategy with a rather large probability of profit, provided that the defensive \naction described above is adhered to. The spread will make money if the stock never \nrallies above the striking price, since the spread is established for a credit. This in \nChapter 12: Combining Calendar and Ratio Spreads 227 \nitself is a rather high-probability event, because the stock is initially below the strik\ning price. In addition, the spread can make large potential profits if the stock rallies \nafter the near-term calls expire. Although this is a much less probable event, the prof\nits that can accrue add to the expected return of the spread. The only time the spread \nloses is when the stock rallies quickly, and the strategist should close out the spread \nin that case to limit losses. \nAlthough Table 12-2 is not mathematically definitive, it can be seen that this \nstrategy has a positive expected return. Small profits occur more frequently than \nsmall losses do, and sometimes large profits can occur. These expected outcomes, \nwhen coupled with the fact that the strategist may utilize collateral such as stocks, \nbonds, or government securities to set up these spreads, demonstrate that this is a \nviable strategy for the advanced investor. \nTABLE 12-2. \nProfitability of ratio calendar spreading. \nEvent \nStock never rallies above \nstrike \nStock rallies above strike in a \nshort time \nStock rallies above strike after \nnear-term call expires \nOutcome \nSmall profit. \nSmall loss if defensive \naction employed \nLarge potential profit \nDELTA-NEUTRAL CALENDAR SPREADS \nProbability \nLarge probability \nSmall probability \nSmall probability \nThe preceding discussion dealt with a specific kind of ratio calendar spread, the out\nof-the-money call spread. A more accurate ratio can be constructed using the deltas \nof the calls involved, similar to the ratio spreads in Chapter 11. The spread can be \ncreated with either out-of-the-money calls or in-the-money calls. The former has \nnaked calls, while the latter has extra long calls. Both types of ratio calendars are \ndescribed. \nIn either case, the number of calls to sell for each one purchased is determined \nby dividing the delta of the long call by the delta of the short call. This is the same \nfor any ratio spread, not just calendars. \nExample: Suppose XYZ is trading at 45 and one is considering using the July 50 call \nand the April 50 call to establish a ratio calendar spread. This is the same situation \n228 Part II: Call Option Strategies \nthat was described earlier in this chapter. Furthermore, assume that the deltas of", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 103}
{"text": "the long call by the delta of the short call. This is the same \nfor any ratio spread, not just calendars. \nExample: Suppose XYZ is trading at 45 and one is considering using the July 50 call \nand the April 50 call to establish a ratio calendar spread. This is the same situation \n228 Part II: Call Option Strategies \nthat was described earlier in this chapter. Furthermore, assume that the deltas of the \ncalls in question are .25 for the July and .15 for the April. Given that information, one \ncan compute the neutral ratio to be 1.667 to 1 (.25/.15). That is, one would sell 1.667 \ncalls for each one he bought; restated, he would sell 5 for each 3 bought. \nThis out-of-the-money neutral calendar is typical. One normally sells more calls \nthan he buys to establish a neutral calendar when the calls are out-of-the-money. The \nramifications of this strategy have already been described in this chapter. Follow-up \nstrategy is slightly different, though, and is described later. \nTHE IN-THE-MONEY CALENDAR SPREAD \nWhen the calls are in-the-money, the neutral spread has a distinctly different look. \nAn example will help in describing the situation. \nExample: XYZ is trading at 49, and one wants to establish a neutral calendar spread \nusing the July 45 and April 45 calls. The deltas of these in-the-money calls are .8 for \nthe April and .7 for the July. Note that for in-the-rrwney calls, a shorter-term call has \na higher delta than a longer-term call. \nThe neutral ratio for this in-the-money spread would be .875 to 1 (.7/.8). This \nmeans that .875 calls would be sold for each one bought; restated, 7 calls would be \nsold and 8 bought. Thus, the spreader is buying more calls than he is selling when \nestablishing an in-the-money neutral calendar. In some sense, one is establishing \nsome \"regular'' calendar spreads (seven of them, in this example) and simultaneous\nly buying a few extra long calls to go along with them ( one extra long call, in this \nexample). \nThis type of position can be quite attractive. First of all, there is no risk to the \nupside as there is with the out-of-the-money calendar; the in-the-money calendar \nwould make money, because there are extra long calls in the position. Thus, if there \nwere to be a large gap to the upside in XYZ perhaps caused by a takeover attempt \n- the in-the-money calendar would make money. If, on the other hand, XYZ stays in \nthe same area, then the regular calendar spread portion of the strategy will make \nmoney. Even though the extra call would probably lose some time value premium in \nthat event, the other seven spreads would make a large enough profit to easily com\npensate for the loss on the one long call. The least desirable result would be for XYZ \nto drop precipitously. However, in that case, the loss is limited to the amount of the \ninitial debit of the spread. Even in the case of XYZ dropping, though, follow-up \naction can be taken. There are no naked calls to margin with this strategy, making it \nattractive to many smaller investors. In the above example, one would need to pay for \nthe entire debit of the position, but there would be no further requirements. \nChapter 12: Combining Calendar and Ratio Spreads \nFOLLOW-UP ACTION \n229 \nIf one decides to preserve a neutral strategy with follow-up action in either type of \nratio call calendar, he would merely need to look at the deltas of the calls and keep \nthe ratio neutral. Doing so might mean that one would switch from one type of cal\nendar spread to the other, from the out-of-the-money with naked calls to the in-the\nmoney with extra long calls, or vice versa. For example, if XYZ started at 45, as in the \nfirst example, one would have sold more calls than he bought. If XYZ then rallied \nabove 50, he would have to move his position into the in-the-money ratio and get \nlong more calls than he is short. \nWhile such follow-up action is strategically correct maintaining the neutral \nratio - it might not make sense practically, especially if the size of the original spread \nwere small. If one had originally sold 5 and bought 3, he would be better to adhere \nto the follow-up strategy outlined earlier in this chapter. The spread is not large \nenough to dictate adjusting via the delta-neutral ratios. If, however, a large trader had \noriginally sold 500 calls and bought 300, then he has enough profitability in the \nspread to make several adjustments along the way. \nIn a similar manner, the spreader who had established a small in-the-money cal\nendar might decide not to bother rationing the spread if the stock dropped below the \nstrike. He knows his risk is limited to his initial debit, and that would be small for a \nsmall spread. He might not want to introduce naked options into the position if XYZ \ndeclines. However, if the same spread were established by a large trader, it should be \nadjusted because of the greater tolerance of the spread to being adjusted, merely \nbecause of its size. \nReverse Spreads \nIn general, when a strategy has the term \"reverse\" in its name, the strategy is the \nopposite of a more commonly used strategy. The reader should be familiar with this \nnomenclature from the earlier discussions comparing ratio writing (buying stock and \nselling calls) with reverse hedging (shorting stock and buying calls). If the reverse \nstrategy is sufficiently well-known, it usually acquires a name of its own. For exam\nple, the bear spread is really the reverse of the bull spread, but the bear spread is a \npopular enough strategy in its own right to have acquired a shorter, unique name. \nREVERSE CALENDAR SPREAD \nThe reverse calendar spread is an infrequently used strategy, at least for public cus\ntomers trading stock or index options, because of the margin requirements. However, \neven then, it does have a place in the arsenal of the option strategist. Meanwhile, pro\nfessionals and futures option traders use the strategy with more frequency because \nthe margin treatment is more favorable for them. \nAs its name im", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 104}
{"text": "erse calendar spread is an infrequently used strategy, at least for public cus\ntomers trading stock or index options, because of the margin requirements. However, \neven then, it does have a place in the arsenal of the option strategist. Meanwhile, pro\nfessionals and futures option traders use the strategy with more frequency because \nthe margin treatment is more favorable for them. \nAs its name implies, the reverse calendar spread is a position that is just the \nopposite of a \"normal\" calendar spread. In the reverse calendar spread, one sells a \nlong-term call option and simultaneously buys a shorter-term call option. The spread \ncan be constructed with puts as well, as will be shown in a later chapter. Both calls \nhave the same striking price. \nThis strategy will make money if one of two things happens: Either (1) the stock \nprice moves away from the striking price by a great deal, or (2) the inplied volatility \nof the options involved in the spread shrinks. For readers familiar with the \"normal\" \ncalendar spread strategy, the first way to profit should be obvious, because a \"normal\" \n230 \nChapter 13: Reverse Spreads 231 \ncalendar spread makes the most money if the stock is right at the strike price at expi\nration, and it loses money if the stock rises or falls too far. \nAs with any spread involving options expiring in differing months, it is common \npractice to look at the profitability of the position at or before the near-term expira\ntion. An example will show how this strategy can profit. \nExample: Suppose the current month is April and that XYZ is trading at 80. \nFurthermore, suppose that XYZ's options are quite expensive, and one believes the \nunderlying stock will be volatile. A reverse calendar spread would be a way to profit \nfrom these assumptions. The following prices exist: \nXYZ December 80 call: 12 \nXYZ July 80 call: 7 \nA reverse calendar spread is established by selling the December 80 call for 12 \npoints, and buying the July 80 call for 7, a net credit of 5 points for the spread. \nIf, later, XYZ falls dramatically, both call options will be nearly worthless and the \nspread could be bought back for a price well below 5. For example, if XYZ were to \nfall to 50 in a month or so, the July 80 call would be nearly worthless and the \nDecember 80 call could be bought back for about a point. Thus, the spread would \nhave shrunk from its initial price of 5 to a price of about 1, a profit of 4 points. \nThe other way to make money would be for implied volatility to decrease. \nSuppose implied volatility dropped after a month had passed. Then the spread might \nbe worth something like 4 points - an unrealized profit of about 1 point, since it was \nsold for a price of 5 initially. \nThe profit graph in Figure 13-1 shows the profitability of the reverse calendar. \nThere are two lines on the graph, both of which depict the results at the expiration \nof the near-term option (the July 80 call in the above example). The lower line shows \nwhere profits and losses would occur if implied volatility remained unchanged. You \ncan see that the position could profit if XYZ were to rise above 98 or fall below 70. \nIn addition, the higher curve on the graph shows where profits would lie if implied \nvolatility fell prior to expiration of the near-term options. In that case, additional prof\nits would accrue, as depicted on the graph. \nSo there are two ways to make money with this strategy, and it is therefore best \nto establish it when implied volatility is high and the underlying has a tendency to be \nvolatile. \nThe problem with this spread, for stock and index option traders, is that the call \nthat is sold is considered to be naked. This is preposterous, of course, since the short\nterm call is a perfectly valid hedge until it expires. Yet the margin requirements \nremain onerous. When they were overhauled recently, this glaring inefficiency was \n232 Part II: Call Option Strategies \nFigure 13-1 • \nCalendar spread sale at near-term expiration. \n$400 \n$300 \nImplied Volatility \nLower \n$200 \\ \nf/) \n$100 f/) \n0 \n~ \n$0 50 60 110 120 \na. -$100 \n-$200 \n-$300 \nImplied Volatility \n-$400 Remains High \n-$500 \nUnderlying Price \nallowed to stand because none of the member firms cared about changing it. Still, if \none has excess collateral - perhaps from a large stock portfolio - and is interested in \ngenerating excess income in a hedged manner, then the strategy might be applicable \nfor him as well. Futures option traders receive more favorable margin requirements, \nand it thus might be a more economical strategy for them. \nREVERSE RATIO SPREAD (BACKSPREAD) \nA more popular reverse strategy is the reverse ratio call spread, which is comrrwnly \nknown as a backspread. In this type of spread, one would sell a call at one striking \nprice and then would buy several calls at a higher striking price. This is exactly the \nopposite of the ratio spread described in Chapter 11. Some traders refer to any \nspread with unlimited profit potential on at least one side as a backspread. Thus, in \nmost backspreading strategies, the spreader wants the stock to rrwve dramatically. He \ndoes not generally care whether it moves up or down. Recall that in the reverse \nhedge strategy (similar to a straddle buy) described in Chapter 4, the strategist had \nthe potential for large profits if the stock moved either up or down by a great deal. \nIn the backspread strategy discussed here, large potential profits exist if the stock \nmoves up dramatically, but there is limited profit potential to the downside. \nExample: XYZ is selling for 43 and the July 40 call is at 4, with the July 45 call at l. \nA reverse ratio spread would be established as follows: · \nChapter 13: Reverse Spreads \nBuy 2 July 45 calls at 1 each \nSell 1 July 40 call at 4 \nNet \n2 debit \n4 credit \n2 credit \n233 \nThese spreads are generally established for credits. In fact, if the spread cannot \nbe initiated at a credit, it is usually not attractive. If the underlying stock drops in \npric", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 105}
{"text": "is at 4, with the July 45 call at l. \nA reverse ratio spread would be established as follows: · \nChapter 13: Reverse Spreads \nBuy 2 July 45 calls at 1 each \nSell 1 July 40 call at 4 \nNet \n2 debit \n4 credit \n2 credit \n233 \nThese spreads are generally established for credits. In fact, if the spread cannot \nbe initiated at a credit, it is usually not attractive. If the underlying stock drops in \nprice and is below 40 at July expiration, all the calls will expire worthless and the \nstrategist will make a profit equal to his initial credit. The maximum downside poten\ntial of the reverse ratio spread is equal to the initial credit received. On the other \nhand, if the stock rallies substantially, the potential upside profits are unlimited, since \nthe spreader owns more calls than he is short. Simplistically, the investor is bullish \nand is buying out-of the-money calls but is simultaneously hedging himself by selling \nanother call. He can profit if the stock rises in price, as he thought it would, but he \nalso profits if the stock collapses and all the calls expire worthless. \nThis strategy has limited risk. With most spreads, the maximum loss is attained \nat expiration at the striking price of the purchased call. This is a true statement for \nbackspreads. \nExample: IfXYZ is at exactly 45 at July expiration, the July 45 calls will expire worth\nless for a loss of $200 and the July 40 call will have to be bought back for 5 points, a \n$100 loss on that call. The total loss would thus be $300, and this is the most that can \nbe lost in this example. If the underlying stock should rally dramatically, this strategy \nhas unlimited profit potential, since there are two long calls for each short one. In \nfact, one can always compute the upside break-even point at expiration. That break\neven point happens to be 48 in this example. At 48 at July expiration, each July 45 \ncall would be worth 3 points, for a net gain of $400 on the two of them. The July 40 \ncall would be worth 8 with the stock at 48 at expiration, representing a $400 loss on \nthat call. Thus, the gain and the loss are offsetting and the spread breaks even, except \nfor commissions, at 48 at expiration. If the stock is higher than 48 at July expiration, \nprofits will result. \nTable 13-1 and Figure 13-2 depict the potential profits and losses from this \nexample of a reverse ratio spread. Note that the profit graph is exactly like the prof\nit graph of a ratio spread that has been rotated around the stock price axis. Refer to \nFigure 11-1 for a graph of the ratio spread. There is actually a range outside of which \nprofits can be made - below 42 or above 48 in this example. The maximum loss \noccurs at the striking price of the purchased calls, or 45, at expiration. \nThere are no naked calls in this strategy, so the investment is relatively small. \nThe strategy is actually a long call added to a bear spread. In this example, the bear \n234 Part II: Call Option Strategies \nTABLE 13·1. \nProfits and losses for reverse ratio spread. \nXYZ Price at Profit on Profit on Total \nJuly Expiration 1 July 40 2 July 45's Profit \n35 +$ 400 -$ 200 +$ 200 \n40 + 400 200 + 200 \n42 + 200 200 0 \n45 100 200 300 \n48 400 + 400 0 \n55 - 1,100 + 1,800 + 700 \n70 - 2,600 + 4,800 + 2,200 \nspread portion is long the July 45 and short the July 40. This requires a $500 collat\neral requirement, because there are 5 points difference in the striking prices. The \ncredit of $200 received for the entire spread can be applied against the initial \nrequirement, so that the total requirement would be $300 plus commissions. There \nis no increase or decrease in this requirement, since there are no naked calls. \nNotice that the concept of a delta-neutral spread can be utilized in this strate\ngy, in much the same way that it was used for the ratio call spread. The number of \ncalls to buy and sell can be computed mathematically by using the deltas of the \noptions involved. \nExample: The neutral ratio is determined by dividing the delta of the July 45 into the \ndelta of the July 40. \nPrices \nXYZ common: = 43 \nXYZ July 40 call: 4 \nXYZ July 45 call: \nDelta \n.80 \n.35 \nIn this case, that would be a ratio of 2.29:1 (.80/.35). That is, if one sold 5 July 40's, \nhe would buy 11 July 45's (or if he sold 10, he would then buy 23). By beginning with \na neutral ratio, the spreader should be able to make money on a quick move by the \nstock in either direction. \nThe neutral ratio can also help the spreader to avoid being too bearish or too \nbullish to begin with. For example, a spreader would not be bullish enough if he \nChapter 13: Reverse Spreads \nFIGURE 13-2. \nReverse ratio spread (backspread). \nC: \n~ +$200 \n;% \n:!:: \ne \na. -$300 \nStock Price at Expiration \n235 \nmerely used a 2:1 ratio for convenience, instead of using the 2.3:l ratio. If anything, \none might normally establish the spread with an extra bullish emphasis, since the \nlargest profits are to the upside. There is little reason for the spreader to have too lit\ntle bullishness in this strategy. Thus, if the deltas are correct, the neutral ratio can aid \nthe spreader in the determination of a more accurate initial ratio. \nThe strategist must be alert to the possibility of early exercise in this type of \nspread, since he has sold a call that is in-the-money. Aside from watching for this pos\nsibility, there is little in the way of defensive follow-up action that needs to be imple\nmented, since the risk is limited by the nature of the position. He might take profits \nby closing the spread if the stock rallies before expiration. \nThis strategy presents a reasonable method of attempting to capitalize on a \nlarge stock movement with little tie-up of collateral. Generally, the strategist would \nseek out volatile stocks for implementation of this strategy, because he would want as \nmuch potential movement as possible by the time the calls expire. In Chapter 14, it \nwill be shown that this strategy can become more attractive by buying calls with a \nlonger mat", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 106}
{"text": "ble method of attempting to capitalize on a \nlarge stock movement with little tie-up of collateral. Generally, the strategist would \nseek out volatile stocks for implementation of this strategy, because he would want as \nmuch potential movement as possible by the time the calls expire. In Chapter 14, it \nwill be shown that this strategy can become more attractive by buying calls with a \nlonger maturity than the calls sold. \nCH.APTER 14 \nDiagonalizing a Spread \nWhen one uses both different striking prices and different expiration dates in a \nspread, it is a diagonal spread. Generally, the long side of the spread would expire \nlater than the short side of the spread. Note that this is within the definition of a \nspread for margin purposes: The long side must have a maturity equal to or longer \nthan the maturity of the short side. With the exception of calendar spreads, all the \nprevious chapters on spreads have described ones in which the expiration dates of the \nshort call and the long call were the same. However, any of these spreads can be diag\nonalized; one can replace the long call in any spread with one expiring at a later date. \nIn general, diagonalizing a spread in this manner makes it slightly rrwre bear\nish at near-term expiration. This can be seen by observing what would happen if the \nstock fell or rose substantially. If the stock falls, the long side of the spread will retain \nsome value because of its longer maturity. Thus, a diagonal spread will generally do \nbetter to the downside than will a regular spread. If the stock rises substantially, all \ncalls will come to parity. Thus, there is no advantage in the long-term call; it will be \nselling for approximately the same price as the purchased call in a normal spread. \nHowever, since the strategist had to pay more originally for the longer-term call, his \nupside profits would not be as great. \nA diagonalized position has an advantage in that one can reestablish the posi\ntion if the written calls expire worthless in the spread. Thus, the increased cost of \nbuying a longer-term call initially may prove to be a savings if one can write against \nit twice. These tactics are described for various spread strategies. \nTHE DIAGONAL BULL SPREAD \nA vertical call bull spread consists of buying a call at a lower striking price and sell\ning a call at a higher striking price, both with the same expiration date. The diagonal \n236 \nChapter 14: Diagonalizing a Spread 231 \nbull spread would be similar except that one would buy a longer-tenn call at the lower \nstrike and would sell a near-tenn call at the higher strike. The number of calls long \nand short would still be the same. By diagonalizing the spread, the position is hedged \nsomewhat on the downside in case the stock does not advance by near-term expira\ntion. Moreover, once the near-term option expires, the spread can often be reestab\nlished by selling the call with the next maturity. \nExample: The following prices exist: \nStrike April Ju~ October Stock Price \nXYZ 30 3 4 5 32 \nXYZ 35 11/2 2 32 \nA vertical bull spread could be established in any of the expiration series by buying \nthe call with 30 strike and selling the call with 35 strike. A diagonal bull spread would \nconsist of buying the July 30 or October 30 and selling the April 35. To compare a \nvertical bull spread with a diagonal spread, the following two spreads will be used: \nVertical bull spread: buy the April 30 call, sell the April 35 - 2 debit \nDiagonal bull spread: buy the July 30 call, sell the April 35 3 debit \nThe vertical bull spread has a 3-point potential profit if XYZ is above 35 at April expi\nration. The maximum risk in the normal bull spread is 2 points (the original debit) if \nXYZ is anywhere below 30 at April expiration. By diagonalizing the spread, the strate\ngist lowers his potential profit slightly at April expiration, but also lowers the proba\nbility of losing 2 points in the position. Table 14-1 compares the two types of spreads \nat April expiration. The price of the July 30 call is estimated in order to derive the \nestimated profits or losses from the diagonal bull spread at that time. If the underly\ning stock drops too far - to 20, for example - both spreads will experience nearly a \ntotal loss at April expiration. However, the diagonal spread will not lose its entire \nvalue if XYZ is much above 24 at expiration, according to Table 14-1. The diagonal \nspread actually has a smaller dollar loss than the normal spread between 27 and 32 \nat expiration, despite the fact that the diagonal spread was more expensive to estab\nlish. On a percentage basis, the diagonal spread has an even larger advantage in this \nrange. If the stock rallies aboye 35 by expiration, the normal spread will provide a \nlarger profit. There is an interesting characteristic of the diagonal spread that is \nshown in Table 14-1. If the stock advances substantially and all the calls come to par\nity, the profit on the diagonal spread is limited to 2 points. However, if the stock is \nnear 35 at April expiration, the long call will have some time premium in it and the \n238 Part II: Call Option Strategies \nTABLE 14-1. \nComparison of spreads at expiration. \nVertical Bull \nXYZ Price at April 30 April 35 July 30 Spread Diagonal \nApril Expiration Price Price Price Profit Spread Profit \n20 0 0 0 -$200 -$300 \n24 0 0 1/2 - 200 - 250 \n27 0 0 1 - 200 - 200 \n30 0 0 2 - 200 - 100 \n32 2 0 3 0 0 \n35 5 0 51/2 + 300 + 250 \n40 10 5 10 + 300 + 200 \n45 15 10 15 + 300 + 200 \nspread will actually widen to more than 5 points. Thus, the maximum area of profit \nat April expiration for the diagonal spread is to have the stock near the striking price \nof the written call. The figures demonstrate that the diagonal spread gives up a small \nportion of potential upside profits to provide a hedge to the downside. \nOnce the April 35 call expires, the diagonal spread can be closed. However, if \nthe stock is below 35 at that time, it may be more prudent to then sell the July 35 ca", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 107}
{"text": "on for the diagonal spread is to have the stock near the striking price \nof the written call. The figures demonstrate that the diagonal spread gives up a small \nportion of potential upside profits to provide a hedge to the downside. \nOnce the April 35 call expires, the diagonal spread can be closed. However, if \nthe stock is below 35 at that time, it may be more prudent to then sell the July 35 call \nagainst the July 30 call that is held long. This would establish a normal bull spread for \nthe 3 months remaining until July expiration. Note that ifXYZ were still at 32 at April \nexpiration, the July 35 call might be sold for 1 point if the stock's volatility was about \nthe same. This should be true, since the April 35 call was worth 1 point with the stock \nat 32 three months before expiration. Consequently, the strategist who had pursued \nthis course of action would end up with a normal July bull spread for a net debit of 2 \npoints: He originally paid 4 for the July 30 call, but then sold the April 35 for 1 point \nand subsequently sold the July 35 for 1 point. By looking at the table of prices for the \nfirst example in this chapter, the reader can see that it would have cost 2½ points to \nset up the normal July bull spread originally. Thus, by diagonalizing and having the \nnear-term call expire worthless, the strategist is able to acquire the normal July bull \nspread at a cheaper cost than he could have originally. This is a specific example of \nhow the diagonalizing effect can prove beneficial if the writer is able to write against \nthe same long call two times, or three times if he originally purchased the longest\nterm call. In this example, if XYZ were anywhere between 30 and 35 at April expira\ntion, the spread would be converted to a normal July bull spread. If the stock were \nabove 35, the spread should be closed to take the profit. Below 30, the July 30 call \nwould probably be closed or left outright long. \nChapter 14: Diagonalizing a Spread 239 \nIn summary, the diagonal bull spread may often be an improvement over the \nnormal bull spread. The diagonal spread is an improvement when the stock remains \nrelatively unchanged or falls, up until the near-term written call expires. At that time, \nthe spread can be converted to a normal bull spread if the stock is at a favorable price. \nOf course, if at any time the underlying stock rises above the higher striking price at \nan expiration date, the diagonal spread will be profitable. \nOWNING A CALL FOR \"FREE\" \nDiagonalization can be used in other spread strategies to accomplish much the same \npurposes already described; but in addition, it may also be possible for the spreader \nto wind up owning a long call at a substantially reduced cost, possibly even for free. \nThe easiest w~y to see this would be to consider a diagonal bear spread. \nExample: XYZ is at 32 and the near-term April 30 call is selling for 3 points while the \nlonger-term July 35 call is selling for 1 ½ points. A diagonal bear spread could be \nestablished by selling the April 30 and buying the July 35. This is still a bear spread, \nbecause a call with a lower striking price is being sold while a call at a higher strike \nis being purchased. However, since the purchased call has a longer maturity date \nthan the written call, the spread is diagonalized. \nThis diagonal bear spread will make money ifXYZ falls in price before the near\nterm April call expires. For example, ifXYZ is at 29 at expiration, the written call will \nexpire worthless and the July 35 will still have some value, perhaps ½. Thus, the prof\nit would be 3 points on the April 30, less a 1-point loss on the July 35, for an overall \nprofit of 2 points. The risk in the position lies to the upside, just as in a regular bear \nspread. If XYZ should advance by a great deal, both options would be at parity and \nthe spread would have widened to 5 points. Since the initial credit was 1 ½ points, the \nloss would be 5 minus 1 ½, or 3½ points in that case. As in all diagonal spreads, the \nspread will do slightly better to the downside because the long call will hold some \nvalue, but it will do slightly worse to the upside if the underlying stock advances sub\nstantially. \nThe reason that a strategist might attempt a diagonal bear spread would not be \nfor the slight downside advantage that the diagonalizing effect produces. Rather it \nwould be because he has a chance of owning the July 35 call - the longer-term call -\nfor a substantially reduced cost. In the example, the cost of the July 35 call was 1 ½ \npoints and the premium received from the sale of the April 30 call was 3 points. If \nthe spreader can make 1 ½ points from the sale of the April 30 call, he will have com\npletely covered the cost of his July option. He can then sit back and hope for a rally \n240 Part II: Call Option Strategies \nby the underlying stock. If such a rally occurred, he could make unlimited profits on \nthe long side. If it did not, he loses nothing. \nExample: Assume that the same spread was established as in the last example. Then, \nif XYZ is at or below 31 ½ at April expiration, the April 30 call can be purchased for \n1 ½ points or less. Since the call was originally sold for 3, this would represent a prof\nit of at least 1 ½ points on the April 30 call. This profit on the near-term option cov\ners the entire cost of the July 35. Consequently, the strategist owns the July 35 for \nfree. If XYZ never rallies above 35, he would make nothing from the overall trade. \nHowever, if XYZ were to rally above 35 after April expiration (but before July expi\nration, of course), he could make potentially large profits. Thus, when one establish\nes a diagonal spread for a credit, there is always the potential that he could own a call \nfor free. That is, the profits from the sale of the near-term call could equal or exceed \nthe original cost of the long call. This is, of course, a desirable position to be in, for if \nthe underlying stock should rally substantially after pro", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 108}
{"text": "he could make potentially large profits. Thus, when one establish\nes a diagonal spread for a credit, there is always the potential that he could own a call \nfor free. That is, the profits from the sale of the near-term call could equal or exceed \nthe original cost of the long call. This is, of course, a desirable position to be in, for if \nthe underlying stock should rally substantially after profits are realized on the short \nside, large profits could accrue. \nDIAGONAL BACKSPREADS \nIn an analogous strategy, one might buy more than one longer-term call against the \nshort-term call that is sold. Using the foregoing prices, one might sell the April 30 for \n3 points and buy 2 July 35's at 1 ½ points each. This would be an even money spread. \n. The credits equal the debits when the position is established. If the April 30 call \nexpires worthless, which would happen if the stock was below 30 in April, the spread\ner would own 2 July 35 calls for free. Even if the April 30 does not expire totally \nworthless, but if some profit can be made on the sale of it, the July 35's will be owned \nat a reduced cost. In Chapter 13, when reverse spreads were discussed, the strategy \nin which one sells a call with a lower strike and then buys more calls at a higher strike \nwas termed a reverse ratio spread, or backspread. The strategy just described is \nmerely the diagonalizing of a backspread. This is a strategy that is favored by some \nprofessionals, because the short call reduces the risk of owning the longer-term calls \nif the underlying stock declines. Moreover, if the underlying stock advances, the pre\nponderance of long calls with a longer maturity will certainly outdistance the losses \non the written call. The worst situation that could result would be for the underlying \nstock to rise very slightly by near-term expiration. If this happened, it might be pos\nsible to lose money on both sides of the spread. This would have to be considered a \nrather low-probability event, though, and would still represent a limited loss, so it \ndoes not substantially offset the positive aspects of the strategy. \n0.,ter 14: Diagonalizing a Spread 241 \nAny type of spread may be diagonalized. There are some who prefer to diago\nnalize even butterfly spreads, figuring that the extra time to maturity in the purchased \ncalls will be of benefit. Overall, the benefits of diagonalizing can be generalized by \nrecalling the way in which the decay of the time value premium of a call takes place. \nRecall that it was determined that a call loses most of its time value premium in the \nlast stages of its life. When it is a very long-term option, the rate of decay is small. \nKnowing this fact, it makes sense that one would want to sell options with a short life \nremaining, so that the maximum benefit of the decay could be obtained. \nCorrespondingly, the purchase of a longer-term call would mean that the buyer is not \nsubjecting himself to a substantial loss in time value premium, at least over the first \nthree months of ownership. A diagonal spread encompasses both of these features -\nselling a short-term call to try to obtain the maximum rate of time decay, while buy\ning a longer-term call to try to lessen the effect of time decay on the long side. \nCALL OPTION SUMMARY \nThis concludes the description of strategies that utilize only call options. The call \noption has been seen to be a vehicle that the astute strategist can use to set up a wide \nvariety of positions. He can be bullish or bearish, aggressive or conservative. In addi\ntion, he can attempt to be neutral, trying to capitalize on the probability that a stock \nwill not move very far in a short time period. \nThe investor who is not familiar with options should generally begin with a sim\nple strategy, such as covered call writing or outright call purchases. The simplest \ntypes of spreads are the bull spread, the bear spread, and the calendar spread. The \nmore sophisticated investor might consider using ratios in his call strategies - ratio \nwriting against stock or ratio spreading using only calls. \nOnce the strategist feels that he understands the risk and reward relationships \nbetween longer-term and short-term calls, between in-the-money and out-of-the\nmoney calls, and between long calls and short calls, he could then consider utilizing \nthe most advanced types of strategies. This might include reverse ratio spreads, diag\nonal spreads, and more advanced types of ratios, such as the ratio calendar spread. \nA great deal of information, some of it rather technical in detail, has been pre\nsented in preceding chapters. The best pattern for an investor to follow would be to \nattempt only strategies that he fully comprehends. This does not mean that he mere\nly understands the profitability aspects (especially the risk) of the strategy. One must \nalso be able to readily understand the potential effects of early assignments, large div\nidend payments, striking price adjustments, and the like, if he is going to operate \nadvanced strategies. Without a full understanding of how these things might affect \none's position, one cannot operate an advanced strategy correctly. \n\n' ' ; ' ; \n+•-•~/ ----~-•~ •\"~•#•:,,,,!., --.-m~,~ \n: i : ~»•~•= ' \"'''''''\"'''''\"'''''''~--->-' ,,,_,_0-,o-, , ___ ,,,,,cco,,,,,,_, __ ,,,_o,co-ooc0-000,,0-0 \n-• ~ - ~ d,M,,,\"~'-'\"'' ~,·,w~ ' ,n - n,-,,• \"•-•-' \"'''\"'- ,,._._,,.,~~n'\"\"~•-••-- • oco-oc°\"oo.o~,.,,o, ''o,o 0 o- ',,,-;,,.,_ oo,ooooyo0°,, ,;,., , _ _,,,, \nINTRODUCTION \nA put option gives the holder the right to sell the underlying security at the striking \nprice at any time until the expiration date of the option. Listed put options are \nslightly newer than listed call options, having been introduced on June 3, 1977. The \nintroduction of listed puts has provided a much wider range of strategies for both \nconservative and aggressive investors. The call option is least effective in strategies \nin which downward price movement by the underlying stock is concerne", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 109}
{"text": "ny time until the expiration date of the option. Listed put options are \nslightly newer than listed call options, having been introduced on June 3, 1977. The \nintroduction of listed puts has provided a much wider range of strategies for both \nconservative and aggressive investors. The call option is least effective in strategies \nin which downward price movement by the underlying stock is concerned. The put \noption is a useful tool in that case. \nAll stocks with listed call options have listed put options as well. The use of puts \nor the combination of puts and calls can provide more versatility to the strategist. \nWhen listed put options exist, it is no longer necessary to implement strategies \ninvolving long calls and short stock. Listed put options can be used more efficiently \nin such situations. There are many similarities between call strategies and put \nstrategies. For example, put spread strategies and call spread strategies employ sim\nilar tactics, although there are technical differences, of course. In certain strategies, \nthe tactics for puts may appear largely to be a repetition of those used for calls, but \nthey are nevertheless spelled out in detail here. The strategies that involve the use \nof both puts and calls together - straddles and combinations - have techniques of \ntheir own, but even in these cases the reader will recognize certain similarities to \nstrategies previously discussed. Thus, the introduction of put options not only \nwidens the realm of potential strategies, but also makes more efficient some of the \nstrategies previously described. \n244 \nCH.APTER 15 \nPut Option Basics \nMuch of the same terminology that is applied to call options also pertains to put \noptions. Underlying security, striking price, and expiration date are all terms that \nhave the same meaning for puts as they do for calls. The expiration dates of listed put \noptions agree with the expiration dates of the calls on the same underlying stock. In \naddition, puts and calls have the same striking prices. This means that if there are \noptions at a certain strike, say on a particular underlying stock that has both listed \nputs and calls, both calls at 50 and puts at 50 will be trading, regardless of the price \nof the underlying stock. Note that it is no longer sufficient to describe an option as \nan \"XYZ July 50.\" It must also be stated whether the option is a put or a call, for an \nXYZ July 50 call and an XYZ July 50 put are two different securities. \nIn many respects, the put option and its associated strategies will be very near\nly the opposite of corresponding call-oriented strategies. However, it is not correct to \nsay that the put is exactly the opposite of a call. In this introductory section on puts, \nthe characteristics of puts are described in an attempt to show how they are similar \nto calls and how they are not. \nPUT STRATEGIES \nIn the simplest terms, the outright buyer of a put is hoping for a stock price decline \nin order for his put to become more valuable. If the stock were to decline well below \nthe striking price of the put option, the put holder could make a profit. The holder \nof the put could buy stock in the open market and then exercise his put to sell that \nstock for a profit at the striking price, which is higher. \nExample: If XYZ stock is at 40, an XYZ July 50 put would be worth at least 10 points, \nfor the put grants the holder the right to sell XYZ at 50 - 10 points above its current \n245 \nINTRODUCTION \nA put option gives the holder the right to sell the underlying security at the striking \nprice at any time until the expiration date of the option. Listed put options are \nslightly newer than listed call options, having been introduced on June 3, 1977. The \nintroduction of listed puts has provided a much wider range of strategies for both \nconservative and aggressive investors. The call option is least effective in strategies \nin which downward price movement by the underlying stock is concerned. The put \noption is a useful tool in that case. \nAll stocks with listed call options have listed put options as well. The use of puts \nor the combination of puts and calls can provide more versatility to the strategist. \nWhen listed put options exist, it is no longer necessary to implement strategies \ninvolving long calls and short stock. Listed put options can be used more efficiently \nin such situations. There are many similarities between call strategies and put \nstrategies. For example, put spread strategies and call spread strategies employ sim\nilar tactics, although there are technical differences, of course. In certain strategies, \nthe tactics for puts may appear largely to be a repetition of those used for calls, but \nthey are nevertheless spelled out in detail here. The strategies that involve the use \nof both puts and calls together - straddles and combinations - have techniques of \ntheir own, but even in these cases the reader will recognize certain similarities to \nstrategies previously discussed. Thus, the introduction of put options not only \nwidens the realm of potential strategies, but also makes more efficient some of the \nstrategies previously described. \n244 \nCHAPTER 15 \nPut Option Basics \nMuch of the same terminology that is applied to call options also pertains to put \noptions. Underlying security, striking price, and expiration date are all terms that \nhave the same meaning for puts as they do for calls. The expiration dates of listed put \noptions agree with the expiration dates of the calls on the same underlying stock. In \naddition, puts and calls have the same striking prices. This means that if there are \noptions at a certain strike, say on a particular underlying stock that has both listed \nputs and calls, both calls at 50 and puts at 50 will be trading, regardless of the price \nof the underlying stock. Note that it is no longer sufficient to describe an option as \nan \"XYZ July 50.\" It must also be stated whether the option is a put or a call, for an \nX", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 110}
{"text": "riking prices. This means that if there are \noptions at a certain strike, say on a particular underlying stock that has both listed \nputs and calls, both calls at 50 and puts at 50 will be trading, regardless of the price \nof the underlying stock. Note that it is no longer sufficient to describe an option as \nan \"XYZ July 50.\" It must also be stated whether the option is a put or a call, for an \nXYZ July 50 call and an XYZ July 50 put are two different securities. \nIn many respects, the put option and its associated strategies will be very near\nly the opposite of corresponding call-oriented strategies. However, it is not correct to \nsay that the put is exactly the opposite of a call. In this introductory section on puts, \nthe characteristics of puts are described in an attempt to show how they are similar \nto calls and how they are not. \nPUT STRATEGIES \nIn the simplest terms, the outright buyer of a put is hopingfor a stock price decline \nin order for his put to become more valuable. If the stock were to decline well below \nthe striking price of the put option, the put holder could make a profit. The holder \nof the put could buy stock in the open market and then exercise his put to sell that \nstock for a profit at the striking price, which is higher. \nExample: If XYZ stock is at 40, an XYZ July 50 put would be worth at least 10 points, \nfor the put grants the holder the right to sell XYZ at 50 10 points above its current \n245 \n246 Part Ill: Put Option Strategies \nprice. On the other hand, if the stock price were above the striking price of the put \noption at expiration, the put would be worthless. No one would logically want to exer\ncise a put option to sell stock at the striking price when he could merely go to the \nopen market and sell the stock for a higher price. Thus, as the price of the underly\ning stock declines, the put becomes more valuable. This is, of course, the opposite of \na call option's price action. \nThe meaning of in-the-money and out-of-the-money are altered when one is \nspeaking of put options. A put is considered to be in-the-money when the underlying \nstock is below the striking price of the put option; it is out-of the-money when the \nstock is above the striking price. This, again, is the opposite of the call option. IfXYZ \nis at 45, the XYZ July 50 put is in-the-money and the XYZ July 50 call is out-of-the\nmoney. However, ifXYZ were at 55, the July 50 put would be out-of-the-money while \nthe July 50 call would be in-the-money. The broad definition of an in-the-money \noption as \"an option that has intrinsic value\" would cover the situation for both puts \nand calls. Note that a put option has intrinsic value when the underlying stock is \nbelow the striking price of the put. That is, the put has some \"real\" value when the \nstock is below the striking price. \nThe intrinsic value of an in-the-money put is merely the difference between \nthe striking price and the stock price. Since the put is an option (to sell), it will gen\nerally sell for more than its intrinsic value when there is time remaining until the \nexpiration date. This excess value over its intrinsic value is referred to as the time \nvalue premium, just as is the case with calls. \nExample: XYZ is at 47 and the XYZ July 50 put is selling for 5, the intrinsic value is \n3 points (50- 47), so the time value premium must be 2 points. The time value pre\nmium of an in-the-money put option can always be quickly computed by the follow\ning formula: \nTime value premium p . S k · St \"ki · • ) == ut option + toe pnce - n ng pnce (m-the-money put \nThis is not the same formula that was applied to in-the-money call options, although \nit is always true that the time value premium of an option is the excess value over \nintrinsic value. \nTime value premium Call ti S ·ki · St k · . all == op on + tn ng pnce - oc pnce (m-the-money c ) \nIf the put is out-of-the-money, the entire premium of the put is composed of time \nvalue premium, for the intrinsic value of an out-of-the-money option is always zero. \nO.,,ter 15: Put Option Basks 247 \nThe time value premium of a put is largest when the stock is at the striking price of \nthe put. As the option becomes deeply in-the-money or deeply out-of-the-money, the \ntime value premium will shrink substantially. These statements on the magnitude of \nthe time value premium are true for both puts and calls. Table 15-1 will help to illus\ntrate the relationship of stock price and option price for both puts and calls. The \nreader may want to refer to Table 1-1, which described the time value premium rela\ntionship for calls. Table 15-1 describes the prices of an XYZ July 50 call option and \nan XYZ July 50 put option. \nTable 15-1 demonstrates several basic facts. As the stock drops, the actual price \nof a call option decreases while the value of the put option increases. Conversely, as \nthe stock rises, the call option increases in value and the put option decreases in \nvalue. Both the put and the call have their maximum time value premium when the \nstock is exactly at the striking price. However, the call will generally sell for rrwre than \nthe put when the stock is at the strike. Notice in Table 15-1 that, with XYZ at 50, the \ncall is worth 5 points while the put is worth only 4 points. This is true in general, \nexcept in the case of a stock that pays a large dividend. This phenomenon has to do \nwith the cost of carrying stock. More will be said about this effect later. Table 15-1 \nalso describes an effect of put options that normally holds true: An in-the-rrwney put \n( stock is below strike) loses time value premium rrwre quickly than an in-the-rrwney \ncall does. Notice that with XYZ at 43 in Table 15-1, the put is 7 points in-the-money \nand has lost all its time value premium. But when the call is 7 points in-the-money, \nXYZ at 57, the call still has 2 points of time value premium. Again, this is a phenom\nenon that could be affected by the dividend payout of the underlying stock, but is \ntrue in", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 111}
{"text": "lue premium rrwre quickly than an in-the-rrwney \ncall does. Notice that with XYZ at 43 in Table 15-1, the put is 7 points in-the-money \nand has lost all its time value premium. But when the call is 7 points in-the-money, \nXYZ at 57, the call still has 2 points of time value premium. Again, this is a phenom\nenon that could be affected by the dividend payout of the underlying stock, but is \ntrue in general. \nPRICING PUT OPTIONS \nThe same factors that determine the price of the call option also determine the price \nof the put option: price of the underlying stock, striking price of the option, time \nremaining until expiration, volatility of the underlying stock, dividend rate of the \nunderlying stock, and the current risk-free interest rate (Treasury bill rate, for exam\nple). Market dynamics - supply, demand, and investor psychology - play a part as \nwell. \nWithout going into as much detail as was shown in Chapter 1, the pricing curve \nof the put option can be developed. Certain facts remain true for the put option as \nthey did for the call option. The rate of decay of the put option is not linear; that is, \nthe time value premium will decay more rapidly in the weeks immediately preced\ning expiration. The more volatile the underlying stock, the higher will be the price \n248 Part Ill: Put Option Strategies \nTABLE 15-1. \nCall and put options compared. \nXYZ XYZ Coll Coll XYZ Put Put \nStock July 50 Intrinsic Time Value July 50 Intrinsic Time Value \nPrice Coll Price Value Premium Put Price Value Premium \n40 1/2 0 1/2 93/4 10 -1/4* \n43 1 0 1 7 7 0 \n45 2 0 2 6 5 \n47 3 0 3 5 3 2 \n50 5 0 5 4 0 4 \n53 7 3 4 3 0 3 \n55 8 5 3 2 0 2 \n57 9 7 2 0 \n60 101/2 10 1/2 1/2 0 l/2 \n70 193/4 20 -1/4 * 1/4 0 1/4 \n* A deeply in-the-money option may actually trade at a discount from intrinsic value in advance of \nexpiration. \nof its options, both puts and calls. Moreover, the marketplace may at any time value \noptions at a higher or lower volatility than the underlying stock actually exhibits. \nThis is called implied volatility, as distinguished from actual volatility. Also, the put \noption is usually worth at least its intrinsic value at any time, and should be worth \nexactly its intrinsic value on the day that it expires. Figure 15-1 shows where one \nmight expect the XYZ July 50 put to sell, for any stock price, if there are 6 months \nremaining until expiration. Compare this with the similar pricing curve for the call \noption (Figure 15-2). Note that the intrinsic value line for the put option faces in \nthe opposite direction from the intrinsic value line for call options; that is, it gains \nvalue as the stock falls below the striking price. This put option pricing curve \ndemonstrates the effect mentioned earlier, that a put option loses time value pre\nmium more quickly when it is in-the-money, and also shows that an out-of-the\nmoney put holds a great deal of time value premium. \nTHE EFFECT OF DIVIDENDS ON PUT OPTION PREMIUMS \nThe dividend of the underlying stock is a negative factor on the price of its call \noptions. The opposite is true for puts. The larger the dividend, the nwre valuable the \nputs will be. This is true because, as the stock goes ex-dividend, it will be reduced in \nCl,opter 15: Put Option Basics \nFIGURE 1 5-1. \nPut option price curve. \n~ \nit \nC: \n.Q \na. \n0 \nFIGURE 1 5-2. \nCall option price curve. \n~ \nct \nC: \n0 \n11 \n10 \n9 \n8 \n7 \n6 \na 5 \nStriking \nPrice (50) \nGreatest \nValue for \nTime Value \nStock Price \n0 4 ----------------------\n3 \n2 \n1 \n0 \n40 45 \nrepresents the option's \ntime value premium. ________ L ________ _ \n50\\ 55 60 Stock Price Intrinsic value \nremains at zero \nuntil striking price \nis passed. \n249 \nprice by the amount of the dividend. That is, the stock will decrease in price and \ntherefore the put will become more valuable. Consequently, the buyer of the put will \nbe willing to pay a higher price for the put and the seller of the put will also demand \na higher price. As with listed calls, listed puts are not adjusted for the payment of cash \ndividends on the underlying stock. However, the price of the option itself will reflect \nthe dividend payments on the stock. \n250 Part Ill: Put Option Strategies \nExample: XYZ is selling for $25 per share and will pay $1 in dividends over the next \n6 months. Then a 6-month put option with strike 25 should automatically be worth \nat least $1, regardless of any other factor concerning the underlying stock. During the \nnext 6 months, the stock will be reduced in price by the amount of its dividends- $1 \n- and if everything else remained the same, the stock would then be at 24. With the \nstock at 24, the put would be 1 point in-the-money and would thus be worth at least \nits intrinsic value of 1 point. Thus, in advance, this large dividend payout of the \nunderlying stock will help to increase the price of the put options on this stock. \nOn the day before a stock goes ex-dividend, the time value premium of an in\nthe-money put should be at least as large as the impending cash dividend payment. \nThat is, if XYZ is 40 and is about to pay a $.50 dividend, an XYZ January 50 put should \nsell for at least l 0½. This is true because the stock will be reduced in price by the \namount of its dividend on the day of the ex-dividend. \nEXERCISE AND ASSIGNMENT \nWhen the holder of a put option exercises his option, he sells stock at the striking \nprice. He may exercise this right at any time during the life of the put option. When \nthis happens, the writer of a put option with the same terms is assigned an obligation \nto buy stock at the striking price. It is important to notice the difference between \nputs and calls in this case. The call holder exercises to buy stock and the call writer is \nobligated to sell stock. The reverse is true for the put holder and writer. \nThe methods of assignment via the OCC and the brokerage firm are the same \nfor puts and calls; any fair method of random or first-in/first-out assignment is \nallowed. Stock commissions are charged on both the", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 112}
{"text": "he difference between \nputs and calls in this case. The call holder exercises to buy stock and the call writer is \nobligated to sell stock. The reverse is true for the put holder and writer. \nThe methods of assignment via the OCC and the brokerage firm are the same \nfor puts and calls; any fair method of random or first-in/first-out assignment is \nallowed. Stock commissions are charged on both the purchase and sale of the stock \nvia the assignment and exercise. \nWhen the holder of a put option exercises his right to sell stock, he may be sell\ning stock that he currently holds in his portfolio. Second, he may simultaneously go \ninto the open market and buy stock for sale via the put exercise. Finally, he may want \nto sell the stock in his short stock account; that is, he may short the underlying stock \nby exercising his put option. He would have to be able to borrow stock and supply \nthe margin collateral for a short sale of stock if he chose this third course of action. \nThe writer of the put option also has several choices in how he wants to handle \nthe stock purchase that he is required to make. The put writer who is assigned must \nreceive stock. (The call writer who is assigned delivers stock.) The put writer may cur\nrently be short the underlying stock, in which case he will merely use the receipt of \nstock from the assignment to cover his short sale. He may also decide to immediate-\n0.,ter 15: Put Option Basics 251 \nly sell stock in the open market to offset the purchase that he is forced to make via \nthe put assignment. Finally, he may decide to retain the stock that is delivered to him; \nhe merely keeps the stock in his portfolio. He would, of course, have to pay for ( or \nmargin) the stock if he decides to keep it. \nThe mechanics as to how the put holder wants to deliver the stock and how the \nput writer wants to receive the stock are relatively simple. Each one merely notifies \nhis brokerage firm of the way in which he wants to operate and, provided that he can \nmeet the margin requirements, the exercise or assignment will be made in the \ndesired manner. \nANTICIPATING ASSIGNMENT \nThe writer of a put option can anticipate assignment in the same way that the writer \nof a call can. When the time value premium of an in-the-money put option disappears, \nthere is a risk of assignment, regardless of the time remaining until expiration. In \nChapter 1, a form of arbitrage was described in which market-makers or firm traders, \nwho pay little or no commissions, can take advantage of an in-the-money call selling \nat a discount to parity. Similarly, there is a method for these traders to take advantage \nof an in-the-money put selling at a discount to parity. \nExample: XYZ is at 40 and an XYZ July 50 put is selling for 9¾ a ¼ discount from \nparity. That is, the option is selling for ¼ point below its intrinsic value. The arbi\ntrageur could take advantage of this situation through the following actions: \n1. Buy the July put at 9¾. \n2. Buy XYZ common stock at 40. \n3. Exercise the put to sell XYZ at 50. \nThe arbitrageur makes 10 points on the stock portion of the transaction, buying the \ncommon at 40 and selling it at 50 via exercise of his put. He paid 9¾ for the put \noption and he loses this entire amount upon exercise. However, his overall profit is \nthus ¼ point, the amount of the original discount from parity. Since his commission \ncosts are minimal, he can actually make a net profit on this transaction. \nAs was the case with deeply in-the-money calls, this type of arbitrage with \ndeeply in-the-money puts provides a secondary market that might not otherwise \nexist. It allows the public holder of an in-the-money put to sell his option at a price \nnear its intrinsic value. Without these arbitrageurs, there might not be a reasonable \nsecondary market in which public put holders could liquidate. \n252 Part Ill: Put Option Strategies \nDividend payment dates may also have an effect on the frequency of assign\nment. For call options, the writer might expect to receive an assignment on the day \nthe stock goes ex-dividend. The holder of the call is able to collect the dividend by \nso exercising. Things are slightly different for the writer of puts. He might expect \nto receive an assignment on the day after the ex-dividend date of the underlying \nstock. Since the writer of the put is obligated to buy stock, it is unlikely that any\none would put the stock to him until after the dividend has been paid. In any case, \nthe writer of the put can use a relatively simple gauge to anticipate assignment near \nthe ex-dividend date. If the time value premium of an in-the-money put is less than \nthe amount of the dividend to be paid, the writer may often anticipate that he will \nbe assigned immediately after the ex-dividend of the stock. An example will show \nwhy this is true. \nExample: XYZ is at 45 and it will pay a $.50 dividend. Furthermore, the XYZ July 50 \nput is selling at 5¼. Note that the time value premium of the July 50 put is ¼ point \n- less than the amount of the dividend, which is ½ point. An arbitrageur could take \nthe following actions: \n1. Buy XYZ at 45. \n2. Buy the July 50 put at 5¼. \n3. Collect the ½-point dividend (he must hold the stock until the ex-date to collect \nthe dividend). \n4. Exercise his put to sell XYZ at 50 ( writer would receive assignment on the day \nafter the ex-date). \nThe arbitrageur makes 5 points on the stock trades, buying XYZ at 45 and selling it \nat 50 via exercise of the put. He also collects the ½-point dividend, making his total \nintake equal to 5½ points. He loses the 5¼ points that he paid for the put but still \nhas a net profit of ¼ point. Thus, as the ex-dividend date of a stock approaches, the \ntime value premium of all in-the-money puts on that stock will tend to equal or exceed \nthe amount of the dividend payment. \nThis is quite different from the call option. It was shown in Chapter 1 that the \ncall writer only needs to observe whether the call was trading at or", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 113}
{"text": "that he paid for the put but still \nhas a net profit of ¼ point. Thus, as the ex-dividend date of a stock approaches, the \ntime value premium of all in-the-money puts on that stock will tend to equal or exceed \nthe amount of the dividend payment. \nThis is quite different from the call option. It was shown in Chapter 1 that the \ncall writer only needs to observe whether the call was trading at or below parity, \nregardless of the amount of the dividend, as the ex-dividend date approaches. The \nput writer must determine if the time value premium of the put exceeds the amount \nof the dividend to be paid. If it does, there is a much smaller chance of assignment \nbecause of the dividend. In any case, the put writer can anticipate the assignment if \nhe carefully monitors his position. \nO.,ter 15: Put Option Basics \nPOSITION LIMITS \n253 \nRecall that the position limit rule states that one cannot have a position of more than \nthe limit of options on the same side of the market in the same underlying security. \nThe limit varies depending on the trading activity and volatility of the underlying stock \nand is set by the exchange on which the options are traded. The actual limits are \n13,500, 22,500, 31,500, 60,000, or 75,000 contracts, depending on these factors. One \ncannot have more than 75,000 option contracts on the bullish side of the market - long \ncalls and/or short puts - nor can he have more than 75,000 contracts on the bearish \nside of the market - short calls and/or long puts. He may, however, have 75,000 con\ntracts on each side of the market; he could simultaneously be long 75,000 calls and \nlong 75,000 puts. \nFor the following examples, assume that one is concerned with an underlying \nstock whose position limit is 75,000 contracts. \nLong 75,000 calls, long 75,000 puts - no violation; 75,000 contracts bullish (long \ncalls) and 75,000 contracts bearish (long puts). \nLong 38,000 calls, short 37,000 puts - no violation; total of 75,000 contracts bullish. \nLong 38,000 calls, short 38,000 puts - violation; total of 76,000 contracts bullish. \nMoney managers should be aware that these position limits apply to all \"related\" \naccounts, so that someone managing several accounts must total all the accounts' \npositions when considering the position limit rule. \nCONVERSION \nMany of the relationships between call prices and put prices relate to a process \nknown as a conversion. This term dates back to the over-the-counter option days \nwhen a dealer who owned a put ( or could buy one) was able to satisfy the needs of a \npotential call buyer by \"converting\" the put to a call. This terminology is somewhat \nconfusing, and the actual position that the dealer would take is little more than an \narbitrage position. In the listed market, arbitrageurs and firm traders can set up the \nsame position that the converter did. \nThe actual details of the conversion process, which must include the carrying \ncost of owning stock and the inclusion of all dividends to be paid by the stock during \nthe time the position is held, are described later. However, it is important for the put \noption trader to understand what the arbitrageur is attempting to do in order for him \nto fully understand the relationship between put and call prices in the listed option \nmarket. \n254 Part Ill: Put Option Strategies \nA conversion position has no risk. The arbitrageur will do three things: \n1. Buy 100 shares of the underlying stock. \n2. Buy 1 put option at a certain striking price. \n3. Sell l call option at the same striking price. \nThe arbitrageur has no risk in this position. If the underlying stock drops, he can \nalways exercise his long put to sell the stock at a higher price. If the underlying stock \nrises, his long stock offsets the loss on his short call. Of course, the prices that the \narbitrageur pays for the individual securities determine whether or not a conversion \nwill be profitable. At times, a public customer may look at prices in the newspaper \nand see that he could establish a position similar to the foregoing one for a profit, \neven after commissions. However, unless prices are out of line, the public customer \nwould not normally be able to make a better return than he could by putting his \nmoney into a bank or a Treasury bill, because of the commission costs he would pay. \nWithout needing to understand, at this time, exactly what prices would make an \nattractive conversion, it is possible to see that it would not always be possible for the \narbitrageur to do a conversion. The mere action of many arbitrageurs doing the same \nconversion would force the prices into line. The stock price would rise because arbi\ntrageurs are buying the stock, as would the put price; and the call price would drop \nbecause of the preponderance of sellers. \nWhen this happens, another arbitrage, known as a reversal ( or reverse conver\nsion), is possible. In this case, the arbitrageur does the opposite: He shorts the under\nlying stock, sells 1 put, and buys 1 call. Again, this is a position with no risk. If the \nstock rises, he can always exercise his call to buy stock at a lower price and cover his \nshort sale. If the stock falls, his short stock will offset any losses on his short put. \nThe point of introducing this information, which is relatively complicated, at \nthis place in the text is to demonstrate that there is a relationship between put and \ncall prices, when both have the same striking price and expiration date. They are not \nindependent of one another. If the put becomes \"cheap\" with respect to the call, arbi\ntrageurs will move in to do conversions and force the prices back in line. On the other \nhand, if the put becomes expensive with relationship to the call, arbitrageurs will do \nreversals until the prices move back into line. \nBecause of the way in which the carrying cost of the stock and the dividend rate \nof the stock are involved in doing these conversions or reversals, two facts come to \nlight regarding the relationship of p", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 114}
{"text": "versions and force the prices back in line. On the other \nhand, if the put becomes expensive with relationship to the call, arbitrageurs will do \nreversals until the prices move back into line. \nBecause of the way in which the carrying cost of the stock and the dividend rate \nof the stock are involved in doing these conversions or reversals, two facts come to \nlight regarding the relationship of put prices and call prices. Both of these facts have \nto do with the carrying costs incurred during the conversion. First, a put option will \ngenerally sell for less than a call option when the underlying stock is exactly at the \nstriking price, unless the stock pays a large dividend. In the older over-the-counter \na,,pter 15: Put Option Basics 255 \noption market, it was often stated that the reason for this relationship was that the \ndemand for calls was larger than the demand for puts. This may have been partially \ntrue, but certainly it is no longer true in the listed option targets, where a large sup\nply of both listed puts and calls is available through the OCC. Arbitrageurs again \nserve a useful function in increasing supply and demand where it might not other\nwise exist. The second fact concerning the relationship of puts and calls is that a put \noption will lose its time value premium much more quickly in-the-money than a call \noption will (and, conversely, a put option will generally hold out-of-the-money time \nvalue premium better than a call option will). Again, the conversion and reversal \nprocesses play a large role in this price action phenomenon of puts and calls. Both of \nthese facts have to do with the carrying costs involved in the conversion. \nIn the chapter on Arbitrage, exact details of conversions and reversals will be \nspelled out, with specific reasons why these procedures affect the relationship of put \nand call prices as stated above. However, at this time, it is sufficient for the reader to \nunderstand that there is an arbitrage process that is quite widely practiced that will, \nin fact, make true the foregoing relationships between puts and calls. \nPut Option Buying \nThe purchase of a put option provides leverage in the case of a downward move by \nthe underlying stock. In this manner, it is an alternative to the short sale of stock, \nmuch as the purchase of a call option is a leveraged alternative to the purchase of \nstock. \nPUT BUYING VERSUS SHORT SALE \nIn the simplest case, when an investor expects a stock to decline in price, he may \neither short the underlying stock or buy a put option on the stock. Suppose that XYZ \nis at 50 and that an XYZ July 50 put option is trading at 5. If the underlying stock \ndeclines substantially, the buyer of the put could make profits considerably in excess \nof his initial investment. However, if the underlying stock rises in price, the put buyer \nhas limited risk; he can lose only the amount of money that he originally paid for the \nput option. In this example, the most that the put buyer could lose would be 5 points, \nwhich is equal to his entire initial investment. Table 16-1 and Figure 16-1 depict the \nresults, at expiration, of this simple purchase of the put option. \nThe put buyer has limited profit potential, since a stock can never drop in price \nbelow zero dollars per share. However, his potential profits can be huge, percent\nagewise. His loss, which normally would occur if the stock rises in price, is limited to \nthe amount of his initial investment. The simplest use of a put purchase is for specu\nlative purposes when expecting a price decline in the underlying stock. \nThese results for the profit or loss of the put option purchases can be compared \nto a similar short sale of XYZ at 50 in order to observe the benefits of leverage and \nlimited risk that the put option buyer achieves. In order to sell short 100 XYZ at 50, \nassume that the trader would have to use $2,500 in margin. Several points can be ver-\n256 \nGopter 16: Put Option Buying \nTABLE 16-1. \nResults of put purchase at expiration. \nXYZ Price ot Put Price ot \nExpiration Expiration \n20 \n30 \n40 \n45 \n48 \n50 \n60 \n70 \nFIGURE 16-1. \nPut option purchase. \n30 \n20 \n10 \n5 \n2 \n0 \n0 \n0 \nStock Price at Expiration \n257 \nPut Option \nProfit \n+$2,500 \n+ 1,500 \n+ 500 \n0 \n300 \n500 \n500 \n500 \nifled from Table 16-2 and Figure 16-1. If the stock drops in price sufficiently far, the \npercentage profits are much greater on the put option purchase than they are on the \nshort sale of the underlying stock. This is the leveraging effect that an option pur-\n258 Part Ill: Put Option Strategies \nchase can achieve. If the underlying stock remains relatively unchanged, the short \nseller would do better because he does not risk losing his entire investment in a lim\nited amount of time if the underlying stock changes only slightly in price. However, \nif the underlying stock should rise dramatically, the short seller can actually lose more \nthan his initial investment. The short sale of stock has theoretically unlimited risk. \nSuch is not true of the put option purchase, whereby the risk is limited to the amount \nof the initial investment. One other point should be made when comparing the pur\nchase of a put and the short sale of stock: The short seller of stock is obligated to pay \nthe dividends on the stock, but the put option holder has no such obligation. This is \nan additional advantage to the holder of the put. \nTABLE 16-2. \nResults of selling short. \nXYZ Price at Put Option \nExpiration Short Sale Purchase \n20 + $3,000 (+ 120%) +$2,500 (+ 500%) \n30 + 2,000 (+ 80%) + 1,500 (+ 300%) \n40 + 1,000 (+ 40%) + 500 (+ 100%) \n45 + 500(+ 20%) 0( 0%) \n48 + 200(+ 80%) 300 (- 60%) \n50 0( 0%) 500 (- 100%) \n60 - 1,000 (- 40%) 500 (- 100%) \n75 - 2,500 (- 100%) 500 (- 100%) \n100 - 5,000 (- 200%) 500 (- 100%) \nSELECTING WHICH PUT TO BUY \nMany of the same types of analyses that the call buyer goes through in deciding which \ncall to buy can be used by the prospective put buyer as well. First, when approach\ning put buy", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 115}
{"text": "0 (+ 100%) \n45 + 500(+ 20%) 0( 0%) \n48 + 200(+ 80%) 300 (- 60%) \n50 0( 0%) 500 (- 100%) \n60 - 1,000 (- 40%) 500 (- 100%) \n75 - 2,500 (- 100%) 500 (- 100%) \n100 - 5,000 (- 200%) 500 (- 100%) \nSELECTING WHICH PUT TO BUY \nMany of the same types of analyses that the call buyer goes through in deciding which \ncall to buy can be used by the prospective put buyer as well. First, when approach\ning put buying as a speculative strategy, one should not place more than 15% of his \nrisk capital in the strategy. Some investors participate in put buying to add some \namount of downside protection to their basically bullishly-oriented common stock \nportfolios. More is said in Chapter 17 about buying puts on stocks that one actually \nowns. \nThe out-ofthe-nwney put offers both higher reward potentials and higher risk \npotentials than does the in-the-nwney put. If the underlying stock drops substantial-\nG,pter 16: Put Option Buying 259 \nly, the percentage returns from having purchased a cheaper, out-of-the-money put \nwill be greater. However, should the underlying stock decline only moderately in \nprice, the in-the-rrwney put will often prove to be the better choice. In fact, since a \nput option tends to lose its time value premium quickly as it becomes an in-the\nmoney option, there is an even greater advantage to the purchase of the in-the\nmoney put. \nExample: XYZ is at 49 and the following prices exist: \nXYZ, 49; \nXYZ July 45 put, l; and \nXYZ July 50 put, 3. \nIf the underlying stock were to drop to 40 by expiration, the July 45 put would be \nworth 5 points, a 400% profit. The July 50 put would be worth 10 points, a 233% \nprofit over its initial purchase price of 3. Thus, in a substantial downward move, the \nout-of-the-money put purchase provides higher reward potential. However, if the \nunderlying stock drops only moderately, say to t:15, the purchaser of the July 45 put \nwould lose his entire investment, since the put would be worthless at expiration. The \npurchaser of the in-the-money July 50 put would have a 2-point profit with XYZ at \n45 at expiration. \nThe preceding analysis is based on holding the put until expiration. For the \noption buyer, this is generally an erroneous form of analysis, because the buyer \ngenerally tends to liquidate his option purchase in advance of expiration. When \nconsidering what happens to the put option in advance of expiration, it is helpful to \nremember that an in-the-money put tends to lose its time premium rather quickly. \nIn the example above, the July 45 put is completely composed of time value pre\nmium. If the underlying stock begins to drop below 45, the price of the put will not \nincrease as rapidly as would the price of a call that is going into-the-money. \nExample: If XYZ fell by 5 points to 44, definitely a move in the put buyer's favor, he \nmay fmd that the July 45 put has increased in value only to 2 or 2½ points. This is \nsomewhat disappointing because, with call options, one would expect to do signifi\ncantly better on a 5-point stock movement in his favor. Thus, when purchasing put \noptions for speculation, it is generally best to concentrate on in-the-rrwney puts unless \na very substantial decline in the price of the underlying stock is anticipated. \nOnce the put option is in-the-money, the time value premium will decrease \neven in the longer-term series. Since this time premium is small in all series, the put \n260 Part Ill: Put Option Strategies \nbuyer can often purchase a longer-term option for very little extra money, thus gain\ning more time to work with. Call option buyers are generally forced to avoid the \nlonger-term series because the extra cost is not worth the risk involved, especially in \na trading situation. However, the put buyer does not necessarily have this disadvan\ntage. If he can purchase the longer-term put for nearly the same price as the near\nterm put, he should do so in case the underlying stock takes longer to drop than he \nhad originally anticipated it would. \nIt is not uncommon to see such prices as the following: \nXYZ common, 46: \nXYZ April 50 put, 4; \nXYZ July 50 put, 4½; and \nXYZ October 50 put, 5. \nNone of these three puts have much time value premium in their prices. Thus, the \nbuyer might be willing to spend the extra 1 point and buy the longest-term put. If the \nunderlying stock should drop in price immediately, he will profit, but not as much as \nif he had bought one of the less expensive puts. However, should the underlying stock \nrise in price, he will own the longest-term put and will therefore suffer less of a loss, \npercentagewise. If the underlying stock rises in price, some amount of time value \npremium will come back into the various puts, and the longest-term put will have the \nlargest amount of time premium. For example, if the stock rises back to 50, the fol\nlowing prices might exist: \nXYZ common, 50; \nXYZ April 50 put, l; \nXYZ July 50 put, 2½; and \nXYZ October 50 put, 3½. \nThe purchase of the longer-term October 50 put would have suffered the least loss, \npercentagewise, in this event. Consequently, when one is purchasing an in-the\nmoney put, he may often want to consider buying the longest-term put if the time \nvalue premium is small when compared to the time premium in the nearer-term \nputs. \nIn Chapter 3, the delta of an option was described as the amount by which one \nmight expect the option will increase or decrease in price if the underlying stock \nmoves by a fixed amount (generally considered to be one point, for simplicity). Thus, \nif XYZ is at 49 and a call option is priced at 3 with a delta of ½, one would expect the \ncall to sell for 3½ with XYZ at 50 and to sell at 2¼ with XYZ at 48. In reality, the delta \nO.,ter 16: Put Option Buying 261 \nchanges even on a fractional move in the underlying stock, but one generally assumes \nthat it will hold true for a 1-point move. Obviously, put options have deltas as well. The \ndelta of a put is a negative number, reflecting the fact that the put price and the stoc", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 116}
{"text": "ct the \ncall to sell for 3½ with XYZ at 50 and to sell at 2¼ with XYZ at 48. In reality, the delta \nO.,ter 16: Put Option Buying 261 \nchanges even on a fractional move in the underlying stock, but one generally assumes \nthat it will hold true for a 1-point move. Obviously, put options have deltas as well. The \ndelta of a put is a negative number, reflecting the fact that the put price and the stock \nprice are inversely related. As an approximation, one could say that the delta of the \nctill option minus the delta of the put option with the same terms is equal to 1. That is, \nDelta of put = Delta of call - 1. \nThis is an approximation and is accurate unless the put is deeply in-the-money. It has \nalready been pointed out that the time value premium behavior of puts and calls is \ndifferent, so it is inaccurate to assume that this formula holds true exactly for all \ncases. \nThe delta of a put ranges between O and minus 1. If a July 50 put has a delta of \n-½, and the underlying stock rises by 1 point, the put will lose ½ point. The delta of \na deeply out-of-the-money put is close to zero. The put's delta would decrease slow\nly at first as the stock declined in value, then would begin to decrease much more \nrapidly as the stock fell through the striking price, and would reach a value of minus \n1 (the minimum) as the stock fell only moderately below the striking price. This is \nreflective of the fact that an out-of-the-money put tends to hold time premium quite \nwell and an in-the-money put comes to parity rather quickly. \nRANKING PROSPECTIVE PUT PURCHASES \nIn Chapter 3, a method of ranking prospective call purchases was developed that \nencompassed certain factors, such as the volatility of the underlying stock and the \nexpected holding period of the purchased option. The same sort of analysis should be \napplied to put option purchases. \nThe steps are summarized below. The reader may refer to the section titled \n\"Advanced Selection Criteria\" in Chapter 3 for a more detailed description of why \nthis method of ranking is superior. \n1. Assume that each underlying stock can decrease in price in accordance with its \nvolatility over a fixed holding period (30, 60, or 90 days). \n2. Estimate the put option prices after the decrease. \n3. Rank all potential put purchases by the highest reward opportunity for aggressive \npurchases. \n4. Estimate how much would be lost if the underlying stock instead rose in accor\ndance with its volatility, and rank all potential put purchases by best risk/reward \nratio for a more conservative list of put purchases. \n262 Part Ill: Put Option Strategies \nAs was stated earlier, it is necessary to have a computer to make an accurate analysis \nof all listed options. The average customer is forced to obtain such data from a bro\nkerage firm or data service. He should be sure that the list he is using conforms to \nthe above-mentioned criteria. If the data service is ranking option purchases by how \nwell the puts would do if each underlying stock fell by a fixed percentage (such as 5% \nor 10%), the list should be rejected because it is not incorporating the volatility of the \nunderlying stock into its analysis. Also, if the list is based on holding the put purchase \nuntil expiration, the list should be rejected as well, because this is not a realistic \nassumption. There are enough reliable and sophisticated data services that one \nshould not have to work with inferior analyses in today's option market. \nFor those readers who are more mathematically advanced and have the com\nputer capability to construct their own analyses, the details of implementing an analy\nsis similar to the one described above are presented in Chapter 28, Mathematical \nApplications. An application of put purchases, combined with fixed-income securi\nties, is described in Chapter 26, Buying Options and Treasury Bills. \nFOLLOW-UP ACTION \nThe put buyer can take advantage of strategies that are very similar to those the call \nbuyer uses for follow-up action, either to lock in profits or to attempt to improve a \nlosing situation. Before discussing these specific strategies, it should be stated again \nthat it is rarely to the option buyer's benefit to exercise the option in order to liqui\ndate. This precludes, of course, those situations in which the call buyer actually wants \nto own the stock or the put buyer actually wants to sell the stock. If, however, the \noption holder is merely looking to liquidate his position, the cost of stock commis\nsions makes exercising a prohibitive move. This is true even ifhe has to accept a price \nthat is a slight discount from parity when he sells his option. \nLOCKING IN PROFITS \nThe reader may recall that there were four strategies (perhaps \"tactics\" is a better \nword) for the call buyer with an unrealized profit. These same four tactics can be \nused with only slight variations by the put option buyer. Additionally, a fifth strategy \ncan be employed when a stock has both listed puts and calls. \nAfter an underlying stock has moved down and the put buyer has a relatively \nsubstantial unrealized gain, he might consider taking one of the following actions: \n1. Sell the put and liquidate the position for a profit. \n2. Do nothing and continue to hold the put. \nO.,,er 16: Put Option Buying 263 \n3, Sell the in-the-money long put and use part of the proceeds to purchase out-of\nthe-money puts. \n4. Create a spread by selling an out-of-the-money put against the one he currently \nholds. \nThese are the same four tactics that were discussed earlier with respect to call buy\ning. In the fifth tactic, the holder of a listed put who has an unrealized profit might \nconsider buying a listed call to protect his position. \nExample: A speculator originally purchased an XYZ October 50 put for 2 points when \nthe stock was 52. If the stock has now fallen to 45, the put might be worth 6 points, \nrepresenting an unrealized gain of 4 points and placing the put buyer in a position to \nimplement one of these five", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 117}
{"text": "older of a listed put who has an unrealized profit might \nconsider buying a listed call to protect his position. \nExample: A speculator originally purchased an XYZ October 50 put for 2 points when \nthe stock was 52. If the stock has now fallen to 45, the put might be worth 6 points, \nrepresenting an unrealized gain of 4 points and placing the put buyer in a position to \nimplement one of these five tactics. After some time has passed, with the stock at 45, \nan at-the-money October 45 put might be selling for 2 points. Table 16-3 summarizes \nthe situation. If the trader merely liquidates his position by selling out the October 50 \nput, he would realize a profit of 4 points. Since he is terminating the position, he can \nmake neither more nor less than 4 points. This is the most conservative of the tactics, \nallowing no additional room for appreciation, but also eliminating any chance of los\ning the accumulated profits. \nTABLE 16-3. \nBackground table for profit alternatives. \nOriginal Trade Current Prices \nXYZ common: 52 XYZ common: 45 \nBought XYZ October 50 put at 2 XYZ October 50 put: 6 \nXYZ October 45 put: 2 \nIf the trader does nothing, merely continuing to hold the October 50 put, he is \ntaking an aggressive action. If the stock should reverse and rise back above 50 by \nexpiration, he would lose everything. However, if the stock continues to fall, he could \nbuild up substantially larger profits. This is the only tactic that could eventually result \nin a loss at expiration. \nThese two simple strategies - liquidating or doing nothing are the easiest \nalternatives. The remaining strategies allow one to attempt to achieve a balance \nbetween retaining built-up profits and generating even more profits. The third tactic \nthat the speculator could use would be to sell the put that he is currently holding and \n264 Part Ill: Put Option Strategies \nuse some of the proceeds to purchase the October 45 put. The general idea in this \ntactic is to pull one's initial investment out of the market and then to increase the \nnumber of option contracts held by buying the out-of-the-money option. \nExample: The trader would receive 6 points from the sale of the October 50 put. He \nshould take 2 points of this amount and put it back into his pocket, thus covering his \ninitial investment. Then he could buy 2 October 45 puts at 2 points each with the \nremaining portion of the proceeds from the sale. He has no risk at expiration with this \nstrategy, since he has recovered his initial investment. Moreover, if the underlying \nstock should continue to fall rapidly, he could profit handsomely because he has \nincreased the number of put contracts that he holds. \nThe fourth choice that the put holder has is to create a spread by selling the \nOctober 45 put against the October 50 that he currently holds. This would create a \nbear spread, technically. This type of spread is described in more detail later. For the \ntime being, it is sufficient to understand what happens to the trader's risks and \nrewards by creating this spread. The sale of the October 45 put brings in 2 points, \nwhich covers the initial 2-point purchase cost of the October 50 put. Thus, his \"cost\" \nfor this spread is nothing; he has no risk, except for commissions. If the underlying \nstock should rise above 50 by expiration, all the puts would expire worthless. (A put \nexpires worthless when the underlying stock is above the striking price at expiration.) \nThis would represent the worst case; he would recover nothing from the spread. If \nthe stock should be below 45 at expiration, he would realize the maximum potential \nof the spread, which is 5 points. That is, no matter how far XYZ is below 45 at expi\nration, the October 50 put will be worth 5 points more than the October 45 put, and \nthe spread could thus be liquidated for 5 points. His maximum profit potential in the \nspread situation is 5 points. This tactic would be the best one if the underlying stock \nstabilized near 45 until expiration. \nTo analyze the fifth strategy that the put holder could use, it is necessary to \nintroduce a call option into the picture. \nExample: With XYZ at 45, there is an October 45 call selling for 3 points. The put \nholder could buy this call in order to limit his risk and still retain the potential for \nlarge future profits. If the trader buys the call, he will have the following position: \nLong l October 50 put C b' d t 5 . t \nl O b 5 all - om me cos : porn s Long cto er 4 c \nThe total combined cost of this put and call combination is 5 points - 2 points were \noriginally paid for the put, and now 3 points have been paid for the call. No matter \nwhere the underlying stock is at expiration, this combination will be worth at least 5 \nGapter 16: Put Option Buying 265 \npoints. For example, if XYZ is at 46 at expiration, the put will be worth 4 and the call \nworth l; or if XYZ is at 48, the put will be worth 2 and the call worth 3. If the stock \nis above 50 or below 45 at expiration, the combination will be worth more than 5 \npoints. Thus, the trader has no risk in this combination, since he has paid 5 points for \nit and will be able to sell it for at least 5 points at expiration. In fact, if the underly\ning stock continues to drop, the put will become more valuable and he could build \nup substantial profits. Moreover, if the underlying stock should reverse direction and \nclimb substantially, he could still profit, because the call will then become valuable. \nThis tactic is the best one to use if the underlying stock does not stabilize near 45, \nbut instead makes a relatively dramatic move either up or down by expiration. The \nstrategy of simultaneously owning both a put and a call is discussed in much greater \ndetail in Chapter 23. It is introduced here merely for the purposes of the put buyer \nwanting to obtain protection of his unrealized profits. \nEach of these five strategies may work out to be the best one under a different \nset of circumstances. The ultimate result of", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 118}
{"text": "c move either up or down by expiration. The \nstrategy of simultaneously owning both a put and a call is discussed in much greater \ndetail in Chapter 23. It is introduced here merely for the purposes of the put buyer \nwanting to obtain protection of his unrealized profits. \nEach of these five strategies may work out to be the best one under a different \nset of circumstances. The ultimate result of each tactic is dependent on the direction \nthat XYZ moves in the future. As was the case with call options, the spread tactic \nnever turns out to be the worst tactic, although it is the best one only if the underly\ning stock stabilizes. Tables 16-4 and 16-5 summarize the results the speculator could \nexpect from invoking each of these five tactics. The tactics are: \n1. Liquidate - sell the long put for a profit and do not reinvest. \n2. Do nothing - continue to hold the long put. \n3. \"Roll down\" - sell the long put, pocket the initial investment, and invest the \nremaining proceeds in out-of-the-money puts at a lower strike. \n4. \"Spread\" - create a spread by selling the out-of-the-money put against the put \nalready held. \n5. \"Combine\" create a combination by buying a call at a lower strike while con\ntinuing to hold the put. \nTABLE 16-4. \nComparison of the five tactics. \nBy expiration, if XYZ ... \nContinues to fall dramatically \nFalls moderately further \nRemains relatively unchanged \nRises moderately \nRises substantially \nthe best strategy was ... \n\"Roll down\" \nDo nothing \nSpread \nLiquidate \nCombine \nand the worst \nstrategy was ... \nLiquidate \nCombine \nCombine or \"roll down\" \n\"Roll down\" or do nothing \nDo nothing \n266 Part Ill: Put Option Strategies \nTABLE 16-5. \nResults of adopting each of the five tactics. \nXYZ Price at \"Roll Down\" Do-Nothing Spread Liquidate Combine \nExpiration Profit Profit Profit Profit Profit \n30 + $3,000 (8) +$1,800 +$500 +$400 (W) +$1,500 \n35 + 2,000 (8) + 1,300 + 500 + 400 (W) + 1,000 \n41 + 800 (8) + 700 + 500 + 400 (W) + 400 \n42 + 600 (8) + 600 (8) + 500 + 400 + 300 (W) \n43 + 400 + 500 (8) + 500 (8) + 400 + 200 (W) \n45 0(W) + 300 + 500 (8) + 400 0(W) \n46 0(W) + 200 + 400 (8) + 400 (8) O(W) \n48 0(W) 0(W) + 200 + 400 (8) 0(W) \n50 0 200 (W) 0 + 400 (8) 0 \n54 0 200 (W) 0 + 400 (8) + 400 (8) \n60 0 200 (W) 0 + 400 + 1,000 (8) \nNote that each tactic is the best one under one of the scenarios, but that the spread \ntactic is never the worst of the five. The actual results of each tactic, using the figures \nfrom the example above, are depicted in Table 16-5, where B denotes best tactic and \nW denotes worst one. \nAll the strategies are profitable if the underlying stock continues to fall dramat\nically, although the \"roll down,\" \"do nothing,\" and combinations work out best, \nbecause they continue to accrue profits if the stock continues to fall. If the underly\ning stock rises instead, only the combination outdistances the simplest tactic of all, \nliquidation. \nIf the underlying stock stabilizes, the \"do-nothing\" and \"spread\" tactics work out \nbest. It would generally appear that the combination tactic or the \"roll-down\" tactic \nwould be the most attractive, since neither one has any risk and both could generate \nlarge profits if the stock moved substantially. The advantage for the spread was sub\nstantial in call options, but in the case of puts, the premium received for the out-of\nthe-money put is not as large, and therefore the spread strategy loses some of its \nattractiveness. Finally, any of these tactics could be applied partially; for example, one \ncould sell out half of a profitable long position in order to take some profits, and con\ntinue to hold the remainder. \nCl,opter 16:PutOptionBuying \nLOSS-LIMITING ACTIONS \n267 \nThe foregoing discussion concentrated on how the put holder could retain or \nincrease his profit. However, it is often the case in option buying that the holder of \nthe option is faced with an unrealized loss. The put holder may also have several \nchoices of action to take in this case. His first, and simplest, course of action would \nbe to sell the put and take his loss. Although this is advisable in certain cases, espe\ncially when the underlying stock seems to have assumed a distinctly bullish stance, it \nis not always the wisest thing to do. The put holder who has a loss may also consider \neither \"rolling up\" to create a bearish spread or entering into a calendar spread. \nEither of these actions could help him recover part or all of his loss. \nTHE \"ROLLING-UP\" STRATEGY \nThe reader may recall that a similar action to \"rolling up,\" termed \"rolling down,\" was \navailable for call options held at a loss and was described in Chapter 3. The put buyer \nwho owns a put at a loss may be able to create a spread that allows him to break even \nat a more favorable price at expiration. Such action will inevitably limit his profit \npotential, but is generally useful in recovering something from a put that might oth\nerwise expire totally worthless. \nExample: An investor initially purchases an XYZ October 45 put for 3 points when \nthe underlying stock is at 45. However, the stock rises to 48 at a later date and the \nput that was originally bought for 3 points is now selling for 1 ¼ points. It is not \nunusual, by the way, for a put to retain this much of its value even though the stock \nhas moved up and some amount of time has passed, since out-of-the-money puts \ntend to hold time value premium rather well. With XYZ at 48, an October 50 put \nmight be selling for 3 points. The put holder could create a position designed to per\nmit recovery of some of his losses by selling two of the puts that he is long - October \n45's - and simultaneously buying one October 50 put. The net cost for this transac\ntion would be only commissions, since he receives $300 from selling two puts at 1 ¼ \neach, which completely covers the $300 cost of buying the October 50 put. The \ntransactions are summarized in Table 16-6. \nBy selling 2 of the October 45 puts, the investor is now short an October 45 put.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 119}
{"text": "that he is long - October \n45's - and simultaneously buying one October 50 put. The net cost for this transac\ntion would be only commissions, since he receives $300 from selling two puts at 1 ¼ \neach, which completely covers the $300 cost of buying the October 50 put. The \ntransactions are summarized in Table 16-6. \nBy selling 2 of the October 45 puts, the investor is now short an October 45 put. \nSince he also purchased an October 50 put, he has a spread ( technically, a bear \nspread). He has spent no additional money, except commissions, to set up this spread, \nsince the sale of the October 45's covered the purchase of the October 50 put. This \nstrategy is most attractive when the debit involved to create the spread is small. In \nthis example, the debit is zero. \n268 \nTABLE 16-6. \nSummary of rolling-up transactions. \nOriginal trade: \nLater: \nNet position: \nBuy 1 October 45 put for 3 \nwith XYZ at 45 \nWith XYZ at 48, sell 2 \nOctober 45's for 11/2 each \nand buy l October 50 put for 3 \nLong 1 October 50 put \nShort 1 October 45 put \nPart Ill: Put Option Strategies \n$300 debit \n$300 credit \n$300 debit \n$300 debit \nThe effect of creating this spread is that the investor has not increased his risk \nat all, but has raised the break-even point for his position. That is, if XYZ merely falls \na small distance, he will be able to get out even. Without the effect of creating the \nspread, the put holder would need XYZ to fall back to 42 at expiration in order for \nhim to break even, since he originally paid 3 points for the October 45 put. His orig\ninal risk was $300. IfXYZ continues to rise in price and the puts in the spread expire \nworthless, the net loss will still be only $300 plus additional commissions. Admittedly, \nthe commissions for the spread will increase the loss slightly, but they are small in \ncomparison to the debit of the position ($300). On the other hand, if the stock should \nfall back only slightly, to 47 by expiration, the spread will break even. At expiration, \nwith XYZ at 47, the in-the-money October 50 put will be worth 3 points and the out\nof-the-money October 45 put will expire worthless. Thus, the investor will recover his \n$300 cost, except for commissions, with XYZ at 47 at expiration. His break-even point \nis raised from 42 to 47, a substantial improvement of his chances for recovery. \nThe implementation of this spread strategy reduces the profit potential of the \nposition, however. The maximum potential of the spread is 2 points. If XYZ is any\nwhere below 45 at expiration, the spread will be worth 5 points, since the October 50 \nput will sell for 5 points more than the October 45 put. The investor has limited his \npotential profit to 2 points - the 5-point maximum width of the spread, less the 3 \npoints that he paid to get into the position. He can no longer gain substantially on a \nlarge drop in price by the underlying stock. This is normally of little concern to the \nput holder faced with an unrealized loss and the potential for a total loss. He gener\nally would be appreciative of getting out even or of making a small profit. The cre\nation of the spread accomplishes this objective for him. \nIt should also be pointed out that he does not incur the maximum loss of his \nentire debit plus commissions, unless XYZ closes above 50 at expiration. If XYZ is \nO,apter 16: Put Option Buying 269 \nanywhere below 50, the October 50 will have some value and the investor will be able \nto recover something from the position. This is distinctly different from the original \nput holding of the October 45, whereby the maximum loss would be incurred unless \nthe stock were below 45 at expiration. Thus, the introduction of the spread also \nreduces the chances of having to realize the maximum loss. \nIn summary, the put holder faced with an unrealized loss may be able to create \na spread by selling twice the number of puts that he is currently long and simultane\nously buying the put at the next higher strike. This action should be used only if the \nspread can be transacted at a small debit or, preferably, at even money (zero debit). \nThe spread position offers a much better chance of breaking even and also reduces \nthe possibility of having to realize the maximum loss in the position. However, the \nintroduction of these loss-limiting measures reduces the maximum potential of the \nposition if the underlying stock should subsequently decline in price by a significant \namount. Using this spread strategy for puts would require a margin account, just as \ncalls do. \nTHE CALENDAR SPREAD STRATEGY \nAnother strategy is sometimes available to the put holder who has an unrealized loss. \nIf the put that he is holding has an intermediate-term or long-term expiration date, \nhe might be able to create a calendar spread by selling the near-term put against the \nput that he currently holds. \nExample: An investor bought an XYZ October 45 put for 3 points when the stock was \nat 45. The stock rises to 48, moving in the wrong direction for the put buyer, and his \nput falls in value to 1 ½. He might, at that time, consider selling the near-term July \n45 put for 1 point. The ideal situation would be for the July 45 put to expire worth\nless, reducing the cost of his long put by 1 point. Then, if the underlying stock \ndeclined below 45, he could profit after July expiration. \nThe major drawback to this strategy is that little or no profit will be made - in \nfact, a loss is quite possible - if the underlying stock falls back to 45 or below before \nthe near-term July option expires. Puts display different qualities in their time value \npremiums than calls do, as has been noted before. With the stock at 45, the differ\nential between the July 45 put and the October 45 put might not widen much at all. \nThis would mean that the spread has not gained anything, and the spreader has a loss \nequal to his commissions plus the initial unrealized loss. In the example above, ifXYZ \ndropped quickly back to 45, the July 45 might be wo", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 120}
{"text": "value \npremiums than calls do, as has been noted before. With the stock at 45, the differ\nential between the July 45 put and the October 45 put might not widen much at all. \nThis would mean that the spread has not gained anything, and the spreader has a loss \nequal to his commissions plus the initial unrealized loss. In the example above, ifXYZ \ndropped quickly back to 45, the July 45 might be worth 1 ½ and the October worth \n2½. At this point, the spreader would have a loss on both sides of his spread: He sold \nthe July 45 put for 1 and it is now 1 ½; he bought the October 45 for 3 and it is now \n270 Part Ill: Put Option Strategies \n2½; plus he has spent two commissions to date and would have to spend two more \nto liquidate the position. \nAt this point, the strategist may decide to do nothing and take his chances that \nthe stock will subsequently rally so that the July 45 put will expire worthless. \nHowever, if the stock continues to decline below 45, the spread will most certainly \nbecome more of a loss as both puts come closer to parity. \nThis type of spread strategy is not as attractive as the \"rolling-up\" strategy. In \nthe \"rolling-up\" strategy, one is not subjected to a loss if the stock declines after the \nspread is established, although he does limit his profits. The fact that the calendar \nspread strategy can lead to a loss even if the stock declines makes it a less desirable \nalternative. \nEQUIVALENT POSITIONS \nBefore considering other put-oriented strategies, the reader should understand the \ndefinition of an equivalent position. Two strategies, or positions, are equivalent when \nthey have the same profit potential. They may have different collateral or investment \nrequirements, but they have similar profit potentials. Many of the call-oriented \nstrategies that were discussed in Part II of the book have an equivalent put strategy. \nOne such case has already been described: The \"protected short sale,\" or shorting the \ncommon stock and buying a call, is equivalent to the purchase of a put. That is, both \nhave a limited risk above the striking price of the option and relatively large profit \npotential to the downside. An easy way to tell if two strategies are equivalent is to see \nif their profit graphs have the same shape. The put purchase and the \"protected short \nsale\" have profit graphs with exactly the same shape (Figures 16-1 and 4-1, respec\ntively). As more put strategies are discussed, it will always be mentioned if the put \nstrategy is equivalent to a previously described call strategy. This may help to clarify \nthe put strategies, which understandably may seem complex to the reader who is not \nfamiliar with put options. \nPut Buying in Conjunction \nwith Com.m.on Stock \nOwnership \nAnother useful feature of put options, in addition to their speculative leverage in a \ndownward move by the underlying stock, is that the put purchase can be used to limit \ndownside loss in a stock that is owned. When one simultaneously owns both the com\nmon stock and a put on that same stock, he has a position with limited downside risk \nduring the life of the put. This position is also called a synthetic long call, because the \nprofit graph is the same shape as a long call's. \nExample: An investor owns XYZ stock, which is at 52, and purchases an XYZ October \n50 put for 2. The put gives him the right to sell XYZ at 50, so the most that the stock\nholder can lose on his stock is 2 points. Since he pays 2 points for the put protection, his \nmaximum potential loss until October expiration is 4 points, no matter how far XYZ \nmight decline up until that time. If, on the other hand, the price of the stock should \nmove up by October, the investor would realize any gain in the stock, less the 2 points \nthat he paid for the put protection. The put functions much like an insurance policy with \na finite life. Table 17-1 and Figure 17-1 depict the results at October expiration for this \nposition: buying the October 50 put for 2 points to protect a holding in XYZ common \nstock, which is selling at 52. The dashed line on the graph represents the profit poten\ntial of the common stock ownership by itself. Notice that if the stock were below 48 in \nOctober, the common stock owner would have been better off buying the put. However, \nwith XYZ above 48 at expiration, the put purchase was a burden that cost a small por\ntion of potential profits. This strategy, however, is not necessarily geared to maximizing \n211 \n272 Part Ill: Put Option Strategies \nTABLE 17-1. \nResults at expiration on a protected stock holding. \nXYZ Price at Stock Put \nExpiration Profit Profit \n30 -$2,200 +$1,800 \n40 - 1,200 + 800 \n50 200 200 \n54 + 200 200 \n60 + 800 200 \n70 + 1,800 200 \n80 + 2,800 200 \nFIGURE 17-1. \nlong common stock and long put. \nC: \n0 \ne ·5. \nX \nw \n1i'i $0 Cf) \nCf) \n0 ..J \nc5 \ne \n0. \n-$400 \n, \n, , , \nLong ,' \nStock ,, \n,, ,, \n, , , \n48 50 ,'52 \n, ,, , \n,, , \n, \n, ,, , \n, , ,, \nStock Price at Expiration \n,, ,, \n,, ,, \n, , \nTotal \nProfit \n-$ 400 \n400 \n400 \n0 \n+ 600 \n+ 1,600 \n+ 2,600 \none's profit potential on the common stock, but rather provides the stock owner with \nprotection, eliminating the possibility of any devastating loss on the stock holding during \nthe life of the put. In all the put buying strategies discussed in this chapter and Chapter \n18, the put must be paid for in full. That is the only increase in investment. \nAlthough any common stockholder may use this strategy, two general classes of \nstock owners find it particularly attractive: First, the long-term holder of the stock \nwho is not considering selling the stock may utilize the put protection to limit losses \nover a short-term horizon. Second, the buyer of common stock who wants some \n\"insurance\" in case he is wrong may also find the put protection attractive. \nCl,apter 17: Put Buying in Conjunction with Common Stock Ownership 273 \nThe long-term holder who strongly feels that his stock will drop should proba\nbly sell that stock. However, his cost basis may", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 121}
{"text": "y utilize the put protection to limit losses \nover a short-term horizon. Second, the buyer of common stock who wants some \n\"insurance\" in case he is wrong may also find the put protection attractive. \nCl,apter 17: Put Buying in Conjunction with Common Stock Ownership 273 \nThe long-term holder who strongly feels that his stock will drop should proba\nbly sell that stock. However, his cost basis may make the capital gains tax on the sale \nprohibitive. He also may not be entirely sure that the stock will decline - and may \nwant to continue to hold the stock in case it does go up. In either case, the purchase \nof a put will limit the stockholder's downside risk while still allowing room for upside \nappreciation. A large number of individual and institutional investors have holdings \nthat they might find difficult to sell for one reason or another. The purchase of a low\ncost put can often reduce the negative effects of a bear market on their holdings. \nThe second general class of put buyers for protection includes the investor who \nis establishing a position in the stock. He might want to buy a put at the same time \nthat he buys the stock, thereby creating a position with profitability as depicted in the \nprevious profit graph. He immediately starts out with a position that has limited \ndownside risk with large potential profits if the stock moves up. In this way, he can \nfeel free to hold the stock during the life of the put without worrying about when to \nsell it if it should experience a temporary setback. Some fairly aggressive stock traders \nuse this technique because it eliminates the necessity of having to place a stop loss \norder on the stock. It is often frustrating to see a stock fall and touch off one's stop \nloss limit order, only to subsequently rise in price.' The stock owner who has a put for \nprotection need not overreact to a downward move. He can afford to sit back and \nwait during the life of the put, since he has built-in protection. \nWHICH PUT TO BUY \nThe selection of which put the stock owner purchases will determine how much of \nhis profit potential he is giving up and how much risk he is limiting. An out-of-the\nmoney put will cost very little. Therefore, it will be less of a hindrance on profit \npotential if the underlying stock rises in price. Unfortunately, the put's protective fea\nture is small until the stock falls to the striking price of the put. Therefore, the pur\nchase of the out-ofthe-rrwney put will not provide as much downside protection as \nan at- or in-the-money put would. The purchase of a deeply out-of-the-money put as \nprotection is more like \"disaster insurance\": It will prevent a stock owner from expe\nriencing a disaster in terms of a downside loss during the life of the put, but will not \nprovide much protection in the case of a limited stock decline. \nExample: XYZ is at 40 and the October 35 put is selling for ½. The purchase of this \nput as protection for the common stock would not reduce upside potential much at \nall, only by ½ point. However, the stock owner could lose 5½ points if XYZ fell to 35 \nor below. That is his maximum possible loss, for if XYZ were below 35 at October expi\nration, he could exercise his put to sell the stock at 35, losing 5 points on the stock, and \nhe would have paid ½ point for the put, bringing his total loss to 5½ points. \n274 Part Ill: Put Option Strategies \nAt the opposite end of the spectrum, the stock owner might buy an in-the\nmoney put as protection. This would quite severely limit his profit potential, since the \nunderlying stock would have to rise above the strike and more for him to make a \nprofit. However, the in-the-money put provides vast quantities of downside protec\ntion, limiting his loss to a very small amount. \nExample: XYZ is again at 40 and there is an October 45 put selling for 5½. The stock \nowner who purchases the October 45 put would have a maximum risk of½ point, for \nhe could always exercise the put to sell stock at 45, giving him a 5-point gain on the \nstock, but he paid 5½ points for the put, thereby giving him an overall maximum loss \nof ½ point. He would have difficulty making any profit during the life of the put, \nhowever. XYZ would have to rise by more than 5½ points (the cost of the put) for \nhim to make any total profit on the position by October expiration. \nThe deep in-the-money put purchase is overly conservative and is usually not a \ngood strategy. On the other hand, it is not wise to purchase a put that is too deeply \nout-of-the-money as protection. Generally, one should purchase a slightly out-ofthe\nmoney put as protection. This helps to achieve a balance between the positive feature \nof protection for the common stock and the negative feature of limiting profits. \nThe reader may find it interesting to know that he has actually gone through this \nanalysis, back in Chapter 3. Glance again at the profit graph for this strategy of using \nthe put purchase to protect a common stock holding (Figure 17-1). It has exactly the \nsame shape as the profit graph of a simple call purchase. Therefore, the call purchase \nand the long put/long stock strategies are equivalent. Again, by equivalent it is meant \nthat they have similar profit potentials. Obviously, the ownership of a call differs sub\nstantially from the ownership of common stock and a put. The stock owner continues \nto maintain his position for an indefinite period of time, while the call holder does not. \nAlso, the stockholder is forced to pay substantially more for his position than is the call \nholder, and he also receives dividends whereas the call holder does not. Therefore, \n\"equivalent\" does not mean exactly the same when comparing call-oriented and put\noriented strategies, but rather denotes that they have similar profit potentials. \nIn Chapter 3, it was determined that the slightly in-the-money call often offers \nthe best ratio between risk and reward. When the call is slightly in-the-money, the \nstock is above the striking p", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 122}
{"text": "s the call holder does not. Therefore, \n\"equivalent\" does not mean exactly the same when comparing call-oriented and put\noriented strategies, but rather denotes that they have similar profit potentials. \nIn Chapter 3, it was determined that the slightly in-the-money call often offers \nthe best ratio between risk and reward. When the call is slightly in-the-money, the \nstock is above the striking price. Similarly, the slightly out-of-the-money put often \noffers the best ratio between risk and reward for the common stockholder who is buy\ning the put for protection. Again, the stock is slightly above the striking price. Actually, \nsince the two positions are equivalent, the same conclusions should be arrived at; that \nis why it was stated that the reader has been through this analysis previously. \nG,pter 17: Put Buying in Conjunction with Common Stock Ownership \nTAX CONSIDERATIONS \n275 \nAlthough tax considerations are covered in detail in a later chapter, an important tax \nlaw concerning the purchase of puts against a common stock holding should be men\ntioned at this time. If the stock owner is already a long-term holder of the stock at the \ntime that he buys the put, the put purchase has no effect on his tax status. Similarly, \nif the stock buyer buys the stock at the time that he buys the put and identifies the \nposition as a hedge, there is no effect on the tax status of his stock. However, if one \nIs currently a short-tenn holder of the common stock at the time that he buys a put, \nhe eliminates any accrued holding period on his common stock. Moreover, the hold\ning period for that stock does not begin again until the put is sold. \nExample: Assume the long-term holding period is 6 months. That is, a stock owner \nmust own the stock for 6 months before it can be considered a long-term capital gain. \nAn investor who bought the stock and held it for 5 months and then purchased a put \nwould wipe out his entire holding period of 5 months. Suppose he then held the put \nand the stock simultaneously for 6 months, liquidating the put at the end of 6 months. \nHis holding period would start all over again for that common stock. Even though he \nhas owned the stock for 11 months - 5 months prior to the put purchase and 6 \nmonths more while he simultaneously owned the put - his holding period for tax pur\nposes is considered to be zero! \nThis law could have important tax ramifications, and one should consult a tax advisor \nif he is in doubt as to the effect that a put purchase might have on the taxability of \nhis common stock holdings. \nPUT BUYING AS PROTECTION FOR THE COVERED CALL WRITER \nSince put purchases afford protection to the owner of common stock, some investors \nnaturally feel that the same protective feature could be used to limit their downside \nrisk in the covered call writing strategy. Recall that the covered call writing strategy \ninvolves the purchase of stock and the sale of a call option against that stock. The cov\nered write has limited upside profit potential and offers protection to the downside in \nthe amount of the call premium. The covered writer will make money if the stock falls \na little, remains unchanged, or rises by expiration. The covered writer can actually lose \nmoney only if the stock falls by more than the call premium received. He has poten\ntially large downside losses. This strategy is known as a protective collar or, more sim\nply, a \"collar.\" (It is also called a \"hedge wrapper,\" although that is an outdated term.) \n274 Part Ill: Put Option Strategies \nAt the opposite end of the spectrum, the stock owner might buy an in-the\nmoney put as protection. This would quite severely limit his profit potential, since the \nunderlying stock would have to rise above the stiike and more for him to make a \nprofit. However, the in-the-money put provides vast quantities of downside protec\ntion, limiting his loss to a very small amount. \nExample: XYZ is again at 40 and there is an October 45 put selling for 5½. The stock \nowner who purchases the October 45 put would have a maximum risk of½ point, for \nhe could always exercise the put to sell stock at 45, giving him a 5-point gain on the \nstock, but he paid 5½ points for the put, thereby giving him an overall maximum loss \nof ½ point. He would have difficulty making any profit during the life of the put, \nhowever. XYZ would have to rise by more than 5½ points (the cost of the put) for \nhim to make any total profit on the position by October expiration. \nThe deep in-the-money put purchase is overly conservative and is usually not a \ngood strategy. On the other hand, it is not wise to purchase a put that is too deeply \nout-of-the-money as protection. Generally, one should purchase a slightly out-ofthe\nnwney put as protection. This helps to achieve a balance between the positive feature \nof protection for the common stock and the negative feature of limiting profits. \nThe reader may find it interesting to know that he has actually gone through this \nanalysis, back in Chapter 3. Glance again at the profit graph for this strategy of using \nthe put purchase to protect a common stock holding (Figure 17-1). It has exactly the \nsame shape as the profit graph of a simple call purchase. Therefore, the call purchase \nand the long put/long stock strategies are equivalent. Again, by equivalent it is meant \nthat they have similar profit potentials. Obviously, the ovvnership of a call differs sub\nstantially from the ownership of common stock and a put. The stock owner continues \nto maintain his position for an indefinite period of time, while the call holder does not. \nAlso, the stockholder is forced to pay substantially more for his position than is the call \nholder, and he also receives dividends whereas the call holder does not. Therefore, \n\"equivalent\" does not mean exactly the same when comparing call-oriented and put\noriented strategies, but rather denotes that they have similar profit potentials. \nIn Chapter 3, it was determined that the sligh", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 123}
{"text": "does not. \nAlso, the stockholder is forced to pay substantially more for his position than is the call \nholder, and he also receives dividends whereas the call holder does not. Therefore, \n\"equivalent\" does not mean exactly the same when comparing call-oriented and put\noriented strategies, but rather denotes that they have similar profit potentials. \nIn Chapter 3, it was determined that the slightly in-the-money call often offers \nthe best ratio between 1isk and reward. When the call is slightly in-the-money, the \nstock is above the striking price. Similarly, the slightly out-of-the-money put often \noffers the best ratio between risk and reward for the common stockholder who is buy\ning the put for protection. Again, the stock is slightly above the striking price. Actually, \nsince the two positions are equivalent, the same conclusions should be arrived at; that \nis why it was stated that the reader has been through this analysis previously. \n0.,,,,, I 7: Put Buying in Conjundion with Common Stock Ownership \nJAX CONSIDERATIONS \n275 \nAlthough tax considerations are covered in detail in a later chapter, an important tax \nlaw concerning the purchase of puts against a common stock holding should be men\ntioned at this time. If the stock owner is already a long-term holder of the stock at the \ntime that he buys the put, the put purchase has no effect on his tax status. Similarly, \nif the stock buyer buys the stock at the time that he buys the put and identifies the \nposition as a hedge, there is no effect on the tax status of his stock. However, if one \nis currently a short-term holder of the comrrwn stock at the time that he buys a put, \nhe eliminates any accrued holding period on his comrrwn stock. Moreover, the hold\ning period for that stock does not begin again until the put is sold. \nExample: Assume the long-term holding period is 6 months. That is, a stock owner \nmust own the stock for 6 months before it can be considered a long-term capital gain. \nAn investor who bought the stock and held it for 5 months and then purchased a put \nwould wipe out his entire holding period of 5 months. Suppose he then held the put \nand the stock simultaneously for 6 months, liquidating the put at the end of 6 months. \nHis holding period would start all over again for that common stock. Even though he \nhas owned the stock for 11 months - 5 months prior to the put purchase and 6 \nmonths more while he simultaneously owned the put - his holding period for tax pur\nposes is considered to be zero! \nThis law could have important tax ramifications, and one should consult a tax advisor \nif he is in doubt as to the effect that a put purchase might have on the taxability of \nhis common stock holdings. \nPUT BUYING AS PROTECTION FOR THE COVERED CALL WRITER \nSince put purchases afford protection to the owner of common stock, some investors \nnaturally feel that the same protective feature could be used to limit their downside \nrisk in the covered call writing strategy. Recall that the covered call writing strategy \ninvolves the purchase of stock and the sale of a call option against that stock. The cov\nered write has limited upside profit potential and offers protection to the downside in \nthe amount of the call premium. The covered writer will make money if the stock falls \na little, remains unchanged, or rises by expiration. The covered writer can actually lose \nmoney only if the stock falls by more than the call premium received. He has poten\ntially large downside losses. This strategy is known as a protective collar or, more sim\nply, a \"collar.\" (It is also called a \"hedge wrapper,\" although that is an outdated term.) \n276 Part Ill: Put Option Strategies \nThe purchase of an out-of the-money put option can eliminate the risk of large \npotential losses for the covered write, although the money spent for the put purchase \nwill reduce the overall return from the covered write. One must therefore include \nthe put cost in his initial calculations to determine if it is worthwhile to buy the put. \nExample: X'YZ is at 39 and there is an XYZ October 40 call selling for 3 points and an \nXYZ October 35 put selling for ½ point. A covered write could be established by buy\ning the common at 39 and selling the October 40 call for 3. This covered write would \nhave a maximum profit potential of 4 points if XYZ were anywhere above 40 at expi\nration. The write would lose money if XYZ were anywhere below 36, the break-even \npoint, at October expiration. By also purchasing the October 35 put at the time the \ncovered write is initiated, the covered writer will limit his profit potential slightly, but \nwill also greatly reduce his risk potential. If the put purchase is added to the covered \nwrite, the maximum profit potential is reduced to 3½ points at October expiration. The \nbreak-even point moves up to 36½, and the writer will experience some loss if XYZ is \nbelow 36½ at expiration. However, the most that the writer could lose would be 1 ¼ \npoints if XYZ were below 35 at expiration. The purchase of the put option produces \nthis loss-limiting effect. Table 17-2 and Figure 17-2 depict the profitability of both the \nregular covered write and the covered write that is protected by the put purchase. \nCommissions should be carefully included in the covered writer's return calcula\ntions, as well as the cost of the put. It was demonstrated in Chapter 2 that the covered \nwriter must include all commissions and margin interest expenses as well as all divi\ndends received in order to produce an accurate \"total return\" picture of the covered \nwrite. Figure 17-2 shows that the break-even point is raised slightly and the overall prof\nit potential is reduced by the purchase of the put. However, the maximum risk is quite \nsmall and the writer need never be forced to roll down in a disadvantageous situation. \nRecall that the covered writer who does not have the protective put in place is \nforced to roll down in order to gain increased downside protection. R", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 124}
{"text": "2 shows that the break-even point is raised slightly and the overall prof\nit potential is reduced by the purchase of the put. However, the maximum risk is quite \nsmall and the writer need never be forced to roll down in a disadvantageous situation. \nRecall that the covered writer who does not have the protective put in place is \nforced to roll down in order to gain increased downside protection. Rolling down \nmerely means that he buys back the call that is currently written and writes another \ncall, with a lower striking price, in its place. This rolling-down action can be helpful \nif the stock stabilizes after falling; but if the stock reverses and climbs upward in price \nagain, the covered writer who rolled down would have limited his gains. In fact, he \nmay even have \"locked in\" a loss. The writer who has the protective put need not be \nbothered with such things. He never has to roll down, for he has a limited maximum \nloss. Therefore, he should never get into a \"locked-in\" loss situation. This can be a \ngreat advantage, especially from an emotional viewpoint, because the writer is never \nforced to make a decision as to the future price of the stock in the middle of the \nstock's decline. With the put in place, he can feel free to take no action at all, since \nhis overall loss is limited. If the stock should rally upward later, he will still be in a \nposition to make his maximum profit. \nChapter 17: Put Buying in Conjundion with Common Stock Ownership \nTABLE 17·2. \nComparison of regular and protected covered writes. \nXYZ Price at Stock October 40 October 35 \nExpiration Profit Call Profit Put Profit \n25 -$1,400 +$300 +$950 \n30 900 + 300 + 450 \n35 400 + 300 - 50 \n36.50 250 + 300 - 50 \n38 100 + 300 - 50 \n40 + 100 + 300 - 50 \n45 + 600 - 200 - 50 \n50 + 1,100 - 700 - 50 \nFIGURE 17-2. \nCovered call write protected by a put purchase. \nC \n0 \ne ·5. \nX \nLU \nco $0 CJ) \nCJ) \n0 .J \n0 \n~ -$150 a.. \n,, \n},.,,' \n; \n,, \nRegular \nCovered ,,' \nWrite/ \n36 / , , \n;\n,,' \n+$400 \n,----------➔ ,,,' _____ ...,.. \n, +$350 \n,,,' \n40 \nStock Price at Expiration \n277 \nTotal \nProfit \n-$150 \n- 150 \n- 150 \n0 \n+ 150 \n+ 350 \n+ 350 \n+ 350 \nThe longer-term effects of buying puts in combination with covered writes are \nnot easily definable, but it would appear that the writer reduces his overall rate of \nreturn slightly by buying the puts. This is because he gives something away if the \nstock falls slightly, remains unchanged, or rises in price. He only \"gains\" something if \nthe stock falls heavily. Since the odds of a stock falling heavily are small in compari\nson to the other events (falling slightly, remaining unchanged, or rising), the writer \nwill be gaining something in only a small percentage of cases. However, the put buy\ning strategy may still prove useful in that it removes the emotional uncertainty of \n278 Part Ill: Put Option Strategies \nlarge losses. The covered writer who buys puts may often find it easier to operate in \na more rational manner when he has the protective put in place. \nThis strategy is equivalent to one that has been described before, the bull \nspread. Notice that the profit graph in Figure 17-2 has the same shape as the bull \nspread profit graph (Figure 7-1). This means that the two strategies are equivalent. \nIn fact, in Chapter 7 it was pointed out that the bull spread could sometimes be con\nsidered a \"substitute\" for covered writing. Actually, the bull spread is more akin to \nthis strategy - the covered write protected by a put purchase. There are, of course, \ndifferences between the strategies. They are equivalent in profit and loss potential, \nbut the covered writer could never lose all his investment in a short period of time, \nalthough the spreader could. In order to actually use bull spreads as substitutes for \ncovered writes, one would invest only a small portion of his available funds in the \nspread and would place the remainder of his funds in fixed-income securities. That \nstrategy was discussed in more depth in Chapter 7. \nNO-COST COLLARS \nThe \"collar\" strategy is often arrived at in another manner: a stockholder begins \nto worry about the downside potential of the stock market and decides to buy puts \non his stock as protection. However, he is dismayed by the cost of the puts and so he \nalso considers the sale of calls. If he buys an out-of-the-money put, it is quite possi\nble that he might be able to sell an out-of-the-money call whose proceeds complete\nly cover the cost of the put. Thus, he has established a protective collar at no cost -\nat least no debit. His \"cost\" is the fact that he has forsaken the upside profit poten\ntial on his stock, above the striking price of the written call. \nIn fact, certain large institutional traders are able to transact collars through \nlarge over-the-counter option brokers, such as Goldman Sachs or Morgan Stanley. \nThey might even give the broker instructions such as this: \"I own XYZ and I want to \nbuy a put 10 percent out of the money that expires in a year. What would the strik\ning price of a one-year call have to be in order to create a no-cost collar?\" The bro\nker might then tell him that such a call would have to be struck 30 percent out of the \nmoney. The actual strike price of the call would depend on the volatility estimate for \nthe underlying stock, as well as interest rates and dividends. These types of transac\ntions occur with a fair amount of frequency. \nSome very interesting situations can be created with long-term options. One of \nthe most interesting occurred in 1999, when a company that owned 5 million shares \nof Cisco ( CSCO) decided it would like to hedge them by creating a no-cost collar \nover the next three years. At the time, CSCO was trading at about 130, and its volatil\nity was about 50%. It turns out that a three-year put struck at 130 sells for about the \n278 Part Ill: Put Option Strategies \nlarge losses. The covered writer who buys puts may often find it easier to operate in \na more rational manner when he has the prot", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 125}
{"text": "t would like to hedge them by creating a no-cost collar \nover the next three years. At the time, CSCO was trading at about 130, and its volatil\nity was about 50%. It turns out that a three-year put struck at 130 sells for about the \n278 Part Ill: Put Option Strategies \nlarge losses. The covered writer who buys puts may often find it easier to operate in \na more rational manner when he has the protective put in place. \nThis strategy is equivalent to one that has been described before, the bull \nspread. Notice that the profit graph in Figure 17-2 has the same shape as the bull \nspread profit graph (Figure 7-1). This means that the two strategies are equivalent. \nIn fact, in Chapter 7 it was pointed out that the bull spread could sometimes be con\nsidered a \"substitute\" for covered writing. Actually, the bull spread is more akin to \nthis strategy- the covered write protected by a put purchase. There are, of course, \ndifferences between the strategies. They are equivalent in profit and loss potential, \nbut the covered writer could never lose all his investment in a short period of time, \nalthough the spreader could. In order to actually use bull spreads as substitutes for \ncovered writes, one would invest only a small portion of his available funds in the \nspread and would place the remainder of his funds in fixed-income securities. That \nstrategy was discussed in more depth in Chapter 7. \nNO-COST COLLARS \nThe \"collar\" strategy is often arrived at in another manner: a stockholder begins \nto worry about the downside potential of the stock market and decides to buy puts \non his stock as protection. However, he is dismayed by the cost of the puts and so he \nalso considers the sale of calls. If he buys an out-of-the-money put, it is quite possi\nble that he might be able to sell an out-of-the-money call whose proceeds complete\nly cover the cost of the put. Thus, he has established a protective collar at no cost -\nat least no debit. His \"cost\" is the fact that he has forsaken the upside profit poten\ntial on his stock, above the striking price of the written call. \nIn fact, certain large institutional traders are able to transact collars through \nlarge over-the-counter option brokers, such as Goldman Sachs or Morgan Stanley. \nThey might even give the broker instructions such as this: \"I own XYZ and I want to \nbuy a put 10 percent out of the money that e.:\\.J)ires in a year. What would the strik\ning price of a one-year call have to be in order to create a no-cost collar?\" The bro\nker might then tell him that such a call would have to be struck 30 percent out of the \nmoney. The actual strike price of the call would depend on the volatility estimate for \nthe underlying stock, as well as interest rates and dividends. These types of transac\ntions occur with a fair amount of frequency. \nSome very interesting situations can be created with long-term options. One of \nthe most interesting occurred in 1999, when a company that owned 5 million shares \nof Cisco (CSCO) decided it would like to hedge them by creating a no-cost collar \nover the next three years. At the time, CSCO was trading at about 130, and its volatil\nity was about 50%. It turns out that a three-year put struck at 130 sells for about the \n278 Part Ill: Put Option Strategies \nlarge losses. The covered writer who buys puts may often find it easier to operate in \na more rational manner when he has the protective put in place. \nThis strategy is equivalent to one that has been described before, the bull \nspread. Notice that the profit graph in Figure 17-2 has the same shape as the bull \nspread profit graph (Figure 7-1). This means that the two strategies are equivalent. \nIn fact, in Chapter 7 it was pointed out that the bull spread could sometimes be con\nsidered a \"substitute\" for covered writing. Actually, the bull spread is more akin to \nthis strategy - the covered write protected by a put purchase. There are, of course, \ndifferences between the strategies. They are equivalent in profit and loss potential, \nbut the covered writer could never lose all his investment in a short period of time, \nalthough the spreader could. In order to actually use bull spreads as substitutes for \ncovered ,vrites, one would invest only a small portion of his available funds in the \nspread and would place the remainder of his funds in fixed-income securities. That \nstrategy was discussed in more depth in Chapter 7. \nNO-COST COLLARS \nThe \"collar\" strategy is often arrived at in another manner: a stockholder begins \nto worry about the downside potential of the stock market and decides to buy puts \non his stock as protection. However, he is dismayed by the cost of the puts and so he \nalso considers the sale of calls. If he buys an out-of-the-money put, it is quite possi\nble that he might be able to sell an out-of-the-money call whose proceeds complete\nly cover the cost of the put. Thus, he has established a protective collar at no cost -\nat least no debit. His \"cost\" is the fact that he has forsaken the upside profit poten\ntial on his stock, above the striking price of the written call. \nIn fact, certain large institutional traders are able to transact collars through \nlarge over-the-counter option brokers, such as Goldman Sachs or Morgan Stanley. \nThey might even give the broker instructions such as this: \"I own XYZ and I want to \nbuy a put 10 percent out of the money that expires in a year. What would the strik\ning p1ice of a one-year call have to be in order to create a no-cost collar?\" The bro\nker might then tell him that such a call would have to be struck 30 percent out of the \nmoney. The actual strike price of the call would depend on the volatility estimate for \nthe underlying stock, as well as interest rates and dividends. These types of transac\ntions occur with a fair amount of frequency. \nSome very interesting situations can be created with long-term options. One of \nthe most interesting occurred in 1999, when a company that owned 5 million shares \nof Cisco (", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 126}
{"text": "the \nmoney. The actual strike price of the call would depend on the volatility estimate for \nthe underlying stock, as well as interest rates and dividends. These types of transac\ntions occur with a fair amount of frequency. \nSome very interesting situations can be created with long-term options. One of \nthe most interesting occurred in 1999, when a company that owned 5 million shares \nof Cisco ( CSCO) decided it would like to hedge them by creating a no-cost collar \nover the next three years. At the time, CSCO was trading at about 130, and its volatil\nity was about 50%. It turns out that a three-year put struck at 130 sells for about the \nCltapter 17: Put Buying in Conjunction with Common Stock Ownership \nTABLE 17-3. \nHighest Call Strike That Pays for an At-the-Money Put \n(Assuming 2.5 years to expiration) \nVolatility Coll Strike \n30% \n40% \n50% \n70% \n100% \nof Underlying \n30% out of money \n35% out of money \n40% out of money \n50% out of money \n70% out of money \n279 \nsame price as a three-year call struck at 200! That may seem illogical, but the figures \ncan be checked out with the aid of an option-pricing model. Thus, this company was \nable to hedge all of its CSCO stock, with no downside risk ( the striking price of the \nputs was the same as the current stock price) and still had profit potential of over 50% \nto the upside over the next three years. \nThus, one should consider using LEAPS options when he establishes a collar -\neven ifhe is not an institutional trader - because the striking price of the calls can be \nquite high in comparison to that of the put' s strike or in comparison to the price of \nthe underlying stock. Table 17-3 shows how far out-of-the-money a written call could \nbe that still covers the cost of buying an at-the-money put. The time to expiration in \nthis table is 2.5 years - the longest term listed option that currently exists as a LEAPS \noption. \nUSING LOWER STRIKES AS A PARTIAL COVERED WRITE \nIt should also be pointed out that one does not necessarily have to forsake all of \nthe profit potential from his stock. He might buy the puts, as usual, and then sell calls \nwith a somewhat lower strike than needed for a low-cost collar, but the quantity of \ncalls sold would be less than that of stock owned. In that way, there would be unlim\nited profit potential on some of the shares of the underlying stock. \nExample: Suppose that the following prices exist: \nXYZ:61 \nApr 55 put: 1 \nApr 65 call: 2 \nFurthermore, suppose that one owns 1000 shares of XYZ. Thus, the purchase \nof 10 Apr 55 puts at 1 point apiece would protect the downside. In order to cover the \ncost of those puts ($1000), one need only sell five of the Apr 65 calls at 2 points \n280 Part Ill: Put Option Strategies \napiece. Thus, the protection would have cost nothing and there would still be unlim\nited profit potential on 500 of the shares of XYZ, since only five calls were sold against \nthe 1000 shares that are owned. \nIn this manner, one could get quite creative in constructing collars - deciding \nwhat call strike to use in order to strike a balance between paying for the puts and \nallowing upside profit potential. The lower the strike he uses for the written calls, the \nfewer calls he will have to write; the higher the strike of the written calls, the more \ncalls will be necessary to cover the cost of the purchased puts. The tradeoff is that a \nlower call strike allows for more eventual upside profit potential, but it limits what \nhas been written against to a lower price. \nUsing the above example once again, these facts can be demonstrated: \nExample (continued): As before, the same prices exist, but now one more call will \nbe brought into the picture: \nXYZ: 61 \nApr55 put: l \nApr 65 call: 2 \nApr 70 call: l \nAs before one could sell five of the Apr 65 calls to cover the cost of ten puts, or \nas an alternative he could sell ten of the Apr 70 calls. If he sells the five, he has unlim\nited profit potential on 500 shares, but the other 500 shares will be called away at 65. \nIn the alternative strategy, he has limited upside profit potential, but nothing will be \ncalled away until the stock reaches 70. Which is \"better?\" It's not easy to say. In the \nformer strategy, if the stock climbs all the way to 75, it results in the same profit as if \nthe stock is called away at 70 in the latter strategy. This is true because 500 shares \nwould be worth 75, but the other 500 would have been called away at 65 - making \nfor an average of 70. Hence, the former strategy only outperforms the latter if the \nstock actually climbs above 75 - a rather unlikely event, one would have to surmise. \nStill, many investors prefer the former strategy because it gives them protection with\nout asking them to surrender all of their upside profit potential. \nIn summary, one can often be quite creative with the \"collar\" strategy. One thing \nto keep in mind: if one sells options against stock that he has no intention of selling, he \nis actually writing naked calls in his ovm mind. That is, if one owns stock that \"can't\" \nbe sold - perhaps the capital gains would be devastating or the stock has been \"in the \nfamily\" for a long time - then he should not sell covered calls against it, because he will \nbe forced into treating the calls as naked (if he refuses to sell the stock). This can cause \nquite a bit of consternation if the underlying stock rises significantly in price, that could \nhave easily been avoided by not writing calls against the stock in the first place. \nCHAPCIJER 18 \nBuying Puts in Conjunction \nwith Call Purchases \nThere are several ways in which the purchases of both puts and calls can be used to \nthe speculator's advantage. One simple method is actually a follow-up strategy for the \ncall buyer. If the stock has advanced and the call buyer has a profit, he might con\nsider buying a put as a means of locking in his call profits while still allowing for more \npotential upside appreciation. In Chapter 3, four basic alternatives were list", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 127}
{"text": "hich the purchases of both puts and calls can be used to \nthe speculator's advantage. One simple method is actually a follow-up strategy for the \ncall buyer. If the stock has advanced and the call buyer has a profit, he might con\nsider buying a put as a means of locking in his call profits while still allowing for more \npotential upside appreciation. In Chapter 3, four basic alternatives were listed for the \ncall buyer who had a profit: He could liquidate the call and take his profit; he could \ndo nothing; he could \"roll up\" by selling the call for a profit and using part of the pro\nceeds to purchase more out-of-the-money calls; or he could create a bull spread by \nselling the out-of-the-money call against the profitable call that he holds. If the \nunderlying stock has listed puts, he has another alternative: He could buy a put. This \nput purchase would serve to lock in some of the profits on the call and would still \nallow room for further appreciation if the stock should continue to rise in price. \nExample: An investor initially purchased an XYZ October 50 call for 3 points when \nthe stock was at 48. Sometime later, after the stock had risen to 58, the call would be \nworth about 9 points. If there was an October 60 put, it might be selling for 4 points, \nand the call holder could buy this put to lock in some of his profits. His position, after \npurchasing the put, would be: \nLong l October 50 call at 3 points N t t 7 • t - e cos: pom s Long l October 60 put at 4 points \nHe would own a \"strangle\" - any position consisting of both a put and a call with dif\nfering terms - that is always worth at least 10 points. The combination will be worth \nexactly 10 points at expiration if XYZ is anywhere between 50 and 60. For example, \n281 \n282 Part Ill: Put Option Strategies \nif xyz is at 52 at expiration, the call will be worth 2 points and the put will be wort Ii \n8 points. Alternatively, if the stock is at 58 at expiration, the put will be worth 2 points \nand the call worth 8 points. Should xyz be above 60 at expiration, the combination's \nvalue will be equal to the call's value, since the put will expire worthless with XYZ \nabove 60. The call would have to be worth more than 10 points in that case, since it \nhas a striking price of 50. Similarly, if xyz were below 50 at expiration, the combi\nnation would be worth more than 10 points, since the put would be more than 10 \npoints in-the-money and the call would be worthless. \nThe speculator has thus created a position in which he cannot lose money, \nbecause he paid only 7 points for the combination (3 points for the call and 4 points \nfor the put). No matter what happens, the combination will be worth at least 10 \npoints at e:x-piration, and a 3-point profit is thus locked in. If xyz should continue to \nclimb in price, the speculator could make more than 3 points of profit whenever xyz \nis above 60 at expiration. Moreover, if xyz should suddenly collapse in price, the \nspeculator could make more than 3 points of profit if the stock was below 50 by expi\nration. The reader must realize that such a position can never be created as an initial \nposition. This desirable situation arose only because the call had built up a substan\ntial profit before the put was purchased. The similar strategy for the put buyer who \nmight buy a call to protect his unrealized put profits was described in Chapter 16. \nSTRADDLE BUYING \nA straddle purchase consists of buying both a put and a call with the same terms -\nsarne underlying stock, striking price, and expiration date. The straddle purchase \nallows the buyer to make large potential profits if the stock moves far enough in \neither direction. The buyer has a predetermined maximum loss, equal to the amount \nof his initial investment. \nExample: The following prices exist: \nxyz common, 50; \nXYZ July 50 call, 3; and \nXYZ July 50 put, 2. \nIf one purchased both the July 50 call and the July 50 put, he would be buying a \nstraddle. This would cost 5 points plus commissions. The investment required to \npurchase a straddle is the net debit. If the underlying stock is exactly at 50 at expi\nration, the buyer would lose all his investment, since both the put and the call would \nexpire worthless. If the stock were above .55 at expiration, the call portion of the \n18: Buying Puts in Conjundion with Call Purchases 283 \ndle would be worth more than 5 points and the straddle buyer would make \ny, even though his put expired worthless. To the downside, a similar situation \nMists. If XYZ were below 45 at expiration, the put would be worth more than 5 \npoints and he would have a profit despite the fact that the call expired worthless. \nTable 18-1 and Figure 18-1 depict the results of this example straddle purchase at \nexpiration. The straddle buyer can immediately determine his break-even points at \nexpiration - 45 and 55 in this example. He will lose money if the underlying stock is \nbetween those break-even points at expiration. He has potentially large profits if \nXYZ should move a great distance away from 50 by expiration. \nOne would normally purchase a straddle on a relatively volatile stock that has \nthe potential to move far enough to make the straddle profitable in the allotted time. \nThis strategy is particularly attractive when option premiums are low, since low pre\nmiums will mean a cheaper straddle cost. Although losses may occur in a relatively \nlarge percentage of cases that are held all the way until their expiration date, there is \nactually only a minute probability of losing one's entire investment. Even if XYZ \nshould be at 50 at expiration, there would still be the opportunity to sell the straddle \nfor a small amount on the final day of trading. \nTABLE 18-1. \nResults of straddle purchase at expiration. \nXYZ Price at Total Straddle \nExpiration Coll Profit Put Profit Profit \n30 -$ 300 +$1,800 + $1,500 \n40 300 + 800 + 500 \n45 300 + 300 0 \n50 300 200 500 \n55 + 200 200 0 \n60 + 700 200 + 500 \n70 + 1,700 200 + 1,500 \nEQUIVALENCE", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 128}
{"text": "expiration, there would still be the opportunity to sell the straddle \nfor a small amount on the final day of trading. \nTABLE 18-1. \nResults of straddle purchase at expiration. \nXYZ Price at Total Straddle \nExpiration Coll Profit Put Profit Profit \n30 -$ 300 +$1,800 + $1,500 \n40 300 + 800 + 500 \n45 300 + 300 0 \n50 300 200 500 \n55 + 200 200 0 \n60 + 700 200 + 500 \n70 + 1,700 200 + 1,500 \nEQUIVALENCES \nStraddle buying is equivalent to the reverse hedge, a strategy described in Chapter 4 \nin which one sells the underlying stock short and purchases two calls on the under\nlying stock. Both strategies have similar profit characteristics: a limited loss that \nwould occur at the striking price of the options involved, and potentially large prof\nits if the underlying stock should rise or fall far enough in price. The straddle pur-\n284 \nFIGURE 18-1. \nStraddle purchase. \nC: \n.Q \nI!! ·a. \nX \nw \nro $0 en en 0 \n..J \n0 \n-e a.. \n-$500 \nPart Ill: Put Option Strategies \nStock Price at Expiration \nchase is superior to the reverse hedge, however, and where listed puts exist on a stock, \nthe reverse hedge strategy becomes obsolete. The reasons that the straddle purchase \nis superior are that dividends are not paid by the holder and that commission costs \nare much smaller in the straddle situation. \nREVERSE HEDGE WITH PUTS \nA third strategy is equivalent to both the straddle purchase and the reverse hedge. \nIt consists of buying the underlying stock and buying two put options. If the stock \nrises substantially in price, large profits will accrue, for the stock profit will more \nthan offset the fixed loss on the purchase of two put options. If the stock declines in \nprice by a large amount, profits will also be generated. In a decline, the profits gen\nerated by 2 long puts will more than offset the loss on 100 shares of long stock. This \nform of the straddle purchase has limited risk as well. The worst case would occur \nif the stock were exactly at the striking price of the puts at their expiration date - the \nputs would both expire worthless. The risk is limited, percentagevvise and dollar\nwise, since the cost of two put options would normally be a relatively small per\ncentage of the total cost of buying the stock. Furthermore, the investor may receive \nsome dividends if the underlying stock is a dividend-paying stock. Buying stock and \nbuying two puts is superior to the reverse hedge strategy, but is still inferior to the \nstraddle purchase. \nter 18: Buying Puts in Conjunction with Call Purchases \nIILECTING A STRADDLE BUY \n285 \nIn theory, one could find the best straddle purchases by applying the analyses for best \ncall purchases and best put purchases simultaneously. Then, if both the puts and calls \non a particular stock showed attractive opportunity, the straddle could be bought. \nThe straddle should be viewed as an entire position. A similar sort of analysis to that \nproposed for either put or call purchases could be used for straddles as well. First, \none would assume the stock would move up or down in accordance with its volatili\nty within a fixed time period, such as 60 or 90 days. Then, the prices of both the put \nand the call could be predicted for this stock movement. The straddles that off er the \nbest reward opportunity under this analysis would be the most attractive ones to buy. \nTo demonstrate this sort of analysis, the previous example can be utilized again. \nExample: XYZ is at 50 and the July 50 call is selling for 3 while the July 50 put is sell\ning for 2 points. If the strategist is able to determine that XYZ has a 25% chance of \nbeing above 54 in 90 days and also has a 25% chance of being below 46 in 90 days, \nhe can then predict the option prices. A rigorous method for determining what per\ncentage chance a stock has of making a predetermined price movement is presented \nin Chapter 28 on mathematical applications. For now, a general procedure of analy\nsis is more important than its actual implementation. If XYZ were at 54 in 90 days, it \nmight be reasonable to assume that the call would be worth 5½ and the put would \nbe worth 1 point. The straddle would therefore be worth 6½ points. Similarly, if the \nstock were at 46 in 90 days, the put might be worth 4½ points, and the call worth 1 \npoint, making the entire straddle worth 5½ points. It is fairly common for the strad\ndle to be higher-priced when it is a fixed distance in-the-money on the call side (such \nas 4 points) than when it is in-the-money on the put side by that same distance. In \nthis example, the strategist has now determined that there is a 25% chance that the \nstraddle will be worth 6½ points in 90 days on an upside movement, and there is a \n25% chance that the straddle will be worth 5½ points on a downside movement. The \naverage price of these two expectations is 6 points. Since the straddle is currently sell\ning for 5 points, this would represent a 20% profit. If all potential straddles are \nranked in the same manner - allowing for a 25% chance of upside and downside \nmovement by each underlying stock - the straddle buyer will have a common basis \nfor comparing various straddle opportunities. \nFOLLOW-UP ACTION \nIt has been mentioned frequently that there is a good chance that a stock will remain \nrelatively unchanged over a short time period. This does not mean that the stock will \n286 Part Ill: Put Option Strategies \nnever move much one way or the other, but that its net movement over the time peri\nod will generally be small. \nExample: If XYZ is currently at 50, one might say that its chances of being over .5.5 \nat the end of 90 days are fairly small, perhaps 30%. This may even be supported by \nmathematical analysis based on the volatility of the underlying stock. This does not \nimply, however, that the stock has only a 30% chance of ever reaching 55 during the \n90-day period. Rather, it implies that it has only a 30% chance of being over 55 at the \nend of the 90-day period. These are two distinctly different events, with di", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 129}
{"text": "s are fairly small, perhaps 30%. This may even be supported by \nmathematical analysis based on the volatility of the underlying stock. This does not \nimply, however, that the stock has only a 30% chance of ever reaching 55 during the \n90-day period. Rather, it implies that it has only a 30% chance of being over 55 at the \nend of the 90-day period. These are two distinctly different events, with different \nprobabilities of occurrence. Even though the probability of being over 55 at the end \nof 90 days might be only 30%, the probability of ever being over 55 during the 90-\nday period could be amazingly high, perhaps as high as 80%. It is important for the \nstraddle buyer to understand the differences between these events occurring, for he \nmight often be able to take follow-up action to improve his position. \nMany times, after a straddle is bought, the underlying stock will begin to move \nstrongly, making it appear that the straddle is immediately going to become prof\nitable. However, just as things are going well, the stock reverses and begins to change \ndirection, perhaps so quickly that it would now appear that the straddle will become \nprofitable on the other side. These volatile stock movements often result in little net \nchange, however, and at expiration the straddle buyer may have a loss. One might \nthink that he would take profits on the call side when they became available in a \nquick upward movement, and then hope for a downward reversal so that he could \ntake profits on the put side as well. Taking small profits, however, is a poor strategy. \nStraddle buying has limited losses and potentially unlimited profits. One might have \nto suffer through a substantial number of small losses before hitting a big winner, but \nthe magnitude of the gain on that one large stock movement can offset many small \nlosses. By taking small profits, the straddle buyer is immediately cutting off his \nchances for a substantial gain; that is why it is a poor strategy to limit the profits. \nThis is one of those statements that sounds easier in theory than it is in practice. \nIt is emotionally distressing to watch the straddle gain 2 or 3 points in a short time \nperiod, only to lose that and more when the stock fails to follow through. By using a \ndifferent example, it is possible to demonstrate the types of follow-up action that the \nstraddle buyer might take. \nExample: One had initially bought an XYZ January 40 straddle for 6 points when the \nstock was 40. After a fairly short time, the stock jumps up to 45 and the following \nprices exist: \nCl,apter 18: Buying Puts in Conjunction with Call Purchases \nXYZ common, 45: \nXYZ January 40 call, 7; \nXYZ January 40 put, l; and \nXYZ January 45 put, 3. \n287 \nThe straddle itself is now worth 8 points. The January 45 put price is included \nbecause it will be part of one of the follow-up strategies. What could the straddle \nbuyer do at this time? First, he might do nothing, preferring to let the straddle run \nits course, at least for three months or so. Assuming that he is not content to sit tight, \nhowever, he might sell the call, taking his profit, and hope for the stock to then drop \nin price. This is an inferior course of action, since he would be cutting off potential \nlarge profits to the upside. \nIn the older, over-the-counter option market, one might have tried a technique \nknown as trading against the straddle. Since there was no secondary market for \nover-the-counter options, straddle buyers often traded the stock itself against the \nstraddle that they owned. This type of follow-up action dictated that, if the stock \nrose enough to make the straddle profitable to the upside, one would sell short the \nunderlying stock. This involved no extra risk, since if the stock continued up, the \nstraddle holder could always exercise his call to cover the short sale for a profit. \nConversely, if the underlying stock fell at the outset, making the straddle profitable \nto the downside, one would buy the underlying stock. Again, this involved no extra \nrisk if the stock continued down, since the put could always be exercised to sell the \nstock at a profit. The idea was to be able to capitalize on large stock price reversals \nwith the addition of the stock position to the straddle. This strategy worked best for \nthe brokers, who made numerous commissions as the trader tried to gauge the \nwhipsaws in the market. In the listed options market, the same strategic effect can \nbe realized ( without as large a commission expense) by merely selling out the long \ncall on an upward move, and using part of the proceeds to buy a second put similar \nto the one already held. On a downside move, one could sell out the long put for a \nprofit and buy a second call similar to the one he already owns. In the example \nabove, the call would be sold for 7 points and a second January 40 put purchased for \n1 point. This would allow the straddle buyer to recover his initial 6-point cost and \nwould allow for large downside profit potential. This strategy is not recommended, \nhowever, since the straddle buyer is limiting his profit in the direction that the stock \nis moving. Once the stock has moved from 40 to 45, as in this example, it would be \nmore reasonable to expect that it could continue up rather than experience a drop \nof more than 5 points. \n288 Part Ill: Put Option Strategies \nA rrwre desirable sort off allow-up action would be one whereby the straddle \nbuyer could retain much of the profit already built up without limiting further poten\ntial profits if the stock continues to run. In the example above, the straddle buyer \ncould use the January 45 put - the one at the higher price - for this purpose. \nExample: Suppose that when the stock got to 45, he sold the put that he owned, the \nJanuary 40, for 1 point, and simultaneously bought the January 45 put for 3 points. \nThis transaction would cost 2 points, and would leave him in the following position: \nLong 1 January 40 call C b· d t 8 . t -", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 130}
{"text": "bove, the straddle buyer \ncould use the January 45 put - the one at the higher price - for this purpose. \nExample: Suppose that when the stock got to 45, he sold the put that he owned, the \nJanuary 40, for 1 point, and simultaneously bought the January 45 put for 3 points. \nThis transaction would cost 2 points, and would leave him in the following position: \nLong 1 January 40 call C b· d t 8 . t - om me cos : porn s Long 1 January 45 put \nHe now owns a combination at a cost of 8 points. However, no matter where the \nunderlying stock is at expiration, this combination will be worth at least 5 points, \nsince the put has a striking price 5 points higher than the call's striking price. In fact, \nif the stock is above 45 at expiration or is below 40 at expiration, the straddle will be \nworth more than 5 points. This follow-up action has not limited the potential profits. \nIf the stock continues to rise in price, the call will become more and more valuable. \nOn the other hand, if the stock reverses and falls dramatically, the put will become \nquite valuable. In either case, the opportunity for large potential profits remains. \nMoreover, the investor has improved his risk exposure. The most that the new posi\ntion can lose at expiration is 3 points, since the combination cost 8 points originally, \nand can be sold for 5 points at worst. \nTo summarize, if the underlying stock moves up to the ne:t\"t strike, the straddle \nbuyer should consider rolling his put up, selling the one that he is long and buying \nthe one at the next higher striking price. Conversely, if the stock starts out with a \ndownward move, he should consider rolling the call down, selling the one that he is \nlong and buying the one at the next lower strike. In either case, he reduces his risk \nexposure without limiting his profit potential - exactly the type of follow-up result \nthat the straddle buyer should be aiming for. \nBUYING A STRANGLE \nA strangle is a position that consists of both a put and a call, which generally have the \nsame expiration date, but different striking prices. The fallowing example depicts a \nstrangle. \nExample: One might buy a strangle consisting of an XYZ January 45 put and an XYZ \nJanuary 50 call. Buying such a strangle is quite similar to buying a straddle, although \nO.,,ter 18: Buying Puts in Conjunction with Call Purchases 289 \nthere are some differences, as the following discussion will demonstrate. Suppose the \nfollowing prices exist: \nXYZ common, 47; \nXYZ January 45 put, 2; and \nXYZ January 50 call, 2. \nIn this example, both options are out-of-the-money when purchased. This, again, is \nthe most normal application of the strangle purchase. If XYZ is still between 45 and \n50 at January expiration, both options will expire worthless and the strangle buyer \nwill lose his entire investment. This investment - $400 in the example - is generally \nsmaller than that required to buy a straddle on XYZ. If XYZ moves in either direc\ntion, rising above 50 or falling below 45, the strangle will have some value at expira\ntion. In this example, ifXYZ is above 54 at expiration, the call will be worth more than \n4 points (the put will expire worthless) and the buyer will make a profit. In a similar \nmanner, if XYZ is below 41 at expiration, the put will have a value greater than 4 \npoints and the buyer would make a profit in that case as well. The potential profits \nare quite large if the underlying stock should nwve a great deal before the options \nexpire. Table 18-2 and Figure 18-2 depict the potential profits or losses from this \nposition at January expiration. The maximum loss is possible over a much wider range \nthan that of a straddle. The straddle achieves its maximum loss only if the stock is \nexactly at the striking price of the options at expiration. However, the strangle has its \nmaximum loss anywhere between the two strikes at expiration. The actual amount of \nthe loss is smaller for the strangle, and that is a compensating factor. The potential \nprofits are large for both strategies. \nThe example above is one in which both options are out-of-the money. It is also \npossible to construct a very similar position by utilizing in-the-money options. \nExample: With XYZ at 47 as before, the in-the-money options might have the fol\nlowing prices: XYZ January 45 call, 4; and XYZ January 50 put, 4. If one purchased \nthis in-the-rrwney strangle, he would pay a total cost of 8 points. However, the value \nof this strangle will always be at least 5 points, since the striking price of the put is 5 \npoints higher than that of the call. The reader has seen this sort of position before, \nwhen protective follow-up strategies for straddle buying and for call or put buying \nwere described. Because the strangle will always be worth at least 5 points, the most \nthat the in-the-money strangle buyer can lose is 3 points in this example. His poten\ntial profits are still unlimited should the underlying stock move a large distance. \nThus, even though it requires a larger initial investment, the in-the-rrwney strangle \nmay often be a superior strategy to the out-of the-rrwney strangle, from a buyer's \n290 \nTABLE 18-2. \nResults at expiration of a strangle purchase. \nXYZ Price at \nExpiration \n25 \n35 \n41 \n43 \n45 \n47 \n50 \n54 \n60 \n70 \nFIGURE 18-2. \nStrangle purchase. \nC: \n0 \n~ ·c. \nX \nw \n1ii \n(/) $0 (/) \n0 \n..J \n6 \nil= -$400 e a. \nPut Call \nProfit Profit \n+$1,800 -$ 200 \n+ 800 200 \n+ 200 200 \n0 200 \n200 200 \n200 200 \n200 200 \n200 + 200 \n200 + 800 \n200 + 1,800 \nStock Price at Expiration \nPart Ill: Put Option Strategies \nTotal \nProfit \n+$1,600 \n+ 600 \n0 \n200 \n400 \n400 \n400 \n0 \n+ 600 \n+ 1,600 \nviewpoint. The in-the-money strangle purchase certainly involves less percentage \nrisk: The buyer can never lose all his investment, since he can always get back 5 \npoints, even in the worst case (when XYZ is behveen 45 and 50 at expiration). His \npercentage profits are lower with the in-the-money strangle purchase, since he paid \nmore for the strangle to", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 131}
{"text": "0 \n200 \n400 \n400 \n400 \n0 \n+ 600 \n+ 1,600 \nviewpoint. The in-the-money strangle purchase certainly involves less percentage \nrisk: The buyer can never lose all his investment, since he can always get back 5 \npoints, even in the worst case (when XYZ is behveen 45 and 50 at expiration). His \npercentage profits are lower with the in-the-money strangle purchase, since he paid \nmore for the strangle to begin with. These observations should come as no surprise, \n\\O.,ter 18: Buying Puts in Conjunction with Call Purchases 291 \nsince when the outright purchase of a call was discussed, it was shown that the \npurchase of an in-the-money call was more conservative than the purchase of an out\nof-the-money call, in general. The same was true for the outright purchase of puts, \nperhaps even more so, because of the smaller time value of an in-the-money put. \nTherefore, the strangle created by the two an in-the-money call and an in-the\nmoney put - should be more conservative than the out-of-the-money strangle. \nIf the underlying stock moves quickly in either direction, the strangle buyer \nmay sometimes be able to take action to protect some of his profits. He would do so \nin a manner similar to that described for the straddle buyer. For example, if the stock \nmoved up quickly, he could sell the put that he originally bought and buy the put at \nthe next higher striking price in its place. If he had started from an out-of-the-money \nstrangle position, this would then place him in a straddle. The strategist should not \nblindly take this sort of follow-up action, however. It may be overly expensive to \"roll \nup\" the put in such a manner, depending on the amount of time that has passed and \nthe actual option prices involved. Therefore, it is best to analyze each situation on a \ncase-by-case basis to see whether it is logical to take any follow-up action at all. \nAs a final point, the out-of-the-money strangles may appear deceptively cheap, \nboth options selling for fractions of a point as expiration nears. However, the proba\nbility of realizing the maximum loss equal to one's initial investment is fairly large \nwith strangles. This is distinctly different from straddle purchases, whereby the prob\nability of losing the entire investment is small. The aggressive speculator should not \nplace a large portion of his funds in out-of-the-money strangle purchases. The per\ncentage risk is smaller with the in-the-money strangle, being equal to the amount of \ntime value premium paid for the options initially, but commission costs will be some\nwhat larger. In either case, the underlying stock still needs to move by a relatively \nlarge amount in order for the buyer to profit. \nCH.APTER 19 \nThe Sale of a Put \nThe buyer of a put stands to profit if the underlying stock drops in price. As might \nthen be expected, the seller of a put will make money if the underlying stock increas\nes in price. The uncovered sale of a put is a more common strategy than the covered \nsale of a put, and is therefore described first. It is a bullishly-oriented strategy. \nTHE UNCOVERED PUT SALE \nSince the buyer of a put has a right to sell stock at the striking price, the writer of a \nput is obligating himself to buy that stock at the striking price. For assuming this obli\ngation, he receives the put option premium. If the underlying stock advances and the \nput expires worthless, the put writer will not be assigned and he could make a maxi\nmum profit equal to the premium received. He has large downside risk, since the \nstock could fall substantially, thereby increasing the value of the written put and caus\ning large losses to occur. An example will aid in explaining these general statements \nabout risk and reward. \nExample: XYZ is at 50 and a 6-month put is selling for 4 points. The naked put writer \nhas a fixed potential profit to the upside - $400 in this example and a large poten\ntial loss to the downside (Table 19-1 and Figure 19-1). This downside loss is limited \nonly by the fact that a stock cannot go below zero. \nThe collateral requirement for writing naked puts is the same as that for writ\ning naked calls. The requirement is equal to 20% of the current stock price plus the \nput premium minus any out-of-the-money amount. \nExample: If XYZ is at 50, the collateral requirement for writing a 4-point put with a \nstriking price of 50 would be $1,000 (20% of 5,000) plus $400 for the put premium \n292 \nCl,opter 19: The Sale of a Put \nTABLE 19-1. \nResults from the sale of an uncovered put. \nXYZ Price at Put Price at \nExpiration Expiration (Parity) \n30 20 \n40 10 \n46 4 \n50 0 \n60 0 \n70 0 \nf IGURE 19-1. \nUncovered sale of a put. \n$400 \nC \n0 \n~ ·5. \nX \nw \n'lii \n(/l $0 (/l \n.3 50 \n0 \n~ a. \nStock Price at Expiration \n293 \nPut Sale \nProfit \n-$1,600 \n600 \n0 \n+ 400 \n+ 400 \n+ 400 \nfor a total of $1,400. If the stock were above the striking price, the striking price dif\nforential would be subtracted from the requirement. The minimum requirement is \nI 0% of the put' s striking price, plus the put premium, even if the computation above \nyields a smaller result. \nThe uncovered put writing strategy is similar in many ways to the covered call \nwriting strategy. Note that the profit graphs have the same shape; this means that the \ntwo strategies are equivalent. It may be helpful to the reader to describe the aspects \nof naked put writing by comparing them to similar aspects of covered call writing. \n294 Part Ill: Put Option Strategies \nIn either strategy, one needs to be somewhat bullish, or at least neutral, on the \nunderlying stock. If the underlying stock moves upward, the uncovered put writer \nwill make a profit, possibly the entire amount of the premium received. If the under\nlying stock should be unchanged at expiration - a neutral situation - the put writer \nwill profit by the amount of the time value premium received when he initially wrote \nthe put. This could represent the maximum profit if the put was out-of-the-money \ninitially, since that would mean that t", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 132}
{"text": "uncovered put writer \nwill make a profit, possibly the entire amount of the premium received. If the under\nlying stock should be unchanged at expiration - a neutral situation - the put writer \nwill profit by the amount of the time value premium received when he initially wrote \nthe put. This could represent the maximum profit if the put was out-of-the-money \ninitially, since that would mean that the entire put premium was composed of time \nvalue premium. For an in-the-money put, however, the time value premium would \nrepresent something less than the entire value of the option. These are similar qual\nities to those inherent in covered call writing. If the stock moves up, the covered call \nwriter can make his maximum profit. However, if the stock is unchanged at expira\ntion, he will make his maximum profit only if the stock is above the call's striking \nprice. So, in either strategy, if the position is established with the stock above the \nstriking price, there is a greater probability of achieving the maximum profit. This \nrepresents the less aggressive application: writing an out-of-the-money put initially, \nwhich is equivalent to the covered write of an in-the-money call. \nThe more aggressive application of naked put writing is to write an in-the\nmoney put initially. The writer will receive a larger amount of premium dollars for \nthe in-the-money put and, if the underlying stock advances far enough, he will thus \nmake a large profit. By increasing his profit potential in this manner, he assumes \nmore risk. If the underlying stock should fall, the in-the-money put writer will lose \nmoney more quickly than one who initially wrote an out-of-the-money put. Again, \nthese facts were demonstrated much earlier with covered call writing. An in-the\nmoney covered call write affords more downside protection but less profit potential \nthan does an out-of-the-money covered call write. \nIt is fairly easy to summarize all of this by noting that in either the naked put \nwriting strategy or the covered call writing strategy, a less aggressive position is estab\nlished when the stock is higher than the striking price of the written option. If the \nstock is below the striking price initially, a more aggressive position is created. \nThere are, of course, some basic differences between covered call writing and \nnaked put writing. First, the naked put write will generally require a smaller invest\nment, since one is only collateralizing 20% of the stock price plus the put premium, \nas opposed to 50% for the covered call write on margin. Also, the naked put writer is \nnot actually investing cash; collateral is used, so he may finance his naked put writing \nthrough the value of his present portfolio, whether it be stocks, bonds, or government \nsecurities. However, any losses would create a debit and might therefore cause him \nto disturb a portion of this portfolio. It should be pointed out that one can, ifhe wish\nes, write naked puts in a cash account by depositing cash or cash equivalents equal to \nthe striking price of the put. This is called \"cash-based put writing.\" The covered call \nO.,,ter 19: The Sale of a Put 295 \nwriter receives the dividends on the underlying stock, but the naked put writer does \nnot. In certain cases, this may be a substantial amount, but it should also be pointed \nout that the puts on a high-yielding stock will have more value and the naked put \nwriter will thus be taking in a higher premium initially. From strictly a rate of return \nviewpoint, naked put writing is superior to covered call writing. Basically, there is a \ndifferent psychology involved in writing naked puts than that required for covered call \nwriting. The covered call write is a comfortable strategy for most investors, since it \ninvolves common stock ownership. Writing naked options, however, is a more foreign \nconcept to the average investor, even if the strategies are equivalent. Therefore, it is \nrelatively unlikely that the same investor would be a participant in both strategies. \nFOLLOW-UP ACTION \nThe naked put writer would take protective follow-up action if the underlying stock \ndrops in price. His simplest form of follow-up action is to close the position at a small \nloss if the stock drops. Since in-the-money puts tend to lose time value premium rap\nidly, he may find that his loss is often quite small if the stock goes against him. In the \nexample above, XYZ was at 50 with the put at 4. If the stock falls to 45, the writer \nmay be able to quite easily repurchase the put for 5½ or 6 points, thereby incurring \na fairly small loss. \nIn the covered call writing strategy, it was recommended that the strategist roll \ndown wherever possible. One reason for doing so, rather than closing the covered call \nposition, is that stock commissions are quite large and one cannot generally afford to \nbe moving in and out of stocks all the time. It is more advantageous to try to preserve \nthe stock position and roll the calls down. This commission disadvantage does not \nexist with naked put writing. When one closes the naked put position, he merely buys \nin the put. Therefore, rolling down is not as advantageous for the naked put writer. \nFor example, in the paragraph above, the put writer buys in the put for 5½ or 6 \npoints. He could roll down by selling a put with striking price 45 at that time. \nHowever, there may be better put writing situations in other stocks, and there should \nbe no reason for him to continue to preserve a position in XYZ stock \nIn fact, this same reasoning can be applied to any sort of rolling action for the \nnaked put writer. It is extremely advantageous for the covered call writer to roll for\nward; that is, to buy back the call when it has little or no time value premium remain\ning in it and sell a longer-term call at the same striking price. By doing so, he takes in \nadditional premium without having to disturb his stock position at all. However, the \nnaked put writer has little advantage in rolling", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 133}
{"text": "aked put writer. It is extremely advantageous for the covered call writer to roll for\nward; that is, to buy back the call when it has little or no time value premium remain\ning in it and sell a longer-term call at the same striking price. By doing so, he takes in \nadditional premium without having to disturb his stock position at all. However, the \nnaked put writer has little advantage in rolling forward. He can also take in addition\nal premium, but when he closes the initial uncovered put, he should then evaluate \n296 Part Ill: Put Option Strategies \nother available put writing positions before deciding to write another put on the sam<' \nunderlying stock. His commission costs are the same if he remains in XYZ stock or if \nhe goes on to a put writing position in a different stock. \nEVALUATING A NAKED PUT WRITE \nThe computation of potential returns from a naked put write is not as straightforward \nas were the computations for covered call writing. The reason for this is that the col\nlateral requirement changes as the stock moves up or down, since any naked option \nposition is marked to the market. The most conservative approach is to allow enough \ncollateral in the position in case the underlying stock should fall, thus increasing the \nrequirement. In this way, the naked put writer would not be forced to prematurely \nclose a position because he cannot maintain the margin required. \nExample: XYZ is at 50 and the October 50 put is selling for 4 points. The initial col\nlateral requirement is 20% of 50 plus $400, or $1,400. There is no additional require\nment, since the stock is exactly at the striking price of the put. Furthermore, let us \nassume that the writer is going to close the position should the underlying stock fall \nto 43. To maintain his put write, he should therefore allow enough margin to collat\neralize the position if the stock were at 43. The requirement at that stock price would \nbe $1,560 (20% of 43 plus at least 7 points for the in-the-money amount). Thus, the \nput writer who is establishing this position should allow $1,560 of collateral value for \neach put written. Of course, this collateral requirement can be reduced by the \namount of the proceeds received from the put sale, $400 per put less commissions in \nthis example. If we assume that the writer sells 5 puts, his gross premium inflow \nwould be $2,000 and his commission expense would be about $75, for a net premi\num of $1,925. \nOnce this information has been determined, it is a simple matter to determine \nthe maximum potential return and also the downside break-even point. To achieve \nthe maximum potential return, the put would expire worthless with the underlying \nstock above the striking price. Therefore, the maximum potential profit is equal to \nthe net premium received. The return is merely that profit divided by the collateral \nused. In the example above, the maximum potential profit is $1,925. The collateral \nrequired is $1,560 per put (allowing for the stock to drop to 43) or $7,800 for 5 puts, \nreduced by the $1,925 premium received, for a total requirement of $5,875. The \npotential return is then $1,925 divided by $5,875, or 32.8%. Table 19-2 summarizes \nthese calculations. \nt,r 19: The Sale of a Put \nILE 19-2. \n297 \nlculation of the potential return of uncovered put writing. \n50 \n4 \nless commissions \nPotential maximum profit (premium received) \nStriking price \nLess premium per put ($1,925/5) \nBreak-even stock price \nCollateral required (allowing for stock to drop to 43): \n20% of 43 \nPlus put premium \nRequirement for 5 puts \nLess premium received \nNet collateral \nPotential return: \nPremium divided by net collateral \n$2,000 \n75 \n$1,925 \n$50.00 \n3.85 \n46.15 \n$ 860 \n+ 700 \n$1,560 \nX 5 \n$7,800 \n- 1,925 \n$5,875 \n$1,925/$5,875 = 32.8% \nThere are differences of opinion on how to compute the potential returns from \nnaked put writing. The method presented above is a more conservative one in that it \ntakes into consideration a larger collateral requirement than the initial requirement. \nOf course, since one is not really investing cash, but is merely using the collateral \nvalue of his present portfolio, it may even be correct to claim that one has no invest\nment at all in such a position. This may be true, but it would be impossible to com\npare various put writing opportunities without having a return computation available. \nOne other important feature of return computations is the return if unchanged. \nIf the put is initially out-of-the-money, the return if unchanged is the same as the \nmaximum potential return. However, if the put is initially in-the-money, the compu\ntation must take into consideration what the writer would have to pay to buy back the \nput when it expires. \n298 Part Ill: Put Option Strategies \nExample: XYZ is 48 and the XYZ January 50 put is selling for 5 points. The profit \nthat could be made if the stock were unchanged at expiration would be only 3 points, \nless commissions, since the put would have to be repurchased for 2 points with XYZ \nat 48 at expiration. Commissions for the buy-back should be included as well, to \nmake the computation as accurate as possible. \nAs was the case with covered call writing, one can create several rankings of \nnaked put writes. One list might be the highest potential returns. Another list could \nbe the put writes that provide the rrwst downside protection; that is, the ones that \nhave the least chance of losing money. Both lists need some screening applied to \nthem, however. When considering the maximum potential returns, one should take \ncare to ensure at least some room for downside movement. \nExample: If XYZ were at 50, the XYZ January 100 put would be selling at 50 also and \nwould most assuredly have a tremendously large maximum potential return. \nHowever, there is no room for downside movement at all, and one would surely not \nwrite such a put. One simple way of allowing for such cases would be to reject any \nput that did not offer at least 5% downside protec", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 134}
{"text": "for downside movement. \nExample: If XYZ were at 50, the XYZ January 100 put would be selling at 50 also and \nwould most assuredly have a tremendously large maximum potential return. \nHowever, there is no room for downside movement at all, and one would surely not \nwrite such a put. One simple way of allowing for such cases would be to reject any \nput that did not offer at least 5% downside protection. Alternatively, one could also \nreject situations in which the return if unchanged is below 5%. \nThe other list, involving maximum downside protection, also must have some \nscreens applied to it. \nExample: With XYZ at 70, the XYZ January 50 put would be selling for½ at most. \nThus, it is extremely unlikely that one would lose money in this situation; the stock \nwould have to fall 20 points for a loss to occur. However, there is practically nothing \nto be made from this position, and one would most likely not ever write such a deeply \nout-of-the-money put. \nA minimum acceptable level of return must accompany the items on this list of \nput writes. For example, one might decide that the return would have to be at least \n12% on an annualized basis in order for the put write to be on the list of positions \noffering the most downside protection. Such a requirement would preclude an \nextreme situation like that shown above. Once these screens have been applied, the \nlists can then be ranked in a normal manner. The put writes offering the highest \nreturns would be at the top of the more aggressive list, and those offering the high\nest percentage of downside protection would be at the top of the more conservative \nlist. In the strictest sense, a more advanced technique to incorporate the volatility of \nthe underlying stock should rightfully be employed. As mentioned previously, that \ntechnique is presented in Chapter 28 on mathematical applications. \n19: The Sale of a Put 299 \nYING STOCK BELOW ITS MARKET PRICE \naddition to viewing naked put writing as a strategy unto itself, as was the case in \nprevious discussion, some investors who actually want to acquire stock will often \nte naked puts as well. \nbmple: XYZ is a $60 stock and an investor feels it would be a good buy at 55. He \nplaces an open buy order with a limit of 55. Three months later, XYZ has drifted \ndown to 57 but no lower. It then turns and rises heavily, but the buy limit was never \nreached, and the investor misses out on the advance. \nThis hypothetical investor could have used a naked put to his advantage. \nSuppose that when XYZ was originally at 60, this investor wrote a naked three-month \nput for 5 points instead of placing an open buy limit order. Then, if XYZ is anywhere \nbelow 60 at expiration, he will have stock put to him at 60. That is, he will have to buy \nstock at 60. However, since he received 5 points for the put sale, his net cost for the \nstock is 55. Thus, even ifXYZ is at 57 at expiration and has never been any lower, the \ninvestor can still buy XYZ for a net cost of 55. \nOf course, if XYZ rose right away and was above 60 at expiration, the put would \nnot be assigned and the investor would not own XYZ. However, he would still have \nmade $500 from selling the put, which is now worthless. The put writer thus assumes \na more active role in his investments by acting rather than waiting. He receives at \nleast some compensation for his efforts, even though he did not get to buy the stock. \nIf, instead of rising, XYZ fell considerably, say to 40 by expiration, the investor \nwould be forced to purchase stock at a net cost of 55, thereby giving himself an \nimmediate paper loss. He was, however, going to buy stock at 55 in any case, so the \nput writer and the investor using a buy limit have the same result in this case. Critics \nmay point out that any buy order for common stock may be canceled if one's opinion \nchanges about purchasing the stock. The put writer, of course, may do the same thing \nby closing out his obligation through a closing purchase of the put. \nThis technique is useful to many types of investors who are oriented toward \neventually owning the stock. Large portfolio managers as well as individual investors \nmay find the sale of puts useful for this purpose. It is a method of attempting to accu\nmulate a stock position at prices lower than today's market price. If the stock rises \nand the stock is not bought, the investor will at least have received the put premium \nas compensation for his efforts. \nSOME CAUTION IS REQUIRED \nDespite the seemingly benign nature of naked put writing, it can be a highly dan\ngerous strategy for two reasons: (1) Large losses are possible if the underlying stock \n300 Part Ill: Put Option Strategies \ntakes a nasty fall, and (2) collateral requirements are small, so it is possible to utilize \na great deal of leverage. It may seem like a good idea to write out-of-the-money puts \non \"quality\" stocks that you \"wouldn't mind owning.\" However, any stock is subject \nto a crushing decline. In almost any year there are serious declines in one or more of \nthe largest stocks in America (IBM in 1991, Procter and Gamble in 1999, and Xerox \nin 1999, just to name a few). If one happens to be short puts on such stocks - and \nworse yet, ifhe happens to have overextended himself because he had the initial mar\ngin required to sell a great deal of puts - then he could actually be wiped out on such \na decline. Therefore, do not leverage your account heavily in the naked put strategy, \nregardless of the \"quality\" of the underlying stock. \nTHE COVERED PUT SALE \nBy definition, a put sale is covered only if the investor also owns a corresponding put \nwith striking price equal to or greater than the strike of the written put. This is a \nspread. However,formargin purposes, one is covered ifhe sells a put and is also short \nthe underlying stock. The margin required is strictly that for the short sale of the \nstock; there is none required for the short put. This creates a position with limited \nprofit potential that", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 135}
{"text": "also owns a corresponding put \nwith striking price equal to or greater than the strike of the written put. This is a \nspread. However,formargin purposes, one is covered ifhe sells a put and is also short \nthe underlying stock. The margin required is strictly that for the short sale of the \nstock; there is none required for the short put. This creates a position with limited \nprofit potential that is obtained if the underlying stock is anywhere below the strik\ning price of the put at expiration. There is unlimited upside risk, since if the under\nlying stock rises, the short sale of stock will accrue losses, while the profit from the \nput sale is limited. This is really a position equivalent to a naked call write, except that \nthe covered put writer must pay out the dividend on the underlying stock, if one \nexists. The naked sale of a call also has an advantage over this strategy in that com\nmission costs are considerably smaller. In addition, the time value premium of a call \nis generally higher than that of a put, so that the naked call writer is taking in more \ntime premium. The covered put sale is a little-used strategy that appears to be infe\nrior to naked call writing. As a result, the strategy is not described more fully. \nRATIO PUT WRITING \nA ratio put write involves the short sale of the underlying stock plus the sale of 2 puts \nfor each 100 shares sold short. This strategy has a profit graph exactly like that of a \nratio call write, achieving its maximum profit at the striking price of the written \noptions, and having large potential losses if the underlying stock should move too far \nin either direction. The ratio call write is a highly superior strategy, however, for the \nreasons just outlined. The ratio call writer receives dividends while the ratio put \nQapter 19: The Sale ol a Put 301 \nwriter would have to pay them out. In addition, the ratio call writer will generally be \ntaking in larger amounts of time value premium, because calls have more time pre\nmium than puts do. Therefore, the ratio put writing strategy is not a viable one. \nCHAPTER 20 \nThe Sale of a Straddle \nSelling a straddle involves selling both a put and a call with the same terms. As with \nany type of option sale, the straddle sale may be either covered or uncovered. Both \nuses are fairly common. The covered sale of a straddle is very similar to the covered \ncall writing strategy and would generally appeal to the same type of investor. The \nuncovered straddle write is more similar to ratio call writing, and is attractive to the \nmore aggressive strategist who is interested in selling large amounts of time premi\num in hopes of collecting larger profits if the underlying stock remains fairly stable. \nTHE COVERED STRADDLE WRITE \nIn this strategy, one owns the underlying stock and simultaneously writes a straddle \non that stock. This may be particularly appealing to investors who are already \ninvolved in covered call writing. In reality, this position is not totally covered - only \nthe sale of the call is covered by the ownership of the stock. The sale of the put is \nuncovered. However, the name \"covered straddle\" is generally used for this type of \nposition in order to distinguish it from the uncovered straddle write. \nExample: XYZ is at 51 and an XYZ January 50 call is selling for 5 points while an XYZ \nJanuary 50 put is selling for 4 points. A covered straddle write would be established \nby buying 100 shares of the underlying stock and simultaneously selling one put and \none call. The similarity between this position and a covered call writer's position \nshould be obvious. The covered straddle write is actually a covered write - long 100 \nshares of XYZ plus short one call - coupled with a naked put write. Since the naked \nput write has already been shown to be equivalent to a covered call write, this posi\ntion is quite similar to a 200-share covered call write. In fact, all the profit and loss \n302 \ner 20: The Sale of a Straddle 303 \naracteristics of a covered call write are the same for the covered straddle write. \nThere is limited upside profit potential and potentially large downside risk. \nReaders will remember that the sale of a naked put is equivalent to a covered \ncall write. Hence, a covered straddle write can be thought of either as the equivalent \nof a 200-share covered call write, or as the sale of two uncovered puts. In fact, there \n•• some merit to the strategy of selling two puts instead of establishing a covered \nstraddle write. Commission costs would be smaller in that case, and so would the ini\ntial investment required (although the introduction of leverage is not always a good \ntlting). \nThe maximum profit is attained if XYZ is anywhere above the striking price of \n50 at expiration. The amount of maximum profit in this example is $800: the premi\num received from selling the straddle, less the 1-point loss on the stock if it is called \n11way at 50. In fact, the maximum profit potential of a covered straddle write is quick\nly computed using the following formula: \nMaximum profit = Straddle premium + Striking price - Initial stock price \nThe break-even point in this example is 46. Note that the covered writing por\ntion of this example buying stock at 51 and selling a call for 5 points - has a break\neven point of 46. The naked put portion of the position has a break-even point of 46 \nas well, since the January 50 put was sold for 4 points. Therefore, the combined posi\ntion - the covered straddle write - must have a break-even point of 46. Again, this \nobservation is easily defined by an equation: \nB ak . Stock price + Strike price - Straddle premium re -even pnce = \n2 \nTable 20-1 and Figure 20-1 compare the covered straddle write to a 100-share cov\nered call write of the XYZ January 50 at expiration. \nThe attraction for the covered call writer to become a covered straddle writer is \nthat he may be able to increase his return without substantially altering the parame\nters of his covered call writ", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 136}
{"text": ". Stock price + Strike price - Straddle premium re -even pnce = \n2 \nTable 20-1 and Figure 20-1 compare the covered straddle write to a 100-share cov\nered call write of the XYZ January 50 at expiration. \nThe attraction for the covered call writer to become a covered straddle writer is \nthat he may be able to increase his return without substantially altering the parame\nters of his covered call writing position. Using the prices in Table 20-1, if one had \ndecided to establish a covered write by buying XYZ at 51 and selling the January 50 \ncall at 5 points, he would have a position with its maximum potential return anywhere \nabove 50 and with a break-even point of 46. By adding the naked put to his covered \ncall position, he does not change the price parameters of his position; he still makes \nhis maximum profit anywhere above 50 and he still has a break-even point of 46. \nTherefore, he does not have to change his outlook on the underlying stock in order \nto become a covered straddle writer. \nThe investment is increased by the addition of the naked put, as are the poten\ntial dollars of profit if the stock is above 50 and the potential dollars of loss if the stock \n304 Part Ill: Put Option Strategies \nTABLE 20-1. \nResults at expiration of covered straddle write. \nStock (A) 100-Shore (8) Put \nPrice Covered Write Write \n35 \n40 \n46 \n50 \n60 \nFIGURE 20-1. \n-$1, 100 \n600 \n0 \n+ 400 \n+ 400 \nCovered straddle write. \n+$800 \n§ +$400 \ne ·5. \n~ \nal \nen $0 en 0 ...J \nc5 \ne a. ~, \n,,' ,, ,, \n,, ,, \n,, ,, \n,, \n-$1, 100 \n600 \n0 \n+ 400 \n+ 400 \n100-Share Covered \nCall Write \n~-----------------► \n, 46 50 \nStock Price at Expiration \nCovered Straddle \nWrite (A+ 8) \n-$2,200 \n- 1,200 \n0 \n+ 800 \n+ 800 \nis below 46 at expiration. The covered straddle writer loses money twice as fast on \nthe downside, since his position is similar to a 200-share covered write. Because the \ncommissions are smaller for the naked put write than for the covered call write, the \ncovered call writer who adds a naked put to his position will generally increase his \nreturn somewhat. \nFollow-up action can be implemented in much the same way it would be for a \ncovered call write. Whenever one would normally roll his call in a covered situation, \nt,r 20: The Sale ol a Straddle 305 \nnow rolls the entire straddle - rolling down for protection, rolling up for an \nease in profit potential, and rolling forward when the time value premium of the \ndie dissipates. Rolling up or down would probably involve debits, unless one \nled to a longer maturity. \nSome writers might prefer to make a slight adjustment to the covered straddle \nting strategy. Instead of selling the put and call at the same price, they prefer to \nell an out-of-the-money put against the covered call write. That is, if one is buying \nXYZ at 50 and selling the call, he might then also sell a put at 45. This would increase \nhis upside profit potential and would allow for the possibility of both options expir\ning worthless if XYZ were anywhere between 45 and 50 at expiration. Such action \nwould, of course, increase the potential dollars of risk if XYZ fell below 45 by expira\ntion, but the writer could always roll the call down to obtain additional downside pro\ntection. \nOne final point should be made with regard to this strategy. The covered call \nwriter who is writing on margin and is fully utilizing his borrowing power for call writ\ning will have to add additional collateral in order to write covered straddles. This is \nbecause the put write is uncovered. However, the covered call writer who is operat\ning on a cash basis can switch to the covered straddle writing strategy without put\nting up additional funds. He merely needs to move his stock to a margin account and \nuse the collateral value of the stock he already owns in order to sell the puts neces\nsary to implement the covered straddle writes. \nTHE UNCOVERED STRADDLE WRITE \nIn an uncovered straddle write, one sells the straddle without owning the underlying \nstock. In broad terms, this is a neutral strategy with limited profit potential and large \nrisk potential. However, the probability of making a profit is generally quite large, \nand methods can be implemented to reduce the risks of the strategy. \nSince one is selling both a put and a call in this strategy, he is initially taking in \nlarge amounts of time value premium. If the underlying stock is relatively unchanged \nat expiration, the straddle writer will be able to buy the straddle back for its intrinsic \nvalue, which would normally leave him with a profit. \nExample: The following prices exist: \nXYZ common, 45; \nXYZ January 45 call, 4; and \nXYZ January 45 put, 3. \n306 Part Ill: Put Option Strategies \nA straddle could be sold for 7 points. If the stock were above 38 and below 52 at expi\nration, the straddle writer would profit, since the in-the-money option could ht· \nbought back for less than 7 points in that case, while the out-of-the-money option \nexpires worthless (Table 20-2). \nTABLE 20-2. \nThe naked straddle write. \nXYZ Price at Call Put Total \nExpiration Profit Profit Profit \n30 +$ 400 -$1,200 -$800 \n35 + 400 700 - 300 \n38 + 400 400 0 \n40 + 400 200 + 200 \n45 + 400 + 300 + 700 \n50 100 + 300 + 200 \n52 300 + 300 0 \n55 600 + 300 - 300 \n60 - 1,100 + 300 - 800 \nNotice that Figure 20-2 has a shape like a roof. The maximum potential profit \npoint is at the striking price at expiration, and large potential losses exist in either \ndirection if the underlying stock should move too far. The reader may recall that the \nratio call writing strategy - buying 100 shares of the underlying stock and selling two \ncalls - has the same profit graph. These two strategies, the naked straddle write and \nthe ratio call write, are equivalent. The two strategies do have some differences, of \ncourse, as do all equivalent strategies; but they are similar in that both are highly \nprobabilistic strategies that can be somewhat complex. In addition, both have large \npotential risks under adverse market cond", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 137}
{"text": "selling two \ncalls - has the same profit graph. These two strategies, the naked straddle write and \nthe ratio call write, are equivalent. The two strategies do have some differences, of \ncourse, as do all equivalent strategies; but they are similar in that both are highly \nprobabilistic strategies that can be somewhat complex. In addition, both have large \npotential risks under adverse market conditions or if follow-up strategies are not \napplied. \nThe investment required for a naked straddle is the greater of the requirement \non the call or the put. In general, this means that the margin requirement is equal to \nthe requirement for the in-the-money option in a simple naked write. This require\nment is 20% of the stock price plus the in-the-money option premium. The straddle \nwriter should allow enough collateral so that he can take whatever follow-up actions \nhe deems necessary without having to incur a margin call. If he is intending to close \nout the straddle if the stock should reach the upside break-even point - 52 in the \nexample above - then he should allow enough collateral to finance the position with \nler 20: The Sale of a Straddle \nGURE 20-2. \nked straddle sale. \n307 \nStock Price at Expiration \nthe stock at 52. If, however, he is planning to take other action that might involve \nstaying with the position if the stock goes to 55 or 56, he should allow enough collat\neral to be able to finance that action. If the stock never gets that high, he will have \nexcess collateral while the position is in place. \nSELECTING A STRADDLE WRITE \nIdeally, one would like to receive a premium for the straddle write that produces a \nprofit range that is wide in relation to the volatility of the underlying stock. In the \nexample above, the profit range is 38 to 52. This may or may not be extraordinarily \nwide, depending on the volatility of XYZ. This is a somewhat subjective measure\nment, although one could construct a simple straddle writer's index that ranked strad\ndles based on the following simple formula: \nI d Straddle time value premium n ex= _______ ..._ ___ _ \nStock price x Volatility \nRefinements would have to be made to such a ranking, such as eliminating cases in \nwhich either the put or the call sells for less than ¼ point ( or even 1 point, if a more \nrestrictive requirement is desired) or cases in which the in-the-money time premium \nis small. Furthermore, the index would have to be annualized to be able to compare \nstraddles for different expiration months. More advanced selection criteria, in the \n308 Part Ill: Put Option Strategies \nform of an expected return analysis, will be presented in Chapter 28 on mathemati\ncal applications. \nMore screens can be added to produce a more conservative list of straddl<' \nwrites. For example, one might want to ignore any straddles that are not worth at \nleast a fixed percentage, say 10%, of the underlying stock price. Also, straddles that \nare too short-term, such as ones with less than 30 days of life remaining, might b<' \nthrown out as well. The remaining list of straddle writing candidates should be ones \nthat will provide reasonable returns under favorable conditions, and also should be \nreadily adaptable to some of the follow-up strategies discussed later. Finally, one \nwould generally like to have some amount of technical support at or above the lower \nbreak-even price and some technical resistance at or below the upper break-even \npoint. Thus, once the computer has generated a list of straddles ranked by an index \nsuch as the one listed above, the straddle writer can further pare down the list by \nlooking at the technical pictures of the underlying stocks. \nFOLLOW-UP ACTION \nThe risks involved in straddle writing can be quite large. When market conditions are \nfavorable, one can make considerable profits, even with restrictive selection require\nments, and even by allowing considerable extra collateral for adverse stock move\nments. However, in an extremely volatile market, especially a bullish one, losses can \noccur rapidly and follow-up action must be taken. Since the time premium of a put \ntends to shrink when it goes into-the-money, there is actually slightly less risk to the \ndownside than there is to the upside. In an extremely bullish market, the time value \npremiums of call options will not shrink much at all and might even expand. This may \nforce the straddle writer to pay excessive amounts of time value premium to buy back \nthe written straddle, especially if the movement occurs well in advance of expiration. \nThe simplest form of follow-up action is to buy the straddle back when and if the \nunderlying stock reaches a break-even point. The idea behind doing so is to limit the \nlosses to a small amount, because the straddle should be selling for only slightly more \nthan its original value when the stock has reached a break-even point. In practice, \nthere are several flaws in this theory. If the underlying stock arrives at a break-even \npoint well in advance of expiration, the amount of time value premium remaining in \nthe straddle may be extremely large and the writer will be losing a fairly large amount \nby repurchasing the straddle. Thus, a break-even point at expiration is probably a loss \npoint prior to expiration. \nExample: After the straddle is established with the stock at 45, there is a sudden rally \nin the stock and it climbs quickly to 52. The call might be selling for 9 points, even \n20: The Sale of a Straddle 309 \ngh it is 7 points in-the-money. This is not unusual in a bullish situation. \nver, the put might be worth 1 ½points.This is also not unusual, as out-of-the\ny puts with a large amount of time remaining tend to hold time value premium \nwell. Thus, the straddle writer would have to pay 10½ points to buy back this \ndle, even though it is at the break-even point, 7 points in-the-money on the call \nThis example is included merely to demonstrate that it is a misconception to \nieve that one can always buy the straddle bac", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 138}
{"text": "s is also not unusual, as out-of-the\ny puts with a large amount of time remaining tend to hold time value premium \nwell. Thus, the straddle writer would have to pay 10½ points to buy back this \ndle, even though it is at the break-even point, 7 points in-the-money on the call \nThis example is included merely to demonstrate that it is a misconception to \nieve that one can always buy the straddle back at the break-even point and hold \nlosses to mere fractions of a point by doing so. This type of buy-back strategy \nks best when there is little time remaining in the straddle. In that case, the \noptions will indeed be close to parity and the straddle will be able to be bought back \nfor close to its initial value when the stock reaches the break-even point. \nAnother follow-up strategy that can be employed, similar to the previous one \nbut with certain improvements, is to buy back only the in-the-money option when it \nreaches a price equal to that of the initial straddle price. \n~mple: Again using the same situation, suppose that when XYZ began to climb \nheavily, the call was worth 7 points when the stock reached 50. The in-the-money \noption the call - is now worth an amount equal to the initial straddle value. It could \nthen be bought back, leaving the out-of-the-money put naked. As long as the stock \nthen remained above 45, the put would expire worthless. In practice, the put could \nbe bought back for a small fraction after enough time had passed or if the underly\nIng stock continued to climb in price. \nThis type of follow-up action does not depend on taking action at a fixed stock \nprice, but rather is triggered by the option price itself. It is therefore a dynamic sort \nof follow-up action, one in which the same action could be applied at various stock \nprices, depending on the amount of time remaining until expiration. One of the prob\nlems with closing the straddle at the break-even points is that the break-even point is \nC)nly a valid break-even point at expiration. A long time before expiration, this stock \nprice will not represent much of a break-even point, as was pointed out in the last \nexample. Thus, buying back only the in-the-money option at a fixed price may often \nbe a superior strategy. The drawback is that one does not release much collateral by \nbuying back the in-the-money option, and he is therefore stuck in a position with \nlittle potential profit for what could amount to a considerable length of time. The \ncollateral released amounts to the in-the-money amount; the writer still needs to \nC.'Ollateralize 20% of the stock price. \nOne could adjust this follow-up method to attempt to retain some profit. For \nexample, he might decide to buy the in-the-money option when it has reached a \n310 Part Ill: Put Option Strategies \nvalue that is 1 point less than the total straddle value initially taken in. This would \nthen allow him the chance to make a I-point profit overall, if the other option expired \nworthless. In any case, there is always the risk that the stock would suddenly revers(' \ndirection and cause a loss on the remaining option as well. This method of follow-up \naction is akin to the ratio writing follow-up strategy of using buy and sell stops on th<' \nunderlying stock. \nBefore describing other types of follow-up action that are designed to combat \nthe problems described above, it might be worthwhile to address the method used in \nratio writing - rolling up or rolling down. In straddle writing, there is often little to \nbe gained from rolling up or rolling down. This is a much more viable strategy in ratio \nwriting; one does not want to be constantly moving in and out of stock positions, \nbecause of the commissions involved. Howeve1~ with straddle writing, once one posi\ntion is closed, there is no need to pursue a similar straddle in that same stock. It may \nbe more desirable to look elsewhere for a new straddle position. \nThere are two other very simple forms of follow-up action that one might con\nsider using, although neither one is for most strategists. First, one might consider \ndoing nothing at all, even if the underlying stock moves by a great deal, figuring that \nthe advantage lies in the probability that the stock will be back near the striking price \nby the time the options expire. This action should be used only by the most diversi\nfied and well-heeled investors, for in extreme market periods, almost all stocks may \nmove in unison, generating tremendous losses for anyone who does not take some \nsort of action. A more aggressive type off allow-up action would be to attempt to \"leg \nout\" of the straddle, by buying in the profitable side and then hoping for a stock price \nreversal in order to buy back the remaining side. In the example above, when XYZ \nran up to 52, an aggressive trader would buy in the put at 1 ½, taking his profit, and \nthen hope for the stock to fall back in order to buy the call in cheaper. This is a very \naggressive type of follow-up action, because the stock could easily continue to rise in \nprice, thereby generating larger losses. This is a trader's sort of action, not that of a \ndisciplined strategist, and it should be avoided. \nIn essence, follow-up action should be designed to do two things: First, to limit \nthe risk in the position, and second, to still allow room for a potential profit to be \nmade. None of the above types of follow-up action accomplish both of these purpos\nes. There is, however, a follow-up strategy that does allow the straddle writer to limit \nhis losses while still allowing for a potential profit. \nExample: After the straddle was originally sold for 7 points when the stock was at 45, \nthe stock experiences a rally and the following prices exist: \nXYZ common, 50; \nXYZ January 45 call, 7; \nCl,opter 20: The Sale of a Straddle \nXYZ January 45 put, l; and \nXYZ January 50 call, 3. \n311 \nThe January 50 call price is included because it will be part of the follow-up strategy. \nNotice that this straddle has a considerable amo", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 139}
{"text": "e was originally sold for 7 points when the stock was at 45, \nthe stock experiences a rally and the following prices exist: \nXYZ common, 50; \nXYZ January 45 call, 7; \nCl,opter 20: The Sale of a Straddle \nXYZ January 45 put, l; and \nXYZ January 50 call, 3. \n311 \nThe January 50 call price is included because it will be part of the follow-up strategy. \nNotice that this straddle has a considerable amount of time value premium remain\nIng in it, and thus would be rather expensive to buy back at the current time. \nSuppose, however, that the straddle writer does not touch the January 45 straddle \ntliat he is short, but instead buys the January 50 call for protection to the upside. \nSince this call costs 3 points, he will now have a position with a total credit of 4 points. \n(The straddle was originally sold for 7 points credit and he is now spending 3 points \nfor the call at 50.) This action of buying a call at a higher strike than the striking price \nof the straddle has limited the potential loss to the upside, no matter how far the \nstock might run up. If XYZ is anywhere above 50 at expiration, the put will expire \nworthless and the writer will have to pay 5 points to close the call spread short \nJanuary 45, long January 50. This means that his maximum potential loss is 1 point \nplus commissions if XYZ is anywhere above 50 at expiration. \nIn addition to being able to limit the upside loss, this type of follow-up action \nstill allows room for potential profits. If XYZ is anywhere between 41 and 49 at expi\nration - that is, less than 4 points away from the striking price of 45 - the writer will \nhe able to buy the straddle back for less than 4 points, thereby making a profit. \nThus, the straddle writer has both limited his potential losses to the upside and \nalso allowed room for profit potential should the underlying stock fall back in price \ntoward the original striking price of 45. Only severe price reversal, with the stock \nfalling back below 40, would cause a large loss to be taken. In fact, by the time the \nstock could reverse its current strong upward momentum and fall all the way back to \n40, a significant amount of time should have passed, thereby allowing the writer to \npurchase the straddle back with only a relatively small amount of time premium left \nin it. \nThis follow-up strategy has an effect on the margin requirement of the position. \nWhen the calls are bought as protection to the upside, the writer has, for margin \npurposes, a bearish spread in the calls and an uncovered put. The margin for this \nposition would normally be less than that required for the straddle that is 5 points \nin-the-money. \nA secondary move is available in this strategy. \nExample: The stock continues to climb over the short term and the out-of-the\nmoney put drops to a price of less than ½ point. The straddle writer might now \nconsider buying back the put, thereby leaving himself with a bear spread in the \ncalls. His net credit left in the position, after buying back the put at ½, would be \n312 Part Ill: Put Optian Strategies \n3½ points. Thus, if XYZ should reverse direction and be within 3½ points of the \nstriking price - that is, anywhere below 48½ - at expiration, the position will pro\nduce a profit. In fact, if XYZ should be below 45 at expiration, the entire bear \nspread will expire worthless and the strategist will have made a 3½-point profit. \nFinally, this repurchase of the put releases the margin requirement for the naked \nput, and will generally free up excess funds so that a new straddle position can be \nestablished in another stock while the low-requirement bear spread remains in \nplace. \nIn summary, this type of follow-up action is broader in purpose than any of the \nsimpler buy-back strategies described earlier. It will limit the writer's loss, but not \nprevent him from making a profit. Moreover, he may be able to release enough mar\ngin to be able to establish a new position in another stock by buying in the uncov\nered puts at a fractional price. This would prevent him from tying up his money \ncompletely while waiting for the original straddle to reach its expiration date. The \nsame type of strategy also works in a downward market. If the stock falls after the \nstraddle is written, one can buy the put at the next lower strike to limit the down\nside risk, while still allowing for profit potential if the stock rises back to the striking \nprice. \nEQUIVALENT STOCK POSITION FOLLOW-UP \nSince there are so many follow-up strategies that can be used with the short straddle, \nthe one method that summarizes the situation best is again the equivalent stock posi\ntion (ESP). Recall that the ESP of an option position is the multiple of the quantity \ntimes the delta times the shares per option. The quantity is a negative number if it is \nreferring to a short position. Using the above scenario, an example of the ESP \nmethod follows: \nExample: As before, assume that the straddle was originally sold for 7 points, but the \nstock rallied. The following prices and deltas exist: \nXYZ common, 50; \nXYZ Jan 45 call, 7; delta, .90; \nXYZ Jan 45 put, l; delta, - .10; and \nXYZ Jan 50 call, 3; delta, .60. \nAssume that 8 straddles were sold initially and that each option is for 100 shares of \nXYZ. The ESP of these 8 short straddles can then be computed: \nChapter 20: The Sale of a Straddle \nOption \nJan 45 call \nJan 45 put \nTotal ESP \nPosition \nshort 8 \nshort 8 \nDelta \n0.90 \n-0.10 \n313 \nESP \nshort 720 (-8 x . 9 x 1 00) \nlong 80 (-8 x -. 1 x 100) \nshort 640 shares \nObviously, the position is quite short. Unless the trader were extremely bearish \non XYZ, he should make an adjustment. The simplest adjustment would be to buy \n600 shares of XYZ. Another possibility would be to buy back 7 of the short January \n45 calls. Such a purchase would add a delta long of 630 shares to the position (7 x .9 \nx 100). This would leave the position essentially neutral. As pointed out in the previ\nous example, however, the strategist may not want t", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 140}
{"text": "y bearish \non XYZ, he should make an adjustment. The simplest adjustment would be to buy \n600 shares of XYZ. Another possibility would be to buy back 7 of the short January \n45 calls. Such a purchase would add a delta long of 630 shares to the position (7 x .9 \nx 100). This would leave the position essentially neutral. As pointed out in the previ\nous example, however, the strategist may not want to buy that option. If, instead, he \ndecided to try to buy the January 50 call to hedge the short straddle, he would have \nto buy 10 of those to make the position neutral. He would buy that many because the \ndelta of that January 50 is 0.60; a purchase of 10 would add a delta long of 600 shares \nto the position. \nEven though the purchase of 10 is theoretically correct, since one is only short \n8 straddles, he would probably buy only 8 January 50 calls as a practical matter. \nSTARTING OUT WITH THE PROTECTION IN PLACE \nIn certain cases, the straddle writer may be able to initially establish a position that \nhas no risk in one direction: He can buy an out-of-the-money put or call at the same \ntime the straddle is written. This accomplishes the same purposes as the follow-up \naction described in the last few paragraphs, but the protective option will cost less \nsince it is out-of-the-money when it is purchased. There are, of course, both positive \nand negative aspects involved in adding an out-of-the-money long option to the strad\ndle write at the outset. \nExample: Given the following prices: \nXYZ, 45; \nXYZ January 45 straddle, 7; and \nXYZ January 50 call, 1 ½, \nthe upside risk will be limited. If one writes the January 45 straddle for 7 points and \nbuys the January 50 call for 1 ½ points, his overall credit will be 5½ points. He has no \nupside risk in this position, for if XYZ should rise and be over 50 at expiration, he will \nbe able to close the position by buying back the call spread for 5 points. The put will \nexpire worthless. The out-of-the-money call has eliminated any risk above 50 on the \n312 Part Ill: Put Option Strategies \n3½ points. Thus, if XYZ should reverse direction and be within 3½ points of the \nstriking price - that is, anywhere below 48½ - at expiration, the position will pro\nduce a profit. In fact, if XYZ should be below 45 at expiration, the entire bear \nspread will expire worthless and the strategist will have made a 3½-point profit. \nFinally, this repurchase of the put releases the margin requirement for the naked \nput, and will generally free up excess funds so that a new straddle position can be \nestablished in another stock while the low-requirement bear spread remains in \nplace. \nIn summary, this type of follow-up action is broader in purpose than any of the \nsimpler buy-back strategies described earlier. It will limit the writer's loss, but not \nprevent him from making a profit. Moreover, he may be able to release enough mar\ngin to be able to establish a new position in another stock by buying in the uncov\nered puts at a fractional price. This would prevent him from tying up his money \ncompletely while waiting for the original straddle to reach its expiration date. The \nsame type of strategy also works in a downward market. If the stock falls after the \nstraddle is written, one can buy the put at the next lower strike to limit the down\nside risk, while still allowing for profit potential if the stock rises back to the striking \nprice. \nEQUIVALENT STOCK POSITION FOLLOW-UP \nSince there are so many follow-up strategies that can be used with the short straddle, \nthe one method that summarizes the situation best is again the equivalent stock posi\ntion (ESP). Recall that the ESP of an option position is the multiple of the quantity \ntimes the delta times the shares per option. The quantity is a negative number if it is \nreferring to a short position. Using the above scenario, an example of the ESP \nmethod follows: \nExample: As before, assume that the straddle was originally sold for 7 points, but the \nstock rallied. The following prices and deltas exist: \nXYZ common, 50; \nXYZ Jan 45 call, 7; delta, .90; \nXYZ Jan 45 put, l; delta, - .10; and \nXYZ Jan 50 call, 3; delta, .60. \nAssume that 8 straddles were sold initially and that each option is for 100 shares of \nXYZ. The ESP of these 8 short straddles can then be computed: \nChapter 20: The Sale of a Straddle \nOption \nJan 45 call \nJan 45 put \nTotal ESP \nPosition \nshort 8 \nshort 8 \nDelta \n0.90 \n-0.10 \n313 \nESP \nshort 720 (-8 x .9 x 100) \nlong 80 (-8 x -. 1 x 1 00) \nshort 640 shares \nObviously, the position is quite short. Unless the trader were extremely bearish \non XYZ, he should make an adjustment. The simplest adjustment would be to buy \n600 shares of XYZ. Another possibility would be to buy back 7 of the short January \n45 calls. Such a purchase would add a delta long of 630 shares to the position (7 x .9 \nx 100). This would leave the position essentially neutral. As pointed out in the previ\nous example, however, the strategist may not want to buy that option. If, instead, he \ndecided to try to buy the January 50 call to hedge the short straddle, he would have \nto buy 10 of those to make the position neutral. He would buy that many because the \ndelta of that January 50 is 0.60; a purchase of 10 would add a delta long of 600 shares \nto the position. \nEven though the purchase of 10 is theoretically correct, since one is only short \n8 straddles, he would probably buy only 8 January 50 calls as a practical matter. \nSTARTING OUT WITH THE PROTECTION IN PLACE \nIn certain cases, the straddle writer may be able to initially establish a position that \nhas no risk in one direction: He can buy an out-of-the-money put or call at the same \ntime the straddle is written. This accomplishes the same purposes as the follow-up \naction described in the last few paragraphs, but the protective option will cost less \nsince it is out-of-the-money when it is purchased. There are, of course, both positive \nand negative aspects involved in adding an out-of", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 141}
{"text": "that \nhas no risk in one direction: He can buy an out-of-the-money put or call at the same \ntime the straddle is written. This accomplishes the same purposes as the follow-up \naction described in the last few paragraphs, but the protective option will cost less \nsince it is out-of-the-money when it is purchased. There are, of course, both positive \nand negative aspects involved in adding an out-of-the-money long option to the strad\ndle write at the outset. \nExample: Given the following prices: \nXYZ, 45; \nXYZ January 45 straddle, 7; and \nXYZ January 50 call, 1 ½, \nthe upside risk will be limited. If one writes the January 45 straddle for 7 points and \nbuys the January 50 call for 1 ½ points, his overall credit will be 5½ points. He has no \nupside risk in this position, for if XYZ should rise and be over 50 at expiration, he will \nbe able to close the position by buying back the call spread for 5 points. The put will \nexpire worthless. The out-of-the-money call has eliminated any risk above 50 on the \n314 Part Ill: Put Option Strategies \nposition. Another advantage of buying the protection initially is that one is protected \nif the stock should experience a gap opening or a trading halt. Ifhe already owns the \nprotection, such stock price movement in the direction of the protection is of little \nconsequence. However, if he was planning to buy the protection as a follow-up \naction, the sudden surge in the stock price may ruin his strategy. \nThe overall profit potential of this position is smaller than that of the normal \nstraddle write, since the premium paid for the long call will be lost if the stock is \nbelow 50 at expiration. However, the automatic risk-limiting feature of the long call \nmay prove to be worth more than the decrease in profit potential. The strategist has \npeace of mind in a rally and does not have to worry about unlimited losses accruing \nto the upside. \nDownside protection for a straddle writer can be achieved in a similar manner \nby buying an out-of-the-money put at the outset. \nExample: With XYZ at 45, one might write the January 45 straddle for 7 and buy a \nJanuary 40 put for I point if he is concerned about the stock dropping in price. \nIt should now be fairly easy to see that the straddle writer could limit risk in \neither direction by initially buying both an out-of-the-money call and an out-of-the\nmoney put at the same time that the straddle is written. The major benefit in doing \nthis is that risk is limited in either direction. Moreover, the margin requirements are \nsignificantly reduced, since the whole position consists of a call spread and a put \nspread. There are no longer any naked options. The detriment of buying protection \non both sides initially is that commission costs increase and the overall profit poten\ntial of the straddle write is reduced, perhaps significantly, by the cost of two long \noptions. Therefore, one must evaluate whether the cost of the protection is too large \nin comparison to what is received for the straddle write. This completely protected \nstrategy can be very attractive when available, and it is described again in Chapter 23, \nSpreads Combining Calls and Puts. \nIn summary, any strategy in which the straddle writer also decides to buy pro\ntection presents both advantages and disadvantages. Obviously, the risk-limiting fea\nture of the purchased options is an advantage. However, the seller of options does not \nlike to purchase pure time value premium as protection at any time. He would gen\nerally prefer to buy intrinsic value. The reader will note that, in each of the protec\ntive buying strategies discussed above, the purchased option has a large amount of \ntime value premium left in it. Therefore, the writer must often try to strike a delicate \nbalance between trying to limit his risk on one hand and trying to hold down the \nexpenses of buying long options on the other hand. In the final analysis, however, the \nrisk must be limited regardless of the cost. \n314 Part Ill: Put Option Strategies \nposition. Another advantage of buying the protection initially is that one is protected \nif the stock should experience a gap opening or a trading halt. If he already owns the \nprotection, such stock price movement in the direction of the protection is of little \nconsequence. However, if he was planning to buy the protection as a follow-up \naction, the sudden surge in the stock price may ruin his strategy. \nThe overall profit potential of this position is smaller than that of the normal \nstraddle write, since the premium paid for the long call will be lost if the stock is \nbelow 50 at expiration. However, the automatic risk-limiting feature of the long call \nmay prove to be worth more than the decrease in profit potential. The strategist has \npeace of mind in a rally and does not have to worry about unlimited losses accruing \nto the upside. \nDownside protection for a straddle writer can be achieved in a similar manner \nby buying an out-of-the-money put at the outset. \nExample: With XYZ at 45, one might write the January 45 straddle for 7 and buy a \nJanuary 40 put for l point if he is concerned about the stock dropping in price. \nIt should now be fairly easy to see that the straddle writer could limit risk in \neither direction by initially buying both an out-of-the-money call and an out-of-the\nmoney put at the same time that the straddle is written. The major benefit in doing \nthis is that risk is limited in either direction. Moreover, the margin requirements are \nsignificantly reduced, since the whole position consists of a call spread and a put \nspread. There are no longer any naked options. The detriment of buying protection \non both sides initially is that commission costs increase and the overall profit poten\ntial of the straddle write is reduced, perhaps significantly, by the cost of two long \noptions. Therefore, one must evaluate whether the cost of the protection is too large \nin comparison to what is received for the straddle write. T", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 142}
{"text": "ead. There are no longer any naked options. The detriment of buying protection \non both sides initially is that commission costs increase and the overall profit poten\ntial of the straddle write is reduced, perhaps significantly, by the cost of two long \noptions. Therefore, one must evaluate whether the cost of the protection is too large \nin comparison to what is received for the straddle write. This completely protected \nstrategy can be very attractive when available, and it is described again in Chapter 23, \nSpreads Combining Calls and Puts. \nIn summary, any strategy in which the straddle writer also decides to buy pro\ntection presents both advantages and disadvantages. Obviously, the risk-limiting fea\nture of the purchased options is an advantage. However, the seller of options does not \nlike to purchase pure time value premium as protection at any time. He would gen\nerally prefer to buy intrinsic value. The reader will note that, in each of the protec\ntive buying strategies discussed above, the purchased option has a large amount of \ntime value premium left in it. Therefore, the ·writer must often try to strike a delicate \nbalance between trying to limit his risk on one hand and trying to hold down the \nexpenses of buying long options on the other hand. In the final analysis, however, the \nrisk must be limited regardless of the cost. \n314 Part Ill: Put Option Strategies \nposition. Another advantage of buying the protection initially is that one is protected \nif the stock should expe1ience a gap opening or a trading halt. If he already owns the \nprotection, such stock price movement in the direction of the protection is of little \nconsequence. However, if he was planning to buy the protection as a follow-up \naction, the sudden surge in the stock price may ruin his strategy. \nThe overall profit potential of this position is smaller than that of the normal \nstraddle write, since the premium paid for the long call will be lost if the stock is \nbelow 50 at ex-piration. However, the automatic risk-limiting feature of the long call \nmay prove to be worth more than the decrease in profit potential. The strategist has \npeace of mind in a rally and does not have to worry about unlimited losses accruing \nto the upside. \nDownside protection for a straddle writer can be achieved in a similar manner \nby buying an out-of-the-money put at the outset. \nExample: With XYZ at 45, one might write the January 45 straddle for 7 and buy a \nJanuary 40 put for l point if he is concerned about the stock dropping in price. \nIt should now be fairly easy to see that the straddle writer could limit risk in \neither direction by initially buying both an out-of-the-money call and an out-of-the\nmoney put at the same time that the straddle is written. The major benefit in doing \nthis is that risk is limited in either direction. Moreover, the margin requirements are \nsignificantly reduced, since the whole position consists of a call spread and a put \nspread. There are no longer any naked options. The detriment of buying protection \non both sides initially is that commission costs increase and the overall profit poten\ntial of the straddle write is reduced, perhaps significantly, by the cost of two long \noptions. Therefore, one must evaluate whether the cost of the protection is too large \nin comparison to what is received for the straddle write. This completely protected \nstrategy can be very attractive when available, and it is described again in Chapter 23, \nSpreads Combining Calls and Puts. \nIn summary, any strategy in which the straddle writer also decides to buy pro\ntection presents both advantages and disadvantages. Obviously, the risk-limiting fea\nture of the purchased options is an advantage. However, the seller of options does not \nlike to purchase pure time value premium as protection at any time. He would gen\nerally prefer to buy intrinsic value. The reader will note that, in each of the protec\ntive buying strategies discussed above, the purchased option has a large amount of \ntime value premium left in it. Therefore, the writer must often try to strike a delicate \nbalance between trying to limit his risk on one hand and trying to hold down the \nexpenses of buying long options on the other hand. In the final analysis, however, the \nrisk must be limited regardless of the cost. \nChapter 20: The Sale of a Straddle 315 \nSTRANGLE (COMBINATION) WRITING \nRecall that a strangle is any position involving both puts and calls, when there is some \ndifference in the terms of the options. Commonly, the puts and calls will have the \nsame expiration date but differing striking prices. A strangle write is usually estab\nlished by selling both an out-of-the-money put and an out-of-the-money call with the \nstock approximately centered between the two striking prices. In this way, the naked \noption writer can remain neutral on the outlook for the underlying stock, even when \nthe stock is not near a striking price. \nThis strategy is quite similar to straddle writing, except that the strangle \nwriter makes his maximum profit over a much wider range than the straddle \nwriter does. In this or any other naked writing strategy, the most money that the \nstrategist can make is the amount of the premium received. The straddle writer \nhas only a minute chance of making a profit of the entire straddle premium, since \nthe stock would have to be exactly at the striking price at expiration in order for \nboth the written put and call to expire worthless. The strangle writer will make his \nmaximum profit potential if the stock is anywhere between the two strikes at expi\nration, because both options will expire worthless in that case. This strategy is \nequivalent to the variable ratio write described previously in Chapter 6 on ratio \ncall writing. \nExample: Given the following prices: \nXYZ common, 65; \nXYZ January 70 call, 4; and \nXYZ January 60 put, 3, \na strangle write would be established by selling the January 70 call and the January \n60 put.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 143}
{"text": "strikes at expi\nration, because both options will expire worthless in that case. This strategy is \nequivalent to the variable ratio write described previously in Chapter 6 on ratio \ncall writing. \nExample: Given the following prices: \nXYZ common, 65; \nXYZ January 70 call, 4; and \nXYZ January 60 put, 3, \na strangle write would be established by selling the January 70 call and the January \n60 put. IfXYZ is anywhere between 60 and 70 at January expiration, both options will \nexpire worthless and the strangle writer will make a profit of 7 points, the amount of \nthe original credit taken in. If XYZ is above 70 at expiration, the strategist will have \nto pay something to buy back the call. For example, if XYZ is at 77 at expiration, the \nJanuary 70 call will have to be bought back for 7 points, thereby creating a break-even \nsituation. To the downside, if XYZ were at 53 at expiration, the January 60 put would \nhave to be bought back for 7 points, thereby defining that as the downside break\neven point. Table 20-3 and Figure 20-3 outline the potential results of this strangle \nwrite. The profit range in this example is quite wide, extending from 53 on the down\nside to 77 on the upside. With the stock presently at 65, this is a relatively neutral \nposition. \n316 \nTABLE 20-3. \nResults of a combination write. \nStock Price at Coll \nExpiration Profit \n40 +$ 400 \n50 + 400 \n53 + 400 \n57 + 400 \n60 + 400 \n65 + 400 \n70 + 400 \n73 + 100 \n77 300 \n80 600 \n90 - 1,600 \nFIGURE 20-3. \nSale of a combination. \nC: \n~ +$700 \n·5. \nX \nUJ \nrn \nen en \n0 ....I \nci \ne a.. \n$0 \nPut \nProfit \n$1,700 \n700 \n400 \n0 \n+ 300 \n+ 300 \n+ 300 \n+ 300 \n+ 300 \n+ 300 \n+ 300 \nStock Price at Expiration \nPart Ill: Put Option Strategies \nTotal \nProfit \n-$1,300 \n300 \n0 \n+ 400 \n+ 700 \n+ 700 \n+ 700 \n+ 400 \n0 \n300 \n- 1,300 \nAt first glance, this may seem to be a more conservative strategy than straddle \nwriting, because the profit range is wider and the stock needs to move a great deal to \nreach the break-even points. In the absence of follow-up action, this is a true obser\nvation. However, if the stock begins to rise quickly or to drop dramatically, the stran\ngle writer often has little recourse but to buy back the in-the-money option in order \nChapter 20: The Sale of a Straddle 317 \nto limit his losses. This can, as has been shown previously, entail a purchase price \ninvolving excess amounts of time value premium, thereby generating a significant \nloss. \nThe only other alternative that is available to the strangle writer ( outside of \nattempting to trade out of the position) is to convert the position into a straddle if the \nstock reaches either break-even point. \nExample: IfXYZ rose to 70 or 71 in the previous example, the January 70 put would \nbe sold. Depending on the amount of collateral available, the January 60 put may or \nmay not be bought back when the January 70 put is sold. This action of converting \nthe strangle write into a straddle write will work out well if the stock stabilizes. It \nwill also lessen the pain if the stock continues to rise. However, if the stock revers\nes direction, the January 70 put write will prove to be unprofitable. Technical analy\nsis of the underlying stock may prove to be of some help in deciding whether or not \nto convert the strangle write into a straddle. If there appears to be a relatively large \nchance that the stock could fall back in price, it is probably not worthwhile to roll \nthe put up. \nThis example of a strangle write is one in which the writer received a large \namount of premium for selling the put and the call. Many times, however, an aggres\nsive strangle writer is tempted to sell two out-of-the-money options that have only a \nshort life remaining. These options would generally be sold at fractional prices. This \ncan be an extremely aggressive strategy at times, for if the underlying stock should \nmove quickly in either direction through a striking price, there is little the strangle \nwriter can do. He must buy in the options to limit his loss. Nevertheless, this type of \nstrangle writing - selling short-term, fractionally priced, out-of-the-money options -\nappeals to many writers. This is a similar philosophy to that of the naked call writer \ndescribed in Chapter 5, who writes calls that are nearly restricted, figuring there will \nbe a large probability that the option will expire worthless. It also has the same risk: \nA large price change or gap opening can cause such devastating losses that many \nprofitable trades are wiped away. Selling fractionally priced combinations is a poor \nstrategy and should be avoided. \nBefore leaving the topic of strangle writing, it may be useful to determine how \nthe margin requirements apply to a strangle write. Recall that the margin require\nment for writing a straddle is 20% of the stock price plus the price of either the put \nor the call, whichever is in-the-money. In a strangle write, however, both options may \nbe out-of-the-money, as in the example above. When this is the case, the straddle \nwriter is allowed to deduct the smaller out-of-the-money amount from his require\nment. Thus, if XYZ were at 68 and the January 60 put and the January 70 call had \nbeen written, the collateral requirement would be 20% of the stock price, plus the \n318 Part Ill: Put Option Strategies \ncall premium, less $200 - the lesser out-of-the-money amount. The call is 2 points \nout-of-the-money and the put is 8 points out-of-the-money. Actually, the true collat\neral requirement for any write involving both puts and calls - straddle write or stran\ngle write - is the greater of the requirement on the put or the call, plus the amount by \nwhich the other option is in-the-nwney. The last phrase, the amount by which the \nother option is in-the-money, applies to a situation in which a strangle had been con\nstructed by selling two in-the-money options. This is a less popular strategy, since the \nwriter generally receives less time value premium by writing two in-the-money \noptions. An", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 144}
{"text": "rement on the put or the call, plus the amount by \nwhich the other option is in-the-nwney. The last phrase, the amount by which the \nother option is in-the-money, applies to a situation in which a strangle had been con\nstructed by selling two in-the-money options. This is a less popular strategy, since the \nwriter generally receives less time value premium by writing two in-the-money \noptions. An example of an in-the-money strangle is to sell the January 60 call and the \nJanuary 70 put with the stock at 65. \nFURTHER COMMENTS ON UNCOVERED STRADDLE \nAND STRANGLE WRITING \nWhen ratio writing was discussed, it was noted that it was a strategy with a high prob\nability of making a limited profit. Since the straddle write is equivalent to the ratio \nwrite and the strangle write is equivalent to the variable ratio write, the same state\nment applies to these strategies. The practitioner of straddle and strangle writing \nmust realize, however, that protective follow-up action is mandatory in limiting loss\nes in a very volatile market. There are other techniques that the straddle writer can \nsometimes use to help reduce his risk. \nIt has often been mentioned that puts lose their time value premium more \nquickly when they become in-the-money options than calls do. One can often con\nstruct a neutral position by writing an extra put or two. That is, if one sells 5 or 6 puts \nand 4 calls 'Ai.th the same terms, he may often have created a more neutral position \nthan a straddle write. If the stock moves up and the call picks up time premium in a \nbullish market, the extra puts 'Aill help to offset the negative effect of the calls. On \nthe other hand, if the stock drops, the 5 or 6 puts will not hold as much time premi\num as the 4 calls are losing - again a neutral, standoff position. If the stock begins to \ndrop too much, the writer can always balance out the position by selling another call \nor two. The advantage of writing an extra put or two is that it counterbalances the \nstraddle writer's most severe enemy: a quick, extremely bullish rise by the underly\ning stock. \nUSING THE DELTAS \nThis analysis, that adding an extra short put creates a neutral position, can be sub\nstantiated more rigorously. Recall that a ratio writer or ratio spreader can use the \nChapter 20: The Sale of a Straddle 319 \ndeltas of the options involved in his position to determine a neutral ratio. The strad\ndle writer can do the same thing, of course. It was stated that the difference between \na call's delta and a put' s delta is approximately one. Using the same prices as in the \nprevious straddle writing example, and assuming the call's delta to be .60, a neutral \nratio can be determined. \nPrices \nXYZ common: \nXYZ January 45 call: \nXYZ January 45 put: \n45 \n4 \n3 \nDeltas \n.60 \n-.40 (.60 - 1) \nThe put has a negative delta, to indicate that the put and the underlying stock are \ninversely related. A neutral ratio is determined by dividing the call's delta by the put's \ndelta and ignoring the minus sign. The resultant ratio - 1.5:1 (.60/.40) in this case -\nis the ratio of puts to sell for each call that is sold. Thus, one should sell 3 puts and \nsell 2 calls to establish a neutral position. The reader may wonder if the assumption \nthat an at-the-money call has a delta of .60 is a fair one. It generally is, although very \nlong-term calls will have higher at-the-money deltas, and very short-term calls will \nhave deltas near .50. Consequently, a 3:2 ratio is often a neutral one. When neutral \nratios were discussed with respect to ratio writing, it was mentioned that selling 5 \ncalls and buying 300 shares of stock often results in neutral ratio. The reader should \nnote that a straddle constructed by selling 3 puts and 2 calls is equivalent to the ratio \nwrite in which one sells 5 calls and buys 300 shares of stock. \nIf a straddle writer is going to use the deltas to determine his neutral ratio, he \nshould compute each one at the time of his initial investment, of course, rather than \nrelying on a generality such as that 3 puts and 2 calls often result in a neutral posi\ntion. The deltas can be used as a follow-up action, by adjusting the ratio to remain \nneutral after a move by the underlying stock. \nAVOID EXCESS TRADING \nIn any of the straddle and strangle writing strategies described above, too much fol\nlow-up action can be detrimental because of the commission costs involved. Thus, \nalthough it is important to take protective action, the straddle writer should plan in \nadvance to make the minimum number of strategic moves to protect himself. That is \nwhy buying protection is often useful; not only does it limit the risk in the direction \nthat the stock is moving, but it also involves only one additional option commission. \nIn fact, if it is feasible, buying protection at the outset is often a better strategy than \nprotecting as a secondary action. \n320 Part Ill: Put Option Strategies \nAn extension of this concept of trying to avoid too much follow-up action is that \nthe strategist should not attempt to anticipate movement in an underlying stock. For \nexample, if the straddle writer has planned to take defensive action should the stock \nreach 50, he should not anticipate by taking action with the stock at 48 or 49. It is \npossible that the stock could retreat back down; then the writer would have taken a \ndefensive action that not only cost him commissions, but reduced his profit potential. \nOf course, there is a little trader in everyone, and the temptation to anticipate (or to \nwait too long) is always there. Unless there are very strong technical reasons for doing \nso, the strategist should resist the temptation to trade, and should operate his strate\ngy according to his original plan. The ratio writer may actually have an advantage in \nthis respect, because he can use buy and sell stops on the underlying stock to remove \nthe emotion from his follow-up strategy. This technique was described in Chapter 6 \non ratio call writing. Unfortuna", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 145}
{"text": "al reasons for doing \nso, the strategist should resist the temptation to trade, and should operate his strate\ngy according to his original plan. The ratio writer may actually have an advantage in \nthis respect, because he can use buy and sell stops on the underlying stock to remove \nthe emotion from his follow-up strategy. This technique was described in Chapter 6 \non ratio call writing. Unfortunately, no such emotionless technique exists for the \nstraddle or strangle writer. \nUSING THE CREDITS \nIn previous chapters, it was mentioned that the sale of uncovered options does not \nrequire any cash investment on the pait of the strategist. He may use the collateral \nvalue of his present portfolio to finance the sale of naked options. Moreover, once he \nsells the uncovered options, he can take the premium dollars that he has brought in \nfrom the sales to buy fixed-income securities, such as Treasury bills. The same state\nments naturally apply to the straddle writing and strangle writing strategies. However, \nthe strategist should not be overly obsessed with continuing to maintain a credit bal\nance in his positions, nor should he strive to hold onto the Treasury bills at all costs. If \none's follow-up actions dictate that he must take a debit to avoid losses or that he \nshould sell out his Treasury bills to keep a credit, he should by all means do so. \nSynthetic Stock Positions \nCreated by Puts and Calls \nIt is possible for a strategist to establish a position that is essentially the same as a \nstock position, and he can do this using only options. The option position generally \nrequires a smaller margin investment and may have other residual benefits over sim\nply buying stock or selling stock short. In brief, the strategies are summarized by: \n1. Buy call and sell put instead of buying stock. \n2. Buy put and sell call instead of selling stock short. \nSYNTHETIC LONG STOCK \nWhen one buys a call and sells a put at the same strike, he sets up a position that is \nequivalent to owning the stock. His position is sometimes called \"synthetic\" long \nstock. \nExample: To verify that this option position acts much like a long stock position \nwould, suppose that the following prices exist: \nXYZ common, 50; \nXYZ January 50 call, 5; and \nXYZ January 50 put, 4. \nIf one were bullish on XYZ and wanted to buy stock at 50, he might consider the \nalternative strategy of buying the January 50 call and selling (uncovered) the January \n321 \n322 Part Ill: Put Option Strategies \n50 put. By using the option strategy, the investor has nearly the same profit and loss \npotential as the stock buyer, as shown in Table 21-1. The two right-hand columns of \nthe table compare the results of the option strategy with the results that would be \nobtained by merely owning the stock at .50. \nThe table shows that the result of the option strategy is exactly $100 less than \nthe stock results for any price at expiration. Thus, the \"synthetic\" long stock and the \nactual long stock have nearly the same profit and loss potentials. The reason there is \na difference in the results of the two equivalent positions lies in the fact that the \noption strategist had to pay 1 point of time premium in order to set up his position. \nThis time premium represents the $100 by which the \"synthetic\" position underper\nforms the actual stock position at expiration. Note that, with XYZ at 50, both the put \nand the call are completely composed of time value premium initially. The synthetic \nposition consists of paying out 5 points of time premium for the call and receiving in \n4 points of time premium for the put. The net time premium is thus a 1-point pay\nout. \nThe reason one would consider using the synthetic long stock position rather \nthan the stock position itself is that the synthetic position may require a much small\ner investment than buying the stock would require. The purchase of the stock \nrequires $5,000 in a cash account or $2,500 in a margin account (if the margin rate is \n50%). However, the synthetic position requires only a $100 debit plus a collateral \nrequirement - 20% of the stock price, plus the put premium, minus the difference \nbetween the striking price and the stock price. The balance, invested in short-term \nfunds, would earn enough money, theoretically, to offset the $100 paid for the syn\nthetic position. In this example, the collateral requirement would be 20% of $5,000, \nor $1,000, plus the $400 put premium, plus the $100 debit incurred by paying 5 for \nthe call and only receiving 4 for the put. This is a total of $1,500 initially. There is no \nTABLE 21·1. \nSynthetic long stock position. \nXYZ Price at January 50 January 50 Total Option Long Stock \nExpiration Call Result Put Result Result Result \n40 -$500 -$600 -$1, 100 -$1,000 \n45 - 500 - 100 600 500 \n50 - 500 + 400 100 0 \n55 0 + 400 + 400 + 500 \n60 + 500 + 400 + 900 + 1,000 \nChapter 21: Synthetic Stock Positions Created by Puts and Calls 323 \ninitial difference between the stock price and the striking price. Of course, this col\nlateral requirement would increase if the stock fell in price, and would decrease if the \nstock rose in price, since there is a naked put. Also notice that buying stock creates a \n$5,000 debit in the account, whereas the option strategy's debit is $100; the rest is a \ncollateral requirement, not a cash requirement. \nThe effect of this reduction in margin required is that some leverage is obtained \nin the position. If XYZ rose to 60, the stock position profit would be $1,000 for a \nreturn of 40% on margin ($1,000/$2,500). With the option strategy, the percentage \nreturn would be higher. The profit would be $900 and the return thus 60% \n($900/$1,500). Of course, leverage works to the downside as well, so that the percent \nrisk is also greater in the option strategy. \nThe synthetic stock strategy is generally not applied merely as an alternative to \nbuying stock. Besides possibly having a smaller profit potential, the option strategist \ndoes not collect dividen", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 146}
{"text": "urn would be higher. The profit would be $900 and the return thus 60% \n($900/$1,500). Of course, leverage works to the downside as well, so that the percent \nrisk is also greater in the option strategy. \nThe synthetic stock strategy is generally not applied merely as an alternative to \nbuying stock. Besides possibly having a smaller profit potential, the option strategist \ndoes not collect dividends, whereas the stock owner does. However, the strategist is \nable to earn interest on the funds that he did not spend for stock ownership. It is \nimportant for the strategist to understand that a long call plus a short put is equiva\nlent to long stock. It thus may be possible for the strategist to substitute the synthet\nic option position in certain option strategies that normally call for the purchase of \nstock \nSYNTHETIC SHORT SALE \nA position that is equivalent to the short sale of the underlying stock can be estab\nlished by selling a call and simultaneously buying a put. This alternative option strat\negy, in general, offers significant benefits when compared with selling the stock short. \nUsing the prices above - XYZ at 50, January 50 call at 5, and January 50 put at 4 -\nTable 21-2 depicts the potential profits and losses at January expiration. \nBoth the option position and the short stock position have similar results: large \npotential profits if the stock declines and unlimited losses if the underlying stock rises \nin price. However, the option strategy does better than the stock position, because \nthe option strategist is getting the benefit of the time value premium. Again, this is \nbecause the call has more time value premium than the put, which works to the \noption strategist's advantage in this case, when he is selling the call and buying the \nput. \nTwo important factors make the option strategy preferable to the short sale of \nstock: (1) There is no need to borrow stock, and (2) there is no need for an uptick. \nWhen one sells stock short, he must first borrow the stock from someone who owns \nit. This procedure is handled by one's brokerage firm's stock loan department. If, for \n324 Part Ill: Put Option Strategies \nTABLE 21-2. \nSynthetic short sale position. \nXYZ Price at January 50 January 50 Total Option Short Stock \nExpiration Coll Result Put Result Result Result \n40 +$500 +$600 +$1, 100 +$1,000 \n45 + 500 + 100 + 600 + 500 \n50 + 500 - 400 + 100 0 \n55 0 - 400 400 500 \n60 - 500 - 400 900 - 1,000 \nsome reason, no one who owns the stock wants to loan it out, then a short sale can\nnot be executed. In addition, both the NYSE and NASDAQ require that a stock \nbeing sold short must be sold on an uptick. That is, the price of the short sale must \nbe higher than the previous sale. This rule was introduced (for the NYSE) years ago \nin order to prevent traders from slamming the market down in a \"bear raid.\" \nWith the option \"synthetic short sale\" strategy, however, one does not have to \nworry about either of these factors. First, calls can be sold short at will; there is no \nneed to borrow anything. Also, calls can be sold short (and puts bought) even though \nthe underlying stock might be trading on a minus tick (a downtick). Many profes\nsional traders use the \"synthetic short sale\" strategy because it allows them to get \nequivalently short the stock in a very timely manner. If one wants to short stock, and \nif he has not previously arranged to borrow it, then some time is wasted while one's \nbroker checks with the stock loan department in order to make sure that the stock \ncan indeed be borrowed. \nThere is a caveat, however. If one sells calls on a stock that cannot be borrowed, \nthen he must be sure to avoid assignment. For if one is assigned a call, then he too \nwill be short the stock. If the stock cannot be borrowed, the broker will buy him in. \nThus, in situations in which the stock might be difficult to borrow, one should use a \nstriking price such that the call is out-of-the-money when sold initially. This will \ndecrease, but not eliminate, the possibility of early assignment. \nLeverage is a factor in this strategy also. The short seller would need $2,500 to \ncollateralize this position, assuming that the margin rate is 50%. The option strategist \ninitially only needs 20% of the stock price, plus the call price, less the credit received, \nfor a $1,400 requirement. Moreover, one of the major disadvantages that was men\ntioned with the synthetic long stock position is not a disadvantage in the synthetic \nshort sale strategy: The option trader does not have to pay out dividends on the \noptions, but the short seller of stock must. \nChapter 21: Synthetic Stock Positions Created by Puts and Calls 325 \nBecause of the advantages of the option position in not having to pay out the \ndividend and also having a slightly larger profit potential from the excess time value \npremium, it may often be feasible for the trader who is looking to sell stock short to \ninstead sell a call and buy a put. It is also important for the strategist to understand \nthe equivalence between the short stock position and the option position. He might \nbe able to substitute the option position in certain cases when the short sale of stock \nis normally called for. \nSPLITTING THE STRIKES \nThe strategist may be able to use a slight variation of the synthetic strategy to set up \nan aggressive, but attractive, position. Rather than using the same striking price for \nthe put and call, he can use a lower striking price for the put and a higher striking \nprice for the call. This action of splitting apart the striking prices gives him some \nroom for error, while still retaining the potential for large profits. \nBULLISHLY ORIENTED \nIf an out-of-the-money put is sold naked, and an out-of-the-money call is simultane\nously purchased, an aggressive bullish position is established - often for a credit. If \nthe underlying stock rises far enough, profits can be generated on both the long call \nand the short put. If the stock remains relati", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 147}
{"text": "room for error, while still retaining the potential for large profits. \nBULLISHLY ORIENTED \nIf an out-of-the-money put is sold naked, and an out-of-the-money call is simultane\nously purchased, an aggressive bullish position is established - often for a credit. If \nthe underlying stock rises far enough, profits can be generated on both the long call \nand the short put. If the stock remains relatively unchanged, the call purchase will be \na loss, but the put sale will be a profit. The risk occurs if the underlying stock drops \nin price, producing losses on both the short put and the long call. \nExample: The following prices exist: XYZ is at 53, a January 50 put is selling for 2, \nand a January 60 call is selling for 1. An investor who is bullish on XYZ sells the \nJanuary 50 put naked and simultaneously buys the January 60 call. This position \nbrings in a credit of 1 point, less commissions. There is a collateral requirement \nnecessary for the naked put. If XYZ is anywhere between 50 and 60 at January \nexpiration, both options would expire worthless, and the investor would make a small \nprofit equal to the amount of the initial credit received. If XYZ rallies above 60 by \nexpiration, however, his potential profits are unlimited, since he owns the call at 60. \nHis losses could be very large if XYZ should decline well below 50 before expiration, \nsince he has written the naked put at 50. Table 21-3 and Figure 21-1 depict the \nresults at expiration of this strategy. \nEssentially, the investor who uses this strategy is bullish on the underlying stock \nand is attempting to buy an out-of-the-money call for free. If he is moderately wrong \n326 \nTABLE 21-3. \nBullishly split strikes. \nXYZ Price al January 50 \nExpirafion \n40 \n45 \n50 \n55 \n60 \n65 \n70 \nFIGURE 21-1. \nBullishly split strikes. \nPu! Profil \n-$800 \n- 300 \n+ 200 \n+ 200 \n+ 200 \n+ 200 \n+ 200 \nPart Ill: Put Option Strategies \nJanuary 60 Tolal \nCall Profil Profif \n-$100 -$ 900 \n- 100 400 \n- 100 + 100 \n- 100 + 100 \n- 100 + 100 \n+ 400 + 600 \n+ 900 + 1,100 \nStock Price at Expiration \nand the underlying stock rallies only slightly or even declines slightly, he can still \nmake a small profit. If he is correct, of course, large profits could be generated in a \nrally. He may lose heavily if he is very wrong and the stock falls by a large amount \ninstead of rising. \nThis strategy is often useful when options are overpriced. Suppose that one has \na bullish opinion on the underlying stock, yet is dismayed to find that the calls are \nquite expensive. If he buys one of these expensive calls, he can mitigate the expen\nsiveness somewhat by also selling an out-of-the-money put, which is presumably \nChapter 21: Synthetic Stock Positions Created by Puts and Calls 327 \nsomewhat expensive also. Thus, if he is right about the bullish attitude on the stock, \nhe owns a call that is more \"fairly priced\" because its cost was reduced by the amount \nof the put sale. \nBEARISHLY ORIENTED \nThere is a companion strategy for the investor who is bearish on a stock. He could \nattempt to buy an out-of-the-money put, giving himself the opportunity for substan\ntial profits in a stock price decline, and could \"finance\" the purchase of the put by \nwriting an out-of-the-money call naked. The sale of the call would provide profits if \nthe stock stayed below the striking price of the call, but could cost him heavily if the \nunderlying stock rallies too far. \nExample: With XYZ at 65, the bearish investor buys a February 60 put for 2 points, \nand simultaneously sells a February 70 call for 3 points. These trades bring in a cred\nit of 1 point, less commissions. The investor must collateralize the sale of the call. If \nXYZ should decline substantially by February expiration, large profits are possible \nbecause the February 60 put is owned. Even if XYZ does not perform as expected, \nbut still ends up anywhere between 60 and 70 at expiration, the profit will be equal \nto the initial credit because both options will expire worthless. However, if the stock \nrallies above 70, unlimited losses are possible because there is a naked call at 70. \nTable 21-4 and Figure 21-2 show the results of this strategy at expiration. \nThis is clearly an aggressively bearish strategy. The investor would like to own \nan out-of-the-money put for downside potential. In addition, he sells an out-of-the\nmoney call, normally for a price greater than that of the purchased put. The call sale \nTABLE 21-4. \nBearishly split strikes. \nXYZ Price at February 60 February 70 Total \nExpiration Put Profit Call Profit Profit \n50 +$800 +$300 +$1, 100 \n55 + 300 + 300 + 600 \n60 - 200 + 300 + 100 \n65 - 200 + 300 + 100 \n70 - 200 + 300 + 100 \n75 - 200 - 200 400 \n80 - 200 - 700 900 \n328 \nFIGURE 21-2. \nBearishly split strikes. \nC \n0 \ne ·15. \nX \nw \nPart Ill: Put Option Strategies \n1u +$100 \nw $0 I-----------'------ ................. -----\n~ 60 \n....J \n0 \n~ a. \nStock Price at Expiration \nessentially lets him own the put for free. In fact, he can still make profits even if the \nunderlying stock rises slightly or only falls slightly. His risk is realized if the stock rises \nabove the striking price of the written call. \nThis strategy of splitting the strikes in a bearish manner is used very frequently \nin conjunction with the ownership of common stock. That is, a stock owner who is \nlooking to protect his stock will buy an out-of-the-money put and sell an out-of-the\nmoney call to finance the put purchase. This strategy is called a \"protective collar\" \nand was discussed in more detail in the chapter on Put Buying in Conjunction with \nCommon Stock Ownership. A strategy that is similar to these, but modifies the risk, \nis presented in Chapter 23, Spreads Combining Calls and Puts. \nSUMMARY \nIn either of these aggressive strategies, the investor must have a definite opinion \nabout the future price movement of the underlying stock. He buys an out-of-the\nmoney option to provide profit potential for that stock movement. However, an \ninvestor can los", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 148}
{"text": "ership. A strategy that is similar to these, but modifies the risk, \nis presented in Chapter 23, Spreads Combining Calls and Puts. \nSUMMARY \nIn either of these aggressive strategies, the investor must have a definite opinion \nabout the future price movement of the underlying stock. He buys an out-of-the\nmoney option to provide profit potential for that stock movement. However, an \ninvestor can lose the entire purchase proceeds of an out-of-the-money option if the \nstock does not perform as expected. An aggressive investor, who has sufficient collat\neral, might attempt to counteract this effect by also writing an out-of-the-money \noption to cover the cost of the option that he bought. Then, he will not only make \nmoney if the stock performs as expected, but he will also make money if the stock \nremains relatively unchanged. He will lose quite heavily, however, if the underlying \nstock goes in the opposite direction from his original anticipation. That is why he \nmust have a definite opinion on the stock and also be fairly certain of his timing. \nBasic Put Spreads \nPut spreading strategies do not differ substantially in theory from their accompany-\n;,,..,,. ,...,,1] v-n..-a<>rl vl-..-al-arriac Rol-h h11llich nnrl hP<>rich nocitionc r>!'.ln hP r>onctn1r>tPrl with .l.J..1.5 V(A,,1.1. .;Jt'.l.'\\,.,U'L.L J\\...l 1.Vf,A.VoJ• .Jl.,l''\\Jl,....t..1. J.J\\..1..1..1..1.V.a...._ f.4.1..1..._... ,._,...,_,'-4Ji.A.V..._.,._ ,t'\"-\"._,..._ ... ...__..._..._...,, .._,.__...,,._ -....,..., _.._,,.._.,....,,...,._ .....,._,_....,,_ , , ,,..._.,._\"\"-\nput spreads, as was also the case with call spreads. However, because puts are more \noriented toward downward stock movement than calls are, some bearish put spread \nstrategies are superior to their equivalent bearish call spread strategies. \nThe three simplest forms of option spreads· are: \n1. the bull spread, \n2. the bear spread, and \n3. the calendar spread. \nThe same types of spreads that were constructed with calls can be established with \nputs, but there are some differences. \nBEAR SPREAD \nIn a call bear spread, a call with a lower striking price was sold while a call at a high\ner striking price was bought. Similarly, a put bear spread is established by selling a \nput at a lower strike while buying a put at a higher strike. The put bear spread is a \ndebit spread. This is true because a put with a higher striking price will sell for more \nthan a put with a lower striking price. Thus, on a stock with both puts and calls trad\ning, one could set up a bear spread for a credit ( using calls) or alternatively set one \nup for a debit (using puts): \n329 \n330 \nPut Bear Spread \nBuy XYZ January 60 put \nSell XYZ January 50 put \n(debit spread) \nPart Ill: Put Option Strategies \nCall Bear Spread \nBuy XYZ January 60 call \nSell XYZ January 50 call \n(credit spread) \nThe put bear spread has the same sort of profit potential as the call bear spread. \nThere is a limited maximum potential profit, and this profit would be realized if XYZ \nwere below the lower striking price at expiration. The put spread would widen, in this \ncase, to equal the difference between the striking prices. The maximum risk is also \nlimited, and would be realized if XYZ were anywhere above the higher striking price \nat expiration. \nExample: The following prices exist: \nXYZ common, 55; \nXYZ January 50 put, 2; and \nXYZ January 60 put, 7. \nBuying the January 60 put and selling the January 50 would establish a bear \nspread for a 5-point debit. Table 22-1 will help verify that this is indeed a bearish \nposition. The reader will note that Figure 22-1 has the same shape as the call bear \nspread's graph (Figure 8-1). The investment required for this spread is the net debit, \nand it must be paid in full. Notice that the maximum profit potential is realized any\nwhere below 50 at expiration, and the maximum risk potential is realized anywhere \nabove 60 at expiration. The maximum risk is always equal to the initial debit required \nto establish the spread plus commissions. The break-even point is 55 in this example. \nThe following formulae allow one to quickly compute the meaningful statistics \nregarding a put bear spread. \nMaximum risk = Initial debit \nMaximum profit = Difference between strikes - Initial debit \nBreak-even price = Higher striking price - Initial debit \nPut bear spreads have an advantage over call bear spreads. With puts, one is \nselling an out-of-the-money option when setting up the spread. Thus, one is not risk\ning early exercise of his written option before the spread becomes profitable. For the \nwritten put to be in-the-money, and thus in danger of being exercised, the spread \nwould have to be profitable, because the stock would have to be below the lower \nstriking price. Such is not the case with call bear spreads. In the call spread, one sells \nan in-the-money call as part of the bear spread, and thus could be at risk of early exer\ncise before the spread has a chance to become profitable. \nChapter 22: Basic Put Spreads 331 \nTABLE 22-1. \nPut bear spread. \nXYZ Price at January 50 January 60 Total \nExpiration Put Profit Put Profit Profit \n40 -$800 +$1,300 +$500 \n45 - 300 + 800 + 500 \n50 + 200 + 300 + 500 \n55 + 200 200 0 \n60 + 200 700 - 500 \n70 + 200 700 - 500 \n80 + 200 700 - 500 \nFIGURE 22-1. \nPut bear spread. \nStock Price at Expiration \nBeside this difference in the probability of early exercise, the put bear spread \nholds another advantage over the call bear spread. In the put spread, if the underly\ning stock drops quickly, thereby making both options in-the-rrwney, the spread will \nnormally widen quickly as well. This is because, as has been mentioned previously, \nput options tend to lose time value premium rather quickly when they go into-the\nmoney. In the example above, if XYZ rapidly dropped to 48, the January 60 put would \nbe near 12, retaining very little time premium. However, the January 50 put that is \nshort would also not retain much time value premium, perhaps selling at 4 points or \n332", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 149}
{"text": "as well. This is because, as has been mentioned previously, \nput options tend to lose time value premium rather quickly when they go into-the\nmoney. In the example above, if XYZ rapidly dropped to 48, the January 60 put would \nbe near 12, retaining very little time premium. However, the January 50 put that is \nshort would also not retain much time value premium, perhaps selling at 4 points or \n332 Part Ill: Put Option Strategies \nso. Thus, the spread would have widened to 8 points. Call bear spreads often do not \nproduce a similar result on a short-term downward movement. Since the call spread \ninvolves being short a call with a lower striking price, this call may actually pick up \ntime value premium as the stock falls close to the lower strike. Thus, even though the \ncall spread might have a similar profit at expiration, it often will not perform as well \non a quick downward movement. \nFor these two reasons - less chance of early exercise and better profits on a \nshort-term movement - the put bear spread is superior to the call bear spread. Some \ninvestors still prefer to use the call spread, since it is established for a credit and thus \ndoes not require a cash investment. This is a rather weak reason to avoid the superi\nor put spread and should not be an overriding consideration. Note that the margin \nrequirement for a call bear spread will result in a reduction of one's buying power by \nan amount approximately equal to the debit required for a similar put bear spread. \n(The margin required for a call bear spread is the difference between the striking \nprices less the credit received from the spread.) Thus, the only accounts that gain any \nsubstantial advantage from a credit spread are those that are near the minimum equi\nty requirement to begin with. For most brokerage firms, the minimum equity \nrequirement for spreads is $2,000. \nBULL SPREAD \nA bull spread can be established with put options by buying a put at a lower striking \nprice and simultaneously selling a put with a higher striking price. This, again, is the \nsame way a bull spread was constructed with calls: selling the higher strike and buy\ning the lower strike. \nExample: The same prices can be used: \nXYZ common, 55; \nXYZ January 50 put, 2; and \nXYZ January 60 put, 7. \nThe bull spread is constructed by buying the January 50 put and selling the January \n60 put. This is a credit spread. The credit is 5 points in this example. If the underly\ning stock advances by January expiration and is anywhere above 60 at that time, the \nmaximum profit potential of the spread will be realized. In that case, with XYZ any\nwhere above 60, both puts would expire worthless and the spreader would make a \nprofit of the entire credit - 5 points in this example. Thus, the maximum profit poten\ntial is limited, and the maximum profit occurs if the underlying stock rises in price \nChapter 22: Basic Put Spreads 333 \nabove the higher strike. These are the same qualities that were displayed by a call bull \nspread (Chapter 7). The name \"bull spread\" is derived from the fact that this is a bull\nish position: The strategist wants the underlying stock to rise in price. \nThe risk is limited in this spread. If the underlying stock should decline by expi\nration, the maximum loss will be realized with XYZ anywhere below 50 at that time. \nThe risk is 5 points in this example. To see this, note that if XYZ were anywhere below \n50 at expiration, the differential between the two puts would widen to 10 points, \nsince that is the difference between their striking prices. Thus, the spreader would \nhave to pay 10 points to buy the spread back, or to close out the position. Since he \ninitially took in a 5-point credit, this means his loss is equal to 5 points - the 10-point \ncost of closing out less the 5 points he received initially. \nThe investment required for a bullish put spread is actually a collateral require\nment, since the spread is a credit spread. The amount of collateral required is equal \n-1-r.. f-ha rliffa:rannci, hahuaan tho cfr-il;nrr r\\rint::u.:- lace th.-:;). not nrorlit ror-A-iuorl fnr thA \n\\..V l,,J...111._, Ul.J..J..V.lV.l.l.\\..,V LIV\\..VVVVJ..l '-- J.'L, oJ\\..l..l.J.'-l.J.J..o .t'.l.J..\\,.,VoJ J.VoJ,J I..J.J.'-' J..1.V\\.. \\,.,.l.V\"-AJ.l.- .LVV'-'..l.Y'-'\"'--4 .J..'-.-\".I. .__...._.._ ....... \nspread. In this example, the collateral requirement is $500- the $1,000, or 10-point, \ndifferential in the striking prices less the $500 credit received from the spread. Note \nthat the maximum possible loss is always equal to the collateral requirement in a bull\nish put spread. \nIt is not difficult to calculate the break-even point in a bullish spread. ·In this \nexample, the break-even point before commissions is 55 at expiration. With XYZ at \n55 in January, the January 50 put would expire worthless and the January 60 put \nwould have to be bought back for 5 points. It would be 5 points in-the-money with \nXYZ at 55. Thus, the spreader would break even, since he originally received 5 points \ncredit for the spread and would then pay out 5 points to close the spread. The fol\nlowing formulae allow one to quickly compute the details of a bullish put spread: \nMaximum potential risk = Initial collateral requirement \n= Difference in striking prices - Net credit received \nMaximum potential profit= Net credit \nBreak-even price = Higher striking price - Net credit \nCALENDAR SPREAD \nIn a calendar spread, a near-term option is sold and a longer-term option is bought, \nboth with the same striking price. This definition applies to either a put or a call cal\nendar spread. In Chapter 9, it was shown that there were two philosophies available \nfor call calendar spreads, either neutral or bullish. Similarly, there are two philoso\nphies available for put calendar spreads: neutral or bearish. \n334 Part Ill: Put Option Strategies \nIn a neutral calendar spread, one sets up the spread with the idea of closing the \nspread when the near-term call or put expires. In this type of spread, t", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 150}
{"text": "it was shown that there were two philosophies available \nfor call calendar spreads, either neutral or bullish. Similarly, there are two philoso\nphies available for put calendar spreads: neutral or bearish. \n334 Part Ill: Put Option Strategies \nIn a neutral calendar spread, one sets up the spread with the idea of closing the \nspread when the near-term call or put expires. In this type of spread, the maximum \nprofit will be realized if the stock is exactly at the striking price at expiration. The \nspreader is merely attempting to capitalize on the fact that the time value premium \ndisappears more rapidly from a near-term option than it does from a longer-term one. \nExample: XYZ is at 50 and a January 50 put is selling for 2 points while an April 50 \nput is selling for 3 points. A neutral calendar spread can be established for a 1-point \ndebit by selling the January 50 put and buying the April 50 put. The investment \nrequired for this position is the amount of the net debit, and it must be paid for in \nfull. If XYZ is exactly at 50 at January expiration, the January 50 put will expire worth\nless and the April 50 put will be worth about 2 points, assuming other factors are the \nsame. The neutral spreader would then sell the April 50 put for 2 points and take his \nprofit. The spreader's profit in this case would be one point before commissions, \nbecause he originally paid a 1-point debit to set up the spread and then liquidates the \nposition by selling the April 50 put for 2 points. Since commission costs can cut into \navailable profits substantially, spreads should be established in a large enough quan\ntity to minimize the percentage cost of commissions. This means that at least 10 \nspreads should be set up initially. \nIn any type of calendar spread, the risk is limited to the amount of the net debit. \nThis maximum loss would be realized if the underlying stock moved substantially far \naway from the striking price by the time the near-term option expired. If this hap\npened, both options would trade at nearly the same price and the differential would \nshrink to practically nothing, the worst case for the calendar spreader. For example, \nif the underlying stock drops substantially, say to 20, both the near-term and the long\nterm put would trade at nearly 30 points. On the other hand, if the underlying stock \nrose substantially, say to 80, both puts would trade at a very low price, say 1/15 or 1/s, \nand again the spread would shrink to nearly zero. \nNeutral call calendar spreads are generally superior to neutral put calendar \nspreads. Since the amount of time value premium is usually greater in a call option \n(unless the underlying stock pays a large dividend), the spreader who is interested in \nselling time value would be better off utilizing call options. \nThe second philosophy of calendar spreading is a more aggressive one. With put \noptions, a bearish strategy can be constructed using a calendar spread. In this case, \none would establish the spread with out-of-the-money puts. \nExample: With XYZ at 55, one would sell the January 50 put for 1 point and buy the \nApril 50 put for 1 ½ points. He would then like the underlying stock to remain above \nthe striking price until the near-term January put expires. If this happens, he would \nChapter 22: Basic Put Spreads 335 \nmake the I-point profit from the sale of that put, reducing his net cost for the April \n50 put to ½ point. Then, he would become bearish, hoping for the underlying stock \nto decline in price substantially before April expiration in order that he might be able \nto generate large profits on the April 50 put he holds. \nJust as the bullish calendar spread with calls can be a relatively attractive strat\negy, so can the bearish calendar spread with puts. Granted, two criteria have to be \nfulfilled in order for the position to work to the optimum: The near-term put must \nexpire worthless, and then the underlying stock must drop in order to generate prof\nits on the long side. Although these conditions may not occur frequently, one prof\nitable situation can more than make up for several losing ones. This is true because \nthe initial debit for a bearish calendar spread is small, ½ point in the example above. \nThus, the losses will be small and the potential profits could be very large if things \nwork out right. \nThe aggressive spreader must be careful not to \"leg out\" of his spread, since he \ncould generate a large loss by doing so. The object of the strategy is to accept a rather \nlarge number of small losses, with the idea that the infrequent large profits will more \nthan offset the sum of the losses. If one generates a large loss somewhere along the \nway, this may ruin the overall strategy. Also, if the underlying stock should fall to the \nstriking price before the near-term put expires, the spread will normally have \nwidened enough to produce a small profit; that profit should be taken by closing the \nspread at that time. \nSpreads Cotnbining \nCalls and Puts \nCertain types of spreads can be constructed that utilize both puts and calls. One of \nthese strategies has been discussed before: the butterfly spread. However, other \nstrategies exist that off er potentially large profits to the spreader. These other strate\ngies are all variations of calendar spreads and/or straddles that involve both put and \ncall options. \nTHE BUTTERFLY SPREAD \nThis strategy has been described previously, although its usage in Chapter 10 was \nrestricted to constructing the spread with calls. Recall that the butterfly spread is a \nneutral position that has limited risk as well as limited profits. The position involves \nthree striking prices, utilizing a bull spread between the lower two strikes and a bear \nspread between the higher two strikes. The maximum profit is realized at the middle \nstrike at expiration, and the maximum loss is realized if the stock is above the higher \nstrike or below the lower strike at expiration. \nSince either a bull spread or a bear sp", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 151}
{"text": "well as limited profits. The position involves \nthree striking prices, utilizing a bull spread between the lower two strikes and a bear \nspread between the higher two strikes. The maximum profit is realized at the middle \nstrike at expiration, and the maximum loss is realized if the stock is above the higher \nstrike or below the lower strike at expiration. \nSince either a bull spread or a bear spread can be constructed with puts or calls, \nit should be obvious that a butterfly spread ( consisting of both a bull spread and a \nbear spread) can be constructed in a number of ways. In fact, there are four ways in \nwhich the spread can be established. If option prices are fairly balanced - that is, the \narbitrageurs are keeping prices in line - any of the four ways will have the same \npotential profits and losses at expiration of the options. However, because of the ways \nin which puts and calls behave prior to their expiration, certain advantages or disad-\n336 \nChapter 23: Spreads Combining Calls and Puts 331 \nvantages are connected with some of the methods of establishing the butterfly \nspread. \nExample: The following prices exist: \nStrike: \nCall: \nPut: \nXYZ common: 60 \n50 \n12 \n60 \n6 \n5 \n70 \n2 \n1 1 \nThe method using only the calls indicates that one would buy the 50 call, sell two 60 \ncalls, and buy the 70 call. Thus, there would be a bull spread in the calls between the \n50 and 60 strikes, and a bear spread in the calls between the 60 and 70 strikes. In a \nsimilar manner, one could establish a butterfly spread by combining either type of bull \nspread between the 50 and 60 strikes with any type of bear spread between the 60 and \n70 strikes. Some of these spreads would be credit spreads, while others would be debit \nspreads. In fact, one's personal choice between two rather equivalent makeups of the \nbutterfly spread might be decided by whether there were a credit or a debit involved. \nTable 23-1 summarizes the four ways in which the butterfly spread might be \nconstructed. In order to verify the debits and credits listed, the reader should recall \nthat a bull spread consists of buying a lower strike and selling a higher strike, whether \nputs or calls are used. Similarly, bear spreads with either puts or calls consist of buy\ning a higher strike and selling a lower strike. Note that the third choice - bull spread \nwith puts and bear spread with calls - is a short straddle protected by buying the out\nof-the-money put and call. \nIn each of the four spreads, the maximum potential profit at expiration is 8 \npoints if the underlying stock is exactly at 60 at that time. The maximum possible loss \nin any of the four spreads is 2 points, if the stock is at or above 70 at expiration or is \nat or below 50 at expiration. For example, either the top line in the table, where the \nspread is set up only with calls; or the bottom line, where the spread is set up only \nwith puts, has a risk equal to the debit involved - 2 points. The large-debit spread \n(second line of table) will be able to be liquidated for a minimum of 10 points at expi\nration no matter where the stock is, so the risk is also 2 points. (It cost 12 points to \nbegin with.) Finally, the credit combination (third line) has a maximum buy-back of \n10 points, so it also has risk of 2 points. In addition, since the striking prices are 10 \npoints apart, the maximum potential profit is 8 points (maximum profit = striking \nprice differential minus maximum risk) in all the cases. \n338 \nTABLE 23-1. \nButterfly spread. \nBull Spread \n(Buy Option at 50, ... plus ... \nSell at 60) \nCalls (6 debit) \nCalls (6 debit) \nPuts (4 credit) \nPuts (4 credit) \nBear Spread \n(Buy Option at 70, \nSell at 60) \nCalls (4 credit) \nPuts (6 debit) \nCalls (4 credit) \nPuts (6 debit) \nPart Ill: Put Option Strategies \nTotal Money \n2 debit \n12 debit \n8 credit \n2 debit \nThe factor that causes all these combinations to be equal in risk and reward is \nthe arbitrageur. If put and call prices get too far out of line, the arbitrageur can take \nriskless action to force them back. This particular form of arbitrage, known as the box \nspread, is described later, in Chapter 27, Arbitrage. \nEven though all four ways of constructing the butterfly spread are equal at \nexpiration, some are superior to others for certain price movements prior to expira\ntion. Recall that it was previously stated that bull spreads are best constructed with \ncalls, and bear spreads are best constructed with puts. Since the butterfly spread is \nmerely the combination of a bull spread and a bear spread, the best way to set up the \nbutterfly spread is to use calls for the bull spread and puts for the bear spread. This \ncombination is the one listed on the second line of Table 23-1. This strategy involves \nthe largest debit of the four combinations and, as a result, many investors shun this \napproach. However, all the other combinations involve selling an in-the-money put \nor call at the outset, a situation that could lead to early exercise. The reader may also \nrecall that the credit combination, listed on the third line of Table 23-1, was previ\nously described as a protected straddle position. That is, one sells a straddle and \nsimultaneously buys both an out-of-the-money put and an out-of-the-money call with \nthe same expiration month, as protection for the straddle. Thus, a butterfly spread is \nactually the equivalent of a completely protected straddle wiite. \nA butterfly spread is not an overly attractive strategy, although it may be useful \nfrom time to time. The commissions required are extremely high, and there is no \nchance of making a large profit on the position. The limited risk feature is good to \nhave in a position, but it alone cannot compensate for the less attractive features of \nthe strategy. Essentially, the strategist is looking for the stock to remain in a neutral \npattern until the options expire. If the potential profit is at least three times the max\nimum 1isk (and preferably four times) and the under", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 152}
{"text": "of making a large profit on the position. The limited risk feature is good to \nhave in a position, but it alone cannot compensate for the less attractive features of \nthe strategy. Essentially, the strategist is looking for the stock to remain in a neutral \npattern until the options expire. If the potential profit is at least three times the max\nimum 1isk (and preferably four times) and the underlying stock appears to be in trad\ning range, the strategy is feasible. Othe:nvise, it is not. \nChapter 23: Spreads Combining Calls and Puts 339 \nCOMBINING AN OPTION PURCHASE AND A SPREAD \nIt is possible to combine the purchase of a call and a credit put spread to produce a \nposition that behaves much like a call buy, although it has less risk over much of the \nprofit range. This strategy is often used when one has a quite bullish opinion regard\ning the underlying security, yet the call one wishes to purchase is \"overpriced.\" In a \nsimilar manner, if one is bearish on the underlying, he can sometimes combine the \npurchase of a put with the sale of a call credit spread. Both approaches are described \nin this section. \nTHE BULLISH SCENARIO \nIt sometimes happens that one arrives at a bullish opinion regarding a stock, only to \nfind that the options are very expensive. In fact, they may be so expensive as to pre\nclude thoughts of making an outright call purchase. This might happen, for example, \nif the stock has suddenly plummeted in price (perhaps during an ongoing, rapid bear\nish move by the overall stock market). To buy calls at this time would be overly risky. \nIf the underlying began to rally, it would often be the case that the implied volatility \nof the calls would shrink, thus harming one's long call position. \nAs a counter to this, it might make sense to buy the call, but at the same time \nto sell a put credit spread. Recall that a put credit spread is a bullish strategy. \nMoreover, since it is presumed that the options are expensive on this particular stock, \nthe puts being used in the spread would be expensive as well. Thus, the credit \nreceived from the spread would be slightly larger than \"normal\" because the options \nare expensive. \nExample: XYZ is selling at 100. One wishes to purchase the December 100 call as an \noutright bullish speculation. That call is selling for 10. However, one determines that \nthe December 100 call is overpriced at these levels. (In order to make this determi\nnation, one would use an option model whose techniques are described in Chapter \n28 on mathematical applications.) Hence, he decides to use the following put spread \nin addition to buying the December 100 call: \nSell December 90 put, 6 \nBuy December 80 put, 3 \nThe sale of the put spread brings in a 3-point credit. Thus, his total expenditure for \nthe entire position is 7 points ( 10 for the December 100 call, less 3 credit from the sale \nof the put spread). If one is correct about his bullish outlook for the stock (i.e., the \nstock goes up), he can in some sense consider that he paid 7 for the call. Another way \n340 Part Ill: Put Option Strategies \nto look at it is this: The sale of the put spread reduces the call price down to a more \nmoderate level, one that might be in line with its \"theoretical value.\" In other words, \nthe call would not be considered expensive if it were priced at 7 instead of 10. The sale \nof the put spread can be considered a way to reduce the overall cost of the call. \nOf course, the sale of the put spread brings some extra risk into the position \nbecause, if the stock were to fall dramatically, the put spread could lose 7 points ( the \nwidth of the strikes in the spread, 10 points, less the initial credit received, 3 points). \nThis, added to the call's cost of 10 points, means that the entire risk here is 17 points. \nIn fact, that is the margin required for this spread as well. Thus, the overall spread \nstill has limited risk, because both the call purchase and the put credit spread are lim\nited-risk strategies. However, the total risk of the two combined is larger than for \neither one separately. \nRemember that one must be bullish on the underlying in order to employ this \nstrategy. So, if his analysis is correct, the upside is what he wants to maximize. If he \nis wrong on his outlook for the stock, then he needs to employ some sort of stop-loss \nmeasures before the maximum risk of the position is realized. \nThe resulting position is shown in Figure 23-1, along with two other plots. The \nstraight line marked \"Spread at expiration\" shows how the profitability of the call pur\nchase combined with a bull spread would look at December expiration. In addition, \nthere is a plot with straight lines of the purchase of the December 100 call for 10 \npoints. That plot can be compared with the three-way spread to see where extra risk \nand reward occur. Note that the three-way spread does better than the outright pur\nchase of the December 100 call as long as the stock is higher than 87 at expiration. \nSince the stock is initially at 100 and,since one is initially bullish on the stock, one \nwould have to surmise that the odds of it falling to 87 are fairly small. Thus, the three\nway spread outperforms the outright purchase of the call over a large range of stock \nprices. \nThe final plot in Figure 23-1 is that of the three-way spread's profit and losses \nhalfway to the expiration date. You can see that it looks much like the profitability of \nmerely owning a call: The curve has the same shape as the call pricing curve shown \nin Chapter 1. \nHence, this three-way strategy can often be more attractive and more profitable \nthan merely owning a call option. Remember, though, that it does increase risk and \nrequire a larger collateral deposit than the outright purchase of the at-the-money call \nwould. One can experiment with this strategy, too, in that he might consider buying \nan out-of-the-money call and selling a put spread that brings in enough credit to com\npletely pay for the call. In that way,", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 153}
{"text": "more profitable \nthan merely owning a call option. Remember, though, that it does increase risk and \nrequire a larger collateral deposit than the outright purchase of the at-the-money call \nwould. One can experiment with this strategy, too, in that he might consider buying \nan out-of-the-money call and selling a put spread that brings in enough credit to com\npletely pay for the call. In that way, he would have no risk as long as the stock \nremained above the higher striking price used in the put credit spread. \nChapter 23: Spreads Combining Calls and Puts \nFIGURE 23-1. \nCall buy and put credit (bull) spread. \n+$2,000 \n+$1,000 \n(/J \n(/J \n0 ..J \n0 $0 -e a. \n-$1,000 \n-$2,000 \n70 80 \n.... ,, -----,, -=-----' \nTHE BEARISH SCENARIO \n~ Spread at Expiration \nCall Buy Only, at Expiration \n341 \nStock \nIn a similar manner, one can construct a position to take advantage of a bearish opin\nion on a stock. Again, this would be most useful when the options were overpriced \nand one felt that an at-the-money put was too expensive to purchase by itself. \nExample: XYZ is trading at 80, and one has a definite bearish opinion on the stock. \nHowever, the December 80 put, which is selling for 8, is expensive according to an \noption analysis. Therefore, one might consider selling a call credit spread (out-of-the\nmoney) to help reduce the cost of the put. The entire position would thus be: \nBuy 1 December 80 put: \nSell l December 90 call: \nBuy 1 December 100 call: \nTotal cost: \n8 debit \n4 credit \n2 debit \n6 debit ($600) \nThe profitability of this position is shown in Figure 23-2. The straight line on that \ngraph shows how the position would behave at expiration. The introduction of the \ncall credit spread has increased the risk to $1,600 if the stock should rally to 100 or \nhigher by expiration. Note that the risk is limited since both the put purchase and the \ncall credit spread are limited-risk strategies. The margin required would be this max\nimum risk, or $1,600. \n342 Part Ill: Put Option Strategies \nFIGURE 23-2. \nPut buy and call credit (bear) spread. \n+$1,000 Halfway to Expiration \n/ \nStock \n0 60 110 \n-e a. \n-$1,000 At Expiration \n-$2,000 \nThe curved line on Figure 23-2 shows how the three-way spread would behave \nif one looked at it halfway to its expiration date. In that case, it has a curved appear\nance much like the outright purchase of a put option. \nThus, this strategy could be appealing to bearishly-oriented traders, especially \nwhen the options are expensive. It might have certain advantages over an outright put \npurchase in that case, but it does require a larger margin investment and has theo\nretically larger risk. \nA SIMPLE FOLLOW-UP ACTION \nFOR BULL OR BEAR SPREADS \nAnother way of combining puts and calls in a spread can sometimes be used when \none has a bull or bear spread already in place. Suppose that one owns a call bull \nspread and the underlying stock has advanced nicely. In fact, it is above both of the \nstrikes used in the spread. However, as is often the case, the bull spread may not have \nwidened out to its maximum profit potential. One can use the puts for two purposes \nat this point: (1) to determine whether the call spread is trading at a \"reasonable\" \nvalue, and (2) to try to lock in some profits. First, let's look at an example of the \"rea\nsonable value\" verification. \nChapter 23: Spreads Combining Calls and Puts 343 \nExample: A trader buys an XYZ call bull spread for 5 points. The spread uses the \nJanuary 70 calls and the January 80 calls. Later, XYZ advances to a price of 88, but \nthere is still a good deal of time remaining in the options. Perhaps the spread has \nwidened out only to 7 points at that time. The trader finds it somewhat disappoint\ning that the spread has not widened out to its maximum profit potential of 10 points. \nHowever, this is a fairly common occurrence with bull and bear spreads, and is one \nof the factors that may make them less attractive than outright call or put purchases. \nIn any case, suppose the following prices exist: \nJanuary 80 put, 5 \nJanuary 70 put, 2 \nWe can use these put prices to verify that the call spread is \"in line.\" Notice that the \nput spread is 3 points and the call spread is 7 points (both are the January 70-January \n80 spread). Thus, they add up to 10 points the width of the strikes. When that \noccurs, we can conclude that the spreads are \"in line\" and are trading at theoretical\nly correct prices. \nKnowing this information doesn't help one make any more profits, but it does \nprovide some verification of the prices. Many times, one feels frustrated when he \nsees that a call bull spread has not widened out as he expected it to. Using the put \nspread as verification can help keep the strategist \"on track\" so that he makes ration\nal, not emotional, decisions. \nNow let's look at a similar example, in which perhaps the puts can be used to \nlock in profits on a call bull spread. \nExample: Using the same bull spread as in the previous example, suppose that one \nowns an XYZ call bull spread, having bought the January 70 call and sold the January \n80 call for a debit of 5 points. Now assume it is approaching expiration, and the stock \nis once again at 88. At this time, the spread is theoretically nearing its maximum price \nof 10. However, since both calls are fairly deeply in-the-money, the market-makers \nare making very wide spreads in the calls. Perhaps these are the markets, with the \nstock at 88 and only a week or two remaining until expiration: \nColl \nJanuary 70 call \nJanuary 80 call \nBid Price \n17.50 \n8.80 \nAsked Price \n18.50 \n8.20 \nIf one were to remove this spread at market prices, he would sell his long \nJanuary 70 call for 17.50 and would buy his short January 80 call back for 8.20, a cred-\n344 Part Ill: Put Option Strategies \nit of 9.30. Since the maximum value of the spread is l 0, one is giving away 70 cents, \nquite a bit for just such a short time remaining. \nHowever, suppose that one looks at the puts and finds these prices: \nPu", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 154}
{"text": "to remove this spread at market prices, he would sell his long \nJanuary 70 call for 17.50 and would buy his short January 80 call back for 8.20, a cred-\n344 Part Ill: Put Option Strategies \nit of 9.30. Since the maximum value of the spread is l 0, one is giving away 70 cents, \nquite a bit for just such a short time remaining. \nHowever, suppose that one looks at the puts and finds these prices: \nPut \nJanuary 80 put \nJanuary 70 put \nBid Price \n0.20 \nnone \nAsked Price \n0.40 \n0.10 \nOne could \"lock in\" his call spread profits by buying the January 80 put for 40 cents. \nIgnoring commissions for a moment, if he bought that put and then held it along with \nthe call spread until expiration, he would unwind the call spread for a 10 credit at \nexpiration. He paid 40 cents for the put, so his net credit to exit the spread would be \n9.60 - considerably better than the 9.30 he could have gotten above for the call \nspread alone. \nThis put strategy has one big advantage: If the underlying stock should sudden\nly collapse and tumble beneath 70 - admittedly, a remote possibility - large profits \ncould accrue. The purchase of the January 80 put has protected the bull spread's \nprofits at all prices. But below 70, the put starts to make extra money, and the spread\ner could profit handsomely. Such a drop in price would only occur if some material\nly damaging news surfaced regarding X'iZ Company, but it does occasionally happen. \nIf one utilizes this strategy, he needs to carefully consider his commission costs \nand the possibility of early assignment. For a professional trader, these are irrelevant, \nand so the professional trader should endeavor to exit bull spreads in this manner \nwhenever it makes sense. However, if the public customer allows stock to be assigned \nat 80 and exercises to buy stock at 70, he will have two stock commissions plus one \nput option commission. That should be compared to the cost of two in-the-money \ncall option commissions to remove the call spread directly. Furthermore, if the pub\nlic customer receives an early assignment notice on the short January 80 calls, he may \nneed to provide day-trade margin as he exercises his January 70 calls the next day. \nWithout going into as much detail, a bear spread's profits can be locked in via a \nsimilar strategy. Suppose that one owns a January 60 put and has sold a January 50 \nput to create a bear spread. Later, with the stock at 45, the spreader wants to remove \nthe spread, but again finds that the markets for the in-the-money puts are so wide \nthat he cannot realize anywhere near the 10 points that the spread is theoretically \nworth. He should then see what the January 50 call is selling for. If it is fractionally \npriced, as it most likely will be if expiration is drawing nigh, then it can be purchased \nto lock in the profits from the put spread. Again, commission costs should be con\nsidered by the public customer before finalizing his strategy. \nChapter 23: Spreads Combining Calls and Puts 345 \nTHREE USEFUL BUT COMPLEX STRATEGIES \nThe three strategies presented in this section are all designed to limit risk while \nallowing for large potential profits if correct market conditions develop. Each is a \ncombination strategy - that is, it involves both puts and calls and each is a calendar \nstrategy, in which near-term options are sold and longer-term options are bought. (A \nfourth strategy that is similar in nature to those about to be discussed is presented in \nthe next chapter.) Although all of these are somewhat complex and are for the most \nadvanced strategist, they do provide attractive risk/reward opportunities. In addition, \nthe strategies can be employed by the public customer; they are not designed strict\nly for professionals. All three strategies are described conceptually in this section; \nspecific selection criteria are presented in the next section. \nA TWO-PRONGED ATTACK {THE CALENDAR COMBINATION} \nA bullish calendar spread was shown to be a rather attractive strategy. A bullish call \ncalendar spread is established with out-of-the-money calls for a relatively small debit. \nIf the near-term call expires worthless and the stock then rises substantially before \nthe longer-term call expires, the profits could potentially be large. In any case, the \nrisk is limited to the small debit required to establish the spread. In a similar man\nner, the bearish calendar spread that uses put options can be an attractive strategy \nas well. In this strategy, one would set up the spread with out-of-the-money puts. He \nwould then want the near-term put to expire worthless, followed by a substantial drop \nin the stock price in order to profit on the longer-term put. \nSince both strategies are attractive by themselves, the combination of the two \nshould be attractive as well. That is, with a stock midway between two striking prices, \none might set up a bullish out-of-the-money call calendar spread and simultaneously \nestablish a bearish out-of-the-money put calendar spread. If the stock remains rela\ntively stable, both near-term options would expire worthless. Then a substantial stock \nprice movement in either direction could produce large profits. With this strategy, \nthe spreader does not care which direction the stock moves after the near options \nexpire worthless; he only hopes that the stock becomes volatile and moves a large dis\ntance in either direction. \nExample: Suppose that the following prices exist three months before the January \noptions expire: \nJanuary 70 call: 3 \nApril 70 call: 5 \nXYZ common: 65 \nJanuary 60 put: 2 \nApril 60 put: 3 \n346 Part Ill: Put Option Strategies \nThe bullish portion of this combination of calendar spreads would be set up by sell\ning the shorter-term January 70 call for 3 points and simultaneously buying the \nlonger-term April 70 call for 5 points. This portion of the spread requires a 2-point \ndebit. The bearish portion of the spread would be constructed using the puts. The \nnear-term January 60 put would be sold f", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 155}
{"text": ": Put Option Strategies \nThe bullish portion of this combination of calendar spreads would be set up by sell\ning the shorter-term January 70 call for 3 points and simultaneously buying the \nlonger-term April 70 call for 5 points. This portion of the spread requires a 2-point \ndebit. The bearish portion of the spread would be constructed using the puts. The \nnear-term January 60 put would be sold for 2 points, while the longer-term April 60 \nput would be bought for 3. Thus, the put portion of the spread is a I-point debit. \nOverall, then, the combination of the calendar spreads requires a 3-point debit, plus \ncommissions. This debit is the required investment; no additional collateral is \nrequired. Since there are four options involved, the commission cost will be large. \nAgain, establishing the spreads in quantity can reduce the percentage cost of com\nmissions. \nNote that all the options involved in this position are initially out-of-the-money. \nThe stock is below the striking price of the calls and is above the striking price of the \nputs. One has sold a near-term put and call combination and purchased a longer-term \ncombination. For nomenclature purposes, this strategy is called a \"calendar combi\nnation.\" \nThere are a variety of possible outcomes from this position. First, it should be \nunderstood that the risk is limited to the amount of the initial debit, 3 points in this \nexample. If the underlying stock should rise dramatically or fall dramatically before \nthe near-term options expire, both the call spread and the put spread will shrink to \nnearly nothing. This would be the least desirable result. In actual practice, the spread \nwould probably have a small positive differential left even after a premature move by \nthe underlying stock, so that the probability of a loss of the entire debit would be \nsmall. \nIf the near-term options both expire worthless, a profit will generally exist at \nthat time. \nExample: IfXYZ were still at 65 at January expiration in the prior example, the posi\ntion should be profitable at that time. The January call and put would expire worth\nless with XYZ at 65, and the April options might be worth a total of 5 points. The \nspread could thus be closed for a profit with XYZ at 65 in January, since the April \noptions could be sold for 5 points and the initial \"cost\" of the spread was only 3 points. \nAlthough commissions would substantially reduce this 2-point gross profit, there \nwould still be a good percentage profit on the overall position. If the strategist decides \nto take his profit at this time, he would be operating in a conservative manner. \nHowever, the strategist may want to be more aggressive and hold onto the April \ncombination in hopes that the stock might experience a substantial movement before \nthose options expire. Should this occur, the potential profits could be quite large. \nChapter 23: Spreads Combining Calls and Puts 347 \nExample: If the stock were to undergo a very bullish move and rise to 100 before \nApril expiration, the April 70 call could be sold for 30 points. (The April 60 put would \nexpire worthless in that case.) Alternatively, if the stock plunged to 30 by April expi\nration, the put at 60 could be sold for 30 points while the call expired worthless. In \neither case, the strategist would have made a substantial profit on his initial 3-point \ninvestment. \nIt may be somewhat difficult for the strategist to decide what he wants to do \nafter the near-term options expire worthless. He may be torn between taking the lim\nited profit that is at hand or holding onto the combination that he owns in hopes of \nlarger profits. A reasonable approach for the strategist to take is to do nothing imme\ndiately after the near-term options expire worthless. He can hold the longer-term \noptions for some time before they will decay enough to produce a loss in the posi\ntion. Referring again to the previous example, when the January options expire \nworthless, the strategist then owns the April combination, which is worth 5 points at \nthat time. He can continue to hold the April options for perhaps 6 or 8 weeks before \nthey decay to a value of 3 points, even if the stock remains close to 65. At this point, \nthe position could be closed for a net loss of the .commission costs involved in the var\nious transactions. \nAs a general rule, one should be willing to hold the combination, even if this \nmeans that he lets a small profit decay into a loss. The reason for this is that one \nshould give himself the maximum opportunity to realize large profits. He will proba\nbly sustain a number of small losses by doing this, but by giving himself the oppor\ntunity for large profits, he has a reasonable chance of having the profits outdistance \nthe losses. \nThere is a time to take small profits in this strategy. This would be when either \nthe puts or the calls were slightly in-the-money as the near-term options expire. \nExample: IfXYZ moved to 71 just as the January options were expiring, the call por\ntion of the spread should be closed. The January 70 call could be bought back for 1 \npoint and the April 70 call would probably be worth about 5 points. Thus, the call \nportion of the spread could be \"sold\" for 4 points, enough to cover the entire cost of \nthe position. The April 60 put would not have much value with the stock at 71, but it \nshould be held just in case the stock should experience a large price decline. Similar \nresults would occur on the put side of the spread if the underlying stock were slight\nly in-the-money, say at 58 or 59, at January expiration. At no time does the strategist \nwant to risk being assigned on an option that he is short, so he must always close the \nportion of the position that is in-the-money at near-term expiration. This is only nec\nessary, of course, if the stock has risen above the striking price of the calls or has fall\nen below the striking price of the puts. \n348 Part Ill: Put Option Strategies \nIn summary, this is a reasonable str", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 156}
{"text": "s the strategist \nwant to risk being assigned on an option that he is short, so he must always close the \nportion of the position that is in-the-money at near-term expiration. This is only nec\nessary, of course, if the stock has risen above the striking price of the calls or has fall\nen below the striking price of the puts. \n348 Part Ill: Put Option Strategies \nIn summary, this is a reasonable strategy if one operates it over a period of time \nlong enough to encompass several market cycles. The strategist must be careful not \nto place a large portion of his trading capital in the strategy, however, since even \nthough the losses are limited, they still represent his entire net investment. A varia\ntion of this strategy, whereby one sells more options than he buys, is described in the \nnext chapter. \nTHE CALENDAR STRADDLE \nAnother strategy that combines calendar spreads on both put and call options can be \nconstructed by selling a near-term straddle and simultaneously purchasing a longer\nterm straddle. Since the time value premium of the near-term straddle will decrease \nmore rapidly than that of the longer-term straddle, one could make profits on a lim\nited investment. This strategy is somewhat inferior to the one described in the pre\nvious section, but it is interesting enough to examine. \nExample: Suppose that three months before January expiration, the following prices \nexist: \nXYZ common: 40 \nJanuary 40 straddle: 5 April 40 straddle: 7 \nA calendar spread of the straddles could be established by selling the January 40 \nstraddle and simultaneously buying the April 40 straddle. This would involve a cost \nof 2 points, or the debit of the transaction, plus commissions. \nThe risk is limited to the amount of this debit up until {he time the near-term \nstraddle expires. That is, even if XYZ moves up in price by a substantial amount or \ndeclines in price by a substantial amount, the worst that can happen is that the dif\nference between the straddle prices shrinks to zero. This could cause one to lose an \namount equal to his original debit, plus commissions. This limit on the risk applies \nonly until the near-term options expire. If the strategist decides to buy back the near\nterm straddle and continue to hold the longer-term one, his risk then increases by the \ncost of buying back the near-term straddle. \nExample: XYZ is at 43 when the January options expire. The January 40 call can now \nbe bought back for 3 points. The put expires worthless; so the whole straddle was \nclosed out for 3 points. The April 40 straddle might be selling for 6 points at that \ntime. If the strategist wants to hold on to the April straddle, in hopes that the stock \nmight experience a large price swing, he is free to do so after buying back the January \nChapter 23: Spreads Combining Calls and Puts 349 \n40 straddle. However, he has now invested a total of 5 points in the position: the orig\ninal 2-point debit plus the 3 points that he paid to buy back the January 40 straddle. \nHence, his risk has increased to 5 points. If XYZ were to be at exactly 40 at April expi\nration, he would lose the entire 5 points. While the probability of losing the entire 5 \npoints must be considered small, there is a substantial chance that he might lose \nmore than 2 points his original debit. Thus, he has increased his risk by buying back \nthe near-term straddle and continuing to hold the longer-term one. \nThis is actually a neutral strategy. Recall that when calendar spreads were dis\ncussed previously, it was pointed out that one establishes a neutral calendar spread \nwith the stock near the striking price. This is true for either a call calendar spread or \na put calendar spread. This strategy - a calendar spread with straddles is merely the \ncombination of a neutral call calendar spread and a neutral put calendar spread. \nMoreover, recall that the neutral calendar spreader generally establishes the position \nwith the intention of closing it out once the near-term option expires. He is mainly \ninterested in selling time in an attempt to capitalize on the fact that a near-term \noption loses time value premium more rapidly than a longer-term option does. The \nstraddle calendar spread should be treated in the same manner. It is generally best \nto close it out at near-term expiration. If the stock is near the striking price at that \ntime, a profit will generally result. To verify this, refer again to the prices in the pre\nceding paragraph, with XYZ at 43 at January expiration. The January 40 straddle can \nbe bought back for 3 points and the April 40 straddle can be sold for 6. Thus, the dif\nferential between the two straddles has widened to 3 points. Since the original dif\nferential was 2 points, this represents a profit to the strategist. \nThe maximum profit would be realized if XYZ were exactly at the striking price \nat near-term expiration. In this case, the January 40 straddle could be bought back \nfor a very small fraction and the April 40 straddle might be worth about 5 points. The \ndifferential would have widened from the original 2 points to nearly 5 points in this \ncase. \nThis strategy is inferior to the one described in the previous section (the \"calen\ndar combination\"). In order to have a chance for unlimited profits, the investor must \nincrease his net debit by the cost of buying back the near-term straddle. \nConsequently, this strategy should be used only in cases when the near-term straddle \nappears to be extremely overpriced. Furthermore, the position should be closed at \nnear-term expiration unless the stock is so close to the striking price at that time that \nthe near-term straddle can be bought back for a fractional price. This fractional buy\nback would then give the strategist the opportunity to make large potential profits \nwith only a small increase in his risk. This situation of being able to buy back the near\nterm straddle at a fractional price will occur very infrequently, much more infre-\n350 Part Ill: Put Option Strategi", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 157}
{"text": "ice at that time that \nthe near-term straddle can be bought back for a fractional price. This fractional buy\nback would then give the strategist the opportunity to make large potential profits \nwith only a small increase in his risk. This situation of being able to buy back the near\nterm straddle at a fractional price will occur very infrequently, much more infre-\n350 Part Ill: Put Option Strategies \nquently than the case in which both the out-of-the-money put and call expire worth\nless in the previous strategy. Thus, the \"calendar combination\" strategy will afford the \nspreader more opportunities for large profits, and will also never force him to \nincrease his risk. \nOWNING A ✓,,FREE\" COMBINATION (THE \"\"DIAGONAL \nBUTTERFLY SPREAD\") \nThe strategies described in the previous sections are established for debits. This \nmeans that even if the near-term options expire worthless, the strategist still has risk. \nThe long options he then holds could proceed to expire worthless as well, thereby \nleaving him with an overall loss equal to his original debit. There is another strategy \ninvolving both put and call options that gives the strategist the opportunity to own a \n\"free\" combination. That is, the profits from the near-term options could equal or \nexceed the entire cost of his long-term options. \nThis strategy consists of selling a near-term straddle and simultaneously pur\nchasing both a longer-term, out-of the-money call and a longer-term, out-of the\nmoney put. This differs from the protected straddle write previously described in that \nthe long options have a more distant maturity than do the short options. \nExample: \nXYZ common: 40 \nApril 35 put: \nJanuary 40 straddle: \nApril 45 call: \nIf one were to sell the short-term January 40 straddle for 7 points and simultaneous\nly purchase the out-of-the-money put and call combination -April 35 put and April \n45 call - he would establish a credit spread. The credit for the position is 3 points less \ncommissions, since 7 points are brought in from the straddle sale and 4 points are \npaid for the out-of-the-money combination. Note that the position technically con\nsists of a bearish spread in the calls - buy the higher strike and sell the lower strike -\ncoupled with a bullish spread in the puts - buy the lower strike and sell the higher \nstrike. The investment required is in the form of collateral since both spreads are \ncredit spreads, and is equal to the differential in the striking prices, less the net cred\nit received. In this example, then, the investment would be 10 points for the striking \nprice differential (5 points for the calls and 5 points for the puts) less the 3-point \ncredit received, for a total collateral requirement of $700, plus commissions. \nChapter 23: Spreads Combining Calls and Puts 351 \nThe potential results from this position may vary widely. However, the risk is \nlimited before near-tenn expiration. If the underlying stock should advance substan\ntially before January expiration, the puts would be nearly worthless and the calls \nwould both be trading near parity. With the calls at parity, the strategist would have \nto pay, at most, 5 points to close the call spread, since the striking prices of the calls \nare 5 points apart. In a similar manner, if the underlying stock had declined substan\ntially before the near-term January options expired, the calls would be nearly worth\nless and the puts would be at parity. Again, it would cost a maximum of 5 points to \nclose the put spread, since the difference in the striking prices of the puts is also 5 \npoints. The worst result would be a 2-point loss in this example - 3 points of credit \nwere initially received, and the most that the strategist would have to pay to close the \nposition is 5 points. This is the theoretical risk. In actual practice, it is very unlikely \nthat the calls would trade as much as 5 points apart, even if the underlying stock \nadvanced by a large amount, because the longer-term call should retain some small \ntime value premium even if it is deeply in-the-money. A similar analysis might apply \nto the puts. The risk can always be quickly computed as being equal to the difference \nbetween two contiguous striking prices ( two strikes next to each other), less the net \ncredit received. \nThe strategist's objective with this position is to be able to buy back the near\ntenn straddle for a price less than the original credit received. If he can do this, he \nwill own the longer-term combination for free. \nExample: Near January expiration, the strategist is able to repurchase the January 40 \nstraddle for 2 points. Since he initially received a 3-point credit and is then able to \nbuy back the written straddle for 2 points, he is left with an overall credit in the posi\ntion of 1 point, less commissions. Once he has done this, the strategist retains the \nlong options, the April 35 put and April 45 call. If the underlying stock should then \nadvance substantially or decline substantially, he could make very large profits. \nHowever, even if the long combination expires worthless, the strategist still makes a \nprofit, since he was able to buy the straddle back for less than the amount of the orig\ninal credit. \nIn this example, the strategist's objective is to buy back the January 40 straddle \nfor less than 3 points, since that is the amount of the initial credit. At expiration, this \nwould mean that the stock would have to be between 37 and 43 for the buy-back to \nbe made for 3 points or less. Although it is possible, certainly, that the stock will be \nin this fairly narrow range at near-term expiration, it is not probable. However, the \nstrategist who is willing to add to his risk slightly can often achieve the same result by \n\"legging out\" of the January 40 straddle. It has repeatedly been stated that one should \n352 Part Ill: Put Option Strategies \nnot attempt to leg out of a spread, but this is an exception to that rule, since one owns \na long combination and therefore is pro", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 158}
{"text": "-term expiration, it is not probable. However, the \nstrategist who is willing to add to his risk slightly can often achieve the same result by \n\"legging out\" of the January 40 straddle. It has repeatedly been stated that one should \n352 Part Ill: Put Option Strategies \nnot attempt to leg out of a spread, but this is an exception to that rule, since one owns \na long combination and therefore is protected; he is not subjecting himself to large \nrisks by attempting to \"leg out\" of the straddle he has written. \nExample: XYZ rallies before January expiration and the January 40 put drops to a \nprice of ½ during the rally. Even though there is time remaining until expiration, the \nstrategist might decide to buy back the put at ½. This could potentially increase his \noverall risk by ½ point if the stock continues to rise. However, if the stock then \nreversed itself and fell, he could attempt to buy the call back at 2½ points or less. In \nthis manner, he would still achieve his objective of buying the short-term straddle \nback for 3 points or less. In fact, he might be able to close both sides of the straddle \nwell before near-term expiration if the underlying stock first moves quickly in one \ndirection and then reverses direction by a large amount. \nThe maximum risk and the optimum potential objectives have been described, \nbut interim results might also be considered in this strategy. \nExample: XYZ is at 44 at January expiration. The January 40 straddle must be bought \nback for 4 points. This means that the long combination will not be owned free, but \nwill have a cost of I point plus commissions. The strategist must decide at this time \nif he wants to hold on to the April options or if he wants to sell them, possibly pro\nducing a small overall profit on the entire position. There is no ironclad rule in this \ntype of situation. If the decision is made to hold on to the longer-term options, the \nstrategist realizes that he has assumed additional risk by doing so. Nevertheless, he \nmay decide that it is worth owning the long combination at a relatively low cost. The \ncost in this example would be I point plus commissions, since he paid 4 points to buy \nback the straddle after only taking in a 3-point credit initially. The more ex.pensive the \nbuy-back of the near-term straddle is, the more the strategist should be readily will\ning to sell his long options at the same time. For example, if XYZ were at 48 at \nJanuary expiration and the January 40 straddle had to be bought back for 8 points, \nthere should be no question that he should simultaneously sell his April options as \nwell. The most difficult decisions come when the stock is just outside the optimum \nbuy-back area at near-term expiration. In this example, the strategist would have a \nfairly difficult decision if XYZ were in the 44 to 45 area or in the 35 to 36 area at \nJanuary expiration. \nThe reader may recall that, in Chapter 14 on diagonalizing a spread, it was men\ntioned that one is sometimes able to own a call free by entering into a diagonal cred\nit spread. A diagonal bear spread was given as an example. The same thing happens \nto be true of a diagonal bullish put spread, since that is a credit spread as well. The \nChapter 23: Spreads Combining Calls and Puts 3S3 \nstrategy discussed in this section is merely a combination of a diagonal bearish call \nspread and a diagonal bullish put spread and is known as a \"diagonal butterfly \nspread.\" The same concept that was described in Chapter 14 - being able to make \nmore on the short-term call than one originally paid for the long-term call - applies \nhere as well. One enters into a credit position with the hope of being able to buy back \nthe near-term written options for a profit greater than the cost of the long options. If \nhe is able to do this, he will own options for free and could make large profits if the \nunderlying stock moves substantially in either direction. Even if the stock does not \nmove after the buy-back, he still has no risk. The risk occurs prior to the expiration \nof the near-term options, but this risk is limited. As a result, this is an attractive strat\negy that, when operated over a period of market cycles, should produce some large \nprofits. Ideally, these profits would offset any small losses that had to be taken. Since \nlarge commission costs are involved in this strategy, the strategist is reminded that \nestablishing the spreads in quantity can help to reduce the percentage effect of the \ncommissions. \nSELECTING THE SPREADS \nNow that the concepts of these three strategies have been laid out, let us define \nselection criteria for them. The \"calendar combination\" is the easiest of these strate\ngies to spot. One would like to have the stock nearly halfway between two striking \nprices. The most attractive positions can normally be found when the striking prices \nare at least 10 points apart and the underlying stock is relatively volatile. The opti\nmum time to establish the \"calendar combination\" is two or three months before the \nnear-term options expire. Additionally, one would like the sum of the prices of the \nnear-term options to be equal to at least one-half of the cost of the longer-term \noptions. In the example given in the previous section on the \"calendar combination,\" \nthe near-term combination was sold for 5 points, and the longer-term combination \nwas bought for 8 points. Thus, the near-term combination was worth more than one\nhalf of the cost of the longer-term combination. These five criteria can be summa\nrized as follows: \n1. Relatively volatile stock. \n2. Stock price nearly midway between two strikes. \n3. Striking prices at least 10 points apart. \n4. Two or three months remaining until near-term expiration. \n5. Price of near-term combination greater than one-half the price of the longer\nterm combination. \n354 Part Ill: Put Option Strategies \nEven though five criteria have been stated, it is relatively easy to find a position that \nsatisfies all five condi", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 159}
{"text": "rice nearly midway between two strikes. \n3. Striking prices at least 10 points apart. \n4. Two or three months remaining until near-term expiration. \n5. Price of near-term combination greater than one-half the price of the longer\nterm combination. \n354 Part Ill: Put Option Strategies \nEven though five criteria have been stated, it is relatively easy to find a position that \nsatisfies all five conditions. The strategist may also be able to rely upon technical \ninput. If the stock seems to be in a near-term trading range, the position may be more \nattractive, for that would indicate that the chances of the near-term combination \nexpiring worthless are enhanced. \nThe \"calendar straddle\" is a strategy that looks deceptively attractive. As the \nreader should know by now, options do not decay in a linear fashion. Instead, options \ntend to hold time value premium until they get quite close to expiration, when the \ntime value premium disappears at a fast rate. Consequently, the sale of a near-term \nstraddle and the simultaneous purchase of a longer-term straddle often appear to be \nattractive because the debit seems small. Again, certain criteria can be set forth that \nwill aid in selecting a reasonably attractive position. The stock should be at or very \nnear the striking price when the position is established. Since this is basically a neu\ntral strategy, one that offers the largest potential profits at near-term expiration, one \nshould want to sell the most time premium possible. This is why the stock must be \nnear the striking price initially. The underlying stock does not have to be a volatile \none, although volatile stocks will most easily satisfy the next two criteria. The near\nterm credit should be at least two-thirds of the longer-term debit. In the example \nused to explain this strategy, the near-term straddle was sold for 5, while the longer\nterm straddle was bought for 7 points. Thus, the near-term straddle was worth more \nthan two-thirds of the longer-term straddle's price. Finally, the position should be \nestablished with two to four months remaining until near-term expiration. If positions \nwith a longer time remaining are used, there is a significant probability that the \nunderlying stock will have moved some distance away from the striking price by the \ntime the near-term options expire. Summarizing, the three criteria for a \"calendar \nstraddle\" are: \n1. Stock near striking price initially. \n2. Two to four months remaining until near-term expiration. \n3. Near-term straddle price at least two-thirds of longer-term straddle price. \nThe \"diagonal butterfly\" is the most difficult of these three types of positions to \nlocate. Again, one would like the stock to be near the middle striking price when the \nposition is established. Also, one would like the underlying stock to be somewhat \nvolatile, since there is the possibility that long-term options will be owned for free. If \nthis comes to pass, the strategist wants the stock to be capable of a large move in \norder to have a chance of generating large profits. The most restrictive criterion -:\none that will eliminate all but a few possibilities on a daily basis - is that the near\nterm straddle price should be at least one and one-half times that of the longer-term, \nChapter 23: Spreads Combining Calls and Puts 355 \nout-of-the-money combination. By adhering to this criterion, one gives himself area\nsonable chance of being able to buy the near-term straddle back for a price low \nenough to result in owning the longer-term options for free. In the example used to \ndescribe this strategy, the near-term straddle was sold for 7 while the out-of-the\nmoney, longer-term combination cost 4 points. This satisfies the criterion. Finally, \none should limit his possible risk before near-term expiration. Recall that the risk is \nequal to the difference between any two contiguous striking prices, less the net cred\nit received. In the example, the risk would be 5 minus 3, or 2 points. The risk should \nalways be less than the credit taken in. This precludes selling a near-term straddle at \n80 for 4 points and buying the put at 60 and the call at 100 for a combined cost of 1 \npoint. Although the credit is substantially more than one and one-half times the cost \nof the long combination, the risk would be ridiculously high. The risk, in fact, is 20 \npoints ( the difference between two contiguous striking prices) less the 3 points cred\nit, or 17 points - much too high. \nThe criteria can be summarized as follows: \n1. Stock near middle striking price initially. \n2. Three to four months to near-term expiration. \n3. Price of written straddle at least one and one-half times that of the cost of the \nlonger-term, out-of-the-money combination. \n4. Risk before near-term expiration less than the net credit received. \nOne way in which the strategist may notice this type of position is when he sees a rel\natively short-term straddle selling at what seems to be an outrageously high price. \nProfessionals, who often have a good feel for a stock's short-term potential, will some\ntimes bid up straddles when the stock is about to make a volatile move. This will \ncause the near-term straddles to be very overpriced. When a straddle seller notices \nthat a particular straddle looks too attractive as a sale, he should consider establish\ning a diagonal butterfly spread instead. He still sells the overpriced straddle, but also \nbuys a longer-term, out-of-the-money combination as a hedge against a large loss. \nBoth factions can be right. Perhaps the stock will experience a very short-term \nvolatile movement, proving that the professionals were correct. However, this will \nnot worry the strategist holding a diagonal butterfly, for he has limited risk. Once the \nshort-term move is over, the stock may drift back toward the original strike, allowing \nthe near-term straddle to be bought back at a low price - the eventual objective of \nthe strategist utilizing the diagonal butterfly spread.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 160}
{"text": "atile movement, proving that the professionals were correct. However, this will \nnot worry the strategist holding a diagonal butterfly, for he has limited risk. Once the \nshort-term move is over, the stock may drift back toward the original strike, allowing \nthe near-term straddle to be bought back at a low price - the eventual objective of \nthe strategist utilizing the diagonal butterfly spread. \nThese are admittedly three quite complex strategies and thus are not to be \nattempted by a novice investor. If one wants to gain experience in how he would \noperate such a strategy, it would be far better to operate a \"paper strategy\" for a \n356 Part Ill: Put Option Strategies \nwhile. That is, one would not actually make investments, but would instead follow \nprices in the newspaper and make day-to-day decisions without actual risk. This will \nallow the inexperienced strategist to gain a feel for how these complex strategies per\nform over a particular time period. The astute investor can, of course, obtain price \nhistory information and track a number of market cycles in this same way. \nSUMMARY \nPuts and call can be combined to make some very attractive positions. The addition \nof a call or put credit spread to the outright purchase of a put or call can enhance the \noverall profitability of the position, especially if the options are expensive. In addi\ntion, three advanced strategies were presented that combined puts and calls at vari\nous expiration dates. These three various types of strategies that involve calendar \ncombinations of puts and calls may all be attractive. One should be especially alert \nfor these types of positions when near-term calls are overpriced. Typically, this would \nbe during, or just after, a bullish period in the stock market. For nomenclature pur\nposes, these three strategies are called the \"calendar combination,\" the \"calendar \nstraddle,\" and the \"diagonal butterfly.\" \nAll three strategies offer the possibility of large potential profits if the underly\ning stock remains relatively stable until the near-term options expire. In addition, all \nthree strategies have limited risk, even if the underlying stock should move explo\nsively in either direction prior to near-term expiration. If an intermediate result \noccurs - for example, the stock moves a moderate distance in either direction before \nnear-term expiration - it is still possible to realize a limited profit in any of the strate\ngies, because of the fact that the time premiums decay much more rapidly in the \nnear-term options than they do in the longer-term options. \nThe three strategies have many things in common, but each has its own advan\ntages and disadvantages. The \"diagonal butterfly\" is the only one of the three strate\ngies whereby the strategist has a possibility of owning free options. Admittedly, the \nprobability of actually being able to own the options completely for free is small. \nHowever, there is a relatively large probability that one can substantially reduce the \ncost of the long options. The \"calendar combination,\" the first of the three strategies \ndiscussed, offers the largest probability of capturing the entire near-term premium. \nThis is because both near-term options are out-of-the-money to begin with. The \"cal\nendar straddle\" offers the largest potential profits at near-term expiration. That is, if \nthe stock is relatively unchanged from the time the position was established until the \ntime the near-term options expire, the \"calendar straddle\" will show the best profit \nof the three strategies at that time. \nChapter 23: Spreads Combining Calls and l'uts 357 \nLooking at the negative side, the \"calendar straddle\" is the least attractive of the \nthree strategies, primarily because one is forced to increase his risk after near-term \nexpiration, if he wants to continue to hold the longer-term options. It is often diffi\ncult to find a \"diagonal butterfly\" that offers enough credit to make the position \nattractive. Finally, the \"calendar combination\" has the largest probability oflosing the \nentire debit eventually, because one may find that the longer-term options expire \nworthless also. (They are out-of-the-money to begin with, just as the near-term \noptions were.) \nThe strategist will not normally be able to find a large number of these positions \navailable at attractive price levels at any particular time in the market. However, since \nthey are attractive strategies with little or no margin collateral requirements, the \nstrategist should constantly be looking for these types of positions. A certain amount \nof cash or collateral should be reserved for the specific purpose of utilizing it for \nthese types of positions - perhaps 15 to 20% of one's dollars. \nRatio Spreads Using Puts \nThe put option spreader may want to sell more puts than he owns. This creates a ratio \nspread. Basically, two types of put ratio spreads may prove to be attractive: the stan\ndard ratio put spread and the ratio calendar spread using puts. Both strategies are \ndesigned for the more aggressive investor; when operated properly, both can present \nattractive reward opportunities. \nTHE RATIO PUT SPREAD \nThis strategy is designed for a neutral to slightly bearish outlook on the underlying \nstock. In a ratio put spread, one buys a number of puts at a higher strike and sells \nmore puts at a lower strike. This position involves naked puts, since one is short more \nputs than he is long. There is limited upside risk in the position, but the downside risk \ncan be very large. The maximum profit can be obtained if the stock is exactly at the \nstriking price of the written puts at expiration. \nExample: Given the following: \nXYZ common, 50; \nXYZ January 45 put, 2; and \nXYZ January 50 put, 4. \nA ratio put spread might be established by buying one January 50 put and simulta\nneously selling two January 45 puts. Since one would be paying $400 for the pur\nchased put and would be collecting $400 from the sale of the two out-of-the-money \nput", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 161}
{"text": "striking price of the written puts at expiration. \nExample: Given the following: \nXYZ common, 50; \nXYZ January 45 put, 2; and \nXYZ January 50 put, 4. \nA ratio put spread might be established by buying one January 50 put and simulta\nneously selling two January 45 puts. Since one would be paying $400 for the pur\nchased put and would be collecting $400 from the sale of the two out-of-the-money \nputs, the spread could be done for even money. There is no upside risk in this posi\ntion. If XYZ should rally and be above 50 at January expiration, all the puts would \n358 \nCl,apter 24: Ratio Spreads Using Puts 359 \nexpire worthless and the result would be a loss of commissions. However, there is \ndownside risk. If XYZ should fall by a great deal, one would have to pay much more \nto buy back the two short puts than he would receive from selling out the one long \nput. The maximum profit would be realized if XYZ were at 45 at expiration, since the \nshort puts would expire worthless, but the long January 50 put would be worth 5 \npoints and could be sold at that price. Table 24-1 and Figure 24-1 summarize the \nposition. Note that there is a range within which the position is profitable - 40 to 50 \nin this example. If XYZ is above 40 and below 50 at January expiration, there will be \nsome profit, before commissions, from the spread. Below 40 at expiration, losses will \nbe generated and, although these losses are limited by the fact that a stock cannot \ndecline in price below zero, these losses could become very large. There is no upside \nrisk, however, as was pointed out earlier. The following formulae summarize the sit\nuation for any put ratio spread: \nMaximum upside risk \nMaximum profit \npotential \n= Net debit of spread (no upside risk if done for \na credit) \n= Striking price differential x Number of long \nputs - Net debit (or plus net credit) \nDownside break-even price = Lower strike price - Maximum profit potential + \nNumber of naked puts \nThe investment required for the put ratio spread consists of the collateral \nrequirement necessary for a naked put, plus or minus the credit or debit of the entire \nposition. Since the collateral requirement for a naked option is 20% of the stock \nTABLE 24-1. \nRatio put spread. \nXYZ Price at Long January 50 Short 2 January 45 Total \nExpiration Put Profit Put Profit Profit \n20 +$2,600 -$4,600 -$2,000 \n30 + 1,600 - 2,600 - 1,000 \n40 + 600 600 0 \n42 + 400 200 + 200 \n45 + 100 + 400 + 500 \n48 200 + 400 + 200 \n50 400 + 400 0 \n60 400 + 400 0 \n360 \nFIGURE 24-1. \nRatio put spread. \n+$500 \nC: \n0 \n~ ·5. \nX \nw \niil \n(/) $0 (/) \n0 ....I \n0 \ne a. \nPart Ill: Put Option Strategies \nStock Price at Expiration \nprice, plus the premium, minus the amount by which the option is out-of-the-money, \nthe actual dollar requirement in this example would be $700 (20% of $5,000, plus the \n$200 premium, minus the $500 by which the January 45 put is out-of-the-money). As \nwith all types of naked writing positions, the strategist should allow enough collater\nal for an adverse stock move to occur. This will allow enough room for stock move\nment without forcing early liquidation of the position due to a margin call. If, in this \nexample, the strategist felt that he might stay with the position until the stock \ndeclined to 39, he should allow $1,380 in collateral (20% of $3,900 plus the $600 in\nthe-money amount). \nThe ratio put spread is generally most attractive when the underlying stock is \ninitially between the two striking prices. That is, if XYZ were somewhere between 45 \nand 50, one might find the ratio put spread used in the example attractive. If the \nstock is initially below the lower striking price, a ratio put spread is not as attractive, \nsince the stock is already too close to the downside risk point. Alternatively, if the \nstock is too far above the striking price of the written calls, one would normally have \nto pay a large debit to establish the position. Although one could eliminate the debit \nby writing four or five short options to each put bought, large ratios have extraordi\nnarily large downside risk and are therefore very aggressive. \nFollow-up action is rather simple in the ratio put spread. There is very little that \none need do, except for closing the position if the stock breaks below the downside \nbreak-even point. Since put options tend to lose time value premium rather quickly \nafter they become in-the-money options, there is not normally an opportunity to roll \nChapter 24: Ratio Spreads Using Puts 361 \ndown. Rather, one should be able to close the position with the puts close to parity if \nthe stock breaks below the downside break-even point. The spreader may want to buy \nin additional long puts, as was described for call spreads in Chapter 11, but this is not \nas advantageous in the put spread because of the time value premium shrinkage. \nThis strategy may prove psychologically pleasing to the less experienced \ninvestor because he will not lose money on an upward move by the underlying stock. \nMany of the ratio strategies that involve call options have upside risk, and a large \nnumber of investors do not like to lose money when stocks move up. Thus, although \nthese investors might be attracted to ratio strategies because of the possibility of col\nlecting the profits on the sale of multiple out-of-the-money options, they may often \nprefer ratio put spreads to ratio call spreads because of the small upside risk in the \nput strategy. \nUSING DELTAS \nThe \"delta spread\" concept can also be used for establishing and adjusting neutral \nratio put spreads. The delta spread was first described in Chapter 11. A neutral put \nspread can be constructed by using the deltas of the two put options involved in the \nspread. The neutral ratio is determined by dividing the delta of the put at the higher \nstrike by the delta of the put at the lower strike. Referring to the previous example, \nsuppose the delta of the January 45 put is -.30 and the delta of the January 50 put is \n-.50. Then a", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 162}
{"text": "scribed in Chapter 11. A neutral put \nspread can be constructed by using the deltas of the two put options involved in the \nspread. The neutral ratio is determined by dividing the delta of the put at the higher \nstrike by the delta of the put at the lower strike. Referring to the previous example, \nsuppose the delta of the January 45 put is -.30 and the delta of the January 50 put is \n-.50. Then a neutral ratio would be 1.67 (-.50 divided by -.30). That is, 1.67 puts \nwould be sold for each put bought. One might thus sell 5 January 45 puts and buy 3 \nJanuary 50 puts. \nThis type of spread would not change much in price for small fluctuations in the \nunderlying stock price. However, as time passes, the preponderance of time value \npremium sold via the January 45 puts would begin to tum a profit. As the underlying \nstock moves up or down by more than a small distance, the neutral ratio between the \ntwo puts will change. The spreader can adjust his position back into a neutral one by \nselling more January 45's or buying more January 50's. \nTHE RATIO PUT CALENDAR SPREAD \nThe ratio put calendar spread consists of buying a longer-term put and selling a larg\ner quantity of shorter-term puts, all with the same striking price. The position is gen\nerally established with out-of-the-money puts that is, the stock is above the striking \nprice - so that there is a greater probability that the near-term puts will expire worth-\n362 Part Ill: Put Option Strategies \nless. Also, the position should be established for a credit, such that the money \nbrought in from the sale of the near-term puts more than covers the cost of the \nlonger-term put. If this is done and the near-term puts expire worthless, the strate\ngist will then own the longer-term put free, and large profits could result if the stock \nsubsequently experiences a sizable downward movement. \nExample: If XYZ were at 55, and the January 50 put was at 1 ½ with the April 50 at \n2, one could establish a ratio put calendar spread by buying the April 50 and selling \ntwo January 50 puts. This is a credit position, because the sale of the two January 50 \nputs would bring in $300 while the cost of the April 50 put is only $200. If the stock \nremains above 50 until January expiration, the January 50 puts will expire worthless \nand the April 50 put will be owned for free. In fact, even if the April 50 put should \nthen expire worthless, the strategist will make a small profit on the overall position in \nthe amount of his original credit - $100 - less commissions. However, after the \nJanuarys have expired worthless, if XYZ should drop dramatically to 25 or 20, a very \nlarge profit would accrue on the April 50 put that is still owned. \nThe risk in the position could be very large if the stock should drop well below \n50 before the January puts expire. For example, if XYZ fell to 30 prior to January \nexpiration, one would have to pay $4,000 to buy back the January 50 puts and would \nreceive only $2,000 from selling out his long April 50 put. This would represent a \nrather large loss. Of course, this type of tragedy can be avoided by taking appropri\nate follow-up action. Nomwlly, one would close the position if the stock fell rrwre than \n8 to 10% below the striking price before the near-term puts expire. \nAs with any type of ratio position, naked options are involved. This increases the \ncollateral requirement for the position and also means that the strategist should allow \nenough collateral in order for the follow-up action point to be reached. In this exam\nple, the initial requirement would be $750 (20% of $5,500, plus the $150 January \npremium, less the $500 by which the naked January 50 put is out-of-the-money). \nHowever, if the strategist decides that he will hold the position until XYZ falls to 46, \nhe should allow $1,320 in collateral (20% of $4,600 plus the $400 in-the-money \namount). Of course, the $100 credit, less commissions, generated by the initial posi\ntion can be applied against these collateral requirements. \nThis strategy is a sensible one for the investor who is willing to accept the risk of \nwriting a naked put. Since the position should be established with the stock above the \nstriking price of the put options, there is a reasonable chance that the near-term puts \nwill expire worthless. This means that some profit will be generated, and that the \nprofit could be large if the stock should then experience a large downward move \nbefore the longer-term puts expire. One should take care, however, to limit his losses \nChapter 24: Ratio Spreads Using Puts 363 \nbefore near-term expiration, since the eventual large profits will be able to overcome \na series of small losses, but could not overcome a preponderance oflarge losses. \nRATIO PUt CALENDARS \nUsing the deltas of the puts in the spread, the strategist can construct a neutral posi\ntion. If the puts are initially out-of-the-money, then the neutral spread generally \ninvolves selling more puts than one buys. Another type of ratioed put calendar can \nbe constructed with in-the-money puts. As with the companion in-the-money spread \nwith calls, one would buy more puts than he sells in order to create a neutral ratio. \nIn either case, the delta of the put to be purchased is divided by the delta of the \nput to be sold. The result is the neutral ratio, which is used to determine how many \nputs to sell for each one purchased. \nExample: Consider the out-of-the-money case. XYZ is trading at 59. The January 50 \nput has a delta of 0.10 and the April 50 put has a delta of -0.17. If a calendar spread \nis to be established, one would be buying the April 50 and selling the January 50. \nThus, the neutral ratio would be calculated as 1.7 to 1 (-0.17/-0.10). Seventeen puts \nwould be sold for every 10 purchased. \nThis spread has naked puts and therefore has large risk if the underlying stock \ndeclines too far. However, follow-up action could be taken if the stock dropped in an \norderly manner. Such action would be des", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 163}
{"text": "ed, one would be buying the April 50 and selling the January 50. \nThus, the neutral ratio would be calculated as 1.7 to 1 (-0.17/-0.10). Seventeen puts \nwould be sold for every 10 purchased. \nThis spread has naked puts and therefore has large risk if the underlying stock \ndeclines too far. However, follow-up action could be taken if the stock dropped in an \norderly manner. Such action would be designed to limit the downside risk. \nConversely, the calendar spread using in-the-money puts would normally have \none buying more options than he is selling. An example using deltas will demonstrate \nthis fact: \nExample: XYZ is at 59. The January 60 put has a delta of -0.45 and the April 60 put \nhas a delta of -0.40. It is normal for shorter-term, in-the-money options to have a \ndelta that is larger (in absolute terms) than longer-term, in-the-money options. \nThe neutral ratio for this spread would be 0.889 (-0.40/-0.45). That is, one \nwould sell only 0.889 puts for each one he bought. Alternatively stated, he would sell \n8 and buy 9. \nA spread of this type has no naked puts and therefore does have large downside \nprofit potential. If the stock should rise too far, the loss is limited to the initial debit \nof the spread. The optimum result would occur if the stock were at the strike at expi\nration because, even though the excess long put would lose money in that case, the \nspreads involving the other puts would overcome that small loss. \nAnother risk of the in-the-money put spread is that one might be assigned \nrather quickly if the stock should drop. In fact, one must be careful not to establish \n364 Part Ill: Put Option Strategies \nthe spread with puts that are too deeply in-the-money, for this reason. While being \nput will not necessarily change the profitability of the spread, it will mean increased \ncommission costs and margin charges for the customer, who must buy the stock upon \nassignment. \nA LOGICAL EXTENSION (THE RATIO CALENDAR COMBINATION) \nThe previous section demonstrated that ratio put calendar spreads can be attractive. \nThe ratio call calendar spread was described earlier as a reasonably attractive strate\ngy for the bullish investor. A logical combination of these two types of ratio calendar \nspreads (put and call) would be the ratio combination - buying a longer-term out-of\nthe-money combination and selling several near-term out-of-the-money combina\ntions. \nExample: The following prices exist: \nXYZ common: 55 \nXYZ January 50 put: \nXYZ January 60 call: \nXYZ April 50 put: 2 \nXYZ April 60 call: 5 \nOne could sell the near-term January combination (January 50 put and January 60 \ncall) for 5 points. It would cost 7 points to buy the longer-term April combination \n(April 50 put and April 60 call). By selling more January combinations than April com\nbinations bought, a ratio calendar combination could be established. For example, \nsuppose that a strategist sold two of the near-term January combinations, bringing in \n10 points, and simultaneously bought one April combination for 7 points. This would \nbe a credit position, a credit of 3 points in this example. If the near-term, out-of-the\nmoney combination expires worthless, a guaranteed profit of 3 points will exist, even \nif the longer-term options proceed to expire totally worthless. If the near-term com\nbination expires worthless, the longer-term combination is owned for free, and a large \nprofit could result on a substantial stock price movement in either direction. \nAlthough this is a superbly attractive strategy if the near-term options do, in \nfact, expire worthless, it must also be monitored closely so that large losses do not \noccur. These large losses would be possible if the stock broke out in either direction \ntoo quickly, before the near-term options expire. In the absence of a technical opin\nion on the underlying stock, one can generally compute a stock price at which it \nmight be reasonable to take follow-up action. This is a similar analysis to the one \nChapter 24: Ratio Spreads Using Puts 365 \ndescribed for ratio call calendar spreads in Chapter 12. Suppose the stock in this \nexample began to rally. There would be a point at which the strategist would have to \npay 3 points of debit to close the call side of the combination. That would be his \nbreak-even point. \nExample: With XYZ at 65 at January expiration (5 points above the higher strike of \nthe original combination), the near-term January 60 call would be worth 5 points and \nthe longer-term April 60 call might be worth 7 points. If one closed the call side of \nthe combination, he would have to pay 10 points to buy back two January 60 calls, \nand would receive 7 points from selling out his April 60. This closing transaction \nwould be a 3-point debit. This represents a break-even situation up to this point in \ntime, except for commissions, since a 3-point credit was initially taken in. The strate\ngist would continue to hold the April 50 put (the January 50 put would expire worth\nless) just in case the improbable occurs and the underlying stock plunges below 50 \nbefore April expiration. A similar analysis could be performed for the put side of the \nspread in case of an early downside breakout by the underlying stock. It might be \ndetermined that the downside break-even point at January expiration is 46, for exam\nple. Thus, the strategist has two parameters to work with in attempting to limit loss\nes in case the stock moves by a great deal before near-term expiration: 65 on the \nupside and 46 on the downside. In practice, if the stock should reach these levels \nbefore, rather than at, January expiration, the strategist would incur a small loss by \nclosing the in-the-money side of the combination. This action should still be taken, \nhowever, as the objective of risk management of this strategy is to take small losses, if \nnecessary. Eventually, large profits may be generated that could more than compen\nsate for any small losses that were incurred. \nThe foregoing follow-up ac", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 164}
{"text": "at, January expiration, the strategist would incur a small loss by \nclosing the in-the-money side of the combination. This action should still be taken, \nhowever, as the objective of risk management of this strategy is to take small losses, if \nnecessary. Eventually, large profits may be generated that could more than compen\nsate for any small losses that were incurred. \nThe foregoing follow-up action was designed to handle a volatile move by the \nunderlying stock prior to near-term expiration. Another, perhaps more common, time \nwhen follow-up action is necessary is when the underlying stock is relatively \nunchanged at near-term expiration. If XYZ in the example above were near 55 at \nJanuary expiration, a relatively large profit would exist at that time: The near-term \ncombination would expire worthless for a gain of 10 points on that sale, and the \nlonger-term combination would probably still be worth about 5 points, so that the \nunrealized loss on the April combination would be only 2 points. This represents a \ntotal (realized and unrealized) gain of 8 points. In fact, as long as the near-term com\nbination can be bought back for less than the original 3-point credit of the position, \nthe position will show a total unrealized gain at near-term expiration. Should the gain \nbe taken, or should the longer-term combination be held in hopes of a volatile move \nby the underlying stock? Although the strategist will normally handle each position \n366 Part Ill: Put Option Strategies \non a case-by-case basis, the general philosophy should be to hold on to the April com\nbination. A profit is already guaranteed at this time - the worst that can happen is a \n3-point profit (the original credit). Consequently, the strategist should allow himself \nthe opportunity to make large profits. The strategist may want to attempt to trade out \nof his long combination, since he will not risk making the position a losing one by \ndoing so. Technical analysis may be able to provide him with buy or sell zones on the \nstock, and he would then consider selling out his long options in accordance with \nthese technical levels. \nIn summary, this strategy is very attractive and should be utilized by strategists \nwho have the expertise to trade in positions with naked options. As long as risk man\nagement principles of taking small losses are adhered to, there will be a large proba\nbility of overall profit from this strategy. \nPUT OPTION SUMMARY \nThis concludes the section on put option strategies. The put option is useful in a vari\nety of situations. First, it represents a more attractive way to take advantage of a bear\nish attitude with options. Second, the use of the put options opens up a new set of \nstrategies - straddles and combinations - that can present reasonably high levels of \nprofit potential. Many of the strategies that were described in Part II for call options \nhave been discussed again in this part. Some of these strategies were described more \nfully in terms of philosophy, selection procedures, and follow-up action when they \nwere first discussed. The second description the one involving put options - was \noften shortened to a more mechanical description of how puts fit into the strategy. \nThis format is intentional. The reader who is planning to employ a certain strategy \nthat can be established with either puts or calls (a bear spread, for example) should \nfamiliarize himself with both applications by a simultaneous review of the call chap\nter and its analogous put chapter. \nThe combination strategies generally introduced new concepts to the reader. \nThe combination allows the construction of positions that are attractive with either \nputs or calls (out-of-the-money calendar spreads, for example) to be combined into \none position. The four combination strategies that involve selling short-term options \nand simultaneously buying longer-term options are complex, but are most attractive \nin that they have the desirable features of limited risk and large potential profits. \nCHAPTER 25 \nLEAPS \nIn an attempt to provide customers with a broader range of derivative products, the \noptions exchanges introduced LEAPS. This chapter does a fair amount of reviewing \nbasic option facts in order to explain the concepts behind LEAPS. The reader who \nhas a knowledge of the preceding chapters and therefore does not need the review \nwill be able to quickly skim through this chapter and pick out the strategically impor\ntant points. However, if one encounters concepts here that don't seem familiar, he \nshould review the earlier chapter that discusses the pertinent strategy. \nThe term LEAPS is a name for \"long-term option.\" A LEAPS is nothing more \nthan a listed call or put option that is issued with two or more years of time remain\ning. It is a longer-term option than we are used to dealing with. Other than that, there \nis no material difference between LEAPS and the other calls and puts that have been \ndiscussed in the previous chapters. \nLEAPS options were first introduced by the CBOE in October 1990, and were \noffered on a handful of blue-chip stocks. Their attractiveness spurred listings on \nmany underlying stocks on all option exchanges as well as on several indices. (Index \noptions are covered in a later section of the book.) \nStrategies involving long-term options are not substantially different from those \ninvolving shorter-term options. However, the fact that the option has so much time \nremaining seems to favor the buyer and be a detriment to the seller. This is one rea\nson why LEAPS have been popular. As a strategist, one knows that the length of time \nremaining has little to do with whether a certain strategy makes sense or not. Rather, \nit is the relative value of the option that dictates strategy. If an option is overpriced, \nit is a viable candidate for selling, whether it has two years of life remaining or two \nmonths. Obviously, follow-up action may become much more of a necessity during \nthe life of a two-y", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 165}
{"text": "knows that the length of time \nremaining has little to do with whether a certain strategy makes sense or not. Rather, \nit is the relative value of the option that dictates strategy. If an option is overpriced, \nit is a viable candidate for selling, whether it has two years of life remaining or two \nmonths. Obviously, follow-up action may become much more of a necessity during \nthe life of a two-year option; that matter is discussed later in this chapter. \n361 \n368 Part Ill: Put Option Strategies \nTHE BASICS \nCertain facets of LEAPS are the same as for other listed equity options, while others \ninvolve slight differences. The amount of standardization is considerably less, which \nmakes the simple process of quoting LEAPS a bit more tedious. LEAPS are listed \noptions that can be traded in a secondary market or can be exercised before expira\ntion. As with other listed equity options, they do not receive the dividend paid by the \nunderlying common stock. \nRecall that four specifications uniquely describe any option contract: \n1. the type (put or call), \n2. the underlying stock name (and symbol), \n3. the expiration date, and \n4. the striking price. \nType. LEAPS are puts or calls. The LEAPS owner has the right to buy the stock at \nthe striking price (LEAPS call) or sell it there (LEAPS put). This is exactly the same \nfor LEAPS and for regular equity options. \nUnderlying Stock and Quote Symbol. The underlying stocks are the \nsame for LEAPS as they are for equity options. The base symbol in an option quote \nis the part that designates the underlying stock. For equity options, the base symbol \nis the same as the stock symbol. However, until the Option Price Reporting Authority \n( OPRA) changes the way that all options are quoted, the base symbols for LEAPS are \nnot the same as the stock symbols. For example, LEAPS options on stock XYZ might \ntrade under the base symbol WXY; so it is possible that one stock might have listed \noptions trading with different base symbols even though all the symbols refer to the \nsame underlying stock. Check with your broker to determine the LEAPS symbol if \nyou need to know it. \nExpiration Date. LEAPS expire on the Saturday following the third Friday of \nthe expiration month, just as equity options do. One must look in the newspaper, ask \nhis broker, or check the Internet (www.cboe.com) to determine what the expiration \nmonths are, however, since they are also not completely standardized. When LEAPS \nwere first listed, there were differing expiration months through December 1993. At \nthe current time, LEAPS are issued to expire in January of each year, so some \nattempt is being made at standardization. However, there is no guarantee that vary\ning expiration months won't reappear at some future time. \nChapter 25: LEAPS 369 \nStriking Price. There is no standardized striking price interval for LEAPS as \nthere is for equity options. If XYZ is a 95-dollar stock, there might be LEAPS with \nstriking prices of 80, 95, and 105. Again, one must look in the newspaper, ask his bro\nker, or check the Internet (www.cboe.com) to determine the actual LEAPS striking \nprices for any specific underlying stock. New striking prices can be introduced when \nthe underlying stock rises or falls too far. For example, if the lowest strike for XYZ \nwere 80 and the stock fell to 80, a new LEAPS strike of 70 might be introduced. \nOther Basic Factors. LEAPS may be exercised at any time during their life, \njust as is the case with equity options. Note that this statement regarding exercise is \nnot necessarily true for Index LEAPS or Index Options. See Part V of this book for \ndiscussions of index products. \nStandard LEAPS contracts are for 100 shares of the underlying stock, just as \nequity options are. The number of shares would be adjusted for stock splits and stock \ndividends (leading to even more arcane LEAPS symbol problems). LEAPS are quot\ned on a per-share basis, as are other listed options. \nThere are position and exercise limits for LEAPS just as there are for other list\ned options. One must add his LEAPS position and his regular equity option position \ntogether in order to determine his entire position quantity. Exemptions may be \nobtained for bona fide hedgers of common stock. \nAs time passes, LEAPS eventually have less than 9 months remaining until expi\nration. When such a time is reached, the LEAPS are \"renamed\" and become ordi\nnary equity options on the underlying security. \nExample: Assume LEAPS on stock XYZ were initially issued to expire two years \nhence. Assume that one of these LEAPS is the XYZ January 90; that is, it has a strik\ning price of 90 and expires in January, two years from now. Its symbol is WXYAR \n(WXY being the LEAPS base symbol assigned by the exchange where XYZ is traded, \nA for January, and R for 90). \nFifteen months later, the January LEAPS only have 9 months of life remaining. \nThe LEAPS symbol would be changed from WXYAR to XYZAR (a regular equity \noption), and the quotes would be listed in the regular equity option section of the \nnewspaper instead of in the LEAPS section. \nPRICING LEAPS \nTerms such as in-the-money, out-of-the-money, intrinsic value, time value premium, \nand parity all apply and have the same definitions. The factors influencing the prices \nof LEAPS are the same as those for any other option: \n370 Part Ill: Put Option Strategies \n1. underlying stock price, \n2. striking price, \n3. time remaining, \n4. volatility, \n5. risk-free interest rate, and \n6. dividend rate. \nThe relative influence of these factors may be a little more pronounced for \nLEAPS than it is for shorter-term equity options. Consequently, the trader may think \nthat a LEAPS is overly expensive or cheap by inspection, when in reality it is not. One \nshould be careful in his evaluation of LEAPS until he has acquired experience in \nobserving how their prices relate to the shorter-tenn equity options with which he is \nexperienced. \nIt might prove useful to reexamine the option pricing", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 166}
{"text": "it is for shorter-term equity options. Consequently, the trader may think \nthat a LEAPS is overly expensive or cheap by inspection, when in reality it is not. One \nshould be careful in his evaluation of LEAPS until he has acquired experience in \nobserving how their prices relate to the shorter-tenn equity options with which he is \nexperienced. \nIt might prove useful to reexamine the option pricing curve with some LEAPS \nincluded. Please refer to Figure 25-1 for the pricing curves of several options. As \nalways, the solid intrinsic value line is the bottom line; it is the same for any call \noption. The curves are all drawn with the same values for the pertinent variables: \nstock price, striking price, volatility, short-term interest rate, and dividends. Thus, \nthey can be compared directly. \nThe most obvious thing to notice about the curves in Figure 25-1 is that the \ncurve depicting the 2-year LEAPS is quite flat. It has the general shape of the \nshorter-term curves, but there is so much time value at stock prices even 25% in\nor out-of-the-money, that the 2-year curve is much flatter than the others. \nOther observations can be made as well. Notice the at-the-money options: The \n2-year LEAPS sells for a little more than four times the 3-month option. As we shall \nsee, this can change with the effects of interest rates and dividends, but it confirms \nsomething that was demonstrated earlier: Time decay is not linear. Thus, the 2-year \nLEAPS, which has eight times the amount of time remaining as compared to the 3-\nmonth call, only sells for about four times as much. This LEAPS might appear cheap \nto the casual observer, but remember that these graphs depict the fair values for this \nset of input parameters. Do not be deluded into thinking that a LEAPS looks cheap \nmerely by comparing its price to a nearer-term option; use a model to evaluate it, or \nat least use the output of someone else's model. \nThe curves in Figure 25-1 depict the relationships between stock price, striking \nprice, and time remaining. The most important remaining determinant of an option's \nprice is the volatility of the underlying stock. Changes in volatility can greatly change \nthe price of any option. This is especially true for LEAPS, since a long-term option's \nprice will fluctuate greatly when volatility changes only a little. Some observations on \nthe differing effects that volatility changes have on short- and long-term options are \npresented later. \nChapter 25: LEAPS \nFIGURE 25-1. \nLEAPS call pricing curve. \n45 \n40 \n35 \nQ) 30 .g \no. 25 \n'lii U 20 \n15 \n10 \n5 \n, .... ,, \nVarious Expiration Dates \nStrike= 80 \n2 Years (LEAP) , ' \n' ,,,,' \n,, ,, \n,, ,, ,, \n\"' ,, ,, ,, ,, \n,,' ,, \n,. ,, ,, \n0 L----~==--..l.---..J£----1.---L----.I....--\n60 70 80 90 100 110 \nStock Price \n371 \nBefore that discussion, however, it may be beneficial to examine the effects that \ninterest rates and dividends can have on LEAPS. These effects are much, much \ngreater than those on conventional equity options. Recall that it was stated that inter\nest rates and dividends are minor determinants in the price of an option, unless the \ndividends were large. That statement pertains mostly to short-term options. For \nlonger-term options such as LEAPS, the cumulative effect of an interest rate or div\nidend over such a long period of time can have a magnified effect in terms of the \nabsolute price of the option. \nFigure 25-2 presents the option pricing curve again, but the only option depict\ned is a 2-year LEAPS. The striking price is 100, and the straight line at the right \ndepicts the intrinsic value of the LEAPS. The three curves represent option prices \nfor risk-free interest rates of 3%, 6%, and 9%. All other factors (time to expiration, \nvolatility, and dividends) are fixed. The difference between option prices caused \nmerely by a shift in rates of 3% is very large. \nThe difference in LEAPS prices increases as the LEAPS becomes in-the\nmoney. Note that in this figure, the distance between the curves gets wider as one \nscans them from left to right. The price difference for out-of-the-money LEAPS is \nlarge enough- nearly a point even for options fairly far out-of-the-money (that is, the \npoints on the left-hand side of the graph). A shift of 3% in rates causes a larger price \ndifference of over 2 points in the at-the-money, 2-year LEAPS. The largest differen\ntial in option prices occurs in-the-rrwney ! This may seem somewhat illogical, but \nwhen LEAPS strategies are examined later, the reasons for this will become clear. \n372 Part Ill: Put Option Strategies \nSuffice it to say that the in-the-money LEAPS are changed in price by over 4 points \nwhen rates change by 3%. That is a monstrous differential and should cause any trad\ner who is considering trading in-the-money LEAPS to consider what his outlook is \nfor short-term interest rates. \nThere is always a substantial probability that rates can change by 3% in two \nyears. Thus, it is difficult to predict with any certainty what risk-free rate to use in the \npricing of two-year LEAPS. Moreover, one should be very careful when deciding \nLEAPS are \"cheap\" or \"expensive\" because, conventionally, the short-term interest \nrate is not usually considered as a significant factor in making such an analysis. For \nLEAPS, however, Figure 25-2 is obvious proof that interest rate considerations are \nimportant for LEAPS traders. \nNow consider dividends. Figure 25-3 depicts the prices of two-year LEAPS \ncalls. The three curves on the graph are for different dividend rates - the top line \nrepresenting the current rate, the middle line representing prices if the dividend \nwere raised by $1 annually, and the bottom line showing what prices would be if \nthe dividend were raised by $2 annually. All other factors (volatility, time remain\ning, and risk-free interest rates) are the same for each curve in this graph. The \nincrease in dividends manifests itself by decreasing the LEAPS call price. The rea\nson that this is true, of", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 167}
{"text": "line representing prices if the dividend \nwere raised by $1 annually, and the bottom line showing what prices would be if \nthe dividend were raised by $2 annually. All other factors (volatility, time remain\ning, and risk-free interest rates) are the same for each curve in this graph. The \nincrease in dividends manifests itself by decreasing the LEAPS call price. The rea\nson that this is true, of course, is that the stock will be reduced in price more when \nit goes ex-dividend by the larger amounts of the increased dividends. \nFIGURE 25-2. \n2-year LEAPS call pricing curve, interest rate comparison. \n35 \n30 \n25 \nQ) \n(.) \n~ 20 \nC: \n0 \na 15 0 \n10 \n5 \nStock Price \nChapter 25: LEAPS \nFIGURE 25-3. \nLEAPS call pricing curve as dividends increase. \n30 \n25 \n(I) \n.g 20 \n0.. \nC: \n:g_ 15 \n0 \n10 \n5 \n0 \n70 80 90 100 \nStock Price \nWith \nCurrent \nDividend \n110 \n373 \nDividend \n)> Increases \n$1 \nT Increases \n$2 \n120 \nThe actual amount that the LEAPS calls lose in price increases slightly as the \ncall is more in-the-money. That is, the curves are closer together on the left-hand \n(out-of-the-money) side than they are on the right-hand (in-the-money) side. For the \nin-the-money call, a $1 increase in dividends over two years can cause the LEAPS to \nbe worth about 1 ½ points less in value. \nFigure 25-3 is to the same scale as Figure 25-2, so they can be compared direct\nly in terms of magnitude. Notice that the effect of a $1 increase in dividends on the \nLEAPS call prices is much smaller than that of an increase in interest rates by 3%. \nGraphically speaking, one can observe this by noting that the spaces between the \nthree curves in the previous figure are much wider than the spaces between the three \ncurves in this figure. \nFinally, note that dividend increases have the opposite effect on puts. That is, \nan increase in the dividend payout of the underlying common will cause a put to \nincrease in price. If the put is a long-term LEAPS put, then the effect of the increase \nwill be even larger. \nLest one think that LEAPS are too difficult to price objectively, note the follow\ning. The prior figures of interest rate and dividend effects tend to magnify the effects \non LEAPS prices for two reasons. First, they depict the effects on 2-year LEAPS. That \nis a large amount of life for LEAPS. Many LEAPS have less life remaining, so the \neffects would be diminished somewhat for LEAPS with 10 to 23 months of life left. \n374 Part Ill: Put Option Strategies \nSecond, the figures depict the change in rates or dividends as being instantaneous. \nThis is not completely realistic. If rates change, they will change by a little bit at a time, \nusually¼% or½% at a time, perhaps as much as 1 %. If dividends are increased, that \nincrease may be instantaneous, but it will not likely occur immediately after the \nLEAPS are purchased or sold. However, the point that these figures are meant to con\nvey is that interest rates and dividends have a much greater effect on LEAPS than on \nordinary shorter-term equity options, and that is certainly a true statement. \nCOMPARING LEAPS AND SHORT-TERM OPTIONS \nTable 25-1 will help to illustrate the problem in valuing LEAPS, either mentally or \nwith a model. All of the variables - stock price, volatility, interest rates, and dividends \n- are given in increments and the comparison is shown between 3-month equity \noptions and 2-year LEAPS. There are three sets of comparisons: for options 20% out\nof-the-money, options at-the-money, and options 20% in-the-money. \nA few words are needed here to explain how volatility is shown in this table. \nVolatility is normally expressed as a percent. The volatility of the stock market is \nabout 15%. The table shows what would happen if volatility changed by one per\ncentage point, to 16%, for example. Of course, the table also shows what would hap\npen if the other factors changed by a small amount. \nMost of the discrepancies between the 3-month and the 2-year options are \nlarge. For example, if volatility increases by one percentage point, the 3-month out\nof-the-money call will increase in price by only 3 cents (0.03 in the left-hand column) \nwhile the 2-year LEAPS call will increase by 43 cents. As another example, look at \nthe bottom right-hand pair of numbers, which show the effect of a dividend increase \non the options that are 20% in-the-money. The assumption is that the dividend will \nincrease 25 cents this quarter (and will be 25 cents higher every quarter thereafter). \nThis translates into a loss of 14 cents for the 3-month call, since there is only one ex\ndividend period that affects this call; but it translates into a loss of 1 ½ for the 2-year \nLEAPS, since the stock will go ex-dividend by an extra $2 over the life of that call. \nTABLE 25-1. \nComparing LEAPS and Short-Term Calls. \nChange in Price of the Options \n20% out at 20% in \nVariable Increment 3-mo. 2-yr. 3-mo. 2-yr. 3-mo. 2-yr . \nStock Pre. + 1 pt . 03 .41 .54 .70 .97 .89 \nVolatility + 1% .03 .43 .21 .48 .04 .33 \nInt. Rate + 1/2% .01 .27 .08 .55 .14 .72 \nDividend + $.25/qtr 0 -.62 -.08 -1.18 -.14 -1.50 \nChapter 25: LEAPS 375 \nThe table also shows that only three of the discrepancies are not large. Two \ninvolve the stock price change. If the stock changes in price by 1 point, neither the at\nthe-money nor the in-the-money options behave very differently, although the at-the\nmoney LEAPS do jump by 70 cents. The observant reader will notice that the top line \nof the table depicts the delta of the options in question; it shows the change in option \nprice for a one-point change in stock price. The only other comparison that is not \nextremely divergent is that of volatility change for the at-the-money option. The 3-\nmonth call changes by 21 cents while the LEAPS changes by nearly ½ point. This is \nstill a factor of two-to-one, but is much less than the other comparisons in the table. \nStudy the other comparisons in the table. The trader who is used to dealing with \nshort-term options might ordinarily ignor", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 168}
{"text": "arison that is not \nextremely divergent is that of volatility change for the at-the-money option. The 3-\nmonth call changes by 21 cents while the LEAPS changes by nearly ½ point. This is \nstill a factor of two-to-one, but is much less than the other comparisons in the table. \nStudy the other comparisons in the table. The trader who is used to dealing with \nshort-term options might ordinarily ignore the effect of a rise in interest rates of ½ \nof 1 %, of a 25-cent increase in the quarterly dividend, of the volatility increasing by \na mere 1 %, or maybe even of the stock moving by one point (only if his option is out\nof-the-money). The LEAPS option trader will gain or suffer substantially and imme\ndiately if any of these occur. In almost every case, his LEAPS call will gain or lose ½ \npoint of value - a significant amount, to be sure. \nLEAPS STRATEGIES \nMany of the strategies involving LEAPS are not significantly different from their \ncounterparts that involve short-term options. However, as shown earlier, the long\nterm nature of the LEAPS can sometimes cause the strategist to experience a result \ndifferent from that to which he has become accustomed. \nAs a general rule, one would want to be a buyer of LEAPS when interest rates \nwere low and when the volatilities being implied in the marketplace are low. If the \nopposite were true (high rates and high volatilities), he would lean toward strategies \nin which the sale of LEAPS is used. Of course, there are many other specific consid\nerations when it comes to operating a strategy, but since the long-term nature of \nLEAPS exposes one to interest rate and volatility movements for such a long time, \none may as well attempt to position himself favorably with respect to those two ele\nments when he enters a position. \nLEAPS AS STOCK SUBSTITUTE \nAny in-the-money option can be used as a substitute for the underlying stock. Stock \nowners may be able to substitute a long in-the-money call for their long stock. Short \nsellers of stock may be able to substitute a long put for their short stock. This is not \na new idea; it was discussed briefly in Chapter 3 under reasons why people buy calls. \nIt has been available as a strategy for some time with short-term options. Its attrac\ntiveness seems to have increased somewhat with the introduction of LEAPS, howev-\n374 Part Ill: Put Option Strategies \nSecond, the figures depict the change in rates or dividends as being instantaneous. \nThis is not completely realistic. If rates change, they will change by a little bit at a time, \nusually¼% or ½% at a time, perhaps as much as 1 %. If dividends are increased, that \nincrease may be instantaneous, but it will not likely occur immediately after the \nLEAPS are purchased or sold. However, the point that these figures are meant to con\nvey is that interest rates and dividends have a much greater effect on LEAPS than on \nordinary shorter-term equity options, and that is certainly a true statement. \nCOMPARING LEAPS AND SHORT-TERM OPTIONS \nTable 25-1 will help to illustrate the problem in valuing LEAPS, either mentally or \nwith a model. All of the variables - stock price, volatility, interest rates, and dividends \n- are given in increments and the comparison is shown between 3-month equity \noptions and 2-year LEAPS. There are three sets of comparisons: for options 20% out\nof-the-money, options at-the-money, and options 20% in-the-money. \nA few words are needed here to explain how volatility is shown in this table. \nVolatility is normally expressed as a percent. The volatility of the stock market is \nabout 15%. The table shows what would happen if volatility changed by one per\ncentage point, to 16%, for example. Of course, the table also shows what would hap\npen if the other factors changed by a small amount. \nMost of the discrepancies between the 3-month and the 2-year options are \nlarge. For example, if volatility increases by one percentage point, the 3-month out\nof-the-money call will increase in price by only 3 cents (0.03 in the left-hand column) \nwhile the 2-year LEAPS call will increase by 43 cents. As another example, look at \nthe bottom right-hand pair of numbers, which show the effect of a dividend increase \non the options that are 20% in-the-money. The assumption is that the dividend will \nincrease 25 cents this quarter ( and will be 25 cents higher every quarter thereafter). \nThis translates into a loss of 14 cents for the 3-month call, since there is only one ex\ndividend period that affects this call; but it translates into a loss of 1 ½ for the 2-year \nLEAPS, since the stock will go ex-dividend by an extra $2 over the life of that call. \nTABLE 25-1. \nComparing LEAPS and Short-Term Calls. \nChange in Price of the Options \n20% out al 20% in \nVariable Increment 3-mo. 2-yr. 3-mo. 2-yr. 3-mo. 2-yr. \nStock Pre. + 1 pt .03 .41 .54 .70 .97 .89 \nVolatility + 1% .03 .43 .21 .48 .04 .33 \nInt. Rate + 1/2% .01 .27 .08 .55 .14 .72 \nDividend + $.25/qtr 0 -.62 -.08 - l.18 -.14 -1.50 \nChapter 25: LEAPS 375 \nThe table also shows that only three of the discrepancies are not large. Two \ninvolve the stock price change. If the stock changes in price by 1 point, neither the at\nthe-money nor the in-the-money options behave very differently, although the at-the\nmoney LEAPS do jump by 70 cents. The observant reader will notice that the top line \nof the table depicts the delta of the options in question; it shows the change in option \nprice for a one-point change in stock price. The only other comparison that is not \nextremely divergent is that of volatility change for the at-the-money option. The 3-\nmonth call changes by 21 cents while the LEAPS changes by nearly ½ point. This is \nstill a factor of two-to-one, but is much less than the other comparisons in the table. \nStudy the other comparisons in the table. The trader who is used to dealing with \nshort-term options might ordinarily ignore the effect of a rise in interest rates of½ \nof 1 %, of a 25-cent increase in the quarterly dividend", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 169}
{"text": "3-\nmonth call changes by 21 cents while the LEAPS changes by nearly ½ point. This is \nstill a factor of two-to-one, but is much less than the other comparisons in the table. \nStudy the other comparisons in the table. The trader who is used to dealing with \nshort-term options might ordinarily ignore the effect of a rise in interest rates of½ \nof 1 %, of a 25-cent increase in the quarterly dividend, of the volatility increasing by \na mere 1 %; or maybe even of the stock moving by one point (only if his option is out\nof-the-money). The LEAPS option trader will gain or suffer substantially and imme\ndiately if any of these occur. In almost every case, his LEAPS call will gain or lose ½ \npoint of value - a significant amount, to be sure. \nLEAPS STRATEGIES \nMany of the strategies involving LEAPS are not significantly different from their \ncounterparts that involve short-term options. However, as shown earlier, the long\nterm nature of the LEAPS can sometimes cause the strategist to experience a result \ndifferent from that to which he has become accustomed. \nAs a general rule, one would want to be a buyer of LEAPS when interest rates \nwere low and when the volatilities being implied in the marketplace are low. If the \nopposite were true (high rates and high volatilities), he would lean toward strategies \nin which the sale of LEAPS is used. Of course, there are many other specific consid\nerations when it comes to operating a strategy, but since the long-term nature of \nLEAPS exposes one to interest rate and volatility movements for such a long time, \none may as well attempt to position himself favorably with respect to those two ele\nments when he enters a position. \nLEAPS AS STOCK SUBSTITUTE \nAny in-the-money option can be used as a substitute for the underlying stock. Stock \nowners may be able to substitute a long in-the-money call for their long stock. Short \nsellers of stock may be able to substitute a long put for their short stock. This is not \na new idea; it was discussed briefly in Chapter 3 under reasons why people buy calls. \nIt has been available as a strategy for some time with short-term options. Its attrac\ntiveness seems to have increased somewhat with the introduction of LEAPS, howev-\n376 Part Ill: Put Option Strategies \ner. More and more people are examining the potential of selling the stock they own \nand buying long-term calls (LEAPS) as a substitute, or buying LEAPS instead of \nmaking an initial purchase in a particular common stock. \nSubstitution for Stock Currently Held Long. Simplistically, this strate\ngy involves this line of thinking: If one owns stock and sells it, an investor could rein\nvest a small portion of the proceeds in a call option, thereby providing continued \nupside profit potential if the stock rises in price, and invest the rest in a bank to earn \ninterest. The interest earned would act as a substitute for the dividend, if any, to \nwhich the investor is no longer entitled. Moreover, he has less downside risk: If the \nstock should fall dramatically, his loss is limited to the initial cost of the call. \nIn actual practice, one should carefully calculate what he is getting and what he \nis giving up. For example, is the loss of the dividend too great to be compensated for \nby the investment of the excess proceeds? How much of the potential gain will be \nwasted in the form of time value premium paid for the call? The costs to the stock \nowner who decides to switch into call options as a substitute are commissions, the \ntime value premium of the call, and the loss of dividends. The benefits are the inter\nest that can be earned from freeing up a substantial portion of his funds, plus the fact \nthat there is less downside risk in owning the call than in owning the stock. \nExample: XYZ is selling at 50. There are one-year LEAPS with a striking price of 40 \nthat sell for $12. XYZ pays an annual dividend of $0.50 and short-term interest rates \nare 5%. What are the economics that an owner of 100 XYZ common stock must cal\nculate in order to determine whether it is viable to sell his stock and buy the one-year \nLEAPS as a substitute? \nThe call has time value premium of 2 points (40 + 12 - 50). Moreover, if the \nstock is sold and the LEAPS purchased, a credit of $3,800 less commissions would \nbe generated. First, calculate the net credit generated: \nCredit balance generated: \nSale of 1 00 XYZ stock \nLess stock commission \nNet sale proceeds: \nCost of one LEAPS call \nPlus option commission \nNet cost of call: \nTotal credit balance: \n$5,000 \n25 \n$4,975 credit \n$3,760 credit \n$1,200 \n15 \n$1,215 debit \nNow the costs and benefits of making the switch can be computed: \nChapter 25: LEAPS \nCosts of switching: \nTime value premium \nLoss of dividend \nStock commissions \nOption commissions \nTotal cost: \nFixed benefit from switching: \nInterest earned on \ncredit balance of $3,760 \nat 5% interest for one year= 0.05 x $3,760: \nNet cost of switching: \n317 \n-$200 \n-$ 50 \n-$ 25 \n- .l__Ll_ \n-$290 \n+ $188 \n- $102 \nThe stock owner must now decide if it is worth just over $1 per share in order \nto have his downside risk limited to a price of 39½ over the next year. The price of \n39½ as his downside risk is merely the amount of the net credit he received from \ndoing the switch ($3,760) plus the interest earned ($188), expressed in per-share \nterms. That is, if XYZ falls dramatically over the next year and the LEAPS expires \nworthless, this investor will still have $3,948 in a bank account. That is equivalent to \nlimiting his risk to about 39½ on the original 100 shares. \nIf the investor decides to make the substitution, he should invest the proceeds \nfrom the sale in a 1-year CD or Treasury bill, for two reasons. First, he locks in the \ncurrent rate - the one used in his calculations - for the year. Second, he is not tempt\ned to use the money for something else, an action that might negate the potential \nbenefits of the substitution. \nThe above calculations all assume that the LEAPS call or the stock", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 170}
{"text": "bstitution, he should invest the proceeds \nfrom the sale in a 1-year CD or Treasury bill, for two reasons. First, he locks in the \ncurrent rate - the one used in his calculations - for the year. Second, he is not tempt\ned to use the money for something else, an action that might negate the potential \nbenefits of the substitution. \nThe above calculations all assume that the LEAPS call or the stock would have \nbeen held for the full year. If that is known not to be the case, the appropriate costs \nor benefits must be recalculated. \nCaveats. This ($102) seems like a reasonably small price to pay to make the switch \nfrom common stock to call ownership. However, if the investor were planning to sell \nthe stock before it fell to 39½ in any case, he might not feel the need to pay for this \nprotection. (Be aware, however, that he could accomplish essentially the same thing, \nsince he can sell his LEAPS call whenever he wants to.) Moreover, when the year is \nup, he will have to pay another stock commission to repurchase his XYZ common if \nhe still wants to own it ( or he will have to pay two option commissions to roll his long \ncall out to a later expiration date). One other detriment that might exist, although a \nrelatively unlikely one, is that the underlying common might declare an increased \ndividend or, even worse, a special cash dividend. The LEAPS call owner would not \nbe entitled to that dividend increase in whatever form, while, obviously, the common \n378 Part Ill: Put Option Strategies \nstock owner would have been. If the company declared a stock dividend, it would \nhave no effect on this strategy since the call owner is entitled to those. A change in \ninterest rates is not a factor either, since the owner of the LEAPS should invest in a \n1-year Treasury bill or a 1-year CD and therefore would not be subject to interim \nchanges in short-term interest rates. \nThere may be other mitigating circumstances. Mostly these would involve tax \nconsiderations. If the stock is currently a profitable investment, the sale would gen\nerate a capital gain, and taxes might be owed. If the stock is currently being held at \na loss, the purchase of the call would constitute a wash sale and the loss could not be \ntaken at this time. (See Chapter 41 on taxes for a broader discussion of the wash sale \nrule and option trading.) \nIn tl1eory, the calculations above could produce an overall credit, in which case the \nstockholder W(?uld normally want to substitute with the call, unless he has overriding tax \nconsiderations or suspects that a cash dividend increase is going to be announced. Be \nvery careful about switching if this situation should arise. Normally, arbitrageurs - per\nsons trading for exchange members and paying no commission - would take advantage \nof such a situation before the general public could. If they are letting the opportunity \npass by, there must be a reason (probably the cash dividend), so be extremely certain of \nyour economics and research before venturing into such a situation. \nIn summary, holders of common stock on which there exist in-the-money \nLEAPS should evaluate the economics of substituting the LEAPS call for the com\nmon stock. Even if arithmetic calculations call for the substitution, the stockholder \nshould consider his tax situation as well as his outlook for the cash dividends to be \npaid by the common before making the switch. \nBUYING LEAPS AS THE INITIAL PURCHASE \nINSTEAD OF BUYING A COMMON STOCK \nLogic similar to that used earlier to determine whether a stockholder might want to \nsubstitute a LEAPS call for his stock can be used by a prospective purchaser of com\nmon stock. In other words, this investor does not already own the common. He is \ngoing to buy it. This prospective purchaser might want to buy a LEAPS call and put \nthe rest of the money he had planned to use in the bank, instead of actually buying \nthe stock itself. \nHis costs - real and opportunity - are calculated in a similar manner to those \nexpressed earlier. The only real difference is that he has to spend the stock commis\nsion in this case, whereas he did not in the previous example (since he already owned \nthe stock). \nChapter 25: LEAPS 379 \nExample: As before, XYZ is selling at 50; there are 1-year LEAPS with a striking \nprice of 40 that sell for $12; XYZ pays an annual dividend of $0.50, and short-term \ninterest rates are 5%. \nThe initial purchaser of common stock would have certain \"opportunity\" costs \nand savings if he decided instead to buy the LEAPS calls. First, calculate the differ\nence in investment required for the stock versus the LEAPS: \nCosts: \nProspective initial investment: \nStock: $5,000 + $25 commission \nLEAPS: $1,200 + $15 commission \nNet difference: \nNow calculate the costs versus the savings: \nTime value premium \nLoss of dividend \nSavings: \nInterest on $3, 810 for one year at 5%: \nNet opportunity cost: \n$5,025 \n$1,215 \n$3,810 \n-$200 \n-$ 50 \n+$190 \n-$ 60 \nIn this case, it seems even more likely that the prospective stock purchaser \nwould instead buy the LEAPS call. His net \"cost\" of doing so, provided he puts the \ndifference in initial investment in a 1-year CD or Treasury bill, is only $60. For this \nsmall amount, he has all the upside appreciation ( except $60 worth), but has risk only \ndown to 40 (he will have $4,000 in his bank account at the end of one year even if the \nLEAPS expire worthless). \nThis strategy of buying in-the-money LEAPS and putting the difference \nbetween the LEAPS cost and the stock cost in an interest-bearing instrument is an \nattractive one. It might seem it would be especially attractive if interest rates for the \ndifferential were high. Unfortunately, those high rates would present something of a \ncatch-22 because, as was shown earlier, higher rates will cause the LEAPS to be more \nexpensive. \nIn this margin strategy, one has the risk of not participating in cash dividend \nincreases or specials as the stockholder who substitutes does. But the other concerns", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 171}
{"text": "especially attractive if interest rates for the \ndifferential were high. Unfortunately, those high rates would present something of a \ncatch-22 because, as was shown earlier, higher rates will cause the LEAPS to be more \nexpensive. \nIn this margin strategy, one has the risk of not participating in cash dividend \nincreases or specials as the stockholder who substitutes does. But the other concerns \nof the stockholder, such as taxes, are not pertinent here. Again, these specific calcu\nlations only apply if the stock were to be held for the entire year. Adjustments would \nhave to be made if the holding period envisioned is shorter. \n380 Part Ill: Put Option Strategies \nUsing Margin. The same prospective initial purchaser of common stock might \nhave been contemplating the purchase of the stock on margin. If he used the LEAPS \ninstead, he could save the margin interest. Of course, he wouldn't have as much \nmoney to put in the bank, but he should also compare his costs against those of buy\ning the LEAPS call instead. \nExample: As before, XYZ is selling at 50; there are 1-year LEAPS with a striking \nprice of 40 that sell for $12; XYZ pays an annual dividend of $0.50; and short-term \ninterest rates are 5%. Furthermore, assume the margin rate is 8% on borrowed debit \nbalances. \nFirst, calculate the difference in prospective investments: \nCost of buying the stock: \n$5,000 + $25 commission: \nAmount borrowed (50%) \nEquity required \nCost of buying LEAPS: \n$1,200 + $15 commission: \nDifference (available to be placed in bank account) \n$5,025 \n-2,512 \n$2,513 \n$1,215 \n$1,298 \nNow the costs and opportunities can be compared, if it is assumed that he buys \nthe LEAPS: \nCosts: \nTime value premium \nDividend loss \nSavings: \nInterest on $1,298 at 5% \nMargin interest on $2,512 debit balance at 8% for one year \nNet Savings: \n-$200 \n- 50 \n+$ 65 \n+ 201 \n+$ 16 \nFor the prospective margin buyer, there is a real savings in this example. The \nfact that he does not have to pay the margin interest on his debit balance makes the \npurchase of the LEAPS call a cost-saving alternative. Finally, it should be noted that \ncurrent margin rules allow one to purchase a LEAPS option on margin. That can be \naccounted for in the above calculations as well; merely reduce the investment \nrequired and increase the margin charges on the debit balance. \nChapter 25: LEAPS 381 \nIn summary, a prospective purchaser of common stock may often find that if \nthere is an in-the-money option available, the purchase of that option is more attrac\ntive than buying the common stock itself. If he were planning to buy on margin, it is \neven more likely that the LEAPS purchase will be attractive. The main drawback is \nthat he will not participate if cash dividends are increased or a special dividend is \ndeclared. Read on, however, because the next strategy may be better than the one \nabove. \nPROTECTING EXISTING STOCK HOLDINGS WITH LEAPS PUTS \nWhat was accomplished in the substitution strategy previously discussed? The stock \nowner paid some cost ($102 in the actual example) in order to limit the risk of his \nstock ownership to a price of 39½. What if he had bought a LEAPS put instead? \nForgetting the price of the put for a moment, concentrate on what the strategy would \naccomplish. He would be protected from a large loss on the downside since he owns \nthe put, and he could participate in upside appreciation since he still owns the stock. \nIsn't this what the substitution strategy was trying to accomplish? Yes, it is. In this \nstrategy, only one commission is paid- that being on a fairly cheap out-of-the-money \nLEAPS put - and there is no risk of losing out on dividend increases or special divi\ndends. \nThe comparison between substituting a call or buying a put is a relatively sim\nple one. First, do the calculations as they were performed in the initial example \nabove. That example showed that the stockholder's cost would be $102 to substitute \nthe LEAPS call for the stock, and such a substitution would protect him at a price of \n39½. In effect, he is paying $152 for a LEAPS put with a strike of 40- the $102 cost \nplus the difference between 40 and the 39½ protection price. Now, if an XYZ 1-year \nLEAPS put with strike 40 were available at 1 ½, he could accomplish everything he \nhad initially wanted merely by buying the put. \nMoreover, he would save commissions and still be in a position to participate \nin increased cash dividends. These additional benefits should make the put worth \neven more to the stockholder, so that he might pay even slightly more than 1 ½ for \nthe put. If the LEAPS put were available at this price, it would clearly be the bet\nter choice and should be bought instead of substituting the LEAPS call for the com\nmon stock. \nThus, any stockholder who is thinking of protecting his position can do it in one \nof two ways: Sell the stock and substitute a call, or continue to hold his stock and buy \na put to protect it. LEAPS calls and puts are amenable to this strategy. Because of \nthe LEAPS' long-term nature, one does not have to keep reestablishing his position \nand pay numerous commissions, as he would with short-term options. The stock\nholder should perform the simple calculations as shown above in order to decide \n382 Part Ill: Put Option Strategies \nwhether the move is feasible at all, and if it is, whether to use the call substitution \nstrategy or the put protection strategy. \nLEAPS INSTEAD OF SHORT STOCK \nJust as in-the-money LEAPS calls may sometimes be a smarter purchase than the \nstock itself, in-the-money puts may sometimes be a better purchase than shorting the \ncommon stock. Recall that either the put purchase or the short sale of stock is a bear\nish strategy, generally implemented by someone who expects the stock to decline in \nprice. The strategist knows, however, that short stock is a component of many strate\ngies and might reflect other opinions than pure bearishness on the common. In any \ncase, an in-the-money put may prove to", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 172}
{"text": "ase than shorting the \ncommon stock. Recall that either the put purchase or the short sale of stock is a bear\nish strategy, generally implemented by someone who expects the stock to decline in \nprice. The strategist knows, however, that short stock is a component of many strate\ngies and might reflect other opinions than pure bearishness on the common. In any \ncase, an in-the-money put may prove to be a viable substitute for shorting the stock \nitself. The two main advantages that the put owner has are that he has limited risk \n(whereas the short seller of stock has theoretically unlimited risk); and he does not \nhave to pay out any dividends on the underlying stock as the short seller would. Also, \nthe commissions for buying the put would normally be smaller than those required \nto sell the stock short. \nThere is not much in the way of calculating that needs to be done in order to \nmake the comparison between buying the in-the-money put and shorting the stock. \nIf the time value premium spent is small in comparison \\vith the dividend payout that \nis saved, then the put is probably the better choice. \nProfessional arbitrageurs and other exchange members, as well as some large \ncustomers, receive interest on their short sales. For these traders, the put would have \nto be trading with virtually no time premium at all in order for the comparison to \nfavor the put purchase over the stock short sale. However, the public customer who \nis going to be shorting stock should be aware of the potential for buying an in-the\nmoney put instead. \nSPECULATIVE OPTION BUYING WITH LEAPS \nStrategists know that buying calls and puts can have various applications; witness the \nstock substitution strntegies above. However, the most popular reason for buying \noptions is for speculative gain. The leverage inherent in owning options and their lim\nited risk feature make them attractive for this purpose as well. The risk, of course, \ncan be 100% of the investment, and time decay works against the option owner as \nwell. LEAPS calls and puts fit all of these descriptions; they simply have longer matu\nrities. \nTime decay is the major enemy of the speculative option holder. Purchasing \nLEAPS options instead of the shorter-term equity options generally exposes the \nChapter 25: LEAPS 383 \nbuyer to less risk of time decay on a daily basis. This is true because the extreme neg\native effects of time decay magnify as the option approaches its expiration. Recall that \nit was shown in Chapter 3 that time decay is not linear: An option decays more rap\nidly at the end of its life than at the beginning. Eventually, a LEAPS put or call will \nbecome a normal short-term equity option and time will begin to take a more rapid \ntoll. But in the beginning of the life of LEAPS, there is so much time remaining that \nthe short-term decay is not large in terms of price. \nTable 25-2 and Figure 25-4 depict the rate of decay of two options: one is at\nthe-money (the lower curve) and the other is 20% out-of-the-money (the upper \ncurve). The horizontal axis is months of life remaining until expiration. The vertical \naxis is the percent of the option price that is lost daily due to time decay. The options \nthat qualify as LEAPS are ones with more than 9 months oflife remaining, and would \nthus be the ones on the lower right-hand part of the graph. \nThe upward-sloping nature of both curves as time to expiration wanes shows \nthat time decay increases more rapidly as expiration approaches. Notice how much \nmore rapidly the out-of-the-money option decays, percentagewise, than the at-the\nmoney. LEAPS, however, do not decay much at all compared to normal equity \noptions. Most LEAPS, even the out-of-the-money ones, lose less than¼ of one per\ncent of their value daily. This is a pittance when compared with a 6-month equity \noption that is 20% out-of-the-money- that option loses well over 1 % of its value daily \nand it still has 6 months of life remaining. \nFrom the accompanying table, observe that the out-of-the-money 2-month \noption loses over 4% of its value daily! \nThus, LEAPS do not decay at a rapid rate. This gives the LEAPS holder a \nchance to have his opinion about the stock price work for him without having to \nworry as much about the passage of time as the average equity option holder would. \nAn advantage of owning LEAPS, therefore, is that one's timing of the option pur\nchase does not have to be as exact as that for shorter-term option buying. This can be \na great psychological advantage as well as a strategic advantage. The LEAPS option \nbuyer who feels strongly that the stock will move in the desired direction has the lux\nury of being able to wait calmly for the anticipated move to take place. If it does not, \neven in perhaps as long as 6 months' time, he may still be able to recoup a reason\nable portion of his initial purchase price because of the slow percentage rate of decay. \nDo not be deluded into believing that LEAPS don't decay at all. Although the \nrate of decay is slow (as shown previously), an option that is losing 0.15% of its value \ndaily will still lose about 25% of its value in six months. \nExample: XYZ is at 60 and there are 18-month LEAPS calls selling for $8, with a \nstriking price of 60. The daily decay of this call with respect to time will be minus-\n384 \nTABLE 25-2. \nDaily percent time value decay. \nMonths remaining At-the-money \n24 .12 \n18 .14 \n12 .19 \n9 .22 \n6 .27 \n3 .60 \n2 .73 \n1.27 \n2 wks 3.33 \nFIGURE 25-4. \nDaily percent time value decay. \n125 \n100 \n20% Out-of-the-Money \n0 \n0 \n~ \n~ 75 -\n~ \n0 \nc @ 50 \n8: \n25 \n0 \n3 \nAt-the-Money \n6 9 12 15 \nPart Ill: Put Option Strategies \nPercent Decay \n20% Out-of-the-money \n.18 \n.27 \n.55 \n.76 \n1.18 \n3.57 \n4.43 \nLEAPS \n18 21 24 \nMonths Remaining \ncule; it will take about a week for even an eighth of a point to be lost due to time. \nHowever, if the option is held for six months and nothing else happens, the LEAPS \ncall will be selling for about 6. Thus, it will have lost 25% of its value i", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 173}
{"text": "6 9 12 15 \nPart Ill: Put Option Strategies \nPercent Decay \n20% Out-of-the-money \n.18 \n.27 \n.55 \n.76 \n1.18 \n3.57 \n4.43 \nLEAPS \n18 21 24 \nMonths Remaining \ncule; it will take about a week for even an eighth of a point to be lost due to time. \nHowever, if the option is held for six months and nothing else happens, the LEAPS \ncall will be selling for about 6. Thus, it will have lost 25% of its value if the stock \nremains around 60 at the end of six months. \nChapter 25: LEAPS 385 \nThose familiar with holding equity calls and puts are more accustomed to seeing \nan option lose 25% of its value in possibly as little as four or five weeks' time. Thus, the \nadvantage of holding the LEAPS is obvious from the viewpoint of slower time decay. \nThis observation leads to the obvious question: \"When is the best time to sell my \ncall and repurchase a longer-term one?\" Referring again to the figure above may help \nanswer the question. Note that for the at-the-money option, the curve begins to bend \ndramatically upward soon after the 6-month time barrier is passed. Thus, it seems log\nical that to minimize the effects of time decay, all other things being equal, one would \nsell his long at-the-money call when it has about 6 months of life left and simultane\nously buy a 2-year LEAPS call. This keeps his time decay exposure to a. minimum. \nThe out-of-the-money call is more radical. Figure 25-4 shows that the call that \nis 20% out-of-the-money begins to decay much more rapidly (percentagewise) at \nsometime just before it reaches one year until expiration. The same logic would dic\ntate, then, that if one is trading out-of-the-money options, he would sell his option \nheld long when it has about one year to go and reestablish his position by buying a 2-\nyear LEAPS option at the same time. \nADVANTAGES OF BUYING HCHEAP\" \nIt has been demonstrated that rising interest rates or rising volatility would make the \nprice of a LEAPS call increase. Therefore, if one is attempting to participate in \nLEAPS speculative call buying strategies, he should be more aggressive when rates \nand volatilities are low. \nA few sample prices may help to demonstrate just how powerful the effects of \nrates and volatilities are, and how they can be a friend to the LEAPS call buyer. Suppose \nthat one buys a 2-year LEAPS call at-the-money when the following situation exists: \nXYZ: 100 \nJanuary 2-year LEAPS call with strike of 100: 14 \nShort-term interest rates: 3% \nVolatility: below average (historically) \nFor the purposes of demonstration, suppose that the current volatility is low for XYZ \n(historically) and that 3% is a low level for rates as well. If the stock moves up, there \nis no problem, because the LEAPS call will increase in price. But what if the stock \ndrops or stays unchanged? Is all hope of a profit lost? Actually, no. If interest rates \nincrease or the volatility that the calls trade at increases, we know the LEAPS call will \nincrease in value as well. Thus, even though the direction in which the stock is mov\ning may be unfavorable, it might still be possible to salvage one's investment. Table \n25-3 shows where volatility would have to be or where short-term rates would have \n386 Part Ill: Put Option Strategies \nTABLE 25-3. \nFactors necessary for January 2-year LEAPS to be = 14. \nStock price After l month \n100 (unchanged) r = 3 .4% or \nV + 5% \n95 \n90 \nr = 6% or \nV + 20% \nr = 8.5% or \nV + 45% \nAfter 6 months \nr = 6% or \nV + 20% \nr = 9.4% or \nV + 45% \nr = 12.6% or \nV + 70% \nto go in order to keep the value of the LEAPS call at 14 even after the indicated \namount of time had expired. \nTo demonstrate the use of this table, suppose the stock price were 100 \n(unchanged) after one month. If interest rates had 1isen to 3.4% from their original \nlevel of 3% during that time, the call would still be worth 14 even though one month \nhad passed. Alternatively, if rates were the same, but volatility had increased by only \n5% from its original level, then the call would also still be worth 14. Note that this \nmeans that volatility would have to increase only slightly (by ½oth) from its original \nlevel, not by 5 percentage points. \nEven if the stock were to drop to 90 and six months had passed, the LEAPS call \nholder would still be even if rates had iisen to 12.6% (highly unlikely) or volatility had \nrisen by 70%. It is often possible for volatilities to fluctuate to that extent in six \nmonths, but not likely for interest rates. \nIn fact, as interest rates go, only the top line of the table probably represents \nrealistic interest rates; an increase of 0.4% in one month, or 3% in 6 months, is pos\nsible. The other lines, where the stock drops in price, probably require too large a \njump in rates for rates alone to be able to salvage the call price. However, any \nincrease in rates will be helpful. Volatility is another matter. It is often feasible for \nvolatilities to change by as much as 50% from their previous level in a month, and \ncertainly in six months. Hence, as has been stated before, the volatility factor is the \nmore dominant one. \nThis table shows the effect of rising interest rates and volatilities on LEAPS \ncalls. It would be beneficial to the LEAPS call owner and, of course, detrimental to \nthe LEAPS call seller. This is clear evidence that one should be aware of the gener\nal level of rates and volatility before using LEAPS options in a strategy. \nChapter 25: LEAPS \nTHE DELTA \n387 \nThe delta of an option is the amount by which the option price will change if the \nunderlying stock changes in price by one point. In an earlier section of this chapter, \ncomparing the differences between LEAPS and short-term calls, mention was made \nof delta. The subject is explored in more depth here because it is such an important \nconcept, not only for option buyers, but for most strategic decisions as well. \nFigure 25-5 depicts the deltas of two different options: 2-year LEAPS and 3-\nmonth equity options. Their terms are the same except for their expira", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 174}
{"text": "pter, \ncomparing the differences between LEAPS and short-term calls, mention was made \nof delta. The subject is explored in more depth here because it is such an important \nconcept, not only for option buyers, but for most strategic decisions as well. \nFigure 25-5 depicts the deltas of two different options: 2-year LEAPS and 3-\nmonth equity options. Their terms are the same except for their expiration dates; strik\ning price is 100, and volatility and interest rate assumptions are equal. The horizontal \naxis displays the stock price while the vertical axis shows the delta of the options. \nSeveral relevant observations can be made. First, notice that the delta of the at\nthe-money LEAPS is very large, nearly 0.70. This means that the LEAPS call will \nmove much more in line with the common stock than a comparable short-term equi\nty option would. Very short-term at-the-money options have deltas of about½, while \nslightly longer-term ones have deltas ranging up to the 0.55 to 0.60 area. What this \nimplies is that the longer the life of an at-the-nwney option, the greater its delta. \nIn addition, the figure shows that the deltas of the 3-month call and the 2-year \nLEAPS call are about equal when the options a~e approximately 5% in-the-money. If \nthe options are more in-the-money than that, then the LEAPS call has a lower delta. \nThis means that at- and out-of-the-money LEAPS will move more in line with the \ncommon stock than comparable short-term options will. Restated, the LEAPS calls \nwill move faster than the ordinary short-term equity calls unless both options are \nmore than 5% in-the-money. Note that the movement referred to is in absolute terms \nin change of price, not in percentage terms. \nThe delta of the 2-year LEAPS does not change as dramatically when the \nstock moves as does the delta of the 3-month option (see Figure 25-5). Notice that \nthe LEAPS curve is relatively flat on the chart, rising only slightly above horizon\ntal. In contrast, the delta of the 3-month call is very low out-of-the-money and very \nlarge in-the-money. What this means to the call buyer is that the amount by which \nhe can expect the LEAPS call to increase or decrease in price is somewhat stable. \nThis can affect his choice of whether to buy the in-the-money call or the out-of\nthe-money call. With normal short-term options, he can expect the in-the-money \ncall to much more closely mirror the movement in the stock, so he might be tempt\ned to buy that call if he expects a small movement in the stock. With LEAPS, how\never, there is much less discrepancy in the amount of option price movement that \nwill occur. \n388 Part Ill: Put Option Strategies \nFIGURE 25·5. \nCall delta comparison, 2-year LEAPS versus 3-month equity options. \n90 \n80 \n70 \n8 60 ,... \nX \n.l!l 50 \nQ) \n0 40 \n30 t= 3 months \n20 \n10 \nO 70 80 90 100 110 120 130 \nStock Price \nExample: XYZ is trading at 82. There are 3-month calls with strikes of 80 and 90, and \nthere are 2-year LEAPS calls at those strikes as well. The following table summarizes \nthe available information: \nXYZ: 82 Date: January, 2002 \nOption Price Delta \nApril ('02) 80 call 4 s/a \nApril ('02) 90 call i/a \nJanuary ('04) 80 LEAPS call 14 3/4 \nJanuary ('04) 90 LEAPS call 7 1/2 \nSuppose the trader expects a 3-point move by the underlying common stock, from 82 \nto 85. If he were analyzing short-term calls, he would see his potential as a gain of 17/s \nin the April 80 call versus a gain of 3/s in the April 90 call. Each of these gains is pro\njected by multiplying the call's delta times 3 (the expected stock move, in points). \nThus, there is a large difference between the expected gains from these two options, \nparticularly after commissions are considered. \nNow observe the LEAPS. The January 80 would increase by 2¼ while the \nJanuary 90 would increase by 1 ½ if XYZ moved higher by 3 points. This is not near\nly as large a discrepancy as the short-term options had. Observe that the January 90 \nLEAPS sells for half the price of the January 80. These movements projected by the \nChapter 25: LEAPS 389 \ndelta indicate that the January 90 LEAPS will move by a larger percentage than the \nJanuary 80 and therefore would be the better buy. \nPUT DELTAS \nMany of the previous observations regarding deltas of LEAPS calls can be applied to \nLEAPS puts as well. However, Figure 25-5 changes a little when the following for\nmula is applied. Recall that the relationship between put deltas and call deltas, except \nfor deeply in-the-money puts, is: \nPut delta = Call delta - 1 \nThis has the effect of inverting the relationships that have just been described. \nIn other words, while the short-term calls didn't move as fast as the LEAPS, the \nshort-term puts move Jaster than the LEAPS puts in most cases. Figure 25-6 shows \nthe deltas of these options. \nThe vertical axis shows the puts' delta. Notice that out-of-the-money LEAPS \nputs and short-term equity puts don't behave very differently in terms of price \nchange (bottom right-hand section of figure). \nIn-the-money puts (when the stock is below the striking price) move faster if \nthey are shorter-term. This fact is accentuated even more when the puts are more \ndeeply in-the-money. The left-hand side of the figure depicts this fact. \nFIGURE 25-6. \nPut delta comparison, 2-year LEAPS versus 3-month equity options. \n90 \n80 \n70 t= 3 months \n0 60 \n0 \n1 50 \nX \nJg 40 \nQ) \n0 \n30 \n20 \n10 \nO 70 80 90 100 110 120 130 \nStock Price \n388 Part Ill: Put Option Strategies \nFIGURE 25-5. \nCall delta comparison, 2-year LEAPS versus 3-month equity options. \n90 \n80 \n70 \ng 60 \n; 50 \n~ \nO 40 \n30 t= 3 months \n20 \n10 \nO 70 80 90 100 110 120 130 \nStock Price \nExample: XYZ is trading at 82. There are 3-month calls with strikes of 80 and 90, and \nthere are 2-year LEAPS calls at those strikes as well. The following table summarizes \nthe available information: \nXYZ: 82 Date: January, 2002 \nOption Price Delta \nApril ('02) 80 call 4 s/a \nApril ('02) 90 call 1 i/s \nJanuary ('04) 80 LEAPS call 14 3/4 \nJanu", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 175}
{"text": "nths \n20 \n10 \nO 70 80 90 100 110 120 130 \nStock Price \nExample: XYZ is trading at 82. There are 3-month calls with strikes of 80 and 90, and \nthere are 2-year LEAPS calls at those strikes as well. The following table summarizes \nthe available information: \nXYZ: 82 Date: January, 2002 \nOption Price Delta \nApril ('02) 80 call 4 s/a \nApril ('02) 90 call 1 i/s \nJanuary ('04) 80 LEAPS call 14 3/4 \nJanuary ('04) 90 LEAPS call 7 1/2 \nSuppose the trader expects a 3-point move by the underlying common stock, from 82 \nto 85. Ifhe were analyzing short-term calls, he would see his potential as a gain of F/s \nin the April 80 call versus a gain of 3/s in the April 90 call. Each of these gains is pro\njected by multiplying the call's delta times 3 (the expected stock move, in points). \nThus, there is a large difference behveen the expected gains from these two options, \nparticularly after commissions are considered. \nNow observe the LEAPS. The January 80 would increase by 2¼ while the \nJanuary 90 would increase by 1 ½ if XYZ moved higher by 3 points. This is not near\nly as large a discrepancy as the short-term options had. Observe that the January 90 \nLEAPS sells for half the price of the January 80. These movements projected by the \nChapter 25: LEAPS 389 \ndelta indicate that the January 90 LEAPS will move by a larger percentage than the \nJanuary 80 and therefore would be the better buy. \nPUT DELTAS \nMany of the previous observations regarding deltas of LEAPS calls can be applied to \nLEAPS puts as well. However, Figure 25-5 changes a little when the following for\nmula is applied. Recall that the relationship between put deltas and call deltas, except \nfor deeply in-the-money puts, is: \nPut delta = Call delta - 1 \nThis has the effect of inverting the relationships that have just been described. \nIn other words, while the short-term calls didn't move as fast as the LEAPS, the \nshort-term puts nwve fa,ster than the LEAPS puts in nwst cases. Figure 25-6 shows \nthe deltas of these options. \nThe vertical axis shows the puts' delta. Notice that out-of-the-money LEAPS \nputs and short-term equity puts don't behave very differently in terms of price \nchange (bottom right-hand section offigure). \nIn-the-money puts (when the stock is below the striking price) move faster if \nthey are shorter-term. This fact is accentuated even more when the puts are more \ndeeply in-the-money. The left-hand side of the figure depicts this fact. \nFIGURE 25-6. \nPut delta comparison, 2-year LEAPS versus 3-month equity options. \n90 \n80 \n70 t= 3 months \n0 60 \n0 \n1 50 \nX \nJg 40 \nQ) \n0 \n30 \n20 \n10 \nO 70 80 90 100 110 120 130 \nStock Price \n390 Part Ill: Put Option Strategies \nThe LEAPS put delta curve is flat, just as the call delta curve was. Moreover, \nthe delta is not very large anywhere across the figure. For example, at-the-money 2-\nyear LEAPS puts move only about 30 cents for a one-point move in the underlying \nstock. LEAPS put buyers who want to speculate on a stock's downward movement \nmust realize that the leverage factor is not large; it takes approximately a 3-point \nmove by the underlying common for an at-the-money LEAPS put to increase in \nvalue by one point. Long-term puts don't mirror stock movement nearly as well as \nshorter-term puts do. \nIn summary, the option buyer who is considering buying LEAPS puts or calls as \nspeculation should be aware of the different price action that LEAPS exhibit when \ncompared to shorter-term options. Due to the large amount of time that LEAPS have \nremaining in their lives, the time decay of the LEAPS options is smaller. For this rea\nson, the LEAPS option buyer doesn't need to be as precise in his timing. In general, \nLEAPS calls move faster when the underlying stock moves, and LEAPS puts move \nmore slowly. Other than that, the general reasons for speculative option buying apply \nto LEAPS as well: leverage and limited risk. \nSELLING LEAPS \nStrategies involving selling LEAPS options do not differ substantially from those \ninvolving shorter-term options. The discussions in this section concentrate on the two \nmajor differences that sellers of LEAPS will notice. First, the slow rate of time decay \nof LEAPS options means that option writers who are used to sitting back and watch\ning their written options waste away will not experience the same effect with LEAPS. \nSecond, follow-up action for writing strategies usually depends on being able to buy \nback the w1itten option when it has little or no time value premium remaining. Since \nLEAPS retain time value even when substantially in- or out-of-the-money, follow-up \naction involving LEAPS may involve the repurchase of substantial amounts of time \nvalue premium. \nCOVERED WRITING \nLEAPS options can be sold against underlying stock just as short-term options can. \nNo extra collateral or investment is required to do so. The resulting position is again \none with limited profit potential, but enhanced profitability (as compared to stock \nownership), if the underlying stock remains unchanged or falls. The maximum prof\nit potential of the covered write is reached whenever the underlying stock is at or \nabove the striking price of the written option at expiration. \nThe LEAPS covered writer takes in substantial premium, in terms of price, \nwhen he sells the long-term option. He should compare the return that he could \nChapter 25: LEAPS 391 \nmake from the LEAPS write with returns that can be made from repeatedly writing \nshorter-term calls. Of course, there is no guarantee that he will actually be able to \nrepeat the short-term writes during the longer life of the LEAPS. \nAs an aside, the strategist who is utilizing the incremental return concept of cov\nered writing may find LEAPS call writing quite attractive. This is the strategy where\nin he has a higher target price at which he would be willing to sell his common stock, \nand he writes calls along the way to earn an incremental return (see Chapter 2 for \ndetails). Since this type of writer is only concerned", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 176}
{"text": "PS. \nAs an aside, the strategist who is utilizing the incremental return concept of cov\nered writing may find LEAPS call writing quite attractive. This is the strategy where\nin he has a higher target price at which he would be willing to sell his common stock, \nand he writes calls along the way to earn an incremental return (see Chapter 2 for \ndetails). Since this type of writer is only concerned with absolute levels of premiums \nbeing brought into the account and not with things like return if exercised, he should \nutilize LEAPS calls if available, since the premiums are the largest available. \nMoreover, if the incremental return writer is currently in a short-term call and is \ngoing to be called away, he might roll into a LEAPS call in order to retain his stock \nand take in more premium. \nThe rest of this section discusses covered writing from the more normal view\npoint of the investor who buys stock and sells a call against it in order to attain a par\nticular return. \nExample: XYZ is selling at 50. The investor is considering a 500-share covered write \nand he is unsure whether to use the 6-month call or the 2-year LEAPS. The July 50 \ncall sells for 4 and has 6 months of life remaining; the January 50 LEAPS call sells for \n8½ and has 2 years of life. Further assume that XYZ pays a dividend of $0.25 per \nquarter. \nAs was done in Chapter 2, the net required investment is calculated, then the \nreturn (if exercised) is computed, and finally the downside break-even point is deter\nmined. \nStock cost (500 shares @ 50) \nPlus stock commission \nLess option premiums received \nPlus option commissions \nNet cash investment \nNet Investment Required \nJuly 50 call \n$25,000 \n+ 300 \n2,000 \n+ 50 \n$23,350 \nJanuary 50 LEAPS \n$25,000 \n+ 300 \n4,250 \n+ 100 \n$21,150 \nObviously, the LEAPS covered writer has a smaller cash investment, since he is sell\ning a more expensive call in his covered write. Note that the option premium is being \napplied against the net investment in either case, as is the normal custom when doing \ncovered writing. \nNow, using the net investment required, one can calculate the return (if exer\ncised). That return assumes the stock is above the striking price of the written option \n392 Part Ill: Put Option Strategies \nat its expiration, and the stock is called away. The short-term writer would have col\nlected two dividends of the common stock, while the LEAPS writer would have col\nlected eight by expiration. \nStock sale (500 @ 50) \nLess stock commission \nPlus dividends earned \nuntil expiration \nLess net investment \nNet profit if exercised \nReturn if exercised \n(net profit/net investment) \nReturn If Exercised \n+ \nJuly 50 call \n$25,000 \n300 \n250 \n- 23,350 \n$ 1,600 \n6.9% \nJanuary 50 LEAPS \n$25,000 \n300 \n+ 1,000 \n- 21,150 \n$ 4,550 \n21.5% \nThe LEAPS writer has a much higher net return if exercised, again because he \nwrote a more expensive option to begin with. However, in order to fairly compare the \ntwo writes, one must annualize the returns. That is, the July 50 covered write made \n6.9% in six months, so it could make twice that in one year, if it can be duplicated six \nmonths from now. In a similar manner, the LEAPS covered writer can make 21.5% \nin two years if the stock is called away. However, on an annualized basis, he would \nmake only half that amount. \nReturn If Exercised, Annualized \nJuly 50 call January 50 LEAPS \n13.8% 10.8% \nThus, on an annualized basis, the short-term write seems better. The shorter-term \ncall will generally have a higher rate of return, annualized, than the LEAPS call. The \nproblems with annualizing are discussed in the following text. \nFinally, the downside break-even point can be computed for each write. \nDownside Break-Even Calculation \nNet investment \nLess dividends received \nTotal stock cost to expiration \nDivided by shares held (500), \nequals break-even price: \nJuly 50 call \n$23,350 \n250 \n$23,100 \n46.2 \nJanuary 50 LEAPS \n$21,150 \n1 000 \n$20,150 \n40.3 \nChapter 25: LEAPS 393 \nThe larger premium of the LEAPS call that was written produces this dramatically \nlower break-even price for the LEAPS covered write. \nSimilar comparisons could be made for a covered write on margin if the investor \nis using a margin account. The steps above are the mechanical ones that a covered \nwriter should go through in order to see how the short-term write compares to the \nlonger-term LEAPS write. Analyzing them is often a less routine matter. It would \nseem that the short-term write is better if one uses the annualized rate of return. \nHowever, the annualized return is a somewhat subjective number that depends on \nseveral assumptions. \nThe first assumption is that one will be able to generate an equivalent return six \nmonths from now when the July 50 call expires worthless or the stock is called away. \nIf the stock were relatively unchanged, the covered writer would have to sell a 6-\nmonth call for 4 points again six months from now. Or, if the stock were called away, \nhe would have to invest in an equivalent situation elsewhere. Moreover, in order to \nreach the 2-year horizon offered by the LEAPS write, the 6-month return would \nhave to be regenerated three more times (six months from now, one year from now, \nand a year and a half from now). The covered writer cannot assume that such returns \ncan be repeated with any certainty every six months. \nThe second assumption that was made when the annualized returns were cal\nculated was that one-half the return if exercised on the LEAPS call would be made \nwhen one year had passed. But, as has been demonstrated repeatedly in this chapter, \nthe time decay of an option is not linear. Therefore, one year from now, if XYZ were \nstill at 50, the January 50 LEAPS call would not be selling for half its current price \n(½ x 8½ = 4¼). It would be selling for something more like 5.00, if all other factors \nremained unchanged. However, given the variability of LEAPS call premiums when \ninterest rates, volatility, or dividend payouts change, it is extre", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 177}
{"text": "decay of an option is not linear. Therefore, one year from now, if XYZ were \nstill at 50, the January 50 LEAPS call would not be selling for half its current price \n(½ x 8½ = 4¼). It would be selling for something more like 5.00, if all other factors \nremained unchanged. However, given the variability of LEAPS call premiums when \ninterest rates, volatility, or dividend payouts change, it is extremely difficult to esti\nmate the call price one year from now. Consequently, to say that the 21.5% 2-year \nreturn if exercised would be 10.8% after one year may well be a false statement. \nThus, the covered writer must make his decision based on what he knows. He \nknows that with the short-term July 50 write, if the stock is called away in six months, \nhe will make 6.9%, period. If he opts for the longer term, he will make 21.5% if he \nis called away in two years. Which is better? The question can only be answered by \neach covered writer individually. One's attitude toward long-term investing will be a \nmajor factor in making the decision. If he thinks XYZ has good prospects for the long \nterm, and he feels conservative returns will be below 10% for the next couple of \nyears, then he would probably choose the LEAPS write. However, if he feels that \nthere is a temporary expansion of option premium in the short-term XYZ calls that \nshould be exploited, and he would not really want to be a long-term holder of the \nstock, then he would choose the short-term covered write. \n394 Part Ill: Put Option Strategies \nDownside Protection. The actual downside break-even point might enter into \none's thinking as well. A downside break-even point of 40.3 is available by using the \nLEAPS write, and that is a known quantity. No matter how far XYZ might fall, as long \nas it can recover to slightly over 40 by expiration two years from now, the investment \nwill at least break even. A problem arises if XYZ falls to 40 quickly. If that happened, \nthe LEAPS call would still have a significant amount of time value premium remain\ning on it. Thus, if the investor attempted to sell his stock at that time and buy back \nhis call, he would have a loss, not a break-even situation. \nThe short-term write offers downside protection only to a stock price of 46.2. \nOf course, repeated writes of 6-month calls over the next 2 years would lower the \nbreak-even point below that level. The problem is that if XYZ declines and one is \nforced to keep selling 6-month calls every 6 months, he may be forced to use a lower \nstriking price, thereby locking in a smaller profit ( or possibly even a loss) if premium \nlevels shrink. The concepts of rolling down are described in detail in Chapter 2. \nA further word about rolling down may be in order here. Recall that rolling \ndown means buying back the call that is currently written and selling another one \nwith a lower striking price. Such action always reduces the profitability of the over\nall position, although it may be necessary to prevent further downside losses if the \ncommon stock keeps declining. Now that LEAPS are available, the short-term writer \nfaced with rolling down may look to the LEAPS as a means of bringing in a healthy \npremium even though he is rolling down. It is true that a large premium could be \nbrought into the account. But remember that by doing so, one is committing himself \nto sell the stock at a lower price than he had originally intended. This is why the \nrolling down reduces the original profit potential. If he rolls down into a LEAPS call, \nhe is reducing his maximum profit potential for a longer period of time. \nConsequently, one should not always roll dm,vn into an option with a longer maturi\nty. Instead, he should carefully analyze whether he wants to be committed for an \neven longer time to a position in which the underlying common stock is declining. \nTo summarize, the large absolute premiums available in LEAPS calls may make \na covered write of those calls seem unusually attractive. However, one should calcu\nlate the returns available and decide whether a short-term write might not serve his \npurpose as well. Even though the large LEAPS premium might reduce the initial \ninvestment to a mere pittance, be aware that this creates a great amount of leverage, \nand leverage can be a dangerous thing. \nThe large amount of downside protection offered by the LEAPS call is real, but \nif the stock falls quickly, there would definitely be a loss at the calculated downside \nbreak-even point. Finally, one cannot always roll down into a LEAPS call if trouble \ndevelops, because he will be committing himself for an even longer period of time to \nsell his stock at a lower price than he had originally intended. \nChapter 25: LEAPS 39S \n✓,,FREE\" COVERED CALL WRITES \nIn Chapter 2, a strategy of writing expensive LEAPS options was briefly described. \nIn this section, a more detailed analysis is offered. A certain type of covered call \nwrite, one in which the call is quite expensive, sometimes attracts traders looking for \na \"free ride.\" To a certain extent, this strategy is something of a free ride. As you \nmight imagine, though, there can be major problems. \nThe investment required for a covered call write on margin is 50% of the stock \nprice, less the proceeds received from selling the call. In theory, it is possible for an \noption to sell for more than 50% of the stock cost. This is a margin account, a cov\nered write could be established for \"free.\" Let's discuss this in terms of two types of \ncalls: the in-the-money call write and the out-of-the-money call write. \nOut-of-the-Money Covered Call Write. This is the simplest way to approach \nthe strategy. One may be able to find LEAPS options that are just slightly out-of-the\nmoney, which sell for 50% of the stock price. Understandably, such a stock would be \nquite volatile. \nExample: GOGO stock is selling for $38 per share. GOGO has listed options, and a \n2-year LEAPS call with a striking price of 40 is selling for $19. The requirement", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 178}
{"text": "all Write. This is the simplest way to approach \nthe strategy. One may be able to find LEAPS options that are just slightly out-of-the\nmoney, which sell for 50% of the stock price. Understandably, such a stock would be \nquite volatile. \nExample: GOGO stock is selling for $38 per share. GOGO has listed options, and a \n2-year LEAPS call with a striking price of 40 is selling for $19. The requirement for \nthis covered write would be zero, although some commission costs would be \ninvolved. The debit balance would be 19 points per share, the amount the broker \nloans you on margin. \nCertain brokerage firms might require some sort of minimum margin deposit, but \ntechnically there is no further requirement for this position. Of course, the leverage \nis infinite. Suppose one decided to buy 10,000 shares of GOGO and sell 100 calls, \ncovered. His risk is $190,000 if the stock falls to zero! That also happens to be the \ndebit balance in his account. Thus, for a minimal investment, one could lose a for\ntune. In addition, if the stock begins to fall, one's broker is going to want maintenance \nmargin. He probably wouldn't let the stock slip more than a couple of points before \nasking for margin. If one owns 10,000 shares and the broker wants two points main\ntenance margin, that means the margin call would be $20,000. \nThe profits wouldn't be as big as they might at first seem. The maximum gross \nprofit potential is $210,000 if the 10,000 shares are called away at 40. The covered \nwrite makes 21 points on each share - the $40 sale price less the original cost of $19. \nHowever, one will have had to pay interest on the debit balance of $190,000 for two \nyears. At 10%, say, that's a total of $38,000. There would also be commissions on the \npurchase and the sale. \n396 Part Ill: Put Option Strategies \nIn summary, this is a position with tremendous, even dangerous, leverage. \nIn-the-Money Covered Call Write. The situation is slightly different if the \noption is in-the-money to begin with. The above margin requirements actually don't \nquite accurately state the case for a margined covered call write. When a covered call \nis written against the stock, there is a catch: Only 50% of the stock price or the strike \nprice, whichever is less, is available for \"release.\" Thus, one will actually be required \nto put up more than 50% of the stock price to begin with. \nExample: XYZ is trading at 50, and there is a 2-year LEAPS call with a strike price \nof 30, selling for 25 points. One might think that the requirement for a covered call \nwrite would be zero, since the call sells for 50% of the stock price. But that's not the \ncase with in-the-money covered calls. \nMargin requirement: \nBuy stock: 50 points \nLess option proceeds -25 \nLess margin release* -15* \nNet requirement: 10 points \n* 50% of the strike price or 50% of stock price, whichever is less. \nThis position still has a lot ofleverage: One invests 10 points in hopes of making 5, if \nthe stock is called away at 30. One also would have to pay interest on the 15-point \ndebit balance, of course, for the two-year duration of the position. Furthermore, \nshould the stock fall below the strike price, the broker would begin to require main\ntenance margin. \nNote that the above \"formula\" for the net requirement works equally well for \nthe out-of-the-money covered call write, since 50% of the stock price is always less \nthan 50% of the strike price in that case. \nTo summarize this \"free ride\" strategy: If one should decide to use this strate\ngy, he must be extremely aware of the dangers of high leverage. One must not risk \nmore money than he can afford to lose, regardless of how small the initial investment \nmight be. Also, he must plan for some method of being able to make the margin pay\nments along the way. Finally, the in-the-money alternative is probably better, because \nthere is less probability that maintenance margin will be asked for. \nSELLING UNCOVERED LEAPS \nUncovered option selling can be a viable strategy, especially if premiums are over\npriced. LEAPS options may be sold uncovered with the same margin requirements \nas short-term options. Of course, the particular characteristics of the long-term \noption may either help or hinder the uncovered writer, depending on his objective. \nChapter 25: LEAPS 397 \nUncovered Put Selling. Naked put selling is addressed first because, as a strat\negy, it is equivalent to covered writing, and covered writing was just discussed. Two \nstrategies are equivalent if they have the same profit picture at expiration. Naked put \nselling and covered call writing are equivalent because they have the profit picture \ndepicted in Graph I, Appendix D. Both have limited upside profit potential and large \nloss exposure to the downside. In general, when two strategies are equivalent, one of \nthe two has certain advantages over the other. \nIn this case, naked put selling is normally the more advantageous of the two \nbecause of the way margin requirements are set. One need not actually invest cash \nin the sale of a naked put; the margin requirement that is asked for may be satisfied \nwith collateral. This means the naked put writer may use stocks, bonds, T-bills, or \nmoney market funds as collateral. Moreover, the actual amount of collateral that is \nrequired is less than the cash or margin investment required to buy stock and sell a \ncall. This means that one could operate his portfolio normally - buying stock, then \nselling it and putting the proceeds in a Treasury bill or perhaps buying another stock \n- without disturbing his naked put position, as long as he maintained the \ncollateral requirement. \nConsequently, the strategist who is buying stock and selling calls should probably \nbe selling naked puts instead. This does not apply to covered writers who are writing \nagainst existing stock or who are using the incremental return concept of covered writ\ning, because stock ownership is part of their strategy. However, the strategist who is \nlooking", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 179}
{"text": "s he maintained the \ncollateral requirement. \nConsequently, the strategist who is buying stock and selling calls should probably \nbe selling naked puts instead. This does not apply to covered writers who are writing \nagainst existing stock or who are using the incremental return concept of covered writ\ning, because stock ownership is part of their strategy. However, the strategist who is \nlooking to take in premium to profit if the underlying stock remains relatively \nunchanged or rises, while having a modicum of downside protection ( which is the \ndefinition of both naked put writing and covered writing), should be selling naked \nputs. As an example of this, consider the LEAPS covered write discussed previously. \nExample: XYZ is selling at 50. The investor is debating between a 500-share covered \nwrite using 2-year LEAPS calls or selling five 2-year LEAPS puts. The January 50 \nLEAPS call sells for 8½ and has two years of life, while the January 50 LEAPS put \nsells for 3½. Further assume that XYZ pays a dividend of $0.25 per quarter. \nThe net investment required for the covered write is calculated as it was before. \nNet Investment Required - Covered Write \nStock cost (500 shares @ 50) \nPlus stock commission \nLess option premiums received \nPlus option commissions \nNet cash investment \n+ \n$25,000 \n300 \n- 4,250 \n+ 100 \n$21,150 \n398 Part Ill: Put Option Strategies \nThe collateral requirement for the naked put write is the same as that for any \nnaked equity option: 20% of the stock price, plus the option price, less any out-of\nthe-money amount, with an absolute minimum requirement of 15% of the stock \nprice. \nCollateral Requirement - Naked Put \n20% of stock price (.20 x 500 x $50) \nPlus option premium \nLess out-of-the-money amount \nTotal collateral requirement \n$5,000 \n1,750 \n0 \n$6,750 \nNote that the actual premium received by the naked put seller is $1,750 less com\nmissions of $100, for example, or $1,650. This net premium could be used to reduce \nthe total collateral requirement. \nNow one can compare the profitability of the two investments: \nReturn If Stock Over 50 at Expiration \nStock sale {500 @ 50) \nLess stock commission \nPlus dividends earned until expiration \nLess net investment \nNet profit if exercised \nNet put premium received \nDividends received \nNet profit \nCovered Write \n$25,000 \n300 \n+ 1,000 \n- 21,150 \n$ 4,55_0 \nNaked Put Sole \n$1,650 \n0 \n$1,650 \nNow the returns can be compared, if XYZ is over 50 at expiration of the LEAPS: \nReturn if XYZ over 50 \n(net profit/net investment) \nNaked put sale: 24.4% \nCovered write: 21 .5% \nThe naked put write has a better rate of return, even before the following fact \nis considered. The strategist who is using the naked put write does not have to spend \nthe $6,750 collateral requirement in the form of cash. That money can be kept in a \nChapter 25: LEAPS 399 \nTreasury bill and earn interest over the two years that the put write is in place. Even \nif the T-bill were earning only 4% per year, that would increase the overall two-year \nreturn for the naked put sale by 8%, to 32.4%. This should make it obvious that naked \nput selling is rrwre strategically advantageous than covered call writing. \nEven so, one might rightfully wonder if LEAPS put selling is better than selling \nshorter-term equity puts. As was the case with covered call writing, the answer \ndepends on what the investor is trying to accomplish. Short-term puts will not bring \nas much premium into the account, so when they expire, one will be forced to find \nanother suitable put sale to replace it. On the other hand, the LEAPS put sale brings \nin a larger premium and one does not have to find a replacement until the longer\nterm LEAPS put expires. The negative aspect to selling the LEAPS puts is that time \ndecay won't help much right away and, even if the stock moves higher (which is \nostensibly good for the position), the put won't decline in price by a large amount, \nsince the delta of the put is relatively small. \nOne other factor might enter in the decision regarding whether to use short\nterm puts or LEAPS puts. Some put writers are actually attempting to buy stock \nbelow the market price. That is, they would not mind being assigned on the put they \nsell, meaning that they would buy stock at a net cost of the striking price less the pre\nmium they received from the sale of the put. If they don't get assigned, they get to \nkeep a profit equal to the premium they received when they first sold the put. \nGenerally, a person would only sell puts in this manner on a stock that he had faith \nin, so that if he was assigned on the put, he would view that as a buying opportunity \nin the underlying stock. This strategy does not lend itself well to LEAPS. Since the \nLEAPS puts will carry a significant amount of time premium, there is little (if any) \nchance that the put writer will actually be assigned until the life of the put shortens \nsubstantially. This means that it is unlikely that the put writer will become a stock \nowner via assignment at any time in the near future. Consequently, if one is attempt\ning to wTite puts in order to eventually buy the common stock when he is assigned, \nhe would be better served to write shorter-term puts. \nUNCOVERED CALL SELLING \nThere are very few differences between using LEAPS for naked call selling and using \nshorter-term calls, except for the ones that have been discussed already with regard \nto selling uncovered LEAPS: Time value decay occurs more slowly and, if the stock \nrallies and the naked calls have to be covered, the call writer will normally be paying \nmore time premium than he is used to when he covers the call. Of course, the rea\nson that one is engaged in naked call writing might shed some more light on the use \nof LEAPS for that purpose. \n400 Part Ill: Put Option Strategies \nThe overriding reason that most strategists sell naked calls is to collect the time \npremium before the stock can rise above the striking price. These strategists gener\nall", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 180}
{"text": "e time premium than he is used to when he covers the call. Of course, the rea\nson that one is engaged in naked call writing might shed some more light on the use \nof LEAPS for that purpose. \n400 Part Ill: Put Option Strategies \nThe overriding reason that most strategists sell naked calls is to collect the time \npremium before the stock can rise above the striking price. These strategists gener\nally have an opinion about the stock's direction, believing that it is perhaps trapped \nin a trading range or even headed lower over the short term. This strategy does not \nlend itself well to using LEAPS, since it would be difficult to project that the stock \nwould remain below the strike for so long a period of time. \nShort LEAPS Instead of Short Stock. Another reason that naked calls are \nsold is as a strategy akin to shorting the common stock. In this case, in-the-money \ncalls are sold. The advantages are threefold: \nl. The amount of collateral required to sell the call is less than that required to sell \nstock short. \n2. One does not have to borrow an option in order to sell it short, although one must \nborrow common stock in order to sell it short. \n3. An uptick is not required to sell the option, but one is required in order to sell \nstock short. \nFor these reasons, one might opt to sell an in-the-money call instead of shorting \nstock. \nThe profit potentials of the two strategies are different. The short seller of stock \nhas a very large profit potential if the stock declines substantially, while the seller of \nan in-the-money call can collect only the call premium no matter how far the stock \ndrops. Moreover, the call's price decline will slow as the stock nears the strike. \nAnother way to express this is to say that the delta of the call shrinks from a number \nclose to l (which means the call mirrors stock movements closely) to something more \nlike 0.50 at the strike (which means that the call is only declining half as quickly as \nthe stock). \nAnother problem that may occur for the call seller is early assignment, a topic \nthat is addressed shortly. One should not attempt this strategy if the underlying stock \nis not borrowable for ordinary short sales. If the underlying stock is not available for \nborrowing, it generally means that extraneous forces are at work; perhaps there is a \ntender offer or exchange offer going on, or some form of convertible arbitrage is tak\ning place. In any case, if the underlying stock is not borrowable, one should not be \ndeluded into thinking that he can sell an in-the-money call instead and have a worry\nfree position. In these cases, the call will normally have little or no time premium and \nmay be subject to early assignment. If such assignment does occur, the strategist will \nbecome short the stock and, since it is not borrowable, will have to cover the stock. \nAt the least, he will cost himself some commissions by this unprofitable strategy; and \nat worst, he will have to pay a higher price to buy back the stock as well. \nChapter 25: LEAPS 401 \nLEAPS calls may help to alleviate this problem. Since they are such long-term \ncalls, they are likely to have some time value premium in them. In-the-money calls that \nhave time value premium are not normally assigned. As an alternative to shorting a \nstock that is not borrowable, one might try to sell an in-the-money LEAPS call, but \nonly if it has time value premium remaining. Just because the call has a long time \nremaining until expiration does not mean that it must have time value premium, as will \nbe seen in the following discussion. Finally, if one does sell the LEAPS call, he must \nrealize that if the stock drops, the LEAPS call will not follow it completely. As the stock \nnears the strike, the amount of time value premium will build up to an even greater \nlevel in the LEAPS. Still, the naked call seller would make some profit in that case, and \nit presents a better alternative than not being able to sell the stock short at all. \nEarly Assignment. An American-style option is one that can be exercised at any \ntime during its life. All listed equity options, LEAPS included, are of this variety. \nThus, any in-the-money option that has been sold may become subject to early \nassignment. The clue to whether early assignment is imminent is whether there is \ntime value premium in the option. If the option has no time value premium - in other \nwords, it is trading at parity or at a discount then assignment may be close at hand. \nThe option writer who does not want to be assigned would want to cover the option \nwhen it no longer carries time premium. \nLEAPS may be subject to early assignment as well. It is possible, albeit far less \nlikely, that a long-term option would lose all of its time value premium and therefore \nbe subject to early assignment. This would certainly happen if the underlying stock \nwere being taken over and a tender off er were coming to fruition. However, it may \nalso occur because of an impending dividend payment, or more specifically, because \nthe stock is about to go ex-dividend. Recall that the call owner, LEAPS calls includ\ned, is not entitled to any dividends paid by the underlying stock. So if the call owner \nwants the dividend, he exercises his call on the day before the stock goes ex-dividend. \nThis makes him an owner of the common stock just in the nick of time to get the div\nidend. \nWhat economic factors motivate him to exercise the call? If there is any time \nvalue premium at all in the call, the call holder would be better off selling the call in \nthe open market and then purchasing the stock in the open market as well. In this \nmanner, he would still get the dividend, but he would get a better price for his call \nwhen he sold it. If, however, there is no time value premium in the call, he does not \nhave to bother with two transactions in the open market; he merely exercises his call \nin order to buy stock. \nAll well and good, but what makes the call sell at parity before expiration", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 181}
{"text": "ck in the open market as well. In this \nmanner, he would still get the dividend, but he would get a better price for his call \nwhen he sold it. If, however, there is no time value premium in the call, he does not \nhave to bother with two transactions in the open market; he merely exercises his call \nin order to buy stock. \nAll well and good, but what makes the call sell at parity before expiration? It has \nto do with the arbitrage that is available for any call option. In this case, the arbitrage \n402 Part Ill: Put Option Strategies \nis not the simple discount arbitrage that was discussed in Chapter l when this topic \nwas covered. Rather, it is a more complicated form that is discussed in greater detail \nin Chapter 28. Suffice it to say that if the dividend is larger than the interest that can \nbe earned from a credit balance equal to the striking price, then the time value pre\nmium will disappear from the call. \nExample: XYZ is a $30 stock and about to go ex-dividend 50 cents. The prevailing \nshort-term interest rate is 5% and there are LEAPS with a striking price of 20. \nA 50-cent quarterly dividend on a striking price of 20 is an annual dividend rate \n(on the strike) of 10%. Since short-term rates are much lower than that, arbitrageurs \neconomically cannot pay out 10% for dividends and earn 5% for their credit balances. \nIn this situation, the LEAPS call would lose its time value premium and would \nbe a candidate for early exercise when the stock goes ex-dividend. \nIn actual practice, the situation is more complicated than this, because the price \nof the puts comes into play; but this example shows the general reasoning that the \narbitrageur must go through. \nCertain arbitrageurs construct positions that allow them to earn interest on a \ncredit balance equal to the striking price of the call. This position involves being short \nthe underlying stock and being long the call. Thus, when the stock goes ex-dividend, \nthe arbitrageur will owe the dividend. If, however, the amount of the dividend is \nmore than he vvill earn in interest from his credit balance, he will merely exercise his \ncall to cover his short stock. This action will prevent him from having to pay out the \ndividend. \nThe arbitrageur's exercise of the call means that someone is going to be \nassigned. If you are a writer of the call, it could be you. It is not important to under\nstand the arbitrage completely; its effect will be reflected in the marketplace in the \nform of a call trading at parity or a discount. Thus, even a LEAPS call with a sub\nstantial anwunt of time rernaining may be assigned if it is trading at parity. \nSTRADDLE SELLING \nStraddle selling is equivalent to ratio writing and is a strategy whereby one attempts \nto sell ( overpriced) options in order to produce a range of stock prices within which \nthe option seller can profit. The strategy often involves follow-up action as the stock \nmoves around, and the strategist feels that he must adjust his position in order to pre\nvent large losses. LEAPS puts and calls might be used for this strategy. However, \ntheir long-term nature is often not conducive to the aims of straddle selling. \nFirst, consider the effect of time decay. One might normally sell a three-month \nstraddle. If the stock \"behaves\" and is relatively unchanged after two months have \nChapter 25: LEAPS 403 \npassed, the straddle seller could reasonably expect to have a profit of about 40% of \nthe original straddle price. However, if one had sold a 2-year LEAPS straddle, and \nthe stock were relatively unchanged after two months, he would only have a profit of \nabout 7% of the original sale price. This should not be surprising in light of what has \nbeen demonstrated about the decaying of long-term options. It should make the \nstraddle seller somewhat leery of using LEAPS, however, unless he truly thinks the \noptions are overpriced. \nSecond, consider follow-up action. Recall that in Chapter 20, it was shown that \nthe bane of the straddle seller was the whipsaw. A whipsaw occurs when one makes \na follow-up protective action on one side (for instance, he does something bullish \nbecause the underlying stock is rising and the short calls are losing money), only to \nhave the stock reverse and come crashing back down. Obviously, the more time left \nuntil expiration, the more likely it is that a whipsaw will occur after any follow-up \naction, and the more expensive it will be, since there will be a lot of time value pre\nmium left in the options that are being repurchased. This makes LEAPS straddle \nselling less than attractive. \nLEAPS straddles may look expensive because of their large absolute price, and \ntherefore may appear to be attractive straddle sale candidates. However, the price is \noften justified, and the seller of LEAPS straddles will be fighting sudden stock move\nments without getting much benefit from the passage of time. The best time to sell \nLEAPS straddles is when short-term rates are high and volatilities are high as well \n(i.e., the options are overpriced). At least, in those cases, the seller will derive some \nreal benefit if rates or volatilities should drop. \nSPREADS USING LEAPS \nAny of the spread strategies previously discussed can be implemented with LEAPS \nas well, if one desires. The margin requirements are the same for LEAPS spreads as \nthey are for ordinary equity option spreads. One general category of spread lends \nitself well to using LEAPS: that of buying a longer-term option and selling a short\nterm one. Calendar spreads, as well as diagonal spreads, fall into that category. \nThe combinations are myriad, but the reasoning is the same. One wants to own \nthe option that is not so subject to time decay, while simultaneously selling the \noption that is quite subject to time decay. Of course, since LEAPS are long-term and \ntherefore expensive, one is generally taking on a large debit in such a spread and \nmay have substantial risk if the stock performs adversely. Other risks may be", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 182}
{"text": "inations are myriad, but the reasoning is the same. One wants to own \nthe option that is not so subject to time decay, while simultaneously selling the \noption that is quite subject to time decay. Of course, since LEAPS are long-term and \ntherefore expensive, one is generally taking on a large debit in such a spread and \nmay have substantial risk if the stock performs adversely. Other risks may be pres\nent as well. As a means of demonstrating these facts, let us consider a simple bull \nspread using calls. \n404 Part Ill: Put Option Strategies \nExample: The following prices exist in the month of January: \nXYZ: 105 \nApril 100 call: 10 1/2 \nApril 110 call: 5 1/2 \nJanuary (2-year) 100 call: 26 \nJanuary (2-year) 110 call: 21 1/2 \nAn investor is considering a bull spread in XYZ and is unsure about whether to use \nthe short-term calls, the LEAPS calls, or a mixture. These are his choices: \nShort-term bull spread: \nDiagonal bull spread: \nLEAPS bull spread: \nBuy April 100@ 101/2 \nSell April 110@ 51/2 \nNet Debit: $500 \nBuy January LEAPS 100 @ 26 \nSell April 110@ 51/2 \nNet Debit: $2,050 \nBuy January LEAPS 1 00 @ 26 \nSell January LEAPS 110@ 21 1/2 \nNet Debit: $450 \nNotice that the debit paid for the LEAPS spread is slightly less than that of the short\nterm bull spread. This means that they have approximately the same profit potential \nat their respective expiration dates. However, the strategist is more concerned with \nhow these compare directly with each other. The obvious point in time to make this \ncomparison is when the short-term options expire. \nFigure 25-7 shows the profitability of these three positions at April expiration. \nIt was assumed that all of the following were the same in April as they had been in \nJanuary: volatility, short-term rates, and dividend payout. \nNote that the short-term bull spread has the familiar profit graph from Chapter \n7, making its maximum profit over 110 and taking its maximum loss below 100. (See \nTable 25-4.) \nThe LEAPS spread doesn't generate much of either a profit or a loss in only \nthree months' time. Even if XYZ rises to 120, the LEAPS bull spread will have only \na $150 profit. Conversely, if XYZ falls to 80, the spread loses only about $200. This \nprice action is very typical for long-term bull spreads when both options have a sig\nnificant amount of time premium remaining in them. \nChapter 25: LEAPS \nFIGURE 25-7. \nBull spread comparison at April expiration. \nStock Price \n405 \nThe diagonal spread is different, however. Typically, the maximum profit poten\ntial of a bull spread is the difference in the strikes less the initial debit paid. For this \ndiagonal spread, that would be $1,000 minus $2,050, a loss! Obviously, this simple \nformula is not applicable to diagonal spreads, because the purchased option still has \ntime value premium when the written option expires. The profit graph shows that \nindeed the diagonal spread is the most bullish of the three. It makes its best profit at \nthe strike of the written option - a standard procedure for any spread - and that prof\nit is greater than either of the other two spreads at April expiration ( under the sig-\nTABLE 25-4. \nBull spread comparison at April expiration. \nStock Price Short-Term Diagonal LEAPS \n80 -500 -1, 100 -200 \n90 -500 - 600 -150 \n100 -500 50 - 25 \n110 500 750 50 \n120 500 550 150 \n140 500 150 250 \n160 500 50 350 \n180 500 - 350 450 \n406 Part Ill: Put Option Strategies \nnificant assumption that volatility and interest rates are unchanged). If XYZ trades \nhigher than llO, the diagonal spread will lose some of its profit; in fact, if XYZ were \nto trade at a very high price, the diagonal spread would actually have a loss (see Table \n25-4). Whenever the purchased LEAPS call loses its time value premium, the diag\nonal spread will not perform as well. \nIf the common stock drops in price, the diagonal spread has the greatest risk in \ndollar terms but not in percentage terms, because it has the largest initial debit. If \nXYZ falls to 80 in three months, the spread will lose about $1,100, just over half the \ninitial $2,050 debit. Obviously, the short-term spread would have lost 100% of its ini\ntial debit, which is only $500, at that same point in time. \nThe diagonal spread presents an opportunity to earn more money if the under\nlying common is near the strike of the written option when the written option expires. \nHowever, if the common moves a great deal in either direction, the diagonal spread \nis the worst of the three. This means that the diagonal spread strategy is a neutral \nstrategy: One wants the underlying common to remain near the written strike until \nthe near-term option expires. This is a true statement even if the diagonal spread is \nunder the guise of a bullish spread, as in the previous example. \nMany traders are fond of buying LEAPS and selling an out-of-the-money near\nterm call as a hedge. Be careful about doing this. If the underlying common rises too \nfast and/or interest rates fall and/or volatility decreases, this could be a poor strategy. \nThere is really nothing quite as psychologically damaging as being right about the \nstock, but being in the wrong option strategy and therefore losing money. Consider \nthe above examples. Ostensibly, the spreader was bullish on XYZ; that's why he chose \nbull spreads. If XYZ became a wildly bullish stock and rose from 100 to 180 in three \nmonths, the diagonal spreader would have lost money. He couldn't have been happy \n- no one would be. This is something to keep in mind when diagonalizing a LEAPS \nspread. \nThe deltas of the options involved in the spread will give one a good clue as to \nhow it is going to perform. Recall that a short-term, in-the-money option acquires a \nrather high delta, especially as expiration draws nigh. However, an in-the-money \nLEAPS call will not have an extremely high delta, because of the vast amount of time \nremaining. Thus, one is short an option with a high delta and long an option with a \nsmaller delta. These deltas in", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 183}
{"text": "ll give one a good clue as to \nhow it is going to perform. Recall that a short-term, in-the-money option acquires a \nrather high delta, especially as expiration draws nigh. However, an in-the-money \nLEAPS call will not have an extremely high delta, because of the vast amount of time \nremaining. Thus, one is short an option with a high delta and long an option with a \nsmaller delta. These deltas indicate that one is going to lose money if the underlying \nstock rises in price. Consider the following situation: \nXYZ Stock, 120: \nCall \nLong 1 January LEAPS 100 call: \nShort 1 April 110 call: \nPosition Delta \n0.70 \n-0.90 \nChapter 25: LEAPS 401 \nAt this point, if XYZ rises in price by 1 point, the spread can be expected to lose 20 \ncents, since the delta of the short option is 0.20 greater than the delta of the long \noption. \nThis phenomenon has ramifications for the diagonal spreader of LEAPS. If the \ntwo strike prices of the spread are too close together, it may actually be possible to \nconstruct a bull spread that loses money on the upside. That would be very difficult \nfor most traders to accept. In the above example, as depicted in Table 25-4, that's \nwhat happens. One way around this is to widen the strike prices out so that there is \nat least some profit potential, even if the stock rises dramatically. That may be diffi\ncult to do and still be able to sell the short-term option for any meaningful amount \nof premium. \nNote that a diagonal spread could even be considered as a substitute for a cov\nered write in some special cases. It was shown that a LEAPS call can sometimes be \nused as a substitute for the common stock, with the investor placing the difference \nbetween the cost of the LEAPS call and the cost of the stock in the bank (or in T\nbills). Suppose that an investor is a covered writer, buying stock and selling relative\nly short-term calls against it. If that investor were to make a LEAPS call substitution \nfor his stock, he would then have a diagonal bull spread. Such a diagonal spread \nwould probably have less risk than the one described above, since the investor pre\nsumably chose the LEAPS substitution because it was \"cheap.\" Still, the potential \npitfalls of the diagonal bull spread would apply to this situation as well. Thus, if one \nis a covered writer, this does not necessarily mean that he can substitute LEAPS calls \nfor the long stock without taking care. The resulting position may not resemble a cov\nered write as much as he thought it would. \nThe \"bottom line\" is that if one pays a debit greater than the difference in the \nstrike prices, he may eventually lose money if the stock rises far enough to virtually \neliminate the time value premium of both options. This comes into play also if one \nrolls his options down if the underlying stock declines. Eventually, by doing so, he \nmay invert the strikes - i.e., the striking price of the written option is lower than the \nstriking price of the option that is owned. In that case, he will have locked in a loss if \nthe overall credit he has received is less than the difference in the strikes - a quite \nlikely event. So, for those who think this strategy is akin to a guaranteed profit, think \nagain. It most certainly is not. \nBackspreads. LEAPS may be applied to other popular forms of diagonal spreads, \nsuch as the one in which in-the-money, near-term options are sold, and a greater quan\ntity of longer-term (LEAPS) at- or out-of-the money calls are bought. (This was \nreferred to as a diagonal backspread in Chapter 14.) This is an excellent strategy, and \n408 Part Ill: Put Option Strategies \na LEAPS may be used as the long option in the spread. Recall that the object of the \nspread is for the stock to be volatile, particularly to the upside if calls are used. If that \ndoesn't happen, and the stock declines instead, at least the premium captured from \nthe in-the-money sale will be a gain to offset against the loss suffered on the longer\nterm calls that were purchased. The strategy can be established with puts as well, in \nwhich case the spreader would want the underlying stock to fall dramatically while the \nspread was in place. \nWithout going into as much detail as in the examples above, the diagonal back\nspreader should realize that he is going to have a significant debit in the spread and \ncould lose a significant portion of it should the underlying stock fall a great deal in \nprice. To the upside, his LEAPS calls will retain some time value premium and will \nmove quite closely with the underlying common stock. Thus, he does not have to buy \nas many LEAPS as he might think in order to have a neutral spread. \nExample: XYZ is at 105 and a spreader wants to establish a backspread. Recall that \nthe quantity of options to use in a neutral strategy is determined by dividing the \ndeltas of the two options. Assume the following prices and deltas exist: \nOption \nApril 100 call \nJuly 110 call \nJanuary (2-year) LEAPS 100 call \nXYZ: 105 in January \nPrice \n8 \n5 \n15 \nDelta \n0.75 \n0.50 \n0.60 \nTwo backspreads are available with these options. In the first, one would sell the \nApril 100 calls and buy the July llO calls. He would be selling 3-month calls and buy\ning 6-month calls. The neutral ratio is 0.75/0.50 or 3 to 2; that is, 3 calls are to be \nbought for every 2 sold. Thus, a neutral spread would be: \nBuy 6 July 110 calls \nSell 4 April l 00 calls \nAs a second alternative, he might use the LEAPS as the long side of the spread; he \nwould still sell the April 100 calls as the short side of the spread. In this case, his neu\ntral ratio would be 0.75/0.60, or 5 to 4. The resulting neutral spread would be: \nBuy 5 January LEAPS 110 calls \nSell 4 April 100 calls \nChapter 25: LEAPS 409 \nThus, a neutral backspread involving LEAPS requires buyingfewer calls than a neu\ntral backspread involving a 6-rnonth option on the long side. This is because the delta \nof the LEAPS call is larger. The significant point here is that, because of the time \nvalue retention", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 184}
{"text": "or 5 to 4. The resulting neutral spread would be: \nBuy 5 January LEAPS 110 calls \nSell 4 April 100 calls \nChapter 25: LEAPS 409 \nThus, a neutral backspread involving LEAPS requires buyingfewer calls than a neu\ntral backspread involving a 6-rnonth option on the long side. This is because the delta \nof the LEAPS call is larger. The significant point here is that, because of the time \nvalue retention of the LEAPS call, even when the stock moves higher, it is not nec\nessary to buy as many. If one does not use the deltas, but merely figures that 3 to 2 \nis a good ratio for any diagonal backspread, then he will be overly bullish if he uses \nLEAPS. That could cost him if the underlying stock declines. \nCalendar Spreads. LEAPS may also be used in calendar spreads - spreads in \nwhich the striking price of the longer-term option purchased and the shorter-term \noption sold are the same. The calendar spread is a neutral strategy, wherein the \nspreader wants the underlying stock to be as close as possible to the striking price \nwhen the near-term option expires. A calendar spread has risk if the stock moves too \nfar away from the striking price (see Chapters 9 and 22). Purchasing a LEAPS call \nincreases that risk in terms of dollars, not percentage, because of the larger debit that \none must spend for the spread. \nSimplistically, calendar spreads are established with equal quantities of options \nbought and sold. This is often not a neutral strategy in the true sense. As was shown \nin Chapter 9 on call calendar spreads, one may want to use the deltas of the two \noptions to establish a truly neutral calendar spread, particularly if the stock is not ini\ntially right at the striking price. Out-of-the-money, one would sell more calls than he \nis buying. Conversely, in-the-money, one would buy more calls than he is selling. \nBoth strategies statistically have merit and are attractive. When using LEAPS deltas \nto construct the neutral spread, one need generally buy fewer calls than he might \nthink, because of the higher delta of a LEAPS call. This is the same phenomenon \ndescribed in the previous example of a diagonal backspread. \nSUMMARY \nLEAPS are nothing more than long-term options. They are usable in a wide variety \nof strategies in the same way that any option would be. Their margin and investment \nrequirements are similar to those of the more familiar equity options. Both LEAPS \nputs and calls are traded, and there is a secondary market for them as well. \nThere are certain differences between the prices of LEAPS and those of short\ner-term options, but the greatest is the relatively large effect that interest rates and \ndividends have on the price of LEAPS, because LEAPS are long-term options. \nIncreases in interest rates will cause LEAPS to increase in price, while increases in \ndividend payout will cause LEAPS calls to decrease in price and LEAPS puts to \n410 Part Ill: Put Option Strategies \nincrease in price. As usual, volatility has a major effect on the price of an option, and \nLEAPS are no exception. Even small changes in the volatility of the underlying com\nmon stock can cause large price differences in a two-year option. The rate of decay \ndue to time is much smaller for LEAPS, since they are long-term options. Finally, the \ndeltas of LEAPS calls are larger than those of short-term calls; conversely, the deltas \nof LEAPS puts are smaller. \nSeveral common strategies lend themselves well to the usage of LEAPS. A \nLEAPS may be used as a stock substitute if the cash not invested in the stock is \ninstead deposited in a CD or T-bill. LEAPS puts can be bought as protection for \ncommon stock. Speculative option buyers will appreciate the low rate of time decay \nof LEAPS. LEAPS calls can be written against common stock, thereby creating a \ncovered write, although the sale of naked LEAPS puts is probably a better strategy \nin most cases. Spread strategies with LEAPS may be viable as well, but the spreader \nshould carefully consider the ramifications of buying a long-term option and selling \na shorter-term one against it. If the underlying stock moves a great distance quickly, \nthe spread strategy may not perform as expected. \nOverall, LEAPS are not very different from the shorter-term options to which \ntraders and investors have become accustomed. Once these investors become famil\niar with the way these long-term options are affected by the various factors that \ndetermine the price of an option, they will consider the use of LEAPS as an integral \npart of a strategic arsenal. \nAdditional \nConsiderations \n\nBuying Options \nand Treasury Bills \nNumerous strategies have been described, ranging from the simple to the complex. \nEach one has advantages, but there are disadvantages as well. In fact, some of them \nmay be too complex for the average investor to seriously consider implementing. The \nreader may feel that there should be an easier answer. Isn't there a strategy that \nmight not require such a large investment or so much time spent in monitoring the \nposition, but would still have a chance of returning a reasonable profit? In fact, there \nis a strategy that has not yet been described, a strategy considered by some experts \nin the field of mathematical analysis to be the best of them all. Simply stated, the \nstrategy consists of putting 90% of one's money in risk-free investments (such as \nshort-term Treasury bills) and buying options with the remaining 10% of one's funds. \nIt has previously been pointed out that some of the more attractive strategies \nare those that involve small levels of risk with the potential for large profits. Usually, \nthese types of strategies inherently have a rather large frequency of small losses, and \na small probability of realizing large gains. Their advantage lies in the fact that one or \ntwo large profits can conceivably more than make up for numerous small losses. This \nTreasury bill/option strategy is another strategy of this type. \nHOW THE TREASURY BILL/OPTION STRATEGY", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 185}
{"text": "l for large profits. Usually, \nthese types of strategies inherently have a rather large frequency of small losses, and \na small probability of realizing large gains. Their advantage lies in the fact that one or \ntwo large profits can conceivably more than make up for numerous small losses. This \nTreasury bill/option strategy is another strategy of this type. \nHOW THE TREASURY BILL/OPTION STRATEGY OPERATES \nAlthough there are certain details involved in operating this strategy, it is basically a \nsimple one to approach. First, the most that one can lose is 10%, less the interest \nearned on the fixed-income portion of his portfolio (the remaining 90% of his assets), \nduring the life of the purchased options. It is a simple matter to space out one's com-\n413 \n414 Part IV: Additional Considerations \nmitments to option purchases so that his overall risk in a one-year period can be kept \ndown to nearly 10%. \nExample: An investor might decide to put 2½% of his money into three-month \noption purchases. Thus, in any one year, he would be 1isking 10%. At the same time \nhe would be earning perhaps 6% from the overall interest generated on the fixed\nincome securities that make up the remaining 90% of his assets. This would keep his \noverall risk down to approximately 4.6% per year. \nThere are better ways to monitor this risk, and they are described shortly. The \npotential profits from this strategy are limited only by time. Since one is owning \noptions - say call options - he could profit handsomely from a large upward move in \nthe stock market. As with any strategy in which one has limited risk and the poten\ntial of large profits, a small number of large profits could offset a large number of \nsmall losses. In actual practice, of course, his profits will never be overwhelming, \nsince only approximately 10% of the money is committed to option purchases. \nIn total, this strategy has greatly reduced 1isk with the potential of making \nabove-average profits. Since the 10% of the money that is invested in options gives \ngreat leverage, it might be possible for that portion to double or triple in a short time \nunder favorable market conditions. This strategy is something like owning a convert\nible bond. A convertible bond, since it is convertible into the common stock, moves \nup and down in price with the price of the underlying stock. However, if the stock \nshould fall a great deal, the bond will not follow it all the way down, because eventu\nally its yield will provide a \"floor\" for the price. \nA strategy that is not used very often is called the \"synthetic convertible bond.\" \nOne buys a debenture and a call option on the same stock. If the stock rises in price, \nthe call does too, and so the combination of the debenture and the call acts much like \na convertible bond would to the upside. If, on the other hand, the stock falls, the call \nwill expire worthless; but the investor will retain most of his investment, because he \nwill still have the debenture plus any interest that the bond has paid. \nThe strategy of placing 90% of one's money into risk-free, interest-bearing cer\ntificates and buying options with the remainder is superior to the convertible bond \nor the \"synthetic convertible bond,\" since there is no risk of price fluctuation in the \nlargest portion of the investment. \nThe Treasury bill/option strategy is fairly easy to operate, although one does \nhave to do some work every time new options are purchased. Also, periodic adjust\nments need to be made to keep the level of risk approximately the same at all times. \nAs for which options to buy, the reader may recall that specifications were outlined \nin Chapters 3 and 16 on how to select the best option purchases. These criteria can \nbe summarized briefly as follows: \nChapter 26: Buying Options and Treasury Bills 415 \n1. Assume that each underlying stock can advance or decline in accordance with its \nvolatility over a fixed time period (30, 60, or 90 days). \n2. Estimate the call prices after the advance, or put prices after the decline. \n3. Rank all potential purchases by the highest reward opportunity. \nThe user of this strategy need only be interested in those option purchases that \nprovide the highest reward opportunity under this ranking method. In the previous \nchapters on option buying, it was mentioned that one might want to look at the \nrisk/reward ratios of his potential option purchases in order to have a more conser\nvative list. However, that is not necessary in the Treasury bill/option strategy, since \nthe overall risk has already been limited. A ranking of option purchases via the fore\ngoing criteria will generally give a list of at- or slightly out-of-the-money options. \nThese are not necessarily \"underpriced\" options; although if an option is truly under\npriced, it will have a better chance of ranking higher on the selection list than one \nthat is \"overpriced.\" \nA list of potential option purchases that is constructed with criteria similar to \nthose outlined above is available from many data services and brokerage firms. The \nstrategist who is willing to select his option purchases in this manner will find that he \ndoes not have to spend a great deal of time on the selection process. The reader \nshould note that this type of option purchase ranking completely ignores the outlook \nfor the underlying stock. If one would rather make his purchases based on an outlook \nfor the underlying stock - preferably a technical outlook - he will be forced to spend \nmore time on his selection process. Although this may be appealing to some \ninvestors, it will probably yield worse results in the long run than the previously \ndescribed unbiased approach to option purchases, unless the strategist is extremely \nadept at stock selection. \nKEEPING THE RISK LEVEL EQUAL \nThe second function that the strategist has to perform in this Treasury bill/option \nstrategy is to keep his risk level approximately equal at all times. \nExample: An investor starts the s", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 186}
{"text": "ill probably yield worse results in the long run than the previously \ndescribed unbiased approach to option purchases, unless the strategist is extremely \nadept at stock selection. \nKEEPING THE RISK LEVEL EQUAL \nThe second function that the strategist has to perform in this Treasury bill/option \nstrategy is to keep his risk level approximately equal at all times. \nExample: An investor starts the strategy with $90,000 in Treasury bills (T-bills) and \n$10,000 in option purchases. After some time has passed, the option purchases may \nhave worked out well and perhaps he now has $90,000 in T-bills plus $30,000 worth \nof options, plus interest from the T-bills. Obviously, he no longer has 90% of his \nmoney in fixed-income securities and 10% in option purchases. The ratio is now 75% \nin T-bills and 25% in option purchases. This is too risky a ratio, and the strategist \nmust consequently sell some of his options and buy T-bills with the proceeds. Since \nhis total assets are $120,000 currently, he must sell out $18,000 of options to bring his \n416 Part IV: Additional Considerations \noption investment down from the current $30,000 figure to $12,000, or 10% of his \ntotal assets. If one fails to adhere to this readjustment of his funds after profits are \nmade, he may eventually lose those profits. Since options can lose a great percentage \nof their worth in a short time pe1iod, the investor is always running the risk that the \noption portion of his investment may be nearly wiped out. If he has kept all his prof\nits in the option portion of his strategy, he is constantly risking nearly all of his accu\nmulated profits, and that is not wise. \nOne must also adjust his ratio of T-bills to options after losses occur. \nExample: In the first year, the strategist loses all of the $10,000 he originally placed \nin options. This would leave him with total assets of $90,000 plus interest (possibly \n$6,000 of interest might be earned). He could readjust to a 90:10 ratio by selling out \nsome of the T-bills and using the proceeds to buy options. If one follows this strate\ngy, he will be risking 10% of his funds each year. Thus, a series of loss years could \ndepreciate the initial assets, although the net losses in one year would be smaller than \n10% because of the interest earned on the T-bills. It is recommended that the strate\ngist pursue this method of readjusting his ratios in both up and down markets in \norder to constantly provide himself with essentially similar risk/reward opportunities \nat all times. \nThe individual can blend the option selection process and the adjustment of the \nT-bill/option ratio to fit his individual portfolio. The larger portfolio can be diversi\nfied into options \\vith differing holding periods, and the ratio adjustments can be \nmade quite frequently, perhaps once a month. The smaller investor should concen\ntrate on somewhat longer holding periods for his options, and would adjust the ratio \nless often. Some examples might help to illustrate the way in which both the large \nand small strategist might operate. It should be noted that this T-bill/option strategy \nis quite adaptable to fairly small sums of money, as long as the 10% that is going to \nbe put into option purchases allows one to be able to participate in a reasonable man\nner. A tactic for the extremely small investor is also described below. \nANNUALIZED RISK \nBefore getting into portfolio size, let us describe the concept of annualized risk. \nOne might want to purchase options with the intent of holding some of them for 30 \ndays, some for 90 days, and some for 180 days. Recall that he does not want his \noption purchases to represent more than 10% annual risk at any time. In actual \npractice, if one purchases an option that has 90 days of life, but he is planning to \nhold the option only 30 days, he will most likely not lose 100% of his investment in \nChapter 26: Buying Options and Treasury Bills 417 \nthe 30-day period. However, for purposes of computing annualized risk easily, the \nassumption that will be made is that the risk during any holding period is 100%, \nregardless of the length of time remaining in the life of the option. Thus, a 30-day \noption purchase represents an annualized risk of 1,200% (100% risk every 30 days \ntimes twelve 30-day periods in one year). Ninety-day purchases have 400% annual\nized risk, and 180-day purchases have 200% annualized risk. There is a multitude \nof ways to combine purchases in these three holding periods so that the overall risk \nis 10% annualized. \nExample: An investor could put 2½% of his total money into 90-day purchases four \ntimes a year. That is, 2½% of his total assets are being subjected to a 400% annual\nized risk; 400% times 2½% equals 10% annualized risk on the total assets. Of course, \nthe remainder of the assets would be placed in risk-free, income-bearing securities. \nAnother of the many combinations might be to place 1 % of the total assets in 90-day \npurchases and also place 3% of the total assets in 180-day purchases. Thus, 1 % of \none's total money would be subjected to a 400% annual risk and 3% would be sub\njected to a 200% annual risk (.01 times 400 plus .03 times 200 equals 10% annualized \nrisk on the entire assets). If one prefers a formula, annualized risk can be computed \nas: \nA al. d • k • r 1. Percent of total 360 nnu 1ze ns on entire portro 10 = d x assets investe Holding period \nIf one is able to diversify into several holding periods, the annualized risk is merely \nthe sum of the risks for each holding period. \nWith this information in mind, the strategist can utilize option purchases of 1 \nmonth, 3 months, and 6 months, preferably each generated by a separate computer \nanalysis similar to the one described earlier. He will know how much of his total \nassets he can place into purchases of each holding period, because he will know his \nannualized risk. \nExample: Suppose that a very large investor, or pool of investors, has $1 million com\nmitted to this T-bi", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 187}
{"text": "lize option purchases of 1 \nmonth, 3 months, and 6 months, preferably each generated by a separate computer \nanalysis similar to the one described earlier. He will know how much of his total \nassets he can place into purchases of each holding period, because he will know his \nannualized risk. \nExample: Suppose that a very large investor, or pool of investors, has $1 million com\nmitted to this T-bill/option strategy. Further, suppose ½ of 1 % of the money is to be \ncommitted to 30-day option purchases with the idea of reinvesting every 30 days. \nSimilarly, ½ of 1 % is to be placed in 90-day purchases and 1 % in 180-day purchases. \nThe annualized risk is 10%: \nTotal annualized risk = ½% x 360 + ½% x 360 + 1 % x 360 \n30 90 180 \n= .06 + .02 + .02 = 10% \n418 Part IV: Additional Considerations \nWith asset.s of $1 million, this means that $.5,000 would be committed to 30-day pur\nchases; $.5,000 to 90-day purchases; and $10,000 to 180-day purchases. This money \nwould be reinvested in similar quantities at the end of each holding period. \nRISK ADJUSTMENT \nThe subject of adjusting the ratio to constantly reflect 10% risk must be addressed at \nthe end of each holding period. Although it is correct for the investor to keep his per\ncentage commitments constant, he must not be deluded into automatically reinvest\ning the same amount of dollars each time. \nExample: At the end of 30 days, the value of the entire portfolio, including potential \noption profits and losses, and interest earned, was down to $990,000. Then only ½ of \n1 % of that amount should be invested in the next 30-day purchase ($4,9.50). \nBy operating in this manner - first computing the annualized risk and balanc\ning it through predetermined percentage commitments to holding periods of various \nlengths; and second, readjusting the actual dollar commitment at the end of each \nholding period - the overall risk/reward ratios v,ill be kept close to the levels \ndescribed in the earlier, simple desciiption of this strategy. This may require a rela\ntively large amount of work on the part of the strategist, but large portfolios usually \ndo require work. \nThe smaller investor does not have the luxury of such complete diversification, \nbut he also does not have to adjust his total position as often. \nExample: An investor decided to commit $.50,000 to this strategy. Since there is a \n1,200% annualized risk in 30-day purchases, it does not make much sense to even \nconsider purchases that are so short-term for assets of this size. Rather, he might \ndecide to commit 1 % of his assets to a 90-day purchase and 3% to a 180-day pur\nchase. In dollar amounts, this would be $.500 in a 90-day option and $1,.500 in 180-\nday options. Admittedly, this does not leave much room for diversification, but to risk \nmore in the short-term purchases would expose the investor to too much risk. In \nactual practice, this investor would probably just invest .5% of his assets in 180-day \npurchases, also a 10% annualized risk. This would mean that he could operate with \nonly one option buyer's analysis (the 180-day one) and could place $2,.500 into selec\ntions from that list. \nHis adjustments of the assets committed to option purchases could not be done \nas frequently as the large investor, because of the commissions involved. He certain\nly would have to adjust every 180 days, but might prefer to do so more frequently -\nperhaps every 90 days - to be able to space his 180-day commitments over different \nChapter 26: Buying Options and Treasury Bills 419 \noption expiration cycles. It should also be pointed out that T-bills can be bought and \nsold only in amounts of at least $10,000 and in increments of $5,000 thereafter. That \nis, one could buy or sell $10,000 or $15,000 or $20,000 or $25,000, and so on, but \ncould not buy or sell $5,000 or $8,000 or $23,000 in T-bills. This is of little concern \nto the investor with $1 million, since it takes only a fraction of a percentage of his \nassets to be able to round up to the next $5,000 increment for a T-bill sale or pur\nchase. However, the medium-sized investor with a $50,000 portfolio might run into \nproblems. While short-term T-bills do represent the best risk-free investment, the \nmedium-sized investor might want to utilize one of the no-load, money market funds \nfor at least part of his income-bearing assets. Such funds have only slightly more risk \nthan T-bills and offer the ability to deposit and withdraw in any amount. \nThe truly small investor might be feeling somewhat left out. Could it be possi\nble to operate this strategy with a very small amount of money, such as $5,000? Yes \nit could, but there are several disadvantages. \nExample: It would be extremely difficult to keep the risk level down to 10% annual\nly with only $5,000. For example, 5% of the money invested every 180 days is only \n$250 in each investment period. Since the option selection process that is described \nwill tend to select at- or slightly out-of-the-money calls, many of these will cost more \nthan 2½ points for one option. The small investor might decide to raise his risk level \nslightly, although the risk level should never exceed 20% annually, no matter how \nsmall the actual dollar investment. To exceed this risk level would be to completely \ndefeat the purpose of the fixed-income/option purchase strategy. Obviously, this \nsmall investor cannot buy T-bills, for his total investable assets are below the mini\nmum $10,000 purchase level. He might consider utilizing one of the money market \nfunds. Clearly, an investor of this small magnitude is operating at a double disadvan\ntage: His small dollar commitment to option purchases may preclude him from buy\ning some of the more attractive items; and his fixed-income portion will be earning a \nsmaller percentage interest rate than that of the larger investor who is in T-bills or \nsome other form of relatively risk-free, income-bearing security. Consequently, the \nsmall investor should carefully consider his finan", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 188}
{"text": "disadvan\ntage: His small dollar commitment to option purchases may preclude him from buy\ning some of the more attractive items; and his fixed-income portion will be earning a \nsmaller percentage interest rate than that of the larger investor who is in T-bills or \nsome other form of relatively risk-free, income-bearing security. Consequently, the \nsmall investor should carefully consider his financial capability and willingness to \nadhere strictly to the criteria of this strategy before actually committing his dollars. \nIt may appear to the reader that the actual dollars being placed at risk in each \noption purchase are quite small in these examples. In fact, they are rather small, but \nthey have been shown to represent 10% annualized risk. An assumption was made in \nthese examples that the risk in each option purchase was 100% for the holding peri\nod. This is a fairly restrictive assumption and, if it were lessened, would allow for a \nlarger dollar commitment in each holding period. It is difficult and dangerous, how-\n420 Part IV: Additional Considerations \never, to assume that the risk in holding a call option is less than 100% in a holding \nperiod as short as 30 days. The strategist may feel that he is disciplined enough to sell \nout when losses occur and thereby hold the risk to less than 100%. Alternatively, \nmathematical analysis will generally show that the expected loss in a fixed time peri\nod is less than 100%. One can also mitigate the probability oflosing all of his money \nin an option purchase by buying in-the-money options. While they are more expen\nsive, of course, they do have a larger probability of having some residual worth even \nif the underlying stock doesn't rise to the trader's expectations. Adhering to any of \nthese criteria can lead one to become too aggressive and therefore be too heavily \ncommitted to option purchases. It is far safer to stick to the simpler, more restrictive \nassumption that one is risking all his money, even over a fairly short holding period, \nwhen he buys an option. \nAVOIDING EXCESSIVE RISK \nOne final word of caution must be inserted. The investor should not attempt to \nbecome 'Janey\" with the income-bearing portion of his assets. T-bills may appear to \nbe too \"tame\" to some investors, and they consider using GNMA's (Government \nNational Mortgage Association certificates), corporate bonds, convertible bonds, or \nmunicipal bonds for the fixed-income portion. Although the latter securities may \nyield a slightly higher return than do T-bills, they may also prove to be less liquid and \nthey quite clearly involve more risk than a short-term T-bill does. Moreover, some \ninvestors might even consider placing the balance of their funds in other places, such \nas high-yield stock or covered call writing. While high-yield stock purchases and cov\nered call writing are conservative investments, as most investments go, they would \nhave to be considered very speculative in comparison to the purchase of a 90-day T\nhill. In this strategy, the profit potential is represented by the option purchases. The \nyield on short-term T-bills will quite adequately offset the risks. One should take \ngreat care not to attempt to generate much higher yields on the fixed-income portion \nof his investment, for he may find that he has assumed risk with the portion of his \nmoney that was not intended to have any risk at all. \nA fair amount of rigorous mathematical work has been done on the evaluation \nof this strategy. The theoretical papers are quite favorable. Scholars have generally \nconsidered only the purchase of call options as the risk portion of the strategy. \nObviously, the strategist is quite free to purchase put options without harming the \noverall intent of the strategy. When only call options are purchased, both static and \ndown markets harm the performance. If some puts are included in the option pur\nchases, only static markets could produce the worst results. \nChapter 26: Buying Options and Treasury Bills 421 \nThere are trade-offs involved as well. If, after purchasing the options, the mar\nket experiences a substantial rally, that portion of the option purchase money that is \ndevoted to put option purchases will be lost. Thus, the combination of both put and \ncall purchases would do better in a down market than a strategy of buying only calls, \nbut would do worse in an up market. In a broad sense, it makes sense to include some \nput purchases if one has the funds to diversify, since the frequency of market rallies \nis smaller than the combined frequency of market rallies and declines. The investor \nwho owns both puts and calls will be able to profit from substantial moves in either \ndirection, because the profitable options will be able to overcome the limited losses \non the unprofitable ones. \nSUMMARY \nIn summary, the T-bill/option strategy is attractive from several viewpoints. Its true \nadvantage lies in the fact that it has predefined risk and does not have a limit on \npotential profits. Some theorists claim it is the best strategy available, if the options \nare \"underpriced\" when they are purchased. The strategy is also relatively simple to \noperate. It is not necessary to have a margin account or to compute collateral require\nments for uncovered options; the strategy can be operated completely from a cash \naccount. There are no spreads involved, nor is it necessary to worry about details such \nas early assignment (because there are no short options in this strategy). \nThe investor who is going to employ this strategy, however, must not be delud\ned into thinking that it is so simple that it does not take any work at all. The concepts \nand application of annualized risk management are very important to the strategy. So \nare the mechanics of option buying - particularly a disciplined, rational approach to \nthe selection of which calls and/or puts to buy. Consequently, this strategy is suitable \nonly for the investor who has both the time and the discipline to", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 189}
{"text": "at it is so simple that it does not take any work at all. The concepts \nand application of annualized risk management are very important to the strategy. So \nare the mechanics of option buying - particularly a disciplined, rational approach to \nthe selection of which calls and/or puts to buy. Consequently, this strategy is suitable \nonly for the investor who has both the time and the discipline to operate it correctly. \nArbitrage \nArbitrage in the securities market often connotes that one is buying something in \none marketplace and selling it in another marketplace, for a small profit with little \nor no risk. For example, one might buy XYZ at 55 in New York and sell it at 55¼ in \nChicago. Arbitrage, especially option arbitrage, involves a far wider range of tactics \nthan this simple example. Many of the option arbitrage tactics involve buying one \nside of an equivalent position and simultaneously selling the other side. Since there \nis a large number of equivalent strategies, many of which have been pointed out in \nearlier chapters, a full-time option arbitrageur is able to construct a rather large \nnumber of positions, most of which have little or no risk. The public customer can\nnot generally operate arbitrage-like strategies because of the commission costs \ninvolved. Arbitrageurs are firm traders or floor traders who are trading through a \nseat on the appropriate securities exchange, and therefore have only minimal trans\naction costs. \nThe public customer can benefit from understanding arbitrage techniques, even \nifhe does not personally employ them. The arbitrageurs perform a useful function in \nthe option marketplace, often making markets where a market might not otherwise \nexist (deeply in-the-money options, for example). This chapter is directed at the \nstrategist who is actually going to be participating in arbitrage. This should not be \nconfusing to the public customer, for he will better understand the arbitrage strate\ngies if he temporarily places himself in the arbitrageur's shoes. \nIt is virtually impossible to perform pure arbitrage on dually listed options; that \nis, to buy an option on the CBOE and sell it on the American exchange in New York \nfor a profit. Such discrepancies occur so infrequently and in such small size that an \noption arbitrageur could never hope to be fully employed in this type of simple arbi\ntrage. Rather, the more complex forms of arbitrage described here are the ones on \nwhich he would normally concentrate. \n422 \nChapter 27: Arbitrage 423 \nBASIC PUT AND CALL ARBITRAGE (\"DISCOUNTING\") \nThe basic call and the basic put arbitrages are two of the simpler forms of option arbi\ntrage. In these situations, the arbitrageur attempts to buy the option at a discount \nwhile simultaneously taking an opposite position in the underlying stock. He can then \nexercise his option immediately and make a profit equal to the amount of the discount. \nThe basic call arbitrage is described first. This was also outlined in Chapter 1, \nunder the section on anticipating exercise. \nExample: XYZ is trading at 58 and the XYZ July 50 call is trading at 7¾. The call is \nactually at a discount from parity of ¼ point. Discount options generally either are \nquite deeply in-the-money or have only a short time remaining until expiration, or \nboth. The call arbitrage would be constructed by: \n1. buying the call at 7¾; \n2. selling the stock at 58; \n3. exercising the call to buy the stock at 50. \nThe arbitrageur would make 8 points of profit from the stock, having sold it at 58 and \nbought it back at 50 via the option exercise. He loses the 7¾ points that he paid for \nthe call option, but this still leaves him with an overall profit of¼ point. Since he is \na member of the exchange, or is trading the seat of an exchange member, the arbi\ntrageur pays only a small charge to transact the trades. \nIn reality, the stock is not sold short per se, even though it is sold before it is \nbought. Rather, the position is designated, at the time of its inception, as an \"irrevo\ncable exercise.\" The arbitrageur is promising to exercise the call. As a result, no \nuptick is required to sell the stock. \nThe main goal in the call arbitrage is to be able to buy the call at a discount from \nthe price at which the stock is sold. The differential is the profit potential of the arbi\ntrage. The basic put arbitrage is quite similar to the call arbitrage. Again, the arbi\ntrageur is looking to buy the put option at a discount from parity. The put arbitrage \nis completed with a stock purchase and option exercise. \nExample: XYZ is at 58 and the XYZ July 70 put is at 11 ¾. With the put at ¼ discount \nfrom parity, the arbitrageur might take the following action: \n1. Buy put at 11 ¾. \n2. Buy stock at 58. \n3. Exercise put to sell stock at 70. \n424 Part IV: Additional Considerations \nThe stock transaction is a 12-point profit, since the stock was bought at 58 and is sold \nat 70 via the put exercise. The cost of the put - 11 ¾ points - is lost, but the arbi\ntrageur still makes ¼-point profit. Again, this profit is equal to the arrwunt of the dis\ncount in the option when the position was established. Generally, the arbitrageur \nwould exercise his put option immediately, because he would not want to tie up his \ncapital to carry the long stock. An exception to this would be if the stock were about \nto go ex-dividend. Dividend arbitrage is discussed in the next section. \nThe basic call and put arbitrages may exist at any time, although they will be \nmore frequent when there is an abundance of deeply in-the-money options or when \nthere is a very short time remaining until expiration. After market rallies, the call \narbitrage may be easier to establish; after market declines, the put arbitrage will be \neasier to find. As an expiration date draws near, an option that is even slightly in-the\nmoney on the last day or two of trading could be a candidate for discount arbitrage. \nThe reason that this is true is that public buying interest", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 190}
{"text": "very short time remaining until expiration. After market rallies, the call \narbitrage may be easier to establish; after market declines, the put arbitrage will be \neasier to find. As an expiration date draws near, an option that is even slightly in-the\nmoney on the last day or two of trading could be a candidate for discount arbitrage. \nThe reason that this is true is that public buying interest in the option will normally \nwane. The only public buyers would be those who are short and want to cover. Many \ncovered writers will elect to let the stock be called away, so that will reduce even fur\nther the buying potential of the public. This leaves it to the arbitrageurs to supply the \nbuying interest. \nThe arbitrageur obviously wants to establish these positions in as large a size as \npossible, since there is no risk in the position if it is established at a discount. Usually, \nthere will be a larger market for the stock than there will be for the options, so the \narbitrageur spends more of his time on the option position. However, there may be \noccasions when the option markets are larger than the corresponding stock quotes. \nWhen this happens, the arbitrageur has an alternative available to him: He might sell \nan in-the-money option at parity rather than take a stock position. \nExample: XYZ is at 58 and the XYZ July 50 call is at 7¾. These are the same figures \nas in the previous example. Furthermore, suppose that the trader is able to buy more \noptions at 7¾ than he is able to sell stock at 58. If there were another in-the-money \ncall that could be sold at parity, it could be used in place of the stock sale. For exam\nple, if the XYZ July 40 call could be sold at 18 (parity), the arbitrage could still be \nestablished. Ifhe is assigned on the July 40 that he is short, he will then be short stock \nat a net price of 58 - the striking price of 40, plus the 18 points that were brought in \nfrom the sale of the July 40 call. Thus, the sale of the in-the-money call at parity is \nequivalent to shorting the stock for the arbitrage purpose. \nIn a similar manner, an in-the-money put can be used in the basic put arbitrage. \nExample: With XYZ at 58 and the July 70 put at 11¾, the arbitrage could be estab\nlished. However, if the trader is having trouble buying enough stock at 58, he might \nChapter 27: Arbitrage 425 \nbe able to use another in-the-money put. Suppose the XYZ July 80 put could be sold \nat 22. This would be the same as buying the stock at 58, because if the put were \nassigned, the arbitrageur would be forced to buy stock at 80 - the striking price - but \nhis net cost would be 80 minus the 22 points he received from the sale of the put, for \na net cost of 58. Again, the arbitrageur is able to use the sale of a deeply in-the-money \noption as a substitute for the stock trade. \nThe examples above assumed that the arbitrageur sold a deeper in-the-money \noption at parity. In actual practice, if an in-the-money option is at a discount, an even \ndeeper in-the-money option will generally be at a discount as well. The arbitrageur \nwould normally try to sell, at parity, an option that was less deeply in-the-money than \nthe one he is discounting. \nIn a broader sense, this technique is applicable to any arbitrage that involves a \nstock trade as part of the arbitrage, except when the dividend in the stock itself is \nimportant. Thus, if the arbitrageur is having trouble buying or selling stock as part of \nhis arbitrage, he can always check whether there is an in-the-money option that could \nbe sold to produce a position equivalent to the stock position. \nDIVIDEND ARBITRAGE \nDividend arbitrage is actually quite similar to the basic put arbitrage. The trader can \nlock in profits by buying both the stock and the put, then waiting to collect the divi\ndend on the underlying stock before exercising his put. In theory, on the day before \na stock goes ex-dividend, all puts should have a time value premium at least as large \nas the dividend amount. This is true even for deeply in-the-money puts. \nExample: XYZ closes at 45 and is going to go ex-dividend by $1 tomorrow. Then a \nput with striking price of 50 should sell for at least 6 points ( the in-the-money amount \nplus the amount of the dividend), because the stock will go ex-dividend and is expect\ned to open at 44, six points in-the-money. \nIf, however, the put' s time value premium should be less than the amount of the \ndividend, the arbitrageur can take a riskless position. Suppose the XYZ July 50 put is \nselling for 5¾, with the stock at 45 and about to go ex-dividend by $1. The arbi\ntrageur can take the following steps: \n1. Buy the put at 5¼. \n2. Buy the stock at 45. \n3. Hold the put and stock until the stock goes ex-dividend (1 point in this case). \n4. Exercise the put to sell the stock at 50. \n426 Part IV: Additional Considerations \nThe trader makes 5 points from the stock trade, buying it at 45 and selling it at 50 via \nthe put exercise, and also collects the I-point dividend, for a total inflow of 6 points. \nSince he loses the 5¾ points he paid for the put, his net profit is ¼ point. \nFar in advance of the ex-dividend date, a deeply in-the-money put may trade \nvery close to parity. Thus, it would seem that the arbitrageur could \"load up\" on these \ntypes of positions and merely sit back and wait for the stock to go ex-dividend. There \nis a flaw in this line of thinking, however, because the arbitrageur has a carrying cost \nfor the rrwney that he must tie up in the long stock. This carrying cost fluctuates with \nshort-term interest rates. \nExample: If the current rate of carrying charges were 6% annually, this would be \nequivalent to 1 % every 2 months. If the arbitrageur were to establish this example \nposition 2 months prior to expiration, he would have a carrying cost of .5075 point. \n(His total outlay is 50¾ points, 45 for the stock and 5¾ for the options, and he would \npay 1 % to carry that stock and option for the two months until the ex-dividend dat", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 191}
{"text": "rate of carrying charges were 6% annually, this would be \nequivalent to 1 % every 2 months. If the arbitrageur were to establish this example \nposition 2 months prior to expiration, he would have a carrying cost of .5075 point. \n(His total outlay is 50¾ points, 45 for the stock and 5¾ for the options, and he would \npay 1 % to carry that stock and option for the two months until the ex-dividend date.) \nThis is more than ½ point in costs - clearly more than the ¼-point potential profit. \nConsequently, the arbitrageur must be aware of his carrying costs if he attempts to \nestablish a dividend arbitrage well in advance of the ex-dividend date. Of course, if \nthe ex-dividend date is only a short time away, the carrying cost has little effect, and \nthe arbitrageur can gauge the profitability of his position mostly by the amount of the \ndividend and the time value premium in the put option. \nThe arbitrageur should note that this strategy of buying the put and buying the \nstock to pick up the dividend might have a residual, rather profitable side effect. If \nthe underlying stock should rally up to or above the striking price of the put, there \ncould be rather large profits in this position. Although it is not likely that such a rally \ncould occur, it would be an added benefit if it did. Even a rather small rally might \ncause the put to pick up some time premium, allowing the arbitrageur to trade out \nhis position for a profit larger than he could have made by the arbitrage discount. \nThis form of arbitrage occasionally lends itself to a limited form of risk arbi\ntrage. Risk arbitrage is a strategy that is designed to lock in a profit if a certain event \noccurs. If that event does not occur, there could be a loss (usually quite limited); \nhence, the position has risk. This risk element differentiates a risk arbitrage from a \nstandard, no-risk arbitrage. Risk arbitrage is described more fully in a later section, \nbut the following example concerning a special dividend is one form of risk arbitrage. \nExample: XYZ has been known to declare extra, or special, dividends with a fair \namount of regularity. There are several stocks that do so - Eastman Kodak and \nGeneral Motors, for example. In this case, assume that a hypothetical stock, XYZ, has \nChapter 27: Arbitrage 427 \ngenerally declared a special dividend in the fourth quarter of each year, but that its \nnormal quarterly rate is $1.00 per share. Suppose the special dividend in the fourth \nquarter has ranged from an extra $1.00 to $3.00 over the past five years. If the arbi\ntrageur were willing to speculate on the size of the upcoming dividend, he might be \nable to make a nice profit. Even if he overestimates the size of the special dividend, \nhe has a limited loss. Suppose XYZ is trading at 55 about two weeks before the com\npany is going to announce the dividend for the fourth quarter. There is no guarantee \nthat there will, in fact, be a special dividend, but assume that XYZ is having a rela\ntively good year profitwise, and that some special dividend seems forthcoming. \nFurthermore, suppose the January 60 put is trading at 7½. This put has 2½ points of \ntime value premium. If the arbitrageur buys XYZ at 55 and also buys the January 60 \nput at 7½, he is setting up a risk arbitrage. He will profit regardless of how far the \nstock falls or how much time value premium the put loses, if the special dividend is \nlarger than $1.50. A special dividend of $1.50 plus the regular dividend of $1.00 \nwould add up to $2.50, or 2½ points, thus covering his risk in the position. Note that \n$1.50 is in the low end of the $1.00 to $3.00 recent historical range for the special \ndividends, so the arbitrageur might be tempted to speculate a little by establishing \nthis dividend risk arbitrage. Even if the company unexpectedly decided to declare no \nspecial dividend at all, it would most likely still pay out the $1.00 regular dividend. \nThus, the most that the arbitrageur would lose would be 1 ½ points (his 2½-point ini\ntial time value premium cost, less the 1-point dividend). In actual practice, the stock \nwould probably not change in price by a great deal over the next two weeks (it is a \nhigh-yield stock), and therefore the January 60 put would probably have some time \nvalue premium left in it after the stock goes ex-dividend. Thus, the practical risk is \neven less than 1 ½ points. \nWhile these types of dividend risk arbitrage are not frequently available, the \narbitrageur who is willing to do some homework and also take some risk may find that \nhe is able to put on a position with a small risk and a profitability quite a bit larger \nthan the normal discount dividend arbitrage. \nThere is really not a direct form of dividend arbitrage involving call options. If \na relatively high-yield stock is about to go ex-dividend, holders of the calls will \nattempt to sell. They do so because the stock will drop in price, thereby generally \nforcing the call to drop in price as well, because of the dividend. However, the hold\ner of a call does not receive cash dividends and therefore is not willing to hold the \ncall if the stock is going to drop by a relatively large amount (perhaps ¾ point or \nmore). The effect of these call holders attempting to sell their calls may often pro\nduce a discount option, and therefore a basic call arbitrage may be possible. The arbi\ntrageur should be careful, however, if he is attempting to arbitrage a stock that is \n428 Part IV: Additional Considerations \ngoing ex-dividend on the following day. Since he must sell the stock to set up the arbi\ntrage, he cannot afford to wind up the day being short any stock, for he will then have \nto pay out the dividend the following day (the ex-dividend date). Furthermore, his \nrecords must be accurate, so that he exercises all his long options on the day before \nthe ex-dividend date. If the arbitrageur is careless and is still short some stock on the \nex-date, he may find that the dividend he has to pay out wipes", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 192}
{"text": "not afford to wind up the day being short any stock, for he will then have \nto pay out the dividend the following day (the ex-dividend date). Furthermore, his \nrecords must be accurate, so that he exercises all his long options on the day before \nthe ex-dividend date. If the arbitrageur is careless and is still short some stock on the \nex-date, he may find that the dividend he has to pay out wipes out a large portion of \nthe discount profits he has established. \nCONVERSIONS AND REVERSALS \nIn the introductory material on puts, it was shown that put and call prices are relat\ned through a process known as conversion. This is an arbitrage process whereby a \ntrader may sometimes be able to lock in a profit at absolutely no risk. A conversion \nconsists of buying the underlying stock, and also buying a put option and selling a \ncall option such that both options have the same terms. This position will have a \nlocked-in profit if the total cost of the position is less than the striking price of the \noptions. \nExample: The following prices exist: \nXYZ common, 55; \nXYZ January 50 call, 6½; and \nXYZ January 50 put, 1. \nThe total cost of this conversion is 49½ - 55 for the stock, plus 1 for the put, less 6½ \nfor the call. Since 49½ is less than the striking price of 50, there is a locked-in profit \non this position. To see that such a profit exists, suppose the stock is somewhere \nabove 50 at expiration. It makes no difference how far above 50 the stock might be; \nthe result will be the same. With the stock above 50, the call will be assigned and the \nstock will be sold at a price of 50. The put will expire worthless. Thus, the profit is½ \npoint, since the initial cost of the position was 49½ and it can eventually be liquidat\ned for a price of 50 at expiration. A similar result occurs if XYZ is below 50 at expi\nration. In this case, the trader would exercise his put to sell his stock at 50, and the \ncall would expire worthless. Again, the position is liquidated for a price of 50 and, \nsince it only cost 49½ to establish, the same ½-point profit can be made. No matter \nwhere the stock is at expiration, this position has a locked-in-profit of½ point. \nThis example is rather simplistic because it does not include two very important \nfactors: the possible dividend paid by the stock and the cost of carrying the position \nChapter 27: Arbitrage 429 \nuntil expiration. The inclusion of these factors complicates things somewhat, and its \ndiscussion is deferred momentarily while the companion strategy, the reversal, is \nexplained. \nA reversal (or reverse conversion, as it is sometimes called) is exactly the oppo\nsite of a conversion. In a reversal, the trader sells stock short, sells a put, and buys a \ncall. Again, the put and call have the same terms. A reversal will be profitable if the \ninitial credit ( sale price) is greater than the striking price of the options. \nExample: A different set of prices will be used to describe a reversal: \nXYZ common, 55; \nXYZ January 60 call, 2; and \nXYZ January 60 put, 7½. \nThe total credit of the reversal is 60½ - 55 from the stock sale, plus 7½ from the put \nsale, less the 2-point cost of the call. Since 60½ is greater than the striking price of \nthe options, 60, there is a locked-in profit equal to the differential of½ point. To ver\nify this, first assume that XYZ is anywhere below 60 at January expiration. The put \nwill be assigned - stock is bought at 60 - and the call will expire worthless. Thus, the \nreversal position is liquidated for a cost of 60. A ½-point profit results since the orig\ninal sale value ( credit) of the position was 60½. On the other hand, if XYZ were above \n60 at expiration, the trader would exercise his call, thus buying stock at 60, and the \nput would expire worthless. Again, he would liquidate the position at a cost of 60 and \nwould make a ½-point profit. \nDividends and carrying costs are important in reversals, too; these factors are \naddressed here. The conversion involves buying stock, and the trader will thus \nreceive any dividends paid by the stock during the life of the arbitrage. However, the \nconverter also has to pay out a rather large sum of money to set up his arbitrage, and \nmust therefore deduct the cost of carrying the position from his potential profits. In \nthe example above, the conversion position cost 49½ points to establish. If the trad\ner's cost of money were 6% annually, he would thus lose .06/12 x 49½, or .2475 point \nper month for each month that he holds the position. This is nearly ¼ of a point per \nmonth. Recall that the potential profit in the example is ½ point, so that if one held \nthe position for more than two months, his carrying costs would wipe out his profit. \nIt is extremely important that the arbitrageur compute his carrying costs accurately \nprior to establishing any conversion arbitrage. \nIf one prefers formulae, the profit potentials of a conversion or a reversal can \nbe stated as: \n430 l'art IV: Additional Considerations \nConversion profit = Striking price + Call price - Stock price - Put price + \nDividends to be received - Carrying cost of position \nReversal profit = Stock + Put - Strike - Call + Carrying cost - Dividends \nNote that during any one trading day, the only items in the formulae that can change \nare the prices of the securities involved. The other items, dividends and carrying cost, \nare fixed for the day. Thus, one could have a small computer program prepared that \nlisted the fixed charges on a particular stock for all the strikes on that stock. \nExample: It is assumed that XYZ stock is going to pay a ½-point dividend during the \nlife of the position, and that the position will have to be held for three months at a \ncarrying cost of 6% per year. If the arbitrageur were interested in a conversion with \na striking price of 50, his fixed cost would be: \nConversion fixed cost = Carrying rate x Time held x Striking price -\nDividend to be received \n= .06 X 3/12 X 50 - ½ \n= .75- ½ = .25, or¼ point", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 193}
{"text": "y a ½-point dividend during the \nlife of the position, and that the position will have to be held for three months at a \ncarrying cost of 6% per year. If the arbitrageur were interested in a conversion with \na striking price of 50, his fixed cost would be: \nConversion fixed cost = Carrying rate x Time held x Striking price -\nDividend to be received \n= .06 X 3/12 X 50 - ½ \n= .75- ½ = .25, or¼ point \nThe arbitrageur would know that if the profit potential, computed in the simplistic \nmanner using only the prices of the securities involved, was greater than ¼ point, he \ncould establish the conversion for an eventual profit, including all costs. Of course, \nthe carrying costs would be different if the striking price were 40 or 60, so a com\nputer printout of all the possible striking prices on each stock would be useful in \norder for the trader to be able to refer quickly to a table of his fixed costs each day. \nMORE ON CARRYING COSTS \nThe computation of carrying costs can be made more involved than the simple \nmethod used above. Simplistically, the carrying cost is computed by multiplying the \ndebit of the position by the interest rate charged and the time that the position will \nbe held. That is, it could be formulated as: \nCarrying cost = Strike x r x t \nwhere r is the interest rate and t is the time that the position will be held. Relating \nthis formula for the carrying cost to the conversion profit formula given above, one \nwould get: \nConversion profit = Call - Stock - Put + Dividend + Strike - Carrying cost \n= Call - Stock - Put + Dividend + Strike ( 1 - rt) \nChapter 27: Arbitrage 431 \nIn an actuarial sense, the carrying cost could be expressed in a slightly more complex \nmanner. The simple formula (strike x r x t) ignores two things: the compounding \neffect of interest rates and the \"present value\" concept ( the present value of a future \namount). The absolutely correct formula to include both present value and the com\npounding effect would necessitate replacing the factor strike (1- rt) in the profit for\nmula by the factor \nStrike \n(1 + r)f \nIs this effect large? No, not when rand tare small, as they would be for most option \ncalculations. The interest rate per month would normally be less than 1 %, and the \ntime would be less than 9 months. Thus, it is generally acceptable, and is the com\nmon practice among many arbitrageurs, to use the simple formula for carrying costs. \nIn fact, this is often a matter of convenience for the arbitrageur if he is computing \nthe carrying costs on a hand calculator that does not perform exponentiation. \nHowever, in periods of high interest rates when longer-term options are being ana\nlyzed, the arbitrageur who is using the simple formula should double-check his cal\nculations with the correct formula to assure that his error is not too large. \nFor purposes of simplicity, the remaining examples use the simple formula for \ncarrying-cost computations. The reader should remember, however, that it is only a \nconvenient approximation that works best when the interest rate and the holding \nperiod are small. This discussion of the compounding effect of interest rates also rais\nes another interesting point: Any investor using margin should, in theory, calculate \nhis potential interest charge using the compounding formula. However, as a matter \nof practicality, extremely few investors do. An example of this compounding effect on \na covered call write is presented in Chapter 2. \nBACK TO CONVERSIONS AND REVERSALS \nProfit calculation similar to the conversion profit formula is necessary for the rever\nsal arbitrage. Since the reversal necessitates sho1ting stock, the trader must pay out \nany dividends on the stock during the time in which the position is held. However, \nhe is now bringing in a credit when the position is established, and this money can \nbe put to work to earn interest. In a reversal, then, the dividend is a cost and the \ninterest earned is a profit. \n432 Part IV: Additional Considerations \nExample: Use the same XYZ details described above: The stock is going to pay a ½\npoint dividend, the position will be held for three months, and the money will earn \ninterest at a rate of ½ of 1 % per month. If the trader were contemplating an arbi\ntrage with a striking price of 30, the fixed cost would be: \nReversal fixed cost = Dividend to be paid - Interest rate per month x \nMonths held x Striking price \n= .50 - .005 X 3 X 30 \n= ½ - .045 = .005 point \nThe fixed cost in this reversal is extremely small. In fact, the reader should be able to \nsee that it is often possible - even probable - that there will be a fixed credit, not a \nfrxed cost, in a reversal arbitrage. To verify this, rework the example with a striking \nprice of 50 or 60. As in a conversion, the frxed cost (or profit) in a reversal is a num\nber that can be used for the entire trading day. It will not change. \nBORROWING STOCK TO SELL SHORT \nThe above example assumes that the arbitrageur earns the full carrying rate on the \nshort stock. Only certain arbitrageurs are actually able to earn that rate. When one \nsells stock short, he must actually borrow the stock from someone who owns it, and \nthen the seller goes into the market to sell the stock. When customers of brokerage \nfirms keep stock in a margin account, they agree to let the brokerage firm loan their \nstock out without the customer's specific approval. Thus, if an arbitrageur working for \nthat brokerage firm wanted to establish a reversal, and if the stock to be sold short in \nthe reversal were available in one of the margin accounts, the arbitrageur could bor\nrow that stock and earn the full carrying rate on it. This is called \"using box stock,\" \nsince stock held in margin accounts is generally referred to as being in the \"box.\" \nThere are other times, however, when an arbitrageur wants to do a reversal but \ndoes not have access to \"box\" stock. He must then find someone else from whom to \nborrow the stock. Obviously, there are people who own", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 194}
{"text": "could bor\nrow that stock and earn the full carrying rate on it. This is called \"using box stock,\" \nsince stock held in margin accounts is generally referred to as being in the \"box.\" \nThere are other times, however, when an arbitrageur wants to do a reversal but \ndoes not have access to \"box\" stock. He must then find someone else from whom to \nborrow the stock. Obviously, there are people who own stock and would loan it to \narbitrageurs for a fee. There are people who specialize in matching up investors with \nstock to loan and arbitrageurs who want to borrow stock. These people are said to be \nin the \"stock loan\" business. Generally, the fee for borrowing stock in this manner is \nanywhere from 10 to 20% of the prevailing carrying cost rate. For example, if the cur\nrent carrying rate were 10% annually, then one would expect to pay 1 or 2% to the \nlender to borrow his stock. This reduces the profitability of the reversal slightly. Since \nsmall margins are being worked with, this cost to borrow the stock may make a sig\nnificant difference to the arbitrageur. \nThese variations in the rates that an arbitrageur can earn on the credit balances \nin his account affect the marketplace. For example, a particular reversal might be \nChapter 27: Arbitrage 433 \navailable in the marketplace at a net profit of ½ point, or 50 cents. Such a reversal \nmay not be equally attractive to all arbitrageurs. Those who have \"box\" stock may be \nwilling to do the reversal for 50 cents; those who have to pay 1 % to borrow stock may \nwant 0.55 for the reversal; and those who pay 2% to borrow stock may need 0.65 for \nthe reversal. Thus, arbitrageurs who do conversions and reversals are in competition \nwith each other not only in the marketplace, but in the stock loan arena as well. \nReversals are generally easier positions for the arbitrageur to locate than are \nconversions. This is because the fixed cost of the conversion has a rather burdensome \neffect. Only if the stock pays a rather large dividend that outweighs the carrying cost \ncould the fixed portion of the conversion formula ever be a profit as opposed to a \ncost. In practice, the interest rate paid to carry stock is probably higher than the \ninterest earned from being short stock, but any reasonable computer program should \nbe able to handle two different interest rates. \nThe novice trader may find the term \"conversion\" somewhat illogical. In the \nover-the-counter option markets, the dealers create a position similar to the one \nshown here as a result of actually converting a put to a call. \nExample: When someone owns a conventional put on XYZ with a striking price of \n60 and the stock falls to 50, there is often little chance of being able to sell the put \nprofitably in the secondary market. The over-the-counter option dealer might offer \nto convert the put into a call. To do this, he would buy the put from the holder, then \nbuy the stock itself, and then offer a call at the original striking price of 60 to the \nholder of the put. Thus, the dealer would be long the stock, long the put, and short \nthe call - a conversion. The customer would then own a call on XYZ with a striking \nprice of 60, due to expire on the same date that the put was destined to. The put \nthat the customer owned has been converted into a call. To effect this conversion, \nthe dealer pays out to the customer the difference between the current stock price, \n50, and the striking price, 60. Thus, the customer receives $1,000 for this conver\nsion. Also, the dealer would charge the customer for costs to carry the stock, so that \nthe dealer had no risk. If the stock rallied back above 60, the customer could make \nmore money, because he owns the call. The dealer has no risk, as he has an arbitrage \nposition to begin with. In a similar manner, the dealer can effect a reverse conver\nsion - converting a call to a put - but will charge the dividends to the customer for \ndoing so. \nRISKS IN CONVERSIONS AND REVERSALS \nConversions and reversals are generally considered to be riskless arbitrage. That is, \nthe profit in the arbitrage is fixed from the start and the subsequent movement of the \n434 Part IV: Additional Considerations \nunderlying stock makes no difference in the eventual outcome. This is generally a \ntrue statement. However, there are some risks, and they are great enough that one \ncan actually lose money in conversions and reversals if he does not take care. The \nrisks are fourfold in reversal arbitrage: An extra dividend is declared, the interest rate \nfalls while the reversal is in place, an early assignment is received, or the stock is \nexactly at the striking price at expiration. Converters have similar risks: a dividend \ncut, an increase in the interest rate, early assignment, or the stock closing at the strike \nat expiration. \nThese risks are first explored from the viewpoint of the reversal trader. If the \ncompany declares an extra dividend, it is highly likely that the reversal will become \nunprofitable. This is so because most extra dividends are rather large - more than the \nprofit of a reversal. There is little the arbitrageur can do to avoid being caught by the \ndeclaration of a truly extra dividend. However, some companies have a track record \nof declaring extras with annual regularity. The arbitrageur should be aware of which \ncompanies these are and of the timing of these extra dividends. A clue sometimes \nexists in the marketplace. If the reversal appears overly profitable when the arbi\ntrageur is first examining it (before he actually establishes it), he should be somewhat \nskeptical. Perhaps there is a reason why the reversal looks so tempting. An extra div\nidend that is being factored into the opinion of the marketplace may be the answer. \nThe second risk is that of variation in interest rates while the reversal is in \nprogress. Obviously, rates can change over the life of a reversal, normally 3 to 6 \nmonths. There are two ways to compensate for this. The simplest way is", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 195}
{"text": "al. Perhaps there is a reason why the reversal looks so tempting. An extra div\nidend that is being factored into the opinion of the marketplace may be the answer. \nThe second risk is that of variation in interest rates while the reversal is in \nprogress. Obviously, rates can change over the life of a reversal, normally 3 to 6 \nmonths. There are two ways to compensate for this. The simplest way is to leave \nsome room for rates to move. For example, if rates are currently at 12% annually, one \nmight allow for a movement of 2 to 3% in rates, depending on the length of time the \nreversal is expected to be in place. In order to allow for a 2% move, the arbitrageur \nwould calculate his initial profit based on a rate of 10%, 2% less than the currently \nprevailing 12%. He would not establish any reversal that did not at least break even \nwith a 10% rate. The rate at which a reversal breaks even is often called the \"effec\ntive rate\" - 10% in this case. Obviously, if rates average higher than 10% during the \nlife of the reversal, it will make money. Normally, when one has an entire portfolio of \nreversals in place, he should know the effective rate of each set of reversals expiring \nat the same time. Thus, he would have an effective rate for his 2-month reversals, his \n3-month ones, and so forth. \nAllowing this room for rates to move does not necessarily mean that there will \nnot be an adverse affect if rates do indeed fall. For example, rates could fall farther \nthan the room allowed. Thus, a further measure is necessary in order to completely \nprotect against a drop in rates: One should invest his credit balances generated by the \nreversals in interest-bearing paper that expires at approximately the same time the \nreversals do, and that bears interest at a rate that locks in a profit for the reversal \nChapter 27: Arbitrage 435 \naccount. For example, suppose that an arbitrageur has $5 million in 3-month rever\nsals at an effective rate of 10%. If he can buy $5 million worth of 3-month Certificates \nof Deposit with a rate of 11 ½%, then he would lock in a profit of 1 ½% on his $5 mil\nlion. This method of using paper to hedge rate fluctuations is not practiced by all \narbitrageurs; some think it is not worth it. They believe that by leaving the credit bal\nances to fluctuate at prevailing rates, they can make more if rates go up, and that will \ncushion the effect when rates decline. \nThe third risk of reversal arbitrage is reception of an early assignment on the \nshort puts. This forces the arbitrageur to buy stock and incur a debit. Thus, the posi\ntion does not earn as much interest as was originally assumed. If the assignment is \nreceived early enough in the life of the reversal (recall that in-the-money puts can \nbe assigned very far in advance of expiration), the reversal could actually incur an \noverall loss. Such early assignments normally occur during bearish markets. The only \nadvantage of this early assignment is that one is left with unhedged long calls; these \ncalls are well out-of-the-money and normally quite low-priced (¼ or less). If the \nmarket should reverse and turn bullish before the expiration of the calls, the arbi\ntrageur may make money on them. There is no way to hedge completely against a \nmarket decline, but it does help if the arbitrageur tries to establish reversals with the \ncall in-the-money and the put out-of-the-money. That, plus demanding a better \noverall return for reversals near the strike, should help cushion the effects of the \nbear market. \nThe final risk is the most common one, that of the stock closing exactly at the \nstrike at expiration. This presents the arbitrageur with a decision to make regarding \nexercise of his long calls. Since the stock is exactly at the strike, he is not sure whether \nhe will be assigned on his short puts at expiration. The outcome is that he may end \nup with an unhedged stock position on Monday morning after expiration. If the stock \nshould open on a gap, he could have a substantial loss that wipes out the profits of \nmany reversals. This risk of stock closing at the strike may seem minute, but it is not. \nIn the absence of any real buying or selling in the stock on expiration day, the process \nof discounting will force a stock that is near the strike virtually right onto the strike. \nOnce it is near the strike, this risk materializes. \nThere are two basic scenarios that could occur to produce this unhedged stock \nposition. First, suppose one decides that he will not get put and he exercises his calls. \nHowever, he was wrong and he does get put. He has bought double the amount of \nstock - once via call exercise and again via put assignment. Thus, he will be long on \nMonday morning. The other scenario produces the opposite effect. Suppose one \ndecides that he will get put and he decides not to exercise his calls. If he is wrong in \nthis case, he does not buy any stock - he didn't exercise nor did he get put. \nConsequently, he will be short stock on Monday morning. \n436 Part IV: Additional Considerations \nIf one is truly undecided about whether he will be assigned on his short puts, \nhe might look at several clues. First, has any late news come out on Friday evening \nthat might affect the market's opening or the stock's opening on Monday morning? If \nso, that should be factored into the decision regarding exercising the calls. Another \nclue arises from the price at which the stock was trading during the Friday expiration \nday, prior to the close. If the stock was below the strike for most of the day before \nclosing at the strike, then there is a greater chance that the puts will be assigned. This \nis so because other arbitrageurs (discounters) have probably bought puts and bought \nstock during the day and will exercise to clean out their positions. \nIf there is still doubt, it may be wisest to exercise only half of the calls, hoping \nfor a partial assignment on the puts (always a possibility). This halfway measure will \nnormally result", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 196}
{"text": "a greater chance that the puts will be assigned. This \nis so because other arbitrageurs (discounters) have probably bought puts and bought \nstock during the day and will exercise to clean out their positions. \nIf there is still doubt, it may be wisest to exercise only half of the calls, hoping \nfor a partial assignment on the puts (always a possibility). This halfway measure will \nnormally result in some sort of unhedged stock position on Monday morning, but it \nwill be smaller than the maximum exposure by at least half. \nAnother approach that the arbitrageur can take if the stock is near the strike of \nthe reversal during the late trading of the options' life - during the last few days - is \nto roll the reversal to a later expiration or, failing that, to roll to another strike in the \nsame expiration. First, let us consider rolling to another expiration. The arbitrageur \nknows the dollar price that equals his effective rate for a 3-month reversal. If the cur\nrent options can be closed out and new options opened at the next expiration for at \nleast the effective rate, then the reversal should be rolled. This is not a likely event, \nmostly due to the fact that the spread between the bid and asked prices on four sep\narate options makes it difficult to attain the desired price. Note: This entire four-way \norder can be entered as a spread order; it is not necessary to attempt to \"leg\" the \nspread. \nThe second action - rolling to another strike in the same expiration month -\nmay be more available. Suppose that one has the July 45 reversal in place (long July \n45 call and short July 45 put). If the underlying stock is near 45, he might place an \norder to the exchange floor as a three-way spread: Sell the July 45 call (closing), buy \nthe July 45 put (closing), and sell the July 40 call ( opening) for a net credit of 5 points. \nThis action costs the arbitrageur nothing except a small transaction charge, since he \nis receiving a 5-point credit for moving the strike by 5 points. Once this is accom\nplished, he will have moved the strike approximately 5 points away and will thus have \navoided the problem of the stock closing at the strike. \nOverall, these four risks are significant, and reversal arbitrageurs should take \ncare that they do not fall prey to them. The careless arbitrageur uses effective rates \ntoo close to current market rates, establishes reversals with puts in-the-money, and \nroutinely accepts the risk of acquiring an unhedged stock position on the morning \nafter expiration. He will probably sustain a large loss at some time. Since many rever\nsal arbitrageurs work with small capital and/or have convinced their backers that it is \nChapter 27: Arbitrage 437 \na riskless strategy, such a loss may have the effect of putting them out of business. \nThat is an unnecessary risk to take. There are countermeasures, as described above, \nthat can reduce the effects of the four risks. \nLet us consider the risks for conversion traders more briefly. The risk of stock \nclosing near the strike is just as bad for the conversion as it is for the reversal. The \nsame techniques for handling those risks apply equally well to conversions as to \nreversals. The other risks are similar to reversal risks, but there are slight nuances. \nThe conversion arbitrage suffers if there is a dividend cut. There is little the \narbitrageur can do to predict this except to be aware of the fundamentals of the com\npany before entering into the conversion. Alternatively, he might avoid conversions \nin which the dividend makes up a major part of the profit of the arbitrage. \nAnother risk occurs if there is an early assignment on the calls before the ex-div\nidend date and the dividend is not received. Moreover, an early assignment leaves the \narbitrageur with long puts, albeit fractional ones since they are surely deeply out-of\nthe-money. Again, the policy of establishing conversions in which the dividend is not \na major factor would help to ease the consequences of early assignment. \nThe final risk is that interest rates increase during the time the conversion is in \nplace. This makes the carrying costs larger than anticipated and might cause a loss. \nThe best way to hedge this initially is to allow a margin for error. Thus, if the pre\nvailing interest rate is 12%, one might only establish reversals that would break even \nif rates rose to 14%. If rates do not rise that far on average, a profit will result. The \narbitrageur can attempt to hedge this risk by shorting interest-bearing paper that \nmatures at approximately the same time as the conversions. For example, if one has \n$5 million worth of 3-month conversions established at an effective rate of 14% and \nhe shorts 3-month paper at 12½%, he locks in a profit of 1 ½%. This is not common \npractice for conversion arbitrageurs, but it does hedge the effect of rising interest \nrates. \nSUMMARY OF CONVERSION ARBITRAGE \nThe practice of conversion and reversal arbitrage in the listed option markets helps \nto keep put and call prices in line. If arbitrageurs are active in a particular option, the \nprices of the put and call will relate to the stock price in line with the formulae given \nearlier. Note that this is also a valid reason why puts tend to sell at a lower price than \ncalls do. The cost of money is the determining factor in the difference between put \nand call prices. In essence, the \"cost\" (although it may sometimes be a credit) is sub\ntracted from the theoretical put price. Refer again to the formula given above for the \nprofit potential of a conversion. Assume that things are in perfect alignment. Then \nthe formula would read: \n438 Part IV: Additional Considerations \nPut price = Striking price + Call price - Stock price - Fixed cost \nFurthermore, if the stock is at the striking price, the formula reduces to: \nPut price = Call price - Fixed cost \nSo, whenever the fixed cost, which is equal to the carrying charge less the dividends, \nis greater than zero (and it usually is", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 197}
{"text": "perfect alignment. Then \nthe formula would read: \n438 Part IV: Additional Considerations \nPut price = Striking price + Call price - Stock price - Fixed cost \nFurthermore, if the stock is at the striking price, the formula reduces to: \nPut price = Call price - Fixed cost \nSo, whenever the fixed cost, which is equal to the carrying charge less the dividends, \nis greater than zero (and it usually is), the put will sell for less than the call if a stock \nis at the striking price. Only in the case of a large-dividend-paying stock, when the \nfixed cost becomes negative (that is, it is not a cost, but a credit), does the reverse \nhold true. This is supportive evidence for statements made earlier that at-the-money \ncalls sell for more than at-the-money puts, all other things being equal. The reader \ncan see quite clearly that it has nothing to do with supply and demand for the puts \nand calls, a fallacy that is sometimes proffered. This same sort of analysis can be used \nto prove the broader statement that calls have a greater time value premium than \nputs do, except in the case of a large-dividend-paying stock. \nOne final word of advice should be offered to the public customer. He may \nsometimes be able to find conversions or reversals, by using the simplistic formula, \nthat appear to have profit potentials that exceed commission costs. Such positions do \nexist from time to time, but the rate of return to the public customer will almost \nassuredly be less than the short-term cost of money. If it were not, arbitrageurs would \nbe onto the position very quickly. The public option trader may not actually be think\ning in terms of comparing the profit potential of a position with what he could get by \nplacing the money into a bank, but he must do so to convince himself that he cannot \nfeasibly attempt conversion or reversal arbitrages. \nTHE \"INTEREST PLAY\" \nIn the preceding discussion of reversal arbitrage, it is apparent that a substantial por\ntion of the arbitrageur's profits may be due to the interest earned on the credit of the \nposition. Another type of position is used by many arbitrageurs to take advantage of \nthis interest earned. The arbitrageur sells the underlying stock short and simultane\nously buys an in-the-money call that is trading slightly over parity. The actual amount \nover parity that the arbitrageur can afford to pay for the call is determined by the \ninterest that he will earn from his short sale and the dividend payout before expira\ntion. He does not use a put in this type of position. In fact, this \"interest play\" strat\negy is merely a reversal arbitrage without the short put. This slight variation has a \nresidual benefit for the arbitrageur: If the underlying stock should drop dramatically \nin price, he could make large profits because he is short the underlying stock. In any \ncase, he will make his interest credit less the amount of time value premium paid for \nthe call less any dividends lost. \nChapter 27: Arbitrage 439 \nExample 1: XYZ is sold short at 60, and a January 50 call is bought for 10¼ points. \nAssume that the prevailing interest rate is 1 % per month and that the position is \nestablished one month prior to expiration. XYZ pays no dividend. The total credit \nbrought in from the trades is $4,975, so the arbitrageur will earn $49.75 in interest \nover the course of 1 month. If the stock is above 50 at expiration, he will exercise his \ncall to buy stock at 50 and close the position. His loss on the security trades will be \n$25 the amount of time value premium paid for the call option. (He makes 10 \npoints by selling stock at 60 and buying at 50, but loses 10¼ points on the exercised \ncall.) His overall profit is thus $24.75. \nExample 2: A real-life example may point out the effect of interest rates even more \ndramatically. In early 1979, IBM April 240 calls with about six weeks of life remain\ning were over 60 points in-the-money. IBM was not going to be ex-dividend in that \ntime. Normally, such a deeply in-the-money option would be trading at parity or even \na discount when the time remaining to expiration is so short. However, these calls \nwere trading 3½ points over parity because of the prevailing high interest rates at the \ntime. IBM was at 300, the April 240 calls were trading at 63½, and the prevailing \ninterest rate was approximately 1 % per month. The credit from selling the stock and \nbuying the call was $23,700, so the arbitrageur earned $365.50 in interest for 1 ½ \nmonths, and lost $350 - the 3½ points of time value premium that he paid for the \ncall. This still left enough room for a profit. \nIn Chapter 1, it was stated that interest rates affect option prices. The above \nexamples of the \"interest play\" strategy quite clearly show why. As interest rates rise, \nthe arbitrageur can afford to pay more for the long call in this strategy, thus causing \nthe call price to increase in times of high interest rates. If call prices are higher, so \nwill put prices be, as the relationships necessary for conversion and reversal arbitrage \nare preserved. Similarly, if interest rates decline, the arbitrageur will make lower \nbids, and call and put prices will be lower. They are active enough to give truth to the \ntheory that option prices are directly related to interest rates. \nTHE BOX SPREAD \nAn arbitrage consists of simultaneously buying and selling the same security or equiv\nalent securities at different prices. For example, the reversal consists of selling a put \nand simultaneously shorting stock and buying a call. The reader will recall that the \nshort stock/long call position was called a synthetic put. That is, shorting the stock \nand buying a call is equivalent to buying a put. The reversal arbitrage therefore con\nsists of selling a (listed) put and simultaneously buying a (synthetic) put. In a similar \n440 Part IV: Additional Considerations \nmanner, the conversion is merely the purchase of a (listed) put and the simultaneous \nsale of a (synthetic) put. Many equ", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 198}
{"text": "tion was called a synthetic put. That is, shorting the stock \nand buying a call is equivalent to buying a put. The reversal arbitrage therefore con\nsists of selling a (listed) put and simultaneously buying a (synthetic) put. In a similar \n440 Part IV: Additional Considerations \nmanner, the conversion is merely the purchase of a (listed) put and the simultaneous \nsale of a (synthetic) put. Many equivalent strategies can be combined for arbitrage \npurposes. One of the more common ones is the box spread. \nRecall that it was shown that a bull spread or a bear spread could be construct\ned with either puts or calls. Thus, if one were to simultaneously buy a (call) bull \nspread and buy a (put) bear spread, he could have an arbitrage. In essence, he is \nmerely buying and selling equivalent spreads. If the price differentials work out cor\nrectly, a risk-free arbitrage may be possible. \nExample: The following prices exist: \nXYZ common, 55 \nXYZ January 50 call, 7 \nXYZ January 50 put, 1 \nXYZ January 60 call, 2 \nXYZ January 60 put, 5½ \nThe arbitrageur could establish the box spread in this example by executing the \nfollowing transactions: \nBuy a call bull spread: \nBuy XYZ January 50 call \nSell XYZ January 60 call \nNet call cost \nBuy a put bear spread: \nBuy XYZ January 60 put \nSell XYZ January 50 put \nNet put cost \nTotal cost of position \n7 debit \n2 credit \n51/2 debit \n1 credit \n5 debit \nNo matter where XYZ is at January expiration, this position will be worth 10 points. \nThe arbitrageur has locked in a risk-free profit of½ point, since he \"bought\" the box \nspread for 9½ points and will be able to \"sell\" it for 10 points at expiration. To verify \nthis, evaluate the position at expiration, first with XYZ above 60, then with XYZ \nbetween 50 and 60, and finally with XYZ below 50. If XYZ is above 60 at expiration, \nthe puts will expire worthless and the call bull spread will be at its maximum poten\ntial of 10 points, the difference between the striking prices. Thus, the position can be \nliquidated for 10 points if XYZ is above 60 at expiration. Now assume that XYZ is \nChapter 27: Arbitrage 441 \nbetween 50 and 60 at expiration. In that case, the out-of-the-money, written options \nwould expire worthless-the January 60 call and the January 50 put. This would leave \na long, in-the-money combination consisting of a January 50 call and a January 60 \nput. These two options must have a total value of 10 points at expiration with XYZ \nbetween 50 and 60. (For example, the arbitrageur could exercise his call to buy stock \nat 50 and exercise his put to sell stock at 60.) Finally, assume that XYZ is below 50 at \nexpiration. The calls would expire worthless if that were true, but the remaining put \nspread- actually a bear spread in the puts -would be at its maximum potential of 10 \npoints. Again, the box spread could be liquidated for 10 points. \nThe arbitrageur must pay a cost to carry the position, however. In the prior \nexample, if interest rates were 6% and he had to hold the box for 3 months, it would \ncost him an additional 14 cents (.06 x 9½ x 3112). This still leaves room for a profit. \nIn essence, a bull spread ( using calls) was purchased while a bear spread ( using \nputs) was bought. The box spread was described in these terms only to illustrate the \nfact that the arbitrageur is buying and selling equivalent positions. The arbitrageur \nwho is utilizing the box spread should not think in terms of bull or bear spread, how\never. Rather, he should be concerned with \"buying\" the entire box spread at a cost of \nless than the differential between the two striking prices. By \"buying\" the box spread, \nit is meant that both the call spread portion and the put spread portion are debit \nspreads. Whenever the arbitrageur observes that a call spread and a put spread using \nthe same strikes and that are both debit spreads can be bought for less than the dif\nference in the strikes plus carrying costs, he should execute the arbitrage. \nObviously, there is a companion strategy to the one just described. It might \nsometimes be possible for the arbitrageur to \"sell\" both spreads. That is, he would \nestablish a credit call spread and a credit put spread, using the same strikes. If this \ncredit were greater than the difference in the striking prices, a risk-free profit would \nbe locked in. \nExample: Assume that a different set of prices exists: \nXYZ common, 75 \nXYZ April 70 call, 8½ \nXYZ April 70 put, 1 \nXYZ April 80 call, 3 \nXYZ April 80 put, 6 \nBy executing the following transactions, the box spread could be \"sold\": \n442 \nSell a call (bear) spread: \nBuy April 80 call \nSell April 70 call \nNet credit on calls \nSell a put (bull) spread: \nBuy April 70 put \nSell April 80 put \nNet credit on puts \nTotal credit of position \n3 debit \n81/2 credit \n1 debit \n6 credit \nPart IV: Additional Considerations \n5 credit \n10 1/2 credit \nIn this case, no matter where XYZ is at expiration, the position can be bought back \nfor 10 points. This means that the arbitrageur has locked in risk-free profit of¼ \npoint. To verify this statement, first assume that XYZ is above 80 at April expiration. \nThe puts will expire worthless, and the call spread will have widened to 10 points -\nthe cost to buy it back. Alternatively, if XYZ were between 70 and 80 at April expira\ntion, the long, out-of-the-money options would expire worthless and the in-the\nmoney combination would cost 10 points to buy back. (For example, the arbitrageur \ncould let himself be put at 80, buying stock there, and called at 70, selling the stock \nthere - a net \"cost\" to liquidate of 10 points.) Finally, if XYZ were below 70 at expi\nration, the calls would expire worthless and the put spread would have widened to 10 \npoints. It could then be closed out at a cost of 10 points. In each case, the arbitrageur \nis able to liquidate the box spread by buying it back at 10. \nIn this sale of a box spread, he would earn interest on the credit received while \nhe holds the position. \nThere is an additiona", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 199}
{"text": "ly, if XYZ were below 70 at expi\nration, the calls would expire worthless and the put spread would have widened to 10 \npoints. It could then be closed out at a cost of 10 points. In each case, the arbitrageur \nis able to liquidate the box spread by buying it back at 10. \nIn this sale of a box spread, he would earn interest on the credit received while \nhe holds the position. \nThere is an additional factor in the profitability of the box spread. Since the sale \nof a box generates a credit, the arbitrageur who sells a box will earn a small amount \nof money from that sale. Conversely, the purchaser of a box spread will have a charge \nfor carrying cost. Since profit margins may be small in a box arbitrage, these carrying \ncosts can have a definite effect. As a result, boxes may actually be sold for 5 points, \neven though the striking prices are 5 points apart, and the arbitrageur can still make \nmoney because of the interest earned. \nThese box spreads are not easy to find. If one does appear, the act of doing the \narbitrage will soon make the arbitrage impossible. In fact, this is true of any type of \narbitrage; it cannot be executed indefinitely because the mere act of arbitraging will \nforce the prices back into line. Occasionally, the arbitrageur will be able to find the \noption quotes to his liking, especially in volatile markets, and can establish a risk-free \nChapter 27: Arbitrage 443 \narbitrage with the box spread. It can be evaluated at a glance. Only two questions \nneed to be answered: \n1. If one were to establish a debit call spread and a debit put spread, using the same \nstrikes, would the total cost be less than the difference in the striking prices plus \ncarrying costs? If the answer is yes, an arbitrage exists. \n2. Alternatively, if one were to sell both spreads - establishing a credit call spread \nand a credit put spread - would the total credit received plus interest earned be \ngreater than the difference in the striking prices? If the answer is yes, an arbi\ntrage exists. \nThere are some risks to box arbitrage. Many of them are the same as those risks \nfaced by the arbitrageur doing conversions or reversals. First, there is risk that the \nstock might close at either of the two strikes. This presents the arbitrageur with the \nsame dilemma regarding whether or not to exercise his long options, since he is not \nsure whether he will be assigned. Additionally, early assignment may change the prof\nitability: Assignment of a short put will incur large carrying costs on the resulting long \nstock; assignment of a short call will inevitably come just before an ex-dividend date, \ncosting the arbitrageur the amount of the dividend. \nThere are not many opportunities to actually transact box arbitrage, but the fact \nthat such arbitrage exists can help to keep markets in line. For example, if an under\nlying stock begins to move quickly and order flow increases dramatically, the special\nist or market-markers in that stock's options may be so inundated with orders that \nthey cannot be sure that their markets are correct. They can use the principles of box \narbitrage to keep prices in line. The most active options would be the ones at strikes \nnearest to the current stock price. The specialist can quickly add up the markets of \nthe call and put at the nearest strike above the stock price and add to that the mar\nkets of the options at the strike just below. The sum of the four should add up to a \nprice that surrounds the difference in the strikes. If the strikes are 5 points apart, \nthen the sum of the four markets should be something like 4½ bid, 5½ asked. If, \ninstead, the four markets add up to a price that allows box arbitrage to be established, \nthen the specialist will adjust his markets. \nVARIATIONS ON EQUIVALENCE ARBITRAGE \nOther variations of arbitrage on equivalent positions are possible, although they are \nrelatively complicated and probably not worth the arbitrageur's time to analyze. For \nexample, one could buy a butterfly spread with calls and simultaneously sell a but\nterfly spread using puts. A listed straddle could be sold and a synthetic straddle \n444 Part IV: Additional Considerations \ncould be bought - short stock and long 2 calls. Inversely, a listed straddle could be \nbought against a ratio write - long stock and short 2 calls. The only time the arbi\ntrageur should even consider anything like this is when there are more sizable mar\nkets in certain of the puts and calls than there are in others. If this were the case, he \nmight be able to take an ordinary box spread, conversion, or reversal and add to it, \nkeeping the arbitrage intact by ensuring that he is, in fact, buying and selling equiv\nalent positions. \nTHE EFFECTS OF ARBITRAGE \nThe arbitrage process serves a useful purpose in the listed options market, because it \nmay provide a secondary market where one might not otherwise exist. Normally, \npublic interest in an in-the-money option dwindles as the option becomes deeply in\nthe-money or when the time remaining until expiration is very short. There would be \nfew public buyers of these options. In fact, public selling pressure might increase, \nbecause the public would rather liquidate in-the-money options held long than exer\ncise them. The few public buyers of such options might be writers who are closing \nout. However, if the writer is covered, especially where call options are concerned, \nhe might decide to be assigned rather than close out his option. This means that the \npublic seller is creating a rather larger supply that is not offset by a public demand. \nThe market created by the arbitrageur, especially in the basic put or call arbitrage, \nessentially creates the demand. Without these arbitrageurs, there could conceivably \nbe no buyers at all for those options that are short-lived and in-the-money, after pub\nlic writers have finished closing out their positions. \nEquivalence arbitrage - conversion, reversals, and box spreads - helps to keep \nthe relative prices", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 200}
{"text": "ted by the arbitrageur, especially in the basic put or call arbitrage, \nessentially creates the demand. Without these arbitrageurs, there could conceivably \nbe no buyers at all for those options that are short-lived and in-the-money, after pub\nlic writers have finished closing out their positions. \nEquivalence arbitrage - conversion, reversals, and box spreads - helps to keep \nthe relative prices of puts and calls in line with each other and with the underlying \nstock price. This creates a more efficient and rational market for the public to oper\nate in. The arbitrageur would help eliminate, for example, the case in which a public \ncustomer buys a call, sees the stock go up, but cannot find anyone to sell his call to \nat higher prices. If the call were too cheap, arbitrageurs would do reversals, which \ninvolve call purchases, and would therefore provide a market to sell into. \nQuestions have been raised as to whether option trading affects stock prices, \nespecially at or just before an expiration. If the amount of arbitrage in a certain issue \nbecomes very large, it could appear to temporarily affect the price of the stock itself. \nFor example, take the call arbitrage. This involves the sale of stock in the market. The \ncorresponding stock purchase, via the call exercise, is not executed on the exchange. \nThus, as far as the stock market is concerned, there may appear to be an inordinate \namount of selling in the stock. If large numbers of basic call arbitrages are taking \nplace, they might thus hold the price of the stock down until the calls expire. \nChapter 27: Arbitrage 445 \nThe put arbitrage has an opposite effect. This arbitrage involves buying stock in \nthe market. The offsetting stock sale via the put exercise takes place off the exchange. \nIf a large amount of put arbitrage is being done, there may appear to be an inordi\nnate amount of buying in the stock. Such action might temporarily hold the stock \nprice up. \nIn a vast majority of cases, however, the arbitrage has no visible effect on the \nunderlying stock price, because the amount of arbitrage being done is very small in \ncomparison to the total number of trades in a given stock. Even if the open interest \nin a particular option is large, allowing for plenty of option volume by the arbi\ntrageurs, the actual act of doing the arbitrage will force the prices of the stock and \noption back into line, thus destroying the arbitrage. \nRather elaborate studies, including doctoral theses, have been written that try \nto prove or disprove the theory that option trading affects stock prices. Nothing has \nbeen proven conclusively, and it may never be, because of the complexity of the task. \nLogic would seem to dictate that arbitrage could temporarily affect a stock's move\nment if it has discount, in-the-money options shortly before expiration. However, one \nwould have to reasonably conclude that the size of these arbitrages could almost \nnever be large enough to overcome a directional trend in the underlying stock itself. \nThus, in the absence of a definite direction in the stock, arbitrage might help to per\npetuate the inertia; but if there were truly a preponderance of investors wanting to \nbuy or sell the stock, these investors would totally dominate any arbitrage that might \nbe in progress. \nRISK ARBITRAGE USING OPTIONS \nRisk arbitrage is a strategy that is well described by its name. It is basically an arbi\ntrage - the same or equivalent securities are bought and sold. However, there is gen\nerally risk because the arbitrage usually depends on a future event occurring in \norder for the arbitrage to be successful. One form of risk arbitrage was described \nearlier concerning the speculation on the size of a special dividend that an underly\ning stock might pay. That arbitrage consisted of buying the stock and buying the put, \nwhen the put' s time value premium is less than the amount of the projected special \ndividend. The risk lies in the arbitrageur's speculation on the size of the anticipated \nspecial dividend. \nMERGERS \nRisk arbitrage is an age-old type of arbitrage in the stock market. Generally, it con\ncerns speculation on whether a proposed merger or acquisition will actually go \nthrough as proposed. \n446 Part IV: Additional Considerations \nExample: XYZ, which is selling for $50 per share, offers to buy out LMN and is offer\ning to swap one share of its (XYZ's) stock for every two shares of LMN. This would \nmean that LMN should be worth $25 per share if the acquisition goes through as pro\nposed. On the day the takeover is proposed, LMN stock would probably rise to about \n$22 per share. It would not trade all the way up to 25 until the takeover was approved \nby the shareholders of LMN stock. The arbitrageur who feels that this takeover will \nbe approved can take action. He would sell short XYZ and, for every share that he is \nshort, he would buy 2 shares of LMN stock. If the merger goes through, he will prof\nit. The reason that he shorts XYZ as well as buying LMN is to protect himself in case \nthe market price of XYZ drops before the acquisition is approved. In essence, he has \nsold XYZ and also bought the equivalent of XYZ (two shares of LMN will be equal to \none share of XYZ if the takeover goes through). This, then, is clearly an arbitrage. \nHowever, it is a risk arbitrage because, if the stockholders of LMN reject the offer, \nhe will surely lose money. His profit potential is equal to the remaining differential \nbetween the current market price of LMN (22) and the takeover price (25). If the \nproposed acquisition goes through, the differential disappears, and the arbitrageur \nhas his profit. \nThe greatest risk in a merger is that it is canceled. If that happens, stock being \nacquired (LMN) will fall in price, returning to its pre-takeover levels. In addition, the \nacquiring stock (XYZ) will probably rise. Thus, the risk arbitrageur can lose money \non both sides of his trade. If either or both of the stocks involved in the propos", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 201}
{"text": "rential disappears, and the arbitrageur \nhas his profit. \nThe greatest risk in a merger is that it is canceled. If that happens, stock being \nacquired (LMN) will fall in price, returning to its pre-takeover levels. In addition, the \nacquiring stock (XYZ) will probably rise. Thus, the risk arbitrageur can lose money \non both sides of his trade. If either or both of the stocks involved in the proposed \ntakeover have options, the arbitrageur may be able to work options into his strategy. \nIn merger situations, since large moves can occur in both stocks ( they move in \nconcert), option purchases are the preferable option strategy. If the acquiring com\npany (XYZ) has in-the-money puts, then the purchase of those puts may be used \ninstead of selling XYZ short. The advantage is that if XYZ rallies dramatically during \nthe time it takes for the merger to take effect, then the arbitrageur's profits will be \nincreased. \nExample: As above, assume that XYZ is at 50 and is acquiring LMN in a 2-for-l stock \ndeal. LMN is at 22. Suppose that XYZ rallies to 60 by the time the deal closes. This \nwould pull LMN up to a price of 30. If one had been short 100 XYZ at 50 and long \n200 LMN at 22, then his profit would be $600 - a $1,600 gain on the 200 long LMN \nminus a $1,000 loss on the XYZ short sale. \nCompare that result to a similar strategy substituting a long put for the short \nXYZ stock. Assume that he buys 200 LMN as before, but now buys an XYZ put. If \none could buy an XYZ July 55 put with little time premium, say at 5½ points, then \nhe would have nearly the same dollars of profit if the merger should go through with \nXYZ below 55. \nChapter 27: Arbitrage 447 \nHowever, when XYZ rallies to 60, his profit increases. He would still make the \n$1,600 on LMN as it rose from 22 to 30, but now would only lose $550 on the XYZ \nput - a total profit of $1,050 as compared to $600 with an all-stock position. \nThe disadvantage to substituting long puts for short stock is that the arbitrageur \ndoes not receive credit for the short sale and, therefore, does not earn money at the \ncarrying rate. This might not be as large a disadvantage as it initially seems, however, \nsince it is often the case that it is very expensive - even impossible - to borrow the \nacquiring stock in order to short it. If the stock borrow costs are very large or if no \nstock can be located for borrowing, the purchase of an in-the-money put is a viable \nalternative. The purchase of an in-the-money put is preferable to an at- or out-of-the\nmoney put, because the amount of time value premium paid for the latter would take \ntoo much of the profitability away from the arbitrage if XYZ stayed unchanged or \ndeclined. This strategy may also save money if the merger falls apart and XYZ rises. \nThe loss on the long put may well be less than the loss would be on short XYZ stock. \nNote also that one could sell the XYZ July 55 call short as well as buy the put. \nThis would, of course, be synthetic short stock and is a pure substitute for shorting \nthe stock. The use of this synthetic short is recommended only when the arbitrageur \ncannot borrow the acquiring stock. If this is his purpose, he should use the in-the\nmoney put and out-of-the-money call, since if he were assigned on the call, he could \nnot borrow the stock to deliver it as a short sale. The use of an out-of-the-money call \nlessens the chance of eventual assignment. \nThe companion strategy is to buy an in-the-money call instead of buying the \ncompany being acquired (LMN). This has advantages if the stock falls too far, either \nbecause the merger falls apart or because the stocks in the merger decline too far. \nAdditionally, the cost of carrying the long LMN stock is eliminated, although that is \ngenerally built into the cost of the long calls. The larger amount of time value pre\nmium in calls as compared to puts makes this strategy often less attractive than that \nof buying the puts as a substitute for the short sale. \nOne might also consider selling options instead of buying them. Generally this \nis an inferior strategy, but in certain instances it makes sense. The reason that option \nsales are inferior is that they do not limit one's risk in the risk arbitrage, but they cut \noff the profit. For example, if one sells puts on the company being acquired (LMN), \nhe has a bullish situation. However, if the company being acquired (XYZ) rallies too \nfar, there will be a loss, because the short puts will stop making money as soon as \nLMN rises through the strike. This is especially disconcerting if a takeover bidding \nwar should develop for LMN. The arbitrageur who is long LMN will participate nice\nly as LMN rises heavily in price during the bidding war. However, the put seller will \nnot participate to nearly the same extent. \n448 Part IV: Additional Considerations \nThe sale of in-the-money calls as a substitute for shorting the acquiring compa\nny (XYZ) can be beneficial at certain times. It is necessary to have a plus tick in order \nto sell stock short. When many arbitrageurs are trying to sell a stock short at the same \ntime, it may be difficult to sell such stock short. Morever, natural owners of XYZ may \nsee the arbitrageurs holding the price down and decide to sell their long stock rather \nthan suffer through a possible decline in the stock's price while the merger is in \nprogress. Additionally, buyers of XYZ will become very timid, lowering their bids for \nthe same reasons. All of this may add up to a situation in which it is very difficult to \nsell the stock short, even if it can be borrowed. The sale of an in-the-money call can \novercome this difficulty. The call should be deeply in-the-money and not be too long\nterm, for the arbitrageur does not want to see XYZ decline below the strike of the \ncall. If that happened, he would no longer be hedged; the other side of the arbitrage \n- the long LMN stock - would continue to decline, but he would not have any \nremaining short against the long LMN. \nL", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 202}
{"text": "an in-the-money call can \novercome this difficulty. The call should be deeply in-the-money and not be too long\nterm, for the arbitrageur does not want to see XYZ decline below the strike of the \ncall. If that happened, he would no longer be hedged; the other side of the arbitrage \n- the long LMN stock - would continue to decline, but he would not have any \nremaining short against the long LMN. \nLIMITS ON THE MERGER \nThere is another type of merger for stock that is more difficult to arbitrage, but \noptions may prove useful. In some merger situations, the acquiring company (XYZ) \npromises to give the shareholders of the company being acquired (LMN) an amount \nof stock equal to a set dollar price. This amount of stock would be paid even if the \nacquiring company rose or fell moderately in price. If XYZ falls too far, however, it \ncannot pay out an extraordinarily increased number of shares to LMN shareholders, \nso XYZ puts a limit on the maximum number of shares that it will pay for each share \nof LMN stock. Thus, the shareholders ofXYZ are guaranteed that there will be some \ndownside buffer in terms of dilution of their company in case XYZ declines, as is \noften the case for an acquiring company. However, ifXYZ declines too far, then LMN \nshareholders will receive less. In return for getting this downside guarantee, XYZ will \nusually also stipulate that there is a minimum amount of shares that they will pay to \nLMN shareholders, even if XYZ stock rises tremendously. Thus, if XYZ should rise \ntremendously in price, then LMN shareholders will do even better than they had \nanticipated. An example will demonstrate this type of merger accord. \nExample: Assume that XYZ is at 50 and it intends to acquire LMN for a stated price \nof $25 per share, as in the previous example. However, instead of merely saying that \nit will exchange two shares of LMN for one share of XYZ, the company says that it \nwants the offer to be worth $25 per share to LMN shareholders as long as XYZ is \nbetween 45 and 55. Given this information, we can determine the maximum and \nminimum number of shares that LMN shareholders will receive: The maximum is \nChapter 27: Arbitrage 449 \nthe stated price, 25, divided by the lower limit, 45, or 0.556 shares; the minimum is \n25 divided by the higher limit, 55, or 0.455. \nThis type of merger is usually stated in terms of how many shares of XYZ will \nbe issued, rather than in terms of the price range that XYZ will be able to move in. \nIn either case, one can be derived from the other, so that the manner in which the \nmerger deal is stated is merely a convention. In this case, for example, the merger \nmight be stated as being worth $25 per share, with each share of LMN being worth \nat least 0.455 shares of XYZ and at most 0.556 shares of XYZ. Note that these ratios \nmake the deal worth 25 as long as XYZ is between 45 and 55: 45 times 0.556 equals \n25, as does 0.455 times 55. \nIf the acquiring stock, XYZ, is between 45 and 55 at the time the merger is com\npleted, then the number of shares of XYZ that each LMN shareholder will receive is \ndetermined in a preset manner. Usually, at the time the merger is announced, XYZ \nwill say that its price on the closing date of the merger will be used to establish the \nproper ratio. As a slight alternative, sometimes the acquiring company will state that \nthe price to be used in determining the final ratio is to be an average of the closing \nprices of the stock over a stated period of time. This stated period of time might be \nsomething like the 10 days prior to the closing of the merger. \nExample: Suppose that the closing price of XYZ on the day that the merger closes is \nto be the price used in the ratio. Furthermore, suppose that XYZ closes at 51 on that \nday. It is within the prestated range, so a calculation must be done in order to deter\nmine how many shares of XYZ each LMN shareholder will get. This ratio is deter\nmined by dividing the stated price, 25, by the price in question, 51. This would give \na final ratio of 0.490196. The final ratio is usually computed to a rather large number \nof decimal points in order to assure that LMN shareholders get as close to $25 per \nshare as possible. \nThe above two examples explain how this type of merger works. A merger of \nthis type is said to have \"hooks\" - the prices at which the ratio steadies. This makes \nit difficult to arbitrage. As long as XYZ roams around in the 45 to 55 range, the arbi\ntrageur does not want to short XYZ as part of his arbitrage, because the price of XYZ \ndoes not affect the price he will eventually receive for LMN 25. Rather, he would \nbuy LMN and wait until the deal is near closing before actually shorting XYZ. By \nwaiting, he will know approximately how many shares of XYZ to short for each share \nof LMN that he owns. The reason that he must short XYZ at the end of the merger \nis that there is usually a period of time before the physical stock is reorganized from \nLMN into XYZ. During that time, if he were long LMN, he would be at risk if he did \nnot short XYZ against it. \n450 Part IV: Additional Considerations \nProblems arise if XYZ begins to fall below 45 well before the closing of the \nmerger, the lower \"hook\" in the merger. If it should remain below 45, then one \nshould set up the arbitrage as being short 0.556 shares ofXYZ for each share of LMN \nthat is held long. As long as XYZ remains below 45 until the merger closes, this is the \nproper ratio. However, if, after establishing that ratio, XYZ rallies back above 45, the \narbitrageur can suffer damaging losses. XYZ may continue to rise in price, creating a \nloss on the short side. However, LMN will not follow it, because the merger is struc\ntured so that LMN is worth 25 unless XYZ rises too far. Thus, the long side stops fol\nlowing as the short side moves higher. \nOn the other hand, no such problem exists if XYZ rises too far from its original \nprice of 50, going above the upper \"hook\" of 55. In that case, the arbitrageur wo", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 203}
{"text": "ise in price, creating a \nloss on the short side. However, LMN will not follow it, because the merger is struc\ntured so that LMN is worth 25 unless XYZ rises too far. Thus, the long side stops fol\nlowing as the short side moves higher. \nOn the other hand, no such problem exists if XYZ rises too far from its original \nprice of 50, going above the upper \"hook\" of 55. In that case, the arbitrageur would \nalready be long the LMN and would not yet have shorted XYZ, since the merger was \nnot yet closing. LMN would merely follow XYZ higher after the latter had crossed 55. \nThis is not an uncommon dilemma. Recall that it was shown that the acquiring \nstock will often fall in price immediately after a merger is announced. Thus, XYZ may \nfall close to, or below, the lower \"hook.\" Some arbitrageurs attempt to hedge them\nselves by shorting a little XYZ as it begins to fall near 45 and then completing the \nshort if it drops well below 45. The problem with handling the situation in this way \nis that one ends up with an inexact ratio. Essentially, he is forcing himself to predict \nthe movements of XYZ. \nIf the acquiring stock drops below the lower \"hook,\" there may be an opportu\nnity to establish a hedge without these risks if that stock has listed options. The idea \nis to buy puts on the acquiring company, and for those puts to have a striking price \nnearly equal to the price of the lower \"hook.\" The proper amount of the company \nbeing acquired (LMN) is then purchased to complete the arbitrage. If the acquiring \ncompany subsequently rallies back into the stated price range, the puts will not lose \nmoney past the striking price and the problems described in the preceding paragraph \nwill have been overcome. \nExample: A merger is announced as described in the preceding example: XYZ is to \nacquire LMN at a stated value of $25 per share, with the stipulation that each share \nof LMN will be worth at least 0.455 shares of XYZ and at most 0.556 shares. These \nshare ratios equate to prices of 45 and 55 on XYZ. \nSuppose that XYZ drops immediately in price after the merger is announced, \nand it falls to 40. Furthermore, suppose that the merger is expected to close some\ntime during July and that there are XYZ August 45 puts trading at 5½. This repre\nsents only ½ point time value premium. The arbitrageur could then set up the arbi\ntrage by buying 10,000 LMN and buying 56 of those puts. Smaller investors might \nbuy 1,000 LMN and buy 6 puts. Either of these is in approximately the proper ratio \nof 1 LMN to 0.556 XYZ. \nChapter 27: Arbitrage \nTENDER OFFERS \n451 \nAnother type of corporate takeover that falls under the broad category of risk arbi\ntrage is the tender offer. In a tender offer, the acquiring company normally offers to \nexchange cash for shares of the company to be acquired. Sometimes the off er is for \nall of the shares of the company being acquired; sometimes it is for a fractional por\ntion of shares. In the latter case, it is important to know what is intended to be done \nwith the remaining shares. These might be exchanged for shares of the acquiring \ncompany, or they might be exchanged for other securities (bonds, most likely), or \nperhaps there is no plan for exchanging them at all. In some cases, a company ten\nders for part of its own stock, so that it is in effect both the acquirer and the acquiree. \nThus, tender offers can be complicated to arbitrage properly. The use of options can \nlessen the risks. \nIn the case in which the acquiring company is making a cash tender for all the \nshares (called an \"any and all\" offer), the main use of options is the purchase of puts \nas protection. One would buy puts on the company being acquired at the same time \nthat he bought shares of that company. If the deal fell apart for some reason, the puts \ncould prevent a disastrous loss as the acquiring stock dropped. The arbitrageur must \nbe judicious in buying these puts. If they are too expensive or too far out-of-the\nmoney, or if the acquiring company might not really drop very far if the deal falls \napart, then the purchase of puts is a waste. However, if there is substantial downside \nrisk, the put purchase may be useful. \nSelling options in an \"any and all\" deal often seems like easy money, but there \nmay be risks. If the deal is completed, the company being acquired will disappear and \nits options would be delisted. Therefore, it may often seem reasonable to sell out-of\nthe-money puts on the acquiring company. If the deal is completed, these expire \nworthless at the closing of the merger. However, if the deal falls through, these puts \nwill soar in price and cause a large loss. On the other hand, it may also seem like easy \nmoney to sell naked calls with a striking price higher than the price being offered for \nthe stock. Again, if the deal goes through, these will be delisted and expire worthless. \nThe risk in this situation is that another company bids a higher price for the compa\nny on which the calls were written. If this happens, there might suddenly be a large \nupward jump in price, and the written calls could suffer a large loss. \nOptions can play a more meaningful role in the tender off er that is for only part \nof the stock, especially when it is expected that the remaining stock might fall sub\nstantially in price after the partial tender offer is completed. An example of a partial \ntender offer might help to establish the scenario. \nExample: XYZ proposes to buy back part of its own stock It has offered to pay $70 \nper share for half the company. There are no plans to do anything further. Based on \n452 Part IV: Additional Considerations \nthe fundamentals of the company, it is expected that the remaining stock will sell for \napproximately $40 per share. Thus, the average share of XYZ is worth 55 if the ten\nder offer is completed ( one-half can be sold at 70, and the other half will be worth \n40). XYZ stock might sell for $52 or $53 per share until the tender is completed. On \nthe day after the tender of", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 204}
{"text": ": Additional Considerations \nthe fundamentals of the company, it is expected that the remaining stock will sell for \napproximately $40 per share. Thus, the average share of XYZ is worth 55 if the ten\nder offer is completed ( one-half can be sold at 70, and the other half will be worth \n40). XYZ stock might sell for $52 or $53 per share until the tender is completed. On \nthe day after the tender offer expires, XYZ stock will drop immediately to the $40 per \nshare level. \nThere are two ways to make money in this situation. One is to buy XYZ at the \ncurrent price, say 52, and tender it. The remaining portion would be sold at the lower \nprice, say 40, when XYZ reopened after the tender expired. This method would yield \na profit of $3 per share if exactly 50% of the shares are accepted at 70 in the tender \noffer. In reality, a slightly higher percentage of shares is usually accepted, because a \nfew people make mistakes and don't tender. Thus, one's average net price tnight be \n$56 per share, for a $4 profit from this method. The risk in this situation is that XYZ \nopens substantially below 40 after the tender at 70 is completed. \nTheoretically, the other way to trade this tender off er might be to sell XYZ short \nat 52 and cover it at 40 when it reopens after the tender offer expires. Unfortunately, \nthis method cannot be effected because there will not be any XYZ stock to borrow in \norder to sell it short. All owners will tender the stock rather than loan it to arbi\ntrageurs. Arbitrageurs understand this, and they also understand the risk they take if \nthey try to short stock at the last minute: They might be forced to buy back the stock \nfor cash, or they may be forced to give the equivalent of $70 per share for half the \nstock to the person who bought the stock from them. For some reason, many indi\nvidual investors believe that they can \"get away\" with this strategy. They short stock, \nfiguring that their brokerage firm will find some way to borrow it for them. \nUnfortunately, this usually costs the customer a lot of money. \nThe use of calls does not provide a more viable way of attempting to capitalize \non the drop of XYZ from 52 to 40. In-the-money call options on XYZ will normally \nbe selling at parity just before the tender offer expires. If one sells the call as a sub\nstitute for the short sale, he will probably receive an assignment notice on the day \nafter the tender offer expires, and therefore find himself with the same problems the \nshort seller has. \nThe only safe way to play for this drop is to buy puts on XYZ. These puts will be \nvery expensive. In fact, with XY\"L at 52 before the tender offer expires, if the con\nsensus opinion is that XYZ will trade at 40 after the offer expires, then puts with a 50 \nstrike will sell for at least $10. This large price reflects the expected drop in price of \nXYZ. Thus, it is not beneficial to buy these puts as downside speculation unless one \nexpects the stock to drop farther than to the $40 level. There is, however, an oppor\ntunity for arbitrage by buying XYZ stock and also buying the expensive puts. \nChapter 27: Arbitrage 453 \nBefore giving an example of that arbitrage, a word about short tendering is in \norder. Short tendering is against the law. It comes about when one tenders stock into \na tender offer when he does not really own that stock. There are complex definitions \nregarding what constitutes ownership of stock during a tender offer. One must be net \nlong all the stock that he tenders on the day the tender offer expires. Thus, he can\nnot tender the stock on the day before the offer expires, and then short the stock on \nthe next day ( even if he could borrow the stock). In addition, one must subtract the \nnumber of shares covered by certain calls written against his position: Any calls with \na strike price less than the tender off er price must be subtracted. Thus, if he is long \n1,000 shares and has written 10 in-the-money calls, he cannot tender any shares. The \nnovice and experienced investor alike must be aware of these definitions and should \nnot violate the short tender rules. \nLet us now look at an arbitrage consisting of buying stock and buying the expen\nsive puts. \nExample: XYZ is at 52. As before, there is a tender offer for half the stock at 70, with \nno plans for the remainder. The July 55 puts sell for 15, and the July 50 puts sell for \n10. It is common that both puts would be predicting the same price in the after-mar\nket: 40. \nIf one buys 200 shares ofXYZ at 52 and buys one July 50 put at 10, he has a locked\nin profit as long as the tender offer is completed. He only buys one put because he \nis assuming that 100 shares will be accepted by the company and only 100 shares will \nbe returned to him. Once the 100 shares have been returned, he can exercise the put \nto close out his position. \nThe following table summarizes these results: \nInitial purchase \nBuy 200 XYZ at 52 \nBuy 1 July 50 put at 10 \nTotal Cost \nClosing sale \nSell 1 00 XYZ at 70 via tender \nSell 1 00 XYZ at 50 via put exercise \nTotal proceeds \nTotal profit: $600 \n$10,400 debit \n1,000 debit \n$11 ,400 debit \n7,000 credit \n5,000 credit \n$12,000 credit \nThis strategy eliminates the risk ofloss ifXYZ opens substantially below 40 after \nthe tender offer. The downside price is locked in by the puts. \n454 Part IV: Additional Considerations \nIf more than 50% of XYZ should be accepted in the tender offer, then a larger \nprofit will result. Also, if XYZ should subsequently trade at a high enough price so \nthat the July 50 put has some time value premium, then a larger profit would result \nas well. (The arbitrageur would not exercise the put, but would sell the stock and the \nput separately in that case.) \nPartial tender offers can be quite varied. The type described in the above exam\nple is called a \"two-tier\" offer because the tender offer price is substantially different \nfrom the remaining price. In some partial tenders, the remainder of the stock is slat\ned for purc", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 205}
{"text": "uld result \nas well. (The arbitrageur would not exercise the put, but would sell the stock and the \nput separately in that case.) \nPartial tender offers can be quite varied. The type described in the above exam\nple is called a \"two-tier\" offer because the tender offer price is substantially different \nfrom the remaining price. In some partial tenders, the remainder of the stock is slat\ned for purchase at substantially the same price, perhaps through a cash merger. The \nabove strategy would not be applicable in that case, since such an offer would more \nclosely resemble the \"any and all\" offer. In other types of partial tenders, debt secu\nrities of the acquiring company may be issued after the partial cash tender. The net \nprice of these debt securities may be different from the tender offer price. If they \nare, the above strategy might work. \nIn summary, then, one should look at tender offers carefully. One should be \ncareful not to take extraordinary option risk in an \"any and all\" tender. Conversely, \none should look to take advantage of any \"two-tier\" situation in a partial tender offer \nby buying stock and buying puts. \nPROFITABILITY \nSince the potential profits in risk arbitrage situations may be quite large, perhaps 3 \nor 4 points per 100 shares, the public can participate in this strategy. Commission \ncharges will make the risk arbitrage less profitable for a public customer than it \nwould be for an arbitrageur. The profit potential is often large enough, however, to \nmake this type of risk arbitrage viable even for the public customer. \nIn summary, the risk arbitrageur may be able to use options in his strategy, \neither as a replacement for the actual stock position or as protection for the stock \nposition. Although the public cannot normally participate in arbitrage strategies \nbecause of the small profit potential, risk arbitrages may often offer exceptions. The \nprofit potential can be large enough to overcome the commission burden for the \npublic customer. \nPAIRS TRADING \nA stock trading strategy that has gained some adherents in recent years is pairs trad\ning. Simplistically, this strategy involves trading pairs of stocks - one held long, the \nother short. Thus, it is a hedged strategy. The two stocks' price movements are relat\ned historically. The pairs trader would establish the position when one stock was \nChapter 27: Arbitrage 455 \nexpensive with respect to the other one, historically. Then, when the stocks return to \ntheir historical relationship, a profit would result. In reality, some fairly complicated \ncomputer programs search out the appropriate pairs. \nThe interest on the short sale offsets the cost of carry of the stock purchased. \nTherefore, the pairs trader doesn't have any expense except the possible differential \nin dividend payout. \nThe bane of pairs trading is a possible escalation of the stock sold short without \nany corresponding rise in price of the stock held long. A takeover attempt might \ncause this to happen. Of course, pairs traders will attempt to research the situation \nto ensure that they don't often sell short stocks that are perceived to be takeover can\ndidates. \nPairs traders can use options to potentially reduce their risk if there are in-the\nmoney options on both stocks. One would buy an in-the-money put instead of selling \none stock short, and would buy an in-the-money call on the other stock instead of \nbuying the stock itself. In this option combination, traders are paying very little time \nvalue premium, so their profit potential is approximately the same as with the pairs \ntrading strategy using stocks. ( One would, however, have a debit, since both options \nare purchased; so there would be a cost of carry in the option strategy.) \nIf the stocks return to their historical relationship, the option strategy will \nreflect the same profit as the stock strategy, less any loss of time value premium. One \nadded advantage of the option strategy, however, is that if a takeover occurs, the put \nhas limited liability, and the trader's loss would be less. \nAnother advantage of the option strategy is that if both stocks should experience \nlarge moves, it could make money even if the pair doesn't return to historical norms. \nThis would happen, for example, if both stocks dropped a great deal: The call has lim\nited loss, while the put' s profits would continue to accrue. Similarly, to the upside, a \nlarge move by both stocks would make the put worthless, but the call would keep \nmaking money. In both cases, the option strategy could profit even if the pair of \nstocks didn't perform as predicted. \nThis type of strategy- buying in-the-money options as substitutes for both sides \nof a spread or hedge strategy - is discussed in more detail in Chapter 31 on index \nspreading and Chapter 35 on futures spreads. \nFACILITATION (BLOCK POSITIONING) \nFacilitation is the process whereby a trader seeks to aid in making markets for the \npurchase or sale of large blocks of stock. This is not really an arbitrage, and its \ndescription is thus deferred to Chapter 28. \nCHAPTER 28 \nMathetnatical Applications \nIn previous chapters, many references have been made to the possibility of applying \nmathematical techniques to option strategies. Those techniques are developed in this \nchapter. Although the average investor - public, institutional, or floor trader - nor\nmally has a limited grasp of advanced mathematics, the information in this chapter \nshould still prove useful. It will allow the investor to see what sorts of strategy deci\nsions could be aided by the use of mathematics. It will allow the investor to evaluate \ntechniques of an information service. Additionally, if the investor is contemplating \nhiring someone knowledgeable in mathematics to do work for him, the information \nto be presented may be useful as a focal point for the work. The investor who does \nhave a knowledge of mathematics and also has access to a computer will be able to \ndirectly use the techniques", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 206}
{"text": "will allow the investor to evaluate \ntechniques of an information service. Additionally, if the investor is contemplating \nhiring someone knowledgeable in mathematics to do work for him, the information \nto be presented may be useful as a focal point for the work. The investor who does \nhave a knowledge of mathematics and also has access to a computer will be able to \ndirectly use the techniques in this chapter. \nTHE BLACK-SCHOLES MODEL \nSince an option's price is the function of stock price, striking price, volatility, time to \nexpiration, and short-term interest rates, it is logical that a formula could be drawn \nup to calculate option prices from these variables. Many models have been conceived \nsince listed options began trading in 1973. Many of these have been attempts to \nimprove on one of the first models introduced, the Black-Scholes model. This model \nwas introduced in early 1973, very near the time when listed options began trading. \nIt was made public at that time and, as a result, gained a rather large number of \nadherents. The formula is rather easy to use in that the equations are short and the \nnumber of variables is small. \nThe actual formula is: \n456 \nChapter 28: Mathematical Applications \nTheoretical option price= pN(d 1) se-rtN(d2) \np v2 \nln(8 )+ (r +2 )t \nwhere d1 = _ r. \nV-4 t \nd2 = d1 - v--ft \nThe variables are: \np = stock price \ns = striking price \nt = time remaining until expiration, expressed as a percent of a year \nr = current risk-free interest rate \nv = volatility measured by annual standard deviation \nln = natural logarithm \nN(x) = cumulative normal density function \n457 \nAn important by-product of the model is the exact calculation of the delta - that \nis, the amount by which the option price can be expected to change for a small \nchange in the stock price. The delta was described in Chapter 3 on call buying, and \nis more formally known as the hedge ratio. \nDelta= N(d1) \nThe formula is so simple to use that it can fit quite easily on most programmable cal\nculators. In fact, some of these calculators can be observed on the exchange floors as \nthe more theoretical floor traders attempt to monitor the present value of option pre\nmiums. Of course, a computer can handle the calculations easily and with great \nspeed. A large number of Black-Scholes computations can be performed in a very \nshort period of time. \nThe cumulative normal distribution function can be found in tabular form in \nmost statistical books. However, for computation purposes, it would be wasteful to \nrepeatedly look up values in a table. Since the normal curve is a smooth curve (it is \nthe \"bell-shaped\" curve used most commonly to describe population distributions), \nthe cumulative distribution can be approximated by a formula: \nx = l-z(l.330274y 5 - l.821256y 4 + l.781478y 3 - .356538y 2 + .3193815y) \nwhere y 1 and z = .3989423e-<r212 \n= 1 + .2316419lcrl \nThen N(cr) = x if cr > 0 or N(cr) = 1- x if cr < 0 \n458 Part IV: Additional Considerations \nThis approximation is quite accurate for option pricing purposes, since one is not \nreally interested in thousandths of a point where option prices are concerned. \nExample: Suppose that XYZ is trading at 45 and we are interested in evaluating the \nJuly 50 call, which has 60 days remaining until expiration. Furthermore, assume that \nthe volatility of XYZ is 30% and that the risk-free interest rate is currently 10%. The \ntheoretical value calculation is shown in detail, in order that those readers who wish \nto program the model will have something to compare their calculations against. \npage: \nInitially, determine t, d1, and d2, by referring to the formulae on the previous \nt = 60/365 = .16438 years \nd _ In (45/50) + (.1 + .3 x .3/2) x .16438 \n1-\n.3 X ✓.16438 \n= -.10536 + (.145 X .16438) = __ 67025 .3 X .40544 \nd2 = -.67025 - .3 ✓.16438 = -.67025 - (.3 x .40544) = -.79189 \nNow calculate the cumulative normal distribution function for d1 and d2 by \nreferring to the above formulae: \ndl = -.67025 \nl 1 \ny = l + (.2316419 I -.67025 I) = 1.15526 = ·86561 \nz = .3989423e--(-.67025 X -.67025)/2 \n= .3989423e-0·22462 = .31868 \nThere are too many calculations involved in the computation of the fifth-order \npolynomial to display them here. Only the result is given: \nX = .74865 \nSince we are determining the cumulative normal distribution of a negative \nnumber, the distribution is determined by subtracting x from l. \nN(d1) = N(-.67O25) = l -x = l - .74865 = .25134 \nIn a similar manner, which requires computing new values for x, y, and z, \nN(d2) = N(-.79179) = 1- .78579 = .21421 \nChapter 28: Mathematical Applications 459 \nNow, returning to the formula for theoretical option price, we can complete the \ncalculation of the July 50 call's theoretical value, called value here for short: \nvalue = 45 x N(d1) - 50 x e-·1 x ·16438 x N(d2) \n= 45 X .25134 - 50 X .9837 X .21421 \n= .7746 \nThus, the theoretical value of the July 50 call is just slightly over¼ of a point. \nNote that the delta of the call was calculated along the way as N(d1) and is equal to \njust over .25. That is, the July 50 call will change price about¼ as fast as the stock \nfor a small price change by the stock. \nThis example should answer many of the questions that readers of the first edi\ntion have posed. The reader interested in a more in-depth description of the model, \npossibly including the actual derivation, should refer to the article \"Fact and Fantasy \nin the Use of Options.\" 1 One of the less obvious relationships in the model is that call \noption prices will increase (and put option prices will decrease) as the risk-free inter\nest rate increases. It may also be observed that the model correctly preserves rela\ntionships such as increased volatility, higher stock prices, or more time to expiration, \nwhich all imply higher option prices. \nCHARACTERISTICS Of THE MODEL \nSeveral aspects of this model are worth further discussion. First, the reader will \nnotice that the model does not include dividends paid by", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 207}
{"text": "risk-free inter\nest rate increases. It may also be observed that the model correctly preserves rela\ntionships such as increased volatility, higher stock prices, or more time to expiration, \nwhich all imply higher option prices. \nCHARACTERISTICS Of THE MODEL \nSeveral aspects of this model are worth further discussion. First, the reader will \nnotice that the model does not include dividends paid by the common stock. As has \nbeen demonstrated, dividends act as a negative effect on call prices. Thus, direct \napplication of the model will tend to give inflated call prices, especially on stocks that \npay relatively large dividends. There are ways of handling this. Fisher Black, one of \nthe coauthors of the model, suggested the following method: Adjust the stock price \nto be used in the formula by subtracting, from the current stock price, the present \nworth of the dividends likely to be paid before maturity. Then calculate the option. \nprice. Second, assume that the option expires just prior to the last ex-dividend date \npreceding actual option expiration. Again adjust the stock price and calculate the \noption price. Use the higher of the two option prices calculated as the theoretical \nprice. \nAnother, less exact, method is to apply a weighting factor to call prices. The \nweighting factor would be based on the dividend payment, with a heavier weight \nbeing applied to call options on high-yielding stock. It should be pointed out that, in \n1Fisher Black, Financial Analysts Journal, July-August 1975, pp. 36-70. \n460 Part IV: Additional Considerations \nmany of the applications that are going to be prescribed, it is not necessary to know \nthe exact theoretical price of the call. Therefore, the dividend \"correction\" might not \nhave to be applied for certain strategy decisions. \nThe model is based on a lognormal distribution of stock prices. Even though the \nnormal distribution is part of the model, the inclusion of the exponential functions \nmakes the distribution lognormal. For those less familiar with statistics, a normal dis\ntribution has a bell-shaped curve. This is the most familiar mathematical distribution. \nThe problem with using a normal distribution is that it allows for negative stock \nprices, an impossible occurrence. Therefore, the lognormal distribution is generally \nused for stock prices, because it implies that the stock price can have a range only \nbetween zero and infinity. Furthermore, the upward (bullish) bias of the lognormal \ndistribution appears to be logically correct, since a stock can drop only 100% but can \nrise in price by more than 100%. Many option pricing models that antedate the \nBlack-Scholes model have attempted to use empirical distributions. An empirical \ndistribution has a different shape than either the normal or the lognormal distribu\ntion. Reasonable empirical distributions for stock prices do not differ tremendously \nfrom the lognormal distribution, although they often assume that a stock has a \ngreater probability of remaining stable than does the lognormal distribution. Critics \nof the Black-Scholes model claim that, largely because it uses the lognormal distri\nbution, the model tends to overprice in-the-money calls and underprice out-of-the\nmoney calls. This criticism is true in some cases, but does not materially subtract \nfrom many applications of the model in strategy decisions. True, if one is going to buy \nor sell calls solely on the basis of their computed value, this would create a large prob\nlem. However, if strategy decisions are to be made based on other factors that out\nweigh the overpriced/underpriced criteria, small differentials will not matter. \nThe computation of volatility is always a difficult problem for mathematical \napplication. In the Black-Scholes model, volatility is defined as the annual standard \ndeviation of the stock price. This is the regular statistical definition of standard devi\nation: \nwhere \nP = average stock price of all P/s \nPi = daily stock price \nn \n~ (Pi -P)2 \ncr2 = _1=_1 __ _ \nn-1 \nv = a!P \nChapter 28: Mathematical Applications 461 \nn = number of days observed \nv = volatility \nWhen volatility is computed using past stock prices, it is called a historical \nvolatility. The volatilities of stocks tend to change over time. Certain predictable fac\ntors, such as a large stock split increasing the float of the stock, can reduce the volatil\nity. The entry of a company into a more speculative area of business may increase the \nvolatility. Other, less well-defined factors can alter the volatility as well. Since the \nvolatility is a very crucial element of the pricing model, it is important that the mod\neler use a reasonable estimate of the current volatility. It has become apparent that \nan annual standard deviation is not accurate, because it encompasses too long a peri\nod of time. Recent efforts by many modelers have suggested that one should perhaps \nweight the recent stock price action more heavily than older price action in arriving \nat a current volatility. This is a possible approach, but the computation of such fac\ntors may introduce as much error as using the annual standard deviation does. The \nproblem of accurately computing the volatility is critical, because the model is so sen\nsitive to it. \nComputing Lognormal Historical Volatility. The above calculation does \nnot give the proper input for the Black-Scholes model because the model assumes \nthat the logarithms of changes in price are normally distributed, not the prices them\nselves. That is, the term Pi in the above formula should be changed. \nExample: XYZ closed at 51 today and at 50 yesterday. Thus, its percentage change \nfor the day is 51/50 = 1.02. The natural logarithm of 1.02 is then based on the volatil\nity formula: \nln(51/50) = ln(l.02) = 0.0198 \nThis is similar to saying that arithmetically the stock was up 2% today, but on a \nlognormal basis, it was only up 1.98% \nIf the stock is down, this method will yield a negative number. Suppose that on \nthe fol", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 208}
{"text": "today and at 50 yesterday. Thus, its percentage change \nfor the day is 51/50 = 1.02. The natural logarithm of 1.02 is then based on the volatil\nity formula: \nln(51/50) = ln(l.02) = 0.0198 \nThis is similar to saying that arithmetically the stock was up 2% today, but on a \nlognormal basis, it was only up 1.98% \nIf the stock is down, this method will yield a negative number. Suppose that on \nthe following day, XYZ declined from 51 back to 50. The number to use in the volatil\nity formula would then be: \nln(50/51) = ln(0.9804) = -0.0198 \n462 Part IV: Additional Considerations \nA new equation can now be formulated using this concept. It will yield volatili\nties that are consistent with the Black-Scholes model: \nV= \nn I \nwhere Xi = ln(P /Pi _1); Pi = closing price on day i and X = the average of the X/s over \nthe desired number of days. \nSo to compute a IO-day historical volatility, one would need 11 observations. In \nthe following example, do not be concerned with the complete details if you do not \nplan to compute the volatilities yourself; they are provided for the mathematician or \nprogrammer who needs to check his work: \nDay XYZ Stock P./P. 1 I I- X-=ln(P./P. 1) I I I- (X.-X)2 \nI \n1 153.875 \n2 153.625 .9984 -.0016 .000020 \n3 151 .9829 -.0172 .000405 \n4 146 .9669 -.0337 .001336 \n5 144.125 .9872 -.0129 .000250 \n6 147.25 1.0217 .0215 .000345 \n7 146.25 .9932 -.0068 .000094 \n8 149.5 1.0222 .0220 .000365 \n9 152.5 1.0201 .0199 .000289 \n10 158.625 1.0402 .0394 .001332 \n1 1 158.375 0.9984 -.0016 .000020 \nAVG: 0.0028825 :l;: 0.004455 \nThe average of the Ins (4th column) over the 10 days is 0.00288. \nThe difference of each In from the mean, squared, is then summed (5th col\numn). For example, for day 1 the term is (- .0016- .00288)2 = .00002. This is the top \nnumber in the far right-hand column. This process can be computed for each num\nber in the \"In\" column. The sum of all these terms is 0.004455. \nNowv = ✓(.004455/9) = 0.022249 \nThis is a IO-day volatility. To convert it into an annual volatility, we need to mul\ntiply by the square root of the number of trading days in a year. Since there are \napproximately 260 trading days in a year, the final volatility would be: \nV = 0.022249 X ✓(260) = 0.3587 \nThus, one could say that the volatility of XYZ is 36% on an annualized basis. \nChapter 28: Mathematical Applications 463 \nThis is then the proper way to calculate historical volatility. Obviously, the \nstrategist can calculate 10-, 20-, and 50-day and annual volatilities if he wishes - or \nany other number for that matter. In certain cases, one can discern valuable infor\nmation about a stock or future and its options by seeing how the various volatilities \ncompare with one another. \nThere is, in fact, a way in which the strategist can let the market compute the \nvolatility for him. This is called using the implied volatility; that is, the volatility that \nthe market itself is implying. This concept makes the assumption that, for options \nwith striking prices close to the current stock price and for options with relatively \nlarge trading volume, the market is fairly priced. This is something like an efficient \nmarket hypothesis. If there is enough trading interest in an option that is close to the \nmoney, that option will generally be fairly priced. Once this assumption has been \nmade, a corollary arises: If the actual price of an option is the fair price, it can be fixed \nin the Black-Scholes equation while letting volatility be the unknown variable. The \nvolatility can be determined by iteration. In fact, this process of iterating to compute \nthe volatility can be done for each option on a particular underlying stock This might \nresult in several different volatilities for the stock If one weights these various results \nby volume of trading and by distance in- or out-of-the-money, a single volatility can \nbe derived for the underlying stock This volatility is based on the closing price of all \nthe options on the underlying stock for that given day. \nExample: XYZ is at 33 and the closing prices are given in Table 28-1. Each option \nhas a different implied volatility, as computed by determining what volatility in the \nBlack-Scholes model would result in the closing price for each option: That is, if .34 \nwere used as the volatility, the model would give 4¼ as the price of the January 30 \ncall. In order to rationally combine these volatilities, weighting factors must be \napplied before a volatility for XYZ stock itself can be arrived at. \nThe weighting factors for volume are easy to compute. The factor for each \noption is merely that option's daily volume divided by the total option volume on all \nXYZ options (Table 28-2). The weighting functions for distance from the striking \nprice should probably not be linear. For example, if one option is 2 points out-of-the\nmoney and another is 4 points out-of-the-money, the former option should not nec\nessarily get twice as much weight as the latter. Once an option is too far in- or out-of\nthe-money, it should not be given much or any weight at all, regardless of its trading \nvolume. Any parabolic function of the following form should suffice: \n{ \n(x - a)2 if xis less than a \nWeighting factor = -;;,r-\n= 0 if x is greater than a \n464 Part IV: Additional Considerations \nTABLE 28-1. \nImplied volatilities, closing price, and volume. \nOption \nOption Price Volume \nJanuary 30 41/2 \nJanuary 35 11/2 \nApril 35 21/2 \nApril 40 11/2 \nTABLE 28-2. \nVolume weighting factors. \nOption \nJanuary 30 \nJanuary 35 \nApril 35 \nApril 40 \nVolume \n50 \n90 \n55 \n5 \n50 \n90 \n55 \n~ \n200 \nImplied \nVolatility \n.34 \n.28 \n.30 \n.38 \nVolume Weighting Factor \n.25 (50/200) \n.45 (90/200) \n.275 (55/200) \n.025 ( 5/200) \nwhere x is the percentage distance between stock price and strike price and a is the \nmaximum percentage distance at which the modeler wants to give any weight at all \nto the option's implied volatility. \nExample: An investor decides that he wants to discard options from the weighting \ncriterion", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 209}
{"text": ".34 \n.28 \n.30 \n.38 \nVolume Weighting Factor \n.25 (50/200) \n.45 (90/200) \n.275 (55/200) \n.025 ( 5/200) \nwhere x is the percentage distance between stock price and strike price and a is the \nmaximum percentage distance at which the modeler wants to give any weight at all \nto the option's implied volatility. \nExample: An investor decides that he wants to discard options from the weighting \ncriterion that have striking prices more than 25% from the current stock price. The \nvariable, a, would then be equal to .25. The weighting factors, with XYZ at 33, could \nthus be computed as shown in Table 28-3. To combine the weighting factors for both \nvolume and distance from strike, the two factors are multiplied by the implied volatil\nity for that option. These products are summed up for all the options in question. \nThis sum is then divided by the products of the weighting factors, summed over all \nthe options in question. As a formula, this would read: \nImplied _ I,(Volume factor x Distance factor x Implied volatility) \nvolatility - I,(Volume factor x Distance factor) \nIn our example, this would give an implied volatility for XYZ stock of 29.8% \n(Table 28-4). Note that the implied volatility, .298, is not equal to any of the individ-\nChapter 28: Mathematical Applications \nTABLE 28-3. \nDistance weighting factors. \n465 \nOption \nDistonce \nfrom \nStock Price \nDistance \nWeighting Factor \nJanuary 30 \nJanuary 35 \nApril 35 \nApril 40 \nTABLE 28-4. \nOption's implied volatility. \n.091 (3/33) \n.061 (2/33) \n.061 (2/33) \n.212 (7 /33) \n.41 \n.57 \n.57 \n.02 \nVolume Distance Option's Implied \nOption Factor Factor Volotility \nJanuary 30 .25 .41 .34 \nJanuary 35 .45 .57 .28 \nApril 35 .275 .57 .30 \nApril40 .025 .02 .38 \nImplied = .25 x .41 x .34 + .45 x .57 x .28 + .275 x .57 x .30 + .025 x .02 x .38 \nvolatility. .25 x .41 + .45 x .57 + .275 x .57 + .025 x .02 \n= .298 \nual option's implied volatilities. Rather, it is a composite figure that gives the most \nweight to the heavily traded, near-the-money options, and very little weight to the \nlightly-traded (5 contracts), deeply out-of-the-money April 40 call. This implied \nvolatility is still a form of standard deviation, and can thus be used whenever a stan\ndard deviation volatility is called for. \nThis method of computing volatility is quite accurate and proves to be sensitive \nto changes in the volatility of a stock. For example, as markets become bullish or \nbearish (generating large rallies or declines), most stocks will react in a volatile man\nner as well. Option premiums expand rather quickly, and this method of implied \nvolatility is able to pick up the change quickly. One last bit of fine-tuning needs to be \ndone before the final volatility of the stock is arrived at. On a day-to-day basis, the \nimplied volatility for a stock - especially one whose options are not too active may \nfluctuate more than the strategist would like. A smoothing effect can be obtained by \n466 Part IV: Additional Considerations \ntaking a moving average of the last 20 or 30 days' implied volatilities. An alternative \nthat does not require the saving of many previous days' worth of data is to use a \nmomentum calculation on the implied volatility. For example, today's final volatility \nmight be computed by adding 5% of today's implied volatility to 95% of yesterday's \nfinal volatility. This method requires saving only one previous piece of data - yester\nday's final volatility - and still preserves a \"smoothing\" effect. \nOnce this implied volatility has been computed, it can then be used in the \nBlack-Scholes model ( or any other model) as the volatility variable. Thus one could \ncompute the theoretical value of each option according to the Black-Scholes formu\nla, utilizing the implied volatility for the stock. Since the implied volatility for the \nstock will most likely be somewhat different from the implied volatility of this par\nticular option, there will be a discrepancy between the option's actual closing price \nand the theoretical price as computed by the model. This differential represents the \namount by which the option is theoretically overpriced or underpriced, compared to \nother options on that same stock. \nEXPECTED RETURN \nCertain investors will enter positions only when the historical percentages are on \ntheir side. When one enters into a transaction, he normally has a belief as to the pos\nsibility of making a profit. For example, when he buys stock he may think that there \nis a \"good chance\" that there will be a rally or that earnings will increase. The investor \nmay consciously or unconsciously evaluate the probabilities, but invariably, an invest\nment is made based on a positive expectation of profit. Since options have fixed \nterms, they lend themselves to a more rigorous computation of expected profit than \nthe aforementioned intuitive appraisal. This more rigorous approach consists of com\nputing the expected return. The expected retum is nothing more than the retum that \nthe position should yield over a large number of cases. \nA simple example may help to explain the concept. The crucial variable in com\nputing expected return is to outline what the chances are of the stock being at a cer\ntain price at some future time. \nExample: XYZ is selling at 33, and an investor is interested in determining where \nXYZ will be in 6 months. Assume that there is a 20% chance of XYZ being below 30 \nin 6 months, and that there is a 40% chance that XYZ will be above 35 in 6 months. \nFinally, assume that XYZ has an equal 10% chance of being at 31, 32, 33, or 34 in 6 \nmonths. All other prices are ignored for simplification. Table 28-5 summarizes these \nassumptions. \nChapter 28: Mathematical Applications \nTABLE 28-5. \nCalculation of expected returns. \nPrice of XYZ in 6 Months \nBelow 30 \n31 \n32 \n33 \n34 \nAbove 35 \n467 \nChance of XYZ Being at That Price · \n20% \n10% \n10% \n10% \n10% \n40% \n100% \nSince the percentages total 100%, all the outcomes have theoretically been \nallowed for. Now suppose a Februa", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 210}
{"text": "d for simplification. Table 28-5 summarizes these \nassumptions. \nChapter 28: Mathematical Applications \nTABLE 28-5. \nCalculation of expected returns. \nPrice of XYZ in 6 Months \nBelow 30 \n31 \n32 \n33 \n34 \nAbove 35 \n467 \nChance of XYZ Being at That Price · \n20% \n10% \n10% \n10% \n10% \n40% \n100% \nSince the percentages total 100%, all the outcomes have theoretically been \nallowed for. Now suppose a February 30 call is trading at 4 and a February 35 call is \ntrading at 2 points. A bull spread could be established by buying the February 30 and \nselling the February 35. This position would cost 2 points - that is, it is a 2-point \ndebit. The spreader could make 3 points if XYZ were above 35 at expiration for a \nreturn of 150%, or he could lose 100% if XYZ were below 30 at expiration. The \nexpected return for this spread can be computed by multiplying the outcome at expi\nration for each price by the probability of being at that price, and then summing the \nresults. For example, if XYZ is below 30 at expiration, the spreader loses $200. It was \nassumed that there is a 20% chance of XYZ being below 30 at expiration, so the \nexpected loss is 20% times $200, or $40. Table 28-6 shows the computation of the \nexpected results at all the prices. The total expected profit is $100. This means that \nthe expected return (profit divided by investment) is 50% ($100/$200). This appears \nto be an attractive spread, because the spreader could \"expect\" to make 50% of his \nmoney, less commissions. \nWhat has really been calculated in this example is merely the return that one \nwould expect to make in the long run if he invested in the same position many times \nthroughout history. Saying that a particular position has an expected return of 8 or \n9% is no different from saying that common stocks return 8 or 9% in the long run. \nOf course, in bull markets stock would do much better, and in bear markets much \nworse. In a similar manner, this example bull spread with an expected return of 50% \nmay do as well as the maximum profit or as poorly as losing 100% in any one case. It \nis the total return on many cases that has the expected return of 50%. Mathematical \ntheory holds that, if one constantly invests in positions with positive expected returns, \nhe should have a better chance of making rrwney. \n468 Part IV: Additional Considerations \nTABLE 28-6. \nComputation of expected profit. \nChance of Being Profit at Expected \nXYZ Price at at That Price That Price Profit: \nExpiration (A) (B) (A) x (8) \nBelow 30 20% -$200 -$ 40 \n31 10% - 100 - 10 \n32 10% 0 0 \n33 10% + 100 + 10 \n34 10% + 200 + 20 \nAbove 35 40% + 300 + 120 \nTotal expected profit $100 \nAs is readily observable, the selection of what percentages to assign to the pos\nsible outcomes in the stock price is a crucial choice. In the example above, if one \naltered his assumption slightly so that XYZ had a 30% chance of being below 30 and \na 30% chance of being above 35 at expiration, the expected return would drop con\nsiderably, to 25%. Thus, it is important to have a reasonably accurate and consistent \nmethod of assigning these percentages. Furthermore, the example above was too sim\nplistic, in that it did not allow for the stock to close at any fractional prices, such as \n32½. A correct expected return computation must take into account all possible out\ncomes for the stock. \nFortunately, there is a straightforward method of computing the expected per\ncentage chance of a given stock being at a certain price at a certain point in time. This \ncomputation involves using the distribution of stock prices. As mentioned earlier, the \nBlack-Scholes model assumes a lognormal distribution for stock prices, although \nmany modelers today use nonstandard (empirical or heuristic) distributions. No mat\nter what the distribution, the area under the distribution curve between any two \npoints gives the probability of being between those two points. \nFigure 28-1 is a graph of a typical lognormal distribution. The peak always lies \nat the \"mean,\" or average, of the distribution. For stock price distributions, under the \nrandom walk assumption, the \"mean\" is generally considered to be the current stock \nprice. The graph allows one to visualize the probability of being at any given price. \nNote that there is a fairly great chance that the stock will be relatively unchanged; \nthere is no chance that the stock will be below zero; and there is a bullish bias to the \ngraph - the stock could rise infinitely, although the chances of it doing so are \nextremely small. \nChapter 28: Mathematical Applications \nFIGURE 28-1. \nTypical lognormal distribution. \n60% \n0 A Mean (current price) \nStock Price at End of Time Period \n469 \nThe chance that XYZ will be below the meah at the end of the time period is \n50% in a random walk distribution. This also means that 50% of the area under the \ngraph lies to the left of the mean and 50% lies to the right of the mean. Note point \nA on the graph. Forty percent of the area under the distribution curve lies to the left \nof point A and 60% lies to the right of it. This means that there is a 40% chance that \nthe stock will be below price A at the end of the time period and a 60% chance that \nthe stock will be above price A. Consequently, the distribution curve can be used to \ndetermine the probabilities necessary for the expected return computation. The \nreader should take note of the fact that these probabilities apply to the end of the time \nperiod. They say nothing about the chances that XYZ might dip below price A at \nsome time during the time period. To compute that percentage, an involved compu\ntation is necessary. \nThe height and width of the distribution graph are determined by the volatility \nof the underlying stock, when volatility is expressed as a standard deviation. This is \nconsistent with the method of computing volatility described earlier in this chapter. \nImplied volatility can, of course, be used. Since the option modeler is generally inter\nested in time pe", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 211}
{"text": "an involved compu\ntation is necessary. \nThe height and width of the distribution graph are determined by the volatility \nof the underlying stock, when volatility is expressed as a standard deviation. This is \nconsistent with the method of computing volatility described earlier in this chapter. \nImplied volatility can, of course, be used. Since the option modeler is generally inter\nested in time periods other than one year, the annual volatility must be converted into \na volatility for the time period in question. This is easily accomplished by the follow\ning formula: \n470 \nwhere \nv = annual volatility \nt = time, in years \nvt = volatility for time, t. \nPart IV: Additional Considerations \nAs an example, a 3-month volatility would be equal to one-half of the annual \nvolatility. In this case, t would equal .25 (one fourth of a year), so v_25 = v65 = .5v. \nThe necessary groundwork has been laid for the computation of the probabili\nty necessary in the expected return calculation. The following formula gives the prob\nability of a stock that is currently at price p being below some other price, q, at the \nend of the time period. The lognormal distribution is assumed. \nProbability of stock being below price q at end of time period t: \nP (below) = N (In~)) \nwhere \nN = cumulative normal distribution \np = current price of the stock \nq = price in question \nIn = natural logarithm for the time period in question. \nIf one is interested in computing the probability of the stock being above the \ngiven price, the formula is \nP (above)= 1- P (below) \nWith this formula, the computation of expected return is quickly accomplished \nwith a computer. One merely has to start at some price - the lower strike in a bull \nspread, for example - and work his way up to a higher price - the high strike for a \nbull spread. At each price point in between, the outcome of the spread is multiplied \nby the probability of being at that price, and a running sum is kept. \nSimplistically, the following iterative equation would be used. \nP ( of being at price x) = P (below x) - P (below y) \nwhere y is close to but less than x in price. As an example: \nP (of being at 32.4) = P (below 32.4) - P (below 32.3) \nChapter 28: Mathematical Applications 471 \nThus, once the low starting point is chosen and the probability of being below that \nprice is determined, one can compute the probability of being at prices that are suc\ncessively higher merely by iterating with the preceding formula. In reality, one is \nusing this information to integrate the distribution curve. Any method of approxi\nmating the integral that is used in basic calculus, such as the Trapezoidal Rule or \nSimpson's Rule, would be applicable here for more accurate results, if they are \ndesired. \nA partial example of an expected return calculation follows. \nExample: XYZ is currently at 33 and has an annual volatility of 25%. The previous \nbull spread is being established- buy the February 30 and sell the February 35 for a \n2-point debit - and these are 6-month options. Table 28-7 gives the necessary com\nponents for computing the expected return. Column (A), the probability of being \nbelow price q, is computed according to the previously given formula, where p = 33 \nand vt = .177 (t = .25-V ½). The first stock price that needs to be looked at is 30, since \nall results for the bull spread are equal below that price - a 100% loss on the spread. \nThe calculations would be performed for each eighth (or tenth) of a point up through \na price of 35. The expected return is compute<l by multiplying the two right-hand \ncolumns, (B) and (C), and summing the results. Note that column (B) is determined \nby subtracting successive numbers in column (A). It would not be particularly \nenlightening to carry this example to completion, since the rest of the computations \nare similar and there is a large number of them. \nIn theory, if one had the data and the computer power, he could evaluate a wide \nrange of strategies every day and come up with the best positions on an expected \nreturn basis. He would probably get a few option buys (puts or calls), some bull \nTABLE 28-7. \nCalculation of expected returns. \nPrice at Expiration (A) (B) (() \n(q) P (below q) P (of being at q) Profit on Spread \n30 .295 .295 -$200 \n30 1/s .301 .006 - 187.50 \n30 1/4 .308 .007 - 175 \n303/s .316 .008 - 162.50 \n472 Part IV: Additional Considerations \nspreads, some naked writes and ratio calendar spreads, fewer straddles and ratio \nwrites, and a few covered call writes. This theory would be somewhat difficult to apply \nin practice, because of the massive numbers of calculations involved and also because \nof the accuracy of closing price data. It was mentioned previously that a computer will \nassume that \"bad\" closing prices are actually attainable. By a \"bad\" closing price, it is \nmeant that the option did not trade simultaneously with the stock later in the day, and \nthat the actual market for the option is somewhat different in price than is reflected \nby the closing price for the option. A daily contract volume \"screen\" will help allevi\nate this problem. For example, one may want to discard any option from his calcula\ntions if that option did not trade a predetermined, minimum number of contracts \nduring the previous day. Data that give closing bids and offers for each option are \nmore expensive but also more reliable, and would alleviate the problem of \"bad\" \nclosing prices. In addition to a volume screen, another way of reducing the calcula\ntions required is to limit oneself to strategies in which one has interest, or which one \nis reasonably certain will fit in well with his investment objectives. Regardless of the \nlimitations that one places upon the quantity of computations, some computer power \nis necessary to compute expected return. A sophisticated programmable calculator \nmay be able to provide a real-time calculation, but could never be used to evaluate \nthe entire option universe and come up with a ranking of", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 212}
{"text": "is reasonably certain will fit in well with his investment objectives. Regardless of the \nlimitations that one places upon the quantity of computations, some computer power \nis necessary to compute expected return. A sophisticated programmable calculator \nmay be able to provide a real-time calculation, but could never be used to evaluate \nthe entire option universe and come up with a ranking of the preferable situations \neach day. On-line computer systems are also available that can provide these types of \ncalculations using up-to-the-minute prices. While real-time prices may occasionally \nbe useful, it is not an absolute necessity to have them. \nOne other by-product of the expected return calculation is that it could be used \nas another model for predicting the theoretical value of an option. All one would have \nto do is compute the probabilities of the stock being at each successive price above \nthe striking price of the option by expiration, and sum them up. The result would be \nthe theoretical option value. These data are published by some services and general\nly give a different theoretical value than would the Black-Scholes model. The reason \nfor the difference most readily lies in the inclusion of the risk-free interest rate in the \nBlack-Scholes model and its omission in the expected return model. \nAPPLYING THE CALCULATIONS TO STRATEGY DECISIONS \nCALL WRITING \nOne method of ranking covered call writes that was described in Chapter 2 was to \nrank all the writes that provided at least a minimal acceptable level of return by their \nprobability of not losing money. If one were interested in safety, he might decide to \nuse this approach. Suppose he decided that he would consider any write that provid-\nChapter 28: Mathematical Applications 413 \ned an annualized total return (capital gains, dividends, and commissions) of at least \n12%. This would eliminate many potential writes, but would leave him with a fairly \nlarge number of writing candidates each day. He knows the downside break-even \npoint at expiration in each write. Therefore, the probability of the stock being below \nthat break-even point at expiration can be computed quickly. His final list would rank \nthose writes with the least chance of being below the break-even point at expiration \nas the best writes. Again, this ranking is based on an expected probability and is, of \ncourse, no guarantee that the stock will not, in reality, fall below the break-even \npoint. However, over time, a list of this sort should provide the rrwst conservative cov\nered writes. \nExample: XYZ is selling for 43 and a 6-month July 40 call is selling for 8 points. After \nincluding dividends and commission costs for a 500-share position, the downside \nbreak-even point at expiration is 36. If the annualized volatility of XYZ is 25%, the \nprobability of making money at expiration can be computed. The 6-month volatility \nis 17.7% (25% times the square root of½ year). The probability of being below 36 \ncan be computed by using the formula given earlier in this section: \nThe expected probability of XYZ being below 36 in 6 months is 15.8%. Therefore, \nthis would be an attractive write on a conservative basis, because it has a large prob\nability of making money (nearly 85% chance of not being below the break-even point \nat expiration). The return if exercised in this example is approximately 20% annual\nized, so it should be acceptable from a profit potential viewpoint as well. It is a rela\ntively easy matter to perform a similar calculation, with the aid of a computer, on all \ncovered writing candidates. \nThe ability to measure downside protection in terms of a common denomina\ntor - volatility - can be useful in other types of covered call writing analyses. The \nwriter interested in writing out-of-the-money calls, which generally have higher \nprofit potential, is still interested in having an idea of what his downside protection \nis. He might, for example, decide that he wants to invest in situations in which the \nprobability of making money is at least 60%. This is not an unusually difficult \nrequirement to fulfill, and will leave many attractive covered writes with a high prof\nit potential to choose from. A downside requirement stated in terms of probability \nof success removes the necessity of having to impose arbitrary requirements. Typical \nI \nI I \nI i \nI ; \nI \ni ;· \n! \n474 Part IV: Additional Considerations \narbitra:ry requirements would be including only calls that sell for one point or more, \nor stating that the downside protection must be a certain percentage of the stock \nprice. These obviously cannot suffice for stocks with different volatilities. Rather, \nthe downside protection criterion should be stated in terms of \"probability of down \nprotection\" or, alternatively, in terms of the volatility itself. In this manner, a uniform \ncomparison can be made between volatile and nonvolatile stocks. \nCALL BUYING \nThe option buyer can also constructively use the measurement of volatility to aid him \nin his option buying decisions. In Chapter 3, it was shown that evaluating the prof \nitability of calls based on the volatility of the underlying stock is the correct way to \nanalyze an option purchase. One specific method of analysis is described. There are \ncertain variables in this analysis that may be altered to fit the call buyer's individual \npreferences, but the general logic is applicable to all cases. \nAs a first step, one should decide upon a uniform stock rrwvement for ranking \ncall purchases. One might decide to rank all purchases by how they would perform \nif the underlying stock moved up in accordance with its volatility. The phrase \"in \naccordance with its volatility\" must be quantified. For example, one might decide to \nassume that eve:ry stock could move up one standard deviation, and then rank all call \npurchases on that basis. The prospective call buyer must also fix the time period that \nhe wants to use. Generally, one looks at purchases", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 213}
{"text": "rm \nif the underlying stock moved up in accordance with its volatility. The phrase \"in \naccordance with its volatility\" must be quantified. For example, one might decide to \nassume that eve:ry stock could move up one standard deviation, and then rank all call \npurchases on that basis. The prospective call buyer must also fix the time period that \nhe wants to use. Generally, one looks at purchases to be held for 30 days, 60 days, and \n90 days. \nThe exact steps to be followed in the analysis of profitability and risk can be list\ned as follows: \nI. Specify the distance that underlying stock can move, up or down, in terms of its \nvolatility. \n2. Select the holding period over which the analysis is to take place. \nPROFITABILITY \n3. Calculate the stock price that the stock would move up to, when the foregoing \nassumptions are implemented. \n4. Using a pricing model, such as the Black-Scholes model, estimate what the \noption price would become after the upward stock movement. \n5. Calculate the percent profit, after deducting commissions. \n6. Repeat steps 4 and 5 for each option on the stock. \nChapter 28: Mathematical Applications 475 \nA final ranking of all potential call buys can be obtained by performing steps 3 \nthrough 6 on all stocks, and ranking the purchases by their percentage reward. \nRISK \n7. Calculate the stock price that the stock could fall to, when the assumptions in \nsteps 1 and 2 are applied. \n8. With a model, price the option after the stock's decline. \n9. Calculate the percentage loss after commissions. \n10. Compute a reward/risk ratio: Divide the percentage profit from step 5 by the \npercentage risk from step 9. \n11. Repeat steps 8 through 10 for each option on the stock. \nA final ranking of less aggressive option purchases can be constructed by performing \nsteps 7 through 11 on all stocks, and ranking the purchases by their reward/risk ratio. \nThe higher profitability list of option purchases will tend to be at- or slightly \nout-of-the-money calls. The less aggressive list, ranked by reward/risk potential, will \ntend to be in-the-money options. \nExample: Steps 1 and 2: Suppose an investor wants to look at option purchases for a \n90-day holding period, under the assumption that each stock could move up by one \nstandard deviation in that time. (There is only about a 16% chance that a stock will \nmove more than one standard deviation in one direction in a given time period. \nTherefore, in actual practice, one might want to use a smaller stock movement in his \nranking calculations.) Furthermore, assume that the following data are known: \nXYZ common, 41; \nXYZ volatility, 30% annually; \nXYZ January 40 call, 4; and \ntime to January expiration, 6 months \nStep 3: Calculate upward stock potential. This is accomplished by the following \nformula: \nwhere \np = current stock price \nq = potential stock price \n476 Part IV: Additional Considerations \nvt == volatility for the time period, t \na == a constant (see below). \nThe constants, a and t, are fixed under the assumptions in steps 1 and 2. The first \nconstant, a, is the number of standard deviations of movement to be allowed. In our \nexample, a == I. That is, the analysis is being made under the assumption that the \nstock could move up by one standard deviation. The second constant, t, is .25, since \nthe analysis is for a 90-day holding period, which is 25% of a year. In this example: \nVt == v-ft == .30 {is== .30 X .50 == .15 \nso \nq == 4le· 15 == 41 X 1.16 == 47.64 \nThus, this stock would move up to approximately 475/s if it moved one standard devi\nation in exactly 90 days. \nStep 4: Using the Black-Scholes model, the XYZ January 40 call can be priced. \nIt would be worth approximately 81/s if XYZ were at 475/s and there were 90 days' less \nlife in the call. \nStep 5: Calculate the profit potential. For this example, commissions will be \nignored, but they should be included in a real-life situation. \n81/s-4 41/s Percent profit == --- == - == 103% 4 4 \nThus, if XYZ stock moves up by one standard deviation over the next 90 days, this call \nwould yield a projected profit of 103%. Recall again that there is only about a 16% \nchance of the stock actually moving at least this far. If all options on all stocks are \nranked under this same assumption, however, a fair comparison of profitable options \nwill be obtained. \nStep 6 is omitted from this example. It would consist of performing a similar \nprofit analysis (steps 4 and 5) on all other XYZ options, with the assumption that XYZ \nis at 475/s after 90 days. \nStep 7: Calculate the downside potential of XYZ. The formula for the downside \npotential of the stock is nearly the same as that used in step 3 for the upside poten\ntial: \nq = pe-avt \n== 4lc· 15 = 41 x .86 = 35.39 \nXYZ would fall to approximately 35¼ in 90 days if it fell by one standard deviation. \nNote that the actual distances that XYZ could rise and fall are not the same. The \nChapter 28: Mathematical Applications 477 \nupward potential was 65/s points, while the downward potential is about 5¾ points. \nThis difference is due to the use of the lognormal distribution. \nStep 8: Using the Black-Scholes model, one could estimate that the XYZ \nJanuary 40 call would be worth about 11/s if XYZ were at 35¼ in 90 days. \nStep 9: The risk potential in the January 40 call would be: \n. 4- l1/s 27/s Percent nsk = --- = - 72% 4 4 \nStep 10: The reward/risk ratio is merely the percentage reward divided by the per\ncentage risk: \nReward/risk ratio = l03% = 1.43 72% \nStep 11: This analysis would be repeated for all XYZ options, and then for all other \noptionable stocks. The less aggressive call purchases would be ranked by their \nreward/risk ratios, with higher ratios representing more attractive purchases. More \naggressive purchases would be ranked by the potential rewards only (step 5). \nThis completes the call buying example. Before leaving this section, it should be \nnoted that the assumption of ranking the purchases after one full standard deviation \nmovement", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 214}
{"text": "he less aggressive call purchases would be ranked by their \nreward/risk ratios, with higher ratios representing more attractive purchases. More \naggressive purchases would be ranked by the potential rewards only (step 5). \nThis completes the call buying example. Before leaving this section, it should be \nnoted that the assumption of ranking the purchases after one full standard deviation \nmovement by the underlying stock is probably excessive. A more moderate assump\ntion would be that the stock might be able to move . 7 standard deviation. There is \nabout a 25% expected chance that a stock could move up at least . 7 standard devia\ntion at the end of a fixed time period. \nPRICING A PUT OPTION \nTheoretical models for pricing put options have been derived; that is, ones that are \nseparate from call pricing models. Black and Scholes presented such a model in their \noriginal paper. However, as has been demonstrated, there is a relationship between \nput and call prices in the listed option market due to the conversion and reversal \nstrategies. \nOne could use the ba,sic call pricing rrwdel for the purpose of predicting put \nprices if he a,ssumes that arbitrageurs will efficiently influence the market via con\nversions. Theoreticians will argue that such a method of pricing puts assumes that the \narbitrage process is always present and works efficiently, and that this is not true. The \n\"conversion efficiency\" assumption could be a serious fault if one were trying to \ndetermine the exact overpriced or underpriced nature of the put option. However, if \none is merely comparing various put strategies under constant assumptions, the arbi\ntrage model for pricing puts works quite well. \n478 Part IV: Additional Considerations \nThe listed put' s price can be estimated by using the call pricing model and the \narbitrage formula. Recall that the arbitrageur must include the cost of carrying the \nposition as well as the dividends to be received. \nTheoretical Theoretical Strike Stock Carrying n· 'd d = + - - + IVI en s put call price price price cost \nThe \"theoretical call price\" is obtained from the Black-Scholes model. The carrying \ncost is the cost of money (interest rate) times the striking price, multiplied by the \ntime to expiration. Recall that this is the approximation formula for carrying cost (see \nChapter 27 for comments on present value and compounding). Consequently, ifXYZ \nwere at 41 and a 6-month January 40 call option were valued at 4 points by the \nBlack-Scholes model, the theoretical put price could be estimated. Assume that the \ncost of money interest rate is 10% annually, and that the stock will pay $.50 in divi\ndends in 6 months (t = ½ year). \nTheoretical put price = 4 + 40 - 41- (.10 x 40 x ½) + .50 \n=3-2+½ \n=l½ \nThis means that if the call could be sold for 4 points, the arbitrageur would be will\ning to pay up to 1 ½ points for the put to establish a conversion. The arbitrageur's \nprice is used as the theoretical listed put price estimate. \nPUT BUYING \nPut option purchases can be ranked in a manner very similar to that described for call \noption buying. Reward opportunities occur when the stock falls in accordance with \nits volatility. An upward stock movement represents risk for the put buyer. All of the \n11 steps in the previous section on call buying are applicable to put buying. The pric\ning of the put necessary for steps 4 and 8 is done in accordance with the arbitrage \nmodel just presented. \nIf an underlying stock does not have listed puts trading, the synthetic put can \nbe considered. While all U.S.-listed stocks have both puts and calls at every strike, \nthere are still situations with warrants, especially in foreign countries, that are appli\ncable to the following discussion. Recall that synthetic puts are created for customers \nby some brokerage houses. The brokerage sells the stock short and buys a call. The \ncustomer can purchase the synthetic put for the amount of the risk involved, plus any \ndividends to be paid by the underlying stock. The synthetic put pricing formula that \nwould be used in steps 4 and 8 of the option buying analysis is exactly the same as the \narbitrage model for listed puts, except that the carrying costs are omitted: \nChapter 28: Mathematical Applications 479 \nTheoretical synthetic Theoretical Strike Stock D\" .d d = + - + 1vi en s put price call price price price \nWhen the ranking analysis is performed, very few synthetic puts will appear as \nattractive put buys. This is because, when the customer buys a synthetic put, he must \nadvance the full cost of the dividend, but receives no offsetting cost reduction for the \ncredit being earned by the short stock position. Consequently, synthetic puts are \nalways more expensive, on a relative basis, than are listed puts. However, if one is par\nticularly bearish on a stock that has no listed puts, a synthetic put may still prove to \nbe a worthwhile investment. The recommended analysis can give him a feeling for \nthe reward and risk potential of the investment. \nCALENDAR SPREADS \nThe pricing nwdel can help in determining which neutral calendar spreads are nwst \nattractive. Recall that in a neutral calendar spread, one is selling a near-term call and \nbuying a longer-term call, when the stock is relatively close to the striking price of the \ncalls. The object of the spread is to capture the time decay differential between the \ntwo options. The neutral calendar spread is normally closed when the near-term \noption expires. The pricing model can aid the spreader by estimating what the prof\nit potential of the spread is, as well as helping in the determination of the break-even \npoints of the position at near-term expiration. \nTo determine the maximum profit potential of the spread, assume that the near\nterm call expires worthless and use the pricing model to estimate the value of the \nlonger-term call with the stock exactly at the striking price. Since commission costs \nare relatively large in spread transactions, it", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 215}
{"text": "ell as helping in the determination of the break-even \npoints of the position at near-term expiration. \nTo determine the maximum profit potential of the spread, assume that the near\nterm call expires worthless and use the pricing model to estimate the value of the \nlonger-term call with the stock exactly at the striking price. Since commission costs \nare relatively large in spread transactions, it would be best to have the computations \ninclude commissions. Calculating a second profit potential is sometimes useful as \nwell the profit if unchanged. To determine how much profit would be made if the \nstock were unchanged at near-term expiration, assume that the spread is closed with \nthe near-term call equal to its intrinsic value (zero if the stock is currently below the \nstrike, or the difference between the stock price and the strike if the stock is initial\nly above the strike). Then use the pricing model to estimate the value of the longer\nterm call, which will then have three or six months of life remaining, with the stock \nunchanged. The resulting differential between the near-term call's intrinsic value and \nthe estimated value of the longer-term call is an estimate of the price at which the \nspread could be liquidated. The profit, of course, is that differential minus the cur\nrent (initial) differential, less commissions. \nIn the earlier discussion of calendar spreads, it was pointed out that there is \nboth an upside break-even point and a downside break-even point at near-term expi\nration. These break-even points can be estimated with the use of the pricing model. \n480 Part IV: Additional Considerations \nOne method of determination involves estimating the liquidating value of the spread \nat successive stock prices. When the liquidating value is found to be equal to the ini\ntial value, plus commissions, a break-even point has been located. \nExample: If the spread in question is using options with a striking price of 30, one \nwould begin his break-even point calculations at a price of 30. Estimate the liquidat\ning value of the spread at 30, 297/s, 29¾, 29-5/s, and so forth until the break-even point \nis found. Once the downside break-even point has been determined in this manner, \nthe iterations to locate the upside break-even point should begin again at the striking \nprice. Thus, one would evaluate the liquidating value at 30, 301/s, 30¼, and so on. This \nis somewhat of a brute-force method, but with a computer it is fairly fast. The num\nber of calculations can be reduced by adopting a more complicated iteration process. \nA final useful piece of information can be obtained with the aid of the pricing \nmodel - the theoretical value of the spread. Recompute the estimated value of both \nthe near-term and longer-term calls at the current time and stock price, using the \nimplied volatility for the underlying stock. The resultant differential between the two \nestimated call prices may differ substantially from the actual differential, perhaps \nhighlighting an attractive calendar spread situation. One would want to establish \nspreads in which the theoretical differential is greater than the actual differential \n(that is, he would want to buy a \"cheap\" calendar spread). \nOnce these pieces of information have been computed, the strategist can rank \nthe spread possibilities by whatever criterion he finds most workable. The logical \nmethod of ranking the spreads is by their return if unchanged. The spreads with the \nhighest return if unchanged at near-term expiration are those in which the stock price \nand striking price were close together initially, a basic requirement of the neutral cal\nendar spread. More complicated ranking systems should tty to include the theoreti\ncal value of the spread and possibly even the maximum potential of the spread. A \nsimilar analysis can, of course, be worked out for put calendar spreads, using the \narbitrage pricing model for puts. \nRATIO STRATEGIES \nRatio strategies involve selling naked options. Therefore, the strategist has potential\nly large risk, either to the upside or to the downside or both. He should attempt to \nget a feeling for how probable this risk is. The formulae for determining the proba\nbility of a stock being above or below a certain price at some time in the future can \ngive him these probabilities. For example, in a straddle writing situation, the strate\ngist would want to compute such arithmetic quantities as maximum profit potential, \nreturn if unchanged, collateral required at upside break-even point or at upside \nChapter 28: Mathematical Applications 481 \naction point (recall that the collateral requirement increases for naked options on an \nadverse stock movement), and the break-even points themselves. The probabilities of \nbeing above the upper break-even point at expiration or below the lower break-even \npoint should be computed as well. Moreover, an expected return analysis could be \nperformed on the position to determine the general level of profitability of the posi\ntion with respect to all other positions of the same type on other stocks. Such an \nexpected return analysis need not assume that the position is held to expiration. Firm \ntraders, paying little or no commissions, might be interested in seeing the expected \nreswts for a holding period as short as 30 days or less. Public customers might use a \nlonger holding period, on the assumption that they would not trade the position as \nreadily because of commission costs. Ratio positions should be ranked either by \nreturn if unchanged or by expected return. \nThe analyses described for calendar spreads and ratio positions should not be \nrelied upon as gospel. In the proposed forms of analysis, one is projecting future \noption prices and stock prices under the assumption that the volatility of the under\nlying stock will remain the same. Although this may be true in some cases, there will \nalso be many times when the volatility of the underlying stock will change during the \nlife o", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 216}
{"text": "alendar spreads and ratio positions should not be \nrelied upon as gospel. In the proposed forms of analysis, one is projecting future \noption prices and stock prices under the assumption that the volatility of the under\nlying stock will remain the same. Although this may be true in some cases, there will \nalso be many times when the volatility of the underlying stock will change during the \nlife of the position. If the volatility decreases, the projected break-even points for a \ncalendar spread will be too far away from the striking price. Thus, a loss would result \nat some prices where the spreader expected to make money. If the volatility increas\nes, the expected return of a ratio position will drop, because the probabilities of the \nstock moving outside the profit range will increase, thereby increasing the probabil\nity ofloss. \nThe effect of a changing volatility can be counteracted, in theory, by continuing \nto monitor the position daily after it has been established. In a straddle write, for \nexample, if the stock begins to move dramatically, the expected return may become \nvery low. If this happens, adjustments could be made to the position to improve it. \nSuch monitoring is difficult to apply in practice for the public customer, because the \ncommission costs involved in constant position adjustments would mount rapidly. \nThere is no exact method that would allow for infrequent, periodic adjustments, but \nby using a follow-up analysis the public customer may be able to get a better feeling \nfor the timing of adjusting a position. For example, suppose that one initially wrote a \n5-point straddle when the stock was at 30. Sometime later, the stock is at 34. The \nexpected return of writing a 5-point straddle with a strike of 30 when the stock is at \n34 could be computed for the shorter time period remaining until expiration. If the \nexpected return is negative, an adjustment needs to be made. Adopting this form of \nadjusting would keep the number of trades to a minimum, but would still allow the \nstrategist to determine when his position has become improperly balanced. Of \ncourse, the current volatility would be used in making these determinations. Another \n482 Part IV: Additional Considerations \nfollow-up monitoring technique, using the deltas of the options involved, is present\ned later in this chapter, and has been described several times previously. \nFACILITATION OR INSTITUTIONAL BLOCK POSITIONING \nIn this and the following section, the advantages of using the hedge ratio are outlined. \nThese strategies are primarily member firm, not public customer, strategies, since \nthey are best applied in the absence of commission costs. An institutional block trad\ner may be able to use options to help him in his positioning, particularly when he is \ntrying to help a client in a stock transaction. \nSuppose that a block trader wants to make a bid for stock to facilitate a cus\ntomer's sell order. If he wants some sort of a hedge until he can sell the stock that he \nbuys, and the stock has listed options, he can sell some options to hedge his stock \nposition. To determine the quantity of options to sell, he can use the hedge ratio. The \nexact formula for the hedge ratio was given earlier in this chapter, in the section on \nthe Black-Scholes pricing model. It is one of the components of the formula. Simply \nstated, the hedge ratio is merely the delta of the option - that is, the amount by which \nthe option will change in price for small changes in the stock price. By selling the cor\nrect number of calls against his stock purchase, the block trader will have a neutral \nposition. This position would, in theory, neither gain nor lose for small changes in the \nstock price. He is therefore buying himself time until he can unwind the position in \nthe open market. \nExample: A trader buys 10,000 shares of XYZ, and a January 30 call is trading with \na hedge ratio of .50. To have a neutral position, the trader should sell options against \n20,000 shares of stock (10,000 divided by .50 equals 20,000). Thus, he should sell 200 \nof the January 30's. If the hedge ratio is correct - largely a function of the volatility \nestimate of the underlying stock - the trader will have greatly eliminated risk or \nreward on the position for small stock movements. Of course, if the block trader \nwants to assume some risk, that is a different matter. However, for the purposes of \nthis discussion, the assumption is made that the block trader merely wants to facili\ntate the trade in the most risk-free manner possible. In this sample position, if the \nstock moves up by 1 point, the option should move up by ½ point. The trader would \nmake $10,000 on his stock position and would lose $10,000 on his 200 short options \n- he has no gain or loss. Once the trader has the neutral position established, he can \nthen begin to concentrate on unwinding the position. \nIn actual practice, this hedge ratio may not work exactly, because it tends to \nchange constantly as the stock price changes. If the trader finds the stock moving \nChapter 28: Mathematical Applications 483 \nmore than fractionally, he may have to add more calls or buy some in, to maintain a \nneutral hedge ratio. This would expose him to some risk, but the risk is substantially \nsmaller than if he had not hedged at all. Of course, there would also be certain cases \nin which he would profit by the stock price change. For example, implied volatility \ncould decrease, making the calls cheaper. \nA similar hedge can be established by the block trader who sells stock to accom\nmodate a customer buy order. He could buy calls in accordance with the hedge ratio, \nto set up a neutral position. \nThis process off acilitation is quite widely practiced, especially by brokerage \nhouses that are trying to attract the business of the large institutional customer. Since \nthe introduction of listed call options and their applications for facilitating orders, \nmany quotes for large blocks of stock hav", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 217}
{"text": "buy order. He could buy calls in accordance with the hedge ratio, \nto set up a neutral position. \nThis process off acilitation is quite widely practiced, especially by brokerage \nhouses that are trying to attract the business of the large institutional customer. Since \nthe introduction of listed call options and their applications for facilitating orders, \nmany quotes for large blocks of stock have improved considerably. The block trader \n(who works for the brokerage house) is willing to make a higher bid or a lower offer \nif he can use options to hedge his position. This facilitation with options results in a \nbetter market (higher bid or lower off er) from the point of view of the institutional \ncustomer. Without the availability of such listed options, the block trader would prob\nably make a bid or an offer that was substantially away from the prevailing market \nprice in order to work out of his stock-only position with a lessened degree of risk \nThis would obviously present a poorer market for the institutional customer. \nTHE NEUTRAL SPREAD \nThe hedge ratios of two or more options may be used to determine a neutral spread. \nThis strategy is especially useful to market-makers on the options exchanges who may \nwant to reduce the risk of options bought or sold in the process of providing a pub\nlic market. If the hedge ratios of two options are known, the neutral ratio is deter\nmined by dividing the two hedge ratios. \nExample: An XYZ January 35 has a hedge ratio of .25, and an XYZ January 30 has a \nhedge ratio of .50, so a neutral ratio would be 2:1 (.50 divided by .25). That is, one \nwould sell 2 January 35's against one long January 30, or, conversely, would buy 2 \nJanuary 35's against one short January 30. Thus, a market-maker who has just bought \n50 January 30's in an effort to provide a market for a public seller of that call could \nhedge his position by selling 100 January 35's. This should keep his risk small, for \nsmall stock price changes, until he can unwind the position. The ratio for the neutral \nspread is not as sensitive to the volatility estimate of the underlying stock as is the \nratio concerning stock and options. This is because the same volatility estimate is \napplied to both options, and the resultant ratio for the spread would not tend to \nchange greatly. \n484 Part IV: Additional Considerations \nThe risk trader can also use the neutral spread ratio to his advantage. This con\ncept was illustrated several times in previous chapters describing ratio writing, ratio \nspreads, and straddle writes. Ratio spreads are quite popular with member firm \ntraders and floor traders. Recall that a ratio spread consists of buying options at acer\ntain strike, and selling more options further out-of-the-money. The hedge ratios can, \nof course, be used by the trader, or by a public customer, to initially establish a neu\ntral position. Perhaps more important, the hedge ratio can also be used as a follow\nup action to keep the position neutral after the stock changes in price. This strategy \nis the \"delta spread\" described in Chapter 11. \nThe risk trader is not attempting to establish the spread with the idea of mini\nmizing risk for small stock movements. Rather, he is looking to make a profit, but \nwould prefer to remain as neutral as possible on the underlying stock. He is imple\nmenting a risk strategy that has a neutral outlook on the underlying stock. He is sell\ning much more time value premium than he is buying. \nExample: The purchase of 15 January 30 calls and the sale of 30 January 35 calls - a \nratio call spread - may be a position taken for profit potential. It would be a neutral \nposition if the deltas were .60 and .30, for example. This spread would do best if the \nstock were at exactly 35 at expiration. However, if the stock rose quickly before expi\nration, the spread ratio would decrease from 2:1 to perhaps 3:2. That is, the neutral \nratio between the January 30 call and the January 35 call should be 3 short January \n35's to 2 long January 30's. If the trader wants to balance his position, he could buy 5 \nmore January 30's, giving him a total of 20 long versus the 30 short January 35's that \nhe originally sold. Conversely, if the stock dropped in price, the neutral spread ratio \nmight increase, indicating that more calls should be sold. For example, if this stock \ndeclines, the neutral ratio might be 3:1. In that case, 15 more January 35's could be \nsold, making the position short 45 calls versus 15 long calls, which would produce the \nneutral 3:1 ratio. \nIt would not be proper to adjust the ratio constantly, because the frequent \nwhipsaw losses on trading movements would wipe out the profit potential of the posi\ntion. However, the trader may want to pick out points, in advance, at which he wants \nto reevaluate his position before something drastic goes wrong. For example, if the \nforegoing spread were established with the stock at a price of 30, the spreader might \nwant to readjust at 33 or 27, whichever comes first. \nBy monitoring the spread using the hedge ratio, the trader may also be able to \ndiscern whether he has established too bullish or too bearish a position. \nExample: The trader starts with the example described above - long 15 January 30 \ncalls and short 30 January 35 calls - when the hedge ratios were .60 and .30, respec-\nChapter 28: Mathematical Applications 485 \ntively. Some later time, the stock falls to 27 and the trader needs to reevaluate his \nposition. The hedge ratios may have become .42 for the January 30 and .14 for the \nJanuary 35, indicating that a 3:1 ratio would be neutral (.42/.14 = 3). He now has a \nbullish position, because his 2:1 ratio is less than the neutral 3:1 ratio. It is not manda\ntory that the trader act on this information. He may actually be bullish on the stock \nat this point and decide to remain with his position. The usefulness of the hedge ratio \nis that it allows him to see that his position is bullish, so he can make a correct jud", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 218}
{"text": "ould be neutral (.42/.14 = 3). He now has a \nbullish position, because his 2:1 ratio is less than the neutral 3:1 ratio. It is not manda\ntory that the trader act on this information. He may actually be bullish on the stock \nat this point and decide to remain with his position. The usefulness of the hedge ratio \nis that it allows him to see that his position is bullish, so he can make a correct judg\nment. Without this knowledge, he might still think his position to be neutral, a criti\ncal mistake if he indeed wants to be neutral. If the trader's ratio is greater than the \nneutral ratio (2:1 vs. 3:2, for example), he is bearishly positioned. \nAs a final point, it should be noted that the ratio can be adjusted by buying or \nselling either option. \nExample: If the stock falls and it is desired that the ratio be increased to 3:1, one \nmight sell more January 35's or might decide to sell out some of his January 30's. A \nbullish adjustment could be made by buying on either side of the spread in a similar \nmanner. In general, one should adjust by selling time premium or buying intrinsic \nvalue. That is, out-of-the-moneys are usually sold and in-the-moneys are usually \nbought, when adjusting. \nAIDING IN FOLLOW-UP ACTION \nThe computer can also be an invaluable aid to the strategist in that it can help him \nmonitor his positions. It is generally necessary for the strategist to have some way of \ninputting his positions into an inventory database and also to have some way of iden\ntifying different securities that are grouped within the same trading position. Once \nthis has been done, the computer can simultaneously read pricing data ( either real\ntime or closing prices) and the inventory database to generate information concern\ning the current status of any position. \nA current mark to market (profit and loss) statement is of obvious use in that \nthe trader can see how he is doing each day. The computer can also easily generate \na set of warning flags that may be of interest to the trader, and could produce a list \nsummarizing possible positions that need action. In most of the strategies that were \ndescribed, it was shown that the strategist should avoid early assignment if at all pos\nsible. It is a simple matter for the computer to calculate the remaining time value \npremium of any short options, and to warn the trader if there is only a small amount \nof time value premium remaining, perhaps ½ point or less. For similar reasons, the \ntrader may want to have a daily list of positions that are nearing maturity, perhaps \n486 Part IV: Additional Considerations \nwith less than I month oflife remaining in the options. A flag indicating an approach\ning ex-dividend date might also be useful for this purpose. \nIf the trader inputs another piece of information into the database, the com\nputer can help him in another follow-up action. In most strategies that were \ndescribed, especially those involving uncovered options, the trader wants to take \nsome sort of follow-up action based on the price movement of the underlying stock. \nIf the stock rallies too far, he may want to cover short calls or buy other calls as pro\ntection. If the stock declines too far, similar maneuvers would apply to put options or \nto rolling down short calls. If the trader inputs the stock prices at which he would like \nto take action, the computer can monitor each day's closing price of the stock and \ngenerate a list of positions that have exceeded their upside or downside action points. \nThe computer can also do more sophisticated types of position monitoring. \nRecall that it was pointed out that the deltas of the options involved in a position can \nbe compared to each other to tell whether the position is bullish or bearish. The \nBlack-Scholes model can be used to calculate the deltas of the options in one's posi\ntions. Then the net position can be determined by the computer, thereby telling the \ntrader whether his position has become \"delta long\" (bullish), \"delta short\" (bearish), \nor neutral. If he sees that a position is bearish and he does not want to be structured \nin that way, he can make bullish adjustments. The delta spread and neutral spread \nstrategies very conveniently lend themselves to such types of follow-up action, \nalthough any of the more complicated straddle writing and protected straddle writ\ning positions can be monitored usefully in this way as well. \nThe computation for determining whether a position is net short or net long \ngenerally involves calculating the \"equivalent stock position\" (ESP). If one owns 10 \ncalls that have a delta of .45, his equivalent stock position from those calls is IO X 100 \nshares per call x .45 = 450. That is, owning those IO calls is equivalent to owning 450 \nshares of the underlying stock, according to the delta. All puts and calls can be \nreduced to an ESP and can then, of course, be combined with any actual long or \nshort stock in the position to produce an ESP for the entire strategy. The resultant \nESP for each of the trader's positions can be printed from the computer along with \nthe items described above. \nFurther sophisticated measures can be taken. The computer can generate a \ntable of results at expiration. If so desired, this could be presented as a graph, but that \nis not really necessary. A table suffices quite well, as shown by most of the examples \nin this book. Such a picture has meaning only if all options in the position expire at \nthe same time. If they don't, one may instead want the computer to mmpose a table \nof results or a graph at near-term expiration. Thus, in a calendar spread, for example, \none could see what sorts of profitability he would be looking at when it was time to \nremove the spread. \nChapter 28: Mathematical Applications 487 \nFinally, the computer can compute the expected return of a position already in \nplace. This would give a more dynamic picture of the position, and this expected \nreturn is usually for a relatively short time period. That ti", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 219}
{"text": "endar spread, for example, \none could see what sorts of profitability he would be looking at when it was time to \nremove the spread. \nChapter 28: Mathematical Applications 487 \nFinally, the computer can compute the expected return of a position already in \nplace. This would give a more dynamic picture of the position, and this expected \nreturn is usually for a relatively short time period. That time period might be 30 days, \nor the time remaining until expiration, whichever is less. The expected return is cal\nculated in much the same manner as the expected return computation described ear\nlier in this chapter. First, one uses the stock's volatility to construct a range of prices \nover which to examine the position. Second, one uses the Black-Scholes model to \ncalculate the values of the various options in the position at that future time and at \nthe various stock prices. Some of the results should be displayed in table form by the \ncomputer program. The expected profit is computed, as described earlier, by sum\nming the multiples of the probabilities of the stock being at each price by the result \nof the position at that price. The expected return is then computed by dividing the \nexpected profit by the expected investment. Since margin computations can require \ninvolved computer programs, it is sufficient to omit this last step and merely observe \nthe expected profit. The following example shows how a sample position might look \nas the computer displays the position itself, the ESP, the profit at expiration, and the \nexpected profit in 30 days. A complex position is assumed, in order that the value of \nthese analyses can be demonstrated. \nExample: The following position exists when XYZ is at 31 ¾. It is essentially a back\nspread combined with a reverse ratio write. It resembles a long straddle in that there \nis increased profit potential in either direction if the stock moves far enough by expi\nration. Initially, the computer should display the position and the ESP. \nPosition Delta ESP \nShort 4,500 XYZ 1.00 Short 4,500 shares \nShort 100 XYZ April 25 calls 0.89 Short 8, 900 shares \nLong 50 XYZ April 30 calls 0.76 Long 3,800 shares \nLong 139 XYZ July 30 calls 0.74 Long 10,286 shares \nTotal ESP Long 686 shares \nTotal money in position: $163,500 credit \nThe advantage of using the ESP is that this fairly complex position is reduced to a sin\ngle number. The entire position is equivalent to being long 686 shares of the com\nmon stock. Essentially, this is close to delta-neutral for such a large position. The next \nitem that the computer should display is the total credit or debit in the position to \ndate. With this information, an expiration picture can be drawn if it is applicable. In \nthis position, since there is a mixture of April and July options, a strict expiration pie-\n488 Part IV: Additional Considerations \nture does not apply. Rather, the computer should draw a picture based on the posi\ntion at April expiration or on a shorter time horizon. \nAssume that April expiration is still some time away, so that the computer will \ninstead draw the picture 30 days hence. In order to do so, the computer uses the \nstock's volatility to project stock prices 30 days in the future. Seven stock prices are \nshown in the next table; they represent points along the distribution curve of the \nstock, ranging from minus one and one-half standard deviations to plus one and one\nhalf standard deviations of movement from the current stock price. While these \nseven points certainly do not comprise the entire spectrum of possible stock moves, \nthey are a representative sample. \nStock Price Standard Expected \nin 30 Days Deviations Results \n353/a + 1.5 +$15,847 \n34 1/a +1.0 + 12,355 \n327/a +0.5 + 10,097 \n31 3/4 0.0 + 9,443 \n305/a -0.5 + 10,743 \n291/2 -1.0 + 14,172 \n281/2 -1.5 + 19,605 \nExpected profit +$11,426 \nObviously, this position has had some profitable adjustments made to it in the past. \nThat is not important at this point, because the trader is interested only in the future. \nIf the current mark to market of this position were in excess of $11,426, then he \nshould consider removing the position, since it would be more profitable than the \nexpected profit. \nIMPLEMENTATION \nMany of the analyses described in this chapter can be obtained from a reliable data \nservice or brokerage firm. The strategist who plans to prepare his own analysis, either \nby himself or by contracting the programming work out, should be aware that com\nputer programs cannot be written in the COBOL language, because the mathemat\nics are far too complicated for a business language. Languages such as Pascal, C, \nC++, Visual Basic, or any high-level structured programming language would suffice, \nalthough Java could be considered as well, keeping in mind that Java's main usage is \nnot for computational purposes. Reliable option pricing data that include dividend \nChapter 28: Mathematical Applications 489 \ninformation on the underlying stock are also necessary. The larger programmable cal\nculators can handle calculations such as the Black-Scholes model, computing the \nhedge ratio, and determining the probability of a stock being above or below a cer\ntain price at some future time. However, more involved calculations, such as com\nputing the implied volatility or determining the expected return of a position, require \nthe use of a computer. \nSUMMARY \nTwo basic mathematical aids have been presented: the pricing model and the ability \nto predict the probability of a stock's movement. The hedge ratio and the expected \nreturn analysis are extensions of the basic aids. Any strategy can be evaluated with \nthese tools. Such an analysis should be able to give the trader or strategist some idea \nof the relative attractiveness of establishing the position, and may also aid in making \nfollow-up adjustments to the position. All the analyses rely heavily on one's estimate \nof the volatility of the underlying stock Using the implied volatility seems to be one", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 220}
{"text": "basic aids. Any strategy can be evaluated with \nthese tools. Such an analysis should be able to give the trader or strategist some idea \nof the relative attractiveness of establishing the position, and may also aid in making \nfollow-up adjustments to the position. All the analyses rely heavily on one's estimate \nof the volatility of the underlying stock Using the implied volatility seems to be one \nof the best ways to obtain an accurate, current volatility estimate, since it is derived \nfrom the prices in the market itself. The applications presented here are not all-inclu\nsive. The strategist who is, or becomes, familiar with the advantages of rigorous math\nematical analysis will be able to construct many other aids for his trading that utilize \nthe basic mathematics described in this chapter. \n\nIntroduction to Index Option \nProducts and Futures \nSince their introduction in 1981, listed index options have proved to be very popular. \nIndex options are options whose underlying security is not a single stock but rather an \nindex composed of many stocks. These include options on index futures contracts. \nMost popular types of cash settlement options are options on indices or subindices. The \nstrategies employed in trading these options are not substantially different from those \nused in trading stock options, with a few notable exceptions. However, the options \nthemselves tend to be priced differently and to trade differently. It is these differences \nbetween stock options and index options on which we will predominantly concentrate. \nIndex products - cash-based options, futures-based options, and index futures -\nwill be the main topic of discussion in this section of the book. We will look at how \nindices are constructed, how to use these products to speculate, how to hedge, and \nhow to spread one index against another. Both futures and options will be used in \nthese strategies. The discussion of other futures options - currencies, grains, bonds, \netc - will be deferred to a later chapter. \nIn this chapter, we will be looking at introductory facts about index options and \nfutures which differentiate them from the equity options that have encompassed the \nentire previous part of this book. First, however, we will take an in-depth look at stock \nindices and the methods of calculating them. Also in this chapter there will be a dis\ncussion of futures contracts and how trading them differs from trading stocks and \nstock options. \nINDICES \nSince many cash-based or futures options have an index of stocks underlying the \noption, it is useful to understand how indices are calculated, in order that one may \nbe able to understand how an individual stock's movement within the index affects \n493 \n494 Part V: Index Options and Futures \nthe overall value of the index. The indices on which options are traded are generally \nstock indices - that is, the items making up the index are stocks. There are two main \nways of calculating a stock index: weighted by price or weighted by capital. \nCAPITALIZATION-WEIGHTED INDICES \nThe capitalization of a stock is the total dollar value of its securities to current mar\nket prices: It is the multiple of the number of shares outstanding (the float) and the \ncurrent stock price. In a capitalization-weighted index, the capitalizations of all stocks \nin the index are computed and added together to produce the total market value of \nthe index. The price of each stock in the index is multiplied by the total number of \nshares of that stock that are outstanding (the \"float\"), and their sum is calculated. \nFinally, this total sum is divided by another number, termed the \"divisor,\" to produce \nthe final index value. An example will help to illustrate the concept of calculating the \nvalue of a capitalization-weighted index. \nExample: Suppose that an index is composed of three stocks whose prices and floats \nare given in the following table. The multiple of price times float ( capitalization) is \nalso included in the table. \nStock Price Float Capitalization \nA 30 175,000,000 5,250,000000 \nB 90 50,000,000 4,500,000,000 \nC 50 100,000,000 5,000,000,000 \nTotal capitalization: 14,750,000,000 \nMost indices use a divisor since it would be unwieldy to say that the index closed at \n14,750,000,000 (for example, think of trying to quote the Dow-Jones Industrial \nAverage as such a large figure). The divisor is generally an arbitrary number that is \ninitially used to reduce the index value to a workable number. When an index is ini\ntiated, the divisor might be set so that the index starts out at an even number. \nSuppose that in the sample index above, we wanted the initial value - as represent\ned by the given prices and floats - to be 100.00. Then we would set the initial divisor \nto 147,500,000. Thus the total capitalization of the index divided by the divisor would \ngive a value of 100.00. \nThe divisor of an index can be changed to provide continuity for the index's \nvalue when changes occur in the individual components. Note that the divisor does \nnot have to be changed when a stock splits, because the price is adjusted downward \nautomatically by an amount equal to the increase in the float of the stock that is split\nting. Notice that in the above example, if stock B should split 2-for-l then its price \nChapter 29: Introduction to Index Option Products and Futures 495 \nwould be 45 (90 + 2) and its float would double to 100 million shares from 50 mil\nlion. Thus, the capitalization of stock B remains the same: $4,500,000,000. \nHowever, if a stock should alter its capitalization in a manner that is not reflect\ned by an automatic adjustment in its price, then the divisor must be changed. For \nexample, a company might issue more stock in a secondary offering - something that \nwould not cause the exchange where the stock is listed to automatically reduce the \nprice of the stock. To produce continuity in the value of the index between the day \nthe secondary is issued and the day after it is issued,", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 221}
{"text": "reflect\ned by an automatic adjustment in its price, then the divisor must be changed. For \nexample, a company might issue more stock in a secondary offering - something that \nwould not cause the exchange where the stock is listed to automatically reduce the \nprice of the stock. To produce continuity in the value of the index between the day \nthe secondary is issued and the day after it is issued, the divisor is changed to keep \nthe index value the same. Consider the following example. \nExample: Using the same sample index as before, suppose that the following prices \nexist at the closing one day: \nStock Price Float Capitalization \nA 40 175,000,000 7, 000000000 \nB 80 50,000,000 4,000,000,000 \nC 60 100,000,000 6,000,000,000 \nTotal capitalization: 17,000,000,000 \nDivisor: 147,500,000 \nIndex value: 115.25 \nNow suppose that stock A issues a 2-million-share secondary that evening, giving that \nstock a total float of 177 million shares. Such an action would change the value of the \nindex as follows: \nStock Price Float Capitalization \nA 40 177,000,000 7,080,000,000 \nB 80 50,000,000 4,000,000,000 \nC 60 100,000,000 6,000,000,000 \nTotal capitalization: 17,080,000,000 \nDivisor: 147,500,000 \nIndex value: 115.80 \nHowever, it makes no sense to change the value of the index from 115.25 to 115.80 \nwhen nothing actually changed in the marketplace. If investors deem it necessary to \nlower the price of stock A in the marketplace because of the secondary issue, so be \nit. But such a change in investor philosophy would be reflected in the price of the \nindex as the stock drops. So, in order to keep the value of the index the same on the \nmorning after the secondary is issued, the divisor must be changed to reflect the extra \n2 million shares of stock A. The new divisor would be equal to the new total capital-\n496 Part V: Index Options and Futures \nization (17,080,000,000) divided by the old index value (115.2542373). This would \ngive the new divisor: \nNew divisor: 148,194,117.6 \nAs this example demonstrates, the divisor of a capitalization-weighted index can \nchange quite often. Fortunately, there are organizations that are responsible for \nkeeping the index current and for calculating the divisor every time it needs chang\ning. Thus, an investor who needs to know the latest divisor can generally find it out \nby making a phone call or visiting a Web site. This is far easier than keeping track of \neverything by oneself. \nIn a capitalization-weighted index, the stocks with the largest market value have \nthe most weight within the index. This means that indices that contain such largely \ncapitalized stocks as IBM, AT&T, General Electric, Exxon, and General Motors will \nbe dominated by those stocks. For example, the S&P 500 is one of the largest capi\ntalization-weighted indices in terms of the number of stocks (500). However, IBM \nhas such a large capitalization that it accounts for over 5% of the index. Obviously, \nthere are many stocks in the S&P 500 that do not really have much weight at all. In \norder to compute the percentage that a stock comprises of the index, it is merely nec\nessary to divide that stock's capitalization by the total capitalization of the index. \nUsing the previous example, one can see how the percentage is computed. \nStock Price Float Capitalization Pct \nA 40 1 77,000,000 7,080,000,000 41.5% \nB 80 50,000,000 4,000,000,000 23.4% \nC 60 100,000,000 6,000,000,000 35.1% \nTotal capitalization: 17,080,000,000 100.0% \nAnother interesting statistic to know regarding any index is how many shares of \neach stock are in the index. In a capitalization-weighted index, the number of shares \nof each stock is determined by dividing the stock's float by the divisor of the index. In \nthe same sample index, the following table shows how many shares of each stock are \nin the index. \nStock Price Float Capitalization Shares \nA 40 177,000,000 7,080,000,000 1.20 \nB 80 50,000,000 4,000,000,000 0.34 \nC 60 100,000,000 6,000,000,000 0.68 \nTotal capitalization: 17,080,000,000 \nDivisor: 147,500,000 \nIndex value: 115 .80 \nChapter 29: Introduction to Index Option Products and Futures 497 \nThus, if stock A goes up by one point, then the value of the index would increase \nby 1.20 points since there are 1.2 shares of stock A in the index. One can see the value \nof computing such a statistic - it readily allows him to see how any individual stock's \nmovement will affect the index movement during a trading day. This is especially use\nful when a stock is halted, but the index itself keeps trading. \nExample: Suppose that, in the above index, stock Chas halted trading. There are \n0.68 shares of stock C in the index. Suppose that stock C is indicated 3 points lower, \nbut that the index is currently trading unchanged from the previous night's close due \nto the fact that both stocks A and B are unchanged on the day. If one were to try to \nprice the options on the index, he would be wrong to use the current price of the \nindex since that will soon change when stock C opens. However, there is not really a \nproblem since one can readily see that if stock C opens 3 points lower, then the index \nwill drop by 2.04 points (3 x 0.68). Thus one should price the options as if the index \nwere already trading about 2 points lower. This kind of anticipation depends, of \ncourse, on knowing the number of shares of stock C in the index. \nA similar type of analysis is useful when trying to predict longer-term effects of \na stock on an index. If you thought stock C had a chance of rallying 30 points, then \none can see that this would cause the index to rise over 20 points. Given this type of \nrelationship, there are sometimes option spreads between the stock's options and the \nindex's options that will be profitable based on such an assumption. \nIt should also be noted that the number of shares of stock in a capitalization\nweighted index does not change on a daily basis since it does not depend on the price \nof the stocks in the index. However, the pe", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 222}
{"text": "ver 20 points. Given this type of \nrelationship, there are sometimes option spreads between the stock's options and the \nindex's options that will be profitable based on such an assumption. \nIt should also be noted that the number of shares of stock in a capitalization\nweighted index does not change on a daily basis since it does not depend on the price \nof the stocks in the index. However, the percent that each stock comprises of the index \ndoes change each day as prices change. Thus, the number of shares is a more stable \nstatistic to keep track of, and is also more directly usable to anticipate index value \nchanges as stock prices change. \nCapitalization-weighted indices are the most prevalent type, and most investors \nare familiar with several of them: the Standard and Poor's 500, the Standard and \nPoor's 400, the Standard and Poor's 100 (also called by its quote symbol, OEX), the \nNew York Stock Exchange Index, and the American Stock Exchange Index. \nPRICE-WEIGHTED INDICES \nA price-weighted index contains an equal number of shares of each stock in the index. \nA price-weighted index is computed by adding together the prices of the various \nstocks in the index and then dividing that sum by the divisor to produce the index \nvalue. Again, the divisor is initially an arbitrary number that is used to produce a \ndesired original index value-something like 100.00, for example. Let us use the same \n498 Part V: Index Options and Futures \nthree stocks we were using above to construct an example of a price-weighted index. \nAssume the divisor at the time of this example is 1.65843. \nStock \nA \nB \nC \nPrice total: \nDivisor: 1.65843 \nIndex value: 102.51 \nPrice \n30 \n90 \n50 \n170 \nUnlike the capitalization-weighted index, the divisor needs to be changed when \na stock's price is adjusted by the exchange where it is listed (as in a stock split or stock \ndividend) but does not have to be adjusted when the company issues more stock. \nThat is, the divisor in a price-weighted index is changed when the price of the stock \nis adjusted, but not when the stock's capitalization is changed. \nIf a certain stock issues new stock in a secondary offering, the exchange where \nits stock is listed will not automatically adjust the price of the stock downward. \nHence, there is no change to the divisor of any price-weighted index containing that \nstock because the closing price of the stock was not adjusted by the exchange. \nHowever, in the above example, if stock B should split 2-for-l, the exchange \nwould change its closing from 90 to 45. Thus, the sum of the stocks in the price\nweighted index would change without the market even being open. Consequently, \nthe divisor would need to be changed to reflect the split. The following example sums \nup the situation after stock B splits 2-for-l. \nStock \nA \nB \nC \nPrice total: \nOld divisor: 1 .65843 \nPrice \n30 \n45 \n50 \n125 \nPrevious closing index value: 102.51 \nNew divisor (i.e., the divisor necessary to keep the index \nvalue unchanged): 1 .21943 \nThe new divisor is calculated by dividing the new sum of the prices, 125, by the \nold closing price, 102.51. Thus the divisor is reduced in order to produce the same \nindex value - 102.51 - even though the sum of the prices of the stocks in the index \nis now 125 instead of the previous 170. Note that the new divisor is not dependent \non the old divisor. \nChapter 29: Introduction to Index Option Products and Futures 499 \nAnother statistic that we looked at with capitalization-weighted indices was the \nnumber of shares of each stock in the index. In a price-weighted index each stock in \nthe index has the same number of shares and that number is equal to 1 divided by \nthe divisor of the index. In the last example above, with the divisor equal to 1.21943, \nthere would be 1/1.21943 or 0.82 shares of each stock in the index. Thus any stock \nthat was up by 1 point during a given day would be contributing an upward move\nment of 0.82 points in the index. Before the split there were 0.60 (1/1.65843) shares \nof each stock \nAnother way to look at the revision of a price-weighted index following a split \nby one of its stocks is the following: If one stock splits, then to reestablish the fact that \nthere are an equal number of shares of each stock in the index, part of the extra (split) \nshares should be sold off and used to buy an equal number of shares of each of the \nremaining stocks. Note that before the split there were 0.60 shares of each stock, and \n0.82 shares after. When stock B split 2-for-I, it increased its shares from 0.60 to 1.20, \nso to rebalance the index it was necessary to sell 0.38 shares of stock Band use the \nproceeds to buy 0.22 shares of each of stocks A and C. \nA price-weighted index's divisor can be subject to fairly frequent revision, just \nas was the case with the capitalization-weighted index. These divisors are maintained \nby the organizations responsible for originating them, and they can be easily obtained \njust by calling the proper organization. The most popular price-weighted indices are \nthe various DowJones indices and the Major Market Index (XMI). \nThe stock with the most weight in a price-weighted index is the one with the \nhighest price, which is substantially different from the capitalization-weighted index \nwhere the stock with the most weight is the one with the most market value. Thus, \nin the above examples, the stock with the greatest weight in the index would be stock \nB before the split and C after the split. Of course, the matter of a stock's volatility has \nsomething to do with which stock has the most weight in the change of the value of \nthe index. Thus, if stock B was the highest-priced stock at $90 per share, but had a \nvery low volatility, then its price changes would be small and it might consequently \nnot have as great an influence on the changes in the price of the index as some lower\npriced stock would. \nIn general, one is far less concerned with a stock's weight in a price-weighted \nindex than", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 223}
{"text": "n the change of the value of \nthe index. Thus, if stock B was the highest-priced stock at $90 per share, but had a \nvery low volatility, then its price changes would be small and it might consequently \nnot have as great an influence on the changes in the price of the index as some lower\npriced stock would. \nIn general, one is far less concerned with a stock's weight in a price-weighted \nindex than he is in a capitalization-weighted index. That is, one might notice that four \nor five large stocks - IBM, AT&T, Exxon, General Motors, and General Electric, for \nexample - might make up over 30% of the S&P 100 even though they represent only \n5% of the stocks in the index. However, the same five stocks in a price-weighted \nindex of 100 stocks would probably account for very nearly 5% of the index because \ntheir prices are not substantially different from those of the other 95 stocks ( even \nthough their capitalizations are). So if one were to notice a large change in the price \n500 Part V: Index Options and Futures \nof IBM, one might figure that capitalization-weighted indices that contained that \nstock would also be showing somewhat unusual price changes in the same direction \nthat IBM is moving. A price-weighted index that contained IBM would, of course, \nalso be affected by IBM's price change, but not extraordinarily so since IBM would \nhave far less weight in the price-weighted index. \nSECTORS \nSector is a term used to refer to an index of stocks in which all the stocks are mem\nbers of the same industry group. Examples of groups on which sectors have been cre\nated - and on which options have traded - are computers and technology, interna\ntional oils, domestic oils, gold, transportation, airlines, and gaming and hotels. These \nindices are computed in the same ways as described above - either price-weighted \nor capitalization-weighted. They generally consist of fewer stocks than their major \ncounterparts, however. Most sectors are comprised of between 20 and 30 stocks, \nsince that is about all of the stocks in any one specific industry group. The large \nindices are usually referred to as \"broad-based\" indices, as opposed to the smaller \nsectors which are often referred to as \"narrow-based\" indices. \nOptions trade on these sectors. The intent of these options is to allow portfolio \nmanagers -who often are group-oriented- to be able to hedge off parts of their port\nfolio by industry group. The options on these sectors are usually cash-based options. \nStrategies will be discussed later, but there is not much difference in strategy \nbetween broad-based or narrow-based index options. One difference is that broad\nbased option writers receive more favorable margin treatment ( that is, they are \nrequired to put up less collateral) than narrow-based option writers. \nCASH-BASED OPTIONS \nNow that the reader is familiar with indices, let us look at the most popular type of \nlisted index option, the cash-based option. \nCash-based options do not have any physical entity underlying the option con\ntract. Rather, if the option is exercised or assigned, the settlement is done with cash \nonly - there is no equity involved. This type of option is generally issued on an index, \nsuch as the S&P 500, for which it would be virtually impossible to actually deliver the \nunderlying securities in case of assignment or exercise. \nSince many investors feel that it is easier to predict the market's movement \nrather than that of an individual stock, the cash-based index option has become very \npopular. Other indices that underlie cash-based option contracts are the New York \nStock Exchange Index, the S&P 500 Index, the S&P 100 Index (OEX - an index \nChapter 29: lntrodudion to Index Option Produds and Futures S01 \nintroduced by the CBOE), the NASDAQ Index ($NDX), the Dow-Jones 30 \nIndustrials ($DIX), and several other indices. In each of these cases there are too \nmany stocks in the index, and too many varying quantities of each of the stocks, to be \nable to handle the physical delivery of each of the stocks in the case of exercise or \nassignment. Some cash-based options are based on subindices ( that is, subgroups of \nthe larger indices such as the transportation group). \nEXERCISE AND ASSIGNMENT \nIt is important to understand the ramifications of exercise and assignment when deal\ning with this type of option. When a cash-based option is exercised, the owner \nreceives cash equal to the difference between the index's closing price and the strike \nprice of the option. The option writer who is assigned must pay out an equal amount. \nThe following example shows how a call exercise might work. In this and the follow\ning examples we will use a fictional index '.lYX (index symbols often end in X). \nExample: Suppose an investor buys a '.lYX September 160 call option. At a later date, \nthe index has risen substantially in price and closes at 175.24 on a particular day. The \ninvestor decides it is time to take his profit by exercising his call option. Assuming the \n'.lYX contract is worth $100 per point, just as stock options are, he receives cash in \nthe amount of $100 times the difference between the index closing price and the \nstrike price: $100 x (175.24 - 160.00) = $1,524. He has no further position or rights \n- the option position disappears from his account by virtue of the exercise and he \ndoes not acquire any security by the exercise; he gets only cash. \nAn assignment would work in a similar manner, with the seller of an option hav\ning to pay out of his account cash equal to the difference between the index closing \nprice and the option's striking price. As an example, suppose that a trader sells a put \noption on the '.lYX Index - the October 165 put. Subsequently, the index drops in \nprice, and one morning the writer of this put option finds that he has been assigned \n(as of the previous day, as is the case with stock options). If the index closed at 157.58 \non the previous day, then the option writer's account will be deb", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 224}
{"text": "ption's striking price. As an example, suppose that a trader sells a put \noption on the '.lYX Index - the October 165 put. Subsequently, the index drops in \nprice, and one morning the writer of this put option finds that he has been assigned \n(as of the previous day, as is the case with stock options). If the index closed at 157.58 \non the previous day, then the option writer's account will be debited an amount equal \nto $100 X (165.00 - 157.58) = $742. \nEUROPEAN VERSUS AMERICAN EXERCISE \nBefore proceeding with more examples of index option exercise and the accompany\ning strategies, it is necessary to introduce two new definitions. American exercise \nmeans that an option may he exercised at any time; European exercise means that an \noption may only be exercised on its expiration day. Many of the cash-based index \n502 Part V: Index Options and Futures \noptions have the European exercise feature. All stock options and some index options \nhave the American exercise feature. \nThe European exercise feature was introduced because institutional investors \nwho might tend to write calls against their portfolio of stocks wanted some assurance \nthat their protection wouldn't be unexpectedly taken away from them. Thus several \nindex option series became European exercise. Two major ones are the cash-based \nindex options on the S&P 500 Index (SPX) and the cash-based options on the Dow\nJones 30 Industrials. OEX remains an American exercise. \nIn-the-money European put options will be cheaper than their American coun\nterparts. This is because an arbitrageur would have to carry the position all the way \nto expiration; he could not exercise his puts and liquidate the position immediately. \nIn fact, deeply in-the-money European puts will trade at a discount; the higher short\nterm interest rates are, the deeper the discount will be. \nThis can affect the full protective capability of long-term European puts. If a \nportfolio manager buys puts to protect his portfolio and the market crashes, the puts \nmight be deeply in the money. If these puts have a European exercise feature, they \nwould be selling at a deep discount and therefore would not have afforded all the \nprice protection that the portfolio manager had been looking for. \nAmerican Exercise Consideration. The primary reason for the holder of an \nindex option to exercise the option is to take his profit. One might think that, if the \nholder wanted to take a profit, he would merely sell his option in the open market. \nOf course, if he could, he would. However, many times the deeply in-the-money \noptions sell at a substantial discount during the trading day. A deep discount is con\nsidered to be 1/2 to 3/4 of a point, or more. Near the end of the day, these options \ntend to trade at only slight discounts. In either case, the holder of the option may \ndecide to exercise rather than to sell at any discount. Of course, if one is the holder \nof a call option that is trading at a substantial discount in the morning of a particular \nday, and he decides to exercise, he may lose more by the end of the day (if the mar\nket trades down) than he would have if he had merely sold at the deep discount in \nthe first place. In fact, some theoreticians feel that the \"job\" of a deeply in-the-money \ncash-based option during the trading day is to try to predict the market's close. This, \nof course, is not a \"job\" that can be consistently done with accuracy (if it could, the \ntraders doing the predicting would be rich beyond their wildest dreams). \nIf the holder of a cash-based call option turned bearish, that would be another \nreason to exercise. That's right - if the holder of a cash-based call option is bearish, \nhe should exercise because, by so doing, he liquidates his bullish position and takes \nhis profit. This is somewhat opposite from an option that has a physical underlying \nsecurity, such as a stock option. This presents an interesting scenario: If one turns \nChapter 29: Introduction to Index Option Products and Futures 503 \nbearish late in the day, even after the close, he might conceivably try to exercise his \ncalls to liquidate his position. The exchanges recognize that such tactics might not be \nin everyone's best interest - for example, if one waited to see how the money supply \nnumbers looked on a particular evening before exercising, he would definitely have \nan advantage over the writers of those same options. The writers could no longer \nviably hedge their positions after the market had closed. In order to prevent this, \ncash-based option exercise notices are only acceptable until 5 minutes after the \noptions close trading on that exchange on any given trading day ( except expiration, of \ncourse), in order to allow both holders and writers to be on somewhat equal footing. \nThere is one more fact regarding exercise of cash-based options that will inter\nest brokerage customers, retail or institutional. Most brokerage firms will charge a \ncommission for the cash-based option exercise or assignment. When index options \nwere first traded, commissions were quite high. Currently, however, one should gen\nerally be paying a commission based upon the equivalent option price. \nExample: In the previous example, one exercised a ZYX Sep 160 call at expiration \nwhen the index closed at 175.24. This is a differential of 15.24. One should pay a \ncommission as if he had sold his long calls at a price of 15.24, not on anything more. \nFor writers of cash-based options, things are not so different from stock options. \nThe writer is still warned of impending assignment by the fact that the option is trad\ning at a discount. If it is not trading at a discount, it is probably not in danger of being \nassigned. Also, since there is no stock involved and therefore no dividends paid, the \nwriter of a cash-based put option need only be concerned with whether the put is \ntrading at a discount, not with whether it is trading at a discount to underlying price \nless the dividend, as is the c", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 225}
{"text": "he option is trad\ning at a discount. If it is not trading at a discount, it is probably not in danger of being \nassigned. Also, since there is no stock involved and therefore no dividends paid, the \nwriter of a cash-based put option need only be concerned with whether the put is \ntrading at a discount, not with whether it is trading at a discount to underlying price \nless the dividend, as is the case with stock options. \nTraders doing spreads in cash-based options have special worries, however. \nWhat may seem to be a limited-risk spread may acquire more risk than one initially \nperceived, due to early assignment of the short options in the spread. Consider the \nfollowing example. \nExample: Suppose that an investor establishes a bearish call spread in ZYX options \n- he buys the November 160 call at a price of 1 and simultaneously sells the \nNovember 155 call at 3. His risk on the spread is $300 plus commissions if he has to \npay the maximum, limited debit of $500 to buy back the spread, or so it appears. \nHowever, suppose that the index rises substantially in price and the spreader is \nassigned on the short side of his spread with the index at 175.24. He thus is charged \na debit of $2,024 to \"cover\" each short call via the assignment: $100 times the in-the\nmoney amount, 175.24 - 155.00, or 20.24. He receives this assignment notice in the \n504 Part V: Index Options and Futures \nmorning before the next trading day begins. Note that he cannot merely exercise his \nlong, since, if he did that, he would then receive the next night's closing price for his \nlong. Under the worst scenario, suppose the market receives disappointing econom\nic news the next day and opens sharply lower - with the index at 172. If he sells his \nlong Nov 160 calls at parity ($1,200), he will have paid a debit of $824 - larger than \nhis initial, theoretically \"limited\" maximum debit of $500. Thus he loses $624 on this \nspread ( $824 less the initial credit of $200) - over twice the theoretically limited loss \nof $300. \nIf the market should open sharply lower and trade down, he could lose more \nmoney than he thought because his long position is now exposed - there is no longer \na spread in place after the short option is assigned. Of course, this could work to his \nadvantage if the market rallied the next day. The point is, however, that a spread in \ncash-based options acquires more risk than the difference in the strikes (the maxi\nmum risk in stock options) if the short option in the spread becomes a deeply in-the\nmoney option, ripe for assignment. \nNAKED MARGIN \nWhen an index is designated as \"broad-based,\" a lesser margin requirement applies \nto the writer of naked options. The SEC determines which indices are broad-based. \nA broad-based index receives more favorable margin treatment because the under\nlying index will not normally change in price as quickly as a stock or subindex. Thus, \nthe naked writer theoretically has less of a risk with a naked broad-based index \noption. \nThe requirement for writing a broad-based index option naked is 15% of the \nindex, plus the option premium, minus the amount, if any, that the option is out-of \nthe-money. There is a minimum requirement: for calls, it is 10% of the index value; \nfor puts, it is 10% of the striking price. Both minima are in addition to the option pre\nmium. \nExample: Suppose that the ZYX is at 168.00, with a Dec 170 call selling for 6 and a \nDec 170 put selling for 5. The requirement for selling the call naked would be cal\nculated as follows: \n15% of index \nPlus call premium \nLess out-of-money amount \nNaked call requirement \n$2,520 \n+ 600 \n200 \n$2,920 \nChapter 29: Introduction to Index Option Produds and Futures \nThe requirement for writing the Dec 170 put naked would be: \n15% of index \nPlus put premium \nNaked put requirement \n$2,520 \n+ 500 \n$3,020 \nBoth of these requirements are above the minimum of 10% of the index. \n505 \nOptions on narrow-based indices are subject to the same naked requirements \nas stock options: 20% of the index plus the premium less an out-of-the-money \namount, with a minimum requirement of 15% of the index. \nOther margin requirements are similar to those for stock options. For example, \nif one wanted to write the Dec 170 straddle naked, using the same prices as in the \nlast example, he would have a margin requirement equal to $3,020 - the larger of the \nput or call requirement, just as he would for stock options. Spread requirements for \nindex options work in exactly the same manner as they do for stock options. \nLEAPS INDEX OPTIONS \nLEAPS (Long-term Equity AnticiPation Securities) have been introduced on indices \nin recent years. Readers not familiar with LEAPS should review the prior chapter on \nthat subject. Since LEAPS have become popular for stocks, it is only logical to think \nthat they would become popular for indices as well. \nThe main problem was that a LEAPS could be a 2-year option on a 350 dollar \nunderlying index. Such an option might cost 20 points. That is too expensive to attract \nthe public customer. Just one option would cost $2,000. Therefore, the exchanges \ncreated mini-indices out of OEX, SPX, XMI, and others. These mini-indices that \nwere created are exactly the same as the full indices, except that they are divided by \n10. This means that instead of having the 2-year put with strike of 350 cost 20 points, \na 2-year put with a strike of 35 costs 2 points. This is much more affordable for the \nindividual trader. \nThe following example is of OEX options and the corresponding OAX LEAPS \noptions on the same index. NOTE: OAX is not the universal symbol for this mini\nindex. OEX LEAPS are American exercise, while SPX LEAPS are European. A bro\nker should be contacted for symbols, expiration dates, and other details. \nExample: The following is a sample comparison of prices for OEX and for its com\npanion index OLX, which is OEX divided by 5. (Originally, OLX was OEX divided by \n10, but when OEX split 2-for-1 in late 1997, OLX did", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 226}
{"text": "he universal symbol for this mini\nindex. OEX LEAPS are American exercise, while SPX LEAPS are European. A bro\nker should be contacted for symbols, expiration dates, and other details. \nExample: The following is a sample comparison of prices for OEX and for its com\npanion index OLX, which is OEX divided by 5. (Originally, OLX was OEX divided by \n10, but when OEX split 2-for-1 in late 1997, OLX did not split so OLX was thereafter \nequal to OEX divided by 5). \n506 \nOEX: 712 \nPart V: Index Options and Futures \nOLX: 142.40 \nOLX 2-year LEAPS options: \nDec 140 call: 30 \nDec 150 call: 26.5 \nDec 160 call: 20.5 \nNote that striking prices of 140, 150, and 160 for OLX correspond to 700, 750, and \n800 for OEX itself. Also, if a 2-year OEX Dec 700 call existed, it would sell for \napproximately five times as much as the OLX Dec 140 call, or about 150 points (5 \ntimes 30). This is why the LEAPS options use reduced-value strikes, because very \nfew people would have interest in trading an at-the-money option that cost 150 \npoints ($15,000). \nFUTURES \nWe will now take a look at how futures contracts work. This section will be concerned \nonly with cash-based index futures; futures for physical delivery are included in a \nlater chapter. The ordinary stock investor might think that he will be able to employ \nindex option strategies without getting involved in futures. While it may be possible \nto avoid futures, the strategist will realize that they are a necessary part of the entire \nindex-trading strategy. Thus, in order to be completely prepared to hedge one's posi\ntions and to operate in an optimum manner, the use of index futures or index futures \noptions is a necessary complement to nearly all index strategies. \nA comnwdities futures contract is a standardized contract calling for the deliv\nery of a specified quantity of a certain comnwdity at some future time. The older, \nmore conventional types of commodities contracts were futures on grains, meats, and \nmetals. In recent years, futures have expanded extensively and have encompassed \nfinancial securities - bonds, T-bills, Eurodollar Time Deposits, etc. Most recently, \nfutures have been issued that are cash-based; that is, no actual commodity is deliver\nable. Rather, the contract settles for cash. Some of these cash-based futures contracts \nhave stock market indices as their underlying 'commodity. \"It is this latter type of \nfuture that will be the subject of the examples in this section, although the basic facts \nregarding futures are applicable to all futures contracts, cash-based or not. \nSeveral types of traders or investors use futures contracts. One is the specula\ntor: He is able to generate tremendous leverage with futures and may be able to cap\nitalize on small swings in the price of the underlying commodity. Another is the true \nhedger: He is a dealer in the actual underlying commodity and uses futures to hedge \nhis price risk. This is the more economic function of futures. Examples of hedges for \nphysical commodities as well as stocks will be presented in later chapters. However, \nChapter 29: Introduction to Index Option Products and Futures 507 \nlet us look at a simple example of how one might hedge a stock portfolio with stock \nindex futures. \nExample: Suppose that a stock mutual fund operates under the philosophy that \ninvestors cannot outperform a bullish market, so the best investment strategy when \none is bullish is just to \"buy the market.\" That is, this mutual fund actually buys all \nthe stocks in the Standard & Poor's 500 Index and holds them. \nIf the manager of this fund turns bearish, he would want to sell out his positions. \nHowever, the commission costs for liquidating the entire portfolio would be large. \nAlso, the act of selling so much stock might actually depress the market, thereby \ndevaluing the remainder of his portfolio before he can sell it. \nThis manager might sell S&P 500 futures against his portfolio instead of selling \nhis stocks. Such a futures contract would move up or down in line with the S&P 500 \nIndex as it rises or falls. Suppose that he sold enough futures to hedge the entire dol\nlar value of his stock portfolio. Then, even if the stock market declined, his futures \ncontracts would decline also and would theoretically prevent him from having a loss. \nOf course, he couldn't make much of a gain if the market went up, since the futures \nwould then lose money. What this money manager has accomplished is that he has \neffectively sold his stock portfolio without incurring stock commission costs (futures \ncommissions are normally quite small). \nIf he turns bullish again at some later date, he can buy the futures back, and \nhave his long stocks free to profit if the market rises. Again, he does not spend the \nstock commission nor does he have to go through the tedious process of placing 500 \nstock orders to \"buy\" the S&P 500 - he merely places one order in futures contracts. \nFutures contracts often trade at premiums to the underlying commodity, due to \nthe fact that the investor who buys the future does not have to spend the money that \none who buys all the stocks would have to spend. Thus, he saves the carrying costs \nbut forsakes any dividends. This savings is reflected by the marketplace in that a pre\nmium is placed on the price of the futures contract. As a consequence, longer-term \ncontracts trade at a larger premium than do near-term contracts, much as is the case \nwith options. In most cases, however, the index futures trader is concerned with the \nnearest-term contract, and perhaps the next one out in time. \nTERMS OF THE CONTRACT \nThere are cash-based index futures on several indices, although some of these futures \ncontracts are not heavily traded. The most heavily traded contract is the future on the \nS&P 500 Index. This contract trades on the Chicago Mercantile Exchange. It has con\ntracts that expire every 3 months (March, June, September, December) and a 1-point \n508 Part V: Index Options and Futures \nmov", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 227}
{"text": "THE CONTRACT \nThere are cash-based index futures on several indices, although some of these futures \ncontracts are not heavily traded. The most heavily traded contract is the future on the \nS&P 500 Index. This contract trades on the Chicago Mercantile Exchange. It has con\ntracts that expire every 3 months (March, June, September, December) and a 1-point \n508 Part V: Index Options and Futures \nmove in the futures contract is worth $250. There is no particular reason why a I-point \nmove is worth $250, that is merely how the contract is defined. These numbers are \nsubject to change. Originally, a I-point move in S&P futures was worth $500, but \nwhen the S&P advanced so much during the bull market of the 1990's, the point value \nwas halved in order to reduce the trading exposure in trader's accounts. One could \nsurmise that a further bull market advance might cause the number to be reduced \nagain, or possibly a prolonged bear market could result in an increase from $250 back \nto $500, conceivably. \nExample: A futures trader buys I March S&P 500 contract at 401.00 (the smallest \nunit of trading is 0.10 points, a \"dime\"). The contract rises in price to 403.30. The \ntrader has a profit of 2.30 points, or $575 (2.30 points x $250 per point). \nThe terms of futures contracts can change as the exchanges on which they are \ntraded attempt to adjust the contracts to he more competitive in the current trading \nenvironment. Consequently, the strategist should check with his broker to determine \nthe exact terms of any contract before he begins trading it. \nOPEN OUTCRY \nFutures contracts trade on listed commodity exchanges. However, the method of \ntrading is different from that used for stocks and options. Futures trade by \"open \noutcry\" in rings or pits. Members of the exchange are the only ones allowed to trade \non the exchange, of course, just as is the case with stocks and options. If the. member \nis trying to execute a buy order, for example, he would announce his bid out loud \n(open outcry). Sellers would then respond by either showing him an offer or by sell\ning to him at his bid price. This differs from stocks and options which use the spe\ncialist system, in that many people can be buying and selling at once, all over the pit. \nIt also differs from the market-maker system used on some stock options exchanges \nbecause anyone can make the market in the commodity pit, not just a designated few \ntraders. \nThis form of trading can produce some oddities not normally associated with \nstock or stock option trading. There may be slightly different markets at different \nplaces in a large, busy trading pit. Hence a buyer on one side of the pit may be try\ning to pay a price that is being offered on the other side of the pit, but the two do not \ntrade with each other because of the size of the trading crowd. The buyer might buy \non one side of the pit, but the seller on the other side does not sell. Then if the mar\nket trades lower, only one of the two will have received an execution even though \nthey were trying to buy and sell at the same price. Thus, one cannot be certain that \nhis futures order is executed unless the market trades through his price. That is, if \nChapter 29: Introduction to Index Option Products and Futures 509 \none is bidding for futures at a price of 1401.50 and a trade is printed at 1401.40, then \nhe can be certain that he has bought his contracts. \nFutures exchange members who trade mainly for their own account from the \nring or pit are known as locals.\" They are somewhat akin to the stock option market\nmaker in that they may take the other side of public orders. Note, however, that they \ndo not have to make a public market as market-makers do. \nMARGIN, LIMITS, AND QUOTES \nFutures contracts are traded on margin and are marked to market every day. \nGenerally, the amount of margin required is small in comparison to the total size of \nthe contract, so that there is tremendous leverage in trading futures. Anyone trading \nthe futures must deposit the initial margin amount in his account on the day he ini\ntiates the trade. Then at the end of each day, the amount of gain or loss on the con\ntract is computed, and the account is credited if there is a gain or debited if there is \na loss. In case of a loss, the trader must add more cash to his account to cover the \nloss. This daily margin computation is known as maintenance margin. Treasury bills \nor other securities are good collateral for the initial margin, but the daily variation \nmargin is required in cash. \nExample: The S&P 500 futures contract is a cash-based futures contract that trades \non the Chicago Mercantile Exchange. Since the contract is settled in cash, there is \nno actual physical commodity underlying the contract. Rather, the contract is based \non the value of the S&P 500 stock index. At the expiration of the contract, each open \ncontract is marked to market at the closing price of the S&P 500 stock index and dis\nappears. All contracts are settled for cash on their final day and then they no longer \nexist - they expire. The terms of the contract specify that each point of movement is \nworth $250. Thus, if the S&P 500 Index itself is at 1405, then the S&P futures con\ntract is a contract on $250 x 1405, or $351,250 worth of stocks comprising the index. \nAssume the initial margin for one of these contracts is $30,000, although it may vary \nat specific brokerage houses. \nSuppose that a trader buys one December S&P futures contract for his account \nsometime in October. With the underlying index at 1405.00, suppose he pays 1417.50 \nfor the futures contract. It is normal for the futures to trade at a premium to the actu\nal index price. The reasons regarding this will be discussed in a later section. Initially, \nthe customer puts up $30,000 as margin, and this may be in the form of T-bills. On \nthe next day, however, the market declines and the futures close at 1406.00. This rep\nresents a loss of 11.50 points from the purchase price. A", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 228}
{"text": "utures contract. It is normal for the futures to trade at a premium to the actu\nal index price. The reasons regarding this will be discussed in a later section. Initially, \nthe customer puts up $30,000 as margin, and this may be in the form of T-bills. On \nthe next day, however, the market declines and the futures close at 1406.00. This rep\nresents a loss of 11.50 points from the purchase price. At $250 per point, the trader \nhas a loss of $2,875 (250 x 11.50) at this time. He is required to add $2,875 in cash \ninto the account. \n510 Part V: Index Options and Futures \nIf he continued to hold the contract until expiration, this process of adding his \ndaily gain or subtracting his daily loss from the account would recur each day. Finally, \non the last day, the futures contract is deemed to close at the exact opening price of \nthe S&P 500 Index and the variation margin is calculated again at that price. Then \nthe futures contract is expired, so it is \"erased\" from his account. He is then left with \nonly the cash that he made or lost on the trade of his contract. \nThe leverage produced by small margin requirements (as a percent of the total \nvalue of the contract) is a major factor in making futures very volatile, in dollar terms. \nIn the preceding example, a $30,000 margin investment controls $351,250 worth of \nstocks. Due to their volatility, many futures contracts trade with a limit. That is, the \nprice can only fluctuate a fixed amount above or below the previous day's closing \nprice. This concept is intended to prevent traders with large positions from being \nable to manipulate the market drastically in either direction. \nS&P and NYSE Expiration. S&P 500 futures expiration occurs in a some\nwhat complex way, compared to those indices whose options and futures expire \nat the last sale on the final day of trading. Some years ago, in order to attempt \nto reduce the volatility that index futures and options expiration was causing in \nthe stock market, the NYSE and the Chicago Mercantile Exchange (where the \nS&P 500 futures trade) agreed to change the expiration of their index products \nfrom the end of trading on the last Friday to the morning of that day. The effect \nof expiration on the stock market is discussed in the next chapter. \nAs a result, the S&P futures and futures options as well as futures, futures \noptions, and index options on the New York Stock Exchange Index settle in the fol\nlowing manner on their last day of trading. On expiration day - the third Friday of \nthe month - the \"final\" price for purposes of settling futures and options is comprised \nof taking the opening trade of each stock and calculating an index price based on \nthose opening prices. There is no actual trading in the futures and options on that last \nFriday; they cease trading at the close of trading on the previous day, Thursday. \nThe purpose of this change was to give the specialists on the New York Stock \nExchange more time to line up the other side of trades to handle order imbalances. \nUnder the new rules, index arbitrageurs are forced to enter their buy or sell orders \nas market on open orders on that last Friday before 9 am EST. The specialist can then \ntake his time in opening the stock if he needs to; he can solicit orders if there is too \nmuch stock to buy or sell. \nThe effect of all this is that the \"final\" index price for settlement purposes is not \nknown until all the stocks in the index have opened. It may take some time to open \nall 500 stocks in the S&P 500 Index if there is a volatile market that Friday morning \nChapter 29: Introduction to Index Option Products and Futures 511 \n(perhaps caused by news) or if there are severe order imbalances in many of the \nstocks (caused by index arbitrageurs). Index arbitrage is described in Chapter 30. \nLimits. Originally, index futures traded without limits. However, the stock mar\nket crash of 1987 changed that. Certain parties felt that if the futures - which \nwere leading the market down - had ceased trading for a while, the stock mar\nket could have stabilized. As a result, a series of trading limits now exists for \nstock index futures. These are designed to be \"circuit breakers\" - to prevent a \nstock market crash. They are not limits in the sense that other futures have lim\nits, but they are similar. \nThe levels at which these circuit breakers occur may change from time to time, \nbased on the volatility of the stock market and the price levels at which the S&P \nfutures are trading. That is, if the S&P futures are trading at 1500, one can expect \nwider circuit breakers than if they are trading at 600. These circuit breakers only \napply to downside moves by the stock market. The first in the series of circuit break\ners usually halts trading for only 10 minutes. After that, if the market trades lower -\nusually something on the order of a 10% decline - then a longer circuit breaker is \ninstituted for about 30 minutes or so. After that they could open again, and if they \nreached the next limit down - something probably on the order of 20% then trad\ning would be halted for a longer time ( two hours or so again, the details depend on \nthe current regulations). If there is any time left in the trading day, they can open \nagain, and trade down to a final limit, at which time trading would be halted for the \nday. They could not trade any lower that day, although they could trade lower the \nnext day if need be. \nThere are similar limits imposed by the NYSE on its trading - based on the \nDow-Jones Industrial Averages. Those limits don't necessarily line up exactly with the \nlimits on the S&P futures. That fact might cause problems for hedgers should any of \nthese severe downside limits actually occur. \nThere are actually other \"circuit breakers\" designed to prevent runaway stock \nmarkets, but they are not related to limits on futures trading. They will be described \nalong with index arbitrage and program trading in Chapter 30. \nQuotes. While stocks and stock option", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 229}
{"text": "limits on the S&P futures. That fact might cause problems for hedgers should any of \nthese severe downside limits actually occur. \nThere are actually other \"circuit breakers\" designed to prevent runaway stock \nmarkets, but they are not related to limits on futures trading. They will be described \nalong with index arbitrage and program trading in Chapter 30. \nQuotes. While stocks and stock options are always quoted in dimes, or some\ntimes nickels, such is not the case with futures. Some futures trade in fractions, \nwhile others trade in cents. In the coming chapters, there will be many examples \nof the trading details of futures and options. However, the investor should famil\niarize himself with the details of an individual contract before beginning to trade \nit or its options. One's commodity broker can easily supply this information. \n512 Part V: Index Options and Futures \nThere are certain differences between the way futures trade and the way stocks \ntrade. One difference that is extremely important to investors accustomed to dealing \nin stocks and stock options is that quotation vendors rarely show a bid and offer for \nfutures. Thus, if one uses a quote machine to obtain the price of a stock he might see \nthat the stock is currently 31 bid, 31.10 asked, with a last sale of 31. An active futures \ncontract traded on a trading floor (which is typically the type that one would want to \ntrade) virtually never shows a bid and offer, but rather shows last sale only. In addi\ntion, each sale of a stock or stock option is recorded both as to its time of execution \nand the quantity of execution. Such is not the case for futures. Only the price is \nrecorded - one cannot tell how many contracts traded at the price, nor can he tell if \nthere were repeated sales at that price. Where futures are traded in electronic mar\nkets, of course, the bid and offer are available for all to see, and volume may accu\nrately be recorded as well. \nOPTIONS ON INDEX FUTURES \nAs we saw earlier, futures contracts allow a person dealing in a commodity to minimize \nprofit fluctuations in his commodity. The mutual fund manager who sold the futures \nlargely removed any possibility of further upside profit or downside loss. Options, \nhowever, allow a little more leeway than futures do. With the option, a person can lock \nin one side of his position, but can leave room for further profits if conditions improve. \nFor example, the mutual fund manager might buy put options on the S&P 500 Index \nto hedge his downside risk, but still leave room for upside profits if the stock market \nrises. This is different from the sale of a futures contract, which locks in his profit, but \ndoes not leave any room for further profits if the market moves favorably. \nOptions trade on many types of futures contracts. The security underlying the \noption is the futures contract having the same expiration month, not the entity under\nlying the futures contract itself. Thus, if one exercises a listed futures option, he \nreceives a futures contract position, not the physical commodity. \nExample: A trader owns the ZYX futures December 165 call option (165 is the strik\ning price). Assume the ZYX December future closed at 171.20. Both the calls and the \nfutures are worth $500 per point. If the call is exercised, the trader then owns one \nZYX December (same expiration month as the option) futures contract at a price of \n165. Since the current price is 171.20, there is a maintenance margin credit of $3,100 \nin his account (500 x 6.20 points). Note that even though the option is an option on \na future which is cash-based, the exercise provides the holder of the option with a \nfutures contract position, not with cash. \nChapter 29: Introduction to Index Option Products and Futures 513 \nAt the present time, there are futures options on all of the various index futures \ncontracts. \nEXPIRATION DATES \nFutures options have specifics much the same as stock options do: expiration month \n(agreeing with the expiration months of the underlying futures contract), striking \nprice, etc. If a trader buys a futures option, he must pay for it in full, just as with stock \noptions. Margin requirements vary for naked futures options, but are generally more \nlenient than stock options. Often, the naked requirement is based on the futures \nmargin, which is much less than the 20% of the underlying stock price as is the case \nwith listed stock options. \nWhen the futures option has a cash-based futures contract underlying it, the \noption and the future generally expire on the same day. Thus, if one were to exercise \na '.ZYX option on expiration day, one would receive the future in his account, which \nwould in tum become cash because the future is cash-settled and expiring as well. \nExample: Suppose that a trader owns a '.ZYX December 165 futures worth $500 per \npoint - call option and holds it through the last day of trading. On that last day, the \n'.ZYX Index closes at 174.00. He gives instructions to exercise the call, so the follow\ning sequence occurs: \n1. Buy one '.ZYX future at 165.00 via the call exercise. \n2. Mark the future at 17 4.00, the closing price. This is a variation margin profit of \n$4,500 (174.00-165.00) X $500. \n3. The option is removed from the account because it was exercised, and the future \nis removed as well because it expired. \nThus, the exercise of the option generates $4,500 in cash into the account and leaves \nbehind no futures or option contracts. We do not know if this represents a profit or \nloss for this call holder, since we do not know if his original cost was greater than \n$4,500 or not. \nIt should be noted that futures option expiration dates, in general, are fairly \ncomplex. They are not normally the third Friday of the expiration month, as stock \noptions are. Index futures options generally do expire on the third Friday of the expi\nration month, but many physical commodity options do not. These differences will \nbe discussed in the later chapter", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 230}
{"text": "as greater than \n$4,500 or not. \nIt should be noted that futures option expiration dates, in general, are fairly \ncomplex. They are not normally the third Friday of the expiration month, as stock \noptions are. Index futures options generally do expire on the third Friday of the expi\nration month, but many physical commodity options do not. These differences will \nbe discussed in the later chapter on futures options. \n514 Part V: Index Options and Futures \nOPTION PREMIUMS \nThe dollar amount of trading of a futures option contract is normally the same as that \nof the underlying future. That is, since the S&P 500 future is worth $250 per point, \nso are the S&P 500 futures options. The same holds true for the New York Stock \nExchange Index options. \nExample: An investor buys an S&P 500 December 1410 call for 4.20 with the index \nat 1409.50. The cost of the call is $1,050 (4.20 x 250). The call must be paid for in \nfull, as with equity options. \nAn interesting fact about futures options is that the longer-term options have a \n\"double premium\" effect. The option itself has time value premium and its underly\ning security, the future, also has a premium over the physical commodity. This phe\nnomenon can produce some rather startling prices when looking at calendar spreads. \nExample: The ZYX Index is trading at 162.00 sometime during the month of \nJanuary. Suppose that the March ZYX futures contract is trading at 163.50 and the \nJune futures contract at 167.50. These prices are reasonable in that they represent a \npremium over the index itself which is 162.00. These premiums are related to the \namount of time remaining until the expiration of the futures contract. \nNow, however, let us look at two options - the March 165 put and the June 165 \nput. The March 165 put might be trading at 3 with its underlying security, the March \nfutures contract, trading at 163.50. The June 165 put option has as its underlying \nsecurity the June futures contract. Since the June option has more time remaining \nuntil expiration, it will have more time value premium than a March option would. \nHowever, the underlying June future is trading at 167.50, so the June 165 put option \nis 2½ points out-of-the-money and therefore might be selling for 2½. This makes a \nvery strange-looking calendar spread with the longer-term option selling at 2½ and \nthe near-term option selling for 3. This is due to the fact, of course, that the two \noptions have different underlying securities. One is in-the-money and the other is \nout-of-the-money. These two underlyings - the March and June futures - have a \nprice differential of their own. So the option calendar spread is inverted due to this \ndouble premium effect. \nFUTURES OPTION MARGIN \nMost futures exchanges have gone to the form of option margin called SPAN, which \nstands for Standard Portfolio Analysis of Risk. This form of margining is very fair and \nattempts to base the margin requirement of an option position on the probability of \nChapter 29: Introduction to Index Option Products and Futures 515 \nmovement by the underlying futures contract, as well as on the potential change of \nimplied volatility of the options in question. \nThe older method of margining option positions is known as the \"customer mar~ \ngin\" method. The customer margin method generally results in higher margin \nrequirements. The reader is referred to the chapter on futures and futures options \nfor an in-depth discussion of SPAN and other option margin requirements. \nOTHER TERMS \nJust as futures on differing physical commodities have differing terms, so do options \non those futures. Some options have striking prices 5 points apart while others have \nstrikes only 1 point apart, reflecting the volatility of the commodity. Specifically, for \nindex futures options, the S&P 500 options have striking prices 5 points apart, and \nthe NYSE options have striking prices 2 points apart. \nThere is no standard method for quoting futures on options as there is with \nstock options. In some cases, striking price symbols are similar to stock option sym\nbols (A=5, B=lO, C=l5, etc.), while in others the letters are used incrementally (A=l, \nB=2, C=3, etc.). Moreover, the method used may differ with each quote vendor. In \nsome cases, quote systems use the numeric value of the strike instead of letters. This \nmakes quoting options much simpler, and perhaps the entire industry (including \nstock option vendors) will adopt this method someday. Since there is no standard \nmethod for quoting, one must obtain the symbols individually for futures options, a \nfact that makes quoting them extremely inconvenient. \nThere are position limits for some futures options, hut they allow for very large \npositions. Check with your broker for exact limits in the various futures options. \nQUOTES \nMost futures option quotes (bids and offers) are not displayed on quote-vending \nmachines, as is also the case with futures. Options traded on the Chicago Mercantile \nExchange are the exception. This can he somewhat distressing to the trader used to \ndealing in stock options, since options are normally far less liquid than the underly\ning security. It might be acceptable to trade off of last sales in a liquid futures con\ntract, but not so with the options. As a result, futures options have not attracted many \nstock option traders into their fold. Of course, where electronic markets exist, the \nbids and offers of options would be shown publicly. \nThe consequence of the inconsistencies in terms as well as the general unavail\nability of quotes has been that index futures options are generally traded by profes\nsionals, with the public largely ignoring them. This does not mean, however, that \n516 Part V: Index Options and Futures \nfutures options are unworthy of the strategist's time and effort. In fact, just the oppo\nsite may be true - the lack of general information may produce some inefficiencies \nthat the strategist can benefit from. \nOne factor concerning the tradi", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 231}
{"text": "ons are generally traded by profes\nsionals, with the public largely ignoring them. This does not mean, however, that \n516 Part V: Index Options and Futures \nfutures options are unworthy of the strategist's time and effort. In fact, just the oppo\nsite may be true - the lack of general information may produce some inefficiencies \nthat the strategist can benefit from. \nOne factor concerning the trading of futures options can be of major concern \nto many customers and salesmen. Salesmen who are registered to sell stocks are not \nnecessarily registered to sell futures - an additional test must be passed in order to \nsell many types of futures options. Similarly, many customers - primarily institutions \n- have received approval from their constituents to trade in stock options, but would \nneed further approvals to trade futures or futures options. Neither of these things \nshould stand in the way of the strategist - if there are opportunities in futures \noptions, then the customer should find a broker who can trade them. Also if the \nstrategist finds that he requires certain approvals from within his own institution \nbefore he can trade futures, then he should obtain those approvals. \nSTANDARD OPTIONS STRATEGIES USING INDEX OPTIONS \nThe stock option strategies described in all of the preceding chapters of this book can \nbe established with index options as well. The concepts are normally the same for \nindex options as they would be for stock options. If one buys a call at one strike and \nsells a call at a higher strike, that is a bullish spread; if one sells both a put and a call \nat the same strike (a straddle), that is a neutral strategy. One uses deltas to determine \nhow many options to sell against the ones that he buys in order to establish a delta \nneutral strategy. Likewise, he uses the deltas to tell, along the way, how his position \nis progressing and how to adjust it to keep it delta neutral. \nWe will not describe these same strategies over again. They have already been \ndescribed in detail. The risk of early assignment removing one side of a position can \nalter some strategies. In some cases there are particular advantages or disadvantages \nwith index options and futures. Thus, we will briefly go over some major option \nstrategies, giving details pertaining to their usage as index option strategies. \nOPTION BUYING \nThe most common reason for wanting to buy index options is to take advantage of the \ndiversification that they provide, in addition to the normal advantages that option \npurchasing provides: leverage and limited dollar risk. Many people feel that it is eas\nier to predict the general market direction than it is to predict an individual stock's \ndirection. This feeling, can, of course, be put to good advantage by buying index \noptions. However, sometimes it is not better to buy the index options. In such cases, \nit may actually be smarter to purchase a package of individual stock options. \nChapter 29: Introduction to Index Option Products and Futures 517 \nDue to a phenomenon known as volatility skewing, it is possible for index \noptions to have implied volatilities that are out of line with projected index or stock \nprice movements. This phenomenon is discussed in detail in the chapter on advanced \nconcepts. \nFor example, suppose that index puts are expensive, as they became after the \n1987 stock market crash. When this happens it may actually be more profitable for a \ntrader who is bearish on the market to buy a package of equity puts instead of buy\ning index puts. The equity puts are forced to reflect the probability of stock price \nmovement because arbitrage strategies will keep them in line. They will therefore be \nless expensive than index puts when this type of volatility skewing is present. Index \nputs can remain expensive for several reasons - primarily excessive demand and \ninflated margin requirements. In such situations, it is theoretically correct to buy a \ngroup of puts on stock options. In fact, one might even hedge this purchase by sell\ning out-of-the money, overpriced index puts. \nSELLING INDEX OPTIONS \nIn earlier chapters, we saw that many mathematically attractive strategies involve the \nsale of naked options - ratio writes, straddles, ratio spreads, etc. Index options pres\nent an even stronger case for these strategies. Recall that the greatest risk in these \nstrategies with naked options is that the underlying security might move a great dis\ntance, thereby exposing the position to great loss if the movement is in the direction \nin which the naked options lie. That is, if one is naked calls and the underlying secu\nrity rises dramatically, perhaps on a takeover bid, then large losses - potentially \nunlimited in the absence of follow-up action - could occur. \nThe strategist would, of course, never let the loss run uncontrolled. He would \nattempt to take some follow-up action to limit the loss or to neutralize the position. \nHowever, even the best strategist cannot hedge his position if the movement in the \nunderlying occurs while the market is closed. For example, if the underlying securi\nty is a stock, certain news items might cause a large gap to occur between the closing \nprice of a stock and its next opening price. Such news might be related to a takeover \nof the company or to a drastically negative earnings report, for example. \nIndex options do not have this particular drawback. An index - especially a \nbroad-based index - is not as likely to open on a wide gap as a stock is. An index can\nnot be the subject of a takeover attempt. It cannot be severely depressed by bad earn\nings on one of its components. Thus, index options are more viable candidates for \nstrategies involving naked option writing than stock options are. Index futures and \noptions may often open on small gaps of a point or so, due to emotion or possibly due \nto the fact that a market that opens earlier (T-Bond futures, for example) has already \n518 Part V: Index Options and Futures \nmade", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 232}
{"text": "d by bad earn\nings on one of its components. Thus, index options are more viable candidates for \nstrategies involving naked option writing than stock options are. Index futures and \noptions may often open on small gaps of a point or so, due to emotion or possibly due \nto the fact that a market that opens earlier (T-Bond futures, for example) has already \n518 Part V: Index Options and Futures \nmade a rather large move by the time the futures open. Such a small gap is normal\nly not extremely damaging to the naked writer. \nOne cannot assume that an index can never gap open widely - if something \ndrastic were to happen in the marketplace that caused opening gaps in many stocks, \nthen a gap could appear in the index itself. The worst case of such a gap, percentage\nwise, was the stock market crash in 1987 when the major indices such as OEX and \nS&P 500 opened down over 20 points. Nothing has come close to that before or \nsince, but the possibility always exists that it could happen again. Therefore, one can\nnot assume that naked option writing of index options is a low-risk strategy; howev\ner, it is generally less risky than naked option writing of equity options. \nHANDLING EARLY ASSIGNMENT OF CASH-BASED OPTIONS \nThe greatest problem that a spreader of index options has is the possibility of early \nassignment. This removes his hedge on one side of his position, exposing him to \nmuch more risk than he had wanted or anticipated. \nOne can often obtain a clue before early assignment occurs by observing the \nprice of the in-the-money options. If they are trading at a discount, one can expect \nassignment to be more likely. \nExample: '.lYX is trading at 357 a few days before expiration of the January options. \nThe stock market rallies heavily near the close, and the January 340 calls are trading \nwith a market of 16½ to 16¾ after 4 pm EST. Since parity is 17 for these calls, it is \nlikely that a writer will receive an assignment notice in the morning. \nThe strategist who observes this situation taking place must make a rather quick \ndecision. Since the market has rallied heavily on the close, it is likely that arbitrageurs \nor institutional accounts who are long index options are going to exercise them. The \ncynic among us would even think that they might be short stocks as well which they \nplan to cover in the morning. Notice that the effect of hedged call option sellers (i.e., \nspreaders) receiving assignment notices will be to make them all long the market. \nThe short side of their spread will have been removed via assignment, and they will \nbe left with only the long side. Therefore, in order to liquidate or hedge, they will \nhave to sell stocks or index futures and options in the morning. This would force the \nmarket down temporarily and would be a boon to anyone who was short overnight. \nThe spreader's first potential choice of action is to notice what is happening near \nthe close of trading and to try to exercise his long calls since he expects assignment \nof his short calls. The assignment, of course, is not certain - he is merely projecting \nit. Therefore, he could outfox himself and end up being very short if he did not \nr~ceive an assignment notice on his short calls. \nChapter 29: Introduction to Index Option Products and Futures 519 \nAssuming the strategist did not anticipate assignment and therefore did not \nexercise his long calls, he has several choices after receiving an assignment notice the \nnext morning. First, he could do nothing. This would be an overly aggressive bullish \nstance for someone who was previously in a hedged position, but it is sometimes \ndone. The strategist who takes this aggressive tack is banking on the fact that the sell\ning after the assignment will be temporary, and the market will rebound thereafter, \ngiving him the opportunity to close out his remaining longs at favorable prices. This \nis an overly aggressive strategy and is not recommended. \nThe most prudent approach to take when one receives an early assignment on \na cash-based option is to immediately try to do something to hedge the remaining \nposition. The simplest thing to do is to buy or sell futures, depending on whether the \nassignment was on a put or call. If one was assigned on a put, a portion of the bull\nishness (short puts are bullish) of one's position has been removed. Therefore, one \nmight buy futures to quickly add some bullishness to the remaining position. \nGenerally, if one were assigned early on calls, part of the bearishness of his position \nwould have been removed - short calls being bearish - and he might therefore sell \nfutures to add bearishness to his remaining position. Once hedged, the position can \nbe removed during that trading day, if desired; by trading out of the hedge estab\nlished that morning. \nOne should receive this assignment notice early in the morning, so he can \nimmediately hedge his position in the overnight markets. If he waits until the day ses\nsion opens, he might use futures or options to hedge. One should be particularly \ncareful about placing market orders in an opening option rotation, especially on index \noptions after a severe downside move has occurred the previous day. Market makers \nare very nervous and are not willing to sell puts as protection to the public in that sit\nuation. Consequently, puts are notoriously overpriced after a large down day in the \nstock market. One should refrain from buying put options in the opening rotation in \nsuch a case. In the future, it is possible that comparable situations may exist on the \nupside. To date, however, all gaps and severe mispricing anomalies have been on the \nbearish side of the market, the downside. \nCONCLUSION \nThe introduction of index products has opened some new areas for option strategists. \nThe ideas presented in this chapter form a foundation for exploring this new realm \nof option strategies. Many traders are reluctant to trade futures options because \nfutures seem too foreign. Such should not b", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 233}
{"text": "nd severe mispricing anomalies have been on the \nbearish side of the market, the downside. \nCONCLUSION \nThe introduction of index products has opened some new areas for option strategists. \nThe ideas presented in this chapter form a foundation for exploring this new realm \nof option strategies. Many traders are reluctant to trade futures options because \nfutures seem too foreign. Such should not be the case. By trading in futures options, \none can avail himself of the same strategies available in stock option. Moreover, he \nmay be able to take advantage of certain features of futures and futures options that \n520 Part V: Index Options and Futures \nare not available with stock options. For example, if one were to try to use options to \nconstruct a strategy based on his expectation of interest rate movements, he could \nuse T-Bond futures and options, which is the easiest way. However, if he were to try \nto remain with stock options, he would probably be forced to do something with util\nity stocks or illiquid interest rate options - a clearly inferior alternative. \nTrading in index options can be very profitable, but only if one understands the \nrisks involved - especially the risk of early assignment in cash-based options. The \nadvantages to being able to \"trade the market\" as opposed to trading one stock at a \ntime are obvious: If one is right on the market, his index option strategies will be \nprofitable. This is superior to stock-oriented buying whereby one might be right on \nthe market, but not make any money because calls were bought on stocks that didn't \nfollow the market. \nThe strategist should consider all of his alternatives when trading in these mar\nkets. If he is bullish, should he really be buying OEX calls? Maybe futures calls on \nthe S&P 500 are better. Perhaps the OEX is expensive with respect to the NYSE and \nthe NYA calls would be a better buy. In fact, perhaps all the calls are so expensive \nthat stock options are the best buy. The ideas presented in this chapter lay the \ngroundwork for the strategist to explore these questions and make the best decision \nfor his investment strategy. \nFinally, keep in mind that the index futures and options comprise a very diverse \nset of securities. They can be put to work for the investor, the trader, and the strate\ngist in a multitude of ways. The only practical limit is in the mind of the user of these \nderivative securities. \nPUT-CALL RATIO \nGenerally, we have not been concerned with technical trading systems in this book. \nNot that they aren't important, they are just in another category of investments other \nthan option strategies. However, the put-call ratio system is so closely related to \noptions that its inclusion is worthwhile. \nThe put-call ratio is simply the number of puts traded divided by the number \nof calls traded. It can be computed daily, weekly, or over any other time period. It \ncan be computed for stock options, index options, or futures options. Sometimes it \nis computed using open interest instead of volume. Another way to compute the put \ncall ratio is to divide the dollars spent on puts (sum of each put price times its trad\ning volume) divided by the dollars spent on calls (sum of each call price times its \ntrading volume). If it is calculated daily, one usually averages several days' worth of \nfigures to smooth out the fluctuations. \nChapter 29: Introduction to Index Option Products and Futures 521 \nExample: The morning paper shows that yesterday the trading activity for OEX \noptions was: \nTotal OEX Call Volume: 125,000 Contracts \nTotal OEX Put Volume: 135,000 Contracts \nTherefore, the ratio is: \n. 135 000 Index Put-Call Ratio= ' = 1.08 for yesterday \n125,000 \nThis technical indicator is a contrary one. The contrarian thinking is along these lines: \nif everyone is buying puts, then everyone must be bearish; if everyone is doing some\nthing, they can't all be right; therefore the contrarian must assume a bullish stance. \nSo, if the put-call ratio is high, too many traders are buying puts; a contrarian \nwould interpret that as a bullish sign. Conversely, if the put-call ratio is low, too many \ntraders are buying calls; the contrarian would consider that as a bearish indicator. The \ntheory behind contrary systems is that the majority of traders are wrong at major \nturning points in the market. \nThere are several typical put-call ratios that can be computed. Generally, one \nwould not want to mix different types of options. For example, the equity put-call \nratio uses the option trading volume of equity options only. The index put-call ratio \nuses index options only. Each futures contract put-call ratio is generally computed \nseparately, gold, soybeans, currencies, etc. One might also attempt to screen his input \na little further: for example, the index put-call ratio should only include index options \non U.S. exchanges; the others can be computed separately. \nObviously, the more highly traded option contracts produce a more reliable put\ncall ratio: equity options and index options being very liquid. Gold futures options by \nthemselves are not that active and may produce distorted results for a period of time. \nThe Ratio Itself. Traders and investors almost always buy more calls than \nputs where stock options are concerned. Therefore, the equity put-call ratio is \nnormally a number far less than 1.00. If call buying is rampant, the equity put\ncall ratio may dip into the 0.30 range on a daily basis. Very bearish days may \noccasionally produce numbers of 1.00 or higher. An average day will generally \nproduce a ratio of around 0.50. \nIndex options, however, produce much larger ratios. Many institutional and \nother investors are constantly looking to avail themselves of the protective capability \nof index puts. Therefore, far more index puts are purchased than are equity puts. An \naverage day might produce readings of 2.00 for some indices. \nS22 Part V: Index Options and Futures \nInterpreting the Ratio. There are sever", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 234}
{"text": "d 0.50. \nIndex options, however, produce much larger ratios. Many institutional and \nother investors are constantly looking to avail themselves of the protective capability \nof index puts. Therefore, far more index puts are purchased than are equity puts. An \naverage day might produce readings of 2.00 for some indices. \nS22 Part V: Index Options and Futures \nInterpreting the Ratio. There are several philosophies as to how to inter\npret the ratio once it has been calculated. All philosophies are of the contrarian \nvariety, so the general comments made earlier that high ratios are bullish and \nlow ratios are bearish still hold true. However, quantifying just what is \"high\" \nand what is \"low\" leaves room for interpretation. \nOne school believes that absolute ratios should be used. An example might be: \n\"if the 10-day moving average of the equity put-call ratio is over 0.60, that is a buy \nsignal.\" Unfortunately, applying absolute figures to any of the ratios can be counter\nproductive at times. If the market is in the grip of a prolonged bearish move, more \nand more puts will continue to be purchased, sending the ratio quite high before it \ncan reverse and start coming back to normal levels. Therefore, it is better to look for \nthe ratios to make a high or a low before calling a buy or sell signal. This is a more \ndynamic interpretation; it allows for buy and sell signals to come at different absolute \nlevels of the put-call ratio. \nFigure 29-1 shows the 50-day equity put-call ratio going back several years (the \ndaily figures for the previous 50 trading days are averaged to produce the number \nplotted on the chart each day). One can see that at certain times, the put-call ratio \nreached extreme heights before finally generating a buy signal. Attempting to call a \nbuy on the market at an absolute level would have been an error because the entry \npoint would have come too early. Notice that the readings in late 1990- as the mar\nket bottomed in advance of Operation Desert Storm - were actually higher on an \nabsolute basis than those made after the stock market crash in 1987. Similar obser\nvations can be made for sell signals after the ratio has reached low levels: don't antic\nipate - wait for the ratio to bottom out and tum up before declaring a sell signal or \nto roll over and turn down before declaring a buy signal. \nThe index put-call ratio is shown in Figure 29-2. It tells a similar story to the \nequity ratio, although there are certainly differences - beyond the obvious one that \nthe ratios have different absolute values. Note that this ratio averages about 1.00 \nwhile the equity ratio averaged about 0.50. \nAt times, index put buying becomes extensive even as the market climbs. This \ndoes not generally happen with equity options. It seems that institutional money \nmanagers, who are long stocks, are afraid that they will lose their profits after a quick \nstock market advance. However, rather than sell their stocks, they buy puts (possibly \noverpaying for them). Thus, they are really bullish (they own stocks), but they are \nbuying puts as a hedge. \nThis is a difficult situation for the contrarian. What is the institutional manag\ner's true bias? Is he bullish because he still owns stocks or is he bearish because he \nis buying puts? This is the bane of contrary analysis - attempting to accurately inter\npret the data that is being received. Figure 29-2 shows that the index put-call ratio \nChapter 29: Introduction to Index Option Products and Futures 523 \nis less reliable than the equity ratio, but is still helpful in determining market tops \nand bottoms. \nIn summary, the put-call ratio is an easily calculated one. Daily fluctuations can \nbe smoothed out into 10-, 20-, or 50-day moving averages. The ratio should be inter\npreted bullishly when there is too much put buying and bearishly when there is too \nmuch call buying. The phrase \"too much\" is not easily interpreted, but looking for \nlocal maxima or local minima in the chart pattern is a reasonable way to approach the \nproblem. When the put-call ratio moving average is increasing, a buy signal would \nnot be given until the average rolls over and begins declining; a sell signal would be \ngenerated when the average which is declining bottoms out. \nSUMMARY \nThere are several kinds of indices and several kinds of trading vehicles: cash-based \noptions, futures options, and futures. These various underlying securities have dif\nfering terms in the way they trade and also in the way their options are designed. This \nvariety creates many opportunities for astute option strategists. \n524 Part V: Index Options and Futures \nFIGURE 29-1. \n50-day equity put-call ratio: 1985-2000. \n100 \n90 \nR 80 \na \n~ 70 I \n0 \n60 \n50 \n40 \n70 R . \na \nt \ni 60 \n0 \n\\ \n\\ \nMAMJJASONDJFMAMJJASONDJFMAMJ \n1985 1986 Date \nPut-Call Ratio \n~JASONDJFMAMJJASONDJFMAMJJASO \n1987 1988 1989 Date \nPut-Call Ratio \nChapter 29: Introduction to Index Option Products and Futures \nFIGURE 29-1. \n{Continued) \n110 \n100 \n90 \nR \nr 80 \ni \n0 \n70 \n60 \nI I ,,· /,,: ,. ~,., \\ ! \nl \\ .; , \\ ; ,. / ....... i ,,,JV V \n$SPX \n300 \n50~+-+-+-+-+-lf-+-+--+-+-+-+-+--+-+-+-t--1-+-lf-+-t--+-+-1-1--+-t \n90 \nR 80 \na \nt \ni \no 70 \nNDJFMAMJJASONDJFMAMJJASONDJFM \n1990 1991 Date \nPut-Call Ratio \n400 \nAMJJASONDJFMAMJJASONDJFMAMJJ \n1992 1993 Date \nPut-Call Ratio \n525 \n526 \nFIGURE 29-1. \n(Continued) \n80 \n70 \nR 60 \na \nt \n40 \nPart V: Index Options and Futures \n500 \nASONDJFMAMJJASONDJFMAMJJASON \n1994 1995 1996 Date \nPut-Call Ratio \n110 \n100 \n90 \nR 80 \na \nt 70 \n0 \n60 \n50 \n\"\"\"\" \n' ' ! \\ \n1997 1998 Date \nPut-Call Ratio \nChapter 29: Introduction to Index Option Products and Futures \nFIGURE 29-1. \n(Continued) \n70 \nR 60 \na \nt \ni \n0 \n50 \nMJ JASONDJFMAMJ JASON \n1999 2000 Date \nPut-Call Ratio \nFIGURE 29-2. \n50-day index put-call ratio: 1985-91. \n170 300 \n160 \n150 \n140 $SPX \n130 \nR 120 200 \na \nt \n0 \n90 \n80 \n70 \n60 \n50 \nMAMJJASONDJFMAMJJASONDJFMAMJ \n1985 1986 Date \n527 \n528 Part V: Index Options and Futures \nFIGURE 29-2. \n(Continued) \n180 \n17", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 235}
{"text": "on to Index Option Products and Futures \nFIGURE 29-1. \n(Continued) \n70 \nR 60 \na \nt \ni \n0 \n50 \nMJ JASONDJFMAMJ JASON \n1999 2000 Date \nPut-Call Ratio \nFIGURE 29-2. \n50-day index put-call ratio: 1985-91. \n170 300 \n160 \n150 \n140 $SPX \n130 \nR 120 200 \na \nt \n0 \n90 \n80 \n70 \n60 \n50 \nMAMJJASONDJFMAMJJASONDJFMAMJ \n1985 1986 Date \n527 \n528 Part V: Index Options and Futures \nFIGURE 29-2. \n(Continued) \n180 \n170 \n140 \nR 130 a \nt 120 i \no 110 \n100 \n90 \n/\"\"' I\"'\\. I .,..~ .J ~\\ l' . .,..✓ \nAl\"'-... ,. • N \\ ' \nA • \\ I 'y: 'I..! ; \"\"', Ill It, , \n;, \"\"\\ . ,...~ I \"y--'fll r v\\1 ~ ~-\n80---+-1--+-=-+--+--l-......_l-!- ____ -+-+---<1-!--+--I-...-~ ....... _._....__ .......... _._ \n160 \n150 \n140 \nA \ni \no 120 \n100 \n~ \nJASONDJFMAMJJASONDJFMAMJJASO \n1987 1988 1989 Date \n400 \n$SPX \n300 \nlo; \nNDJFMAMJJASONDJFMAMJJASONDJFM \n1990 1991 Date \nChapter 29: Introduction to Index Option Products and Futures \nFIGURE 29-2. \n(Continued) \n160 \n150 \n140 \nR 130 a \nt \n110 \n100 \n00-AMJJASONDJFMAMJJASONDJFMAMJJ \n1992 1993 Date \n230 \n220 \n210 \n200 \n190 \nR 180 \na 170 t 500 \ni 160 \n0 \n150 \n140 A.!..... :,·.r .. \"\"'/#,c \n130 ,.,..... \"\"\"' i. '✓...,.~ ...... l\"\" \"\\ ... /: \n1 \" ~ . ..__ I' ..... ,... .... \n20 .. ,,- ·~.... : • \"\" Vt1. \n\" \\t.f \"-1-' v \n110 AS ON DJ F .M .. A M J J AS ON DJ FM AM J J AS ON \n1994 1995 1996 Date \n529 \n530 Part V: Index Options and Futures \nFIGURE 29-2. \n(Continued) \n250 \n240 \n230 \n220 \n210 \n200 \nR 190 \na 180 \nt 170 \n0 160 \n150 \n140 . \n130 N'¥ \n120 ~.... :-...,_ \n110 i..,..: \n100 \n1000 \n800 \nDJFMAMJJASONDJFMAMJJASONDJFMA \n220 \n210 \n200 \n190 \n180 \nR 170 a \nt 160 \n120 \n110 \n1997 1998 Date \nMJ JASONDJ FMAMJ JASON \n1999 2000 Date \nStock Index Hedging \nStrategies \nThis chapter is devoted primarily to examining the various ways that one might hedge \na portfolio of stocks with index products. This portfolio might be a small one owned \nby an individual investor or it might be as large as the entire S&P 500 Index. We \nexplore this strategy from the various viewpoints of the individual investor, the insti\ntutional money manager, and the arbitrageur. This technique of hedging stocks with \nindex products has become quite popular and has also drawn some attention because \nof the way it can cause short-term movements in the entire stock market. The rea\nsons why these movements occur are also explained. Finally, we look at ways of sim\nulating a broad-based index by buying a group of stocks whose performance is geared \nto that of the index itself. \nMARKET BASKETS \nOne of the most popular strategies using index futures and options has been the tech\nnique of buying stocks whose performance simulates the performance of a broader \nindex and hedging that purchase with the sale of overpriced futures or options based \non that index. The group of stocks that is purchased is commonly known as a \"mar\nket basket\" of stocks. This chapter describes how these baskets can be used to trade \nagainst a very broad index, such as the S&P 500, or a far narrower index, such as the \nDow-Jones 30 Industrials (DJX), or even one as small as just a few stocks - perhaps \na portfolio held by any investor. \n531 \n532 Part V: Index Options and Futures \nThe key to determining whether it will be profitable to trade some derivative \nsecurity - options or futures - against a set of stocks is generally the level of premi\num in the futures contract itself. That is, if the S&P 500 Index is at 405.00 and the \nfutures are trading at 408.00, then there is a premium of 3.00 - the futures contract \nis trading 3.00 points higher than the index itself. The absolute level of the premium \nis not what is important, but rather the relationship between the premium and the \nfair value of the future. We will look at how to determine fair value shortly. \nThe futures are the leaders among the derivative securities, especially the S&P \n500 futures. Whenever these become overpriced, other derivative securities will gen\nerally follow suit. There are also futures on the NYSE Index, the Value Line Index, \nand the Japanese Nikkei 225 Index. Moreover, there are cash-based index options on \nthe S&P 500 Index (as opposed to the futures options on that index) and the NYSE \nIndex. These other securities would include the QEX (S&P 100) options and NYSE \nfutures and options. It follows as well that when the S&P 500 futures become under\npriced, the other derivative securities quickly fall into line. If the other derivative \nsecurities don't follow suit, then there is an opportunity for spreading one market \nagainst another. That type of spreading can frequently be profitable, and is discussed \nin the next chapter. \nThe normal scenario is for most of the derivative securities to follow the lead of \nthe S&P 500 futures. When this happens, the only thing that is fairly priced is the \nindex itself - that is, stocks. Consequently, the logical way to hedge the derivative \nsecurity is to do it with stocks. The small investor might hedge his own individual \nportfolio, although that would not be a perfect hedge since his own portfolio is not \ncomposed of the exact same stocks as any index. If the index is small enough, such as \nthe 30-stock DJX, then one might buy all 30 stocks and sell the futures when they are \noverpriced. This is a complete hedge and would, in fact, be an arbitrage. In the case \nof a larger index such as the S&P 500, it would be possible only for the most profes\nsional traders to buy all 500 stocks, so one might buy a smaller subset of the index in \nhopes that this smaller set of stocks will mirror the performance of the index well \nenough to simulate having bought the entire index. We take in-depth looks at both \ntypes of hedging. \nEven if the investor is not planning to use these hedging strategies, it is impor\ntant for him to understand how they work These strategies have certain ramifications \nfor the way the entire stock market moves. In order to anticipate these movements, \na working knowledge of these hedging strategies is necessary. The first thing that one \nmust know in", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 236}
{"text": "ake in-depth looks at both \ntypes of hedging. \nEven if the investor is not planning to use these hedging strategies, it is impor\ntant for him to understand how they work These strategies have certain ramifications \nfor the way the entire stock market moves. In order to anticipate these movements, \na working knowledge of these hedging strategies is necessary. The first thing that one \nmust know in order to implement any of these hedging strategies is how to determine \nthe fair value of a futures contract. \nChapter 30: Stock Index Hedging Strategies \nFUTURES FAIR VALUE \n533 \nThe formula for calculating the fair value of the futures contract is extremely simple, \nalthough one of the factors is a little difficult to obtain information on. First, let's look \nat the simple futures fair value formula: \nSimple Formula: \nFutures fair value= Index x [l +Timex (Rate - Yield)] \nwhere index is the current value of the index itself, rate is the current carrying rate \n(typically, the broker loan rate), yield is the combined annual yield of all the stocks in \nthe index, and time is the time, in years, remaining until expiration of the contract. \nExample: Suppose the Zl'X Index is trading at 160.00, the broker loan rate is 10%, \nthe yield on the 500 stocks is 5%, and there are exactly 3 months remaining until \nexpiration of the futures contract. The time is .25, expressed in years, so the formu\nla becomes \nFuture fair value= 160.00 x [l + .25 x (.10- .05)] \n= 160.00 X (1 + .0125) = 162.00 \nThus, the future should be trading at about 2 points above the value of the index \nitself. This premium of the future over the index represents the savings in not having \nto pay for and carry 500 stocks, less the loss of the dividends on the stocks ( the future \ndoes not pay dividends). If the future should get very expensive - trading at 3.50 or \n4 points over the index - then it would have to be considered very overvalued, and \nan arbitrageur could move in to take advantage of that fact. Similarly, if the future \nshould trade cheaply, at less than a point over fair value, there might be an arbitrage \navailable in that case as well. \nThe fair value is really only a function of four things: the value of the index itself, \nthe time remaining until expiration, the current carrying rate, and the dividends \nbeing paid by the stocks in the index until expiration. Notice that \"the dividends paid \nby the stock in the index until expiration\" is not quite the same as the yield of the 500 \nstocks, which we used in the above simple formula. We will expand more on that dif\nference shortly. \nBefore doing that, however, let us look at how changes in the variables in the for\nmula affect the fair value of the futures contract. More important, we are interested in \nhow changes in the variables affect the premium of the futures contract over the index \nvalue. This is what one is primarily concentrating on when trading market baskets. \nAs the index value itself rises, the fair value premium rises. For example, if 2 \npoints is the fair premium when the index is at 160, as in the above example, then 4 \nS34 Part V: Index Options and Futures \npoints would be the fair premium if the index were at 320 and all the other variables \nremained the same. Conversely, as the index falls, the fair value of the premium \nshrinks. \nThe premium rises and falls in direct correlation with the carrying rate as well \nas with time remaining until expiration. Note that this statement is true for stock \noptions also, and for the same reason: The savings in carrying costs are greater when \nrates are higher, or when one must hold for a longer time, or both. In the above \nexample, if one were to assume there were 6 months to expiration instead of 3, the \nfair value of the premium would increase to 4 points from 2 points. Similarly, if the \ntime were decreased, the fair value would be smaller. \nSome investors, primarily institutional investors, use the short-term T-bill rate \nrather than the carrying rate in order to determine the futures fair value. The reason \nthey do that is to determine whether the money they have in cash is better off in T\nbills or in an arbitrage strategy such as this. More will be said about this use of the T\nhill rate later. \nDividends Have an Inverse Correlation to the Premium Value. \nAn increase in the overall yield of the index will shrink the fair value of the futures \ncontract. This is because the futures holder does not get the dividends and therefore \nthe future is not as valuable because of the loss of dividends. Conversely, if dividend \nyields fall, then the fair value of the premium increases. This is not the whole story \non dividends, however. \nRecall that a few paragraphs ago, it was pointed out that the yield and the \namount of dividends are not exactly the same thing. This is because stocks don't pay \ntheir dividends in a uniform manner. Rather than paying a continuous yield as bonds \ndo, stocks normally pay their dividends in four lump sums a year. This means that the \nyield variable in the simple formula shown above should be replaced by the actual \namount of dividends remaining until expiration. This fact makes the computation of \nthe fair value of the index a little more difficult. In order to do it accurately, one must \nknow the dividend amounts and ex-dividend dates of each of the stocks in the index. \nKnowing all of this information is a far more formidable task than knowing the yield \nof the index, since the yield is published weekly in several places. In fact, the servic\nes of a computer are required in order to compute the actual dividend on the larger \nindices, where 100 or more stocks are involved. \nAs a result, the actual formula changes slightly from the simple formula shown \nabove: \nActual Formula: \nFutures fair value = Index x ( 1 + Time x Rate) - Dividends \nChapter 30: Stock Index Hedging Strategies S3S \nIn this formula, the dividends are taken to be the present worth of all the dividends \nremaining until expira", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 237}
{"text": "ual dividend on the larger \nindices, where 100 or more stocks are involved. \nAs a result, the actual formula changes slightly from the simple formula shown \nabove: \nActual Formula: \nFutures fair value = Index x ( 1 + Time x Rate) - Dividends \nChapter 30: Stock Index Hedging Strategies S3S \nIn this formula, the dividends are taken to be the present worth of all the dividends \nremaining until expiration of the future. \nExample: In an example similar to the one given for the simple formula, suppose the \nZ¥X Index is trading at 160.00, the broker loan rate is 10%, the present worth of the \ndividends remaining until expiration is $1.89, and there are exactly 3 months remain\ning until expiration of the futures contract. The time is .25, expressed in years, so the \nformula becomes \nFuture fair value = 160.00 x (1 + .25 x .10) 1.89 \n= 160.00 X (1 + .025) 1.89 = 162.11 \nIn order to compute the present worth of the dividends of an index, it is neces\nsary to know the amount of each stock's dividend as well as the payment date of the \ndividend. To compute the index's dividend, one computes the present worth of each \ndividend and multiplies that result by that stock's divisor in the index in order to give \nthe dividend the proper weight. The index's total dividend is the sum of each of these \nindividual stock computations. Each stock's divisor is merely the float of the stock \ndivided by the divisor of the index. In a price-weighted index, it is not necessary to \nadjust the present worth of each dividend - merely add them together and divide by \nthe divisor. As an example, we will look at a hypothetical index composed of three \nstocks in order to see how one computes the present worth of an index's dividends. \nExample: Suppose a capitalization-weighted index is composed of three stocks: AAA, \nBBB, and CCC. Furthermore, suppose that the amount of each of the individual \nstocks' dividends and the time remaining until the dividend is paid are given in the \nfollowing table, as well as each stock's float. Finally, assume the divisor for the index \nis 150,000,000. \nDividend Days until \nStock Amount Dividend Payout Float \nAAA 1.00 35 50,000,000 \nBBB 0.25 60 35,000,000 \nCCC 0.60 8 120,000,000 \nDivisor: 150,000,000 \nIn order to compute the present worth of a future amount, one uses the formula: \nP t rth Future amount resen wo = ------\n(1 + Rate)Time \nwhere rate is the current short-term rate and time is expressed in years. \n536 Part V: Index Options and Futures \nAssume that the current interest rate is 10%. Then the present worth of AAA's \ndividend would be: \nPresent worth AAA 1.00 =------(1 + .10)(35/360) \n1.00 =----(1.10)(-0972) \n1.00 \n1.0093 \n= 0.9908 \nThe present worth of the dividend is always less than the actual dividend. The pres\nent worth of an amount is the amount of money that would have to be invested today \nat the stated rate (10% in this example) to produce the future amount. That is, 99.08 \ncents invested at 10% would be worth exactly 1.00 in 35 days. \nThe present worth of the other two dividends is .2461 for BBB and .5987 for \nCCC. The reader should verify for himself that these are indeed the correct amounts. \nNotice that the present worth of a dividend is not much less than the actual value of \nthe dividend. However, in a larger index, where one is dealing with several hundred \ndividends, the present worth may be significantly different from the actual sum of the \ndividends, especially if short-term rates are high. \nSince we made the assumption that this is a capitalization-weighted index, each \nof these figures must be adjusted for the capitalization of the stock in order to give \neach present worth the proper weight within the index. Thus, for AAA, the adjusted \ndividend would be .9908 times 50,000,000 (AAA's float), divided by 150,000,000, the \ndivisor of the index. This would result in an adjusted dividend of .3303 for AAA. \nWhen similar adjustments are made for BBB and CCC, their adjusted values become \n.0574 and .4790, respectively. \nThus, the present worth of the dividend for the index would be the sum of the \nthree individual adjusted present worths, or .3303 + .0574 + .4790 = $0.8667. \nNote: If the index were a price-weighted index, the index's dividend would be \nthe sum of these three present worths (.9908 + .2461 + .5987), divided by the divi\nsor of that index. \nThe above fair value formula can be applied to options as well. For example, the \nQEX Index does not have futures. However, the fair value calculations can be done \nin the same manner, and the synthetic index then constructed by using puts and calls \ncan be compared with that fair value. \nChapter 30: Stock Index Hedging Strategies 537 \nExample: Suppose that OEX is trading at 364.50 and a September OEX future - if \none existed would have a fair value of 367.10. That is, the future would command \na premium of 2.60. Not only should a future trade with that theoretical premium, but \nso should the \"synthetic OEX\" composed of puts and calls at the same strike. Hence, \nthe synthetic OEX constructed with options should trade at about 367.10 also. \nThat is, if the OEX Sep 365 call were selling for 4.60 and the Sep 365 put were \nselling for 2.50, then the synthetic OEX constructed by the use of these two options \nwould be priced at 367.10. Recall that one determines the synthetic cost by adding \nthe strike, 365, to the call price, 4.60, and then subtracting the put price: 365 + 4.60 \n2.50 = 367.0. This synthetic price of 367.10 is literally the same as the theoretical \nfutures price of 367.10. \nThe same calculations can be applied to any index with listed options trading. \nLet us now return to the broader subject at hand - trading market baskets of stocks \nagainst futures. \nPROGRAM TRADING \nTwo terms that conjure up images of the stock market crash in 1987 and other severe \nprice drops are \"program trading\" and \"index arbitrage.\" Neither one by itself should \naffect the stock market, since they are two-sided strategies - involving b", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 238}
{"text": "dex with listed options trading. \nLet us now return to the broader subject at hand - trading market baskets of stocks \nagainst futures. \nPROGRAM TRADING \nTwo terms that conjure up images of the stock market crash in 1987 and other severe \nprice drops are \"program trading\" and \"index arbitrage.\" Neither one by itself should \naffect the stock market, since they are two-sided strategies - involving buying stocks \nand selling futures. This two-sided aspect should have little effect on the market, the\noretically. However, in practice, it is often the case that trades are not executed simul\ntaneously, and the stock market takes a jump or a dive. \nProgram trading is nothing more than trading futures against a general stock \nportfolio. Index arbitrage is trading futures against the exact stocks that comprise an \nindex. \nLater discussions will assume that one is trying to create or simulate the index \nitself in order to hedge it with futures. This is the arbitrage approach. However, there \nare many other types of stock positions that may be hedged with the futures. These \nmight include a portfolio of one's own construction containing various stocks, or \nmight include a group of stocks from which one wants to remove \"market risk.\" \nNormally, one would not own the makeup of any index, but rather would have a \nunique combination of stocks in his portfolio. Such an investor may want to use \nfutures to hedge what he does own. \nOne reason why an investor who owned stocks would want to sell index prod\nucts against them might be that he has turned bearish and would prefer to sell futures \nrather than incur the costs involved with selling out his stock portfolio (and repur\nchasing it later). Commission charges are quite small on futures transactions as com-\n538 Part V: Index Options and Futures \npared to an equal dollar amount of stock. By selling the futures on an index - say, the \nS&P 500- he removes the \"market risk\" from his portfolio (assuming the S&P 500 \nrepresents the \"market\"). What is left over after selling the futures is the \"tracking \nerror.\" The discrepancy between the movement of the general stock market and any \nindividual portfolio is called \"tracking error.\" This investor will still make money if his \nportfolio outperforms the S&P 500, but he will find that he did not completely elim\ninate his losses if his portfolio underperforms the index. Note that if the market goes \nup, the investor will not make any money except for possible tracking error in his \nfavor. \nREMOVING THE MARKET RISK FROM A PORTFOLIO \nStock portfolios are diverse in nature, not :p.ecessarily reflecting the composition of \nthe index underlying the futures contracts. The characteristics of the individual \nstocks must be taken into account, for they may move more quickly or more slowly \nthan \"the market.\" Let us spend a moment to define this characteristic of stocks that \nis so important. \nVOLATILITY VERSUS BETA \nRecall that when we originally defined volatility for use in the Black-Scholes model, \nwe stated that Beta was not acceptable because it was strictly a measure of the cor\nrelation of a stock's performance to that of the stock market and was not a measure \nof how fast the stock changed in price. Now we are concerned with how the stock's \nmovement relates to the market's as a whole. This is the Beta. \nUnfortunately, Beta is not as readily available to the option strategist as is \nvolatility. Many option traders merely have to punch a button on their quote \nmachines and they can receive estimates of volatility. However, Beta estimates are \nmore difficult to obtain, and the ones that are available are often for very long time \nperiods, such as several years. These long-term Betas cannot be used for the pur\nposes of the index hedging discussed in this chapter. Therefore, if one does not have \naccess to shorter-term Beta calculations, then he can approximate Beta by compar\ning an individual stock's volatility with the market's volatility. \nExample: XYZ is a relatively volatile stock, having both an implied and historical \nvolatility of 36%. The overall stock market has a volatility of 15%. Therefore, one \ncould approximate the Beta of XYZ as \nBeta approximation = 36/15 = 2.40 \nChapter 30: Stock Index Hedging Strategies 539 \nThere are certain situations in which this approximation would not work well, \nbecause the stock has little or no correlation to the overall stock market (e.g., gold or \noil stocks). If one has a portfolio of stocks of that type, then he should make a serious \nattempt to attain their Betas, for the Beta estimate method just described will not be \naccurate. Such stocks may be volatile - that is, they change in price fairly rapidly -\nbut they may go in totally different directions from the overall stock market: They \nwould thus have high volatility, but low Beta. This is not conducive to the above \nshort-cut for approximating Beta from volatility. \nThe remaining examples in this chapter use the terms Beta and adjusted volatil\nity synonymously. Adjusted volatility is merely the approximation of Beta from \nvolatility as described above: the stock's volatility divided by the market's volatility. \nTHE PORTFOLIO HEDGE \nIn attempting to hedge a diverse portfolio, it is necessary to use the Beta or adjusted \nvolatility because one does not want to sell too many or too few futures. For exam\nple, if the portfolio were composed of nonvolatile stocks and one sold too many \nfutures against it, one could lose money if the market rallied, even if his portfolio out\nperformed the market. This would happen because the general market, being more \nvolatile, would rally farther than the nonvolatile portfolio. Ideally, one should sell \nonly enough futures so that there would be no gain or loss if the market rallied. There \nwould be only tracking error. Conversely, if one does not sell enough futures against \na volatile portfolio, then there is risk of loss if the market declines, since the portfo\nlio would decline faster", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 239}
{"text": "market, being more \nvolatile, would rally farther than the nonvolatile portfolio. Ideally, one should sell \nonly enough futures so that there would be no gain or loss if the market rallied. There \nwould be only tracking error. Conversely, if one does not sell enough futures against \na volatile portfolio, then there is risk of loss if the market declines, since the portfo\nlio would decline faster than the market. \nThe Beta or adjusted volatility of each stock is used in order to determine the \nproper number of futures to sell against the portfolio. The dollar value (capitaliza\ntion) of each stock in the index is adjusted by that stock's volatility to give an \"adjust\ned capitalization\" for each stock. Then, when all these are added together, one will \nhave determined how much \"adjusted capitalization\" must be hedged with futures. \nThe suggested method, described in the following example, uses an adjusted volatil\nity for each stock. \nThe steps to follow in determining how many futures to sell against a diverse \nportfolio of stocks are as follows: \n1. If you don't know the Beta, divide each stock's volatility by the market's (S&P \n500) volatility. This is the stock's adjusted volatility. \n2. Multiply the quantity of each stock owned by its price and then multiply by the \nadjusted volatility from step 1. This gives the adjusted capitalization of the stock \nin the portfolio. \n540 Part V: Index Options and Futures \n3. Add the results from step 2 together for each stock to get the total adjusted cap\nitalization of the portfolio. \n4. Divide the sum from step 3 by the index price of the futures to be used and the \nunit of trading for the futures ($500 per point for the S&P 500 futures) to deter\nmine how many futures to sell. \nExample: Suppose that one owns a portfolio of three diverse stocks: 3,000 GOGO, \nan over-the-counter technology stock; 5,000 UTIL, a major public utility stock; and \n2,000 OIL, a large oil company. The owner of this portfolio has become bearish on \nthe market and would like to sell futures against the portfolio. He needs to determine \nhow many futures to sell. \nThe prices and volatilities of these stocks are given in the following table. Assume \nth't the volatility of the fictional ZYX Index is 15%. This is the \"market's volatility\" that \nis divided into each stock's volatility to get its adjusted volatility (step 1, above). \nAdjusted Adjusted \nVolatility Quantity Capitolization \nStock Volatility (Step l) Price Owned (Step 2) \nGOGO .60 ·4.00 25 3,000 $300,000 \nUTIL .12 0.80 60 5,000 240,000 \nOIL .30 2.00 45 2,000 180,000 \nTotal adjusted capitalization: $720,000 (step 3) \nNow suppose that the ZYX Index is trading at 178.65 and a 1-point move in the \nfutures is worth $500. Step 4 can now be calculated: $720,000 + 500 + 178.65, or 8.06 \nfutures contracts. Thus, the sale of 8 futures contracts would adequately hedge this \ndiverse portfolio. \nThere is an important nuance in this simple example: The price of the index \nshould be used in aU hedging calculations, as opposed to using the price of the future. \nThere are many examples of hedging portfolios and market baskets with futures or \noptions in this chapter and the next. Regardless of the situation, the value of the index \nshould always be used to determine how much stock to buy or how much of the \nderivative security to sell. \nNote that the actual capitalization of the above example portfolio was only \n$465,000 ($75,000 for GOGO, $300,000 for UTIL, and $90,000 for OIL). However, \nthe portfolio is more volatile than the general market because of the presence of the \ntwo higher-volatility stocks. It is thus necessary to hedge $720,000 worth of \"market,\" \nChapter 30: Stock Index Hedging Strategies 541 \nor adjusted capitalization, in order to compensate for the higher volatility of the port\nfolio. \nA similar process can be used for far larger portfolios. The estimate of volatili\nty is, of course, crucial in these calculations, but as long as one is consistent in the \nsource from which he is extracting his volatilities, he should have a reasonable hedge. \nThere is no way to judge the future performance of a portfolio of stocks versus the \nZYX Index. Thus, one has to expect a rather large tracking error. In this type of \nhedge, one hopes to keep the tracking error down to a few percent, which could be \nseveral points in the futures contracts over a long enough period of time. Of course, \nthe tracking error can work in one's favor also. The main point to recognize here is \nthat the vast majority of the risk of owning the portfolios has been eliminated by sell\ning the futures contracts. The upside profit potential of the portfolios has been elim\ninated as well, but the premise was that the investor was bearish on the market. \nNote that if the futures are overpriced when one enacts his bearishly-oriented \nportfolio hedge, he will gain an additional advantage. This will act to offset some neg\native tracking error, should such tracking error occur. However, there is no guaran\ntee that overpriced futures will be available at the time that the investor or portfolio \nmanager decides to tum bearish. It is better to sell the futures and establish the \nhedge at the time one turns bearish, rather than to wait and hope that they will \nacquire a large premium before one sells them. \nHEDGING PORTFOLIOS WITH INDEX OPTIONS \nAs mentioned earlier, one could substitute options for futures wherever appropriate. \nIf he were going to sell futures, he could sell calls and buy puts instead. In this sec\ntion, we are also going to take a more sophisticated look at using index options against \nstock portfolios. \nFirst, let us examine how the investor from the previous example might use \nindex options to hedge his portfolio. \nExample: Suppose that an investor owns the same portfolio as in the previous exam\nple: 3,000 COCO, 5,000 UTIL, and 2,000 OIL. He decides to hedge with index \nUVX, which has options worth $100 per point. Assume that the volatility of the UV", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 240}
{"text": "ing index options against \nstock portfolios. \nFirst, let us examine how the investor from the previous example might use \nindex options to hedge his portfolio. \nExample: Suppose that an investor owns the same portfolio as in the previous exam\nple: 3,000 COCO, 5,000 UTIL, and 2,000 OIL. He decides to hedge with index \nUVX, which has options worth $100 per point. Assume that the volatility of the UVX \nis 15%. This investor would then compute his total adjusted capitalization in the same \nmanner as in the previous example, again arriving at a figure of $720,000. \nSuppose that the UVX Index is at 175.60. This investor would want to hedge his \n$720,000 of adjusted capitalization with 4,100 \"shares\" of UVX ($720,000 + 175.60). \nSince a 1-point move in UVX options is worth $100, this means that one would sell \n41 UVX calls and buy 41 UVX puts. He would probably use the 175 strike or possi-\n542 Part V: Index Options and Futures \nbly the 180 strike, since those strikes are the ones whereby the calls have the least \nchance for early assignment. \nWhere short options are involved, as with the calls in the above example, one \nmust be aware of the possibility of early assignment exposing the portfolio. \nConsequently, if the marketplace has an equal premium on the futures and the \"syn\nthetic\" UVX, one should sell the futures in that case, because there is no possibility \nof unwanted assignment. However, if the options represent a synthetic price that is \nmore expensive than the futures, then using the options may be more attractive. \nExample: Suppose that our same investor has decided to hedge his portfolio with its \n$720,000 of adjusted capitalization. He is indifferent as to whether to use the ZYX \nfutures or the UV:X options. He will use whichever one affords him the better oppor\ntunity. The following table depicts the prices of the securities that he is considering, \nas well as their fair values. \nCurrent Fair Index \nSecurity Price Value Price \nZYX Jun Future 180.50 180.65 178.65 \nUVX Jun 175 Call 5 5 175.60 \nUVX Jun 175 Put 2 21/2 175.60 \nUVX Jun 180 Call 21/2 21/2 175.60 \nUVX Jun 1 80 Put 41/2 5 175.60 \nThis investor essentially has three choices: (1) to use the ZYX futures, (2) to use \nthe UVX options with the 175 strike, or (3) to use the UV:X options with the 180 \nstrike. Notice that the ZYX future is trading 15 cents below its fair value (180.50 vs. \n180.65). The UV:X Index fair value, as shown by the fair values of the options, is \n177.50. This can be computed by adding the call price to the strike and subtracting \nthe put price. In the case of either strike, the fair values indicate a UV:X Index fair \nvalue of 177.50. \nHowever, the actual markets are slightly out of line. When using the actual \nprices, one sees that he can sell the UV:X Index synthetically for 178.00 whether he \nuses the l 75's or the 180's. Thus, by using the UV:X options he can sell the UVX \n\"future\" synthetically for ½ point over fair value, while the ZYX futures would have \nto be sold at 15 cents under fair value. Thus, the options appear to be a better choice \nsince 65 cents ( the 50 cents that the UV:X options are overvalued plus the 15 cents \nthat the futures are undervalued) is probably enough of an edge to offset the possi\nbility of early assignment. \nChapter 30: Stock Index Hedging Strategies 543 \nWith the futures having been eliminated as a possibility, the investor must now \nchoose which strike to use. Since he will be selling calls and buying puts, and since \neither strike allows him to synthetically sell the UVX \"future\" at 178, he should \nchoose the 180 strike. This should be his choice because the 180 calls are out-of-the\nmoney and thus less likely to be the object of an early assignment. \nHEDGING WITH INDEX PUTS \nLet us now move on to discuss ways of hedging in which a complete hedge is not \nestablished, but rather some risk is taken. The main difference between options and \nfutures is that futures lock in a price, while options lock in a worst-case price (at \ngreater cost) but leave room for further profit potential. To see this, consider a long \nstock portfolio hedged by short futures. In this case, one eliminates his upside profit \npotential except for positive tracking error. However, if he buys put options instead, \nhe expends money - thereby incurring a greater cost to himself than if he had used \nfutures - but he still has profit potential if the market rallies. \nOne could hedge a long stock portfolio with options by either buying index puts \nor selling index calls. Buying the puts is generally the more attractive strategy, espe\ncially if the puts are cheap. In order to properly establish the hedge, it is not only nec\nessary to adjust the dollars of stock in accordance with the Beta, but the deltas of the \noptions must be taken into account as well. The following example will demonstrate \nthe use of puts to hedge a portfolio of diverse stocks. \nExample: Assume that an investor has the same portfolio of three stocks that was \nused in a previous example: 3,000 GOGO, 5,000 UTIL, and 2,000 OIL. He has \nbecome somewhat bearish on the market in general and would like to hedge some of \nhis downside risk. However, he decides to use puts for the hedge just in case there is \na further rally in the market. \nThe table from the earlier example is reprinted below, showing the adjusted \nvolatilities and capitalizations for each stock in the portfolio. The total adjusted cap\nitalization of the portfolio is $720,000, as before. \nAdjusted Adjusted \nVolatility Quantity Capitalization \nStock Volatility (Step l) Price Owned (Step 2) \nGOGO .60 4.00 25 3,000 $300,000 \nUTIL .12 0.80 60 5,000 240,000 \nOIL .30 2.00 45 2,000 180,000 \nTotal adjusted capitalization: $720,000 (step 3) \n544 Part V: Index Options and Futures \nThere are two ways that one might want to approach hedging this $720,000 \nportfolio with puts. \n1. As disaster insurance: Buy enough (out-of-the-money) puts so that the portfolio \nwould be 100% hedged below th", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 241}
{"text": "p 2) \nGOGO .60 4.00 25 3,000 $300,000 \nUTIL .12 0.80 60 5,000 240,000 \nOIL .30 2.00 45 2,000 180,000 \nTotal adjusted capitalization: $720,000 (step 3) \n544 Part V: Index Options and Futures \nThere are two ways that one might want to approach hedging this $720,000 \nportfolio with puts. \n1. As disaster insurance: Buy enough (out-of-the-money) puts so that the portfolio \nwould be 100% hedged below the striking price of the puts. \n2. As a hedge against current market movements: Buy enough puts so that all cur\nrent portfolio movements are hedged. \nExample - Method 1: In this method, the portfolio manager is looking for disaster \ninsurance. He is not so much concerned with hedging current market movements as \nhe is with preventing a major loss if the market should collapse. The manager often \nuses an out-of-the-money put for disaster insurance. \nAssume that he is going to use the UVX Index puts, which are worth $100 per \npoint. The March 170 puts, trading at 1, are going to be used in the hedge. The index \nis currently at 178.00. \nHe would therefore divide his portfolio's adjusted capitalization ($720,000) by \nthe value of the striking price of the puts to be used. In this case, the value of the \nstriking price is $17,000 (100 x 170). \nPuts to buy = $720,000 I $17,000 = 42.3 \nCost of 42 puts: $4,200 \nStriking value of 42 puts: $714,000 (42 x $17,000) \nThe cost of buying 42 puts is $4,200. This can be thought of as an insurance pre\nmium, paid to buy $714,000 worth of insurance. He will have market risk on his port\nfolio between the current price of the index (178.00) and the striking price (170.00). \nThe 42 puts would hedge a little of the drop in his portfolio during that 8-point drop \nin the index, but their full protective value would not be felt until they were in-the\nmoney. It is not an exact hedge, of course, since the UVX Index may perform differ\nently from the portfolio once UVX drops below 170. However, this put purchase will \ndefinitely remove a great deal of the market risk of further drops. \nExample - Method 2: In this method, the portfolio manager is attempting to hedge \nthe current value of his portfolio. He wants no further downside losses in his portfo\nlio at all. He would generally buy at- or in-the-money puts in this case and would use \nthe put's delta in order to construct a complete hedge. \nAgain assume that he is going to use the UVX Index puts, which are worth $100 \nper point. In this case, however, with the index at 178.00, he is considering the March \n180 puts, trading at 4½, with a delta of -0.60 to be used in the hedge. \nChapter 30: Stock Index Hedging Strategies 545 \nIn this case, the number of puts is determined by using the same formula as in \nthe above example and then also dividing by the absolute value of the delta: \nPuts to buy = $720,000 / (100 X 180) / 0.60 \n= 67 \nCost of protection: 67 x $450 = $30,150 \nIn this case, the portfolio manager is spending much more for the puts, but for \nhis additional expense, he acquires immediate protection for his portfolio. \nFurthermore, there is some intrinsic value to the puts he bought (2 points, or $13,400 \non 67 of them). If the UVX Index drops at all, these puts will immediately begin to \nhedge his entire portfolio against loss. Of course, if the market rises, he loses his \nmuch more expensive insurance cost. \nWhen one uses options instead of futures to hedge his position, he must make \nadjustments when the deltas of the options change. This was not the case when futures \nwere used; perhaps with futures, one might recalculate the adjusted capitalization of \nthe portfolio occasionally, but that would not be expected to affect the quantity of \nfutures to any great degree. With put options, however, the changing delta can make \nthe position delta short when the market declines, or can make it delta long if the mar\nket rises. This situation is akin to being long a straddle the position becomes delta \nshort as the market declines and becomes delta long as the market rises. \nBasically, the adjustments would be same as those that a long straddle holder \nwould make. If the market rallied, the position would be delta long because the delta \nof the puts would have shrunk and they would not be providing the portfolio with as \nmuch adjusted dollar protection as it needs. The investor might roll the puts up to a \nhigher strike, a move that essentially locks in some of his stock profits. Alternatively, \nhe could buy more puts at the current (low) strike to increase his protection. \nConversely, if the market had declined immediately after the position was \nestablished, the investor will find himself delta short. The delta of the long puts will \nhave increased and there will actually be too much protection in place. His adjust\nment alternatives are still the same as those of a long straddle holder - he might sell \nsome of the puts and thereby take a profit on them while still providing the required \nprotection for the stock portfolio. Also, he might roll the puts down to a lower strike, \nalthough that is a less desirable alternative. \nHEDGING WITH INDEX CALLS \nAnother strategy to protect a stock portfolio is to establish a ratio write using short \ncalls against the long stock. This is the opposite of using puts for protection, in that \nit is more equivalent to being short a straddle. \n546 Part V: Index Options and Futures \nExample: In the last example, the March 180 put had a delta of -0.60. The March \n180 call should then have a delta of 0.40. If the portfolio manager wanted to hedge \nhis portfolio by ratio writing calls against it, he could use the same formula as in the \nprevious example: \nCalls to sell = $720,000 I (100 x 180) I 0.40 = 100 \nHe would sell 100 calls to hedge his portfolio. \nAdjustments would be made in much the same manner as those that a straddle \nseller would make. If the market rises, the delta of the calls will increase and the posi\ntion will be delta short. One would probably buy calls in that case. Follow-up ac", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 242}
{"text": "use the same formula as in the \nprevious example: \nCalls to sell = $720,000 I (100 x 180) I 0.40 = 100 \nHe would sell 100 calls to hedge his portfolio. \nAdjustments would be made in much the same manner as those that a straddle \nseller would make. If the market rises, the delta of the calls will increase and the posi\ntion will be delta short. One would probably buy calls in that case. Follow-up action \nfor an actual short straddle might dictate buying in some of the underlying security \nrather than buying the calls, but that is not a realistic alternative in this case, since the \nsample portfolio is probably stable. \nIf, on the other hand, the market declined after the short calls were sold against \nthe portfolio, the position would become delta long as the delta of the calls shrinks. \nThe normal action in that case would be to roll the calls down and reestablish the \nproper amount of protection for the portfolio. \nOverall, hedging the portfolio with short index calls does not present as attrac\ntive a position as hedging with long index puts. This is due mostly to the nature of \nwhat the portfolio manager is trying to accomplish, as opposed to the relative merits \nof long and short straddles. As was pointed out in previous chapters, straddle selling, \nwhile risky, is an excellent strategy on a statistical basis. However, in this section we \nare not dealing with a strategist who is going to go out and buy stocks and then write \nindex calls against them. Rather, we have an existing portfolio and the portfolio man\nager is becoming bearish on the market. Thus, the stock portfolio is a fixed entity and \nthe index options or futures are being built around it for protection. \nLong puts serve the purpose of protection far better than short calls, for the fol\nlowing reasons. First, the types of adjustments that need to be made by a straddle \nseller often involve buying stock or at least buying relatively deep in-the-money calls. \nA portfolio manager or investor holding a portfolio stock may not need or want to get \ninvolved in a multi-optioned position. Second, with calls there is large risk to the \nupside in case of a large market rally. Someone holding a portfolio of stocks might be \nwilling to forego upside profits ( as in the sale of futures), but generally would be quite \nupset to sustain large losses on the upside. Using puts, of course, leaves room for \nupside profit potential. Third, there is risk of early assignment with short index calls, \nalthough that is of minor significance in this case since the portfolio of stocks would \nhave been long in any case. Other calls could be written immediately on the day after \nthe assignment. The only real drawback to using the puts is that premium dollars are \nCbapter 30: Stock Index Hedging Strategies 547 \npaid out and, if the market stabilizes, the time value decay will cause a loss on the \nputs. If one actually suspects that such a stabilization might occur, he should use \nfutures against his position instead of puts or calls. \nINDEX ARBITRAGE \nAs previously stated, index arbitrage consists of buying virtually all of the stocks in an \nindex and selling futures against them, or vice versa. Whenever the futures on an \nindex are mispriced, as determined by comparing their actual value with their fair \nvalue, there may be opportunities for arbitrage if the mispricing is large enough. \nWhen futures are extremely overpriced: buy stocks, sell futures; or when futures are \nunderpriced: sell stocks, buy futures. In either case, the arbitrageur is attempting to \ncapture the differential between the fair value price of the futures contract and the \nprice at which he actually buys or sells the index. First, we will examine fully hedged \nsituations - ones in which the entire index is bought or sold. After that, we will exam\nine smaller sets of stocks that are designed to simulate the performance of the entire \nindex. \nHedging indices which contain fewer stocks is easier than hedging larger \nindices. Hedging a price-weighted index is probably the simplest type of hedge. As \nexamples, the same sample indices that were constructed in the previous chapter will \nbe used. \nWhenever futures or index options trade on an index, it is possible to set up \nmarket baskets for arbitrage. The trader should determine, in advance, how many \nshares of each stock he will buy or sell in order to duplicate the index. In a price\nweighted index, of course, he will buy the same number of shares of each stock. In a \ncapitalization-weighted index, he will be buying different numbers of shares of each \nstock. Let us first look at how the number of shares to buy is determined. Then we \nwill discuss some of the nuances, such as monitoring bids and offers of the indices, \norder execution, and others. \nHOW MANY SHARES TO BUY \nIn advance of actually trading the stocks and futures or options, one should deter\nmine exactly how many shares of each stock he will be buying in each index he plans \nto arbitrage. Normally, one would decide in advance how many futures contracts or \noption contracts he will trade at one time. Then the number of shares of stock to be \nbought as a hedge can be determined as well. Essentially, one is going to hedge equal \ndollar amounts - that is, he will buy enough stocks to offset the total dollar amount \nrepresented by the index. \n548 Part V: Index Options and Futures \nExample: Suppose that one decides he will set up his market baskets by using 50 \nZYX futures at a time. How much stock should he buy against these 50 contracts? \nThe futures contract has a trading unit of $500 per point. Assume the ZYX Index is \ntrading at 168.89. Then the total dollar amount represented by 50 contracts is 50 x \n$500 x 168.89 = $422,225. The hedger would buy this much stock to hedge 50 \nfutures contracts sold. \nAgain note that the index price, not the futures price, is used in order to deter\nmine how many futures to sell. \nIn a price-weighted index, one determines the number of shares t", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 243}
{"text": "per point. Assume the ZYX Index is \ntrading at 168.89. Then the total dollar amount represented by 50 contracts is 50 x \n$500 x 168.89 = $422,225. The hedger would buy this much stock to hedge 50 \nfutures contracts sold. \nAgain note that the index price, not the futures price, is used in order to deter\nmine how many futures to sell. \nIn a price-weighted index, one determines the number of shares to buy by \ndetermining the total dollar value of the index he plans to trade and then dividing \nthat dollar amount by the divisor of the index. The resulting number is how many \nshares of each stock to buy in order to duplicate the price-weighted index. \nExample: Suppose that we have a price-weighted index composed of three stocks, A, \nB, and C. The following data describe the index: \nStock Price \nA 30 \nB 90 \nC 50 \nPrice total: 170 \nDivisor: 1.65843 \nIndex value: 102.51 \nThe number of shares of each stock that is in the index is 1 divided by the divisor, or \n1/1.65843 = 0.60298 shares. Thus, if we were to buy .60298 shares of each of the \nthree stocks, we would have created the index. \nSuppose that futures exist on this index and that the trading unit in these futures \nis $250 per point. That is, the futures represent a total dollar value of the index times \n250. With this information, it is easy to determine the number of shares of stock to \nbuy to hedge one futures contract: 250 times the number of shares of each stock, \n.60298, for a total of 150.745 shares of each stock. \nNormally, one would not merely sell one futures contract and hedge it with \nstock. Rather, he would employ larger quantities. Say that he decided to trade in lots \nof 100 futures contracts versus the stocks. In that case, he would buy the following \nnumber of shares of each stock: \nNumber of shares = .60298 x $250/point x 100 futures contacts \n= 1507 4.5 shares \nChapter 30: Stock Index Hedging Strategies S49 \nActually he would probably buy 15,100 shares of each stock against the index, \nand on every fourth \"round\" (100 futures vs. stock) would buy 15,000 shares. This \nwould be a very close approximation without dealing in odd lots. \nThe trader might also use index options as his hedge instead of futures. The \nstriking price of the options does not come into play in this situation. Typically, one \nwould fully hedge his position with the index options - that is, if he bought stock, he \nwould then sell calls and buy puts against that stock. Both the puts and the calls \nwould have the same strike and expiration month. This creates a riskless position. \nThis position is a conversion. \nExample: Suppose that cash-based options trade on this index, and that these \noptions are worth $100 per point as are normal stock options - that is, an option is \nessentially an option on 100 shares of the index. The trader is going to synthetically \nshort the index by buying 100 June 105 puts and selling 100 June 105 calls. Assume \nthat the index data is the same as in the previous example, that 0.60298 shares of each \nstock comprise the index. How many shares would one hedge these 100 option syn\nthetics with? \nNumber of shares = .60298 x 100 contracts x 100 shares/contract \n= 6029.8 shares \nNote that in the case of a price-weighted index, neither the current index value \nnor the striking price of the options involved (if options are involved) affects the \nnumber of shares of stock to buy. Both of the above examples demonstrate the fact \nthat the number of shares to buy is strictly a function of the divisor of the price\nweighted index and the unit of trading of the option or future. \nHedging a capitalization-weighted index is more complicated, although the \ntechnique revolves around determining the makeup of the index in terms of shares \nof stock, just as the price-weighted examples above did. Recall that we could deter\nmine the number of shares of stock in a capitalization-weighted index by dividing the \nfloat of each stock by the divisor of the index. The general formula for the number of \nshares of each stock to buy is: \nShares of stock N Shares of N F . Futures unit \n= . . x utures quantity x . to buy m mdex of trading \nWe will use the fictional capitalization-weighted index from the previous chap\nter to illustrate these points. \nExample: The following table identifies the pertinent facts about the fictional index, \nincluding the important data: number of shares of each stock in the index. \n550 \nStock \nA \nB \nC \nPrice Float \n40 177,000,000 \n80 50,000,000 \n60 l 00,000,000 \nTotal capitalization: \nDivisor: 147,500,000 \nIndex value: 115.80 \nPart V: Index Options and Futures \nCapitalization \n7,080,000,000 \n4,000,000,000 \n6,000,000,000 \n17,080,000,000 \nShares \nl.20 \n0.34 \n0.68 \nThus, if one were to buy 1.20 shares of A, .34 shares of B, and .68 shares of C, he \nwould duplicate the index. Recall that one determines the number of shares of an \nindividual stock in a capitalization-weighted index by dividing the float of the stock \nby the divisor of the index. \nSuppose that a futures contract trades on this index, with one point being worth \n$500 in futures profit or loss. Then one would buy an amount of each stock equal to \n500 times the number of shares in the index. Further suppose that one decides to \ntrade 5 futures at a time. Thus, the number of shares of each stock that one would \nhave to buy to hedge the 5-lot futures position would be: \nShares to buy = Shares in index x 5 futures x $500/future \nThe following table lists that information, as well as totaling the dollar amount \nof stock represented by the total. We will verify that the dollar amount of stock pur\nchas!:d is equal to the dollar amount of index represented by the futures. \nShares Shares to Buy to S Amount of \nStock in Index Hedge 5 Futures Price Stock Bought \nA 1.20 3,000 40 $120,000 \nB 0.34 850 80 68,000 \nC 0.68 1,700 60 102,000 \n$290,000 \nThus, $290,000 worth of stock has been purchased. From an earlier example, \nwe saw how to compute the total dollar worth of a futures trade. In t", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 244}
{"text": "ock pur\nchas!:d is equal to the dollar amount of index represented by the futures. \nShares Shares to Buy to S Amount of \nStock in Index Hedge 5 Futures Price Stock Bought \nA 1.20 3,000 40 $120,000 \nB 0.34 850 80 68,000 \nC 0.68 1,700 60 102,000 \n$290,000 \nThus, $290,000 worth of stock has been purchased. From an earlier example, \nwe saw how to compute the total dollar worth of a futures trade. In this case, the \nindex is at 115.80, 5 contracts were sold, and each point is worth $500. Thus, the total \ndollar amount represented by the futures sale is 5 x 500 x 115.80 = $289,500. This \nverifies that our stock purchases hedge the futures sale adequately. Nate that the \nslight difference in the stock purchase amount and the futures sale amount is due to \nthe fact that the number of shares in the index is carried out to only two decimal \npoints in this example. \nCl,apter 30: Stock Index Hedging Strategies 551 \nThere is an alternative method to determine how many shares to buy. In this \nmethod, one first determines how much stock he is going to buy in total dollars. For \nexample, he might decide that he is going to buy $10,000,000 worth of the S&P 100 \n( 0 EX) Index. Next, one determines what percentage his dollar amount is of the total \ncapitalization of the index. For example, $10,000,000 might be something like .02% \nof the total capitalization of the OEX. One would then buy .02% of the total number \nof shares outstanding of each of the stocks in the OEX. After the number of shares \nof each stock to buy has been determined, one would have to determine ho'Y many \nfutures to sell against this stock- he would divide $10,000,000 by the index price and \nalso divide by the unit of trading for the futures. This procedure is demonstrated in \nthe following example. \nExample: Suppose that one wants to set up an arbitrage against the same index as in \nthe previous example. For purposes of comparison with that example, we will sup\npose that this hedger wants to buy a total of $290,000 worth of stock. In reality, one \nwould probably use a round number such as $300,000 or $500,000 worth of stock. \nHowever, by making a direct comparison, we will be able to more easily demonstrate \nthat these two methods produce the same answer. \nFirst, the hedger must· determine the percent of the total capitalization that he \nis going to buy. In this case, he is buying $290,000 worth of stock and the total capi\ntalization of the index is $17,080,000,000 (refer to the table at the beginning of the \nprevious example). This means that he is buying .0016979% of the total capitalization \nof the index. \nNext, he uses this percentage and multiplies it by the float of each stock. That \nis, he is going to buy .0016979% of the total number of shares outstanding of each \nstock in the index. This results in purchases as shown in the following table: \nStock \nA \nB \nC \nFloat \n177,000,000 \n50,000,000 \n100,000,000 \nShores to Buy \n3,005 \n849 \n1,698 \nCompare these share purchases with the previous example. The number of \nshares to buy is the same, allowing for rounding off in the previous example. Thus, \nthese two methods of determining how many shares to buy are equivalent. \nBefore leaving this section, it should be pointed out that arbitrageurs can also \nestablish an arbitrage when futures are underpriced. They can sell stocks short and \nbuy the underpriced futures. This is a more difficult type of arbitrage t~,establish \n552 Part V: Index Options and Futures \nbecause short sales must be made on plus ticks. However, when futures are under\npriced for an extensive period of time - perhaps during extreme pessimism on the \npart of speculators - it is possible to set up the arbitrage from this viewpoint. \nPROFITABILITY OF THE ARBITRAGE \nThe key for many arbitrageurs and institutional investors is whether, after costs, there \nis enough of a return in this stock versus futures strategy. The method in which we \npreviously computed the fair value of the futures will be used in determining the \noverall incremental return of doing the arbitrage. \nThe major cost in executing the arbitrage is the cost of commissions. Since there \nare large quantities of stocks being bought or sold when an entire index is traded, the \ncommission rate is generally quite low. For example, an institutional investor might \npay 3 cents per share or even less. This still could be a substantial cost, especially \nwhen a large index such as the S&P 500 Index is being purchased. Even profession\nal arbitrageurs may have to pay commission costs if they are using the services of a \ncomputer firm to buy stocks. These methods of trading stocks are described in the \nnext section. \nOnce one's rate of commission charges is known, he can convert that into a \nnumber that represents a portion of the index price. He does so by multiplying his \nper-share commission rate by the current index value and then dividing that result by \nthe average share price of the index. The following example describes that method of \nconversion. \nExample: Suppose that one is going to buy the entire ZY:X Index at a commission \nrate of 3 cents per share. The index is trading at 185.00. Furthermore, assume that \nthe average price of a share in the index is 45 dollars per share. With this informa\ntion, one can determine how much he is paying in commissions, in terms of the index \nitself. \nCommission rate \nCommission in terms = -~p_e_r_s_h_ar_e __ x_I_n_d_e_x_v_al_u_e_ \nof index Average price \nper share \n.03 X 185.00 =-----\n45 \n= .123 \nThus, a commission rate of 3 cents per share translates into 12.3 cents of index value. \nChapter 30: Stack Index Hedging Strategies 553 \nThe most difficult factor to determine in the above equation is the average price \nper share for a capitalization-weighted index. There is a shortcut that can be used. It \nis easy to determine the average price per share for a price-weighted index, such as \nXMI. The average price per share for large-capitalization indices such as the OEX \nand S&P 500", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 245}
{"text": "hapter 30: Stack Index Hedging Strategies 553 \nThe most difficult factor to determine in the above equation is the average price \nper share for a capitalization-weighted index. There is a shortcut that can be used. It \nis easy to determine the average price per share for a price-weighted index, such as \nXMI. The average price per share for large-capitalization indices such as the OEX \nand S&P 500 is about 80% of that of the XML \nExample: It is a simple matter to compute the average price per share. for a price\nweighted index. Merely divide the index value by the number of stocks comprising \nthe index and then multiply that result by the divisor of the index. Suppose the XMI \nis trading at 352 and the divisor of the XMI is 4.4. Then, since there are 20 stocks in \nthe XMI, we can quickly determine the average price per share of stocks in the XMI: \nAverage price = Index price x Divisor \nper share Number of stocks \nin index \n352 X 4.4 =----\n20 \n= 77.44 \nGiven this information, we can estimate that the average price per share for stocks in \na broader-based index would be about 80% of that figure, or something like 62 or 63 \ndollars per share. \nNow that the commission rate has been converted into an index value, one can \ndetermine his net profit from trading the exact index against the futures. One must \nfigure in his futures commission costs as well. The following example demonstrates \nthe net profit from executing the arbitrage, including all costs. Once the net profit \nhas been calculated, a rate of return can be computed. \nExample: Suppose that the ZYX Index is trading at 185.00 and the futures, which \nexpire in two months, have a fair value premium of 2.00 points, but are trading at \n188.50, a premium of 3.50. The futures are worth $500 per point. Thus, the futures \nare expensive and one might attempt to buy stocks and sell the futures. His net prof\nit consists of the premium over fair value less all costs of entering and exiting the \nposition. \nAs we saw in the previous example, at 3 cents per share stock commission, we \npay an index value of .123 to enter the position. Similarly, we would pay .123 in index \nvalue to exit the position at a later date. Thus, the net round-tum stock commission \nis approximately 25 cents of index value. \n554 Part V: Index Options and Futures \nCommissions on futures are generally charged only when the position is closed \nout. Generally, a futures commission on an S&P 500 contract might be reduced to \nsomething like $10 per contract for this type of hedging. Since 185.00, the index \nvalue, represents 11500th of the value of the futures contract, we can reduce the \nfutures commission to an index-related number by dividing the actual dollar com\nmission by 500. Thus, the futures commission is, in index terms, 10/500, or .02. The \ntotal commission for entering and exiting the position is thus 0.266 of index value, \n0.123 each for the purchase and sale of the stocks and .02 for the futures. \nNet profit = Futures \nprice \nFutures fair Commission \nvalue costs \n= 188.50 - 187.00 - 0.27 \n= 1.23 \nThis absolute net profit number can be converted into a rate of return by annualiz\ning the profit and dividing by the current index price. Suppose that there are \ntwo months exactly remaining until expiration. Then the rate of return is computed \nas follows: \nIncremental = Net profit x ( 1/Time remaining) \nrate of return Index price \n1.23 X ( 12/2) \n185.00 \n= 3.99% \nFor the two-month time period, his return is about 2h of one percent. \nAt first glance, a rate of return of almost 4% does not seem like much. But what \nwe have computed here is an incremental rate of return. That is, this return is over \nand above whatever rate we used in determining the fair value of the futures. Thus, \nif an institution were going to invest its cash at the prevailing short-term rate, and that \nrate were used to determine the futures fair value in the above example, then the \ninstitution could earn an additional 4%, annualized, if it arbitraged the futures rather \nthan put its money in the short-term money market. \nTRADE EXECUTION \nMost customers are not concerned with how the trades are executed, for they give \nthe order to their broker and let him work out the details. However, for those who \nare interested in the actual trade execution, a short section dealing with that topic is \nin order. \nChapter 30: Stock Index Hedging Strategies 555 \nIdeally, one should be able to monitor the progress of his index in terms of bid \nprices, offer prices, and last sales. There are several modern quote services that allow \nsuch monitoring. It is important to know the bids and offers because, when one actu\nally executes the trades, he generally will be trading on the bid and offer, not the last \nsale. \nExample: Suppose the fair value of the futures contract is represented by a premi\num of 1.25 points, but that the actual future is trading with a premium of 2.00 points: \nThe index is at 165.75 and the futures are 167.75 (last sale). This might seem like \nenough \"room\" to execute a profitable arbitrage - buy the stocks in .the index and sell \nthe futures. However, the index value of 165. 75 is the composite of the last sales of \neach of the individual stocks in the index. If one were to look at the offering prices \nof each stock and then recompute the index, he might end up with an index value \nthat was 50 cents higher. This, then, would mean that he would be doing the arbi\ntrage for 25 cents less costs, which is not enough of a margin to work with. \nSimilarly, when one is looking to sell out the stocks he has bought and simulta\nneously buy back the futures, he needs to know the bid value of the index in order to \nsee what kind of premium he is paying to take his position off. \nOne normally executes the hedge by giving a series of stock orders to brokers \non the floor of the exchange and simultaneously giving a futures order to the futures \nexchange. The actual trader controlling the order generally lets the stock", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 246}
{"text": "simulta\nneously buy back the futures, he needs to know the bid value of the index in order to \nsee what kind of premium he is paying to take his position off. \nOne normally executes the hedge by giving a series of stock orders to brokers \non the floor of the exchange and simultaneously giving a futures order to the futures \nexchange. The actual trader controlling the order generally lets the stocks be execut\ned at prevailing market prices, but might try to control the futures execution more \nclosely. \nThere are two basic ways in which the actual stock order entry takes place. One \nis the conventional method of giving orders to brokers on the floor of the New York \nStock Exchange. This method can be somewhat computerized by having a computer \nat the broker's main location send a series of orders to various locations of that bro\nkerage firm on the floor of the exchange. The orders are then given to several bro\nkers who quickly execute them. The speed with which the executions must take place \ndemonstrates why the price paid is usually the offering price and not the last sale: \nThere simply isn't enough time for the broker to try to save an eighth of a point on \none stock, since he has several other orders to execute. \nThe other method of order entry is completely computerized. The computer \nknows the quantity of each stock to buy and, when prompted, sends those buy orders \nvia telecommunications lines to one of the automatic order execution systems on the \nexchange floor. The most common automatic system is the POT system on the \nNYSE. The system attempts to guarantee the offering price for large quantities of \nstock. In this highly sophisticated method of order entry, the entire execution proce-\n556 Part V: Index Options and Futures \ndure may take place in about one minute for the entire index. This method of order \nentry is so quick and accurate that some brokerage firms with this capability offer it \nfor a commission fee to other brokerage firms that do not have the capability. \nINSTITUTIONAL STRATEGIES \nHolders of large portfolios of stocks can use futures and/or market basket strategies \nto their advantage. There are two basic strategies that can be easily used by these \nlarge traders. One is to buy futures instead of buying stocks, and the other is to sell \nfutures instead of selling stocks. Both of these strategies will be examined in more \ndetail. \nWhen one of these large institutions has money to invest in buying stocks, it \nmight make more sense to buy Treasury bills and futures instead of buying stocks. Of \ncourse, this alternative strategy only makes sense for the institution if the stock pur\nchase were going to be broad-based - something akin to duplicating the S&P 500 \nperformance. The institution does not necessarily have to be intent on purchasing an \nexact index, but if the purchase were going to be diversified, the purchase of index \nfutures might help accomplish an equivalent result. If, however, the purchase were \ngoing to be quite specific, then this strategy would probably not apply. \nThis strategy works best when futures are underpriced. If the equivalent dollar \namount of underpriced futures can be purchased instead of buying stocks, the entire \namount intended for stock purchase can be put in Treasury bills instead. Recall that \ncash will have to be put into the futures account if the futures mark at a loss (main\ntenance margin). Even so, there can be substantial savings to the institution if the \nfutures are truly underpriced. \nThe second institutional strategy is applicable when futures are overpriced and \nthe institution wants to sell stock. In such a case, it makes more sense to sell the \nfutures than to sell the stock. First, there are large savings in transaction costs ( com\nmissions). Second, the overpriced nature of the futures actually means that there is \nadditional profitability in selling them as opposed to selling the stocks. Again, this \nstrategy only makes sense if one were going to sell a diversified portfolio of stocks, \nsomething that is broad-based like the S&P 500 Index. \nOf course, institutions may want to participate in the arbitrage regardless of their \nmarket stance. That is, if a money manager has a certain amount of money that he is \ngoing to put into short-term instruments (perhaps T-bills), he might instead decide to \nparticipate in this arbitrage of stocks versus futures if the incremental return is high \nenough. Recall that we saw how to determine the incremental return in a previous \nsection of this chapter. If he were going to get a 7½% return from T-bills but could \nget an 11 ½% return from futures arbitrage, he might opt for the latter. \nChapter 30: Stack Index Hedging Strategies \nFOLLOW-UP STRATEGIES \n557 \nOnce any hedge has been established, it must be monitored in case an adjustment \nneeds to be made. The first and simplest type of monitoring is to take care of spin\noffs or other adjustments in stocks in the market basket that is owned. Of a more seri\nous nature, in terms of profitability, one also needs to monitor the hedge to see if it \nshould be removed or if the futures should be rolled forward into a more distant expi\nration month. \nAdjusting one's portfolio for stock spinoffs is a simple matter which we will \naddress briefly. In many cases, one of the stocks in the index will spin off a division \nor segment of its business and issue stock to its shareholders. Such a spinoff is gen\nerally not included in the price of the index, so that the hedger should sell off such \nitems as soon as he receives them, for they do not pertain to his hedge. \nIn a similar vein, in any portfolio certain stocks may occasionally be targets of \ntender offers or other reorganizations. If one does nothing in such a situation, he will \nnot lose any money in terms of his portfolio versus the underlying index. However, it \nis generally wise for one to tender his stock in such situations and replace it at a lower \nprice after the tender. Sometimes, in", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 247}
{"text": "s hedge. \nIn a similar vein, in any portfolio certain stocks may occasionally be targets of \ntender offers or other reorganizations. If one does nothing in such a situation, he will \nnot lose any money in terms of his portfolio versus the underlying index. However, it \nis generally wise for one to tender his stock in such situations and replace it at a lower \nprice after the tender. Sometimes, in fact, such a tender offer will entirely absorb an \nindex component member. In that case, one must replace the disappearing stock with \nwhatever stock is announced as the new member of the index. \nTechnically, in an arbitrage hedge one should adjust his portfolio every time the \ndivisor of the index changes. Thus, in a capitalization-weighted hedge he would be \nadjusting every time one of the components issues new common stock. This is really \nnot necessary in most cases, because the new issue is so small in comparison to the \ncurrent float of the stock. Such a new issue does not include stock splits, for the divi\nsor of the index does not change in that case. A more common case is for one of the \nstocks in a price-weighted index to split. In this case, one must adjust his portfolio. \nAn example of such an adjustment was given in Chapter 29. In essence, one must sell \noff some of the split stock and buy extra shares of each of the other stocks in the \nprice-weighted index. \nLet us now take a look at follow-up methods of removing or preserving the \nhedge. \nROLLING TO ANOTHER MONTH \nAs expiration nears, the hedger is faced with a decision regarding taking off the mar\nket basket. If the futures premium is below fair value, he would probably unwind the \nentire position, selling the stocks and buying back the futures. However, if the futures \nremain expensive - especially the next series - then the hedger might roll his futures. \n558 Part V: Index Options and Futures \nThat is, he would buy back the ones he is short and sell the next series of futures. For \nS&P 500 futures, this would mean rolling out 3 months, since that index has futures \nthat expire every 3 months. For the XMI futures and OEX index options, there are \nmonthly expirations, so one would only have to roll out 1 month if so desired. \nIt is a simple matter to determine if the roll is feasible: Simply compare the fair \nvalue of the spread between the two futures in question. If the current market is \ngreater than the theoretical value of the spread, then a roll makes sense if one is long \nstocks and short futures. If an arbitrageur had initially established his arbitrage when \nfutures were underpriced, he would be short stocks and long futures. In that case he \nwould look to roll forward to another month if the current market were less than the \ntheoretical value of the spread. \nExample: With the S&P 500 Index at 416.50, the hedger is short the March future \nthat is trading at 417.50. The June future is trading at 421.50. Thus, there is a 4-point \nspread between the March and June futures contracts. \nAssume that the fair value formula shows that the fair value premium for the \nMarch series is 35 cents and for the June series is 3.25. Thus, the fair value of the \nspread is 2.90, the difference in the fair values. \nConsequently, with the current market making the spread available at 4.00, one \nshould consider buying back his March futures and selling the June futures. The \nrolling forward action may be accomplished via a spread order in the futures, much \nlike a spread order in options. This roll would leave the hedge established for anoth\ner 3 months at an overpriced level. \nAnother way to close the position is to hold it to expiration and then sell out the \nstocks as the cash-based index products expire. If one were to sell his entire stock \nholding at the time the futures expire, he would be getting out of his hedge at exact\nly parity. That is, he sells his stocks at exactly the last sale of the index, and the futures \nexpire, being marked also to the last sale of the index. \nFor settlement purposes of index futures and options, the S&P 500 Index and \nmany other indices calculate the \"last sale\" from the opening prices of each stock on \nthe last day of trading. For some other indices, the last sale uses the closing price of \neach stock. \nExample: In a normal situation, if the S&P 500 index is trading at 415, say, then that \nrepresents the index based on last sales of the stocks in the index. If one were to \nattempt to buy all the stocks at their current offering price, however, he would prob\nably be paying approximately another 50 cents, or 415.50, for his market basket. \nSimilarly, if he were to sell all the stocks at the current bid price, then he would sell \nthe market basket at the equivalent of approximately 414.50. \nChapter 30: Stock Index Hedging Strategies 559 \nHowever, on the last day of trading, the cash-based index product will expire at \nthe opening price of the index. If one were to sell out his entire market basket of \nstocks at the current bid prices at the exact opening of trading on that day, he would \nsell his market basket at the calculated last sale of the index. That is, he would actu\nally be creating the last sale price of the index himself, and would thereby be remov\ning his position at parity. \nThe problem with this is that it is correct theory, but difficult to put into prac\ntice. For example, if one has several million dollars of stocks to sell, he cannot expect \nthe marketplace to absorb them easily when they are all being sold at the last minute \non a Friday afternoon. We will discuss this more fully momentarily, when we look at \nthe impact of stock index arbitrage on the stock market in general. \nThere is another interesting facet of the arbitrage strategy that combines the \nspread between the near-term future and the next longest one with the idea of exe\ncuting the stock portion of the arbitrage at the close of trading on the day the index \nproducts expire. Use of this strategy actually allows one to enter a", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 248}
{"text": "we look at \nthe impact of stock index arbitrage on the stock market in general. \nThere is another interesting facet of the arbitrage strategy that combines the \nspread between the near-term future and the next longest one with the idea of exe\ncuting the stock portion of the arbitrage at the close of trading on the day the index \nproducts expire. Use of this strategy actually allows one to enter and exit the hedge \nwithout having to lose the spread between last sale and bid or last sale and offer in \neither case. Suppose that one feels that he would set up the arbitrage for 3 months if \nhe could establish it at a net price of 1.50 over fair value. Furthermore, if the fair \nvalue of the 3-month spread is 2.10, but it is currently trading at 3.60, then that rep\nresents 1.50 over fair value. One initiates the position by buying the near-term future \nand selling the longer-term future for a net credit of 3.60 points. At expiration of the \nnear-term future, rather than close out the spread, one buys the stocks that comprise \nthe index at the last sale of the trading day, thereby establishing his long stock posi\ntion at the last sale price of the index at the same moment that his long futures expire. \nThe resultant position is long stocks and short futures that expire in 3 months at a \npremium of 3.60. Since the fair value of such a 3-month future should be 2.10, the \nhedge is established at 1.50 over fair value. The position can be removed at expira\ntion in the same manner as described in the previous paragraph, again saving the dif\nferential between last sale and the bids of the stocks in the index. Note that this strat\negy creates buying pressure on the stock market at expiration of the near-term side \nof the spread, and selling pressure at the latter expiration. \nThe final way to exit from one's position is to remove it before expiration. \nSometimes, there are opportunities during the last two or three weeks before the \nfutures expire. If one hedged with long stock and short futures, the opportunities \nto remove the hedge arise when the futures trade below fair value - perhaps even \nat an actual discount to parity. If the futures never trade below fair value, but \ninstead continue to remain expensive, then rolling to the next expiration series is \noften warranted. \n560 Part V: Index Options and Futures \nMARKET BASKET RISK \nThere are some uncertainties in this type of hedging, even though the entire index is \nbeing bought. Since one owns the actual index, there is no risk that the stocks one \nowns will fail to hedge the futures price movements properly. However, there are \nother risks. One is the risk of execution. That is, it may appear that the futures are \ntrading at a premium of 1.50 points when one enters the orders. However, if other \nhedgers are doing the same thing at the same time, one may pay more for the stocks \nthan he thought when he entered his order, and he may sell the futures for less as \nwell. This \"execution risk\" is generally small, but if one is too slow in getting his stock \norders executed, he may have set up a hedge that was not as attractive as he first \nthought. \nOne major risk is that interest rates might move against the arbitrageur while \nthe position is in place. If he is long stocks and short the futures, then he would not \nwant interest rates to rise. In the previous example, the incremental return for the 2-\nmonth time period that the position was going to be held was 2h of one percent. If \nshort-term rates should rise by more than that, on average, for the 2-month period, \nthe incremental strategy would be inferior. His carrying costs would have increased \nto the point of wiping out the profit from his arbitrage. \nFor institutional arbitrageurs who don't exactly have cost of carry, this situation \nwould be viewed in the following manner: If rates increase, he may find that he \nwould have been better off having his money invested in a money market fund at the \nprevailing short-term rate than in the incremental arbitrage strategy. Conversely, if \nthe arbitrage was originally established with short stocks and long futures, the arbi\ntrageur would not want rates to drop for similar reasons. \nOne might leave a cushion against a movement in rates. If rates are currently \n8%, then one might decide to use a 10% rate as a cushion. Hedges established that \nare profitable at the higher rate level will consequently be able to withstand rates \nmoving up to 10%. \nExample: Suppose that one would normally use a rate of 7½% and would establish \nthe long stock versus short futures hedge at an incremental rate of return of 1 ½%. \nThis is a relatively narrow cushion and if the hedge is on for a moderate length of \ntime, rates could move up to such an extent that they advance to 9½% or higher. \nSuch a move would make the hedge position unprofitable. Instead, one might calcu\nlate the fair value of the futures using a rate equal to his current prevailing rate plus \na cushion. That is, if his current rate is 7½%, he might use 8½% and still demand an \nincremental return of 1 ½%. Ifhe established the hedge at these levels, he could suf\nfer a move of 1 %, the cushion, against him and still earn his incremental rate of 1 ½%. \nCbapter 30: Stock Index Hedging Strategies 561 \nAnother risk that the arbitrageur faces is that of changes in the dividend payout \nof the stocks in the index. Suppose that he is long stocks and short futures. If there \nare enough cuts in dividend payout, or dividend payments are delayed past the expi\nration date of the futures, then he will lose some of his return. Arbitrageurs who are \nshort stocks and long futures would have similar problems if dividend payout were \nincreased especially if a large special dividend were declared by a company that ,is \na major component of the index - or payment dates were accelerated. \nIf one holds the arbitrage until expiration, he will be able to unwind it at parity. \nHowever, if he decides to remove the arbitrage before expira", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 249}
{"text": "ageurs who are \nshort stocks and long futures would have similar problems if dividend payout were \nincreased especially if a large special dividend were declared by a company that ,is \na major component of the index - or payment dates were accelerated. \nIf one holds the arbitrage until expiration, he will be able to unwind it at parity. \nHowever, if he decides to remove the arbitrage before expiration, he might incur \nincreased costs that would harm his projected return. Instead of selling his stocks at \nthe last sale of the index, as he is able to do on expiration day, he would have to sell \nthem on their bids, a fact that could cost him a significant portion of his profit. \nIn a later section, where we discuss hedging the futures with a market basket of \nstocks that does not exactly represent the entire index, we will be concerned with the \ngreatest risk of all, \"tracking error\" - the difference between the performance of the \nindex and the performance of the market basket of stocks being purchased. \nIMPACT ON THE STOCK MARKET \nThe act of establishing and removing these hedge positions affects the stock market \non a short-term basis. It is affected both before expiration and also at expiration of \nthe index products. We will examine both cases and will also address how the strate\ngist can attempt to benefit from his knowledge of this situation. \nIMPACT BEFORE EXPIRATION \nWhen bullish speculators drive the price of futures too high, arbitrageurs will attempt \nto move in to establish positions by buying stock and selling futures. This action will \ncause the stock market to jump higher, especially since positions are normally estab\nlished with great speed and stocks are bought at offering prices. Such acceleration on \nthe upside can move the market up by a great deal in terms of the Dow-Jones \nIndustrials in a matter of minutes. \nConversely, if futures become cheap there is also the possibility that arbi\ntrageurs can drive the market downward. If positions are already established from \nthe long side (long stock, short futures), then arbitrageurs might decide to unwind \ntheir positions if futures become too cheap. They would do this if futures were so \ncheap that it becomes more profitable to remove the position, even though stocks \nmust be sold on their bid, rather than hold it to expiration or roll it to another series. \n562 Part V: Index Options and Futures \nWhen these long hedges are unwound in this manner, the stock market will decline \nquickly as stocks are sold on bids. In this case, the market can fall a substantial \namount in just a few minutes. \nOnce long hedges are unwound, however, cheap futures will not cause the mar\nket to decline. If there is no more stock held long in hedges, then the only strategy \nthat arbitrageurs can employ when futures become cheap is to sell stock short and \nbuy futures. Since stock must be sold short on upticks, this action may put a \"lid\" on \nthe market, but will not cause it to decline quickly. \nHaving long stock and short futures when these large discounts occur is so valu\nable to an arbitrageur that some traders will establish the long stock/short futures \nhedge for no profit or even a loss. They hope that subsequently futures will plunge \nto a large discount and they can unwind their positions for large profits. If that never \noccurs, they only lose a few cents of index value. Assume futures fair value is 3.50 \nover. Such arbitrageurs might buy stock and sell futures at a net cost of 3.45 over. \nThat is, if they hold the position until expiration they will lose 5 cents, but if a large \nfutures discount ever occurs, they will profit. \nRegulatory bodies have become increasingly concerned over the years as to the \neffect that program trading and index arbitrage have on the stock market. In reality, \nwhen stocks and futures are executed more or less simultaneously, these strategies \nshould not overly disturb the stock market. However, since they are not executed \nsimultaneously (there are no rules in the futures markets against frontrunning), the \nNew York Stock Exchange has imposed an arbitrary limit, called a \"circuit breaker,\" \non these activities. If the Dow-Jones averages rise or fall more than a specified dis\ntance (for example, 200 points) at any time during a trading day, all computer-driven \nprogram order entry is prohibited for the rest of the day, or until the Dow-Jones \nmoves back to within 25 points of being unchanged on the day. This trading ban \neffectively shuts down program trading and index arbitrage, although it is still allow\nable to do it by having the trades executed by individual floor brokers. Some of the \nlarger trading houses, trading for their own accounts, are therefore still able to exe\ncute index arbitrage if the discount in the futures is extremely wide, even when the \ntrading ban is in effect. \nThe trading ban is really meant to halt declining markets, although in the inter\nest of fairness, the ban goes into effect on days when the Dow-Jones rises by the \nspecified distance (for example, 200 points) as well. Of the various measures that \nhave been tried in order to stop a declining market from becoming a crash (e.g., cir\ncuit breaker trading limits on S&P 500 futures), this seems to be the most effective. \nThere have been many times when the Dow-Jones has accelerated to the limit, and \nthen once the trading ban went into effect, the Dow-Jones would slide slowly back \nthe other way, but at a much more leisurely pace. \nCl,opter 30: Stock Index Hedging Strategies 563 \nReaders should remember, of course, that the stock market can move inde\npendently of the overpriced or underpriced nature of index products. That is, if \nfutures are overpriced, the stock market can still decline. Perhaps there is a prepon\nderance of natural sellers of stocks. Similarly, if futures are cheap, the stock market \ncan still go up if enough traders are bullish. Thus, one should be cautious about try\ning to link every movement of the stock market", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 250}
{"text": "move inde\npendently of the overpriced or underpriced nature of index products. That is, if \nfutures are overpriced, the stock market can still decline. Perhaps there is a prepon\nderance of natural sellers of stocks. Similarly, if futures are cheap, the stock market \ncan still go up if enough traders are bullish. Thus, one should be cautious about try\ning to link every movement of the stock market to index products. \nPORTFOLIO INSURANCE \nPortfolio insurance is the generic name used to describe a strategy in which a port\nfolio manager uses the index derivatives market to protect his portfolio in case the \nmarket crashes. He could either sell futures or buy puts. \nThe generic concept was put into effect using futures in the mid 1980s. In the \nform of the strategy that was being practiced at the time, the portfolio manager did \nnot sell futures against his entire portfolio right away. Rather, he sold only a few to \nbegin with. This allowed him to retain a good deal of upside profit potential for his \nportfolio. If the market dropped further, then he would sell more. Eventually, if it \ndropped far enough, he would keep selling futures until his entire portfolio was prop\nerly hedged. There were computer programs that calculated when to sell the futures \nand how many to sell in order for the portfolio manager to eventually end up with the \nproper amount of insurance at the right price. \nUnfortunately, the concept did not work properly in practice. In fact, it has \noften been identified as one of the major factors in the 500-point crash of October \n19, 1987. What happened during the days leading up to that date was that the mar\nket was already going down fast. Futures, as a result, began to trade at a discount. \nThe portfolio insurance strategy assumes futures are sold at fair value, more or less. \nThus, the portfolio insurance managers did not sell their futures when they had orig\ninally intended; or they could not sell enough without driving the futures to tremen\ndous discounts. In any case, the market kept going further down without any rebound \n(essentially from about mid-afternoon on Thursday, October 15, through the close on \nMonday, October 19), a total of over 650 points on the Dow-Jones averages.\" As the \nmarket plunged, the portfolio insurance strategy kept demanding that more futures \nbe sold, and they were, but often at prices well below where the strategy had origi\nnally dictated. This continued selling kept futures at a discount, which triggered even \nmore selling by other program traders and index arbitrageurs. \nAs a result, the portfolios were not completely protected - although it should be \nnoted that they were somewhat protected since they had been selling some futures. \nHence, the portfolio managers were not pleased. Stock market regulators were not \npleased, either, although nothing illegal had been done. The strategy lost most of its \nadherents at that time and has not been resurrected in its previous form. \n•This represented a decline of over 25% from the relatively low levels (mid-2000s) that the index was trading \nat during that time frame. \nS64 Part V: Index Options and Futures \nHowever, the concept is still a valid one, and it is now generally being practiced \nwith the purchase of put options. The futures strategy was, in theory, superior to buy\ning puts because the portfolio manager was supposed to be able to collect the pre\nmium from selling the futures. However, its breakdown came during the crash in that \nit was impossible to buy the insurance when it was most needed - similar to attempt\ning to buy fire insurance while your house is burning down. \nCurrently, the portfolio manager buys puts to protect his portfolio. Many of \nthese puts are bought directly over-the-counter from major banks or brokerage hous\nes, for they can be tailored directly to the portfolio manager's liking. This practice \nconcerns regulators somewhat, because the major banks and brokerage houses that \nare selling the puts are taking some risk, of course. They hedge the sales (with futures \nor other puts), but regulators are concerned that, if another crash occurred, it would \nbe the writers of these puts who would be in the market selling futures. in a mad fren\nzy to protect their short put positions. Hopefully, the put sellers will be able to hedge \ntheir positions properly without disturbing the stock market to any great degree. \nIMPACT AT EXPIRATION - THE RUSH TO EXIT \nSome traders persist in attempting to get out of their positions on the last day, at the \nlast minute. These traders are not normally professional arbitrageurs, but institu\ntional clients who are large enough to practice market basket hedging. Moreover, \nthey have positions in indices whose options expire at the close of trading (OEX, for \nexample). If these hedgers have stock to sell, what generally happens is that some \ntraders begin to sell before the close, figuring they will get better prices by beating \nthe crowd to the exit. Thus, about an hour before the close, the market may begin to \ndrift down and then accelerate as the closing bell draws nearer. Finally, right on the \nbell that announces the end of trading for the day, whatever stock has not yet been \nsold will be sold on blocks - normally significantly lower than the previous last sale. \nThese depressed sales will make the index decline in price dramatically at the last \nminute, when there is no longer an opportunity to trade against it. \nThese blocks are often purchased by large trading houses that advance their \nown capital to take the hedgers out of their positions. The hedgers are generally cus\ntomers of the block trading houses. Normally, on Monday, the market will rebound \nsomewhat and these blocks of stock can be sold back into the market at a profit. \nWhatever happens on Monday, though, is of little solace to the trader trapped \nin the aftermath of the Friday action. For example, if one happened to be short puts \nand the index was near the strike as the cl", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 251}
{"text": "e hedgers are generally cus\ntomers of the block trading houses. Normally, on Monday, the market will rebound \nsomewhat and these blocks of stock can be sold back into the market at a profit. \nWhatever happens on Monday, though, is of little solace to the trader trapped \nin the aftermath of the Friday action. For example, if one happened to be short puts \nand the index was near the strike as the close of trading was drawing near on Friday \nafternoon, he might decide to do nothing and merely allow the puts to expire, figur\ning that he would buy them back for a small cost when he was assigned at expiration. \nCbapter 30: Stock Index Hedging Strategies 565 \nHowever, this flurry of block prints on the close might drive the index down by 2 or \n3 points! This is an extremely large move for the index, and the option trader has no \nrecourse as the options cease trading. An index composed of only a few stocks, such \nas the Dow-Jones 30 Industrials, will fall most dramatically when these events occur, \nalthough the OEX will drop heavily as well. \nWe have also previously seen that the late market action on expiration day might \nbe bullish. If institutional arbitrageurs have established the futures spread by being \nlong the short-term futures and short the next series, then they will be buyers of \nstocks at the close of trading on expiration day. Additionally, if the only remaining \narbitrage positions at expiration are short stocks versus long futures, then there might \nalso be buying pressure at expiration. \nAs might be expected, these events have not gone unnoticed and have caused \nsome consternation among both regulators and traders. There have been accusations \nthat some traders particularly those with foreknowledge of the block prints to come \nbuy very cheap index options on the last afternoon of trading and then force those \noptions to become profitable by selling their clients' portfolios in the manner \ndescribed above. \nThe strategist cannot be concerned with whether someone is acting irrationally \nor worse. Rather, he must decide how he will handle the situation should it occur. \nThe key is to try to determine the direction that the market will move at the close of \nexpiration day, if that is discernible. If futures have had a large premium for a long \nperiod of time, then one must assume that many hedgers have long stock versus short \nfutures. Furthermore, even if futures subsequently trade below fair value, there will \nstill be some hedgers who have stubbornly kept their positions, waiting to roll. The \nstrategist should recognize that fact and take appropriate action late on the last day \nof trading: Don't establish bullish positions at that time and don't allow positions that \nare expiring that day to become too bullish. That is, if one is short puts and the index \nis trading near the striking price of the puts, then buy them back. \nThus, the strategist must be aware of how the futures have traded during the \nlast 3 months in order to determine how he will address his positions on the last day. \nEven with this information, there is no guarantee that one can exactly predict what \nwill happen at expiration unless one is privy to the actual stock buy and sell orders. \nThis order flow information is closely guarded and known only to the firms that will \nbe executing the orders, generally on behalf of institutions. Consequently, it is a very \nrisky strategy to attempt to apply this information for establishing positions on expi\nration day itself. That is, if one expects stock buy orders at expiration, he might \ndecide to buy some cheap, expiring calls for himself on the last afternoon of trading. \nConversely, if he expects stock selling, he might buy puts. Given the fact that such \nmovements are hard to predict, such aggressive strategies are not warranted. \n566 Part V: Index Options and Futures \nSIMULATING AN INDEX \nThe discussion in the previous section assumed that one bought enough stocks to \nduplicate the entire index. This is unfeasible for many investors for a variety of rea\nsons, the most prominent being that the execution capability and capital required \nprevent one from being able to duplicate the indices. Still, these traders obviously \nwould like to take advantage of theoretical pricing discrepancies in the futures con\ntracts. The way to do this, in a hedged manner, would be to set up a market basket \nof a small number of stocks, in order to have some sort of hedge against the futures \nposition. \nIn this section, we will demonstrate approaches that can be taken to hedge the \nfutures position with a small number of stocks. This is different from when we looked \nat how to hedge individualized portfolios with index futures or options, because we \nare now going to try to duplicate the performance of the entire index, but do it with \na subset of stocks in the index. In either of these cases, a mathematical technique \ncalled regression analysis can be used to measure the performance of these portfo\nlios or small market baskets. However, we will take a simpler approach that does not \nrequire such sophisticated calculations, but will produce the desired results. \nUSING THE HIGH-CAPITALIZATION STOCKS \nRecall that in a capitalization-weighted index, the stocks with the largest capitaliza\ntions (price times float) have the most weight. In many such indices, there are a \nhandful of stocks that carry much more weight than the other stocks. Therefore, it is \noften possible to try to create a market basket of just those stocks as a hedge against \na futures position. While this type of basket will certainly not track the index exactly, \nit will have a definite positive correlation to the index. \nWhat one essentially tries to accomplish with the smaller market basket is to \nhedge dollars represented by the index with the same dollar amount of stocks. No \nhedge works in which the total dollars involved are not nearly equal. Listed below are \nthe steps necessary to compute how many shares of each st", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 252}
{"text": "nly not track the index exactly, \nit will have a definite positive correlation to the index. \nWhat one essentially tries to accomplish with the smaller market basket is to \nhedge dollars represented by the index with the same dollar amount of stocks. No \nhedge works in which the total dollars involved are not nearly equal. Listed below are \nthe steps necessary to compute how many shares of each stock to buy in order to cre\nate a \"mini-index\" to hedge futures or options on a larger index: \n1. Determine the percent of the large index to be hedged (OEX, NYSE, S&P 500, \netc.) that each stock comprises. This information is readily available from the \nexchange on which the futures or options trade or can be calculated by the meth\nods shown in Chapter 29. \n2. Determine the percent of the mini-index to be constructed that each stock com\nprises, by inflating their relative percentages to total 100%. \nCltapter 30: Stock Index Hedging Strategies 567 \n3. Decide the total dollar amount of the index to be traded at one time: index value \ntimes futures or option quantity times unit of trading in the futures. \n4. Multiply the total dollar amount from step 3 by each individual percentage from \nstep 2 to determine how many dollars of each stock to buy. \n5. Divide the result from step 4 by the price of the stock in order to determine how \nmany shares to buy. \nThese steps will result in the construction of a mini-index consisting of a small \nnumber of stocks that are grouped together in relative proportion to their weights in \nthe larger index, and have a total dollar amount sufficient to trade against the desired \nfutures or options trading lot. This approach ignores volatility. Even without account\ning for volatility, this approach is reasonable when using high-capitalization stocks to \nhedge a broad-based index. \nAmong the largest-capitalization stocks are International Business Machines \n(IBM), Exxon (XON), General Electric (GE), and General Motors (GM). As a result, \nthese four form the foundation of many small market baskets. All four are in the OEX \n(S&P 100), the S&P 500, and other major capitalization-weighted indices. As a first \nexample, let us examine how one would hedge the futures using these four stocks \nonly, according to the five steps outlined above. \nExample: Suppose we are attempting to create a hedge for a fictional index, the \nUVX, by using IBM, XON, GM, and GE. The following table gives certain informa\ntion that will be necessary in computing how many shares of each stock to use in the \nsmall basket. \nStock Float \nIBM 600,000 \nXON 850,000 \nCE 450,000 \nGM 300,000 \nUVX price: 170.25 \nDivisor: 3,500,000 \nShores in \nPrice Index \n130 0.171 \n40 0.243 \n70 0.129 \n85 0.086 \nTotal capitalization: 595,875,000 (price times divisor) \nPct of \nIndex \nCapitalization (Step 1) \n78,000,000 13.1% \n34,000,000 5.7% \n31,500,000 5.3% \n25,500,000 4.3% \n28.4% \n568 Part V: Index Options and Futures \nRecall how these items are calculated: The number of shares of a stock in the \nindex is that stock's float divided by the divisor of the index. Also, the percent of the \nindex is the stock's capitalization (float times price) divided by the total capitalization \nof the index (this is step 1 above). Finally, the index value is the index's total capital\nization divided by the index divisor. \nWith this information, we can now construct a mini-index that could be used to \nhedge the UVX itself. Notice that these four stocks alone comprise 28.4% of the \nentire UVX index. We would want each of these four stocks to have the same relative \nweight within our mini-index as they do within the UVX itself. The sum of the capi\ntalizations of the four stocks in the above table as well as their relative percentages \nare given in the following table. \nPct of Pct of \nIndex Mini-Index \nStock Copitolizotion (Step 1) (Step 2) \nIBM 78,000,000 13.1% 46.2% \nXON 34,000,000 5.7% 20.1% \nGE 31,500,000 5.3% 18.6% \nGM 25,500,000 4.3% 15.1% \nTotal: 169,000,000 28.4% 100.0% \nThe percent of the mini-index is each of the four stocks' capitalizations as a per\ncent of the sum of their capitalizations (step 2 from above). There are two ways to \ncompute step 2. First, for IBM one would divide 78 million (its capitalization) by 169 \nmillion (the total capitalization). Second, using the percentages from step 1, divide \nIBM's percent, 13.1, by 28.4, the total percent. Either method gives the answer of \n46.2 percent. We have now constructed the relative percentages of the mini-index \nthat each stock comprises. Note that they are in the same relationship to each other \nas they are in the UVX itself. Now it is a simple matter to convert that percent into \nshares of stock, once we decide how many futures contracts to trade against our mini\nindex. \nWhen we know the total dollar amount of futures to hedge and we know the \npercent of the mini-index that each stock comprises, we can compute each stock's \ncapitalization within the mini-index. Finally, we divide by that stock's price to see how \nmany shares of each stock to buy. Assume that we are going to use UVX options, \nwhich are worth $100 per point, in lots of 50 options. The total dollar amount of the \nindex with the UVX at 170.25 would then be $851,250 (170.25 x 100 x 50). This \naccomplishes step 3. The following table shows the calculations necessary to deter\nmine how many shares of stock to buy against these 50 option contracts. \n0.,ter 30: Stock Index Hedging Strategies 569 \nCapitalization Shares \nPct of in Mini-Index to Buy \nStock Mini-Index (Step 4) Price (Step 5) \nIBM 46.2% 393,277 130 3,025 \nXON 20.1% 171,102 40 4,277 \nGE 18.6% 158,332 70 2,261 \nGM 15.1% 128,539 85 1,512 \nTotal: 100.0% 851,250 \nNote that the capitalization of each stock in the mini-index is determined by multi\nplying the desired trading lot ($851,250) by the percent of the mini-index that that \nstock comprises. This completes step 4, and step 5 follows: The number of shares of \neach stock to buy is then determined by dividing that numb", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 253}
{"text": "40 4,277 \nGE 18.6% 158,332 70 2,261 \nGM 15.1% 128,539 85 1,512 \nTotal: 100.0% 851,250 \nNote that the capitalization of each stock in the mini-index is determined by multi\nplying the desired trading lot ($851,250) by the percent of the mini-index that that \nstock comprises. This completes step 4, and step 5 follows: The number of shares of \neach stock to buy is then determined by dividing that number by the price of the \nstock. For example, the calculation for IBM in the above table would be $851,250 x \n.462 = $393,277; then $393,277/130 = 3,025. \nThus, one could attempt to hedge 50 UVX option contracts with the above \namounts of each of the four stocks. As a matter of practicality, one would not buy the \nodd lots, but would probably round off each stock quantity to round lots: 3,000 IBM, \n4,300 XON, 2,300 GE, and 1,500 GM. \nAs the prices of the stocks in the mini-basket change, the mini-basket needs to \nbe recalculated. This is because the current prices of the stocks in the index were \nused to compute the mini-index. Thus, as the prices of the stocks change, the com\nposition of our mini-index will begin to deviate from the composition of the UVX. \nExample: Suppose that oil stocks do poorly and XON falls to 35 (it was 40 when we \nconstructed the mini-index), while the other stocks are the same price as in the pre\nvious example. Finally, suppose that the overall UV:X is unchanged at 170.25, even \nthough Exxon has changed substantially. We must recalculate step 1: Determine the \npercent that each stock is of the UV:X. Assume the divisor is unchanged and each \nstock's float is unchanged, so the percent is the price times the float divided by the \ntotal capitalization (595,875,000). \nPercent Percent of \nFloat Capitalization of Index Mini-Index \nStock Price (OOOs) (Millions) (Step l) (Step 2) \nIBM 130 600 78.00 13.1% 47.3% \nXON 35 850 29.75 5.0% 18.1% \nGE 70 450 31.50 5.3% 19.1% \nGM 85 300 25.50 4.3% 15.5% \nTotal: 164.75 27.7% 100.0% \n570 Part V: Index Options and Futures \nNote that the percent that Exxon comprises of the UVX as well as of the mini-index \nhas fallen. All three of the other stock's percentages have increased proportionately. \nThese percentage changes reflect the changes in the stock prices. Since we assumed \nthe UVX is unchanged, the capitalization of the desired mini-index is still $851,250 \n(170.25 x $100 per point x 50 options). Now, if we complete steps 4 and 5, we will \nsee how many shares of each stock make up the new version of the mini-index. \nCapitalization Shores \nin Mini-Index to Buy \nStock (Step 4) Price (Step 5) \nIBM $402,641 130 3,097 \nXON 154,076 35 4,402 \nGE 162,589 70 2,323 \nGM 131,944 85 1,552 \nTotal: $851,250 \nCompare the number of shares to be bought in this example with the number \nof shares to be bought in the previous example. Actually, we are buying more shares \nof each of the stocks. There are two reasons for this. In Exxon's case, we are buying \nmore shares since the price has dropped more as a percentage of its previous price \nthan its capitalization has dropped as a percentage. For the other stocks, we are buy\ning more shares because the capitalization of each has increased within the mini\nindex and the price is unchanged. \nThis example serves to show that as the prices of the stocks in the mini-index \nchange, the number of shares of each of the stocks might change. This means that \nthe hedger using this type of hedge should recalculate the makeup of the index rather \nfrequently - at least once a week. In actual practice, the hedger will know which \nstocks are underperforming and which are outperforming. Hence, he will have some \nidea of what needs to be done in advance of actually computing it. \nThere are many methods of approaching these \"mini-indices.\" Some traders \nwho are extremely short-term oriented - possibly moving in and out of the futures \none or more times daily - might attempt to hedge the futures with only one stock \n(generally the largest-capitalization stock, such as IBM, unless there is some reason \nto believe that the general market is moving in a substantially different direction from \nthe largest of all stocks). \nIn other cases, hedgers with more capital and more resources but who are \nunwilling to hedge the entire index might ti:y to use a larger mini-index to hedge with. \nGopter 30: Stock Index Hedging Strategies 571 \nIn cases such as these, one is generally not interested in day-trading the futures and \nstocks, but rather in attempting to simulate the full hedge against fair value, as \ndescribed earlier. For example, the top 30 capitalization stocks in the OEX make up \nover 70% of the capitalization of the index. This provides very accurate tracking, but \nstill does not overly tax the execution capabilities of even a small trading desk. Such \na 30-stock mini-index can be calculated in exactly the same manner as in the previ\nous examples. Since it represents over 70% of the index, it will track the index quite \nwell, although not perfectly of course. \nHowever, if one tried to simulate the S&P 500 Index by buying the top 50 \nstocks, he would still not own even 40% of the capitalization of the index. This does \nnot provide as accurate tracking as one would hope after having bought 50 stocks. As \na result, if one were trying to hedge the S&P 500 Index, he should use at least 200 \nstocks. \nTRACKING ERROR RISK \nIn any such simulated index portfolio, there is the largest risk of all with regard to \nindex hedging, the tracking error. Tracking error is the difference in performance \nbetween the actual index and the simulated index portfolio. There are statistical ways \nto predict how closely a certain portfolio of stocks will simulate a given index. This is \nsomething akin to pollsters predicting the margin of victory of an election before the \nelection is held. One may hear that a certain portfolio has a 98% correlation, say, to \nan index it is intended to simulate. \nWhat does this measure represent? First, it must be understood that", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 254}
{"text": "here are statistical ways \nto predict how closely a certain portfolio of stocks will simulate a given index. This is \nsomething akin to pollsters predicting the margin of victory of an election before the \nelection is held. One may hear that a certain portfolio has a 98% correlation, say, to \nan index it is intended to simulate. \nWhat does this measure represent? First, it must be understood that statistics \ncannot predict the exact performance of any set of stocks with respect to any other \nset, just as polls cannot exactly predict the outcome of an election. What the statis\ntics do tell us is how probable it is that a certain portfolio will perform nearly the \nsame as another one. The concept of expected return, which was described earlier in \nthis book, is something like this. The statistical number does not guarantee that the \nportfolio will perform like the index 98% of the time or that it will never deviate from \nthe index by more than 2%. It is merely a comparative measure that says that such a \nportfolio has a good correlation to the index. \nThe actual risk that one is taking by using the simulated index instead of the \nindex itself is not completely measurable. If it were, then we could predict the exact \nperformance of the simulated index, which we just showed we could not. However, \nassume an average performance - that the simulated index deviates from the real \nindex by 2% over the course of 1 year. If we are speaking of the S&P 500 at 415, then \n2% would be 9.30 points over a 1-year period, or 2.33 points over a 3-month period. \n572 Part V: Index Options and Futures \nThat is a substantial amount of movement when one considers that most of our arbi\ntrage examples were assuming profits of not much more than that. The compensat\ning factor to this risk is that the simulated index may outperform the actual index and \none could make more profits than would be available with arbitrage. If one had \nenough capital and enough time to constantly be participating in such a simulated\nindex strategy, he would, over time, have a tracking error that is relatively small if his \nsimulated index has a high correlation to the index. \nMONITORING THE HEDGE \nOnce the position has been established, the trader should have some way of moni\ntoring the position. Ideally, he would have a computer system that could compute his \nmini-index in real time. This would allow accurate comparisons between the actual \nindex movement and the mini-index. Tracking error can, of course, work for or \nagainst the trader. \nIt is not necessary to have a computer system built specifically for index hedg\ning. Many computerized systems provide for real-time profit and loss calculations on \na portfolio of the user's choosing. Any of these systems would be sufficient for com\nputation of the relative value of the mini-index. In the course of computing the prof\nit or loss on the portfolio, the program must compute the net value of the portfolio. \nAs long as this is available, one can convert it into a mini-index value, suitable for \ncomparison to the larger index. The \"trick\" is to use a mini-index multiplier that is a \npower of 10. That is, the futures unit of trading times the futures quantity is a power \nof 10. For example, if the futures unit of trading is $250 as with the S&P 500 futures, \nthen a quantity of 40 would result in a power of 10 ($250 X 40 = 10,000). This means \nthat the total capitalization of the mini-index portfolio should be able to be read as \nthe \"index value\" with the mere adjustment of a decimal point. \nExample: If one is trading against futures that have a trading move of $500 per point, \nthen he might choose to use 20 futures against his mini-index. That is, the multipli\ner is 20 x $500 or $10,000. If he were hedging against an index trading at 170.25, he \nwould then buy 10,000 x 170.25 or $1,702,500 worth of stock. The total value of the \nstocks in his mini-index would total $1,702,500 initially and he could therefore deter\nmine his mini-index value to be 170.2500 by moving the decimal point over four \nplaces. The following table summarizes how this might be constructed using the four \nstocks in the most recent example. Recall that in the previous example, the total cap\nitalization of the four-stock mini-index was $851,250. In this example we would have \nhad a total mini-index capitalization of twice that, or $1,702,500. Thus, the capital\nization and the number of shares to buy are doubled from the previous example. \nCl,apter 30: Stock Index Hedging Strategies \nCapitalization \nin Mini-Index \nStock (Step 4) \nIBM $ 805,282 \nXON 308,152 \nGE 325,178 \nGM 263,888 \nTotal: $1,702,500 \nPrice \n130 \n35 \n70 \n85 \n573 \nShares \nto Buy \n6,194 \n8,804 \n4,646 \n3,104 \nLater, as the stocks change in value, one's computerized profit and loss system \ncould readily compute the total capitalization of the mini-index and, by moving the \ndecimal point over four places, have a \"mini-index value\" that could be compared \nagainst the actual index (UVX in this case) in order to determine tracking error. \nExample: Suppose that the stocks in the mini-index were to increase to have a total \nvalue of $1,761,872 as shown in the following table. \nShares Current \nStock Owned Price Capitalization \nIBM 6,194 135 $ 836,190 \nXON 8,804 37 325,748 \nGE 4,646 69 320,574 \nGM 3,104 90 279,360 \nTotal: $1,761,872 \nThe mini-index value is now 176.1872 (moving the decimal point over four places), \nor 176.19. This means that our mini-index increased from a value of 170.25 to 176.19, \nan increase of 5.94. This could be compared to the UVX movement during the same \nperiod of time. For example, if the UVX had increased by 6.50 points over the time \nperiod, then it is easy to see that the mini-index underperformed the UVX by 56 \ncents. If, at some other time, our mini-index had increased faster than the UVX, then \nwe would have tracking error in our favor. \nUSING OPTIONS INSTEAD OF FUTURES \nAs pointed out earlier, one could use options instead of futures wh", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 255}
{"text": "e \nperiod of time. For example, if the UVX had increased by 6.50 points over the time \nperiod, then it is easy to see that the mini-index underperformed the UVX by 56 \ncents. If, at some other time, our mini-index had increased faster than the UVX, then \nwe would have tracking error in our favor. \nUSING OPTIONS INSTEAD OF FUTURES \nAs pointed out earlier, one could use options instead of futures when hedging these \nindices. Assuming one is creating a fully hedged situation, he would have positions \nsimilar to conversions when he uses options to hedge a long stock market basket posi-\n574 Part V: Index Options and Futures \ntion. He would both sell calls and buy puts with the same striking price in order to \ncreate the hedge. This is similar to a conversion arbitrage. \nWhen attempting to hedge the S&P 500, one could use the S&P 500 futures \noptions or the S&P 500 cash options, but that would not necessarily present a more \nattractive situation than using the futures. On the other hand, there is not a liquid \nS&P 100 (OEX) futures contract, so that when hedging that contract, one generally \nuses the OEX options. As mentioned earlier, inter-index option spreads between var\nious indices, including the S&P 100 and 500, will be discussed in the next chapter. \nThere is not normally much difference as to which of the two is better at any \none time. However, since a full option hedge requires two executions (both selling \nthe call and buying the put), the futures probably have a slight advantage in that they \ninvolve only a single execution. \nIn order to substitute options for futures in any of the examples in these chap\nters on indices, one merely has to use the appropriate number of options as com\npared to the futures. If one were going to sell OEX calls instead of S&P 500 futures, \nhe would multiply the futures quantity by 5. Five is the multiple because S&P 500 \nfutures are worth $250 per point while OEX options are worth $100 per point, and \nbecause the S&P 500 Index (SPX) trades at twice the price of OEX (OEX split 2-for\nl in November 1997). Thus, if an example calls for the sale of 20 S&P 500 futures, \nthen an equivalent hedge with OEX options would require 100 short calls and 100 \nlong puts. \nOne could attempt to create less fully hedged positions by using the options \ninstead of the futures. For example, he might buy stocks and just write in-the-money \ncalls instead of selling futures. This would create a covered call write. He would still \nuse the same techniques to decide how much of each stock to buy, but he would have \ndownside risk if he decided not to buy the puts. Such a position would be most attrac\ntive when the calls are very overpriced. \nSimilarly, one might try to buy the stocks and buy slightly in-the-money puts \nwithout selling the calls. This position is a synthetic long call; it would have upside \nprofit potential and would lose if the index fell, but would have limited risk. Such a \nposition might be established when puts are cheap and calls are expensive. \nTRADING THE TRACKING ERROR \nAnother reason that one might sell futures against a portfolio of stocks is to actually \nattempt to capture the tracking error. If one were bullish on oil drilling stocks, for \nexample, and expected them to outperform the general market, he might buy sever-\nCbapter 30: Stock Index Hedging Strategies 515 \nal drillers and sell S&P 500 futures against them. The sale of the futures essentially \nremoves \"the market\" from the package of drilling stocks. What would be left is a \nposition that will reflect how well the drillers perform against the general stock mar\nket. If they outperform, the investor will make money. In this section, we are going \nto look at ways of implementing these hedging strategies. This investor is not partic\nularly concerned with predicting whether the market will go up or down; all he wants \nto do is remove the \"market\" from his set of stocks. Then he hopes to profit if these \nstocks do, indeed, outperform the broad market. Again, we will not use regression \nanalysis, but instead will concentrate on methods that are more simply implemented. \nOften, investors or portfolio managers think in terms of industry groups. That \nis, one may think that the oil drilling stocks will outperform the market, or that the \nauto stocks will underperform, for example. In either case, one sells futures to \nattempt to remove the market action and capitalize on the performance differential. \nIn some sense, one is creating a hedge in which he hopes to profit from tracking error. \nIn previous discussions, tracking error has not been considered a particularly desir\nable thing. In this situation, however, one is going to attempt to profit by predicting \nthe direction of the tracking error and trading it. \nThe technique for establishing this hedge is exactly the same as in the examples \nat the beginning of this chapter, when we looked at hedging a specific stock portfo\nlio. The exception is that now one must decide which stocks to buy. Once that is \ndecided, he can use the four steps outlined previously to decide how many futures to \nsell against them: \nStep l: Compute each stock's adjusted volatility by dividing its volatility by that \nof the market. Use Beta if the group's movement does not correlate well with the \ngeneral market. \nStep 2: Multiply by the quantity and price of each stock to get an adjusted capi\ntalization. \nStep 3: Add these to get the total capitalization for the portfolio. \nStep 4: Determine how many futures to sell by dividing the index price into the \ntotal adjusted capitalization. \nExample: Suppose that an investor feels that oil drilling stocks will outperform the \nmarket. He decides to invest $500,000 to buy equal dollar amounts of five drilling \nstocks. Normally one would buy an equal dollar amount of each stock in this situa\ntion. The stocks are Hughes Tool (HT), Fluor Corp (FLR), Schlumberger (SLB), \nKaneb (KAB), and Halliburton (HAL). The first table shows the price of ea", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 256}
{"text": "mple: Suppose that an investor feels that oil drilling stocks will outperform the \nmarket. He decides to invest $500,000 to buy equal dollar amounts of five drilling \nstocks. Normally one would buy an equal dollar amount of each stock in this situa\ntion. The stocks are Hughes Tool (HT), Fluor Corp (FLR), Schlumberger (SLB), \nKaneb (KAB), and Halliburton (HAL). The first table shows the price of each stock \nand how many shares of each will be purchased; $100,000 is invested in each stock. \n576 \nStock \nFLR \nHAL \nHT \nKAB \nSLB \nPrice \n20 \n50 \n25 \n10 \n40 \nPart V: Index Options and Futures \nQuantify \nPurchased \n5,000 \n2,000 \n4,000 \n10,000 \n2,500 \nNow, if one obtains the volatilities of these stocks, he can perform the necessary \ncomputations. These computations will tell him how many futures to sell against the \nportfolio of drilling stocks. The volatilities and computations are given in the follow\ning table, assuming the market volatility is 15%. First, dividing the stock's volatility by \nthe market's volatility gives the adjusted volatility (step 1). That result multiplied by \nthe price and quantity of the stock gives the adjusted capitalization (step 2), and \nadding these together gives the total adjusted capitalization (step 3). \nAdjusted Adjusted \nVolatility Quantity Capitalization \nStock Volatility (Step I) Price Owned (Step 2) \nFLR .46 3.07 20 5,000 $ 306,667 \nHAL .30 2.00 50 2,000 200,000 \nHT .21 1.67 25 4,000 166,667 \nKAB .50 3.33 10 10,000 333,333 \nSLE .35 2.33 40 5,000 233,333 \nTotal adjusted capitalization: $1,240,000 (step 3) \nAssume that one wants to hedge with a fictional index, ZYX, and that ZYX futures are \nworth $500 per point. If the ZYX Index is selling at 175, then one would sell 14 \nfutures against this portfolio of drilling stocks: $1,240,000 + $500 per point+ 175 is \napproximately equal to 14 (step 4). \nIn a situation such as this, one does not have to be bullish or bearish on the \nmarket in order to establish the hedge. He is rather attempting to time the per\nformance of the group in question. Similarly, the decision as to when to remove the \nposition is not a matter of market opinion. Perhaps one has an unrealized profit and \ndecides to take it, or perhaps something changes fundamentally within the group \nChapter 30: Stock Index Hedging Strategies 577 \nthat leads the investor to believe that the group no longer has the potential to out\nperform the market. \nIf the futures are underpriced when one begins to investigate this strategy, he \nshould not establish the position. What is gained in tracking error could be lost in \ntheoretical value of the futures. Since one is establishing both sides of the hedge \n(stocks and futures) at essentially the same time, he can afford to wait until the \nfutures are attractively priced. This is not to say that the futures must be overpriced \nwhen the position is established, although that fact would be an enhancement to the \nposition. \nIf one thinks that a particular group will underperform the market, he merely \nneeds to decide how many shares of each stock to sell short and then can determine \nhow many futures to buy against the short sales in order to try to capture the track\ning error. If one decides to capture the negative tracking error in this manner, he \nmust be careful not to buy overpriced futures. Rather, he should wait for the futures \nto be near fair value in order to establish the position. \nCOLLATERAL REQUIREMENTS \nIn any of the portfolio hedging strategies that we have discussed in this section, there \nis no reduction in margin requirements for either the futures or the options. That is, \nthe stocks must be paid for in full or margined as if they had no protection against \nthem, and the hedging security - the futures or options - must be margined fully as \nwell. Long puts would have to be paid for in full, short futures would require their \nnormal margin and would be marked to the market via variation margin, and short \ncalls would have to be margined as naked and would also be marked to the market. \nA trader who has not margined his stocks could use them as collateral for the naked \ncall requirements if he so desired. \nSUMMARY \nThere have been two major impacts of index futures and options. One is that they \nallow a trader to \"buy the market\" without having to select individual stocks. This is \nimportant because many traders have some idea of the direction in which the mar\nket is heading, but may not be able to pick individual stocks well. The other, perhaps \nmore major, impact is that large holders of stocks can now hedge their portfolios \nwithout nearly as much difficulty. The use of these futures and options against actu\nal stock indices - real or simulated - has introduced a strategy into the marketplace \nthat did not previously exist. The versatility of these derivative securities is evidenced \n572 Part V: Index Options and Futures \nThat is a substantial amount of movement when one considers that most of our arbi\ntrage examples were assuming profits of not much more than that. The compensat\ning factor to this risk is that the simulated index may outperform the actual index and \none could make more profits than would be available with arbitrage. If one had \nenough capital and enough time to constantly be participating in such a simulated\nindex strategy, he would, over time, have a tracking error that is relatively small if his \nsimulated index has a high correlation to the index. \nMONITORING THE HEDGE \nOnce the position has been established, the trader should have some way of moni\ntoring the position. Ideally, he would have a computer system that could compute his \nmini-index in real time. This would allow accurate comparisons between the actual \nindex movement and the mini-index. Tracking error can, of course, work for or \nagainst the trader. \nIt is not necessary to have a computer system built specifically for index hedg\ning. Many computerized systems provide for real-time profit and loss calculations on \na portfo", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 257}
{"text": "a computer system that could compute his \nmini-index in real time. This would allow accurate comparisons between the actual \nindex movement and the mini-index. Tracking error can, of course, work for or \nagainst the trader. \nIt is not necessary to have a computer system built specifically for index hedg\ning. Many computerized systems provide for real-time profit and loss calculations on \na portfolio of the user's choosing. Any of these systems would be sufficient for com\nputation of the relative value of the mini-index. In the course of computing the prof\nit or loss on the portfolio, the program must compute the net value of the portfolio. \nAs long as this is available, one can convert it into a mini-index value, suitable for \ncomparison to the larger index. The \"trick\" is to use a mini-index multiplier that is a \npower of 10. That is, the futures unit of trading times the futures quantity is a power \nof 10. For example, if the futures unit of trading is $250 as with the S&P 500 futures, \nthen a quantity of 40 would result in a power of 10 ($250 x 40 = 10,000). This means \nthat the total capitalization of the mini-index portfolio should be able to be read as \nthe \"index value\" with the mere adjustment of a decimal point. \nExample: If one is trading against futures that have a trading move of $500 per point, \nthen he might choose to use 20 futures against his mini-index. That is, the multipli\ner is 20 x $500 or $10,000. If he were hedging against an index trading at 170.25, he \nwould then buy 10,000 x 170.25 or $1,702,500 worth of stock. The total value of the \nstocks in his mini-index would total $1,702,500 initially and he could therefore deter\nmine his mini-index value to be 170.2500 by moving the decimal point over four \nplaces. The following table summarizes how this might be constructed using the four \nstocks in the most recent example. Recall that in the previous example, the total cap\nitalization of the four-stock mini-index was $851,250. In this example we would have \nhad a total mini-index capitalization of twice that, or $1,702,500. Thus, the capital\nization and the number of shares to buy are doubled from the previous example. \nChapter 30: Stock Index Hedging Strategies \nCapitalization \nin Mini-Index \nStock (Step 4) \nIBM $ 805,282 \nXON 308,152 \nGE 325,178 \nGM 263,888 \nTotal: $1,702,500 \nPrice \n130 \n35 \n70 \n85 \n573 \nShores \nto Buy \n6,194 \n8,804 \n4,646 \n3,104 \nLater, as the stocks change in value, one's computerized profit and loss system \ncould readily compute the total capitalization of the mini-index and, by moving the \ndecimal point over four places, have a \"mini-index value\" that could be compared \nagainst the actual index (UVX in this case) in order to determine tracking error. \nExample: Suppose that the stocks in the mini-index were to increase to have a total \nvalue of $1,761,872 as shown in the following table. \nShares Current \nStock Owned Price Capitalization \nIBM 6,194 135 $ 836,190 \nXON 8,804 37 325,748 \nGE 4,646 69 320,574 \nGM 3,104 90 279,360 \nTotal: $1,761,872 \nThe mini-index value is now 176.1872 (moving the decimal point over four places), \nor 176.19. This means that our mini-index increased from a value of 170.25 to 176.19, \nan increase of 5.94. This could be compared to the UVX movement during the same \nperiod of time. For example, if the UVX had increased by 6.50 points over the time \nperiod, then it is easy to see that the mini-index underperformed the UVX by 56 \ncents. If, at some other time, our mini-index had increased faster than the UVX, then \nwe would have tracking error in our favor. \nUSING OPTIONS INSTEAD OF FUTURES \nAs pointed out earlier, one could use options instead of futures when hedging these \nindices. Assuming one is creating a fully hedged situation, he would have positions \nsimilar to conversions when he uses options to hedge a long stock market basket posi-\n574 Part V: Index Options and Futures \ntion. He would both sell calls and buy puts with the same striking price in order to \ncreate the hedge. This is similar to a conversion arbitrage. \nWhen attempting to hedge the S&P 500, one could use the S&P 500 futures \noptions or the S&P 500 cash options, but that would not necessarily present a more \nattractive situation than using the futures. On the other hand, there is not a liquid \nS&P 100 (OEX) futures contract, so that when hedging that contract, one generally \nuses the OEX options. As mentioned earlier, inter-index option spreads between var\nious indices, including the S&P 100 and 500, will be discussed in the next chapter. \nThere is not normally much difference as to which of the two is better at any \none time. However, since a full option hedge requires two executions (both selling \nthe call and buying the put), the futures probably have a slight advantage in that they \ninvolve only a single execution. \nIn order to substitute options for futures in any of the examples in these chap\nters on indices, one merely has to use the appropriate number of options as com\npared to the futures. If one were going to sell OEX calls instead of S&P 500 futures, \nhe would multiply the futures quantity by 5. Five is the multiple because S&P 500 \nfutures are worth $250 per point while OEX options are worth $100 per point, and \nbecause the S&P 500 Index (SPX) trades at twice the price of OEX (OEX split 2-for\nl in November 1997). Thus, if an example calls for the sale of 20 S&P 500 futures, \nthen an equivalent hedge with OEX options would require 100 short calls and 100 \nlong puts. \nOne could attempt to create less fully hedged positions by using the options \ninstead of the futures. For example, he might buy stocks and just write in-the-money \ncalls instead of selling futures. This would create a covered call write. He would still \nuse the same techniques to decide how much of each stock to buy, but he would have \ndownside risk if he decided not to buy the puts. Such a position would be most attrac\ntive when the calls are very overpriced. \nSimilarly, one mi", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 258}
{"text": "ad of the futures. For example, he might buy stocks and just write in-the-money \ncalls instead of selling futures. This would create a covered call write. He would still \nuse the same techniques to decide how much of each stock to buy, but he would have \ndownside risk if he decided not to buy the puts. Such a position would be most attrac\ntive when the calls are very overpriced. \nSimilarly, one might ti:y to buy the stocks and buy slightly in-the-money puts \nwithout selling the calls. This position is a synthetic long call; it would have upside \nprofit potential and would lose if the index fell, but would have limited risk. Such a \nposition might be established when puts are cheap and calls are expensive. \nTRADING THE TRACKING ERROR \nAnother reason that one might sell futures against a portfolio of stocks is to actually \nattempt to capture the tracking error. If one were bullish on oil drilling stocks, for \nexample, and expected them to outperform the general market, he might buy sever-\nChapter 30: Stock Index Hedging Strategies 575 \nal drillers and sell S&P 500 futures against them. The sale of the futures essentially \nremoves \"the market\" from the package of drilling stocks. What would be left is a \nposition that will reflect how well the drillers perform against the general stock mar\nket. If they outperform, the investor will make money. In this section, we are going \nto look at ways of implementing these hedging strategies. This investor is not partic\nularly concerned with predicting whether the market will go up or down; all he wants \nto do is remove the \"market\" from his set of stocks. Then he hopes to profit if these \nstocks do, indeed, outperform the broad market. Again, we will not use regression \nanalysis, but instead will concentrate on methods that are more simply implemented. \nOften, investors or portfolio managers think in terms of industry groups. That \nis, one may think that the oil drilling stocks will outperform the market, or that the \nauto stocks will underperform, for example. In either case, one sells futures to \nattempt to remove the market action and capitalize on the performance differential. \nIn some sense, one is creating a hedge in which he hopes to profit from tracking error. \nIn previous discussions, tracking error has not been considered a particularly desir\nable thing. In this situation, however, one is going to attempt to profit by predicting \nthe direction of the tracking error and trading it. \nThe technique for establishing this hedge is exactly the same as in the examples \nat the beginning of this chapter, when we looked at hedging a specific stock portfo\nlio. The exception is that now one must decide which stocks to buy. Once that is \ndecided, he can use the four steps outlined previously to decide how many futures to \nsell against them: \nStep 1: Compute each stock's adjusted volatility by dividing its volatility by that \nof the market. Use Beta if the group's movement does not correlate well with the \ngeneral market. \nStep 2: Multiply by the quantity and price of each stock to get an adjusted capi\ntalization. \nStep 3: Add these to get the total capitalization for the portfolio. \nStep 4: Determine how many futures to sell by dividing the index price into the \ntotal adjusted capitalization. \nExample: Suppose that an investor feels that oil drilling stocks will outperform the \nmarket. He decides to invest $500,000 to buy equal dollar amounts of five drilling \nstocks. Normally one would buy an equal dollar amount of each stock in this situa\ntion. The stocks are Hughes Tool (HT), Fluor Corp (FLR), Schlumberger (SLB), \nKaneb (KAB), and Halliburton (HAL). The first table shows the price of each stock \nand how many shares of each will be purchased; $100,000 is invested in each stock. \n576 \nStock \nFLR \nHAL \nHT \nKAB \nSLB \nPrice \n20 \n50 \n25 \n10 \n40 \nPart V: Index Options and Futures \nQuantity \nPurchased \n5,000 \n2,000 \n4,000 \n10,000 \n2,500 \nNow, if one obtains the volatilities of these stocks, he can perform the necessary \ncomputations. These computations will tell him how many futures to sell against the \nportfolio of drilling stocks. The volatilities and computations are given in the follow\ning table, assuming the market volatility is 15%. First, dividing the stock's volatility by \nthe market's volatility gives the adjusted volatility (step 1). That result multiplied by \nthe price and quantity of the stock gives the adjusted capitalization (step 2), and \nadding these together gives the total adjusted capitalization (step 3). \nAdjusted Adjusted \nVolatility Quantity Capitalization \nStock Volatility (Step 1) Price Owned (Step 2) \nFLR .46 3.07 20 5,000 $ 306,667 \nHAL .30 2.00 50 2,000 200,000 \nHT .21 1.67 25 4,000 166,667 \nKAB .50 3.33 10 10,000 333,333 \nSLE .35 2.33 40 5,000 233,333 \nTotal adjusted capitalization: $1,240,000 (step 3) \nAssume that one wants to hedge with a fictional index, ZY.X, and that ZY.X futures are \nworth $500 per point. If the ZY.X Index is selling at 175, then one would sell 14 \nfutures against this portfolio of drilling stocks: $1,240,000 + $500 per point+ 175 is \napproximately equal to 14 (step 4). \nIn a situation such as this, one does not have to be bullish or bearish on the \nmarket in order to establish the hedge. He is rather attempting to time the per\nformance of the group in question. Similarly, the decision as to when to remove the \nposition is not a matter of market opinion. Perhaps one has an unrealized profit and \ndecides to take it, or perhaps something changes fundamentally within the group \nCbapter 30: Stock Index Hedging Strategies 577 \nthat leads the investor to believe that the group no longer has the potential to out\nperform the market. \nIf the futures are underpriced when one begins to investigate this strategy, he \nshould not establish the position. What is gained in tracking error could be lost in \ntheoretical value of the futures. Since one is establishing both sides of the hedge \n(stocks and futures) at essentially", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 259}
{"text": "577 \nthat leads the investor to believe that the group no longer has the potential to out\nperform the market. \nIf the futures are underpriced when one begins to investigate this strategy, he \nshould not establish the position. What is gained in tracking error could be lost in \ntheoretical value of the futures. Since one is establishing both sides of the hedge \n(stocks and futures) at essentially the same time, he can afford to wait until the \nfutures are attractively priced. This is not to say that the futures must be overpriced \nwhen the position is established, although that fact would be an enhancement to the \nposition. \nIf one thinks that a particular group will underperform the market, he merely \nneeds to decide how many shares of each stock to sell short and then can determine \nhow many futures to buy against the short sales in order to try to capture the track\ning error. If one decides to capture the negative tracking error in this manner, he \nmust be careful not to buy overpriced futures. Rather, he should wait for the futures \nto be near fair value in order to establish the position. \nCOLLATERAL REQUIREMENTS \nIn any of the portfolio hedging strategies that we have discussed in this section, there \nis no reduction in margin requirements for either the futures or the options. That is, \nthe stocks must be paid for in full or margined as if they had no protection against \nthem, and the hedging security - the futures or options - must be margined fully as \nwell. Long puts would have to be paid for in full, short futures would require their \nnormal margin and would be marked to the market via variation margin, and short \ncalls would have to be margined as naked and would also be marked to the market. \nA trader who has not margined his stocks could use them as collateral for the naked \ncall requirements if he so desired. \nSUMMARY \nThere have been two major impacts of index futures and options. One is that they \nallow a trader to \"buy the market\" without having to select individual stocks. This is \nimportant because many traders have some idea of the direction in which the mar\nket is heading, but may not be able to pick individual stocks well. The other, perhaps \nmore major, impact is that large holders of stocks can now hedge their portfolios \nwithout nearly as much difficulty. The use of these futures and options against actu\nal stock indices - real or simulated has introduced a strategy into the marketplace \nthat did not previously exist. The versatility of these derivative securities is evidenced \n578 Part V: Index Options and Futures \nby the various strategies that were described in this chapter - hedging an actual index \nor a simulated one, trading the tracking error, selling the futures instead of the entire \nportfolio when one turns bearish, or buying the futures when they are cheap instead \nof buying stocks. The owner of a stock portfolio, whether an individual or a large \ninstitution, should understand these strategies because they are often preferable to \nmerely buying or selling stock. \nCHAPTER 31 \nIndex Spreading \nIn this chapter, we will look at strategies oriented toward spreading one index against \nanother. This may be done with either futures or options. In some cases, this is almost \nan arbitrage because the indices track each other quite well. In others, it is a high\nrisk venture because the indices bear little relationship to each other. In any case, if \nthe futures relationship between the two indices is out of line, one may have an extra \nadvantage. \nINTER-INDEX SPREADING \nThere are general relationships between many stock indices, both in the United \nStates and worldwide. The idea behind inter-index spreading is often to capitalize on \none's view of the relationships between the two indices without having to actually \npredict the direction of the stock market. Note that this is often the philosophy \nbehind many option spreads as well. \nSometimes an analyst will say that he expects small-cap stocks to outperform \nlarge-cap stocks. This analyst should consider using an inter-index spread between \nthe S&P 500 Index and the Value Line Index (which contains many small stocks), or \nperhaps between the S&P and a NASDAQ-based index. If he buys the index that is \ncomprised of smaller stocks and sells the S&P 500 Index, he will make money if his \nanalysis is right, regardless of whether the stock market goes up or down. All he wants \nis for the index he is long to outperform the index he is short. \nOccasionally, the futures or options on these indices are mispriced in compar\nison to the way the indices are priced. When this happens, one may be able to cap\nitalize on the pricing discrepancy. At times, the spread between the index products \n579 \n580 Part V: Index Options and Futures \non two indices can trade at significantly different price levels from the spread \nbetween the two indices themselves. When this happens, an inter-index spread \nbecomes feasible. \nThe margin requirements for these spreads are often reduced because margin \nrules recognize that futures on one index can be hedged by futures on another index. \nThe general rule of thumb as far as selecting a futures spread to establish \nbetween two indices is to compare the price difference in the respective futures to \nthe actual price difference in the indices themselves. If the difference in the futures \nis substantially different from the difference in the cash prices of the indices, then \none would sell the more expensive future and buy the cheaper one. Several specific \nspreads are discussed in this chapter. \nRegardless of whether one is entering into the spread because he is trying to \npredict the relationships between the cash indices, or because he knows the two \nrespective futures are out of line, he must decide in what ratio he wants to establish \nthe spread. There are two lines of thinking on this subject. The first is to merely buy \none future and sell one future (on two different indices, of course). Man", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 260}
{"text": "of whether one is entering into the spread because he is trying to \npredict the relationships between the cash indices, or because he knows the two \nrespective futures are out of line, he must decide in what ratio he wants to establish \nthe spread. There are two lines of thinking on this subject. The first is to merely buy \none future and sell one future (on two different indices, of course). Many chart books \nand spread history charts are graphed in this manner - they compare one index to \nanother index on a one-for-one basis. \nExample: A spreader wants to buy the ZYX Index futures and sell ABX futures \nagainst them. They are both trading in units of $500 per point, but ZYX is currently \nat 175.00 while ABX is at 130.00. Thus, the current differential is 45.00 points. This \nspreader would want the spread to widen to something larger in order to make \nmoney. The following profit table shows how he could make a $2,500 profit if the \nspread widens to 50.00 points, no matter which way the market goes. \nMarket ZYX ZYX ABX ABX Total \nDirection Price Profit Price Profit Profit \nup 185.00 +$5,000 135.00 -$2,500 +$2,500 \nneutral 177.00 + 1,000 127.00 + 1,500 + 2,500 \ndown 160.00 - 7,500 110.00 + 10,000 + 2,500 \nNotice that in each case, the difference in the prices of the indices ZYX and ABX is \n50.00 points. The profit is the same regardless of whether the general stock market \nrose, was relatively unchanged, or fell. \nThe $2,500 profit is the five points of profit that the spreader makes by buying \nthe spread of 45.00 and selling it at 50.00 (5.00 points x $500 per point = $2,500). \nThe second approach to index spreading is to use a ratio of the two indices. This \napproach is often taken when the two indices trade at substantially different prices. \nChpt,r 31: Index Spreading 581 \nJ!\"<>r example, if one index sells for twice the price of the other, and if both indices \nhave similar volatilities, then a one-to-one spread gives too much weight to the \nhigher-priced index. A two-to-one ratio would be better, for that would give equal \nweighting to the spread between the indices. \nExample: UVX is an index of stock prices that is currently priced at 100.00. ZYX, \nanother index, is priced at 200.00. The two indices have some similarities and, there\nfore, a spreader might want to trade one against the other. They also display similar \nvolatilities. \nIf one were to buy one UVX future and sell one ZYX future, his spread would \nbe too heavily oriented to ZYX price movement. The following table displays that, \nshowing that if both indices have similar percentage movements, the profit of the \none-by-one spread is dominated by the profit or loss in the ZYX future. Assume both \nfi1tures are worth $500 per point. \nMarket ZYX ZYX uvx uvx Total \nDirection Price Profit Price Profit Profit \nup 20% 240 -$20,000 120 +$10,000 -$10,000 \nup 10% 220 - 10,000 110 + 5,000 - 5,000 \ndown 10% 180 + 10,000 90 - 5,000 + 5,000 \ndown 20% 160 + 20,000 80 - 10,000 + 10,000 \nThis is not much of a hedge. If one wanted a position that reflected the movement \nof the ZYX index, he could merely trade the ZYX futures and not bother with a \nspread. \nIf, however, one had used the ratio of the indices to decide how many futures \nto buy and sell, he would have a more neutral position. In this example, he would buy \ntwo UVX futures and sell one ZYX future. \nProponents of using the ratio of indices are attempting strictly to capture any \nperformance difference between the two indices. They are not trying to predict the \noverall direction of the stock market. \nTechnically, the proper ratio should also include the volatility of the two indices, \nbecause that is also a factor in determining how fast they move in relationship to each \nother. \n582 Part V: Index Options and Futures \nwhere \np1 and p2 are the prices of the indices \nv 1 and v 2 are the respective volatilities \nand u1 and u2 are the units of trading ($500 per point, for example). \nIncluding the volatility ensures that one is spreading essentially equal \"volatili\nty dollars\" of each index. Moreover, if the two futures don't have the same unit of \ntrading, that should be factored in as well. \nExample: The ZYX Index is not very volatile, having a volatility of 15%. A trader is \ninterested in spreading it against the ABX Index, which is volatile, having a historical \nvolatility of 25%. The following data sum up the situation: \nUnit of \nPrice Volatility Trading \nZYX Futures 175.00 15% $250/pt \nABX Futures 225.00 25% $500/pt \nR . .25 225.00 500 abo=-X--X-\n.15 175.00 250 \n= 4.286 \nIn round numbers, one would probably trade four ZYX futures against one ABX \nfuture. \nINDEX CHARACTERISTICS \nBefore discussing specific spreads, it might be constructive to describe how the \nmakeup of the various indices that have listed options affects their price movements. \nThe Value Line Index is composed of 1,600 stocks, some of which are traded over the \ncounter. The Value Line Index movement is much more closely related to how small \nstocks perform, while the S&P 500 Index reflects more heavily the performance of \nthe large-capitalization stocks. In fact, it has been said that a chart of the Value Line \nIndex looks almost like the advance-decline line ( the running daily total of advances \nminus declines). The S&P 500, on the other hand, looks much more like the Dow\nJones 30 Industrials because of the heavy weighting given the large-capitalization \nstocks. \nThe S&P 100 (OEX) contains 100 stocks, but is capitalization-weighted and the \nstocks are generally the largest ones with listed options trading on the CBOE. Thus, \nits performance is much more like the S&P 500 and NYSE indices. The OEX is \nChapter 31: Index Spreading 583 \nslightly more volatile than these two larger indices, and also has more technology and \nless basic industry such as steel and chemicals. The OEX movement definitely has \ngood correlation to the S&P 500. The S&P 500 Index (SPX) currently trades at about \ntwice the \"speed\" of the OEX Ind", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 261}
{"text": "us, \nits performance is much more like the S&P 500 and NYSE indices. The OEX is \nChapter 31: Index Spreading 583 \nslightly more volatile than these two larger indices, and also has more technology and \nless basic industry such as steel and chemicals. The OEX movement definitely has \ngood correlation to the S&P 500. The S&P 500 Index (SPX) currently trades at about \ntwice the \"speed\" of the OEX Index. This has been true since OEX split 2-for-l in \nNovember 1997. A one-point move in SPX is approximately equal to a move of 7.5 \npoints in the Dow-Jones Industrial Average, while a one-point move in OEX is \napproximately equal to 15 Dow points. \nIn general, it is easier to spread the indices by using futures rather than options, \nalthough only the S&P 500 Index has liquid futures markets. (There is a mini-Value \nLine futures market, as well as Dow-Jones futures - both of which are fairly illiq\nuid - but no futures trade on OEX.) One reason for this is liquidity - the index \nfutures markets have large open interest. Another reason is tightness of markets. \nFutures markets are normally 5 or 10 cents wide, while option markets are 10 cents \nwide or more. Moreover, an option position that is a full synthetic requires both a put \nand a call. Thus, the spread in the option quotes comes into play twice. \nThe Japanese stock market can be spread against the U.S. markets by spread\ning a U.S. index against Nikkei futures or futures options, traded on the Chicago \nMere, or against JPN options, traded on the AMEX. \nINTER-INDEX SPREADS USING OPTIONS \nAs mentioned before, it may not be as efficient to try to use options in lieu of the \nactual futures spreads since the futures are more liquid. However, there are still \nmany applications of the inter-index strategy using options. \nOEX versus S&P 500. The OEX cash-based index options are the most liquid \noption contracts. Thus, any inter-index spread involving the OEX and other indices \nmust include the OEX options. \nThe S&P 100 was first introduced in 1982 by the CBOE. It was originally \nintended to be an S&P 500 look-alike whose characteristics would allow investors \nwho did not want to trade futures ( S&P 500 futures) the opportunity to be able to \ntrade a broad index by offering options on the OEX. Initially, the index was known as \nthe CBOE 100, but later the CBOE and Standard and Poor's Corp. reached an \nagreement whereby the index would be added to S&P's array of indices. It was then \nrenamed the S&P 100. \nInitially, the two indices traded at about the same price. The OEX was the more \nexpensive of the two for a while in the early 1980s. As the bull market of the 1980s \nmatured, the S&P 500 ground its way higher, eventually reaching a price nearly 30 \npoints higher than OEX. As one can see, there is ample room for movement in the \nspread between the cash indices. \n584 Part V: Index Options and Futures \nThe S&P 500 has more stocks, and while both indices are capitalization-weight\ned, 500 stocks include many smaller stocks than the 100-stock index. Also, the OEX \nis more heavily weighted by technology issues and is therefore slightly more volatile. \nFinally, the OEX does not contain several stocks that are heavily weighted in the S&P \n500 because those stocks do not have options listed on the CBOE: Procter and \nGamble, Philip Morris, and Royal Dutch, to name a few. There are two ways to \napproach this spread - either from the perspective of the derivative products differ\nential or by attempting to predict the cash spread. \nIn actual practice, most market-makers in the OEX use the S&P 500 futures to \nhedge with. Therefore, if the futures have a larger premium - are overpriced - then \nthe OEX calls will be expensive and the puts will be cheap. Thus, there is not as much \nof an opportunity to establish an inter-index spread in which the derivative products \n(futures and options in this case) spread differs significantly from the cash spread. \nThat is, the derivative products spread will generally follow the cash spread very \nclosely, because of the number of people trading the spread for hedging purposes. \nNevertheless, the application does arise, albeit infrequently, to spread the \npremium of the derivative products in two indices on strictly a hedged basis with\nout trying to predict the direction of movement of the cash indices. In order to \nestablish such a spread, one would take a position in futures and an opposite posi\ntion in both the puts and calls on OEX. Due to the way that options must be exe\ncuted, one cannot expect the same speed of execution that he can with the futures, \nunless he is trading from the OEX pit itself. Therefore, there is more of an execu\ntion risk with this spread. Consequently, most of this type of inter-index spreading \nis done by the market-makers themselves. It is much more difficult for upstairs \ntraders and customers. \nUSING OPTIONS IN INDEX SPREADS \nWhenever both indices have options, as most do, the strategist may find that he can \nuse the options to his advantage. This does not mean merely that he can use a syn\nthetic option position as a substitute for the futures position (long call, short put at \nthe same strike instead of long futures, for example). There are at least two other \nalternatives with options. First, he could use an in-the-money option as a substitute \nfor the future. Second, he could use the options' delta to construct a more leveraged \nspread. These alternatives are best used when one is interested in trading the spread \nbetween the cash indices - they are not really amenable to the short-term strategy of \nspreading the premiums between the futures. \nUsing in-the-money options as a substitute for futures gives one an additional \nadvantage: If the cash indices move far enough in either direction, the spreader could \nO,apter 31: Index Spreading 585 \nstill make money, even if he was wrong in his prediction of the relationship of the \ncash indices. \nExample: The following prices exist: \nZYX: 175.00 \nUVX: 15", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 262}
{"text": "ading the premiums between the futures. \nUsing in-the-money options as a substitute for futures gives one an additional \nadvantage: If the cash indices move far enough in either direction, the spreader could \nO,apter 31: Index Spreading 585 \nstill make money, even if he was wrong in his prediction of the relationship of the \ncash indices. \nExample: The following prices exist: \nZYX: 175.00 \nUVX: 150.00 \nZYX Dec 185 put: 10½ \nUVX Dec 140 call: 11 \nSuppose that one wants to buy the UVX index and sell the ZYX index. He \nexpects the spread between the two - currently at 25 points - to narrow. He could \nbuy the UVX futures and sell the ZYX futures. However, suppose that instead he buys \nthe ZYX put and buys the UVX call. \nThe time value of the Dec 185 put is 1/2 point and that of the Dec 140 call is 1 \npoint. This is a relatively small amount of time value premium. Therefore, the com\nbination would have results very nearly the same as the futures spread, as long as \nboth options remain in-the-money; the only difference would be that the futures \nspread would outperform by the amount of the time premium paid. \nEven though he pays some time value premium for this long option combina\ntion, the investor has the opportunity to make larger profits than he would with the \nfutures spread. In fact, he could even make a profit if the cash spread widens, if the \nindices are volatile. To see this, suppose that after a large upward move by the over\nall market, the following prices exist: \nZYX: 200.00 \nUVX: 170.00 \nZYX Dec 185 put: 0 ( virtually worthless) \nUVX Dec 140 call: 30 \nThe combination that was originally purchased for 21 ½ points is now worth 30, \nso the spread has made money. But observe what has happened to the cash spread: \nIt has widened to 30 points, from the original price of 25. This is a movement in the \nopposite direction from what was desired, yet the option position still made money. \nThe reason that the option combination in the example was able to make \nmoney, even though the cash spread moved unfavorably, is because both indices rose \nso much in price. The puts that were owned eventually became worthless, but the \nlong call continued to make money as the market rose. This is a situation that is very \nsimilar to owning a long strangle (long put and call with different strikes), except that \n586 Part V: Index Options and Futures \nthe put and call are based on different underlying indices. This concept is discussed \nin more detail in Chapter 35 on futures spreads. \nThe second way to use options in index spreading is to use options that are less \ndeeply in-the-money. In such a case, one must use the deltas of the options in order \nto accurately compute the proper hedge. He would calculate the number of options \nto buy and sell by using the formula given previously for the ratio of the indices, \nwhich incorporates both price and volatility, and then multiplying by a factor to \ninclude delta. \nwhere \nvi is the volatility of index i \nPi is the price of index i \nui is the unit of trading \nand di is the delta of the selected option on index i \nExample: The following data is known: \nZYX: 175.00, volatility= 20% \nUVX: 150.00, volatility = 15% \nZYX Dec 175 put: 7, delta= - .45, worth $500/pt. \nUVX Dec 150 call: 5, delta= .52, worth $100/pt \nSuppose one decides that he wants to set up a position that will profit if the \nspread between the two cash indices shrinks. Rather than use the deeply in-the\nmoney options, he now decides to use the at-the-money options. He would use the \noption ratio formula to determine how many puts and calls to buy. (Ignore the put's \nnegative delta for the purposes of this formula.) \n.20 175.00 500 .45 Option Ratio= -x ---x - x - = 6 731 .15 150.00 100 .52 . \nHe would buy nearly 7 UVX calls for every ZYX put purchased. \nIn the previous example, using in-the-money options, one had a very small \nexpense for time value premium and could profit if the indices were volatile, even if \nthe cash spread did not shrink. This position has a great deal of time value premium \ne:x--pense, but could make profits on smaller moves by the indices. Of course, either \none could profit if the cash indices moved favorably. \nCl,apter 31: Index Spreading 587 \nVolatility Differential. A theoretical \"edge\" that sometimes appears is that of \nvolatility differential. If two indices are supposed to have essentially the same volatil\nity, or at least a relationship in their volatilities, then one might be able to establish \nan option spread if that relationship gets out ofline. In such a case, the options might \nactually show up as fair-valued on both indices, so that the disparity is in the volatili\nty differential, and not in the pricing of the options. \nOEX and SPX options trade with essentially the same implied volatility. \nThus, if one index's options are trading with a higher implied volatility than the \nother's, a potential spread might exist. Normally, one would want the differential \nin implied volatilities to be at least 2% apart before establishing the spread for \nvolatility reasons. \nIn any case, whether establishing the spread because one thinks the cash index \nrelationship is going to change, or because the options on one index are expensive \nwith respect to the options on the other index, or because of the disparity in volatili\nties, the spreader must use the deltas of the options and the price ratio and volatili\nties of the indices in setting up the spread. \nStriking Price Differential. The index relationships can also be used by the \noption trader in another way. When an option spread is being established with \noptions whose strikes are not near the current index prices - that is, they are rela\ntively deeply in- or out-of-the-money- one can use the ratio between the indices to \ndetermine which strikes are equivalent. \nExample: ZYX is trading at 250 and the ZYX July 270 call is overpriced. An option \nstrategist might want to sell that call and hedge it with a call on another index. \nS", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 263}
{"text": "ng established with \noptions whose strikes are not near the current index prices - that is, they are rela\ntively deeply in- or out-of-the-money- one can use the ratio between the indices to \ndetermine which strikes are equivalent. \nExample: ZYX is trading at 250 and the ZYX July 270 call is overpriced. An option \nstrategist might want to sell that call and hedge it with a call on another index. \nSuppose he notices that calls on the UVX Index are trading at approximately fair \nvalue with the UVX Index at 175. What UVX strike should he buy to be equivalent \nto the ZYX 270 strike? \nOne can multiply the ZYX strike, 270, by the ratio of the indices to arrive at the \nUVX strike to use: \nUVX strike= 270 x (175/250) \n= 189.00 \nSo he would buy the UVX July 190 calls to hedge. The exact number of calls to \nbuy would be determined by the formula given previously for option ratio. \n588 \nSUMMARY \nPart V: Index Options and Futures \nThis concludes the discussion of index spreading. The above examples are intended \nto be an overview of the most usable strategies in the complex universe of index \nspreading. The multitude of strategies involving inter-index and intra-index spreads \ncannot all be fully described. In fact, one's imagination can be put to good use in \ndesigning and implementing new strategies as market conditions change and as the \nemotion in the marketplace drives the premium on the futures contracts. \nOften one can discern a usable strategy by observation. Watch how two popu\nlar indices trade with respect to each other and observe how the options on the two \nindices are related. If, at a later time, one notices that the relationship is changing, \nperhaps a spread between the indices is warranted. One could use the NASDAQ\nbased indices, such as the NASDAQ-100 (NDX) or smaller indices based on it (QQQ \nor MNX). Sector indices can be used as well. This brings into play a fairly large num\nber of indices with listed options (few, if any, of which have futures), such as the \nSemiconductor Index (SOX), the Oil & Gas Index (XOI), the Gold and Silver Index \n(XAU), etc. The key point to remember is that the index option and futures world is \nmore diverse than that of stock options. Stock option strategies, once learned or \nobserved, apply equally well to all stocks. Such is not the case with index spreading \nstrategies. The diversification means that there are more profit opportunities that are \nrecognized by fewer people than is the case with stock options. The reader is thus \nchallenged to build upon the concepts described in this part of the book. \nStructured Products \nThe popularity of derivative instruments and the kinds of risk-reducing, volatility\nreducing effects that they can have on portfolios led to a new type of product in the \n1990s. This new product, termed a structured product, has more appeal for investors \nthan for traders. In essence, enterprising designers at the major institutional broker\nage firms have constructed a single security that behaves like a portfolio hedged by \noptions. These designers structure the combination of derivatives and stocks so that \nthe resulting product behaves in a manner that is attractive to many investors, \nwhether institutional or private. In this chapter, these structured products are exam\nined in detail, to give the reader the background so that in the future, he may ana\nlyze similar products for himself. \nWould you like to own an index fund that had no risk? Or, how about owning a \npopular stock and getting a dividend payment that is much, much larger than the \nstock itself pays? I think everyone would like to do those things. With structured \nproducts, one can own similar investments, but they come with a cost. The two ques\ntions asked previously might then be better restated as follows: Would you like to \nown an index fund that had no risk, but that perhaps did not fully participate in all of \nthe upside movement of the market? It still has downside protection, and unlimited \nprofit potential on the upside. This is akin to owning the stock or the index and hav\ning protected it by buying a put option. Or, would you like to own that popular stock \nand receive that huge dividend, but know that your profit potential is limited to a \nfixed amount on the upside? This is akin to a covered call write. \nThese two questions describe the majority of the listed structured products in \nexistence today. They are attractive investments in their own right, but one must \ncarefully assess the products before buying them. This chapter is divided into two \nmain parts to discuss the two types of products: First, we'll discuss the \"protected\" \nstock or index. Later, the discussion will tum to \"covered write\" products. \n589 \n590 Part V: Index Options and Futures \nThe discussion in this chapter concentrates on the structured products that are \nlisted and traded on the major stock exchanges. A broader array of products -\ntypically called exotic options - is traded over-the-counter. These can be very com\nplicated, especially with respect to currency and bond options. It is not our intent to \ndiscuss exotic options, although the approaches to valuing the structured products \nthat are presented in this chapter can easily be applied to the overall valuation of \nmany types of exotic products. Also, the comments at the end of the chapter regard\ning where to find information about these products may prove useful for those seek\ning further information about either listed structured products or exotic options. \nPart I: \"Riskless\" Ownership \nof a Stock or Index \nTHE \"STRUCTURE\" OF A STRUCTURED PRODUCT \nAt many of the major institutional banks and brokerages, people are employed who \ndesign structured products. They are often called financial engineers because they \ntake existing financial products and build something new with them. The result is \npackaged as a fund of sorts (or a unit trust, perhaps), and shares are sold to the pub\nlic. Not only that, but the shares are then lis", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 264}
{"text": "UCTURED PRODUCT \nAt many of the major institutional banks and brokerages, people are employed who \ndesign structured products. They are often called financial engineers because they \ntake existing financial products and build something new with them. The result is \npackaged as a fund of sorts (or a unit trust, perhaps), and shares are sold to the pub\nlic. Not only that, but the shares are then listed on the American or New York Stock \nExchanges and can be traded just like any other stock. These attributes make the \nstructured product a very desirable investment. An example will show how a generic \nindex structured product might look. \nExample: Let's look at the structured index product to see how it might be designed \nand then how it might be sold to the public. Suppose that the designers believe there \nis demand for an index product that has these characteristics: \n1. This \"index product\" will be issued at a low price - say, $10 per share. \n2. The product will have a maturity date - say, seven years hence. \n3. The owner of these shares can redeem them at their maturity date for the \ngreater of either a) $10 per share orb) the percentage appreciation of the \nS&P 500 index over that seven-year time period. That is, if the S&P doubles \nover the seven years, then the shares can be redeemed for double their issue \nprice, or $20. \nThus, this product has no price risk! The holder gets his $10 back in the worst \ncase (except for credit risk, which will be addressed in a minute). \nMoreover, these shares will trade in the open market during the seven years, so \nthat if the holder wants to exit at any time, he can do so. Perhaps the S&P has rallied \nO,apter 32: Structured Products 591 \ndramatically, or perhaps he needs cash for something else - both might be reasons \nthat the holder of the shares would want to sell before maturity. \nSuch a product has appeal to many investors. In fact, if one thought that the \nstock market was a \"long-term\" buy, this would be a much safer way to approach it \nthan buying a portfolio of stocks that might conceivably be much lower in value seven \nyears hence. The risk of the structured product is that the underwriter might not be \nable to pay the $10 obligation at maturity. That is, if the major institutional bank or \nbrokerage firm who underwrote these products were to go out of business over the \ncourse of the next seven years, one might not be able to redeem them. In essence, \nthen, structured products are really forms of debt (senior debt) of the brokerage firm \nthat underwrote them. Fortunately, most structured products are underwritten by \nthe largest and best-capitalized institutions, so the chances of a failure to pay at matu\nrity would have to be considered relatively tiny. \nHow does the bank create these items? It might seem that the bank buys stock \nand buys a put and sells units on the combined package. In reality, the product is not \nnormally structured that way. Actually, it is not a difficult concept to grasp. This \nexample shows how the structure looks from the viewpoint of the bank: \nExample: Suppose that the bank wants to raise a pool of $1,000,000 from investors \nto create a structured product based on the appreciation of the S&P 500 index over \nthe next seven years. The bank will use a part of that pool of money to buy U.S. zero\ncoupon bonds and will use the rest to buy call options on the S&P 500 index. \nSuppose that the U.S. government zero-coupon bonds are trading at 60 cents \non the dollar. Such bonds would mature in seven years and pay the holder $1.00. \nThus, the bank could take $600,000 and buy these bonds, knowing that in seven \nyears, they would mature at a value of $1,000,000. The other $400,000 is spent to buy \ncall options on the S&P 500 index. Thus, the investors would be made whole at the \nend of seven years even if the options that were bought expired worthless. This is why \nthe bank can \"guarantee\" that investors will get their initial money back. \nMeanwhile, if the stock market advances, the $400,000 worth of call options will \ngain value and that money will be returned to the holders of the structured product \nas well. \nIn reality, the investment bank uses its own money ($1,000,000) to buy the secu\nrities necessary to structure this product. Then they make the product into a legal \nentity (often a unit trust) and sell the shares (units) to the public, marking them up \nslightly as they would do with any new stock brought to market. \nAt the time of the initial offering, the calls are bought at-the-money, meaning \nthe striking price of the calls is equal to the closing price of the S&P 500 index on the \n592 Part V: Index Options and Futures \nday the products were sold to the public. Thus, the structured product itself has a \n\"strike price\" equal to that of the calls. It is this price that is used at maturity to deter\nmine whether the S&P has appreciated over the seven-year period - an event that \nwould result in the holders receiving back more than just their initial purchase price. \nAfter the initial offering, the shares are then listed on the AMEX or the NYSE \nand they will begin to rise and fall as the value of the S&P 500 index fluctuates. \nSo, the structured product is not an index fund protected by a put option, but \nrather it is a combination of zero-coupon government bonds and a call option on an \nindex. These two structures are equivalent, just as the combination of owning stock \nprotected by a put option is equivalent to being long a call option. \nStructured products of this type are not limited to indices. One could do the \nsame thing with an individual stock, or perhaps a group of stocks, or even create a \nsimulated bull spread. There are many possibilities, and the major ones will be dis\ncussed in the following sections. In theory, one could construct products like this for \nhimself, but the mechanics would be too difficult. For example, where is one going \nto buy a seven-year option in small quantity? Thus, it is often", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 265}
{"text": "thing with an individual stock, or perhaps a group of stocks, or even create a \nsimulated bull spread. There are many possibilities, and the major ones will be dis\ncussed in the following sections. In theory, one could construct products like this for \nhimself, but the mechanics would be too difficult. For example, where is one going \nto buy a seven-year option in small quantity? Thus, it is often worthwhile to avail one\nself of the product that is packaged (structured) by the investment banker. \nIn actuality, many of the brokerage firms and investment banks that undetwrite \nthese products give them names - usually acronyms, such as MITTS, TARGETS, \nBRIDGES, LINKS, DINKS, ELKS, and so on. If one looks at the listing, he may see \nthat they are called notes rather than stocks or index funds. Nevertheless, when the \nterms are described, they will often match the examples given in this chapter. \nINCOME TAX CONSEQUENCES \nThere is one point that should be made now: There is \"phantom interest\" on a struc\ntured product. Phantom interest is what one owes the government when a bond is \nbought at a discount to maturity. The IRS technically calls the initial purchase price \nan Original Issue Discount (OID) and requires you to pay taxes annually on a pro\nportionate amount of that OID. For example, if one buys a zero-coupon U.S. gov\nernment bond at 60 cents on the dollar, and later lets it mature for $1.00, the IRS \ndoes not treat the 40-cent profit as capital gains. Rather, the 40 cents is interest \nincome. Moreover, says the IRS, you are collecting that income each year, since you \nbought the bonds at a discount. (In reality, of course, you aren't collecting a thing; \nyour investment is simply worth a little more each year because the discount decreas\nes as the bonds approach maturity.) However, you must pay income tax on the \"phan-\nChapter 32: Structured Products 593 \ntom interest\" you supposedly received each year. Those are the rules, and there isn't \nanything you can do about them. \nSince some structured products involve the purchase of zero-coupon bonds, the \nIRS has ruled that owners of this type of structured product must pay phantom inter\nest each year. Thus, structured products should be bought in a tax-free retirement \naccount (IRA, SEP, etc.) if at all possible, in order to avoid having to declare phan\ntom interest on your tax return for each year you hold the product. The phantom \ninterest tax applies only to this type of structured product - one on which you are \nguaranteed to get back a fixed amount at maturity - because this is the only type that \nrequires buying a zero-coupon bond in order to ensure that you'll get your money \nback if the stock market goes down. The phantom interest concept does not apply to \nthe type of structured product to be discussed in the second part of this chapter. To \nbe certain, one should get the necessary information from his broker or should read \nthe prospectus of the structured product. Of course, any tax strategies should also be \ndiscussed with a qualified tax professional. \nCASH VALUE \nThe cash value of the structured product is what it will be worth at maturity. It is usu\nally stated in terms similar to those in the preceding example, and a formula is often \ngiven. This example will clarify the typical nature of this formula: \nExample: A structured product is issued at $10 per share. The terms stipulate that \nthe holder will receive back, at maturity, either $10 or 100% of the appreciation of \nthe S&P 500 index above a value of 1,245.27. (One would assume that the S&P 500 \ncash index closed at 1,245.27 on the day the structured product was issued.) The \nprospectus will usually provide a formula for the cash surrender value, and it will be \nstated something like this: \nAt maturity, the cash value will be equal to the greater of: \n(a) $10 \nor (b) $10 + 10 x (Final Index Value - 1,245.27) / 1,245.27 \nwhere Final Index Value is, say, the closing value of the S&P 500 \nindex on the maturity date. \nThe formula given is merely the arithmetic equivalent of the statement that one \nwill receive 100% of the appreciation of the S&P 500 Index above the strike price of \n1,245.27. For those more adept at math, the formula can be reduced to common \nterms, in which case it reads: \n594 Part V: Index Options and Futures \nCash Surrender Value = $10 x Final Value/ 1,245.27 \nThis shortened version of the formula only works, though, when the participa\ntion rate is 100% of the increase in the Final Index Value above the striking price. \nOtherwise, the longer formula should be used. \nNot all structured products of this type offer the holder 100% of the appreci\nation of the index over the initial striking price. In some cases, the percentage is \nsmaller ( although in the early days of issuance, some products offered a percentage \nappreciation that was actually greater than 100%). After 1996, options in general \nbecame more expensive as the volatility of the stock market increased tremendous\nly. Thus, structured products issued after 1997 or 1998 tend to include an \"annual \nadjustment factor.\" Adjustment factors are discussed later in the chapter. \nTherefore, a more general formula for Cash Surrender Value - one that applies \nwhen the participation rate is a fixed percentage of the striking price - is: \nCash Surrender Value = \nGuarantee + Guarantee x Participation Rate x (Final Index Value/ Striking Price - I) \nTHE COST OF THE IMBEDDED CALL OPTION \nFew structured products pay dividends. 1 Thus, the \"cost\" of owning one of these \nproducts is the interest lost by not having your money in the bank ( or money market \nfund), but rather having it tied up in holding the structured product. \nContinuing with the preceding example, suppose that you had put the $10 in \nthe bank instead of buying a structured product with it. Let's further assume that the \nmoney in the bank earns 5% interest, compounded continuously. At the end of seven \nyears, compounded continuously, the $10 would be", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 266}
{"text": "in the bank ( or money market \nfund), but rather having it tied up in holding the structured product. \nContinuing with the preceding example, suppose that you had put the $10 in \nthe bank instead of buying a structured product with it. Let's further assume that the \nmoney in the bank earns 5% interest, compounded continuously. At the end of seven \nyears, compounded continuously, the $10 would be worth: \nMoney in the bank = Guarantee Price x ert \n= $10 x e 0-05 x 7 = 14.191, in this case \nThis calculation usually raises some eyebrows. Even compounded annually, the \namount is 14.07. You would make roughly 40% (without considering taxes) just by \n1Some do pay dividends, though. A structured product existed on a contrived index, called the Dow-Jones \nTop 10 Yield index (symbol: $XMT). This is a sort of \"dogs of the Dow\" index. Since part of the reason for owning a \n\"dogs of the Dow\" product is that dividends are part of the performance, the creators of the structured product \n(Merrill Lynch) stated that the minimum price one would receive at maturity would be 12.40, not the 10 that was \nthe initial offering price. Thus, this particular structured product had a \"dividend\" built into it in the form of an ele\nvated minimum price at maturity. \nChapter 32: Structured Products 595 \nhaving your money in the bank. Forgetting structured products for a moment, this \nmeans that stocks in general would have to increase in value by over 40% during the \nseven-year period just for your performance to beat that of a bank account. \nIn this sense, the cost of the imbedded call option in the structured product is \nthis lost interest - 4.19 or so. That seems like a fairly expensive option, but if you con\nsider that it's a seven-year option, it doesn't seem quite so expensive. In fact, one \ncould calculate the implied volatility of such a call and compare it to the current \noptions on the index in question. \nIn this case, with the stock at 10, the strike at 10, no dividends, a 5% interest \nrate, and seven years until expiration, the implied volatility of a call that costs $4.19 \nis 28.1 %. Call options on the S&P 500 index are rarely that expensive. So you can see \nthat you are paying \"something\" for this call option, even if it is in the form of lost \ninterest rather than an up-front cost. \nAs an aside, it is also unlikely that the underwriter of the structured product \nactually paid that high an implied volatility for the call that was purchased; but he is \nasking you to pay that amount. This is where his underwriting profit comes from. \nThe above example assumed that the holder of the structured product is par\nticipating in 100% of the upside gain of the underlying index over its striking price. \nIf that is not the case, then an adjustment has to be made when computing the price \nof the imbedded option. In fact, one must compute what value of the index, at matu\nrity, would result in the cash value being equal to the \"money in the bank\" calcula\ntion above. Then calculate the imbedded call price, using that value of the index. In \nthat way, the true value of the imbedded call can be found. \nYou might ask, \"Why not just divide the 'money in the bank' formula by the par\nticipation rate?\" That would be okay if the participation were always stated as a per\ncentage of the striking price, but sometimes it is not, as we will see when we look at \nthe more complicated examples. Further examples of structured products in this \nchapter demonstrate this method of computing the cost of the imbedded call. \nPRICE BEHAVIOR PRIOR TO MATURITY \nThe structured product cannot normally be \"exercised\" by the holder until it \nmatures. That is, the cash surrender value is only applicable at maturity. At any other \ntime during the life of the product, one can compute the cash surrender value, but \nhe cannot actually attain it. What you can attain, prior to maturity, is the market price, \nsince structured products trade freely on the exchange where they are listed. In actu\nal fact, the products generally trade at a slight discount to their theoretical cash sur\nrender value. This is akin to a closed-end mutual fund selling at a discount to net \n596 Part V: Index Options and Futures \nasset value. Eventually, upon maturity, the actual price will be the cash surrender \nvalue price; so if you bought the product at a discount, you would benefit, providing \nyou held all the way to maturity. \nExample: Assume that two years ago, a structured product was issued with an initial \noffering price of $10 and a strike price of 1,245.27, based upon the S&P 500 index. \nSince issuance, the S&P 500 index has risen to 1,522.00. That is an increase of \n22.22% for the S&P 500, so the structured product has a theoretical cash surrender \nvalue of 12.22. I say \"theoretical\" because that value cannot actually be realized, since \nthe structured product is not exercisable at the current time - five years prior to \nmaturity. \nIn the real marketplace, this particular structured product might be trading at \na price of 11. 75 or so. That is, it is trading at a discount to its theoretical cash sur\nrender value. This is a fairly common occurrence, both for structured products and \nfor closed-end mutual funds. If the discount were large enough, it should serve to \nattract buyers, for if they were to hold to maturity, they would make an extra 4 7 cents \n(the amount of this discount) from their purchase. That's 4% (0.47 divided by 11.75 \n= 4%) over five years, which is nothing great, but it's something. \nWhy does the product trade at a discount? Because of supply and demand. It is \nfree to trade at any price - premium or discount - because there is nothing to keep \nit fixed at the theoretical cash surrender value. If there is excess demand or supply in \nthe open market, then the price of the structured product will fluctuate to reflect that \nexcess. Eventually, of course, the discount will disappear, but five years prior to \nmaturity, one will often find that the product di", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 267}
{"text": "free to trade at any price - premium or discount - because there is nothing to keep \nit fixed at the theoretical cash surrender value. If there is excess demand or supply in \nthe open market, then the price of the structured product will fluctuate to reflect that \nexcess. Eventually, of course, the discount will disappear, but five years prior to \nmaturity, one will often find that the product differs from its theoretical value by \nsomewhat significant amounts. If the discount is large enough, it will attract buyers; \nalternatively, if there should be a large premium, that should attract sellers. \nSIS \nOne of the first structured products of this type that came to my attention was one \nthat traded on the AMEX, entitled \"Stock Index return Security\" or SIS. It also trad\ned under the symbol SIS. The product was issued in 1993 and matured in 2000, so \nwe have a complete history of its movements. The terms were as follows: The under\nlying index was the S&P Midcap 400 index (symbol: $MID). Issued in June 1993, the \noriginal issue price was $10, and $MID was trading at 166.10 on the day of issuance, \nso that was the striking price. Moreover, buyers were entitled to 115% of the appre\nciation of $MID above the strike price. Thus, the cash value formula was: \nGopter 32: Structured Products 597 \nCash value of SIS $10 + $10 x 1.15 x ($MID - 166.10) / 166.10 \nwhere \nGuarantee price = $10 \nUnderlying index: S&P Midcap 400 ($MID) \nStriking price: 166.10 \nParticipation rate: 115% of the increase of $MID above 166.10 \nSIS matured seven years later, on June 2, 2000. At the time of issuance, seven-year \ninterest rates were about 5.5%, so the \"money in the bank\" formula shows that one \ncould have made about 4.7 points on a $10 investment, just by utilizing risk-free gov\nernment securities: \nMoney in the bank= 10 x e0-055 x 7 = 14.70 \nWe can't simply say that the cost of the imbedded call was 4. 7 points, though, because \nthe participation rate is not 100% - it's greater. So we need to find out the Final Value \nof $MID that results in the cash value being equal to the \"money in the bank\" result. \nUsing the cash value formula and inserting all the terms except the final value of \n$MID, we have the following equation. Note: $MIDMIB stands for the value of $MID \nthat results in the \"money in the bank\" cash value, as computed above. \n14.70 = 10 + 10 X 1.15 X ($MIDMIB 166.10) I 166.10 \nSolving for $MIDMIB' we get a value of 233.98. Now, convert this to a percent \ngain of the striking price: \nImbedded call price = 233.98 I 166.10 - 1 = 0.4087 \nHence, the imbedded call costs 40.87% of the guarantee price. In this example, \nwhere the guarantee price was $10, that means the imbedded call cost $4.087. \nThus, a more generalized formula for the value of the imbedded call can be \nconstrued from this example. This formula only works, though, where the participa\ntion rate is a fixed percentage of the strike price. \nImbedded call value= Guarantee price x (Final Index ValueMIB / Striking Price - 1) \nFinal Index ValueMIB is the final index price that results in the cash value \nbeing equal to the \"money in the bank\" calculation, where \nMoney in the bank = Guarantee Price x ert \nr = risk-free interest rate \nt = time to maturity \nThus, the calculated value of the imbedded call was approximately 4.087 points, \nwhich is an implied volatility of just over 26%. At the time, listed short-term options \n598 Part V: Index Options and Futures \non $MID were trading with an implied volatility of about 14%, so this was an expen\nsive call in terms of its initial cost. \nHowever, one should remember that owning SIS gave one more than full par\nticipation in the $MID for seven years, with virtually no risk. That has to be worth \nsomething. \nAs it turned out, $MID was strong during this seven-year period, and SIS \nwound up being worth just over $30 per share. So, in the end, the owner of SIS \ntripled his money in seven years and had no risk to begin with. Not a bad scenario. \nSIS TRACK RECORD \nWhat SIS also imparts to us, though, is a track record of how it traded during its life. \nFigure 32-1 shows the discount at which SIS traded during its lifetime. It is the lower \nline on the chart. The upper line is the corresponding cash value on the same dates. \nNote that the upper line has the exact same shape as the S&P Midcap 400 ($MID) \nwould, since it is merely $MID multiplied by some arithmetic constant. The graph of \nthe discount is rather \"choppy\" because it uses last sales of SIS to compute the dis\ncount. In reality, since SIS was a somewhat low-volume security, the last sale was not \nalways representative of the closing bid-asked market in SIS. Nevertheless, the \ngraph shows that the discount was greater than 2 points at the left side of the graph \n(1995) and gradually decreased until it reached zero near maturity (2000). \nThe graph in Figure 32-1 is useful because it encompasses cases where $MID \ntraded both above and below the striking price of 166.10. No matter whether SIS was \nin-the-money ($MID above 166.1) or out-of-the-money, SIS traded at a discount. As \nmentioned previously, this is akin to a closed-end mutual fund trading at a discount \nto net asset value. \nAt a minimum, this discount allows the buyer of SIS to add an additional com\nponent of overall return to his investment. Also, in some cases - when $MID was \ntrading below the striking price - the buyer of SIS actually has a guaranteed return, \nas one might have with a bond paying interest or a stock paying a dividend. The \nexamples in the next section examine those situations. \nSIS TRADING AT A DISCOUNT TO CASH VALUE \nWhen SIS is trading at a discount to cash value, the buyer of SIS actually has some \ndownside protection. \nExample: In late 1996, $MID closed at 238.54 one day, and SIS closed at 13. The \ncash value of SIS for that price of $MID is: \nCash Value = 10 + 10 x 1.15 x (238.54/166.10 - 1) = 15.02 \nCbapter 32: Strudured Products \nFIGURE 32-1. \nSIS trading at a discount. \nC", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 268}
{"text": "NG AT A DISCOUNT TO CASH VALUE \nWhen SIS is trading at a discount to cash value, the buyer of SIS actually has some \ndownside protection. \nExample: In late 1996, $MID closed at 238.54 one day, and SIS closed at 13. The \ncash value of SIS for that price of $MID is: \nCash Value = 10 + 10 x 1.15 x (238.54/166.10 - 1) = 15.02 \nCbapter 32: Strudured Products \nFIGURE 32-1. \nSIS trading at a discount. \nCash Value and SIS Discount \n30 \n20 \n10 \n0 \n-1 \n-2 \n1997 \nDate· \n599 \nTherefore, SIS is trading at almost exactly a 2-point discount to cash value. That \nis a fairly large discount of 15.4% (2/13 = .154). \nOne way to look at this would be to say that an investor is making an \"extra\" \n15.4% on his investment. That is, if $MID were at exactly the same price at expira\ntion, the cash value would be the settlement price - 15.02. In other words, the \"stock \nmarket\" as measured by $MID was exactly unchanged. However, the investor would \nmake a return of 15.4% because he bought SIS at a discount. \nIn fact, no matter where $MID is at maturity, the investor feels the positive \neffect of having bought at a discount. \nThus, the discount can and should be perceived as adding to the overall return of \nowning the structured product. These discounts to net asset value are commonplace \nwith structured products. However, there is another way to view it: as downside pro\ntection. \nExample: Using the same prices, $MID is at 238.54 and SIS is at 13 - a 15.4% dis\ncount to the cash value of 15.02. Another way to view what this discount means is to \nview it as downside protection. In other words, $MID could decline in price by matu\nrity and this investor could still break even. The exact amount of the downside pro\ntection can be calculated. Essentially, one wants to know, at what price for $MID \nwould the cash value be 13? \n600 Part V: Index Options and Futures \nSolving the following equation for $MID would give the desired answer: \nCash Value = 13 = 10 + 11.5 x ($MID/166.l - 1) \n3 = 11.5 x $MID/ 166.1 - 11.5 \n14.5 x 166.1 / 11.5 = $MID \n209.43 = $MID \nSo, if $MID were at 209.43, the cash value would be 13 - the price the investor \nis currently paying for SIS. This is protection of 12.2% down from the current price \nof 238.54. That is, $MID could decline 12.2% at maturity, from the current price of \n238.54 to a price of 209.43, and the investor who bought SIS would break even \nbecause it would still have a cash value of 13. \nOf course, this discount could have been computed using the SIS prices of 13 \nand 15.02 as well, but many investors prefer to view it in terms of the underlying \nindex - especially if the underlying is a popular and often-cited index such as the S&P \n500 or Dow-Jones Industrials. \nFrom Figure 32-1, it is evident that the discount persisted throughout the \nentire life of the product, shrinking more or less linearly until expiration. \nSIS TRADING AT A DISCOUNT TO THE GUARANTEE PRICE \nIn the previous example, the investor could have bought SIS at a discount to its cash \nvalue computation, but if the stock market had declined considerably, he would still \nhave had exposure from his SIS purchase price of 13 down to the guarantee price of \n10. The discount would have mitigated his percentage loss when compared to the \n$MID index itself, but it would be a loss nevertheless. \nHowever, there are sometimes occasions when the structured product is trad\ning at a discount not only to cash value, but also to the guarantee price. This situation \noccurred frequently in the early trading life of SIS. From Figure 32-1, you can see \nthat in 1995 the cash value was near 11, but SIS was trading at a discount of more \nthan 2 points. In other words, SIS was trading below its guarantee price, while the \ncash value was actually above the guarantee price. It is a \"double bonus\" for an \ninvestor when such a situation occurs. \nExample: In February 1995, the following prices existed: \n$MID: 177.59 \nSIS: 8.75 \nFor a moment, set aside considerations of the cash value. If one were to buy SIS \nat 8. 75 and hold it for the 5.5 years remaining until maturity, he would make 1.25 \npoints on his 8.75 investment- a return of 14.3% for the 5.5-year holding period. As \na compounded rate of interest, this is an annual compound return of 2.43%. \nCl,apter 32: Structured Produds 601 \nNow, a rate of return of 2.43% is rather paltry considering that the risk-free \nT•bill rate was more than twice that amount. However, in this case, you own a call \noption on the stock market and get to earn 2.43% per year while you own the call. In \nother words, \"they\" are paying you to own a call option! That's a situation that \ndoesn't arise too often in the world of listed options. \nIf we introduce cash value into this computation, the discrepancy is even larg\ner. Using the $MID price of 177.59, the cash value can be computed as: \nCash Value = 10 + 11.5 x (177.59/166.10 - 1) = 10.80 \nThus, with SIS trading at 8. 75 at that time, it was actually trading at a whopping \n19% discount to its cash value of 10.80. Even if the stock market declined, the guar\nantee price of 10 was still there to provide a minimal return. \nIn actual practice, a structured product will not normally trade at a discount to its \nguarantee price while the cash value is higher than the guarantee price. There's only \na narrow window in which that occurs. \nThere have been times when the stock market has declined rather substantial\nly while these products existed. We can observe the discounts at which they then \ntraded to see just how they might actually behave on the downside if the stock mar\nket declined after the initial offering date. Consider this rather typical example: \nExample: In 1997, Merrill Lynch offered a structured product whose underlying \nindex was Japan's Nikkei index. At the time, the Nikkei was trading at 20,351, so that \nwas the striking price. The participation rate was 140% of the increase of the Nikkei \nabove 20,351 - a very favorable participation rate. This structured prod", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 269}
{"text": "d after the initial offering date. Consider this rather typical example: \nExample: In 1997, Merrill Lynch offered a structured product whose underlying \nindex was Japan's Nikkei index. At the time, the Nikkei was trading at 20,351, so that \nwas the striking price. The participation rate was 140% of the increase of the Nikkei \nabove 20,351 - a very favorable participation rate. This structured product, trading \nunder the symbol JEM, was designed to mature in five years, on June 14, 2002. \nAs it turned out, that was about the peak of the Japanese market. By October of \n1998, when markets worldwide were having difficulty dealing with the Russian debt \ncrisis and the fallout from a major hedge fund in the U.S. going broke, the Nikkei had \nplummeted to 13,300. Thus, the Nikkei would have had to increase in price by just \nover 50% merely to get back to the striking price. Hence, it would not appear that \nJEM was ever going to be worth much more than its guarantee price of 10. \nSince we have actual price histories of JEM, we can review how the market\nplace viewed the situation. In October 1998, JEM was actually trading at 8.75 - only \n1.25 points below its guarantee price. That discount equates to an annual com\npounded rate of 3.64%. In other words, if one were to buy JEM at 8.75 and it \nmatured at 10 about 40 months later, his return would have been 3.64% compound\ned annually. That by itself is a rather paltry rate of return, but one must keep in mind \nthat he also would own a call option on the Nikkei index, and that option has a 140% \nparticipation rate on the upside. \n602 Part V: Index Options and Futures \nCOMPUTING THE VALUE OF THE IMBEDDED CALL WHEN \nTHE UNDERLYING IS TRADING AT A DISCOUNT \nCan we compute the value of the imbedded call when the structured product itself \nis trading at a discount to its guarantee price? Yes, the formulae presented earlier can \nalways be used to compute the value of the imbedded call. \nExample: Again using the example of JEM, the structured product on the Nikkei \nindex, recall that it was trading at 8. 75 with a guaranteed price of 10, with maturity \n40 months hence. Assume that the risk-free interest rate at the time was 5.5%. \nAssuming continuous compounding, $8.75 invested today would be worth $10.51 in \n40 months. \nMoney in the bank = 8. 75 x ert \nwhere r = 0.05 and t = 3.33 years (40 months) \nMoney in the bank= 8.75 x e0-055 x 3-333 = 10.51 \nSince the structured product will be worth 10 at maturity, the value of the call \nis 0.51. \nThere is another, nearly equivalent way to determine the value of the call. It \ninvolves determining where the structured product would be trading if it were com\npletely a zero-coupon debt of the underwriting brokerage. The difference between \nthat value and the actual trading price of the structured product is the value of the \nimbedded call. \nThe credit rating of the underwriter of the structured product is an important \nfactor in how large a discount occurs. Recall that the guarantee price is only as good \nas the creditworthiness of the underwriter. The underwriter is the one who will pay \nthe cash settlement value at maturity - not the exchange where the product is listed \nnor any sort of clearinghouse or corporation. \nTHE ADJUSTMENT FACTOR \nIn recent years, some of the structured products have been issued with an adjustment \nfactor. The adjustment factor is generally a negative thing for investors, although the \nunderwriters try to couch it in language that makes it difficult to discern what is going \non. Simply put, the adjustment factor is a multiplier (less than 100%) applied to the \nunderlying index value before calculating the Final Cash Value. Adjustment factors \nseemed to come into being at about the time that index option implied volatility \nbegan to trade at much higher levels than it ever had (1997 onward). \nCl,opter 32: Structured Products 603 \nExample: A structured product is issued at an initial price of $10. It ostensibly allows \none to participate in the appreciation of the S&P 500 index over a price of 1,100.00. \nHowever, upon closer inspection, what the product really offers is the opportunity for \none to participate in the appreciation of the S&P 500 index ($SPX) over an adjusted \nvalue, which is a percentage of the $SPX price - not the actual price itself. The cash \nvalue settlement formula is stated as: \nCash settlement value = 10 + 10 x (Adjusted $SPX - 1,100.00) / 1,100.00 \nThe formula looks similar to the \"normal\" cash settlement value formulae \nshown earlier in the chapter, but the term \"adjusted $SPX\" has yet to be defined. In \nfact, it is defined as a percentage of the final $SPX Price - 91.25% in this case. In real\nity, the prospectus says something to the effect that the final price of $SPX will be \nadjusted downward by an annual adjustment factor of 1.25%. Thus, at the end of the \nseven-year maturity period, the total adjustment factor would be seven times 1.25%, \nor 8.75%. The adjusted value is then equal to 100% - 8.75%, or 91.25%. \nThe adjustment factor is an onerous burden for the investor. It means that the final \nvalue of $SPX will be reduced by the adjustment factor before it is determined how \nfar, or if at all, $SPX is above the striking price of 1,100.00. \nExample: Suppose that $SPX exactly doubles in price during the life of the example \nstructured product. That is, it finishes at 2,200.00 - exactly twice the amount of the \nstriking price. Before the cash settlement value can be determined, $SPX must be \nadjusted: \n$SPX adjusted value = 0.9125 x 2,200.00 = 2,007.50 \nSo the final cash settlement value is based on the adjusted value of $SPX: \nCash settlement value = 10 + 10 x (2,007.50 - l,100.00)/1,100.00 = 18.25 \nHence, instead of doubling your money, as you might expect to do since the \n$SPX Index doubled in price, you \"only\" make 82.5%. \nAnother way to view it: If the index doubles, then the structured product \n\"should\" be worth double the initial price, or 20. But instead, it's", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 270}
{"text": "lement value is based on the adjusted value of $SPX: \nCash settlement value = 10 + 10 x (2,007.50 - l,100.00)/1,100.00 = 18.25 \nHence, instead of doubling your money, as you might expect to do since the \n$SPX Index doubled in price, you \"only\" make 82.5%. \nAnother way to view it: If the index doubles, then the structured product \n\"should\" be worth double the initial price, or 20. But instead, it's worth 91.25% of 20, \nor 18.25. \nCarrying the example a little further, suppose that $SPX had tripled in price by \nthe maturity date, and was thus at 3,300. In this case, the cash settlement value would \nbe: \n$SPX adjusted value = 0.9125 x 3,300.00 = 3,011.25 \nCash settlement value = 10 + 10 x (3,011.25 - l,100.00)/1,100.00 = 27.375 \n604 Part V: Index Options and Futures \nOr, thinking in the alternative, if the index triples, then the structured produc1 \n(before adjustment factor) would be triple its initial price, or 30. Then 30 x 91.25o/c \n== 27.375. \nThis example begins to demonstrate just how onerous the adjustment factor is. \nNotice that if the underlying doubles, you don't make \"double\" less 8.75% (the \nadjustment factor). No, you make \"double\" times the adjustment factor - 17.5% -\nless than double. In the case of tripling, you make 3 x 8.75%, or 26.25%, less than \ntriple (i.e., the structured product is worth 27.375, not 30, so the percentage increase \nwas 173. 75%, not 200% - a difference of 26.25%, stated in terms of the initial invest\nment). How can that be? It is a result of the adjustment factor being applied to the \n$SPX price before your profit (cash settlement value) is computed. \nTHE BREAK-EVEN FINAL INDEX VALUE \nBefore discussing the adjustment factor in more detail, one more point should be \nmade: The owner of the structured product doesn't get back anything more than the \nbase value unless the underlying has increased by at least a fixed amount at maturi\nty. In others words, the underlying must appreciate to a price large enough that the \nfinal price times the adjustment factor is greater than the striking price of the struc\ntured product. We'll call this price the break-even final index value. \nAn example will demonstrate this concept. \nExample: As in the preceding example, suppose tl1at the striking price of the struc\ntured product is 1,100 and the adjustment factor is 8.75%. At what price would the \nfinal cash settlement value be something greater than the base value of 10? That \nprice can be solved for with the following simple equation: \nBreak-even final index value== Striking price/ (1- Adjustment factor) \n= 1,100 / (0.9125) == 1,205.48. \nGenerally speaking, the underlying index must increase in value by a specific \namount just to break even. In this case that amount is: \n1 / (1 -Adjustment factor) = 1 / 0.9175 = 1.0959 \nIn other words, the underlying index must increase in value by more than 9.5% \nby maturity just to overcome the weight of the adjustment factor. If the index increas\nes by a lesser amount, then the structured product holder will merely receive back \nhis base value ( 10) at maturity. \nThe previous examples all show that the adjustment factor is not a trivial thing. \nAt first glance, one might not realize just how burdensome it is. After all, one might \n605 \nhimself, what does 1.25% per year really matter? However, you can see that it \nmatter. In fact, our above examples did not even factor in the other cost that any \nInvestor has when his money is at risk - the cost of carry, or what he could have made \nhad he just put the money in the bank. \nMEASURING THE COST OF THE ADJUSTMENT FACTOR \nThe magnitude of the adjustment increases as the price of the underlying increases. \nlt is an unusual concept. We know that the structured product initially had an \nimbedded call option. Earlier in this chapter, we endeavored to price that option. \nHowever, with the introduction of the concept of an adjustment factor, it turns out \nthat the call option's cost is not a fixed amount. It varies, depending on the final value \nof the underlying index. In fact, the cost of the option is a percentage of the final \nvalue of the index. Thus, we can't really price it at the beginning, because we don't \nknow what the final value of the index will be. In fact, we have to cease thinking of \nthis option's cost as a fixed number. Rather, it is a geometric cost, if you will, for it \nincreases as the underlying does. \nPerhaps another way to think of this is to visualize what the cost will be in per\ncentage terms. Figure 32-2 compares how much of the percent increase in the index \nis captured by the structured product in the preceding example. The x-axis on the \ngraph is the percent increase by the index. The y-axis is the percent realized by the \nstructured product. The terms are the same as used in the previous examples: The \nstrike price is 1,100, the total adjustment factor is 8. 75%, and the guarantee price of \nthe structured product is 10. \nThe dashed line illustrates the first example that was shown, when a doubling \nof the index value (an increase of 100%) to 2,200 resulted in a gain of 83.5% in the \nprice of the structured. Thus, the point (100%, 83.5%) is on the line on the chart \nwhere the dashed lines meet. \nFigure 32-2 points out just how little of the percent increase one captures if the \nunderlying index increases only modestly during the life of the structured product. \nWe already know that the index has to increase by 9.59% just to get to the break-even \nfinal price. That point is where the curved line meets the x-axis in Figure 32-2. \nThe curved line in Figure 32-2 increases rapidly above the break-even price, \nand then begins to flatten out as the index appreciation reaches 100% or so. This \ndepicts the fact that, for small percentage increases in the index, the 8.75% adjust\nment factor - which is a flat-out downward adjustment in the index price - robs one \nof most of the percentage gain. It is only when the index has doubled in price or so \nthat the curve stops rising s", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 271}
{"text": "ly above the break-even price, \nand then begins to flatten out as the index appreciation reaches 100% or so. This \ndepicts the fact that, for small percentage increases in the index, the 8.75% adjust\nment factor - which is a flat-out downward adjustment in the index price - robs one \nof most of the percentage gain. It is only when the index has doubled in price or so \nthat the curve stops rising so quickly. In other words, the index has increased enough \nin value that the structured product, while not capturing all of the percentage gain \nby any means, is now capturing a great deal of it. \n604 Part V: Index Options and Futures \nOr, thinking in the alternative, if the index triples, then the structured product \n(before adjustment factor) would be triple its initial price, or 30. Then 30 x 91.25% \n= 27.375. \nThis example begins to demonstrate just how onerous the adjustment factor is. \nNotice that if the underlying doubles, you don't make \"double\" less 8.75% (the \nadjustment factor). No, you make \"double\" times the adjustment factor - 17.5% -\nless than double. In the case of tripling, you make 3 x 8.75%, or 26.25%, less than \ntriple (i.e., the structured product is worth 27.375, not 30, so the percentage increase \nwas 173. 75%, not 200% - a difference of 26.25%, stated in terms of the initial invest\nment). How can that be? It is a result of the adjustment factor being applied to the \n$SPX price before your profit (cash settlement value) is computed. \nTHE BREAK-EVEN FINAL INDEX VALUE \nBefore discussing the adjustment factor in more detail, one more point should be \nmade: The owner of the structured product doesn't get back anything more than the \nbase value unless the underlying has increased by at least a fixed amount at maturi\nty. In others words, the underlying must appreciate to a price large enough that the \nfinal price times the adjustment factor is greater than the striking price of the struc\ntured product. We'll call this price the break-even final index value. \nAn example will demonstrate this concept. \nExample: As in the preceding example, suppose that the striking price of the struc\ntured product is 1,100 and the adjustment factor is 8.75%. At what price would the \nfinal cash settlement value be something greater than the base value of 10? That \nprice can be solved for with the following simple equation: \nBreak-even final index value = Striking price/ (1- Adjustment factor) \n= 1,100 / (0.9125) = 1,205.48. \nGenerally speaking, the underlying index must increase in value by a specific \namount just to break even. In this case that amount is: \n1 / (1 - Adjustment factor) = 1 / 0.9175 = 1.0959 \nIn other words, the underlying index must increase in value by more than 9.5% \nby maturity just to overcome the weight of the adjustment factor. If the index increas\nes by a lesser amount, then the structured product holder will merely receive back \nhis base value (10) at maturity. \nThe previous examples all show that the adjustment factor is not a trivial thing. \nAt first glance, one might not realize just how burdensome it is. After all, one might \n605 \nhimself, what does 1.25% per year really matter? However, you can see that it \nmatter. In fact, our above examples did not even factor in the other cost that any \nhtvt?stor has when his money is at risk - the cost of carry, or what he could have made \nhe just put the money in the bank. \nMIASURING THE COST OF THE ADJUSTMENT FACTOR \nThe magnitude of the adjustment increases as the price of the underlying increases. \nIt is an unusual concept. We know that the structured product initially had an \nhnbedded call option. Earlier in this chapter, we endeavored to price that option. \nHowever, with the introduction of the concept of an adjustment factor, it turns out \nthat the call option's cost is not a fixed amount. It varies, depending on the final value \nof the underlying index. In fact, the cost of the option is a percentage of the final \nvalue of the index. Thus, we can't really price it at the beginning, because we don't \nknow what the final value of the index will be. In fact, we have to cease thinking of \nthis option's cost as a fixed number. Rather, it is a geometric cost, if you will, for it \nincreases as the underlying does. \nPerhaps another way to think of this is t.o visualize what the cost will be in per\ncentage terms. Figure 32-2 compares how much of the percent increase in the index \nis captured by the structured product in the preceding example. The x-axis on the \ngraph is the percent increase by the index. The y-axis is the percent realized by the \nstructured product. The terms are the same as used in the previous examples: The \nstrike price is 1,100, the total adjustment factor is 8.75%, and the guarantee price of \nthe structured product is 10. \nThe dashed line illustrates the first example that was shown, when a doubling \nof the index value (an increase of 100%) to 2,200 resulted in a gain of 83.5% in the \nprice of the structured. Thus, the point (100%, 83.5%) is on the line on the chart \nwhere the dashed lines meet. \nFigure 32-2 points out just how little of the percent increase one captures if the \nunderlying index increases only modestly during the life of the structured product. \nWe already know that the index has to increase by 9.59% just to get to the break-even \nfinal price. That point is where the curved line meets the x-axis in Figure 32-2. \nThe curved line in Figure 32-2 increases rapidly above the break-even price, \nand then begins to flatten out as the index appreciation reaches 100% or so. This \ndepicts the fact that, for small percentage increases in the index, the 8.75% adjust\nment factor -which is a flat-out downward adjustment in the index price - robs one \nof most of the percentage gain. It is only when the index has doubled in price or so \nthat the curve stops rising so quickly. In other words, the index has increased enough \nin value that the structured product, while not capturing all of the percentage gain \nby", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 272}
{"text": "percentage increases in the index, the 8.75% adjust\nment factor -which is a flat-out downward adjustment in the index price - robs one \nof most of the percentage gain. It is only when the index has doubled in price or so \nthat the curve stops rising so quickly. In other words, the index has increased enough \nin value that the structured product, while not capturing all of the percentage gain \nby any means, is now capturing a great deal of it. \n606 Part V: Index Options and Futu \nFIGURE 32-2. \nPercent of increase captured by structured product. \n90 \n80 \n70 \n60 \n\"O \nI!: 50 ::, \n0.. \nttl \n(.) \n40 :£ 0 \n30 Break-even: 9.59% Increase \n20 \n10 \n0 100 200 300 400 500 \n% Increase by Index \nAfter that, the curve in Figure 32-2 flattens dramatically. It eventually flattens \nout completely at 91.25%. That is, if the index increases enough in value (about \n3,000% or morel), then the structured product final cash value will reflect the full \n91.25% percent of appreciation of the index itself. That kind of increase in seven \nyears is virtually unattainable. In reality, the index - if it increases at all - will proba\nbly be more in line with the values shown on the x-axis in Figure 32-2. In those cases, \nespecially for increases of 100% or less, the oppressive weight of the adjustment fac\ntor significantly harms the return from the structured product. \nOne could visualize the graph in Figure 32-2 another way, if it would help. \nReplace the values on the x-axis with the actual index values: 2,200, 3,300, 4,400, \n5,500, and 6,600 would replace the figures shown as 100, 200, 300, 400, and 500. \nThus, the x-axis could then represent the final value of the index (before adjustment). \nThat might help to relate just how far the index would have to rise in order to over\ncome the downward adjustment. \nFigure 32-3 shows a more conventional look at the comparison between the \nindex value at maturity and the cash value of the structured product. For example, \nthe dashed line shows that, with the final value (unadjusted) of the index at 3,300, the \nstructured product's final cash value would be 27.375, as shown in a prior example. \nThe line on Figure 32-3 looks like that of owning a call - limited risk, with large \n32: Structured Products \nPIGURE 32-3. \nCash value of structured product at maturity. \nQ) \n::, \n50 \n40 \n~ 30 \n.c \nl{5 \n(.) \n20 \n10----r \n0 1100 \nBreak-even: 1205.48 \n2200 3300 4400 5500 \nIndex Final Price (Unadjusted) \n607 \n6600 \nupside profit potential. It is much more difficult to tell that the adjustment factor is \nweighing down the value of the structured product so dramatically from this chart. \nBoth Figures 32-2 and 32-3 are mathematically correct. However, only Figure 32-2 \ndepicts the real cost of owning a structured product with an adjustment factor. \nThe final graph on this topic, Figure 32-4, shows the cash value of the adjusted \nstructured product ( the same line as was shown in Figure 32-3), compared with an \nunadjusted line. For example, the unadjusted line shows a true doubling of the price \nof the structured product if the underlying index has doubled. The difference between \nthe two lines (the shaded area) can be thought of as the cost of the imbedded call- or \nat least as the cost of the adjustment factor. You can see from Figure 32-4 how the \ncall's \"cost\" increases as the value of the underlying index increases. \nOTHER CONSTRUCTS \nThe financial engineers who create structured products have come up with a num\nber of different constructs over time. Some resemble spreads, and some have two or \nthree different products bundled into one. In fact, just about anything is possible. All \nthat is required is that the underwriter thinks there is enough interest somewhere for \nhim to be able to create the product, mark it up, and sell it to whomever has inter-\n608 Part V: Index Options and Future; \nFIGURE 32-4. \nComparison of adiusted and unadiusted cash values at maturity. \n50 \n40 \n20 \n0 1100 2200 3300 \nCost of the \nCall Option \n4400 5500 \nIndex Final Price (Unadjusted) \n6600 \nest. In this section, a couple of different constructs, ones that have been brought to \nthe public marketplace in the past, are discussed. \nTHE BUI.I. SPREAD \nSeveral structured products have represented a bull spread, in effect. In some cases, \nthe structured product terms are stated just like those of a call spread in that the final \ncash value is defined with both a minimum and a maximum value. For example, it \nmight be described something like this: \n\"The final cash value of the (structured) product is equal to a minimum of a base \nprice of 10, plus any appreciation of the underlying index above the striking price, \nsubject to a maximum price of 20\" (where the striking price is stated elsewhere). \nIt's fairly simple to see how this resembles a bull spread: The worst you can do \nis to get back your $10, which is presumably the initial offering price, just as in any \nof the structured products described previously in this chapter. Then, above that, \nyou'd get some appreciation of the index price above the stated striking price - again \n609 \nthe products discussed earlier. However, in this case, there is a maximum that the \nc,1.,;h value can be worth: 20. In other words, there is a ceiling on the value of this \n1tructured product at maturity. It is exactly like a bull spread with two striking prices, \none at 10 and one at 20. In reality, this structured product would have to be evaluat-\nusing both striking prices. We'll get to that in a minute. \nThere is another way that the underwriter sometimes states the terms of the \nstructured product, but it is also a bull spread in effect. The prospectus might say \nsomething to the effect that the structured product is defined pretty much in the \nstandard way, but that it is callable at a certain (higher) price on a certain date. In \nuther words, someone else can call your structured product away on that date. In \neffect, you have sold a call with a higher striking price against you", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 273}
{"text": "d product, but it is also a bull spread in effect. The prospectus might say \nsomething to the effect that the structured product is defined pretty much in the \nstandard way, but that it is callable at a certain (higher) price on a certain date. In \nuther words, someone else can call your structured product away on that date. In \neffect, you have sold a call with a higher striking price against your structured prod\nUt1:. Thus, you own an imbedded call via the usual purchase of the structured prod\nuct and you have written a call with a higher strike. That, again, is the definition of a \nbull spread. \nWhen analyzing a product such as this, one must be mindful that there are two \ncalls to price, not only in determining the final value, but more importantly in deter\nmining where you might expect the structured product to trade during its life, prior \nto maturity. An option strategist knows that a bull spread doesn't widen out to its max\nimum profit potential when there is still a lot of time remaining before expiration, \nunless the underlying rises by a substantial amount in excess of the higher striking \nprice of the spread. Thus, one would expect this type of structured product to behave \nin a similar manner. \nThe example that will be used in the rest of this section is based on actual \"bull \nspread\" structured products of this type that trade in the open marketplace. \nExample: Suppose that a structured product is linked to the Internet index. The \nstrike price, based on index values, is 150. If the Internet index is below 150 at matu\nrity, seven years hence, then the structured product will be worth a base value of 10. \nThere is no adjustment factor, nor is there a participation rate factor. So far, this is \njust the same sort of definition that we've seen in the simpler examples presented \npreviously. The final cash value formula would be simply stated as: \nFinal cash value = 10 x (Final Internet index value/150) \nHowever, the prospectus also states that this structured product is callable at a \nprice of 25 during the last month of its life. \nThis call feature means that there is, in effect, a cap on the price of the under\nlying. In actual practice, the call feature may be for a longer or shorter period of time, \nand may be callable well in advance of maturity. Those factors merely determine the \nexpiration date of the imbedded call that has been \"written.\" \n610 Part V: Index Options and Futures \nThe first thing one should do is to convert the striking price into an equivalent \nprice for the underlying index, so that he can see where the higher striking price is \nin relation to the index price. In this example, the higher striking price when stated \nin terms of the structured product is 2.5 times the base price. So the higher striking \nprice, in index terms, would be 2.5 times the striking price, or 375: \nIndex call price = ( Call price / Base price) x Striking price \n= (25 I 10) X 150 \n= 375 \nHence, if the Internet index rose above 375, the call feature would be \"in effect\" \n(i.e., the written call would be in-the-money). The value at which we can expect the \nstructured product to trade, at maturity, would be equal to the base price plus the \nvalue of the bull spread with strikes of 10 and 25. \nValuing the Bull Spread. Just as the single-strike structured products have \nan imbedded call option in them, whose cost can be inferred, so do double-strike \nstructured products. The same line of analysis leads to the following: \n\"Theoretical\" cash value = 10 + Value of bull spread - Cost of carry \nCost of carry refers to the cost of carry of the base price (10 in this example). \nBy using an option model and employing knowledge of bull spreads, one can \ncalculate a theoretical value for the structured product at any time during its life. \nMoreover, one can decide whether it is cheap or expensive - factors that would lead \nto a decision as to whether or not to buy. \nExample: Suppose that the Internet index is trading at a price of 210. What price can \nwe expect the structured product to be trading at? The answer depends on how \nmuch time has passed. Let's assume that two years have passed since the inception \nof the structured product (so there are still five years of life remaining in the option). \nWith the Internet index at 210, it is 40% above the structured product's lower \nstriking price of 150. Thus, the equivalent price for the structured product would be \n14. Another way to compute this would be to use the cash value formula: \nCash value= 10 x (210 / 150) = 14 \nNow, we could use the Black-Scholes (or some other) model to evaluate the two \ncalls - one with a striking price of 10 and the other with a striking price of 25. Using \na volatility estimate of 50%, and assuming the underlying is at 14, the two calls are \nroughly valued as follows: \nUnderlying price: 14 \nCl,opter 32: Structured Products \nOption \n5-year call, strike = 10 \n5-year call, strike = 25 \nTheoretical Price \n7.30 \n3.70 \n611 \nThus, the value of the bull spread would be approximately 3.60 (7.30 minus \n3.70). The structured product would then be worth 13.60- the base price of 10, plus \nthe value of the spread: \n\"Theoretical\" cash value= 10 + 3.60 - Cost of carry= 13.60 - Cost of carry \nIt may seem strange to say that the value of the structured product is actually \nless than the cash value, but that is what the call feature does: It reduces the worth \nof the structured product to values below what the cash value formula would indi\ncate. \nGiven this information, we can predict where the structured product would trade at \nany price or at any time prior to maturity. Let's look at a more extreme example, then, \none in which the Internet index has a tremendously big run to the upside. \nExample: Suppose that the Internet index has risen to 525 with four years of life \nremaining until maturity of the structured product. This is well above the index\nequivalent call price of 375. Again, it is first necessary to translate the index price", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 274}
{"text": "any time prior to maturity. Let's look at a more extreme example, then, \none in which the Internet index has a tremendously big run to the upside. \nExample: Suppose that the Internet index has risen to 525 with four years of life \nremaining until maturity of the structured product. This is well above the index\nequivalent call price of 375. Again, it is first necessary to translate the index price \nback to an equivalent price of the structured product, using either percentage gains \nor the cash value formula: \nCash value = 10 x (525/ 150) = 35 \nAgain, using the Black-Scholes model, we can determine the following theo\nretical values: \nUnderlying price: 35 \nOption \n3-year c~strike = 10 \n3-year call, strike = 25 \nTheoretical Price \n25.50 \n14.70 \nNow, the value of the bull spread is 10.80 (25.50 minus 14.70). The deepest in\nthe-money option is trading near parity, but the (written) option is only 10 points in\nthe-money and thus has quite a bit of time value premium remaining, since there are \nthree years of life left: \n\"Theoretical\" cash value = 10 + 10.80 = 20.80 - Cost of carry \n612 Part V: Index Options and Futures \nHence, even though the Internet index is at 525 - far above the equivalent cal \nprice of 375 - the structured product is expected to be trading at a price well belo\\\\ \nits maximum price of 25. \nFigure 32-5 shows the values over a broad spectrum of prices and for various \nexpiration dates. One can clearly see that the structured product will not trade\"near \nits maximum price of 25 until time shrinks to nearly the maturity date, or until the \nunderlying index rises to very high prices. In particular, note where the theoretical \nvalues for the bull spread product lie when the index is at the higher striking price of \n375 (there is a vertical line on the chart to aid in identifying those values). The struc\ntured product is not worth 20 in any of the cases, and for longer times to maturity, it \nisn't even worth 15. Thus, the call feature tends to dampen the upside profit poten\ntial of this product in a dramatic manner. \nThe curves in Figure 32-5 were drawn with the assumption that volatility is \n50%. Should volatility change materially during the life of the structured product, \nthen the values would change as well. A lower volatility would push the curves up \ntoward the \"at maturity\" line, while an increase in volatility would push the curves \ndown even further. \nFIGURE 32-5. \nValue of bull spread structured product. \nAt Maturity \n25 \n1 Year Left \n20 3Years Left \n15 \n5 \n100 150 200 250 300 350 400 450 500 550 600 \nPrice of Index \nGtpter 32: Structured Products \nMULTIPLE EXPIRATION DATES \n613 \nIn some cases, more than one expiration date is involved when the structured prod\nuct is issued. These products are very similar to the simple ones first discussed in this \nchapter. However, rather than maturing on a specific date, the final index value -\nwhich is used to determine the final cash value of the structured product - is the \naverage of the underlying index price on two or three different dates. \nFor example, one such listed product was issued in 1996 and used the S&P 500 \nindex ($SPX) as the underlying index. The strike price was the price of $SPX on the \nday of issuance, as usual. However, there were three maturity dates: one each in April \n2001, August 2002, and December 2003. The final index value used to determine the \ncash settlement value was specified as the average of the $SPX closings on the three \nmaturity dates. \nIn effect, this structured product was really the sum of three separate struc\ntured products, each maturing on a different date. Hence, the values of the imbed\nded calls could each be calculated separately, using the methods presented earlier. \nThen those three values could be averaged to determine the overall value of the \nimbedded call in this structured product. \nOPTION STRATEGIES INVOLVING STRUCTURED PRODUCTS \nSince the structured products described previously are similar to well-known option \nstrategies (long call, bull spread, etc.), it is possible to use listed options in conjunc\ntion with the structured products to produce other strategies. These strategies are \nactually quite simple and would follow the same lines as adjustment strategies dis\ncussed in the earlier chapters of this book. \nExample: Assume that an investor purchased 15,000 shares of a structured product \nsome time ago. It is essentially a call option on the S&P 500 index ($SPX). The prod\nuct was issued at a price of 10, and that is the guarantee price as well. The striking \nprice is 700, which is where $SPX was trading at the time. However, now $SPX is \ntrading at 1,200, well above the striking price. The cash value of the product is: \n)ox (1,2001100) = 11.14 \nFurthermore, assume that there are still two years remaining until maturity of \nthe structured product, and the investor is getting a little nervous about the market. \nHe is thinking of selling or hedging his holding in the structured product. However, \nthe structured product itself is trading at 16.50, a discount of 64 cents from its theo-\n614 Part V: Index Options and Futurei \nretical cash value. He is not too eager to sell at such a discount, but he realizes tha \nhe has a lot of exposure between the current price and the guarantee price of 10. \nHe might consider writing a listed call against his position. That would conver \nit into the equivalent of a bull spread, since he already holds the equivalent of a lonf \ncall via ownership of the structured product. Suppose that he quotes the $SP) \noptions that trade on the CBOE and finds the following prices for 6-month options \nexpiring in December: \n$SPX: 1,200 \nOption \nDecember 1,200 call \nDecember 1,250 call \nDecember 1,300 call \nPrice \n85 \n62 \n43 \nSuppose that he likes the sale of the December 1,250 call for 62 points. How \nmany should he sell against his position in order to have a proper hedge? \nFirst, one must compute a multiplier that indicates how many shares of the \nstructured", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 275}
{"text": "lowing prices for 6-month options \nexpiring in December: \n$SPX: 1,200 \nOption \nDecember 1,200 call \nDecember 1,250 call \nDecember 1,300 call \nPrice \n85 \n62 \n43 \nSuppose that he likes the sale of the December 1,250 call for 62 points. How \nmany should he sell against his position in order to have a proper hedge? \nFirst, one must compute a multiplier that indicates how many shares of the \nstructured product are equivalent to one \"share\" of the $SPX. That is done in the \nsimple case by dividing the striking price by the guarantee price: \nMultiplier = Striking price/ Base price \n= 700 / 10 = 70 \nThis means that buying 70 shares of the structured product is equivalent to \nbeing long one share of $SPX. To verify this, suppose that one had bought 70 shares \nof the structured product initially at a price of 10, when $SPX was at 700. Later, \nassume that $SPX doubles to 1,400. With the simple structure of this product, which \nhas a 100% participation rate and no adjustment factor, it should also double to 20. \nSo 70 shares bought at 10 and sold at 20 would produce a profit of $700. As for $SPX, \none \"share\" bought at 700 and later sold at 1,400 would also yield a profit of $700. \nThis verifies that the 70-to-l ratio is the correct multiplier. \nThis multiplier can then be used to figure out the current equivalent structured \nproduct position in terms of $SPX. Recall that the investor had bought 15,000 shares \ninitially. Since the multiplier is 70-to-l, these 15,000 shares are equivalent to: \n$SPX equivalent shares = Shares of structured product held/ Multiplier \n= 15,000 / 70 = 214.29 \nThat is, owning this structured product is the equivalent of owning 214+ shares \nof $SPX at current prices. Since an $SPX call option is an option on 100 \"shares\" of \n$SPX, one would write 2 calls (rounding off) against his structured profit position. \nSince the SPX December 1,250 calls are selling for 62, that would bring in $12,400 \nless commissions. \n615 \nNote that the sale of these calls effectively puts a cap on the profit potential of \ninvestor's overall position until the December expiration of the listed calls. If $SPX \nwere to rise substantially above 1,250, his profits would be \"capped\" because the two \nwere sold. Thus, he has effectively taken his synthetic long call position and con\nverted it into a bull spread (or a collared index fund, if you prefer that description). \nIn reality, any calls written against the structured product would have to be \nmargined as naked calls. In a virtual sense, the 15,000 shares of the structured prod\nUt't \"cover\" the sale of 2 $SPX calls, but margin rules don't allow for that distinction. \nIn essence, the sale of two calls would create a bull spread. Alternatively, if one thinks \nuf the structured product as a long index fully protected by a put (which is another \nway to consider it), then the sale of the $SPX listed call produces a \"collar.\" \nOf course, one could write more than two $SPX calls, if he had the required \nmargin in his account. This would create the equivalent of a call ratio spread, and \nwould have the properties of that strategy: greatest profit potential at the striking \nprice of the written calls, limited downside profit potential, and theoretically unlim\nited upside risk if $SPX should rise quickly and by a large amount. \nIn any of these option writing strategies, one might want to write out-of-the\nmoney, short-term calls against his structured product periodically or continuously. \nSuch a strategy would produce good results if the underlying index does not advance \nquickly while the written calls are in place. However, if the index should rise through \nthe striking price of the written calls, such a strategy would detract from the overall \nreturn of the structured product. \nChanging the Striking Price. Another strategy that the investor could use \nif he so desired is to establish a vertical call spread in order to effectively change \nthe striking price of the (imbedded) call. For example, if the market had advanced \nby a great deal since the product was bought, the imbedded call would theoreti\ncally have a nice profit. If one could sell it and buy another, similar call at a high\ner strike, he would effectively ~olling his call up. This would raise the striking \nprice and would reduce downside risk greatly (at the cost of slightly reducing \nupside profit potential). \nExample: Using the same product as in the previous example, suppose that the \ninvestor who owns the structured product considers another alternative. In the pre\nvious example, he evaluated the possibility of selling a slightly out-of-the-money list\ned call to effectively produce a collared position, or a bull spread. The problem with \nthat is that it limits upside profit potential. If the market were to continue to rise, he \nwould only participate up to the higher strike (plus the premium received). \n616 Part V: Index Options and Futu, \nA better alternative might be to roll his imbedded call up, thereby taking s01 \nmoney out of the position but still retaining upside profit potential. Recall that t \nstructured product had these terms: \nGuarantee price: 10 \nUnderlying index: S&P 500 index ($SPX) \nStriking price: 700 \nAs in the earlier example, the investor owns 15,000 shares of the structun \nproduct. Furthermore, assume that there are about two years remaining until mat \nrity of the structured product, and that the current prices are the same as in the pr \nvious example: \nCurrent price of structured product: 16.50 \nCurrent price of $SPX: 1,200 \nFor purposes of simplicity, let's assume that there are listed two-year LEAP \noptions available for the S&P index, whose prices are: \nS&P 2-year LEAPS, striking price 700: 550 \nS&P 2-year LEAPS, striking price 1,200: 210 \nIn reality, S&P LEAPS options are normally reduced-value options, meanin. \nthat they are for one-tenth the value of the index and thus sell for one-tenth the pricE \nHowever, for the purposes of this theoretical example, we will assume", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 276}
{"text": "listed two-year LEAP \noptions available for the S&P index, whose prices are: \nS&P 2-year LEAPS, striking price 700: 550 \nS&P 2-year LEAPS, striking price 1,200: 210 \nIn reality, S&P LEAPS options are normally reduced-value options, meanin. \nthat they are for one-tenth the value of the index and thus sell for one-tenth the pricE \nHowever, for the purposes of this theoretical example, we will assume that the full \nvalue LEAPS shown here exist. \nIt was shown in the previous example that the investor would trade two of thest \ncalls as an equivalent amount to the quantity of calls imbedded in his structurec \nproduct. So, this investor could buy two of the 1,200 calls and sell two of the 700 calli \nand thereby roll his striking price up from 700 to 1,200. This roll would bring in 34( \npoints, two times; or $68,000 less commissions. \nSince the difference in the striking prices is 500 points, you can see that he is \nleaving something \"on the table\" by receiving only 340 points for the roll-up. This is \ncommon when rolling up: One loses the time value premium of the vertical spread. \nHowever, when viewed from the perspective of what has been accomplished, the \ninvestor might still find this roll worthwhile. He has now raised the striking price of \nhis call to 1,200, based on the S&P index, and has taken in $68,000 in doing so. Since \nhe owns 15,000 shares of the structured product, that means he has taken in 4.53 p~r \nshare (68,000 / 15,000). Now, for example, if the S&P crashes during the next two \nyears and plummets below 700 at the maturity date, he will receive $10 as the guar\nantee price plus the $4.53 he got from the roll - a total \"guarantee\" of $14.53. Thus, \nhe has protected his downside. \nOtpt,r 32: Structured Products 617 \nNote that his downside risk is not completely eliminated, though. The current \nprke of the structured product is 16.50 and the cash value at the current S&P price \n11117.14 (see the previous example for this calculation), so he has risk from these lev\ndown to a price of $14.53. \nHis upside is still unlimited, because he is net long two calls - the S&P 2-year \n1,,EAPS calls, struck at 1,200. The two LEAPS calls that he sold, struck at 700, effec\ntively offsets the call imbedded in the structured product, which is also struck at 700. \nThis example showed how one could effectively roll the striking price of his \nstructured product up to a higher price after the underlying had advanced. The indi\nvidual investor would have to decide if the extra downside protection acquired is \nworth the profit potential sacrificed. That depends heavily, of course, on the prices of \nthe listed S&P options, which in turn depend on things such as volatility and time \nremaining until expiration. \nOf course, one other alternative exists for a holder of a structured product who \nhas built up a good profit, as in the previous two examples: He could sell the prod\nuct he owns and buy another one with a striking price closer to the current market \nvalue of the underlying index. This is not always possible, of course, but as long as \nthese products continue to be brought to market every few months or so by the \nunderwriters, there will be a wide variety of striking prices to choose from. A possi\nble drawback to rolling to another structured product is that one might have to \nextend his holding's maturity date, but that is not necessarily a bad thing. \nA different scenario exists when the underlying index drops after the structured \nproduct is bought. In that case, one would own a synthetic call option that might be \nquite far out-of the-rrwney. A listed call spread could be used to theoretically lower \nthe call's striking price, so that upside movement might more readily produce prof\nits. In such a case, one would sell a listed call option with a striking price equal to the \nstriking price of the structured product and would buy a listed call option with a \nlower striking price - one more in line with current market values. In other words, \nhe would buy a listed call bull spread to go along with his structured product. \nWhatever debit he pays for this call bull spread will increase his downside risk, of \ncourse. However, in return he ~s the ability to make profits more quickly if the \nunderlying index rises above the new, lower striking price. \nMany other strategies involving listed options and the structured product could \nbe constructed, of course. However, the ones presented here are the primary strate\ngies that an investor should consider. All that is required to analyze any strategy is to \nremember that this type of structured product is merely a synthetic long call. Once \nthat concept is in mind, then any ensuing strategies involving listed options can easily \nbe analyzed. For example, the purchase of a listed put with a striking price essential-\n618 Part V: Index Options and Future \nly equal to that of the structured product would produce a position similar to a 101 \nstraddle. The reader is left to interpret and analyze other such strategies on his OWI \nLISTS OF STRUCTURED PRODUCTS \nThe descriptions provided so far encompass the great majority of listed structure \nproducts. There are many similar ones involving individual stocks instead ofJndice \n(often called equity-linked notes). The concepts are the same; merely substitute \nstock price for an index price in the previous discussions in this chapter. \nSome large insurance companies offer similar products in the form of annuities \nThey behave in exactly the same way as the products described above, except tha \nthere is no continuous market for them. However, they still afford one the opportu\nnity to own an index fund with no risk Many of the insurance company products, in \nfact, pay interest to the annuity holder - something that most of the products listed \non the stock exchanges do not. \nBoth the CBOE and American Exchange Web sites (www.cboe.com and \nwww.amex.com) contain details of the structured products listed on their respective \nexch", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 277}
{"text": "However, they still afford one the opportu\nnity to own an index fund with no risk Many of the insurance company products, in \nfact, pay interest to the annuity holder - something that most of the products listed \non the stock exchanges do not. \nBoth the CBOE and American Exchange Web sites (www.cboe.com and \nwww.amex.com) contain details of the structured products listed on their respective \nexchanges. A sampling at the time of this writing showed the following breakdowns \nof listed structured products: \nUnderlying Index Percent of Listed Products \nBroad-based index (S&P 500, e.g.) 23% \nSector index \nStocks \n43% \n34% \nIf you browse those lists, an investor may find indices or stocks that are of particular \ninterest to him. In addition, it may be possible to find ones trading at a substantial \ndiscount to cash settlement value, something a strategist might find attractive. \nPERCS \nPart II: Products Designed \nto Provide /,/Income\" \nAt the beginning of this chapter, it was stated that most listed structured products~ \nfall into one of two categories. The first category was the type of structured prod\nuct that resembled the ownership of a call option. The second portion, to be dis-\n0.,t,r 32: Structured Products 619 \nt'Ussed in the remainder of this chapter, resembles the covered write of a call \noption. These often have names involving the term preferreds. Some are called \nTrust Preferreds; another popular term for them is Preferred Equity Redemption \nCumulative Stock (PERCS). We will use the term PERCS in the following exam\nples, but the reader should understand that it is being used in a generic sense - that \nany of the similar types of products could be substituted wherever the term PERCS \nis used. \nA PERCS is a structured product, issued with a maturity date and tied to an \nindividual stock. At the time of issuance, the PERCS and the common stock are usu\nally about the same price. The PERCS pays a higher dividend than the common \nstock, which may pay no dividend at all. If the underlying common should decline in \nprice, the PERCS should decline by a lesser amount because the higher dividend \npayout will provide a yield floor, as any preferred stock does. \nThere is a limited life span with PERCS that is spelled out in the prospectus at \nthe time it is issued. Typically, that life span is about three years. At the end of that \ntime, the PERCS becomes ordinary common stock. \nA PERC S may be called at any time by the issuing corporation if the company's \ncommon stock exceeds a predetermined call price. In other words, this PERCS stock \nis callable. The call price is normally higher than the price at which the common is \ntrading when the PERCS is issued. \nWhat one has then, if he owns a PERCS, is a position that will eventually \nbecome common stock unless it is called away. In order to compensate him for the \nfact that it might he called away, the owner receives a higher dividend. What if one \nsubstitutes the word \"premium\" for \"higher dividend\"? Then the last statement \nreads: In order to compensate him for the fact that it might be called away, the owner \nreceives a premium. This is exactly the definition of a covered call option write. \nMoreover, it is an out-of-the-money covered write of a long-term call option, since \nthe call price of the PERCS is akin to a striking price and is higher than the initial \nstock price. \nExample: XYZ is selling at $35 per share. XYZ common stock pays $1 a year in div\nidends. The company decides to issue a PERCS. \nThe PERCS will have a three~ life and will be callable at $39. Moreover, the \nPERCS will pay an annual dividend of $2.50. \nThe PERCS annual dividend rate is 7% as compared to 2.8% for the common \nstock. \nIf XYZ were to rise to 39 in exactly three years, the PERCS would be called. \nThe total return that the PERCS holder would have made over that time would be: \n620 \nStock price appreciation 139 - 35): \nDividends over 3 years: \nTotal gain \nTotal return: \nAnnualized return: \nPart V: Index Options and Future. \n4 \n7.50 \n11.50 \n11.50/35 = 32.9% \n32.9%/3 = 11% \nIf the PERCS were called at an earlier time, the annualized return might be ever \nhigher. · \nCALL FEATURE \nThe company will most likely call the PER CS if the common is above the call price \nfor even a short period of time. The prospectus for the PERCS will describe any \nrequirements regarding the call. A typical one might be that the common must close \nabove the call price for five consecutive trading days. If it does, then the company \nmay call the PERCS, although it does not have to. The decision to call or not is strict\nly the company's. The PERCS holder has no choice in the matter of when or if his \nshares are called. This is the same situation in which the writer of a covered call finds \nhimself: He cannot control when the exercise will occur, although there are often \nclues, including the disappearance of time value premium in the written listed call \noption. The PERCS holder is more in the dark, because he cannot actually see the \nseparate price of the imbedded call within the PERCS. Still, as will be shown later, \nhe may be able to use several clues to determine whether a call is imminent. \nMost PERCS may be called for either cash or common stock. This does not \nchange the profitability from the strategist's standpoint. He either receives cash in \nthe amount of the call price, or the same dollar amount of common stock. The only \ndifference between the two is that, in order to completely close his position, he would \nhave to sell out any common stock received via the call feature. If he had received \ncash instead, he wouldn't have to bother with this final stock transaction. \nIn the case of most PERCS, the call feature is more complicated than that pre\nsented in the preceding example. Recall that the company that issued the PERCS \ncan call it at any time during the three years, as long as the common is above the call \nprice. The holder of the XYZ PERCS in the example would not be pleased", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 278}
{"text": "ved \ncash instead, he wouldn't have to bother with this final stock transaction. \nIn the case of most PERCS, the call feature is more complicated than that pre\nsented in the preceding example. Recall that the company that issued the PERCS \ncan call it at any time during the three years, as long as the common is above the call \nprice. The holder of the XYZ PERCS in the example would not be pleased to find \nthat the PER CS was called before he had received any of the higher dividends that \nthe PERCS pays. Therefore, in order to give a PERCS holder essentially the same \nreturn no matter when the PERCS is called, there is a \"sliding scale\" of call prices. -\nAt issuance, the call price will be the highest. Then it will drop to a slightly \nlower level after some of the dividends have been paid (perhaps after the first year). \n621 \nThis lowering of the call price continues as more dividends are paid, until it finally \nreaches the final call price at maturity. The PERCS holder should not be confused \nthis sliding scale of call prices. The sliding call feature is designed to ensure that \nPERC S holder is compensated for not receiving all his \"promised\" dividends if the \nPERCS should be called prior to maturity. \nExample: As before, XYZ issues a PERCS when the common is at 35. The PERCS \npays an annual dividend of $2.50 per share as compared to $1 per share on the com\nmon stock. The PERCS has a final call price of 39 dollars per share in three years. \nIf XYZ stock should undergo a sudden price advance and rise dramatically in a \nvery short period of time, it is possible that the PERCS could be called before any \ndividends are paid at all. In order to compensate the PERCS holder for such an \nc>ecurrence, the initial call price would be set at 43.50 per share. That is, the PERCS \ncan't be called unless XYZ trades to a price over 43.50 dollars per share. Notice that \nthe difference between the eventual call price of 39 and the initial call price of 43.50 \nis 4.50 points, which is also the amount of additional dividends that the PERCS \nwould pay over the three-year period. The PER CS pays $2.50 per year and the com\nmon $1 per year, so the difference is $1.50 per year, or $4.50 over three years. \nOnce the PERCS dividends begin to be paid, the call price will be reduced to \nreflect that fact. For example, after one year, the call price would be 42, reflecting \nthe fact that if the PERCS were not called until a year had passed, the PERCS hold\ner would be losing $3 of additional dividends as compared to the common stock \n($1.50 per year for the remaining two years). Thus, the call price after one year is set \nat the eventual call price, 39, plus the $3 of potential dividend loss, for a total call \nprice of 42. \nThis example shows how the company uses the sliding call price to compensate \nthe PERCS holder for potential dividend loss if the PERCS is called before the \nthree-year time to maturity has elapsed. Thus, the PER CS holder will make the same \ndollars of profit - dividends and price appreciation combined - no matter when the \nPERCS is called. In the case of the XYZ PERCS in the example, that total dollar \nprofit is $11.50 (see the prior example). Notice that the investor's annualized rate of \nreturn would be much higher if he were called prior to the eventual maturity date. \nOne final point: The call price §lides on a scale as set forth in the prospectus for \nthe PERCS. It may be every time a dividend is paid, but more likely it will be daily! \nThat is, the present worth of the remaining dividends is added to the final call price \nto calculate the sliding call price daily. Do not be overwhelmed by this feature. \nRemember that it is just a means of giving the PERCS holder his entire \"dividend \npremium\" if the PERCS is called before maturity. \n622 Part V: Index Options and Futures \nFor the remainder of this chapter, the call price of the PERCS will be referrea \nto as the redemption price. Since much of the rest of this chapter will be concemec \nwith discussing the fact that a PERCS is related to a call option, there could be somE \nconfusion when the word call is used. In some cases, call could refer to the price at \nwhich the PER CS can be called; in other cases, it could refer to a call option - either \na listed one or one that is imbedded within the PERCS. Hence, the word redemp\ntion will be used to refer to the action and price at which the issuing compa:J)ly may \ncall the PERCS. \nA PERCS IS A COVERED CALL WRITE \nIt was stated earlier that a PER CS is like a covered write. However, that has not yet \nbeen proven. It is known that any two strategies are equivalent if they have the same \nprofit potential. Thus, if one can show that the profitability of owning a PER CS is the \nsame as that of having established a covered call write, then one can conclude that \nthey are equivalent. \nExample: For the purposes of this example, suppose that there is a three-year listed \ncall option with striking price 39 available to be sold on XYZ common stock. Also, \nassume that there is a PERCS on XYZ that has a redemption price of 39 in three \nyears. The following prices exist: \nXYZ common: 35 \nXYZ PERCS: 35 \n3-year call on XYZ common with striking price of 39: 4.50 \nFirst, examine the XYZ covered call write's profitability from buying 100 XY2 and \nselling one call. It was initially established at a debit of 30.50 (35 less the 4.50 \nreceived from the call sale). The common pays $1 per year in dividends, for a total of \n$3 over the life of the position. \nXYZ Price Price of a Profit/loss on Total Profit/loss \nin 3 Years 3-Year Call Securities Incl. Dividend \n25 0 -$550 -$250 \n30 0 -50 +250 \n35 0 +450 +750 \n39 0 +850 + 1,150 \n45 6 +850 + 1,150 \n50 11 +850 + 1,150 \nO.,,ter 32: Structured Products 623 \nTI1is is the typical picture of the total return from a covered write - potential losses on \nthe downside with profit potential limited above the striking price of the written call. \nNow look at the profitability of buying th", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 279}
{"text": "all Securities Incl. Dividend \n25 0 -$550 -$250 \n30 0 -50 +250 \n35 0 +450 +750 \n39 0 +850 + 1,150 \n45 6 +850 + 1,150 \n50 11 +850 + 1,150 \nO.,,ter 32: Structured Products 623 \nTI1is is the typical picture of the total return from a covered write - potential losses on \nthe downside with profit potential limited above the striking price of the written call. \nNow look at the profitability of buying the PER CS at 35 and holding it for three \n(Assume that it is not called prior to maturity.) The PER CS holder will earn a \ntotal of $750 in dividends over that time period. \nXYZ Price Profit/Loss on Total Profit/Loss \nin 3 Years PERCS Incl. Dividend \n25 -$1,000 -$250 \n30 -500 +250 \n35 0 +750 \n>=39 +400 + 1, 150 \nThis is exactly the same profitability as the covered call write. Therefore, it can be \nconcluded with certainty that a PERCS is equivalent to a covered call write. Note \nthat the PER CS potential early redemption feature does not change the truth of this \nstatement. The early redemption possibility merely allows the PERCS holder to \nreceive the same total dollars at an earlier point in time if the PERCS is demanded \nprior to maturity. The covered call writer could theoretically be facing a similar situ\nation if the written call option were assigned before expiration: He would make the \nsame total profit, but he would realize it in a shorter period of time. \nThe PERCS is like a covered write of a call option with striking price equal to \nthe redemption price of the PERCS, except that the holder does not receive a call \noption premium, but rather receives additional dividends. In essence, the PERCS \nhas a call option imbedded within it. The value of the imbedded call is really the \nvalue of the additional dividends to be paid between the current date and maturity. \nThe buyer of a PERCS is, in effect, selling a call option and buying common \nstock. He should have some idea of whether or not he is selling the option at a rea\nsonably fair price. The next section of this chapter addresses the problem of valuing \nthe call option that is imbedded in the PERCS. \nPRICE BEHAVIOR \nThe way that a PERCS price is often discussed is in relationship to the common \nstock. One may hear that the PERCS is trading at the same price as the common or \nat a premium or discount to the common. As an option strategist who understands \ncovered call writing, it should be a simple matter to picture how the PERCS price \nwill relate to the common price. \n624 Part V: Index Options and Futures \nFIGURE 32-6. \nPERCS price estimate versus common stock. \n44 \n(I) \niii 39 6 Months \nE \n~ w \n(I) \nu \nct 34 \nCf) \n(.) \na: w a. \n29 \n0 1-.J. ____ ,__ ___ ...._ ___ _._ ___ __._ ___ _.__ \n25 30 35 40 \nStock Price \n45 50 \nFirst, consider the out-of-the-money situation. If the underlying common \ndeclines in price, the PERCS will not decline as fast because the additional dividends \nwill provide yield support. The PER CS will therefore trade at a higher price than the \ncommon. Howeve1~ as the maturity date nears and the remaining number of addi\ntional dividends dwindles to a small amount, then the PER CS price and the common \nprice will converge. \nThe opposite effect occurs if the underlying common moves higher. The \nPERCS will trade at a lower price than the common when the common trades above \nthe issue price. In fact, since there is a redemption price on the PERCS, it will not \ntrade higher than the redemption price. The common, however, has no such restric\ntion, so it could continue to trade at prices significantly higher than the PERCS does. \nThese points are illustrated in Figure 32-6, which contains the price curves of two \nPER CS: one at issuance, thus having three years remaining, and the other with just six \nmonths remaining until the maturity of the PERCS. For purposes of comparison, it \nwas assumed that there is no sliding redemption feature involved. Several significant \npoints can be made from the figure. First, notice that the PERCS and the common._ \ntend to sell at approximately the same price at the point labeled \"I.\" This would be the \nprice at which the PER CS are issued. This issue price must be below the redemption \nprice of the PERCS. More will be said later about how this price is determined. \nOapter 32: Structured Products 625 \nAnother observation that can be made from the figure is that the PERCS pric\ning curves level off at the redemption price. They cannot sell for more than that \nprice. \nNow look on the left-hand side of the figure. Notice that the more time remain\nIng until maturity, the higher the PERCS will trade above the common stock. This is \nbecause of the extra dividends that the PER CS pay. Obviously, the PERCS with three \nyears until maturity has the potential to pay more dividends than the one with three \nmonths remaining, so the three-year PERCS will sell for more than the six-month \nPERCS when the common is below the issue price. Since either PERCS pays more \ndividends than the common, they both trade for higher prices than the common. \nWhen the common trades above the issue price (point 'T'), the opposite is true. \nThe six-month PERCS trades for a slightly higher price than the three-year PERCS, \nbut both sell for significantly less than the common, which has no limit on its poten\ntial price. \nOne other observation can be made regarding the situation in which the com\nmon trades well below the issue price: After the last additional dividend has been \npaid by the PERCS, it will trade for approximately the same price as the common in \nthat situation. · \nViewed strictly as a security, a PERCS may not appear all that attractive to some \ninvestors. It has much, but not all, of the downside risk of the common stock, and not \nnearly the upside potential. It does provide a better dividend, however, so if the com\nmon is relatively unchanged from the issue price when the PERCS matures, the \nPERCS holder will have come out ahead. If this description of the PER CS does not \nappeal to you, then neither should co", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 280}
{"text": "l that attractive to some \ninvestors. It has much, but not all, of the downside risk of the common stock, and not \nnearly the upside potential. It does provide a better dividend, however, so if the com\nmon is relatively unchanged from the issue price when the PERCS matures, the \nPERCS holder will have come out ahead. If this description of the PER CS does not \nappeal to you, then neither should covered call writing, for it is the same strategy; a \ncall option premium is merely substituted for the higher dividend payout. \nPERCS STRATEGIES \nSince the PERCS is equivalent to a covered write, strategies that have covered writes \nas part of their makeup are amenable to having PERCS as part of their makeup as \nwell. Covered writing is part of ratio writing. Other modifications to the covered writ\ning strategy itself, such as the protected covered write, can also be applied to the \nPERCS. \nPROTECTING THE PERCS WITH LISTED OPTIONS \n~ \nThe safest way to protect the PERC S holding with listed options is to buy an out-of \nthe-nwney put. The resultant position - long PERCS and long put - is a protected \ncovered write, or a \"collar.\" The long put prevents large losses on the downside, but \nit costs the PERCS holder something. He won't make as much from his extra divi\ndend payout, because he is spending money for the listed put. Still, he may want the \ndownside comfort. \n626 Part V: Index Options and Futures \nOnce one realizes that a PERCS is equivalent to a covered write, he can easily \nextend that equivalence to other positions as well. For example, it is known that a \ncovered call write is equivalent to the sale of a naked put. Thus, owning a PERCS is \nequivalent to the sale of a naked put. Obviously, the easiest way to hedge a naked put \nis to buy another put, preferably out-of-the-money, as protection. \nDo not be deluded into thinking that selling a listed call against the PERCS is \na safe way of hedging. Such a call option sale does add a modicum of downside pro\ntection, but it exposes the upside to large losses and therefore introduces a potential \nrisk into the position. It is really a ratio write. The subject is covered later in this \nchapter. \nREMOVING THE REDEMPTION FEATURE \nAt issuance, the imbedded call is a three-year call, so it is not possible to exactly \nduplicate the PERCS strategy in the listed market. However, as the PERCS nears \nmaturity, there will be listed calls that closely approximate the call that is imbedded \nin the PERCS. Consequently, one may be able to use the listed call or the underly\ning stock to his advantage. \nIf one were to buy a listed call with features similar to the imbedded call in a \nPERCS that he owned, he would essentially be creating long common stock. Not that \none would necessarily need to go to all that trouble to create long common stock, but \nit might provide opportunities for arbitrageurs. \nIn addition, it might appeal to the PERCS holder if the common stock has \ndeclined and the imbedded call is now inexpensive. If one covers the equivalent of \nthe imbedded call in the listed market, he would be able to more fully participate in \nupside participation if the common were to rally later. This is not always a profitable \nstrategy, however. It may be better to just sell out the PERCS and buy the common \nif one expects a large rally. \nExample: XYZ issued a PERCS some time ago. It has a redemption price of 39; the \ncommon pays a dividend of $1 per year, while the PER CS pays $2.50 per year. \nXYZ has fallen to a price of 30 and the PERCS holder thinks a rally may be \nimminent. He knows that the imbedded call in the PERCS must be relatively inex\npensive, since it is 9 points out-of-the-money (the PERCS is redeemable at 39, while \nthe common is currently 30). Ifhe could buy back this call, he could participate more \nfully in the upward potential of the stock. \nSuppose that there is a one-year LEAPS call on XYZ with a striking price of 40. \nIf one were to buy that call, he would essentially be removing the redemption fea-\nture from his PERCS. \nAssume the following prices exist: \nGapter 32: Structured Products \nXYZ Common: 30 \nXYZ PERCS: 31 \nXYZ January 40 LEAPS call: 2 \n627 \nIf one buys this LEAPS call and holds it until maturity of the PERCS one year \nfrom now, the profit picture of the long PERCS plus long call position will be the fol\nlowing: \nTotal Value \nXYZ Price in PERCS January 40 of long PERCS \nJanuary Next Year Price LEAPS + long LEAPS \n25 25 0 25 \n30 30 0 30 \n35 35 0 35 \n40 39 0 39 \n45 39 5 44 \n50 39 10 49 \nThus, the PE RCS + long call position is worth almost exactly what the common \nstock is after one year. The PERCS holder has regained his upside profit potential. \nWhat did it cost the investor to reacquire his upside? He paid out 2 points for \nthe call, thereby more than negating his $1.50 dividend advantage over the course of \nthe year (the common pays a $1 dividend;'the PERCS $2.50). Thus, it may not actu\nally be worth the bother. In fact, notice that if the PERCS holder really wanted to \nreacquire his upside profit potential, he would have been better off selling his \nPERCS at 31 and buying the common at 30. If he had done this, he would have taken \nin 1 point from the sale and purchase, which is slightly smaller than the $1.50 divi\ndend he is forsaking. In either case, he must relinquish his dividend advantage and \nthen some in order to reacquire his upside profit potential. This seems fair, however, \nfor there must be some cost involved with reacquiring the upside. \nRemember that an arbitrageur might be able to find a trade involving these sit\nuations. He could buy a PERCS, sell the common short, and buy a listed call. If there \nwere price discrepancies, he could profit. It is actions such as these that are required \nto keep prices in their proper relationship. \n1 \nCHANGING THE REDEMPTION PRICE OF THE PERCS \nWhen covered writing was discussed as a strategy, it was shown that the writer may \nwant to buy back the call that was written and sell", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 281}
{"text": "ns. He could buy a PERCS, sell the common short, and buy a listed call. If there \nwere price discrepancies, he could profit. It is actions such as these that are required \nto keep prices in their proper relationship. \n1 \nCHANGING THE REDEMPTION PRICE OF THE PERCS \nWhen covered writing was discussed as a strategy, it was shown that the writer may \nwant to buy back the call that was written and sell another one at a different strike. \n628 Part V: Index Options and Futu, \nIf the action results in a lower strike, it is known as rolling down; if it results in a hi§ \ner strike, it is rolling up. \nThis rolling action changes the profit potential of the position. If one rolls dov; \nhe gets more downside protection, but his upside is even more limited than it prei \nously was. Still, if he is worried about the stock falling lower, this may be a prop \naction to take. Conversely, if the common is rallying, and the covered writer is mo \nbullish on the stock, he can roll up in order to increase his upside profit potenti~( \ncourse, by rolling up, he creates more downside risk if the common stock should sue \ndenly reverse direction and fall. \nThe PERCS holder can achieve the same results as the covered writer. He ca \neffectively roll his redemption price down or up if he so chooses. His reasons fc \ndoing so would be substantially the same as the covered writer's. For example, if th \ncommon were dropping in price, the PERCS holder might become worried that hi \nextra dividend income would not be enough to protect him in the case of furthe \ndecline. Therefore, he would want to take in even more premium in exchange fo \nallowing himself to be called away at a lower price. \nExample: XYZ issued PERCS when both were trading at 35. Now, XYZ has fallen t< \n30 with only a year remaining until maturity, and the PERCS holder is nervous abou \nfurther declines. He could, of course, merely sell his stock; but suppose that ht: \nprefers to keep it and attempt to modify his position to more accurately reflect hb \nattitude about future price movements. \nAssume the following prices exist: \nXYZ Common: 30 \nXYZ PERCS: 31 \nXYZ January 40 call: 2 \nXYZ January 35 call: 4 \nIfhe buys the January 40 call and sells the January 35 call, he will have accomplished \nhis purpose. This is the same as selling a call bear spread. As shown in the previous \nexample, buying the January 40 call is essentially the same as removing the redemp\ntion feature from the PERCS. Then, selling the January 35 call will reinstate a \nredemption feature at 35. Thus, the PERCS holder has taken in a premium of 2 \npoints and has lowered the redemption price. \nIf XYZ is below 35 when the options expire, he will have an extra $200 profit \nfrom the option trades. If XYZ rallies and is above 35 at expiration, he will be effec\ntively called away at 37 (the striking price of 35 plus the two points from the rollr, \ninstead of at the original demand price of 39. In actual practice, if the January 35 call \n629 \nwere assigned, the trader could then be simultaneously long the PERCS and short \ncommon stock, with a long January 40 call in addition. He would have to unwind \npieces separately, an action that might include exercising the January 40 call (if \nIt were in-the-money at expiration) to cover the short common stock. \nThe conclusion that can be drawn is that in order to roll down the redemption \nfiature of a PERCS, one must sell a vertical call spread. In a similar manner, if he \nwanted to roll the strike up, he would buy a vertical call spread. Using the same \nexample, one would still buy the January 40 call ( this effectively removes the redemp\ntion feature of the PERCS) and would then sell a January 45 call in order to raise the \nredemption price. Thus, buying a vertical call spread raises the effective redemption \nprice of a PERCS. \nThere is nothing magic about this strategy. Covered writers use it all the time. \nIt merely evolves from thinking of a PERCS as a covered write. \nSELLING A CALL AGAINST A LONG PERCS IS A RATIO WRITE \nIt is obvious to the strategist that if one owns a PERCS and also sells a call against it, \nhe does not have a covered write. The PERCS is already a covered write. What he \nhas when he sells another call is a ratio write. His equivalent position is long the com\nmon and short two calls. \nThere is nothing inherently wrong with this, as long as the PERCS holder \nunderstands that he has exposed himself to potentially large upside losses by selling \nthe extra call. If the common stock were to rally heavily, the PERCS would stop ris\ning when it reached its redemption price. However, the additional call that was sold \nwould continue to rise in price, possibly inflicting large losses if no defensive action \nwere taken. \nThe same strategies that apply to ratio writing or straddle writing would have to \nbe used by someone who owns a PERCS and sells a call against it. He could buy com\nmon stock if the position were in danger on the upside, or he could roll the call(s) up. \nA difference between ordinary ratio writing and selling a listed call option \nagainst a PERCS is that the imbedded call in the PERCS may be a very long-term \ncall (up to three years). The listed call probably wouldn't be of that duration. So the \nratio writer in this case has two different expiration dates for his options. This does \nnot change the overall strategy, but it does mean that the imbedded long-term call \nwill not diminish much in price due to thepssage of time, until the PERCS is near\ner maturity. \nNeutrality is normally an important consideration for a ratio writer. If one is \nlong a PERCS and short a listed call, he is by definition a ratio writer, so he should \n630 Part V: Index Options and Futures \nbe interested in neutrality. The key to determining one's neutrality, of course, is tc \nuse the delta of the option. In the case of the PERCS stock, one would have to usE \nthe delta of the imbedded call. \nExample: An investor is long 1,000 shares ofXYZ PERCS maturing in tw", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 282}
{"text": "long a PERCS and short a listed call, he is by definition a ratio writer, so he should \n630 Part V: Index Options and Futures \nbe interested in neutrality. The key to determining one's neutrality, of course, is tc \nuse the delta of the option. In the case of the PERCS stock, one would have to usE \nthe delta of the imbedded call. \nExample: An investor is long 1,000 shares ofXYZ PERCS maturing in two years. He \nthinks XYZ is stuck in a trading range and does not expect much volatility in the near \nfuture. Thus, a ratio write appeals to him. How many calls should he sell in order to \ncreate a neutral position against his 1,000 shares? \nFirst, he needs to compute the delta of the imbedded option in the PER CS, and \ntherefore the delta of the PERCS itself. The delta of a PERCS is not 1.00, as is the \ndelta of common stock. \nAssume the XYZ PERCS matures in two years. It is redeemable at 39 at that \ntime. XYZ common is currently trading at 33. The delta of a two-year call with strik\ning price 39 and common stock at 33 can be calculated (the dividends, short-term \ninterest rate, and volatility all play a part). Suppose that the delta of such an option is \n0.30. Then the delta of the PER CS can be computed: \nPERCS delta= 1.00- Delta of imbedded call \n= 1.00 - 0.30 = 0.70 in this example \nAssume the following data is known: \nSecurity \nXYZ Common \nXYZ PERCS \nXYZ October 40 call \nPrice \n33 \n34 \n2 \nDelta \n1.00 \n0.70(!) \n0.35 \nBeing long 1,000 PER CS shares is the equivalent of being long 700 shares of \ncommon (ESP= 1,000 x 0.70 = 700). In order to properly hedge that ESP with the \nOctober 40 call, one would need to sell 20 October 40 calls. \nQuantity to sell = ESP of PER CS/ESP of October 40 call \n= 700/(100 shares per option x 0.35) \n= 700/35 = 20 \nThus, the position - long 1,000 PER CS, short 20 October 40 calls - is a neutral one \nand it is a ratio write. \nOne may not want to have such a steep ratio, since the result of this example is \nthe equivalent of being long 1,000 common and short 30 calls in total (10 are imbed\nded in the long PERCS). Consequently, he could look at other options - perhaps \nwriting in-the-money October calls - that have higher deltas and won't require so \nmany to be sold in order to produce a neutral position. \nCl,apter 32: Structured Produds 631 \nTo remain neutral, one would have to keep computing the deltas of the options, \nboth listed and imbedded, as time passes, because stock movements or the passage \nof time could change the deltas and therefore affect the neutrality of the position. \nHEDGING PERCS WITH COMMON STOCK \nSome traders may want to use the common stock to hedge the purchase of PERCS. \nThese would normally be market-makers or block traders who acquire the PERCS in \norder to provide liquid markets or because they think they are slightly mispriced. The \nsimplest way for these traders to hedge their long PERCS would be with common \nstock. \nThis strategy might also apply to an individual who holds PERCS, if he wants to \nhedge them from a potential price decline but does not actually want to sell them (for \ntax reasons, perhaps). \nIn either case, it is not correct to sell 100 shares of common against each 100 \nshares of PERCS owned. That is not a true hedge. In fact, what one accomplishes by \ndoing that is to create a naked call option. A PERCS is a covered write; if one sells \n100 shares of common stock from a covered write, he is left with a naked call. This \ncould cause large losses if the common rallies. \nRather, the proper way to hedge the PERCS with common stock is to calculate \nthe equivalent stock position of the PERC S and hedge with the calculated amount of \ncommon stock. The example showed how to calculate the ESP of the PERCS: One \nmust calculate the delta of the imbedded call option, which may be a long-term one. \nThen the delta of the PERCS can be computed, and the equivalent stock position can \nbe determined. \nExample: V sing the same prices from the previous example, one can see how much \nstock he would have to sell in order to properly hedge his PERCS holding of 1,000 \nshares. \nAssume XYZ is trading at 33, and the PE RCS has two years until maturity. If the \nPERCS is redeemable at 39 at maturity, one can determine that the delta of the \nimbedded option is 0.30 (see previous example). Then: \nDelta of PE RCS = 1 - Delta of imbedded call \n= 1- 0.30 \n= 0.70 \nHence, the equivalent stock position of 1,000 PERCS is 700 shares (1,000 x \n0.10). 1 Consequently, one would sell short 700 shares of XYZ common in order to \nhedge this long holding of 1,000 PERCS. \n632 Part V: Index Options and Futures \nThis is not a static situation. If XYZ changes in price, the delta of the imbedded \noption will change as well, so that the proper amount of stock to sell as a hedge will \nchange. The deltas will change with the passage of time as well. A change in volatili\nty of the common stock can affect the deltas, too. Consequently, one must constant\nly recalculate the amount of stock needed to hedge the PERCS. \nWhat one has actually created by selling some common stock against his long \nPERCS holding is another ratio write. Consider the fact that being long 1,000 \nPE RCS shares is the equivalent of being long 1,000 common and short 10 imbedded, \nlong-term calls. If one sells 700 common, he will be left with an equivalent position \nof long 300 common and short 10 imbedded calls - a ratio write. \nThe person who chooses to hedge his PER CS holding with a partial sale of com\nmon stock, as in the example, would do well to visualize the resulting hedged posi\ntion as a neutral ratio write. Doing so will help him to realize that there is both upside \nand downside risk if the underlying common stock should become very volatile (ratio \nwrites have risk on both the upside and the downside). If the common remains fair\nly stable, the value of the imbedded call will decrease and he will profit. However, if \nit is a long-term imbedded call (that is, if there is a long time until maturity o", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 283}
{"text": "Doing so will help him to realize that there is both upside \nand downside risk if the underlying common stock should become very volatile (ratio \nwrites have risk on both the upside and the downside). If the common remains fair\nly stable, the value of the imbedded call will decrease and he will profit. However, if \nit is a long-term imbedded call (that is, if there is a long time until maturity of the \nPER CS), the rate of time decay will be quite small; the hedger should realize that \nfact as well. \nIn summary, the sale of some common against a long holding of PERCS is a \nviable way to hedge the position. When one hedges in this manner, he must contin\nue to monitor the position and would be best served by viewing it as a ratio write at \nall times. \nSELLING PERCS SHORT \nCan it make sense to sell PER CS short? The payout of the large dividend seems to \nbe a deterrent against such a short sale. However, if one views it as the opposite of a \nlong-term, out-of-the-money covered write, it may make some sense. \nA covered write is long stock, short call; it is also equivalent to being long a \nPERCS. The opposite of that is short stock, long call - a synthetic put. Therefore, a \nlong put is the equivalent of being short a PERCS. Profit graph Hin Appendix D \nshows the profit potential of being short stock and long a call. There is large down\nside profit potential, but the upside risk is limited by the presence of the long call. \nThe amount of premium paid for the long call is a wasting asset. If the stock does not \ndecline in price, the long call premium may be lost, causing an overall loss. \nShorting a PERCS would result in a position with those same qualities. The \nupside risk is limited by the redemption feature of the PERCS. The downside prof\nit potential is large, because the PER CS will trade down in price if the common stoek \nChapter 32: Structured Products 633 \ndoes. The problem for the short seller of the PER CS is that he has to pay a lot for \nthe imbedded call that affords him the protection from upside risk. The actual price \nthat he has to pay is the dividends that he, as a short seller, must pay out. But this can \nalso be thought of as having purchased a long-term call out-of-the-money as protec\ntion for a short sale of common stock. The long-term call is bound to be expensive, \nsince it has a great deal of time premium remaining; moreover, the fact that it is out\nof-the-money means that one is also assuming the price risk from the current com\nmon price up to the strike of the call. Hence, this out-of-the-money amount plus the \ntime value premium of the imbedded call can add up to a substantial amount. \nThis discussion mainly pertains to shorting a PERCS near its issuance price and \ndate. However, one is free to short PERCS at any time if they can be borrowed. They \nmay be a more attractive short when they have less time remaining until the maturi\nty date, or when the underlying common is closer to the redemption price. \nOverall, one would not normally expect the short sale of a PERCS to be vastly \nsuperior to a synthetic put constructed with listed options. Arbitrageurs would be \nexpected to eliminate such a price discrepancy if one exists. However, if such a situ\nation does present itself, the short seller of the PERCS should realize he has a posi\ntion that is the equivalent of owning a put, and plan his strategy accordingly. \nDETERMINING THE ISSUE PRICE \nAn investor might wonder how it is always possible for the PERCS and the common \nto be at the same price at the issue date. In fact, the issuing company has two vari\nables to work with to ensure that the common price and the PERCS issue price are \nthe same. One variable is the amount of the additional dividend that the PERCS will \npay. The other is the redemption price of the PER CS. By altering these two items, \nthe value of the covered write (i.e., the PERCS) can be made to be the same as the \ncommon on the issue date. \nFigure 32-7 shows the values that are significant in determining the issue price \nof the PE RCS. The line marked Final Value is the shape of the profit graph of a cov\nered write at expiration. This is the PERCS's final value at its maturity. The curved \nline is the value of the covered write at the current time, well before expiration. Of \ncourse, these two are linked together. \nThe line marked Common Stock is merely the profit or loss of owning stock. \nThe curved line (present PERCS value) crosses the Common Stock line at the issue \nprice. \nAt the time of issuance, the difference between the current stock price and the \neventual maturity value of the PER CS is the present value of all the additional divi\ndends to be paid. That amount is marked a1/11e vertical line on the graph. Therefore, \n634 Part V: Index Options and Futures \nFIGURE 32-7. \n3-year PERCS issue price. \ni a. \nStock Price \nanywhere out-of-the-money, the difference between the Final Value line and the \nCommon Stock line, is the present worth of the additional dividends to be paid \nbetween now and maturity of the PERCS. \nThus, on the day the PERCS is to be issued (or shortly before), the issuing cor\nporation can alter the PERCS dividend or demand price in order to \"move\" the \ncurved line (present PERCS value) so that it intersects the Common Stock line at \ntoday's stock price. The terms of the PER CS would then be set to those parameters. \nPRICING PERCS \nThe crucial factor in detennining whether a PERC S is fairly priced lies in valuing the \nimbedded call option within the PERCS. This may be a somewhat subjective task, \nespecially if the PER CS has a long time until maturity. Recall that it was shown that \nsmall changes in the assumptions for LEAPS calls can seriously alter their theoreti\ncal values. The same holds true for valuing the call within the PERCS. If one trader \nis using a volatility assumption of 25%, say, for the common stock and another is using \n28%, then they are going to arrive at different values for a three-year call. In such a", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 284}
{"text": "time until maturity. Recall that it was shown that \nsmall changes in the assumptions for LEAPS calls can seriously alter their theoreti\ncal values. The same holds true for valuing the call within the PERCS. If one trader \nis using a volatility assumption of 25%, say, for the common stock and another is using \n28%, then they are going to arrive at different values for a three-year call. In such a \ncase, one trader may think the PERCS is expensive at its current price and another \nmay think it is cheap. \nG,pter 32: Strudured Products 635 \nSuch discrepancies will be most notable when there is not a listed option that \nhas terms near the terms of the PERCS's imbedded call. If there is such a listed \noption, then arbitrageurs should be able to use it and the common stock to bring the \nPERCS into line. However, if there is not any such listed option available, there may \nbe opportunities for theoretical value traders. \nModels used for pricing call options, such as the Black-Scholes model, are dis\ncussed in Chapter 28 on mathematical applications. These models can be used to \nvalue the imbedded call in the PERCS as well. If the strategist determines the \nimplied value of the imbedded call is out of line, he may be able to make a profitable \ntrade. It is a fairly simple matter to determine the implied value of the imbedded call. \nThe formula to be used is: \nImbedded call implied value = Current stock price \n+ Present value of dividends - Current PERCS price \nThe validity of this formula can be seen by referring again to Figure 32-7. The \ndifference between the Final Value (that is, the profit of the covered write at expira\ntion) and the Issue Value or current value of the PERCS is the imbedded call price. \nThat is, the difference between the curved line and the line at expiration is merely \nthe present time value of the imbedded call. Since this formula is describing an out\nof-the-money situation, then the time value of the imbedded call is its entire price. \nIt is also known that the Final Value line differs from the current stock price by the \npresent value of all the additional dividends to be paid by the PERCS until maturity. \nThus, the four variables are related by the simple formula given above. \nExample: XYZ has fallen to 32 after the PERCS was issued. The PERCS is current\nly trading at 34 and, as in previous examples, the PERCS pays an additional $1.50 per \nyear in dividends. If there are two years remaining until maturity of the PERCS, what \nis the value of the imbedded call option? \nFirst, calculate the present value of the additional dividends. One should calcu\nlate the present value of each dividend. Since they are paid quarterly, there will be \neight of them between now and maturity. \nAssume the short-term interest rate is 6%. Each additional quarterly dividend \nis $0.375 ($1.50 divided by 4). Thus, the present value of the dividend to be paid in \nthree months is: \npw = 0.375/(1 + .06)114 = $0.3696 \nThe present value of the dividend to be paid two years from now is: \npw = 0.375/(1 + .06)2 = $0.338 \ni \n636 Part V: Index Options and Futures \nAdding up all eight of these, it is determined that the present worth of all the \nremaining additional dividends is $2.81. Note that this is less than the actual amount \nthat will eventually be paid over the two years, which is $3.00. \nNow, using the simple formula given earlier, the value of the imbedded call can \nbe determined: \nXYZ: 32 \nPERCS: 34 \nPresent worth of additional dividends: 2.81 \nImbedded call = Stock price + pw divs - PERCS price \n= 32 + 2.81 - 34 \n= 0.81 \nOnce this call value is determined, the strategist can use a model to see if this call \nappears to be cheap or expensive. In this case, the call looks cheap for a two-year call \noption that is 7 points out-of-the-money. Of course, one would need to know how \nvolatile XYZ stock is, in order to draw a definitive conclusion regarding whether the \nimbedded call is undervalued or not. \nA basic relationship can be drawn between the PER CS price and the calculated value \nof the imbedded call: If the imbedded call is undervalued, then the PERCS is too \nexpensive; if the imbedded call is overpriced, then the PERCS is cheap. In this exam\nple, the value of the imbedded call was only 81 cents. If XYZ is a stock with average \nor above average volatility, then the call is certainly cheap. Therefore, the PERCS, \ntrading at 34, is too expensive. \nOnce this determination has been made, the strategist must decide how to use \nthe information. A buyer of PER CS will need to know this information to determine \nif he is paying too much for the PER CS; alternatively stated, he needs to know if he \nis selling the imbedded call too cheaply. A hedger might establish a true hedge by \nbuying common and selling the PERCS, using the proper hedge ratio. It is possible \nfor a PER CS to remain expensive for quite some time, if investors are buying it for \nthe additional dividend yield alone and are not giving proper consideration to the \nlimited profit potential. Nevertheless, both the outright buyer and the strategist \nshould calculate the correct value of the PER CS in order to make rational decisions. \nPERCS SUMMARY \nA PERCS is a preferred stock with a higher dividend yield than the common, and it \nis demandable at a predetermined series of prices. The decision to demand is strict\nly at the discretion of the issuing company; the PER CS holder has no say in the deci-\nCl,opter 32: Structured Products 637 \n:don. The PERCS is equivalent to a covered write of a long-term call option, which is \nimbedded in the PERCS value. Although there are not many PERCS trading at the \ncurrent time, that number may grow substantially in the future. \nAny strategies that pertain to covered call writing will pertain to PER CS as well. \nConventional listed options can be used to protect the PERCS from downside risk, \nto remove the limited upside profit potential, or to effectively change the price at \nwhich the PERCS is redeemable.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 285}
{"text": "Although there are not many PERCS trading at the \ncurrent time, that number may grow substantially in the future. \nAny strategies that pertain to covered call writing will pertain to PER CS as well. \nConventional listed options can be used to protect the PERCS from downside risk, \nto remove the limited upside profit potential, or to effectively change the price at \nwhich the PERCS is redeemable. Ratio writes can be constructed by selling a listed \ncall. Shorting PERCS creates a security that is similar to a long put, which might be \nquite expensive if there is a significant amount of time remaining until maturity of \nthe PERCS. \nNeutral traders and hedgers should be aware that a PERCS has a delta of its \nown, which is equal to one minus the delta of the imbedded call option. Thus, hedg\ning PERCS with common stock requires one to calculate the PERCS delta. \nFinally, the implied value of the call option that is imbedded with the PERCS \ncan be calculated quite easily. That information is used to determine whether the \nPERCS is fairly priced or not. The serious outright buyer as well as the option strate\ngist should make this calculation, since a PERCS is a security that is option-related. \nEither of these investors needs to know if he is making an attractive investment, and \ncalculating the valuation of the imbedded call is the only way to do so. \nOTHER STRUCTURED PRODUCTS \nEXCHANGE-TRADED FUNDS \nOther listed products exist that are simpler in nature than those already discussed, \nbut that the exchanges sometimes refer to as structured products. They often take \nthe form of unit trusts and mutual funds. The general term for these products is \nExchange-Traded Funds (ETFs). In a unit trust, an underwriter (Merrill Lynch, for \nexample) packages together 10 to 12 stocks that have similar characteristics; perhaps \nthey are in the same industry group or sector. The underwriter forms a unit trust with \nthese stocks. That is, the shares are held in trust and the resulting entity - the unit \ntrust - can actually be traded as shares of its own. The units are listed on an exchange \nand trade just like stocks. \nExample: One of the better-known and popular unit trusts is called the Standard & \nPoor's Depository Receipt{SPDR). It is a unit trust that exactly matches the S&P 500 \nindex, divided by 10. Th&-SPDR unit trust is affectionately called Spiders (or \nSpyders). It trades on the AMEX under the symbol SPY. If the S&P 500 index itself \nis at 1,400, for example, then SPY will be trading near 140. Unit trusts are very active, \nmostly because they allow any investor to buy an index fund, and to move in and out \nof it at will. The bid-asked spread differential is very tight, due to the liquidity of the \n638 Part V: Index Options and Futures \nproduct. When a customer trades the SPY, he pays a commission, just as he would \nwith any listed stock. \nExchange-traded funds are attractive to all investors who like to trade or invest in \nindex funds, preferring the diversity provided by an index (passive management of \nstocks) to an active role in managing individual stocks. Exchange-traded funds can be \nsold short as long as the shares can be borrowed. Some of them don't even require \nan uptick when executing the short sale. \nTwo other large and well-known unit trusts are similar to SPY. One is the NAS\nDAQ-100 tracking stock, whose symbol is QQQ. QQQ is 1140th of the value of the \nNASDAQ-100 index ($NDX), although it should be noted that $NDX has split two\nfor-one in the past, as has QQQ, so the relationship could change by a factor of two. \nThe other large, popular unit trust is linked to the Dow-Jones 30 Industrials; it is \ncalled Diamonds and trades under the symbol DIA. Both QQQ and DIA trade on \nthe AMEX. Since this concept has proved to be popular, sector SPDRs were created \non a large number of S&P index sectors - technology, oil, semiconductors, etc. These \nhave proven to be less popular. There are even ETFs that are equal to one-tenth of \nthe $OEX index, although they have not proven to be liquid. \nETFs are \"created\" by institutions in blocks of shares known as Creation Units. \nA creation requires a deposit with the trustee of a specified number of shares of a \nportfolio of stocks closely approximating the composition of a specific index, and cash \nequal to accumulated dividends in return for specific index shares. Similarly, block\nsized units of ETFs can be redeemed in return for a portfolio of stocks approximat\ning the index and a specified amount of cash. Very large blocks of shares - 50,000 or \nmore - are required to create SPY, QQQ, DIA, and so forth. Slightly smaller blocks \nof shares are required to create the sector funds. \nIf one is interested in knowing exactly what funds are listed at any time, he \nshould consult the Web site of the exchange where the ETF is listed. The AMEX \ngenerally has extensive information about the nature of these products on its site at \nwww.amex.com. \nA very large segment of ETFs, called iShares, was created by Barclays Global \nInvestors to track all kinds of index funds. Many of these are not well known to the \npublic, such as the Russell 2000 Value Fund and the Russell 2000 Growth Fund, but \nmost of them are understandable upon inspection. There are iShares on funds that \ntrack foreign industries, plus a broad spectrum of funds that track small-cap stocks, \nvalue stocks, growth stocks, or individual sectors such as health care, the Internet, or \nreal estate. A Web site, www.ishares.com, shows all of the currently available iShares. \nThe iShares are all traded on major stock exchanges. \nChapter 32: Structured Products 639 \nAnother major segment of ETFs are called Holding Company Depository \nReceipts (HOLDRS). They were created by Merrill Lynch and are listed on the \nAMEX. \nOptions on ETFs. Options are listed on many ETFs. QQQ options, for example, \nare listed on all of the option exchanges and are some of the most liquid contracts in \nexistence. Things can always cha", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 286}
{"text": "exchanges. \nChapter 32: Structured Products 639 \nAnother major segment of ETFs are called Holding Company Depository \nReceipts (HOLDRS). They were created by Merrill Lynch and are listed on the \nAMEX. \nOptions on ETFs. Options are listed on many ETFs. QQQ options, for example, \nare listed on all of the option exchanges and are some of the most liquid contracts in \nexistence. Things can always change, of course: Witness OEX, which at one time \ntraded a million contracts a day and now barely trades one-thirtieth of that on most \ndays. \nThe options on ETFs can be used as substitutes for many expensive indices. \nThis brings index option trading more into the realm of reasonable cost for the small \nindividual investor. \nExample: The PHLX Semiconductor index ($SOX) has been a popular index since \nits inception, especially during the time that tech stocks were roaring. The index, \nwhose options are expensive because of its high statistical volatility, traded at prices \nbetween 500 and 1,300 for several years. During that time, both implied and histor\nical volatility was near 70%. So, for example, if $SOX were at 1,000 and one wanted \nto buy a three-month at-the-money call, it would cost approximately 135 points. \nThat's $13,500 for one call option. For many investors, that's out of the realm of fea\nsibility. \nHowever, there are HOLDRS known as Semiconductor HOLDRS (symbol: \nSMH). The Semiconductor HOLD RS are composed of 20 stocks (in differing quan\ntities, since it is a capitalization-weighted unit trust) that behave in aggregate in much \nthe same manner as the Semiconductor index ($SOX) does. However, SMH has trad\ned at prices between 40 and 100 over the same period of time that $SOX was trad\ning between 500 and 1,300. The implied volatility of SMH options is 70% - just like \n$SOX options - because the same stocks are involved in both indices. However, a \nthree-month at-the-money call on the $100 SMH, say, would cost only 13.50 points \n($1,350) - a much more feasible option cost for most investors and traders. \nThus, a strategy that most option traders should keep in mind is one in which ETFs \nare substituted when one has a trading signal or opinion on a high-priced index. \nSimilarities exist among many of them. For example, the Morgan Stanley High-Tech \nindex ($MSH) is well known for the7eliability of its put-call ratio sentiment signals. \nHowever, the index is high-priced and volatile, much like $SOX. Upon examination, \nthough, one can discover that QQQ trades almost exactly like $MSH. So QQQ \noptions and \"stock\" can be used as a substitute when one wants to trade $MSH. \n640 Part V: Index Options and Futures \nSTRUCTURED PRODUCT SUMMARY \nStructured products whether of the simple style of the Exchange-Traded Fund or \nthe more complicated nature of the PERCS, bull spreads, or protected index funds \n- can and should be utilized by investors looking for unique ways to protect long\nterm holdings in indices or individual stocks. \nThe number of these products is constantly evolving and changing. Thus, \nanyone interested in trading these items should check the Web sites of the exchanges \nwhere the shares are listed. Analytical tools are available on the Web as well. \nFor example, the site www.derivativesmodels.com has over 40 different models \nespecially designed for evaluating options and structured products. They range from \nthe simple Black-Scholes model to models that are designed to evaluate extremely \ncomplicated exotic options. \nAll of these products have a place, but the most conservative seem to be the \nstructured products that provide upside market potential while limiting downside \nrisk- the products discussed at the beginning of the chapter. As long as the credit\nworthiness of the underwriter is not suspect, such products can be useful longer\nterm investments for nearly everyone who bothers to learn about and understand \nthem. \nCHAPTER 33 \nMathetnatical Considerations \nfor Index Products \nIn this chapter, we look at some riskless arbitrage techniques as they apply to index \noptions. Then a summary of mathematical techniques, especially modeling, is pre\nsented. \nARBITRAGE \nMost of the normal arbitrage strategies have been described previously. We will \nreview them here, concentrating on specific techniques not described in previous \nchapters on hedging (market baskets) and index spreading. \nDISCOUNTING \nWe saw that discounting in cash-based options is done with in-the-money options as \nit is with stock options. However, since the discounter cannot exactly hedge the cash\nbased options, he will normally do his discounting near the close of the day so that \nthere is as little time as possible between the time the option is bought and the close \nof the market. This reduces the risk that the underlying index can move too far before \nthe close of trading. \nExample: OEX is trading at 673.53 7nd an arbitrageur can buy the June 690 puts for \n16. That is a discount of 0.47 since,parity is 16.47. Is this enough of a discount? That \nis, can the discounter buy this put, hold it unhedged until the close of trading, and \n641 \n642 Part V: Index Options and Futures \nexercise it; or is there too great a chance that OEX will rally and wipe out his dis\ncount? \nIf he buys this put when there is very little time left in the trading day, it might \nbe enough of a discount. Recall that a one-point move in OEX is roughly equivalent \nto 15 points on the Dow (while a one-point move in SPX is about 7.5 Dow points). \nThus, this O EX discount of 0.4 7 is about equal to 7 Dow points. Obviously, this is not \na lot of cushion, because the Dow can easily move that far in a short period of time, \nso it would be sufficient only if there are just a few minutes of trading left and there \nwere not previous indications oflarge orders to buy \"market on close.\" \nHowever, if this situation were presented to the discounter at an earlier time in \nthe trading day, he might defer because he would have to hedge his position and that \nm", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 287}
{"text": "ecause the Dow can easily move that far in a short period of time, \nso it would be sufficient only if there are just a few minutes of trading left and there \nwere not previous indications oflarge orders to buy \"market on close.\" \nHowever, if this situation were presented to the discounter at an earlier time in \nthe trading day, he might defer because he would have to hedge his position and that \nmight not be worth the trouble. If there were several hours left in the trading day, \neven a discount of a full point would not be enough to allow him to remain unhedged \n(one full OEX point is about 15 Dow points). Rather, he would, for example, buy \nfutures, buy OEX calls, or sell puts on another index. At the end of the day, he could \nexercise the puts he bought at a discount and reverse the hedge in the open market. \nCONVERSIONS AND REVERSALS \nConversions and reversals in cash-based options are really the market basket hedges \n(index arbitrage) described in Chapter 30. That is, the underlying security is actually \nall the stocks in the index. However, the more standard conversions and reversals can \nbe executed with futures and futures options. \nSince there is no credit to one's account for selling a future and no debit for buy\ning one, most futures conversions and reversals trade very nearly at a net price equal \nto the strike. That is, the value of the out-of-the-money futures option is equal to the \ntime premium of the in-the-money option that is its counterpart in the conversion or \nreversal. \nExample: An index future is trading at 179.00. If the December 180 call is trading \nfor 5.00, then the December 180 put should be priced near 6.00. The time value pre\nmium of the in-the-money put is 5.00 (6.00 + 179.00 - 180.00), which is equal to the \nprice of the out-of-the-money call at the same strike. \nIf one were to attempt to do a conversion or reversal with these options, he \nwould have a position with no risk of loss but no possibility of gain: A reversal would \nbe established, for example, at a \"net price\" of 180. Sell the future at 179, add the \npremium of the put, 6.00, and subtract the cost of the call, 5.00: 179 + 6.00 - 5.00 = \n180.00. As we know from Chapter 27 on arbitrage, one unwinds a conversion or \nreversal for a \"net price\" equal to the strike. Hence, there would be no gain or loss \nfrom this futures reversal. \nChapter 33: Mathematical Considerations for Index Products 643 \nFor index futures options, there is no risk when the underlying closes near the \nstrike, since they settle for cash. One is not forced to make a choice as to whether to \nexercise his calls. (See Chapter 27 on arbitrage for a description of risks at expiration \nwhen trading reversals or conversions.) \nIn actual practice, floor traders may attempt to establish conversions in futures \noptions for small increments - perhaps 5 or 10 cents in S&P futures, for example. \nThe arbitrageur should note that futures options do actually create a credit or debit \nin the account. That is, they are like stock options in that respect, even though the \nunderlying instrument is not. This means that if one is using a deep in-the-money \noption in the conversion, there will actually be some carrying cost involved. \nExample: An index future is trading at 179.00 and one is going to price the \nDecember 190 conversion, assuming that December expiration is 50 days away. \nAssume that the current carrying cost of money is 10% annually. Finally, assume that \nthe December 190 call is selling for 1.00, and the December 190 put is selling for \n11.85. Note that the put has a time value premium of only 85 cents, less than the pre\nmium of the call. The reason for this is that one would have to pay a carrying cost to \ndo the December 190 conversion. \nIf one established the 190 conversion, he would buy the futures (no credit or \ndebit to the account), buy the put (a debit of 11.85), and sell the call (a credit of 1.00). \nThus, the account actually incurs a debit of 10.85 from the options. The carrying cost \nfor 10.85 at 10% for 50 days is 10.85 x 10% x 50/365 = 0.15. This indicates that the \nconverter is willing to pay 15 cents less time premium for the put (or conversely that \nthe reversal trader is willing to sell the put for 15 cents less time premium). Instead \nof the put trading with a time value premium equal to the call price, the put will trade \nwith a premium of 15 cents less. Thus, the time premium of the put is 85 cents, \nrather than being equal to the price of the call, 1.00. \nBOX SPREADS \nRecall that a \"box\" consists of a bullish vertical spread involving two striking prices, \nand a bearish vertical spread using the same two strikes. One spread is constructed \nwith puts and the other with calls. The profitability of the box is the same regardless \nof the price of the underlying security at expiration. \nBox arbitrage with equity options involves trying to buy the box for less than the \ndifference in the striking prices, for ~ple, trying to buy a box in which the strikes \nare 5 points apart for 4. 75. Selling the box for more than 5 points would represent \narbitrage as well. In fact, even selling the box at exactly 5 points would produce a \nprofit for the arbitrageur, since he earns interest on the credit from the sale. \n644 Part V: Index Options and Futures \nThese same strategies apply to options on futures. However, boxes on cash\nbased options involve another consideration. It is often the case with cash-based \noptions that the box sells for more than the difference in the strikes. For example, a \nbox in which the strikes are 10 points apart might sell for 10.50, a substantial premi\num over the striking price differential. The reason that this happens is because of the \npossibility of early assignment. The seller of the box assumes that risk and, as a result, \ndemands a higher price for the box. \nIf he sells the box for half a point more than the striking price differential, then \nhe has a built-in cushion of .50 point of index movem", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 288}
{"text": "might sell for 10.50, a substantial premi\num over the striking price differential. The reason that this happens is because of the \npossibility of early assignment. The seller of the box assumes that risk and, as a result, \ndemands a higher price for the box. \nIf he sells the box for half a point more than the striking price differential, then \nhe has a built-in cushion of .50 point of index movement if he were to be assigned \nearly. In general, box strategies are not particularly attractive. However, if the pre\nmium being paid for the box is excessively high, then one should consider selling the \nbox. Since there are four commissions involved, this is not normally a retail strategy. \nMATHEMATICAL APPLICATIONS \nThe following material is intended to be a companion to Chapter 28 on mathemati\ncal applications. Index options have a few unique properties that must be taken into \naccount when trying to predict their value via a model. \nThe Black-Scholes model is still the model of choice for options, even for index \noptions. Other models have been designed, but the Black-Scholes model seems to \ngive accurate results without the extreme complications of most of the other models. \nFUTURES \nModeling the fair value of most futures contracts is a difficult task. The \nBlack-Scholes model is not usable for that task. Recall that we saw earlier that the \nfair value of a future contract on an index could be calculated by computing the pres\nent value of the dividend and also knowing the savings in carrying cost of the futures \ncontract versus buying the actual stocks in the index. \nCASH-BASED INDEX OPTIONS \nThe futures fair value model for a capitalization-weighted index requires knowing the \nexact dividend, dividend payment date, and capitalization of each stock in the index \n(for price-weighted indices, the capitalization is unnecessary). This is the only way of \ngetting the accurate dividend for use in the model. The same dividend calculation \nmust be done for any other index before the Black-Scholes formula can be applied. \nIn the actual model, the dividend for cash-based index options is used in much \nthe same way that dividends are used for stock options: The present value of the div-\nChapter 33: Mathematical Considerations for Index Products 64S \nidend is subtracted from the index price and the model is evaluated using that adjust\ned stock price. With stock options, there was a second alternative - shortening the \ntime to expiration to be equal to the ex-date - but that is not viable with index options \nsince there are numerous ex-dates. \nLet's look at an example using the same fictional dividend information and index \nthat were used in Chapter 30 on stock index hedging strategies. \nExample: Assume that we have a capitalization-weighted index composed of three \nstocks: AAA, BBB, and CCC. The following table gives the pertinent information \nregarding the dividends and floats of these three stocks: \nDividend Days until \nStock Amount Dividend Float \nAAA 1.00 35 50,000,000 \nBBB 0.25 60 35,000,000 \nCCC 0.60 8 120,000,000 \nDivisor: 150,000,000 \nOne first computes the present worth of each stock's dividend, multiplies that \namount by the float, and then divides by the index divisor. The sum of these compu\ntations for each stock gives the total dividend for the index. The present worth of the \ndividend for this index is $0.8667. \nAssume that the index is currently trading at 175.63 and that we want to evalu\nate the theoretical value of the July 175 call. Then, using the Black-Scholes model, \nwe would perform the following calculations: \n1. Subtract the present worth of the dividend, 0.8667, from the current index price \nof 175.63, giving an adjusted index price of 174.7633. \n2. Evaluate the call's fair value using 17 4. 7633 as the stock price. All other variables \nare as they are for stocks, including the risk-free interest rate at its actual value \n(10%, for example). \nThe theoretical value for puts is computed in the same way as for equity \noptions, by using the arbitrage model. This is sufficient for cash-based index options \nbecause it is possible - albeit difficult to hedge these options by buying or selling \nthe entire index. Thus, the options should reflect the potential for such arbitrage. \nThe put value should, of course, reflect the potential for dividend arbitrage with the \nindex. The arbitrage valuation model p\"resented in Chapter 28 on modeling called for \nthe dividend to be used. For these index puts, one would use the present worth of \n646 Part V: Index Options and Futures \nthe dividend on the index - the same one that was used for the call valuation, as in \nthe last example. \nTHE IMPLIED DIVIDEND \nIf one does not have access to all of the dividend information necessary to make the \n\"present worth of the dividends\" calculation (i.e., if he is a private individual or pub\nlic customer who does not subscribe to a computer-based dividend \"service\"), there \nis still a way to estimate the present worth of the dividend. All one need do is make \nthe assumption that the market- makers know what the present worth of the dividend \nis, and are thus pricing the options accordingly. The individual public customer can \nuse this information to deduce what the dividend is. \nExample: OEX is trading at 700, the June options have 30 days of life remaining, the \nshort-term interest rate is 10%, and the following prices exist: \nJune 700 call: 18.00 \nJune 700 put: 14.50 \nOne can use iterations of the Black-Scholes model to determine what the OEX \n\"dividend\" is. In this case, it turns out to be something on the order of $2.10. \nBriefly, these are the steps that one would need to follow in order to determine \nthis dividend: \n1. Assume the dividend is $0.00. \n2. Using the assumed dividend, use the Black-Scholes model to determine the \nimplied volatility of the call option, whose price is known (18.00 in the above \nexample). \n3. Using the implied volatility determined from step 2 and the assumed dividend, \nis the a", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 289}
{"text": "$2.10. \nBriefly, these are the steps that one would need to follow in order to determine \nthis dividend: \n1. Assume the dividend is $0.00. \n2. Using the assumed dividend, use the Black-Scholes model to determine the \nimplied volatility of the call option, whose price is known (18.00 in the above \nexample). \n3. Using the implied volatility determined from step 2 and the assumed dividend, \nis the arbitrage put value as derived from the Black-Scholes calculations at the \nend of step 2 roughly equal to the market value of the put (14.50 in the above \nexample)? If yes, you are done. If not, increase the assumed dividend by some \nnominal amount, say $0.10, and return to step 2. \nThus, without having access to complete dividend information, one can use the \ninformation provided to him by the marketplace in order to imply the dividend of an \nindex option. The only assumption one makes is that the market-makers know what \nthe dividend is (they most assuredly do). Note that the implied volatility of the \noptions is determined concurrently with the implied dividend (step 2 above). A veiy \nuseful tool, this simple \"implied dividend calculator\" can be added to any software \nthat employs the Black-Scholes model. \nO,apter 33: Mathematical Considerations for Index Products \nEUROPEAN EXERCISE \n647 \nTo account for European exercise, one basically ignores the fact that an in-the-money \nput option's minimum value is its intrinsic value. European exercise puts can trade at \na discount to intrinsic value. Consider the situation from the viewpoint of a conver\nsion arbitrage. If one buys stock, buys puts, and sells calls, he has a conversion arbi\ntrage. In the case of a European exercise option, he is forced to carry the position to \nexpiration in order to remove it: He cannot exercise early, nor can he be called early. \nTherefore, his carrying costs will always be the maximum value to expiration. These \ncarrying costs are the amount of the discount of the put value. \nFor a deeply in-the-money put, the discount will be equal to the carrying \ncharges required to carry the striking price to expiration: \nCarry = s Ji - 1 ] L (1+ r)t \nLess deeply in-the-money puts, that is, those with deltas less than - 1.00, would \nnot require the full discounting factor. Rather, one could multiply the discounting \nfactor by the absolute value of the put' s delta to arrive at the appropriate discounting \nfactor. \nFUTURES OPTIONS \nA modified Black-Scholes model, called the Black Model, can be used to evaluate \nfutures options. See Chapter 29 on futures for a futures discussion. Essentially, the \nadjustment is as follows: Use 0% as the risk-free rate in the Black-Scholes model and \nobtain a theoretical call value; then discount that result. \nBlack model: \nCall value= e-rt x Black-Scholes call value [using r = 0%] \nwhere \nr is the risk-free interest rate \nand t is the time to expiration in years. \nThe relationship between a futures call theoretical value and that of a put can \nalso be discussed from the model: \nCall = Put + e-rf(J - s) \nwhere \nf is the futures price \nands is the striking price. \n648 Part V: Index Options and Futures \nExample: The following prices exist: \nZYX Cash Index: 17 4.49 \nZYX December future: 177.00 \nThere are 80 days remaining until expiration, the volatility of ZYX is 15%, and \nthe risk-free interest rate is 6%. \nIn order to evaluate the theoretical value of a ZYX December 185 call, the fol\nlowing steps would be taken: \nl. Evaluate the regular Black-Scholes model using 185 as the strike, 177.00 as the \nstock price, 15% as the volatility, 0.22 as the time remaining (80/365), and 0% as \nthe interest rate. Note that the futures price, not the index price, is input to the \nmodel as stock price. \nSuppose that this yields a result of 2.05. \n2. Discount the result from step l: \nBlack Model call value = e-(.0 6 x 0-22) x 2.05 \n= 2.02 \nIn this case, the difference between the Black model and the Black-Scholes \nmodel is small (3 cents). However, the discounting factor can be large for longer-term \nor deeply in-the-money options. \nThe other items of a mathematical nature that were discussed in Chapter 28 on \nmathematical applications are applicable, without change, to index options. Expected \nreturn and implied volatility have the same meaning. Implied volatility can be calcu\nlated by using the Black-Scholes formulas as specified above. \nNeutral positioning retains its meaning as well. Recall that any of the above the\noretical value computations gives the delta of the option as a by-product. These deltas \ncan be used for cash-based and futures options just as they are used for stock options \nto maintain a neutral position. This is done, of course, by calculating the equivalent \nstock position (or equivalent \"index\" or \"futures\" position, in these cases). \nFOLLOW-UP ACTION \nThe various types of follow-up action that were applicable to stock options are avail\nable for index options as well. In fact, when one has spread options on the same \nunderlying index, these actions are virtually the same. However, when one is doing \ninter-index spreads, there is another type of follow-up picture that is useful. The rea-\nChapter 33: Mathematical Considerations for Index Products 649 \nson for this is that the spread will have different outcomes not only based on the price \nof one index, but also based on that index's relationship to the other index. \nIt is possible, for example, that a mildly bullish strategy implemented as an \ninter-index spread might actually lose money even if one index rose. This could hap\npen if the other index performed in a manner that was not desirable. If one could \nhave his computer \"draw\" a picture of several different outcomes, he would have a \nbetter idea of the profit potential of his strategy. \nExample: Assume a put spread between the ZYX and the ABX indices was estab\nlished. An ABX June 180 put was bought at 3.00 and a ZYX June 175 put was sold at \n3.00, when the ZYX was at 175.00 and the ABX Index w", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 290}
{"text": "ed in a manner that was not desirable. If one could \nhave his computer \"draw\" a picture of several different outcomes, he would have a \nbetter idea of the profit potential of his strategy. \nExample: Assume a put spread between the ZYX and the ABX indices was estab\nlished. An ABX June 180 put was bought at 3.00 and a ZYX June 175 put was sold at \n3.00, when the ZYX was at 175.00 and the ABX Index was at 178.00. This spread will \nobviously have different outcomes if the prices of the ZYX and the ABX move in dra\nmatically different patterns. \nOn the surface, this would appear to be a bearish position - long a put at a high\ner strike and short a put at a lower strike. However, the position could make money \neven in a rising market if the indices move appropriately: If, at expiration, the ZYX \nand ABX are both at 179.00, for example, then the short option expires worthless and \nthe long option is still worth 1.00. This would mean that a 1-point profit, or $500, was \nmade in the spread ($1,500 profit on the short ZYX puts less a $1,000 loss on the one \nABX put). \nConversely, a downward movement doesn't guarantee profits either. If the ZYX \nfalls to 170.00 while the ABX declines to 175.00, then both puts would be worth 5 at \nexpiration and there would be no gain or loss in the spread. \nWhat the strategist needs in order to better understand his position is a \"sliding scale\" \npicture. That is, most follow-up pictures give the outcome (say, at expiration) of the \nposition at various stock or index prices. That is still needed: One would want to see \nthe outcome for ZYX prices of, say, 165 up to 185 in the example. However, in this \nspread something else is needed: The outcome should also take into account how the \nZYX matches up with the ABX. Thus, one might need three (or more) tables of out\ncomes, each of which depicts the results as ZYX ranges from 165 up to 185 at expi\nration. One might first show how the results would look if ZYX were, say, 5 points \nbelow ABX; then another table would show ZYX and ABX unchanged from their \noriginal relationship (a 3-point differential); finally, another table would show the \nresults if ZYX and ABX were equal at expiration. \nIf the relationship between the two indices were at 3 points at expiration, such \na table might look like this: \n6S0 Part V: Index Options and Futures \nPrice at Expiration \nZYX 165 170 175 180 185 \nABX 168 173 178 183 188 \nZYX June 175P 10 5 0 0 0 \nABX June 1 80P 12 7 2 0 0 \nProfit +$1,000 +$1,000 +$1,000 0 0 \nThis picture indicates that the position is neutral to bearish, since it makes \nmoney even if the indices are unchanged. However, contrast this with the situation \nin which the ZYX falls to a level 5 points below the ABX by expiration. \nPrice at Expiration \nZYX 165 170 175 180 185 \nABX 170 175 180 185 190 \nZYX June 175P 10 5 0 0 0 \nABX June l 80P 10 5 0 0 0 \nProfit 0 0 0 0 0 \nIn this case, the spread has no potential for profit at all, even if the market col\nlapses. Thus, even a bearish spread like this might not prove profitable if there is an \nadverse movement in the relationship of the indices. \nFinally, observe what happens if the ZYX rallies so strongly that it catches up to \nthe ABX. \nPrice at Expiration \nZYX 165 170 175 180 185 \nABX 165 170 175 180 185 \nZYX June 175P 10 5 0 0 0 \nABX June 180P 15 10 5 0 0 \nProfit +$2,500 +$2,500 +$2,500 +$2,500 +$2,500 \nThese tables can be called \"sliding scale\" tables, because what one is actually \ndoing is showing a different set of results by sliding the ABX scale over slightly each \ntime while keeping the ZYX scale fixed. Note that in the above two tables, the ZYX \nresults are unchanged, but the ABX has been slid over slightly to show a different \nresult. Tables like this are necessary for the strategist who is doing spreads in options \nwith different underlying indices or is trading inter-index spreads. \n650 Part V: Index Options and Futures \nPrice at Expiration \nZYX 165 170 175 180 185 \nABX 168 173 178 183 188 \nZYX June 175P 10 5 0 0 0 \nABX June 180P 12 7 2 0 0 \nProfit +$1,000 +$1,000 +$1,000 0 0 \nThis picture indicates that the position is neutral to bearish, since it makes \nmoney even if the indices are unchanged. However, contrast this with the situation \nin which the Z¥X falls to a level 5 points below the ABX by expiration. \nPrice at Expiration \nZYX 165 170 175 180 185 \nABX 170 175 180 185 190 \nZYX June 175P 10 5 0 0 0 \nABX June 1 80P 10 5 0 0 0 \nProfit 0 0 0 0 0 \nIn this case, the spread has no potential for profit at all, even if the market col\nlapses. Thus, even a bearish spread like this might not prove profitable if there is an \nadverse movement in the relationship of the indices. \nFinally, observe what happens if the ZYX rallies so strongly that it catches up to \nthe ABX. \nPrice at Expiration \nZYX 165 170 175 180 185 \nABX 165 170 175 180 185 \nZYX June 175P 10 5 0 0 0 \nABX June 1 80P 15 10 5 0 0 \nProfit +$2,500 +$2,500 +$2,500 +$2,500 +$2,500 \nThese tables can be called \"sliding scale\" tables, because what one is actually \ndoing is showing a different set of results by sliding the ABX scale over slightly each \ntime while keeping the Z¥X scale fixed. Note that in the above two tables, the Z¥X \nresults are unchanged, but the ABX has been slid over slightly to show a different \nresult. Tables like this are necessary for the strategist who is doing spreads in options \nwith different underlying indices or is trading inter-index spreads. \n650 \nZYX \nABX \nZYX June 175P \nABX June 1 80P \nProfit \n165 \n168 \n10 \n12 \n+$1,000 \n170 \n173 \n5 \n7 \n+$1,000 \nPart V: Index Options and Futures \nPrice at Expiration \n175 180 185 \n178 183 188 \n0 0 0 \n2 0 0 \n+$1,000 0 0 \nThis picture indicates that the position is neutral to bearish, since it makes \nmoney even if the indices are unchanged. However, contrast this with the situation \nin which the ZYX falls to a level 5 points below the ABX by expiration. \nPrice at Expiration \nZYX 165 170 175 180 185 \nABX 170 175 180 185 190 \nZYX June 175P 10 5 0 0 0 \nABX J", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 291}
{"text": "ration \n175 180 185 \n178 183 188 \n0 0 0 \n2 0 0 \n+$1,000 0 0 \nThis picture indicates that the position is neutral to bearish, since it makes \nmoney even if the indices are unchanged. However, contrast this with the situation \nin which the ZYX falls to a level 5 points below the ABX by expiration. \nPrice at Expiration \nZYX 165 170 175 180 185 \nABX 170 175 180 185 190 \nZYX June 175P 10 5 0 0 0 \nABX June 1 80P 10 5 0 0 0 \nProfit 0 0 0 0 0 \nIn this case, the spread has no potential for profit at all, even if the market col\nlapses. Thus, even a bearish spread like this might not prove profitable if there is an \nadverse movement in the relationship of the indices. \nFinally, observe what happens if the ZYX rallies so strongly that it catches up to \nthe ABX. \nPrice at Expiration \nZYX 165 170 175 180 185 \nABX 165 170 175 180 185 \nZYX June 175P 10 5 0 0 0 \nABX June 1 80P 15 10 5 0 0 \nProfit +$2,500 +$2,500 +$2,500 +$2,500 +$2,500 \nThese tables can be called \"sliding scale\" tables, because what one is actually \ndoing is showing a different set of results by sliding the ABX scale over slightly each \ntime while keeping the ZYX scale fixed. Note that in the above two tables, the ZYX \nresults are unchanged, but the ABX has been slid over slightly to show a different \nresult. Tables like this are necessary for the strategist who is doing spreads in options \nwith different underlying indices or is trading inter-index spreads. \nCl,apter 33: Mathematical Considerations for Index Products 651 \nThe astute reader will notice that the above example can be generalized by \ndrawing a three-dimensional graph. The X axis would be the price of ZYX; the Y axis \nwould be the dollars of profit in the spread; and instead of \"sliding scales,\" the Z axis \nwould be the price of ABX. There is software that can draw 3-dimensional profit \ngraphs, although they are somewhat difficult to read. The previous tables would then \nbe horizontal planes of the three-dimensional graph. \nThis concludes the chapter on riskless arbitrage and mathematical modeling. \nRecall that arbitrage in stock options can affect stock prices. The arbitrage \ntechniques outlined here do not affect the indices themselves. That is done by the \nmarket basket hedges. It was also known that no new models are necessary for \nevaluation. For index options, one merely has to properly evaluate the dividend for \nusage in the standard Black-Scholes model. Future options can be evaluated by set\nting the risk-free interest rate to 0% in the Black-Scholes model and discounting the \nresult, which is the Black model. \n) \nCHAPTER 34 \nFutures and Futures Options \nIn the previous chapters on index trading, a particular type of futures option - the \nindex option - was described in some detail. In this chapter, some background infor\nmation on futures themselves is spelled out, and then the broad category of futures \noptions is investigated. In recent years, options have been listed on many types of \nfutures as well as on some physical entities. These include options on things as diverse \nas gold futures and cattle futures, as well as options on currency and bond futures. \nMuch of the information in this chapter is concerned with describing the ways \nthat futures options are similar to, or different from, ordinary equity and index \noptions. There are certain strategies that can be developed specifically for futures \noptions as well. However, it should be noted that once one understands an option \nstrategy, it is generally applicable no matter what the underlying instrument is. That \nis, a bull spread in gold options entails the same general risks and rewards as does a \nbull spread in any stock's options - limited downside risk and limited upside profit \npotential. The gold bull spread would make its maximum profit if gold futures were \nabove the higher strike of the spread at expiration, just as an equity option bull spread \nwould do if the stock were above the higher strike at expiration. Consequently, it \nwould be a waste of time and space to go over the same strategies again, substituting \nsoybeans or orange juice futures, say, for XYZ stock in all the examples that have been \ngiven in the previous chapters of this book. Rather, the concentration will be on areas \nwhere there is truly a new or different strategy that futures options provide. \nBefore beginning, it should be pointed out that futures contracts and futures \noptions have far less standardization than equity or index options do. Most futures \ntrade in different units. Most options have different expiration months, expiration \ntimes, and striking price intervals. All the different contract specifications are not \nspelled out here. One should contact his broker or the exchange where the contracts \n652 \nCl,apter 34: Futures and Futures Options 6S3 \nare traded in order to receive complete details. However, whenever examples are \nused, full details of the contracts used in those examples are given. \nFUTURES CONTRACTS \nBefore getting into options on futures, a few words about futures contracts them\nselves may prove beneficial. Recall that a futures contract is a standardized contract \ncalling for the delivery of a specified quantity of a certain commodity at some future \ntime. Future contracts are listed on a wide variety of commodities and financial \ninstruments. In some cases, one must make or take delivery of a specific quantity of \na physical commodity (50,000 bushels of soybeans, for example). These are known as \nfutures on physicals. In others, the futures settle for cash as do the S&P 500 Index \nfutures described in a previous chapter; there are other futures that have this same \nfeature (Eurodollar time deposits, for example). These types of futures are cash\nbased, or cash settlement, futures. \nIn terms of total numbers of contracts listed on the various exchanges, the more \ncommon type of futures contract is one with a physical commodity underlying it. \nThese are sometimes broken down into subcategories, such as", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 292}
{"text": "ious chapter; there are other futures that have this same \nfeature (Eurodollar time deposits, for example). These types of futures are cash\nbased, or cash settlement, futures. \nIn terms of total numbers of contracts listed on the various exchanges, the more \ncommon type of futures contract is one with a physical commodity underlying it. \nThese are sometimes broken down into subcategories, such as agricultural futures \n(those on soybeans, oats, coffee, or orange juice) and financial futures (those on U.S. \nTreasury bonds, bills, and notes). \nTraders not familiar with futures sometimes get them confused with options. \nThere really is very little resemblance between futures and options. Think of futures \nas stock with an expiration date. \nThat is, futures contracts can rise dramatically in price and can fall all the way \nto nearly zero (theoretically), just as the price of a stock can. Thus, there is great \npotential for risk. Conversely, with ownership of an option, risk is limited. The only \nreal similarity between futures and options is that both have an expiration date. In \nreality, futures behave much like stock, and the novice should understand that con\ncept before moving on. \nHEDGING \nThe primary economic function of futures markets is hedging - taking a futures \nposition to offset the risk of actually owning the physical commodity. The physical \ncommodity or financial instrument is known as the \"cash.\" For index futures, this \nhedging was designed to remove the risk from owning stocks (the \"cash market\" that \nunderlies index futures). A portfolio manager who owned a large quantity of stocks \ncould sell index futures against the stock to remove much of the price risk of that \n654 Part V: Index Options and Futures \nstock ownership. Moreover, he is able to establish that hedge at a much smaller com\nmission cost and with much less work than would be required to sell thousands of \nshares of stock. Similar thinking applies to all the cash markets that underlie futures \ncontracts. The ability to hedge is important for people who must deal in the \"cash\" \nmarket, because it gives them price protection as well as allowing them to be more \nefficient in their pricing and profitability. A general example may be useful to demon\nstrate the hedging concept. \nExample: An international businessman based in the United States obtains a large \ncontract to supply a Swiss manufacturer. The manufacturer wishes to pay in Swiss \nfrancs, but the payment is not due until the goods are delivered six months from now. \nThe U.S. businessman is obviously delighted to have the contract, but perhaps is not \nso delighted to have the contract paid in francs six months from now. If the U.S. dol\nlar becomes stronger relative to the Swiss franc, the U.S. businessman will be receiv\ning Swiss francs which will be worth fewer dollars for his contract than he originally \nthought he would. In fact, if he is working on a narrow profit margin, he might even \nsuffer a loss if the Swiss franc becomes too weak with respect to the dollar. \nA futures contract on the Swiss franc may be appropriate for the U.S. business\nman. He is \"long\" Swiss francs via his contract (that is, he will get francs in six months, \nso he is exposed to their fluctuations during that time). He might sell short a Swiss \nfranc futures contract that expires in six months in order to lock in his current profit \nmargin. Once he sells the future, he locks in a profit no matter what happens. \nThe future's profit and loss are measured in dollars since it trades on a U.S. \nexchange. If the Swiss franc becomes stronger over the six-month period, he will lose \nmoney on the futures sale, but will receive more dollars for the sale of his products. \nConversely, if the franc becomes weak, he will receive fewer dollars from the Swiss \nbusinessman, but his futures contract sale will show a profit. 111 either case, the \nfutures contract enables him to lock in a future price (hence the name \"futures\") that \nis profitable to him at today's level. \nThe reader should note that there are certain specific factors that the hedger \nmust take into consideration. Recall that the hedger of stocks faces possible problems \nwhen he sells futures to hedge his stock portfolio. First, there is the problem of sell\ning futures below their fair value; changes in interest rates or dividend payouts can \naffect the hedge as well. The U.S. businessman who is attempting to hedge his Swiss \nfrancs may face similar problems. Certain items such as short-term interest rates, \nwhich affect the cost of carry, and other factors may cause the Swiss franc futures to \ntrade at a premium or discount to the cash price. That is, there is not necessarily a \ncomplete one-to-one relationship between the futures price and the cash price. \nChapter 34: Futures and Futures Options 655 \nHowever, the point is that the businessman is able to substantially reduce the cur\nrency risk, since in six months there could be a large change in the relationship \nbetween the U.S. dollar and the Swiss franc. While his hedge might not eliminate \nevery bit of the risk, it will certainly get rid of a very large portion of it. \nSPECULATING \nWhile the hedgers provide the economic function of futures, speculators provide the \nliquidity. The attraction for speculators is leverage. One is able to trade futures with \nvery little margin. Thus, large percentages of profits and losses are possible. \nExample: A futures contract on cotton is for 50,000 pounds of cotton. Assume the \nMarch cotton future is trading at 60 (that is, 60 cents per pound). Thus, one is con\ntrolling $30,000 worth of cotton by owning this contract ($0.60 per pound x 50,000 \npounds). However, assume the exchange minimum margin is $1,500. That is, one has \nto initially have only $1,500 to trade this contract. This means that one can trade cot\nton on 5% margin ($1,500/$30,000 = 5%). \nWhat is the profit or risk potential here? A one-cent move in cotton, from 60 to \n61, would gene", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 293}
{"text": "e is con\ntrolling $30,000 worth of cotton by owning this contract ($0.60 per pound x 50,000 \npounds). However, assume the exchange minimum margin is $1,500. That is, one has \nto initially have only $1,500 to trade this contract. This means that one can trade cot\nton on 5% margin ($1,500/$30,000 = 5%). \nWhat is the profit or risk potential here? A one-cent move in cotton, from 60 to \n61, would generate a profit of $500. One can always determine what a one-cent move \nis worth as long as he knows the contract size. For cotton, the size is 50,000 pounds, \nso a one-cent move is 0.01 x 50,000 = $500. \nConsequently, if cotton were to fall three cents, from 60 to 57, this speculator \nwould lose 3 x $500, or $1,500 - his entire initial investment. Alternatively, a 3-cent \nmove to the upside would generate a profit of $1,500, a 100% profit. \nThis example clearly demonstrates the large risks and rewards facing a specula\ntor in futures contracts. Certain brokerage firms may require the speculator to place \nmore initial margin than the exchange minimum. Usually, the most active customers \nwho have a sufficient net worth are allowed to trade at the exchange minimum mar\ngins; other customers may have to put up two or three times as much initial margin \nin order to trade. This still allows for a lot of leverage, but not as much as the specu\nlator has who is trading with exchange minimum margins. Initial margin require\nments can be in the form of cash or Treasury bills. Obviously, if one uses Treasury \nbills to satisfy his initial margin requirements, he can be earning interest on that \nmoney while it serves as collateral for his initial margin requirements. If he uses cash \nfor the initial requirement, he will not earn interest. (Note: Some large customers do \nearn credit on the cash used for margin requirements in their futures accounts, but \nmost customers do not.) \nA speculator will also be required to keep his account current daily through the \nuse of maintenance mar~is account is marked to market daily, so unrealized \n656 Part V: Index Options and Futures \ngains and losses are taken into account as well as are realized ones. If his account \nloses money, he must add cash into the account or sell out some of his Treasury bills \nin order to cover the loss, on a daily basis. However, if he makes money, that unreal\nized profit is available to be withdrawn or used for another investment. \nExample: The cotton speculator from the previous example sees the price of the \nMarch cotton futures contract he owns fall from 60.00 to 59.20 on the first day he \nowns it. This means there is a $400 unrealized loss in his account, since his holding \nwent down in price by 0.80 cents and a one-cent move is worth $500. He must add \n$400 to his account, or sell out $400 worth of T-bills. \nThe next day, rumors of a drought in the growing areas send cotton prices much \nhigher. The March future closes at 60.90, up 1.70 from the previous day's close. That \nrepresents a gain of $850 on the day. The entire $850 could be withdrawn, or used as \ninitial margin for another futures contract, or transferred to one's stock market \naccount to be used to purchase another investment there. \nWithout speculators, a futures contract would not be successful, for the specu\nlators provide liquidity. Volatility attracts speculators. If the contract is not trading \nand open interest is small, the contract may be delisted. The various futures \nexchanges can delist futures just as stocks can be delisted by the New York Stock \nExchange. However, when stocks are delisted, they merely trade over-the-counter, \nsince the corporation itself still exists. When futures are delisted, they disappear -\nthere is no over-the-counter futures market. Futures exchanges are generally more \naggressive in listing new products, and delisting them if necessary, than are stock \nexchanges. \nTERMS \nFutures contracts have certain standardized terms associated with them. However, \ntrading in each separate commodity is like trading an entirely different product. The \nstandardized terms for soybeans are completely different from those for cocoa, for \nexample, as might well be expected. The size of the contract (50,000 pounds in the \ncotton example) is often based on the historical size of a commodity delivered to \nmarket; at other times it is merely a contrived number ($100,000 face amount of U.S. \nTreasury bonds, for example). \nAlso, futures contracts have expiration dates. For some commodities (for exam\nple, crude oil and its products, heating oil and unleaded gasoline), there is a futures \ncontract for every month of the year. Other commodities may have expirations in only \n5 or 6 calendar months of the year. These items are listed along with the quotes in a \ngood financial newspaper, so they are not difficult to discover. \nGapter 34: Futures and Futures Options 657 \nThe number of expiration months listed at any one time varies from one mar\nket to another. Eurodollars, for example, have futures contracts with expiration dates \nthat extend up to ten years in the future. T-bond and 10-year note contracts have \nexpiration dates for only about the next year or so. Soybean futures, on the other \nhand, have expirations going out about two years, as do S&P futures. \nThe day of the expiration month on which trading ceases is different for each \ncommodity as well. It is not standardized, as the third Friday is for stock and index \noptions. \nTrading hours are different, even for different commodities listed on the same \nfutures exchange. For example, U.S. Treasury bond futures, which are listed on the \nChicago Board of Trade, have very long trading hours (currently 8:20 A.M. to 3 P.M. \nand also 7 P.M. to 10:30 P.M. every day, Eastern time). But, on the same exchange, soy\nbean futures trade a very short day (10:30 A.M. to 2:15 P.M., Eastern time). Some mar\nkets alter their trading hours occasionally, while others have been fixed for years. For \nexample, as the foreign demand for U.S.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 294}
{"text": "sted on the \nChicago Board of Trade, have very long trading hours (currently 8:20 A.M. to 3 P.M. \nand also 7 P.M. to 10:30 P.M. every day, Eastern time). But, on the same exchange, soy\nbean futures trade a very short day (10:30 A.M. to 2:15 P.M., Eastern time). Some mar\nkets alter their trading hours occasionally, while others have been fixed for years. For \nexample, as the foreign demand for U.S. Treasury bond futures increases, the trad\ning hours might expand even further. However, the grain markets have been using \nthese trading hours for decades, and there is little reason to expect them to change \nin the future. · \nUnits of trading vary for different futures contracts as well. Grain futures trade \nin eighths of a point, 30-year bond futures trade in thirty-seconds of a point, while \nthe S&P 500 futures trade in 10-cent increments (0.10). Again, it is the responsibili\nty of the trader to familiarize himself with the units of trading in the futures market \nif he is going to be trading there. \nEach futures contract has its own margin requirements as well. These conform \nto the type of margin that was described with respect to the cotton example above: \nAn initial margin may be advanced in the form of collateral, and then daily mark-to\nmarket price movements are paid for in cash or by selling some of the collateral. \nRecall that maintenance margin is the term for the daily mark to market. \nFinally, futures are subject to position limits. This is to prevent any one entity \nfrom attempting to comer the market in a particular delivery month of a commodi\nty. Different futures have different position limits. This is normally only of interest to \nhedgers or very large speculators. The exchange where the futures trade establishes \nthe position limit. \nTRADING LIMITS \nMost futures contracts have some limit on their maximum daily price change. For \nindex futures, it was shown that the limits are designed to act like circuit breakers to \nprevent the stock market from crashing. Trading limits exist in many futures con-\n( \n658 Part V: Index Options and Futures \ntracts in order to help ensure that the market cannot be manipulated by someone \nforcing the price to move tremendously in one direction or the other. Another rea\nson for having trading limits is ostensibly to allow only a fixed move, approximately \nequal to or slightly less than the amount covered by the initial margin requirement, \nso that maintenance margin can be collected if need be. However, limits have been \napplied to all futures, some of which don't really seem to warrant a limit - U.S. \nTreasury bonds, for example. The bond issue is too large to manipulate, and there is \na liquid \"cash\" bond market to hedge with. \nRegardless, limits are a fact of life in futures trading. Each individual commod\nity has its own limits, and those limits may change depending on how the exchange \nviews the volatility of that commodity. For example, when gold was trading wildly at \na price of more than $700 per ounce, gold futures had a larger daily trading limit than \nthey do at more stable levels of $300 to $400 an ounce (the current limit is a $15 \nmove per day). If a commodity reaches its limit repeatedly for two or three days in a \nrow, the exchange will usually increase the limit to allow for more price movement. \nThe Chicago Board of Trade automatically increases limits by 50% if a futures con\ntract trades at the limit three days in a row. \nWhenever limits exist there is always the possibility that they can totally destroy \nthe liquidity of a market. The actual commodity underlying the futures contract is \ncalled the \"spot\" and trades at the \"spot price.\" The spot trades without a limit, of \ncourse. Thus, it is possible that the spot commodity can increase in price tremen\ndously while the futures contract can only advance the daily limit each day. This sce\nnario means that the futures could trade \"up or down the limit\" for a number of days \nin a row. As a consequence, no one would want to sell the futures if they were trad\ning up the limit, since the spot was much higher. In those cases there is no trading in \nthe futures - they are merely quoted as bid up the limit and no trades take place. This \nis disastrous for short sellers. They may be wiped out without ever naving the chance \nto close out their positions. This sometimes happens to orange juice futures when an \nunexpected severe freeze hits Florida. Options can help alleviate the illiquidity \ncaused by limit moves. That topic is covered later in this chapter. \nDELIVERY \nFutures on physical commodities can be assigned, much like stock options can be \nassigned. When a futures contract is assigned, the buyer of the contract is called upon \nto receive the full contract. Delivery is at the seller's option, meaning that the owner \nof the contract is informed that he must take delivery. Thus, if a corn contract is \nassigned, one is forced to receive 5,000 bushels of corn. The old adage about this \nbeing dumped in your yard is untrue. One merely receives a warehouse receipt and \nChapter 34: Futures and Futures Options 659 \nis charged for storage. His broker makes the actual arrangements. Futures contracts \ncannot be assigned at any time during their life, as options can. Rather, there is a \nshort period of time before they expire during which one can take delivery. This is \ngenerally a 4- to 6-week period and is called the \"notice period\" - the time during \nwhich one can be notified to accept delivery. The first day upon which the futures \ncontract may be assigned is called the \"first notice day,\" for logical reasons. \nSpeculators close out their positions before the first notice day, leaving the rest of the \ntrading up to the hedgers. Such considerations are not necessary for cash-based \nfutures contracts (the index futures), since there is no physical commodity involved. \nIt is always possible to make a mistake, of course, and receive an assignment \nwhen you didn't intend to. Your broker will norm", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 295}
{"text": "al reasons. \nSpeculators close out their positions before the first notice day, leaving the rest of the \ntrading up to the hedgers. Such considerations are not necessary for cash-based \nfutures contracts (the index futures), since there is no physical commodity involved. \nIt is always possible to make a mistake, of course, and receive an assignment \nwhen you didn't intend to. Your broker will normally be able to reverse the trade for \nyou, but it will cost you the warehouse fees and generally at least one commission. \nThe terms of the futures contract specify exactly what quantity of the commod\nity must be delivered, and also specify what form it must be in. Normally this is \nstraightforward, as is the case with gold futures: That contract calls for delivery of 100 \ntroy ounces of gold that is at least 0.995 fine, cast either in one bar or in three one\nkilogram bars. \nHowever, in some cases, the commodity necessary for delivery is more compli\ncated, as is the case with Treasury bond futures. The futures contract is stated in \nterms of a nominal 8% interest rate. However, at any time, it is likely that the pre\nvailing interest rate for long-term Treasury bonds will not be 8%. Therefore, the \ndelivery terms of the futures contract allow for delivery of bonds with other interest \nrates. \nNotice that the delivery is at the seller's option. Thus, if one is short the futures \nand doesn't realize that first notice day has passed, he has no problem, for delivery is \nunder his control. It is only those traders holding long futures who may receive a sur\nprise delivery notice. \nOne must be familiar with the specific terms of the contract and its methods of \ndelivery if he expects to deal in the physical commodity. Such details on each futures \ncontract are readily available from both the exchange and one's broker. However, \nmost futures traders never receive or deliver the physical commodity; they close out \ntheir futures contracts before the time at which they can be called upon to make \ndelivery. \nPRICING OF FUTURES \nIt is beyond the scope of this book to describe futures arbitrage versus the cash com\nmodity. Suffice it to say that this arbitrage is done, more in some markets (U.S. \nTreasury bonds, for example) than others (soybeans). Therefore, futures can be over-\n660 Part V: Index Options and Futures \npriced or underpriced as well. The arbitrage possibilities would be calculated in a \nmanner similar to that described for index futures, the futures premium versus cash \nbeing the determining factor. \nOPTIONS ON FUTURES \nThe reader is somewhat familiar with options on futures, having seen many examples \nof index futures options. The commercial use of the option is to lock in a worst-case \nprice as opposed to a future price. The U.S. businessman from the earlier example \nsold Swiss franc futures to lock in a future price. However, he might decide instead \nto buy Swiss franc futures put options to hedge his downside risk, but still leave room \nfor upside profits if the currency markets move in his favor. \nDESCRIPTION \nA futures option is an option on the futures contract, not on the cash commodity. \nThus, if one exercises or assigns a futures option, he buys or sells the futures contract. \nThe options are always for one contract of the underlying commodity. Splits and \nadjustments do not apply in the futures markets as they do for stock options. Futures \noptions generally trade in the same denominations as the future itself ( there are a few \nexceptions to this rule, such as the T-bond options, which trade in sixty-fourths while \nthe futures trade in thirty-seconds). \nExample: Soybean options will be used to illustrate the above features of futures \noptions. \nSuppose that March soybeans are selling at 575. \nSoybean quotes are in cents. Thus, 575 is $5.75 - soybeans cost $5.75 per \nbushel. A soybean contract is for 5,000 bushels of soybeans, so a one-cent move is \nworth $50 (5,000 x .01). -\nSuppose the following option prices exist. The dollar cost of the options is also \nshown (one cent is worth $50). \nOption Price Dollar Cost \nMarch 525 put 5 $ 250 \nMarch 550 call 35 1/2 $1,775 \nMarch 600 call 81/4 $ 412.50 \nThe actual dollar cost is not necessary for the option strategist to determine the \nprofitability of a certain strategy. For example, if one buys the March 600 call, he \nChapter 34: Futures and Futures Options 661 \nneeds March soybean futures to be trading at 608.25 or higher at expiration in order \nto have a profit at that time. This is the normal way in which a call buyer views his \nbreak-even point at expiration: strike price plus cost of the call. It is not necessary to \nknow that soybean options are worth $50 per point in order to know that 608.25 is \nthe break-even price at expiration. \nIf the future is a cash settlement future (Eurodollar, S&P 500, and other \nindices), then the options and futures generally expire simultaneously at the end of \ntrading on the last trading day. (Actually, the S&P's expire on the next morning's \nopening.) However, options on physical futures will expire before the first notice day \nof the actual futures contract, in order to give traders time to close out their positions \nbefore receiving a delivery notice. The fact that the option expires in advance of the \nexpiration of the underlying future has a slightly odd effect: The option often expires \nin the month preceding the month used to describe it. \nExample: Options on March soybean futures are referred to as \"March options.\" \nThey do not actually expire in March - however, the soybean futures do. \nThe rather arcane definition of the last trading day for soybean options is \"the \nlast Friday preceding the last business day of the month prior to the contract month \nby at least 5 business days\"! \nThus, the March soybean options actually expire in February. Assume that the \nlast Friday of February is the 23rd. If there is no holiday during the business week of \nFebruary 19th to 23rd, then the soybean options w", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 296}
{"text": "ne definition of the last trading day for soybean options is \"the \nlast Friday preceding the last business day of the month prior to the contract month \nby at least 5 business days\"! \nThus, the March soybean options actually expire in February. Assume that the \nlast Friday of February is the 23rd. If there is no holiday during the business week of \nFebruary 19th to 23rd, then the soybean options will expire on Friday, February \n16th, which is 5 business days before the last Friday of February. \nHowever, if President's Day happened to fall on Monday, February 19th, then \nthere would only be four business days during the week of the 19th to the 23rd, so \nthe options would have to expire one Friday earlier, on February 9th. \nNot too simple, right? The best thing to do is to have a futures and options expi\nration calendar that one can refer to. Futures Magazine publishes a yearly calendar \nin its December issue, annually, as well as monthly calendars which are published \neach month of the year. Alternatively, your broker should be able to provide you with \nthe information. \nIn any case, the March soybean futures options expire in February, well in \nadvance of the first notice day for March soybeans, which is the last business day of \nthe month preceding the expiration month (February 28th in this case). The futures \noption trader must be careful not to assume that there is a long time between option \nexpiration and first notice day of the futures contract. In certain commodities, the \nfutures first notice day is the day after the options expire (live cattle futures, for \nexample). \n\\ \n662 Part V: Index Options and Futures \nThus, if one is long calls or short puts and, therefore, acquires a long futures \ncontract via exercise or assignment, respectively, he should be aware of when the first \nnotice day of the futures is; he could receive a delivery notice on his longfutures posi\ntion unexpectedly if he is not paying attention. \nOTHER TERMS \nStriking Price Intervals. Just as futures on differing physical commodities have \ndiffering terms, so do options on those futures. Striking price intervals are a prime \nexample. Some options have striking prices 5 points apart, while others have strikes \nonly 1 point apart, reflecting the volatility of the futures contract. Specifically, S&P \n500 options have striking prices 5 points apart, while soybean options striking prices \nare 25 points (25 cents) apart, and gold options are 10 points ($10) apart. Moreover, \nas is often the case ,vith stocks, the striking price differential for a particular com\nmodity may change if the price of the commodity itself is vastly different. \nExample: Gold is quoted in dollars per ounce. Depending on the price of the futures \ncontract, the striking price interval may be changed. The current rules are: \nStriking Price \nInterval \n$10 \n$20 \n$50 \nPrice of Futures \nbelow $500/oz. \nbetween $500 and $1,000/oz. \nabove $1,000/oz. \nThus, when gold futures are more expensive, the striking prices are further \napart. Note that gold has never traded above $1,000/oz., but the option exchanges are \nall set if it does. \nThis variability in the striking prices is common for many commodities. In fact, \nsome commodities alter the striking price interval depending on how much time is \nremaining until expiration, possibly in addition to the actual prices of the futures \nthemselves. \nRealizing that the striking price intervals may change - that is, that new strikes \nwill be added when the contract nears maturity - may help to plan some strategies, \nas it will give more choices to the strategist as to which options he can use to hedge \nor adjust his position. \nAutomatic Exercise. All futures options are subject to automatic exercise as are \nstock options. In general, a futures option will be exercised automatically, even if it is \nChapter 34: Futures and Futures Options 663 \none tick in the money. You can give instructions to not have a futures option auto\nmatically exercised if you wish. \nSERIAL OPTIONS \nSerial options are futures options whose expiration month is not the same as the expi\nration month of their corresponding underlying futures. \nExample: Gold futures expire in February, April, June, August, October, and \nDecember. There are options that expire in those months as well. Notice that these \nexpirations are spaced two months apart. Thus, when one gold contract expires, there \nare two months remaining until the next one expires. \nMost option traders recognize that the heaviest activity in an option series is in \nthe nearest-term option. If the nearest-term option has two months remaining until \nexpiration, it will not draw the trading interest that a shorter-term option would. \nRecognizing this fact, the exchange has decided that in addition to the regular \nexpiration, there will be an option contract that expires in the nearest non-cycle \nrrwnth, that is, in the nearest month that does not have an actual gold future expir\ning. So, if it were currently January 1, there might be gold options expiring in \nFebruary, March, April, etc. \nThus, the March option would be a serial option. There is no actual March gold \nfuture. Rather, the March options would be exercisable into Arpl futures. \nSerial options are exercisable into the nearest actual futures contract that exists \nafter the options' expiration date. The number of serial option expirations depends \non the underlying commodity. For example, gold will always have at least one serial \noption trading, per the definition highlighted in the example above. Certain futures \nwhose expirations are three months apart (S&P 500 and all currency options) have \nserial options for the nearest two months that are not represented by an actual \nfutures contract. Sugar, on the other hand, has only one serial option expiration per \nyear - in December - to span the gap that exists between the normal October and \nMarch sugar futures expirations. \nStrategists trading in options that may have serial expirat", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 297}
{"text": "ree months apart (S&P 500 and all currency options) have \nserial options for the nearest two months that are not represented by an actual \nfutures contract. Sugar, on the other hand, has only one serial option expiration per \nyear - in December - to span the gap that exists between the normal October and \nMarch sugar futures expirations. \nStrategists trading in options that may have serial expirations should be careful \nin how they evaluate their strategies. For example, June S&P 500 futures options \nstrategies can be planned with respect to where the underlying S&P 500 Index of \nstocks will be at expiration, for the June options are exercisable into the June futures, \nwhich settle at the same price as the Index itself on the last day of trading. However, \nif one is trading April S&P 500 options, he must plan his strategy on where the June \nfutures contract is going to be trading at April expiration. The April options are exer-\n664 Part V: Index Options and Futures \ncisable into the June futures at April expiration. Since the June futures contract will \nstill have some time premium in it in April, the strategist cannot plan his strategy with \nrespect to where the actual S&P 500 Index will be in April. \nExample: The S&P 500 Stock Index (symbol SPX) is trading at 410.50. The follow\ning prices exist: \nCash (SPX): 410.50 \nJune futures: 415.00 \nOptions \nApril 415 coll: 5.00 \nJune 415 coll: 10.00 \nIf one buys the June 415 call for 10.00, he knows that the SPX Index will have \nto rise to 425.00 in order for his call purchase to break even at June expiration. Since \nthe SPX is currently at 410.50, a rise of 14.50 by the cash index itself will be neces\nsary for break-even at June expiration. \nHowever, a similar analysis will not work for calculating the break-even price for \nthe April 415 call at April expiration. Since 5.00 points are being paid for the 415 call, \nthe break-even at April expiration is 420. But exactly what needs to be at 420? The \nJune future, since that is what the April calls are exercisable into. \nCurrently, the June futures are trading at a premium of 4.50 to the cash index \n(415.00 - 410.50). However, by April expiration, the fair value of that premium will \nhave shrunk. Suppose that fair .value is projected to be 3.50 premium at April expi\nration. Then the SPX would have to be at 416.50 in order for the June futures to be \nfairly valued at 420.00 (416.50 + 3.50 = 420.00). \nConsequently, the SPX cash index would have to rise 6 points, from 410.50 to \n416.50, in order for the June futures to trade at 420 at April expiration. If this hap\npened, the April 415 call purchase would break even at expiration. \nQuote symbols for futures options have improved greatly over the years. Most \nvendors use the convenient method of stating the striking price as a numeric num\nber. The only \"code\" that is required is that of the expiration month. The codes for \nfutures and futures options expiration months are shown in Table 34-1. Thus, a \nMarch (2002) soybean 600 call would use a symbol that is something like SH2C600, \nwhere S is the symbol for soybeans, H is the symbol for March, 2 means 2002, C \nstands for call option, and 600 is the striking price. This is a lot simpler and more flex\nible than stock options. There is no need for assigning striking prices to letters of the \nalphabet, as stocks do, to everyone's great consternation and confusion. \nChapter 34: Futures and Futures Options \nTABLE 34-1. \nMonth symbols for futures or futures options. \nFutures or Futures Options \nExpiration Month Month Symbol \nJanuary F \nFebruary G \nMarch H \nApril J \nMay K \nJune M \nJuly N \nAugust Q \nSeptember u \nOctober V \nNovember X \nDecember z \n665 \nBid-Offer Spread. The actual markets - bids and offers - for most futures \noptions are not generally available from quote vendors ( options traded on the \nChicago Mere are usually a pleasant exception). The same is true for futures con\ntracts themselves. One can always request a ~rket from the trading floor, but that \nis a time-consuming process and is impractic!al if one is attempting to analyze a large \nnumber of options. Strategists who are used to dealing in stock or index options will \nfind this to be a major inconvenience. The situation has persisted for years and shows \nno sign of improving. \nCommissions. Futures traders generally pay a commission only on the closing \nside of a trade. If a speculator first buys gold futures, he pays no commission at that \ntime. Later, when he sells what he is long - closes his position - he is charged a com\nmission. This is referred to as a \"round-tum\" commission, for obvious reasons. Many \nfutures brokerage firms treat future options the same way - with a round-tum com\nmission. Stock option traders are used to paying a commission on every buy and sell, \nand there are still a few futures option brokers who treat futures options that way, \ntoo. This is an important difference. Consider the following example. \nExample: A futures option trader has been paying a commission of $15 per side -\nthat is, he pays a commission of $15 per contract each time he buys and sells. His bro-\n666 Part V: Index Options and Futures \nker informs him one day that they are going to charge him $30 per round tum, \npayable up front, rather than $15 per side. That is the way most futures option bro\nkerage firms charge their commissions these days. Is this the same thing, $15 per side \nor $30 round turn, paid up front? No, it is not! What happens if you buy an option \nand it expires worthless? You have already paid the commission for a trade that, in \neffect, never took place. Nevertheless, there is little you can do about it, for it has \nbecome the industry standard to charge round-turn commission on futures options. \nIn either case, commissions are negotiated to a flat rate by many traders. \nDiscount futures commission merchants (i.e., brokerage houses) often attract \nbusiness this way. In general, this method of paying commissions is to the customer's", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 298}
{"text": "er took place. Nevertheless, there is little you can do about it, for it has \nbecome the industry standard to charge round-turn commission on futures options. \nIn either case, commissions are negotiated to a flat rate by many traders. \nDiscount futures commission merchants (i.e., brokerage houses) often attract \nbusiness this way. In general, this method of paying commissions is to the customer's \nbenefit. However, it does have a hidden effect that the option trader should pay \nattention to. This effect makes it potentially more profitable to trade options on some \nfutures than on others. \nExample: A customer who buys com futures pays $30 per round turn in option com\nmissions. Since corn options are worth $50 per one point (one cent), he is paying 0.60 \nof a point every time he trades a corn option (30/50 = 0.60). \nNow, consider the same customer trading options on the S&P 500 futures. The \nS&P 500 futures and options are worth $250 per point. So, he is paying only 0.12 of \na point to trade S&P 500 options (30/250 = .12). \nHe clearly stands a much better chance of making money in an S&P 500 option \nthan he does in a corn option. He could buy an S&P option at 5.00 and sell it at 5.20 \nand make .08 points profit. However, with com options, if he buys an option at 5, he \nneeds to sell it at 55/s to make money- a substantial difference between the two con\ntracts. In fact, if he is participating in spread strategies and trading many options, the \ndifferential is even more important. \nPosition limits exist for futures options. While the limits for financial futures are \ngenerally large, other futures - especially agricultural ones - may have small limits. \nA large speculator who is doing spreads might inadvertently exceed a smaller limit. \nTherefore, one should check with his broker for exact limits in the various futures \noptions before acquiring a large position. \n) \nOPTION MARGINS \nFutures option margin requirements are generally more logical than equity or index \noption requirements. For example, if one has a conversion or reversal arbitrage in \nplace, his requirement would be nearly zero for futures options, while it could be \nquite large for equity options. Moreover, futures exchanges have introduced a better \nway of margining futures and futures option portfolios. \nChapter 34: Futures and Futures Options 667 \nSPAN Margin. The SPAN margin system (Standard Portfolio ANalysis of Risk) \nis used by nearly all of the exchanges. SPAN is designed to determine the entire risk \nof a portfolio, including all futures and options. It is a unique system in that it bases \nthe option requirements on projected movements in the futures contracts as well as \non potential changes in implied volatility of the options in one's portfolio. This cre\nates a more realistic measure of the risk than the somewhat arbitrary requirements \nthat were previously used (called the \"customer margin\" system) or than those used \nfor stock and index options. \nNot all futures clearing firms automatically put their customers on SPAN mar\ngin. Some use the older customer margin system for most of their option accounts. \nAs a strategist, it would be beneficial to be under SPAN margin. Thus, one should \ndeal with a broker who will grant SPAN margin. \nThe main advantages of SPAN margin to the strategist are twofold. First, \nnaked option margin requirements are generally less; second, certain long option \nrequirements are reduced as well. This second point may seem somewhat unusual \n- margin on long options? SPAN calculates the amount of a long option's value that \nis at risk for the current day. Obviously, if there is time remaining until expiration, a \ncall option will still have some value even if the underlying futures trade down the \nlimit. SPAN attempts to calculate this remaining value. If that value is less than the \nmarket price of the option, the excess can be applied toward any other requirement \nin the portfoliol Obviously, in-the-money options would have a greater excess value \nunder this system. \n~ \nHow SPAN Works. Certain basic requirements are determined by the futures \nexchange, such as the amount of movement by the futures contract that must be mar\ngined (maintenance margin). Once that is known, the exchange's computers gener\nate an array of potential gains and losses for the next day's trading, based on futures \nmovement within a range of prices and based on volatility changes. These results are \nstored in a \"risk array.\" There is a different risk array generated for each futures con\ntract and each option contract. The clearing member (your broker) or you do not \nhave to do any calculations other than to see how the quantities of futures and \noptions in your portfolio are affected under the gains or losses in the SPAN risk array. \nThe exchange does all the mathematical calculations needed to project the potential \ngains or losses. The results of those calculations are presented in the risk array. \nThere are 16 items in the risk array: For seven different futures prices, SPAN \nprojects a gain or loss for both increased and decreased volatility; that makes 14 \nitems. SPAN also projects a profit or loss for an \"extreme\" upward move and an \n\"extreme\" downward move. The futures exchange determines the exact definition of \n\"extreme,\" and defines \"increased\" or \"decreased\" volatility. \n668 Part V: Index Options and Futures \nSPAN \"margin\" applies to futures contracts as well, although volatility consid\nerations don't mean anything in terms of evaluating the actual futures risk As a first \nexample, consider how SPAN would evaluate the risk of a futures contract. \nExample: The S&P 500 futures will be used for this example. Suppose that the \nChicago Mercantile Exchange determines that the required maintenance margin for \nthe futures is $10,000, which represents a 20-point move by the futures (recall that \nS&P futures are worth $500 per point). Moreover, the exchange determines that an \n\"extreme\" move is 14 points, or $7,000 of", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 299}
{"text": "he risk of a futures contract. \nExample: The S&P 500 futures will be used for this example. Suppose that the \nChicago Mercantile Exchange determines that the required maintenance margin for \nthe futures is $10,000, which represents a 20-point move by the futures (recall that \nS&P futures are worth $500 per point). Moreover, the exchange determines that an \n\"extreme\" move is 14 points, or $7,000 of risk \nScenario \nFutures unchanged; volatility up \nFutures unchanged; volatility down \nFutures up one-third of range; volatility up \nFutures up one-third of range; volatility down \nFutures down one-third of range; volatility up \nFutures down one-third of range; volatility down \nFutures up two-thirds of range; volatility up \nFutures up two-thirds of range; volatility down \nFutures down two-thirds of range; volatility up \nFutures down two-thirds of range; volatility down \nFutures up three-thirds of range; volatility up \nFutures up three-thirds of range; volatility down \nFutures down three-thirds of range; volatility up \nFutures down three-thirds of range; volatility down \nFutures up \"extreme\" move \nFutures down \"extreme\" move \nLong 1 \nFuture \nPotential \nPit/Loss \n0 \n0 \n+ 3,330 \n+ 3,330 \n- 3,330 \n- 3,330 \n+ 6,670 \n+ 6,670 \n- 6,670 \n- 6,670 \n+ 10,000 \n+ l 0,000 \n-10,000 \n- 10,000 \n+ 7,000 \n- 7,000 \nThe 16 array items are always displayed in this order. Note that since this array \nis for a futures contract, the \"volatility up\" and \"volatility down\" scenarios are always \nthe same, since the volatility that is referred to is the one that is used as the input to \nan option pricing model. \nNotice that the actual price of the futures contract is not needed in order to \ngenerate the risk array. The SPAN requirement is always the largest potential loss \nfrom the array. Thus, if one were long one S&P 500 futures contract, his SPAN mar\ngin requirement would be $10,000, which occurs under the \"futures down three\nthirds\" scenarios. This will always be the maintenance margin for a futures contract. \nCl,apter 34: Futures and Futures Options 669 \nNow let us consider an option example. In this type of calculation, the exchange \nuses the same moves by the underlying futures contract and calculates the option \ntheoretical values as they would exist on the next trading day. One calculation is per\nformed for volatility increasing and one for volatility decreasing. \nExample: Using the same S&P 500 futures contract, the following array might depict \nthe risk array for a long December 410 call. One does not need to know the option \nor futures price in order to use the array; the exchange incorporates that information \ninto the model used to generate the potential gains and losses. \nScenario \nFutures unchanged; volatility up \nFutures unchanged; volatility down \nFutures up one-third of range; volatility up \nFutures up one-third of range; volatility down \nFutures down one-third of range; volatility up \nFutures down one-third of range; volatility down \nFutures up two-thirds of range; volatility up \nFutures up two-thirds of range; volatility down \nFutures down two-thirds of range; volatility ur \nFutures down two-thirds of range; volatility /o:n \nFutures up three-thirds of range; volatility up \nFutures up three-thirds of range; volatility down \nFutures down three-thirds of range; volatility up \nFutures down three-thirds of range; volatility down \nFutures up \"extreme\" move \nFutures down \"extreme\" move \nLong 1 \nDec 410 call \nPotential \nPh/Loss \n+ 460 \n610 \n+ 2,640 \n+ 1,730 \n- 1,270 \n- 2,340 \n+ 5,210 \n+ 4,540 \n- 2,540 \n- 3,430 \n+ 8,060 \n+ 7,640 \n- 3,380 \n- 3,990 \n+ 3,130 \n- 1,500 \nThe items in the risk array are all quite logical: Upward futures movements pro\nduce profits and downward futures movements produce losses in the long call posi\ntion. Moreover, worse results are always obtained by using the lower volatility as \nopposed to the higher one. In this particular example, the SPAN requirement would \nbe $3,990 (\"futures down three-thirds; volatility down\"). That is, the SPAN system \npredicts that you could lose $3,990 of your call value if futures fell by their entire \nrange and volatility decreased - a worst-case scenario. Therefore, that is the amount \nof margin one is required to keep for this long option position. \n670 Part V: Index Options and Futures \nWhile the exchange does not tell us how much of an increase or decrease it uses \nin terms of volatility, one can get something of a feel for the magnitude by looking at \nthe first two lines of the table. The exchange is saying that if the futures are \nunchanged tomorrow, but volatility \"increases,\" then the call will increase in value by \n$460 (92 cents); if it \"decreases,\" however, the call will lose $610 (1.22 points) of \nvalue. These are large piice changes, so one can assume that the volatility assump\ntions are significant. \nThe real ease of use of the SPAN iisk array is when it comes to evaluating the \niisk of a more complicated position, or even a portfolio of options. All one needs to \ndo is to combine the risk array factors for each option or future in the position in \norder to arrive at the total requirement. \nExample: Using the above two examples, one can see what the SPAN requirements \nwould be for a covered wiite: long the S&P future and short the Dec 410 call. \nShort 1 \nLong Dec 410 call \n1 S&P Potential Covered \nScenario Future Pft/Loss Write \nFutures unchanged; vol. up 0 460 - 460 \nFutures unchanged; vol. down 0 + 610 + 610 \nFutures up 1 /3 of range; vol. up + 3,330 - 2,640 + 690 \nFutures up 1 /3 of range; vol. down + 3,330 - 1,730 + 1,600 \nFutures down 1 /3 of range; vol. up - 3,330 + 1,270 -2,060 \nFutures down 1 /3 of range; vol. down 3,330 + 2,340 - 990 \nFutures up 2/3 of range; vol. up + 6,670 - 5,210 + 1,460 \nFutures up 2/3 of range; vol. down + 6,670 - 4,540 +2, 130 \nFutures down 2/3 of range; vol. up 6,670 + 2,540 -4, 130 \nFutures down 2/3 of range; vol. down - 6,670 + 3,430 -3,240 \nFutures up 3/3 of range; vol. up + 10,000 - 8,060 + 1,940 \nFutures up 3/", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 300}
{"text": "vol. up - 3,330 + 1,270 -2,060 \nFutures down 1 /3 of range; vol. down 3,330 + 2,340 - 990 \nFutures up 2/3 of range; vol. up + 6,670 - 5,210 + 1,460 \nFutures up 2/3 of range; vol. down + 6,670 - 4,540 +2, 130 \nFutures down 2/3 of range; vol. up 6,670 + 2,540 -4, 130 \nFutures down 2/3 of range; vol. down - 6,670 + 3,430 -3,240 \nFutures up 3/3 of range; vol. up + 10,000 - 8,060 + 1,940 \nFutures up 3/3 of range; vol. down + 10,000 - 7,640 +2,360 \nFutures down 3/3 of range; vol. up -10,000 + 3,380 -6,620 \nFutures down 3/3 of range; vol. down -10,000 + 3,990 -6,010 \nFutures up ,, extreme\" move + 7,000 - 3,130 +3\\870 \nFutures down \"extreme\" move - 7,000 + 1,500 -5,500 \nAs might be expected, the worst-case projection for a covered wiite is for the \nstock to drop, but for the implied volatility to increase. The SPAN system projects \nthat this covered wiiter would lose $6,620 if that happened. Thus, \"futures down 3/3 \nof range; volatility up\" is the SPAN requirement, $6,620. \nChapter 34: Futures and Futures Options 671 \nAs a means of comparison, under the older \"customer margin\" option require\nments, the requirement for a covered write was the futures margin, plus the option \npremium, less one-half the out-of-the-money amount. In the above example, assume \nthe futures were at 408 and the call was trading at 8. The customer covered write \nmargin would then be more than twice the SPAN requirement: \nFutures margin \nOption premium \n1/2 out-of-money amount \n$10,000 \n+ 4,000 \n- 1,000 \n$13,000 \nObviously, one can alter the quantities in the use of the risk array quite easily. \nFor example, ifhe had a ratio write oflong 3 futures and short 5 December 410 calls, \nhe could easily calculate the SPAN requirement by multiplying the projected futures \ngains and losses by 3, multiplying the projected option gains and losses by 5, and \nadding the two together to obtain the total requirement. Once he had completed this \ncalculation, his SPAN requirement would be the worst expected loss as projected by \nSPAN for the next trading day. \nIn actual practice, the SPAN calculations are even more sophisticated: They \ntake into account a certain minimum option margin (for deeply out-of-the-money \noptions); they account for spreads between futures contracts on the same commodi\nty (different expiration months); they add a delivery month charge (if you are hold\ning a position past the first notice day); ~ they even allow for slightly reduced \nrequirements for related, but different, futures spreads (T-bills versus T-bonds, for \nexample). \nIf you are interested in calculating SPAN margin yourself, your broker may be \nable to provide you with the software to do so. More likely, though, he will provide \nthe service of calculating the SPAN margin on a position prior to your establishing it. \nThe details for obtaining the SPAN margin requirements should thus be requested \nfrom your broker. \nPHYSICAL CURRENCY OPTIONS \nAnother group oflisted options on a physical is the currency options that trade on the \nPhiladelphia Stock Exchange (PHLX). In addition, there is an even larger over-the\ncounter market in foreign currency options. Since the physical commodity underly\ning the option is currency, in some sense of the word, these are cash-based options \nas well. However, the cash that the options are based in is not dollars, but rather may \nbe deutsche marks, Swiss francs, British pounds, Canadian dollars, French francs, or \n672 Part V: Index Options and Futures \nJapanese yen. Futures trade in these same currencies on the Chicago Mercantile \nExchange. Hence, many traders of the physical options use the Chicago-based \nfutures as a hedge for their positions. \nUnlike stock options, currency options do not have standardized terms - the \namount of currency underlying the option contract is not the same in each of the \ncases. The striking price intervals and units of trading are not the same either. \nHowever, since there are only the six different contracts and since their terms corre\nspond to the details of the futures contracts, these options have had much success. \nThe foreign currency markets are some of the largest in the world, and that size is \nreflected in the liquidity of the futures on these currencies. \nThe Swiss franc contract will be used to illustrate the workings of the foreign \ncurrency options. The other types of foreign currency options work in a similar man\nner, although they are for differing amounts of foreign currency. The amount of for\neign currency controlled by the foreign currency contract is the unit of trading, just \nas 100 shares of stock is the unit of trading for stock options. The unit of trading for \nthe Swiss franc option on the PHLX is 62,500 Swiss francs. Normally, the currency \nitself is quoted in terms of U.S. dollars. For example, a Swiss franc quote of 0.50 \nwould mean that one Swiss franc is worth 50 cents in U.S. currency. \nNote that when one takes a position in foreign currency options (or futures), he \nis simultaneously taking an opposite position in U.S. dollars. That is, if one owns a \nSwiss franc call, he is long the franc (at least delta long) and is by implication there\nfore short U.S. dollars. \nStriking prices in Swiss options are assigned in one-cent increments and are \nstated in cents, not dollars. That is, if the Swiss franc is trading at 50 cents, then there \nmight be striking prices of 48, 49, 50, 51, and 52. Given the unit of trading and the \nstriking price in U.S. dollars, one can compute the total dollars involved in a foreign \ncurrency exercise or assignment. \nExample: Suppose the Swiss franc is trading at 0.50 and there are striking prices of \n48, 50, and 52, representing U.S. cents per Swiss franc. If one were to exercise a call \nwith a strike of 48, then the dollars involved in the exercise would be 125,000 (the \nunit of trading) times 0.48 (the strike in U.S. dollars), or $60,000. \nOption premiums are stated in U.S. cents. That is, if a Swiss franc option is \nquoted at 0. 75, its c", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 301}
{"text": "is trading at 0.50 and there are striking prices of \n48, 50, and 52, representing U.S. cents per Swiss franc. If one were to exercise a call \nwith a strike of 48, then the dollars involved in the exercise would be 125,000 (the \nunit of trading) times 0.48 (the strike in U.S. dollars), or $60,000. \nOption premiums are stated in U.S. cents. That is, if a Swiss franc option is \nquoted at 0. 75, its cost is $.0075 times the unit of trading, 125,000, for a total of \n$937.50. Premiums are quoted in hundredths of a point. That is, the next \"tick\" from \n0.75 would be 0.76. Thus, for the Swiss franc options, each tick or hundredth of a \npoint is equal to $12.50 (.0001 x 125,000). \nChapter 34: Futures and Futures Options 673 \nActual delivery of the security to satisfy an assignment notice must occur with\nin the country of origin. That is, the seller of the currency must make arrangements \nto deliver the currency in its country of origin. On exercise or assignment, sellers of \ncurrency would be put holders who exercise or call writers who are assigned. Thus, \nif one were short Swiss franc calls and he were assigned, he would have to deliver \nSwiss francs into a bank in Switzerland. This essentially means that there have to be \nagreements between your firm or your broker and foreign banks if you expect to \nexercise or be assigned. The actual payment for the exercise or assignment takes \nplace between the broker and the Options Clearing Corporation (OCC) in U.S. dol\nlars. The OCC then can receive or deliver the currency in its country of origin, since \nOCC has arrangements with banks in each country. \nEXERCISE AND ASSIGNMENT \nThe currency options that trade on the PHLX (Philadelphia Exchange) have exercise \nprivileges similar to those for all other options that we have studied: They can be \nexercised at any time during their life. \nEven though PHLX currency options are \"cash\" options in the most literal \nsense of the word, they do not expose the writer to the same risks of early assignment \nthat cash-based index options do. \nExample: Suppose that a currency trader has established the following spread on the \nPHLX: long Swiss franc December 50 puts, short Swiss franc December 52 puts - a \nbullish spread. As in any one-to-one spread, there is limited risk. However, the dol\nlar rallies and the Swiss franc falls, pushing the exchange rate down to 48 cents (U.S.) \nper Swiss franc. Now the puts that were wri,tten - the December 52 contracts - are \ndeeply in-the-money and might be subject to early assignment, as would any deeply \nin-the-money put if it were trading at a discount. \nSuppose the trader learns that he has indeed been assigned on his short puts. \nHe still has a hedge, for he is long the December 50 puts and he is now long Swiss \nfrancs. This is still a hedged position, and he still has the same limited risk as he did \nwhen he started (plus possibly some costs involved in taking physical delivery of the \nfrancs). This situation is essentially the same as that of a spreader in stock or futures \noptions, who would still be hedged after an assignment because he would have \nacquired the stock or future. Contrast this to the cash-based index option, in which \nthere is no longer a hedge after an assignment. \n674 Part V: Index Options and Futures \nFUTURES OPTION TRADING STRATEGIES \nThe strategies described here are those that are unique to futures option trading. \nAlthough there may be some general relationships to stock and index option strate\ngies, for the most part these strategies apply only to futures options. It will also be \nshown - in the backspread and ratio spread examples - that one can compute the \nprofitability of an option spread in the same manner, no matter what the underlying \ninstrument is (stocks, futures, etc.) by breaking everything down into \"points\" and not \n\"dollars.\" \nBefore getting into specific strategies, it might prove useful to observe some \nrelationships about futures options and their price relationships to each other and to \nthe futures contract itself. Carrying cost and dividends are built into the price of stock \nand index options, because the underlying instrument pays dividends and one has to \npay cash to buy or sell the stock. Such is not the case with futures. The \"investment\" \nrequired to buy a futures contract is not initially a cash outlay. Note that the cost of \ncarry associated with futures generally refers to the carrying cost of owning the cash \ncommodity itself. That carrying cost has no bearing on the price of a futures option \nother than to determine the futures price itself. Moreover, the future has no divi\ndends or similar payout. This is even true for something like U.S. Treasury bond \noptions, because the interest rate payout of the cash bond is built into the futures \nprice; thus, the option, which is based on the futures price and not directly on the \ncash price, does not have to allow for carry, since the future itself has no initial car\nrying costs associated with it. \nSimplistically, it can be stated that: \nFutures Call = Futures Put + Futures Price - Strike Price \nExample: April crude oil futures closed at 18.74 ($18.74 per barrel). The following \nprices exist: \nStrike April Call April Put Put + Futures \nPrice Price Price - Strike \n17 1.80 0.06 1.80 \n18 0.96 0.22 0.96 \n19 0.35 0.61 \\ 0.35 \n20 0.10 1.36 0.10 \nNote that, at every strike, the above formula is true (Call = Put + Futures -\nStrike). These are not theoretical prices; they were taken from actual settlement \nprices on a particular trading day. \nChapter 34: Futures and Futures Options 675 \nIn reality, where deeply in-the-money or longer-term options are involved, this \nsimple formula is not correct. However, for most options on a particular nearby \nfutures contract, it will suffice quite well. Examine the quotes in today's newspaper \nto verify that this is a true statement. \nA subcase of this observation is that when the futures contract is exactly at the \nstriking price, the call and put", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 302}
{"text": "lity, where deeply in-the-money or longer-term options are involved, this \nsimple formula is not correct. However, for most options on a particular nearby \nfutures contract, it will suffice quite well. Examine the quotes in today's newspaper \nto verify that this is a true statement. \nA subcase of this observation is that when the futures contract is exactly at the \nstriking price, the call and put with that strike will both trade at the same price. Note \nthat in the above formula, if one sets the futures price equal to the striking price, the \nlast two terms cancel out and one is left with: Call price = Put price. \nOne final observation before getting into strategies: For a put and a call with the \nsame strike, \nNet change call - Net change put = Net change futures \nThis is a true statement for stock and index options as well, and is a useful rule \nto remember. Since futures options bid and offer quotes are not always disseminat\ned by quote vendors, one is forced to use last sales. If the last sales don't conform to \nthe rule above, then at least one of the last sales is probably not representative of the \ntrue market in the options. \nExample: April crude oil is up 50 cents to 19.24. A trader punches up the following \nquotes on his machine and sees the following prices: \nOption \nApril 19 call: \nApril 19 put: \nLast Sale \n0.55 \n0.31 \nThese options conform to the abo~rule: \nNet change futures = Net change call - Net change put \n= +0.20 - (-0.30) \n= +0.50 \nNet Change \n+ 0.20 \n- 0.30 \nThe net changes of the call and put indicate the April future should be up 50 \ncents, which it is. \nSuppose that one also priced a less active option on his quote machine and saw \nthe following: \nOption \nApril 17 call: \nApril 17 put: \nLast Sale \n2.10 \n0.04 \nNet Change \n+ 0.30 \n- 0.02 \n676 Part V: Index Options and Futures \nIn this case, the formula yields an incorrect result: \nNet change futures= +0.30 - (-0.02) = +0.32 \nSince the futures are really up 50 cents, one can assume that one of the last sales \nis out of date. It is obviously the April 17 call, since that is the in-the-money option; \nif one were to ask for a quote from the trading floor, that option would probably be \nindicated up about 48 cents on the day. \nDELTA \nWhile we are on the subject of pricing, a word about delta may be in order as well. \nThe delta of a futures option has the same meaning as the delta of a stock option: It \nis the amount by which the option is expected to increase in price for a one-point \nmove in the underlying futures contract. As we also know, it is an instantaneous meas\nurement that is obtained by taking the first derivative of the option pricing model. \nIn any case, the delta of an at-the-money stock or index option is greater than \n0.50; the more time remaining to expiration, the higher the delta is. In a simplified \nsense, this has to do with the cost of carrying the value of the striking price until the \noption expires. But part of it is also due to the distribution of stock price movements \n- there is an upward bias, and with a long time remaining until expiration, that bias \nmakes call movements more pronounced than put movements. \nOptions on futures do not have the carrying cost feature to deal with, but they \ndo have the positive bias in their price distribution. A futures contract, just like a \nstock, can increase by more than 100%, but cannot fall more than 100%. \nConsequently, deltas of at-the-money futures calls will be slightly larger than 0.50. \nThe more time remaining until expiration of the futures option, the higher the at-the\nmoney call delta will be. \nMany traders erroneously believe that the delta of an at-the-money futures \noption is 0.50, since there is no carrying cost involved in the futures conversion or \nreversal arbitrage. That is not a true statement, since the distribution of futures prices \naffects the delta as well. \nAs always, for futures options as well as for stock and index options, the delta of \na put is related to the delta of a call with the same striking price and expiration date: \nDelta of put = 1 - Delta of call \nFinally, the concept of equivalent stock position applies to futures opti<i>n strate\ngies, except, of course, it is called the equivalent futures position (EFP). The EFP is \ncalculated by the simple formula: \nEFP = Delta of option x Option quantity \nChapter 34: Futures and Futures Options 677 \nThus, if one is long 8 calls with a delta of 0. 75, then that position has an EFP of \n6 (8 x 0.75). This means that being long those 8 calls is the same as being long 6 \nfutures contracts. \nNote that in the case of stocks, the equivalent stock position formula has anoth\ner factor shares per option. That concept does not apply to futures options, since \nthey are always options on one futures contract. \nMATHEMATICAL CONSIDERATIONS \nThis brief section discusses modeling considerations for futures options and options \non physicals. \nFutures Options. The Black model (see Chapter 33 on mathematical consider\nations for index options) is used to price futures options. Recall that futures don't pay \ndividends, so there is no dividend adjustment necessary for the model. In addition, \nthere is no carrying cost involved with futures, so the only adjustment that one needs \nto make is to use 0% as the interest rate input to the Black-Scholes model. This is an \noversimplification, especially for deeply in-the-money options. One is tying up some \nmoney in order to buy an option. Hence, the Black model will discount the price \nfrom the Black-Scholes model price. Therefore, the actual pricing model to be used \nfor theoretical evaluation of futures options is the Black model, which is merely the \nBlack-Scholes model, using 0% as the interest rate, and then discounted: \nCall Theoretical Price = e-rt x Black-Scholes formula [r = O] \nRecall that it was stated above that: \nFutures call = Futures put + Future price - Strike price \nThe actual relationship is: ~ \nFutures call= Futures put+ e-rt (Futures price", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 303}
{"text": "for theoretical evaluation of futures options is the Black model, which is merely the \nBlack-Scholes model, using 0% as the interest rate, and then discounted: \nCall Theoretical Price = e-rt x Black-Scholes formula [r = O] \nRecall that it was stated above that: \nFutures call = Futures put + Future price - Strike price \nThe actual relationship is: ~ \nFutures call= Futures put+ e-rt (Futures price - Strike price) \nwhere \nr = the short-term interest rate, \nt = the time to expiration in years, and \ne-rt = the discounting factor. \nThe short-term interest rate has to be used here because when one pays a debit \nfor an option, he is theoretically losing the interest that he could earn if he had that \nmoney in the bank instead, earning money at the short-term interest rate. \nThe difference between these two formulae is so small for nearby options that \nare not deeply in-the-money that it is normally less than the bid-asked spread in the \noptions, and the first equation can be used. \n678 Part V: Index Options and Futures \nExample: The table below compares the theoretical values computed with the two \nformulae, where r = 6% and t = 0.25 (1/4 of a year). Furthermore, assume the futures \nprice is 100. The strike price is given in the first column, and the put price is given \nin the second column. The predicted call prices according to each formula are then \nshown in the next two columns. \nPut Formula l Formula 2 \nStrike Price (Simple) ( Using e-rf) \n70 0.25 30.25 29.80 \n80 1.00 21.00 20.70 \n90 3.25 13.25 13.10 \n95 5.35 10.35 10.28 \n100 7.50 7.50 7.50 \n105 10.70 5.70 5.77 \n110 13.90 3.90 4.05 \n120 21.80 1.80 2.10 \nFor options that are 20 or 30 points in- or out-of-the-money, there is a notice\nable differential in these three-month options. However, for options closer to the \nstrike, the differential is small. \nIf the time remaining to expiration is shorter than that used in the example \nabove, the differences are smaller; if the time is longer, the differences are magnified. \nOptions on Physicals. Determining the fair value of options on physicals such \nas currencies is more complicated. The proper way to calculate the fair value of an \noption on a physical is quite similar to that used for stock options. Recall that in the \ncase of stock options, one first subtracts the present worth of the dividend from the \ncurrent stock price before calculating the option value. A similar process is used for \ndetermining the fair value of currency or any other options on physicals. In any of \nthese cases, the underlying security bears interest continuously, instead of quarterly \nas stocks do. Therefore, all one needs to do is to subtract from the underlying price \nthe amount of interest to be paid until option expiration and then add the amount of \naccrued interest to be paid. All other inputs into the Black-Scholes model would \nremain the same, including the risk-free interest rate being equal to the 90-day T-bill \nrate. \nAgain, the practical option strategist has a shortcut available to him. If one \nassumes that the various factors necessary to price currencies have been assimilated \ninto the futures markets in Chicago, then one can merely use the futures price as the \nprice of the underlying for evaluating the physical delivery options in Philadelphia. \nChapter 34: Futures and Futures Options 679 \nThis will not work well near expiration, since the future expires one week prior to the \nPHLX option. In addition, it ignores the early exercise value of the PHLX options. \nHowever, except for these small differentials, the shortcut will give theoretical values \nthat can be used in strategy-making decisions. \nExample: It is sometime in April and one desires to calculate the theoretical values \nof the June deutsche mark physical delivery options in Philadelphia. Assume that one \nknows four of the basic items necessary for input to the Black-Scholes formula: 60 \ndays to expiration, strike price of 68, interest rate of 10%, and volatility of 18%. But \nwhat should be used as the price of the underlying deutsche mark? Merely use the \nprice of the June deutsche mark futures contract in Chicago. \nSTRATEGIES REGARDING TRADING LIMITS \nThe fact that trading limits exist in most futures contracts could be detrimental to \nboth option buyers and option writers. At other times, however, the trading limit may \npresent a unique opportunity. The following section focuses on who might benefit \nfrom trading limits in futures and who would not.. \nRecall that a trading limit in a futures contract limits the absolute number of \npoints that the contract can trade up or down from the previous close. Thus, if the \ntrading limit in T-bonds is 3 points and they closed last night at 7 421132, then the high\nest they can trade on the next day is 7721132, regardless of what might be happening \nin the cash bond market. Trading limits exist in many futures contracts in order to \nhelp ensure that the market cannot be manipulated by someone forcing the price to \nmove tremendously in one direction or the other. Another reason for having trading \nlimits is ostensibly to allow only a fixed move, approximately equal to the amount cov\nered by the initial margin, so that maintenance margin can be collected if need be. \nHowever, limits have been applied in case~which they are unnecessary. For exam\nple, in T-bonds, there is too much liquidity for anyone to be able to manipulate the \nmarket. Moreover, it is relatively easy to arbitrage the T-bond futures contract against \ncash bonds. This also increases liquidity and would keep the future from trading at a \nprice substantially different from its theoretical value. \nSometimes the markets actually need to move far quickly and cannot because of \nthe trading limit. Perhaps cash bonds have rallied 4 points, when the limit is 3 points. \nThis makes no difference when a futures contract has risen as high as it can go for \nthe day, it is bid there (a situation called \"limit bid\") and usually doesn't trade again \nas lo", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 304}
{"text": "stantially different from its theoretical value. \nSometimes the markets actually need to move far quickly and cannot because of \nthe trading limit. Perhaps cash bonds have rallied 4 points, when the limit is 3 points. \nThis makes no difference when a futures contract has risen as high as it can go for \nthe day, it is bid there (a situation called \"limit bid\") and usually doesn't trade again \nas long as the underlying commodity moves higher. It is, of course, possible for a \nfuture to be limit bid, only to find that later in the day, the underlying commodity \nbecomes weaker, and traders begin to sell the future, driving it down off the limit. \n680 Part V: Index Options and Futures \nSimilar situations can also occur on the downside, where, if the future has traded as \nlow as it can go, it is said to be \"limit offered.\" \nAs was pointed out earlier, futures options sometimes have trading limits \nimposed on them as well. This limit is of the same magnitude as the futures limit. \nMost of these are on the Chicago Board of Trade (all grains, U.S. Treasury bonds, \nMunicipal Bond Index, Nikkei stock index, and silver), although currency options on \nthe Chicago Mere are included as well. In other markets, options are free to trade, \neven though futures have effectively halted because they are up or down the limit. \nHowever, even in the situations in which futures options themselves have a trading \nlimit, there may be out-of-the-money options available for trading that have not \nreached their trading limit. \nWhen options are still trading, one can use them to imply the price at which the \nfutures would be trading, were they not at their trading limit. \nExample: August soybeans have been inflated in price due to drought fears, having \nclosed on Friday at 650 ($6.50 per bushel). However, over the weekend it rains heav\nily in the Midwest, and it appears that the drought fears were overblown. Soybeans \nopen down 30 cents, to 620, down the allowable 30-cent limit. Furthermore, there \nare no buyers at that level and the August bean contract is locked limit down. No fur\nther trading ensues. \nOne may be able to use the August soybean options as a price discovery mech\nanism to see where August soybeans would be trading if they were open. \nSuppose that the following prices exist, even though August soybeans are not \ntrading because they are locked limit down: \nLost Sole Net Change \nOption Price for the Day \nAugust 625 call 19 - 21 \nAugust 625 put 31 +16 \nAn option strategist knows that synthetic long futures can be created by buying \na call and selling a put, or vice versa for short futures. Knowing this, one can tell what \nprice futures are projected to be trading at: \nImplied Futures Price = Strike Price + Call Price - Put Price \n= 625 + 19 - 31 = 613 \nWith these options at the prices shown, one can create a synthetic futures posi\ntion at a price of 613. Therefore, the implied price for August soybean futures in this \nexample is 613. \nChapter 34: Futures and Futures Options 681 \nNote that this formula is merely another version of the one previously present\ned in this chapter. \nIn the example above, neither of the options in question had moved the 30-\npoint limit, which applies to soybean options as well as to soybean futures. If they \nhad, they would not be useable in the formula for implying the price of the future. \nOnly options that are freely trading - not limit up or down - can be used in the above \nformula. \nA more complete look at soybean futures options on the day they opened and \nstayed down the limit would reveal that some of them are not tradeable either: \nExample: Continuing the above example, August soybeans are locked limit down 30 \ncents on the day. The following list shows a wider array of option prices. Any option \nthat is either up or down 30 cents on the day has also reached its trading limit, and \ntherefore could not be used in the process necessary to discover the implied price of \nthe August futures contract. \nlast Sale Net Change \nOption Price for the Day \nAugust 550 call 71 - 30 \nAugust 575 call 48 30 \nAugust 600 call 31 - 26 \nAugust 625 call 19 - 21 \nAugust 650 call 11 - 15 \nAugust 675 call 6 - 10 \nAugust 550 put 4 + 3 \nAugust 575 put 9 + 6 \nAugust 600 put 18 + 11 \nAugust 625 put -----------31 + 16 \nAugust 650 put 48 + 22 \nAugust 675 put 67 + 30 \nThe deeply in-the-money calls, August 550's and August 575's, and the deeply in\nthe-money August 675 puts are all at the trading limit. All other options are freely trad\ning and could be used for the above computation of the August future's implied price. \nOne may ask how the market-makers are able to create markets for the options \nwhen the future is not freely trading. They are pricing the options off cash quotes. \nKnowing the cash quote, they can imply the price of the future (613 in this case), and \nthey can then make option markets as well. \n682 Part V: Index Options and Futures \nThe real value in being able to use the options when a future is locked limit up \nor limit down, of course, is to be able to hedge one's position. Simplistically, if a trad\ner came in long the August soybean futures and they were locked limit down as in \nthe example above, he could use the puts and calls to effectively close out his posi\ntion. \nExample: As before, August soybeans are at 620, locked down the limit of 30 cents. \nA trader has come into this trading day long the futures and he is very worried. He \ncannot liquidate his long position, and if soybeans should open down the limit again \ntomorrow, his account will be wiped out. He can use the August options to close out \nhis position. \nRecall that it has been shown that the following is true: \nLong put + Short call is equivalent to short stock. \nIt is also equivalent to short futures, of course. So if this trader were to buy a \nput and short a call at the same strike, then he would have the equivalent of a short \nfutures position to offset his long futures position. \nUsing the following prices, which ar", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 305}
{"text": "close out \nhis position. \nRecall that it has been shown that the following is true: \nLong put + Short call is equivalent to short stock. \nIt is also equivalent to short futures, of course. So if this trader were to buy a \nput and short a call at the same strike, then he would have the equivalent of a short \nfutures position to offset his long futures position. \nUsing the following prices, which are the same as before, one can see how his \nrisk is limited to the effective futures price of 613. That is, buying the put and selling \nthe call is the same as selling his futures out at 613, down 37 cents on the trading day. \nCurrent prices: \nOption \nAugust 625 call \nAugust 625 put \nPosition: \nBuy August 625 put for 19 \nSell August 625 call for 31 \nAugust Futures \nat Option \nExpiration Put Price \n575 50 \n600 25 \n613 12 \n625 0 \n650 0 \nPut \nP/L \n+ $1,900 \n600 \n- 1,900 \n- 3,100 \n3,100 \nLast Sale \nPrice \n19 \n31 \nCall Price \n0 \n0 \n0 \n0 \n25 \nCall \nP/L \n+$1,900 \n+ 1,900 \n+ 1,900 \n+ 1,900 \n600 \nNet Change \nfor the Day \n-21 \n+16 \nNet Profit \nor loss on \nPosition \n+$3,800 \n+ 1,300 \n0 \n- 1,200 \n- 3,700 \nOtapter 34: Futures and Futures Options 683 \nThis profit table shows that selling the August 625 call at 19 and buying the \nAugust 625 put at 31 is equivalent to - that is, it has the same profit potential as -\nselling the August future at 613. So, if one buys the put and sells the call, he will \neffectively have sold his future at 613 and taken his loss. \nHis resultant position after buying the put and selling the call would be a con\nversion (long futures, long put, and short call). The margin required for a conversion \nor reversal is zero in the futures market. The margin rules recognize the riskless \nnature of such a strategy. Thus, any excess money that he has after paying for the \nunrealized loss in the futures will be freed up for new trades. \nThe futures trader does not have to completely hedge off his position ifhe does \nnot want to. He might decide to just buy a put to limit the downside risk. \nUnfortunately, to do so after the futures are already locked limit down may be too lit\ntle, too late. There are many kinds of partial hedges that he could establish - buy \nsome puts, sell some calls, utilize different strikes, etc. \nThe same or similar strategies could be used by a naked option seller who can\nnot hedge his position because it is up the limit. He could also utilize options that are \nstill in free trading to create a synthetic futures position. \nFutures options generally have enough out-of-the-money striking prices listed \nthat some of them will still be free trading, even if the futures are up or down the \nlimit. This fact is a boon to anyone who has a losing position that has moved the daily \ntrading limit. Knowing how to use just this one option trading strategy should be a \nworthwhile benefit to many futures traders. \nCOMMONPLACE MISPRICING STRATEGIES \nFutures options are sometimes prone to severe mispricing. Of course, any product's \noptions may be subject to mispricing from time to time. However, it seems to appear \nin futures options more often than it does in stock options. The following discussion \nof strategies concentrates on a specific pattern of futures options mispricing that \noccurs with relative frequency. It generally m{inifests itself in that out-of-the-money \nputs are too cheap, and out-of-the-money calls are too expensive. The proper term \nfor this phenomenon is \"volatility skewing\" and it is discussed further in Chapter 36 \non advanced concepts. In this chapter, we concentrate on how to spot it and how to \nattempt to profit from it. \nOccasionally, stock options exhibit this trait to a certain extent. Generally, it \noccurs in stocks when speculators have it in their minds that a stock is going to expe\nrience a sudden, substantial rise in price. They then bid up the out-of-the-money \ncalls, particularly the near-term ones, as they attempt to capitalize on their bullish \nexpectations. When takeover rumors abound, stock options display this mispricing \n684 Part V: Index Options and Futures \npattern. Mispricing is, of course, a statistically related term; it does not infer anything \nabout the possible validity of takeover rumors. \nA significant amount of discussion is going to be spent on this topic, because the \nfutures option trader will have ample opportunities to see and capitalize on this mis\npricing pattern; it is not something that just comes along rarely. He should therefore \nbe prepared to make it work to his advantage. \nExample: January soybeans are trading at 583 ($5.83 per bushel). The following \nprices exist: \nStrike \n525 \n550 \n575 \n600 \n625 \n650 \n675 \nJanuary beans: 583 \nCall \nPrice \n191/2 \n11 \n51/4 \n31/2 \n21/4 \nPut \nPrice \nSuppose one knows that, according to historic patterns, the \"fair values\" of these \noptions are the prices listed in the following table. \nStrike \n525 \n550 \n575 \n600 \n625 \n650 \n675 \nCall \nPrice \n191/2 \n11 \n53/4 \n31/2 \n21/4 \nCall \nTheo. \nValue \n21.5 \n10.4 \n4.3 \n1.5 \n0.7 \nPut \nPut Theo. \nPrice Value \n1/2 1.6 \n31/4 5.4 \n12 13.7 \n28 27.6 \nNotice that the out-of-the-money puts are priced well below their theoretical \nvalue, while the out-of-the-money calls are priced above. The options at the 575 and \n600 strikes are much closer in price to their theoretical values than are the out-of\nthe-money options. \nChapter 34: Futures and Futures Options 685 \nThere is another way to look at this data, and that is to view the options' implied \nvolatility. Implied volatility was discussed in Chapter 28 on mathematical applica\ntions. It is basically the volatility that one would have to plug into his option pricing \nmodel in order for the model's theoretical price to agree with the actual market price. \nAlternatively, it is the volatility that is being implied by the actual marketplace. The \noptions in this example each have different implied volatilities, since their mispricing \nis so distorted. Table 34-2 gives those implied volatilities. The deltas of the opti", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 306}
{"text": "ne would have to plug into his option pricing \nmodel in order for the model's theoretical price to agree with the actual market price. \nAlternatively, it is the volatility that is being implied by the actual marketplace. The \noptions in this example each have different implied volatilities, since their mispricing \nis so distorted. Table 34-2 gives those implied volatilities. The deltas of the options \ninvolved are shown as well, for they will be used in later examples. \nThese implied volatilities tell the same story: The out-of-the-money puts have \nthe lowest implied volatilities, and therefore are the cheapest options; the out-of-the\nmoney calls have the highest implied volatilities, and are therefore the most expen\nsive options. \nSo, no matter which way one prefers to look at it - through comparison of the \noption price to theoretical price or by comparing implied volatilities - it is obvious \nthat these soybean options are out of line with one another. \nThis sort of pricing distortion is prevalent in many commodity options. \nSoybeans, sugar, coffee, gold, and silver are all subject to this distortion from time to \ntime. The distortion is endemic to some - soybeans, for example - or may be pres\nent only when the speculators tum extremely bullish. \nThis precise mispricing pattern is so prevalent in futures options that strategists \nshould constantly be looking for it. There are two major ways to attempt to profit \nfrom this pattern. Both are attractive strategies, since one is buying options that are \nrelatively less expensive than the options that are being sold. Such strategies, if \nimplemented when the options are mispriced, tilt the odds in the strategist's favor, \ncreating a positive expected return for the position. \nTABLE 34-2. \nVolatility skewing of soybean options. \nStrike \n525 \n550 \n575 \n600 \n625 \n650 \n675 \nCall \nPrice \n19 1/2 \n11 \n53/4 \n31/2 \n21/4 \nPut \nPrice \n1/2 \n31/4 ; \n12 \n28 \nImplied Delta \nVolatility Call/Put \n12% /-0.02 \n13% /-0.16 \n15% 0.59/-0.41 \n17% 0.37 /-0.63 \n19% 0.21 \n21% 0.13 \n23% 0.09 \n686 Part V: Index Options and Futures \nThe two theoretically attractive strategies are: \n1. Buy out-of-the-money puts and sell at-the-money puts; or \n2. Buy at-the-money calls and sell out-of-the-money calls. \nOne might just buy one cheap and sell one expensive option - a bear spread \nwith the puts, or a bull spread with the calls. However, it is better to implement these \nspreads with a ratio between the number of options bought and the number sold. \nThat is, the first strategy involving puts would be a backspread, while the second \nstrategy involving calls would be a ratio spread. By doing the ratio, each strategy is a \nmore neutral one. Each strategy is examined separately. \nBACKSPREAD/NG THE PUTS \nThe backspread strategy works best when one expects a large degree of volatility. \nImplementing the strategy with puts means that a large drop in price by the under\nlying futures would be most profitable, although a limited profit could be made if \nfutures rose. Note that a moderate drop in price by expiration would be the worst \nresult for this spread. \nExample: Using prices from the above example, suppose that one decides to estab\nlish a backspread in the puts. Assume that a neutral ratio is obtained in the following \nspread: \nBuy 4 January bean 550 puts 31/4 \nSell 1 January bean 600 put at 28 \nNet position: \n13 DB \n28 CR \n15 Credit \nThe deltas (see Table 34-2) of the options are used to compute this neutral ratio. \nFigure 34-1 shows the profit potential of this spread. It is the typical picture for \na put backspread - limited upside potential with a great deal of profit potential for \nlarge downward moves. Note that the spread is initially established for a credit of 15 \ncents. If January soybeans have volatile movements in either direction, the position \nshould profit. Obviously, the profit potential is larger to the downside, where there \nare extra long puts. However, if beans should rally instead, the spreader could still \nmake up to 15 cents ($750), the initial credit of the position. \nNote that one can treat the prices of soybean options in the same manner as he \nwould treat the prices of stock options in order to determine such things as break\neven points and maximum profit potential. The fact that soybean options are worth \nChapter 34: Futures and Futures Options 687 \nFIGURE 34-1. \nJanuary soybean, backspread. \n60 \n50 \n40 \n30 ..... \ne 20 a.. \n0 10 ~ r::: \n~ 550 600 625 \n-20 \n-30 \nFutures Price \n$50 per point ( which is cents when referring to soybeans) and stock options are worth \n$100 per point do not alter these calculations for a put backspread. \nMaximum upside profit potential= Initial debit or credit of position \n= 15 points \nMaximum risk = Maximum upside Distance between strikes \nx Number of puts sold short \n= 15-50 X 1 \n= -35 points \nDownside break-even point = Lower strike \n- Points of risk/Number of excess puts \n= 550- 35/3 \n= 538.3 \nThus, one is able to analyze a futures option p~tion or a stock option position \nin the same manner - by reducing everything to be in terms of points, not dollars. \nObviously, one will eventually have to convert to dollars in order to calculate his prof\nits or losses. However, note that referring to everything in \"points\" works very well. \n688 Part V: Index Options and Futures \nLater, one can use the dollars per point to obtain actual dollar cost. Dollars per point \nwould be $50 for soybeans options, $100 for stock or index options, $400 for live cat\ntle options, $375 for coffee options, $1,120 for sugar options, etc. In this way, one \ndoes not have to get hung up in the nomenclature of the futures contract; he can \napproach everything in the same fashion for purposes of analyzing the position. He \nwill, of course, have to use proper nomenclature to enter the order, but that comes \nafter the analysis is done. \nRATIO SPREADING THE CALLS \nReturning to the subject at hand - spreads that capture this particular mispricing \nphenomenon of", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 307}
{"text": "not have to get hung up in the nomenclature of the futures contract; he can \napproach everything in the same fashion for purposes of analyzing the position. He \nwill, of course, have to use proper nomenclature to enter the order, but that comes \nafter the analysis is done. \nRATIO SPREADING THE CALLS \nReturning to the subject at hand - spreads that capture this particular mispricing \nphenomenon of futures options - recall that the other strategy that is attractive in \nsuch situations is the ratio call spread. It is established with the maximum profit \npotential being somewhat above the current futures price, since the calls that are \nbeing sold are out-of-the-money. \nExample: Again using the January soybean options of the previous few examples, \nsuppose that one establishes the following ratio call spread. Using the calls' deltas \n(see Table 34-2), the following ratio is approximately neutral to begin with: \nBuy 2 January bean 600 calls at 11 \nSell 5 January bean 650 calls at 31/2 \nNet position: \n22 DB \n171/2 CR \n41/2 Debit \nFigure 34-2 shows the profit potential of the ratio call spread. It looks fairly typ\nical for a ratio spread: limited downside exposure, maximum profit potential at the \nstrike of the written calls, and unlimited upside exposure. \nSince this spread is established with both options out-of-the-money, one needs \nsome upward movement by January soybean futures in order to be profitable. \nHowever, too much movement would not be welcomed (although follow-up strate\ngies could be used to deal with that). Consequently, this is a moderately bullish strat\negy; one should feel that the underlying futures have a chance to move somewhat \nhigher before expiration. \nAgain, the analyst should treat this position in terms of points, not dollars or \ncents of soybean movement, in order to calculate the significant profit and loss \npoints. Refer to Chapter 11 on ratio call spreads for the original explanation of these \nformulae for ratio call spreads: \nMaximum downside loss = Initial debit or credit \n= -4½ (it is a debit) \nChapter 34: Futures and Futures Options \nFIGURE 34-2. \nJanuary soybean, ratio spread. \n90 \n80 \n70 \n60 \n50 \n:!:: \n40 0 ... a.. 30 \n0 20 .le \nC 10 \n~ 0 \n-10 \n-20 \n-30 \n575 625 650 \nAt Expiration \nFutures Price \nPoints of maximum profit = Maximum downside loss \n+ Difference in strikes \nx Number of calls owned \n=-4½ + 50 X 2 \n=95½ \nUpside break-even price = Higher striking price \n700 \n+ Maximum profit/Net number of naked calls \n= 650 + 95½/3 \n= 681.8 \n689 \nThese are the significant points of profitability at expiration. One does not care \nwhat the unit of trading is (for example, cents for soybeans) or how many dollars are \ninvolved in one unit of trading ($50 for soybeans and soybean options). He can con\nduct his analysis strictly in terms of points, and he should do so. \nBefore proceeding into the comparisons beleen the backspread and the ratio \nspread as they apply to mispriced futures options, it should be pointed out that the seri\nous strategist should analyze how his position will perform over the short term as well \nas at expiration. These analyses are presented in Chapter 36 on advanced concepts. \n690 Part V: Index Options and Futures \nWHICH STRATEGY TO USE \nThe profit potential of the put backspread is obviously far different from that of the \ncall ratio spread. They are similar in that they both offer the strategist the opportu\nnity to benefit from spreading mispriced options. Choosing which one to implement \n(assuming liquidity in both the puts and calls) may be helped by examining the tech\nnical picture ( chart) of the futures contract. Recall that futures traders are often more \ntechnically oriented than stock traders, so it pays to be aware of basic chart patterns, \nbecause others are watching them as well. If enough people see the same thing and \nact on it, the chart pattern will be correct, if only from a \"self-fulfilling prophecy\" \nviewpoint if nothing else. \nConsequently, if the futures are locked in a (smooth) downtrend, the put strat\negy is the strategy of choice because it offers the best downside profit. Conversely, if \nthe futures are in a smooth uptrend, the call strategy is best. \nThe worst result will be achieved if the strategist has established the call ratio \nspread, and the futures have an explosive rally. In certain cases, very bullish rumors \n- weather predictions such as drought or El Nifio, foreign labor unrest in the fields \nor mines, Russian buying of grain - will produce this mispricing phenomenon. The \nstrategist should be leery of using the call ratio spread strategy in such situations, \neven though the out-of-the-money calls look and are ridiculously expensive. If the \nrumors prove true, or if there are too many shorts being squeezed, the futures can \nmove too far, too fast and seriously hurt the spreader who has the ratio call spread in \nplace. His margin requirements will escalate quickly as tl1e futures price moves high\ner. The option premiums will remain high or possibly even expand if the futures rally \nquickly, thereby overriding the potential benefit of time decay. Moreover, if the fun\ndamentals change immediately - it rains; the strike is settled; no grain credits are \noffered to the Russians - or rumors prove false, the futures can come crashing back \ndown in a hurry. \nConsequently, if rumors of fundamentals have introduced volatility in the \nfutures rnarket, implement the strategy with the put backspread. The put backspread \nis geared to taking advantage of volatility, and this fundamental situation as described \nis certainly volatile. It may seem that because the market is exploding to the upside, \nit is a waste of time to establish the put spread. Still, it is the wisest choice in a volatile \nmarket, and there is always the chance that an explosive advance can turn into a quick \ndecline, especially when the advance is based on rumors or fundamentals that could \nchange overnight. \nThere are a few \"don'ts\" associated with th", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 308}
{"text": "le. It may seem that because the market is exploding to the upside, \nit is a waste of time to establish the put spread. Still, it is the wisest choice in a volatile \nmarket, and there is always the chance that an explosive advance can turn into a quick \ndecline, especially when the advance is based on rumors or fundamentals that could \nchange overnight. \nThere are a few \"don'ts\" associated with the ratio call spread. Do not be tempt\ned to use the ratio spread strategy in volatile situations such as those just described; \nit works best in a slowly rising market. Also, do not implement the ratio spread with \nChapter 34: Futures and Futures Options 691 \nridiculously far out-of-the-money options, as one is wasting his theoretical advantage \nif the futures do not have a realistic chance to climb to the striking price of the writ\nten options. Finally, do not attempt to use overly large ratios in order to gain the most \ntheoretical advantage. This is an important concept, and the next example illustrates \nit well. \nExample: Assume the same pricing pattern for January soybean options that has \nbeen the basis for this discussion. January beans are trading at 583. The (novice) \nstrategist sees that the slightly in-the-money January 575 call is the cheapest and the \ndeeply out-of-the-money January 675 call is the most expensive. This can be verified \nfrom either of two previous tables: the one showing the actual price as compared to \nthe \"theoretical\" price, or Table 34-2 showing the implied volatilities. \nAgain, one would use the deltas (see Table 34-2) to create a neutral spread. A \nneutral ratio of these two would involve selling approximately six calls for each one \npurchased. \nBuy 1 January bean 575 call at 191/z \nSell 6 January bean 675 calls at 21/4 \nNet position: \n191/z DB \n131/z CR \n6 Debit \nFigure 34-3 shows the possible detrimental effects of using this large ratio. \nWhile one could make 94 points of profit if beans were at 675 at January expiration, \nhe could lose that profit quickly if beans shot on through the upside break-even \npoint, which is only 693.8. The previous formulae can be used to verify these maxi\nmum profit and upside break-even point calculations. The upside break-even point \nis too close to the striking price to allow for reasonable follow-up action. Therefore, \nthis would not be an attractive position from a practical viewpoint, even though at \nfirst glance it looks attractive theoretically. \nIt would seem that neutral spreading could get one into trouble if it \"recom\nmends\" positions like the 6-to-l ratio spread. In reality, it is the strategist who is get\nting into trouble if he doesn't look at the whole picture. The statistics are just an aid \n- a tool. The strategist must use the tools to his advantage. It should be pointed out \nas well that there is a tool missing from the toolkit at this point. There are statistics \nthat will clearly show the risk of this type of high-rati<,Yspread. In this case, that tool \nis the gamma of the option. Chapter 40 covers the -Lise of gamma and other more \nadvanced statistical tools. This same example is expanded in that chapter to include \nthe gamma concept. \n692 Part V: Index Options and Futures \nFIGURE 34-3. \nJanuary soybean, heavily ratioed spread. \n90 \n60 \n30 \n- 0 \ne 575 625 650 675 725 a. -30 0 \n.1!l -60 C \n~ \n-90 \n-120 At Expiration \n-150 \n-180 \nFutures Price \nFOLLOW-UP ACTION \nThe same follow-up strategies apply to these futures options as did for stock options. \nThey will not be rehashed in detail here; refer to earlier chapters for broader expla\nnations. This is a summary of the normal follow-up strategies: \nRatio call spread: \nFollow-up action in strategies with naked options, such as this, generally involves \ntaking or limiting losses. A rising market will produce a negative EFP. \nNeutralize a negative EFP by: \nBuying futures \nBuying some calls \nLimit upside losses by placing buy stop orders for futures at or near the upside \nbreak-even point. \nPut backspread: \nFollow-up action in strategies with an excess of long options generally involves \ntaking or protecting profits. A falling market will produce a negative EFP. \nNeutralize a negative EFP by: \nBuying futures \nSelling some puts \nChapter 34: Futures and Futures Options 693 \nThe reader has seen these follow-up strategies earlier in the book. However, \nthere is one new concept that is important: The mispricing continues to propagate \nitself no matter what the price of the underlying futures contract. The at-the-money \noptions will always be about fairly priced; they will have the average implied volatility. \nExample: In the previous examples, January soybeans were trading at 583 and the \nimplied volatility of the options with striking price 575 was 15%, while those with a \n600 strike were 17%. One could, therefore, conclude that the at-the-money January \nsoybean options would exhibit an implied volatility of about 16%. \nThis would still be true if beans were at 525 or 675. The mispricing of the other \noptions would extend out from what is now the at-the-money strike. Table 34-3 shows \nwhat one might expect to see if January soybeans rose 75 cents in price, from 583 to \n658. \nNate that the same mispricing properties exist in both the old and new situa\ntions: The puts that are 58 points out-of-the-money have an implied volatility of only \n12%, while the calls that are 92 points out-of-the-money have an implied volatility of \n23%. \nTABLE 34-3. \nPropagation of volatility skewing. \nOriginal Situation \nJanuary beans: 583 \nImplied \nStrike Volatility \n525 12% \n550 13% \n575 15% \n600 17% \n625 19% \n650 21% \n675 23% \nNew Situation \nJanuary beans: 658 \nStrike \n600 \n625 \n650 \n675 \n700 \n725 \n750 \nThis example is not meant to infer that the volatility of an at-the-money soybean \nfutures option will always be 16%. It could be anything, depending on the historical \nand implied volatility of the futures contract itself. However, the volatility skewing \nwill still persist even if the futur", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 309}
{"text": "625 19% \n650 21% \n675 23% \nNew Situation \nJanuary beans: 658 \nStrike \n600 \n625 \n650 \n675 \n700 \n725 \n750 \nThis example is not meant to infer that the volatility of an at-the-money soybean \nfutures option will always be 16%. It could be anything, depending on the historical \nand implied volatility of the futures contract itself. However, the volatility skewing \nwill still persist even if the futures rally or decline. \nThis fact will affect how these strategies behave as the(linderlying futures con\ntract moves. It is a benefit to both strategies. First, look at the put backspread when \nthe stock falls to the striking price of the purchased puts. \n694 Part V: Index Options and Futures \nExample: The put backspread was established under the following conditions: \nStrike \n550 \n600 \nPut \nPrice \nTheoretical \nPut Price \n5.4 \n27.6 \nImplied \nVolatility \n13% \n17% \nIf January soybean futures should fall to 550, one would expect the implied \nvolatility of the January 550 puts that are owned to be about 16% or 17%, since they \nwould be at-the-money at that time. This makes the assumption that the at-the\nmoney puts will have about a 17% implied volatility, which is what they had when the \nposition was established. \nSince the strategy involves being long a large quantity of January 550 puts, this \nincrease in implied volatility as the futures drop in price will be of benefit to the \nspread. \nNote that the implied volatility of the January 600 puts would increase as well, \nwhich would be a small negative aspect for the spread. However, since there is only \none put short and it is quite deeply in the money with the futures at 550, this nega\ntive cannot outweigh the positive effect of the expansion of volatility on the long \nJanuary 550 puts. \nIn a similar manner, the call spread would benefit. The implied volatility of the \nwritten options would actually drop as the futures rallied, since they would be less far \nout-of-the-money than they originally were when the spread was established. While \nthe same can be said of the long options in the spread, the fact that there are extra, \nnaked, options means the spread will benefit overall. \nIn summary, the futures option strategist should be alert to mispricing situations \nlike those described above. They occur frequently in a few commodities and occa\nsionally in others. The put backspread strategy has limited risk and might therefore \nbe attractive to more individuals; it is best used in downtrending and/or volatile mar\nkets. However, if the futures are in a smooth uptrend, not a volatile one, a ratio call \nspread would be better. In either case, the strategist has established a spread that is \nstatistically attractive because he has sold options that are expensive in relation to the \nones that he has bought. \nChapter 34: Futures and Futures Options 695 \nSUMMARY \nThis chapter presented the basics of futures and futures options trading. The basic \ndifferences between futures options and stock or index options were laid out. In a \ncertain sense, a futures option is easier to utilize than is a stock option because the \neffects of dividends, interest rates, stock splits, and so forth do not apply to futures \noptions. However, the fact that each underlying physical commodity is completely \ndifferent from most other ones means that the strategist is forced to familiarize him\nself with a vast array of details involving striking prices, trading units, expiration \ndates, first notice days, etc. \nMore details mean there could be more opportunities for mistakes, most of \nwhich can be avoided by visualizing and analyzing all positions in terms of points and \nnot in dollars. \nFutures options do not create new option strategies. However, they may afford \none the opportunity to trade when the futures are locked limit up. Moreover, the \nvolatility skewing that is present in futures options will offer opportunities for put \nbackspreads and call ratio spreads that are not normally present in stock options. \nChapter 35 discusses futures spreads and how one can use futures options with \nthose spreads. Calendar spreads are discussed as well. Calendar spreads with futures \noptions are different from calendar spreads using stock or index options. These are \nimportant concepts in the futures markets - distinctly different from an option \nspread - and are therefore significant for the futures option trader. \nFutures Option Strategies for \nFutures Spreads \nA spread with futures is not the same as a spread with options, except that one item \nis bought while another is simultaneously sold. In this manner, one side of the spread \nhedges the risk of the other. This chapter describes futures spreading and offers ways \nto use options as an adjunct to those spreads. \nThe concept of calendar spreading with futures options is covered in this chap\nter as well. This is the one strategy that is very different when using futures options, \nas opposed to using stock or index options. \nFUTURES SPREADS \nBefore getting into option strategies, it is necessary to define futures spreads and to \nexamine some common futures spreading strategies. \nFUTURES PRICING DIFFERENTIALS \nIt has already been shown that, for any paiticular physical commodity, there are, at \nany one time, several futures that expire in different months. Oil futures have month\nly expirations; sugar futures expire in only five months of any one calendar year. The \nfrequency of expiration months depends on which futures contract one is discussing. \nFutures on the same underlying commodity will trade at different prices. The \ndifferential is due to several factors, not just time, as is the case with stock options. A \nmajor factor is carrying costs - how much one would spend to buy and hold the phys-\n696 \nChapter 35: Futures Option Strategies for Futures Spreads 697 \nical commodity until futures expiration. However, other factors may enter in as well, \nincluding supply and demand considerations. In a normal carrying cost market, \nfutures that e", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 310}
{"text": "veral factors, not just time, as is the case with stock options. A \nmajor factor is carrying costs - how much one would spend to buy and hold the phys-\n696 \nChapter 35: Futures Option Strategies for Futures Spreads 697 \nical commodity until futures expiration. However, other factors may enter in as well, \nincluding supply and demand considerations. In a normal carrying cost market, \nfutures that expire later in time are more expensive than those that are nearer-term. \nExample: Gold is a commodity whose futures exhibit forward or normal carry. \nSuppose it is March 1st and spot gold is trading at 351. Then, the futures contracts \non gold and their respective prices might be as follows: \nExpiration Month Price \nApril 352.50 \nJune 354.70 \nAugust 356.90 \nDecember 361.00 \nJune 366.90 \nNotice that each successive contract is more expensive than the previous one. \nThere is a 2.20 differential between each of the first three expirations, equal to 1.10 \nper month of additional expiration time. However, the differential is not quite that \ngreat for the December, which expires in 9 months, or for the June contract, which \nexpires in 15 months. The reason for this might be that longer-term interest rates are \nslightly lower than the short-term rates, and so the cost of carry is slightly less. \nHowever, prices in all futures don't line up this nicely. In some cases, different \nmonths may actually represent different products, even though both are on the same \nunderlying physical commodity. For example, wheat is not always wheat. There is a \nsummer crop and a winter crop. While the two may be related in general, there could \nbe a substantial difference between the July wheat futures contract and the \nDecember contract, for example, that has very little to do with what interest rates are. \nSometimes short-term demand can dominate the interest rate effect, and a \nseries of futures contracts can be aligned such that the short-term futures are more \nexpensive. This is known as a reverse carrying charge market, or contango. \nINTRAMARKET FUTURES SPREADS \nSome futures traders attempt to predict the relationships between various expiration \nmonths on the same underlying physical commodity. That is, one might buy July \nsoybean futures and sell September soybean futures. When one both buys and sells \ndiffering futures contracts, he has a spread. When both contracts are on the same \nunderlying physical commodity, he has an intramarket spread. \n~ \n698 Part V: Index Options and Futures \nThe spreader is not attempting to predict the overall direction of prices. Rather, \nhe is trying to predict the differential in prices between the July and September con\ntracts. He doesn't care if beans go up or down, as long as the spread between July and \nSeptember goes his way. \nExample: A spread trader notices that historic price charts show that if September \nsoybeans get too expensive with respect to July soybeans, the differential usually dis\nappears in a month or two. The opportunity for establishing this trade usually occurs \nearly in the year - February or March. \nAssume it is February 1st, and the following prices exist: \nJuly soybean futures: 600 ($6.00/bushel) \nSeptember soybean futures: 606 \nThe price differential is 6 cents. It rarely gets worse than 12 cents, and often revers\nes to the point that July futures are more expensive than soybean futures - some \nyears as much as 100 cents more expensive. \nIf one were to trade this spread from a historical perspective, he would thus be \nrisking approximately 6 cents, with possibilities of making over 100 cents. That is \ncertainly a good risk/reward ratio, if historic price patterns hold up in the current \nenvironment. \nSuppose that one establishes the spread: \nBuy one July future @ 600 \nSell one September future @ 606 \nAt some later date, the following prices and, hence, profits and losses, exist. \nFutures Price \nJuly: 650 \nSeptember: 630 \nTotal Profit: \nProfit/Loss \n+50 cents \n-24 cents \n26 cents ($1,300) \nThe spread has inverted, going from an initial state in which September was 6 \ncents more expensive than July, to a situation in which July is 20 cents more expen\nsive. The spreader would thus make 26 cents, or $1,300, since 1 cent in beans is \nworth $50. \nChapter 35: Futures Option Strategies for Futures Spreads 699 \nNotice that the same profit would have been made at any of the following pairs \nof prices, because the price differential between July and September is 20 cents in \nall cases (with July being the more expensive of the two). \nJuly Futures September Futures July Profit September Profit \n420 400 -180 +206 \n470 450 -130 +156 \n550 530 -50 +76 \n600 580 0 +26 \n650 630 +50 -24 \n700 680 +100 -74 \n800 780 +200 -174 \nTherefore, the same 26-cent profit can be made whether soybeans are in a \nsevere bear market, in a rousing bull market, or even somewhat unchanged. The \nspreader is only concerned with whether the spread widens from a 6-cent differen\ntial or not. \nCharts, some going back years, are kept of the various relationships between \none expiration month and another. Spread traders often use these historical charts to \ndetermine when to enter and exit intramarket spreads. These charts display the sea\nsonal tendencies that make the relationships between various contracts widen or \nshrink. Analysis of the fundamentals that cause the seasonal tendencies could also be \nmotivation for establishing intramarket spreads. \nThe margin required for intramarket spread trading (and some other types of \nfutures spreads) is smaller than that required for speculative trading in the futures \nthemselves. The reason for this is that spreads are considered less risky than outright \npositions in the futures. However, one can still make or lose a good deal of money in \na spread - percentage-wise as well as in dollars - so it cannot be considered conser\nvative; it's just less risky than outright futures speculation. \nExample: Using the soybean spread from the example above, assume the sp", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 311}
{"text": "s \nthemselves. The reason for this is that spreads are considered less risky than outright \npositions in the futures. However, one can still make or lose a good deal of money in \na spread - percentage-wise as well as in dollars - so it cannot be considered conser\nvative; it's just less risky than outright futures speculation. \nExample: Using the soybean spread from the example above, assume the speculative \ninitial margin requirement is $1,700. Then, the spread margin requirement might be \n$500. That is considerably less than one would have to put up as initial margin if each \nside of the spread had to be margined separately, a situation that would require \n$3,400. \nIn the previous example, it was shown that the soybean spread had the poten\ntial to widen as much as 100 points ($1.00), a move that would be worth $5,000 if it \n700 Part V: Index Options and Futures \noccurred. While it is unlikely that the spread would actually widen to historic highs, \nit is certainly possible that it could widen 25 or 30 cents, a profit of $1,250 to $1,500. \nThat is certainly high leverage on a $500 investment over a short time period, \nso one must classify spreading as a risk strategy. \nINTERMARKET FUTURES SPREADS \nAnother type of futures spread is one in which one buys futures contracts in one mar\nket and sells futures contracts in another, probably related, market. When the futures \nspread is transacted in two different markets, it is known as an intermarket spread. \nIntermarket spreads are just as popular as intramarket spreads. \nOne type of intermarket spread involves directly related markets. Examples \ninclude spreads between currency futures on two different international currencies; \nbetween financial futures on two different bond, note, or bill contracts; or between a \ncommodity and its products - oil, unleaded gasoline, and heating oil, for example. \nExample: Interest rates have been low in both the United States and Japan. As a \nresult, both currencies are depressed with respect to the European currencies, where \ninterest rates remain high. A trader believes that interest rates will become more uni\nform worldwide, causing the Japanese yen to appreciate with respect to the German \nmark. \nHowever, since he is not sure whether Japanese rates will move up or German \nrates will move down, he is reluctant to take an outright position in either currency. \nRather, he decides to utilize an intermarket spread to implement his trading idea. \nAssume he establishes the spread at the following prices: \nBuy I June yen future: 77.00 \nSell I June mark future: 60.00 \nThis is an initial differential of 17.00 between the two currency futures. He is \nhoping for the differential to get larger. The dollar trading terms are the same for \nboth futures: One point of movement (from 60.00 to 61.00, for example) is worth \n$1,250. His profit and loss potential would therefore be: \nSpread Differential \nal a Later Date Profit/Loss \n14.00 $3,750 \n16.00 - $1,250 \n18.00 + 1,250 \n20.00 + 3,750 \nChapter 35: Futures Option Strategies for Futures Spreads 701 \nIn some cases, the exchanges recognize frequently traded intermarket spreads \nas being eligible for reduced margin requirements. That is, the exchange recognizes \nthat the two futures are hedges against one another if one is sold and the other is \nbought. \nThese spreads between currencies, called cross-currency spreads, are so heavi\nly traded that there are other specific vehicles - both futures and warrants - that \nallow the speculator to trade them as a single entity. Regardless, they serve as a prime \nexample of an intermarket spread when the two futures are used. \nIn the example above, assume the outright speculative margin for a position in \neither currency future is $1,700 per contract. Then, the margin for this spread would \nprobably be nearly $1,700 as well, equal to the speculative margin for one side of the \nspread. This position is thus recognized as a spread position for margin purposes. The \nmargin treatment isn't as favorable as for the intramarket spread (see the earlier soy\nbean example), but the spread margin is still only one-half of what one would have to \nadvance as initial margin if both sides of the spread had to be margined separately. \nOther intermarket spreads are also eligible for reduced margin requirements, \nalthough at first glance they might not seem to be as direct a hedge as the two cur\nrencies above were. \nExample: A common intermarket spread is the TED spread, which consists of \nTreasury bill futures on one side and Eurodollar futures on the other. Treasury bills \nrepresent the safest investment there is; they are guaranteed. Eurodollars, however, \nare not insured, and therefore represent a less safe investment. Consequently, \nEurodollars yield more than Treasury bills. How much more is the key, because as \nthe yield differential expands or shrinks, the spread between the prices of T-bill \nfutures and Eurodollar futures expands or shrinks as well. In essence, the yield dif\nferential is small when there is stability and confidence in the financial markets, \nbecause uninsured deposits and insured deposits are not that much different in times \nof financial certainty. However, in times of financial uncertainty and instability, the \nspread widens because the uninsured depositors require a comparatively higher yield \nfor the higher risk they are taking. \nAssume the outright initial margin for either the T-bill future or the Eurodollar \nfuture is $800 per contract. The margin for the TED spread, however, is only $400. \nThus, one is able to trade this spread for only one-fourth of the amount of margin \nthat would be required to margin both sides separately. \nThe reason that the margin is more favorable is that there is not a lot of volatil\nity in this spread. Historically, it has ranged between about 0.30 and 1.70. In both \nfutures contracts, one cent (0.01) of movement is worth $25. Thus, the entire 140-\ncent historic range of the spread only represent", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 312}
{"text": "r only one-fourth of the amount of margin \nthat would be required to margin both sides separately. \nThe reason that the margin is more favorable is that there is not a lot of volatil\nity in this spread. Historically, it has ranged between about 0.30 and 1.70. In both \nfutures contracts, one cent (0.01) of movement is worth $25. Thus, the entire 140-\ncent historic range of the spread only represents $3,500 (140 x $25). \n( \n702 Part V: Index Options and Futures \nMore will be said later about the TED spread when the application of futures \noptions to intermarket spreads is discussed. Since there is a liquid option market on \nboth futures, it is sometimes more logical to establish the spread using options \ninstead of futures. \nOne other comment should be made regarding the TED spread: It has carry\ning cost. That is, if one buys the spread and holds it, the spread will shrink as time \npasses, causing a small loss to the holder. When interest rates are low, the carrying \ncost is small (about 0.05 for 3 months). It would be larger if short-term rates rose. \nThe prices in Table 35-1 show that the spread is more costly for longer-term con\ntracts. \nTABLE 35-1. \nCarrying costs of the TED spread. \nMonth T-Bill Future \nMarch 96.27 \nJune 96.15 \nSeptember 95.90 \nEurodollar Future \n95.86 \n95.69 \n95.39 \nTED Spread \n0.41 \n0.46 \n0.51 \nMany intermarket spreads have some sort of carrying cost built into them; the \nspreader should be aware of that fact, for it may figure into his profitability. \nOne final, and more complex, example of an intermarket spread is the crack \nspread. There are two major areas in which a basic commodity is traded, as well as \ntwo of its products: crude oil, unleaded gasoline, and heating oil; or soybeans, soy\nbean oil, and soybean meal. A crack spread involves trading all three - the base com\nmodity and both byproducts. \nExample: The crack spread in oil consists of buying two futures contracts for crude \noil and selling one contract each for heating oil and unleaded gasoline. \nThe units of trading are not the same for all three. The crude oil future is a con\ntract for 1,000 barrels of oil; it is traded in units of dollars per barrel, so a $1 increase \nin oil prices from $18.00 to $19.00, say - is worth $1,000 to the futures contract. \nHeating oil and unleaded gasoline futures contracts have similar terms, but they are \ndifferent from crude oil. Each of these futures is for 42,000 gallons of the product, \nand they are traded in cents. So, a one-cent move - gasoline going from 60 cents a \ngallon to 61 cents a gallon - is worth $420. This information is summarized in Table \n35-2 by showing how much a unit change in price is worth. \nChapter 35: Futures Option Strategies for Futures Spreads \nTABLE 35-2. \nTerms of oil production contract. \nContract \nCrude Oil \nUnleaded Gasoline \nHeating Oil \nInitial \nPrice \n18.00 \n.6000 \n.5500 \nSubsequent \nPrice \n19.00 \n.6100 \n.5600 \nThe following formula is generally used for the oil crack spread: \nCrack= (Unleaded gasoline + Heating oil) x 42 - 2 x Crude \n2 \n(.6000 + .5500) X 42 - 2 X 18.00 = \n2 \n= (48.3 - 36)/2 \n= 6.15 \n703 \nGain in \nDollars \n$1,000 \n$ 420 \n$ 420 \nSome traders don't use the divisor of 2 and, therefore, would arrive at a value \nof 12.30 with the above data. \nIn either case, the spreader can track the history of this spread and will attempt \nto buy oil and sell the other two, or vice versa, in order to attempt to make an over\nall profit as the three products move. Suppose a spreader felt that the products were \ntoo expensive with respect to crude oil prices. He would then implement the spread \nin the following manner: \nBuy 2 March crude oil futures @ 18.00 \nSell 1 March heating oil future @ 0.5500 \nSell l March unleaded gasoline future @ 0.6000 \nThus, the crack spread was at 6.15 when he entered the position. Suppose that \nhe was right, and the futures prices subsequently changed to the following: \nMarch crude oil futures: 18.50 \nMarch unleaded gas futures: .6075 \nMarch heating oil futures: .5575 \nThe profit is shown in Table 35-3. \n704 \nTABLE 35-3. \nProfit and loss of crack spread. \nContract \n2 March Crude \n1 March Unleaded \n1 March Heating Oil \nNet Profit (before commissions) \nInitial \nPrice \n18.00 \n.6000 \n.5500 \nPart V: Index Options and Futures \nSubsequent \nPrice \n18.50 \n.6075 \n.5575 \nGain in \nDollars \n+ $1,000 \n- $ 315 \n- $ 315 \n+ $ 370 \nOne can calculate that the crack spread at the new prices has shrunk to 5.965. \nThus, the spreader was correct in predicting that the spread would narrow, and he \nprofited. \nMargin requirements are also favorable for this type of spread, generally being \nslightly less than the speculative requirement for two contracts of crude oil. \nThe above examples demonstrate some of the various intermarket spreads that \nare heavily watched and traded by futures spreaders. They often provide some of the \nmost reliable profit situations without requiring one to predict the actual direction of \nthe market itself. Only the differential of the spread is important. \nOne should not assume that all intermarket spreads receive favorable margin \ntreatment. Only those that have traditional relationships do. \nUSING FUTURES OPTIONS IN FUTURES SPREADS \nAfter viewing the above examples, one can see that futures spreads are not the same \nas what we typically know as option spreads. However, option contracts may be use\nful in futures spreading strategies. They can often provide an additional measure of \nprofit potential for very little additional risk. This is true for both intramarket and \nintermarket spreads. \nThe futures option calendar spread is discussed first. The calendar spread with \nfutures options is not the same as the calendar spread with stock or index options. In \nfact, it may best be viewed as an alternative to the intramarket futures spread rather \nthan as an option spread strategy. \nCALENDAR SPREADS \nA calendar spread with futures options would still be constructed in the familiar \nmanner - buy the May call, se", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 313}
{"text": "ndar spread is discussed first. The calendar spread with \nfutures options is not the same as the calendar spread with stock or index options. In \nfact, it may best be viewed as an alternative to the intramarket futures spread rather \nthan as an option spread strategy. \nCALENDAR SPREADS \nA calendar spread with futures options would still be constructed in the familiar \nmanner - buy the May call, sell the March call with the same striking price. However, \nChapter 35: Futures Option Strategies for Futures Spreads 705 \nthere is a major difference between the futures option calendar spread and the stock \noption calendar spread. That difference is that a calendar spread using futures \noptions involves two separate underlying instruments, while a calendar spread using \nstock options does not. When one buys the May soybean 600 call and sells the March \nsoybean 600 call, he is buying a call on the May soybean futures contract and selling \na call on the March soybean futures contract. Thus, the futures option calendar \nspread involves two separate, but related, underlying futures contracts. However, if \none buys the IBM May 100 call and sells the IBM March 100 call, both calls are on \nthe same underlying instrument, IBM. This is a major difference between the two \nstrategies, although both are called \"calendar spreads.\" \nTo the stock option trader who is used to visualizing calendar spreads, the \nfutures option variety may confound him at first. For example, a stock option trader \nmay conclude that if he can buy a four-month call for 5 points and sell a two-month \ncall for 2 points, he has a good calendar spread possibility. Such an analysis is mean\ningless with futures options. If one can buy the May soybean 600 call for 5 and sell \nthe March soybean 600 call for 3, is that a good spread or not? It's impossible to tell, \nunless you know the relationship between May and March soybean futures contracts. \nThus, in order to analyze the futures option calendar spread, one must not only ana\nlyze the options' relationship, but the two futures contracts' relationship as well. \nSimply stated, when one establishes a futures option calendar spread, he is not only \nspreading time, as he does with stock options, he is also spreading the relationship \nbetween the underlying futures. \nExample: A trader notices that near-term options in soybeans are relatively more \nexpensive than longer-term options. He thinks a calendar spread might make sense, \nas he can sell the overpriced near-term calls and buy the relatively cheaper longer\nterm calls. This is a good situation, considering the theoretical value of the options \ninvolved. He establishes the spread at the following prices: \nSoybean Trading \nContract Initial Price Position \nMarch 600 call 14 Sell 1 \nMay 600 call 21 Buy 1 \nMarch future 594 none \nMay future 598 none \nThe May/March 600 call calendar spread is established for 7 points debit. \nMarch expiration is two months away. At the current time, the May futures are trad\ning at a 4-point premium to March futures. The spreader figures that if March \n706 Part V: Index Options and Futures \nfutures are approximately unchanged at expiration of the March options, he should \nprofit handsomely, because the March calls are slightly overpriced at the current \ntime, plus they will decay at a faster rate than the May calls over the next two months. \nSuppose that he is correct and March futures are unchanged at expiration of the \nMarch options. This is still no guarantee of profit, because one must also determine \nwhere May futures are trading. If the spread between May and March futures \nbehaves poorly (May declines with respect to March), then he might still lose money. \nLook at the following table to see how the futures spread between March and May \nfutures affects the profitability of the calendar spread. The calendar spread cost 7 \ndebit when the futures spread was +4 initially. \nFutures Calendar \nFutures Prices Spread May 600 Call Spread \nMarch/May Price Price Profit/Loss \n594/570 -24 4 -3 cents \n594/580 -14 61/2 _1/2 \n594/590 -4 10 +3 \n594/600 +6 141/2 +71/2 \nThus, the calendar spread could lose money even with March futures \nunchanged, as in the top two lines of the table. It also could do better than expected \nif the futures spread widens, as in the bottom line of the table. \nThe profitability of the calendar spread is heavily linked to the futures spread \nprice. In the above example, it was possible to lose money even though the March \nfutures contract was unchanged in price from the time the calendar spread was \ninitially established. This would never happen with stock options. If one placed a \ncalendar spread on IBM and the stock were unchanged at the expiration of the near\nterm option, the spread would make money virtually all of the time ( unless implied \nvolatility had shrunk dramatically). \nThe futures option calendar spreader is therefore trading two spreads at once. \nThe first one has to do with the relative pricing differentials (implied volatilities, for \nexample) of the two options in question, as well as the passage of time. The second \none is the relationship between the two underlying futures contracts. As a result, it is \ndifficult to draw the ordinary profit picture. Rather, one must approach the problem \nin this manner: \n1. Use the horizontal axis to represent the futures spread price at the expiration of \nthe near-term option. \nChapter 35: Futures Option Strategies for Futures Spreads 707 \n2. Draw several profit curves, one for each price of the near-term future at near\nterm expiration. \nExample: Expanding on the above example, this method is demonstrated here. \nFigure 35-1 shows how to approach the problem. The horizontal axis depicts \nthe spread between March and May soybean futures at the expiration of the March \nfutures options. The vertical axis represents the profit and loss to be expected from \nthe calendar spread, as it always does. \nThe major difference between this profit graph and stan", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 314}
{"text": "ng on the above example, this method is demonstrated here. \nFigure 35-1 shows how to approach the problem. The horizontal axis depicts \nthe spread between March and May soybean futures at the expiration of the March \nfutures options. The vertical axis represents the profit and loss to be expected from \nthe calendar spread, as it always does. \nThe major difference between this profit graph and standard ones is that there \nare now several sets of profit curves. A separate one is drawn for each price of the \nMarch futures that one wants to consider in his analysis. The previous example \nshowed the profitability for only one price of the March futures - unchanged at 594. \nHowever, one cannot rely on the March futures to remain unchanged, so he must \nview the profitability of the calendar spread at various March futures prices. \nThe data that is plotted in the figure is summarized in Table 35-4. Several things \nare readily apparent. First, if the futures spread improves in price, the calendar \nspread will generally make money. These are the points on the far right of the figure \nand on the bottom line of Table 35-4. Second, if the futures spread behaves miser-\nFIGURE 35-1. \nSoybean futures calendar spreads, at March expiration. \ngj \n20 \n16 \n12 \n.3 8 \n::.: \n0 \nct 4 \n0 \n-8 \nMarch/May Spread \nMarch =604 \nMarch =594 \nMarch= 614 \nMarch =584 \nMarch= 574 \n708 Part V: Index Options and Futures \nably, the calendar spread will almost certainly lose money (points on the left-hand \nside of the figure, or top line of the table). \nThird, if March futures rise in price too far, the calendar spread could do poor\nly. In fact, if March futures rally and the futures spread worsens, one could lose more \nthan his initial debit (bottom left-hand point on figure). This is partly due to the fact \nthat one is buying the March options back at a loss if March futures rally, and may \nalso be forced to sell his May options out at a loss if May futures have fallen at the \nsame time. \nFourth, as might be expected, the best results are obtained if March futures \nrally slightly or remain unchanged and the futures spread also remains relatively \nunchanged (points in the upper right-hand quadrant of the figure). \nIn Table 35-4, the far right-hand column shows how a futures spreader would \nhave fared if he had bought May and sold March at 4 points May over March, not \nusing any options at all. \nTABLE 35-4. \nProfit and loss from soybean call calendar. \nAll Prices at March Option Expiration \nFutures Future \nSpread Calendar Spread Profit Spread \n(May-March) March Future Price: 574 584 594 604 614 Profit \n-24 -5.5 - 4.5 -3 -4.5 -11.5 -28 \n-14 -4.5 3 -0.5 -1 -7 -18 \n-4 -2.5 0 +3 +3.5 -1 - 8 \n6 0 + 3 +7.5 +9 +5.5 + 2 \n16 +7 + 11 +17 +19 +13 +12 \nThis example demonstrates just how powerful the influence of the futures \nspread is. The calendar spread profit is predominantly a function of the futures \nspread price. Thus, even though the calendar spread was attractive from the theo\nretical viewpoint of the option's prices, its result does not seem to reflect that theo\nretical advantage, due to the influence of the futures spread. Another important \npoint for the calendar spreader used to dealing with stock options to remember is \nthat one can lose more than his initial debit in a futures calendar spread if the spread \nbetween the underlying futures inverts. \nThere is another way to view a calendar spread in futures options, however, and \nthat is as a substitute or alternative to an intramarket spread in the futures contracts \nthemselves. Look at Table 35-4 again and notice the far right-hand column. This is \nChapter 35: Futures Option Strategies for Futures Spreads 709 \nthe profit or loss that would be made by an intramarket soybean spreader who bought \nMay and sold March at the initial prices of 598 and 594, respectively. The calendar \nspread generally outperforms the intramarket spread for the prices shown in this \nexample. This is where the true theoretical advantage of the calendar spread comes \nin. So, if one is thinking of establishing an intrarnarket spread, he should check out \nthe calendar spread in the futures options first. If the options have a theoretical pric\ning advantage, the calendar spread may clearly outperform the standard intramarket \nspread. \nStudy Table 35-4 for a moment. Note that the intramarket spread is only better \nwhen prices drop but the spread widens (lower left comer of table). In all other \ncases, the calendar spread strategy is better. One could not always expect this to be \ntrue, of course; the results in the example are partly due to the fact that the March \noptions that were sold were relatively expensive when compared with the May \noptions that were bought. \nIn summary, the futures option calendar spread is more complicated when \ncompared to the simpler stock or index option calendar spread. As a result, calendar \nspreading with futures options is a less popular strategy than its stock option coun\nterpart. However, this does not mean that the strategist should overlook this strate\ngy. As the strategist knows, he can often find the best opportunities in seemingly \ncomplex situations, because there may be pricing inefficiencies present. This strate\ngy's main application may be for the intramarket spreader who also understands the \nusage of options. \nLONG COMBINATIONS \nAnother attractive use of options is as a substitute for two instruments that are being \ntraded one against the other. Since intermarket and intramarket futures spreads \ninvolve two instruments being traded against each other, futures options may be able \nto work well in these types of spreads. You may recall that a similar idea was pre\nsented with respect to pairs trading, as well as certain risk arbitrage strategies and \nindex futures spreading. \nIn any type of futures spread, one might be able to substitute options for the \nactual futures. He might buy calls for the long side of the spread instead of actually \nbuying futures. Likewise,", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 315}
{"text": "be able \nto work well in these types of spreads. You may recall that a similar idea was pre\nsented with respect to pairs trading, as well as certain risk arbitrage strategies and \nindex futures spreading. \nIn any type of futures spread, one might be able to substitute options for the \nactual futures. He might buy calls for the long side of the spread instead of actually \nbuying futures. Likewise, he could sell calls or buy puts instead of selling futures for \nthe other side of the spread. In using options, however, he wants to avoid two prob\nlems. First, he does not want to increase his risk. Second, he does not want to pay a \nlot of time value premium that could waste away, costing him the profits from his \nspread. \n710 Part V: Index Options and Futures \nLet's spend a short time discussing these two points. First, he does not want to \nincrease his risk. In general, selling options instead of utilizing futures increases one's \nrisk. If he sells calls instead of selling futures, and sells puts instead of buying futures, \nhe could be increasing his risk tremendously if the futures prices moved a lot. If the \nfutures rose tremendously, the short calls would lose money, but the short puts would \ncease to make money once the futures rose through the striking price of the puts. \nTherefore, it is not a recommended strategy to sell options in place of the futures in \nan intramarket or intennarket spread. The next example will show why not. \nExample: A spreader wants to trade an intramarket spread in live cattle. The con\ntract is for 40,000 pounds, so a one-cent move is worth $400. He is going to sell April \nand buy June futures, hoping for the spread to narrow between the two contracts. \nThe following prices exist for live cattle futures and options: \nApril future: 78.00 \nJune future: 74.00 \nApril 78 call: 1.25 \nJune 74 put: 2.00 \nHe decides to use the options instead of futures to implement this spread. He \nsells the April 78 call as an alternative to selling the April future; he also sells the June \n74 put as an alternative to buying the June future. \nSometime later, the following prices exist: \nApril future: 68.00 \nJune future: 66.00 \nApril 78 call: 0.00 \nJune 74 put: 8.05 \nThe futures spread has indeed narrowed as expected - from 4.00 points to 2.00. \nHowever, this spreader has no profit to show for it; in fact he has a loss. The call that \nhe sold is now virtually worthless and has therefore earned a profit of 1.25 points; \nhowever, the put that was sold for 2.00 is now worth 8.05 - a loss of 6.05 points. \nOverall, the spreader has a net loss of 4.80 points since he used short options, instead \nof the 2.00-point gain he could have had if he had used futures instead. \nThe second thing that the futures spreader wants to ensure is that he does not \npay for a lot of time value premium that is wasted, costing him his potential profits. \nIf he buys at- or out-of-the-money calls instead of buying futures, and if he buys at-\nChapter 35: Futures Option Strategies for Futures Spreads 711 \nor out-of-the-money puts instead of selling futures, he could be exposing his spread \nprofits to the ravages of time decay. Do not substitute at- or out-of-the-rrwney options \nfor the futures in intramarket or intennarket spreads. The next example will show \nwhy not. \nExample: A futures spreader notices that a favorable situation exists in wheat. He \nwants to buy July and sell May. The following prices exist for the futures and options: \nMay futures: 410 \nJuly futures: 390 \nMay 410 put: 20 \nJuly 390 call: 25 \nThis trader decides to buy the May 410 put instead of selling May futures; he \nalso buys the July 390 call instead of buying July futures. \nLater, the following prices exist: \nMay futures: 400 \nJuly futures: 400 \nMay 410 put: 25 \nJuly 390 call: 30 \nThe futures spread would have made 20 points, since they are now the same \nprice. At least this time, he has made money in the option spread. He has made 5 \npoints on each option for a total of 10 points overall - only half the money that could \nhave been made with the futures themselves. Nate that these sample option prices \nstill show a good deal of time value premium remaining. If more time had passed and \nthese options were trading closer to parity, the result of the option spread would be \nworse. \nIt might be pointed out that the option strategy in the above example would \nwork better if futures prices were volatile and rallied or declined substantially. This \nis true to a certain extent. If the market had moved a lot, one option would be very \ndeeply in-the-money and the other deeply out-of-the-money. Neither one would \nhave much time value premium, and the trader would therefore have wasted all the \nmoney spent for the initial time premium. So, unless the futures moved so far as to \noutdistance that loss of time value premium, the futures strategy would still outrank \nthe option strategy. \nHowever, this last point of volatile futures movement helping an option position \nis a valid one. It leads to the reason for the only favorable option strategy that is a sub-\n712 Part V: Index Options and Futures \nstitute for futures spreads - that is, using in-the-money options. If one buys in-the\nrnoney calls instead of buying futures, and buys in-the-money puts instead of selling \nfutures, he can often create a position that has an advantage over the intramarket or \nintermarket futures spread. In-the-money options avoid most of the problems \ndescribed in the two previous examples. There is no increase of risk, since the options \nare being bought, not sold. In addition, the amount of money spent on time value \npremium is small, since both options are in-the-money. In fact, one could buy them \nso far in the money as to virtually eliminate any expense for time value premium. \nHowever, that is not recommended, for it would negate the possible advantage of \nusing moderately in-the-money options: If the underlyingfutures behave in a volatile \nmanner, it might be possible for t", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 316}
{"text": "t of money spent on time value \npremium is small, since both options are in-the-money. In fact, one could buy them \nso far in the money as to virtually eliminate any expense for time value premium. \nHowever, that is not recommended, for it would negate the possible advantage of \nusing moderately in-the-money options: If the underlyingfutures behave in a volatile \nmanner, it might be possible for the option spread to make money, even if the futures \nspread does not behave as expected. \nIn order to illustrate these points, the TED spread, an intermarket spread, will \nbe used. Recall that in order to buy the TED spread, one would buy T-bill futures \nand sell an equal quantity of Eurodollar futures. \nOptions exist on both T-bill futures and Eurodollar futures. If T-bill calls were \nbought instead of T-bill futures, and if Eurodollar puts were bought instead of sell\ning Eurodollar futures, a similar position could be created that might have some \nadvantages over buying the TED spread using futures. The advantage is that if T-bills \nand/or Eurodollars change in price by a large enough amount, the option strategist \ncan make money, even if the TED spread itself does not cooperate. \nOne might not think that short-term rates could be volatile enough to make this \na worthwhile strategy. However, they can move substantially in a short period of time, \nespecially if the Federal Reserve is active in lowering or raising rates. For example, \nsuppose the Fed continues to lower rates and both T-bills and Eurodollars substan\ntially rise in price. Eventually, the puts that were purchased on the Eurodollars will \nbecome worthless, but the T-bill calls that are owned will continue to grow in value. \nThus, one could make money, even if the TED spread was unchanged or shrunk, as \nlong as short-term rates dropped far enough. \nSimilarly, if rates were to rise instead, the option spread could make money as \nthe puts gained in value (rising rates mean T-bills and Eurodollars will fall in price) \nand the calls eventually became worthless. \nExample: The following prices for June T-bill and Eurodollar futures and options \nexist in January. All of these products trade in units of 0.01, which is worth $25. So a \nwhole point is worth $2,500. \nJune T-bill futures: 94.75 \nJune Euro$ futures: 94.15 \nChapter 35: Futures Option Strategies for Futures Spreads \nJune T-bill 9450 calls: 0.32 \nJune Euro$ 9450 puts: 0.40 \n713 \nThe TED spread, basis June, is currently at 0.60 (the difference in price of the \ntwo futures). Both futures have in-the-money options with only a small amount of \ntime value premium in them. \nThe June T-bill calls with a striking price of 94.50 are 0.25 in the money and are \nselling for 0.32. Their time value premium is only 0.07 points. Similarly, the June \nEurodollar puts with a striking price of 94.50 are 0.35 in the money and are selling \nfor 0.40. Hence, their time value premium is 0.05. \nSince the total time value premium - 0.12 ($300) - is small, the strategist \ndecides that the option spread may have an advantage over the futures intermarket \nspread, so he establishes the following position: \nBuy one June T-bill call @ 0.40 \nBuy one June Euro$ put @ 0.32 \nTotal cost: \nCost \n$1,000 \n$ 800 \n$1,800 \nLater, financial conditions in the world are very stable and the TED spread \nbegins to shrink. However, at the same time, rates are being lowered in the United \nStates, and T-bill and Eurodollar prices begin to rally substantially. In May, when the \nJune T-bill options expire, the following prices exist: \nJune T-bill futures: 95.50 \nJune Euro$ futures: 95.10 \nJune T-bill 9450 calls: 1.00 \nJune Euro$ 9450 puts: 0.01 \nThe TED spread has shrunk from 0.60 to only 0.40. Thus, any trader attempt\ning to buy the TED spread using only futures would have lost $500 as the spread \nmoved against him by 0.20. \nHowever, look at the option position. The options are now worth a combined \nvalue of 1.01 points ($2,525), and they were bought for 0.72 points ($1,800). Thus, \nthe option strategy has turned a profit of $725, while the futures strategy would have \nlost money. \nAny traders who used this option strategy instead of using futures would have \nenjoyed profits, because as the Federal Reserve lowered rates time after time, the \nprices of both T-bills and Eurodollars rose far enough to make the option strategist's \n714 Part V: Index Options and Futures \ncalls more profitable than the loss in his puts. This is the advantage of using in-the\nmoney options instead of futures in futures spreading strategies. \nIn fairness, it should be pointed out that if the futures prices had remained rel\natively unchanged, the 0.12 points of time value premium ($300) could have been \nlost, while the futures spread may have been relatively unchanged. However, this \ndoes not alter the reasoning behind wanting to use this option strategy. \nAnother consideration that might come into play is the margin required. Recall \nthat the initial margin for implementing the TED spread was $400. However, if one \nuses the option strategy, he must pay for the options in full - $1,800 in the above \nexample. This could conceivably be a deterrent to using the option strategy. Of \ncourse, if by investing $1,800, one can make money instead of losing money with the \nsmaller investment, then the initial margin requirement is irrelevant. Therefore, the \nprofit potential must be considered the more important factor. \nFOLLOW-UP CONSIDERATIONS \nWhen one uses long option combinations to implement a futures spread strategy, he \nmay find that his position changes from a spread to more of an outright position. This \nwould occur if the markets were volatile and one option became deeply in-the\nmoney, while the other one was nearly worthless. The TED spread example above \nshowed how this could occur as the call wound up being worth 1.00, while the put \nwas virtually worthless. \nAs one side of the option spread goes out-of-the-money, the spread nature \nbegins to disappear and a", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 317}
{"text": "ore of an outright position. This \nwould occur if the markets were volatile and one option became deeply in-the\nmoney, while the other one was nearly worthless. The TED spread example above \nshowed how this could occur as the call wound up being worth 1.00, while the put \nwas virtually worthless. \nAs one side of the option spread goes out-of-the-money, the spread nature \nbegins to disappear and a more outright position takes its place. One can use the \ndeltas of the options in order to calculate just how much exposure he has at any one \ntime. The following examples go through a series of analyses and trades that a strate\ngist might have to face. The first example concerns establishing an intermarket \nspread in oil products. \nExample: In late summer, a spreader decides to implement an intermarket spread. \nHe projects that the coming winter may be severely cold; furthermore, he believes \nthat gasoline prices are too high, being artificially buoyed by the summer tourist sea\nson, and the high prices are being carried into the future months by inefficient mar\nket pricing. \nTherefore, he wants to buy heating oil futures or options and sell unleaded \ngasoline futures or options. He plans to be out of the trade, if possible, by early \nDecember, when the market should have discounted the facts about the winter. \nTherefore, he decides to look at January futures and options. The following prices \nexist: \nChapter 35: Futures Option Strategies for Futures Spreads \nFuture or Option \nJanuary heating oil futures: \nJanuary unleaded gasoline futures: \nJanuary heating oil 60 call: \nJanuary unleaded gas 62 put: \nPrice \n.6550 \n.5850 \n6.40 \n4.25 \n715 \nTime Value \nPremium \n0.90 \n0.75 \nThe differential in futures prices is .07, or 7 cents per gallon. He thinks it could \ngrow to 12 cents or so by early winter. However, he also thinks that oil and oil prod\nucts have the potential to be very volatile, so he considers using the options. One cent \nis worth $420 for each of these items. \nThe time value premium of the options is 1.65 for the put and call combined. If \nhe pays this amount ($693) per combination, he can still make money if the futures \nwiden by 5.00 points, as he expects. Moreover, the option spread gives him the \npotential for profits if oil products are volatile, even if he is wrong about the futures \nrelationship. \nTherefore, he decides to buy five combinations: \nPosition \nBuy 5 January heating oil 60 calls @ 6.40 \nBuy 5 January unleaded 62 puts @ 4.25 \nTotal cost: \nCost \n$13,440 \n8,925 \n$22,365 \nThis initial cost is substantially larger than the initial margin requirement for \nfive futures spreads, which would be about $7,000. Moreover, the option cost must \nbe paid for in cash, while the futures requirement could be taken care of with \nTreasury bills, which continue to earn money for the spreader. Still, the strategist \nbelieves that the option position has more potential, so he establishes it. \nNotice that in this analysis, the strategist compared his time value premium cost \nto the profit potential he expected from the futures spread itself This is often a good \nway to evaluate whether or not to use options or futures. In this example, he thought \nthat, even if futures prices remained relatively unchanged, thereby wasting away his \ntime premium, he could still make money - as long as he was correct about heating \noil outperforming unleaded gasoline. \nSome follow-up actions will now be examined. If the futures rally, the position \nbecomes long. Some profit might have accrued, but the whole position is subject to \nlosses if the futures fall in price. The strategist can calculate the extent to which his \n716 Part V: Index Options and Futures \nposition has become long by using the delta of the options in the strategy. He can \nthen use futures or other options in order to make the position more neutral, if he \nwants to. \nExample: Suppose that both unleaded gasoline and heating oil have rallied some and \nthat the futures spread has widened slightly. The following information is known: \nFuture or Option \nJanuary heating oil futures: \nJanuary unleaded gasoline futures: \nJanuary heating oil 60 call: \nJanuary unleaded gas 62 put: \nTotal profit: \nPrice \n.7100 \n.6300 \n11.05 \n1.50 \nNet \nChange \n+ .055 \n+ .045 \n+ 4.65 \n- 2.75 \nProfit/loss \n+$9,765 \n- 5,775 \n+$3,990 \nThe futures spread has widened to 8 cents. If the strategist had established the \nspread with futures, he would now have a one-cent ( $420) profit on five contracts, or \na $2,100 profit. The profit is larger in the option strategy. \nThe futures have rallied as well. Heating oil is up 5½ cents from its initial price, \nwhile unleaded is up 4½ cents. This rally has been large enough to drive the puts out\nof-the-money. When one has established the intermarket spread with options, and \nthe futures rally this much, the profit is usually greater from the option spread. Such \nis the case in this example, as the option spread is ahead by almost $4,000. \nThis example shows the most desirable situation for the strategist who has \nimplemented the option spread. The futures rally enough to force the puts out-of\nthe-money, or alternatively fall far enough to force the calls to be out-of-the-money. \nIf this happens in advance of option expiration, one option will generally have almost \nall of its time value premium disappear (the calls in the above example). The other \noption, however, will still have some time value ( the puts in the example). \nThis represents an attractive situation. However, there is a potential negative, \nand that is that the position is too long now. It is not really a spread anymore. If \nfutures should drop in price, the calls will lose value quickly. The puts will not gain \nmuch, though, because they are out-of-the-money and will not adequately protect \nthe calls. At this juncture, the strategist has the choice of taking his profit - closing \nthe position - or making an adjustment to make the spread more neutral once again. \nHe could also", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 318}
{"text": ". It is not really a spread anymore. If \nfutures should drop in price, the calls will lose value quickly. The puts will not gain \nmuch, though, because they are out-of-the-money and will not adequately protect \nthe calls. At this juncture, the strategist has the choice of taking his profit - closing \nthe position - or making an adjustment to make the spread more neutral once again. \nHe could also do nothing, of course, but a strategist would normally want to protect \na profit to some extent. \nChapter 35: Futures Option Strategies for Futures Spreads 717 \nExample: The strategist decides that, since his goal was for the futures spread to \nwiden to 12 cents, he will not remove the position when the spread is only 8 cents, \nas it is now. However, he wants to take some action to protect his current profit, while \nstill retaining the possibility to have the profit expand. \nAs a first step, the equivalent futures position (EFP) is calculated. The pertinent \ndata is shown in Table 35-5. \nTABLE 35-5. \nEFP of long combination. \nFuture or Option \nJanuary heating oil futures: \nJanuary unleaded gasoline futures: \nJanuary heating oil 60 call: Long 5 \nJanuary unleaded gas 62 put: Long 5 \nPrice \n.7100 \n.6300 \n11.05 \n1.50 \nDelta \n0.99 \n-0.40 \nEFP \n+4.95 \n-2.00 \nTotal EFP: +2.95 \nOverall, the position is long the equivalent of about three futures contracts. The \nposition's profitability is mostly related to whether the futures rise or fall in price, not \nto how the spread between heating oil futures and unleaded gas futures behaves. \nThe strategist could easily neutralize the long delta by selling three contracts. \nThis would leave room for more profits if prices continue to rise ( there are still two \nextra long calls). It would also provide downside protection if prices suddenly drop, \nsince the 5 long puts plus the 3 short futures would offset any loss in the 5 in-the\nmoney calls. \nWhich futures should the strategist short? That depends on how confident he is \nin his original analysis of the intermarket spread widening. If he still thinks it will \nwiden further, then he should sell unleaded gasoline futures against the deeply in\nthe-money heating oil calls. This would give him an additional profit or loss opportu\nnity based on the relationship of the two oil products. However, ifhe decides that the \nintermarket spread should have widened more than this by now, perhaps he will just \nsell 3 heating oil futures as a direct hedge against the heating oil calls. \nOnce one finds himself in a profitable situation, as in the above example, the \nrrwst conservative course is to hedge the in-the-rrwney option with its own underly\ning future. This action lessens the further dependency of the profits on the inter\nmarket spread. There is still profit potential remaining from futures price action. \nFurthermore, if the futures should fall so far that both options return to in-the\nmoney status, then the intermarket spread comes back into play. Thus, in the above \n718 Part V: Index Options and Futures \nexample, the conservative action would be to sell three heating oil futures against the \nheating oil calls. \nThe more aggressive course is to hedge the in-the-money option with the future \nunderlying the other side of the intermarket spread. In the above example, that \nwould entail selling the unleaded gasoline futures against the heating oil calls. \nSuppose that the strategist in the previous example decides to take the conser\nvative action, and he therefore shorts three heating oil futures at .7100, the current \nprice. This action preserves large profit potential in either direction. It is better than \nselling out-of-the-money options against his current position. \nHe would consider removing the hedge if futures prices dropped, perhaps \nwhen the puts returned to an in-the-money status with a put delta of at least -0. 75 \nor so. At that point, the position would be at its original status, more or less, except \nfor the fact that he would have taken a nice profit in the three futures that were sold \nand covered. \nEpilogue. The above examples are taken from actual price movements. In reality, \nthe futures fell back, not only to their original price, but far below it. The funda\nmental reason for this reversal was that the weather was warm, hurting demand for \nheating oil, and gasoline supplies were low. By the option expiration in December, \nthe following prices existed: \nJanuary heating oil futures: .5200 \nJanuary unleaded gas futures: .5200 \nNot only had the futures prices virtually crashed, but the intermarket spread \nhad been decimated as well. The spread had fallen to zero! It had never reached any\nthing near the 12-cent potential that was envisioned. Any spreader who had estab\nlished this spread with futures would almost certainly have lost money; he probably \nwould not have held it until it reached this lowly level, but there was never much \nopportunity to get out at a profit. \nThe strategist who established the spread with options, however, most certain\nly would have made money. One could safely assume that he covered the three \nfutures sold in the previous example at a nice profit, possibly 7 points or so. One \ncould also assume that as the puts became in-the-money options, he established a \nsimilar hedge and bought three unleaded gasoline futures when the EFP reached \n-3.00. This probably occurred with unleaded gasoline futures around .5700-5 cents \nin the money. \nAssuming that these were the trades, the following table shows the profits and \nlosses. \nChapter 35: Futures Option Strategies for Futures Spreads 719 \nInitial Final Net Profit/ \nPosition Price Price Loss \nBought 5 calls 6.40 0 -$13,440 \nBought 5 puts 4.25 10.00 + 12,075 \nSold 3 heating oil futures .7100 .6400 + 8,820 \nBought 3 unleaded gas futures .5700 .5200 - 6,300 \nTotal profit: +$ 1,155 \nIn the final analysis, the fact that the intermarket spread collapsed to zero actu\nally aided the option strategy, since the puts were the in-the-money option at expi", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 319}
{"text": "nal Net Profit/ \nPosition Price Price Loss \nBought 5 calls 6.40 0 -$13,440 \nBought 5 puts 4.25 10.00 + 12,075 \nSold 3 heating oil futures .7100 .6400 + 8,820 \nBought 3 unleaded gas futures .5700 .5200 - 6,300 \nTotal profit: +$ 1,155 \nIn the final analysis, the fact that the intermarket spread collapsed to zero actu\nally aided the option strategy, since the puts were the in-the-money option at expira\ntion. This was not planned, of course, but by being long the options, the strategist was \nable to make money when volatility appeared. \nINTRAMARKET SPREAD STRATEGY \nIt should be obvious that the same strategy could be applied to an intramarket spread \nas well. If one is thinking of spreading two different soybean futures, for example, he \ncould substitute in-the-money options for futures in the position. He would have the \nsame attributes as shown for the intermarket spread: large potential profits if volatil\nity occurs. Of course, he could still make money if the intramarket spread widens, but \nhe would lose the time value premium paid for the options. \nSPREADING FUTURES AGAINST STOCK SECTOR INDICES \nThis concept can be carried one step further. Many futures contracts are related to \nstocks - usually to a sector of stocks dealing in a particular commodity. For example, \nthere are crude oil futures and there is an Oil & Gas Sector Index (XOI). There are \ngold futures and there is a Gold & Silver Index (XAU). If one charts the history of \nthe commodity versus the price of the stock sector, he can often find tradeable pat\nterns in terms of the relationship between the two. That relationship can be traded \nvia an intermarket spread using options. \nFor example, if one thought crude oil was cheap with respect to the price of oil \nstocks in general, he could buy calls on crude oil futures and buy puts on the Oil & \nGas (XOI) Index. One would have to be certain to determine the number of options \nto trade on each side of the spread, by using the ratio that was presented in Chapter \n31 on inter-index spreading. (In fact, this formula should be used for futures inter\nmarket spreading if the two underlying futures don't have the same terms.) Only now, \nthere is an extra component to add if options are used - the delta of the options: \n720 Part V: Index Options and Futures \nwhere vi = volatility \nPi = price of the underlying \nui = unit of trading of the option \nLli = delta of the option \nExample: Suppose that one indeed wants to buy crude oil calls and also buy puts on \nthe XOI Index because he thinks that crude oil is cheap with respect to oil stocks. \nThe following prices exist: \nJuly crude futures: 16.35 \nCrude July 1550 call: 1.10 \nVolatility: 25% \nCall delta: O. 7 4 \n$XOI: 256.50 \nJune 265 put: 14½ \nVolatility: 17% \nPut delta: 0. 73 \nThe unit of trading for XOI options is $100 per point, as it is with nearly all stock and \nindex options. The unit of trading for crude oil futures and options is $1,000 per \npoint. With all of this information, the ratio can be computed: \nCrude= 1,000 x 0.25 x 16.35 x 0.74 \nXOI = 100 x 0.17 x 256.50 x 0.73 \nRatio = Crude/ XOI = 0.91 \nTherefore, one would buy 0.91 XOI put for every 1 crude oil call that he bought. For \nsmall accounts, this is essentially a 1-to-l ratio, but for large accounts, the exact ratio \ncould be used (for example, buy 91 XOI puts and 100 crude oil calls). The resultant \nquantities encompass the various differences in these two markets - mainly the price \nand volatility of the underlyings, plus the large differential in their units of trading \n(100 vs. 1,000). \nSUMMARY \nFutures spreading is a very important and potentially profitable endeavor. Utilizing \noptions in these spreads can often improve profitability to the point that an originally \nmistaken assumption can be overcome by volatility of price movement. \nChapter 35: Futures Option Strategies for Futures Spreads 721 \nFutures spreads fall into two categories - intermarket and intramarket. They \nare important strategies because many futures exhibit historic and/or seasonal ten\ndencies that can be traded without regard to the overall movement of futures prices. \nOptions can be used to enhance these futures spreading strategies. The futures \ncalendar spread is closely related to the intramarket spread. It is distinctly different \nfrom the stock or index option calendar spread. \nUsing in-the-money long option combinations in lieu of futures can be a very \nattractive strategy for either intermarket or intramarket spreads. The option strategy \ngives the spreader two ways to make money: ( 1) from the movement of the underly\ning futures in the spread; or (2) if the futures prices experience a big move, from the \nfact that one option can continually increase in value while the other can drop only \nto zero. The option strategy also affords the strategist the opportunity for follow-up \naction based on the equivalent futures position that accumulates as prices rise or fall. \nThe concepts introduced in this chapter apply not only to futures spreads, but \nto intermarket spreads between any two entities. An example was given of an inter\nmarket spread between futures and a stock sector index, but the concept can be gen\neralized to apply to any two related markets of any sort. \nTraders who utilize futures spreads as part of their trading strategy should give \nserious consideration to substituting options when applicable. Such an alternative \nstrategy will often improve the chances for profit. \n\nPART VI \nMeasuring and \nvv, V V' VV ,MN' V V V \n. Trading Volatility \n724 Part VI: Measuring and Trading Volatility \nEven though a myriad of strategies and concepts have been presented so far, a com\nmon thread among them is lacking. The one thing that ties all option strategies \ntogether and allows one to make comparative decisions is volatility. In fact, volatility \nis the most important concept in option trading. Oh, sure, if you're a great picker of \nstocks, then you might be able to get by without considering vola", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 320}
{"text": "hough a myriad of strategies and concepts have been presented so far, a com\nmon thread among them is lacking. The one thing that ties all option strategies \ntogether and allows one to make comparative decisions is volatility. In fact, volatility \nis the most important concept in option trading. Oh, sure, if you're a great picker of \nstocks, then you might be able to get by without considering volatility. Even then, \nthough, you'd be operating without full consideration of the main factor influencing \noption prices and strategy. For the rest of us, it is mandatory that we consider volatil\nity carefully before deciding what strategy to use. In this section of the book, an \nextensive treatment of volatility and volatility trading is presented. The first part \ndefines the terms and discusses some general concepts about how volatility can - and \nshould - be used. Then, a number of the more popular strategies, described earlier \nin the book, are discussed from the vantage point of how they perform when implied \nvolatilities change. After that, volatility trading strategies are discussed - and these \nare some of the most important concepts for option traders. A discussion is present\ned of how stock prices actually behave, as opposed to how investors perceive them to \nbehave, and then specific criteria and methodology for both buying and selling \nvolatility are introduced. \nThe information to be presented here is not overly theoretical. All of the con\ncepts should be understandable by most option traders. Whether or not one chooses \nto actually \"trade volatility,\" it is nevertheless important for an option trader to under\nstand the concepts that underlie the basic principles of volatility trading. \nWHY TRADE \n11\nTHE MARKET\"? \nThe \"game\" of stock market predicting holds appeal for many because one who can \ndo it seems powerful and intelligent. Everyone has his favorite indicators, analysis \ntechniques, or \"black box\" trading systems. But can the market really be predicted? \nAnd if it can't, what does that say about the time spent trying to predict it? The \nanswers to these questions are not clear, and even if one were to prove that the mar\nket can't be predicted, most traders would refuse to believe it anyway. In fact, there \nmay be more than one way to \"predict\" the market, so in a certain sense one has to \nqualify exactly what he is talking about before it can be determined if the market can \nbe predicted or not. \nThe astute option trader knows that market prediction falls into two categories: \n(1) the prediction of the short-term movement of prices, and (2) the prediction of \nvolatility of the underlying. These are not independent predictions. For example, \nanyone who is using a \"target\" is trying to predict both. That's pretty hard. Not only \ndo you have to be right about the direction of prices, but you also have to be able to \nPart VI: Measuring and Trading Volatility 725 \npredict how volatile the underlying is going to be so that you can set a reasonable tar\nget. In certain cases, the first prediction can be made with some degree of accuracy, \nbut the second one is extremely difficult. \nNearly every trader uses something to aid him in determining what to buy and \nwhen to buy it. Many of these techniques, especially if they are refined to a trading \nsystem, seem worthwhile. In that sense, it appears that the market can be predicted. \nHowever, this type of predicting usually involves a lot of work, including not only the \ninitial selection of the position, but money management in determining position size, \nrisk management in placing and watching ( trailing) stops, and so on. Thus, it's not \neasy. \nTo make matters even worse, most mathematical studies have shown that the \nmarket can't really be predicted. They tend to imply that anyone who is outperform\ning an index fund is merely \"hot\" - has hit a stream of winners. Can this possibly be \ntrue? Consider this example. Have you ever gone to Las Vegas and had a winning \nday? How about a weekend? What about a week? You might be able to answer \"yes\" \nto all of those, even though you know for a certainty that the casino odds are mathe\nmatically stacked against you. What if the question were extended to your lifetime: \nAre you ahead of the casinos for your entire life? This answer is most certainly \"no\" \nif you have played for any reasonably long period of time. \nMathematicians have tended to believe that outperforming the broad stock \nmarket is just about the same as beating the casinos in Las Vegas - possible in the \nshort term, but virtually impossible in the long term. Thus, when mathematicians say \nthat the stock market can't be predicted, they are talking about consistently beating \nthe \"index\" - say, the S&P 500 - over a long period of time. \nThose with an opposing viewpoint, however, say that the market can be beat. \nThey say the \"game\" is more like poker - where a good player can be a consistent \nwinner through money management techniques - than like casino gambling, where \nthe odds are fixed. It would be impossible to get everyone to agree for sure on who \nis right. There's some credibility in both viewpoints, but just as it's very hard to be a \ngood poker player, so it is difficult to beat the market consistently with directional \nstrategies. Moreover, even the best directional traders know that there are large \nswings or drawdowns in one's net worth during the year. Thus, the consistency of \nreturns is generally erratic for the directional trader. \nThis inconsistency of returns, the amount of work required, and the necessity \nto have sufficient capital and to manage it well are all factors that can lead to the \ndemise of a directional trader. As such, short-term directional trading probably is not \nreally a \"comfortable\" trading strategy for most traders - and if one is trading a strat\negy that he is not comfortable with, he is eventually going to lose money doing it. \n726 Part VI: Measuring and Trading Volatility \nSo, is there a better", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 321}
{"text": "capital and to manage it well are all factors that can lead to the \ndemise of a directional trader. As such, short-term directional trading probably is not \nreally a \"comfortable\" trading strategy for most traders - and if one is trading a strat\negy that he is not comfortable with, he is eventually going to lose money doing it. \n726 Part VI: Measuring and Trading Volatility \nSo, is there a better alternative? Or should one just pack it in, buy some index \nfunds, and forget it? As an option strategist, one should most certainly believe that \nthere's something better than buying the index fund. The alternative of volatility trad\ning offers significant advantages in terms of the factors that make directional trading \ndifficult. \nIf one finds that he is able to handle the rigors of directional trading, then stick \nwith that approach. You might want to add some volatility trading to your arsenal, \nthough, just to be safe. However, if one finds that directional trading is just too time\nconsuming, or you have trouble utilizing stops properly, or are constantly getting \nwhipsawed, then it's time to concentrate more heavily on volatility trading, preferably \nin the form of straddle buying. \nCHAPTER 36 \nThe Basics of \nVolatility Trading \nVolatility trading first attracted mathematically oriented traders who noticed that the \nmarket's prediction of forthcoming volatility - for example, implied volatility - was \nsubstantially out of line with what one might reasonably expect should happen. \nMoreover, many of these traders (market-makers, arbitrageurs, and others) had \nfound great difficulties with keeping a \"delta neutral\" position neutral. Seeking a bet\nter way to trade without having a market opinion on the underlying security, they \nturned to volatility trading. This is not to suggest that volatility trading eliminates all \nmarket risk, turning it all into volatility risk, for example. But it does suggest that a \ncertain segment of the option trading population can handle the risk of volatility with \nmore deference and aplomb than they can handle price risk \nSimply stated, it seems like a much easier task to predict volatility than to pre\ndict prices. That is said notwithstanding the great bull market of the 1990s, in which \nevery investor who strongly participated certainly feels that he understands how to \npredict prices. Remember not to confuse brains with a bull market. Consider the chart \nin Figure 36-1. This seems as if it might be a good stock to trade: Buy it near the lows \nand sell it near the highs, perhaps even selling it short near the highs and covering \nwhen it later declines. It appears to have been in a trading range for a long time, so \nthat after each purchase or sale, it returns at least to the midpoint of its trading range \nand sometimes even continues on to the other side of the range. There is no scale on \nthe chart, but that doesn't change the fact that it appears to be a tradable entity. In \nfact, this is a chart of implied volatility of the options on a major U.S. corporation. It \nreally doesn't matter which one (it's IBM), because the implied volatility chart of near\nly every stock, index, or futures contract has a similar pattern - a trading range. The \nonly time that implied volatility will totally break out of its \"normal\" range is if some\nthing material happens to change the fundamentals of the way the stock moves - a \ntakeover bid, for example, or perhaps a major acquisition or other dilution of the stock \n727 \n728 Part VI: Measuring and Trading Volatility \nFIGURE 36-1. \nA sample chart. \nBuy at these points. \nSo, many traders observed this pattern and have become adherents of trying to \npredict volatility. Notice that if one is able to isolate volatility, he doesn't care where \nthe stock price goes he is just concerned with buying volatility near the bottom of \nthe range and selling it when it gets back to the middle or high end of the range, or \nvice versa. In real life, it is nearly impossible for a public customer to be able to iso\nlate volatility so specifically. He will have to pay some attention to the stock price, but \nhe still is able to establish positions in which the direction of the stock price is irrel\nevant to the outcome of the position. This quality is appealing to many investors, who \nhave repeatedly found it difficult to predict stock prices. Moreover, an approach such \nas this should work in both bull and bear markets. Thus, volatility trading appeals to \na great number of individuals. Just remember that, for you personally to operate a \nstrategy properly, you must find that it appeals to your own philosophy of trading. \nTrying to use a strategy that you find uncomfortable will only lead to losses and frus\ntration. So, if this somewhat neutral approach to option trading sounds interesting to \nyou, then read on. \nDEFINITIONS OF VOLATILITY \nVolatility is merely the term that is used to describe how fast a stock, future, or index \nchanges in price. When one speaks of volatility in connection with options, there are \ntwo types of volatility that are important. The first is historical volatility, which is a \nmeasure of how fast the underlying instrument has been changing in price. The other \nis implied volatility, which is the option market's prediction of the volatility of the \nChapter 36: The Basics of Volatility Trading 729 \nunderlying over the life of the option. The computation and comparison of these two \nmeasures can aid immensely in predicting the forthcoming volatility of the underly\ning instrument - a crucial matter in determining today's option prices. \nHistorical volatility can be measured with a specific formula, as shown in the · \nchapter on mathematical applications. It is merely the formula for standard deviation \nas contained in most elementary books on statistics. The important point to under\nstand is that it is an exact calculation, and there is little debate over how to compute \nhistorical volatility. It is not important to know wh", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 322}
{"text": "ces. \nHistorical volatility can be measured with a specific formula, as shown in the · \nchapter on mathematical applications. It is merely the formula for standard deviation \nas contained in most elementary books on statistics. The important point to under\nstand is that it is an exact calculation, and there is little debate over how to compute \nhistorical volatility. It is not important to know what the actual measurement means. \nThat is, if one says that a certain stock has a historical volatility of 20%, that by itself \nis a relatively meaningless number to anyone but an ardent statistician. However, it \ncan be used for comparative purposes. \nThe standard deviation is expressed as a percent. One can determine that the \nhistorical volatility of the broad stock market has usually been in the range of 15% to \n20%. A very volatile stock might have an historical volatility in excess of 100%. These \nnumbers can be compared to each other, so that one might say that a stock with the \nlatter historical volatility is five times more volatile that the \"stock market.\" So, the \nhistorical volatility of one instrument can be compared with that of another instru\nment in order to determine which one is more volatile. That in itself is a useful func\ntion of historical volatility, but its uses go much farther than that. \nHistorical volatility can be measured over different time periods to give one a \nsense of how volatile the underlying has been over varying lengths of time. For exam\nple, it is common to compute a 10-day historical volatility, as well as a 20-day, 50-day, \nand even 100-day. In each case, the results are annualized so that one can compare \nthe figures directly. \nConsider the chart in Figure 36-2. It shows a stock (although it could be a \nfutures contract or index, too) that was meandering in a rather tight range for quite \nsome time. At the point marked \"A\" on the chart, it was probably at its least volatile. \nAt that time, the 10-dayvolatility might have been something quite low, say 20%. The \nprice movements directly preceding point A had been very small. However, prior to \nthat time the stock had been more volatile, so longer-term measures of the historical \nvolatility would shown higher numbers. The possible measures of historical volatility, \nthen at point A, might have been something like: \n10-day historical volatility: 20% \n20-day historical volatility: 23% \n50-day historical volatility: 35% \n100-day historical volatility: 45% \nA pattern of historical volatilities of this sort describes a stock that has been \nslowing down lately. \n730 \nFIGURE 36-2. \nSample stock chart. \n:::::::::r;~.w· r \nI \n, .. ~ \nn \nI \nll•• ~N \nIT \nPart VI: Measuring and Trading Volatllity \n: \nI \nI \nj \nj \n~ \nJI \n• I' \n'Vn ~- A \nIts price movements have been less extreme in the near term. \nAgain referring to Figure 36-2, note that shortly after point A, the stock jumped \nmuch higher over a short period of time. Price action like this increases the implied \nvolatility dramatically. And, at the far right edge of the chart, the stock had stopped \nrising but was swinging back and forth in far more rapid fashion than it had been at \nmost other points on the chart. Violent action in a back-and-forth manner can often \nproduce a higher historical volatility reading that straight-line move can; it's just the \nway the numbers work out. So, by the far right edge of the chart, the 10-day histori\ncal volatility would have increased rather dramatically, while the longer-term meas\nures wouldn't be so high because they would still contain the price action that \noccurred prior to point A. \nAt the far right edge of Figure 36-2, these figures might apply: \nl 0-day historical volatility: 80% \n20-day historical volatility: 75% \n50-day historical volatility: 60% \nl 00-day historical volatility: 55% \nWith this alignment of historical volatilities, one can see that the stock has been \nmore volatile recently than in the more distant past. In Chapter 38 on the distribu\ntion of stock prices, we will discuss in some detail just which one, if any, of these his\ntorical volatilities one should use as \"the\" historical volatility input into option and \nChapter 36: The Basics of Volatility Trading 731 \nprobability models. We need to be able to make volatility estimates in order to deter\nmine whether or not a strategy might be successful, and to determine whether the \ncurrent option price is a relatively cheap one or a relatively expensive one. For exam\nple, one can't just say, \"I think XYZ is going to rise at least 18 points by February expi\nration.\" There needs to be some basis in fact for such a statement and, lacking inside \ninformation about what the company might announce between now and February, \nthat basis should be statistics in the form of volatility projections. \nHistorical volatility is, of course, useful as an input to the (Black-Scholes) option \nmodel. In fact, the volatility input to any model is crucial because the volatility com\nponent is such a major factor in determining the price of an option. Furthermore, \nhistorical volatility is useful for more than just estimating option prices. It is neces\nsary for making stock price projections and calculating distributions, too, as will be \nshown when those topics are discussed later. Any time one asks the question, \"What \nis the probability of the stock moving from here to there, or of exceeding a particu\nlar target price?\" the answer is heavily dependent on the volatility of the underlying \nstock (or index or futures). \nIt is obvious from the above example that historical volatility can change dra\nmatically for any particular instrument. Even if one were to stick with just one \nmeasure of historical volatility ( the 20-day historical is commonly the most popular \nmeasure), it changes with great frequency. Thus, one can never be certain that bas\ning option price predictions or stock price distributions on the current historical \nvolatility will yield the \"correct\" results. Statistical", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 323}
{"text": "ge dra\nmatically for any particular instrument. Even if one were to stick with just one \nmeasure of historical volatility ( the 20-day historical is commonly the most popular \nmeasure), it changes with great frequency. Thus, one can never be certain that bas\ning option price predictions or stock price distributions on the current historical \nvolatility will yield the \"correct\" results. Statistical volatility may change as time \ngoes forward, in which case your projections would be incorrect. Thus, it is impor\ntant to make projections that are on the conservative side. \nANOTHER APPROACH: GARCH \nGARCH stands for Generalized Autoregressive Conditional Heteroskedasticity, \nwhich is why it's shortened to GARCH. It is a technique for forecasting volatility that \nsome analysts say produces better projections than using historical volatility alone or \nimplied volatility alone. GARCH was created in the 1980s by specialists in the field of \neconometrics. It incorporates both historical and implied volatility, plus one can throw \nin a constant (\"fudge factor\"). In essence, though, the user of GARCH volatility mod\nels has to make some predictions or decisions about the weighting of the factors used \nfor the estimate. By its very nature, then, it can be just as vague as the situations \ndescribed in the previous section. \nThe model can \"learn,\" though, if applied correctly. That is, if one makes a \nvolatility prediction for today (using GARCH, let's say), but it turns out that the actu-\n732 Part VI: Measuring and Trading Volatility \nal volatility was lower, then when you make the volatility prediction for tomorrow, \nyou'll probably want to adjust it downward, using the experience of the real world, \nwhere you see volatility declining. This also incorporates the common-sense notion \nthat volatility tends to remain the same; that is, tomorrow's volatility is likely to be \nmuch like today's. Of course, that's a little bit like saying tomorrow's weather is likely \nto be the same as today's (which it is, two-thirds of the time, according to statistics). \nIt's just that when a tornado hits, you have to realize that your forecast could be wrong. \nThe same thing applies to GAR CH volatility projections. They can be wrong, too. \nSo, GARCH does not do a perfect job of estimating and forecasting volatility. In \nfact, it might not even be superior, from a strategist's viewpoint, to using the simple \nminimum/maximum techniques outlined in the previous section. It is really best \ngeared to predicting short-term volatility and is favored most heavily by dealers in \ncurrency options who must adjust their markets constantly. For longer-term volatility \nprojections, which is what a position trader of volatility is interested in, GARCH may \nnot be all that useful. However, it is considered state-of-the-art as far as volatility pre\ndicting goes, so it has a following among theoretically oriented traders and analysts. \nMOVING AVERAGES \nSome traders try to use moving averages of daily composite implied volatility read\nings, or use a smoothing of recent past historical volatility readings to make volatility \nestimates. As mentioned in the chapter on mathematical applications, once the com\nposite daily implied volatility has been computed, it was recommended that a \nsmoothing effect be obtained by taking a moving average of the 20 or 30 days' \nimplied volatilities. In fact, an exponential moving average was recommended, \nbecause it does not require one to keep accessing the last 20 or 30 days' worth of data \nin order to compute the moving average. Rather, the most recent exponential mov\ning average is all that's needed in order to compute the next one. \nIMPLIED VOLATILITY \nImplied volatility has been mentioned many times already, but we want to expand on \nits concept before getting deeper into its measure and uses later in this section. \nImplied volatility pertains only to options, although one can aggregate the implied \nvolatilities of the various options trading on a particular underlying instrument to \nproduce a single number, which is often referred to as the implied volatility of the \nunderlying. \n732 Part VI: Measuring and Trading Volatility \nal volatility was lower, then when you make the volatility prediction for tomorrow, \nyou'll probably want to adjust it downward, using the experience of the real world, \nwhere you see volatility declining. This also incorporates the common-sense notion \nthat volatility tends to remain the same; that is, tomorrow's volatility is likely to be \nmuch like today's. Of course, that's a little bit like saying tomorrow's weather is likely \nto be the same as today's (which it is, two-thirds of the time, according to statistics). \nIt's just that when a tornado hits, you have to realize that your forecast could be wrong. \nThe same thing applies to GARCH volatility projections. They can be wrong, too. \nSo, GARCH does not do a perfect job of estimating and forecasting volatility. In \nfact, it might not even be superior, from a strategist's viewpoint, to using the simple \nminimum/maximum techniques outlined in the previous section. It is really best \ngeared to predicting short-term volatility and is favored most heavily by dealers in \ncurrency options who must adjust their markets constantly. For longer-term volatility \nprojections, which is what a position trader of volatility is interested in, GAR CH may \nnot be all that useful. However, it is considered state-of-the-art as far as volatility pre\ndicting goes, so it has a following among theoretically oriented traders and analysts. \nMOVING AVERAGES \nSome traders try to use moving averages of daily composite implied volatility read\nings, or use a smoothing of recent past historical volatility readings to make volatility \nestimates. As mentioned in the chapter on mathematical applications, once the com\nposite daily implied volatility has been computed, it was recommended that a \nsmoothing effect be obtained by taking a moving average of the 20 o", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 324}
{"text": "ome traders try to use moving averages of daily composite implied volatility read\nings, or use a smoothing of recent past historical volatility readings to make volatility \nestimates. As mentioned in the chapter on mathematical applications, once the com\nposite daily implied volatility has been computed, it was recommended that a \nsmoothing effect be obtained by taking a moving average of the 20 or 30 days' \nimplied volatilities. In fact, an exponential moving average was recommended, \nbecause it does not require one to keep accessing the last 20 or 30 days' worth of data \nin order to compute the moving average. Rather, the most recent exponential mov\ning average is all that's needed in order to compute the next one. \nIMPLIED VOLATILITY \nImplied volatility has been mentioned many times already, but we want to expand on \nits concept before getting deeper into its measure and uses later in this section. \nImplied volatility pertains only to options, although one can aggregate the implied \nvolatilities of the various options trading on a particular underlying instrument to \nproduce a single number, which is often referred to as the implied volatility of the \nunderlying. \n732 Part VI: Measuring and Trading Volatility \nal volatility was lower, then when you make the volatility prediction for tomorrow, \nyou'll probably want to adjust it downward, using the experience of the real world, \nwhere you see volatility declining. This also incorporates the common-sense notion \nthat volatility tends to remain the same; that is, tomorrow's volatility is likely to be \nmuch like today's. Of course, that's a little bit like saying tomorrow's weather is likely \nto be the same as today's (which it is, two-thirds of the time, according to statistics). \nIt's just that when a tornado hits, you have to realize that your forecast could be wrong. \nThe same thing applies to GARCH volatility projections. They can be wrong, too. \nSo, GAR CH does not do a perfect job of estimating and forecasting volatility. In \nfact, it might not even be superior, from a strategist's viewpoint, to using the simple \nminimum/maximum techniques outlined in the previous section. It is really best \ngeared to predicting short-term volatility and is favored most heavily by dealers in \ncurrency options who must adjust their markets constantly. For longer-term volatility \nprojections, which is what a position trader of volatility is interested in, GARCH may \nnot be all that useful. However, it is considered state-of-the-art as far as volatility pre\ndicting goes, so it has a following among theoretically oriented traders and analysts. \nMOVING AVERAGES \nSome traders try to use moving averages of daily composite implied volatility read\nings, or use a smoothing of recent past historical volatility readings to make volatility \nestimates. As mentioned in the chapter on mathematical applications, once the com\nposite daily implied volatility has been computed, it was recommended that a \nsmoothing effect be obtained by taking a moving average of the 20 or 30 days' \nimplied volatilities. In fact, an exponential moving average was recommended, \nbecause it does not require one to keep accessing the last 20 or 30 days' worth of data \nin order to compute the moving average. Rather, the most recent exponential mov\ning average is all that's needed in order to compute the next one. \nIMPLIED VOLATILITY \nImplied volatility has been mentioned many times already, but we want to expand on \nits concept before getting deeper into its measure and uses later in this section. \nImplied volatility pertains only to options, although one can aggregate the implied \nvolatilities of the various options trading on a particular underlying instrument to \nproduce a single number, which is often referred to as the implied volatility of the \nunderlying. \nChapter 36: The Basics of Volatility Trading 733 \nAt any one point in time, a trader knows for certain the following items that \naffect an option's price: stock price, strike price, time to expiration, interest rate, and \ndividends. The only remaining factor is volatility - in fact, implied volatility. It is the \nbig \"fudge factor\" in option trading. If implied volatility is too high, options will be \noverpriced. That is, they will be relatively expensive. On the other hand, if implied \nvolatility is too low, options will be cheap or underpriced. The terms \"overpriced\" and \n\"underpriced\" are not really used by theoretical option traders much anymore, \nbecause their usage implies that one knows what the option should be worth. In the \nmodem vernacular, one would say that the options are trading with a \"high implied \nvolatility\" or a \"low implied volatility,\" meaning that one has some sense of where \nimplied volatility has been in the past, and the current measure is thus high or low in \ncomparison. \nEssentially, implied volatility is the option market's guess at the forthcoming sta\ntistical volatility of the underlying over the life of the option in question. If traders \nbelieve that the underlying will be volatile over the life of the option, then they will \nbid up the option, making it more highly priced. Conversely, if traders envision a non\nvolatile period for the stock, they will not pay up for the option, preferring to bid \nlower; hence the option will be relatively low-priced. The important thing to note is \nthat traders normally do not know the future. They have no way of knowing, for sure, \nhow volatile the underlying is going to be during the life of the option. \nHaving said that, it would be unrealistic to assume that inside information does \nnot leak into the marketplace. That is, if certain people possess nonpublic knowledge \nabout a company's earnings, new product announcement, takeover bid, and so on, \nthey will aggressively buy or bid for the options and that will increase implied volatil\nity. So, in certain cases, when one sees that implied volatility has shot up quickly, it is \nperhaps a signal that some traders do", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 325}
{"text": "mation does \nnot leak into the marketplace. That is, if certain people possess nonpublic knowledge \nabout a company's earnings, new product announcement, takeover bid, and so on, \nthey will aggressively buy or bid for the options and that will increase implied volatil\nity. So, in certain cases, when one sees that implied volatility has shot up quickly, it is \nperhaps a signal that some traders do indeed know the future - at least with respect \nto a specific corporate announcement that is about to be made. \nHowever, most of the time there is not anyone trading with inside information. \nYet, every option trader - market-maker and public alike - is forced to make a \n\"guess\" about volatility when he buys or sells an option. That is true because the price \nhe pays is heavily influenced by his volatility estimate ( whether or not he realizes that \nhe is, in fact, making such a volatility estimate). As you might imagine, most traders \nhave no idea what volatility is going to be during the life of the option. They just pay \nprices that seem to make sense, perhaps based on historic volatility. Consequently, \ntoday's implied volatility may bear no resemblance to the actual statistical volatility \nthat later unfolds during the life of the option. \nFor those who desire a more mathematical definition of implied volatility, con\nsider this. \n734 Part VI: Measuring and Trading Volatillty \nOpt price = f(Stock price, Strike price, Time, Risk-free rate, Volatility, Dividends) \nFurthermore, suppose that one knows the following information: \nXYZ price: 52 \nApril 50 call price: 6 \nTime remaining to April expiration: 36 days \nDividends: $0.00 \nRisk-free interest rate: 5% \nThis information, which is available for every option at any time, simply from an \noption quote, gives us everything except the implied volatility. So what volatility \nwould one have to plug in the Black-Scholes model ( or whatever model one is using) \nto make the model give the answer 6 (the current price of the option)? That is, what \nvolatility is necessary to solve the equation? \n6 = f(52, 50, 36 days, 5%, Volatility, $0.00) \nWhatever volatility is necessary to make the model yield the current market price (6) \nas its value, is the implied volatility for the XYZ April 50 call. In this case, if you're \ninterested, the implied volatility is 75.4%. The actual process of determining implied \nvolatility is an iterative one. There is no formula, per se. Rather, one keeps trying var\nious volatility estimates in the model until the answer is close enough to the market \nvalue. \nTHE VOLATILITY OF VOLATILITY \nIn order to discuss the implied volatility of a particular entity - stock, index, or \nfutures contract one generally refers to the implied volatility of individual options \nor perhaps the composite implied volatility of the entire option series. This is gener\nally good enough for strategic comparisons. However, it turns out that there might be \nother ways to consider looking at implied volatility. In paiticular, one might want to \nconsider how wide the range of implied volatility is - that is, how volatile the indi\nvidual implied volatility numbers are. \nIt is often conventional to talk about the percentile of implied volatility. That is \na way to rank the current implied volatility reading with past readings for the same \nunderlying instrument. \nHowever, a fairly important ingredient is missing when percentiles are involved. \nOne can't really tell if \"cheap\" options are cheap as a practical matter. That's because \none doesn't know how tightly packed together the past implied volatility readings are. \nFor example, if one were to discover that the entire past range of implied volatility \nfor XYZ stretched only from 39% to 45%, then a current reading of 40%, while low, \nChapter 36: The Basics of Volatility Trading 135 \nmight not seem all that attractive. That is, if the first percentile of XYZ options were \nat an implied volatility reading of 39% and the 100th percentile were at 45%, then a \nreading of 40% is really quite mundane. There just wouldn't be much room for \nimplied volatility to increase on an absolute basis. Even if it rose to the 100th per\ncentile, an individual XYZ option wouldn't gain much value, because its implied \nvolatility would only be increasing from about 40% to 45%. \nHowever, if the distribution of past implied volatility is wide, then one can truly \nsay the options are cheap if they are currently in a low percentile. Suppose, rather \nthan the tight range described above, that the range of past implied volatilities for \nXYZ instead stretched from 35% to 90% - that the first percentile for XYZ implied \nvolatility was at 35% and the 100th percentile was at 90%. Now, if the current read\ning is 40%, there is a large range above the current reading into which the options \ncould trade, thereby potentially increasing the value of the options if implied volatil\nity moved up to the higher percentiles. \nWhat this means, as a practical matter, is that one not only needs to know the \ncurrent percentile of implied volatility, but he also needs to know the range of num\nbers over which that percentile was derived. If the range is wide, then an extreme \npercentile truly represents a cheap or expensive option. But if the range is tight, then \none should probably not be overly concerned with the current percentile of implied \nvolatility. \nAnother facet of implied volatility that is often overlooked is how it ranges with \nrespect to the time left in the option. This is particularly important for traders of \nLEAPS (long-term) options, for the range of implied volatility of a LEAPS option will \nnot be as great as that of a short-term option. In order to demonstrate this, the \nimplied volatilities of $OEX options, both regular and LEAPS, were charted over \nseveral years. The resulting scatter diagram is shown in Figure 36-3. \nTwo curved lines are drawn on Figure 36-3. They contain most of the data \npoints. One can see from these lines that the", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 326}
{"text": "f implied volatility of a LEAPS option will \nnot be as great as that of a short-term option. In order to demonstrate this, the \nimplied volatilities of $OEX options, both regular and LEAPS, were charted over \nseveral years. The resulting scatter diagram is shown in Figure 36-3. \nTwo curved lines are drawn on Figure 36-3. They contain most of the data \npoints. One can see from these lines that the range of implied volatility for near-term \noptions is greater than it is for longer-term options. For example, the implied volatil\nity readings on the far left of the scatter diagram range from about 14% to nearly 40% \n(ignore the one outlying point). However, for longer-term options of 24 months or \nmore, the range is about 17% to 32%. While $0EX options have their own idiosyn\ncracies, this scatter diagram is fairly typical of what we would see for any stock or \nindex option. \nOne conclusion that we can draw from this is that LEAPS option implied \nvolatilities just don't change nearly as much as those of short-term options. That can \nbe an important piece of information for a LEAPS option trader especially if he is \ncomparing the LEAPS implied volatility with a composite implied volatility or with \nthe historical volatility of the underlying. \n736 Part VI: Measuring and Trading Volatility \nOnce again, consider Figure 36-3. While it is difficult to discern from the graph \nalone, the 10th percentile of $OEX composite implied volatility, using all of the data \npoints given, is 17%. The line that marks this level (the tenth percentile) is noted on \nthe right side of the scatter diagram. It is quite easy to see that the LEAPS options \nrarely trade at that low volatility level. \nIn Figure 36-3, the distance between the curved lines is much greater on the \nleft side (i.e., for shorter-term options) than it is on the right side (for longer-term \noptions). Thus, it's difficult for the longer-term options to register either an extreme\nly high or extremely low implied volatility reading, when all of the options are con\nsidered. Consequently, LEAPS options will rarely appear \"cheap\" when one looks at \ntheir percentile of implied volatility, including all the short-term options, too: \nOne might say that, if he were going to buy long-term options, he should look \nonly at the size of the volatility range on the right side of the scatter diagram. Then, \nhe could make his decision about whether the options are cheap or not by only com\nparing the current reading to past readings of long-term options. This line of think\ning, though, is somewhat fallacious reasoning, for a couple of reasons: First, if one \nholds the option for any long period of time, the volatility range will widen out and \nthere is a chance that implied volatility could drop substantially. Second, the long\nterm volatility range might be so small that, even though the options are initially \ncheap, quick increase in implied volatility over several deciles might not translate into \nmuch of a gain in price in the short term. \nFIGURE 36-3. Implied volatilities of $OEX options over several \nyears. \n50 \n45 \n40 \n~ 35 \n~ 30 \ng 25 \"O \n.91 20 C. \nE 15 -0th \n10 \n5 \n0 \n0 10 20 30 40 \nTime to Expiration (months) \nChapter 36: The Basics ol Volatility Trading 737 \nIt's important for anyone using implied volatility in his trading decisions to \nunderstand that the range of past implied volatilities is important, and to realize that \nthe volatility range expands as time shrinks. \nIS IMPLIED VOLATILITY A GOOD PREDICTOR OF ACTUAL VOLATILITY? \nThe fact that one can calculate implied volatility does not mean that the calculation \nis a good estimate of forthcoming volatility. As stated above, the marketplace does not \nreally know how volatile an instrument is going to be, any more than it knows the \nforthcoming price of the stock. There are clues, of course, and some general ways of \nestimating forthcoming volatility, but the fact remains that sometimes options trade \nwith an implied volatility that is quite a bit out of line with past levels. Therefore, \nimplied volatility may be considered to be an inaccurate estimate of what is really \ngoing to happen to the stock during the life of the option. Just remember that implied \nvolatility is a forward-looking estimate, and since it is based on traders' suppositions, \nit can be wrong - just as any estimate of future events can be in error. \nThe question posed above is one that should probably be asked more often than \nit is: \"Is implied volatility a good predictor of actual volatility?\" Somehow, it seems \nlogical to assume that implied and historical (actual) volatility will converge. That's \nnot really true, at least not in the short term. Moreover, even if they do converge, \nwhich one was right to begin with - implied or historical? That is, did implied volatil\nity move to get more in line with actual movements of the underlying, or did the \nstock's movement speed up or slow down to get in line with implied volatility? \nTo illustrate this concept, a few charts will be used that show the comparison \nbetween implied and historical volatility. Figure 36-4 shows information for the \n$0EX Index. In general, $0EX options are overpriced. See the discussion in \nChapter 29. That is, implied volatility of $0EX options is almost always higher than \nwhat actual volatility turns out to be. Consider Figure 36-4. There are three lines in \nthe figure: (a) implied volatility, (b) actual volatility, and (c) the difference between \nthe two. There is an important distinction here, though, as to what comprises these \ncurves: \n(a) The implied volatility curve depicts the 20-day moving average of daily compos\nite implied volatility readings for $0EX. That is, each day one number is com\nputed as a composite implied volatility for $0EX for that day. These implied \nvolatility figures are computed using the averaging formula shown in the chapter \non mathematical applications, whereby each option's implied volatility is weight\ned by trading volume", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 327}
{"text": "ity curve depicts the 20-day moving average of daily compos\nite implied volatility readings for $0EX. That is, each day one number is com\nputed as a composite implied volatility for $0EX for that day. These implied \nvolatility figures are computed using the averaging formula shown in the chapter \non mathematical applications, whereby each option's implied volatility is weight\ned by trading volume and by distance in- or out-of-the-money, to arrive at a sin\ngle composite implied volatility reading for the trading day. To smooth out those \ndaily readings, a 20-day simple moving average is used. This daily implied volatil-\n738 Part VI: Measuring and Trading Volatility \nFIGURE 36-4. \n$OEX implied versus historical volatility. \n10 \nImplied minus Actual 1999 Date \nity of $OEX options encompasses all the $OEX options, so it is different from the \nVolatility Index ($VIX), which uses only the options closest to the money. By \nusing all of the options, a slightly different volatility figure is arrived at, as com\npared to $VIX, but a chart of the two would show similar patterns. That is, peaks \nin implied volatility computed using all of the $OEX options occur at the same \npoints in time as peaks in $VIX. \n(b) The actual volatility on the graph is a little different from what one normally \nthinks of as historical volatility. It is the 20-day historical volatility, computed 20 \ndays later than the date of the implied volatility calculation. Hence, points on the \nimplied volatility curve are matched with a 20-day historical volatility calculation \nthat was made 20 days later. Thus, the two curves more or less show the predic\ntion of volatility and what actually happened over the 20-day period. These actu\nal volatility readings are smoothed as well, with a 20-day moving average. \n(c) The difference between the two is quite simple, and is shown as the bottom \ncurve on the graph. A \"zero\" line is drawn through the difference. \nWhen this \"difference line\" passes through the zero line, the projection of \nvolatility and what actually occurred 20 days later were equal. If the difference line \nis above the zero line, then implied volatility was too high; the options were over\npriced. Conversely, if the difference line is below the zero line, then actual volatility \nturned out to be greater than implied volatility had anticipated. The options were \nunderpriced in that case. Those latter areas are shaded in Figure 36-4. Simplistically, \nyou would want to own options during the shaded periods on the chart, and would \nwant to be a seller of options during the non-shaded areas. \nChapter 36: The Basics of Volatility Trading 739 \nNote that Figure 36-4 indeed confirms the fact that $OEX options are consis\ntently overpriced. Very few charts are as one-dimensional as the $OEX chart, where \nthe options were so consistently overpriced. Most stocks find the difference line \noscillating back and forth about the zero mark. Consider Figures 36-5 and 36-6. \nFigure 36-5 shows a chart similar to Figure 36-4, comparing actual and implied \nvolatility, and their difference, for a particular stock. Figure 36-6 shows the price \ngraph of that same stock, overlaid on implied volatility, during the period up to and \nincluding the heavy shading. \nThe volatility comparison chart (Figure 36-5) shows several shaded areas, dur\ning which the stock was more volatile than the options had predicted. Owners of \noptions profited during these times, provided they had a more or less neutral outlook \non the stock. Figure 36-6 shows the stock's performance up to and including the \nMarch-April 1999 period - the largest shaded area on the chart. Note that implied \nvolatility was quite low before the stock made the strong move from 10 to 30 in little \nmore than a month. These graphs are taken from actual data and demonstrate just \nhow badly out of line implied volatility can be. In February and early March 1999, \nimplied volatility was at or near the lowest levels on these charts. Yet, by the end of \nMarch, a major price explosion had begun in the stock, one that tripled its value in \njust over a month. Clearly, implied volatility was a poor predictor of forthcoming \nactual volatility in this case. \nWhat about later in the year? In Figure 36-5, one can observe that implied and \nactual volatility oscillated back and forth quite a few times during the rest of 1999. It \nmight appear that these oscillations are small and that implied volatility was actually \ndoing a pretty good job of predicting actual volatility, at least until the final spike in \nDecember 1999. However, looking at the scale on the left-hand side of Figure 36-5, \none can see that implied volatility was trying to remain in the 50% to 60% range, but \nactual volatility kept bolting higher rather frequently. \nOne more example will be presented. Figures 36-7 and 36-8 depict another \nstock and its volatilities. On the left half of each graph, implied volatility was quite \nhigh. It was higher than actual volatility turned out to be, so the difference line in \nFigure 36-7 remains above the zero line for several months. Then, for some reason, \nthe option market decided to make an adjustment, and implied volatility began to \ndrop. Its lowest daily point is marked with a circle in Figure 36-8, and the same point \nin time is marked with a similar circle in Figure 36-7. At that time, options traders \nwere \"saying\" that they expected the stock to be very tame over the ensuing weeks. \nInstead, the stock made two quick moves, one from 15 down to 11, and then anoth\ner back up to 17. That movement jerked actual volatility higher, but implied volatili\nty remained rather low. After a period of trading between 13 and 15, during which \ntime implied volatility remained low, the stock finally exploded to the upside, as evi\ndenced by the spikes on the right-hand side of both Figures 36-7 and 36-8. Thus, \n740 Part VI: Measuring and Trading Volatility \nFIGURE 36-5. \nImplied versus historical volatility of a stock.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 328}
{"text": "atility higher, but implied volatili\nty remained rather low. After a period of trading between 13 and 15, during which \ntime implied volatility remained low, the stock finally exploded to the upside, as evi\ndenced by the spikes on the right-hand side of both Figures 36-7 and 36-8. Thus, \n740 Part VI: Measuring and Trading Volatility \nFIGURE 36-5. \nImplied versus historical volatility of a stock. \n150 \n140 \n130 \n120 \n110 \n100 \n90 \n80 \n70 \n60 \n50 \n40 \n30 \n20 \n10 \noi--\"\"\"\"'\"\"\"\"',,,.....\"\"' -10 \n-20 \n-30 \"O \n-40 ct! \n-50 ~ \n-80 0. \n-701'-'-=CIJ+---+---+--+; \n-80 \n1999 \nFIGURE 36-6. \nImplied minus Actual \nThe price graph of the stock. \n. . . \n•• , •••••••• ,. •••••••• .,. ••• + ••••••••••• ••••• -~······ •••••• ,. ••••••••••• ·t . ······ . . . ... [\" \n·· · ·· ·· ··· ·· · · · Stock Price · ·· · : ·· ·· I \n~ !'\"Y\"d\"'il~tilirrs::•of'T! \n' ' .· ............ ; ·--·•·····! ............ · ................ : ............... : ...........•.. :. \n············•·:••············•:•···········•;••·············(·········•: Implied Volatility \n98 0 N D J F M A M 99 \n29.000 \n27.000 \n25.000 \n23.000 \n21.000 \n19.000 \n17.000 \n15.000 \n13.000 \n11.000 \n9.000 \n7.000 \n5.000 \nDate \nChapter 36: The Basics of Volatility Trading \nFIGURE 36-7. \nImplied versus historical volatility of a stock. \n120 \n110 \n100 \n90 \n80 \n70 \n60 \n50 \n40 \n30 \n20 \n10 \n01-----------~~r:cr:1---\n-10 \"O \n-20 ~ \n-30\"5\" F M A M J J A S O N D-\nImplied minus Actual 1999 \nFIGURE 36-8. \nThe price graph of the stock • \n... : ....... --: ......... : ·······.··········, ····-·-:· ....... : ........ ..; ... . \n······: ---:·······•: J. ...... 1 ....... ) ....... --) .... ----1 .).. ! .). \n······-·········-··· -.. ;..... : ...... ;.. . : ......... : .... . \n...... .: ......... : .......... : .......... : ....... , ......... •. \n..... ; ...... ) ....... .L.. ... .L .. Stock· Pri~e ..... ) ...... ) .. . \n·······'• ...... _.: ____ .... •. ·······:----\n.•.•••• j ' . \nJ F M A M J J A S 0 N D J \n1999 \nDate \n27.000 \n25.000 \n23.000 \n21.000 \n19.000 \n17.000 \n15.000 \n13.000 \n11.000 \n9.000 \n7.000 \n5.000 \n741 \n742 Part VI: Measuring and Trading Volatility \nimplied volatility was a poor predictor of actual volatility for most of the time on these \ngraphs. Moreover, implied volatility remained low at the right-hand side of the charts \n(January 2000) even though the stock doubled in the course of a month. \nThe important thing to note from these figures is that they clearly show that \nimplied volatility is really not a very good predictor of the actual volatility that is to \nfollow. If it were, the difference line would hover near zero most of the time. Instead, \nit swings back and forth wildly, with implied volatility over- or underestimating actu\nal volatility by quite wide levels. Thus, the current estimates of volatility by traders \n(i.e., implied volatility) can actually be quite wrong. \nConversely, one could also say that historical volatility is not a great predictor of \nvolatility that is to follow, either, especially in the short term. No one really makes any \nclaims that it is a good predictor, for historical volatility is merely a reflection of what \nhas happened in the past. All we can say for sure is that implied and historical volatil\nity tend to trade within a range. \nOne thing that does stand out on these charts is that implied volatility seems to \nfluctuate less than actual volatility. That seems to be a natural function of the volatil\nity predictive process. For example, when the market collapses, implied volatilities of \noptions rise only modestly. This can be observed by again referring to Figure 36-4, \nthe $0EX option example. The only shaded area on the graph occurred when the \nmarket had a rather sharp sell-off during October 1999. In previous years, when \nthere had been even more severe market declines (October 1997 or August-October \n1998) $0EX actual volatility had briefly moved above implied volatility (this data for \n1997 and 1998 is shown in Figure 36-9). In other words, option traders and market\nmakers are predicting volatility when they price options, and one tends to make a \nFIGURE 36-9. \n$OEX implied versus historical volatility, 1997-1998. \nActual \n40 \n30 \n10 \n0 \nD J F M A \n-20 1997 1998 \nChapter 36: The Basics of Volatility Trading 743 \nprediction that is somewhat \"middle of the road,\" since an extreme prediction is \nmore likely to be wrong. Of course, it turns out to be wrong anyway, since actual \nvolatility jumps around quite rapidly. \nThe few charts that have been presented here don't constitute a rigorous study \nupon which to draw the conclusion that implied volatility is a poor predictor of actu\nal volatility, but it is this author's firm opinion that that statement is true. A graduate \nstudent looking for a master's thesis topic could take it from here. \nVOLATILITY TRADING \nAs a result of the fact that implied volatility can sometimes be at irrational extremes, \noptions may sometimes trade with implied volatilities that are significantly out of line \nwith what one would normally expect. For example, suppose a stock is in a relatively \nnonvolatile period, like the price of the stock in Figure 36-2, just before point A on \nthe graph. During that time, option sellers would probably become more aggressive \nwhile option buyers, who probably have been seeing their previous purchases decay\ning with time, become more timid. As a result, option prices drop. Alternatively stat\ned, implied volatility drops. When implied volatilities are decreasing, option sellers \nare generally happy (and may often become more aggressive), while option buyers \nare losing money (and may often tend to become more timid). This is just a function \nof looking at the profit and loss statements in one's option account. But anyone who \ntook a longer backward look at the volatility of the stock in Figure 36-2 would see that \nit had been much more volatile in the past. Consequently, he might decide that the \nimplied volatility of the options had gotten too low and he would be", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 329}
{"text": "ey (and may often tend to become more timid). This is just a function \nof looking at the profit and loss statements in one's option account. But anyone who \ntook a longer backward look at the volatility of the stock in Figure 36-2 would see that \nit had been much more volatile in the past. Consequently, he might decide that the \nimplied volatility of the options had gotten too low and he would be a buyer of \noptions. \nIt is the volatility trader's objective to spot situations when implied volatility is \npossibly or probably erroneous and to take a position that would profit when the \nerror is brought to light. Thus, the volatility trader's main objective is spotting situa\ntions when implied volatility is overvalued or undervalued, irrespective of his outlook \nfor the underlying stock itself. In some ways, this is not so different from the funda\nmental stock analyst who is attempting to spot overvalued or undervalued stocks, \nbased on earnings and other fundamentals. \nFrom another viewpoint, volatility trading is also a contrarian theory of invest\ning. That is, when everyone else thinks the underlying is going to be nonvolatile, the \nvolatility trader buys volatility. When everyone else is selling options and option buy\ners are hard to find, the volatility trader steps up to buy options. Of course, some rig\norous analysis must be done before the volatility trader can establish new positions, \nbut when those situations come to light, it is most likely that he is taking positions \nopposite to what \"the masses\" are doing. He will be buying volatility when the major-\n744 Part VI: Measuring and Trading Volatility \nity has been selling it (or at least, when the majority is refusing to buy it), and he will \nbe selling volatility when everyone else is panicking to buy options, making them \nquite expensive. \nWHY DOES VOLATILITY REACH EXTREMES? \nOne can't just buy every option that he considers to be cheap. There must be some \nconsideration given to what the probabilities of stock movement are. Even more \nimportant, one can't just sell every option that he values as expensive. There may be \nvalid reasons why options become expensive, not the least of which is that someone \nmay have inside information about some forthcoming corporate news (a takeover or \nan earnings surprise, for example). \nSince options off er a good deal of leverage, they are an attractive vehicle to any\none who wants to make a quick trade, especially if that person believes he knows \nsomething that the general public doesn't know. Thus, if there is a leak of a takeover \nrumor - whether it be from corporate officers, investment bankers, printers, or \naccountants - whoever possesses that information may quite likely buy options \naggressively, or at least bid for them. Whenever demand for an option outstrips sup\nply - in this case, the major supplier is probably the market-maker - the options \nquickly get more expensive. That is, implied volatility increases. \nIn fact, there are financial analysts and reporters who look for large increases in \ntrading volume as a clue to which stocks might be ready to make a big move. \nInvariably, if the trading volume has increased and if implied volatility has increased \nas well, it is a good warning sign that someone with inside information is buying the \noptions. In such a case, it might not be a good idea to sell volatility, even though the \noptions are mathematically expensive. \nSometimes, even more minor news items are known in advance by a small seg\nment of the investing community. If those items will be enough to move the stock \neven a couple of points, those who possess the information may try to buy options in \nadvance of the news. Such minor news items might include the resignation or firing \nof a high-ranking corporate officer, or perhaps some strategic alliance with another \ncompany, or even a new product announcement. \nThe seller of volatility can watch for two things as warning signs that perhaps \nthe options are \"predicting\" a corporate event (and hence should be avoided as a \n\"volatility sale\"). Those two things are a dramatic increase in option volume or a sud\nden jump in implied volatility of the options. One or both can be caused by traders \nwith inside information trying to obtain a leveraged instrument in advance of the \nactual corporate news item being made public. \nChapter 36: The Basics of Volatility Trading 745 \nA SUDDEN INCREASE IN OPTION VOLUME OR IMPLIED VOLATILITY \nThe symptoms of insider trading, as evidenced by a large increase in option trading \nactivity, can be recognized. Typically, the majority of the increased volume occurs in \nthe near-term option series, particularly the at-the-money strike and perhaps the next \nstrike out-of-the-money. The activity doesn't cease there, however. It propagates out \nto other option series as market-makers (who by the nature of their job function are \nshort the near-term options that those with insider knowledge are buying) snap up \neverything on the books that they can find. In addition, the market-makers may try \nto entice others, perhaps institutions, to sell some expensive calls against a portion of \ntheir institutional stock holdings. Activity of this sort should be a warning sign to the \nvolatility seller to stand aside in this situation. \nOf course, on any given day there are many stocks whose options are extraordi\nnarily active, but the increase in activity doesn't have anything to do with insider trad\ning. This might include a large covered call write or maybe a large put purchase \nestablished by an institution as a hedge against an existing stock position, or a rela\ntively large conversion or reversal arbitrage established by an arbitrageur, or even a \nlarge spread transaction initiated by a hedge fund. In any of these cases, option vol\nume would jump dramatically, but it wouldn't mean that anyone had inside knowl\nedge about a forthcoming corporate event. Rather, the increases in option trading \nvolume as described in t", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 330}
{"text": "t an existing stock position, or a rela\ntively large conversion or reversal arbitrage established by an arbitrageur, or even a \nlarge spread transaction initiated by a hedge fund. In any of these cases, option vol\nume would jump dramatically, but it wouldn't mean that anyone had inside knowl\nedge about a forthcoming corporate event. Rather, the increases in option trading \nvolume as described in this paragraph are merely functions of the normal workings \nof the marketplace. \nWhat distinguishes these arbitrage and hedging activities from the machina\ntions of insider trading is: (1) There is little propagation of option volume into other \nseries in the \"benign\" case, and (2) the stock price itself may languish. However, \nwhen true insider activity is present, the market-makers react to the aggressive \nnature of the call buying. These market-makers know they need to hedge themselves, \nbecause they do not want to be short naked call options in case a takeover bid or \nsome other news spurs the stock dramatically higher. As mentioned earlier, they try \nto buy up any other options offered in \"the book,\" but there may not be many of \nthose. So, as a last result, the way they reduce their negative position delta is to buy \nstock. Thus, if the options are active and expensive, and if the stock is rising too, you \nprobably have a reasonably good indication that \"someone knows something.\" \nHowever, if the options are expensive but none of the other factors are present, espe\ncially if the stock is declining in price - then one might feel more comfortable with a \nstrategy of selling volatility in this case. \nHowever, there is a case in which options might be the object of pursuit by \nsomeone with insider knowledge, yet not be accompanied by heavy trading volume. \nThis situation could occur with illiquid options. In this case, a floor broker holding \n746 Part VI: Measuring and Trading Volatility \nthe order of those with insider information might come into the pit to buy options, \nbut the market-makers may not sell them many, preferring to raise their offering \nprice rather than sell a large quantity. If this happens a few times in a row, the options \nwill have gotten very expensive as the floor broker raises his bid price repeatedly, but \nonly buys a few contracts each time. Meanwhile, the market-maker keeps raising his \noffering price. \nEventually, the floor broker concludes that the options are too expensive to \nbother with and walks away. Perhaps his client then buys stock. In any case, what has \nhappened is that the options have gotten very expensive as the bids and offers were \nrepeatedly raised, but not much option volume was actually traded because of the \nilliquidity of the contracts. Hence the normal warning light associated with a sudden \nincrease in option volume would not be present. In this case, though, a volatility sell\ner should still be careful, because he does not want to step in to sell calls right before \nsome major corporate news item is released. The clue here is that implied volatility \nliterally exploded in a short period of time (one day, or actually less time), and that \nalone should be enough warning to a volatility seller. \nThe point that should be taken here is that when options suddenly become very \nexpensive, especially if accompanied by strong stock price movement and strong \nstock volume, there may very well be a good reason why that is happening. That rea\nson will probably become public knowledge shortly in the form of a news event. In \nfact, a major market-maker once said he believed that rrwst increases in implied \nvolatility were eventually justified - that is, some corporate news item was released \nthat made the stock jump. Hence, a volatility seller should avoid situations such as \nthese. Any sudden increase in implied volatility should probably be viewed as a \npotential news story in the making. These situations are not what a neutral volatility \nseller wants to get into. \nOn the other hand, if options have become expensive as a result of corporate \nnews, then the volatility seller can feel more comfortable making a trade. Perhaps the \ncompany has announced poor earnings and the stock has taken a beating while \nimplied volatility rose. In this situation, one can assess the information and analyze it \nclearly; he is not dealing with some hidden facts known to only a few insider traders. \nWith clear analysis, one might be able to develop a volatility selling strategy that is \nprudent and potentially profitable. \nAnother situation in which options become expensive in the wake of market \naction is during a bear market in the underlying. This can be true for indices, stocks, \nand futures contracts. The Crash of '87 is an extreme example, but implied volatility \nshot through the roof during the crash. Other similar sharp market collapses - such \nas October 1989, October 1997, and August-September 1998 - caused implied \nvolatility to jump dramatically. In these situations, the volatility seller knows why \nChapter 31,: 1be Basics of Volatility Trading 747 \nimplied volatility is high. Given that fact, he can then construct positions around a \nneutral strategy or around his view of the future. The time when the volatility seller \nmust be careful is when the options are expensive and no one seems to know why. \nThat's when insider trading may be present, and that's when the volatility seller \nshould defer from selling options. \nCHEAP OPTIONS \nWhen options are cheap, there are usually far less discernible reasons why they have \nbecome cheap. An obvious one may be that the corporate structure of the company \nhas changed; perhaps it is being taken over, or perhaps the company· has acquired \nanother company nearly its size. In either case, it is possible that the combined enti\nty's stock will be less volatile than the original company's stock was. As the takeover \nis in the process of being consummated, the implied volatility of the company's \noptions will drop, giving the false", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 331}
{"text": "tructure of the company \nhas changed; perhaps it is being taken over, or perhaps the company· has acquired \nanother company nearly its size. In either case, it is possible that the combined enti\nty's stock will be less volatile than the original company's stock was. As the takeover \nis in the process of being consummated, the implied volatility of the company's \noptions will drop, giving the false impression that they are cheap. \nIn a similar vein, a company may mature, perhaps issuing more shares of stock, \nor perhaps building such a.., good earnings stream that the stock is considered less \nvolatile than it formerly was. Some of the Internet companies will be classic cases: In \nthe beginning they were high-flying stocks with plenty of price movement, so the \noptions traded with a relatively high degree of implied volatility. However, as the com\npany matures, it buys other Internet companies and then perhaps even merges with a \nlarge, established company (America Online and Time-Warner Communications, for \nexample). In these cases, actual (statistical) volatility will diminish as the company \nmatures, and implied volatility will do the same. On the surface, a buyer of volatility \nmay see the reduced volatility as an attractive buying situation, but upon further \ninspection he may find that it is justified. If the decrease in implied volatility seems \njustified, a buyer of volatility should ignore it and look for other opportunities. \nAll volatility traders should be suspicious when volatility seems to be extreme -\neither too expensive or too cheap. The trader should investigate the possibilities as to \nwhy volatility is trading at such extreme levels. In some cases, the supply and demand \nof the public just pushes the options to extreme levels; there is nothing more involved \nthan that. Those are the best volatility trading situations. However, if there is a hint \nthat the volatility has gotten to an extreme reading because of some logical (but per\nhaps nonpublic) reason, then the volatility trader should be suspicious and should \nprobably avoid the trade. Typically this happens with expensive options. \nBuyers of volatility really have little to fear if they miscalculate and thus buy an \noption that appears inexpensive but turns out not to be, in reality. The volatility buyer \nmight lose money if he does this, and overpaying for options constantly will lead to \nruin, but an occasional mistake will probably not be fatal. \n748 Part VI: Measuring and Trading Volatility \nSellers of volatility, however, have to be a lot more careful. One mistake could \nbe the last one. Selling naked calls that seem terrifically expensive by historic stan\ndards could be ruinous if a takeover bid subsequently emerges at a large premium to \nthe stock's current price. Even put sellers must be careful, although a lot of traders \nthink that selling naked puts is safe because it's the same as buying stock. But who \never said buying stock wasn't risky? If the stock literally collapses - falling from 80, \nsay, to 15 or 20, as Oxford Health did, or from 30 to 2 as Sunrise Technology did -\nthen a put seller will be buried. Since the risk of loss from naked option selling is \nlarge, one could be wiped out by a huge gap opening. That's why it's imperative to \nstudy why the options are expensive before one sells them. If it's known, for exam\nple, that a small biotech company is awaiting FDA trial results in two weeks,~and all \nthe options suddenly become expensive, the volatility seller should not attempt to be \na hero. It's obvious that at least some traders believe that there is a chance for the \nstock to gap in price dramatically. It would be better to find some other situation in \nwhich to sell options. \nThe seller of futures options or index options should be cautious too, although \nthere can't be takeovers in those markets, nor can there be a huge earnings surprise \nor other corporate event that causes a big gap. The futures markets, though do have \nthings like crop reports and government economic data to deal with, and those can \ncreate volatile situations, too. The bottom line is that volatility selling - even hedged \nvolatility selling - can be taxing and aggravating if one has sold volatility in front of \nwhat turns out to be a news item that justifies the expensive volatility. \nSUMMARY \nVolatility trading is a predictable way to approach the market, because volatility \nalmost invariably trades in a range and therefore its value can be estimated with a \ngreat deal more precision than can the actual prices of the underlyings. Even so, one \nmust be careful in his approach to volatility trading, because diligent research is \nneeded to determine if, in fact, volatility is \"cheap\" or \"expensive.\" As with any sys\ntematic approach to the market, if one is sloppy about his research, he cannot expect \nto achieve superior results. In the next few chapters, a good deal of time will be spent \nto give the reader a good understanding of how volatility affects positions and how it \ncan be used to construct trades with positive expected rates of return. \n· GHAR:f ER :8'7 . . -\nHow Volatility Affects \nPopular Strategies \nThe previous chapter addressed the calculation or interpretation of implied volatili\nty, and how to relate it to historic volatility. Another, related topic that is important is \nhow implied volatility affects a specific option strategy. Simplistically, one might think \nthat the effect of a change in implied volatility on an option position would be a sim\nple matter to discern; but in reality, most traders don't have a complete grasp of the \nways that volatility affects option positions. In some cases, especially option spreads \nor more complex positions, one may not have an intuitive \"picture\" of how his posi\ntion is going to be affected by a change in implied volatility. In this chapter, we'll \nattempt a relatively thorough review of how implied volatility changes affect most of \nthe popular option strategies.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 332}
{"text": "complete grasp of the \nways that volatility affects option positions. In some cases, especially option spreads \nor more complex positions, one may not have an intuitive \"picture\" of how his posi\ntion is going to be affected by a change in implied volatility. In this chapter, we'll \nattempt a relatively thorough review of how implied volatility changes affect most of \nthe popular option strategies. \nThere are ways to use computer analysis to \"draw\" a picture of this volatiiity \neffect, of course, and that will be discussed momentarily. But an option strategist \nshould have some idea of the general changes that a position will undergo if implied \nvolatility changes. Before getting into the individual strategies, it is important that \none understands some of the basics of the effect of volatility on an option's price. \nVEGA \nTechnically speaking, the term that one uses to quantify the impact of volatility \nchanges on the price of an option is called the vega of the option. In this chapter, the \nreferences will be to vega, but the emphasis here is on practicality, so the descriptions \n749 \n750 Part VI: Measuring and Trading Volatility \nof how volatility affects option positions will be in plain English as well as in the more \nmathematical realm of vega. Having said that, let's define vega so that it is understood \nfor later use in the chapter. \nSimply stated, vega is the amount by which an option's price changes when \nvolatility changes by one percentage point. \nExample: XYZ is selling at 50, and the July 50 call is trading at 7.25. Assume that \nthere is no dividend, that short-term interest rates are 5%, and that July expiration is \nexactly three months away. With this information, one can determine that the implied \nvolatility of the July 50 call is 70%. That's a fairly high number, so one can surmise \nthat XYZ is a volatile stock. What would the option price be if implied volatility were \nrise to 71 %? Using a model, one can determine that the July 50 call would theoreti\ncally be worth 7.35 if that happened. Hence, the vega of this option is 0.10 (to two \ndecimal places). That is, the option price increased by 10 cents, from 7.25 to 7.35, \nwhen volatility rose by one percentage point. (Note that \"percentage point\" here \nmeans a full point increase in volatility, from 70% to 71 %.) \nWhat if implied volatility had decreased instead? Once again, one can use the \nmodel to determine the change in the option price. In this case, using an implied \nvolatility of 69% and keeping everything else the same, the option would then theo\nretically be worth 7.15- again, a 0.10 change in price (this time, a decrease in price). \nThis example points out an interesting and important aspect of how volatility \naffects a call option: If implied volatility increases, the price of the option will \nincrease, and if implied volatility decreases, the price of the option will decrease. \nThus, there is a direct relationship between an option's price and its implied volatili-\nty. \nMathematically speaking, vega is the partial derivative of the Black-Scholes \nmodel (or whatever model you're using to price options) with respect to volatility. In \nthe above example, the vega of the July 50 call, with XYZ at 50, can be computed to \nbe 0.098 - very near the value of 0.10 that one arrived at by inspection. \nVega also has a direct relationship with the price of a put. That is, as implied \nvolatility rises, the price of a put will rise as well. \nExample: Using the same criteria as in the last example, suppose that XYZ is trading \nat 50, that July is three months away, that short-term interest rates are 5%, and that \nthere is no dividend. In that case, the following theoretical put and call prices would \napply at the stated implied volatilities: \nChapter 37: How Volatility Affects Popular Strategies 751 \nStock Price July 50 call July 50 put Implied Volatility Put's Vega \n50 7.15 6.54 69% 0.10 \n7.25 6.64 70% 0.10 \n7.35 6.74 71% 0.10 \nThus, the put's vega is 0.10, too - the same as the call's vega was. \nIn fact, it can be stated that a call and a put with the same terms have the same \nvega. To prove this, one need only refer to the arbitrage equation for a conversion. If \nthe call increases in price and everything else remains equal - interest rates, stock \nprice, and striking price - then the put price must increase by the same amount. A \nchange in implied volatility will cause such a change in the call price, and a similar \nchange in the put price. Hence, the vega of the put and the call must be the same. \nIt is also important to know how the vega changes as other factors change, par\nticularly as the stock price changes, or as time changes. The following examples con\ntain several tables that illustrate the behavior of vega in a typically fluctuating envi\nronment. \nExample: In this case, let the stock price fluctuate while holding interest rate (5% ), \nimplied volatility (70%), time (3 months), dividends (0), and the strike price (50) con\nstant. See Table 37-1. \nIn these cases, vega drops when the stock price does, too, but it remains fairly \nconstant if the stock rises. It is interesting to note, though, that in the real world, \nwhen the underlying drops in price especially if it does so quickly, in a panic mode \n- implied volatility can increase dramatically. Such an increase may be of great ben\nefit to a call holder, serving to mitigate his losses, perhaps. This concept will be dis\ncussed further later in this chapter. \nTABLE 37-1 \nImplied Volatility Theoretical \nStock Price July 50 Call Price Coll Price Vega \n30 70% 0.47 0.028 \n40 2.62 0.073 \n50 7.25 0.098 \n60 14.07 0.092 \n70 22.35 0.091 \n752 Part VI: Measuring and Trading Volatility \nThe above example assumed that the stock was making instantaneous changes \nin price. In reality, of course, time would be passing as well, and that affects the vega \ntoo. Table 37-2 shows how the vega changes when time changes, all other factors \nbeing equal. \nExample: In this example, the follow", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 333}
{"text": "2 0.073 \n50 7.25 0.098 \n60 14.07 0.092 \n70 22.35 0.091 \n752 Part VI: Measuring and Trading Volatility \nThe above example assumed that the stock was making instantaneous changes \nin price. In reality, of course, time would be passing as well, and that affects the vega \ntoo. Table 37-2 shows how the vega changes when time changes, all other factors \nbeing equal. \nExample: In this example, the following items are held fixed: stock price (50), strike \nprice (50), implied volatility (70%), risk-free interest rate (5%), and dividend\\(0). But \nnow, we let time fluctuate. \nTable 37-2 clearly shows that the passage of time results not only in a decreas\ning call price, but in a decreasing vega as well. This makes sense, of course, since one \ncannot expect an increase in implied volatility to have much of an effect on a very \nshort-term option - certainly not to the extent that it would affect a LEAPS option. \nSome readers might be wondering how changes in implied volatility itself would \naffect the vega. This might be called the \"vega of the vega,\" although I've never actu\nally heard it referred to in that manner. The next table explores that concept. \nExample: Again, some factors will be kept constant - the stock price (50), the time \nto July expiration (3 months), the risk-free interest rate (5%), and the dividend (0). \nTable 37-3 allows implied volatility to fluctuate and shows what the theoretical price \nof a July 50 call would be, as well as its vega, at those volatilities. \nThus, Table 37-3 shows that vega is surprisingly constant over a wide range of \nimplied volatilities. That's the real reason why no one bothers with \"vega of the vega.\" \nVega begins to decline only if implied volatility gets exceedingly high, and implied \nvolatilities of that magnitude are relatively rare. \nOne can also compute the distance a stock would need to rise in order to over\ncome a decrease in volatility. Consider Figure 37-1, which shows the theoretical price \nTABLE 37-2 \nImplied Time Theoretical \nStock Price Volatility Remaining Call Price Vega \n50 70% One year 14.60 0.182 \nSix months 10.32 0.135 \nThree months 7.25 0.098 \nTwo months 5.87 0.080 \nOne month 4.16 0.058 \nTwo weeks 2.87 0.039 \nOne week 1.96 0.028 \nOne day 0.73 0.010 \nChapter 37: How Volatility Affeds Popular Strategies \nTABLE 37-3 \nImplied \nStock Price Volatility \n50 10% \n30% \n50% \n70% \n100% \n150% \n200% \nTheoretical \nColl Price \n1.34 \n3.31 \n5.28 \n7.25 \n10.16 \n14.90 \n19.41 \n753 \nVega \n0.097 \n0.099 \n0.099 \n0.098 \n0.096 \n0.093 \n0.088 \nof a 6-month call option with differing implied volatilities. Suppose one buys an \noption that currently has implied volatility of 170% (the top curve on the graph). \nLater, investor perceptions of volatility diminish, and the option is trading with an \nimplied volatility of 140%. That means that the option is now \"residing\" on the sec\nond curve from the top of the list. Judging from the general distance between those \ntwo curves, the option has probably lost between 5 and 8 points of value due to the \ndrop in implied volatility. \nHere's another way to think about it. Again, suppose one buys an at-the-money \noption (stock price = 100) when its implied volatility is 170%. That option value is \nmarked as point A on the graph in Figure 37-1. Later, the option's implied volatility \ndrops to 140%. How much does the stock have to rise in order to overcome the loss \nof implied volatility? The horizontal line from point A to point B shows that the \noption value is the same on each line. Then, dropping a vertical line from B down to \npoint C, we see that point C is at a stock price of about 109. Thus, the stock would \nhave to rise 9 points just to keep the option value constant, if implied volatility drops \nfrom 170% to 140%. \nIMPLIED VOLATILITY AND DELTA \nFigure 37-1 shows another rather unusual effect: When implied volatility gets very \nhigh, the delta of the option doesn't change much. Simplistically, the delta of an \noption measures how much the option changes in price when the stock moves one \npoint. Mathematically, the delta is the first partial derivative of the option model with \nrespect to stock price. Geometrically, that means that the delta of an option is the \nslope of a line drawn tangent to the curve in the preceding chart. \n754 Part VI: Measuring and Trading Volatility \nFIGURE 37-1. \nTheoretical option prices at differing implied \nvolatilities (6-month calls). \n80 \n70 \nQ) 60 \n(.) \n·;::: \nCl.. 50 \nC: \n0 \n·a 40 \n0 \n30 \n20 \n10 \nStock Price \n60 80 100 C 120 140 \n_JY.._ \n170% \n140% \n110% \n80% \n50% \n20% \nThe bottom line in Figure 37-1 (where implied volatility= 20%) has a distinct \ncurvature to it when the stock price is between about 80 and 120. Thus the delta \nranges from a fairly low number (when the stock is near 80) to a rather high number \n(when the stock is near 120). Now look at the top line on the chart, where implied \nvolatility= 170%. It's almost a straight line from the lower left to the upper right! The \nslope of a straight line is constant. This tells us that the delta (which is the slope) \nbarely changes for such an expensive option - whether the stock is trading at 60 or \nit's trading at 150! That fact alone is usually surprising to many. \nIn addition, the value of this delta can be measured: It's 0. 70 or higher from a \nstock price of 80 all the way up to 150. Among other things, this means that an out~ \nof-the-money option that has extremely high implied volatility has a fairly high delta \n- and can be expected to mirror stock price movements more closely than one might \nthink, were he not privy to the delta. \nFigure 37-2 follows through on this concept, showing how the delta of an option \nvaries with implied volatility. From this chart, it is clear how much the delta of an \noption varies when the implied volatility is 20%, as compared to how little it varies \nwhen implied volatility is extremely high. \nThat data is interesting enough by itself, but it becomes even more thought-pro\nvoking when one conside", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 334}
{"text": "gure 37-2 follows through on this concept, showing how the delta of an option \nvaries with implied volatility. From this chart, it is clear how much the delta of an \noption varies when the implied volatility is 20%, as compared to how little it varies \nwhen implied volatility is extremely high. \nThat data is interesting enough by itself, but it becomes even more thought-pro\nvoking when one considers that a change in the implied volatility of his option (vega) \nalso can mean a significant change in the delta of the option. In one sense, it explains \nwhy, in the first chart (Figure 37-1), the stock could rise 9 points and yet the option \nholder made nothing, because implied volatility declined from 170% to 140%. \nChapter 37: How Volatility Affects Popular Strategies \nEFFECTS ON NEUTRALITY \n755 \nA popular concept that uses delta is the \"delta-neutral\" spread a spread whose prof\nitability is supposedly ambivalent to market movement, at least for short time frames \nand limited stock price changes. Anything that significantly affects the delta of an \noption can affect this neutrality, thus causing a delta-neutral position to become \nunbalanced ( or, more likely, causing one's intuition to be wrong regarding what con\nstitutes a delta-neutral spread in the first place). \nLet's use a familiar strategy, the straddle purchase, as an example. Simplistically, \nwhen one buys a straddle, he merely buys a put and a call with the same terms and \ndoesn't get any fancier than that. However, it may be the case that, due to the deltas \nof the options involved, that approach is biased to the upside, and a neutral straddle \nposition should be established instead. \nExample: Suppose that XYZ is trading at 100, that the options have an implied \nvolatility of 40%, and that one is considering buying a six-month straddle with a strik\ning price of 100. The following data summarize the situation, including the option \nprices and the deltas: \nXYZ Common: l 00; Implied Volatility: 40% \nOption \nXYZ October l 00 call \nXYZ October l 00 put \nFIGURE 37-2. \nPrice \n12.00 \n10.00 \nDelta \n0.60 \n-0.40 \nValue of delta of a 6-month option at differing implied volatilities. \n90 \n80 \n70 \n.!!l \nai 60 \nCl \nC: 50 ,g \n8° 40 \n30 \n20 \n10 \n60 80 100 \nStock Price \n120 140 \n756 Part VI: Measuring and Trading Volatility \nNotice that the stock price is equal to the strike price (100). However, the deltas \nare not at all equal. In fact, the delta of the call is 1.5 times that of the put (in absolute \nvalue). One must buy three puts and two calls in order to have a delta-neutral posi\ntion. \nMost experienced option traders know that the delta of an at-the-money call is \nsomewhat higher than that of an at-the-money put. Consequently, they often esti\nmate, without checking, that buying three puts and two calls produces a delta-neu\ntral \"straddle buy.\" However, consider a similar situation, but with a much higher \nimplied volatility- 110%, say. \nAAA Common: 100; Implied Volatility: 110% \nOption \nAAA October 100 call \nAAA October 1 00 put \nPrice \n31.00 \n28.00 \nDelta \n0.67 \n-0.33 \nThe delta-neutral ratio here is two-to-one (67 divided by 33), not three-to-two \nas in the earlier case - even though both stock prices are 100 and both sets of options \nhave six months remaining. This is a big difference in the delta-neutral ratio, espe\ncially if one is trading a large quantity of options. This shows how different levels of \nimplied volatility can alter one's perception of what is a neutral position. It also points \nout that one can't necessarily rely on his intuition; it is always best to check with a \nmodel. \nCarrying this thought a step further, one must be mindful of a change in implied \nvolatility if he wants to keep his position delta-neutral. If the implied volatility of AAA \noptions should drop significantly, the 2-to-l ratio will no longer be neutral, even if the \nstock is still trading at 100. Hence, a trader wishing to remain delta-neutral must \nmonitor not only changes in stock price, but changes in implied volatility as well. For\nmore complex strategies, one will also find the delta-neutral ratio changing due to a \nchange in implied volatility. \nThe preceding examples summarize the major variables that might affect the \nvega and also show how vega affects things other than itself, such as delta and, there\nfore, delta neutrality. By the way, the vega of the underlying is zero; an increase in \nimplied volatility does not affect the price of the underlying instrument at all, in the\nory. In reality, if options get very expensive (i.e., implied volatility spikes up), that \nusually brings traders into a stock and so the stock price will change. But that's not a \nmathematical relationship, just a market cause-and-effect relationship. \nChapter 37: How Volatility Affects Popular Strategies \nPOSITION VEGA \n757 \nAs can be done with delta or with any other of the partial derivatives of the model, \none can compute a position vega - the vega of an entire position. The position vega \nis determined by multiplying the individual option vegas by the quantity of options \nbought or sold. The \"position vega\" is merely the quantity of options held, times the \nvega, times the shares per options ( which is normally 100). \nExample: Using a simple call spread as an example, assume the following prices \nexist: \nSecurity Position Vega Position Vego \nXYZ Stock No position \nXYZ July 50 call Long 3 calls 0.098 +0.294 \nXYZ July 70 call Short 5 calls 0.076 -0.380 \nNet Position Vega: -0.086 \nThis concept is very important to a volatility trader, for it tells him if he has con\nstructed a position that is going to behave in the manner he expects. For example, \nsuppose that one identifies expensive options, and he figures that implied volatility \nwill decrease, eventually becoming more in line with its historical norms. Then he \nwould want to construct a position with a negative position vega. A negative position \nvega indicates that the position will profit if implied volatility de", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 335}
{"text": "position that is going to behave in the manner he expects. For example, \nsuppose that one identifies expensive options, and he figures that implied volatility \nwill decrease, eventually becoming more in line with its historical norms. Then he \nwould want to construct a position with a negative position vega. A negative position \nvega indicates that the position will profit if implied volatility decreases. Conversely, \na buyer of volatility - one who identifies some underpriced situation - would want to \nconstruct a position with a positive position vega, for such a position will profit if \nimplied volatility rises. In either case, other factors such as delta, time to expiration, \nand so forth will have an effect on the position's actual dollar profit, but the concept \nof position vega is still important to a volatility trader. It does no good to identify \ncheap options, for example, and then establish some strange spread with a negative \nposition vega. Such a construct would be at odds with one's intended purpose - in \nthis case, buying cheap options. \nOUTRIGHT OPTION PURCHASES AND SALES \nLet us now begin to investigate the affects of implied volatility on various strategies, \nbeginning with the simplest strategy of all - the outright option purchase. It was \nalready shown that implied volatility affects the price of an individual call or put in a \n758 Part VI: Measuring and Trading Volatility \ndirect manner. That is, an increase in implied volatility will cause the option price to \nrise, while a decrease in volatility will cause a decline in the option price. That piece \nof information is the most important one of all, for it imparts what an option trader \nneeds to know: An explosion in implied volatility is a boon to an option owner, but \ncan be a devastating detriment to an option seller, especially a naked option seller. \nA couple of examples might demonstrate more clearly just how powerful the \neffect of implied volatility is, even when there isn't much time remaining in the life \nof an option. One should understand the notion that an increase in implied volatility \ncan overcome days, even weeks, of time decay. This first example attempts to quan\ntify that statement somewhat. \nExample: Suppose that XYZ is trading at 100 and one is interested in analyzing a 3-\nmonth call with striking price of 100. Furthermore, suppose that implied volatility is \ncurrently at 20%. Given these assumptions, the Black-Scholes model tells us that the \ncall would be trading at a price of 4.64. \nStock Price: \nStrike Price: \nTime Remaining: \nImplied Volatility: \nTheoretical Call Value: \n100 \n100 \n3 months \n20% \n4.64 \nNow, suppose that a month passes. If implied volatility remained the same \n(20% ), the call would lose nearly a point of value due to time decay. However, how \nmuch would implied volatility have had to increase to completely counteract the \neffect of that time decay? That is, after a month has passed, what implied volatility \nwill yield a call price of 4.64? lt turns out to be just under 26%. \nStock Price: \nStrike Price: \nTime Remaining: \nImplied Volatility: \nTheoretical Call Value: \n100 \n100 \n2 months \n25.9% \n4.64 \nWhat would happen after another month passes? There is, of course, some \nimplied volatility at which the call would still be worth 4.64, but is it so high as to be \nunreasonable? Actually, it turns out that if implied volatility increases to about 38%, \nthe call will still be worth 4.64, even with only one month of life remaining: \nChapter 37: How Volatility Affects Popular Strategies \nStock Price: \nStrike Price: \nTime Remaining: \nImplied Volatility: \nTheoretical Call Value: \n100 \n100 \n1 month \n38.1% \n4.64 \n759 \nSo, if implied volatility increases from 20% to 26% over the first month, then \nthis call option would still be trading at the same price - 4.64. That's not an unusual \nincrease in implied volatility; increases of that magnitude, 20% to 26%, happen all \nthe time. For it to then increase from 26% to 38% over the next month is probably \nless likely, but it is certainly not out of the question. There have been many times in \nthe past when just such an increase has been possible - during any of the August, \nSeptember, or October bear markets or mini-crashes, for example. Also, such an \nincrease in implied volatility might occur if there were takeover rumors in this stock, \nor if the entire market became more volatile, as was the case in the latter half of the \n1990s. \nPerhaps this example was distorted by the fact that an implied volatility of 20% \nis a fairly low number to begin with. What would a similar example look like if one \nstarted out with a much higher implied volatility - say, 80%? \nExample: Making the same assumptions as in the previous example, but now setting \nthe implied volatility to a much higher level of 80%, the Black-Scholes model now \nsays that the call would be worth a price of 16.45: \nStock Price: \nStrike Price: \nTime Remaining: \nImplied Volatility: \nTheoretical Call Value: \n100 \n100 \n3 months \n80% \n16.45 \nAgain, one must ask the question: \"If a month passes, what implied volatility \nwould be necessary for the Black-Scholes model to yield a price of 16.45?\" In this \ncase, it turns out to be an implied volatility of just over 99%. \nStock Price: \nStrike Price: \nTime Remaining: \nImplied Volatility: \nTheoretical Call Value: \n100 \n100 \n2 months \n99.4% \n16.45 \n758 Part VI: Measuring and Trading Volatility \ndirect manner. That is, an increase in implied volatility will cause the option price to \nrise, while a decrease in volatility will cause a decline in the option price. That piece \nof information is the most important one of all, for it imparts what an option trader \nneeds to know: An explosion in implied volatility is a boon to an option owner, but \ncan be a devastating detriment to an option seller, especially a naked option seller. \nA couple of examples might demonstrate more clearly just how powerful the \neffect of implied volatility is, even when there is", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 336}
{"text": "e. That piece \nof information is the most important one of all, for it imparts what an option trader \nneeds to know: An explosion in implied volatility is a boon to an option owner, but \ncan be a devastating detriment to an option seller, especially a naked option seller. \nA couple of examples might demonstrate more clearly just how powerful the \neffect of implied volatility is, even when there isn't much time remaining in the life \nof an option. One should understand the notion that an increase in implied volatility \ncan overcome days, even weeks, of time decay. This first example attempts to quan\ntify that statement somewhat. \nExample: Suppose that XYZ is trading at 100 and one is interested in analyzing a 3-\nmonth call with striking price of 100. Furthermore, suppose that implied volatility is \ncurrently at 20%. Given these assumptions, the Black-Scholes model tells us that the \ncall would be trading at a price of 4.64. \nStock Price: \nStrike Price: \nTime Remaining: \nImplied Volatility: \nTheoretical Call Value: \n100 \n100 \n3 months \n20% \n4.64 \nNow, suppose that a month passes. If implied volatility remained the same \n(20% ), the call would lose nearly a point of value due to time decay. However, how \nmuch would implied volatility have had to increase to completely counteract the \neffect of that time decay? That is, after a month has passed, what implied volatility \nwill yield a call price of 4.64? It turns out to be just under 26%. \nStock Price: \nStrike Price: \nTime Remaining: \nImplied Volatility: \nTheoretical Call Value: \n100 \n100 \n2 months \n25.9% \n4.64 \nWhat would happen after another month passes? There is, of course, some \nimplied volatility at which the call would still be worth 4.64, but is it so high as to be \nunreasonable? Actually, it turns out that if implied volatility increases to about 38%, \nthe call will still be worth 4.64, even with only one month of life remaining: \nChapter 37: How Volatility Affects Popular Strategies \nStock Price: \nStrike Price: \nTime Remaining: \nImplied Volatility: \nTheoretical Call Value: \n100 \n100 \n1 month \n38.1% \n4.64 \n759 \nSo, if implied volatility increases from 20% to 26% over the first month, then \nthis call option would still be trading at the same price 4.64. That's not an unusual \nincrease in implied volatility; increases of that magnitude, 20% to 26%, happen all \nthe time. For it to then increase from 26% to 38% over the next month is probably \nless likely, but it is certainly not out of the question. There have been many times in \nthe past when just such an increase has been possible - during any of the August, \nSeptember, or October bear markets or mini-crashes, for example. Also, such an \nincrease in implied volatility might occur if there were takeover rumors in this stock, \nor if the entire market became more volatile, as was the case in the latter half of the \n1990s. \nPerhaps this example was distorted by the fact that an implied volatility of 20% \nis a fairly low number to begin with. What would a similar example look like if one \nstarted out with a much higher implied volatility say, 80%? \nExample: Making the same assumptions as in the previous example, but now setting \nthe implied volatility to a much higher level of 80%, the Black-Scholes model now \nsays that the call would be worth a price of 16.45: \nStock Price: \nStrike Price: \nTime Remaining: \nImplied Volatility: \nTheoretical Call Value: \n100 \n100 \n3 months \n80% \n16.45 \nAgain, one must ask the question: \"If a month passes, what implied volatility \nwould be necessary for the Black-Scholes model to yield a price of 16.45?\" In this \ncase, it turns out to be an implied volatility of just over 99%. \nStock Price: \nStrike Price: \nTime Remaining: \nImplied Volatility: \nTheoretical Call Value: \n100 \n100 \n2 months \n99.4% \n16.45 \n760 Part VI: Measuring and Trading Volatility \nFinally, to be able to completely compare this example with the previous one, it \nis necessary to see what implied volatility would have to rise to in order to offset the \neffect of yet another month's time decay. It turns out to be over 140%: \nStock Price: \nStrike Price: \nTime Remaining: \nImplied Volatility: \nTheoretical Call Value: \n100 \n100 \n1 month \n140.9% \n16.45 \nTable 37-4 summarizes the results of these examples, showing the levels to \nwhich implied volatility would have to rise to maintain the call's value as time passes. \nAre the volatility increases in the latter example less likely to occur than the \nones in the former example? Probably yes - certainly the last one, in which implied \nvolatility would have to increase from 80% to nearly 141 % in order to maintain the \ncall's value. However, in another sense, it may seem more reasonable: Note that the \nincrease in volatility from 20% to 26% is a 30% increase. That is, 20% times 1.30 \nequals 26%. That's what's required to maintain the call's value for the lower volatility \nover the first month - an increase in the magnitude of implied volatility of 30%. At \nthe higher volatility, though, an increase in magnitude of only about 25% is required \n(from 80% to 99%). Thus, in those terms, the two appear on more equal footing. \nWhat makes the top line of Table 37-4 appear more likely than the bottom line \nis merely the fact that an experienced option trader knows that many stocks have \nimplied volatilities that can fluctuate in the 20% to 40% range quite easily. However, \nthere are far fewer stocks that have implied volatilities in the higher range. In fact, \nuntil the Internet stocks got hot in the latter portion of the 1990s, the only ones with \nvolatilities like those were very low-priced, extremely volatile stocks. Hence one's \nexperience factor is lower with such high implied volatility stocks, but it doesn't mean \nthat the volatility fluctuations appearing in Table 37-4 are impossible. \nIf the reader has access to a software program containing the Black-Scholes \nmodel, he can experiment with other situations to see how powerful the effect of \nimplied volatilit", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 337}
{"text": "re very low-priced, extremely volatile stocks. Hence one's \nexperience factor is lower with such high implied volatility stocks, but it doesn't mean \nthat the volatility fluctuations appearing in Table 37-4 are impossible. \nIf the reader has access to a software program containing the Black-Scholes \nmodel, he can experiment with other situations to see how powerful the effect of \nimplied volatility is. For example, without going into as much detail, if one takes the \ncase of a 12-month option whose initial implied volatility is 20%, all it takes to main-\nTABLE 37-4 \nInitial Implied \nVolatility \n20% \n80% \nVolatility Leveled Required to Maintain Call Value ... \n... After One Month ... After Two Months \n26% \n99% \n38% \n141% \nChapter 37: How Volatility Affects Popular Strategies 761 \ntain the call's value over a 6-month time period is an increase in implied volatility to \n27%. Taken from the viewpoint of the option seller, this is perhaps most enlighten\ning: If you sell a one-year (LEAPS) option and six months pass, during which time \nimplied volatility increases from 20% to 27% - certainly quite possible -you will have \nmade nothing! The call will still be selling for the same price, assuming the stock is \nstill selling for the same price. \nFinally, it was mentioned earlier that implied volatility often explodes during a \nmarket crash. In fact, one could determine just how much of an increase in implied \nvolatility would be necessary in a market crash in order to maintain the call's value. \nThis is similar to the first example in this section, but now the stock price will be \nallowed to decrease as well. Table 37-5, then, shows what implied volatility would be \nrequired to maintain the call's initial value (a price of 4.64), when the stock price falls. \nThe other factors remain the same: time remaining (3 months), striking price (100), \nand interest rate (5% ). Again, this table shows instantaneous price changes. In real \nlife, a slightly higher implied volatility would be necessary, because each market crash \ncould take a day or two. \nThus, from Table 37-5, one could say that even if the underlying stock dropped \n20 points (which is 20% in this case) in one day, yet implied volatility exploded from \n20% to 67% at the same time, the call's value would be unchanged! Could such an \noutrageous thing happen? It has: In the Crash of '87, the market plummeted 22% in \none day, while the Volatility Index ($VIX) theoretically rose from 36% to 150% in one \nday. In fact, call buyers of some $OEX options actually broke even or made a little \nmoney due to the explosion in implied volatility, despite the fact that the worst mar\nket crash in history had occurred. \nIf nothing else, these examples should impart to the reader how important it is \nto be aware of implied volatility at the time an option position is established. If you \nare buying options, and you buy them when implied volatility is \"low,\" you stand to \nTABLE 37-5 \nStock Price \n100 \n95 \n90 \n85 \n80 \n75 \n70 \nImplied Volatility Necessary for Call to Maintain Value \n20% (the initial parameters) \n33% \n44% \n55% \n67% \n78% \n89% \n762 Part VI: Measuring and Trading Volatility \nbenefit if implied volatility merely returns to \"normal\" levels while you hold the posi\ntion. Of course, having the underlying increase in price is also important. \nConversely, an option seller should be keenly aware of implied volatility when \nthe option is initially sold - perhaps even more so than the buyer of an option. This \npertains equally well to naked option writers and to covered option writers. If implied \nvolatility is \"too low\" when the option writing position is established, then an increase \n(or worse, an explosion) in implied volatility will be very detrimental to the position, \ncompletely overcoming the effects of time decay. Hence, an option writer should not \njust sell options because he thinks he is collecting time decay each day that passes. \nThat may be true, but an increase in implied volatility can completely domin.ate what \nlittle time decay might exist, especially for a longer-term option. \nIn a similar manner, a decrease in implied volatility can be just as important. \nThus, if the call buyer purchases options that are \"too costly,\" ones in which implied \nvolatility is \"too high,\" then he could lose money even if the underlying makes a mod\nest move in his favor. \nIn the next chapters, the topic of just how an option buyer or seller should \nmeasure implied volatility to determine what is \"too low\" or \"too high\" will be dis\ncussed. For now, suffice it to grasp the general concept that a change in implied \nvolatility can have substantial effects on an option's price far greater effects than the \npassage of time can have. \nIn fact, all of this calls into question just exactly what time value premium is. \nThat part of an option's value that is not intrinsic value is really affected much more \nby volatility than it is by time decay, yet it carries the term \"time value premium.\" \nTIME VALUE PREMIUM IS A MISNOMER \nMany (perhaps novice) option traders seem to think of time as the main antagonist to \nan option buyer. However, when one really thinks about it, he should realize that the \nportion of an option that is not intrinsic value is really much more related to stock \nprice movement and/or volatility than anything else, at least in the short term. For \nthis reason, it might be beneficial to more closely analyze just what the \"excess value\" \nportion of an option represents and why a buyer should not primarily think of it as \ntime value premium. \nAn option's price is composed of two parts: (1) intrinsic value, which is the \"real\" \npart of the option's value - the distance by which the option is in-the-money, and (2) \n\"excess value\" - often called time value premium. There are actually five factors that \naffect the \"excess value\" portion of an option. Eventually, time will dominate them \nChapter 37: How Volah'lity Affects Popular Strategies 763 \nall, but the longer", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 338}
{"text": "sed of two parts: (1) intrinsic value, which is the \"real\" \npart of the option's value - the distance by which the option is in-the-money, and (2) \n\"excess value\" - often called time value premium. There are actually five factors that \naffect the \"excess value\" portion of an option. Eventually, time will dominate them \nChapter 37: How Volah'lity Affects Popular Strategies 763 \nall, but the longer the life of the option, the more the other factors influence the \n\"excess value.\" \nThe five factors influencing excess value are: \n1. stock price movements, \n2. changes in implied volatility, \n3. the passage of time, \n4. changes in the dividend (if any exist), and \n5. changes in interest rates. \nEach is stated in terms of a movement or change; that is, these are not static \nthings. In fact, to measure them one uses the \"greeks\": delta, vega, theta, (there is no \n\"greek\" for dividend change), and rho. Typically, the effect of a change in dividend or \na change in interest rate is small (although a large dividend change or an interest rate \nchange on a very long-term option can produce visible changes in the prices of \noptions). \nIf everything remains static, then time decay will eventually wipe out all of the \nexcess value of an option. That's why it's called time value premium. But things don't \never remain static, and on a daily basis, time decay is small, so it is the remaining two \nfactors that are most important. \nExample: XYZ is trading at 82 in late November. The January 80 call is trading at 8. \nThus, the intrinsic value is 2 (82 minus 80) and the excess value is 6 (8 minus 2). If \nthe stock is still at 82 at January expiration, the option will of course only be worth 2, \nand one will say that the 6 points of excess value that was lost was due to time decay. \nBut on that day in late November, the other factors are much more dominant. \nOn this particular day, the implied volatility of this option is just over 50%. One \ncan determine that the call's greeks are: \nDelta: 0.60 \nVega: 0.13 \nTheta: -0.06 \nThis means, for example, that time decay is only 6 cents per day. It would \nincrease as time went by, but even with a day or so to go, theta would not increase \nabove about 20 cents unless volatility increased or the stock moved closer to the \nstrike price. \nFrom the above figures, one can see - and this should be intuitively appealing that \nthe biggest factor influencing the price of the option is stock price movement (delta). \n764 Part VI: Measuring and Trading VolatiRty \nIt's a little unfair to say that, because it's conceivable (although unlikely) that volatil\nity could jump by a large enough margin to become a greater factor than delta for \none day's move in the option. Furthermore, since this option is composed mostly of \nexcess value, these more dominant forces influence the excess value more than time \ndecay does. \nThere is a direct relationship between vega and excess value. That is, if implied \nvolatility increases, the excess value portion of the option will increase and, if implied \nvolatility decreases, so will excess value. \nThe relationship between delta and excess value is not so straightforward. The \nfarther the stock moves away from the strike, the more this will have the effect of \nshrinking the excess value. If the call is in-the-money (as in the above example), then \nan increase in stock price will result in a decrease of excess value. That is, a deeply in\nthe-money option is composed primarily of intrinsic value, while excess value is quite \nsmall. However, when the call is out-of-the-money, the effect is just the opposite: \nThen, an increase in call price will result in an increase in excess value, because the \nstock price increase is bringing the stock closer to the option's striking price. \nFor some readers, the following may help to conceptualize this concept. The \npart of the delta that addresses excess value is this: \nOut-of-the-money call: 100% of the delta affects the excess value. \nIn-the-money call: \"1.00 minus delta\" affects the excess value. (So, if a call is very \ndeeply in-the-money and has a delta of 0.95, then the delta only has 1.00 - 0.95, \nor 0.05, room to increase. Hence it has little effect on what small amount of \nexcess value remains in this deeply in-the-money call.) \nThese relationships are not static, of course. Suppose, for example, that in the \nsame situation of the stock trading at 82 and the January 80 call trading at 8, there is \nonly week remaining until expiration! Then the implied volatility would be 155% \n(high, but not unheard of in volatile times). The greeks would bear a significantly dif\nferent relationship to each other in this case, though: \nDelta: 0.59 \nVega: 0.044 \nTheta: -0 .5 1 \nThis very short-term option has about the same delta as its counterpart in the previ\nous example (the delta of an at-the-money option is generally slightly above 0.50). \nMeanwhile, vega has shrunk. The effect of a change in volatility on such a short-term \noption is actually about a third of what it was in the previous example. However, time \ndecay in this example is huge, amounting to half a point per day in this option. \nChapter 37: How Volatility Affects Popular Strategies 765 \nSo now one has the idea of how the excess value is affected by the \"big three\" \nof stock price movement, change in implied volatility, and passage of time. How can \none use this to his advantage? First of all, one can see that an option's excess value \nmay be due much more to the potential volatility of the underlying stock, and there\nfore to the option's implied volatility, than to time. \nAs a result of the above information regarding excess value, one shouldn't think \nthat he can easily go around selling what appear to be options with a lot of excess \nvalue and then expect time to bring in the profits for him. In fact, there may be a lot \nof volatility both actual and implied - keeping that excess value nearly intact for a \nfairly long period of time. In fact, in the coming ch", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 339}
{"text": "e. \nAs a result of the above information regarding excess value, one shouldn't think \nthat he can easily go around selling what appear to be options with a lot of excess \nvalue and then expect time to bring in the profits for him. In fact, there may be a lot \nof volatility both actual and implied - keeping that excess value nearly intact for a \nfairly long period of time. In fact, in the coming chapters on volatility estimation, it \nwill be shown that option buyers have a much better chance of success than conven\ntional wisdom has maintained. \nVOLATILITY AND THE PUT OPTION \nWhile it is obvious that an increase in implied volatility ½ill increase the price of a put \noption, much as was shown for a call option in. the preceding discussion, there are \ncertain differences between a put and a call, so a little review of the put option itself \nmay be useful. A put option tends to lose its premium fairly quickly as it becomes an \nin-the-money option. This is due to the realities of conversion arbitrage. In a con\nversion arbitrage, an arbitrageur or market-maker buys stock and buys the put, while \nselling the call. If he carries the position to expiration, he will have to pay carrying \ncosts on the debit incurred to establish the position. Furthermore, he would earn any \ndividends that might be paid while he holds the position. This information was pre\nsented in a slightly different form in the chapter on arbitrage, but it is recounted \nhere: \nIn a perfect world, all option prices would be so accurate that there would be \nno profit available from a conversion. That is, the following equation (1) would apply: \n(1) Call price+ Strike price - Stock price - Put price+ Dividend- Carrying cost= 0 \nwhere carrying cost = strike price/ (1 + r)t \nt = time to expiration \nr = interest rate \nNow, it is also known that the time value premium of a put is the amount by which \nits value exceeds intrinsic value. The intrinsic value of an in-the-money put option is \nmerely the difference between the strike price and the stock price. Hence, one can \nwrite the following equation (2) for the time value premium (TVP) of an in-the\nmoney put option: \n766 Part VI: Measuring and Trading Volatility \n(2) Put TVP = Put price - Strike price + Stock price \nThe arbitrage equation, (1), can be rewritten as: \n(3) Put price - Strike price+ Stock price= Call price+ Dividends - Carrying cost \nand substituting equation (2) for the terms in equation (3), one arrives at: \n( 4) Put TVP = Call price + Dividends - Carrying cost \nIn other words, the time value premium of an in-the-money put is the same as the \n(out-of-the-money) call price, plus any dividends to be ea med until expiration, less \nany carrying costs over that same time period. \nAssuming that the dividend is small or zero (as it is for most stocks), one can see \nthat an in-the-money put would lose its time value premium whenever carrying costs \nexceed the value of the out-of-the-money call. Since these carrying costs can be rel\natively large ( the carrying cost is the interest being paid on the entire debit of the \nposition - and that debit is approximately equal to the strike price), they can quickly \ndominate the price of an out-of-the-money call. Hence, the time value premium of \nan in-the-money put disappears rather quickly. \nThis is important information for put option buyers, because they must under\nstand that a put won't appreciate in value as much as one might expect, even when \nthe stock drops, since the put loses its time value premium quickly. It's even more \nimportant information for put sellers: A short put is at risk of assignment as soon as \nthere is no time value premium left in the put. Thus, a put can be assigned well in \nadvance of expiration even a LEAPS put! \nNow, returning to the main topic of how implied volatility affects a position, one \ncan ask himself how an increase or decrease in implied volatility would affect equa\ntion ( 4) above. If implied volatility increases, the call price would increase, and if the \nincrease were great enough, might impart some time value premium to the put. \nHence, an increase in implied volatility also may increase the price of a put, but if the \nput is too far in-the-nwney, a modest increase in implied volatility still won't budge \nthe put. That is, an increase in implied volatility would increase the value of the call, \nbut until it increases enough to be greater than the carrying costs, an in-the-money \nput will remain at parity, and thus a short put would still remain at risk of assignment. \nSTRADDLE OR STRANGLE BUYING AND SELLING \nSince owning a straddle involves owning both a put and a call with the same terms, \nit is fairly evident that an increase in implied volatility will be very beneficial for a \nstraddle buyer. A sort of double benefit occurs if implied volatility rises, for it will \nChapter 37: How Volatility Affects Popular Strategies 767 \npositively affect both the put and the call in a long straddle. Thus, if a straddle buyer \nis careful to buy straddles in situations in which implied volatility is \"low,\" he can \nmake money in one of two ways. Either (1) the underlying price makes a move great \nenough in magnitude to exceed the initial cost of the straddle, or (2) implied volatil\nity increases quickly enough to overcome the deleterious effects of time decay. \nConversely, a straddle seller risks just the opposite - potentially devastating loss\nes if implied volatility should increase dramatically. However, the straddle seller can \nregister gains faster than just the rate of time decay would indicate if implied volatil\nity decreases. Thus, it is very important when selling options - and this applies to cov\nered options as well as to naked ones - to sell only when implied volatility is \"high.\" \nA strangle is the same as a straddle, except that the call and put have different \nstriking prices. Typically, the call strike price is higher than the put strike price. \nNaked option sellers often prefer selling stra", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 340}
{"text": "atil\nity decreases. Thus, it is very important when selling options - and this applies to cov\nered options as well as to naked ones - to sell only when implied volatility is \"high.\" \nA strangle is the same as a straddle, except that the call and put have different \nstriking prices. Typically, the call strike price is higher than the put strike price. \nNaked option sellers often prefer selling strangles in which the options are well out\nof-the-money, so that there is less chance of them having any intrinsic value when \nthey expire. Strangles behave much like straddles do with respect to changes in \nimplied volatility. \nThe concepts of straddle ownership will be discussed in much more detail in the \nfollowing chapters. Moreover, the general concept of option buying versus option \nselling will receive a great deal of attention. \nCALL BULL SPREADS \nIn this section, the bull spread strategy will be examined to see how it is affected by \nchanges in implied volatility. Let's look at a call bull spread and see how implied \nvolatility changes might affect the price of the spread if all else remains equal. Make \nthe following assumptions: \nAssumption Set 1 : \nStock Price: 1 00 \nTime to Expiration: 4 months \nPosition: long Call Struck at 90 \nShort Call Struck at 110 \nAsk yourself this simple question: If the stock remains unchanged at 100, and implied \nvolatility increases dramatically, will the price of the 90-110 call bull spread grow or \nshrink? Answer before reading on. \nThe truth is that, if implied volatility increases, the price of the spread will \nshrink. I would suspect that this comes as something of a surprise to a good number \nof readers. Table 37-6 contains some examples, generated from a Black-Scholes \n768 \nTABLE 37-6 \nImplied \nVolatility \n20% \n30% \n40% \n50% \n60% \n70% \n80% \nStock Price = I 00 \nPart VI: Measuring and Trading VolatHity \n90-110 Call \nBull Spread \n(Theoretical Value) \n10.54 \n9.97 \n9.54 \n9.18 \n8.87 \n8.58 \n8.30 \nmodel, using the assumptions stated above, the most important of which is that the \nstock is at 100 in all cases in this table. \nOne should be aware that it would probably be difficult to actually trade the \nspread at the theoretical value, due to the bid-asked spread in the options. \nNevertheless, the impact of implied volatility is clear. \nOne can quantify the amount by which an option position will change for each \npercentage point of increase in implied volatility. Recall that this measure is called \nthe vega of the option or option position. In a call bull spread, one would subtract the \nvega of the call that is sold from that of the call that is bought in order to arrive at the \nposition vega of the call bull spread. Table 37-7 is a reprint of Table 37-6, but now \nincluding the vega. \nSince these vegas are all negative, they indicate that the spread will shrink in \nvalue if implied volatility rises and that the spread will expand in value if implied \nTABLE 37-7 \n90-110 Call \nImplied Bull Spread Position \nVolatility (Theoretical Value) Vega \n20% 10.54 -0.67 \n30% 9.97 -0.48 \n40% 9.54 -0.38 \n50% 9.18 -0.33 \n60% 8.87 -0.30 \n70% 8.58 -0.28 \n80% 8.30 -0.26 \nChapter 37: How VolatHity Afleds Popular Strategies 769 \nvolatility decreases. Again, these statements may seem contrary to what one would \nexpect from a bullish call position. \nOf course, it's highly unlikely that implied volatility would change much in the \ncourse of just one day while the stock price remained unchanged. So, to get a bet\nter handle on what to expect, one really to needs to look at what might happen at \nsome future time (say a couple of weeks hence) at various stock prices. The graph \nin Figure 37-3 begins the investigation of these more complex scenarios. \nThe profit curve shown in Figure 37-3 makes certain assumptions: (1) The bull \nspread assumes the details in Assumption Set 1, above; (2) the spread was bought \nwith an implied volatility of 20% and remained at that level when the profit picture \nabove was drawn; and (3) 30 days have passed since the spread was bought. Under \nthese assumptions, the profit graph shows that the bull spread conforms quite well to \nwhat one would expect; that is, the shape of this curve is pretty much like that of a \nbull spread at expiration, although if you look closely you'll see that it doesn't widen \nout to nearly its maximum gain or loss potential until the stock is well above llO or \nbelow 90 the strike prices used in the spread. \nNow observe what happens if one keeps all the other assumptions the same, \nexcept one. In this case, assume implied volatility was 80% at purchase and remains \nat 80% one month later. The comparison is shown in Figure 37-4. The 80% curve is \noverlaid on top of the 20% curve shown earlier. The contrast is quite startling. \nInstead of looking like a bull spread, the profit curve that uses 80% implied volatili-\nFIGURE 37-3. \nBull spread profit picture in 30 days, at 20% IV. \n1000 \n500 \n<J) \n<J) \n0 0 ...J \n?i:: 70 80 90 100 110 120 130 140 \ne a. \n\"' -500 \nStock Price \n770 Part VI: Measuring and Trading Volatility \nFIGURE 37-4. \nBull spread profit picture in 30 days. \n1000 \n500 \niv=80% \n(/) \n(/) \n0 \n0 -' :;:, \n70 801 90 e \n~ \na. \nfl'> \n-500 \n130 140 \niv= 20% \n-1000 Stock \nty is a rather flat thing, sloping only slightly upward - and exhibiting far less risk and \nreward potential than its lower implied volatility counterpart. This points out anoth\ner important fact: For volatile stocks, one cannot expect a 4-rrwnth bull spread to \nexpand or contract much during the first rrwnth of life, even if the stock makes a sub\nstantial rrwve. Longer-term spreads have even less movement. \nAs a corollary, note that if implied volatility shrinks while the stock rises, the \nprofit outlook will improve. Graphically, using Figure 37-4, if one's profit picture \nmoves from the 80% curve to the 20% curve on the right-hand side of the chart, that \nis a positive development. Of course, if the stock drops and the implied volatility \ndrops too, then one's los", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 341}
{"text": "spreads have even less movement. \nAs a corollary, note that if implied volatility shrinks while the stock rises, the \nprofit outlook will improve. Graphically, using Figure 37-4, if one's profit picture \nmoves from the 80% curve to the 20% curve on the right-hand side of the chart, that \nis a positive development. Of course, if the stock drops and the implied volatility \ndrops too, then one's losses would be worse - witness the left-hand side of the graph \nin Figure 37-4. \nA graph could be drawn that would incorporate other implied volatilities, but \nthat would be overkill. The profit graphs of the other spreads from Tables 37-6 or \n37-7 would lie between the two curves shown in Figure 37-4. \nIf this discussion had looked at bull spreads as put credit spreads instead of call \ndebit spreads, perhaps these conclusions would not have seemed so unusual. \nExperienced option traders already understand much of what has been shown here, \nbut less experienced traders may find this information to be different from what they \nexpected. \nSome general facts can be drawn about the bull spread strategy. Perhaps the \nmost important one is that, if used on a volatile stock, you won't get much expansion \nin the spread even if the stock makes a nice move upward in your favor. In fact, for \nCbapter 37: How Volatility Affects Popular Strategies 771 \nhigh implied volatility situations, the bull spread won't expand out to its maximum \nprice until expiration draws nigh. That can be frustrating and disappointing. \nOften, the bull spread is established because the option trader feels the options \nare \"too expensive\" and thus the spread strategy is a way to cut down on the total \ndebit invested. However, the ultimate penalty paid is great. Consider the fact that, \nif the stock rose from 100 to 130 in 30 days, any reasonable four-month call pur\nchase (i.e., with a strike initially near the current stock price) would make a nice \nprofit, while the bull spread barely ekes out a 5-point gain. To wit, the graph in \nFigure 37-5 compares the purchase of the at-the-money call with a striking price of \n100 and the 90-110 call bull spread, both having implied volatility of 80%. Quite \nclearly, the call purchase dominates to a great extent on an upward move. Of course, \nthe call purchase does worse on the downside, but since these are bullish strategies, \none would have to assume that the trader had a positive outlook for the stock when \nthe position was established. Hence, what happens on the downside is not primary \nin his thinking. \nThe bull spread and the call purchase have opposite position vegas, too. That is, \na rise in implied volatility will help the call purchase but will harm the bull spread \n( and vice versa). Thus, the call purchase and the bull spread are not very similar posi\ntions at all. \nIf one wants to use the bull spread to effectively reduce the cost of buying an \nexpensive at-the-money option, then at least make sure the striking prices are quite \nFIGURE 37-5. \nCall buy versus bull spread in 30 days; IV = 80%. \nCl) \n~ \n2500 \n2000 \n1500 \n1000 \ne 500 \nCl. \n-500 \n-1000 \nOutright Call Buy \nBull Spread \n---\n140 \nStock \n772 Part VI: Measuring and Trading Volatility \nwide apart. That will allow for a reasonable amount of price appreciation in the bull \nspread if the underlying rises in price. Also, one might want to consider establishing \nthe bull spread with striking prices that are both out-of-the-money. Then, if the stock \nrallies strongly, a greater percentage gain can be had by the spreader. Still, though, \nthe facts described above cannot be overcome; they can only possibly be mitigated \nby such actions. \nA FAMILIAR SCENARIO? \nOften, one may be deluded into thinking that the two positions are more similar than \nthey are. For example, one does some sort of analysis - it does not matter if it's fun\ndamental or technical - and comes to a conclusion that the stock ( or futures contract \nor index) is ready for a bullish move. Furthermore, he wants to use options to imple\nment his strategy. But, upon inspecting the actual market prices, he finds that the \noptions seem rather expensive. So, he thinks, \"Why not use a bull spread instead? It \ncosts less and it's bullish, too.\" \nFairly quickly, the underlying moves higher - a good prediction by the trader, \nand a timely one as well. If the move is a violent one, especially in the futures mar\nket, implied volatility might increase as well. If you had bought calls, you'd be a happy \ncamper. But if you bought the bull spread, you are not only highly disappointed, but \nyou are now facing the prospect of having to hold the spread for several more weeks \n(perhaps months) before your spread widens out to anything even approaching the \nmaximum profit potential. \nSound familiar? Every option trader has probably done himself in with this line \nof thinking at one time or another. At least, now you know the reason why: High or \nincreasing implied volatility is not a friend of the bull spread, while it is a friendly ally \nof the outright call purchase. Somewhat surprisingly, many option traders don't real\nize the difference between these two strategies, which they probably consider to be \nsomewhat similar in nature. \nSo, be careful when using bull spreads. If you really think a call option is too \nexpensive and want to reduce its cost, ti:y this strategy: Buy the call and simultane\nously sell a credit put spread (bull spread) using slightly out-of-the-money puts. This \nstrategy reduces the call's net cost and maintains upside potential (although it \nincreases downside risk, but at least it is still a fixed risk). \nExample: With XYZ at 100, a trader is bullish and wants to buy the July 100 calls, \nwhich expire in two months. However, upon inspection, he finds that they are trad\ning at 10 - an implied volatility of 59%. He knows that, historically, the implied \nvolatility of this stock's options range from approximately 40% to 60%, so these are \nChapter 37: How Volatility Affec", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 342}
{"text": "ast it is still a fixed risk). \nExample: With XYZ at 100, a trader is bullish and wants to buy the July 100 calls, \nwhich expire in two months. However, upon inspection, he finds that they are trad\ning at 10 - an implied volatility of 59%. He knows that, historically, the implied \nvolatility of this stock's options range from approximately 40% to 60%, so these are \nChapter 37: How Volatility Affects Popular Strategies 773 \nvery expensive options. If he buys them now and implied volatility returns to its \nmedian range near 50%, he will suffer from the decrease in implied volatility. \nAs a possible remedy, he considers selling an out-of-the-money put credit \nspread at the same time that he buys the calls. The credit from this spread will act as \na means of reducing the net cost of the calls. If he's right and the stock goes up, all \nwill be well. However, the introduction of the put spread into the mix has introduced \nsome additional downside risk. \nSuppose the following prices exist: \nXYZ: 100 \nJuly 100 call: 10 (as stated above) \nJuly 90 put: 5 \nJuly 80 put: 2 \nThe entire bullish position would now consist of the following: \nBuy 1 July 100 call at 1 0 \nBuy 1 July 80 put at 2 \nSell 1 July 90 put at 5 \nNet expenditure: 7 point debit (plus commission) \nFigure 37-6 shows the profitability, at expiration, of both the outright call pur\nchase and the bullish position constructed above. \nFIGURE 37-6. \nProfitability at expiration. \n2000 \nBullish Spread // \n/ \n1000 \n\"' \"' 0 ...J \n87 :!:: \nOutright Call Purchase \ne 0 \nC. 70 80 90 \n<Ft 100 /100 ,,....... ___ \n120 \n-1000 \nStock \n-2000 \n774 Part VI: Measuring and Trading Volatility \nFirst, one can see that the bullish spread position has a total risk of 17 points, if \nX'YZ is below 80 (the lower striking price of the put spread) at expiration. That, of \ncourse, is more than the 10-point cost of the July 100 call by itself, but if one is using \na trading stop of any sort, he probably would not be at risk for the entire 17 points, \nsince he wouldn't hold on while the stock fell all the way to 80 and below. Note also \nthat the bullish spread position would have a loss of 10 points (the same as the call) \nat a price of 87 for the common at expiration. Hence, the combined position actual\nly has less risk than the outright call purchase as long as XYZ is 87 or higher at expi\nration. Since one is supposedly bullish initially when establishing this strategy, it \nseems likely that he would figure the stock would be 87 or higher at expiration. · \nFigure 37-7 offers another comparison, that of the two positions after 30 days \nhave passed. Note that the spread position once again does better on the upside and \nworse on the downside. The crossover point between the two curves is at about a \nprice of95. That is, ifXYZ is above 95 in 30 days, the bullish spread position will out\nperform the call buy. \nOne final point should be made regarding the investment required. The out\nright call purchase requires an investment of $1,000 - the cost of the long call. The \nbullish spread position requires that $1,000, plus $700 for the spread (IO-point dif\nference in the strikes, less the 3-point credit received for selling the spread). That's a \ntotal of $1,700, the risk of the bullish spread position. Hence, the rate of return might \nfavor the outright call purchase, depending on how far the stock rallies. \nFIGURE 37-7. \nResults of the two positions in 30 days. \nCl) \n_g \n:;::, \ne \nCl.. \n~ \n1000 \n-1000 \n-2000-\nSpread \n95 \n110 \nStock \n/ \nOutright Call Purchase \n120 \nChapter 37: How Volatility Affects Popular Strategies 775 \nOverall, the bullish spread position is an attractive alternative to an outright call \npurchase, especially when the call is overpriced. The spread does risk a greater \namount of money if the underlying stock should collapse heavily. Still, if one is truly \nbullish, and if one employs a reasonably tight downside stop on his entire position, \nthis spread can perform better than the outright purchase of an overpriced call. \nVERTICAL PUT SPREADS \nAlso of interest is the effect that implied volatility has on put spreads. One of the \nmore popular strategies involving puts is the sale of a credit spread - a bull spread \nwith puts. Assume that a stock is selling at 100, and one is going to sell a put with a \n110 strike and buy a put with a 90 strike. That is a put credit (bull) spread. Also \nassume that the options have four months of life remaining. (See Table 37-8.) \nOne would not rationally sell this credit spread if implied volatility were as low \nas 20%, because at that low level of volatility, the in-the-money December llO put is \ntrading for 10 dollars - parity - and thus would immediately be at risk of early \nassignment. But one can see that an increase in implied volatility increases the value \nof the spread. Now, if one had sold this spread to begin with, he would thus be los\ning money when implied volatility increased. This was proven with call bull spreads, \ntoo: They lose money when implied volatility increases. Conversely, of course, the \nput credit spread makes money when implied volatility decreases. \nWhat happens after thirty days have passed? Figure 37-8 shows just two cases \n- implied volatility at 30% and implied volatility at 80%. One can surmise that other \nlevels of implied volatility between 30% and 80% would have profit graphs that lie \nbetween the two shown in Figure 37-8. \nTABLE 37·8 \nImplied \nVolatility \n20% \n30% \n40% \n50% \n60% \n70% \n80% \n*Short option trading at parity \n90-110 \nPut Bull Spread \n(Theoretical Value) \n9.15 er* \n9.70 er \n10.12 er \n10.46 er \n10.78 er \n11.05 er \n11.33 er \n174 Part VI: Measuring and Trading Volatility \nFirst, one can see that the bullish spread position has a total risk of 17 points, if \nXYZ is below 80 (the lower striking price of the put spread) at expiration. That, of \ncourse, is more than the 10-point cost of the July 100 call by itself, but if one is using \na trading stop of any sort, he probably would not", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 343}
{"text": ".46 er \n10.78 er \n11.05 er \n11.33 er \n174 Part VI: Measuring and Trading Volatility \nFirst, one can see that the bullish spread position has a total risk of 17 points, if \nXYZ is below 80 (the lower striking price of the put spread) at expiration. That, of \ncourse, is more than the 10-point cost of the July 100 call by itself, but if one is using \na trading stop of any sort, he probably would not be at risk for the entire 17 points, \nsince he wouldn't hold on while the stock fell all the way to 80 and below. Note also \nthat the bullish spread position would have a loss of 10 points (the same as the call) \nat a price of 87 for the common at expiration. Hence, the combined position actual\nly has less risk than the outright call purchase as long as XYZ is 87 or higher at expi\nration. Since one is supposedly bullish initially when establishing this strategy, it \nseems likely that he would figure the stock would be 87 or higher at expiration. \nFigure 37-7 offers another comparison, that of the two positions after 30 days \nhave passed. Note that the spread position once again does better on the upside and \nworse on the downside. The crossover point between the two curves is at about a \nprice of 95. That is, ifXYZ is above 95 in 30 days, the bullish spread position will out\nperform the call buy. \nOne final point should be made regarding the investment required. The out\nright call purchase requires an investment of $1,000 - the cost of the long call. The \nbullish spread position requires that $1,000, plus $700 for the spread (IO-point dif\nference in the strikes, less the 3-point credit received for selling the spread). That's a \ntotal of $1,700, the risk of the bullish spread position. Hence, the rate of return might \nfavor the outright call purchase, depending on how far the stock rallies. \nFIGURE 37-7. \nResults of the two positions in 30 days. \n1000 \nen \nIll \n0 \n...J \nO 70 :;::, \n~ ... a. \nw \n-1000 \n-2000-\n80 \n95 \nBullish Spread \nStock \nSpread \n110 \n/ \n1/ \nOutright Call Purchase \n120 \nChapter 37: How Volatility Affects Popular Strategies 775 \nOverall, the bullish spread position is an attractive alternative to an outright call \npurchase, especially when the call is overpriced. The spread does risk a greater \namount of money if the underlying stock should collapse heavily. Still, if one is truly \nbullish, and if one employs a reasonably tight downside stop on his entire position, \nthis spread can perform better than the outright purchase of an overpriced call. \nVERTICAL PUT SPREADS \nAlso of interest is the effect that implied volatility has on put spreads. One of the \nmore popular strategies involving puts is the sale of a credit spread - a bull spread \nwith puts. Assume that a stock is selling at 100, and one is going to sell a put with a \n110 strike and buy a put with a 90 strike. That is a put credit (bull) spread. Also \nassume that the options have four months of life remaining. (See Table 37-8.) \nOne would not rationally sell this credit spread if implied volatility were as low \nas 20%, because at that low level of volatility, the in-the-money December llO put is \ntrading for 10 dollars - parity - and thus would immediately be at risk of early \nassignment. But one can see that an increase in implied volatility increases the value \nof the spread. Now, if one had sold this spread to begin with, he would thus be los\ning money when implied volatility increased. This was proven with call bull spreads, \ntoo: They lose money when implied volatility increases. Conversely, of course, the \nput credit spread makes money when implied volatility decreases. \nWhat happens after thirty days have passed? Figure 37-8 shows just two cases \n- implied volatility at 30% and implied volatility at 80%. One can surmise that other \nlevels of implied volatility between 30% and 80% would have profit graphs that lie \nbetween the two shown in Figure 37-8. \nTABLE 37-8 \nImplied \nVolatility \n20% \n30% \n40% \n50% \n60% \n70% \n80% \n*Short option trading at parity \n90-110 \nPut Bull Spread \n(Theoretical Value) \n9.15 er* \n9.70 er \n10. 12 er \n10.46 er \n10.78 er \n11.05 er \n11.33 er \n776 \nFIGURE 37-8. \nPut credit (bull) spread profit in 30 days. \n1000 \n500 \n- 1000 _ _,±8± \nAssignment Risk Area \nIV=30% \nStock \nPart VI: Measuring and Trading Volatility \n-~ \nIV= 30% \n130 140 \nFirst, one can observe that a bull put spread does not widen out to anywhere \nnear its maximum potential if implied volatility increases. The same thing was seen \nwith the call bull spread in the previous section. But a put bull spreader is caught in \nanother trap: If implied volatility falls and the stock falls too, the risk of early assign\nment materializes quicky. Note the shaded area at the lower left of the graph, extend\ning from a price of about 94 on down. After thirty days (so there would be three \nmonths life remaining at that point in time), if implied volatility is 30%, the 110 put \n(the short put) would be trading at parity for stock prices of 94 and below. Thus, it \nwould be at risk of early assignment. If implied volatility were even lower, the puts \nwould be at parity for much higher stock prices. \nNow, in and of itself, early assignment on an equity or futures put spread is not \nnecessarily a terrible thing. There will be a request for additional margin (because \nthe stock has to be paid for or the futures contract margined), but the risk is still the \nsame in dollar terms. Of course, the request for extra margin could be backbreaking \nfor a stock trader if he can't afford to fully pay for the stock, and the early assignment \nwould probably incur additional commission costs, too. However, with cash-based \nindex options there is a more serious increase in risk after an early assignment, \nbecause one is left with only the long side of the spread. If that option happens to \nhave substantial value, then there is considerable risk if the underlying should quick\nly move higher. In fact, by the time one unwinds the spread, he might actually end \nup losing", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 344}
{"text": "commission costs, too. However, with cash-based \nindex options there is a more serious increase in risk after an early assignment, \nbecause one is left with only the long side of the spread. If that option happens to \nhave substantial value, then there is considerable risk if the underlying should quick\nly move higher. In fact, by the time one unwinds the spread, he might actually end \nup losing more than his original limited risk amount - all due to the early assignment. \n(This could happen if the underlying first plunges in price, placing both options \nChapter 37: How Volatility Affects Popular Strategies 777 \ndeeply in-the-money, after which one gets assigned on the short put option, followed \nby the underlying then dramatically rising in price.) \nThe lesson to be learned is this: If one is considering using bull spreads in which \nat least one of the options is at- or in-the-rrwney, then a call bull spread is a superior \nchoice over a put bull spread. Early assignment is not really a consideration for most \ncall spreads. \nIn both cases, however, a more serious problem exists, and that is that the \nspread does not widen out much even when the stock makes a nice bullish move. \nThus, once again it is actually better to buy a call option in most cases than to use the \nbull spread, because profits are larger and an increase in implied volatility is a favor\nable thing for an outright call buyer. \nNote that these effects are similar, but much less pronounced, for out-of-the\nmoney put credit spreads. Still, it should be noted that an increase in implied volatil\nity will harm an out-of-the-money put credit spread, too. Hence, if the underlying \ngoes into a rapid fall (crash, plunge), then implied volatility usually increases quickly \nand dramatically. So an out-of-the-money credit spreader is hit with the double \nwhammy of expanding implied volatility and the fact that the underlying is fast \napproaching the strike price of his options, . thereby expanding the price of the \nspread. \nPUT BEAR SPREADS \nWhat about the put spread in a bearish situation? In a vertical put spread one buys \nthe put with the higher strike and sells the put with the lower strike to construct a \nsimple put bear spread. Actually, a sudden increase in implied volatility is of help to \nthe bear put spread. That is, the spread will widen out slightly. To verify this, look at \nTable 37-8 again, only now imagine that one is buying the spread for a debit. Note \nthat the smallest debit is at the lower implied volatility- 9.15 debit with IV at 30%. \nIf implied volatility were to instantaneously jump to 80%, the spread would widen \nout to 11.33 debit. A very quick profit could be had. So there's a difference right away \nbetween a debit call bull spread (which loses money when implied volatility sudden\nly increases) and a debit put bear spread. \nUnfortunately, the other major drawback - that the spread doesn't widen out \nmuch if the underlying makes a favorable move - is still true. Figure 37-9 shows a \nbear put spread, 30 days hence, for two different implied volatilities. Once again, the \nlower-volatility spread widens out more quickly, because both options tend to go to \nparity in that case. In fact, one can see on the graph that there is early assignment \nrisk in the low-volatility case, below a price of about 77 on the stock. That is not a \n778 Part VI: Measuring and Trading Volatility \nFIGURE 37-9. \nBear put spread profit in 30 days. \n1000 IV= 30% \nAssignment \nRisk \nArea \n(/) \n(/) \n0 \n...J \n~ 0 \ne 70 80 110 120 130 140 \na. \nff7 \nIV= 80% \n-1000 \n'~ \nStock \nproblem, though, since the spread would have widened to its maximum potential in \nthat case and could just be removed when the risk of early assignment materialized. \nWhen implied volatility remains high, though, the spread doesn't widen out \nmuch, even when the stock drops a lot after 30 days. Since it is common for implied \nvolatility to rise (even skyrocket) when the underlying drops quickly, the put bear \nspread probably won't widen out much. That may not be a psychologically pleasing \nstrategy, because one won't make the level of profits that he had hoped to when the \nunderlying fell quickly. \nOnce again, it seems that the outright purchase of an option is probably superi\nor to a spread. In these cases, it is true with respect to puts, much as it was with call \noptions. Spreading often unnecessarily complicates a trader's outlook. \nCALENDAR SPREADS \nIn the earlier chapter on calendar spreads, it was mentioned that an increase in \nimplied volatility will cause a calendar spread to widen out. Both options will become \nmore expensive, of course, since the increase in implied volatility affects both of \nthem, but the absolute price change will be greatest in the long-term option. \nTherefore, the calendar spread will widen. This may seem somewhat counterintu\nitive, especially where highly volatile stocks are concerned, so some examples may \nprove useful. \nChapter 37: How Volatility Affects Popular Strategies 779 \nExample: Suppose that XYZ is trading at 100, and one is interested in a calendar \nspread in which an August (5-month) call is bought and a May (2-month) call is sold. \nFor the purpose of this example, it will be assumed that these are both at-the-money \noptions. First, the vegas of the two options will be examined, assuming that implied \nvolatility is 40%: \nStock: 100 \nImplied Volatility: \n40% Option \nSell May 100 call \nBuy August 1 00 call \nTheoretical Price \n6.91 \n11.22 \nVega \n0.162 \n0.251 \nIn theory, this spread should be worth 4.31 - the difference in the theoretical \nvalues. Perhaps more important, it has volatility exposure of 0.089 - the difference \nbetween the vega of the long call and that of the short call. Since vega is positive, this \nmeans that an increase in implied volatility will be beneficial to the spread. In other \nwords, one can expect the spread to widen if implied volatility rises, and can expect \nthe spread to shrink if implied volatility de", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 345}
{"text": "values. Perhaps more important, it has volatility exposure of 0.089 - the difference \nbetween the vega of the long call and that of the short call. Since vega is positive, this \nmeans that an increase in implied volatility will be beneficial to the spread. In other \nwords, one can expect the spread to widen if implied volatility rises, and can expect \nthe spread to shrink if implied volatility declines. \nThe following table can also be constructed, showing the theoretical value of \nthe spread at various levels of implied volatility. This table makes the assumption that \nvery little time has passed ( only one week) before the implied volatility changes take \nplace. It also assumes that the stock is still at 100. \nStock Price: 100 \nOne week ofter the spread hos been established: \nImplied Volatility Theoretical Spread Value \n20% 2.58 \n30% 3.52 \n40% 4.46 \n50% 5.40 \n60% 6.33 \n80% 8.16 \n100% 12.92 \nFrom the above data, it is quite obvious that implied volatility levels have a huge \neffect on the value of a calendar spread. The actual initial contribution of time decay \nis rather small in comparison. For example, note that if volatility remains unchanged \nat 40%, then the spread will have widened only slightly - to 4.46 from 4.31 - after \nthe passage of one week's time. That is small in comparison to the changes dictated \nby volatility expansion or contraction. \n780 Part VI: Measuring and Trading Volatility \nA common mistake that calendar spreaders make is to think that such a spread \nlooks overly attractive on a very volatile stock. Consider the same stock as above, still \ntrading at 100, but for some reason implied volatility has skyrocketed to 80% (per\nhaps a takeover rumor is present). \nStock: JOO \nImplied Volatility: 80% \nColl \nMay 100 call \nJune 100 call \nTheoretical Value \n12.55 \n16.81 \nOn the surface, this seems like a very attractive spread. There are two months \nof life remaining in the May options (and three months in the Junes) and the spread \nis trading at 4.36. However, both options are completely composed of time value \npremium, and most certainly the June 100 call would be worth far more than 4.36 \nwhen the May expires, if the stock is still near 100. The fact that many traders miss \nwhen they think of the calendar spread this way is that the June call will only be \nworth \"far more than 4.36\" if implied volatility holds up. If implied volatility for this \nstock is normally something on the order of 40%, say, then it is probably not reason\nable to expect that the 80% level will hold up. Just for comparison, note that if the \nstock is at 100 at May expiration - the maximum profit potential for such a calendar \nspread - the June 100 call, with implied volatility now at 40%, and with one month \nof life remaining, would be worth only 4. 77. Thus the spread would only have made \na profit of a few cents (4.36 to 4.77), and if the underlying stock were farther from \nthe strike price at expiration, there would probably be a loss rather than a profit. \nThe point to be remembered is that a calendar spread is a \"long volatility\" play \n(and a reverse calendar spread is just the opposite). Evaluate the position's risk with \nan eye to what might happen to implied volatility, and not just to where the stock \nprice might go or how much time decay there might be in the position. \nRATIO SPREADS AND BACKSPREADS \nThe previous descriptions in this chapter describe fairly fully and accurately what \nthe effect of volatility changes are. More complicated strategies are usually nothing \nmore than combinations of the strategies presented earlier, so it is easy to discern \nthe effect that changes in implied volatility would have; just combine the effects on \nthe simpler strategies. For example, a ratio call write is really just the equivalent of \na straddle sale - a strategy whose volatility ramifications are fairly simple to under\nstand. \nRatio spreads, on the other hand, might not be as intuitive to interpret, but they \nare fairly simple nonetheless. A call ratio spread is really just the combination of some \nChapter 37: How Volatility Affects Popular Strategies 781 \ncall bull spreads and some naked call options. For example, a call ratio spread might \nconsist of buying an XYZ July 100 call and selling two XYZ July 120 calls. If one were \nto break it down into its components, this spread is really long one XYZ July 100-120 \ncall bull spread, plus an additional naked July 120 call. \nWe already know that an increase in implied volatility is very detrimental to a \nnaked call option. In addition, it was shown earlier than an increase in implied volatil\nity actually harms the value of an at-the-money call bull spread. So, for a ratio call \nspread, both components are harmed by an increase in implied volatility. Conversely, \na decrease in implied volatility would be beneficial to a ratio spread, but where naked \noptions are concerned, one should be more mindful of his risk than of this reward. \nIt was also shown previously that a call bull spread does not widen out much if \nthe underlying stock makes a quick upward move. The spread won't widen out to its \nmaximum profit potential until expiration draws nigh or the stock is well above the \nupper strike in the spread. This scenario also does not bode well for the ratio call \nspread. Suppose that the underlying stock suddenly jumps upward and implied \nvolatility increases at the same time. That combination is seen quite frequently, espe\ncially if the stock were previously \"dull\" or if there is some sort of active corporate \n(takeover) rumor. The call ratio spread will fare miserably under these conditions, \nbecause the increase in stock price certainly harms the naked call position and the \nbull spread is not widening out much to compensate for it. In addition, the increase \nin implied volatility is working against both components. \nThe same sort of thing happens with put ratio spreads. They are really the com\nbination of a put bear spread plus some additional n", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 346}
{"text": "are miserably under these conditions, \nbecause the increase in stock price certainly harms the naked call position and the \nbull spread is not widening out much to compensate for it. In addition, the increase \nin implied volatility is working against both components. \nThe same sort of thing happens with put ratio spreads. They are really the com\nbination of a put bear spread plus some additional naked put options. If the under\nlying falls in price, while implied volatility increases - a very common occurrence in \nall markets then the put ratio spread will fare poorly. In fact, implied volatility \nsometimes explodes if the underlying falls very rapidly (crashes), so the ratio put \nspreader should clearly assess his risk in this light. \nIn summary, a trader utilizing ratio spread strategies should clearly understand \nand attempt to analyze the risks of an increase in implied volatility. This includes not \nonly assessing the vega risk of the spread, but also using a probability calculator with \nsome inflated volatility estimates to see just what the chances are of the spread get\nting into real trouble. \nBACKSPREADS \nA call backspread is merely the opposite of a call ratio spread. Thus, any of the earli\ner commentary about how an increase in implied volatility is detrimental to a ratio \nspread can be reversed when discussing the backspread. An increase in implied \nvolatility will be beneficial to a backspread strategy, while a decrease in implied \n782 Part VI: Measuring and Trading Volatility \nvolatility will be slightly harmful to the spread. However, since risk is limited in a \nbackspread, such a decrease in implied volatility would not have catastrophic conse\nquences unless one had overcommitted his funds to one position. \nSUMMARY \nIn general, one can always determine the exposure of his position to volatility by com\nputing the vega of this position. However, it is also useful for a strategist to have some \ngeneral feeling for how implied volatility will affect his positions and strategies. Thus, \nthis chapter was designed to point out the most common effects that changes .in \nimplied volatility will have on the basic types of option strategies. Once one has a \nfeeling for his exposure to volatility, he can then assess whether an adverse volatility \nmovement is likely. For example, if an increase in implied volatility would be harm\nful, and the strategist sees that current levels of implied volatility are quite low in \ncomparison to historical norms, then perhaps he should remove or adjust the posi\ntion. \nVolatility and the price of the underlying are the two major components \naffecting profitability for most option positions. Time decay is only most pertinent \nas expiration approaches. Yet, many traders concentrate greatly on potential price \nmovements of the underlying, often while ignoring what changes in implied volatil\nity could do. That is a mistake, for the most knowledgeable option traders plan for \nvolatility risk at all times. Understanding and handling that risk can have a positive \neffect on an option trader's profits. \nThe Distribution of \nStock Prices \nMuch of the work that has been done in statistics and related areas regarding the \nstock market has made the assumption that stock prices are distributed normally, or \nmore specifically, lognonnally. In actual practice, this is usually an incorrect assump\ntion. For the option strategist, this means that some of the things one might believe \nabout certain option strategies having an advantage over certain other option strate\ngies might be incorrect. In this chapter, a number of facts concerning stock price dis\ntribution will be brought to light, including how it might affect the option strategist. \nMISCONCEPTIONS ABOUT VOLATILITY \nStatistics are used to estimate stock price movement (and futures and indices as well) \nin many areas of financial analysis. Many authors have written extensively about the \nuse of probabilities to aid in choosing viable option strategies. Stock mutual fund \nmanagers often use volatility estimates to help them determine how risky their port\nfolios are. The uses are myriad. Unfortunately, almost all of these applications are \nwrong! Perhaps wrong is too strong a word, but almost all estimates of stock price \nmovement are overly conservative. This can be very dangerous if one is using such \nestimates for the purposes of, say, writing naked options or engaging in some other \nsuch strategy in which volatile stock price movement is undesirable. \nAs a review for those not familiar with mathematical distributions, the lognor\nmal distribution is what's commonly used to describe stock prices because its shape \nis intuitively similar to the way stocks behave - they can't go below zero, they can rise \nto infinity, and most of the time they don't go much of anywhere. On top of that, the \ndistribution's shape is based on the historical volatility of the underlying instrument. \nIn a lognormal distribution (and normal distribution, too), stocks remain within 3 \nstandard deviations of their current price 99. 7 4% of the time. A standard deviation \n783 \n784 Part VI: Measuring and Trading Volatility \n(sigma) is a statistical measure whose absolute distance grows larger with time, and \nit is something that can be easily calculated for any individual stock or futures con\ntract, using historical prices. \nThere are great differences between the way stocks really behave and the \nassumptions that many mathematical models make about the way stocks theoretical\nly behave. The problem lies in assuming that normal or lognormal distribution pre\ndicts stock price movements. Such an assumption does not allow for the occasional \nwild days that many stocks, some futures, and the relatively rare index undergo. The \nnormal distribution pretty much says that a stock can't rise or fall by more than 3 stan\ndard deviations. In fact, according to math, the probability of something that behaves \naccording to the normal distribution ( the \"cla", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 347}
{"text": "on pre\ndicts stock price movements. Such an assumption does not allow for the occasional \nwild days that many stocks, some futures, and the relatively rare index undergo. The \nnormal distribution pretty much says that a stock can't rise or fall by more than 3 stan\ndard deviations. In fact, according to math, the probability of something that behaves \naccording to the normal distribution ( the \"classic\" bell curve is a normal distribution) \nmoving three standard deviations is 0.0013 (or just a little more than one tenth of one \npercent). So, if there are 2,500 optionable stocks, say, then one would expect maybe \n3 of them to move three standard deviations on any given day. \nHowever, in real market trading, there are routinely moves in stocks of more \nthan 3 standard deviations - some as much as 5 standard deviations or more. \nStatistically (if the lognormal distribution were correct), one would only expect to see \nmoves of that size maybe once in his lifetime, yet there are five or ten each day! \nSpecifically, the normal distribution's probability of something being able to move 8 \nstandard deviations is 0.000000000000000629. This number is so small that one \nwould expect to see only one such occurrence in the known life of the universe, if \nprices were truly distributed via the normal distribution. If the normal distribution \nwere the correct format for stock prices, such a small probability would indicate that \none would not see an 8-standard deviation move until billions of trading days had \npassed. However, one can find several such moves on nearly any trading day, and it \nis not necessary to use some low-priced, oddball stock that dropped from 1 to . 75 or \nsome such nonsense as an example. \nIf those numbers don't convince you that stocks aren't lognormally distributed, \nperhaps the following study will. Table 38-1 lists moves that occurred on Monday, \nApril 5, 1999 - a day that was somewhat volatile (the Dow was up 174 points). \nThere were many other substantial moves that day. In the list in Table 38-1, all \nthree that fell in price were on earnings warnings, and the two that rose were just \nswept up in the that day's version of the Internet mania. All in all, 58 stocks had \nmoves of greater than four standard deviations on that day! It was not any sort of spe\ncial day, although it did fall during earnings warnings season and in the midst of the \nInternet mania. But the fact that the market is somewhat volatile shouldn't justify all \nof these huge moves, if one still adheres to the belief that lognormal is the correct \ndistribution. \nChapter 38: The Distribution ol Stock Prices 785 \nTABLE 38-1. \nStock Last Sale Change Standard Deviations \nAspect Devt (ASDV) 8 -14.38 -31.2 \nAxent (ANT) 8 -12 -11.2 \nAmeritrade (AMTD) 91.63 +29 .13 + 8.6 \nCheckPoint (CHKP) 28.75 -10.75 - 8.4 \nSabre Gp. (TSG) 55 + 8.50 + 8.0 \nSo, just to make sure that wasn't a bad sample, a low-volatility period was cho\nsen to sample. Since the inception of the CBOE's Volatility Index ($VIX) trading, its \nlowest market volatility readings were in January and July of 1993. The lowest single \nday was July 25, 1993. On that day, twelve stocks had moves of more than four stan\ndard deviations. They included some big names, like Adaptec (ADPT), Bethlehem \nSteel (BS), U.S. Steel (X), Chiquita Brands (CQB), and Novell (NOVL). \nThe only way to tell how many standard deviations a stock has moved is to use \nits historical volatility - say, the 20-day historical volatility, for example - in the meas\nurement. Thus, a 4-point move for a nonvolatile stock like Bethlehem Steel in 1993 \npales in comparison to Ameritrade's 29-point gain in 1999 (Table 38-1), but both \nwere large moves in terms of standard deviations, determined by using each stock's \nhistorical volatility. \nAs another test, prices from October 8, 1998 - the day the market bottomed \nafter a severe and rather swift decline brought on by Russian debt problems (it was \na very volatile day after several volatile weeks of trading) - were tested to see how \nmany stocks had moves of four standard deviations or more. There were 33, but that \nseemingly low number reflects the fact that many stocks' 20-day historical volatilities \nwere already well inflated by October 8, 1998. On that day, the Utility Index ($UTY) \nfell over 14 points, which was about 5.5 standard deviations. American Power \nConversion (APCC) was up over six points that day, to 36.88 - a gain of over five stan\ndard deviations. \nPerhaps you might think that these one-day moves overstate things, that over a \nmore prolonged period of time, the lognormal distribution fits better. A study was \nconstructed to measure the volatility over a slightly longer time period. The results \nof the study not only confirmed our suspicions, but actually were somewhat startling \nin quantifying just how volatile certain individual issues can be. \nThe first example comprised the 30-trading day period between October 22, \n1999 and December 7, 1999. There is nothing magical about these dates; that just \nhappened to be the most recent 30-day period for which data was available when the \nstudy was conducted. \n786 Part VI: Measuring and Trading VolatiRty \nThis particular period started out as a rather normal one in the market - in fact, \nprices had perhaps been a little less volatile than normal leading into that period. To \nsupport that statement, it should be noted that on October 22, the CBOE's Volatility \nIndex ($VIX) stood at about 23 - a relatively middle-of-the-range level. So it wasn't \nas if this was an extremely volatile period. \nThe example is simple enough. The performance of 2,900 optionable stocks was \nmeasured to see if, beginning on October 22, 1999, any of them experienced moves of \ngreater than three standard deviations at any time during the 30-day period. The stan\ndard deviation was based on the 20-day historical volatility of each individual stock. \nObviously, a stock would have to make a much greater move to exceed the", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 348}
{"text": "ple is simple enough. The performance of 2,900 optionable stocks was \nmeasured to see if, beginning on October 22, 1999, any of them experienced moves of \ngreater than three standard deviations at any time during the 30-day period. The stan\ndard deviation was based on the 20-day historical volatility of each individual stock. \nObviously, a stock would have to make a much greater move to exceed the 3-standard \ndeviation limit if it waited until the end of the 30-day period to do it, as opposed to mak\ning a big move on the first day. So, before reading on, take a guess: How many of the \nstocks do you think exceeded three standard deviation moves at some point during the \n30 days? Remember that the lognormal distribution would predict virtually no moves \nof that size. The answer is in the next paragraph. \nThere were more stocks that had large upside moves than there were that had \nlarge downside moves over the period in question. That isn't too surprising, since the \nmarket moved up during that time. The final total showed this: Of the 2,900 stocks, \nnearly 650 experienced moves of 3 standard deviations or more during the life of the \nstudy, including 65 that moved more than six standard deviations. If the lognormal \ndistribution were correct, the two lines in Table 38-2 would be filled with zeroes. This \nclearly shows stocks during this period didn't conform to the \"normal\" expectations. \nThe study results are shown in Table 38-2. (Note that \"cr\" is the greek letter sigma, \nwhich mathematicians traditionally use to denote standard deviations, so 3cr means \nthree standard deviations.) \nTABLE 38·2 \nStock price movements. \nTotal Stocks: 2,888 \nUpside Moves: \nDownside Moves: \n3cr \n309 \n69 \n4cr \n116 \n29 \nSa \n44 \n15 \nDates: I 0/22/99-12/7 /99 \n>6cr \n47 \n19 \nTotal \n516 \n132 \nTotal number of stocks moving >=3cr: 648 [22% of the stocks studied! \nThe largest move was registered by a stock that jumped from a price of 5 to nearly \n12 in about six trading days. One of the bigger downside movers was a stock that fell \nfrom about 20 to 8 in a matter of a couple of weeks, with most of the damage occur\nring in a two-day time period. \nChapter 38: The Distribution of Stock Prices 187 \nLest you think that this example was biased by the fact that it was taken during \na strong run in the NASDAQ market, here's another example, conducted with a dif\nferent set of data- using stock prices between June 1 and July 18, 1999 (also 30 trad\ning days in length). At that time, there were fewer large moves; about 250 stocks out \nof 2,500 or so had moves of more than three standard deviations. However, that's still \none out of ten - way more than you've been led to expect if you believe in the nor\nmal distribution. The results are shown in Table 38-3. \nTABLE 38-3. \nMore stock price movements. \nTotal Stocks: 2,447 Dates: 6/1 /99-7 /18/99 \nUpside Moves: \nDownside Moves: \n3cr \n104 \n54 \n4cr \n28 \n19 \nScr \n13 \n7 \n>6cr \n12 \n14 \nTotal number of stocks moving >=3cr: 251 ( 10% of the stocks studied) \nTotal \n157 \n94 \nFinally, one more example was conducted, using the least volatile period that \nwe had in our database - July of 1993. Those results are in Table 38-4. \nTABLE 38-4. \nStock price movements during a nonvolatile period. \nTotal Stocks: 588 Dates: 7 /1 /93-8/17 /93 \n3cr 4cr Scr >6cr Total \nUpside Moves: 14 5 1 1 21 \nDownside Moves: 28 5 3 4 40 \nTotal number of stocks moving >=3cr: 61 ( 10% of the stocks studied) \nAt first glance, it appears that the number of large stock moves diminished dra\nmatically during this less volatile period in the market - until you realize that it still \nrepresents 10% of the stocks in the study. There were just a lot fewer stocks with list\ned options in 1993 than there were in 1999, so the database is smaller (it tracks only \nstocks with listed options). Once again, this means that there is a far greater chance \nfor large standard deviations moves - about one in ten - than the nearly zero percent \nchance that the lognormal distribution would indicate. \nVOLATILITY BUYER'S RULE! \nThe point of the previous discussion is that stocks move a lot farther than you might \nexpect. Moreover, when they make these moves, it tends to be with rapidity, gener-\n788 Part VI: Measuring and Trading VolatiDty \nally including gap moves. There are not always gap moves, though, over a study of \nthis length. Sometimes, there will be a more gradual transition. Consider the fact that \none of the stocks in the study moved 5.8 sigma in the 30 days. There weren't any huge \ngaps during that time, but anyone who was short calls while the stock made its run \nsurely didn't think it was a gradual advance. \nSo, what does this information mean to the average option trader? For one, \nyou should certainly think twice about selling stock options in a potentially volatile \nmarket ( or any market, for that matter, since these large moves are not by any means \nlimited to the volatile market periods). This statement encompasses naked option \nselling, but also includes many forms of option selling, because of the possibilities of \nlarge moves by the underlying stocks. \nFor example, covered call writing is considered to be \"conservative.\" However, \nwhen the stock has the potential to make these big moves, it will either cause one to \ngive up large upside profits or to suffer large downside losses. ( Covered call writing \nhas limited profit potential and relatively large downside risk, as does its equivalent \nstrategy, naked put selling.) When these large stock moves occur on the upside, a cov\nered writer is often disappointed that he gave up too much of the upside profit poten\ntial. Conversely, if the stock drops quickly, and one is assigned on his naked put, he \noften no longer has much appetite for acquiring the stock ( even though he said he \n\"wouldn't mind\" doing so when he sold the puts to begin with). \nEven spreading has problems along these lines. For example, a vertical spread \nlimits profits so that one can't participate in these relati", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 349}
{"text": "the upside profit poten\ntial. Conversely, if the stock drops quickly, and one is assigned on his naked put, he \noften no longer has much appetite for acquiring the stock ( even though he said he \n\"wouldn't mind\" doing so when he sold the puts to begin with). \nEven spreading has problems along these lines. For example, a vertical spread \nlimits profits so that one can't participate in these relatively frequent large stock \nmoves when they occur. \nWhat can an option seller do? First, he must carefully analyze his position and \nallow for much larger stock movements than one would expect under the lognormal \ndistribution. Also, he must be careful to sell options only when they are expensive in \nterms of implied volatility, so that any decrease in implied will work in his favor. \nProbably most judicious, though, is that an option seller should really concentrate on \nindices (or perhaps certain futures contracts), because they are statistically much less \nvolatile than stocks. Hard as it is to believe, futures are less volatile than stocks \n(although the leverage available in futures can make them a riskier investment overall). \nTwo 30-day studies, similar to those conducted on stocks, were run on option\nable indices, covering the same time periods: 10/22/99 to 12/7/99 for one study and \n7/1/93 to 8/17/93 for the other. The results are shown in Tables 38-5 and 38-6. This \nmay be a somewhat distorted picture, though, because many of these indices overlap \n(there are four Internet indices, for example). The largest mover was the Morgan \nStanley High-Tech Index (5 standard deviations), but it should also be noted that \nsomething that is considered fairly tame, such as the Russell 2000 ($RUT), also had \na 3-standard deviation move in one study. The first study showed that 37% of the \nChapter 38: The Distribution of Stock Prices \nTABLE 38-5. \nIndex price movements. \nTotal Indices: 135 \nUpside Moves: \nDownside Moves: \nTABLE 38-6. \n3cr \n32 \nNone \n4cr \n15 \nScr \n3 \nIndex price movements, least volatile period. \nTotal Indices: 66 \nUpside Moves: \nDownside Moves: \n3cr \nl \n3 \n4cr \nl \n0 \nScr \n0 \n0 \n789 \nDates: 10/22/99-12/7/99 \n>6cr \n0 \nTotal \n50 \nDates: 7/1/93-8/17/93 \n>6cr \n0 \n0 \nTotal \n2 \n3 \nTotal number of indices moving >=3cr: 5 (8% of the indices studied) \nindices made oversized moves - probably a bias because of the strong Internet stock \nmarket during that time period. The low-volatility period showed a more reasonable, \nbut still somewhat eye-opening, 8% making moves of greater than three standard \ndeviations. So, even selling index options isn't as safe as it's cracked up to be, when \nthey can make moves of this size, defying the \"normal\" probabilities. \nSince that period in 1999 was rather volatile, and all on the upside, the same \nstudy was conducted, once again using the least volatile period of July 1993. \nIn Table 38-6, the numbers are lower than they are for stocks, but still much \ngreater than one might expect according to the lognormal distribution. \nThese examples of stock price movement are interesting, but are not rigorous\nly complete enough to be able to substantiate the broad conclusion that stock prices \ndon't behave lognormally. Thus, a more complete study was conducted. The follow\ning section presents the results of this research. \nTHE DISTRIBUTION OF STOCK PRICES \nThe earlier examples pointed out that, at least in those specific instances, stock price \nmovements don't conform to the lognormal distribution, which is the distribution \nused in many mathematical models that are intended to describe the behavior of \nstock and option prices. This isn't new information to mathematicians; papers dating \nback to the mid-1960s have pointed out that the lognormal distribution is flawed. \nHowever, it isn't a terrible description of the way that stock prices behave, so many \napplications have continued to use the lognormal distribution. \n790 Part VI: Measuring and Trading Volatility \nSince 1987, the huge volatility that stocks have exhibited - especially on certain \nexplosive down days such as the Crash of '87 or the mini-crash of April 14, 2000 - has \nalerted more people to the fact that something is probably amiss in their usual assump\ntions about the way that stocks move. The lognonnal distribution \"says\" that a stock \nreally can't move farther than three standard deviations (whether it's in a day, a week, \nor a year). Actual stock price movements make a mockery of these assumptions, as \nstocks routinely move 4, 5, or even 10 standard deviations in a day (not all stocks, mind \nyou, but some - many more than the lognormal distribution would allow for). \nIn order to further quantify these thoughts, computer programs were written to \nanalyze our database of stock prices, going back over six years. As it turns out, that is \na short period of time as far as the stock market is concerned. While it is certainly a \nlong enough time to provide meaningful analysis (there are over 2.5 million individ\nual stock \"trading days\" in the study), it is a biased period in that the market was ris\ning for most of that time. \nTHE \"'BIG\" PICTURE \nThe first part of the analysis shows that the total distribution of stock prices conforms \npretty much to what the expectations were for the study, and - not surprisingly - to \nwhat others have written about the \"real\" distribution of stock prices. That is, there \nis a much greater chance of a large standard deviation move than the lognormal dis\ntribution would indicate. The high probabilities on the ends of the distribution are \ncalled \"fat tails\" by most mathematicians and stock market practitioners alike. These \n\"tails\" are what get option writers in trouble - and perhaps even leveraged stock own\ners - because margin buyers and naked writers figure that they will never occur. It is \nnot intuitively obvious to them and to many other stock market participants that stock \nprices behave in this manner. \nThe graphs in Figure 38-1 show this total distribution. The top grap", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 350}
{"text": "ock market practitioners alike. These \n\"tails\" are what get option writers in trouble - and perhaps even leveraged stock own\ners - because margin buyers and naked writers figure that they will never occur. It is \nnot intuitively obvious to them and to many other stock market participants that stock \nprices behave in this manner. \nThe graphs in Figure 38-1 show this total distribution. The top graph is that of the \nlognormal distribution and the actual distribution, using the data from September 1993 \nto April 2000 overlaid upon each other. The actual distribution was drawn using 30-\nday moves (i.e., the number of standard deviations was computed by looking at the \nstock price on a certain day, and then where it was 30 calendar days later). The x-axis \n(bottom axis) shows the number of standard deviations moved. Note that the curves \nhave the shape of a normal distribution rather than a lognormal distribution, because \nthe x-axis denotes number of standard deviations moved rather than stock prices them\nselves. For this reason, the term \"normal\" will be used in the remainder of this section; \nit should be understood that it is the distribution of standard deviations that is \"normal,\" \nwhile the distribution of the stock prices measured by those standard deviation moves \nis \"lognormal.\" The y-axis (left axis) shows the \"count\" - the number of times out of the \n2.5 million data points computed that each point on the x-axis actually occurred (in the \nChapter 38: The Distribution of Stock Prices \nFIGURE 38-1. \nStock price distribution is not ''normal.\" \nNormal Stock Price Distribution \nvs. Actual Stock Distribution (30-Day Moves) \n0 \n£ \nC ::, \n0 (.) \n4000 \n3000 \n2000 \n1000 \n0 \n-1.0 0 +1.0 \nSigmas \n240 Includes All Moves 180 \n220 below-4.0 0 160 \n210 £ 140 \n200 C 120 \n0 180 ::, \n0 100 \n£ 160 (.) 80 C 140 ::, \n120 60 0 \n(.) 100 40 \n80 20 \n60 0 \n40 +3.0 \n20 \n0 -4.0 \nSigmas \n791 \n792 Part VI: Measuring and Trading Volatility \ncase of the \"actual\" distribution) or could be expected to occur (in the case of the \"nor\nmal\" distribution). The notation on the y-axis shows the actual count divided by 10. So, \nfor example, the highest point (0 standard deviations moved) for the \"normal\" distri\nbution shows that about 95,000 times out of 2.5 million, you could expect a stock to be \nunchanged at the end of 30 calendar days. \nAt first glance, it appears that the two curves have almost identical shapes. \nUpon closer inspection, however, it is clear that they do not, and in fact some rather \nstartling differences are evident. \nFat Tails \nFigure 38-1 shows the fat tails quite clearly. Magnified views of the fat tails are pro\nvided to show you the stark differences between the theoretical (\"normal\") distribu\ntion and actual stock price movements. Consider the downside (the lower left circled \ngraph in Figure 38-1). First, note that both the \"actual\" and \"normal\" graphs lift up \nat the end - the leftmost point. This is because the graph was terminated at -4.0 stan\ndard deviations, and all moves that were greater than that were accumulated and \ngraphed as the leftmost data point. You can see that the \"normal\" distribution expects \nfewer than 200 moves out of 2.5 million to be of -4.0 standard deviations or more \n(yes, the \"normal\" distribution does allow for moves greater than 3 standard devia\ntions; they just aren't very probable). On the other hand, actual stock prices - even \nduring the bull market that was occurring during the term of the data in this study -\nfell more than -4.0 standard deviations nearly 2,500 times out of 2.5 million. Thus, \nin reality, there was really more than 12 times the chance (2,500 vs. 200) that stocks \ncould suffer a severely dramatic fall, when comparing actual to theoretical distribu\ntion. Also notice in that lower left circle that the actual distribution is greater than the \nnormal distribution all along the graph. \nThe upside fat tail shows much the same thing: Actual stock prices can rise far\nther than the normal distribution would indicate. At the extreme - moves of +4.0 \nstandard deviations or more - there were about 2,000 such moves in actual stock \nprices, compared with fewer than 100 expected by the normal distribution. Again, a \nvery large discrepancy: twenty-to-one. \nInflection Points \nIf the actual distribution is higher at both ends, it must be lower than the normal \ndistribution somewhere, because there are only a total of 2.5 million data points \nplotted. It turns out in this case that the normal distribution is higher (i.e., is expect\ned to occur more often than it actually does) between -2.5 standard deviations and \n+0.5 standard deviations. Those are the points where the two curves cross over each \nother - the inflection points. Outside of that range, the actual distribution is more \nfrequent than it was expected to be. \nChapter 38: The Distribution of Stock Prices 793 \nIt is probably the case that this data reflected an overly bullish period. That is, \nactual stock prices rose farther than they were expected to, not necessarily at the tails, \nbut in the intermediate ranges, say between +0.5 and +1.5 standard deviations. This \ndoes not change the results of the study as far as the tails go, but one may not always \nbe able to count on intermediate upside moves being more frequent than predicted. \nSIDE BENEFITS OF THIS STUDY \nIn the course of doing these analyses, a lot of smaller distributions were calculated \nalong the way. One of these is the distribution on any individual trading day that was \ninvolved in the study. Now, one must understand that one day's trading yields only \nabout 3,000 data points (there were about 3,000 stocks in the database), so the result\ning curve is not going to be as smooth as the ones shown in Figure 38-1. \nNevertheless, some days could be interesting. For example, consider the day of the \nmini-crash, Friday, April 14, 2000. The Dow-Jones Industrials were down 617 that \nday; the S&P 500 index was down 83 points; and the NASDAQ-100 was", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 351}
{"text": "only \nabout 3,000 data points (there were about 3,000 stocks in the database), so the result\ning curve is not going to be as smooth as the ones shown in Figure 38-1. \nNevertheless, some days could be interesting. For example, consider the day of the \nmini-crash, Friday, April 14, 2000. The Dow-Jones Industrials were down 617 that \nday; the S&P 500 index was down 83 points; and the NASDAQ-100 was down 346. \nExcept for the Crash of 1987, these were the largest single-day declines in history. \nThe distribution graph is shown in Figure 38-2. \nFirst of all, notice how heavily the distribution is skewed to the left; that agrees \nwith one's intuition that the distribution should be on the left when there is such a seri\nous down day as 4/14/2000. Also, notice that the leftmost data point- representing all \nmoves of -4.0 standard deviations and lower, shows that about 750 out of the 2,984 \nstocks had moves of that size! That is unbelievable, and it really points out just how \nFIGURE 38-2. \nStock price distribution for 4/14/2000 - 2,984 Stocks in Study. \n110 \n100 \n90 \n80 \n0 70 ,.... \n~ 60 C ::, \n50 0 \n() \n40 \n30 \n20 \n10 \n-4.0 -3.0 -2.0 -1.0 0.0 + 1.0 +2.0 _3.0 +4.0 \nSigmas \n794 Part VI: Measuring and Trading Volatility \nFIGURE 38-3. \nStock price distribution, IBM, 7-year. \n7 \n6 \n5 \n~ 4 :;:, \nC: :::, \n8 3 \n2 \no----------------+---,.._,._\"\"-¥-+-\n-4.o -3.o -2.0 -1.0 o.o +1.0 +2.0 +3.o +4.o \nSigmas \ndangerous naked puts and long stock on margin can be on days like this. No proba\nbility calculator is going to give much likelihood to a day like this occurring, but it did \noccur and it benefited those holding long puts greatly, while it seriously hurt others. \nIn addition to distributions for individual dates, distributions for individual stocks \nwere created for the time period in question. The graph for IBM, using data from the \nsame study as above (September 1993 to April 2000) is shown in Figure 38-3. In the \nnext graph, Figure 38-4, a longer price history of IBM is used to draw the distribution: \n1987 to 2000. Both graphs depict 30-day movements in IBM. \nFIGURE 38-4. \nActual stock price distribution, IBM, 13-year. \n13 \n12 \n11 \n10 \n9 \no a ,-\nE 7 \ng 6 \n(.) 5 \n4 \n3 \n2 \no -4.0 -3.0 -2.0 -1.0 0.0 + 1.0 +2.0 +3.0 +4.0 \nSigmas \nChapter 38: The Distribution of Stock Prices 795 \nFigure 38-3 perhaps shows even more starkly how the bull market has affected \nthings over the last six-plus years. There are over 1,600 data points for IBM (i.e., daily \nreadings) in Figure 38-3, yet the whole distribution is skewed to the right. It appar\nently was able to move up quite easily throughout this time period. In fact, the worst \nmove that occurred was one move of -2.5 standard deviations, while there were \nabout ten moves of +4.0 standard deviations or more. \nFor a longer-term look at how IBM behaves, consider the longer-term distribu\ntion of IBM prices, going back to March 1987, as shown in Figure 38-4. \nFrom Figure 38-4, it's clear that this longer-term distribution conforms more \nclosely to the normal distribution in that it has a sort of symmetrical look, as opposed \nto Figure 38-3, which is clearly biased to the right (upside). \nThese two graphs have implications for the big picture study shown in Figure \n38-1. The database used for this study had data for most stocks only going back to \n1993 (IBM is one of the exceptions); but if the broad study of all stocks were run \nusing data all the way back to 1987, it is certain that the \"actual\" price distribution \nwould be more evenly centered, as opposed to its justification to the right (upside). \nThat's because there would be more bearish periods in the longer study (1987, 1989, \nand 1990 all had some rather nasty periods). Still, this doesn't detract from the basic \npremise that stocks can move farther than the normal distribution would indicate. \nWHAT THIS MEANS FOR OPTION TRADERS \nThe most obvious thing that an option trader can learn from these distributions and \nstudies is that buying options is probably a lot more feasible than conventional wisdom \nwould have you believe. The old thinking that selling an option is \"best\" because it \nwastes away every day is false. In reality, when you have sold an option, you are exposed \nto adverse price movements and adverse movements in implied volatility all during the \nlife of the option. The likelihood of those occurring is great, and they generally have \nmore influence on the price of the aption in the short run than does time decay. \nYou might ask, \"But doesn't all the volatility in 1999 and 2000 just distort the \nfigures, making the big moves more likely than they ever were, and possibly ever will \nbe again?\" The answer to that is a resounding, \"Nol\" The reason is that the current \n20-day historical volatility was used on each day of the study in order to determine \nhow many standard deviations each stock moved. So, in 1999 and 2000, that histori\ncal volatility was a high number and it therefore means that the stock would have had \nto move a very long way to move four standard deviations. In 1993, however, when \nthe market was in the doldrums, historical volatility was low, and so a much smaller \n794 Part VI: Measuring and Trading Volatility \nFIGURE 38-3. \nStock price distribution, IBM, 7-year. \n7 \n6 \n5 \n0 4 \n:g \n::, \n0 3 () \n2 \n0f-<--,.Jil,,J:.~------+---+---+----+--____;_,=!!:¥+-\n-4.0 -3.0 -2.0 -1.0 0.0 + 1.0 +2.0 +3.0 +4.0 \nSigmas \ndangerous naked puts and long stock on margin can be on days like this. No proba\nbility calculator is going to give much likelihood to a day like this occurring, but it did \noccur and it benefited those holding long puts greatly, while it seriously hurt others. \nIn addition to distributions for individual dates, distributions for individual stocks \nwere created for the time period in question. The graph for IBM, using data from the \nsame study as above (September 1993 to April 2000) is shown in Figure 38-3. In the \nnext graph, Figure 38-4, a longer price history of IBM is used to draw the d", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 352}
{"text": "those holding long puts greatly, while it seriously hurt others. \nIn addition to distributions for individual dates, distributions for individual stocks \nwere created for the time period in question. The graph for IBM, using data from the \nsame study as above (September 1993 to April 2000) is shown in Figure 38-3. In the \nnext graph, Figure 38-4, a longer price history of IBM is used to draw the distribution: \n1987 to 2000. Both graphs depict 30-day movements in IBM. \nFIGURE 38-4. \nActual stock price distribution, IBM, 13-year. \n13 \n12 \n11 \n10 \n9 \n0 8 ,... \nE 7 \n5 6 \n() 5 \n4 \n3 \n2 \n1 \no -4.0 -3.0 -2.0 -1.0 0.0 + 1.0 +2.0 +3.0 +4.0 \nSigmas \nChapter 38: The Distribution of Stock Prices 195 \nFigure 38-3 perhaps shows even more starkly how the bull market has affected \nthings over the last six-plus years. There are over 1,600 data points for IBM (i.e., daily \nreadings) in Figure 38-3, yet the whole distribution is skewed to the right. It appar\nently was able to move up quite easily throughout this time period. In fact, the worst \nmove that occurred was one move of -2.5 standard deviations, while there were \nabout ten moves of +4.0 standard deviations or more. \nFor a longer-term look at how IBM behaves, consider the longer-term distribu\ntion of IBM prices, going back to March 1987, as shown in Figure 38-4. \nFrom Figure 38-4, it's clear that this longer-term distribution conforms more \nclosely to the normal distribution in that it has a sort of symmetrical look, as opposed \nto Figure 38-3, which is clearly biased to the right (upside). \nThese two graphs have implications for the big picture study shown in Figure \n38-1. The database used for this study had data for most stocks only going back to \n1993 (IBM is one of the exceptions); but if the broad study of all stocks were run \nusing data all the way back to 1987, it is certain that the \"actual\" price distribution \nwould be more evenly centered, as opposed to its justification to the right (upside). \nThat's because there would be more bearish periods in the longer study (1987, 1989, \nand 1990 all had some rather nasty periods). Still, this doesn't detract from the basic \npremise that stocks can move farther than the normal distribution would indicate. \nWHAT THIS MEANS FOR OPTION TRADERS \nThe most obvious thing that an option trader can learn from these distributions and \nstudies is that buying options is probably a lot more feasible than conventional wisdom \nwould have you believe. The old thinking that selling an option is \"best\" because it \nwastes away every day is false. In reality, when you have sold an option, you are exposed \nto adverse price movements and adverse movements in implied volatility all during the \nlife of the option. The likelihood of those occurring is great, and they generally have \nmore influence on the price of the option in the short run than does time decay. \nYou might ask, \"But doesn't all the volatility in 1999 and 2000 just distort the \nfigures, making the big moves more likely than they ever were, and possibly ever will \nbe again?\" The answer to that is a resounding, \"Nol\" The reason is that the current \n20-day historical volatility was used on each day of the study in order to determine \nhow many standard deviations each stock moved. So, in 1999 and 2000, that histori\ncal volatility was a high number and it therefore means that the stock would have had \nto move a very long way to move four standard deviations. In 1993, however, when \nthe market was in the doldrums, historical volatility was low, and so a much smaller \n796 Part VI: Measuring and Trading Volatility \nmove was needed to register a 4-standard deviation move. To see a specific example \nof how this works in actual practice, look carefully at the chart of IBM in Figure 38-\n4, the one that encompasses the crash of '87. Don't you think it's a little strange that \nthe chart doesn't show any moves of greater than minus 4.0 standard deviations? The \nreason is that IBM's historical volatility had already increased so much in the days \npreceding the crash day itself, that when IBM fell on the day of the crash, its move \nwas less than minus 4.0 standard deviations. (Actually, its one-day move was greater \nthan -4 standard deviations, but the 30-day move - which is what the graphs in Figure \n38-3 and 38-4 depict - was not.) \nSTOCK PRICE DISTRIBUTION SUMMARY \nOne can say with a great deal of certainty that stocks do not conform to the normal \ndistribution. Actually, the normal distribution is a decent approximation of stock \nprice movement rrwst of the time, but it's these \"outlying\" results that can hurt any\none using it as a basis for a nonvolatility strategy. \nScientists working on chaos theo:ry have been trying to get a better handle on \nthis. An article in Scientific American magazine (\"A Fractal Walk Down Wall Street,\" \nFebrua:ry 1999 issue) met some criticism from followers of Elliot Wave theo:ry, in that \nthey claim the article's author is purporting to have \"invented\" things that R. N. \nElliott discovered years ago. I don't know about that, but I do know that the article \naddresses these same points in more detail. In the article, the author points out that \nchaos theo:ry was applied to the prediction of earthquakes. Essentially, it concluded \nthat earthquakes can't be predicted. Is this therefore a useless analysis? No, says the \nauthor. It means that humans should concentrate on building stronger buildings that \ncan withstand the earthquakes, for no one can predict when they may occur. Relating \nthis to the option market, this means that one should concentrate on building strate\ngies that can withstand the chaotic movements that occasionally occur, since chaotic \nstock price behavior can't be predicted either. \nIt is important that option traders, above all people, understand the risks of \nmaking too conservative an estimate of stock price movement. These risks are espe\ncially great for the writer of an option (and that includes covered writers and spre", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 353}
{"text": "on building strate\ngies that can withstand the chaotic movements that occasionally occur, since chaotic \nstock price behavior can't be predicted either. \nIt is important that option traders, above all people, understand the risks of \nmaking too conservative an estimate of stock price movement. These risks are espe\ncially great for the writer of an option (and that includes covered writers and spread\ners, who may be giving away too much upside by writing a call against long stock or \nlong calls). By quantifying past stock price movements, as has been done in this chap\nter, my aim is to convince you that \"conventional\" assumptions are not good enough \nfor your analyses. This doesn't mean that it's okay to buy overpriced options just \nbecause stocks can make large moves with a greater frequency than most option \nChapter 38: The Distribution of Stock Prices 797 \nmodels predict; but it certainly means that the buyer of underpriced options stands \nto benefit in a couple of ways. Conversely, an option seller must certainly concentrate \nhis efforts where options are expensive, and even then should be acutely aware that \nhe may experience larger-than-expected stock price movements while the option \nposition is in place. \nSo what does this mean for option strategies? On the surface, it means that if \none uses the normal (or lognormal) distribution for estimating the probability of a \nstrategy's success, he may get a big move in the stock that he didn't originally view as \npossible. If one were long straddles, that's great. However, if he is short naked \noptions, then there could be a nasty surprise in store. That's one reason why extreme \ncaution should be used regarding selling naked options on stocks; they can make \nmoves of this sort too often. At least with indices, such moves are far less frequent, \nalthough the Dow drop of over 550 points in October 1997 was a move of seven stan\ndard deviations, and the crash of '87 was about a 16-standard deviation move - which \nProfessor Mark Rubenstein of the University of California at Berkeley says was some\nthing that should occur about once in ten times the life of our current universe! That's \naccording to lognormal distribution, of course, which we know understates things \nsomewhat, but it's still a big number under any distribution. \nThere are two approaches that one can take, then, regarding option strategies. \nOne is to invent another method for estimating stock price distributions. Suffice it to \nsay that that is not an easy task, or someone would have made it well-known already. \nThere have been many attempts, including some in which a large history of stock \nprice movements is observed and then a distribution is fitted to them. The problem \nwith accounting for these occasional large price moves is that it is perhaps an even \nmore grievous error to overestimate the probabilities of such moves than to underes\ntimate them. \nThe second approach is to continue to use the normal distribution, because it's \nfast and accessible in a lot of places. Then, either rely on option buying strategies \n( straddles, for example) where implied volatility appears to be low - knowing that you \nhave a chance at better results than the statistics might indicate - or adjust your cal\nculations mentally for these large potential movements if you are using option selling \nstrategies. \nTHE PRICING OF OPTIONS \nThe extreme movements of the fat tail distribution should be figured into the pricing \nof an option, but they really are not, at least not by most models. The Black-Scholes \n798 Part VI: Measuring and Trading Volatility \nmodel, for example, uses a lognormal distribution. Personally, this author believes \nthat the Black-Scholes model is an excellent tool for analyzing options and option \nstrategies, but one must understand that it may not be affording enough probability \nto large moves by the underlying. \nDoes this mean that most options are underpriced, since traders and market\nmakers are using the Black-Scholes model (or similar models) to price them? \nWithout getting too technical, the answer is that yes, some options - particularly out\nof-the-money options - are probably underpriced. However, one must understand \nthat it is still a relatively rare occurrence to experience one of these big moves - ifs \njust not as rare as the lognormal distribution would indicate. So, an out-of-the-money \noption might be slightly underpriced, but often not enough to make any real differ\nence. \nIn fact, futures options in grains, gold, oil, and other markets that often experi\nence large and sudden rallies display a distinct volatility skew. That is, out-of-the-money \ncall options trade at significantly higher implied volatilities than do at-the-money \noptions. Ironically, there is far less chance of one of these hyper-standard-deviation \nmoves occurring in commodities than there is in stocks, at least if history is a guide. So, \nthe fact that some out-of-the-money futures options are expensive is probably an incor\nrect overadjustment for the possibility of large moves. \nTHE PROBABILITY OF STOCK PRICE MOVEMENT \nThe distribution information introduced in this chapter can be incorporated into \nsomewhat rigorous methods of determining probabilities. That is, one can attempt to \nassess the chances of a stock, futures contract, or index moving by a given distance, \nand those chances can incorporate the fat tails or other non-lognormal behavior of \nprices. \nThe software that calculates such probabilities is typically named a \"probability \ncalculator.\" There are many such software programs available in the marketplace. \nThey range from free calculators to completely overpriced ones selling for more than \n$1,000. In reality, high-level probability calculation software can be created by some\none with a good understanding of statistics, or a program can be purchased for a \nrather nominal fee - perhaps $100 or so. \nBefore getting into these various methods of probability estimation, it should b", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 354}
{"text": "e in the marketplace. \nThey range from free calculators to completely overpriced ones selling for more than \n$1,000. In reality, high-level probability calculation software can be created by some\none with a good understanding of statistics, or a program can be purchased for a \nrather nominal fee - perhaps $100 or so. \nBefore getting into these various methods of probability estimation, it should be \nnoted that all of them require the trader to input a volatility estimate. There are only \na few other inputs, usually the stock price, target price(s), and length of time of the \nstudy. The volatility one inputs is, of course, an estimate of future volatility - some-\nChapter 38: The Distribution of Stock Prices 799 \nthing that cannot be predicted with certainty. Nevertheless, any probability calcula\ntor requires this input. So, one must understand that the results one obtains from any \nof these probability calculators is an estimate of what might happen. It should not be \nrelied on as \"gospel.\" \nAdditionally, probability calculators make a second assumption: that the volatil\nity one inputs will remain constant over the entire length of the study. We know this \nis incorrect, for volatility can change daily. However, there really isn't a good way of \nestimating how volatility might change in the course of the study, so we are pretty \nmuch forced to live with this incorrect assumption as well. \nThere is no certain way to mitigate these volatility \"problems\" as far as the prob\nability calculator is concerned, but one helpful technique is to bias the volatility pro\njection against your objectives. That is, be overly conservative in your volatility pro\njections. If things tum out to be better than you estimated, fine. However, at least \nyou won't be overstating things initially. An example may help to demonstrate this \ntechnique. \nExample: Suppose that a trader is considering buying a straddle on XYZ. The five\nmonth straddle is selling for a price of 8, with the stock currently trading near 40. A \nprobability calculator will help him to determine the chances that XYZ can rise to 48 \nor fall to 32 (the break-even points) prior to the options' expiration. However, the \nprobability calculator's answer will depend heavily on the volatility estimate that the \ntrader plugs into the probability calculator. Suppose that the following information is \nknow about the historical volatility of XYZ: \nl 0-day historical volatility: \n20-day historical volatility: \n50-day historical volatility: \nl 00-day historical volatility \n22% \n20% \n28% \n33% \nWhich volatility should the trader use? Should he choose the 100-day historical \nvolatility since this is a five-month straddle, which encompasses just about 100 trad\ning days until expiration? Should he use the 20-day historical volatility, since that is \nthe \"generally accepted\" measure that most traders refer to? Should he calculate a \nhistorical volatility based exactly on the number of days until expiration and use that? \nTo be most conservative, none of those answers is right, at least not for the right \nreasons. Since one is buying options in this strategy, he should use the lowest of the \nabove historical volatility measures as his volatility estimate. By doing so, he is taking \na conservative approach. If the straddle buy looks good under this conservative \nassumption, then he can feel fairly certain that he has not overstated the possibilities \n800 Part VI: Measuring and Trading Volatility \nof success. If it turns out that volatility is higher during the life of the position, that \nwill be an added benefit to this position consisting of long options. So, in this exam\nple, he should use the 20-day historical volatility because it is the lowest of the four \nchoices that he has. \nSimilarly, if one is considering the sale of options or is taking a position with a \nnegative vega ( one that will be harmed if volatility increases), then he should use the \nhighest historical volatility when making his probability projections. By so doing, he \nis again being conservative. If the strategy in question still looks good, even under an \nassumption of high volatility, then he can figure that he won't be unpleasantly sur\nprised by a higher volatility during the life of the position. \nThere have been times when a 100-day lookback period was not sufficient for \ndetermining historical volatility. That is, the underlying has been performing in an \nerratic or unusual manner for over 100 days. In reality, its true nature is not described \nby its movements over the past 100 days. Some might say that 100 days is not enough \ntime to determine the historical volatility in any case, although most of the time the \nfour volatility measures shown above will be a sufficient guide for volatility. \nWhen a longer lookback period is required, there is another method that can be \nused: Go back in a historical database of prices for the underlying and compute the \n20-day, 50-day, and l 00-day historic volatilities for all the time periods in the data\nbase, or at least during a fairly large segment of the past prices. Then use the medi\nan of those calculations for your volatility estimates. \nExample: XYZ has been behaving erratically for several months, due to overall mar\nket volatility being high as well as to a series of chaotic news events that have been \naffecting XYZ. A trader wants to trade XYZ's options, but needs a good estimate of \nthe \"true\" volatility potential of XYZ, for he thinks that the news events are out of the \nway now. At the current time, the historical volatility readings are: \n20-day historical: 130% \n50-day historical l 00% \n100-day historical 80% \nHowever, when the trader looks farther back in XYZ's trading history, he sees \nthat it is not normally this volatile. Since he suspects that XYZ's recent trading histo\nry is not typical of its true long-term performance, what volatility should he use in \neither an option model or a probability calculator? \nRather than just using the", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 355}
{"text": "istorical: 130% \n50-day historical l 00% \n100-day historical 80% \nHowever, when the trader looks farther back in XYZ's trading history, he sees \nthat it is not normally this volatile. Since he suspects that XYZ's recent trading histo\nry is not typical of its true long-term performance, what volatility should he use in \neither an option model or a probability calculator? \nRather than just using the maximum or minimum of the above three numbers \n(depending on whether one is buying or selling options), the trader decides to look \nChapter 38: The Distribution of Stock Prices 801 \nback over the last 1,000 trading days for XYZ. A 100-day historical volatility can be \ncomputed, using 100 consecutive trading days of data, for 901 of those days (begin\nning with the 100th day and continuing through the l,000th day, which is presumably \nthe current trading day). Admittedly, these are not completely unique time periods; \nthere would only be ten non-overlapping (independent) consecutive 100-day periods \nin 1,000 days of data. However, let's assume that the 901 periods are used. One can \nthen arrive at a distribution of 100-day historical volatilities. Suppose it looks some\nthing like this: \nPercentile 100-Day Historical \noth 34% \n10th 37% \n20th 43% \n30th 45% \n40th 46% \n50th 48% \n60th 51% \n70th 58% \naoth 67% \n90th 75% \n1 ooth 81% \nIn other words, the 901 historical volatilities (100 days in each) are sorted and then \nthe percentiles are determined. The above table is just a snapshot of where the per\ncentiles lie. The range of those 901 volatilities is from 34% on the low side to 81 % on \nthe high side. Notice also that there is a very flat grouping from about the 20th per\ncentile to the 60th percentile: The 100-day historical volatility was between 43% and \n51 % over that entire range. The median of the above figures is 48% - the 100-day \nvolatility at the 50th percentile. \nReferring to the early part of this example, the current 100-day historical is \n80%, a very high reading in comparison to what the measures were over the past \n1,000 days, and certainly much higher than the median of 48%. \nOne could perform similar analyses on the 1,000 days of historical data to deter\nmine where the 10-day, 20-day, and 50-day historical volatilities were over that time. \nThose, too, could be sorted and arranged in percentile format, using the 50% per\ncentile (median) as a good estimate of volatility. After such computations, the trader \nmight then have this information: \n802 Part VI: Measuring and Trading Volatility \nUsing 1,000 days of data: \nMedian 100-day historical volatility: 48% \nMedian 50-day historical volatility: 49% \nMedian 20-day historical volatility: 52% \nMedian 10-day historical volatility: 49% \nIf these were all the data that one had, then he would probably use a volatility esti\nmate of 48% or so in his option models or probability calculators. Of course, this is \nstarkly different from the current levels of historical volatility (shown at the begin\nning of this example). So, one must be careful in assessing whether he expects the \nstock to perform more in line with its longer-term (1,000 trading days) characteristics \nor if there is some reason to think that the stock's behavior patterns have changed and \nthe higher, more recent volatilities should be used. \nThe pertinent volatilities to consider, then, in a strategy analysis are the medi\nans as well as the current figures. If the trader were going to be buying options in his \nstrategy, should he use the minimum of the volatilities shown, 48%? Probably. \nHowever, if he's a seller of options, should he use the maximum, 130%? That might \nbe a little too much of a penalty, but at least he would feel safe that if his volatility \nselling position had a positive expected return with that high a volatility projection, \nthen it must truly be an attractive position. \nIn an analysis like that shown in this example, there is nothing magical about \nusing 1,000 trading days. Perhaps something like 600 trading days would be better. \nThe idea is to use enough trading days to bring in some historic data to counterbal\nance the recent, erratic behavior of the stock. \nAmong other things, this example also shows that volatilities are unstable, no \nmatter how much work and mathematics one puts into calculating them. Therefore, \nthey are at best a fragile estimate of what might happen in the future. Still, it's the \nbest guess that one can make. The trader should realize, though, that when volatili\nties are this disparate when comparing recent and more distant activity, the results of \nany mathematical projections using those volatilities should not be relied upon too \nheavily. Those results will be just as tenuous as the volatility projections themselves. \nOf course, in any case, the actual volatility that occurs while the position is in place \nmay be even more unfavorable than the one the trader used in his initial analysis. There \nis nothing that one can do about that. But if you choose what appears to be a somewhat \nunfavorable volatility, and the position still looks good under those assumptions, then it \nis likely that the trader will be pleasantly surprised more often than not - that actual \nvolatility during the life of the position will tend to be more in his favor than not. \nChapter 38: The Distribution of Stock Prices 803 \nIn a recent chapter, the various methods of trying to predict volatility were out\nlined, using either historical volatility, implied volatility, a moving average of either of \nthose, or even GARCH volatility. None of these will predict with certainty what is \ngoing to happen in the future. Hence, the prediction of volatility is necessarily vague \nat best. \nIn addition to the vagaries of estimating volatility, the probability calculators will \nreturn an answer that represents the probability of something happening \"in the long \nrun.\" That is, if the same scenario were to arise many, many times, the answer is rel\nevant to how many times the s", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 356}
{"text": "ty what is \ngoing to happen in the future. Hence, the prediction of volatility is necessarily vague \nat best. \nIn addition to the vagaries of estimating volatility, the probability calculators will \nreturn an answer that represents the probability of something happening \"in the long \nrun.\" That is, if the same scenario were to arise many, many times, the answer is rel\nevant to how many times the stock would move to the indicated target price. This is \nsmall solace if one happens to be caught in the vortex of the Crash of '87, for exam\nple. So, just remember that these probability calculators are tools that can help you \nin assessing the relative risks of similar positions ( evaluating various naked option \nsales, say), but the resulting stock movement in any one case can be quite different \nfrom what any probability calculator describes as the chances of that move actually \nhappening. \nTHE ENDPOINT CALCULATION \nThe following paragraphs describe how the various probability calculation mecha\nnisms work. The simplest and most straightforward probability calculation has \nalready been presented in Chapter 28 on mathematical applications. It was included \nin the section on \"expected returns\" in that chapter. The formula is presented here \nagain, for completeness. \nThe formula gives the probability of a stock, which is currently at price p, being \nbelow some other price, q, at the end of the time period. The lognormal distribution \nis assumed. \nProbability of stock being below price q at end of time period, t \nwhere \nN = cumulative normal distribution \np = current price of the stock \nq = price in question \nln = natural logarithm for the time period in question \n804 Part VI: Measuring and Trading Volatility \nIf one is interested in computing the probability of the stock being above the \ngiven price, the formula is \nP (above) = 1 - P (below) \nIn the above formula, Vt = v✓t where t is time to expiration in years and v is \nannual volatility, as usual. \nThis formula is quite elementary for predictive purposes, and it is used by \nmany traders. This calculator can be found for free at the Web site www.option\nstrategist.com. Its main problem is that it gives the probability of the stock being \nabove or below the target price at the end of the time period, t. That's not a totally \nrealistic way of approaching probability analysis. Most option traders are very con\ncerned with what happens to their positions during the life of the option, not just at \nexpiration. \nExample: suppose a trader is a seller of naked put options. He sells $OEX October \n550 puts naked, with $OEX currently trading at 600. He would not normally just walk \naway from this position until October expiration, because of the large risk involved \nwith the sale of a naked option. There are essentially three scenarios that can occur: \n1. $OEX might never fall to 550 by expiration. In this case, he would have a \nvery comfortable trade that was never in jeopardy, and the options would \nexpire worthless. \n2. $OEX might fall below 550 and remain there until expiration. In this case, \nhe would surely have a loss unless $OEX were just a tiny bit below 550. \n3. $OEX might fall below 550 at some time between when the trade was estab\nlished and when expiration occurred, but then subsequently rally back above \n550 by the time expiration arrived. \nAn experienced option trader would almost certainly adjust if scenario 3 arose, \nin order to prevent large losses from occurring. He might roll his naked puts down \nand out to another strike, or he might just close them out altogether. However, it is \nunlikely that he would do nothing. \nThe simple probability calculator formula shown above does not take into \naccount the trader's third scenario. Since it is only concerned with where the stock is \nat expiration of the options, only scenarios 1 and 2 apply to it. Hence the usage of this \nsimple calculator is not really descriptive of what might happen to a trade during its \nlifetime. \nLet's assign some numbers to the above trade, so that you might see the differ\nence. Suppose that the volatility estimate is 25%, there are 30 days until expiration, \nand the prices are as stated in the previous example: $OEX is at 600, and the strik-\nChapter 38: The Distribution of Stock Prices 805 \ning price of the naked put being sold is 550. The resulting probabilities might be \nsomething like this: \nScenario Actual Probability of Occurrence \n1 . $OEX never falls below 550 \n2. $OEX falls below 550 and remains there \n3. $OEX falls below 550 but rallies later \n67% \n19% \n14% \nThe probabilities stated above are the \"real\" probabilities of the three various \nscenarios occurring. However, if one were using the simple probability calculator \npresented above, he would only have the following information: \nProbability of $OEX being above 550 at expiration: 81 % \nProbability of $OEX being below 550 at expiration: 19% \nSo, with the simple calculator, it looks like there's an 81 % chance of a worry-free \ntrade. Just sit back and relax and let the option expire worthless. However, in real \nlife - as shown by the previous set of probabilities, there's only a 67% chance of a \nworry-free trade. The difference - the other 14% - is the probability of the third \nscenario occurring ($OEX falls below 550, but rallies back above it by expiration). \nThe simple probability calculator doesn't account for that scenario at all. \nHence, most serious traders don't use the simple model. Does that mean it's not \nuseful at all? No, it is certainly viable as a comparative tool; for example, to compare \nthe chances of the $OEX put expiring worthless versus those of another put sale \nbeing considered, perhaps something in a stock option. However, better analyses can \nbe undertaken. \nBefore leaving the scenario of the simple probability calculator, one more point \nshould be made. It has been mentioned earlier in this book that the delta of an option \nis actually a fairly good estimate of the probability of the", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 357}
{"text": "f the $OEX put expiring worthless versus those of another put sale \nbeing considered, perhaps something in a stock option. However, better analyses can \nbe undertaken. \nBefore leaving the scenario of the simple probability calculator, one more point \nshould be made. It has been mentioned earlier in this book that the delta of an option \nis actually a fairly good estimate of the probability of the option being in-the-money \nat its expiration date. Thus, the delta and the simple endpoint probability calculator \nshown above attempt to convey the same information to a trader. In reality, because \nof the fact that implied volatility might be different for various strikes (a volatility \nskew), especially in index options, the delta of the option might not agree exactly with \nthe probability calculator. Even so, the delta is a quick and dirty way of estimating the \nprobability of the stock being above the strike price (in the case of call options) or \nbelow the strike price (in the case of put options) at expiration. \nTHE nEVER\" CALCULATOR \nHaving seen the frailties of the endpoint calculator, the next step is to try to design a \ncalculator that can estimate the probability of the stock ever hitting the target price(s) \n806 Part VI: Measuring and 1iading Vo/atillty \nat any time during the life of the probability study, usually the life of an option. It \nturns out that there are a couple of ways to approach this problem. One is with a \nMonte Carlo analysis, whereby one lets a computer run a large number of random\nly-generated scenarios (say, 100,000 or so) and counts the number of times the tar\nget price is hit. A Monte Carlo analysis is a completely valid way of estimating the \nprobability of an event, but it is a somewhat complicated approach. \nIn reality, there is a way to create a single formula that can estimate the \"ever\" \nprobability, although it is not any easy task either. In the following discussion, I am \nborrowing liberally from correspondence with Dr. Stewart Mayhew, Professor of \nMathematics at the University of Georgia. For proprietary reasons, the exact formu\nla is not given here, but the following description should be sufficient for a mathe\nmatics or statistics major to encode it. If one is not interested in implementing the \nactual formula, the calculation can be obtained through programs sold by McMillan \nAnalysis Corp. at www.optionstrategist.com. \nThis discussion is quite technical, so readers not interested in the description of \nthe mathematics can skip the next paragraph and instead move ahead to the next sec\ntion on Monte Carlo studies. \nThese are the steps necessary in determining the formula for the \"ever\" proba\nbility of a stock hitting an upside target at any time during its life. First, make the \nassumption that stock prices behave randomly, and perform at the risk-free rate, r. \nMathematicians call random behavior \"Brownian motion.\" There are a number of \nformulae available in statistics books regarding Brownian motion. If one is to esti\nmate the probability of reaching a maximum (upside target) point, what is needed is \nthe known formula for the cumulative density function (CDP) for a running maxi\nmum of a Brownian motion. In that formula, it is necessary to use the lognormal \nfunction to describe the upside target. Thus, instead of using the actual target price \nin the CDF formula, one substitutes ln( qlp ), where q is the target price and p is the \ncurrent stock price. \nThe \"ever\" probability calculator provides much more useful information to a \ntrader of options. Not only does a naked option seller have a much more realistic esti\nmate of the probability that he's going to have to make an adjustment during the life \nof an option, but the option buyer can find the information useful as well. For exam\nple, if one is buying an option at a price of 10, say, then he could use the \"ever\" prob\nability calculator to estimate the chances of the stock trading 10 points above the \nstriking price at any time during the life of the option. That is, what are the chances \nthat the option is going to at least break even? The option buyer can, cf course, deter\nmine other things too, such as the probability that the option doubles in price ( or \nreaches some other return on investment, such as he might deem appropriate for his \nanalysis). \nChapter 38: The Distribution of Stock Prices 807 \nTHE MONTE CARLO PROBABILITY CALCULATOR \nUp to this point, the calculators we have discussed are subject to the limitations \ndescribed earlier - mainly, that they rely heavily on one's volatility estimate, that they \nassume the volatility will remain constant over time, and that they assume a lognor\nmal distribution. The early part of this chapter was spent explaining that the lognor\nmal distribution is not the real distribution that stock prices adhere to. So, what we'd \nlike to see in a probability calculator is one that could adjust for various volatility sce\nnarios as time passed and one in which the assumed distribution of stock prices was \nnot lognormal. \nWhen one starts to make these sorts of assumptions, I do not believe there is a \nsingle formula that can be derived for the probability calculations. Rather, what is \nknown as a Monte Carlo simulation must be undertaken. Essentially, one \"tells\" the \ncomputer what he is trying to simulate. It could be any number of things in real life, \nperhaps the rocket engine components in a NASA space shuttle, or the operation of \nan internal combustion engine, or the movement of a stock. As long as the process \ncan be described, it can be simulated by a computer. Then, the computer can run a \nlarge number of those simulations to determine the answers to such things as \"What \nis the failure rate of the NASA engine components,\" or \"How long can the internal \ncombustion engine go without an oil change,\" or \"What is the probability of the stock \ntrading at a certain target price?\" The Monte Carlo simulation technique can be \nthought of as letting the co", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 358}
{"text": "puter. Then, the computer can run a \nlarge number of those simulations to determine the answers to such things as \"What \nis the failure rate of the NASA engine components,\" or \"How long can the internal \ncombustion engine go without an oil change,\" or \"What is the probability of the stock \ntrading at a certain target price?\" The Monte Carlo simulation technique can be \nthought of as letting the computer run through the simulation a lot of times and \ncounting how many times a certain outcome occurs. If the number of trials (simula\ntions) is large enough and the model is good enough, then the resulting count divid\ned by the number of trials undertaken is a good probability estimate of the said event \noccurring. The reason one runs a lot of trials is that over a large number of trials, the \nfrequency with which an event occurs will approximate the actual probability of its \noccurrence for a single trial - the single trial being your trade, for example. \nThe next three paragraphs describe the general process necessary for con\nstructing a stock probability calculator using a Monte Carlo simulation. Again, this is \nfairly technical, so if the reader is not interested in the background behind the math\nematics, then skip ahead three paragraphs. In the case of a stock probability calcula\ntor, the Monte Carlo simulation can be undertaken as follows. \nWe know what the distribution of stock prices looks like. The fat tails can be \nbuilt into the distribution if one wants to simulate real life. See Figure 38-1 for both \nthe lognormal distribution and the actual distribution. It's a simple matter to tell the \ncomputer this information. For example, recall that 2.5 million points went into mak\ning up Figure 38-1. In the actual distribution in Figure 38-1, about 92,000 (or 3.68%) \n808 Part VI: Measuring and Trading Volatility \nof them resulted in the stock being unchanged. Also, only about 2,500 or them, or \n1110th of one percent, resulted in a move of-4.0 standard deviations or more. Those \npercentages, along with all of the others, would be built into the computer, so that \nthe total distribution accounts for 100% of all possible stock movements. \nThen, we tell the computer to allow a stock to move randomly in accordance \nwith whatever volatility the user has input. So, there would be a fairly large proba\nbility that it wouldn't move very far on a given day, and a very small probability that \nit would move three or more standard deviations. Of course, with the fat tail distri\nbution, there would be a larger probability of a movement of three or more standard \ndeviations than there would be with the regular lognormal distribution. The Monte \nCarlo simulation progresses through the given number of trading days, moving the \nstock cumulatively as time passes. If the stock hits the break-even price, that partic\nular simulation can be terminated and the next one begun. At the end of all the tri\nals (100,000 perhaps), the number in which the upside target was touched is divided \nby the total number of trials to give the probability estimate. \nIs it really worth all this extra trouble to evaluate these more complicated prob\nability distributions? It seems so. Consider the following example: \nExample: Suppose that a trader is considering selling naked puts on XYZ stock, \nwhich is currently trading at a price of 80. He wants to sell the November 60 puts, \nwhich expire in two months. Although XYZ is a fairly volatile stock, he feels that he \nwouldn't mind owning it if it were put to him. However, he would like to see the puts \nexpire worthless. Suppose the following information is available to him via the vari\nous probability calculators: \nSimple \"end point\" probability of XYZ < 60 at expiration: 10% \nProbability that XYZ ever trades < 60 (using the lognormal distribution) 20% \nProbability that XYZ ever trades < 60 (using the fat tail distribution): 22% \nIf the chances of the put never needing attention were truly only 10%, this trader \nwould probably sell the puts naked and feel quite comfortable that he had a trade \nthat he wouldn't have to worry too much about later on. However, if the true proba\nbility that the put will need attention is 22%, then he might not take the trade. Many \nnaked option sellers try to sell options that have only probabilities of 15% or less of \npotentially becoming troublesome. \nHence, the choice of which probability calculation he uses can make a differ\nence in whether or not a trade is established. \nOther strategies lend themselves quite well to probability analysis as well. \nCredit spreaders - sellers of out-of-the-money put spreads - usually attempt to quan\ntify the probability of having to take defensive action. Any action to adjust or remove \nChapter 38: The Distribution of Stock Prices 809 \na deeply out-of-the-money put credit spread usually destroys most or all of its prof\nitability, so an accurate initial assessment of the probabilities of having to make such \nan adjustment is important. \nOption buyers, too, would benefit from the use of a more accurate probability \nestimate. This is especially true for neutral strategies, such as straddle or strangle \nbuying, when the trader is interested in the chances of the stock being able to move \nfar enough to hit one or the other of the straddle's break-even points at some time \nduring the life of the straddle. \nThe Monte Carlo probability calculation can be expanded to include other sorts \nof distributions. In the world of statistics, there are many distributions that define ran\ndom patterns. The lognormal distribution is but one of them (although it is the one \nthat most closely follows stock prices movements in general). Also, there is a school of \nthought that says that each stock's individual price distribution patterns should be ana\nlyzed when looking at strategies on that stock, as opposed to using a general stock \nprice distribution accumulated over the entire market. There is much debate about \nthat, because an individual st", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 359}
{"text": "lthough it is the one \nthat most closely follows stock prices movements in general). Also, there is a school of \nthought that says that each stock's individual price distribution patterns should be ana\nlyzed when looking at strategies on that stock, as opposed to using a general stock \nprice distribution accumulated over the entire market. There is much debate about \nthat, because an individual stock's trading pattern can change abruptly just consider \nany of the Internet stocks in the late 1990s and early 2000s. Thus, a probability esti\nmate based on a single stock's behavior, even if that behavior extends back several \nyears, might be too unreliable a statistic upon which to base a probability estimate. \nIn summary, then, one should use a probability calculator before taking an \noption position, even an outright option buy. Perhaps straight stock traders should \nuse a probability calcutor as well. In doing so, though, one should be aware of the \nlimitations of the estimate: It is heavily biased by the volatility estimate that is input \nand by the assumption of what distribution the underlying instrument will adhere to \nduring the life of the position. While neither of those limitations can be overcome \ncompletely, one can mitigate the problems by using a conservative volatility estimate. \nAlso, he can look at the results of the probability calculation under several distribu\ntions (perhaps lognormal, fat tail, and the distribution using only the past price \nbehavior of the underlying instrument in question) and see how they differ. In that \ncase, he would at least have a feeling for what could happen during the life of the \noption position. \nEXPECTED RETURN \nThe concept of expected return was described in the chapter on mathematical appli\ncations. In short, expected return is a position's expected profit divided by its invest\nment ( or expected investment if the investment varies with stock price, as in a naked \noption position or a futures position). The crucial component, though, is expected \nprofit. \n810 Part VI: Measuring and Trading Volatility \nExpected profit is computed by calculating the profitability of a position at a \ncertain stock price times the probability of the stock being at that price, and summing \nthat multiple over all possible stock prices. When the concept was first introduced, \nthe \"probability of the stock being at that price\" was given as what we now know is \nthe \"endpoint\" probability. In reality, a much better measure of the expected profit \nof a position can be obtained by using one of the more advanced probability estima\ntion models presented above. \nIn generalized expected return studies done using the fat tails Monte Carlo sim\nulation, certain general conclusions can be drawn about some strategies. \n• A bull spread is an inferior strategy when the options are fairly priced, no matter \nwhich distribution is assumed. This more or less agrees with observations that \nhave been made previously regarding the disappointments that traders often \nencounter when using vertical spreads. \n• While covered writing might seem superior to stock ownership under the log\nnormal distribution, the two are about equal under a fat tail distribution. \n• Most startling, though, is the fact that option buying strategies fare much, much \nbetter under a fat tail distribution than a lognormal one. This most clearly \ndemonstrates the \"power\" of the fat tail distribution: A limited-risk investment \nwith unlimited profit potential can be expected to perform very well if the fat tails \nare allowed for. \nUsing the lognormal distribution more or less represents the conventional wisdom \nregarding option strategies - the one that many brokers promote: \"Don't buy options, \ndon't mess with spreads, either buy stocks or do covered call writes.\" The fat tail dis\ntribution column stands much of that advice on its head. In real life (as demonstrat\ned by the fat tail distribution), strategies with limited profit potential and unlimited \nor large risk potential are inferior strategies. \nOne should be aware that the phrase \"expected return\" is used in many quasi\nsophisticated option analyses (and even in analyses not using options). Many \ninvestors accept these \"returns\" on blind faith, figuring that if they're generated by a \ncomputer, they must be correct. In reality, they may be not be representative, even \nfor comparisons. \nSUMMARY \nThis chapter has demonstrated that probability analysis is an inexact science, because \nmarkets behave in ways that are very difficult to describe mathematically. However, \nprobability analysis is also necessary for the option strategist; without it he would be \nChapter 38: The Distribution of Stock Prices 811 \nin the dark as to the likelihood of profitable outcomes for his strategy. Overall, in a \ndiversified set of positions, the option strategist should use the fat tail distribution in \na Monte Carlo simulation to estimate probabilities. However, if that is not available, \nhe can use the normal or lognormal distribution with the proviso that he understands \nit is not \"gospel.\" He should require ve:ry stringent criteria on any strategies that are \nantivolatility strategies, such as naked option writing of stock options, for there is a \ngreater than normal chance of a large move by the underlying, especially if the \nunderlying is stock. \nThe sophisticated trader may want to view his probabilities in the light of more \nthan one proposed distribution of prices. Of course, this type of analysis ( using sev\neral distributions) puts the onus on the investor to choose the distribution that he \nwants to use in order to analyze his investment. However, such an approach should \nbe extremely illustrative in that he can compare returns from different strategies and \nhave a reasonable expectation as to which ones might perform the best under differ\nent market conditions. \nCHAPTER 39 \nVolatility Trading Techniques \nThe previous three chapters laid the foundation for volatility tra", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 360}
{"text": "ion that he \nwants to use in order to analyze his investment. However, such an approach should \nbe extremely illustrative in that he can compare returns from different strategies and \nhave a reasonable expectation as to which ones might perform the best under differ\nent market conditions. \nCHAPTER 39 \nVolatility Trading Techniques \nThe previous three chapters laid the foundation for volatility trading. In this chapter, \nthe actual application of the technique will be described. It should be understood \nthat volatility trading is both an art and a science. It's a science to the extent that one \nmust be rigorous about determining historical volatility or implied volatility, calculat\ning probabilities, and so forth. However, given the vagaries of those measurements \nthat were described in some detail in the previous chapters, volatility trading is also \nsomething of an art. Just as two fundamental analysts with the same information \nregarding earnings, sales projection, and so on might have two different opinions \nabout a stock's fortunes, so also can two volatility traders disagree about the potential \nfor movement in a stock. \nHowever, volatility traders do agree on the approach. It is based on comparing \ntoday's implied volatility with what one expects volatility to do in the future. As noted \npreviously, one's expectations for volatility might be based on volatility charts, pat\nterns of historical volatility and implied volatility, or something as complicated as a \nGAR CH forecasting model. None of them guarantees success. However, we do know \nthat volatility tends to trade in a range in the long run. Therefore, the approach that \ntraders agree upon is this: If implied volatility is \"low,\" buy it. If it's \"high,\" sell it with \ncaution. So simple: Buy low, sell high (not necessarily in that order). The theory \nbehind volatility trading is that it's easier to buy low and sell high (or at least to deter\nmine what's \"low\" and \"high\") when one is speaking about volatility, than it is to do \nthe same thing when one is talking about stock prices. \nMost of the time, implied volatility will not be significantly high or low on any \nparticular stock, futures contract, or index. Therefore, the volatility trader will have \nlittle interest in most stocks on any given day. This is especially true of the big-cap \nstocks, the ones whose options are most heavily traded. There are so many traders \n812 \nChapter 39: Volatility Trading Techniques 813 \nwatching the situation for those stocks that they will rarely let volatility get to the \nextremes that one would consider \"too high\" or \"too low.\" Yet, with the large num\nber of optionable stocks, futures, and indices that exist, there are always some that \nare out of line, and that's where the independent volatility trader will concentrate \nhis efforts. \nOnce a volatility extreme has been uncovered, there are different methods of \ntrading it. Some traders - market-makers and short-term traders - are just looking \nfor very fleeting trades, and expect volatility to fall back into line quickly after an \naberrant move. Others prefer more of a position traders' approach: attempting to \ndetermine volatility extremes that are so far out of line with accepted norms that it \nwill probably take some time to move back into line. Obviously, the trader's own sit\nuation will dictate, to a certain extent, which strategy he pursues. Things such as \ncommission rates, capital requirements, and risk tolerance will determine whether \none is more of a short-term trader or a position trader. The techniques to be \ndescribed in this chapter apply to both methods, although the emphasis will be on \nposition trading. \nTWO WAYS VOLATILITY PREDICTIONS CAN BE WRONG \nWhen traders determine the implied volatility of the options on any particular under\nlying instrument, they may generally be correct in their predictions; that is, implied \nvolatility will actually be a fairly good estimate of forthcoming volatility. However, \nwhen they're wrong, they can actually be wrong in two ways: either in the outright \nprediction of volatility or in the path of their volatility predictions. Let's discuss both. \nWhen they're wrong about the absolute level of volatility, that merely means that \nimplied volatility is either \"too low\" or \"too high.\" In retrospect, one could only make \nthat assessment, of course, after having seen what actual volatility turned out to be \nover the life of the option. The second way they could be wrong is by making the \nimplied volatility on some of the options on a particular underlying instrument much \ncheaper or more expensive than other options on that same underlying instrument. \nThis is called a volatility skew and it is usually an incorrect prediction about the way \nthe underlying will perform during the life of the options. \nThe rest of this chapter will be divided into two main parts, then. The first part \nwill deal with volatility from the viewpoint of the absolute level of implied volatility \nbeing \"wrong\" (which we'll call \"trading the volatility prediction\"), and the second \npart will deal with trading the volatility skew. \n814 Part VI: Measuring and Trading Volatility \nTRADING THE VOLATILITY PREDICTION \nThe volatility trader must have some way of determining when implied volatility is \nsufficiently out of line that it warrants a trade. Then he must decide what trade to \nestablish. Furthermore, as with any strategy- especially option strategies - follow-up \naction is important too. We will not be introducing any new strategies, per se, in this \nchapter. Those strategies have already been laid out in the previous chapters of this \nbook. However, we will briefly review important points about those strategies and \ntheir follow-up actions where it is appropriate. \nFirst, one must try to find situations in which implied volatility is out of line. \nThat is not the end of the analysis, though. After that, one needs to do some proba\nbility work and needs to see how the und", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 361}
{"text": "ve already been laid out in the previous chapters of this \nbook. However, we will briefly review important points about those strategies and \ntheir follow-up actions where it is appropriate. \nFirst, one must try to find situations in which implied volatility is out of line. \nThat is not the end of the analysis, though. After that, one needs to do some proba\nbility work and needs to see how the underlying has behaved in the past. Other fine\ntuning measures are often useful, too. These will all be described in this chapter. \nDETERMINING WHEN VOLATILITY IS OUT OF LINE \nThere is much disagreement among volatility traders regarding the best method to use \nfor determining if implied volatility is \"out ofline.\" Most favor comparing implied with \nhistorical volatility. However, it was shown two chapters ago that implied volatility is \nnot necessarily a good predictor of historical volatility. Yet this approach cannot be dis\ncarded; however it must be used judiciously. Another approach is to compare today's \nimplied volatility with where it has been in the past. This concept relies heavily on the \nconcept of the percentile of implied volatility. Finally, there is the approach of trying \nto \"read\" the charts of implied and historical volatility. This is actually something akin \nto what GARCH tries to do, but on a short-term horizon. So the approaches are: \n1. Compare implied volatility to its own past levels (percentile approach). \n2. Compare implied volatility to historical volatility. \n3. Interpret the chart of volatility. \nIn addition, we will examine two lesser-used methods: comparing current levels of \nhistorical volatility to past measures of historical volatility, and finally, using only a \nprobability calculator and trading the situation that has the best probabilities of \nsuccess. \nTHE PERCENTILE APPROACH \nIn this author's opinion, there is much merit in the percentile approach. When one says \nthat volatility tends to trade in a range, which is the basic premise behind volatility trad-\nChapter 39: Volatility Trading Techniques 815 \ning, he is generally talking about implied volatility. Thus, it makes sense to know where \nimplied volatility is within the range of the past readings of implied volatility. If volatil\nity is low with respect to where it usually trades, then we can say the options are cheap. \nConversely, if it's high with respect to those past values, then we can say the options are \nexpensive. These conclusions do not draw on historical volatility. \nThe percentile of implied volatility is generally used to describe just where the \ncurrent implied volatility reading lies with respect to its past values. The \"implied \nvolatility\" reading that is being used in this case is the composite reading - the one \nthat takes into account all the options on an underlying instrument, weighting them \nby their distance in- or out-of-the-money (at-the-money gets more weight) and also \nweighting them by their trading volume. This technique has been referred to many \ntimes and was first described in Chapter 28 on mathematical applications. That com\nposite implied volatility reading can be stored in a database for each underlying \ninstrument every day. Such databases are available for purchase from firms that spe\ncialize in option data. Also, snapshots of such data are available to members of \nwww.optionstrategist.com. \nIn general, most underlying instruments would have a composite implied \nvolatility reading somewhere near the 50th percentile on any given day. However, it \nis not uncommon to see some underlyings with percentile readings near zero or 100% \non a given day. These are the ones that would interest a volatility trader. Those with \nreadings in the 10th percentile or less, say, would be considered \"cheap\"; those in the \n90th percentile or higher would be considered expensive. \nIn reality, the percentile of implied volatility is going to be affected by what the \nbroad market is doing. For example, during a severe market slide, implied volatilities \nwill increase across the board. Then, one may find a large number of stocks whose \noptions are in the 90th percentile or higher. Conversely, there have been other times \nwhen overall implied volatility has declined substantially: 1993, for example, and the \nsummer of 2001, for another. At those times, we often find a great number of stocks \nwhose options reside in the 10th percentile of implied volatility or lower. The point \nis that the distribution of percentile readings is a dynamic thing, not something stat\nic like a lognormal distribution. Yes, perhaps over a long period of time and taking \ninto account a great number of cases, we might find that the percentiles of implied \nvolatility are normally distributed, but not on any given day. \nThe trader has some discretion over this percentile calculation. Foremost, he \nmust decide how many days of past history he wants to use in determining the per\ncentiles. There are about 255 trading days in a year. So, if he wanted a two-year his\ntory, he would record the percentile of today's composite implied volatility with \nrespect to the 510 daily readings over the past two years. This author typically uses \n816 Part VI: Measuring and Trading Volatility \n600 days of implied volatility history for the purpose of determining percentiles, but \na case could be made for other lengths of time. The purpose is to use enough implied \nvolatility history to give one a good perspective. Then, a reading of the 10th per\ncentile or the 90th percentile will truly be significant and would therefore be a good \nstarting point in determining whether the options are cheap or expensive. \nIn addition to the actual percentile, the trader should also be aware of the width \nof the implied volatility distribution. This was discussed in an earlier chapter, but \nessentially the concept is this: If the first percentile is an implied volatility of 40% and \nthe 100th percentile is an implied volatility of 45%, then that entire range", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 362}
{"text": "determining whether the options are cheap or expensive. \nIn addition to the actual percentile, the trader should also be aware of the width \nof the implied volatility distribution. This was discussed in an earlier chapter, but \nessentially the concept is this: If the first percentile is an implied volatility of 40% and \nthe 100th percentile is an implied volatility of 45%, then that entire range is so nar\nrow as to be meaningless in terms of whether one could classify the options as cheap \nor expensive. \nThe advantage of buying options in a low percentile of implied volatility is to \ngive oneself two ways to make money: one, via movement in the underlying (if a \nstraddle were owned, for example), and two, by an increase in implied volatility. That \nis, if the options were to return to the 50th percentile of implied volatility, the volatil\nity trader who has bought \"cheap\" options should expect to make money from that \nmovement as well. That can only happen if the 50th percentile and the 10th per\ncentile are sufficiently far apart to allow for an increase in the price of the option to \nbe meaningful. Perhaps a good rule of thumb is this: If the option rises from the cur\nrent (low) percentile reading to the 50th percentile in a month, will the increase in \nimplied volatility be equal to or greater than the time decay over that period? \nAlternatively stated, with all other things being equal, will the option be trading at \nthe same or a greater price in a month, if implied volatility rises to the 50th percentile \nat the end of that time? If so, then the width of the range of implied volatilities is \ngreat enough to produce the desired results. \nThe attractiveness to this method for determining if implied volatility is out of \nline is that the trader is \"forced\" to buy options that are cheap ( or to sell options that \nare expensive), on a relative basis. Even though historical volatility has not been taken \ninto consideration, it will be later on when the probability calculators are brought to \nbear. There is no guarantee, of course, that implied volatility will move toward the \n50th percentile while the position is in place, but if it does, that will certainly be an \naid to the position. \nIn effect this method is measuring what the option trading public is \"thinking\" \nabout volatility and comparing it with what they've thought in the past. Since the pub\nlic is wrong (about prices as well as volatility) at major turning points, it is valid to want \nto be long volatility when \"everyone else\" has pushed it down to depressed levels. The \nconverse may not necessarily be true: that we would want to be short volatility when \neveryone else has pushed it up to extremely high levels. The caveat in that case is that \nChapter 39: Volatility Trading Techniques 817 \nsomeone may have inside information that justifies expensive options. This is another \nreason why selling volatility can be difficult: You may be dealing with far less infor\nmation than those who are actually making the implied volatility high. \nCOMPARING IMPLIED AND HISTORICAL VOLATILITY \nThe most common way that traders determine which options are cheap or expensive \nis by comparing the current composite implied volatility with various historical \nvolatility measures. However, just because this is the conventional wisdom does not \nnecessarily mean that this method is the preferred one for determining which options \nare best for volatility trades. In this author's opinion, it is inferior to the percentile \nmethod (comparing implied to past measures of implied), but it does have its merits. \nThe theory behind using this method is that it is a virtual certainty that implied and \nhistorical volatility will eventually converge with each other. So, if one establishes \nvolatility trading positions when they are far apart, there is supposedly an advantage \nthere. \nHowever, this argument has plenty of holes in it. First of all, there is no guar\nantee that the two will converge in a timely manner, for example, before the options \nin the trader's position can become profitable. Historical and implied volatility often \nremain fairly far apart for weeks at a time. \nSecond, even if the convergence does occur, it doesn't necessarily mean one will \nmake money. As an example, consider the case in which implied volatility is 40% and \nhistorical volatility is 60%. That's quite a difference, so you'd want to buy volatility. \nFurthermore, suppose the two do converge. Does that mean you'll make money? No, \nit does not. What if they converge and meet at 40%? Or, worse yet, at 30%? You'd \nmost certainly lose in those cases as the stock slowed down while your options lost \ntime value. \nAnother problem with this method is that implied volatility is not necessarily \nlow when it is bought, nor high when it is sold. Consider the example just cited. We \nmerely knew that implied volatility was 40% and that historical volatility was 60%. We \nhad no perspective on whether 40% was high, medium, or low. Thus, it is also nec\nessary to see what the percentile of implied volatility is. If it turns out that 40% is a \nrelatively high reading for implied volatility, as determined by looking at where \nimplied volatility has been over the past couple of years, then we would probably not \nwant to buy volatility in this situation, even though implied and historical volatility \nhave a large discrepancy between them. \nMany market-makers and floor traders use this approach. However, they are \noften looking for an option that is briefly mispriced, figuring that volatilities will \n818 Part VI: Measuring and Trading Volatility \nquickly revert back to where they were. But for a position trader, the problems cited \nabove can be troublesome. \nHaving said that, if one looks to implement this method of trying to determine \nwhen options are out of line, something along the following lines should be imple\nmented. One should ensure that implied volatility is significantly different from all of \nth", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 363}
{"text": "asuring and Trading Volatility \nquickly revert back to where they were. But for a position trader, the problems cited \nabove can be troublesome. \nHaving said that, if one looks to implement this method of trying to determine \nwhen options are out of line, something along the following lines should be imple\nmented. One should ensure that implied volatility is significantly different from all of \nthe pertinent historical volatilities. For example, one might require that implied \nvolatility is less than 80% of each of the 10-, 20-, 50-, and 100-day historical volatili\nty calculations. In addition, the current percentile of implied volatility should be \nnoted so that one has some relative basis for determining if all of the volatilities, his\ntorical and implied, are very high or very low. One would not want to buy options if \nthey were all in a very high percentile, nor sell them if they were all in a very low per\ncentile. \nOften, a volatility chart showing both the implied and certain historical volatili\nties will be a useful aid in making these decisions. One can not only quickly tell if the \noptions are in a high or low percentile, but he may also be able to see what happened \nat similar times in the past when implied and historical volatility deviated substan\ntially. \nFinally, one needs some measure to ensure that, if convergence between \nimplied and historical volatility does occur, he will be able to make money. So, for \nexample, if one is buying a straddle, he might require that if implied rises to meet his\ntorical (say, the lowest of the historicals) in a month, he will actually make money. \nOne could use a different time frame, but be careful not to make it something unrea\nsonable. For example, if implied volatility is currently 40% and historical is 60%, it is \nhighly unlikely that implied would rise to 60% in a day or two. Using this criterion \nalso ensures that the absolute difference between implied and historical volatility is \nwide enough to allow for profits to be made. That is, if implied is 10% and historical \nis 13%, that's a difference of 30% in the two - ostensibly a \"wide\" divergence \nbetween implied and historical. However, if implied rises to meet historical, it will \nmean only an absolute increase of 3 percentage points in implied volatility - proba\nbly not enough to produce a profit, after costs, if any length of time passes. \nIf all of these criteria are satisfied, then one has successfully found \"mispriced\" \noptions using the implied versus historical method, and he can proceed to the next \nstep in the volatility analysis: using the probability calculator. \nREADING THE VOLATILITY CHART \nAnother technique that traders use in order to determine if options are mispriced is \nto actually try to analyze the chart of volatility - typically implied volatility, but it \ncould be historical. This might seem to be a subjective approach, except that it is real-\n818 Part VI: Measuring and Trading Volatility \nquickly revert back to where they were. But for a position trader, the problems cited \nabove can be troublesome. \nHaving said that, if one looks to implement this method of trying to determine \nwhen options are out of line, something along the following lines should be imple\nmented. One should ensure that implied volatility is significantly different from all of \nthe pertinent historical volatilities. For example, one might require that implied \nvolatility is less than 80% of each of the 10-, 20-, 50-, and 100-day historical volatili\nty calculations. In addition, the current percentile of implied volatility should be \nnoted so that one has some relative basis for determining if all of the volatilities, his\ntorical and implied, are very high or very low. One would not want to buy options if \nthey were all in a very high percentile, nor sell them if they were all in a very low per\ncentile. \nOften, a volatility chart showing both the implied and certain historical volatili\nties will be a useful aid in making these decisions. One can not only quickly tell if the \noptions are in a high or low percentile, but he may also be able to see what happened \nat similar times in the past when implied and historical volatility deviated substan\ntially. \nFinally, one needs some measure to ensure that, if convergence between \nimplied and historical volatility does occur, he will be able to make money. So, for \nexample, if one is buying a straddle, he might require that if implied rises to meet his\ntorical (say, the lowest of the historicals) in a month, he will actually make money. \nOne could use a different time frame, but be careful not to make it something unrea\nsonable. For example, if implied volatility is currently 40% and historical is 60%, it is \nhighly unlikely that implied would rise to 60% in a day or two. Using this criterion \nalso ensures that the absolute difference between implied and historical volatility is \nwide enough to allow for profits to be made. That is, if implied is 10% and historical \nis 13%, that's a difference of 30% in the two - ostensibly a \"wide\" divergence \nbetween implied and historical. However, if implied rises to meet historical, it will \nmean only an absolute increase of 3 percentage points in implied volatility - proba\nbly not enough to produce a profit, after costs, if any length of time passes. \nIf all of these criteria are satisfied, then one has successfully found \"mispriced\" \noptions using the implied versus historical method, and he can proceed to the next \nstep in the volatility analysis: using the probability calculator. \nREADING THE VOLATILITY CHART \nAnother technique that traders use in order to determine if options are mispriced is \nto actually try to analyze the chart of volatility - typically implied volatility, but it \ncould be historical. This might seem to be a subjective approach, except that it is real-\n818 Part VI: Measuring and Trading Volatility \nquickly revert back to where they were. But for a position trader, the problems cited \na", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 364}
{"text": "other technique that traders use in order to determine if options are mispriced is \nto actually try to analyze the chart of volatility - typically implied volatility, but it \ncould be historical. This might seem to be a subjective approach, except that it is real-\n818 Part VI: Measuring and Trading Volatility \nquickly revert back to where they were. But for a position trader, the problems cited \nabove can be troublesome. \nHaving said that, if one looks to implement this method of trying to determine \nwhen options are out of line, something along the following lines should be imple\nmented. One should ensure that implied volatility is significantly different from all of \nthe pertinent historical volatilities. For example, one might require that implied \nvolatility is less than 80% of each of the 10-, 20-, 50-, and 100-day historical volatili\nty calculations. In addition, the current percentile of implied volatility should be \nnoted so that one has some relative basis for determining if all of the volatilities, his\ntorical and implied, are very high or very low. One would not want to buy options if \nthey were all in a very high percentile, nor sell them if they were all in a very low per\ncentile. \nOften, a volatility chart showing both the implied and certain historical volatili\nties will be a useful aid in making these decisions. One can not only quickly tell if the \noptions are in a high or low percentile, but he may also be able to see what happened \nat similar times in the past when implied and historical volatility deviated substan\ntially. \nFinally, one needs some measure to ensure that, if convergence between \nimplied and historical volatility does occur, he will be able to make money. So, for \nexample, if one is buying a straddle, he might require that if implied rises to meet his\ntorical (say, the lowest of the historicals) in a month, he will actually make money. \nOne could use a different time frame, but be careful not to make it something unrea\nsonable. For example, if implied volatility is currently 40% and historical is 60%, it is \nhighly unlikely that implied would rise to 60% in a day or two. Using this criterion \nalso ensures that the absolute difference between implied and historical volatility is \nwide enough to allow for profits to be made. That is, if implied is 10% and historical \nis 13%, that's a difference of 30% in the two - ostensibly a \"wide\" divergence \nbetween implied and historical. However, if implied rises to meet historical, it will \nmean only an absolute increase of 3 percentage points in implied volatility - proba\nbly not enough to produce a profit, after costs, if any length of time passes. \nIf all of these criteria are satisfied, then one has successfully found \"mispriced\" \noptions using the implied versus historical method, and he can proceed to the next \nstep in the volatility analysis: using the probability calculator. \nREADING THE VOLATILITY CHART \nAnother technique that traders use in order to determine if options are mispriced is \nto actually try to analyze the chart of volatility - typically implied volatility, but it \ncould be historical. This might seem to be a subjective approach, except that it is real-\nChapter 39: Volatility Trading Techniques 819 \nly not much different from the GARCH approach, which is considered to be highly \nadvanced. When one views the volatility chart, he is not looking for chart patterns like \ntechnical analysts might do with stock charts: support, resistance, head-and-shoul\nders, flags, pennants, and so on. Rather, he is merely looking for the trend of volatil\nity to change. \nThis is a valid approach in the use of many indicators, particularly sentiment \nindicators, that can go to extreme levels. By waiting for the trend to change, the user \nis not subjecting himself to buying into the midst of a downtrend in volatility, nor sell\ning into the midst of a steep uptrend in volatility. \nExample: Suppose a volatility trader has determined that the current level of implied \nvolatility for XYZ stock is in the 1st percentile of all past readings. Thus, the options \nare as cheap as they've ever been. Perhaps, though, the overall market is experienc\ning a very dull period, or XYZ itself has been in a prolonged, tight trading range -\neither of which might cause implied volatility to decline steadily and substantially. \nHaving found these cheap options, he wants to buy volatility. However, he has no \nguarantee that implied volatility won't continue to decline, even though it is already \nas cheap as it's ever been. \nIf he follows the technique of waiting for a reversal in the trend of implied \nvolatility, then he would keep an eye on XYZ's implied volatility daily until it had at \nleast a modest increase, something to indicate that option buyers have become more \ninterested in XYZ's options. The chart in Figure 39-1 shows how this situation might \nlook. \nThere are a number of items marked on the chart, so it will be described in \ndetail. There are two graphs in Figure 39-1: The top line is the implied volatility \ngraph, while on the bottom is the stock price chart. The implied volatility chart shows \nthat, near the first ofJune, it made new all-time lows near 28% (i.e., it was in the 0th \npercentile of implied volatility). Hence, one might have bought volatility at that \npoint. However, it is obvious that implied volatility was in a steep downtrend at that \ntime, so the volatility trader who reads the charts might have decided to wait for a \npop in volatility before buying. This turned out to be a judicious decision, because \nthe stock went nowhere for nearly another month and a half, all the while volatility \nwas dropping. At the right of the chart, implied volatility has dropped to nearly 20%. \nThe solid lines on the two graphs indicate the data that is known about the \nimplied volatility and price history of XYZ. The dotted lines indicate a scenario that \nmight unfold. If implied volatility were to jump ( and the stock price migh", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 365}
{"text": "nowhere for nearly another month and a half, all the while volatility \nwas dropping. At the right of the chart, implied volatility has dropped to nearly 20%. \nThe solid lines on the two graphs indicate the data that is known about the \nimplied volatility and price history of XYZ. The dotted lines indicate a scenario that \nmight unfold. If implied volatility were to jump ( and the stock price might jump, too), \nthen one might think that the trend of implied volatility was no longer down, and he \nwould then buy volatility. \n820 Part VI: Measuring and Trading VolatHity \nThe reason that this approach has merit is that one never knows how low volatil\nity can go, and more important, how high it can get. It was mentioned that the same \nsort of approach works well for other sentiment indicators, the put-call ratio, in par\nticular. During the bull market of the 1990s, the equity-only put-call ratio generally \nranged between about 30 and 55. Thus, some traders became accustomed to buying \nthe market when the put-call ratio reached numbers exceeding 50 (high put-call \nratio numbers are bullish predictors for the market in general). However, when the \nbull market ended, or at least faltered, the put-call ratios zoomed to heights near 70 \nor 75. Thus, those using a static approach (that is, \"Buy at 50 or higher\") were buried \nas they bought too early and had to suffer while the put-call ratios went to new all\ntime highs. A trend reversal approach would have saved them. It is a more dynamic \nprocedure, and thus one would have let the put-call ratio continue to rise until it \npeaked. Then the market could have been bought. \nThis is exactly what reading the volatility chart is about. Rather than relying on \npast data to indicate where the absolute maxima and minima of movements might \noccur, one rather notes that the volatility data is at extreme levels ( 1st percentile or \n100th percentile) and then watches it until it reverses direction. This is especially \nuseful for options sellers, because it avoids stepping into the vortex of massive option \nFIGURE 39-1. \nChart of the trend of implied volatility. \nXYZ \n,J' \n········································ · ························ ....................... ··················· 50. 0 \n... · ····················· 40. 0 \nImplied Volatility I/vi A r \n···-····························· .. •·•······•·········-·············································-··vw•···················)·•······ 30. 0 \nAll-Time Volatility Low -\n, .... , ..... , .. ··················,·······~················ \nt :t·•····•····· ...•. ':·LJJSL5~?. \n--;---··········•·: \no, b ::r F f1 h j ::r \n34.000 \n32.000 \n30. 000 \n28. 000 \n26.000 \n24.000 \n22.000 \n20. 000 \nChapter 39: VolatiDty Trading Techniques 821 \nbuying, where the buyers perhaps have inside information about some forthcominf \ncorporate event such as a takeover. True, the options might be very expensive ( 10ot \npercentile), but there is a reason they are, and those with the inside information know \nthe reason, whereas the typical volatility trader might not. However, if the volatility \ntrader merely waits for a downturn in implied volatility readings before selling these \noptions, he will most likely avoid the majority of trouble because the options will \nprobably not lose implied volatility until news comes out or until the buyers give up \n(perhaps figuring that the takeover rumor has died). \nVolatility buyers don't face the same problems with early entry that volatility \nsellers do, but still it makes sense to wait for the trend of volatility to increase (as in \nFigure 39-1) before trying to guess the bottom in volatility. Just as it is usually fool\nhardy to buy a stock that is in a severe downtrend, so it may be, too, with buying \nvolatility. \nA less useful approach would be to apply the same techniques to historical \nvolatility charts, for such charts say nothing about option prices. See the next section \nfor expansion on these thoughts. \nCOMPARING HISTORICAL VERSUS HISTORICAL \nThe above paragraphs summarize the three major ways that traders attempt to find \noptions that are out of line. Sometimes, another method is mentioned: comparing \ncurrent levels of historical volatility with past levels of the same measure, historical \nvolatility. This method will be described, but it is generally an inferior method \nbecause such a comparison doesn't tell us anything about the option prices. It would \ndo little good, for example, to find that current historical volatility is in a very low per\ncentile of historical volatilities, only to learn later that the options are expensive and \nthat perhaps implied volatility is even higher than historical volatility. One would nor\nmally not want to buy options in that case, so the initial analysis of comparing histor\nical to historical is a wasted effort. \nComparing current levels of historical volatility with past measures of historical \nvolatility is sort of a backward-looking approach, since historical volatility involves \nstrictly the use of past stock prices. There is no consideration of implied volatility in \nthis approach. Moreover, this method makes the tacit assumption that a stock's \nvolatility characteristics do not change, that it will revert to some sort of \"normal\" past \nprice behavior in terms of volatility. In reality, this is not true at all. Nearly every stock \ncan be shown to have considerable changes in its historical volatility patterns over \ntime. \n822 Part VI: Measuring and Trading Volatility \nConsider the historical volatilities of one of the wilder stocks of the tech stock \nboom, Rambus (RMBS). Historical volatilities had ranged between 50% and ll0%, \nfrom the listing of RMBS stock, through February 2000. At that time, the stock aver\naged a price of about $20 per share. \nThings changed mightily when RMBS stock began to rise at a tremendous rate \nin February 2000. At that time, the stock blasted to ll5, pulled back to 35, made a \nnew high near 135, and then collapsed to a price n", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 366}
{"text": "(RMBS). Historical volatilities had ranged between 50% and ll0%, \nfrom the listing of RMBS stock, through February 2000. At that time, the stock aver\naged a price of about $20 per share. \nThings changed mightily when RMBS stock began to rise at a tremendous rate \nin February 2000. At that time, the stock blasted to ll5, pulled back to 35, made a \nnew high near 135, and then collapsed to a price near 20. Hence, the stock itself had \ncompleted a wild round-trip over the two-year period. See Figures 39-2 and 39-3 for \nthe stock chart and the historical volatility chart of RMBS over the time period in \nquestion. \nAs this happened, historical volatility skyrocketed. After February 2000, and \nwell into 2001, historical volatility was well above 120%. Thus it is clear that the \nbehavior patterns of Rambus changed greatly after February 2000. However, if one \nhad been comparing historical volatilities at any time after that, he would have erro\nneously concluded that RMBS was about to slow down, that the historic volatilities \nwere too high in comparison with where they'd been in the past. If this had led one \nto sell volatility on RMBS, it could have been a very expensive mistake. \nWhile RMBS may be an extreme example, it is certainly not alone. Many other \nstocks experienced similar changes in behavior. In this author's opinion, such behav\nior debunks the usefulness of comparing historical volatility with past measures of \nhistorical volatility as a valid way of selecting volatility trades. \nFIGURE 39-2. \nHistorical volatilities of RMBS. \nRMBS 19.000 17.250 18.875 20010410 \n............ ······· 60.0 \n· ·················· 50.0 \n...... ······· 40. 0 \n39 M i·h··-:; s ·~ s a ~--f:i--·5--r;;····~··h s·s- A s a N □ s--r·;; r \nChapter 39: Volatility Trading Techniques 823 \nFIGURE 39-3. \nStock chart of RMBS. \n19. 000 17. 250 18. 875 20010410 \n30.000 \n22. 000 \n14. 000 \n' ' : : \n! : : : ; 1 : : 1 r : ! : : : : ; : : : : : i l : l : 6. ooo \n99 M il M :i J ii s b N b J F M il M :i J il s b N b J F h 1 \nWhat this method may be best used for is to complement the other methods \ndescribed previously, in order to give the volatility trader some perspective on how \nvolatile he can expect the underlying instrument to be; but it obviously has to be \ntaken only as a general guideline. \nCHECK THE FUNDAMENTALS \nOnce these mispriced options have been found, it is always imperative to check the \nnews to see if there is some fundamental reason behind it. For example, if the options \nare extremely cheap and one then checks the news stories and finds that the under\nlying stock has been the beneficiary of an all-cash tender offer, he would not buy \nthose options. The stock is not going to go anywhere, and in fact will disappear if the \ndeal goes through as planned. \nSimilarly, if the options appear to be very expensive, and one checks the news \nand finds that the underlying has a product up for review before a governmental \nagency (FDA, for example), then the options should not be sold because the stock \nmay be about to undergo a large gap move based on the outcome of FDA hearings. \nThere could be any number of similar corporate events that would make the options \nvery expensive. The seller of volatility should not try to intercede when such events \nor rumors are occurring. \n824 Part VI: Measuring and Trading Volatllity \nHowever, if there is no news that would seem to explain why the options are so \ncheap or so expensive, then the volatility trader can continue on to the rest of his \nanalyses. \nSELECTING THE STRATEGY TO USE \nIn general, when one wants to trade volatility, a simple approach is best, especially if \none is buying volatility. If there is a volatility skew involved, then there may be other \nstrategies that are superior, and they are discussed in the latter part of this chapter. \nHowever, when one is interested in the straight trading of volatility because he thinks \nimplied volatility is out of line, then only a few strategies apply. \nIf volatility is too low, then either a straddle or a strangle should be purchased. \nOne would normally choose a straddle if the underlying instrument is currently trad\ning near an available striking price. However, if the underlying is currently trading \nbetween two ~riking prices, then a strangle might be the better choice. In either case, \na position trader would want to buy a straddle with several months of life remaining, \nin order to improve his chances of making a profit. There is no \"best\" time length to \nuse, so one should use a probability calculator to aid in that decision. The use of prob\nability calculators will be discussed shortly. \nExample: XYZ is trading at 39.60 and a volatility trader has determined that he wants \nto buy volatility. With this information, he should attempt to buy a straddle with a \nstriking of 40 for both the put and the call. \nSuppose that the current date is in December, and the available expiration \nmonths for XYZ are January, February, April, July, and October, plus LEAPS for \nJanuary of the next year. Then he would analyze each straddle (January 40, February \n40, April 40, etc.) to see which is the best one to buy. It generally seems to work out \nthat the midrange straddles have the best probabilities of success, given the way that \noption prices are usually structured. Of course, the actual prices of each straddle \nwould be considered when using the probability calculator. In this case, then, the July \n40 or October 40 straddle would probably be the best choices from a statistical view\npoint for a position trader. \nIf XYZ had been trading at a price of 37.50, say, then the trader would proba\nbly want to consider buying a strangle: buying a call with a striking price of 40 and a \nput with a striking price of 35. From the viewpoint of buying strangles, it does not \nmake sense to separate the strikes by more than one striking price unit - 5 points for \nstock options, for example. This just makes the position more neutral to begin with. \nChap", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 367}
{"text": "ice of 37.50, say, then the trader would proba\nbly want to consider buying a strangle: buying a call with a striking price of 40 and a \nput with a striking price of 35. From the viewpoint of buying strangles, it does not \nmake sense to separate the strikes by more than one striking price unit - 5 points for \nstock options, for example. This just makes the position more neutral to begin with. \nChapter 39: Volatility Trading Techniques 825 \nSpeaking of neutrality, one can also use the deltas of the options in question to \nalter the ratio of puts to calls, making the position initially as neutral as possible. This \nis the suggested approach, since the volatility buyer does not care whether the stock \ngoes up or down. He is merely interested in stock movement and/or an increase in \nimplied volatility. \nExample: XYZ is again trading at 39.60, and the trader wants a neutral position. He \nshould use the deltas of the options to construct a neutral position. Consider the \nOctober 40 straddle, for example. Assume the volatility used for the probability cal\nculations is 40%. Under those conditions (and the ones assumed in the previous \nexample), the October 40 call has a delta of 0.60 and the October 40 put has a delta \nof -0.40. Thus a ratio of buying 2 calls and 3 puts is a neutral ratio. If the call is sell\ning for 6 and the put is selling for 5, then the break-even points for a 2-by-3 position \nwould be 53.5 on the upside and 31 on the downside. This information is summarized \nas follows: \nDelta of October 40 call: \nDelta of October 40 put: \n+0.60 \n-0.40 \nDelta-neutral ratio: buy 2 calls and 3 puts \nPrice of October 40 coll: \nPrice of October 40 put: \nNet cost of 2-by-3 position: 27 points \nBreak-even points: \n6.00 \n5.00 \nUpside = 40 + 27 /2 = 53.50 \nDownside = 40 - 27 /3 = 31 .00 \nSo, the probability calculations would endeavor to determine what the chances are of \nthe stock ever trading at either 53.50 or 31.00 at any time prior to expiration. In fact, \nsince there are straddles available in several expiration months, the strategist would \nwant to analyze each of them in a similar fashion. Table 39-1 shows how his choices \nmight look. If one were considering buying a strangle, similar calculations could be \nmade using the deltas of the put and the call, where the call strike is higher than the \nput strike. \nAnother simple strategy that can be used when volatility is low is the calendar \nspread, because it has a positive vega. That is, it can be expected to expand if implied \nvolatility increases. For most traders, though, the limited profit nature of the calen-\n826 Part VI: Measuring and Trading Volatility \nTABLE 39-1 \nJanuary February April July October January LEAP \nCall price 1.25 2.25 3.50 5.00 6.00 7.15 \nPut price 1.50 2.35 3.35 4.35 5.00 5.55 \nCall delta 0.48 0.52 0.55 0.58 0.60 0.62 \nPut delta -0.52 -0.48 -0.45 -0.42 -0.40 -0.38 \nNeutral ~ 1-to-1 ~l-to-1 ~ 1-to-1 ~2-to-3 2-to-3 ~2-to-3 \nDebit 2.75 4.60 6.85 23.05 27.00 30.95 \nUpside break-even 42.75 44.60 46.85 51.57 53.50 55.47 \nDownside break-even 37.25 35.40 33.15 32.30 31.00 29.68 \ndar spread is too much of a burden\"° either psychologically or in terms of commis\nsions, and so this strategy is only modestly used by volatility traders. Some traders will \nuse the calendar spread if they don't see immediate prospects for an increase in \nimplied volatility. They perhaps buy a call calendar slightly out-of-the-money and also \nbuy a put calendar with slightly out-of-the-money puts. Then, if not much happens \nover the short term, the options that were sold expire worthless, and the remaining \nlong straddle or strangle is even more attractive than ever. Of course, this strategy has \nits drawback in that a quick move by the underlying may result in a loss, something \nthat would not have happened had a simple straddle or strangle been purchased. \nSELLING VOLATILITY \nIf one were selling volatility (i.e., volatility is too high), his choices are more complex. \nVirtually anyone who has ever sold volatility has had a bad experience or two with \neither exploding stock prices or exploding volatility. Some of the concerns regarding \nthe sale of volatility will be discussed at length later in this chapter. For now, the sim\npler strategies will be considered, in keeping with the discussion involving the cre\nation of a volatility trading position. \nSimplistically, a volatility seller would generally have a choice between one of \ntwo strategies (although there is a more complicated strategy that can be introduced \nas well). The simplest strategy is just to sell both an out-of-the-money put and an out\nof-the-money call. The striking prices chosen should be far enough away from the \ncurrent underlying price so that the probabilities of the position getting in trouble \n(i.e., the probabilities that the underlying actually trades at the striking prices of the \nnaked options during the life of the position) are quite small. Just as the option buyer \nChapter 39: Volatility Trading Techniques 827 \nabove outlined several expiration months, then computed the break-even prices, so \nshould a volatility seller. Generally he will probably want to sell short-term options, \nbut all expiration months should be considered, at least initially. Also, he may want to \ntry different strike prices in order to get a balance between a low probability of the \nstock reaching the striking price of the naked options and taking in enough premium \nto make the trade worthwhile. To this author, the sale of naked options at small frac\ntional prices does not appear attractive. \nOf course, merely selling such a put and a call means the options are naked, and \nthat strategy is not suitable for all traders. The next best choice then, I suppose, is a \ncredit spread. The problem with a credit spread is that one is both selling expensive \noptions and also buying expensive options as protection. The ramifications of volatil\nity changes on the credit spread strategy were detailed two chapters p", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 368}
{"text": "y selling such a put and a call means the options are naked, and \nthat strategy is not suitable for all traders. The next best choice then, I suppose, is a \ncredit spread. The problem with a credit spread is that one is both selling expensive \noptions and also buying expensive options as protection. The ramifications of volatil\nity changes on the credit spread strategy were detailed two chapters previously, so \nthey won't be recounted here, except to say that if volatility decreases, the profits to \nbe realized by a credit spreader are quite small (perhaps not even enough to over\ncome the commission expense of removing the position), whereas a naked option \nseller would benefit to a greater and more obvious extent. \nThe choice between naked writing and credit spreading should be made based \nlargely on the philosophy and psychological makeup of the trader himself. If one feels \nuncomfortable with naked options, or if he doesn't have the ability to watch the mar\nket pretty much all the time (or have someone watch it for him), or ifhe doesn't have \nthe financial wherewithal to margin the positions and carry them until the stock hits \nthe break-even point, then naked writing is not for that trader. \nAnother factor that might affect the choice of strategy for the option seller is \nwhat type of underlying instrument is being considered. Index options are by far the \nbest choices for naked option selling. Futures are next, and stocks are last. This is \nbecause of the ways those various instruments behave; stocks have by far the great\nest capability of making huge gap moves that are the bane of naked option selling. So, \nif one has found expensive stock or futures options, that might lend more credence \nto the credit spread strategy. \nThere is one other strategy that can be employed, upon occasion, when options \nare expensive. It is called the volatility backspread, but its discussion will be deferred \nuntil later in the chapter. \nUSING A PROBABILITY CALCULATOR \nNo matter which method is used to find options that are out of line, and no matter \nwhich strategy is preferred by the trader, it is still necessary to use a probability cal\nculator to get a meaningful idea of whether or not the underlying has the ability to \n828 Part VI: Measuring and Trading Volatility \nmake the move to profitability (or not make the move into loss territory, if you're sell\ning options). This is where historical volatility plays a big part, for it is the input into \nthe probability calculator. In fact, no probability calculator will give reasonable pre\ndictions without a good estimate of volatility. Please refer to the previous chapter for \na more in-depth discussion of probability calculators and stock price distributions. \nThe use of probability analysis also mitigates some of the problems inherent in \nthe method of selection that compares implied and historical volatilities. If the prob\nabilities are good for success, then we might not care so much whether the options \nare currently in a low percentile of implied volatility or not (although we still would \nnot want to buy volatility when the options were in a high percentile of implied \nvolatility and we would not want to sell options that are in a low percentile). \nIn using the probability calculator, one first selects a strategy (straddle buying, \nfor example, if options are cheap) and then calculates the break-even points as \ndemonstrated in the previous section. Then the probability calculator is used to \ndetermine what the chances are of the underlying instrument ever trading at one or \nthe other of those break-even prices at any time during the life of the option position. \nIt was shown in the previous chapter that a Monte Carlo simulation using the fat tail \ndistribution is best used for this process. \nAn attractive volatility buying situation should have probabilities in excess of \n80% of the underlying ever exceeding the break-even point, while an attractive \nvolatility selling situation should have probabilities of less than 25% of ever trading \nat prices that would cause losses. The volatility seller can, of course, heavily influence \nthose probabilities by choosing options that are well out-of-the-money. As noted \nabove, the volatility seller should, in fact, calculate the probabilities on several dif\nferent striking prices, striving to find a balance between high probability of success \nand the ability to take in enough premium to make the risk worthwhile. \nExample: The OEX Index is trading at 650. Suppose that one has determined that \nvolatilities are too high and wants to analyze the sale of some naked options. \nFurthermore, suppose that the choices have been narrowed down to selling the \nSeptember options, which expire in about five weeks. The main choices under con\nsideration are those in Table 39-2. The option prices in this example, being index \noptions, reflect a volatility skew (to be discussed later) to make the example realistic. \nThe two right-hand columns should be rejected because the probabilities of \nthe stock hitting one or the other of the striking prices prior to expiration are too \nhigh well in excess of the 25% guideline mentioned earlier. That leaves the \nSeptember 500-800 strangle or the September 550-750 strangle to consider. The \nprobabilities are best for the farthest out-of-the-money options (September 500-\n800 strangle), but the options are selling at such small prices that they will not pro-\nChapter 39: Volatility Trading Techniques 829 \nTABLE 39-2 \nSeptember September September September \n800 call 750 call 730 call 700 call \nSeptember September September September \nNaked sale: 500 put 550 put 570 put 600 put \nCall price 0.20 1.50 3.50 8.80 \nPut price 0.40 2.00 3.70 8.50 \nProbability of call strike 4% 17% 30% 44% \nProbability of put strike 1% 11% 20% 40% \nvide much of a return even if they expire worthless. Remember that one is \nrequired to establish the position with margin of at least 10% of the index price \nfor naked index", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 369}
{"text": "er September September September \nNaked sale: 500 put 550 put 570 put 600 put \nCall price 0.20 1.50 3.50 8.80 \nPut price 0.40 2.00 3.70 8.50 \nProbability of call strike 4% 17% 30% 44% \nProbability of put strike 1% 11% 20% 40% \nvide much of a return even if they expire worthless. Remember that one is \nrequired to establish the position with margin of at least 10% of the index price \nfor naked index options, which would be $6,500 in this case. In fact, it has been \nrecommended that one margin the position at the striking price itself (15% of 800, \nor $12,000 in this case). So, taking in only $60, less commissions, for the sale of \nthe September 500-800 strangle doesn't seem to provide enough of a reward. \nThus, the best choice seems to be the September 550-750 strangle. One would be \nmaking about $320 after commissions if the options expired worthless, and the \nrecommended margin would be 15% of 750 (the higher strike), or $11,250 - a \nreturn of about 2.8% for one month. One cannot annualize these returns, for he \nhas no idea if the same option pricing structure will exist in five weeks, when these \noptions expire. \nOther probabilities can be calculated as well. For example, suppose one has \ndecided to buy a straddle. He might want to know what the odds are not only of \nbreaking even, but also of making at least a certain percentage return- say 20%. One \ncould also calculate the probability of the stock moving 20% past the break-even \npoints. That distance - 20% - is a reasonable figure to use because one would most \nlikely be taking some partial profits or adjusting his position if the stock did indeed \nmove that far. \nUSING STOCK PRICE HISTORY \nAll of the work done so far - determining which options are expensive, selecting a \nstrategy, and calculating the probabilities of success - has been somewhat theoretical \nin that we haven't done any \"back testing\" with regard to the volatility of the under\nlying instruments. At this point, one should look at past prices to see if the stock has \nbeen able to make large moves (whether or not such a move is desired). \n830 Part VI: Measuring and Trading Volatility \nExample: A trader is considering the purchase of the XYZ October 40 straddle for \n11 points, with the stock at 39.60. The options are cheap and the probabilities of suc\ncess appear to be good, according to the probability calculator. The question that now \nneeds to be asked and answered is this: \"In the past, has this stock been able to move \n11 points in 10 months (the time remaining in the straddle's life)?\" Or, more impor\ntantly, since 11 divided by 39.60 is about 28%, \"Has this stock been able to make \nmoves of 28% over 10 months, in the past?\" The answers to these questions can be \nreadily obtained if stock price history data is available. One could even look at a chart \nof the stock and attempt to answer the questions himself without the aid of a com\nputer, but computer analysis of the price history is more rigorous and is therefore \nencouraged. \nThe answers can be expressed in the form of probabilities, much as the results \nof the probability calculator are. \nSuppose one determines that the stock has been able to move 11 points in 10 \nmonths 77% of the time in the past. That's okay, but not great. However, when one \nlooks at the price chart ofXYZ, he sees that it traded at much lower prices - near $10 \na share - for a long time before rising to its current levels. It would be very hard to \nexpect a $10 stock to move 11 points in 10 months. That's why the second figure, the \none involving the 28% move, is the more significant one. In this case, one might find \nthat XYZ has been able to move 28% in 10 months over 90% of the time in the past. \nNow one has what appears to be a decent-looking straddle buy. \nThis analysis of past prices can be done in a more sophisticated manner. Rather than \njust asking whether or not the stock has moved the required distance in the past, one \nmight want to see just how the stock's movements \"look.\" That is, there are a couple \nof scenarios under which the past movements might look attractive, but upon closer \nexamination, one would not be so sanguine. \nFor example, what ifXYZ had repeatedly moved 28%, but never much more in \nmost of the IO-month periods that comprise its stock history? Then, one would be \nless inclined to want to own this straddle. \nAnother scenario of past movements might be that XYZ had made moves that \none could not reasonably expect to be repeated. Perhaps there was a huge gap down \non an earnings shortfall, or if it was an Internet stock around the tum of the millen\nnium, it had a huge move upward, followed by a huge move downward. That would \nbe another nonrepeating type of move, because absent the Internet mania, the stock \nmight have been a rather range-bound item both prior to and after the one huge, \nround-trip move. \nChapter 39: Volatility Trading Techniques 831 \nFIGURE 39-4. \nHistogram of XYZ movements. {Testing 28% move in ten months.) \n15% \nX \nxx \nXXX \nX XXX \nXX XXX \n5% xxxxxxx xxxxxxx \nX XXXXXXXX \nXXX XXXXXXXX \nxxxxxxxxxxxxxxxx \n-3 -2 -1 0 \nMovement \n1 \nX X \nX X X X \nXXX XX X XXXX \nxxxxxxxxxxxxxxxxxxx \n2 3 \nThese problems could be addressed by merely looking at the chart, but the \nnaked eye can be deceiving in many cases. Rather, a more rigorous approach would \nbe to construct a histogram of these past stock movements and analyze the histogram. \nFigure 39-4 shows such a histogram. The x-axis shows the magnitude of each \n10-month move that is in the database of XYZ stock prices. A move to 'T' would \nmean that it moved the 28% and no further over the 10-month period. A move to \n\"-2\" indicates that it fell 56% (twice the required distance) during the 10-month \nperiod. The y-axis (left-hand scale) shows the percentage of times that the move \noccurred. The sample histogram shown in Figure 39-4 is actually a very favorable \none. Notice that the stock was always able to move at least 28%. Furthermore, it \nFIGURE 39-5. \nExample o", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 370}
{"text": "no further over the 10-month period. A move to \n\"-2\" indicates that it fell 56% (twice the required distance) during the 10-month \nperiod. The y-axis (left-hand scale) shows the percentage of times that the move \noccurred. The sample histogram shown in Figure 39-4 is actually a very favorable \none. Notice that the stock was always able to move at least 28%. Furthermore, it \nFIGURE 39-5. \nExample of poor movement. \n15% \n10% \n5% \n-3 -2 \nX \nxx xx xxxx \nX XXXX XXXX \nX \nX X \nxx xxxx,\"lrx~x~x~x--...----=.:.;:r· \n0 \nX \nX \nX XXX \n2 3 \n832 Part VI: Measuring and Trading Volatility \nmoved two or three times that far with great frequency. Finally, there is a continu\nity to the points on the histogram: There are some y-axis data points at almost all \npoints on the x-axis (between the minimum and maximum x-axis points). That is \ngood, because it shows that there has not been a clustering of movements by XYZ \nthat might have dominated past activity. \nAs for what is not a \"good\" histogram, we would not be so enamored of a his\ntogram that showed a huge cluster of points near and between the \"-1\" and 'T' points \non the X-axis. We want the stock to have shown an ability to move farther than just the \nbreak-even distance, if possible. As an example, see Figure 39-5, which shows a stock \nwhose movements rarely exceed the \"-1\" or \"+l\" points, and even when they do, they \ndon't exceed it by much. Most of these would be losing trades because, even though \nthe stock might have moved the required percentage, that was its maximum move \nduring the 10-month period, and there is no way that a trader would know to take \nprofits exactly at that time. The straddles described by the histogram in Figure 39-5 \nshould not be bought, regardless of what the previous analyses might have shown. \nNor would it be desirable for the histogram to show a large number of move\nments above the \"+3\" level on the histogram, with virtually nothing below that. Such \na histogram would most likely be reflective of the spiky, Internet-type stock activity \nthat was referred to earlier as being unreasonable to expect that it might repeat itself. \nIn a general sense, one doesn't want to see too many open spaces on the histogram's \nX-axis; continuity is desired. \nIf the histogram is a favorable one, then the volatility analysis is complete. One \nwould have found mispriced options, with a good theoretical probability of profit, \nwhose past stock movements verify that such movements are feasible in the future. \nANOTHER APPROACH? \nAfter having considered the descriptions of all of these analyses, one other approach \ncomes to mind: Use the past movements exclusively and ignore the other analyses \naltogether. This sounds somewhat radical, but it is certainly a valid approach. It's \nmore like giving some rigor to the person who \"knows\" IBM can move 18 points and \nwho therefore wants to buy the straddle. If the histogram (study of past movements) \ntells us that IBM does, indeed, have a good chance of moving 18 points, what do we \nreally care about the relationship of implied and historical volatility, or about the cur\nrent percentiles of either type of volatility, or what a theoretical probability calcula\ntor might say? In some sense, this is like comparing implied volatility (the price of the \nstraddle) with historical volatility (the history of stock price movements) in a strictly \npractical sense, not using statistics. \nChapter 39: Volatility Trading Techniques 833 \nIn reality, one would have to be mindful of not buying overly expensive options ( or \nselling overly cheap ones), because implied volatility cannot be ignored. However, the \nprice of the straddle itself, which is what determines the x-axis on the histogram, does \nreflect option prices, and therefore implied volatility, in a nontechnical sense. This author \nsuspects that a list of volatility trading candidates generated only by using past movements \nwould be a rather long list. Therefore, as a practical matter, it may not be useful. \nMORE THOUGHTS ON SELLING VOLATILITY \nEarlier, it was promised that another, more complex volatility selling strategy would \nbe discussed. An option strategist is often faced with a difficult choice when it comes \nto selling (overpriced) options in a neutral manner - in other words, \"selling volatili\nty.\" Many traders don't like to sell naked options, especially naked equity options, yet \nmany forms of spreads designed to limit risk seem to force the strategist into a direc\ntional (bullish or bearish) strategy that he doesn't really want. This section addresses \nthe more daunting prospect of trying to sell volatility with protection in the equity \nand futures option markets. \nThe quandary in trying to sell volatility is in trying to find a neutral strategy that \nallows one to benefit from the sale of expensive options without paying too much for \na hedge - the offsetting purchase of equally expensive options. The simple strategy \nthat most traders first attempt is the credit spread. Theoretically, if implied volatility \nwere to fall during the time the credit spread position is in place, a profit might be \nrealized. However, after commissions on four different options in and possibly out \n(assuming one sold both out-of-the-money put and call spreads), there probably \nwouldn't be any real profit left if the position were closed out early. In sum, there is \nnothing really wrong with the credit spread strategy, but it just doesn't seem like any\nthing to get too excited about. What other strategy can be used that has limited risk \nand would benefit from a decline in implied volatility? The highest-priced options are \nthe longer-term ones. If implied volatility is high, then if one can sell options such as \nthese and hedge them, that might be a good strategy. \nThe simplest strategy that has the desired traits is selling a calendar spread \nthat is, sell a longer-term option and hedge it by buying a short-term option at the \nsame strike. True, both are expensive (and", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 371}
{"text": "d volatility? The highest-priced options are \nthe longer-term ones. If implied volatility is high, then if one can sell options such as \nthese and hedge them, that might be a good strategy. \nThe simplest strategy that has the desired traits is selling a calendar spread \nthat is, sell a longer-term option and hedge it by buying a short-term option at the \nsame strike. True, both are expensive (and the near-term option might even have a \nslightly higher implied volatility than the longer-term one). But the longer-term one \ntrades with a far greater absolute price, so if both become cheaper, the longer-term \none can decline quite a bit farther in points than the near-term one. That is, the vega \nof the longer-term option is greater than the vega of the shorter-term one. When one \nsells a calendar spread, it is called a reverse calendar spread. The strategy was \n834 Part VI: Measuring and Trading Volatility \ndescribed in the chapter on reverse spreads. The reader might want to review that \nchapter, not only for the description of the strategy, but also for the description of the \nmargin problems inherent in reverse spreads on stocks and indices. \nOne of the problems that most traders have with the reverse calendar spread is \nthat it doesn't produce very large profits. The spread can theoretically shrink to zero \nafter it is sold, but in reality it will not do so, for the longer-term option will retain \nsome amount of time value premium even if it is very deeply in- or out-of-the-money. \nHence the spread ·will never really shrink to zero. \nYet, there is another approach that can often provide larger profit potential and \nstill retain the potential to make money if implied volatility decreases. In some sense \nit is a modification of the reverse calendar spread strategy that can create a poten\ntially even more desirable position. The strategy, known as a volatility backspread, \ninvolves selling a long-term at-the-money option (just as in the reverse calendar \nspread) and then buying a greater number of near-er term out-of-the-money options. \nThe position is generally constructed to be delta-neutral and it has a negative vega, \nmeaning that it will profit if implied volatility decreases. \nExample: XYZ is trading at 115 in early June. Its options are very expensive. A trad\ner would like to construct a volatility backspread using the following two options: \nCall Option \nJuly 130 call: \nOctober 120 call: \nPrice \n2.50 \n13 \nDelta \n0.26 \n0.53 \nVega \n0.10 \n0.27 \nA delta-neutral position would be to buy 2 of the July 130 calls and sell one of \nthe October 120 calls. This would bring in a credit of 8 points. Also, it would have a \nsmall negative position vega, since tvvo times the vega of the July calls minus one \ntimes the vega of the October call is -0.07. That is, for each one percentage point \ndrop in implied volatility of XYZ options in general, this position would make $7 -\nnot a large amount, but it is a small position. \nThe profitability of the position is shown in Figure 39-6. This strategy has lim\nited risk because it does not involve naked options. In fact, if XYZ were to rally by a \ngood distance, one could make large profits because of the extra long call. \nMeanwhile, on the downside, if XYZ falls heavily, all the options would lose most of \ntheir value and one would have a profit approaching the amount of the initial credit \nreceived. Furthermore, a decrease in implied volatility produces a small profit as \nwell, although time decay may not be in the trader's favor, depending on exactly \nwhich short-term options were bought. The biggest risk is that XYZ is exactly at 130 \nat July expiration, so any strategist employing this strategy should plan to close it out \nChapter 39: Volatility Trading Techniques \nFIGURE 39-6. \nVolatility backspread neutral position. \nUnderlying Price \n835 \nin advance of the near-term expiration. It should not be allowed to deteriorate to the \npoint of maximum loss. \nModifications to the strategy can be considered. One is to sell even longer-term \noptions and of course hedge them with the purchase of the near-term options. The \nlonger-term the option is, the bigger its vega will be, so a decrease in implied volatil\nity will cause the heftier-priced long-term option to decline more in price. This mod\nification is somewhat tempered, though, by the fact that when options get really \nexpensive, there is often a tendency for the near-term options to be skewed. That is, \nthe near-term options will be trading with a much higher implied volatility than will \nthe longer-term options. This is especially true for LEAPS options. For that reason, \none should make sure that he is not entering into a situation in which the shorter\nterm options could lose volatility while the longer-term ones more or less retain the \nsame implied volatility, as LEAPS options often do. This concept of differing volatil\nity between near- and long-term options was discussed in more detail in Chapter 36 \non the basics of volatility trading. As a sort of general rule, if one finds that the longer\nterm option has a much lower implied volatility than the one you were going to buy, \nthis strategy is not recommended. As a corollary, then, it is unlikely that this strate\ngy will work well with LEAPS options. \nOne other thing that you should analyze when looking for this type of trade is \nwhether it might be better to use the puts than the calls. For one thing, you can estab\nlish a position in which the heavy profitability is on the downside (as opposed to the \nupside, as in the XYZ example above). Then, of course, having considered that, it \nmight actually behoove one to establish both the call spread and the put spread. If \n836 Part VI: Measuring and Trading Volatility \nyou do both, though, you create a \"good news, bad news\" situation. The good news \nis that the maximum risk is reduced; for example, if XYZ goes exactly to 130 (the \nworst point for the call spread), the companion put spread's credit would redu", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 372}
{"text": "ing considered that, it \nmight actually behoove one to establish both the call spread and the put spread. If \n836 Part VI: Measuring and Trading Volatility \nyou do both, though, you create a \"good news, bad news\" situation. The good news \nis that the maximum risk is reduced; for example, if XYZ goes exactly to 130 (the \nworst point for the call spread), the companion put spread's credit would reduce that \nrisk a little. However, the bad news is that there is a much wider range over which \nthere is not profit, since there are two spots where losses are more or less maximized \n(at the strike price of the long calls and again at the strike price of the long puts). \nMargin will be discussed only briefly, since it was addressed in the chapter on \nreverse spreads. For both index and stock options, this strategy is considered to have \nnaked options - a preposterous assumption, since one can see from the profit graph \nthat the position is fully hedged until the near-term options expire. This raises the \ncapital requirement for nonmember traders. The margin anomaly is not a problem \nwith futures options, however. For those options, one need only margin the differ\nence in the strikes, less any credit received, because that is the true risk of the posi\ntion. In summary, the volatility trader who wants to sell volatility in equity and futures \noptions markets needs to be hedged, because gaps are prevalent and potentially very \ncostly. This strategy creates a more neutral, less price-dependent way to benefit if \nimplied volatility decreases, especially when compared with simple credit spreads. \nSUMMARY: TRADING THE \nVOLATILITY PREDICTION \nAttempting to establish trades when implied volatility is out of line is a theoretically \nattractive strategy. The process outlined above consisted of a few steps, employing \nboth statistical and theoretical analysis. In any case, though, probability calculators \nmust \"say\" that a volatility trade has good probabilities of success. It's merely a mat\nter of what criteria we apply to limit our choices before we run the probability analy\nsis. So, it might be more useful to view volatility trading analysis in this light: \nStep I: Use a selection criterion to limit the myriad of volatility trading choices. Any \nof these could be used as the first criterion, but not all of them at once: \na. Require implied volatility to be at an extreme percentile. \nb. Require historical and implied volatility to have a large discrepancy \nbetween them. \nc. Interpret the chart of implied volatility to see if it has reversed trend. \nStep 2: Use a probability calculator to project whether the strategy can be expected \nto be a success. \nStep 3: Using past price histories, determine whether the underlying has been able \nto create profitable trades in the past. (For example, if one is considering \nChapter 39: Volatility Trading Techniques 837 \nbuying a straddle, ask the question, \"Has this stock been able to move far \nenough, with great enough frequency, to make this straddle purchase prof\nitable?\") Use histograms to ensure that the past distribution of stock prices \nis smooth, so that an aberrant, nonrepeatable move is not overly influenc\ning the results. \nEach criterion from Step 1 would produce a different list of viable volatility \ntrading candidates on any given day. If a particular candidate were to appear on more \nthan one of the lists, it might be the best situation of all. \nTRADING THE VOLATILITY SKEW \nIn the early part of this chapter, it was mentioned that there are two ways in which \nvolatility predictions could be \"wrong.\" The first was that implied volatility was out of \nline. The second is that individual options on the same underlying instrument have \nsignificantly different implied volatilities. This is called a volatility skew, and presents \ntrading opportunities in its own right. \nDIFFERING IMPLIED VOLATILITIES ON THE SAME UNDERLYING SECURITY \nThe implied volatility of an option is the volatility that one would have to use as input \nto the Black-Scholes model in order for the result of the model to be equal to the \ncurrent market price of the option. Each option will thus have its own implied volatil\nity. Generally, they will be fairly close to each other in value, although not exactly the \nsame. However, in some cases, there will be large enough discrepancies between the \nindividual implied volatilities to warrant the strategist's attention. It is this latter con\ndition of large discrepancies that will be addressed in this section. \nExample: XYZ is trading at 45. The following option prices exist, along with their \nimplied volatilities: \nActual Implied \nOption Price Volatility \nJanuary 45 call 2.75 41% \nJanuary 50 call 1.25 47% \nJanuary 55 call 0.63 53% \nFebruary 45 call 3.50 38% \nFebruary 50 call 4.00 45% \n838 Part VI: Measuring and Trading Volatility \nNote that the implied volatilities of the individual options range from a low of \n38% to a high of 53%. This is a rather large discrepancy for options on the same \nunderlying security, but it is useful for exemplary purposes. \nA neutral strategy could be established by buying options with lower implied \nvolatilities and simultaneously selling ones with higher volatilities, such as buy 10 \nFebruary 45 calls and sell 20 January 50 calls. Examples of neutral spreads will be \nexpanded upon in the next chapter, when more exact measures for determining how \nmany calls to buy and sell are discussed. \nBefore jumping into such a position, the strategist should ask himself if there is \na valid reason why the different options have such different implied volatilities. As a \ngeneralization, it might be fair to say that out-of-the-money options have slightly \nhigher implieds than at-the-money ones, and that longer-term options have lower \nimplieds than short-term ones. But there are many instances in which such is not the \ncase, so one must be careful not to overgeneralize. \nSpeculators often desire the lowest dollar-cost option available", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 373}
{"text": "nt implied volatilities. As a \ngeneralization, it might be fair to say that out-of-the-money options have slightly \nhigher implieds than at-the-money ones, and that longer-term options have lower \nimplieds than short-term ones. But there are many instances in which such is not the \ncase, so one must be careful not to overgeneralize. \nSpeculators often desire the lowest dollar-cost option available. Thus, in a \ntakeover rumor situation, they would buy the out-of-the-moneys as opposed to the \nhigher-priced at- or in-the-moneys. If the out-of-the-moneys are extremely expen\nsive because of a takeover rumor, then the strategist must be careful, because the \nneutral strategy concept may lead him into selling naked calls. This is not to say \nhe should avoid the situation altogether; he may be able to structure a position \nwith enough upside room to protect himself, or he may believe the rumors are \nfalse. \nReturning to the general topic of differing implied volatilities on the same \nunderlying stock, the strategist might ask how he is to determine if the discrepancies \nbetween the individual options are significantly large to warrant attention. A mathe\nmatical approach is presented at the end of the next chapter in a section on advanced \nmathematical concepts. Suffice it to say that there is a way that the differences in the \nvarious implieds can be reduced to a single number - a sort of \"standard deviation of \nthe implieds\" that is easy for the strategist to use. A list of these numbers can be con\nstructed, comparing which stocks or futures might be candidates for this type of neu\ntral spreading. On a given day, the list is usually quite short - perhaps 20 stocks and \n10 futures contracts will qualify. \nThe concept of the implied volatilities of various options on the same underly\ning stock remaining out of line with each other is one that needs more discussion. In \nthe following section, the idea of semipermanent distortion between the volatilities \nof different striking prices is discussed. \nChapter 39: Volatility Trading Techniques \nVOLATILITY SKEWING \n839 \nAfter the stock market crashed in 1987, index options experienced what has since \nproven to be a permanent distortion: Out-of-the-money puts have remained more \nexpensive than out-of-the-money calls. Furthermore, out-of-the-money puts are \nmore expensive than at-the-money puts; out-of-the-money calls are cheaper than at\nthe-money calls. This distorted effect is due to several factors, but it is so deep-seat\ned that it has remained through all kinds of up and down markets since then. Other \nmarkets, particularly futures markets, have also experienced a long-lasting distortion \nbetween the implied volatilities at various strikes. \nThe proper name given to this phenomenon is volatility skewing: the long-last\ning effect whereby options at different striking prices trade with differing implied \nvolatilities. It should be noted that the calls and puts at the same strike must trade \nfor the same implied volatility; otherwise, conversion or reversal arbitrage would \neliminate the difference. However, there is no true arbitrage between different strik\ning prices. Hence, arbitrage cannot eliminate volatility skewing. \nExample: Volatility skewing exists in OEX index options. Assume the average volatil\nity of OEX and its options is 16%. With volatility skewing present, the implied volatil\nities at the various striking prices might look like this: \nOEX: 580 \nImplied Volatility \nStrike of Both Puts and Calls \n550 22% \n560 19% \n570 17% \n580 16% \n590 15% \n600 14% \n610 13% \nIn this form of volatility skewing, the out-of-the-money puts are the most \nexpensive options; the out-of-the-money calls are the cheapest. This pattern of \nimplied volatilities is called a reverse volatility skew or, alternatively, a negative \nvolatility skew. \n840 Part VI: Measuring and Trading Volatility \nThe causes of this effect stem from the stock market's penchant to crash occa\nsionally. Investors who want protection buy index puts; they don't sell index futures \nas much as they used to because of the failure of the portfolio insurance strategy dur\ning the 1987 crash. In addition, margin requirements for selling naked index puts \nhave increased, especially for market-makers, who are the main suppliers of naked \nputs. Consequently, demand for index puts is high and supply is low. Therefore, out\nof-the-money index puts are overly expensive. \nThis does not entirely explain why index calls are so cheap. Part of the reason \nfor that is that institutional traders can help finance the cost of those expensive index \nputs by selling some out-of-the-money index calls. Such sales would essentially be \ncovered calls if the institution owned stocks, which it most certainly would. This strat\negy is called a collar. \nThis distortion in volatilities is not in accordance with the probability distribu\ntion of stock prices. These distorted implied volatilities define a different probability \ncurve for stock movement. They seem to say that there is more chance of the market \ndropping than there is of it rising. This is not true; in fact, just the opposite is true. \nRefer to the reasons for using lognormal distribution to define stock price move\nments. Consequently, there are opportunities to profit from volatility skewing, if one \nis able to hold the position until expiration. \nIt was shown in previous examples that one would attempt to sell the options \nwith higher implied volatilities and buy ones with lower implieds as a hedge. Hence, \nfor OEX traders, three strategies seem relevant: \n1. Buy a bear put spread in OEX. \nExample: Buy 10 OEX June 560 puts \nSell IO OEX June 540 puts \n2. Buy OEX puts and sell a larger number of out-of-the-money puts - a ratio write \nof put options. \nExample: Buy 10 OEX June 560 puts \nSell 20 OEX June 550 puts \n3. Sell OEX calls and buy a larger number of out-of-the-money calls - a backspread \nof call options. \nExample: Buy 20 OEX June 590 calls \nSell IO OEX June 580", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 374}
{"text": "spread in OEX. \nExample: Buy 10 OEX June 560 puts \nSell IO OEX June 540 puts \n2. Buy OEX puts and sell a larger number of out-of-the-money puts - a ratio write \nof put options. \nExample: Buy 10 OEX June 560 puts \nSell 20 OEX June 550 puts \n3. Sell OEX calls and buy a larger number of out-of-the-money calls - a backspread \nof call options. \nExample: Buy 20 OEX June 590 calls \nSell IO OEX June 580 calls \nIn all three cases, one is selling the higher implied volatility and buying options \nwith lower implied volatilities. The first strategy is a simple bear spread. While it will \nChapter 39: Volatility Trading Techniques 841 \nbenefit from the fact that the options are skewed in terms of implied volatility, it is not \na neutral strategy. It requires that the underlying drop in price in order to become \nprofitable. There is nothing wrong with using a directional strategy like this, but the \nstrategist must be aware that the skew is unlikely to disappear ( until expiration) and \ntherefore the index price movement is going to be necessary for profitability. \nThe second strategy would be best suited for moderately bearish investors, \nalthough a severe market decline might drive the index so low that the additional \nshort puts could cause severe losses. However, statistically this is an attractive strat\negy. At expiration, the volatility skewing must disappear; the markets will have moved \nin line with their real probability distribution, not the false one being implied by the \nskewed options. This makes for a potentially profitable situation for the strategist. \nThe backspread strategy would work best for bullish investors, although some \nbackspreads can be created for credits, so a little money could also be made if the \nindex fell. In theory, a strategist could implement both strategies simultaneously, \nwhich would give him an edge over a wide range of index prices. Again, this does not \nmean that he cannot lose money; it merely means that his strategy is statistically \nsuperior because of the way the options are priced. That is, the odds are in his favor. \nIn reality, though, a neutral trader would choose either the ratio spread or the \nbackspread - not both. As a general rule of thumb, one would use the ratio spread \nstrategy if the current level of implied volatility were in a high percentile. The back\nspread strategy would be used if implied volatility were in a low percentile current\nly. In that way, a movement of implied volatility back toward the 50th percentile \nwould also benefit the trade that is in place. \nAnother interesting thing happens in these strategies that may be to their ben\nefit: The volatility skewing that is present propagates itself throughout the striking \nprices as OEX moves around. It was shown in the previous section's example that one \nshould probably continue to project his profits using the distorted volatilities that \nwere present when he establishes a position. This is a conservative approach, but a \ncorrect one. In the case of these OEX spreads, it may be a benefit. \nAssuming that the skewing is present wherever OEX is trading means that the \nat-the-money strike will have 16% as its implied volatility regardless of the absolute \nprice level; the skewing will then extend out from that strike. So, if OEX rises to 600, \nthen the 600 strike would have a volatility of 16%; or if it fell to 560, then the 560 \nputs and calls would have a volatility of 16%. Of course, 16% is just a representative \nfigure; the \"average\" volatility of OEX can change as well. For illustrative purposes, \nit is convenient to assume that the at-the-money strike keeps a constant volatility. \nExample: Initially, a trader establishes a call backspread in OEX options in order to \ntake advantage of the volatility skewing: \n842 \nInitial situation: OEX: 580 \nOption \nJune 590 call \nJune 600 call \nA neutral spread would be: \nBuy 2 June 600 calls \nSell I June 590 call \nImplied Volatility \n15% \n14% \nsince the deltas are in the ratio of 2-to-l. \nPart VI: Measuring and Trading Volatility \nDelta \n0.40 \n0.20 \nNow, suppose that OEX rises to 600 at a later date, but well before expiration. \nThis is not a particularly attractive price for this position. Recall that, at expiration, a \nbackspread has its worst result at the striking price of the purchased options. Even \nprior to expiration, one would not expect to have a profit with the index right at 600. \nHowever, the statistical advantage that the strategist had to begin with might be \nable to help him out. The present situation would probably look like this: \nOption \nJune 590 call \nJune 600 call \nImplied Volatility \n17% \n16% \nThe June 600 call is now the at-the-money call, since OEX has risen to 600. As \nsuch, its implied volatility will be 16% ( or whatever the \"average\" volatility is for OEX \nat that time - the assumption is made that it is still 16% ). The June 590 call has a \nslightly higher volatility (17%) because volatility skewing is still present. \nThus, the options that are long in this spread have had their implied volatility \nincrease; that is a benefit. Of course, the options that are short had theirs increase as \nwell, but the overall spread should benefit for two reasons: \n1. Twice as many options are owned as were sold. \n2. The effect of increased volatility is greatest on the at-the-money option; the in\nthe-money will be affected to a lesser degree. \nAll index options exhibit this volatility skewing. Volatility skewing exists in other \nmarkets as well. The other markets where volatility skewing is prevalent are usually \nChapter 39: Volatility Trading Techniques 843 \nfutures option markets. In particular, gold, silver, sugar, soybeans, and coffee options \nwill from time to time display a form of volatility skewing that is the opposite of that \ndisplayed by index options. In these futures markets, the cheapest options are out-of\nthe-money puts, while the most expensive options are out-of-the-money calls. \nExample: January soybeans are tradin", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 375}
{"text": "ing Techniques 843 \nfutures option markets. In particular, gold, silver, sugar, soybeans, and coffee options \nwill from time to time display a form of volatility skewing that is the opposite of that \ndisplayed by index options. In these futures markets, the cheapest options are out-of\nthe-money puts, while the most expensive options are out-of-the-money calls. \nExample: January soybeans are trading at 580 ($5.80 per bushel). The following \ntable of implied volatilities shows how volatility skewing that is present in the soybean \nmarket is the opposite of that shown by the OEX market in the previous examples: \nJanuary beans: 580 \nStrike Implied Volatility \n525 12% \n550 13% \n575 15% \n600 17% \n625 19% \n650 21% \n675 23% \nNotice that the out-of-the-money calls are now the more expensive items, while \nout-of-the-money puts are the cheapest. This pattern of implied volatilities is called \nforward volatility skew or, alternatively, positive volatility skew. \nThe distribution of soybean prices implied by these volatilities is just as incor\nrect as the OEX one was for the stock market. This soybean implied distribution is \ntoo bullish. It implies that there is a much larger probability of the soybean market \nrising 100 points than there is of it falling 50 points. That is incorrect, considering the \nhistorical price movement of soybeans. \nA strategist attempting to benefit from the forward ( or positive) volatility skew \nin this market has essentially three strategies available. They are the opposite of the \nthree recommended for the $OEX, which had a reverse (or negative) volatility skew. \nFirst would be a call bull spread, second would be a put backspread, and third would \nbe a call ratio spread. In all three cases, one would be buying options at the lower \nstriking price and selling options at the higher striking price. This would give him the \ntheoretical advantage. \nThe same sorts of comments that were made about the OEX strategies can be \napplied here. The bull spread is a directional strategy and can probably only be \nexpected to make money if the underlying rises in price, despite the statistical advan-\n844 Part VI: Measuring and Trading VolatiRty \ntage of the volatility skew. The put backspread is best established when the overall \nlevel of implied volatility is in a low percentile. Finally, the call ratio spread has a \ngreat deal of risk to the upside ( and futures prices can fly to the upside quickly, espe\ncially if bad fundamental conditions develop, such as weather in the grain markets). \nThe call ratio spread would best be used when implied volatilities are already in a \nhigh percentile. \nAs a general comment, it should be noted that if the volatility skew disappears \nwhile the trader has the position in place, a profit will generally result. It would nor\nmally behoove the strategist to take the profit at that time. Otherwise, follow-up \naction should adhere to the general kinds of action recommended for the strategies \nin question: protective action to prevent large losses in the case of the ratio spreads, \nor the taking of partial profits and possibly rolling the long options to a more at-the\nmoney strike in the case of the backspread strategies. \nSUMMARY OF VOLATILITY SKEWING \nWhenever volatility skewing exists - no matter what market - opportunities arise for \nthe neutral strategist to establish a position that has advantages. These advantages \narise out of the fact that normal market movements are different from what the \noptions are implying. Moreover, the options are wrong when there is skewing at all \nstrikes, from the lowest to the highest. The strategist should be careful to project his \nprofits prior to expiration using the same skewing, for it may persist for some time to \ncome. However, at expiration, it must of course disappear. Therefore, the strategist \nwho is planning to hold the position to expiration will find that volatility skewing has \npresented him with an opportunity for a positive expected return. \nSUMMARY OF VOLATILITY TRADING \nThe theoretical trading of options, mostly in a neutral manner, has evolved into one \nlarge branch - volatility trading. This part of the book has attempted to lay out the \nfoundations, structures, and practices prevalent in this branch of trading. As the read\ner can see, there are some sophisticated techniques being applied - not so much in \nterms of strategy, but in terms of the ways that one looks at volatility and in the ways \nthat stocks can move. \nStatistical methods are used liberally in trying to determine the ways that either \nvolatility can move or stocks can move. The probability calculators, stock price dis\ntributions, and related topics are all statistical in nature. The volatility trader is intent \non finding situations in which current market implied volatility is incorrect, either in \nits absolute value or in the skew that is prevalent in the options on a particular under-\nChapter 39: VolatiDty Trading Techniques 845 \nlying instrument. Upon finding such discrepancies, the trader attempts to take \nadvantage by constructing a more or less neutral position, preferring not to predict \nprice so much, but rather attempting to predict volatility. \nMost volatility traders attempt to buy volatility rather than sell it, for the rea\nsons that the strategies inherent in doing so have limited risk and large potential \nrewards, and don't require one to monitor them continuously. If one owns a straddle, \nany major market movements resulting in gaps in prices are a benefit. Hence, mon\nitoring of positions as little as just once a day is sufficient, a fact that means that the \nvolatility buyer can have a life apart from watching a trading screen all day long. In \naddition, volatility buyers of stock options can avail themselves of the chaotic move\nments that stocks can make, taking advantage of the occasional fat tail movements. \nHowever, since volatility and prices are so unstable, one cannot predict their \nmovements with any certaint", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 376}
{"text": "cient, a fact that means that the \nvolatility buyer can have a life apart from watching a trading screen all day long. In \naddition, volatility buyers of stock options can avail themselves of the chaotic move\nments that stocks can make, taking advantage of the occasional fat tail movements. \nHowever, since volatility and prices are so unstable, one cannot predict their \nmovements with any certainty. The vagaries of historical volatility as compared to \nimplied volatility, the differences between the implied volatility of short- and long\nterm options, and the difficulty in predicting stock price distributions all compli\ncate the process of predicting volatility. Hence, volatility trading is not a \"lock,\" but \nits practitioners normally believe that it is by far the best approach to theoretical \noption trading available today. Moreover, most option professionals primarily trade \nvolatility rather than directional positions. \n, CHAPTER 40 \nAdvanced Concepts \nAs the option markets have matured, strategists have been forced to rely more on \nmathematics in order to select new positions as well as to discern how their positions \nwill behave in fluctuating markets. These techniques can be used on simple strategies, \nsuch as bull spreads or ratio spreads, or on far more complex portfolios of options. \nFirst, the concept of implied volatility will be examined in more detail, prima\nrily as an aid in choosing new positions that have a positive expected return. Then, \nthe concept of risk management will be explored. In effect, one can reduce his option \nposition into several components of risk measurement that can be readily under\nstood. This chapter describes the techniques used to evaluate one's position, and \nshows how to use this information to reduce the risk in the position. The actual math\nematical calculations required to perform these analyses are included at the end of \nthe chapter. \nNEUTRALITY \nIn many of the examples in previous chapters, it was generally assumed that one \nwould take a \"neutral\" position in order to capture the pricing or volatility differen\ntial. Why this concentration on neutrality? Neutrality, as it applies to option positions, \nmeans that one is noncommittal with respect to at least one of the factors that influ\nence an option's price. Simply put, this means that one can design an option position \nin which he can profit, no matter which way the underlying security moves. \n846 \nChapter 40: Advanced Concepts 847 \nMost option strategies fall into one of two categories: as a hedge to a stock or \nfutures strategy (for example, buying puts to protect a portfolio of stocks), or as a \nprofit venture unto itself. The latter category is where most traders find themselves, \nand they often approach it in a fairly speculative manner - either by buying options \nor by being a premium seller (covered or uncovered). In such strategies, the trader \nis taking a view of the market; he needs certain price action from the underlying \nsecurity in order to profit. Even covered call writing, which is considered to be a con\nservative strategy, is subject to large losses if the underlying stock drops drastically. \nIt doesn't have to be that way. Strategies can be devised that will have a chance \nto profit regardless of price changes in the underlying stock, as well as because of \nthem. Such strategies are neutral strategies and they always require at least two \noptions in the position - a spread, straddle, or some other combination. Often, when \none constructs a neutral strategy, he is neutral with respect to price changes in the \nunderlying security. It is also possible, and often wise, to be neutral with respect to \nthe rate of price change of the underlying security, with respect to the volatility of \nthe security, or with respect to time decay. This is not to imply that any option spread \nthat is neutral will automatically be a money-maker; rather, one looks for an \nopportunity - perhaps an overpriced series of options - and attempts to capture that \noverpricing by constructing a neutral strategy around it. Then, regardless of the \nmovement of the underlying stock, the strategist has a chance of making money if the \noverpricing disappears. \nNote that the neutral approach is distinctly different from the speculator's, who, \nupon determining that he has discovered an underpriced call, would merely buy the \ncall, hoping for the stock to increase in price. He would not make money if XYZ fell \nin price unless there was a huge expansion in implied volatility - not something to \ncount on. The next section of this chapter deals with how one determines his neu\ntrality. In effect, if he is not neutral, then he has risk of some sort. The following sec\ntions outline various measures of risk that the strategist can use to establish a new \nposition or manage an existing one. \nThe most important of these risk measurements is how much market exposure \nthe position currently has. This has previously been described as the \"delta.\" Of near\nly equal importance to the strategist is how much the option strategy will change with \nrespect to the rate of change in the price of the underlying security. Also of interest \nare how changes in volatility, in time remaining until expiration, or even in the risk\nfree interest rate will affect the position. Once the components of the option position \nare defined, the strategist can then take action to reduce the risk associated with any \nof the factors, should he so desire. \n848 Part VI: Measuring and Trading Volatmty \nTHE \"GREEKS\" \nRisk measurements have generally been given the names of actual or contrived \nGreek letters. For example, \"delta\" was discussed in previous chapters. It has become \ncommon practice to refer to the exposure of an option position merely by describing \nit in terms of this \"Greek\" nomenclature. For example, \"delta long 200 shares\" means \nthat the entire option position behaves as if the strategist were merely long 200 shares \nof the underlying stock", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 377}
{"text": "ames of actual or contrived \nGreek letters. For example, \"delta\" was discussed in previous chapters. It has become \ncommon practice to refer to the exposure of an option position merely by describing \nit in terms of this \"Greek\" nomenclature. For example, \"delta long 200 shares\" means \nthat the entire option position behaves as if the strategist were merely long 200 shares \nof the underlying stock. In all, there are six components, but only four are heavily \nused. \nDELTA \nThe first risk measurement that concerns the option strategist is how much current \nexposure his option position has as the underlying security moves. This is called the \n\"delta.\" In fact, the term delta is commonly used in at least two different contexts: to \nexpress the amount by which an option changes for a I-point move in the underlying \nsecurity, or to describe the equivalent stock position of an entire option portfolio. \nReviewing the definition of the delta of an individual option (first described in \nChapter 3), recall that the delta is a number that ranges between 0.0 and 1.0 for calls, \nand between -1.0 and 0.0 for puts. It is the amount by which the option will move if \nthe underlying stock moves 1 point; stated another way, it is the percentage of any \nstock price change that will be reflected in the change of price of the option. \nExample: Assume an XYZ January 50 call has a delta of 0.50 with XYZ at a price of \n49. This means that the call will move 50% as fast as the stock will move. So, if XYZ \njumps to 51, a gain of 2 points, then the January 50 call can be expected to increase \nin price by 1 point (50% of the stock increase). \nIn another context, the delta of a call is often thought of as the probability of the \ncall being in-the-money at expiration. That is, ifXYZ is 50 and the January 55 call has \na delta of 0.40, then there is a 40% probability that XYZ will be over 55 at January \nexpiration. \nPut deltas are expressed as negative numbers to indicate that put prices move \nin the opposite direction from the underlying security. Recall that deltas of out-of\nthe-money options are smaller numbers, tending toward 0 as the option becomes \nvery far out-of-the-money. Conversely, deeply in-the-money calls have deltas \napproaching 1.0, while deeply in-the-money puts have deltas approaching -1.0. \nNote: Mathematically, the delta of an option is the partial derivative of the \nBlack-Scholes equation ( or whatever formula one is using) with respect to stock \nprice. Graphically, it is the slope of a line that is tangent to the option pricing curve. \nChapter 40: Advanced Concepts 849 \nLet us now take a look at how both volatility and time affect the delta of a call \noption. Much of the data to be presented in this chapter will be in both tabular and \ngraphical form, since some readers prefer one style or the other. \nThe volatility of the underlying stock has an effect on delta. If the stock is not \nvolatile, then in-the-money options have a higher delta, and out-of-the-money \noptions have a lower delta. Figure 40-1 and Table 40-1 depict the deltas of various \ncalls on two stocks with differing volatilities. The deltas are shown for various strike \nprices, with the time remaining to expiration equal to 3 months and the underlying \nstock at a price of 50 in all cases. Note that the graph confirms the fact that a low\nvolatility stock's in-the-money options have the higher delta. The opposite holds true \nfor out-of-the-money options: The high-volatility stock's options have the higher delta \nin that case. Another way to view this data is that a higher-volatility stock's options will \nalways have more time value premium than the low-volatility stock's. In-the-money, \nthese options with more time value will not track the underlying stock price move\nment as closely as ones with little or no time value. Thus, in-the-money, the low\nvolatility stock's options have the higher delta, since they track the underlying stock \nprice movements more closely. Out-of-the-money, the entire price of the option is \ncomposed of time value premium. The ones with higher time value (the ones on the \nhigh-volatility stock) will move more since they have a higher price. Thus, out-of-the\nmoney, the higher-volatility stock's options have the greater delta. \nTime also affects delta. Figures 40-2 (see Table 40-2) and 40-4 show the rela\ntionships between time and delta. Figure 40-2's scales are similar to those in Figure \n40-2, delta vs. volatility: The deltas are shown for various striking prices, with XYZ \nassumed to be equal to 50 in all cases. Notice that in-the-money, the shorter-term \noptions have the higher delta. Again, this is because they have the least time value \npremium. Out-of-the-money, the opposite is true: The longer-term options have the \nhigher deltas, since these options have the most time value premium. \nFigure 40-3 (see Table 40-3) depicts the delta for an XYZ January 50 call with \nXYZ equal to 50. The horizontal axis in this graph is \"weeks until expiration.\" Note \nthat the delta of a longer-term at-the-money option is larger than that of a shorter\nterm option. In fact, the delta shrinks more rapidly as expiration draws nearer. Thus, \neven if a stock remains unchanged and its volatility is constant, the delta of its options \nwill be altered as time passes. This is an important point to note for the strategist, \nsince he is constantly monitoring the risk characteristics of his position. He cannot \nassume that his position is the same just because the stock has remained at the same \nprice for a period of time. \nPosition Delta. Another usage of the term delta is what has previously been \nreferred to as the equivalent stock position (ESP); for futures options, it would be \n850 \nFIGURE 40-1. \nDelta comparison, with XYZ = 50. \n100 \n75 \n$ \n<ii 50 \n0 ',, .. .......... \nLow-Volatility Stock , \nPart VI: Measuring and Trading Volatility \n25 ', ', High-Volatility Stock \n', ',, .............. \n---.............. \n0 L..L _______ .....L _____", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 378}
{"text": "sage of the term delta is what has previously been \nreferred to as the equivalent stock position (ESP); for futures options, it would be \n850 \nFIGURE 40-1. \nDelta comparison, with XYZ = 50. \n100 \n75 \n$ \n<ii 50 \n0 ',, .. .......... \nLow-Volatility Stock , \nPart VI: Measuring and Trading Volatility \n25 ', ', High-Volatility Stock \n', ',, .............. \n---.............. \n0 L..L _______ .....L _______ __:::::i~~ ..... -..:L-_ \n40 45 50 \nTABLE 40-1. \n55 \nStrike Price \n60 65 \nDelta comparison for different volatilities with XYZ = 50 and \ntime = 3 months. \nDelta \nStrike Price Low-Volatility Stock High-Volatility Stock \n40 100 94 \n45 93 78 \n50 51 53 \n55 11 29 \n60 1 13 \n65 0 5 \nreferred to as EFP (equivalent futures position). To differentiate between the two \nterms, the delta of the option is generally referred to as \"option delta,\" while the ESP \nor EFP is called \"position delta.\" Recall that the position delta is computed accord\ning to the following simple equation: \nPosition delta = Option's delta x Shares per option x Option quantity \nChapter 40: Advanced Concepts \nFIGURE 40-2. \nDelta comparison, with XYZ = 50. \n100 \n75 \n~ ai 50 \n0 \n25 \n40 \nTABLE 40-2. \n45 50 55 \nStrike Price \n60 65 \nDelta comparison - varying time remaining with XYZ = 50. \nDelta \nStrike Price t = 1 year t = 6 months \n40 92 97 \n45 79 83 \n50 61 57 \n55 41 30 \n60 25 12 \n65 14 4 \n851 \nt = 3 months \n99 \n90 \n55 \n18 \n3 \n0 \nFor futures options, the term \"shares per option\" would be replaced by \"shares \nper contract,\" which is always 1. This is the risk measurement of how much market \nexposure the option position has. Whether called position delta, ESP, or EFP, one \nuses the deltas of the individual options in his portfolio to calculate the overall expo\nsure. By summing the calculations for each item in a position, or even in an entire \noption portfolio, one can approximate how much market exposure the entire option \n852 \nFIGURE 40-3. \nDelta as a function of time. \n57 \n56 \n55 \n.s \n8 54 \n53 \n52 \nTABLE 40-3. \n2 4 6 \nDelta as a function of time. \n8 10 12 \nWeeks Remaining \nWeeks Remaining \n20 \n18 \n15 \n13 \n10 \n8 \n6 \n4 \n2 \nPart VI: Measuring and Trading Volatility \n14 16 18 20 \nDelta \n.566 \n.562 \n.557 \n.553 \n.547 \n.543 \n.538 \n.531 \n.521 \n.515 \nposition has. The next example, reprinted from the chapter on mathematical appli\ncations, shows how one computes the net exposure of a complicated position. \nExample: The following position exists when XYZ is at 31. 75. It resembles a long \nstraddle (or backspread), in that there is increased profit potential in either direction \nChapter 40: Advanced Concepts 853 \nif the stock moves far enough by expiration. Many market-makers and professional \ntraders attempt to structure these types of positions, if possible, in order to take \nadvantage of the sudden volatility that is inherent in today's markets. \nPosition \nPosition Delta Delta \nShort 4,500 XYZ 1.00 - 4,500 \nShort 1 00 XYZ April 25 calls 0.89 - 8,900 \nLong 50 XYZ April 30 calls 0.76 + 3,800 \nLong 139 XYZ July 30 calls 0.74 + 10,286 \nTotal ESP: + 686 \nThis position, though complicated to the naked eye, reduces to being long only \napproximately 700 shares of XYZ. This is commonly referred to as being \"delta long \n700 shares.\" Thus, the terms \"delta,\" when referring to the sum of the deltas of a \nwhole position, and \"equivalent stock position\" are synonymous. \nThis position has some exposure to the market since it is delta long. If the posi\ntion delta were zero, it would be referred to as being delta neutral and would, theo\nretically, have no exposure to the market at that time. \nNote that one can derive some general characteristics of his delta by just exam\nining his portfolio by eye: Short calls or long puts will introduce negative delta into \nthe position; long calls or short puts will introduce positive delta. Furthermore, it is \nobvious that being long the underlying security adds to the long delta of the position, \nwhile being short the underlying security places more negative delta in the position. \nThe use of this information to adjust the delta of one's position will be discussed in a \nlater section of this chapter. \nObviously, the delta of this entire position will change as the stock price moves \nup or down as time passes. The figure given is merely an instantaneous look at how \nthe position is structured. It is the need to know how the position will change when \nother factors change that has led strategists to employ the following concepts. \nGAMMA \nSimply stated, the gamma is how fast the delta changes with respect to changes in the \nunderlying stock price. It is known that the delta of a call increases as the call moves \nfrom out-of-the-money to in-the-money. The gamma is merely a precise measure\nment of how fast the delta is increasing. \n854 Part VI: Measuring and Trading Volatility \nExample: With XYZ at 49, assume the January 50 call has a delta of 0.50 and a \ngamma of 0.05. If XYZ moves up one point to 50, the delta of the call will increase \nby the amount of the gamma: It will increase from 0.50 to 0.55. \nAs with the delta, the gamma can also be expressed as a percentage. But in this \ncase, the increase or decrease applies to the delta. \nExample: Again, with XYZ at 49, assume the January 50 call has a delta of 0.50 and a \ngamma of 0.05. If XYZ moves up 2 points to 51, the delta of the call will increase by \n5% of the stock rrwve, because the gamma is 0.05, or 5 percent. Five percent of the \nstock move is 0.05 x 2, or 0.10. Thus, the delta will increase by 0.10, from 0.50 to 0.60. \nObviously, the delta cannot keep increasing by 0.05 each time XYZ gains anoth\ner point in price, for it will eventually exceed 1.00 by that calculation, and it is known \nthat the delta has a maximum of 1.00. Thus, it is obvious that the gamma changes. In \ngeneral, the gamma is at its maximum point when the stock is near the strike of the \noption. As the stock moves away from the strike in either direction, the gamma \ndecreases, approaching its minimum val", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 379}
{"text": "me XYZ gains anoth\ner point in price, for it will eventually exceed 1.00 by that calculation, and it is known \nthat the delta has a maximum of 1.00. Thus, it is obvious that the gamma changes. In \ngeneral, the gamma is at its maximum point when the stock is near the strike of the \noption. As the stock moves away from the strike in either direction, the gamma \ndecreases, approaching its minimum value of zero. \nConceptually, this means that a deeply in-the-money or deeply out-of-the\nmoney option has a gamma of nearly zero. This makes sense - it implies that the delta \nof a deep in- or deep out-of-the-money option does not change very much at all, even \nif the stock moves by one point. \nExample: Assume XYZ is 25, and the January 50 call has a delta of virtually zero. If \nXYZ moves up one point to 26, the call is still so far out-of-the-money that the delta \nwill still be zero. Thus, the gamma of this call is zero, since the delta does not change \nwhen the stock increases in price by a point. \nIn a similar manner, the January 45 put on XYZ would have a delta of -1.0 with \nXYZ at 25. If XYZ moved up one point to 26, the put' s delta would not change; it is \nstill so far in-the-money that it would still be - 1.0. Thus, the gamma of this deeply \nin-the-money option is also zero, since the delta remains unchanged in the face of a \nI-point rise in the underlying security. \nNote that the gamma of any option is expressed as a positive number, whether \nthe option is a put or a call. \nOther properties of gamma are useful to know as well. As expiration nears, the \ngamma of at-the-money options increases dramatically. Consider an option with a day \nor two of life remaining. If it is at-the-money, the delta is approximately 0.50. \nHowever, if the stock were to move 2 points higher, the delta of the option would jump \nChapter 40: Advanced Concepts 855 \nto nearly 1.00 because of the short time remaining until expiration. Thus, the gamma \nwould be roughly 0.25 (the delta increased by 0.50 when the stock moved 2 points), \nas compared to much smaller values of gamma for at-the-money options with several \nweeks or months of life remaining. The same 2-point rise in the underlying stock \nwould not result in much of an increase in the delta of longer-term options at all. \nOut-of-the-money options display a different relationship between gamma and \ntime remaining. An out-of-the-money option that is about to expire has a very small \ndelta, and hence a very small gamma. However, if the out-of-the-money option has a \nsignificant amount of time remaining, then it will have a larger gamma than the \noption that is close to expiration. \nFigure 40-4 (see Table 40-4) depicts the gammas of three options with varying \namounts of time remaining until expiration. The properties regarding the relation\nship of gamma and time can be observed here. Notice that the short-term options \nhave very low gammas deeply in- or out-of the-money, but have the highest gamma \nat-the-money (at 50). Conversely, the longest-term, one-year option has the highest \ngamma of the three time periods for deeply in- or out-of-the-money options. The \ndata is presented in Table 40-4. This table contains a slight amount of additional data: \nthe gamma for the at-the-money option at even shorter periods of time remaining \nuntil expiration. Notice how the gamma explodes as time decreases, for the at-the\nmoney option. With only one week remaining, the gamma is over 0.28, meaning that \nthe delta of such a call would, for example, jump from 0.50 to 0.78 if the stock mere\nly moved up from 50 to 51. \nGamma is dependent on the volatility of the underlying security as well. At-the\nmoney options on less volatile securities will have higher gammas than similar options \non more volatile securities. The following example demonstrates this fact. \nExample: Assume XYZ is at 49, as is ABC. Moreover, XYZ is a more volatile stock \n(30% implied) as compared to ABC (20% ). Then, similar options on the two stocks \nwould have significantly different gammas. \nXYZ Gammas ABC Gammas \nOption (Volatility = 30%) (Volatility= 20%) \nJanuary 50 .066 .097 \nJanuary 55 .045 .039 \nJanuary 60 .019 .0053 \nFebruary 50 .055 .081 \nFebruary 60 .024 .011 \n856 Part VI: Measuring and Trading VolatHity \nFIGURE 40-4. \nGamma comparison, with XYZ = 50. \n8 \n7 \n0 6 0 ..-\nX 5 \nCl! \nE 4 E \nCl! 3 (!) \n2 t= 1 year \nt= 6 months \nt= 3 months 0 '-'----~---__._ ___ _._ ___ _._ ___ ....___ \n40 45 50 55 60 65 \nStrike Price \nTABLE 40-4. \nGamma comparison - various amounts of time remaining \n(with XYZ = 50). \nTime Remaining Strike Price \n40 45 50 55 60 \n1 year .015 .029 .039 .04 .033 \n6 months .011 .037 .058 .051 .030 \n3 months .003 .039 .086 .057 .015 \n2 months .108 \n1 month .166 \n1 week .288 \n65 \n.023 \n.013 \n.002 \nNote that the at-the-money options (January 50's and February 50's) on ABC, \nthe less volatile stock, have larger gammas than do their XYZ counterparts. However, \nlook one strike higher (January 55's), and notice that the more volatile options have a \nslightly higher gamma. Look two strikes higher and the more volatile options have a \nvastly higher gamma, both for the January 60's and the February 60's. \nThis concept makes sense if one thinks about the relationship between volatili\nty and delta. On nonvolatile stocks, one finds that the delta of even a slightly in\nthe-money option increases rapidly. This is because, since the stock is not volatile, \nbuyers are not willing to pay much time premium for the option. As a result, the \ngamma is high as well, because as the stock moves into-the-money, the increase in \nChapter 40: Advanced Concepts 857 \ndelta will be more dramatic than it would be for a volatile stock. Out-of-the-money \noptions are an entirely different story. Since the nonvolatile stock will have difficulty \nmoving fast enough to reach an out-of-the-money striking price, the delta of the out\nof-the-money option is small and it will not change quickly (that is, the gamma is \nsmall also). \nThese con", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 380}
{"text": "pter 40: Advanced Concepts 857 \ndelta will be more dramatic than it would be for a volatile stock. Out-of-the-money \noptions are an entirely different story. Since the nonvolatile stock will have difficulty \nmoving fast enough to reach an out-of-the-money striking price, the delta of the out\nof-the-money option is small and it will not change quickly (that is, the gamma is \nsmall also). \nThese concepts are summarized in Figure 40-5 (see Table 40-5), which depicts \nthe gammas for similar options on stocks with differing volatilities. For the purposes \nof these graphs, XYZ is equal to 50 and there are three months remaining until expi\nration. \nNotice that for a very volatile stock, the gamma is quite stable over nearly all \nstriking prices when there are 3 months remaining until expiration. This means that \nthe deltas of all options on such a volatile stock will be changing quite a bit for even \na 1-point move in the underlying stock. This is an important point for neutral strate\ngists to note, because a position that starts out as delta neutral may quickly change if \nthe underlying stock is very volatile. As this table implies, the deltas of the options in \nthat \"neutral\" spread may be altered quickly, thereby rendering the spread quite un\nneutral. This concept will be discussed in greater detail later in this chapter. \nAs delta was used to construct the equivalent stock position of an entire option \nposition or portfolio, gamma can be used in a similar manner. An example of this fol\nlows, using the same securities from the preceding example on the delta of a posi\ntion. An important point to note is that the gamma of the underlying security itself is \nzero. This is true because the delta of the underlying security (which is always 1.0) \nnever changes - hence the gamma is zero. The gamma is measuring the amount of \nchange of the delta; if the delta of the underlying security never changes, the gamma \nof the underlying security must be zero. \nExample: The following position exists when XYZ is at 31.75. Recall that it resem\nbles a long straddle ( or backspread) in that there is increased profit potential in either \ndirection if the stock moves far enough by expiration. In addition to the delta previ\nously listed, the gamma is now shown as well. Note that since gamma is a small \nabsolute number, it is sometimes calculated out to three or four decimal places. \nOption Position Option Position \nPosition Delta Delta Gamma Gamma \nShort 4,500 XYZ 1.00 - 4,500 0.0000 0 \nShort l 00 XYZ April 25 calls 0.89 - 8,900 0.0100 -100 \nLong 50 XYZ April 30 calls 0.76 + 3,800 0.0300 +150 \nLong 139 XYZ July 30 calls 0.74 +10,286 0.0200 +278 \nTotals: + 686 +328 \n858 Part VI: Measuring and Trading Volatility \nFIGURE 40-5. \nGamma comparison, with XYZ = 50, t = three months. \n8 \n7 \n0 6 \n0 \n~ 5 \n<ti \nE 4 E \n~ 3 \n2 \nTABLE 40-5. \n40 45 \nLow Volatility \nVery High Volatility \n50 55 60 \nStrike Price \n65 \nGamma comparison for varying volatilities (XYZ = 50, t = 3 \nmonths). \nGamma Very \nStrike Low Volatility High Volatility High Volatility \n40 .003 .013 .017 \n45 .039 .039 .022 \n50 .086 .057 .024 \n55 .057 .049 .025 \n60 .015 .028 .023 \n65 .002 .012 .020 \nAs before, the position still has a delta long of almost 700 shares. In addition, \none can now see that it has a positive gamma of over 300 shares. This means that the \ndelta can be expected to change by 328 shares for each point that XYZ moves: If it \nmoves up 1 point, the delta will increase to +1,014 (the current delta, 686, plus the \ngamma of 328). However, ifXYZ moves down by 1 point, then the delta will decrease \nto +358 (the current delta, 686, less the gamma of 328). \nNote that, in the above example, if XYZ continues higher, the gamma will \nremain positive (although it will eventually shrink some), and the delta will continue \nto increase. This means the position is getting longer and longer - a fact that makes \nChapter 40: Atlvanced Concepts 859 \nsense when one notes that there are extra long calls and they would be getting deep\ner in-the-money as the stock moves up. Conversely, if XYZ continues to move lower, \nthe delta will continue to decrease and will quickly become negative, meaning that \nthe position would become short overall. Hence, the position does indeed resemble \na long straddle: It gets longer as the market moves up and it gets shorter as the mar\nket moves down. \nLong options, whether puts or calls, have positive gamma, while short options \nhave negative gamma. Thus, a strategist with a position that has positive gamma has \na net long option position and is generally hoping for large market movements. \nConversely, if one has a position with negative gamma, it means he has shorted \noptions and wants the market to remain fairly stable. \nNote that it is possible to be delta neutral, but to have a significant gamma. (For \nexample, if one owns puts and calls with offsetting deltas, he would be delta neutral, \nbut would have positive gamma since both options are long.) If one is delta neutral, \nhe knows he has no market exposure at this time, but his gamma will show him what \nexposure his position will acquire as the market moves. These concepts will be dis\ncussed in greater detail later in this chapter. \nVEGA OR TAU \nThere is no letter in the Greek alphabet called \"vega.\" Thus, some strategists, being \npurists, prefer to use a real Greek letter, \"tau,\" to refer to this risk measurement. The \nterm \"vega\" will be used in this book, but the reader should note that \"tau\" means \nthe same thing. Vega is the arrwunt by which the option price changes when the \nvolatility changes. Vega is always expressed as a positive number, whether it refers to \na put or a call. \nIt is known that more volatile stocks have more expensive options. Thus, as \nvolatility increases, the price of an option will rise. If volatility falls, the price of the \noption will fall as well. The vega is merely an attempt to quantify how much the \noption price will increase or decrease as the volatil", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 381}
{"text": "nges. Vega is always expressed as a positive number, whether it refers to \na put or a call. \nIt is known that more volatile stocks have more expensive options. Thus, as \nvolatility increases, the price of an option will rise. If volatility falls, the price of the \noption will fall as well. The vega is merely an attempt to quantify how much the \noption price will increase or decrease as the volatility moves, all other factors being \nequal. \nBefore considering an example, a review of the term volatility is in order. \nVolatility is a measure of how quickly the underlying security moves around. \nStatistically, it is usually calculated as the standard deviation of stock prices over some \nperiod of time, generally annualized. This statistical measure is expressed as a per\ncent, although relating that percent to actual stock movements can be complicated. \nSuffice it to say that a stock that has a 50% volatility is more volatile than a stock with \n30% volatility. The stock market generally has a volatility of about 15% overall, \nalthough that may change from time to time (crashes, for example). \n860 Part VI: Measuring and Trading Vo/atiHty \nExample: Again, assume XYZ is at 49, and the January 50 call is selling for 3.50. The \nvega of the option is 0.25, and the current volatility of XYZ is 30%. \nIf the volatility increases by one percentage point or 1 % to 31 %, then the vega \nindicates that the option will increase in value by 0.25, to 3. 75. \nIf the volatility had instead decreased by 1 percent to 29%, then the January 50 \ncall would have decreased to 3.25 (a loss of 0.25, the amount of the vega). \nIf the implied volatility of an option increases, the option price will increase as \nwell. Consequently, even though XYZ stock may be exhibiting the same historic \nmovement that it always has, and therefore its (historical) volatility would be \nunchanged, if option buyers appear in sufficient quantity, they may drive the implied \nvolatility ofXYZ's options higher. Likewise, an excess of option sellers could drive the \nimplied volatility lower, even though the historical volatility does not change. So, it \nmust be concluded that vega measures how much the option price changes as implied \nvolatility changes. \nVega is related to time. Figure 40-6 (see Table 40-6) shows the vegas for options \nwith differing times remaining until expiration. The underlying stock is assumed to \nbe 50 in all cases. Notice that the more time that remains, the higher the vega is. It \nis interesting to note that, for very long-term options, the vega of the slightly out-of\nthe-money calls (strike = 55) is actually higher than that of the at-the-money. \nHowever, this discrepancy disappears as time passes. Not shown, but equally true, is \nthat the vega of a slightly out-of-the-money option on a very volatile stock may be \nhigher than that of the at-the-money. \nAs with the measurements of risk discussed already, vega can refer to the option \nitself (\"option vega\") or to the position as a whole (\"position vega\"). Since vega is \nexpressed as a positive number, if one is long options, then his position vega will be \npositive. This means he has exposure if volatilities decrease, or can make money if \nvolatilities increase. \nExample: Again, assume that we have the same backspread position as before, with \nXYZ at 31.75. \nOption Position \nPosition Vega Vega \nShort 4,500 XYZ 0.00 0 \nShort 100 XYZ April 25 calls 0.02 - 200 \nLong 50 XYZ April 30 calls 0.05 + 250 \nLong 139 XYZ July 30 calls 0.07 + 973 \nTotal Vega: + 1,023 \nChapter 40: Advanced Concepts \nFIGURE 40-6. \nVega comparison, XYZ = 50. \n20 \n18 \n16 \n14 \n0 \n0 12 ,--\n.2S 10 C1l \nCl \n~ 8 \n6 t= 3 months \n4 \n2 \n0 \n40 45 50 \nStrike Price \nTABLE 40-6. \n861 \n55 60 65 \nVega comparison for different time periods (with XYZ = 50). \nVega \nStrike Price t = 1 Year t = 6 Months t = 3 Months \n40 0.12 0.06 0.02 \n45 0.16 0.11 0.06 \n50 0.19 0.13 0.09 \n55 0.20 0.13 0.08 \n60 0.18 0.11 0.05 \n65 0.16 0.07 0.02 \nThe vega is a positive 10.23 points ($1,023 since each point for these equity \noptions is worth $100). The fact that the position has a positive vega means that it is \nexposed to variations in volatility. If volatility decreases, the position will lose money: \n$1,023 for each one percentage point decrease in volatility. However, if volatility \nincreases, the position will benefit. \nVega is greatest for at-the-money options and approaches zero as the option is \ndeeply in- or out-of-the-money. Again, this is common sense, since a deep in- or out-\n860 Part VI: Measuring and Trading Volatility \nExample: Again, assume XYZ is at 49, and the January 50 call is selling for 3.50. The \nvega of the option is 0.25, and the current volatility of XYZ is 30%. \nIf the volatility increases by one percentage point or 1 % to 31 %, then the vega \nindicates that the option will increase in value by 0.25, to 3. 75. \nIf the volatility had instead decreased by 1 percent to 29%, then the January 50 \ncall would have decreased to 3.25 (a loss of 0.25, the amount of the vega). \nIf the implied volatility of an option increases, the option price will increase as \nwell. Consequently, even though XYZ stock may be exhibiting the same historic \nmovement that it always has, and therefore its (historical) volatility would be \nunchanged, if option buyers appear in sufficient quantity, they may drive the implied \nvolatility of XYZ's options higher. Likewise, an excess of option sellers could drive the \nimplied volatility lower, even though the historical volatility does not change. So, it \nmust be concluded that vega measures how much the option price changes as implied \nvolatility changes. \nVega is related to time. Figure 40-6 (see Table 40-6) shows the vegas for options \nwith differing times remaining until expiration. The underlying stock is assumed to \nbe 50 in all cases. Notice that the more time that remains, the higher the vega is. It \nis interesting to note that, for very long-term options, the vega of the slightly out-of\nthe-mon", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 382}
{"text": "price changes as implied \nvolatility changes. \nVega is related to time. Figure 40-6 (see Table 40-6) shows the vegas for options \nwith differing times remaining until expiration. The underlying stock is assumed to \nbe 50 in all cases. Notice that the more time that remains, the higher the vega is. It \nis interesting to note that, for very long-term options, the vega of the slightly out-of\nthe-money calls (strike = 55) is actually higher than that of the at-the-money. \nHowever, this discrepancy disappears as time passes. Not shown, but equally true, is \nthat the vega of a slightly out-of-the-money option on a very volatile stock may be \nhigher than that of the at-the-money. \nAs with the measurements of risk discussed already, vega can refer to the option \nitself (\"option vega\") or to the position as a whole (\"position vega\"). Since vega is \nexpressed as a positive number, if one is long options, then his position vega will be \npositive. This means he has exposure if volatilities decrease, or can make money if \nvolatilities increase. \nExample: Again, assume that we have the same backspread position as before, with \nXYZ at 31.75. \nOption Position \nPosition Vega Vego \nShort 4,500 XYZ 0.00 0 \nShort 100 XYZ April 25 calls 0.02 - 200 \nLong 50 XYZ April 30 calls 0.05 + 250 \nLong 139 XYZ July 30 calls 0.07 + 973 \nTotal Vega: + 1,023 \nChapter 40: Advanced Concepts \nFIGURE 40-6. \nVega comparison, XYZ = 50. \n20 \n18 \n16 \n14 \n0 \n0 12 ... \n6 10 (13 \n0) \n;g? 8 \n6 \n4 \n2 \n0 \n40 45 \nTABLE 40-6. \n861 \n50 55 60 65 \nStrike Price \nVega comparison for different time periods (with XYZ = 50). \nVega \nStrike Price t = 1 Year t = 6 Months t = 3 Months \n40 0.12 0.06 0.02 \n45 0.16 0.11 0.06 \n50 0.19 0.13 0.09 \n55 0.20 0.13 0.08 \n60 0.18 0.11 0.05 \n65 0.16 0.07 0.02 \nThe vega is a positive 10.23 points ($1,023 since each point for these equity \noptions is worth $100). The fact that the position has a positive vega means that it is \nexposed to variations in volatility. If volatility decreases, the position will lose money: \n$1,023 for each one percentage point decrease in volatility. However, if volatility \nincreases, the position will benefit. \nVega is greatest for at-the-money options and approaches zero as the option is \ndeeply in- or out-of-the-money. Again, this is common sense, since a deep in- or out-\n862 Part VI: Measuring and Trading Volatility \nof-the-money option will not be affected much by a change in volatility. In addition, \nfor at-the-money options, longer-term options have a higher vega than short-term \noptions. To verify this, think of it in the extreme: An at-the-money option with one \nday to expiration will not be overly affected by any change in volatility, due to its \npending expiration. However, a three-month at-the-money option will certainly be \nsensitive to changes in volatility. \nVega does not directly correlate with either delta or gamma. One could have a \nposition with no delta and no gamma (delta neutral and gamma neutral) and still have \nexposure to volatility. This does not mean that such a position would be undesirable; \nit merely means that if one had such a position, he would have removed most of the \nmarket risk from his position and would be concerned only with volatility risk. \nIn later sections, the use of volatility to establish positions and the use of vega \nto monitor them will be discussed. \nTHETA \nTheta measures the time decay of a position. All option traders know that time is the \nenemy of the option holder, and it is the friend of the option writer. Theta is the name \ngiven to the risk measurement of time in one's position. Theta is generally expressed \nas a negative number, and it is expressed as the amount by which the option value \nwill change. Thus, if an option has a theta of -0.12, that means the option will lose \n12 cents, or about an eighth of a point, per day. This is true for both puts and calls, \nalthough the theta of a put and a call with the same strike and expiration date are not \nequal to each other. \nVery long-term options are not subject to much time decay in one day's time. \nThus, the theta of a long-term option is nearly zero. On the other hand, short-term \noptions, especially at-the-money ones, have the largest absolute theta, since they are \nsubject to the ravages of time on a daily basis. The theta of options on a highly volatile \nstock will be higher than the theta of options on a low-volatility stock. Obviously, the \nformer options are more expensive (have more time value) and therefore have more \ntime value to lose on a daily basis, thereby implying that they have a higher theta. \nFinally, the decay is not linear - an option will lose a greater percent of its daily value \nnear the end of its life. \nFigure 40-7 (see Table 40-7) depicts the relationships of thetas for various strik\ning prices and for differing volatilities on options with three months of life remain\ning. Again, notice that for very volatile stocks, the out-of-the-money options have \nthetas as large as the at-the-moneys. This is saying that as each day passes, the prob\nability of the stock reaching that out-of-the-money strike drops and causes the option \nChapter 40: Advanced Concepts \nFIGURE 40-7. \nTheta comparison, with XYZ = 50, t = three months. \n-16 \nVery High Volatility \n-14 \n-12 \n0 0 \nT\"\" \nX \n~ \n-10 \n.i::: \nI-\n-8 Low Volatility \n-6 \n0 \n40 45 50 55 60 \nStrike Price \nTABLE 40-7. \n863 \n65 \nTheta comparison for differing volatilities (XYZ = 50, t = 3 months). \nStrike low Volatility Medium Volatility High Volatility \n40 -0.005 -0.008 -0.013 \n45 -0.007 -0.010 -0.014 \n50 -0.008 -0.010 -0.015 \n55 -0.007 -0.010 -0.016 \n60 -0.006 -0.009 -0.016 \n65 -0.004 -0.008 -0.015 \nto lose value. This does not change the fact that, for very short-term options, the theta \nis largest at-the-money. \nNormally, the theta of an individual option is of little interest to the strategist. \nHe generally would be more concerned with delta or gamma. However, as with the \nother risk measures, theta can be compute", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 383}
{"text": "55 -0.007 -0.010 -0.016 \n60 -0.006 -0.009 -0.016 \n65 -0.004 -0.008 -0.015 \nto lose value. This does not change the fact that, for very short-term options, the theta \nis largest at-the-money. \nNormally, the theta of an individual option is of little interest to the strategist. \nHe generally would be more concerned with delta or gamma. However, as with the \nother risk measures, theta can be computed for an entire portfolio of options. This \nmeasure, the \"position theta,\" can be quite important because it gives the strategist \na good idea of how much gain or loss he can expect on a daily basis, due to time ero\nsion. The following example demonstrates this point. Note that the underlying secu\nrity itself has a theta of zero, since it cannot lose any value due to time decay. \n864 Part VI: Measuring and Trading Volatility \nExample: With XYZ at 49, the strategist has the following position in February, so \nthat the April calls are nearer to expiration than the July calls. This position is similar \nto a large calendar spread position. \nOption Position \nPosition Theta Theta \nShort 4,000 XYZ 0.00 0 \nShort 150 XYZ April 50 calls -0.04 +600 \nLong 150 XYZ April 30 calls -0.02 -300 \nShort 78 XYZ July 30 puts -0.02 +156 \nTotal Theta: +456 \nThis position is expected to make $456 per day due to time decay. Note that \nshort options, whether puts or calls, have a positive position theta, while long options \nhave a negative position theta. A negative position theta means the position has risk \ndue to time, while a positive position theta means time is working for the position. \nRHO \nRho is the name given to the price change of an option's value due to a change in \ninterest rates. Recall that one of the components that contributes to an option's price \nis interest rates. As interest rates rise, call prices will rise, but put prices will fall. The \nopposite is true as well: As interest rates fall, call prices decline and put prices rise. \nRho measures the amount by which these prices rise or fall. \nThis behavior of puts and calls with respect to interest rates may not be imme\ndiately obvious, but recall that the arbitrage that can be established with in-the\nmoney calls (the \"interest play,\" discussed in Chapter 27 on arbitrage) demonstrates \nthat arbitrageurs are willing to pay more for an in-the-money call as interest rates rise \nbecause they will be earning more interest on the stock that they sell short against \nthat in-the-money call. Thus, rising interest rates cause call prices to increase. \nThe opposite is true for puts: Rising interest rates cause put prices to decline. \nAgain, an arbitrage can be used to demonstrate the point. Recall that in a reversal \narbitrage, the arbitrageur is selling the stock and the put while buying the call. We \nhave just demonstrated that, as interest rates rise, he is willing to pay more for the \ncall since he can earn extra interest on the short sale of his stock. This automatically \nmeans that he will be willing to sell the put for less. \nRho is expressed as a positive number for calls and a negative one for puts. Rho \nis smallest for deeply out-of-the-money options and is large for deeply-in-the-money \noptions. It is larger for longer-tenn options and is nearly zero for very short-tenn \nChapter 40: Advanced Concepts 865 \noptions. The following table of option prices may help to demonstrate these rela\ntionships: \nExample: With XYZ at 49, the following options have the rho indicated (January is \nthe near-term expiration): \nMonth/Strike Call Rho Put Rho \nJanuary 35 0.05 -0.01 \nJanuary 50 0.03 -0.03 \nJanuary 60 0.00 -0.05 \nJuly 35 0.18 -0.02 \nJuly 50 0.14 -0.15 \nJuly 60 0.07 -0.18 \nNote that the in-the-money calls (35 strike) have larger rho than the out-of-the\nmoney 60's, in both January and July. Similarly, the in-the-money puts (the 60's) have \nlarger rho on an absolute basis than the out-of-the-money 35's. Again, this is true for \nboth January and July. \nFurthermore, note that the longer-term July rhos are all larger (again as \nabsolute numbers) than their shorter-term January counterparts. \nRho can also be calculated for an entire portfolio to obtain a \"position rho,\" sim\nilar to previous examples. Generally, one would not be overly concerned with his \nposition rho unless his portfolio contained quite a few long-term options and/or \ndeeply in-the-money ones. Thus, rho is more important as a consideration when one \nis trading LEAPS or warrants, both of which may be extremely long-term vehicles. \nOf the risk measures discussed so far, rho is the least used, since many traders tend \nto have relatively short-term options in their positions. \nTHE GA,\\1MA OF THE GAMMA \nOccasionally, one may hear reference to the \"six measures of risk.\" This is the sixth \none and it is the most arcane. At any point, one knows the delta and gamma of an \noption. As the stock moves, the delta changes (by the amount of the gamma), but so \ndoes the gamma. Some traders are interested in knowing how much the gamma will \nchange when the stock moves. Hence, they will compute the gamma of the gamma, \nwhich is the arrwunt by which the gamma will change when the stock price changes. \nThis concept will be discussed at the end of this chapter. It is most important for \nstrategists involved in positions on highly volatile stocks, for if the stock moves far \n866 Part VI: Measuring and Trading VolatOity \nenough, the gamma (and therefore the delta) may change dramatically. Thus, one \nmight want to know how this risk measure affects his profitability. \nSUMMARY \nDelta: Positive delta indicates that a position is currently bullish; if the underly\ning security goes up in price, the position should make money. A negative \ndelta indicates a bearish slant. \nGamma: Positive gamma means that the delta will increase if the underlying secu\nrity rises in price. Positive gamma generally implies that there is a pre\nponderance of long options in the position, either puts or calls; negative \ngamma indicates written or naked", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 384}
{"text": "ntly bullish; if the underly\ning security goes up in price, the position should make money. A negative \ndelta indicates a bearish slant. \nGamma: Positive gamma means that the delta will increase if the underlying secu\nrity rises in price. Positive gamma generally implies that there is a pre\nponderance of long options in the position, either puts or calls; negative \ngamma indicates written or naked options in the position. \nTheta: Negative theta means that the position will lose money as time passes \n(typical of positions with long options); positive theta implies that time is \nworking for the position (positions with written options). \nVega: Positive vega means that an increase of (perceived) volatility will benefit \nthe position - usually true of positions with long options in them; nega\ntive vega means that a decrease of volatility would be beneficial. \nSTRATEGY CONSIDERATIONS: USING THE \n11\nGREEKS\" \nBefore looking at how one operates a particular strategy using delta, gamma, etc., it \nmight be beneficial to see how these factors relate to the individual strategies that \nhave been described throughout this book. Table 40-8 is a general guide to how the \nvarious strategies are exposed to various market factors. It is not an all-purpose or \nspecific table, because as the stock moves higher or lower, some of the risk measure\nment factors will certainly be affected. \nA few assumptions were made in constructing the table. First, it was assumed \nthat the strategies where delta is noted as being zero are established in a neutral \nstance. The bull spread and bear spread strategies assumed that the stock was mid\nway between the striking prices. Two other spread strategies - ratio call and ratio put \n- assumed the stock was at the striking price of the option that was sold. In all other \ncases, there is only one striking price involved, and it was assumed that the stock was \nat the strike. \nThe table may help to clarify some of the concepts concerning the risk meas\nurement factors. First, notice that stock or futures - or any underlying security- have \nonly delta. None of the other factors pertains to the underlying security itself. \nChapter 40: Advanced Concepts 867 \nTABLE 40·8. \nGeneral risk exposure of common strategies. \nStrategy Delta Gamma Theta Vega RHo \nBuy stock + 0 0 0 0 \nSell stock short 0 0 0 0 \nCall buy + + + + \nPut buy + + \nStraddle buy 0 + + + \nCovered write + + \nNaked call sale + \nNaked put sale + + + \nRatio write \n(straddle sale) 0 + \nCalendar spread 0 + + \nBull spread + + \nBear spread + \nRatio call spread 0 + \nRatio put spread 0 + + \nAs might be expected, spread strategies involving both long and short options are \nless easily quantified than outright buys or sells. The calendar spread strategy is one \nin which the spreader does not want a lot of stock movement - he would prefer the \nunderlying security to remain near the striking price, for that is the area of maximum \nprofit potential. This is reflected by the fact that gamma is negative. Also, for calendar \nspreads, the passage of time is good, a fact that is reflected by the fact that theta is pos\nitive. Finally, since an increase in implied volatilities or interest rates would boost \nprices and widen the spread (creating a profit), vega is positive and rho is negative. \nA bull spread has positive delta, reflecting the bullish nature of the spread, but \nit has negative gamma. The reason gamma is negative is that the position becomes \nless bullish as the underlying security rises, since the profit potential, and hence the \nbullishness of the position, is limited. For similar reasons, a bear spread has negative \ndelta (reflecting bearishness) and negative gamma (reflecting limited bearishness). \nBoth the bull spread and the bear spread are the same with respect to the other risk \nmeasurements: Theta is negative, reflecting the fact that time decay can hurt the \nspread. Less obvious is the fact that these spreads are hurt by an increase in per\nceived volatility; a negative vega tells us this is true, however. \nThese risk measurement tools are important in that they can quite graphically \ndepict the risk and reward characteristics of an option position or option portfolio. \n868 Part VI: Measuring and Trading Volatility \nThey are useful in establishing a new position, because one can see how much expo\nsure he is taking on. In addition, they are extremely useful for follow-up action, since \none can see how his position's characteristics have developed in the current market\nplace at the present time. In the following sections, the use of the risk measurement \ntools as aids in establishing a position or in following up on a position will be dis\ncussed in detail. \nDELTA NEUTRAL \nOne popular type of neutral position is to be delta neutral - that is, to have the equiv\nalent stock position (ESP) or equivalent futures position (EFP) be zero. A delta neu\ntral position is one in which the sum of the projected price changes of the long options \nin the spread is essentially offset by the projected price changes of the short options \nin the same spread. \nExample: XYZ is trading at 50. The following three options are trading with the \nprices and deltas indicated. Furthermore, the \"theoretical value\" of each option is \nshown: \nXYZ:50 \n\"Theoretical \nOption Price Delta Value\" \nJanuary 50 call 3.00 0.55 3.50 \nJanuary 55 call 1.50 0.35 1.48 \nFebruary 50 put 3.50 -0.40 3.44 \nAssuming that one can rely upon these \"theoretical values\" (a big assumption, \nby the way), it is obvious that the January 50 call is cheap with respect to the other \noptions: They are close to their values, while the January 50 is 50 cents under. The \nneutral strategist would want to buy the January 50 call and hedge his purchase with \none of the other two options presented. One choice would be to establish a spread \nwherein the January 50 calls are bought and a number of January 55's are sold. To \ndetermine how many are to be bought and sold, one merely has to divide the delt", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 385}
{"text": "close to their values, while the January 50 is 50 cents under. The \nneutral strategist would want to buy the January 50 call and hedge his purchase with \none of the other two options presented. One choice would be to establish a spread \nwherein the January 50 calls are bought and a number of January 55's are sold. To \ndetermine how many are to be bought and sold, one merely has to divide the deltas \nof the two options: \nDelta neutral spread ratio = 0.55/0.35 = 11-to-7 \nThus, a delta neutral ratio spread would consist of buying 7 January 50's and sell\ning 11 January 55's. To verify that this spread is neutral with respect to the change in \nprice ofXYZ, notice that ifXYZ moves up in price 1 point, the January 50 will increase \nChapter 40: Advanced Concepts 869 \nin price by 0.55; so seven of them will increase by 7 x 0.55, or 3.85 points total. \nSimilarly, the January 55 will increase in price by 0.35, so eleven of them would \nincrease in price by 11 x 0.35, or 3.85 points total. Hence, the long side of the spread \nwould profit by 3.85 points, while the short side loses 3.85 points - a neutral situation. \nThe resulting position is a ratio spread. The profitability of the spread occurs \nbetween about 51 and 62 at expiration as shown in Figure 40-8, but that is not the \nmajor point. The real attractiveness of the spread to the neutral trader is that if the \nunderpriced nature of the January 50 call (vis-a-vis the January 55 call) should dis\nappear, the spread should produce a profit, regardless of the short-term market \nmovement of XYZ. The spread could then be closed if this should occur. \nTo illustrate this fact, suppose that XYZ actually falls to 49, but the January 50 \ncall returns to \"fair value\": \nXYZ: 49 \n\"Theoretical \nOption Price Delta Value\" \nJanuary 50 call 3.00 0.52 3.00 \nJanuary 55 call 1.10 0.34 1.13 \nFebruary 50 put 3.90 -0.42 3.84 \nNotice that the theoretical values in this table are equal to the theoretical val\nues from the previous table, less the amount of the delta. Since the XYZ January 50 \ncall is no longer underpriced, the position would be removed, and the strategist \nwould make nothing on his January 50's, but would make .40 on each of the eleven \nshort January 55's, for a profit of $440 less commissions. \nThis example leans heavily on the assumption that one is able to accurately esti\nmate the theoretical value and delta of the options. In real life, this chore can be \nquite difficult, since the estimate requires one to define the future volatility of the \ncommon stock. This is not easy. However, for the purposes of a spread, the ratio of \nthe two deltas is used. Moreover, the example didn't require that one know the exact \ntheoretical value of each option; rather, the only knowledge that was required was \nthat one of the options was cheap with respect to the other options. \nAs an alternative to a ratio spread, another type of delta neutral position could \nbe established from the previous data: Buy the January 50 call (this is the basis of the \nposition since it is supposedly the cheap option) and buy the February 50 put - the \nonly other choice from the data given. This position is a long straddle of sorts. Recall \nthat the delta of a put is negative; so again, the delta neutral ratio can be calculated \nby dividing the absolute value of two deltas: \nDelta neutral straddle ratio= 0.55/1-0.401 = 11-to-8 \n870 \nFIGURE 40-8. \nXYZ ratio spread. \nf/) \nf/) \n3000 \n2000 \n.3 1000 \n~ \ne a.. \n(r.> \n40 \nPart VI: Measuring and Trading Volatility \n45 55 60 \nAt Expiration \nStock Price \nThus, a delta neutral straddle position would consist of buying 8 J anua:ry 50 calls \nand buying 11 Februa:ry 50 puts. The straddle has no market exposure, at least over \nthe short term. Note that the delta neutral straddle has a significantly different prof\nit picture from the delta neutral ratio spread, but they are both neutral and are both \nbased on the fact that the Janua:ry 50 call is cheap. The straddle makes money if the \nstock moves a lot, while the other makes money if the stock moves only a little. (See \nFigure 40-9.) \nCan these two vastly different profit pictures be depicting strategies in which \nthe same thing is to be accomplished ( that is, to capture the underpriced nature of \nthe XYZ Janua:ry 50 call)? Yes, but in order to decide which strategy is \"best,\" the \nstrategist would have to take other factors into consideration: the historical volatility \nof the underlying security, for example, or how much actual time remains until \nJanua:ry expiration, as well as his own psychological attitude toward selling uncovered \ncalls. A more precise definition of the other risks of these two positions can be \nobtained by looking at their position gammas. \nDelta Neutral Is Not Entirely Neutral. In fact, delta neutral means that \none is neutral only with respect to small price changes in the underlying securi\nty. A delta neutral position may have seriously unneutral characteristics when \nChapter 40: Advanced Concepts \nFIGURE 40-9. \nXYZ straddle buy. \nCl) \n8000 \n7000 \n6000 \n5000 \n4000 \n~ 3000 \n~ 2000 \n! 1000 \n01------------------------\n-1000 \n-2000 \n-3000 At January Expiration \nStock Price \n871 \nsome of the other risk measurements are considered. Consequently, one cannot \nblithely go around establishing delta neutral positions and ignoring them, for \nthey may have significant market risk as certain factors change. \nFor example, it is obvious to the naked eye that the two positions described in \nthe previous section - the ratio spread and the long straddle - are not alike at all, \nbut both are delta neutral. If one incorporates the usage of some of the other risk \nmeasurements into his position, he will be able to quantify the differences between \n\"neutral\" strategies. The sale of a straddle will be used to examine how these vari\nous factors work. \nPositions with naked options in them have negative position gamma. This \nmeans that as the underlying security moves, the position will acquire traits op", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 386}
{"text": ". If one incorporates the usage of some of the other risk \nmeasurements into his position, he will be able to quantify the differences between \n\"neutral\" strategies. The sale of a straddle will be used to examine how these vari\nous factors work. \nPositions with naked options in them have negative position gamma. This \nmeans that as the underlying security moves, the position will acquire traits opposite \nto that movement: If the security rises, the position becomes short; if it falls, the posi\ntion becomes long. This description generally fits any position with naked options, \nsuch as a ratio spread, a naked straddle, or a ratio write. \nExample: XYZ is at 88. There are three months remaining until July expiration, and \nthe volatility of XYZ is 30%. Suppose 100 July 90 straddles are sold for 10 points -\nthe put and the call each selling for 5. Initially, this position is nearly delta neutral, as \n872 Part VI: Measuring and Trading Volatility \nshown in Table 40-9. However, since both options are sold, each sale places negative \ngamma in the position. \nThe usefulness of calculating gamma is shown by this example. The initial posi\ntion is NET short only 100 shares of XYZ, a very small delta. In fact, a person who is \na trader of small amounts of stock might actually be induced into believing that he \ncould sell these 100 straddles, because that is equivalent to being short merely 100 \nshares of the stock. \nTABLE 40-9. \nPosition delta and gamma of straddle sale. XYZ = 88. \nOption Position Option Position \nPosition Delto Delta Gamma Gamma \nSell l 00 July 90 calls 0.505 -5,050 0.03 -300 \nSell 1 00 July 90 puts 0.495 +4,950 0.03 -300 \nTotal shares - 100 -600 \nCalculating the gamma quickly dispels those notions. The gamma is large: 600 \nshares of negative gamma. Hence, if the stock moves only 2 points lower, this trad\ner's straddle position can be expected to behave as if it were now long 1,100 shares \n(the original 100 shares short plus 1,200 that the gamma tells us we can expect to get \nlong)! The position might look like this after the stock drops 2 points: \nXYZ: 86 \nPosition \nSold 1 00 July 90 calls \nSold 100 July 90 puts \nOption \nDelta \n0.44 \n0.55 \nPosition \nDelta \n-4,400 \n+5,500 \n+ 1 , 100 shares \nHence, a 2-point drop in the stock means that the position is already acquiring \na \"long\" look. Further drops will cause the position to become even \"longer.\" This is \ncertainly not a position - being short 100 straddles - for a small trader to be in, even \nthough it might have erroneously appeared that way when one observed only the \ndelta of the position. Paying attention to gamma more fully discloses the real risks. \nIn a similar manner, if the stock had risen 2 points to 90, the position would \nquickly have become delta short. In fact, one could expect it to be short 1,300 shares \nin that case: the original short 100 shares plus the 1,200 indicated by the negative \ngamma. A rise to 90, then, would make the position look like this: \nChapter 40: Advanced Concepts \nXYZ:90 \nPosition \nSold 100 July 90 calls \nSold 1 00 July 90 puts \nOption \nDelto \n0.56 \n0.43 \nPosition \nDelta \n-5,600 \n+4,300 \n873 \n1,300 shares \nThese examples demonstrate how quickly a large position, such as being short \n100 straddles, can acquire a large delta as the stock moves even a small distance. \nExtrapolating the moves is not completely correct, because the gamma changes as \nthe stock price changes, but it can give the trader some feel for how much his delta \nwill change. \nIt is often useful to calculate this information in advance, to some point in the \nnear future. Figure 40-10 depicts what the delta of this large short straddle position \nwill be, two weeks after it was first sold. The points on the horizontal axis are stock \nprices. The quickness with which the neutrality of the position disappears is alarm\ning. A small move up to 93 - only one standard deviation - in two weeks makes the \noverall position short the equivalent of about 3,300 shares of XYZ. Figure 40-10 real\nly shows nothing more than the effect that gamma is having on the position, but it is \npresented in a form that may be preferable for some traders. \nWhat this means is that the position is \"fighting\" the market: As the market goes \nup, this position becomes shorter and shorter. That can be an unpleasant situation, \nboth from the point of view of creating unrealized losses as well as from a psycho\nlogical viewpoint. The position delta and gamma can be used to estimate the amount \nof unrealized loss that will occur: Just how much can this position be expected to lose \nif there is a quick move in the underlying stock? The answer is quickly obtained from \nthe delta and gamma: With the first point that XYZ moves, from 88 to 89, the posi\ntion acts as if it is short 100 shares (the position delta), so it would lose $100. With \nthe next point that XYZ rises, from 89 to 90, the position will act as if it is short the \noriginal 100 shares (the position delta), plus another 600 shares (the position \ngamma). Hence, during that second point of movement by XYZ, the entire position \nwill act as if it is short 700 shares, and therefore lose another $700. Therefore, an \nimmediate 2-point jump in XYZ will cause an unrealized loss of $800 in the position. \nSummarizing: \nLoss, first point of stock movement = position delta \nLoss, second point of stock movement = position delta + gamma \nTotal loss for 2 points of stock movement \n= 2 x position delta + position gamma \n874 Part VI: Measuring and Trading Volatility \nFIGURE 40· 1 O. \nProiected delta, in 14 days. \n6000 \n4500 \n3000 \nCl) 1500 ~ ro .c \n(/) \n0 'E \n(1) \n80 85 ~ ·5 -1500 \n95 \nXYZ Stock Price \nC\" \nUJ \n-3000 \n-4500 \nUsing the example data: \nLoss, XYZ moves from 88 to 89: -$100 (the position delta) \nLoss, XYZ moves from 89 to 90: -$100 (delta) - $600 (gamma) \n: -$700 \nTotal loss, XYZ moves from 88 to 90: -$100 x 2 - $600 = -$800 \nThis can be verified by looking at the prices of the call and put after XYZ has jumped \nfrom", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 387}
{"text": "500 ~ ro .c \n(/) \n0 'E \n(1) \n80 85 ~ ·5 -1500 \n95 \nXYZ Stock Price \nC\" \nUJ \n-3000 \n-4500 \nUsing the example data: \nLoss, XYZ moves from 88 to 89: -$100 (the position delta) \nLoss, XYZ moves from 89 to 90: -$100 (delta) - $600 (gamma) \n: -$700 \nTotal loss, XYZ moves from 88 to 90: -$100 x 2 - $600 = -$800 \nThis can be verified by looking at the prices of the call and put after XYZ has jumped \nfrom 88 to 90. One could use a model to calculate expected prices if that happened. \nHowever, there is another way. Consider the following statements: \nIf the stock goes up by 1 point, the call will then have a price of: \np 1 = Po + delta \n5.505 = 5.00 + 0.505 (if XYZ goes to 89 in the example) \nIf the stock goes up 2 points, the call will have an increase of the above amount \nplus a similar increase for the next point of stock movement. The delta for that sec\nond point of stock movement is the original delta plus the gamma, since gamma tells \none how much his delta is going to change. \nChapter 40: Advanced Concepts \np2 = p 1 +delta+ gamma, or substituting from above \np2 = (p0 + delta) + delta + gamma \n= Po + 2 x delta + gamma \n6.04 = 5.00 + 2 x 0.505 + 0.03 (in the example if XYZ = 90) \n875 \nBy the same calculation, the put in the example will be priced at 4.04 if XYZ imme\ndiately jumps to 90: \n4.04 = 5.00 - 2 X 0.495 + 0.03 \nSo, overall, the call will have increased by 1.04, but the put will only have \ndecreased by 0.96. The unrealized loss would then be computed as -$10,400 for the \n100 calls, offset by a gain of $9,600 on the sale of 100 puts, for a net unrealized loss \nof $800. This verifies the result obtained above using position delta and position \ngamma. Again, this confirms the logical fact that a quick stock movement will cause \nunrealized losses in a short straddle position. \nContinuing on, let us look at some of the other factors affecting the sale of this \nstraddle. The straddle seller has time working in his favor. After the position is estab\nlished, there will not be as much decay in the first two-week period as there will be \nwhen expiration draws near. The exact amount of time decay to expect can be calcu\nlated from the theta of the position: \nXYZ: 88 \nPosition \nSold l 00 July 90 calls \nSold l 00 July 90 puts \nOption \nTheta \n-0.03 \n-0.03 \nPosition \nTheta \n+$300 \n+$300 \n+$600 \nThis is how the position looked with respect to time decay when it was first \nestablished (XYZ at 88 and three months remaining until expiration). The theta of the \nput and the call are essentially the same, and indicate that each option is losing about \n3 cents of value each day. Note that the theta is expressed as a negative number, and \nsince these options are sold, the position theta is a positive number. A positive posi\ntion theta means time decay is working in your favor. One could expect to make $300 \nper day from the sale of the 100 calls. He could expect to make another $300 per day \nfrom the sale of the 100 puts. Thus, his overall position is generating a theoretical \nprofit from time decay of $600 per day. \nThe fact that the sale of a straddle generates profits from time decay is not \nearth-shattering. That is a well-known fact. However, the amount of that time decay \n876 Part VI: Measuring and Trading Volatility \nis quantified by using theta. Furthermore, it serves to show that this position, which \nis delta neutral, is not neutral with respect to the passage of time. \nFinally, let us examine the position with respect to changes in volatility. This is \ndone by calculating the position vega. \nXYZ:88 \nPosition \nSold 1 00 July 90 calls \nSold 100 July 90 puts \nOption \nVega \n0.18 \n0.18 \nPosition \nVega \n-$1,800 \n-$1,800 \n-$3,600 \nAgain, this information is displayed at the time the position was established, \nthree months to expiration, and with a volatility of 30% for XYZ. The vega is quite \nlarge. The fact that the call's vega is 0.18 means that the call price is expected to \nincrease by 18 cents if the implied volatility of the option increases by one percent\nage point, from 30% to 31 %. Since the position is short 100 calls, an increase of 18 \ncents in the price of the call would translate into a loss of $1,800. The put has a sim\nilar vega, so the overall position would lose $3,600 if the options trade with an \nincrease in volatility of just one percentage point. Of course, the position would make \n$3,600 if the volatility decreased by one percentage point, to 29%. \nThis volatility risk, then, is the greatest risk in this short straddle position. As \nbefore, it is obvious that an increase in volatility is not good for a position with naked \noptions in it. The use of vega quantifies this risk and shows how important it is to \nattempt to sell overpriced options when establishing such positions. One should not \nadhere to any one strategy all the time. For example, one should not always be sell\ning naked puts. If the implied volatilities of these puts are below historical norms, \nsuch a strategy is much more likely to encounter the risk represented by the posi\ntion vega. There have been several times in the recent past - mostly during market \ncrashes - when the implied volatilities of both index and equity options have leaped \ntremendously. Those times were not kind to sellers of options. However, in almost \nevery case, the implied volatility of index options was quite low before the crash \noccurred. Thus, any trader who was examining his vega risk would not have been \ninclined to sell naked options when they were historically \"cheap.\" \nIn summary then, this \"neutral\" position is, in reality, much more complex when \none considers all the other factors. \nChapter 40: Advanced Concepts \nPosition summary \nRisk Factor \nPosition delta = l 00 \nPosition gamma = -600 \nPosition theta = +$600 \nPosition vega = -$3,600 \n877 \nComment \nNeutral; no immediate exposure to small \nmarket movements; lose $100 for 1 \npoint move in underlying. \nFairly negative; position will react \ninversely to market movements, causing \nlosses", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 388}
{"text": "n \none considers all the other factors. \nChapter 40: Advanced Concepts \nPosition summary \nRisk Factor \nPosition delta = l 00 \nPosition gamma = -600 \nPosition theta = +$600 \nPosition vega = -$3,600 \n877 \nComment \nNeutral; no immediate exposure to small \nmarket movements; lose $100 for 1 \npoint move in underlying. \nFairly negative; position will react \ninversely to market movements, causing \nlosses of $700 for second point of \nmovement by underlying. \nFavorable; the passage of time works in the \nposition's favor. \nVery negative; position is extremely \nsubject to changes in implied volatility. \nThis straddle sale has only one thing guaranteed to work for it initially: time \ndecay. (The risk factors will change as price, time, and volatility change.) Stock price \nmovements will not be helpful, and there will always be stock price movements, so \none can expect to feel the negative effect of those price changes. Volatility is the big \nunknown. If it decreases, the straddle seller will profit handsomely. Realistically, \nhowever, it can only decrease by a limited amount. If it increases, very bad things will \nhappen to the profitability of the position. Even worse, if the implied volatility is \nincreasing, there is a fairly likely chance that the underlying stock will be jumping \naround quite a bit as well. That isn't good either. Thus, it is imperative that the strad\ndle seller engage in the strategy only when there is a reasonable expectation that \nvolatilities are high and can be expected to decrease. If there is significant danger of \nthe opposite occurring, the strategy should be avoided. \nIf volatility remains relatively stable, one can anticipate what effects the passage \nof time will have on the position. The delta will not change much, since the options \nare nearly at-the-money. However, the gamma will increase, indicating that nearer to \nexpiration, short-term price movements will have more exaggerated effects on the \nunrealized profits of the position. The theta will grow even more, indicating that time \nwill be an even better friend for the straddle writer. Shorter-term options tend to \ndecay at a faster rate than do longer-term ones. Finally, the vega will decrease some \nas well, so that the effect of an increase in implied volatility alone will not be as dam\naging to the position when there is significantly less time remaining. So, the passage \n878 Part VI: Measuring and Trading Volatility \nof time generally will improve most aspects of this naked straddle sale. However, that \ndoes not mitigate the current situation, nor does it imply that there will be no risk if \na little time passes. \nThe type of analysis shown in the preceding examples gives a much more in\ndepth look than merely envisioning the straddle sale as being delta short 100 shares \nor looking at how the position will do at expiration. In the previous example, it is \nknown that the straddle writer will profit if XYZ is between 80 and 100 in three \nmonths, at expiration. However, what might happen in the interim is another matter \nentirely. The delta, gamma, theta, and vega are useful for the purpose of defining \nhow the position will behave or misbehave at the current point in time. \nRefer back to the table of strategies at the beginning of this section. Notice that \nratio writing or straddle selling ( they are equivalent strategies) have the characteris\ntics that have been described in detail: Delta is 0, and several other factors are neg\native. It has been shown how those negative factors translate into potential profits or \nlosses. Observing other lines in the same table, note that covered writing and naked \nput selling ( they are also equivalent, don't forget) have a description very similar to \nstraddle selling: Delta is positive, and the other factors are negative. This is a worse \nsituation than selling naked straddles, for it entails all the same risks, but in addition \nwill suffer losses on immediate downward moves by the underlying stock. The point \nto be made here is that if one felt that straddle selling is not a particularly attractive \nstrategy after he had observed these examples, he then should feel even less inclined \nto do covered writing, for it has all the same risk factors and isn't even delta neutral. \nAn example that was given in the chapter on futures options trading will be \ne,,'Panded as promised at this time. To review, one may often find volatility skewing \nin futures options, but it was noted that one should not normally buy an at-the-money \ncall (the cheapest one) and sell a large quantity of out-of-the-money calls just because \nthat looks like the biggest theoretical advantage. The following example was given. It \nwill now be expanded to include the concept of gamma. \nExample: Heavy volatility skewing exists in the prices of January soybean options: \nThe out-of-the-money calls are much more expensive than the at-the-money calls. \nThe following data is known: \nJanuary soybeans: 583 \nOption Price Implied Volatility Delta Gamma \n575 call 19.50 15% 0.55 .0100 \n675 call 2.25 23% 0.09 .0026 \nChapter 40: Advanced Concepts \nUsing deltas, the following spread appears to be neutral: \nBuy l January bean 57 5 call at 19 .50 \nSell 6 January bean 675 calls at 2.25 \nNet position: \n19.50 DB \n13.50 CR \n6 Debit \n879 \nAt the time the original example was presented, it was demonstrated through \nthe use of the profit picture that the ratio was too steep and problems could result in \na large rally. \nNow that one has the concept of gamma at his disposal, he can quantify what \nthose problems are. \nThe position gamma of this spread is quite negative: \nPosition gamma = .01 - 6 x .0026 = -0.0056 \nThat is, for every 10 points that January soybeans rally, the position will become \nshort about 1/2 of one futures contract. The maximum profit point, 675, is 92 points \nabove the current price of 583. While beans would not normally rally 92 points in \nonly a few days, it does demonstrate that this position could become ver", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 389}
{"text": "his spread is quite negative: \nPosition gamma = .01 - 6 x .0026 = -0.0056 \nThat is, for every 10 points that January soybeans rally, the position will become \nshort about 1/2 of one futures contract. The maximum profit point, 675, is 92 points \nabove the current price of 583. While beans would not normally rally 92 points in \nonly a few days, it does demonstrate that this position could become very short if \nbeans quickly rallied to the point of maximum profit potential. Rest assured there \nwould be no profit if that happened. \nEven a small rally of 20 cents (points) in soybeans - less than the daily limit -\nwould begin to make this tiny spread noticeably short. If one had established the \nspread in some quantity, say buying 100 and selling 600, he could become seriously \nshort very fast. \nA neutral spreader would not use such a large ratio in this spread. Rather, he \nwould neutralize the gamma and then attempt to deal with the resulting delta. The \nnext section deals with ways to accomplish that. \nCREATING MULTIFACETED NEUTRALITY \nSo what is the strategist to do? He can attempt to construct positions that are neutral \nwith respect to the other factors if he perceives them as a risk. There is no reason why \na position cannot be constructed as veg a neutral rather than delta neutral, if he wants \nto eliminate the risk of volatility increases or decreases. Or, maybe he wants to elim\ninate the risk of stock price movements, in which case he would attempt to be gamma \nneutral as well as delta neutral. \nThis seems like a simple concept until one first attempts to establish a position \nthat is neutral with respect to more than one risk variable. For example, if one is \n880 Part VI: Measuring and Trading VolatiRty \nattempting to create a spread that is neutral with respect to both gamma and delta, \nhe could attempt it in the following way: \nExample: XYZ is 60. A spreader wants to establish a spread that is neutral with \nrespect to both gamma and delta, using the following prices: \nOption \nOctober 60 call \nOctober 70 call \nDelta \n0.60 \n0.25 \nGamma \n0.050 \n0.025 \nThe secret to determining a spread that is neutral with respect to both risk meas\nures is to neutralize gamma first, for delta can always be neutralized by taking an off\nsetting position in the underlying security, whether it be stock or futures. First, deter\nmine a gamma neutral spread by dividing the two gammas: \nGamma neutral ratio= 0.050/0.025 = 2-to-l \nSo, buying one October 60 and selling two October 70 calls would be a gamma \nneutral spread. Now, the position delta of that spread is computed: \nPosition \nLong 1 October 60 call \nShort 2 October 70 calls \nNet position delta: \nDelta \n0.60 \n0.25 \nPosition Delta \n+60 shares \n-50 shares \n+ 10 shares \nHence, this gamma neutral ratio is making the position delta long by 10 shares \nof stock for each l-by-2 spread that is established. For example, if one bought 100 \nOctober 60 calls and sold 200 October 70 calls, his position delta would be long 1,000 \nshares. \nThis position delta is easily neutralized by selling short 1,000 shares of the stock. \nThe resulting position is both gamma neutral and delta neutral: \nOption Position Option Position \nPosition Delta Delta Gamma Gamma \nShort 1,000 XYZ 1.00 -1,000 0 0 \nLong 1 00 October 60 calls 0.60 +6,000 0.050 + 500 \nShort 200 October 70 calls 0.25 -5,000 0.025 - 500 \nNet Position: 0 0 \nChapter 40: Advanced Concepts 881 \nHence, it is always a simple matter to create a position that is both gamma and delta \nneutral. In fact, it is just as simple to create a position that is neutral with respect to \ndelta and any other risk measure, because all that is necessary is to create a neutral \nratio of the other risk measure (gamma, vega, theta, etc.) and then eliminate the \nresulting position delta by using the underlying. \nIn theory, one could construct a position that was neutral with respect to all five \nrisk measures (or six, if you really want to go overboard and include \"gamma of the \ngamma\" as well). Of course, there wouldn't be much profit potential in such a posi\ntion, either. But such constructions are actually employed, or at least attempted, by \ntraders such as market-makers who try to make their profits from the difference \nbetween the bid and off er of an option quote, and not from assuming market risk \nStill, the concept of being neutral with respect to more than one risk factor is a \nvalid one. In fact, if a strategist can determine what he is really attempting to accom\nplish, he can often negate other factors and construct a position designed to accom\nplish exactly what he wants. Suppose that one thought the implied volatility of a cer\ntain set of options was too high. He could just sell straddles and attempt to capture \nthat volatility. However, he is then exposed to movements by the underlying stock He \nwould be better served to construct a position with negative vega to reflect his expec\ntation on volatility, but then also have the position be delta neutral and gamma \nneutral, so that there would be little risk to the position from market movements. This \ncan normally be done quite easily. An example will demonstrate how. \nExample: XYZ is 48. There are three months to expiration, and the volatility of XYZ \nand its options is 35%. The following information is also known: \nXYZ:48 \nOption Price Delta Gamma Vega \nApril 50 call 2.50 0.47 0.045 0.08 \nApril 60 call l.00 0.17 0.026 0.06 \nFor whatever reasons - perhaps the historical volatility is much lower - the \nstrategist decides that he wants to sell volatility. That is, he wants to have a negative \nposition vega so that when the volatility decreases, he will make money. This can \nprobably be accomplished by buying some April 50 calls and selling more April 60 \ncalls. However, he does not want any risk of price movement, so some analysis must \nbe done. \nFirst, he should determine a gamma neutral spread. This is done in much the \nsame manner as determining a delta neutral spread, except that g", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 390}
{"text": "position vega so that when the volatility decreases, he will make money. This can \nprobably be accomplished by buying some April 50 calls and selling more April 60 \ncalls. However, he does not want any risk of price movement, so some analysis must \nbe done. \nFirst, he should determine a gamma neutral spread. This is done in much the \nsame manner as determining a delta neutral spread, except that gamma is used. \n882 Part VI: Measuring and Trading Volatmty \nMerely divide the two gammas to determine the neutral ratio to be used. In this case, \nassume that the April 50 call and the April 60 call are to be used: \nGamma neutral ratio: 0.045/0.026 = 1.73-to-l \nThus, a gamma neutral position would be created by buying 100 April 50's and sell\ning 173 April 60's. Alternatively, buying 10 and selling 17 would be close to gamma \nneutral as well. The larger position will be used for the remainder of this example. \nNow that this ratio has been chosen, what is the effect on delta and vega? \nOption Position Option Position Option Position \nPosition Delta Delta Gamma Gamma Vega Vega \nLong 1 00 April 50 0.47 +4,700 0.045 +450 0.08 + $800 \nShort 173 April 60 0.17 -2,941 0.026 -450 0.06 -1,038 \nTotal: + 1,759 0 - $238 \nThe position delta is long 1,759 shares of XYZ. This can easily be \"cured\" by \nshorting 1,700 or 1,800 shares ofXYZ to neutralize the delta. Consequently, the com\nplete position, including the short 1,700 shares, would be neutral with respect to both \ndelta and gamma, and would have the desired negative vega. \nThe actual profit picture at expiration is shown in Figure 40-11. Bear in mind, \nhowever, that the strategist would normally not intend to hold a position like this until \nexpiration. He would close it out if his expectations on volatility decline were fulfilled \n( or proved false). \nFIGURE 40-11. \nSpread with negative vega; gamma and delta neutral. \n40000...., .... \n10000 \n50 55 60 \nXVZ :Stock Price \nChapter 40: Advanced Concepts 883 \nOne other point should be made: The fact that gamma and delta are neutral to \nbegin with does not mean that they will remain neutral indefinitely as the stock \nmoves (or even as volatility changes). However, there will be little or no effect of \nstock price movements on the position in the short run. \nIn summary, then, one can always create a position that is neutral with respect \nto both gamma and delta by first choosing a ratio that makes the gamma zero, and \nthen using a position in the underlying security to neutralize the delta that is created \nby the chosen ratio. This type of position would always involve two options and some \nstock. The resulting position will not necessarily be neutral with respect to the other \nrisk factors. \nTHE MATHEMATICAL APPROACH \nThe strategist should be aware that the process of determining neutrality in several \nof the risk variables can be handled quite easily by a computer. All that is required is \nto solve a series of simultaneous equations. \nIn the preceding example, the resulting vega was negative: -$238. For each \ndecline of 1 percentage point in volatility from .the current level of 35%, one could \nexpect to make $238. This result could have been reached by another method, as \nlong as one were willing to spell out in advance the amount of vega risk he wants to \naccept. Then, he can also assume the gamma is zero and solve for the quantity of \noptions to trade in the spread. The delta would be neutralized, as above, by using the \ncommon stock. \nExample: Prices are the same as in the preceding example. XYZ is 48. There are \nthree months to expiration, and the volatility of XYZ and its options is 35%. The fol\nlowing information is also the same: \nOption \nApril 50 call \nApril 60 call \nPrice \n2.50 \n1.01 \nDelta \n0.47 \n0.17 \nGamma \n0.045 \n0.026 \nVega \n0.08 \n0.06 \nA spreader expects volatility to decline and is willing to set up a position where\nby he will profit by $250 for each one percentage decrease in volatility. Moreover, he \nwants to be gamma and delta neutral. He knows that he can eventually neutralize any \ndelta by using XYZ common stock, as in the previous example. How many options \nshould be spread to achieve the desired result? \n884 Part VI: Measuring and Trading VolatiHty \nTo answer the question, one must create two equations in two unknowns, x and \ny. The unknowns represent the quantities of options to be bought and sold, respec\ntively. The constants in the equations are taken from the table above. \nThe first equation represents gamma neutral: \n0.045 X + 0.026 y = 0, \nwhere \nxis the number of April 50's in the spread and y is the number of April 60's. Note \nthat the constants in the equation are the gammas of the two calls involved. \nThe second equation represents the desired vega risk of making 2.5 points, or $250, \nif the volatility decreases: \n0.08 X + 0.06 y = - 2.5, \nwhere \nx and y are the same quantities as in the first equation, and the constants in this equa\ntion are the gammas of the options. Furthermore, note that the vega risk is negative, \nsince the spreader wants to profit if volatility decreases. \nSolving the two equations in two unknowns by algebraic methods yields the fol\nlowing results: \nEquations: \n0.045 X + 0.026 y = 0 \n0.08 X + 0.06 Y = - 2.5 \nSolutions: \nX = 104.80 \ny = -181.45 \nThis means that one would buy 105 April 50 calls, since x being positive means that \nthe options would be bought. He would also sell 181 April 60 calls (y is negative, \nwhich implies that the calls would be sold). This is nearly the same ratio determined \nin the previous example. The quantities are slightly higher, since the vega here is \n-$250 instead of the -$238 achieved in the previous example. \nFinally, one would again determine the amount of stock to buy or sell to neu\ntralize the delta by computing the position delta: \nPosition delta = 105 x 0.47 - 181 x 0.17 = 18.58 \nThus 1,858 shares of XYZ would be shorted to neutralize the position. \nChapter 40: Advanced Concepts 885 \nNote: All the equations cannot be s", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 391}
{"text": "the vega here is \n-$250 instead of the -$238 achieved in the previous example. \nFinally, one would again determine the amount of stock to buy or sell to neu\ntralize the delta by computing the position delta: \nPosition delta = 105 x 0.47 - 181 x 0.17 = 18.58 \nThus 1,858 shares of XYZ would be shorted to neutralize the position. \nChapter 40: Advanced Concepts 885 \nNote: All the equations cannot be set equal to zero, or the solution will be all \nzeros. This is easily handled by setting at least one equation equal to a small, nonzero \nquantity, such as 0.1. As long as at least one of the risk factors is nonzero, one can \ndetermine the neutral ratio for all other factors merely by solving these simultaneous \nequations. There are plenty of low-cost computer programs that can solve simultane\nous equations such as these. \nThis concept can be carried to greater lengths in order to determine the best \nspread to create in order to achieve the desired results. One might even try to use \nthree different options, using the third option to neutralize delta, so that he wouldn't \nhave to neutralize with stock. The third equation would use deltas as constants and \nwould be set to equal zero, representing delta neutral. Solving this would require \nsolving three equations in three unknowns, a simple matter for a computer. \nAs long as at least one of the risk factors is nonzero, one can determine the neu\ntral ratio for all other factors merely by solving these simultaneous equations. Even \nmore importantly, the computer can scan many combinations of options that produce \na position that is both gamma and delta neutral and has a specific position vega \n(-$238, for example). One would then choose the \"best\" spread of the available pos\nsibilities by logical methods including, if possible, choosing one with positive theta, \nso time is working in his favor. \nTo summarize, one can neutralize all variables, or he can specify the risk that he \nwants to accept in any of them. Merely write the equations and solve them. It is best \nto use a computer to do this, but the fact that it can be done adds an entirely new, \nbroad dimension to option spreading and risk-reducing strategies. \nEVALUATING A POSITION USING THE RISK MEASURES \nThe previous sections have dealt with establishing a new position and determining its \nneutrality or lack thereof. However, the most important use of these risk measures is \nto predict how a position will perform into the future. At a minimum, a serious strate\ngist should use a computer to print out a projection of the profits and losses and posi\ntion risk at future expected prices. Moreover, this type of analysis should be done for \nseveral future times in order to give the strategist an idea of how the passage of time \nand the resultant larger movements by the underlying security would affect the posi\ntion. \nFirst, one would choose an appropriate time period - say, 7 days hence - for the \nfirst analysis. Then he should use the statistical projection of stock prices (see Chapter \n28 on mathematical applications) to determine probable prices for the underlying \nsecurity at that time. Obviously, this stock price projection needs to use volatility, and \n886 Part VI: Measuring and Trading Volatility \nthat is somewhat variable. But, for the purposes of such a projection, it is acceptable \nto use the current volatility. The results of as many as 9 stock prices might be dis\nplayed: every one-half standard deviation from -2 through + 2 (-2.0, -1.5, -1.0, \n-0.5, 0, 0.5, 1.0, 1.5, 2.0). \nExample: XYZ is at 60 and has a volatility of 35%. A distribution of stock prices 7 \ndays into the future would be determined using the equation: \nFuture Price = Current Price x eav-ft \nwhere \na corresponds to the constants in the following table: (-2.0 ... 2.0): \n# Standard Deviations \n-2.0 \n- 1.5 \n- 1.0 \n-0.5 \n0 \n0.5 \n1.0 \n1.5 \n2.0 \nProjected Stack Price \n54.46 \n55.79 \n57.16 \n58.56 \n60.00 \n61.47 \n62.98 \n64.52 \n66.11 \nAgain, refer to Chapter 28 on mathematical applications for a more in-depth \ndiscussion of this price determination equation. \nNote that the formula used to project prices has time as one of its components. \nThis means that as we look further out in time, the range of possible stock prices will \nexpand - a necessary and logical component of this analysis. For example, if the \nprices were being determined 14 days into the future, the range of prices would be \nfrom 52.31 to 68.82. That is, XYZ has the same probability of being at 54.46 in 7 days \nthat it has of being at 52.31 in 14 days. At expiration, some 90 days hence, the range \nwould be quite a bit wider still. Do not make the mistake of trying to evaluate the \nposition at the same prices for each time period (7 days, 14 days, 1 rnonth, expiration, \netc.). Such an analysis would be wrong. \nOnce the appropriate stock prices have been determined, the following quanti\nties would be calculated for each stock price: profit or loss, position delta, position \ngamma, position theta, and position vega. (Position rho is generally a less important \nrisk measure for stock and futures short-term options.) Armed with this information, \nthe strategist can be prepared to face the future. An important item to note: A model \nChapter 40: Advanced Concepts 887 \nwill necessarily be used to make these projections. As was shown earlier, if there is a \ndistortion in the current implied volatilities of the options involved in the position, \nthe strategist should use the current implieds as input to the model for future option \nprice projections. If he does not, the position may look overly attractive if expensive \noptions are being sold or cheap ones are being bought. A truer profit picture is \nobtained by propagating the current implied volatility structure into the near future. \nUsing an example similar to the previous one a ratio spread using short stock \nto make it delta neutral - the concepts will be described. \nInitial Position. XYZ is at 60. The January 70 calls, which h", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 392}
{"text": "erly attractive if expensive \noptions are being sold or cheap ones are being bought. A truer profit picture is \nobtained by propagating the current implied volatility structure into the near future. \nUsing an example similar to the previous one a ratio spread using short stock \nto make it delta neutral - the concepts will be described. \nInitial Position. XYZ is at 60. The January 70 calls, which have three months \nuntil expiration, are expensive with respect to the January 60 calls. A strategist \nexpects this discrepancy to disappear when the implied volatility of XYZ options \ndecreases. He therefore established the following position, which is both gamma \nand delta neutral. \nPosition Delta Gamma \nLong 100 January 60 calls 0.57 0.0723 \nShort 240 January 70 calls 0.20 0.0298 \nShort 800 XYZ \nThe risk measures for the entire position are: \nPosition delta: -38 shares (virtually delta neutral) \nPosition gamma: + 7 shares (gamma neutral) \nPosition theta: + $263 \nPosition vega: -$827 \nTheta Vega \n-0.020 0.109 \n-0.019 0.080 \nThus, the position is both gamma and delta neutral. Moreover, it has the attrac\ntive feature of making $263 per day because of the positive theta. Finally, as was the \nintention of the spreader, it will make money if the volatility of XYZ declines: $827 \nfor each percentage point decrease in implied volatility. Two equations in two \nunknowns (gamma and vega) were solved to obtain the quantities to buy and sell. The \nresulting position delta was neutralized by selling 800 XYZ. \nThe following analyses will assume that the relative expensiveness of the April \n70 calls persists. These are the calls that were sold in the position. If that overpricing \nshould disappear, the spread would look more favorable, but there is no guarantee \nthat they will cheapen - especially over a short time period such as one or two weeks. \nHow would the position look in 7 days at the stock prices determined above? \n888 Part VI: Measuring and Trading Vo/atillty \nStock \nPrice P&L Delta Gamma Theta Vega \n54.46 1905 - 7.40 1.62 0.94 - 1.57 \n55.79 1077 - 4.90 2.07 1.18 - 1.96 \n57.16 606 1.97 2.13 1.53 - 2.90 \n58.56 528 0.74 1.65 2.00 -4.62 \n60.00 771 2.38 0.56 2.63 -7.22 \n61.47 1127 2.07 - 1.01 3.38 -10.63 \n62.98 1252 - 0.87 - 2.85 4.22 -14.56 \n64.52 702 - 6.73 - 4.67 5.07 -18.61 \n66.11 - 1019 -15.42 - 6.21 5.85 -22.31 \nIn a similar manner, the position would have the following characteristics after \n14 days had passed: \nStock \nPrice P&L Delto Gamma Theta Vega \n52.31 4221 - 9.10 0.69 0.55 - 0.98 \n54.14 2731 - 6.93 1.69 0.75 - 0.89 \n56.02 1782 - 2.87 2.51 1.06 - 1.21 \n57.98 1717 2.17 2.44 1.61 - 2.69 \n60.00 2577 5.85 1.00 2.51 -6.00 \n62.09 3839 5.29 - 1.63 3.73 -11.05 \n64.26 4361 - 1.55 - 4.61 5.09 -16.90 \n66.50 2631 -14.80 - 7.02 6.31 -22.17 \n68.82 - 2799 -32.83 - 8.32 7.18 -25.72 \nThe same information will be presented graphically in Figure 40-13 so that \nthose who prefer pictures instead of columns of numbers can follow the discussions \neasily. \nFirst, the profitability of the spread can be examined. This profit picture \nassumes that the volatility of XYZ remains unchanged. Note that in 7 days, there is a \nsmall profit if the stock remains unchanged. This is to be expected, since theta was \npositive, and therefore time is working in favor of this spread. Likewise, in 14 days, \nthere is an even bigger profit if XYZ remains relatively unchanged - again due to the \npositive theta. Overall, there is an expected profit of $800 in 7 days, or $2,600 in 14 \ndays, from this position. This indicates that it is an attractive situation statistically, but, \nof course, it does not mean that one cannot lose money. \nChapter 40: Advanced Concepts 889 \nContinuing to look at the profit picture, the downside is favorable to the spread \nsince the short stock in the position would contribute to ever larger profits in the case \nthat XYZ tumbles dramatically (see Figure 40-12). The upside is where problems \ncould develop. In 7 days, the position breaks even at about 65 on the upside; in 14 \ndays, it breaks even at about 67.50. \nThe reader may be asking, \"Why is there such a dramatic risk to the upside? I \nthought the position was delta neutral and gamma neutral.\" True, the position was \noriginally neutral with respect to both those variables. That neutrality explains the \nflatness of the profit curves about the current stock price of 60. However, once the \nstock has moved 1.50 standard deviations to the upside, the neutrality begins to dis\nappear. To see this, let us look at Figures 40-13 and 40-14 that show both the posi\ntion delta and position gamma 7 days and 14 days after the spread was established. \nAgain, these are the same numbers listed in the previous tables. \nFirst, look at the position delta in 7 days (Figure 40-13). Note that the position \nremains relatively delta neutral with XYZ between 57 and 63. This is because the \ngamma was initially neutral. However, the position begins to get quite delta short if \nXYZ rises above 63 or falls below 57 in 7 days. What is happening to gamma while \nthis is going on? Since we just observed that the delta eventually changes, that has to \nmean that the position is acquiring some gamma. \nFIGURE 40-12. \nXYZ ratio spread, gamma and delta neutral. \n4300 \n3400 \n2500 \n1600 \n~ 700 a.. \n0 \n-200 53 55 57 59 61 63 \n.-1100 \n-2000 \nStock Price \n890 \nFIGURE 40-13. \nXYZ ratio spread, position delta. \n-300 \n-800 \nfu -1300 w \n-1800 \n-2300 \n-2800 \nFIGURE 40-14. \nStock Price \nXYZ ratio spread, position gamma. \n100 \nPart VI: Measuring and Trading Volatility \n67 \n0t----....----....----,---.---'\"\"\"\".,------,----,---r--\n-100 \n«l \nE E -300 \n«l \n0 \n-500 \n-700 \n63 65 67 \nStock Price \nChapter 40: Advanced Concepts 891 \nFigure 40-14 depicts the fact that gamma is not very stable, considering that it \nstarted at nearly zero. If XYZ falls, gamma increases a little, reflecting the fact that \nthe position will get somewhat shorter as XYZ falls. But since there are only calls cou\npled with short stock in this po", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 393}
{"text": "---,---r--\n-100 \n«l \nE E -300 \n«l \n0 \n-500 \n-700 \n63 65 67 \nStock Price \nChapter 40: Advanced Concepts 891 \nFigure 40-14 depicts the fact that gamma is not very stable, considering that it \nstarted at nearly zero. If XYZ falls, gamma increases a little, reflecting the fact that \nthe position will get somewhat shorter as XYZ falls. But since there are only calls cou\npled with short stock in this position, there is no risk to the downside. Positive \ngamma, even a small positive gamma like this one, is beneficial to stock movement. \nThe upside is another matter entirely. The gamma begins to become seriously \nnegative above a stock price of 63 in 7 days. Recall that negative gamma means that \none's position is about to react poorly to price changes in the market - the position \nwill soon be \"fighting the market.\" As the stock goes even higher, the gamma \nbecomes even more negative. These observations apply to stock price movements in \neither 7 days or 14 days; in fact, the effect on gamma does not seem to be particu\nlarly dependent on time in this example, since the two lines on Figure 40-15 are very \nclose to each other. \nThe above information depicts in detailed form the fact that this position will \nnot behave well if the stock rises too far in too short a time. However, stable stock \nprices will produce profits, as will falling prices. These are not earth-shattering con\nclusions since, by simple observation, one can see that there are extra short calls plus \nsome short stock in the position. However, the point of calculating this information \nin advance is to be able to anticipate where to make adjustments and how much to \nadjust. \nFollow-Up Action. How should the strategist use this information? A sim\nplistic approach is to adjust the delta as it becomes non-neutral. This won't do \nanything for gamma, however, and may therefore not necessarily be the best \napproach. If one were to adjust only the delta, he would do it in the following \nmanner: The chart of delta (Figure 40-13) shows that the position will be \napproximately delta short 800 shares if XYZ rises to 64.50 in a week. One sim\nple plan would be to cover the 800 shares of XYZ that are short if the stock rises \nto 64.50. Covering the 800 shares would return the position to delta neutral at \nthat time. Note that if the stock rises at a slower pace, the point at which the \nstrategist would cover the 800 shares moves higher. For example, the delta in 14 \ndays (again in Figure 40-13) shows that XYZ would have to be at about 65.50 for \nthe position to be delta short 800 shares. Hence, if it took two weeks for XYZ to \nbegin rising, one could wait until 65.50 before covering the 800 shares and \nreturning the position to delta neutral. \nIn either case, the purchase of the 800 shares does not take care of the negative \ngamma that is creeping into the position as the stock rises. The only way to counter \nnegative gamma is to buy options, not stock. To return a position to neutrality with \n892 Part VI: Measuring and Trading Volatility \nrespect to more than one risk variable requires one to approach the problem as he \ndid when the position was established: Neutralize the gamma first, and then use stock \nto adjust the delta. Note the difference between this approach and the one described \nin the previous paragraph. Here, we are trying to adjust gamma first, and will get to \ndelta later. \nIn order to add some positive gamma, one might want to buy back (cover) some \nof the January 70 calls that are currently short. Suppose that the decision is made to \ncover when XYZ reaches 65.50 in 14 days. From the graph above, one can see that \nthe position would be approximately gamma short 700 shares at the time. Suppose \nthat the gamma of the January 70 calls is 0.07. Then, one would have to cover 100 \nJanuary 70 calls to add 700 shares of positive gamma to the position, returning it to \ngamma neutral. This purchase would, of course, make the position delta long, so \nsome stock would have to be sold short as well in order to make the position delta \nneutral once again. \nThus, the procedure for follow-up action is somewhat similar to that for estab\nlishing the position: First, neutralize the gamma and then eliminate the resulting \ndelta by using the common stock. The resulting profit graph will not be shown for \nthis follow-up adjustment, since the process could go on and on. However, a few \nobservations are pertinent. First, the purchase of calls to reduce the negative gamma \nhurts the original thesis of the position - to have negative vega and positive theta, if \npossible. Buying calls will add vega to and subtract theta from the position, which is \nnot desirable. However, it is more desirable than letting losses build up in the posi\ntion as the stock continues to run to the upside. Second, one might choose to rerrwve \nthe position if it is profitable. This might happen if the volatility did decrease as \nexpected. Then, when the stock rallies, producing negative gamma, one might actu\nally have a profit, because his assumption concerning volatility had been right. If he \ndoes not see much further potential gains from decreasing volatility, he might use the \npoint at which negative gamma starts to build up as the exit point from his position. \nThird, one might choose to accept the acquired gamma risk. Rather than jeopardize \nhis initial thesis, one may just want to adjust the delta and let the gamma build up. \nThis is no longer a neutral strategy, but one may have reasons for approaching the \nposition this way. At least he has calculated the risk and is aware of it. If he chooses \nto accept it rather than eliminate it, that is his decision. \nFinally, it is obvious that the process is dynamic. As factors change (stock price, \nvolatility, time), the position itself changes and the strategist is presented with new \nchoices. There is no absolutely correct adjustment. The process is more of an art than \na science at times. Moreover, the strategist should conti", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 394}
{"text": "it. If he chooses \nto accept it rather than eliminate it, that is his decision. \nFinally, it is obvious that the process is dynamic. As factors change (stock price, \nvolatility, time), the position itself changes and the strategist is presented with new \nchoices. There is no absolutely correct adjustment. The process is more of an art than \na science at times. Moreover, the strategist should continue to recalculate these prof\nit pictures and risk measures as the stock moves and time passes, or if there is a \nChapter 40: Advanced Concepts 893 \nchange in the securities involved in the position. There is one absolute truism and \nthat is that the serious strategist should be aware of the risk his position has with \nrespect to at least the four basic measures of delta, gamma, theta, and vega. To be \nignorant of the risk is to be delinquent in the management of the position. \nTRADING GAMMA FROM THE LONG SIDE \nThe strategist who is selling overpriced options and hedging that purchase with other \noptions or stock will often have a position similar to the one described earlier. Large \nstock movements - at least in one direction will typically be a problem for such \npositions. The opposite of this strategy would be to have a position that is long \ngamma. That is, the position does better if the stock moves quickly in one direction. \nWhile this seems pleasing to the psyche, these types of positions have their own \nbrand of risk. \nThe simplest position with long gamma is a long straddle, or a backspread \n(reverse ratio spread). Another way to construct a position with long gamma is to \ninvert a calendar spread - to buy the near-term option and to sell a longer-term one. \nSince a near-term option has a higher gamma than a longer-term one with the same \nstrike, such a position has long gamma. In fact, traders who expect violent action in \na stock often construct such a position for the very reason that the public will come \nin behind them, bid up the short-term calls (increasing their implied volatility), and \nmake the spread more profitable for the trader. \nUnfortunately, all of these positions often involve being long just about every\nthing else, including theta and vega as well. This means that time is working against \nthe position, and that swings in implied volatility can be helpful or harmful as well. \nCan one construct a position that is long gamma, but is not so subject to the other \nvariables? Of course he can, but what would it look like? The answer, as one might \nsuspect, is not an ironclad one. \nFor the following examples, assume these prices exist: \nXYZ: 60 \nOption \nMarch 60 call \nJune 60 call \nPrice \n3.25 \n5.50 \nDelta \n0.54 \n0.57 \nGamma \n0.0510 \n0.0306 \nTheta \n0.033 \n0.021 \nVega \n0.089 \n0.147 \nExample: Suppose that a strategist wants to create a position that is gamma long, but \nis neutral with respect to both delta and vega. He thinks the stock will move, but is \nnot sure of the price direction, and does not want to have any risk with respect to \n894 Part VI: Measuring and Trading Volatility \nquick changes in volatility. In order to quantify the statement that he \"wants to be \ngamma long,\" let us assume that he wants to be gamma long 1,000 shares or 10 con\ntracts. \nIt is known that delta can always be neutralized last, so let us concentrate on the \nother two variables first. The two equations below are used to determine the quanti\nties to buy in order to make gamma long and vega neutral: \n0.0510x + 0.0306y = 10 (gamma, expressed in# of contracts) \n0.089x + 0.147y = 0 (vega) \nThe solution to these equations is: \nX = 308, y = -186 \nThus, one would buy 308 March 60 calls and would sell 186 June 60 calls. This is the \nreverse calendar spread that was discussed: Near-term calls are bought and longer\nterm calls are sold. \nFinally, the delta must be neutralized. To do this, calculate the position delta \nusing the quantities just determined: \nPosition delta= 0.54 x 308 - 0.57 x 186 = 60.30 \nSo, the position is long 60 contracts, or 6,000 shares. It can be made delta neutral by \nselling short 6,000 shares of XYZ. \nThe overall position would look like this: \nPosition \nShort 6,000 XYZ \nLong 308 March 60 calls \nShort 186 June 60 calls \nIts risk measurements are: \nDelta \n1.00 \n0.54 \n0.57 \nPosition delta: long 30 shares (neutral) \nPosition vega: $7 (neutral) \nPosition gamma: long 1,001 shares \nGamma \n0 \n0.0510 \n0.0306 \nVega \n0 \n0.089 \n0.147 \nThis position then satisfies the initial objectives of wanting to be gamma long \n1,000 shares, but delta and vega neutral. \nFinally, note that theta = -$625. The position will lose $625 per day from time \ndecay. \nThe strategist must go further than this analysis, especially if one is dealing with \npositions that are not simple constructions. He should calculate a profit picture as \nChapter 40: Advanced Concepts 895 \nwell as look at how the risk measures behave as time passes and the stock price \nchanges. \nFigure 40-15 (see Tables 40-10, 40-11, and 40-12) shows the profit potential in \n7 days, in 14 days, and at March expiration. Figure 40-16 shows the position vega at \nthe 7- and 14-day time intervals. Before discussing these items, the data will be pre\nsented in tabular form at three different times: in 7 days, in 14 days, and at March \nexpiration. \nThe data in Table 40-10 depict the position in 7 days. \nTable 40-11 represents the results in 14 days. \nFinally, the position as it looks at March expiration should be known as well (see \nTable 40-12). \nIn each case, note that the stock prices are calculated in accordance with the \nstatistical formula shown in the last section. The more time that passes, the further it \nis possible for the stock to roam from the current price. \nThe profit picture (Figure 40-15) shows that this position looks much like a long \nstraddle would: It makes large, symmetric profits if the stock goes either way up or \nway down. Moreover, the losses if the stock remains relatively unchanged can be \nlarge. These losses tend to mount right away", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 395}
{"text": "on. The more time that passes, the further it \nis possible for the stock to roam from the current price. \nThe profit picture (Figure 40-15) shows that this position looks much like a long \nstraddle would: It makes large, symmetric profits if the stock goes either way up or \nway down. Moreover, the losses if the stock remains relatively unchanged can be \nlarge. These losses tend to mount right away, becoming significant even in 14 days. \nHence, if one enters this type of position, he had better get the desired stock move\nment quickly, or be prepared to cut his losses and exit the position. \nThe most startling thing to note about the entire position is the devastating effect \nof time on the position. The profit picture shows that large losses will result if the stock \nmovement that is expected does not materialize. These losses are completely due to \ntime decay. Theta is negative in the initial position ($625 of losses per day), and \nremains negative and surprisingly constant - until March expiration ( when the long \ncalls expire). Time also affects vega. Notice how the vega begins to get negative right \naway and keeps getting much more negative as time passes. Simply, it can be seen that \nas time passes, the position becomes vulnerable to increases in implied volatility. \nThis relationship between time and volatility might not be readily apparent to \nthe strategist unless he takes the time to calculate these sorts of tables or figures. In \nfact, one may be somewhat confounded by this observation. What is happening is \nthat as time passes, the options that are owned are less explosive if volatility increas\nes, but the options that were sold have a lot of time remaining, and are therefore apt \nto increase violently if volatility spurts upward. \nFigures 40-17 and 40-18 provide less enlightening information about delta and \ngamma. Since gamma was positive to start with, the delta increases dramatically as \nthe stock rises, and decreases just as fast if the stock falls (Figure 40-18). This is stan\ndard behavior for positions with long gamma; a long straddle would look very similar. \n896 \nFIGURE 40-15. \nTrading long gamma, profit picture. \n80,000 \n60,000 \n40,000 \n20,000 \n-20,000 \n-40,000 \n-60,000 \nTABLE 40-1 O. \nStock Price \nPart VI: Measuring and Trading Volatility \nRisk measures of long gamma position in 7 days. \nStock \nPrice P&L Delta Gamma Theta Vega \n54.46 12259 - 58.72 8.28 4.15 - 5.74 \n55.79 5202 - 46.60 9.78 5.20 - 4.18 \n57.16 - 224 - 32.45 10.80 6.09 - 2.85 \n58.56 - 3670 - 16.91 11.25 6.73 - 1.94 \n60.00 - 4975 - 0.80 11.08 7.04 - l .63 \n61.47 - 3901 15.01 10.32 6.98 - 1.96 \n62.98 - 507 29.69 9.09 6.57 - 2.89 \n64.52 5105 42.56 7.54 5.87 -4.29 \n66. l l 12717 53. l 7 5.86 4.97 - 5.96 \nNotice that gamma remains positive throughout (Figure 40-17), although it falls to \nsmaller levels if the stock moves toward the end of the pricing ranges used in the \nanalyses. Again, this is standard action for a long straddle. \nChapter 40: Advanced Concepts \nFIGURE 40-16. \nTrading long gamma, position vega. \n55 60 \n0 \n-2 \n-4 \nal \n0) \n~ \n-6 \n-8 \n-10 \nStock Price \nTABLE 40-11. \n65 \nRisk measures of long gamma position in 14 days. \nStock \nPrice P&L Delta Gamma \n52.31 24945 - 79.34 4.75 \n54.14 11445 - 67.68 8.00 \n56.02 277 -49.79 10.79 \n57.98 - 7263 -26.87 12.42 \n60.00 - 10141 - 1.44 12.47 \n62.09 - 7784 23.32 10.99 \n64.26 347 44.47 8.45 \n66.50 11491 60.12 5.55 \n68.82 26672 69.81 2.92 \n891 \nTheta Vega \n2.10 - 9.91 \n3.91 - 7.87 \n5.76 - 5.56 \n7.21 - 3.73 \n7.88 - 3.04 \n7.60 - 3.78 \n6.47 - 5.71 \n4.82 - 8.20 \n3.09 -10.48 \nSo, is this a good position? That is a difficult question to answer unless one \nknows what is going to happen to the underlying stock. Statistically, this type of posi\ntion has a negative expected return and would generally produce losses over the long \nrun. However, in situations in which the near-term options are destined to get over\nheated - perhaps because of a takeover rumor or just a leak of material information \n898 Part VI: Measuring and Trading Volatility \nTABLE 40-12. \nRisk measures of long gamma position at March expiration. \nStock \nPrice P&L Delta \n46.19 81327 - 75.69 \n49.31 55628 - 89.84 \n52.64 22378 -110.50 \n56.20 - 21523 -136.65 \n60.00 78907 144.68 \n64.06 - 25946 117.44 \n68.39 19787 95.03 \n73.01 59732 79.05 \n77.95 96062 69.19 \nFIGURE 40-17. \nTrading long gamma, position gamma. \n(J) \n(I) \n1200 \n1000 \n800 \n~ 600 .c \n(/) \n400 \n200 \n55 60 \nStock Price \nGamma Theta Vega \n- 3.65 -1.32 - 6.88 \n- 5.39 -2.25 -11.43 \n- 6.89 -3.33 -16.50 \n- 7.62 -4.28 -20.67 \n- 7.29 -4.79 -22.49 \n- 6.03 -4.70 -21.26 \n- 4.31 -4.10 -17.44 \n- 2.67 -3.24 -12.43 \n- 1.43 -2.41 - 7.69 \n65 \nabout a company - many sophisticated traders establish this type of position to take \nadvantage of the expected explosion in stock price. \nOther Variations. Without going into as much detail, it is possible to com\npare the above position with similar ones. The purpose in doing so is to illustrate \nhow a change in the strategist's initial requirements would alter the established \nChapter 40: Advanced Concepts \nFIGURE 40-1 8. \nTrading long gamma, position delta. \n6000 \n4000 \n2000 \n\"' ~ 01---------,-----~rr------,,-----\n.s::. \n(J) \n-2000 \n-4000 \n-8000 \n-8000 \n55 65 \nStock Price \n899 \nposition. In the preceding position, the strategist wanted to be gamma long, but \nneutral with respect to delta and volatility. Suppose he not only expects price \nmovement (meaning he wants positive gamma), but also expects an increase in \nvolatility. If that were the case, he would want positive vega as well. Suppose he \nquantifies that desire by deciding that he wants to make $1,000 for every one \npercentage increase in volatility. The simultaneous equations would then be: \n0.050lx + 0.0306y = 10 (gamma) \n0.089x + 0.147y = 10 (vega) \nThe solution to these equations is: \nX = 243, y = -80 \nFurthermore, 8,500 shares would have to be sold short in order to make the position \ndelta neutral. The resulting position would then be: \nShort 8,500 XYZ \nLong 243 Mar", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 396}
{"text": "e wants to make $1,000 for every one \npercentage increase in volatility. The simultaneous equations would then be: \n0.050lx + 0.0306y = 10 (gamma) \n0.089x + 0.147y = 10 (vega) \nThe solution to these equations is: \nX = 243, y = -80 \nFurthermore, 8,500 shares would have to be sold short in order to make the position \ndelta neutral. The resulting position would then be: \nShort 8,500 XYZ \nLong 243 March 60 calls \nShort 80 June 60 calls \nDelta: neutral \nGamma: long 1,000 shares \nVega: long $1,000 \nTheta: long $630 \n900 Part VI: Measuring and Trading VolatiHty \nRecall that the position discussed in the last section was vega neutral and was: \nShort 6,000 XYZ \nLong 308 March 60 calls \nShort 186 June 60 calls \nDelta: neutral \nGamma: long 1,000 shares \nVega: neutral \nTheta: long $625 \nNotice that in the new position, there are over three times as many long March \n60 calls as there are short June 60 calls. This is a much larger ratio than in the vega \nneutral position, in which about 1.6 calls were bought for each one sold. This even \ngreater preponderance of near-term calls that are purchased means the newer posi\ntion has an even larger exposure to time decay than did the previous one. That is, in \norder to acquire the positive vega, one is forced to take on even more risk with \nrespect to time decay. For that reason, this is a less desirable position than the first \none; it seems overly risky to want to be both long gamma and long volatility. \nThis does not necessarily mean that one would never want to be long volatility. \nIn fact, if one expected volatility to increase, he might want to establish a position that \nwas delta neutral and gamma neutral, but had positive vega. Again, using the same \nprices as in the previous examples, the following position would satisfy these criteria: \nShort 2,600 XYZ \nShort 64 March 60 calls \nLong 106 June 60 calls \nDelta: neutral \nGamma: neutral \nVega: long $1,000 \nTheta: long $11 \nThis position has a more conventional form. It is a calendar spread, except that \nmore long calls are purchased. Moreover, the theta of this position is only $11- it will \nonly lose $11 per day to time decay. At first glance it might seem like the best of the \nthree choices. Unfortunately, when one draws the profit graph (Figure 40-19), he \nfinds that this position has significant downside risk: The short stock cannot com\npensate for the large quantity of June 60 calls. Still, the position does make money on \nthe upside, and will also make money if volatility increases. If the near-term March \ncalls were overpriced with respect to the June calls at the time the position was estab\nlished, it would make it even more desirable. \nTo summarize, defining the risks one wants to take or avoid specifies the con\nstruction of the eventual position. The strategist should examine the potential risks \nand rewards, especially the profit picture. If the potential risks are not desirable, the \nstrategist should rethink his requirements and try again. Thus, in the example pre\nsented, the strategist felt that he initially wanted to be long gamma, but it involved too \nChapter 40: Advanced Concepts \nFIGURE 40-19. \nTrading long gamma, 11 conventional\" calendar. \n7500 \n5000 \n2500 \nfJ) \nfJ) \n.3 :;:, 0 '§ 45 50 Q. \n-2500 \n-5000 At March Expiration \n-7500 \nStock Price \n901 \n75 \nmuch risk of time decay. A second attempt was made, introducing positive volatility \ninto the situation, but that didn't seem to help much. Finally, a third analysis was gen\nerated involving only long volatility and not long gamma. The resulting position has lit\ntle time risk, but has risk if the stock drops in price. It is probably the best of the three. \nThe strategist arrives at this conclusion through a logical process of analysis. \nADVANCED MATHEMATICAL CONCEPTS \nThe remainder of this chapter is a short adjunct to Chapter 28 on mathematical \napplications. It is quite technical. Those who desire to understand the basic concepts \nbehind the risk measures and perhaps to utilize them in more advanced ways will be \ninterested in what follows. \nCALCULATING THE \"'GREEKS\" \nIt is known that the equation for delta is a direct byproduct of the Black-Scholes \nmodel calculation: \n~ = N(dl) \n902 Part VI: Measuring and Trading Volatility \nEach of the risk measures can be derived mathematically by taking the partial \nderivative of the model. However, there is a shortcut approximation that works just \nas well. For example, the formula for gamma is as follows: \nx=ln[ P ]/v-ft+v-ft \ns X (1 + r)t 2 \nr - e(-x212) \n- pv ✓ 27tt \nThere is a simpler, yet correct, way to arrive at the gamma. The delta is the par\ntial derivative of the Black-Scholes model with respect to stock price - that is, it is \nthe amount by which the option's price changes for a change in stock price. The \ngamma is the change in delta for the same change in stock price. Thus, one can \napproximate the gamma by the following steps: \n1. Calculate the delta with p = Current stock price. \n2. Set p = p + 1 and recalculate the delta. \n3. Gamma = delta from step 1 - delta from step 2. \nThe same procedure can be used for the other \"greeks\": \nVega: 1. Calculate the option price with a particular volatility. \n2. \n3. \nTheta: 1. \n2. \n3. \nRho: 1. \n2. \n3. \nCalculate another option price with volatility increased by 1 %. \nVega = difference of the prices in steps 1 and 2. \nCalculate the option price with the current time to expiration. \nCalculate the option price with 1 day less time remaining to expiration. \nTheta = difference of the prices in steps 1 and 2. \nCalculate the option price with the current risk-free interest rate. \nCalculate the option price with the rate increased by 1 % . \nRho = difference of the prices in steps 1 and 2. \nTHE GAMMA OF THE GAMMA \nThe discussion of this concept was deferred from earlier sections because it is some\nwhat difficult to grasp. It is included now for those who may wish to use it at some \ntime. Those readers who are not interested in such matters may skip to the", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 397}
{"text": "ree interest rate. \nCalculate the option price with the rate increased by 1 % . \nRho = difference of the prices in steps 1 and 2. \nTHE GAMMA OF THE GAMMA \nThe discussion of this concept was deferred from earlier sections because it is some\nwhat difficult to grasp. It is included now for those who may wish to use it at some \ntime. Those readers who are not interested in such matters may skip to the next sec\ntion. \nChapter 40: Advanced Concepts 903 \nRecall that this is the sixth risk measurement of an option position. The gamma \nof the gamma is the anwunt by which the gamma will change when the stock price \nchanges. \nRecall that in the earlier discussion of gamma, it was noted that gamma \nchanges. This example is based on the same example used earlier. \nExample: With XYZ at 49, assume the January 50 call has a delta of 0.50 and a \ngamma of 0.05. If XYZ moves up 1 point to 50, the delta of the call will increase by \nthe amount of the gamma: It will increase from 0.50 to 0.55. Simplistically, if XYZ \nmoves up another point to 51, the delta will increase by another 0.05, to 0.60. \nObviously, the delta cannot keep increasing by 0.05 each time XYZ gains anoth\ner point in price, for it will eventually exceed 1.00 by that calculation, and it is known \nthat the delta has a maximum of 1.00. Thus, it is obvious that the gamma changes. \nIn reality, the gamma decreases as the stock moves away from the strike. Thus, \nwith XYZ at 51, the gamma might only be 0.04. Therefore, if XYZ moved up to 52, \nthe call's delta would only increase by 0.04, to 0.64. Hence, the gamma of the gamma \nis -0.01, since the gamma decreased from .05 to .04 when the stock rose by one \npoint. \nAs XYZ moves higher and higher, the gamma will get smaller and smaller. \nEventually, with XYZ in the low 60's, the delta will be nearly 1.00 and the gamma \nnearly 0.00. \nThis change in the gamma as the stock moves is called the gamma of the \ngamma. It is probably referred to by other names, but since its use is limited to only \nthe most sophisticated traders, there is no standard name. Generally, one would use \nthis measure on his entire portfolio to gauge how quickly the portfolio would be \nresponding to the position gamma. \nExample: With XYZ at 31. 75 as in some of the previous examples, the following risk \nmeasures exist: \nOption Option Option Position \nPosition Delta Gamma Gamma/Gamma Gamma/Gamma \nShort 4,500 XYZ 1.00 0.00 0.0000 0 \nShort 100 XYZ April 25 calls 0.89 0.01 -0.0015 -15 \nLong 50 XYZ April 30 calls 0.76 0.03 -0.0006 - 3 \nLong 139 XYZ July 30 calls 0.74 0.02 -0.0003 - 4 \nTotal Gamma of Gamma: -22 \n904 Part VI: Measuring and Trading Volatility \nRecall that, in the same example used to describe gamma, the position was delta \nlong 686 shares and had a positive gamma of 328 shares. Furthermore, we now see \nthat the gamma itself is going to decrease as the stock moves up ( it is negative) or will \nincrease as the stock moves down. In fact, it is expected to increase or decrease by \n22 shares for each point XYZ moves. \nSo, if XYZ moves up by 1 point, the following should happen: \na. Delta increases from 686 to 1,014, increasing by the amount of the gamma. \nb. Gamma decreases from 328 to 306, indicating that a further upward move by \nXYZ will result in a smaller increase in delta. \nOne can build a general picture of how the gamma of the gamma changes over \ndifferent situations - in- or out-of-the-money, or with more or less time remaining \nuntil expiration. The following table of two index calls, the January 350 with one \nmonth of life remaining and the December 350 with eleven months of life remain\ning, shows the delta, gamma, and gamma of the gamma for various stock prices. \nIndex January 350 call December 350 call \nPrice Delta Gamma Gamma/Gamma Delta Gamma Gamma/Gamma \n310 .0006 .0001 .0000 .3203 .0083 .0000 \n320 .0087 .0020 .0004 .3971 .0082 .0000 \n330 .0618 .0100 .0013 .4787 .0080 -.0000 \n340 .2333 .0744 .0013 .5626 .0078 -.0001 \n350 .5241 .0309 -.0003 .6360 .0073 -.0001 \n360 .7957 .0215 -.0014 .6984 .0067 -.0001 \n370 .9420 .0086 -.0010 .7653 .0060 -.0001 \n380 .9892 .0021 -.0003 .8213 .0052 -.0001 \nSeveral conclusions can be drawn, not all of which are obvious at first glance. \nFirst of all, the gamma of the gamma for long-term options is very small. This should \nbe expected, since the delta of a long-term option changes very slowly. The next fact \ncan best be observed while looking at the shorter-term January 350 table. The \ngamma of the gamma is near zero for deeply out-of-the-money options. But, as the \noption comes closer to being in-the-money, the gamma of the gamma becomes a pos\nitive number, reaching its maximum while the option is still out-of-the-money. By the \ntime the option is at-the-money, the gamma of the gamma has turned negative. It \nthen remains negative, reaching its most negative point when slightly in-the-money. \nFrom there on, as the option goes even deeper into-the-money, the gamma of the \ngamma remains negative but gets closer and closer to zero, eventually reaching \n(minus) zero when the option is very far in-the-money. \nChapter 40: Advanced Concepts 905 \nCan one possibly reason this risk measurement out without making severe \nmathematical calculations? Well, possibly. Note that the delta of an option starts as a \nsmall number when the option is out-of-the-money. It then increases, slowly at first, \nthen more quickly, until it is just below 0.60 for an at-the-money option. From there \non, it will continue to increase, but much more slowly as the option becomes in-the\nmoney. This movement of the delta can be observed by looking at gamma: It is the \nchange in the delta, so it starts slowly, increases as the stock nears the strike, and then \nbegins to decrease as the option is in-the-money, always remaining a positive num\nber, since delta can only change in the positive direction as the stock rises. Finally, \nthe gamma of the gamma is the change in the gamma, so it in tum starts as a positive \nnumber as ga", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 398}
{"text": "erved by looking at gamma: It is the \nchange in the delta, so it starts slowly, increases as the stock nears the strike, and then \nbegins to decrease as the option is in-the-money, always remaining a positive num\nber, since delta can only change in the positive direction as the stock rises. Finally, \nthe gamma of the gamma is the change in the gamma, so it in tum starts as a positive \nnumber as gamma grows larger; but then when gamma starts tapering off, this is \nreflected as a negative gamma of the gamma. \nIn general, the gamma of the gamma is used by sophisticated traders on large \noption positions where it is not obvious what is going to happen to the gamma as the \nstock changes in price. Traders often have some feel for their delta. They may even \nhave some feel for how that delta is going to change as the stock moves (i.e., they \nhave a feel for gamma). However, sophisticated traders know that even positions that \nstart out with zero delta and zero gamma may eventually acquire some delta. The \ngamma of the gamma tells the trader how much and how soon that eventual delta will \nbe acquired. \nMEASURING THE DIFFERENCE OF IMPLIED VOLATILITIES \nRecall that when the topic of implied volatility was discussed, it was shown that if one \ncould identify situations in which the various options on the same underlying securi\nty had substantially different implied volatilities, then there might be an attractive \nneutral spread available. The strategist might ask how he is to determine if the dis\ncrepancies between the individual options are significantly large to warrant attention. \nFurthermore, is there a quick way (using a computer, of course) to determine this? \nA logical way to approach this is to look at each individual implied volatility and \ncompute the standard deviation of these numbers. This standard deviation can be \nconverted to a percentage by dividing it by the overall implied volatility of the stock. \nThis percentage, if it is large enough, alerts the strategist that there may be opportu\nnities to spread the options of this underlying security against each other. An exam\nple should clarify this procedure. \nExample: XYZ is trading at 50, and the following options exist with the indicated \nimplied volatilities. We can calculate a standard deviation of these implieds, called \nimplied deviation, via the formula: \n906 Part VI: Measuring and Trading Volatility \nImplied deviation = sqrt (sum of differences from mean) 2/(# options - 1) \nXYZ:50 \nImplied \nOption Volatility \nOctober 45 call 21% \nNovember 45 call 21% \nJanuary 45 call 23% \nOctober 50 call 32% \nNovember 50 call 30% \nJanuary 50 call 28% \nOctober 55 call 40% \nNovember 55 call 37% \nJanuary 55 call 34% \nAverage: 30.44% \nSum of ( difference from avg)2 = 389.26 \nImplied deviation = sqrt (sum of diff)2/(# options - 1) \n= sqrt (389.26 I 8) \n= 6.98 \nDifference \nfrom Average \n-9.44 \n-9.44 \n-7.44 \n+ 1.56 \n-0.44 \n-2.44 \n+9.56 \n+6.56 \n+3.56 \nThis figure represents the raw standard deviation of the implied volatilities. To \nconvert it into a useful number for comparisons, one must divide it by the average \nimplied volatility. \nP d . . Implied deviation ercent eV1at10n = A . 1. d verage imp ie \n= 6.98/30.44 \n= 23% \nThis \"percent deviation\" number is usually significant if it is larger than 15%. \nThat is, if the various options have implied volatilities that are different enough from \neach other to produce a result of 15% or greater in the above calculation, then the \nstrategist should take a look at establishing neutral spreads in that security or futures \ncontract. \nThe concept presented here can be refined further by using a weighted average \nof the implieds ( taking into consideration such factors as volume and distance from the \nstriking price) rather than just using the raw average. That task is left to the reader. \nChapter 40: Advanced Concepts 907 \nRecall that a computer can perform a large number of Black-Scholes calcula\ntions in a short period of time. Thus, the computer can calculate each option's \nimplied volatility and then perform the \"percent deviation\" calculation even faster. \nThe strategist who is interested in establishing this type of neutral spread would only \nhave to scan down the list of percent deviations to find candidates for spreading. On \na given day, the list is usually quite short - perhaps 20 stocks and 10 futures contracts \nwill qualify. \nSUMMARY \nIn today's highly competitive and volatile option markets, neutral traders must be \nextremely aware of their risks. That risk is not just risk at expiration, but also the cur\nrent risk in the market. Furthermore, they should have an idea of how the risk will \nincrease or decrease as the underlying stock or futures contract moves up and down \nin price. Moreover, the passage of time or the volatility that the options are being \nassigned in the marketplace - the implied volatility - are important considerations. \nEven changes in short-term interest rates can be of interest, especially iflonger-term \noptions (LEAPS) are involved. \nOnce the strategist understands these concepts, he can use them to select new \npositions, to adjust existing ones, and to formulate specific strategies to take advan\ntage of them. He can select a specific criteria that he wants to exploit - selling high \nvolatility, for example and use the other measures to construct a position that has \nlittle risk with respect to any of the other variables. Furthermore, the market-maker \nor specialist, who does not want to acquire any market risk if he can help it, will use \nthese techniques to attempt to neutralize all of the current risk, if possible. \nTaxes \nIn this chapter, the basic tax treatment of listed options will be outlined and sev\neral tax strategies will be presented. The reader should be aware of the fact that tax \nlaws change, and therefore should consult tax counsel before actually implementing \nany tax-oriented strategy. The interpretation of certain tax strategies by the Internal \nRevenue Servic", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 399}
{"text": "f the current risk, if possible. \nTaxes \nIn this chapter, the basic tax treatment of listed options will be outlined and sev\neral tax strategies will be presented. The reader should be aware of the fact that tax \nlaws change, and therefore should consult tax counsel before actually implementing \nany tax-oriented strategy. The interpretation of certain tax strategies by the Internal \nRevenue Service is subject to reclarification or change, as well. \nAn option is a capital asset and any gains or losses are capital gains or losses. \nDiffering tax consequences apply, depending on whether the option trade is a \ncomplete transaction by itself, or whether it becomes part of a stock transaction via \nexercise or assignment. Listed option transactions that are closed out in the options \nmarket or are allowed to expire worthless are capital transactions. The holding period \nfor option transactions to qualify as long-term is always the same as for stocks ( cur\nrently, it's one year). Gains from option purchases could possibly be long-term gains if \nthe holding period of the option exceeds the long-term capital gains holding period. \nGains from the sale of options are short-term capital gains. In addition, the tax \ntreatment of futures options and index options and other listed nonequity options \nmay differ from that of equity options. We will review these points individually. \nHISTORY \nIn the short life of listed option trading. there have been several major changes in the \ntax rules. When options were first listed in 1973, the tax laws treated the gains and \nlosses from writing options as ordinary income. That is, the thinking was that only \nprofessionals or those people in the business actually wrote over-the-counter options, \nand thus their gains and losses represented their ordinary income, or means of mak\ning a living. This rule presented some interesting strategies involving spreads, \nbecause the long side of the spread could be treated as long-term gain (if held for \n908 \nChapter 41: Taxes 909 \nmore than 6 months, which was the required holding period for a long-term gain at \nthat time), and the short side of the spread could be ordinary loss. Of course, the \nstock would have had to move in the desired direction in order to obtain this result. \nIn 1976, the tax laws changed. The major changes affecting option traders were \nthat the long-term holding period was extended to one year and also that gains or \nlosses from writing options were considered to be capital gains. The extension of the \nlong-term period essentially removed all possibilities of listed option holders ever \nobtaining a long-term gain, because the listed option market's longest-term options \nhad only 9 months of life. \nAll through this period there were a wide array of tax strategies that were avail\nable, legally, to allow investors to defer capital gains from one year to the next, there\nby avoiding payment of taxes. Essentially, one would enter into a spread involving \ndeep in-the-money options that would expire in the next calendar year. Perhaps the \nspread would be established during October, using January options. Then one would \nwait for the underlying stock to move. Once a move had taken place, the spread \nwould have a profit on one side and a loss on the other. The loss would be realized \nby rolling the losing option into another deep in-the-money option. The realized loss \ncould thus be claimed on that year's taxes. The remaining spread - now an unrealized \nprofit - would be left in place until expiration, in the next calendar year. At that time, \nthe spread would be removed and the gain would be realized. Thus, the gain was \nmoved from one year to the next. Then, later in that year, the gain would again be \nrolled to the next calendar year, and so on. \nThese practices were effectively stopped by the new tax ruling issued in 1984. \nTwo sweeping changes were made. First, the new rules stated that, in any spread \nposition involving offsetting options - as the two deep in-the-money options in the \nprevious example - the losses can be taken only to the extent that they exceed the \nunrealized gain on the other side of the spread. (The tax literature insists on calling \nthese positions \"straddles\" after the old commodity term, but for options purposes \nthey are really spreads or covered writes.) As a by-product of this rule, the holding \nperiod of stock can be terminated or eliminated by writing options that are too deeply \nin-the-money. Second, the new rules required that all positions in nonequity options \nand all futures be marked to market at the end of the tax year, and that taxes be paid \non realized and unrealized gains alike. The tax rate for nonequity options was low\nered from that of equity options. Then, in 1986, the long-term and short-term capi\ntal gains rates were made equal to the lowest ordinary rate. All of these points will be \ncovered in detail. \n910 Part VI: Measuring and Trading Volatility \nBASIC TAX TREATMENT \nListed options that are exercised or assigned fall into a different category for tax pur\nposes. The original premium of the option transaction is combined into the stock \ntransaction. There is no tax liability on this stock position until the stock position itself \nis closed out. There are four different combinations of exercising or assigning puts or \ncalls. Table 41-1 summarizes the method of applying the option premium to the stock \ncost or sale price. \nExamples of how to treat these various transactions are given in the following \nsections. In addition to examples explaining the basic tax treatment, some supple\nmentary strategies are included as well. \nCALL BUYER \nIf a call holder subsequently sells the call or allows it to expire worthless, he has a \ncapital gain or loss. For equity options, the holding period of the option determines \nwhether the gain or loss is long-term or short-term. As mentioned previously, a long\nterm gain would be possible if held for more than one year. For tax purpos", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 400}
{"text": "ome supple\nmentary strategies are included as well. \nCALL BUYER \nIf a call holder subsequently sells the call or allows it to expire worthless, he has a \ncapital gain or loss. For equity options, the holding period of the option determines \nwhether the gain or loss is long-term or short-term. As mentioned previously, a long\nterm gain would be possible if held for more than one year. For tax purposes, an \noption that expires worthless is considered to have been sold at zero dollars on the \nexpiration date. \nExample: An investor purchases an XYZ October 50 call for 5 points on July l. He \nsells the call for 9 points on September 1. That is, he realizes a capital gain via a clos\ning transaction. His taxable gain would be computed as shown in Table 41-1, assum\ning that a $25 commission was paid on both the purchase and the sale. \nTABLE 41-1. \nApplying the option premium to the stock cost or sale price. \nAction \nCall buyer exercises \nPut buyer exercises \nCall writer assigned \nPut writer assigned \nNet proceeds of sale ($900 - $25) \nNet cost ($500 + $25) \nShort-term gain: \nTax Treatment \nAdd call premium to stock cost \nSubtract put premium from stock sale price \nAdd call premium to stock sale price \nSubtract put premium from stock cost \n$875 \n-525 \n$350 \nChapter 41: Taxes 911 \nAlternatively, if the stock had fallen in price by October expiration and the October \n50 call had expired worthless, the call buyer would have lost $525 - his entire net \ncost. If he had held the call until it expired worthless, he would have a short-term \ncapital loss of $525 to report among his taxable transactions. \nPUT BUYER \nThe holder of a put has much the same tax consequences as the holder of a call, pro\nvided that he is not also long the underlying stock. This initial discussion of tax con\nsequences to the put holder will assume that he does not simultaneously own the \nunderlying stock. If the put holder sells his put in the option market or allows it to \nexpire worthless, the gain or loss is treated as capital gain, long-term for equity puts \nheld more than one year. Historically, the purchase of a put was viewed as perhaps \nthe only way an investor could attain a long-term gain in a declining market. \nExample: An investor buys an XYZ April 40 put for 2 points with the stock at 43. \nLater, the stock drops in price and the put is sold for 5 points. The commissions were \n$25 on each option trade, so the tax consequences would be: \nNet sale proceeds ($500 - $25) \nNet cost ($200 + $25) \nShort-term capital gain: \n$475 \n-225 \n$250 \nAlternatively, if he had sold the put at a loss, perhaps in a rising market, he would \nhave a short-term capital loss. Furthermore, if he allowed the put to expire totally \nworthless, his short-term loss would be equal to the entire net cost of $225. \nCALL WRITER \nWritten calls that are bought back in the listed option market or are allowed to expire \nworthless are short-term capital gains. A written call cannot produce a long-term \ngain, regardless of the holding period. This treatment of a written call holds true even \nif the investor simultaneously owned the underlying stock (that is, he had a covered \nwrite). As long as the call is bought back or allowed to expire worthless, the gain or \nloss on the call is treated separately from the underlying stock for tax purposes. \nExample: A trader sells naked an XYZ July 30 call for 3 points and buys it back three \nmonths later at a price of 1. The commissions were $25 for each trade, so the tax gain \nwould be: \n912 \nNet sale proceeds ($300 - $25) \nNet cost ($100 + $25) \nShort-term gain: \nPart VI: Measuring and Trading Volatility \n$275 \n-125 \n$150 \nIf the investor had not bought the call back, but had been fortunate enough to be \nable to allow it to expire worthless, his gain for tax purposes would have been the \nentire $275, representing his net sale proceeds. The purchase cost is considered to \nbe zero for an option that expires worthless. \nPUT WRITER \nThe tax treatment of written puts is quite similar to that of written calls. If the put is \nbought back in the open market or is allowed to expire worthless, the transaction is \na short-term capital item. \nExample: An investor writes an XYZ July 40 put for 4 points, and later buys it back \nfor 2 points after a rally by the underlying stock. The commissions were $25 on each \noption trade, so the tax situation would be: \nNet put sale price ($400 - $25) \nNet put cost ($100 + $25) \nShort-term gain: \n$375 \n-125 \n$250 \nIf the put were allowed to expire worthless, the investor would have a net gain of \n$375, and this gain would be short-term. \nTHE 60/40 RULE \nAs mentioned earlier, nonequity option positions and future positions must be \nmarked to market at the end of the tax year and taxes paid on both the unrealized and \nrealized gains and losses. This same rule applies to futures positions. The tax rate on \nthese gains and losses is lower than the equity options rate. Regardless of the actual \nholding period of the positions, one treats 60% of his tax liability as long-term and \n40% as short-term. This ruling means that even gains made from extremely short\nterm activity such as day-trading can qualify partially as long-term gains. \nSince 1986, long-term and short-term capital gains rates have been equal. If \nlong-term rates should drop, then the rule would again be more meaningful. \nExample: A trader in nonequity options has made three trades during the tax year. \nIt is now the end of the tax year and he must compute his taxes. First, he bought S&P \nChapter 41: Taxes 913 \n500 calls for $1,500 and sold them 6 weeks later for $3,500. Second, he bought an \nOEX January 160 call for 3.25 seven months ago and still holds it. It currently is trad\ning at 11.50. Finally, he sold 5 SPX February 250 puts for 1.50 three days ago. They \nare currently trading at 2. The net gain from these transactions should be computed \nwithout regard to holding period. \nNonequity Original Current Gain/ \nContract Price Price Cost", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 401}
{"text": "weeks later for $3,500. Second, he bought an \nOEX January 160 call for 3.25 seven months ago and still holds it. It currently is trad\ning at 11.50. Finally, he sold 5 SPX February 250 puts for 1.50 three days ago. They \nare currently trading at 2. The net gain from these transactions should be computed \nwithout regard to holding period. \nNonequity Original Current Gain/ \nContract Price Price Cost Proceeds Loss \nS&P calls $1,500 $3,500 +$2,000 realized \nOEX January 160 3.25 11.50 $ 325 $1,150 + 825 unrealized \nSPX February 250 1.50 2.00 $1,000 $ 750 250 unrealized \nTotal caeital gains +$2,575 \nThe total taxable amount is $2,575, regardless of holding period and regardless of \nwhether the item is realized or unrealized. Of this total taxable amount, 60% ($1,545) \nis subject to long-term treatment and 40% ($1,030) is subject to short-term treat\nment. \nIn practice, one computes these figures on a separate form (Section 1256) and \nmerely enters the two final figures - $1,545 and $1,030- on the tax schedule for cap\nital gains and losses. Note that if one loses money in nonequity options, he actually \nhas a tax disadvantage in comparison to equity options, because he must take some \nof his loss as a long-term loss, while the equity option trader can take all of his loss as \nshort-term. \nEXERCISE AND ASSIGNMENT \nExcept for a specified situation that we will discuss later, exercise and assignment do \nnot have any tax effect for nonequity options because everything is marked to mar\nket at the end of the year. However, since equity options are subject to holding peri\nod considerations, the following discussion pertains to them. \nCALL EXERCISE \nAn equity call holder who has an in-the-money call might decide to exercise the call \nrather than sell it in the options market. If he does this, there are no tax consequences \non the option trade itself. Rather, the cost of the stock is increased by the net cost of \nthe original call option. Moreover, the holding period begins on the day the stock is \n914 Part VI: Measuring and Trading Volatility \npurchased (the day after the call was exercised). The option's holding period has no \nbearing on the stock position that resulted from the exercise. \nExample: An XYZ October 50 call was bought for 5 points on July 1. The stock had \nrisen by October expiration, and the call holder decided to exercise the call on \nOctober 20th. The option commission was $25 and the stock commission was $85. \nThe cost basis for the stock would be computed as follows: \nBuy 1 00 XYZ at 50 via exercise \n($5,000 plus $85 commission) \nOriginal call cost ($500 plus $25) \nTotal tax basis of stock \nHolding period of stock begins on October 21. \n$5,085 \n525 \n$5,610 \nWhen this stock is eventually sold, it will be a gain or a loss, depending on the stock's \nsale price as compared to the tax basis of $5,610 for the stock. Furthermore, it will \nbe a short-term transaction unless the stock is held until October 21st of the follow\ning year. \nCALL ASSIGNMENT \nIf a written call is not closed out, but is instead assigned, the call's net sale proceeds \nare added to the sale proceeds of the underlying stock. The call's holding period is \nlost, and the stock position is considered to have been sold on the date of the assign\nment. \nExample: A naked writer sells an XYZ July 30 call for 3 points, and is later assigned \nrather than buying back the option when it was in-the-money near expiration. The \nstock commission is $75. His net sale proceeds for the stock would be computed as \nfollows: \nNet call sale proceeds ($300 - $25) \nNet stock proceeds from assignment \nof 100 shares at 30 ($3,000 - $75) \nNet stock sale proceeds \n$ 275 \n2,925 \n$3,200 \nIn the case in which the investor writes a naked, or uncovered, call, he sells \nstock short upon assignment. He may, of course, cover the short sale by purchasing \nstock in the open market for delivery. Such a short sale of stock is governed by the \nChapter 41: Taxes 915 \napplicable tax rules pertaining to short sales that any gains or losses from the short \nsale of stock are short-term gains or losses. \nTax Treatment for the Covered Writer. If, on the other hand, the \ninvestor was assigned on a covered call - that is, he was operating the covered \nwriting strategy and he elects to deliver the stock that he owns against the \nassignment notice, he has a complete stock transaction. The net cost of the stock \nwas determined by its purchase price at an earlier date and the net sale proceeds \nare, of course, determined by the assignment in accordance with the preceding \nexample. \nDetermining the proceeds from the stock purchase and sale is easy, but deter\nmining the tax status of the transaction is not. In order to prevent stockholders from \nusing deeply in-the-money calls to protect their stock while letting it become a long\nterm item, some complicated tax rules have been passed. They can be summarized \nas follows: \n1. If the equity option was out-of-the-money when first written, it has no effect on \nthe holding period of the stock. \n2. If the equity option was too deeply in-the-money when first written and the stock \nwas not yet held long-term, then the holding period of the stock is eliminated. \n3. If the equity option was in-the-money, but not too deeply, then the holding peri\nod of the stock is suspended while the call is in place. \nThese rules are complicated and merit further explanation. The first rule mere\nly says that one can write out-of-the-money calls without any problem. If the stock \nlater rises and is called away, the sale proceeds for the stock include the option pre\nmium, and the transaction is long-term or short-term depending on the holding peri\nod of the stock. \nExample: Assume that on September 1st of a particular year, an investor buys 100 \nXYZ at 35. He holds the stock for a while, and then on July 15th of the following year \n- after the stock has risen to 43 - he sells an October 45 call for 3 points. \nNet call sale proceeds ($300 - $25) \nNet stock", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 402}
{"text": "pre\nmium, and the transaction is long-term or short-term depending on the holding peri\nod of the stock. \nExample: Assume that on September 1st of a particular year, an investor buys 100 \nXYZ at 35. He holds the stock for a while, and then on July 15th of the following year \n- after the stock has risen to 43 - he sells an October 45 call for 3 points. \nNet call sale proceeds ($300 - $25) \nNet stock proceeds from \nassignment ($4,500 - $75) \nNet stock sale proceeds \nNet stock cost ($3,500 + $75) \nNet long-term gain \n$ 275 \n$4,425 \n$4,700 $4,700 \n$3,575 \n+$1, 125 \n916 Part VI: Measuring and Trading Volatllity \nThus, this covered writer has a net gain of $1,125 and it is a long-term gain because \nthe stock was held for more than one year (from September 1st of the year in which \nhe bought it, to October expiration of the next year, when the stock was called away). \nNote that in a similar situation in which the stock had been held for less than \none year before being called away, the gain would be short-term. \nLet us now look at the other two rules. They are related in that their differen\ntiation relies on the definition of \"too deeply in-the-money.\" They come into play \nonly if the stock was not already held long-term when the call was written. If the writ\nten call is too deeply in-the-money, it can eliminate the holding period of short-term \nstock. Otherwise, it can suspend it. If the call is in-the-money, but not too deeply in\nthe-money, it is referred to as a qualified covered call. There are several rules regard\ning the determination of whether an in-the-money call is qualified or not. Before \nactually getting to that definition, which is complicated, let us look at two examples \nto show the effect of the call being qualified or not qualified. \nExample: Qualified Covered Write: On March 1st, an investor buys 100 XYZ at 35. \nHe holds the stock for 3% months, and, on July 15th, the stock has risen to 43. This \ntime he sells an in-the-money call, the October 40 call for 6. By October expiration, \nthe stock has declined and the call expires worthless. \nHe would now have the following situation: a $575 short-term gain from the \nsale of the call, plus he is long 100 XYZ with a holding period of only 3% months. \nThus, the sale of the October call suspended his holding period, but did not elimi\nnate it. \nHe could now hold the stock for another 8½ months and then sell it as a long\nterm item. \nIf the stock in this example had stayed above 40 and been called away, the net \nresult would have been that the option proceeds would have been added to the stock \nsale price as in previous examples, and the entire net gain would have been short\nterm due to the fact that the writing of the qualified covered call had suspended the \nholding period of the stock at 3½ months. \nThat example was one of writing a call which was not too deeply in-the-money. \nIf, however, one writes a call on stock that is not yet held long-term and the call is too \ndeeply in-the-money, then the holding period of the stock is eliminated. That is, if the \ncall is subsequently bought back or expires worthless, the stock must then be held for \nanother year in order to qualify as a long-term investment. This rule can work to an \ninvestor's advantage. If one buys stock and it goes down and he is in jeopardy of hav\ning a long-term loss, but he really does not want to sell the stock, he can sell a call \nChapter 41: Taxes 917 \nthat is too deeply in-the-money (if one exists), and eliminate the holding period on \nthe stock \nQualified Covered Call. The preceding examples and discussion summa\nrize the covered writing rules. Let us now look at what is a qualified covered call. \nThe following rules are the literal interpretation. Most investors work from \ntables that are built from these rules. Such a table may be found in Appendix E. \n(Be aware that these rules may change, and consult a tax advisor for the latest \nfigures.) A covered call is qualified if: \n1. the option has more than 30 days of life remaining when it is written, and \n2. the strike of the written call is not lower than the following benchmarks: \na. First determine the applicable stock price (ASP). That is normally the closing \nprice of the stock on the previous day. However, if the stock opens more than \nll0% higher than its previous close, then the applicable stock price is that \nhigher opening. \nb. If the ASP is less than $25, then the benchmark strike is 85% of ASP. So any \ncall written with a strike lower than 85% of ASP would not be qualified. (For \nexample, if the stock was at 12 and one wrote a call with a striking price of 10, \nit would not be qualified- it is too deeply in-the-money.) \nc. If the ASP is between 25.13 and 60, then the benchmark is the next lowest \nstrike. Thus, if the stock were at 39 and one wrote a call with a strike of 35, it \nwould be qualified. \nd. If the ASP is greater than 60 and not higher than 150, and the call has more \nthan 90 days of life remaining, the benchmark is two strikes below the ASP. \nThere is a further condition here that the benchmark cannot be more than 10 \npoints lower than the ASP. Thus, if a stock is trading at 90, one could write a \ncall with a strike of 80 as long as the call had more than 90 days remaining \nuntil expiration, and still be qualified. \ne. If the ASP is greater than 150 and the call has more than 90 days of life remain\ning, the benchmark is two strikes below the ASP. Thus, if there are 10-point \nstriking price intervals, then one could write a call that was 20 points in-the\nmoney and still be qualified. Of course, if there are 5-point intervals, then one \ncould not write a call deeper than 10 points in-the-money and still be qualified. \nThese rules are complicated. That is why they are summarized in Appendix E. \nIn addition, they are always subject to change, so if an investor is considering writing \nan in-the-money covered call against stock that is still short-term in nature, he should \ncheck with his tax advisor", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 403}
{"text": "are 5-point intervals, then one \ncould not write a call deeper than 10 points in-the-money and still be qualified. \nThese rules are complicated. That is why they are summarized in Appendix E. \nIn addition, they are always subject to change, so if an investor is considering writing \nan in-the-money covered call against stock that is still short-term in nature, he should \ncheck with his tax advisor and/or broker to determine whether the in-the-money call \nis qualified or not. \n918 Part VI: Measuring and Trading Volatility \nThere is one further rule in connection with qualified calls. Recall that we stat\ned that the above rules apply only if the stock is not yet held long-term when the call \nis written. If the stock is already long-term when the call is written, then it is consid\nered long-term when called away, regardless of the position of the striking price when \nthe call was written. However, if one sells an in-the-money call on stock already held \nlong-term, and then subsequently buys that call back at a loss, the loss on the call \nmust be taken as a long-term loss because the stock was long-term. \nOverall, a rising market is the best, taxwise, for the covered call writer. If he \nwrites out-of-the-money calls and the stock rises, he could have a short-term loss on \nthe calls plus a long-term gain on the stock. \nExample: On January 2nd of a particular year, an investor bought 100 shares of XYZ \nat 32, paying $75 in commissions, and simultaneously wrote a July 35 call for 2 points. \nThe July 35 expired worthless, and the investor then wrote an October 35 call for 3 \npoints. In October, with XYZ at 39, the investor bought back the October 35 call for \n6 points (it was in-the-money) and sold a January 40 call for 4 points. In January, on \nthe expiration day, the stock was called away at 40. The investor would have a long\nterm capital gain on his stock, because he had held it for more than one year. He \nwould also have two short-term capital transactions from the July 35 and October 35 \ncalls. Tables 41-2 and 41-3 show his net tax treatment from operating this covered \nwriting strategy. The option commission on each trade was $25. \nThings have indeed worked out quite well, both profit-wise and tax-wise, for this \ncovered call writer. Not only has he made a net profit of $850 from his transactions on \nthe stock and options over the period of one year, but he has received very favorable \ntax treatment. He can take a short-term loss of $175 from the combined July and \nOctober option transactions, and is able to take the $1,025 gain as a long-term gain. \nTABLE 41-2. \nSummary of trades. \nJanuary 2 \nJuly \nOctober \nJanuary \nBought 100 XYZ at 32 \nSold 1 July 35 call at 2 \nJuly call expired worthless (XYZ at 32) \nSold 1 October 35 call at 3 \nBought back October 35 call for 6 points (XYZ at 39) \nSold 1 January 40 call for 4 points \n(of the following year) \n1 00 XYZ called away at 40 \nChapter 41: Taxes \nTABLE 41-3. \nTax treatment of trades. \nShort-term capital items: \nJuly 35 call: Net proceeds ($200 - $25) \nNet cost {expired worthless) \nShort-term capital gain \nOctober 35 call: Net proceeds ($300 - $25) \nNet cost ($600 + $25) \nShort-term capital loss \n919 \n$175 \n0 \n$175 \n$275 \n- 625 \n($350) \nLong-term capital item: \n100 shares XYZ: Purchased January 2 of one year and sold at January \nexpiration of the following year. Therefore, held for \nmore than one year, qualifying for long-term treatment. \nNet sale proceeds of stock {assigned call): \nJanuary 40 call sale proceeds \n($400 - $25) \nSold 1 00 XYZ at 40 strike \n{$4,000 $75) \nNet cost of stock (January 2 trade): \nBought 100 at 32 {$3,200 + $75) \nLong-term capital gain \n$375 \n+ 3,925 \n$4,300 \n- 3,275 \n$1,025 \nThis example demonstrates an important tax consequence for the covered call \nwriter: His optimum scenario tax-wise is a rising market, for he may be able to \nachieve a long-term gain on the underlying stock if he holds it for at least one year, \nwhile simultaneously subtracting short-term losses from written calls that were \nclosed out at higher prices. Unfortunately, in a declining market, the opposite result \ncould occur: short-term option gains coupled with the possibility of a long-term loss \non the underlying stock. There are ways to avoid long-term stock losses, such as buy\ning a put ( discussed later in the chapter) or going short against the box before the \nstock becomes long-term. However, these maneuvers would interrupt the covered \nwriting strategy, which may not be a wise tactic. \nIn summary, then, the covered call writer who finds himself with an in-the\nmoney call written and expiration date drawing near may have several alternatives \nopen to him. If the stock is not yet held long-term, he might elect to buy back the \nwritten call and to write another call whose expiration date is beyond the date \nrequired for a long-term holding period on the stock. This is apparently what the \nhypothetical investor in the preceding example did with his October 35 call. Since \n920 Part VI: Measuring and Trading VolatiRty \nthat call was in-the-money, he could have elected to let the call be assigned and to \ntake his profit on the position at that time. However, this would have produced a \nshort-term gain, since the stock had not yet been held for one year, so he elected \ninstead to terminate the October 35 call through a closing purchase transaction and \nto simultaneously write a call whose expiration date exceeded the one year period \nrequired to make the stock a long-term item. He thus wrote the January 40 call, \nexpiring in the next year. Note that this investor not only decided to hold the stock \nfor a long-term gain, but also decided to try for more potential profits: He rolled the \ncall up to a higher striking price. This lets the holding period continue. An in-the\nmoney write would have suspended it. \nDELIVERING .,.,NEW\" STOCK TO AVOID A LARGE LONG· TERM GAIN \nSome covered call writers may not want to deliver the stock that they are using to \ncov", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 404}
{"text": "stor not only decided to hold the stock \nfor a long-term gain, but also decided to try for more potential profits: He rolled the \ncall up to a higher striking price. This lets the holding period continue. An in-the\nmoney write would have suspended it. \nDELIVERING .,.,NEW\" STOCK TO AVOID A LARGE LONG· TERM GAIN \nSome covered call writers may not want to deliver the stock that they are using to \ncover the written call, if that call is assigned. For example, if a covered writer were \nwriting against stock that had an extremely low cost basis, he might not be willing to \ntake the tax consequences of selling that particular stock holding. Thus, the writer of \na call that is assigned may sometimes wish to buy stock in the open market to deliv\ner against his assignment, rather than deliver the stock he already owns. Recall that \nit is completely in accordance with the Options Clearing Corporation rules for a call \nwriter to buy stock in the open market to deliver against an assignment. For tax pur\nposes, the confirmation that the investor receives from his broker for the sale of the \nstock via assignment should clearly specify which particular shares of stock are being \nsold. This is usually accomplished by having the confirmation read \"Versus Purchase\" \nand listing the purchase date of the stock being sold. This is done to clearly identify \nthat the \"new\" stock, and not the older long-term stock, is being delivered against the \nassignment. The investor must give these instructions to his broker, so that the \nbrokerage firm puts the proper notation on the confirmation itself. If the investor \nrealizes that his stock might be in danger of being called away and he wants to avail \nhimself of this procedure, he should discuss it with his broker beforehand, so that the \nproper procedures can be enacted when the stock is actually called away. \nExample: An investor owns 100 shares ofXYZ and his cost basis, after multiple stock \nsplits and stock dividends over the years, is $2 per share. With XYZ at 50, this investor \ndecides to sell an XYZ July 50 call for 5 points to bring in some income to his port\nfolio. Subsequently, the call is assigned, but the investor does not want to deliver his \nXYZ, which he owns at a cost basis of $2 per share, because he would have to pay cap\nital gains on a large profit. He may go into the open market and buy another 100 \nshares of XYZ at its current market price for delivery against the assignment notice. \nChapter 41: Taxes 921 \nSuppose he does this on July 20th, the day he receives the assignment notice on his \nXYZ July 50 call. The confirmation that he receives from his broker for the sale of \n100 XYZ at 50 - that is, the confirmation for the call assignment - should be marked \n\"Versus Purchase July 20th.\" The year of the sale date should be noted on the con\nfirmation as well. This long-term holder of XYZ stock must, of course, pay for the \nadditional XYZ bought in the open market for delivery against the assignment notice. \nThus, it is imperative that such an investor have a reserve of funds that he can fall \nback on if he thinks that he must ever implement this sort of strategy to avoid the tax \nconsequences of selling his low-cost-basis stock. \nPUT EXERCISE \nIf the put holder does not choose to liquidate the option in the listed market, but \ninstead exercises the put - thereby selling stock at the striking price - the net cost of \nthe put is subtracted from the net sale proceeds of the underlying stock. \nExample: Assume an XYZ April 45 put was bought for 2 points. XYZ had declined in \nprice below 45 by April expiration, and the put holder decides to exercise his in-the\nmoney put rather than sell it in the option market. The commission on the stock sale \nis $85, so the net sale proceeds for the underlying stock would be: \nSale of 100 XYZ at 45 strike ($4,500 - $85) \nNet cost of put ($200 + 25) \nNet sale proceeds on stock for tax purposes: \n$4,415 \n- 225 \n$4,190 \nIf the stock sale represents a new position - that is, the investor has shorted the \nunderlying stock - it will eventually be a short-term gain or loss, according to pres\nent tax rules governing short sales. If the put holder already owns the underlying \nstock and is using the put exercise as a means of selling that stock, his gain or loss on \nthe stock transaction is computed, for tax purposes, by subtracting his original net \nstock cost from the sale proceeds as determined above. \nPUT ASSIGNMENT \nIf a written put is assigned, stock is bought at the striking price. The net cost of this \npurchased stock is reduced by the amount of the original put premium received. \nExample: If one initially sold an XYZ July 40 put for 4 points, and it was assigned, \nthe net cost of the stock would be determined as follows, assuming a $75 commission \ncharge on the stock purchase: \n922 \nCost of 100 XYZ assigned at 40 ($4,000 + $75) \nNet proceeds of put sale ($400 - $25) \nNet cost basis of stock \nPart VI: Measuring and Trading Volatility \n$4,075 \n- 375 \n$3,700 \nThe holding period for stock purchased via a put assignment begins on the day of the \nput assignment. The period during which the investor was short the put has no bear\ning on the holding period of the stock. Obviously, the put transaction itself does not \nbecome a capital item; it becomes part of the stock transaction. \nSPECIAL TAX PROBLEMS \nTHE WASH SALE RULE \nThe call buyer should be aware of the wash sale rule. In general, the wash sale rule \ndenies a tax deduction for a security sold at a loss if a substantially identical security, \nor an option to acquire that security, is purchased within 30 days before or 30 days \nafter the original sale. This means that one cannot sell XYZ to take a tax loss and also \npurchase XYZ within the 61-day period that extends 30 days before and 30 days after \nthe sale. Of course, an investor can legally make such a trade, he just cannot take the \ntax loss on the sale of the stock. A call option is certainly an option to acquire the \nse", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 405}
{"text": "s purchased within 30 days before or 30 days \nafter the original sale. This means that one cannot sell XYZ to take a tax loss and also \npurchase XYZ within the 61-day period that extends 30 days before and 30 days after \nthe sale. Of course, an investor can legally make such a trade, he just cannot take the \ntax loss on the sale of the stock. A call option is certainly an option to acquire the \nsecurity. It would thus invoke the wash sale rule for an investor to sell XYZ stock to \ntake a loss and also purchase any XYZ call within 30 days before or after the stock \nsale. \nVarious series of call options are not generally considered to be substantially \nidentical securities, however. If one sells an XYZ January 50 call to take a loss, he may \nthen buy any other XYZ call option without jeopardizing his tax loss from the sale of \nthe January 50. It is not clear whether he could repurchase another January 50 call\nthat is, an identical call - without jeopardizing the taxable loss on the original sale of \nthe January 50. \nIt would also be acceptable for an investor to sell a call to take a loss and then \nimmediately buy the underlying security. This would not invoke the wash sale rule. \nAvoiding a Wash Sale. It is generally held that the sale of a put is not the \nacquisition of an option to buy stock, even though that is the effect of assign\nment of the written put. This fact may be useful in certain cases. If an investor \nholds a stock at a loss, he may want to sell that stock in order to take the loss on \nhis taxes for the current year. The wash sale rule prevents him from repurchas\ning the same stock, or a call option on that stock, within 30 days after the sale. \nThus, the investor will be \"out of\" the stock for a month; that is, he will not be \nChapter 41: Taxes 923 \nable to participate in any rally in the stock in the next 30 days. If the underlying \nstock has listed put options, the investor may be able to partially offset this neg\native effect. By selling an in-the-money put at the same time that the stock is \nsold, the investor will be able to take his stock loss on the current year's taxes \nand also will be able to participate in price movements on the underlying stock. \nIf the stock should rally, the put will decrease in price. However, if the stock ral\nlies above the striking price of the put, the investor will not make as much from the \nput sale as he would have from the ownership of the stock. Still, he does realize some \nprofits if the stock rallies. \nConversely, if the stock falls in price, the investor will lose on the put sale. This \ncertainly represents a risk although no more of a risk than owning the stock did. An \nadditional disadvantage is that the investor who has sold a put will not receive the div\nidends, if any are paid by the underlying stock. \nOnce 30 days have passed, the investor can cover the put and repurchase the \nunderlying stock. The investor who utilizes this tactic should be careful to select a put \nsale in which early assignment is minimal. Therefore, he should sell a long-term, in\nthe-money put when utilizing this strategy. (He needs the in-the-money put in order \nto participate heavily in the stock's movements.) Note that if stock should be put to \nthe investor before 30 days had passed, he would thus be forced to buy stock, and the \nwash sale rule would be invoked, preventing him from taking the tax loss on the stock \nat that time. He would have to postpone taking the loss until he makes a sale that \ndoes not invoke the wash sale rule. \nFinally, this strategy must be employed in a margin account, because the put \nsale will be uncovered. Obviously, the money from the sale of the stock itself can be \nused to collateralize the sale of the put. If the stock should drop in value, it is always \npossible that additional collateral will be required for the uncovered put. \nTHE SHORT-SALE RULE - PUT HOLDER'S PROBLEM \nA put purchase made by an investor who also owns the underlying stock may have an \neffect on the holding period of the stock. If a stock holder buys a put, he would nor\nmally do so to eliminate some of the downside risk in case the stock falls in price. \nHowever, if a put option is purchased to protect stock that is not yet held long enough \nto qualify for long-term capital gains treatment, the entire holding period of the stock \nis wiped out. Furthermore, the holding period for the stock will not begin again until \nthe put is disposed of. For example, if an investor has held XYZ for 11 months - not \nquite long enough to qualify as a long-term holding - and then buys a put on XYZ, \nhe will wipe out the entire accrued holding period on the stock. Furthermore, when \nhe finally disposes of the put, the holding period for the stock must begin all over \n924 Part VI: Measuring and Trading VolatHity \nagain. The previous 11-month holding period is lost, as is the holding period during \nwhich the stock and put were held together. This tax consequence of a put purchase \nis derived from the general rules governing short sales, which state that the acquisi\ntion of an option to sell property at a fixed price (that is, a put) is treated as a short \nsale. This ruling has serious tax consequences for an investor who has bought a put \nto protect stock that is still in a short-term tax status. \n✓,,Married\" Put and Stock. There are two cases in which the put purchase \ndoes not affect the holding period of the underlying stock. First, if the stock has \nalready been held long enough to qualify for long-term capital treatment, the \npurchase of a put has no bearing on the holding period of the underlying stock. \nSecond, if the put and the stock that it is intended to protect are bought at the \nsame time, and the investor indicates that he intends to exercise that particular \nput to sell those particular shares of stock, the put and the stock are considered \nto be \"married\" and the normal tax rulings for a stock holding would apply. The \ninvestor must actually go through wit", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 406}
{"text": "eriod of the underlying stock. \nSecond, if the put and the stock that it is intended to protect are bought at the \nsame time, and the investor indicates that he intends to exercise that particular \nput to sell those particular shares of stock, the put and the stock are considered \nto be \"married\" and the normal tax rulings for a stock holding would apply. The \ninvestor must actually go through with the exercise of the put in order for the \n\"married\" status to remain valid. If he instead should allow the put to expire \nworthless, he could not take the tax loss on the put itself but would be forced to \nadd the put' s cost to the net cost of the underlying stock. Finally, if the investor \nneither exercises the put nor allows it to expire worthless but sells both the put \nand the stock in their respective markets, it would appear that the short sale \nrules would come back into effect. \nThis definition of \"married\" put and stock, with its resultant ramifications, is \nquite detailed. What exactly are the consequences? The \"married\" rule was original\nly intended to allow an investor to buy stock, protect it, and still have a chance of real\nizing a long-term gain. This is possible with options with more than one year of life \nremaining. The reader must be aware of the fact that, if he initially \"marries\" stock \nand a listed 3-month put, for example, there is no way that he can replace that put at \nits expiration with another put and still retain the \"married\" status. Once the original \n\"married\" put is disposed of - through sale, exercise, or expiration - no other put may \nbe considered to be \"married\" to the stock. \nProtecting a Long· Term Gain or Avoiding a Long-Term Loss. The \ninvestor may be able, at times, to use the short-sale aspect of put purchases to \nhis advantage. The most obvious use is that he can protect a long-term gain with \na put purchase. He might want to do this if he has decided to take the long-term \ngain, but would prefer to delay realizing it until the following tax year. A pur\nchase of a put with a maturity date in the following year would accomplish that \npurpose. \nChapter 41: Taxes 92S \nAnother usage of the put purchase, for tax purposes, might be to avoid a long\nterm loss on a stock position. If an investor owns a stock that has declined in price \nand also is about to become a long-term holding, he can buy a put on that stock to \neliminate the holding period. This avoids having to take a long-term loss. Once the \nput is removed, either by its sale or by its expiring worthless, the stock holding peri\nod would begin all over again and it would be a short-term position. In addition, if \nthe investor should decide to exercise the put that he purchased, the result would be \na short-term loss. The sale basis of the stock upon exercise of the put would be equal \nto the striking price of the put less the amount of premium paid for the put, less all \ncommission costs. Furthermore, note that this strategy does not lock in the loss on \nthe underlying stock. If the stock rallies, the investor would be able to participate in \nthat rally, although he would probably lose all of the premium that he paid for the \nput. Note that both of these long-term strategies can be accomplished via the sale of \na deeply in-the-money call as well. \nSUMMARY \nThis concludes the section of the tax chapter dealing with listed option trades and \ntheir direct consequences on option strategies. In addition to the basic tax treatment \nfor option traders of liquidation, expiring worthless, or assignment or exercise, sev\neral other useful tax situations have been described. The call buyer should be aware \nof the wash sale rule. The put buyer must be aware of the short sale rules involving \nboth put and stock ownership. The call writer should realize the beneficial effects of \nselling an in-the-money call to protect the underlying stock, while waiting for a real\nization of profit in the following tax year. The put writer may be able to avoid a wash \nsale by utilizing an in-the-money put write, while still retaining profit potential from \na rally by the underlying stock. \nTAX PLANNING STRATEGIES FOR EQUITY OPTIONS \nDEFERRING A SHORT· TERM CALL GAIN \nThe call holder may be interested in either deferring a gain until the following year \nor possibly converting a short-term gain on the call into a long-term gain on the stock. \nIt is much easier to do the former than the latter. A holder of a profitable call that is \ndue to expire in the following year can take any of three possible actions that might \nlet him retain his profit while deferring the gain until the following tax year. One way \nin which to do this would be to buy a put option. Obviously, he would want to buy an \n926 Part VI: Measuring and Trading Volatillty \nin-the-money put for this purpose. By so doing, he would be spending as little as pos\nsible in the way of time value premium for the put option and he would also be lock\ning in his gain on the call. The gains and losses from the put and call combination \nwould nearly equal each other from that time forward as the stock moves up or down, \nunless the stock rallies strongly, thereby exceeding the striking price of the put. This \nwould be a happy event, however, since even larger gains would accrue. The combi\nnation could be liquidated in the following tax year, thus achieving a gain. \nExample: On September 1st, an investor bought an XYZ January 40 call for 3 points. \nThe call is due to expire in the following year. XYZ has risen in price by December \n1st, and the call is selling for 6 points. The call holder might want to take his 3-point \ngain on the call, but would also like to defer that gain until the following year. He \nmight be able to do this by buying an XYZ January 50 put for 5 points, for example. \nHe would then hold this combination until after the first of the new year. At that \ntime, he could liquidate the entire combination for at least 10 points, since the strik\ning price of the put is 1", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 407}
{"text": "ight want to take his 3-point \ngain on the call, but would also like to defer that gain until the following year. He \nmight be able to do this by buying an XYZ January 50 put for 5 points, for example. \nHe would then hold this combination until after the first of the new year. At that \ntime, he could liquidate the entire combination for at least 10 points, since the strik\ning price of the put is 10 points greater than that of the call. In fact, if the stock should \nhave climbed to or above 50 by the first of the year, or should have fallen to or below \n40 by the first of the year, he would be able to liquidate the combination for more \nthan 10 points. The increase in time value premium at either strike would also be a \nbenefit. In any case, he would have a gain - his original cost was 8 points (3 for the \ncall and 5 for the put). Thus, he has effectively deferred taking the gain on the orig\ninal call holding until the next tax year. The risk that the call holder incurs in this type \nof transaction is the increased commission charges of buying and selling the put as \nwell as the possible loss of any time value premium in the put itself. The investor \nmust decide for himself whether these risks, although they may be relatively small, \noutweigh the potential benefit from deferring his tax gain into the next year. \nAnother way in which the call holder might be able to defer his tax gain into the \nnext year would be to sell another XYZ call against the one that he currently holds. \nThat is, he would create a spread. To assure that he retains as much of his current \ngain as possible, he should sell an in-the-money call. In fact, he should sell an in-the\nmoney call with a lower striking price than the call held long, if possible, to ensure \nthat his gain remains intact even if the underlying stock should collapse substantial\nly. Once the spread has been established, it could be held until the following tax year \nbefore being liquidated. The obvious risk in this means of deferring gain is that one \ncould receive an assignment notice on the short call. This is not a remote possibility, \nnecessarily, since an in-the-money call should be used as protection for the current \ngain. Such an assignment would result in large commission costs on the resultant pur\nchase and sale of the underlying stock, and could substantially reduce one's gain. \nChapter 41: Taxes 927 \nThus, the risk in this strategy is greater than that in the previous one (buying a put), \nbut it may be the only alternative available if puts are not traded on the underlying \nstock in question. \nExample: An investor bought an XYZ February 50 call for 3 points in August. In \nDecember, the stock is at 65 and the call is at 15. The holder would like to \"lock in\" \nhis 12-point call profit, but would prefer deferring the actual gain into the following \ntax year. He could sell an XYZ February 45 call for approximately 20 points to do this. \nIf no assignment notice is received, he will be able to liquidate the spread at a cost \nof 5 points with the stock anywhere above 50 at February expiration. Thus, in the end \nhe would still have a 12-point gain - having received 20 points for the sale of the \nFebruary 45 and having paid out 3 points for the February 50 plus 5 points to liqui\ndate the spread to take his gain. If the stock should fall below 50 before February \nexpiration, his gain would be even larger, since he would not have to pay out the \nentire 5 points to liquidate the spread. \nThe third way in which a call holder could lock in his gain and still defer the gain \ninto the following tax year would be to sell the stock short while continuing to hold \nthe call. This would obviously lock in the gain, since the short sale and the call pur\nchase will offset each other in profit potential as the underlying stock moves up or \ndown. In fact, if the stock should plunge downward, large profits could accrue. \nHowever, there is risk in using this strategy as well. The commission costs of the short \nsale will reduce the call holder's profit. Furthermore, if the underlying stock should \ngo ex-dividend during the time that the stock is held short, the strategist will be liable \nfor the dividend as well. In addition, more margin will be required for the short stock. \nThe three tactics discussed above showed how to defer a profitable call gain into \nthe following tax year. The gain would still be short-term when realized. The only way \nin which a call holder could hope to convert his gain into a long-term gain would be \nto exercise the call and then hold the stock for more than one year. Recall that the \nholding period for stock acquired through exercise begins on the day of exercise - the \noption's holding period is lost. If the investor chooses this alternative, he of course is \nspending some of his gains for the commissions on the stock purchase as well as sub\njecting himself to an entire year's worth of market risk. There are ways to protect a \nstock holding while letting the holding period accrue - for example, writing out-of\nthe-money calls - but the investor who chooses this alternative should carefully \nweigh the risks involved against the possible benefits of eventually achieving a long\nterm gain. The investor should also note that he will have to advance considerably \nmore money to hold the stock. \n928 Part VI: Measuring and Trading Volatility \nDEFERRING A PUT HOLDER'S SHORT· TERM GAIN \nWithout going into as much detail, there are similar ways in which a put holder who \nhas a short-term gain on a put due to expire in the following tax year can attempt to \ndefer the realization of that gain into the following tax year. One simple way in which \nhe could protect his gain would be to buy a call option to protect his profitable put. \nHe would want to buy an in-the-money call for this purpose. This resulting combina\ntion is similar in nature to the one described for the call buyer in the previous section. \nA second way that he could attempt to protect hi", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 408}
{"text": "defer the realization of that gain into the following tax year. One simple way in which \nhe could protect his gain would be to buy a call option to protect his profitable put. \nHe would want to buy an in-the-money call for this purpose. This resulting combina\ntion is similar in nature to the one described for the call buyer in the previous section. \nA second way that he could attempt to protect his gain and still defer its real\nization into the following tax year would be to sell another XYZ put option against the \none that he holds long. This would create a vertical spread. This put holder should \nattempt to sell an in-the-money put, if possible. Of course, he would not want to sell \na put that was so deeply in-the-money that there is risk of early assignment. The \nresults of such a spread are analogous to the call spread described in detail in the last \nsection. \nFinally, the put holder could buy the underlying stock if he had enough avail\nable cash or collateral to finance the stock purchase. This would lock in the profit, as \nthe stock and the put would offset each other in terms of gains or losses while the \nstock moved up or down. In fact, if the stock should experience a large rally, rising \nabove the striking price of the put, even larger profits would become possible. \nIn each of the tactics described, the position would be removed in the follow\ning tax year, thereby realizing the gain that was deferred. \nDIFFICULTY OF DEFERRING GAINS FROM WRITING \nAs a final point in this section on deferring gains from option transactions, it might \nbe appropriate to describe the risks associated with the strategy of attempting to \ndefer gains from uncovered option writing into the following tax year. Recall that in \nthe previous sections, it was shown that a call or put holder who has an unrealized \nprofit in an option that is due to expire in the following tax year could attempt to \"lock \nin\" the gain and defer it. The dollar risks to a holder attempting such a tax deferral \nwere mainly commission costs and/or small amounts of time value premium paid for \noptions. However, the option writer who has an unrealized profit may have a more \ndifficult time finding a way to both \"lock in\" the gain and also defer its realization into \nthe following tax year. It would seem, at first glance, that the call writer could mere\nly take actions opposite to those that the call buyer takes: buying the underlying \nstock, buying another call option, or selling a put. Unfortunately, none of these \nactions \"locks in\" the call writer's profit. In fact, he could lose substantial investment \ndollars in his attempt to defer the gain into the following year. \nChapter 41: Taxes 929 \nExample: An investor has written an uncovered XYZ January 50 call for 5 points and \nthe call has dropped in value to 1 point in early December. He might want to take \nthe 4-point gain, but would prefer to defer realization of the gain until the following \ntax year. Since the call write is at a profit, the stock must have dropped and is prob\nably selling around 45 in early December. Buying the underlying stock would not \naccomplish his purpose, because if the stock continued to decline through year-end, \nhe could lose a substantial amount on the stock purchase and could make only 1 more \npoint on the call write. Similarly, a call purchase would not work well. A call with a \nlower striking price - for example, the XYZ January 45 or the January 40- could lose \nsubstantial value if the underlying stock continued to drop in price. An out-of-the\nmoney call - the XYZ January 60 - is also unacceptable, because if the underlying \nstock rallied to the high 50's, the writer would lose money both on his January 50 call \nwrite and on his January 60 call purchase at expiration. Writing a put option would \nnot \"lock in\" the profit either. If the underlying stock continued to decline, the loss\nes on the put write would certainly exceed the remaining profit potential of 1 point \nin the January 50 call. Alternatively, if the stock rose, the losses on the January 50 call \ncould offset the limited profit potential provided by a put write. Thus, there is no rel\natively safe way for an uncovered call writer to attempt to \"lock in\" an unrealized gain \nfor the purpose of deferring it to the following tax year. The put writer seeking to \ndefer his gains faces similar problems. \nUNEQUAL TAX TREATMENT ON SPREADS \nThere are two types of spreads in which the long side may receive different tax treat\nment than the short side. One is the normal equity option spread that is held for more \nthan one year. The other is any spread between futures, futures options, or cash\nbased options and equity options. \nWith equity options, if one has a spread in place for more than one year and if \nthe movement of the underlying stock is favorable, one could conceivably have a \nlong-term gain on the long side and a short-term loss on the short side of the spread. \nExample: An investor establishes an XYZ bullish call spread in options that have 15 \nmonths of life remaining: In October of one year, he buys the January 70 LEAPS call \nexpiring just over a year in the future. At the same time, he sells the January 80 \nLEAPS call, again expiring just over a year hence. Suppose he pays 13 for the January \n70 call and receives 7 for the January 80 call. In December of the following year, he \ndecides to remove the spread, after he has held it for more than one year - specifi\ncally, for 14 months in this case. XYZ has advanced by that time, and the spread is \nworth 9. With XYZ at 90, the January 70 call is trading at 20 and the January 80 call \nis trading at 11. The capital gain and loss results for tax purposes are summarized in \nthe following table (commissions are omitted from this example): \n930 \nOption \nXYZ January 70 LEAPS call \nXYZ January 80 LEAPS call \nCost \n$1,300 \n$1,100 \nPart VI: Measuring and Trading Volatllity \nProceeds \n$2,000 \n$ 700 \nGoin/Loss \n$700 long-term gain \n$400 short-term l", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 409}
{"text": "trading at 20 and the January 80 call \nis trading at 11. The capital gain and loss results for tax purposes are summarized in \nthe following table (commissions are omitted from this example): \n930 \nOption \nXYZ January 70 LEAPS call \nXYZ January 80 LEAPS call \nCost \n$1,300 \n$1,100 \nPart VI: Measuring and Trading Volatllity \nProceeds \n$2,000 \n$ 700 \nGoin/Loss \n$700 long-term gain \n$400 short-term loss \nNo taxes would be owed on this spread since one-half of the long-term gain is \nless than the short-term loss. The investor with this spread could be in a favorable \nposition since, even though he actually made money in the spread - buying it at a 6-\npoint debit and selling it at a 9-point credit - he can show a loss on his taxes due to \nthe disparate treatment of the two sides of the spread. \nThe above spread requires that the stock move in a favorable direction in order \nfor the tax advantage to materialize. If the stock were to move in the opposite direc\ntion, then one should liquidate the spread before the long side of the spread had \nreached a holding period of one year. This would prevent taking a long-term loss. \nAnother type of spread may be even more attractive in this respect. That is a \nspread in which nonequity options are spread against equity options. In this case, the \ntrader would hope to make a profit on the nonequity or futures side, because part of \nthat gain is automatically long-term gain. He would simultaneously want to take a loss \non the equity option side, because that would be entirely short-term loss. \nThere is no riskless way to do this, however. For example, one might buy a pack\nage of puts on stocks and hedge them by selling an index put on an index that per\nforms more or less in line with the chosen stocks. If the index rises in price, then one \nwould have short-term losses on his stock options, and part of the gain on his index \nputs would be treated as long-term. However, if the index were to fall in price, the \nopposite would be true, and long-term losses would be generated - not something \nthat is normally desirable. Moreover, the spread itself has risk, especially the tracking \nrisk between the basket of stocks and the index itself. \nThis brings out an important point: One should be cautious about establishing \nspreads merely for tax purposes. He might wind up losing money, not to mention that \nthere could be unfavorable tax consequences. As always, a tax advisor should be con\nsulted before any tax-oriented strategy is attempted. \nSUMMARY \nOptions can be used for many tax purposes. Short-term gains can be deferred into \nthe next tax year, or can be partially protected with out-of-the-money options until \nthey mature into long-term gains. Long-term losses can be avoided with the purchase \nof a put or sale of a deeply in-the-money call. Wash sales can be avoided without giv\ning up the entire ownership potential of the stock. There are risks as well as rewards \nChapter 41: Taxes 931 \nin any of the strategies. Commission costs and the dissipation of time value premium \nin purchased options will both work against the strategist. \nA tax advisor should be consulted before actually implementing any tax strate\ngy, whether that strategy employs options or not. Tax rules change from time to time. \nIt is even possible that a certain strategy is not covered by a written rule, and only a \ntax advisor is qualified to give consultation on how such a strategy might be inter\npreted by the IRS. \nFinally, the options strategist should be careful not to confuse tax strategies with \nhis profit-oriented strategies. It is generally a good idea to separate profit strategies \nfrom tax strategies. That is, if one finds himself in a position that conveniently lends \nitself to tax applications, fine. However, one should not attempt to stay in a position \ntoo long or to close it out at an illogical time just to take advantage of a tax break. The \ntax consequences of options should never be considered to be more important than \nsound strategy management. \nThe Best Strategy? \nThere is no one best strategy. Although this statement may appear to be unfair and \ndisappointing to some, it is nevertheless the truth. Its validity lies in the fact that there \nare many types of investors, and no one strategy can be best for all of them. \nKnowledge and suitability are the keys to determining which strategy may be the best \none for an individual. The previous chapters have been devoted to imparting much of \nthe knowledge required to understand an individual strategy. This chapter attempts to \npoint out how the investor might incorporate his own risk/reward attitude and finan\ncial condition to select the most feasible strategies for his own use. The final section \nof this chapter describes which strategies have the better probabilities of success. \nGENERAL CONCEPT: MARKET ATTITUDE \nAND EQUIVALENT POSITIONS \nA wide variety of strategies has been described. Certain ones are geared to capitaliz\ning on one's (hopefully correct) outlook for a particular stock, or for the market in \ngeneral. These tend to be the more aggressive strategies, such as outright put or call \nbuying and low-debit (high-potential) bull and bear spreads. Other strategies are \nmuch more conservative, having as their emphasis the possibility of making a rea\nsonable but limited return, coupled with decreased risk exposure. These include cov\nered call writing and in-the-money (large-debit) bull or bear spreads. Even in these \nstrategies, however, one has a general attitude about the market. He is bullish or \nbearish, but not overly so. If he is proven slightly wrong, he can still make money. \nHowever, if he is gravely wrong, relatively large percentage losses might occur. The \nthird broad category of strategies is the one that is not oriented toward picking stock \nmarket direction, but is rather an approach based on the value of the option-what \n932 \nChapter 42: The Best Strategy? 933 \nis generally called volatility trading. If the ne", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 410}
{"text": "is proven slightly wrong, he can still make money. \nHowever, if he is gravely wrong, relatively large percentage losses might occur. The \nthird broad category of strategies is the one that is not oriented toward picking stock \nmarket direction, but is rather an approach based on the value of the option-what \n932 \nChapter 42: The Best Strategy? 933 \nis generally called volatility trading. If the net change in the market is small over a \nperiod of time, these strategies should perform well: ratio writing, ratio spreading \n(especially \"delta neutral spreads\"), straddle and strangle writing, neutral calendar \nspreading, and butterfly spreads. On the other hand, if options are cheap and the \nmarket is expected to be volatile, then these would be best: straddle and strangle \nbuys, backspreads, and reverse hedges and spreads. \nCertain other strategies overlap into more than one of the three broad \ncategories. For example, the bullish or bearish calendar spread is initially a neutral \nposition. It only assumes a bullish or bearish bias after the near-term option expires. \nIn fact, any of the diagonal or calendar strategies whose ultimate aim is to generate \nprofits on the sale of shorter-term options are similar in nature. If these near-term \nprofits are generated, they can offset, partially or completely, the cost oflong options. \nThus, one might potentially own options at a reduced cost and could profit from a \ndefinitive move in his favor at the right time. It was shown in Chapters 14, 23, and \n24 that diagonalizing a spread can often be very attractive. \nThis brief grouping into three broad categories, does not cover all the strategies \nthat have been discussed. For example, some strategies are generally to be avoided \nby most investors: high-risk naked option writing (selling options for fractional prices) \nand covered or ratio put writing. In essence, the investor will normally do best with \na position that has limited risk and the potential of large profits. Even if the profit \npotential is a low-probability event, one or two successful cases may be able to over\ncome a series of limited losses. Complex strategies that fit this description are the \ndiagonal put and call combinations described in Chapters 23 and 24. The simplest \nstrategy fitting this description is the T-bill/option purchase program described in \nChapter 26. \nFinally, many strategies may be implemented in more than one way. The \nmethod of implementation may not alter the profit potential, but the percentage risk \nlevels can be substantially different. Equivalent strategies fit into this category. \nExample: Buying stock and then protecting the stock purchase with a put purchase \nis an equivalent strategy in profit potential to buying a call. That is, both have limit\ned dollar risk and large potential dollar profit if the stock rallies. However, they are \nsubstantially different in their structure. The purchase of stock and a put requires \nsubstantially more initial investment dollars than does the purchase of a call, but the \nlimited dollar risk of the strategy would normally be a relatively small percentage of \nthe initial investment. The call purchase, on the other hand, involves a much small\ner capital outlay; in addition, while it also has limited dollar risk, the l~ss may easily \nrepresent the entire initial investment. The stockholder will receive cash dividends \nwhile the call holder will not. Moreover, the stock will not expire as the call will. This \n934 Part VI: Measuring and Trading Volatility \nprovides the stock/put holder with an additional alternative of choosing to extend his \nposition for a longer period of time by buying another put or possibly by just contin\nuing to hold the stock after the original put expires. \nMany equivalent positions have similar characteristics. The straddle purchase \nand the reverse hedge (short stock and buy calls) have similar profit and loss poten\ntial when measured in dollars. Their percentage risks are substantially different, how\never. In fact, as was shown in Chapter 20, another strategy is equivalent to both of \nthese-buying stock and buying several puts. That is, buying a straddle is equivalent \nto buying 100 shares of stock and simultaneously buying two puts. The \"buy stock and \nputs\" strategy has a larger initial dollar investment, but the percentage risk is small\ner and the stockholder will receive any dividends paid by the common stock. \nIn summary, the investor must know two things well: the strategy that he is con\ntemplating using, and his own attitude toward risk and reward. His own attitude \nrepresents suitability, a topic that is discussed more fully in the following section. \nEvery strategy has risk. It would not be proper for an investor to pursue the best \nstrategy in the universe (such a strategy does not exist, of course) if the risks of that \nstrategy violated the investor's own level of financial objectives or accepted investment \nmethodology. On the other hand, it is also not sufficient for the investor to merely feel \nthat a strategy is suitable for his investment objectives. Suppose an investor felt that \nthe T-bill/option strategy was suitable for him because of the profit and risk levels. \nEven if he understands the philosophies of option purchasing, it would not be proper \nfor him to utilize the strategy unless he also understands the mechanics of buying \nTreasury bills and, more important, the concept of annualized risk. \nWHAT IS BEST FOR ME MIGHT NOT BE BEST FOR YOU \nIt is impossible to classify any one strategy as the best one. The conservative investor \nwould certainly not want to be an outright buyer of options. For him, covered call \nwriting might be the best strategy. Not only would it accomplish his financial aims\nmoderate profit potential with reduced risk-but it would be much more appealing \nto him psychologically. The conservative investor normally understands and accepts \nthe risks of stock ownership. It is only a small step from that under", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 411}
{"text": "uld certainly not want to be an outright buyer of options. For him, covered call \nwriting might be the best strategy. Not only would it accomplish his financial aims\nmoderate profit potential with reduced risk-but it would be much more appealing \nto him psychologically. The conservative investor normally understands and accepts \nthe risks of stock ownership. It is only a small step from that understanding to the \ncovered call writing strategy. The aggressive investor would most likely not consider \ncovered call writing to be the best strategy, because he would consider the profit \npotential too small. He is willing to take larger risks for the opportunity to make larg\ner profits. Outright option purchases might suit him best, and he would accept, by \nhis aggressive stature, that he could lose nearly all his money in a relatively short time \nChapter 42: The Best Strategy? 935 \nperiod. ( Of course, one would hope that he uses only 15 to 20% of his assets for spec\nulative option buying.) \nMany investors fit somewhere in between the conservative description and the \naggressive description. They might want to have the opportunity to make large prof\nits, but certainly are not willing to risk a large percentage of their available funds in \na short period of time. Spreads might therefore appeal to this type of investor, espe\ncially the low-debit bullish or bearish calendar spreads. He might also consider occa\nsional ventures into other types of strategies-bullish or bearish spreads, straddle \nbuys or writes, and so on-but would generally not be into a wide range of these \ntypes of positions. The T-bill/option strategy might work well for this investor also. \nThe wealthy aggressive investor may be attracted by strategies that offer the \nopportunity to make money from credit positions, such as straddle or combination \nwriting. Although ratio writing is not a credit strategy, it might also appeal to this type \nof investor because of the large amounts of time value premium that are gathered in. \nThese are generally strategies for the wealthier investor because he needs the \"stay\ning power\" to be able to ride out adverse cycles. If he can do this, he should be able \nto operate the strategy for a sufficient period of time in order to profit from the con\nstant selling of time value premiums. \nIn essence, the answer to the question of \"which strategy is best\" again revolves \naround that familiar word, \"suitability.\" The financial needs and investment objectives \nof the individual investor are more important than the merits of the strategy itself. It \nsounds nice to say that he would like to participate in strategies with limited risk and \npotentially large profits. Unfortunately, if the actual mechanics of the strategy involve \nrisk that is not suitable for the investor, he should not use the strategy, no matter how \nattractive it sounds. \nExample: The T-bill/option strategy seems attractive: limited risk because only 10% \nof one's assets are subjected to risk annually; the remaining 90% of one's assets earn \ninterest; and if the option profits materialize, they could be large. What if the worst \nscenario unfolds? Suppose that poor option selections are continuously made and \nthere are three or four years of losses, coupled with a declining rate of interest earned \nfrom the Treasury bills (not to mention the commission charges for trading the secu\nrities). The portfolio might have lost 15 or 20% of its assets over those years. A good \ntest of suitability is for the investor to ask himself, in advance: \"How will I react if the \nworst case occurs?\" If there will be sleepless nights, pointing of fingers, threats, and \nso forth, the strategy is unsuitable. If, on the other hand, the investor believes that he \nwould be disappointed (because no one likes to lose money), but that he can with\nstand the risk, the strategy may indeed be suitable. \n936 Part VI: Measuring and Trading Volatility \nMATHEMATICAL RANKING \nThe discussion above demonstrates that it is not possible to ultimately define the best \nstrategy when one considers the background, both financial and psychological, of the \nindividual investor. However, the reader may be interested in knowing which strate\ngies have the best mathematical chances of success, regardless of the investor's per\nsonal feelings. Not unexpectedly, strategies that take in large amounts of time value \npremium have high mathematical expectations. These include ratio writing, ratio \nspreading, straddle writing, and naked call writing (but only if the \"rolling for cred\nits\" follow-up strategy is adhered to). The ratio strategies would have to be operated \naccording to a delta-neutral ratio in order to be mathematically optimum. Unfor\ntunately, these strategies are not for everyone. All involve naked options, and also \nrequire that the investor have a substantial amount of money ( or collateral) available \nto make the strategies work properly. Moreover, naked option writing in any form is \nnot suitable for some investors, regardless of their protests to the contrary. \nAnother group of strategies that rank high on an expected profit basis are those \nthat have limited risk with the potential of occasionally attaining large profits. The T\nhill/option strategy is a prime example of this type of strategy. The strategies in which \none attempts to reduce the cost of longer-term options through the sale of near-term \noptions fit in this broad category also, although one should limit his dollar commit\nment to 15 to 20% of his portfolio. Calendar spreads such as the combinations \ndescribed in Chapter 23 (calendar combination, calendar straddle, and diagonal but\nterfly spread) or bullish call calendar spreads or bearish put calendar spreads are all \nexamples of such strategies. These strategies may have a rather frequent probability \nof losing a small amount of money, coupled with a low probability of earning large \nprofits. Still, a few large profits may be able to more than overcome the fre", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 412}
{"text": "r 23 (calendar combination, calendar straddle, and diagonal but\nterfly spread) or bullish call calendar spreads or bearish put calendar spreads are all \nexamples of such strategies. These strategies may have a rather frequent probability \nof losing a small amount of money, coupled with a low probability of earning large \nprofits. Still, a few large profits may be able to more than overcome the frequent, but \nsmall, losses. Ranking behind these strategies are the ones that offer limited profits \nwith a reasonable probability of attaining that profit. Covered call writing, large debit \nbull or bear spreads (purchased option well in-the-money and possible written option \nas well), neutral calendar spreads, and butterfuly spreads fit into this category. \nUnfortunately, all these strategies involve relatively large commission costs. \nEven though these are not strategies that normally require a large investment, the \ninvestor who wants to reduce the percentage effect of commissions must take larger \npositions and will therefore be advancing a sizable amount of money. \nSpeculative buying and spreading strategies rank the lowest on a mathematical \nbasis. The T-bill/option strategy is not a speculative buying strategy. In-the-money \npurchases, including the in-the-money combination, generally outrank out-of-the\nmoney purchases. This is because one has the possibility of making a large percent\nage profit but has decreased the chance of losing all his investment, since he starts \nChapter 42: The Best Strategy? 937 \nout in-the-money. In general, however, the constant purchase of time value premi\nums, which must waste away by the time the options expire, will have a burdensome \nnegative effect. The chances of large profits and large losses are relatively equal on a \nmathematical basis, and thus become subsidiary to the time premium effect in the \nlong run. This mathematical outlook, of course, precludes those investors who are \nable to predict stock movements with an above-average degree of accuracy. Although \nthe true mathematical approach holds that it is not possible to accurately predict the \nmarket, there are undoubtedly some who can and many who try. \nSUMMARY \nMathematical expectations for a strategy do not make it suitable even if the expect\ned returns are good, for the improbable may occur. Profit potentials also do not \ndetermine suitability; risk levels do. In the final analysis, one must determine the \nsuitability of a strategy by determining if he will be able to withstand the inherent \nrisks if the worst scenario should occur. For this reason, no one strategy can be des\nignated as the best one, because there are numerous attitudes regarding the degree \nof risk that is acceptable. \nPostscript \nOption strategies cannot be unilaterally classified as aggressive or conservative. \nThere are certainly many aggressive applications, the simplest being the outright pur\nchase of calls or puts. However, options can also have conservative applications, most \nnotably in reducing some of the risks of common stock ownership. In addition, there \nare less polarized applications, particularly spreading techniques, that allow the \ninvestor to take a middle-of-the-road approach. \nConsequently, the investor himself-not options--becomes the dominant force \nin determining whether an option strategy is too risky. It is imperative that the \ninvestor understand what he is trying to accomplish in his portfolio before actually \nimplementing an option strategy. Not only should he be cognizant of the factors that \ngo into determining the initial selection of the position, but he must also have in mind \na plan of follow-up action. If he has thought out, in advance, what action he will take \nif the underlying entity rises or falls, he will be in a position to make a more rational \ndecision when and if it does indeed make a move. The investor must also determine \nif the risk of the strategy is acceptable according to his financial means and objec\ntives. If the risk is too high, the strategy is not suitable. \nEvery serious investor owes it to himself to acquire an understanding of listed \noption strategies. Since various options strategies are available for a multitude of pur\nposes, alrrwst every money manager or dedicated investor will be able to use options \nin his strategies at one time or another. For a stock-oriented investor to ignore the \npotential advantages of using options would be as serious a mistake as it would be for \na large grain company to ignore the hedging properties available in the futures mar\nket, or as it would be for an income-oriented investor to concentrate only in utilities \nand Treasury bills while ignoring less well known, but equally compatible, alterna\ntives such as GNMAs. \n938 \nPostsaipt 939 \nMoreover, in today's markets, with options being available on futures, equities, \nand indices, the strategist in any one field should familiarize himself with the others, \nbecause any of them will provide profit opportunities at one time or another. \n\nAppendices \n\nStrategy Sullllllary \nExcept for arbitrage strategies and tax strategies, the strategies we have described \ndeal with risk of market movement. It is therefore often convenient to summarize \noption strategies by their risk and reward characteristics and by their market out\nlook-bullish, bearish, or neutral. Table A-1 lists all the risk strategies that were dis\ncussed and gives a general classification of their risks and rewards. If a strategist has \na definite attitude about the market's outlook or about his own willingness to accept \nrisks, he can scan Table A-1 and select the strategies that most closely resemble his \nthinking. The number in parentheses after the strategy name indicates the chapter in \nwhich the strategy was discussed. \nTable A-1 gives a broad classification of the various risk and reward potentials \nof the strategies. For example, a bullish call calendar spread does not actually have \nunlimited profit potential unless its n", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 413}
{"text": "an Table A-1 and select the strategies that most closely resemble his \nthinking. The number in parentheses after the strategy name indicates the chapter in \nwhich the strategy was discussed. \nTable A-1 gives a broad classification of the various risk and reward potentials \nof the strategies. For example, a bullish call calendar spread does not actually have \nunlimited profit potential unless its near-tenn call expires worthless. In fact, all cal\nendar spread or diagonal spread positions have limited profit potential at best until \nthe near-term options expire. \nAlso, the definition of limited risk can vary widely. Some strategies do have a \nrisk that is truly limited to a relatively small percentage of the initial investment-the \nprotected stock purchase, for example. In other cases, the risk is limited but is also \nequal to the entire initial investment. That is, one could lose 100% of his investment \nin a short time period. Option purchases and bull, bear, or calendar spreads are \nexamples. \nThus, although Table A-1 gives a broad perspective on the outlook for various \nstrategies, one must be aware of the differences in reward, risk, and market outlook \nwhen actually implementing one of the strategies. \n943 \n944 \nTABLE A-1. \nGeneral strategy summary. \nStrategy (Chapter) \nBullish strategies \nCall purchase (3) \nSynthetic long stock (short put/long call) (21) \nBull spread-puts or calls (7 and 22) \nProtected stock purchase (long stock/long put) ( 17) \nBullish call calendar spread (9) \nCovered call writing (2) \nUncovered put write ( 19) \nBearish Strategies \nPut purchase ( 16) \nProtected short sale (synthetic put) (4 and 16) \nSynthetic short sale (long put/short call) (21) \nBear spread-put or call (and 22) \nCovered put write ( 19) \nBearish put calendar spread (22) \nNaked call write (5) \nNeutral strategies \nStraddle purchase ( 1 8) \nReverse hedge (simulated straddle buy) (4) \nFixed income + option purchase (25) \nDiagonal spread (14, 23, and 24) \nNeutral calendar spread-puts or calls (9 and 22) \nButterfly spread ( 10 and 23) \nCalendar straddle or combination (23) \nReverse spread ( 13) \nRatio write-put or call (6 and 19) \nStraddle or combination write (20) \nRatio spread-put or call ( 11 and 24) \nRatio calendar spread-put or call (12 and 24) \nRisk \nLimited \nUnlimited 0 \nLimited \nLimited \nLimited \nUnlimited 0 \nUnlimited 0 \nLimited \nLimited \nUnlimited \nLimited \nUnlimited \nLimited \nUnlimited \nLimited \nLimited \nLimited \nLimited \nLimited \nLimited \nLimited \nLimited \nUnlimited \nUnlimited \nUnlimited \nUnlimited \nAppendix A \nReward \nUnlimited \nUnlimited \nLimited \nUnlimited \nUnlimited \nLimited \nLimited \nUnlimited 0 \nUnlimited 0 \nUnlimited 0 \nLimited \nLimited \nUnlimited 0 \nLimited \nUnlimited \nUnlimited \nUnlimited \nUnlimited \nLimited \nLimited \nUnlimited \nUnlimited \nLimited \nLimited \nLimited \nUnlimited \n0 Wherever the risk or reword is limited only by the fact that o stock cannot foll below zero in price, \nthe entry is marked. Obviously, although the potential may technically be limited, it could still be quite \nlarge if the underlying stock did foll a large distance. \nAPPENDIX B \nEquivalent Positions \nSome strategies can be constructed with either puts or calls to attain the same prof\nit potential. These are called equivalent strategies and are given in Table B-1. They \ndo not necessarily have the same potential returns, because the investment required \nmay be quite different. However, equivalent positions have profit graphs with exact\nly the same shape. \nOther equivalences can be determined by combining any two strategies in the \nleft-hand column and setting that combination equivalent to the two corresponding \nstrategies in the right-hand column. \n945 \n946 \nTABLE B-1. \nEquivalent strategies. \nThis Strategy is equivalent to \nCall purchase \nPut purchase \nLong stock \nShort stock \nNaked call write \nNaked put write \nBullish call spread \n(long call at lower strike/ \nshort call at higher strike) \nBearish call spread \n(long call at higher strike/ \nshort call at lower strike) \nRatio call write \n(long stock/short calls) \n... and is also equivalent to ... \nStraddle buy (long call/long put) \nAppendix B \nThis Strategy \nLong stock/long put \nShort stock/long call (synthetic put) \nLong call/ short put (synthetic stock) \nLong put/ short call (synthetic short sale) \nShort stock/short put \nCovered call write (long stock/ short call) \nBullish put spread \n(long put at lower strike/ \nshort put at higher strike) \nBearish put spread \n(long put at higher strike/ \nshort put at lower strike) \nStraddle write (short put/short call) \nRatio put write (short stock/ short puts) \nReverse hedge (short stock/long calls) \nor buy stock/buy puts \nButterfly call spread Butterfly put spread \n(long 1 call at each outside strike/ (long one put at each outer strike/ \nshort 2 calls at middle strike) short two calls at middle strike) \nAll four of these \"butterfly\" strategies are equivalent \nButterfly combination Protected straddle write \n(bullish call spread at two (short straddle at middle strike/ \nlower strikes/bearish put spread \nat two higher strikes) \nlong call at highest strike/ \nlong put at lowest strike \nAPPENDIX C \nFormulae \nChapter references are given in parentheses. The following notation is used through\nout this appendix. \nX = current stock price \ns = striking price \nC = call price \np = put price \nr = interest rate \nt = time (in years) \nB = break-even point \nu = upside break-even point \nD = downside break-even point \np = maximum profit potential \nR = maximum risk potential \nSubscripts indicate multiple items. For example s1, s2, s3 would designate three \nstriking prices in a formula. The formulae are arranged alphabetically by title or by \nstrategy. \n948 \nAnnualized Risk (Ch. 26) \nAnnualized risk = L INV 360 \ni \n1\nHi \nwhere INVi = percent of total assets invested in options \nwith holding periods, Hi \nlength of holding period in days \nBear Spread \n-Calls (Ch. 8) \n-Puts (Ch. 22) \np = Cl - C2 \nR = s2 - s1 - P \nB = s1 + P \nR = P2 - Pl \np = S2", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 414}
{"text": "e three \nstriking prices in a formula. The formulae are arranged alphabetically by title or by \nstrategy. \n948 \nAnnualized Risk (Ch. 26) \nAnnualized risk = L INV 360 \ni \n1\nHi \nwhere INVi = percent of total assets invested in options \nwith holding periods, Hi \nlength of holding period in days \nBear Spread \n-Calls (Ch. 8) \n-Puts (Ch. 22) \np = Cl - C2 \nR = s2 - s1 - P \nB = s1 + P \nR = P2 - Pl \np = S2 - S1 - R \nB = s1 + P = s2 + Pl - P2 \nBlack Model (Ch. 34): \nX \ns \nC \np \nr \nTheoretical futures call price= e-rt x BSM[r = 0%] \nwhere BSM[r = O) is the Black-Scholes Model \nusing r = 0% as the short-term interest rate \nPut price = Call price - e-rt x (f - s) \nwhere f = futures price \ncurrent stock price \nstriking price \ncall price \nput price \ninterest rate \ntime (in years) \nB \nu \nD \np \nR \nbreak-even point \nupside break-even point \ndownside break-even point \nmaximum profit potential \nmaximum risk potential \nf futures price \nAppendix C \nSubscripts indicate multiple items. For example s1, s2, s3 would designate three striking prices in a formula. \nThe formulae are arranged alphabetically by title or by strategy. \nAppendix C \nBlack-Scholes Model (Ch. 28) \nwhere d1 \nandd2 \nln \nN() \nV \nDelta \nBull Spread \n= \n= \n= \n= \n= \n= \nTheoretical call price= xN(d 1) - se-rtN(d2) \nln(x/s) + (r + ½v2)t \nvTt \nd1 -v-ft \nnatural logarithm \ncumulative normal density function \nannual volatility \nN(d1) \n-Calls ( Ch. 7) \n-Puts (Ch. 22) \nButterfly Spread \nR = C1 - C2 \nP = s2- s1 - R \nB = s2 - P = s 1 - c2 + c1 \nP = P2 -p1 \nR = s2- s1 - P \nB = s2- P \n949 \nA butterfly spread combines a bull spread using strikes s1 and s2 with a bear \nspread using strikes s2 and s3. \n-if using all calls (Ch. 10) \nR = c1 + c3 - 2c2 \n-if using all puts ( Ch. 23) \nR =PI+ P2 - 2p2 \n-if using put bull spread and call bear spread ( Ch. 23) \np = C2 + P2 - C3 - p 1 \n950 \n-if using call bull spread and put bear spread ( Ch. 23) \nR = P2 + c2 - PI c3 - s3 + s2 \nThen \nP = s3 - s2 - R or R = s3 - s2 - P \nD = s1 + R \nU = S3-R \nCombination Buy (Ch. 18) \nS1 < S2 \nOut-of-the-money: R = c2 + PI \nIn-the-money: R = c1 + p2 - s2 + s1 \nD = s1 -P \nU = s2 + P \nCombination Sale (Ch. 20) \nX \ns \nC \np \nr \nOut-of-the-money: P = c2 + PI \nIn-the-money: P = c1 + p2 - s2 + s1 \nD = s1 -P \ncurrent stock price \nstriking price \ncall price \nput price \ninterest rate \ntime (in years) \nB \nu \nD \np \nR \nbreak-even point \nupside break-even point \ndownside break-even point \nmaximum profit potential \nmaximum risk potential \nf futures price \nAppendix C \nSubscripts indicate multiple items. For example s1, s2, s3 would designate three striking prices in a fonnula. \nThe formulae are arranged alphabetically by title or by strategy. \n950 \n-if using call bull spread and put bear spread ( Ch. 23) \nR = p2 + c2 - Pl - c3 - s3 + s2 \nThen \nP = s3 - s2 - R or R = s3 - s2 - P \nD = s1 + R \nU = S3-R \nCombination Buy (Ch. 18) \nS1 < S2 \nOut-of-the-money: R = c2 + Pl \nIn-the-money: R = c1 + p2 - s2 + s1 \nD = s1 -P \nU = s2 + P \nCombination Sale (Ch. 20) \nOut-of-the-money: P = c2 + PI \nIn-the-money: P = c1 + p2 s2 + s1 \nD = s1 - P \nX \ns \nC \np \ncurrent stock price \nstriking price \ncall price \nput price \nr interest rate \nt ~ time (in years) \nf futures price \nU = s2 + P \nB \nu \nD \np \nR \nbreak-even point \nupside break-even point \ndownside break-even point \nmaximum profit potential \nmaximum risk potential \nAppendix C \nSubscripts indicate multiple items. For example s1, s2, s3 would designate three striking prices in a formula. \nThe formulae are arranged alphabetically by title or by strategy. \n950 \n-if using call bull spread and put bear spread ( Ch. 23) \nR = P2 + c2 - PI - c3 - s3 + s2 \nThen \nP = s3 - s2 - R or R = s3 - s2 - P \nD =SI+ R \nU = S3-R \nCombination Buy (Ch. 18) \nS1 < S2 \nOut-of-the-money: R = c2 + PI \nIn-the-money: R = cI + p2 - s2 + sI \nD = SI -P \nU = s2 + P \nCombination Sale (Ch. 20) \nOut-of-the-money: P = c2 + PI \nIn-the-money: P = cI + P2 - s2 + sI \nD = sI -P \nX \ns \nC \np \ncurrent stock price \nstriking price \ncall price \nput price \nr interest rate \nt = time ( in years) \nf futures price \nU = s2 + P \nB \nu \nD \np \nR \nbreak-even point \nupside break-even point \ndownside break-even point \nmaximum profit potential \nmaximum risk potential \nAppendix C \nSubscripts indicate multiple items. For example s1, s2, s3 would designate three striking prices in a formula. \nThe formulae are arranged alphabetically by title or by strategy. \nAppendix C \nConversion and Reversal Profit (Ch. 27) \nConversion: P = s + c - x - p + dividends - carrying cost \nReversal: P = x + p - c - s - dividends + carrying cost \nwhere \n951 \n. t {srt (simple interest) carrymg cos = \ns[l- (1 + r)-t] (compound interest, present worth) \nCovered Call Write (Ch. 2) \nP=s+c-x \nB =X-C \nCovered Straddle Write (Ch. 20) \nP=s+c+p x \nB = s - ½P = ½(x + s - p - c) \nCumulative Normal Density Function (Ch. 28) \nApproximation by fifth-order polynomial \na= 1- z(l.330274y 5 - l.821256y 4 + l.781478y 3 - .3565638y2 \n+ .3193815y) \n1 \nwhere y = l + .23164191crl \nz = .3989423e--0212 \nThen \nN(cr) = fa \nU-a \nDelta-see Black-Scholes Model \nDelta Neutral Ratio: \n-stock versus option (Ch. 6) \nifcr>O \nifcr<O \nNeutral ratio = 1 ~ De ta o option \n-spread (Chs. 11 and 24) \n952 \nN t l t. Delta of long option eu ra ra 10 = -----=---=--Delta of short option \nEquivalent Futures Position (Ch. 34) \nEFP = Delta x Number of options \nEquivalent Stock Position (Ch. 28) \nESP = Unit of trading x Delta x number of options \nAppendix C \nwhere unit of trading is the number of shares of the underlying stock that \ncan be bought or sold with the option (normally 100). \nFutures Contract Fair Value (Ch. 29) \n-Stock index futures \nIndex value x (1 + rt) + Present worth (dividends) \nAlso see Present worth. \nFuture Stock Price (Ch. 28) \nwhere \n-lognormal distribution, assuming a movement of a fixed number of stan\ndard deviations \nq = future stock price \nVt = volatility for the time period \na = number of standard deviations of movement \n(normally-3.0::; a::; 3.0) \nGamma (Ch. 40) \nX \ns \nC \np \nr \nlet z =", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 415}
{"text": ") \n-Stock index futures \nIndex value x (1 + rt) + Present worth (dividends) \nAlso see Present worth. \nFuture Stock Price (Ch. 28) \nwhere \n-lognormal distribution, assuming a movement of a fixed number of stan\ndard deviations \nq = future stock price \nVt = volatility for the time period \na = number of standard deviations of movement \n(normally-3.0::; a::; 3.0) \nGamma (Ch. 40) \nX \ns \nC \np \nr \nlet z = In [ x ] /v --ft + v --ft \nS X (1 + r)t 2 \nThen (-x212) \nr- __ e-===--\n- xv ✓ 2nt \ncurrent stock price B \nstriking price \ncall price \nput price \ninterest rate \ntime (in years) \nu \nD \np \nR \nbreak-even point \nupside break-even point \ndownside break-even point \nmaximum profit potential \nmaximum risk potential \nSubscripts indicate multiple items. For example s1, s2, s3 would designate three striking prices in a formula. \nThe formulae are arranged alphabetically by title or by strategy. \nAppendix C \nProbability of Stock Movement (Ch. 28) \n-lognormal distribution \nP(below q) = N {1:~q/x)} \nP(above q) = 1- P(below q) \nwhere \nq = stock price in question \nN() = cumulative normal density function \nIn = natural logarithm \nVt = volatility for the time period \nPresent Worth of a Future Arrwunt (Ch. 28) \np t rth _ Future amount resen wo - (l + r)t \nPut Pricing Model-Arbitrage Model (Ch. 28) \nwhere \nTheoretical put price = Theoretical call price + s - x + dividends \n- carrying cost \n. t { srt (simple interest) carrv1ng cos = \n· r s [1- (1 + r)-t] (compound interest, present worth) \nRatio Call Write (Ch. 6) \nGeneral case: long m round lots of stock, short n calls \nP = m(s -x) + nc \nU=s+-P __ \nn-m \np \nD=s-m \n2:1 ratio (straddle sale) \nP=s-x+2c \nU=s+p \nD=s-p=x-2c \n953 \n954 Appendix C \nRatio Spread \n-Calls (Ch. 11): buy n1 calls at lower strike, s1, and sell n2 calls at higher \nstrike, s2 \nS1 < s2 \nn1 < n2 \nR = n1c1 - n2c2 \nP = (s2-s1)n1 -R \np \nU=s2+ --n2-n1 \nBreak-even cost of long calls for follow-up action (Ch. 11) \nBreak-even cost = n2(s2 - si) - R \nn2 n1 \n-Puts (Ch. 24): buy n2 puts at higher strike, s2, and sell n1 puts at lower \nstrike, s1 \nS1 < S2 \nn2 < n1 \nR = n2p2 - n1p1 \nP = n2(s2 - s1) - R \np \nD =S1 ----n1 -n2 \nReversal-See Conversion and Reversal Profit \nReverse Hedge (Ch. 4)-simulated straddle purchase \nGeneral case: short m round lots of stock and long n calls \nR = m(s -x) + nc \nU=s+-R-n-m \nR D=s--m \nX \ns \nC \ncurrent stock price \nstriking price \ncall price \np put price \nr interest rate \nt = time (in years) \nB \nu \nD \np \nR \nbreak-even point \nupside break-even point \ndownside break-even point \nmaximum profit potential \nmaximum risk potential \nSubscripts indicate multiple items. For example s1, s2, s3 would designate three striking prices in a formula. \nThe formulae are arranged alphabetically by title or by strategy. \nAppendix C \n2:1 ratio (straddle buy): \nR=s+2c-x \nU=s+R \nD=s-R=x 2c \nUsing puts (long 100 stock, long 2 puts) (Ch. 18) \nR = x + 2p-s \nStraddle Buy (Ch. 18) \nStraddle Sale ( Ch. 20) \nU = s + R = x + 2p \nD =s-R \nR=p+c \nU = s + R \nD=-R \nP=p+c \nU=s+p \nD =s-p \nSynthetic Put Purchase-short stock and long call ( Ch. 4) \nR=s+c-x \nB = s-c \nVariable Ratio Write (Ch. 6) \n-long 100 shares of stock, short one call at strike s1, short one call at \nstrike s2 \np = Cl + C2 + S1 - X \nD = s1 - P = x - c1 - c2 \nU = s2 + P \n955 \n954 Appendix C \nRatio Spread \n-Calls (Ch. 11): buy n1 calls at lower strike, s1, and sell n2 calls at higher \nstrike, s2 \ns1 < s2 \nn1 < n2 \nR = n1c1 - n2c2 \nP = (s2 - s1)n1 -R \np \nU=s 2 +--n2-n1 \nBreak-even cost oflong calls for follow-up action (Ch. 11) \nBreak-even cost = n2(s2 - si) - R \nn2-n1 \n-Puts (Ch. 24): buy n2 puts at higher strike, s2, and sell n1 puts at lower \nstrike, s1 \nS1 < S2 \nn2 < n1 \nR = n2p2 - n1p1 \nP = n2(s2 - s1) - R \np D =S1----\nn1 -n2 \nReversed-See Conversion and Reversal Profit \nReverse Hedge (Ch. 4)-simulated straddle purchase \nGeneral case: short m round lots of stock and long n calls \nR = m(s -x) + nc \nU=s+-R-n-m \nR D=s--m \nX \ns \nC \ncurrent stock price \nstriking price \ncall price \np put price \nr interest rate \nt = time (in years) \nB \nu \nD \np \nR \nbreak-even point \nupside break-even point \ndownside break-even point \nmaximum profit potential \nmaximum risk potential \nSubscripts indicate multiple items. For example s1, s2, s3 would designate three striking prices in a formula. \nThe formulae are arranged alphabetically by title or by strategy. \nAppendix C \n2:1 ratio (straddle buy): \nR=s+2c-x \nU = s + R \nD=s-R=x-2c \nUsing puts (long 100 stock, long 2 puts) (Ch. 18) \nR = x + 2p -s \nStraddle Buy (Ch. 18) \nStraddle Sale ( Ch. 20) \nU = s + R = x + 2p \nD=s-R \nR=p+c \nU = s + R \nD=-R \nP=p+c \nu = s +p \nD =S-p \nSynthetic Put Purchase-short stock and long call ( Ch. 4) \nR=s+c-x \nB = s-c \nVariable Ratio Write (Ch. 6) \n-long 100 shares of stock, short one call at strike s1, short one call at \nstrike s2 \np = Cl + C2 + S 1 - X \nD = S1 - p = X - C1 - C2 \nU = S2 + p \n955 \n956 Appendix C \nVolatility-Standard Deviation (Ch. 28) \nWhere \nn \nL (xi - x)2 \ni l \nV2=----\nn-l \nxi = daily stock closing price \nx = mean (average) of the x/s \nn = number of observations \n-if vis the annual volatility, then the volatility for a time period, t, is \nVt= V ..ft \nGraphs \nChapter references are in parentheses. \nA. Intrinsic Value-Call (Ch. 1) \nC. Call Option Pricing Curve \n(Ch. 1) \nB. Intrinsic Value-Put (Ch. 15) \nD. Put Option Pricing Curve \n(Ch. 15) \n957 \n958 \nE. Time Value Premium Decay \n(Ch. 1) \nG. Call Purchase (Ch. 1) \n(long stock/long put-Ch. 17) \nI. Covered Call Write (Ch. 2) \nNaked Put Write (Ch. 19) \nF. Lognormal Distribution \n(Ch. 28) \nH. Put Purchase (Ch. 16) \n(short stock/long call-Ch. 4) \nJ. Naked Call Write (Ch. 5) \n(short stock/sh01t put\nCh. 19) \nAppendix D \nAppendix D \nK. Bull Spread (Chs. 7 and 22) \n( covered call write + long put \nout-of-the-money-Ch. 17) \n1_, / \nM. Calendar Spread (Chs. 9 and \n22) \n0. Naked Straddle Write (Ch. 20) \nRatio Call Write (long 100 \nstock, short 2 calls-Ch. 6) \nRatio Put Write (short 100 \nstock, short 2 puts-Ch. 19) \nIA \nL. Bear Spread (Chs. 8 and 22) \nN.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 416}
{"text": "ed Call Write (Ch. 5) \n(short stock/sh01t put\nCh. 19) \nAppendix D \nAppendix D \nK. Bull Spread (Chs. 7 and 22) \n( covered call write + long put \nout-of-the-money-Ch. 17) \n1_, / \nM. Calendar Spread (Chs. 9 and \n22) \n0. Naked Straddle Write (Ch. 20) \nRatio Call Write (long 100 \nstock, short 2 calls-Ch. 6) \nRatio Put Write (short 100 \nstock, short 2 puts-Ch. 19) \nIA \nL. Bear Spread (Chs. 8 and 22) \nN. Butterfly Spread ( Chs. 10 and \n23) \nP. Straddle Purchase (Ch. 18) \nReverse hedge (short 100 \nstock, long 2 calls-Ch. 4) \nPut Hedge (long 100 stock, \nlong 2 puts-Ch. 18) \n959 \n960 \nQ. Combination Sale (Ch. 20) \nVariable Ratio Write (long 100 \nstock, short 2 calls with \ndifferent strikes-Ch. 6) \n7 \nS. Ratio Call Spread (Ch. 11) \nU. Reverse Calendar Spread \n(Ch. 13) \nI~ \nAppendix D \nR. Combination Purchase (Ch. 18) \n(short 100 stock, long 2 calls \nwith different strikes-Ch. 4) \nT. Ratio Put Spread (Ch. 24) \nQualified Covered Calls \nFor tax purposes, there is no effect on the holding period of the stock when one \nwrites an out-of-the-money call. However, when one writes an in-the-money call, \nhe eliminates the holding period on his common stock unless the stock is already \nheld long-term. The only exception to this is that if the covered call is deemed to \nbe qualified, then the holding period is merely suspended rather than eliminated. \nTable E-1 shows the lowest striking price that may be written if the stock is in the \nprice range shown. \n961 \nTABLE E-1. ~ \nQualified covered call options. \n~ \nCall is not \"deep-in-the-money\" Call is not \nII \ndeep-in-the-money\" \nApplicable if Strike Price2 is at least: Applicable if Strike Price2 is at least: \nStock More than Stock More than \nPrice1 31-90-Day Call 90-Day Call Price1 31-90-Day Call 90-Day Call \n5.13-5.88 5 5 75.13-80 75 70 \n6-10 None None 80.13-85 80 75 \n10.13-11.75 10 10 85.13-90 85 80 \n11.88-15 None None 90.13-95 90 85 \n15.13-17.63 15 15 95.13-100 95 90 \n17.75-20 None None 100.13-105 100 95 \n20.13-23.50 20 20 105.13-110 100 100 \n23.63-25 None None 110.13-120 110 110 \n25.13-30 25 25 120.13-130 120 120 \n30.13-35 30 30 130.13-140 130 130 \n35.13-40 35 35 140.13-150 140 140 \n40.13-45 40 40 150.13-160 150 140 \n45.13-50 45 45 160.13-170 160 150 \n50.13-55 50 50 170.13-180 170 160 \n55.13-60 55 55 180.13-190 180 170 \n60.13-65 60 55 190.13-200 190 180 \n65.13-70 65 60 200.13-210 200 190 \n70.13-75 70 65 210.13-220 210 200 \n1 Applicable stock price is either the closing price of the stock on the day preceding the date the option was granted, or the opening price on \nt the day the option is granted if such price is greater than 100% of the preceding day's closing price. \n2Assumption is that strike prices are only at $5 intervals up to $ 100 and $10 intervals over $100. Note: If the stock splits, option strike prices 5:c· \nwill have smaller intervals for a period of time. \"\"' \nGlossary \nAmerican Exercise: a feature of an option that indicates it may be exercised at any \ntime. Therefore, it is subject to early assignment. \nArbitrage: the process in which professional traders simultaneously buy and sell the \nsame or equivalent securities for a riskless profit. See also Risk Arbitrage. \nAssign: to designate an option writer for fulfillment of his obligation to sell stock (call \noption writer) or buy stock (put option writer). The writer receives an assignment \nnotice from the Options Clearing Corporation. See also Early Exercise. \nAssignment Notice: see Assign. \nAutomatic Exercise: a protection procedure whereby the Options Clearing \nCorporation attempts to protect the holder of an expiring in-the-money option by \nautomatically exercising the option on behalf of the holder. \nAverage Down: to buy more of a security at a lower price, thereby reducing the \nholder's average cost. (Average Up: to buy more at a higher price.) \nBackspread: see Reverse Strategy. \nBear Spread: an option strategy that makes its maximum profit when the underly\ning stock declines and has its maximum risk if the stock rises in price. The strate\ngy can be implemented with either puts or calls. In either case, an option with a \nhigher striking price is purchased and one with a lower striking price is sold, both \noptions generally having the same expiration date. See also Bull Spread. \nBearish: an adjective describing an opinion or outlook that expects a decline in \nprice, either by the general market or by an underlying stock, or both. See also \nBullish. \n963 \n964 Glossary \nBeta: a measure of how a stock's movement correlates to the movement of the entire \nstock market. The beta is not the same as volatility. See also Standard Deviation, \nVolatility. \nBlack Model: a model used to predict futures option prices; it is a modified version \nof the Black-Scholes model. See Model. \nBoard Broker: the exchange member in charge of keeping the book of public \norders on exchanges utilizing the \"market-maker\" system, as opposed to the \"spe\ncialist system,\" of executing orders. See also Market-Maker, Specialist. \nBox Spread: a type of option arbitrage in which both a bull spread and a bear spread \nare established for a riskless profit. One spread is established using put options and \nthe other is established using calls. The spreads may both be debit spreads ( call \nbull spread vs. put bear spread), or both credit spreads (call bear spread vs. put \nbull spread). \nBreak-Even Point: the stock price (or prices) at which a particular strategy neither \nmakes nor loses money. It generally pertains to the result at the expiration date of \nthe options involved in the strategy. A \"dynamic\" break-even point is one that \nchanges as time passes. \nBroad-Based: generally referring to an index, it indicates that the index is composed \nof a sufficient number of stocks or of stocks in a variety of industry groups. Broad\nbased indices are subject to more favorable treatment for naked option writers. \nSee also Narrow- Based. \nBull Spread: an option strategy that achieves its maximum potential if the underly\ning security rises f", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 417}
{"text": "s as time passes. \nBroad-Based: generally referring to an index, it indicates that the index is composed \nof a sufficient number of stocks or of stocks in a variety of industry groups. Broad\nbased indices are subject to more favorable treatment for naked option writers. \nSee also Narrow- Based. \nBull Spread: an option strategy that achieves its maximum potential if the underly\ning security rises far enough, and has its maximum risk if the security falls far \nenough. An option with a lower striking price is bought and one with a higher strik\ning price is sold, both generally having the same expiration date. Either puts or \ncalls may be used for the strategy. See also Bear Spread. \nBullish: describing an opinion or outlook in which one expects a rise in price, either \nby the general market or by an individual security. See also Bearish. \nButterfly Spread: an option strategy that has both limited risk and limited profit \npotential, constructed by combining a bull spread and a bear spread. Three strik\ning prices are involved, with the lower two being utilized in the bull spread and the \nhigher two in the bear spread. The strategy can be established with either puts or \ncalls; there are four different ways of combining options to construct the same \nbasic position. \nCalendar Spread: an option strategy in which a short-term option is sold and a \nlonger-term option is bought, both having the same striking price. Either puts or \nGlossary 965 \ncalls may be used. A calendar combination is a strategy that consists of a call cal\nendar spread and a put calendar spread at the same time. The striking prices of \nthe calls would be higher than the striking prices of the puts. A calendar straddle \nconsists of selling a near-term straddle and buying a longer-term straddle, both \nwith the same striking price. \nCalendar Straddle or Combination: see Calendar spread. \nCall: an option that gives the holder the right to buy the underlying security at a \nspecified price for a certain, fixed period of time. See also Put. \nCall Price: the price at which a bond or preferred stock may be called in by the issu\ning corporation; see Redemption Price. \nCapitalization-Weighted Index: a stock index that is computed by adding the cap\nitalizations (float times price) of each individual stock in the index, and then divid\ning by the divisor. The stocks with the largest market values have the heaviest \nweighting in the index. See also Divisor, Float, Price-Weighted Index. \nCarrying Cost: the interest expense on a debit balance created by establishing a \nposition. \nCash- Based: Referring to an option or future that is settled in cash when exercised \nor assigned. No physical entity, either stock or commodity, is received or delivered. \nCBOE: the Chicago Board Options Exchange; the first national exchange to trade \nlisted stock options. \nCircuit Breaker: a limit applied to the trading of index futures contracts designed \nto keep the stock market from crashing. \nClass: a term used to refer to all put and call contracts on the same underlying secu\nrity. \nClosing Transaction: a trade that reduces an investor's position. Closing buy trans\nactions reduce short positions and closing sell transactions reduce long positions. \nSee also Opening Transaction. \nCollateral: the loan value of marginable securities; generally used to finance the \nwriting of uncovered options. \nCombination: (1) any position involving both put and call options that is not a strad\ndle. See also Straddle. (2) the name given to the trade at expiration whereby an \narbitrageur rolls his options from one month to the next. For example, if he sells \nhis synthetic long stock position in June and reestablishes it by buying a synthetic \nlong stock position in September, the entire four-sided trade is called a combina\ntion by floor traders. See also Straddle, Strangle. \n966 Glossary \nCommodities: see Futures Contract. \nContingent Order: an order whose execution or price is dependent on the align\nment or price of the underlying security and/or its options. Most commonly it is an \norder to buy stock and sell a covered call option that is given as one order to the \ntrading desk of a brokerage firm. Also called a \"net order.\" This is a \"not held\" \norder. See also Market Not Held Order. \nConversion Arbitrage: a riskless transaction in which the arbitrageur buys the \nunderlying security, buys a put, and sells a call. The options have the same terms. \nSee also Reversal Arbitrage. \nConversion Ratio: see Convertible Security. \nConverted Put: see Synthetic Put. \nConvertible Security: a security that is convertible into another security. Generally, \na convertible bond or convertible preferred stock is convertible into the underly\ning stock of the same corporation. The rate at which the shares of the bond or pre\nferred stock are convertible into the common is called the conversion ratio. \nCover: to buy back as a closing transaction an option that was initially written, or \nstock that was initially sold short. \nCovered: a written option is considered to be covered if the writer also has an oppos\ning market position on a share-for-share basis in the underlying security. That is, a \nshort call is covered if the underlying stock is owned, and a short put is covered \n(for margin purposes) if the underlying stock is also short in the account. In addi\ntion, a short call is covered if the account is also long another call on the same secu\nrity, with a striking price equal to or less than the striking price of the short call. A \nshort put is covered if there is also a long put in the account with a striking price \nequal to or greater than the striking price of the short put. \nCovered Call Write: a strategy in which one writes call options while simultane\nously owning an equal number of shares of the underlying stock. \nCovered Put Write: a strategy in which one sells put options and simultaneously is \nshort an equal number of shares of the underlying security. \nCovered Straddle Write: the term use", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 418}
{"text": "ing price \nequal to or greater than the striking price of the short put. \nCovered Call Write: a strategy in which one writes call options while simultane\nously owning an equal number of shares of the underlying stock. \nCovered Put Write: a strategy in which one sells put options and simultaneously is \nshort an equal number of shares of the underlying security. \nCovered Straddle Write: the term used to describe the strategy in which an \ninvestor owns the underlying security and also writes a straddle on that security. \nThis is not really a covered position. \nCredit: money received in an account. A credit transaction is one in which the net \nsale proceeds are larger than the net buy proceeds ( cost), thereby bringing money \ninto the account. See also Debit. \nGlossary 967 \nCycle: the expiration dates applicable to various classes of options. There are three \ncycles: January/April/July/October, February/May/ August/November, and \nMarch/J une/Septem ber/Decem ber. \nDebit: an expense, or money paid out from an account. A debit transaction is one in \nwhich the net cost is greater than the net sale proceeds. See also Credit. \nDeliver: to take securities from an individual or firm and transfer them to another \nindividual or firm. A call writer who is assigned must deliver stock to the call hold\ner who exercised. A put holder who exercises must deliver stock to the put writer \nwho is assigned. \nDelivery: the process of satisfying an equity call assignment or an equity put exer\ncise. In either case, stock is delivered. For futures, the process of transferring the \nphysical commodity from the seller of the futures contract to the buyer. \nEquivalent delivery refers to a situation in which delivery may be made in any of \nvarious, similar entities that are equivalent to each other (for example, Treasury \nbonds with differing coupon rates). \nDelta: (1) the amount by which an option's price will change for a corresponding 1-\npoint change in price by the underlying entity. Call options have positive deltas, \nwhile put options have negative deltas. Technically, the delta is an instantaneous \nmeasure of the option's price change, so that the delta will be altered for even frac\ntional changes by the underlying entity. Consequently, the terms \"up delta\" and \n\"down delta\" may be applicable. They describe the option's change after a full 1-\npoint change in price by the underlying security, either up or down. The \"up delta\" \nmay be larger than the \"down delta\" for a call option, while the reverse is true for \nput options. (2) the percent probability of a call being in-the-money at expiration. \nSee also Hedge Ratio. \nDelta Neutral Spread: a ratio spread that is established as a neutral position by uti\nlizing the deltas of the options involved. The neutral ratio is determined by divid\ning the delta of the purchased option by the delta of the written option. See also \nDelta, Ratio Spread. \nDepository Trust Corporation (OTC): a corporation that will hold securities for \nmember institutions. Generally used by option writers, the DTC facilitates and \nguarantees delivery of underlying securities when assignment is made against \nsecurities held in DTC. \nDiagonal Spread: any spread in which the purchased options have a longer matu\nrity than do the written options, as well as having different striking prices. Typical \n968 Glossary \ntypes of diagonal spreads are diagonal bull spreads, diagonal bear spreads, and \ndiagonal butterfly spreads. \nDiscount: an option is trading at a discount if it is trading for less than its intrinsic \nvalue. A future is trading at a discount if it is trading at a price less than the cash \nprice of its underlying index or commodity. See also Intrinsic Value, Parity. \nDiscount Arbitrage: a riskless arbitrage in which a discount option is purchased \nand an opposite position is taken in the underlying security. The arbitrageur may \neither buy a call at a discount and simultaneously sell the underlying security \n(basic call arbitrage), or buy a put at a discount and simultaneously buy the under\nlying security (basic put arbitrage). See also Discount. \nDiscretion: see Limit Order, Market Not Held Order. \nDividend Arbitrage: in the riskless sense, an arbitrage in which a put is purchased \nand so is the underlying stock. The put is purchased when it has time value pre\nmium less than the impending dividend payment by the underlying stock. The \ntransaction is closed after the stock goes ex-dividend. Also used to denote a form \nof risk arbitrage in which a similar procedure is followed, except that the amount \nof the impending dividend is unknown and therefore risk is involved in the trans\naction. See also Ex-Dividend, Time Value Premium. \nDivisor: a mathematical quantity used to compute an index. It is initially an arbitrary \nnumber that reduces the index value to a small, workable number. Thereafter the \ndivisor is adjusted for stock splits (price-weighted index) or additional issues of \nstock (capitalization-weighted index). \nDownside Protection: generally used in connection with covered call writing, this \nis the cushion against loss, in case of a price decline by the underlying security, that \nis afforded by the written call option. Alternatively, it may be expressed in terms \nof the distance the stock could fall before the total position becomes a loss (an \namount equal to the option premium), or it can be expressed as percentage of the \ncurrent stock price. See also Covered Call Write. \nDynamic: for option strategies, describing analyses made during the course of \nchanging security prices and during the passage of time. This is as opposed to an \nanalysis made at expiration of the options used in the strategy. A dynamic break\neven point is one that changes as time passes. A dynamic follow-up action is one \nthat will change as either the security price changes or the option price changes or \ntime passes. See also Break-Even Point, Follow-Up Action. \nEarly Exercise (assignment): the exercise or assign", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 419}
{"text": "ssage of time. This is as opposed to an \nanalysis made at expiration of the options used in the strategy. A dynamic break\neven point is one that changes as time passes. A dynamic follow-up action is one \nthat will change as either the security price changes or the option price changes or \ntime passes. See also Break-Even Point, Follow-Up Action. \nEarly Exercise (assignment): the exercise or assignment of an option contract \nbefore its expiration date. \n968 Glossary \ntypes of diagonal spreads are diagonal bull spreads, diagonal bear spreads, and \ndiagonal butterfly spreads. \nDiscount: an option is trading at a discount if it is trading for less than its intrinsic \nvalue. A future is trading at a discount if it is trading at a price less than the cash \nprice of its underlying index or commodity. See also Intrinsic Value, Parity. \nDiscount Arbitrage: a riskless arbitrage in which a discount option is purchased \nand an opposite position is taken in the underlying security. The arbitrageur may \neither buy a call at a discount and simultaneously sell the underlying security \n(basic call arbitrage), or buy a put at a discount and simultaneously buy the under\nlying security (basic put arbitrage). See also Discount. \nDiscretion: see Limit Order, Market Not Held Order. \nDividend Arbitrage: in the riskless sense, an arbitrage in which a put is purchased \nand so is the underlying stock. The put is purchased when it has time value pre\nmium less than the impending dividend payment by the underlying stock. The \ntransaction is closed after the stock goes ex-dividend. Also used to denote a form \nof risk arbitrage in which a similar procedure is followed, except that the amount \nof the impending dividend is unknown and therefore risk is involved in the trans\naction. See also Ex-Dividend, Time Value Premium. \nDivisor: a mathematical quantity used to compute an index. It is initially an arbitrary \nnumber that reduces the index value to a small, workable number. Thereafter the \ndivisor is adjusted for stock splits (price-weighted index) or additional issues of \nstock (capitalization-weighted index). \nDownside Protection: generally used in connection with covered call writing, this \nis the cushion against loss, in case of a price decline by the underlying security, that \nis afforded by the written call option. Alternatively, it may be expressed in terms \nof the distance the stock could fall before the total position becomes a loss (an \namount equal to the option premium), or it can be expressed as percentage of the \ncurrent stock price. See also Covered Call Write. \nDynamic: for option strategies, describing analyses made during the course of \nchanging security prices and during the passage of time. This is as opposed to an \nanalysis made at expiration of the options used in the strategy. A dynamic break\neven point is one that changes as time passes. A dynamic follow-up action is one \nthat will change as either the security price changes or the option price changes or \ntime passes. See also Break-Even Point, Follow-Up Action. \nEarly Exercise (assignment): the exercise or assignment of an option contract \nbefore its expiration date. \n968 Glossary \ntypes of diagonal spreads are diagonal bull spreads, diagonal bear spreads, and \ndiagonal butterfly spreads. \nDiscount: an option is trading at a discount if it is trading for less than its intrinsic \nvalue. A future is trading at a discount if it is trading at a price less than the cash \nprice of its underlying index or commodity. See also Intrinsic Value, Parity. \nDiscount Arbitrage: a riskless arbitrage in which a discount option is purchased \nand an opposite position is taken in the underlying security. The arbitrageur may \neither buy a call at a discount and simultaneously sell the underlying security \n(basic call arbitrage), or buy a put at a discount and simultaneously buy the under\nlying security (basic put arbitrage). See also Discount. \nDiscretion: see Limit Order, Market Not Held Order. \nDividend Arbitrage: in the riskless sense, an arbitrage in which a put is purchased \nand so is the underlying stock. The put is purchased when it has time value pre\nmium less than the impending dividend payment by the underlying stock. The \ntransaction is closed after the stock goes ex-dividend. Also used to denote a form \nof risk arbitrage in which a similar procedure is followed, except that the amount \nof the impending dividend is unknown and therefore risk is involved in the trans\naction. See also Ex-Dividend, Time Value Premium. \nDivisor: a mathematical quantity used to compute an index. It is initially an arbitrary \nnumber that reduces the index value to a small, workable number. Thereafter the \ndivisor is adjusted for stock splits (price-weighted index) or additional issues of \nstock (capitalization-weighted index). \nDownside Protection: generally used in connection with covered call writing, this \nis the cushion against loss, in case of a price decline by the underlying security, that \nis afforded by the written call option. Alternatively, it may be expressed in terms \nof the distance the stock could fall before the total position becomes a loss (an \namount equal to the option premium), or it can be expressed as percentage of the \ncurrent stock price. See also Covered Call Write. \nDynamic: for option strategies, describing analyses made during the course of \nchanging security prices and during the passage of time. This is as opposed to an \nanalysis made at expiration of the options used in the strategy. A dynamic break\neven point is one that changes as time passes. A dynamic follow-up action is one \nthat will change as either the security price changes or the option price changes or \ntime passes. See also Break-Even Point, Follow-Up Action. \nEarly Exercise (assignment): the exercise or assignment of an option contract \nbefore its expiration date. \nGlossary 969 \nEquity Option: an option that has common stock as its underlying security. See also \nNon-Equity Option.", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 420}
{"text": "ic follow-up action is one \nthat will change as either the security price changes or the option price changes or \ntime passes. See also Break-Even Point, Follow-Up Action. \nEarly Exercise (assignment): the exercise or assignment of an option contract \nbefore its expiration date. \nGlossary 969 \nEquity Option: an option that has common stock as its underlying security. See also \nNon-Equity Option. \nEquity Requirement: a requirement that a minimum amount of equity must be \npresent in a margin account. Normally, this requirement is $2,000, but some bro\nkerage firms may impose higher equity requirements for uncovered option writing. \nEquivalent Positions: positiohs that have similar profit potential, when measured \nin dollars, but are constructed with differing securities. Equivalent positions have \nthe same profit graph. A covered call write is equivalent to an uncovered put write, \nfor example. See also Profit Graph. \nEscrow Receipt: a receipt issued by a bank in order to verify that a customer ( who has \nwritten a call) in fact owns the stock and therefore the call is considered covered. \nEuropean Exercise: a feature of an option that stipulates that the option may be \nexercised only at its expiration. Therefore, there can be no early assignment with \nthis type of option. \nExchange-Traded Fund (ETF): an index fund that is listed on a stock exchange. \nOptions are listed on some ETFs. See also Index Fund. \nEx-Dividend: the process whereby a stock's price is reduced when a dividend is \npaid. The ex-dividend date (ex-date) is the date on which the price reduction takes \nplace. Investors who own stock on the ex-date will receive the dividend, and those \nwho are short stock must pay out the dividend. \nExercise: to invoke the right granted under the terms of a listed options contract. \nThe holder is the one who exercises. Call holders exercise to buy the underlying \nsecurity, while put holders exercise to sell the underlying security. \nExercise Limit: the limit on the number of contracts a holder can exercise in a fixed \nperiod of time. Set by the appropriate option exchange, it is designed to prevent \nan investor or group of investors from \"cornering\" the market in a stock. \nExercise Price: the price at which the option holder may buy or sell the underlying \nsecurity, as defined in the terms of his option contract. It is the price at which the \ncall holder may exercise to buy the underlying security or the put holder may exer\ncise to sell the underlying security. For listed options, the exercise price is the \nsame as the striking price. See also Exercise. \nExpected Return: a rather complex mathematical analysis involving statistical dis\ntribution of stock prices, it is the return an investor might expect to make on an \ninvestment if he were to make exactly the same investment many times through\nout history. \n970 Glossary \nExpiration Date: the day on which an option contract becomes void. The expiration \ndate for listed stock options is the Saturday after the third Friday of the expiration \nmonth. All holders of options must indicate their desire to exercise, if they wish to \ndo so, by this date. See also Expiration Time. \nExpiration Time: the time of day by which all exercise notices must be received on \nthe expiration date. Technically, the expiration time is currently 5:00 P.M. on the \nexpiration date, but public holders of option contracts must indicate their desire \nto exercise no later than 5:30 P.M. on the business day preceding the expiration \ndate. The times are Eastern Time. See also Expiration Date. \nFacilitation: the process of providing a market for a security. Normally, this refers \nto bids and offers made for large blocks of securities, such as those traded by insti\ntutions. Listed options may be used to offset part of the risk assumed by the trad\ner who is facilitating the large block order. See also Hedge Ratio. \nFair Value: normally, a term used to describe the worth of an option or futures con\ntract as determined by a mathematical model. Also sometimes used to indicate \nintrinsic value. See also Intrinsic Value, Model. \nFirst Notice Day: the first day upon which the buyer of a futures contract can be \ncalled upon to take delivery. See also Notice Period. \nFloat: the number of shares outstanding of a particular common stock. \nFloor Broker: a trader on the exchange floor who executes the orders of public cus\ntomers or other investors who do not have physical access to the trading area. \nFollow-Up Action: any trading in an option position after the position is established. \nGenerally, to limit losses or to take profits. \nFundamental Analysis: a method of analyzing the prospects of a security by observ\ning accepted accounting measures such as earnings, sales, assets, and so on. See \nalso Technical Analysis. \nFutures Contract: a standardized contract calling for the delivery of a specified \nquantity of a commodity at a specified date in the future. \nGamma: a measure of risk of an option that measures the amount by which the delta \nchanges for a I-point change in the stock price; alternatively, when referring to an \nentire option position, the amount of change of the delta of the entire position \nwhen the stock changes in price by one point. \nGamma of the Gamma: a mathematical measure of risk that measures by how \nmuch the gamma will change for a I-point move in the stock price. See Gamma. \nGlossary 971 \nGood Until Canceled (GTC): a designation applied to some types of orders, mean\ning that the order remains in effect until it is either filled or canceled. See also \nLimit, Stop-Limit Order, Stop Order. \nHedge Ratio: the mathematical quantity that is equal to the delta of an option. It is \nuseful in facilitation in that a theoretically riskless hedge can be established by tak\ning offsetting positions in the underlying stock and its call options. See also Delta, \nFacilitation. \nHistoric Volatility: See Volatility. \nHolder: the owner of a security. \nHorizontal Spread: an option strategy", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 421}
{"text": "Stop Order. \nHedge Ratio: the mathematical quantity that is equal to the delta of an option. It is \nuseful in facilitation in that a theoretically riskless hedge can be established by tak\ning offsetting positions in the underlying stock and its call options. See also Delta, \nFacilitation. \nHistoric Volatility: See Volatility. \nHolder: the owner of a security. \nHorizontal Spread: an option strategy in which the options have the same striking \nprice, but different expiration dates. \nImplied Volatility: a prediction of the volatility of the underlying stock, it is deter\nmined by using prices currently existing in the option market at the time, rather \nthan using historical data on the price changes of the underlying stock See also \nVolatility. \nIncremental Return Concept: a strategy of covered call writing in which the \ninvestor is striving to earn an additional return from option writing against a stock \nposition that he is targeted to sell, possibly at substantially higher prices. \nIndex: a compilation of the prices of several common entities into a single number. \nSee also Capitalization-Weighted Index, Price-Weighted Index. \nIndex Arbitrage: a form of arbitraging index futures against stock If futures are \ntrading at prices significantly higher than fair value, the arbitrager sells futures and \nbuys the exact stocks that make up the index being arbitraged; if futures are at a \ndiscount to fair value, the arbitrage entails buying futures and selling stocks. \nIndex Fund: a mutual fund whose components exactly match the stocks that make \nup a widely disseminated index, such as the S&P 500, Dow-Jones, Russell 2000, or \nNASDAQ-100. See also Exchange-Traded Fund. \nIndex Option: an option whose underlying entity is an index. Most index options are \ncash-based. \nInstitution: an organization, probably very large, engaged in investing in securities. \nNormally a bank, insurance company, or mutual fund. \nIntermarket Spread: a futures spread in which futures contracts in one market are \nspread against futures contracts trading in another market. Examples: Currency \nspreads (yen vs. deutsche mark) or TED spread (T-Bills vs. Eurodollars). \n972 Glossary \nIn-the-Money: a term describing any option that has intrinsic value. A call option is \nin-the-money if the underlying security is higher than the striking price of the call. \nA put option is in-the-money if the security is below the striking price. See also \nIntrinsic Value, Out-of-the-Money. \nIntramarket Spread: a futures spread in which futures contracts are spread against \nother futures contracts in the same market; example, buy May soybeans, sell \nMarch soybeans. \nIntrinsic Value: the value of an option if it were to expire immediately with the \nunderlying stock at its current price; the amount by which an option is in-the\nmoney. For call options, this is the difference between the stock price and the \nstriking price, if that difference is a positive number, or zero otherwise. For put \noptions it is the difference between the striking price and the stock price, if that \ndifference is positive, and zero otherwise. See also In-the-Money, Parity, Time \nValue Premium. \nLast Trading Day: the third Friday of the expiration month. Options cease trading \nat 3:00 P.M. Eastern Time on the last trading day. \nLEAPS: Long-term Equity Anticipation Securities. These are long-term listed \noptions, currently having maturities as long as two and one-half years. \nLeg: a risk-oriented method of establishing a two-sided position. Rather than enter\ning into a simultaneous transaction to establish the position (a spread, for exam\nple), the trader first executes one side of the position, hoping to execute the other \nside at a later time and a better price. The risk materializes from the fact that a \nbetter price may never be available, and a worse price must eventually be accept\ned. \nLetter of Guarantee: a letter from a bank to a brokerage firm stating that a cus\ntomer (who has written a call option) does indeed own the underlying stock and \nthe bank will guarantee delivery if the call is assigned. Thus, the call can be con\nsidered covered. Not all brokerage firms accept letters of guarantee. \nLeverage: in investments, the attainment of greater percentage profit and risk \npotential. A call holder has leverage with respect to a stockholder-the former will \nhave greater percentage profits and losses than the latter, for the same movement \nin the underlying stock. \nLimit: see Trading Limit. \nLimit Order: an order to buy or sell securities at a specified price (the limit). A limit \norder may also be placed \"with discretion\" -a fixed; usually small, amount such as \n1/s or ¼ of a point. In this case, the floor broker executing the order may use his \nGlossary 973 \ndiscretion to buy or sell at 1/s or ¼ of a point beyond the limit if he feels it is nec\nessary to fill the order. \nListed Option: a put or call option that is traded on a national option exchange. \nListed options have fixed striking prices and expiration dates. See also Over-the\nCounter Option. \nLocal: a trader on a futures exchange who buys and sells for his own account and \nmay fill public orders. \nLognormal Distribution: a statistical distribution that is often applied to the move\nment of the stock prices. It is a convenient and logical distribution because it \nimplies that stock prices can theoretically rise forever but cannot fall below zero-\na fact which is, of course, true. \nMargin: to buy a security by borrowing funds from a brokerage house. The margin \nrequirement-the maximum percentage of the investment that can be loaned by \nthe broker firm-is set by the Federal Reserve Board. \nMarket Basket: a portfolio of common stocks whose performance is intended to \nsimulate the performance of a specific index. See Index. \nMarket-Maker: an exchange member whose function is to aid in the making of a \nmarket, by making bids and offers for his account in the absence of public buy or \nsell orders. Several market-makers are", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 422}
{"text": "oaned by \nthe broker firm-is set by the Federal Reserve Board. \nMarket Basket: a portfolio of common stocks whose performance is intended to \nsimulate the performance of a specific index. See Index. \nMarket-Maker: an exchange member whose function is to aid in the making of a \nmarket, by making bids and offers for his account in the absence of public buy or \nsell orders. Several market-makers are normally assigned to a particular security. \nThe market-maker system encompasses the market-makers and the board bro\nkers. See also Board Broker, Specialist. \nMarket Not Held Order: also a market order, but the investor is allowing the floor \nbroker who is executing the order to use his own discretion as to the exact timing \nof the execution. If the floor broker expects a decline in price and he is holding a \n\"market not held\" buy order, he may wait to buy, figuring that a better price will \nsoon be available. There is no guarantee that a \"market not held\" order will be \nfilled. \nMarket Order: an order to buy or sell securities at the current market. The order \nwill be filled as long as there is a market for the security. \nMarried Put and Stock: a put and stock are considered to be married if they are \nbought on the same day, and the position is designated at that time as a hedge. \nModel: a mathematical formula designed to price an option as a function of certain \nvariables-generally stock price, striking price, volatility, time to expiration, divi\ndends to be paid, and the current risk-free interest rate. The Black\nScholes model is one of the more widely used models. \n974 Glossary \nMonte Carlo Simulation: a model designed to simulate a real-world event that can\nnot be approximated merely with a mathematical formula. The Monte Carlo sim\nulation approximates such an event (the movement of the stock market, for exam\nple) and then it is simulated a great number of times. The net result of all the sim\nulations is then interpreted as the result, generally expressed as a probability of \noccurrence. For example, a Monte Carlo simulation can be used to determine how \nstocks might behave under certain stock price distributions that are different from \nthe lognormal distribution. \nNaked Option: see Uncovered Option. \nNarrow-Based: Generally referring to an index, it indicates that the index is com\nposed of only a few stocks, generally in a specific industry group. Narrow-based \nindices are not subject to favorable treatment for naked option writers. See also \nBroad-Based. \n\"Net\" Order: see Contingent Order. \nNeutral: describing an opinion that is neither bearish or bullish. Neutral option \nstrategies are generally designed to perform best if there is little nor no net change \nin the price of the underlying stock. See also Bearish, Bullish. \nNon-Equity Option: an option whose underlying entity is not common stock; typi\ncally refers to options on physical commodities, but may also be extended to \ninclude index options. \n\"Not Held\": see Market Not Held Order. \nNotice Period: the time during which the buyer of a futures contract can be called \nupon to accept delivery. Typically, the 3 to 6 weeks preceding the expiration of the \ncontract. \nOpen Interest: the net total of outstanding open contracts in a particular option \nseries. An opening transaction increases the open interest, while any closing trans\naction reduces the open interest. \nOpening Transaction: a trade that adds to the net position of an investor. An open\ning buy transaction adds more long securities to the account. An opening sell \ntransaction adds more short securities. See also Closing Transaction. \nOption Pricing Curve: a graphical representation of the projected price of an \noption at a fixed point in time. It reflects the amount of time value premium in the \noption for various stock prices, as well. The curve is generated by using a mathe\nmatical model. The delta ( or hedge ratio) is the slope of a tangent line to the curve \nat a fixed stock price. See also Delta, Hedge Ratio, Model. \nGlossary 975 \nOptions Clearing Corporation (OCC): the issuer of all listed option contracts that \nare trading on the national option exchanges. \nOriginal Issue Discount (O1D): the initial price of a zero-coupon bond. The owner \nowes taxes on the theoretical interest, or phantom income, generated by the annu\nal appreciation of the bond toward maturity. In reality, no interest is paid by the \nzero-coupon bond, but the government is taxing the appreciation of the bond as if \nit were interest. \nOut-of-the-Money: describing an option that has no intrinsic value. A call option is \nout-of-the-money if the stock is below the striking price of the call, while a put \noption is out-of-the-money if the stock is higher than the striking price of the put. \nSee also In-the-Money, Intrinsic Value. \nOver-the-Counter Option (OTC): an option traded over-the-counter, as opposed \nto a listed stock option. The OTC option has a direct link between buyer and sell\ner, has no secondary market, and has no standardization of striking prices and expi\nration dates. See a'lso Listed Option, Secondary Market. \nOvervalued: describing a security trading at a higher price than it logically should. \nNormally associated with the results of option price predictions by mathematical \nmodels. If an option is trading in the market for a higher price than the model indi\ncates, the option is said to be overvalued. See a'/so Fair Value, Undervalued. \nPairs Trading: a hedging technique in which one buys a particular stock and sells \nshort another stock. The two stocks are theoretically linked in their price history, \nand the hedge is established when the historical relationship is out of line, in hopes \nthat it will return to its former correlation. \nParity: describing an in-the-money option trading for its intrinsic value: that is, an \noption trading at parity with the underlying stock. Also used as a point of refer\nence-an option is sometimes said to be trading at a half-point over parity or at a \nquart", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 423}
{"text": "ry, \nand the hedge is established when the historical relationship is out of line, in hopes \nthat it will return to its former correlation. \nParity: describing an in-the-money option trading for its intrinsic value: that is, an \noption trading at parity with the underlying stock. Also used as a point of refer\nence-an option is sometimes said to be trading at a half-point over parity or at a \nquarter-point under parity, for example. An option trading under parity is a dis\ncount option. See a'/so Discount, Intrinsic Value. \nPERCS: Preferred Equity Redemption Cumulative Stock. Issued by a corporation, \nthis preferred stock pays a higher dividend than the common and has a price at \nwhich it can be called in for redemption by the issuing corporation. As such, it is \nreally a covered call write, with the call premium being given to the holder in the \nform of increased dividends. See Call Price, Covered Call Write, Redemption Price. \nPhysical Option: an option whose underlying security is a physical commodity that \nis not stock or futures. The physical commodity itself, typically a currency or \n976 Glossary \nTreasury debt issue, underlies that option contract. See also Equity Option, Index \nOption. \nPortfolio Insurance: a method of selling index futures or buying index put options \nto protect a portfolio of stocks. \nPosition: as a noun, specific securities in an account or strategy. A covered call writ\ning position might be long 1,000 XYZ and short 10 XYZ January 30 calls. As a verb, \nto facilitate; to buy or sell-generally a block of securities-thereby establishing a \nposition. See also Facilitation, Strategy. \nPosition Limit: the maximum number of put or call contracts on the same side of \nthe market that can be held in any one account or group of related accounts. Short \nputs and long calls are on the same side of the market. Short calls and long puts \nare on the same side of the market. \nPremium: for options, the total price of an option contract. The sum of the intrinsic \nvalue and the time value premium. For futures, the difference between the \nfutures price and the cash price of the underlying index or commodity. \nPresent Worth: a mathematical computation that determines how much money \nwould have to be invested today, at a specified rate, in order to produce a desig\nnated amount at some time in the future. For example, at 10% for one year, the \npresent worth of $ll0 is $100. \nPrice-Weighted Index: a stock index that is computed by adding the prices of each \nstock in the index, and then dividing by the divisor. See also Capitalization\nWeighted Index, Divisor. \nProfit Graph: a graphical representation of the potential outcomes of a strategy. \nDollars of profit or loss are graphed on the vertical axis, and various stock prices \nare graphed on the horizontal axis. Results may be depicted at any point in time, \nalthough the graph usually depicts the results at expiration of the options involved \nin the strategy. \nProfit Range: the range within which a particular position makes a profit. Generally \nused in reference to strategies that have two break-even points-an upside break\neven and a downside break-even. The price range between the two break-even \npoints would be the profit range. See also Break-Even Point. \nProfit Table: a table of results of a particular strategy at some point in time. This is \nusually a tabular compilation of the data drawn on a profit graph. See also Profit \nGraph. \nGlossary 917 \nProgram Trading: the act of buying or selling a particular portfolio of stocks and \nhedging with an offsetting position in index futures. The portfolio of stocks may be \nsmall or large, but it is not the makeup of any stock index. See also Index Arbitrage. \nProtected Strategy: a position that has limited risk. A protected short sale (short \nstock, long call) has limited risk, as does a protected straddle write ( short straddle, \nlong out-of-the-money combination). See also Combination, Straddle. \nPublic Book (of orders): the orders to buy or sell, entered by the public, that are \naway from the current market. The board broker or specialist keeps the public \nbook. Market-makers on the CBOE can see the highest bid and lowest offer at any \ntime. The specialist's book is closed ( only he knows at what price and in what quan\ntity the nearest public orders are). See also Board Broker, Market-Maker, \nSpecialist. \nPut: an option granting the holder the right to sell the underlying security at a cer\ntain price for a specified period of time. See also Call. \nPut-Call Ratio: the ratio of put trading volume divided by call trading volume; \nsometime~ calculated with open interest or total dollars instead of trading volume. \nCan be calculated daily, weekly, monthly, etc. Moving averages are often used to \nsmooth out short-term, daily figures. \nRatio Calendar Combination: a strategy consisting of a simultaneous position of a \nratio calendar spread using calls and a similar position using puts, where the strik\ning price of the calls is greater than the striking price of the puts. \nRatio Calendar Spread: selling more near-term options than longer-term ones \npurchased, all with the same strike, either puts or calls. \nRatio Spread: constructed with either puts or calls, the strategy consists of buying a \ncertain amount of options and then selling a larger quantity of out-of-the-money \noptions. \nRatio Strategy: a strategy in which one has an unequal number of long securities \nand short securities. Normally, it implies a preponderance of short options over \neither long options or long stock. \nRatio Write: buying stock and selling a preponderance of calls against the stock that \nis owned. ( Occasionally constructed as shorting stock and selling puts.) \nRedemption Price: the price at which a structured product may be redeemed for \ncash. This is distinctly different from a \"call price,\" which is the price at which an \nissue may be called away by the issuer. See also Call Price, PERCS, Structured \nProduct. \n978 Gloss", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 424}
{"text": "d selling a preponderance of calls against the stock that \nis owned. ( Occasionally constructed as shorting stock and selling puts.) \nRedemption Price: the price at which a structured product may be redeemed for \ncash. This is distinctly different from a \"call price,\" which is the price at which an \nissue may be called away by the issuer. See also Call Price, PERCS, Structured \nProduct. \n978 Glossary \nResistance: a term in technical analysis indicating a price area higher than the cur\nrent stock price where an abundance of supply exists for the stock, and therefore \nthe stock may have trouble rising through the price. See also Support. \nReturn (on investment): the percentage profit that one makes, or might make, on \nhis investment. \nReturn if Exercised: the return that a covered call writer would make if the under\nlying stock were called away. \nReturn if Unchanged: the return that an investor would make on a particular posi\ntion if the underlying stock were unchanged in price at the expiration of the \noptions in the position. \nReversal Arbitrage: a riskless arbitrage that involves selling the stock short, writing \na put, and buying a call. The options have the same terms. See also Conversion \nArbitrage. \nReverse Hedge: a strategy in which one sells the underlying stock short and buys \ncalls on more shares than he has sold short. This is also called a synthetic straddle \nand is an outmoded strategy for stocks that have listed puts trading. See also Ratio \nWrite, Straddle. \nReverse Strategy: a general name that is given to strategies that are the opposite of \nbetter-known strategies. For example, a ratio spread consists of buying calls at a \nlower strike and selling more calls at a higher strike. A reverse ratio spread, also \nknown as a backspread, consists of selling the calls at the lower strike and buying \nmore calls at the higher strike. The results are obviously directly opposite to each \nother. See also Reverse Hedge Ratio Write, Reverse Hedge. \nRho: the measure of how much an option changes in price for an incremental mov<' \n(generally l % ) in short-term interest rates; more significant for longer-term or i11-\nthe-money options. \nRisk Arbitrage: a form of arbitrage that has some risk associated with it. Commonly \nrefers to potential takeover situations in which the arbitrageur buys the stock of \nthe company about to be taken over and sells the stock of the company that is \neffecting the takeover. See also Dividend Arbitrage. \nRoll: a follow-up action in which the strategist closes options currently in the posi\ntion and opens other options with different terms, on the same underlying stock. \nSee also Roll Down, Roll Forward, and Roll Up. \nRoll Down: close out options at one strike and simultaneously open other options al \na lower strike. \nGlossary 979 \nRoll Forward: close out options at a near-term expiration date and open options at \na longer-term expiration date. \nRoll Up: close out options at a lower strike and open options at a higher strike. \nRotation: a trading procedure on the open exchanges whereby bids and offers, but \nnot necessarily trades, are made sequentially for each series of options on an \nunderlying stock or index. \nSecondary M~ket: any market in which securities can be readily bought and sold \nafter their initial issuance. The national listed option exchanges provided, for the \nfirst time, a secondary market in stock options. \nSerial Option: a futures option for which there is no corresponding futures contract \nexpiring in the same month. The underlying futures contract is the next futures \ncontract out in time. Example: There is no March gold futures contract, but there \nis an April gold futures contract, so March gold options, which are serial options, \nare options on April gold futures. \nSeries: all op,tion contracts on the same underlying stock having the same striking \nprice, expiration date, and unit of trading. \nSkew: See Volatility Skew. \nSpecialist: an exchange member whose function it is both to make markets-buy \nand sell for his own account in the absence of public orders-and to keep the book \nof public orders. Most stock exchanges and some option exchanges utilize the spe\ncialist system of trading \nSpread Order: an order to simultaneously transact two or more option trades. \nTypically, one option would be bought while another would simultaneously be \nsold. Spread orders may be limit orders, not held orders, or orders with discretion. \nThey cannot be stop orders, however. The spread order may be either a debit or a \ncredit. \nSpread Strategy: any option position having both long options and short options of \nthe same type on the same underlying security. \nStandard Deviation: a measure of the volatility of a stock. It is a statistical quanti\nty measuring the magnitude of the daily price changes of that stock. See also, \nVolatility. \nStop Order: an order, placed away from the current market, that becomes a market \norder if the security trades at the price specified on the stop order. Buy stop orders \nare placed above the market, while sell stop orders are placed below. \n980 Glossary \nStop-Limit Order: similar to a stop order, the stop-limit order becomes a limit \norder, rather than a market order, when the security trades at the price specified \non the stop. See also Stop Order. \nStraddle: the purchase or sale of an equal number of puts and calls having the same \nterms. \nStrangle: a combination involving a put and a call at different strikes with the same \nexpiration date. \nStrategy: with respect to option investments, a preconceived, logical plan of position \nselection and follow-up action. \nStriking Price: see Exercise Price. \nStriking Price Interval: the distance between striking prices on a particular under\nlying security. For stocks, the interval is normally 2.5 points for lower-priced stocks \nand 5 points for higher-priced stocks. For indices, the interval is either 5 or 10 \npoints. For futures, the interval is often as low as one or two points. \nStr", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 425}
{"text": "ection and follow-up action. \nStriking Price: see Exercise Price. \nStriking Price Interval: the distance between striking prices on a particular under\nlying security. For stocks, the interval is normally 2.5 points for lower-priced stocks \nand 5 points for higher-priced stocks. For indices, the interval is either 5 or 10 \npoints. For futures, the interval is often as low as one or two points. \nStructured Product: a combination of securities and possibly options into a single \nsecurity that behaves like stock and trades on a listed stock exchange. Structured \nproducts are created by many of the largest financial institutions (banks and bro\nkerage firms). Many of the more popular ones are known by their acronyms, cre\nated by the institutions that issued them: MITTS, TARGETS, BRIDGES, LINKS, \nDINKS, ELKS, and PERCS. See also PERCS. \nSubindex: see Narrow-Based. \nSuitable: describing a strategy or trading philosophy in which the investor is operat\ning in accordance with his financial means and investment objectives. \nSupport: a term in technical analysis indicating a price area lower than the current \nprice of the stock, where demand is thought to exist. Thus, a stock would stop \ndeclining when it reached a support area. See also Resistance. \nSynthetic Put: a strategy constructed by shorting the underlying instrument and \nbuying a call. The resulting position has the same profit and loss characteristics as \na long put option. \nSynthetic Stock: an option strategy that is equivalent to the underlying stock. A long \ncall and a short put is synthetic long stock. A long put and a short call is synthetic \nshort stock. \nTechnical Analysis: the method of predicting future stock price movements based \non observation of historical stock price movements. \nGlossary 981 \nTerms: the collective name denoting the expiration date, striking price, and under\nlying stock of an option contract. \nTheoretical Value: the price of an option, or a spread, as computed by a mathe\nmatical model. \nTheta: the measure of how much an option's price decays for each day of time that \npasses. \nTime Spread: see Calendar Spread. \nTime Value Premium: the amount by which an option's total premium exceeds its \nintrinsic value. \nTotal Return Concept: a covered call writing strategy in which one views the \npotential profit of the strategy as the sum of capital gains, dividends, and option \npremium.income, rather than viewing each one of the three separately. \nTracking Error: the amount of difference between the performance of a specific \nportfolio of stocks and a broad-based index with which they are being compared. \nSee Market Basket. \nTrader: a speculative investor or professional who makes frequent purchases and \nsales. \nTrading Limit: the exchange-imposed maximum daily price change that a futures \ncontract or futures option contract can undergo. \nTreasury BilVOption Strategy: a method of investment in which one places \napproximately 90% of his funds in risk-free, interest-bearing assets such as \nTreasury bills, and buys options with the remainder of his assets. \nType: the designation to distinguish between a put or call option. \nUncovered Option: a written option is considered to be uncovered if the investor \ndoes not have a corresponding position in the underlying security. See also \nCovered. \nUnderlying Security: the security that one has the right to buy or sell via the terms \nof a listed option contract. \nUndervalued: describing a security that is trading at a lower price than it logically \nshould. Usually determined by the use of a mathematical model. See also Fair \nValue, Overvalued. \nVariable Ratio Write: an option strategy in which the investor owns 100 shares of \nthe underlying security and writes two call options against it, each option having a \ndifferent striking price. \n982 Glossary \nVega: the measure of how much an option's price changes for an incremental \nchange-usually one percentage point-in volatility. \nVertical Spread: any option spread strategy in which the options have different \nstriking prices but the same expiration dates. \nVolatility: a measure of the amount by which an underlying security is expected to \nfluctuate in a given period of time. Generally measured by the annual standard \ndeviation of the daily price changes in the security, volatility is not equal to the beta \nof the stock. Also called historical volatility, statistical volatility, or actual volatility. \nSee also Implied Volatility. \nVolatility Skew: the term used to describe a phenomenon in which individual \noptions on a single underlying instrument have different implied volatilities. I 11 \ngeneral, not only are the individual options' implied volatilities different, but they \nform a pattern. If the lower striking prices have the lowest implied volatilities, and \nthen implied volatility progresses higher as one moves up through the striking \nprices, that is called a forward or positive skew. A reverse or negative skew works \nin the opposite way: The higher strikes have the lowest implied volatilities. \nWarrant: a long-term, nonstandardized security that is much like an option. \nWarrants on stocks allow one to buy (usually one share of) the common at a (\"(•r\ntain price until a certain date. Index warrants are generally warrants on the pri<·<· \nof foreign indices. Warrants have also been listed on other things such as cross-('m \nrency spreads and the future price of a barrel of oil. \nWrite: to sell an option. The investor who sells is called the writer. \nIndex \nAdjusted volatility, 539 \nAdvanced concepts, 846-907 \n\"greeks,\" 848-866, 902-905 \ndelta, 848-853, 866 \ngamma, 853-859, 867, 882 \ngamma of the gamma, 865-866, 902-905 \nrho, 864-865 \n\"six measures of risk,\" 865 \nstrategy considerations using, 866-901 (see also \nAdvanced concepts, strategy considerations, \nusing greeks) \nsummary, 866 \ntheta, 862-864, 866 \nvega/tau, 859-862, 866 \nmathematical concepts, advanced, 901-907 \ndifference of implied volatilities, measuring, 905-907 \ngamma of the", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 426}
{"text": "48-853, 866 \ngamma, 853-859, 867, 882 \ngamma of the gamma, 865-866, 902-905 \nrho, 864-865 \n\"six measures of risk,\" 865 \nstrategy considerations using, 866-901 (see also \nAdvanced concepts, strategy considerations, \nusing greeks) \nsummary, 866 \ntheta, 862-864, 866 \nvega/tau, 859-862, 866 \nmathematical concepts, advanced, 901-907 \ndifference of implied volatilities, measuring, 905-907 \ngamma of the gamma, 902-905 \n\"greeks,\" calculating, 901-902 \nneutrality, 846-847 \nstrategy considerations, using \"greeks,\" 866-901 \ndelta neutral, 868-879 \nevaluating position using risk measures, 885-892 \nmathematical approach, 883-885 \nmultifaceted neutrality, creating, 879-883 \nrisk exposure, general, of common, 866-868 \ntrading gamma from long side, 893-901 \nsummary, 907 \ntau, 859-862 \nAmerican exercise, 501-504 \nAmerican Stock Exchange, 22 \nIndex,497,500 \nstructured products listed, 618 \nArbitrage, 251-252, 253-255, 422-455, 641-644 \nblock positioning, 455 \nboxspreads,439-443,643-644 \nrisks, 443 \ncall arbitrage, 444 \ncarrying costs, 430-431 \nconversions and reversals, 428-430, 431-438, \n642-643 \nborrowing stock to sell short, 432-433 \nrisksin,fou½433-437 \nsummary, 437-438 \n\"using box stock,\" 432 \ndiscounting, 423-425, 641-642 \ndividend, 425-428 \neffects, 444-445 \nequivalence, variations on, 443-444 \nfacilitation (block positioning), 455 \n\"interest play\" strategy, 438-439 \npairs trading, 454-455 \nas hedged strategy, 454 \nput arbitrage, 445 \nput and call, basic (discounting), 423-425 \nrisk arbitrage, 21, 426-427 \ndefinition, 445 \nrisk arbitrage using options, 445-454 \n\"hooks,\" 449-450 \nlimits on merger, 448-450 \nmergers, 445-448 \nprofitability, 454 \nshort tendering, 453 \ntender offers, 451-454 (see also Tender offers) \nsynthetic put, 439-440 \nArbitrageurs, 19-21 (see also Arbitrage) \ndefinition, 422 \nrole of in butterfly spread, 338 \nbox spread, 338 \n983 \n984 \nAssignment of options, 7, 16-22 \nanticipating, 18-22 \nautomatic, 18-19 \ncall options, 7 \nof cash-based options, 501 \ncommissions, 17-18 \nmargin requirements, 16-17 \nput options, 7 \nBackspreads, 232-235 (see also Reverse spreads) \ndiagonal, 240-241 \neffect on of implied volatility changes, 781-782 \nand LEAPS, 407-408 \nBear spreads using call options, 186-190 \ncall bear spread, 186-188 \nas credit spread, 186 \nfollow-up action, 190 \nassignment of short call, impending, 190 \nselecting, 189-190 \nan aggressive position usually, 189 \nsummary, 190 \nBear spread, put, 329-332 (see also Put spreads, basic) \nBeta, 533-539 \nBlack, Fisher, 459 \nBlack-Scholes model, 456-466, 538, 610, 611, 635, 640, \n644-645,646,647-648,651,677,678, 731,734, \n758, 767-768, 798,902 (see also Mathematical \napplications) \nBlack model, 647-648, 651, 677 \ncharacteristics, 459-461 \ndividends paid by common stock not included, 459 \nformula, 456-457 \nhedge ratio, 457 \nhistorical volatility, lognormal, computing, 461-466 \nlognormal distribution of stock prices, 460 \nvega, 750 \nvolatility, computation of, 460-466 \nweighting factor, 459-460, 463-465 \nBlock positioning, 455, 482-485 (see also Mathematical \napplications) \nBoard broker system, 22 \nBox spread, 338, 439-44,3, 643-644 \nrisks, 443 \n\"Box\" stock, 432 \nBroad-based indices, 500 \nBrownian motion, 806 \nBull spread, structured product as, 608-612 \nvaluing, 610-612 \nBull spreads, 110-111, 113-116, 117, 172-185 \naggressiveness, degrees of, 175-176 \ncall bull spread, 172-173 \neffect on of implied volatility changes, 767-775 \nfollow-up action, 178-180 \ncredit spread, 179 \n\"legging\" out of spread, 180 \nand outright purchase, comparison of, 179 \nand LEAPS, 403-404 \nranking, 176-178 \ndiagonal bull spread, 177 \nsummary, 185 \nuses, other, 180-184 \nIndex \nbreak-even price on common stock, lowering, 182, \n183 \nsimple form of spreading, 180, 185 \nas \"substitute\" for covered writing, 182-184 \nvertical, 172 \nwhen options are expensive, 177 \nBull spread, put, 332-333 (see also Put spreads, basic) \nBullish calendar spread, 196-198 (see also Calendar \nspread) \nButterfly spread, 200-209, 336-338 (see also Put \nspreads, basic) \ncombination of bull and bear spreads, 200, 209 \ncommissions costly, 200, 203 \nexample, 201 \nfollow-up action, 206-209 \nassignment, 206 \n\"legging out,\" 207 \nneutral position, 200 \nresults of at expiration, 201-203 \nselecting, 203-206 \nstriking prices, three, 200-203 \nsummary, 209 \nCalendar combination of calls and puts, 345-348 \nCalendar spread, 116-117, 191-199 \nas antivolatility strategy, 194 \nbullish, 196-198, 199 \nfollow-up action, 197-198 \ndefinition, 191 \nexpiration series, using all three, 198-199 \nhorizontal spread, 191 \nin volatility trading, 825-826 \nand LEAPS, 408-409 \nmathematical calculations of volatility, applying lo. \n478-480 \nneutral, 192-194, 199 \nfollow-up action, 194-196 \nvolatility, effect of, 194 \nsummary, 199 \ntime spread another name, 191 \nvolatility changes, effect of on, 778-780 \nwith futures options, 704-709 (see also Futtm's \noptions and strategies) \nIndex \nCalendar spread, put, 333-335 (see also Put spreads, \nbasic) 333-335 \nCalendar and ratio spreads, combining, 222-229 \nchoosing spread, 225-226 \npricing model, using, 225 \ndelta-neutral calendar spreads, 227-228 \nin-the-money, 228 \nfollow-up action, 226-227, 229 \nprobabilities, good, 226-227 \nout-of-the-money call spread, 222-225 (see also \nCalendar and ratio spreads, combining, ratio \ncalendar spread) \nratio calendar spread, 222-225 \ncollateral requirements possibly large, 223-224 \nprofitability of, 227 \nCalendar straddle, 348-350 (see also Spreads combining \ncalls and puts) \nCall arbitrage, 444 (see also Arbitrage) \nCall bull spread, effect on of implied volatility changes, \n767-775 \nCall buying, 95-117 \nadvanced selection criteria, 103-107 \noverpriced/underpriced calls, 106-107 \ntime value premium and volatility trading, 106-107 \nvolatilities of underlying stock, 103-106 \nfollow-up actions, 107-117 \nbull spread, 110-111, 113-116, 117 \ncalendar spread, creating, 116-117 \ncommissions, 108 \ndefensive action, two strategies for, 112-117 \nlocking in profits", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 427}
{"text": "lity changes, \n767-775 \nCall buying, 95-117 \nadvanced selection criteria, 103-107 \noverpriced/underpriced calls, 106-107 \ntime value premium and volatility trading, 106-107 \nvolatilities of underlying stock, 103-106 \nfollow-up actions, 107-117 \nbull spread, 110-111, 113-116, 117 \ncalendar spread, creating, 116-117 \ncommissions, 108 \ndefensive action, two strategies for, 112-117 \nlocking in profits, four strategies for, 108-111 \n\"mental\" stop to cut losses, 107 \nrolling down strategy, 112-116 \nrolling up, 109-110 \nfrustrations, 107 \nmathematical calculations of volatility, applying, 47 4 \noption to buy, selecting, 101-103 \nday trading, 101-102 \nintermediate-term trading, 102-103 \nlong-term trading, 103 \nshort-term trading, 102 \ntime horizon as criterion, 101 \nrisk and reward, 97-101 \ndelta, 99-101 \nhedge ratio, 99-101 \nintermediate-term call most attractive, 98 \noption pricing curve, 99 \ntiming, certainty of, 98-99 \nsimplest form of option investment, 95 \nstrategies, other, 118-131 (see also Call buying \nstrategies) \nwhy buy, 95-96 \nand LEAPS, 95 \n985 \nCall buying strategies, 118-131 \naltering ratio oflong calls to short stock, 128-131 \nprotected short sale, 118-122 \nat-the-money or out-of-the-money as protection, \n120 \nfollow-up action, 122 \nmargin requirements, 121 \nreverse hedge, 123-128, 130, 131 \nfollow-up action, 126-128 \nlimited loss potential and unlimited profit poten\ntial, 123, 128 \ntrading against the straddle, 126-127 \nvolatile stock preferred, 126 \nsimulated straddle, 123-128 (see also Call buying \nstrategies, reverse hedge) \nsummary, 131 \n\"synthetic\" strategies, 118 \nput, 118-121 (see also Call buying strategies, pro\ntected short sale) \nCall option price curve, 10-13 \nCall option strategies, 37-241 (see also under particular \nheading) \nbear spreads using call options, 186-190 \nbull spreads, 172-185 \nbutterfly spreads, 200-209 \ncalendar spreads, 191-199 \ncalendar and ratio spreads, combining, 222-229 \ncall buying, 95-117 \ncall buying strategies, 118-131 \ncovered call writing, 39-94 \ndiagonalizing spread, 236-241 \nnaked call writing, 132-145 \nratio call spreads, 210-221 \nratio call writing, 146-171 \nreverse spreads, 230-235 \nsummary, 241 \nCall options: \nassignment of, 7 \nCall writing, applying mathematical calculations of \nvolatility to, 4 72-4 7 4 \nCapitalization-weighted indices, 494-497 \ndivisor, 494-496 \nfloat, 494-495 \nlargest market value stocks have most weight, 496 \nmost prevalent, 497 \nCash-based futures, 653 \nCash-based options, 500-506 (see also Index option \nproducts) \nEuropean versus American exercise, 501-504 \nCash-based put writing, 294-295 \nCash dividend role of underlying stock as factor in \noption price, 14-15 \nCash settlement futures, 653 \n986 \nChicago Board Options Exchange (CBOE), 22 \nstructured products listed, 618 \nChicago Mercantile Exchange, 507, 509, 510, 672 \noption quotes, 515-516 \ntrading limits on futures options, 680 \nChicago Board of Trade: \ntrading limits on futures contracts, 658 \ntrading limits on futures options, 680 \nClasses of options, 5-6 \nClosing transactions, 6 \nCollar, 275, 840 \nno-cost, 278-280 \nCommissions, 17-18 \nConcepts, advanced, 846-907 (see also Advanced \nconcepts) \nConservative covered write, 46 \nContango, 697 \nConversion, 253-255, 428-430, 431-438 (see also Put \noptions basics and Arbitrage) \nreversal, 254, 428-430, 431-438 \nrisks in, four, 433-43 7 \nsummary, 437-438 \nConvertible security, covered writing against, 88-90, 94 \nCovered call writing, 39-94 \ndefinition, 39 \ndiversifying return and protection, 66-70 \n\"combined\" write, 67-69 \ntechniques, fundamental, 66-69 \ntechniques, other, 69-70 \nexecution of order, 56-58 \ncontingent order, 57 \nnet position, establishing, 57-58 \nfollow-up action, 70-87, 94 \naggressive action if stock rises, 71, 79-81 \nassignment, action to avoid if time premium \ndisappears, 71, 86-87 \nexpiration, at or near, 83-85 \ngetting out, 82-83 \nlocked-in loss, 73 \nprotective action if stock drops, 71-79 \nrolling action, 71-80 (see also Rolling action) \nrolling forward/down, 83-85 \nspread, 76 \nuncovered position, avoiding, 86 \nwhen to let stock be called away, 86-87 \nimportance, 39-42 \nfor downside protection, 39 \nincrease in stock price, benefits of, 40-41 \nprofit graph, 41-42 \nquantification, 41-42 \nand naked put writing, differences between, \n294-295 \nobjective, 42 \nIndex \nPERCS (Preferred Equity Redemption Cumulative \nStock), 91 \nphilosophy, 42-45 \nannual returns, 47 \nas conservative strategy, 46-4 7 \nDepository Trust Corp (DTC), role of, 43 \nin-the-money covered writes, 43-45, 93 \nletter of guarantee, 43 \nout-of-the-money covered writes, 43-45, 93 \nphysical location of stock, 43 \ntotal return concept, 45-47, 60-61, 93 \nreturn on investment, computing, 47-56 \ncompound interest, 53-54 \ndownside break-even point, 48, 49-50 \nin margin accounts, 50-53 \nprice,changesin,55-56 \nreturn if exercised, 47-48 \nreturn if unchanged, 48, 49 \nsize of position, 54-55 \nstatic return, 49 \nselecting position, 58-62 \ndownside protection, 59-60 \nreturns, projected, 59 \nstrategy, importance of, 60-62 \ntotal return concept, 60-61 \nspecial writing situations, 87-93 \nagainst convertible security, 88-90, 94 \nagainst LEAPS, 91, 94 \nagainst warrants, 90-91 \nincremental return concept, 87-88, 91-93 \nand stock ownership, 42 \nsummary, 93-94 \nand uncovered put writing strategy, similarity of, \n293-294 \nwriting against stock already owned, 62-66 \ncaution, 65-66 \nCovered pit sale, 300 \nCovered straddle write, 302-305 \nCrack spread, 702-704 \nCredit spread, 170, 179 \nCross-currency spreads, 701 \nCumulative density function (CDF), 806 \nCustomer margin method, 5 \nCustomer margin option requirements, 667 \nDay trading, call buying and, 101-102 \nDebit spread, 170 \nDefinitions, 3-35 (see also under particular definition or \nunder Options) \nDelta, 848-853, 866 \ncalculation of by Black-Scholes model, 457 \nexcess value, 764 \nIndex \nDelta (continued) \nand implied volatility, 753-754, 755-756 \nof LEAPS, 387-390 \nput delta, 389-390 \noption delta, 849", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 428}
{"text": "gin method, 5 \nCustomer margin option requirements, 667 \nDay trading, call buying and, 101-102 \nDebit spread, 170 \nDefinitions, 3-35 (see also under particular definition or \nunder Options) \nDelta, 848-853, 866 \ncalculation of by Black-Scholes model, 457 \nexcess value, 764 \nIndex \nDelta (continued) \nand implied volatility, 753-754, 755-756 \nof LEAPS, 387-390 \nput delta, 389-390 \noption delta, 849 \nposition delta, 849-853 \nspread, 484 \nDelta-neutral spreads: \ncalendar spreads, 227-228 (see also Calendar and \nratio spreads) \neffects on of implied volatility changes, 755-756 \nDelta-neutral trading, 167-168, 868-879 \nDelta of option, 99-101 \nof futures aption, 676-677 \n\"Delta spread,\" 213, 216-217 (see also Ratio call \nspread) \nfor ratio put spread, 361 \nDepository Trust Corp. (DTC), 43 \nDiagonal butterfly spread, 350-353 (see also Spreads \ncombining calls and puts) \nDiagonal spread, 169, 236-241 (see also Spread, \ndiagonalizing) \nbackspreads, 240-241 \nbear spread, 239-240 \nbull spread, 177, 236-239 \nand LEAPS, 405-407 \nbackspread,407-408 \nDividend arbitrage, 425-428 \nDividends: \ninfluence of on option price, 14-15 \nand LEAPS, effect on, 371-374 \nput option premiums, effect of on, 248-250 \nfrom structured products, 594 \nDivisor, 494-496, 497-500, 568 \n\"Dogs of the Dow\" Index, 594 \nDow Jones Industrial Average, 494, 499, 793 \n30 Industrials ($DIX), 501, 502, 582 \nTop 10 Yield index ($XMT), 594 \nDown delta concept, 100-101 \nElliott Wave theory, 796 \nEquity-linked notes, 618 \nEquivalent futures position (EFP), 676-677, 853 \nEquivalent stock position (ESP), 162-163, 167, \n853 \nin ratio call spreads, 220-221 \nof straddle, 312-313 \nEquivalent strategies, 943-944 \n\"European\" exercise, 501-504, 647 \noptions, 7 \nEven money spread, 240 \n\"Ever\" probability calculator, 805-806 \nExcess value of option price, effect on of implied \nvolatility changes, 762-765 \n\"greeks\" to measure, 763-764 \nExchange-Traded Funds (ETFs), 637-639 \n987 \nHolding Company Depository Receipts (HOLD RS), \n639 \niShares, 638 \noptions on, 637 \nsector, 638 \nStandard & Poor's Depository Receipt (SPDR), 637-\n638 \nCreation Units, 638 \nExercise of cash-based options, 501-504 \nExercise price, definition, 3-4 \nExercising option, 6-7, 15-16 \nafter, 17 \ncommissions, 17-18 \nearly, due to discount, 19-20 \nearly, due to dividends on underlying stock, 20-22 \nExotic options, 590 \nExpiration date, 4 \nstandardization, 5 \nExxon (XON), 567 \nFacilitation, 455, 482-485 (see also Mathematical \napplications) \nFat tails, 790- 792, 810, 828 \nFinancial engineers, role of in structured products, 590 \nForeign currency options, 671-673 \nFormulae, 947-956 \n\"Fudge factor,\" 731, 733 \nFutures, 506-512 (see also Index option products) \ncalculating fair value of, 533-534 \nfactors, four, 533 \nT-bill rate, use of, 534 \ncontracts, 653-660 (see also Futures and futures \noptions) \non physicals, 653 (see also Futures and future \noptions) \nFutures and futures options, 652-695 \nfutures contracts, 653-660 \n\"cash,\" 653-654 \ncash-based/cash settlement futures, 653 \ndelivery, 658-659 \nexpiration dates, 656-657 \nfirst notice day, 659 \nfutures on physicals, 653 \nhedging, 653-655 \nlimits, 657-658 \nmonth symbols, 665 \nnotice period, 659 \nand options, differences between, 653 \n988 \nFutures and futures options (continued) \nposition limits, 657 \npricing, 659-660 \nspeculating, 655-656 \nspot and spot price, 658 \nas stock with expiration date, 653 \ntenns, 656-657 \ntrading hours, 657 \ntrading limits, 657-658 \nunits of trading, 657 \nfutures options trading strategies, 67 4-683 \ndelta, 676-677 \nequivalent futures position (EFP), 676-677 \nfollow-up actions, 692-694 \nlimit bid, 679 \nlimit offered, 680 \nmathematical considerations, 677-679 \nmispricing strategies, common, 683-694 (see also \nFutures and futures option, mispricing strate\ngies) \nprice relationships, 67 4-676 \nsummary, 694 \nand trading limits, 679-683 \nmispricing strategies, common, for futures options, \n683-694 \nbackspreading puts, 686-688 \nfollow-up action, 692-694 \nimplied volatility, 685 \npoints, 687-688 \nratio spreading calls, 688-689 \nstrategies for profiting, two, 685-689 \nsummary, 694 \nvolatility skewing, 683, 685, 693-694 \nwhich strategy to use, 690-692 \noptions on futures, 660-673 \nassignment, 673 \nautomatic exercise, 662-663 \nbid-offer spread, 665 \ncash settlement future, 661 \ncommissions, 665 \ncustomer margin system, 667, 671 \ndefinition, 660 \ndescription, 660-662 \nexercise, 673 \nforeign currency options, 671-673 \nmargins, 666-671 \nmathematical considerations, 677-679 \nmonth symbols, 665 \nnotice day, 661-662 \nPhiladelphia Stock Exchange (PHUC), 671, 673, \n678-679 \nphysical currency options, 671-673 \non physical futures, 661, 678-679 \nposition limits, 666 \nquote symbols, 664 \n\"round-tum\" commission, 665-666 \nserial options, 663-666 \nIndex \nSPAN margin (Standard Portfolio Analysis of \nRisk), 667-671 (see also SPAN) \nstriking price intervals, 662 \nstandardization less than for equity or index options, \n652 \nsummary, 695 \nFutures Magazine, 661 \nFutures option strategies for futures spreads, 696-721 \nfutures options, using in futures spreads, 704-720 \ncalendar spread, 704-709 \nfollow-up considerations, 714-719 \nintramarket spread strategy, 719 \nlong combinations, 709-714 \nspreading futures against stock sector indices, \n719-720 \nfutures spreads, 696-704 \ncontango, 697 \ncrack spread, 702-704 \ncross-currency spreads, 701 \nintermarket, 700-704 \nintramarket, 697-700 \npricing differentials, 696-697 \nreverse carrying charge market, 697 \nTED spread, 701-702, 712-714 \nsummary, 720-721 \nFutures spread, futures option strategies for, 696-721 \n(see also Futures option strategies) \nGamma, 853-859, 867, 882 \nneutral spread, 882 \nGamma of the gamma, 865-866, 902-905 \nGARCH (Generalizes Autoregressive Conditional \nHeteroskedasticity), 731-732, 814, 819 \nGeneral Electric (GE), 567 \nGeneral Motors (GM), 567 \nGold and Silver Index (XAU), 588, 719 \nGood-until-canceled order, 34 \nGovernment National Mortgage Association \ncertificates, 420 \nGraphs", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 429}
{"text": "see also Futures option strategies) \nGamma, 853-859, 867, 882 \nneutral spread, 882 \nGamma of the gamma, 865-866, 902-905 \nGARCH (Generalizes Autoregressive Conditional \nHeteroskedasticity), 731-732, 814, 819 \nGeneral Electric (GE), 567 \nGeneral Motors (GM), 567 \nGold and Silver Index (XAU), 588, 719 \nGood-until-canceled order, 34 \nGovernment National Mortgage Association \ncertificates, 420 \nGraphs, 957-960 \n\"Greeks,\" 848-866 (see also Advanced concepts) \ncalculating, 901-902 \nto measure excess value, 763-764 \nHedge ratio, 99-101, 457 \nadvantages of, 482-485 \ndelta spread, 484 \nneutral spread, 483-485 \nHedge wrapper, 275 \nHedging, futures contracts and, 653-655 \nIndex \nHistorical volatility, 461, 728-731 \nlognormal, computation of, 461-466 \nHolder, 6 \nHOLDRS, 639 \n\"Hooks,\" 449-450 \nHorizontal spread, 169 \nIBM (International Business Machines), 567 \nImplied volatility, 132, 248, 685, 727, 734-743 (see also \nVolatility trading) \ndifference of, measuring, 905-907 \neffect of on specific option strategies, 7 49-782 (see \nalso Volatility, effects of) \nand delta, 753-754 \nin trading techniques, 812-845 (see also Volatility \ntrading) \nIn-the-money: \ncalendar spread, 228 \ncovered writes, 43-45, 93 \ndefinition, 7, 8 \nfor put options, 246-247 \nIncremental return concept of covered writing, 91-93 \n(see also Covered call writing) \nrolling for credit, 92 \nIndex arbitrage, 547-556 (see also Stock index hedging \nstrategies) \nIndex calls, hedging with, 545-547 \nIndex option products and futures, introduction to, \n493-530 \ncash-based options, 500-506 \nassignment, 501 \ncommissions, 503 \nEuropean versus American exercise, 501-504 \nexercise, 501-504 \nindices underlying, 500-501 \nnaked margin, 504-505 \ndefinition, 493 \nand equity options, difference between, 493 \nfutures, 506-512 \ncash-based only, 506 \n\"circuit breakers,\" 511 \ncommodities contract, definition, 506 \ncontract, terms of, 507-508 \nhedgers, 506-507 \nlimits, 511 \n\"locals,\" 509 \nmaintenance margin, 509 \nmargin, limits, and quotes, 509-510 \n\"open outcry\" method, 508-509 \nquotes, 511-512 \nspeculators, 506-507 \nS&P 500 Index, 507-509 \nS&P and NYSE expiration, 510-511 \n989 \nand stock trading, differences between, 508, 512 \ntraders, types of, 506-507 \nLEAPS (Long-term Equity AnticiPation Securities) \nindex options, 367-410, 505-506 \noptions on index futures, 512-516 \ncaution,516 \ncustomer margin method, 515 \nexpiration dates, 513 \noption margin, 514-515 \npremiums, 514 \nquotes, 515-516 \nSPAN (Standard Portfolio Analysis of Risk), \n514-515 \nterms, other, 515 \nput-call ratio, 520-530 \nfigures, 524-530 \ninterpreting, 522-523 \nstandard options strategies using index options, \n516-520 \nconclusion, 519-520 \nearly assignment of cash-based options, handling, \n518-519 \noption buying, 516-517 \nselling index options, 517-518 \nvolatility skewing, 517 \nstock indices, 493-500 \nbroad-based, 500, 504-505 \ncapitalization-weighted indices, 494-497 (see also \nCapitalization-weighted indices) \nnarrow-based, 500, 505 \nprice-weighted indices, 500 (see also Price\nweighted indices) \nsector, 500 \nsummary, 523 \nIndex options and futures, 138, 491-721 (see also under \nparticular heading) \nfutures and futures options, 652-695 \nfutures option strategies for futures spreads, 696-721 \nhedging portfolios with, 541-543 \nindex spreading, 579-588 \nintroduction, 493-530 \nmathematical considerations for index products, \n641-651 \nproducts and futures, introduction to, 493-530 \nstock index hedging strategies, 531-578 \nstructured products, 589-640 \nIndex puts, hedging with, 543-545 \nIndex spreading, 579-588 \napproaches,two,580-581 \ncharacteristics, 682-583 \ninter-index spreading, 579-587 \nphilosophy, 579 \nS&P 100,583 \nS&P 500, 583, 584 \n990 \nIndex spreading (continued) \nspreads using options, 583-584 \noptions, using in index spreads, 584-587 \nstriking price differential, 587 \nvolatility differential, 587 \nsummary, 588 \nValue Line Index, 579, 582 \nInflection points, 792-793 \nInsider trading, 7 45-7 46 \nInstitutional block positioning, 482-485 (see also \nMathematical applications) \nInstitutional use of market basket strategies, 556 \nInter-index spreading, 579-587 (see also Index \nspreading) \n\"Interest play\" strategy, 438-439 \nInterest rates, effects of on LEAPS, 371-37 4 \nIntermarket futures spreads, 700-704 \nIntermediate-term trading, call buying and, 102-103 \nIntramarket futures spreads, 697-700 \niShares, 638 \nJapanese Nikkei 225 Index, 532, 601 \nKicker, 136, 169 \nLEAPS (Long-term Equity AnticiPation Securities), 5, \n367-410 \nbasics, 368-369 \nexpiration date, 368 \nstandardization less, 368 \nstriking price, 369 \ntype,368 \nunderlying stock and quote symbol, 368 \nand call buying, 95 \ndefinition, 367 \ndividends, effects of, 371-37 4 \nto establish collar, 279 \nhistory, 367 \nand implied volatility, 735, 736 \nindex options, 505-506 \ninterest rates, effects of, 371-372 \nand long-term trading, 103 \noptions, 616-617 \npopularity, 367 \npricing, 369-37 4 \nrho, 864-865 \nselling, 390-403 \nassignment, early, 401-402 \ncovered writing, 390-396 \nincremental return, 391 \nrolling down, 394 \nIndex \nshort LEAPS instead of short stock, 400-402 \nstraddle selling, 402-403 \nuncovered call selling, 399-400 \nuncovered LEAPS, 396-399 \nwhipsaw, 403 \nshort-term options, three sets of comparison with, \n374-375 \nand speculative option buying, 382-390 \nbuying \"cheap,\" advantages of, 385-386 \ndelta, 387-390 \nless risk of time decay, 383-385 \nspreads using, 403-409 \nbackspreads,407-408 \nbull spread using calls, 403-404 \ncalendar spreads, 408-409 \ndiagonal, 405-407 \nstrategies, 375-382 \nbuying LEAPS as initial purchase instead of buy-\ning common stock, 378-381 \nLEAPS instead of short stock, 382 \nmargin, using, 380-381 \nprotecting existing stock holdings with LEAPS \nputs, 381-382 \nas stock substitute, 375-378 \nsummary, 409-410 \nsymbols, 26-27 \nwriting against, 91, 94 \n\"Leg\" into spread, 171 \nout of spread, 180, 207 \nout of put calendar spread, 335 \nLetter of guarantee, 43 \nLimit bid, 679 \nLimit offered, 680 \nLimit order, 28, 33 \n\"Loc", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 430}
{"text": "ommon stock, 378-381 \nLEAPS instead of short stock, 382 \nmargin, using, 380-381 \nprotecting existing stock holdings with LEAPS \nputs, 381-382 \nas stock substitute, 375-378 \nsummary, 409-410 \nsymbols, 26-27 \nwriting against, 91, 94 \n\"Leg\" into spread, 171 \nout of spread, 180, 207 \nout of put calendar spread, 335 \nLetter of guarantee, 43 \nLimit bid, 679 \nLimit offered, 680 \nLimit order, 28, 33 \n\"Locals,\" 509 \nLocked-in loss, 73-76 \nLocking in profits, four strategies for, 108-1 11 \nLognormal distribution of stock prices, 783-81 I \n(See also Stock prices, distribution oO \nLong-term Equity AnticiPation Securities (LEAl'Si \nSee also LEAPS \nLong-term trading, call buying and, 103 \nMaintenance margin, 509 \nMajor Market Index (XMI), 499 \nMarket basket of stocks, 531-537 (see also Stock ind,·\\ \nhedging strategies) \nMarket dynamics, nonquantifiable, as influt·11t·,· 011 \nmarket price, 15 \nMarket-makers, 22 \nMarket order, 32 \nMarket not held order, 33 \n\"Married\" put and stock for tax purposC's, !J:l I \nIndex \nMartingale strategy, 140, 145 \nMathematical applications, 456-489 \nBlack-Scholes model, 456-466 (see also \nBlack-Scholes model) \nexpected return, 466-472 \ncalculation of, 467, 4 71 \ndefinition,466 \nexpected profit, computation of, 468 \nlognormal distribution, typical, 469 \nSimpson's Rule, 471 \nTrapezoidal Rule, 471 \nfacilitation (institutional block positioning), 482-485 \ndelta spread, 484 \nfollow-up action, computer as aid in, 485-488 \nimplementation, 488-489 \nneutral spread, 483-485 \nhedge ratio, 482-485 (see also Mathematical applica\ntions, facilitation [institutional block position\ning]) \nstrategy decisions, applying calculations to, 4 72-482 \ncalendar spreads, 479-480 \ncall buying, 474 \ncall writing, 472-474 \nprofitability, 474-475 \nput buying, 478-479 \nput option, pricing, 477-478 \nratio strategies, 480-482 \nrisk, 4 75-4 77 \ntheoretical value of spread, using, 480 \nsummary, 489 \nMathematical applications for index options, 644-651 \nBlack model, 647-648, 651 \nBlack-Scholes model, 644-645, 646, 651 \ncash-based, 644-646 \ndeltas, 648 \nEuropean exercise, 647 \nfollow-up action, 648-651 \nfor inter-index spreads, 648-649 \n\"sliding scale,\" 649-650 \nfutures, 644 \noptions, 647-648 \nimplied dividend, 646 \nMathematical concepts, advanced, 901-907 \nMathematical considerations for index products, 641-651 \nMathematical models: \nfor index products, 641-651 \narbitrage, 641-644 (see also Arbitrage) \ngraph, three-dimensional, 651 \nmathematical applications, 644-651 (see also \nMathematical applications) \nsummary, 651 \nfor pricing options, 14 \nMayhew, Dr. Stewart, 806 \nMergers, risk arbitrage and, 445-450 \nMonte Carlo analysis, 806 \nsimulation, 807-809, 828 \n991 \nMorgan Stanley High-Tech index ($MSH), 639, 788 \nNaked call writing, 132-145 \nhigh risk strategy, 135-136 \n\"kicker,\" 136 \nmarked to market daily, 136 \nimplied volatility, 132 \ninvestment required, 134-137 \nmargin requirements, 134-137 \nnot same as short sale of underlying stock, 133-134 \nrisk and reward, 138-145 \nMartingale strategy, 140, 145 \nrolling for credits, 140-144 \ntime value as misnomer, 144 \nselling naked options, philosophy of, 137-138 \nindex options, 138 \nsummary, 144-145 \nuncovered (naked) call option, 133-134 \nNaked put write, evaluating, 296-298 \nNarrow-based indices, 500 \nNASDAQ: \nIndex ($NDX), 501 \n-100 (NDX), 588 \ntracking stock (QQQ), 638,639 \nNeutral calendar spread, 192-194 \nNeutrality: \neffects of implied volatility changes on, 755-756 \nin options positions, 846-84 7 \nNew York Stock Exchange: \n\"circuit breaker,\" 562 \nexpiration, 510-511 \nIndex,497,500,532 \nlimits on index futures traded, 511 \nPOT system, 555-556 \nNikkei 225 Index, 532, 601 \nNo-cost collars, 278-280 \nNotice period, 659, 661-662 \nOEX, 497, 500-501 \nOil and Gas Index (XOI), 588, 719 \nOpen interest, 6 \n\"Open outcry\" method of trading futures, 508-509 \nOpening transactions, 6 \nOption markets, 22 \nboard broker system, 22 \nChicago Board Options Exchange (CBOE), 22 \nWeb site, 23 \nmarket-makers, 22 \nOption Price Reporting Authority (OPRA), 368 \nOption pricing curve, 99 \n992 \nOption purchase and spread, combining, 339-341 (see \nalso Spreads combining calls and puts) \nOptions: \narbitrageurs, role of, 19-21 \nrisk arbitrage, 21 \nassignment, 7, 16-17 \nanticipating, 18-22 (see also Assignment) \nmargin requirements, 15-17 \nclasses and series, 5-6 \nclosing transaction, 6 \ncommissions, 17-18 \ndefinition, 3-4 \nas derivative security, 4 \n\"European\" exercise options, 7 \nexercising, 6-7, 15-16 \nafter, 17 \nearly, due to discount, 19-20 \nearly, due to dividends on underlying stock, 20-22 \npremature, 19-22 \nholder, 6 \nin-the-money, 7, 8 \nLEAPS, 5 \nsymbols, 26-27 \nmarkets, 22 (see also Option markets) \nopen interest, 6 \nopening transaction, 6 \noption price and stock price, relationship of, 7-9 \norder entry, 32-34 \ngood-until-canceled order, 34 \ninformation, 32 \nlimit order, 33 \nmarket order, 32 \nmarket not held order, 33 \nstop-limit order, 33-34 \nstop order, 33 \nout-of-the-money, 7 \nparity, 8-9 \npremature exercise, 19-22 (see also Options, exercis\ning) \npremium, 7-8 \nprice, factors influencing, 9-15 (see also Price of \noption) \nprofits and profit graphs, 34-35 \nspecifications, four, 4 \nstandardization, 4-5 \nexpiration dates, 5 \nstriking price, 5 \nsymbology, 23-27 \nCBOE's Web site, 23 \nexpiration month code, 23 \nLEAPS, 26-27 \noption base symbol, 23 \nstock splits, 27 \nstriking price code, 24-25 \nsummary, 27 \nwraps, 25-26 \ntime value premium, 7-8, 11 \ntrading details, 27-32 \nlimit order, 28 \none-day settlement cycle, 28 \nposition limit and exercise limit, 31-32 \nrotation, 28 \nvalue, 4 \nas \"wasting\" asset, 4 \nwriter, 6 \nIndex \nOptions to buy, selecting, 101-103 (see also Call buying) \nOptions Clearing Corp. (OCC), 6, 15-16, 673 \nOptions on futures, 660-673 (see also Futures and \nfutures options) \nOptions and Treasury bills, buying, 413-421 \nadvantages, 413, 421 \nannualized risk, 416-418 \nexcessive risk, avoiding, 420-421 \nhow strategy works, 413-421 \nrisk adjustment, 418-420 \nrisk level, kee", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 431}
{"text": "asset, 4 \nwriter, 6 \nIndex \nOptions to buy, selecting, 101-103 (see also Call buying) \nOptions Clearing Corp. (OCC), 6, 15-16, 673 \nOptions on futures, 660-673 (see also Futures and \nfutures options) \nOptions and Treasury bills, buying, 413-421 \nadvantages, 413, 421 \nannualized risk, 416-418 \nexcessive risk, avoiding, 420-421 \nhow strategy works, 413-421 \nrisk adjustment, 418-420 \nrisk level, keeping even, 415-416 \nsummary, 421 \nsynthetic convertible bond, 414 \nOrder entry for options, 32-34 (see also Options) \nOriginal Issue Discount (OID), 592-593 \nOut-of-the-money: \ncall spread, 222-225 \ncovered writes, 43-45, 93 \ndefinition, 7 \nfor put options, 246-247 \nOutright option purchases and sales, effect of, on \nimplied volatility changes on, 757-762 \nPairs trading, 454-455 \nParity, 8-9 \nPercentile of implied volatility approach, 814-818 \ncomposite implied volatility reading, 815 \nhistorical and implied volatility, comparing, 817-818 \nPERCS (Preferred Equity Redemption Cumulative \nStock), 91, 619-637 \ncall feature, 620-622 \nredemption price, 622 \nsliding scale, 620-621 \ncovered call write, equivalent to, 622-623 \ndefinition, 619 \nlife span, 619 \nowning as equivalent to sale of naked put, 626 \nprice behavior, 623-625 \nstrategies, 625-636 \ndelta of imbedded call, using, 630-631 \nhedging PERCS with common stock, 631-6:32 \nissue price, determining, 633-634 \nIndex \nPERCS (Preferred Equity Redemption Cumulative \n' Stock) (continued) \npricing, 634-636 \nprotecting PERCS with listed options, 625-626 \nredemption feature, removing, 626-627 \nredemption price, changing, 627-629 \nrolling down/up, 628-629 \nselling call against long PERCS as ratio write, \n629-631 \nselling short, 632-633 \nsummary, 636-637 \nPhantom interest, 592 \nPhiladelphia Stock Exchange (PHLX), 671, 673, \n678-679 \nPortfolio hedge, 539-541 \nPortfolio insurance, 563-564 \nPosition delta, 162-163, 167 \nPosition limit rule, 253 \nPosition vega, 757 \nPOT system of NYSE, 555-556 \nPremium, 7-8 \ntime value, 7-8 \nPrice of option, factors influencing, 9-15 \ncash dividend rate of underlying stock, 14-15 \ndividends and lower call option price, 14-15 \ncall option price curve, 10-13 \nmarket dynamics, nonquantitative, 15 \nrisk-free interest rate, 14 \nstriking price of option, 9-10 \ntime remaining until expiration, 11-13 \ntime value premium decay, 13-14 \nunderlying stock, price of, 9-10 \nvolatility of underlying stock, 13-14 \nPrice-weighted indices, 497-500 \ncomputing, 497-498 \ndivisor, 497-500 \nDow Jones indices, 499 \neach stock with equal number of shares, 497, 499 \nMajor Market Index (XMI), 499 \nProbability calculator, 798-799, 824, 827-829 \nProbability of stock price movement, 798-809 (see also \nStock prices) \nProfits, locking in, four strategies for, 108-111 \nProgram trading, 537-547 (see also Stock index \nhedging) \nProtected short sale, 118-121, 270 (see also Call buying \nstrategies) \nProtective collar, 275 \nno-cost, 278-280 \nand splitting strikes, 328 \nPut, sale of, 291-301 \nbuying stock below its market price, 299-300 \ncaution, 299-300 \ncovered put, 300 \nfollow-up action, 295-296 \nnaked put write, evaluating, 296-298 \nratio put writing, 300-301 \nuncovered, 292-295 \ncash-based put writing, 294-295 \n993 \ncovered call writing, similarity to, 293-294 \nnaked put writing, differences between, 294-295 \nPut arbitrage, 445 (see also Arbitrage) \nPut bear spreads, effects on of implied volatility \nchanges, 777-778 \nPut buying: \nin conjunction with call purchases, 281-291 \nmathematical calculations of volatility, applying to, \n478-479 \nstraddle buying, 282-288 \nequivalences, 283-284 \nfollow-up action, 285-288 \nreverse hedge, equivalent to, 283 \nreverse hedge with puts, 284 \nselecting, 285 \nstrangle, buying, 288-291 \ntrading against straddle, 287 \nPut buying in conjunction with common stock owner\nship, 271-280 \nas protection for covered call writer, 275-278 \nbull spread as equivalent, 278 \nlong-term effects, 277-278 \nprotective collar, 275, 278-280 \nrolling down, 276 \nno-cost collars, 278-280 \nlower strikes as partial covered write, 279-280 \nsynthetic long call, 271 \ntax considerations, 275 \nwhich put to buy, 273-274 \nequivalent strategies, 27 4 \nslightly out-of-the-money put preferable, 27 4 \nPut option: \neffects on of implied volatility changes, 765-766 \npricing, applying mathematical calculations of \nvolatility to, 4 77-4 78 \nPut option basics, 245-255 \nassignment, 250-253 \nanticipating, 251-252 \nand dividend payment dates, 252 \nposition limits, 253 \nconversion, 253-255 \nno risk, 254 \nreversal. 254 \ndividends, effect of on premiums, 248-250 \nexercise, 250-253 \nin-the-money, 246-247 \nout-of-the-money, 246-247 \npricing, 247-248, 249 \nimplied volatility, 248 \n994 \nPut option basics (continued) \nstrategies, 245-247 \ntime value premium, 246-247 \nPut option buying, 256-270 \nas alternative to short sale of stock, 256-258 \npurpose, 256 \nequivalent positions, 270 \nprotected short sale, 270 \nfollow-up action, 262-266 \ncall option, 264 \nlisted call, buying, 263 \nprofits, five tactics for locking in, 262-266 \nloss-limiting actions, 267-270 \ncalendar spread strategy, 269-270 \n\"rolling-up\" strategy, 267-269 \nmargin account required, 269 \nranking prospective purchases, 261-262 \nselection of which put to buy, 258-261 \ndelta, 260-261 \nin-the-money puts, concentrating on, 259 \nPut option strategies, 243-410 (see also under particular \nheading) \nbasics, 245-255 \nbuying, 256-270 \ncall and put strategies, similarities between, 244 \nLEAPS, 367-410 \nlisted put options newer than listed call options, 244 \nput, sale of, 292-301 \nput buying in conjunction with call purchases, \n281-291 \nput buying in conjunction with common stock own-\nership, 271-280 \nput spreads, basic, 329-335 \nratio spreads using puts, 358-366 \nspreads combining calls and puts, 336-357 \nstraddle, sale of, 302-320 \nsummary, 366 \nsynthetic stock positions created by puts and calls, \n321-328 \nPut options, assignment of, 7 \nPut spreads, basic, 329-335 \nbear spread, 329-332 \nadvantage over call bear spread, 330-332 \nas", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 432}
{"text": "buying in conjunction with common stock own-\nership, 271-280 \nput spreads, basic, 329-335 \nratio spreads using puts, 358-366 \nspreads combining calls and puts, 336-357 \nstraddle, sale of, 302-320 \nsummary, 366 \nsynthetic stock positions created by puts and calls, \n321-328 \nPut options, assignment of, 7 \nPut spreads, basic, 329-335 \nbear spread, 329-332 \nadvantage over call bear spread, 330-332 \nas debit spread, 329 \nbull spread, 332-333 \nas credit spread, 332 \nformulae, 333 \nrisk limited, 333 \ncalendar spread, 333-335 \nbearish, 334-335 \nneutral, 334 \noption spreads, three simplest forms of, 329 \nIndex \nQualified covered calls, 961-962 \nRatio calendar combination, 364-366 (see also Ratio \nspreads using puts) \nRatio calendar spread, 222-225 (see also Calendar and \nratio spreads) \nRatio call spreads, 210-221 \nand calendar spreads, combining, 222-229 (see also \nCalendar and ratio spreads) \ncombination of bull spread and naked call write, 212 \ndefinition, 210 \nfollow-up action, 217-221 \ndelta, adjusting with, 219-221 \nequivalent stock position (ESP), using, 220-221 \nprofits, taking, 221 \nratio, reducing, 218-218 \nphilosophies, three differing, 213-217 \naltering ratio, 215-216 \nas ratio write, 213-214 \n\"delta spread,\" 213, 216-217 \nfor credits, 213, 214-215 \npreferred over ratio writes, 211-212 \nratio write, similarity to, 210 \ndissimilarity, 210-211 \nsummary, 221 \nRatio call write equivalent to naked straddle write, 306 \nRatio call writing, 146-171 \ncall spread strategies, introduction to, 168-171 \ncredit/debit spread, 170 \ndiagonal spread, 169 \nhorizontal spread, 169 \nkicker, 169 \n\"leg\" into spread, 171 \nlong/short side, 170 \nsplitting quote, 171 \nspread, definition, 168 \nspread order, 169-171 \nvertical spread, 169 \ncombination of covered call writing and naked call \nwriting, 146, 150 \ndefinition, 146 \ndelta-neutral trading, 167-168 \nfollow-up action, 158-168 \naltering ration of covered write, 160 \nclosing out write, 166-167 \ndelta, adjusting with, 160-163 \nequivalent stock position (ESP), 162-163, 167 \nposition delta, 162-163, 167 \nrolling up/down as defensive action, 160 \nstop orders, using as defensive strategy, 163-166 \n\"telescoping\" action points, 166-167 \ninvestment required, 150-151 \nand ratio call spreads, similarity to, 210 \nIndex \nRatio call writing (continued) \ndissimilarity, 210-211 \nratio write, 146-149 \nobjections, two, 148-149 \nprobability curve for stock movement, 149 \nprofit range, 14 7 \nratio spread as, 213-214 (see also Ratio call \nspreads) \nand reverse hedge (simulated straddle), similarity of, \n154 \nrisk, two-sided, 146 \nselection criteria, 151-155 \nbreak-even points of position, 151-152 \nneutral ratio, 152-154 \nvolatile stocks preferred, 152 \nsummary, 168 \nnot suitable for all investors, 168 \nvariable, 155-157 \ntrapezoidal hedge, 155, 156, 157 \nRatio put spread, 358-361 (see also Ratio spreads) \ncalendar spread, 361-364 \nRatio put writing, 300-301 \nRatio spreads, effects on of implied volatility changes, \n780-781 \nRatio spreads using puts, 358-366 \nratio calendar combination, 364-366 \nratio put spread, 358-361 \ndeltas, 361 \nfollow-up action, 360-361 \nlimited upside risk, large downside risk, 358, 359 \nratio put calendar spread, 361-364 \nand naked options, 362-363 \nRatio strategies, applying mathematical calculations of \nvolatility to, 480-482 \nRegression analysis, 566 \nReversals, 254-255, 428-430, 431-438 (see also \nArbitrage) \nrisks in, four, 433-437 \nReverse calendar spread, 230-232 (see also Reverse \nspreads) \nselling, 833-834 \nReverse carrying charge market, 697 \nReverse conversion, 428-430, 431-438 \nrisks in, four, 433-437 \nReverse hedge 123-128, 130, 131 (see also Call buying \nstrategies) \nratio writing, similarity to, 154-155 \nstraddle buying, equivalent to, 283 \nReverse ratio spread (backspread), 232-235 (see also \nReverse spreads) \nReverse spreads, 230-235 \nbackspread, 232-235 (see also Reverse spreads, \nreverse ratio spread) \nreverse calendar spread, 230-232 \nmargin requirements onerous, 230, 231-232 \nused infrequently, 230 \nreverse ratio spread (backspread), 232-235 \nand delta-neutral spread, 234-235 \nearly exercise, possibility of, 235 \nestablished for credits, 233 \ninvestment small, 233-234 \nlimited risk, 233 \nvolatile stocks preferable, 235 \nRho, 864-865 \nfor LEAPS or warrants, 873 \nRisk arbitrage, 21, 426-427, 445-454 (see also \nArbitrage) \n\"hooks,\" 449-450 \nlimits on merger, 448-450 \nmergers, 445-448 \ntender offers, 451-454 \nRisk-free interest rate, 14 \nRolling action, 71-80, 94, 158-160 \nalternative, 76-77 \ndebit incurred in roll-up, 80-81 \ndifferent expiration series, using, 78-79 \npartial, 77 \nRolling for credits, 140-144 \nMartingale strategy, 140, 145 \nRolling down strategy, 112-116, 628-629 \nLEAPS, 394 \nand protective put, 276 \nRolling forward/down, 83-85 \nRolling up, 109-110, 267-269, 628-629 \n\"Round-tum\" commission, 665-666 \nRubenstein, Professor Mark, 797 \nRussell 2000 Growth Fund, 638, 788 \nRussell 2000 Value Fund, 638, 788 \nS&P: see also Standard & Poor \nScientific American, 796 \nSector, 500 \nSemiconductor Index ($SOX), 588, 6,39 \nHOLDRS, 639 \nSerial options, 663-666 \nSeries of options, ,5-6 \nShort-sale rule, 923-924 \nShort tendering, 453 \nShort-term trading, call buying and, 102 \nSigma, 783-786 \nSimpson's Rule, 471 \nSimulated straddle, 123-128 (see also Call buying \nstrategies) \nratio writing, similarity to, 154-155 \nSIS (Stock Index return Security), 596-601 \ncash value formula, 596-597 \nimbedded call, 597-598 \nissued in 1993 and matured in 2000, 596 \n995 \n996 \nSIS (Stock Index return Security) (continued) \ntrack record, 598, 599 \ntrading at discount to cash value, 598-600 \ntrading at discount to guarantee price, 600-601 \n60/40 rule, 919-920 \nSPAN (Standard Portfolio Analysis of Risk), 514-515, \n667-671 \nadvantages,667 \nexample, 668, 669, 670 \nhow it works, 667-671 \nmaintenance margin, 667 \npurpose, 667 \nrisk array, 667, 668, 669 \nSpeculating in futures contracts, 655-656 \nSplitting quote, 171 \nSplitting strikes, 325-328 (see also Synthetic s", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 433}
{"text": "to cash value, 598-600 \ntrading at discount to guarantee price, 600-601 \n60/40 rule, 919-920 \nSPAN (Standard Portfolio Analysis of Risk), 514-515, \n667-671 \nadvantages,667 \nexample, 668, 669, 670 \nhow it works, 667-671 \nmaintenance margin, 667 \npurpose, 667 \nrisk array, 667, 668, 669 \nSpeculating in futures contracts, 655-656 \nSplitting quote, 171 \nSplitting strikes, 325-328 (see also Synthetic stock \npositions) \nSpot/spot price for futures contracts, 658 \nSpread, diagonalizing, 236-241 \nadvantage,236,241 \nbackspreads,240-241 \neven-money spread, 240 \nbear spread, 239-240 \nbull spread, 236-239 \noften improvement over normal bull spread, 239 \ndefinition, 236 \nfor any type of spread, 241 \nSpreads, 76, 168-171 (see also under particular head) \nbackspread,232-235 \ndiagonal, 240-241 \nbear, using call options, 186-190 \nbull, 110-111, 113-116, 117, 172-185 \nbutterfly, 200-209 \ncalendar, 116-117, 191-199 \ncategories, three, 169 \ndefinition, 168 \ndiagonal, 169, 236-241 (see also Spreads, \ndiagonalizing) \neven money, 240 \nhorizontal, 169 \nusing LEAPS, 403-409 (see also LEAPS) \n\"leg\" into, 171 \nout of, 180, 207 \nout-of-the-money call spread, 222-225 \nratio call, 210-221 \nreverse, 230-235 \nreverse calendar, 230-232 \nreverse ratio, 232-235 \nunequal tax treatment on, 929-930 \nvertical, 169 \nSpread order, 169-171 \nSpreads combining calls and puts, 336-357 \nbutterfly spread, 336-338 \narbitrageur, role of, 338 \nbox spread, 338 \ncommissions high, 338 \nIndex \nequivalent of completely protected straddle write, \n338 \nestablishing, four ways for, 336-338 \nstriking prices, three, 336 \ncalendar combination, 345-348, 353-354, 356-357 \nsuperior to calendar straddle, 349-350 \ncalendar straddle, 348-350, 354, 356-357 \nas neutral strategy, 349 \ncriteria for, three, 354 \ninferior to calendar combination, 349-350 \ndiagonal butterfly spread, 350-353, 354-355, 356-357 \ncriteria, four, 355 \nlegging out, 351-352 \nfollow-up action for bull or bear spreads, 341-344 \noption purchase and spread, combining, 339-341 \nbearish scenario, 341, 342 \nbullish scenario, 339-340, 342 \nselecting, 353-356 \ncriteria, five, 353-354 \nsummary, 356-357 \nStandard Portfolio Analysis of Risk (SPAN), 514-515 \nStandard & Poor (S&P): \nDepository Receipt (SPDR), 637-638 \nexpiration, 510-511 \n100 Index (OEX), 497, 500-501, 582-583 \n400 Index, 497 \n500 Futures, 532 \n500 Index (SPX), 497, 502, 507, 583, 584 \nStandard & Poor's Stock/Bond Guide, 88 \nStock: \nbuying below its market price, 299-300 \nunderlying, price of as related to option price, 9-10 \nStock index hedging strategies, 531-578 \nfollow-up strategies, 557-559 \nrolling to another month, 557-559 \nimpact on stock market, 561-565 \n\"circuit breaker\" of NYSE, 562 \nat expiration, 564-565 \nbefore expiration, 561-563 \nportfolio insurance, 563-564 \nregulatory bodies, concern of, 562 \ntrading ban, 562 \nindex, simulating, 566-574 \nhedge, monitoring, 572-573 \nhigh-capitalization stocks, using, 566-571 \nlargest-capitalization stocks, four, 567 \noptions instead of futures, using, 573-57 4 \nregression analysis, 566 \ntracking error risk, 571-572 \nindex arbitrage, 547-556 \ncommissions, 552-554 \ncomputerized method of order entry, 555-556 \nIndex \nStock index hedging strategies (continued) \nhedging price-weighted index, 547,548 \nhow many shares to buy, 547-552 \ninstitutional strategies, 556 \nPOT system of NYSE, 555-556 \nprofitability, 552-554 \ntrade execution, 554-556 \nmarket baskets, 531-537 \ndividends, inverse correlation of to premium \nvalue, 534-537 \nexecution risk, 560 \nfutures fair value, 533-534 \nrisk, 560-561 \ntracking error, 538,561, 571-572 \n\"mini-index,\" creating, 566-574 (see also Stock index \nhedging strategies, index, simulating) \nprogram trading, 537-547 \nadjusted volatility, 539 \narbitrage approach, 537 \nhedging with index calls, 545-547 \nhedging with index puts, 543-545 \nhedging portfolios with index options, 541-543 \nmarket risk, removing, 538 \nportfolio hedge, 539-541 \ntracking error, 538, 561, 571-572 \nvolatility versus Beta, 538-539 \nsummary, 577-578 \ntracking error, trading, 57 4-577 \ncollateral requirements, 577 \nStock indices, 493-500 \nStock options: \nbasic properties of, 1-35 \ndefinitions, 3-35 \ndefinition, 3-35 \nStock price and option price, relationship between, \n7-9 \nStock prices, distribution of, 783-811 \ndistribution, 789-795 \n\"big\" picture, 790 \nfat tails, 790-792, 810 \ninflection points, 792-793 \nnormal, 780-795 \nrisk of too conservative estimate of stock price \nmovement, 796 \nsummary, 796-797 \nElliott Wave theory, 796 \nexpected return, 809-810 \nlognormal distribution, 783-789 \noptions, pricing of, 798 \nprobability of stock price movement, 798-809 \nBrownian motion, 806 \ncalculation mechanisms, 803-805 \ncumulative density function (CDF), 806 \ndelta, 805 \n\"ever\" probability calculator, 805-806 \nMonte Carlo analysis, 806, 807-809 \nprobability calculator, 798-799 \nsummary, 810-811 \nvolatility, prediction of, 799-803 \nsigma, 783-784 \nvolatility buyer's rule, 787-789 \nvolatility, misconceptions about, 783-787 \nstandard deviations, 783-786 \nwhat this means for option traders, 795-796 \nStock splits, symbols for, 27 \n997 \nStock trading and futures trading, difference between, \n508,512 \nStop order, 33 \nStop-limit order, 33-34 \nStraddle: \nbuying, 282-288 (see also Put buying) \nequivalent stock position follow-up, 312-313 \nfollow-up action, 308-312 \n\"legging out,\" 310 \nrisk large, 308, 314 \nrolling up/down, 310 \nin volatility trading, 824, 825, 829 \nsale of, 302-320 \ncovered, 302-305 \nuncovered, 305-307 \nselecting write, 307-308 \nselling, LEAPS and, 402-403 \nstarting out with protection in place, 313-314 \nstrangle (combination) writing, 315-320 \ncredits, using, 320 \ndefinition, 315 \ndeltas, 318-319 \nexcess trading, avoiding, 319-320 \nmargin requirements, 317-318 \nStraddle calendar spread, 348-350 (see also Spreads \ncombining calls and puts) \nStraddle/strangle buying and selling, effects on of \nimplied volatility changes, 766-767 \nStrangle, 281 \nbuying, 288-291 \ndefinition, 315 \nin volatility tr", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 434}
{"text": "14 \nstrangle (combination) writing, 315-320 \ncredits, using, 320 \ndefinition, 315 \ndeltas, 318-319 \nexcess trading, avoiding, 319-320 \nmargin requirements, 317-318 \nStraddle calendar spread, 348-350 (see also Spreads \ncombining calls and puts) \nStraddle/strangle buying and selling, effects on of \nimplied volatility changes, 766-767 \nStrangle, 281 \nbuying, 288-291 \ndefinition, 315 \nin volatility trading, 824, 825, 828-829 \nstrangle (combination) writing, 315-320 (see also \nStraddle) \nStrategy, best, 932-937 \ninvestor as dominant force in determining strategy, \n938 \nmarket attitude and equivalent positions, 932-934 \nmathematical ranking, 936-937 \nstrategies to be avoided, 933 \nsummary, 937 \nvolatility trading, 932-933 \nStrategy summary, 943-944 \n998 \nStriking price: \nas factor influencing price, 9-10 \ncode, 24-25 \ndefinition, 3, 4 \nfractional, 29 \nstandardization, 5 \nStructured products, 589-640 \nadjustment factor, 602-604 \ncost, measuring, 605-607, 608 \nbreak-even final index value, 604-605 \nexotic options, 590 \nimbedded call, computing value of when underlying \nis trading at discount, 602 \nincome, products designed to provide, 618-639 \ncovered write of call option, resembling, 619 \nCreation Units, 638 \nDiamonds, 638 \nExchange-Traded Funds (ETFs), 637-639 (see \nalso Exchange-Traded Funds) \nHOLDRS, 639 \niShares, 638 \nNASDAQ-100 tracking stock (QQQ), 638, 639 \noptions on ETFs, 639 \nPERCS (Preferred Equity Redemption \nCumulative Stock (PERCS), 619-637 (see also \nPERCS) \nRussell 2000 Value Fund and 2000 Growth Fund, \n638 \nmore appeal for investors than for traders, 589 \n\"riskless\" ownership of stock or index, 590-618 \nannual adjustment factor, 594 \nbull spread, 608-612 \ncash value, 593-594 \nconstructs, other, 607-613 \ndividends, 594 \nequity-linked notes, 618 \nfinancial engineers, role of in structured products, \n590,607 \nimbedded call option, cost of, 594-595 \nincome tax consequences, 592-593 \nLEAPS options, 616-617 \nlist, 618 \nmultiple expiration dates, 613 \nmultiplier, 614 \noption strategies involving structured products, \n613-618 \nOriginal Issue Discount (OID), 592-593 \nphantom interest, 592 \nprice behavior p1ior to maturity, 595-596 \nSIS (Stock Index return Security), 596-601 (see \nalso SIS) \nstrike price, 592, 615-618 \nstructure, 590-593 \nwhen underlying index drops, 617 \nIndex \nsummary, 640 \nSuitability of strategy for individual investor, 3 \nSwiss franc contract for foreign currency options, 672 \nSymbology, options, 23-27 (see also Options) \nSynthetic convertible bond, 441 (see also Options and \nTreasury bills) \nSynthetic long call, 271 \nSynthetic long stock, 321-323 \nSynthetic stock positions created by puts and calls, 321-\n328 \nsplitting strikes, 325-328 \nbearishly oriented, 327-328 \nbullishly oriented, 325-327 \nprotective collar, 328 \nsummary, 328 \nsynthetic long stock, 321-323 \nsynthetic short sale, 323-325 \nleverage, 324 \n\"Synthetic\" strategies, 118 \nput, 118-121 \nTau, 859-862 \nTax considerations, put purchase, 275 \nTaxes, 908-931 \nassignment, 914-920 \napplicable stock price (ASP), 917 \nqualified covered call, 917-920, 961-962 \n\"too-deeply-in-the-money\" definition, 916 \nequity options, strategies for, 925-930 \ndeferring put holder's short-term gain, 928 \ndeferring short-term call gain, three tactics for, \n928 \ndifficulty of deferring gains from writing, 928-929 \nspreads, unequal tax treatment on, 929-930 \nexercise, 913-914 \nhistory, 908-909 \n\"married\" put and stock, 924 \n\"new\" stock, delivering to avoid large long-term gain, \n920-921 \n\"versus purchase\" notation 921 \noption as capital asset, 908 \nproblems, special, 922-925 (see also under particular \nproblem heading) \nprofit strategies and tax strategies, separating, 931 \nprotecting long-term gain/avoiding long-term loss, \n924-925 \nput assignment, 921-922 \nput exercise, 921 \nshort sale rule, 923-925 \nsummary, 925, 930-931 \ntax treatment, basic, 910-913 \ncall buyer, 910-911 \ncall writer, 910, 911-912 \nIndex \nTaxes (continued) \nput buyer, 910 \nput writer, 910, 912 \n60/40 rule, 912-913 \nwash sale rule, 922-923 \nTED spread, 701-702, 712-714 \ncarrying cost, 702 \nTender offers, risk arbitrage and, 451-454 \npartial, 454 \nshort tendering, 453 \ntwo-tier offers, 454 \nTheta, 862-864, 866 \nposition theta, 877 \nTime spread, 191-199 (see also Calendar spread) \n. Time value premium, 7-8, 11, 762-765 \nand volatility trading, 106-107 \ndecay, 13-14 \nfor put options, 246-247 \n\"greeks\" to measure, 763 \nTotal return concept of covered writing, 45-47, 60-61, \n93 \nTracking error: \nrisk, index hedging and, 538,561, 571-572 \ntrading, 574-577 \nTrading against the straddle strategy, 126-127, 287 \nTrading options, details of, 27-32 (see also Options) \nTrapezoidal hedge, 155, 156, 157 \nTrapezoidal Rule, 471 \nTreasury bills, 413-421 (see also Options and \nTreasury bills) \nUncovered call writing, 132-145 (see also Naked call \nwriting) \ncall option, 133-134 \nUncovered straddle write equivalent to ratio call write, \n306 \nUnderlying security, definition, 3 \nUnderlying stock, price of as factor influencing option \nprice, 9-10 \nUp delta concept, 100-101 \n\"Using box stock,\" 432 \nValue Line Index, 532, 579, 582 \nVega of option, 749-753, 860-862 (see also Volatility, \neffects of) \nand excess value, 764 \noption or position vega, 757,862 \nVertical put spreads, effect on of implied volatility, \n775-777 \nVertical spread, 169, 186 \nVolatility, effect of on popular strategies, 7 49-782 \nbackspreads, 781-782 \ncalendar spreads, 778-780 \ncall bull spreads, 767-775 \nvega of option, 768 \nimplied volatility, effect of, 749-782 \nand delta, 753-754 \nneutrality, effects on, 755-756 \noutright option purchases and sales, 757-762 \nposition vega, 757 \nput bear spreads, 777-778 \nput option, 765-766 \nratio spreads, 780-781 \nstraddle/strangle buying and selling'. 766-767 \nsummary, 782 \n999 \ntime value premium, 762-765 \ndelta, 764 \nfactors, five, 762-763 \n\"greeks\" to measure, 763-764 \nvega, 7 49-753 \nand excess value, 764 \ndefinition, 7 49-750 \nvertical put spreads, 775-777 \nVolatility, measu", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 435}
{"text": "option purchases and sales, 757-762 \nposition vega, 757 \nput bear spreads, 777-778 \nput option, 765-766 \nratio spreads, 780-781 \nstraddle/strangle buying and selling'. 766-767 \nsummary, 782 \n999 \ntime value premium, 762-765 \ndelta, 764 \nfactors, five, 762-763 \n\"greeks\" to measure, 763-764 \nvega, 7 49-753 \nand excess value, 764 \ndefinition, 7 49-750 \nvertical put spreads, 775-777 \nVolatility, measuring and trading, 723-931 (see also \nunder particular heading) \nadvanced concepts, 846-907 \nbasics of volatility trading, 727-7 48 \ndefinition, 859-860 \nmost important concept in option trading, 724 \nstock prices, distribution of, 783-811 \ntaxes, 908-931 \nvolatility, effect of on popular strategies, 7 49-782 \nvolatility trading techniques, 812-845 \nwhy trade \"the market,\" 724-726 \nVolatility, misconceptions about, 783-787 \nbuyer's rule, 787-789 \nVolatility, prediction of, 799-803 \nVolatility backspread, 827, 834-836, 841 \nmargin, 836 \nnot for LEAPS options, 835 \nVolatility in Black-Scholes model, 460 \nhistorical, 461-466 (see also Historical volatility) \nVolatility Index ($VIX), 738, 761, 785-786 \nVolatility of stocks, 538-539 \nadjusted, 539 \nof underlying stock: \nas factor in option price, 13-14 \ncall option rankings and, 103-106 \nVolatility skew, 517, 683, 685, 693-694, 813 \ntrading, 837-844 (see also Volatility trading) \nVolatility trading, basics of, 727-7 48 \ndefinitions, 728-731 \nhistorical volatility, 728-731 \nimplied volatility, 727, 732-743 \nGARCH (Generalized Autoregressive Conditional \nHeteroskedasticity), 731-732 \n1000 \nVolatility trading, basics of (continued) \n\"fudge factor,\" 731, 733 \nimplied volatility, 727, 732-743 \nas predictor of actual volatility, 737-7 43 \nLEAPS, 735, 736 \npercentile, 734-735 \nrange, 735-737 \ntime left in option, 736-737 \nVolatility Index ($VIX), 738 \nmoving averages, 732 \nsummary, 748 \ntrading, 7 43-7 44 \nwhy volatility reaches extremes, 7 44-7 48 \nbear market in underlying stock, 746-747 \ncheap options, 747-748 \nilliquid options, 745-746 \ninsider trading, 7 45 \nsellers of volatility, danger for, 7 48 \nsupply and demand of public, 747 \nVolatility trading techniques, 812-845 \nas art and science, 812 \nsummary, 844-845 \ntrading volatility prediction, 814-837 \nbackspreads, 827, 834-836 (see also Volatility \ntrading techniques, volatility backspread) \ncalendar spread, selling, 833 \ncomposite implied volatility reading, 815 \nhistogram, construction of, 831-832 \nhistorical volatility, comparing current and past, \n821-824 \nimplied and historical volatility, comparing, 817-\n818 \npercentile of implied volatility approach, 814-817 \nprobability calculator, 824, 827-829 \nreverse calendar spread, 833-834 \nselecting strategy to use, 824-826 \nselling volatility, 826-827, 833-836 \nstock price history, using, 829-832 \nsummary, 836-837 \nvolatility chart, reading, 818-821 \nwhen volatility is out of line, determining, \n814 \nvolatility backspread, 827, 834-836, 841 \nmargin, 836 \nnot for LEAPS options, 835 \nvolatility skew, trading, 837-844 \ncollar, 840 \nIndex \ndiffering implied volatilities on same underlying \nsecurity, 837-838 \nforward/positive volatility skew, 843 \nreverse/negative volatility skew, 839-840 \nsummary, 844 \nwrong predictions, two ways for, 813 \nvolatility skew, 813 \nWarrants: \ncovered writing against, 90-91 \nrho, 872-873 \nWash sale rule, 922-923 \nWhipsaw, 403 \nWrap symbols, 25-26 \nWriter, definition, 6 \nXMI (Major Market Index), 499 \nIndex 1001 \nSPECIAL OFFER \nTrial subscriptions to the advisory services published by McMillan Analysis Corp. are \navailable to owners of this book. All of these services make specific recommendations \nin the stock, index, and futures option markets, including detailed follow-up action -\nwith recommendations regarding broad market movements, implemented with index \noptions. \n• The Option Strategist \nPublished twice per month by email, US Mail, or fax (additional charge for fax) \nContains educational and topical articles \nCovers a wide variety of option strategies \nFREE telephone or web site HOTLINE updated weekly \n• The Daily Strategist \nPublished once or twice per day by email or fax \nFollows many of the same strategies as The Option Strategist above \nCovers put-call ratios, market commentary, momentum trading, and volatility \ntrading \n• Daily Volume Alerts \nPublished once per day, before the trading day begins, via email or fax \nAnalysis of stocks with unusually heavy option activity \nLooking for takeovers, earnings surprises, and momentum plays \nTrack records and further descriptions off all these services are available on our web \nsite at www.optionstrategist.com. \nYES! Sign me up for the following trial subscriptions: \n0 3 months of The Option Strategist ( 6 issues) \n0 1 month of Daily Volume Alerts for $75 (regularly $95) \n0 1 month of The Daily Strategist for $250 (regularly $350) \nName __________________________ _ \nAddress ---------------------------City __________ State/Province __ Zip/Postal _____ _ \nCharge to my: 0 VISA O Mastercard O American Express 0 Discover \nCard Number Expiration Date ____ _ \nCall 800-724-1817 or 908-850-7113 \nor shop at http://www.optionstrategist.com \nOr copy this form and mail to: \nMcMillan Analysis Corp., P. 0. Box 1323, Morristown, NJ 07962-1323", "source": "eBooks\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf", "doc_id": "d4f5a403908cac96af3c5a24ede4256a636800cf59a7c17c001084657c05938b", "chunk_index": 436}
{"text": "Technical Analysis \nof Stock Trends\nEleventh Edition\n\nTechnical Analysis \nof Stock Trends\nEleventh Edition\nRobert D. Edwards\nJohn Magee\nW. H. C. Bassetti\nA PRODUCTIVITY PRESS BOOK\nRoutledge\nTaylor & Francis Group\n711 Third Avenue, New York, NY 10017\n© 2019 by Taylor & Francis Group, LLC\nProductivity Press is an imprint of Taylor & Francis Group, an Informa business\nNo claim to original U.S. Government works\nPrinted on acid-free paper\nInternational Standard Book Number-13: 978-1-138-06941-1 (Hardback)\nThis book contains information obtained from authentic and highly regarded sources. Reasonable efforts have been \nmade to publish reliable data and information, but the author and publisher cannot assume responsibility for the \nvalidity of all materials or the consequences of their use. The authors and publishers have attempted to trace the \ncopyright holders of all material reproduced in this publication and apologize to copyright holders if permission to \npublish in this form has not been obtained. If any copyright material has not been acknowledged please write and let \nus know so we may rectify in any future reprint.\nExcept as permitted under U.S. Copyright Law, no part of this book may be reprinted, reproduced, transmitted, or \nutilized in any form by any electronic, mechanical, or other means, now known or hereafter invented, including pho -\ntocopying, microfilming, and recording, or in any information storage or retrieval system, without written permission \nfrom the publishers.\nFor permission to photocopy or use material electronically from this work, please access www.copyright.com ( http://\nwww.copyright.com/ ) or contact the Copyright Clearance Center, Inc. (CCC), 222 Rosewood Drive, Danvers, MA \n01923, 978-750-8400. CCC is a not-for-profit organization that provides licenses and registration for a variety of users. \nFor organizations that have been granted a photocopy license by the CCC, a separate system of payment has been \narranged.\nTrademark Notice: Product or corporate names may be trademarks or registered trademarks, and are used only for \nidentification and explanation without intent to infringe.\nLibrary of Congress Cataloguing-in-Publication Data\nNames: Edwards, Robert D. (Robert Davis), 1893- author. | Magee, John, 1901- \nauthor. | Bassetti, W. H. C., author.\nTitle: Technical analysis of stock trends / Robert D. Edwards, John Magee, \nW.H.C. Bassetti.\nDescription: Eleventh Edition. | New York : CRC Press, [2018] | Revised \nedition of the authors’ Technical analysis of stock trends, c2013. | \nIncludes bibliographical references and index.\nIdentifiers: LCCN 2018010151 | ISBN 9781138069411 (hardback : alk. paper)\nSubjects: LCSH: Investment analysis. | Stock exchanges--United States. | \nSecurities--United States.\nClassification: LCC HG4521 .E38 2018 | DDC 332.63/20420973--dc23\nLC record available at https://lccn.loc.gov/2018010151\nVisit the Taylor & Francis Web site at\nhttp://www.taylorandfrancis.com\nand the Productivity Press site at\nhttp://www.ProductivityPress.com\nFigure 0.1 DOW 25000! What a birthday present for the 11th edition! The Dow continues to set records since March of 2009, as vividly illustrated \nby this chart.\n\nvii\nContents\nPreface to the eleventh edition ....................................................................................................xv\nPreface to the tenth edition ....................................................................................................... xvii\nPreface to the ninth edition ....................................................................................................... xxi\nPreface to the eighth edition ..................................................................................................... xxv\nIn memoriam ............................................................................................................................ xxxv\nPreface to the seventh edition ..............................................................................................xxxvii\nPreface to the fifth edition .......................................................................................................... xli\nPreface to the fourth edition .....................................................................................................xliii\nPreface to the second edition ..................................................................................................... xlv\nForeword ....................................................................................................................................xlvii\nPart I: Technical theory\nChapter 1 The technical approach to trading and investing ..............................................3\nDefinition of technical analysis .....................................................................................................4\nChapter 2 Charts .........................................................................................................................7\nDifferent types of scales .................................................................................................................8\nChapter 3 The Dow Theory.....................................................................................................11\nThe Dow Averages ........................................................................................................................12\nBasic tenets .....................................................................................................................................12\nTide, wave, and ripple .............................................................................................................. 14\nMajor trend phases ................................................................................................................... 14\nPrinciple of confirmation ........................................................................................................ 16\nChapter 4 The Dow Theory’s defects ...", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 0}
{"text": "...................................................................................... 14\nMajor trend phases ................................................................................................................... 14\nPrinciple of confirmation ........................................................................................................ 16\nChapter 4 The Dow Theory’s defects ....................................................................................21\nThe Dow Theory is too late ......................................................................................................... 21\nThe Dow Theory is not infallible ................................................................................................23\nThe Dow Theory frequently leaves the investor in doubt .................................................23\nThe Dow Theory does not help the Intermediate Trend investor .....................................23\nThe Dow Theory in the 20th and 21st centuries .......................................................................26\nChapter 5 Replacing Dow Theory with John Magee’s Basing points Procedure ........31\nThe fractal nature of the market ................................................................................................. 31\nviii Contents\nChapter 6 Important Reversal Patterns ................................................................................41\nImportant Reversal Patterns ........................................................................................................42\nTime required to reverse a trend ................................................................................................42\nThe Head-and-Shoulders Top Formation ..................................................................................44\nVolume is important .....................................................................................................................44\nBreaking the neckline ...................................................................................................................47\nVariations in Head-and-Shoulders Tops ....................................................................................49\nPrice action following confirmation: the measuring formula ................................................ 52\nRelation of Head-and-Shoulders to Dow Theory .....................................................................55\nChapter 7 Important Reversal Patterns: continued ............................................................57\nHead-and-Shoulders (EN: or Kilroy) Bottoms ..........................................................................57\nMultiple Head-and-Shoulders Patterns .....................................................................................59\nTendency to symmetry ................................................................................................................. 61\nA leisurely pattern ........................................................................................................................65\nRounding Tops and Bottoms .......................................................................................................66\nHow Rounding Turns affect trading activity ........................................................................... 70\nThe Dormant Bottom variation ...................................................................................................73\nVolume pattern at Tops ................................................................................................................ 74\nChapter 8 Important Reversal Patterns: the Triangles ......................................................77\nSymmetrical Triangles..................................................................................................................79\nSome cautions about Symmetrical Triangles ............................................................................82\nHow prices break out of a Symmetrical Triangle .....................................................................88\nA typical Triangle development .................................................................................................90\nReversal or Consolidation ............................................................................................................94\nThe Right-Angle Triangles ...........................................................................................................97\nA planned distribution .................................................................................................................98\nDescending Triangles ...................................................................................................................98\nVolume characteristics same as the Symmetrical type ...........................................................99\nMeasuring implications of Triangles ....................................................................................... 100\nTriangles on weekly and monthly charts ................................................................................ 100\nOther Triangular formations ..................................................................................................... 100\nChapter 9 More important Reversal Patterns ...................................................................103\nThe Rectangles, Double and Triple Tops ................................................................................. 103\nPool operations ............................................................................................................................ 105\nRelation of rectangle to Dow Line ............................................................................................ 112\nRectangles from Right-Angle Triangles ................................................................................... 113\nDouble and Triple Tops and Bottoms .....................................", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 1}
{"text": ".................................................................. 105\nRelation of rectangle to Dow Line ............................................................................................ 112\nRectangles from Right-Angle Triangles ................................................................................... 113\nDouble and Triple Tops and Bottoms ....................................................................................... 113\nDistinguishing characteristics .................................................................................................. 115\nDouble Bottoms ........................................................................................................................... 118\nTriple Tops and Bottoms ............................................................................................................ 118\nChapter 10 Other Reversal phenomena ................................................................................121\nThe Broadening Formations ...................................................................................................... 121\nVolume during Broadening Formations ..................................................................................122\nA typical example ....................................................................................................................... 128\nixContents\nThe Orthodox Broadening Top ................................................................................................. 130\nWhy no Broadening Bottoms?................................................................................................... 135\nRight-Angled Broadening Formations ..................................................................................... 135\nThe Diamond ............................................................................................................................... 137\nWedge Formations ...................................................................................................................... 139\nThe Falling Wedge ...................................................................................................................... 142\nWedges on weekly and monthly charts................................................................................... 143\nRising Wedges common in Bear Market Rallies .................................................................... 144\nThe One-Day Reversal ................................................................................................................ 144\nThe Selling Climax ..................................................................................................................... 145\nShort-term phenomena of potential importance .................................................................... 147\nSpikes ............................................................................................................................................ 147\nRunaway Days ............................................................................................................................. 148\nKey Reversal Days....................................................................................................................... 148\nChapter 11 Consolidation Formations ..................................................................................151\nFlags and Pennants ..................................................................................................................... 151\nThe Pennant: a pointed Flag ...................................................................................................... 153\nThe measuring formula ............................................................................................................. 154\nReliability of Flags and Pennants ............................................................................................. 156\nWhere they may be expected .................................................................................................... 157\nFlag pictures on weekly and monthly charts ......................................................................... 158\nRectangular Consolidations: an early phase phenomenon .................................................. 159\nHead-and-Shoulders Consolidations ....................................................................................... 160\nScallops: repeated Saucers ......................................................................................................... 162\nModern versus old-style markets ............................................................................................. 168\nChapter 12 Gaps ........................................................................................................................171\nWhich gaps are significant? ....................................................................................................... 171\nClosing the gap ............................................................................................................................ 171\nEx-dividend gaps......................................................................................................................... 174\nThe common or area gap ....................................................................................................... 175\nBreakaway gaps ...................................................................................................................... 177\nContinuation or runaway gaps and the measuring rule .................................................. 182\nTwo or more runaway gaps .................................................................................................. 184\nExhaustion gaps ..................................................................................................................... 185\nThe Island Reversal ..........................................................................", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 2}
{"text": "................................... 182\nTwo or more runaway gaps .................................................................................................. 184\nExhaustion gaps ..................................................................................................................... 185\nThe Island Reversal ..................................................................................................................... 186\nGaps in the Averages .................................................................................................................. 187\nChapter 13 Support and Resistance .......................................................................................189\nNormal trend development ....................................................................................................... 190\nThe explanation ........................................................................................................................... 191\nEstimating Support–Resistance potential ............................................................................... 193\nLocating precise levels ............................................................................................................... 196\nSignificance of Support failure .................................................................................................. 197\nPopular misconceptions ............................................................................................................. 198\nThe round figures .......................................................................................................................200\nRepeating historical levels .........................................................................................................200\nx Contents\nPattern Resistance ....................................................................................................................... 202\nVolume on breaks through Support .........................................................................................205\nSupport and Resistance in the Averages .................................................................................206\nChapter 14 Trendlines and Channels ...................................................................................207\nThe Trendline............................................................................................................................... 207\nHow Trendlines are drawn ........................................................................................................209\nArithmetic versus logarithmic scale ........................................................................................ 211\nTests of authority ......................................................................................................................... 216\nValidity of penetration ...............................................................................................................220\nAmendment of Trendlines .........................................................................................................222\nDouble Trendlines and trend ranges .......................................................................................222\nTrend Channels ...........................................................................................................................223\nExperimental Lines ..................................................................................................................... 224\nConsequences of Trendline penetration: Throwbacks .......................................................... 224\nIntermediate Downtrends .........................................................................................................225\nCorrective trends: the Fan Principle .........................................................................................226\nChapter 15 Major Trendlines ..................................................................................................229\nMajor Downtrends ...................................................................................................................... 242\nMajor Trend Channels ................................................................................................................ 242\nTrendlines in the Averages ........................................................................................................ 243\nTrading the Averages in the 21st century ................................................................................244\nChapter 16 Technical analysis of commodity charts .........................................................245\nTechnical analysis of commodity charts, part 2: a 21st-century perspective ..................... 249\nRocket scientists .......................................................................................................................... 249\nTurtles? ..........................................................................................................................................250\nThe application of Edwards and Magee’s methods to 21st-century futures markets ....... 252\nStops .........................................................................................................................................258\nA variety of methods ..................................................................................................................259\nEverything you need to know as a chart analyst trading futures .......................................259\nChapter 17 A summary and concluding comments ...........................................................261\nTechnical analysis and technology in the 21st century: the computer and the \ninternet: tools of the investment/information revolution .....................................................265\nThe importance of computer technology ................................................................", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 3}
{"text": "hapter 17 A summary and concluding comments ...........................................................261\nTechnical analysis and technology in the 21st century: the computer and the \ninternet: tools of the investment/information revolution .....................................................265\nThe importance of computer technology ................................................................................ 267\nSummary 1 ..............................................................................................................................268\nOther technological developments of importance to the technical Magee analyst \nand all investors\n ..........................................................................................................................268\nThe Internet: the eighth wonder of the modern world (EN9: Appendix B, \nResources, for the ninth edition has been enormously expanded and is of \nparamount importance to modern investors.)\n ...................................................................268\nMarking-to-market ................................................................................................................. 269\nSeparating the wheat from the chaff ................................................................................... 270\nChaff ......................................................................................................................................... 270\nSummary 2 .............................................................................................................................. 270\nAdvancements in investment technology, part 1: developments in finance theory \nand practice\n .................................................................................................................................. 271\nxiContents\nOptions .................................................................................................................................... 271\nQuantitative analysis .............................................................................................................272\nOptions pricing models and their importance .................................................................. 273\nFutures on indexes ................................................................................................................. 273\nOptions on futures and indexes ........................................................................................... 274\nModern Portfolio Theory ...................................................................................................... 275\nThe wonders and joys of investment technology .............................................................. 275\nAdvancements in investment technology, part 2: futures and options on futures on \nthe Dow–Jones Industrial Index at the CBOT ......................................................................... 275\nInvestment and hedging strategies using the CBOT® DJIASM futures contract ............ 276\nSettlement of futures contracts............................................................................................. 276\nMarking-to-market ................................................................................................................. 276\nFungibility ............................................................................................................................... 276\nDifferences between cash and futures ................................................................................277\nDow Index futures .................................................................................................................277\nUsing stock index futures to control exposure to the market .........................................277\nInvestment uses of Dow Index futures ............................................................................... 279\nSituation 1: Portfolio protection ....................................................................................... 279\nSituation 2: Increasing exposure with futures ..............................................................280\nSituation 3: Using bond and index futures for asset allocation ..................................280\nPerspective............................................................................................................................... 282\nOptions on Dow Index futures ............................................................................................ 282\nOption premiums ...................................................................................................................283\nVolatility ..................................................................................................................................283\nExercising the option .............................................................................................................284\nUsing futures options to participate in market movements ............................................284\nProfits in rising markets ........................................................................................................284\nExploiting market reversals ..................................................................................................285\nUsing puts to protect profits in an appreciated portfolio .................................................285\nSituation 1 ...........................................................................................................................285\nImproving portfolio yields ....................................................................................................286\nSituation 2 ...........................................................................................................................286\nUsing option spreads in high- or low-volatility markets .................................................286\nSituation 3 ...............................................", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 4}
{"text": ".........................................................................................286\nSituation 2 ...........................................................................................................................286\nUsing option spreads in high- or low-volatility markets .................................................286\nSituation 3 ...........................................................................................................................286\nSituation 4 ........................................................................................................................... 287\nPerspective............................................................................................................................... 287\nRecommended further study .................................................................................................... 287\nPart II: Trading tactics\nChapter 18 The tactical problem ............................................................................................293\nStrategy and tactics for the long-term investor—What’s a speculator? What’s an \ninvestor? ........................................................................................................................................ 297\nOne definition of the long-term investor .................................................................................299\nThe strategy of the long-term investor .....................................................................................299\nRhythmic investing ....................................................................................................................300\nSummary ......................................................................................................................................302\nxii Contents\nChapter 19 The all-important details ....................................................................................303\nThe simplest and most direct way to use a computer for charting analysis ......................304\nSummary ......................................................................................................................................305\nChapter 20 The kind of stocks we want: the speculator’s viewpoint .............................307\nThe kind of stocks we want: the long-term investor’s viewpoint ........................................ 310\nChanging opinions about conservative investing ............................................................. 310\nThe kinds of stocks long-term investors want: the long-term investor’s viewpoint ......... 311\nConstruction of the Index Shares and similar instruments ................................................. 311\nAn outline of instruments available for trading and investing ...................................... 312\nThe importance of these instruments: diversification, dampened risks, tax, and \ntechnical regularity ..................................................................................................................... 313\nSummary ...................................................................................................................................... 313\nChapter 21 Selection of stocks to chart .................................................................................315\nChapter 22 Selection of stocks to chart: continued ............................................................319\nChapter 23 Choosing and managing high-risk stocks: tulip stocks, Internet \nsector, and speculative frenzies ........................................................................325\nManaging tulipomanias and Internet frenzies and…Bitcoin ............................................... 326\nDetailed techniques for management of the runaway issues .............................................. 328\nHope springs eternal and there is one born every second ................................................... 332\nChapter 24 The probable moves of your stocks ..................................................................341\nChapter 25 Two touchy questions ..........................................................................................345\nThe use of margin .......................................................................................................................345\nShort selling .................................................................................................................................346\nChapter 26 Round lots or odd lots?........................................................................................351\nChapter 27 Stop orders .............................................................................................................353\nThe progressive stop ...................................................................................................................355\nStop systems and methods ........................................................................................................ 357\nA brief survey of stop methods .................................................................................................358\nSome other stop methods ..........................................................................................................358\nAverage True Range ...............................................................................................................358\nParabolic stop and reverse ....................................................................................................359\nTarget stops .............................................................................................................................359\nA natural method used by the Turtles ..................................................................................... 359\nChapter 28 What is a Bottom and what is a Top? ...............................................................361\nBasing Points ......................................................", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 5}
{"text": ".......................................................................................359\nA natural method used by the Turtles ..................................................................................... 359\nChapter 28 What is a Bottom and what is a Top? ...............................................................361\nBasing Points ................................................................................................................................ 362\nBasing Points: a case analyzed ..................................................................................................364\nThe Basing Points paradigm......................................................................................................365\nKey to Figure 28.2 analysis ...................................................................................................366\nA narrative of the events in the chart....................................................................................... 367\nxiiiContents\nThe complete Basing Points Procedure: taking into consideration the setting of \nBasing Points on both wave lows and new highs ..................................................................368\nThe complete Basing Points procedure .................................................................................... 369\nTwo charts giving a long-view perspective on the complete (Variant 2) procedure ......... 370\nThe representative case fully analyzed using wave lows and new highs .......................... 370\nA narrative of the events in the chart....................................................................................... 371\nChapter 29 Trendlines in action .............................................................................................373\nBuying stock, “going long” ........................................................................................................ 375\nLiquidating, or selling a long position ..................................................................................... 378\nSelling stock short ....................................................................................................................... 379\nCovering short sales.................................................................................................................... 379\nAdditional suggestions ..............................................................................................................380\nGeneral outline of policy for trading in the Major Trend .....................................................380\nChapter 30 Use of Support and Resistance ..........................................................................383\nChapter 31 Not all in one basket ............................................................................................389\nEN: diversification and costs .....................................................................................................390\nChapter 32 Measuring implications in technical chart patterns .....................................391\nChapter 33 Tactical review of chart action ...........................................................................393\nThe Dow Theory ......................................................................................................................... 393\nHead-and-Shoulders Top ...........................................................................................................400\nHead-and-Shoulders Bottom ..................................................................................................... 401\nComplex or multiple Head-and-Shoulders .............................................................................403\nRounding Tops and Bottoms .....................................................................................................403\nSymmetrical Triangles................................................................................................................406\nRight-Angle Triangles.................................................................................................................408\nBroadening Tops..........................................................................................................................408\nRectangles ....................................................................................................................................408\nDouble Tops and Bottoms ..........................................................................................................409\nRight-Angled Broadening Formations .....................................................................................409\nThe Diamond ...............................................................................................................................409\nWedges ..........................................................................................................................................409\nOne-Day Reversals ...................................................................................................................... 410\nFlags and Pennants ..................................................................................................................... 410\nGaps .............................................................................................................................................. 411\nSupport and Resistance .............................................................................................................. 414\nTrendlines..................................................................................................................................... 414\nChapter 34 A quick summation of tactical methods ..........................................................417\nGet out of present commitments .............................................................................................. 417\nMake new commitments ............................................", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 6}
{"text": "......................................................................................... 414\nChapter 34 A quick summation of tactical methods ..........................................................417\nGet out of present commitments .............................................................................................. 417\nMake new commitments ............................................................................................................ 418\nChapter 35 Effect of technical trading on market action ..................................................419\nxiv Contents\nChapter 36 Automated trendline: the Moving Average ....................................................421\nSensitizing Moving Averages ....................................................................................................422\nCrossovers and penetrations .....................................................................................................422\nThe PENTAD Moving Average system from Formula Research ......................................... 424\nChapter 37 The same old patterns .........................................................................................427\nNot all the same ...........................................................................................................................428\nChapter 38 Balanced and diversified ....................................................................................481\nSeptember 28, 1985: an oversold market ..................................................................................486\nChapter 39 Trial and error .......................................................................................................487\nChapter 40 How much capital to use in trading .................................................................489\nChapter 41 Application of capital in practice ......................................................................491\nPut and call options .................................................................................................................... 493\nChapter 42 Portfolio risk management .................................................................................495\nOvertrading: a paradox .............................................................................................................. 496\nRisk of a single stock .................................................................................................................. 498\nRisk of a portfolio ........................................................................................................................499\nEN9: Risk and trend ....................................................................................................................499\nValue-at-Risk procedure .............................................................................................................499\nPragmatic Portfolio Theory (and practice) ..............................................................................500\nPragmatic portfolio risk measurement ....................................................................................500\nDetermining the risk of one stock .......................................................................................500\nDetermining the risk for a portfolio .................................................................................... 501\nMeasuring maximum drawdown (maximum retracement) ................................................502\nPragmatic portfolio analysis: measuring the risk ..................................................................502\nPortfolio Ordinary or Operational Risk ..............................................................................502\nPortfolio risk over time ..........................................................................................................503\nPortfolio extraordinary or catastrophic risk .......................................................................503\nControlling the Risk ...................................................................................................................503\nSummary of Risk and Money Management Procedures ......................................................503\nInfinitely more sophisticated risk and money management procedures—Ralph \nVince and optimal f ....................................................................................................................504\nChapter 43 Stick to your guns ................................................................................................505\nAppendix A: The Dow Theory in practice ..............................................................................507\nAppendix B: Resources .............................................................................................................. 523\nAppendix C: Technical Analysis: beyond Edwards & Magee .............................................. 537\nList of Illustrations and Text Diagrams ...................................................................................565\nAlphabetic Index of Stock Charts ............................................................................................. 579\nGlossary ........................................................................................................................................ 595\nBibliography ................................................................................................................................. 621\nIndex ............................................................................................................................................. 623\nxv\nPreface to the eleventh edition\nBeyond Edwards & Magee\nI would be remiss if I did not note the passing of two important figures in the discipline \nof technical analysis—Richard Arms Jr. and Professor Hank Pruden of Golden Gate \nUniversity. Well liked and admired they leave large gaps in the community. The article \nhere b", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 7}
{"text": "...................................................................... 623\nxv\nPreface to the eleventh edition\nBeyond Edwards & Magee\nI would be remiss if I did not note the passing of two important figures in the discipline \nof technical analysis—Richard Arms Jr. and Professor Hank Pruden of Golden Gate \nUniversity. Well liked and admired they leave large gaps in the community. The article \nhere by Arms is literally his last contribution to the field. Long the central figure in San \nFrancisco, Hank Pruden, much loved and admired leaves the entire field with an enormous \ngap. He was my particular friend and mentor. He will be infinitely missed.\nThe reader is advised to read the prefaces to previous editions. They are of a piece \nwith the internal text and some practices—of notation and treatment may not make sense \notherwise. Those who think gender should be catered to will find my previous comments \non that issue. Why repeat it here?\nLet me address the central question focused on by this new edition: This book has \nstudiously ignored an entire field of technical analysis—number driven and statistical \nanalysis. This has left previous new readers without the guidance they need if they are \nuneasy with the qualitative method as invented (or discovered) by Edwards & Magee. That \nlack is resolved by Appendix C. There the new reader will find number-driven material \npresented from the point of view of an Edwards & Magee analyst. There also the reader \nwill find presentations of tools by their creators—a very special treat, and extremely \neducational. I venture to say any analyst will have his field of vision broadened by Mike \nMoody’s presentation of Point and Figure charting and the tools of Richard Arms, two \nprominent analysts for whom many of us, especially we chartists, have not given their \nwork the study it deserves.\nThe list of acknowledgments is as long as a Hollywood awards night. I will shorten it by \npointing out previously acknowledged colleagues, assistants, and supporters in previous \nprefaces. Generally speaking, it is the usual suspects. Some especially merit additional \nmention here: Nehemiah Brown III, my much-valued and sometime graduate student helps \nme keep my spreadsheets rational and accurate. My old friend Mark Wainwright (a Tuck \ngraduate) helps me solve technological problems. Part of the pleasure of preparing a new \nedition comes from interacting with these bright and capable people.\nI have not mentioned Ralph Vince (a formidable figure) or Chris Glon, Richard Arms, \nand Mike Moody.\nMy efforts have been made easier by the support of Chip Anderson of stockcharts.com, \nan invaluable resource. I am also indebted to thinkorswim. If I mention them often it is a \nmeasure of their importance to my work—and not a paid promotion.\nW. H. C. Bassetti\nSan Francisco, California\nJune 15, 2018\n\nxvii\nPreface to the tenth edition\nA 10th milestone\nSixty-three years. Sixty-three years and Technical Analysis of Stock Trends still towers over \nthe discipline of technical analysis like a mighty redwood. An evergreen sequoia. And now \na 10th edition. It is a propitious moment to refresh it for the new millennium, to prune its \nsolecisms and obsolescence, and to further develop the sometimes prescient work of its \noriginators.\nWith this premise in mind, I have attempted to make the book shorter, simpler, and \nmore usable in the modern context. I know there are still manual chartists out there. \nOccasionally they are ecstatic when they find that—as a profit-losing service—I still have \nTEKNIPLAT™ chart paper in my attic. Like travelers in the desert finding an oasis.\nBut they are the 1%. Everyone else uses software, desktop or internet to do his charting \n(See note “ About Gender” in the Preface to the eighth edition.). So, I have excised the \nmaterial on manual charting from the new edition. Budding manual chartists may always \nturn to the eighth and ninth editions. I have also deleted Magee’s chapters on “Composite \nLeverage” (Chapter 42 in the seventh edition, Appendix A in the eighth) as they are abstruse \nand cumbersome in the modern context—not to mention being rooted in manual chart \nanalysis. I have made every attempt to summarize and replace Magee’s work, as I believe it \nhas intellectual validity. Primarily this is done in the present Chapter 42. I repeat, Magee’s \nthinking and practical work predated much modern portfolio management and volatility \ntheory. Additionally, Modern Portfolio Theory has still not caught up to his work on trend \nanalysis and risk. All this material is available in previous editions.\nI have moved, perhaps, the most difficult chapter in the book, Chapter 4, to Appendix \nA. Edwards’ chapter on the minutiae of the operation of Dow Theory has stopped more \nthan one reader cold. Now it is available to the detail scholar, and the general reader is \nrelieved of the necessity of slogging through it.\nMany critics deplored Chapter 16 from the seventh edition, which I relegated to an \nappendix in the ninth edition. This chapter covered an analysis of futures and derivatives \nusing number-driven analysis. Critics said it was shallow. More important, it was completely \nextraneous to the theme of the book, chart analysis, not the exploration of statistical routines \nand indicators, which is a different branch of technical analysis. There are numerous books \non the subject, starting with Murphy, Kirkpatrick, and Kaufman. I have deleted it along \nwith other material in the book that was not compatible with Edwards and Magee’s original \nintent.\nxviii Preface to the tenth edition\nI quote here appropriate remarks from the preface to the eighth edition:\nAbout apparent anachronisms\nCritics with limited understanding of long-term trading success may \nthink that discussions of “what happened in 1929” or “charts of ancient \nhistory from 1946” have no relevance to the markets of the present \nmillennium. They will point out that AT&T no longer exists in that \nform, that the New", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 8}
{"text": "n\nI quote here appropriate remarks from the preface to the eighth edition:\nAbout apparent anachronisms\nCritics with limited understanding of long-term trading success may \nthink that discussions of “what happened in 1929” or “charts of ancient \nhistory from 1946” have no relevance to the markets of the present \nmillennium. They will point out that AT&T no longer exists in that \nform, that the New Haven has long since ceased to exist as a stock, \nthat many charts are records of long-buried skeletons. This neglects \nthe value of the charts as metaphor. It ignores their representations \nof human behavior in the markets which will be replicated tomorrow \nin some stock named today.com or willtheynevergetit.com. Even \nmore important, it ignores the significance of the past to trading in \nthe present. I cite here material from Jack Schwager’s illuminating \nbook, The New Wizards of Wall Street . Schwager, in conversation \nwith Al Weiss: “Precisely how far back did you go in your chart \nstudies?” Answer: “It varied with the individual market and the \navailable charts. In the case of the grain markets, I was able to go \nback as far as the 1840s.” “Was it really necessary to go back that far?” \nAnswer: “ Absolutely. One of the keys in long-term chart analysis \nis realizing that markets behave differently in different economic \ncycles. Recognizing these repeating and shifting long-term patterns \nrequires lots of history. Identifying where you are in an economic \ncycle—say, an inflationary phase versus a deflationary phase—is \ncritical to interpreting the chart patterns evolving at that time.\nIdentification of original manuscript and revisions\nTrue believers (and skeptics) will find here virtually all of the original material written \nby Edwards and Magee, including their charts and observations on them. Changes and \ncomments introduced by editors since the fifth edition have been rearranged and, when \nappropriate, have been identified as a revision by that editor.\nMaintaining this policy, where updates to the present technological context and market \nreality were necessary, the present editor has clearly identified them as his own work by \nbeginning such annotations with “EN” for Editor’s Note. (The eighth edition was the first \nto use editor’s notes. Editor’s notes for the ninth edition are identified as EN9, and notes \nadded for the present edition are identified as EN10).\nSo, we have here a simpler, shorter, clearer edition of the famous book—easier to read, \neasier to understand, and easier to use. None of the considerable virtues of the book have been \naffected. I have attempted to add to these virtues with my work on Magee’s Basing Points \nProcedure (see Chapter 28, 28.1, and 28.2) and portfolio control and risk (see Chapter 42).\nIn spite of my remarks, I have listened to critics of the hand-drawn charts in this book. \nThese charts are the glory of the book and of the discipline of technical analysis. Their \napplication to modern markets seems ridiculously obvious to me—and I am perhaps a \ndinosaur. So, I have decided to take a number of examples of the manual charts and post \nthem at http:/ /www.edwards-magee.com along with the same data charted by computer \nso skeptics can compare the two methods. These will be found at http:/ /www.edwards-\nmagee.com/manualcharts.html.\nxixPreface to the tenth edition\nThe internet so extends one’s capabilities and is so easy to use that it would be \nirresponsible not to avail oneself. In Figures 9.2 and 9.3, I have printed charts that demand—\nscream—to be viewed in a larger format. These will be found at http:/ /www.edwards-\nmagee.com/supercharts.html.\nThe reader is urged to read the prefaces to the eighth and ninth editions. I have not \nrepeated here all the editorial conventions detailed in those prefaces.\nW. H. C. Bassetti\nSan Francisco, California\nAcknowledgments for the tenth edition\nSo many colleagues and friends contribute to a book like this that one is in danger of getting \ninto the Academy Awards syndrome—endless thank yous and acknowledgments until \nthey bring out the hook and pull you off stage. So, I will not thank my parents and aunts \nand uncles and wife and family, although they should be and by this mention are thanked.\nMore particularly, acknowledgments are due to my editorial and research assistant, \nCarlos Bassetti.\nMy colleagues at Golden Gate University (GGU) are an invaluable source of advice, \nwisdom, and support, particularly Professor Henry Pruden. It is no mystery why he is \ninternationally known and respected—besides being a world authority on Wyckoff. GGU \nhas also furnished me with an unending supply of bright, formidable graduate students \nwho have made major contributions to my work and to my thinking. Nehemiah Brown does \nhis best to keep me semi-organized as to spreadsheets. Matt Mullens and Brian Brooker \nhave assisted me with many of the Basing Point studies herein. Stergios Marinopoulos \nhas stimulated and challenged me in my systems work. All these people are members in \nthe local technical analysis fraternity and our much-valued organization, the Technical \nSecurities Analysts Association of San Francisco.\nMore remote colleagues have also assisted me in many invaluable ways—Jack Schannep \nwith Dow Theory data, Robert Colby, also with Dow data; Tim Knight with Prophet data \n(now part of http:/ /www.thinkorswim, http:/ /www.tdamertrade.com), Chip Anderson \nat http:/ /www.stockcharts.com, and Scott Brown of Metastock for support with charting \nsoftware.\nI am indebted to Ralph Vince and Nelson Freeburg for material found herein that \nincreases the value of this book.\nAnd finally, amigo Française, and fellow chart enthusiast Chris Glon at http:/ /www.\npublicharts.com, for his charts, assistance, and friendship. He has supplied some of the \nmost interesting charts in this book.\n\nxxi\nPreface to the ninth edition\nWarp speed universe. Warp speed financial markets. The eighth edition of this classic book \nappeared when it seemed t", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 9}
{"text": "increases the value of this book.\nAnd finally, amigo Française, and fellow chart enthusiast Chris Glon at http:/ /www.\npublicharts.com, for his charts, assistance, and friendship. He has supplied some of the \nmost interesting charts in this book.\n\nxxi\nPreface to the ninth edition\nWarp speed universe. Warp speed financial markets. The eighth edition of this classic book \nappeared when it seemed the millennium and paradise had been achieved and that, like \nMackay’s Tulipomania, the price of stocks would rise forever and men would rush from the \nworld over and pay whatever price was asked for what-was-its-name.com, internet groceries, \nor ihype.com or icon.com or gotcha.com. and, feature this, Dow 36,000. The bubble was just \nin the process of bursting, of course. Before it burst, fabulous fortunes were made by roller \nblader and scooter tycoons and by young geeks with nothing but chutzpah and a laptop. One \nof my favorite stories is of the young entrepreneur who said, “Why don’t I deserve it (the $100 \nmillion he made in the IPO)? I’ve devoted three years of my life to this project.” He is now dead.\nNow, many of those people are in prison and the hangover lingers on along with lying, \ncheating, and stealing on all sides. From Enron to Arthur Anderson, billions, if not trillions, \nfell into a black hole. As all this developed, I warned of the impending collapse in the John \nMagee Investment Letters on the web. There was nothing magical or brilliant about seeing \nwhat was going on; perspective and perception came from applying the lessons taught in \nthis book by Edwards and Magee. Like Benedict XVI (in a different area), I am a humble \nworker in their vineyard.\nI press on attempting to modernize (where necessary) and extend their work, fit it to \nthe modern situation, and make it even more useful to current day traders and investors.\nIn this ongoing labor of love, I have been immeasurably assisted by my graduate \nstudents and colleagues at Golden Gate University in San Francisco. In constant interaction \nwith them I have been stimulated to see important aspects of Edwards and Magee’s work \nand develop and emphasize these elements in my teaching and in this new edition.\nSpecifically, both long-term and short-term traders will find important new material \nin this edition. In my graduate seminars, I have seen the power of what Magee called the \n“Basing Points Procedure” and so have extended the treatment of this material. My interest \nin, and respect for, Dow Theory has recently increased as the result of a paper done with \nBrian Brooker for the Market Technicians Association (“Dissecting Dow Theory”). Material \nfrom that paper will be found in this edition. Short-term traders and futures speculators \nwill appreciate extensive new material on commodity trading. These traders have been \nentirely too influenced by mechanical number-driven systems of recent years and need to \nrestore perspective by mastering the material of this book.\nIt was never the intent of this book to forecast or analyze current markets; rather, its \npurpose was, and is, to learn from history and the past to better deal with the present \nand the future. Current markets are analyzed (and forecast?) at the John Magee website. \nNonetheless, the very process of keeping current involves picturing issues and instruments \nin play. The major indexes themselves in 2005 are in play, along with gold, silver, and oil. \nWe don’t know how they will pan out, but we can make an analysis with the data we have, \nfor this is the situation the analyst is faced with every day. He doesn’t know how it will turn \nxxii Preface to the ninth edition\nout, but, by following the methods and principles taught in this book, he can put himself \non the right side of the probabilities.\nThis is no idle remark. The power and effectiveness of classical chart analysis can \nbe seen by examining how it performed in the past at critical times. At the John Magee \nTechnical Analysis website, the following comment was made in January 2000:\nDow: The Dow can expect to find support at 10000 and is buyable, but \nin small commitments or portions of a portfolio or additions thereto. \nWe expect to see it in a very large see saw from 9–12000 for some time \nand would hedge at the high end and increase commitments and lift \nhedges on oversold conditions at the low end.\nIn November 2000, the following comment was made:\nNovember 18, 2000\nThere is really only one chart pattern of significance in these markets, \nand that is the big one, more than 12 months long now, and the pattern \nis a big serpent, whipping back and forth and, as Shakespeare said, \nsignifying nothing. Nothing that is but more of the same. How will we \nknow when it signifies something? Well, we won’t really know till we \nknow, but we’ll let you know when we know. So, we would continue to \npick likely shorts and employ short term trading strategies for traders, \nand hedge at interim tops and lift the hedges at bottoms. Based on the \nchart picture and last week’s anemic behavior, we would not trade \nfor bounces in the NASDAQ. If anything, it is a short, but a risky one.\nThese past letters, dramatically illustrating the effectiveness of the methods of this book, \nmay be found online through links at the address specified below. Your editor, personally, \nis not a genius for having made these analyses. It is the method which is to credit, and any \nnumber of my graduate students can make the same analyses, as can any alert chart analyst.\nThe reader should not skip the prefatory material to the eighth edition. The same \npractices outlined there have been followed in this edition. Magee said the reader should \nnot skim through this book and put it on his library shelf. Instead, it should be read and \nreread and constantly referred to and so the reader should, yes, so he should.\nRichard Russell, the dean of Dow Theory Analysts, has reportedly said the price of the \nDow and the price of gold will cross in coming years. He", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 10}
{"text": "es outlined there have been followed in this edition. Magee said the reader should \nnot skim through this book and put it on his library shelf. Instead, it should be read and \nreread and constantly referred to and so the reader should, yes, so he should.\nRichard Russell, the dean of Dow Theory Analysts, has reportedly said the price of the \nDow and the price of gold will cross in coming years. He has also remarked that the S&P \nappears to evince a 10-year head-and-shoulders pattern. Robert Prechter believes we are at \nthe crest of the tidal wave and the tsunami cometh.\nDow 36,000. Dow 3,000. This book contains the best tools to cope with whatever the \nfuture holds.\nW. H. C. Bassetti\nSan Francisco, California\nMay 1, 2005\nA special note concerning resources on the Web\nIn the age of instant and easy (and free) access to information on the internet, it would \nbe foolish to ignore the opportunities available to interact with the material of this book. \nThe reader will find free materials that augment the book at http://www.edwards-magee.\ncom. For example, when the reader learns in Chapter 28 of the Basing Points Procedure, he \nxxiiiPreface to the ninth edition\nwill be able to go to the website and print out a PDF of material that he can place beside \nFigure 28.1 for instant and easy cross-reference, instead of having to turn pages constantly \nback and forth from the chart to the keys and commentary or having to bend the book \ninto pretzels at a copy machine. In general, wherever references are made in the text to the \nwebsite, it is for this purpose, to give the reader easy and flexible usage of the material. And, \nlikewise, at this address the reader will find links to past letters that show how the method \nfunctioned in real time in real markets.\nA special note about Dow Theory\nSenator Everett Dirkson said one time that trying to get U.S. senators herded together and \nmoving in one direction was like trying to transport bullfrogs in a wheelbarrow. Trying \nto synchronize the signals of the various Dow Theory analysts is a similarly challenging \nproposition. No Ayatollah exists to issue the final fatwa as to whether the signal is valid. \nAlways one to abhor a vacuum, I have organized a committee at Golden Gate University \nto evaluate pronouncements of signals and opine as to whether the signals are valid. This \ncommittee died an unnatural death, unfortunately, for lack of demand as to its expertise.\nAcknowledgments for the ninth edition\nFor professional assistance: Jack Schannep, Robert W. Colby, Curtis Faith, Greg Morris, John \nMurphy, Tim Knight, and Chi Huang.\nFor assistance at Taylor and Francis: Richard O’Hanley, Raymond O’Connell, Pat \nRoberson, Andrea Demby, and Roy Barnhill.\nFor research assistance and manuscript preparation: Brian Brooker and Grace Ryan, \nmy fearsomely bright and efficient teaching and research assistants. And my inimitable \ntechnical assistant, Samuel W. D. Bassetti.\nAt Golden Gate University for ongoing support and assistance: Professor Henry \nPruden, Barbara Karlin, Janice Carter, Tracy Weed, and Cassandra Dilosa.\nSpecial appreciation goes to makers of software packages and their supportive \nexecutives for software used in the preparation of this and previous editions:\nJohn Slauson\nAdaptick\n1082 East 8175 South\nSandy, UT 84094\nhttp://www.adaptick.com\nSteven Hill\nAIQ Systems\nP.O. Box 7530\nIncline Village, NV 89452\n702-831-2999\nhttp://www.AIQsystems.com\nAlan McNichol\nMetastock\nEquis International, Inc.\n3950 S. 700 East, Suite 100\nSalt Lake City, UT 84107\nhttp://www.equis.com\n\nxxv\nPreface to the eighth edition\nHere is a strange event—a book written in the mid-20th century retains its relevancy and \nimportance to the present day. In fact, Technical Analysis of Stock Trends remains the definitive \nbook on the subject of analyzing the stock market with charts. Knock-offs, look-alikes, and \npale imitations have proliferated in its wake like seagulls after a productive fishing boat. \nBut the truth is they have added nothing new to the body of knowledge Edwards and \nMagee originally produced and Magee refined up to the fifth edition.\nWhat accounts for this rare occasion of a book’s passing to be a classic? To be more, in \nfact, than a classic, to be the manual or handbook for current usage?\nTo answer this question, we must ask another: What are chart formations? Chart \nformations identified and analyzed by the authors are graphic representations of \nunchanging human behavior in complex multivariate situations. They are the depiction \nof multifarious human actions bearing on a single variable (price). On price, converge a \ngalaxy of influences: fear, greed, desire, cunning, malice, deceit, naiveté, earnings estimates, \nbroker need for income, gullibility, professional money managers’ need for performance \nand job security, supply and demand of stocks, monetary liquidity and money flow, self-\ndestructiveness, passivity, trap setting, manipulation, blind arrogance, conspiracy and \nfraud and double dealing, phases of the moon and sun spots, economic cycles and beliefs \nabout them, public mood, and the indomitable human need to be right.\nChart formations are the language of the market, telling us that this stock is in its death \nthroes; that stock is on a rocket to the moon; that a life and death battle is being waged in \nthis issue; and in that other, the buyers have defeated the sellers and are breaking away.\nThey are, in short, the inerasable fingerprints of human nature made graphic in the \ngreatest struggle in human experience, next to war.\nAs Freud mapped the human psyche, so have Edwards and Magee mapped the human \nmind and emotions as expressed in the financial markets. Not only did they produce a \ndefinitive map, they also produced a methodology for interpreting and profiting from the \nbehavior of men and markets. It is difficult to imagine further progress in this area until \nthe science of artificial intelligence, aided by yet unimaginable computer hardware, makes \nn", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 11}
{"text": "e Edwards and Magee mapped the human \nmind and emotions as expressed in the financial markets. Not only did they produce a \ndefinitive map, they also produced a methodology for interpreting and profiting from the \nbehavior of men and markets. It is difficult to imagine further progress in this area until \nthe science of artificial intelligence, aided by yet unimaginable computer hardware, makes \nnew breakthroughs.\nIf it is definitive, why offer a new edition?\nUnlike Nostradamus and Jules Verne (and many current investment advisors), the authors \ndid not have a crystal ball or a time machine. Magee did not foresee the electronic calculator \nand made do with a slide rule. And while he knew of the computer, he did not anticipate \nthat every housewife and investor would have 1,000 times the power of a Whirlwind or \nUnivac I on his (her) desk (cf., “ About Gender”). In short, the March of Time. The Progress \nof Science. The Inexorable Advance of Technology.\nxxvi Preface to the eighth edition\nAmazingly, the great majority of this book needed no update or actualization. Who is \nto improve on the descriptions of chart formations and their significance?\nBut insofar as updates are necessary to reflect the changes in technology and in the \ncharacter and composition of the markets, that is another story. Human character may \nnot change, but in the new millennium, there is nothing but change in the character and \ncomposition of the markets. And while regulatory forces might not be completely in agreement, \nthe majority of these changes have been positive for the investor and the commercial user. Of \ncourse, Barings Bank and some others are less than ecstatic with these developments.\nThe most important additions to this book to reflect \nchanges in the times, technology, and markets\nGenerally speaking, these additions, annotations, and updates are intended to inform the \ngeneral reader of conditions of which he must be aware for investing success. In most cases, \nbecause of the enormous amount of material, no attempt is made to be absolutely exhaustive \nin the treatment of these developments. Rather, the effort is made to put changes and new \nconditions in perspective and furnish the investor with the resources and proper guide to \npursue subjects at greater length if desired. In fact, an appendix has been provided, entitled \nResources (EN10: now Appendix B), to which the reader may turn when he has mastered the \nmaterial of the book proper.\nThe stubborn individualist may realize investment success with the use of this book \nalone (and paper, pencil, ruler, and chart paper [cf., Section on TEKNIPLAT™ chart paper]).\nTechnology\nIn order to equip this book to serve as a handbook and guide for the markets of the new \nmillennium, certain material has been added to the text of the fifth and seventh editions. \nClearly, the astounding advances in technology must be dealt with and put in the context of \nthe analytical methods and material of the original. To achieve success in the new, brave world, \nan investor must be aware of and utilize electronic markets, the internet, the microcomputer, \nwireless communications, and new exchanges offering every kind of exotica imaginable.\nThe advanced investor should also be aware of and understand some of the \ndevelopments in finance and investment theory and technology—the Black–Scholes Model, \nModern Portfolio Theory, Quantitative Analysis. Fortunately, all these will not be dealt \nwith here because, in truth, one intelligent investor with a piece of chart paper, a pencil, \nand a quote source can deal with the markets, but that is another story we will explore \nlater in the book. Some of these germane subjects will be discussed sufficiently to put them \nin perspective for the technical analyst, and then guides and resources will be pointed \nout for continued study. My opinion is that the mastery of all these subjects is not wholly \nnecessary for effective investing at the private level. What need does the general investor \nhave for an understanding of the Cox–Ross–Rubinstein (CRR) options analysis model to \nrecognize trends? The Edwards–Magee model knows things about the market the CRR \nmodel does not.\nTrading and investment instruments\nThe new universe of available trading and investment instruments must be taken into \naccount. The authors would have been in paradise at the profusion of alternatives. In this \nfuture world, they could have traded the Averages (one of the most important changes \nxxviiPreface to the eighth edition\nexplored in this book); used futures and options as investment and hedging mechanisms; \npracticed arbitrage strategies beyond their wildest dreams; and contemplated a candy \nstore full of investment products. The value and utility of these products would have been \nimmeasurably enhanced by their mastery of the charting world of technical analysis. As \nonly one example, one world-prominent professional trader I know has made significant \nprofits selling calls on stocks he correctly analyzed to be in down trends, and vice versa—\nan obvious (or, as they say, no-brainer) to a technician, but not something you should \nattempt at home without expert advice. Techniques like this occasioned the loss of many \nmillions of dollars in the Reagan Crash of 1987 .\nChanges and developments in technical analysis\nHave any new chart patterns (that is to say, changes in human behavior and character) emerged \nsince the fifth edition? Not to my knowledge, although there are those who take the same data \nand draw different pictures from them. How else could you say that you had something new! \ndifferent! better!? There are other ways of looking at the data that are interesting, sometimes \nvaluable, and often profitable, which goes to prove that many are the ways and gateless is the \ngate to the great Dow. Point and figure charting have been used very effectively by traders I \nknow, and candlestick charting depicts data in interesting ways. Furthermore, since Magee’s", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 12}
{"text": "ad something new! \ndifferent! better!? There are other ways of looking at the data that are interesting, sometimes \nvaluable, and often profitable, which goes to prove that many are the ways and gateless is the \ngate to the great Dow. Point and figure charting have been used very effectively by traders I \nknow, and candlestick charting depicts data in interesting ways. Furthermore, since Magee’s \ntime, aided by the computer, technicians have developed innumerable, what I call, number-\ndriven technical analysis tools: (the puzzlingly named) stochastics, oscillators, exponential and \nother moving averages, etc., etc., etc. It is not the intent of this book to explore these tools in \ndepth. That will be done in a later volume. These concepts are briefly explored in an appendix \n(Appendix C, 8th edition) supplied by Richard McDermott, editor of the seventh edition.\nI have also made additions to the book (see Chapter 18) to give a perspective on long-\nterm investing, since Magee specifically addressed the second part of the book (on tactics) \nto the speculator. I have substantially rewritten Chapters 24 and 42 to reflect current ideas \non portfolio management and risk management. I have expanded on the idea of rhythmic \ntrading—an idea which is implicit in the original. I have expanded the treatment of runaway \nmarkets so the internet stocks of the 1990s might be put in perspective (see Chapter 23).\nAnd then, paradigms. Paradigms, as everyone should know by now, are the last refuge \nof a fundamentalist when all other explanations fail.\nParadigm changes\nWhenever the markets, as they did at the end of the 20th century, depart from the commonly \naccepted algorithms for determining what their prices ought to be, fundamentalists (those \nanalysts and investors who believe they can determine value from such fixed verities as \nearnings, cash flow, etc.) are confronted with new paradigms. Are stock prices (values) \nto be determined by dividing price by earnings to establish a reasonable price/earnings \n(p/e) ratio? Or should sales be used, or cash flow, or the phases of the moon, or—in the late \n1990s—should losses be multiplied by price to determine the value of the stock? Technicians \nare not obliged to worry about this kind of financial legerdemain. The stock is worth what \nit can be sold for today in the market.\nThe crystal ball\nInvestors will get smarter and smarter, starting with those who learn what this book has to say. \nThe professionals will stay one step ahead of them because they are preternaturally cunning \nand spend all their time figuring out how to keep ahead of the public, but the gap will narrow. \nxxviii Preface to the eighth edition\nSoftware and hardware will continue to advance, but not get any smarter. Mechanical systems \nwill work well in some areas, yet not in others. Mechanical systems are only as good as the \nengineer who designs them and the mechanic who maintains them. Buying systems is buying \ntrouble. Everyone should find his own method (usually some variant of the Magee method, in \nmy opinion). All good things will end; all bad things will end. The bag of tricks with which the \ninsiders bilk the public will get smaller and smaller. New and ingenious procedures will be \ndeveloped by the insiders. The well of human naiveté is bottomless. For every one educated, a \nnew one will be born in a New York minute. It is deeply disturbing at the turn of the century \nthat the owners of the NASDAQ and the NYSE should be thinking of going public. Could there \nbe any more ominous sign that enormous changes are about to occur?\nVigorous development of the systems, methods, procedures, and philosophy outlined \nin this book is about the only protective shield I know of to guard against inimical change.\nW. H. C. Bassetti\nSan Geronimo, California\nJanuary 1, 2001\nAbout the editorial practices in this eighth edition\nNeedless to say, one approaches the revision of a classic work with some trepidation. Every \ncritic and reader has his or her (cf., “ About Gender”) opinion as to how revision should \nbe done—whether the authors’ original text should be invisibly changed as though they \nhad written the book in 2000 instead of 1948 and were omniscient, or whether errors and \nanachronisms were to be lovingly preserved, or footnoted, or … etc., etc . (I have preserved \nMagee’s favorite usage of “etc., etc., etc.” against the protestation of generations of English \ncomposition teachers because I like its evocation of an ever-expanding universe.)\nNotwithstanding every reader having an opinion, I am certain all critics will be \ndelighted with the practices followed in this third millennium edition of the most important \nbook on technical analysis written in the second millennium.\nIntegrity of the original text\nBy and large, the fifth edition has been the source of the authors’ original text. Amazingly, \nalmost no stylistic or clarifying emendation has been necessary to that edition. This is a \ntribute to the clarity, style, and content of the original—one might almost say awesome if \nthe word were not in such currency on “Saturday Night Live” and the Comedy Central. \nConsidering its complex subject was written in the middle of the last century and the \nmarkets were one-tenth of their present complexity, awesome may be the appropriate word. \nNo change or update has been necessary to the technical observations and analysis. They \nare as definitive today as they were in 1950.\nWhile I have preserved the authors’ original intent and text, I have taken the liberty of \nrearranging some of the chapters. Novices wishing to learn manual charting will find the \nappropriate chapters moved to appendices at the back of the book, along with the chapters \non Composite Leverage and Sensitivity Indexes.\nAbout apparent anachronisms\nCritics with limited understanding of long-term trading success may think that \ndiscussions of “what happened in 1929” or “charts of ancient history from 1946” \nxxixPreface to the eighth edition", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 13}
{"text": "o learn manual charting will find the \nappropriate chapters moved to appendices at the back of the book, along with the chapters \non Composite Leverage and Sensitivity Indexes.\nAbout apparent anachronisms\nCritics with limited understanding of long-term trading success may think that \ndiscussions of “what happened in 1929” or “charts of ancient history from 1946” \nxxixPreface to the eighth edition\nhave no relevance to the markets of the present millennium. They will point out that \nAT&T no longer exists in that form, that the New Haven has long since ceased to exist \nas a stock, that many charts are records of long-buried skeletons. This neglects the \nvalue of the charts as metaphor. It ignores their representations of human behavior \nin the markets which will be replicated tomorrow in some stock named today.com or \nwilltheynevergetit.com. Even more important, it ignores the significance of the past to \ntrading in the present. I cite here material from Jack Schwager’s illuminating book, The \nNew Wizards of Wall Street . Schwager, in conversation with Al Weiss: “Precisely how far \nback did you go in your chart studies?” Answer: “It varied with the individual market \nand the available charts. In the case of the grain markets, I was able to go back as far as \nthe 1840s.” “Was it really necessary to go back that far?” Answer: “ Absolutely. One of the \nkeys in long-term chart analysis is realizing that markets behave differently in different \neconomic cycles. Recognizing these repeating and shifting long-term patterns requires \nlots of history. Identifying where you are in an economic cycle—say, an inflationary \nphase versus a deflationary phase—is critical to interpreting the chart patterns evolving \nat that time.”\nIdentification of original manuscript and revisions\nTrue believers (and skeptics) will find here virtually all of the original material written \nby Edwards and Magee, including their charts and observations on them. Changes and \ncomments introduced by editors since the fifth edition have been rearranged, and, when \nappropriate, have been identified as a revision by that editor.\nMaintaining this policy, where updates to the present technological context and market \nreality were necessary, the present editor has clearly identified them as his own work by \nbeginning such annotations with “EN” for Editor’s Note. Figure insertions are identified \nas “x.1, x.2.”\nAbsolutely necessary revisions\nNot too long ago my youngest son, Pancho, overheard a conversation in which I referred \nto a slide rule. “What’s a slide rule, Dad?” he asked. Well, needless to say the world has, in \ngeneral, moved on from the time of Edwards and Magee when instead of calculators we \nhad slide rules. Where time has made the text useless, moot, or irrelevant, that problem has \nunobtrusively been corrected.\nWhere the passage of time has made the text obsolete, I have either footnoted the \nanachronism and/or provided a chapter-ending annotation, which are marked in the text \nwith “EN.” It is absolutely essential to read the annotations; failure to do so will leave the \nreader stranded in the 20th century.\nIn some cases, these annotations amount to new chapters—for example, trading \ndirectly in the averages was difficult in Magee’s time. Nowadays, if there is not a proxy \nor option or index for some Index or Average or basket of stocks, there will be one in \nless than a New York minute (which, as everyone knows, has only 59 seconds). This new \nreality has resulted in major additions to this new edition, which are detailed in the \nForeword. Major chapter additions necessary to deal with developments in technology \nand finance theory have been clearly identified as this editor’s work by designating \nthem as interpolations, viz., Chapter 18 (with the exception of Chapter 23, which I have \nsurreptitiously inserted).\nxxx Preface to the eighth edition\nAbsolutely necessary revisions that arose in the 30 \nminutes since this editorial note was written\nIn a number of instances, the book relayed information that, in those days of fixed \ncommissions and monopolistic control by the existing exchanges, remained valid for long \nperiods of time; for instance, brokerage commissions and trading costs. It is no longer \npossible to maintain such information in a printed book because of the rate of change \nin the financial industry. It must now be filed and updated in real time on the internet. \nConsequently, readers will be able to refer to the internet for this kind of ephemeral data. \nThe general importance of the ephemera to the subject is always discussed.\nAbout gender\nI quote here from my foreword to the second edition of Magee’s General Semantics of Wall \nStreet (charmingly renamed according to the current fashions, Winning the Mental Game on \nWall Street):\nAbout Gender in Grammar\nIch bin ein feminist. How could any modern man, son of a beloved \nwoman, husband of an adored woman, and father of a joyful and \ndelightful daughter not be? I am also a traditionalist and purist in \nmatters of usage, grammar, and style. So where does that leave me \nand my cogenerationalists, enlightened literary (sigh) men (and \nwomen), with regards to the use of the masculine pronoun when \nused in the general sense to apply to the neuter situation?\nIn Dictionary of Modern American Usage, Garner notes: “English \nhas a number of common-sex general words, such as person, anyone, \neveryone, and no one, but it has no common-sex singular personal \npronouns. Instead we have he, she, and it. The traditional approach \nhas been to use the masculine pronouns he and him to cover all \npersons, male and female alike … . The inade quacy of the English \nlanguage in this respect becomes apparent in many sentences in \nwhich the generic masculine pronoun sits uneasily.”\nInadequate or not, it is preferable to s/he/it and other \nbastardizations of the English language. (Is it not interesting that \n“bastard,” in common usage, is never used of a woman, even \nwhen she is illegit", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 14}
{"text": "over all \npersons, male and female alike … . The inade quacy of the English \nlanguage in this respect becomes apparent in many sentences in \nwhich the generic masculine pronoun sits uneasily.”\nInadequate or not, it is preferable to s/he/it and other \nbastardizations of the English language. (Is it not interesting that \n“bastard,” in common usage, is never used of a woman, even \nwhen she is illegitimate?) As for the legitimacy of the usage of the \nmasculine (actually neuter) pronoun in the generic, I prefer to lean \non Fowler, who says, “There are three makeshifts: first, as anybody \ncan see for himself or herself; second, as anybody can see for \nthemselves; and third, as anybody can see for himself. No one who \ncan help it chooses the first; it is correct, and is sometimes necessary, \nbut it is so clumsy as to be ridiculous except when explicitness is \nurgent, and it usually sounds like a bit of pedantic humor. The \nsecond is the popular solution; it sets the literary man’s (!) teeth \non edge, and he exerts himself to give the same meaning in some \nentirely different way if he is not prepared to risk the third, which \nis here recommended. It involves the convention (statutory in the \nxxxiPreface to the eighth edition\ninterpretation of documents) that where the matter of sex is not \nconspicuous or important the masculine form shall be allowed to \nrepresent a person instead of a man, or say a man (homo) instead \nof a man (vir).”\nPolitically correct fanatics may rail, but so are my teeth set on \nedge; thus, I have generally preserved the authors’ usage of the \nmasculine for the generic case. This grammatical scourge will pass \nand be forgotten, and weak-willed myn (by which I intend to indicate \nmen and women) who pander to grammatical terrorists will, in the \nfuture, be seen to be stuck with malformed style and sentences no \nwomyn will buy. What would Jane Austen have done, after all?\nAbout Gender in Investors\nAs long as we are on the subject of gender, we might as well discuss, \nunscientifically, gender in investors. Within my wide experience as a \ntrading advisor, teacher, and counselor, it strikes me that the women \ninvestors I have known have possessed certain innate advantages \nover the men. I know there are women gamblers—I have seen some. \nBut I have never seen a woman plunger (shooter, pyramider, pie-eyed \ngambler) in the markets, though I have known many men who fit this \ndescription. I have also noted among my students and clients that, \nas a group, women seem to have more patience than men. I refer \nspecifically to the patience that a wise investor must have to allow \nthe markets to do what they are going to do.\nThese are wholly personal observations. I have made no study of \nthe question and can’t speak to the entire class of women investors—\nand do not personally know Barbra Streisand (who I understand is a \nformidable investor, especially in IPOs). But just as I believe the world \nwould be better off if more women ran countries and were police \nofficers, I expect the world of finance will benefit from the steadily \nincreasing number of women investors and managers.\nA crucial question: sensitivity indexes and betas\nLong before the investment community had formalized the beta measure—the coefficient \nmeasuring a stock’s volatility relative to the market—Magee and Edwards were computing \na Sensitivity Index, which, for all practical purposes, was the same thing. Readers interested \nin this aspect of their work may find references in Resources (EN10: now Appendix B), which \nwill enable them to obtain betas to plug into the Composite Leverage formula with which \nMagee intended to determine risk levels. The old appendix on Sensitivity Indexes has been \nconsigned to Appendix A (8th edition), along with the chapter on Composite Leverage, \nboth originals of which have been emended to reflect current practices in finance theory \nand practice.\nBetwixt and between, 1/8 of a dollar or 12.5 cents\nAs this edition went to press, the financial services industry was once again threatening \nto implement decimals in stock prices. Pricing in eighths has endured long past its time \nxxxii Preface to the eighth edition\nbecause it was in the self-interest of the financial industry—it allowed brokers and market \nmakers to enforce larger bid–ask spreads and fatten their profit margins. The importance \nfor this book, and for traders, is what will happen as full decimalization occurs. Often \nin these pages, Magee will recommend placing a stop 1/8 off the low or high, or placing \nprogressive near stops in eighths. We do not yet know what the psychological interval will \nbe in the new era; it may be 12.5 cents, or more psychologically, 10 cents, or for gaming \npurposes, 9 or 11 cents. This remains to be seen. As all the charts in this book are in the old \nnotation, that usage has been preserved in this edition.\nThe editorial “I”\nReaders will quickly note the “editorial we” of Edwards and Magee has been replaced by \nthe first-person voice—or, the “editorial I” or perhaps the “professorial I.” Well, there were \ntwo authors in Edwards and Magee, and there is only one of me; my text is immediately \nnoticeable as mine, and the reader may discriminate quickly. As for the use of “I” as an \nexpression of ego, the reader is assured that after 40 years in the market, the editor has \nno ego left to promote. Perhaps the best way to put the editor’s sense of importance in \nperspective is to quote Dr. Johnson’s definition of lexicographer from his dictionary. Some \npeople might have thought Johnson self-important in creating the first English dictionary; \nhis definition of his trade put that right: “Lexicographer: a writer of dictionaries. A harmless \ndrudge.” An editor is something like the same.\nAs this book goes to the printer, the publisher, recognizing the importance of the work \ndone on this edition, will credit the editor as co-author of the eighth edition. John Magee \nwould be pleased. We had a cordial master–st", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 15}
{"text": "e first English dictionary; \nhis definition of his trade put that right: “Lexicographer: a writer of dictionaries. A harmless \ndrudge.” An editor is something like the same.\nAs this book goes to the printer, the publisher, recognizing the importance of the work \ndone on this edition, will credit the editor as co-author of the eighth edition. John Magee \nwould be pleased. We had a cordial master–student relationship, and nothing pleases a Zen \nmaster more than to transfer the dharma to a passionate student.\nAcknowledgments\nIn General:\nJohn Magee, for his ever-patient tutoring.\nBlair Hull, for teaching me the mercurial nature of options.\nBill Dreiss, for teaching me the nature of trading systems.\nArt von Waldburg, respected colleague and discoverer of the Fractal Wave Algorithm.\nFischer Black, who should have lived to get the Nobel Prize.\nBill Scott, friend and fellow trader.\nFor specific support and assistance in the preparation of this eighth edition:\nProfessor Henry Pruden, Golden Gate University, San Francisco, for invaluable support \nand advice.\nMartin Pring; Lawrence Macmillan; Mitch Ackles, Omega Research Corporation; \nCarson Carlisle; Edward Dobson; David Robinson; Shereen Ash; Steven W. Poser; \nLester Loops, late of Hull Trading Company; Tom Shanks, Turtle.\nAt St. Lucie Press, the dedication and support of the publisher, Drew Gierman, and \nProduction Associate, Pat Roberson, have been invaluable, as has been the dedication \nof Gail Renard, the Production Editor.\nAnd special acknowledgment to my Research Assistant, Don Carlos Bassetti y Doyle.\nxxxiiiPreface to the eighth edition\nSpecial appreciation goes to makers of software packages used in the preparation of \nthis and previous editions:\nAIQ Systems\nP.O. Box 7530\nIncline Village, NV 89452\n702-831-2999\nhttp://www.AIQsystems.com\nMetastock\nEquis International, Inc.\n3950 S. 700 East, Suite 100\nSalt Lake City, UT 84107\nhttp://www.equis.com\nTradestation\nOmega Research\n14257 SW 119th Avenue\nMiami, FL 33186\n305-485-7599\nhttp://www.tradestation.com\n\nxxxv\nIn memoriam\nThis book is a memorial for John Magee, who died on June 17 , 1987 . John Magee was \nconsidered a seminal pioneer in technical analysis, and his research with co-author, Robert \nD. Edwards, clarified and expanded the ideas of Charles Dow, who laid the foundation for \ntechnical analysis in 1884 by developing the “ Averages,” and Richard Schabacker, former \neditor of Forbes in the 1920s, who showed how the signals, which had been considered \nimportant when they appeared in the averages, were applicable to stocks themselves. The \ntext, which summarized their findings in 1948, was, of course, Technical Analysis of Stock \nTrends, now considered the definitive work on pattern recognition analysis. Throughout \nhis technical work, John Magee emphasized three principles: stock prices tend to move in \ntrends; volume goes with the trend; and a trend, once established, tends to continue in force.\nA large portion of Technical Analysis of Stock Trends is devoted to the patterns which \ntend to develop when a trend is being reversed: Head and Shoulders, Tops and Bottoms, \n“W” patterns, Triangles, Rectangles, etc.—common patterns to stock market technicians. \nRounded Bottoms and Drooping Necklines are some of the more esoteric ones.\nJohn urged investors to go with the trend, rather than trying to pick a bottom before it \nwas completed, averaging down a declining market. Above all, and at all times, he refused \nto get involved in the game of forecasting where “the market” was headed, or where the \nDow–Jones Industrial Averages would be on December 31st of the coming year. Rather, he \npreached care in individual stock selection regardless of which way the market “appeared” \nto be headed.\nTo the random walker, who once confronted John with the statement that there was \nno predictable behavior on Wall Street, John’s reply was classic. He said, “You fellows \nrely too heavily on your computers. The best computer ever designed is still the human \nbrain. Theoreticians try to simulate stock market behavior, and, failing to do so with any \ndegree of predictability, declare that a journey through the stock market is a random walk. \nIsn’t it equally possible that the programs simply aren’t sensitive enough or the computers \nstrong enough to successfully simulate the thought process of the human brain?” Then John \nwould walk over to his bin of charts, pull out a favorite, and show it to the random walker. \nThere it was—spike up, heavy volume; consolidation, light volume; spike up again, heavy \nvolume. A third time. A fourth time. A beautifully symmetrical chart, moving ahead in a \nwell-defined trend channel, volume moving with price. “Do you really believe that these \npatterns are random?” John would ask, already knowing the answer.\nWe all have a favorite passage or quotation by our favorite author. My favorite quotation \nof John’s appears in the short booklet he wrote especially for subscribers to his Technical \nStock Advisory Service: “When you enter the stock market, you are going into a competitive \nfield in which your evaluations and opinions will be matched against some of the sharpest \nand toughest minds in the business. You are in a highly specialized industry in which there \nare many different sectors, all of which are under intense study by men whose economic \nxxxvi In memoriam\nsurvival depends upon their best judgment. You will certainly be exposed to advice, \nsuggestions, offers of help from all sides. Unless you are able to develop some market \nphilosophy of your own, you will not be able to tell the good from the bad, the sound from \nthe unsound.”\nI doubt if any man alive has helped more investors develop a sound philosophy of \ninvesting on Wall Street than John Magee.\nRichard McDermott\nPresident, John Magee, Inc.\nSeptember 1991\nxxxvii\nPreface to the seventh edition\nMore than 100 years ago, in Springfield, MA, there lived a man named Charles H. Dow. \nHe was one of the editors of a great newsp", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 16}
{"text": "good from the bad, the sound from \nthe unsound.”\nI doubt if any man alive has helped more investors develop a sound philosophy of \ninvesting on Wall Street than John Magee.\nRichard McDermott\nPresident, John Magee, Inc.\nSeptember 1991\nxxxvii\nPreface to the seventh edition\nMore than 100 years ago, in Springfield, MA, there lived a man named Charles H. Dow. \nHe was one of the editors of a great newspaper, the Springfield Republican . When he left \nSpringfield, it was to establish another great newspaper, the Wall Street Journal.\nCharles Dow also laid the foundation for a new approach to stock market problems.\nIn 1884, he made up an average of the daily closing prices of 11 important stocks, nine \nof which were rails, and recorded the fluctuations of this average.\nHe believed the judgment of the investing public, as reflected in the movements of stock \nprices, represented an evaluation of the future probabilities affecting the various industries. \nHe saw in his average a tool for predicting business conditions many months ahead. This \nwas true because those who bought and sold these stocks included people intimately \nacquainted with the industrial situation from every angle. Dow reasoned the price of a \nsecurity, as determined by a free competitive market, represented the composite knowledge \nand appraisal of everyone interested in that security—financiers, officers of the company, \ninvestors, employees, customers—everyone, in fact, who might be buying or selling stock.\nDow felt this market evaluation was probably the shrewdest appraisal of conditions to \ncome that could be contained, since it integrated all known facts, estimates, surmises, and \nthe hopes and fears of all interested parties.\nIt was William Peter Hamilton who really put these ideas to work. In his book, The \nStock Market Barometer, published in 1922, he laid the groundwork for the much-used and \nmuch-abused Dow Theory.\nUnfortunately, a great many superficial students of the market never understood the \noriginal premise of the “barometer” and seized on the bare bones of the theory as a sort of \nmagic touchstone to fame and easy fortune.\nOthers, discovering the “barometer” was not perfect, set about devising corrections. \nThey tinkered with the rules of classic Dow Theory, trying to find the wonderful formula \nthat would avoid its periodic disappointments and failures.\nOf course, what they forgot was the Averages were only averages at best. There is \nnothing very wrong with the Dow Theory. What is wrong is the attempt to find a simple, \nuniversal formula—a set of measurements that will make a suit to fit every man, fat, thin, \ntall, or short.\nDuring the 1920s and 1930s, Richard W. Schabacker reopened the subject of technical \nanalysis in a somewhat new direction. Schabacker, who had been financial editor of Forbes \nMagazine, set out to find some new answers. He realized whatever significant action appeared \nin the average must derive from similar action in some of the stocks making up the average.\nIn his books, Stock Market Theory and Practice, Technical Market Analysis, and Stock Market \nProfits, Schabacker showed how the “signals” that had been considered important by Dow \ntheorists when they appeared in the Averages were also significant and had the same \nmeanings when they turned up in the charts of individual stocks.\nxxxviii Preface to the seventh edition\nOthers, too, had noted these technical patterns, but it was Schabacker who collated, \norganized, and systematized the technical method. Not only that, he also discovered \nnew technical indications in the charts of stocks; indications of a type that would \nordinarily be absorbed or smothered in the averages, and, hence, not visible or useful \nto Dow theorists.\nIn the final years of his life, Richard Schabacker was joined by his brother-in-law, Robert \nD. Edwards, who completed Schabacker’s last book and carried forward the research of \ntechnical analysis.\nEdwards, in turn, was joined in this work in 1942 by John Magee. Magee, an alumnus of \nthe Massachusetts Institute of Technology, was well oriented to the scientific and technical \napproach.\nEdwards and Magee retraced the entire road, reexamining the Dow Theory and \nrestudying the technical discoveries of Schabacker.\nBasically, the original findings were still good; however, with additional history and \nexperience, it was possible to correct some details of earlier studies. Also, a number of new \napplications and methods were brought to light. The entire process of technical evaluation \nbecame more scientific.\nIt became possible to state more precisely the premises of technical analysis: that the \nmarket represents a most democratic and representative criterion of stock values; that the \naction of a stock in a free, competitive market reflects all that is known, believed, surmised, \nhoped, or feared about that stock; and, therefore, that it synthesizes the attitudes and \nopinions of all. That the price of a stock is the result of buying and selling forces and \nrepresents the “true value” at any given moment. That a Major Trend must be presumed to \ncontinue in effect until clear evidence of Reversal is shown. And, finally, that it is possible to \nform opinions having a reasonably high probability of confirmation from the market action \nof a stock as shown in daily, weekly, or monthly charts, or from other technical studies \nderived from the market activity of the security.\nIt is important to point out that the ultimate value of a security to the investor or trader \nis what he or she ultimately receives from it. That is to say, the price the investor gets when it \nis sold, or the market price obtainable for it at any particular time, adjusted for dividends or \ncapital distribution in either case. If, for example, he or she has bought a stock at $25 a share, \nand it has paid $5 in dividends and is now bid at $35, he or she has realized an accrued \nbenefit of $5 plus $10, or $15 in all. It is the combination of dividends and", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 17}
{"text": "e price the investor gets when it \nis sold, or the market price obtainable for it at any particular time, adjusted for dividends or \ncapital distribution in either case. If, for example, he or she has bought a stock at $25 a share, \nand it has paid $5 in dividends and is now bid at $35, he or she has realized an accrued \nbenefit of $5 plus $10, or $15 in all. It is the combination of dividends and appreciation of \ncapital that constitutes the total gain.\nIt seems futile to try to correlate or compare the market value of a stock with the “book \nvalue” or with the “value” figured on a basis of capitalized earnings or dividends, projected \ngrowth, etc. There are too many other factors that may also affect the value, and some of \nthese cannot easily be expressed in simple ratios. For example, a struggle for control of a \ncorporation can as surely increase the value of its securities in the market as a growth of \nearnings. Again, a company may lose money for years and pay no dividends, yet still be \nan excellent investment on the basis of its development of potential resources as perceived \nby those who are buying and selling its stock. The market is not evaluating last year’s \naccomplishments as such; it is weighing the prospects for the year to come.\nThen, too, in a time of inflation, a majority of stocks may advance sharply in price. This \nmay reflect a depreciation in the purchasing power of dollars more than improvement in \nbusiness conditions—but it is important, nonetheless, in such a case to be “out of dollars” \nand “into” equities.\nAs a result of their research from 1942 to 1948, Edwards and Magee developed new \ntechnical methods. They put these methods to practical use in actual market operation. \nxxxixPreface to the seventh edition\nEventually, in 1948, these findings were published in their definitive book, Technical Analysis \nof Stock Trends.\nThis book, now in its seventh edition, has become the accepted authority in this field. \nIt has been used as a textbook by various schools and colleges and is the basic tool of many \ninvestors and traders.\nIn 1951, Edwards retired from his work as a stock analyst and John Magee continued \nthe research, at first, independently, and then from January 1953 to March 1956 as Chief \nTechnical Analyst with an investment counseling firm.\nMeanwhile, beginning in 1950, Magee started on a new road, which, as it turned out, \nwas destined to open up virgin fields of technical market research.\nUsing the methods of Dow, Hamilton, Schabacker, and Edwards as a base, he initiated \na series of studies intended to discover new technical devices. These investigations were \nlong and laborious, and, often, they were fruitless. One study required four months of \nwork, involved hundreds of sheets of tabulations, many thousands of computations, and \nproved nothing.\nBut from this type of work, eventually in late 1951, there began to emerge some important \nnew and useful concepts—new bricks to build into the structure of the technical method.\nThe new devices are not revolutionary. They do not vitiate the basic technical approach. \nRather, they are evolutionary and add something to the valuable kit of tools already at \nhand. The new studies often make it possible to interpret and predict difficult situations \nsooner and more dependably than any other method previously used.\nMr. Magee has designated these newest technical devices the Delta Studies. They are \nbasically an extension and refinement of the technical method. There is no magic in the \nDelta Studies. They do not provide infallible formulas for sure profits at all times in every \ntransaction, but they have proved eminently successful over a period of years in practical \nuse in actual market operations, as an auxiliary to the methods outlined in the book, \nTechnical Analysis of Stock Trends.\nThrough his technical work, John Magee emphasized these three principles:\n 1. Stock prices tend to move in trends.\n 2. Volume goes with the trends.\n 3. A trend, once established, tends to continue in force.\nA large portion of the book, Technical Analysis of Stock Trends, is devoted to the patterns \nthat tend to develop when a trend is being reversed. Head and Shoulders, Tops and Bottoms, \n“W” Patterns, Triangles, Rectangles, etc., are common patterns to stock market technicians. \nRounded Bottoms and Drooping Necklines are some of the more esoteric ones.\nMagee urged investors to go with the trend, rather than trying to pick a Bottom before \nit was completed or averaging down in a declining stock. Above all, and at all times, he \nrefused to get involved in the game of forecasting where “the market” was headed, or \nwhere the Dow Jones Industrial Average® would be on December 31st of the coming year. \nRather, he preached care in individual stock selection regardless of which way the market \n“appeared” headed. Finally, his service recommended short positions as regularly as it did \nlong positions, based simply on what the charts said.\nRichard McDermott\nEditor and Reviser\nTechnical Analysis of Stock Trends, Seventh Edition\nJanuary 1997\n\nxli\nPreface to the fifth edition\nDuring the 16 printings of the fourth edition of Technical Analysis of Stock Trends, very few \nchanges have been made in the original text, mainly because the lucid presentation of \nmarket action by the late Robert D. Edwards covered so thoroughly the basic and typical \nmarket action of common stocks. There has seemed no reason, for example, to discard a \nchart picture illustrating some important technical phenomenon merely because it occurred \nseveral or many years ago.\nInstead, over the various printings of the book, pages have been added showing similar \nexamples, or in some cases entirely new types of market action taken from recent history; \nbut these demonstrate mainly that the inherent nature of a competitive market does not \nchange very much over the years, and that “the same old patterns” of human behavior \ncontinue to produce much the same types of market tr", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 18}
{"text": "ead, over the various printings of the book, pages have been added showing similar \nexamples, or in some cases entirely new types of market action taken from recent history; \nbut these demonstrate mainly that the inherent nature of a competitive market does not \nchange very much over the years, and that “the same old patterns” of human behavior \ncontinue to produce much the same types of market trends and fluctuations.\nThe principal change in this fifth edition, and it is a spectacular improvement, is \nthat practically all of the chart examples drawn to the TEKNIPLAT™ scale have been \nredrawn and new plates of these have been substituted. In the course of this work, several \nminor errors of scaling, titling, etc., previously undiscovered, came to light and have been \ncorrected.\nThe difficult work of revision was initiated in our charting room by two ambitious \nteenagers, Anne E. Mahoney and Joseph J. Spezeski, who took on the entire job of preparing \nthe finished drawings and making necessary corrections. This enormous project was \nundertaken and carried through by these two young people spontaneously. In order to \nfree them entirely from other distractions, their regular charting work was taken over for \na period of months by the rest of the chartroom staff, so that a great deal of credit is due to \nthe fine efforts of the entire chartroom group.\nJohn Magee\nDecember 3, 1966\n\nxliii\nPreface to the fourth edition\nIn the several years since publication of the first edition of this work, “the stock market \ngoes right on repeating the same old movements in much the same old routine.” Nearly all \nof the technical phenomena outlined in the first edition have appeared many times since \nthen, and we see no reason to expect these habits of stocks will change materially in the \nyears ahead, barring revolutionary changes in the economy, such as the abolishment of the \nfree market entirely.\nSince the basic nature of the market has not changed appreciably, it has been \nunnecessary to make sweeping alterations in the text of “Part One: Technical Theory.” The \nprevious edition has been very carefully restudied, and revisions have been made where \nthey were called for to bring the material up to date. In “Part Two: Trading Tactics,” more \nextensive changes were needed, due to the more specific nature of the material and some \ndifferences in the present margin requirements, trading rules, etc. Also, there have been \nsome improvements in the application of technical methods at the tactical level, and these \nhave been incorporated in this section.\nSomewhat less emphasis has been put on the use of stop-loss orders, since their need is \nnot so great in the case of the experienced trader as it might be with the novice. The principle \nof always following the Major Trend has been modified to achieve better protection of \ncapital through balance and diversification. In line with avoiding “all-out” situations, with \ntheir consequent dangers, the idea of using an Evaluative Index has been introduced, and \nthis concept has modified somewhat the tactics of following the Major Trend. It also has a \nbearing on the Composite Leverage or determination of total risk.\nType for the entire book has been reset in this edition. The illustrative charts originally \nused have been, in the main, retained, since they demonstrate the various points very well, \nbut a new chapter includes a number of additional charts taken from the market history \nof recent years, showing how the same phenomena continue to appear again and again.\nThe appendix (Appendix C, 5th edition) on the Sensitivity Indexes has been completely \nrecomputed and extended to cover a broad list of the more important issues. The arduous \nlabor of determining these index figures was undertaken by Frank J. Curto and Marcella \nP . Curto. Material help in proofreading and revision for this edition was given by Beverly \nMagee and Elinor T. Magee.\nJohn Magee\nJanuary 1, 1957\n\nxlv\nPreface to the second edition\nIt is, needless to say, gratifying to the authors of this treatise to report that not only has a \nlarge first edition been exhausted (although it was originally assumed it would suffice for \nmany years), but also, the demand for copies has been increasing at a rather astonishing \npace during the past six months without any “promotion” except word-of-mouth \nrecommendation from one investor to another.\nIn preparing this new edition, a careful perusal of everything that was written in the \nprevious printing, checked by the market events of the past 24 months and compared \nwith all of the additional chart data accumulated during that period, resulted in the not \nunexpected, but nevertheless mildly surprising conclusion that nothing of real consequence \nneeded to be changed or amplified. Hence, only minor revisions of an editorial nature have \nbeen made.\nIt would have been interesting to augment our already copious illustrations with a \nnumber of charts from current months of market action, but costs of engraving and printing \nhave risen to such a distressingly high level that any additions of that sort would, it was \nfound, be prohibitively expensive. Aside from their novelty, they would add nothing to \nthe book; they would only be substituted for other charts of precisely the same nature and \nsignificance, and fully as pertinent to present-day conditions.\nThe stock market, as I wrote in the original Foreword, “goes right on repeating the same \nold movements in much the same old routine. The importance of a knowledge of these \nphenomena to the trader and investor has been in no whit diminished.” We see the same \nforecasting patterns developing on the charts today that we have seen over and over again \nfor the past 20 years. Neither the mechanics nor the “human element” of the stock market \nhas changed, and there is no reason to think they will.\nRobert D. Edwards\nMay 1, 1951\n\nxlvii\nForeword\nThis book has been written for the layman rather than for the Wall Street professional", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 19}
{"text": "diminished.” We see the same \nforecasting patterns developing on the charts today that we have seen over and over again \nfor the past 20 years. Neither the mechanics nor the “human element” of the stock market \nhas changed, and there is no reason to think they will.\nRobert D. Edwards\nMay 1, 1951\n\nxlvii\nForeword\nThis book has been written for the layman rather than for the Wall Street professional. But, \nit assumes the reader is already possessed of at least an elementary knowledge of the nature \nof stocks and bonds, and he has had some dealings with a broker and some familiarity with \nthe financial pages of his newspapers. Hence, no attempt is made herein to define common \nstock market terms and procedures. Every effort, however, has been exerted to explain, in \nfull, the theories and the terminology of our specific subject, technical market analysis.\nPart One is based, in large part, on the pioneer researches and writings of the late \nRichard W. Schabacker. Students of his Technical Analysis and Stock Market Profits (the latest \nrevision of which is now out of print was made in 1937 by the present writer and Albert \nL. Kimball) will find in the pages of this section much that is familiar and, except for the \nillustrations, only a little that is really novel. It has been a matter of surprise, in fact, to the \nauthors and other students of market technics that all the new controls and regulations of \nthe past several years, the new taxes which have placed a heavy handicap on successful \ninvestors, the greatly augmented and improved facilities for acquiring dependable \ninformation on securities, even the quite radical changes in certain portions of our basic \neconomy, have not much altered the “pattern” of the stock market.\nCertain of the evidences of pool manipulation that used to appear on the charts are now \nseldom seen. A few of the price formations that formerly were quite common, now appear \nrarely or may have lost much of their practical utility for the trader; they have been omitted \nfrom this text. Others have altered their habits slightly, or their consequences to a degree \n(but not their fundamental nature), which has, of course, been noted herein. The distressing \nthinness of the market at times—one of the undoubted effects of regulation—has resulted \nin a few more “false moves,” more spells of uninteresting (and unprofitable) inactivity. But, \nin the main, the market goes right on repeating the same old movements in much the same \nold routine. The importance of a knowledge of these phenomena to the trader and investor \nhas been in no whit diminished.\nPart Two, which has to do with the practical application of these market patterns and \nphenomena, with the tactics of trading, is all new. For more than 15 years (his total market \nexperience extends back nearly 30 years), John Magee has invested and traded exclusively \nvia the technical theory, kept thousands of charts, made hundreds of actual trades, tested \nall sorts of applications, audited and analyzed methods, tactics, and results from every \nconceivable angle, depended on his profits for his living. His contribution is that of one \nwho has tried and knows.\nIt may well be added here—and will be often repeated in the following pages—that the \ntechnical guides to trading in stocks are by no means infallible. The more experience one \ngains in their use, the more alive one becomes to their pitfalls and their failures. There is no \nsuch thing as a sure-fire method of “beating the market”; the authors have no hesitancy in \nsaying that there never will be. Nevertheless, a knowledge and judicious application of the \nxlviii Foreword\nprinciples of technical analysis does pay dividends—is more profitable (and far safer) for \nthe average investor than any other of the presently recognized and established approaches \nto the problems of buying and selling securities.\nRobert D. Edwards\nJuly 1948\npart one\nTechnical theory\n\n3\nchapter one\nThe technical approach to \ntrading and investing\nFew human activities have been so exhaustively studied during the past century, from \nso many angles and by so many different sorts of people, as the buying and selling of \ncorporate securities. The rewards the stock market holds out to those who read it right \nare enormous; the penalties it exacts from careless, dozing, or “unlucky” investors are \ncalamitous. No wonder it has attracted some of the world’s most astute accountants, \nanalysts, and researchers, along with a motley crew of eccentrics, mystics, “hunch players,” \nand a multitude of just ordinary hopeful citizens.\nAble brains have sought, and continue constantly to seek, for safe and sure methods \nof appraising the state and trend of the market, as well as discovering the right stock \nto buy and the right time to buy it. This intensive research has not been fruitless—far \nfrom it. There are a great many successful investors and speculators (using the word in its \ntrue sense, which is without opprobrium) who, by one road or another, have acquired the \nnecessary insight into the forces with which they deal and the judgment, the forethought, \nand the all-important self-discipline to deal with them profitably.\nIn the course of years of stock market study, two quite distinct schools of thought \nhave arisen, providing two radically different methods of arriving at the answers to the \ntrader’s problem of what and when. In the parlance of “the Street,” one of these is commonly \nreferred to as the fundamental or statistical, and the other as the technical. (In recent years a \nthird approach, the cyclical, has made rapid progress, and although still beset by a “lunatic \nfringe,” it promises to contribute a great deal to our understanding of economic trends.)\nThe stock market fundamentalist depends on statistics. He examines the auditors’ \nreports, the profit-and-loss statements, the quarterly balance sheets, the dividend records, \nand the policies of the companies whose shares he has under observation. He ana", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 20}
{"text": "apid progress, and although still beset by a “lunatic \nfringe,” it promises to contribute a great deal to our understanding of economic trends.)\nThe stock market fundamentalist depends on statistics. He examines the auditors’ \nreports, the profit-and-loss statements, the quarterly balance sheets, the dividend records, \nand the policies of the companies whose shares he has under observation. He analyzes \nsales data, managerial ability, plant capacity, and the competition. He turns to bank and \ntreasury reports, production indexes, price statistics, and crop forecasts, to gauge the state \nof business in general, and reads the daily news carefully to arrive at an estimate of future \nbusiness conditions. Taking all these into account, he evaluates his stock; if it is selling \ncurrently below his appraisal, he regards it as a buy. (EN9: And, no surprise, the buyer’s name \nis Warren Buffet, and he buys the company, not the stock, for although this is an excellent way to \nbuy companies, it is not a very good way to buy stocks.) EN: Read Robert Prechter’s summation of \nthe fundamental methodology as an amusing endnote at the end of this chapter.\nAs a matter of fact, aside from the greenest of newcomers when they first tackle the \ninvestment problem, and to whom, in their inexperience, any other point of view is not \nonly irrational but incomprehensible, your pure fundamentalist is a rare bird. Even those \nmarket authorities who pretend to scorn charts and “chartists” utterly are not oblivious \nto the “action” chronicled by the ticker tape, and they do not conceal their respect for the \nDow Theory, which, whether they realize it or not, is, in its very essence, purely technical.\n4 Technical Analysis of Stock Trends\nDefinition of technical analysis\nThe term “technical,” in its application to the stock market, has come to have a special \nmeaning, quite different from its ordinary dictionary definition. It refers to the study of the \naction of the market itself as opposed to the study of the goods in which the market deals. \nTechnical Analysis is the science of recording, usually in graphic form, the actual history of \ntrading (price changes, volume of transactions, etc.) in a certain stock or in “the Averages” \nand then deducing from that pictured history the probable future trend. EN: With the advent \nof the computer, many schools of technical analysis have arisen. Number-driven technical analysis \n(e.g., moving average studies, oscillators, etc.) attempts to completely objectify the analysis of the \nmarkets. The work of Edwards and Magee is the embodiment and definition of “classical technical \nanalysis.”\nThe technical student argues thus: it is futile to assign an intrinsic value to a stock \ncertificate. One share of U.S. Steel, for example, was worth $261 in the early fall of 1929, \nbut you could buy it for only $22 in June 1932. By March 1937 , it was selling for $126 and \njust one year later it was selling for $38. In May 1946, it had climbed back up to $97 , and \n10 months later, in 1947 , had dropped below $70, although the company’s earnings on \nthis last date were reputed to be nearing an all-time high and interest rates in general \nwere still near an all-time low. The book value of this share of U.S. Steel, according to the \ncorporation’s balance sheet, was about $204 in 1929 (end of the year), $187 in 1932, $151 \nin 1937 , $117 in 1938, and $142 in 1946. This sort of wide divergence between presumed \nvalue and actual price is not the exception—it is the rule. It is going on all the time. The \nfact is the real value of a share of U.S. Steel common is determined at any given time \nsolely, definitely, and inexorably by supply and demand, which are accurately reflected \nin the transactions consummated on the floor of the New York Stock Exchange (see \nFigure 1.1).\nOf course, the statistics fundamentalists study play a part in the supply– demand \nequation—that is freely admitted. But many other factors are affecting it as well. The market \nprice reflects not only the differing value opinions of many orthodox security appraisers, \nbut also all the hopes and fears and guesses and moods, rational and irrational, of hundreds \nof potential buyers and sellers, as well as their needs and their resources—in total, factors \nthat defy analysis and for which no statistics are obtainable, but that nevertheless are \nsynthesized, weighed, and finally expressed in the one precise figure at which a buyer and \na seller get together and make a deal (through their agents, their respective stock brokers). \nThis is the only figure that counts.\nMoreover, the technician claims, with complete justification, that the bulk of the \nstatistics the fundamentalists study are past history, already out of date and sterile because \nthe market is not interested in the past or even in the present. It is constantly looking ahead, \nattempting to discount future developments, weighing and balancing all the estimates and \nguesses of thousands of investors who look into the future from different points of view \nand through glasses of many different hues. In brief, the going price, as established by the \nmarket itself, comprehends all the fundamental information the statistical analyst can hope \nto learn (plus some that is perhaps secret from him or known only to a few insiders) and \nmuch else besides of equal or even greater importance.\nAll of which, admitting its truth, would be of little significance were it not for the fact, \nwhich no one of experience doubts, that prices move in trends and trends tend to continue \nuntil something happens to change the supply–demand balance. Such changes are usually \ndetectable in the action of the market. Certain patterns or formations, levels or areas, appear \non the charts that have a meaning and that can be interpreted in terms of probable future \n5Chapter one: The techn ical approach to trading and investing\ntrend development. They are not infallible, it must be noted, but the odds are defi", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 21}
{"text": "ns to change the supply–demand balance. Such changes are usually \ndetectable in the action of the market. Certain patterns or formations, levels or areas, appear \non the charts that have a meaning and that can be interpreted in terms of probable future \n5Chapter one: The techn ical approach to trading and investing\ntrend development. They are not infallible, it must be noted, but the odds are definitely in \ntheir favor. Time after time, as experience has amply proved, they are far more prescient \nthan the best informed and most shrewd of statisticians.\nThe technical analyst may go even further in his claims. He may offer to interpret the \nchart of a stock whose name he does not know, so long as the record of trading is accurate \nand covers a long enough term to enable him to study its market background and habits. He \nmay suggest he could trade with profit in a stock knowing only its ticker symbol, completely \nignorant of the company, the industry, what it manufactures or sells, or how it is capitalized. \nNeedless to say, such practice is not recommended, but if your market technician is really \nexperienced at his business, he could, in theory, do exactly what he claims.\n240\n220\n200\n180\n160\n140\n120\n100\n80\n60\n40\n20\n1929 1930 1931 1932 1933 1934 1935 1936 1937 1938 1939 1940 1941 1942 1943 1944 1945 1946\nU. S. STEEL X\nFigure 1.1 Monthly price ranges of U.S. Steel common from January 1929 to December 1946. Compare \nthe great swings in the market price for this stock—from 1929 (extreme high, 261 3/4) to 1932 (extreme \nlow, 21 1/4), from 1932 to 1937 , from 1937 to 1938, from 1942 to 1946—with its book values for those \nyears as cited on the previous page.\n6 Technical Analysis of Stock Trends\nShould the reader, at this point, find the technical approach to trading or investing, as \nexplained in the foregoing, completely abhorrent, perhaps he had better close the book now, \nfor it is primarily the technical approach, the science of technical analysis, with which the \nremainder of the book deals.\nEN: The Elliott Wave Theory: perspective and comments from a Magee investment letter of the \n80s. This week, we had the pleasure of attending the December meeting of the Market Technicians \nAssociation of New York (MTANY).\nLong-term subscribers will remember the MTANY as the organization that honored John Magee \nwith its Man of the Year award in 1978. The speaker was Robert Prechter, publisher of “The Elliott \nWave Theorist,” an investment advisory that bases its forecasts on interpretations of R. N. Elliott’s \nwork on the stock market.\nOf primary interest to subscribers are Prechter’s comments on technical analysis itself. The \nElliott Wave Theory, it must be remembered, is really no more than a “catalog” of stock market \nprice movements, laid one on top of the other, so to speak, until a grand, underlying, and enduring \npattern is observed; in short, pure technical analysis. Among Prechter’s definitions and observations \nregarding fundamental analysis are the following:\n 1. First, let’s define “technical” versus “fundamental” data … technica l data is that \nwhich is generated by the action of the market under study.\n 2. The main problem with fundamental analysis is its indicators are removed from the \nmarket itself. The analyst assumes causality between external events and market \nmovements, a concept which is almost certainly false. But, just as important (and less \nrecognized), is that fundamental analysis almost always requires a forecast of the \nfundamental data itself before conclusions about the market are drawn. The analyst is \nthen forced to take a second step in coming to a conclusion about how those forecasted \nevents will affect the markets! Technicians only have one step to take, which gives \nthem an edge right off the bat. Their main advantage is they don’t have to forecast \ntheir indicators.\n 3. What’s worse, even the fundamentalists’ second step is probably a process built on \nquicksand. … The most co mmon application of fundamental analysis is estimating \ncompanies’ earnings for both the current year and next year and recommending stocks \non that basis. … And the rec ord on that basis alone is very poor, as Barron’s pointed \nout in a June 4 article, which showed that earnings estimates averaged 18% error in \nthe 30 Dow Jones Industrial Average (DJIA) stocks for any year already completed \nand 54% error for the year ahead. The weakest link, however, is the assumption that \ncorrect earnings estimates are a basis for choosing stock market winners. According \nto a table in the same Barron’s article, a purchase of the 10 DJIA stocks with the \nbest earnings estimates would have produced a 10-year cumulative gain of 40.5%, \nwhile choosing the 10 DJIA with the worst earnings estimates would have produced \na whopping 142.5% gain.\nWe enjoyed Prechter’s polished exposition of a technical approach, which is different from our \nown. As for his observations about fundamental analysis, we simply couldn’t agree more.\n7\nchapter two\nCharts\nCharts are the working tools of the technical analyst. They have been developed in a \nmultitude of forms and styles to represent graphically almost anything that takes place in \nthe market as well as to plot an “index” derived therefrom. They may be monthly charts \non which an entire month’s trading record is condensed into a single entry, or they may be \nweekly, daily, hourly, transaction, “point-and-figure,” and candlestick charts. They may be \nconstructed on arithmetic, logarithmic, or square-root scale, or they may be projected as \n“oscillators.” They may delineate moving averages, proportion of trading volume to price \nmovement, average price of most active issues, odd-lot transactions, the short interest, and \nan infinitude of other relations, ratios, and indexes—all technical in the sense that they are \nderived, directly or indirectly, from what actually has been transacted on the exchanges.\nFortunately, we shall not need to concern ourselves with most of thes", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 22}
{"text": "g averages, proportion of trading volume to price \nmovement, average price of most active issues, odd-lot transactions, the short interest, and \nan infinitude of other relations, ratios, and indexes—all technical in the sense that they are \nderived, directly or indirectly, from what actually has been transacted on the exchanges.\nFortunately, we shall not need to concern ourselves with most of these charts; they are \nof interest only to the full-time economic analyst. Many of these charts have derived from a \ncompletely futile (so far, at least) endeavor to discover a “mechanical” index or combination \nof indexes that will always, automatically, without ever failing or going wrong, give warning \nof a change in trend; in our experience, such charts are often confusing and sometimes \ndownright deceptive at a most critical juncture. This book, however, is designed for the \nlayman, the professional who cannot spend all of his hours on his investing or trading \noperations, but to whom these operations are, nevertheless, of sufficient importance or \ninterest to warrant his devoting at least a few minutes a day to their study and management. \n(EN9: In retrospect, this is an underestimation of the importance of the work. In the 21st century, \nthe best professionals are acutely aware of the importance of trend analysis and use this work as their \ntextbook.) The theories and methods outlined herein will require only the simplest form of \nstock chart—a record of the price range (open, high/low and close) and volume of shares \ntraded each day. These daily graphs will be supplemented, for certain purposes that will \nbe discussed later in this text, by weekly or monthly charts, which for most stocks can be \neasily generated by almost all commercially available investment software and websites.\nNearly all the illustrations throughout the following chapters are examples of such \ndaily charts. They are easy to make and maintain manually, requiring only a supply of \ngraph or cross-section paper (almost any kind can serve), a daily newspaper that gives full \nand accurate reports on stock exchange dealings, a sharp pencil, and a few minutes of time. \nEN: Alternatively, numerous data services are available for use with computer software packages, not \nto mention internet sites (which are mentioned in Appendix B, Resources). The use of this technology \neliminates the burden of manual chart keeping. If there is a drawback to this technology, it might be \nin the loss of the “feel” the investor gets through manual charting.\nIt is customary in preparing ordinary daily stock charts to let the horizontal axis \nrepresent time, with the vertical cross-lines (or as some prefer, the spaces between them) \nfrom left to right, thus standing for successive days. The vertical scale is used for prices, \nwith each horizontal cross-line then representing a specific price level. Space is usually \nprovided at the bottom of the sheet to plot volume, that is, the number of shares that change \nhands each day. The newspapers publishing complete stock market reports give the day’s \nturnover or volume (exclusive of odd-lot transactions that for our present purpose may \n8 Technical Analysis of Stock Trends\nbe disregarded), the highest and lowest price at which each stock sold during the day, the \nclosing price (which is the price at which the last sale effected during the day was made), \nand usually the opening or first sale price. On our charts, the daily price range is plotted \nby drawing a vertical line connecting the points representing the high and the low. Then \na short horizontal “tick” is added, either crossing the vertical range line or extending out \nto the right from it, at the level of the closing price. Sometimes all transactions in a stock \nduring a day take place at one and the same price; the high, low, and close are thus all on \nlevel and the only mark on our chart will be the horizontal dash representing the closing \nfigure. Volume is depicted by drawing a vertical line up from the baseline of the chart.\nThe opening price need not be recorded. (EN10: Candlestick charts require this piece of \ndata.) Experience has shown that it seldom, if ever, has any significance in estimating future \ndevelopments, which is all that ordinarily should interest us. The closing price is important, \nhowever. It is, in fact, the only price that many casual readers of the financial pages ever \nlook at. It represents the final evaluation of the stock made by the market during the day. \nThe closing price may be registered in the first hour of trading, provided no other sales are \nsubsequently affected, but, it nevertheless becomes the figure upon which a majority of \nprospective traders base their plans for the following day. Hence, its technical significance \nis evident and will appear in various contexts in later chapters.\nDifferent types of scales\nMany specific suggestions as to the details of charting are deferred for discussion in Section \nII of this book, but there is one chart feature that may well be considered here. Until recent \nyears, nearly all stock price charts were kept on the common form of graph paper ruled to \nwhat is known as plain or arithmetic scale. But more and more chartists have now come to \nuse what is known as semilogarithmic paper, or sometimes as ratio or percentage paper. \nOur experience indicates that the semilogarithmic scale has definite advantages in this \nwork, and most of the charts reproduced in this book employ this scale. The two types \nof scales may be distinguished at a glance: on arithmetic paper, equal distances on the \nvertical scale (i.e., between horizontal lines) represent equal amounts in dollars, whereas on \nthe semilogarithmic paper, they represent equal percentage changes. Thus, on arithmetic \npaper, the distance between 10 and 20 on the vertical scale is exactly the same as that \nfrom 20 to 30 and from 30 to 40. On the semilogarithmic scale the difference from 10 to 20, \nrepresenting an incr", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 23}
{"text": "nces on the \nvertical scale (i.e., between horizontal lines) represent equal amounts in dollars, whereas on \nthe semilogarithmic paper, they represent equal percentage changes. Thus, on arithmetic \npaper, the distance between 10 and 20 on the vertical scale is exactly the same as that \nfrom 20 to 30 and from 30 to 40. On the semilogarithmic scale the difference from 10 to 20, \nrepresenting an increase of 100%, is the same as that from 20 to 40 or from 40 to 80, in each \ncase representing another 100% increase.\nPercentage relations, it goes without saying, are important in trading in securities. \nThe semilogarithmic scale permits direct comparison of high- and low-priced stocks and \nmakes it easier to choose the one offering the greater (percentage) profit on the funds \nto be invested. It facilitates the placing of stop-loss orders. Area patterns appear much \nthe same on either type of paper, but certain trendlines develop more advantageously \non the ratio scale. Almost anyone can quickly become accustomed to making entries on \nsemilogarithmic paper. (We recommend its use.) Its advantages, however, are not so great \nas to require one to change—one who, because of long familiarity and practice, prefers an \narithmetic sheet. Such percentage calculations, as may seem to be required, can be made \non another sheet or in the head, and the results then can be entered on the arithmetic chart, \nif a record is desired.\nSeveral firms specializing in the manufacture of graph paper and other engineers’ and \narchitects’ supplies now offer sheets specifically designed for stock charting, on which \nheavier lines to define the business week mark each sixth day on the time scale, and the \n9Chapter two: Charts\nprice scale is subdivided into eighths to represent the standard fractions of the dollar in \nwhich stocks are traded on all U.S. exchanges. (EN9: Eighths went the way of the New Haven \nand now decimals reign.) These sheets are available in various sizes and with either arithmetic \nor logarithmic price and volume scales. EN: This paper is only of interest to the manual chartist, \nas modern software, as detailed in Appendix B, Resources, enables the computer chartist to easily \nswitch between price scales and methods of charting. References to such paper are also found there.\nOn weekly charts, each vertical line represents a week’s worth of trading. The price \nrange for the week is plotted thereon and usually the total volume, but the closing price \nmay be omitted. The range extends from the highest price at which the stock sold on any \nday during the week to the lowest price at which it sold on any day; these two extremes \nmight, and sometimes do, occur on the same day, but the weekly chart makes no distinction \nas to day. Monthly charts are prepared in the same way but do not, as a rule, record volume. \nThese two charts—often referred to as long-term or major charts—are used chiefly for \ndetermining important support and resistance levels and for marking long-term trends. \nWeekly charts—if the reader prefers to keep his own—can be posted easily from the \nSunday morning editions of those daily newspapers (e.g., the New York Times or Barron’s \nBusiness and Financial Weekly) that publish a summary of the previous week’s transactions.\nIn concluding this chapter on the construction of the charts that we shall study in \nsucceeding chapters, it can well be said that there is no special virtue, certainly no magic, in \nthe chart itself. It is simply a pictorial record of the trading history of the stock or stocks in \nwhich we may be interested. To the person possessed of a photographic memory, no chart \nwork is necessary; his mind records all the necessary data—he carries his charts in his \nhead. Many of the expert “tape-readers” who have no use for charts are gifted with that rare \nmemory talent that renders reference to graphic records unnecessary. But most of us are \nnot so blessed; to use the chart is necessary and useful because it lends itself conveniently \nto the type of analysis that indicates future probabilities.\nThere is a saying on Wall Street to the effect that “there is nothing wrong with charts—\nthe trouble is with the chartists,” which is simply another way of expressing the truth that \nit is not the chart but its interpretation that is important. Chart analysis is neither easy nor \nfoolproof. Yet, it is not at all uncommon for some casual investor who has no idea whatever \nof market technics to pick up a chart by chance and see in it something he had not hitherto \nsuspected, something perhaps that saves him from making an unfavorable commitment.\nIf you have never used stock charts, and have never paid much attention to them, you \nmay be surprised at some of the significant things you will detect as soon as you begin to \nstudy them seriously.\nEN9: Surprise and astonishment are the words used to describe the reactions of even professionals \nwhen they are fully exposed to a coherent presentation of the methods of Edwards and Magee. I have \noften commented that no understanding of other (number driven statistical) methods of technical \nanalysis is possible without a firm grasp of the concepts and principles of this book.\nSome other comments are worth noting relevant to Edwards’ discussion. For manual charting, \nsemilog remains the superior scale. Given the ease of changing scale and time frames on internet sites \n(e.g., prophet.net, thinkorswim.com, tdameritrade.com, and stockcharts.com) and in the standalone \nsoftware, one may switch from a close-up of a month to a long-range perspective of years. In this \nprocess, it is important to maintain perspective. Multiyear log charts of large ranges lose graphic \nimportance at the top as chart intervals shrink. This distortion must be countered by breaking the \ntime frame into smaller increments. Thus, instead of five years of a chart that spans a range of \n10–200, we look at five charts of one year each as well as the five-year chart.\nIn the modern era,", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 24}
{"text": "s \nprocess, it is important to maintain perspective. Multiyear log charts of large ranges lose graphic \nimportance at the top as chart intervals shrink. This distortion must be countered by breaking the \ntime frame into smaller increments. Thus, instead of five years of a chart that spans a range of \n10–200, we look at five charts of one year each as well as the five-year chart.\nIn the modern era, a new graphic representation has gained enormous popularity—candlestick \ncharting. In this method, color is added to the chart by coloring the body of the candlestick—white \n10 Technical Analysis of Stock Trends\nfor rising prices, black for falling prices (or colors of your choice). Thus, the direction of the trend \nis dramatized. Also, candlestick patterns are said to be of value in recognizing trend reversals and \nother trend states.\nA host of other charting methods exists: Three Line Break, Renko, Kagi… These may be researched \nin Nison’s book, Beyond Candlesticks. I will not treat these in this book, but I do include them in \nan appendix on examination of Point and Figure charting.\n11\nchapter three\nThe Dow Theory\nThe Dow Theory is the granddaddy of all technical market studies. Although it is frequently \ncriticized for being “too late” and occasionally derided (particularly in the early stages of a \nBear Market) by those who rebel against its verdicts, it is known by name to nearly everyone \nwho has had any association with the stock market, and it is respected by most. Many who \nheed it in greater or lesser degrees in determining their investment policies never realize \nthat it is purely and simply “technical.” It is built upon and concerned with nothing but \nthe action of the stock market (as expressed in certain averages), deriving nothing from the \nbusiness statistics on which the fundamentalists depend.\nThere is much in the writings of its original promulgator, Charles H. Dow, to suggest \nhe did not think of his theory as a device for forecasting the stock market, or even as a \nguide for investors, but rather as a barometer of general business trends. Dow founded \nthe Dow–Jones Financial News Service and is credited with the invention of stock market \naverages. He outlined the basic principles of the theory, which was later named after him, \nin editorials he wrote for the Wall Street Journal . Upon his death in 1902, his successor, \nWilliam P . Hamilton, as editor of the Journal, took up Dow’s principles and, in the course \nof 27 years of writing on the stock market, organized and formulated them into the Dow \nTheory as we know it today.\nBefore we proceed to an explanation of the theory, it will be necessary to examine \nthe stock averages that it employs. Long before the time of Dow, the fact was familiar to \nbankers and businessmen that the securities of most established companies tended to go \nup or down in price together. Exceptions—stocks that moved against the general financial \ntide—were rare, nor did they as a rule persevere in that contrary course for more than a \nfew days or weeks at a time. It is true that when a boom was on, the prices of some issues \nrose faster and farther than others, and when the trend was toward depression, some stocks \ndeclined rapidly whereas others would put up considerable resistance to the forces that \nwere dragging down the market. The fact remained, however, that most securities tended \nto swing together. (They still do and always will.)\nThis fact, as we have said, has long been commonly known and accepted (so completely \ntaken for granted that its importance is usually overlooked), for it is important—\ntremendously important—from many angles in addition to those that come within the \nprovince of this volume. One of the best reasons for a student of market technics to start \nwith the Dow Theory is because that theory stresses the general market trend .\nCharles Dow is believed to have been the first to make a thorough effort to express the \ngeneral trend (or, more correctly, level) of the securities market in terms of the average price \nof a selected few representative stocks. As finally set up in January of 1897 , in the form that \nhas continued to date and used by Dow in his studies of market trends, there were two \nDow–Jones Averages. One was composed solely of the stocks of 20 railroad companies, \nfor the railroads were the dominant corporate enterprises of his day. The other, called the \nIndustrial Average, represented all other types of businesses and was made up, at first, of \nonly 12 issues. This number was increased to 20 in 1916 and to 30 on October 1, 1928.\n12 Technical Analysis of Stock Trends\nThe Dow Averages\nThe stocks included in these two Averages have been changed from time to time to keep \nthe lists up to date and as nearly representative as possible of their respective groups. Only \nGeneral Electric, of the present 30 industrial stocks, was included in the original Industrial \nAverage, and that was dropped at one time (in 1898) and subsequently reinserted. In 1929, \nall stocks of public utility companies were dropped from the Industrial Average and a new \nUtility Average of 20 issues was set up; in 1938, its number was reduced to 15. The 20 rail, \n30 industrial, and 15 utility stocks are now averaged together to make what is known as \nthe Dow–Jones Stock Composite. The history of these Averages, the various adjustments \nthat have been made in them and their method of computation is an interesting story in \nitself, which the reader may want to look up elsewhere. EN: See Appendix B, Resources, for \nreferences. Note also there is now a proliferation of Dow–Jones Averages. For our present purpose, \nit remains only to add that the Dow Theory pays no attention to the Utility or Composite \nAverages; its interpretations are based on the Rail and Industrial Averages only. EN: The \nRails are now known as Transportations.\nIn recent years, the values of the Dow–Jones Averages have been computed for the \nend of each hour of trading as well a", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 25}
{"text": "liferation of Dow–Jones Averages. For our present purpose, \nit remains only to add that the Dow Theory pays no attention to the Utility or Composite \nAverages; its interpretations are based on the Rail and Industrial Averages only. EN: The \nRails are now known as Transportations.\nIn recent years, the values of the Dow–Jones Averages have been computed for the \nend of each hour of trading as well as the end of the day. EN: Now computed in real time and \navailable over the internet, these hourly figures are published in the Wall Street Journal as well as \non all market tickers. In fact, presently, the Averages are computed in real time, a necessity for options \nand futures trading that takes place on them. The Wall Street Journal also prints in each issue a \nsummary of the important highs and lows of each average by date for the preceding two \nor three years. Their daily closing prices are reported in many other metropolitan daily \nnewspapers.\nBasic tenets\nTo get back to the Dow Theory, here are its basic tenets:\n 1. The Averages discount everything (except “acts of God”): Since they reflect the \ncombined market activities of thousands of investors, including those possessed of \nthe greatest foresight and the best information on trends and events, the Averages in \ntheir day-to-day fluctuations discount everything known, everything foreseeable, and \nevery condition that can affect the supply of or the demand for corporate securities. \nEven unpredictable natural calamities, when they happen, are quickly appraised and \ntheir possible effects discounted.\n 2. The Three Trends: The “market,” meaning the price of stocks in general, swings in trends, \nof which the most important are its Major or Primary Trends. These are the extensive up or \ndown movements that usually last for a year or more and result in general appreciation \nor depreciation in value of more than 20%. Movements in the direction of the Primary \nTrend are interrupted at intervals by Secondary Swings in the opposite direction—\nreactions or corrections that occur when the Primary Move has temporarily “gotten \nahead of itself.” (Both Secondary and the intervening segments of the Primary Trend are \nfrequently lumped together as Intermediate Movements—a term we shall find useful in \nsubsequent discussions.) Finally, the Secondary Trends are composed of Minor Trends \nor day-to-day fluctuations that are unimportant to Dow Theory.\n 3. The Primary Trends: These, as aforesaid, are the broad, overall, up and down \nmovements that usually (but not invariably) last for more than a year and may run \nfor several years. So long as each successive rally (price advance) reaches a higher level \n13Chapter three: The Dow The ory\nthan the one before it, and each Secondary Reaction stops (i.e., the price trend reverses \nfrom down to up) at a higher level than the previous reaction, the Primary Trend is \nup. This is called a Bull Market. Conversely, when each Intermediate Decline carries \nprices to successively lower levels and each intervening rally fails to bring them back \nup to the top level of the preceding rally, the Primary Trend is down. This is called \na Bear Market. (The terms Bull and Bear are frequently used loosely with reference, \nrespectively, to any sort of up or down movements, but we shall use them in this book \nonly in connection with the Major or Primary Movements of the market in the Dow \nsense.) Ordinarily—theoretically, at least—the Primary Trend is the only one of the \nthree trends with which the true long-term investor is concerned. His aim is to buy \nstocks as early as possible in a Bull Market—just as soon as he can be sure that one \nhas started—and then hold them until (and only until) it becomes evident it has ended \nand a Bear Market has started. He knows he can safely disregard all the intervening \nSecondary Reactions and Minor Fluctuations. The trader, however, may well concern \nhimself also with the Secondary Swings, and it will appear later on in this book that \nhe can do so with profit.\n 4. The Secondary Trends: These are the important reactions that interrupt the progress \nof prices in the Primary Direction. They are the Intermediate Declines or corrections \nthat occur during Bull Markets and the Intermediate Rallies or recoveries that occur \nin Bear Markets. Normally, they last for three weeks to many months, rarely longer. \nNormally, they retrace from one-third to two-thirds of the gain (or loss, as the case \nmay be) in prices registered in the preceding swing in the Primary Direction. Thus, \nin a Bull Market, prices in terms of the Industrial Average might rise steadily, or with \nonly brief and minor interruptions, for a total gain of 30 points before a Secondary \nCorrection occurred. That correction might then be expected to produce a decline \nof not less than 10 points and not more than 20 points before a new Intermediate \nAdvance in the Primary Bull Trend develops.\n Note, however, the one-third/two-thirds rule is not an unbreakable law; it is simply \na statement of probabilities. Most Secondaries are confined within these limits; many \nof them stop very close to the halfway mark, retracing 50% of the preceding Primary \nSwing. They seldom run less than one-third, but some of them cancel nearly all of it.\n Thus, we have two criteria by which to recognize a Secondary Trend. Any price \nmovement contrary in direction to the Primary Trend that lasts for at least three weeks \nand retraces at least one-third of the preceding net move in the Primary Direction \n(from the end of the preceding Secondary to the beginning of this one, disregarding \nMinor Fluctuations) is labelled as Intermediate Rank, that is, a true Secondary. Despite \nthese criteria, however, the Secondary Trend is often confusing in its recognition, and \nits correct appraisal at the time it develops, and while it is in process poses the Dow \ntheorist’s most difficult problem. We shall have more to say about this later.\n 5. The Minor Trends: These are the bri", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 26}
{"text": "disregarding \nMinor Fluctuations) is labelled as Intermediate Rank, that is, a true Secondary. Despite \nthese criteria, however, the Secondary Trend is often confusing in its recognition, and \nits correct appraisal at the time it develops, and while it is in process poses the Dow \ntheorist’s most difficult problem. We shall have more to say about this later.\n 5. The Minor Trends: These are the brief (rarely as long as three weeks—usually less than \nsix days) fluctuations that are, so far as the Dow Theory is concerned, meaningless \nin themselves, but which, in toto, make up the Intermediate Trends. Usually, but not \nalways, an Intermediate Swing, whether a Secondary or the segment of a Primary \nbetween successive Secondaries, is made up of a series of three or more distinguishable \nMinor Waves. Inferences drawn from these day-to-day fluctuations are quite apt \nto be misleading. The Minor Trend is the only one of the three trends that can be \n“manipulated” (although it is, in fact, doubtful if under present conditions even that \ncan be purposely manipulated to any important extent). Primary and Secondary Trends \ncannot be manipulated; it would strain the resources of the U.S. Treasury to do so.\n14 Technical Analysis of Stock Trends\nRight here, before we go on to state a sixth Dow tenet, we may well take time out for \na few minutes to clarify the concept of the three trends by drawing an analogy between \nthe movements of the stock market and the movements of the sea. The Major (Primary) \nTrends in stock prices are like the tides. We can compare a Bull Market to an incoming or \nflood tide that carries the water farther and farther up the beach until finally it reaches \nhigh-water mark and begins to turn; it then follows the receding or ebb tide, comparable \nto a Bear Market. But all the time, during both ebb and flow of the tide, the waves are \nrolling in, breaking on the beach, and then receding. Although the tide is rising, each \nsucceeding wave pushes a little farther up onto the shore and, as it recedes, does not carry \nthe water quite so far back as did its predecessor. During the tidal ebb, each advancing \nwave falls a little short of the mark set by the one before it, and each receding wave \nuncovers a little more of the beach. These waves are the Intermediate Trends, Primary \nor Secondary, depending on whether their movement is with or against the direction of \nthe tide. Meanwhile, the surface of the water is constantly agitated by wavelets, ripples, \nand “cat’s-paws” moving with or against or across the trend of the waves—these are \nanalogous to the market’s Minor Trends, its unimportant day-to-day fluctuations. The tide, \nthe wave, and the ripple represent, respectively, the Primary or Major, the Secondary or \nIntermediate, and the Minor Trends of the market.\nTide, wave, and ripple\nA shore dweller who had no tide table might set about determining the direction of the tide \nby driving a stake in the beach at the highest point reached by an incoming wave. Then, if \nthe next wave pushed the water up beyond his stake, he would know the tide was rising. If \nhe shifted his stake with the peak mark of each wave, a time would come when one wave \nwould stop and start to recede short of his previous mark; then he would know that the \ntide had turned and had started to ebb. That, in effect (and much simplified), is what the \nDow theorist does in defining the trend of the stock market.\nThe comparison with tide, wave, and ripple has been used since the earliest days of \nthe Dow Theory. It is even possible that the movements of the sea may have suggested the \nelements of the theory to Dow. But the analogy cannot be pushed too far. The tides and \nwaves of the stock market are not as regular as those of the ocean. Tables can be prepared \nyears in advance to predict accurately the time of every ebb and flow of the waters, but no \ntimetables are provided by the Dow Theory for the stock market. We may return to some \npoints of this comparison later, but we must proceed now to take up the remaining tenets \nand rules of the Theory.\nMajor trend phases\n 1. The Bull Market: Primary Uptrends are usually (but not invariably) divisible into \nthree phases. The first is the phase of accumulation during which farsighted investors, \nsensing that business, although now depressed, is due to turn up, are willing to pick \nup all the shares offered by discouraged and distressed sellers and to raise their \nbids gradually as such selling diminishes in volume. Financial reports are still bad—\nin fact, often at their worst—during this phase. The public is completely disgusted \nwith the stock market—out of it entirely. Activity is only moderate but beginning to \nincrease on the rallies (Minor Advances).\n The second phase is one of fairly steady advance and increasing activity as the \nimproved tone of business and a rising trend in corporate earnings begin to attract \n15Chapter three: The Dow The ory\nattention. It is during this phase that the technical trader normally is able to reap his \nbest harvest of profits.\n Finally comes the third phase when the market boils with activity as the public flocks \nto the boardrooms. All the financial news is good, price advances are spectacular and \nfrequently make the front page of the daily papers, and new issues are brought out in \nincreasing numbers. It is during this phase that one of your friends will call up and \nblithely remark, “Say, I see the market is going up. What’s a good buy?”—oblivious to \nthe fact it has been going up for perhaps two years, has already gone up a long way, \nand is now reaching the stage at which it might be more appropriate to ask, “What’s a \ngood thing to sell?” In the last stage of this phase, with speculation rampant, volume \ncontinues to rise, but “air pockets” appear with increasing frequency; the “cats and \ndogs” (low-priced stocks of no investment value) are whirled up, but more and more \nof the top-grade issues refuse to follow.\n 2. The Bear Ma", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 27}
{"text": "d is now reaching the stage at which it might be more appropriate to ask, “What’s a \ngood thing to sell?” In the last stage of this phase, with speculation rampant, volume \ncontinues to rise, but “air pockets” appear with increasing frequency; the “cats and \ndogs” (low-priced stocks of no investment value) are whirled up, but more and more \nof the top-grade issues refuse to follow.\n 2. The Bear Market: Primary Downtrends are also usually (but again, not invariably) \ncharacterized by three phases. The first is the distribution period (which really starts in \nthe later stages of the preceding Bull Market). During this phase, farsighted investors \nsense the fact that business earnings have reached an abnormal height and unload \ntheir holdings at an increasing pace. Trading volume is still high, although tending \nto diminish on rallies, and the public is still active but beginning to show signs of \nfrustration, as hoped-for profits fade away.\n The second phase is the panic phase. Buyers begin to thin out and sellers become \nmore urgent; the downward trend of prices suddenly accelerates into an almost \nvertical drop, whereas volume mounts to climactic proportions. After the Panic Phase \n(which usually runs too far relative to then-existing business conditions), there may \nbe a fairly long Secondary Recovery or a sideways movement, and then the third \nphase begins.\n This is characterized by discouraged selling on the part of those investors who held \non through the Panic or, perhaps, bought during it because stocks looked cheap in \ncomparison with prices that had ruled a few months earlier. The business news now \nbegins to deteriorate. As the third phase proceeds, the downward movement is less \nrapid, but it is maintained by more and more distress selling from those who have to \nraise cash for other needs. The “cats and dogs” may lose practically all their previous \nBull Advance in the first two phases. Better-grade stocks decline more gradually, as \ntheir owners cling to them to the last. In consequence, the final stage of a Bear Market \nis frequently concentrated in such issues. The Bear Market ends when everything in \nthe way of possible bad news, the worst to be expected, has been discounted, and it \nis usually over before all the bad news is “out.”\n The three Bear Market phases described in the preceding paragraph are not the \nsame as those named by others who have discussed this subject, but the writers of \nthis study feel they represent a more accurate and realistic division of the Primary \ndown moves of the past 30 years. The reader should be warned, however, that no two \nBear Markets are exactly alike, and neither are any two Bull Markets. Some may lack \none or another of the three typical phases. A few Major Advances have passed from \nthe first to the third stage with only a brief and rapid intervening mark-up. A few \nshort Bear Markets have developed no marked Panic Phase and others have ended \nwith it, as in April 1939. No time limits can be set for any phase; the third stage of a \nBull Market, for example, the phase of excited speculation and great public activity, \nmay last for more than a year or run out in a month or two. The Panic Phase of a Bear \nMarket is usually exhausted in a very few weeks if not in days, but the 1929 through \n16 Technical Analysis of Stock Trends\n1932 decline was interspersed with at least five Panic Waves of major proportions. \nNevertheless, the typical characteristics of Primary Trends are well worth keeping \nin mind. If you know the symptoms that normally accompany the last stage of a Bull \nMarket, for example, you are less likely to be deluded by its exciting atmosphere.\nPrinciple of confirmation\n 1. The two Averages must confirm: This is the most-often questioned and the most \ndifficult to rationalize of all the Dow principles. Yet it has stood the test of time; the \nfact it has worked is not disputed by any who have carefully examined the records. \nThose who have disregarded it in practice have, more often than not, had occasion to \nregret their apostasy. What it means is that no valid signal of a change in trend can \nbe produced by the action of one Average alone. Take, for example, the hypothetical \ncase shown in Diagram 3.1. In this, we assume that a Bear Market has been in effect \nfor several months and then, starting at a, the Industrial Average rises (along with the \nRails) in a Secondary Recovery to b . On their next decline, however, the Industrials \ndrop only to c, which is higher than a, and then turn up to d, which is higher than b. \nb\nRAIL AVERAGE\na\nc\nd\nc\na\nb\ndINDUSTRIAL AVERAGE\nDiagram 3.1 A hypothetical daily market chart to show how one average may fail to confirm the \nother’s Dow signal. Closing prices, indicated by short horizontal dashes, are connected with vertical \nlines to make the day-to-day trend easier to follow.\n17Chapter three: The Dow The ory\nAt this point, the Industrials have “signaled” a change in trend from down to up. But \nnote the Rails during this period: their decline from b to c carried them lower than \na, and their subsequent advance from c to d has not taken them above b. They have \n(so far) refused to confirm the Industrials and, hence, the Major Trend of the market \nmust be regarded as still down. Should the Rails go on to rise eventually above their b, \nthen, and then only, would we have a definite signal of a turn in the tide. Until such \na development, however, the chances remain that the Industrials will not be able to \ncontinue their upward course alone, that they ultimately will be dragged down again \nby the Rails. At best, the direction of the Primary Trend is still in doubt.\n This example illustrates only one of the many ways in which the principle of \nconfirmation applies. Note also that at c, it might have been said that the Industrials \nhad thus far not confirmed the Rails in continuing the Downtrend, but this had to do \nonly with the continuation or reaffirmation of an existing trend. It is not ne", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 28}
{"text": "ils. At best, the direction of the Primary Trend is still in doubt.\n This example illustrates only one of the many ways in which the principle of \nconfirmation applies. Note also that at c, it might have been said that the Industrials \nhad thus far not confirmed the Rails in continuing the Downtrend, but this had to do \nonly with the continuation or reaffirmation of an existing trend. It is not necessary \nthat the two Averages confirm on the same day. Frequently, both will move into new \nhigh (or low) ground together, but there are plenty of cases in which one or the other \nlags behind for days, weeks, or even a month or two. One must be patient in these \ndoubtful cases and wait until the market declares itself in definite fashion.\n 2. “Volume goes with the trend”: Those words, which you may often hear spoken \nwith ritual solemnity but little understanding, are the colloquial expression for the \ngeneral truth that trading activity tends to expand as prices move in the direction \nof the prevailing Primary Trend. Thus, in a Bull Market, volume increases when \nprices rise and dwindles as prices decline; in Bear Markets, turnover increases when \nprices drop and dries up as they recover. To a lesser degree, this holds for Secondary \nTrends also, especially in the early stages of an extended Secondary Recovery within \na Bear Market, when activity may show a tendency to pick up on the Minor Rallies \nand diminish on the Minor Setbacks. But to this rule, again, there are exceptions, \nand useful conclusions can seldom be drawn from the volume manifestations of a \nfew days, much less from a single trading session; it is only the overall and relative \nvolume trend over a period of time that may produce helpful indications. Moreover, \nin Dow Theory, conclusive signals as to the market’s trend are produced in the final \nanalysis only by price movement. Volume simply affords collateral evidence that may \naid interpretation of otherwise doubtful situations. (We shall have much more to say \nin later chapters about volume in specific relation to other technical phenomena.)\n 3. “Lines” may substitute for Secondaries: A line in Dow Theory parlance is a sideways \nmovement (as it appears on the charts) in one or both of the Averages, which lasts \nfor two or three weeks or, sometimes, for as many months, in the course of which \nprices fluctuate within a range of approximately 5% or less (of their mean figure). \nThe formation of a Line signifies that pressure of buying and selling is more or less \nin balance. Eventually, of course, either the offerings within that price range are \nexhausted and those who want to buy stocks have to raise their bids to induce owners \nto sell, or else those who are eager to sell at the Line price range find that buyers \nhave vanished and that, in consequence, they must cut their prices to dispose of their \nshares. Hence, an advance in prices through the upper limits of an established Line \nis a Bullish Signal and, conversely, a breakdown through its lower limits is a Bearish \nSignal. Generally speaking, the longer the Line (in duration) and the narrower or more \ncompact its price range, the greater the significance of its ultimate breakout.\n Lines occur often enough to make their recognition essential to followers of Dow’s \nprinciples. They may develop at important Tops or Bottoms, signaling periods of \ndistribution or of accumulation, respectively, but they come more frequently as \n18 Technical Analysis of Stock Trends\ninterludes of rest or Consolidation in the progress of established Major Trends. \nUnder those circumstances, they take the place of normal Secondary Waves. A Line \nmay develop in one Average while the other is going through a typical Secondary \nReaction. A price movement out of a Line, either up or down, is usually followed \nby a more extensive additional move in the same direction than can be counted on \nto follow the “signal” produced when a new wave pushes beyond the limits set by \na preceding Primary Wave. The direction in which prices will break out of a Line \ncannot be determined in advance of the actual movement. The 5% limit ordinarily \nassigned to a Line is arbitrarily based on experience; there have been a few slightly \nwider sideways movements that, by virtue of their compactness and well-defined \nboundaries, could be construed as true Lines. (Later in this book, we shall see that the \nDow Line is, in many respects, similar to the more strictly defined patterns known as \nrectangles that appear on the charts of individual stocks.)\n 4. Only closing prices used: Dow Theory pays no attention to any extreme highs or \nlows that may be registered during a day and before the market closes, but takes into \naccount only the closing figures, that is, the average of the day’s final sale prices for the \ncomponent issues. We have discussed the psychological importance of the end-of-day \nprices under the subject of chart construction and need not deal with it further here, \nexcept to say that this is another Dow rule that has stood the test of time. It works thus: \nsuppose an Intermediate Advance in a Primary Uptrend reaches its peak on a certain \nday at 11:00 a.m., at which hour the Industrial Average figures at, say, 152.45, and then \nfalls back to close at 150.70. All that the next advance will have to do to indicate the \nPrimary Trend is still up is register a daily close above 150.70. The previous intraday \nhigh of 152.45 does not count. Conversely, using the same figures for our first advance, \nif the next upswing carries prices to an intraday high at, say, 152.60, but fails to register \na closing price above 150.70, the continuation of the Primary Bull Trend is still in \ndoubt.\n In recent years, differences of opinion have arisen among market students as to \nthe extent to which an Average should push beyond a previous limit (Top or Bottom \nfigure) to signal (or confirm or reaffirm, as the case may be) a market trend. Dow and \nHamilton evidently regarded any pene", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 29}
{"text": "ails to register \na closing price above 150.70, the continuation of the Primary Bull Trend is still in \ndoubt.\n In recent years, differences of opinion have arisen among market students as to \nthe extent to which an Average should push beyond a previous limit (Top or Bottom \nfigure) to signal (or confirm or reaffirm, as the case may be) a market trend. Dow and \nHamilton evidently regarded any penetration, even as little as 0.01, in closing price \nas a valid signal, but some modern commentators have required penetration by a full \npoint (1.00). We think the original view has the best of the argument—that is, that \nthe record shows little or nothing in practical results to favor any of the proposed \nmodifications. One incident in June 1946, to which we shall refer in the following \nchapter (EN10: Now in Appendix A), shows a decided advantage for the orthodox “any-\npenetration-whatever” rule.\n 5. A trend should be assumed to continue in effect until such time as its reversal \nhas been definitely signaled: This Dow Theory tenet is one that, perhaps more \nthan any other, has evoked criticism. Yet, when correctly understood, it, like all \nthe others we have enumerated, stands up under practical test. What it states is \nreally a probability . It is a warning against changing one’s market position too \nsoon, against “jumping the gun.” It does not imply that one should delay action \nby one unnecessary minute once a signal of change in trend has appeared. But it \nexpresses the experience that the odds are in favor of the man who waits until he \nis sure, and against the other fellow who buys (or sells) prematurely. These odds \ncannot be stated in mathematical language such as 2–1 or 3–1; as a matter of fact, \nthey are constantly changing. Bull Markets do not climb forever and Bear Markets \nalways reach a Bottom sooner or later. When a new Primary Trend is first definitely \n19Chapter three: The Dow Theo ry\nsignaled by the action of the two Averages, the odds that it will be continued, \ndespite any near-term reactions or interruptions, are at their greatest. But as this \nPrimary Trend carries on, the odds in favor of its further extension grow smaller. \nThus, each successive reaffirmation of a Bull Market (new Intermediate high in \none average confirmed by a new Intermediate high in the other) carries relatively \nless weight. The incentive to buy, the prospect of selling new purchases at a profit, \nis smaller after a Bull Market has been in existence for several months than it was \nwhen the Primary Uptrend was first recognized; this 12th Dow tenet says, “Hold \nyour position pending contrary orders.”\n A corollary to this tenet, which is not so contradictory as it may at first seem, is this: \na reversal in trend can occur any time after that trend has been confirmed. This can \nbe taken simply as a warning that the Dow Theory investor must watch the market \nconstantly if he has any commitment in it.\nEN: Modern market importance of Dow Theory and necessity for moving to a new composite \nmarket theory\nDow Theory has much to recommend it. Concepts embodied within Dow Theory retain their \nvalidity to the present day and retain their importance as the foundation thinking for technical \nanalysis. Concepts of waves, major, secondary, and minor movements are absolutely descriptive of \nthe reality of the market. Other constructs within Dow Theory are similarly important—that all \ninformation is discounted; that major market movements are like the tide and, as it were, raise all \nboats; that trends tend to continue. These are not just theoretical musings, but observations of reality.\nIn addition to its technical validity, the Dow has now taken on a mythic dimension. It has a \nsymbolic function that interacts with its originally intended purpose. Dow and Hamilton saw their \nmeasurement of the market as an economic barometer for the entire economy; its use as a tool for \ninvesting in the market came later.\nIn the opinion of this editor, the Dow Theory is no longer adequate to its original purpose—or \neven to its secondary purpose. It is a simple theory propounded in a simple time. Expounders of \nDow Theory have implicitly recognized the necessity for evolutionary changes to the doctrine with \nthe addition of the Rails (now Transportations) and the Utilities ad infinitum. Thirty stocks may \nhave been sufficient originally to reflect the U.S. economy. No one would deny that simple paradigm \nmust be changed to reflect an economic structure geometrically more diverse than that of Dow and \nHamilton. Entering the twenty-first century, the U.S. and global economy require more sophisticated \neconometrics than the Dow alone.\nFor that reason, I consider that to fulfill the functions of the old Dow, we now must consider \na variety of averages and indexes to measure the state of the market—not to mention the economy, \nwhich is another question, although not altogether another question, but at least another question. \nMagee foreshadowed some instruments of great value to this end in his writings, specifically on the \nMagee Evaluative Index (Chapter 38), which may be used for the entire market, and not just for one \nsummary index or average. The value and power of this tool are still little used and understood.\nIn twenty-first-century markets, there are not just broad tides and markets flowing in one direction \nas they might on Magee’s Cape Cod. Instead, the currents, riptide, and crosscurrents are like the \neconomy of the country, moved West. They are now symbolized by the Pacific Ocean roaring in and out \nof San Francisco Bay. Although the Dow is in a secondary Downtrend, the broader Standard & Poor’s \n500 is going to new highs, and although they are both whipping sideways, the National Association of \nSecurities Dealers Automated Quotations (NASDAQ) is rocketing into space. For this reason, I now \nbelieve that only a composite of the three indexes can express the true state of the markets as a whole. \nAnd, in addition, to dis", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 30}
{"text": "h the Dow is in a secondary Downtrend, the broader Standard & Poor’s \n500 is going to new highs, and although they are both whipping sideways, the National Association of \nSecurities Dealers Automated Quotations (NASDAQ) is rocketing into space. For this reason, I now \nbelieve that only a composite of the three indexes can express the true state of the markets as a whole. \nAnd, in addition, to dissect the entrails of the market, the Magee Evaluative Index should be run across \nthe three indexes.\n20 Technical Analysis of Stock Trends\nThe Dow Theory required the Rails and Industrial Averages move in harmony to signal Bull or \nBear Markets. In this century, there is a similar need for harmonic convergence among the averages \nto indicate to us the state of the markets as a whole.\nWhen all three indexes agree in the direction of their trends, up or down or sideways, Bulls may \nbe assumed to be safe in general, and vice versa for Bears. Failure of the three to be in harmony is \na clear sign of mixed markets and advises one to arrange his bets and portfolio to correspond with \neconomic uncertainty. Capital should flow naturally to the most productive area. What reason is \nthere to ride the Dow down when the NASDAQ is raging up? If the investor follows the philosophy \nof this book, he will never sit passively through an extended Downtrend. At the very least, he will be \nhedged, if not outright short. (As Edwards and Magee preferred and as this editor prefers.)\nEN10: Notes on Edwards’ description of Dow Theory\nWe must keep in perspective Edwards’ description of Dow Theory. When he speaks of Secondaries \nof 10 and 20 points, or a Primary of 30 points, we should be reminded that the entire market could be \naccommodated in the backseat of a Packard. The top in 1929 was approximately 386 and the bottom \napproximately 64; hence, 10, 20, or 30 points constituted important percentage moves.\nSimilarly, a primary market move of 20%, although still of importance, hardly describes the \nviolence and range of modern markets. From March 2009 to November 2017, the Dow moved from \n6469.95 to 23,602.12—a move of 17,132.17 or 264%.\n21\nchapter four\nThe Dow Theory’s defects\nEN10: Figures 2–9 from the ninth edition now appear in Appendix A along with Edwards’ detailed \naccount of Dow Theory operations.\nOur readers, we suspect, heaved a deep sigh of relief when they closed the preceding \nchapter (EN10: Chapter 4 in the ninth edition, now Appendix A ), which covered a difficult, \ntedious, and, at times, confusing subject. Some may even wish at this point that the Dow \nTheory had never been conceived. Others doubtless spotted one or more of its real or \nsupposed defects and have questions to ask. Before we proceed to more interesting chart \nmatters, we had better devote a few pages to clearing up these questions.\nFirst, let’s take up the charge of “second-guessing,” which is so often flung at writers \non Dow Theory. It is a charge that will continue to crop up so long as opinions differ \namong Dow theorists at critical periods (which, unfortunately, is often the case). Even the \nmost experienced and careful Dow analysts find it necessary occasionally to change their \ninterpretations when a stand first ventured is rendered untenable by some subsequent \naction of the market. They would not attempt to deny it, but, they say, in the long run, \nsurprisingly little is lost by such temporary misinterpretations. Many of them publish \ntheir comments regularly and can refer you to the printed files of opinions and advice \nexpressed before and during the event, as well as after it. Regarding Chapter 4 in the ninth \nedition (now Appendix A), the reader, if he cares to check such records, will find that the \ninterpretations given therein (aside from the remarks made “in retrospect” and so labeled) \nwere precisely the interpretations published at the time by the best-established Dow \nanalysts. EN9: Although, in the modern age Richard Russell (now deceased) (dowtheoryletters.\ncom) was senior in terms of reputation, a host of other Dow theorists (actually trying to round \nthem up is like herding cats) inhabit the scene, among them Jack Schannep (thedowtheory.com) and \nRichard Moroney (dowtheory.com) who must be taken into account when consulting the sacred-\nchicken bones. Robert W. Colby (robertwcolby.com) is also currently doing authoritative work in \nDow Theory. Note that it is the chicken that is sacred, and the bones only secondarily.\nThe Dow Theory is too late\nThe objection that the Dow Theory is too late is more valid. It is sometimes expressed in the \nrather intemperate statement that “the Dow Theory is a surefire system for depriving the \ninvestor of the first third and the last third of every Major Move, and sometimes there isn’t \nany middle third!” Or, to give a specific example: A Primary Bull Market started in 1942 \nwith the Industrial Average at 92.92 and ended in 1946 at 212.50, for a total gain of 119.58 \nAverage points, but the strict Dow theorists could not buy until the Industrials were up to \n125.88 and could not sell until prices had already declined to 191.04; thus, capturing, at best, \nonly about 65 points, or not much more than half of the total move. This specific statement \ncannot be disputed, yet the answer to the general objection is to “try to find a man who \nfirst bought his stocks at 92.92 (or even within 5 points of that level) and stayed 100% long \nthroughout the intervening years, and finally sold out at 212.50, or within 5 points thereof.” \n22 Technical Analysis of Stock Trends\nThe reader is welcome to try; he will, in fact, find it very difficult to locate even a dozen who \ndid as well as the Dow Theory.\nA still better answer, because it comprehends all of the hazards of every known kind \nof Bull and Bear Market to date, is the overall dollars and cents record of the past 60 years. \nWe are indebted to Richard Durant for permission to reprint the following computation of \nwhat would, in theory, have re", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 31}
{"text": "will, in fact, find it very difficult to locate even a dozen who \ndid as well as the Dow Theory.\nA still better answer, because it comprehends all of the hazards of every known kind \nof Bull and Bear Market to date, is the overall dollars and cents record of the past 60 years. \nWe are indebted to Richard Durant for permission to reprint the following computation of \nwhat would, in theory, have resulted if a fund of only $100 could have been invested in the \nstocks of the Dow–Jones Industrial Average on July 12, 1897 , when a Primary Bull Market \nwas signaled by the Dow Theory, and those stocks were thereafter sold and repurchased \nwhen, and only when, the Dow Theory had definitely confirmed a change in the Major \nTrend (see Table 4.1).\nTable 4.1 The Dow Theory’s 60-Year Record\nSignal Date\nDow Jones \nAverage \nPrice\nLoss \n(√)\nChange \n(%)\nCapital \nGain\nAccumulated \nProfit\nBought 7/12/1897 44.61 100\nSold 12/16/1899 63.84 43.11 143.11\nBought 10/20/1900 59.44\nSold 6/1/1903 59.59 0.25 0.36 143.47\nBought 7/12/1904 51.37\nSold 4/26/1906 92.44 79.95 114.7 258.18\nBought 4/24/1908 70.01\nSold 5/3/1910 84.72 21.01 54.25 312.42\nBought 10/10/1910 81.91\nSold 1/14/1913 84.96 3.72 11.63 324.05\nBought 4/9/1915 65.02\nSold 8/28/1917 86.12 32.45 105.16 429.22\nBought 5/13/1918 82.16\nSold 2/3/1920 99.96 21.67 92.99 522.21\nBought 2/6/1922 83.7\nSold 6/20/1923 90.81 8.49 44.36 566.56\nBought 12/7/1923 93.8\nSold 10/23/1929 305.85 226.07 1,280.81 1,847.38\nBought 5/24/1933 84.29\nSold 9/7/1937 164.39 95.03 1,755.54 3,602.92\nBought 6/23/1938 127.41\nSold 3/31/1939 136.42 7.07 254.79 3,857.7\nBought 7/17/1939 142.58\nSold 5/13/1940 137.5 √ −3.56 −137.45 3,720.26\nBought 2/1/1943 125.88\nSold 8/27/1946 191.04 51.76 1,925.74 5,646\nBought 10/2/1950 228.94\nSold 4/2/1953 280.03 22.32 1,259.95 6,905.95\nBought 1/19/1954 288.27\nSold 10/1/1956 468.7 62.59 4,322.48 11,228.43\n23Chapter four: The Dow The ory’s defects\nIn brief, an investment of $100 in 1897 would have become $11,228.43 in 1956 simply by \nbuying the Industrial Average stocks each time the Dow Theory announced a Bull Market \nand holding them until the Dow Theory announced a Bear Market. During this period, \nthe investor would have made 15 purchases and 15 sales, or about one transaction every \ntwo years on average.\nThe record is not perfect. It shows one losing transaction and three instances in which \nreinvestment would have been made at a higher level than the preceding liquidation. But, \nat that, it hardly needs defending. Also, it takes no account of commissions and transfer \ntaxes, but neither does it include the dividends the investor would have received during \nthe time he held his stocks; the latter would have added many more dollars to the fund.\nFor the enlightenment of the man who believes in “just buying good stocks and putting \nthem away,” compare these results with the best that could have been done by buying \nshares only once at the lowest price recorded by the Industrial Average during these entire \n60 years and selling them only once at the highest: $100 invested at the all-time low, 29.64, on \nAugust 10, 1896, would have become only $1,757 .93 at the then all-time high, 521.05, 60 years \nlater on April 6, 1956. Compare this to the $11,228.43 gained from the Dow Theory program.\nEN: This record of the Dow Theory is updated to end of year 2017 in Table 4.2. I have left this \nrecord as is so that the reader may clearly distinguish my work from that of Edwards.\nThe Dow Theory is not infallible\nThe Dow Theory is not infallible. It depends on interpretation and is subject to all the \nhazards of human interpretive ability. But, again, the record speaks for itself.\nThe Dow Theory frequently leaves the investor in doubt\nThe fact that the Dow Theory frequently leaves the investor in doubt is true in one sense, yet \nnot in another. There is never a time when the Dow Theory does not afford a presumptive \nanswer to the question of the direction of the Primary Trend. That answer will be wrong \nfor a relatively short time at the beginning of each new Major Swing. There will also be \ntimes when a good Dow analyst should say, “The Primary Trend is still presumably up, \nbut it has reached a dangerous stage, and I cannot conscientiously advise you to buy now. \nIt may be too late.”\nFrequently, however, the above objection simply reflects the inability of the critic \nmentally to accept the fundamental concept that the Averages discount all the news and \nstatistics. He doubts the Dow Theory because he cannot reconcile its message with his own \nideas, derived from other sources, of what stocks should do. The theory is usually more \nnearly right.\nThis criticism in other cases reflects nothing but impatience. There may be weeks or \nmonths (as, e.g., during the formation of a Line) when the Dow Theory cannot “talk.” \nThe active trader quite naturally rebels, but patience is a virtue in the stock market as \nelsewhere—in fact, essential if serious mistakes are to be avoided.\nThe Dow Theory does not help the Intermediate Trend investor\nIt is perfectly true that the Dow Theory does not help the Intermediate Trend investor, as \nit gives little or no warning of changes in Intermediate Trend. Yet, if a fair share of these \ncan be captured, the profit amounts to more than can be derived from the Primary Trend \nalone. Some traders have worked out supplementary rules on the basis of Dow principles \n24 Technical Analysis of Stock Trends\nTable 4.2 The Dow Theory’s 121-Year Record\nSignal Date\nAverage \nPrice\nLoss \n(√)\nPercentage \nChange (%)\nCapital \nGain\nAccumulated \nWealth\n1 Buy 7/12/1897 44.61 100.00\n2 Sell 12/16/1899 63.84 43.11 143.11\n3 Buy 10/20/1900 59.44\n4 Sell 6/1/1903 59.59 0.25 0.36 143.47\n5 Buy 7/12/1904 51.37\n6 Sell 4/26/1906 92.44 79.950 114.70 258.18\n7 Buy 4/24/1908 70.01\n8 Sell 5/3/1910 84.72 21.01 54.25 312.42\n9 Buy 10/10/1910 81.91\n10 Sell 1/14/1913 84.96 3.72 11.63 324.05\n11 Buy 4/9/1915 65.02\n12 Sell 8/28/1917 86.12 32.45 105.16 429.22\n13 Buy 5/13/1918 82.16\n14 Sell 2/3/1920 99.", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 32}
{"text": "Sell 12/16/1899 63.84 43.11 143.11\n3 Buy 10/20/1900 59.44\n4 Sell 6/1/1903 59.59 0.25 0.36 143.47\n5 Buy 7/12/1904 51.37\n6 Sell 4/26/1906 92.44 79.950 114.70 258.18\n7 Buy 4/24/1908 70.01\n8 Sell 5/3/1910 84.72 21.01 54.25 312.42\n9 Buy 10/10/1910 81.91\n10 Sell 1/14/1913 84.96 3.72 11.63 324.05\n11 Buy 4/9/1915 65.02\n12 Sell 8/28/1917 86.12 32.45 105.16 429.22\n13 Buy 5/13/1918 82.16\n14 Sell 2/3/1920 99.96 21.67 92.99 522.21\n15 Buy 2/6/1922 83.7\n16 Sell 6/20/1923 90.81 8.49 44.36 566.56\n17 Buy 12/7/1923 93.8\n18 Sell 10/23/1929 305.85 226.07 1280.81 1,847.38\n19 Buy 5/24/1933 84.29\n20 Sell 9/7/1937 164.39 95.03 1755.54 3,602.92\n21 Buy 6/23/1938 127.41\n22 Sell 3/31/1939 136.42 7.07 254.79 3,857.70\n23 Buy 7/17/1939 142.58\n24 Sell 5/13/1940 137.5 × −3.56 −137.45 3,720.26\n25 Buy 2/1/1943 125.88\n26 Sell 8/27/1946 191.04 51.76 1925.74 5,646.00\n27 Buy 10/2/1950 228.94\n28 Sell 4/2/1953 280.03 22.32 1259.95 6,905.95\n29 Buy 1/19/1954 288.27\n30 Sell 10/1/1956 468.7 62.59 4322.48 11,228.43\n31 Buy 5/2/1958 459.56\n32 Sell 3/3/1960 612.05 33.18 3725.79 14,954.22\n33 Buy 2/23/1961 654.42\n34 Sell 4/26/1962 678.68 3.71 554.37 15,508.59\n35 Buy 11/9/1962 616.13\n36 Sell 5/5/1966 899.77 46.04 7139.49 22,648.08\n37 Buy 1/11/1967 822.49\n38 Sell 10/24/1967 888.18 7.99 1808.84 24,456.92\n39 Buy 10/1/1968 942.32\n40 Sell 2/25/1969 899.8 × −4.51 −1103.56 23,353.36\n41 Buy 10/27/1969 860.28\n42 Sell 1/26/1970 768.88 × −10.62 −2481.17 20,872.19\n(Continued)\n25Chapter four: The Dow The ory’s defects\nTable 4.2 (Continued) The Dow Theory’s 121-Year Record\nSignal Date\nAverage \nPrice\nLoss \n(×)\nPercentage \nChange (%)\nCapital \nGain\nAccumulated \nWealth\n43 Buy 9/28/1970 758.97\n44 Sell 7/28/1971 872.01 14.89 3108.68 23,980.87\n45 Buy 2/10/1972 921.28\n46 Sell 2/23/1973 959.89 4.19 1005.02 24,985.88\n47 Buy 1/27/1975 692.66\n48 Sell 10/24/1977 802.32 15.83 3955.70 28,941.58\n49 Buy 6/6/1978 866.51\n50 Sell 7/2/1981 959.19 10.70 3095.53 32,037.11\n51 Buy 10/7/1982 965.97\n52 Sell 1/25/1984 1231.89 27.53 8819.43 40,856.54\n53 Buy 11/6/1984 1244.15\n54 Sell 10/15/1987 2355.09 89.29 36482.07 77,338.61\n55 Buy 2/29/1988 2071.62\n56 Sell 10/13/1989 2569.26 24.02 18578.11 95,916.72\n57 Buy 6/4/1990 2935.19\n58 Sell 8/3/1990 2809.65 × −4.28 −4102.42 91,814.30\n59 Buy 1/18/1991 2646.78\n60 Sell 10/5/1992 3179 20.11 18462.21 110,276.51\n61 Buy 11/25/1992 3266.22\n62 Sell 8/4/1998 8487.31 159.85 176278.26 286,554.76\n63 Buy 11/2/1998 8706.5\n64 Sell 9/23/1999 10318.59 18.52 53058.30 339,613.06\n65 Buy 11/8/2001 9587.52\n66 Sell 6/25/2002 9126.8 × −4.81 −16319.81 323,293.25\n67 Buy 1/6/2003 8773.57\n68 Sell 11/21/2007 12799.04 45.88 148332.69 471,625.94\n69 Buy 4/18/2008 12849.36\n70 Sell 9/29/2008 10365.45 × −19.33 −91170.02 380,455.93\n71 Buy 4/9/2009 8083.38\n72 Sell 6/30/2010 9774.02 20.92 79572.41 460,028.33\n73 Buy 9/27/2010 10812.04\n74 Sell 8/2/2011 11866.62 9.75 44870.04 504,898.37\n75 Buy 12/23/2011 12294\n76 Sell 6/4/2012 12101.46 −1.57 −7907.36 496,991.01\n77 Buy 1/18/2013 13649.7\n78 Sell 8/20/2015 16990.69 24.48 121646.78 618,637.78\n79 Buy 10/19/2015 17084.49\n80 Sell 1/6/2016 16906.51 −1.04 −6444.74 612,193.04\n81 Buy 4/20/2016 18053.6 ×\n82 Sell 6/24/2016 17400.75 −3.62 −15926.29 596,266.75\n83 Buy 9/7/2016 18526.14\n84 Sell 12/29/2017 24719.22 33.43 199325.26 795,592.01\n26 Technical Analysis of Stock Trends\nthat they apply to Intermediate Movements, but these have not proved to be satisfactory. \nThe remainder of our book is devoted to a better approach to this problem.\nThe Dow Theory is a mechanical device designed to tell the direction of the Primary \nMarket Trend, which is important because, as said at the beginning of this book, most \nstocks tend to go with the trend. The Dow Theory does not and cannot tell you which \nindividual stocks to buy, aside from those stocks that make up the Averages. That, again, \nis a problem for the remainder of this book.\nEN: An old criticism, irrelevant in modern markets.\n“The Dow Theory does not tell you which stocks to buy.” This was true at the time Edwards \nwrote this, but in modern markets, the investor can buy substitute instruments that almost perfectly \nmimic its behavior (DIA). This is possible because the investor can trade in surrogates for the Dow \nAverages in present markets (see Chapter 15).\nThe Dow Theory in the 20th and 21st centuries\nAs may be seen in Table 4.2, augmenting Table 4.1, the Dow Theory continued to provide its \nuser an advantage over the unaware Buy-and-Hold Investor. From its original investment \nof $100 in 1897 , the Dow Theory investment would have grown to $795,592.01 by December \n29, 2017 , with the long trade still open. Table 4.2 shows the details, including the post-2000 \nbust drawdown. To my mind, this table is a powerful demonstration of the effectiveness \nof methodical technical investing, be it Dow Theory or some other robust method—which \nI will discuss in Chapter 5.\nBy contrast, the buy-and-hold investment of $100, if bought at the low, 29.64, and sold \nat the close, December 29, 2017 , would have grown to $55,411.83.\nI am indebted to Jack Schannep of TheDowTheory.Com ( http:/ /www.thedowtheory.\ncom) for the data recapitulated here. On Schannep’s website, a clear exposition of the Dow \nTheory and its record may be found—much more complete than that which is found here, \noutside of Edwards’ magisterial presentation.\nMinor discrepancies are acknowledged within these and others’ data, a point that will \nbe raised by purists. This is occasioned by disagreements within the priestly circles of those \nwho keep the sacred records. That is, not all theorists are in 100% agreement as to the exact \ndate or nature of the signals. (Some will say the reentry date of October 1, 1956 should have \nbeen October 7 , 1957 , for example.) Meaning some judgment is involved in interpretation of \nthe entrails. The Dow Theory is not a 100% objective algorithm, just as chart analysis is not \nreducible to an objective algorithm. (I am allowed to jest at the priesthood as I am a minor \nacolyte in these matters. It would not be", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 33}
{"text": "e signals. (Some will say the reentry date of October 1, 1956 should have \nbeen October 7 , 1957 , for example.) Meaning some judgment is involved in interpretation of \nthe entrails. The Dow Theory is not a 100% objective algorithm, just as chart analysis is not \nreducible to an objective algorithm. (I am allowed to jest at the priesthood as I am a minor \nacolyte in these matters. It would not be seemly for the uninitiated to burlesque.)\nIn brief, an investment of $100 in 1897 would have become $795,592.01 simply by buying \nthe Industrial Average stocks each time the Dow Theory announced a Bull Market and \nholding them until the Dow Theory announced a Bear Market, and then selling, with the \nentire equity reinvested on each trade.\nThe Technical Investor would have had this amount in pocket marked to market at the \nend of 2017 , as opposed to the $55,411.83 of his dozing counterpart, or the Trust Department \nof the Rip Van Winkle Bank of Sleepy Hollow. And, in addition, he would not have been \nilliquidified during Bear Markets.\nWhether the Dow Theory retains its validity over the market as a whole, there can be \nno question that it still calls the turn for its sector of the market, which as Jack Schannep \ncorrectly notes, has five times the capitalization of the NASDAQ (see Table 4.2).\nAs Mark Twain observed, everybody talks about the Dow Theory, but nobody does \nanything about it. Perhaps that is not precisely what Twain said, but close enough for \n27Chapter four: The Dow The ory’s defects\ngovernment work. As further inquiry into the inner workings of the Dow Theory, I initiated \na series of studies of the record with Brian Brooker, who holds a master’s of science in \nfinance from Golden Gate University, and Matt Mullens, and Nehemiah Brown III my \ngraduate students at Golden Gate University. Included here are some of the results of our \nstudy, from the book, Sacred Chickens, the Holy Grail and Dow Theory (Amazon).\nIt seems obvious that the risk characteristics of Dow Theory investing are unique, and I \nwill belabor the obvious. The Buy-and-Hold Investor mentioned above for comparison with \nthe Dow Theory Investor not only realized less profit over the period of his investment but \nalso experienced greatly expanded risk over the life of the investment. At first blush, all the \nprofits garnered by the reversing investor in Table 4.3 represent risk actually experienced \nby the Buy-and-Hold Investor—but that is only first blush. A little deeper thought reveals \nthe true extent of the Buy-and-Hold Investor’s risk is measured by maximum drawdowns \nover any given period of time. It is not necessary to theorize about this question; the \nmeasurement is empirical.\nWhen viewed in perspective, these risks are startling. From the top in 2000 to the low \nin 2002, a 39% drawdown occurred. Is this disquieting? A 41% drawdown occurred during \nthe Reagan crash of 1987 . A mere bagatelle. The Hoover drawdown from 1929 to 1932 was \n89%. Such things are unlikely to happen again. The big guys would step in and support \nthe market.\nClearly, the way to reduce market risk to zero is to be out of the market. Less obviously, \nor perhaps blatantly, the second most important way to reduce risk is to be right about the \ntrend—or to not be wrong. Moreover, because of the nature of the Dow Theory, much time \nis spent on the sidelines by the Dow investor. This is a natural reduction of risk. In fact, of \nthe total days from 1897 to 2018, 44,193, the Dow Investor spent 15,492 (or about 35% of the \ntime) days at the beach or at the S&L. But his accumulated profits have not been credited \nwith interest, as this is a “pure” study.\nAs will be readily apparent, Table 4.3 is much richer in data than just the duration of \ninvestments in the long side of the market. Acting on the maxim (my own) that it is unwise \nto invest on only one side of the market, I have computed the accumulated profits gained \nby trading the Dow long and short. After all, the market goes down as well as up, and for \na reversing system a liquidation of longs is a signal to go short. If the record on the long \nside is impressive, showing accumulated profits to 2018 of $795,592.01, how much more \nimpressive is the accumulated profit of $5,757 ,390.17 garnered from trading both sides of \nthe Dow, long and short?\nThe reader who listens carefully will hear the metamessage. For the great majority of \ninvestors, it is the long run that is important. In the right-now culture of the internet and \ncomputer age and the get-rich-quick mentality, one wonders whether there are still such \ninvestors, outside of the very rich and very intelligent. Perhaps there are still a few aging \nreaders of early editions of this book, and, not to despair, perhaps some new converts.\nA note of caution is in order here: beware of spreadsheets run amuck. As the spreadsheet \nserenely grinds through a trade it doesn’t care how it may be creating a fantasy universe. \nLikewise, the more transactions the greater the eventual figure as the compounding effect \nof reinvesting the total bankroll on every roll of the dice. This being said, putting the matter \ninto mathematical perspective and discounting inflated totals still makes the performance \nimpressive—much more so considering most professional fund managers can’t beat the \nmarket.\n28 Technical Analysis of Stock Trends\nTable 4.3 Performance of Dow Theory through 2017: Longs and Shorts\nTrade# Signal Date Price PL%\nAccumulated \nProfit Bull Bear\n1 Long 7/12/1897 44.61 100.00\n2 Short 12/16/1899 63.84 43.11 143.11 887\n3 Long 10/20/1900 59.44 6.89 152.97 308\n4 Short 6/1/1903 59.59 0.25 153.36 954\n5 Long 7/12/1904 51.37 13.79 174.51 407\n6 Short 4/26/1906 92.44 79.95 314.04 653\n7 Long 4/24/1908 70.01 24.26 390.24 729\n8 Short 5/3/1910 84.72 21.01 472.23 739\n9 Long 10/10/1910 81.91 3.32 487.89 160\n10 Short 1/14/1913 84.96 3.72 506.06 827\n11 Long 4/9/1915 65.02 23.47 624.83 815\n12 Short 8/28/1917 86.12 32.45 827.60 872\n13 Long 5/13/1918 82.16 4.60 8", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 34}
{"text": "97 308\n4 Short 6/1/1903 59.59 0.25 153.36 954\n5 Long 7/12/1904 51.37 13.79 174.51 407\n6 Short 4/26/1906 92.44 79.95 314.04 653\n7 Long 4/24/1908 70.01 24.26 390.24 729\n8 Short 5/3/1910 84.72 21.01 472.23 739\n9 Long 10/10/1910 81.91 3.32 487.89 160\n10 Short 1/14/1913 84.96 3.72 506.06 827\n11 Long 4/9/1915 65.02 23.47 624.83 815\n12 Short 8/28/1917 86.12 32.45 827.60 872\n13 Long 5/13/1918 82.16 4.60 865.66 258\n14 Short 2/3/1920 99.96 21.67 1,053.20 631\n15 Long 2/6/1922 83.7 16.27 1,224.52 734\n16 Short 6/20/1923 90.81 8.49 1,328.54 499\n17 Long 12/7/1923 93.8 −3.29 1,284.79 170\n18 Short 10/23/1929 305.85 226.07 4,189.28 2147\n19 Long 5/24/1933 84.29 72.44 7,224.02 1309\n20 Short 9/7/1937 164.39 95.03 14,088.94 1567\n21 Long 6/23/1938 127.41 22.50 17,258.28 289\n22 Short 3/31/1939 136.42 7.07 18,478.73 281\n23 Long 7/17/1939 142.58 −4.52 17,644.33 108\n24 Short 5/13/1940 137.5 −3.56 17,015.68 301\n25 Long 2/1/1943 125.88 8.45 18,453.66 994\n26 Short 8/27/1946 191.04 51.76 28,005.93 1303\n27 Long 10/2/1950 228.94 −19.84 22,449.90 1497\n28 Short 4/2/1953 280.03 22.32 27,459.79 913\n29 Long 1/19/1954 288.27 −2.94 26,651.78 292\n30 Short 10/1/1956 468.7 62.59 43,333.29 986\n31 Long 5/2/1958 459.56 1.95 44,178.32 578\n32 Short 3/3/1960 612.05 33.18 58,837.46 671\n33 Long 2/23/1961 654.42 −6.92 54,764.35 586\n34 Short 4/26/1962 678.68 3.71 56,794.52 198\n35 Long 11/9/1962 616.13 9.22 62,028.94 197\n36 Short 5/5/1966 899.77 46.04 90,584.42 1273\n37 Long 1/11/1967 822.49 8.59 98,364.60 251\n38 Short 10/24/1967 888.18 7.99 106,220.70 286\n39 Long 10/1/1968 942.32 −6.10 99,745.90 343\n40 Short 2/25/1969 899.8 −4.51 95,245.10 147\n41 Long 10/27/1969 860.28 4.39 99,428.35 244\n42 Short 1/26/1970 768.88 −10.62 88,864.63 91\n(Continued)\n29Chapter four: The Dow The ory’s defects\nTable 4.3 (Continued) Performance of Dow Theory through 2017: Longs and Shorts\nTrade# Signal M/D/Y Price PL%\nAccumulated \nProfit Bull Bear\n43 Long 9/28/1970 758.97 1.29 90,010.00 245\n44 Short 7/28/1971 872.01 14.89 1,03,415.97 303\n45 Long 2/10/1972 921.28 −5.65 97,572.80 197\n46 Short 2/23/1973 959.89 4.19 101,661.99 411\n47 Long 1/27/1975 692.66 27.84 129,964.33 588\n48 Short 10/24/1977 802.32 15.83 150,539.92 1084\n49 Long 6/6/1978 866.51 −8.00 138,495.90 225\n50 Short 7/2/1981 959.19 10.70 153,309.11 135\n51 Long 10/7/1982 965.97 −0.71 152,225.45 572\n52 Short 1/25/1984 1231.89 27.53 194,131.30 415\n53 Long 11/6/1984 1244.15 −1.00 192,199.27 462\n54 Short 10/15/1987 2355.09 89.29 363,819.94 475\n55 Long 2/29/1988 2071.62 12.04 407,611.06 362\n56 Short 10/13/1989 2569.26 24.02 505,526.50 997\n57 Long 6/4/1990 2935.19 −14.24 433,526.27 84\n58 Short 8/3/1990 2809.65 −4.28 414,984.06 645\n59 Long 1/18/1991 2646.78 5.80 439,039.89 234\n60 Short 10/5/1992 3179 20.11 527,322.94 60\n61 Long 11/25/1992 3266.22 −2.74 512,855.15 124\n62 Short 8/4/1998 8487.31 159.85 1,332,659.97 2799\n63 Long 11/2/1998 8706.5 −2.58 1,298,243.21 42\n64 Short 9/23/1999 10318.59 18.52 1,538,625.09 373\n65 Long 11/8/2001 9587.52 7.08 1,647,636.37 777\n66 Short 6/25/2002 9126.8 −4.81 1,568,460.62 229\n67 Long 1/6/2003 8773.57 3.87 1,629,163.97 195\n68 Short 11/21/2007 12799.04 45.88 2,376,653.39 1780\n69 Long 4/18/2008 12849.36 −0.39 2,367,309.47 149\n70 Short 9/29/2008 10365.45 −19.33 1,909,684.83 149\n71 Long 4/9/2009 8083.38 22.02 2,330,123.36 192\n72 Short 6/30/2010 9774.02 20.92 2,817,468.97 447\n73 Long 9/27/2010 10812.04 −10.62 2,518,248.26 89\n74 Short 8/2/2011 11866.62 9.75 2,763,872.05 309\n75 Long 12/23/2011 12294 3.60 2,863,413.76 143\n76 Short 6/4/2012 12101.46 −1.57 2,818,568.99 164\n77 Long 1/18/2013 13649.7 12.79 3,179,171.86 228\n78 Short 8/20/2015 16990.69 24.48 3,957,326.79 944\n79 Long 10/19/2015 17084.49 0.55 3,979,173.89 60\n80 Short 1/6/2016 16906.51 −1.04 3,937,720.30 79\n81 Long 4/20/2016 18053.6 6.78 4,204,890.74 105\n82 Short 6/24/2016 17400.75 −3.62 4,052,834.47 65\n83 Long 9/7/2016 18526.14 6.47 4,314,950.73 75\n84 MtoMkt 12/31/2017 24719.22 33.43 5,757,390.17 480\n85 15417\n\n31\nchapter five\nReplacing Dow Theory with John Magee’s \nBasing points Procedure\nI have humorously compared the interpretation of the market using Dow Theory to the \nancient Roman practice of haruspication—that is, the examination of animal or bird entrails \nto forecast the future. Dow Theory analysts examine the market and venture their expert \nopinions as to whether Dow Theory says the market is a buy, a sell, or a hold. Sometimes \nit seems as if they might be sitting on a tripod at Delphi and inhaling substances legal in \nCalifornia but forbidden in Washington, D.C. Additionally, from the same data they often \nextract different conclusions. (No disrespect of Dow theorists is intended. Some of my \nbest friends are Dow analysts.) From this observation came the motivation to look for a \nbetter way. That better way is found in Chapter 28 in which Magee outlined (and I have \nfurther articulated) a method that is eminently adaptable to long-long term investing. We \nare talking about investments that might last for years. One reason the rich get richer is \nthey practice this kind of investing. They correctly assess business conditions and economic \ncircumstances and take deeply entrenched positions that, in secular bull markets, return \nthem profits beyond the hope of swing traders and midterm traders. Perhaps in some cases \nthey even use Dow Theory. Whatever they use, they are not chased from the market, except \nby true changes in the major trend.\nInvesting on this time scale has never been easy—except for the well-capitalized \nmature and patient investor. Using Magee’s Basing Points Procedure, it is now possible for \nthe general investor to invest on the Dow Theory (or longer) time scale. To demonstrate the \npower of this procedure, I undertook a number of studies. The first and most important of \nthese was a study of the Dow Industrials since 1900 using Dow Theory. By studying the \nIndustrials, we have an excellent benchmark in the performance of Dow Theory over that \ntime.\nThe fractal nature of the market\nA fact that all traders", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 35}
{"text": "o invest on the Dow Theory (or longer) time scale. To demonstrate the \npower of this procedure, I undertook a number of studies. The first and most important of \nthese was a study of the Dow Industrials since 1900 using Dow Theory. By studying the \nIndustrials, we have an excellent benchmark in the performance of Dow Theory over that \ntime.\nThe fractal nature of the market\nA fact that all traders know in their bones was enunciated by the polymath, Benoit \nMandelbrot, who stated market price behavior is fractal. Fractal literally means self-similar \nat all scales. In other words, a two-minute bar chart exhibits the same kind of formations and \ncharacteristics as a daily chart, and so does a weekly chart. If you were presented a chart \nand told to determine the time scale, you would be unable to answer from the data alone. \nWhen you read about moving average systems in Chapter 36, you will see—as you probably \nknow already—that a 10-day moving average system trades 10 times as much as a 200-day \nmoving average system. The closer you are to the market, the more prone you are to be led \nastray by noise. This is one reason day traders are so seldom successful—noise and random \nprice activity make for difficult data to analyze. Important traders of my acquaintance trade \non weekly data: in other words, they trade using one bar to represent a week of market \nactivity. Not surprisingly, they trade infrequently compared with daily bar traders.\n32 Technical Analysis of Stock Trends\nConsidering these facts, I constructed a Basing Points Procedure using weekly bars to \ntest the method. Instead of using “three-days-away” data to determine Basing Points, I used \n“three-bars-away” data. I took all the Industrials data and back studied it to see what the \nperformance would have been using Magee’s procedure. The results are impressive; not \neye-popping in terms of profits but sufficient. Furthermore, when considering operating \ncharacteristics overall, especially in ease of operation, the Magee method wins hands down.\nThe results of using Magee’s simple-as-pie method are superior to the results obtained \nby using the complex and often obtuse Dow Theory. Later in this chapter, I will summarize \nthe results of the study and illustrate the tables.\n• Profits produced by the Magee Procedure are superior to those produced by the Dow \nTheory: $1,147 ,486.52 as opposed to $795,592.01.\n• Profits produced by Variant 2 of the Magee Procedure were $2,982,577 .83.\n• Compound Annual Growth Rates (CAGR) were also similar: 7 .9% (Variant 1) versus \n7 .87% and 8.37% for Variant 2.\n• Risk profiles were also quite similar: average drawdown for Dow Theory was 13.78% \nand for the Magee Procedure was 16%. Maximum drawdown was 25.3% for Dow \nTheory and 30% for the Magee Procedure.\n• Also pertinent to risk, considering long-side trades only, the Dow Theory was out of \nthe market 36% of the time and the Magee Procedure 35%. This is a little remarked \nfact about Dow Theory—and unknown before this about Magee’s Procedure. This \nis a radically important fact; it means each procedure is risk-free more than a third \nof the time. Calculating the out-of-market returns is such a hairy process, it was not \nundertaken.\n• As a result of differences in drawdowns and stop methods, Magee’s Procedure is \noperationally superior to Dow Theory. Since 1900, the Dow Theory has made 42 \ntrades, the Magee Procedure has made 25. Considering the similarity of risk and \nprofit characteristics, a system that trades less is preferable—less cost, less slippage, \nfewer chances to lose market position. This is to say, better control of the vigorish.\nIn short, the Magee Basing Points Procedure represents the best alternative to the Dow \nTheory for the true long-term investor. It can be used on weekly bars, in which case its \nfull long-term power is evidenced. It also can be used on daily bars for a more sensitive \napproach.\nThe Basing Points Procedure may be operated in two ways, which I call Variant 1 \nand Variant 2. Variant 1 sets stops based on wave lows. Variant 2, in addition to wave \nlows, uses new wave highs (see Chapter 28). Table 5.1 denotes trades for the Basing Points \nProcedure, Variant 1. Table 5.2 denotes trades for the Basing Points Procedure, Variant 2. \nKeys to trades are shown in Figures 5.2 and 5.3. Readers, and investors in general, have \nevery right to be skeptical of academic studies. Every morning, the mailbox is full of “can’t \nfail” “get-rich-quick” systems being sold by Wall Street hucksters who always show mouth-\nwatering profits. Yet these are always paper studies. By contrast, the Magee Basing Points \nProcedure has been in operation in the market for some years, and its effectiveness has \nbeen demonstrated. It exited, and shorted, the market in January 2008 and remained short \nuntil March 2009. In 2011, the Procedure exited longs and went short in late July before the \nGreek debt crisis. Letters written in real time during these events are in the http:/ /www.\nedwards-magee.com archives and are available for audit. Charts made at the time follow \nhere. (See Figures 5.2 and 5.3. Figure 5.1 shows a detailed chart of the analysis of the top of \nthe 2007 market and the short that resulted in early 2008.)\n33Chapter five: Replacin g Dow Theory with John Magee’s Basing points Procedure\nTable 5.1 Trades Made by the Magee Basing Points Procedure, Variant 1\nDate Signal\nWave \nHigh\nWave \nLow\nStop \nPrice\nP/L \nLong %\nAccum \nLng\nRisk \npts Risk %\nDuration \nLong\nDuration \nShort\n9/24/1900 Long 53.00 50.35 143.1\n6/17/1901   78.30 371\n9/30/1901 Short 64.03 11.03 20.81 172.88 14.27 18.22\n11/2/1903   42.20\n7/11/1904 Long 52.02 1015\n1/15/1906   103.00\n8/5/1907 Short 76.76 24.75 47.57 255.13 26.24 25.48 1120\n1/11/1907   53.00\n3/23/1908 Long 67.77 231\n9/27/1909   100.50\n1/31/2010 Short 91.11 23.34 34.43 342.97 9.39 9.34 679\n9/25/1911   72.90\n4/22/1912 Long 88.58 812\n9/30/1912   94.20\n12/9/1912 Short 85.88 −2.70 −3.05 332.52 8.32 8.83 231\n12/21/1914   53.20", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 36}
{"text": ".03 20.81 172.88 14.27 18.22\n11/2/1903   42.20\n7/11/1904 Long 52.02 1015\n1/15/1906   103.00\n8/5/1907 Short 76.76 24.75 47.57 255.13 26.24 25.48 1120\n1/11/1907   53.00\n3/23/1908 Long 67.77 231\n9/27/1909   100.50\n1/31/2010 Short 91.11 23.34 34.43 342.97 9.39 9.34 679\n9/25/1911   72.90\n4/22/1912 Long 88.58 812\n9/30/1912   94.20\n12/9/1912 Short 85.88 −2.70 −3.05 332.52 8.32 8.83 231\n12/21/1914   53.20\n3/29/1915 Long 60.26 840\n11/13/1916   110.13\n8/27/1917 Short 84.65 24.40 40.49 467.14 25.48 23.14 882\n12/17/1917   65.90\n8/19/1918 Long 84.56 357\n11/3/1919   119.60\n8/9/1920 Short 83.72 −0.84 −0.99 462.50 35.88 30.00 721\n8/22/1921   63.90\n10/24/1921 Long 72.10 441\n3/19/1923   105.40\n7/23/1923 Short 87.40 15.30 21.22 560.65 18.00 17.08 637\n10/22/1923   85.76\n1/21/1924 Long 96.51 182\n9/2/1929   386.10\n10/21/1929 Short 319.30 222.79 230.84 1854.86 66.80 17.30 2100\n7/4/1932   40.60\n4/24/1933 Long 70.97 1281\n3/8/1937   195.60\n9/6/1937 Short 166.54 95.57 134.67 4352.85 29.06 14.86 1596\n3/28/1938   97.50\n7/18/1938 Long 136.89 315\n9/11/1939   157.80\n5/13/1940 Short 135.95 −0.94 −0.68 4323.06 21.85 13.85 665\n4/27/1942   92.70\n7/6/1942 Long 105.99 784\n5/27/1946   213.4\n9/16/1946 Short 172.43 66.44 62.69 7033.17 40.97 19.20 1533\n6/13/1949   160.6\n10/24/1949 Long 184.27 1134\n4/9/1956   524.4\n9/23/1957 Short 468.26 283.99 154.12 17872.73 56.14 10.71 2891\n10/21/1957   416.2\n(Continued)\n34 Technical Analysis of Stock Trends\nTable 5.1 (Continued) Trades Made by the Magee Basing Points Procedure, Variant 1\nDate Signal\nWave \nHigh\nWave \nLow\nStop \nPrice\nP/L \nLong %\nAccum \nLng\nRisk \npts Risk %\nDuration \nLong\nDuration \nShort\n6/23/1958 Long 465.77 273\n1/4/1960   688.2\n9/26/1960 Short 582.64 116.87 25.09 22357.51 105.56 15.34 826\n10/24/1960   564.2\n4/3/1961 Long 664.66 189\n11/13/1961   741.3\n5/7/1962 Short 654.46 −10.20 −1.53 22014.44 86.84 11.71 399\n6/25/1962   524.6\n12/31/1962 Long 640.66\n1/17/1966   1000.6 238\n5/9/1966 Short 878.18 237.52 37.07 30176.13 122.42 12.23 1225\n10/10/1966   735.7\n10/14/1968 Long 937.71 889\n12/2/1968   994.7\n6/9/1969 Short 895.4 −42.31 −4.51 28814.51 99.30 9.98 238\n5/25/1970   627.5\n1/11/1971 Long 827.40 581\n1/8/1973   1067.2\n5/14/1973 Short 871.25 43.85 5.30 30341.63 195.95 18.36 854\n12/2/1974   572.1\n12/10/1975 Long 713.58 940\n9/20/1976   1026.3\n5/23/1977 Short 904.12 190.54 26.70 38443.24 122.18 11.90 530\n2/27/1978   742.13\n8/14/1978 Long 875.60 448\n9/4/1978   907.73\n3/24/1980 Short 780.15 −95.45 −10.90 34252.39 127.58 14.05 588\n4/21/1980   759.13\n8/4/1980 Long 930.96 133\n3/30/1981   1030.98\n8/3/1981 Short 877.8 −53.16 −5.71 32296.66 153.18 14.86 364\n8/9/1982   769.98\n10/4/1982 Long 902.82 427\n8/24/1987   2746.7\n10/19/1987 Short 2071.51 1,168.69 129.45 74104.67 675.19 24.58 1841\n8/24/1987   1616.2\n1/23/1989 Long 2234.53\n7/20/1998   9367.94 462\n8/24/1998 Short 8141.86 5,907.33 264.37 270011.56 1,226.08 13.09 3500\n7/20/1998   7402.61\n3/8/1999 Long 9015.28 196\n1/10/2000   11750.28\n2/21/2000 Short 9889.28 874.00 9.69 296188.21 1,861.00 15.84 350\n10/7/2002   7197.49\n9/1/2003 Long 9314.67 1288\n10/8/2007   14198.1\n1/7/2008 Short 12503.04 3,188.37 34.23 397572.06 1,695.06 11.94 1589\n3/2/2009   6469.95\n(Continued)\n35Chapter five: Replacin g Dow Theory with John Magee’s Basing points Procedure\nTable 5.2 Trades Made by the Magee Basing Points Procedure, Variant 2\nDate Signal Stop Profit %\nAccumulated \nProfit\nDuration \nLong\nDuration \nShort\n9/25/1900 Buy 143.10\n6/18/1901 371\n10/1/1901 Sell 64.03 11.03 20.81 172.88\n11/3/1903\n7/12/1904 Buy 52.02 1015\n1/16/1906\n8/6/1907 Sell 76.76 24.75 47.57 255.13 1120\n1/12/1907\n3/24/1908 Buy 67.77 231\n9/28/1909\n2/1/1910 Sell 91.11 23.34 34.43 342.97 679\n9/26/1911\n4/23/1912 Buy 88.58 812\n10/1/1912\n12/10/1912 Sell 85.88 −2.70 −3.05 332.52 231\n12/22/1914\n3/30/1915 Buy 60.26 840\n11/14/1916\n8/28/1917 Sell 84.65 24.40 40.49 467.14 882\n12/18/1917\n8/20/1918 Buy 84.56 357\n11/4/1919\n8/10/1920 Sell 83.72 −0.84 −0.99 462.50 721\n8/23/1921\n10/25/1921 Buy 72.10 441\n3/20/1923\n7/24/1923 Sell 87.40 15.30 21.22 560.65 637\n10/23/1923\n1/22/1924 Buy 96.51 182\n9/3/1929\n10/22/1929 Sell 337.92 241.41 250.14 1963.03 2100\n7/5/1932\n(Continued)\nTable 5.1 (Continued) Trades Made by the Magee Basing Points Procedure, Variant 1\nDate Signal\nWave \nHigh\nWave \nLow\nStop \nPrice\nP/L \nLong %\nAccum \nLng\nRisk \npts Risk %\nDuration \nLong\nDuration \nShort\n5/4/2009 Long 8564.52 484\n12/31/2009   10428.05\n12/29/2017 Mark to \nmarket \n12/29/17\n16928.03 24719.22 16154.70 749914.46 188.62 1147486.52 14291.17 137.05% 3161\n36 Technical Analysis of Stock Trends\nTable 5.2 (Continued) Trades Made by the Magee Basing Points Procedure, Variant 2\nDate Signal Stop Profit %\nAccumulated \nProfit\nDuration \nLong\nDuration \nShort\n4/25/1933 Buy 70.97 1281\n3/9/1937\n9/7/1937 Sell 166.54 95.57 134.67 4606.69 1596\n3/29/1938\n7/19/1938 Buy 136.89 315\n9/12/1939\n5/14/1940 Sell 135.95 −0.94 −0.68 4575.16 665\n4/28/1942\n7/7/1942 Buy 105.99 784\n5/28/1946\n9/17/1946 Sell 172.43 66.44 62.69 7443.31 1533\n6/14/1949\n10/25/1949 Buy 184.27 1134\n4/10/1956\n9/24/1957 Sell 468.26 283.99 154.12 18914.98 2891\n10/21/1957\n6/24/1958 Buy 465.77 273\n1/5/1960\n9/27/1960 Sell 582.64 116.87 25.09 23661.29 826\n10/25/1960\n4/4/1961 Buy 664.66 189\n11/14/1961\n5/8/1962 Sell 654.46 −10.20 −1.53 23298.21 399\n6/26/1962\n1/1/1962 Buy 640.66\n1/18/1966 238\n5/10/1966 Sell 878.18 237.52 37.07 31935.85 1225\n10/11/1966\n10/15/1968 Buy 937.71 889\n12/3/1968\n6/9/1969 Sell 895.40 −42.31 −4.51 30494.83 238\n5/26/1970\n1/12/1971 Buy 827.40 581\n1/9/1973\n5/15/1973 Sell 871.25 43.85\n5.30 32111.01 854\n12/3/1974\n12/11/1975 Buy 713.58 940\n9/21/1976\n5/24/1977 Sell 904.12 190.54 26.70 40685.06 530\n2/28/1978\n8/15/1978 Buy 875.60 448\n9/5/1978\n3/25/1980 Sell 780.15 −95.45 −10.90 36249.82 588\n4/22/1980\n(Continued)\n37Chapter five: Replacin g Dow Theory with John Magee’s Basing points Procedure\nThis study and the use of Magee’s Basing Points Procedure to replace Dow Theory \nis explained in exquisite detail in the book Sacred Chickens, the Holy Grail and Dow Theory \n(available at http:/ /www.amazon.com).\nTabl", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 37}
{"text": "15/1978 Buy 875.60 448\n9/5/1978\n3/25/1980 Sell 780.15 −95.45 −10.90 36249.82 588\n4/22/1980\n(Continued)\n37Chapter five: Replacin g Dow Theory with John Magee’s Basing points Procedure\nThis study and the use of Magee’s Basing Points Procedure to replace Dow Theory \nis explained in exquisite detail in the book Sacred Chickens, the Holy Grail and Dow Theory \n(available at http:/ /www.amazon.com).\nTable 5.2 (Continued) Trades Made by the Magee Basing Points Procedure, Variant 2\nDate Signal Stop Profit %\nAccumulated \nProfit\nDuration \nLong\nDuration \nShort\n8/5/1980 Buy 930.96 133\n3/31/1981\n8/4/1981 Sell 877.80 −53.16 −5.71 34180.04 364\n8/10/1982\n10/5/1982 Buy 902.82 427\n8/25/1987\n10/20/1987 Sell 2458.46 1555.64 172.31 93075.78 1841\n8/25/1987\n1/24/1989 Buy 2234.53\n7/21/1998 462\n8/25/1998 Sell 8141.86 5907.33 264.37 339135.65 3500\n7/21/1998\n3/9/1999 Buy 9015.28 196\n9/21/1999\n9/21/1999 Sell 10470.08 1454.80 16.14 393862.09 196\n1/3/2000\n10/15/2002 Buy 8138.30 1120\n10/1/2002\n1/28/2003 Sell 7984.95 −153.35 −1.88 386440.54 105\n10/8/2006\n3/18/2003 Buy 8220.90 49\n5/11/2004 Sell 9966.41 1745.51 21.23 468491.88 420\n2/28/2005 Buy 10887.90\n7/30/2007 Sell 13110.42 2222.52 20.41 564123.97 882\n10/1/2007\n3/23/2009 Buy 7411.89\n3/2//2009 602\n12/29/2017 Mark to \nMarket\n24719.22 17307.33 233.51 1881396.57 3262\n38 Technical Analysis of Stock Trends\nFigure 5.1 How the 2008 top in the Industrials was managed with Basing Points.\nCertainly, one of the most interesting charts of the last 20 years. Here we can see the stairstops \nrising as higher wave lows are made. Moreover, one—or two—of those instances of surprising \nserendipity occurs. The Basing Point stop is quite close to a stop that would have been calculated \nfrom the neckline of the head-and-shoulders formation. The very long-term trendline from 2003 \nintersects prices very near the Basing Point calculated stop, calling to mind the “rule of multiple \ntechniques,” which states any conclusion arrived at by multiple techniques is much more probable \nthan that using only one method. This Basing Points system—or method, or what-have-you—\nremained short until March 2009.\n39Chapter five: Replacin g Dow Theory with John Magee’s Basing points Procedure\n1924 - 1934\nDOW JONES\n116.47 116.47\n336.96 336.96\n96.26\n104.04\n19241924\n15\n19251925 19261926 19271927 19281928 19291929\n?\n19301930 19311931 19321932 19331933\n17\n19\n19341934\nFigure 5.2 The Dow-Jones Industrials 1924–1934. This is a period of the chart covered in Figure 5.3 .\n40 Technical Analysis of Stock Trends\nFigure 5.3 This is one of the most interesting charts ever made of the Dow-Jones Industrials. It shows every trade made by Dow Theory since the \nbeginning and also shows trades made by Magee’s Basing Points Procedure.\n41\nchapter six\nImportant Reversal Patterns\nIn our discussion of certain deficiencies in the Dow Theory from the point of view of the \npractical trader, we mentioned the fact that it did not tell us what specific stocks to trade \nin. (EN9: Obviously, no longer a problem as the investor may buy the DIA and trade the Average \nlike a stock.) A conservative and wealthy investor, more interested in safety than maximum \nprofit, can solve this problem by making up a comprehensive and thoroughly diversified \nlist of sound, well-seasoned “blue chip” issues and handing his broker an order to buy the \nlot when the Dow Theory signals a Bull Trend. Some of his selections will do better than \nothers; some may “go sour,” but wide diversification will ensure he gets a fair Average \nresult. Better results should be obtained if we can find a way to select for purchase the \nmost favorably situated issues at any given time and can manage to sell them promptly and \nswitch to others whenever the prospects for the first have been fully discounted.\nThere is the possibility, too, of increasing our gains if we can, at times, buy with safety \nearlier in an uptrend than the Dow theorist does, and sell before the market has reacted far \nenough to give a Dow Bear Signal.\nWe mentioned also the fact that the Dow Theory is of little or no assistance in trading \non the Intermediate Trends. There is obviously more money to be made if we can get the \nbenefit of each up move without having to write off some of our profits in each reaction. Or, \nif we can profit both ways by trading on both the “long side” and “short side” of the market.\nFinally, although all stocks tend to move with “the market” as typified in the Averages, \nthere are, in fact, wide variations in the price paths of individual issues. An average, after all, \nis just that, a device for expressing in one figure a diversity of other figures. A Primary Bull \nMarket ended in the Dow–Jones Industrial Average on May 29, 1946, but United Airlines \nregistered its highest price in December 1945; General Motors saw its peak in January 1946; \nGoodyear in April, DuPont in June, and Schenley in August. Is there a way of capitalizing \non these divergences?\nTechnical analysis of the charts of individual stocks definitely answers the first and \nmost important of these four problems: the matter of selection. It frequently, but not always, \ngives us a running start on the Dow Theory; it also, in large part, takes care of the question \nof the Intermediate Trend, although there are certain reservations as to policy and risk \nin connection with both these points that will be taken up in due course. Finally, careful \ntechnical analysis should, in nearly every case, get us out of a stock that “tops out” ahead of \nthe Averages long before it has suffered any considerable decline, often in time to transfer \nfunds to other issues that have yet to complete their advances.\nJust as the Averages constantly discount all known and foreseeable factors affecting \nthe future of security prices in general, the market action of an individual issue reflects all \nthe factors affecting its individual future. Among these factors, and expressed in its chart, \nare the general market conditions that influence all stock", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 38}
{"text": "funds to other issues that have yet to complete their advances.\nJust as the Averages constantly discount all known and foreseeable factors affecting \nthe future of security prices in general, the market action of an individual issue reflects all \nthe factors affecting its individual future. Among these factors, and expressed in its chart, \nare the general market conditions that influence all stocks to a greater or lesser degree, as \nwell as the particular conditions applying to the particular stock, including the operations \nof “insiders.”\nLet us assume right from the start that you, the reader, are not a member of that mysterious \ninner circle known to the boardrooms as “the insiders.” Such a group—genuinely entitled to \n42 Technical Analysis of Stock Trends\nbe called insiders, thoroughly informed on every fact, figure, and development that might \ndetermine the fortunes of a certain corporation—may exist from time to time and may \ninfluence the market price of its stock (EN9: and wind up in prison). But it is fairly certain that \nthere are not nearly so many “insiders” as the amateur trader supposes and that they do not \ncause one-tenth of the market movements for which the public blames them. It is even more \ncertain that insiders can be wrong; they would, in fact, be the first to admit it. Frequently, \ntheir plans are upset by some development that they could not foresee or by some blind \nforce that puts to scorn all expert estimates of value. Any success they have, however, can be \naccomplished only by buying and selling on the floor of the Exchange. [EN9: No longer strictly \ntrue. Insiders sold stock to their companies in the tulip (dot.com) bubble, which went unreported \npublicly for up to a year. Still, only an isolated problem.] They can do neither without altering the \ndelicate poise of supply and demand that governs prices. Whatever they do is sooner or later \nreflected on the charts where you, the “outsider,” can detect it, or at least detect the way in \nwhich the supply–demand equation is being affected by insiders’ operations, plus all other \nprevailing market factors. So, you do not need to be an insider to ride with them frequently.\nImportant Reversal Patterns\nStock prices move in trends. Some of those trends are straight, some are curved; some are \nbrief and some are long-continued; some are irregular or poorly defined and others are \namazingly regular or “normal,” produced in a series of action and reaction waves of great \nuniformity. Sooner or later, these trends change direction; they may reverse (as from up to \ndown), or they may be interrupted by some sort of sideways movement and then, after a \ntime, proceed again in their former direction.\nIn most cases, when a price trend is in the process of reversal, either from up to down or \nfrom down to up, a characteristic area or pattern takes shape on the chart, which becomes \nrecognizable as a Reversal Formation. Some of these chart pictures are built and completed \nquickly, whereas others may require several weeks to reach a stage at which one can surely \nsay a Reversal of Trend is definitely indicated. Speaking in broad generalities, the greater the \nReversal Area—the wider the price fluctuations within it, the longer it takes to build, and \nthe more shares transferred during its construction—the more important its implications. \nThus, roughly speaking, a big Reversal Formation suggests a big move to follow and a small \npattern, a small move. Needless to say, the first and most important task of the technical \nchart analyst is to learn to know the important Reversal Formations and to judge what they \nmay signify in terms of trading opportunities.\nThere is one recognized Reversal Pattern that appears and is completed within a single \nday’s trading, and is, in consequence, named the “One-Day Reversal.” At times, it has great \nsignificance—such as calling a halt, at least temporarily, to any up or down move—but in \nits ordinary manifestations, it does not imply much of an immediate move in the opposite \ndirection. It is a useful pattern, and we shall have more to say about it later, but the price \nformations from which extensive new trends proceed take time to build. One does not \nbring instantly to a stop a heavy car moving at 70 miles an hour and, all within the same \nsplit second, turn it around and get it moving back down the road in the opposite direction \nat 70 miles an hour.\nTime required to reverse a trend\nWe do not need to lean on a racing automobile analogy to explain why it takes time (and \nvolume and price action) to produce an important Trend Reversal. The logic of it is plain \n43Chapter six: Importa nt Reversal Patterns\nenough if we take but a moment to examine it. We can do so most easily by describing \nwhat might have (and, doubtless, many times has) happened in specific terms. Suppose \na certain well-informed and well-financed coterie (EN9: A congerie of mutual funds, for \nexample) decides the shares of a certain company, now selling around 40, are cheap; that \nthis company’s affairs are progressing so satisfactorily that, before long, it will attract the \nattention of many investors; and that its stock will be in demand at much higher levels, \nperhaps at 60 or 65. Our group realizes if they manage their market operations skillfully, if \nnothing unforeseen intervenes to upset their calculations, they can “take” 20 points out of \nthe situation. So they proceed to buy in all offerings, going about this business as quietly \nas possible, until they have accumulated their line, which may run to several thousand \nshares and represent practically all of the current floating supply of the issue. Then they \nwait. Professionals become suspicious and the rumor circulates that there is “something \ndoing in PDQ,” or other canny bargain hunters discover the company’s bright prospects, \nor chart analysts detect the signs of accumulation in the stock’s action. Buyers now find \nthe stock is scarce; there are few offerings", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 39}
{"text": "and represent practically all of the current floating supply of the issue. Then they \nwait. Professionals become suspicious and the rumor circulates that there is “something \ndoing in PDQ,” or other canny bargain hunters discover the company’s bright prospects, \nor chart analysts detect the signs of accumulation in the stock’s action. Buyers now find \nthe stock is scarce; there are few offerings on the books, and they have to raise their bids \nto get it—an advance starts.\nThe up-move gathers momentum as more and more traders are attracted by rising \nprices. It is helped along by the good reports (higher earnings, increased dividend, etc.), \nwhich our group knew were to be expected. Eventually, prices approach the level at which \nthey had planned to take profits. But this operation, the distribution of their holdings may \nrequire even more patient and skillful handling than did the accumulation. Suppose they \nhave 20,000 shares to unload; they cannot throw all of the shares on the market at once—\ndoing so would defeat their own ends immediately and, perhaps, permanently. They must \nfeed their line out little by little, trying to avoid attention, feeling their way along and never \npermitting a surplus of offerings to kill the demand. If activity in their stock has reached a \nlevel of, say, 2000 shares transferred daily, they may be able to dispose of 500 shares a day \nfrom their holdings without bringing the price down. (They will be competing, sooner or \nlater, with others who have followed their play, bought lower down, and will be ready to \ntake profits as soon as the advance shows signs of weakening.) So they start to sell when \nthe rising trend appears to have attained maximum momentum, or as it nears their price \nobjective, but well before it has reached its probable limit, and they push out their shares \nas rapidly as buyers will take them.\nBefore long—as a rule, before they have distributed their entire line—a lull in demand \nwill occur. Perhaps prospective buyers sense the increase in supply. A reaction develops. \nOur group quickly ceases selling, withdraws its offers, and perhaps even buys back a few \nshares to support prices if they threaten to drop too far. With supply temporarily held off \nthe market, the decline halts and the advance resumes. Our group lets it proceed this time \nuntil it carries prices into new high ground; this reassures other holders and brings in more \nbuyers. As soon as the pot is once again merrily boiling, distribution is started anew and, \nif the maneuver has been well directed, completed in perhaps two or three weeks, before \nthe second wave of demand has been exhausted.\nOur group is now out of its stock with a nice profit; its 20,000 shares have passed into \nother hands. If they gauged the market correctly and distributed their line at a price about \nas high as the situation would bear, demand will have been satiated for a long time to come. \nPrices will probably first drift back to somewhere near the level at which they were supported \non the previous dip and then rally feebly on the strength of a little new buying from traders \nwho were waiting for just such a minor reaction, meet sales from other traders who failed to \nseize the opportunity to take their profits on the preceding volume Top and are now anxious \nto get out, and then break down into a decline of Intermediate or Major proportions.\n44 Technical Analysis of Stock Trends\nYou can see now why, under one specific set of circumstances, a Top area (a chart \npattern of distribution) takes time and volume to complete. Nevertheless, it does not \nmatter whether we have to deal with the highly organized operations of a single group of \ninsiders or of an investment syndicate or, as is more often the case, the quite unorganized \nactivities of all the investors variously interested in an issue—the result is pretty much the \nsame. Distribution, which is simply Wall Street’s way of expressing the process of supply \novercoming demand, takes time and a change in ownership (turnover) of a large number \nof shares. And it is amazing to see how these patterns of distribution, which hereafter we \nshall find it simpler to refer to as “Tops,” tend to assume certain well-defined forms. Most \nof the same pattern forms appear also as “Bottoms,” in which manifestation they signify \naccumulation instead of distribution.\nThe Head-and-Shoulders Top Formation\nIf you followed closely and were able successfully to visualize how the foregoing example \nof distribution would appear on a chart, you saw a Head-and-Shoulders Top Formation. \nThis is one of the more common and, by all odds, the most reliable of the Major Reversal \nPatterns. You probably have heard this pattern mentioned, as many traders are familiar \nwith its name, but not so many really know it and can distinguish it from somewhat similar \nprice developments that do not portend a real Reversal of Trend.\nThe typical or, if you will, the ideal, Head-and-Shoulders Top is illustrated in Diagram \n6.1. You can easily see how this formation got its name. It consists of the following:\n A. A strong rally, climaxing a more or less extensive advance, on which trading volume \nbecomes very heavy, followed by a Minor Recession on which volume runs considerably \nlower than it did during the days of rise and at the Top. This is the “left shoulder.”\n B. Another high-volume advance that reaches a higher level than the top of the left shoulder, \nand then another reaction on less volume that takes prices down to somewhere near \nthe bottom level of the preceding recession, somewhat lower perhaps or somewhat \nhigher, but, in any case, below the top of the left shoulder. This is the “Head.”\n C. A third rally, but this time on decidedly less volume than accompanied the formation \nof either the left shoulder or the head, which fails to reach the height of the head before \nanother decline sets in. This is the “right shoulder.”\n D. Finally, decline of prices in this third recession down", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 40}
{"text": "perhaps or somewhat \nhigher, but, in any case, below the top of the left shoulder. This is the “Head.”\n C. A third rally, but this time on decidedly less volume than accompanied the formation \nof either the left shoulder or the head, which fails to reach the height of the head before \nanother decline sets in. This is the “right shoulder.”\n D. Finally, decline of prices in this third recession down through a line (the “neckline”) drawn \nacross the Bottoms of the reactions between the left shoulder and head, and the head \nand right shoulder, respectively, and a close below that line by an amount approximately \nequivalent to 3% of the stock’s market price. This is the “confirmation” or “breakout.”\nNote that each and every item cited in A, B, C, and D of Diagram 6.1 is essential to a valid \nHead-and-Shoulders Top Formation. The lack of any one of them casts in doubt the forecasting \nvalue of the pattern. In naming them, we have left the way clear for the many variations that \noccur (for no two Head-and-Shoulders are exactly alike) and have included only the features \nthat must be present if we are to depend on the pattern as signaling an important Reversal \nof Trend. Let us examine them in greater detail (see Figures 6.1 through 6.12).\nVolume is important\nFirst, let us consider the matter of volume. It is always to be watched as a vital part of the \ntotal picture. The chart of trading activity makes a pattern just as does the chart of price \n45Chapter six: Importa nt Reversal Patterns\nranges. The two go together and each must conform to the requirements of the case. But \nnote also that volume is relative. When we speak of high volume, we mean a rate of trading \nnotably greater than has been customary in that particular stock during that particular \nperiod under examination. The exact number of shares traded is not important, and it will \nnot ordinarily signify anything for our purposes to compare a daily volume of, say, 6500 \nshares in Radio Corporation with 500 in Bohn Aluminum and Brass. The former may be \nvery low and the latter very high as judged by the proper technical criterion, which is, in \neach case, the average recent activity in the same issue. In the case of a Head-and-Shoulders \nTop, as mentioned, high volume attends the making of the left shoulder; this means that \nactivity on the rise to and at the top of the left shoulder should be greater than on the \npreceding rally waves in the same issue, followed by a Minor Recession on dwindling \nactivity, and then a new advance on high volume. The action thus far does not differ from \nwhat we should expect of normal wave development within a continuing uptrend. In these \nrespects, any two typical, successively higher waves in an advance may, as you can see, \nbecome the left shoulder and head, respectively, of a Head-and-Shoulders Reversal.\nA\nB\nC\nD\nNECKLINE\nVOLUME\nDiagram 6.1 A hypothetical daily stock chart . Price in the upper part and volume at bottom—drawn \nto show how an ideal Head-and-Shoulders Top Reversal Formation would develop. A, B, C, and D \nrefer to essential features listed on the previous page.\n46 Technical Analysis of Stock Trends\nHUMANA INCORPORATED HUM 1988\nS\nH\nS\nNL\n38\n36\n34\n32\n30\n28\n26\n24\n22\n20\nMARCHA PRIL MAYJ UNEJ ULYA UGUST SEPTEMBER\n27 51 21 92 62 91 62 33 07 14 21 28 41 11 82 52 9 16 23 30 61 32 02 73 10 17\nXD.2 X0D .23\n4000\n3200\n2400\n1600\n800\nSales\n100’S\nFigure 6.1 Starting in March, “HUM” formed a broad Head-and-Shoulders Top pattern on the \ndaily chart. August’s decline penetrated the neckline by 3%, confirming the Reversal Pattern. The \nminimum objective for the Head-and-Shoulders Top would be 18.\nCHI., MIL., ST. P. & PAC. ST 1946S\nG\nH\nS\nG\nNL\nS\nH S\n38\n36\n34\n32\n30\n28\n26\nJANUARY FEBR UARY MARCHA PRIL MAYJ UNE\n51 21 92 62 91 62 32 91 62 33 0613 20 27 41 11 82 51 81 52 22 9\nSales\n100’s\n250\n200\n150\n100\n50\nFigure 6.2 Daily chart of Chicago, Milwaukee, St. Paul, & Pacific common from January 1 to June 29, \n1946. Head-and-Shoulders that topped this issue’s Primary Advance in February was unmistakable, \ndespite the small size of shoulders (SS). Note the volume pattern. Measuring implication (see \nfollowing pages) of this formation was carried out by April. Rectangular price congestion of March \n30 to May 4 is a subject of Chapter 9. “ST” fell to 11 1/2 in October.\n47Chapter six: Importan t Reversal Patterns\nThe first suggestion a Head-and-Shoulders is really developing may come when the \nvolume record shows that activity accompanying the most recent Top was somewhat less \nthan the one preceding it. If this volume disparity is conspicuous, and if it becomes evident \nfrom the way prices are receding that the second and higher rally has ended, then the chart \nshould be tabbed with a “red” signal and further developments should be scrutinized. But \nsuch a preliminary warning does not always appear and should not be taken as conclusive \nwhen it does. Roughly estimated, about one-third of all confirmed Head-and-Shoulders \nFormations show more volume on the left shoulder than on the head, another third show \nabout equal volume, and the final third show greater volume on the head than on the left \nshoulder.\nAnother warning—or, more often, the first—comes when prices drop in the course of \nthe second reaction (i.e., from the head) below the level of the Top of the left shoulder. Such \naction, as we shall see later on in our specific study of Support and Resistance levels, is \nsignificant of weakness in the price structure. So far it is Minor, it may be only temporary, \nand it is certainly not conclusive. Nevertheless, when this occurs, put a double red tab on \nyour chart.\nBreaking the neckline\nThe real tip-off appears when activity fails to pick up appreciably on the third rally, the right \nshoulder. If the market remains dull as prices recover (at which stage you can draw a tentative \n“neckline” on your chart) and if, as they approach the approximate level of the left shoulder \nWESTINGHOUSE ELECTRIC WX\n1945–1946\nS H S\nGNL\nS?", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 41}
{"text": "s, put a double red tab on \nyour chart.\nBreaking the neckline\nThe real tip-off appears when activity fails to pick up appreciably on the third rally, the right \nshoulder. If the market remains dull as prices recover (at which stage you can draw a tentative \n“neckline” on your chart) and if, as they approach the approximate level of the left shoulder \nWESTINGHOUSE ELECTRIC WX\n1945–1946\nS H S\nGNL\nS? S?\nH?\n44\n40\n38\n36\n34\n32\n30\nDECEMBER JANUARY FEBRUARY MARCHA PRIL MAY\n18 15 22 29 51 21 92 62 91 62 32 91 62 33 0613 20 2741 11 82 5\nSales\n100’s\n250\n200\n150\n100\n50\nS H S\nFigure 6.3 Bull market top of Westinghouse Electric in 1946 was the “wide-swinging,” powerful type \nof Head-and-Shoulders Pattern (S-H-S). Decline that broke neckline (NL) on February 13 produced \na breakaway gap (G) discussed in Chapter 12. Measuring formula (see following pages) called for \ninitial decline to 33. The possible Bottom Head-and-Shoulders Pattern (S?-H?-S?) formed in March \nwas never completed (see Chapter 7). Note the failure of prices to push up through the neckline of \nthe latter at any time, despite several rally efforts in late spring while general market Averages were \nactually reaching new high levels. By the following November, “WX” had broken on down to 21 1/2. \nStudy in detail the change in volume pattern after the end of January.\n48 Technical Analysis of Stock Trends\nTop and begin to round over (volume is still relatively small), your Head-and-Shoulders Top \nis at least 75% completed. Although the specific application of these pattern studies in trading \ntactics is the province of the second part of this book, we note here that many stock traders \nsell or switch just as soon as they are sure a low-volume right shoulder has been completed, \nwithout waiting for the final confirmation named under D as the breaking of the neckline.\nNevertheless, the Head-and-Shoulders is not complete, and an important Reversal of \nTrend is not conclusively signaled until the neckline has been penetrated downside by a \ndecisive margin. Until the neckline is broken, a certain percentage of Head-and-Shoulders \ndevelopments, perhaps 20%, are “saved”—that is, prices do not go lower, but simply flounder \nlistlessly for a period of time in the general range of the right shoulder, then eventually firm \nup and renew their advance.\nFinally, in rare cases, a Head-and-Shoulders Top is confirmed by a decisive neckline \npenetration and still prices do not go down much farther. “False moves” such as this are the \nmost difficult phenomena with which the technical analyst has to cope. Fortunately, in the \ncase of the Head-and-Shoulders, they are extremely rare. The odds are so overwhelmingly \nin favor of the downtrend continuing once a Head-and-Shoulders Formation has been \nconfirmed, it pays to believe the evidence of the chart no matter how much it may appear \nto be out of accord with the prevailing news or market psychology.\nOne thing is worth noting about Head-and-Shoulders Formations that fail completion or \nproduce false confirmations—that is, such developments almost never occur in the early stages \nof a Primary Advance. A Head-and-Shoulders Formation that does not work is a warning \nthat even though there is still some life in the situation, a genuine turn is near. The next time \nsomething in the nature of a Reversal Pattern begins to appear on the charts, it is apt to be final.\nTELEDYNE INC. TDY 1984\nS\nH\nS\n304\n288\n272\n256\n240\n224\n208\n192\n176\n160\nJUNE JULY AUGUSTS EPTEMBERO CTOBERN OVEMBERD ECEMBER\n16 23 30 71 42 12 84 11 18 25 18 15 22 29 61 32 02 73 10 17 24 18 15 22 29\nSales\n100’s\n2000\n1600\n1200\n800\n400\nFigure 6.4 A large Head-and-Shoulders Topping Pattern evolved in “TDY” over five months, with \nDecember’s high-volume plunge through the neckline confirming the Trend Reversal. Because this \nwas a very expensive stock, you might have considered buying the April 260 puts instead of selling \n“TDY” shares outright. Our measured objective in this issue was 44 points from penetration of the \n264 neckline, or 220.\n49Chapter six: Importa nt Reversal Patterns\nVariations in Head-and-Shoulders Tops\nThere is a tendency, surprising when one thinks of all the vagaries of news and crosscurrents \nthat may influence day-to-day trading, for Head-and-Shoulders Patterns to develop a high \ndegree of symmetry. The neckline tends to be horizontal and the right shoulder tends to \nresemble the left in price confirmation (although not, of course, in volume); there is a sort of \nsatisfying balance to the overall picture. But symmetry is not essential to a significant Head-\nand-Shoulders development. The neckline may slope up (from left to right) or down. The \nonly qualification on an up-sloping neckline is that the Bottom of the recession between the \nhead and right shoulder must form appreciably below the general level of the Top of the left \nshoulder. It is sometimes said that a down-sloping neckline indicates an unusually weak \nsituation. This is so obvious that it is apt to be given even more weight than it deserves. A \nshare of that excessive weakness, it should be noted, will have already been discharged \nby the time the down-sloping pattern is formed and prices have broken the neckline. The \nmeasuring formula, which we shall discuss later, applies to such situations.\nDue to the tendency toward symmetry in shoulder development, some traders, as \nsoon as the neckline has formed, will draw on their charts a line parallel to the neckline, \nextending from the top of the left shoulder through the head and on to the right. This \nfurnishes a guide as to the approximate height the right shoulder rally should attain and, \nI C INDUSTRIES ICX1 986\nS\nH\nS\nNL\n32\n30\n28\n26\n24\n22\n64\n60\n56\n52\n48 \n10356\n12414\nJUNE JULY AUGUST SEPTEMBERO CTOBERN OVEMBERD ECEMBER\n14 21 28 51 21 92 62 92 36 30 13 20 27 41 11 82 51 81 52 22 96 13 20 2716\nSales\n100’s\n1000\n800\n600\n400\n200\n2/1SPLITXD.40 XD.20XD.20\nFigure 6.5 “ICX” was in a powerful uptrend for more than a decade and gains wer", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 42}
{"text": "mate height the right shoulder rally should attain and, \nI C INDUSTRIES ICX1 986\nS\nH\nS\nNL\n32\n30\n28\n26\n24\n22\n64\n60\n56\n52\n48 \n10356\n12414\nJUNE JULY AUGUST SEPTEMBERO CTOBERN OVEMBERD ECEMBER\n14 21 28 51 21 92 62 92 36 30 13 20 27 41 11 82 51 81 52 22 96 13 20 2716\nSales\n100’s\n1000\n800\n600\n400\n200\n2/1SPLITXD.40 XD.20XD.20\nFigure 6.5 “ICX” was in a powerful uptrend for more than a decade and gains were spectacular. \nBut the upward momentum began to fade and topping indications were evident. The August peak \nfulfilled the objective of the measuring flag formed during 1985. The August gap to new highs was \nquickly filled, indicating it was an Exhaustion Gap. The reaction back to Support, followed by a \nslow, relatively low-volume rally to the July high, formed a credible right shoulder. The final week’s \nhigh-volume plunge through the neckline confirmed the Reversal. The minimum objective for the \nHead-and-Shoulders Pattern was 19 1/4, the top of the 1985 Flag. A possible alternative cover point \nwas the Bottom of the Flag at 14 1/4.\n50 Technical Analysis of Stock Trends\nDU PONT DD\n1936–1937\n208\n192\n176\n160\n152\n144\nOCTOBERN OVEMBERD ECEMBERJ ANUARY FEBRUARY MARCH\nS H\nS\nS H S\n31 01 72 43 17 14 21 28 51 21 92 62 91 62 33 061 32 02 7613 20 27\nSales\n100’s\n50\n40\n30\n20\n10\nFigure 6.6 Reversal Formations, which develop in important stocks while the general market is still \napparently in a strong trend, are often difficult to believe, much less act on. But they may be highly \nsignificant. DuPont topped out in 1936, four months ahead of the Averages. Despite its extended \nright shoulder (but note volume), Reversal implications were clear on December 19. The Pullback of \nJanuary, meeting supply at the old neckline level, and the second try in March were interesting and \ntypical of such a general market situation. Compare with Figure 6.11.\nCONSOLIDATED EDISONE D\n1937\n48\n44\n40\n38 \n36\n34\n32\nJANUARYF EBRUARYM ARCH APRILM AY JUNE\n29 16 23 30 61 32 02 72 01 01 72 41 81 52 22 95 12 19 2627 361 3\nSales\n100’s\n50\n40\n30\n20\n10\nS S\nH\nS S\nH\nNL\nFigure 6.7 Another 1937 Bull Market Top of Head-and-Shoulders Form, with only one quick Pullback \n(February 10). In this case, volume increased sharply on February 5 with the initial break through \nthe neckline (NL). Measuring formula was satisfied in March. Study this picture in connection with \n“ED’s” long-range chart (Figure 10.4) in Chapter 10; turn back to it later when you come to the \nSupport-Resistance study in Chapter 13.\n51Chapter six: Importan t Reversal Patterns\nREPUBLIC AVIATION RA 1946\nFEBRUARY MARCHA PRIL MAYJ UNE JULY\n29 16 23 29 16 23 61 32 02 74 11 18 25 18 15 22 29 61 32 02 73\nMEASUREMENT\nMEASUREMENT\n24\n22\n20\n19\n18\n17\n16\nS\nH\nH\nS\nS\nS\nSales\n100’s\n250\n200\n150\n100\n50\nFigure 6.8 The six-month-long Head-and-Shoulders Top of Republic Aviation in 1946. Such a pattern \nbecame a possibility to be watched for when prices broke down in May below the level of the February \nhigh (first S). Refer to requirement B. Note also how the Head-and-Shoulders Measuring Formula \n(Chapter 7) is applied to patterns with up-slanting necklines. Minimum downside requirement here \nwas 12 1/2, reached in November. The quick Pullback on July 27 gave a last good selling opportunity.\nDISNEY WALT PRODUCTIOND IS 198656\n52\n48\n44\n15 22 2951 21 92 63 10 17 24 31 71 42 12 85 12 19 26 29 16 23 30 61 32 02 74 11\nMARCH APRILM AY JUNEJ ULY AUGUST SEPTEMBER OCTOBER\nS\nH\nS\nNL\n20787 1.1260\n19066\n20102\n19244\n18056\n17473\nSales\n100’s\n2000\n1600\n1200\n800\n400\nXD. 08 XD. 08\nFigure 6.9 After a sharp reaction from its 1983 high, which lasted a year and pushed “DIS” back to \nlong-term Support, the Bulls took over and sent Walt and friends on a trip to the moon. But beginning \nin April, the rocket began to lose power, and it looked like reentry had begun. Since the big-volume \ndays of spring, this issue etched out a large Head-and-Shoulders Top. High-volume penetration of \nthe neckline by 3% confirmed the Reversal.\n52 Technical Analysis of Stock Trends\nconsequently, a selling level. But you will not see very many formations as perfect and \nsymmetrical as our ideal picture, a fact the several actual examples accompanying this \nchapter amply illustrate. Either shoulder may, in fact, go higher or take more time than the \nother. Either or both may come up nearly to the level of the head (but not equal it, or else no \nHead-and-Shoulders exists) or both may fall considerably short of it. If activity attending \nthe right shoulder is abnormally dull, that shoulder is apt to be low but protracted in \ntime. In general, there seems to be a balanced relation between the three elements of price \npattern, time, and volume that is practically impossible to express in words or figures, but \ncomes with experience to sense in its development. However, there are no laws beyond \nthose stated in our A, B, C, and D of Diagram 6.1; within those limits, look for an infinity \nof minor variations.\nPrice action following confirmation: the measuring formula\nThe final step, the downside penetration of the neckline, may be attended by some increase \nin activity, but it usually is not at first. If volume remains small for a few days as prices drift \nlower, a “Pullback” move frequently ensues that brings quotations up again to the neckline \nlevel (rarely through it). Normally, this is the “last gasp”; prices then turn down quickly, as \na rule, and break away on a sharply augmented turnover. Whether or not a Pullback Rally \nwill occur after the initial penetration seems often to depend on the condition of the market \nin general. If the whole market trend is turning down at the same time as our individual \nissue, which has just completed its Head-and-Shoulders, there will probably be no Pullback; \nNEW YORK CENTRALC N 1945\n32\n30\n28\n26\n24\n22\n71 42 12 851 21 92 62 91 62 33 07 14 21 28 41 11 82 51 81 52 52 9\nSales\n100’s\n500\n400\n300\n200\n100\nAPRIL MAYJ UNEJ ULYA UGUSTS EPTEMBER\nS S\nH\nIUT\nNL\nFigure 6.10 New York Central made a Head-and-Shoulders Top in June 1", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 43}
{"text": "urning down at the same time as our individual \nissue, which has just completed its Head-and-Shoulders, there will probably be no Pullback; \nNEW YORK CENTRALC N 1945\n32\n30\n28\n26\n24\n22\n71 42 12 851 21 92 62 91 62 33 07 14 21 28 41 11 82 51 81 52 52 9\nSales\n100’s\n500\n400\n300\n200\n100\nAPRIL MAYJ UNEJ ULYA UGUSTS EPTEMBER\nS S\nH\nIUT\nNL\nFigure 6.10 New York Central made a Head-and-Shoulders Top in June 1945. Intermediate Up \nTrendline (IUT) was broken by drop from head on July 5. Minimum measuring implication was \ncarried out at 24 on August 18. Reaction ended a few days later at 22 3/4. Prices recovered to projected \nneckline (see September 25), dropped again to 26 7 /8 in October, and then pushed up, giving “rebuy” \nsignal (on Fan Line construction) at 30 in the first week of November. Final Bull Market High was \nmade in January at 35 1/2. The period from August 1945 to February 1946 was difficult for technical \ntraders in this stock. Those who sold at 26–27 in July 1945 could, however, congratulate themselves \nin May 1947 when “CN” hit 12.\n53Chapter six: Importan t Reversal Patterns\nprices instead will tend to accelerate their decline, with activity increasing as they leave the \nvicinity of the Top. If, on the other hand, the general market is still firm, then an attempt \nat a Pullback is likely. Also, the odds seem slightly to favor a Pullback if the neckline has \nbeen broken before much of a right shoulder developed, but certainly no sure rules can \nbe laid down. In any event, the Pullback Rally is of practical interest chiefly to the trader \nwho wants to sell the stock short, or who has sold it short and has then to decide where he \nshould place a stop-loss order.\nNow we come to one of the most interesting features of this basic Reversal Formation—\nthe indication that it gives as to the extent (in points) of the move that is likely to follow \nthe completion of a Head-and-Shoulders. Measure the number of points down vertically \nUNION CARBIDE & CARBON UK\n1929\n136\n128\n120\n112\n104\n96\n88\n76\n72\n68\n64\n80\n61 32 02 73 10 17 24 31 71 42 12 85 12 19 26 29 16 23 30 71 42 12 8\nJULY AUGUSTS EPTEMBERO CTOBER NOVEMBERD ECEMBER\nSales\n100’s\n125\n100\n75\n50\n25\nS\nS S\nS\nH\nFigure 6.11 The great 1929 Bull Market Top was characterized by many impressive Head-and-\nShoulders Formations, of which this is an interesting example. Note the small Head-and-Shoulders \nPattern of September, which became the head of a much larger formation of the same character. The \nPullback of October 9 to the upper neckline afforded a second chance to get out at 128 to those who \ndid not sell immediately when this first line was decisively penetrated on September 28. The larger \npattern “broke” on October 19, with a quick pullback on October 22. Less than a month later “UUK” \nhad lost half its peak value. By 1932 it had fallen to 15 1/2. Although such a catastrophic decline as \n1929–1932 may never come again, the moral is, nonetheless, plain: never scorn a Head-and-Shoulders \nFormation. Patterns such as this merge into the “multiple” types discussed in Chapter 7 . Although \nthis example is selected from the 1929 portfolio, they were not at all uncommon in the mid-20th \ncentury. Several modern examples appear in our later pages.\n54 Technical Analysis of Stock Trends\nFigure 6.12 Dow Jones Industrials, Head-and-Shoulders Top 2007–2008; edwards-magee.com identified this massive Head-and-Shoulders Formation \nin early 2008, after having already exited the market in January 2008 and wrote the following letter. Note “ A low” and “B low”; if this yearlong \nformation is a massive Top (perhaps a double-headed Head-and-Shoulders) and A low is its lower boundary, then a low of 9680 is predicted. If B \nlow is the defining point, the predicted low is 10836. Remember Niels Bohr and the difficulty of forecasting? Again, it is not necessary to believe this \nscenario to know how to bet. The Dow is in a six-month downtrend, the last 2 1/2 months of which are sideways, with lower highs in the sidetrend. \nThe low of 9680 is a probable minimum. Mark Hulbert says Richard Band is predicting a 16000 Dow. Watch out for low flying eggs (as in getting \negg on your face). Then the Dow went to 6469.95 in the great Bush Bear Market.\n55Chapter six: Importan t Reversal Patterns\nfrom the Top of the head to the neckline as drawn in Figure 6.4. Then measure the same \ndistance down from the neckline at the point at which prices finally penetrated it following \nthe completion of the right shoulder. The price level thus marked is the minimum probable \nobjective of the decline.\nLet us hasten to state one important qualification to the Head-and-Shoulders Measuring \nFormula. Refer back to our original set of specifications for a Head-and-Shoulders. Under \nA, we required “strong rally climaxing a more or less extensive advance.” If the up-move \npreceding the formation of a Reversal Area has been small, the down-move following \nit may—in fact, probably will—be equally small. In brief, a Reversal Pattern has to have \nsomething to reverse. So, we really have two minimums: one being the extent of the \nadvance preceding the formation of the Head-and-Shoulders and the other derived from \nour measuring formula, whichever is the smaller will apply. The measuring rule is indicated \non several of the examples that illustrate this chapter. You can see now why a down-sloping \nneckline indicates a “weaker” situation than an up-sloping neckline, and just how much \nweaker, as well as the fact that more than half of the minimum expected weakness has \nalready been expended in the decline from the top of the head to the penetration of the \nneckline.\nThe maximum indications are quite another matter, for which no simple rules can be \nlaid down. Factors that enter into this are the extent of the previous rise, the size, volume, \nand duration of the Head-and-Shoulders Formation, the general market Primary Trend \n(very important), and the distance that prices can fall before they come to an established", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 44}
{"text": "e head to the penetration of the \nneckline.\nThe maximum indications are quite another matter, for which no simple rules can be \nlaid down. Factors that enter into this are the extent of the previous rise, the size, volume, \nand duration of the Head-and-Shoulders Formation, the general market Primary Trend \n(very important), and the distance that prices can fall before they come to an established \nSupport Zone. Some of these are topics for later discussion.\nRelation of Head-and-Shoulders to Dow Theory\nWithout doubt, some readers have already suspected the Head-and-Shoulders Pattern is, \nin a sense, just an adaptation of the principles of Dow Theory to the action of an individual \nstock. So it is. The decline of prices from the head to the neckline, the rally to the right \nshoulder, and then the ensuing decline that breaks the neckline set up a sequence of lower \nTops and Bottoms analogous to those that signal a downtrend in Dow Theory. This logical \nrelation of the Head-and-Shoulders to Dow Theory is another reason, in addition to its \nbasic importance, frequency, and dependability, why we have placed it first in our study of \nReversal Formations. But it also is more definite, gives advance warnings that are relatively \neasier to detect, and is quicker with its signals in the case of up-sloping necklines. Moreover, \nit requires no specified minimum time for any of its component moves, and no confirmation \nby another stock or Average.\nThere are Head-and-Shoulders Bottoms (EN: An undescriptive term for a bottom formation \nthat I would prefer to call the “Kilroy Bottom.” See Fig u r e 7.4.) as well as Tops, with equally \nimportant implications. The Bottom Formations will be taken up in our next chapter.\n\n57\nchapter seven\nImportant Reversal Patterns: continued\nHead-and-Shoulders (EN: or Kilroy) Bottoms\nA formation of the Head-and-Shoulders type may develop at an important Reversal of \nTrend from down to up. In that case, it is called a Head-and-Shoulders Bottom, and its \nprice pattern (as compared with a Top) is turned upside down, that is, it stands on its \nhead. EN: The present Editor has always been impatient with the undescriptive nature of the term \n“Head-and-Shoulders Bottom,” and so he has renamed it the “Kilroy Bottom.” See Figure 7.4. The \nvolume pattern is somewhat the same (not turned upside down) as at a Top but with some \nimportant changes in the latter half of the formation, which we shall discuss in detail. We \ncan lay down specifications for it in much the same words as we used for the Head-and-\nShoulders Top. Here they are, with the portions that differ in principle from the Top printed \nin italics (see Figures 7.1 through 7. 2 5):\n A. A decline, climaxing a more or less extensive downtrend, on which trading volume \nincreases notably, followed by a Minor Recovery, on which volume runs less than \nit did during the days of final decline and at the Bottom. This is the “left shoulder.” \nEN9: Or left hand.\n B. Another decline that carries prices below the Bottom of the left shoulder, on which \nactivity shows some increase (as compared with the preceding recovery) but usually \ndoes not equal the rate attained on the left-shoulder decline, followed by another recovery \nthat carries above the Bottom level of the left shoulder and on which activity may pick \nup, or at any rate exceed that on the recovery from the left shoulder. This is the “head.” EN9: \nOr nose.\n C. A third decline on decidedly less volume than accompanied the making of either the \nleft shoulder or head, which fails to reach the low level of the head before another \nrally starts. This is the “right shoulder.” EN9: Or right hand.\n D. Finally, an advance on which activity increases notably , which pushes up through the \nneckline (EN9: Or fenceline) and closes above by an amount approximately equivalent \nto 3% of the stock’s market price, with a conspicuous burst of activity attending this \npenetration. This is the “confirmation” or “breakout.”\nThe essential difference between Top and Bottom Patterns, you can see, lies in their \nvolume charts. Activity in Head-and-Shoulders Bottom Formation usually begins to show \nuptrend characteristics at the start of the head and always to a detectable degree on the \nrally from the head. It is even more marked on the rally from the right shoulder. It must be \npresent on the penetration of the neckline, or else the breakout is not to be relied on as a decisive \nconfirmation.\nAn important basic principle of techniques that is involved here merits further \ndiscussion. Wall Street has an old saying that expresses it: “It takes buying to put stocks \nup, but they can fall of their own weight.” Thus, we trust, and regard as conclusive, any \nprice break (by a decisive margin) down through the neckline of a Head-and-Shoulders Top \n58 Technical Analysis of Stock Trends\neven though it occurs on a light turnover, but we do not trust a breakout from a Head-and-\nShoulders Bottom unless it is definitely attended by high volume. A low-volume breakout \nfrom a Bottom Pattern may only be premature, to be followed after more “work” around the \nBottom levels by a genuine advance, or it may be a “false” move entirely. It pays generally \nto wait and see. This same distinction in volume development applies to some of the other \nReversal Patterns we shall take up later in this chapter.\nOther differences between Top and Bottom Head-and-Shoulders do not involve any \nnew principles. It can be said that Bottoms are generally longer and flatter, that is, they \ntake more time in relation to depth of pattern in points than do Tops. This is particularly \ntrue when they occur at Reversals in the Primary Trend. The overall volume at Bottoms \ntends to be less than at Tops, and the turns tend to be more “rounded.” In the construction \nof a Head-and-Shoulders Top, the activity that goes into the left shoulder usually exceeds \nthat on any preceding rally in the entire uptrend. In a downtrend, on the other hand, \nthere may", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 45}
{"text": "do Tops. This is particularly \ntrue when they occur at Reversals in the Primary Trend. The overall volume at Bottoms \ntends to be less than at Tops, and the turns tend to be more “rounded.” In the construction \nof a Head-and-Shoulders Top, the activity that goes into the left shoulder usually exceeds \nthat on any preceding rally in the entire uptrend. In a downtrend, on the other hand, \nthere may be Panic Selling in some of the earlier phases of decline, which runs the volume \nchart up to a mark higher than any that is subsequently registered in the final Bottom \nFormation. None of these differences, however, affects our essential Head-and-Shoulders \nspecifications.\nThe measuring implications of the Head-and-Shoulders Bottom are the same in all \nrespects and are applied in the same way as with Tops. Tendency toward symmetry is \nagain the rule, with variations as to slope of neckline, relative size of shoulders about the \nsame as in Tops. Reactions to the neckline following the initial breakout from the Bottom \ntype appear in about the same frequency and proportions as do the Pullback Rallies, which \nfollow the initial breakdown from the Top type.\nLOCKHEED AIRCRAFT LK\n1943–1944\n18\n17\n16\n15\n14\n13\n29 16 23 30 61 32 02 74 11 18 25 18 15 22 29 51 21 92 64 11 18 25\nOCTOBERN OVEMBERD ECEMBERJ ANUARY FEBRUARY MARCH\nS\nS S\nS\nH\nH\nSales\n100’s\n125\n100\n75\n50\n25Figure 7.1 After “rounding over” in October 1943 in the last phase of a long decline from 41 in \n1940, Lockheed made a conspicuous two-month Head-and-Shoulders Bottom. Note especially, on \nthe above chart, the volume on the rally in early December and in the first week of January with \nreference to points B and D on the preceding pages. “LK” dropped back to 15 again in June 1944, \nand then ran up quickly to 23 by November, finally reaching 45 in January 1946. One advantage of \nlogarithmically scaled charts is they expand, and thus call attention to important formations that \ndevelop at low price levels, and that would be obscured on an arithmetic scale.\n59Chapter seven: Importa nt Reversal Patterns: continued\nMultiple Head-and-Shoulders Patterns\nThe Head-and-Shoulders Formations we have examined up to this point have been, \ndespite minor variations, relatively simple and clear-cut, consisting of three well-defined \nelements. We come now to a group of related patterns that carry much the same technical \nsignificance but have more elements and are much less clearly defined. These are the \nMultiple Head-and-Shoulders Tops and Bottoms, also known as Complex Formations. \nWe need not take much of our space to define or lay down specifications for them, as \nthey may be described quite sufficiently as Head-and-Shoulders Reversals in which \neither the shoulders or the head, or both, has been doubled or proliferated into several \ndistinct waves.\nAlmost any combination is possible, of which only a few can be illustrated in the \nactual chart examples reproduced in this chapter. Formations of this type appear with \nfair frequency at Primary Bottoms and Tops, but more often at Bottoms than at Tops. They \nappear less frequently at Intermediate Reversals.\nDOME MINES DM 1941–1943\n19\n18\n17\n16\n15\n14\n13\n12\n11\n10\n9\nSO ND JF MA MJ JO ND JF MAS\nS S\nH\nNL\nSales\n100’s\n125\n100\n75\n50\n25Figure 7.2 Weekly charts are particularly useful for detecting Major Bottom Reversals because \nBottom Formations characteristically take longer to build than Tops. Dome Mines made a typical \nHead-and-Shoulders base, 13 months’ long, at its Primary Trend Reversal in 1942. Note the volume \npattern. (Volume detail, however, is better studied on daily charts.) Dome’s powerful Head-and-\nShoulders Bottom was “high” enough to be conspicuous on an arithmetic monthly chart. It reached \n25 in 1944.\n60 Technical Analysis of Stock Trends\nA common form consists of two left shoulders of approximately equal size, a single \nhead, and then two right shoulders, again, of approximately even size and balancing the \ntwo on the left. Another is made up of two heads with two or more shoulders on either \nside. Still another form, of which you will usually find several good examples at any Major \nMarket Turn, consists of double shoulders on either side of a head, which is itself composed \nof a small but quite distinguishable Head-and-Shoulders development.\nFEDERAL NATIONAL MORTGAGE ASSN. FNM 1984\nMAYJ UNE JULY AUGUSTS EPTEMBER OCTOBERN OVEMBER\n51 21 92 62 91 62 33 07 14 21 28 41 11 82 51 81 52 22 96 13 20 27 31 01 72 4\nS\nH\nS\nNL\n20\n19\n18\n17\n16\n15\n14\n13\n12\n11\nSales\n100’s\n4000\n3200\n2400\n1600\n800\nX D .04 X D .04\nFigure 7.3 With a strong movement toward lower interest rates evident since June, the timing of the \nlow in “FNM” is not surprising. Neither is the massive width (from March through October) of its \nevolving pattern, which closely matches that of the huge, complex Inverse Head-and-Shoulders Bottom \nin Treasury Bills (December 1984), September 25, 1984. Even the slight timing lag is appropriate.\nFigure 7.4 EN: At the risk of being considered a comic (actually, a satirist), I suggest that, although the image \nis comical, the pattern is more descriptive of the incongruously named “Head-and-Shoulders Bottom” than the \npresent terminology. Left hand equals left shoulder, right hand equals right shoulder, nose equals head, and \nneckline equals fence line, or, as easily, neckline. I am teaching all of my students to think and use these terms, \nwhich makes much more sense than the absurd “upside down Head-and-Shoulders Bottom standing on its head.” \nOne hundred years from now, this contribution to the nomenclature will be accepted as totally descriptive and \nappropriate, and the term “Head-and-Shoulders Bottom” will have disappeared from the lexicon.\n61Chapter seven: Importa nt Reversal Patterns: continued\nTendency to symmetry\nWe have mentioned the tendency toward symmetry in the simple Head-and-Shoulders \nFormation. Patterns of the Multiple or Complex type show an even stronger urge toward \nsymmetry—so strong, in fact,", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 46}
{"text": "ted as totally descriptive and \nappropriate, and the term “Head-and-Shoulders Bottom” will have disappeared from the lexicon.\n61Chapter seven: Importa nt Reversal Patterns: continued\nTendency to symmetry\nWe have mentioned the tendency toward symmetry in the simple Head-and-Shoulders \nFormation. Patterns of the Multiple or Complex type show an even stronger urge toward \nsymmetry—so strong, in fact, that it may be counted on in determining trading policy. If \nthere are two shoulders on the left, there are almost always two on the right of nearly the \nsame size and duration. (One does not know that a Multiple is in the process of formation \nuntil its right shoulder becomes evident.) Except in volume, the right-hand half of the \npattern is, in the great majority of cases, an approximate mirror image of the left.\nNecklines on Multiple Head-and-Shoulders Formations are not always easy to draw \nbecause the reactions between the shoulders and heads may not stop at levels that all fall \non a single line. Up-sloping and down-sloping variants seldom appear in this class of \npatterns; necklines are almost always very close to the horizontal. Sometimes, it is possible \nto estimate by simple inspection where the critical line really lies. More often, there are two \nnecklines, an inner and an outer, and no price movement of consequence is to be expected \nuntil the outer has been penetrated (which is simply another expression of that tendency \ntoward symmetry referred to above).\nCuriously enough, the “power” of a Multiple Head-and-Shoulders Pattern is more apt \nto be over rather than underestimated. One might think, in view of the length of time and \n10300.00 \n9847.00 \n9414.00 \n9000.00 \n8604.00 \n8226.00 \n7864.00 \n7518.00 \nF M A M J J A S O N D 03 F M A M J J A S 02 \nCreated with TradeStation \n9082.64 Fenceline–Neckline\nHand \nNose \nHand \n$INDU - Daily US L= 10125 .40 –114 .52 –1 .12% O= 10239.84 C= 10125.40 \n10125.40 \nFigure 7.5 A ragged Kilroy (or, if from the old school, a Head-and-Shoulders) Bottom that ended the \nBear Market (or first phase thereof) of 2001–2002. Some seven and a half months in formation it threw a \nfew knuckle balls and curves and looked right up to March 2003 as though it were a Bear Market rally. \nOnce the neckline was taken out, there was no arguing with it—it was a real Bottom. It balked at the \nneckline for a couple of months before becoming a full Bull. Complex economic and political realities \naffected the markets: the terrorist attacks of September 11, 2001, which put paid to the tulipomania of \nthe roaring 1990s and the ill-advised tax cuts of the Bush Jr. administration. Using the formula of cut \ntaxes and increase spending to start a war, the market was sufficiently stimulated to rally exuberantly. \nThe downtrend line is drawn here and the reader should have no trouble seeing the break of the \nlong-term downtrend as well as the Kilroy Bottom demanded a shifting of gears from Bear to Bull.\n62 Technical Analysis of Stock Trends\nM C A INCORPORATED MCA 1986 68 \n64 \n60 \n56 \n52 \n48 \n44 \nS \nH H \nS S \nS \nNL \nFEBRUARY MARCH APRIL MAY JUNE JULY AUGUST \n8 15 22 1 8 15 22 29 5 12 19 26 3 10 17 24 31 7 14 21 28 5 12 19 26 2 9 16 23 30 \nSales\n100’s\n2000 1600 \n1200 800 \n400 \nFigure 7.6 “MCA” enjoyed an excellent advance from 1980 to 1986, but the going became increasingly \ndifficult after the turn of the year, when this issue began to challenge its 1985 high. Although the \nBulls did manage to set a new high-water mark in April, a series of Pullbacks kept this issue well \naway from any further tests. Indeed, a large Complex Head-and-Shoulders Top appeared to be \nunfolding with the Major Neckline penetrated slightly on the sell-off.\nBUDD MANUFACTURING\n1945–194626\n24\n22\n20\n19\nS H H\nS\nS\nH\nH\nS\nBF\nDECEMBERJ ANUARY FEBRUARY MARCHA PRIL MAY\n18 15 22 29 51 21 92 62 91 62 32 91 62 33 0613 20 27 41 11 82 5\nNL\n125\n100\n75\n50\n25\nSales\n100’s\nFigure 7.7 An “ideal” Multiple Top made by Budd in 1946, with two heads. Observe accompanying \nvolume. Prices often break away from Complex Formations more reluctantly than from the simple \nHead-and-Shoulders type. The late-March rally, which went back through the old neckline, was greater \nthan normal in that respect, but the general market Averages were pushing to new highs at this time. \nRepenetration of a neckline does not, of itself, cancel the implications of a Reversal Formation.\n63Chapter seven: Importan t Reversal Patterns: continued\nAMERICAN LOCOMOTIVE LA 1946\n40\n38\n36\n34\n32\n30\n28\n26\nAPRILM AY JUNE JULY AUGUST SEPTEMBER\n61 32 02 74 11 18 25 18 15 22 29 61 32 02 73 10 17 24 31 71 42 12 8\n125\n100\n75\n50\n25\nG G\nSales\n100’s\nRL\nSIL\nFigure 7.8 The long Multiple Head-and-Shoulders Top made by American Locomotive in 1946 \ndisplays very well the sort of volume pattern—irregular but taking on definitely Bearish character in \nits latter half—that is normal to this formation. The rounded Bear Market Rally of August (compare \nprice and volume trends) was unable to attain the old neckline and was stopped at a Resistance \n(RL) created by earlier Bottom levels (see Chapter 13). G and G mark Breakaway Gaps that were not \n“covered” (see Chapter 12).\nDIGITAL EQUIPMENT CORPORATIOND EC 1985\n136\n128\n120\n112\n104\n96\n88\n80\nMARCH APRIL MAY JUNE JULY AUGUST SEPTEMBER\n91 62 33 06 13 20 27 41 11 82 51 81 52 22 96 13 20 27 31 01 72 43 17 14 21 28 5\nSS\nS\nS\nH\n40003200\n2400\n1600800\nSales\n100’s\nNL\nFigure 7.9 From a Head-and-Shoulders Top in February, Digital plunged sharply lower into mid-\nJune, retracting roughly two-thirds of the 1983–1985 advance. The summer low was the head of a \nBroad, Complex Head-and-Shoulders (EN: Or Kilroy) Bottom. “DEC,” however, had already enjoyed \na high-volume penetration of the neckline and was, therefore, in a buying position.\n64 Technical Analysis of Stock Trends\nGENERAL BRONZ EG LZ 1945\n28\n26\n24\n22\n20\n19\nJULY AUGUST SEPTEMBER OCTOBERN OVEMBER DECEMBER\n71 42 12 841 11 82 51 81 52 22 96 13 20 27 31 01 72 41 81 52 12 8\n50\n40\n30\n20\n10\nXD 20 ¢\nXD 20 ¢\nSales\n1", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 47}
{"text": "ex Head-and-Shoulders (EN: Or Kilroy) Bottom. “DEC,” however, had already enjoyed \na high-volume penetration of the neckline and was, therefore, in a buying position.\n64 Technical Analysis of Stock Trends\nGENERAL BRONZ EG LZ 1945\n28\n26\n24\n22\n20\n19\nJULY AUGUST SEPTEMBER OCTOBERN OVEMBER DECEMBER\n71 42 12 841 11 82 51 81 52 22 96 13 20 27 31 01 72 41 81 52 12 8\n50\n40\n30\n20\n10\nXD 20 ¢\nXD 20 ¢\nSales\n100’s\nFigure 7.11 An Intermediate Bottom of the Complex class, abnormal in its lack of symmetry but, \nnonetheless, easy to recognize. Low volume on reactions after the Head was completed gave the \nusual (and essential) Bullish Confirmation. The sluggish start of the new trend was a common feature \nof Multiple Head-and-Shoulder Reversals.\nARCHER DANIELS MIDLAND CO.A DM 1984\nARCHER DANIELS MIDLAND\n38\n36\n34\n32\n30\n28\n26\n24\n22\n20\n19\n18\n17\n16\n15\nMARCHA PRIL MAY JUNE JULY AUGUST SEPTEMBER OCTOBERN OVEMBERD ECEMBER\n17 24 31 71 42 12 85 12 19 26 29 16 2330 71 42 12 84 11 18 25 18 15 22 29 61 32 02 73 10 17 24 18 15 22 29\n400032002400\n1600800 XD.035 XD.035 XD.0355 % STK.\nS\nS\nS S\nH\nNL\n30\n25\n20\n15\n10\n5\n77 78 79 80 81 82 83 84\nSales\n100’s\nFigure 7.10 After testing its 1980 high in mid-1983, “ ADM” turned sharply lower, retracing roughly \n40% of the 1982–1983 advance by mid-1984. The summer low, however, appeared to be a Bottom. \nIndeed, if one looked at the volume pattern from April to November and correlated it with price \nactivity, it was not difficult to make a good case for a Complex Head-and-Shoulders Bottom. A \nneckline through the closes gave us a go signal on a penetration of 20 5/8.\n65Chapter seven: Importa nt Reversal Patterns: continued\namount of trading entering into its construction, that it would signal a move (in reverse \ndirection to the trend preceding it) of greater extent than the simple Head-and-Shoulders. \nYet, in its immediate consequences, at least, the Complex shows consistently less power. \nMinimum measuring rules for the two types of formations are the same and are applied in \nthe same manner. The difference between the patterns appears in the price action after the \nminimum has been reached. The first downswing out of a plain Head-and-Shoulders Top, \nnot counting any early Pullback Rally, will frequently carry out the minimum measuring \nimplications of that pattern quickly and run well beyond it. From a Multiple Top, the first \ndownswing is often more leisurely, and very seldom does it exceed the bare minimum—a \nprobability well worth remembering when you are dealing with an Intermediate rather \nthan a Primary Top. If the Complex does develop at a turn in the Primary Trend, prices \nwill eventually go much farther; however, even then, there is usually a strong recovery (or \nreaction, in the case of a Bottom) from the “minimum rule” level.\nA leisurely pattern\nThe volume attending the construction of Multiple Head-and-Shoulders conforms in general \nto the “laws” we have previously stated and explained for simple Head-and-Shoulders \nReversals. During the earlier stages of Multiple Formation development, the volume chart \nmay show much irregularity with little recognizable pattern, but in the latter stages, its \ncorrespondence with the Head-and-Shoulders Trend should be plainly seen.\nThere is something about Multiple Head-and-Shoulders Patterns that is especially \npleasing to technical chart followers. Due to their symmetrical tendencies, it is fascinating \nto watch them evolve to completion. Once completed, however, they may try your patience \nby their seeming reluctance to “get going” with a new trend. On that account, it becomes \nAMDAHL CORPORATIONA MH 1985\n15\n14\n13\n12\n11\nAPRIL MAY JUNEJ ULYA UGUST SEPTEMBERO CTOBER\n33 06 13 20 27 41 11 82 51 81 52 22 96 13 20 27 31 01 72 43 17 14 21 28 51 21 9\n2000\n1600\n1200\n800\n600\nS S\nS\nH\nNL\nXD.0 X5D .05\nSales\n100’s\nS\nFigure 7.12 The slide in Amdahl occupied the Bears from March to June before a sharp rally gave \nnotice that the Bulls were still alive. After that, a choppy sideways trading range evolved with \nSupport near the Pullback lows established earlier in the year. Overall, there was a fine symmetry \nto this chart, including volume, which indicated the price action from March to September was \nactually a Broad Head-and-Shoulders Bottom. Entry was on a 3% breakout of the neckline with a \nminimum objective of 19 3/4.\n66 Technical Analysis of Stock Trends\neasy at times to jump to the conclusion that they have “blown out,” that is, produced a false \nsignal. Actually, except in the matter of extent of move, which we have already discussed, \nthey are fully as reliable as the plain Head and Shoulders. False moves are relatively rare \nwith both. And in those extraordinary cases when a Complex Formation does go wrong, it \nstill stands, like the plain Head-and-Shoulders, as a warning that the final Reversal is near.\nRounding Tops and Bottoms\nThe Multiple Formations we have just examined are produced by a sort of extension or \nproliferation of the ordinary Head-and-Shoulders Pattern. Carry this process still further \nand the Complexes merge into our next class of Reversals, known as Rounding Turns.\nPUBLIC SERVICE CORP. OF N. J. P J\n1941–1943\n20\n19\n18\n17\n16\n15\n14\n13\n12\n11\n10\nSO ND JF MA MJ JA SO ND JF M\n1000\n800\n600\n400\n200\nS\nS H\nS\nS\nSales\n100’s\nFigure 7.13 Another variant of the Head-and-Shoulders within a Major Reversal Formation. The \nsmaller Head-and-Shoulders Pattern was easily overlooked on the daily chart. Moreover, although \nit was six months long, this pattern in itself did not necessarily imply Primary Reversal. Although, \nwhen it pushed “PJ’s” prices up in October through the great supply that had been lodged at 12–13 \nthe previous December, something more than a Secondary Advance could obviously be in prospect. \nAn up-move of consequence was not finally signaled, though, until February 1943 when the upper \nneckline was penetrated and prices closed at 14. Public Service “threw back” to 12 in November 1943 \n(to the old neckline exactly), but t", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 48}
{"text": "up in October through the great supply that had been lodged at 12–13 \nthe previous December, something more than a Secondary Advance could obviously be in prospect. \nAn up-move of consequence was not finally signaled, though, until February 1943 when the upper \nneckline was penetrated and prices closed at 14. Public Service “threw back” to 12 in November 1943 \n(to the old neckline exactly), but then advanced steadily to 30. Study this again when you take up \nSupport and Resistance in Chapter 13. This chart reiterates the point that, whereas Top Formations \nare often completed in a relatively short time, Major Bottoms usually require many months, and call \nfor a great deal of patience. Allowing for the greater time needed, however, most Top Patterns have \ntheir counterparts in Bottom Formations.\n67Chapter seven: Important R eversal Patterns: continued\nIn our first approach to the theory of chart Reversal Patterns, we saw why it takes \ntime and a considerable volume of trading to swing an established trend in prices from \nup to down or down to up. In the Head-and-Shoulders type of Reversal, the trend surges, \nstruggles, and attacks again and again before it finally gives up and retreats. During this \nstruggle, the balance between the forces of supply and demand fluctuates, often wildly, \nNATIONAL SUPPLY NS 1946\nAPRIL MAY JUNEJ ULY AUGUST SEPTEMBER\n61 32 02 74 11 18 25 18 15 22 29 61 32 02 73 10 17 24 31 71 42 12 8\n24\n22\n20\n19\n18\n17\n16\n15\n14\n125\n100\n75\n50\n25\nSales\n100’s\nFigure 7.14 Still another form the Complex Reversal may take. This can be described as a Head-and-\nShoulders Pattern with two widely separated heads. Study its volume pattern, noting the breakout \non June 20 and the subsequent Pullback. Compare it with Bethlehem Steel’s Bottom Reversal shown \nin Chapter 12, Figure 12.12.\nPHILIPS PETROLEUM P1 946\nAPRIL MAYJ UNE JULY AUGUST SEPTEMBER\n61 32 02 74 11 18 25 18 15 22 2961 32 02 73 10 17 24 31 71 42 12 8\n72\n68\n64\n60\n56\n125\n100\n75\n50\n25\nG\nSales\n100’s\nFigure 7.15 Major Top Reversal Patterns in high-priced investment issues are frequently long and \n“flat.” The 1946 Top of Phillips Petroleum could be classified as either a Multiple Head-and-Shoulders \nor an irregular Rounding Top. An important trendline (see Chapter 14) was broken downside in July.\n68 Technical Analysis of Stock Trends\nuntil finally the one overcomes the other. In the Multiple Formations, a similar process \ngoes on but rather less violently and, over a period of time, the progressive change from \none force to the other becomes clearly apparent.\nThe Rounding Turn is a much simpler and more logical manifestation of this technical \nphenomenon. It pictures simply and plainly a gradual, progressive, and fairly symmetrical \nchange in the trend direction, produced by a gradual shift in the balance of power between \nbuying and selling.\nIf, for example, the buying has been stronger than the selling for some time past, we \nknow the result will have been a general upward trend in the price of our stock, as indicated \nby our pictorial chart record of its trading history. So long as the buyers of the stock remain \nmore anxious, more numerous, more aggressive, and more powerful than the sellers, that \npreceding upward trend will continue. Now, suppose the selling grows a little stronger \nwhile the buying either weakens slightly or remains stationary at its previous strength; \nthis slight change in the technical balance will be indicated by a slowing up of the previous \nadvance. As the selling increases in relative power, it will finally become equal to the buying \npower, with the result of the market level neither moving up nor down but remaining, for \na time, quite stationary (except for Minor and insignificant fluctuations).\nAssume the new development continues and the selling pressure grows until it is \nfinally stronger than buying power. Now the balance is moving the other way. There \nare now more sellers than buyers, and the result will be a gradual decline in the market \nquotations for the stock. If this change in the balance of power is fairly steady and continues \nto its logical conclusion, we can see, even without the aid of a chart, that our picture of the \nprice movement for that stock would be one of a long advancing trend slowly beginning \nto round off, holding in stationary suspense for a time, and then commencing a retreat, \nreversing the previous upward movement into a new and Accelerating Downward Trend.\nAMERICAN & FOREIGN POWER 2d PFD. A FPD Pr\n1945\nJULY AUGUSTS EPTEMBERO CTOBER NOVEMBERD ECEMBER\n71 42 12 841 11 82 51 81 52 22 96 13 20 2731 01 72 41 81 52 22 9\n40\n38\n36\n34\n32\n30\n28\n26\n125\n100\n75\n50\n25\nSales\n100’s\nFigure 7.16 The war-end reaction of 1945 in American & Foreign Power 2d Preferred, as well as in \nmany other issues, took the form of a Rounding Bottom. Compare the price and volume trends. By \nOctober 4, the implications were plain to see.\n69Chapter seven: Importa nt Reversal Patterns: continued\nRounding Bottoms are commonly referred to as Bowl or Saucer Patterns. Rounding \nTops are sometimes called Inverted Bowls. Despite the logic of their construction, neither \ntype appears as frequently as Head-and-Shoulders Formations. Rounding Bottoms occur \nmost often in low-priced stocks, in an extended, flat-bottomed form that usually takes many \nmonths to complete. There was a host of such developments during 1942 and 1943 among \nissues selling under $10.00 a share. (It should be noted here that “Saucer” Bottoms of two \nor three months’ duration also appear frequently, one right after another, in the charts of \nlow-priced issues during an extended up-movement. Their characteristics and denotations \nwill be discussed in the section “Consolidation.”)\nTops of the Rounding type are rare among stocks in the lower and medium-price \nranges, but they are found occasionally in the charts of those high-priced common stocks \nthat command an AA rating among wealthy investors and do not ordinarily interest the \ngeneral publi", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 49}
{"text": "ed issues during an extended up-movement. Their characteristics and denotations \nwill be discussed in the section “Consolidation.”)\nTops of the Rounding type are rare among stocks in the lower and medium-price \nranges, but they are found occasionally in the charts of those high-priced common stocks \nthat command an AA rating among wealthy investors and do not ordinarily interest the \ngeneral public. They also appear frequently in the charts of high-grade preferred stocks, \nquite naturally because the demand for their shares reflects chiefly two factors—supply of \nfunds seeking conservative investment and interest rates—both of which tend to change very \nslowly. The speculative appeal that produces wide-swinging price fluctuations is absent in \nsuch issues. The same line of reasoning explains why Rounding Tops almost never develop \nAMERICAN SAFETY RAZORA RZ\n20 \n15 \n10 \n5 \n1931 1932 1933 1934 1935 1936 1937 1938 1939 1940 1941 1942 1943 1944 1945 1946 \n3/1 SPLIT \n3/1 SPLIT \nFigure 7.17 Monthly chart on an arithmetic scale. American Safety Razor’s 1932 Major Bottom was a \nHead-and-Shoulders and also its 1936 Bull Top. Its 1942 to 1946 Bull Market started from a Rounding \nBottom nearly two and a half years long. Monthly chart study pays.\n70 Technical Analysis of Stock Trends\nin lower priced, speculative common stocks; Bull Markets in those stocks are topped off by \nexcited public buying that pays little or no heed to long-range investment considerations.\nHow Rounding Turns affect trading activity\nWe have not yet mentioned the volume half of the Rounding Turn picture, which is interesting, \nas well as meaningful. In the case of Rounding Bottoms, its pattern is usually as clean-cut \nand decisive as the price pattern. The first step in the gradual conquest of supply by demand, \nwhich produces a Rounding Bottom, appears as a lessening in selling pressure. Volume, \nwhich has been running high, gradually decreases. Demand is still timid, but the pressure \non it is less; so, while prices still decline, the pace is slower and the trend curves more and \nmore to the horizontal. At the Bottom, with the two forces technically in balance, relatively \nfew transactions are recorded. Then demand begins to increase, and as the price curve turns \nup, trading becomes more active. Volume accelerates with the trend until often it reaches a \nsort of climactic peak in a few days of almost “vertical” price movement on the chart.\nIn such formations, the tips of the volume lines at the bottom of the chart, when \nconnected, will describe an arc that often roughly parallels the arc formed by the price \nBUDD CO. BF 30 \n20 \n10 \n1938 1939 1940 1941 1942 1943 1944 1945 1946 \nSales\n100’s\nFigure 7.18 Monthly chart of Budd Company. Note that 1942 was the first year to produce a dull \nSaucer-Shaped Pattern, a Rounding Bottom of Major import. “BF” climbed from below 3 in 1942 to \nabove 26 in 1946.\nCERTAIN–TEED PRODS. CT\n30\n20\n10\n100\n50\n1938 1939 1940 1941 1942 1943 1944 1945 1946\nSales\n100’s\nFigure 7.19 Similar formation in CertainTeed Products, which rose from below 2 in 1942 to above 25 \nin 1946. Study volume, 1940 to 1945. The up-curving type of Major Bull Trend shown on these charts \nwill be discussed in Chapter 15.\n71Chapter seven: Importan t Reversal Patterns: continued\n“Bowl” above. These patterns, when they occur after an extensive decline, are of outstanding \nimportance, for they nearly always denote a change in Primary Trend and an extensive \nadvance yet to come. That advance, however, seldom carries in a “skyrocket” effect, which \ncompletes the entire Major Move in a few weeks. On the contrary, the uptrend that follows \nthe completion of the pattern itself is apt to be slow and subject to frequent interruptions, \ntiring out the impatient trader, but yielding eventually a substantial profit.\nLet us repeat that trading volume should ebb to an extreme low at the Bottom of a \nBowl Pattern if its implications are to be trusted. After prices have passed dead center, \nhowever, and have begun their first gradual climb with as yet only a slight pickup in \nactivity, something in the nature of a premature breakout may occur. Without warning, \na burst of buying may shoot quotations straight up for a day or two. These incidents are \nby no means rare, but, almost invariably, prices will quickly drop back again into their \nformer channel, and the gradual rounding movement is resumed. There is no particular \ndanger for the trader in these premature bursts, but if he is tempted to jump in on such a \nsudden showing of strength, he should realize there probably will still be need for patience. \nA classic example of this type of premature break is shown in Fig u r e 7. 20.\nSee Chapter 16 for some very important 2005 rounding bottoms and their consequences \nup to 2011.\nJ. I. CASE J I 1932\nMARCHA PRILM AY JUNE JULY\n20 27 51 21 92 62 91 62 33 071 42 12 84 11 18 25 29 16 23 30 61 3\n60\n50\n40\n30\n20\n10\n800600\n400\n200\nSales\n100’s\nFigure 7.20 A classic example of Rounding Bottom at the Major Trend Reversal of 1932. The jump \nout of line on June 10 and subsequent return to the Saucer Pattern is a common development in \nRounding Bottoms.\n72 Technical Analysis of Stock Trends\nGAMEWELL CO. GAC1 944\nJANUARY FEBRUARY MARCH APRILM AY JUNE\n81 52 22 95 12 19 26 41 11 82 51 81 52 22 96 13 20 2 731 01 72 41\n42\n40\n38\n36\n34\n32\n30\n28\n26\n25\n20\n15\n10\n5\nSales\n100’s\nFigure 7.21 An extreme case of Dormant Bottom. There were many days in the first four months \nduring which no shares were traded. A “buy” signal appeared on April 26. Note the volume.\nINLAND STEEL IAD\nJANUARYF EBRUARYM ARCH APRILM AY JUNE\n51 21 92 62 91 62 32 91 62 33 061 32 02 74 11 18 25 18 15 22 29\n1935\nG\n68\n64\n60\n56\n52\n48\n44\n50\n40\n30\n20\n10\nSales\n100’s\nFigure 7.22 The March 1935 reaction produced many Rounding Bottoms. This one verges on the \ndormant type. The gap (G), a Breakaway through a Resistance Level, was not closed until late 1937 \n(see Chapter 12).\n73Chapter seven: Importa nt Reversal Patt", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 50}
{"text": "F EBRUARYM ARCH APRILM AY JUNE\n51 21 92 62 91 62 32 91 62 33 061 32 02 74 11 18 25 18 15 22 29\n1935\nG\n68\n64\n60\n56\n52\n48\n44\n50\n40\n30\n20\n10\nSales\n100’s\nFigure 7.22 The March 1935 reaction produced many Rounding Bottoms. This one verges on the \ndormant type. The gap (G), a Breakaway through a Resistance Level, was not closed until late 1937 \n(see Chapter 12).\n73Chapter seven: Importa nt Reversal Patterns: continued\nThe Dormant Bottom variation\nOne sort of Major Bottom chart picture has been called a Dormant Bottom. This variation \nrelates logically to our Bowl Pattern, being, in effect, an extreme development of the \n“extended, flat-bottomed form” to which we have alluded above. It appears characteristically \nin “thin” stocks, that is, those in which the total number of shares outstanding or, more \nparticularly, the floating supply of shares is very small. In such issues, a normal day’s \nturnover may be only two or three hundred shares in an active rising market. Finally, \nweeks and sometimes months will pass during which no sales will be registered for days at \na time, or only an occasional lot at a figure that fluctuates within a fractional range, making \nthe chart appear “flyspecked.”\nEventually, there may appear a sudden and usually quite inexplicable flurry of activity. \nSeveral hundred shares appear on the tape and prices advance sharply. This “breakout of \ndormancy” can be a premature move, such as we have noted in connection with typical \nRounding Bottoms, to be followed by several more weeks of inactivity, or it can be the first \nlift in a sort of step-up process with shorter and shorter intervals between each step, until \na consistent uptrend finally develops. In any event, it is a signal that we are dealing with \nan important Accumulation Pattern.\nWhat has happened to form these Dormant Bottoms is easy to guess. With relatively \nfew shares outstanding, and only an occasional lot put up for sale “at the market,” investors \n(perhaps insiders connected with the company) would succeed only in running the price \nup out of reach if they started to bid for the stock. So they simply “hold a basket under it,” \nas the saying goes, quickly picking up anything that is offered but never reaching for it, \nAPPLIED MAGNETICS CORP. APM\nSDT\n1988\nJUNE JULY AUGUST SEPTEMBER OCTOBERN OVEMBERD ECEMBER\n18 25 29 16 23 3061 32 02 7310 17 24 18 15 22 2951 21 92 6310 17 24 31\n20\n19\n18\n17\n16\n15\n14\n13\n12\n1000\n800\n600\n400\n200\nSales\n100’s\nFigure 7.23 In a broad trading range (11–17 1/2) during 1988, “ APM” turned down from Resistance \nin the summer. The reaction, however, was slow, forming a Saucer-like Pattern from July through \nNovember on generally Bullish price–volume correlation. Of particular note was the fact the low \npoint of the Saucer was above the February low, that is, higher lows were beginning to emerge. The \nHigh-Volume Rally through the Short-Term Downtrend Line signaled the start of the next up-leg.\n74 Technical Analysis of Stock Trends\nuntil eventually the tree is shaken clean. Then they may raise their bids a point or so; if that \nseems to bring out a lot of stock for sale, they go back to their waiting tactics.\nVolume pattern at Tops\nThe volume pattern on Rounding Tops is seldom as clearly defined as at Bottoms. Indeed, \nit is apt to be rather high and irregular throughout the entire rounding-over movement in \nprices. Under scrutiny, one can usually see some signs of a change from Bullish to Bearish \nactivity in the Minor Fluctuations after the peak has been passed, but the volume warnings \ndo not become conspicuous in most cases until the downtrend has begun to accelerate \ntoward the vertical.\nWe know of no measuring formula that can be applied to Rounding Turns (except for \nthe minimum qualifications we mentioned in connection with Head-and-Shoulders, that \nis, they cannot be counted on to produce a greater move than the preceding price swing in \nthe opposite direction), but they almost never deceive. Their implications can be roughly \nestimated from the magnitude of the trends that led to them and the length of time they \ntake in the rounding-over process. The Rounding Turns that often appear on weekly and \nmonthly charts, thus, have major import.\nThis leads us to the general consideration of weekly and monthly chart patterns. Thus far, \nwe have been speaking in detail of only daily chart developments, but all of the formations \nwe have taken up appear, as well, in the much larger swings into which daily movements \nCRAY RESEARCH INC. CYR 1987\nJANUARYF EBRUARYM ARCH APRILM AY JUNE JULY\n31 01 72 43 17 14 21 2871 42 12 841 11 82 52 91 62 33 06 13 20 27 41 11 8\n144\n136\n128\n120\n112\n104\n96\n88\n2000\n1600\n1200\n800\n400\nSales\n100’s\nFigure 7.24 Cray Research, a powerhouse stock for over a decade. Trading at under $1.00 in 1976, \nit reached 135 3/4 before the late April gap, through the Bottom of a seven-week Diamond, started \nthe decline. However, after the High-Volume Rally in mid-January, “CYR” also managed to form an \nimpressive Rounding Top. The concave volume pattern, clearly evident after the high-volume decline \nto Support that followed the Diamond breakdown, was particularly significant in illuminating this \nTopping Pattern.\n75Chapter seven: Importa nt Reversal Patterns: continued\nare condensed on weekly and monthly charts, and with identical significance. Thus, volume \nrecord may not be quite so easy to read (climactic activity may occur on one day of a week and \nthe other days run dull, which would not show at all in the week’s total figure), but it is less \ncritical and may almost be disregarded. Head-and-Shoulders Tops are particularly plentiful \non monthly charts and should be accorded due respect. In fact, any clearly defined pattern, \nwhich is built to completion on a weekly or monthly chart, is proportionately significant \n(bearing in mind that “a Reversal must have something to reverse”).\nNORTHERN INDIANA PUBLIC SERVICEN I1 984\nJANUARY FEBRUARYM ARCH APRIL MAYJ UNE JULY AUGUST SEPTE", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 51}
{"text": "Head-and-Shoulders Tops are particularly plentiful \non monthly charts and should be accorded due respect. In fact, any clearly defined pattern, \nwhich is built to completion on a weekly or monthly chart, is proportionately significant \n(bearing in mind that “a Reversal must have something to reverse”).\nNORTHERN INDIANA PUBLIC SERVICEN I1 984\nJANUARY FEBRUARYM ARCH APRIL MAYJ UNE JULY AUGUST SEPTEMBER OCTOBER\n71 42 12 841 11 82 53 10 17 24 31 71 42 12 85 12 19 26 29 16 23 30 71 42 12 84 11 18 25 18 15 22 29 61 3\n30\n28\n26\n24\n22\n20\n19\n18\n17\n16\n15\n14\n13\n12\n11\n13990\n5642\n8900\n10018\n8420\n200016001200800\n400 XD . 375 XD . 39 XD . 39\nSales\n100’s\nFigure 7.25 1984. We love the Scalloping tendency of Northern Indiana Public Service. Although it \nis obviously not a pattern portending rocket-like advance, the technical picture brightens with the \nhigh-volume breakout through Resistance at chart end.\n\n77\nchapter eight\nImportant Reversal Patterns: \nthe Triangles\nWe come next to an entirely different family of technical patterns, the Triangles, a group \nthat has not been as well represented on the charts of the decade of the 1940s as it was \nduring the 1920s and 1930s (EN10: In plentiful supply in modern markets of the 2000s). Their \nscarcity in that decade is regrettable because they are an intriguing lot with excellent profit \npotential. Before we examine them in detail, however, a quick review of the basic theory, \nwhich gives meaning and value to technical analysis, may be appropriate. That theory can \nbe summarized in the following brief statements (see Figures 8.1 through 8.25).\n 1. The market value of a security is determined solely by the interaction of supply and \ndemand.\n 2. Supply and demand are governed at any given moment by many hundreds of factors, \nsome rational and some irrational. Information, opinions, moods, and guesses \n(shrewd or otherwise) as to the future combine with blind necessities in this equation. \nNo ordinary man can hope to grasp and weigh them all, but the market does this \nautomatically.\n 3. Disregarding Minor Fluctuations, prices move in trends that persist for an appreciable \nlength of time.\n 4. Changes in trend, which represent an important shift in the balance between supply and \ndemand, however caused, are detectable sooner or later in the action of the market itself.\nBy this time, the fact expressed in the italicized words of the last statement may have \nbegun to raise some misgivings in your mind. The complaint that the Dow Theory is often \n“late” has already been discussed. The Reversal Patterns studied in the two preceding \nchapters give no certain signal until after the trend has changed, usually “sooner” as \ncompared with Dow Theory, but never at the absolute top or bottom price. The man who \nsells a stock as soon as, but not until, a Head-and-Shoulders Top has been completed on its \nchart may cash in on no more than half of the total decline from its extreme high to extreme \nbottom; this is due to the very terms of our measuring formula, the first half of the decline \ncan have taken place before the Top Reversal Formation was finally confirmed.\nMake up your mind that there is no help for it. Somebody managed to sell his shares at \nthe very top eighth of a point on the peak of the Head (and some poor devil bought them). \nThe seller was just plain lucky. His exploit can be truly compared with a hole-in-one in golf; \neven a complete duffer occasionally enjoys that thrill. But the more experienced a player, \nthe better satisfied he is to land safely on the green and not too far from the cup. The more \nexperienced an investor, the less concerned he is with getting the last point, or even the last \n10 points, out of his market commitments.\nNo one can ever be sure at the time that he is selling at the final high. No rules or \nmethods have ever been devised—or ever will be—to ensure buying within fractions of \nthe Bottom or selling within fractions of the Top. Of course, a man can make certain of \nbuying a stock at its absolute low provided he is prepared to take at that figure every last \n78 Technical Analysis of Stock Trends\nHUDSON BAY MINING & SMELTING HD\n1941–1943\nSO N DJ F MA MJ JA SO ND JF M\n26\n24\n22\n20\n19\n18\n17\n50\n40\n30\n20\n10\nSales\n100’s\nFigure 8.1 A fine Symmetrical Triangle Reversal Formation on a weekly chart. Upper boundary \nsloping down from February 1942 recovery high at 21 and lower boundary sloping up from “Pearl \nHarbor” Bottom at 16 3/8 converge to an apex of about 18 5/8. From this Major Bottom Pattern, “HD” \nadvanced to 45 in 1946. Note the shrinkage in volume as a pattern formed and the increase as the \nprice broke out through the Top in October 1942. Breakout came not quite three-quarters of the way \nover from the first Top to the apex.\nSEARS, ROEBUCKS\n1946\nAPRILM AY JUNE JULY AUGUSTS EPTEMBER\n61 32 02 74 11 18 25 18 15 22 29 61 32 02 73 10 17 24 31 71 42 12 8\n48\n44\n40\n38\n250\n200\n150\n100\n50\nSales\n100’s\nFigure 8.2 Sears Roebuck made a Symmetrical Triangle Reversal at its Bull Market Top in 1946, and \nthen it went into another long Triangle that turned out to be a Consolidation rather than Reversal \nFormation. (Logarithmic volume scaling minimizes volume variations.) Sell signal was given at 44 \n1/2 and again at 41. Decline continued to 30 1/2.\n79Chapter eight: Importa nt Reversal Patterns: the Triangles\nshare offered, even to the entire outstanding issue if necessary. It might, in theory, require \nas much as $3.7 billion to “put a bottom” under U.S. Steel at 70 (EN9: ca. 1950s) in case you \nare tempted.\nThe reader, who at this point may think we “protest too much,” will see more excuses \nfor the foregoing remarks when we take up the habits of Triangles, for these formations \nare not always indicative of Trend Reversal. On the contrary, except in certain rather \nuncommon varieties, they are more apt to signal what may most conveniently be termed \nConsolidation, terminating an up or down move only temporarily and setting the stage for \nanother str", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 52}
{"text": "t too much,” will see more excuses \nfor the foregoing remarks when we take up the habits of Triangles, for these formations \nare not always indicative of Trend Reversal. On the contrary, except in certain rather \nuncommon varieties, they are more apt to signal what may most conveniently be termed \nConsolidation, terminating an up or down move only temporarily and setting the stage for \nanother strong move in the same direction later on. (Schabacker called such chart formations \n“Continuation Patterns.”) The reason for including Triangles in this section of our studies \nunder the general heading of Reversal Formations is that they do, at times, develop at \nperiods of Major Trend change, and those are, by all odds, the periods that are the most \nessential for the investor to recognize.\nSymmetrical Triangles\nThe most common form of a Triangle is composed of a series of price fluctuations, each \nof which is smaller than its predecessor , each Minor Top failing to attain the height of the \npreceding rally, and each Minor Recession stopping above the level of the preceding Bottom. \nThe result is a sort of contracting “Dow Line” on the chart—a sideways price area or trading \nrange whose Top can be more or less accurately defined by a down-slanting boundary line \nand whose Bottom can be similarly bounded by an up-slanting line. This type of Triangle \nis called a Symmetrical Triangle. If we wanted to make a more accurate application of \nthe language of geometry, we might better call it an Acute Triangle because it is not at \nJOHNS – MANVILLEJ M\n1941–1943\nSO ND JF MA MJ JA SO ND JF M\n80\n76\n72\n68\n64\n60\n56\n52\n50\n40\n30\n20\n10\nSales\n100’s\nFigure 8.3 Johns-Manville’s Primary Trend Reversal in 1942 developed out of a Symmetrical Triangle \nthat also had some aspects of a Head-and-Shoulders Pattern with a long right shoulder. Although this \nis a weekly chart, the volume here is worthy of detailed study in connection with the price action. \n“JM” (old stock) advanced more than 100 points in the next four years.\n80 Technical Analysis of Stock Trends\nall necessary that its Top and Bottom boundaries be of equal length or, in other words, \nthat they make the same angle with the horizontal axis. However, there is a very strong \ntendency in these formations to approximate the symmetrical form; so, the established \nname will do well enough. This pattern is also sometimes referred to as a “Coil.”\nWhile the process of contraction or coiling, which makes up the price action of the \nSymmetrical Triangle Pattern, is going on, trading activity exhibits a diminishing trend, \nirregularly perhaps, but nevertheless quite noticeably as time goes on. The converging \nupper and lower boundary lines of the price formation come together somewhere out to \nthe right (the future in the time sense) of the chart, at the apex of our Triangle. As prices \nwork their way along in narrower and narrower fluctuations toward the apex, volume ebbs \nto an abnormally low daily turnover and, if we are dealing with a typical example, comes \nthe action that first suggested the name “Coil.” Suddenly and without warning, as though \na coil spring had been wound tighter and tighter and then snapped free, prices break out of \ntheir Triangle with a notable pickup in volume, and leap away in a strong move that tends \nto approximate in extent the up or down move that preceded its formation.\nThere is seldom any clue given on the one chart containing the Triangle to tell in \nwhich direction prices are going to break out of the pattern until that action finally occurs. \nSometimes you can get a pretty good idea of what is likely to happen by observing what \nis going on at the same time in the charts of other stocks (which is an important topic for \nDELAWARE & HUDSON DH\n1941–1943\nSO ND JF MA MJ JA SO N DJ FM\n13\n12\n11\n10\n9\n8\n7 \n125\n150\n75\n50\n25\nSales\n100’s\nFigure 8.4 Logarithmic price scaling on weekly chart emphasizes important technical developments \nat low price levels. “DH’s” Symmetrical Triangle Bottom started a Bull Market that reached 57 in \n1945. Note the Throwback to apex of Triangle, not an uncommon development. The apex itself is a \nstrong Support (see Chapter 13).\n81Chapter eight: Importa nt Reversal Patterns: the Triangles\nCUBAN – AMERICAN SUGARC SU\n1945 G\nJULY AUGUSTS EPTEMBERO CTOBER NOVEMBERD ECEMBER\n71 42 12 84 11 18 25 18 15 22 29 61 32 02 73 10 17 24 18 15 22 29\n28\n26\n24\n22\n20\n19\n18\n125\n100\n75\n50\n25\nSales\n100’s\nG−G\nFigure 8.5 Triangles often form as a part of a larger and more important pattern of some other \ntype. Here a symmetrical figure constitutes the latter half of a Rounding Turn. Note the premature \nbreakout on October 17 , return to pattern, and then final breakaway on November 8.\nNATIONAL GYPSUMN G\n1945\nFEBRUARY MARCHA PRIL JUNE JULYMAY\n31 01 72 43 10 17 24 31 71 42 12 85 12 19 26 29 16 23 30 71 4 21 28\n24\n22\n20\n19\n18\n17\n16\n15\n14\n125\n100\n75\n50\n25\nSales\n100’s\nFigure 8.6 Prices in this Symmetrical Triangle squeezed way out into the apex before erupting. \nBreakout at that stage is unreliable; above is a fair sample of the false moves that occur there. Real \nmove was down.\n82 Technical Analysis of Stock Trends\nlater discussion). Often, however, there is nothing to do but wait until the market makes up \nits mind which way to go. And “making up its mind” is just what the market seems to be \ndoing when it builds a Triangle; everything about this pattern appears to exemplify doubt, \nvacillation, and stalling until finally a decision is reached.\nSome cautions about Symmetrical Triangles\nA compact, clean-cut Triangle is a fascinating picture, but it has its tricky features. The \nbeginner in technical chart analysis is quite naturally prone to look for Triangles constantly, \nand will often think he has detected them when, in fact, something entirely different is in the \nprocess of development. Remember, it takes 2 points to determine a line. The top boundary \nline of a price area cannot be drawn until two Minor Trend Tops have been definitely \ne", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 53}
{"text": "s its tricky features. The \nbeginner in technical chart analysis is quite naturally prone to look for Triangles constantly, \nand will often think he has detected them when, in fact, something entirely different is in the \nprocess of development. Remember, it takes 2 points to determine a line. The top boundary \nline of a price area cannot be drawn until two Minor Trend Tops have been definitely \nestablished, which means prices must have moved up to and then down away from both far \nenough to leave the two peaks standing out clear and clean on the chart. A bottom boundary \nline, by the same token, cannot be drawn until two Minor Trend Bottoms have been definitely \nestablished. Therefore, before you can conclude that a Symmetrical Triangle is building, you \nmust be able to see four Reversals of Minor Trend. If it comes after an advance in prices, you \nmust first have a Top, next a Bottom, then a second Top lower than the first, and finally a \nsecond Bottom higher than the first Bottom (and prices must move up away from the second \nBottom before you can be sure it is a Bottom). Then, and only then, can you draw your \nboundary lines and proceed on the assumption you have a Symmetrical Triangle.\nNORTH AMERICAN CO. NA\n1937–1938\nOCTOBERN OVEMBERD ECEMBERJ ANUARY FEBRUARY MARCH\n29 16 23 30 61 32 02 74 11 18 25 18 15 22 29 51 21 92 65 12 19 26\n24\n22\n20\n19\n18\n17\n16\n15\n14\n250\n200\n150\n100\n50\nSales\n100’s\nFigure 8.7 Recovery rallies from “Panic” Bottoms are often capped by Triangles, for those are periods \nin which doubt and indecision are prevalent. The doubt in such cases, however, is usually resolved \nin favor of renewed decline. “Panic” Bottoms seldom hold. This chart shows a typical Symmetrical \nPattern topping the recovery from the famous Selling Climax of October 19, 1937 . Note Pullback to apex.\n83Chapter eight: Importa nt Reversal Patterns: the Triangles\nVERTIENTES – CAMAGUEY SUGARV EC\n1946\nAPRIL MAY JUNEJ ULYA UGUSTS EPTEMBER\n61 32 02 74 11 18 25 18 15 22 29 61 32 02 73 10 17 24 31 71 42 12 8\n26\n24\n22\n20\n19\n18\n17\n16\n125\n100\n75\n50\n25\nSales\n100’s\nFigure 8.8 A Major Symmetrical Triangle Top in which prices squeezed out into the apex and then \nproduced a false move upside (see Figure 8.6). “VEC,” as a matter of fact, was a bad actor technically, \nbut this particular breakout would be suspect anyway.\nEASTERN AIRLINES EAL 1946–1947\nNOVEMBER DECEMBER JANUARY FEBRUARY MARCH APRILM AY JUNE JULY AUGUST SEPTEMBER\n29 16 23 3071 42 12 84 11 18 25 18 15 22 18 15 22 29 51 21 92 63 10 17 24 31 71 42 12 85 12 19 26 29 16 23 30 61 32 02 74\n24\n22\n20\n19\n18\n17\n16\n1251007550\n25\nSales100’s\nFigure 8.9 The other side of the story—an imposing Symmetrical Triangle which failed badly, \nalthough for the alert and experienced technician, there were warnings of something amiss in March \nand April. Eastern Airlines built, in late 1946 and early 1947 , a formation which, so far as price \npattern was concerned, left little to be desired. Prices broke out topside decisively in late March. A \nThrowback in April met normal Support at the upper Triangle boundary, but the subsequent advance \nfell short, weakened, and finally broke down, producing an “end run” around the apex. Warnings \nreferred to were high and irregular volume, particularly on reactions, in February and March—not \ncharacteristic of valid Triangle development—and failure of prices to push up rapidly and vigorously \nafter the April 14 Throwback.\n84 Technical Analysis of Stock Trends\nNATIONAL GYPSUM NG\n1944–1945\nJF MA MJ JA SO ND JF MAM J\n19\n18\n17\n16\n15\n14\n13\n12\n11\n10\n9\nSales\n100’s\n50\n40\n30\n20\n10\nFigure 8.10 A weekly chart. The seventh-month Consolidation area of 1944—in “NG,” undefinable \nat first, developed eventually into a typical Symmetrical Triangle. Two months after the high-volume \nbreakout in January 1945, prices reacted nearly to apex level and then pushed away rapidly. Minimum \nmeasuring implications of this Triangle were satisfied at 16.\nU. S. INDUSTRIALC HEMICALS UD\n1944–1945\nOCTOBERN OVEMBERD ECEMBERJ ANUARY FEBRUARY MARCH\n71 42 12 84 11 18 25 29 16 23 30 61 32 02 73 10 17 24 31 01 72 43 1\n44\n40\n38\n36\nSales\n100’s\n25\n20\n15\n10\n5\nFigure 8.11 A small Symmetrical Triangle that tended toward the “ Ascending” type. Note that the \nhigher volume that developed within this pattern in early January came on a rally. This sort of action \nis fairly typical of very “thin” stocks.\n85Chapter eight: Importa nt Reversal Patterns: the Triangles\nAMERICAN BANK NOTE ABN\n1941–1943\n14\n13\n12\n11\n10\n9\n8\n7\n6\nSales\n100’s\n50\n40\n30\n20\n10\nSO ND JF MA MJ J\nAS ON DJ FM\nFigure 8.12 An Ascending Triangle 10 months long, which was the start of a Major Bull Trend, \ncarrying “ ABN” to 45. Refusal of prices to react to the lower pattern boundary, as here in August \n1942, is a frequent development in strong formations, a warning of near completion and breakout.\nCELANESE CORPORATIONC Z\n1946\nJANUARYF EBRUARYM ARCH APRILM AY JUNE\n61 32 02 73 10 17 24 31 01 72 43 17 14 21 28 51 21 92 62 91 62 33 0\n52\n48\n44\n40\n38\n50\n40\n30\n20\n10\nSales\n100’s\nFigure 8.13 Premature breakouts from Right-Angle Triangles, such as appeared in Celanese in \nMarch 1946, are temporarily disappointing to the trader who buys on them, but they eventually \nwork out all right. Celanese, before its 1946 split, was subject to frequent and peculiar shakeouts, as \nhere on March 9 and 26.\n86 Technical Analysis of Stock Trends\nSEARS ROEBUCK S\n1936–1637\nOCTOBERN OVEMBERD ECEMBERJ ANUARY FEBRUARY MARCH\n112\n104\n96\n88\n80\n76\n125\n150\n25\n50\n25\n31 01 72 43 17 14 21 28 51 21 92 62 91 62 33 06 13 20 27 61 32 02 7\nXR\nSales\n100’s\nFigure 8.15 Sears’ 1936 Bull Market Top was a Symmetrical Triangle, out of which it declined 15 \npoints. An Ascending Triangle then produced an Intermediate Recovery to the Supply Zone (see \nChapter 13) at the lower side of the top Triangle. Compare this chart with the 1946 Top in Figure 8.2.\nBRIGGS MANUFACTURING CO.B G\n1941–1943\n26\n24\n22\n20\n19\n18\n17\n16\n15\n50\n40\n30\n20\n10\nSO ND JF MA MJ JA SO ND JF M\nSales\n100’s\nFigure 8.14", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 54}
{"text": "ll Market Top was a Symmetrical Triangle, out of which it declined 15 \npoints. An Ascending Triangle then produced an Intermediate Recovery to the Supply Zone (see \nChapter 13) at the lower side of the top Triangle. Compare this chart with the 1946 Top in Figure 8.2.\nBRIGGS MANUFACTURING CO.B G\n1941–1943\n26\n24\n22\n20\n19\n18\n17\n16\n15\n50\n40\n30\n20\n10\nSO ND JF MA MJ JA SO ND JF M\nSales\n100’s\nFigure 8.14 A steep recovery from a Panic Bottom (the “Pearl Harbor” selling) flattened out into a \nfine Ascending Triangle. Note the horizontal Supply Line at 19, above a gradually rising Demand \nLine. The breakout at the end of September signaled initiation of an advance of some consequence. \nIt turned out to be a Primary Bull Market, which took Briggs up to 53.\n87Chapter eight: Importa nt Reversal Patterns: the Triangles\nAnother point to remember—and one that does not conform at all to the “Coil” simile—\nis the farther out into the apex of the Triangle prices push without bursting its boundaries, \nthe less force or power the pattern seems to have. Instead of building up more pressure, it \nbegins to lose its efficacy after a certain stage. The best moves (up or down) seem to ensue \nwhen prices break out decisively at a point somewhere between half and three-quarters of \nthe horizontal distance from the base (left-hand end) to the apex. If prices continue to move \n“sideways” in narrower and narrower fluctuations from day to day after the three-quarter \nmark is passed, they are quite apt to keep right on to the apex and beyond in a dull drift or \nripple that leaves the chart analyst completely at sea. The best thing to do in such cases is \ngo away and look for something more promising elsewhere in your chart book.\nA third tricky point is that it becomes necessary sometimes to redraw one or both \nboundaries of a Triangle before it is finally completed (i.e., before prices break out and \nmove away from it in a decisive fashion). This can happen, for example, when, after the \nfirst two Rally Tops have established a down-slanting upper boundary line, the third rally \nstarting from the lower boundary pushes up and through the original Top line by a moderate \nSOUTHERN RAILWAY PFD.S R Pr\n1936\nAPRILM AY JUNE JULY AUGUST\n40\n38\n36\n34\n32\n30\n28\n26\n24\n22\n20\n50\n40\n30\n20\n10\n41 11 82 52 92 3 16 30 61 32 02 74 11 18 25 18 15 23 29\nSales\n100’s\nFigure 8.16 An Ascending Triangle at an Intermediate Bottom. This chart runs from April through \nAugust 1936. Extreme shrinkage in trading volume during this formation indicated a very strong \ntechnical situation.\n88 Technical Analysis of Stock Trends\nmargin and then, without developing a recognizable breakout volume on this move, stops \nshort of surpassing the highest level of the preceding (second) pattern Top. When prices \nsubsequently drop back again into pattern, it is necessary to abandon the original upper \nboundary line and draw a new one across the highs of the first and third rally tops.\nHow prices break out of a Symmetrical Triangle\nPrices may move out of a Symmetrical Triangle either up or down. There is seldom, if ever, \nas said above, any clue as to direction until the move has actually started, that is, until prices \nhave broken out of their triangular “area of doubt” in decisive fashion. In a very general \nway, the precepts laid down for breakouts from Head-and-Shoulders Formations apply here \nas well. For example, the margin by which prices should close beyond the pattern lines is \nthe same, roughly 3%. It is equally essential that an upside break in prices be confirmed by \na marked increase in trading volume; lacking volume, do not trust the price achievement. \nBut a downside breakout, again as in the case of the Head-and-Shoulders, does not require \nconfirmation by a pickup in activity. As a matter of record, volume does visibly increase \nin most cases, but in a majority of down breaks, it does not do so to any notable extent \nuntil after prices have fallen below the level of the last preceding Minor Bottom within the \nTriangle, which, as you can see, may be several points lower than the boundary line at the \nplace (date) of the actual breakout.\nThe curious fact is a downside breakout from a Symmetrical Triangle attended to right \nfrom the start by conspicuously heavy volume is much more apt to be a false signal rather \nthan the start of a genuine downtrend that will be worth following. This is particularly \ntrue if the break occurs after prices have worked their way well out into the apex of the \nTriangle; a high volume crack then frequently—we might even say usually—develops into \nARMOUR & COMPANYA M 1946–1947\nMAYJ UNE JULY AUGUST SE PTEMBERO CTOBERN OVEMBERD ECEMBERJANUARYF EBRUARYM ARCH\n19\n18\n17\n16\n15\n14\n13\n12\n11\n12510075\n50\n25\n41 11 82 51 81 52 22 96 13 20 27 31 01 72 43 17 14 21 28 51 21 92 62 91 62 33 07 14 21 28 41 11 82 51 81 52 21 85 22 29 5\nSales\n100’s\nFigure 8.17 One of the early 1947 disappointments (to the Bulls) was the failure of “ AM” to break out \ntopside from the long Ascending Triangle depicted above. Here is a case where supply at 15 finally \noverwhelmed demand. A pattern such as this indicates a potentially strong underlying situation \nfor the long pull. Ordinarily, the consequence of an Ascending Triangle’s “failure” of this sort is the \ndevelopment either of an extended Rectangular base within the general range of the Triangle (in \nthis case, 10 to 15), or formation of a Double Bottom at or near the earlier low (in this case near 10). \nHowever, “ AM” dropped lower after several more attempts to overcome the Major Supply at the 15 \nlevel, which was not substantially penetrated until 1955.\n89Chapter eight: Importa nt Reversal Patterns: the Triangles\na two- or three-day “shakeout,” which quickly reverses itself and is followed by a genuine \nmove in the up direction.\nAll of the above the reader will have undoubtedly found most disconcerting. \nHere is a pretty technical pattern, and it cannot always be trusted. Unfortunately, \nSymmetrical Triangle", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 55}
{"text": "t substantially penetrated until 1955.\n89Chapter eight: Importa nt Reversal Patterns: the Triangles\na two- or three-day “shakeout,” which quickly reverses itself and is followed by a genuine \nmove in the up direction.\nAll of the above the reader will have undoubtedly found most disconcerting. \nHere is a pretty technical pattern, and it cannot always be trusted. Unfortunately, \nSymmetrical Triangles are subject to false moves to a far greater extent than the Head-\nand-Shoulders Formation or any of the other formations we have discussed or will \ndiscuss later. Unfortunately, some of these false moves cannot be identified as such until \nafter a commitment has been risked (although good trading tactics should prevent their \noccasioning much more than a trivial loss). Unfortunately again, even a typical shakeout, \nsuch described in the preceding paragraph, may produce a double cross, proceeding right \non down in a genuine decline. No technical chart formation is 100% reliable and, of all our \npresent subject, is the worst offender.\nBut most Symmetrical Triangles—lacking an actual statistical count, our experience \nwould suggest more than two-thirds of them—behave themselves properly, produce no false \nsignals that cannot be spotted before any damage is done. Upside breakouts on high volume \nmay be premature in the sense that prices return to pattern and do some more “work” there \nbefore the genuine uptrend gets under way, but they seldom are false. We shall have a little \nmore to say about false signals in this chapter and more later on that we trust will be helpful \nin developing the experience a trader needs to defend himself against them.\nSOCONY-VACUUM OILS OV 1941–1943 \n12 \n11 \n10 \n9 \n8 \n7 \n6 \n125 \n100 \n75 \n50 \n25 \nS O N D J F M A M J J A \nS O N D J F M \nSales \n100’s \nFigure 8.18 The 1942 Bear Market Bottom in Socony–Vacuum was an unusual Head-and-Shoulders \nFormation, with the head consisting of an Ascending Triangle. Note the increase in volume on the \nbreakout from the Triangle in July and again on the break through Head-and-Shoulders neckline \nin October.\n90 Technical Analysis of Stock Trends\nA typical Triangle development\nThe several actual chart examples of Symmetrical Triangles that illustrate this chapter \nwill serve, we trust, to give the reader a working acquaintance with their appearance in \nvarious manifestations. Yet it may help to clear up some of the more important points \nif we describe in detail just how a typical pattern develops step by step. Let us suppose \nyou are watching a stock on your charts that has climbed, with only the normal, brief \nhesitations and inconsequential reactions, from around 20 to 30, 32, 35, and is still moving \nup. (Let’s hope you bought it at 20!) Lower down, its turnover ran between 300 and 600 \nshares daily, but now, above 30, it has attracted quite a following, and daily volume has \nincreased to around 1,000. As it approaches 40, activity shoots up to nearly 2,000 shares, \nthe market “churns” between 39 and 40, and then prices begin to drop. As they fall back, \nyou (especially if you own the stock) watch it with some concern, but you know it is hardly \nlikely that it is going to go straight down again to 20; stocks do not act that way. (EN9: \nSometimes they do now, in the twenty-first century.) If the trend of this issue has actually been \nreversed, it should, nevertheless, spend some more time and effort around its top levels \nand make some sort of a Distribution Pattern.\nBATH IRON WORKS BIW1 946\nJANUARYF EBRUARYM ARCH APRILM AY JUNE\n51 21 92 62 92 3 1629 16 23 30 61 32 02 74 11 18 25 18 15 22 29\n38\n36\n34\n32\n30\n28\n26\n24\n22\n125\n100\n75\n50\n25\nX D S1.00\nSales\n100’s\nFigure 8.19 Due to a dividend of $1.00 went ex on March 14, the lower boundary of this Descending \nTriangle Top in “BIW” had to be dropped 1 point from 33 and redrawn at 32. Despite the added \nleeway thus afforded, however, the original pattern implications were quickly carried out. Prices \npulled back three times to the new lower boundary line of this Triangle on April 4, April 16, and May \n31—unusual, but explained by the existence of a strong general market uptrend during this period. \nWhenever a stock goes ex-dividend during the formation of an Area Pattern of any type, the lines \nbounding that pattern should immediately be adjusted to the new value by lowering them a distance \ncorresponding to the amount of the dividend.\n91Chapter eight: Importan t Reversal Patterns: the Triangles\nThe decline continues for 10 days with the turnover also declining quite appreciably. \nBy the time prices have worked back to 33, volume is running at about 700 shares daily. At \n33, it may pick up again for a single day to 800 or 900 shares, but the reaction stops there, \nand after a day or two, prices begin to climb again with little change in their turnover \nrate. In eight or nine days, quotations have gotten back into the upper 30s and activity \nincreases and reaches, say, 1,200 shares on the day 39 is reached. Instead of going on to 40 \nor beyond, however, a new reaction sets in and prices drift back to 37 . (Perhaps you will find \nthis growing picture easier to visualize if you pencil its development on a scrap of chart \npaper.) Now it is evident that a second Top has formed at 39; you can now draw a tentative \npattern line (there are other names for this, as we shall see later) on your chart across the \ntwo extreme high ranges (not closing prices), which will slant downward from left to right. \nSo far you have only one Bottom point, so you cannot draw lines from that, but this second \ndecline brings out even less trading activity than the first. Volume ebbs to 400 shares and \nthe down move halts at 34; the price track “rounds out” and turns up again; trading is very \ndull, but it begins to pick up as 36 is reached.\nThis action defines a second Minor Bottom and now you can draw a Bottom “tangent,” \nan up-slanting line across the extreme low prices registered on the two reactions, the first \nat 33", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 56}
{"text": "even less trading activity than the first. Volume ebbs to 400 shares and \nthe down move halts at 34; the price track “rounds out” and turns up again; trading is very \ndull, but it begins to pick up as 36 is reached.\nThis action defines a second Minor Bottom and now you can draw a Bottom “tangent,” \nan up-slanting line across the extreme low prices registered on the two reactions, the first \nat 33 and the second at 34. Your two pattern lines will converge, meeting near the 36H \nREVERE COPPER & BRASSR VB 1946\nAPRIL MAYJ UNEJ ULYA UGUSTS EPTEMBER\n32\n30\n28\n26\n24\n22\n20\n19\n18\n125\n100\n75\n50\n25\n61 32 02 74 11 25 18 18 15 22 29 61 32 02 73 10 17 24 31 71 42 12 8\nSales\n100’s\nFigure 8.20 On the basis of “fundamentals,” Revere was an attractive holding in 1946, which may \naccount for its reluctance to “give up” when the market generally started downhill in earnest in \nJune of that year. Its fluctuations from mid-May to late August constructed a fine, large Descending \nTriangle, in which, however, Bearish Volume Signals had already appeared in late June and on July \n23. The breakout came (with a wide Breakaway Gap) on August 27 . Prices clung to the edge of the \npattern for four days and then collapsed. The small formations outlined in April and May are Flags, \nto be discussed in Chapter 11.\n92 Technical Analysis of Stock Trends\nlevel about four weeks ahead (i.e., to the right) on your chart. You have a Symmetrical \nTriangle—but you do not know whether prices are going to fall out of it eventually or shake \noff present doubts and push up in a new advance worth following. You can only watch \nfurther developments very closely and be prepared to take whatever action is, in due time, \nindicated.\nThe second rally picks up a little in activity, attains a daily turnover of about 700 shares, \nand pushes up to 38 and on for part of a day to 38 3/ 4. This nudges through the previously \ndrawn pattern line by perhaps a quarter of a point (because each swing is shorter in points \ntraveled and, accordingly, in duration). But the volume on this Minor Penetration is less \nthan on the preceding Top (at 39) and buying again ebbs. As the price range line falls back \nto 37 and 36, draw a new upper tangent across the first Top at 40 and the last Top at 38½. \nThere is the suggestion here in this slight “lift” that the balance may be swinging slightly to \nthe demand side, but do not count on it. Pinpoint accuracy is not to be expected; Triangles \nmust be allowed some leeway.\nOn the third reaction, activity dwindles away to the lowest yet. The up-slanting Bottom \nboundary will be reached at about the 35 level, if prices continue their present course. It is \nworth noting now whether they will come all the way down to it this time because if they \ndo not—if their recession is halted half a point or so above it—that action would give some \nsignificance to the previous bulge through the upper boundary. But this does not happen; \nthe drift continues right on down to 35, and now volume is running at the rate of only 200 \nshares daily, less than it ran in the early stages of the original advance above 20. This is a \ncritical spot. The price track flattens out momentarily, turns up feebly, yet keeps hitching \nWESTINGHOUSE ELECTRIC WX 1936–1937\nOCTOBERN OVEMBERD ECEMBERJ ANUARY FEBRUARY MARCH\n160\n152\n144\n136\n128\n120\n112\n104\n50\n40\n30\n20\n10\n31 01 72 43 17 14 21 28 51 21 92 62 91 62 33 06 13 20 27 61 32 72 0\nSales\n100’s\nFigure 8.21 The 1937 Bull Market Top in Westinghouse was this Descending Triangle, which started \nin January and broke on February 15. Prices hung at the lower edge of the Triangle for four days, fell \naway, and then pulled back to its lower line on March 4 at the time when the general market Averages \nwere making their final Bull highs.\n93Chapter eight: Importa nt Reversal Patterns: the Triangles\nup, crosses 36½, picks up activity, reaches the (new) upper Triangle boundary at 37½ and, \non the next day, punches through on a turnover of 1,500 shares to close at 39 ⅛. This is a \nbreakout; the doubt is resolved and (barring a false move, unlikely at this point) the trend \nis once again up. Note that it was not necessary for prices to surpass the previous high at 40 \nto produce this signal—that is one of the interesting things about Symmetrical Triangles.\nFigure 8.22 A series of Triangles, Symmetrical and Descending, which evolved during the 1929–1932 \nBear Market in Hudson Motors. Note that at no time during this decline did anything resembling a \nMajor Bottom appear. Note also how each Triangle’s measuring implications were carried out before \nany temporary halt or consequential rally developed. Follow your daily charts for the proper timing \nof your trading operations but keep an eye always on the long-range pictures that evolve on weekly \nand monthly projections, so as to maintain your perspective on the Major Trend.\n94 Technical Analysis of Stock Trends\nReversal or Consolidation\nWe started to discuss Symmetrical Triangles as Reversal Patterns, yet our example has \nturned out to be, instead, a Consolidation Pattern, that is, only a sort of resting stage in a \ncontinued uptrend. Well, three out of four of these formations will turn out to be just that; \nthe fourth is the dangerous one (if you own the stock). How would it differ?\nThe example described might have been a Reversal instead of a Consolidation Formation \nany time up to the point of the decisive breakthrough to 39. If it had been a typical Reversal, \nthe first change probably would have appeared shortly after the final rally started up from \nthe third Bottom at 35. That rally would have petered out at about 36½, and prices would \nhave started to drift back again. Then, with the activity increasing slightly, the Bottom \nboundary would be penetrated. As quotations dropped to 34, daily volume might mount \nto 600 or 700 shares. Any further decline would constitute a down signal, resulting in a \nfurther pickup in turnover and an acceleration in the price decline as", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 57}
{"text": "t rally would have petered out at about 36½, and prices would \nhave started to drift back again. Then, with the activity increasing slightly, the Bottom \nboundary would be penetrated. As quotations dropped to 34, daily volume might mount \nto 600 or 700 shares. Any further decline would constitute a down signal, resulting in a \nfurther pickup in turnover and an acceleration in the price decline as the stop-loss orders \n(to be discussed later) spotted under 34 were “touched off.”\nBefore we leave our typical example, we might make some mention of the post-breakout \nreactions or Pullbacks that sometimes occur. As in the case of the Head-and-Shoulders \nAMERICAN ROLLING MILLSR M 1941–1943\nSO ND JF MA MJ JA SO ND JF M\n14\n13\n12\n11\n10\n9\n125\n100\n75\n50\n25\nSales\n100’s\nFigure 8.23 The curious, and in its early stages confusing, Major Bottom Formation that American \nRolling Mills constructed in 1941–1943. The recovery from the “Pearl Harbor Panic” of 1941 ran into \na large Symmetrical Triangle that broke out on the downside in April 1942. The subsequent decline \nsatisfied the measuring requirements of that Triangle, but it did not carry below the December low. \nThe rally of June and reaction of August–September built the whole area out into another and larger \nSymmetrical Triangle, out of which prices broke on the upside in September. Then the reaction to the \napex of the latter, in December 1942, and the following advance built up into a 15-month Ascending \nTriangle, which constituted the final Major Bottom for a trend that carried prices up eventually to 42 \nin 1946. The low volume on the June and August–September reactions, the increase on the October \nmarkup, and, even more, the January 1943 rise and breakout in February were unmistakably of Major \nBullish implications. It takes time, remember, to build a foundation for a Bull Market.\n95Chapter eight: Importan t Reversal Patterns: the Triangles\nFormation, the initial breakout move from a Symmetrical Triangle may halt before prices \nare carried very far away from the pattern and be followed by a Minor Reaction, usually \nlasting only two or three days, which will carry quotations back to the nearest pattern \nboundary. Thus, in our first example in which the break, when it came, took our stock \nup through the top side to 39 ⅛, the next day might have seen a push on to 40, and then \nprices might have backed off again in a couple of days of decreased activity to 37½ or 38. \nThe up-move would then normally be resumed with greater vigor. Downside breakouts \nare sometimes followed in much the same manner by pullbacks to the lower boundary \nGOODRICH ( B. F. ) COMPANYG R\n1941–1943\nSO ND JF MAM JJ AS ON DJ FM\n36\n34\n32\n30\n28\n26\n24\n22\n20\n19\n18\n17\n16\n15\n14\n13\n250\n200\n150\n100\n50\nSales\n100’s\nFigure 8.24 A beautifully compact Ascending Triangle that turned out to be the Major Bear-to-\nBull Reversal in Goodrich in 1942. The breakout from this pattern (in April) was not signaled by \nany extraordinary pickup in activity so far as this weekly record shows (but remember significant \nvolume detail is often hard to see in a weekly plotting). The Triangle’s measuring implications were \ncarried out by the first upswing, which reached \n18 14 at the end of May. Supply had to be absorbed \nin the 18 to 21 range (refer to this chart when you study Support and Resistance in Chapter 13), but a \nMajor Up Signal was given in September when prices erupted through that zone with a conspicuous \nincrease in trading volume.\n96 Technical Analysis of Stock Trends\nof the pattern, after which the decline is resumed with an increase in volume. However, \nthese post-breakout reactions occur less often with Triangles than they do with Head-and-\nShoulders Patterns.\nAnother matter we might take up before going on to study the next formation is the \nrationale of the Symmetrical Triangle. It may help to fix its characteristics in mind if we try to \ndeduce what sequence of events might typically produce it. Of course, any effort of this sort \ncan result only in a gross oversimplification, which will not fit all of the Triangle’s various \nmanifestations, but it is an interesting mental speculation—and one not without benefit to \nour understanding of the general theory of chart formations. Let us turn back again to our \ntypical example. We started with a stock that ran up rather steadily from around 20 to 40 \nand then reacted. It is fairly obvious what happened at 40: many investors had substantial \npaper profits, approaching 100% at that price. (A “round figure” such as 40, 50, 75, or 100 \nebay Inc-(Nasdaq NM) 57.75 0.240 0.417% \n63 \n57 \n51 \n45 \n42 \n39 \n36 \n33 \n30 \n27 \n24 \n125 \n100 \n75 \n50 \n25 \n0 \n1998–2003 Prophet Financial Systems, Inc. Terms of use apply.\nVolume (Millions) \n02 A\npr Jul Oct 03 A pr Jul Oct \nFigure 8.25 A real-time chart from prophet.net. The volume blowout in July 2002 drew attention to \neBay and the sloping line was drawn at that time. Although the lines are sloppy and the pattern is \nragged, it looked at the time like a Descending Triangle with all its implications. Nevertheless, when \nit broke out of the pattern on emphatic volume in October 2003 the handwriting was on the wall. \neBay was for real. So, what’s for real? It could really make money, not just capture free eyeballs, like \nits internet brethren and sistern. It actually performed a service of economic benefit to many people, \nunlike the internet fantasy follies. See Figure 10.26 for a longer perspective on eBay. Lessons for the \nattentive: power of trendlines; alarm-clock nature of unusual volume; not believing any forecast. \nForecast in this case would have been for a downtrend if, as it seemed, the pattern was a descending \ntriangle.\n97Chapter eight: Importa nt Reversal Patterns: the Triangles\nis apt to become a sort of mental profit objective and, hence, bring in increased selling.) \nSome of them were ready to cash in and did so, temporarily swinging the technical balance \nfrom demand to supply; they sold less freel", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 58}
{"text": "Forecast in this case would have been for a downtrend if, as it seemed, the pattern was a descending \ntriangle.\n97Chapter eight: Importa nt Reversal Patterns: the Triangles\nis apt to become a sort of mental profit objective and, hence, bring in increased selling.) \nSome of them were ready to cash in and did so, temporarily swinging the technical balance \nfrom demand to supply; they sold less freely, of course, as prices receded. Other would-be \ninvestors had been attracted to the stock, but too late to “get aboard” below 30. Unwilling \nto “chase” it up to 40, they welcomed the reaction and, by the time prices had dropped back \nto 33, enough of them were ready to buy to swing the balance back again to the demand \nside of the equation.\nWatching the ensuing rally, however, were the owners of the stock who had failed to \ngrab their profits near 40 on the previous advance and had made up their minds to be a \nlittle less greedy if given a second opportunity. Their offerings began to come in above 37 , \nsay, and were sufficiently copious at 39 to stem the advance at that level. Behind the scenes, \nwe can imagine this process repeated again and again, with new money constantly coming \nin and meeting supply from owners increasingly anxious to cinch their profits. Eventually, \nthe offerings of the latter are all absorbed, or perhaps withdrawn, and then professionals, \nas well as hopeful investors, suddenly discover there is no stock ahead on the books and \nrush to buy results.\nSince the advance (or decline) that follows the completion of a Symmetrical Triangle \nusually runs to worthwhile trading proportions (we shall discuss measuring implications \nlater), there would be an evident advantage to the trader who could tell in advance of the \nbreakout which way prices were going to move. The odds are, as already stated, the new \nmove will proceed in the same direction as the one before the Triangle’s formation. These \nodds are greatest, of course, in the early stages of either a Primary Bull or Bear Market with \nthe chances of Reversal increasing as those Major Trends mature. Nevertheless, the charts \nof other stocks often furnish valuable collateral evidence; thus, if at the same time you \ndetect a Symmetrical Triangle in the process of formation in “PDQ,” a majority of your \ncharts are showing Saucers or Head-and-Shoulders Bottoms or Ascending Triangles or \nsome other pattern of typically Bullish import, it is a fair assumption that your Symmetrical \nTriangle will break out topside. There are times when advance indications of this sort are \nstrong enough to justify taking a position on it.\nThe Right-Angle Triangles\nWe mentioned Ascending Triangles in the preceding paragraph. The Ascending and \nDescending are the Bullish and Bearish manifestations, respectively, of our next class of \npatterns, the Right-Angle Triangles. In many respects, in most in fact, they perform like their \nSymmetrical cousins, but with this very gratifying difference: they give advance notice of \ntheir intentions. Hence, their names, for the supposition always is that prices will ascend \nout of the Ascending form and descend from the Descending form.\nThe Symmetrical Triangles, as we have seen, are constructed of a series of successively \nnarrower price fluctuations that can be approximately bounded across their Tops by a \ndown-sloping line and across their Bottoms by an up-sloping line. Right-Angle Triangles \nare distinguished by the fact that one of their boundaries is practically horizontal, whereas \nthe other slants toward it. If the top line is horizontal and the bottom line slopes up to \nmeet it somewhere out to the right of the chart (at the apex), the Triangle is of the Ascending \npersuasion. If the bottom line is horizontal and the top line slopes down, the Triangle is \nDescending.\nThese formations are perfectly logical and easy to explain. The Ascending Triangle, for \ninstance, pictures in the simplest and most normal form what happens when a growing \ndemand for a certain stock meets a large block of shares for sale at a fixed price. If the demand \n98 Technical Analysis of Stock Trends\ncontinues, the supply being distributed at that price will eventually be entirely absorbed by new \nowners looking for still higher levels, and prices will then advance rapidly. A typical Ascending \nPattern starts to develop in much the same way as the “ideal” Symmetrical Triangle previously \ndescribed, with an advance in our certain stock from 20 to 40 at which point sufficient supply \nsuddenly appears on the market to fill the orders of all buyers and produce a reaction. Sensing \nthe temporary satiation of demand, some owners may dump their holdings on the decline, \nbut offerings are soon exhausted as prices drop back to, say, 34, and renewed demand then \nstimulates a new rally. This runs into supply again at 40, and again, all buyers are accommodated \nat that level. The second recession, however, carries quotation down only to 36 before another \nup-move develops. But the pool or inside group that is distributing at 40 still has some of its \nholdings left to sell, so it may take more time, another backing away and another attack at the \n40 line before the supply there is exhausted and the trend can push along up.\nA planned distribution\nThis type of market action evidences a planned campaign by owners of a fairly large \nquantity of shares to liquidate at a predetermined price. It contains little of the element of \ndoubt that we mentioned as characterizing the Symmetrical Pattern. So long as demand \npersists, the distributing pool knows it can ultimately cash in its entire line at 40 and need \nnot sell for less. It is equally apparent, so long as demand keeps coming in at higher and \nhigher levels that, once the supply at 40 has all been absorbed, the market will advance \nrapidly and easily. As soon as prices break out above 40, those who took over the supply \nat that figure will feel their judgment has been vindicated and will not be dis", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 59}
{"text": "timately cash in its entire line at 40 and need \nnot sell for less. It is equally apparent, so long as demand keeps coming in at higher and \nhigher levels that, once the supply at 40 has all been absorbed, the market will advance \nrapidly and easily. As soon as prices break out above 40, those who took over the supply \nat that figure will feel their judgment has been vindicated and will not be disposed to sell \nuntil they, in turn, can register a good profit.\nThe crux of the matter is contained in the two preceding sentences. Demand must \ncontinue to come in at higher and higher levels, otherwise, our formation will cease to be \nan Ascending Triangle. Plus, the overhead supply must eventually be absorbed, permitting \nan upside breakout. If demand begins to falter any time before the Supply Line (horizontal \nTop boundary) has been broken through, the ensuing reaction may drop prices down “out of \npattern,” and then the chart technician is faced with the necessity of revising his chart picture. \nOne might think that such a development, blasting the earlier promise of the chart, would \noccur fairly often, but, as a matter of experience, it is surprisingly rare. We say “surprisingly” \nbecause it is obvious that in many cases of Ascending Triangle development, the group selling \ncreates its Top boundary or Supply Line must believe that level to be just about as high as the \nstock has any right to go. As holders of a large enough block to influence the market for several \nweeks, sometimes months, their judgment is hardly to be scorned. Yet, once it becomes evident \nthe lower boundary or Demand Line is slanting up, the odds are certainly somewhere in the \nneighborhood of 9–1 that the new buyers will eventually have the best of it.\nOn occasion, the third reaction or fourth reaction within an Ascending Triangle \nFormation will break down through the previously established up-slanting Demand Line \n(lower boundary), but it will be halted at the same level as the previous reaction. The pattern \nfrom there on is apt to develop as a Rectangle, a formation to be discussed in our next chapter, \nand should be treated as such. (The tactics of trading on Ascending and Descending Triangles, \nincluding protection against the rare cases of collapse, will be taken up in Section II.)\nDescending Triangles\nDescending Triangles have a horizontal lower boundary or Demand Line and a down-\nsloping upper boundary or Supply Line. It is evident they are created by reverse market \n99Chapter eight: Important R eversal Patterns: the Triangles\nconditions than those of the Ascending Pattern; however, their implications are equally \nstrong and their failures equally rare. Development of a Descending Formation hinges on \na campaign by a group or syndicate (often an investment trust) (EN9: or Mutual Fund or a \ntakeover group) to acquire a large block of shares in a certain company at a predetermined \nprice below the market. Their orders are placed and allowed to stand until executed at that \nlevel. If the successive rallies therefrom, which their buying generates, are stifled by new \nsupplies of stock for sale at lower and lower levels (thus creating the typical Descending \npicture on the chart), orders to buy are eventually all filled and quotations break through \nand on down. The mere breaking of the critical line, which many traders have seen \nfunction as a support under the market for a more or less extended period, often shakes \nthe confidence of holders who had not previously considered selling. Their offerings now \ncome on the market and accelerate the decline.\nVolume characteristics same as the Symmetrical type\nThe volume section of the Right-Angle Triangle’s chart requires little comment. It will \nordinarily present a picture practically identical with that accompanying the development \nof a Symmetrical Triangle. Activity tends to lessen as prices move out toward the apex. \nIn the Ascending Formation, there will usually be a pickup on each rally and an ebb in \nturnover on each decline within the pattern; in the Descending Formation, the opposite \nis true, but sometimes it is not quite so evident. These Minor fluctuations do not affect the \noverall diminishing trend of volume until the breakout point is reached.\nAs to breakouts, practically everything discussed about the Symmetrical Triangle will \napply as well to the Right-Angle type. Upside breakouts (from an Ascending Pattern, of \ncourse) are attended by a conspicuous increase in trading volume; if not, they should be \ntreated as suspect. Downside breakouts (from Descending Patterns) may not evince much \nof a pickup in activity, but turnover usually speeds up the second or third day out of \npattern. Throwback reactions to the pattern’s boundary line after a breakout are fairly \ncommon; their occurrence seems to depend largely on general market conditions. Thus, if \nprices break down out of a Descending Triangle in an individual stock at a time when the \nrest of the market is firm, a Pullback Rally is fairly certain to intervene before any extensive \nfurther decline takes place.\nThis chart, and a number that have preceded it, illustrate an important point for the \nmarket technician that may well be restated here: When a large number of individual \nissues, after an extensive advance, make well-defined Reversal Patterns of plainly Bearish \nimport, break down out of them, and then succeed only in pulling back no farther than \ntheir lower boundaries or “Resistance Lines” at a time when the Averages are going on \nup to new highs, the whole market is in a dangerous condition and a Major Downturn \nis imminent. Divergences of this particular sort between many important issues and the \nAverages seldom develop at Intermediate Turns. The warning is particularly pointed when \nstocks of the caliber of Westinghouse, DuPont, General Motors, and others fail to “confirm” \nnew highs in the Averages.\nRefer back to Figures 6.3, 6.6, 6.9, and 8.15, for example, and compare the “timing” in", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 60}
{"text": "Major Downturn \nis imminent. Divergences of this particular sort between many important issues and the \nAverages seldom develop at Intermediate Turns. The warning is particularly pointed when \nstocks of the caliber of Westinghouse, DuPont, General Motors, and others fail to “confirm” \nnew highs in the Averages.\nRefer back to Figures 6.3, 6.6, 6.9, and 8.15, for example, and compare the “timing” in \nthose with the trend of the Averages for the same periods. The Saucer-Like Reaction Pattern \nof October to January in the above chart analyzes into a Complex Head-and-Shoulders \nConsolidation, a formation that will be taken up in Chapter 11.\nIncidentally, “WX” continued on down to 130 in April 1937 , made a Rectangle base there, \nand recovered to 158 (see above Descending Triangle) in August and then fell to 88 in November. \nCompare this daily chart with the monthly chart of “WX” for 1935 to 1938 in Figure 15.15.\n100 Technical Analysis of Stock Trends\nGood, reliable breakouts from Right-Angle Triangles usually occur at about the same \nstage of pattern completion as they do in Symmetrical Triangles. The earlier the breakout, \nthe less apt it is to be a false move (although false moves from Right-Angle Formations are \nconsiderably rarer, it should be noted, than from Symmetrical). In those infrequent cases \nwhen prices “squeeze” right on out of the apex without producing a definite breakout, the \npattern seems to lose much of its power.\nMeasuring implications of Triangles\nIn Chapter 6, we stated a minimum measuring rule to apply to price movements developing \nfrom a Head-and-Shoulders Formation, and we can lay down a somewhat similar rule \nfor Triangles—one that applies to both the Symmetrical and the Right-Angle species. The \nmethod of deriving the Triangle formula is not easy to explain in words, but the reader \ncan familiarize himself with it quickly by studying its application on several of the actual \nexamples that illustrate this chapter. Assuming we are dealing with an up-movement \n(upside breakout), draw from the Top of the first rally that initiated the pattern (in other \nwords, from its upper left-hand corner) a line parallel to the Bottom boundary. This line \nwill slope up away from the pattern to the right. Prices may be expected to climb until they \nreach this line. Also, as a rule, they will climb, following their breakout from the pattern, \nat about the same angle or rate as characterized their trend before entering the pattern. \nThis principle permits us to arrive at an approximate time and level for them to attain the \nmeasuring line. The same rules apply (but measuring down, of course, from the lower left \ncorner) to a descending move.\nAlthough application of the above formula does afford a fair estimate of the extent of \nmove to be expected from a Triangle, it is neither as definite nor as reliable as the Head-and-\nShoulders formula. Do not forget the important qualification that the Triangle has somehow \nlost a part of its potential strength if the breakout is delayed until prices are crowded into \nthe apex.\nTriangles on weekly and monthly charts\nWe have seen in preceding studies how Head-and-Shoulders Formations may appear on \nthe long-range (weekly or monthly) charts and will have importance commensurate with \ntheir size. Triangles also may develop on weekly charts with their implications usually \nclear and dependable, but the coarse Triangular Patterns—which can be found on graphs of \nmonthly price ranges, especially the great, loose convergences that take years to complete—\nhad better be dismissed as without useful significance.\nOther Triangular formations\nThere are other patterns of price consolidation or congestion that can be bounded by \nconverging lines and might, therefore, be classified as Triangles. However, they deviate \nfrom the true Triangles of this chapter so markedly in one or more important respects \nthat they are best treated under other headings elsewhere, such as Flags, Pennants, and \nWedges. Still another group of chart patterns develops between diverging boundary lines, \non which account they have sometimes been called Inverted Triangles. But their causes, \ncharacteristics, and forecasting implications are so radically different that we have chosen \nto rename them Broadening Formations and discuss them in a later chapter.\n101Chapter eight: Importa nt Reversal Patterns: the Triangles\nThe reader may have become dismayed at this point by our frequent recourse to such \nqualifying adverbs as usually, ordinarily, and the like. It cannot be avoided if one wishes to \npresent a true picture of what actually happens. No two chart patterns are ever precisely \nalike; no two market trends develop in quite the same way. History repeats itself in the \nstock market, but never exactly. Nevertheless, the investor who familiarizes himself with \nthe historical pattern, with the normal market action, and refuses to be tempted into a \ncommitment in the belief that “this time will be different,” will be far and away ahead of \nthe fellow who looks for the exception rather than the rule.\nThe beginner is proverbially lucky. He will find Triangles, Head-and-Shoulders, or \nother significant patterns, one after the other, on his charts, watch them develop, and see \nthem carry through with profitable moves according to rule, until the exception comes \nalong—or he will overlook the larger picture while concentrating on some Minor Pattern \ndevelopment—and suddenly awake to the fact he is caught in a very bad play. Hence, \nwe constantly emphasize the nonconforming movements. Our words of qualification are \nnecessary because technical analysis of market action is not an exact science and never \nwill be.\n\n103\nchapter nine\nMore important Reversal Patterns\nThe Rectangles, Double and Triple Tops\nThe Triangular Price Formations, which we examined in Chapter 8 , can be either Reversal \nor Consolidation Patterns. In the case of the Right-Angle Triangles, we know as soon as they \nhave attained", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 61}
{"text": "fication are \nnecessary because technical analysis of market action is not an exact science and never \nwill be.\n\n103\nchapter nine\nMore important Reversal Patterns\nThe Rectangles, Double and Triple Tops\nThe Triangular Price Formations, which we examined in Chapter 8 , can be either Reversal \nor Consolidation Patterns. In the case of the Right-Angle Triangles, we know as soon as they \nhave attained recognizable form in which direction the trend will (or should) proceed. With \nthe Symmetrical Triangles, we have no way of knowing whether they point up or down \nuntil prices finally break away from them, although the odds are, as we have seen, the \nprevious trend will be continued rather than reversed. In this respect, and in many others, \nour next class of technical formations, the Rectangles, resemble the Symmetrical Triangles. \nThere are, in fact, so many points of similarity between them that we can forego any long \nand detailed discussion. (For illustrations in this chapter, see Figures 9.1 through 9.18.)\nA Rectangle consists of a series of sideways price fluctuations, a “trading area,” as it is \nsometimes called, which can be bounded both top and bottom by horizontal lines. A glance \nat any one of the examples that illustrate these pages will show how it got its name. On \nrare occasions, you may discover a chart pattern whose upper and lower boundary lines \nare parallel but either slightly down-sloping or up-sloping. So long as their departure from \nthe horizontal is trivial, they may be treated as Rectangles. You will also find, on occasion, \npatterns whose boundaries, while nearly horizontal, tend somewhat to converge. These \nmay be considered Rectangles or Symmetrical Triangles; it does not matter which because \nthe “prognosis” will be the same in either case.\nIf you will give a quick mental review also to the Head-and-Shoulders, the Complex, \nand the Rounding types of formations, you will see how, if you disregard the volume part \nof their charts, any one of these patterns might merge or grade into a Rectangle. As a matter \nof fact, however, you will seldom be left in doubt as to proper classification because the \ncircumstances of trading, the type of buying and selling, which produce Rectangles are \ndifferent, which is usually apparent.\nWe characterized the Symmetrical Triangle as a “picture of doubt.” The Rectangle \nmight, with even greater propriety, be called a picture of conflict. Of course, any fairly \ncompact price formation represents conflict in the supply–demand sense. A Head-and-\nShoulders Top, for example, portrays a conflict between “strong” sellers and “weak” \nbuyers with the outcome already clearly seen before the combat has ended. But a Rectangle \ndefines a contest between two groups of approximately equal strength—between owners \nof the stock who wish to dispose of their shares at a certain price and others who wish to \naccumulate the stock at a certain lower figure. They bat the ball back and forth (up and \ndown, that is) between them until ultimately, and usually quite suddenly, one team is \nexhausted (or changes its mind) and the other proceeds to knock the ball out of the lot. \nNobody (often, not even the contestants themselves) can tell who is going to win until one \nline or the other is decisively broken.\nWe speak of two groups operating in the development of a rectangular trading area \nbecause, under present-day conditions, that is what is usually the fact behind the scenes. \nThis, it should be noted, does not imply “manipulation” in any invidious sense. An \ninvestment trust or an estate or, in some cases, an individual heavy stockholder has good \n104 Technical Analysis of Stock Trends\nand sufficient reasons for selling at the top price (the “Supply Line” of the Rectangle) with \nno intent to mislead the public. Another investment trust or a group of insiders interested \nin the company may have equally good and, from their point of view, wise reasons for \nbuying at the bottom price (“Demand Line”). Such are the forces at work in the market at \nthe start of most Rectangular Chart Patterns, but if the “spread” between top and bottom \nNASH – KELVINATOR NK 1945–1946\nOCTOBERN OVEMBERD ECEMBERJ ANUARY FEBRUARY MARCH\n26\n24\n22\n20\n250\n200\n150\n100\n50\n61 32 02 73 10 17 24 18 15 22 29 51 21 92 62 91 62 32 91 62 33 0\nSales\n100’s\nFigure 9.1 Although its Bottom boundary had a slight tendency to “lift,” the formation that put a \nTop on Nash–Kelvinator in 1946 was an unmistakable four-month distribution Rectangle. Long and \nrather loose Rectangular Patterns of the type shown here may not evince constantly and noticeably \ndiminishing volume, but note, nevertheless, the general, although irregular, downtrend in volume \nfrom mid-October to mid-February.\nLIMA LOCOMOTIVE WORKS LMW 1944–1945\n56\n52\n48\n44\n50\n40\n30\n20\n10\nOCTOBERN OVEMBERD ECEMBERJ ANUARY FEBRUARY MARCH\n71 42 12 84 11 18 25 29 16 23 30 61 32 02 73 10 17 24 31 01 72 43 1\nSales\n100’s\nG\nFigure 9.2 Consolidation Rectangles in uptrends have been less common in recent years than during \nthe 1920s and early 1930s. The large price gap (G) in this example is of the “last in pattern” type, \nwhich we shall come to in Chapter 12. When a gap within a pattern area is followed by breakout \nfrom that pattern, as in this case, the gap is infrequently closed quickly.\n105Chapter nine: More impor tant Reversal Patterns\nlines is wide enough (say 8%–10% of the market value of the stock), the situation may \nquickly attract a following from quick-turn scalpers and the professional element. Thus, a \nsyndicate holding a large block of U.S. Steel may decide to liquidate at 76, whereas another \ngroup decides to invest heavily in “Steel” at 69. The price of X will naturally fluctuate for \na time between those two levels. Traders, seeing this, will try to ride the play, buying at 69 \nand selling at 76 (perhaps also selling short at 76 and covering at 69). Their operations will \ntend to accentuate or extend the Rectangle, although the number of shares", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 62}
{"text": "de to liquidate at 76, whereas another \ngroup decides to invest heavily in “Steel” at 69. The price of X will naturally fluctuate for \na time between those two levels. Traders, seeing this, will try to ride the play, buying at 69 \nand selling at 76 (perhaps also selling short at 76 and covering at 69). Their operations will \ntend to accentuate or extend the Rectangle, although the number of shares involved in such \nparasitic trading is seldom great enough to affect the final outcome. As a matter of fact, this \ntype of trading inside a Rectangle can be quite profitable at times, especially if protected by \njudicious stops (see Section II).\nPool operations\nIn times past, before the U.S. Securities and Exchange Commission (SEC) outlawed \nthe practice, Rectangles were frequently created by the well-organized operations of a \nsingle “pool” or syndicate. Such a pool might undertake to accumulate a large block of \n1936–1937\nLOEW’S, INC. LW\nOCTOBERN OVEMBERD ECEMBERJ ANUARY FEBRUARY MARCH\n96\n80\n76\n72\n68\n64\n60\n56\n52\n48\n44\n125\n100\n75\n50\n25\n31 01 72 43 17 14 21 2851 21 92 62 91 62 33 06 13 20 2761 32 02 7\nSales\n100’s\nFigure 9.3 A perfect example of Consolidation Rectangle that formed in Loew’s near the end of the \n1932–1937 Bull Market. In this case, a large block of “inside” stock was distributed at 64 to 65 but taken \nover around 62 by other investors who had the satisfaction of seeing it go on up to 87 the following \nAugust. Note the Throwback following breakout in January.\n106 Technical Analysis of Stock Trends\nSOCONY–VACUUM OILS OV 1946\nAPRILM AY JUNEJ ULYA UGUSTS EPTEMBER\n19\n18\n17\n16\n15\n14\n13\nSales\n100’s\n250\n200\n150\n100\n50\n61 32 02 74 11 18 25 18 15 22 29 61 32 02 7310 17 24 31 71 42 12 8\nX D 5.25\nFigure 9.4 Here is a Rectangle in Socony–Vacuum, a low-priced stock characterized by fluctuations \nwithin a narrow range. After reaching a high of 18 in December 1945, it fell back to 15 and then rallied \nin mid-1946 as shown above. In late August, prices broke down through an Intermediate Trendline \n(see Chapter 14) and four days later fell out of the Rectangle. This formation, in conjunction with \nthe earlier and higher Top, implied lower levels for “SOV” for some time to come. See also comment \nunder Figure 9.5.\nYOUNGSTOWN SHEET & TUBE YB\n1946\nAPRILM AY JUNEJ ULYA UGUSTS EPTEMBER\n80\n76\n72\n68\n64\n60\nSales\n100’s\n50\n40\n30\n20\n10\n61 32 02 74 11 18 25 18 15 22 29 61 32 02 7310 17 24 31 71 42 12 8\nFigure 9.5 Another long, loose Rectangle of Major Reversal implications, somewhat similar to that \npictured in Figure 9.1 . Both an Intermediate and Major Up Trendline (to be discussed later) were \ndecisively punctured by “YB” in August, just before its Rectangle broke down. Under Figure 8.21, we \ndiscussed one sort of warning of a Primary Downturn that may be derived from the comparison of \nindividual stock charts with the Averages. Here is another hint: the better-grade steels and oils (see \n“ S OV,” Figure 9.4) frequently hold up, or make stronger Secondary Recoveries, after the Averages \nhave turned down at Major Tops. The Street sometimes speaks of “distribution under cover of \nstrength in the steels.”\n107Chapter nine: More import ant Reversal Patterns\nstock in a certain company with a view to marking it up and taking profits when some \npiece of good news, of which they had inside knowledge, eventually became public. To \nacquire the desired “line,” they would find it necessary first to shake out shares held by \nother traders and uninformed investors. They might start their campaign by suddenly \nselling short a few hundred shares to quench any current demand and start a reaction. \nThen, on that reaction to the previously determined accumulation level, they would \nstart to buy, scattering their orders carefully and avoiding any publicity. Their buying \nwould, sooner or later, engender a rally, but then they would “plant” rumors around the \nboardrooms to the effect that such-and-such insiders were selling, or that a projected \nmerger was being called off, or a dividend would have to be passed, and, if necessary, \nthey would ostentatiously let out a few of their own recently purchased shares to \ngive color to the rumor. The process might be repeated several times with the “pool” \ngradually securing more and more shares on balance until, finally, its intended line is \ncompleted or could not shake out more of the floating supply. Often, what was going \non was fairly evident to the alert chartist back in the 1920s even before the operation \nwas concluded, and perfectly evident, of course, as soon as prices broke out topside \nfrom their Rectangle.\nBut such tactics are no longer permitted. “Wash sales” are strictly condemned; the \nconstant policing of all exchange transactions and prompt investigation by the SEC of any \nsuspicious news or activity in a stock effectually deters the blatant “pool” manipulations \nof previous years. This probably is the chief reason why Rectangles are nowhere near so \ncommon on the charts of the 1950s as they were in the 1920s. (EN: Not uncommon in the 2000s.)\nEASTERN AIRLINES EAL\n1945\nJANUARYF EBRUARYM ARCH APRILM AY JUNE\n64\n60\n56\n52\n48\n44\n40\n50\n40\n30\n20\n10\nG\nG\n61 32 02 73 10 17 24 31 01 72 43 17 14 21 28 5\n12 19 26 29 16 23 30\nSales\n100’s\nFigure 9.6 The Rectangle in early 1945 in “EAL ” was actually the final stage of a nearly two-year \nConsolidation in the rise, which started around 17 in 1942 and ended above 125 in December \n1945. G, G mark gaps (see Chapter 12), the first a Breakaway and the second a Measuring Gap, \nwhich marked the probable objective of the move as 55. When prices reached that level, another \nConsolidation developed, a Symmetrical Triangle. Neither of these gaps was “closed” during the \nfollowing two years.\n108 Technical Analysis of Stock Trends\nPerhaps we can clear up various details of the Rectangle formation most quickly and \neasily by comparison with that most nearly related chart pattern, the Symmetrical Triangle, \nas follows:\n• Volume—Follows the same rules", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 63}
{"text": "d that level, another \nConsolidation developed, a Symmetrical Triangle. Neither of these gaps was “closed” during the \nfollowing two years.\n108 Technical Analysis of Stock Trends\nPerhaps we can clear up various details of the Rectangle formation most quickly and \neasily by comparison with that most nearly related chart pattern, the Symmetrical Triangle, \nas follows:\n• Volume—Follows the same rules as in the Triangles, gradually diminishing as the \nRectangle lengthens. Any contrary development, unless it be a momentary news \nflurry, is suspect.\n• Breakouts— Here also the same rules apply as with Triangles. Review volume \nrequirements, margin of penetration, and so on thereunder.\n• False moves—Much less frequent from Rectangles than from Symmetrical Triangles. \nA clearly defined Rectangle is, in fact, almost as reliable as a Head-and-Shoulders, \nalthough not as powerful in its implications.\n• Premature breakouts— Slightly more frequent, perhaps, from Rectangles than from \nTriangles.\n(Note: Both false moves and premature breakouts, in the sense in which we employ these \nterms, are indistinguishable at the time they occur from genuine breakouts. Following both \nfalse and premature breaks, prices return inside the pattern. But, in the case of a false move, \nthe trend ultimately proceeds out of pattern in the opposite direction, while in the case of \nthe premature move, the trend finally breaks out again and proceeds in the same direction.)\nAMERICAN ZINC, LEAD & SMELTINGZ A\n1945–1946\nDECEMBER JANUARY FEBR UARY MARCHA PRIL MAYJ UNE JULY AUGUST SEPTEMBERO CTOBER NOVEMBER\n17\n16\n15\n14\n13\n12\n11\n10\n9\n8\n7\n6\n250\n200\n150\n100\n50\nS S\nS\nS H\nH\nNL\n81 52 2295 12 19 2622 91 62 391 62 33 06 13 20 2741 11 82 51 81 52 22 96 13 20 2731 01 72 4317 14 21 2851 21 9262 91 6\nS\nS\nS S\nH H\nH H\nSales\n100’s\nFigure 9.7 An extraordinary, fine, long Rectangle that developed after “ZA” had broken down out of \na Head-and-Shoulders Top in February 1946. A perfect opportunity to sell this stock short was given \nby its Pullback of July 17–18 after prices had broken out of the Rectangle on the 15th. The Multiple \nHead-and-Shoulders Bottom that it subsequently made from September to November produced a \nrecovery to 11, but prices later fell to 6 in early 1947 .\n109Chapter nine: More impor tant Reversal Patterns\nSEARS ROEBUCK S 1941–1943\n76\n72\n68\n64\n60\n56\n52\n48\n50\n40\n30\n20\n10\nS ON DJ FM AM JJ AS ON DJ FM\nSales\n100’s\nFigure 9.8 In this weekly chart showing Sears Roebuck’s 1942 Bear Market Bottom, a Consolidation \nRectangle (June to November) forms the right shoulder of a large “unbalanced” Double Head-and-\nShoulders Pattern.\nBELL AIRCRAFT BLL 1945\n22\n20\n19\n18\n17\n16\n15\n14\n13\nSales\n100’s\n125\n100\n75\n50\n25\nJANUARYF EBRUARYM ARCH APRILM AY JUNE\n61 32 02 73 10 17 24 31 01 72 43 17 14 21 28 51 21 92 62 91 62 33 0\nG\nFigure 9.9 After advancing to 16 in January 1945, “BLL ” dropped back to 13 and then constructed \na 15-week Rectangle. Note that the down gap (G) on April 30 was caused by a $1.00 dividend going \noff. The revised bottom line of the pattern, drawn $1.00 lower, was not violated.\n110 Technical Analysis of Stock Trends\n• Pullbacks—Return of prices to the boundary of the pattern, subsequent to its initial \npenetration (breakout), takes place more frequently with Rectangles than with \nSymmetrical Triangles. Our estimate would be that a Pullback or Throwback (the \nfirst is the common term for a rally after a downside breakout, and the second for a \nreaction following an upside breakout) occurs within three days to three weeks in \nabout 40% of all cases.\n• Directional tendency—The Rectangle is more often a Consolidation Formation than \na Reversal Formation, the ratio being about the same as with Symmetrical Triangles. \nAs Reversal Patterns, Rectangles appear more frequently at Bottoms (either Major or \nIntermediate) than at Tops. Long, thin, dull Rectangles are not uncommon at Primary \nBottoms, sometimes grading into the type of Flat-Bottomed Saucer or Dormancy \ndescribed in Chapter 7 .\n• Measuring implications—A safe minimum measuring formula for the Rectangle is \ngiven by its width. Prices should go at least as far in points beyond the pattern as the \ndifference in points between the top and bottom lines of the pattern itself, though \nthey may go much farther. Generally speaking, the brief, wide-swinging forms, which \nappear nearly square in shape on the chart and in which turnover is active, are more \ndynamic than the longer and narrower manifestations. Moves out of the latter almost \nalways hesitate or react at the “minimum” point before carrying on.\nKENNECOTT COPPERK N\n1937\nJULY AUGUST SEPTEMBERO CTOBER NOVEMBER DECEMBER\n64\n60\n56\n52\n48\n44\n40\n38\n36\n34\n32\n30\n28\n250\n200\n150\n100\n50\n31 01 72 4 31 71 42 12 84 11 18 25 29 16 23 30 61 32 02 7411 18 25\nSales\n100’s\nFigure 9.10 A brief and very “high” Rectangle formed in September 1937 in the rapid Bear Market \nDecline of “KN,” followed by a Descending and then a Symmetrical Triangle Consolidation.\n111Chapter nine: More impor tant Reversal Patterns\nUNITED AIRCRAFT UR\n1941–1943\n40\n38\n36\n34\n32\n30\n28\n26\n24\n50\n40\n30\n20\n10\nS ON DJ FM AM JJ AS ON DJ FM\nSales\n100’s\nFigure 9.11 This formation, constructed by United Aircraft in 1942, was not completed and could \nnot be called a Double Bottom until prices rose above 31 in February 1943. (See following pages.)\nINCO CO LTDN1988\nS\nS\nH\nNL\nAPRIL MAY JUNE JULY AUGUST SEPTEMBERO CTOBER\n38\n36\n34\n32\n30\n28\n26\n4000\n3200\n2400\n1600\n800\n62 91 62 33 07 14 21 28 41 11 82 52 91 62 33 06 13 20 27 31 01 72 41 81 52 2\nXD.2 X0D .20\nSales\n100’s\nFigure 9.12 INCO quickly recovered from the Reagan Crash of 1987 and by year’s end, it was nearly \nback to its 1987 high; the latter was decisively broken in April 1988. The powerful rally continued \nto carry “N” higher. But the August reaction, followed by a poor rally in September, created a large \nHead-and-Shoulders Top. The early September decline broke the neckline to confirm the Reversal \nand the subsequent Throwback, to Neckline", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 64}
{"text": "the Reagan Crash of 1987 and by year’s end, it was nearly \nback to its 1987 high; the latter was decisively broken in April 1988. The powerful rally continued \nto carry “N” higher. But the August reaction, followed by a poor rally in September, created a large \nHead-and-Shoulders Top. The early September decline broke the neckline to confirm the Reversal \nand the subsequent Throwback, to Neckline Resistance, was an excellent selling point.\n112 Technical Analysis of Stock Trends\nRelation of rectangle to Dow Line\nThe resemblance of this individual stock chart formation, which we have discussed under \nthe name of Rectangle, to the Average formation known to Dow theorists as a “Line” has \ndoubtless occurred to you. Obviously, their rationale and forecasting implications are much \nthe same, but true Rectangles with sharply delimited Top (Supply) and Bottom (Demand) \nboundaries are truly characteristic only of trading in individual issues. Line formations \nin the Averages are seldom rigorously defined, with successive Minor Heights forming \nquite precisely at a certain horizontal tangent and successive Bottoms at a similarly precise \nhorizontal level. If you will examine the separate charts of the issues composing an Average \nat a time when the Average is “making a Line,” you will surely find some of them showing \nan irregular uptrend, others showing an irregular downtrend, still others may be forming \nTriangles, and a few may be constructing Rectangles, or what not, but it is the algebraic sum \nof all these more or less divergent pictures that makes up the Average “Line.”\nTo be sure, there is some tendency on the part of active traders to sell (or buy) stocks \nwhen a certain Average reaches a certain figure, regardless of the status of individual \nissues involved. An investment counsel will occasionally advise his clients, for example, to \n“sell all speculative holdings when the Dow Industrials reach 500” (EN: or 5,000 or 15,000). \nBut trading commitments based solely on general Average levels are so seldom followed \nconsistently that they have little effect. (EN10: In the modern era, with the availability of index \nexchange-traded funds, this is no longer true.)\nREPUBLICS TEEL RS\n1945–1946\nG\nG\nG\nG\nDECEMBER JANUA RY FEBRUARY MARCHA PRIL MAYJ UNEJ ULYA UGUST\n52\n48\n44\n40\n38\n36\n34\n32\n30\n28\n26\n24\n22\n25020015010050\n18 15 22 2951 21 9262 91 62 32 91 62 3306 13 20 27 11 18 25 18 15 22 2961 32 02 7310 17 24 3171 44\nSales\n100’s\nFigure 9.13 Owing to the long-time-between-Tops requirement for true Double Top Reversals, these \nformations can seldom be seen to advantage on a daily chart, but here is a good 1946 example in Republic \nSteel. Note the five months and 20% decline between Tops. This chart contains many interesting lesser \ntechnical formations also. The “Broadening” Swings (see Chapter 10) in June and July, as the second Top \nwas made, and the rounding rally in August were extremely Bearish in their implications.\n113Chapter nine: More impor tant Reversal Patterns\nRectangles from Right-Angle Triangles\nIn the preceding chapter, we referred to a type of partial “failure” in the development of \na Right-Angle Triangle that necessitates reclassifying the Triangle as a Rectangle. Now \nthat we have examined the latter pattern in detail, we need say little more about this \nphenomenon, except to note the odds still appear to be somewhat in favor of ultimate \nbreakout in the direction originally implied by the incipient Triangle. The fact there is this \nslight presumption, however, certainly does not warrant disregard of an opposite breakout \nfrom the rectangular reconstruction.\nDouble and Triple Tops and Bottoms\nTo some of the old hands in the Street, our relegation of that good old byword, the Double \nTop, to a Minor Position in our array of Reversal Formations may seem almost sacrilegious. \nIt is referred to by name perhaps more often than any other chart pattern by traders who \npossess a smattering of technical “lingo” but little organized knowledge of technical facts. \nTrue Double Tops and Double Bottoms are exceedingly rare; Triple Forms are even rarer. \nAdditionally, the true patterns (as distinguished from chart pictures that might mistakenly \nAMERICAN AIRLINES AMR\n1945–1947\n19\n18\n17\n16\n15\n14\n13\n12\n11 \n10\n9\n50\n40\n30\n20\n10\nA MND JF MA MJ JA SO ND JF M\nSales\n100’s\nFigure 9.14 Shares of “ AMR,” then selling for around 90, were split 5-for-1 in April 1946, resulting in \na quick rally to a new high. But the overall aspect of a Double Top with the high made the previous \nDecember was nevertheless apparent and confirmed when prices broke down through the “valley” \nlevel on August 28. Popular buying brought in by “splits” is usually short-lived and only temporarily \ndistorts the broad picture.\n114 Technical Analysis of Stock Trends\nbe called such but are really assignable to some one of our other Reversal Formations) can \nseldom be positively detected until prices have gone quite a long way away from them, and \ncan never be foretold or identified as soon as they occur from chart data alone.\nBut we are getting ahead of our story; we should first define what we are talking about. \nA Double Top is formed when a stock advances to a certain level with, usually, high volume \nat and approaching the Top figure, then retreats with diminishing activity, then comes up \nagain to the same (or practically the same) top price as before with some pickup in turnover, \nbut not as much as on the first peak, and then finally turns down a second time for a Major \nor Consequential Intermediate Decline. A Double Bottom is the same picture upside down; \nthe Triple types make three Tops (or Bottoms) instead of two.\nIt is not difficult to skim through a book of several hundred monthly charts and pick \nout two or three examples of Major Double Tops and, perhaps, one or two Double Bottoms. \nOne will find cases in which stocks made two successive Bull Market Peaks several years \napart at almost identical levels. Such phenomena stand", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 65}
{"text": "ure upside down; \nthe Triple types make three Tops (or Bottoms) instead of two.\nIt is not difficult to skim through a book of several hundred monthly charts and pick \nout two or three examples of Major Double Tops and, perhaps, one or two Double Bottoms. \nOne will find cases in which stocks made two successive Bull Market Peaks several years \napart at almost identical levels. Such phenomena stand out, in distant retrospect, like the \nproverbial sore thumb, which undoubtedly accounts for the undue awe with which the \namateur chartist regards them. He neglects, for the moment, to consider the fact a thousand \nother issues might have done the same thing but did not—that some of these even acted, \nfor a time, as though they were going to Double Top, but then went on through and higher.\nIs there any practical utility for the trader or investor in the Double Top concept? Yes, \nthere is, but it will be easier for us to formulate it if we first consider what is not a Double Top. \nRefer back for a moment to the Ascending Triangles and the Rectangles previously studied; \nCONTAINER CORPORATION CNR\n1941–1943\n22\n20\n19\n18\n17\n16\n15\n14\n13\n12\n11\n25\n20\n15\n10\n5\nS ON DJ FM AM JJ AS ON DJ FM\nSales\n100’s\nFigure 9.15 The Major Reversal Formation in “CNR” at the start of a Primary Advance that reached \n54. Note how an attempt at an Ascending Triangle turned into a Double Bottom.\n115Chapter nine: More impor tant Reversal Patterns\nwhen these start to evolve, the majority of the time their first step is the construction of two \nTops at an identical level with an intervening recession, and with less volume on the second \nTop than on the first. In the ordinary course of events, a third Top will develop there, and \nultimately, prices will break through and move on up to still higher levels. Thus, we see we \nmust have some rule or criterion to distinguish a true Double Top Reversal Pattern from \nthe Double Tops that do not imply Reversal when they appear as a part of a Consolidation \nArea in an uptrend.\nDistinguishing characteristics\nNo absolute and unqualified rule can be laid down to fit all cases involving stocks of \ndifferent values and market habits, but one relative distinction quickly suggests itself when \nwe study these different kinds of chart formations: if two Tops appear at the same level but \nquite close together in time and with only a Minor Reaction between them, chances are \nthey are part of a Consolidation Area; or, if a Reversal of Trend is to ensue, there will first \nbe more pattern development—more “work” done—around those top ranges. If, on the \nother hand, there is a long, dull, deep, and more or less rounding reaction after the initial \npeak has appeared, and then an evident lack of vitality when prices come up again to the \nprevious high, we can at least be suspicious of a Double Top.\nHow deep is deep, and how long is long? Fair questions, to which, unfortunately, it \nis impossible to give simple, definite answers, but we can attempt approximations. Thus, \nif the two Tops are more than a month apart, they are not likely to belong to the same \nConsolidation or Congestion Formation. If, in addition, the reaction between the first and \nsecond high reduces prices by 20% of their top value, the odds swing toward a Double Top \nTRINITY INDUSTRIES INC. TRN1 985\n1 2 3 ONE DAY\nREVERSAL\nAPRIL MAY JUNE JULY AUGUST SEPTEMBERO CTOBER\n20\n19\n18\n17\n16\n15\n14\n13\n12\n11\n500\n400\n300\n200\n100\n23 30 61 32 02 74 11 18 25 18 15 22 29 61 32 02 73 10 17 24 31 71 42 12 85 12 19\n57 60\nX D.125 X D.125\nSales\n100’s\nFigure 9.16 Although Trinity Industries did not have the well-formed pattern exhibited by our other \nrecommendations, we found the high-volume plunge, with the low of the day the third test of the \nyear’s low, a very beguiling technical situation. Basically, it was a Triple Bottom with a One-Day \nReversal to get the uptrend started.\n116 Technical Analysis of Stock Trends\ninterpretation. But both of these criteria are arbitrary, and not without exception. There \nare cases in which the two peaks have occurred only two or three weeks apart, and others \nin which the “valley” between them descended only about 15%. Most true Double Tops, \nhowever, develop two or three months or more apart. Generally speaking, the time element \nis more critical than the depth of the reaction. The greater the time between the two highs, \nthe less the need of any extensive decline of prices in the interim.\nGiven the conditions we have specified, namely, two Tops at approximately the \nsame level but more than a month apart on the chart, with somewhat less activity on \nthe second advance than on the first, and a rather dull or irregular and rounding type of \nrecession between them, we can then be suspicious that a Double Top Reversal has actually \nevolved. Should a small Head-and-Shoulders or Descending Triangle start to develop at \nthe second Top, as is frequently the case, we can be on guard, to the extent of protecting \nlong commitments at once with a close stop or by switching to something else with a more \npromising chart picture.\nYet, even all these signs together are not final and conclusive. The situation can still \nbe saved, and often is. Let us take a look at what is, presumably, going on behind the \nscenes to create our chart picture up to this point. The first Top on relatively high volume \nwas a normal incident and tells us little except that here, for the moment, demand met \nwith sufficient supply to stop the advance and produce a reaction. That supply may have \nrepresented only traders’ profit-taking, in which event the trend is likely to push on up \nafter a brief setback. But, when the reaction drifts off lower and lower until it has given up \n15% and more of the stock’s peak market value, and flattens out without any prompt and \nPUBLICKER INDUSTRIESP UL\n1946\nUP FROM 24\nIN MARCH\nOVER THE COUNTER\nAPRIL MAY JUNE JULY AUGUSTS EPTEMBER\n64\n60\n56\n52\n48\n44\n40\n38\n50\n40\n30\n20\n10\n6 13 20 27 4 11 18 25 1 8 15 22 29 6 13 20 27 3 10 17 24 31", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 66}
{"text": "o push on up \nafter a brief setback. But, when the reaction drifts off lower and lower until it has given up \n15% and more of the stock’s peak market value, and flattens out without any prompt and \nPUBLICKER INDUSTRIESP UL\n1946\nUP FROM 24\nIN MARCH\nOVER THE COUNTER\nAPRIL MAY JUNE JULY AUGUSTS EPTEMBER\n64\n60\n56\n52\n48\n44\n40\n38\n50\n40\n30\n20\n10\n6 13 20 27 4 11 18 25 1 8 15 22 29 6 13 20 27 3 10 17 24 31 7 14 21 28\nSales\n100’s\nFigure 9.17 Publicker made its Bull Market high only a few weeks after it was listed on the “big \nboard.” Then it started to build a Descending Triangle but pulled up out of it. The final outcome was \na Triple Top, completed in August (see Figures 8.17 and 9.15).\n117Chapter nine: More impor tant Reversal Patterns\nvigorous rebound, it becomes evident that either the demand was pretty well played out on \nthe last advance or the selling represented something more than short-term profit cashing. \nThe questions then are these: did the first high give evidence of important distribution, and \nis there much more to meet at the same price range?\nNevertheless, as our chart picture shows, demand did finally come in and absorb \nenough of the floating supply to turn the trend around. When prices pushed up and \nbegan to run into selling again near the level of the first Top, that was to be expected on \n“psychological” grounds; many quick-turn operators naturally would take profits at the old \nhigh (perhaps with the intention of jumping right back in at a still higher price if the old \nhigh should be exceeded). Hence, a Minor Hesitation there was quite in order. But selling \nin sufficient quantity to produce another extensive reaction would be quite another matter. \nWe have, by now, established a zone of Supply or Resistance at the peak levels and a zone \nof Support or Demand at the Bottom of the valley between. The final and decisive question \nnow is this: will the “valley” Support reappear and stop the second decline?\nNATIONAL GYPSUM NG\n1941–1943\n8\n7\n6\n5\n4\n125\n100\n75\n50\n25\nS ON DJ FM AM JJ AS ON DJ FM\n4 2\n1\n3 2\n1\nSales\n100’s\nFigure 9.18 In the ordinary course of events, at the time this Bottom Pattern developed in “NG,” \nconsisting, as it did, of fluctuations for 10 long months within a range of only 1 full point, most traders \nwould pay no attention to it. Certainly, it suggested very little opportunity for short-term profits. On \nan arithmetically scaled chart, the pattern could hardly be seen. Logarithmic price scaling, however, \nas we have remarked in an earlier chapter, has the great advantage of bringing to light the percentage \nimportance of significant market action at very low price levels.\n118 Technical Analysis of Stock Trends\nThe conclusive definition of a Double Top is given by a negative answer to that last \nquestion. If prices, on their recession from the second peak, drop through the Bottom level \nof the valley, a Reversal of Trend from up to down is signaled, which is usually a signal of \nmajor importance. Fully confirmed Double Tops seldom appear at turns in the Intermediate \nTrend; they are characteristically a Primary Reversal phenomenon. Hence, when you are \nsure you have one, do not scorn it. Even though prices may have already receded 20%, the \nchances are they have very much farther to go before they reach bottom.\nAs to measuring implications, the Double Top affords no formula comparable with what \nwe have attributed to Head-and-Shoulders and Triangle Formations, but it is safe to assume \nthe decline will continue at least as far below the valley level as the distance from peak to \nvalley. It may not be so in one interrupted slide; on the contrary, considerable time may be \nrequired to carry out the full descent in a series of waves. Pullbacks to the “valley” price \nrange, following the first breakthrough, are not uncommon. (Take into account the general \nrule that a Reversal Formation can be expected to produce no more than a retracement of \nthe trend that preceded it.)\nOne more point: we have said the Tops need not form at precisely the same level. Use \nhere the 3% rule we have previously laid down as a measuring stick for breakouts. A first \nTop at 50, for example, and a second at 51 1/2 would come within this limit. Curiously \nenough, the second peak often does exceed the first by a fraction. The important points are \n(1) that buying cannot push prices up into the clear by a decisive margin, and (2) the Support \nbelow is subsequently broken.\nDouble Bottoms\nIn identifying a Double Bottom, we can apply all of the precepts we have formulated \nfor the Double Top Pattern, but upside down. The differences between the two pictures \nare just what you might expect them to be, having in mind the characteristic differences \nbetween Head-and-Shoulders Tops and Bottoms, for example. Thus, the second Bottom is \nusually conspicuously dull (little trading volume) and is apt to be quite rounded, whereas \nthe second Top in a Double Top is moderately active and nearly as sharp and “spiky” in \ncontour as the first. The rally up from the second Bottom shows an increase in turnover, \nand volume should pick up to a marked degree as the valley level, or more properly, in this \ncase, the height between the two Bottoms, is surpassed. Double Bottoms appear just about as \nfrequently as do Double Tops at Primary Trend Reversals, and Double Bottoms also occur \nsometimes at the end of Intermediate Corrections in a Major Uptrend.\nIf you are familiar with some of the jargon of the Street, it has probably occurred to you \nthat the second low of a Double Bottom is an example of the market action so often referred \nto as a “test.” In a sense, that is just what it is—a test or corroboration of the Support (i.e., \ndemand) that stemmed the first decline at the same level. The success of that test is not proved, \nhowever—and this is a point to remember—until prices have demonstrated their ability to \nrise on increasing volume above the preceding high (the height of the rally between the two \nBott", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 67}
{"text": "often referred \nto as a “test.” In a sense, that is just what it is—a test or corroboration of the Support (i.e., \ndemand) that stemmed the first decline at the same level. The success of that test is not proved, \nhowever—and this is a point to remember—until prices have demonstrated their ability to \nrise on increasing volume above the preceding high (the height of the rally between the two \nBottoms). Until such time, there is always the possibility a second test (third bottom) may be \nnecessary, or even a third, and that one of these will fail with prices then breaking on down \ninto further decline. This thought leads us to our next type of Reversal Formation.\nTriple Tops and Bottoms\nLogically, if there are Double Tops, then we might expect that there will also be Triple Tops, \nwhich will develop in somewhat similar fashion. The fact is that Reversal Formations, \n119Chapter nine: More impor tant Reversal Patterns\nwhich can only be classed as Triple Tops, do occur, but they are few and far between. \nMany patterns evolve at an important turn from up to down in the trend that contains \nthree Top points, but most fall more readily into the category of Rectangles. For that \nmatter, any Head-and-Shoulders Formation, particularly if it be rather “flat” with the \nhead not extending much above the level of the two shoulders, might be called a sort of \nTriple Top.\nThe true Triple Top (as distinct, that is, from other types of three-peak formations) \ncarries a recognizable family resemblance to the Double Top. Its Tops are widely spaced and \nwith quite depth and usually rounding reactions between them. Volume is characteristically \nless on the second advance than on the first, and still less on the third, which often peters \nout with no appreciable pickup in activity. The three highs need not be spaced quite so far \napart as the two that constitute a Double Top, and they need not be equally spaced. Thus, \nthe second Top may occur only about three weeks after the first and the third six weeks or \nmore after the second. Also, the intervening valleys need not bottom out at exactly the same \nlevel; the first may be shallower than the second and vice versa. Also, the three highs may \nnot come at precisely the same price; our 3% tolerance rule is again useful here. Yet, despite \nall these permissible variations, there should be, and generally is, something suspiciously \nfamiliar about the overall picture, something that immediately suggests the possibility of \na Triple Top to the experienced chartist.\nThe conclusive test, however, is a decline from the third Top that breaks prices down \nthrough the level of the valley floor (the lower one, if the two valleys form at different \nlevels). Not until that has occurred can a Triple Top be regarded as confirmed and actually \nin effect; so long as demand persists at the valley price range, the trend can be turned up \nagain. Only in those cases in which activity is conspicuously lacking on the third peak and \nthen begins to show Bearish characteristics by accelerating on the ensuing decline is one \njustified in “jumping the gun.”\nNote this formation qualifies as a Triple Bottom in every detail—spacing between \nBottoms, extent in percent of intervening rallies, volume. Of course, its completion in \nOctober 1942 did not necessarily forecast that “NG” would climb to 33, as it ultimately did. \nBut the fact that many other stocks were making sound Major Bottom Formations at higher \nprice levels at the same time certainly warranted the conclusion that “NG” was on its way \nup, and that it was a bargain at 5.\nTriple Bottoms are simply Triple Tops turned upside down, with the same qualifications \nnoted when discussing Double Bottoms. The third low should always be attended by small \nvolume, and the rise therefrom must show a decided increase in turnover and carry prices \ndecisively above the Tops of the rallies that formed between the Bottoms. One is never \njustified in “jumping the gun” on a presumed Triple Bottom Formation unless nearly \nevery other chart in the book is in an unmistakably Bullish position. The risk of premature \nbuying is expressed in a saying one sometimes hears in the boardrooms to the effect of “a \nTriple Bottom is always broken.” This is not a true saying. Once a Triple Bottom has been \nestablished and confirmed by the necessary up-side breakout, it seldomly fails—it almost \nalways produces an advance of distinctly worthwhile proportions. But an uncompleted \n“possible” Triple Bottom chart picture must be regarded as treacherous. Stick to the \nbreakout rule and you will be safe.\nTriple Tops are sometimes referred to as “W” Patterns because of their occasional \nresemblance to that capital letter on the chart. There is a sort of hybrid between the Double \nand Triple Top, in which the middle one of the three Tops does not attain the height of \nthe first and third, and thus, even more strikingly resembles a “W.” For the same reason, \nDouble Tops are sometimes called “M” Formations.\n120 Technical Analysis of Stock Trends\nBecause the elements in Double and Triple patterns are normally spaced well apart \nin time, they are often easier to detect and appreciate on a weekly chart than on a daily. \nMonthly graphs disclose numbers of widely spread Double and Triple Bottoms but, on the \nother hand, are too coarse to reveal many good Double and Triple Top Patterns.\nIn our foregoing discussion of the Triple Top, we referred to a sort of intuition that \ncomes with experience and enables a technical analyst to recognize the potentialities for \nReversal of a certain chart development, sometimes long before it has reached a conclusive \nstage. This is a not uncommon talent, but it is one that is seldom attained except through \nsearching study and long experience (in which the latter usually involves a few expensive \nmistakes). The reader of this book need not despair of acquiring “chart sense” and without \nundue cost—if he will concentrate on his study, watch, check,", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 68}
{"text": "evelopment, sometimes long before it has reached a conclusive \nstage. This is a not uncommon talent, but it is one that is seldom attained except through \nsearching study and long experience (in which the latter usually involves a few expensive \nmistakes). The reader of this book need not despair of acquiring “chart sense” and without \nundue cost—if he will concentrate on his study, watch, check, and double-check every new \ndevelopment on his charts, and “keep score” on himself.\nIt has been said that chart interpretation is not a science but an art . It is not an exact \nscience, to be sure, because it has no rules to which there are not exceptions. Its finer points \ndefy expression in rule or precept. It requires judgment in appraisal of many factors, \nsome of which may seem, at times, to conflict radically with others. But to call it an art, \nwhich implies the need for genius, or at least for a high degree of native talent, is certainly \nimproper. Say, rather, that it demands skill, but a skill that can be acquired by anyone of \nordinary intelligence.\n121\nchapter ten\nOther Reversal phenomena\nWe have considered so far eight classes of chart patterns that appear at more or less \nimportant Reversals of direction in the trend of prices. They are as follows:\n 1. The Head-and-Shoulders\n 2. Multiple or Complex Head-and-Shoulders\n 3. Rounding Turns\n 4. Symmetrical Triangles\n 5. Right-Angle Triangles\n 6. Rectangles\n 7 . Double and Triple Tops and Bottoms\n 8. One-Day Reversal\nOf these, numbers 1, 2, 3, and 7 develop most often at Major Turns, whereas numbers 4, \n5, and 6 occur more frequently at Intermediate Stages. Numbers 1, 2, 3, and 5 give indication \nbefore they are completed as to which way the price trend is likely to proceed from them. \nNumbers 4 and 6 give no such indication and, as we have seen, are rather more apt to \nsignal Consolidation or Continuation than Reversal. But all of them can, and on occasion \ndo, appear at both Major Tops or Bottoms. EN: Number 8 appears typically after uncontrollable \nmoves, up and down.\nWe have yet to take up a few other technical patterns that, because of their limited \nsignificance, rarity, or doubtful utility to long-term traders, have been relegated to the end \nof our Reversal studies (see Figures 10.1 through 10.28).\nThe Broadening Formations\nIn concluding our discussion of Triangles in Chapter 8, we mentioned certain types of price \ncongestion or trading areas that have sometimes been called “Inverted Triangles” because, \nstarting with very narrow fluctuations, they widen out between diverging rather than \nconverging boundary lines. Herein, we have chosen to classify them instead as Broadening \nPatterns since, except for that inverted resemblance in superficial appearance, they are quite \ndifferent in nature and trend implications.\nIf the Symmetrical Triangle presents a picture of “doubt” awaiting clarification and \nthe Rectangle a picture of controlled “conflict,” the Broadening Formation may be said to \nsuggest a market lacking intelligent sponsorship that is out of control—a situation, usually, \nin which the “public” is excitedly committed and is being whipped around by wild rumors. \nNote though we say it only suggests such a market; there are times when it is obvious those \nare precisely the conditions that create a Broadening Pattern in prices, yet other times when \nthe reasons for it are obscure or undiscoverable. Nevertheless, the very fact that chart \npictures of this type make their appearance, as a rule, only at the end or in the final phases \nof a long Bull Market lends credence to our characterization of them.\n122 Technical Analysis of Stock Trends\nHence, after studying the charts for some 20 years and watching what market action \nhas followed the appearance of Broadening Price Patterns, we have come to the conclusion \nthey are definitely Bearish in purport—that, while further advance in price is not ruled \nout, the situation is, nevertheless, approaching a dangerous stage. New commitments \n(purchases) should not be made in a stock that produces a chart of this type, and any \nprevious commitments should be switched at once or cashed in at the first good opportunity.\nThe Broadening Formation may evolve in any one of three forms, comparable, respectively, \nto inverted Symmetrical, Ascending, or Descending Triangles. The “Symmetrical” type, \nfor example, consists of a series of price fluctuations across a horizontal axis, with each \nMinor Top higher and each Minor Bottom lower than its predecessor. The pattern may \nthus be roughly marked off by two diverging lines, the upper sloping up (from left to \nright) and the lower sloping down. But these Broadening Patterns are characteristically \nloose and irregular, whereas Symmetrical Triangles are normally regular and compact. The \nconverging boundary lines of a Symmetrical Triangle are clearly defined as a rule, and the \nTops and Bottoms within the formation tend to fall with fair precision on those boundary \nlines. In a Broadening Formation, the rallies and declines usually do not all stop at clearly \nmarked boundary lines.\nVolume during Broadening Formations\nAnother distinction between Triangle and Broadening Formation is in the volume chart. \nThe construction of a true Triangle is attended, as we have seen, by diminishing activity, \nstarting with high volume on the first Minor Reversal that initiates the pattern, but growing \nless and less as prices fluctuate in ever-smaller waves out toward the apex. Then activity \npicks up again after prices have broken out of the Triangle, immediately and sharply if the \nbreakout is through the topside. With the Broadening Formation, on the other hand, trading \nactivity usually remains high and irregular throughout its construction. If it develops after \nCRANE COMPANYC R 1945–1946\nNOVEMBERD ECEMBERJ ANUARY FEBRUARY MARCHA PRIL\n48\n44\n40\n38\n36\n34\nSales\n100’s\n125\n100\n75\n50\n25\n10 17 24 1 8 15 22 29 5 12 19 26 2 9 16 23 2 9 16 23 30 6 13 20 27 4\nFigure 10.1 T", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 69}
{"text": "y if the \nbreakout is through the topside. With the Broadening Formation, on the other hand, trading \nactivity usually remains high and irregular throughout its construction. If it develops after \nCRANE COMPANYC R 1945–1946\nNOVEMBERD ECEMBERJ ANUARY FEBRUARY MARCHA PRIL\n48\n44\n40\n38\n36\n34\nSales\n100’s\n125\n100\n75\n50\n25\n10 17 24 1 8 15 22 29 5 12 19 26 2 9 16 23 2 9 16 23 30 6 13 20 27 4\nFigure 10.1 The Symmetrical type of Broadening Formation, which develops most frequently in \nthe later and more “excited” stages of a Primary Bull Market, is perfectly exemplified in this Crane \nCompany chart. Note that the Broadening Pattern here started to form in December 1945 after a 10% \nreaction; if it had formed on Top of a rally, it would have been suspected as a possible Broadening \nTop. Nevertheless, it carried the usual Bearish implications. “CR” topped out at 49½ in June.\n123Chapter ten: Other Rever sal phenomena\nan advance, as is almost always the case, the first Minor Reversal that starts the pattern will \noccur on a large turnover, but so will the second rally in the pattern, and the third, and high \nvolume also frequently develops on one or more of its Minor Bottoms. The whole picture—\nboth price and volume—is, thus, one of wild and apparently “unintelligent” swings.\nAs can easily be seen, under such circumstances, a true breakout from the area may be \ndifficult, if not impossible, to detect at the time it eventuates. The volume part of the chart \nAIR REDUCTION CO.A N\n1929\nJULY AUGUSTS EPTEMBERO CTOBER NOVEMBERD ECEMBER\nRG 2\n4\nB\nP\n31 5a 5b\nBG\nEG\nSales\n100’s\n250\n200\n150\n100\n50\n240\n208\n192\n176\n160\n152\n144\n136\n128\n120\n112\n104\n96\n88\n80\n76\n224\n61 32 02 73 10 17 24 31 7 14 21 28 51 21 92 62 91 62 3 30 71 42 12 8\nFigure 10.2 Although this particular Major Reversal Formation appeared on the charts more than \n35 years ago, it is so perfectly developed and on such a large scale that it may well stand as our \nelementary model for an Orthodox Broadening Top. This pattern in Air Reduction is discussed in \ndetail on previous pages. Note also the Symmetrical Triangle Consolidation of July–August, and the \nexamples of Runaway, Breakout, and Exhaustion Gaps (RG, BG, and EG), which will be taken up in \nChapter 12.\n124 Technical Analysis of Stock Trends\nAMERICAN ROLLING MILLSR M\n1946\nAPRILM AY JUNE JULY AUGUST SEPTEMBER\nSales\n100’s\n125\n100\n75\n50\n25\n40\n38\n36\n34\n32\n30\n28\n61 32 02 741 11 82 51 81 52 22 96 13 20 27 31 01 72 4 31 71 42 12 8\n1 3 5\n2 4\nFigure 10.3 A small, but perfect, 1946 Broadening Top that formed at the end of a three-month chart \npattern, which also had overall Broadening (and, hence, Bearish) aspects. The five critical points of \nReversal are numbered on the chart. The “breakout” was registered on August 27 . The Pullback Rally \nthat followed immediately was strong, but it still held within normal bounds. Another interesting \nBroadening Top of 1946 appears in Figure 33.7 .\nCONSOLIDATED EDISON ED\nJ\n1\n2 4\n3 550\n45\n40\n35\n30\n25\n20\nA SO ND JF MMAJ JA SO ND JF MAM JJ AS ON DJ FM A\n1935 1936 1937 1938\nFigure 10.4 When they appear as plain and as compact as this example, Broadening Tops on weekly \ncharts carry very powerful Reversal indications. The Top of the fifth turn in this formation was \ncapped on the daily chart by a Head and Shoulders, which was pictured in Figure 6.7 . The dashed \nlines on the above chart are trendlines—to be discussed in Chapter 14.\n125Chapter ten: Other Reve rsal phenomena\nINTERNATIONAL PAPERI P\n1945–1947\n56\n52\n48\n44\n40\n38\n36\nSales\n100’s\n5040\n302010\nND JF SO ND JF MM AMMAJ JA\nFigure 10.5 Broadening tendencies that appear on monthly charts, or very wide spread (with Tops \nfive or six months apart) like the above on weekly charts, should not be regarded as significant \ntechnical formations. Reversal points in a true Broadening Top should not be more than two months \napart, as in Figure 10.4.\nASSOCIATED DRY GOODSD G\n1945\nJANUARYF EBRUARYM ARCH APRILM AY JUNE\n28\n26\n24\n22\n20\n19\n18\nSales\n100’s\n50\n40\n30\n20\n10\nXD .25\nXD .25\n61 32 02 731 01 72 431 01 72 43 1714 21 28 51 21 92 6 29 16 23 30\nFigure 10.6 Three successive reactions in “DG” in February–March 1945 made successively lower \nBottoms, but the intervening rallies came up to the same high (about 21¼), thus forming a Right-\nAngled Broadening Formation with a horizontal Top (Supply) Line. Penetration of this technically \nimportant top line on April 16 was a Bullish signal. The flat-topped type of pattern does not \nnecessarily portray a Bearish situation.\n126 Technical Analysis of Stock Trends\nPARAMOUNT PICTURES PX\n1946\n88\n80\n76\n72\n68\n64\n60\n56\nSales\n100’s\n125\n100\n75\n50\n25\nJANUARY FEBRUARY MARCHA PRIL MAYJ UNE\n51 21 92 62 91 62 32 91 62 33 06 13 20 2741 11 82 5 18 15 22 29\nFigure 10.7 The 1946 Top in Paramount Pictures, from which it fell to 46 a year later, was a Right-\nAngled Broadening Formation with a horizontal bottom line that was “cracked” the first week of \nJune, but not decisively broken until June 20. (This stock was later split 2-for-1.)\nALLIED STORES LS\n1945 G\nGG\nG\nJULY AUGUSTS EPTEMBERO CTOBER NOVEMBER DECEMBER\n48\n44\n40\n38\n36\n34\n32\n30\n28\nSales\n100’s\n125\n100\n75\n50\n25\n71 42 12 84 11 18 25 18 15 22 2961 32 02 73 10 17 24 18 15 22 29\nFigure 10.8 Another example of the Flat-Topped type of Broadening Price Pattern that appeared near \nthe end of 1945. “LS” went on up to 63 in 1946. Prices broke out of this formation with a Breakout \nGap (G) and another Breakout Gap appeared on December 3. G-G marks an “Island.” See Chapter 12 \nfor Gaps.\n127Chapter ten: Other Reve rsal phenomena\nobviously furnishes no clue, while the very looseness and lack of definition of the price \npattern prevent the drawing of any line that surely says, “this far and no farther.” (We are \nreferring now to the “Symmetrical” type only of Broadening Formation.) Once prices have \nrun well away, either up or down, from the pattern area, it becomes plain that a breakout \nhas occurred, but by that time, it may be too late to risk a trade on the situation; the move", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 70}
{"text": "lack of definition of the price \npattern prevent the drawing of any line that surely says, “this far and no farther.” (We are \nreferring now to the “Symmetrical” type only of Broadening Formation.) Once prices have \nrun well away, either up or down, from the pattern area, it becomes plain that a breakout \nhas occurred, but by that time, it may be too late to risk a trade on the situation; the move \nmay already have gone too far. What can we do about Broadening Formations then? Well, \nU. S. STEEL X 1946\nAPRILM AY JUNE JULY AUGUSTS EPTEMBER\n96\n88\n80\n76\n72\n68\nSales\n100’s\n250\n200\n150\n100\n50\nXD 1.00\n61 32 02 74 11 18 25 18 15 22 2961 32 02 731 01 72 4 31 71 42 12 8\nFigure 10.9 The 1946 Bull Market Top in U.S. Steel was a three-month Diamond that might also be \nconstrued as a Head-and-Shoulders.\nAMERICAN BOSCH CORP.B OS\n1945\nJULY AUGUSTS EPTEMBERO CTOBER NOVEMBERD ECEMBER\n24\n22\n20\n19\n18\n17\n16\nSales\n100’s\n50\n40\n30\n20\n10\n71 42 12 84 11 18 25 18 15 22 29 61 32 02 73 10 17 24 18 15 22 29\nFigure 10.10 A Diamond (November) that broke out topside and thus functioned as Consolidation \nrather than Reversal.\n128 Technical Analysis of Stock Trends\nwe have already noted 9 times out of 10 they carry Bearish implications. They appear most \noften at or near an important topping out of the trend. Hence, it is reasonably safe to assume \nthat prices, when they finally break away from the formation, will go down, or if they do \ngo up, will very soon turn around and come back down again. Therein lies one answer to \nthe problem of what to do about a Broadening Formation.\nIn addition, the price action within the formation, in many cases, furnishes an advance \nindication of breakout direction. If the trend is going to break down from the Broadening \nArea, the last rally within the area may fail to rise as high as its predecessor, thus breaking \nthe sequence of ever higher Tops within the pattern. Alternatively, if the trend is going to \nemerge on the topside, the last reaction within the pattern may fail to depress prices as low \nas the preceding reaction. These “failures” within the pattern occur, as we have stated, in \na majority of all Broadening Formations. Note that one cannot be sure of such a significant \ndevelopment (what we have referred to above as a failure, for lack of a better descriptive \nname) until prices go on and out the other side of the formation or, more precisely, have \nexceeded the last preceding move in that direction by a decisive margin (our 3% rule again).\nA typical example\nNo doubt the foregoing paragraph sounds rather complicated. It will be easier to visualize \nthe development of a “failure” signal if we cite an example using actual price figures. Easier \nyet, perhaps, if the reader will sketch out our example on a scrap of chart paper. Suppose \nstock XYZ, after advancing some 30 points on gradually increasing turnover, runs into \nheavy selling at 62 and reacts to 58. But there is still plenty of interest in the issue; it stops \nSHELL UNION OILS UO\n1945–1947\n44\n40\n38\n36\n34\n32\n30\n28\n26\n24\nSales\n100’s\n125\n100\n75\n50\n25\nND JF SO ND JF MM AMMAJ JA\nFigure 10.11 Diamond Reversal Formations are often easier to detect on weekly than on daily charts. \nTrace out the price swings and volume in this May–June 1946 Diamond in Shell. Note also the \nremarkable Descending Triangle that developed from September 1946 to February 1947 , and the \nMarch Pullback to its apex, another ideal place to sell short.\n129Chapter ten: Other Reve rsal phenomena\nat 58 and then swings up to a new peak at 63. It “churns” there for a day or two and drops \nback again, this time to 56½ before it is halted by another burst of buying. Its third rally \ntakes it up to 62, where it hesitates and falls back to 59, but it is then picked up again and \ncarried on to 65. (By this time, a Broadening Formation has become evident on the chart.) \nAt 65, there is a great show of trading, followed by another reaction that drops quotations \nquickly back to 60. Support appears there momentarily and prices fluctuate for three or \nfour days between 60 and 62 and then fall away again, finally to close at 56, with volume \nrunning high all through this phase. A fourth rally starts, but now the traders who bought \nin at 60 on the preceding downswing are frightened and looking for a chance to “get out \neven,” and the advance is stifled at that level. Quotations start to slip and soon are down \nto 55, below the previous pattern Bottom . When this occurs, the “failure” of the preceding \nrally is confirmed—its failure, that is, to rise above 65 and, thus, carry on the Broadening \nMovement. The decline below 56, by virtue of that failure, may be regarded as a breakout.\nIf you followed the foregoing example closely, you will have noted there can be (and \nvery often are) Minor Fluctuations inside the pattern that do not affect its outcome. Thus, \nthe rise from 56½ to 65 really consisted of three moves, first from 56½ to 62, then from 62 \nback to 59, and, finally, from 59 up to 65. The reaction from 62 had no significance so long \nINDU LAST-Daily 10/04/2001\nCreated with TradeStation www.TradeStation.com\nCreated with TradeStation 2000i by Omega Research1999\n11500\n11000\n10500\n10000\n9500\n9000\n8500\n4/1999 7/1999 10/1999 00 4/2000 7/2000 10/2000 01 4/2001 7/2001\nFigure 10.12 Technicians in the future will look back with amazement at the Top, which put the \nexclamation point on the Bull 1990s. The most amazing thing being that what was going on at the \ntime was recognizable and subject to analysis with a ruler (see Resources). The analysis furthermore \nindicated the party was over (or at least the fat lady was in the process of singing). As Edwards noted, \nthe Broadening Top, which had (and has) implications of its own, morphed into a Diamond, which threw \noff a false signal, breaking out on the upside, which developed into another triangular-like pattern \n(could be looked at as ragged triangular or ascending—only bottom line shown here), which after a \nhead fak", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 71}
{"text": "ty was over (or at least the fat lady was in the process of singing). As Edwards noted, \nthe Broadening Top, which had (and has) implications of its own, morphed into a Diamond, which threw \noff a false signal, breaking out on the upside, which developed into another triangular-like pattern \n(could be looked at as ragged triangular or ascending—only bottom line shown here), which after a \nhead fake broke down, made a modified V-Bottom and returned to the top of what could be looked \nat as a monster rectangle. The top horizontal line, drawn in August 2000, stops the 2001 rally cold \nand from there it is a slippery slide to the tragedy of September 11, 2001. It was obvious that the \ninvestor had no business being long and that trading strategy was in order. Was there any prescience \nin recognizing the mulish sideways trend of the market? None whatsoever. Is all this hindsight? The \nreader may see for himself by examining the record of how this market was analyzed at the time at \nthe edwards-magee.com newsletter archives.\n130 Technical Analysis of Stock Trends\nas it stopped above 56½ and was succeeded by a new rise carrying beyond the previous \npattern high, which, in this case, had been 63.\nThe example just detailed is one of the more common types in which the failure occurs \non a rally and the breakout eventuates on the downside. But it could have been converted \ninto the opposite form if the last decline had stopped at 60, and then, instead of fluctuating \nfor a few days between 60 and 62 and breaking down again, had pushed right back up and \npast 65. That action would have given us a failure on a decline and an upside breakout. \n(The odds would be, however, that the final Top was not far away.)\nThe Orthodox Broadening Top\nThere is one particular manifestation—a special case, as the mathematicians might say—of \nthe Broadening Price Formation whose general nature we have discussed in the preceding \nparagraphs. This particular form appeared at the 1929 Tops of many of the active and \npopular stocks of that day, but it has done so with less frequency at Bull Market highs \nsince 1929, and rarely has done so at high-volume Tops preceding extensive Intermediate \nDeclines, as in 1933 and 1934. It is known to market technicians under the specific name of \nBroadening Top, and although it conforms to our general descriptions for all Symmetrical \nHUDSON MOTORS HT\n1945–1947\n34\n32\n30\n28\n26\n24\n22\n20\n19\n18\n17\n16\n15\nSales\n100’s\n5040\n302010\nND JF SO ND J F M AMMAJ J AO\nFigure 10.13 Hudson is another stock that ended its Bull Market in 1946 with a Major Diamond, \nwhich also could be taken as a Complex Head and Shoulders. This formation was plain on the weekly \nchart but hard to see on the daily. Note how the Diamond gave a sell signal about 2 points higher \nthan the Head-and-Shoulders. The 14½–17½ area at the end of the year, when construed as a weak \nRectangle, was barely fulfilled in February 1947 .\n131Chapter ten: Other Rever sal phenomena\nBroadening Price Patterns, it has been so precisely defined, and so often cited in technical \nwritings, that we may well take some time to examine it.\nThe Orthodox Broadening Top has three peaks at successively higher levels with two \nBottoms between them, with the second Bottom lower than the first. The assumption has \nbeen it is completed and in effect as an important Reversal indication just as soon as the \nreaction from its third peak carries below the level of its second Bottom.\nPerhaps we can best see what this formation is like if we examine one of the classic \npatterns that developed in 1929. Our chart (Figure 10.2) shows the daily market action (price \nand volume) of Air Reduction from July 1 to December 31 of that year. We have numbered \nfrom 1 to 5 the significant turning points within the Broadening Top that ended that stock’s \nBull Market in October. A Broadening Price Pattern was not detectable until prices had \nstarted to move up from the second Minor Low (point 4); by then 3 had formed above 1 and \n4 below 2. New highs at 5 (a and b), followed by the definite downside breakout at B (nearly \n6% under 4), completed the pattern and, according to the rules, signaled a Major Trend \nReversal. In this case, there can be no doubt as to the importance of the Reversal indication \nbecause, as our chart shows, the price of Air Reduction dropped from above 220 on October \n18 to below 80 on November 14, just four weeks later, and the final Bottom was not seen \nuntil nearly three years later in 1932.\nThere are some fine points of this classic example that should be noted. First, a new \nhigh, that is, a third and higher Top, was made at 5 a and the subsequent reaction was \nhalted at 195, well above 4, and succeeded by renewed advance. This looked like one of the \nadvance notices (“failures”) to which we have referred on a preceding page, portending \nan upside breakout. But the example before us will serve to emphasize the warning \nU. S. STEEL X 1937\nAPRILM AY JUNE JULY AUGUST SEPTEMBER\nG\nG G\n120\n112\n104\n96\n88\n80\n76\nSales\n100’s\n500\n400\n300\n200\n100\n31 01 72 41 81 52 22 951 21 92 631 01 72 43 17 14 21 28 41 11 82 5\nFigure 10.14 As U.S. Steel approached the Top of its Secondary Recovery in August 1937 , its price \nfluctuations tended to grow narrower, between upward sloping but converging boundaries, while \nvolume diminished. This pattern—a Wedge—carried a definitely Bearish message. The entire swing \nfrom July to the end of August was essentially a Rounding Top. The three Gs mark Breakaway \nGaps (see Chapter 12), the last (September 7) made as prices broke down through a Support Level \n(see Chapter 13).\n132 Technical Analysis of Stock Trends\nthat we attached thereto—that such an indication is not to be trusted until prices have \ndecisively exceeded the previous Top. At 5 b Air Reduction was traded briefly at 223, 2 \npoints, but less than 3% higher than 5 a, and the day closed with quotations below 5a. The \nbreak on October 24 (to B) took prices more than 3% under the le", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 72}
{"text": "t Level \n(see Chapter 13).\n132 Technical Analysis of Stock Trends\nthat we attached thereto—that such an indication is not to be trusted until prices have \ndecisively exceeded the previous Top. At 5 b Air Reduction was traded briefly at 223, 2 \npoints, but less than 3% higher than 5 a, and the day closed with quotations below 5a. The \nbreak on October 24 (to B) took prices more than 3% under the level of 4. Now occurred \na development typical of Broadening Tops—a Pullback Rally (to B) retracing about half \nof the ground lost between the last pattern Top (5b ) and the end of the initial breakout \nmove (B). Such a recovery (and failure) will be attempted, according to our experience, in \nat least four out of five Broadening Top Patterns, and it may not fail until it has regained \ntwo-thirds of the preceding decline, although it usually peters out around or even below \nthe halfway mark.\nAs stated, this is a classic example; there were many others at that time. The very fact \nthat so many evolved at the 1929 peak, which was followed by history’s most disastrous \nlosses, probably accounts for the extremely Bearish implications market technicians have \nascribed to the Broadening Top Formation. We regard it now with somewhat less awe; its \nmeasuring implications are probably no greater than those of a large, high-volume Head-\nand-Shoulders, but it is a pattern characteristic of the last stages of a Primary Uptrend.\nThe insistence that the third Top (our number 5), when followed by a decline below \nthe second Bottom (our number 4), completes the Reversal Pattern may be regarded, in the \nlight of experience, as setting too strict a limitation because Broadening Formations do, \non occasion, go on to make a fourth and higher Top. Yet this rule may be, and usually is, \njustified by the fact the overall indications are undeniably Bearish and, hence, one should \nnot wait too long to get out. On the other hand, the requirement for a third Top does seem \nto be justified on the score that Major Reversals are seldom completed until at least three \nLOEW’S, INC. LW \nJULY AUGUST SEPTEMBER OCTOBER NOVEMBER DE CEMBER \n1936 \n72 \n68 \n64 \n60 \n56 \n52 \n48 \n44 \nSales \n100’s \n125\n100\n75\n50\n25\n4 11 18 25 1 8 15 22 29 5 12 19 26 3 10 17 24 31 7 14 21 28 5 12 19 26 \nFigure 10.15 An “ideal” Falling Wedge that developed in Loew’s in 1936. Note the volume trend \ntherein, which is irregular but generally diminishing. July produced a small Flag (see Chapter 11), \nand at the end of the year, “LW” went into a Rectangle out of which prices “skyrocketed” to 75.\n133Chapter ten: Other Rever sal phenomena\nattempts have been made to push prices on in the direction of the previous trend. This \nis the reason why pioneer technical students lumped together many formations under \nthe classification “Five-Point Reversals.” The Broadening Top is a Five-Point Reversal (our \nnumbers 1–5) and so it is a Head-and-Shoulders. A Broadening Top might, in fact, be called \na Head-and-Shoulders with a high right shoulder and a down-sloping neckline.\nSCHENLEY DISTILLERSS H\n1945–1947\n96\n88\n80\n76\n72\n68\n64\n60\n56\n52\n48\n44\n40\n38\n36\n34\n32\n30\n28\n26\n24\nSales\n100’s\n125\n100\n75\n50\n25\nND JF SO ND JF MM AMM AJ JA\nFigure 10.16 Wedges seldom appear at Major Trend Reversals, but Schenley’s Bull high in 1946 was \nmade at the end of an eight-month Rising Wedge, plainly seen on its weekly chart. The dashed line at \n60 marks a Support Level (see Chapter 13) that served to stem the subsequent decline for nine weeks.\n134 Technical Analysis of Stock Trends\nTRANSCONTINENTAL & WESTERN AIRLINES TWA\n1945–1946\nRD\nOCTOBERN OVEMBER DECEMBER JANU ARYF EBRUARYM ARCH APRILM AY JUNE JULY AUGUST SEPTEMBER\n76\n72\n68\n64\n60\n56\n52\n48\n44\n40\n38\n36\n34\n32\nSales\n100’s\n504030\n20\n10\n61 32 02 7 31 01 72 41 81 52 22 95 12 19 26 29 16 23 29 16 23 3061 32 02 78 15 22 29 61 32 02 73 10 17 24 3171 42 12 8 41 11 82 51\nFigure 10.17 There are many interesting and technically significant features in this 12-month daily \nchart record of “TWA.” Note the extraordinary One-Day Reversal, December 3, which marked its \nMajor Top. Although the next four weeks produced a sort of poorly formed Descending Triangle, the \nReversal Day was the only clear-cut and unmistakable signal to sell. When you study Pennants, turn \nback to this chart for its November Pennant. Its long Intermediate Down Trendline was tentatively \nbroken in August 1946, without confirming volume (see Chapter 14). Note that at no time during the \ndecline did a “Buy” Pattern appear.\nGREYHOUND CORP.G\n1946RD\nG\nG\nI. U. T.\nAPRILM AY JUNE JULY AUGUST SEPTEMBER\n56\n52\n48\n44\n40\n38\n36\nSales\n100’s\n125\n100\n75\n50\n25\n61 32 02 74 11 18 25 18 15 22 29 61 32 02 73 10 17 24 31 71 42 12 8\nFigure 10.18 The strong One-Day Reversal that marked Greyhound’s 1946 Bull Market high; note the \nclimax volume. A less conspicuous Reversal Day appeared on August 26. It is suggested the reader \ngo back over all charts in the preceding chapters; he will find many Reversal Days of greater or lesser \nconsequence. Many gaps (G) were of measuring type (see Chapter 12).\n135Chapter ten: Other Reve rsal phenomena\nWhy no Broadening Bottoms?\nAll of the other types of Reversal Formations we have studied thus far can occur as either \nTops or Bottoms; they can develop at the end of a decline to turn the trend up or at the end \nof an advance to turn the trend down. But this does not seem to be true of the Broadening \nFormation. It has been assumed in the past that Broadening Bottoms must exist, but \nthe writer has never found a good one in his examination of the charts of thousands of \nindividual stocks over many years, and only one or two patterns that bore a resemblance \nto it in the charts of the Averages. Apparently, the circumstances that create Broadening \nFormations do not exist after a prolonged decline in prices. This would seem to bear out \nour earlier characterization of this sort of pattern as suggesting active, excited trading with \nmuch public (and, hence, not too well-informed or man", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 73}
{"text": "er many years, and only one or two patterns that bore a resemblance \nto it in the charts of the Averages. Apparently, the circumstances that create Broadening \nFormations do not exist after a prolonged decline in prices. This would seem to bear out \nour earlier characterization of this sort of pattern as suggesting active, excited trading with \nmuch public (and, hence, not too well-informed or managed) participation. Such conditions \nare naturally associated with the final phases of a Bull Market.\nRight-Angled Broadening Formations\nPrice patterns of the “Inverted Triangle” shape, having a horizontal Top or Bottom boundary, \noccur about as often as the symmetrical type, which is to say, not nearly as often as true \nTriangles, Rectangles, and so on. In the mid-twentieth century, there were very few of them \n(EN9: Still scarce in the 2000s). Although the true Right-Angle Triangle with a horizontal top \nline and up-slanting bottom line is called an Ascending Triangle, just as its counterpart with \nAPPLE COMPUTER INC-(Nasdaq NM) 62.72 –0.03 –0.05 %\n14\n13\n12\n11\n10\n9\n8\n7\n6\n5\n4\n3\nAugS ep OctN ov DecA ug SepO ct NovD ecFebM ar AprM ay JunJ ul87\n1998-2004 Prophet Financial Systems, Inc. Terms of use apply.\nFigure 10.19 Apple, 1987 Reagan Crash. Does this plunge appear to be out of the blue? Not really. \nNumerous signs are given: break of major trendline; short-term momentum down before the crash \nin an environment of extreme top psychology; then the crash itself, the Panic Selling exhibiting the \ntypical pattern of short covering; and then further decline.\n136 Technical Analysis of Stock Trends\na horizontal bottom boundary and a down-slanting top boundary is called a Descending \nTriangle, we cannot apply these terms to the Inverted or Broadening Forms. Generally \nspeaking, Right-Angled Broadening Formations carry Bearish implications, regardless of \nwhich side is horizontal, in nearly the same degree as the symmetrical manifestations.\nObviously, however, they differ essentially from Symmetrical formations in one respect: \na horizontal side indicates either accumulation or distribution at a fixed price, depending \non which side is horizontal. Logically, it follows any decisive break through that horizontal \nside has immediate forceful significance. Thus, if a Broadening Price Pattern with a flat top \nboundary develops after a good advance, and if prices finally burst up through that top \nline on high volume and close above it to a conclusive extent (roughly 3%), then it is safe \nto assume the preceding uptrend will be resumed and carried on for a worthwhile move. \nThis does happen, although it is rare. The odds favor the opposite, that is, the eventual \nvictory of the forces of distribution that created the horizontal Top and a breakaway into \nan extensive decline.\nMoreover, if an advance is to ensue from a Flat-Topped Broadening Formation, chances \nare the third reaction in the formation will be attended by much diminished trading activity \nNEW YORK CENTRALC N\n1937\nJULY AUGUSTS EPTEMBERO CTOBER NOVEMBER DECEMBER\n40\n35\n30\n25\n20\nSales\n100’s\n400300\n200\n100\nSC\nNL\nSS\nH\nHS S\n31 01 72 43 17 14 21 2841 11 82 52 91 62 33 06 13 20 27 41 11 82 5\nFigure 10.20 The Panic Selling of October 19, 1937 , produced a conspicuous Climax Reversal Day \nin nearly all leading stocks, as well as in the Averages. This New York Central chart shows, beside \nthe Selling Climax (SC), its Head-and-Shoulders Recovery Top of July–August and a Consolidation \nRectangle that ended as a Triangle in early October. “CN” made a final Bear Market low the following \nMarch at 10½. On a logarithmic price scale, its down trendline from August was not broken until \nJune 1938.\n137Chapter ten: Other Rever sal phenomena\ninstead of the continued high or irregular volume characteristic of Bearish Broadening \nMovements; either it or the fourth reaction will be halted and reversed above the low point \nof the preceding reaction. This turns the formation into a Consolidation Head-and-Shoulders, \na Continuation-of-Trend Pattern, which we shall take up in Chapter 11. The message here \nfor the trader owning a stock whose chart begins to develop a Broadening Formation of \nthis type is to watch the third reaction. If it carries below the second and volume does not \nfall off to a marked degree, sell out on the next rally. (You can always repurchase the same \nstock, if you wish, without much “loss of position” should prices finally and, improbably, \nrecover and push up through the Top.)\nRight-Angled Broadening Formations with horizontal lower boundaries (flat Bottoms) \nalmost always break down. Once prices have fallen below the lower boundary line, there is \nfrequently a Pullback Rally to that line, either in a few days or in two or three weeks, similar \nto the Pullbacks that so often follow the breakdown from a Head-and-Shoulders Top.\n(Note that the third or fourth rally in a pattern that starts out as a Flat-Bottomed \nBroadening Formation may fail to carry prices as high as its predecessor, in which case a \nHead-and-Shoulders deal will instill. In other words, every Head-and-Shoulders begins as \na Broadening Formation and the statement of that relation takes us logically to our next \ntype of Reversal picture.)\nThe Diamond\nThe Diamond Reversal Formation might be described either as a more or less Complex \nHead-and-Shoulders with a V-shaped neckline or as a Broadening Formation which, after \ntwo or three “swings,” suddenly reverts into a regular Triangle that is nearly always of the \nSymmetrical form. So far as the accompanying volume pattern is concerned, the latter is \n$INDUA LAST-Daily 12/24/1987 C = 1998 .67 –9000 .74 –81 .82% O = 10039 .58 H = 10204 .03 L = 10029 .96 V = 1181488000\nCreated with TradeStation www.TradeStation .com\nVolume 108803664.00\n2700.00\n2600.00\n2500.00\n2400.00\n2300.00\n2200.00\n2100.00\n2000.00\n1900.00\n1800.00\n1700.00\n2700.00\n2600.00\n2500.00\n2400.00\n2300.00\n2200.00\n2100.00\n2000.00\n1900.00\n1800.00\n1700.00\n5500000\n4500000\n3500000\n2500000", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 74}
{"text": "r is \n$INDUA LAST-Daily 12/24/1987 C = 1998 .67 –9000 .74 –81 .82% O = 10039 .58 H = 10204 .03 L = 10029 .96 V = 1181488000\nCreated with TradeStation www.TradeStation .com\nVolume 108803664.00\n2700.00\n2600.00\n2500.00\n2400.00\n2300.00\n2200.00\n2100.00\n2000.00\n1900.00\n1800.00\n1700.00\n2700.00\n2600.00\n2500.00\n2400.00\n2300.00\n2200.00\n2100.00\n2000.00\n1900.00\n1800.00\n1700.00\n5500000\n4500000\n3500000\n2500000\n1500000\n55000000\n45000000\n35000000\n25000000\n15000000\n3/1987 4/1987 5/1987 6/1987 7/1987 8/1987 9/1987 10/1987 11/1987 12/1987\nFigure 10.21 Dow Industrials, 1987 Reagan Crash. Rumors proliferated—ironically, one that Reagan \nhad Alzheimer’s. Proximate cause: professional panic exacerbated by an ill-considered portfolio \ninsurance scheme propagated by academics. Note the authoritative (lower) trendline here (75 days) \nis broken by more than 2% (Magee’s suggestion) in early September. The broken upper trendline (25 \ndays) would have pulled the ripcord for the more agile trader. Savvy investors were hedging and \nliquidating through September, and fund managers panicked in October. According to the Brady \nReport, Hull Trading Co. bought the bottom on October 20, thus saving American capitalism.\n138 Technical Analysis of Stock Trends\npossibly the better description; its name obviously derives from its pictorial resemblance \nto the conventional diamond shape.\nAlthough it is fairly conspicuous and easily detected when it appears on the charts, the \nDiamond is not a common pattern. Since its development requires fairly active markets, it \nrarely occurs at Bottom Reversals. Its “natural habitat” is Major Tops and the High-Volume \nTops that precede extensive Intermediate Reactions. Many Multiple Head-and-Shoulders \nFormations are borderline Diamond cases; that is, they permit the drawing of slightly bent \nnecklines. The reader is cautioned, however, against trying too hard to make Diamonds out \nof price patterns of the Head-and-Shoulders type. There is a temptation to do so because \na V-shaped neckline may promise to give an earlier (and, hence, more profitable) breakout \nsignal than the straight neckline of the Head-and-Shoulders. It is much safer to stick to \nthe latter, however, unless the second half of the formation consists of a series of clean-\ncut, converging Minor Fluctuations, which plainly demands definition by converging \nboundary lines, and unless activity shows some tendency to diminish during this period \nas it would in a Triangle.\nThe Diamond requires little further comment. Our illustrations will suffice to acquaint \nyou with its typical details. It carries a minimum measuring implication that, having studied \nNATIONAL CASH REGISTER NC\n1941–1943\n24\n22\n20\n19\n18\n17\n16\n15\n14\n13\n12\n11\nSales\n100’s\n50\n40\n30\n20\n10\nND JF SO ND JF MMM AJ JAO S\nFigure 10.22 The Selling Climax discussed on the preceding pages is typically a one-day phenomenon, \nand on only one occasion (April 1939) in history has a general market One-Day Reversal signaled \nthe final low of a Primary Bear Trend (although many individual stocks evinced a Selling Climax \non their charts in March 1938).\n139Chapter ten: Other Rever sal phenomena\nthe Head-and-Shoulders and Triangle formulas, you can probably deduce for yourself. \nPrices should move at least as far from the breakout point as the greatest width in points of \nthe pattern from its Top (head) to Bottom (V in neckline). This, it must be emphasized, is a \nminimum rule and subject only to the usual qualification that a Reversal Formation must \nhave something to reverse. Generally, the new trend carries prices eventually well beyond \nthe minimum measurement.\nWedge Formations\nAll of the chart formations we have discussed up to this point can and do develop at \nchanges in the Major Trend of prices; a few of them seldomly occur at any other change \nthan a Major Reversal. We have to consider three patterns that are ordinarily Minor, or, \nat most, only Intermediate in their trend implications. They are useful, nevertheless, in \ntrading operations. One of them, the Wedge , we have already alluded to (in Chapter 8) as \nhaving some resemblance to the Triangles.\nThe Wedge is a chart formation in which the price fluctuations are confined within \nconverging straight (or practically straight) lines but differs from a Triangle in that both \nboundary lines either slope up or slope down. In a Symmetrical Triangle, the Top border \nslants down, whereas the Bottom border slants up. In Right-Angle Triangles, one boundary \nslopes either up or down, but the other is horizontal. In a Rising Wedge, both boundary \nlines slant up from left to right, but because the two lines converge, the lower must project \nat a steeper angle than the upper. In a Falling Wedge, the opposite is true.\nQUALCOMM (58.7500, 62.0625, 58.0000, 59.8750, →1.5625)\nCreated with Meta Stock www.equis.com\n210\n200\n190\n180\n170\n160\n150\n140\n130\n120\n110\n100\n90\n80\n70\n60\n50\n40\n30\n10000\n9000\n8000\n7000\n6000\n5000\n4000\n3000\n2000\n000x100\nSeptemberO ctober NovemberDecember 2000 February March AprilM ay June July August\nFigure 10.23 A church spire top in Qualcomm. The December gap might be mistaken for a buy \nsignal, as might be the runaway days, but they are actually hand-engraved invitations to leave the \nparty with near progressive stops a hair off the day’s low. Also valid is the exit on the Key Reversal \non day two after the gap. How does the trader know this is a blow-off and not a signal to pyramid? \nBy the age, length, state, and slope of the market. When trendlines go vertical, blow-off management \nmust be used. The return to the base of the first runaway day is notification that it is a Bull trap—the \nfirst Bull trap. The second Bull trap is the breakout of the triangle in March. A wonderful chart filled \nwith fin de siècle and fin de millennium lessons.\n140 Technical Analysis of Stock Trends\nMSFT(D) - Daily NASDAQ L = 27.56 +0.35 +1 .29% B = 27.55 A = 27.56 O = 27.67 Hi = 27.73 Lo = 27.44 C = 27.56 V = 57145012 \nBull Trap \nRunaway Days \nRu", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 75}
{"text": "unaway day is notification that it is a Bull trap—the \nfirst Bull trap. The second Bull trap is the breakout of the triangle in March. A wonderful chart filled \nwith fin de siècle and fin de millennium lessons.\n140 Technical Analysis of Stock Trends\nMSFT(D) - Daily NASDAQ L = 27.56 +0.35 +1 .29% B = 27.55 A = 27.56 O = 27.67 Hi = 27.73 Lo = 27.44 C = 27.56 V = 57145012 \nBull Trap \nRunaway Days \nRunaway Gap \nExhaustion Gap\nDepartment of Justice Gap \n48.00 \n42.00 \n37.00 \n32.00 31.33 \n28.00 \n25.00 \n44.06 \n35.30 \nS O N D 00 F M A M J J A S O N \nCreated with TradeStation \nFigure 10.24 Microsoft. A Key Reversal Day in March. Department of Justice breakaway gaps: \nrunaway gaps, exhaustion gaps. Selling Climax. As usual, further lows are achieved. A cornucopia \nof chartists’ delights.\nEBAY INC-(Nasdaq NM) 39.00 –0.29 –0.74%\n32\n30\n28\n26\n24\n22\n20\n18\n16\n14\n12\n10\n8\nAprM ay JunJ ul AugS ep OctN ov Dec0 0F eb MarA pr\n1998–2004 Prophet Financial Systems, Inc. | Terms of use apply.\nk\nk kk\nkk\nk\nFigure 10.25 eBay. As eBay broke its trendline and drifted sideways, it became a good subject for \nKey Reversal Day trading. Note several instances.\n141Chapter ten: Other Reve rsal phenomena\nSuperficially, one might think because an Ascending Triangle with one horizontal and \none up-line is a Bullish picture, the Rising Wedge, with both of its pattern lines up, should \nbe even more Bullish. But such is not the case. Remember, the flat top of an Ascending \nTriangle signifies a supply of shares being distributed at a fixed price; when that supply \nhas been absorbed (and the rising lower boundary line indicates it will be absorbed), the \npressure is off and prices will leap forward. In a Rising Wedge, on the other hand, there is \nno evident barrier of supply to be vaulted, but rather, a gradual petering out of investment \ninterest. Prices advance, but each new up-wave is feebler than the last. Finally, demand fails \nentirely and the trend reverses. Thus, a Rising Wedge typifies a situation that is growing \nprogressively weaker in the technical sense.\nIt might be said any advance in prices, no matter what shape it may take on the chart, \nweakens the technical status of the market. Prospective buyers are—or, at least, should \nbe—more reluctant to pay high prices than low, and owners are more willing to sell at high \nprices than at low; in other words, any sort of rise tends to increase supply and diminish \ndemand. (Although theoretically true, the preceding statement must be qualified by the \nfact that rising prices actually attract rather than discourage public buying.) The difference \nbetween a Rising Wedge and what might be called a normal Uptrend Channel (of which we \nEBAY(D) -Weekly NASDAQ L = 35 .14 –0 .24 –0 .68% B = 35 .14 A = 35 .15 O = 35 .15 Hi = 35 .58 Lo = 34 .93 C = 35 .14 V = 11216380\n35 .83\n47.00\n35.14\n25.00\n18.00\n13.00\n10.00\n7.00\n5.00\n4.00\n3.00\n2.00\n1999 2000 2001 2002 2003 2004 2005 Created with TradeStation\nFigure 10.26 If you cannot deliver groceries electronically what good is the internet? Meg Whitman \n(a competent, well, more than competent, CEO) and eBay found a use for it: the biggest flea market \never invented (and growing every day). Every military commander knows the axiom, Exploit \nSuccess! and eBay exploits and exploits and exploits. Is there a fundamental lesson here for the \ntechnician? Absolutely. Although the technician should be able to take a nameless chart and trade \nit competently (CEO of his own ship) no real information or data should be ignored. In this case, \nthe real information—that eBay was an 800-pound gorilla (or flea)—fit the chart perfectly. So eBay \nseparated itself from a bunch of nags to run long and hard. Handicappers know to always keep \nan eye on winning jockeys: Whitman. Ellison at Oracle. Moore at Intel. Gates at Microsoft. Jobs at \nApple (and Pixar and NEXT and so on … and so on …). In 2005 , what is to be done with eBay? Draw \na trendline, raise your stops, and sell it if it reverses.\n142 Technical Analysis of Stock Trends\nshall have more to say later) is the Wedge sets a sort of limit on the advance. Its converging \nboundary lines focus on a point near where the advance will halt and reaction will set in.\nWe can state most of the essential facts about the Up-Pointed Wedge Formation in a few \nshort sentences. It can develop either as a sort of Topping-Out Pattern on a previously existing \nuptrend or start to form right at the Bottom of a preceding downtrend. It (the Wedge) normally \ntakes more than three weeks to complete; a shorter pattern of this shape is nearly always \nbetter classified as a Pennant, which we will discuss in the next chapter. Prices almost always \nfluctuate within the Wedge’s confines for at least two-thirds of the distance from the base \n(beginning of convergence) to the apex; in many cases, they rise clear to the apex, and in some, \nthey actually go a short distance beyond, pushing on out at the Top in a last-gasp rally before \ncollapsing. Once prices break out of the Wedge downside, they usually waste little time before \ndeclining in earnest. The ensuing drop ordinarily retraces all of the ground gained within the \nWedge itself, and sometimes more. Trading volume in a Wedge tends to follow the regular \nTriangle Pattern, diminishing gradually as prices move up toward the apex of the Wedge.\nThe Falling Wedge\nExcept for the fact it is pointed down, the Falling Wedge appears in all respects like the rising \nform just described, except the price trend that follows its completion differs in character. \nWhen prices break out of a Rising Wedge, they usually fall away rapidly, but when they \nLU (Lucent Tech Inc)\n08/26/2006 3:34 PM EDT \nLucent tech inc 2.23 0.02 0.90%\n87\n84\n81\n78\n75\n72\n69\n66\n63\n60\n57\n54\n51\n48\n45\nMar Apr May Jun Jul Aug Sep Oct Nov Dec 00 Feb\n© 2002-2006 Prophet Financial Systems, Inc. All Rights Reserved.\nFigure 10.27 Lucent. Late twentieth- and early twenty-first-century schizophrenia. Runaway Days, \nBreakaway Gaps. Maalox is to b", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 76}
{"text": "lly fall away rapidly, but when they \nLU (Lucent Tech Inc)\n08/26/2006 3:34 PM EDT \nLucent tech inc 2.23 0.02 0.90%\n87\n84\n81\n78\n75\n72\n69\n66\n63\n60\n57\n54\n51\n48\n45\nMar Apr May Jun Jul Aug Sep Oct Nov Dec 00 Feb\n© 2002-2006 Prophet Financial Systems, Inc. All Rights Reserved.\nFigure 10.27 Lucent. Late twentieth- and early twenty-first-century schizophrenia. Runaway Days, \nBreakaway Gaps. Maalox is to be prescribed for the investor. Ecstasy for the trader. Reversal Days \nand short-term tactics win the day when the subject is insane. An excellent example of fitting the \ntrader to the stock. Why would a rational investor own such a stock?\n143Chapter ten: Other Reve rsal phenomena\nmove out of a Falling Wedge, they are more apt to drift sideways or in a dull “Saucering-\naround” movement before they begin to rise. The Rising Wedge may, therefore, call for \nquick action to secure profits, whereas with a Falling Wedge, the trader ordinarily can take \nhis time about making his commitment for the ensuing rise.\nBoth types of wedges should be well defined on the chart. Unless a trend pattern is \nquite compact with frequent fluctuations, nicely bounded by lines that clearly converge \nto a point, and their up (or down) slant is marked, the Wedge construction must be \nconsidered doubtful. You will find borderline cases in which one of the pattern lines so \nnearly approaches the horizontal in direction that it resembles a Right-Angle Triangle, \nand the latter would carry quite different implications for future trend development. It is \ndifficult to lay down any hard and fast rules for distinguishing the two. If one boundary \nline is nearly horizontal, or if the daily closing prices tend to fall at about the same level, then \nthe formation is more safely construed as a Triangle. The reader need not let this problem \nworry him unduly, as he will rarely be left in doubt for long after he has acquired a little \nexperience with charts. One soon gets to recognize the characteristic “symptoms” of the \ndifferent formations and make correct diagnoses almost instinctively.\nWedges on weekly and monthly charts\nMost true Wedges are too short-lived (seldom longer than three months) to take on \na recognizable definition on a monthly chart, but they may be spotted occasionally on \nthe weeklies. Long continued, gradual downtrends, when plotted on arithmetic scale, \nsometimes assume the Wedge form. Thus, an entire Major Bear Decline on any arithmetic \nLU(D) -Weekly NYSE L = 2 .84 –0 .02 –0 .70% B = 0 .00 A = 0 .00 O = 2 .85 Hi = 2 .90 Lo = 2 .81 C = 2 .84 V = 31864800\n8th Edition\nFig. 104 .4\n3.97\n1.99\n55.00\n40.00\n29.00\n21.00\n15.00\n11.00\n8.00\n5.00\n4.00\n3.00\n2.00\n2.84\n1.00\n1998 1999 2000 2001 2002 2003 2004 2005 \nCreated with TradeStation\nFigure 10.28 In the caption to Figure 10.27, the editor asked, apparently rhetorically, why a rational \ninvestor would own Lucent. The picture here shows what happens when apparently rational investors \ndo not set a stop to protect themselves from irrational volatility. The market knows things investors \ndo not know, but it will reveal these things to the most basic of investors if he reads the chart. This \nchart is added for the ninth edition to pick up the picture where the eighth left off.\n144 Technical Analysis of Stock Trends\nmonthly chart may appear like a giant Falling Wedge. This is due to the fact that the up and \ndown fluctuations that compose the Major Swing, while maintaining about the same extent \nin percentage, tend to shorten in terms of points (dollars) as prices move from higher to lower \nlevels. Such Major chart patterns are not the true Wedges we have discussed herein. When \nplotted on semilogarithmic scale, these same moves would normally show a Parallel or \neven slightly widening, instead of Converging, Channel.\nRising Wedges common in Bear Market Rallies\nAs a final note, we might add that the Rising Wedge is a quite characteristic pattern for \nBear Market Rallies. It is so typical, in fact, that frequent appearance of Wedges at a time \nwhen, after an extensive decline, there is some question as to whether a new Bull Trend \nis in the making may be taken as evidence that the Primary Trend is still down. When a \nMajor Bear Swing ends in a Head-and-Shoulders Bottom, the last Rising Wedge will often \nappear as prices rally from the left shoulder to the neckline and just before they break down \nto the head (final low). A Rising Wedge on an arithmetically scaled weekly chart is almost \ninvariably a Bear Market phenomenon, expressing the diminishing vigor that is the normal \nproperty of any reaction against a prevailing Primary Trend.\nThe One-Day Reversal\nWe referred in Chapter 6 to a price pattern known as the One-Day Reversal. This particular \ntechnical Reversal indication, when taken alone, can be accorded only temporary or strong \nMinor Trend significance. True, it may appear at the very peak of a long advance, forming \nperhaps on the high day of the head in a Head-and-Shoulders Pattern, which will be \nfollowed by a long decline, but it can hardly be credited with forecasting that entire decline; \nall it really signaled was the turn in the “head” itself. A One-Day Reversal may just as well \noccur, for example, at the beginning (the first peak) of a Symmetrical Triangle which only \nConsolidates instead of Reversing the previous uptrend. Even so, as you can see, it warns \nus of at least temporary exhaustion of Bullish forces.\nOn the downside, a One-Day Reversal often appears in magnified and conspicuous \nform at the end of a Panic Sell-Off, in which case it usually is referred to as a Climax Day \nor Selling Climax. This manifestation of it has special significance, which we shall take up \nlater. First, however, just what is a One-Day Reversal?\nTo begin, it is a day of unusually high volume, exceeding, as a rule, by a notable margin \nany trading turnover registered in any one-market session for the past several months. It \ncomes after a fairly long and steady advance (or a simil", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 77}
{"text": "Climax Day \nor Selling Climax. This manifestation of it has special significance, which we shall take up \nlater. First, however, just what is a One-Day Reversal?\nTo begin, it is a day of unusually high volume, exceeding, as a rule, by a notable margin \nany trading turnover registered in any one-market session for the past several months. It \ncomes after a fairly long and steady advance (or a similar decline), on which activity has \nbeen increasing gradually. Prices push right ahead from the opening gong as if nothing \ncould stop them. Frequently, even the opening sales are so far beyond the previous day’s \nclosing level as to leave a large gap on the chart. (We shall discuss gaps later.) The tape runs \nlate and before the advance (or decline) halts, prices have been carried as far in an hour or \ntwo as three or four days would ordinarily take them. But the halt does come finally, maybe \nat the end of the first hour or perhaps not until late in the day. Then quotations “churn,” \nregistering only fractional changes to and fro, with the tape still “fast” and often running \nlate by spurts. Suddenly, the trend reverses and prices move just as rapidly in the opposite \ndirection. The session ends with a final burst of activity that puts the price at the close \nright back where it started the day. There has been an enormous amount of activity, and \nquotations may have traversed intraday a range of 2% or 3%, but the net change from the \nprevious day at the end of trading is very small.\n145Chapter ten: Other Rever sal phenomena\nOne-Day Reversals at Tops appear quite often in the charts of individual stocks that \nare thin (relatively small floating supply of shares), have had an active advance, and have \nattracted a large public following. They rarely develop in the Averages. Selling Climaxes \n(One-Day Reversals at Bottoms), on the other hand, are found conspicuously in the Averages \nat the end of many abnormal or Panic Declines.\nOne-Day Reversals, as already stated, do not carry Major Trend implications. The \nnimble in-and-out trader can capitalize on them—maybe pick up several points if he has \nfunds available and jumps in at the right moment. But, as a rule, the new trend (i.e., the trend \nat the close of the day) does not carry very far right away; prices usually “work” around \nin the nearby ranges for some time and build some sort of area pattern before they move \naway in a swing of Intermediate proportions. The One-Day Reversal, as a phenomenon \nthat occurs frequently within or at the start of more pregnant technical formations, gives \nan important clue to probable trend developments. In any event, it is an urgent warning \nto watch closely the chart in which it has appeared to see what pattern of price action may \nfollow and be prepared for the worthwhile move when it comes.\nThe type of false move or shakeout described in Chapter 8 as occurring at the apex end \nof a Symmetrical Triangle often takes the form of a One-Day Reversal.\nThe Selling Climax\nIn the “bad old days” when stocks could be bought by putting up as little as 10% of their \ncost in cash and there were no restrictions on short selling, professional operators could (and \ntradition says they often did) organize Bear Raids to shake out weakly margined holdings. \nBy selling short in quantity at a favorable moment when the “public” had gotten itself pretty \nwell extended on the long side, they could break prices down. Brokers then would send out \ncalls for more margin from their “long” accounts, many of whom could not or would not put \nit up, with the result of their stocks dumped on the market, which in turn produced further \ndeclines. The professionals could then step in, cover their shorts with a profit, and secure a \nline of long stock for the next advance. Bear Raids of this sort were effectively checked by \nthe imposition of the Securities and Exchange Commission (SEC) regulations, but margin \ncalls and forced selling will always exist as a market factor so long as stocks can be bought \non margin and whenever prices drop extensively following a spree of public buying.\nMost true Selling Climaxes, if not all, have been produced by distress selling such \nas referred to in the preceding paragraph. They have come at the end of rapid and \ncomprehensive declines that exhausted the margin reserves of many speculators and \nnecessitated the dumping of their shares at whatever the market would bring. This process is \nprogressive—feeding upon itself, so to speak—with each wave of forced sales jeopardizing \nanother lot of margined accounts, until, at last, millions of shares are tossed overboard, \nwilly-nilly, in a final cleanup. Such is a Selling Climax in which the total turnover may \nexceed any single day’s volume during the previous upswing. It is a harvest time for traders \nwho, having avoided the Bullish infection at the top of the market, have funds in reserve \nto pick up stocks available at panic prices.\nObviously, a cleanout day or Selling Climax radically reverses the technical condition of the \nmarket, for in its process, shares have passed from weak hands into strong hands at very much \nlower prices. The ominous weight of potential selling that has been overhanging the market \nhas been removed. Usually, the Panic has carried quotations (although only temporarily, as a \nrule) well below even conservative values based on current business conditions.\nA Selling Climax need not be completed, and the Reversal of Trend actually becomes \nevident, within a single day. We have classified it as a variety of One-Day Reversal, but some \n146 Technical Analysis of Stock Trends\nof them have actually spread out over two days, with the decline exhausted and coming \nto a halt late on the first day, too near the end of the session to permit much recovery. The \nnext day sees an extensive rally right from the opening gong, as it is immediately apparent \nthen, if not late on the preceding day, that there are no more distress offerings.\nThe all-time per", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 78}
{"text": "Analysis of Stock Trends\nof them have actually spread out over two days, with the decline exhausted and coming \nto a halt late on the first day, too near the end of the session to permit much recovery. The \nnext day sees an extensive rally right from the opening gong, as it is immediately apparent \nthen, if not late on the preceding day, that there are no more distress offerings.\nThe all-time percentage record for Selling Climaxes is held by October 29, 1929. Prices \nin terms of the Dow–Jones Industrial Average opened that day practically at their high, \n252.38, which was more than 8 points below the previous day’s closing level. Panic selling \nflooded the Exchange from the start; before it was over, the Industrial Average had lost 40.05 \npoints. From that low, 212.33, it rallied in the final two hours to 230.07 for a gain of nearly \n18 points and went on up another 28 points the following day. This 1929 climax set the all-\ntime record also for daily turnover: 16,410,000 shares were traded in those five hours, more \nthan twice as many as in any one day during the entire preceding Bull Market. But the low \nlevel of October 29 was broken a week later, and the bottom of that particular early phase \nof the 1929–1932 Bear Market was not reached until November 13. EN: See comments on the \nfollowing page on the Reagan Crash of 1987.\nThe Panic of 1937 ended with a classic Selling Climax on October 19, another “Black \nTuesday” in stock market annals. The Dow Industrials had closed at 125.73 the night before; \nprices had already fallen without a rally of consequence from a high of 190 in mid-August, \nand margin accounts were nearly all in a precarious situation. The telephones had worked \novertime the preceding day by brokers demanding additional margin, most of which was \nnot forthcoming. When the Exchange opened on the 19th, quotations hit the toboggan \nunder a flood of offerings. By 11:30 a.m., with the Industrial Average around 115, the selling \nwas over and offerings disappeared. An hour later, prices were jumping a point between \nsales and the day closed at 126.85, recovering its entire loss. Volume on that climax was \n7 ,290,000 shares, double that of any day at the top of the preceding Bull Market. An intraday \nhigh of 141.22 was reached 10 days later, but the Panic Low was subsequently broken on \nNovember 20, 1937 , and that Bear Market finally ended at 98.95 (Dow–Jones Industrials’ \nclosing level) on March 31, 1938.\nEN: No wonder investors have instinctual angst on October 19. In 1987, the Bear returned to \ncreate another great Panic—on the very same date. From a high of 2746.65 on August 25 the Dow \nbungeed to a low of 1,616.21 on October 20. The actual full-blown panic took place from October \n14 (high 2,485.15) to October 20 (low 1,616.21) with October 19 and 20 traversing a range of \n547.95 points or 25% of the market at that point. Top to bottom, 1130 points were lost, comprising \na retracement of 41%. The more things change the more they stay the same, as André Malraux is \nsaid to have remarked. Actually, he said it in French, which is more elegant, and expresses the same \nidea: Plus ça change, c’est plus la meme chose. Readers should not assume that similar crashes \nwill not occur in the future.\nThe foregoing were general market climaxes, a phenomenon that produces (or rather is \nproduced by) simultaneous selling in practically every actively traded individual issue. \nA Climax Bottom, as a matter of fact, appears in an individual stock chart, as a rule, only \nas a concomitant of a general market cleanout, although there are cases in which some \nparticular and completely unexpected piece of bad news affects one certain company and \ncauses panicky liquidation of its shares alone, terminating with a One-Day Reversal. The \nTop Reversal Day, on the other hand, is normally a manifestation of an individual stock \nrather than of the general market average.\nThe two outstanding examples of Selling Climaxes (cited above) and numbers of \nothers that have appeared at the conclusion of various Panic Sell-offs offered extraordinary \nopportunities for a quick turn to the trader who was smart (or lucky) enough to get in at the \nbottom. He could cash in a few days later with exceptional profits. Professional operators \n147Chapter ten: Other Rever sal phenomena\ncapitalize on such opportunities. The problem is to recognize the climactic nature of the \nselling in time to seize the chance—and that is not as easy as it may have sounded in our \ndiscussion. Just to emphasize the possibilities of error, there was a 30-point drop, followed \nby a 30-point recovery, on a turnover of nearly 13 million shares, on October 24, 1929, but \nthe trader who did not grab his profits within 48 hours never had another chance to get out \neven (in terms of the Averages, that is).\nBut it is not impossible to recognize a Selling Climax, if you have friends in the Street \nto keep you informed on the condition of margin accounts and the amount of necessitous \nselling to be expected. EN: This information is now not difficult to come by. It is easily obtainable \nin the general financial press. The climax comes after a decline approaching Panic proportions. \nThe day usually opens with a substantial Downside Gap (opening prices considerably below \nthe previous night’s closing); offerings appear too great to be absorbed; prices collapse; \nvolume is extreme; the market is exceptionally “broad” with nearly every listed stock \ncrowding into the record. Then, some time after 11:00 a.m., perhaps not until afternoon, \nthe selling appears to dry up; a few issues continue to decline while others begin to climb. \nSuddenly prices are jumping, which is the time to act. Buy a stock that has been thoroughly \ndepressed but normally has a good following at all times (e.g., U.S. Steel). Do not hang on \ntoo long; take a reasonable profit as soon as it is available and sell, in any event, whenever \nthe recovery shows signs of bogging down.\nRemember", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 79}
{"text": "up; a few issues continue to decline while others begin to climb. \nSuddenly prices are jumping, which is the time to act. Buy a stock that has been thoroughly \ndepressed but normally has a good following at all times (e.g., U.S. Steel). Do not hang on \ntoo long; take a reasonable profit as soon as it is available and sell, in any event, whenever \nthe recovery shows signs of bogging down.\nRemember, a One-Day Reversal is not a dependable Major Trend indicator. Selling \nClimaxes do not normally occur at the final Bottoms of Bear Markets—weak holdings \nusually have been shaken out long before that stage is reached. Only one Primary \nDowntrend in all the record has, in fact, ended with the first Panic Phase, that being the \nfive-month Bear Market of 1938–1939 that was followed by an equally short Bull Market.\nOccasionally, a weekly chart will produce a formation that might be called a “One-\nWeek Reversal,” in some such conspicuous fashion as is shown above in “NC.” In this \ninstance, the subsequent rise proves that a Major change in its technical balance occurred \nin December 1941. Curiously enough, no other obvious Reversal Pattern appeared on \nthe weekly chart at this turn in the Primary Trend of “NC.” (Its daily chart showed an \nAscending Triangle.) But this example of a One-Week Reversal is not shown to give the \nidea that such phenomena carry important technical indications. On the contrary, most \n“Reversal weeks” are followed by very disappointing moves.\nOne remaining Reversal Formation, the Island Pattern, involves the whole subject of \nGaps, which will be taken up in detail in Chapter 12; thus, we will defer our discussion of \nthe Island Reversal until then.\nShort-term phenomena of potential importance\nVery short-term phenomena—of a one-day or a few days’ duration—can sometimes be \nindicative of not only short-term direction, but also give hints as to long-term price behavior. \nGaps (see Chapter 12) and One-Day Reversals (this Chapter) belong to this group. Other \nshort-term patterns of interest include Spikes, Key Reversal Days (sometimes merely called \nReversal Days), and Runaway Days (sometimes called Wide-Ranging Days).\nSpikes\nOn the day it occurs, a Spike is not immediately identifiable for by definition it protrudes \nHead-and-Shoulders above days before and after if it is at or near a Top and plunges \nmuch below the surrounding days if it occurs at a Bottom. So after a day that exhibits an \n148 Technical Analysis of Stock Trends\nunusually wide range, the subsequent days must be observed to discriminate the day from \na Runaway Day. Both are the marks of a far-ranging battle between Bulls and Bears, with \nthe close giving a clue as to whom the eventual winner will be.\nThe importance of the spike is highlighted by the following:\n 1. The strength and length of the action that preceded it.\n 2. The close of the day, whether up on a Bottom or down on a Top.\n 3. Its prominence when compared with the days before and after it.\nAn extremely wide-range day at the end of a long Bull move that closes down after \nmaking unusual new highs might even be construed as a one-day signal. Whether one \ntrades on it or not would depend on his particular style and taste and the nature of his \ntrading—long range, scalping, and so on. In fact, the Spike might also be a One-Day \nReversal—that pattern in which an opening gap often is followed by avid buying that \ncollapses and closes below the opening or at the low of the day. Such action might be \ncompared with an army pursuing a seemingly defeated enemy only to discover the retreat \nwas a ruse, then turning and fleeing the other way in a rout.\nTurn this description on its head and you have a Spike Bottom. It is not infrequent that \na Spike will be followed by significant price movement in the opposite direction. Figure \n10.23 illustrates a modern Spike. Figures 1.1 and 7 .16 show some spikes on Edwards’ and \nMagee’s charts.\nRunaway Days\nA Runaway Day is a day that stands out on the chart as having an unusually long range, \noften opening at the low and closing at the high, or vice versa for Bear runaways. Here \nthe enemy has retreated precipitously, or treacherously, to draw the Bulls into a trap. The \nholders and sellers cannot or will not satisfy the eager demand of the buyers and so the \nprice transverses perhaps two to three times the daily range. Although the agile speculator \nmay jump on this charging train and realize a nice scalp, it is the following days that \nreveal the true significance. Nice consolidation and continued volume will confirm the \nday as significant while a tapering of volume and rounding or volatile pullback will call \ninto question its validity. Although these days may be taken as hair-trigger buy signals (or \nsell signals, depending) the return of prices to the low of the Runaway Day will probably \nindicate the day was a false signal and a trade in the opposite direction is shaping up. \nSee Figure 7 .20 for runaways complete with gaps.\nOne such example is shown in Figure 10.24 in which a bull trap precipitated by a \nRunaway Day with a subsequent collapse foretold the 50% decline in Microsoft stock in 2000.\nKey Reversal Days\nThe Key Reversal Day pattern occurs when one sees a new high in an up-move and then \na close below the close of the previous day. As a short-term trading signal it has much to \nrecommend it, but like every other technical pattern, judgment and timing are required to \nprofit from it. In a Bull Market, there will be some if not many such interim highs marked \nby Key Reversal Days. On the Key Reversal Day at a major or important Top, the trader \nshorts the stock on the close with a stop at the high of the reversal day, or slightly above. \nHe may then exit on the profit side on the occurrence of a Key Reversal Day in the opposite \ndirection, or on a profit target, or a chart pattern. If adventurous, he may use the trade as \n149Chapter ten: Other Reve rsal phenomena\nthe first of accumulating a position for an ant", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 80}
{"text": "important Top, the trader \nshorts the stock on the close with a stop at the high of the reversal day, or slightly above. \nHe may then exit on the profit side on the occurrence of a Key Reversal Day in the opposite \ndirection, or on a profit target, or a chart pattern. If adventurous, he may use the trade as \n149Chapter ten: Other Reve rsal phenomena\nthe first of accumulating a position for an anticipated Bear Market, adding other positions \nas more significant patterns occur and as support levels are broken.\nThis pattern also is useful in trading range markets, as shown in some internet stocks \nfrom 2000, where trading with Key Reversal Days would have allowed the trader to escape \nunscathed in the minicrash of the NASDAQ in early 2000 (see Figures 10.25 and 10.27 for \neBay and Lucent.)\nOf all the Very Short-Term Patterns, Gaps, One-Day Reversals, Key Reversal Days, \nSpikes, and Runaway Days, it should be noted that the return of prices to the origination \nof the formation marks the formation as a false signal and a reason to reverse the trade \ndirection and look for significant profits.\nClearly, these are the tactics of scalpers and speculators, but it profits the long-term \ninvestor to know and understand them.\n\n151\nchapter eleven\nConsolidation Formations\nAn army, which has pushed forward too rapidly, penetrated far into enemy territory, \nsuffered casualties, and outrun its supplies, must halt eventually, perhaps retreat a bit to \na more easily defended position and dig in, bring up replacements, and establish a strong \nbase from which later to launch a new attack. In the military parlance with which we have \nall become more or less familiar these past few years, that process is known as consolidating \none’s gains. Although it will not do to overwork the analogy, there is much in the action \nof the stock market that may be compared to a military campaign. When a stock pushes \nahead (up or down) too fast, it reaches a point at which the forces that produced its move \nare exhausted. Then it either reverses its trend (in a Major or Intermediate sense), reacts to \na good Support Level, or Consolidates its position, in some sort of “sideways” chart pattern \ncomposed of Minor Fluctuations, until it has caught up with itself, so to speak, and is ready \nto go on again. (For illustrations in this chapter, see Figures 11.1 through 11.18.)\nWe already have had occasion to refer to Consolidation Formations in our study of \nSymmetrical Triangles and Rectangles; exactly how those two chart formations might \neither reverse the previous trend or Consolidate it in preparation for its continuation \nwere shown. We noted about three out of four Symmetrical Triangles will turn out to be \nConsolidations rather than Reversals—and Rectangles in about the same proportion. Even \na Flat-Topped Broadening Pattern constructed at the Top of an Intermediate Advance may, \ndespite its normally Bearish implications, be converted into a Consolidation or Continuation \nFormation if its Flat Top is decisively penetrated on the upside.\nA Dow Theory Line in the chart of one of the Averages may be a Consolidation or \nReversal Formation, but is rather more likely to be the former than the latter. A Dow Line \nis, of course, a sort of loose Rectangle. The fact is almost any sort of sideways price pattern, \nsuch as is often termed a “Congestion” or trading area, provided trading volume tends \nto diminish during its construction (and provided it does not show definite broadening \ntendencies), usually functions as a Consolidation. But most areas of Trend Consolidation \nare fairly well defined, taking on a recognizable pattern.\nFlags and Pennants\nWe do not need to spend more time here on the Triangles and Rectangles; they have been \nexamined in both their Reversal and Consolidation manifestations in previous chapters. \nOur first two formations, which are characteristic of Consolidation only, are the Flags and \nPennants, which are curiously related in certain aspects to Triangles, Rectangles, and \nWedges.\nA Flag looks like a flag on the chart. That is, it does if it appears in an uptrend; the \npicture is naturally turned upside down in a downtrend. It might be described as a small, \ncompact parallelogram of price fluctuations, or a tilted Rectangle that slopes back moderately \nagainst the prevailing trend. Let us consider the Uptrend Flag first. It usually forms after \na rapid and fairly extensive advance that produces a nearly vertical, or at least quite steep \nprice track on the charts. On such moves, volume normally shows a progressive increase \nuntil it reaches a high rate. This volume (since every transaction signifies a sale as well as \n152 Technical Analysis of Stock Trends\na purchase) is a warning that many holders of the stock are taking profits. Eventually the \npressure of profit-taking halts the markup. Prices “churn” without further gain and then \nreact 2 or 3 points on reduced turnover. A new rally occurs but fails to equal the previous \nhigh or attain the previous top volume. Another reaction carries quotations slightly below \nthe preceding Bottom with further diminution of activity and then follows a series of \nsimilar Minor Fluctuations, each of whose Tops and Bottoms are successively a trifle lower \nthan its predecessor, and with volume shrinking markedly and constantly as the pattern \ndevelops. On the chart, the initial, steep up-move followed by the compact, sideways, and \nslightly down-sloping price Congestion Area, which can be roughly bounded, top and \nbottom, by parallel lines, takes on the appearance of a mast (or halyard) with a flag flying \nfrom its peak, hence, the name of the formation.\nSometimes each rally and setback within the Flag takes three or four days, rarely more. \nIn other cases, prices will skip back and forth between the upper and lower Flag boundaries \nin a single day or two, in which event the pattern on the chart consists of an almost solid \nblock of price range lines. The wider the pattern", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 81}
{"text": "yard) with a flag flying \nfrom its peak, hence, the name of the formation.\nSometimes each rally and setback within the Flag takes three or four days, rarely more. \nIn other cases, prices will skip back and forth between the upper and lower Flag boundaries \nin a single day or two, in which event the pattern on the chart consists of an almost solid \nblock of price range lines. The wider the pattern (from top to bottom) the longer time, \nMARTIN – PARRYM RT\n1945\nAPRILM AY JUNE JULY AUGUST SEPTEMBER\nG\nX D 150\n24\n22\n20\n19\n18\n17\n16\n15\n14\n13\n12\n11\nSales\n100’s\n125\n100\n75\n50\n25\n7 14 21 28 5 12 19 26 2 9 16 23 30 7 14 21 28 4 11 18 25 1 8 15 22 29\nFigure 11.1 This is a typical and practically perfect Flag, constructed May 12 to June 2, 1945, in \nMartin–Parry. Daily turnover diminished to a low rate as prices settled down for exactly three weeks \nafter their swift advance from 11 to 16 1/2 but held up away from the lower boundary line during \nthe third week, and then burst out topside with high volume in another straight-line push from 15 \nto 21. Study this chart again when you come to the Flag-measuring formula later in this chapter. The \ndashes at 12 indicate the upper range of an old Resistance Level (see Chapter 13).\n153Chapter eleven: Consolid ation Formations\nnaturally, it should take for each swing within it to be completed. This process of Minor \nFluctuations may continue for only five days to a week if the Flag is narrow, or it can go \non for as long as three weeks. Daily turnover by that time usually will have shrunk to a \nrelatively low ebb. Then, suddenly, prices will erupt with a new burst of activity from the \nend of the Flag and push straight up again in another advance that practically duplicates \nthe original “mast” atop which the Flag was constructed.\nWe have spoken of the Flag pattern as being moderately down-slanting, but the very \nshort and “solid” ones will frequently develop horizontally and look like small squares. (On \nrare occasions, a pattern of the Flag type in an uptrend will even slope up a trifle.)\nFlags form on steep down moves in much the same manner and with precisely the \nsame implications as they do in uptrends. Down Flags, of course, tend to slope up—that is, \nthey simply invert the picture presented by an Up Flag. Trading volume diminishes during \ntheir formation and increases again as prices break down away from them.\nThe Pennant: a pointed Flag\nThe only important difference between a Pennant and a Flag is the former is bounded by \nconverging boundary lines rather than parallel lines. The normal Pennant, in other words, \nis a small, compact, sloping Triangle. It slants down when it appears in an uptrend, and it \nNATIONAL GYPSUM NG\n1945\nJUNE JULY AUGUSTS EPTEMBERO CTOBER NOVEMBER\n24\n22\n20\n19\n18\n17\n16\n15\n14\nSales\n100’s\n12510075\n50\n25\n16 23 30 7 14 21 28 4 11 18 25 1 8 15 22 29 6 13 20 27 3 10 17 24 1 8\nFigure 11.2 Another typical Flag of three weeks’ duration, August 30 to September 18. This National \nGypsum chart overlaps that in Figure 8.6, showing the false move at the apex of the May–June \nSymmetrical Triangle. A buy signal was given when prices pushed up through the old apex level on \nAugust 23 with increased volume. Most interesting is the second Symmetrical Triangle that formed \nin October–November, an almost exact replica of the first, but with a downside false move at its apex. \nThe sharp increase in volume on November 27 left no doubt as to its being a Consolidation rather \nthan Reversal Pattern. “NG” went on up to 33.\n154 Technical Analysis of Stock Trends\nslants up in a downtrend. It forms, as a rule, after a rapid advance (or decline), and trading \nvolume shrinks notably during its construction. In fact, activity tends to diminish even \nmore rapidly in a Pennant than in a Flag (which we naturally would expect on account of \nthe progressively shorter fluctuations that compose it), and it may drop almost to nothing \nbefore the Pennant is completed and prices break away from it in a new and rapid move.\nThe Pennant might also be described as a short, compact Wedge, characterized by \nmarked diminution of activity. When, as is usual, it slants back against the preceding trend, \nits forecasting implications are similar to those of the Wedge, in that prices break out of \nit in a direction opposite to its slant. But there are rarer Minor variations of the Pennant, \ncomparable with those sometimes found in the Flag, in which the price area is very short \nand “solid” and practically horizontal (like a Symmetrical Triangle), or in which the slope \nis actually slightly in the same direction as the preceding trend instead of against it. When \nprices move out of the last-named type, they ordinarily do so, not in a sudden straight-line \nbreakaway, but rather in an accelerating curve with volume increasing gradually instead \nof abruptly at the break; the whole pattern resembles a curved horn that runs to a long, \nslender point. Do not let these variations worry you; there is nothing deceptive about their \nappearance; their kinship to the more common, normal form is quite apparent.\nThe measuring formula\nThe same approximate measuring formula applies to the Pennant as to the Flag. They are \nboth “Half-Mast” Patterns that ordinarily form after a fairly steady and rapid (steep) price \nmovement. In applying the measuring rule, go back to the beginning of that immediately \npreceding move, to the point at which it broke away from a previous Consolidation or \nNASH – KELVINATOR NK 1937\nJANUARYF EBRUARYM ARCH APRILM AY JUNE\n24\n22\n20\n19\n18\n17\n16\n15\nSales\n100’s\n250\n200\n150\n100\n50\n2 9 16 23 30 6 13 20 27 6 13 20 27 3 10 17 24 1 8 15 22 29 5 12 19 26\nFigure 11.3 Flags of the “Half-Mast” type appear most often in the later and most active stages of a \nPrimary Advance. The above example (January) was the last Consolidation Formation before “NK’s” \n1937 Bull Market Top. Note the Rectangle Reversal Pattern in March and the series of step-down \npatterns that followed.\n155Chapter eleven", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 82}
{"text": "23 30 6 13 20 27 6 13 20 27 3 10 17 24 1 8 15 22 29 5 12 19 26\nFigure 11.3 Flags of the “Half-Mast” type appear most often in the later and most active stages of a \nPrimary Advance. The above example (January) was the last Consolidation Formation before “NK’s” \n1937 Bull Market Top. Note the Rectangle Reversal Pattern in March and the series of step-down \npatterns that followed.\n155Chapter eleven: Consolid ation Formations\nReversal Formation (or through a significant trendline or Resistance Level, with which \nlater chapters are concerned), a point recognizable as a rule by a quick spurt in activity, \nand measure from there to the Minor Reversal level at which the Flag or Pennant started \nto form. Then measure the same distance from the point at which prices break out of the \nFlag or Pennant, and in the same direction. The level thus arrived at is the minimum \nexpectation of this type of Consolidation Pattern. As a matter of fact, advances from Flags \nVANADIUM CORP.V A\n1936–1937\nOCTOBERN OVEMBERD ECEMBERJ ANUARY FEBRUARY MARCH\n44\n40\n38\n36\n34\n32\n30\n28\n26\n24\n22\n20\n19\n18\n17\n16\nSales\n100’s\n125\n100\n75\n50\n25\n3 10 17 24 31 7 14 21 28 5 12 19 26 2 9 16 23 30 6 13 20 27 6 13 20 27\nFigure 11.4 Sometimes a stock will make a long series of small Consolidation Patterns in its uptrend, \none following right on the heels of another as successive groups of traders buy in while others take \ntheir profits on previous purchases. In this sequence of step-ups in Vanadium, the Flag Pattern \nformed in January 1937 ran a few days over, but the volume breakout of February 4 left no doubt \nthe trend was still up. A final Top was made at 39 1/2 in March. Note the strong buy signal given \non December 14. Refer to this record again in connection with Support and Resistance studies in \nChapter 13.\n156 Technical Analysis of Stock Trends\nor Pennants in an uptrend generally go farther (in terms of points or dollars) than the \npreceding move, whereas declines may not carry quite so far. Hence, the formula is best \napplied on a semilogarithmic chart by measuring actual chart distance rather than by \ncounting points. You can check this by referring to the examples illustrating this study.\nReliability of Flags and Pennants\nThese pretty little patterns of Consolidation are justly regarded as among the most \ndependable of chart formations, both as to directional and measuring indications. They \ndo fail occasionally, but almost never without giving warning before the pattern itself is \ncompleted. All that is necessary to guard against such failures is to strictly apply the tests \nas to the authenticity of the pattern incorporated in their description. These are as follows:\n 1. The Consolidation (Flag or Pennant) should occur after a “straight-line” move.\n 2. Activity should diminish appreciably and constantly during the pattern’s construction \nand continue to decline until prices break away from it.\n 3. Prices should break away (in the expected direction) in not more than four weeks. \nA pattern of this type that extends beyond three weeks should be watched with \nsuspicion.\nThe matter of practical trading on these particular formations will be taken up in \nSection II of this book, which is devoted to tactics. Our second test deserves some further \nBRIGGS BG\n1936\nJANUARYF EBRUARY MARCHA PRIL MAYJ UNE\n68\n64\n60\n56\n52\n48\n44\n40\nSales\n100’s\n250\n200\n150\n100\n50\n4 11 18 25 1 8 15 22 29 7 14 21 28 4 11 18 25 2 9 16 23 30 6 13 20 27\nFigure 11.5 A Bull Flag in February and a Bear Flag in April 1936, in Briggs. The Top between was \na Symmetrical Triangle. April 30 was a Reversal Day. Prices recovered to 64 1/2 in November 1936, \nmaking there a long-term Major Double Top with this March high. The Support–Resistance Zone at \n51–53, indicated by dashed line, was still effective in 1946 (see Chapter 13).\n157Chapter eleven: Consoli dation Formations\ncomment here though. If a pattern begins to develop on the chart—which, so far as the price \npicture alone is concerned, qualifies as a Flag or Pennant, but during which trading volume \nremains high or obviously irregular instead of diminishing—then the outcome is more \napt to be a quick reaction against, rather than continuation of, the previous trend. In other \nwords, such high or irregular activity formations are characteristically Minor Reversal \nAreas rather than true Consolidations. Watch the volume half of your chart at all times.\nWhere they may be expected\nFlag and Pennant Consolidations are characteristic of fast moves. Therefore, they show up \nmost frequently in the later, dynamic phase of Bull Markets, after the first accumulation and \nthe more orderly early markup stages have passed. Hence, the appearance of these patterns \nmay be taken as a warning that an advance is approaching its final weeks. The rapid phase \nof a Major Bear Trend, on the other hand, is its second stage, often characterized by almost \n“vertical” Panic Declines. The Flags and Pennants that develop therein are usually short—\ncompleted in a matter of three or four days rather than weeks. In the late months of a Bear \nMarket, formations that evolve on the charts in the Flag or Pennant similitude often will \nrun too long (four weeks or more), begin to show an increase in volume on the rallies, and \nbe succeeded by only dull and limited reactions.\nANACONDA COPPERA\n1936–1937 \nOCTOBER NOVEMBER DECEMBER JANUARY FEBR UARY MARCH \n72 \n68 \n64 \n60 \n56 \n52 \n48 \n44 \n40 \n38 \n36 \nSales \n100’s \n500\n400\n300\n200\n100\nG G \nG \n3 10 17 24 31 7 14 21 28 5 12 19 26 2 9 16 23 30 6 13 20 27 6 13 20 27 \nFigure 11.6 The down-sloping, Converging Price Formation of November 4 through December 9 \nmight be called either a short Wedge or a Pennant. Note the small Flag in October; also Runaway \nGaps November 4 and February 19, and the Breakout Gap December 10.\n158 Technical Analysis of Stock Trends\nIn general, it may be said these particular chart patterns are most common (and most \ndependable) in uptrends. The appearance, after a Major Decline, of price", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 83}
{"text": "ion of November 4 through December 9 \nmight be called either a short Wedge or a Pennant. Note the small Flag in October; also Runaway \nGaps November 4 and February 19, and the Breakout Gap December 10.\n158 Technical Analysis of Stock Trends\nIn general, it may be said these particular chart patterns are most common (and most \ndependable) in uptrends. The appearance, after a Major Decline, of price pictures that, at the \nstart, assume the downtrend Flag or Pennant form must be regarded with caution. Unless \nsuch developments hold strictly to the limitations we have stated above under the heading \nof “reliability,” do not trade on them.\nFlag pictures on weekly and monthly charts\nOne of our requisites for a dependable Flag (or Pennant) was it should not take more \nthan four weeks to complete its pattern and break out in a new move. It stands to reason, \ntherefore, that a true Flag cannot show up at all on a monthly chart and barely appears \non a weekly chart. You will find price areas on long-range charts, patterns that have taken \n8 or 10 weeks to as many months, sometimes a year or two, in their construction, which \nassume the shape of a Flag, but do not expect them to function as Flags. Examined in \ndetail on a daily chart, these same long areas almost always will be found to contain price \nformations having entirely different significance. Frequently, what is really a Major Reversal \nArea following a long, rapid advance will look something like a Flag when it is condensed \non a monthly chart. So, do not trust such pictures on long-range charts; do not take it for \ngranted that they represent Consolidation for a new rise; find out what the detailed daily \nplotting for the same period says.\nThe July–August Flag ran for five weeks—too long to be trusted without additional \ntechnical evidence (see point 3 under “Reliability of Flags and Pennants”). The danger in \nPACIFIC TINP TC\n1944\nAPRILM AY JUNEJ ULYA UGUSTS EPTEMBER\n7\n6\n5\n412\nSales\n100’s\n125\n100\n75\n50\n25\n8 15 22 29 6 13 20 27 3 10 17 24 1 8 15 22 29 5 12 19 26 2 9 16 23 30\nFigure 11.7 An example (in June 1944) of the brief and compact type of price “Congestion” that can \nbe classed as a Flag. The advance here started at 5 from a 13-month Symmetrical Triangle of which \nonly the last two months appear above. The measuring implication of this tiny Flag was not fulfilled \nuntil after prices had undergone a sort of Triangular Consolidation in July.\n159Chapter eleven: Consoli dation Formations\nsuch prolonged formations is either when the breakout finally appears it will fail to follow \nthrough, or prices will keep drifting right on down. For the moment—on August 25—it \nlooked as though this Flag had “gone stale,” but when prices rose above the previous high \non August 27 , with a smart pickup in volume, purchases were obviously safe.\nRectangular Consolidations: an early phase phenomenon\nIn contrast with Flags and Pennants, which are typically last-stage Bull Market Concomitants, \nConsolidations of the Rectangle class are found more often in the earlier phases of Bull \nTrend evolution. In Major Bear Moves, Rectangles may develop in the first stage just before \na Panic Decline, or in the last stage preceding a strictly limited final sell-off. The latter \nmanifestation presumably betokens premature accumulation by interests who feel that \nprices have already gone low enough to suit their purposes. (They come out all right, if \nthey are able to hold on through the remainder of the Bear Swing and long enough for the \nnext Bull Market to put prices back up again to profitable levels.)\nMULLINS MANUFACTURING BM NS 1936\nAPRILM AY JUNE JULY AUGUST SEPTEMBER\nG\n28\n26\n24\n22\n20\n19\n18\n17\n16\n15\n14\n13\n12\nSales\n100’s\n50\n40\n30\n20\n10\n4 11 18 25 2 9 16 23 30 6 13 20 27 4 11 18 25 1 8 15 22 29 5 12 19 26\nFigure 11.8 Another example of the series of Flag-type Consolidations that may form in a rapid, \nthird-phase Bull Market Advance. Mullins went from 15 to above 39 in six months in 1936, dropped \nback to 31, and then rose again in March 1, 1937 , to its previous high, making a Major Double Top. \n(Note that “MNS” was split 2-for-1 in 1937 .)\n160 Technical Analysis of Stock Trends\nHead-and-Shoulders Consolidations\nAll our references to the Head-and-Shoulders Formations up to this point (see Chapters \n6 and 7) have considered that pattern as typifying a Reversal of Trend, and, in its normal \nand common manifestation, that is most definitely the Head-and-Shoulders function. But, \noccasionally, prices will go through a series of fluctuations that construct a sort of inverted \nHead-and-Shoulders picture, which in turn leads to continuation of the previous trend.\nThere is no danger of confusing such Continuation or Consolidation Formations with \nregular Head-and-Shoulders Reversals because, as stated, they are inverted or abnormal with \nrespect to the direction of the price trend before their appearance. In other words, one of the \npatterns that develops in a rising market will take the form of a Head-and-Shoulders Bottom. \nThose that appear in decline assume the appearance of a Head-and-Shoulders Top. By the \ntime these price formations are completed (left shoulder, head, and right shoulder evident), \nthere is no question as to their implications. But at the head stage, before the right shoulder \nis constructed, there may be—usually is—considerable doubt as to what really is going on.\nWYANDOTTE WORSTEDW YO\n1945–1946\nM\nM\nG\nJANUARYF EBRUARYM ARCH APRILM AY JUNE\n48\n44\n40\n38\n36\n34\n32\n30\n28\n26\n24\n22\nSales\n100’s\n125\n100\n75\n50\n25\n22 29 5 12 19 26 2 9 16 23 2 9 16 23 30 6 13 20 27 4 11 18 25 1 8 15\nFigure 11.9 The vertical lines marked “M” show how the measuring formula is applied to a Flag \nPattern. Note the first measurement is taken from the level at which the mast leaves the previous \n“Congestion” up to the peak of the Flag. This same distance is then measured up from the Flag \nbreakout. In “WYO,” the formula worked out exactly. Trading commitments should normally have \nbeen", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 84}
{"text": "8 25 1 8 15\nFigure 11.9 The vertical lines marked “M” show how the measuring formula is applied to a Flag \nPattern. Note the first measurement is taken from the level at which the mast leaves the previous \n“Congestion” up to the peak of the Flag. This same distance is then measured up from the Flag \nbreakout. In “WYO,” the formula worked out exactly. Trading commitments should normally have \nbeen cashed in above 36 on this move. They might then have been reinstated when it became apparent \nby April 2 that a Rounding Bottom was completed (note volume) for a new advance.\n161Chapter eleven: Consolid ation Formations\nThe volume pattern in Consolidations of this type does not follow the rule for Reversal \nHead and Shoulders. In a downtrend, for example, the Consolidation Formation resembled \nin its price contour a Head-and-Shoulders Top, but the attendant volume will diminish \ninstead of increase on the left shoulder and head as well as on the right shoulder. The same \nholds true for the “Bottom” Patterns that develop as Consolidation in an advance market; \nhowever, Breakouts resemble, in all respects, those arising from Reversal Formations.\nHead-and-Shoulders Consolidations of the Complex or Multiple type seldom appear \non the charts. Theoretically, they might and should be as easy for the chart technician to \nhandle as the simple forms.\nThe formula for determining the probable minimum price move (beyond the neckline) \nfrom a Head-and-Shoulders Reversal Formation was discussed in Chapter 6. To anyone \nfamiliar with the verities of stock market trends and the endless variety of pictures that \nthe charts can present, it is amazing how accurately that formula works out and how often \nthe first consequential move away from a Head-and-Shoulders Top or Bottom will carry \nthrough to the point (or a little beyond) implied by the measurement of the formation. But, \nthe same formula applied to Consolidation Patterns of the Head-and-Shoulders form does \nnot work out as well. Such patterns are usually quite “flat,” and the ensuing move generally \nAMERICAN WOOLEN WY\n1946\nG\nG\nJANUARYF EBRUARYM ARCH APRILM AY JUNE\n68\n64\n60\n56\n52\n48\n44\n40\n38\n36\n34\n32\n30Sales\n100’s\n125\n100\n75\n50\n25\n5 12 19 26 2 9 16 23 2 9 16 23 30 6 13 20 27 4 11 18 25 1 8 15 22 29\nFigure 11.10 A 1946 chart that delighted technicians contains a perfect “Half-Mast” Pattern in \nJanuary, with measuring gaps (G, G) above and below it; a downside Flag in early February (check \nmeasurement); a fine Ascending Triangle at the bottom of this reaction with a Throwback in April, \ngiving an ideal “buy spot.”\n162 Technical Analysis of Stock Trends\nextends well beyond the measurement implied thereby, although, in some cases, it may \nnot go quite as far. Consequently, the Head-and-Shoulders formula cannot be applied to \nConsolidation Areas with the assurance that it sets up a definite and dependable objective; \none has to look, in these cases, to a variety of other chart indications to appraise the probable \nproportions of the move to follow.\nScallops: repeated Saucers\nOur next chart picture differs from the Consolidation Formations previously discussed, in \nthat it does not constitute a more or less definite area of Congestion or fluctuation to which \none or more critical boundary lines can be affixed. We could, perhaps, take it up as well in a \nsubsequent chapter under the general heading of normal trend action. Yet it is a pattern so \ncharacteristic of certain types of stocks and certain types of markets, and so nearly related \nto the principle of Consolidation for further advance, that it may be better treated here.\nWhen a stock for which there is a large number of shares outstanding, and for which \nthere is, at all times, a fairly active and “close” market emerges from a long-time Bottom \n(as exemplified by the past history of Radio Corporation and Socony-Vacuum), which will \noften make a long Major Advance in a series of “Saucers.” These successive patterns, each \nof which resembles, in both price and volume action, the Reversal Formation described in \nChapter 7 as a Rounding Bottom, are slightly uptilted, that is, the rising end always carries \nthe price a little higher than the preceding Top at the beginning of the Saucer. The net gain \naccomplished by each Saucering movement will vary from stock to stock, but there seems \nMO(D) - Daily NYSE L = 65.41 +0.42 +0.65% B = 0.00 A = 0.00 O = 65.65 Hi = 65.65 Lo = 65.05 C = 65.41 V = 4968500\n52 .51 \n69.00 \n66.00 \n65 .41 \n60.00 \n56.00 \n52.00 \n48.00 \n45.00 \n42.00 \n39.00 \nS O N D 04 F M A M J J A S O N D 05 F M A M \nCreated with TradeStation\nFigure 11.11 MO. Talk about your technician’s delights. Altria Group throws off some pretty good \ndelights here: a breakaway gap and run days to the downside, a down flagpole with flag, and pattern \ngaps. But they are good pattern gaps and really interesting. Then a triangle complete with a breakaway \nand an up flagpole with flag. The non-technician probably is suffering from nausea at this point. It \nis a roller coaster that bodes ill for everyone. Additionally note a completely tradable situation for \nthe alert short-term technician.\n163Chapter eleven: Consoli dation Formations\nto be a strong tendency for it to amount to about 10%–15% of the price of the issue. The total \nreaction from the left-hand lip of each Saucer to its Bottom level is usually a little greater, \nfrom 20% to 30%, and the length (duration) of the Saucers is normally five to seven weeks, \nrarely less than three. Thus, the overall advance is slow but steady, in much the same sense \nas the progress of the man who eventually got out of the deep well by climbing three steps \nfor each two that he slipped back.\nThe charts of stocks that take this sort of course show a picture of strikingly similar \nand symmetrical Rising Scallops, one succeeding another with little or no pause between. \nTrading activity runs up to a peak at the latter stage of each Scallop, as the previous high is \napproached and exceeded", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 85}
{"text": "who eventually got out of the deep well by climbing three steps \nfor each two that he slipped back.\nThe charts of stocks that take this sort of course show a picture of strikingly similar \nand symmetrical Rising Scallops, one succeeding another with little or no pause between. \nTrading activity runs up to a peak at the latter stage of each Scallop, as the previous high is \napproached and exceeded, then diminishes into dullness as prices curve down and flatten \nout at the Bottom of the next Saucer, picking up again as prices curve up into their next rise.\nThe trading opportunities afforded by stocks of the Saucering habit hardly require \nextended comment (although we shall set down some detailed specifications in Section II \nof this book). The Bottom level of each Scallop is usually easy to detect by watching price \ntrend and volume, and so is the topping out at the end. Yet it is curiously a fact that most \n“tape watchers” handle such stocks in the wrong way, becoming interested in them and \nbuying when they show activity (“make a new high on volume”) and neglecting them \nentirely when they are in the dull, rounding-out stage of their trends.\nAMERICAN LOCOMOTIVE LA\n1935\nJULY AUGUSTS EPTEMBERO CTOBER NOVEMBERD ECEMBER\n28\n26\n24\n22\n20\n19\n18\n17\n16\n15\n14\nSales\n100’s\n50\n40\n30\n20\n10\n6 13 2 27 3 10 17 24 31 7 14 21 28 5 12 19 26 2 9 16 23 30 7 14 21 28\nFigure 11.12 A Flag (end of November) that seemed for several weeks to have failed completely. \nPrices, however, rose quickly to 36 1/4 from their December 23 low, thus finally carrying through \naccording to formula. Note the Flat-Topped Broadening Formation that started the move.\n164 Technical Analysis of Stock Trends\nAMERICAN & FOREIGN POWER 2d Pfd AF P 2d Pr\n1945\nJANUARYF EBRUARYM ARCH APRILM AY JUNE\n28\n26\n24\n22\nSales\n100’s\n125\n100\n75\n50\n25\n6 13 20 27 3 10 17 24 3 10 17 24 31 7 14 21 28 5 12 19 26 2 9 16 23 30\nFigure 11.14 A 1945 Head-and-Shoulders Consolidation in which both of the shoulders and the head \ntook a “Saucer” form. Compare price and volume trends. Prices advanced to 31 1/2 in July, came back \nagain to 25 1/2 in August, and then shot up to 40 in November.\nANACONDA COPPERA\n1936\nS S\nH\nJULY AUGUSTS EPTEMBER OCTOBERN OVEMBERD ECEMBER\n52\n48\n44\n40\n38\n36\n34\n32\nSales\n100’s\n500\n400\n300\n200\n100\n4 11 18 25 1 8 15 22 29 5 12 19 26 3 10 17 24 31 7 14 21 28 5 12 19 26\nFigure 11.13 Typical of the form that Head-and-Shoulders Consolidation Patterns may take, both as \nto price pattern and volume, was this development in Anaconda. Measuring formula for the small \nFlag in October should be applied from the point of breakout through the Head-and-Shoulders \nneckline.\n165Chapter eleven: Consoli dation Formations\nMIAMI COPPERM I\n1945\nJULY AUGUSTS EPTEMBERO CTOBER NOVEMBER\n14\n13\n12\n11\n10\n9\n8\nSales\n100’s\n125\n100\n75\n50\n25\nXD .25 ¢\n23 30 7 14 21 28 4 11 18 25 1 8 15 22 9 6 13 20 27 3 10 17 24 1 8 15\nFigure 11.15 Part of a genuine “Scallop” uptrend, typical except for the short duration and relatively \nsmall decline in the October Saucer. The next Scallop, which started in December, dropped prices \nback to 12 1/2 in January, and then carried them to 18 1/2 in February. A four-month Saucer, from \nFebruary 1945 to June, preceded this chart. Note the position traders found themselves in if they \nbought at 9 on the “new high volume” in June.\nCOMMONWEALTH EDISONC WE\n1945\nJULY AUGUSTS EPTEMBERO CTOBER NOVEMBER DECEMBER\n36\n34\n32\n30\n28\nSales\n100’s\n125\n100\n75\n50\n25\n7 14 21 28 4 11 18 25 1 8 15 22 29 6 13 20 27 3 10 17 24 1 8 15 22 29\nFigure 11.16 Although the Scalloping habit characteristically appears in low-priced issues, it is \nsometimes found in widely held, semi-investment stocks of medium price, such as “CWE.”\n166 Technical Analysis of Stock Trends\nMany boardroom tape watchers scorn charts with unfortunate consequences to their \ncapital in the long run. Genuinely expert tape readers—those who are able to show fairly \nconsistent profits in their trades—are really extremely rare. (EN: For “tape readers” substitute \n“day traders,” 99% of whom are unsuccessful.) When you do meet such an individual, you will \nfind that he either, in effect, “carries charts in his head” or else takes a careful look at the \nrecord before he buys on a ticker showing activity.\nAs a stock with the Scalloping habit finally works up in price to 15 or so, its pattern \ntends to become less regular; it begins to depart from the smooth, narrow Saucer-like curve \nof the lower levels. Above 20, it is apt to break away entirely from the Scallop sequence and \nproduce, from there on, more rapid straight-line advances, interspersed with sharp reactions \nand standard types of Consolidation Formations, which are characteristic at all times of \nmedium- and high-priced issues. (There are exceptions: some high-priced preferred stocks \nfor which there is always a market, but whose trends depend almost entirely on the gradual \nchanges in prevailing interest rates and supply of funds for investment, have a persistent \nScallop habit in their Primary Upswings.)\nWe have named rather specific price levels (15 and 20) in the preceding paragraph, but \nprice is not the sole factor determining the departure of a stock from a Scallop Trend. The \nonly safe assumption is that, once such a habit is detectable, it will be continued until the \nchart shows a definite divergence from it, and such divergence usually takes first the form \nINTERNATIONAL TEL. & TEL. IT 1944\nJANUARY FEBR UARY MARCHA PRIL MAY JUNE\n19\n18\n17\n16\n15\n14\n13\n12\n11\nSales\n100’s\n250\n200\n150\n100\n50\n8 15 22 29 5 12 19 26 4 11 18 25 1 8 15 22 29 6 13 20 27 3 10 17 24 1\nFigure 11.17 This chart shows the last five months of a broad, 13-month Saucer-like Consolidation \nin “IT,” which followed its rapid run up from 3 to 16 in late 1943 and early 1944. “IT” is an erratic \nactor, and its volume is apt to be particularly deceptive in day-to-day movements. Major Price \nPatterns in it, however, are dependable. This final phase of its long Consolidation (distribution", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 86}
{"text": "1\nFigure 11.17 This chart shows the last five months of a broad, 13-month Saucer-like Consolidation \nin “IT,” which followed its rapid run up from 3 to 16 in late 1943 and early 1944. “IT” is an erratic \nactor, and its volume is apt to be particularly deceptive in day-to-day movements. Major Price \nPatterns in it, however, are dependable. This final phase of its long Consolidation (distribution \nand re-accumulation) first took the form of a Rectangle (with a premature breakout) and then an \nAscending Triangle. Its 1945–1946 Bull Market Top was a massive Head-and-Shoulders.\n167Chapter eleven: Consolid ation Formations\nof a greater-than-wanted advance arising at the end of one of the Saucers. Consequently, if \nyou have previously taken a position in it at a favorable point (near the Bottom of a Scallop), \nyou will unlikely be hurt when the stock finally alters its action.\nVery low-priced issues may persist in a Scalloping Trend right up to their Major Bull \nTops, and even attempt another Saucer Movement following what turns out to have been \nthe final high, which attempt then fails to carry out the previous successively higher and \nhigher pattern. Such failures are not difficult to detect; the change from the previous pattern \nappears before any appreciable damage is done to a properly assumed commitment.\nFLINTKOTEF O\n1941–1943\n19\n18\n17\n16\n15\n14\n13\n12\n11\n10\n9\nSales\n100’s\n50\n40\n30\n20\n10\nND JF SO ND JF MMMAJ JAO S\nFigure 11.18 There are times when a Consolidation Pattern gives the only good technical signal \nthat a Reversal in an issue’s Primary Trend has actually taken place. Although cases of a Major \nTurn, particularly a Bottom, without some sort of recognizable Reversal Formation on the chart \nare quite rare, they do occur. This weekly chart of Flintkote illustrates such a phenomenon. A \nBear Market low, from which it rose to 47 in 1946, was made at 8 5/8 in December 1941. Without \ndeveloping any important technical foundation on either a daily or weekly chart, its first upswing \ntook it to 11 7 /8 the following April. From that point, it went into a six-month Symmetrical Triangle \nand then broke out topside at the three-quarters stage on increased volume. This action, plus the \nfact it immediately thereafter burst up through an old and highly significant Resistance Level at \n12, was sufficient to mark it as being in at least a strong Intermediate if not a full Primary Uptrend. \nThe combination of technical developments illustrated in this chart—a large Consolidation Pattern \nforming just under a Major Resistance and then a breakout upside from both—is something to \nwatch for when it appears a Reversal from a Bear to Bull Trend is due. Resistance Levels will be \ndiscussed in Chapter 13.\n168 Technical Analysis of Stock Trends\nModern versus old-style markets\nWe have mentioned in our discussion of Reversal Formations that some of them have \nappeared less frequently in the charts of the 1960s than they did in prior years, and others \nmore frequently. The same is true of Consolidation Formations. Patterns of the compact, \nstrictly defined sort such as Rectangles and Right-Angle Triangles are less common now. \nSymmetrical Triangles are apt to be somewhat looser than they were in the 1920s and \n1930s—not as clean-cut and conspicuous on the charts. Typical profit-taking patterns such \nas Flags and Pennants seem to be as common as ever, whereas “normal” trend pictures, \nincluding those formations associated with normal trend development (such as Head-and-\nShoulders, Rounding Turns, and so on), are more common.\nThe reasons for these changes are fairly apparent; Securities and Exchange Commission \n(SEC) regulations, higher margin requirements, greater public sophistication, and a \nmore conservative—we might better say more pessimistic—approach to the problems of \ninvestment and stock trading generally have all played a part in this evolution. SEC and \nStock Exchange vigilance have done away with the flagrant pool manipulations designed \nto take advantage of the “lambs” of former years. Nowadays, there is even very little of the \nmore “legitimate” sort of syndicate operation planned to facilitate large-scale accumulation \nor distribution.\nIt is still possible for “insiders” to hold back for a limited time, or to prematurely \nrelease announcements of good or bad portent with regard to the affairs of a particular \ncorporation to serve their personal strategic purposes. But the stock purchase and sales of \nofficers, directors, and principal owners are now too closely watched to allow a great deal of \n“skullduggery.” (Nevertheless, the average investor had better still be a trifle skeptical as to \nthe probability of any great advance in the market following publication of a good report.)\nCollusion between investment advisory services and trading pools has been effectively \noutlawed. (It is safe to say it never did exist as flagrantly, even in the 1920s, as many amateur \ntraders seem to think.) The SEC (with the thorough cooperation of the Stock Exchange) \npolices the investment counsel profession thoroughly, constantly, and most effectively. No \nwell-established investment counsel can afford to indulge in deceptive or collusive practices \neven if the desire were there. Most professionals go far beyond the most reasonable needs \nto safeguard themselves against any contacts that, however innocent or useful, might be \nviewed with suspicion.\nThe old-time “plunger” has not disappeared entirely, but high margins and regulations \npreventing “Bear Raiding” have made present-day stock markets relatively difficult and \nunprofitable for him. The out-and-out boardroom gamblers (EN: day traders rushing to and fro \nprobably exacerbates daily volatility) still come in, although high margins have cramped them \ntoo. In recent years, they have appeared in numbers only in the final stages of Bull Markets. \n(EN: Note the day-trading craze that infected the markets in the late 1990s.) Their operations never \ndid affect the", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 87}
{"text": "unprofitable for him. The out-and-out boardroom gamblers (EN: day traders rushing to and fro \nprobably exacerbates daily volatility) still come in, although high margins have cramped them \ntoo. In recent years, they have appeared in numbers only in the final stages of Bull Markets. \n(EN: Note the day-trading craze that infected the markets in the late 1990s.) Their operations never \ndid affect the charts much except to augment activity.\nOn the other hand, higher taxes and greater regulation have most certainly not \nprovided safer, closer, or more stable markets for the small investor. Higher margins have \nnot prevented Panic Collapses. If anything, markets have been “thinner” on the downside, \nmore vulnerable to rapid and drastic decline than they were before modern regulation. We \nstill have the very same sort of Bull and Bear Markets, and much the same sort of market \ntrend development as 50 years ago. The surprising thing is not that a few types of chart \npatterns that were, on occasion, produced by unregulated trading are now less common, \nbut rather that the great majority of technical phenomena have been practically unaffected. \nThe chart student of 1907 would be quite at home with the charts of 1966. (EN: And with those \n169Chapter eleven: Consoli dation Formations\nof 2000. That is why so little change has been necessary to bring Edwards’ classic account current to \nthe third millennium. EN9: A note to a note. Pools and manipulators disappear and are replaced by \nsome new pernicious form of skullduggery. Specialists and market makers are hauled before the bar of \njustice for cheating. In the twenty-first century, hedge funds proliferate like rabbits in Australia. For \nany exacerbation of volatility they cause, they probably make up for in additional market liquidity. \nThe same patterns keep appearing because, computers to the contrary notwithstanding, humans are \neventually responsible for pulling the trigger. It does seem that frequently patterns are not so neat as \nthey were “in the old days.” Trendlines, especially horizontal lines, seem to be more “zones” than hard \nand fast lines and more judgment might be necessary in interpretation. But everything that Edwards \nsays here might have been written in 2005 instead of in the mid-twentieth century.)\n\n171\nchapter twelve\nGaps\nA gap, in the language of the chart technician, represents a price range at which (at the time \nit occurred) no shares changed hands. This is a useful concept to keep in mind because it \nhelps to explain some of their technical consequences, which are illustrated in Figures 12.1 \nthrough 12.13.\nGaps on daily charts are produced when the lowest price at which a certain stock \nis traded on any one day is higher than the highest price at which it was traded on the \npreceding day. When the ranges of any two such days are plotted, they will not overlap or \ntouch the same horizontal level on the chart; there will be a price gap between them. For a \ngap to develop on a weekly chart, it is necessary for the lowest price recorded at any time \nin one week be higher than the highest recorded during any day of the preceding week. \nThis can and does happen, of course, but for obvious reasons not as often as daily gaps. \nMonthly chart gaps are rare in actively traded issues; their occurrence is confined almost \nentirely to those few instances in which a Panic Decline commences just before the end of \na month and continues through the first part of the succeeding month.\nWhich gaps are significant?\nFrom the earliest days of stock charting, gaps attracted attention. These “holes” in the price \ntrend graph were conspicuous. It was only natural that observers should attach importance \nto them and should try to assign some special significance to their occurrence. But the result \nwas unfortunate, for there soon accumulated a welter of “rules” for their interpretation, \nsome of which have acquired an almost religious force and are cited by the superficial chart \nreader with little understanding as to why they work when they work (and, as is always the \ncase with any superstition, an utter disregard of those instances where they do not work). \nWe refer to this situation as unfortunate not so much because the gap “rules” are wrong, \nbut rather because their blind acceptance has barred the way to a real understanding of \na gap’s implications and the establishment of a more logical basis for its uses in trading.\nThe most common superstition is that “a gap must be closed.” Sometimes it is stated \nmore cautiously in such words as follows: “If a gap is not closed in three days, it will be \nclosed in three weeks, and if it is not closed in three weeks, it will be closed in three months, \netc.” There are numerous variations, but they all add up to the belief that a gap must be \nclosed and the trend is not to be trusted until the gap has been covered. It is the latter \ninference that leads to error.\nClosing the gap\nBut first, what is meant by “closing” or “covering” a gap? Suppose a stock in an Advancing \nTrend moves up day after day, from 20 to 21, 22, 23, 24, and closes one night at the top of its \nrange for that day, at 25. The next morning it opens at 26 and keeps right on moving up from \nthere. This action leaves a 1-point gap, between 25 and 26, on the chart. Then suppose the \nrise continues to 28, halts there and is followed by a reaction in the course of which prices \n172 Technical Analysis of Stock Trends\nslip to 28, and then halts there and is followed by a reaction in the course of which prices \nslip back to 27 , 26, and finally to 25. The return move has carried prices back through the \ngap area (25–26); the gap has thereby been covered or closed. In brief, a gap is closed when \na subsequent price trend comes back and retraces the range of the gap.\nMust a gap be closed before prices move very far away from it? Certainly not. Will \nit be closed eventually? Probably, yes. If it is not closed by the next Minor Reaction, \nthere is a", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 88}
{"text": "he return move has carried prices back through the \ngap area (25–26); the gap has thereby been covered or closed. In brief, a gap is closed when \na subsequent price trend comes back and retraces the range of the gap.\nMust a gap be closed before prices move very far away from it? Certainly not. Will \nit be closed eventually? Probably, yes. If it is not closed by the next Minor Reaction, \nthere is a chance it will be covered by the next Intermediate Retracement, and if not \nthen, pretty surely by the next great Major Swing in the opposite trend. But that may be \nyears later—hardly a matter of interest to the ordinary trader. The investor who bought \nChesapeake and Ohio shares at 260 on October 21, 1929, counting on the closing of the \ngap which that issue had made on the preceding Friday, 2 points down from 266 to 264, \nhad to wait nearly seven years to get out even. Not until it neared the Top of the next \nMajor Bull Market did CO attain an equivalent market value (65, since it was split 4-for-1 \nin 1930). In the meantime, he saw his investment shrink in 1932 to less than a sixth of his \npurchase price. As a matter of fact, there were hundreds of gaps made in the charts of \nthe 1929–1930 markets that never have been covered since then, and many of them, it is \nsafe to say, never will be closed.\nIf you will think the matter over for a moment, you will see that the probabilities we \nhave stated above for a gap’s being closed apply just as well to a stock’s returning to any \nprice range at which it has once been traded, gap or no gap.\nAMERICAN WATER WORKS & ELECTRIC AW\n1945\nG\nG\nJANUARYF EBRUARYM ARCH APRILM AY JUNE\n16\n15\n14\n13\n12\n11\n10\n9\nSales\n100’s\n250\n200\n150\n100\n50\n6 13 20 27 3 10 17 24 3 10 17 24 31 7 14 21 28 5 12 19 26 2 9 16 23 30\nFigure 12.1 The April–June Rectangle on this 1945 chart of “ AW” contained a number of insignificant \nPattern Gaps. The two larger gaps marked “G” are of the Continuation or Runaway class. Note that \nprices closed at or near the top on each day that made a gap; neither of these was closed for two years.\n173Chapter twelve: Gaps\nAnother point: there are thousands of price gaps made in trading—some of them quite \nwide—that do not appear at all on the standard daily range charts because they are made \nduring a single day and not between one day’s closing and the next day’s opening. Such \nintraday gaps are ordinarily overlooked entirely; the gap theorists are oblivious of them, \nalthough their significance is often greater than that of many interday gaps. Practically \nevery emphatic breakout move from a strictly defined Rectangle or Right-Angle Triangle is \nattended by a gap, but only those few show up on the charts that occur at the day’s opening \ngong.\nIf we seem to have “protested too much” in the foregoing, it is only because we want \nour readers to study this topic with an open mind, free from preconceived notions as to \nany mystic qualities that gaps may possess. Turning to the other side of the picture, some \ngaps have technical import. Some gaps are useful to the chart analyst in appraising trend \npossibilities. Let us see what we can make of them.\nBETHLEHEM STEEL BS \n1937 \nAPRIL MAY JUNE JULY AUGUST SEPTEMBER \nG \nG \nG \nG \n120 \n112 \n104 \n96 \n88 \n80 \n76 \n72 \n68 \n64 \n60 \n56 \nSales \n100’s \n250\n200\n150\n100\n50\nG \n3 10 17 24 1 8 15 22 29 5 12 19 26 3 10 17 24 31 7 14 21 28 4 11 18 25 \nFigure 12.2 The large up-gap made on July 5 in this chart was a typical Breakaway Gap, occurring \nas prices broke out of the complex base for the July–August Secondary Recovery. (Compare this \nchart with Figure 7 .14.) Another type of Breakaway Gap—through a trendline—occurred on \nAugust 26. That of September 7 was primarily due to the “ex-dividend,” whereas that of September \n18 was still another type of breakaway—through a Support Level. The first gap marked, on April \n26, must be classified as a Runaway; it made a sort of an “Island” of the whole April–June complex \nbase.\n174 Technical Analysis of Stock Trends\nEx-dividend gaps\nFirst, however, we must eliminate from consideration the gaps that do not mean anything. \nAn eighth-point gap obviously has no technical significance as it represents only the \nminimum permitted change in price. By the same token, a gap of a quarter of a point \nor even a half point in a high-priced stock, such as Norfolk & Western (before the split), \nrepresents only a normal, in fact tight, spread between successive bids. In brief, to carry \ninterest for the chart technician, a gap must be wider than the usual changes in price that \noccur under normal or prevailing trading conditions. A second class of gaps that have no \nforecasting implications are those formed consistently and habitually by “thin” issues in \nZENITH RADIOZ E1 941–1943\nS S\nH\nG\n26\n24\n22\n20\n19\n18\n17\n16\n15\n14\n13\n12\n11\n10\n9\n8\nSales\n100’s\n500\n400\n300\n200\n100\nND JF SO ND JF MMM AJ JAO S\nFigure 12.3 A potent Breakaway Gap that showed on Zenith’s weekly chart when it broke out of a \nHead-and-Shoulders Bottom in early 1942. Note high volume developed beyond the gap, suggesting \nit would not be quickly closed. The April reaction stopped short of it. In fact, this gap still had not \nbeen closed in 1956, more than 14 years later.\n175Chapter twelve: Gaps\nthe medium- and high-price brackets. You can spot them easily; if your chart of a certain \nissue shows numerous gaps as a regular thing, then no one of them is apt to mean anything \nspecial.\nFinally, gaps that appear on the charts when a stock goes ex-dividend (whether the \ndividend be in cash, stock, rights, or warrants) possess no trend implications. They are \noccasioned not by a change in the Supply–Demand relation that governs the trend, but \nrather by a sudden and irreversible alteration in the actual book value of the issue.\nAlso of interest in this chart is the Descending Triangle, which started to form in March, \nbut it was never completed—a deceptive and discouraging picture until the April 7 gap was \nmade.\nThe Flag of mid-April “measured” t", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 89}
{"text": "are \noccasioned not by a change in the Supply–Demand relation that governs the trend, but \nrather by a sudden and irreversible alteration in the actual book value of the issue.\nAlso of interest in this chart is the Descending Triangle, which started to form in March, \nbut it was never completed—a deceptive and discouraging picture until the April 7 gap was \nmade.\nThe Flag of mid-April “measured” the move from 9 1/2 to 14. The gaps measured the \ntwo halves of it, on either side of the Flag.\nEliminating the technically meaningless types named above, we are left with the gaps \nthat occur infrequently (and that are not occasioned by an ex-dividend change in value) \nin issues that are so closely and actively traded as ordinarily to produce “solid” charts. \nA 1-point gap, for example, in the chart of New York Central would be an unusual event; it \nwould demand attention and presumably have some forecasting significance.\nSuch gaps, for the purposes of our study, may be divided into four classes: Common or \nArea Gaps, Breakout Gaps, Continuation or Runaway Gaps, and Exhaustion Gaps.\nThe common or area gap\nThis type of gap gets its name from its tendency to occur within a trading area or Price \nCongestion Pattern. All of the Congestion Formations we have studied in the preceding \nchapters—both Reversal and Consolidation types—are attended by a diminution in \ntrading turnover. The more strictly defined sorts—the Triangles and Rectangles—show \nZENITH RADIOZ E\n40\n30\n20\n10\n1936 1937 1938 1939 1940 19411 9421 9431 9441 9451 946\nFigure 12.4 As a matter of interest, this monthly chart of Zenith Radio is reproduced for comparison \nwith Figure 12.3. The Head-and-Shoulders Bottom is easily seen.\n176 Technical Analysis of Stock Trends\nthis characteristic most conspicuously. Moreover, activity in these patterns tends to be \nconcentrated pretty much at or near the top and bottom edges, their Supply and Demand \nLines, while the area in between is a sort of “no-man’s land.” It is easy to see, therefore, \nwhy gaps develop frequently within such areas. You will find numbers of good examples \nof Pattern Gaps in the charts illustrated in Chapters 8 and 9.\nSuch Pattern Gaps are usually closed within a few days, and for obvious reasons, before \nthe Congestion Formation in which they have appeared is completed and prices break away \nfrom it, but not always. Sometimes a gap will develop in the last traverse of prices across \nthe pattern area just before a breakout, and in such cases, it is not closed for a long time, \nnor is there any reason why it should be.\nThe forecasting significance of Common or Pattern Gaps is practically nil. They have \nsome use to the technician simply because they help him recognize an Area Pattern—that \nis, their appearance implies a Congestion Formation is in the process of construction. If, for \nexample, a stock moves up from 10 to 20, drops back to 17 , and then returns to 20, making a \ngap in the course of that rally, it is a fair assumption that further pattern development will \ntake place between approximately 17 and 20. This is a convenient thing to know and may, \non occasion, be turned to profit in short-term trading policy.\nPattern Gaps are more apt to develop in Consolidation than in Reversal Formations. \nThus, the appearance of many gaps within an evolving Rectangle or Symmetrical Triangle \nBLAW – KNOX BX\n1946\nFEBRUARYM ARCH APRIL MAY JUNE JULY\n32\n30\n28\n26\n24\nG\nG\nRD\nSales\n100’s\n125\n100\n75\n50\n25\n2 9 16 23 2 9 16 23 30 6 13 20 27 4 11 18 25 1 8 15 22 29 6 13 20 27\nFigure 12.5 The early 1946 daily chart of Blaw–Knox contained a number of interesting technical \nfeatures. Its spurt from 19 to 25 in December 1945 was followed by a nine-week Rectangle \nConsolidation, the end of which appears in the chart above. Prices erupted from this Rectangle on \nFebruary 11 with a typical Breakaway Gap. Four days later, another gap appeared on even greater \nvolume, and prices closed at the top of the day’s range. This looked like a Runaway Gap, in which \ncase continuation to 32 was implied according to the “rule” stated above. (Note the Rectangle \n“measurement” called for only 31.) On the following day, however, a One-Day Reversal, from 31 \nback to 30, appeared and the next session closed the February 15 gap, which now had to be relabeled, \ntentatively, as an Exhaustion Gap. Prices subsequently dropped back to the support of the nine-\nweek Rectangle, rallied grudgingly along an established Intermediate Up Trendline, and broke that \non April 24 to return again to the 25 support. In May, another advance took “BK” up once more to \n30, where it bumped against the previously broken trendline. That was its last effort; in late July, \nthe “valley” level at 25 was penetrated and a Major Double Top had been completed. To return to \nthe February 15 gap, this is fairly typical of many cases in which it is impossible to say whether \nContinuation or Exhaustion is being signaled until two or three days after the day the gap is made.\n177Chapter twelve: Gaps\nreinforces the normal expectation that the pattern in question will turn out to be a \nConsolidation rather than a Reversal Area.\nBreakaway gaps\nThe Breakaway type of gap also appears in connection with a Price Congestion Formation, \nbut it develops at the completion of the formation in the breakaway move. Any breakout \nthrough a horizontal pattern boundary, such as the Top of an Ascending Triangle, is likely \nto be attended by a gap. In fact, it is safe to say that most of them are. And, if we consider \nwhat goes on in the market to create a Flat-Topped Price Formation, it is easy to see why \nBreakaway Gaps should be expected. An Ascending Triangle, for example, is produced \nby persistent demand for a stock meeting a large supply of it for sale at a fixed price. \nSuppose that supply is being distributed at 40. Other holders of the stock, who may have \nintended originally to liquidate at 40.5 or 41, see quotations come up to 40 time after time, \nstop there, and tu", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 90}
{"text": "it is easy to see why \nBreakaway Gaps should be expected. An Ascending Triangle, for example, is produced \nby persistent demand for a stock meeting a large supply of it for sale at a fixed price. \nSuppose that supply is being distributed at 40. Other holders of the stock, who may have \nintended originally to liquidate at 40.5 or 41, see quotations come up to 40 time after time, \nstop there, and turn back. They tend, in consequence, either to join the crowd selling at 40, \nBALTIMORE & OHIO BO 1936–1937 \nG \nS S \nH \nOCTOBER NOVEMBER DE CEMBER JANUARY FEBR UARY MARCH \n40 \n38 \n36 \n34 \n32 \n30 \n28 \n26 \n24 \n22 \nSales \n100’s \n250\n200\n150\n100\n50\n3 10 17 24 31 7 14 21 28 5 12 19 26 2 9 16 23 30 6 13 20 27 6 13 20 27 \nFigure 12.6 This is a good example of a Runaway Gap that performed according to rule. After \nreacting from 26 1/4 in late 1936, “BO” formed a Head-and-Shoulders Bottom (the left shoulder was \na Triangle) and broke out of it on February 6, 1937 . A small Flag formed immediately thereafter, \ncalling for 28. At that level, another Flag developed which signaled 30 1/4 or better. As prices reached \nthis latter goal, however, a gap was made, on March 3, on extraordinary volume. The next two days \nconfirmed this to be a Runaway or Continuation Gap. As such, it implied further advance (measuring \nfrom the Head-and-Shoulders neckline) to 37 plus. “BO” made its Bull Market high at 40 1/4 on \nMarch 17 . The measuring-gap rule should be used for purposes of “getting out” rather than “getting \nin.” It does not guarantee a move will continue to the implied limit, but it does give assurance the \nmove is near an end when the rule has been fulfilled.\n178 Technical Analysis of Stock Trends\nor else to figure that once through 40, prices will go much higher; they may either lower or \nraise their selling price. The result is a “vacuum” on the books, a dearth of offerings in the \nprice range immediately above the pattern. Hence, when the supply at 40 in our Ascending \nTriangle example is finally all absorbed, the next buyer of the stock finds none offered \nat 40.125 or 40.25 and he has to bid up a point or more to get his shares, thus creating a \nBreakaway Gap.\nAs we remarked earlier in this chapter, gaps of this type actually occur on almost every \ndecisive breakout from a Horizontal Congestion, although many of them do not show \non the charts because they occur during a day and not between one day’s close and the \nfollowing day’s opening. Breakaway Gaps also develop at times when prices move out of \nother types of Reversal or Consolidation Formations; they are not uncommon in connection \nSOUTHERN PACIFIC SX \n1937 \nJULY AUGUST SEPTEMBER OCTOBER NOVEMBERD ECEMBER \nS \nS H \nG \nRD \nS S H \n48 \n44 \n40 \n38 \n36 \n34 \n32 \n30 \n28 \n26 \n24 \n22 \n20 \n19 \n18 \n17 \nSales \n100’s \n250\n200\n150\n100\n50\n3 10 17 24 31 7 14 21 28 4 11 18 25 2 9 16 23 30 6 13 20 27 4 11 18 25 \nFigure 12.7 Panic Declines often produce large Runaway Gaps. The September 7 gap in this chart, \njudged by its size, volume, subsequent action, and the fact that it was made in “new low ground,” \nmarked it as being of the measuring type. The implied goal was 26 or below. All other gaps in this \nchart were obviously of the “common” variety.\n179Chapter twelve: Gaps\nwith Head-and-Shoulders Patterns, for instance, and they even occur on the penetration of \ntrendlines, which we shall discuss in a subsequent chapter.\nWhat forecasting value can we ascribe to them? First, they serve to call attention to, \nand emphasize the fact of, a breakout. There can be little doubt that a genuine breakout \nhas eventuated when prices jump out of a pattern with a conspicuous gap. False moves \nare seldom attended by gaps. Second, they carry the suggestion that the buying demand \n(or selling pressure, as the case may be) that produced the gap is stronger than would be \nindicated by a gapless breakout. Hence, it may be inferred the ensuing move will carry \nWILLYS – OVERLAND WO\n1944\nNL\nG\nG\nG\nG\nAPRILM AY JUNE JULY AUGUST SEPTEMBER\n19\n18\n17\n16\n15\n14\n13\n12\n11\n10\n9\n8\n7\nSales\n100’s\n500\n400\n300\n200\n100\n8 15 22 29 6 13 20 27 3 10 17 24 1 8 15 22 29 5 12 19 26 2 9 16 23 30\nFigure 12.8 The “skyrocket” run-up of Willys–Overland in June 1944 was marked by a number \nof small gaps. The first two were too small to have much technical significance. The larger gap \nmade June 16 was marked by the “stickiness” of prices on that day as Exhaustion. A small Flag \nConsolidation ensued. The June 27 gap also acted like an Exhaustion Gap insofar as price action was \nconcerned, but volume had declined instead of climbing to a new peak. On June 28, prices jumped \naway again, so the June 27 gap was marked as another Runaway with an implied objective of 18 1/4 \nplus, which had already been reached. Note the Head-and-Shoulders Reversal that formed and the \nsubsequent Intermediate Reaction.\n180 Technical Analysis of Stock Trends\nA. O. SMITH CORPORATION SMC\n1945–1947\nG\n96\n88\n80\n76\n72\n68\n64\n60\n56\n52\n48\n44\n40\n38\nSales\n100’s\n50\n40\n30\n20\n10\nND JS FO ND JF MMMAJ JA M A\nFigure 12.9 “SMC” is a thin stock whose daily chart is usually “full of holes,” but this large gap that \nappeared on its weekly chart in September 1946 evidently possessed technical significance. Treated \nas a Runaway measuring from the eight-week Congestion at 68, it called for a downside objective of \n44 or below, which was duly fulfilled.\nBALTIMORE & OHIO PFD. BO Pr\n1946\nJANUARYF EBRUARYM ARCH APRIL MAY JUNE\n48\n44\n40\n38\n36\nS SH\nSales\n100’s\n50\n40\n30\n20\n10\nS\nSH\nG G-5 12 19 26 2 9 16 23 2 9 16 23 30 6 13 20 27 4 11 18 25 1 8 15 22 29\nFigure 12.10 A small Island in the right shoulder of the Head-and-Shoulders Top that marked this \nissue’s Major Reversal. The Island served only to emphasize the chart’s Bearish implications.\n181Chapter twelve: Gaps\nprices farther or faster, or both. It does not do to make too much of this point; it is a logical \ninference and one that has been borne out in the majority of cases, but it has its exceptions \nand may prove most dis", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 91}
{"text": "he right shoulder of the Head-and-Shoulders Top that marked this \nissue’s Major Reversal. The Island served only to emphasize the chart’s Bearish implications.\n181Chapter twelve: Gaps\nprices farther or faster, or both. It does not do to make too much of this point; it is a logical \ninference and one that has been borne out in the majority of cases, but it has its exceptions \nand may prove most disappointing on occasion. Nevertheless, other things being equal , of \ntwo stocks that emerged from Ascending Triangles at the same time, we should choose to \nbuy the one that gapped out over the one that pushed its way out by small fractional steps.\nExcept for the presumption of somewhat greater “steam” behind the move, the Breakaway \nGap carries no particular measuring implication, nor any other forecasting significance. The \nnext question is this: should we expect a Breakaway Gap to be closed within a relatively \nshort time? Or, to put the question in more practical and pragmatic terms: should we defer \nbuying in the expectation that it will be closed before any worthwhile move develops?\nTo give a fair answer to that question, it is necessary to scrutinize the volume of \ntransactions before and after the gap. If a great many sales were recorded at the takeoff level \nfrom which prices jumped the gap, but relatively few as prices moved away from the far \nside of the gap, then there is a chance—perhaps about 50–50—that the next Minor Reaction \nwill carry prices back to the edge of the pattern of origin, thus filling the gap. On the other \nhand, if high volume developed at the far side of the gap, and a great many transactions \ntook place there as prices moved on away from the gap, then the chances are remote that \nany near-term Throwback will close the gap. In such cases, a Throwback reaction is almost \nalways stopped at the outside of the gap.\n(One is constantly tempted in a work of this sort to employ the words always or never \nwithout qualification. Unfortunately, the authors have never been able to discover a rule of \ntechniques to which the market did not, on rare occasion, produce an exception. It is always \nnecessary to be on guard against such exceptional developments. Many of them are caused by \ngeneral market conditions that counteract the technical trend in individual issues. Keep an eye \non the charts of the “ Averages,” as well as the particular issues in which you are interested.)\nWhere Breakaway Gaps develop intraday, the daily chart cannot, of course, indicate \nhow the day’s volume was distributed. In that event, it may be necessary to examine the \nLION OIL COMPANYL NO\n1947\nMARCHA PRIL MAYJ UNE JULY AUGUST\nGG\n28\n26\n24\n22\n20\n19\nSales\n100’s\n50\n40\n30\n20\n10\n8 15 22 29 5 12 19 26 3 10 17 24 31 7 14 21 28 5 12 19 26 2 9 16 23 30\nFigure 12.11 Island “shakeouts” are not uncommon in “thin” stocks. Why they should develop as \nthey do is hard to explain, but their forecasting implications are obvious.\n182 Technical Analysis of Stock Trends\nticker tape or ask your broker to refer to the published record of individual transactions to \nwhich most brokerage firms subscribe. (EN: This data may now be easily obtained. See Appendix \nD, Resources. EN9: Candlestick charts, now much in use, will allow the analyst to see the intraday \nbreakaway gap.) Lacking any clear-cut volume clue, it is safest to figure that a Breakaway Gap \nwill not be filled until long after the full move implied by the pattern of origin (usually a \nmove of Intermediate Extent in the Dow sense) has been carried out.\nContinuation or runaway gaps and the measuring rule\nLess frequent in their appearance than either of the two forms we have discussed above, \ngaps of the Continuation or Runaway type are of far greater technical significance because \nBETHLEHEM STEEL BS\n1937\nG G\nJANUARYF EBRUARY MARCHA PRIL MAYJ UNE\n128\n120\n112\n104\n96\n88\n80\n76\n72\n68\n64\n60\n56\nSales\n100’s\n250\n200\n150\n100\n50\n2 9 16 23 30 6 13 20 27 6 13 20 27 3 10 17 24 1 8 15 22 29 5 12 19 26\nFigure 12.12 This Island Reversal Pattern at Bethlehem Steel’s Major Top in 1937 is a “classic,” yet it \nwas followed by a curious and disturbing abnormality in the strong rally that developed on March \n30. Those who sold out on the Island’s signal around 95 on March 19 or 20 were startled, and, if they \nhad also sold short, justifiably alarmed when prices jumped up a week later, not only through the \nsecond gap level but well above it. But eventually, as can be seen, everything worked out according \nto the original forecast. This incident will illustrate a general principle: when a clear-cut technical \npattern of unquestionable significance has been completed on your charts, do not let some apparently \ncontrary development that occurs shortly thereafter lead you to forget or neglect the previous plain \nsignal. Give such situations time to work out. Figure 12.2 shows the sequel to the above chart and, \nincidentally, another Island. Compare the volume.\n183Chapter twelve: Gaps\nPENNSYLVANIA RAILROADP A\n1936\nJULY AUGUST SEPTEMBERO CTOBER NOVEMBERDECEMBER\n44\n40\n38\n36\n34\n32\n30\n28\nSales\n100’s\n125\n100\n75\n50\n25\nXD .50\nG G\n4 11 18 25 1 8 15 22 29 5 12 19 26 3 10 17 24 31 7 14 21 28 5 12 19 26\nFigure 12.13 This looked like an Island in “PA,” but the second gap was actually attributable to a \n$0.50 dividend which went ex on November 20 and, therefore, had to be discounted technically. Due \nto this dividend, it was necessary to lower the Support Line at 40 (see Chapter 13) by half a point. \nThat Support, therefore, was not violated in December and prices subsequently advanced to above \n50 the following March.\nFigure 12.14 TLT shown here in computer notation produces gaps in profusion. As the reader can \nsee, if one just traded in the direction of the gap many short-term scalps would be garnered. This \nchart also lends perspective to the hand drawn charts. A gap is a gap is a gap.\n184 Technical Analysis of Stock Trends\nthey afford a rough indication of the probable extent of the move in which they", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 92}
{"text": "rch.\nFigure 12.14 TLT shown here in computer notation produces gaps in profusion. As the reader can \nsee, if one just traded in the direction of the gap many short-term scalps would be garnered. This \nchart also lends perspective to the hand drawn charts. A gap is a gap is a gap.\n184 Technical Analysis of Stock Trends\nthey afford a rough indication of the probable extent of the move in which they occur. For \nthat reason they have sometimes been called “Measuring” Gaps.\nBoth the Common or Pattern Gap and the Breakout Gap develop in association with \nPrice Formations of the Area or Congestion type, the former within the formation and \nthe latter as prices move out of it. The Runaway Gap, on the other hand, as well as the \nExhaustion Gap, which we will take up later, is not associated with Area Patterns, but \noccurs in the course of rapid, straight-line advances or declines.\nWhen a dynamic move starts from an area of accumulation, the upward trend of \nprices will seem often to gather “steam,” to accelerate for a few days, perhaps a week \nor more, and then begin to lose momentum as supply increases when the very extent \nof the advance invites more and more profit-taking. Trading volume jumps to a peak on \nthe initial breakout, tapers off somewhat in the middle of the advance, and then leaps \nup again to a terrific turnover as the move is finally halted. In such moves—and in rapid \ndeclines of corresponding character—a wide gap is quite likely to appear at the time \nwhen the Runaway is at its height, when quotations are moving most rapidly and easily \nwith relation to the volume of transactions. That period comes normally at just about the \nhalfway point between the breakout that inaugurated the move and the Reversal Day or \nCongestion Pattern that calls an end to it. Hence, a Continuation or Runaway Gap affords \nan approximate measurement of the move in which it develops. Its inference is that prices \nwill go as much farther beyond the gap as they already have gone between the beginning of the \nmove and the gap, as measured directly (and vertically) on the chart.\nSince there is a tendency for advances to run, in terms of points, beyond the price \nlevels arithmetically implied by this rule, and for declines to be more strictly limited, the \ngap-measuring rule works out particularly well when applied directly on semilogarithmic \nscale charts. On arithmetic charts, look for a trifle more on the upside and a trifle less on the \ndownside. (In any event, you will be wise to “bank” on something short of the theoretical \ngoal.)\nRunaway Gaps are easy to find and identify in retrospect, but our task is to recognize \nthem as such at the time they appear; there is no danger of confusing them with Pattern or \nBreakout Gaps. With those aside, any gap that shows up in a fast advance or decline after \nprices have moved well away from an Area Formation (or the penetration of an important \ntrendline or break through a potent Support or Resistance Level, which we shall discuss \nlater) may be a Runaway Gap. What then becomes necessary is to distinguish it from our \nnext type, the Exhaustion Gap. Usually, the price and volume action on the day following \nthe gap furnishes the evidence required for a safe diagnosis.\nTwo or more runaway gaps\nIt will be much easier to bring out the characteristics distinguishing Runaway and \nExhaustion Gaps when we take up the latter in detail. Before doing so, we must mention \nthose cases in which two and, rarely, even three gaps intervene in a fast move and are \nevidently all classifiable as of the Continuation or Runaway breed. It does not happen often \nand is particularly unlikely to appear in the chart of a fairly large and active issue, but one \nof the thinner stocks in the midst of a “skyrocket” move may go skipping along for three \nor four days, making gaps between each successive pair. The only question of practical \nimportance that arises in such cases is this: where should the halfway measuring point \nbe located? No quick and easy rule can be laid down, but studious inspection of the chart, \nespecially of the volume trend, will usually afford an answer. Remember that halfway in \nthese fast moves tends to come at the stage at which prices are moving most easily and \n185Chapter twelve: Gaps\nrapidly with respect to the number of transactions recorded (hence the tendency to gap). \nIf there are two gaps, the halfway stage may very likely have been reached somewhere \nbetween them. Inspect your chart carefully and try to “average” the picture mentally; look \nfor what appears to be the center of “thinness” and use that for your measuring level. But \nremember also that each successive gap brings the move inevitably nearer to Exhaustion, \nso let your judgment lean to the conservative side; do not expect too much of the second \nor third gap.\nExhaustion gaps\nThe Breakout Gap signals the start of a move; the Runaway Gap marks its rapid continuation \nat or near its halfway point, and the Exhaustion Gap comes at the end. The first two of these \nare easily distinguished as to type by their location with respect to the preceding price \npattern, but the last is not always immediately distinguishable from the second.\nExhaustion Gaps, like Runaway Gaps, are associated with rapid, extensive advances \nor declines. We have described the Runaway type as the sort that occurs in the midst of \na move that accelerates to high velocity and then slows down again and finally stops as \nincreasing Resistance overcomes its momentum. Sometimes, however, “skyrocket” trends \nevidence no such gradual increase of Resistance as they proceed, showing no tendency \nto lose momentum, but rather continue to speed up until, suddenly, they hit a stone wall \nof supply (or, in cases of a decline, demand) and are brought to an abrupt end by a day \nof terrific trading volume. In such moves, a wide gap may appear at the very end, that is, \nbetween the next to the last and the last day of the move. This gets the name of Ex", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 93}
{"text": "istance as they proceed, showing no tendency \nto lose momentum, but rather continue to speed up until, suddenly, they hit a stone wall \nof supply (or, in cases of a decline, demand) and are brought to an abrupt end by a day \nof terrific trading volume. In such moves, a wide gap may appear at the very end, that is, \nbetween the next to the last and the last day of the move. This gets the name of Exhaustion \nGap because the trend seems thereby to have exhausted itself in one final leaping spurt.\nThe best test of whether a gap formed in a rapid, straight-line advance or decline is of \nthe Continuation or Exhaustion type comes on the day after the gap (more precisely, the \nday that makes the gap), although there are frequently other clues in the preceding chart \npicture. If trading activity mounts to an extraordinary height during the session following \nthe gap, and particularly if the previous trend in prices does not appear to be carried along \nat a pace commensurate with that day’s activity, the gap is probably of the Exhaustion class. \nThis interpretation is reinforced, in fact, made a virtual certainty, if the day after, the gap \ndevelops into a Reversal Day (as described in Chapter 10) with the closing price registered \nback near the edge of the gap.\nEvidence that may be derived from the chart anteceding the gap may be enumerated \nas follows: If the trend has already carried out the full implications of the price formation \nor Congestion Area from which it emerged, Exhaustion is more likely than Continuation. \nBy the same token, if the reasonable measuring implications of the pattern of origin are \nstill far short of attainment, the gap is probably of the Continuation type. An Exhaustion \nGap is seldom the first gap in a runaway move; it is usually preceded by at least one \nContinuation Gap. Thus, you may ordinarily assume (unless the contrary appears from \nother and weightier indications) the first gap in a rapid advance or decline is a Continuation \nGap, but each succeeding gap must be regarded with more and more suspicion, especially \nif it is wider than its predecessor.\nWe have referred to Exhaustion Gaps as wide gaps. Width is, of necessity, relative in \nthis study; it is impossible to lay down any exact rules to define wide or narrow. Do not let \nthis bother you too much. Recognition of what constitutes an unusually wide gap for the \nparticular stock you have under observation soon comes with a little charting experience.\nRunaway Gaps are usually not covered for a considerable length of time, as a rule, not \nuntil the market stages a swing of Major or full Intermediate proportions in the opposite \n186 Technical Analysis of Stock Trends\ndirection. But Exhaustion Gaps are quickly closed, most often within two to five days, a \nfact that furnishes a final clue to distinguish Exhaustion from Continuation, if it should \nstill be needed at that stage. This, incidentally, upsets the common superstition that all \ngaps must be closed before the trend can be trusted to continue very far. In the case of the \nRunaway Gap, it is not closed, but the trend moves right along, nevertheless, and often for a \nsurprising distance. In the case of the Exhaustion Gap, the closing of it actually contributes \nto the signal the trend has run out.\nAn Exhaustion Gap, taken by itself, should not be read as a sign of Reversal, or even, \nnecessarily, of Reversal at all. It calls “stop,” but the halt is ordinarily followed by some sort \nof area pattern development that may, in turn, lead to either Reversal or Continuation of \nthe move before the gap. In practically every case, however, enough of a Minor Reaction or \ndelay ensues from the formation of an Exhaustion Gap before a new trend is established \nto warrant closing out commitments at once. (One can always reenter if it subsequently \nappears that the previous trend is to be resumed.)\nThe Island Reversal\nWe mentioned (at the end of Chapter 10 ) a Reversal Pattern, the Island, which was to be \ntaken up under the general study of gaps. The Island Pattern is not common and it is not, in \nitself, of major significance in the sense of denoting a long-term Top or Bottom, but it does, \nas a rule, send prices back for a complete retracement of the Minor Move that preceded it.\nAn Island Reversal might be described as a compact trading range separated from \nthe move that led to it (and that was usually fast) by an Exhaustion Gap and from the \nmove in the opposite direction that follows it (and that is also equally fast, as a rule) by \na Breakaway Gap. The trading range may consist of only a single day, in which event it \nnormally develops as a One-Day Reversal, or it may be made up of from several days to a \nweek or so of Minor Fluctuations within a compact price zone. It is characterized, as might \nbe expected, by relatively high volume. The gaps at either end occur at approximately the \nsame level (they should overlap to some extent) so that the whole area stands out as an \nIsland on the chart, isolated by the gaps from the rest of the price path.\nWe have said an Island does not, of itself, appear as a Major Reversal Formation, but \nIslands frequently develop within the larger patterns at turning points of Primary or \nimportant Intermediate consequence, as, for example, in the head of a dynamic Head-and-\nShoulders Top. By the same token, they appear occasionally at the extremes of the Minor \nSwings that compose a Triangle or a Rectangle (in which event, the gaps that set them off \nare really better classified as Common or Pattern Gaps).\nThe reasons why Islands can and do develop—in other words, why gaps can and do \nrepeat at the same price level—will be more apparent when we take up the general subject \nof Support and Resistance in a later chapter. Suffice it to repeat at this point that prices \ncan move most rapidly and easily, either up or down, through a range where little or no \nstock changed hands in the past, where, in other words, previous owners have no “ves", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 94}
{"text": "velop—in other words, why gaps can and do \nrepeat at the same price level—will be more apparent when we take up the general subject \nof Support and Resistance in a later chapter. Suffice it to repeat at this point that prices \ncan move most rapidly and easily, either up or down, through a range where little or no \nstock changed hands in the past, where, in other words, previous owners have no “vested \ninterest.”\nSometimes the second gap—the Breakaway that completes the Island—is closed a few \ndays later by a quick Pullback or reaction. More often it is not. Rarely, the first gap—the \nExhaustion Gap that starts the Island—is covered in a few days before the second gap \nappears, in which event the Island Congestion takes on a sort of V-Shape (if it is a Top), and \nthere is no clear “open water” across the chart horizontally between the Island and the \ntrends preceding and following it. Yet, in any of these variations, the interpretation remains \nthe same: the preceding Minor Move should be practically retraced.\n187Chapter twelve: Gaps\nAn Island Pattern is not easy to trade on unless it be for a short-term “scalp,” as, \nobviously, a good share of the retracement already may have been accomplished by the \ntime the Island is charted and an order to buy or sell on its indications can be executed. If \nthe entering gap is recognized as an Exhaustion Gap, the trader who is interested in the \nstock presumably will take action before the second gap forms and before the Island is in \nevidence. Perhaps the greatest utility that Islands have for the chart analyst is that of calling \nattention to a situation of putting him on the alert as to its potentialities.\nGaps in the Averages\nGaps appear also in nearly all Averages but, for obvious reasons, with rather less frequency \nthan in the charts of individual issues. Although it is not necessary for all of the stocks \ncomposing an average to make a gap simultaneously to produce a gap in the Average \nfigures, a majority of them must. As might therefore be expected, Common or Pattern \nGaps are particularly rare in Average charts, but Breakaway and Runaway types are not \nuncommon, although they are small as compared with the size of such gaps in single \nstocks. Exhaustion Gaps, and, in consequence, Islands, again are rare. The conditions that \ncreate an Exhaustion Gap seldom develop in a sufficient number of individual issues at any \none time to produce a counterpart in the Averages.\nThe technical interpretation of gaps in Averages is, in the main, the same as in single \nstocks. The authors have not found that an Average gap possesses any peculiar potency \nor significance over and above that attributable to a gap in the chart of any actively and \nclosely traded single issue.\nThe broader, and hence, most representative market indexes show the fewest and \nsmallest gaps. EN: On the other hand, the NASDAQ is quite volatile and a good gap producer.\nIt is suggested the reader review this chapter after he has finished studying the \nprinciples of Support and Resistance in Chapter 13. (EN9: The truth is there is nothing more \nthat need be said about gaps, and the truth also is that no modern examples need be added. But gaps \nare fun, so see Figure 11.11 and Chapter 16 for modern examples.)\n\n189\nchapter thirteen\nSupport and Resistance\nAs illustrated by Figures 13.1 through 13.12, the phenomena we shall study in this chapter are \nmarkedly different in kind from those discussed in preceding sections. We shall look at the \nstock market from a new angle and, in so doing, may find it possible to develop some very \npractical additional rules to guide us in selecting stocks for purchase or sale, in estimating \ntheir potential moves, and in foreseeing where they are likely to “run into trouble.” As a \nmatter of fact, some experienced traders have built their “systems” almost entirely on the \nprinciples of what we call Support and Resistance, paying no attention to the specific pictorial \npatterns of price and volume action we have been investigating in preceding pages.\nSupport and Resistance phenomena are not, by any means, unrelated to the various \npatterns and formations previously studied. We have already had occasion to hint at a basic \nprinciple of Support and Resistance in our explanation of gaps, and, as you read on, you \nwill find a number of the other patterns of price behavior are explained thereby, or at least \nbecome more readily understood.\nThe term Support is commonly used in the Street. In one or more of its connotations, it \nmust be fairly familiar to the reader. For example, we may hear such-and-such a crowd is \nsupporting XYZ at 50 or is prepared to support the market by buying all stock offered on \nany 5-point concession. For the purposes of this chapter, we may define Support as buying, \nactual or potential, sufficient in volume to halt a downtrend in prices for an appreciable \nperiod. Resistance is the antithesis of Support; it is selling, actual or potential, sufficient in \nvolume to satisfy all bids and, hence, stop prices from going higher for a time. Support and \nResistance, as thus defined, are nearly but not quite synonymous with demand and supply, \nrespectively.\nA Support Level is a price level at which sufficient demand for a stock appears to hold \na downtrend temporarily at least, and possibly reverse it, that is, start prices moving up \nagain. A Resistance Zone, by the same token, is a price level at which sufficient supply of a \nstock is forthcoming to stop, and possibly turn back, its uptrend. There is, theoretically, a \ncertain amount of supply and a certain amount of demand at any given price level. (The \nrelative amount of each will vary according to circumstances and determine the trend.) But \na Support Range represents a concentration of demand, and a Resistance Range represents \na concentration of supply.\nAccording to the foregoing definitions, you can see the top boundary of a Horizontal \nCongestion Pattern such as a Rectangle is a Resi", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 95}
{"text": "certain amount of demand at any given price level. (The \nrelative amount of each will vary according to circumstances and determine the trend.) But \na Support Range represents a concentration of demand, and a Resistance Range represents \na concentration of supply.\nAccording to the foregoing definitions, you can see the top boundary of a Horizontal \nCongestion Pattern such as a Rectangle is a Resistance Level, and its bottom edge is a \nSupport Level; the top line of an Ascending Triangle is unmistakably a Resistance Level, \nand so on. But we are more interested now in the reasons why Support or Resistance, as \nthe case may be, can be anticipated to appear at certain price ranges. Within reasonable \nlimits, and with a certain few exceptions to be examined later, it is quite possible to do this. \nExpert chart readers are frequently able to make some amazingly accurate predictions as \nto where an advance will encounter Resistance (supply) or where a declining trend will \nmeet Support.\nThe basis for such predictions—the elementary data from which Support and Resistance \ntheories are derived—is that turnover in any given issue tends to be concentrated at the \n190 Technical Analysis of Stock Trends\nseveral price levels at which a large number of shares changed hands in times past. Since \nany level at which a great volume of transactions takes place usually becomes a Reversal \npoint (Major, Intermediate, or Minor) in that stock’s trend, it follows naturally that Reversal \nLevels tend to “repeat.” However, here is the interesting and the important fact that, \ncuriously enough, many casual chart observers appear never to grasp: these critical price \nlevels constantly switch their roles from Support to Resistance and from Resistance to \nSupport. A former Top, once it has been surpassed, becomes a Bottom zone in a subsequent \ndowntrend; and an old Bottom, once it has been penetrated, becomes a Top zone in a later \nadvancing phase.\nNormal trend development\nPerhaps we can make this plainer by citing a typical example of normal trend development. \nSuppose a stock in a Bull Trend moves up from 12 to 24, and there runs into a large volume \nof selling. The result is a reaction that may take the form of a full Intermediate Correction to, \nsay, 18, or a series of Minor Fluctuations forming a Consolidation Pattern between, say, 24 \nand 21, the effect being the same in either case. Following this Correction or Consolidation, \na new advance gets under way and carries the price on up to 30 before running again into \nsupply in sufficient concentration to stifle the move. Now another reaction is evidently \ndue. Again, it may take the form of a sideways Consolidation Pattern or an Intermediate \nCorrection. If the latter, where will that corrective setback be reversed, or in other words, \nwill it meet Support? The answer is at 24, the level of the first Top in the trend. That is the \nlevel (below current quotations) where a large turnover had previously occurred. Then it \nfunctioned as Resistance, producing a halt or Reversal in the first upswing; now it functions \nas Support, stemming and reversing, at least in a Minor sense, the latest downswing.\nWhy should this be? It will be easier to suggest an answer to that question if we first go \non with a similar example of typical action in a downtrend. This time, suppose our stock \nmakes a Major Top and declines from, say, 70 to 50. There, at 50, a temporary Selling Climax \noccurs; there is a large turnover, prices rally, perhaps slip back for a “test” of 50, and then \nstage a good recovery to 60. At 60, buying peters out, the trend rounds over, turns down, \nand accelerates in renewed decline, which carries to a new low at 42. Again, a wave of \nbuying comes in and a second recovery swing gets under way. We can confidently expect \nthis recovery (from 42) will run into strong Resistance at 50. The price level that functioned \nas a Support for the first phase of decline, now that it has been broken through the downside \nby the second phase, will reverse its role and function as Resistance to the second recovery \nmove. The former Bottom level will now become a Top level.\nHere, we may ask again why this should be so, and now we can suggest an answer. In \nthe example of downtrend action cited in the preceding paragraph, our stock first dropped \nto 50, ran into considerable volume there, reversed its trend, and rallied to 60 with activity \ndwindling on the rise. A lot of shares changed hands at 50, and for every seller there was a \nbuyer. A few of those buyers may have been covering short positions and, having done so, \nhad no further interest in the issue. Other short-term traders and professionals may have \npurchased simply because they sensed a temporary Bottom in the making and hoped to \nscalp a few points on the ensuing rally; presumably, they (or at least some of them) took \ntheir profits and were out before prices broke very far on the next decline. But a majority \nof those who acquired shares at 50, it is safe to say, did so because they thought the stock \nwas cheap at that price, figuring it had gone low enough. Only a few months ago, it was \nselling above 70; surely, it was a bargain at 50 and could be picked up and put away “for \nthe long term.”\n191Chapter thirteen: Support and Resistance\nThe explanation\nImagine yourself, for the moment, in the place of those new owners. They see prices turn \nup, reach 55, 58, 60; their judgment appears to have been vindicated. They hang on until the \nrally peters out and prices start to drift off again, slipping to 57 , 55, 52, and finally 50. They \nare mildly concerned but still convinced the stock is a bargain at that price. Most likely, \nthere is momentary hesitation in the decline at 50 and then prices break on down. Briefly, \nthere is hope the break is only a shakeout to be recovered quickly, but that hope vanishes \nas the downtrend continues. Now our new owners begin to worry. Something has gone \nwrong. When the stock gets d", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 96}
{"text": "y 50. They \nare mildly concerned but still convinced the stock is a bargain at that price. Most likely, \nthere is momentary hesitation in the decline at 50 and then prices break on down. Briefly, \nthere is hope the break is only a shakeout to be recovered quickly, but that hope vanishes \nas the downtrend continues. Now our new owners begin to worry. Something has gone \nwrong. When the stock gets down below 45, the former bargain does not look so good. \n“Well, I guess I picked a lemon that time, but I won’t take a loss in it. I’ll just wait until it \ngets back up to 50 some day where I can get out even (except for expenses), and then they \ncan have it.” (Does this sound familiar, by any chance?)\nWe can skip over the next few swings that “followed the rules” and go on to the change \nin the picture, which came with the first notable violation of a Support Level in 1946. Prices \nhad pushed up the first of February nearly to 54, well out above the Tops around 46, which \nformed the previous November. The late-February reaction should have “caught Support” \nJONES & LAUGHLIN JL 1944–1947\n1944 1945 1946 1947\n52\n48\n44\n40\n38\n36\n34\n32\n30\n28\n26\n24\n22\n20\nSales\n100’s500400300\n200\n100\nFigure 13.1 Why now was so much time spent and “work” done during mid-1945 under 33–34? \nWe cannot see it on this chart, but the previous monthly history shows that the Bottoms of long \nCongestion Areas were made in this zone in late 1939 and late 1940. These old Bottoms, representing \nSupport, originally, were able to produce some supply (Resistance) five years later. Once prices had \nworked through that supply, however, they were able to rise quickly to 44, and then their subsequent \nreaction found Support just where you might have expected—at 33–34. Support had turned to \nResistance and then to Support again.\n192 Technical Analysis of Stock Trends\naround 46—but it did not; it crashed on down to the “round figure” 40. This was an ominous \n(although not necessarily “fatal”) development. Thereafter, a massive Symmetrical Triangle \nwas formed and broke downside in September.\nThe first Panic Decline in the Bear Market is no respecter of Support Levels. This one \nwas no exception, although it is noteworthy that prices “bounced” several times from the \nimportant old 33–34 zone. By November, the Top Triangle’s measurement had been exactly \nfulfilled. (You should turn back to this record and study it again after you have read further \nin this chapter.)\nTake the opposite side of the picture—the uptrend process. You, along with many \nothers, bought XYZ at 12, carried it up to 24, decided that was plenty high for it, and cashed \nin. Thereupon XYZ reacted to 20, and you congratulate yourself on your astuteness. But \nthen, unexpectedly, it turns around and rushes up to 30. Now you do not feel as smart \nknowing that was a better stock than you gave it credit for being. You wish you had it back, \nyet you will not pay more for it; if it comes back down to 24, the price at which you sold, \nyou’ll “reinstate your position.”\nPerhaps you have never been in either of these situations. Perhaps your own reactions \nwould not, in such cases, have been the same as those we have indicated. If you have had \na fair amount of experience in the market—have some knowledge of the psychology of the \n“average investor”—you know the pictures described are typical.\nAt this point, you may not be satisfied we have succeeded in giving an adequate \nexplanation for our basic principle of Support and Resistance Levels. Remember, however, \nthat the supply and demand balance in the market is nearly always a delicate thing. Only \na moderate oversupply at any one price will suffice to stifle an advance; only a little extra \ndemand concentrated at a certain level will stem a decline. Remember, other traders \nare watching the tape as well and will be quick to sense any change in the situation \nand be quick to join the parade whenever a change in trend appears to be developing. \nConsequently, orders to buy or sell a few hundred shares may induce the transfer of \nseveral thousand.\nAnother point worth bearing in mind is that the traders and investors who (because of \nthe presumption their previous mistakes in either selling or buying prematurely) created \nSupport and Resistance Levels are not necessarily ignorant or inexperienced. On the \ncontrary, we must list them among the wiser and more alert of those who operate in the \nmarket. To make one more use of our previous theoretical example of typical downtrend \naction, those who bought at 50 were certainly smarter than those who bought at the top (70) \nor on the way down to 50, even though the latter price was broken later on. Giving them \ncredit for somewhat superior judgment, it follows that they may be expected to appraise \nlater developments pretty carefully and display something better than a wooden and \nstubborn determination to “get out even” when it comes to selling on a Recovery Move. \nHence, in a marked Bear Trend “overhanging supply”; that is, stock bought at higher levels \nby holders now waiting for a good chance to unload, will begin to come on the market below \nthe theoretical Resistance Level. Wise owners will be willing to sacrifice a point or so to \navoid getting caught in a worse loss.\nBy the same token, “sold-out Bulls,” when a Major Uptrend is under way, may be \nwilling to pay a point or two more to replace the shares they had previously cashed in too \nsoon. Thus, it is characteristic of reactions in well-established (second phase) Bull Markets \nto drop back only to the very uppermost limits of a Support Range—and for recoveries in \nestablished Bear Markets to reach only the lowest edges of Resistance Zones, or perhaps \neven fail of that by an appreciable margin. We shall have more of this sort of thing to point \nout later on, but first we must take up two other matters—how to estimate the potential \n193Chapter thirteen: Support and Resistance\nimportance of Support and Resistance Zones, and how to more", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 97}
{"text": "and for recoveries in \nestablished Bear Markets to reach only the lowest edges of Resistance Zones, or perhaps \neven fail of that by an appreciable margin. We shall have more of this sort of thing to point \nout later on, but first we must take up two other matters—how to estimate the potential \n193Chapter thirteen: Support and Resistance\nimportance of Support and Resistance Zones, and how to more accurately locate the centers \nof axes of such zones.\nEstimating Support–Resistance potential\nTo go back to first principles, the Resistance that an upward move may meet at any given \nlevel depends on the quantity of stock overhanging there—the number of shares previously \nbought at that price by owners who now would like to get out without loss. Obviously then, \nvolume is our first criterion in estimating the power of a Resistance Range. An old Minor \nBottom level, at which only four or five hundred shares changed hands, cannot set up much \nResistance to a subsequent advance, but a Selling Climax Bottom, where several thousand \nshares were bought, will provide a lot of potential supply after prices have dropped well \nbelow it, at some later date, and then attempt to rise up through it again.\nA long Rectangle or a Descending Triangle has a number of Bottoms at the same level. \nWe can get a crude approximation of the amount of Resistance there by summing up the \nvolume of trading on all its Bottoms, but then some discount must be taken for the shares \nthat may have been bought at the Bottom of the pattern in its early stages and then sold \nnear the Top before it was completed. In brief, a single, sharp, high-volume Bottom offers \nsomewhat more Resistance than a series of Bottoms with the same volume spread out in \ntime and with intervening rallies.\nAnother criterion is the extent of the subsequent decline. Or, to put it another way, how \nfar prices will have to climb before they encounter the old Bottom zone whose Resistance \npotential we are attempting to appraise. Generally speaking, the greater the distance, the \ngreater the Resistance. Suppose PDQ sells off from 30 to 20, “churns” at that level for several \ndays, rallies to 24, and then drifts back down to 19. Investors who picked it up at 20 will \nnot be greatly concerned at that stage. If a rally now develops from 19, there will be little or \nno disappointed selling at 20. Should prices dip to 18 before the rally starts, there may be \nsome supply forthcoming at 20, but still not a formidable quantity. From 17 , Resistance will \nbecome evident. In brief, prices have to break far enough below the price at which a trader \nbought his stock to convince him that he made a bad investment and, hence, that he should \nsell when he gets a chance to do so without too great a loss.\nIt is impossible to formulate any precise rule or equation to define how far a decline \nmust proceed to set up Resistance above it. However, do not look for much supply to come \nout of a Bottom level in the low-middle price ranges (20–35) unless the trend later takes \nquotations more than 10% under it. This 10% rule cannot be applied to very low-priced \nissues. A man may buy a stock at 5 and see it drop to 4 or 3.5 with considerable equanimity \ndespite the fact he stands a loss of 30% at the latter figure. His “dollar” loss looks small, and \nhe still thinks it will be easy for his stock to get back up to 6 or 7; so, he is willing to wait.\nAnother factor enters into and reinforces the “extent of decline” criterion. If our PDQ \nrallies, as before, from 20 to 24 and then drops rapidly to 12, not only will many of the old \nowners at 20 be thoroughly disgusted and glad to get out at that price, given an opportunity, \nbut the new owners at 12 also will be pleased to take 20 (66 2/3% profit) and quick to do \nso if they detect any signs of trouble there. New buyers at 18, needless to say, would not be \nquite so ready to sell at 20.\nA third criterion for appraising the Resistance potential at an old Bottom level is the \nlength of time that has elapsed since it was formed and the nature of general market \ndevelopments in the interim. You will, no doubt, find it reasonable to suppose that an \nIntermediate Bottom formed in the early stages of a Bear Market will offer relatively little \nResistance after prices have fallen far below it, have taken perhaps the better part of a year \n194 Technical Analysis of Stock Trends\nto make a Major base, and then have gradually climbed up to it again four or five years \nlater. To some small extent, this is true. A supply only a year or two old is apt to be more \neffective than one that is four or five years old, but the latter does not lose all of its potency \nby any means. In fact, it is often surprising how effective the Resistance will be at a very old \nBottom zone, provided it has not been “attacked” in the interim, and provided no changes \nhave been made in the capitalization of the company that might obscure, in the mind of \nthe owner, the original cost of his stock. Under the latter heading, we would put split-ups \nand large stock dividends, or even an unusually generous cash “melon.” We do not mean \nto imply that an investor is ever actually deceived as to the actual cost of his shares, no \nmatter how they may have been split, or what dividend distribution has been made, but \nhis disappointment (and desire to get out even) may be abated.\nIf, however, a Resistance Zone has once been attacked—if prices have come back up \nto it, hit it, and then retreated—some of its power has obviously been removed. Some of \nits overhanging supply has been used up in repelling the first attack. The next advance, \ntherefore, will have less stock to absorb at that level. Here again, the volume chart may be \nlooked to for some approximation of the amount of Resistance consumed. In any event, it is \nan odds-on assumption that a third attack at a Resistance Level will succeed in penetrating it.\nWe have named three criteria—volume, distance away, and time elapsed—to be", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 98}
{"text": "elling the first attack. The next advance, \ntherefore, will have less stock to absorb at that level. Here again, the volume chart may be \nlooked to for some approximation of the amount of Resistance consumed. In any event, it is \nan odds-on assumption that a third attack at a Resistance Level will succeed in penetrating it.\nWe have named three criteria—volume, distance away, and time elapsed—to be used \nin assessing the amount of Resistance to be expected at any given level. At this point, it \nmust be apparent (and perhaps disappointing) to the reader that his own judgment must \nplay a large role in applying them. This cannot be helped; it is impossible to set up an exact \nmathematical formula for any of them.\nBut, after all, the problem is not too complicated. The general principles are simple \nenough and, we believe, easy to understand. We can look back at the charted history and \nsee where, in the last preceding downtrend, a Bottom formed that may produce more or \nBENDIX AVIATION BX\n1944–1945\n56\n52\n48\n44\n40\n38\n36\n34\nSales\n100’s\n50\n40\n30\n20\n10\nJF SO ND JF MMM AJ JA MAJ\nFigure 13.2 Support–Resistance Levels in a long Intermediate Uptrend. The reader will need no \nguidance in applying the principles stated in this chapter to the Bendix weekly chart reproduced \nabove. Observe that when prices broke down in 1945 through a long trendline, their decline stopped, \nnevertheless, at the Support set up by the previous November’s Top.\n195Chapter thirteen: Support and Resistance\nless Resistance when the current advance reaches back up to its range. We have to estimate \nhow much supply resides there, how many shares were bought originally at that price and \nare still held by owners who may welcome a chance to get out even.\nThe greatest danger in applying judgment to the measuring of these factors lies in \nunderestimating the amount of Resistance to be expected. Guard against that effort; it \nis safer always to overestimate it. You may be Bullishly disposed yourself; you may say, \n“Those fellows who were hung up there in this stock must realize that conditions have \nimproved, and they will not be so anxious now to sell.” Don’t count on it. Recall, they have \nbeen “hung up” for a long time; even if they are mildly Bullish on the market in general, \nthey may be so disappointed with this particular stock that they want to switch out of it \nand try something else. (The stubborn and often costly refusal of the average American \ninvestor to “take a loss” operates even against timely switching.)\nEverything we have said in the foregoing paragraphs about estimating potential \nResistance applies as well—but in a reverse direction, of course—to estimating potential \nSupport. The principles are precisely the same, even though the underlying rationale may \nbe less easy to grasp.\nNATIONAL DISTILLERS DR\n30\n25\n20\n15\n10\n5\n3 for 1 3 for 1\n1926 1927 1928 1929 1930 1931 1932 1933 1934 1935 1936 1937 1938 1939 1940 1941 1942 1943 1944 1945 1947 1948\nFigure 13.3 For Major Support–Resistance Level study, monthly charts are most useful. This one \npresents many points of interest. Observe how important levels are formed and how, once formed, \nthey appear again, and reverse their roles. The price scale shows 1947 values with previous years \nadjusted for the splits of 1933 and 1946.\n196 Technical Analysis of Stock Trends\nPrices were able to “skyrocket” when that Resistance was finally overcome. You will \nfind that several additional Support–Resistance Lines might have been drawn on this chart. \nNote Major Bottom Formations of 1937–1938 and 1942.\nLocating precise levels\nOur next problem to consider is how, in practical day-to-day chart analysis, we can locate \nas exactly as possible the limits of a Support or Resistance Range and, in many cases, \nthe specific price figure representing the core or axis of such a range. In the theoretical \nexamples we have made up so far to illustrate basic principles, we have used even \nfigures, but in actual trading, the levels are seldom so nicely marked. Even the sharp and \nrelatively patternless Bottom of a Recession may consist of a week of price fluctuations \nwithin a narrow range. Perhaps the lowest day of that week’s Congestion will appear on \nthe chart as a One-Day Reversal, or there will be two or three days that “spike” down \nbelow the general mass. Here again, although no mathematical rule can be laid down, it \nis easy to relate the price and volume patterns visually, and by simple inspection, arrive \nat a near estimate of the figure at which supply in quantity is likely to be forthcoming. \nLook particularly at the closing levels of the days making up the Bottom Congestion and \naverage them mentally; this figure is apt to be pretty close to the “center of gravity” of \nthe entire Resistance Area.\nSome supply is likely to start coming in as soon as a subsequent advance reaches the \nbottommost fraction of the Resistance Zone, and more and more will appear as the move \nKRESGE (S.S.) CO. KG\n50\n40\n30\n20\n10\nSales\n100’s\n800\n400\n1936 1937 1938 1939 1940 1941 1942 1943 1944 1945 1946\nFigure 13.4 Particularly noteworthy in this monthly record is the Resistance met in 1939, 1940, 1941, \nand even in 1944, at the Bottom level (just above 26), the three-month Congestion of 1936. Also, the \nappearance eight years later (!) in 1945 of Resistance at the Bottom level (28) of the High-Volume Top \nCongestion of 1936–1937.\n197Chapter thirteen: Support an d Resistance\npushes up into it. Sometimes, it is possible to predict “to a hair” just how far prices will \npenetrate a Resistance Range by carefully comparing the vigor (volume of trading) on \nthe advance with the volume registered at various levels in the original formation of the \nResistance. This takes experience, but it is experience that you will find quite easy and not \nat all costly to gain. In most cases, however, it is neither necessary nor particularly desirable \nto be so exacting.\nNearly every chart in this book shows some example of Support a", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 99}
{"text": "he vigor (volume of trading) on \nthe advance with the volume registered at various levels in the original formation of the \nResistance. This takes experience, but it is experience that you will find quite easy and not \nat all costly to gain. In most cases, however, it is neither necessary nor particularly desirable \nto be so exacting.\nNearly every chart in this book shows some example of Support and Resistance \nphenomena, and the reader should make it a point when he has finished this chapter to \ngo back over and study them all in detail. The practical application of the rules we have \nbeen discussing will be greatly clarified. Equally instructive, if you can manage to obtain \nsuch a collection, is a study of the Support and Resistance Levels appearing in the monthly \ncharts of all actively traded stocks over a period of 10 years or more. EN: Easily generated \nby most currently available software and on the internet at stockcharts.com and other sites. You \nwill undoubtedly be amazed to see how Tops, Bottoms, and Sideways Congestions tend to \nform at the same approximate levels in successive Major Swings, while prices move freely \nand rapidly, up or down, through the ranges between such levels. It is hardly necessary \nto dwell on the practical dollars-and-cents value of such information that may be derived \nfrom the chart history.\nThis brings up a matter that we may as well pause to consider here—the kind of charts \nmost useful for locating and appraising Support and Resistance Levels. For near-term Minor \nMoves, the daily chart is naturally the only source of information, and a daily chart record \nthat extends back for a year or more may, if necessary, be used in the location of levels \nof Intermediate Trend importance. The writers have found, however, that a daily chart \ndoes not give the perspective on the long range that one really needs to determine Major \nand Intermediate Support and Resistance Zones. It is apt to overemphasize the potential \nof a recently set up Minor Support (or Resistance) Zone and obscure the importance of a \ntrue Intermediate Level. For true perspective, a weekly chart, showing volume as well as \nprice ranges, and covering at least the whole previous Major Bull and Bear cycle, is most \ndesirable. Also, very good results can be obtained with a little study and experience from \nmonthly charts.\nTo return to our study of Support phenomena, we have had several occasions to refer in \nprevious chapters to a “normal” trend. What we have had in mind might perhaps be better \ncalled an “ideal” trend because, like so many other so-called normal things, it represents a \npattern from which the facts of experience frequently deviate. In stock trends, nevertheless, \nthis normal or ideal appears as a fairly common pattern. If it is an uptrend, it consists of \na series of zigzags ( EN10: think waves, as in Chapter 28), each “zig” carrying prices to a \nnew high and each “zag” taking them back to the approximate top of the preceding “zig.” \nTo illustrate with figures, up to 10, back to 6, up to 15, back to 10, up to 20, back to 15, up \nto 26, back to 20, and so on. Such a move is what technicians refer to as “self-correction” \nand regard as particularly sound and, hence, likely to be continued. You can see it really \nrepresents a reaction to the nearest Minor Support Level following each step forward. If \nyou become interested in an issue with such a trend pattern, the normal return to a Support \nproduces a good place to buy.\nSignificance of Support failure\nSooner or later, however, a normal Minor Wave Pattern is bound to be broken up. This \ngenerally occurs in one of two ways (although there is an infinity of possible variations). \nIn one, prices spurt away in an advance out of all proportion to the previous succession \n198 Technical Analysis of Stock Trends\nof up waves. Such a move is seldom followed by a reaction to the Support now left far \nbehind, but rather, by the construction of some sort of Area Pattern—which may be either \nConsolidation or Reversal.\nThe other type of disruption appears when a reaction does not halt and reverse at the \nlevel of the previous Minor Top, but sifts on down through that zone, perhaps to the level \nof the preceding Minor Bottom. This move has “broken its Support,” and any such action \ncarries a distinct warning of a change in trend, a particularly emphatic warning if activity \nshows a tendency to increase as or after the Support is violated. Note we said change in \ntrend rather than Reversal because the puncturing of a Minor Support Level may signify \nonly a halt for sideways Consolidation, yet it may also foretoken an impending Reversal; \neither of these is a change.\nIf you will now call to mind the picture of a typical Head-and-Shoulders Top, you will \nsee the decline from the head constitutes just such a break in Minor Support because it \ncomes down through the level of the top of the left shoulder. You will recall this decline \nis often the first intimation we have that something in the nature of a Reversal Formation \nis developing.\nThus, even the violation of a nearby Support Level has a practical meaning in technical \nchart analysis. The breaking of a Minor Support should always be regarded as the first \nstep in the Reversal of the Intermediate Trend. (If it turns out to be Consolidation only, \nthere will be an opportunity later to reenter an abandoned commitment if desired.) By the \nsame token, the breaking of an Intermediate Support Range is frequently the first sign of a \nReversal in the Major Trend. We do not believe it is necessary to expatiate further on this \nprinciple. Recommended trading tactics based thereon are discussed in Section II of this \nbook; Support and Resistance Levels are particularly useful as Basing Points for stop-loss \norders, which are discussed there.\nPopular misconceptions\nThe reader will understand all we have said here about the breaking of Supports applies as \nwell, but in reverse direction to the penetrati", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 100}
{"text": "ate further on this \nprinciple. Recommended trading tactics based thereon are discussed in Section II of this \nbook; Support and Resistance Levels are particularly useful as Basing Points for stop-loss \norders, which are discussed there.\nPopular misconceptions\nThe reader will understand all we have said here about the breaking of Supports applies as \nwell, but in reverse direction to the penetration of Resistance Levels. One more point may \nwell be mentioned before we leave this subject; if you happen to have spent much time in \nJEWEL TEA CO.J WT\n2 for 1\n60\n52\n44\n36\n28\nSales\n100’s\n80\n40\n1936 1937 1938 1939 1940 1941 1942 1943 1944 1945 1946\nFigure 13.5 A monthly chart of Jewel Tea Company with its Major Support–Resistance Levels \nmarked. Note the reversal of roles.\n199Chapter thirteen: Support and Resistance\nboardrooms, you will have noticed the concepts of Support and Resistance prevalent there \nare somewhat different from those outlined in this chapter. For example, if X has advanced \nto 62, reacted to 57 , and then pushed on to 68, many traders will speak of 57 as being the \nSupport Level, presumably because that was the last price at which X was supported in \nsufficient strength to turn its trend from down to up. We, as you have seen, would name the \nvicinity of 62 as the Support Range. The distinction is important to grasp and sometimes \nextremely important in practical results.\nAdmittedly, it does not come easy to think of a former Top as denoting the level at \nwhich a later Bottom should form, or vice versa; it would seem superficially to be much \nmore logical to relate Top to Top and Bottom to Bottom. Moreover, it is perfectly true, to \nuse our X example again, that some of the investors who wanted to buy it at 57 might not \nhave succeeded in getting it before the second advance to 68 took it away, and their buy \norders might still stand at 57 or might be reentered on any return to that price. Nevertheless, \nthere is certainly no assurance that such is the case; there is no “vested interest” in X at 57 \nthat will “automatically” bring in new buying. On the other hand, we have seen how there \nis a sort of vested interest set up at an old Bottom that produces selling (Resistance), and \nthereby creates a new Top, and at an old Top that produces buying (Support) and thereby \ncreates a new Bottom.\nThe reader is urged to keep this concept well in mind. Any analytical study of the chart \nrecords will quickly show it is much easier for prices to push up through a former Top level \nthan through the Resistance set up at a previous volume Bottom (and vice versa, of course, \nwith respect to declines). You will find a little selling may come in at a former high, but \nusually only enough to cause a brief halt rather than the more or less extensive reactions \nor Consolidations that develop when the trend comes up against a real Resistance Zone.\nREMINGTON RAND RR 1945–1947\n48\n44\n40\n38\n36\n34\n32\n30\n28\n26\nSales\n100’s50\n40\n30\n20\n10\nND JS FO ND JF MMMAJ JA M A\nFigure 13.6 When prices broke down out of the large Descending Triangle that formed on Remington \nRand’s weekly chart in 1946, the decline might have halted, at least temporarily, around 37 at the level \nof the four-week Congestion made in April and should have “caught Support” at 35–36, the level of \nthe February top. Failure of the latter carried Major Trend significance. Note later Resistance at 40 1/2.\n200 Technical Analysis of Stock Trends\nThe round figures\nThere are certain other levels that may, at times, evidently produce considerable Resistance \nor Support without any reference to a previous “vested interest.” We have in mind the \n“round” figures 20, 30, 50, 75, 100, etc. In setting a goal for taking profits when we buy a \nstock, it is natural for us to think in terms of such round prices. If a low-priced stock has \nadvanced steadily from around 10, it is pretty certain on this account to meet with profit-\ntaking sales at 20, especially if that figure represents a new high for several years. In fact, any time \nan issue gets out into new all-time high ground, where there is nothing in its chart history \nto indicate otherwise, it is a fairly safe bet that Resistance will appear at the round figures. \nIn old and actively traded stocks, such as U.S. Steel (EN: or IBM and GE), the round figures \ndiminish in importance.\nRepeating historical levels\nIf, once they had been set up, important Support and Resistance Levels always “worked,” we \nshould see Intermediate Tops and Bottoms form at exactly the same ranges year after year \nin one Bull and Bear cycle after another. As a matter of fact, there is a well-marked tendency \nfor this to occur in old-line, actively traded stock. In General Electric, for example, the 22–24, \n34–35, 40–42, and 48–50 zones were characterized by large turnover (and, consequently, by \nmany Intermediate Reversals of trend) throughout the 1920s and into the 1950s. In Southern \nPacific, there are historical Support and Resistance Zones at 21–22, 28–30, 38–40, and 55–56. \nIn U.S. Steel, 42–45, 55–58, 69–72, 78–80, and 93–96 are conspicuously marked as Reversal \nYORK CORPORATIONY OK\n1945–1946\nOCTOBERN OVEMBERD ECEMBERJ ANUARY FEBRUARY MARCH\n26\n24\n22\n20\n19\n18\n17\n16\nSales\n100’s\n125\n100\n75\n50\n25\n6 13 20 27 3 10 17 24 1 8 15 22 29 5 12 19 26 2 9 16 23 2 9 16 23 30\nFigure 13.7 York is a relatively thin stock, which normally makes many small, technically \nmeaningless gaps, but its large, high-volume gap of October 8, 1945, demanded attention. It looked \nlike a Runaway Gap, and as such implied continuation to 26 1/2 plus, but prices halted their advance \nat 24 1/2 and went into a three-month Rectangle. An upside breakout on January 10, 1946, carried \nout the minimum measurement of the Rectangle (and October gap); prices then reacted. See sequel \nin Figure 13.8.\n201Chapter thirteen: Support and Resistance\nRanges. Additionally, many other stocks might be cited. (EN9: While the particular stocks are \ndead or transmogrified, the princ", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 101}
{"text": "d their advance \nat 24 1/2 and went into a three-month Rectangle. An upside breakout on January 10, 1946, carried \nout the minimum measurement of the Rectangle (and October gap); prices then reacted. See sequel \nin Figure 13.8.\n201Chapter thirteen: Support and Resistance\nRanges. Additionally, many other stocks might be cited. (EN9: While the particular stocks are \ndead or transmogrified, the principle is alive and well.)\nOver long periods, however, such Support and Resistance Levels do tend to be gradually \nmodified, broadened, or “blurred” as new ones are created. One source of many important \nnew Supply Zones is a Bear Market Panic. For this is the one type of decline that can \nbe counted on to pay no heed whatsoever to previous underlying Support Zones. Panics \n(which, as seen in our earlier study of Primary Swings in connection with Dow Theory, \ntypify the second phase of Bear Markets), once they get under way, seem to sweep away all \npotential Support in their calamitous plunges until they exhaust themselves in a general \nmarket Selling Climax for which may or may not come at a level that bears a relation to \nsome previously established Support. To use U.S. Steel again as an example, the 1937 Panic \nDecline took the stock down through its 93–96 range, hesitated briefly at the 78–80 level, \nand then plunged through 69–72 and 55–58 to stop just above 50. In the 1946 Panic, X again \nbroke swiftly through 78–80 and 69–72 to halt at 66.\nWhen there is a large turnover at a Panic Bottom in any given stock, that level acquires \na strong “vested interest” for the future and will usually furnish conspicuous Resistance \nto a subsequent advance (after another Bear Market Decline has taken quotations below \nthe Panic Level).\nThis discussion of Panics brings us back to a consideration of Support and Resistance \nperformance at other stages of the Primary Trend. Bearing in mind the relation of Resistance \nto volume, it is easy to see why in a long drawn out but otherwise typical Bear Swing in \nwhich trading interest diminishes to a very low ebb as the final low is approached, the next \nYORK CORPORATION YOK1 946\nAPRILM AY JUNEJ ULYA UGUSTS EPTEMBER\n26\n24\n22\n20\n19\n18\n17\n16\nSales\n100’s\n50\n40\n30\n20\n10\n6 13 20 27 4 11 18 25 1 8 15 22 29 6 13 20 27 3 10 17 24 31 7 14 21 28\nFigure 13.8 The February reaction in Figure 13.7 met momentary Support at 24; prices bounced far \nenough to close the February 7 gap and then broke down through the Rectangle Top-Line Support \ntechnically a distinct warning. Then a Symmetrical Triangle formed, but the breakout came too \nnear the apex, produced only a rally to the former high, and then an “end run.” One did not need to \nwait for the Double Top signal on August 22 to forecast a decline of more than minor consequence.\n202 Technical Analysis of Stock Trends\nto the last Intermediate Bottom may produce relatively little supply and, consequently, only \na small reaction when the new uptrend reaches its level. Add to this the fact that many of \nthe buyers in the last stages of a Major Decline are deliberate scale-down investors who \nfully expect prices will go lower and, hence, are not easily shaken out. The slow progress \nso often seen in the first part of a new Primary Bull Market is due not so much to overhead \nResistance as to lack of impatient public bidding.\nThe Recovery Trends that follow precipitous Bear Market Panics usually exhaust \nthemselves, for obvious reasons, long before they get back up to the last Resistance Level left \nbehind in that Primary Downswing (which is usually the Bottom of the first Intermediate \nDecline from the extreme Top of the cycle), but they often meet supply at a lower Resistance \nZone set up in the preceding Bull Market . Look way back on your charts, therefore, when \nsizing up the prospective advance in such situations.\nA further thought along that line is this: there is no law that requires an advancing \ntrend to keep right on climbing until it reaches a distant overhead Supply Zone. It is true, \nas a corollary that we have already mentioned to our Support and Resistance Theory, that \nprices can and do rise easily through a price range at which no Bottoms or Congestion \nAreas have formed in previous downtrends, but if the first established Resistance Level is \na long way above, the advance may exhaust itself before it gets there. Heavy supply may \ncome in for other reasons at a lower level. Think, then, of a distant Resistance Level as a \nmaximum possibility rather than as a certain goal. However, between two stocks whose \npurchase you are considering, you should select the one, other things being equal, with \nthe “thinner” track overhead and can rise farther before it encounters a charted Supply \nZone.\nPattern Resistance\nWe can revert now to some of the Minor phenomena discussed in connection with Reversal \nand Consolidation Patterns in earlier chapters. Take gaps, for instance. You will now see \nwhy it is easy and, hence, quite in order for a reaction that comes soon after a gap has been \nmade to slip back and close that gap. There is no “vested interest” whatever in the range \nthrough which prices skipped to form the gap on the chart. You will also see why such a \nreaction may stop short and reverse as soon as it has closed the gap, provided there was a \nhigh-volume turnover in the price range immediately preceding the gap. Such is usually \nthe case with a Breakaway Gap.\nAny gap, for the same reason, is easy to close once a reaction starts prices moving back \nin that direction, if it is not too far away and if there are no intervening Resistance Levels \nto stop the reaction before it gets there. In the case of a Runaway Gap, however, there is no \nreason why a reaction should halt as soon as it has covered the gap range; on the contrary, \nit will probably continue on through the “thin” price track that preceded the gap.\nPullbacks and Throwbacks—the quick return moves that we noted as developing so \noften shortly after a breakout from a", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 102}
{"text": "ce Levels \nto stop the reaction before it gets there. In the case of a Runaway Gap, however, there is no \nreason why a reaction should halt as soon as it has covered the gap range; on the contrary, \nit will probably continue on through the “thin” price track that preceded the gap.\nPullbacks and Throwbacks—the quick return moves that we noted as developing so \noften shortly after a breakout from a Head-and-Shoulders or other Area Pattern—exemplify \nthe principles of Support and Resistance. When prices break down, for example, out of a \nDescending Triangle, the horizontal lower boundary of the formation, which was originally \na Demand Line, promptly reverses its role and becomes a Resistance Level. Any attempt to \nput prices back up through it, therefore, after a decisive breakout, is stopped by supply at \nor near the line. By the same token, the neckline of a Head-and-Shoulders Top, which was \na Demand Line, becomes a Resistance Level after it has been broken. The Top or Supply \nLine of a Rectangle becomes a Support after prices have pushed above it on volume and \nby a decisive margin.\n203Chapter thirteen: Support an d Resistance\nEarlier in this chapter, in our discussion of the three criteria for appraising the amount \nof Resistance to be expected at a former Bottom level, we named “distance away” as one of \nthe criteria and stated as a general rule that prices should have gone at least 10% beyond \nthat level in a medium-priced stock before much Resistance would be set up. This 10%-away \nrule does not apply in the case of a Throwback to a well-defined area formation when it \nfollows shortly after a breakout. All that is necessary to establish strong Resistance to such \nmoves at the pattern boundary is a conclusive breakout.\nThe Symmetrical Triangle has a different sort of Support and Resistance “field.” You \nwill recall that the first Reversal point in the formation of a Symmetrical Triangle (a Top, \nif it forms on a rising trend, or a Bottom if on a decline) is normally accompanied by high \ntrading volume, but that activity diminishes rapidly on succeeding fluctuations within its \nconverging boundaries. Consequently, once prices have broken out of the Triangle and have \nproceeded well beyond the level of the pattern’s first Reversal point, that level, because of \nthe volume of shares traded there, becomes a Support (or Resistance) against a subsequent \nreaction. But, if the breakout move does not carry beyond the Triangle’s first Reversal Level \nby a clear margin, any Throwback will probably bring quotations back to the extended \n(sloping) pattern boundary. If the reaction does not occur until the trend has worked out \nto or beyond the Triangle’s apex, then the Throwback usually will not meet Support (or \nGOODYEAR TIRE GT 1945–1947\n76\n72\n68\n64\n60\n56\n52\n48\n44\nSales\n100’s\n50\n40\n30\n20\n10\nND JF S\nON DJ FMM MAJ JA M A\nFigure 13.9 We first discussed Pullbacks in connection with the Head-and-Shoulders in Chapter 6 \nand refer to them again in this chapter as Support–Resistance phenomena. At least one Pullback to \nthe neckline (after the breakout) occurs in the great majority of cases. Many Head-and-Shoulders \nFormations produce two, the first within a few days after the breakout and before prices have gotten \nvery far away, and the second weeks later, sometimes after the minimum measurement of the Head-\nand-Shoulders has been fulfilled. Goodyear saw the unusual number of four Pullbacks to its 1946 \nneckline in the first two weeks after the August breakout, another in October, a third in November, \nand a fourth in February 1947 , which met the Double Resistance of the neckline and the down \ntrendline (see Chapter 14) projected from the 1946 April head and August right shoulder.\n204 Technical Analysis of Stock Trends\nINTERNATIONAL TEL. & TEL. IT\n1945\nJANUARYF EBRUARY MARCHA PRIL MAYJ UNE\n30\n28\n26\n24\n22\n20\n19\nSales\n100’s\n500\n400\n300\n200\n100\n6 13 20 27 3 10 17 24 3 10 17 24 31 7 14 21 28 5 12 19 26 2 9 16 23 30\nFigure 13.10 Several examples of the Support “field” of the Symmetrical Triangle appear in this 1945 \ndaily chart of “IT.” Following the belated February 5 breakout from the first Triangle, prices returned \non the 9th to the level of the mid-January Top, but then suffered a more extensive reaction, which \ncame down on February 26 to the Triangle’s apex level. This was a critical juncture. The apex point \nitself is a strong Support (or Resistance), but its level becomes weaker as time passes. In this case an \n“end run” might have been developing. Stop-loss orders should always be entered under an apex \nlevel (see Chapter 27). Here the apex held, however, and prices went into another “Coil,” breaking \nout topside on March 10. Their next reaction was supported, as was to be expected after an early \nbreakout like this, at the Top Pattern Line. The price track from mid-March to the end of April fell \ninto an Ascending Triangle Pattern, the top boundary of which functioned as Support in June but \nwas broken in July. Refer to Figure 11.17 .\nINTERLAKE IRONI K1 944\nJULY AUGUST SEPTEMBERO CTOBER NOVEMBER DECEMBER\n10\n9\n8\nSales\n100’s\n125\n100\n75\n50\n25\n1 8 15 22 29 5 12 19 26 2 9 16 23 30 7 14 21 28 4 11 18 25 2 9 16 23\nFigure 13.11 In this instance, a belated upside breakout (August 10) from a Symmetrical Triangle \nfailed quickly and the subsequent reaction, after holding for several days at the apex level, finally \nbroke down for an “end run.” Thereafter, note the apex level turned into a Resistance against \nRecovery Moves.\n205Chapter thirteen: Support and Resistance\nResistance) until it has carried back to the level of the apex, which, in brief, represents the \nconcentration level or axis of the Triangle’s Support and Resistance.\nThe intersection of the two converging boundary lines of a Symmetrical Triangle has \nsometimes been called a “cradle.” The axis Support (or Resistance) is strongest near the \ncradle point and gets weaker as the axis line (apex level) is extended out to the right on the \nchart", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 103}
{"text": "level of the apex, which, in brief, represents the \nconcentration level or axis of the Triangle’s Support and Resistance.\nThe intersection of the two converging boundary lines of a Symmetrical Triangle has \nsometimes been called a “cradle.” The axis Support (or Resistance) is strongest near the \ncradle point and gets weaker as the axis line (apex level) is extended out to the right on the \nchart (i.e., as time passes). Thus, if a late breakout move fails to carry prices very far from \nthe Triangle area, and the trend then peters out, flattens, and begins to react after the cradle \npoint has been passed in terms of time, its action, as it reaches the axis line, must be closely \nwatched. (A stop-loss order may be indicated here.) Should the axis Support fail to hold, \nthe reaction may plunge through and accelerate in a more extensive swing, which has aptly \nbeen termed an “end run around the line.”\nVolume on breaks through Support\nOn those occasions when prices fail to retreat when they hit a Resistance (or Support) Range, \nbut perhaps after holding there for several days, push on through, there is nearly always a \nsudden acceleration and a marked pickup in volume. This may be taken as confirmatory \nevidence of a decisive break and, consequently, an indication the move will carry on. The \nreasons for this volume increase are obscure. Some say, “It takes volume to overcome \nSOUTHERN RAILWAYS R\n1946\nAPRIL MAY JUNE JUL YA UGUSTS EPTEMBER\nXD 75C\nXD 75C\nNL\nH\nSS\nH SS\n64\n60\n56\n52\n48\n44\n40\n38\n36\n34\nSales\n100’s\n125\n100\n75\n50\n25\n6 13 20 27 4 11 18 25 1 8 15 22 29 6 13 20 27 3 10 17 24 31 7 14 21 28\nFigure 13.12 Here is a typical case of two Pullbacks to a Head-and-Shoulders neckline, the first \nimmediately after the breakout and the second three weeks later. Note the initial breakthrough \n“bounced” from the early April Top Support and the late July decline met Support at the general \nApril–May Congestion Area. However, what this chart particularly illustrates is how volume \nincreases when a good Support Range is penetrated. Note the decided pickup on August 27 , when \nthe April–May area was left behind.\n206 Technical Analysis of Stock Trends\nResistance,” which is true enough, but the volume usually comes after the Resistance has \nbeen penetrated. Therefore, others say, “The volume is evidence that technicians see what \nhas happened and are now jumping in.” But that line of thought, in the authors’ opinions, \nalso has little to substantiate it. (We shall have more to say about the questionable influence \nof technicians on the trend later on.) Many of the arguments over volume change versus \nprice change smack of the old hen-or-egg riddle. In any event, causes for many technical \nphenomena, such as this one, may be left to the academicians, provided the practical \nimplications are clear.\nSupport and Resistance in the Averages\nAs has been the case with nearly every other technical phenomenon we have studied, the \nprinciples of Support and Resistance apply, with suitable allowances, to Averages as well \nas to individual stocks. Since an Average reflects the combined charts of the majority of \nthe issues that compose it, but with a minority of them frequently evincing quite divergent \npatterns, it follows naturally that Support and Resistance Zones in the Averages cannot be \nas sharply and narrowly construed. Minor Tops and Bottoms in the Averages, particularly, \nare less dependable as Resistance Levels. Clearly defined and important Intermediate \nReversals, however, as they nearly always represent Reversals in the entire market \n(practically all stocks), will normally produce strong Resistance (or Support, as the case \nmay be) in the subsequent Average Trend.\nWhen the Averages break down through a Support Level, but simultaneously one \nor more stocks hold firm at or above their corresponding individual Supports, there is a \npresumption that those particular stocks are in a stronger position than others to participate \nin the next recovery. The phrase “other things being equal” should be added, however, for \nthere are qualifications to this presumption that must be considered. For instance, it may \nbe that the stock that has resisted decline will, for that very reason, be less attractive to new \nbuyers than one that broke drastically and is now purchasable at a more “attractive” price.\nMany of the claims made regarding future prospects for stocks that have, by one \ncriterion or another, previously evinced “better-than-Average” or “worse-than-Average” \nmarket performance permit argument either way. It is safest to treat all such relative \nperformance indications as only one minor factor to be appraised in the overall chart \npicture.\n207\nchapter fourteen\nTrendlines and Channels\nOne of our basic tenets in this system of technical stock chart analysis—indeed, a fact \nthat any neophyte can quickly verify for himself by inspection of the market records for \nwhatever period he chooses—is that prices move in trends. The market, in general, and the \nmany stocks that compose it, do not jump up and down in an altogether random fashion; \non the contrary, they show definite organization and pattern in their charted course. (For \nillustrations in this chapter, see Figures 14.1 through 14.17.)\nPrices move in trends. These trends may be either up or down or sideways (horizontal). \nThey may be brief or of long duration. They may be classified as Major (Primary), \nIntermediate (Secondary), or Minor, according to the rules of Dow Theory, or as Horizontal \nLine Formations. (The distinction between a short Intermediate and an extended Minor \nTrend is often more difficult to make with individual stocks than it is with the Averages, \nbut it is not so important.) Sooner or later, trends change; they may change by reversing \nfrom up to down or down to up, or they may also change direction without reversing as \nfrom up to sideways and then perhaps to up again, or from a moderate slope to a steep \nslope, and vice versa.\nProfits a", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 104}
{"text": "ded Minor \nTrend is often more difficult to make with individual stocks than it is with the Averages, \nbut it is not so important.) Sooner or later, trends change; they may change by reversing \nfrom up to down or down to up, or they may also change direction without reversing as \nfrom up to sideways and then perhaps to up again, or from a moderate slope to a steep \nslope, and vice versa.\nProfits are made by capitalizing on up- or downtrends by following them until they are \nreversed. The investor’s problem is to recognize a profitable trend at the earliest possible \nstage of its development and then later to detect, again as quickly as possible, its end and \nReversal. The Reversal of any important trend is usually characterized, as we have already \nseen, by the construction of some sort of joint price and volume pattern—in brief, of a \nReversal Formation.\nThe Trendline\nAll of the foregoing statements regarding trends have been expressed or implied in earlier \nchapters of this text. It is our purpose now to examine trends, as such, more closely, to \nsee how they may be plotted most effectively on the charts, and to determine to what \nextent they can be used to reinforce or supplement the technical forecasts derived from our \nother chart formation and Support–Resistance studies—sometimes to furnish even earlier \nforecasts or warnings of change.\nOne of the first discoveries a new student is likely to make when he begins to inspect \nstock charts with a critical eye is that nearly all Minor and most Intermediate Trends \nfollow nearly straight lines. A few readers will, perhaps, dismiss this as perfectly natural, \nsomething to be taken for granted. But the majority become increasingly amazed and excited \nas they delve deeper. Not only the smaller fluctuations, but also the great Primary Swings \nof several years’ duration frequently appear on the charts as though their courses had \nbeen plotted with a straight-edge ruler. This phenomenon is, in truth, the most fascinating, \nimpressive, and mysterious all the stock charts exhibit.\nIf we actually apply a ruler to a number of charted price trends, we quickly discover the \nline that most often is really straight in an uptrend is a line connecting the lower extremes \nof the Minor Recessions within those trends. In other words, an advancing wave in the \n208 Technical Analysis of Stock Trends\nstock market is composed of a series of ripples and the Bottoms of each of these ripples \ntend to form on, or very close to, an upward-slanting straight line. The Tops of the ripples \nare usually less even; sometimes they also can be defined by a straight line, but more often, \nthey vary slightly in amplitude, and so any line connecting their upper tips would be more \nor less crooked.\nOn a Descending Price Trend, the line most likely to be straight is the one that connects \nthe Tops of the Minor Rallies within it, while the Minor Bottoms may or may not fall along \na straight edge.\nThese two lines—the one that slants up along the successive wave Bottoms within a \nbroad up-move and the one that slants down across successive wave Tops within a broad \ndown-move—are the basic trendlines.\nIt is unfortunate that a more distinctive name for them has never been devised than the \nthreadbare word “line,” which has so many other uses and connotations. A few analysts \nhave called them “tangents,” a term that has the advantage of novelty, but, because it is a \ndistinct perversion of the true meaning of the word tangent , confuses many readers even \nmore. Perhaps tangent will eventually become established in this new sense. We shall be \nsatisfied herein with the overworked “line,” and will give it some distinctiveness in its \npresent context by joining it to trend in the one word “trendline.”\nATLANTIC REFINING AFI\n1944 1945 1946 1947\n52\n48\n44\n40\n38\n36\n34\n32\n30\n28\n26\nSales\n100’s\n250200\n150\n10050\nFigure 14.1 A series of Intermediate Trendlines drawn to illustrate the “basic” principle (see \n“How Trendlines Are Drawn”) on a weekly chart of Atlantic Refining, extending from January \n1944 through August 1947 . Observe that each up trendline required two distinct Bottom points to \ndetermine it, and each down trendline, two Tops. In some cases, the two determining points were \nformed only a few weeks apart, as in August and September 1945. The Bottom points that fixed the \nearly 1946 up trendline, on the other hand, were months apart—February and June. Note that only \nfinal Trendlines are shown here. Many other experimental lines might have been drawn on this chart \noriginally, including several uptrends whose Intermediate authority was questionable because they \nwere “too steep”—as in early 1944, late 1945, and early 1946. There are also some interesting examples \nof Pullbacks (after trendline penetration) that are discussed later in this chapter. Note July 1944, April \n1945, September 1945, and May 1947 .\n209Chapter fourteen: Trendlin es and Channels\nTrendlines, you may have heard it said, “are made to be broken,” but that is one of those \nexasperatingly sententious remarks that fails to clarify anything. Of course they are broken; \nthey are all always broken, ultimately, and some very shortly after they are set up. The \nproblem is to decide which breaks (i.e., penetrations by a price movement) are of important \ntechnical significance and which are of no practical consequence, requiring possibly only \na Minor Correction in the drawing of the original trendline. There are no 100% certain \nquick answers to this problem; the significance of some penetrations cannot be determined \nas soon as they appear, but rather must await confirmatory indications from other chart \ndevelopments. In a great majority of instances, however, an important break—one that \nrequires a prompt review and possibly a revision of trading policy—is easy to recognize.\nHow Trendlines are drawn\nFirst, how are trendlines drawn? A straight line is mathematically determined by any \ntwo points along it. To draw a trendli", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 105}
{"text": "ey appear, but rather must await confirmatory indications from other chart \ndevelopments. In a great majority of instances, however, an important break—one that \nrequires a prompt review and possibly a revision of trading policy—is easy to recognize.\nHow Trendlines are drawn\nFirst, how are trendlines drawn? A straight line is mathematically determined by any \ntwo points along it. To draw a trendline, therefore, we require two determining points—\ntwo established Top Reversal points to fix a Down Trendline and two established Bottom \nReversal points to fix an Up Trendline. The principle here is the same as the one we laid \ndown in our specifications for drawing Triangle boundary lines in Chapter 8. The fact is that \nboundary lines of Triangles and Rectangles, as well as necklines of Head-and-Shoulders \nFormations, are simply special types of trendlines.\nSuppose we start with a Major Bottom point and describe how a series of Up Trendlines \nmight develop therefrom. To make this first illustration simple, let us assume the Bear \nATCHINSON, TOPEKA, & SANTA FE SF\n1935–1936\nOCTOBERN OVEMBERD ECEMBER JANUARYF EBRUARYM ARCH\n80\n76\n72\n68\n64\n60\n56\n52\n48\nSales\n100’s\n50\n40\n30\n2010\n5 12 19 26 2 9 16 23 30 7 14 21 28 4 11 18 25 1 8 15 22 29 7 14 21 28\nFigure 14.2 This 1935–1936 daily chart of Atchison illustrates how the latter part of a long, strong \nIntermediate Advance may accelerate away from its trendline. Notice the action in late January and \nearly February. Prices dropped back to 66 in April 1936 after this Up Trendline was broken at the \nend of March. Note also at the point at which the December 1935 reaction met Support, the trendline \ncoincided with a Triangle apex level. Such “coincidences” appear frequently in technical studies.\n210 Technical Analysis of Stock Trends\nMarket Bottom in our stock consisted of a Rectangle area between 6.5 and 8, and the last \nmove in this formation arose from the 6.5 level, broke through the pattern’s Top at 8, and \nproceeded to 9. From 9, prices reacted to 8 and then headed back up again. As soon as this \nlast rally had gone far enough to leave the dip to 8 showing in the clear as a Minor Bottom, \nwe could draw our first Up Trendline because we then had two Bottom points, the second \n(8) higher than the first (6.5), to fix its slope. This would be a Minor Up Trendline. We would \nrule it in lightly on our chart in pencil and extend it on up and ahead for, perhaps, a week \nor more. (It will help you to visualize our example if you sketch it on a scrap of chart paper.)\nTo proceed, suppose prices push up to 10, then move sideways for a few days, or \ndip slightly, until they have approached and touched, once more, our extended Minor \nTrendline. Then they start to move up in a third advance, but they run into supply again \nwithout making much progress, quickly make a fourth contact with the trendline, hesitate, \nand then break down through it. If prices now close clearly below the line and if there has \nbeen some pickup in trading volume evident on the penetration, we may conclude our \nfirst Minor Trend is completed, plus our stock either will build some sort of Consolidation \nPattern before it stages another advance or it will suffer a more extensive “Correction” than \nany of the brief dips it registered during its first Minor Upswing.\nThe whole Minor Uptrend we have described as an example in the foregoing paragraphs \nmight well have run its course in two weeks; our first trendline would then have been very \nsteep—too steep, obviously, to hold for any very long period of time. Now, let us assume \na series of downward fluctuations produces the more extensive correction that we have \nforeseen as one probability following the trendline break that carries prices back to the \nSupport Level set up at the Top of the original Rectangle, that is, at 8. (From our previous \nSupport–Resistance studies, we would recognize this as a prime “buy spot.”) Assuming \nCRANE COMPANYC R 1945\nJANUARYF EBRUARYM ARCH APRILM AY JUNE\nXD .25\nXD .25\nS S\nH36\n34\n32\n30\n28\n26\nSales\n100’s\n125\n100\n75\n50\n25\n6 13 20 27 3 10 17 24 3 10 17 24 31 7 14 21 28 5 12 19 26 2 9 16 23 30\nFigure 14.3 Trendlines that defined the short-term swings in Crane Company in 1945. Note three \nBottoms formed on the first up-line and the third rally (late February) in this advance failed to reach \na line drawn across the earlier Tops parallel to the Basic Trendline. A failure of this sort frequently \nprecedes a break in the trend. The same thing happened at the end of the second uptrend in late \nMay. “Failures” and the use of parallel or “Return” Lines will be discussed later in this chapter. The \ndowntrend in March assumed a Wedge form. Observe how the April 6 reaction met Support at its \npreviously penetrated Top line. In June, a rally met Resistance at the previously broken Up Trendline. \nSuch Pullbacks are common. The small Complex Head-and-Shoulders in June was never completed \nbecause prices did not break down out of it by the required margin.\n211Chapter fourteen: Trendli nes and Channels\nthat subsequent developments pursue a normal course, prices should not linger long at \n8, but should start promptly on a new series of advancing fluctuations. As soon as this \nbecomes evident and the new Bottom at 8 is “in the clear,” we can rule in a new trendline \nacross the original base point at 6.5 and the new point at 8. This should be, and probably \nis, an Intermediate Up Trendline that will not be penetrated for several weeks, maybe for \nseveral months, until the Intermediate Advance tops out.\nSubsequently, if that Intermediate Top takes the form of a Head-and-Shoulders Reversal \nPattern, our Intermediate Up Trendline may be broken by the recession from the top of the \nhead to the neckline. As a rule, however, the final advance in a strong Intermediate Move \naccelerates far enough away from the extended trendline to leave room (to the right on the \nchart) for considerable pattern construction before the line is again touched a", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 106}
{"text": "kes the form of a Head-and-Shoulders Reversal \nPattern, our Intermediate Up Trendline may be broken by the recession from the top of the \nhead to the neckline. As a rule, however, the final advance in a strong Intermediate Move \naccelerates far enough away from the extended trendline to leave room (to the right on the \nchart) for considerable pattern construction before the line is again touched and penetrated. \nHence, the actual puncturing of the trendline is more apt to occur either on the decline \nfrom the right shoulder to the neckline, or at about the same time as prices break down \nthrough the neckline to complete the Head-and-Shoulders signal. It is surprising to see how \noften the two lines, neckline and trendline, are broken simultaneously . In other instances, \nand there are many of them also, in which the trendline is the first to be punctured, perhaps \nshortly after prices turn down from the right shoulder, we do not have to wait for a neckline \nbreak but can take action at once. Here is one type of trendline indication that produces a \nworking signal a little earlier, and often at a much more favorable price level, than is given \nby the completion of a Reversal Formation.\nArithmetic versus logarithmic scale\nBy this time, the more mathematically inclined among our readers must have begun to \nponder the difference between trendlines projected on the ordinary or arithmetic scale \nCOMMERCIAL SOLVENTS CV\n1946\nJANUARYF EBRUARYM ARCH APRILM AY JUNE\n32\n30\n28\n26\n24\n22\n20\nSales\n100’s\n250\n200\n150\n100\n50\n51 21 92 62 91 62 32 91 62 33 06 13 20 27 41 11 82 5 18 15 22 29\nFigure 14.4 Intermediate Downtrend and Uptrend in Commercial Solvents in 1946. Note the \nincreased volume on the March 30 penetration of the basic Down Trendline (and, at the same time, \na breakout from a small Head-and-Shoulders Bottom). The drop through the lower parallel at the \nend of February had no technical significance. The Up Trendline from the March low was broken \non June 14, simultaneously with a breakout from a Descending Triangle, which, as it turned out, was \nthe final Bull Market Top.\n212 Technical Analysis of Stock Trends\nand on the logarithmic or ratio scale. A series of points that fall on a perfectly straight, \nup-sloping line on arithmetic chart paper will, when transferred to a semilogarithmic sheet, \nproduce a curved line that rises sharply at first and then gradually rounds over. Points that \nfall on a straight line on a semilogarithmic sheet will produce an accelerating curve on \nan arithmetic sheet, a line that slants up more and more steeply the farther it is projected.\nAs a matter of fact, this variance is of little or no importance in defining Minor Trends, \nas they seldom run far enough for the dissimilar characteristics of the two types of scales \nto become effective. The same holds true for average Intermediate Moves of normal slope. \nHowever, when it comes to very long and strong Intermediates, the divergence may become \nmarked and may make a considerable difference in the time and level of ultimate trendline \npenetration. Therein lies one of the strongest reasons for using semi-logarithmic paper in \ncharting stocks for technical analysis. Let us postpone further discussion of this point until \nwe take up Major Trends and go on now with the Intermediate Lines that are much the \nsame on either type of scale, concentrating on Intermediate Uptrends. (Intermediate Moves, \nrather than Minor, are emphasized for the obvious reason Minors are of little practical \nimportance in either trading or investing.)\nPHILLIPS PETROLEUM P 1935–1938\n64\n60\n56\n52\n48\n44\n40\n38\n36\n34\n32\n30\n28\n26\n24\n22\n20 \n19\n18\n17\nSales\n100’s\n1000800600\n400\n200\nND JF SO ND JF MMMAJ JA SO ND JFJJ ASOJA M MA M A\n1935 1936 1937 1938\nFigure 14.5 Valid trendline penetration and its normal consequences—Reaction or Consolidation—is \nillustrated on nearly every chart in this chapter and on many others throughout the book. This weekly \nchart of Phillips Petroleum is reproduced here to show an outstanding exception. The Intermediate \nUp Trendline projected from “P’s” September 1936 low up across its early October and late-November \nBottoms was penetrated downside decisively the third week of May 1937 . Moreover, a Multiple Head-\nand-Shoulders Top Reversal Pattern had been forming since February, with a critical neckline at 52. \nAnd the then-current Bull Market had already run for four years; “P” had come all the way up from 2! \nCover up the chart from July 1, 1937 , and you will agree there was plenty of reason for any technician \nto sell at once without waiting for the 52 neckline to be broken. But this, as we have said, was one of \nthe exceptions that occurs to all technical patterns and rules. “P” turned right around and shot up to \n64 before it was finished. Nevertheless, developments such as this carry a valuable warning. They very \nseldomly appear unless the Major Trend has almost run out; any further rise is dangerous to follow.\n213Chapter fourteen: Trendli nes and Channels\nPARA MOUNT PICTURES PX\n1945–1946\nOCTOBERN OVEMBERD ECEMBER JANUARY FEBRUARY MARCH\nXD .50C\n76\n72\n68\n64\n60\n56\n52\n48\n44\n40\nSales\n100’ s\n125\n100\n75\n50\n25\n61 32 02 73 10 17 24 18 15 22 29 51 21 92 62 91 62 3 29 16 23 30\nFigure 14.6 Double Trendlines (see next section) usually are not evident until after a trend has \nrun for several months. In Paramount’s accelerated phase of Intermediate Uptrend, which began \nin October 1945, the double nature of the basic trendline was not detectable until January 1946. The \ninner (upper) line was broken again in April, but the outer (lower) line was not decisively penetrated \ndownside until May, at the Bull Market Top.\nBETHLEHEM STEEL BS\n1945\nJULY AUGUST SEPTEMBERO CTOBER NOVEMBERD ECEMBER\n96\n88\n80\n76\nSales\n100’s\n125\n100\n75\n50\n25\n71 42 12 84 11 18 25 18 15 22 29 61 32 02 73 10 17 24 18 15 22 29\nFigure 14.7 Trend Channels in Bethlehem Steel in 1945. Prices burst out of the 92–98 Horizontal \nChannel (Rectangle) on the upside in January 1", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 107}
{"text": "ne was not decisively penetrated \ndownside until May, at the Bull Market Top.\nBETHLEHEM STEEL BS\n1945\nJULY AUGUST SEPTEMBERO CTOBER NOVEMBERD ECEMBER\n96\n88\n80\n76\nSales\n100’s\n125\n100\n75\n50\n25\n71 42 12 84 11 18 25 18 15 22 29 61 32 02 73 10 17 24 18 15 22 29\nFigure 14.7 Trend Channels in Bethlehem Steel in 1945. Prices burst out of the 92–98 Horizontal \nChannel (Rectangle) on the upside in January 1946 and went on to 114. A short-term trader might \nhave sold around 94–96 in early November (because of the uptrend break) and rebought at 99 in \nJanuary on the Rectangle breakout. (See discussion of Channels.)\n214 Technical Analysis of Stock Trends\nPAN AMERICAN AIRWAYSP N\n1945–1946\nDECEMBER JANUA RY FEBRUARY MARCHA PRIL MAYJ UNEJ ULYA UGUSTS EPTEMBER\n30\n28\n26\n24\n22\n20\n19\n18\n17\n16\n15\n14\nSales\n100’s\n500400\n300\n200\n100\nG\n24 1 8 15 22 29 5 12 19 26 2 9 16 23 2 9 16 23 30 6 13 20 27 4 11 18 25 1 8 15 22 29 6 13 20 27 53 10 17 24 31 7 14 21 28\nFigure 14.8 A 10-month downtrend, extraordinarily long and straight, which was nicely defined by \nDouble Basic Trendlines above the Price Channel and also by a double set of Return Lines below it. \nThe Major Top started with a strong One-Day Reversal on December 3, 1945 and worked out into a \nDescending Triangle that broke February 19, 1946. The Symmetrical Triangle beginning to appear \nin September 1946 also broke out downside.\nSOUTHERN PACIFICS X\n1945\nAPRILM AY JUNEJ ULYA UGUSTS EPTEMBER\nRL\nRL\nIUT\nIDT\n56\n52\n48\n44\n40\nSales\n100’s\n250\n200\n150\n100\n50\n71 42 12 85 12 19 26 29 16 23 30 71 42 12 84 11 18 25 18 15 22 29\nFigure 14.9 Well-marked Intermediate Basic Trendline and Return Lines in Southern Pacific, 1945. \nNote the Flags within Trend Channels—an up Flag in June and a down Flag in August. The Uptrend \nChannel, which began August 22, ran until February 1946.\n215Chapter fourteen: Trendli nes and Channels\nTo go back to first principles, granting that price advances trend up in more or less \nstraight lines, it follows that finding and drawing the lines that accurately define those \ntrends, they will serve two purposes:\n 1. When the trendline is broken (i.e., when prices drop down through it in decisive \nfashion), it signals the advance has run out. It calls time for the intermediate-term \ntrader to sell out that issue and to look for reinvestment opportunities elsewhere.\n 2. When a small Top Reversal Pattern forms on the chart of an issue well up and away \nfrom that issue’s Intermediate Up Trendline, so that there apparently is room for \nHUDSON MOTORS HT\n1945\nJULY AUGUSTS EPTEMBERO CTOBER NOVEMBER DECEMBER\n34\n32\n30\n28\n26\nSales\n100’s\n125\n100\n75\n50\n25\n71 42 12 84 11 18 25 18 15 22 29 61 32 02 73 10 17 24 18 15 22 29\nFigure 14.10 Note the extent by which prices failed to come down to their Return Line in late \nNovember measured the distance by which they advanced through and above the Basic Down \nTrendline in early December. This rule is stated in the discussion of Trend Channels.\nCONSOLIDATED VULTEE F\n1945\nJANUARYF EBRUARYM ARCH APRILM AY JUNE\n26\n24\n22\n20\n19\n18\nSales\n100’s\n250\n200\n150\n100\n50\n61 32 02 73 10 17 24 31 01 72 43 1714 21 28 51 21 92 6 29 16 23 30\nFigure 14.11 Six months of an Uptrend Channel that actually started to form in December 1943. It \nwas broken downside in August 1945.\n216 Technical Analysis of Stock Trends\nthe downside implications of the Reversal Formations to be carried out before the \ntrendline is violated, then the intermediate-trend trader may well decide to ignore \nthe small Reversal Pattern. He can hold on so long as the trendline holds.\nThe advantages of the first-named trendline function are obvious. Those of the \nsecond, although less obvious to the inexperienced, are equally important to the investor \nwho has learned it is an expensive practice to switch out of every holding as soon as it \nshows evidence of a Minor Setback, provided the chance of further Intermediate Advance \nstill exists.\nTo accomplish these purposes it is necessary, as we have said, to find and draw the line \nthat accurately defines the Intermediate Trend, and then to recognize when that line has \nbeen broken in decisive fashion. Our earlier quick review of how a trendline is constructed \ndid not attempt to cover these points thoroughly.\nTests of authority\nThe following are some of the tests that may be applied to judge the technical validity, or \nauthority, of an Up Trendline:\n 1. The greater the number of Bottoms that have developed at (or very near) a trendline in \nthe course of a series of Minor Up Waves, the greater the importance of that line in the \ntechnical sense. With each successive “test,” the significance of the line is increased. \nNASH – KELVINATOR NK 1946\nAPRILM AY JUNE JULY AUGUST SEPTEMBER\nMUT\nIDT\nRL\n24\n22\n20\n19\n18\n17\n16\nSales\n100’s\n125\n100\n75\n50\n25\n6 13 20 27 4 11 18 25 1 8 15 22 29 6 13 20 27 3 10 17 24 31 7 14 21 28\nFigure 14.12 The downtrend that started in June 1946 in Nash–Kelvinator, signaled by the break \nof both its Intermediate and Major Up Trendlines (MUT) on July 15, made a nice channel until \nSeptember. An Intermediate Down Trendline, drawn across the June 17 and July 1 highs, held for \nthe August rally. The Return Line, drawn parallel to it across the June 20 low, held in late July but \nremained intact for only a few days at the end of August. The August rally in both price and volume \npattern showed Bear Market characteristics. Compare this chart with Figure 8.25 and you will see \nthat a Major Double Top was signaled on July 23.\n217Chapter fourteen: Trendli nes and Channels\nA first and tentative Up Trendline can be drawn as soon as two Bottoms have formed, \nthe second higher than the first, but if prices move back to that line a third time, \nmake a third Bottom there, and start a renewed advance, then the validity of that line \nas a true definition of the trend has been confirmed by the action of the market. Should \na fourth Bottom later form on it, and prices move up away from it again, its value as a \ntrend criterion is very consid", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 108}
{"text": "ms have formed, \nthe second higher than the first, but if prices move back to that line a third time, \nmake a third Bottom there, and start a renewed advance, then the validity of that line \nas a true definition of the trend has been confirmed by the action of the market. Should \na fourth Bottom later form on it, and prices move up away from it again, its value as a \ntrend criterion is very considerably enhanced.\n 2. The length of the line, that is, the longer it has held without being penetrated downside \nby prices, the greater its technical significance. This principle, however, requires some \nqualification. If your trendline is drawn from two original Bottoms that are very \nclose together in time—say, less than a week apart—it is subject to error; it may be \ntoo steep or (more often) too flat. If the latter, prices may move away from it and stay \nhigh above it for a long time; they may then turn down and have declined well along \nin an Intermediate Correction before the trendline thus drawn is reached. But if the \ntrendline has been drawn from Bottoms that are far enough apart to have developed \nas independent wave components of the trend you are trying to define, with a good \nrally and “open water” between them, then it is more apt to be the true trendline. \nGreater weight should be given to the number of Bottoms that have formed on a \ntrendline (Test 1) than to its length alone (Test 2).\n 3. The angle of the trendline (to the horizontal) is also, to some degree, a criterion of its \nvalidity as a true delimiter of Intermediate Trend. A very steep line can easily be broken \nby a brief sideways Consolidation move—as, for example, by a compact Flag forming \non an advance of the “mast” type—only to have prices shoot up again in another \nextensive advance. Such steep lines are of little forecasting value to the technician. The \nflatter, more nearly horizontal the trendline, the more important it is technically and, \nin consequence, the greater the significance of any downside break through it.\nR . H . MACY MZ 1946\nAPRILM AY JUNE JULY AUGUST\nNL–2\nF– 1\nF–2\nF–3\nS\nSRL\nIUT\nH\n64\n60\n56\n52\n48\n44\nSales\n100’s\n50\n40\n30\n20\n10\n23 30 6 13 20 27 4 11 18 25 1 8 15 22 29 6 13 20 27 3 10 17 24 31 7 14\nFigure 14.13 The decline that took Macy down through an Intermediate Up Trendline (IUT) in June \n1946 turned out to be also the drop from the head of a “Flat-Shouldered” Head-and-Shoulders Top, \nwhich was, in turn, part of a larger Complex. The upper neckline was broken June 19 and the lower \non July 16. Note Pullbacks to each. F1, F2, and F3 are tentative Fan Lines. Prices were finally able to \nclear F3 in December, but by that time, a Primary Bear Market had been signaled, so the Fan Rule no \nlonger applied. Fans call the turn only on Secondary (Corrective) Moves.\n218 Technical Analysis of Stock Trends\nBut “steep,” as applied to stock trends, is a relative term and one that we defies exact \ndefinition. Experience, which can only be gained by studying many charts and by actually \nbuilding and working with them over a period of many months, brings an almost intuitive \nability to distinguish between a trendline that is “too steep to hold” and one whose angle of \nrise is reasonable and should be maintained until such time as the trend is actually reversed \nfrom Intermediate Up to Intermediate Down. Trend slopes will vary from stock to stock \naccording to their characteristic market habits. They will vary also according to the stages \nof the Primary Cycle—tending to become somewhat steeper in its later phases. The more \nchart history you have on any particular issue in which you are interested, the better able \nyou will be to judge its present trend. (The foregoing statement, we might remark, applies to \nthe interpretation of most other technical patterns and phenomena as well as to trendlines.)\nARKANSAS BEST ABZ1 987\nJANUARY FEBRUARY MARCHA PRIL MAYJ UNEJ ULY AUGUST\nS\nH\nF1\nF2\nF3\nS\nNL\n36\n34\n32\n30\n28\n26\n24\n22\n20\n19\n18\n17\n16\n15\n14\n13\n12\n11\nSales\n100’s\n1000800600\n400200\n7 24 31 7 14 21 28 7 14 21 28 4 11 18 25 2 9 16 23 30 6 13 20 27 4 11 18 25 1 8 15\nXD.0 X9D .09\nARKANSAS BEST\n30\n80 81 82 83 84 85 86 87\n25\n20\n15\n10\n5\nFigure 14.14 “ ABZ” dropped sharply following its late January high, capping off a nearly \nuninterrupted two-year rally. But despite the rapidity and severity of the Pullback, it was, in fact, a \npicture-perfect reaction, which stopped just above excellent long-term Support at the 1983 high after \nretracing almost exactly 50% from its January peak. Not only is the reaction a classic, but so, too, is \nthe Fan Line development, which, when coupled with the recently completed Head-and-Shoulders \nBottom, suggests “ ABZ” has reversed its short-term downtrend.\n219Chapter fourteen: Trendli nes and Channels\nOne clue to relative steepness is afforded to those who employ the TEKNIPLAT \nsemilogarithmic chart sheet, which has been used for most of the illustrations in this \nbook. When projected on this scale, Intermediate Uptrends on the daily charts, in the great \nmajority of issues selling in the 10 to 50 range, rise at an angle of approximately 30 degrees \nto the horizontal. Some will be a trifle flatter, some a trifle steeper, but it is surprising to see \nBARBER ASPHALTA S\n1946\nJANUARYF EBRUARYM ARCH APRILM AY JUNE\nXD .25C\nXD .25CF 2F 1\nF 3\n56\n52\n48\n44\n40\n38\n36\nSales\n100’s\n50\n40\n30\n20\n10\n51 21 92 62 91 62 32 91 62 33 06 13 20 27 41 11 82 5 18 15 22 29\nFigure 14.15 A valid application of the Three-Fan Principle. Note prices after they pushed up \nthrough F1 in March fell back to it but did not repenetrate it. When F2 was broken in late March, \nprices came back to it at the end of April but did not go below it. F3 was surmounted in May. This \nwas a Bull Market Reaction; “ AS” made its final Top above 64 in August. The March–May pattern \nmight be called a weak Double Bottom.\nDELAWARE & HUDSON DH\n1944\nJULY AUGUSTS EPTEMBERO CTOBER NOVEMBER DECEMBER\n38\n36\n34\n32\n30\nSales\n100’s\n125\n100\n75\n50\n25\n81 52 22 951 21 92 62", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 109}
{"text": "as broken in late March, \nprices came back to it at the end of April but did not go below it. F3 was surmounted in May. This \nwas a Bull Market Reaction; “ AS” made its final Top above 64 in August. The March–May pattern \nmight be called a weak Double Bottom.\nDELAWARE & HUDSON DH\n1944\nJULY AUGUSTS EPTEMBERO CTOBER NOVEMBER DECEMBER\n38\n36\n34\n32\n30\nSales\n100’s\n125\n100\n75\n50\n25\n81 52 22 951 21 92 62 91 62 33 0714 21 28 41 11 82 5 29 16 23 30\nFigure 14.16 Try the Three-Fan Principle on this chart of the late 1944 Bull Market Reaction out \nof a Symmetrical Triangle in “DH.” F1 should be drawn from the August 30 high down across the \nSeptember 12 closing. F2 is already marked on the chart but not labeled. F3 would extend from \nAugust 30 across the Rally Top of November 9. It was surmounted on increased volume November \n21. The mid-September to November price pattern looked at first like a Descending Triangle, but \nvolume began to rise in October.\n220 Technical Analysis of Stock Trends\nhow often the trendline falls very close to the 30-degree slope in stocks of average volatility \nand activity. Thin, highly speculative issues and heavy investment stocks offer exceptions, \nthe former usually steeper and the latter flatter. The semilogarithmic scale has the virtue \nof reducing all movements, regardless of price level, to a ratio or percentage basis. On a \nstraight arithmetic scale, the trendline will ordinarily be steeper on a stock trading in the \n50 range, for example, than on an issue selling around 15.\nOn weekly charts employing the same price scale, the angle of Intermediate Advance \nwill be much steeper than on the daily plotting. Different scaling will produce different \nangles. It is pure happenstance that TEKNIPLAT sheets tend to produce the 30-degree \nascending line.\nUnfortunately, TEKNIPLAT paper is no longer produced but a comparable analysis is \neasily produced with software from packages and online.\nValidity of penetration\nWe have these three criteria, then, for appraising the authority or accuracy of an Intermediate \nUp Trendline: (1) the number of times it has been “tested” or contacted without breaking, \nBUCYRUS ERIE CO.B Y 1984\nMARCHA PRIL MAY JUNE JULY AUGUST SEPTEMBER OCTOBERN OVEMBER DECEMBER\nF1\nF2\nF3\n30\n28\n26\n24\n22\n20\n19\n18\n17\n16\n15\n14\n13\n12\n11\nSales\n100’s\n1000800600\n400\n200\n10479\n7621\n17 24 31 7 14 21 28 5 12 19 26 2 9 16 23 30 7 14 21 28 4 11 18 25 1 8 15 22 29 6 13 20 27 3 10 17 24 1 8 15 22 29\nXD. 11 XD. 11\nFigure 14.17 In a downtrend throughout the first half, “BY” gave back a large part of its 1983 rally \nby mid-summer. Nevertheless, the 1982 low held the Bears in check, and over the following several \nmonths, this issue etched out an excellent Fan Pattern. Fan Line 1 gave way in mid-September on a \nhigh-volume penetration. The advance quickly lost its momentum, but old Resistance–new Support \ncontained the Pullback perfectly, setting the stage for a rally through Fan Line 2. This occurred in \nmid-November on good volume. Following a five-week correction, “BY” charged through Fan Line \n3 on the best volume of the three breakouts.\n221Chapter fourteen: Trendli nes and Channels\n(2) its length or duration, and (3) its angle of ascent. Given a trendline that, by the application \nof one or more of these criteria (preferably by at least two of them), appears to be a reasonably \naccurate delimiter of the trend, our next problem is to determine when it has been finally \nand definitely broken.\nAgain, we can set up three tests or criteria, two of which are practically identical with \nthe rules laid down in earlier chapters for determining decisive breakouts from Reversal or \nConsolidation Formations. The first is extent of penetration . To be decisive, prices must not \nonly push through the line but also close beyond it by a margin equal to about 3% of the \nstock’s price. This does not need to be accomplished in a single day, although it often is. The \n3% penetration may come as a result of two or three days of gradual decline.\nThe second is volume of trading . We saw how activity should always be expected to \nrise notably on a genuine upside breakout from an Area Pattern but need not increase \nto confirm a downside break. We have seen how, in many cases, volume does not show \nmuch increase on the first day of a down-break from Descending Triangles, for example, \nbut usually it picks up rapidly as the decline proceeds. In our present discussion, we are \ndealing with Up Trendlines, and their penetration is, therefore, analogous to a downside \nbreakout. We should expect the same rules to apply, and in general, they do. Given a close \nbeyond the line by a price margin of 3%, it is not necessary for volume to have expanded \nmuch at that point to confirm the validity of the penetration.\nThe fact is, however, that the breaking of an Intermediate Up Trendline, much more \noften than not, is attended by some visible intensification of trading activity. To that extent, \nthen, an increase in volume may be regarded as confirmation of a decisive penetration. It is \na particularly useful adjunct in borderline cases. If, for example, prices start to decline from \na point somewhat above the trendline, move down through it on conspicuously expanding \nturnover, and close beyond it, say, only 2% of the price but at or near the bottom of the day’s \nrange, then our 3% margin rule has not been satisfied, but the lesser margin plus the volume \naction may be construed as decisive.\nBeware, however, and do not be stampeded into a hasty commitment by the shakeout \nmove that cracks down through a trendline with a great flurry of activity—perhaps several \nminutes of late tape—and then turns up again to close the day back above the trend or at \nleast very close to it. This may very well be—in fact, usually is—a false move so far as that \nparticular moment is concerned. But watch the next few days’ performance very closely; the \ntechnical situation is evidently critical, or else a shakeout could not have been", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 110}
{"text": "reat flurry of activity—perhaps several \nminutes of late tape—and then turns up again to close the day back above the trend or at \nleast very close to it. This may very well be—in fact, usually is—a false move so far as that \nparticular moment is concerned. But watch the next few days’ performance very closely; the \ntechnical situation is evidently critical, or else a shakeout could not have been easily staged.\nThe third test is also one that applies particularly to breaks that are borderline so far \nas margin of penetration is concerned. Suppose a stock that is quoted in the neighborhood \nof 40 declines through a well-established Intermediate Up Trendline and closes 1 or 1 1/ 4 \npoints below it—a margin that is only slightly less than our specified 3%—without much, \nif any, enlargement in trading volume. Suppose it fluctuates there for a day or two in a dull \nand narrow market and then starts to rally; if there is no pickup in activity on this recovery \nmove—if prices simply edge up feebly to the underside of the trendline and tend to “round \nover” there without being able to close clearly above it—then the situation is indeed critical, \nand the slightest sign of renewed selling pressure may be taken as a signal that the uptrend \nhas been decisively broken.\nSuch a return move as we have described in the preceding paragraph is known as \na Throwback or Pullback. We previously described analogous developments that follow \nbreakouts from Head-and-Shoulders and other patterns, and we will have more to say \nabout them in connection with trendlines later on.\nThe three tests we have been discussing, which help to establish the validity of a \ntrendline penetration, cannot, unfortunately, be applied inflexibly and without a modicum \n222 Technical Analysis of Stock Trends\nof judgment. The majority of Intermediate Trendlines can hardly be said to possess the \nprecision of pattern boundary lines, and even in the latter, some leeway must be allowed. \nThere are exceptions, as we have taken occasion to remark several times before, to every \ntechnical rule of price action, but judgment in the establishing of significant trendlines and \nin interpreting their penetrations does come with experience.\nAmendment of Trendlines\nWhen a trendline is broken by a margin less than decisive, and prices subsequently rally \nback up through it again, doubt naturally arises as to the continued authority of the original \nline. Should it be discarded, revised, or allowed to stand as is?\nHere again, judgment and experience must be called into play, but a few general principles \nare helpful in deciding. If the original trendlines depended on only 2 points, that is, on the \nfirst two Bottoms across which it was projected and the indecisive penetration occurred when \nprices returned to it for the third time, then the line had better be redrawn across the original \nfirst and the new third Bottoms. (Of course, you will not do this until prices have moved up \nfrom the third Bottom point and it has become clearly established as a Minor Bottom.) Or, \nyou may find in such cases that a new line drawn across the second and third Bottoms works \nbetter; if the first Bottom was a Reversal Day with its closing level well above the low of its \nrange, you may find this new line, when extended back, strikes just about at that closing level.\nIf, on the other hand, the original trendline has been “tested” one or more times after \nit was drawn—if, that is, a third and perhaps a fourth Bottom have formed on it without \npenetrating it and have thus “confirmed” it—then the subsequent indecisive penetration \nmay be disregarded and the original line considered to be still in effect.\nAn intraday break through an established trendline that, however, does not result in \nprices closing beyond the line may be disregarded and the line left as is. In fact, as has \nalready been suggested, the closing prices frequently make a better trendline than the \nextreme intraday lows of successive Bottoms, which is most apt to be true with “thin” \nstocks subject to erratic swings. A bit of experimenting with different lines often pays. A \nthin, transparent ruler is especially useful for trendline study.\nThere is another type of price action that may require redrawing a trendline. Sometimes, \nafter a line has been projected up across the first two Minor Bottoms in an advancing trend, \na third Minor Bottom will form, not on that line, but well above it. In such cases, let the \noriginal line stand, but draw in a new one across the second and third Bottom points, and \nwatch developments. If the rally from the third Bottom peters out quickly, and the new \ntrendline, as a consequence, is soon broken, then the original trendline is probably the \ncorrect one. But, if the third Bottom turns out to be a “strong” one, and the new line stands \nup well for several weeks (and if it was not, patently, too steep to begin with), then the old \nline may be abandoned and the new one regarded as the better trend definer.\nDouble Trendlines and trend ranges\nIn the course of your “cutting and trying” in an effort to fit a good line to an Intermediate \nUptrend, you may find that two parallel lines, perhaps a point or so apart in a stock selling \nin the 30s, will define the true trend pattern much better than any single line that can be \ndrawn. Sharp Bottoms and shakeout thrusts in such cases will often fall along the outer \nor lower line, while the duller, more rounded reactions will stop at or near the upper or \ninner line. Or the two lines will mark off a range somewhere within which successive Minor \nDown Waves tend to halt and reverse.\n223Chapter fourteen: Trendli nes and Channels\nSuch Double Trendlines are really plentiful, although most chart technicians seem \nto be quite unaware of them. It pays to develop an eye for them—to watch constantly for \ntrends to which they can be applied. They will clear up many situations in which attempts \nto find a single critical line lead only to frustr", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 111}
{"text": "or \nDown Waves tend to halt and reverse.\n223Chapter fourteen: Trendli nes and Channels\nSuch Double Trendlines are really plentiful, although most chart technicians seem \nto be quite unaware of them. It pays to develop an eye for them—to watch constantly for \ntrends to which they can be applied. They will clear up many situations in which attempts \nto find a single critical line lead only to frustration and to your finally giving up in disgust.\nTrends that you find are best defined by Double Trendlines (or by a very Broad \nTrendline, if you prefer) cannot be regarded as having ended until the outer, lower line \nhas been decisively penetrated. In that connection, note what we said at the beginning of \nthis topic: sharp, shakeout Bottoms tend to fall on the outer line. The recoveries from such \nBottoms are usually just as sharp, and prices, therefore, rally back above the upper, inner \nline quickly. Warning of an impending break in the trend is given when prices come down \nto the outer line steadily, rather than by the quick “shake” type of reaction, and then have \ndifficulty rallying back through the inner line. Watch such developments closely. A break \ndown may not follow; the situation may still be “saved,” but the chances are that the trend \nis near its end.\nTrend Channels\nAt the start of this trend study, we applied the term Basic Trendline to the line that slopes \nup across the Wave Bottoms in an advance and to the line that slopes down across the \nWave Tops in a decline. Furthermore, we noted the opposite Reversal Points, that is, the \nwave crests in an advance and the wave troughs in a decline, were, as a rule, less clearly \ndelimited. That is one of the reasons why all of our discussion up to this point has been \ndevoted to Basic Trendlines. Another reason is that the technician’s most urgent task \nis to determine when a trend has run out, and for that purpose, the Basic Line is all \nimportant.\nIn a fair share of normal trends, however, the Minor Waves are sufficiently regular to \nbe defined at their other extremes by another line. That is, the Tops of the rallies composing \nan Intermediate Advance sometimes develop along a line that is approximately parallel to \nthe Basic Trendline projected along their Bottoms. This parallel might be called the Return \nLine because it marks the zone where reactions (return moves against the prevailing trend) \noriginate. The area between Basic Trendline and Return Line is the Trend Channel.\nNicely defined Trend Channels appear most often in actively traded stocks of large \noutstanding issue—least often in the less popular and the relatively thin equities that \nreceive only sporadic attention from investors. The value of the Trend Channel concept \nfor the technical trader would hardly seem to require extended comment here; its tactical \nutilization is discussed in the second half of this book.\nIts greatest utility, however, is not what usually appeals to the beginner when he first \nmakes its acquaintance, namely, the determination of good profit-taking levels. Experienced \ntechnicians find it more helpful in a negative sense. Thus, once a Trend Channel appears to \nhave become well established, any failure of a rally to reach the Return Line (top parallel \nof the channel in an Intermediate Advance) is taken as a sign of deterioration in the trend. \nFurthermore, the margin by which a rally fails to reach the Return Line (before turning \ndown) frequently equals the margin by which the Basic Trendline is penetrated by the \nensuing decline before a halt or Throwback in the latter occurs.\nBy the same token, given an established Trend Channel, when a reaction from the \nReturn Line fails to carry prices all the way back to the Basic Trendline but bottoms out \nsomewhere above it, the advance from that Bottom will usually push up out of the channel \non the top side (through the Return Line) by a margin approximately equal to the margin \nby which the reaction failed to reach the bottom of the channel (Basic Trendline).\n224 Technical Analysis of Stock Trends\nExperimental Lines\nYour experienced technician, in fact, is constantly drawing trendlines of all sorts—Minor, \nIntermediate, and Major—on his charts. He will first very lightly pencil them in wherever \nhe can find an excuse to draw one. Many will quickly prove to be of no significance; those \nhe may erase. Others will “stand out,” showing evidence of technical authority, which he \nwill make heavier or color, as suggested later on. He will be constantly on the watch for \nDouble Trendlines and will draw tentative Return Lines to mark off possible channels at \nevery opportunity. As soon as he has what appears to be a Basic Up Trendline, for example \nprojected from two Bottoms, he will go back to the Top of the rally between those two \nBottoms and draw from that parallel to the Bottom Trendline. If the next rally comes up \nto that parallel, stops there and turns down, he has a probable Return Line and channel \nestablished.\nThis practice of drawing in and experimenting with every trendline, which the price \naction permits or suggests, is earnestly recommended to the reader of this book, particularly \nif the technical approach is new to him. It is the quickest way—in fact, the only way—\nof acquiring the experience we have stressed as essential to recognition, judgment, and \nutilization of trendline implications in trading.\nPerhaps we should add here one “don’t” for the beginner. You will have noted we have \nnot mentioned a line projected from a Bottom to a Top, or vice versa. Trendlines are always \ndrawn across two or more Bottoms, or two or more Tops. They should never be drawn to \ncross through the price track. (Prices may cross their extensions later, but this should not \nhave happened at the time the lines are first drawn.) If you did not know better, you might, \nfor example, put in a line from the Top of the left shoulder to the Top of the right shoulder \nof a Head-and-Shoulders Formation, thus cutting thro", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 112}
{"text": "ore Bottoms, or two or more Tops. They should never be drawn to \ncross through the price track. (Prices may cross their extensions later, but this should not \nhave happened at the time the lines are first drawn.) If you did not know better, you might, \nfor example, put in a line from the Top of the left shoulder to the Top of the right shoulder \nof a Head-and-Shoulders Formation, thus cutting through the head, but such a line would \nhave no technical validity.\nConsequences of Trendline penetration: Throwbacks\nAt the beginning of this chapter, we mentioned the probable consequences of a breakdown \nthrough an Intermediate Up Trendline. To repeat, if an Intermediate Up Trendline has \nbeen constructed, has qualified as technically significant by the tests previously discussed, \nand has then been decisively broken, the inference is the uptrend is finished. And the \nconsequences to be expected are either a full Intermediate Recession or a period of \nConsolidation (usually becoming a recognizable Area Formation). Technical indications of \nother sorts may be seen on the chart, which will suggest which of these two consequences \nis the more likely. In either event, the Intermediate Trend trader will certainly look twice \nbefore attempting to find further profit in that particular situation at that time.\nA more immediate but less important probable consequence of trendline penetration \nhas also been mentioned—the “Pullback.” Pullbacks that follow breakouts from Reversal \nand Consolidation Formations have been described in our earlier studies of those price \npatterns. It is easy to understand why a rally that develops after prices break out through \nthe lower boundary of a Rectangle, for example, will be stopped when it gets back to that \nboundary by the Resistance (supply) now residing there. Support–Resistance Theory \nenables us to rationalize most of the Throwback moves that occur after prices have broken \nout of other types of Reversal or Consolidation Areas. The Pullbacks that follow trendline \npenetrations cannot be thus rationalized; yet they occur much more frequently, and they \nappear to be stopped much more exactly at the old trendline level than is the case with Area \nFormations. Why should prices, after they have thrust down through a rising trendline, \n225Chapter fourteen: Trendlin es and Channels\nperhaps for several points, turn back up and ascend to or very near the old trendline, stop \nthere, and then go off in renewed decline? The Top of that Pullback Rally may be 2 or 3 \npoints above the original penetration level, because the trendline is sloping up all the \ntime; nevertheless, there it stops, falters, and gives up. No one knows why supply should \novercome demand or why Resistance should be so plainly evident at that particular point \nwhose level is determined by two variants—the slope of the line and the time it is reached.\nYou cannot reasonably expect a Pullback Rally to climb all the way back to a trendline \nthat is ascending at a very steep angle, which may mean the attainment of a new high price \nfor the entire Intermediate Uptrend; yet even that happens in more than just a few cases. \nWhat can be counted on in the great majority of typical Up Trendlines (those that slant up \nat a normal or fairly flat angle) is that after the line has been broken, a Pullback Rally will \ndevelop, either in a few days or in the usual Minor Wave tempo and will carry prices back \nup to the projected trendline.\nThrowbacks do not occur, it should be noted, when prices erupt through a Return \nLine, that is, break out of the top side of an Uptrend Channel. Or, more correctly stated, the \nReturn Line does not function as a Support against a Throwback after prices have gone \nthrough it. An unusually strong upswing in a Rising Trend Channel may carry beyond the \ntop of the Channel as defined by its Return Line, but the next reaction may go right back \ndown through it without evidencing any hesitation at its level.\nThe Throwback is one of the mysteries in trendline price action to which we alluded at \nthe outset. The technical analyst who studies trends and trendlines over any considerable \nperiod will discover many other even more mysterious phenomena that cannot find space \nin this treatise, as no way has yet been found to put them to practical use in trading and \ninvesting. They are extraordinarily interesting in retrospect, but they are not subject to \nforecast.\nIntermediate Downtrends\nIn all of the foregoing discussion of trends and trendlines, we have concentrated on uptrends; \nwe have, in fact, had in mind specifically Intermediate Advances in the direction of the \nPrimary Trend, that is, within a Major Bull Market. Those particular trends are most apt \nto develop “normally” and are most amenable to trendline definition. Intermediate Down \nMoves in a Major Bear Market may well be taken up next. Before discussing the respects in \nwhich they differ from Primary Advances, recall that the Basic Trendline on a down-move \nis the line projected across the Tops of the rallies within it. The Trend Channel will be to \nthe left of that trendline and below it on the chart. The Return Line (if any) will define the \nBottom of the channel.\nIntermediate (Bear Market) Downtrends are far less regular and uniform in their \ndevelopment than Bull Market Advances. Their angles of decline are characteristically \nsteeper, and this is particularly true, of course, of the Panic Moves typical of the second \nphase of a Bear Market, as in our discussion of Major Trends in Chapter 3. Moreover, prices \nhave a tendency to drop away from any trendline drawn across the first two Rally Tops; \nin other words, to curve down or accelerate as the move proceeds. This shows plainly on \nan arithmetically scaled chart and even more conspicuously on a semilogarithmic sheet.\nThe practical results of this down-curving tendency are not so important, insofar as it \ndelays the penetration of the original trendline and, hence, the giving of a s", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 113}
{"text": "om any trendline drawn across the first two Rally Tops; \nin other words, to curve down or accelerate as the move proceeds. This shows plainly on \nan arithmetically scaled chart and even more conspicuously on a semilogarithmic sheet.\nThe practical results of this down-curving tendency are not so important, insofar as it \ndelays the penetration of the original trendline and, hence, the giving of a signal of trend \nchange. The fact is prices tend to thrash around for some time, making a base at the Bottom \nof one of these precipitous declines. In so doing, they work out sideways on the chart and \nthe trend frequently does not turn up visibly until after the trendline has finally been \n226 Technical Analysis of Stock Trends\nreached and broken through on the upside after all. Thus, there is justification for drawing \ndown trendlines and keeping them in view even though they may seem, for some time, \nsimply to travel off into space with no apparent relevance to the actual trend of prices.\nIt naturally follows from the above that Return Lines on most Bear Market Declines \nhave little practical utility; they are, more often than not, very quickly broken downside. \nGood channels are hard to find.\nHowever, and this is of considerable practical importance, the very last Intermediate \nDownswing in a Major Bear Market is the last Primary Move that leads to the final, long-\nterm Bottom, which is usually cleaner, more regular, and less precipitous—in other words, \nit is a more nearly normal trend of the sort we expect to find in most Intermediate Advances \nin a Bull Market (except that it slants down instead of up). This interesting habit is, as we \nsaid, of practical importance. Knowing it, we have an additional and very useful clue to \nthe end of a Bear Market.\nWhen, after a Major Bear Trend has proceeded for some time and distance, and has \nexperienced at least one Panic Sell-Off, it then goes off in another but less active and more \norderly decline, and this decline develops and follows a good trendline. Watch it closely \nthough. If this Intermediate holds to its steady and not-too-steep downward course—if \nits trendline is contacted several times by Minor Rallies or it produces a fairly consistent \nchannel and prices do not “fall out of bed” down through its parallel Return Line, then \nthe eventual upside penetration of this trendline may well signal a Major Turn, that is, the \ninception of a new Bull Market.\nCorrective trends: the Fan Principle\nIn this study of Intermediate Trendlines, we have left to be taken up last the subject of \nSecondary or Corrective Trends. These are the Intermediate Declines that interrupt the \nPrimary Advances in a Bull Market, and the Intermediate Recoveries that alternate with \nPrimary Declines in Bear Markets.\nIntermediate Reactions against the Major Direction of the market take a variety of \nforms. Sometimes, as we have seen in our earlier study of chart patterns, they run out \ninto Consolidation Formations—Triangles, Rectangles, and so on—in which the net price \nreaction is of minor consequence, but time is consumed in backing and filling before the \nPrimary Trend can be resumed. In such cases, there is no basis for drawing an Intermediate \nTrendline, nor is one needed for any practical purpose.\nAt the other extreme, so to speak, we find Corrective Swings that develop as a more or \nless orderly straight-line return of moderate slope to the nearest good Intermediate Support \nor Resistance Level, retracing perhaps a third to a half of the preceding Primary Swing. \nThese reactions produce good trendlines, as a rule, and the eventual penetration of their \ntrendlines is a good technical signal of Reversal. Intermediate Corrections clearly of this \ntype are relatively rare.\nA third form taken by Intermediate Corrections is nearly as common as the first named \nabove (Consolidation Pattern) and much more common on the charts than the second. In a \nBull Market, it starts with a sharp reaction that proceeds for several days—perhaps for as \nmuch as two weeks—producing a steep Minor Trendline. This line is broken upside by a \nquick Minor Rally, after which prices slide off again in a duller and less precipitate trend. \nA second Minor Trendline may now be drawn from the original high point across the Top \nof the upthrust that broke the first trend. This second trendline is broken by another partial \nrecovery thrust, and a third and still duller and flatter sell-off ensues. A third trendline \ncan now be drawn from the original high across the Top of the second upthrust. The whole \n227Chapter fourteen: Trendli nes and Channels\nmove, by this time, has taken roughly and irregularly a “Saucering-out” form. The three \ntrendlines drawn from the original Reversal points from which the Corrective Decline \nstarted, each at a flatter angle than its predecessor, are known as Fan Lines. The rule is when \nthe third Fan Line is broken upside, the low of the Intermediate Correction has been seen.\nThere are exceptions to this rule—as there are to every so-called rule of technical chart \nanalysis. Rarely, a correction of this type will go on to make another dip to a new low for \nthe whole corrective move before prices really start to round up again. But the Three-Fan \nPrinciple works in the great majority of cases. Moreover, it offers the trader an opportunity \nto take a position at a point at which he can logically employ a very near stop order and, \nthus, limit his loss to a controlled amount if the rule does not work out.\nIt is interesting to note that prices consistently throw back in these movements to the \npreceding Fan Line after each upthrust. The new Primary Swing, once the low has been \npassed, usually starts slowly and carries out for a time the Saucer picture.\nThe Three-Fan Rule works just as well in calling the turn on Intermediate Recoveries in \na Bear Market, the majority of which take the rounding form that is adapted to its use. Note, \nhowever, that the Fan Principle is normally", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 114}
{"text": "s to the \npreceding Fan Line after each upthrust. The new Primary Swing, once the low has been \npassed, usually starts slowly and carries out for a time the Saucer picture.\nThe Three-Fan Rule works just as well in calling the turn on Intermediate Recoveries in \na Bear Market, the majority of which take the rounding form that is adapted to its use. Note, \nhowever, that the Fan Principle is normally applied only to corrective moves, that is, to \ndetermine the end of Intermediate Reactions in a Bull Market and the end of Intermediate \nRecoveries in a Bear Market.\nMajor Trendlines will be outlined in the following chapter, but before we leave this \nstudy of Intermediate Trends, it will be well to state again that the practical application \nof trendlines in actual trading requires experience and the good judgment to be attained \nonly therefrom. Some technical analysts depend largely on trendline studies, few attempt \nto use trendlines almost exclusively, but the majority have found they are best employed \nas an adjunct to other technical data.\nTechnical analysis of a stock chart is something like putting together a jigsaw \npuzzle. There are many items to be considered, among them volume, pattern, and the \nmeasurements derived therefrom, Support and Resistance Levels, trendlines, and general \nmarket prospects—and all fit into place to get the complete picture.\n\n229\nchapter fifteen\nMajor Trendlines\nIn the preceding chapter on Intermediate Trendlines, mention was made of the distinctive \neffects produced by arithmetic and semilogarithmic plotting, but it was noted that these \ndifferences were unimportant in connection with Minor Trends or Intermediate Trends of \naverage duration. When we come to Major Trends, however, we find the difference does \nbecome important. Major Trendlines are illustrated by Figures 15.1 through 15.20.\nIf you will examine a large collection of arithmetically scaled monthly charts covering \n10 years or more of market history, you will quickly see that Bull Trends, in the great \nmajority of actively traded, more or less speculative common stocks, tend to accelerate. They \nstart slowly and push up at a steeper and steeper angle as they approach a Major Top. This \nup-curving path takes them farther and farther away from any straight trendline drawn \nfrom two Bottom points in the first, slow-moving stage of advance. As a consequence, they \ntop out and have gone down a long way in a recession that may be of Major consequence \nbefore their straight trendline is again touched.\nMany of the stocks that show such typical accelerating curves in their advance (Major) \nTrends on arithmetic paper produce straight trends on a logarithmic scale. As a consequence, \ntheir logarithmic Major Trendlines are broken more quickly, and usually at a higher price \nlevel, when at last their trends do top out and turn down. In the case of such stocks, then, \nthe logarithmic scale gives a better trend signal.\nBut there are other stocks—mostly of the more substantial investment or semi-\ninvestment type—that tend to advance in straight arithmetic trends. Consolidated Edison, \nGeneral Motors, and Libbey–Owens–Ford Glass are examples. (The trends of these on a \nlogarithmic scale show a decelerating curve.) Still a third class, made up largely of high-\ngrade preferred stocks, produces a rounding over or decelerating Bull Trendline even on \nthe arithmetic scale. And, finally, there are a number of issues whose normal Bull Market \nTrendlines fall somewhere between our first two types—that is, they curve up away from \na straight path on the arithmetic scale, but curve over to the right (breaking through a \nstraight line) on the logarithmic scale. (EN: Fortunately, in this age of computers and easily \nprocessed data, there is analytical software that allows the analyst to instantaneously switch between \nthe scales. Desktop packages are available[(see Appendix B, Resources] and a number of internet sites \nhave these capabilities.)\nAll of which, the reader, at this point, no doubt finds most discouraging. Some stocks \ndo this and some stocks do that, but what help is there for us in such a mix-up? The answer \nlies in studying the history of each issue in which you may be interested. Most stocks do \nnot change their habits and their technical characteristics much from one Bull and Bear \ncycle to the next. An issue, like General Motors, that produces a straight-line Bull Trend \non an arithmetic chart in one Primary Upswing is likely to repeat that performance in \nthe next. EN10: GM after the fall will, we suspect, retain its previous habits, but that remains to \nbe seen.\nAs a matter of interest, stocks do sometimes change over a long period of years. \nCompanies that were regarded as extremely speculative when their shares were first listed \n230 Technical Analysis of Stock Trends\nGENERAL MOTORS GM\n80\n60\n40\n20\nSales\n100’s\n4000\n2000\n1938 1939 1940 1941 1942 1943 1944 1945 1946\nFigure 15.1 The straight-line Bull Market Trend of General Motors on an arithmetic monthly chart: \n1941 low, 28 5/8; 1946 high, 80 3/8.\nHUDSON MOTORS HT\n40\n30\n20\n10\nSales\n100’s\n1000\n500\n1938 1939 1940 1941 1942 1943 1944 1945 1946\nFigure 15.2 The up-curving trend of a speculative motors stock, Hudson Motors. Compare this with \n“GM”: 1941 low, 2 5/8; 1946 high, 34.\n231Chapter fifteen: Major Tre ndlines\nCURTIS PUBLISHING $ 7 PFD. CPC Pr160\n120\n80\n40\nSales\n100’s\n100\n50\n1938 1939 1940 1941 1942 1943 1944 1945 1946\nFigure 15.3 Typical decurving Major Bull Trend of a high-grade preferred stock. This is Curtis \nPublishing $7 .00 Preferred: 1942 low, 12; 1945 high, 154.\nCURTIS PUBLISHING COM. CPC\n30\n20\n10\nSale\ns\n100’s\n1200\n1000\n1938 1939 1940 1941 1942 1943 1944 1945 1946\nFigure 15.4 The accelerating uptrend of the common stock of the same publishing company: 1942 \nlow, 3/8; 1946 high, 26.\n232 Technical Analysis of Stock Trends\nCOMMONWEALTH EDISON CWE\n40\n30\n20\nSales\n100’s\n800\n400\n1938 1939 1940 1941 1942 1943 1944 1945 1946\nFigure 15.5 A conservative i", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 115}
{"text": "high, 154.\nCURTIS PUBLISHING COM. CPC\n30\n20\n10\nSale\ns\n100’s\n1200\n1000\n1938 1939 1940 1941 1942 1943 1944 1945 1946\nFigure 15.4 The accelerating uptrend of the common stock of the same publishing company: 1942 \nlow, 3/8; 1946 high, 26.\n232 Technical Analysis of Stock Trends\nCOMMONWEALTH EDISON CWE\n40\n30\n20\nSales\n100’s\n800\n400\n1938 1939 1940 1941 1942 1943 1944 1945 1946\nFigure 15.5 A conservative investment-type utility stock makes a straight-line Major Bull Trend. \nThis is Commonwealth Edison: 1942 low, 17 3/8; 1946 high, 36 1/8. Leverage is an important factor \nin trends.\nINTERNATIONAL HYDRO-ELECTRIC IH\n15\n10\n5\nSales\n100’s\n400\n200\n1938 1939 1940 1941 1942 1943 1944 1945 1946\nFigure 15.6 The up-curving trend of a low-priced “junior” utility, International Hydro-Electric: 1942 \nlow, 1/4; 1946 high, 15 1/2.\n233Chapter fifteen: Major Tre ndlines\nHOUSTON OILH O\n30\n20\n10\nSales\n100’s\n1000\n500\n1938 1939 1940 1941 1942 1943 1944 1945 1946\nFigure 15.7 A speculative oil stock, Houston Oil: 1942 low, 2 1/4; 1946 high, 30. Compare this picture \nwith “SOH” in Figure 5.8.\nSTANDARD OIL OF OHIO SOH\n30\n20\n10\nSales\n100’s\n200\n100\n1938 1939 1940 1941 1942 1943 1944 1945 1946\nFigure 15.8 Straight-line uptrends in an investment oil, Standard Oil of Ohio: 1942 low, 10 1/8; 1946 \nhigh, 30. Note: trendline unbroken until 1948.\n234 Technical Analysis of Stock Trends\nREPUBLIC STEEL RS\n40\n30\n20\n10\n1938 1939 1940 1941 1942 1943 1944 1945 1946\nFigure 15.9 Steel stocks have the speculative or accelerating type of Primary Uptrend, Republic \nSteel: 1942 low, 13 3/8; 1946 high, 40 7 /8.\nAMERICAN CAR & FOUNDRY AF\n80\n60\n40\n20\nSales\n100’s\n400\n200\n1938 1939 1940 1941 1942 1943 1944 1945 1946\nFigure 15.10 The normal Major Bull Trend of heavy industrial issues is up-curving, American Car & \nFoundry: 1942 low, 20; 1946 high, 72 3/8.\n235Chapter fifteen: Major Tre ndlines\nCELOTEX CORP. CLO\n40\n30\n20\n10\nSales\n100’s\n400\n200\n1938 1939 1940 1941 1942 1943 1944 1945 1946\n2 for 1\nFigure 15.11 A low-priced building stock, Celotex Corporation: 1942 low, 6 1/8; 1946 high, 38 1/8.\nCLAUDE NEON LIGHTS CEO\n10\n8\n6\n4\n2\nSale\ns\n100’s\n1000\n500\n1938 1939 1940 1941 1942 1943 1944 1945 1946\nFigure 15.12 A highly speculative, low-priced issue, traded on the Curb Exchange, Claude Neon \nLights: 1942 low, 1/8; 1946 high, 9.\n236 Technical Analysis of Stock Trends\nLIGGETT & MYERS LM–B\n135\n105\n75\n45\nSales\n100’s\n200\n100\n1938 1939 1940 1941 1942 1943 1944 1945 1946\nFigure 15.13 The tobacco stocks follow the investment type of trend. This is Liggett & Myers: 1942 \nlow, 50 1/2; 1946 high, 103 1/2. Note the Double Trendline.\nCORN PRODUCTS REFININGC FG\n70\n60\n50\n40\nSales\n100’s\n400\n200\n1938 1939 1940 1941 1942 1943 1944 1945 1946\nFigure 15.14 High-grade food issues (Corn Products Refining) resemble the tobaccos: 1940 low, 40 \n1/4; 1946 high, 75 3/4.\n237Chapter fifteen: Major Tren dlines\nmay attain an increasingly important and stable position in the general economy, with the \nresult that, eventually, their stock acquires a solid investment rating. Their Bull Market \nTrends will then gradually change from an up-curve to a straight line and, finally, to a \ndecelerating curve. Other old, established corporations may lose position and rating, as \nwell as shift from the investment type of trendline to the speculative. But, it is true in \ngeneral, that Major Patterns do repeat.\nIf you are keeping your own set of manual monthly charts, you can choose whichever \nscale you please. But most technical chart followers prefer to buy their long-range pictures \nreadymade, thereby getting a much more extensive history of many more issues than \nthey could hope to chart themselves. Since the only comprehensive portfolios of monthly \ncharts that are available at reasonable cost are arithmetically scaled, you will possibly \nhave to make these serve all purposes. (EN: No longer necessary because of the availability of \ngood software and internet chart sites. See Appendix B, Resources.) You will find with a little \nexperimentation that an architect’s French curve can be used to plot good Major Uptrend \nLines on many of the issues whose normal Bull Trends accelerate away from a straight line.\nWESTINGHOUSE ELECTRIC WX\n192\n176\n160\n152\n144\n136\n128\n120\n112\n104\n96\n88\n80\n76\n72\n68\n64\n60\n56\n52\n48\n44\nSales\n100’s\n500400\n300\n200\n100\nND JS FO ND JF MMMAJ JA SO ND JFJJ ASOJA M MA M A\n1935 1936 1937 1938\nFigure 15.15 In the process of “pulling back” to a very steep Up Trendline, prices may easily go to \na new high. Note the Pullback of August 1936 in this weekly chart of Westinghouse Electric. The \nsecond, less steep line turned out to be the true Major Bull Trend. Note that the February–April price \npattern in 1936 could not be considered a true Double Top Reversal of Primary import because the \nrecession between the two highs was only about 10% of the Top’s value (around 122). Figure 8.21 \nshows on a daily chart the final Top Reversal Formation that “WX” made in 1937 .\n238 Technical Analysis of Stock Trends\nDOW – JONES\nINDUSTRIAL AVERAGE\nA\nB\nC\nD\nE\nF\nG\nH\n400\n360\n320\n280\n240\n200\n160\n120\n80\n40\n1924 1925 1926 1927 1928 1929 19301 9311 9321 9331 9341 9351 9361 937\nFigure 15.16 The 1929–1932 Primary Bear Market was the only one in all stock market records that \nproduced a Straight-Line Major Downtrend. Trace also the Support and Resistance Levels throughout \nthis 14-year history of the Dow Industrials. Each rally in the great Bear Move stopped at or near a \nprevious Bottom level. Each decline stopped near the level of a Congestion in the 1924–1929 Bull \nMarket. See also the level of 1937 Top. (Source: Chart courtesy of Market Research, Inc., at h t t p : //\nwwwbarchart.com .)\n239Chapter fifteen: Major Trendl ines\nSPX LAST-Daily\nCreated with TradeStation www.TradeStation.com\n339.99\n329.99\n319.99\n309.99\n299.99\n289.99\n279.99\n269.99\n259.99\n249.99\n239.99\n229.99\n219.99\n3/1986 4/1986 5/1986 6/1986 7/1986 8/1986 9/1986 10/19861 1/1986 7/1987 8/19879 /19871 0/1987 11/19871 2/198712/19862 /198787 3/1987 4/1987 5/198", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 116}
{"text": "sy of Market Research, Inc., at h t t p : //\nwwwbarchart.com .)\n239Chapter fifteen: Major Trendl ines\nSPX LAST-Daily\nCreated with TradeStation www.TradeStation.com\n339.99\n329.99\n319.99\n309.99\n299.99\n289.99\n279.99\n269.99\n259.99\n249.99\n239.99\n229.99\n219.99\n3/1986 4/1986 5/1986 6/1986 7/1986 8/1986 9/1986 10/19861 1/1986 7/1987 8/19879 /19871 0/1987 11/19871 2/198712/19862 /198787 3/1987 4/1987 5/1987 6/1987\nFigure 15.17 S&P Reagan Crash. As can be clearly seen, this crash sent numerous signals, starting \nwith the breaking of a Major Trendline by more than 2% in late August. Once this occurs extreme \ncaution and watchfulness must be exercised. The darker and darker complexion of things is brought \nout by the “smart selling,” which shows many “downthrust days” toward the end (October 10–20). \nThe April trendline breaks (by more than 2%) would have ejected the trend trader also to be put back \nlong in June. Observance of the 2%–3% trendline-break rule or use of Basing Points and progressive \nstops (see Chapters 27 and 28) would have avoided much needless grief.\nSPX LAST-Monthly 02/29/2000 C = 1366.42 O = 1357.56 H = 1369.63 L = 1356.05 V =1181488000 \nCreated with TradeStation www.TradeStation. com 1400.00 \n1200.00 \n1000.00 \n800.00 \n600.00 \n400.00 \n200.00 \n1965 1970 1975 1980 1985 1990 1995 \nFigure 15.18 S&P Long-Term Perspective. Viewed from afar it seems an exercise in futility to attempt \nto “time the market.” One must keep in perspective the crashes in market prices are timed to coincide \nwith personal and business needs for short-term liquidity, or cash. One must also remember the market \nbehavior from 1965–1982, as well as the table of Dow Theory Performance from Chapter 4 (Table 4.2).\n240 Technical Analysis of Stock Trends\n2700\n2600\n2500\n2400\n2300\n2200\n2100\n2000\n1900\n1800\n1700\n5/1987 6/1987 7/1987 8/1987 9/1987\n$INDUA LAST-Daily 10/26/1987\n380\n360\n340\n320\n300\n280\n260\n240\n220\nCreated with TradeStation\n4/1929 5/1929 6/1929 7/1929 8/1929 9/1929 10/1929\n$INDUA LAST-Daily 10/31/1929\n9400\n9200\n9000\n8800\n8600\n8400\n8200\n8000\n7800\n7600\n7400\n12/1997 98 2/1998 3/1998 4/1998 5/1998 6/1998 7/1998 8/1998\nwww.TradeStation\n$INDUA LAST-Daily 09/01/1998\nFigure 15.19 Three Bull Market Tops, 1929, 1987 , 1998. Notice here that in each case the crash \noccurred after the nearest important trendline had been decisively broken—usually trendlines of \napproximately three months by 2% or more, and sometimes accompanied by reversal formations. \nAll historic tops will show evidence of attempts to resume the trend after a break of this kind. Belief \ndies hard. Nonetheless, hedging or exiting on these trend breaks proves to be the best strategy over \nand over again.\n241Chapter fifteen: Major Tre ndlines\nThe tests for the technical significance of a Major Trendline are substantially the same \nas those specified for Intermediate Lines in the preceding chapter. A little more leeway \nmust be allowed on penetrations—again, a matter of judgment—but you are dealing with \ncoarse data and long swings here, and what you want from your monthly charts, primarily, \nis perspective on the broad picture.\nOne more point regarding the construction of Major Bull Trendlines: the best \nlines—the most useful—are drawn, as a rule, not from the absolute low of the preceding \nBear Market but starting from the next Intermediate Bottom. The accumulation area \nat the beginning of a Bull Market is usually long and drawn out in time and relatively \nflat. The first trendline that can be drawn from the extreme low point may, therefore, \nbe too nearly horizontal to express the genuine Bull Trend that starts with the markup \nphase. The several charts showing Major Trendlines that illustrate this chapter \nwill demonstrate this point (EN: Especially Figure 15.14 ). It applies as well to many \nIntermediate Moves that start from Area Formations. Take the Head-and-Shoulders \nPattern, for example: the true Intermediate Trendline usually starts from the right \nshoulder rather than from the head.\n$INX - Weekly US L = 1297.28 –0.20 –0.02% B = 0.00 A = 0.00 O = 1297.71 Hi = 1298.69 Lo = 1294 .97 C = 1297.28 V = 0 \n1174.35 \n952.30 \n1 ,496.00 \n1,372.00 \n1,259.00 \n1,154.00 \n1,059.00 \n971.00 \n890.00 \n817.00 \n749.00 \n1,295.68 \n1998 1999 2000 2001 2002 2003 2004 2005 2006 \nCreated with TradeStation\nFigure 15.20 The Bull 1990s top in the S&P gave much clearer readings than the Dow top, with the \nbroken trendlines being paramount. But while the Dow flirted with the emotions of Bulls who wanted \nto believe in the Dow 36,000, the S&P broke its trendlines and went south for the winter, a potentially \nvery long winter. This might have started off as a rounding top and then became a complex-complex \ntop, and you can even see traces of a Head-and-Shoulders top in it. It is the editor’s opinion we may \nnever see such unruly tops again in this generation. The pent-up greed, lust, and naiveté as even \nthe bootblacks (they still have those don’t they?) rushed to get the latest tulip bulbs. Tulips are like \ncentury plants; they only bloom once each hundred years. A little old lady with a ruler could have \nsaved her portfolio here. All it takes is not believing the hype (Dow 36,000 indeed!) and making an \nunemotional analysis and honoring the stops.\n242 Technical Analysis of Stock Trends\nMajor Downtrends\nFrom the technical analyst’s point of view, it is regrettable that few Bear Markets have \nproduced Major Trendlines of any practical significance on the charts of individual stocks. \nA notable exception was the long Bear Market of 1929–1932, which produced magnificently \nstraight trendlines on the arithmetic plotting of a host of issues (as well as in the Averages, \nto which we shall refer later). But it is almost impossible to find other instances in which \na Bear Trendline having any forecasting value can be drawn on either arithmetic or \nsemilogarithmic scale.\nThe normal Major Bear Market Trend is not only steeper than the normal Bull Trend \n(because Bear Markets last, on the", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 117}
{"text": "nes on the arithmetic plotting of a host of issues (as well as in the Averages, \nto which we shall refer later). But it is almost impossible to find other instances in which \na Bear Trendline having any forecasting value can be drawn on either arithmetic or \nsemilogarithmic scale.\nThe normal Major Bear Market Trend is not only steeper than the normal Bull Trend \n(because Bear Markets last, on the average, only about half as long as Bull Markets), but it \nis also accelerating or down-curving in its course. This feature is accentuated and, hence, \nparticularly difficult to project effectively on the semilogarithmic scale.\nThe technician cannot expect to obtain much in the net of it, help from his Major \nTrendlines in determining the change from a Primary Downswing to a Primary Upswing. \nThis should not be taken, however, as advice to not draw trendlines on a Major Down Move, \nor to disregard entirely any trendlines that may develop with some appearance of authority. \nIf you do not expect too much of them, they may, nevertheless, afford some useful clue as \nto the way in which conditions are tending to change.\nThe student of stock market action who is not altogether concerned with dollars and \ncents results from his researches will find Bear Market Trendlines a fascinating field of \ninquiry. They do some strange things even though they fail in the practical function of \ncalling the actual Major Turn and go shooting off into space, they sometimes produce \ncurious reactions (or, at least, appear to produce what would be otherwise inexplicable \nmarket action) when the real price trend catches up with them months or years later. But \nsuch effects, interesting as they may be, are, in our present state of knowledge, uncertain \nand unpredictable. (EN: This fact may persist into the mists of the future and be thought of like \nFermat’s Last Theorem. Our present state of knowledge in the twenty-first century is no further \nadvanced than it was in Magee’s time.)\nWe must dismiss this rather unfruitful topic with the reminder that one clue to the end \nof a Primary Bear Market is afforded by the Intermediate Trendline of its final phase, which \nwe cited in the preceding chapter.\nMajor Trend Channels\nAnother difficulty is met when trying to draw Return Lines and construct channels for Major \nTrends on an arithmetic chart. Owing to the marked tendency for prices to fluctuate in ever-\nwider swings (both Intermediate and Minor) as they work upward in a Primary Bull Market, \ntheir channel grows progressively broader. The Return Line does not run parallel to the \nBasic Trendline (assuming there is a good Basic Trendline to begin with) but diverges from \nit. Occasionally, a stock produces a clear-cut Major Channel Pattern, but the majority do not.\nA large Rectangle base was made on this weekly chart in April, May, and June 1937 , but \nobserve the poor volume that accompanied the breakout and rise from that formation—an \nextremely Bearish indication for the Major Trend. The “measurement” of the Rectangle was \ncarried out by August, but that was all.\nAs is usually the case, it was impossible to draw a Major Down Trendline that had \nany forecasting value on this chart. The beautiful straight trendlines that appeared in the \n1929–1932 Primary Bear Market led many chart students to expect similar developments in \nevery Bear Market, but the fact is that 1929–1932 was unique in that respect.\n243Chapter fifteen: Major Tre ndlines\nSemilogarithmic scaling will correct, in many cases, for the Widening Channel effect \nin Bull Trends, but then we run into the opposite tendency in Primary Bear Markets, and \nfor that, neither type of scaling will compensate.\nTrendlines in the Averages\nPractically everything stated in the preceding chapter regarding Intermediate Trendline \ndevelopment in individual stocks applies, as well, to the various Averages. The broad \nAverages or Indexes, in fact, produce more regular trends and, in consequence, more exactly \napplicable trendlines. This may be partly due to the fact most Averages are composed \nof active, well-publicized, and widely owned issues whose market action individually is \n“normal” in the technical sense. Another reason is the process of averaging smooths out \nthe vagaries of component stocks, and the result more truly reflects the deep and relatively \nsteady economic trends and tides.\nIn any event, it is a fact that such averages as the Dow–Jones Rails, Industrials, and \n65-Stock Composite, The New York Times 50, and Standard & Poor’s Average of 90 stocks \n(the last two named being probably the most scientifically composed to typify the entire \nbroad market) do propagate excellent trendlines on their charts. (EN: As the reader will \nnote, most of these indices are obsolete. In the modern age, the S&P 500 probably best fulfills this \nfunction.)\nThe very accuracy of their trends, particularly their Intermediate Moves, permits \nus to construe their trendlines more tightly. Less leeway need be allowed for doubtful \npenetrations. Thus, although we ask for a 3% penetration in the case of an individual stock \nof medium range, 2% is ample in the Averages to give a dependable break signal.\nExperienced traders know it pays to heed the Broad Market Trend. It is still easier to \nswim with the tide than against it.\nEN: Trendlines in the Averages and Trading in the Averages\nNumerous averages and indexes have come online since the fifth edition, including the S&P 100, \nS&P 500, Russell 2000, and so on. It would be an exercise in daily journalism to attempt to list all \nthe indexes now available, as new ones spring up like weeds after the spring rain. This is because \nthe invention of a widely adopted index can be very lucrative for its creator. S&P and Dow–Jones \ncollect licensing fees from the “use” of their indexes by the exchanges. The constant addition of new \ntrading instruments requires that current lists be kept in Resources, and the reader may also consult \nthe Wall Street Journal, Ba", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 118}
{"text": "ew ones spring up like weeds after the spring rain. This is because \nthe invention of a widely adopted index can be very lucrative for its creator. S&P and Dow–Jones \ncollect licensing fees from the “use” of their indexes by the exchanges. The constant addition of new \ntrading instruments requires that current lists be kept in Resources, and the reader may also consult \nthe Wall Street Journal, Barron’s, and the Investor’s Business Daily where prices of indexes and \naverages are reported. Online brokerages and financial news sites also offer up-to-the-minute lists \nand quotes on virtually all trading instruments. A list and links to these sites may also be found in \nAppendix B, Resources, and at http:/ /www.edwards-magee.com.\nAs of the turn of the century, the most important of these indexes joining the Dow are \nprobably the S&P 500, the S&P 100, and the NASDAQ. In fact, these are probably sufficient \nfor economic analysis and forecasting purposes, and certainly good trading vehicles by means \nof surrogate instruments, options, and futures. Some would include the Russell 2000 in this \nlist. These indexes and averages have been created to fill needs not addressed adequately by the \nDow–Jones Averages.\nWith this proliferation of measures of the market and various parts of it, a different question \narises questioning the value of the Dow alone in indicating the Broad Market Trend. Limited \nresearch has been done on this question; however, my opinion is the Broad Market Trend \nmust now be determined by examining the Dow Industrials, the S&P 500, and the NASDAQ \nComposite.\n244 Technical Analysis of Stock Trends\nTrading the Averages in the 21st century\nAs pointed out in other new chapters and notes in the eighth edition, the ability to trade \nthe Averages instead of individual stocks is a powerful choice offered by modern markets. \nThe index ETFs offer ideal vehicles for investing: The DIA, SPY, QQQ and IWM give the \nmodern investor unparalleled flexibility and convenience. Magee was of the opinion that \nthe Averages offered technical smoothness often lacking in individual issues. This would \nseem to be true intuitively. After all, just as a moving average smooths data, the average of \na basket of stocks should dampen price volatility. Of course, as Mandelbrot pointed out, in \na 10-sigma market storm everything sinks.\nIllustrated in this chapter are several detailed cases following Magee’s suggestion of \nAverage trading. I attempt to demonstrate here two perspectives: one, the horror of the \nimmediate, what the crash and panic look like as they occur; and two, what the crash and \npanic look like in retrospect. We all live in the present, except for the great billionaires who \ncan afford to doze through horrific Bear Markets. Bill Gates’ net worth varied by $16 billion \nor $17 billion in early 2000. This would put the ordinary investor out of business.\nSo the ordinary investor, you and I, have to respect the great yawning Bear Market. \nWe must step to the sidelines and let the bear eat the foolish virgins, to borrow a Biblical \nmetaphor.\nYou will remember Magee opined that a trendline break of 2% was sufficient to cause \nliquidation of longs when analyzing the Averages. In the accompanying figures, this \nhypothesis is examined.\nEN9: In respect to the breaking of trendlines (by 2% or 3%), I should note the breaking of a \ntrendline is as much a warning as a signal to act. The break, instead of a change of trend to the \nreverse, may indicate a change of trend to the sideways—into a reversal or continuation pattern.\n245\nchapter sixteen\nTechnical analysis of commodity charts\n(EN9: Following the practice of allowing the reader to discriminate between the work of Edwards \nand Magee and that of the editor, a section on commodity trading, Chapter 16, has been added to the \nninth edition. See same.)\nA little thought suggests the variously interesting and significant patterns we have \nexamined in the foregoing chapters on stock charts should logically appear as well in the \ncharts of any other equities and commodities that are freely, constantly, and actively bought \nand sold on organized public exchanges. In general, this is true. The price trends of anything \nfor which market value is determined solely (or for all practical purposes within very wide \nlimits) by the free interplay of supply and demand will, when graphically projected, show \nthe same pictorial phenomena of rise and fall, accumulation and distribution, congestion, \nconsolidation, and reversal that we have seen in stock market trends. Speculative aims and \nspeculators’ psychology are the same whether the goods dealt in are corporate shares or \ncontracts for the future delivery of cotton bales. (For illustrations in this chapter, see Figures \n16.1 through 16.13.)\nIt should be possible in theory, therefore, to apply our principles of technical analysis \nto any of the active commodity futures (wheat, corn, oats, cotton, cocoa, hides, eggs, etc.) \nfor which accurate daily price and volume data are published. It should be, that is, if proper \nallowance is made for the intrinsic differences between commodity futures contracts and \nstocks and bonds.\nIn previous editions of this book (EN9: up to the eighth), traders who cast longing eyes \non the big, quick profits apparently available in wheat, for example, were warned that \ncommodity charts were “of very little help,” as of 1947 .\nIt was pointed out that successful technical analysis of commodity futures charts had \nbeen possible up to about 1941 or 1942, but the domination of these markets thereafter by \ngovernment regulations, loans, and purchases completely subject to the changing (and \noften conflicting) policies and acts of the several governmental agencies concerned with \ngrains and other commodities had seriously distorted the normal evaluative machinery of \nthe market. At that time, radical reversals of trend could and did happen overnight without \nany warning so far as the action of the m", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 119}
{"text": "government regulations, loans, and purchases completely subject to the changing (and \noften conflicting) policies and acts of the several governmental agencies concerned with \ngrains and other commodities had seriously distorted the normal evaluative machinery of \nthe market. At that time, radical reversals of trend could and did happen overnight without \nany warning so far as the action of the market could show. The ordinary and orderly \nfluctuations in supply–demand balance, which create significant definite patterns for the \ntechnician to read, did not exist. Yet, while fortunes were made (and lost) in wheat, corn, \nand cotton futures during the World War II period, it is safe to say they were not made \nfrom the charts.\nDuring the past five or six years, however, the application of technical methods to \ncommodity trading has been reexamined. Under 1956 conditions, it appears that charts \ncan be a most valuable tool for the commodity trader. The effects of present government \nregulation have apparently resulted in “more orderly” markets without destroying their \nevaluative function. Allowing for the various essential differences between commodities \nand stocks, the basic technical methods can be applied.\n246 Technical Analysis of Stock Trends\nIt may be in order here to discuss briefly some of the intrinsic differences between \ncommodity futures and stocks referred to above and to some of the special traits of \ncommodity charts. First, the most important difference is the contracts for future delivery, \nwhich are the stock-in-trade of the commodity exchange, have a limited life. For example, \nthe October cotton contract for any given year has a trading life of about 18 months. It \ncomes “on the board” as a “new issue,” is traded with volume increasing more or less \nsteadily during that period, and then vanishes. Theoretically, it is a distinct and separate \ncommodity from all other cotton deliveries. Practically, it seldom gets far out of line with \nsuch other deliveries as are being bought and sold during the same period, or with the \n“cash” price of the physical cotton in warehouses. Nevertheless, it has this special quality \nof a limited independent life, as a consequence of which long-term Support and Resistance \nLevels have no meaning whatever. (EN10: This absolute may not be absolute. Evaluate the long-\nterm charts for your issue to see whether influence is evident.)\nSecond, a very large share of the transactions in commodity futures—as much as \n80% certainly in normal times—represents commercial hedging rather than speculation. \n(EN10: Less true in the twenty-first century.) It is, in fact, entered in to obviate risk and to \navoid speculation. Hence, even near-term Support and Resistance Levels have relatively \nless potency than with stocks. Also, because hedging is to a considerable degree subject to \nseasonal factors, there are definite seasonal influences on the commodity price trends that \nthe commodity speculator must keep in mind, even if only to weigh the meaning of their \napparent absence at any given period.\nA third difference is in the matter of volume. The interpretation of volume with respect \nto trading in stocks is relatively simple, but it is greatly complicated in commodities by the \nfact that there is, in theory, no limit to the number of contracts for a certain future delivery \nthat may be sold in advance of the delivery date. In the case of any given stock, the number \nSEPTEMBER OATS Chicago\n1947\nG\nG G\nJANUARYF EBRUARYM ARCH APRILM AY JUNEJ ULY\nH SS\n104\n96\n88\n80\n76\n72\n68\n64\n60\nSales\n100’s\n12510075\n50\n25\n4 11 18 25 1 8 15 22 1 8 15 22 29 5 12 19 26 3 10 17 24 31 7 14 21 28 5 12 19 26 2 9\nFigure 16.1 Oats, for obvious reasons, traced more “normal” patterns than Wheat during the 1940s. \nThis chart contains an H & S bottom, a Symmetrical Triangle that merged into the Ascending form, \na gap through a former top level, and an interesting trendline. The Island shake-out through the \ntrendline was an extremely deceptive development.\n247Chapter sixteen: Technica l analysis of commodity charts\nof shares outstanding is always known. As this is written (1956), there are in the hands of \nstockholders 13,700,203 common shares of Consolidated Edison, and that quantity has not \nvaried for many years nor is it likely to change for several years to come. Every transaction \nin Consolidated Edison involves an actual transfer of one or more of those existing shares. \nIn the case of commodity future contracts—say, September wheat—trading begins long \nbefore anyone knows how many bushels of wheat will exist to be delivered that coming \nSeptember, and the open interest at some time during the life of the contract may exceed \nthe potential supply many times over, and all quite legitimately. (EN9: As always, volume \ndata is a supplementary indicator to price. No one makes a profit on it.)\nOne more important difference may be mentioned. Certain kinds of news—about \nweather, drought, floods, and so on that affect the growing crop, if we are dealing with \nan agricultural commodity—can change the trend of the futures market immediately \nOCTOBER COTTON 1947\nFEBRUARY MARCHA PRIL MAY JUNE JULY AUGUST SE PTEMBER\nS7\nS7\nH7\n35.00\n34.00\n33.00\n32.00\n31.00\n30.00\n29.00\n28.00\n27.00\n8 15 22 1 8 15 22 29 5 12 19 26 3 10 17 24 31 7 14 21 28 5 12 19 26 2 9 16 23 30 6 13 20\n?? ??\nFigure 16.2 In contrast with the grains, the technical action of the Cotton futures markets has been fairly \nconsistent with normal supply–demand functioning ever since prices rose well above government \nsupport levels. In this daily chart of the 1947 October delivery (New York Cotton Exchange), the \nreader will find a variety of familiar technical formations, including critical trendlines, a Head-and-\nShoulders top that was never completed (no breakout), and Support–Resistance phenomena much \nthe same as appear in stock charts. Double trendlines are not at all unusual in Cotton charts.\n248 Technical Analysis of Stock Trends\nand d", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 120}
{"text": "t of the 1947 October delivery (New York Cotton Exchange), the \nreader will find a variety of familiar technical formations, including critical trendlines, a Head-and-\nShoulders top that was never completed (no breakout), and Support–Resistance phenomena much \nthe same as appear in stock charts. Double trendlines are not at all unusual in Cotton charts.\n248 Technical Analysis of Stock Trends\nand drastically and are not foreseeable given the present stage of our weather knowledge. \nAnalogous developments in the stock market are extremely rare. (EN: Except for acts of God \nand Alan Greenspan [and Ben Bernanke]).\nIt is not the purpose of this book to explain the operation of commodity futures \nmarkets, nor to offer instruction to those who wish to trade therein. This brief chapter \nis included only as a starter for readers who may want to pursue the study further. They \nshould be advised that successful speculation in commodities requires far more specialized \nknowledge and demands more constant daily and hourly attention. The ordinary individual \ncan hope to attain a fair degree of success in investing in securities by devoting only his \nspare moments to his charts, but he might better shun commodity speculation entirely \nunless he is prepared to make a career of it.\n(EN: The editor has been, during his checkered career, a registered commodity trading advisor. \nAt the beginning of that career, I discussed these subjects with Magee and received essentially the \nabove comments, which are here reproduced from the fifth edition. Subsequently, I observed among \nmy associates and partners, and on my own, that futures are eminently tradable with the adaptation \nof techniques and methods described in this book. It is also true, as Magee says, that futures trading \nis so different in tempo, leverage, and character that the novice risks life, limb, and capital in entering \nthe area unescorted. Resource references are essential reading, but the beginner is urged to educate \nhimself before beginning trading with extensive study and paper trading.)\n@GC.C(D) - Weekly COMEX L = 419.30 –0.70 –0.17% O = 419.80 C = 419.30\n419.30\n397.00\n377.00\n359.00\n341.00\n325.00\n309.00\n394.00\n 279.00\n266.00\n1997 1998 1999 2000 2001 2002 2003 2004\nCreated with TradeStation\n380.30\nFigure 16.3 A Rounding Bottom in Gold 1997–2004. “These patterns, when they occur after an extensive \ndecline, are of outstanding importance, for they nearly always denote a change in Primary Trend \nand an extensive advance yet to come. That advance, however, seldom carries in a ‘skyrocket’ effect, \nwhich completes the entire Major Move in a few weeks. On the contrary, the uptrend that follows the \ncompletion of the pattern itself is apt to be slow and subject to frequent interruptions, tiring out the \nimpatient trader, but yielding eventually a substantial profit.” So said Robert Edwards in remarking \non Rounding Bottoms in stock charts. As may be seen here, this Rounding Bottom consists of a \ndowntrend, a false signal off the Double Bottom (upon which a pretty penny might have been made \nby the agile trader), and a handsome uptrend—and it all looks like a huge Rounding Bottom.\n249Chapter sixteen: Technica l analysis of commodity charts\nTechnical analysis of commodity charts, \npart 2: a 21st-century perspective\nIn the search for the Philosopher’s Stone, more sweat and money have been put into the \narea of commodities and futures than were ever expended in the securities arena. There \nis a simple reason for this—great fortunes are made and lost with much greater rapidity \nin the futures area than in securities. Of all the great dramatic moments in stock market \nhistory, few are so memorable as the great Hunt silver market, or Soros facing off against \nthe Bank of England, or of gold soaring to $1,000 an ounce (deferred contracts). And the saga \ncontinues in 2005: $50 oil? $60? $70? $100? And the effects, economic and psychological! In \ndimly lit garrets and brightly lit computer rooms thousands of researchers concoct systems \nto trade these markets—corn, soybeans, silver, copper …\nRocket scientists\nAt times, individual traders and groups of traders have plundered (harvested?) these markets \nfor fairy tale profits. I know whereof I speak, having been a principal in California’s first \nlicensed commodity trading advisor that was founded by the NASA rocket scientist R. T. \nWieckowicz. During the 1970s, as the stock markets ground futilely around the 1,000 level on \nthe Dow, the futures markets returned yearly gains in the 100% range. Consistently. For years. \nThose were the years of the California systems traders and the beginning of computerized \ntrading. From the primeval slime of NASA, rocket scientists emerged to create a renaissance in \nmarket technology. At the time it seemed clear that science and genius had at last conquered \nthe markets and that clients would come buzzing from the world over like bees to a honey \nFigure 16.4 Gold, October 2011. The momentous earth-shaking power of a massive rounding bottom \nis vividly dramatized by the gold chart since 2005, as well as the power of chart analysis to anticipate \nit. Regrettably, the editor did not compute the price target implications of the pattern in the ninth \nedition in 2005. That computation was made at the http:/ /www.edwards-magee.com website at the \ntime. There it was computed as follows (and the reader can do it for himself): depth of pattern, 248.20 \nplus neckline 507 .40, target 755.60. In fact, the possibility was entertained that the entire formation \nfrom 1980 to 2008 might be a Rounding Bottom. In which case, the depth was 700.70, added to the \nneckline of 959 and resulted, actually achieve, in a target of 1,660. Remember Edwards said these \nwere probable minimum measurements.\n250 Technical Analysis of Stock Trends\npot and that the rivers of profits would last forever. They did last for some time, and then the \nmarkets changed. Mechanical systems that cut through the markets lik", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 121}
{"text": "Bottom. In which case, the depth was 700.70, added to the \nneckline of 959 and resulted, actually achieve, in a target of 1,660. Remember Edwards said these \nwere probable minimum measurements.\n250 Technical Analysis of Stock Trends\npot and that the rivers of profits would last forever. They did last for some time, and then the \nmarkets changed. Mechanical systems that cut through the markets like a reaper in a wheat \nfield in Bull Markets grind up capital like sausage in sideways markets. Science and genius \nwere revealed as the happy combination of man, moment, system, and market.\nTurtles?\nDuring the 1980s from the sea came crawling the Turtles. Progeny of the protean trading \nwizard, Richard Dennis, the Turtles again harvested outsize profits from the markets, \nreportedly running in the 80% yearly range. The so-called Turtles got their name from a \ncomment that Dennis is reported to have made that traders were made not born, and he \nwas going to raise traders like turtles. Additional reading about the Turtles is available in \nJack Schwager’s fascinating books, including Market Wizards and others. Schwager’s books \nare required reading for aspiring futures traders. Additionally, the trading manual of the \nTurtles will be found online at http:/ /www.originalturtles.org. This workbook, written by \n@SI.P(D) - Weekly COMEX L = 7.035 +0.077 +1.11% B = 0.000 A = 0.000 O = 6.985 Hi = 7.085 Lo = 6.980 C = 7.045 V = 145\n8.000\n7.045\n6.000\n5.000\n1998 1999 2000 2001 2002 2003 2004 2005\nCreated with TradeStation\n6.00\nFigure 16.5 A Rounding Bottom in Silver, 1998–2005. The apparent Rounding Bottom in silver, \ncombined with the same pattern in gold, would seem to cast a pall over the economic situation for \nsome time to come in 2005. This coincides with the apparent long-term patterns setting up in the \nsecurities markets. If the best that can be hoped for in securities is a 1965–1982 kind of widely whipping \nmarket, commodities may react as they did in the 1970s—with tidal wave markets. These markets can \nbe traded by the well-capitalized chart analyst who is well seasoned. Tyros will lose money learning \nthe game whatever markets they trade. Their chances will be immeasurably improved by applying \nthe techniques taught in this book. In addition to the technical pattern pictured here, there is every \nreason to suspect that a large fundamental shortage of silver bullion exists and will worsen. Ted \nButler, at http:/ /www.doomgloom.com, is a long-term silver analyst (and associate of the editor) who \nanticipates a new silver blow-off is coming. One wonders what Nelson and Bunker Hunt are doing \nat present. A very cautious investor (like Warren Buffet who is reported to have invested $1 billion \nin silver bullion) may defeat futures silver volatility by buying the bullion.\n251Chapter sixteen: Technica l analysis of commodity charts\nCurtis Faith, an original Turtle, contains virtually all of the elements necessary in a trader’s \nsystems and procedures manual. The manual was prepared according to the training \nDennis gave his Turtles. Serious traders do not operate without some such document. \nCertainly all of the serious traders I have known (a considerable number) have had fully \ndeveloped manuals like the Turtle workbook. I cite the Turtle workbook rather than others \nin my possession because it is publicly available at http:/ /www.originalturtles.org (as well \nas in the 9th edition of this book) and because it is beautifully articulated.\nIn the late 1990s, the Turtles were made into turtle soup in the futures markets as \nthe majority of systems traders wound up as hamburger meat. Is there a moral? Yes. The \nmarkets giveth and the markets taketh away. Science and genius are again revealed to be the happy \ncombination of man, method, moment, and market.\nThe Turtle system is basically an adaptation of Richard Donchian’s channel breakout \nsystem. In the Donchian system, the trader goes long when the 20-day high is broken \nand sells and goes short when the 20-day low is broken. In the 1970s, Dunn and Hargitt \nevaluated a number of mechanical trading systems and found that Donchian’s system \nwas superior to the others evaluated at that time. Will Donchian’s system still work? Yes, \nSIK05(D) -Daily COMEX L = 6.900 –0.003 –0.04% B = 6.920 A = 6.935 O = 6.900 Hi = 6.905 Lo = 6.900 C = 6.900 V = 6\n8.000\n7.500\n7.000\n6.903\n6.500\n6.000\nAM JJ AS ON D0 5F MA M\nCreated with TradeStation\n2\n3 4\n1\nFigure 16.6 Silver, May 2005. Although the long-term silver outlook may be Bullish, the short term \nwill be very volatile, especially for the thinly capitalized trader. Then short-term tactics must be \nadopted. The Island Top here at 1 is a gentle invitation to the trader to take his profits and be gone. \nEven to short, with a stop just above the high. The run day after 1 adds a note of urgency to the \ninvitation. The gap is punishment for the hard of hearing and a bonus for the quick-witted (everybody \nwho survives in futures is either quick witted or extremely well financed). The stop moves down \nto the top of the gap day, then to the top of the next gap day, and for the very apt profits are taken \non the next run day down, on the principle of sell weakness, buy weakness. The tight trendline at \n2 crossed by the heavy run day is a buy signal with the stop moving to the bottom of the gap at 3, \nwhere it is taken out a few days later by the long-range day down. The run day at 4 is a short signal \nwith the stop being at the day’s high. Is it necessary to say short-term futures trading can be quite \nrapid? There is always bullion or associated stock plays.\n252 Technical Analysis of Stock Trends\nin broadly trending markets. Will the Turtle system still work? Yes, in broadly trending \nmarkets. Plus, like virtually all mechanical systems, they do not know whether they are \nin a broadly trending market or not. They are blind—all they see are ones and zeros. The \naddition to these systems of prudently applied chart analysis will im", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 122}
{"text": "ssociated stock plays.\n252 Technical Analysis of Stock Trends\nin broadly trending markets. Will the Turtle system still work? Yes, in broadly trending \nmarkets. Plus, like virtually all mechanical systems, they do not know whether they are \nin a broadly trending market or not. They are blind—all they see are ones and zeros. The \naddition to these systems of prudently applied chart analysis will immeasurably improve \ntheir performance and risk characteristics.\nThe application of Edwards and Magee’s \nmethods to 21st-century futures markets\nDuring my career as a commodity trading advisor, I have known a number of successful \ntraders and advisors who used what I would describe as Magee-type chart analysis to \nmake their trades. Often, other elements were input into their decision-making process, but \nmanual charting was a key factor in their operations. Some of these traders used simple \ntrendline analysis with price or volume filters and some used a combination of trendlines \nand support and resistance. All were trend followers.\nHaving looked at the futures markets with some attention over the past several years, it \nseems to me there is no reason why chart analysis should not work as well now in futures \nas it has always worked in stocks. Essentially, the questions raised by securities trading are \nthe same as those presented by futures trading in the analysis of a chart. Is there a trend? \nWhere are support and resistance? Is there a breakout? Are there waves and wavelets? How \ndo you enter and how do you exit?\nThe great bug-a-boo of securities traders coming to the futures trading is the speed of \nthe game. Like college football players stepping up to the NFL, there is a brutal learning \ncurve and rookies are the most likely to get killed. I am not going to make any effort \nhere to present a primer for new futures traders, but rather, I will look at some futures \ncharts at the end of this chapter to show the journeyman that chart analysis can be used \nFigure 16.7 Silver, October 2011. Here is what happened in silver after the ninth edition was \npublished. Could there be any greater vindication of the value of charts looking at the issue six \nyears later? Just as in the case of gold, the analysis allowed the analyst to anticipate a monster Bull \nMarket. On http:/ /www.edwards-magee.com, the authors wrote letters all during this time pointing \nout the silver Bull. Measuring the entire formation, the depth is 33.96, added to the neckline of 37 .5 \nequals 71.46. This seems quite fanciful to us, but that is the measurement.\n253Chapter sixteen: Technical a nalysis of commodity charts\nas a decision-making method in these dramatic markets. Again, chart analysis has the \nweakness (or strength) of being a qualitative process. It will not make decisions for the \naverage trader, as a mechanical system will.\nOn the other hand, a breakout is a breakout. A gap is a gap, leaving aside the question \nof limit move gaps for the moment. A trend is a trend. And here is the great advantage that \na firm grasp of charting methods can give the practitioner. It can give him the perspective \nto recognize the essential nature of the market at hand and choose to wait or to enter. Mechanical \nmethods not having the qualitative discrimination of an experienced chartist will blindly \ntake every trade until they are out of money. The experienced chart analyst can sit back and \nsay, this market has not yet made a bottom and the time to begin trading it long has not \nyet come. Or, he can recognize the essential differences between a trading and a trending \nmarket and adjust his tactics accordingly. As Magee noted in Chapter 16:\nUnder what might be called normal market conditions, those chart \npatterns which reflect trend changes in most simple and logical \nfashion work just as well with commodities as with stocks. Among \nthese we would list Head-and-Shoulders formations, Rounding Tops \nFigure 16.8 Treasury Bonds. The double-pump triple-nod head fake is a specialty of futures markets. \nThe fear and greed factor are multiplied by 10, like the leverage. But here in September 2004 Bonds, we \ncan see how simple chart analysis can serve the trader. The downtrend from March (1) is completely \nmanageable with a simple trendline and trend analysis. The end of the downtrend in May is marked \nby two strong run days. At any rate, the stop would have been at May 1, using a Basing Point kind \nof analysis. If we were going to trade it long, this would have been traded for a scalp (because we do \nnot know whether or not there is a bottom). The break of the trendline at 2 is an engraved invitation \nto get long and the trendline at 3 keeps us long until broken by the signal day at the end of July. This \nwould put us short again, whereas a two-day trade as the signal day on the trendline at 4 puts us \nlong again. Obviously, we are using very tight, short trendlines and long-range days (or run days) \nas signals. The use of the run day as a signal, combined with other indicators, is common in my \nexperience among traders.\n254 Technical Analysis of Stock Trends\nand Bottoms, and basic trendlines. Trendlines, in fact, are somewhat \nbetter defined and more useful in commodities than in stocks. Other \ntypes of chart formations which are associated with stocks with \nshort-term trading or with group distribution and accumulation, \nsuch as the Triangles, Rectangles, Flags, etc., appear less frequently in \ncommodities and are far less reliable as to either direction or extent of \nthe ensuing move. Support and Resistance Levels, as we have already \nnoted, are less potent in commodities than in stocks; sometimes they \nseem to work to perfection, but just as often they don’t. For similar \nreasons, gaps have relatively less technical significance.\nThese words remain true today, as do virtually all the principles enunciated in this \nbook by Edwards and Magee and myself. In fact, if most futures charts were given to an \nCR0504-CRB Index (Apr 2005) 306.00 2.", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 123}
{"text": "less potent in commodities than in stocks; sometimes they \nseem to work to perfection, but just as often they don’t. For similar \nreasons, gaps have relatively less technical significance.\nThese words remain true today, as do virtually all the principles enunciated in this \nbook by Edwards and Magee and myself. In fact, if most futures charts were given to an \nCR0504-CRB Index (Apr 2005) 306.00 2.25 0.74%\n306\n303\n300\n297\n294\n291\n288\n285\n282\n279\n276\n273\n270\nSepO ct Nov Dec0 5F eb Mar\n1998–2004 Prophet Financial Systems, Inc. Terms of use apply.\nFigure 16.9 Commodity Research Bureau Index, April 2005 Futures. Just as Triangles often work in \nsecurities, they often work in futures. Breakaway gap, second breakaway gap, runaway gap, second \nrunaway gap—this is the formation before the second runaway gap is somewhat quizzical—it might \nbe considered a flag, but it has the same effect, and depending on the trader’s operating methods, \nthe stop would be just under the gap/run day anyway. It will not take much study for the reader to \nsee the principles of chart analysis used in this entire book are validated here. The main difference \nis in the setting of stops, and in fact, the same stop methods may be used if the trader is sufficiently \nwell financed.\n255Chapter sixteen: Technical a nalysis of commodity charts\n$CRY0(D) -Weekly NYBOT L = 294.09 +1.03 +0.35% B = 0.00 A = 0.00 O = 293.08 Hi = 294.12 Lo = 292.96 C = 294.09 V = 0\n307.00\n294.09\n288.00\n270.00\n253.00\n237.00\n222.00\n208.00\n195.00\n1998 1999 2000 2001 2002 2003 2004 2005\nCreated with TradeStation\n234.65\nFigure 16.10 Commodity Research Bureau (CRB), long-term view. It does not take much analysis of \nthis 10-year CRB chart to see a huge Double Bottom and to consider its implications. If China and \nIndia are going to compete with us for natural resources, we could see an entirely new economic \nparadigm, if the reader will excuse the term. Clearly, there is a Bull market in commodities. In \nChapter 42, Pragmatic Portfolio Management, it is suggested that capital should flow to markets \nthat are moving, rather than remaining committed to markets that are mired in mulish trends. \nFurthermore, it is suggested in that chapter that a good natural hedge is to go long on the uptrend \nof an index and short the components of it that are in downtrends. The CRB is somewhat thin but \nmight lend itself to this strategy.\nFigure 16.11 The 20-year bonds as expressed in the TLT; ETF Bonds display classical signals of \nabsolute clarity.\n256 Technical Analysis of Stock Trends\nFigure 16.12 September, 1994. Coffee was so easy in retrospect that it should be engraved on a brass plate. The long is taken on the breakout of the \nhorizontal trendline. The position is never in any danger, as there is no down-wave of significance until May when stops are advanced to stay 5% \nunder lows (Basing Points). The May down-wave allows a Basing Point stop to be established. The breakaway gap is a windfall profit. The flag tells \nus that more is coming—as it does with another gap and run days—until the spike reversal, which is a clear signal to be out on the close. A gap up \non the open, an exploration up, and a close down—an absolutely clear message of reversal from the market.\n257Chapter sixteen: Technica l analysis of commodity charts\nFigure 16.13 The May 11 top in silver. In the first quarter of 2011, silver took off in a roaring uptrend. Any surprise here, after looking at the \nBounding Bottom? As seen in the chart, it came near to going parabolic. The top notice came on April 25—interestingly on a reversal bar. Reading \nthe Candlestick, the market gapped wide on the opening and took a long excursion down to close the opening gap. Then bargain hunters thought \nthey were getting a good price on silver and drove the price back up, so it did not close on the lows. The next day, it gapped down on the open and \nbasically wandered down all day long—the party was over. The signs were subtle.\n258 Technical Analysis of Stock Trends\nanalyst, without issue identification and dates would not be identifiable as commodity \ncharts. When limit moves appear, the difference slaps one in the face. On this point I might \ndiffer from Magee slightly as regards to gaps. Obviously, limit move gaps have breathtaking \nsignificance. All in all, it seems to me gaps often say the same thing to futures analysts as \nthey do to stock analysts.\nAnother mathematical reason might be adduced for the practicality of using simple \nchart analysis to trade futures. That is the tautological nature of the method. A trend is a \ntrend, and a trendline is a trendline. If you enter a suspected trend (setting a protective \nstop at a technically analyzed place) and follow the trend using Basing Points or observing \nthe trendline and exiting on a break and reversal there will be no difference from doing \nthe same with a stock. Well, some difference. Due to the leverage, you will be required to \nbe hyperaware of risk. In futures, the penalty for holding a position through “a normal \nreaction” can be extremely harsh. That is why stops are so important.\nThe TLT chart from late 2008 is a spectacular display of patterns and signals. This \npattern has appeared many times before and will appear again in the future.\nPrices break out of a sideways pattern on a strong gap. The gap is across the trendline, \nwhich is what makes the signal significant. Every gap is not a signal. In this case, the gap \nis extra significant because there is a power bar on the gap day—it should be bought. This \nis called a breakaway gap. Prices continue to progress, and a few days later another gap \noccurs. This is a runaway gap and is another signal.\nShortly thereafter, prices drift sideways for a few days. This is a flag. Flags are vivid \nmessages to traders. Robert Edwards described how they are used. He said, “The flag \nflies at half-mast,” meaning after a rocket-like advance and this formation, prices should \nadvance on at least as far as they had co", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 124}
{"text": "ss, and a few days later another gap \noccurs. This is a runaway gap and is another signal.\nShortly thereafter, prices drift sideways for a few days. This is a flag. Flags are vivid \nmessages to traders. Robert Edwards described how they are used. He said, “The flag \nflies at half-mast,” meaning after a rocket-like advance and this formation, prices should \nadvance on at least as far as they had come.\nPower bars (signals) exit from the flag, and then another gap occurs. This is the \nexhaustion gap. This is a message to exit longs and to short the issue. The message could \nnot have been clearer.\nThe skilled trader, first of all, catches the original signal—the power bar exiting from \nthe sideways pattern. He then pyramids on the subsequent signals. Exiting from the flag, a \ngood trader should have a boatload of this issue, and at the top, selling after the exhaustion \ngap, he should have made at least a small killing.\nStops\nSome traders set their stops using money management rules rather than technically \nidentified points. I believe it is always better to find the technical point using a Basing Point, \nor support and resistance. To me it makes better sense to adjust position size to control risk \nas I describe in Chapter 26. The use of money management stops has been very successful \nfor many traders. If some logical and disciplined method of setting and observing stops is not \ninstalled, the trader is assured of failure.\nA money management stop is, simply enough, a stop calculated by deciding to risk \n2% (or 3% or 4% or x%) of capital on a trade. For example, William O’Neil says that when a \nstock trader enters a position, he should set a stop 8% under his entry price. This is a little \ncrude, and not strictly speaking, a money management stop, but it is better than no risk \ncalculation at all. In a stricter sense, if we said we wanted to limit the risk of the trade to \n3% of capital, we would use the 8% rule to set the stop and the Scott Procedure in Chapter \n26 to determine the number of shares or contracts. The Turtle system contains similar \n259Chapter sixteen: Technical a nalysis of commodity charts\nprocedures. Numerous studies have proven the size of the risk per trade—1%, 2%, 3%—is \ndirectly correlated to equity volatility.\nThe 25th looked like a reversal day. The gap down on the 26th could have been \nconsidered the closing of an exhaustion gap—not apparent here because the tails (shadows) \nof the candlesticks obscure the complete price behavior.\n(EN10: In the 10th edition, a new section on stops in Chapter 27 examines a number of stop \nmethods.)\nA variety of methods\nAs noted above, a competent chart analyst may, in my opinion (and in Magee’s opinion), \nperform profitably in the futures markets. There are other questions, of course, namely of \ncharacter, temperament, intelligence, judgment, and so on. Let us leave those questions \nto Dr. Elder and confine ourselves to the method question. Chart analysts proved their \nabilities in the futures markets long before computers existed. In fact, long before in the \ncase of Japanese rice traders, enlightening their efforts with candlesticks in the eighteenth \ncentury.\nIn the 1970s, I saw point and figure chartists enjoy great success at Dean Witter and \nMerrill Lynch and other major firms in futures. I have seen least squares curve fitters, \nmoving average calculators, and abstruse statistical analysts all enjoy profitable outings \nin commodities. Not to speak of the Turtles who, using naturalistic high–low systems, \nharvested good profits in the markets. As the saying goes, gateless is the gate and many are \nthe ways to the great Dow. Although I have enjoyed great success myself using mechanical \nnumber-driven systems over the years, I have become more and more attracted to “natural” \nsystems. Chart analysis is essentially natural, as is the Turtle system. The Dow Theory is \na natural system in which no mathematical algorithm comes between the analyst and the \ndata. The essential, more, quintessential, weakness of all number-driven systems is their \nblindness. They do not have the ability to discriminate between the forest and the trees. \nThe experienced human chartist can see (and hear) the changing rhythms of the market \nand respond to them, responding to factors too subtle (and even subconscious) to program. \nNevertheless, even natural systems, like the Turtle systems, can fall into this trap. When \nthe markets learn a lot of capital is waiting just above the 20-day high, they will set a trap \nfor it. For “markets” you may read “they.” If you apply the knowledge of this book to such \nsituations, you may avoid the trap.\nEverything you need to know as a chart analyst trading futures\n“Jack be nimble, Jack be quick, Jack jump over the Candlestick.” Yes, it is true, as the \nleverage is 10 times greater and the speed is 10 times faster. I have illustrated in Figure 16.9 \nthe combination of a very tight trendline with a run day, which it seems to me is a good \ncurrent (twenty-first century) combination. Otherwise, the same qualities that make a good \nsecurities trader make a good futures trader once the great leap to leveraged quick-fire \nmarkets is made. If you have been successful trading stocks, you will probably be successful \ntrading futures, and you probably should practice on stocks while studying futures. A \nsobering fact I often recount to my graduate students is that Richard Wyckoff worked in \nthe securities business for eight years before making his first investment; he studied the \nmarkets an additional six years before trading.\n260 Technical Analysis of Stock Trends\nThe Magee methodology will serve as a valuable cornerstone of your futures operations \nand you must never cease studying. Mechanical systems have their attractions, especially \nwhen seasoned with experienced chart analysis. No method will survive unless practiced \nwith diligence, persistence, judgment, and patience. Time and again you will hear famous \ntraders say di", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 125}
{"text": "nical Analysis of Stock Trends\nThe Magee methodology will serve as a valuable cornerstone of your futures operations \nand you must never cease studying. Mechanical systems have their attractions, especially \nwhen seasoned with experienced chart analysis. No method will survive unless practiced \nwith diligence, persistence, judgment, and patience. Time and again you will hear famous \ntraders say discipline is the secret of their success. What they mean by discipline is their \nability to measure and contain the risk, set a stop based on technical or money management \nprocedures, and then honor the stop. The most important lesson the futures trader has to \nlearn from Edwards and Magee is the ability to see the character of the market, trading or \ntrending, and then to adjust his tactics accordingly.\nIn the next great Bull Market in commodities, which is inevitable, these methods and \nsystems derived from them will once again reap windfall profits.\nI have attempted in the ninth edition of this classic book to show the book’s usefulness \nto the intelligent futures trader. Simple classical chart analysis alone can be successful in \nthe futures markets in the hands of an experienced competent analyst. Natural mechanical \nsystems such as the Turtle system have been effective and will be again, perhaps with some \ntweaking (such as imposing a chart analysis superstructure). Wave analysis methods such \nas the Basing Points Procedure of Chapter 28 can be used. Even number-driven systems, \nsuch as moving averages, can be successful, especially if combined with chart analysis.\n261\nchapter seventeen\nA summary and concluding comments\nWe began our study of technical stock chart analysis in Chapter 1 with a discussion of the \nphilosophy underlying the technical approach to the problems of trading and investing. \nWe could ask the reader to turn back now and review those few pages to recapture a \nperspective on the subject that must have been dimmed by the many pages of more or less \narduous reading that have intervened. (For illustrations in this chapter, see Figures 17.1 \nthrough 17.4.)\nIt is easy, in a detailed study of the many and fascinating phenomena that stock charts \nexhibit, to lose sight of the fact they are only the rather imperfect instruments by which \nwe hope to gauge the relative strength of supply and demand, which, in turn, exclusively \ndetermines what way, how fast, and how far a stock will go.\nRemember, in this work, it does not matter what creates the supply and the demand. \nThe fact of their existence and the balance between them are all that count. No man, no \norganization (and we mean this verbatim et literatim ) can hope to know and accurately \nappraise the infinity of factual data, mass moods, individual necessities, hopes, fears, \nestimates, and guesses that, with the subtle alterations ever proceeding in the general \neconomic framework, combine to generate supply and demand. Nevertheless, the \nsummation of all these factors is reflected virtually instantaneously in the market.\nThe technical analyst’s task is to interpret the action of the market itself—to read the \nflux in supply and demand mirrored therein. For this task, charts are the most satisfactory \ntools thus far devised. Lest you become enrapt, however, with the mechanics of the chart—\nthe minutiae of daily fluctuations—ask yourself constantly, “What does this action really \nmean in terms of supply and demand?”\nJudgment, perspective, and a constant reversion to first principles is required. A chart, \nas we have said and should never forget, is not a perfect tool nor a robot; it does not give \nall the answers quickly, easily, or positively, in terms anyone can read and translate at once \ninto certain profit.\nWe have examined and tested exhaustively many technical theories, systems, indexes, \nand devices that have not been discussed in this book (chiefly because they tend to short-\ncircuit judgment) to see the impossible by a purely mechanical approach to what is far from \na purely mechanical problem. The methods of chart analysis that have been presented are \nthose that have proved most useful because they are relatively simple and easily rationalized \nsince they stick closely to first principles. Additionally, they are of a nature that does not \nlead us to expect too much of them and they supplement each other and work well together.\nLet us review these methods briefly. They fall roughly into four categories:\n 1. The Area Patterns or formations of price fluctuation that, with their concomitant \nvolume, indicate an important change in the supply–demand balance. They can \nsignify Consolidation, a recuperation or gathering of strength for renewed drive in \nthe same direction as the trend that preceded them. Or they can indicate Reversal, the \nplaying out of the force formerly prevailing, and the victory of the opposing force, \nresulting in a new drive in the reverse direction. In either case, they may be described \nas periods during which energy is brewed or pressure is built up to propel prices in \n262 Technical Analysis of Stock Trends\nSPIEGEL , INCORPORATED SM\n1946–1947\nAPRILM AY JUNE JULY AUGUST SEPTEMBERO CTOBER NOVEMBER DECEMBER JANUARYF EBRUARY MARCH\n38\n36\n34\n32\n30\n28\n26\n24\n22\n20\n19\n18\n17\n16\n15\n14\nSales\n100’s\n12510075\n50\n25\n6 13 20 2 1 471 18 25 18 15 22 29 61 32 0 27 31 0 17 24 31 71 42 1 28 5 12 19 26 2 9 16 23 30 7 14 21 28 4 11 18 25 18 15 22 811 52 22 9\nG\nFigure 17.1 Spiegel’s Bear Market started in April 1946 from a Symmetrical Triangle that changed into a Descending Triangle. Note the Pullback \nin June and two Flags. This history is carried on in Figure 17.2 , which overlaps Fig u r e 17.1; this chart shows the move that ensued from the wide \nDescending Triangle of early 1947 , culminating in a Reversal Day on May 19. Note various Minor and Intermediate Resistance Levels.\n263Chapter seventeen: A summary a nd concluding comments\nSPIEGEL, INC. SM 1946–1947\nGG\nOCTOBERN OVEMBERD ECEMBERJ ANUARY FEBRUARY MARCHA PRI", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 126}
{"text": "This history is carried on in Figure 17.2 , which overlaps Fig u r e 17.1; this chart shows the move that ensued from the wide \nDescending Triangle of early 1947 , culminating in a Reversal Day on May 19. Note various Minor and Intermediate Resistance Levels.\n263Chapter seventeen: A summary a nd concluding comments\nSPIEGEL, INC. SM 1946–1947\nGG\nOCTOBERN OVEMBERD ECEMBERJ ANUARY FEBRUARY MARCHA PRIL MAY JUNEJ ULYA UGUST SEPTEMBER\n20\n19\n18\n17\n16\n15\n14\n13\n12\n11\n10\n9\n8\nSales\n100’s\n125\n100\n75\n50\n25\n5 12 19 26 2 9 16 23 30 7 14 21 28 4 11 18 25 1 8 15 22 1 8 15 22 29 51 21 9 26 31 01 72 4 7 14 21 28 51 2 19 26 2 9 16 23 30 6 13 2031\nFigure 17.2 Overlapping Fig u r e 17.1, this chart shows the move that ensued from the wide Descending Triangle of early 1947 , culminating in a \nReversal Day on May 19. Note various Minor and Intermediate Resistance Levels.\n264 Technical Analysis of Stock Trends\na move (up or down) that can be turned to profit. Some of them provide an indication \nas to how far their pressure will push prices. These chart formations, together with \nvolume, furnish the technician with most of his “get-in” and many of his “get-out” \nsignals.\n Volume, which has not been discussed in this book as a feature apart from price \naction, and which cannot, in fact, be utilized as a technical guide by itself, deserves \nsome further comment. Remember it is relative that it tends naturally to run higher \nnear the top of a Bull Market than near the bottom of a Bear Market. Volume \n“follows the trend,” meaning it increases on rallies and decreases on reactions in \nan overall uptrend, and vice versa. But use this rule judiciously; do not place too \nmuch dependence on the showing of a few days and bear in mind that even in a Bear \nMarket (except during Panic Moves), there is always a slight tendency for activity \nto pick up on rises. (“Prices can fall of their own weight, but it takes buying to put \nthem up” as Edwards said.)\n A notable i ncrease in activity, as compared with previous days or weeks, may \nsignify either the beginning (breakout) or the end (climax) of a move, temporary or \nfinal. (More rarely, it may signify a “shakeout.”) Its meaning, in any given case, can \nbe determined by its relation to the price pattern.\n 2. Trend and trendline studies supplement Area Patterns as a means of determining the \ngeneral direction in which prices are moving and of detecting changes in direction. \nAlthough lacking the nice definition of Area Formations, they may frequently be used \nfor “get-in” and “get-out” purposes in short-term trading, as well as provide a defense \nagainst premature relinquishment of profitable long-term positions.\n 3. Support and Resistance Levels are created by the previous trading and investment \ncommitments of others. They may indicate where it should pay to take a position, \nbut their more important technical function is to show where a move is likely to slow \ndown or end, and at what level it should encounter a sudden and important increase \nin supply or demand.\n Before entering a trade, look both to the pattern of origin for an indication of the \npower behind the move and to the history of Support–Resistance for an indication \nas to whether it can proceed without difficulty for a profitable distance. Support– \nResistance studies are especially useful in providing “cash-in” or “switch” signals.\n 4. Broad market background, including the Dow Theory, should not be scorned. This \ntime-tested device designates the (presumed) prevailing Major Trend of the market. \nIts signals are “late,” but with all its faults (like the greatly augmented following it has \nacquired in recent years resulting in a considerable artificial stimulation of activity at \ncertain periods), it is still an invaluable adjunct to the technical trader’s toolkit.\nThe general characteristics of the various stages in the stock market’s great Primary \nBull and Bear cycles, which were discussed in our Dow Theory chapters, should never be \nlost to view. This brings us back to the idea of perspective, which we emphasized as essential \nto successful technical analysis at the beginning of our summary. The stock that does not, to \nsome degree, follow the Major Trend of the market as a whole is an extraordinary exception. \nMore money has been lost by buying perfectly good stocks in the later and most exciting \nphases of a Bull Market, and then selling them, perhaps from necessity, in the discouraging \nconditions prevailing in a Bear Market, than from all other causes combined.\nHence, keep your perspective on the broad market picture. The basic economic tide is one \nof the most important elements in the supply–demand equation for each individual stock. \nIt may pay to buck “the public,” but it does not ever pay to buck the real underlying trend.\n265Chapter seventeen: A summary a nd concluding comments\nMajor Bull and Bear Markets have recurred in fairly regular patterns throughout all \nrecorded economic history, and there is no reason to suppose they will not continue to recur \nfor as long as our present system exists. It is well to keep in mind that caution is in order \nwhenever stock prices are at historically high levels and that purchases will usually work \nout well eventually when they are at historically low levels.\nIf you make known your interest in your charts, you will be told the chart analyst (like \nthe Dow theorist) is always late—buying after prices have already started up (maybe not \nuntil long after the “smart money” has completed its accumulation) and sells after the trend \nhas unmistakably turned down. Partly true, as you have no doubt already discovered for \nyourself. The secret of success lies not in buying at the very lowest possible price and selling \nat the absolute top, but rather in the avoidance of large losses. (Small losses you will have to \ntake, and as quickly as possible as warranted by the situation.)\nOne of the most successful “operators” Wall Street has ever seen, Bernard Baruch, a \nmultimill", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 127}
{"text": "as you have no doubt already discovered for \nyourself. The secret of success lies not in buying at the very lowest possible price and selling \nat the absolute top, but rather in the avoidance of large losses. (Small losses you will have to \ntake, and as quickly as possible as warranted by the situation.)\nOne of the most successful “operators” Wall Street has ever seen, Bernard Baruch, a \nmultimillionaire and a nationally respected citizen today, is reputed to have said never in \nhis entire career had he succeeded in buying within 5 points of the bottom or selling within \n5 points of the top! (EN: For perspective, the 5 points mentioned constituted roughly 10% of the \nmarket at that time.)\nBefore we leave this treatise on theory and proceed to the more practical matters of \napplication and market tactics that are the province of Section II of this book, the reader will, \nwe hope, forgive one more admonition. There is nothing in the science of technical analysis \nthat requires one always to have a position in the market. There is nothing that dictates \nsomething must happen every day. There are periods—sometimes long months—when \nthe conservative trader’s best policy is to stay out entirely. What is more there is nothing in \ntechnical analysis to compel the market to go ahead and complete (in a few days) a move \nthe charts have foretold; it will take its own good time. Patience is as much a virtue in stock \ntrading as in any other human activity.\nTechnical analysis and technology in the 21st \ncentury: the computer and the internet: tools of \nthe investment/information revolution\nThe purpose of this section is to put computer and information technology into proper \ncontext and perspective for chart-oriented technical analysts.\nIn John Magee’s time, in his office in Springfield, Massachusetts, there was a chart \nroom—a room filled with all-age chartists from teenagers to senior citizens. These people \nspent all their time keeping charts and assisting Magee in interpretation. These were \nwonderful and intelligent people who developed marvelous insights into the stocks they \ncharted as well as created the manual charts that adorn this book.\nToday, that room and all those technicians have been replaced by a beige (sometimes \nlime) box that sits crowded on our desktops and that is often worshipped as a fount of \ninsight and wisdom: “Computer, analyze my stocks.”\nUnfortunately, the computer does not have the discrimination and pattern recognition \nability of the people in that chart room. Undeterred by this weakness in computer \ntechnology, traders and investors have poured incalculable money and effort into computer-\naided research, attempting to discover the keys to market success. More money has been \nspent in this effort than was ever put into the search for the philosopher’s stone. Much of it \nwas wasted, but it has not all been spent in vain. In some areas, it has been quite productive. \nBut no fail-safe algorithm, in spite of all this effort, has been found for investment success, \n266 Technical Analysis of Stock Trends\nand certainly not for stock trading. The research has demonstrated that even the algorithm \nof “buy low, sell high” has fatal flaws in it.\nTo fully understand the importance of the computer, the reader should appreciate some \nbasic differences in participants’ approach to the markets, or, we might say, schools of \nanalysts and investors. We will not bother with fundamental analysts here, as they are of \na different religious persuasion. Chart analysts, or Magee-type technical analysts, pretty \nmuch confine their analysis of the market to the interpretation of bar charts. (This does not \nmean their minds must be closed to other inputs. On the contrary—anything that works.) \nAnother chart analyst school uses point and figure charts, and another candlestick charts. \nAnother breed of technical analysts takes basic market data, price and volume, and uses \nthem as the input to statistical routines that calculate everything from moving averages to \nmystically designated indicators like %R or Bollinger Bands (see Glossary); they are known \nas statistical or number-driven technical analysts. All these analysts attempt to invest or \ntrade stocks and other financial instruments (not including options) using some form of \nwhat is called technical analysis—that is, they all take hard data that people cannot lie \nabout, misrepresent, and manipulate, (unlike the data inputted to fundamental analysis \nlike earnings, cash flow, sales, etc.) as input to their analysis.\nUsing number-driven or statistical technical analysis, these latter schools attempt, just \nas chart analysts do, to predict market trends and trading opportunities. This can be more \nthan a little difficult because the stock and bond markets are behavioral markets driven \nby human emotion, perhaps the most important of many variables influencing price. Plus, \nhuman emotion and behavior dictates manic and depressive elements, which have not yet \nbeen quantified. Yet, some chart analysts believe they can recognize it when they see it on \nthe charts.\nIn another area, the computer has yielded much more dramatic and profitable results, \nbut that is in a model-driven market, namely the options markets. Quantitative analysts, \nthose who investigate and trade the options markets, are a breed apart from technical \nanalysts. In an interesting irony, emotion-driven markets, the stock markets, are used as \nthe basis for derivatives, or options, whose price is determined largely by the operation of \nalgorithms called “models;” for example, the Black Scholes model. Quantitative analysts \nbelieve, as does this editor, the options markets can be successfully gamed through \nquantitative analysis. Results of skilled practitioners indicate this belief is accurate.\nAlas, life is not so simple for the simple stock trader. Stock prices having nothing to do \nwith mathematics, except for being expressed as natural numbers, are not susceptible to \neas", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 128}
{"text": "ck Scholes model. Quantitative analysts \nbelieve, as does this editor, the options markets can be successfully gamed through \nquantitative analysis. Results of skilled practitioners indicate this belief is accurate.\nAlas, life is not so simple for the simple stock trader. Stock prices having nothing to do \nwith mathematics, except for being expressed as natural numbers, are not susceptible to \neasy prediction as to their future direction. Not even with Magee chart analysis or any other \nform of analysis—technical, fundamental, or psychic. (From a theoretical point of view, \neach trade made on the basis of a chart analysis should be looked at as an experiment made \nto confirm a probability. The experiment is ended quickly if the trend does not develop.) \nThe fact chart analysis is not mechanizable is important. It is one reason chart analysis \ncontinues to be effective in the hands of a skilled practitioner. Not being susceptible to \nmechanization, counterstrategies cannot be brought against it, except in situations whose \nmeaning is obvious to everyone, for instance, a large important Support or Resistance Level \nor a glaringly obvious chart formation. These days everyone looks at charts to trade even \nif they do not believe in their use. In these obvious cases, some market participants will \nattempt to push prices through these levels to profit from volatility and confusion. Indeed, \nhuman nature has not changed much since Jay Gould and Big Jim Fisk.\nWhen these manipulations of price occur, they create false signals—Bull and Bear \ntraps. Interestingly, the failure of these signals may constitute a reliable signal in itself—but \nin the direction opposite to the original signal.\n267Chapter seventeen: A summary a nd concluding comments\nThe importance of computer technology\nOf what use and importance then is this marvelous tool—the most interesting tool man \n(homo) has acquired since papyrus? (Numerous computer software packages available are \ncapable of executing the functions described in the following discussion.) If the computer \ncannot definitively identify profitable opportunities, what good is it?\nProbably the most important function the computer has for the Magee analyst is the \nautomation of rote detail work. Data can be gathered by downloading from database \nservers. Charts can be called up in an instant. Portfolio accounting, maintenance, and tax \npreparation can be disposed of with one hand while drinking coffee with the other. All in \nall, this might make it sound as though the computer is a great tool, but with a pretty dull \nedge. Not strictly true. There is at least one great leap forward for Magee analysts with this \ntool, leaving aside the rote drudgery it saves. This great advantage is portfolio analysis. In \nAppendix B, Resources, a complex portfolio analysis of the kind used by professional traders \n(Blair Hull and Options Research Inc.) is illustrated. Even simpler portfolios of the average \ninvestor can benefit from the facilities afforded by most portfolio programs, either on the \nnet or in commercial software packages (locations and software identified in Appendix B, \nResources).\nAnother advantage is the ability to see basic data displayed in many different forms: \npoint and figure charts, candlestick charts, close-only charts—these are prepared in the \nflick of an eyelash and may indeed contribute to understanding the particular situation \nunder the magnifying glass. The effortless quantification of some aspects of analysis may \nbe useful—volume studies, for instance, and given the popularity of moving averages, \nseeing the 50- and 200-day moving averages can be interesting. These moving averages \nare considered significant by many market participants—even fundamental analysts. The \nanalysis of any of these should be considered in relation to the current state of the market \nas understood by the careful chart analyst.\nBut what about (the strangely named) stochastics, Bollinger Bands, %R, MACD, Moving \nAverages (plain vanilla, exponential, crossover, etc.), price/volume divergence, RSI (plain \nvanilla and Wilder), VP Trend, TCI, OBV , Upper/Lower Trading Bands, ESA Trading Bands, \nand AcmDis? Well, there is a certain whiff of alchemy to some of them, and some have some \nusefulness sometimes. What is more, all systems work beautifully at least twice in their \nlives: in research and in huge monumental Bull Markets. These number-driven indicators \nare also the times when trading genius is most likely to be discovered. (EN9: It is also true, as \nI have said, that you can drive a nail with a screwdriver. And the inventor of a tool may be fabulously \nsuccessful with it while its adopters lose their assets.)\nIt is also possible the excess of technical information created by these indicators may be \nlike the excess of fundamental information—another shell to hide the pea under, another \nmagician’s trick to keep the investor from seeing what is truly important, and what is \nnecessary and sufficient to know to trade well. Perhaps the investor would be better off with \na behavioral model because the markets are behavioral. Number-driven technical analysis \ncan do many things, some like Dr. Johnson’s dog, which walked on its hind legs, but they \ncannot put the market in perspective—only the human mind can do that. Number-driven \nmodels after all do not consider skirt lengths, moon cycles, sun spots, the length of the \neconomic cycle, or the Bullish or Bearish state of the market (if Bear Markets still exist) (EN9: \nA wry ironical comment written before the market crash of the 2000s .) In the end, the human \nbrain is still the only organ capable of synthesizing all this quantitative and qualitative \ninformation and assessing those elements that cannot be reduced to ones and zeros. The \neducated mind is still the best discriminator of patterns and their contexts.\n268 Technical Analysis of Stock Trends\nSummary 1\nThe computer is a tool, a powerful tool, but a tool nonetheless. It i", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 129}
{"text": "In the end, the human \nbrain is still the only organ capable of synthesizing all this quantitative and qualitative \ninformation and assessing those elements that cannot be reduced to ones and zeros. The \neducated mind is still the best discriminator of patterns and their contexts.\n268 Technical Analysis of Stock Trends\nSummary 1\nThe computer is a tool, a powerful tool, but a tool nonetheless. It is not an intelligent problem \nsolver or decision maker. We use a mechanical ditch digger to dig a ditch, but not to figure \nout where the ditch should be.\nThe multitude of indicators and systems should be viewed with a skeptical eye and \nevaluated within the context of informed chart analysis. Sometimes an indicator or \ntechnique will work for one user or its inventor but strangely mislead the chart analyst \nwho tries to use it—or buys it, even based on a verified track record.\nTherefore, the experienced investor keeps his methods and analysis simple until he \nhas definitive knowledge of any technique, method, or indicator he would like to add to \nhis repertoire. Most of all, he depends on his own observations and experience to evaluate \nhis and others’ trading techniques.\nOther technological developments of importance to \nthe technical Magee analyst and all investors\nThe computer is not the only technological development of interest to the technical investor. \nA number of information revolution technologies need to be put in perspective. These are, \nin broad categories, the internet and all its facilities, developments in electronic markets, \nand advances in finance and investment theory and practice. This last is treated in the final \nsection of this chapter.\nOwing to the enormous body of material on these subjects, no attempt will be made to \nexplore these subjects exhaustively, but the general investor will be given the information \nhe needs to know to put these subjects in their proper perspective. Resources will point the \nanalyst to avenues for further investigation if the need is felt.\nFirst of all, are there any technological developments of whatever sort that have made \ncharting obsolete? No. Are there any developments that have made trading a guaranteed \nsuccess? No. The only sure thing is some huckster will claim to have a sure thing. Those \nwho believe such claims are the victims of their own naiveté.\nThe Internet: the eighth wonder of the modern world (EN9: Appendix \nB, Resources, for the ninth edition has been enormously expanded \nand is of paramount importance to modern investors.)\nThe internet has been called the most complex project ever built by man, which is probably \ntrue. Complex, sprawling, and idiosyncratic, it has something for everyone, especially the \ninvestor. Every form of investment creature known to man has set up a site on the internet \nand waits like the hungry arachnid for the casual surfer: brokers and advisors—technical \nand fundamental; newspapers, news magazines, newsgroups, and touts; mutual funds, \nmutual fund advisories, critics and evaluators of all the above; database vendors, chat \nrooms, electronic marketplaces and exchanges, and Exchange Traded Notes (ECNs)—the \nonly unfilled niche that seems to exist is investment pornography. Perhaps naked options \nwill be able to satisfy this need.\nThis is a bewildering array of resources. How does one sort them out? The implications \nof all this for the electronic or cyber investor may be further expanded to indicate the \nservices and facilities available: quotes and data; portfolio management and accounting; \nonline interactive charting; automatic alerts to PBDAs (personal body digital assistants \nor gizmos carried on the body, for example, cell phones and handheld computers, and \n269Chapter seventeen: A summary a nd concluding comments\nso on); analysis and advice; electronic boardrooms; and electronic exchanges where \ntrading takes place without intermediaries. Appendix B, Resources, supplies the specifics \non these categories while this chapter supplies perspective. It is one thing to contemplate \nthis cornucopia of facilities and another thing to appreciate the importance and priority \nof its elements. What good are real-time quotes if you are only interested in reviewing \nyour portfolio once a week, except for special occasions? What good are satellite alerts and \nvirtual reality glasses to a long-term investor? It is easy for the investor with no philosophy \nor method to be drawn into the maelstrom of electronic wonders and stagger out of it a \nlittle wiser and much poorer.\nObserve then the goods and services of all of this are of importance to the levelheaded \ninvestor with his feet on the ground and his head out of the clouds (or Cloud). This, hopefully \nnot, abstract investor, the object of our attention here, needs what? He needs data, charts, and \na connection to a trading place. Data are available at the click of a mouse. A chart occupies the \nscreen in another click. Another click and a trade is placed. In the Internet Age, it would be \ntautological to attempt to describe this process in prose when live demonstrations are as \nclose as the desktop computer and an internet connection. A demonstration of this rather \nsimple process (easy to say when one does it without thinking) may be seen at locations \nlinked in Appendix B, Resources. The trade will be made, of necessity, through a broker of \nsome sort, perhaps an electronic broker or even a non-virtual broker who communicates \nvia telephone. This will occur shortly, if not already, an electronic pit where one matches \nwits with a computer instead of a market maker or specialist.\nHow long brokers will be necessary is a question that is up in the air in the new century. \n(The broker who earns his keep will always be with us, and welcome, too.) Electronic \nmarketplaces where investors meet without the necessity of a broker or specialist are \nalready proliferating (see Appendix B, Resources) and will continue to gain the advantage for \nthe investor over", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 130}
{"text": "maker or specialist.\nHow long brokers will be necessary is a question that is up in the air in the new century. \n(The broker who earns his keep will always be with us, and welcome, too.) Electronic \nmarketplaces where investors meet without the necessity of a broker or specialist are \nalready proliferating (see Appendix B, Resources) and will continue to gain the advantage for \nthe investor over the trading pit, which is one of the last remaining edges the professionals \nhold over off-floor traders. Suffice it to say, their initial phases will undoubtedly be periods \nof dislocation, risk, and opportunity as their glitches are ironed out.\nPlacing electronic orders, whether to an electronic exchange or to the New York Stock \nExchange, has certain inherent advantages over oral orders. No one can quarrel about a \ntrade registered electronically as opposed to orally where the potential for disagreement \nexists. In addition, the trader has only handled the data once—rather than making an \nanalysis, calling a broker, recording the trade, and passing it to the portfolio. If he just hits \nthe trade button and the transaction is routed through his software package, no one will \nhave any doubt as to where an error might lie. The manual method presents an opportunity \nfor error at each step. Rest assured, errors occur and can be disastrous to trading.\nThe efficiency and ease of the process with a computer have much to recommend it—\nautomation of trade processing, elimination of confusion and ambiguities, audit tracks, \nautomation of portfolio maintenance, and, perhaps most important of all, automatic mark-\nto-market of the portfolio (the practice of valuing a portfolio at its present market value \nwhether trades are open or closed).\nMarking-to-market\nThis book might have been entitled Zen and the Art of Technical Analysis if that title were \nnot so hackneyed and threadbare. It conveys, nonetheless, the message of Zen in the art \nof archery, that of direct attachment to reality and the importance of the present moment. \nIn his seminal book The General Semantics of Wall Street (now Winning the Mental Game on \nWall Street), John Magee inveighed at some length against the very human tendency to \n270 Technical Analysis of Stock Trends\nkeep two sets of books in the head—one recording profits, open and closed, and another \nrecording losses, but only closed losses. Open losses were not losses until booked. Having \nan electronic portfolio accountant that refuses to participate in such self-deception has \nmuch to recommend it. If the portfolio is always marked to the market when the computer \ncommunicates with the data vendor, or the trade broker, it is difficult not to see red ink, \nand to see the equity of the account reflects all trades, open and closed.\nSeparating the wheat from the chaff\nIt requires a gimlet-eyed investor to pick his way through the minefield of temptations in \nelectronic investing and number-driven technical analysis. Playing with the toys, seeing \nwhat the pundits have to say, and fiddling with “research” can subtly replace profitable \ntrading as the activity. Actually, almost all the research the Magee analyst must do is \naddressed in this book.\nChaff\nChat rooms, touts, news, predictions, punditry, brokerage house buy, sell, hold, strong hold, \nweak buy, strong buy, and any other species of brokerage house recommendation should \nbe taken at face value. Remember, brokerage firms survive by selling securities and make \ntheir money in general on activity. Actually, much of their money is made servicing their \ninstitutional clients and distributing their clients’ shares to their retail clientele—a blatant \nconflict of interest that blew up in their faces in the early 2000s, resulting in many fines and \nsome jail terms (plus ça change\n … ). In the surging Clinton–Gore Bull Markets of the 1990s, \nall of these worked. In a serious Bear Market, none of them will work. (EN9: A serious Bear \nMarket started in earnest in 2000 and was correctly identified with Magee chart analysis as may be \nseen from the John Magee Letters at the http:/ /www.edwards-magee.com.)\nSummary 2\nNever in the history of the markets have so many facilities for private investors been \navailable. The computer is necessary to take advantage of those facilities.\nData may be acquired automatically via internet or dial-up sites at little or no cost. A (as \nthey say) plethora of websites offer cyber investors everything from portfolio accounting to \nalerts sent to their personal body-carried devices (cell phones, pagers, handheld PDAs, and \nso on). Some of these even offer real-time data, which is a way for the unsophisticated trader \nto go broke in real time. Many of these sites offer every kind of analysis from respectable \ntechnical analysis (usually too complicated) to extraterrestrial channeling.\nInternet chat rooms will provide real-time touting and numerous rumors to send the \nlemmings and impressionable scurrying hither and yon. But, one expects, not the readers \nof this book.\nOf more importance, the information revolution and the computer will:\n 1. Relieve the analyst of manual drudgery, accelerate all the steps of analysis: \ndata gathering, chart preparation, portfolio accounting, and analysis and tax \npreparation.\n 2. Give the analyst virtually effortless portfolio accounting and mark-to-market \nprices—a valuable device to have to keep the investor from mixing his cash and \naccrual accounting, as Magee says.\n271Chapter seventeen: A summary an d concluding comments\n 3. Enable processing of a hitherto unimaginable degree. An unlimited number of stocks \nmay be analyzed. Choosing those to trade with a computer will be dealt with in \nChapter 21, Selection of Stocks to Chart.\n 4. Allow the investor to trade on ECNs or in electronic marketplaces where there are no \npit traders or locals to fiddle with prices.\nAdvancements in investment technology, part 1: \ndevelopments in finance theory and practice\nNumerous pernicious and", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 131}
{"text": "nlimited number of stocks \nmay be analyzed. Choosing those to trade with a computer will be dealt with in \nChapter 21, Selection of Stocks to Chart.\n 4. Allow the investor to trade on ECNs or in electronic marketplaces where there are no \npit traders or locals to fiddle with prices.\nAdvancements in investment technology, part 1: \ndevelopments in finance theory and practice\nNumerous pernicious and useless inventions, services, and products litter the internet \nand the financial industry marketplace; but modern finance theory and technology are \nimportant and must be taken into consideration by the general investor. This chapter will \nexplore the minimum the moderately advanced investor needs to know about advances \nin theory and practice. And it will point the reader to further resources if he desires to \ncontinue more advanced study.\nInstruments of limited (or non) availability during the time of Edwards and Magee \nincluded exchange traded options on stocks, futures on averages and indexes, options \non futures and indexes, and securitized indexes and averages, as a partial list of only the \nmost important instruments. Undoubtedly, one of the most important developments of \nthe modern era is the creation of trading instruments that allow the investor to trade and \nhedge the major indexes. Of these, the instruments created by the Chicago Board of Trade \n(CBOT\n®) are of singular importance. These are the CBOT® DJIASM Futures and the CBOT® \nDJIASM Futures Options, which are discussed in greater detail at the end of this chapter. \n(EN9: Not so singular, perhaps. Probably of greater importance to readers of this book are the AMEX \niShares, particularly DIA, SPY, and QQQ, which are instruments (ETFs) that offer the investor \ndirect participation in the major indexes as though they were stocks.)\nGeneral developments of great importance in finance theory and practice are found in \nthe following sections.\nOptions\nFrom the pivotal moment in 1973 when Fischer Black (friend and college classmate) and his \npartner, Myron Scholes, published their—excuse the usage—paradigm-setting Model, the \noptions and derivatives markets have grown from negligible to trillions of dollars a year. \nThe investor who is not informed about options is playing with half a deck. The subject, \nhowever, is beyond the scope of this book, which hopes only to offer some perspective on \nthe subject and guides to the further study necessary for most traders and many investors.\nSomething in the neighborhood of 30% or more of options expire worthless. This is \nprobably the most important fact to know about options. (There is a rule of thumb about \noptions called the 60–30–10 rule: 60% are closed out before expiration, 30% are “long at \nexpiration,” meaning they are worthless, and 10% are exercised.) Another fact to know \nabout options occurred in the Reagan Crash of 1987; the money puts bought at $0.625 on \nOctober 16 were worth hundreds of dollars on October 19—if you could get the broker to \npick up the telephone and trade them. (The editor had a client at Options Research, Inc. \nduring that time who lost $57 million in three days and almost brought down a major \nChicago bank; he had sold too many naked puts.)\nThe most sophisticated and skilled traders in the world make their livings (quite \nsumptuous livings, thank you) trading options. Educated estimates have been made that \nas many as 90% of retail options traders lose money. That combined with the fact that by far \n272 Technical Analysis of Stock Trends\nit is the general public that buys (rather than sells) options should suggest some syllogistic \nreasoning to the reader.\nWith these facts firmly fixed in mind, let us put options in their proper perspective \nfor the general investor. Options have a number of useful functions, such as offering the \ntrader powerful leverage. With an option, he can control much more stock than by the direct \npurchase of stock—his capital stretches much further. So options are an ideal speculative \ninstrument (Exaggerated leverage is almost always a characteristic of speculative \ninstruments.), but they can also be used in a most conservative way—as an insurance \npolicy. For example, a position on the long security side may be hedged by the purchase of \na put on the option side. (This is not a specific recommendation to do this. Every specific \nsituation should be evaluated by the prudent investor with professional assistance as to its \nmonetary consequences.)\nThe experienced investor may also use options to increase yield on his portfolio of \nsecurities. He may write covered calls or naked puts on a stock to acquire it at a lower cost \n(e.g., he sells out of the money put options. This is a way of being long the stock; if the stock \ncomes back to the exercise price, he acquires the stock. If not, he pockets the premium.)\nThere are numerous tactics of this sort that may be played with options. Played because, \nfor the general investor, the options game can be disastrous, as professionals are not \nplaying. They are seriously practicing skills the amateur can never hope to master. Many \nfloor traders, indeed, would qualify as idiot savants—they can compute the “fair value” \nof options in their heads and make money on price anomalies of 1/16, or, as they call \nit, a “teenie.” For perspective, the reader may contemplate a conversation the editor had \nwith one of the most important options traders in the world who remarked casually that \nhis fortune was built on teenies. The reader may imagine at some length what would be \nnecessary for the general investor to make a profit on anomalies of 1/16. (EN10: The advent \nof digital pricing has given market makers and specialists even more flexibility to beat the investor \nby shaving spreads, theoretically, to $0.01.)\nThis does not mean the general investor should never touch options; it just means he \nshould be thoroughly prepared before he goes down to play that game. In options trading, \ntraders speak of bull", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 132}
{"text": "ake a profit on anomalies of 1/16. (EN10: The advent \nof digital pricing has given market makers and specialists even more flexibility to beat the investor \nby shaving spreads, theoretically, to $0.01.)\nThis does not mean the general investor should never touch options; it just means he \nshould be thoroughly prepared before he goes down to play that game. In options trading, \ntraders speak of bull spreads, bear spreads, and alligator spreads. The alligator spread is \nan options strategy that eats the customer’s capital in toto.\nAmong these strategies is covered call writing. This strategy is touted as being an \nincome producer on a stock portfolio. There is no purpose in writing a call on a stock in \nwhich the investor is long—unless that stock is stuck in a clear congestion phase that is not \ndue to expire before the option expires. Besides, if the stock is in a downtrend, it should \nbe liquidated, but to write a call on a stock in a clear uptrend is to make oneself beloved of \nthe broker, whose good humor improves markedly with account activity and commission \nincome. The outcome of a covered call on an ascending stock is that the writer (you, dear \nreader) has the stock called at the exercise price, losing his position and future appreciation, \nnot to mention costs. The income is actually small consolation, a sort of booby prize—a \nway of cutting your profits while increasing your costs. Nevertheless, covered writes are \njustified and profitable in some cases.\nQuantitative analysis\nThe investor should be aware of another area of computer and investment technology \nthat has yielded much more dramatic and profitable results, but that is in a model-driven \nmarket—namely, the options markets. Quantitative analysts, those who investigate and \ntrade the options markets, are a breed apart from technical analysts. In an interesting \n273Chapter seventeen: A summary a nd concluding comments\nirony, behavioral markets, the stock markets, are used as the basis for derivatives, or \noptions whose price is determined largely by the operation of algorithms called “models.” \nThe original model that created the modern world of options trading was the Black–\nScholes options analysis model, which assumed the “fair value” of an option could be \ndetermined by entering five parameters into the formula: the strike price of the option, \nthe price of the stock, the “risk-free” interest rate, the time to expiration, and the volatility \nof the stock.\nThe eventual universal acceptance of this model resulted in the derivatives industry we \nhave today. To list all the forms of derivatives available for trading today would be to expand \nthis book by many pages, and it is not the purpose of this book anyway. The purpose of this \nparagraph is to sternly warn general investors who are thinking of “beating the derivatives \nmarkets” to undergo rigorous training first. The alternative could be extremely expensive.\nAt first, the traders who saw the importance of this model and used it to price options \nvirtually skinned older options traders and the public, who traded pretty much by the seat \nof the pants or the strength of their convictions, meaning human emotion. But professional \nlosers learn fast and now all competent options traders use some sort of model or anti-model, \nor anti-antimodel to trade. True to form, options sellers, who are largely professionals, take \nmost of the public’s (the buyers) money. This is the way of the world.\nOptions pricing models and their importance\nAfter the introduction of the Black–Scholes model, numerous other models followed, among \nthem the Cox–Ross–Rubinstein, the Black Futures, and others. For the general investor, the \nmessage is this: he must be acquainted with these models and what their functions are if \nhe intends to use options. Recall, the model computes the “fair value” of the option. One \nway professionals make money off amateurs is by selling overpriced options and buying \nunderpriced options to create a relatively lower risk spread (for themselves). Not knowing \nwhat these values are for the private investor is like not knowing where the present price is \nfor a stock; it is a piece of ignorance for which the professional will charge him a premium \nto be educated about. Unfortunately, many private options traders never get educated, in \nspite of paying tuition over and over again. But ignorance is not bliss—it is expensive.\nTechnology and knowledge works its way from innovators and creative geniuses \nthrough the ranks of professionals and sooner or later is disseminated to the general public. \nBy that time, the innovators have developed new technology. Nonetheless, even assuming \nthat professionals have superior tools and technology, the general investor must thoroughly \neducate himself before using options. As it is not the province of this book to dissect options \ntrading, though the reader may find references in Appendix B, Resources.\nHere it would not be untoward to mention one of the better books on options as a \nstarting point for the moderately advanced and motivated trader. Lawrence McMillan’s \nOptions as a Strategic Investment is necessary reading. In addition, the newcomer may contact \nthe Chicago Board Options Exchange (the CBOE) at http:/ /www.cboe.com , which has \ntutorial software.\nFutures on indexes\nFutures, like options, offer the speculator intense leverage—the ability to control a \ncomparatively large position with much less capital than the purchase of the underlying \ncommodity or index. Futures salesmen are fond of pointing out the fact that, if you are \nmargined at 5% or 10% of the contract value, a similar move in the price of the index will \n274 Technical Analysis of Stock Trends\ndouble your money. They are often not so conscientious about pointing out a similar move \nagainst your position will wipe out your margin (actually earnest money). Unlike (long) \noptions, a mishap in the market can result in more than the loss of margin; it can become a \ndef", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 133}
{"text": "ed at 5% or 10% of the contract value, a similar move in the price of the index will \n274 Technical Analysis of Stock Trends\ndouble your money. They are often not so conscientious about pointing out a similar move \nagainst your position will wipe out your margin (actually earnest money). Unlike (long) \noptions, a mishap in the market can result in more than the loss of margin; it can become a \ndeficit account and debts to the broker—in other words, losses of more than 100%. For this, \namong other reasons, it is wise not to plunge into futures without considerable preparation. \nThis preparation might well begin, for the adroit investor, with the reading of Schwager’s \nTechnical Analysis, Schwager on Futures, currently one of the better books on the subject.\nLet us say that, instead of using futures to speculate, we want to use them as a hedge \nfor our portfolio of Dow–Jones DIAMONDS (DIA) or portfolio of Dow–Jones stocks. Now \nwe are purchasing insurance, rather than speculating. As an oversimplified example, the \ninvestor might see the failure of the DJIA to break through a top as the beginning of a \ncongestion zone (a consolidation or reversal pattern). He could then hedge his position by \nshorting the Dow–Jones futures. Now he is both long and short—long the cash, short the \nfutures. He would place a stop on the futures above his purchase price to close the trade \nif the market continued rising. If the market fell, he would maintain the futures position \nuntil he calculated that the reaction had passed its worst point, or until it were definitely \nanalyzed to have reversed. He would then take his profits on the futures position (taxable), \nbut his cash position would be intact, and presumably, the greater capital gains on those \npositions would be safe from taxation, and also safe from the costs, slippage, and difficulties \nof reestablishing the stock position.\nOptions on futures and indexes\nConservative as well as speculative use may be made of options. For example, the investor \nmight, after a vigorous spike upwards, feel the Standard & Poor’s (S&P) 500, or the SPYs \nwhich he is long, were overbought. He might then buy an index put on the S&P as a hedge \nagainst the expected decline. If it occurs, he collects his profit on the option and his cash \nposition in the S&P is undisturbed. If the index continues to climb, he loses the option \npremium—an insurance policy he took out to protect his stock portfolio.\nNote: The tactics described here are for the reader’s conceptual education. Before \nexecuting tactics of this kind, or any other unfamiliar procedure, the investor should \nthoroughly inform himself and rehearse the procedure, testing outcomes through paper \ntrading before committing real capital. He must, in short, figure out how you lose. A number of \nwebsites offer facilities of this kind, and the investor may also build on his own computer \na research or paper-trading portfolio segregated from his actual transactions.\nThe trader might also choose to buy an option on a future. At the CBOT\n®, the trader \ncan trade both options and futures on the DJIA. These can be used as the above examples \nfor speculating or hedging, except in this case, the successful option buyer might wind \nup owning a futures contract instead of the cash position. This could be disconcerting \nto one not accustomed to the futures market, especially if large price anomalies between \nfutures and cash occurred, as happened in 1987 and 1989 when futures prices went to huge \ndiscounts to cash. A primary reason for employing the futures would be for leverage and \nthe reason for using the options on futures would be the analysis that uncertainty was in \nstore and the wish to only risk the amount of the options premium.\nObviously, a speculator can choose to forget the stock or futures part of the portfolio \nand trade only options. Before taking such a step, the trader should pass a postgraduate \ncourse. The proportion of successful amateur option traders to successful professional \ntraders is extremely skewed. In fact, one might say all successful options traders are \nprofessionals.\n275Chapter seventeen: A summary an d concluding comments\nModern Portfolio Theory\nModern Portfolio Theory (MPT) is a procedure and process whereby a portfolio manager \nmay classify and analyze the components of his portfolio in such a way as to, hopefully, be \naware of and control risk and return. It attempts to quantify the relationship between risk \nand return. Rather than analyzing only the individual instruments within a portfolio, MPT \nattempts to determine the statistical relationships among the members of the portfolio and \ntheir relationships to the market.\nThe processes involved in MPT analysis are as follows (1) portfolio valuation , or \ndescribing the portfolio in terms of expected risk and expected return; (2) asset allocation, \ndetermining how capital is to be allocated among the classes of instruments (bonds, stocks, \nand so on); (3) optimization, or finding the trade-offs between risk and return in selecting the \ncomponents of the portfolio; and (4) performance measurement, or the division of each stock’s \nrisk into systemic and security-related classes.\nHow important is this for the general investor? Not very and there is a large question \namong pragmatic analysts, such as the editor, as to its pragmatic usefulness for professionals, \nalthough they cling to it as to a life ring in a shipwreck. Mandelbrot observed in articles \n(“ A Multifractal Walk Down Wall Street”) and letters in the Scientific American (February \n1999 and June 1999) that MPT discards about 5% of statistical experience as if it did not \nexist (although it [the experience] does). He also observed the ignored experience includes \n10-sigma market storms that are blamed for portfolio failures as though it were the fault of \nthe data instead of the fault of the process.\nThe wonders and joys of investment technology\nAre there any other innovations in finance an", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 134}
{"text": "999) that MPT discards about 5% of statistical experience as if it did not \nexist (although it [the experience] does). He also observed the ignored experience includes \n10-sigma market storms that are blamed for portfolio failures as though it were the fault of \nthe data instead of the fault of the process.\nThe wonders and joys of investment technology\nAre there any other innovations in finance and investment theory of which the general \ninvestor should be aware? (See Chapter 42 for discussion of Value at Risk and Pragmatic \nPortfolio Theory.) Well, it never hurts to know everything, and the very best professionals \nnot only are aware of everything, but also are in the constant process of finding new \nwrinkles and glitches and anomalies. Though, as Magee would ask, what is necessary and \nsufficient to know (see Winning the Mental Game on Wall Street )? Absolute certainty is the \nhallmark of religious extremists and the naïve, who do not know what they do not know. \nSo I will remark that probably this book contains either what is necessary and sufficient for \nthe investor to know about these matters or guides the reader to further study.\nNot to mention, nota bene, any number of little old ladies with a chart, a pencil, a ruler, \nand previous editions of this book have beaten the pants off professional stock pickers with \nsupercomputers and MPT and Nobel Laureates and who knows what other resources. \nI personally know investment groups that have thrown enormous resources into the \ndevelopment of real-time systems that, in research, were 100% successful in beating the \nmarket. The only real glitch was the systems required so much computer power they could not \nbe run quickly enough in real time to actually trade in the markets. Philosopher’s stone redux.\nAdvancements in investment technology, part 2: \nfutures and options on futures on the Dow–Jones \nIndustrial Index at the CBOT\n(EN9: The general investor must be aware that the methods and techniques described in this chapter \nare for advanced practitioners. Careless use of the described instruments can be extremely damaging \nto a portfolio.)\n276 Technical Analysis of Stock Trends\nInvestment and hedging strategies using the CBOT® DJIASM futures contract\nA futures contract is the obligation to buy or sell a specific commodity on or by some \nspecified date in the future. For example, if one went long corn futures, he would be \nobligated to accept delivery of corn on the delivery date, unless he sold the contract before \nthe settlement date. Shorting the contract would obligate the seller to deliver corn unless \nhe offset (by repurchase) the contract. The “commodity” in our present case is the basket \nof stocks represented by the DJIA futures index. All futures contracts specify the date \nby which the transaction must conclude, known as the “settlement date,” and how the \ntransaction will be implemented, known as “delivery.” The DJIA futures contract price \nclosely tracks the price of the Dow–Jones Industrials as computed from stock market values.\nThe value of the future is found by multiplying the index price of the futures contract \nby $10.00. For example, if the futures index price is 10,000, the value of the contract is \n10,000 × $10.00 = $100,000. So the buyer or seller of the futures contract is trading \napproximately $100,000 worth of stocks at that Dow futures level. The value may be higher \nor lower owing to several factors, for example, cost of carry, which will be discussed below.\nSettlement of futures contracts\nAll futures contracts must be “settled.” Some futures are settled by delivery, the famous \nnightmare of finding 5,000 bushels of soybeans delivered on your front lawn. Dow Index \nfutures “settle” (are delivered) in cash. The short does not dump a basket of Dow stocks \non the yard of the long. Thus, on the settlement date of the contract, the settlement price is \n$10.00 times a figure called the “Special Opening Quotation,” a value calculated from the \nopening prices of the member stocks of the Dow Future following the last day of trading in \nthe futures contract. This value is compared with the price paid for the contract when the \ntrade initiated. For example, if the Dow Future is 10,000 at expiration, a long who bought \nthe contract at 9,000 receives $10,000 ($10.00 × 1000) from the short.\nMarking-to-market\nThis $10,000, however, is paid daily over the life of the contract, rather than in one payment \nupon expiration of the contract. It is paid as successive daily “margin” payments. These \npayments are not really margin but are in effect “earnest money” or a performance bond. \nThe practice of squaring up accounts at the end of every day’s trading is called “marking-to-\nmarket.” These daily payments are determined based on the difference between the previous \nday’s settlement price and the contract settlement price at the close of trading each day.\nAs a practical example, if the settlement price of June Dow Index futures increases \nfrom 9,800 to 9,840 from May 17 to May 18, the short pays $400 ($10.00 × 40) and the long’s \naccount is credited $400. If the futures settlement price decreases 10 points the following \nday, the long pays $100 to the short’s account—and so on each day until expiration of the \ncontract, when the futures price and the index price achieve parity.\nAt any time, the trader can close his position by offsetting the contract, that is, by \nselling to close an open long, or buying to close an open short. At the expiration date, open \ncontracts are settled in cash at the final settlement price.\nFungibility\nOne of the great contributions of the great established exchanges like the CBOT ® and the \nChicago Mercantile Exchange is their institutionalization of contract terms and relationships \n277Chapter seventeen: A summary a nd concluding comments\nis known as “fungibility.” Any one futures contract for corn, or an index, or any other \ncommodity is substitutable for another of the same commodity. Similarly, the E", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 135}
{"text": "great contributions of the great established exchanges like the CBOT ® and the \nChicago Mercantile Exchange is their institutionalization of contract terms and relationships \n277Chapter seventeen: A summary a nd concluding comments\nis known as “fungibility.” Any one futures contract for corn, or an index, or any other \ncommodity is substitutable for another of the same commodity. Similarly, the Exchange has \nnegated counterparty risk by placing a Clearing Corporation between all parties to trades. \nThus, even if the other party to a trade went broke, the Clearing Corporation would assume \nhis liability and, using the mechanism of daily settlement, whereby losers pay winners \ndaily, the danger of major default is avoided.\nFutures “margins” (or “earnest money”) are deposited with the broker on opening \na trade. The leverage obtainable is quite extreme for a stock trader. The initial margin \nis usually 3%–5% of the total value of the contract. Each day thereafter, margins vary \naccording to the process described above of marking-to-market.\nAs the reader can see, the purchase or sale of a Dow Future is the equivalent of a fairly \nlarge portfolio transaction, with the understanding it is a transaction that will be closed in \nthe future, unlike a stock purchase, which may be held indefinitely.\nDifferences between cash and futures\nThe main two differences between the cash and the futures transactions are as follows:\n 1. In cash, the value of the portfolio must be paid up front or financed in a stock margin \naccount.\n 2. The owner of the cash portfolio receives cash dividends.\nThese are not the only differences. The leverage employed in the futures transaction is \na two-edged sword. If the trader has no reserves, a minor move in the index wipes him out. \nSuch a minor move would be barely noticed by the owner of a cash portfolio.\nDow Index futures\nThe price of the future and the price of the index are closely linked. Any price anomaly \nis quickly corrected by arbitragers. On any significant price difference, arbitragers will \nbuy the underpriced and sell the overpriced, bringing the relationship back in line. \nTheir prices are not exactly the same because the futures contract value must reflect \nthe costs of short-term financing of stocks and the dividends paid by index stocks until \nfutures expiration, known as the “cost of carry.” The “theoretical value” of the future \nshould equal the price of the index plus the carrying cost, what is called the “fair” or \n“theoretical” value.\nUsing stock index futures to control exposure to the market\nThe owner of a cash portfolio in the Dow, or of DIAMONDS, can control his exposure, \nhis risk, by using futures to hedge. If, for example, he is pessimistic about the market, \nor more to the point, a lot of uptrend lines have been broken and the technical situation \nseems to be deteriorating, he can sell a futures contract equivalent to his portfolio and \nbe flat the market.\nReaders will immediately recognize the advantages of this strategy. Tax consequences \non the cash portfolio are avoided, as are the other negative consequences of trading— \nslippage, errors, and so on. Long-term positions are better left alone. By flattening his \nposition, the investor has now insured the future value of his portfolio, and the capital \ninvolved is now earning the money market rate of return.\n278 Technical Analysis of Stock Trends\nWhat happens if the forecast market decline occurs? The portfolio is protected from \nloss and the capital earns the market rate of return; however, the investor should monitor \nhis hedge closely, lifting it when he calculates the correction has run its course. Taxes will \nthen be due on the profits on the hedge.\nIn monitoring the hedge, the possibility the market rises instead of falls must \nbe considered. In planning the hedge in the first place, the investor must plan for this \neventuality and determine at which point he will lift the hedge on the losing side. At worst, \nthe investor has surrendered portfolio appreciation. Not considering cash flow implications.\nIt is worth emphasizing, in fact strongly emphasizing, that these techniques require \nknowledge, expertise, and study. Careless use of techniques of this nature can bloody the \namateur investor. Hence, it is probably best to have a professional guide for the first several \nof these expeditions and to execute first a number of paper transactions.\nThe canny investor can increase his exposure to the market and the risk to his capital \nby buying index futures. But the canny investor must be careful not to turn into a burned \nspeculator. Futures trading, because of the extreme leverage, is an area for dedicated and \nexperienced speculators.\nA Dow futures transaction costs less than if you had to buy or sell a whole basket \nof stocks. Professional fund managers—as well as other professionals—regularly use \nfutures for asset allocation and reallocation. In all likelihood, they are not using the \nextreme leverage afforded by futures. In other words, if they have a $1 million cash \nportfolio, they do not buy $10 million worth of futures. It is not the leverage in which \nthey are interested, but rather it is the extreme convenience and agility offered by doing \nshort-term allocations in futures. The ability to almost instantaneously move in and out \nof the market without disturbing the underlying portfolio is a powerful feature of these \n“proxy markets.”\n118\n116\n114\n112\n110\n108\n106\n104\n102\n100\n12000\n11600\n11200\n10800\n10400\n9/1999 10/1999 11/1999 12/19992 /200000\n10400\n10800\n11200\n11600\n12000\n100\n102\n104\n106\n108\n110\n112\n114\n116\n118\n/DI200006 LAST-Daily 02/24/2000\nCreated with TradeStation www.TradeStation.com\nDIA LAST-Daily 02/24/2000\nFigure 17.3 Diamonds and Futures. The 2% plus break at the arrow of an 11-month trendline is \nan unmistakable invitation to hedge the DIAMONDS by shorting the futures. Profits on the short \nwould have offset losses in the DIAMONDS. This convenient drill would have pres", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 136}
{"text": "6\n108\n110\n112\n114\n116\n118\n/DI200006 LAST-Daily 02/24/2000\nCreated with TradeStation www.TradeStation.com\nDIA LAST-Daily 02/24/2000\nFigure 17.3 Diamonds and Futures. The 2% plus break at the arrow of an 11-month trendline is \nan unmistakable invitation to hedge the DIAMONDS by shorting the futures. Profits on the short \nwould have offset losses in the DIAMONDS. This convenient drill would have preserved liquidity, \npostponed capital gains taxes, and avoided loss of equity. Notice the return to the trendline after the \nbreak. More of the foolish virgin syndrome?\n279Chapter seventeen: A summary a nd concluding comments\nInvestment uses of Dow Index futures\nThe following examples describe the basic mechanics of using Dow futures contracts. \nThese can be used to adjust equity exposure in anticipation of volatile market cycles and \nto rebalance portfolios among different asset classes. The futures also may be used for other \npurposes not illustrated here. The following examples are not intended to be absolutely \nprecise, but only to illustrate the mechanics involved. For the sake of simplicity, mark-to-\nmarket payments and cost of carry have been eliminated from the examples.\nSituation 1: Portfolio protection\nYou are a long-term Magee-type investor and you have old and profitable positions with which \nyou are satisfied. Yet, you have seen the broadening top of the Dow Jones (ca. 2000) and it is \nalmost October, so you would not be surprised to see a little bloodshed. You have $400,000 \nin the Dow and $100,000 in money market instruments. You decide to reverse this ratio, but \nyou do not want to liquidate the Dow portfolio, as there is no sign of a confirmed downtrend, \nonly that of consolidation. You sell $300,000 of index futures, leaving yourself with a $100,000 \nkicker in case you are wrong about the market’s declining. At the time, the market is 10,000 \nand the futures are 10,500, meaning the cost of carry is approximately 0.5% (10,500/10,000 – 1).\nYou sell three futures contracts [$300,000/($10 × 10,000)]. You now have reversed your \nposition and are long $100,000 Dow stocks and long $400,000 money market equivalents.\nValidating your technical analysis, the market has begun to swing in broad undulations \nand, at the expiration of the futures, the Dow is at 10,000. On your stocks, you have a return \nof –0.5%, and the money market position has a rate of return of 0.5%.\nWhat would have been the situation had you not hedged?\nStock Portfolio $400,000 × 0.95 $380,000\nMoney Market + 100,000 × 1.005 $100,500\nTotal $480,500\nHow the futures position affects the portfolio:\nShort three futures 3 × $10.00 × (10,000–9,500) +$15,000\nTotal $495,000\nValue of portfolio with reallocation of assets in cash market:\nStocks $100,000 × 0.95 $95,000\nMoney market + $400,000 × 1.005 $402,000\nTotal $497,000\nBy hedging in the futures market, you now have the equivalent of a $100,000 investment \nin Dow futures stocks and a $400,000 investment in the money market instrument. The \nstock market decline now affects only $100,000 of your stock portfolio rather than $400,000; \nin addition, you earn a money market rate of return of 0.5% on the $300,000 difference.\nWithout the futures transaction, the portfolio is worth $480,500. The $15,000 profit on \nthe short futures position offsets the loss on the $300,000 of the portfolio that was moved \nout of equities by the short futures position. In brief, by selling futures, you are able to \nprotect $300,000 of your initial portfolio value from a stock price decline, nearly breaking \n280 Technical Analysis of Stock Trends\neven, an achievement given these market conditions. Had you been more confident of the \nmarket decline, you might have completely neutralized the equity risk on the portfolio \nby selling more futures contracts. This would have converted the entire stock position to \na $400,000 investment in the money market. The amount of protection you should obtain \ndepends on your assessment of the market and your tolerance for risk.\nSituation 2: Increasing exposure with futures\nNow let us look at the other side of the coin. The market has come off its highs in a \npredictable and controlled secondary reaction and your technical analysis is that the Bull \nMarket will continue. At 10,000, it appears headed for 11,000, and you want to increase your \ncommitment. Your portfolio is as previously described, split 80/20 between Dow stocks \nand money markets. It is time to go whole hog, you decide. You are acutely aware of the \nmarket maxim (bulls make money and bears make money and hogs wind up slaughtered), \nbut there is also a market maxim that no market maxim is true 100% of the time, which is \nalso true of this maxim.\nRather than liquidate your money market holdings, you buy one futures contract, \nwhich puts you long another $100,000 of stocks. The rate of return on the money markets \nin your portfolio is 0.5%. To get a $500,000 exposure in blue chips, you buy the following \nnumber of contracts: $100,000/($10 × 10,000) = 1 contract.\nResults: Your technical analysis of the direction of the market is correct, and the Dow \nfuture rises to 11,000 at the September expiration, or by 10%.\nValue of portfolio with passive management:\nStocks $400,000 × 1.10 $440,000\nMoney market+ $100,000 × 1.005 $100,500\nTotal $540,500\nValue of portfolio with futures position:\nLong DJIA futures 1 × $10.00 × (11,000 – 10,000) $10,000\nTotal $550,500\nValue of portfolio with reallocation of assets in cash market:\nStocks $500,000 × 1.10 $550,000\nMoney market $0\nTotal $550,000\nIn buying Dow Index futures, you are able to “equitize” $100,000 of your money market \ninvestment, effectively increasing your return from the money market rate of 0.5%–10%. If \nyou had not bought futures, the total value of your portfolio at the September expiration \nwould have been $540,500 instead of $550,500. Not only do you have a $10,000 extra gain \nin your portfolio, but also you have taken advantage of the market’s continuing upward", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 137}
{"text": "“equitize” $100,000 of your money market \ninvestment, effectively increasing your return from the money market rate of 0.5%–10%. If \nyou had not bought futures, the total value of your portfolio at the September expiration \nwould have been $540,500 instead of $550,500. Not only do you have a $10,000 extra gain \nin your portfolio, but also you have taken advantage of the market’s continuing upward \nclimb without having to adjust your portfolio.\nSituation 3: Using bond and index futures for asset allocation\nSpeculation in bonds can be quite profitable, notwithstanding David Dreman’s assertion \nthat long-term investments in bonds are net losers. (EN9: An oversimplification of a sophisticated \n281Chapter seventeen: A summary a nd concluding comments\nthesis by an important figure .) Subsequently, it is not unusual for an investor to have both \nbonds and stocks in his portfolio. In this event, the portfolio can be managed with facility \nby using both Index futures and Treasury bond futures.\nMany investors consider it prudent to reallocate their capital commitments based \non inflation rates, interest rates, and the reported expression on Alan Greenspan’s (or \nBernanke’s) face before congressional testimony.\nAn efficient and inexpensive way to reallocate assets between stocks and bonds is to \nput on spreads of Treasury bond futures and Dow Index futures.\nAnalysis of recent long- and medium-term trends in the market, however, has led you \nto consider increasing your equity portfolio and decreasing your bond portfolio. You have \n$200,000 invested in Dow stocks and $200,000 invested in Treasury bonds. You would like \nto take advantage of the sustained market rally by increasing your equities exposure to 75% \nand decreasing your bond holdings to 25%.\nAs for tactics, you can reallocate both sides of your portfolio—buying $100,000 of stocks \nand selling $100,000 of bonds—with the sale of Treasury bond futures and the purchase \nof Dow Index futures.\nThe Treasury bonds in your portfolio have a market price of 103–20. The price of \nSeptember Treasury bond futures is 102–20 per $100 of face value, and $100,000 of face \nvalue must be delivered against each contract. The value of the Dow futures is 10,000, and \nthe price of the Dow Index futures contract is 10,000 (ignoring the cost of carry).\nThe number of T-bond futures to sell is: short T-bond futures: $100,000/\n(102 – 20 × $1,000) = 1 (number of futures is rounded to the nearest whole number). The \nnumber of stock index futures to buy is as follows: long stock index futures: $100,000/\n($10.00 × 10,000) = 1 (number of futures is rounded to the nearest whole number).\nResults: at the September futures expiration, the value of the Dow future is 11,000, a \nrate of return of 10%, and the market value of the bonds is 101–08, a rate of return of –1%.\nPortfolio value with no market action taken:\nStocks $200,000 × 1.10 $220,000\nMoney market $200,000 × 0.99 $198,000\nTotal $418,000\nValue of futures positions:\nLong Dow futures $10 × 1 × (11,000 – 10,000) $10,000\nShort bond futures +$1000 × 1 × (102–20 – 101–08) $1375\nTotal $11,375\nGrand total $429,375\nValue of portfolio had transaction been done in cash market:\nStocks $300,000 × 1.10 $330,000\nBonds +$100,000 × 0.99 $99,000\nTotal $429,000\nBy this simple maneuver, you have quickly and easily changed your market posture \nto add an additional $100,000 exposure to stocks and subtract $100,000 exposure to bonds. \n282 Technical Analysis of Stock Trends\nHaving correctly analyzed market trends, your action results in an increase in portfolio \nvalue from $418,000 to $429,375. You could have accomplished the same result by buying and \nselling bonds and stocks, but not without tax consequences and the attendant transaction \nheadaches. The use of futures to accomplish your goals allowed you to implement your \ntrading plan without disturbing your existing portfolio.\nPerspective\nAlthough there can be no argument about the importance of CBOT® DJIASM Index futures—\nthey are markets of enormous usefulness and importance—there can also be no doubt the \nfutures novice should thoroughly prepare himself before venturing into these pits. In such \na highly leveraged environment, mistakes will be punished much more severely than an \nerror in the stock market. By the same token, ignorance of this vital tool is the mark of an \ninvestor who is not serious about his portfolio, or who is less intense in his investment \ngoals. “They” (the infamous “they”) use all the weapons at their disposal; so should “we.”\nOptions on Dow Index futures\nThe buyer of this instrument has the choice, or the right, to assume a position. It is his option \nto do so—unlike a futures contract in which he has an obligation once entered. There are \ntwo kinds of options: calls (the right to buy the underlying instrument) and puts (the right \nto sell). Also, options can be bought (long) or sold (short) like futures contracts.\nA long call option on Dow Index futures gives the buyer the right to buy one futures \ncontract at a specified price which is called the “exercise” or “strike” price. A long put option \n12000\n11800\n11600\n11400\n11200\n11000\n10800\n10600\n10400\n10200\n1600\n1200\n800\n400\n11/1999 12/1999 00 2/2000\n/DI200006 LAST-Daily 02/24/2000\nCreated with TradeStation www.TradeStation.com\nFigure 17.4 Dow–Jones Futures and Options. A put purchased at the arrow on the break would have \nprotected patiently won gains over the previous 11 months. The increase in the value of the put can \nbe seen as futures track declining Dow cash. A theoretical drill, but theoretical drills precede actual \ntactics in the market.\n283Chapter seventeen: A summary a nd concluding comments\non Dow Index futures gives the buyer the right to sell one futures contract at the strike \nprice. For example, a call at a strike price of 10,000 entitles the buyer to be long one futures \ncontract at a price of 10,000 when he exercises the option. A put at the same strike price \nentitles the buyer to be short one f", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 138}
{"text": "l \ntactics in the market.\n283Chapter seventeen: A summary a nd concluding comments\non Dow Index futures gives the buyer the right to sell one futures contract at the strike \nprice. For example, a call at a strike price of 10,000 entitles the buyer to be long one futures \ncontract at a price of 10,000 when he exercises the option. A put at the same strike price \nentitles the buyer to be short one futures contract at 10,000. The strike prices of Dow Index \nfutures options are listed in increments of 100 index points, giving the trader the flexibility \nto express his opinions about upward or downward movement of the market.\nThe seller, or writer, of a call or put is short the option. Effectively selling a call makes \nthe writer short the market, just as selling a put makes the writer long the market. As in a \nfutures contract, the seller is obligated to fulfill the terms of the option if the buyer exercises. \nIf you are short a call, and the long exercises, you become short one futures contract at \n10,000. If you are short one put and the long exercises, you become long one futures contract \nat 10,000.\nBuyers of options enjoy fixed risk. They can lose no more than the premium they pay \nto go long an option. On the other hand, sellers of options have potentially unlimited risk. \nCatastrophic moves in the markets often bankrupt imprudent option sellers.\nOption premiums\nThe purchase price of the option is called the option premium. The option premium is \nquoted in points, each point being worth $100. The premium for a Dow Index option is paid \nby the buyer at initiation of the transaction.\nThe underlying instrument for one CBOT\n® futures option is one CBOT® DJIASM futures \ncontract; so the option contract and the futures contract are essentially different expressions \nof the same instrument, and both are based on the Dow–Jones Index.\nOptions premiums consist of two elements: intrinsic value and time value. The \ndifference between the futures price and strike price is the intrinsic value of the option. If \nthe futures price is greater than the strike price of a call, the call is said to be “in-the-money.” \nIn fact, you can be long the futures contract at less than its current price. For example, if the \nfutures price is 10,020 and the strike price is 10,000, the call is in-the-money and immediate \nexercise of the call pays $10.00 times the difference between the futures and strike price, \nor $10 × 20 = $200. If the futures price is less than the strike price, the call is “out-of-the-\nmoney.” If the two are equal, the call is “at-the-money.” A put is in-the-money if the futures \nprice is less than the strike price and out-of-the-money if the futures price is greater than \nthe strike price. It is at-the-money when these two prices are equal.\nSince a Dow Index futures option can be exercised at any date until expiration, and \nexercise results in a cash payment equal to the intrinsic value, the value of the option must \nbe at least as great as its intrinsic value. The difference between the option price and the \nintrinsic value represents the time value of the option. The time value reflects the possibility \nthat exercise will become more profitable if the futures price moves farther away from the \nstrike price. Generally, the more time until expiration, the greater the time value of the \noption because the likelihood of the option becoming profitable to exercise is greater. At \nexpiration, the time value is zero and the option price equals the intrinsic value.\nVolatility\nThe degree of fluctuation in the price of the underlying futures contract is known as \n“volatility” (see Appendix B, Resources, for the formula). The greater the volatility of the \nfutures, the higher the option premium. The price of a futures option is a function of the \nfutures price, the strike price, the time left to expiration, the money market rate, and the volatility \n284 Technical Analysis of Stock Trends\nof the futures price. Of these variables, volatility is the only one that cannot be observed \ndirectly. Considering all the other variables are known, however, it is possible to infer from \noption prices an estimate of how the market is gauging volatility. This estimate is called the \n“implied volatility” of the option. It measures the market’s average expectation of what the \nvolatility of the underlying futures return will be until the expiration of the option. Implied \nvolatility is usually expressed in annualized terms. The significance and use of implied \nvolatility is potentially complex and confusing for the general investor, professionals having \na decided edge in this area. Their edge can be removed by serious study.\nExercising the option\nAt expiration, the rules of optimal exercise are clear. The call owner should exercise the \noption if the strike price is less than the underlying futures price. The value of the exercised \ncall is the difference between the futures price and the strike price. Conversely, the put \nowner should exercise the option if the strike price is greater than the futures price. The \nvalue of the exercised put is the difference between the strike price and the futures price.\nTo illustrate, if the price of the expiring futures contract is 7 ,600, a call struck at 7 ,500 \nshould be exercised, but a put at the same or lower strike price should not. The value of the \nexercised call is $1,000. The value of the unexercised put is $0.00. If the price of the expiring \nfutures contract is 7 ,500, a 7 ,600 put should be exercised but not a call at 7 ,600 or a higher \nstrike. The value of the exercised put is $1,000 and that of the unexercised call is $0.00.\nThe profit on long options is the difference between the expiration value and the option \npremium. The profit on short options is the expiration value plus the option premium. \nThe expiration values and profits on call and put options can often be an important tool \nin an investment strategy. Their payoff patterns and risk parameters make options", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 139}
{"text": "$1,000 and that of the unexercised call is $0.00.\nThe profit on long options is the difference between the expiration value and the option \npremium. The profit on short options is the expiration value plus the option premium. \nThe expiration values and profits on call and put options can often be an important tool \nin an investment strategy. Their payoff patterns and risk parameters make options quite \ndifferent from futures. Their versatility makes them good instruments to adjust a portfolio \nto changing expectations about stock market conditions. Moreover, these expectations \ncan range from general to specific predictions about the future direction and volatility of \nstock prices. Effectively, there is an option strategy suited to virtually every set of market \nconditions.\nUsing futures options to participate in market movements\nTraders must often react to rapid and surprising events in the market. The transaction \ncosts and price impact of buying or selling a portfolio’s stocks on short notice inhibit many \ninvestors from reacting to short-term market developments. Shorting stocks is an even \nless palatable option for average investors because of the margin and risks involved and \nsemantical prejudices.\nThe flexibility that options provide can allow one to take advantage of the profits from \nmarket cycles quickly and conveniently. A long call option on Dow Index futures profits \nat all levels above its strike price. A long put option similarly profits at all levels below its \nstrike price. Let us examine both strategies.\nProfits in rising markets\nIn August, the Dow Index is 10,000 and the Dow Index September future is 10,050. You \nexpect the current Bull Market to continue, and you would like to take advantage of the \ntrend without tying up too much capital and also undertake only limited risk.\n285Chapter seventeen: A summary a nd concluding comments\nYou buy a September call option on Dow Index futures. These options will expire \nsimultaneously with September futures, and the futures price will be the same as the cash \nindex at expiration.\nYour analysis is bullish, so the 10,500 call (out-of-the-money strike price) is a reasonable \nalternative at a quoted premium of 10.10. You pay $1,010 for the call ($100 × 10.10).\nThe payoff: at the September expiration, the value of the Dow Future is 10,610. Now, your \ncall is in-the-money, and you exercise it and garner the exercise value less the premium, or \n$90.00 = $10.00 × (10,610 – 10,500) – $100 × (10.10) = $1,100 – $1,010. If the Dow future stays \nat or below 10,500, you let the call expire worthless and simply lose the premium. This is \nthe maximum possible loss on the call. If the Dow future increases by 101 points above the \nstrike price, you break even.\nInstead of buying the call option, the trader could have invested $100,500 directly in \nthe Dow stocks. Given a value of the Dow future of 10,110 in September, he would have had \na gain of $3,030. If he had invested directly in the stocks, however, an unexpected market \ndecline would have led to a loss.\nExploiting market reversals\nThe trader expects a reversal of the Bull Market now at 7 ,800 and would like some downside \nprotection.\nHe buys a put with a strike price of 7 ,700 (out-of-the-money). The put premium is 9.80, \nfor a total cost of $980 = $100 × 9.80. If the Index decreases to 7 ,600, with a corresponding \ndecrease in the futures contract in September, the put is worth $1,000. The maximum loss \nis the premium cost, which is lost if the Dow future is above 7 ,700 at expiration. The trader \nbreaks even if the Dow future decreases by 98 points below the strike price.\nUsing puts to protect profits in an appreciated portfolio\nDuring a sustained Bull Market, investors often search for ways to protect their paper profits \nfrom a possible market break. Even when fundamental economic factors tend to support a \ncontinued market upside, investors have to guard against unpredictable “technical market \ncorrections” and market over-reactions to news.\nSelling stocks to reduce downside risk is costly in fees and taxes and sacrifices potential \nprice gains. What is desirable in a sideways market environment is an instrument that \nprotects the value of a portfolio against a market drop but does not constrain upside \nparticipation. This is precisely what put options are designed to do.\nSituation 1\nThe market is in an uptrend in August, which is when the market lives with the anxiety the \nFederal Reserve will tighten short-term interest rates further in the coming months. The \ntrader has $78,000 invested in the Dow portfolio, and the Dow Future is at 7 ,800.\nTo hedge his portfolio, he purchases a put option on September futures against a \npossible market downturn. He buys a 7 ,600 put at a premium of 6.60, cost $100 × 6.60 = $660.\nBuying the put places a floor on the value of the portfolio at the strike price. Buying a \nput with a strike price of 7600 effectively locks in the value of the portfolio at $76,000. Above \nits strike price, a put is not exercised and the portfolio value is unconstrained. If the trader is \nwrong, and the market goes up, he loses the premium paid for the put. Depending on which \nstrike price he chooses, he increases or decreases downside risk. He breaks even when the \n286 Technical Analysis of Stock Trends\nDow future reaches a value of 7 ,534 = 7 ,600 – 66, the strike price less the put premium. At \nthis level, the unprotected and put-protected portfolios are equally profitable.\nThe similarity to life insurance is striking. If you do not die, the premium is wasted. \nBut if you do…\nImproving portfolio yields\nSituation 2\nAll markets, as the reader is perhaps aware, are not trending. Days, weeks, months, \nsometimes years can pass while the markets grind up and down in what are euphemistically \nknown as trading range markets. When the astute technician identifies one of these market \ndoldrums and judges that it will continue, he can reap other returns on his portfolio by \ns", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 140}
{"text": "do…\nImproving portfolio yields\nSituation 2\nAll markets, as the reader is perhaps aware, are not trending. Days, weeks, months, \nsometimes years can pass while the markets grind up and down in what are euphemistically \nknown as trading range markets. When the astute technician identifies one of these market \ndoldrums and judges that it will continue, he can reap other returns on his portfolio by \nselling puts and calls on Dow Index futures.\nFor example, when the Dow Index is 10,000 and the trader calculates it will not break \nout for the next month above 10,200, he sells calls at a strike price of 10,200. The quoted \npremium of the 10,200 call is, say, 10.10; selling a 10,200 call generates $1010 income.\nThe trader pockets the entire premium as a profit if the index remains below 10,200 at the \nSeptember expiration. The downside of this trade is that the trader gives up price appreciation \nabove 10,200. Above 10,200, the combined value of the portfolio and short call premium is \n$101,010. The break-even point is 10,301, where the Dow Future is equal to the sum of the strike \nprice and call premium. Above this point the covered call portfolio becomes less profitable \nthan the original portfolio. Since the short call is covered by the portfolio, this strategy is not \nexposed to the risk represented by a naked call. The main risk is the trader giving up the profit \npotential above the strike price of the call. As is obvious to the technician, this is a bad strategy \nin trending markets. Only in clearly range-bound markets would an enlightened trader want \nto write covered calls. The call premium collected is some compensation for this risk, but cold \ncomfort when the trader has misanalyzed the market. The best strike price of the call depends \non the probabilities you have assigned to future increases and behavior of the Dow.\nUsing option spreads in high- or low-volatility markets\nLong and short stock positions reflect definite market opinions or analyses. The market will \ngo up or the market will go down and the moderately competent technician should be right \nabout this more often than the unwashed general public. In markets of coiling volatility (i.e., \nlower than average volatility and declining), it is sometimes possible to exploit uncertainty \nby putting on a long straddle. The long straddle combines a long put and a long call at the \nsame strike price. This spread generates a return over two ranges of market values: values \nbelow the strike price of the put and values above the strike price of the call. It is a profitable \nstrategy given sufficient volatility; the editor’s company used such a strategy immediately \nbefore the crash of 1987 for managed accounts and collected disproportionate profits on a \nvery low-risk position. Experienced speculators and traders generally sell high-volatility \nmarkets and try to backspread (go long) in chosen less-volatile markets, expecting volatility \nto return to the mean. Sometimes they do this by writing a short straddle, a position with \na short put and a short call at the same strike price.\nSituation 3\nIn August, a technical analysis predicts that volatility will increase, and the market is in \na coiling process. The direction of prices is uncertain but potentially explosive. The trader \n287Chapter seventeen: A summary a nd concluding comments\nbuys a straddle of a long put at 7 ,800 and a long call at 7 ,800. The quoted call premium is 18.90 \nand the quoted put premium is 13.90. The total cost of the straddle is $3280 = $100 × 32.80. \nThis is the maximum loss if the Dow Future stalls at 7 ,800.\nThe straddle makes a profit when the Dow Future moves enough to recover the cost \nof the straddle, either below 7 ,472 = 7 ,800 – 328 or above 8,128 = 7, 8 0 0 + 328. The potential \nupside profit is unlimited. The maximum profit on the downside is $10.00 × (7 ,800 – 328), \nor $74,720, if the Dow future goes to zero (somewhat unlikely, but one never knows what \nChicken Little the investor will do if he thinks the sky is falling).\nSituation 4\nIn August, the investor calculates options are overvalued and volatility will be lower than \nimplied volatility. He expects a dormant market to continue through the end of the summer. \nHe decides to sell the September put and call at 7 ,800, collecting $3,280. The return on this \nshort straddle will turn negative if the Dow future in September goes below 7 ,472 or above \n8,128. The maximum loss on the downside is $10.00 × (7 ,800 – 328), or $74,720, and the loss \non the upside is unlimited. The investor, however, perceives the risk as limited because he \nbelieves the Dow future will neither increase nor decrease to these levels within the next \nmonth when the options expire. In these cases, the trader must also consider catastrophic \nrisk—as, for example, the editor’s client who was short puts in the crash of 1987 and lost \n$57 million.\nPerspective\n(EN9: Once again, do not practice the methods and techniques described in this chapter without \ncomplete confidence in their use. A course in futures and options is recommended, or professional \nconsultation.)\nI like to tell these stories so prospective options traders and general investors are made \ndramatically aware of the potential dangers, as well as the potential profits. As stated \nelsewhere in this book, the novice should work to achieve competence and experience before \nattempting advanced tricks in futures and options. On the other hand, the investment use \nof these instruments for prudent hedging and insurance is recommended to the investor \nwilling to do his homework, acquire competence, and grow in investment skills.\nDow Index futures and futures options present new techniques of portfolio protection \nand profit-making for the general investor. Numerous strategies can be practiced by the \nmoderately competent investor using these instruments. Keep in mind always that all \nthe methods of analytical investing espoused in this book are the base discipline—that \nis", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 141}
{"text": "cquire competence, and grow in investment skills.\nDow Index futures and futures options present new techniques of portfolio protection \nand profit-making for the general investor. Numerous strategies can be practiced by the \nmoderately competent investor using these instruments. Keep in mind always that all \nthe methods of analytical investing espoused in this book are the base discipline—that \nis, knowledge of the instruments and their use, prudent trade management, stop–loss \ndiscipline, and close attention to the dynamics of the situation. Above all, the existence \nof these instruments allows the most conservative of investors insurance and hedging \ntechniques not previously available.\nIn summation, knowledge of the DJIA futures and options on futures is absolutely \nessential for the competent technical investor and trader.\nRecommended further study\nIn view of the importance of this chapter, noted here are references to advanced material, \nwhich are also found in Appendix B, Resources.\n288 Technical Analysis of Stock Trends\nThe CBOE has a website explaining the math behind hedging. To hedge a portfolio of \n$500,000 tracking the S&P 500, you need four puts. The address for the calculation of the \nhedging ratio is available at http:/ /www.cboe.com/portfoliohedge.\nFor further study, see the following:\n• Options as a Strategic Investment by Lawrence Macmillan, http://www.optionstrategist.\ncom\n• Chicago Board Options Exchange, http:/ /www.cboe.com\n• Chicago Board of Trade, 312-435-3558 or 800-THE-CBOT; 312-341-3168 (fax); h t t p : //\nwww.cbot.com\npart two\nTrading tactics\nMidword\nAs a kind of foreword to Section II of this book, we might mention a commentary, “On \nUnderstanding Science: An Historical Approach,” by James Bryant Conant, president \nemeritus of Harvard.\nDr. Conant points out that, in school, we learn science is a systematic collection of \nfacts that are classified in orderly array, broken down, analyzed, examined, synthesized, \nand pondered; and then lo! a Great Principle emerges—pat, perfect, and ready for use in \nindustry, medicine, or what-have-you.\nHe further points out that all of this is a mistaken point of view held by most laymen. \nDiscovery takes form little by little, shrouded in questioning, and only gradually assumes \nthe substance of a clear, precise, well-supported theory. The neat tabulation of basic data, \nforming a series of proofs and checks, does not come at the start but much later. In fact, it \nmay be the work of other men entirely, men who, being furnished with the conclusions, are \nthen able to construct a complete, integrated body of evidence. Theories of market action \nare not conceived in a flash of inspiration; they are built, step by step, out of the experience \nof traders and students, to explain the typical phenomena that appear over and over again \nthrough the years.\nIn market operations, the practical trader is not concerned with theory as such. The \nneophyte's question, “What is the method?” probably means, actually, “What can I buy to \nmake a lot of money easily and quickly?” If such a trader reads this book, he may feel there \nis “something in it.” He may feel “It's worth a try” (a statement, incidentally, that reflects \nlittle credit on his own previous tries). He may also start out quite optimistically, without \nany understanding of theory or any experience in these methods, and without any basis \nfor real confidence in the method.\nIn such cases, the chances are great he will not immediately enjoy the easy success he \nhopes for. His very inexperience in a new approach will result in mistakes and failures. Yet, \neven with the most careful application of these methods, in correctly entered commitments, \nhe may encounter a series of difficult market moves that may give him a succession of \nlosses. Whereupon, having no solid confidence in what he is doing, he may sigh, put the \nbook back on the shelf, and say, “Just as I thought. It's no damn good.”\nNow, if you were about to go into farming for the first time, you might be told (and it \nwould be true) the shade tobacco business offers spectacular profits. But you would not \nexpect to gain these profits without investing capital, without studying how shade tobacco \nis grown and in what kinds of soils and what localities, nor without some experience with \n290 Trading tactics\nthe crop. Furthermore, you would need confidence—faith in the opportunity and also in \nthe methods you were using. If your first season's crop were blighted (and these things do \nhappen), you would naturally be disappointed. If it should happen that your second year's \ncrop were destroyed by a hailstorm, you would be hurt and understandably despondent. \nMoreover, if your third season's crop were to be a total loss because of drought, you would \nprobably be very gloomy indeed (and who could blame you?). But you would not say, \n“There's nothing to it. It's no damn good.”\nYou would know (if you had studied the industry and the approved cultivation \nmethods) that you were right, regardless of any combination of unfavorable circumstances, \nand you would know the ultimate rewards would justify your continuation, no matter how \nhard the road, rather than turn to some easier but less potentially profitable crop.\nSo it is with technical methods in the stock market; anyone may encounter bad seasons. \nThe Major Turns inevitably will produce a succession of losses to Minor Trend operators \nusing the methods suggested in this book. There will also be times when a man who has \nno understanding of basic theory will be tempted to give up the method entirely and look \nfor a “system” that will fit into the pattern of recent market action nicely, so he can say, “If \nI had only averaged my trades … . If I had fo llowed the Dream Book … . If I had ta ken \nCharlie's tip on XYZ … . If I had done i t this way or that way, I would have come out with \na neat profit.”\nIt would be better, and safer, to understand at the start that no method ever devised", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 142}
{"text": "entirely and look \nfor a “system” that will fit into the pattern of recent market action nicely, so he can say, “If \nI had only averaged my trades … . If I had fo llowed the Dream Book … . If I had ta ken \nCharlie's tip on XYZ … . If I had done i t this way or that way, I would have come out with \na neat profit.”\nIt would be better, and safer, to understand at the start that no method ever devised \nwill unfailingly protect you against a loss, or sometimes even a painful succession of losses. \nYou should realize what we are looking for is the probability inherent in any situation. \nLikewise, just as you would be justified in expecting to draw a white bean from a bag \nwhich you knew contained 700 white beans and 300 black beans (even though you had just \ndrawn out 10 black beans in succession!), so too you are justified in continuing to follow the \nmethods that, over long periods, seem most surely and most frequently to coincide with \nthe mechanism of the market.\nThus, this book should not be given a quick “once-over” and adopted straightaway as \na sure and easy road to riches. It should be read over and over, a number of times, and it \nshould be consulted as a reference work. Furthermore, and most importantly, you will need \nthe experience of your own successes and failures so you will know what you are doing \nis the only logical thing you can do under a given set of circumstances. In such a frame \nof mind, you will have your portion of successes and your failures, which you can take in \nstride, as part of the business, will not ruin either your pocketbook or your morale.\nIn short, the problem stated and analyzed through this whole volume is not so much a \nmatter of “systems” as it is a matter of philosophy. The end result of your work in technical \nanalysis is a deep understanding of what is going on in the competitive free auction, what is \nthe mechanism of this auction, and what is the meaning of it all. Be mindful this philosophy \ndoes not grow on trees; it does not spring full-bodied from the sea foam either. It comes \ngradually from experience and from sincere, intelligent, hard work.\nSection II of this book, which follows, is concerned with tactics. Up to this point, we \nhave been studying the technical formations and their consequences. We should have a \ngood general understanding of what is likely to happen after certain manifestations on the \ncharts. Knowing that, however, we will still need a more definite set of guides as to when \nand how it is best to execute this or that sale.\nThese chapters are based on one man's experience and his analysis of thousands of \nspecific cases. It takes up questions of method, of detail, and of application, and should \nprovide you with a workable basis for your actual market operations. As time goes on, you \nwill very likely adopt refinements of your own or modify some of the suggested methods \n291Trading tactics\naccording to your own experience. However, the authors feel the suggestions made here \nwill enable you to use technical analysis in an intelligent and orderly way that should help \nto protect you from losses and increase your profits.\nJohn Magee\n\n293\nchapter eighteen\nThe tactical problem\n(EN: In this chapter, Magee addresses the question of tactics for the “speculator” who follows short \nand medium-term trends. The later sections of the chapter address the question of strategy and tactics \nfor the long-term investor and provide a discussion of the term “speculator.”)\nIt is possible (as many traders have discovered) to lose money in a Bull Market—and, \nlikewise, to lose money trading short in a Bear Market. You may be perfectly correct in \njudging the Major Trend; your long-term strategy, let us say, may be 100% right. Except, \nwithout tactics, without the ability to shape the details of the campaign on the field, it is \nnot possible to put your knowledge to work to your best advantage.\nThere are several reasons why traders, especially inexperienced traders, so often do so \npoorly. At the time of buying a stock, if it should go up, they have no objectives and no idea \nof what policy to use in deciding when to sell and take a profit. If it should go down, they \nhave no way of deciding when to sell and take a loss. Result: they often lose their profits; \nand their losses, instead of being nipped off quickly, run heavily against them. Also, there \nis this psychological handicap: the moment a stock is bought (or sold short), commissions \nand costs are charged against the transaction. The trader knows the moment he closes the \ntrade there will be another set of charges. Also, since he is not likely to catch the extreme \ntop of a rally or the extreme bottom of a reaction, he is bound, in most cases, to see the \nstock running perhaps several points against him after he has made his commitment. Even \non a perfectly sound, wise trade, he may see a 10% or more paper loss before the expected \nfavorable move gets under way (see Figure 18.1). Obviously, if he weakens and runs for \ncover without sufficient reason before the stock has made the profitable move he looked \nfor, he is taking an unnecessary loss and forfeiting entirely his chance to register a gain.\nThe long-term investor who buys in near the bottom and remains in the market to a \npoint near the top, to later liquidate and remain in cash or bonds until (perhaps several \nyears later) there is another opportunity to buy in at the bottom, does not face the continual \nproblem of when to buy and when to sell. This assumes one can tell precisely when such \na bottom has been reached and when the trend has reached its ultimate top (and those are \nvery broad assumptions indeed). The long-term investment problem for large gains over \nthe Major Trends is by no means as simple as it sounds when you say, “Buy them when \nthey’re low, and sell them near the top.” However, such large gains have been made over \nthe long pull, and they are very impressive. (EN: Note the record of the Dow Theory in Chapters", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 143}
{"text": "reached its ultimate top (and those are \nvery broad assumptions indeed). The long-term investment problem for large gains over \nthe Major Trends is by no means as simple as it sounds when you say, “Buy them when \nthey’re low, and sell them near the top.” However, such large gains have been made over \nthe long pull, and they are very impressive. (EN: Note the record of the Dow Theory in Chapters \n4 and 5.)\nThis section of the book is concerned more particularly with the speculative purchase \nand sale of securities.\nThere are some basic differences between the “investment” point of view and the \n“speculative.” It is a good thing to know these differences and make sure you know exactly \nwhere you stand (see Figure 18.2). Either viewpoint is tenable and workable, but you can \ncreate serious problems for yourself, and sustain heavy losses, if you confuse them.\nOne difference is a speculator deals with stocks as such. A stock, to be sure, represents \nownership in a company, but the stock is not the same thing as the company. The securities \n294 Technical Analysis of Stock Trends\nof a strong company are often weak, and sometimes the securities of a very weak concern \nare exceedingly strong. It is important to realize the company and the stock are not precisely \nidentical. The technical method is concerned only with the value of the stock as perceived \nby those who buy, sell, or own it.\nA second difference is in the matter of dividends. The “pure investor,” who, by the way, \nis a very rare person, is supposed to consider only the “income” or potential income from \nstocks—the return on his investment in cash dividends. (EN: This rara avis is largely extinct \nnow.) Nevertheless, there are many cases of stocks that have maintained a steady dividend \nwhile losing as much as 75% or more of their capital value. There are other cases in which \nstocks have made huge capital gains while paying only nominal dividends or none at all. If the \ndividend rate were as important as some investors consider it, the only research tool one would \nneed would be a calculator to determine the percentage yields of the various issues; hence, \ntheir “value,” which, on this basis, stocks paying no dividends would have no value at all.\nFrom the technical standpoint, “income,” as separate from capital gains and losses, \nceases to have any meaning. The amount realized in the sale of a stock, less the price paid \nand plus total dividends received, is the total gain. Whether the gain is made entirely in \ncapital increase, entirely in dividends, or in some combination of these, makes no difference. \nIn the case of short sales, the short seller must pay the dividends. Although, here again, \nthis is simply one factor to be lumped with the capital gain or loss in determining the net \nresult of the transaction.\nCUDAHY PACKINGC UX\n1928\nSS\nSS\nH\nH\nJULY AUGUSTS EPTEMBER OCTOBERN OVEMBERD ECEMBER\n76\n72\n68\n64\n60\nSales\n100’s\n125\n100\n75\n50\n25\n7 14 21 28 4 11 18 25 1 8 15 22 29 6 13 20 27 3 10 17 24 1 8 15 22 29\nFigure 18.1 It is possible to lose money owning stocks in a Bull Market. Notice this Major Top \nFormation did not occur in 1929, but in the summer of 1928. For more than a year after this, a \nmajority of stocks and the Averages continued the Bull Market Advance. But Cudahy declined \nsteadily, reaching a price below 50 well before the 1929 Panic, and continued in its Bearish course \nfor more than four years, ultimately selling at 20. Except for the somewhat unusual volume on the \nhead on August 21, this is a typical Head-and-Shoulders Pattern with a perfect Pullback Rally in \nmid-November. It underscores what we have mentioned before—a Head-and-Shoulders Top in a \nstock, even when other stocks look strong, cannot safely be disregarded.\n The Head-and-Shoulders Pattern, either in its simple form or with multiple heads or shoulders, is \nlikely to occur at Major and Intermediate Tops, and in reverse position at Major and Intermediate \nBottoms. It has the same general characteristics as volume, duration, and breakout as the Rectangles \nand the Ascending and Descending Triangles. In conservative stocks, it tends to resemble the \nRounding T urns.\n295Chapter eighteen: The tactical p roblem\nSuppose you had bought HT after the decline from its 1929 high of 93 1/2, say at 56, \nin the belief that the 37-point drop had brought it into a “bargain” range. On your daily \nchart, you would have seen the pattern shown above (which you will now recognize as \na Descending Triangle) taking shape in the early months of 1930. Would you have had a \nprotective stop at 51? Would you have sold at the market the day after HT broke and closed \nbelow 54? Or would you have hoped for a rally, perhaps even bought more “bargains” at \n50, at 48, at 40? Would you still have been holding onto your “good long-term investment” \nwhen HT reached 25 1/2 in June? Would you still have been holding HT when it reached its \nultimate 1932 bottom at less than 3 (see Figure 8.22)? (EN: See Figure 18.4 for a recapitulation \nof the lesson from the 2000s.)\nThere is a third source of confusion; very often, the “pure investor” will insist he has no \nloss in the stock he paid $30.00 for, which is now selling at $22.00, because he has not sold it. \nUsually he will tell you he has confidence in the company and he will hold the stock until \nit recovers. Sometimes he will state emphatically that he never takes losses.\nHow such an investor would justify his position if he had bought Studebaker at more \nthan $40.00 in 1953 and still held Studebaker Packard at around $5.00 in 1956 (EN: Or \nHUDSON MOTORS HT\n1930\nJANUARY FEBR UARY MARCHA PRILM AY JUNE\n60\n56\n52\n48\n44\n40\n38\n36\n34\n32\n30\n28\n26\nSales\n100’s\n50\n40\n30\n20\n10\n4 11 18 25 1 8 15 22 1 8 15 22 29 5 12 19 26 3 10 17 24 31 7 14 21 28\nFigure 18.2 What would you have done with Hudson Motors? The great Panic Move of October– \nNovember 1929 carried the Dow–Jones Industrial Average down from its September all-time high \nof 386.10 to a November low of 1", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 144}
{"text": "HT\n1930\nJANUARY FEBR UARY MARCHA PRILM AY JUNE\n60\n56\n52\n48\n44\n40\n38\n36\n34\n32\n30\n28\n26\nSales\n100’s\n50\n40\n30\n20\n10\n4 11 18 25 1 8 15 22 1 8 15 22 29 5 12 19 26 3 10 17 24 31 7 14 21 28\nFigure 18.2 What would you have done with Hudson Motors? The great Panic Move of October– \nNovember 1929 carried the Dow–Jones Industrial Average down from its September all-time high \nof 386.10 to a November low of 198.69. A rally, bringing the Average back to 294.07 in April 1930, \nrecovered 95 points, or 51% of the ground lost, a perfectly normal correction.\n296 Technical Analysis of Stock Trends\nOsborne at $25.00 and $0.00 in the 1980s or Visacalc at similar prices in the same decade. EN9: Or \nEnron and WorldCom in the 2000s. Or Bear Stearns, or Lehman, or … ) is hard to say; however, \nfor him, the loss does not exist until it becomes a “realized” loss.\nActually, his faith the stock will eventually be worth what he paid for it may be no more \nthan a speculative hope—and a forlorn one at that.\nFurthermore, one may question whether his reasoning is always consistent. For \nexample, suppose another stock this investor had bought at $30.00 was now selling at \n$45.00. Would he tell you he did not consider a profit or loss until the stock was sold? Or \nwould he be tempted to speak of the “profit” he had in this purchase?\nIt is all right to consider gains or losses either on the basis of “realized” or completed \ntransactions, or on the basis of the market values “accrued” at a particular time? Yet, it is \nnot being honest with yourself to use one method to conceal your mistakes and the other \nmethod to accentuate your successes. The confusion of these concepts is responsible for \nmany financial tragedies. (EN: One might almost say, in the modern context, such confusion \namounts to willful or neurotic behavior. Given the easy availability of portfolio software that marks-\nto-market positions, avoidance of this knowledge can only be regarded as self-defeating.)\nAs a trader using technical methods, you will probably find the most realistic view is \nto consider your gains and losses “as accrued.” In other words, your gain or loss at a given \ntime will be measured with reference to the closing pricing of the stock on that day.\nRecapitulating, it is important (1) to avoid regarding a stock and the company it \nrepresents as identical or equivalent; (2) to avoid the conscious or unconscious attribution \nof “value” to a stock on the basis of dividend yield, without regard to market prices; and \n(3) to avoid confusing “realized” and “accrued” gains or losses.\nThe technical trader is not committed to a buy-and-hold policy. There are times when it \nis clearly advantageous to retain a position for many months or for years, but there are also \ntimes when it will pay to get out of a stock, either with a profit or with a loss. The successful \ntechnician will never, for emotional causes, remain in a situation that, on the evidence at \nhand, is no longer tenable.\nAn experienced trader using technical methods can take advantage of the shorter \nIntermediate Trends, and it can be shown that the possible net gains are larger than the \nentire net gains on the Major Trend, even after allowing for the greater costs in commissions \nand allowing for the greater income tax liability on short-term operations.\nIt should be understood that any such additional profits are not easily won. They can be \nobtained only by continual alertness and adherence to systematic tactical methods. For the \nmarket, regarded as a gambling machine, compares very poorly with stud poker or roulette, \nand it is not possible to “beat the market” by the application of any simple mathematical \nsystem. If you doubt this, it would be best to stop at this point and make a careful study \nof any such “system” that may appeal to you, checking it against a long record of actual \nmarket moves. Ask yourself whether you have ever known anyone who followed such a \nsystem alone, as a guide to market operations, and was successful. (EN: After Magee wrote \nthis, many successful traders, aided by computer technology and advances in finance theory, have \ncreated algorithmic systems that have been successful in the financial markets. However, the markets \nusually become aware of the success of these systems and develop counterstrategies to defeat them. So \nthere is a tendency for the performance of mechanical systems to degenerate or totally fail over time. \nIt is the happy combination of the system with markets hospitable to it that makes mechanical \nsystems successful over defined periods of time.)\nThe practice of technical analysis, on the other hand, is not a mathematical process, \nalthough it does involve mathematics. It is intended to search out the significance of market \nmoves in the light of past experience in similar cases, by means of charts, with a full \n297Chapter eighteen: The tactical p roblem\nrecognition of the fact that the market is a sensitive mechanism by which all of the opinions \nof all interested persons are reduced by a competitive democratic auction to a single figure, \nrepresenting the price of the security at any particular moment. The various formations \nand patterns we have studied are not meaningless or arbitrary. They signify changes in real \nvalues, the expectations, hopes, fears, developments in the industry, and all other factors \nthat are known to anyone. It is not necessary to know, in each case, what particular hopes, \nfears, or developments are represented by a certain pattern. It is important to recognize the \npattern and understand what results may be expected to emerge from it.\nThe short-term profits are, you might say, payment for service in the “smoothing out” \nof inequalities of trends, and for providing liquidity in the market. As compared with \nthe long-term investor, you will be quicker to make commitments and quicker to take \neither profits or (if necessary) losses. You will not concern yourself with maintaining \n“position” in a market o", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 145}
{"text": "xpected to emerge from it.\nThe short-term profits are, you might say, payment for service in the “smoothing out” \nof inequalities of trends, and for providing liquidity in the market. As compared with \nthe long-term investor, you will be quicker to make commitments and quicker to take \neither profits or (if necessary) losses. You will not concern yourself with maintaining \n“position” in a market on any particular stocks (although, as you will see, we will try to \nmaintain a certain “total Composite Leverage” [or risk and profit exposure] according \nto the state of the market, which accomplishes the same result). You will have smaller \ngains on each transaction than the long-term investor, but you will have the advantage \nof being able to frequently step aside and review the entire situation before making a \nnew commitment.\nMost particularly, you will be protected against Panic Markets. There are times (and \n1929 was by no means the only time) (EN: 1987 and 1989 also come to mind. EN9: Add 2001– \n2002, if you please: May 2, 2001, Dow 11,350; September 17, 2001, 8,062; March 18, 2002, 10,673; \nand July 22, 2002, 7,532), when the long-term investor stands to see a large part of his slowly \naccumulated gains wiped out in a few days. The short-term trader, in such catastrophes, \nwill be taken out by his stop-loss orders, or his market orders, with only moderate losses, \nand will still have his capital largely intact to use in the new trend as it develops. (EN: The \nbest technical analysts’ opinion in “modern times” is that even long-term investors should not grin \nand bear a Bear Market. This is a necessity only for bank trust departments and believers in Burton \nMalkiel.)\nFinally, before we get on with the subject of tactics, the operations we are speaking \nof are those of the small and midsize trader. The methods suggested here, either for \ngetting into a market or getting out of it, will apply to the purchase or sale of odd lots, 100 \nshares, 200 shares, and sometimes up to lots of thousands of shares or more of a stock, \ndepending on the activity and the market for the particular issue. The same methods \nwould not work for the trader who was dealing in 10,000-share blocks (except in the \nlargest issues) because, in such cases, his own purchases or sales would seriously affect \nthe price of the stock. Such large-scale operations are in a special field governed by the \nsame basic trends and strategy, but that requires a different type of market tactics (see \nFigure 18.3). (EN: Or, put another way, as Magee said to me one time, a mouse can go where \nan elephant cannot .)\nStrategy and tactics for the long-term investor—\nWhat’s a speculator? What’s an investor?\nIn the years since Magee wrote the original Chapter 18 , some different connotations have \nattached themselves to the terms “speculator” and “investor.” A great cultural shift has also \noccurred. The days when the New Haven (New York, New Haven, and Hartford Railroad) \nwas a beacon of respectability (and lent luster to its investor) and paid “good dividends” \nare gone forever; as is the New Haven. In fact, after the turn of the century, corporations \nsaw a change in investor sentiment about dividends. Investors wanted capital appreciation \n298 Technical Analysis of Stock Trends\nand cared less for dividends. In fact, it has lately been considered the mark of a “growth \nstock” not to pay dividends. Evidently, the days of the New Haven are gone forever, when \nan “investor” was one who bought, held, and collected dividends, and “speculators” were \nslightly suspect men like Magee who played the medium-term trends and bought “unchic, \nspeculative” stocks. It all has a sepia tone to it. Yesterday’s Magee speculator might be called \na medium-term investor today.\nAlthough the term “speculator” could still be applied to anyone who “trades” the \nmarket, today that old-time speculator and his kind would more likely be called traders \nthan speculators. Commodity traders who have no business interest in the contracts they \nexchange are always referred to as speculators, as opposed to commercials, who are hedgers \nand users of the commodities they trade. Now “day traders” might be considered the \nequivalent of the old-time speculators—except that day trading veers dangerously close to \ngambling. And only the passive, in the opinion of this editor, never trade at all and sit on \ntheir holdings during Bear Markets.\nOn the spectrum of investors, from investor to gambler, the old “New Haven Investor” \nwho “wants his dividends” is pretty rare these days, and, again, may be one of those trust \ndepartments that does not want to get sued and so stays out of stocks that go up. After all, \nprudent men do not “trade in volatile stocks” but “invest in safe issues, like bonds,” which \nonly lose about 1.5%–2.0% of their purchasing value per year but preserve the illusion of \nhaving “preserved principal.”\nENE LAST-Weekly 01/11/200290\n7050\n40\n30\n20\n10\n1998 1999 2000 2001\nCreated with TradeStation 2000i by Omega Research 1999\nFigure 18.3 If an investor only learned one thing from this book, it would be that one thing might \nbe the salvation of his portfolio or his retirement plan (if all his assets in the investment plan were \nshares of Enron). Instead, the employees of Enron made a major mistake in not having a diversified \nretirement portfolio—they had all their eggs in one basket, their income and savings came from one \nsource. But diversification is not even the crucial lesson here; the lesson is get out of the stock when \nit reverses. The corollary of that lesson is never buy a stock in a downtrend. However, the more \nimportant lesson is never buy a stock when it is in a swan dive. So obvious you say, but not so obvious \nat the time for portfolio managers for the University of Miami who continued to accumulate Enron \nstock even as it neared earth at 100 miles an hour. Of course, they had a sophisticated (?) company; \nthe Motley Fools had a death grip on the stock", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 146}
{"text": "r buy a stock in a downtrend. However, the more \nimportant lesson is never buy a stock when it is in a swan dive. So obvious you say, but not so obvious \nat the time for portfolio managers for the University of Miami who continued to accumulate Enron \nstock even as it neared earth at 100 miles an hour. Of course, they had a sophisticated (?) company; \nthe Motley Fools had a death grip on the stock all the way to the bottom.\n299Chapter eighteen: The tactical p roblem\nOne definition of the long-term investor\nLet us take as a long-term investor now one who expects to at least track market returns, \nfor it has been demonstrated over a relatively long period of time that this can be done by \npassive indexing. At the turn of the century, as this is written, it would seem neither long-\nterm, medium-term, nor short-term investors think about the risks involved in matching \nthe market because, entering the third millennium, it has been so many years since we have \nhad a really vicious Bear Market. Dow 36,000? This is a passing phase. As each Bull Market \nreaches higher and higher, the odds are lower and lower that it will continue— historic Bull \nMarkets of the 1990s notwithstanding.\nWhat then are the strategy and tactics for the long-term investor to achieve a goal of \nmatching the market? (EN9: Is it necessary to remind the reader of Chapter 4 and the Dow Theory?)\nLet us remark immediately that the tactics Magee described for the speculator—or \ntrader if you will—are not at all in conflict with the short-term tactics used occasionally \nby the long-term investor. As buying or selling time approaches the stops of the long-term \ninvestor, that investor becomes a trader who can and should adopt the trader’s tactics. \nSooner or later, the focus even narrows to real time at the moment of trade execution. \nInterestingly, the charting techniques we have described here work on tick-by-tick data in \nreal time also. Hence, if the trader wants to enter into the real-time environment, he can \nattempt to time his trade right down to the real-time chart formations. Only the really active \nand skilled long-term investor will be concerned with squeezing the last half point or points \nout of his position. This illustration of the time focus is addressed to any investor or trader \nor speculator to demonstrate the fractal nature of both price data and the applicability of \nMagee-type technical analysis to it.\nThe strategy of the long-term investor\nThe strategy of the long-term investor is to catch the long trends—to participate in trades \nthat lasts months and years. However, this strategy does not intend to be sucked into \nlong Bear Markets. Rather, portfolios are liquidated or hedged when Bear Market signals \nare received. As has been previously seen in examples of the performance of (more or \nless) mechanical Dow Theory (see Chapter 4), this kind of performance can be quite \nsatisfactory—better indeed than buy-and-hold strategies that have come much into vogue \nbecause of the Clinton–Gore Bull Markets of the 1990s.\nIf the goal is to beat not only the markets but also the mutual funds (only 20% of which \noutperform the market over the long term anyway—and sometimes none of them make \nmoney), then passive indexing is the most likely strategy. This may be done in a number of \nways—index funds, buying the basket, buying the futures, and so on. Nevertheless, the most \nattractive method might be the use of the Standard & Poor’s Depositary Receipts (SPDRs; \nSPY) and DIAMONDS™ (DIA) and the like. The tactics may be calibrated to the risk tolerance \nand character of the investor. He might hedge or sell on Dow Theory signals, or on breaks \nof the 200-day moving average, or on breaks of the long-term or intermediate trendlines \nwith a filter (Magee recommended 2%, and this might be calibrated to the character of the \nmarkets and increased to 3% or a factor relevant to actual market volatility). Basing Points \n(see Chapter 28) is also a powerful method. Instruments we have previously discussed—\nSPDRs, DIAMONDS, index futures, and options—can be used to execute these tactics.\nSuffice it to say that every strategy must provide for the plan gone wrong, in other \nwords, the dreaded Bear Market. Bear Markets would not be so fearsome if the average \ninvestor did not insist on seeing only the long side of the market. Long-term strategies go \n300 Technical Analysis of Stock Trends\nout the window quickly when blood runs on the floor of the New York Stock Exchange. The \nwell-prepared technical investor has a plan that provides for the liquidation of positions \ngone bad and presumably the discipline to execute it.\nThis involves the regular recomputation of stops as markets go in the planned direction, \nand ruthless liquidation of losers that do not perform. One may think of a portfolio as a \nfruit tree. Weak branches must be pruned to improve the yield. Stop computation is treated \nin a number of places in this book (see Chapters 27 and 28). For the investor trading long \nterm, this may be, as an example only and not as a recommendation, the breaking of the \n200-day moving average or the breaking of a long-term trendline. The 200-day moving \naverage is widely believed to be the long-term trend indicator, for which believing will \nsometimes make it come true. (EN9: Let me emphasize here that “200” is a parameter and an \nexample. Personal research may fit a better parameter to the actual market.)\nIn reality, more than just the 200-day moving average or a manually drawn trendline \nshould be looked at. The chart patterns comprising the portfolio should be considered also, \nas well as charts of major indexes and averages. Also, consider the condition of the averages \nand their components—their technical state—whether they are topping, consolidating, or \ntrending as indicated by their charts.\nMoreover, it would be impossible not to mention Magee’s Basing Points Procedure (see \nChapter 28). Possibly the most powerful trailing stop method in", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 147}
{"text": "should be considered also, \nas well as charts of major indexes and averages. Also, consider the condition of the averages \nand their components—their technical state—whether they are topping, consolidating, or \ntrending as indicated by their charts.\nMoreover, it would be impossible not to mention Magee’s Basing Points Procedure (see \nChapter 28). Possibly the most powerful trailing stop method in existence.\nRhythmic investing\nIn addition, if Chapter 31 on “Not All in One Basket” is weighed seriously, one might be \nrolling a portfolio from long to short gradually in natural rhythm with the markets and in \nharmony with the Magee Evaluative Index described there. That is the preferred strategy \nof the authors and editor of this book.\nThese things all depend on the goals, temperament, and character of the investor. If \nhe is going to spend full time on the markets, he is probably not a long-term investor. Such \nmen eat well and sleep soundly at night. The trader is lean and hungry—not necessarily for \nmoney, but for activity. It behooves one to know his type as a trader or investor. Knowing \none’s type or character is best established before finding it out in the markets, as the markets \ncan be an expensive place to search for self-knowledge.\nThere is no inherent conflict in holding long-term positions and also attempting to \nprofit from intermediate trends, depending on the amount of capital in hand and how \nmuch time, energy, and capital the investor wants to put into trading. A long-term strategy \ncan be implemented with a modicum of time and energy, as follows: pay attention to the \nmajor indexes and averages and buy on breakouts, at the bottoms of consolidations and \non pullbacks; sell or hedge on the breaking of trendlines, calculated on Basing Points (see \nChapter 28) and the penetration of support zones.\nThe long-term investor will accept greater swings against his position than the \nintermediate-term trader or speculator. As an example with the method of using Basing \nPoints in Chapter 28, the speculator is using a three-days-away rule, whereas a long-term \ninvestor might be using a three-week Basing Point or some such analogy. Plus, if interested, \nwhen he suspects or analyzes a long Bull Market is approaching a climax, he might adopt \nthe three-days rule also, or even begin following his stock with a daily stop just under the \nmarket. Beware though, as professionals look for stops just under the close of the previous \nday in situations such as these.\nIt would be wise not to confuse long-term investing with “buy and hold,” or as it was \nexpressed in one investment fad in the 1970s, “one-decision investing.” As an example of this \n301Chapter eighteen: The tactical p roblem\nmisguided thinking, in 1972, the “best and brightest” investment analysts (fundamental) \non the Street picked a portfolio of stocks for the generation, or 20 years. The companies \nwould be difficult to argue with as the crème de la crème of American business. After all, who \ncould kvetch at Avon, Eastman Kodak, IBM, Polaroid (unless he happened to look at Figure \n37 .27), Sears Roebuck, and Xerox? Even today, if you did not have a close eye on the market, \nyou would immediately respond, “blue chips.” Consider the following table showing the \nstocks and the results achieved over the long term.\nPrice Price Percent\nStock 4/14/72 12/31/92 Change\nAvon Products 61.00 27.69 (54.6)%\nEastman Kodak 42.47 32.26 (24.0)%\nIBM 39.50 25.19 (36.2)%\nPolaroid 65.75 31.13 (52.7)%\nSears Roebuck 21.67 17.13 (21.0)%\nXerox 47.37 26.42 (44.2)%\nIn 2017 , the vagaries of unsupervised portfolios is again seen: Avon 2.50; Kodak 7 .75; IBM \n141; Polaroid unlisted; Sears 7 .21; Xerox 32.64. Beware of pundits and mindless investing.\nCharts (Figures 18.4 and 18.5) showing activity for IBM and Xerox appear on the \nfollowing pages.\n45 \n40 \n35 \n30 \n25 \n20 \n15 \n10 \n1970 1975 1980 1985 1990 \nIBM LAST-Monthly 02/26/1993 \nFigure 18.4 The questionable—even bizarre—results of “one-decision investing” (i.e., buy and hold) \nare amply illustrated by this chart. First of all, the “best and brightest” recommended IBM at a \ndecade high to see it decline by more than 50%. It subsequently recovered to double from their \noriginal recommendation. Ah, sweet justification! Only, unfortunately, at the end of 20 years to see \nit rest approximately 40% beneath the recommendation. The analytical lines give some hint of how \na technician might have traded the issue. I like to say that there are bulls, bears, and ostriches, and \nanyone who followed this one-decision investment proves my case.\n302 Technical Analysis of Stock Trends\nSummary\nThe long-term investor attempts to catch major market moves—those lasting hundreds, if \nnot thousands, of Dow points and stay in trades for many months if not years.\nWithin this time frame, he expects to take secondary trends against his position. \nDepending on his temperament and inclination, he may attempt to hedge his portfolio \nupon recognizing secondary market moves against his primary direction.\nHis preference for stocks and portfolio will be for market leaders, for baskets that \nreproduce the major indexes (or Index Shares) as the ballast for his portfolio, and he may \nchoose some speculative stocks to add spice to his portfolio.\nIn spite of his penchant for long-lasting trades he will not tolerate weak, losing, or \nunderperforming stocks. They are the shortest of his trades. He will cut losses and let \nprofits run, the truest of the market maxims and the least understood by unsuccessful \ninvestors. The other maxim least understood by investors is “buy strength, sell weakness.”\nTruly sophisticated investors attempt to participate in Bear Market trends also. This is \nthe greatest difference between professional and general investors—professionals have no \nbias against the short side.\nFor the convenience of day traders, the URL of Gamblers Anonymous is noted: h t t p : //\nwww.gamblersanonymous.org.\nFigure 18.5 Like IBM in the previo", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 148}
{"text": "estors is “buy strength, sell weakness.”\nTruly sophisticated investors attempt to participate in Bear Market trends also. This is \nthe greatest difference between professional and general investors—professionals have no \nbias against the short side.\nFor the convenience of day traders, the URL of Gamblers Anonymous is noted: h t t p : //\nwww.gamblersanonymous.org.\nFigure 18.5 Like IBM in the previous figure, Xerox was recommended at a place at which it should \nhave been sold instead of bought. The comments there might apply to the chart here. The foolishness \nof “buy and hold” or “one-decision investing” is amply illustrated by observing the long-term swings \nof the stock and thus of the investor’s equity. Technical analysis is intended to be an antidote to such \nfoolishness.\n303\nchapter nineteen\nThe all-important details\nIn this chapter and the one following, we take up a number of elementary suggestions \nintended largely for the benefit of those who have never kept charts before. Much of this \nwill seem obvious and repetitive to the advanced student, although even he may find some \nthoughts that will simplify his work. The beginner should read these chapters carefully \nand use them for later reference.\nThe details of how and when you keep the charts will not guarantee you profits, but \nif you fail to work out these details in such a way as to make your work easy, as part of \na regular systematic routine, you cannot expect to keep up your charts properly or make \nany profits.\nCharting and analyzing your charts is not a difficult process, nor will it take too much \nof your time if you have determined a reasonable number of charts and have arranged for \ndoing the work regularly, meaning every day without fail.\nYou will need a source of data—the day’s market prices and volume. If you live in a \nbig city, your evening paper will carry the complete list, and you can plan to set aside a \ncertain period before dinner, or after dinner, or during the evening. If you cannot allot such \na period and keep it sacred against all other social or business obligations, then plan to \ndo the charting in the morning. The key is to set a definite time and let nothing interfere, \never, or you are lost. (EN: This process is radically simplified by automated computer downloading \nprocedures and access to data sources and internet sites, but the principle is the same.)\nYou should have a suitable place to work and keep your charts. If it is at home, in the \ndining room or living room, other members of the family should understand that what you \nare doing is important. You should be able to shut the door and work without interruption. \nThe light should be bright and as free from shadows as possible. (It makes a big difference, \nespecially if you are keeping a large number of charts.) The ordinary desk lamp throws \na reflected glare directly across the paper and into the eyes. It can be a strain if you are \ndoing much of this close work. Better to have an overhead light, placed just a few inches \nin front of your head and a convenient distance above; and if this light can be a fluorescent \nfixture using two 40-watt lamps, you will get almost perfect shadowless lighting. These \nsuggestions apply in case you are not working by daylight.\nAdditionally, have plenty of room. A big desk top or a dining room table with a large \nclear space for chart books, extra sheets, pencils, scratch paper, ruler, calculator, computer \nequipment, and anything else you need. If your working surface is fairly low, say 28 or 29 \ninches from the floor, it will be less tiring than the usual 30-inch desk height.\nWhether you are working in ink or in pencil, pick out the writing tool that is easiest for \nyou to use. If you are using pencils, try several different makes and degrees of hardness. \nFind one that is hard enough not to smudge too easily, and yet is not so hard you have to \nbear down to make a clean black mark. The wrong kind of pencil can tire you and irritate \nyou more than you realize. Also, have plenty of pencils, a dozen at least, well-sharpened, \nso as soon as one becomes a trifle dull and you are not getting a clean, fine line, you can \nsimply lay it aside and continue at once with another freshly-sharpened pencil.\n304 Technical Analysis of Stock Trends\nKeep your charts in loose leaf books with big enough rings to make turning the pages \neasy. Do not overcrowd the books; get new books if a volume is too crowded. Finished \ncharts may be kept in file folders. The only ones that need to be in the books are the current \nsheets and the sheets for the immediately preceding period. If possible, use a seven-ring \nbinder. Pages are easily torn loose from two- and three-ring binders, but seven rings will \nhold the pages safely and you will seldom have one tear out.\nThe charts you keep will become increasingly valuable to you as the chart history \nbuilds up. The old chart sheets will be very helpful to you for reference. Provide a file or \nspace where they can be indexed and kept in chronological order, and also have file folders \nfor brokers’ slips, dividend notices, corporate reports, clippings and articles, notes on your \nown methods, and analyses and special studies of the work you are doing.\nIn this connection you will, of course, keep a simple but complete record of each \npurchase, sale, dividend, and so on, on stocks you have bought or sold. This record will \nmake your work much easier when the time comes to figure out income taxes. It will \nalso give you all the statistical information you need to judge the results of your trading \noperations.\n(EN: At the beginning of my investment career, and often in the middle of it, I thought the above \nwas cracker-barrel wisdom. The longer I last the more I think that homespun wisdom might be the \nbest kind to have in investing—somewhat like Mark Twain, who was astounded at how much his \nfather increased in wisdom the older Twain himself got.\nWe may restate the modest homilies above: Be serio", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 149}
{"text": "ions.\n(EN: At the beginning of my investment career, and often in the middle of it, I thought the above \nwas cracker-barrel wisdom. The longer I last the more I think that homespun wisdom might be the \nbest kind to have in investing—somewhat like Mark Twain, who was astounded at how much his \nfather increased in wisdom the older Twain himself got.\nWe may restate the modest homilies above: Be serious. Be methodical. Be disciplined. Be business-\nlike. Anyone who succeeds in investing without these qualities is the recipient of blind luck and will \nbe fortunate not to fall into a hole before his career is over.\nThese thoughts occur when one is wondering how Magee would have viewed the advent of the \nmicrocomputer and its impact on technical analysis and investing. Might he have said, “What hath \nthis tool wrought?! Wonders and abominations!!”\nGiven the possibilities for complicating analysis and operations when confronted with all the \nbells and whistles of the average computer software package, the investor must maintain perspective. \nWhat, then, are the all-important details in practicing technical analysis with the aid of a computer?)\nThe simplest and most direct way to use \na computer for charting analysis\nIn reality, the computer can be used as a simple tool to do a simple job. There is nothing inherently \ncomplicated about keeping a chart on a computer. All computer software packages enable bar \ncharting and many, if not most, enable many other kinds of charting, from candlesticks to oscillator \ncharting. The process, in almost all commercially available packages, is so simple that explaining \nit here would be superfluous (see Appendix B, Resources, for demonstrations), except to generally \nsay it consists of retrieving data, updating the program’s price database, and clicking an icon to \nrun a chart. The software packages themselves explain their features better than can be done here. \nWhat is important here is to give perspective. Even simpler when the whole process takes place \non the internet, as at http://www.stockcharts.com or http://www.bigcharts.com , or http://www.\ntradestation.com.\nIn this respect, charting can be done with quite expensive programs and also on publicly available \nfree programs or freeware. Charting can also be done with interactive charting programs on many \ninternet sites. The basic bar chart can be enhanced with an unending number of technical studies—\nmoving averages, oscillators, and so on. Therein lies the danger. Chart analysis in itself is a qualitative \nprocess. Decorating graphic charts with number-driven information and studies can lead the general \ninvestor astray—and into confusion and indecision.\n305Chapter nineteen: The all-i mportant details\nThus, the first preference of this analyst is to keep the process as simple as possible. Get the \ndata, draw a chart, analyze the patterns, consider the volume, and draw the appropriate analytical \nlines—this can usually be done by the program on the screen. Often a better graphic picture may be \nobtained by printing the chart and hand-drawing the analytical lines. This brings to the fore one of \nthe main problems of almost all the software packages—screen graphics are poor and, at least to old \nchartists, disorienting. They are especially befuddling to analysts who are accustomed to working \non TEKNIPLAT™ chart paper. With passing editions of Resources, this problem will be dealt with. \n(EN9: In the intervening years since the eighth edition, two things have occurred: the editor \nadjusted to modern technology and the technology achieved a level of excellence acceptable \nto a carping analyst. Internet technical analysis sites such as http:/ /www.stockcharts.com \nand http:/ /www.thinkorswim.com improved to be surprisingly valuable resources at \nunbelievably low prices—even free.)\nThe question of graphic representation of the facts is worth noting as a persistent one. To a \ncertain extent, the individual analyst will solve this conundrum by adapting his eye and mind to a \ngraphic environment, using one graphic method consistently and seeing how it relates to the facts \nin the market. John Magee–oriented solutions to this problem will be available on the website http://\nwww.edwards-magee.com.\nIn Appendix B, Resources, the reader may see some examples of simple and inexpensive software \npackages and internet sites that are quite adequate to the required tasks of charting technical analysis, \nas well as more complex number-driven analysis.\nSummary\nThe computer is an invaluable tool for analysis. Use of it will enable the following:\n• Data may be acquired automatically via internet or dial-up sites at little or no cost. Some of \nthese even offer real-time data, which is a way for the unsophisticated trader to go broke in real \ntime, but which the general investor may desire on the day of executing a trade. Many of these \nsites offer every kind of analysis from respectable technical analysis (usually too complicated) \nto extraterrestrial channeling.\n• A computer package and internet portfolio sites will give the analyst virtually effortless \nportfolio accounting and mark-to-market prices—a valuable device to have to keep the investor \nfrom mixing his cash and accrual accounting, as Magee says.\n• The computer will enable processing of a hitherto unimaginable degree. An unlimited number \nof stocks may be analyzed. Choosing those to trade with a computer will be dealt with in \nChapters 20 and 21.\n• Appendix B, Resources, contains information on software packages that the reader may try \nand purchase at quite reasonable prices. In all likelihood, the least expensive of these will be \nadequate to the needs of most general investors. In addition, I present a brief discussion of \ninternet sites and resources.\n\n307\nchapter twenty\nThe kind of stocks we want: \nthe speculator’s viewpoint\nThe specifications of the kind of stock we want to chart are fairly simple and few. We want \na stock that will enable us to make a profit", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 150}
{"text": "es. In all likelihood, the least expensive of these will be \nadequate to the needs of most general investors. In addition, I present a brief discussion of \ninternet sites and resources.\n\n307\nchapter twenty\nThe kind of stocks we want: \nthe speculator’s viewpoint\nThe specifications of the kind of stock we want to chart are fairly simple and few. We want \na stock that will enable us to make a profit through trading operations, meaning a stock \nwhose price will move over a wide enough range to make trading worthwhile. There are \nthose who are concerned mainly with safety of principal and the assurance of income \nfrom a stock. For them, there are (EN9: or were) stocks that afford a considerable degree \nof stability. You may (and probably will) want to keep a substantial part of your total \ncapital in stocks of this type. They move in a narrow price range; are extremely resistant \nto downside breaks in the market; are also (and necessarily) unresponsive to fast upside \nmoves in the market as a whole, and are highly desirable for the conservative investor. \nThey are not, however, the most suitable issues for trading operations, because their swings \nare small, and commissions would tend to diminish the narrow trading profits that could \nbe taken. Also, they do not make the sharp, clear chart patterns of the more speculative \nissues, but move in rounding, sluggish undulations. (EN9: These remarks reflect a bygone \ntime. The described stocks by and large went the way of the Dodo. When T can disappear from the \nmarket as a factor, there is no place to hide, except in bonds, which, when stagnant, only lose real \nvalue at the rate of inflation and loss of purchasing power of the dollar. Even bonds should be subject \nto frequent reevaluation using the tools described in this book.) (For illustrations in this chapter, \nsee Figures 20.1 through 20.4.)\nTo amplify this comment and explain a bit about what underlies what we are doing, \nlet us assume a certain company has two issues of stock, a preferred and a common. We \nwill assume the concern has a certain steady minimum profit it has earned for years, \nsufficient to pay the preferred dividend, the continuance of these dividends seems \npractically assured. The dividends on the preferred are fixed at, let us say, 6%. Now \nthe common stock gets all that is left. In one year, there may be $0.50 a share for the \ncommon stockholders. The next year, there may be $2.00 a share or four times as much. \nIn a case like this, if there are no other factors, you would expect the preferred stock to \nsell at a fairly steady price without much change, whereas the common stock is subject \nto a “leverage” and might shoot up to four times its former value. The more speculative \nissues represent either a business that is, by its nature, uncertain as to net profit from year \nto year, where the volume of business or the profit margin fluctuates widely, or one in \nwhich the majority of the “sure” net profit has been sheared off for the benefit of senior \nobligations. There are also other factors that affect the speculative swing of a stock, and, \nas a result, one issue may be very sensitive and another extremely conservative, and \nbetween them there would be all shades and degrees of sensitivity or risk. It is enough \nhere to note briefly the nature of the business itself does not always account for the habits \nof the stock because the other factors may be very important. Most stocks have a fairly \nwell-defined “swing” power, which can usually be determined by past performance of \n308 Technical Analysis of Stock Trends\nGOODYEAR TIRE\nCOMMON\n1943 1944 1945 1946 1947\n76\n72\n68\n64\n60\n56\n52\n48\n44\n40\n36\n32\n28\nGOODYEAR TIRE\n1ST PREFERRED\n1943 1944 1945 1946 1947\n120 \n112 \n104 \n96 \n88 \n80 \nFigure 20.1 Opportunity vs. Security. Here (at left) is Goodyear Common, representing the residual \ninterest in all profits after senior obligations have been met, compared (at right) with the Goodyear \n$5.00 Preferred, which carries a high degree of assurance that the $5.00 dividend will be met, but \nno promise of further participation in profits. Monthly range of each stock for the same 54-month \nperiod is shown on a ratio scale. As the Common makes an advance of more than 300%, the Preferred \nadvances about 25%, leveling off at a point that represents the maximum price investors are willing \nto pay for the sure $5.00 dividend.\nSPX LAST-Monthly\nCreated with TradeStation www.TradeStation.com\n88 89 90 91 92 93 94 95 96 97 98 99 00\n1500\n1400\n1300\n1200\n1100\n1000\n900\n800\n700\n600\n500\n400\n300\nFigure 20.2 S&P . Here the benefits of relaxed long-term investing may be seen, buttressed, of course, \nby the longest and handsomest Bull Market in American history in the Clinton–Gore years. At the \nend of this record, the effects of public enthusiasm (or as Chairman Greenspan of the Fed said, \n“irrational exuberance” vide tulipomania) can be seen in the wide undisciplined swings (best seen \nin Figure 20.3). The dotted line represents 150-day (approximately) Moving Average. Just using the \nMoving Average as a signal (or the Basing Points Procedure) would have beaten the market and 99% \n(the 99%) of other investors.\n309Chapter twenty: The kind of st ocks we want: the speculator’s viewpoint\nSPY LAST-Daily\nCreated with TradeStation www.TardeStation.com 144.999\n139.999\n134.999\n129.999\n124.999\n119.999\n114.999\n109.999\n104.999\n99.999\n94.999\n2400000\n2000000\n1600000\n1200000\n8000000\n4000000\n5/19986/19987/19988/19989/1998 10/1998 11/1998 12/1998 992/1999 3/19994/19995/1999 6/1999 7/19998/1999 9/1999 10/1999 11/1999 12/1999 00\nFigure 20.3 SPY. For illustration, here is a chart of the AMEX Index Share, the SPY, or ETF based \non the S&P 500. After the crash of 1998 (the Asian Economic Flu crash), the fan lines tell a story, as \ndoes the last phase of the chart where the market whips in what appears a Broadening Top. (EN9: \nNote this Broadening Top was identified in 1999–2000 before the crash as documented in the http:/ /www.\nedw", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 151}
{"text": "20.3 SPY. For illustration, here is a chart of the AMEX Index Share, the SPY, or ETF based \non the S&P 500. After the crash of 1998 (the Asian Economic Flu crash), the fan lines tell a story, as \ndoes the last phase of the chart where the market whips in what appears a Broadening Top. (EN9: \nNote this Broadening Top was identified in 1999–2000 before the crash as documented in the http:/ /www.\nedwards-magee.com archives. See Figure 20.4.)\n$INX - Weekly US\nA\nB\nC\nD\n1\n2\n3\n1193.03\n1077.90\n938.57\n1464 .00\n1356.00\n1255.00\n1100 .001156.85\n1076.00\n996.00\n922.00\n854.00\n790.00\n1998\n1999 2000 2001 2002 2003 2004 2005\nCreated with TradeStation\nFigure 20.4 The S&P 500 in all its glory and tragedy. An especially good portrait by Holbein, the \nyounger. The Broadening Top pointed out in Figure 20.3 in 2000 foretold the decline of the S&P to \nbelow 790—not quite 50% but close enough to catch the eye. Particularly fine lessons here, besides the \nBroadening Top lesson. All of them screaming for action. The broken trendline at A, the broken trendline \nat B, the broken “neckline” or horizontal line at C. Notice the close correspondence of the break at B and \nC. The next lesson is not to buy downtrends until a clear bottom is made in a major bear market. Clearly \nno bottom is made until the Kilroy Bottom at 1–2–3. Even then, the least risky trade for the long-term \ninvestor is when the Kilroy Fenceline (Neckline) is broken at D. All of this was knowable at the time.\n310 Technical Analysis of Stock Trends\nhow a stock will behave in the future as to the extent of its swing. (EN9: Or we might say, \nshort-term volatility and long-term range.)\nIncidentally, for short-term trading (EN9: amusing in the modern context; by short-term \ntrading Magee means trading of trends of shorter length than Dow Waves) , we are thinking \nabout the habits of the stock that are only partly determined by the business it represents. \nPurchase of stock in one company that has a somewhat uncertain or fluctuating profit \nrecord may be more conservative than purchase of a highly leveraged stock of another \ncompany whose basic business is steadier and more conservative. We will take up the \nmatter of determining these risk constants a little later.\nOne should also understand the short sale of a stock does not imply any feeling that the \ncountry is going to the dogs or even that the concern represented is going to the dogs. Such \na sale merely indicates your belief the stock may be temporarily overpriced; that earnings \nor dividends may have been abnormal in recent years and are likely to be reduced; or that \nfor one reason or another, the stock of the company may be worth a bit less than it has been \nworth.\nFor technical trading, we want a fairly speculative stock, one that will make sizable \nswings up in a Bullish Trend and down in a Bearish Trend. The very factors that tend to \nmake a stock safe and desirable to the investor may make it entirely unsuitable for trading. \nAlso, with certain reservations that will be taken up later on, the more speculative the stock \nthe better it is for our purposes.\n(EN: Entering the third millennium (since we Anglo-Saxons started counting—the fourth \nor fifth by other measures), the distinctions between “speculative” stocks and every other kind of \nstock has grown increasingly blurry. Rather than apply a perhaps pejorative (in the minds of some \nreaders) term like “speculative” to otherwise-innocent stocks, we would do better to describe stocks \nas wide ranging or narrow ranging, as volatile or nonvolatile. Stocks may then be evaluated one \nagainst another by their betas and historical volatilities, statistical data easy to obtain. “Betas” and \n“volatilities” are dealt with in Chapters 24 and 42.)\nIn line with this more current thinking, there is another question for readers of this book—the \nchoice of trading (or investment) instruments for the long-term investor.\nThe kind of stocks we want: the long-term investor’s viewpoint\nChanging opinions about conservative investing\nVirtually no one invests like the conservative investor described above in Chapter 20 —\nexcept perhaps trust departments of antediluvian banks. There may be some investors \nstill out there who are so risk averse they still follow the method described. Bank trust \ndepartments may be still doing it; they used to do it so the trust beneficiaries could not sue \nthem. This is the reason trust departments exist, to give legal cover (the so-called prudent \nman rule) to trustees in case of suit by beneficiaries. Most enlightened trust departments \nand trustees now probably follow indexing or other more productive strategies to cater to \nnew understandings of the prudent man rule.\n“Indexing” refers to the practice of constructing a portfolio to replicate or closely \nreproduce the behavior of a widely followed index such as the Standard & Poor’s (S&P) \n500 or the Dow–Jones Industrials. These portfolios never track the Indexes exactly because \nthe advisors and funds who manage them take management fees and expenses. These \nfees are generally less than fees and expenses on actively managed funds, but in fact are \nnot necessary for the private investor to pay because even the tyro investor can now use \n“Index Shares” (e.g., DIAMONDS™ [DIA], S&P Depositary Receipts [SPDR; SPY, QQQ,] and \n311Chapter twenty: The kind of sto cks we want: the speculator’s viewpoint\nso on) or other proxy instruments to do what the funds and professionals do. Essentially \nwhat indexing does is track the Averages, a strategy that was impossible or difficult \n(expensive) when Magee examined it, as in Chapter 15. (EN9: In the opinion of this editor, \nhiring a management company to run an indexing strategy is a waste of capital. Much better for the \ninvestor to invest directly in ETFs and to exit the market when uptrends end and reverse. This is \na much better strategy than “passive indexing,” which cleverly manages to capture both losses and \nprofits in the Averages.)\nThe kin", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 152}
{"text": "examined it, as in Chapter 15. (EN9: In the opinion of this editor, \nhiring a management company to run an indexing strategy is a waste of capital. Much better for the \ninvestor to invest directly in ETFs and to exit the market when uptrends end and reverse. This is \na much better strategy than “passive indexing,” which cleverly manages to capture both losses and \nprofits in the Averages.)\nThe kinds of stocks long-term investors want: \nthe long-term investor’s viewpoint\nPerhaps one of the most important actualizations of recent editions is to bring current this \nbook’s treatment of the Averages, noting that it is now possible to trade the Averages in \nstock-like instruments. This fact deserves to be marked as a vitally important development \nin modern markets. This chapter will confine itself to describing facilities for trading and \ninvesting in the Averages and Indexes.\nIn 1993, the American Stock Exchange (AMEX) introduced trading in SPDRs™, an \nExchange-traded unit investment trust based on the S&P 500 Composite Stock Price Index. \nThe AMEX calls these securities Index Shares™, a name they also use for other similar \ninstruments. As noted above, large investors and funds have long traded “baskets” of \nstocks representing the S&P 500, obviously an activity requiring large capital. In fact, \na certain class of investment managers and funds have practiced “passive investing” \nmeaning indexing, primarily for large clients. The purchase and liquidation of these and \nother “baskets” is one form of “program trading.”\nRecognizing the utility of this investment practice, the AMEX created the SPDR \nas a proxy instrument to allow the smaller investor to practice the same strategy. The \neffectiveness of this product introduction may be measured by public participation in the \ntrading of the SPDR (SPY). By 2000, almost $15 billion was invested in SPDRs with more \nthan 100,000,000 shares outstanding. These units allow the investor to buy or sell the entire \nportfolio or basket of the S&P 500 stocks just as he would an individual stock, but the capital \nrequired to do so is radically reduced.\nIn 1998, the AMEX introduced DIA, Index Shares on the Dow–Jones Industrial \nAverage™ (DJIA), which is analogous in every way to the SPDRs. Thus, an investor may \n“buy the DJIA.” So in current financial markets, it is possible to “buy the market,” unlike \nthose conditions under which Edwards and Magee operated.\nConstruction of the Index Shares and similar instruments\nThe AMEX unit investment trusts are constructed to replicate the composition of their base \ninstrument. The SPDR, for example, is an instrument that represents one-tenth of the full \nvalue of a basket of the S&P stocks and trades on the AMEX, just like a stock (SPY). Other \ncharacteristics of stocks are also reproduced such as long life (the SPDR Trust lasts into \nthe twenty-second century) and quarterly dividends (cash paid on the SPDRs reproducing \ndividends accumulated on the stocks of the S&P 500). Even dividend reinvestment is \npossible, and the units may be traded on the AMEX during regular trading hours. Under \nnormal conditions, there should be little variance in the price of the SPY relative to the \nS&P 500. (In 2008, the AMEX merged with the New York Stock Exchange. Trading and \ninstruments remain as described.)\n312 Technical Analysis of Stock Trends\nThese elements, as discussed for SPDRs, are common to all the Index Shares—\nDIAMONDS, World Equity Benchmarks (WEBs), and others. There are, of course, some \nexpenses and costs to using the Index Shares—a small price to pay for the use of the \ninstrument and generally less than the costs of a fund. Index Shares are also much more \nflexible for the independent investor. Among other advantages, the private investor can \ncontrol the tax consequences of his investment, which is not possible in funds.\nOther Exchanges have created similar security instruments or derivatives or futures to \nreplicate or track the well-known averages and indexes. Among these are tracking shares \nor index shares or futures (let us call them “instruments”) on other indexes (Russell, \nNikkei, and so on) or options on the futures or indexes until there is a bewildering array \nof instruments available for trading, investing, and hedging. Among the more important \nexchanges and instruments traded are the Chicago Board of Trade (futures and options \non futures on the Dow); the Chicago Mercantile Exchange (futures on the S&P , Nikkei 225, \nMini S&P 500, S&P Midcap 400, Russell 2000, and NASDAQ 100); and the Chicago Board \nOptions Exchange (S&P 100 and 500 options). This, by no means, is an exhaustive list. All \nthe futures and options that matter will be found listed in the Wall Street Journal under \nFutures Prices or Futures Options Prices.\nThis book does not deal in comprehensive detail with futures and options, but it is \nworth mentioning these exchanges and their futures and options products because of \nthe facility they offer the investor and trader for hedging portfolios in Index Shares and \nAverage trading, not to mention opportunities for speculating.\nBriefly, hedging is the practice of being neutral in the market. That is, one might be long \nthe DIAMONDS and buy a put option on the DJIA at the Chicago Board of Trade, meaning \nthat advances in the DJIA would result in profits in the DIAMONDS, and a loss of premium \nin the put. Conversely, a decline in the Dow would result in profits in the put and losses in \nthe DIAMONDS. As this area is not the province of this book, this is a highly simplified \ndescription of a hedge. Nevertheless, the reader should see and understand that hedging \ncan be an important strategy. Hedging can take the place of liquidation of a portfolio when \nthe analyst recognizes a change of trend or unstable conditions but does not wish to incur \ntaxes or wishes to defer them.\nAn outline of instruments available for trading and investing\nIt would be herculean to attempt to list the entire panoply of", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 153}
{"text": "theless, the reader should see and understand that hedging \ncan be an important strategy. Hedging can take the place of liquidation of a portfolio when \nthe analyst recognizes a change of trend or unstable conditions but does not wish to incur \ntaxes or wishes to defer them.\nAn outline of instruments available for trading and investing\nIt would be herculean to attempt to list the entire panoply of averages, indexes, futures, \nand options available for trading—herculean due to the fact new trading instruments are \nconstantly in creation and due to the fact, now operating at internet speed, we may expect \nthe rate of change to accelerate. In addition to those listed above, there are WEBS (meaning \nthat exposure to world markets may be arranged).\nIn all, approximately 30 or more Index Share units or instruments were available \nfor trading on the AMEX at the turn of the century, in addition to DIAMONDS and \nSPDRs. Similar instruments exist on the Philadelphia and in Chicago, and others are \nbeing created daily. To reduce the confusion, the general investor will probably find the \nmajor indices of the most importance. The more instruments one deals with the more \ncomplicated the strategy and tactics become. Therefore, the Dow, the S&P 500, and the \nNASDAQ composite (DIA, SPY, QQQ) are probably sufficient for the purposes of the \ngentleman (or lady) investor. The Mid-Caps, the Nikkei, and others begin to come into \nplay when the trader begins to try to catch sector rotation, fads, short-term cycles, and \nso on.\n313Chapter twenty: The kind of stoc ks we want: the speculator’s viewpoint\nThe importance of these instruments: diversification, \ndampened risks, tax, and technical regularity\nIt would be difficult to underestimate the importance of these new trading instruments. \nFirst of all, they afford the private investor what was previously reserved for the large \ncapital trader—the ultimate in market diversification. The S&P 500 represents stocks \ncomprising 69% of the value of stocks on the New York Stock Exchange. Buying it is buying \nthe American economy. The 30 Dow Industrial stocks represent the most important symbol \nin the American economy—and perhaps in the world. Investors are well advised to pay \nattention to both Averages if they would fare well in the markets (Note the plural: markets). \nThese two Averages now have the influence or clout that once the Dow alone had to express \nthe state of the markets and stocks in general.\nBuying the SPY or DIA then represents the immediate acquisition of a diversified \nportfolio. And buying the NASDAQ or QQQ gives one immediate exposure to the more \nspeculative and volatile sector of the American economy. Given the long-term bullish bias \nof the averages and the American economy, it is difficult to argue with this as both strategy \nand tactics for the long-term investor. This does not mean positions should be taken blindly \nwithout thought or not monitored. On the contrary, recall if you will the record of the Dow \nTheory; even for the long-term investor, bear markets should not be allowed to destroy \nliquidity and equity value. These questions are discussed at greater length in Chapter 18.\nAlthough we believe these instruments are good vehicles, it is wise to remember \nMagee’s frequent admonition (less important now than when spoken) that it is a market \nof stocks, not a stock market. Meaning when the tide is flowing down with the Dow and \nS&P , prudence and care must be used in taking long positions in stocks that are in doubt as \nto direction. Additionally, it is worth noting investments in these instruments will be less \nprofitable than an astutely chosen individual stock. For example, Qualcomm appreciated \napproximately 240% (temporarily) in 1999–2000 compared with about 24% in the S&P over \nthe same period. Those who bought Qualcomm at its top and sold it at the bottom of its \nreaction lost about 75% or about $148 a share. Traders in Qualcomm tended to obsess and \npay hyper attention to the stock, whereas investors in the SPY reviewed it once a week or \nless or told their computers or their brokers to give them a call if it broke the trendline or \nentered stops. Then they slept at night and had eupeptic digestion.\nOther advantages accrue to the trading of the SPDRs. Ownership of a fund can result in \ntax liabilities as managers adjust portfolios to reflect changing membership in the fund or \nwithdrawals in capital by irate stockholders. Since Index Shares last into the twenty-second \ncentury, the long-term investor has no need to realize gains and pay taxes. Bear markets \nmay be dealt with by hedging with other instruments—futures, options, or proxy baskets \nof stock, or individual stocks, and accepting the tax consequences of these trades.\nJohn Magee aptly observed before the direct trading of the Averages was possible that \nthe Dow–Jones Industrials were very regular and dependable from the technical point of \nview. This observation is annotated at some length in comments on Dow Theory in Chapter \n36. Therefore, the investor in the Index Shares may have a smoother time technically than \na trader of an individual stock.\nSummary\nThe long-term investor and mid-term speculator attempt to capture long secular (as \nwell as cyclical) trends in the markets. They shun frequent trading and capital-eroding \n314 Technical Analysis of Stock Trends\ntransactions. They recognize that risk fluctuates with time and trend, and they know that \nfrequent turnover benefits mainly the broker.\nThe strategy of the long-term investor may be to match the market by using funds or \nSPDRs or baskets, but he does not like to participate in Bear trends. He hedges or liquidates \nhis positions on major trend shifts. In fact, he may even short the indexes if his analysis \nindicates major bear markets.\nIf he desires to outperform the market (which will happen automatically if he follows \nthe methods of this work), he finds some individual speculative stocks to trade in addition", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 154}
{"text": "or \nSPDRs or baskets, but he does not like to participate in Bear trends. He hedges or liquidates \nhis positions on major trend shifts. In fact, he may even short the indexes if his analysis \nindicates major bear markets.\nIf he desires to outperform the market (which will happen automatically if he follows \nthe methods of this work), he finds some individual speculative stocks to trade in addition \nto his foundation portfolio. Depending on his risk tolerance, he may always be somewhat \nhedged. When long the indexes, he finds some stocks in downtrends to short. When he \nis short the indexes, he finds some strong stocks to hold long. There is no excuse for a \nmoderately skilled and reasonably capitalized investor to lose money over the long term \nin the market.\nAs a reminder, Chapters 5 and 28 describe powerful methods for the long-term investor \nusing Magee’s Basing Points Procedure.\n315\nchapter twenty-one\nSelection of stocks to chart\nThe trader who operates on the “fundamental” basis, making his commitments on his \nanalysis of earnings, dividends, corporate management, prospects for the industry, and so \non, will usually (of necessity) confine himself to a few stocks or a single group of stocks in \nthe same field.\nTo the contrary, the technical trader, using daily charts, should have a large portfolio \nof issues. Since he is primarily interested in the technical chart patterns, he will not try to \nmake an exhaustive study of the background of each company. In fact, the characteristics of \nthe stocks themselves, as they act in the market, are more important to him than what these \ncompanies make or what they are earning. This is because, although the stocks represent \nownership in the company, the capital structure, “leverage,” and floating supply of the \nstock may (and very often does) mean fluctuations in the stock price that are not directly \nin proportion to changes in the affairs of the business.\nYou will also find many cases in which the stock of a well-regarded, well-managed, \nlong-established concern, whose latest earnings report shows increased profits, and with \na long record of dividends paid, would not be a good buy at the market price. It may be \noverpriced and due for a serious depreciation. You will find other cases in which a stock, \nwhich apparently represents no great promise of either earnings or dividends, suddenly \nstarts a series of spectacular moves upward, and is indicated clearly as a buy. Of course, \nthe answer, in each case, is the records available apply to the past, not the future; and very \noften, chart action will indicate the inside knowledge of those who are in possession of facts \nthe public has not yet received.\nTo change our example to something more easily visualized, let’s assume there are \ntwo houses for sale. One is a fine, well-built, modern home in an attractive part of town at, \nsay, $200,000—and the other property, a somewhat shabby six-family tenement in a less \nattractive section, at the same price of $200,000. There is no question which is the “better” \nhouse, but in a case like this, the market for well-built single homes at this price may be \npoor, whereas the demand for apartments may be good. The six-family house may be the \nbetter investment.\nThen again, we have the question of what is conservative and what is highly speculative. \nIt is not always enough to judge from the type of business of the company itself. You may \nhave a highly conservative concern, carrying on a stable volume of business, with a long \nrecord of successful operation. Yet, if there are bonds, debentures, preferred stocks, and \nother senior obligations, the common stock may be subject to wide fluctuations. Also, if the \nissue is small, or if a large part of it is closely held, you will have a “leverage” effect that \nresults in wide swings in the stock.\nTherefore, in choosing your stock to chart, you will want to consider the kind of \nstock and its character and habits in the market, rather than the business of the concern it \nrepresents. We will come back to this point and show you how you can shape up a list that \nwill give you the kind of stocks you want for trading.\nMeanwhile, the question “How many charts?” has been left hanging. One answer to \nthis is that the more stocks you chart, the more good opportunities you will have. Many \n316 Technical Analysis of Stock Trends\nstocks, even of active issues, will go through long periods when, indeed, there is nothing \nmuch to tell. In a period of stability, the chart simply indicates it is a period of stability, and \nthe only possible trading activity would be purchases and sales at the Bottoms and Tops \nof its undulations. The charts are more informative when a change in the situation occurs; \nthey will signal a change of trend as soon as (and usually before) the news of the changed \nconditions has come out. If you have enough charts, you will always have some stocks \nmaking decisive and clear-cut moves either up or down, at any time.\nYou should, therefore, keep as many charts as you can. Do not bite off more than you \ncan chew, however. A man with only 15 minutes to half an hour a day for this work might \nhave to confine himself to 20 or 30 charts. It would be much better if he could have 100. If he \nis in a position to give a major part of his time to the work, he could very well run as many \nas 300 charts. A most important word of caution is indicated here: Do not start anything \nyou cannot finish. It is better to have too few at the beginning than too many. Then, if you \nfind you can add others, you will be in a better position, from your experience, to pick out \nthe ones you want to include. However, if you start with too many charts or begin to run \nbehind with your analyses, you will not be getting the best use from your portfolio and it \nwould be better to cut down at once. (EN: Magee’s admonitions are still in effect for the manual \nchartist. The modern computer-equipped investor has a different problem. He can", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 155}
{"text": "tion, from your experience, to pick out \nthe ones you want to include. However, if you start with too many charts or begin to run \nbehind with your analyses, you will not be getting the best use from your portfolio and it \nwould be better to cut down at once. (EN: Magee’s admonitions are still in effect for the manual \nchartist. The modern computer-equipped investor has a different problem. He can chart every issue \nin the market every day. The question becomes how many can he effectively study and analyze? There \nis even a computer answer to this question. Namely, the cyber trader can program the computer to \nreport stocks on an exception basis. For example, “Computer, show me all the stocks which are above \ntheir 50-day moving average and which have unusual volume.”)\nFrom what we have already been over, you know it is possible to chart anything \nthat is sold in identical units in a free competitive market. This includes all kinds of \ncommodities, bonds, debentures, when-issued contracts, and so on, as well as stocks. You \nmay have some special interest that will call for charting something outside the field of \nstocks—well and good.\nIn general, however, you will want to chart active, listed stocks of well-established \ncorporations. There is no reason an unlisted stock cannot be charted, but ordinarily, the \nonly figures you can obtain on it are the bid and offer prices. On these stocks, you do not \nhave a published statement of the volume of sales each day or any record of prices at which \nsales actually took place, and those are essential to the charting of daily technical action. \nTherefore, you will usually be charting stocks listed on some exchange. This is also an \nadvantage because concerns listed on the larger exchanges are required to meet certain \nconditions, publish certain information, and comply with definite rules and practices.\nIn this book, most of the examples have been taken from stocks listed on the New \nYork Stock Exchange (NYSE). There are thousands of issues traded on the NYSE, and these \nstocks represent every type of security, from the most conservative to the most speculative, \nfrom the cheapest to the most expensive, and they include every principal type of industry \nand business. There is no reason, however, that stocks should not be chosen from the \nAmerican Stock Exchange, the NASDAQ, or from any other exchange in this country, or \nfor that matter, in some other country. (EN: So far as the chart action is concerned, the patterns \nand their meanings will be the same).\n(EN9: In general the stocks to watch, or chart, will tend to leap out of the haystack of stocks. For \nstock pickers Investor’s Business Daily is in the constant process of sifting the markets for nuggets \nwith its CANSLIM system. (Not a recommendation to use that system, only a recommendation \nto examine every tool that might be of use.) Stocks that appear suddenly on the most active lists of \nhttp://www.stockcharts.com might bear examination by the chart analyst. These include optionable \nstocks that suddenly show a radical change in implied volatility,; stocks that pop up with suspicious \n317Chapter twenty-one: Selection of s tocks to chart\nvolume spikes compared with average volume, and those with internet and software packages one \nmight construct a filter to be informed by the computer of stocks breaking their 14-, 44-, 150-, and \n200-day moving averages: 14 because some professionals think the public thinks in this time frame; \n44 because some think funds think in 44-day time frames. The others because everyone thinks they \nare important.\nIn reality, if the investor aim is to beat the market, he may choose just to confine his activities \nto the ETFs that represent the indices—DIAMONDS™ (DIA), Standard & Poor’s Depository \nReceipts (SPY), and QQQ. ETFs are inherently less risky than any individual stock.)\n\n319\nchapter twenty-two\nSelection of stocks to chart: continued\nIn choosing your stocks, you will probably look for the greatest diversity in the kind of \nindustry. As you are not specializing in the detailed study of a single group, you will \ntry to get stocks from as many different groups as possible. You will want to include \nmines and oils, rails and chemicals, liquors and amusements, airlines, utilities, techs, \ninternets, biotechs, ad infinitum. The reason for this is simply that, very often, many \nstocks in a particular industrial group will show the same or similar patterns, as the \nentire industry is affected by certain Major conditions. You will often find, for instance, \nwhen Allis-Chalmers (EN: or Dell) makes a Triangle or other Area Pattern, followed by \na sharp upward move, Deere (EN: or Compaq), Minneapolis-Moline, Harvester, and Case \nwill make similar Triangles, or possibly Rectangles or some other Consolidation Pattern, \nfollowed by a similar upward move. When Schenley is moving in a long downtrend, \nyou will very likely find that Distillers—Seagram’s, National Distillers, Publicker, and \nAmerican Distilling—are also moving in a long downtrend. (EN: Metaphorical names, like \nthe names of Greek gods or Ulysses and Leopold Bloom. The present-day reader may read Intel, \nFairchild, and National Semiconductor or 3COM. The idea is the same.) (For an illustration in \nthis chapter, see Figure 22.1 .)\nTherefore, unless you plan to keep enough charts to include several stocks of each \nimportant group, it is best to pick your stocks to make up as widely diversified a list as \npossible. In this way, during times when certain groups are moving indecisively, or are \ninactive, you will have some representation in other groups that may be active. (Do not \ninfer from this that all stocks of a group move together at all times. Individual concerns \nwill frequently move according to special influences that bear on a single company. Where \nthe Major influence is some industry-wide condition, the group will move more or less as \na unit.)\nWe, therefore, choose stocks representing a wide variety", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 156}
{"text": "e representation in other groups that may be active. (Do not \ninfer from this that all stocks of a group move together at all times. Individual concerns \nwill frequently move according to special influences that bear on a single company. Where \nthe Major influence is some industry-wide condition, the group will move more or less as \na unit.)\nWe, therefore, choose stocks representing a wide variety of groups or basic industries. \nNevertheless, suppose we are limited as to the number of charts and we must choose one \nstock from a group; which stock to choose? For instance, we must choose one stock from the \ntransportation group (EN: or Biotech, or internets.) As a matter of fact, you would probably \nwant more than one because this particular group is so important and so large, but for the \nmoment, let us choose just one. (EN9: Or, even better, why not one of the indexes—for example, \nan ETF—for the desired group. An example of betting on all the horses rather than trying to pick the \nwinner, and there is no conflict between making both bets.)\nShould it be a high-priced stock or a low-priced stock? Let us examine that point first.\nIf you examine the past records of stocks, you will generally find the lower priced \nissues make much larger percentage moves than the higher priced stocks. It is not unusual \nfor a stock selling around 5 to make a rise of 100%, moving up to 10 sometimes within a \nfew weeks. On the other hand, you do not find 100% moves in days or weeks among the \nstocks selling at 100 or 200. The same industry-wide move that carries your $5.00 stock \nfrom 5 to 10 might carry your $100 stock from 100 to 140. Obviously, if you had put $1,000 \ninto outright purchase of the stock at 5, the move would have increased the value of your \nstock 100% or $1,000. In the other case, if you had put the same amount into a stock at 100, \n320 Technical Analysis of Stock Trends\nthe move to 140 (although many more points) would have increased your capital to only \n$1,400. The gain in the lower priced stock would be about two and one-half times as great.\nThe authors have worked out and tabulated the percentage moves of large groups of \nstocks over long periods of time (see Appendix A, ninth edition) and have set up a table that \nshows the relative average sensitivity of stocks at different price levels. This table pertains \nonly to the price level of stocks; thus, the same stock that today sells at 5 and makes wide \nBALTIMORE & OHIO BO\n1945\nUNION PACIFICU P\n1945\nJANF EB MARA PR JUNEMAY JANF EB MARA PR JUNEMAY\n34\n32\n30\n28\n26\n24\n22\n20\n19\n18\n17\n16\n15\n14\n13\n12\n136\n128\n120\n112\n104\n96\n88\n80\nFigure 22.1 Low-priced stocks move faster than high-priced stocks. Here are weekly charts of two \nrail stocks, charted on ratio scale over the same six-month period. Baltimore and Ohio during this \ntime advanced from 12 3/8 to 28 7 /8, a gain of 16 1/2 points, while Union Pacific moved up from 109 \nto 137 , a gain of 28 points. The advance in “UP ,” however, compared with its price, is much less than \nthe advance in “BO.” A thousand dollars used for outright purchase of “UP” would show you a \ncapital increase of 25%. On the other hand, if you had put a thousand dollars into outright purchase \nof “BO,” your increase would have been 133%, or more than five times as much.\n Bear in mind low-priced stocks not only go up much faster, but also come down much \nfaster than high-priced stocks. When you own a low-priced stock, you cannot safely “put it \naway in the box and forget it.” For security and stability, you would do better to buy a few \nshares of a high-priced, gilt-edge security. For trading purposes, you will want to strike a \ncompromise between the rather sluggish “blue chips” and the extremely erratic “cats and \ndogs” in the lowest price bracket.\n321Chapter twenty-two: Selection of s tocks to chart: continued\npercentage swings will not swing so widely when it has moved up to a price level of 20–30. \n(EN10: These concepts replaced by beta and volatility.)\nSeveral questions may come to your mind at this point. Do not the costs of trading low-\npriced stocks relative to high-priced issues have to be taken into account? (EN: Yes, they do. \nGiven the extreme changeability in these costs in the internet economy, calculation of those costs \nhere would be tantamount to wasting trees. This cost question may be researched quickly and easily \ngiven the availability of search engines such as Google and access to the internet.)\nIn selecting the price level of the stocks you prefer to trade in, you cannot set too \narbitrary a limit because there are other factors to consider and you may have to make \nsome compromises on one score to get what you want in some other direction. Stocks from \n20 to 30 are in a good trading price range. Very often, you will find stocks in the 10–20 \nrange that are so interesting you will want to chart and trade in them. You will find good \nsituations in stocks selling at 30–40. Furthermore, you will understand, of course, the \nstocks that are now selling at 10 may be selling next year at 40, or vice versa. Considering \nyou cannot be changing your portfolio of charts all the time, you must not be too “choosy” \nin picking the price range of your stocks. You would not ordinarily pick out a stock that \nwas selling far above the price range of most stocks of its group, say at 150, when several \nothers in the same industry were selling at 15, 28, or 37 . For the high-priced stock, as we \nhave said, is likely to be sluggish as a trading medium. On the other hand, you would not \ntake the very lowest priced issues of the group, selling at, say, 4 or 2 when others were in \nthe 10–30 bracket. You would not only be faced with erratic and tricky chart action, and \nmuch higher percentage costs for commissions, but also you might not be able to operate \non margin at all. There are, from time to time, limitations on the amount of margin on \nstocks at all levels. In the lower priced issues, these limits are often more st", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 157}
{"text": "group, selling at, say, 4 or 2 when others were in \nthe 10–30 bracket. You would not only be faced with erratic and tricky chart action, and \nmuch higher percentage costs for commissions, but also you might not be able to operate \non margin at all. There are, from time to time, limitations on the amount of margin on \nstocks at all levels. In the lower priced issues, these limits are often more stringent. Plus, \nin the lowest priced stocks, you are sometimes not permitted to trade on margin. (EN: \nAs these requirements are subject to the vagaries of the Federal Reserve Board, the investor must \ninform himself at his personal broker or ECN. For quite some years, the general margin requirement \nhas been 50%. The Fed came in for some sharp criticism for not dampening speculation in the fin \nde siècle bubble by raising margin rates to 100%, and its lack of action exacerbated the blow off \nof 2000. A change in margin rates should get the immediate attention of the technical analyst. \nSomething will be up.)\nOrdinarily, you will get the greatest effective leverage at some point in the 20s, \nconsidering all these factors, and your trading can run down through the teens and up \nthrough the 40s. Above 40 and below 10, you will have to have strong reasons for trading, \nwhich might be, of course, ample capital. It would therefore be best for the moderately \nfinanced investor to choose a majority of his stocks from the middle price range (10–40), \nplus only those special situations you are particularly interested in watching among the \nvery low and very high brackets.\nIf, however, you will go back to the long-time past record of any group of stocks, you will \nfind that even among stocks moving at nearly the same price levels today, there are widely \ndifferent behavior patterns. You will find some stocks respond to a severe market setback \nby reacting, let us say, 20%—that is, if they were selling at 30, they would move down to \naround 24. Others will respond to the same setback in the general market by a reaction \nof 50%—that is, if they were selling at 30, they would end up at around 15. Additionally, \nif you examine the records, the same stocks that make these relatively different reactions \nin one setback will make about the same moves, relative to each other, in other setbacks. \nFurthermore, the same ones that make only moderate corrections on declines will make \nonly moderate advances on rises. The ones that go down sharply on setbacks will also \nskyrocket in a Bullish Market. This has nothing to do with the phenomenon we discussed \n322 Technical Analysis of Stock Trends\nearlier, by which we saw that cheap stocks move faster than expensive stocks. This is due \nto the habits of particular stocks, and these habits seem to be quite stable over periods of \nmany years.\nWe will find, for instance, volatile and speculative issues that make larger percentage \nswings than most other stocks at their price level. On the other hand, we will find a stock, \nselling for much less, that has smaller percentage swings than most stocks at its price level. \nThis fact may be obscured, as the comparatively low-priced stock may actually make larger \nswings than the higher priced. It is only when we have taken the price level into account \nthat we can see the individual habit of the stock. Knowing this, we can project that habit \nto other price levels.\nWe are not too interested, as we have said before, in stocks that do not ordinarily make \nsubstantial moves. We are very much interested in those that make the wider moves. We \ncan compute the basic swing power of a stock, which we call the Sensitivity Index, and will \noutline the method for doing this in Appendix A, ninth edition. (EN: The procedure Magee \nspeaks of here, of computing a “Sensitivity Index,” may be regarded as the historical predecessor \nof what are now called “betas.” The beta of a stock compares its relative volatility with that of the \nmarket as a whole, so if the beta of the market is 1.00 and the beta of the stock in question is 1.50, a \nmove of 1.00 in the market will probably be matched by a move of 1.50 in the higher beta stock. The \nformula for beta will be found in Appendix B, Resources, and calculated betas at finance.yahoo.com.)\nTherefore, you will have eliminated from your list stocks at the wrong price level and \nstocks without enough swing power (for you want to chart only those stocks in which you \ncan trade profitably). Of the ones left, you will eliminate others and find that some stocks, \nwhich make wide price moves and apparently offer large opportunities for profit, may be \nvery “thin.” The charts will be spotty, filled with gaps, days of “no sale,” and moves of \nseveral points on only a few hundred shares of business. These stocks are thin because of \na small issue, because of ownership of a large block of shares by some corporation or by \ninsiders, or for other reasons. They are difficult to trade in because they are hard to buy \nand hard to sell; you stand to lose heavily on the “spread” between bid and offer. It might \nbe hard to liquidate even 500 shares without driving the price down badly, to your loss, \nand sometimes you will see changes of 1 or 2 full points between sales of single hundreds. \nThese you will want to eliminate, and if you do not know the habits before you choose \nyour portfolio, you will probably find it worthwhile to drop any stocks that prove too thin, \nsubstituting new and more dependable choices.\nAfter you have culled the list from all these angles you will find you have left a choice \nof a number of stocks, all of them selling in a price range that is attractive, all of them \nsufficiently active and responsive to market trends, and all of them available in sufficient \nsupply to provide a good trading medium. The final choice of any one (or several) of these \nstocks is then a matter of personal preference.\nAfter you pick out your stocks from one group, study the other groups—the motors \ngroup, the amusemen", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 158}
{"text": "f them selling in a price range that is attractive, all of them \nsufficiently active and responsive to market trends, and all of them available in sufficient \nsupply to provide a good trading medium. The final choice of any one (or several) of these \nstocks is then a matter of personal preference.\nAfter you pick out your stocks from one group, study the other groups—the motors \ngroup, the amusements, the computers (EN: the internets) and so forth, until you have \nfinally made up your selection of stocks to follow. Try to get as complete and balanced a \nrepresentation of groups as the number of your charts will allow. (EN: In this context, the \nprocess described here is made infinitely simpler by available software and by the proliferation of \ngroup indexes, ETFs, and indicators. In fact, if the investor desires, rather than trading an individual \nstock in an industry group, he may often choose to trade the average or index itself and cushion his \nrisks. This will almost never be as profitable as a well-chosen individual issue but will always be \nbetter than a badly chosen individual issue. And ETFs never go broke (so far).)\nIn this connection, if you are not planning to represent all groups, there are some \ngroups more likely to provide good trading stocks than others. Foods and tobaccos, for \n323Chapter twenty-two: Selection of st ocks to chart: continued\nexample, are generally less responsive to market swings than the rails, liquors, and airlines, \nwhich are very responsive. Do not worry too much, however, about exactly which stocks \nto choose for even if you took the first 50 or 100 stocks in the listed issues, you would have \namong them at least 25 good trading stocks. You can start with almost any list, and, as time \ngoes on, you will drop some and add others, improving your portfolio and tailoring it to \nyour own needs.\n(EN: As additional commentary here it is worth noting that “techs,” “biotechs” (or whatever \nthe mania of the moment is—probably space hotels and intergalactic travel in this millennium) will \npresent areas of risk and reward sufficient to excite the seventeenth-century tulip trader. The centered \ninvestor and trader will consider vogues and manias as he chooses his active portfolio and choose \nto participate (or not) depending on his appetite for risk and excitement. Or, as the popular maxim \nhas it, one man’s champagne is another man’s poison. This question is pursued in greater detail in \nChapter 23.)\nBy way of further simplification, the investor may choose to follow only one or two issues—\nStandard & Poor’s Depositary Receipts (SPY) or DIAMONDS™ (DIA). If it were not only bought, \nbut also sold or hedged, the market would be outperformed. This would be a simple investor’s life \nindeed.\n\n325\nchapter twenty-three\nChoosing and managing high-risk \nstocks: tulip stocks, Internet sector, and \nspeculative frenzies\nNothing could more vividly illustrate the timeless nature of chart patterns and situations \nthan the internet stocks that bloomed at the turn of the century. These stocks repeated that \neternal pattern—the Tulipomania, the Gold Rush, the can’t-fail-opportunity-to-get-rich-\nquick. (For illustrations in this chapter, see Figures 23.1 through 23.17.)\nIt is almost impossible to resist comparing the speculative frenzy that took place in \nthe internet and technology issues to the famous seventeenth-century mania that Holland \nexperienced in the famous Tulipomania. In MacKay’s undying classic account (Extraordinary \nPopular Delusions and the Madness of Crowds ), the trading of tulip bulbs replaced sober \ncommerce and business as the occupation of the country, and enormous fortunes were \nmade trading the tubers. Blocks of real estate, breweries, assets of real and large value \nwere traded for one tulip bulb. MacKay produced my favorite paragraph in the literature of \nfinance: “ A golden bait hung temptingly out before the people, and one after the other, they \nrushed to tulip-marts, like flies around a honey pot. Every one imagined that the passion \nfor tulips would last forever, and that the wealthy from every part of the world would send \nto Holland, and pay whatever prices were asked for them.”\nThat mania ended in ruin. A better long-term prospect may be in store for the internet, \nas there is a basis of technology and economic substance to the sector. You could not, after \nall, use your tulip to check the market for prices. In fact, there were those, admittedly a \nsmall number, who struck it rich in the California Gold Rush of 1849. It is an ill wind, etc.\nAs an exercise in rueful perspective, the seventh edition of this book remarked, in the \nwords of Richard McDermott,\nCompanies like Lotus or Microsoft went public and grew into business \ngiants in a short period of time… A significant theme stock for the 1990s \nhas been Internet stocks. Names like America Online, CompuServe, \nand Netscape have provided important products and services that \nallow individuals to “surf the net” for information around the world.\nYoung students of the market will search in vain for Lotus, CompuServe, and Netscape \nin the lists of stock symbols. The giant Lotus was swallowed by IBM, in part because \nMicrosoft, a ruthless competitor, disemboweled it. CompuServe and Netscape disappeared \ninto the belly of a larger fish, AOL, with some of the same factors involved. Later Microsoft \ngot its comeuppance—halving in value as the U.S. Justice Department brought successful \nantitrust action against it.\nThere are those who fault the great Wall Street investment banks for having brought \nhalf-baked potatoes (or unblooming tulips) to market. The Street firms, cashing in on the \nmania, were willing to sell the public every immature profitless idea and company named \n326 Technical Analysis of Stock Trends\n“dot.com Inc.” that venture capitalists floated on a sea of seed money. Mining engineers will \nrecognize the phenomenon of “salting the mine.” It was the finest moment for the great old \nfirms o", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 159}
{"text": "tatoes (or unblooming tulips) to market. The Street firms, cashing in on the \nmania, were willing to sell the public every immature profitless idea and company named \n326 Technical Analysis of Stock Trends\n“dot.com Inc.” that venture capitalists floated on a sea of seed money. Mining engineers will \nrecognize the phenomenon of “salting the mine.” It was the finest moment for the great old \nfirms of the Street since the investment trusts of the 1920s. The reader is most recommended \nto look into The Great Crash, 1929 by John Kenneth Galbraith to compare the Street firms’ \nbehavior from one mania to the next. It will be found most edifying. At the pinnacle of \ngreat manias, no one can be trusted.\nManaging tulipomanias and Internet frenzies and…Bitcoin\nIn a time of excess, the centered investor maintains his composure and focus. Probably \neasier said than done. Nonetheless, many investors and traders profited from the internet \nboom or were not severely damaged. Many managers and traders watched with envy from \nthe sidelines, and with schadenfreude when the bubble burst.\nFor technical analysts speculating and trading according to the principles of this \nbook, important opportunities arise in speculative frenzies and buying panics—namely, \nimportant profits may be made by remaining calm and methodical while the uninformed \nand naïve cause speculative blow-offs, which have some things in common with the ends \nof great bull trends in substantive issues.\nThe question becomes that of realizing some of the profits to be made in these exciting \ntimes. Of course, the first thing to do is not get excited. These manias come and go—\nsometimes they are called biotechs, sometimes computers, sometimes internets, and \nprobably, at some point, human genome miracle drugs or Martian real estate. It should \nbe emphasized these profits are made on both sides, long and short. The crowd will only \nMSFT(D) - Daily NASDAQ L = 27.56 +0.35 +1 .29% B = 27.55 A = 27.56 O = 27.67 Hi = 27.73 Lo = 27.44 C = 27.56 V = 57145012 \nBull Trap \nRunaway Days \nRunaway Gap \nExhaustion Gap\nDepartment of Justice Gap \n48.00 \n42.00 \n37.00 \n32.00 31.33 \n28.00 \n25.00 \n44.06 \n35.30 \nS O N D 00 F M A M J J A S O N \nCreated with TradeStation \nFigure 23.1 Multitudinous lessons in Microsoft. However, short-lived joy. The top rounds over, price \nmakes another attempt, and then the momentum is clearly, if puzzlingly, down. The cancellation of \nthe runaway day in January definitely marked this move as a bull trap, and the short-term trendline \nfrom October would also have taken the trader out of the trap. Use of the Basing Points technique \n(see Chapter 28) would also have allowed escape from the trap. Failed signals, as this one, often are \nexcellent signals for a trade in the other direction.\n327Chapter twenty-three: Choosin g and managing high-risk stocks\nthink of the riches to be made long. Professionals and skilled technicians, professional or \nnot, will take the profits on the short side.\nHere is the most important concept in trading these runaway issues: all of the techniques \nand methods described in this book remain valid for dealing with these kinds of stocks. In addition, \nhere are some other points that should be taken into consideration. The best way to control \nrisk in the Bitcoin market is by trading a position so small (like a roulette bet) that a 100% loss will \ncause no distress or discomfort. The sector in question, tech-tech, web-tech, biotech, internet, \nspace travel, whatever, will be a market unto itself, and special technical factors will apply \nto it. The phases of market lives, accumulation, attraction, markup, mania, and blow-off \nwill occur in compressed time spans—much shorter than the cyclical life of an issue with \nfundamental data to attach it to reality (see Figure 23.4 of Palm Computing).\nBy the time the IPO occurs, the insiders are already prepared to begin the distribution \nphase. For example, when Palm Computing was spun off from 3Com in 2000, only 3% of the \nshares were sold—creating an artificial scarcity and propelling it to absurd heights—Palm \nattained an instant market value greater than that of 3Com, which owned most of its stock. \n(EN9: We have, since The Fall, learned of “laddering.” To let their inside clients in on the IPO, some of the \nunderwriters required the clients to buy more of the stock in the open market after the IPO at higher prices. \nA clever way to throw gasoline on a raging bonfire. Whether Palm was laddered or not is not known.)\nMicrosoft Corporation-(Nasdaq NM) 26.86 0.03 0.11%\n52\n44\n36\n28\n24\n20\n16\n12\n8\n4\n0.07\n87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07\n1998-2004 Prophet Financial System, Inc. Term of use apply.\nFigure 23.2 MSFT monthly. It is easy to lose perspective when looking at a daily chart of a bull trap \nin which one has lost a leg. A monthly long-term look at Microsoft can help restore perspective. \nUnfortunately, the Dow–Jones Company was looking at this chart, not the nearby, when they added \nMicrosoft to the Dow 30 in 2000. Expert timing? At the time, the John Magee Newsletter observed it \nwas a negative indicator of a major top in the Industrials.\n328 Technical Analysis of Stock Trends\nThese issues must be traded with the utmost care and attention. For example, it is \nthe height of foolishness to enter a market order to buy on the issue of the IPO. An issue \ngoing public at 12 might trade on the opening at 50 in these frenzies—a sign to the savvy \ntechnician the sheep are headed for the shearing shed.\nCertain factors must be kept in mind. Some IPOs collapse shortly after going public. \nOthers rocket off before distribution is complete. So stops must be carefully computed. \nOnce it is clear the rocket is taking off, as indicated by price and volume, some discreet \npyramiding might be possible for the experienced and skilled speculator.\nDetailed techniques for management of the runaway issues\nThe technique described in Chapter 28 for tight progressive", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 160}
{"text": "shortly after going public. \nOthers rocket off before distribution is complete. So stops must be carefully computed. \nOnce it is clear the rocket is taking off, as indicated by price and volume, some discreet \npyramiding might be possible for the experienced and skilled speculator.\nDetailed techniques for management of the runaway issues\nThe technique described in Chapter 28 for tight progressive stops is certainly one way \nof dealing with these stocks. There, the method for finding Basing Points and raising \nstops based on the three-days-away rule is detailed. Also, especially in the case of these \nrocket stocks, the practice of raising stops based on new percentage highs should be \nMSFT(D) - Weekly NASDAQ L = 25.27 +0.82 +3.35% B = 24.27 A = 26.28 O = 24.88 Hi = 25.30 Lo = 24.79 C = 25.30 V = 98849923\n48.00\n41.00\n35.00\n30.00\n22.00\n25.30\n18.00\n16.00\n13.00\n11.00\n10.00\n26.96\n21.34\n1998 1999 2000 2001 2002 2003 2004 2005\nB A\nC\nCreated with TradeStation\nFigure 23.3 The editor learns a lesson. Never leave a chart unanalyzed, even if the implications are \nobvious. Also, never be afraid to belabor the obvious. Obviously, this figure should have had a long-\nterm trendline drawn on it. No monumental bull market should be ignored. Why give the market its \nmoney back? It should have been obvious from this figure that the Microsoft party was over and not \njust the fat lady but the entire chorus was beating on anvils. Plus, the protective line must be drawn. \nHere the broken line at A is the most important and saves a bit of capital rather than waiting for the \nplaintive signal at C. Given the robust Bull Market in Microsoft, the long-term investor might have been \njustified in waiting until the C trendline was broken. A matter of investing style and philosophy. There \nappears to be some long-term support at 18. The five-year sideways market appears to be resolving \nitself into a macro triangle that might break out one way or the other in 2005. This is a case in which an \ninvestor might make a fundamental analysis to guide his position (always confirming with the chart \nanalysis). Microsoft is beset with howling wolves on all sides. Linux, Unix, sales of only one copy of \nWindows in China, hackers playing hob with security holes in its software. Can it rise again? Only \nthe chart knows for sure, and it is silent at this recording. In 2011, MSFT was in an 11-year sidewave.\n329Chapter twenty-three: Choosin g and managing high-risk stocks\nPLMO(D) - Weekly NASDAQ L = 21.40 –0.40 –1.03 %O = 21.36C = 21.43\n2001 2002 2003 2004 2005\n18.23\n1610.00\n1010.00\n633.00\n397.00\n249.00\n156.00\n98.00\n61.00\n39.00\n24.00\n21.43\n15.00\n10.00\nCreated with TradeStation\nFigure 23.5 Dealers palmed all the missing capital in PALM? Somebody made the money disappear \nup a shirtsleeve. What makes you think the deck was stacked? Or that the initial public offering (IPO) \nwas laddered? Maybe it was just fools chasing tulips. Those investors (gamblers) playing the shell \ngame with PALM found themselves playing with six shells instead of three as like an insidious amoeba \nPALM divided into two tulips, PLMO and PSRC. Keep your eye on the magician closely. For the analyst, \nall the smoke and mirrors could not hide the fact gravity took PALM in all its manifestations down. The \ndowntrend lines are broken in 2003 and 2004 and a respectable Kilroy Bottom is made. Nevertheless, \nthe implications of the bottom may have already been carried out. A continuing story for speculators \nor astute (very astute) investors who know something fundamental and have very long-term vision.\nPALM\nCreated with MetaStock www.equis.com\n2000 AprilM ay June July August September\n21 32 02 73 10 17 24 18 15 22 30 51 21 92 63 10 17 24 31 71 42 12 84 11\n170\n160\n150\n140\n130\n120\n110\n100\n90\n80\n70\n60\n50\n40\n30\n20\n10\n35000\n30000\n25000\n20000\n15000\n10000\n5000\nX10\nFigure 23.4 PALM. Fool’s gold. Fool’s gold with naiveté writ large on it. Here is a spike reversal \nday on the initial day of trading. The accumulation, markup, and most of the distribution occurred \nbehind closed doors before this trick was perpetrated. After the matanza, the continuation takes on \nthe shape of a rounding bottom. Perhaps there is some real gold there—but only over the long term.\n330 Technical Analysis of Stock Trends\nimplemented. Since these are “game” situations, and irrational, one may employ tactics \nhe might not ordinarily use with his serious capital—some light pyramiding and some \nscaling out of the position based on continuous new highs. Additionally, in the blow-off \nphase when close monitoring is necessary, one might want to exit on a long reversal day, \nor on a key reversal pattern, and then go to the beach; or, if from Texas, one might want \nto short the issue.\nEssentially, I view these stocks as interesting aberrations in the early part of their lives. \nSo I would not look for long-term investment-type trades. Take the money and run. In \nall likelihood, these stocks will explode like fireworks and then expire. There will be the \ncompanies like Microsoft and—it remains to be seen—Yahoo!. After the fireworks show, \nthe patient technician may return to the scene of the crime to see whether there are any \nburning embers. Once they have blown off, crashed, and made reasonable bottoms, then \none begins to look for investment possibilities, which there definitely will be. There is too \nmuch potential in the technology of the internet—and biotech and the human genome—for \nsome phoenix not to rise from the ashes.\nIn the beginning it behooves the trader to regard them as speculative instruments of \nexceptional risk and opportunity.\nSeveral caveats are in order:\n• The prudent speculator does not commit too much of his capital to such enterprises. \nProbably no more than 5%–10%.\nPSRC(D) -Daily NASDAQ L = 8.89 +0.02 +0.23% O = 8.85 C = 8.89\n42.00\n35.00\n29.00\n24.00\n20.00\n17.00\n14.00\n12.00\n10.00\n8.89\nOD 04 FM AM JJ AS ON D0 5F MA M\nCreated with TradeStation\nFigure 23.6 PSRC in its amoeba-like glory. The", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 161}
{"text": "onal risk and opportunity.\nSeveral caveats are in order:\n• The prudent speculator does not commit too much of his capital to such enterprises. \nProbably no more than 5%–10%.\nPSRC(D) -Daily NASDAQ L = 8.89 +0.02 +0.23% O = 8.85 C = 8.89\n42.00\n35.00\n29.00\n24.00\n20.00\n17.00\n14.00\n12.00\n10.00\n8.89\nOD 04 FM AM JJ AS ON D0 5F MA M\nCreated with TradeStation\nFigure 23.6 PSRC in its amoeba-like glory. The failure of what might have been a rounding bottom, \nespecially with the breakdown gap in October and the failure to rally back to the neckline left no \ndoubt as to the fate of PALM by any other symbol. Broken trendlines are also indicative. Remember \nthat any large pattern can be broken down into smaller patterns susceptible to short trendline \nanalysis, as in this case. Sooner or later a palm-size computer, PDA, widget device is going to be the \nwave of the future. (EN10: A visionary prediction of the iPhone.) The canny investor will not mistake the \ncompany for the stock and will also not venture capital until there is a better chart story.\n331Chapter twenty-three: Choosin g and managing high-risk stocks\n• When selling them short, one should not be early. A definite top should be seen \nbecause there might be a second stage of the rocket.\n• Emotional involvement with tulips and internet stocks—or stocks of any kind \nactually—can lead to a broken heart. In the charts, note the success in a number of \ncases of trading the key reversal day.\n(EN9: Reviewing charts from the apocalypse is a sobering experience. So many rash and mad \nadventures. So much capital sucked into the black hole of underwriters and 21-year-old huckster CEO \nwallets. Better than the South Seas Bubble. And, as definite proof that man is directly descended from geese \nand sees no farther ahead than the next feeding bowl, the ghost of the mania oozes from the closet in 2005, \nreborn as Google mania. Man (or goose if you will) never learns. That is why he is so much fun to watch.)\nGoogle—what a creature is man! What a game is the market! Google, a wonderful \ncompany, and a great concept goes public in 2004 after world-class hype (world class? \nintergalactic class!). Floated as a red herring at 135, it eventually goes IPO at 85 in an \ninnovative public offering. Then the fun starts. Future readers of this book may observe the \nmarkup made as of the date of this writing (November 2004) and judge whether the method \nworked. A company on roller blades, impossible to dislike as a company. Remember, unless \nyou are Warren Buffet, you are buying the stock, not the company.\n3com Corporation-(Nasdaq NM) 3.71 0.10 2.77%\nVolume (Millions)\n1998=2004 Prophet Financial Systems, Inc. I Terms of use apply.\nAprJ ul Oct9 7A pr JulO ct 98 AprJ ul OctA pr JulO ct 00 AprJ ul Oct0 1A pr JulO ct99\n24\n22\n20\n18\n16\n14\n12\n10\n8\n6\n4\n2\n54\n0\n480\n420\n360\n300\n240\n180\n120\n60\n0\nFigure 23.7 COMS. Underwriters cleverly doled out only 3% of 3Com-owned Palm stock onto the \nmarket at the IPO. Palm wound up “worth” more than 3Com for a short time. Here the lesson of \ntulipomania is vivid. The contrast in before and after volume. The necessity of analysis to deal with \ntulips in bloom. The fatal lesson of heeding (or not heeding) gaps across horizontal trendlines. \nImpossible to manage for the buy-and-hold investor.\n332 Technical Analysis of Stock Trends\nHope springs eternal and there is one born every second\nOne might have thought the age of the tulip was over as we moved into the second decade \nof the new millennium—but what naiveté! Not over at all. Investors rushed into the \nLinkedIn and Groupon IPOs and stood quivering on the sideline begging for Facebook to \ngo public. But Facebook, the ultimate practitioner of chutzpah, satisfied itself by feeding on \nthe venture capital community, demanding ever higher valuations from venture capitalists \ndesperate to own a sliver of the deal at whatever cost. The public will have to wait to be \nshorn. But have faith, it will be. Remember Palm.\nYou can buy these things, but you have to remain glued to the screen and the ride will \nbe rough. Unless you have your professional speculator’s license and have lost money on \nthese deals before, watch the snake pit from the sidelines—and do not buy any snake oil.\nOracle Corporation-(Nasdaq NM) 12.28 –0.04 –0.32% \n45\n39\n36\n33\n30\n27\n24\n21\n18\n15\n12\n9\n6\n3\n296 Apr Jul Oct 97 Apr Jul Oct 98 Apr Jul Oct 99 Apr Jul Oct 00 Apr Jul Oct 01 Apr \nFigure 23.8 ORCL. True to the character of stocks during the Tulipomania, Oracle was difficult to \nhandle without careful analysis. Stock splits preceded a number of the sell-offs (note gaps post splits). \nBullish gaps are also frequent here, and the tulip top is obvious, and was at the time. An excellent \ntrading vehicle though a wreck for the casual investor.\n333Chapter twenty-three: Choosin g and managing high-risk stocks\nInktomi Corp-(OTC)\n260 \n220 \n180 \n160 \n140 \n120 \n100 \n80 \n60 \n40 \n20 \n2 \nJul Oct 99 Apr Jul Oct 00 Apr Jul Oct 01 Apr \n1999–2004 Prophet Financial Systems, Inc. Terms of use apply. \nFigure 23.9 INKT. The pleasures and delights (and disappointments) of internet stocks. The last \ntrendline, in conjunction with the second horizontal trendline, clearly marks the end of the party \n(AND WILL FOR ANY STOCK WHATSOEVER). The break of the long-term trendline is the last exit \nsignal, as if the previous signals were not clear enough. Is it not obvious that this issue was (and is) \nmanageable with technical analysis?\n334 Technical Analysis of Stock Trends\nEmulex Corp 19.74 0.01 0.05%\n120\n100\n80\n70\n60\n50\n40\n30\n20\n10\n0.6\n96 AprJ ul OctAprJ ul Oct9 79 8A pr JulO ct 99 AprJ ul Oct0 0A pr JulO ct 01 AprJ ul\n© 1999–2004 Prophet Financial Systems, Inc. Terms of use apply.\nFigure 23.10 EMULEX (ELX). The message of 2000, a severe drubbing, and precipitous at that, would \nhave been lost on the non-technician. Those who continued to ride the roller coaster relearned a \nlesson some technicians know—stocks often repeat the same behavior (or misbehavior). The less", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 162}
{"text": "O ct 99 AprJ ul Oct0 0A pr JulO ct 01 AprJ ul\n© 1999–2004 Prophet Financial Systems, Inc. Terms of use apply.\nFigure 23.10 EMULEX (ELX). The message of 2000, a severe drubbing, and precipitous at that, would \nhave been lost on the non-technician. Those who continued to ride the roller coaster relearned a \nlesson some technicians know—stocks often repeat the same behavior (or misbehavior). The lesson \nof monster breakaway gaps (or air gaps) may have needed relearning also. Oh well, after such a \ngap the damage is done, the unenlightened investor says, only to see the damage continue down \nto 10 (from 110!). These are signals of such magnitude that disaster awaits the trader who denies its \nsignificance. The air gap here nicely complements those of Figures 12.9 and 37 .43.\n335Chapter twenty-three: Choosing a nd managing high-risk stocks\nAmazon.com Inc.-(Nasdaq NM) 47.15 –0.84 –1.75%\nVolume (Millions)\n120100\n80\n60\n50\n40\n30\n20\n10\n1\nAprJ ul OctJulO ct 98 99 AprJ ul Oct0 0A pr JulO ct 01 AprJ ul\n1999-2004 Prophet Financial Systems, Inc. I Terms of use apply.\n120\n100\n80\n60\n40\n20\n0\nFigure 23.11 Amazon weekly. Amazing Amazon dances in the internet follies. The breathtaking \nplunges are the direct result of the breathtaking speculative excess. See the daily chart (Figure 23.12) \nfor a closer look at the details of the blow-off.\nAMZN (Amazon.com, Inc.)\n08/26/2006 5:51 PM EDT \nMar Apr May Jun Jul Aug SepO ct Nov Dec9 9F eb 4\n10\n20\n30\n40\n50\n60\n70\n80\n90\n100\nAmazon.com Inc.–(Nasdaq NM) 28.03 0.06 0.21%\n© 2002-2006 Prophet Financial Systems, Inc. All Rights Reserved.\nFigure 23.12 Amazon daily. In cases of speculative blow-off, trendlines are of little use. A dozing \ntrader (presumably it was obvious this was not an investment issue) would have been mauled in the \nplunge. An alert trader, knowing that in blow-offs the procedure is to sell strength, might have avoided \nit. Other techniques include recognition of the second exhaustion gap and exit. Also, a trader using \nthe techniques described in Chapter 28, setting progressively tight stops, might have avoided the fall.\n336 Technical Analysis of Stock Trends\nAMZN(D) - Weekly NASDAQ L = 32.31 –0.21 –0.65 %O = 32.85C = 32.36\n42.04\n18.35\n88.00\n62.00\n44.00\n32.36\n22.00\n15.00\n11.00\n8.00\n5.00\n4.00\n3.00\n2.00\n1998 1999 2000 2001 2002 2003 2004 2005\nCreated with TradeStation\nFigure 23.13 The wild frontier of the internet and of the gunslinger speculators (gamblers?). Amazon \nbucks on. Give us a slug of rotgut whiskey and get out the ruler. A clear top for the rational analyst \nwith clear broken trendlines and broken horizontal lines and then a clear Bear Market with a clear \nbottom resembling a Kilroy Bottom and then a clear breakout and another Bull Market and then \nanother downtrend. Talk about your fearless bull riders down at the rodeo. But this Bull–Bear is \nridable with a little technical analysis. Without technical analysis it is like being the target in a shooting \ngallery—a sitting duck.\n337Chapter twenty-three: Choosin g and managing high-risk stocks\nCisco Systems Inc.-(Nasdaq NM) 17.29 0.08 0.46%\n18\n17\n16\n15\n14\n13\n12\n11\n10\n9\n8\n7\n6\n5\n497 JunJ ul AugFeb Mar AprM ay SepO ct Nov Dec9 8J un JulA ugFebM ar AprM ay SepO ct Nov\n© 1999–2004 Prophet Financial Systems, Inc. Terms of use apply.\nFigure 23.14 CISCO (CSCO). Although the first long-term trendline beautifully intercepts the downtrend \nin progress at a gap (a coincidence of indicators that occurs too often to be a coincidence), the trendlines \ndrawn later are of such strength that even the novice analyst should know how to exit. In fact, one of my \nstudents, an employee of Cisco, did just that, saving himself thousands of paper dollars in this very case.\n338 Technical Analysis of Stock Trends\nCSCO LAST-Daily 08/22/2001\n75\n70\n65\n60\n55\n50\n45\n40\n35\n30\n25\n20\n15\n4/2000 5/2000 6/2000 7/2000 8/2000 9/2000 10/200011/20001 2/20000 1 2/2001 3/2001 4/2001 5/20016 /2001 7/2001\nCreated with TradeStation 2000i by Omega Research1 999\nFigure 23.15 Is there any way the trader (investors keep away) could avoid stepping off this cliff? \nExtreme paranoia is one way. Another way is by being acutely conscious of the pattern of behavior \nmanifested by Cisco in Figure 23.14.\n339Chapter twenty-three: Choosin g and managing high-risk stocks\nGOOG(D) - Daily NASDAQ L = 219.75 +0.30 +0 14%O = 221.91 C = 220.00\n204.79\n163.99\n216.00\n220.00\n204.00\n193.00\n182.00\n171.00\n162.00\n153.00\n144.00\n136.00\n128.00\n121.00\n114.00\n108.00\n101.00\nAugS ep Oct Nov Dec0 5F eb Mar AprM ay\nCreated with TradeStation\nFigure 23.16 You thought all the tulips and Bulls had been exhausted in the Tulipomania in 2000? \nSilly you. There is an inexhaustible supply. All you need is a company and a story and an underwriter \nto peddle it. Sometimes there are even earnings. Sometimes the earnings are even real. Sometimes \nthe earnings are skating uphill on roller blades. Then sometimes the characters are so appealing that \nyou are almost willing to buy the IPO at face value, but not if you are a cynic, as are all technical \nanalysts. Google was rumored at $200 or more on the IPO. The editor offered to sell all of it at that \nprice and throw in the Brooklyn Bridge for free. This offer (well, there may have been other factors \nalso) knocked the IPO down to $85 (still an errant speculation), but only insane, not unreasonable. \nThe oversubscription in an innovative offering revealed that the tulip virus was not dead, but very \nmuch alive and infecting not just the same old suspects, but many new ones. We love a horse race, \nand this is a great one. Notice the obvious defensive lines and support and resistance. How long \nGoogle can defy gravity (a galactic price-earnings ratio) remains to be seen. Prudent gamblers will \nhave a stop identified. On this chart, for the long-term gambler, it might be in the 182 area. For the \nmore agile gambler, it might be failure of the support around 204, or closing of the breakaway gap \nthere. No opprobrium is attached to the term gambler. In", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 163}
{"text": "and support and resistance. How long \nGoogle can defy gravity (a galactic price-earnings ratio) remains to be seen. Prudent gamblers will \nhave a stop identified. On this chart, for the long-term gambler, it might be in the 182 area. For the \nmore agile gambler, it might be failure of the support around 204, or closing of the breakaway gap \nthere. No opprobrium is attached to the term gambler. In fact, bolder investors (competent readers of \nthis book) should take a flyer from time to time with about 5% of their capital. This is the flyer that \nshould have been taken. The breakaway gaps in October and April, operating against disbelief, were \nsignals of enormous technical strength. And Google went to 475! The lesson here, which must be \nlearned and relearned and … ad infinitum … is this: trust the chart. Ignore the story. In 2008, GOOG \nwent to 700, halved in the Bush Bear Market, recovered to 600, and entered a two-year sidewave.\n340 Technical Analysis of Stock Trends\nFigure 23.17 Google, 2011. Google turned out to be the real thing and had a herd of cash cows that \nproduced and produced and produced. Mother’s milk? Or America’s love affair with advertising? \nWhatever, the reader can see the simple-minded management of the issue with trendlines. Using \ntrendlines would have avoided bungee-like equity, which is never pleasant. Basing Points might have \nbeen used the same way with the same effect. GOOG has essentially been in a large sidewave (very \nlarge) since 2010. The exit from this sidewave should have dramatic consequences—up or down.\n341\nchapter twenty-four\nThe probable moves of your stocks\nAt first glance, all stocks appear to move helter-skelter without rhyme or reason, all over \nthe lot. All stocks go up at times, and all go down at times—and not always at the same \ntime. We already have seen in these rises and falls stocks do follow trends, make various \ntypical patterns, and behave in a not completely disorderly manner. (For illustrations in \nthis chapter, see Figures 24.1 and 24.2.)\nIt is also true that each stock has its own habits and characteristics, which are more \nor less stable from year to year. Certain stocks normally respond to a Bullish Phase of the \nmarket with a very large upsurge, whereas others, perhaps in the same price class, will \nmake only moderate moves. You will find that the same stocks that make wide upward \nswings are also the ones that make large declines in Bear Markets, whereas the ones that \nmake less spectacular up-moves are more resistant to downside breaks in the market. There \nare stocks that ordinarily move many, many times faster than others. We do not know, \nfor example, whether a year from now Glenn Martin (EN: read, Microsoft, eBay) will be \nmoving up or down, but we do know, and it is one of the most dependable things we know, \nwhichever way it is going, it will be covering ground much faster than American Telephone \nand Telegraph. (EN9: Even T accelerated into hyperspace after its unfortunate divestment of \nlocal Bells. And, unlike the leopard, completely changed its spots.) These differences of habit, of \ncourse, are due to the size of issue, floating supply, nature of business, and leverage in the \ncapital structure, matters we have touched on briefly before. As a matter of fact, we are not \nespecially concerned with why the differences exist. We are interested mainly in what the \ndifferences are, and how we can determine them.\nThis is important: stocks that habitually move in a narrow range, although excellent \nfor investment purposes in cases in which stability and income (dividends) are the chief \ndesiderata, are not good trading stocks. A fairly high degree of sensitivity (EN: volatility), \nwith wide percentage moves, is necessary to make possible profitable commitments that \nwill cover costs and leave a net gain. To be in a position to make a profit, you should see \nthe probability of at least a 15% move in your stock.\nHow then are you going to tell which stocks are most sensitive and potentially most \nprofitable?\nBy examining the record of a certain stock for a number of years back, and comparing \nthe percentage moves it has made with the percentage moves of the market as a whole, you \ncan obtain a fair picture of that stock’s habits. You will not be able to say, at any particular \nmoment, “This stock is now going to move up 25%,” but you can say, with a good deal of \nconfidence, “If the market as a whole makes an advance of 10%, this stock will probably \nadvance about 25%.” Or, conversely, “If the market goes down 10%, this stock will very \nlikely go down at least 25%.” (EN10: The concept of beta.)\nMany methods have been used for measuring and checking these percentage-move \nhabits, differing only in detail. (EN10: With the ready availability of desktop and internet \nsoftware, the investor may call up a two- or five-year chart and see the potential range of the stock at \nhand.) Indexes on several hundred important stocks listed on the New York Stock Exchange \nhave been computed by the authors and are presented in Appendix A, ninth edition. \n342 Technical Analysis of Stock Trends\n(EN10: Magee’s concept of “sensitivity” appears to combine some aspects of our modern concept of \nbeta and modern computation of volatility. The replacement for Magee’s Sensitivity Index is readily \navailable at finance.yahoo.com and http://www.abg-analytics.com as well as any number of other \nsites findable by Google.)\nIndividual stocks have their characteristic habits, as do some entire industries. In \ngeneral, the food stocks, of which “CFG” is one, are stable and slow-moving. On the other \nhand, liquor stocks make wide moves on any general advance or decline of the market. At \nthis time “CFG” had a Sensitivity Index (EN9: or beta equivalent) of 0.58, whereas Schenley’s \nwas 2.05.\n(EN: Current-day betas or volatilities may be compared with these and/or substituted for them in \nother computations suggested in this book, for example, in Composite Levera", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 164}
{"text": "e and slow-moving. On the other \nhand, liquor stocks make wide moves on any general advance or decline of the market. At \nthis time “CFG” had a Sensitivity Index (EN9: or beta equivalent) of 0.58, whereas Schenley’s \nwas 2.05.\n(EN: Current-day betas or volatilities may be compared with these and/or substituted for them in \nother computations suggested in this book, for example, in Composite Leverage formulas. The reader \nCORN PRODUCTS REF. CFG\n1945 1946\n80\n76\n72\n68\n64\n60\n56\nMJ JA SO ND JF MA MJ JA SO\nSCHENLEY DIST.S H\n1945 1946\nMJ JA SO ND JF MA MJ JA SO\n100\n96\n92\n88\n84\n80\n76\n72\n68\n64\n60\n56\n52\n46\n44\n40\n36\n32\n28\nFigure 24.1 Some stocks move faster than others. We have already noticed that low-priced stocks \nhave much larger percentage moves than high-priced issues. Yet, even between two stocks that \nmay, at a particular time, be selling at the same price, there are enormous differences in their habits. \nFurthermore, these habits change very little from year to year.\n Here we have a weekly chart of Corn Products Refining Company (left), covering an 18-month \nperiod in the years 1945 and 1946. We also have a chart of Schenley Distillers (right) for the same \nperiod. The average price between the high and low on these charts is about 64 1/2, the same for \nboth stocks.\n However, during this period, we see “CFG” moving between a low of 58 1/2 and a high of 71, a \nrange of 12 1/2 points, while at the same time, “SH” has moved between 28 1/2 and 100, a range of \n71 1/2. A thousand dollars put into an outright purchase of “CFG” at its extreme low would have \ngrown to $1,210 at its extreme high, whereas the same amount used for outright purchase of “SH” \nat its low would have grown to $3,510. Your gain of $2,510 in “SH” would be more than 10 times the \ngain of $210 in “CFG,” and this without using margin.\n It is not likely you would actually purchase either stock at the extreme low, nor sell at \nthe extreme high. The point we are bringing out here is there are enormous differences in \nthe swing habits of stocks.\n343Chapter twenty-four: The proba ble moves of your stocks\nmay read in the following text “beta” for “Sensitivity Index” and avoid the annoyance of excessive \nnotation by the editor.)\nThe Indexes are relative. They show stocks with a high Sensitivity Index (EN: beta) will \nmove much faster in either Bull Markets or Bear Markets than stocks with low Indexes, and \nabout how much faster, relative to the other stocks.\n(EN: As is obvious to the experienced reader, and new to the inexperienced, Magee’s method \npredates the modern compilation of betas and volatilities . Beta measures the systematic risk \nof a stock, or for those who are not into financial industry jargon, the sensitivity of a stock to the \nmarket. Volatility measures the dispersion of returns in the stock itself. Thus, if the market moves 1 \npoint, a stock with beta of 1.5 will move 1.5 points. A stock with a beta of 0.5 will move 0.5 points, \napproximately or more or less. Not surprisingly, high beta stocks are volatile. For readers who like \nto roll their own, I offer here the formula for computing the beta of a stock, which is somewhat more \nsophisticated than Magee’s method:\n ((N)(Sum of XY)) − ((Sum of X)(Sum of Y))\nwhere\nN = the number of observations,\nX = rate of return for the S&P 500 Index,\nY = rate of return for stock or fund.\nThe general investor may not be avidly interested in this calculation, especially when the beta is \nreadily available at Value Line and finance.yahoo.com and is published regularly by Merrill Lynch. \nBetas litter the internet, found by searching Google; seekingalpha.com has lists; and finance.yahoo.\ncom displays the stock beta in “Key Statistics” for each stock covered.\nCUBAN - AMERICAN SUGARC SU\n1945 1946\n36\n34\n32\n30\n28\n26\n24\n22\n20\n18\n16\n14\nMJ JA SO ND JF MA MJ JA SO\nELECTRIC BOAT EB\n1945 1946\n36\n34\n32\n30\n28\n26\n24\n22\n20\n18\n16\n14\nMJ JA SO ND JF MA MJ JA SO\nFigure 24.2 Another example of the difference in swings between stocks. In this case also, the stocks \nshow the same average price between the high and low of the period, and both stocks are plotted for \nthe same 18 months in 1945 and 1946. Although in a lower price range and even though the disparity \nin their Sensitivity Indexes is less, there is a considerable difference in their actions. Cuban–American \nSugar (left), a food stock, shows a range of 76% from its low of 16 1/2 to its high of 29, whereas Electric \nBoat (right), a shipbuilding concern, advances more than 140%.\n344 Technical Analysis of Stock Trends\nOf equal or greater importance is the individual risk of a stock that professionals like to determine \nby computing its volatility. Somewhat akin to Magee’s “normal range for price,” volatility measures \nthe variability of a stock’s returns (price movement). The general investor should be informed the \nstudy of volatility is an extremely sophisticated subject, and professionals expend enormous resources \ndealing with the question. Numerous methods are used to derive volatilities, but these mainly come \ninto play in options arbitrage and professional trading on exchange floors.\nFor the private investor, it is sufficient to know of the dangers of this arcane area. Before venturing \ninto “volatility plays,” the newcomer should take a postgraduate course. For the general investor \nwho wants to know enough to calculate his own volatilities (not recommended or necessary), I note \nthe formula here:\nTo calculate volatility, first find the difference between each return and the average. Then square \neach difference and add them together. Divide the sum by the number of returns minus one. This \nresult is known as the variance. Finally, take the square root of the variance to get the volatility. \nCombining these steps into a formula:\n \nσ\nµ\n=\n−\n−\n=\n∑\ni\nn\niR\nn\n1\n2\n1\n()\n• Step 1: Calculate the average return.\n• Step 2: Calculate the deviation of each return.\n• Step 3: Square each period’s deviation.\n• Step 4: Add them together.\n• Step 5: Divide the", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 165}
{"text": "by the number of returns minus one. This \nresult is known as the variance. Finally, take the square root of the variance to get the volatility. \nCombining these steps into a formula:\n \nσ\nµ\n=\n−\n−\n=\n∑\ni\nn\niR\nn\n1\n2\n1\n()\n• Step 1: Calculate the average return.\n• Step 2: Calculate the deviation of each return.\n• Step 3: Square each period’s deviation.\n• Step 4: Add them together.\n• Step 5: Divide the sum by the number of periods – 1. This is the variance.\n• Step 6: Take the square root.\nThe less punctilious (or more practical) investor may find volatilities at ht tp://www .\noptionstrategist.com, ht tp: // www .cboe.com, and finance.yahoo.com, as well as other locations that \ncan be located by searching on Google.)\n345\nchapter twenty-five\nTwo touchy questions\nThis chapter is directed largely to the new trader, to the investor who has followed other \nanalytical methods, and to the investor type who is now, for the first time, taking up the \ntechnical trading of stocks for the shorter term.\nThe use of margin\nThe first question here is the use of margin. There are many people who, knowing of the \ndisastrous margin calls of 1929 and the staggering way losses can be multiplied against one \nin a margined account during a sharp break in the market, take the attitude that the use of \nmargin is intrinsically bad, dangerous, foolish, and unsound. They will tell you they are \nwilling to risk their own money, but they never speculate on borrowed funds. They will tell \nyou that by buying securities outright, they are safe against any kind of break in the market.\nThere is something to this line of argument, although very often you will find the \narguer has not really thought the case through all the way. If he had, he might realize \nthat, in buying outright stocks that are sensitive or highly leveraged, he is accomplishing \nalmost exactly the same thing as someone else who buys more conservative stocks on a \nmargin basis. Very often, despite his feeling that outright purchase is more conservative \nthan margin buying, he is a speculator at heart. He is not really interested in dividends and \na stable investment. Rather, he is looking for “something with appreciation opportunity.” \nConsidering he is not facing the issue squarely, he may fall into expensive errors.\nTo be thoroughly consistent here, a man who shuns the risks inherent in margin trading \nshould shun the risks of leverage and volatility. He should avoid risk, forget “opportunity \nfor appreciation,” and confine himself to sound, income-producing stocks of a sort that \nwill not fluctuate widely.\nIf we are looking for stability, we do not want excessive fluctuation and there are \nsecurities that provide stability. In this work, however, we are looking for “swing power.” \nWe want the highest degree of fluctuation we can handle safely. We can secure this by \nbuying outright a stock that is normally subject to fairly broad swings—that is, a stock \nwith a high Sensitivity Index (EN: beta). We can get the same effect by trading in a stock of \nmore conservative habits but increasing the Composite Leverage (EN: or simply leverage) by \nusing margin. (The method of computing and comparing Composite Leverages in various \nsituations is covered in Appendix A, ninth edition and may be studied in Chapter 42.)\nLet us assume, for example, we will buy 100 shares of a rather speculative stock, which \nwe will call UVW, on an outright basis. It has a Sensitivity Index of 1.50, and now sells (let \nus say) at 20. At the same time, we buy a somewhat less speculative stock, XYZ, also selling \nat 20; but in this case, we buy on 70% margin, putting up only three-quarters of the value of \nthe stock. In a general advance affecting both of these stocks, the probabilities would favor \na somewhat greater percentage move in UVW than in XYZ. If such a general rise should \nbring UVW to 30, we might expect XYZ to rise to a lesser degree, say to 28. Now the advance \nof 10 points on the $2,000 invested in outright purchase of UVW will represent a gain of \n$1,000 or 50%. The advance of XYZ to 28 on the $1,400 invested at 70% margin will mean a \n346 Technical Analysis of Stock Trends\ngain of $800 or 57%. In other words, we have, by the use of margin, increased the effective \nleverage of XYZ; we have made it, in fact, slightly more speculative than UVW.\nThe effect of margin use is simply to accentuate or increase the sensitivity of a situation. \nIt is a mechanism for assuming more risks and, therefore, more opportunities for faster \ngains. Assuming you are willing to assume risk (as you must be if you intend to make \nspeculative commitments), it is simply a matter of knowing approximately what risks you \nare taking and whether you can afford to take them. The danger in margin lies in cases \nin which the customer grossly overextends himself, taking on a risk far beyond his ability \nto protect himself. This will not happen if he sets a reasonable limit to his total leverage \n(EN: put another way, his portfolio risk).\nThe margin transaction is simply a matter of buying (or selling short) more stock than \nyou have money to pay for in full. The purchase of a home on a mortgage is essentially a \nmargin transaction. The financing of business operations, using borrowed money for part \nof the capital, is the same. The buying of anything for which the purchaser puts up part of \nthe capital and borrows the rest, using the value of the purchased property as security for \nthe loan, is exactly similar to the trading of stocks on margin. In each case, any change in \nthe value of the property will cause a larger net change in the value of the margin capital. \nThus, if a man buys a home for $100,000, paying $50,000 cash, and later sells it for $150,000 \n(an increase of 50% in the value of his property), he will benefit to the extent of $50,000 \nprofit, or 100% on his invested capital.\nThe question of margin calls, being “wiped out” on margin transactions, will seldom, if \never, come up if you protect your", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 166}
{"text": "net change in the value of the margin capital. \nThus, if a man buys a home for $100,000, paying $50,000 cash, and later sells it for $150,000 \n(an increase of 50% in the value of his property), he will benefit to the extent of $50,000 \nprofit, or 100% on his invested capital.\nThe question of margin calls, being “wiped out” on margin transactions, will seldom, if \never, come up if you protect yourself properly by maintaining stops at all times or by closing \nout the transaction when it has violated certain predetermined danger points. Needless to \nsay, if you have allowed a trade to go so bad it reaches the minimum margin maintenance \nrange, the best thing is to take your loss and forget it; not try to meet the margin call. Yet \nagain—this need not ever happen.\nAs we will see in discussions of sensitivity and leverage, stop levels, and so on, there \nare certain limits that can be fairly well defined, beyond which you cannot safely venture. \nIf you could buy stock on a 10% margin, as you could at one time, you might have visions \nof highballing $1,000 up to $1 million in one Bull Market; that is not a reasonable hope and \nit is not safe to risk your capital on a 10% margin because, in many cases, your perfectly \nlogical purchase would sag enough to wipe you out entirely before going ahead to the \nnormal advance you expected. (EN: In a nutshell, the risk of trading commodities and futures.) \nIn judging how much margin you can or should use within the limits of margin trading \nlaid down by law, you must take into account the method of trading you are using, the \namount of adverse fluctuation you must expect in the normal operation of your method, \nand the nature of the stock you are dealing with, that is, its Sensitivity Index and Normal \nRange-for-Price (EN: at the risk of being repetitive, beta and volatility), at the time you make \nthe original commitment.\nShort selling\nThe other touchy question is that of short sales. A majority of traders avoid the short side \nof the market. Six out of seven investors you meet, who have bought or sold stocks, will \ntell you they would never sell a stock short under any conditions, at any time. In fact, short \nselling is limited, very largely, to skilled professionals. (EN: The private investor, because of \nhis fears and prejudices, voluntarily grants this “edge” or advantage to professionals. Magee dealt \nwith this subject at length in Winning the Mental Game on Wall Street, which I wholeheartedly \nrecommend to the reader. EN9: The widespread proliferation of hedge funds in the new century \n347Chapter twenty-five: Two touchy q uestions\nattests to the frustration of professional managers with mutual fund rules requiring them to maintain \nonly long positions. Even with this development, short selling by the general investor remains a \nlimited technique—to the disadvantage of the nonprofessional.)\nNow, if you have studied long-term charts (weekly and monthly), and the daily charts \nin this book, you will recognize several facts about the action of markets. Most stocks go \nup most of the time. There are almost always more advances than declines in the list of the \nmost active stocks published each day. Stocks, in general, advance about two-thirds of the \ntime, and go down only about one-third of the time. (EN9: Probably a truth over the long term, \nbut in the modern context, ample short opportunities exist.)\nFurthermore, most of the news releases, rumors, and comments in the press related to \nstocks and corporate affairs have to do with the brighter side of industry. It is only natural \nthat executives, public relations people, and the reporters themselves should be interested in \nforward-looking developments, new processes, expansion of facilities, increased earnings, \nand the like, and that such items should prove more newsworthy than less optimistic \nreports.\nThese various factors may explain why “the public” is always Bullish. The public is \nalways hoping and expecting stocks to go up all the time. If stocks are rising and in a Bullish \nPhase, the public expects them to still go higher. If stocks have declined sharply, the public \nwill argue they are now better buys than before and must surely go up soon. It is up, up, \nUP, always up, in the mind of the public.\nYet, examination of the long-term charts covering the action of the Averages over many \nyears will show you that, through these long periods, the levels rise and fall about the same \namount. This being the case, it must follow that stocks come down as far as they go up \nand because they go up about two-thirds of the time, they must come down much faster \nthan they go up. This you will find is true. The angles of decline in the Averages and also \nin individual stocks are usually steeper in Bear Market Moves than the advances are in \nBull Market Moves. A corollary to that is that profits can be made faster on the downside of the \nmarket than on the upside.\nSuch profits are made by selling short. It is important if you are a trader to understand \nthe meaning of a short sale. When you sell a stock short, you borrow that stock from \nsomeone who owns it, and then you turn around and sell it to someone else, agreeing \nwith the original owner to replace his shares at some unspecified time in the future. All \nof the details of this transaction is handled by your broker. Shares of most stocks of large \noutstanding issue are available for loan at all times in the hands of brokers, and your broker \nhas access to them. The mechanics of this borrowing and sale are interesting; you may \nwish to get from your broker the whole story of how these operations are carried out. For \nall practical purposes, however, all you need to do is tell your broker what you wish to sell \nand leave the rest to him.\nHe will advise you if, by any chance, the stock you have selected for short sale is not \navailable for loan. Another practical point, although of minor consequence, is that a slight \nadditional tax is assessed against", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 167}
{"text": "e whole story of how these operations are carried out. For \nall practical purposes, however, all you need to do is tell your broker what you wish to sell \nand leave the rest to him.\nHe will advise you if, by any chance, the stock you have selected for short sale is not \navailable for loan. Another practical point, although of minor consequence, is that a slight \nadditional tax is assessed against short sales. (EN: In that gains on short sales are not eligible \nfor long-term capital gains tax.)\nIt is important also, if you are a trader, to accept opportunities to sell short as readily \nas you go long stock. Unfortunately, there are psychological barriers to short selling. There \nare, for example, the unintelligent and entirely irrelevant slogans about “selling America \nshort.” There is the feeling on the part of many who are poorly informed that short selling \nis the somewhat unethical trick of the manipulator. Others have the impression that, in \nselling short, one is hoping to profit by the misfortunes of others at times of disaster and \nPanic. It is not the purpose of this book to persuade anyone to sell stocks short, any more \n348 Technical Analysis of Stock Trends\nthan it is our purpose to advise anyone who should not to speculate on the long side of the \nmarket. Nevertheless, so many questions are constantly raised, even by fairly sophisticated \ninvestors, about the ethics, as well as the practical procedure of short selling, that we may \nperhaps be pardoned for saying a few more words in its defense.\nAll of the popular ideas about short selling mentioned in the preceding paragraph \nmay be branded as so much nonsense. There is nothing more reprehensible about selling \nshort than buying long. Each is a speculation in relative values. The truth is money is \na commodity, just as much as a share of stock. There is no moral or practical difference \nbetween borrowing money to buy stock because you believe the latter will go up in value \nin terms of the former and borrowing stock to “buy” money because you believe the latter \nis going to go up in value in terms of the former. In each case, you are obligated eventually \nto repay the loan whether it be money or stock. In each case, you are taking a risk on the \nbasis of your considered forecast as to the future trend of relative values.\nThere are, in fact, many common business practices that are more or less analogous to \nselling stocks short. For example, every time the publisher of a magazine accepts cash in \nadvance for a subscription, he is making something like a short sale. His ultimate profit \nor loss will depend on what the magazines he will eventually supply have cost him by the \ntime the subscription runs out.\nWhen you sell stocks short, you (or rather your broker) receive the proceeds of the sale \nat once but you are obligated to turn back an equal number of the same shares at some \nfuture date to the man from whom the stock certificates were borrowed. (EN: One of the \nadvantages or edges that professionals enjoy over private investors is the credit of short sales to \ntheir accounts and the payment of interest thereon. Although the proceeds are credited to the private \ninvestor, no interest is generally paid on it, unless the investor has influence with the broker. A \nfavorable situation is created, however, if a short sale of $100,000 were made on, say, 50% margin, a \ncredit of $150,000 would be made to his account, and no interest would be charged. Any dividends \nthe trader paid on the transaction would be expensable.) Consequently, sooner or later, you have \nto go into the market again and buy those shares. When you buy them, you (or rather your \nbroker) return the shares to the original lender, thus discharging your obligation. If the cost \nof your purchase was less than the proceeds of the earlier sale, the difference is your profit. \nIf it costs you more to buy in the shares—or as it is termed, cover your short—the difference \nrepresents a loss. You do not enter into a short-side transaction unless you expect the price \nof the stock to go down; hence, showing you a profit.\nOne of the little-appreciated results of a large volume of short selling is actually to \nstrengthen the market. Every short seller is a potential buyer. Most short sellers are glad \nto cover and take their profits on a relatively Minor Decline. Consequently, if there is a \nbig short interest at any given time in a particular issue, it means there are many people \nwaiting to buy that stock when it goes down. This situation tends to “cushion” bad breaks. \nSome astute operators will actually buy a stock when they learn there is a very large short \ninterest in it, meaning a great many shares of it have been sold short and not yet covered, \nbecause they realize competition among the short sellers to buy the stock whenever it has \na small decline may result in a very fast and profitable Short-Covering Rally. Any stock is \nstronger, technically, if there is a good-size short interest in it.\nThere is one further objection raised against short selling. It will be pointed out when \nyou buy stock that your loss, if worse comes to worst, can be no more than the total amount \nyou paid for it. In the case of a short sale, the price of your stock could, theoretically, rise \nagainst you to $50.00, $100, $1,000, $10,000 a share; in other words, it could rise without \nlimit. This argument sounds much more alarming than it really is. Certainly there is no \noccasion to lose sleep over it. Stocks do not go up without limit all of a sudden. It is just \n349Chapter twenty-five: Two touchy q uestions\nas easy to set a stop on the loss you are willing to take on a short-side transaction as it is \non a long purchase. Such situations as the famous 1901 corner in Northern Pacific are not \nlikely ever to occur again under present regulations. (EN: The famous “short squeeze.” Short \nsqueezes still occur but are extremely rare in big liquid issues. A famous short squeeze occurred \nin the", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 168}
{"text": "y q uestions\nas easy to set a stop on the loss you are willing to take on a short-side transaction as it is \non a long purchase. Such situations as the famous 1901 corner in Northern Pacific are not \nlikely ever to occur again under present regulations. (EN: The famous “short squeeze.” Short \nsqueezes still occur but are extremely rare in big liquid issues. A famous short squeeze occurred \nin the silver markets of the 1980s when the Hunt brothers trapped Exchange members and almost \nbankrupted them. The members, being in control, retaliated by quintupling margin requirements \nand bankrupted the Hunts.) The authors realize nothing said, and probably no amount of \ncold-blooded analysis on the part of the reader himself, will remove entirely the trepidation \nthat most nonprofessional traders experience when they sell short. The mental hazards will \nalways be slightly greater than in buying long. Nevertheless, from every practical angle, \na short sale is exactly the same thing (although in a reverse direction) as a long purchase, \nwith no greater risk, with actually somewhat greater chance of quick profit, and differing \nonly in details of execution.\nA commitment in commodity futures contracts, whether long or short, although quite \ndifferent in theory, has some similarities to a short sale of stock. In making a contract, \nno actual sale takes place, and no loan of either cash or the commodity is involved. Such \na contract is simply a binding legal agreement to accept delivery or to deliver a certain \ncommodity at a certain price at a certain time. In this respect, it is different from a short \nsale of stock. It is also different in that it must be closed out on or before a definite date. \nAlthough, the purchase or sale of a commodity contract is similar to a stock short sale in \nthat (1) it is necessarily a margin transaction, and (2) it creates an “open” or incomplete \ntransaction that eventually must be liquidated.\nA short sale of stock must always and necessarily be a margin transaction. Thus, if \nyou buy 100 shares of stock outright at 20, it can sink to 15 and you cannot be called for \nmore margin. You have lost $500, but the stock is still yours. If you sell, you get back $1,500, \ndisregarding commissions. On the other hand, if you sell a stock short at 20, putting up a \nmargin of 100%, and the stock rises to 25, you will also have lost $500. The broker, under \ncertain conditions, such as the 100% margin requirements in effect at one time, might call \non you for $500 additional margin. Or, if the transaction were to be closed out at that point, \nyou would receive back $1,500 less commissions, the same as in the long transaction. In \nthe case of this short sale, had the price dropped to 15, your profit would have been $500.\nOn short-term moves, the effect of short selling is exactly the same as the buying of long \nstock, but in the opposite direction. You simply apply the same methods here in reverse, \nduring a Bear Market, that you would use in a Bull Market. As we have already seen, the \nvarious technical indications that point to upward moves in a Bullish Phase have their \ncounterparts in downside signals during a Bearish Phase.\nExecution of short sales cannot be made at any time and at any price you wish. A \nshort sale must be made in a rising market. You are not permitted to sell a stock short on \nthe New York Stock Exchange during a market break when each regular sale is at a lower \nprice than the one before it (EN9: the uptick rule). However, this need not bother you much \nbecause, ordinarily, you would make such a sale on the rally as it reached your price, and \nthis would naturally fill the requirement of a rising market. Your broker can give you, \nin detail, the special rules and regulations that apply to short sales. It will pay for you to \nstudy these so you can place your orders correctly when the proper time comes to make \nsuch sales. (EN9: At the AMEX, short sales on ETFs and some HOLDRS are exempt from the \nuptick rule as are futures contracts on the futures exchanges. EN10: In 2007, the uptick rule was \nremoved in an ill-considered bow by the Securities and Exchange Commission to large speculative \ninterests. The reader may judge for himself whether subsequent markets have been more volatile \non the downside. It is our observation that the loss of this rule results in accelerating slides in fast \n350 Technical Analysis of Stock Trends\ndownside markets. Since 2009, there has been wide debate about reinstatement of the uptick rule, \nso far to no avail.\nIn the current context, short selling has been institutionalized. The public may buy ETFs, which \ntake the short side of almost any instrument, as, for instance, QID for the Qs is a short bet, as is \nDOG for the DIAMONDS™ (DIA). There are even leveraged [two times, three times] ETFs [long \nand short].)\n351\nchapter twenty-six\nRound lots or odd lots?\n(EN: Or, put another way, size?)\nOne of the minor tactical questions bound to plague you is whether to trade in round lots \nof 100 shares or odd lots (less than 100 shares in active stocks).\n (EN: In Internet-age markets, this question has virtually lost its relevancy. In Magee’s time, there \nwas a distinct disadvantage to trading odd lots, and one traded odd lots only if hampered by limited \ncapital. Now that an investor can achieve full diversification in an odd lot position by buying odd \nlots of Standard & Poor’s Depositary Receipts (SPYs) and DIAMONDs™ (DIA), there seems little \npoint in discussing it. There is, of course, always the question of broker commission—if the broker \nhas a fixed commission rate, regardless of the size of the trade, then the small investor gets nicked. It \nwould seem this follows the old adage that the rich get richer. Nevertheless, now the small investor \ncan strike back by finding a broker who does not charge commissions. At first I thought commission-\nfree brokers were making up their profit on volume; in fact, there are other ways to make a pr", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 169}
{"text": "a fixed commission rate, regardless of the size of the trade, then the small investor gets nicked. It \nwould seem this follows the old adage that the rich get richer. Nevertheless, now the small investor \ncan strike back by finding a broker who does not charge commissions. At first I thought commission-\nfree brokers were making up their profit on volume; in fact, there are other ways to make a profit on \ntrades than charging a commission—for example, directing the execution of the orders to a trader \nwho needs “order flow.”\nIn the Internet age, the question of what size a trade or investment should be is different from \nthe question that confronted traders of, as it were, ancient times. Now, it is not so much a matter \nof cost disadvantage in trading odd lots as it is a much deeper question—that of risk and portfolio \nmanagement. So how does the aware investor determine the size of any individual trade?\nI am indebted to a longtime friend, colleague, broker, and fellow trader, William Scott, for \narticulating the common-sense procedure here for calculating trade size and controlling risk.\nFirst, we determine the percentage of our capital we want to risk on any given trade. Among many \nprofessional traders of our acquaintance, this figure is often 2% or 3%. For the sake of illustration, \nusing round numbers, if we have $100,000 capital this means we will be risking $3,000 on a trade. \nLet us say we are going to buy a $20.00 stock and defend our position with a stop-loss order $5.00 \naway. Our formula for computing position size is as follows:\n 3,000/5 = n number of shares (600 shares)\nIf we were going to accept a $10.00 risk, our trade size would be 3,000/10 = 300 shares. Thus, \nwe adjust our trade size to fit our risk parameters.\nThis is a simple, practical, and elegant way to implement risk control at the individual trade \nlevel.\nTrade size is, without doubt, one of the most crucial factors in success for the general investor. \nIgnorance, or denial, of its importance is a major reason for the failure of many traders. In short, \novertrading. Other perspectives on risk and trade size are found in Chapter 42 and in Appendix B, \nwhere the Leverage Space Model is explained.)\n\n353\nchapter twenty-seven\nStop orders\nWe are going to take up two kinds of stop orders, or, rather, two entirely different uses of \nthe mechanism of stop orders.\nFirst, let us look at the protective stop order. At best, it is not a happy subject. Stop orders \nof this type are like fire extinguishers; the occasions when they are put into operation are \nnot times of rejoicing. Stop orders are used for emergency rescue when things get so bad \nthere seems no reasonable hope for a situation.\nWherever you set your protective stop, it is likely to be touched off at what seems to \nbe the worst possible moment. You will set it at a safe distance under a certain bottom; the \nstock will break through, catch your stop, and then proceed to build a new bottom at this \nlevel for the next rise, or to rally at once and make new highs. No matter, you had your \nreasons for setting the stop. The stock did not act the way it should have. The situation is \nnot working out according to Hoyle and certainly not the way you hoped it would. Better \nto be out of it, even at a loss, rather than face a period of uncertainty and worry. If the stock \nhas started to act badly, you cannot tell how much worse it is going to behave. If you fail \nto set a stop, you may go on day after day hoping for a rally that never comes while your \nstock sinks lower and lower until, eventually, you find (as millions have found) that what \nstarted to be a small reaction, and an annoying but trivial loss, has turned out to be a \nruinous catastrophe. Stop orders cannot always be placed; in certain cases in active stocks, \nthe exchanges may even restrict the use of stop orders.\nThe question is where and when to set the stop, realizing there is no perfect and \nabsolutely satisfactory rule. If the stop is too close, you will take unnecessary losses; you \nwill lose your holdings of stocks that eventually forge ahead and complete the profitable \nrise you hoped for. If stops are too wide (too far away), you will take larger losses than \nnecessary in those cases in which your stock definitely has broken out of pattern.\nNow, it will be obvious, as the setting of stop orders depends on the price of the stock \nand its habits. You would not place your stop level at the same percentage distance under a \nBottom in a conservative, high-priced stock when it is selling at 80 that you would to protect \na speculative issue at a time when it is selling at 8.\nThe higher priced stocks, as we have already seen, make smaller percentage moves. \nConversely, the lower-priced stocks make wider percentage moves. Therefore, the lower-\npriced stocks should have more leeway for their gyrations. We will need a wider stop for \nthem than we will for the less volatile “blue chips.”\nSimilarly, we can take our Sensitivity Indexes (EN: betas in considering a stock relative to \nthe market, and volatilities for absolute measure of one stock against another) to give us a picture of \nthe individual habits of the stock. Although two stocks may be selling at the same price at \na given moment, you would expect a high-beta, high-volatility stock to make wider swings \nthan a low-beta, low-volatility stock; therefore, you will set your stops wider on the higher \nvolatility stock.\nWe must take these factors into account and work out some sort of simple rule of thumb \nto follow. Let us arbitrarily assume an imaginary stock of “average” habits and a price of \n354 Technical Analysis of Stock Trends\n25 and further assume we will be satisfied, in this particular case, with stop protection 5% \nbelow the last established Minor Bottom.\nFor a stock of the same sensitivity selling at 5, we would need about half again as much \nstop leeway (on a percentage basis). That is, the stop would be placed 7 .5% below the last \nBottom (EN9:", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 170}
{"text": "erage” habits and a price of \n354 Technical Analysis of Stock Trends\n25 and further assume we will be satisfied, in this particular case, with stop protection 5% \nbelow the last established Minor Bottom.\nFor a stock of the same sensitivity selling at 5, we would need about half again as much \nstop leeway (on a percentage basis). That is, the stop would be placed 7 .5% below the last \nBottom (EN9: significant low).\n(EN10: Here Magee gave an account of how, using his Sensitivity Index and his normal range \nfor price, he computed stop positions. The process is too convoluted for modern investors—and \nunnecessary because Magee boiled the procedure down to a table I have modernized below. The \nProcedure is intact in the eighth and ninth editions for the scholarly (or obsessed) investor or academic.)\nFor most ordinary purposes, a simplified table of stop distances will be sufficient. \nTa ble   27.1 gives you the approximate stop distance you would get by the method outlined \nabove, for stocks in various price classifications and of various degrees of sensitivity \n(volatility).\n(EN10: Magee originally constructed this table based on his Sensitivity Index. The informed \nreader may consider an alternative to Magee’s Sensitivity Index, which I have conjectured here for \nthe modern context—that is, basing the stop distance on volatility, which would present a dynamic \nmethod of adjustment.)\nThe stop level should be marked on your chart as a horizontal line as soon as an actual \nor theoretical transaction has been entered into, and it should be maintained until the \ntransaction is closed, or until progressive stops (which we will explain in a moment) have \nbeen started to close it out. In the case of purchases, the stop level ordinarily will be at \nthe indicated distance below the last previous Minor Bottom. In the case of short sales, it \nordinarily would be at the indicated distance above the last Minor Top.\nTo determine the position of this stop level, simply figure what the percentage distance \nwould amount to at the price of the stock. If you are dealing with a stock selling at 30 and \nthe stop distance comes out 10%, then allow 3 points under your last Minor Bottom.\nIn no case would we ever set a protective stop level at less than a 5% interval, even for \nthe most conservative, high-priced stocks.\nThese questions remain: What constitutes a Minor Bottom? What makes an established \nMinor Top? How do we know how to choose the Basing Point (EN9: see Chapter 28 ) from \nwhich to measure off our stop level interval? The constitution of a Bottom or a Top (EN10: \nwave high, wave low) will be taken up in the next chapter. For the present, let us accept the \nproposition we will determine the correct Basing Point and will always, always set our stop \nlevel at the moment we make the commitment.\nTable 27.1 Table of stop distances (expressed in percent of the price of \nthe stock)\nConservative \nsensitivity\nMedian \nsensitivity\nSpeculative \nsensitivity\nPrice\nVolatility \nunder 0.40\nVolatility \n0.41–0.79\nVolatility \nover 0.79\nOver 100 5% 5% 5%\n40–100 5% 5% 6%\n20–40 5% 5% 8%\n10–20 5% 6% 10%\n5–10 5%a 7% 12%\nUnder 5 5%a 10% 15%\na Ordinarily, stocks in these price ranges would not be in the conservative group.\n355Chapter twenty-seven: Stop orde rs\nIt is understood protective stops under long stock are never moved down, nor are \nprotective stops over shorts ever moved up. As soon as the stock has moved in the right \ndirection far enough to establish a new Basing Point, the stop level is moved up (on longs) \nor down (on shorts), using the same rules for determining the new stop level as were used \nin fixing the original level.\nThe progressive stop\nThere is another use of a stop that is properly considered here. This is the progressive stop, \nwhich is used to close out a stock that has made a profitable move, or in some cases, where \na stock has given a danger signal before either completing a profitable move or violating a \nprevious Minor Bottom.\nYou will find on many moves, the stock will progress in the primary direction for \nseveral days and then may develop exceptional volume. Often, this occurs just as the stock \nreaches an important trendline or pattern border or Resistance Area. This heavy volume \nmeans one of two things: usually, that the Minor Move has come to an end, being this is the \ntop of the rise for the moment; occasionally, the volume may signal the start of a breakaway \nmove that may run up several (and perhaps many) points, almost vertically. (The reverse \nsituation may develop on downside moves.)\nIf, noticing the heavy volume following a good rise, and assuming this day marks the \nend of the move, you sell the stock at the market or at a limit, you are going to be dreadfully \ndisappointed if this should be one of those rare cases in which the stock opens the next day \non an upside gap and continues 3, 5, or 20 points up in the following days. On the other \nhand, experience will have shown you it will not pay to expect that sort of move very often. \nYou will know that, 9 times out of 10, you will be better off out of the stock.\nAfter such a day when volume is exceptionally high (provided this is not the first day of \nbreakout into new high ground beyond the last previous Minor Top), cancel your protective \nstop and set a stop order, for the day only, just 1/8 (0.125) point under the closing price. For \nexample, you have bought a stock at 21; it goes up on moderate volume, smashes through \nthe old Minor Top one day at 23 on very heavy volume, the next day continues to 23 3/ 4 on \nmoderate volume, the third day advances on moderate volume to 24 1/ 4, and, finally, the \nfourth day makes a rise to 25 on much heavier volume than it has shown on any day of the \nrise except the day it broke through 23. The morning after this close at 25, you will notice \nthe volume signal. You will cancel your protective stop, which may be at 18, and you will \nplace a stop order, for the day only, to sell on stop at 24 7 /8", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 171}
{"text": "y advances on moderate volume to 24 1/ 4, and, finally, the \nfourth day makes a rise to 25 on much heavier volume than it has shown on any day of the \nrise except the day it broke through 23. The morning after this close at 25, you will notice \nthe volume signal. You will cancel your protective stop, which may be at 18, and you will \nplace a stop order, for the day only, to sell on stop at 24 7 /8. In most cases, this will mean \nyour stock will be stopped out on the first sale of the day. Plus, you may get a slightly lower \nprice than you would get with a straight market order. On the other hand, after a day of \nhigh volume activity, you are not likely to be left in a thin market; there should be bids \nenough, near the top, to get you out at or near your stop price.\nMeanwhile, you are protected against losing the stock if there should be a continued \nmove in the right direction. Suppose the opening the morning after you set your stop at \n24 7 /8 should be a gap at 25 1/ 4, and that prices then move up further, closing at 26. (On \n“runaway” moves of this sort, the closing for the day during the move is likely to be at \nthe top.) You will then set your stop, again for a single day only, at 25 7 /8. If the stock then \nopens at 26 3/8 and moves up to 28, you will set another day stop at 27 7 /8, which, let us \nassume, is caught at the opening the following day at 27 5/8. In this example, you risked \nonly 1/8 point on the first day, and eventually netted an extra gain of 2 5/8 points. This, \nit should be pointed out, is all net gain because your commissions are approximately the \nsame in either case.\n356 Technical Analysis of Stock Trends\nA progressive stop of this sort can be indicated on the chart by any mark you choose to \nuse—for example, a band of short diagonal lines. When a stock moves for several days in a \nrunaway move, you may repeat this mark each day, indicating a tight stop 1/8 point under \nthe close for each successive day, until finally, one of these stops is caught. In the case of \nshort sales, a buy stop is used in precisely the same way as the selling stop, by following \nthe stock down on a sharp runaway dive.\nThis use of tight progressive stop orders is indicated wherever a stock has reached its \nreasonable objective on high volume, or where it has exceeded its objective and is moving \nout of the Trend Channel in free air, so to speak, and in some cases, where the stock has \nfailed to reach its objective.\nIf your stock, for instance, is rising in a Trend Channel, and, about halfway between the \nlower and upper trendlines, suddenly develops great volume, then a progressive tight stop \nwill protect you against the threatened failure of the move. Extreme volume in such a case, \nbefore there has been a breakout to a new high above the last Minor High, is definitely a \nwarning and a threat. This would be especially true if there were also a gap or a One-Day \nReversal at this point.\nThe one day on which a tight stop would not be applied after heavy volume had \nappeared would be the day the stock made a new high, running entirely through the \nprevious Minor Top and closing above it. This action generally means the move is not yet \ncompleted. Should the move continue higher and again show heavy volume, even if it is \nthe very next day, we would then protect with a progressive stop.\nIn this chapter, as throughout the book, the expression “heavy volume” means heavy \nonly with respect to the recent volume of sale in the stock you are watching. A thousand \nshares may be significantly heavy volume in some thin issues, whereas 10,000 shares would \nbe no more than a normal turnover in more actively traded stocks. The volume chart itself \nwill show, by a market peak, when a day of abnormally heavy volume occurs.\nIt should be understood the progressive stops we have been discussing are intended to \ntake short-term gains, or to close out an exceptionally profitable runaway move terminating \nin an Intermediate Climax. Although the extreme conditions that call for this type of \noperation are by no means rare, they are not the usual, everyday action of the market. In \nthe case of ordinary Minor Tops, even when they are fairly apparent on the basis of Trend \nChannels, volume peak, and other indications, many traders and investors will prefer to \nwait out the expected reaction rather than pay additional commissions and lose a position \nthat is still presumably in a favorable Major Trend.\nIn short, the progressive stop is a device that may be very useful on occasion, but it is \nintended to cope with a special and somewhat unusual move.\nThe protective stops, on the other hand, offer the average trader, the man who is not \nable to spend his entire time studying the market, or who has not had long experience, a \ndevice by which he can limit his possible loss. He will be protected from his own reluctance \nto close out the bad holding, and he will avoid the ruinous condition of becoming frozen \ninto a hopeless situation. Since he will be taken out automatically, regardless of whether \nhe has an ultimate gain or loss, he will have the capital to use in better-looking issues and \nwill not have to worry about the prospects of recovery in his stock after it has gone many \npoints against him.\nIf one has sufficient knowledge and sufficient determination to get out as soon as the \ntrend has shown convincing evidence on a turn, there is less need for the stop orders. (EN: \nThis editor believes that only the proven trader-investor should trade without a stop in the market. \nThe reader may determine whether he meets this criterion by examining his portfolio to see whether \nhe has ever let a loss run or allowed a significant profit to slip away. If so he, or she, or they, or it, is \n357Chapter twenty-seven: Stop orders\nnot proven.) It is possible for such a person to operate successfully without them; and there \nare some advantages in doing this because a stop order will occasionally be caught by a \nfalse move or", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 172}
{"text": "s criterion by examining his portfolio to see whether \nhe has ever let a loss run or allowed a significant profit to slip away. If so he, or she, or they, or it, is \n357Chapter twenty-seven: Stop orders\nnot proven.) It is possible for such a person to operate successfully without them; and there \nare some advantages in doing this because a stop order will occasionally be caught by a \nfalse move or an extended dull reaction. There are also advantages in not using stop orders \nfor the experienced technician who is looking toward a possible long-term gain and who \nis willing to wait out a Secondary Reaction. Yet it is a thousand times better for the person \nwho is not sure of his methods to be stopped out early, than to be left holding a stock bought \nat, say 60, when it has declined to 29—or to 5!\nStop systems and methods\nThe two most important concepts in investing and trading are trends and stops. Being right, \nthe trend immeasurably diminishes risk and increases our probability of profit. However, \nwithout skillful setting of stops, all our work and study can easily result in nothing as \nthe markets dodge and weave, deceive, and throw off false signals. If our analysis has not \nresulted in skillful stop setting, we will be no better off than that unfortunate fellow who \nis acting on a tip from his brother-in-law—or his bootblack.\nConsequently, let us first attack this question from the viewpoint of the trend-following \ninvestor and deal with trading stops thereafter. In Magee’s systems for the trend follower, \nthere are two basic stop methods. One is based on trendlines (sloped and horizontal), and \nthe other is rooted in Basing Points. Chart patterns interact with these two methods. This \nentire book treats the former at length in too many chapters to mention here. The second, \nBasing Points, is discussed exhaustively in Chapter 28.\nThe breaking of trendlines is always significant. Magee tested the validity of the \nbreak by requiring that prices penetrate the line by 2%–3%. This may not be perfect, but \nit serves for the majority of situations. The longer the trendline the more important the \nbreak, as illustrated in the market breaks of 2008 and 2011 (a trendline of more than 700 \ndays). The downwaves (crashes?) resulting from these trendline breaks were recognized \nand commented on at the time at http:/ /www/edwards-magee.com. Figure 5.1 illustrates \nthe serendipitous convergence of all three methods combining to exit longs and short the \nmarket in 2008. Trendline analysis, pattern analysis, and Basing Points analysis by their \nvery nature are complementary and lead to similar conclusions, as, for example, in August \n2011 when the long-term trendline from March 2009 was broken, a Head-and-Shoulders \nTop was identified, and the Basing Point stops were taken out.\nTherefore, we have three ways of setting stops in extended trends—trendlines, patterns, \nand Basing Points. Are there other stop methods for trend following? Indeed. A multitude. \nA plethora. A cornucopia. An excess. First, let us remark on the crucial question of stop \nsetting in trends.\nStops set too close to the market result in the trader losing his position. The stop must be \nset to give the market room to move against his position, thus (crocodile tears) apparently \nsurrendering precious profits. As the market advances in waves (truism)—wave up, wave \ndown—stops must be, as in the Basing Points Procedure, set sufficiently below wave-low \npoints to avoid being exercised. In an interview in Market Wizards, Jack Schwager asked a \nmajor trader, Bruce Kovner, where he set his stops. “Where they’re hard to get to,” replied \nKovner.\nThis is the principle at work in Basing Point stops. Knowing that locals and market \nmischief-makers probe for stops at wave lows and support zones, the stop is set with a \nfilter, thus some distance below the wave low (or wave high). This stop is hard to access.\nThe same thing is true if using a moving average. Magee used a 2% or 3% stop for \ntrendlines and a stop of this type is probably good for a moving average, too. At the same \n358 Technical Analysis of Stock Trends\ntime, if volatility and excitement are running high, the trader must adjust the size of his \nfilter. In a rising market tracked with a moving average, the trailing stop would be moving \nevery day the dotted line moved up. Naturally, with a filter that might be enlarged if market \nvolatility became excessive.\nA brief survey of stop methods\nHere we are going to deal primarily in exit stops. (EN: My book Signals [available on Amazon’s \nKindle platform] analyzes at length methods for entering trades and trends.) Many traders use \nstops to enter positions, but that is not our interest at this moment. We want to know how \nto protect our initial entry and how to advance our stops so as to lock in our profits when \nthe trade has gone our direction. The initial stop may be set as with Basing Points (as \ndescribed in Chapter 28), or it may be set above or below a Support–Resistance zone, or as \na percentage (William O’Neil says a stop should be set 8% below the entry), or even as a \npercentage of capital—for example, 2% risk per trade—a $2,000 stop ($100,000 capital) is a \ncommon money management system.\nIf the market moves against our trade, the protective stop limits the loss. If the market \nmoves with us and begins to accumulate profits for us, we have a different, and happy, \nproblem. It is only a matter of time until the market throws us a downwave to test our \nmettle—or to dislodge us altogether. We are trend followers, so we buy strength and \nsell weakness, but our antagonists are contrarians—they do the opposite. Thus, after a \nreasonable upwave, contrarians will be taking profits and driving prices down. Swing \ntraders will be doing the same thing. We want to stick to the trend until it changes, even \ntaking these “corrective” waves against our position. Basing Point stops will do this, \nand the inevitable result is fluctuation in e", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 173}
{"text": "sell weakness, but our antagonists are contrarians—they do the opposite. Thus, after a \nreasonable upwave, contrarians will be taking profits and driving prices down. Swing \ntraders will be doing the same thing. We want to stick to the trend until it changes, even \ntaking these “corrective” waves against our position. Basing Point stops will do this, \nand the inevitable result is fluctuation in equity. Long experience has shown that fleeing \nfrom downwaves and exiting invariably results in smaller long-range profits. Accepting \ndownwaves and fluctuations in profit leads to greater long-range profits. Look at the tables \nof Dow and Basing Points performance. It is not unusual to see downwaves of 10%–30% \nwithout a change of trend occurring. We have seen how we can stop these trends with trend \nanalysis and Basing Points analysis—and there are other philosophies and other methods.\nSome other stop methods\nAverage True Range\nAverage True Range (ATR) is an interesting concept and tool. It is a measure of volatility, \nin actuality, and tracking it gives us some interesting information. True Range is defined \nas the largest of the following:\nToday’s high minus today’s low.\nToday’s high minus yesterday’s close.\nToday’s low minus yesterday’s close.\nATR is the average of True Range over some defined period. Twenty days is a not \nuncommon parameter, as is 14. Five days is very sensitive, which has advantages and \ndisadvantages.\nATR may be used to set stops. For example, we might set our initial protective stop 2 \n(or x) ATRs below our entry. We might set our trailing profit protection stop in the same \nway: x ATRs below the recent high—or the low of the recent high.\n359Chapter twenty-seven: Stop orde rs\nStops set this close are typical of trading situations. There is at least one practitioner of \nmy knowledge (Eric Crittenden, http:/ /www.blackstarfunds.com) who judges if prices take \nout the stop 10 ATRs below the most recent high, the trend has changed. This is sometimes \ncalled a Chandelier Exit. This kind of concept can be examined using trendlines and reversal \nformations. ATR is a natural way of measuring market volatility and it rhythmically adjusts \nto market behavior. This makes a system more flexible than fixed percentages or fixed \ndollar amounts. An interesting paper on Crittenden’s method is found at http:/ /www.\ntrendfollowing.com/whitepaper/Does_trendfollowing_work_on_stocks.pdf. Feature this, \nrelevant to my point, that the market must be given room to work: Crittenden found that \na 10-ATR filter averaged a space of 27%. So what we have here is an inherent stop system \nthat posits a 27% reversal to indicate a change of trend.\nParabolic stop and reverse\nWelles Wilder’s (1978) parabolic stop and reverse (SAR) technique uses an “acceleration \nfactor.” Consequently, the stop rises parabolically, which has its strengths and weaknesses \nas the reader can imagine. Chuck LeBeau has conjectured a Modified Parabolic Exit, which \ntweaks the acceleration factor at http:/ /lcchong.files.wordpress.com/2011/05/precise-\nexits-entries-manual.pdf. This presentation includes other interesting comments on stop \nmethods.\nTarget stops\nI am not a great proponent of target stops, but many traders analyze a formation or market \nsituation and compute a possible target and exit the market when their target is reached. \nOther target criteria may be used—a dollar or point amount, or as in Bill Scott’s method, \nfive days down causes liquidation of half the position, six days the other half.\nSimilar to the target method, the trailing stop is raised when x% of profits are achieved \nand raised again as prices advance. An old Japanese saying has it as follows: “Sell half at 8 \nnew prices, half again at 10 new prices, and the rest at 12 new prices.”\nOf a similar nature, some traders will close the trade when an extreme move occurs \nin their direction.\nA natural method used by the Turtles\nThe Turtles used the breakdown from a 10-day channel to exit their long trades. This can \nbe modified to as little as three days, in which case the trader would set a very tight stop \nbased on the three-day low if a market were running away. Such a situation might also be \nmanaged with Magee’s tight progressive stops—raising the stop each day to just under the \nlow of the day to be in effect for the next day.\nIn the end, as the reader can see, there are as many stop methods as there are traders. \nFor our purposes, the more natural and less algorithmic the method, the better—so it \ncomes back down to trendlines, formations, and Basing Points, which can be tweaked to \nthe individual taste.\nIf there is a truism about the markets it is this: a trader without stops will soon be a \ntrader without capital.\n\n361\nchapter twenty-eight\nWhat is a Bottom and what is a Top?\n(EN9: In this extremely important chapter, I have left intact Magee’s usage of “Tops and Bottoms.” \nIt will be less potentially confusing for the reader to think of “highs and lows” as that terminology \nis commonly used in the business in the modern era. Also, thinking in terms of highs and lows is an \nimportant concept in itself. Thus, for a Bull trend, higher highs, higher lows. When this pattern is \nbroken in an important way, the trader should be alert for a trend change. Also, as the use of eighths is \nof the essence in Figure 28.1, I have left the discussion in eighths, although the reader knows decimals \nare now used in the markets.)\nIn this chapter, we are not talking about what makes a Major Top or Bottom or what \nmakes an Intermediate Top or Bottom. We are speaking of the Minor Tops and Bottoms \nthat give us important hooks on which to hang our technical operations. Stop-order levels, \ntrendlines, objectives, and Supports and Resistances are determined by these Minor Tops \nand Bottoms. They are of prime importance to us as traders. (For illustrations in this \nchapter, see Figures 28.1 through 28.4.)\nUsually, these Minor Tops and Bottoms are well marked and perfectly", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 174}
{"text": "nor Tops and Bottoms \nthat give us important hooks on which to hang our technical operations. Stop-order levels, \ntrendlines, objectives, and Supports and Resistances are determined by these Minor Tops \nand Bottoms. They are of prime importance to us as traders. (For illustrations in this \nchapter, see Figures 28.1 through 28.4.)\nUsually, these Minor Tops and Bottoms are well marked and perfectly clear, though \noften they are not. Sometimes, it is not possible to say definitely that this or that place is or \nis not a Top or Bottom, but it is possible to set certain standards and practical working rules \nthat will help us in making these points, and these rules will not fail us too often.\nA good rule for setting stop levels is to consider a Bottom has been made when the \nstock has moved “three days away” from the day marking the suspected low of the Bottom. \nIf a stock reacts for some days and finally makes a low at 24, with a high for that day at 25, \nthen we will not have an established Bottom until we have had three days in which the stock \nsells at no lower than 25 1/8. The entire price range for three full days must be entirely \nabove the top price for the day making the low. This is the three-days-away rule, and it \nwould apply in reverse in declining markets, in which the range for three days must be \nentirely below the entire range of the day making the high.\nThis gives a rule for setting an original stop order. It also gives a rule for changing the \nstop order. As soon as the stock has moved three days away from a new Bottom, we move \nthe stop order to a position below that Bottom. (We have already explained in Chapter 27 \nhow we determine the distance this stop level should be below the Bottom.)\nProtective stops for long stocks can move only up. A stop level, once established, is \nnever to be moved down except when the stock goes ex-dividend or ex-rights; then, the \nstop may be dropped the amount of the dividend or rights. Similarly, protective stops for \nshort sales are to be moved only down and may not be raised. (In the case of ex-dividends \nand ex-rights, the short-sale stop would be dropped the amount of the dividend or rights.)\nThere are certain situations in which it is difficult to determine Bottoms and Tops; \nwhere, indeed, it seems as though a Consolidation or Correction had been made without \nany significant move in the Secondary Direction. In such cases (as contrasted to the obvious \nsituation in which the stock moves up or down in series of well-marked steps and reactions, \nlike a staircase), you will need all your judgment and experience to determine the point at \nwhich the Minor Basing Points actually occur.\n362 Technical Analysis of Stock Trends\nThe first protective stop would immediately be placed 6% below the previous Minor \nBottom of August 21, using Table 27 .1 in Chapter 27 . This would put the stop level at 9 7 /8. \nOn September 19 and 20, we would have two days of market action entirely “away” from \nthe September 17 Minor Bottom, and, on September 28, a third day. We would then move \nthe stop up to 6% under the September 17 Bottom, or to 10 5/8. The next move would come \nafter the new high closing of October 11, which is more than 3% higher than the October 1 \nMinor Peak. The stop would now be placed at 11 7 /8. On November 2, a new high close was \nregistered more than 3% over the October 15 Minor Peak; the stop would be raised to 12 \n3/ 4. On November 15, another high closing topped by more than 3% the Minor Peak made \non November 7 . The stop would be moved up again, this time to 13 1/2. November 29 made \nthe third day the entire range was “three days away” from the November 26 Bottom, and \nthe stop was upped to 13 3/ 4. The closing on December 5 gave us a 3% advance over the \nNovember 17 high, and again we moved the stop, raising it to 14 7 /8. Finally, on January 3, \n1946, this stop was caught as shown on the chart. In a Bear Market, protective stops would \nbe moved down in exactly the same manner to protect a short sale. (EN9: A number of \ninconsistencies exist in this figure and caption that are clarified later in the text.)\nBasing Points\nLet us call the levels that determine where stops should be placed Basing Points. In a Bull \nMarket Move, we will consider the Bottom of each Minor Reaction as a Basing Point, from \nAMERICAN CABLE and RADIOA CR\n1945–1946\nJULY AUGUSTS EPTEMBERO CTOBERN OVEMBERD ECEMBER\n17\n16\n15\n14\n13\n12\n11\n10\nSales\n100’s\n250\n200\n150\n100\n50\n7 14 21 28 4 11 18 25 1 8 15 22 29 6 13 20 27 3 10 17 24 1 8 15 22 29 5\nFigure 28.1 Advance of a protective stop order in a long commitment. The daily chart of American \nCable and Radio in the summer of 1945 made a Rounded Bottom, part of a long period of Consolidation \nfollowing the advance that ended in July 1944. A breakout on heavy volume occurred September 12, \nand purchases were then possible on any Minor Reactions.\n363Chapter twenty-eight: What is a Bot tom and what is a Top?\nwhich we will figure our stop-order level as soon as the stock has moved up to “three days \naway.” We will also use each Minor Top as a Basing Point in a Bull Move. In a Bear Market, \nwe will consider the Tops of each rally and also each Minor Bottom as Basing Points for the \nprotective stops in the same way.\nWhere a stock makes a substantial move in the Primary Direction, say a move of 15% \nor more, and then moves back at least 40% of the distance covered from the previous Basing \nPoint to the end of the Primary Move, that surely gives us a Basing Point as soon as the stock \nagain starts off in the Primary Direction. If the stock reacts less than 40%, however, perhaps \neven marks time at the same level for a week or more, that should also be considered a \nBasing Point as soon as the move in the Primary Direction is continued (provided the \nvolume indications are right).\nThe daily volume, as we have seen, is like the trained nurse’s clinical thermometer; it \ntells a great deal about what is happening in a stock, more th", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 175}
{"text": "ock reacts less than 40%, however, perhaps \neven marks time at the same level for a week or more, that should also be considered a \nBasing Point as soon as the move in the Primary Direction is continued (provided the \nvolume indications are right).\nThe daily volume, as we have seen, is like the trained nurse’s clinical thermometer; it \ntells a great deal about what is happening in a stock, more than the superficial symptoms \nof price alone. There are three times at which you may look for exceptionally heavy volume: \n(1) on the day of breakout from a pattern or a period of inaction, especially if the breakout \nis on the upside; (2) on the day on which the stock goes into new ground in the Primary \nor Intermediate Direction, that is, goes above the last Minor Top in a Bull Market or below \nthe last Minor Bottom in a Bear Market; and (3) on the day on which the Minor Move is \ncompleted or nearly completed, that is, the new Minor Top in a Bull Market and the Minor \nBottom in a Bear Market. To this we might add that extra heavy volume on any other day \nduring a move in the Primary Direction is likely to indicate the move is at an end and will \nnot complete the hoped-for advance or decline.\nNow, after a Minor Top has occurred, the stock now being in new high ground, and \nthe Top having been made on very heavy volume, we may look for the corrective move. \nOrdinarily, that would be a decline of several days, a week, sometimes longer. Occasionally, \nthe correction, as we said a few paragraphs back, will take the form of a horizontal hesitation \nlasting a week or more without any particular corrective move in the downward direction. \nWhere there is a downward correction, it is likely to come down to or near the Top of the last \nprevious Minor High (support). Also, and often at the same time, the corrective move will \ncarry down to the Basic Trendline drawn through two or more previous Minor Bottoms; or \nto the “parallel”; or to a trendline drawn through the last two or more previous Minor Tops. \nIf the corrective move is horizontal, it is likely to run out until it meets one of these lines.\nIn any case, the thing to watch for is the decline of volume. If the trading shrinks, \nperhaps irregularly, but on the whole, steadily, for some days after a new Top has been \nmade, during which time the stock either reacts or, at any rate, makes no progress in the \nPrimary Direction, then you are justified in considering this as a Minor Correction. If the \nstock now continues the Primary Move and gets to a point that is “three days away,” you \ncan consider the Bottom (i.e., the point you draw your trendline through, not necessarily \nthe extreme low point in the case of horizontal moves) as a new Basing Point.\nWhere a stock is starting what appears to be a new move or a breakout from a period \nof vacillating moves, it is sometimes hard to say precisely what point should be considered \nthe Bottom. There may be several small and indecisive moves on low volume preceding \nthe real breakout. In such a case, we would consider the appearance of high volume as the \nbreakout signal and set our Basing Point at the low point immediately preceding this signal. \nThere usually will be such a point on one of the low-volume days in the three or four days \njust before the breakout.\nAll that has been said about Basing Points in a Bull Market would also be true, in \nreverse, in a Bear Market, except that heavy volume does not always accompany a downside \nbreakout.\n364 Technical Analysis of Stock Trends\nNow comes the difficult and distressing situation in which the stock, having made \na long runaway move (let us assume it is an upward move), starts out to make a Flag; is \nbought after a sufficient correction of 40% with a decline of volume; and then continues to \ngo down steadily, without any rallies and without any clear volume indications. This is an \nunusual situation, but it does happen on both the upside and the downside, from time to \ntime. In the case we have just mentioned, we would look for Support Levels (Consolidation \nPatterns, Multiple Tops, and so on) formed on the way down in the previous trend and lying \nbelow the level at which we purchased the stock. We would use these supports as Basing \nPoints rather than hold a stop under the extreme Bottom of the vertical move.\nIn many cases of this type, you will not be able to find adequate Basing Points. Therefore, it \nseems unwise to try to get in on corrections after long runaway moves except in the following \ncases: (1) the stock has risen well above good Support that can serve as a Basing Point, or (2) \nthe stock is completely above all prices for several years and is moving “in the clear.” (And \nthe reverse: in Bear Markets, the stock should have fallen below a strong Resistance Area or \nmust be in new low ground for the past several months before you consider a short sale.) In \nany case of this sort in which you are thinking of a trade in a stock that appears to be making \na Consolidation after a fast, long, vertical move, you must have pronounced and conspicuous \ndrying up of volume throughout the formation of the Flag or Pennant Correction.\nThere is one more word of caution needed here regarding trading in an Intermediate \nTrend. A series of moves in a trend will often take place in very regular form. There may \nbe a good trendline, and the reactions may be about 40%–50% and may come back to the \nprevious Minor Tops. The volume on the Corrections may shrink with increasing volume \non the new Tops. It is easy to start trading on such a “staircase” in the expectation the moves \nwill continue to be regular and consistent, but trends do not go on forever. Any Minor Top \nmay be the last. The importance of finding your Basing Points is to enable you to get out, at \nbest, on any closing violation of one of these points, and at worst, on your protective stop \norder. The volume may again come to your aid in this question of when to stop trading on \na trend. Although you loo", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 176}
{"text": "es \nwill continue to be regular and consistent, but trends do not go on forever. Any Minor Top \nmay be the last. The importance of finding your Basing Points is to enable you to get out, at \nbest, on any closing violation of one of these points, and at worst, on your protective stop \norder. The volume may again come to your aid in this question of when to stop trading on \na trend. Although you look for high volume on the Tops, you will be exceedingly suspicious \nof volume that is much higher than on any of the preceding Minor Tops (or Bottoms in \na Bear Market). The final, or the next-to-final, “blow-off” of a trend usually will show \nmore volume than any of the Minor blow-offs along the way. When you see such climactic \nvolume, you should prepare to retire into your shell and wait for a full Correction of the \nentire series of moves making up your Intermediate Trend. Later, weeks later, or perhaps \nmonths later, you may find the stock has corrected 40% or more of the whole Intermediate \nMove and is resting quietly with very little activity. Then is the time to watch it for new \nopportunities and a new trend in the Primary Direction.\n(EN9: In a book composed of nothing but important chapters, this Chapter 28 might not get the \nemphasis it deserves from the unwary reader. In fact, the procedure outlined here is of absolutely basic \nimportance in analyzing and trading trends. I have added to this chapter material that has been of \ngreat importance to my trading and to the trading of my students.)\nBasing Points: a case analyzed\nThe longer one thinks about the chart so casually tossed off in Figure 28.1, the more he \nrealizes it embodies a profound and natural understanding of trends and the market. \nConsider—wave up, wave recedes, wave up, wave recedes, and so on. As long as the trader \nor investor is not chased from his position by the corrective wave, he will, under normal \ncircumstances, ride the trend to its natural end. Nevertheless, locals and hedge funds and \nthose who profit from volatility know the previous low is where investors and traders set \n365Chapter twenty-eight: What is a Bott om and what is a Top?\ntheir stops. So in the ordinary flow of trading, if they see an opportunity to take out an \nimportant low, they will do it—if possible. Indeed, it is sometimes possible and the low \nsometimes falls from the natural flow of trading.\nBruce Kovner, on being interviewed by Jack Schwager ( Market Wizards), was asked \nwhere he set his stops. “Where they’re hard to get to,” he said. A twice told tale for its \nimportance a stop set on a Basing Point with a prudently calculated filter is hard to get to \nunless the market has truly reversed direction. In fact, what is a long-term moving average \nbut a lagging stop with a filter built in?\nBasing Points are merely the marking of highs and lows in full realization that a pattern \nof higher highs and higher lows is a Bull trend, and when that pattern changes to one of \nlower highs and lower lows the trend is changing or has changed. This is the principle \nbehind Dow Theory, and it is the principle behind trading trends of lesser duration than \nDow trends. Moreover, as is quickly realized, a pattern of lower highs and lower lows \nmeans inevitably the trendline has been broken.\nAs for Figure 28.1, Mark Twain had some cogent comments on it. He said anyone trying to \nmake sense of it would go crazy, and anyone trying to justify the prices with the chart would \nbe shot. Figure 28.1 preserves unexplainable conundrums and conflicts carefully preserved \nsince the earliest editions. The reader is urged to take it as a concept rather than using it as a \nlesson (See Figure 28.2). Let me codify the rules implicitly presented in the figure:\n• A high is made, being recognized by no higher prices occurring for the moment.\n• Prices recede and a low is made. This low is found by watching each day after the \nprevious high until no lower prices are made. As prices begin to rise again, we note \neach day on which prices are completely outside the range of our low day candidate.\n• When three such days are observed (three days away) before a new low is made, we \nmark the candidate day as a Basing Point and raise our stop to 6% (or x%) under the \nlow of the Basing Point day (see Chapter 27).\n• If a new high is 3% greater than the previous high, a new Basing Point is found at the \nlow of the new high day.\nThe Basing Points paradigm\nBy no means will every issue be amenable to this kind of analysis. However, the method \nis so paradigmatic, it is worth examining at greater length. Similar to virtually every other \nmethod of classical chart analysis, it must be used with caution and good, thoughtful \njudgment. Sometimes some stocks will seem to work as smooth as silicon lubricant, while \nother issues will appear to be useless. Even on recalcitrant issues, however, the principles \nunderlying the method will be of use, if not the actual method itself. With this in mind, \nFigure 28.2 is presented; the careful reader will see the chart in this example uses only \nbottoms or lows in stop setting and does not advance stops on the making of new highs \nas in Figure 28.1. This is done for instructional purposes and to keep the example simple \nfor the general investor. More advanced traders will want to study and perhaps utilize the \nnew high techniques in Figure 28.1.\nFigure 28.2 actually serves more than one instructional purpose. It illustrates a picture-\nperfect case of the use of Basing Points, as well as a complete analysis of a Bull Market from \nentry to exit with keys marking events in the life of the market. Thus, the observation of \nBasing Points, the setting of the stops, the tracking of potentially false turns are all noted. \nThe chart is accompanied by the keys. Originally the marked and keyed chart was used in \ngraduate seminars at Golden Gate University for instructional purposes. Shortly, it became \n366 Technical Analysis of Stock Trends\nobvious that marking the cha", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 177}
{"text": "s in the life of the market. Thus, the observation of \nBasing Points, the setting of the stops, the tracking of potentially false turns are all noted. \nThe chart is accompanied by the keys. Originally the marked and keyed chart was used in \ngraduate seminars at Golden Gate University for instructional purposes. Shortly, it became \n366 Technical Analysis of Stock Trends\nobvious that marking the chart in this manner was extremely useful in trading. Thus, it is \nsuggested to the reader as a way of making his charts more communicative and more useful.\nKey to Figure 28.2 analysis\n 1. A rounding bottom, or perhaps a scallop.\n 2. Resistance or breakout line.\n 3. Wake-up call on volume.\n 4. Run day, big volume. Breakout through line 2. Sure entry signal.\n 5. First Basing Point (BP). Notice prior volume fall-off in consolidation and surge on run \nday. A stop was entered before this BP using the low of the formation before the entry.\n 6. BP.\n 7. A weak BP (because of shallowness of retracement).\n 8. BP.\n 9. Test of BP at 8.\n 10. A trendline drawn after point 9.\n 11. BP.\n 12. BP candidate that fails the three-day-away rule.\n 13. BP.\n 14. A potential BP , but not a very good one because a new high has not been made from 13.\n 15. A Support–Resistance line.\n 16. A test of 16 BP .\n 17. BP.\n 18. A Resistance–Support line.\n30.000\n26\n18\n15\n1\nVolume 7635200.00\nCreated with TradeStation 2000i by Omega Research © 1999\nAS ON D8 7F MA MJ JA SO\n16000000\n12000000\n8000000\n4000000\n3\n5\n8\n16\n14 17\n22\n24\n25\n27\n21\n10\n2320\n19\n12\n11\n13\n97\n6\n2\n4\nAAPL LAST-Daily 10/16/1987 C=24.125 O=.000 H=.000 L=.000 V=0\n28.000\n26.000\n24.000\n22.000\n20.000\n18.000\n16.000\n14.000\n12.000\n10.000\nFigure 28.2 Apple Computer, Bull Market of 1987 . A near-perfect example of the use of Basing \nPoints for trading of a reasonably regular and smooth Bull Market. Only wave-low Basing Points \nare illustrated.\n367Chapter twenty-eight: What is a Bot tom and what is a Top?\n 19. Flag that becomes BP .\n 20. Trendline, but too steep to last.\n 21. Trendline.\n 22. BP.\n 23. Trendline.\n 24. BP.\n 25. BP.\n 26. Horizontal trendline.\n 27. BP at 26.75 (stop 25.41). Stopped out at 25.41.\nA narrative of the events in the chart\n 1–3. Had we been asleep, the event at number 3 should have awakened us; a volume day \nlike this should catch our attention. We begin paying attention to the stock and note \nthe pattern that has been developing—the rounding bottom, or scallop.\n 4. At number 4 we see a run day on heavy volume. A good signal for entry with the \nbreaking of the horizontal line at number 2. When we enter, we set our stop 5% \nunder the recent low. After entering on strength, there is every possibility that some \nprofit-taking will occur as well as probing by locals to chase out arrivistes.\n 5. We watch with interest for the first reaction. Each day we observe as a candidate for a \npossible Basing Point. This occurs at 5, and we now begin to count “days away” from \nthe Basing Point—days whose range is entirely outside the range of the candidate \nday and occur before a lower low is made. When the Basing Point at 5 is confirmed, \nwe raise our stop to 5% under the low of 5.\n 6. A higher high is made after 5 with a subsequent reaction to 6, which proves to be \nanother Basing Point. Therefore, we raise our stop to 5% under 6.\n 7. Prices continue to climb and another Basing Point is made at 7. The procedure is \nbecoming clear: find a Basing Point and establish a stop a prudent distance under \nit. If a new Basing Point is made, raise the stop. Watch with interest the reactions \nagainst the trend. Either they allow you to establish a new higher Basing Point, or \nthey end your trade.\n 8–10. We find a new Basing Point at 9, raise our stop and draw the trendline at 10. At 9 we \nhave a lower low than 8, but our “filter,” our 5% padding, keeps our position intact. \nWe do not lower our stops using 9 as a new Basing Point. One of the inviolable rules \nis stops are never lowered. The filter is important because traders try to take out \nnearby lows and exacerbate volatility. It is called the running of the sheep.\n 11. At 11 we find a new, if tenuous, Basing Point. An advance with a thin higher high.\n 12. At 12 we have a candidate for a Basing Point that fails the three-day-away rule.\n 13. At 13 we find the Basing Point that is good and raise our stop.\n 14. At 14 we are confronted with a marginal situation. It is a potential Basing Point, but \na marginal one because a higher high was not made after 13.\n 15. At 15 we are able to draw a line defining resistance—a line that will become a support \nline.\n 16. At 16 we have a new Basing Point that would have tested a point at 14.\n 17–21. At 17 we find a new Basing Point, and at 18, we can identify a resistance line. The \nspurt across this line is both gratifying and a warning because it becomes a flagpole \nfrom which the flag at 19 flies. Flags and flagpoles are messages the market has \nheated up and now wants close watching. A flag can serve as a Basing Point, so we \nmove our stop again, fully aware the end may be approaching. The trendline at 20 \n368 Technical Analysis of Stock Trends\nis further confirmation of this environment because of its steepness, but we see two \ngood anchor points in 16 and 17 and draw trendline 21—a better line to defend.\n 22, 23. A good reaction finally occurs at 22, giving a strong Basing Point and good rationale \nfor raising the stop. Notice the interesting fact that points 22 and 24 have come back \nto rest on the trendline we drew at 10.\n 24. As the tempo has increased and the volatility 24 furnishes us another valid Basing \nPoint.\n 25, 26. Even 25 is a valid point, and we can now see the clear support line at 26.\n 27. When this line is pierced at 27 upon extraordinary volume, and in the process takes \nout our Basing Point stop from 25, it is clearly time to exit the train. The Basing Points \nconcept is even more thoroughly explored in the book entitled, StairStops, which is \navailable on the John Magee Technica", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 178}
{"text": "sing \nPoint.\n 25, 26. Even 25 is a valid point, and we can now see the clear support line at 26.\n 27. When this line is pierced at 27 upon extraordinary volume, and in the process takes \nout our Basing Point stop from 25, it is clearly time to exit the train. The Basing Points \nconcept is even more thoroughly explored in the book entitled, StairStops, which is \navailable on the John Magee Technical Analysis website at http:/ /www.edwards-\nmagee.com and on http:/ /www.amazon.com, including Kindle edition.\nThe complete Basing Points Procedure: taking into consideration \nthe setting of Basing Points on both wave lows and new highs\nAs previously discussed by Magee, the Basing Points Procedure may set Basing Points on \nboth wave lows and on new highs. We find the wave-low Basing Point by the three-days-\naway rule; we find the new high Basing Point, by marking wave highs and subsequent \nnew highs so when price exceeds by 3% the old wave high, or recent high, whether or not \nan intervening wave low has occurred, we may set the new Basing Point at the low of the \nnew high day. If a new high were made subsequent to this new high, we would reset the \nBasing Point again if we were using this variant of the procedure, which I call Variant 2.\nOnce again, the one-armed economist rules. On the one hand, raising the stops like \nthis on new highs may easily result in being ejected from the position by a price dip; \nthen you watch the train leaving the station on the way to incredible new highs amid \nmuch teeth gnashing and irritation. (Incidentally, if emotional distress occurs in this or \nother like situations it is a message to you are too emotionally attached to the market. \nComplete market maturity is not achieved until such situations can be viewed with relative \nequanimity so the event is viewed with detached interest and a plan to set things right.)\nOn the other hand, after having accumulated large paper profits, the issue collapses \nand snatches back from you a third (or more) of your hard-earned profits. (If you had only \nadvanced stops based on new highs!) Remember, the problem with Dow Theory (and trend \nfollowing) is you give up the first third of the move and the last third of the move and \nsometimes there is not a middle third, as conventional market wisdom has it.\nWhat essentially occurs when using Variant 2 of the procedure is as follows: when \nblow-off or runaway conditions occur, the procedure changes from selling weakness to \nselling strength. I believe very strongly in the variation of tactics, generally. Also, I am \nintimately familiar with the pitfalls of varying tactics, but I like the procedure in general \nand also think knowing when to use it and when not to use it can require a great deal \nof experience and emotional coolness in potentially high-stress conditions. If the entire \n(Variant 2) procedure is executed and also combined with a scale-in/scale-out plan, the \nuser may succeed in shooting the moon.\nThe phlegmatic Marc Antony (who sleeps well of night and is sleek and well fed) \nfollows the conservative wave-low method (Variant 1) and probably wins in the long \nrun. The Variant 1 procedure is simpler and naturally expands to accommodate the high-\nvolatility market that ejects the trader attempting to escape the inevitable collapse before \ngoing on to new completely unexpected heights.\n369Chapter twenty-eight: What is a Bot tom and what is a Top?\nAs it goes, damned if you do, damned if you don’t, unless you are charmed or kissed \nby the market fairy—or lucky.\nThe complete Basing Points procedure\n 1. A wave high is made, recognized by no higher prices coming for the moment. If this \nhigh is 3% (Magee’s number, but could be a parameter) higher than the previous wave \nhigh (or the recent high in a run or blow off), the Basing Point is raised to the low of \nthe new high day. Obviously, this comes into effect for the next trading day.\n 2. Prices recede and a low is made. This low is found by watching each day after the \nprevious high until no lower prices are made (a potential wave low or Basing Points \ncandidate). As prices begin to rise again, we note each day on which prices are \ncompletely out of the range of (away from) our low-day candidate, or a “day away.”\n 3. When three such days are observed (the three-days-away rule) before a new low is \nmade, we mark the candidate day as a Basing Point and raise our stop to 6% (or x% as \nthis is a parameter) under the low of the Basing Point day. Obviously, the new stop is \nestablished the day after the three days away have occurred.\n 4. If a new high is made without an intervening wave low Basing Point, the process \nstarts over from the new high.\n 5. If the new high is 3% (or x%) higher than the previous high (whether made from a wave \nlow or wave high), or from surging prices continually making new highs, a new Basing \nPoint is found at the low of the new high day. Thus, a price move that went from 10 to \n10.3 to 10.61 to 10.93 would create new Basing Points at the low of each new high day.\nApple Inc.- (Nasdaq NM) 85.70 -1.09 -11.26%\n19A\nNew High 12.55\nNew High 13.82\n24B 25A\n14BP 13.36\n13.41\n24A\nStop\nStop 11.19\n2219\n17A\nBP Low of New high 9.89\n17\nYY Y\nBP\nStop based on low of New High\nNew Stop\nNN\n16\nBP\nBPC\nY\nNN N\n13\nBP\nY\nNN\nBP\nY\nY\nNBPC\nY\nN\nYY\nN\nNN NNNN N\nNew High 10.81\n17B\n16A\nH 10.35\nBP Flag\n17C\nHigh 11.62\nStop from new high\n24\nBP\nLow 11.91\nStop12.56\n12.93\n25\nStop 11.68\n12.24\nNew\nNew\nBP\nBP 12.43High\n13.67High\n13.5\n13\n12.5\n12\n11.5\n11\n10.5\n10\n9.5\n9\n8.5\n8\n7.5\n7OctSepAugJul\n©1998-2006 Prophet Financial Systems, Inc. Terms of use apply.\nJunMayApr\nFigure 28.3 Basing Points candlestick version. This chart is a candlestick version of Figure 28.2. It \nillustrates the complete procedure, showing establishment of Basing Points made by wave lows and \nby higher highs. This is a blow up of the period in the chart during which higher high conditions \nexist. As might be obvious, the higher high rules begin to come into play late in the life of a tr", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 179}
{"text": "r\nFigure 28.3 Basing Points candlestick version. This chart is a candlestick version of Figure 28.2. It \nillustrates the complete procedure, showing establishment of Basing Points made by wave lows and \nby higher highs. This is a blow up of the period in the chart during which higher high conditions \nexist. As might be obvious, the higher high rules begin to come into play late in the life of a trend, \nin the runaway and blow-off stages.\n370 Technical Analysis of Stock Trends\nTwo charts giving a long-view perspective on \nthe complete (Variant 2) procedure\nThere is another method Magee advocated for surging and blow-off markets. He called this \nalternative method “progressive stops,” which is explained in the ninth edition. Strictly \nspeaking, although there is a variation in tactics involved in using new highs for stop \ncalculation, this method is a twist on selling on strength. Variant 2 is still lagging stops \nbehind prices. A pure strength selling method would attempt to time exit on a blow-off day, \nor a key reversal day or a one-day reversal, or even on a strong long running day up. This \nis perhaps a little easier to visualize on the downside. A panic selling day (which tends to \nfinish at the lows) would provoke an exit on the close.\nThe representative case fully analyzed \nusing wave lows and new highs\nThe case will not be unfamiliar to readers, and its use will fully highlight the differences \nfound in the procedure. The same materials will be used, and the differences will be boldfaced in \nthe text.\n 1. A rounding bottom, or perhaps a scallop.\n 2. Resistance or breakout line.\nAAPL(D) - Daily NASDAQ L=62.69 -0.03 -0.05% B=62.60 A=62.72 O=63.67 Hi=64.12 Lo=62.61 C=62.65 V=29150123\n12.59\n14.00\n10\n20\n24\n19\n11.33\n21\n17\n13\n18\n26\n15 12\n11\n98\n7\n6\n1\nMA MJ JA SO ND 87 FM AM JJ AS ON D\n3 2\n4\n5\n14\n16\n22 27\n25 13.72\n23\n13.00\n12.00\n11.00\n10.00\n9.00\n8.00\n7.63\n7.00\n6.00\n5.00\n4.00\nCreated with TradeStation\n10.92\n9.05\n4.76\nFigure 28.4 Apple Variant 2 of the Basing Points Procedure. This chart shows the trend from \nbeginning to end as in Figure 28.2, with the addition of dotted lines to show where stops fell when \ncomputed from higher highs. The previous candlestick chart is used for the close-up analysis. This \nchart puts into broad perspective the relative level of stops using the Variant 2 method. As can be \nseen, setting stops from new higher highs results in stops closer to the market prices. This can be \ngood or bad, depending on what the market does to you.\n371Chapter twenty-eight: What is a Bot tom and what is a Top?\n 3. Wake-up call on volume.\n 4. Run day, big volume; breakout through line 2; sure entry signal.\n 5. First Basing Point (BP). Notice prior volume fall-off in consolidation, and surge on run \nday.\n 6 . BP.\n 7 . A weak BP (because of shallow retracement).\n 8. BP.\n 9. Test of BP at 8.\n 10. A trendline drawn after point 9.\n 11. BP.\n 12. BP candidate that fails the three-day-away rule.\n 13. BP.\n 14. A potential BP but not a very good one because new high has not been made from 13.\n 15. A Support-Resistance line.\n 16 . BP.\n 16A. New High: 10.35.\n 17. BP.\n 17A. New Higher High 10.81; Low BP 9.89 (+3% 11.13); Stop 9.30.\n 17B. New Higher High 11.16; Low BP 10.58 (+3% 11.49); Stop 10.49.\n 17C. New Higher High 11.62; Low BP 11.22 (+3% 11.96); Stop 10.55.\n 18. A Resistance–Support line.\n 19. Flag that becomes BP . High 11.62.\n 19A. New Higher High 12.55; Low BP 11.91 (+3% 12.93); Stop 11.19.\n 20. Trendline, but too steep to last.\n 21. Trendline.\n 22. BP .\n 23. Trendline.\n 24 . BP.\n 24A. New Higher High 12.93; Low BP 12.43 ( +3% 13.34); Stop 11.68.\n 24B. New Higher High 13.41; Low BP 13.07 (+3% 13.81); Stop 12.29.\n 2 5. BP.\n 25A. New Higher High 13.82; Low BP 13.36 ( +3% 14.23); Stop 12.56.\n 25B. Stopped out at 12.56.\n 26. Horizontal trendline.\n 27 . BP at 25 (stop 11.80); Stopped out at 11.80.\nA narrative of the events in the chart\n 1–3. Had we been asleep, the event at number 3 should have awakened us; a volume day \nlike this (Cf. chart 28.2) should catch the attention. We begin paying attention to \nthe stock and note the pattern that has been developing—the rounding bottom, or \nscallop.\n 4. At number 4 we see a run day on heavy volume. A good signal for entry with the \nbreaking of the horizontal line at 2. When we enter, we set our stop 6% under the \nrecent low. After entering on strength, there is every possibility that some profit-\ntaking will occur as well as probing by locals to chase out arrivistes.\n 5. We watch with interest for the first reaction. Each day we observe as a candidate for \na possible Basing Point. This occurs at 5 and we now begin to count “days away” \nfrom the Basing Point, that is, days whose range is entirely outside the range of the \n372 Technical Analysis of Stock Trends\ncandidate day, and that occur before a lower low is made. When the Basing Point at \n5 is confirmed, we raise our stop to 6% under 5.\n 6. A higher high is made after 5 with a subsequent reaction to 6, which proves to be \nanother Basing Point, so we raise our stop to 6% under 6.\n 7 . Prices continue to climb and another Basing Point is made at 7 . The procedure is \nbecoming clear: find a Basing Point and establish a stop a prudent distance under \nit. If a new Basing Point is made, raise the stop. Watch with interest the reactions \nagainst the trend. Either they allow you to establish a new higher Basing Point, or \nthey end your trade.\n 8–10. We find a new Basing Point at 8, raise our stop, and draw the trendline at 10. At 9 we \nhave a lower low than 8, but our “filter,” our 6% padding, keeps our position intact. \nWe do not lower our stops using 9 as a new Basing Point. One of the inviolable rules \nis that stops are never lowered. The filter is important, because traders try to take \nout nearby lows and exacerbate volatility. It is called the running of the lambs.\n 11. At 11 we find a new, if tenuous, Basing Point. An advance with a thin higher high.\n 12. At 12 we have a candidate for a Basing Poi", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 180}
{"text": "intact. \nWe do not lower our stops using 9 as a new Basing Point. One of the inviolable rules \nis that stops are never lowered. The filter is important, because traders try to take \nout nearby lows and exacerbate volatility. It is called the running of the lambs.\n 11. At 11 we find a new, if tenuous, Basing Point. An advance with a thin higher high.\n 12. At 12 we have a candidate for a Basing Point that fails the three-day-away rule.\n 13. At 13 we find the Basing Point that is good and raise our stop.\n 14. At 14 we are confronted with a marginal situation. It is potential Basing Point, but a \nmarginal one because a higher high was not made after 13.\n 15. At 15 we are able to draw a line defining resistance—a line that will become a \nsupport line.\n 16. At 16 we get a Basing Point.\n 16A. New High: 10.35 (a benchmark).\n 17 . At 17 we find a new Basing Point and at 18 we can identify a resistance line. The \nspurt across this line is both gratifying and a warning because it becomes a flagpole \nfrom which the flag at 19 flies. Flags and flagpoles are messages that the market has \nheated up and now wants close watching. A flag can serve as a Basing Point, so we \nmove our stop again, fully aware the end may be approaching. The trendline at 20 \nis further confirmation of this environment due to its steepness. However, we see \ntwo good trendline anchor points in 16 and 17 and draw trendline 21—a better line \nto defend.\n 17A. New Higher High 10.81; Low BP 9.89 (+3% 11.13).\n 17B. New Higher High 11.16; Low BP 10.58 (+3% 11.49).\n 17C. New Higher High 11.62; Low BP 11.22 (+3% 11.96).\n 18. Support-resistance line.\n 19. Flag that becomes BP . High 11.62.\n 19A. New Higher High 12.55; Low BP 11.91 (+3% 12.93); Stop 11.19.\n 22–24. A good reaction finally occurs at 22 giving a strong Basing Point and good rationale \nfor raising the stop. Notice the interesting fact that points 22 and 24 have come back \nto rest on the trendline we drew at 10. As the tempo has increased, and the volatility, \n24 furnishes us another valid Basing Point.\n 24A. New Higher High 12.93; Low BP 12.43 ( +3% 13.34); Stop 11.68.\n 24B. New Higher High 13.41; Low BP 13.07 (+3% 13.81); Stop 12.29.\n 25. Even 25 is a valid point and we can now see the clear support line at 26.\n 25A. New Higher High 13.82; Low BP 13.36 ( +3% 14.23); Stop 12.56.\n 25B. Stopped out at 12.56.\n 26. Support-resistance line.\n 27 . When this line is pierced at 27 upon extraordinary volume, and in the process takes \nout our Basing Point stop from 25, it is clearly time to exit the train.\n373\nchapter twenty-nine\nTrendlines in action\nFrom what has already been said in Section I of this book, you will be familiar with the \ncharacteristic single-line trends of stocks and the numerous exceptions and deviations that \ncome into the picture from time to time. We know stocks often move in parallel trends, \nsometimes for months, occasionally even for years. We also know they may, and do, break \nout of trend or change the direction of their trends without notice. \nMost of the pattern formations we have studied can be considered as manifestations of \ntrend action, or Continuations or Reversals of a trend.\nThus, a Symmetrical Triangle is simply the meeting of two trends. During the formation \nof the Triangle, the stock is following both trends in a narrowing pattern until, finally, the \ndominant trend asserts itself. An Ascending Triangle is following an upward trend but has \nencountered a Resistance Level at the Top. A Head-and-Shoulders Formation shows the \nend of an upward trend and the beginning of a downward trend. A Rectangle is a Parallel \nTrend Channel running in a horizontal direction, and so on.\nWe can project a Parallel Trend and, in the case of stocks continuing to move in that \ntrend, we can buy and sell at almost the precise points of contact with the trendline. \nUnfortunately, long and perfect straight-line trends of this sort are the exception rather than \nthe rule. For actual trading purposes, we will project our trends more or less continuously \non the basis of the most recently established data.\nFrom the standpoint of tactics, let us consider the trends as they are indicated by the \nsuccessive Minor Tops and Minor Bottoms. For illustration of this, and as a guide to what \nwe are leading up to, we will consider simplified, ideal situations (see the examples in \nDiagrams 29.1 through 29.6).\nTo avoid confusion, mark the top trendline in blue pencil and the bottom trendline in \nred pencil. We will refer to the upper trendline as the Blue Trend, and the lower trendline as \nthe Red Trend. From time to time, we will also want to draw a line parallel to a Blue Trend \nacross the Bottom of the trend so as to include a segment of the Trend Channel between \ntwo Tops within parallel lines. This we will call the Blue Parallel, and we will mark it with \na dotted or broken blue line. Conversely, we may wish to draw a parallel to the Red Trend \nso as to include the segment of the Trend Channel between two Bottoms, and this dotted \nred line we will call the Red Parallel.\nOrdinarily, a Top (wave high) will be formed after a Bottom (wave low) and a Bottom after \na Top; thus, we will expect to draw, alternately, a Blue Trendline and a Red Trendline with \nthese lines being drawn as soon as the new Top or Bottom is established. (In some cases, a \nlight pencil line may be drawn to indicate suspected Tops or Bottoms, until developments \nconfirm their validity.)\nWe have already taken up the important and rather difficult question of determining \nthe Minor Tops and Bottoms. Very often, these points will be clear and obvious. Sometimes \nthey will be obscure, and you will be able to draw trendlines with confidence, in such cases, \nonly after considerable experience covering many types of actions. The most difficult times \nto determine Minor Trends are during Reversals, especially in cases in which these are of \n374 Technical Analysis of Stock Trends\nthe rounded and irregular types. In thes", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 181}
{"text": "nts will be clear and obvious. Sometimes \nthey will be obscure, and you will be able to draw trendlines with confidence, in such cases, \nonly after considerable experience covering many types of actions. The most difficult times \nto determine Minor Trends are during Reversals, especially in cases in which these are of \n374 Technical Analysis of Stock Trends\nthe rounded and irregular types. In these cases (of Reversal), however, we will not depend \nmuch on the trendlines to determine buying and selling points.\nAs long as a stock persists in a Parallel Trend Channel, it is perfectly clear to buy \nnear the Bottom of the channel and sell near the Top. From the geometry of the situation \n(see examples), you will see at a glance it is not likely to be profitable to sell short in an \nDiagram 29.1 Here is a rising trend showing the Basic Trendline across two Bottoms, which we call \nthe Red Trendline, and its parallel (indicated by a broken line) through the Top of the intervening \npeak. The parallel suggests the approximate objective of the next move if the stock continues in trend.\nDiagram 29.2 The same rising trend with the Return Line, which we call the Blue Trendline, drawn \nthrough two Tops. The broken line represents its parallel through the intervening Bottom. This Blue \nParallel is useful in determining a buying point, especially in trends of rapidly changing form when \nthe stock may not react to its Basic Trendline.\nDiagram 29.3 This is a declining trend showing the Basic Trendline across two Tops, which we call \nthe Blue Trendline, and its parallel (indicated by a broken line) through the Bottom of the intervening \ndecline. The parallel suggests the approximate objective of the next move if the stock continues in \ntrend.\n375Chapter twenty-nine: Trendli nes in action\nupward-moving trend (because the reactions are necessarily smaller than the advances), \nor to buy stock in a downward-moving trend. \nTherefore, a trend must show it is presumably an uptrend before you are justified in \nbuying stock. Plus, you must have what is presumably a downtrend to justify a short sale.\nYou will notice from the simplified examples shown here that pattern formations \nindicate trends. The breaking of a Rectangle on the upside results in an upward slope of \nthe Blue Trend. The move up out of an Ascending Triangle confirms the rising Red Trend \nand creates a rising Blue Trend. The downside breaking of a Head-and-Shoulders neckline \nconfirms a descending Blue Trend and sets up a descending Red Trend, and so on.\nFrom studies of these patterns and various trend actions, we arrive at a compact set of \ntrading rules based on these Red and Blue trendlines. These rules are summarized below.\nBuying stock, “going long”\n• Preparatory buying signals (indicating a buying opportunity may be in the making). \nPenetration of Blue Trend to a new high closing (in most cases). The simple breaking \nof a descending Blue Trendline, in cases in which no other pattern or indication is \npresent, is not sufficiently conclusive evidence of Reversal to justify commitments.\nA\nB D\nC E F\nG\nH I\nK\nJ\nW Y\nDiagram 29.5 Simplified diagram of a stock chart showing trend action. Basic Trendlines are \nmarked with heavy lines; Return Lines are marked lightly.\nDiagram 29.4 The same declining trend with the Return Line, which we call the Red Trendline, \ndrawn through two Bottoms. The broken line represents its parallel through the intervening Top. \nThis Red Parallel is useful in determining a point at which to make short sales, especially in trends \nof rapidly changing form when the stock may not rally to its Basic Trendline.\n376 Technical Analysis of Stock Trends\n• Contact with the ascending Blue Trend if the Red Trend is also ascending, provided \nthe trends do not converge (Parallel or Divergent Trend Channel).\n• Contact with the horizontal Blue Trend if the Red Trend is also horizontal or \nascending (Rectangle, Ascending Triangle).\n• Penetration of the descending Blue Trend on volume if the Red Trend is ascending \n(Symmetrical Triangle).\n• Execution of buys (after preparatory buying signal).\n• In case the previous Blue Trend has been ascending, draw the Blue Parallel and \nbuy at or near this line.\na b c\nd e f\ng h i\nDiagram 29.6 Preparatory buying signals shown by trend action.\n a. Penetration of an ascending Blue Trendline.\n b. Penetration of a horizontal Blue Trendline.\n c. The penetration of a descending Blue Trendline without other technical indications is not \nconclusive evidence of a change in trend and does not justify long commitments.\n d. Contact with the Blue Trendline of an Ascending Parallel Trend Pattern.\n e. Contact with the Blue Trendline of an Ascending Divergent Trend Pattern.\n f. In this case, contact with the Blue Trendline does not suggest a buy on the next reaction, \nbecause the trend appears to be converging; a possible Wedge in the making, with Bearish \nimplications.\n g. Contact with the Blue Trendline of a Rectangle at its fifth point of Reversal.\n h. Contact with the Blue Trendline of an Ascending Triangle.\n i. Penetration on volume of descending Blue Trendline when Red Trendline is ascending \n(Symmetrical Triangle).\n377Chapter twenty-nine: Trendli nes in action\n• In case the previous Blue Trend has been horizontal or descending (that is to say, \nemerging from Rectangles, Triangles, and various Reversal Patterns), buy on a \nreaction of 40%–45% of the distance from the last previous Minor Bottom to the \nextreme Top of the most recent move.\nj k l\nm n o\np q r\nDiagram 29.6 (Continued ) Preparatory signals for short sales shown by trend action.\n j. Penetration of a descending Red Trendline.\n k. Penetration of a horizontal Red Trendline.\n l. The penetration of an ascending Red Trendline without other technical indications is not \nconclusive evidence of a change in trend and does not justify short commitments.\n m. Line of a Descending Parallel Trend Channel.\n n. Contact with the Red Trendline of a Descending Divergent Trend Patte", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 182}
{"text": "d action.\n j. Penetration of a descending Red Trendline.\n k. Penetration of a horizontal Red Trendline.\n l. The penetration of an ascending Red Trendline without other technical indications is not \nconclusive evidence of a change in trend and does not justify short commitments.\n m. Line of a Descending Parallel Trend Channel.\n n. Contact with the Red Trendline of a Descending Divergent Trend Pattern.\n o. In this case, contact with the Red Trendline does not suggest a short sale on the next rally, \nbecause the trend appears to be converging; a possible Wedge in the making, with Bullish \nimplications.\n p. Contact with the Red Trendline of a Rectangle at its fifth point of Reversal.\n q. Contact with the Red Trendline of a Descending Triangle.\n r. Penetration of ascending Red Trendline (with or without volume) when Blue Trendline is \ndescending (Symmetrical Triangle).\n In descending trends, the Red Trendline is a return Line, and short sales will be made on \nrallies to a line parallel to the new Red Trendline established at the Bottom of the signal move \nand drawn through the intervening peak. Note in the case of decisive breakouts from patterns \nsuch as Rectangles and Triangles, a short sale might also be made on the basis of a computed \n40%–50% correction of the breakout move, or on a return to Resistance.\n378 Technical Analysis of Stock Trends\nLiquidating, or selling a long position\nImmediately on execution of the buy order, determine the stop level (see Chapter 27, Stop \nOrders) and place your protective stop. Penetration of this stop level will automatically \nclose out your transaction. The stop level may be moved up according to the “three-days-\naway” rule but may never be moved down (except to adjust for ex-dividend or ex-rights). If \nthe stock closes below a previous Minor Bottom (thus setting up a descending Red Trend), \nsell on tight (EN: or hair-trigger) progressive stops.\nAt the start, the stock declines in a Parallel Trend Channel. The Blue Trendline is basic \nhere. A short sale on a rally to the Red Parallel at point A will find its objective on the Blue \nParallel at B. Another short sale on the Red Parallel at C would be followed by failure to \nreach the objective. Chances are good, however, that increased volume would develop at the \nDouble Bottom and give warning to get out of short commitments. The upside penetration \nof the basic Blue Trendline at E, alone, is not sufficient reason to reverse position and go long. \nTrendlines set up during formation of the Rectangle would be marked in the regular way, but \nthey are indicated here by broken lines to emphasize the pattern. Another short sale, if tried \non the sixth point of contact with the Rectangle at F, would be stopped out on the breakout.\nThe trend is now rising, although we cannot yet draw a Basic (Red) Trendline. The first \nbuy would be made on a 40%–50% correction of the breakout move from the Rectangle, or \non a return to the Top (Support) level at H.\nA trendline would be drawn to the first Bottom established in the Triangle. This is \nnot shown, as it would ultimately be replaced by the line shown through the outermost \npoint in the Triangle. We have indicated by broken lines the trendlines set up during the \nformation of the pattern.\nThe objective of the breakout move from the Triangle would be the Red Parallel to our \nnow rising Basic Trendline; this objective is reached at J. A Return Line (Blue) would be \ndrawn from the first Reversal Top of the Triangle at G through the Top of the breakout move \nat J, and the parallel to this through point I would indicate about where to make the next \npurchase. As a matter of fact, the stock does not actually get back to that point; in practice, \nthe purchase would probably be made at K on the basis of a 40%–50% correction, or on a \nreaction to the Support Level G.\nThe subsequent upward move would not carry through to the Red Parallel marked W; \nhowever, the alarm would probably be sounded clearly by a day of heavy volume, a One-\nDay Reversal, or a gap. Since the trend is now obviously convergent, no further purchases \nwould be considered. The next move fails to make such headway and falls far short of the \nobjective set by the Red Parallel marked Y. Soon after, the Wedge breaks out downside.\nIf the stock advances on moderate volume and then develops unusually high volume \non any day during the advance before either the Blue Trend is broken (with a close above \nthat trendline) or before the stock has made a new high closing over the last Minor Top, \nclose out the transaction on tight progressive stops.\nIf the stock develops high volume on the day on which it either tops and closes above \nthe Blue Trend or makes a new high closing over the previous Minor Top, hold it. If heavy \nvolume again occurs on the following day or any subsequent day, however, sell on tight \nprogressive stops.\nIn rising trends, the Blue Trendline is a Return Line, and purchases will be made on \nreactions to a line parallel to the new Blue Trendline established at the Top of the signal \nmove and drawn through the intervening Bottom. Note in the case of decisive breakouts \nfrom patterns such as Rectangles and Triangles, a purchase may also be made on the basis \nof a computed 40%–50% correction of the breakout move, or on a return to Support.\n379Chapter twenty-nine: Trendlin es in action\nYou will find in many cases the heavy volume signal will develop (sometimes with also \na One-Day Reversal or an Exhaustion Gap) on or near the Red Parallel; watch especially for \nthis volume indication as a sign of a good profit-taking point. If the volume signal does not \nshow up, your selling objective is this Red Parallel, at a limit or on tight progressive stops. \nIn case there is no such volume signal at the top of the move and the move does not reach \nthe Blue Trend or make a new high, you are very likely running into a Triangle situation. \nIn that case, you will have to wait for a breakout one way or another. Meanwhil", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 183}
{"text": "ing point. If the volume signal does not \nshow up, your selling objective is this Red Parallel, at a limit or on tight progressive stops. \nIn case there is no such volume signal at the top of the move and the move does not reach \nthe Blue Trend or make a new high, you are very likely running into a Triangle situation. \nIn that case, you will have to wait for a breakout one way or another. Meanwhile, maintain \nyour stop protection underneath.\nSelling stock short\n• Preparatory selling signals (indicating an opportunity for short sales may be in the \nmaking).\n• Penetration of Red Trend to a new low closing (in most cases). The simple breaking \nof an ascending Red Trendline where no other pattern or indication is present is \nnot sufficiently conclusive evidence of Reversal to justify commitments.\n• Contact with descending Red Trend if Blue Trend is also descending, provided the \ntrends do not converge (Parallel or Divergent Trend Channel).\n• Contact with horizontal Red Trend if Blue Trend is also horizontal or descending \n(Rectangle, Descending Triangle).\n• Penetration of ascending Red Trend (with or without volume increase) if Blue \nTrend is descending (Symmetrical Triangle).\n• Execution of short sales (after preparatory selling signal).\n• In case the previous Red Trend has been descending, draw the Red Parallel and \nsell at or near this line.\n• In case the previous Red Trend has been horizontal or ascending (that is to say, \nemerging from Rectangles, Triangles, and various Reversal Patterns), sell on a \nrally of 40%–45% of the distance from the last previous Minor Top to the extreme \nBottom of the most recent move.\nCovering short sales\nImmediately on execution of the short sale, determine the stop level (see Chapter 27, Stop \nOrders) and place your protective stop. Penetration of this stop level will automatically \nclose out your transaction. The stop level may be moved down according to the three-days-\naway rule, but it may never be moved up.\nIf the stock closes above a previous Minor Top (thus setting up an ascending Blue \nTrend), buy to cover on tight progressive stops.\nIf the stock declines on moderate volume and then develops unusually high volume on \nany day during the decline before either the Red Trend is broken (with a close below that \ntrendline), or before the stock has made a new low closing under the last Minor Bottom, \nclose out the transaction on tight progressive stops.\nIf the stock develops high volume on the day on which it either breaks and closes below \nthe Red Trend or makes a new low closing under the previous Minor Bottom, hold it short. \nIf heavy volume again occurs on the following day or any subsequent day, however, buy \nto cover on tight progressive stops.\nYou will find in many cases the heavy volume signal will develop (sometimes with also \na One-Day Reversal or an Exhaustion Gap) on or near the Blue Parallel; watch especially \nfor this volume indication as a sign of a good profit-taking point. If the volume signal does \n380 Technical Analysis of Stock Trends\nnot show up, your buying objective is the Blue Parallel, at a limit or on tight progressive \nstops. In case there is no such volume signal at the bottom of the move and the move does \nnot reach the Red Trend or make a new low, you are very likely running into a Triangle \nsituation. In that case, you will have to wait for a breakout one way or another, meanwhile \nmaintaining your stop protection overhead.\nAdditional suggestions\nWhen a level is reached that appears to be either a Minor Bottom on a reaction or a Minor \nTop on a rally, and when the stock continues to stall and remain at this point, moving in \na very narrow range for three weeks or more without giving any signal either by way of \nprice change or volume action as to its next move, it is wise to assume this congestion is \ndefinitely a key area and should be considered a Minor Top or Bottom; protective stops \nshould be adjusted to it as a Basing Point, instead of the previously established Top or \nBottom, as against the possibility that the move out of this area, when it comes, may be in \nthe wrong direction.\nAfter a series of moves in a trend, with each move in the Primary Direction marked \nby heavier volume than the retreats or Corrective Moves against the trend, you are likely \nto have a move in the Primary Direction, which is marked by extraordinary volume (much \nlarger volume than the normal increase for a Primary Move). On such a move, after taking \nyour profits on previous commitments, you would ordinarily begin to plan the next \ncommitment on the Correction. In this particular case, noting the extreme volume, you \nwould cancel any immediate plans for further commitments in the Primary Direction.\nThe reason for this is such climactic volume normally indicates the final “blow-off” \nof the Intermediate Trend, to be followed either by a Reversal, or at least by a period of \nstagnation, or by formation of Consolidation Patterns, or by Intermediate Correction. In \nsuch a case, it is not safe to make any further commitments on this trend pending further \ndevelopments and the positive reassertion of the trend.\nIf you examine daily charts of various stocks, covering long and important trends, \nyou will find the series of Minor Moves making up the Intermediate Trend is likely to \nculminate in a Minor Move marked by tremendous volume. This is truer of Tops than \nBottoms, although at the end of the Panic Phase of a Bear Market, we very often see \nclimactic volume. The climax indicates, on the other hand, the sale of large amounts of \nstock by strong investors to weak traders, near the top; on the other hand, the liquidation \nof holdings by weak traders occurs near the bottom, into the hands of strong investors who \nwill hold them for the next Major Move.\nOne of the most common errors, and easiest to fall into, is to mistake a Climactic Top \nor Bottom for a normal confirmation or preparatory signal for a new commitment in line \nwith the preceding trend.", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 184}
{"text": "to weak traders, near the top; on the other hand, the liquidation \nof holdings by weak traders occurs near the bottom, into the hands of strong investors who \nwill hold them for the next Major Move.\nOne of the most common errors, and easiest to fall into, is to mistake a Climactic Top \nor Bottom for a normal confirmation or preparatory signal for a new commitment in line \nwith the preceding trend.\nIt is similar in nature to the error often made by novices in the market of buying on \nthe Minor Tops (becoming dazzled with the rapid price advance and the great volume of \nactivity). However, in the case of these final “blow-off” moves, the volume is greater and \nthe adverse portent far more serious.\nGeneral outline of policy for trading in the Major Trend\n A. Always trade in the direction of the Major or Primary Dow Trend (EN: see the editor’s \ncomments in Chapter 3) as it is indicated at the time.\n381Chapter twenty-nine: Trendli nes in action\n B. If the two component Averages of the Dow Theory (Industrials and Rails; EN9: \nTransportations) are not in agreement, trade in the direction of the last established \nPrimary Trend but only in the component that is still following that trend.\n C. Examine charts of group Averages covering groups of businesses in the same or \nrelated lines; trade in the Primary Direction when the trend of the group corresponds.\n D. Trade in any particular stock when its own individual chart indicates a trend in the \nsame direction as the Primary Trend, and when the technical picture has indicated a \nprobable move in that direction.\nMake all new commitments on the reactions or rallies following the signaling move \nin the Primary direction, except in the case of Primary Reversals from Bull Market to Bear \nMarket, when short sales may be made at the market immediately following the Reversal.\nException: after an extended move or a series of moves in the Primary Direction, when \nsigns of exhaustion and Reversal appear in individual charts, commitments in the opposite \ndirection may be made with objectives limited to a correction of the preceding Intermediate \nMove in the Primary Direction.\n(EN9: Now the reader’s head is spinning and the color blind are completely confused. As this \nbook is unfortunately printed in black and white, the reader without colored pencils will be at sea. \nThis is what I recommend: take out your colored pencils and color the lines yourself. The principles \narticulated here by Magee are of great value to a trader and are worth studying.)\n\n383\nchapter thirty\nUse of Support and Resistance\nWe know that after many breakouts from well-defined Reversal and Consolidation Patterns, \nwe get a short countermove back to the edge of the pattern and the checking of this move \nat that point is an example of Support or Resistance, as the case may be. Also, we should \nbe familiar by now with the tendency of stocks to move up or down in a series of zigzag \nsteps (EN10: i.e., waves and wavelets). If the move is upward, the reaction after each advance \ntends to stop at the level of the preceding peak. If the move is downward, the rally after \neach decline tends to stop at the level of the preceding bottom. This is again a matter of \nSupport and Resistance and provides the basis for buying on reactions or selling on rallies. \nIt has also been pointed out Intermediate Secondary Moves will frequently stop at or close \nto the previous Intermediate Top or Bottom.\nIt is necessary to evaluate the importance of these phenomena of Support and Resistance \nand apply them in market practice, for they are among the most important tools we have. \nUnfortunately, it is not easy to reduce this particular subject to a neat formula or body of \nrules. (EN9: And the effort will be made. See endnote of this chapter for an interesting effort to do \njust that.) Here you will depend very largely on experience and observation. You will have \nto be alert in spotting the levels at which Resistance or Support is likely to be encountered, \nand some judgment is needed in balancing the various factors that will affect the situation.\nFor example, there is a stock that has broken up out of a well-defined Rectangle of \nconsiderable duration. Should the heavy volume of the breakout move give way to a dull \nreaction, you will look for an opportunity to buy this stock at a point a little above the top \nlevel of the Rectangle. It will probably not penetrate very far below that level and, indeed, \nwill often fail to react all the way to the Support. If the stock should then advance to a new \nhigh, and once more decline on low volume, you may look for another buying point at about \nthe level of the peak reached on the original breakout. Another advance may be followed \nby reaction to the second peak, and this process may be repeated a number of times, each \nreaction carrying back to the level of the preceding high.\nNow we all know this sort of thing does not continue indefinitely. When the stock first \nbreaks out, moving from, say, 15 to 19, we may buy rather confidently on the reaction to 17 , \nif that is the Support Level. If we did not buy on this move, we may buy with considerable \nassurance on the reaction to Support after the next advance. This advance might have \ncarried the price to 21 and our buying point would be at the previous peak of 19. As the \nstock moves up to 25, 30, 40, it must be clear we are approaching a real Top; although we \ncannot say where that Top will be reached, we can be sure it is becoming increasingly \ntempting to long-time holders of this stock to sell and take their substantial gains. The \nseries of steps is bound to come to an end. To be sure, the Major course of the stock and \nof the market may continue up for months or years, but after a series of sharp rises, we \nmay reasonably expect a Reversal and a rather substantial Intermediate Decline before the \nupward move is continued.\nTherefore, we must regard each successive step of advance with increasing suspicion; \nafter a s", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 185}
{"text": ". The \nseries of steps is bound to come to an end. To be sure, the Major course of the stock and \nof the market may continue up for months or years, but after a series of sharp rises, we \nmay reasonably expect a Reversal and a rather substantial Intermediate Decline before the \nupward move is continued.\nTherefore, we must regard each successive step of advance with increasing suspicion; \nafter a stock has made three such moves in the Primary Direction, it is time to look for an \nIntermediate Correction or at least for an important period of Consolidation. Thus, we have \n384 Technical Analysis of Stock Trends\nthe rough shape of a rule. Buy on the reaction to Support after the first breakout; buy on \nthe reaction to the first Minor Peak after the next move, but do not buy on the reaction to \nthe second Minor Peak.\nLet us say, then, we have been successful in two short-term moves, buying on the \nreaction to Support and selling on the climax after a new Top has been made. Nevertheless, \nwe have decided not to attempt a third such trade. What, then, may we expect next? We \nmay see a period of Consolidation, we may see the beginning of an Intermediate Decline, \nor we may see the stock actually go right on moving up. No matter—we will wait for the \nIntermediate Reaction. We will wait until the stock makes a very substantial decline, and \nthis may take many weeks. Then, if the Major Trend has not reversed itself, we will again \nlook for a buying opportunity at (or somewhat above) the Intermediate Support, which \nwill usually be the top level of the advance preceding the one just completed, for this is the \nlevel from which the next Primary Advance is likely to proceed and is a good buying point.\nWe find the same situation in Bear Markets. A breakout is likely to be followed by one, \ntwo, three, or more steps of decline, with intervening rallies to Minor Resistance. Sooner \nor later (and we would count on no more than three such steps in a series), we will get a \nturn and an Intermediate Recovery. We will then wait for this rally, which may itself be \nmade up of several Minor steps, to reach or approach closely the preceding Intermediate \nBottom, at which point we may look for substantial Resistance. Here is the place again to \nput out shorts.\nQuestions will come to your mind. One of them, and one of the most important: how \ndo we decide when an expected Support or Resistance has failed us, and at what point do \nwe then abandon our position?\nIt will be clear this question can be a very painful one. Let us suppose you have seen a \nstock rise to 25 and have placed an order to buy it at 23 1/2 on the basis of expected Support \nat 23, the level of a previous Minor Peak. The order is executed during a dull reaction. The \nnext day, the stock slips down to 22 1/2, on perhaps only two or three sales. The next day, \nit continues down to 21 1/2, still on low volume. Plus, during the next week, it goes down \nsteadily, without much volume, nearly every sale being at a lower price, as though no new \nbids were being received, and as though no substantial number of bids were standing on \nthe book at any point. A decline of this sort can eventually assume the magnitude of an \nIntermediate Reaction. The move may carry down to 15 before it turns. Obviously, this was \nnot what you expected, and you should be out of the stock.\nThe painful part of these drifting moves is you do not want to sell your stock (which \nyou bought at 23 1/2) on just a slight move down, say to 22 3/ 4, because the probability \nis strong it will shoot up at any moment to new high levels. Yet, at some point during a \ncontinued decline, you must decide, “This has gone through the Support; I should sell and \ntake a small loss now, rather than risk a more serious loss.” The most painful part of all is, \nsometimes, the moment you have sold and taken your loss, the stock will come to life and \ncomplete what would have been an extremely profitable move.\nYou might just as well prepare yourself for this sort of disappointment, for it will \nhappen to you. To avoid nights of pacing the floor and days of worry, you should decide, \nat the time you make the original commitment, just how much leeway you are prepared to give \nthe stock. Then you will not be tempted to put off a decision from day to day if things are \nnot going the way you hoped.\nIn the case of purchases or short sales made against Minor Peaks or Bottoms, as the \ncase may be, you might set up the following rule. Measuring from the extreme high of the \nprevious (Supporting) Minor Top, or the extreme low of the previous (resisting) Minor \nBottom, set a stop using the method we have outlined in Chapter 27 . (EN9: See also Chapter 28 \n385Chapter thirty: Use of Suppo rt and Resistance\nand consider the risk limitation procedures in Chapter 42.) This often would be the intraday high \nor low, not necessarily the closing price. Penetration to that extent should be presumptive \nevidence that your expected Support or Resistance is not going to function.\nWhere you are buying against Major or Intermediate Support, or selling short against \nMajor or Intermediate Resistance, you can allow a little more leeway for penetration. In \nsuch cases, examine the Support or Resistance Area, and estimate visually its core or axis; \nin other words, try to gauge the “center of gravity” of this area, the point is most nearly the \nmean price of sales occurring there, taking into account the volume, because the important \nthing is to determine the approximate price level at which a great many shares changed \nhands. Having determined this point, set your stop beyond it, according to the methods \nspecified in Chapter 27 .\nUp to this point we have concerned ourselves (reversing the usual order) with how to \nget out of situations that have gone bad. We have said nothing about where, precisely, to \nget in, nor where, precisely, to take profits.\nIn the matter of getting in, that is, making the original commitment, you might feel", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 186}
{"text": "ed this point, set your stop beyond it, according to the methods \nspecified in Chapter 27 .\nUp to this point we have concerned ourselves (reversing the usual order) with how to \nget out of situations that have gone bad. We have said nothing about where, precisely, to \nget in, nor where, precisely, to take profits.\nIn the matter of getting in, that is, making the original commitment, you might feel \nthere is a conflict between acting on Support or Resistance and acting on either trendline \naction or a computed reaction of 40% to 50% after a previous move. At times, these conflicts \nmight arise and it is not possible to state any exact rule that will reconcile these three \ndifferent trading indications. In a great number of cases, however, you will be delighted to \nobserve a reaction of about 45% will bring your stock to the trendline and will also bring \nit near to the Support or Resistance Level. After a move to a new Minor Top, a stock may \nbe expected to react (1) about 40% to 50% of that move, (2) to the Basic Trendline, and (3) to \nthe previous supporting Minor Top. Your purchase, then, will be based on a consideration \nof all three factors. If you have bought “early,” on the basis of one factor alone, you may \nexpect the stock to react a bit further without spoiling the triple indications to the extent \nof catching your stop. It would be best to make your purchases on the basis of whichever \nfactor indicates the smallest reaction and to place your stop beyond the greatest reaction \nindicated by any of the three. Ordinarily, there will not be too much difference between \nthese three factors. As usual, the method applies in reverse to short sales.\nIn cases in which you are buying after an Intermediate Decline or selling after an \nIntermediate Rally, you will lean somewhat more heavily on Support and Resistance than \non either a computed percentage for the Secondary Move or a trendline. You will examine \nthe history of the stock, preferably on weekly or monthly charts first, to see its Major Trend, \nto locate important Support or Resistance Areas, and to estimate roughly the extent of \nthe Corrective Move, the termination of which you are trying to gauge. You will then \ncheck these data in the more detailed picture you can get from your daily charts. As the \nIntermediate Corrective Move approaches within 4% or 5% of the Support or Resistance \nLevel, you may come to a day of extremely heavy volume, and this day may also be a \nOne-Day Reversal. If so, your commitment should be made at once and protected by a \nstop. Otherwise, you may make your commitment whenever the chart begins to hesitate \nor flatten out, or, lacking other indications, when it has come to within 3% of the Support \nor Resistance.\nIn this case, your problem in taking profits is a bit more difficult than in the case of \nMinor Moves. You are expecting a Reversal of the Intermediate Corrective Move and the \nestablishment of a new Intermediate Trend in the Primary Direction. You are at a point \nat which the course of the market is uncertain. You must realize prices may stay at the \nSupport (or Resistance) Level, forming a Line or Rectangle, and finally penetrate that level, \nestablishing Reversal of the Major Trend. However, they may be stopped and turned at the \nSupport or Resistance Level, only to make a small move away and then return for another, \n386 Technical Analysis of Stock Trends\nand possibly successful, attempt at penetration. Then again (and this is what you hope), a \ncontinuation of the Major Trend may develop with a sharp move on increased volume in \nthe favorable direction, to be followed by a Minor Corrective Move and another thrust in \nthe Primary direction—perhaps a new series of Minor Moves carrying the entire Primary \nTrend into new ground.\nTaking these cases one by one, if the stock remains at the Support or Resistance Level \nfor many days or several weeks and then penetrates that level, closing at a price that is \nclearly through it, get out at once. If the stock makes a small move in the right direction \nand returns to the Support or Resistance, prepare to get out if there is a definite penetration. \nIf, however, the move is in the right direction, watch for volume indications, and prepare \nto set tight stops to take your profits as soon as heavy volume appears (except on a day of \nbreakout). Once such a signal has appeared, you are then justified in continuing to make \nnew commitments on the following Minor Correction, and the one following that, for you \nare again moving in the Major Trend.\nOne other situation should be mentioned; up to this point, we have assumed all of your \ncommitments have been made to take advantage of a move in the direction of the Major \nTrend. Let us suppose a move that has carried a stock up to new high levels in a series of \nMinor steps proceeds to form and then breaks out of a Reversal Pattern. We must now \nlook for a Secondary Move of Intermediate extent. We may sell short on the rally to the \nMinor Resistance, and, if the move continues down, we may make a second and even (more \ncautiously) a third commitment against successive Minor Bottoms. In this case, we will be \nlooking for the decline to end somewhere in the vicinity of the last previous Intermediate \nTop, which is now a Support Level. Similarly, following a recognized Reversal Pattern \nand upward breakout on volume during a Bear Market, we may expect an Intermediate \nRally that can be used for trading up to the previous Intermediate Bottom where strong \nResistance is likely to show up. A skillful trader can turn these Secondary Moves into \nprofits during periods when it is not possible to trade along the indicated Primary Trend; \nhowever, it should be remembered, ordinarily, such moves cannot be expected to go as far \nas will those in the Primary Direction.\nWe might close this chapter by reminding you again that, although Support and \nResistance action in the Minor Trend is shown clearly in daily charts, the Int", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 187}
{"text": "econdary Moves into \nprofits during periods when it is not possible to trade along the indicated Primary Trend; \nhowever, it should be remembered, ordinarily, such moves cannot be expected to go as far \nas will those in the Primary Direction.\nWe might close this chapter by reminding you again that, although Support and \nResistance action in the Minor Trend is shown clearly in daily charts, the Intermediate and \nMajor Supports and Resistances are most easily recognized on weekly or monthly charts.\n(EN9: It seems to this editor that Magee’s discussion here of the use of Support and Resistance \nis really most pertinent to position building and pyramiding. Alternatively, the method applies to \nan issue that has just caught the analyst’s attention, and he has missed the breakout, which is \nusually obvious (at least in hindsight). I feel strongly that the serious trader should not miss the \noriginal breakout. Chasing moving trains is never a healthy activity. Does this appear an impossible \noccupation, to watch thousands of stocks? Impossible for your average analyst, but not for your \naverage computer. For example, the computer may be programmed to alert you when a stock is \ngapping on volume or trading at volumes that are suspiciously large. And given the plethora of \nservices and user groups, the trader stands a good chance of spotting an issue to put on his watch \nlist before it takes off.\nInvestors should, in theory, never miss a breakout, because they should be watching a much \nmore limited group of issues. In my opinion, these are primarily indexes and iShares. An investor’s \nportfolio might include a few well-chosen individual issues, but these would be of obvious visibility \nto the individual, for example, biotechs for an investor with some knowledge of the area, or Internets \nfor an engineer, and so on.\nThe unending effort to remove ambiguity from market interpretation extends to identifying areas \nof Support and Resistance. Metastock ( http://www.metastock.com), an excellent software package, \n387Chapter thirty: Use of Supp ort and Resistance\nhas a number of value-added packages. One of the more interesting of these, Powerstrike™ by John \nSlauson of Adaptick, Inc. (http://www.adaptick.com) attempts to mathematically define Support and \nResistance zones. Slauson’s package is interesting, and the reasoning and observation behind it are \ninteresting as well. Market analysis is rooted in one thing: the intelligent observation of the operation \nof the market. Dow watched the markets for years and came to the understanding of waves that led \nto Dow Theory. Schabacker and Edwards, equipped with these observations and comments, collated \nand observed more data and recognized the persistent patterns that occurred over and over in the \nmarkets, and added Magee for his practical engineer’s approach to solving the tactical and strategic \nquestions. In the 1980s, one of my friends, a Chicago market maker in the options pit, noticed that \nthere was a 90-second delay on data coming out of the futures pits to the options pit. He set up a \n“human ticker” with a direct phone connection to his pit and enjoyed a 90-second advantage over \nother market makers until the glitch was noticed and corrected.\nSlauson (among others) noticed that important trading and Support and Resistance in optionable \nstocks tended to cluster around important option strike price levels. In fact, these levels influence \nstock prices and may be said to determine where “important” buying and selling occur. Obviously, \nSupport and Resistance Levels are set by concentrated face-offs between buyers and sellers. A \nbattleground metaphor is appropriate: since the time of the Greeks, battles have occurred time and \nagain in the same physical locations. The reason is obvious. You need physical space to deploy an \narmy. So commanders will be attracted to the plain or open ground for face-offs and to the high \nground for defensive purposes. Option strike prices have the same attractiveness for traders that a \ngood battleground has for a military commander. A good place to test the enemy.\nPowerstrike™ analyzes the instrument price and volume around the nearby option strike prices \nand determines whether Support or Resistance is stronger. All in all, this is a clever application of \nnumber-driven analysis to the Support and Resistance question. The chart analyst may supplement \nhis analysis with a routine like this.)\n\n389\nchapter thirty-one\nNot all in one basket\n(EN: As diversification for the general investor is nowadays infinitely easier, an important endnote \nfollows Magee’s text.)\nDiversification is important because technical patterns do not always carry out their \noriginal promise. If all your capital is tied up in one stock, or in a few stocks of the same \ngroup or line of business, you may be hurt by a false move affecting only your holdings, \neven though the rest of the market may continue to hold firm or even to move farther along \nthe Primary Trend. By diversifying, you are protected by the law of averages against all of \nyour holdings going the wrong way, except in the case of some Reversal affecting the entire \nmarket or a large segment of it.\nIntelligent diversification calls for study of the costs of buying and selling stocks, \nespecially in small quantities. You might wish to have a portfolio of stocks representing \nthe entire Dow–Jones Averages, or a selection that includes at least one stock of every \nmajor group. However, if your capital is limited, this might mean buying only a half-dozen \nshares of each stock, and the minimum commission charges would make this an expensive \noperation, entirely too costly for short-term trading. The short-term trader must always \nthink of these costs. They are more important to him than to the long-term investor who \nmay intend to hold the same stock for many months or years. To you as a trader, a quarter \npoint or a half point may amount to serious proportions when it is multiplied thr", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 188}
{"text": "commission charges would make this an expensive \noperation, entirely too costly for short-term trading. The short-term trader must always \nthink of these costs. They are more important to him than to the long-term investor who \nmay intend to hold the same stock for many months or years. To you as a trader, a quarter \npoint or a half point may amount to serious proportions when it is multiplied through a \nnumber of transactions.\nYour broker can give you a schedule showing commission and tax costs, and in case \nthere are any important changes in the rates, which you should study to see what effect \nthey will have on your costs of trading in stocks at various prices. (EN: You may also evaluate \nthese charges at http://www.gomez.com and by checking websites of http://www.scottrade.com, http://\nwww.etrade.com, and http://www.tdameritrade.com. Google is, as ever, an important price-checking \nresource, and Barron’s publishes a yearly edition evaluating brokerage houses. In general, this editor \nbelieves the investor who does it the “old-fashioned way,” that is, by phone and human broker, operates \nat a disadvantage unless the broker’s value added can be quantified and proven.)\nYou will find your round-trip costs are a higher percentage of the capital invested in \nlow-priced stocks than in high-priced stocks. Also, the percentage costs will be higher on \na smaller number of shares than on a round lot and increasing as the number of shares \ndecreases. Additionally, the percentage costs rise as the total amount of capital used is less.\nIf your capital is, say $1,000 or $2,000, you might do well to divide it into units of about \n$500 each and confine your trading to odd lots of stocks selling at 40 or higher. With larger \ncapital, you could use larger trading units and extend the range of trading into somewhat \nlower priced stock. In any case, it is important to diversify your holdings. By dividing your \ncapital and using it in such a way as to avoid unnecessary penalties in high costs, you will \nhave greater protection against freak moves and sudden changes that might affect a single \nstock very seriously.\nOn the other hand, if you have sufficient capital to secure plenty of diversification (8 or \n10 stocks should be a maximum for an active trading account), you can increase the size of \nthe trading units. The whole question here is as to the minimum amounts to be invested in \n390 Technical Analysis of Stock Trends\na single commitment and, if these amounts were doubled or tripled, it would not increase \ncosts, but would, in many cases, reduce them.\nEN: diversification and costs\nIn this original chapter, Magee discussed the necessity for considering costs while striving for \ndiversification. In present-day markets, diversification may be achieved through the use of Standard \n& Poor’s Depository Receipts (SPDRs; SPY) and DIAMONDS™ (DIA) and similar instruments \n(ETFs) at comparatively reasonable costs. Index funds and mutual funds also represent diversification \nand cost control for the general investor. Mutual funds will not control costs and expenses as \nefficiently as the Index Shares and ETFs. This is because mutual funds create costs that the Index \nShares do not: management fees and expenses, slippage, the spread, turnover, and taxes resulting \nfrom realized gains. These costs may be avoided by the careful independent investor.\nAn internationally prominent trader has told me, on more than one occasion, his considerable \ntrading fortune amounts to what brokers and specialists would have made off of him if he had been \na member of the general public instead of a member of the Exchanges. The most important weapons \nin his quiver were seats in Chicago, New York, and San Francisco.\nThe message is extremely clear. The general investor must control his costs. The more frequently he \ntrades, the greater his chances of having his capital ground to hamburger meat by brokers, specialists, \nfloor traders, market makers, tax authorities, Exchanges, etc., etc., because there is undoubtedly \nanother party out there taking a chunk as the capital changes hands. The phone company maybe.\nTrading costs are the last item brokerage firms want to focus on (see the book Where Are \nthe Customers’ Yachts?). For years, the Street firms and Exchanges controlled commission costs, \nkeeping them high, but entering the Internet age a different ethos rules—cutthroat (and cut fees) \ncompetition, reluctantly brought to the old-line exchanges and brokers by upstart competitors, and \nnot suppressed by the Securities and Exchange Commission (SEC) and the Commodities Futures \nTrading Commission.\nIt would be misleading to attempt to analyze costs in this book because of the mercurial nature \nof cost figures as firms compete in the Internet age.\nThe SEC runs a mutual fund calculator for computing costs of mutual funds. Mutual funds are \namong those that manage somehow to not be overly punctilious in estimating (read, disclosing) their \ncosts to investors. Another good resource for researching mutual funds is http://www.morningstar.\ncom.\nBut let me emphasize once again that iShares and ETFs have really made mutual funds obsolete \nif the investor uses the simple procedures outlined in this book.\n391\nchapter thirty-two\nMeasuring implications in \ntechnical chart patterns\nIf you show one of your charts to a friend and tell him it looks Bullish, he will reply \nimmediately, “How far do you think it will go?” This is an automatic response; you can \ncount on it.\nThe question is a good one. How far is this expected move likely to go? You do not \nknow, nor does anyone. Very often you can say, with a fair degree of assurance, “This stock, \nwhich has just made such-and-such an advance, is likely to react to around such-and-such \na price.” That you can estimate fairly closely 7 or 8 times out of 10, by referring to the Basic \nTrendline, the parallel projection of the top trendline, or the Support Level.\nThese rules work out fairly well as applied", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 189}
{"text": "nor does anyone. Very often you can say, with a fair degree of assurance, “This stock, \nwhich has just made such-and-such an advance, is likely to react to around such-and-such \na price.” That you can estimate fairly closely 7 or 8 times out of 10, by referring to the Basic \nTrendline, the parallel projection of the top trendline, or the Support Level.\nThese rules work out fairly well as applied to reactions in the Bull Trend, and similarly, \nwe can estimate rallies in a Bear Trend. Not so with the move in the direction of the trend \nitself. A Bullish Move may, and often does, overrun the upper trendline by running up as far \nagain as the move to the trendline. A Bearish Move may exceed the downtrend, dropping \napparently without limit. (That is one reason we have protective stops—to prevent disaster \nin case the trend suddenly reverses itself.) Additionally, it is why we prefer the use of nearby \nprogressive stops as a method of taking profits, rather than using limit orders placed at a \ntrendline, Resistance Level, or at some other definite point. Very often, to be sure, a stock \nwill check its advance at one of these indicated points, but the cases in which a move \ncarries beyond its objectives are fairly common, and in such cases, no one can make even \na reasonable guess as to what limit the stock will reach on the move.\nThis follows because the move itself is an unreasonable one. It is an example of public \nparticipation, the surge of uncontrolled speculation (and, very often, it is the final surge of \nthat particular trend).\nIn exactly the same way, and often more violently, the uncontrolled falling out of trend \nin a downward move is an example of Panic, and being completely beyond reason, it follows \nno rule and knows no predetermined limits.\nThere are, however, certain patterns and certain situations in which we can make some \nestimate of the probable extent of a move in the Primary Direction—usually an estimate of \nits minimum extent. In these cases, we have a guide to help us in making the decision as to \nwhether the situation offers enough potential gain to be worth the risks involved. Also, the \nindicated measurement gives us at least a hint of about where we might reasonably begin \nto look for the volume that will indicate the Top.\nFor example, a decisive breakout from a Symmetrical Triangle is likely to carry at least \nas far as the height of the Triangle measured along its first reaction. This is a conservative \nmeasurement. The move may go much farther. In fact, the trend implications of the Triangle \nwould suggest a continuation equal to the move preceding the Triangle and leading into it, \nfor if the trend continues valid, the move should run up to the upper limit of the channel. \nIn the case of a Reversal, we would also use the height of the first reaction as a minimum \nmeasure. With Right-Angle Triangles, we also can take the long side (formed by the first \nreaction) as a rough measure of the minimum expected move.\n392 Technical Analysis of Stock Trends\nWhat is more, with Rectangles the minimum we may reasonably expect after a breakout \nis a distance equal to the height of the Rectangle. The Head-and-Shoulders Pattern carries \na good measuring stick. The height of the formation from the extreme Top of the head \ndown to the point directly beneath where the neckline crosses represents the minimum \nprobable move from the neckline down. Again, this is a matter of Trend Channels, and \nmost emphatically, this is only a minimum move. Some Head-and-Shoulders Patterns, \nrepresenting an implied move of no more than 3 or 4 points, have marked the start of a \ndecline eventually running to hundreds of points.\nThe rather unusual breakout that takes the form of an almost vertical “mast” running \nup (or down) many points before arriving at a stopping point, where some Consolidation \nPattern is made, carries with it a most explicit measuring rule, and one that works out with \namazing accuracy. The Flag or Pennant Consolidation will occur at the halfway point—“the \nFlag flies at half-mast.” The speculation move leading up to the Flag very likely will be \nduplicated by another rise, at least equal to the first, in the near future. Following this rise, \nthere may be another Consolidation and other rises, or there may not. After two surges of \nthis sort, it is best to stand back and let someone else carry the ball. If you keep enough \ncharts, and for a long enough time, you will see many perfect examples of this beautiful \nformation. You will also see some imperfect examples and some failures. And because the \nmove is so spectacularly profitable when it works out, you will be tempted to buy on every \nConsolidation Pattern formed after a sharp rise. It would be best to wait until the example \nis clear—a nearly vertical, almost unbelievable rise, followed by several days of congestion \nwith practically no volume. If the congestion continues or sags off for more than about three \nweeks, sell the stock; it is probably not the real thing.\nNeedless to say, this same pattern appears in reverse in downtrends and can be traded \non accordingly.\nThe questions relating to the measuring attributes of gaps have been reviewed in detail \nin Chapter 12. The only type of gap that carries substantial implications as to the extent of the \nmove to follow is the Runaway or Continuation Gap. The appearance of such a gap during a \nrapid price move is likely to mark approximately the halfway point; two or more such gaps \ncan be weighed, in connection with volume and total extent of the move, to estimate the \nprobable midpoint of the move and thus to predict a probable ultimate objective.\nMeasuring properties have been ascribed to other patterns and occasionally work out \naccording to plan. In general, the best measuring devices are your trendlines, Support-and-\nResistance Levels, and the all-important signals of increased volume.\nOther tools exist for measuring moves. Arthur Sklarew (see Bibliography) describes", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 190}
{"text": "idpoint of the move and thus to predict a probable ultimate objective.\nMeasuring properties have been ascribed to other patterns and occasionally work out \naccording to plan. In general, the best measuring devices are your trendlines, Support-and-\nResistance Levels, and the all-important signals of increased volume.\nOther tools exist for measuring moves. Arthur Sklarew (see Bibliography) describes \nthe-rule-of-seven, which I have often found effective. In addition, Wyckoff used PnF charts \nto measure moves and I have seen some impressive analyses produced by Professor Hank \nPruden using PnF charts.\n(EN9: I have always been extremely chary of measuring moves. If the measurement does not \nlead the trader to indulge in expectations that distract him from the crucial nature of the moment \nat hand, it might be quite all right. So, as an off-hand casual tool, it might serve some use. Always \nbetter to observe closely what the situation is when the price arrives at the measured point. Decisions \nshould always be made in the here and now, and not in the “I measured it then.”)\n393\nchapter thirty-three\nTactical review of chart action\nThe Dow Theory\n(EN: In this chapter, multiple references are made to the tight stop – 1/8 point which decimalizes to \n.125. Readers should read this as decimal.13 to.25, depending on the habits of the issue. Issues greater \nthan a dollar are quoted at two decimal places. Penny stocks can go to 4 decimal places.)\nThe record shows an investor who had bought a representative group of stocks on every \nMajor Bull Market signal according to the Dow Theory, as outlined in Chapters 3 through \n5, and sold all his stocks on every Major Bear Market signal, since the start of the Dow \nAverages, would have come out very well indeed over the years. (EN: see tables in Chapter 4.) \nAlthough this tabulation does not take short sales into account (EN9: now taken into account \nin the ninth edition), it would be perfectly consistent to add a representative group of stocks \nmight be sold short on every Major Bear Market signal and covered at the next Bull Market \nsignal. Additionally, if the figures for such short sales, based on the level of the Industrial \nAverage, were included, the total profits on these theoretical transactions, both long and \nshort, would be enormous. (EN9: Buy and Hold to 2018: $55,411.83. Dow Theory, long only: \n$795,592.01. Dow Theory, long and short: $5,757,390.17.) (For illustrations in this chapter, see \nFigures 33.1 through 33.16.)\nWe believe this record carries some weighty implications that have a bearing on the \noperations of every trader and investor. We will comment on these shortly, but before doing \nso, it should be pointed out that few, if any, investors have actually followed the long-time \nDow signals, buying or selling 100% on every Major signal.\nIn the first place, to do so would require a long market lifetime and would presuppose \nthe investor had accepted the Dow Theory in its classic form in toto from the start and he \nhad never wavered, never altered the definitions nor his method of trading, and never \nwithdrew any of his capital during the entire period.\nIn the second place, we would have to assume our ideal investor had an extraordinary \ndegree of courage to stand firm in periods during which the Major Trend appeared to be \nmaking dangerous threats against his position and an extraordinary degree of patience \nto wait out the many months of stagnation when the trend seemed to be getting nowhere \nat all.\nFinally, we would have to make the assumption the group of stocks actually bought or \nsold really represented a fair cross-section of the Averages in that they would make about \nthe same moves as the Average itself. As a matter of fact, if the group were well diversified, \nthe chances are good its moves might approximate those of the Averages.\nHowever, it is taking a lot for granted to suppose an investor could meet all of these \nconditions over a period of years, which he would have to do to operate strictly as a “Dow \nTheory” trader. It is not seriously suggested anyone try to follow any such plan literally. \n(EN: Well, in retrospect, why not? Given, in the Internet age, the availability of trading instruments \nand markets [DIAMOND™—DIA, Standard & Poor’s Depositary Receipts—SPY] it might not \n394 Technical Analysis of Stock Trends\nbe such a bad idea. The implementation of such a plan in Magee’s time would have been extremely \ncumbersome and expensive, but it is eminently practicable in modern markets.)\nThe important implications of which we spoke are these: if the record of the Averages \nshows on these Major Signals it is possible to take substantial theoretical profits over the \nlong term, and if the Averages are composed of the prices of individual stocks, then the \nprobabilities favor buying or selling a majority of stocks in line with the Major Trend of the \nAverages. The evidence shows Major Trends normally continue for months or years. The \nline of “most probable gain,” therefore, is the line of the Major Trend.\nOn this basis, we would be on safe ground to say when a trend of sufficient importance \ngives a Major Signal, the Averages are under way and there will be a greater likelihood of \nfinding profitable situations among individual stocks moving in that trend than among \nthose moving in the reverse trend.\n1946SOUTHERN PACIFICS X\n72\n68\n64\n60\n56\n52\n48\n44\nSales\n100’s\n125\n100\n75\n50\n25\nXD 1.00\nXD 1.00\nS S\nH\nS\nSH\nNL\nAPRIL MAYJ UNE JULY AUGUST SEPTEMBER\n61 32 02 74 11 18 25 18 15 22 29 61 32 02 73 10 17 24 31 71 42 12 8\nFigure 33.1 Head-and-Shoulders Top. The Bull Market that carried Southern Pacific from 8 to 70 in \nthe years 1941 through 1946 culminated in June 1946 with this formation. Notice the heavy volume \non the left shoulder, lower volume on the head, and small volume on the right shoulder. The breakout \nsignal, which was decisive on July 15, served notice on holders of long commitments to sell at the \nmarket the next day (at ab", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 191}
{"text": "lders Top. The Bull Market that carried Southern Pacific from 8 to 70 in \nthe years 1941 through 1946 culminated in June 1946 with this formation. Notice the heavy volume \non the left shoulder, lower volume on the head, and small volume on the right shoulder. The breakout \nsignal, which was decisive on July 15, served notice on holders of long commitments to sell at the \nmarket the next day (at about 63) instead of waiting for the protective stop, which would have been set \nat 61, to be caught. Volume eventually developed at the Bottom of the breakout move at about 58 1/2, \nwhich move, incidentally, carried out the minimum measure of the Head-and-Shoulders prediction.\n From this point, however, a weak rally on low volume started and continued up for four weeks. \nThe weakness of this picture would justify a short sale on a rally of 40% to 50% of the move from the \nleft shoulder to the bottom or on a return to the neckline, say, at 63. The rally actually extended to \nthe neckline at 64, broke away on a gap with volume, and continued down in a move that led, in the \nnext three months, to prices below 40, and later even lower.\n An extraordinary feature of Head-and-Shoulders Tops is the frequency with which a comparatively \nsmall formation, such as the one shown here, will herald a Major Move, changing the course of the \nstock for months or even years to come. Not all patterns of this type will lead to such big moves as \nthis, but no Head-and-Shoulders should be regarded lightly, ever.\n395Chapter thirty-three: Tactical re view of chart action\nIt is suggested you read this preceding paragraph again, carefully. It means we do not \ntry to sell stocks “at the Top” in a Bull Market. We do not try to “pick up bargains at the \nBottom” in a Bear Market. We do not deliberately buck the kind of trend that history shows \nis likely to continue for an undetermined and possibly long time.\nWhat we have said here is stated with a little different emphasis than in previous \neditions of this book. You will notice we have not said you will never sell a stock short \nduring a Major Bull Market or buy a stock in a Bear Market. There will be, and often \nare, cases of stocks moving against the Major Trend and, on the basis of their individual \ntechnical behavior, may justify a commitment against the trend of the Averages.\nBRANIFF AIRWAYSB NF\n1945\nJULY AUGUSTS EPTEMBERO CTOBERN OVEMBERD ECEMBER\nS\nS\nS\nS\nH\nH\n36\n34\n32\n30\n28\n26\n24\n22\n20\n125\n100\n75\n50\n25\n71 42 12 84 11 18 25 18 15 22 29 61 32 02 73 10 17 24 18 15 22 29\nSales\n100’s\nFigure 33.2 Head-and-Shoulders (or Kilroy) Bottom in Braniff Airways, 1945. Strictly speaking, a \nContinuation Head-and-Shoulders after a Secondary Correction in the Bull Market. A Major Bottom, \nreversing a long Bear Market, would normally take much longer to form.\n Here we see heavy volume on the left shoulder, somewhat less on the head, and very little on the \nright shoulder, with a sharp increase, as required, on the breakout move of September 21. The breakout \nwas followed by a Throwback to the neckline on diminishing volume, providing a good opportunity \nfor purchases at 23. The upward move was resumed, and again there was a reaction to the neckline \nSupport. A second reaction of this sort is not unusual. The closing at 22 3/4 on October 19, below the \nprevious Minor Bottom, and on increased volume, was mildly disturbing. But in view of the strength \nof the pattern and breakout, we would not have sold the stock, and the protective stop at 21 7 /8 was \nnot even threatened. On October 25, the advance was resumed with a Breakaway Gap and continued \nup to 29 1/2, where the move was signed off with a One-Day Reversal and Exhaustion Gap.\n Notice on reaching 29 1/2, “BNF” went into a Consolidation Pattern for more than three weeks, \nmaking an Ascending Triangle, before leaping to 37 1/2. Notice also (we might as well get all we \ncan out of these examples) the Ascending Triangle takes shape at approximately the halfway point \nof the whole advance. We are already familiar with this tendency of stocks in fast moves to form \n“halfway” patterns.\n396 Technical Analysis of Stock Trends\nWe feel such trades should be made cautiously and with a full realization the majority \nof stocks are moving in a contrary manner. Such trades might be made, for example, in \nparticular cases as indicated by the charts of the stocks involved, as partial hedges to \nreduce overall risk. For example, if a Bull Market had persisted for several years and was \nstill presumably in effect, but certain stocks had broken badly and showed individual \nweakness, a trader might continue to hold three-quarters of his capital in good long \npositions but might make a limited number of short sales in the weaker stocks. If, then, the \nASSOCIATED DRY GOODSD G\n1946\nJANUARYF EBRUARYM ARCH APRILM AY JUNE\n72\n68\n64\n60\n56\n52\n48\n44\n50\n40\n30\n20\n10\n51 21 92 62 91 62 32 92 33 0613 20 2741 11 82 51 81 52 22 916\nSales\n100’s\nFigure 33.3 Associated Dry Goods winds up its Bull Market Trend with a Rounding Top. This is a \ndaily chart for the first six months of 1946.\n The advance in “DG” from 4 to above 72 in just 3 1/2 years, when seen on monthly charts, is a \nsmooth, accelerating curve that emerged from a long Bottom Formation that had lasted five years \nfrom 1938 through 1942.\n As we enter the final six months leading up to the ultimate peak, note first the action during \nJanuary and February. “DG” had just completed a fast run-up in the last quarter of 1945 and was \nabout due for a Consolidation or a Secondary Correction. On reaching 48, it turned back to 45, \nadvanced to 50 1/2, to 51, and finally to 52, and then reacted to 44 at the end of February. Had the \nmove on January 22 gone a little lower and closed below the January 3 low, followed by an even lower \nclosing on February 26, we would have had to consider this January–February pattern a completed \nBroadening Top, a definite Reversal signal. However, the pattern was not perfect, and, therefore, n", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 192}
{"text": "advanced to 50 1/2, to 51, and finally to 52, and then reacted to 44 at the end of February. Had the \nmove on January 22 gone a little lower and closed below the January 3 low, followed by an even lower \nclosing on February 26, we would have had to consider this January–February pattern a completed \nBroadening Top, a definite Reversal signal. However, the pattern was not perfect, and, therefore, not \nvalid, but the erratic price action shows incipient weakness.\n It is not unusual in these last stages, when public participation is running high, for the climactic \nadvances to be spectacular and fast; that is what we see here. A five-point Breakaway Gap occurred \non March 25, followed by an advance that petered off at 63 1/2 reacted, and then ran up to more \nthan 68.\n From here on the move advanced slowly with suggestions of a Convergent Trend and a succession \nof “heads” and “shoulders,” and volume dropped off as the Top was reached. The drop on June 4 \nto below the May 7 Minor Bottom on increased volume would complete the Rounding Top and \ncall for immediate sale if we were still long; and the penetration of the “neckline” on June 18 was a \nconclusive break.\n397Chapter thirty-three: Tactical rev iew of chart action\nBull Market continued, he might eventually have to close out the shorts for losses, which \ncould be regarded as the reasonable cost of “insurance.” On the other hand, if the general \nweakness became greater and eventually reversed the Major Trend, then the short sales \nwould cushion the depreciation of the longs up to the time of the Reversal signal. (EN9: An \nextremely wise observation the present editor has developed at greater length in the theory of “natural \nhedging.” Given the complexity of modern markets, profits may be made on both sides of the hedge, \nand this should be the objective.)\nBy using an Evaluative Index (see Chapter 38) instead of, or in addition to, the Averages, \nit is possible to say, “The market appears to be about 60% Bullish,” or “55% Bullish,” instead \nof merely Bullish or Bearish. This takes account of the fact that some markets are more \nGREYHOUND CORP G\n1945\nJULY AUGUSTS EPTEMBERO CTOBER NOVEMBERD ECEMBER\nG\n34\n32\n30\n28\n26\n24\n22\n125\n100\n75\n50\n25\n71 42 12 84 11 18 25 18 15 22 29 61 32 02 73 10 17 24 18 15 22 29\nSales\n100’s\nFigure 33.4 Greyhound: a Rounding Bottom in 1945. A Continuation Pattern after the May run-up \nto more than 29 and reaction to Support at 24, the 1944 high.\n In July, volume ran fairly high on downside days, drying up as we entered August. August 10 \nshowed a spurt of volume on the upside, and then more dullness.\n The various small moves through August and September would not give us any basis for trading \noperations. The move to a new high in the pattern on August 31 suggested an upturn, and again on \nSeptember 19–20, we see another little push up to the 26 level—still not conclusive, however.\n The move that got under way in the week ending October 13 is more definite. This decisive move \nwith good volume carries right out of the “Bowl” in an almost vertical ascent; not a big move, but a \nclear indication of the probable trend. We would look for a point to buy “G” on a correction of 40–50% \nof the entire move up from the Bottom, or on a return to near the Support Level around 26. The \npurchase would probably be made around 26 1/2. Notice the drying up of volume on this reaction.\n The advance from here to 30, marking an entirely new Bull Market high, came almost immediately. \nOn November 3, with very heavy volume for a Saturday, “G” closed at 30; since this volume was not \non the day of breakout, we would have closed out the transaction on a tight stop at 29 7 /8 on Monday \n(unless we had elected to wait out the next Minor Reaction for a further advance).\n Two weeks later, on the basis of the reaction to good Support, we would have bought “G” again at \nabout 29 (you cannot figure on getting the extreme low price on any reaction). The following advance \ncarried up to 34 1/4 in two days. At that point, profits could have been taken or the stock held for the \nlonger term. “G,” it might be noted, continued up eventually to 54.\n398 Technical Analysis of Stock Trends\nBullish or more Bearish than others, and it enables the investor to “roll with the punch” \ninstead of having to take an all-out position one way or the other. (EN9: I have called this \n“Rhythmic Trading.”)\nIt should be noted, however, while he may take such a partial position against the \n(presumed) Major Trend, he will continue to use the bulk of his capital in situations that \naccord with the main trend. He will never risk the larger part of his assets in opposition \nto the trend, and he will make any countermoves with a clear understanding they are of \nthe nature of insurance and serve this purpose even though they ultimately may be closed \nout as small losses.\nALLIED STORES LS\n1946\nJULY AUGUSTS EPTEMBERO CTOBERN OVEMBERD ECEMBER\nS\nS\nH\nG\nS\nS\nH\nSC\nSC\n52\n48\n44\n40\n38\n36\n34\n32\n125\n100\n75\n50\n25\n61 32 02 73 10 17 24 3171 42 12 85 12 19 26 29 16 23 30 71 42 12 8\nSales\n100’s\nFigure 33.5 Symmetrical Triangle in Allied Stores, a Consolidation in the 1946 decline. Notice heavy \nvolume as “LS” crashed to the first Reversal point of the pattern on September 10, and the drying up of \nvolume during the successive swings of the Triangle. In Point-and-Figure charts, this type of pattern is \nknown as a Pendulum Swing because it does seem to come to rest like a pendulum. Often, volume will \npick up somewhat at each Reversal point, but a valid Triangle must show some overall decrease of volume.\n If, by some unhappy chance, you were then long “LS,” you should have had your protective stop \nat 33 1/8, 8% below the Bottom reached at 36. However, the move down out of the Triangle on \nFriday and Saturday, October 4 and 5, although on slight volume, was a true breakout (remember \nthat downside breakouts do not require volume confirmation), and you would have been justified in \nselling your long co", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 193}
{"text": "by some unhappy chance, you were then long “LS,” you should have had your protective stop \nat 33 1/8, 8% below the Bottom reached at 36. However, the move down out of the Triangle on \nFriday and Saturday, October 4 and 5, although on slight volume, was a true breakout (remember \nthat downside breakouts do not require volume confirmation), and you would have been justified in \nselling your long commitment at the market on Monday. You would have received about 38 1/2. To \njustify a short sale, however, the breakout would have had to close at least 3% outside the Triangle. \nThe return to the border of the pattern at 40 was interesting, and you will notice volume increased \ncharacteristically as the decline really got under way on October 9 and 10.\n No question about the validity of this breakout. Short sales were in order on a return to the border \nof the Triangle, or a 40–50% Correction of the breakout move, say, at 38 1/2 to 39. The rally carried \nto the apex of the Triangle and then broke away fast for the decline to 33, where, on October 30, a \nSelling Climax and One-Day Reversal occurred—a signal to take profits.\n Notice the small Head-and-Shoulders in August. This was a Continuation Pattern marking the top \nof the rally before the September–November crack-up.\n399Chapter thirty-three: Tactical re view of chart action\nSummarizing all these implications of the Dow Theory: do not make a majority of your \ncommitments against the Major Trend. During periods of potential Reversal, gradually \nreduce your long holdings, and make short sales to a limited amount in weak stocks; but \ndo not attempt to anticipate either a Major Top or Major Bottom in the Averages by making \nan all-out commitment counter to the main trend.\nCONTINENTAL MOTORS CMR\n1945\nJULY AUGUSTS EPTEMBERO CTOBER NOVEMBER DECEMBER\n19\n18\n17\n16\n15\n14\n13\n12\n11\n125\n100\n75\n50\n25\n71 42 12 84 11 18 25 18 15 22 2 961 32 02 73 10 17 24 18 15 22 29\nSales\n100’s\nFigure 33.6 An Ascending Triangle. “CMR,” after emerging from the doldrums in 1943, forged up \nto about 12 early in 1945. The first eight months of the year on a monthly chart showed an Ascending \nTriangle with Top at 12 1/4. On daily charts, however, we see the more detailed aspects of this \nlarge pattern. For instance, the final reaction of the whole (monthly) formation in August became \nhere a Symmetrical Triangle. The breakout from this pattern carried out the minimum measuring \nrequirements, bringing the price again to the 12 1/4 Top, from which point there was a reaction \nthat was stopped cold at 11, the apex of the Triangle. A purchase on the reaction after the powerful \nbreakout from the Triangle, say around 11 1/2, would have been closed out on progressive stops, \nstarting September 28 when “CMR” reached 14, the sale being consummated October 2 at 14 1/2, a \nhighly profitable move.\n Profit-taking of this sort would largely explain the stopping of the rise and the formation of a \nConsolidation Pattern that turned out to be the Ascending Triangle with Top at 16 1/4, lasting eight \nweeks. Notice the November 7 volume when price went through the 16 1/4 level, but failed to close \noutside the pattern, and the volume on November 30 when a clean, decisive breakout move closed \nat 17 . This move ran to 20, and purchases would have been made at 18 or less on the reaction. The \nnext wave took “CMR” to its ultimate Bull Market Top at 24 in January. On the ratio scale, the Top of \nthe Ascending Triangle was exactly halfway between the September Bottom at 11, and the extreme \nhigh of 24. This type of halfway consolidation is typical of Flags and Pennants, and this is a very \nsimilar case.\n400 Technical Analysis of Stock Trends\nHead-and-Shoulders Top\n A. If you are long a stock, should a breakout down through the neckline occur, with a \nclosing at least 3% below the neckline, next morning place a stop 1/8 point below the \nlast close. Continue to place such “tight stops” if not caught the first day, 1/8 point \nunder each day’s close until one is caught.\n B. Short sales may be made after a breakout, on a recovery of 40% of the distance from \nthe top of the right shoulder to the bottom of the breakout move, or on a recovery to \na line drawn down across the top of the head and right shoulder, or on a Pullback to \nCERTAIN–TEED PRODUCTSC T1 946\nAPRIL MAYJ UNE JULY AUGUST SEPTEMBER\n1\n2\n3\n4\n5\nB\nP\n26\n24\n22\n20\n19\n18\n17\n125\n100\n75\n50\n25\n61 32 02 741 11 82 51 81 52 22 961 32 02 7310 17 24 31 71 42 130\nSales\n100’s\nFigure 33.7 A Broadening Top. This somewhat rare but beautiful and highly dependable formation \ndeveloped as CertainTeed made its Bull Market Peak in 1946. A quick glance at the volume scale in \nthis daily chart shows the high volume on the final stages of the advance, the dullness during the \ndevelopment of the Top Pattern, and the increased volume after the breakout.\n As we all know by now (or go back to Chapter 10 and review the specifications), a Broadening Top \nis a Five-Point Reversal, differing from the Head-and-Shoulders, Triangles, Rectangles, and so on, in \nthat each Reversal must be at a new high or low for the pattern. It is, if you wish, a sort of reversed \nTriangle with its apex to the left, the swings becoming continually wider.\n In the second week of May, “CT” (the symbol has since been changed to “CRT”) made a new Bull \nMarket high at 25 1/4 (marked “1”). The reaction carried back to Support at the previous Minor Peak \n(point “2”) and the following week, “CT” advanced to another new high at 3, closing 1/8 point above \nthe previous Top.\n Another week had brought “CT” down to point “4” with a closing at 22 1/2, three-quarters of a \npoint below point “2.” This, in itself, is not sufficient reason for making short commitments. Three \nweeks later, “CT” closed at 25 5/8, another new high, at point “5.” Finally, the stock dropped to 21 \n1/2 on July 23, and at this point (marked “B”), the pattern was completed. Notice the tendency of \nvolume to rise at each Reversal point of the patt", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 194}
{"text": "with a closing at 22 1/2, three-quarters of a \npoint below point “2.” This, in itself, is not sufficient reason for making short commitments. Three \nweeks later, “CT” closed at 25 5/8, another new high, at point “5.” Finally, the stock dropped to 21 \n1/2 on July 23, and at this point (marked “B”), the pattern was completed. Notice the tendency of \nvolume to rise at each Reversal point of the pattern.\n Long holdings would be sold at the market the day after the breakout, but short sellers should \nwait for a correction of 40–50% of the move from point “5” to point “B.” If shorts were put out at \n23, we would not worry if the stock advanced for a time, as it did, without making a new high. The \ndownside move in “CT” went quickly to 15 1/2, and within 12 months to 11 1/2.\n401Chapter thirty-three: Tactical rev iew of chart action\nthe neckline, whichever point is reached first. If the breakout move continues down \nanother day, or for several days, the 40% recovery would be based on the entire move \nfrom the top of the right shoulder to the lowest point reached.\nHead-and-Shoulders Bottom\n(EN: The editor, long distressed by the paradox of the term “Head-and-Shoulders Bottom,” proposes \nthis formation be renamed in technician’s nomenclature to “the Kilroy Bottom” [see Fig u r e 7.4.])\nREMINGTON RAND RR\n1944–1945\nOCTOBERN OVEMBERD ECEMBERJ ANUARY FEBRUARY MARCH\n26\n24\n22\n50\n40\n30\n20\n10\n71 42 12 84 11 18 25 29 16 23 30 61 32 02 73 10 17 24 31 01 72 43 1\nSales\n100’s\nFigure 33.8 Rectangles in Remington Rand. This is part of a long Bull Market rise that carried “RR” \nfrom under 10 to above 50 in the period from 1942 to 1946. The last three years of this advance were \nalmost continuous, as seen on monthly charts, without any extensive reactions. When we put the \nchart on a daily basis, such as this section covering the end of 1944 and the early months of 1945, right \nin the middle of the advance, we see that the rise was not actually continuous but rather was built \nup of steps in an ascending “staircase” of Accumulation Patterns. Each sharp advance on increased \nvolume is followed by a period of dullness and slight recession.\n A picture of this type suggests the methodical campaign of buyers who intended to purchase large \nblocks of the stock for large long-term advances without creating a “skyrocket” market by their own \nbuying operations. Presumably, each advance was checked by the temporary distribution of part of \nthe stock held by such buyers, and accumulation restarted on reactions.\n In October and November, there is a well-marked Rectangle between 20 3/4 and 22. A purchase \ncould have been made at or near the bottom limit, say at 21, on the fifth Reversal on November 14. \nThe move out of pattern in the week of December 2 did not carry 3% out of pattern, but about two \nweeks later, a move got under way that qualified as a valid breakout, with volume confirmation as \nrequired on upside moves. Notice the volume increase and One-Day Reversal on December 20 as \nthis move neared its Top. Purchases would have been made at about 22 1/2 on the basis of a normal \ncorrection, and you would have expected Support at the 22 level. This Support was respected, but \nthe move did not advance beyond 23 3/4 (made this same Top three times in a period of two weeks) \nand returned again to 22 1/4.\n There was no question about the breakout on January 25. Extent and volume were decisive. Notice \nthe gap and One-Day Reversal on the following day as this Minor Move reached its end.\n In mid-March, as you will see, “RR” plunged down from its high of 27 , but the decline was stopped \nin its tracks at the top level of the January Rectangle, a good Support shelf. Never again during the \nBull Market did “RR” even threaten this level because it moved up in April and continued its long \nmarch to the 1946 Top.\n402 Technical Analysis of Stock Trends\n A. If you are short a stock, should a breakout on increased volume occur, penetrating \nthe neckline and closing at least 3% above it, place a stop next morning to cover at 1/8 \npoint higher than the close. If such a stop is not caught, continue each day to place a \nstop 1/8 point higher than the previous day’s close until one is caught.\n B. New purchases may be made after a breakout, on a reaction of 40% of the distance \nfrom the bottom of the right shoulder to the top of the breakout move (which reaction \nmust be on decreasing volume), or on a reaction to a line drawn across the bottom \nof the head and the right shoulder, or on a Throwback to the neckline, whichever is \nreached first. As in the case of the Top Formation, this 40% reaction is figured on the \nentire distance of the breakout move if it should continue up for several days.\nPARAMOUNT PICTURES PX\n1941–1943\n22\n20\n19\n18\n17\n16\n15\n14\n13\n12\n50\n40\n30\n20\n10\nSO ND JF MA MJ JA SO ND JF M\nSales\n100’s\nFigure 33.9 A Double Bottom in Paramount Pictures. Double Tops and Double Bottoms are not as \ncommon as many traders like to think. They require considerable time to develop and must conform \nto specifications as to price range and time, and also (on upside breakouts from Double Bottoms) as \nto volume. They are easier to spot on weekly charts than on dailies.\n This is a weekly chart of “PX” from September 1941 through March 1943. A Bottom was made \non climactic volume at 11 3/4 during the “Pearl Harbor Panic” Move. Then came a rise lasting eight \nweeks that brought “PX” back to 15 5/8—a rise, incidentally, on feeble volume, strongly suggesting \nthe possibility of another crack-up to even lower levels. This rise, you will notice, was a considerable \none, amounting to 35% of the price at the December low.\n The downward move, however, which lasted to mid-April, was on low volume and ended precisely \nat the December low of 11 3/4. (Note: it is not necessary moves of this sort end at exactly the same \nlevel; the second Bottom could have been a bit higher or lower without spoiling the pattern.)\n The second week in July shows the first sign of", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 195}
{"text": "ble \none, amounting to 35% of the price at the December low.\n The downward move, however, which lasted to mid-April, was on low volume and ended precisely \nat the December low of 11 3/4. (Note: it is not necessary moves of this sort end at exactly the same \nlevel; the second Bottom could have been a bit higher or lower without spoiling the pattern.)\n The second week in July shows the first sign of a possible Reversal when the price advanced on \nincreased volume, but it did not close above 15 5/8 and, therefore, was not a breakout. Two weeks \nlater, on heavy volume, “PX” had moved up to 16 1/2, closing the week at 16. This is a true breakout \nand purchases would have been in order on reactions from this point on.\n The move continued up for three years to an ultimate Top at 85.\n403Chapter thirty-three: Tactical rev iew of chart action\nComplex or multiple Head-and-Shoulders\nThe same tactical suggestions apply to these as to the simple Head-and-Shoulders. \nDefinitions and special features of these formations are covered in Chapter 7 .\nRounding Tops and Bottoms\nIt is difficult to set precise rules for trading on these gradual changes of trend. In the case of \nRounding Tops, if one is long the stock, the general appearance of a Rounding Formation, \nASSOCIATED DRY GOODSD G\n1945\nJANUARYF EBRUARYM ARCH APRILM AY JUNE\n28\n26\n24\n22\n20\n19\n18\n50\n40\n30\n20\n10\nXD .25\nXD .25\n61 32 02 731 01 72 4310 17 24 31 71 42 12 85 12 19 26 29 16 23 30\nSales\n100’s\nFigure 33.10 A Right-Angled Broadening Formation in Associated Dry Goods. A beautiful example \nof a breakout through Multiple Tops, followed by an important move. This is, however, a pattern \nthat is more fun to observe in retrospect than to follow as an active trader. The stock had moved up \nfrom an important Bottom around 4, established in 1938, 1940, and 1942. At the time of this chart in \n1945, “DG” was starting the accelerating climb that eventually ended with the 1946 Rounding Top \nat more than 70 (see Figure 33.3).\n If you had been holding the stock, you would have been watching for a substantial corrective move \nafter the advance from 12 to 20. In late February and the first week of March, “DG” went into a new \nBull Market high-ground, reacted to Support around 19 to 19 1/2, and then advanced again in the \nweek of March 17 , failing in this move to make a new high. Ten days later, “DG” had reacted to 18 \n1/2, closing below the previous Minor Bottom. An inexperienced observer, at this point, might have \ncommented “Double Top” and planned to sell “DG” at once or even to make a short sale. The pattern, \nhowever, was not large enough in duration or extent of price movement to qualify as a Double Top, \nnor did it conform to any other recognizable pattern of Reversal. Nor was the volume as high as one \nwould expect on an important Top.\n The rally in early April carried through to a decisive breakout of more than 3% in the move that \nreached 22 7 /8 on April 18. This move was a near penetration of the middle Top and confirmed the \nuptrend. If you still held your long stock, you would not rest easier, and in any case, you would \nhave looked for a chance to buy on a reaction after the breakout. If you had tried to buy at the 21 \n1/2 Support Level, you would have been left behind, but if you had put your order in a little higher, \nsay at 22, you would have had a nice profit on the advance to 25 7 /8, where you would have sold on \na tight stop at 25 3/4.\n404 Technical Analysis of Stock Trends\nextending over a period of several weeks, leveling off from the rise and then turning down, \nvery likely with a tapering off of volume nearing the top of the rise and a pick-up of volume \nas the turn starts down, would suggest getting out of the stock at the market as soon as the \npicture looks more or less definite. A short sale of a Rounding Top could be very profitable; \nbut no exact rule could be stated except, in the absence of fixed Basing Points, one would \nwant to be very certain the formation was unmistakably a Rounding Top. It would need \nto be well formed and following a long rise and extending over a period of some weeks in \nits formation. It would also need to be protected with a stop above the Top of the curve, as \nexplained in the chapter on stops.\nAMERICAN CANA C 1946–1947\nDECEMBERJ ANUARY FEBRUARY MARCHA PRIL MAY\n104\n96\n88\n50\n40\n30\n20\n10\n71 42 12 84 11 18 25 18 15 22 18 15 22 2951 21 92 63 10 17 24 31\nXD .75\nXD .75\nSales\n100’s\nFigure 33.11 A Diamond Pattern in American Can. The daily chart covers the period from December \n3, 1946, through May 1947 , inclusive. For background on this situation, keep in mind that “ AC” made \nits Bull Market Peak in October 1945 when it reached 112. The tendency of high-grade, high-priced \nstocks to top out early at the end of a Bull Market has already been noted. The first decline carried \nnearly to 90 and was followed by a rally to 106. The stock then dropped to below 80 and a second \nrally brought us to the situation we see here.\n You will notice at once the moves have a gradual “rounding” appearance, due to the fact, at this \nprice, conservative stocks do not make large percentage moves. If charted on a scale having larger \nvertical intervals, the patterns would look very much like those in more speculative stocks.\n The first part of the pattern is similar to a Broadening Top. The first Minor Peak at 96 is followed \nby a reaction to 92. The second peak carries even higher, to 98; and the reaction this time goes down \nto 91 1/4. A third rally takes “ AC” to 99. So far, we have the five Reversal points of a Broadening Top, \nneeding only a close below 91 1/4 to confirm the Bearish indications. The next decline fails to break out \nof the pattern, however, and for several weeks, we have a narrowing picture like a Symmetrical Triangle.\n Eventually, the stock makes a clean breakout to 89, which is the signal to get out of longs and to \nconsider short sales on the next rally. As a matter of fact, the three-week rally that started", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 196}
{"text": "only a close below 91 1/4 to confirm the Bearish indications. The next decline fails to break out \nof the pattern, however, and for several weeks, we have a narrowing picture like a Symmetrical Triangle.\n Eventually, the stock makes a clean breakout to 89, which is the signal to get out of longs and to \nconsider short sales on the next rally. As a matter of fact, the three-week rally that started never \nmade an upside penetration of the Resistance Level at 94, the level of the apex of the converging lines \nbounding the latter part of the Diamond.\n American Can did not make a spectacular move down from this point, which is not surprising \nconsidering the markdown that had already taken place in “ AC,” the habits and price of the stock, \nand the general condition of the market. It did not, however, again rise to the level shown here and, \nin fact, retreated to the 80 level.\n To review the nature of the Diamond—it is not a common pattern. It is somewhat like a Complex \nHead-and-Shoulders with a bent neckline. It resembles, at the start, a Broadening Top, and its latter \nphase narrows like a Symmetrical Triangle.\n405Chapter thirty-three: Tactical re view of chart action\nYou would not be likely to be short a stock on a Rounding Bottom. The long and gradual \nrounding appearance with dull volume, followed by a sudden revival on greatly increased \nvolume, would be signal enough to cover if you should find yourself in this uncomfortable \nposition. Purchases would be justified in a stock whose chart showed a Rounded Bottom \nor Saucer, after the first spasm of activity following a long, dull period of dormancy. You \nwould buy, according to the rules we have given for purchases on reactions, not on the \nbreakout, but on the reaction following it, which would almost surely come.\nGULF MOBILE & OHIO RR. GFO\n1945\nJANUARY FEBR UARY MARCHA PRIL MAYJ UNE\n30\n28\n26\n24\n22\n20\n19\n18\n17\n16\n15\n250\n200\n150\n100\n50\n61 32 02 73 10 17 24 31 01 72 43 17 14 21 28 51 21 92 62 91 62 33 0\nSales\n100’s\nFigure 33.12 Gulf, Mobile, and Ohio builds a beautiful Wedge, as shown on this daily chart for \nthe first half of 1945. This was the move that terminated the spectacular rise of “GFO,” its final Bull \nMarket Top.\n Immediately after the downside breakdown from the Wedge, “GFO” came down to 18 3/4, and \nfrom this Intermediate low, which was reached in August, rallied into a long Rectangle between 23 \n3/4 and 26 3/4 from which it eventually broke down in a series of crashes that found it, in May 1947 , \nselling for 6 1/8!\n It is rather hard, with a formation of this sort, to say at what precise point the convergence of the \ntrends is established. The breakout move late in April was normal; the stock was a buy on the next \nreaction. The following advance in May, which reached 23 1/2, did not carry out a Parallel Trend \nChannel, and we saw a tendency to converge as prices retreated on the reaction. The next three \nadvances all repeated and confirmed the Wedge picture, and at the top, we see a sort of “bunching \nup” as prices make little or no headway. The chances are at 11 an alert trader would have taken profits \non long commitments after the high volume appeared at the top of the Minor Move ending June 4 \nand 5. In any case, he would have maintained a protective stop at all times to take him out if and \nwhen a downside breakout occurred.\n406 Technical Analysis of Stock Trends\nSymmetrical Triangles\n A. If you already have a position in the stock. During the formation of a Symmetrical Triangle, \nyou may be unable to make any change in your holdings. Let us say you have bought \nthe stock on a reaction after a Bullish Move. The next upsurge fails to make a new high \nand gives no sufficient volume signal to cause you to sell out. The next reaction fails \nto carry below the previous one. You are “locked” into the Triangle, and you cannot \nsafely sell, because the Triangle that has formed may eventually break out in the \noriginal direction and show you a good profit (in fact, the odds favor that it will break \nMARTIN-PARRY MRT\n1945\nAPRILM AY JUNE JULY AUGUSTS EPTEMBER\n24\n22\n20\n19\n18\n17\n16\n15\n14\n13\n12\n11\n125\n100\n75\n50\n25\nG\nXD .15\n71 42 12 851 21 92 62 91 62 33 07 14 21 2 841 11 82 51 81 52 22 9\nSales\n100’s\nFigure 33.13 A Pennant in Martin–Parry. This type of pattern is fairly common in fast-moving \nmarkets. The extraordinary point about Flags and Pennants (and sometimes other Consolidation \nPatterns in fast moves) is their tendency to form almost exactly halfway between Bottom and Top.\n Just before this move, “MRT” had built a Rectangle between 10 and 12 lasting seven months, which \nfollowed the 1944 rise from around 4 to 12. The May breakout on heavy volume carried “MRT” right \nto the top of the Pennant without any adequate reaction. Note the increase of volume at the top of \nthat rise. For three weeks prices drifted off with a drying up of volume that is clearly shown in the \nchart. The pattern did not correct the entire first phase but found Support at the Minor Peak at 14 1/2.\n Suddenly, on high volume, the move was resumed and this time went right up to 24 3/4. The \nchances are traders who were still long their original stock or who had bought in around 15 on the \nPennant would have sold after the high volume of June 6 when “MRT” reached 19 7 /8.\n407Chapter thirty-three: Tactical re view of chart action\nout in that direction). In case of a breakout move (which must be on increased volume \non the upside), you can close it out for a profit (according to the rules for trading we \nhave already given) and immediately mark it as a rebuy on the next reaction. If the \nbreakout is down (whether or not on increased volume), with a closing outside the \nTriangle, you should protect yourself with a tight (1/8 point) stop the next day and \ncontinue to set such tight progressive stops under each day’s close until it is sold.\nIf you are short the stock, the same rules would apply in reverse, except the breakout \nin the right direction (down) would", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 197}
{"text": "ext reaction. If the \nbreakout is down (whether or not on increased volume), with a closing outside the \nTriangle, you should protect yourself with a tight (1/8 point) stop the next day and \ncontinue to set such tight progressive stops under each day’s close until it is sold.\nIf you are short the stock, the same rules would apply in reverse, except the breakout \nin the right direction (down) would require no volume confirmation while the adverse \nbreakout (up) would need such increased volume.\nLEHIGH VALLEY R . R .L V\n1945–1946\nOCTOBERN OVEMBERD ECEMBERJ ANUARY FEBRUARY MARCH\n17\n16\n15\n14\n13\n12\n11\n125\n100\n75\n50\n25\nG\nG\nG\nG\nG G\n61 32 02 73 10 17 24 18 15 22 29 51 21 92 62 91 62 32 91 62 33 0\nSales\n100’s\nFigure 33.14 This daily chart of Lehigh Valley R.R. through late 1945 and early 1946 shows a variety \nof gaps. At this particular time, “LV” was completing a Secondary Corrective Move before making \none more (and as it turned out, final) effort to exceed the 1945 Top just above 17 . This long-term \nsituation could be used for a discussion of Double Tops because the Bottom of the intervening move \nwas violated in the summer of 1946 and the stock continued a downward course to below the 5 level.\n Not all gaps are significant, as displayed in the first gap on October 3, when the stock was moving \nin a narrow range on low volume. The gap on Saturday, November 3, however, is important because \nthe Saturday volume (when doubled) is high. The move failed to qualify by a 3% new high closing as a \ntrue breakout, but the implications of the move were Bullish and might well have justified purchases \non Minor Reactions. The low-volume gaps on these reactions were of no particular interest.\n It is not until the third week of January that we see another gap that looks like a real breakaway. \nOn January 14, with high volume, “LV” moved up and out in a rush that took it to 15 7 /8 on January \n16, closing at 15 1/2. The second appearance of volume here would have suggested application of \nprogressive stops, and long trades would have been closed out at 15 3/8.\n New purchases could have been made on the reaction at 14 1/2. A second advance accompanied by \na Breakaway Gap developed on January 23. If we consider the second gap (of January 24) a Runaway \nor Measuring Gap, we would estimate the probable top of this move at around 17 3/4. When a third \ngap appeared on January 28 with a One-Day Reversal and climactic volume, it would be clear this \nmove was about finished and progressive stops would be used to clear out longs at 16 3/4.\n Note the attempt to rally after the sharp drop and the One-Day Island formed by two gaps as “LV” \nfails to hold at the 15 level.\n408 Technical Analysis of Stock Trends\n B. If you do not have a position in the stock. Stay away from any stocks making Symmetrical \nTriangles until a clear and definite breakout close has been made. After such a \nbreakout, if on the upside, buy on the next reaction if the Major Trend is up; on the \ndownside, sell short on the next rally if the Major Trend is down. Rules for making \nsuch commitments have already been given.\nNote: Avoid breakouts from Symmetrical Triangles of the type that have continued to \nnarrow until the breakout point comes far out toward the apex. The most reliable breakouts \noccur about two-thirds along the Triangle.\nRight-Angle Triangles\nThe same rules would apply to Right-Angle Triangles as to Symmetrical Triangles (see \nChapter 8, Important reversal patterns: the triangles). Early breakouts are more dependable \nhere, as in the case of Symmetrical Triangles. Volume confirmation is more important on \nupside breakouts from Ascending Triangles and is not strictly required on downside \nbreakouts from Descending Triangles. Commitments already made are retained until the \nbreakout and then closed out in the same way as any transaction that shows a gain.\nAs the Ascending and Descending Triangles carry a directional forecasting implication \nthat the Symmetrical Triangles do not have, it is possible to make new commitments on \nreactions within an Ascending Triangle or rallies within a Descending one. Since the flat \nhorizontal side of one of these Triangles represents a supply or demand area of unknown \nmagnitude, and because such a Triangle can be (and sometimes is) turned back before \nthe horizontal line has been decisively penetrated, it might be better policy to note such \nformations in the making and wait until the decisive breakout before making the new \ncommitment.\nBroadening Tops\nPresumably, you would not be long a Broadening Top. The early Reversals in the pattern \nwould have taken you out of the stock, if you follow the tactical rules based on trendlines, \nas previously outlined, long before completion of the pattern. Neither would you be \ntempted to buy into such a pattern because the trend indications would be clearly against \na move.\nOn the other hand, a Broadening Top, after its completion, offers excellent opportunities \nfor a short sale. After downside penetration and a close below the fourth point of Reversal \nin the pattern, you are justified in selling short on a rally of about 40% of the distance \ncovered from the extreme top (fifth point of Reversal) and the lowest point reached on the \nbreakout move. The stop would be placed at the proper distance above the fifth Reversal, \nthat is, the extreme top of the pattern.\nRectangles\n A. If you already have a commitment in the stock. The early moves of a Rectangle may provide \nno volume signals to permit you to get out. There will be no “breakout” moves during \nthe formation of a Rectangle that will allow you to take a profit. However, as soon \nas the character of the Rectangle is well established (which requires at least four \nReversals to set up a clear Top and Bottom), you may trade on the Tops and Bottoms—\nthat is, sell at or near the Top, or buy at or near the bottom. For, as in the case of \n409Chapter thirty-three: Tactical rev iew of chart action\nSymmetrical Triangles,", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 198}
{"text": "angle that will allow you to take a profit. However, as soon \nas the character of the Rectangle is well established (which requires at least four \nReversals to set up a clear Top and Bottom), you may trade on the Tops and Bottoms—\nthat is, sell at or near the Top, or buy at or near the bottom. For, as in the case of \n409Chapter thirty-three: Tactical rev iew of chart action\nSymmetrical Triangles, there is a definite presumption in such formations that they \nare more likely to lead to continuous moves than to Reversals, this would mean you \nwould probably pass up your first opportunity to get out (on the fifth Reversal) and \nwould indeed probably decide to “ride along” in the expectation of a continuation \nof the original move, which will be in the “right” direction for your commitment. In \nthe case of a breakout in the right direction, you would dispose of your commitment \naccording to the rules for trading already stated. If in the wrong direction, use the \ntight (1/8 point) progressive stops, the same as with the Triangles.\n B. If you are not committed in the stock. Trades can be made within the Rectangle on the \nfifth and subsequent Reversals. Due to the slight probability, the move will eventually \ncontinue in the same direction as the preceding move leading up or down to the \nRectangle; thus, it might be best to wait until the sixth Reversal for new commitments, \nwhich would set your interests in the same direction as a continuation. Also, short \nsales can be made after any downside breakout close from a Rectangle or purchases \nafter an upside breakout close with increased volume. Both the short sales and the \nlong purchases would be made on the Corrective Move following the breakout.\nDouble Tops and Bottoms\nDouble and Multiple Tops or Bottoms are not valid unless they conform to the requirements \nfor such formations. Chapter 9 on these patterns should be read carefully in this context.\n A. If you are long a stock. On penetration and close at a price lower than the extreme \nBottom of the pattern between the Multiple Tops, dispose of the stock on tight (1/8 \npoint) progressive stops.\n B. If you are short a stock. On penetration of the highest point of the Inverted Bowl or rise \nbetween the Bottoms, with a close above that point, close out the short sale on tight stops.\n C. If you are not committed in the stock. Consider a penetration and close beyond the limit \nof the correction between the Tops (or Bottoms) as a signal of Reversal and make new \ncommitments on rallies or reactions.\nRight-Angled Broadening Formations\nThe handling of these on breakouts through the horizontal side would be similar to what \nhas been said about Multiple Tops and Bottoms, and Right-Angle Triangles.\nThe Diamond\nIf you are sure what you have is a valid Diamond Pattern, the rules for trading will be the \nsame as those we have already covered in connection with breakouts from Symmetrical \nTriangles. As in the case of such Triangles, new commitments should wait for a definite \nbreakout. Commitments already in force would have to remain until such a breakout \nhad occurred, either declaring a Reversal or indicating a probable continuation of the \noriginal trend.\nWedges\nThere is no need to set forth detailed rules for policy within a Wedge and during its \nformation because the general principles taken up in connection with trendlines and \n410 Technical Analysis of Stock Trends\nSupport and Resistance would take you out of such a situation at the first opportunity after \nthe convergent nature of the pattern became clear. At the very worst, your stops (which we \nhope you maintain faithfully in all situations) will take you out before the consequences \nbecome serious.\nRegarding new purchases (from a Falling Wedge breakout) or short sales (from a Rising \nWedge), the same volume characteristics would be expected: notably increased volume on \nan upside breakout from a Falling Wedge and less pronounced volume action on the first \nstages of breakout from a Rising Wedge. New commitments, in line with the implications \nof the breakout, may be placed on rallies or reactions after a clear breakout closing occurs, \ncarrying beyond the trendlines forming the Wedge.\nOne-Day Reversals\nOne-Day Reversals are not technical patterns suitable for trading in the same sense as \nthe important Reversal and Consolidation pictures we have examined. They are mainly \nuseful as a gauge in helping to find the precise Top or Bottom of a Minor Move to protect \nprofits on commitments previously made. The One-Day Reversal, the Exhaustion Gap, and \nthe day of exceptionally heavy volume following several days of movement in a Minor \nTrend are strong indications that the move may have run out. Any of these three signals is \nworth watching for; any two of them together carry more weight than one alone; and the \nappearance of all three carries very strong implications of a Minor (EN: or even a Major) \nTop or Bottom.\nRegarding trading on movements signaled by One-Day Reversals, this type of trading \nwould lie almost in the field of gambling, or at least trading for quick, small profits on short \nmoves. It would not be the same kind of trading at all that we have been studying in the \ngreater part of this book. The indications and some suggestions for trading on those one-\nday moves are covered in their discussion in Chapter 10.\nFlags and Pennants\nIn many cases, the total decline from a Flag in an uptrend will bring the price back to a \npoint at which the stock may be bought according to our regular trading tactics, namely, \nthe decline may carry down to the Basic (Red) Trendline, to the Blue Parallel, or make \na 40% to 50% correction of the rising “mast” preceding the Flag. If the “mast” move is \nthe first such move out of a level or only moderately rising trend, and if the Major Trend \nof the market is Bullish, we would be justified in buying at the first opportunity, which \nwould be on the Blue Parallel. In such a case we would expect, and ordinarily ge", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 199}
{"text": "(Red) Trendline, to the Blue Parallel, or make \na 40% to 50% correction of the rising “mast” preceding the Flag. If the “mast” move is \nthe first such move out of a level or only moderately rising trend, and if the Major Trend \nof the market is Bullish, we would be justified in buying at the first opportunity, which \nwould be on the Blue Parallel. In such a case we would expect, and ordinarily get, some \nfurther reaction, but it is important to get in early because sometimes the reaction is \nvery brief and does not meet either of the other requirements for the correction. It is \nmost important in a situation like this that the volume drop off sharply. Volume must \ndecrease and remain slight; any increase of volume during the formation of the Flag \nshould be reviewed as casting suspicion on the entire pattern, except the increasing \nvolume that characteristically attends the start of the breakout drive. This drive is \nusually so virile that we would be safe in placing a tight (1/8 point) stop under the \nclose of any day during formation of a Flag or Pennant that showed notably increased \nvolume. Hence, if the volume indicated failure of the pattern, we would be taken out at \nonce; but if the breakout was under way, we would probably be left in because the stock \nwould ordinarily move up then without a reaction, very often making a Breakaway \nGap.\n411Chapter thirty-three: Tactical re view of chart action\nIn downward movements, when the Major Trend of the market is Bearish, the same \nsuggestions would apply, with one difference. The final high day of the Flag type of rally \nmay be on high volume and also may show the Exhaustion Gap or One-Day Reversal. If a \nshort sale has been made into such a day showing high volume, gap, or One-Day Reversal, \na stop order placed above the peak of the Flag will protect you should the advance be \nresumed unexpectedly.\nIn either the up-moving or down-moving manifestations of this type of action, there \nmay be Flags having horizontal Tops and Bottoms, which are Rectangles. If the drying-up \nof volume and other aspects of the picture, including the sharp upward or downward \nmove preceding it, suggest a Flag-type Consolidation, you would be justified in making \na commitment on the sixth Reversal point, or for that matter, at almost any point in the \npattern (because you cannot expect this pattern to continue very long).\nFlags and Pennants continuing too long (more than three weeks) are open to question. \nStops should then be set at the usual computed distance above or below their extreme Tops \nor Bottoms (as the case may be). The fairly frequent appearance of Flag-like Formations that \neventually fail is unfortunate because it is particularly hard to give up hoping with this \nkind of pattern, and it is necessary to set the three-week time limit to prevent the stock \nfrom drifting all the way back to previously established stop levels. On the other hand, \nbreakout moves from these patterns, when completed normally, are among the fastest and \nmost profitable forms of market action.\nThe question remains what to do in the case of stocks you may be holding as they \ngo into Flag or Pennant Formation. Obviously, they should be held if you are long and \nthe move leading to the Flag is up; or short positions should be retained if the move is \ndown. This would not happen ordinarily, however, if you had followed the trading rules \nstrictly. In most cases, your signals calling for tight (1/8 point) progressive stops would have \nappeared during the formation of the “mast.” You would have been taken out of the picture \nsomewhere along the way, possibly at the extreme top of the mast (although ordinarily, you \ncould not count on being so fortunate).\nIf no signal should appear and you still are holding a position as the Flag starts to \nmake its appearance, by all means hold your position. The odds favor a continuation of the \noriginal move.\nNow, if you have been holding the stock long (in a Bull Market) and have seen it break \nout and start leaping to new highs, say from 20 to 32, and you have been stopped out at \n30, and then you see the price advance, halt, and during the next several days retreat, with \nthe rather high previous volume drying up to practically nothing (it must be a drastic \ndrying-up, and no mistake about it), then you are justified in buying right back in again, \neven at a higher price than you received only a few days before.\nGaps\nIf you are long a stock that is in a well-marked pattern formation, or in an area of dull \nmovement within fairly narrow limits, and the stock suddenly breaks out on the upside \nwith high volume and a gap, that is a Bullish indication. You will hold the stock until signs \nof exhaustion appear as the rise continues, or reappearance of high volume, or another \ngap or One-Day Reversal. Then, particularly if two or all three of these indications show \nup at the same time, you can protect your commitment with tight progressive stops. You \nwill have to consider whether a second gap should be considered an exhaustion gap or a \ncontinuation gap, depending on the volume and the speed of the rise, as discussed in the \nchapters on gaps and their measuring implications.\n412 Technical Analysis of Stock Trends\nOrdinarily, after a Breakaway Gap, regardless of whether you sell on the next Minor \nTop, you would consider the move Bullish and would prepare to make a purchase on the \nnext reaction.\nNow if you are long a stock and during the course of a sharp rise it develops a gap \nafter several days of the move, you must make your decision as to whether or not it is a \nContinuation (Runaway) Gap. If so, you would prepare to hold the stock for a further rise \napproximately equal to the rise up to the gap. You would watch the approach to the ultimate \nobjective indicated very closely; on the appearance then of Reversal signals, you could \nprotect your holding with tight stops.\nNORTHERN PACIFICN P\n1944\nAPRILM AY JUNEJ ULYA UGUSTS EPTEMBER\n19\n18\n17\n1", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 200}
{"text": "or not it is a \nContinuation (Runaway) Gap. If so, you would prepare to hold the stock for a further rise \napproximately equal to the rise up to the gap. You would watch the approach to the ultimate \nobjective indicated very closely; on the appearance then of Reversal signals, you could \nprotect your holding with tight stops.\nNORTHERN PACIFICN P\n1944\nAPRILM AY JUNEJ ULYA UGUSTS EPTEMBER\n19\n18\n17\n16\n15\n14\n125\n100\n75\n50\n25\n81 52 22 96 13 20 27 31 01 72 41 81 52 22 95 12 19 26 29 16 23 30\nSales\n100’s\nFigure 33.15 This daily chart in Northern Pacific, covering six months during 1944, shows several \nexamples of Support and Resistance. The entire chart covers only part of the series of Consolidations \nthat took place in 1943 and 1944 preceding the 1945–1946 advance that carried beyond 38.\n Support and Resistance phenomena appear on many, in fact, on most of the charts in this book, and \nyou will find them on the charts you set up for yourself. There is nothing unique or even unusual \nabout the Support–Resistance action in “NP .”\n Starting at the left in April, after the downside move on volume to 14 1/4, notice the recovery to 15 \n5/8 where the move stops at the Resistance Level of the preceding two weeks. After the formation \nof the Symmetrical Triangle, there is a breakaway move with a gap that runs right on up to above \n17 , where a small Rectangle is built during the next three weeks. The stock ultimately breaks down \nfrom this pattern on considerable volume. It is doubtful whether one would want to trade on this \nas a normal reaction after the breakout from the Triangle because of the downside volume and the \nimplications of the Rectangle.\n Note, however, how the reaction stops cold at the 15 line, the apex level of the Triangle, and then \nmoves right on up. Rather surprisingly, there is only a three-day hesitation at the Bottom of the \nRectangle, but a little setback occurs at the Top of that pattern.\n The July Top might be classed as a Head-and-Shoulders or Complex or Rounding Top; in fact, it is \nalmost a Rectangle, and after the downside breakout, prices hesitate at the level of the Top of the May \nRectangle, continue down, find temporary Support again at the April Support Shelf around 16, and \nultimately wind up a bit under 15. Although “NP” actually did penetrate and close slightly below \nthe apex of the Triangle, the violation was barely 3%, and it is interesting to note this September \nBottom was the lowest point reached. From here, the stock started its climb to the 38 level, which \nwas reached in December 1945.\n413Chapter thirty-three: Tactical re view of chart action\nIf you are satisfied a gap following a good rise is actually an Exhaustion Gap, then you \nshould protect your stock with a tight progressive stop at once.\nIn Bear Markets, you would apply these same rules in reverse to your short sales, \nremembering a downside breakaway is not necessarily accompanied by the high volume \nyou expect on an upside breakaway.\nWhere you are long or short a stock that is moving in a Pattern Formation and the stock \nthen makes a Breakaway Gap in the adverse direction, the commitment should be closed \nout immediately at the market, or on tight progressive stops.\nAMERICAN STEEL FOUNDRIESF J\n1947\nMARCHA PRIL MAYJ UNEJ ULY\n38\n36\n34\n32\n30\n28\n26\n50\n40\n30\n20\n10\nXD 50C\nXD 50C\n81 52 21 81 52 22 9512 19 26 31 01 72 43 17 14 21 28 5 12 19 26 2\nSales\n100’s\nFigure 33.16 Trendlines in American Steel Foundries. This daily chart shows the tendency of \ntrendlines to develop along straight channels. We have already pointed out that these channels \nare frequently easier to see in retrospect than during their formation, that stocks move in perfect \nchannels only occasionally, and that all channels come to an end, frequently without warning. In \nthis case, the long trend channel does give a warning of Reversal.\n In 1946, “FJ” had declined from 48 to a Support Level of 30. From here it rallied for three months \nin a Trend Channel that brought us to the February Top at 37 . The next decline broke the previous \ntrend, and volume developed at the bottom of this break. If you will follow the entire chart, you \nwill notice volume nearly always shows an increase at the points of Reversal, which are also usually \npoints of contact with the Trend Channel. Notice also the way the Corrective Rallies tend to stop at \nor near the previous Minor Bottoms in the downward trend, and how reactions tend to stop at the \nprevious Minor Tops in the upward trend.\n Trading on this situation would have been profitable. The Secondary Intermediate Rally up to \nFebruary approached the Resistance Level marked by a 1946 Bottom around 40, and a correction \nof the drop from 48 to 30 would indicate short sales around 37 (which objective was just barely \nreached). Such sales, if made, would have been covered after the first drop (week of March 1) around \n33 1/4. New shorts at 34 1/2 would have been closed in the week of March 15 at about 31 1/2. Shorts \nmade on the rally of the March 22 week around 33 would be covered in the week of April 19 at 30. \nIf shorted again, the same week at 31, the sale would have been covered after the Climactic Bottom \nin the week of May 24. The combination, here, of great volume and a One-Day Reversal would have \nwarned against further shorts.\n The Rising Channel, being a Secondary, presumably of limited extent, would not offer any great \ninducement to long-side trading in the absence of other good reasons.\n414 Technical Analysis of Stock Trends\nSupport and Resistance\nWhen you are long a stock, you do not want to see it violate any Minor Bottoms previously \nmade. Neither do you want to see it violate any of the preceding Minor Tops that it has \nsurpassed. Therefore, your stop orders will be placed at a computed distance, as explained \nin Chapter 27 on stop orders, using both the Minor Bottoms and the Minor Tops as Basing \nPoints. Normally, the Minor Bottom most recently formed will be at the approximate level \nof", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 201}
{"text": "iolate any Minor Bottoms previously \nmade. Neither do you want to see it violate any of the preceding Minor Tops that it has \nsurpassed. Therefore, your stop orders will be placed at a computed distance, as explained \nin Chapter 27 on stop orders, using both the Minor Bottoms and the Minor Tops as Basing \nPoints. Normally, the Minor Bottom most recently formed will be at the approximate level \nof the preceding Minor Top, so that these Basing Points often will coincide. Ordinarily, \ntherefore, in a rising trend, we look to the most recently formed Minor Bottom. When the \nstock has, for three days, made a price range that is entirely above the entire range of the \nday marking this Bottom, you may move up your stop protection to a place indicated by \nthis new Basing Point.\nThe same procedure will apply in Bear Markets; the “three-days-away” rule being \nused to confirm Basing Points established by Minor Peaks and also by the preceding Minor \nBottoms. Ordinarily, it will be sufficient to use the Minor Peaks as Basing Points.\nIntermediate Tops and Bottoms are used in determining the probable objectives \nof Intermediate Moves because previous Tops constitute Support under Intermediate \nReactions, and previous Bottoms indicate Resistance over Intermediate Rallies.\nMultiple Tops are Support Levels. Multiple Bottoms are Resistance Levels. The neckline \nof a Head-and-Shoulders Pattern is a Support or Resistance Level, as the case may be. The \napex of a Symmetrical Triangle is a strong Support and Resistance point that may show its \neffect again on a subsequent move. Any congestion or area at a certain price level or within \nnarrow price limits may provide Support or Resistance when a stock moves again to that \nprice or range.\nTrendlines\nWe have already gone into the methods of following trends in stocks, and the use of the \nTop and Bottom Trendlines (Basic and Return Lines) as indicators of Bullish and Bearish \nopportunities, and as price determinants for executing purchases or short sales.\nThere remains the tactical problem of the stock in which you are committed, which \nis acting badly, but which has neither broken out of a recognized pattern nor violated an \nestablished Minor Peak. This is not a common situation, but it can present a very difficult \nproblem when it does come up. Let us say the Major Trend is Bullish, and a certain stock \nthat has been moving up irregularly in a Parallel Trend Channel confirms its uptrend by \na long, more or less continuous advance and calls for repurchase on the next reaction. You \nbuy on the reaction, and the stock continues down; namely, the reaction continues with \nprices sagging for days and weeks, without any rallies, Consolidations, or Corrections that \nare sufficiently well-defined to serve as Basing Points for stop orders.\nIn the absence of clear indications during the reaction, and also during the preceding \nlarge upward move, your stop would be placed at a computed distance below the top of the \npreceding rise. Plus, if the reaction continues down until that level is reached, you will have \nsustained an abnormally large loss.\nIn a case like this, you should examine the trendlines making up the long advance \nin the Trend Channel. The points of contact with the Basic Trendline can serve as a fair \nemergency substitute for Minor Bottoms. Your stop level, therefore (in the absence of more \ndefinite Basing Points), should be placed at the computed distance below the last point at \nwhich the stock made contact with the bottom trendline and moved decisively up away \nfrom it. If a penetration and close below this point occurs without catching the stop, sell on \n415Chapter thirty-three: Tactical re view of chart action\ntight progressive stops. (EN: The editor feels that such situations should occur only in position-\nbuilding or pyramiding cases. Every effort should be made to join trends on breakout or origination, \nwhatever the source. There is no excuse for “chasing stocks” in the modern environment in which \nliterally monitoring all stocks and instructing the system to alert one to the conditions attending \nbreakouts is possible with a computer. EN9: On the other hand, human frailty being what it is, we \nwill all find ourselves chasing a train at some time or other.)\nThe reverse of this rule would apply to the same type of situation in a Bear Market, \nwhere stops for short sales would be placed at the computed distance above the point at \nwhich the stock made contact with and fell away from the upper trendline.\nThe changes of angularity and direction in Intermediate trendlines are helpful in \nshowing the gradual turning of a Major Trend.\n\n417\nchapter thirty-four\nA quick summation of tactical methods\nThere are three types of tactical operations: (1) getting into new commitments; (2) getting \nout of commitments that have moved as expected and show a profit; and (3) getting out of \ncommitments that have not moved as expected, whether the transaction shows a profit or \na loss.\nThe principles of taking profits based on trends, Resistance and Support Levels, \nmeasuring implications of patterns, and most especially, on the daily technical and volume \naction of the stock, already have been covered. These profit-taking operations seldom \npresent very difficult problems because the picture has developed normally and in the way \nyou hoped and expected it would. The “stepping off” point is usually easy to determine.\nThe more difficult problems arise in making new commitments correctly, and in the \nvery important defensive operations of getting out of losing commitments with the least \npossible loss.\nIt should be emphasized that a stock ceasing to act in a Bullish manner should, \ntherefore, be sold and is not necessarily a short sale on the next rally. In other words, the \nsignal that shows weakness or failure of a move in one trend is not always a signal to make \nnew commitments on the opposite side of the market. More often than not, in fact, it is \nnothing of the kind", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 202}
{"text": "least \npossible loss.\nIt should be emphasized that a stock ceasing to act in a Bullish manner should, \ntherefore, be sold and is not necessarily a short sale on the next rally. In other words, the \nsignal that shows weakness or failure of a move in one trend is not always a signal to make \nnew commitments on the opposite side of the market. More often than not, in fact, it is \nnothing of the kind.\nWe know certain moves, such as adverse breakouts from Symmetrical Triangles or \nRectangles, advise us simultaneously to get out of commitments in what is now clearly \nthe “wrong” direction and to make new commitments in the “right” direction. The simple \nfailure of a trendline, however, where the stock merely penetrates an old Minor Bottom \nwithout completing a Head-and-Shoulders or other Reversal Pattern, although reason \nenough to get out of commitments that are showing losses, is not sufficiently conclusive by \nitself to justify reversing policy and making new commitments in the opposite direction. \nTherefore we separate the two types of signals as follows:\nGet out of present commitments\n• On adverse breakout from Head-and-Shoulders Formation.\n• On adverse breakout from Symmetrical Triangle.\n• On adverse breakout from Rectangle.\n• On establishment of new Minor low or new Minor high in adverse direction.\n• On adverse breakout from Diamond.\n• On adverse breakout from Wedge.\n• On One-Day Reversal if marked by heavy volume or a gap.\n• On adverse breakout from Flag or Pennant.\n• On clear penetration of any Resistance or Support Level in the adverse direction.\n• On an adverse Breakaway Gap.\n• On the appearance of an Island after a move in the favorable direction.\n• On penetration of basic trendline in the absence of pattern or other favorable criteria.\n418 Technical Analysis of Stock Trends\nNote: It is understood all breakouts must close in the breakout area. A closing 3% beyond \nthe Support, trend, or pattern is sufficient to give the danger signal. All takeouts are \nperformed by the use of 1/8-point progressive stops.\nMake new commitments\n• In line with the Major Dow Trend, or to a limited extent in countertrend, moves as \ninsurance to reduce overall risk.\n• On breakout from Head-and-Shoulders Pattern.\n• On breakout from Symmetrical Triangle, provided it is not working into the final third \nof its length toward the apex.\n• On breakout from Right-Angle Triangle.\n• On breakout from Rectangle, or (possibly) on points of contact, beginning with the \nsixth Reversal.\n• On breakout from a Broadening Top.\n• On breakout from Double or Multiple Top or Bottom. (Namely breakout through the \nBottom of the valley between Tops, or upside penetration of the “dome” between \nBottoms.)\n• On breakout from Wedge, or (possibly) commitments within the Wedge in the last \nthird of its length as it approaches its apex.\n• On Flags and Pennants, after sufficient Secondary or Corrective Move by the pattern, \nor (possibly) within the pattern, provided volume and all other indications tend \nstrongly to confirm the pattern.\n• On clear penetration of a well-defined Support or Resistance Area.\n• On Breakaway Gap (possibly).\n• After formation of an important and well-defined Island following a considerable \nmove.\n• On contact with, or penetration of, the “favorable” trendline if both trendlines are \nmoving in the Major Trend direction. (Blue Top Trendline in a Bull Market, Red \nBottom Trendline in a Bear Market.) Note: Breakouts and penetrations must show \na closing in the breakout area and must conform to volume requirements. Breakout \nclosings should conform to the 3% rule.\nNew commitments (marked “possibly”) may be made in certain cases within some \npatterns: Rectangles, Wedges, Flags, and Pennants. Exceptional care should be used in \nsuch cases.\nIt is extremely difficult to catch Breakaway Gaps; we would not recommend this \nas a general practice. (EN: This is not so difficult as it was in Magee’s time thanks to modern \ncommunications, computers, and access to the internet.)\nAll commitments, except those just noted, are made on the next following reaction or \nrally, to rules previously stated.\nAll commitments are protected by stops from the moment they are made. Stops are \nmoved, as conditions justify moving them, but always in the favorable direction, never in \nthe adverse direction.\n419\nchapter thirty-five\nEffect of technical trading \non market action\nThe question often is asked whether the very fact that traders are studying methods and \npatterns tends to create those very patterns and trends—in other words, whether the \ntechnical method sets up, to some extent, an artificial market in which the market action is \nmerely the reflection of chart action instead of the reverse.\nThis does not seem to be true. The charts we make today seem to follow the old patterns; \nthe presumption is very strong that markets have followed these patterns long before there \nwere any technicians to chart them. The differences mentioned briefly in Section I, due to \nchanged margin requirements, restraining of manipulative practices, and so on, seem to \nhave changed these habits, if at all, only in degree and not in their fundamental nature.\nThe market is big, too big for any person, corporation, or combine to control as \na speculative unit. (EN9: And even beyond big in the twenty-first century. Gargantuan.) \nIts operation is extremely free and extremely democratic in the sense it represents the \nintegration of the hopes and fears of many kinds of buyers and sellers. Not all are short-\nterm traders; there are investors, industrialists, employees of corporations, those who buy \nto keep, those who buy to sell years later—all grades and types of buyers and sellers.\nWhat is more, not all short-term traders are technicians by any manner of means. \nThere are those who trade on fundamentals for the short term, and those who rely on tips, \nhunches, on reading the stars, or on personal knowledge of the company. They are all part \nof the competitive market", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 203}
{"text": "ations, those who buy \nto keep, those who buy to sell years later—all grades and types of buyers and sellers.\nWhat is more, not all short-term traders are technicians by any manner of means. \nThere are those who trade on fundamentals for the short term, and those who rely on tips, \nhunches, on reading the stars, or on personal knowledge of the company. They are all part \nof the competitive market and all use methods different from yours—and sometimes they \nwill be right and you will be wrong.\nThe technician using the various tools of technical analysis, Dow Theory, Point-and-\nFigure charts, oscillators, scale order systems, and monthly, weekly, and daily charts is \nin the minority. The cold attempt to analyze a situation on the basis of the market record \nalone does not appeal to many people. Technical analysis leaves out the warmth and human \ninterest of the boardroom, the trading room, the fascinating rumors of fat extra dividends \nto come, the whispered information on new patents, and the thrilling study of the quarterly \nearnings reports. (EN9: Unless I am mistaken the only appearance of irony in Magee’s work.)\nIt is the influence of all these rumors, facts, and statistics that causes people to buy \nand sell their stocks. It is their actions that build the familiar chart patterns. You are not \ninterested in why they are doing what they are doing. So far as your trading is concerned, \nyou are interested only in the results of their actions.\nThe habits and evaluative methods of people are deeply ingrained. The same kinds of \nevents produce the same kinds of emotional responses, hence, the same kinds of market \naction. These characteristic approaches are extremely durable. It is not quite true that “you \ncan’t change human nature,” but it is true it is very difficult to change the perceptive habits \nof a lifetime. Considering the “orthodox” investors greatly outnumber the technicians, \nwe may confidently assume technical trading will have little or no effect on the typical \nbehavior of free markets.\n420 Technical Analysis of Stock Trends\n(EN: This statement by Magee is still true in principle and it should be noted in modern markets \nprofessional investors attempt to learn (or perhaps it is “the mysterious and anomalous market”) \nwhat makes systems and other investors successful. They then take action to frustrate those methods, \nwhich are inimical to their self-interest. For example, locals and professionals will search for stops \nabove a congestion zone in an attempt to cause the market to break away. This might be in an attempt \nto create a trend or it might be in an attempt to create a Bull trap.\nThe proliferation of systems trend traders in the futures markets has, some of those traders feel, \ncreated conditions hostile to systems traders as a group. The moral of the story is the trader–investor \nmust be ever alert for the false move and the changing rhythm of the markets.\nNo one has been able to quantify chart analysis or to disguise his own activities from the x-ray of \nthe charts. Nor has anyone changed human nature to eliminate treachery and perfidy and truculent \ndefense of self-interest.)\n(EN9: And—dramatic drum roll—in 2005, Smith-Barney fires its entire technical analysis staff. \nWhat to make of this is left to the imagination of the reader. Some commentators attribute it to the \nBearish outlook of the technical staff as opposed to the need of the firm to sell long positions to its \ncustomers. In my view, an unintended validation of the craft. When you have to shoot the messenger, \nit says something about the state of the market, as well as something about the industry.\nAlso, in conversation at a meeting of the Technical Securities Analysts Association of San \nFrancisco (http://www.tsaasf.org), Larry Williams said, “I hate technical analysis.” I am reasonably \ncertain the “technical analysis” referred to is number-driven analysis.)\n421\nchapter thirty-six\nAutomated trendline: the \nMoving Average\nIn 1941, we were still filled with starry-eyed ignorance and felt if only we worked hard \nenough and looked shrewdly enough, we would discover the sure, unbeatable formula or \nsystem that would solve all our problems in the stock market, and all we would have to do \nfor the rest of life was apply the magic and telegraph our broker periodically from Nassau, \nor Tahiti, or Switzerland, or wherever we happened to be enjoying life at the time.\nWe have learned (we hope) quite a bit since then. We have learned most particularly a \nnumber of things not to do and by not repeating the same errors over and over, we have \nbeen able to improve our performance substantially. We have also learned (to date) (EN: \nstill true in the twenty-first century) there are no sure, unbeatable formulas or systems in \nthe market, even the most useful and generally dependable forecasting methods must be \nregarded as statements of probability only, subject to revision and vulnerable to failure at \nall times.\nOne of the useful tools, and one of the first many students of market action adopt, is \nthe trendline. Whether a stock is moving generally up or down or sideways, there seems \nto be a tendency for the Major Trend to persist. It is true every trend is broken sooner or \nlater, and the fact that it has been broken is often significant. But given a well-established \ntrend, the probabilities certainly appear to favor its continuance rather than its Reversal.\nAs with all other market studies, however, there are times and conditions in which the \nsimple trendline action seems “not quite good enough.” One feels there should be some \nmechanical or mathematical way of determining the trend that might avoid some of the \nperplexities of choosing the right point through which to draw a trendline. It was back in \n1941 when we delightedly made the discovery (although many others had made it before) \nthat by averaging the data for a stated number of days, weeks, or months, one could derive \na sort of Automated Trendline that", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 204}
{"text": "be some \nmechanical or mathematical way of determining the trend that might avoid some of the \nperplexities of choosing the right point through which to draw a trendline. It was back in \n1941 when we delightedly made the discovery (although many others had made it before) \nthat by averaging the data for a stated number of days, weeks, or months, one could derive \na sort of Automated Trendline that would definitely interpret the changes of trend over the \npast 30 days, or 200 days, or 12 months, or whatever period was chosen. It seemed almost \ntoo good to be true. As a matter of fact, it was too good to be true.\nThe Moving Average is a fascinating tool and has real value in showing the trend of an \nirregular series of figures (like a fluctuating market) more clearly. It also has value in the \nfact it can be used to cancel out the effect of any regular cyclical variation, such as a normal \nseasonal range of temperatures, to get a better picture of the true secular trend.\nThe trouble with a Moving Average (which we discovered long since but keep bumping \ninto from time to time) is it cannot entirely escape from its past. The smoother the curve \n(longer cycle) one has, the more “inhibited” it is in responding to recent important changes \nof trend. Plus, there is a very bad fault of Moving Averages in that “the tail tends to wag the \ndog”; the figures back to the first date of the current tabulation, perhaps six months ago, \nor a year ago, if they are large, may unduly affect the present average, and may conceal \nor mask some important feature by distorting the curve. We feel the Moving Averages \ntrendlines are useful, but they should be understood and used with discretion and with a \nfull perception of their limitations.\n422 Technical Analysis of Stock Trends\nAfter going through some of the caveats of Moving Averages, let us give you some of \nthe ways to construct them. Moving Averages can be classified as Simple Moving Averages, \nWeighted or Exponential Moving Averages, and Linear Moving Averages. We have found \nover the years, and prefer, the simple methods that work just as well and sometimes better \nthan the more complicated Moving Averages, while the others are more useful when using \ncomputers.\nFor this reason, we will concentrate on Simple Moving Averages. The most common \nare the 50-day and the 200-day Moving Averages. If you want to increase the sensitivity of \na Moving Average, shorten the Moving Average by using 10 or 20 days. Another way is to \nincrease the lead time by starting on the third day for the 10-day Moving Average, or on \nthe 20th day for a 50-day Moving Average, and so on.\nTo construct a Simple Moving Average, whether it is 5 days, 10 days, 50 days, or 200 days, \nadd the price of 5 days and divide by 5, or the 10 days and divide by 10, or the 50 days and \ndivide by 50, or 200 days and divide by 200. A simple way of doing the five-day Moving \nAverage, instead of adding all five prices each time, is to drop day one and add day six. \nA similar method can be used in calculating the 50-day Moving Average or the 200-day \nMoving Average. Instead of adding the 50-day Moving Average each time, just drop the \nfirst day of the previous average and add the 51st day. The same with the 200-day Moving \nAverage; drop the first day of the previous 200 and add the 201st day. Another way of \ncalculating the 200-day Moving Average is to take one day of the week of 30 weeks, such as \nWednesday or Thursday, add them, and divide by 30. This will give you the same Moving \nAverages as you would have doing 200. Another way to put it is, on the second day, take the \ntotal, add the new day’s price, and subtract the oldest day’s price from your 5-day, 10-day, \n50-day, or 200-day Moving Average, whichever way you are doing it. Repeat the process \non a daily basis and divide by the representative day—for the 5 day, you would divide by \n5; for the 10 day, you would divide by 10; for the 50 day, divide by 50; and for the 200 day, \nyou would divide by 200.\nSensitizing Moving Averages\nThe shorter the time period, the greater the sensitivity you will develop in your Moving \nAverage. The 5-day Moving Average will be much more sensitive than a 10-day. The \nproblem with short-term Moving Averages is you can have a greater number of false moves. \nShorter Moving Averages are more suitable for commodities. On commodities, we would \neven advise using a 30-hour, a three-day, and a six-day Moving Average.\nIt is often better to use two Moving Averages, one of shorter duration and one of longer \nduration. In addition, you can use channels, a Moving Average of lows and a Moving \nAverage of highs. (EN10: In the markets of the 2000s, the most watched Moving Averages are the \n50-day and the 200-day. In fact, these two have gained almost iconic status.)\nCrossovers and penetrations\nAs a general rule, consider the crossing of two lines (EN10: as 50 and 200) by the price line \nas a sell or buy signal in the direction of the crossover or penetration.\n 1. Uptrends—Long positions are retained as long as the price trend remains above the \nMoving Average Line.\n a. When the price line intersects or penetrates the Moving Average Line on the \nupside, it activates a buy signal.\n423Chapter thirty-six: Automat ed trendline: the Moving Average\n b. When the pr ice line goes above the 200-day Moving Average, but falls sharply \ntoward it without penetration, it is a possible buy signal. Additionally, conditions \nat the time must be closely observed.\n c. When the pr ice line falls below the Moving Average Line while the line is still \nrising, it could be a buy signal.\n d. When the pr ice line spikes down too fast and far below a declining Moving \nAverage Line, a short-term rebound toward the line may be expected: a possible \nwhipsaw trap.\n 2. Downtrends—Short positions are held as long as the price trend remains below \nthe Moving Average. When the price trend reaches a bottom and turns upward, a \npenetration of the Moving Average is a po", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 205}
{"text": "could be a buy signal.\n d. When the pr ice line spikes down too fast and far below a declining Moving \nAverage Line, a short-term rebound toward the line may be expected: a possible \nwhipsaw trap.\n 2. Downtrends—Short positions are held as long as the price trend remains below \nthe Moving Average. When the price trend reaches a bottom and turns upward, a \npenetration of the Moving Average is a possible buy signal.\n a. When the price line moves above the average line while the average line is still \nfalling, it is a sell signal.\n b. When the stock price line moves below the average line and rises toward it, but \nfails to penetrate and breaks down again, it is a possible sell signal.\n c. If the price line rises too fast above the rising average line, a short-term reaction \nmay be expected: could be a whipsaw.\n d. Occasionally, penetration of the Moving Average Line will occur in close \nconjunction with the penetration of a trendline, and then according to its direction, \nit is a buy or sell signal.\n 3. Horizontal, Diagonal, or Sideways Movements—If the fluctuations are broad in \ncomparison to the length of the Moving Averages being used, the price trend will \nfluctuate back and forth as the Moving Average, true to its character or purpose, \nmoves horizontally. The trader must be alert to the need to change tactics.\n 4. Gaps—Moving Averages, depending on their length, may have a tendency to be \npenetrated in proximity to a Breakaway Gap, particularly at the beginning of a Major \nPhase of an Intermediate cycle, and also in such cases in which Breakaway Gaps occur \nat the beginning of correction phases.\nArea Patterns can be a pitfall for the Moving Averages. Normally, the Moving Average \noscillates through the center of these areas, producing buy and sell signals in rapid \nsuccession. In Area Patterns, the Moving Average is a headache to the trader because he \nnever knows which penetration is the one preceding either the renewal of the trend or the \nConfirmation of a Reversal.\nWhen trading areas develop in the form of Triangles—Descending, Declining, or \nSymmetrical—the Moving Average will trend through the center of the Triangle. The \ntechnician has some small advantage in judging which of the series of penetrations of a \nMoving Average is the important one. When the Triangle reaches its apex and the stock \nbreaks out in one direction or another and penetrates the Moving Average, the penetration \nis likely to be the most important one during the sideways movement of the Triangle’s \ndevelopment. Penetrations occur many times in close conjunction with the penetration of \na trendline.\nAs a price derivative product, the Moving Average can be a trend indicator by the way \nit fits a trendline. Nevertheless, it should be considered an adjunctive tool to everything \nelse you have learned in relation to technical analysis.\n(EN10: Magee had, and I have, an instinctive aversion to mechanical systems. We want to see \nand feel the analysis and the moment and consider the context and the subtle variables. A mechanical \nsystem of any type—and a Moving Average system is not bad in broadly trending markets—is \nblind. It will throw your capital in front of an on-rushing train and merrily hum along while the \n424 Technical Analysis of Stock Trends\nmarket is eating your lunch. I have called these “unnatural” systems—they interpose an algorithm \nbetween the trader and the facts. This reduces decision-making stress but can go badly awry in some \ntypes of markets.)\nA 150-day Moving Average is charted in Figure 36.1.\nThe PENTAD Moving Average system from Formula Research\nOne of the solid and prestigious technical research firms in the country is Ned Davis \nResearch, Inc. (NDR). Nelson Freeburg of Formula Research has taken one of NDR’s systems \nand tweaked it to yield what may be an effective long-range approach to the market. It \nis presented here because Magee was interested in Moving Average systems, as well as \ninvestors who are graphically challenged, meaning they can relate to numbers but not to \npictures.\nFreeburg took an NDR Moving Average system and a 20-week Moving Average, added \na filter, and produced a system that reportedly has an 80% profitability on signals and \ngenerated returns in the 15% range going back to 1942. Since 1980, returns averaged 19%. \nWe all know (or the reader can quickly demonstrate to himself with a software package) \nthat a Moving Average tends to create whipsaws in a sideways market. As the market \nmoves sideways, the Moving Average moves through the pattern creating buy and sell \n$INDUA LAST-Monthly\nCreated with TradeStation www.TradeStation.com499.99\n449.99\n399.99\n349.99\n299.99\n249.99\n199.99\n149.99\n99.99\n49.99\n1920 1925 1930 1935 1940 1945 1950 1955\nFigure 36.1 150-day Moving Average (dotted line). Up to the 1980s (the period during which Ronald \nReagan tripled the national debt) trading the 150-day Moving Average (buying on an up crossover \nand selling on a down crossover) gave a trader somewhat the same advantage that trading the \nDow Theory afforded. In the 1980s, the system stopped working. Here in 1929 it would have been \na lifesaver, as can be seen. Not illustrated here is what the Moving Average does in a Dow Line, or \nrectangle or congestion pattern. If taking signals on crossovers one could find his capital ground to \nhamburger meat.\n425Chapter thirty-six: Automat ed trendline: the Moving Average\nsignals as price oscillates about it. In a common-sense move, Freeburg added a filter to the \nsystem that immeasurably improved it. Readers should be aware we include this method \nbecause experience tells us this kind of system can be effective, but we have not validated \nthe research. Also, any system including the 1990s is guaranteed to have good, if not \nspectacular, results. Diagrams illustrating the idea are shown in Figure 36.2 .\n440\nNov\n20-Wk MA-1%\n= Buy, S&P 500 Crosses 1% Above 20-Wk MA\n= Sell, S&P 500 Crosses 1% Below 20-Wk MA\n= Buy, S&P 500 Crosses Above 20-Wk MA", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 206}
{"text": "ecause experience tells us this kind of system can be effective, but we have not validated \nthe research. Also, any system including the 1990s is guaranteed to have good, if not \nspectacular, results. Diagrams illustrating the idea are shown in Figure 36.2 .\n440\nNov\n20-Wk MA-1%\n= Buy, S&P 500 Crosses 1% Above 20-Wk MA\n= Sell, S&P 500 Crosses 1% Below 20-Wk MA\n= Buy, S&P 500 Crosses Above 20-Wk MA\n440\n445\n450\n455\n460\n465\n470\n475\n480\n490\n485\n= Sell, S&P 500 Crosses Below 20-Wk MA\nFiltered Signals\n20-Wk MA+1%\nS&P 500 Close\n20-Wk MA\nS&P 600 and 20-Week MA:\nUnfiltered Signals\nDec9 4F eb Mar AprM ay JunJ ul AugS ep Oct Nov Dec9 5F eb Mar\n445\n450\n455\n460\n465\n470\n475\n480\n485\n490\n440\n445\n450\n455\n460\n465\n470\n475\n480\n485\n490\n440\n445\n450\n455\n460\n465\n470\n475\n480\n485\n490\nFigure 36.2 Looking at the top chart, we can see the deleterious effects of using a Moving Average \nsystem in a sideways market. Of course, at the end in January 1995, the system gets ready to cash in \nbig time. You will never miss a big market with a Moving Average system—if you have any capital \nleft after the whipsaws. Yet when a 1% filter is added, the number of trades is dramatically reduced \nand the accuracy improved. Something systems traders never think of is a qualitative filter—looking \nat the context when price crosses the average. What is the volume and what is the price action? Also, \nthe trader can experiment with different-size filters and filtering conditions.\n\n427\nchapter thirty-seven\nThe same old patterns\nTo the newcomer, the market appears filled with wonders and mysteries as the landscape \nof Mars will appear to the first space travelers to land there. There are strange rumblings, \napparently unexplainable upheavals, weird growths. An unknown stock will suddenly \nemerge from a morass of debt and deficit and proceed to soar to great heights. An old and \ntrusted issue will paradoxically sag and droop, although apparently rooted in the soil of \neconomic stability. All will seem peaceful and secure, and, suddenly, the ground opens up \nand swallows values in a sensational market break. (For illustrations in this chapter, see \nFigures 37.1 through 37. 5 4.)\nSuch a newcomer, perhaps not realizing what appears unusual and alarming is only \nthe normal fluctuation and adjustment that goes on continually in the market according \nto the changing evaluations of millions of investors, will feel frightened, insecure, and \nindecisive. He may scurry from boardroom to boardroom, personally or on the telephone, \nscan the financial pages, talk with friends, accumulate a mass of conflicting information, \nand end up shutting his eyes and making a blind stab in the hope he may come up with \nthe right answer.\nSome never, even after years of contact with the market, achieve a tranquil and assured \napproach.\nHowever, it is possible to learn something about the basic nature of stock trends. It \nis possible to know, within reasonable limits, about what might be expected in certain \nsituations. It is also possible to find ways of coping with these situations, including the \nexceptional cases that persist in doing the unexpected. To repeat: it is possible to deal \nsuccessfully with the unexpected and with what cannot be precisely predicted.\nTo put it another way, it is possible to be wrong part of the time and still to be successful \non the balance. To do this, it is only necessary to have a background of experience sufficient \nto know what will usually happen under particular conditions, about how often the \nunexpected will occur, and how to deal with the unexpected when it does happen. These \nare the same general problems that would confront the space traveler, the chemist, the \nphysician, or almost anyone else in his daily affairs.\nThere are men who have observed the market long enough and carefully enough to \ndiscover there are not quite so many unexpected events as the newcomer might be led to \nbelieve.\nThe charts in this book are, in the main, the same as those used for examples in the first \nedition in 1947 . Some of them show situations from 1928 and 1929, others from the 1930s and \n1940s. (EN: And still others from the 1980s, 1990s, and 2000s.) The reader can hardly overlook \nthe similarities that occur in various stocks at different times during corresponding phases \nof their trends or turning points.\nWe have said that these same patterns, trends, and Support/Resistance phenomena \nrepeat themselves over and over again, and that they may be observed by anyone in his \nown current charts for any period of time, in any normally active stocks, and on any \nexchange or market.\nBy way of demonstration, there were included in this chapter of the fifth edition a \nnumber of typical technical examples, similar to those already discussed, but taken from \n428 Technical Analysis of Stock Trends\nthe period 1947–1966. (EN: The eighth edition includes examples taken up through the turn of the \nmillennium.) It would be possible to include ten times the number of good examples, for \nalmost every situation that has been previously illustrated has appeared again and again \nin recent years.\nNot all the same\nAlthough a majority of stocks will participate in a big market trend, they will not all move \nat the same time or to the same degree. Some will move quite independently and contrary \nto the Averages. There was a “boom” in the 1920s and there was a Panic in October 1929, \nbut these are inadequate statements, half-truths if you will, and can be very misleading if \nthey are swallowed whole. A technician, following the individual behavior of stocks, would \nhave been able, through a balanced and diversified portfolio, to protect himself against \nirreparable loss.\nThe facts are that of 676 stocks we have studied through the period 1924–1935, only 184 \nmade a Bull Market Top in August–September–October 1929 and suffered Major Declines \nin October and November of that year. There were 262 stocks actually in Major Downtrends \nbefore the year 1929. Another 181 stoc", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 207}
{"text": "able, through a balanced and diversified portfolio, to protect himself against \nirreparable loss.\nThe facts are that of 676 stocks we have studied through the period 1924–1935, only 184 \nmade a Bull Market Top in August–September–October 1929 and suffered Major Declines \nin October and November of that year. There were 262 stocks actually in Major Downtrends \nbefore the year 1929. Another 181 stocks made their Bull Market Tops in the first nine \nmonths of the year and were already moving down before the end of the summer. Five \nstocks did not start their decline until after 1929 and 44 stocks continued to make new \nhighs after 1929. In Figures 37.9 through 37.11, there are three stocks showing very different \ntrends during the years 1927–1930.\nU.S. SMELTING, REFINING AND MINING COMPANY UV\n1951–1952–1953\nS S\nH88\n80\n76\n72\n68\n64\n60\n56\n52\n48\n44\n40 \n250200\n150\n10050\nJF MA MJ J AS ON DJ FM AM JJ AS ON DJ FM AM JJ AS ON D\nSales\n100’s\nFigure 37.1 A 1952 Major Head-and-Shoulders Top in U.S. Smelting, Refining and Mining. This stock \nhad moved up from a bottom at 33 in 1950 to the peak at nearly 88 shown here. The decline carried \ndown to 37 . This chart shows the typical high volume on the left shoulder. The volume at the head is \na little higher than in the “ideal” pattern. Light volume on the right shoulder is a definite warning. \nNotice the Pullback Rally to the neckline in the last week of August. Also, the Secondary Recovery \nin November and December. There also appears, at the left side of this chart in 1951, a beautiful \nexample of an Ascending Triangle, indicating the resumption of the previous interrupted advance.\n429Chapter thirty-seven: The same ol d patterns\nINSPIRATION COPPERI C1 956–1957\nSEPTEMBERO CTOBERN OVEMBERD ECEMBERJ ANUARY\n64\n60\n56\n52\n48\n44\n50\n40\n30\n20\n10\nXD\nXD\n52.00\n52.00\n25 18 15 22 2961 32 02 73 10 17 24 18 15 22 29 51 21 92 62 91 6\nSales\n100’s\nFigure 37.2 Downtrends seldom show the perfect and regular trendlines we often see in uptrends, \nbut in spite of the irregular, ragged rallies and spotty volume action, the basic principles are about \nthe same as for advances. Notice in this six-month period, Inspiration Copper had no rally that \ncarried above the Top of a preceding rally. A well-marked downtrend of this sort must be presumed \nto continue until there is a marked change in the pattern and volume action. Notice the volume on \nthe day “IC” broke the historically important 52 level, and subsequent action.\n430 Technical Analysis of Stock Trends\nGRANITE CITY STEEL GRC\n1956\nJULY AUGUSTS EPTEMBERO CTOBER NOVEMBERD ECEMBER\n60\n56\n52\n48\n44\n40\n38\nSales\n100’s\n125\n100\n75\n50\n25\nXD 75\nXD 75\n14 21 28 41 11 82 51 81 52 22 96 13 20 27 31 01 72 41 81 52 22 95\nFigure 37.3 Part of the Major Advance in Granite City Steel. Here we see the familiar phenomenon \nof Support and Resistance in almost every move through the period shown.\nThe August–September Rectangle held for six weeks between the top limit of 47 , which was \nreached on three occasions, and the bottom at 44. Like most Rectangles, it was marked by heavy \nvolume at the start on July 19, and gradually declining volume as the pattern progressed. The \nbreakout move on August 29 was on enormous volume.\nAfter this breakout, there was a typical Flag-like reaction on sharply diminished volume, and \nalthough this move penetrated the top border of the Rectangle, the penetration was not decisive or \nsignificant, and the lower border was never violated. Now, see how volume appears on October 15 \nas the old high is reached, and again at the top of the move on November 14. The decline returns to \nthe level of the September high on a low-volume reaction. It is interesting how, on five occasions in \nthis chart, the 52 level served as a Support or Resistance point: twice as Resistance on the way up, \nand three times after the new October high, as Support.\nOn the next rise, we see almost the same type of advance. In this case, the Support–Resistance \nLevel is about 57 . Notice the approach to the critical level, the backing away, the aggressive move into \nnew high ground (in mid-December), and the recession to the Support at 57 .\nAdvances of this sort seem to represent the ebb and flow of the Minor Moves during a Major \nTrend when there are no great “news developments” to change the normal progress of the trend. \nWhere there are frequent and important changes in the market or in news affecting the industry, we \nmay see long Consolidations or Secondary Reactions, but the Major Trend is durable. We must not \nassume a Major Reversal prematurely.\n431Chapter thirty-seven: The same ol d patterns\nMASONITE MNC1 956\nJULY AUGUSTS EPTEMBERO CTOBERN OVEMBERD ECEMBER\nXD .30\nAND 50\nAND 4% STOCK\nXD .30\n48\n44\n40\n38\n36\n34\n32\n30\n28\n125\n100\n75\n50\n25\n71 42 12 84 11 18 25 18 15 22 29 61 32 02 73 10 17 24 18 15 22 29\nSales\n100’s\nFigure 37.4 During the same period that Granite City Steel was making the series of steps upward, \nas shown in Fig u r e 37. 3, Masonite was doing almost the same thing in reverse.\nTo have continued to hope for a change in trend with a stock that was acting as “MNC” did \nthrough the latter part of 1956 would have required an unusual amount of optimism or innocence \nabout the habits of stocks. Actually, there would be good reason for optimism if the stock had been \nsold short early in the trend.\nThis is almost a perfect counterpart to the “GRC” chart. We have not only a series of declines \nwith rallies that fail to establish even Minor highs above the previous Tops, but we are also able to \ndraw a trendline with a number of points of contact on the way down, which is somewhat unusual \nin a downtrending situation. Notice the tendency of the rallies to stop short at the level of previous \nbottoms in a series of Support–Resistance Levels. We see such action at 44, at 41, at 38, and at 36.\nWe would certainly not consider the breaking of the trendline on the upside in late December \nas evidence of a Reversal. Such a break after a trend of this sort", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 208}
{"text": "down, which is somewhat unusual \nin a downtrending situation. Notice the tendency of the rallies to stop short at the level of previous \nbottoms in a series of Support–Resistance Levels. We see such action at 44, at 41, at 38, and at 36.\nWe would certainly not consider the breaking of the trendline on the upside in late December \nas evidence of a Reversal. Such a break after a trend of this sort probably means no more than a \nSecondary Recovery. To be of greater significance, it would certainly call for some volume showing, \nwhich was utterly lacking here, and before we would consider the stock again strong enough to buy, \nthere would have to be some sort of Reversal Pattern. A faltering rally back to around 40 would, in \nfact, suggest the advisability of further short sales.\n432 Technical Analysis of Stock Trends\nDELAWARE, LACKAWANNA AND WESTERN DL\n1945–1955\nSEPTEMBERO CTOBERN OVEMBERD ECEMBER JANUARYF EBRUARY\n24\n22\n20\n19\n18\n17\n16\n15\n14\n13\n12\n11\n125\n100\n75\n50\n25\n41 11 82 52 91 62 33 06 13 20 27 41 11 82 51 81 52 22 951 21 92 6\nSales\n100’s\nFigure 37.5 Very often you will hear the question, “But how can you tell whether a technical formation \nor a breakout is valid?” In many cases, and in a great majority of upside patterns, the volume gives \nsuch a decisive answer that all doubts are removed. Not always is the volume confirmation as clear \nas in this chart of Delaware, Lackawanna and Western, but this is typical of a good many breakouts \nin uptrends. You will see the volume was generally light during the Rectangle, in which we see five \nplainly marked Tops and Bottoms.\nOn Thursday, November 4, the volume increased sharply as the price moved up to the top of the \nRectangle and closed at that point. The following day, Friday, we see good volume again with a close \nbeyond the top border. From this point on, the move is obviously upward.\nThere was no indication of Reversal at any time after the breakout. A Top was reached in March \nat 25 1/2.\nThis was an especially vigorous move as it came out of the Rectangle. Normally, we would look for \nMinor Setbacks such as the series of reactions in “GRC,” Fig u r e 37. 3. If these had occurred, it would \nin no way have weakened the Bullish Pattern.\n433Chapter thirty-seven: The same ol d patterns\nAMERICAN LOCOMOTIVEL A\n1954\nJULY AUGUSTS EPTEMBERO CTOBER NOVEMBER DECEMBER\nXD 25C\nXD 25C\n22\n20\n19\n18\n17\n16\n15\n14\n13\n12\n11\n250\n200\n150\n100\n50\n31 01 72 43 17 14 21 2841 11 82 52 91 62 33 06 13 20 27 41 11 82 5\nSales\n100’s\nFigure 37.6 The situation, somewhat similar to “DL ” in Fig u r e 37. 5, presents a little complication. \nThe problem would have been whether to sell or continue to hold “LA” after the late October break \ndown through the Bottom of the Rectangle. There was no important volume on this drift move, and \non only one day did the price close barely 3% below the bottom of the pattern. A holder of the stock \nmight well have sold it, might even have executed a short sale.\nSuppose now, you had actually sold the stock short; observe the volume and the price action on \nThursday, November 4, and Friday, November 5. Notice the volume and the price on the following \nMonday and Tuesday as it reacted slightly. Then see the quick pick up in volume as the price advanced \non Wednesday, the week and a half of dull Consolidation, and the larger volume on the move up on \nFriday. Surely by the middle of the first week of December, if not before, you would have seen the \ndanger signals and closed out your short.\nSuch a turnabout does not need to be a tragedy nor even a discouragement. Some easily \ndiscouraged traders would be so concerned about the small loss realized on their unsuccessful short \nsale they would not be ready to seize the opportunity to reverse position and buy the stock after the \nstrong up signals. This move carried to 26 3/4 in March 1955.\n434 Technical Analysis of Stock Trends\nFANSTEEL METALLURGICALF NL\n1955 – 1956\n52\n48\n44\n40\n38\n36\n34\n32\n30\n28\n26\n24\n22\n250\n200\n150\n100\n50\nFM AM JJ AS ON DJ FM AM JJ\nSales\n100’s\nFigure 37.7 Bottoms normally take longer to complete than Tops. That is one reason we have this \nchart of Fansteel on a weekly basis, so that a year and a half of the action can be shown. The pattern \nshown at the left is a Consolidation formed after a rise from the 1953–1954 Multiple Bottoms around \n21. The top of the Ascending Triangle corresponds roughly with the April 1953 peak.\nAt the time this Triangle started, in early 1955, it was not possible to identify it as such—particularly \nsince the February high ran a little higher than the horizontal Tops that eventually formed. However, \nduring the seven months preceding the first breakout move, it became increasingly clear each rally \nto the neighborhood of 32 1/2 was followed by a reaction on low volume, and these reactions were \nforming a series of Rising Bottoms.\nIn the first week of September we see a clean penetration upside, and from here on, the advances \nand declines fit into the typical pattern of a Major Advance. Notice the Breakaway Gap in November \nand the low volume throughout the December–January–February reaction.\n435Chapter thirty-seven: The same ol d patterns\nTEXTRON TXT1 956–1957\nAUGUSTS EPTEMBERO CTOBERN OVEMBERD ECEMBERJ ANUARY\nXD .40\nXD .40\n24\n22\n20\n19\n18\n17\n16\n15\n14\n125\n100\n75\n50\n25\n11 18 25 18 15 22 29 61 32 02 73 10 17 24 18 15 22 29 51 21 92 62\nSales\n100’s\nFigure 37.8 Here, in a daily chart, we see once again the dramatic sequel to a Descending Triangle. \nHere is the typical series of declining Tops on rather low volume with retreats between the rallies \nto a horizontal line.\nNotice the important Support here was violated with heavy volume on Friday, January 25. \nAlthough the degree of penetration was not great, in view of the generally Bearish reaction to \nthis point we would sell at once. A Descending Triangle has Bearish implications even before the \nbreakout. There was no substantial Pullback after the breakout. Since it is not possible to count on \nsuch a reco", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 209}
{"text": "ne.\nNotice the important Support here was violated with heavy volume on Friday, January 25. \nAlthough the degree of penetration was not great, in view of the generally Bearish reaction to \nthis point we would sell at once. A Descending Triangle has Bearish implications even before the \nbreakout. There was no substantial Pullback after the breakout. Since it is not possible to count on \nsuch a recovery after a break through Support, it is safest to sell long holdings immediately or to \nplace a very near stop on them as soon as a close outside pattern occurs (in this case, outside the \npattern as adjusted for ex-dividend).\nNotice the pickup of volume as the price drops into a tailspin at the end of January. Heavy volume \nis not necessarily a feature of important downside moves, but it may, and often does, accompany \nthem, and when it does, it simply underscores the significance of the move.\nQuestion: does Textron look like a “bargain” to you at the end of January on this chart? Would you \nbe tempted to buy this stock because “it can’t go down any more,” or because it is “due for a rally,” \nor because it is “selling below its true value”?\nSuppose “TXT” did have a technical rally, which seems quite likely after the move shown. How far \nwould you look for it to go? Would you expect it to penetrate the 20 level in the near future? Would \nyou call this a Bullish Situation at the end of January 1957?\n436 Technical Analysis of Stock Trends\nLIBBY, McNEILL\nAND LIBBY30\n25\n20\n15\n10\n1927 1928 1929 1930\n(a)\nCHRYSLER\n150\n120\n90\n60\n30\n1927 1928 1929 1930\n(b)\nEAGLE-PICHER\nLEAD50\n40\n30\n20\n10\n1927 1928 1929 1930\n(c)\nFigure 37.9 (a) Libby, McNeill and Libby showed no serious effects at the time of the October 1929 \npanic, and went on to new highs in March and April 1930. (b) Chrysler, one of the great market \nleaders, made its Bull Market Top in 1928, more than a year before the Panic, and had already lost \n60% of its value before October 1929. (c) Eagle–Picher Lead never enjoyed any Bull Market at all. Aside \nfrom an unimpressive rally in 1928, it was in a downtrend all the way.\nThe examples given are not rare exceptions; there are many others involving important stocks \nthat did not follow the pattern set by the Averages. This variety of behavior is typical of the market. \nIt is to be seen today. They are not “all the same,” and each stock must be studied individually. In \nFig u r e 37.10, there are a few examples showing disparate action during the years 1953–1956. There \nare hundreds of others that would illustrate the point equally well.\n437Chapter thirty-seven: The same ol d patterns\nWEST INDIES\nSUGAR50\n40\n30\n20\n750\n500\n250\n1953 1954 1955 1956 \nSales\n100’s\nWESTINGHOUSE\nELECTRIC100\n80\n60\n40\n3000\n2000\n1000\nSales\n100’s\n1953 1954 1955 1956 \nKRESGE (S.S.) CO.\n50\n40\n30\n20\n600\n400\n200\n1953 1954 1955 1956 \nSales\n100’s\n(a) (b) (c)\nFigure 37.10 (a) West Indies Sugar broke out of its “Scalloping” Pattern in late 1956 to make its own \nBull Market at a time when action in the Averages was apathetic and generally weak. (b) Although \nthe Averages continued to make new highs through the spring of 1956, Westinghouse Electric made \nits top and went into a Major Decline more than a year earlier. (c) Here is a companion piece to \nEagle–Picher’s chart of more than 25 years ago, shown above it. Kresge, like a number of other “blue \nchips,” did not participate in the Bull Market Moves of 1953–1956.\nThese six charts were adapted from “Graphic Stocks” (F.W. Stephens, New York). The 1927–1930 \ncharts are from a Special Edition covering nearly 700 stocks through the period 1924–1935. The \n1953–1956 charts are from a later edition of “Graphic Stocks.”\n438 Technical Analysis of Stock Trends\nNORTHROP AIRCRAFT NOC\n1954–1955\nDECEMBER JANUARYF EBRUARYM ARCH APRILM AY\nAdjusted for 2/1 SPLIT\n38\n36\n34\n32\n30\n28\n26\n24\n22\n20\n19\n18\n250\n200\n150\n100\n50\n41 11 82 51 81 52 22 95 12 19 26 51 21 92 62 91 62 33 0714 21 28\nSales\n100’s\nXD 40C\nFigure 37.11 A beautiful Top Formation in Northrop Aircraft, 1954–1955. The move, which ended \nhere at 39 3/4 in January 1955, emerged from a Bottom in 1953 at 6 1/4.\nThe Descending Triangle is marked by rather unusual volume at the peaks of rallies in February \nand March. Otherwise it is typical of this sort of Reversal Pattern. As so frequently happens, there \nwas a Pullback effort after the March 14 breakout, but this rally lasted only two days.\nYou will notice the volume on the breakout and throughout the downside move was not so \nspectacularly heavy, not nearly as heavy, in fact, as on the Minor Rallies within the Triangle. As \npointed out previously, however, we do not need or expect so much volume on a decline as we look \nfor in an advance.\nVolume did not develop until the end of the first stage of the decline. It is quite usual for heavy \nvolume to show up at the end of a Minor Move whether on the upside or the downside.\nNotice the Flag formed on the subsequent rally in mid-April. The measuring implications of this \nFlag were approximately carried out a month later.\nDuring the following year and a half, “NOC” never reached 31 again.\n439Chapter thirty-seven: The same ol d patterns\nNORTHROP AIRCRAFT NOC\n1956–1957\nAUGUSTS EPTEMBERO CTOBERN OVEMBERD ECEMBERJ ANUARY\nXD 40C\nXD 40C\n28\n26\n24\n22\n20\n19\n18\n17\n125\n100\n75\n50\n25\n11 18 25 18 15 22 29 61 32 02 7310 17 24 18 15 22 29 51 21 92 62\nSales\n100’s\nFigure 37.12 Bearing in mind the 1954–1955 chart of Northrop in Fig u r e 37.11, we now turn to the \naction in this same stock in the latter part of 1956 and the beginning of 1957 . The question is whether \nthe Major Downtrend is still in effect or whether an important upturn has taken place.\nAs usual, it is the volume that must be watched and studied. Notice the Minor Peak on August \n14, then the very heavy volume on August 24. See how the activity dries up during September but \nresumes briskly as a new Minor Top is established in October. Observe the drying-up of volume on \ndeclines and the activity on rallies to the", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 210}
{"text": "is still in effect or whether an important upturn has taken place.\nAs usual, it is the volume that must be watched and studied. Notice the Minor Peak on August \n14, then the very heavy volume on August 24. See how the activity dries up during September but \nresumes briskly as a new Minor Top is established in October. Observe the drying-up of volume on \ndeclines and the activity on rallies to the 25 1/2 level, which, by the middle of December, has become \nthe horizontal Top of an Ascending Triangle.\nThere was no question about the validity of the breakout move on December 10, and the subsequent \nreaction in the next two weeks confirmed this by the lack of activity on the decline. Again, in early \nFebruary, we see volume pick up notably as a new high is registered.\nAt the time this is written (EN: 1957), it is not possible to say whether or not “NOC” will continue \nthis upward course and eventually smash the “31 barrier.” We feel there will be no doubt in the \nreader’s mind at the beginning of February, Northrop was presumably moving in an uptrend and \nmust be presumed to be in that trend until a definite change in its market action has taken place. \nIt seems quite probable if “NOC” should advance to the 30–31 level, there is likely to be a period \nof Consolidation with the formation of an Area Pattern before a successful advance above 31 is \naccomplished.\nAs a sidelight on this chart, it might be mentioned that during the period of advance shown above, \nmany aircraft stocks were moving lower.\n440 Technical Analysis of Stock Trends\nCHICAGO, MILWAUKEE, ST. PAUL AND PACIFIC ST \n1954–1955\nJULY AUGUSTS EPTEMBER OCTOBERN OVEMBERD ECEMBERJ ANUARYF EBRUARYM ARCH APRILM AY JUNE\nXD 1.00\nXD 1.50\n38\n36\n34\n32\n30\n28\n26\n24\n22\n20\n19\n18\n17\n16\n15\n14\n13\n12\n11\n250\n200\n150\n100\n50\n31 01 72 43 17 14 21 28 41 11 82 55 12 19 26 51 21 92 629 16 23 30 29 16 23 3061 32 02 741 11 82 58 15 22 2917 14 21 28 41 11 82 52\nSales\n100’s\nFigure 37.13 The 1954–1955 advance in Chicago, Milwaukee, St. Paul and Pacific is an object lesson \nin Bull Market techniques. Where would such a trend (of which there are many similar cases) leave \nthe man who sells just “because he has a good profit,” say at 15, or who feels “17 is too high a price”?\nHere is a chart worth considerable study because it exemplifies a great many features of the \n“ideal” uptrend. In this full year of advance, there is no point at which even a tyro technician could \nfind reasonable cause for anxiety or justification for selling the stock. What is more, we should not \noverlook the tax advantages of long-term gains.\nIn August and September, we have a perfect example of the Symmetrical Triangle as a \nConsolidation. The volume is typically heavy at the start of the pattern and shrinks to almost nothing \nas it progresses. The breakout volume is decisive. The reaction after the breakout, also on lower \nvolume, as it should be, runs right back to the apex, the “cradle point” that is nearly always a strong \nSupport on such a reaction.\nNow follow the action from here; the two days of higher volume in the early November rally \nrepresent the penetration of the previous Minor Top, and the end of the rally, respectively. The \nreaction comes back to the previous top.\nThe December rally is marked by heavier volume when the November top is exceeded, and again, \nto a lesser degree, at the end of the move. Once more there is a reaction, this time to the November \ntop.\nA fast move near the end of December repeats the same price and volume action, and it is followed \nby a typical low-volume reaction to the early December top. (This is becoming monotonous, but it is \nimportant. You are seeing here a long-term demonstration of Bullish technical action.)\nNext, we have the January breakout. How far would you expect its Minor Reaction to go? Would \nyou be surprised if it found Support at the level of the three little Tops formed early in the month \nat 17 1/2?\nThe following advance drives through the 20 level, and, in a series of small fluctuations, forms \nan Ascending Triangle. By the end of February, another new high has been established. Can you \nestimate where to look for support on the reaction?\n441Chapter thirty-seven: The same ol d patterns\nFigure 37.13 (Continued ) Now we see the formation of the second Ascending Triangle (notice the \nrelatively low volume), which is broken on the upside in a burst of trading activity toward the end \nof April. The next reaction comes back to the support of the former Tops as you would expect. Once \nagain, an Ascending Triangle is formed, and you will see how the volume dries up throughout this \npattern, coming to life emphatically on the breakout on Wednesday, June 8.\nMany students, on first seeing this chart, remark, “Well, the trend wasn’t broken until Tuesday, \nJune 21.” Actually, no break occurred on that day. The stock simply went ex-dividend $1.50, which, \nas you will see if you adjust the price by that amount, merely brings it back to the Support at the top \nlevel of the April–May Ascending Triangle.\nIt is inconceivable that any such regular series of Bullish Patterns could appear throughout a \nfull year of trading in a stock “by accident.” This is part of the normal mechanism of the market, \nrepresenting the judgments, opinions, fears, hopes, and trading tactics of thousands of traders and \ninvestors. It should be added, however, that it is not often that one sees such a long and “perfect” \nMajor Advance as this. Normally, there are interruptions, distortions, or Secondary Reactions from \ntime to time.\n442 Technical Analysis of Stock Trends\nWESTINGHOUSE ELECTRIC AND MANUFACTURING CO. \nWX 1955\nFEBRUARYM ARCH APRIL MAYJ UNEJ ULY\nXD 50C\nXD 50C\n80\n76\n72\n68\n64\n60\n56\n52\n48\n44\n250\n200\n150\n100\n50\n51 21 92 651 21 92 62 91 62 33 07 14 21 28 41 11 82 52 91 62 33 0\nSales\n100’s\nFigure 37.14 Does it require second sight to perceive this is a Bearish stock? If you were keeping a \nchart on Westinghouse Electric and Manufacturing, wouldn’t you have reco", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 211}
{"text": "TINGHOUSE ELECTRIC AND MANUFACTURING CO. \nWX 1955\nFEBRUARYM ARCH APRIL MAYJ UNEJ ULY\nXD 50C\nXD 50C\n80\n76\n72\n68\n64\n60\n56\n52\n48\n44\n250\n200\n150\n100\n50\n51 21 92 651 21 92 62 91 62 33 07 14 21 28 41 11 82 52 91 62 33 0\nSales\n100’s\nFigure 37.14 Does it require second sight to perceive this is a Bearish stock? If you were keeping a \nchart on Westinghouse Electric and Manufacturing, wouldn’t you have recognized, long before the \nend of the period shown above, that the trend was down, not up?\nIt is one of the great delusions of the market that the stock we own must be “good.” As prices \ndecline, the price–dividend ratio, based on past history, will improve. Additionally, the price–\nearnings ratio likewise will look continually better. Investors will begin to speak of “averaging \ntheir cost” by putting more money into a tumbling stock (instead of looking for something going \ntheir way). They will talk endlessly about improved outlook, new products, and a forward-looking \nmanagement; they will prove to you it is selling “below its true value,” whatever that may mean. \nThey will bend every effort to establish what is going on before their eyes is not true; that the very \nweak-looking stock is actually strong; that the American public is making a great mistake and is \nmisjudging this stock; that the tape is wrong because they must be right.\nNevertheless, values in the market are determined democratically and, by and large, probably \nrepresent the best composite appraisal you can find. A move like this is not meaningless, and it is not \npossible today to attribute it to the machinations of a few manipulators. In the chart, we are seeing \nthe reflection of a collective evaluation that cannot be lightly disregarded. Westinghouse reached 50 \n7 /8 in November 1956.\n443Chapter thirty-seven: The same ol d patterns\nTEKNIPLAT Chart Paper\nPublished and Distributed by JOHN MAGEE, Inc. Technical Analysis of Stock Trends, 360 Worthington Street, Springfield 3, Massachusetts\nType RU\nCOPYRIGHT 1961 BY JOHN MAGEE, SPRINGFIELD, MASS.\nDECEMBER JANUARYF EBRUARYM ARCH APRILM AY JUNE JULY AUGUST SE PTEMBERO CTOBER NOVEMBER\nOTIS ELEVATOR CO. OT1954–1955\n152\n144\n136\n128\n120\n112\n104\n96\n88\n80\n76\n72\n68\n64\n60\n56\n52\n48\n44\n50\n40\n30\n20\n10\n41 11 82 5 1 81 52 22 951 21 92 65 12 19 26 41 11 82 522 91 62 33 0 91 62 33 071 42 12 86 13 20 27 31 01 72 41 81 52 22 9512 19 26 3\nXD .625 XD .625 XD .625\nSales\n100’s\nFigure 37.15 A typical stock chart on TEKNIPLAT™ charting paper. Allowing for ex-dividends, “OT” never significantly violated the apex of the Triangle. \nThe advance ultimately added 60% to the value of the stock. This chart, in its long, mostly sideways movement, is a good example of the importance of \nmaking allowance for the ex-dividend drop in the price. During the first five months shown, we see an almost perfect Symmetrical Triangle. The first \ncritical point would be on the slight breakdown in the middle of May. The lower border of the Triangle was violated just a trifle, even if we had allowed \nfor the 62 1/2¢ March dividend. If one had sold the stock here, who could blame him? No great or immediate harm would have been done. However, an \nexperienced technician might have taken into account the insignificant volume at this point and waited a bit, with a stop at, say, 60. (See the somewhat-\nsimilar situation in the chart of “LA,” Fig u r e 37.6.) If “OT” had been held, the volume pickup on the rally would have shown the trend had not yet reversed \nitself. The second critical point came in late September and early October, at the time of President Eisenhower’s illness. However, if we allow for the two \ndividends that went ex in July and October, the break did not violate the May Bottom. Furthermore, it was on relatively light volume. If the stock was still \nheld, there was no valid reason for selling on this decline. From here on, breaking upward sharply from the October–November Island, “OT” resumed \nthe Major Advance interrupted by this long period of Consolidation, and advanced to the equivalent of over 100 (adjusted for two-for-one split) in 1956.\n444 Technical Analysis of Stock Trends\nClose\n454.82\nFeb 12\nClose\n520.77\nJul 12\nClose\n419.79\nOct 12\nDOW - JONES\nINDUSTRIAL\nAVERAGE\nJANF EB MARA PR MAYJ UN JULA UG SEPO CT NOVD EC\n550\n540\n530\n520\n510\n500\n490\n480\n470\n460\n450\n440\n430\n420\nBREAK OUT\n1\n2\n3\n4\n5\nFigure 37.16 The Broadening Top in the Dow–Jones Industrial Average that formed in May, June, \nJuly, and August 1957 . Although Broadening Tops have appeared many times in individual stocks, \nand, as a rule, have carried out their Bearish implications, such a chart pattern has never before been \ncompleted in the Industrial Average. In 1929, on two occasions, there were patterns that began to \nshow Broadening tendencies, but because these were interrupted by continuation moves, about all \none can say of them is they may have indicated a growing technical weakness in the market.\n The 1957 situation, on the other hand, was very definite and was fully completed. During the \nearly stages of the pattern, several of our friends wrote, calling attention to the possible Broadening \nTop, among them Charles E. Carden of Fort Worth, TX, who has handled Dow Theory comment and \nanalysis for the Fort Worth Star Telegram. The chart shown in Fig u r e 37.16 is adapted from one of Mr. \nCarden’s charts and is reproduced with his permission.\nThe first significant point after the February 12 Bottom was the Minor Peak of Tuesday May 21, \nmarked (1). The Minor Decline from this point on Tuesday, May 28 (2), was quite normal, as was the \nrenewed advance to Monday, June 17 (3).\nThe first sign of a broadening tendency was when the Average closed on Monday, June 24 (4), \nbelow the May 28 bottom. However, this by itself did not indicate a Reversal. The advance was \nresumed, and surmounted the May 21 and June 17 Minor Tops, reaching a high closing figure of \n520.77 on Friday, July 12 (5). The Broadening picture was now quite evident, and the completion of a", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 212}
{"text": "ay, June 17 (3).\nThe first sign of a broadening tendency was when the Average closed on Monday, June 24 (4), \nbelow the May 28 bottom. However, this by itself did not indicate a Reversal. The advance was \nresumed, and surmounted the May 21 and June 17 Minor Tops, reaching a high closing figure of \n520.77 on Friday, July 12 (5). The Broadening picture was now quite evident, and the completion of a \nBroadening Top required only a close below the June 24 Bottom.\nOn Tuesday, August 6, the Industrial Average closed decisively below the June 24 Bottom, signaling \nthe completion of the Broadening Top. This was an indication of Major weakness, a warning not to \nbe taken lightly.\nThe Broadening Top, as we have pointed out previously, is an indication of a wildly gyrating \nmarket, a market without leadership or definite trend. The presumption is that heavy distribution is \ngoing on under cover of the rallies and the breakout move is seldom a false one.\n445Chapter thirty-seven: The same ol d patterns\n$INDU - Daily US L=10125.40 -114 .52 -1 .12% O=10239.84 C=10125.40\nHand\nFenceline–Neckline\n9082.62\n11378.00\n10897.00\n10437.00\n9996.00\n9573.00\n9169.009119.00\n8781.00\n8410.00\n8055.00\n7714.00\nOct9 9A pr JulO ct 00 AprJ ul Oct0 1A pr JulO ct\nCreated with TradeStation\nFigure 37.17 The Broadening Top in the Dow in 1999–2000. If repetition is the heart of pedagogy, \nthe reader may die of heart disease with looking at the Dow Broadening Top, especially if he was \nlong at the time and either disregarded the signs or was not educated as to their significance. The \nlesson is always the same: bad news is on the way. The numerous technical aspects of this historic \nmarket top are discussed at length in other views of the Dow taken at this time. Remember, this \ntime it is different. The market paradigm has changed, and so on and so on. … Those who l isten to \nfools will be fooled.\nFigure 37.16 (Continued ) Since we are dealing with an Average rather than a single stock, we would \nconsider any closing below point (4) after the peak at (5), regardless of how slight the margin might \nbe, would constitute a valid breakout, because Averages are less sensitive than individual stocks, \nand it is customary to consider even slight penetrations at signal points (as in Dow Theory) as \nperfectly satisfactory. You will notice also that, although it would be possible to draw the Broadening \nTop through the extreme ranges of the price, as we have done with the wide-dashed line, we have \nused the closing prices as marked by the narrow-dashed line. This, too, is in line with Dow Theory \npractice, where only closing prices are considered.\nThe implication of the pattern here was Bearish for the “market-as-a-whole.” As might be \nexpected, a majority of stocks showed weak patterns of trends at this time. As always, however, \nit was necessary to examine each stock separately on its merits, because, as we will show in the \nfollowing pages, not all stocks behaved alike even in this extremely weak market situation. Compare \nthe broadening top from 1999 to 2000 (Fig u r e 37.17).\n446 Technical Analysis of Stock Trends\nTEKNIPLAT Chart Paper\nPublished and Distributed by JOHN MAGEE, Inc. Technical Analysis of Stock Trends, 360 Worthington Street, Springfield 3, Massachusetts\nType RU\nCOPYRIGHT 1961 BY JOHN MAGEE, SPRINGFIELD, MASS.\nJANUARYM ARCH APRILM AY JUNE JULY AUGUST SEPTEMBERO CTOBER NOVEMBER\nINDUSTRIAL RAYON CORPORATION ILR1957\n38\n36\n34\n32\n30\n28\n26\n24\n22\n20\n19\n18\n17\n16\n15\n14\n13\n12\n11\nSales\n100’s\n50\n40\n30\n20\n10\n51 21 92 6 41 11 82 52 291 62 32 91 62 33 0 91 62 33 0 71 42 12 871 42 12 861 32 02 76 132 02 73 101 72 43 118 15 22 29 51 21 92 6\nXD .50 ¢XD .75 ¢ XD .25 ¢ XD .25 ¢\nDECEMBERFEBRUARY\nFigure 37.18 1957 Bearish Trend in Industrial Rayon. At no time did this stock show significant strength.\n Averages do not tell the whole story. Each stock has to be considered on its own merits. Long before the formation of the 1957 Broadening Top in \nthe Industrial Average, Industrial Rayon was moving down in a Major Decline. You will find many cases in which it is difficult to “see” what a stock \nis doing or to determine its Major Trend, but in such a situation as this (and this is not a rare case), it is perfectly obvious that the trend is down. \nAlthough there were a number of Minor Rallies and Consolidations during the decline, the entire pattern was so obviously part and parcel of the same \nbig decline that no one who was even slightly familiar with typical stock behavior would have been tempted to buy the stock, even to cover shorts.\n On Monday, July 29, there was a sharp downward break with a gap on climactic volume. This would have suggested the probability of a Minor \nBottom, and for three and a half weeks, the stock did stabilize at around 24. But even during this Consolidation, the continuing weakness showed up \non the small Descending Triangle that was formed, and ultimately on Wednesday, August 21, the price broke sharply to continue the Major Decline.\n447Chapter thirty-seven: The same ol d patterns\nTEKNIPLAT Chart Paper\nPublished and Distributed by JOHN MAGEE, Inc. Technical Analysis of Stock Trends, 360 Worthington Street, Springfield 3, Massachusetts\nType RU\nCOPYRIGHT 1961 BY JOHN MAGEE, SPRINGFIELD, MASS.\nJANUARYF EBRUARYM ARCH APRILM AY JUNE JULY AUGUST SEPTEMBERO CTOBER NOVEMBER\nLORILLARD LL1957\n38\n36\n34\n32\n30\n28\n26\n24\n22\n20\n19\n18\n17\n16\n15\n14\n13\n12\n11\n250\n200\n150\n100\n50\n51 21 92 6 41 1 18 252 291 62 32 91 62 33 0 91 62 33 07 14 21 2871 42 12 861 32 0 27 61 3 20 27 31 0 17 24 3118 15 22 29 51 21 92 6\nXD .30 XD .30\nDECEMBER\nSales\n100’s\nFigure 37.19 1957 Bullish Trend in Lorillard. Although most stocks declined in 1957 , there were a number of strong issues like this one that appeared \nto be totally unaffected by the general pessimism.\n Averages do not tell the whole story. It will come as a shock to many readers, who rightly regard the latter half of 1957 as a Major Bear Market, \nto see Lorillard making a typical Bull Market Advance. Lo", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 213}
{"text": "7.19 1957 Bullish Trend in Lorillard. Although most stocks declined in 1957 , there were a number of strong issues like this one that appeared \nto be totally unaffected by the general pessimism.\n Averages do not tell the whole story. It will come as a shock to many readers, who rightly regard the latter half of 1957 as a Major Bear Market, \nto see Lorillard making a typical Bull Market Advance. Lorillard moved up from 15L to 34 during the year—and reached 54J during the first three \nmonths of 1958. It is hard to believe this chart and the Industrial Rayon chart we just looked at cover the same period, the year 1957 .\n The majority of stocks did suffer severe depreciation, but there were a good many issues, like Lorillard, which enjoyed a generally Bullish Trend \nall year. Among the important stocks that moved up consistently in 1957 were American Chicle, Anchor Hocking Glass, Colgate-Palmolive, General \nFoods, General Cigar, Grand Union, National Biscuit, Parke Davis, Penick and Ford, Plough, Inc., Proctor and Gamble, Ruberoid, Vick Chemical, \nWinn-Dixie Stores, and Zenith Radio.\n Whatever theories we may have as to the condition of the “market-as-a-whole,” we must always realize we are buying and selling individual \nstocks. (EN: Unless we are trading Index Shares.) We may get a picture of extreme Bullishness or extreme Bearishness in the “general market,” but if \nthis picture conflicts with the clear evidence in a particular stock, we must recognize it is the stock, not the Average, with which we have to deal. We \ncannot assume a stock “must” follow the Average. Often, it is possible to obtain greater stability and safety by buying a few strong stocks in a Bear \nMarket or by selling short a few weak stocks in a Bull Market, than by attempting to maximize profits with an “all-out” position one way or the other.\n448 Technical Analysis of Stock Trends\nAVNET ELECTRONICS CORP. AVT\n1961\nMAYJ UNE JULY AUGUST SEPTEMBERO CTOBER\n68\n64\n60\n56\n52\n48\n44\n40\n38\n36\n34\n32\n30\n28\n26\n24\n22\n500\n400\n300\n200\n100\n61 32 02 731 01 72 41 81 52 22 95 12 19 26 29 16 23 30 71 42 12 8\nSales\n100’s\nFigure 37.20 During the latter nine months of 1961, some well-known market Averages continued \nto show new all-time highs. However, the Evaluative Index (see Chapter 38), in this period did not \nindicate any such overall strength; many stocks were in almost continuous decline for the nine \nmonths. These included such important issues as Air Reduction, Allied Chemical, Allis-Chalmers, \nAluminum, Ltd., Fansteel Metallurgical, Flintkote, Heyden Newport Chemical, Sperry Rand, Texas \nInstruments, Trans World Airlines, Universal Match, and many others. At such times, it is best to \nchoose stocks selectively and maintain adequate liquid reserves.\n449Chapter thirty-seven: The same ol d patterns\nBURNDY CORPORATIONB DC\n1961\nAPRILM AY JUNE JULY AUGUST\n40\n38\n36\n34\n32\n30\n28\n26\n24\n50\n40\n30\n20\n10\n29 1625 18 15 22 2961 32 02 7310 17 24 18 15 22 29 51 21 92 6\nSales\n100’s\nFigure 37.21 A familiar Top Pattern. From the end of 1957 to the spring of 1961, Burndy Corporation \nmoved from below 10 to 37 in a generally Bullish Trend. The advance accelerated sharply on the \npostelection rally of late 1960 and early 1961. However, with Burndy, as with many other stocks, the \nrally ended in the early months of 1961. Here, we have not only a perfect example of the Head-and-\nShoulders Top in the price action, but we also have the typical volume confirmation. The early April \nrally was on heavy volume. The rally in the last week of April was on somewhat-disappointing \nvolume, although a new high was made at that time. We have a definite increase of volume on the \nretreat from this peak, and practically no enthusiasm in the final rally of the first week of June. The \nbreakdown on Monday, June 19, accompanied by heavier volume and a definite gap in the price \ntrack, confirmed the Top Formation. Although Burndy held around the 30 level for a time, and after \na further drop recovered to 31, the Major Trend had definitely been reversed. By June 1962, Burndy \nwas selling at 11 3/4.\n450 Technical Analysis of Stock Trends\nTEKNIPLAT Chart Paper\nPublished and Distributed by JOHN MAGEE, Inc. Technical Analysis of Stock Trends, 360 Worthington Street, Springfield 3, Massachusetts\nType RU\nCOPYRIGHT 1961 BY JOHN MAGEE, SPRINGFIELD, MASS.\nBRUNSWICK CORPORATIONS BC1960–1962\n76\n72\n68\n64\n60\n56\n52\n48\n44\n40\n38\n36\n34\n32\n30\n28\n26\n24\n22\n500\n400\n300\n200\n100\nNJ D FM AM JJ AS ON DJ FM AM JJ AS ON DJ FM AM JA S \n′\n60 ′61 ′62\nSales\n100’s\nFigure 37.22 Weekly chart of Brunswick Corporation showing the final stages of the long Bull Market in “BC,” the Climactic Top in March 1961, the \ndistributive phase through December 1961, and the ultimate breakdown.\n For five years, from 1956 into early 1961, Brunswick advanced in a great Bull Market surge. During this period, the stock was split four times. In \nthe first week of March 1961, terminating the postelection rally, “BC” made a new high on extraordinary volume, but closed the week nearly at the \nbottom of the weekly range. The One-Week Reversal might well have served as a warning to the market trader.\n Assuming, however, the owner of shares in Brunswick was not a trader and was interested in the stock from a long-term point of view, he might \nhave held the stock through the breakdown from the Symmetrical Triangle formed in March and early April. He might have continued to keep his \nshares through the summer and fall of 1961 and the rally of September and October. If so, and if he had been watching the action of the stock, he \nwould realize the 50–52 level was a critical area. A break through this previous Bottom would represent a serious failure of Support and, certainly, \nthe decisive violation of the 50 level in the first week of January 1962 (with heavy volume) could be recognized as a very dangerous Reversal Signal, \ncalling for immediate sale of the stock regardless of capital gains tax or anything else. Although this move preceded the", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 214}
{"text": "2 level was a critical area. A break through this previous Bottom would represent a serious failure of Support and, certainly, \nthe decisive violation of the 50 level in the first week of January 1962 (with heavy volume) could be recognized as a very dangerous Reversal Signal, \ncalling for immediate sale of the stock regardless of capital gains tax or anything else. Although this move preceded the general collapse of the \nmarket by several months, it was a clear technical indication of extreme weakness and extreme danger in Brunswick, regardless of the action of \nother stocks at that time. If an investor had noted the break but decided to “wait for a rally” to sell his stock, he would have had no chance to get \nout. Brunswick never recovered, never rallied, and by October 1962 it was selling at 17 .\n451Chapter thirty-seven: The same ol d patterns\nPOLAROID CORPORATION PRD\n1962\nJANUARYF EBRUARYM ARCH APRILM AY JUNE\n240\n224\n208\n192\n176\n160\n152\n144\n136\n128\n120\n112\n104\n96\n88\n1100\n1000\n900\n800\n700\n600\n500\n400\n300\n200\n100\n61 32 02 7310 17 24 31 01 72 43 17 14 21 28 51 21 92 62 91 62 33 0\nSales\n100’s\nFigure 37.23 A beautiful example of a Rectangle in Polaroid. Notice the low-volume fluctuations \nbetween (approximately) 178 and 202. On Thursday, May 10, on the highest volume of that year to \ndate, Polaroid broke Support and plunged to 168. This was a clearly Bearish Move. It would have been \nfatal to “hold for a rally,” for there was no rally. It can be very expensive to hold onto a stock wishfully \nwhen the situation has changed radically, no matter how good it may have looked previously. Note \nthis break came more than two weeks before the “near-panic” of May 28. By that time, “PRD” had \ndropped 50 points and was headed for still lower levels.\n452 Technical Analysis of Stock Trends\nCOPPER RANGE CO.C PX\n1962\nJANUARYF EBRUARYM ARCH APRILM AY JUNE\n26\n24\n22\n20\n19\n18\n17\n16\n15\n14\n13\n50\n40\n30\n20\n10\n61 32 02 73 10 17 24 31 01 72 43 1714 21 2851 21 92 62 91 62 33 1\nSales\n100’s\nFigure 37.24 At a time when a majority of stocks were already showing signs of serious weakness, \nearly in 1962, Copper Range was making vigorous new highs. Actually, the move did not get far; it \nnever substantially broke above the 1961 Top.\n The evidence of weakness in “CPX” did not become apparent until, after the relatively weak April \nrally, the stock broke through 19 on Monday, April 30, and closed at 17 . This was the completion \nof a well-marked Head-and-Shoulders Top. In this case, there were three days of rally before the \ndownward move really got under way, but it might have been dangerous to count on a rally after \nthe clearly Bearish signal.\n Incidentally, this Top Formation was completed well before the precipitous drop of May and June.\n453Chapter thirty-seven: The same ol d patterns\nU.S. SMELTING, REFINING AND MINING CO.U V\n1962\nAPRILM AY JUNEJ ULYA UGUSTS EPTEMBER\n40\n38\n36\n34\n32\n30\n28\n26\n24\n22\n50\n40\n30\n20\n10\n71 42 12 851 21 92 62 91 62 33 071 42 12 84 11 18 25 18 15 22 29\nSales\n100’s\nFigure 37.25 Like practically all stocks, “UV” went into a tailspin in the spring of 1962. After the \n“bad day,” May 28, it continued to slide throughout the month of June. At this point, there started \nwhat could be considered no more than a technical rally in a Bear Market. This rally stopped at 29 \nand was followed by a dull decline lasting about two weeks.\n The next move, in the second week of August, was marked by considerable volume, and although \nthere was no obvious, clear-cut pattern, it seemed significant that the 29 level, briefly touched on May \n23, May 28, and July 12, was penetrated on August 6.\n Whether to regard this August 6 closing as an immediate buy signal, or to wait for the completion \nof the breakout move and look for an opportunity to buy on a reaction, would be a problem. In this \ncase, it would have paid to wait. Notice the late August reaction came back to the 29 level, where it \nfound Support, and then continued its upward move.\n Considering the weakness of most stocks in this period, the action of “UV” is remarkable. The \nimportant thing to recognize is individual stocks do not necessarily follow “the main trend” of the \nAverages.\n454 Technical Analysis of Stock Trends\nDOW–JONES INDUSTRIAL AVERAGE\n1961–62\nSALES IN \nMILLIONS\nJULY AUGS EPTO CT NOVD EC JANF EB MARA PR MAYJ UNE\n740\n720\n700\n680\n660\n640\n620\n600\n580\n560\n540\n520\n5\n4\n3\n2\n1\nFigure 37.26 Weekly, July 1961 through June 1962. This chart shows the Head-and-Shoulders \nTop Formation in the Industrial Average that preceded the collapse of April, May, and June 1962. \nNormally, especially in the charts of individual stocks, there would tend to be heavier volume on \nthe left shoulder. The price pattern alone is sufficient to mark the pattern as a dangerously toppy \nsituation. During the entire period in which this formation took shape, many individual stocks \nrepresenting important companies were showing Top Reversal symptoms, as might be expected. \nNote, so far as this Head-and-Shoulders Pattern is concerned, the Reversal Signal is not definite until \nthe neckline has been penetrated.\n455Chapter thirty-seven: The same ol d patterns\nABC VENDING CORP.A BC1961\nAPRILM AY JUNE JULY AUGUSTS EPTEMBER\n72\n68\n64\n60\n56\n52\n48\n44\n40\n38\n36\n34\n32\n30\n50\n40\n30\n20\n10\nSPLIT2\n1\n18\n19\n20\n22\n24\n26\n28\n61 32 02 731 01 72 41 81 52 22 95 12 19 26 29 1626 18 15 22 29\nSales\n100’s\nFigure 37.27 Daily, April through September 1961. Here is a rather confusing and complicated chart, \nbut one that contains several points of interest worth a bit of analysis. Notice the beautiful little \nHead-and-Shoulders Top in April and May, especially the volume weakness on the final rally before \nthe downside breakout. Notice also this stock was split two-for-one in June, but such a split does not \nmaterially affect the technical action of the stock, except because there are now two shares of stock (at \nhalf the market value) for each share of old stock, there may be some increase in the average number \nof", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 215}
{"text": "ders Top in April and May, especially the volume weakness on the final rally before \nthe downside breakout. Notice also this stock was split two-for-one in June, but such a split does not \nmaterially affect the technical action of the stock, except because there are now two shares of stock (at \nhalf the market value) for each share of old stock, there may be some increase in the average number \nof shares traded per day. Notice also that once the downtrend was established, the rallies (especially \nthe mid-July rally) do not penetrate the trendline drawn through the April and May peaks. This trend \ncontinued down for more than a year after this, reaching a low of 11 1/4 in October 1962.\n456 Technical Analysis of Stock Trends\nCERRO CORPORATION CDP1 963\nJANUARYF EBRUARYM ARCH APRILM AY JUNE\n30\n28\n26\n24\n22\n20\n19\n18\n17\n125\n100\n75\n50\n25\n51 21 92 62 91 62 32 91 62 33 06 13 20 27 41 11 82 51 81 52 22 9\nSales\n100’s\nFigure 37.28 Daily, January through June 1963. Here is a good example of a Symmetrical Triangle \nas a Continuation Pattern. Triangles of this (Symmetrical) type may mark Consolidations in a Major \nTrend, or they may constitute a Reversal Formation. The characteristics in either case are an active \nmove to the first turning point of the Triangle, and then, generally diminishing volume as the price \nfluctuates in a narrowing pattern. During this period, it could be said the stock was in both an \nuptrend, marked by the lower boundary of the formation, and a downtrend, indicated by the upper \nboundary. Notice the increase of volume on the breakout, which, in this case, was on the upside. Also, \nnotice the reaction to the “cradle point” defined by the intersection of the two boundary trends of \nthe Triangle. The advance of the stock from April to June measures just a little more than the height \nof the open side of the Triangle. The attainment of this “objective” does not necessarily mean the \ntermination of the Major Trend, however, and by August 1963, Cerro had reached 33 1/4.\n457Chapter thirty-seven: The same ol d patterns\nCRUCIBLE STEEL CO. OF AMERICAX A\n1963\nMARCHA PRIL MAYJ UNE JULY AUGUST\n26\n24\n22\n20\n19\n18\n17\n16\n125\n100\n75\n50\n25\n91 62 33 061 32 02 7411 18 25 18 15 22 29 61 32 02 7310 17 24 31\nSales\n100’s\nFigure 37.29 XA. Daily, March through August 1963. Here is a good example of an Ascending \nTriangle, in which the rallies advance repeatedly to a given level; the reactions find Support at \ngradually higher points. Such a pattern normally indicates a potentially Bullish situation in the \nmaking, just as the reverse (Descending Triangle) implies a Bearish tendency. Notice the higher \nvolume on the various peaks near 22, and the very high volume on the breakout move in August. If \nany further evidence of the strength of this move was needed, the Breakaway Gap at the opening, \nMonday, August 12, would supply it. After a breakout of this sort, it would be quite normal for the \nstock to suffer some profit-taking reaction, usually on light volume, and such a reaction might run \nback to 22 or even a little below this without altering the essentially Bullish nature of this picture.\n458 Technical Analysis of Stock Trends\nSUPERIOR OIL CO. (CALIF.) SOC1 962\nJUNE JULY AUGUSTS EPTEMBER OCTOBERN OVEMBER\n1408\n1280\n1216\n1152\n1088\n1024\n960\n896\n832\n704\n768\n5\n4\n3\n2\n1\n29 16 23 30 71 42 12 84 11 18 25 18 15 22 29 61 32 02 73 10 17 24\nSales\n100’s\nFigure 37.30 SOC. Daily, June through November 1962. Before commenting on the November \nbreakout here, we should call attention to the fact “SOC” was one of the stocks that held up fairly \nwell during the Cuban crisis in October 1961 and did not make a new low under the June bottoms. \nThis chart picture is an excellent example of a Double Bottom. It is not necessary for the two Bottoms \nto be at exactly the same level if they are reasonably close. The important thing is the stock has found \nSupport once, has rallied, then declined again, and has found Support at nearly the same point. The \nBottoms should be some distance apart; there should be at least six weeks between them, preferably \nmore. Also, the rally between them should be definite and should amount to at least a 15% gain at its \npeak. The formation does not acquire significance as a Major Bottom Pattern until the level of the top \nof the rally is penetrated on substantial volume. This penetration took place on Tuesday, November \n13, and from that time continued in a Major Bullish Trend, reaching 1559 in May 1963, an advance of \nmore than 500 points from the close on the day of breakout.\n Double Tops have an opposite significance; they are similar to the Double Bottoms, but they consist \nof two tops at approximately the same level, separated by some weeks or months, and with a decline \nbetween them, which must be penetrated to validate the Top Formation.\n459Chapter thirty-seven: The same ol d patterns\nGENERAL STEEL INDUSTRIES, INC. GSI\n1962–1963\nSPLIT2\n1\nNOVEMBERD ECEMBER JANUARYF EBRUARYM ARCH APRIL\n64\n60\n56\n52\n48\n44\n40\n38\n36\n34\n32\n30\n50\n40\n30\n20\n10\n30\n28\n26\n24\n20\n19\n18\n27 31 01 72 41 81 52 22 951 21 92 62 91 62 32 91 62 33 06 13 20\nSales\n100’s\nFigure 37.31 Daily, November 1962 to April 1963. To the average person unfamiliar with the usual \nbehavior of stocks in the market, the price fluctuations appear meaningless and entirely fortuitous. \nIf they are aware of general trends lasting months or years, they are often inclined to consider only \nthe trend of “the Averages,” and are not conscious of the fact many stocks may be making large \nadvances at the very same time that others are sliding lower and lower. It is not always possible to \nlay a straight-edge ruler along the trend and show \\ it makes a perfect straight line (although this \ndoes sometimes happen); however, as in the case of General Steel Industries, there is no question the \nadvance is fairly consistent over a long period of time, barring the relatively unimportant reactions, \nConsolidations, and so on, along the way. You will notice, too, th", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 216}
{"text": "not always possible to \nlay a straight-edge ruler along the trend and show \\ it makes a perfect straight line (although this \ndoes sometimes happen); however, as in the case of General Steel Industries, there is no question the \nadvance is fairly consistent over a long period of time, barring the relatively unimportant reactions, \nConsolidations, and so on, along the way. You will notice, too, the two-for-one split in early March \ndid not materially affect the upward trend except to show somewhat more volume, as might be \nexpected with a greater number of (new) shares. For a contrasting (downside) trend, see the chart of \nAvnet Electronics, Fig u r e 37. 20.\n460 Technical Analysis of Stock Trends\nUNITED ARTIST CORPORATION UNA\n1963\nMARCHA PRILM AY JUNEJ ULY\n32\n30\n28\n26\n24\n22\n20\n19\n250\n200\n150\n100\n50\n16 23 29 16 23 30 61 32 02 741 11 82 51 81 52 22 96 13 20 27 31 0\nSales\n100’s\nFigure 37.32 Daily, February to August 1963. This is an interesting study of Support and Resistance \nphenomena. Incidentally, it is also an example of a Bearish Stock (and not the only one by any means) \nin what was generally considered a Bullish Market, during the spring and summer of 1963. We \nwould point out several rallies to 31 in March and April, and the breakdown in early May. In May \nand June, the stock rallied, but it stalled at about the level of the March low. Then there was another \ndrop, and in the rally, this time came back to the late April low. The next drop, in July, was followed \nby a little rally to the June Bottom at 25. This is fairly typical Support–Resistance behavior. The price \nlevel that has been a Support tends to become a Resistance once the Support has been substantially \nbroken. Vice versa, as regards overhead Resistance; after it has been broken, it tends to serve as a \nSupport level.\n461Chapter thirty-seven: The same ol d patterns\nUTAH – IDAHO SUGAR CO.U IS\n1963\nJANUARYF EBRUARYM ARCH APRILM AY JUNE\n19\n18\n17\n16\n15\n14\n13\n12\n11\n10\n9\n125\n100\n75\n50\n25\n61 32 02 74 11 18 25 18 15 22 2951 21 92 62 91 62 32 91 62 33 0\nSales\n100’s\nFigure 37.33 January through June 1963. Sometimes a move happens all of a sudden and does not \nresult in a continuing long trend. In this case, it is not possible to say whether the long-term trend will \nbe up or not. The purpose of showing this chart is to point up the remarkable action that can follow \na break through an important Support or Resistance Level. You will notice that the entire period \nfrom mid-January to Tuesday, May 14, can be regarded as a Rectangle on the chart with Bottoms at \nabout 10 1/8 or 10 1/4, and Tops at about 11 3/4. Notice the increase of activity on the several rallies \nduring the formation. The move, which was a “situational” thing in sugars, affected all sugars in \nMay, and turned out to be somewhat of a flash in the pan. Nevertheless, it was a spectacular one, and \na trader with courage and acuity might have picked up this stock as a speculation after the close of \nTuesday, May 14. The next five trading days advanced the price from Wednesday’s opening at 12 to \nthe Tuesday, May 21, close at 17 1/2, an advance of 46%. This is a type of market trading we would \nnot recommend generally; it calls for courage, experience, and the willingness to take a number of \nsmall losses to secure one substantial gain. However, the in-and-out trader who observed the action \non May 21 and noticed the One-Day Reversal with abnormal volume and a gap could have secured \nmaximum quick profits either by selling his stock at the opening of the next day or by placing a stop-\nloss order just under the close, say, at 17 3/8.\n462 Technical Analysis of Stock Trends\nCONTROL DATA CORP.C DA\n1965\nFEBRUARY MARCHA PRILM AY JUNE JULY\nWEDGE\n64\n60\n56\n52\n48\n44\n40\n38\n36\n34\n32\n30\n28\n26\n24\n22\n500\n400\n300\n200\n100\n13 20 2761 32 02 73 10 17 24 18 15 22 29 51 21 92 63 10 17 24 31 7\nSales\n100’s\nFigure 37.34 There are some warning signs in “CDA” in the Minor Breakdowns of late March and \nearly May. What seems especially significant, however, is the nature of the recovery move in May \nand early June 1965. The two convergent boundaries of the Recovery Trend form an up-sloping \nWedge, which has rather definite Bearish implications. If the Wedge had been pointed down, it would \nstrongly suggest the possibility of a decisive upward breakout. Notice on the two days during which \nthe highest prices were attained during this Wedge Pattern, the stock closed near the Bottom of the \nday’s range. The subsequent history here, the collapse on heavy volume, shows clearly how dramatic \na break from this not-too-common formation can be.\n463Chapter thirty-seven: The same ol d patterns\nU.S. SMELTING, REFINING AND\nMINING CO . UV\n1965\n4\n1 SPLIT\nJULY AUGUSTS EPTEMBERO CTOBER NOVEMBER DECEMBER\n256\n240\n224\n208\n192\n176\n160\n152\n144\n136\n128\n120\n112\n104\n96\n88\n500\n400\n300\n200\n100\n61 32 02 74 11 18 2531 01 72 43 171 42 12 841 12 82 52 91 62 33 0\n64\n60\n56\n52\n48\n44\n40\n38\n36\n34\n32\n30\n28\n24\n22\nSales\n100’s\nFigure 37.35 Here is a chart that shows several interesting technical features. In July, August, and \nmost of September, “W” was in a period of dormancy. The breakout of September 27 was followed \nby a week of inaction and then a strong continuation of the move on big volume. Notice the October– \nNovember Consolidation, which took the form of a large Symmetrical Triangle. If we draw the upper \nboundary of this Triangle, and the lower, we see the breakout signaling a continuation of the move, \non Wednesday, December 1, was decisive both in price and volume action. At no time during the \nadvance from 28 1/2 to more than 62 was there any indication of potential weakness.\n464 Technical Analysis of Stock Trends\nLIVINGSTON OIL COMPANYL VO\n1965–1966\n16\n15\n14\n13\n12\n11\n10\n9\n8\n7\n6\n500\n400\n300\n200\n100\nJF MA MJ JA SO ND J\nSales\n100’s\nFigure 37.36 The weekly chart of Livingston Oil from January 1965 into January 1966 is a good \nexample of a Major Bottom. Just how weak the stock was during the early months of 1965 can be \njudge", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 217}
{"text": "was there any indication of potential weakness.\n464 Technical Analysis of Stock Trends\nLIVINGSTON OIL COMPANYL VO\n1965–1966\n16\n15\n14\n13\n12\n11\n10\n9\n8\n7\n6\n500\n400\n300\n200\n100\nJF MA MJ JA SO ND J\nSales\n100’s\nFigure 37.36 The weekly chart of Livingston Oil from January 1965 into January 1966 is a good \nexample of a Major Bottom. Just how weak the stock was during the early months of 1965 can be \njudged by the clear Downside Gap during the month of May. Also, you will notice the volume on \nthis whole headlong collapse was rather heavy. From July to the middle of October, however, the \ntrading activity “dried up,” and the stock fluctuated in narrower and narrower swings, forming \na Symmetrical Triangle. The pickup of volume on the October breakout was spectacular, and an \nobservant investor would have had a “second chance” to buy on the reaction in the first week of \nNovember when the stock drifted back to the top of the Triangle.\n465Chapter thirty-seven: The same old p atterns\nPACKARD – BELL ELECTRONIC CORP.P KB\n1965–1966\nAUGUSTS EPTEMBERO CTOBERN OVEMBERD ECEMBERJ ANUARY\n30\n28\n26\n24\n22\n20\n19\n18\n17\n16\n15\n14\n13\n12\n11\n500\n400\n300\n200\n100\n14 21 28 41 11 82 52 91 62 33 06 13 20 2741 11 82 51 81 52 22 9\nSales\n100’s\nFigure 37.37 Here is a beautiful picture of technical market action in Packard–Bell Electronics from \nAugust 1965 into January 1966. The first point of interest is the Flag Consolidation in September and \nOctober, a classic example (“The Flag flies at half-mast”) and on the resumption of the up-move, the \nstock did duplicate the earlier move, and a bit more. (Compare with the 1945 chart of Martin–Parry, \nFigure 33.13.) Notice the nearly flat Tops and the rising Bottoms from October to January, with \ngenerally declining volume (Ascending Triangle), and the magnificent breakout move in the second \nweek of January 1966. In this case, we can see no evidence calling for selling the stock all the way \nfrom September into January.\n466 Technical Analysis of Stock Trends\nPARKE, DAVIS AND COMPANYP DC 1969–1970\nJULY AUGUSTS EPTEMBERO CTOBER NOVEMBERD ECEMBERJ ANUARY FEBRUARY MARCH APRILM AY JUNE\n76\n72\n68\n64\n60\n56\n52\n48\n44\n40\n38\n36\n34\n32\n30\n28\n26\n24\n22\n1000\n800\n600\n400\n200\nXD .25\nXD .25\nXD .25\n61 32 02 74 11 18 25 18 15 22 29 61 32 02 751 21 92 62 91 62 33 0 71 42 12 84 11 18 25 29 16 23 30 61 32 02 731 01 72 43 17 14 21 28\nSales\n100’s\nFigure 37.38 This could be regarded as a very flat Head-and-Shoulders Top or as a long Rounding \nTop. The breakdown through 66 was a warning, and certainly the sharp break below 60 in February \nwas a definitely Bearish signal.\n467Chapter thirty-seven: The same ol d patterns\nASTRODATA INC. ADA\n1969–1970\nOCTOBERN OVEMBERD ECEMBERJ ANUARYF EBRUARY\n38\n36\n34\n32\n30\n28\n26\n24\n22\n20\n19\n18\n17\n16\n15\n14\n13\n12\n11\n125\n100\n75\n50\n25\n708\n620\n1828\n1072 988\n689\n890\n41 11 82 51 81 52 22 961 32 02 73 10 17 24 3171 42 12 8\nSales\n100’s\nFigure 37.39 A complete collapse in one day, Astrodata in January 1970. Not the sort of action you see \nevery day, or even every month, but it is “normal” in the sense it is a phenomenon we have seen many \ntimes in the past and undoubtedly will be seen many times in years to come. When it does happen, \nit should be heeded—it means trouble. “ ADA” was doing well in what appeared to be a typical and \nperfectly healthy uptrend. After a one-day suspension on January 15, it reopened many points lower and \nnever recovered. Trading was halted in late September. Some readers may remember other downside \nmoves of this nature in the past. In Mack Trucks, in Fifth Avenue Coach, and some may even recall, \nmany years ago, a break like this in American Woolen. Such a break is due to some sudden development \nor change in company affairs, but it is not necessary “to know the reasons”: the chart speaks for itself. \nAs Lady Macbeth put it (in another connection), “Stand not upon the order of your going, but go at \nonce.” There was a good example of this type of a “Gap Move” in Villager Industries on April 30, 1971, \nwhen the stock dropped 42%, from 7 3/8 to 4 1/4 in one day. Such moves as we are discussing here \nare nearly always on the downside; we do not often see comparable upside gap moves. After this type \nof break, although there may be brief rallies, the stock nearly always resumes the downtrend, and in \nmany cases, is delisted from the Exchange. Anyone caught holding such a stock should not feel he had \nmade a mistake in buying it, nor should he look for evidence of weakness before the big breakdown, \nfor ordinarily, there is none, however, he should get out immediately to avoid further loss. By way of \nreassurance, it can be repeated though this kind of collapse is a rather rare occurrence.\n468 Technical Analysis of Stock Trends\nOracle Corporation-(Nasdaq NM) 12.21 –0.08 –0.65%\nVolume (Billions) \nJul Oct 97 Apr Jul Oct 98 Apr Jul Oct 99 \n7 \n6.5 \n6 \n5.5 \n5 \n4.5 \n4 \n3.5 \n2.5 \n3 \n1.2 \n1 \n0.6 \n0.6 \n0.4 \n0.2 \n0 \n1999-2004 Prophet Financial Systems, Inc. I Terms of use apply. \nFigure 37.40 Oracle Corporation. Lest one think the air pocket gap does not still exist, here is an \nexample from the turn of the century (third millennium). These gaps, caused by disappointing \nearnings, were so prevalent at the end of the century at the top of that Bull Market that one could \nshort vulnerable stocks before earnings reports with little upside risk and often collect nice scalps \nlike this one.\n469Chapter thirty-seven: The same ol d patterns\nPUBLIC SERVICE ELECTRIC AND GASP EG\n9/1 SPLIT\nTHOUSANDS OF SHARES\n1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970\n1.14\n.90. 92 1.02 1.48 1.55 1.61 1.64 1.64\n1.35 1.60 1.87 1.96 2.06 2.23 2.39 2.54 2.57 2.60 2.63\n1\n2 1.12 1\n2 1.22 1\n2 1.31 1\n2 1.38 1\n2\n48\n46\n44\n42\n40\n38\n36\n34\n32\n30\n28\n26\n24\n22\n20\n18\n16\n14\n12\n250\n200\n150\n100\n50\nEARN.\nDIV.\nFigure 37.41 A typical electric and gas utility stock. There are a great many stocks in this group, \nserving various municipalities or regions. They tend to show similar market behavior because they \nar", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 218}
{"text": "1.61 1.64 1.64\n1.35 1.60 1.87 1.96 2.06 2.23 2.39 2.54 2.57 2.60 2.63\n1\n2 1.12 1\n2 1.22 1\n2 1.31 1\n2 1.38 1\n2\n48\n46\n44\n42\n40\n38\n36\n34\n32\n30\n28\n26\n24\n22\n20\n18\n16\n14\n12\n250\n200\n150\n100\n50\nEARN.\nDIV.\nFigure 37.41 A typical electric and gas utility stock. There are a great many stocks in this group, \nserving various municipalities or regions. They tend to show similar market behavior because they \nare basically similar in nature.\n There is a relation between the earnings of a company and the dividends paid, and the market \nprice of the shares. Neither earnings nor dividends alone, however, are sufficient to constitute a \ncomplete determination of “value” because there are many other factors that can affect the “value” \nconsidered from different angles, such as dependability of earnings, future prospects, taxability, \nresearch and development investment by the company, and so forth.\n The electric and gas companies, enjoying a regulated monopoly position in most communities, \nhave a sure and steady income. They are also in a definite “growth” situation because of the constantly \nincreasing demands for power by users. Most utilities will show a record and pattern of trading over \na period of years very similar to that of “PEG.” You will notice reported earnings have been larger \neach year from 1959 through 1970. Also, the dividend rate has been increased each year except in \n1970, when it was unchanged from the year before. Anyone basing his estimate of “value” on a simple \nindex such as “price–earnings ratio” would conclude the stock was 2 1/2 times as good a buy in 1970 \nas it had been in early 1965.\n Obviously, there is more to it; the big funds and other large holders of stock are not giving up \n“bargains” of that sort lightly and for no reason. The depressed chart is undoubtedly reflecting \nthe whole thorny outlook facing the utility industry, including costly new facilities, anti-pollution \ndevices, and other problems including deregulation.\n470 Technical Analysis of Stock Trends\nMEMOREX CORP. MRX 1969–1970\nSEPTEMBERO CTOBER NOVEMBER DECEMBER JANUA RY FEBRUARY MARCHA PRIL MAYJ UNEJ ULYA UGUST\n176\n160\n152\n144\n136\n128\n120\n112\n104\n96\n88\n80\n76\n72\n68\n64\n60\n56\n52\n48\n2000\n1600\n1200\n800\n400\n61 32 02 74 11 18 25 18 15 22 29 61 32 02 723 30 71 42 12 84 11 18 25 29 16 23 30 61 32 2731 01 72 43 17 14 21 28 41 11 82 51 81 5\nSales\n100’s\nFigure 37.42 Although 1969 was Bearish for most stocks, “MRX” was enjoying the final fling of a \ndramatic four-year advance. Notice the Island-like Top in November, December, and January, and \nthe low volume all through this period. The Breakaway Gap in early February speaks for itself. See \nalso Fig u r e 37. 39.\n471Chapter thirty-seven: The same ol d patterns\n1969, 1970, 1971\nFLYING TIGER CORP FLY\n44\n40\n38\n36\n34\n32\n30\n28\n26\n24\n22\n20\n19\n18\n17\n16\n15\n14\n13\n12\n11\n250\n200\n150\n100\n50\n69 70 70 71\nON DJ FM AM JJ AS ON DJ F\nFigure 37.43 From a 1967 high of 48 1/2, “FLY” started a downtrend that lasted two years and \ntook the stock down to 11 1/4; but during the spring and summer of 1970, the stock found bottom, \nmade a Head-and-Shoulders Reversal, and took off in a skyrocket move that, by February 1971, had \nrecovered nearly all of the two-year drop.\n472 Technical Analysis of Stock Trends\nACTION IND, INC. ACX\n1971–1972\nNOVEMBERD ECEMBERJ ANUARY FEBRUARY MARCHA PRIL\n44\n42\n40\n38\n36\n34\n32\n30\n28\n26\n24\n22\n20\n19\n18\n17\n16\n15\n14\n13\n12\n11\n250\n200\n150\n100\n50\n340\n365\n335\n424\n23 30 61 32 02 741 11 82 51 81 52 22 95 12 19 26 41 11 82 51 81 5\nSales\n100’s\nFigure 37.44 Here is a familiar pattern you have seen many times before in the pages of this book \nor in your own charts—a large Ascending Triangle in the daily chart of Action Industries, formed \nin December of 1971 and January of 1972. Notice the typical breakout and reaction moves and the \ncontinued uptrend into April of 1972.\n473Chapter thirty-seven: The same ol d patterns\nDELL LAST- Monthly\nCreated with TradeStation www. TradeStation.com160140\n120\n100\n80\n60\n40\n20\n80000000\n60000000\n40000000\n20000000\n89 90 91 92 93 94 95 96 97 98 99 00\nFigure 37.45 Two things are remarkable here: (1) the amazing story of a business emerging from a \ncollege dorm room—a computer business, of course—and (2) the regular occurrence of air pockets, \nwhich will be seen better on the next chart. Not a stock for those who dislike carnival rides and \nsurprises. One should fit his portfolio to his digestion. Dell broke its long-term trendline, which the \nreader may easily draw here with a ruler, and after setting a bull trap, went to 20, displaying several \nmajor warning downside gaps (see next chart). The out-of-proportion volume at the chart end is a \nforewarning.\n474 Technical Analysis of Stock Trends\ny l h t n o M - T S A L L L E D\nm o c . n o i t a t S e d a r T . w w w n o i t a t S e d a r T h t i w d e t a e r C0 6 1\n0 4 1\n0 2 1\n0 0 1\n80\n60\n40\n20\n0 0 0 0 0 0 08\n0 0 0 0 0 0 06\n0 0 0 0 0 0 04\n0 0 0 0 0 0 02\n3 9 2 9 1 9 0 9 9 8 8 9 7 9 6 9 5 94090 9 9\nFigure 37.46 DELL. The breakaway or air pocket gap continues to astound, so frequently choosing to \noccur at horizontal lines. An exceptionally alert trader might have avoided the air pocket, observing \nthe broken trendlines. The average technician would have got out and shorted the breakaway gap. \nSeen one tulip, seen them all.\nINTC LAST-Weekly\nCreated with TradeStation www. TradeStation.com\n1996 19974/1996 7/1996 10/1996 4/1997 7/1997 10/19971 9984 /19987 /19981 0/1998 1999 4/19997 /19991 0/1999\n100\n80\n60\n40\n20\n100\n80\n60\n40\n20\n50000000\n40000000\n30000000\n20000000\n10000000\n50000000\n40000000\n30000000\n20000000\n10000000\nFigure 37.47 The benefits of the “Wintel” partnership are reflected in Intel’s chart. The trader might \nhave been in and out of Intel several times based on tightening trendlines, whereas the long-term \ninvestor would have patiently waited out the—call it a “rectangular wedge”—that never was violated \non the downside. The steeper the trendline the more likely—even the more certainly—it will be broke", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 219}
{"text": "gure 37.47 The benefits of the “Wintel” partnership are reflected in Intel’s chart. The trader might \nhave been in and out of Intel several times based on tightening trendlines, whereas the long-term \ninvestor would have patiently waited out the—call it a “rectangular wedge”—that never was violated \non the downside. The steeper the trendline the more likely—even the more certainly—it will be broken.\n475Chapter thirty-seven: The same ol d patterns\nNokia Cp Ads 18.38 0.09 0.49%\nVolume(Millions)\n60 \n52 \n44 \n40 \n36 \n32 \n26 \n24 \n20 18.39 \n16 \n12 \n3 \n4 \n6 \n97 98 99 00 01 02 03 04 05 06 \n1999-2004 Prophet Financial Systems, Inc. I Terms of use apply. \n225 \n200 \n175 \n150 \n125 \n100 \n75 \n50 \n25 \n0 \nFigure 37.48 NOKIA (NOK). Not enough is made of the marking of zones of Support and Resistance \n(highs and lows) with horizontal trendlines. These benchmarks help the technician to mark the \nrunning of the tide, just like Dow’s stakes on the beach. Notice how the high of 1999 influences the \nhigh of 2004. The breaking of horizontal lines here after the breaking of the steepest trendline once \nagain tells the tale for the technician.\nAMD LAST –Daily 02/18/2000 C = 43.000 O = 39.375 H = 40.250 L = 39.000 V = 4151700\nCreated with TradeStation www. TradeStation.com\nVolume 3225500.00\n44.999\n39.999\n34.999\n29.999\n24.999\n19.999\n14.999\n20000000\n15000000\n12000000\n80000000\n40000000\n12/1998 2/1999 3/19994 /19995 /19996 /19997 /19998 /19999 /19991 0/1999 11/1999 12/199 92 /200099 00\nFigure 37.49 AMD. Reflecting the vagaries of the semiconductor business, including the felicity (or \ninfelicity) of being a competitor of Intel, AMD shows trading opportunities both up and down. Here \nthe intermediate-term trader would respond to the vigorous breaking of short-term downtrend lines \nto get long.\n476 Technical Analysis of Stock Trends\nYahoo! Inc.–(Nasdaq NM) 40.49 –0.19 –0.47%\nVolume (Millions)\n120\n100\n40.49\n80\n60\n50\n30\n20\n10\n0.6\n225\n200\n175\n150\n125\n100\n75\n50\n25\n0\nJulO ct 97 AprJ ul Oct9 8A pr JulO ct 99 AprJ ul Oct0 0A pr AprJulO ct 01\n1999-2004 Prophet Financial Systems, Inc. I Terms of use apply.\nFigure 37.50 Yahoo! (YHOO). A superb trendline that should have kept the technician long until \nApril of 2000—and then got him out, especially when combined with the top horizontal trendline. \nThe extravagant volume at the very top is the exclamation point on the warning.\n477Chapter thirty-seven: The same old p atterns\nYHOO(D)–Weekly NASDAQ L = 3 .50 +0.17 +0.50% O = 34.60 C = 34.50\n30.73\n10.97\n1997 1998 1999 2000 2001 2002 2003 2004 2005\nCreated with TradeStation \n97.00\n66.00\n45.00\n31.0034.50\n21.00\n14.00\n10.00\n7.00\n5.00\n3.00\n2.00\n1.00\nFigure 37.51 Any resemblance between this chart and Amazon (see Figure 23.13 ) is not strictly \ncoincidental. Readers will remember Magee’s principle that birds of a feather flock together. Internet \ngoony birds certainly do—or did. Yahoo! looks in this guise somewhat stronger than Amazon, but \nthen selling books and mortar is a harder row to hoe than selling electronic images (best business \nin the world). Again, such an attractive fundamental story. Gooks (or geeks) on skates helping \nrevolutionize the wild frontier—we love these stories, but not enough to stop drawing lines on the \nchart and selling them when they violate our lines. Even love must obey the rule of the ruler.\n478 Technical Analysis of Stock Trends\nAPPLE COMPUTER INC–(Nasdaq NM) 71.89 0.44 0.62%\n7571.09\n65\n60\n55\n50\n45\n40\n35\n30\n25\n20\n15\n10\n5\n3\n97 98 99 00 01 02 03 04 05 06\n1999–2004 Prophet Financial Systems, Inc. Terms of use apply.\nFigure 37.52 Apple (APPL). Apple is a remarkable delight because it illustrates vividly one of the \ncentral principles of technical analysis: ignore (or take with a cellar of salt) the news. Any time the \nmedia swarms on a company, be skeptical. If we believed the media, Apple would have more lives \nthan a cat, considering how many times the media has written it off as dead. It is also a chartist’s \ndelight as illustrated in my Basing Point studies (Chapter 28), and here, by trendlines (horizontal \nand sloped) and a large fan. Readers years from now will want to observe how the trendlines here \nforecast Apple’s future. Fig u r e 37. 53 vividly illustrates the technical signal that kicked off Apple’s \nrun, complete with Triangle and run day, and wake up volume. We constantly deprecated the \npress disrespect of Apple—hounds of the press are appropriate—and they paid the price for their \ndisrespect as Apple went to 425 in 2011. It is satisfying to see the know-nothings of the financial press \nexposed for how little they know.\n479Chapter thirty-seven: The same ol d patterns\nApple Computer Inc(32.5090, 32.9700, 31.8900, 32.5400, +0.04000) 35\n34\n33\n32\n31\n30\n29\n28\n27\n26\n25\n24\n23\n22\n21\n20\n19\n18\n17\n16\n15\n14\n13\n12\n11\n3000\n0\n25000\n20000\n15000\n10000\n5000\nx10\nAugJulS ep Oct Nov Dec2 003 FebM ar AprM Ay JunJ ul AugS ep OctN ov Dec2 004F eb MarA pr Ma yJ un Jul\nFigure 37.53 The file of press clippings predicting the death of Apple weighs as much as the daily \noutput of the Augean Stables, and it is worth as much. One wonders why the press likes to beat on \nApple so, especially when the wizard was up to his never-ending tricks; the wizard (Steve Jobs) had \nmillions of fanatics ready to support his next trick. Although the Beatles are mad at Jobs and Apple, \nApple is now a music company as well as a computer company. The smooth-as-silicon lubricant \niPod made music to investor’s ears and Apple took off on another run. The start of the latest trick is \npictured here. The volume in April is the wake-up call. Of course, what is that volume? A shakeout. \nThe breakout across the Descending Triangle line after the false signal (Remember? Those false \nsignals are often followed by valid signals), the volume, and the surging run days—all good grist \nfor the analyst’s mill. Furthermore, the surge across the downtrend line on big volume should be \nrecognized as an important technical pattern regardless of what proceeds it.\n480", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 220}
{"text": "that volume? A shakeout. \nThe breakout across the Descending Triangle line after the false signal (Remember? Those false \nsignals are often followed by valid signals), the volume, and the surging run days—all good grist \nfor the analyst’s mill. Furthermore, the surge across the downtrend line on big volume should be \nrecognized as an important technical pattern regardless of what proceeds it.\n480 Technical Analysis of Stock Trends\n20052004200320022001200019991998199719961995199419931992199119901989\n767.30\n2\n3\n4 5\n6\n7\n8\n9\n10\n10.1\n11\n12\n13\n14\n15\n16\nCreated with TradeStation\n17 \n18 19 20 2122 23\n3,704.00\n2,613.00\n1,844.00\n1,301.00\n918.00\n648.00\n457.00\n323.00\n228.00\n1,703.84\n1\n2867.40\n3354.39\n$ NDX.X(D) - Weekly NASDAQ L=1703.84 +30.81 +1.84% B=0.00 A=0.00 O=1676.32 Hi=1711.26 Lo=1674.88 C=1703.84 V=0 \nFigure 37.54 $NDX, THE NASDAQ 100. Following the Basing Points Procedure in Chapter 28 , an \nalmost completely objective procedure may be devised for the very long-term investor to replace or \naugment Dow Theory. In this chart, the Basing Points Procedure is applied to weekly bars. Thus, \ninstead of three days away, we look for three bars away. The result is a trade that lasts around 10 \nyears! The method gets long in 1991 at the arrow, holds the trade until about 2001, and reverses. \nObserves the bottom of 2002 and reverses again and is long into the Bull Markets of 2006. Arrows \nshow the signals; numbers mark the Basing Points, and Stops, which would be about 5% under the \nBasing Points, are not illustrated.\n481\nchapter thirty-eight\nBalanced and diversified\nThe average investor wants a clear-cut, simple, easy answer to his question, “What do \nyou think of the market?” To him, it must be at all times either a Bull Market or a Bear \nMarket. If, in answer to his insistent demand, you reply with the question, “What particular \nstocks are you interested in?” he will avoid that issue and say, “Oh, I mean in general.” (For \nillustrations in this chapter see Diagrams 38.1 and 38.2.)\nIf you will examine the pages of any magazine or newspaper carrying a great deal of \nfinancial advertising, you will find many advisers and advisory services make a great point \nof giving unhedged opinions as to the future course of the market, and these opinions are \nmost frequently couched in terms of what the market as a whole is going to do.\nNow, there is just enough truth in the common belief that they all move together to \nmake this an exceedingly dangerous assumption. It is true, for example, we can set up \ndefinitions of what we feel constitutes a Bull Market or a Bear Market, such as the Dow \nTheory, and if a given set of conditions meets the rules we have laid down (i.e., our \ndefinitions), then we can say accurately, “according to my premises this is now a Bull \nMarket” (or a Bear Market, as the case may be). It is also true that over the years, if we \nhad treated the Dow Industrial Average (DIA) as if it were a stock and had theoretically \nbought it and sold it according to classic Dow Theory, we would have done very well. \n(EN: As is vividly illustrated in Chapter 4, where buying and selling by the Theory netted one \n$795,592.01 as opposed to $55,411.83 [as of December 29, 201]) through buying and holding. Of \ncourse, now it is the same as a stock [ETF], DIA.)\nIt is also true in the great inflationary and deflationary movements, which reflect the \nchanges in the relative values of dollars to equities, there is a tendency for the majority of \nstocks to move with the tide. Furthermore, it is true in the day-to-day movement of stock \nprices that most stocks move up or move down together.\nWe should never lose sight of the fact the Averages themselves are abstractions, not \nrailroads, manufacturing companies, airlines, and so on. If the Averages move, it is because \nthe individual stocks making up the Averages have moved; although, it is true during \na time when the Averages are advancing, a majority of stocks are also advancing, it is \nnot quite possible to reverse this and make it absolute by saying because the Averages are \nadvancing, therefore, all stocks must advance. If we carried this to its logical conclusion, we \nwould arrive at the point (that some have arrived at) at which the fact that a stock has not \nadvanced, but rather has declined in a Bull Market, is considered sufficient reason to make \nthe stock attractive for purchase on the basis it must catch up with the others.\nIf we examine the facts, namely, the long-term records of what stocks have actually \ndone, we find there are periods when most stocks go up in value and other times when most \nof them go down. We find, sometimes, laggard stocks eventually will join the procession \nin an upward trend.\nHowever, this does not always happen and it can be extremely uncomfortable to have \nbought stocks in a presumably Bullish Market because they are behind the market or they \nare all going to go up, and then wait for months as we watch other stocks climbing to new \nhighs, whereas our own securities continue to languish or decline further.\n482 Technical Analysis of Stock Trends\nFrom what you already know of the market, you will surely agree it is not a wise policy \nto put all your capital into buying stocks in what is clearly a Bear Market in the Averages \nand in most stocks. You will agree, too, it is not a safe thing to sell stocks short to the limit \nof your resources in a skyrocketing Bull Market.\nIf you have to be 100% on one side or the other, it is much better to go with the trend. \nIn that way, you will be in line with the probabilities as shown by a majority of stocks and \nby the Averages.\nNevertheless, you should realize going with the trend is not always as easy as it sounds. \nWe can set up definitions, as we have, of what constitutes the Major Trend. Then the question \nis whether you have the patience and the courage to maintain a position in line with these \ndefinitions through months of uncertainty and possible adverse moves. During turning", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 221}
{"text": "rity of stocks and \nby the Averages.\nNevertheless, you should realize going with the trend is not always as easy as it sounds. \nWe can set up definitions, as we have, of what constitutes the Major Trend. Then the question \nis whether you have the patience and the courage to maintain a position in line with these \ndefinitions through months of uncertainty and possible adverse moves. During turning \nperiods, it is often hard to make the decision whether to buy or sell.\nMost especially, there is the difficulty of knowing what to buy or what to sell and \nwhen. The simple patterns and signals of the Averages do not tell the whole story. There is a \ncertain usefulness in regarding the market as a whole in studying Dow Theory, just so long \nas we keep in mind the Averages we are studying are generalities (high-order abstractions) \nand the rules for determining their trend apply to these generalities and not necessarily to \neach and every stock listed on the Stock Exchange.\nIn many cases, for example, a group of stocks will top out and start an important Bearish \nTrend, whereas other groups of stocks are continuing to make new highs. This occurred \nin 1946, when we saw a large number of stocks topping out in January and February, and \nothers continuing strong until the end of May.\nWe think of 1929 as the year the market made its great peak and crashed in October to \nstart the series of breaks that continued into 1932. There is some truth in this, but it is not \nthe whole truth. There were some important stocks that made their highs long before the \n1929 Top. Chrysler, for example, made its high in October 1928, and had dropped from 140 \nto 60 before the Panic of 1929. There were stocks that never enjoyed a Bull Market at all in \nthe whole period from 1924 to 1929. By actual count of nearly 700 listed stocks, 262 issues \nmade their Bull Market highs before 1929, and 181 topped in 1929, but before August of that \nyear. There were several stocks that did not have their first downside break until after 1929. \nForty-four stocks went into new Bull Market high ground after 1929 and before mid-1932. \nOnly 184 of the 676 stocks studied made their Bull Market highs in August, September, or \nOctober of 1929 and crashed in October and November.\nIn other words, only 27% of the stocks acted the way everybody knows all stocks \nacted. (EN: As the Dow and S&P 500 made all-time highs in 1999 and were near those highs in \n2000, the same condition held true again. Many stocks had topped and were in long downtrends. \nEN9: And as stocks crashed after the top of March 2000, Dow stocks held up well compared with \nNASDAQ stocks and Standard & Poor’s (S&P) 500, which saw declines of around 50% [see \nFigure 20.3].)\nIt is all right to accept the general trend as a useful device, as long as we know it \nis a device only, and not a picture of the detailed reality. We have to face the problem \nthat continually confronts every student of the market: how to protect ourselves from \nuncertainties in interpretation of the Averages, and how to protect ourselves against stocks \nthat are not moving with the majority. The problem can be met, first of all, by not taking an \nunreasonable amount of risk at any time (see Chapter 41).\nIt can also be met by using an Evaluative Index instead of switching from all-out Bullish \nto all-out Bearish. By this we mean using an indicator that will show not merely whether it \nis a Bull Market or a Bear Market, but how Bullish or how Bearish it seems to be at a given \ntime.\n483Chapter thirty-eight: Balance d and diversified\nAt first glance, this may seem not too different a conception from that of the classic \nDow Theory; the same technical methods apply. Also, during a strongly Bullish Market, \nan Evaluative Index will also indicate approximately the degree of strength. As the market \nbegins to develop weak spots, as did the market in 1928 and 1929, the degree of Bullishness \nwill gradually decline.\nBefore considering the use of this Index, let us outline what it is and how it may be \nconstructed. You will understand it is not a precise tool; it gives only an approximate \npicture of the state of the market; it gives no positive signals; and, in the final analysis, it is \na reflection of the judgment and opinion of the person who is maintaining it.\nSuppose you are keeping daily charts of 100 stocks; at the end of each week, you can \nmark these along the bottom of the chart with a small plus or minus, indicating your \nopinion as to whether each particular stock is moving in a Bullish Major Trend or is Bearish. \nIn some cases, you will find it hard to make a decision. This is not too important, however, \nbecause these cases will not be numerous, and in the majority of stocks, you normally will \nbe able to mark them plus or minus on the basis of their obvious action. If you now total \nthe plus stocks and also the minus stocks, including those in which you have had to make \na tentative decision, you will have two figures totaling the number of your charts. If 75 of \nthese are plus, you can say the market looks 75% Bullish to you. If next week the percentage \nis higher, say 80%, it indicates a stronger or more Bullish condition. If it is lower, say 70%, it \nshows that, on balance, fewer of your stocks look strong; hence, the market is presumably \nweaker.\nTHE EVALUATIVE INDEX 1961\n% WEAK (RIGHT-HAND SCALE)\nNEUTRAL(AREA BETWEEN GRAPH LINES)\n% STRONG (LEFT-HAND SCALE)\n90\n80\n70\n60\n50\n40\n30\n20\n10\n10\n20\n30\n40\n50\n60\n70\n80\n90\nJANUARYF EBRUARYM ARCH APRIL MAYJ UNE JULY AUGUST SE PTEMBER OCTOBERN OVEMBER DEC EMBER\n71 42 12 8 71 42 12 841 11 82 54 11 9 2 2 2 5 1 8 19 2 2 2 5 1 8 1 5 28611 22 02 73 10 17 24 51 21 92 62 91 62 33 04 11 18 25 29 16 23 30\nDiagram 38.1 The Evaluative Index shows the percentage of stocks that appear in Bullish or \nBearish Major Trends. In 1961, this Index conflicted with “stock Averages,” suggesting a possible \nMajor Tur n.\n484 Technical Analysis of Stock Trends\n(EN10: A quick way to constru", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 222}
{"text": "71 42 12 841 11 82 54 11 9 2 2 2 5 1 8 19 2 2 2 5 1 8 1 5 28611 22 02 73 10 17 24 51 21 92 62 91 62 33 04 11 18 25 29 16 23 30\nDiagram 38.1 The Evaluative Index shows the percentage of stocks that appear in Bullish or \nBearish Major Trends. In 1961, this Index conflicted with “stock Averages,” suggesting a possible \nMajor Tur n.\n484 Technical Analysis of Stock Trends\n(EN10: A quick way to construct an Index of this sort is to run Moving Average studies on the \nmarket, examining how many stocks are above their 50-day Moving Average, how many above and \nbelow their 200-day Moving Average, and so on. Obviously, you can also do it as Magee did, by \nexamining each chart of the Dow to see whether it looks strong or not.)\nAs we have said before, if the Averages are making new highs, you will expect (and \nfind) the Evaluative Index will range well above 50%. In an obvious Bear Market, the Index \nwill stand considerably lower than 50%.\nHowever, notice we do not speak, here, of signals. There is no point at which we need \nto say, “Sell everything.” Neither is there a point at which we can say, “Buy now,” in an \nall-out sense. The Index will float and adjust itself continually to the shifting conditions.\nIt must be clear that a market in which only 53% of a large group of representative \nstocks are moving Bullishly is not as strong as one in which 80% of these stocks are acting \nBullish.\nTherefore, you would be justified in making larger commitments on the long side in \nthis second case.\nYou would still have the problem of selection of the individual stocks to buy, but you \nwould be justified in making larger total commitments or in assuming total greater risk (see \nagain Chapter 41), than in a market that was barely qualifying as a Bull Market.\nBy bringing the total of one’s investment program in line with this Index, it is possible \nto roll with the punches, and one would almost automatically be withdrawn from a \ndeteriorating market before things became too dangerous. Furthermore, this would be \naccomplished without the need for torturing decisions as to whether to sell now or wait a \nwhile.\nThere is a further extension of this method. If an investor were to follow the Evaluative \nIndex only by increasing or decreasing his long commitments with the rise and fall of the \nIndex, he might be better off than if he had only the two alternatives of complete optimism \nor complete pessimism. In this case, he would still be pointed always in one direction and \nwould stand to lose to some degree on his long commitments if the market did eventually \nreverse and go into a Panic Move.\nThe extension of the method is to proportion capital, or a certain portion of capital, \nbetween the long side and the short side of the market. Assuming your interpretation of \nyour own charts is reasonably correct in a majority of cases, you can, at any particular time, \nselect several stronger-than-average stocks, and similarly, several weaker-than-average \nissues.\nWith the Index standing in the vicinity of 50% (as it did for a number of months in \nmid-1956), you can then select several strong stocks to buy, and several candidates for short \nsale, making commitments that will approximately balance your total risk. In the case of \nan upward surge that sweeps all before it, you will accrue losses on the short sales and \neventually may have to reverse your classification of them from minus to plus, closing them \nout for a loss. In such a case, the gains on your good long positions will more than offset \nthe loss, assuming your choices were well made, and the loss realized can be absorbed as \ninsurance, namely, the price you have paid to be in a protected position.\nOn the other hand, should the market collapse suddenly (as it did, for example, at \nthe time of President Eisenhower’s illness in 1955) (EN: and as it did on rumors of Reagan’s \nincompetence in October 1987, and the Asian Flu of 1998, and so on and so on), the accrual of \nloss in the long positions will be offset by accrual of gains in the short positions. If the \ndecline should continue to a point calling for sale of the long stock, the losses here could \nbe considered the price of the insurance protection to the shorts provided by the longs. \n(EN: In the tradition of the Texas Hedge, I take a somewhat different view of shorts. Although they \n485Chapter thirty-eight: Balance d and diversified\nwould be viewed in Pragmatic Portfolio Theory as reducing risk, I like to view shorts as another \nprofit opportunity with the added benefit of reducing total risk. Being short a stock in a confirmed \nUptrend is simply feckless, and vice versa.)\nIt is also quite possible, in a more normal market, for both the long positions and \nthe short positions to show gains. What we are proposing is a systematic and continuous \narbitrage or hedge. As the Evaluative Index advances, the proportion of short positions \nwould gradually be reduced, and the long positions increased. As the Index declines, the \nreverse would happen. (EN9: I have suggested the method outlined here be called a “Natural \nHedge,” and the implementation of the hedge be called “Rhythmic Trading.” A Natural Hedge of \nthe Dow would consist of a long commitment to, for example, the DIA in a Bull Market and short \npositions in Bear stocks within the Dow. Or, even better, short positions in stocks positively correlated \nto the weak Dow stocks. This last because even weak members of the Dow will tend to be cushioned \nby the large holdings of passive indexers.)\nThis method is essentially conservative. Those who have always feared the short sale \nas a purely speculative gamble might well reexamine short selling from the standpoint of \nusing the short sale as a regular part of their investment program as counterbalance to the \nlong holdings.\nThe result to be looked for in this conservative balanced and diversified program is \nprimarily protection of capital. By its very nature, it eliminates the possibility of plunging \nfor specta", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 223}
{"text": "ort sale \nas a purely speculative gamble might well reexamine short selling from the standpoint of \nusing the short sale as a regular part of their investment program as counterbalance to the \nlong holdings.\nThe result to be looked for in this conservative balanced and diversified program is \nprimarily protection of capital. By its very nature, it eliminates the possibility of plunging \nfor spectacular profits, but it also provides the mechanism by which the technical method \ncan stand on its merits, largely independent of the changes and chances of the market. It \nmakes it possible to eliminate a large part of the anxiety and uncertainty so many traders \nand investors carry every day and often late into the night.\n(EN: Many modern readers are probably unaware that John Magee wrote a weekly advisory \nletter for four decades. These wise and practical letters comprise the John Magee Market Letter \nDOW–JONES INDUSTRIAL AVERAGE \nTURBULENT PERIODGOLDEN AGE\nRENEWED UPSWING\nMAGEE EVALUATIVE INDEX LESS THAN 5% STRONG \nSOURCE \nM.C. HORSEY & CO \n416 \n564 \n525 \n688 \n741 \n736 \n627 \n570 \n784 737 730 770 824 \n918 \n1031 1067 \n958 \n995 1001 1079 \n1297 \n1372 \n1500 \n1375 \n1250 \n1125 \n1000 \n875 \n750 \n625 \n500 \n375 \n250 \n125 \n56 57 58 59 60 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 \n1026 \nDiagram 38.2 From Collected Market Letters, September 28, 1985. Magee Evaluative Index computed \non the Dow–Jones Industrials illustrating the use of the Index to identify Tops and Bottoms in the \nmarket. A sort of “oversold-overbought” indicator.\n486 Technical Analysis of Stock Trends\nArchive. From this Archive, I append here the letter of September 28, 1985, relative to the Magee \nEvaluative Index (MEI). It speaks very strongly for itself.)\nSeptember 28, 1985: an oversold market\nThis week, the MEI fell to 9% Strong, its deepest penetration into the oversold quadrant \nthis year. Not since June of 1984 has this index been lower (see Diagram 38.1). Shortly after \nits June low of 8% Strong, the MEI headed steadily higher, giving an Aggressive Buy signal \nthroughout late June and July.\nThe June 1984 MEI low of 8% Strong, together with the 8% level reached on February \n25, 1984, constituted a Double Bottom oversold reading for this index. It corresponded to \nthe 1,079 Bottom recorded by the Dow–Jones Industrial Average (DJIA) on June 18, 1984, \nafter which that Index advanced steadily to its recent July peak of 1,372.\nFor more than 20 years, all major stock market Bottoms have corresponded with \nextremely low MEI readings. During the “turbulent period” when the stock market oscillated \nviolently but showed no gain at all, MEI readings of 5% Strong or less corresponded with \nall Major DJIA Bottoms until the June 1982 low of 9% Strong, which immediately preceded \nthe stock market’s upward explosion.\nThat slightly higher than “5% Strong or less” Bottom was an important clue that a \nreinvigorated stock market was at hand; the straight-line DJIA advance from 770 to nearly \n1,300 ended a 17-year “do-nothing” period for stock prices and ushered in the “renewed \nupswing” period shown on the chart.\nIn this context, the “8% Strong Bottom” of June 1984, and the current MEI reading of 9% \nStrong, take on added meaning. If, in fact, we are in a period of Renewed (or major secular) \nUpswing, stock market Bottoms will tend to be less severe and Tops more extremely \noverbought than would otherwise be the case. Both the June 1982 DJIA low and that of \nJune 1984 fit this model. Because secular stock market waves tend to last for many years, \neven decades, the likelihood is that the current MEI reading of 9% Strong will also define \na Major DJIA low.\n487\nchapter thirty-nine\nTrial and error\nYou will not expect to turn in a perfect record from the start. You may indeed do poorly, \nwhich is one of the reasons we have suggested using only a safe amount of your capital, \nallowing enough leeway so if you should misread and misdirect your campaigns, or if you \nshould encounter an Intermediate Setback in the trend of a Major Turn, you will be able to \nget back on course, undismayed, and richer in experience.\nYour records of actual transactions (and notes on theoretical transactions) will help you. \nAs time goes on, you will discover new trading refinements. Try these methods against \nyour previous chart records. See whether your improvements work out consistently to your \nadvantage. In that way, you can test new details of method without risking actual capital \nuntil you have checked the operation thoroughly.\nIn one actual case, a trader who had shown a rather poor record of performance through \na fast-moving Bear Phase of the market, rechecked 30 of his actual trades made during that \nperiod in light of new methods he had subsequently developed. Where the original record \nshowed a loss at the rate of about 40% per year on the capital for the time it was tied up, \nthe changes he introduced, applied to the same situations, would have resulted in a profit \nat the annual rate of 156%. Such a result, although not conclusive, would strongly suggest \ntrying out the new method in all similar situations in the future, and if the performance \ncontinued to show this advantage, to adopt it as a permanent policy. It is only by continual \nchecking and testing that you can learn to pick up more of the profitable opportunities and \nprotect yourself better against the unexpected Reversals.\nIf you follow the suggestions of this book, those already given, and those in the \nfollowing chapters, you will proceed slowly and cautiously, not risking all your capital on \na single move in a single stock; subsequently, errors and plain bad luck, when they hurt you, \nwill not hurt you too seriously. You will be prepared for false moves, wrong interpretations, \nand complete Reversals of expected developments.\nIf you have worked thoughtfully and serenely, without permitting your emotions to \nrule your judgment, the law of averages will bring you cont", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 224}
{"text": "l your capital on \na single move in a single stock; subsequently, errors and plain bad luck, when they hurt you, \nwill not hurt you too seriously. You will be prepared for false moves, wrong interpretations, \nand complete Reversals of expected developments.\nIf you have worked thoughtfully and serenely, without permitting your emotions to \nrule your judgment, the law of averages will bring you continually greater success. You are \nnot gambling blindly in this work; you are intelligently using past experience as a guide—\nand it is a dependable guide. Your operations are part of the competitive workings of a free \nmarket; your purchases and sales are part of the process of interpreting the trend, checking \nrunaway inflation and crashes, and determining the value of the American industrial plant.\nThe market will continue to go up and down in the future as it has in the past. Your \ntechnical knowledge will save you from “buying at the Top” in the final Climactic Blow-\noff, and it will save you from selling everything in a fit of depression and disgust when the \nBottom is being established. In your studies of past market action, you have a strong shield \nagainst the sudden thrusts that surprise and often defeat the novice trader.\n(EN9: I have often told my students if their knowledge of this material does nothing more than \nkeep them from making stupid mistakes like buying a Top or buying a downtrend or buying \nbefore a Bottom has completed forming, then their time will have been well spent. The elimination of \namateur blunders such as these can immeasurably improve investment performance.)\n\n489\nchapter forty\nHow much capital to use in trading\nUp to this point, we have been talking mostly in terms of points and percentages. Little \nhas been said about dollars. From here on we are going to turn the spotlight on the \nquestions revolving around money, capital, and the dollars you will actually be using \nin your operations; just as an understanding of the technical signals and patterns alone \nwill not guarantee your profits without a tactical method of applications, so too your \ntactics alone will not ensure you profits until you have tailored your method to fit your \npocketbook, and until you have a systematic control of your trading in terms of dollars \nand cents.\nAt the start of your charting operations, you will be using no capital. You will be \nmaking no trades either actual or theoretical. Any commitment you might make during the \nfirst four or five weeks on a new chart would be no more than gambling on a hunch. It will \ntake about two months of thankless charting before you have any clear picture of how any \nof your stocks are acting technically. From then on, your chart history will become more \nvaluable each week. Your first trades probably will be theoretical ones. You will want to \nget the feel of the charts and learn to apply the methods you have studied. Eventually, you \nwill want to make an actual transaction.\n(EN: The prudence of this approach can hardly be disputed. Just as markets have changed, stock \nmarket mentality and awareness have changed. The mere existence of this book and of the general \natmosphere enable the modern investor to progress more rapidly than the old pencil-and-paper and \nslide-rule chap. The availability of computers and databases and tutorial tools, not to mention online \nand offline courses in the subject, are unparalleled resources.)\nThen the question will come up, “How much of my capital shall I use for trading \npurposes?” (EN: In a certain sense, this question begs the question. It presupposes the reader has \ncapital. If the reader does not have capital but is gambling with the milk money or the mortgage \npayment, his failure is virtually assured. Do not speculate with money whose loss will occasion you \nmore than passing discomfort.)\nThe amount will depend on your circumstances and how much of your time and effort \nyou plan to put into stock trading, as well as your experience in the market. If you have \nbeen buying and selling stocks for a number of years, you will naturally continue along the \nsame lines, simply applying the new techniques to your operations.\nOn the other hand, if stock trading is entirely a new field for you, or if it is only a \nminor hobby or sideline, it would pay to make haste slowly. Some writers have pointed out \nit usually takes about two years to gain enough practical experience to operate safely in \nthe market; during the two-year apprenticeship period, many traders come in, gradually \nlose their capital, and retire permanently from the field, leaving their money behind them. \nTherefore, no matter how confident you may be or how anxious to get in and start pitching, \nit would be safest to do most of your experimenting on the theoretical basis and to use \nonly a small amount of your actual capital, so that after, say, two years, if you have shown \nsome actual profits, consistently and regularly, even though small, you will be much better \nprepared to use more of your capital wisely and safely. Conversely, if during that time you \nhave made repeated mistakes and have registered many unnecessary losses, you will be \n490 Technical Analysis of Stock Trends\nable to correct your methods and continue on a sounder basis, without having lost your \nmain capital reserve.\nIn no case do you want to risk everything you can scrape together on the theory that \nhere is the quick way to make easy money. That simply is not true and the chances are \noverwhelmingly against you if you go ahead under any such plan.\nIt is better to figure out how much you can spare, how much you could afford to spend \nfor experience, considering the amount you start with is in the same category as money \nyou might use for taking a special course of instruction, or for improving property you \nhope to sell. Or, to take another example, it would be similar to the salary you might lose \nin accepting a lower paid position in a new kind of work that eventually should be wo", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 225}
{"text": "n spare, how much you could afford to spend \nfor experience, considering the amount you start with is in the same category as money \nyou might use for taking a special course of instruction, or for improving property you \nhope to sell. Or, to take another example, it would be similar to the salary you might lose \nin accepting a lower paid position in a new kind of work that eventually should be worth \nmore than your present job.\nIn other words, you will not depend, from the start, on any returns from the capital \nyou use in trading. You will plan your own budget outside of these funds, even if that calls \nfor trimming your budget to make that possible. Then you can go ahead and follow your \ntrading method free from any pressure to take unnecessary risks, free from the need to sell \nstock prematurely to meet obligations, and free from heckling fears and worries.\nYou can start operations with as little as $500. (EN: This is especially true in the Internet \nage. Free commissions in many sites and the availability of low-cost diversified trading instruments \nlike index ETFs [(the SPY (S&P 500), DIA (Dow Jones Industrials), and QQQ (NASDAQ 100)] offer \nthe small investor more opportunity than ever before in financial market history.) Better to have \n$1,000 or several thousand, but it makes little difference, so long as you have worked out \nwhat you can afford to use during the apprenticeship period, and as long as you are sure you \nwill have capital to continue your operation as you develop ability. The important thing at \nthe start is not how many dollars you can make, but what percentage of increase per year \nyou can average with the capital you are using.\nIf you approach the serious business of trading in this frame of mind, you will not be \nafraid to take losses when it is necessary (and there are times when that is the only wise \ncourse to adopt). You will not be straining to make an unreasonable or impossible profit (with \nthe usual disastrous results). Additionally, you will be able calmly to build your trading \npolicy in the sure conviction the market will still be there next year, that opportunities will \nstill be waiting for you, and that the basic procedures you are developing are more valuable \nthan any “lucky break” you might pull out of thin air or a boardroom rumor.\n491\nchapter forty-one\nApplication of capital in practice\n(EN: Today we would refer to this as “asset allocation,” about which many learned books and articles \nhave been written (see Appendix B, Resources). The modest suggestions in this chapter are, like \nMagee, very pragmatic and simple—and quite possibly more effective for the general investor than \nthose complicated procedures spun out by supercomputers for complicated Street portfolios.)\nLet us now restate a number of ideas we have already investigated and on which (let’s \nhope) we are thoroughly agreed.\n 1. Major Trends ordinarily run for long periods of time, covering a tremendous number \nof points in total advance or decline—15733.05, 2009 to 2017 .\n 2. Almost unbelievable profits could be made by one who could buy stocks at the extreme \nBottom of a Bear Market and sell at the extreme Top of the following Bull Market; or \nsell short at the extreme peak of a Bull Market and cover at the extreme Bottom of the \nfollowing Bear Market.\n 3. It is not possible to accomplish either of these desirable results.\n 4. It is possible to avoid becoming trapped in purchases made at or near the extreme \nBull Market Top so that losses become dangerous or ruinous in a Major Reversal. It is \nalso possible, of course, to avoid such losses through ill-advised short sales near the \nextreme Bottom of a Bear Market.\n 5. It is possible to make profits by trading in line with the Major Trend, and in some \ncases, by trading on the Intermediate Corrections to the Major Trend, or, occasionally, \non the individual behavior of a stock moving contrary to the Major Trend.\n 6. The greatest and most dependable profits may be made along the Major Trend during \nthe principal period of advance (or decline, in the case of short sales), but not during \nthe earliest phases when the movement first gets under way or during the rounding \noff or Reversal phenomena near the end of the movement.\nTherefore, to get the greatest benefits from following the Major Trends, one would want \nto have a relatively small equity in the market at the very start of the move and very little at \nor near the termination of the move, but a very substantial interest during the mid-portion \nwhen the advance or decline was making the greatest headway.\nThe writers have felt it should be possible to express this relation between the amount \nof capital tied up and the state of the Major Trend in a neat and definite equation. Yet, \ninasmuch as the idea of a Major Trend is, itself, a matter of definition, and because the trend \nis an abstraction from the individual movements of many stocks, it does not seem possible \nto arrive at any such easy solution to the problem of how much capital to use at a given time.\nNor is it necessary to have a definite and exact answer. As we have already stated, it is \npossible to set up an Evaluative Index that will give an approximate answer good enough \nfor all practical purposes so far as weighing the “strength” of the trend at a particular time. \n(EN: To clarify and make more explicit the concept here, I would point out the Asset Allocation \nimplications of the Magee Evaluative Index. If the analyst’s evaluation of the market indicated 30% of \nstocks were Bullish, 30% Bearish, and 40% neutral, he might so commit his capital—30% long, 30% \n492 Technical Analysis of Stock Trends\nshort, and 40% cash. This would also assume his assessment of risk also indicated the risks of the \nlong and short positions were balanced, or approximately equal since infinite precision is achievable \nonly by the writers of academic treatises working with perfect hindsight.)\nThere are, however, some other questions. Most i", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 226}
{"text": "commit his capital—30% long, 30% \n492 Technical Analysis of Stock Trends\nshort, and 40% cash. This would also assume his assessment of risk also indicated the risks of the \nlong and short positions were balanced, or approximately equal since infinite precision is achievable \nonly by the writers of academic treatises working with perfect hindsight.)\nThere are, however, some other questions. Most important is the question of how much \ntotal “risk” you are assuming because some stocks are very conservative and others are \nvery speculative, it is not enough to determine what part of your capital should be applied \nin a market trend. The proportion of your total capital used is not necessarily the whole \nmeasure of your participation. The price level of a stock will affect its habits (low-priced \nstocks make bigger percentage moves than high-priced stocks). The amount of margin you \nare using will have an effect on the degree of risk.\nThere is some substance to this plan (otherwise we would not be taking the time to \ndiscuss it here at all), but there is a serious question whether the decision as to the amount \nof capital to be used at any specified time can ever be reduced to a simple mathematical \noperation. (EN: Still true although there are those who attempt it.)\nLet us suppose you are convinced this is a Bull Market, in a phase of such potency \nthat you would be justified in using 80% of your capital. However, you will immediately \nrealize, from what has been said in earlier chapters, if this money is put into a high-priced \n(EN: and low-beta) stock, it will not give you as much likelihood of either profit (if you are \nright) or loss (if you are wrong), as it would if put into a lower priced (EN: and high-beta) \nstock. In the same way, your money put into a stock having a low Sensitivity Index, that \nis, a conservative stock like a Utility stock, will not give you as much likelihood for either \nprofit or loss as a stock of a high Sensitivity Index (EN: volatility) , namely, a speculative \nstock such as an internet issue. These factors, quite as much as the amount of actual dollars, \naffect your status, and are factors in answering the question, “ Am I out on a limb and, if \nso, how far out?”\nTo make this perfectly clear, we could take 80% of our capital, say $8,000 out of $10,000, \nand put this amount into the market by purchasing a conservative preferred stock, outright. \nA great rise in the general market might bring us an increase in value of a few points, \nperhaps 4% or 5%. Conversely, a great decline might depress the issue by about the same \namount. An example of going to the other extreme might be to purchase $8,000 worth of \noptions on a low-priced, extremely speculative stock, in which the probable result within \n90 days would be either a profit of several hundred percent, or a total loss of $8,000.\nObviously, we could vary our status during the progress of the market either by \nincreasing or decreasing the amount of the total commitment, or by changing the nature \nof the account, switching part of the total into more or less speculative stocks, higher or \nlower priced stocks, and also by varying the amount of margin used.\nIn Appendix A, ninth edition, and Chapter 42, we will show how the principal factors \naffecting a given sum of capital used (sensitivity, price, and margin) can be combined into \none figure, which we are going to call the Composite Leverage Index. (EN: Once again, Magee \ndemonstrates a practical vision and intuitive understanding both of the markets and of the basic \ncharacter of investing far ahead of investment theory and understanding of his time. What we have \nin this concept is nothing less than the original glimmerings of VAR, or Value at Risk. The concepts \nand practices of VAR are succinctly summarized in Chapter 42. Composite Leverage is a complex \nsubject and based on manual charting. For that reason, it has been left in the ninth edition, where \nthe truly dedicated scholar may study it at leisure.)\nIt is perfectly true you must vary your Composite Leverage (EN: risk exposure) to take \nadvantage of the fast-moving central portions of important moves, using a lower Composite \nLeverage at the beginning of such moves and during the tapering-off or turning periods \nnear the end.\n493Chapter forty-one: Applicatio n of capital in practice\nIt is one thing to express the Composite Leverage accurately, however, another thing to \nwrite a formula for applying specific degrees of leverage at particular times. The method \nsuggested at the very beginning of this chapter has some value but owing to the Secondary \nReactions and the difficulty of determining Major Trends in individual stocks, it is not \npossible to make this into the neat, pat rule we are looking for.\nIt must be a matter of experience, or intuition based on experience. You will not permit \nyour Composite Leverage factor (i.e., your Portfolio Risk Factor; see Chapter 42, Portfolio \nRisk Management) to run out to a dangerous point on the limb. Neither will you allow it \nto become so low during times of good market opportunity that you are not getting full \nbenefits from the move.\nWe can keep the general shape of a Major Swing in our minds as we consider this. Bull \nMarkets normally rise through a series of irregular advances and declines, starting with a \nmoderate upward trend, and gradually accelerating as the market approaches its ultimate \ntop. Bear Markets are likely to move fastest at the start and to taper off gradually toward \nthe end. Bear Markets are steeper than Bull Markets. These considerations will help us \nto judge the times when the market will offer the best opportunities, the times when our \nComposite Leverage should be increased.\nThere are other factors, even harder to pin down in simple figures. We would, at times, \nmake switches of our holdings for reasons indirectly related to the factors making up the \nComposite Leverage Index of the stocks. We know, for example, high-grade issues", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 227}
{"text": "l help us \nto judge the times when the market will offer the best opportunities, the times when our \nComposite Leverage should be increased.\nThere are other factors, even harder to pin down in simple figures. We would, at times, \nmake switches of our holdings for reasons indirectly related to the factors making up the \nComposite Leverage Index of the stocks. We know, for example, high-grade issues, the \nactive market leaders, and perhaps some stocks of a more conservative nature will tend \nto start their moves in a Bull Market fairly early and to continue their advance at a fairly \nsteady pace. Eventually, they will reach their tops and make a Reversal Pattern. They will \ndecline from this point, probably at a steeper average angle than the ascent. Low-priced \nand low-grade issues, on the other hand, tend to be slow in getting started, will remain \ndormant during the early phases of a Bull Market, and will then suddenly and spectacularly \nskyrocket in a series of moves that brings them to their ultimate Top. This Top, however, is \nlikely to be reached at a later point (perhaps months later) than the point at which many of \nthe more conservative stocks topped out. The speculative group will then drop very fast \nand will return to the dead levels of inaction before the conservative group has finished its \nmore leisurely Major Decline.\nThis means you will do well to concentrate your Bull Market trading in the early stages, \nin the higher grade stocks, and in the later stages, in the lower grade stocks. In a Bear \nMarket, you would perhaps be able to make short sales unsuccessfully in high-grade stocks \neven while some of the “cats and dogs” were still completing their final run-up; however, \nyou would be watching for the opportunity to cover those shorts and go short the low-grade \nstocks as soon as their Reversal was signaled.\nAppendix A, ninth edition, will go into the Composite Leverage Index. It should be \na useful gauge for you in your market operations, and a protection against overtrading. \nExcept, do not expect to use it mechanically as an index against the market to answer all \nyour questions involving the nature and size of your commitments. For in gauging the \ncondition of the Major Trend at any time, your personal experience and judgment must be \nthe final arbiters.\nPut and call options\nOptions of various sorts have a long history in commercial markets. Nearly 2,000 years ago, \nthe merchants who operated in the Mediterranean region used “to arrive” at agreements \nthat amounted to option contracts, as insurance to reduce the risks of storm and piracy. \n494 Technical Analysis of Stock Trends\nModern commodity futures contracts resemble stock options in their dual nature of serving \neither as trading media or as insurance devices. Options are also widely used in real estate \ntransactions and in various other applications.\nFor many years, stock options were traded only on the basis of individual agreement \nbetween a buyer or a writer, and an opposite number, directly or through a broker or dealer. \nThe customer and the writer were free to decide what stock (any stock) would be optioned, \nat what exercise or striking price, for what period of time, and at what premium.\nIn 1973, a new method of handling option contracts was inaugurated by the Chicago \nBoard Options Exchange and later the American Stock Exchange, and then to other \nExchanges across the country in which call options on a selected list of actively traded \nstocks are offered with standard expiration dates (like commodity contracts) and at definite \nexercise prices, the premium depending on the bids and offers of buyers and writers. An \nexcellent guide to this rapidly expanding market is (EN) Options as a Strategic Investment \nby Lawrence G. McMillan.\n(EN: In the Internet age, options and derivatives markets have attained an astounding economic \nimportance. One amusing way of measuring this importance is by listing some of the great debacles \nthat have occurred to major traders of derivatives. Bank Negara, Malaysia’s central bank, lost $5 \nbillion in 1992–1993 through bad bets on exchange rates. Showa Shell Sekiyu, Japan, lost $1.58 \nbillion in 1993; Metallgesellschaft, Germany, lost $1.34 billion in the same period. Barings Bank lost \n$1.33 billion on stock index futures. From 1987–1995, known losses like this totaled $16.7 billion. \nAs Magee would say, etc., etc., which is appropriate considering in 2012 JP Morgan Chase lost 2 \nto 5 billion trading derivatives. Of course, compared with the estimated total market in 1995 of $25 \ntrillion, this is a mere bagatelle. Perhaps this is sufficient to warn the general investor that the field \nis strewn with financial mines even for the sophisticated.\nEN9: If the investor considers stocks a complex or difficult area [although it is hoped this book will \nmake it less so for him] options are exponentially more difficult. Professionals beat amateurs at that \ngame so thoroughly and so often as to consider it easy money. So, the general investor should be sternly \nwarned that much training and study should be undertaken before becoming fodder for the pros.\nEN9: Tradestation, the superlatively fine trading system and brokerage operation, distributed at \none time an intelligent little book by Charlie Wright, Trading for a Living, which among its other \nfine points offered a plan for the ongoing allocation of capital to trading.)\n495\nchapter forty-two\nPortfolio risk management\nAs we suggested in the preceding chapter, there is some relation between the state or stage of a \nMajor Market and its potentialities for profit. There are many mechanical plans and systems \nfor coping with the problem, but we do not believe it can be fully solved by mechanical \nmeans alone. We mentioned one plan by which the commitments were governed according \nto the consensus of trends in an entire portfolio of charts. (EN: The Magee Evaluative Index, \nor MEI.) There are other plans dependent on pyramiding the com", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 228}
{"text": "entialities for profit. There are many mechanical plans and systems \nfor coping with the problem, but we do not believe it can be fully solved by mechanical \nmeans alone. We mentioned one plan by which the commitments were governed according \nto the consensus of trends in an entire portfolio of charts. (EN: The Magee Evaluative Index, \nor MEI.) There are other plans dependent on pyramiding the commitment as the trend \nproceeds, and still others based on averaging costs by increasing the commitment working \nagainst the trend, namely, by buying on a scale-down at progressively lower levels in a Bear \nMarket and selling on a scale-up in Bull Markets. (EN9: Invitations to disaster, the first, and \ndemanding adroit skill, the second. Avoid such methods unless you are an expert position trader.)\nNone of the plans, taken by themselves, are adequate to answer the questions of \nwhen to buy and when to sell. The primary purpose of this book is to study the technical \nphenomena of individual stocks. If we can learn from the charts at what points to buy and \nunder what conditions to sell, we have acquired the basic machinery for successful trading. \nOn the other hand, if buying and selling at points that more often than not result in net \nlosses, then it makes no difference how you divide up your capital or apply it in the market, \nfor it will be bound to shrink until, eventually, it has all disappeared. (EN: An investor who \nfinds himself in this situation should set a benchmark. He should decide if he loses 50% of his capital \nhe will quit trading and put his money in index or mutual funds or in the hands of an advisor. \nGenerally speaking, an advisor is preferable to a mutual fund, yet both are preferable to an investor \nwith two left feet. They can certainly do no worse than a consistently losing performer. EN10: On \nsecond thought, from the vantage point of 2011, maybe they can.)\nThe first problem, then, is to learn to use the technical tools, patterns, trends, Supports, \nResistances, and so on. Then we can consider how much money we will risk and in what \nway.\nWe have already grasped it makes a difference, sometimes a great difference, how we \napply our capital. The various factors of price level, sensitivity, and margin enter into the \nconcept we are going to call the Portfolio Risk. Meanwhile, we have said enough so you \nwill understand what we are driving at if we use the term in connection with your market \ncommitments.\nYou realize, of course, you do not want to be so conservative to rule out practically all \nopportunities for making gains. If you decide never to oppose the Primary Trend, you will \nhave to be inactive during long Secondary Trends and may be left waiting, sometimes for \nweeks on end, for a continuation of the Primary Move. Naturally, you will pass up all weak \nsignals and convergent trends and shun new commitments after very active blow-offs or \nPanic Climaxes. You could, no doubt, carry your refinement of caution so far that your \npercentage of success, instead of being a mere 60%, 70%, or 80%, might approach 90%; you \nmight actually be right 95% of the time in your decisions, but this extreme conservatism \nwould also mean you would trade only in the very finest possible situations, when every \nfactor was clean-cut and favorable. You would not have such opportunities very often. The \nresult might be a profit, but too small a profit to justify all the work and study you would be \n496 Technical Analysis of Stock Trends\nputting into your charts, for you can obtain nominally respectable returns on your capital \nwithout very much study and without much risk, and you must expect a much higher rate \nof return if your efforts are to be worthwhile.\n(EN: These “nominally respectable returns” are obtained by investing in T Bonds and similar \ninstruments. Bond traders and investors traditionally consider these investments “risk free,” which \nis another form of the denial of reality. In reality, as David Dreman has demonstrated (Contrarian \nInvestment Strategy, Simon & Schuster), bonds are a kind of deteriorating asset because of the \nunarrestable depreciation in the commodity-denominated value of currency.)\nTo put your charts to work, you have to avail yourself of the higher leveraged stocks that \ncarry more opportunity for gain, hence, more risk of loss. You have to accept, deliberately, \na greater risk than the man who is content to buy a “safe” security, put it in the box, and \nforget it.\nBy maintaining your Portfolio Risk at or near some constant level that your experience \nand judgment tells you is safe for the particular state of the market, you will be protected \nagainst overcaution and irrational exuberance. More important, if you maintain this risk \nposture in your operations, you will be protected against unconsciously overtrading. This \nis a fault more common than extreme caution and can be a dangerous enemy even when \nyour percentage of theoretical trading gains is high. When you select a definite Portfolio \nRisk Strategy and adhere to it in your trading commitments, changing it as necessary to \nmeet changed conditions, you will be forced to restrain your enthusiasm within safe limits, \nand you will be continually aware of the risks you are taking.\nOvertrading: a paradox\nA series of identical percentage gains and losses on your capital does not give you a series of \nequal gains and losses in dollars and cents. This is a serious problem, worth understanding, \nfor a trader who is greatly overextended is intensifying this problem (which exists in any \ncase, but which does not need to cause him too much worry if he has planned his program).\nYou can understand the paradoxical statement that percentage gains and losses are not \nequal if you take the extreme case, first, of a man, who, in every business venture he enters, \nrisks his entire capital with the expectation of either a 100% gain or a 100% loss. If this first \nventure is a loss, he loses 100%. He is finished, because he", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 229}
{"text": "cause him too much worry if he has planned his program).\nYou can understand the paradoxical statement that percentage gains and losses are not \nequal if you take the extreme case, first, of a man, who, in every business venture he enters, \nrisks his entire capital with the expectation of either a 100% gain or a 100% loss. If this first \nventure is a loss, he loses 100%. He is finished, because he cannot gain by making 100% \non nothing. However, if the first venture is successful and he then uses his entire capital, \nincluding the new profits, again on the same terms, and the second venture is a failure, he \nwill be wiped out completely. No matter how many successes he may have, he stands to \nlose everything on his first failure.\nIn a lesser degree, this is the situation in which we speak; you would not risk all of \nyour capital on the basis of doubling your money or losing all. Though, suppose you were \nextended, continually, to a point at which you were taking the risk of a 40% net loss on \neach transaction, with the hope of a 40% net gain. Should you start with $1,000 and have a \nsuccession of 10 losses, you would wind up with about $6.00. Now suppose the very next \n10 transactions were all successful. You would finally come out, after 10 losses and 10 gains, \neach of 40%, with capital of less than $100. It would not be necessary either that these 10 \nlosses and 10 gains come in the order given. You might have the 10 gains first, or three \ngains, four losses, seven gains, and then six losses. The result would be the same. After 10 \ngains and losses, in any order, you would have lost more than 90% of your capital.\nOn the other hand, if you risked your entire capital each time on 20 ventures, in 10 \nof which you took an 8% net gain and in 10 an 8% net loss, your $1,000 after the 10 gains \nand losses would be reduced only to $937 . You would still have about 94% of your original \n497Chapter forty-two: Portfolio risk management\ncapital. Therefore, in this case (and 8% is a fair average figure for short-term transactions \nresulting in a loss, in fact, a rather liberal figure according to extensive tabulations of actual \ntransactions), you would have a handicap due to this paradox of only about one-third of \n1% on each trade.\nNow it is conceivable that 10 successive trades might go wrong, although that would \nbe an unusual condition. There was one period of 10 months between the actual turn of \nthe market and the Dow Signal for a Reversal of the Primary Trend. True, the resulting \nnew trend, once established, ran far and long, and it would have made up all losses and \nproduced fine profits; however, during the 10 hard months, allowing the fair average time \nof 30 days per transaction, it is possible that 10 successive wrong-way trades might have \nbeen stopped out for losses, reducing the original $1,000 to $434.\nThe important thing is that the next 10 successful trades would have brought this \n$434 back to $937; in other words, you could have righted the boat and sailed right on if \nyou were working on the 8% basis, whereas if you had been following the 40% basis we \ngave previously as an example, you would have been sunk without a trace, a victim of \novertrading.\nTherefore, by maintaining a sane Portfolio Risk Strategy and letting the law of averages \nwork for you and with you, you will be on solid mathematical ground. Your technical \nstudies will have every opportunity to make you a profit. Otherwise, you can, simply \nby unwise overextension of your trading, prevent even the best technical analysis from \nproducing a net profit.\nEN: John Magee could easily be called the father of modern investment theory but modern \ninvestment theory is so unenlightened as to technical analysis that academics largely have not \nrecognized his contributions—and many probably have not read his work. If they had, he would be \nrecognized as having identified what theorists now call systematic risk, and what is now called the \nbeta (Greek letter β) with his concept of the Sensitivity Index. Similarly, his work on Composite \nLeverage precedes (and may be more practical than) modern Portfolio Risk analysis, if cumbersome \nin the modern context.\nSystematic risk, simply put, is market risk in aggregate; beta relates the individual instrument \nrisk to the market. Thus, Magee’s Sensitivity Index did what beta calculations do—relate instrument \nbehavior to market behavior. A stock with a beta of 1 will move up or down 1 point for each 1 point \nof market move. A 1.5 will move 1.5 for each 1 point of market move, and a 0.5 will move 0.5 for \neach 1 point of market move. This number tells us immediately which stocks are more volatile and \nsensitive to aggregate market behavior.\nComposite Leverage was Magee’s method of determining how much risk the investor was \nassuming in a stock or portfolio.\nThe formula was (is) as follows:\n CL = SNT\n 15.5 × C\nwhere S = the Sensitivity Index, N = Normal Range-for-Price (an attempt to quantify volatility), \nT = Total Paid, C = Capital dedicated to this commitment, 15.5 a constant Magee called a Market \nReciprocal, a sort of proxy for market volatility. The same formula, using sums, was used for Portfolio \nComposite Leverage. The number that falls out of this formula quantifies risk for Magee and uses \nconcepts that are extremely modern.\nIn his original exposition of Composite Leverage in this chapter, Magee made use of some \ncumbersome manual chart procedures and tables that I have relegated to Appendix A in the eighth \n498 Technical Analysis of Stock Trends\nand ninth editions, and deleted in this edition. There is nothing invalid about them, even now, I \nfeel, but there might be simpler and more convenient ways for the present-day trader to assess his \nleverage, risk, and profit exposure. One of these is certainly utilizing Value at Risk (VAR) technology. \nHowever, there might be simpler more pragmatic (and even more effective) ways of extracting this \ninformation from our trading port", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 230}
{"text": "his edition. There is nothing invalid about them, even now, I \nfeel, but there might be simpler and more convenient ways for the present-day trader to assess his \nleverage, risk, and profit exposure. One of these is certainly utilizing Value at Risk (VAR) technology. \nHowever, there might be simpler more pragmatic (and even more effective) ways of extracting this \ninformation from our trading portfolios. In short, Pragmatic Portfolio Theory and practice, which \nwe will explore shortly.\nVolatility, for example, tells us something about the risk of a stock insofar as the dispersion \nof returns. Portfolio volatility gives us a way of measuring the riskiness of a group of stocks. In \nresearching our systems and methods, we should be able to get some handle on “drawdown,” or the \naverage and largest negative swings against our equity in an account. Simple conclusions follow: if \nwe are willing to accept larger risks, we pick a portfolio of volatile stocks—a portfolio of Internet (or \nwhatever the current frenzy is) stocks rather than a portfolio of utility stocks.\nIt is indispensable to maintain a regular periodic review of portfolio statistics to assure oneself \nthat excessive risks are not being undertaken heedlessly. These important numbers include the \nfollowing:\n• Original risk per trade\n• Actual realized loss\n• Average (and ranges) loss and profit per trade and their relationship (average profit divided \nby average loss)\n• Number of winning and losing trades and their ratio\n• Time in winning and losing trades (long-time trades combined with oversize losses is an \nominous sign)\n• Equity swings: average drawdown, maximum drawdown\n• Costs and expenses, summation, and per trade\n• Daily risk, yearly risk, and catastrophic risk, as computed by Pragmatic Portfolio Theory (as \ndiscussed below)\nRisk of a single stock\nThe beginning of conventional, or academic, analysis of risk is the examination of volatility.\nThe formula for calculating the volatility of a stock (or downloading it) was discussed in Chapter \n24. As a theoretical exercise, the formula and the theory make certain assumptions that are not \nnecessarily of interest to the pragmatic practitioner. One of the assumptions is the holder chooses to \naccept the inherent volatility of the stock at hand. Except the point of technical analysis is to limit \nthe risk accepted while attempting to realize profit opportunities. Thus, the volatility of a stock, its \n(academic) risk, is 0.30% or 30%, but when we trade it, we put a stop loss on it and only risk a move \nof (say arbitrarily) 5%–8% against our position (where the 5%–8% sums to 2%–3%, or x% of total \ncapital.) Thus, our method of risk control is basically more dynamic than the theory. Nonetheless, \nvolatility will give us a measure of the stocks that make interesting trading vehicles.\nIt is perfectly possible to take our own experience with a stock or our system’s experience with \na stock and calculate its volatility to ourselves, using the method described in Chapter 24. If the \ndispersion of its returns (in our trading) was greater than our appetite, we could then eliminate it \nfrom our watch list. To my knowledge, the literature does not mention this method for customizing \nour analysis of risk. Use of a customizing procedure like this would give us an idea of the reliability \nof our methods in a particular case. Stocks that did not behave would be banished to the portfolios \nof mutual fund managers.\nWe subscribe to a much more pragmatic and practical concept of risk. Risk is, to us, drawdown, \nor the probability of loss. Volatility qua risk is static and non-descriptive of the “risks” we take \n499Chapter forty-two: Portfolio r isk management\nin trading and investing. We will choose a volatile stock or instrument because that is where the \nprofit opportunity is—in movement. Less risk-oriented investors will choose utility stocks. As some \ncarnival goers choose the Ferris wheel and others the roller coaster. The probability of an exciting \nride will be in the volatile instruments. Our skills as traders give us the confidence to manage the \nprobabilities of the more “dangerous” instrument.\nBy measuring the drawdowns, we empirically measure the risks of trading.\nRisk of a portfolio\nIf you have sufficient experience with a portfolio, you can calculate its volatility the same way you \ncalculate the volatility of a stock using the method in Chapter 24. Note Modern Portfolio Theory \n(MPT) has a complex procedure for computing portfolio volatility. (The value of MPT may be \ncomputed by examining MPT portfolios after a market collapse.) You may also dramatize the \nvolatility of your portfolio by preparing a frequency distribution. The dispersion of the returns \nwould certainly highlight characteristics of your trading system or style.\nAcademicians and investment managers use a measure called the Sharpe Ratio to compare the \nperformance of two systems or competing money managers. It is discussed in Appendix B, Resources, \nand has deficiencies in analyzing Portfolio Risk. I will address this question later in this chapter after \nlooking at some of the ways professionals treat risk.\nThe reader may judge for himself in the use of Composite Leverage as presented in Appendix A of \nthe ninth Edition by Magee, or he may consider the following brief presentation of modern portfolio \nmanagement and risk analysis. The purpose of Magee’s Composite Leverage is to measure and control \nrisk and profit exposure in a more or less quantitative manner. Present-day portfolio managers might \nuse VAR technology or do this as follows. The editor offers this exposition only for perspective. His \nown preferred method, Pragmatic Portfolio Theory, follows thereafter.\nEN9: Risk and trend\nRisk of a portfolio and risk of a stock are affected by being the right way in the trend. It \nseems intuitive and it is observable that losses (thus risk) expand in an Enron case in which \nthe trader remains long while the stock dies. The", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 231}
{"text": "s follows. The editor offers this exposition only for perspective. His \nown preferred method, Pragmatic Portfolio Theory, follows thereafter.\nEN9: Risk and trend\nRisk of a portfolio and risk of a stock are affected by being the right way in the trend. It \nseems intuitive and it is observable that losses (thus risk) expand in an Enron case in which \nthe trader remains long while the stock dies. The converse is also true; Risk is diminished \nto a portfolio and a stock when it is with the trend. In a paper submitted to the Market \nTechnicians Association ( http:/ /www.mta.org), “Dissecting Dow Theory,” Bassetti and \nBrooker argue (with some success in the opinion of this editor) that risk can be proved to \ndiminish in the Industrials when the portfolio (of Industrials) is with the trend as identified \nby Dow Theory. This paper is available at the Magee website, http:/ /www.edwardsmagee.\ncom. The paper was subsequently expanded into the book, Sacred Chickens, the Holy Grail \nand Dow Theory.\nValue-at-Risk procedure\n(EN: VAR is a method of assessing and controlling risk. Particularly, VAR measures the worst \nexpected loss over a given time interval under normal market conditions at a given confidence \nlevel. This rather complex statistical process is in use in numerous banks, American and \nEuropean regulators in Basel and at the Federal Reserve have largely accepted it as an acceptable \nrisk control procedure. The hole in the procedure is in the words “normal market conditions.” \nThe procedure is based in MPT. As Mandelbrot has remarked, MPT ignores 5% of market data, \ntreating market collapse as if it did not exist. VAR and MPT both ignore trend risk, as though \nit does not exist.\n500 Technical Analysis of Stock Trends\nAs a brief description of the VAR procedure, I offer the following: returns of the individual securities \nare determined and, from these, returns of the portfolio are calculated. This is done based on some time \nperiod for which the portfolio is held. Thus, from day to day the returns, or changes in value, of the \nportfolio will vary—some positive and some negative. Taking a totality of returns, an average return \nwill be determined. A frequency distribution of returns may be constructed. The width of this frequency \ndistribution measures the riskiness of the portfolio. Thus, a portfolio with a minimum return of 1% and \na maximum return of 8% is inherently less risky (according to investment theory) than one with returns \nvarying from −1% to 20%. Although a frequency distribution is illustrative, it does not give us a \ncommon measure for two different portfolios. That is done by determining the volatility of the portfolio.)\nVolatility measures the deviation of returns from the mean, known as the standard deviation and \nis indicated by the Greek letter sigma (σ). (EN: The higher the volatility of a portfolio the greater its \nrisk, according to the academic theory. This would seem to be intuitive, in that a commodity portfolio \nmight range from −30% to 100% returns because of leverage, whereas a bond portfolio would vary \nonly by the market price of the bonds and would return face value at maturity. In calculating bond \nrisks, managers ignore the deterioration of money—but that is a little secret among us pragmatic \nanalysts and we need not bother academicians and bond traders with that information, as they would \nnot want to know it anyway.\nAs pointed out, portfolio volatility can be easily obtained if we have sufficient experience with \nthe portfolio. If we have to calculate the volatility, the procedure gets quite complicated and the entire \nprocedure for determining our VAR requires some statistical sophistication as well as a gamut of data. \nWe must weigh the components of our portfolio, determine their correlations, compute correlation \ncoefficients, and on and on. As Mandelbrot notes in Scientific American, at the end of all this, we \nwould still be wondering what to do in the Perfect Storm. A crystal-clear procedure for computing \nVAR is presented in Philippe Jorion’s excellent book Value at Risk.\nPragmatic Portfolio Theory (and practice)\nPerhaps, rather than giving ourselves headaches trying to remember college statistics, we should look for \nsomething simpler and more pragmatic—something just as serviceable for the general investor: Pragmatic \nPortfolio Theory. The academic world, and the world of rarefied Wall Street, strives madly to quantify \neverything in the world except the risks and liabilities that they themselves create for their customers.\nLet us seek simpler methods to quantify the risks of individual stocks and the portfolios they \nreside in, knowing all the time that absolute precision is impossible (namely, professional portfolio \nmanagers’ performance in the Great Panics—1929, 1957, 1987, 1989, 2008–2009; Long-Term Capital \nManagement, which almost brought down the world financial system in 1998; and Leland O’Brien \nRubinstein Portfolio Insurance, which contributed significantly to the Reagan Crash in 1987).\nPragmatic portfolio risk measurement\nDetermining the risk of one stock\nThe theoretical risk of a stock is commonly agreed to be its volatility, which is determined as detailed \nin Chapter 24. Subsequently, we might say the theoretical risk of our stock, Microsoft, for example, \nequals on 100 shares, our position, at the market price of 120 and annualized volatility of 0.44:\n Theoreti cal Risk = Volatility × Position × Price\n V × Po × Pr = T$Risk\n .44 × 100 × 120 = $5,200\n501Chapter forty-two: Portfolio risk management\nwhere\nT$Risk = Theoretical Risk (dollar)\n V = Volatility\n Po = Position (number of shares)\n Pr = Price\nTheoretically speaking, the annual risk for Microsoft should be Volatility × Price or (in \n2000) 0.44 × 120 or $52.00. In fact, those non-chart analysts who bought Microsoft at 120 \n(there were some), and who did not have the technician’s ability to set a stop and discipline to \nstick to it, saw a risk of 50% from its top of 120 in Febr", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 232}
{"text": "V = Volatility\n Po = Position (number of shares)\n Pr = Price\nTheoretically speaking, the annual risk for Microsoft should be Volatility × Price or (in \n2000) 0.44 × 120 or $52.00. In fact, those non-chart analysts who bought Microsoft at 120 \n(there were some), and who did not have the technician’s ability to set a stop and discipline to \nstick to it, saw a risk of 50% from its top of 120 in February 2000 to its (presumed) bottom of \n60 in June 2000.\nThere is another measurement that might be more meaningful to us, Operational Risk. \nOperational Risk refers to the specific instance of the particular trade. For example, we have \ntaken an initial position in Microsoft of 100 shares. Our analysis has identified a stop point at \nwhich we put our stop, which is 5% away from the market price. Our Operational Risk is as \nfollows:\n Operational Risk = Market Price − Stop Price × Position\n (MP − S) × Po = O$Risk\n (120 − 114) × 100 = 600\nwhere\nO$Risk\n = Operational Risk (dollar)\n MP = Market Price\n Po = Position\n S = Stop Price\nDetermining the risk for a portfolio\nComputing the theoretical risk for a portfolio is quite a complex process. It involves, in \nessence, finding the volatility for the portfolio as a whole, and multiplying the portfolio \nmarket value by the portfolio volatility. This does not sound so complex, but volatility \nis not determined by simply adding together volatilities of individual securities. Rather, \ncorrelations between instrument returns must be computed, and variance and covariance \nof securities must be determined as steps along the way. This by no means presumes to be \na complete description of the process, further study of which may be guided by entries in \nAppendix B, Resources.\nThe theoretical risk for a portfolio is, for a simple case, as follows:\n Volatility × Market Value\n TP$Risk = MV × V\nwhere\nTP$Risk = Portfolio Theoretical Risk (dollar)\n MV = Market Value\n V = Volatility\n502 Technical Analysis of Stock Trends\nUnder normal market conditions, the Operational Risk of a simple Portfolio, PO$Risk, may be \ncalculated by first taking the sum of the Operational Risk figures, O$Risk, for each stock held long. \nThen the sum of O$Risk for short positions is subtracted from the first figure.\n PO$Risk = (sum of O$Risk longs) − (sum of O$Risk shorts)\nIn the situation of perfect negative correlation, the two factors would be summed.\nMeasuring maximum drawdown (maximum retracement)\nIn the designing and testing of a system, or in actual trading experience, we care little about standard \ndeviations and cold statistics. What bothers us is the flow of blood—the worst run of “luck” or \nexperience we have. What is the greatest sustained loss we suffer before our system or trading method \nrights itself, stanches the flow of blood, and begins to accumulate profits again? Constructing a wave \nchart is one way to look at this experience.\nMeasuring from the top of the wave to the bottom gives us our maximum drawdown, and \nan idea of what amount of capital we need and how much reserves to maintain. It also gives us \na vivid depiction of our results. A chart with many tsunamis (in the wrong direction) probably \nmeans we need to modify our methods—unless we genuinely enjoy riding roller coasters (with the \nfull understanding that dreadful accidents do sometimes happen on thrill rides). If constructing a \nsystem without actual market experience, one should multiply maximum drawdown by 3 or 4 to get \na reasonable amount of capital with which to back the system.\nPragmatic portfolio analysis: measuring the risk\nIn analyzing a portfolio, we must first know what is important to measure. To be able to control risk, we \nmust be able to measure it. Theoreticians identify risk with volatility. There are some real-life problems \nwith this concept, but we will use it for the moment anyway. In a portfolio, we want to be able to separate \nour various types and weights of risk. In terms of volatility, bonds are obviously less volatile than stocks, \nand unleveraged commitments are less volatile than, say, futures. Similarly, if the portfolio is not risk \nbalanced, that is, if one issue represents a large proportion of the whole, then it represents a larger portion \nof the risk. But, if a portfolio consisted of only the Standard & Poor’s 500, that would obviously be a \ndifferent case, because a commitment like this would be by definition diversified. Thus, we must know \nwhat is important to measure (see Philippe Jorion’s Value at Risk. In addition, there is a piece of tutorial \nsoftware called Risk Management 101, Zoologic Corp., which is excellent in presenting these concepts).\nIn operational or pragmatic terms, a trader wants to know what his operational risk is, rather than his \ntheoretical risk, and does not consider upside equity volatility a negative. A trader may choose to measure \nrisk by the pragmatic method outlined here. In doing so, he will want to know for his Portfolio Ordinary \nor Normal Risk, POR, his Risk Over Time, PRT, and his Extraordinary or Catastrophic Risk, PCR.\nPortfolio Ordinary or Operational Risk\n“Ordinary” and “Operational” may be used interchangeably when discussing daily risk. First \nconsider we want to measure our risk today. Our Ordinary Risk today is easily computed by taking \nthe stop price from the market price on each position and summing the differences, as above. Dividing \nthis figure by the allocated capital (Total Capital, TC) will give us a Portfolio Risk Factor (PRF), \nwhich is the risk factor the trader is willing to assume for one day.\n POR = sum of differences\n PRF = PO$Risk/TC\n503Chapter forty-two: Portfolio r isk management\nPortfolio risk over time\nThe Daily Operational Risk number can be annualized to give us a number for risk over time—or it \ncan be computed for a week or a month, and so on. Or, this factor may be collected from operations. \nIt may be collected by taking each day’s Ordinary Risk, summing and dividing for the desired time \nperiod (and plott", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 233}
{"text": "PO$Risk/TC\n503Chapter forty-two: Portfolio r isk management\nPortfolio risk over time\nThe Daily Operational Risk number can be annualized to give us a number for risk over time—or it \ncan be computed for a week or a month, and so on. Or, this factor may be collected from operations. \nIt may be collected by taking each day’s Ordinary Risk, summing and dividing for the desired time \nperiod (and plotted). It also may be computed by taking the average return and the variances therefrom \nand calculating the standard deviation. This is Risk Over Time. Annualized risk, for example:\n DR × (square root 365) where DR = Daily Risk\nPortfolio extraordinary or catastrophic risk\nExtraordinary Risk is the risk of market collapse or panic on any given day. The way to look at this \nrisk is, first of all, to assume normal behavior of the markets, or your everyday panic. In this case, if \nall of one’s positions cratered, one would take his worst-case, one-day loss and be out of the market. \nTo extend this analysis, assume the market makes a two, then four, then six standard deviation move. \nWhat will be the effect on your position in this event, when stops will not be honored by specialists \nand market makers and the market will be stampeding like spooked cattle for the exits? That is, \nmeltdown. This is Extraordinary or Catastrophic Risk. If you have no capital reserve you are out \nof business.\nControlling the Risk\nThe most danger in these meltdown events is in the greatest leverage—so the greatest risk is in short \noptions—and usually short puts. You will remember my story of my customer at Options Research \nInc. who lost $57 million during the Reagan Crash of 1987; he was short puts. Some market makers \nhave been destroyed by shorting calls, but the case is rare and specifically results in the case of \ntakeovers and unwise concentration of commitments in one issue only.\nThe least risk lies in being hedged. To oversimplify, long the stock, long the put. The profit of one \nmakes up for the loss on the other. Also, if one were long some stocks and short others, that also is a \nkind of hedge. Or long the Dow and short futures on the Dow, or some of its components.\nNow, let us be pragmatic; if during the management of our portfolios we consistently measured \nthe market with the MEI and balanced our portfolio accordingly, we will be at less risk, both from \nthe Ordinary and the Extraordinary viewpoint. In fact, we may profit from an event that disemploys \nmany professional money managers.\nIf you have been religiously raising your stops, following the market with progressive stops, \nand in fact raising them on the basis of new highs as described in Chapter 28 (the three-days-away \nrule), it is quite possible that while the market is storming, you will be sailing to Byzantium in your \ncustomer yacht.\nSummary of Risk and Money Management Procedures\nThe procedures described above are easily reducible to simple formulas, even for the math phobic. \nTrade size is the basic unit for controlling risk. Regardless of volatility, 500 shares of anything is \nriskier than 100 shares.\nTo determine trade size, take the difference between the entry price and the stop price, giving \nDollar Risk 1 ($R1). Take the Risk Control Factor, the percentage of total capital to be ventured on \nthe trade, and multiply times Total Capital—for example, 3% times TC of $100,000, giving Risk-\nper-Trade. Divide Risk-per-Trade by Dollar Risk 1 to determine Trade Size.\n504 Technical Analysis of Stock Trends\n EP − SP = $R1\n RCF × TC = RpT\n RpT/$R1 = TS\nwhere\n TS = Trade Size\n EP = Entry Price\n SP = Stop Price\n $R1 = Dollar Risk 1\nRCF = Risk Control Factor\n TC = Total Capital\n RpT = Risk-per Trade\nMeasure daily Operational Risk as described above. Divide Operational Risk by Total Capital \nto determine Portfolio Operational Risk Factor. If this factor is too high, look for hedges or positions \nto eliminate, starting with those that are underwater.\nRecompute stops frequently (daily for a trader), raising them according to the Basing Points \nProcedure, Support and Resistance, or Trendlines. Additionally, a money management stop may be \nemployed, where the trader says, for instance, no more than 8% from the market price will be risked \nand this 8% must represent no more than x% of total capital. Money management stops, it should \nbe noted, are inherently less dynamic than technically placed stops.\nAs the markets proceed inevitably through their phases, track their internal composition with the \nMEI, and as positions are naturally terminated, put on new positions in accord with the general long \nand short strength readings of the MEI. Remember that exceptionally high MEI readings coincide \nwith broad market tops, and exceptionally low MEI readings coincide with broad market bottoms.\nProfessional risk managers compute daily the Extraordinary Risk potential in the markets using \nthe procedure described in this chapter to constrain traders under their authority from overexposure. \nIn fact, panics and crashes rarely occur out of the blue. There is almost always a pre-panic phase the \ntruly alert trader can identify, especially with the aid of a computer; these are marked by insider and \nprofessional selling that creates increasing volume with Reversal Days occurring in many stocks \nand Gaps and Runaway down days. Almost always, these conditions will be preceded by many top \nformations among key stocks—Double and Triple Tops and Heads-and-Shoulders and V-Tops.\nEternal vigilance is the cost of freedom. It is also the cost of investing success.\nInfinitely more sophisticated risk and money management \nprocedures—Ralph Vince and optimal f\nUndoubtedly, one of the most sophisticated analysts now practicing is Ralph Vince, author of The \nHandbook of Portfolio Mathematics and progenitor of the Leverage Space Model. He defines \nrisk as we do, as drawdown, not as the variance of returns. His procedure for determining trade size \nis extremely sophisticated—more so than th", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 234}
{"text": "ted risk and money management \nprocedures—Ralph Vince and optimal f\nUndoubtedly, one of the most sophisticated analysts now practicing is Ralph Vince, author of The \nHandbook of Portfolio Mathematics and progenitor of the Leverage Space Model. He defines \nrisk as we do, as drawdown, not as the variance of returns. His procedure for determining trade size \nis extremely sophisticated—more so than the procedures I have outlined here. Although I feel these \nprocedures meet the needs of the general investor, Vince’s procedure is must reading for the more \nsophisticated investor and trader. He has described the Leverage Space Model in a short article found \nin Section 8 of Appendix B, Resources.\n505\nchapter forty-three\nStick to your guns\nIt has often been pointed out that any of several different plans of operation, if followed \nconsistently over a period of years, would have produced consistently a net gain on market \noperations. The methods we have discussed in this book (representing the technical \napproach) are a case in point.\nThe fact is, however, that many traders, not having set up a basic strategy and having \nno sound philosophy of what the market is doing and why, are at the mercy of every Panic, \nboom, rumor, tip, in fact, of every wind that blows. Since the market, by its very nature, \nis a meeting place of conflicting and competing forces, they are constantly torn by worry, \nuncertainty, and doubt. As a result, they often drop their good holdings for a loss on a \nsudden dip or shakeout; they can be scared out of their short commitments by a wave of \noptimistic news; they spend their days picking up gossip, passing on rumors, trying to \nconfirm their beliefs or alleviate their fears; and they spend their nights weighing and \nbalancing, checking, and questioning, in a welter of bright hopes and dark fears.\nFurthermore, a trader of this type is in continual danger of getting caught in a situation \nthat might be truly ruinous. Since he has no fixed guides or danger points to tell him when \na commitment has gone bad and it is time to get out with a small loss, he is prone to let \nstocks run entirely past the red light, hoping the adverse move will soon be over, and there \nwill be a “chance to get out even,” a chance that often never comes. What is more, even \nshould stocks be moving in the right direction and showing him a profit, he is not in a much \nhappier position because he has no guide as to the point at which to take these profits. The \nresult is he is likely to get out too soon and lose most of his possible gain or overstay the \nmarket and lose part or all of the expected profits.\nIf you have followed the preceding chapters carefully, you will have realized none of \nthe technical formations and signals is certain and unfailing. The chart action of a stock \ndiscounts and records all presently known information about that stock (which includes all \nmatters of dividends declared or expected, split-ups, and mergers that are known to be \nplanned, political angles as they affect the market, world affairs, management, earning \nrecords, and so on). The chart does not and cannot forecast unforeseeable events, matters \nthat are completely unknown to anybody. In a majority of cases, the charts are dependable. If \nyou are not satisfied this is true, you should study further, or else plan not to use charts at all.\nOn the other hand, if you are satisfied the charts are, for you, the most dependable \nindication of the probable future course of stock prices, then you should follow explicitly \nthe signals given on your charts, either according to the rules we suggest here or according \nto such other rules and modifications as your experience dictates. Nevertheless, while you \nare following any set of rules and policies, follow them to the letter. It is the only way they \ncan help you.\nIf you do this, you will have certain large advantages, right at the start: (1) you will \nnever be caught in a situation in which a single stock commitment can wipe out your entire \ncapital and ruin you; (2) you will not find yourself frozen in a market that has turned \nagainst you badly, with a large accumulated loss and your capital tied up, so that you \ncannot use it in the reversed trend to make new and potentially profitable commitments; \n506 Technical Analysis of Stock Trends\nand (3) you can make your decisions calmly, knowing exactly what you will be looking \nfor as a signal to take profits, and knowing also that your losses, at the very worst, will be \nlimited to a certain definite amount.\nAll of this means you will have peace of mind. You will take losses and you will make \ngains. In neither case will you have to take your notebooks home and lie awake worrying. \nYou will have made certain decisions. If developments prove you were right, you will, at \nthe proper point, take your profit. And if it turns out that you were wrong, then you can \ntake your comparatively small loss, and start looking for a better situation, with your capital \nstill largely intact, liquid, and available.\nYour job, as a speculator, is to provide liquidity in the market and to counteract the \nirrational excesses of market-in-motion. Part of that job is to keep yourself free to become \nliquid whenever it is necessary to reverse your position. It is part of your job to keep \nyourself free from irrational and excessive emotional actions. If you do this intelligently \nand consistently, you will be performing a useful and necessary service to the general \neconomic welfare, and you will find the market offers as good or better returns for your \nefforts as any other line of endeavor.\n(EN9: With the ninth edition, I expect the reader will have some powerful new guns to stick to: \nnew lessons in Basing Points that show what a powerful procedure it can be; new analyses of Dow \nTheory that refresh and reinforce the validity and persuasiveness not just of the Theory, but also of \nlong-term investing as such. EN10: And a host of new stop systems", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 235}
{"text": "fforts as any other line of endeavor.\n(EN9: With the ninth edition, I expect the reader will have some powerful new guns to stick to: \nnew lessons in Basing Points that show what a powerful procedure it can be; new analyses of Dow \nTheory that refresh and reinforce the validity and persuasiveness not just of the Theory, but also of \nlong-term investing as such. EN10: And a host of new stop systems to work with. Good trading and \nstick to all your guns!)\n507\nAppendix A: The Dow Theory in practice\nEN10: This appendix appears as Chapter 4 in the ninth edition.\nEN9: The casual and careless reader will shake his head at this chapter and ask why on earth the \neditor has not excised it from the book. The editor has not deleted the chapter because, like old-\nfashioned cod liver oil, it is good medicine. It will appeal mainly to the serious student of not just Dow \nTheory but also of long-term investing. If the reader has absolutely no interest in Dow Theory or \nlong-term investing, he may skip over this chapter and return to it in his old age, when he is wiser.\nAt this point, the reader, if he has little previous knowledge of the stock market, may be \nsuffering a mild attack of mental indigestion. The Dow Theory is a pretty big dose to \nswallow at one sitting. We departed deliberately in the foregoing chapter from the order \nin which its principles are usually stated in an effort to make it a little easier to follow and \nunderstand. Actually, not all of the 12 tenets we named are of equal import. The essential \nrules are contained in 2, 3, 4, 5, 8, 10, and 11. Number 1 is, of course, the basic assumption, \nthe philosophical justification for these rules. The other points (6, 7 , 9, and 12) furnish \n“background material,” as the news reporters might put it, which aid in interpretation. \nTheoretically, one should, by strict adherence to the essential rules alone, accomplish just \nas much as he could with the added collateral evidence. (For illustrations in this appendix, \nsee Figures A.1 through A.9.)\nHowever, the utilization of Dow Theory is, after all, a matter of interpretation. You may \nmemorize its principles verbatim and yet be confounded when you attempt to apply them to \nan actual market situation. We can better organize our knowledge of the theory and acquire \nsome understanding of its interpretation by following through a few years of market action \nand seeing how it looked at the time through the eyes of a Dow theorist. For this purpose, \nwe may well take the period from late 1941 to the beginning of 1947 because this covers the \nend of one Bear Market, an entire long Bull Market, and part of another Bear Market, and \nincludes examples of most of the market phenomena with which the Dow Theory has to deal.\nFive years of Dow interpretation\nFigure A.2 is a condensed chart of the course of the two Dow–Jones Averages from January \n1, 1941, to December 31, 1946, on which most of the Minor Trends have been disregarded \nbut all the recognized Intermediate Swings (Primary and Secondary) have been indicated. \nCertain portions of this history will be supplemented by complete daily charts in connection \nwith our detailed discussion that follows.\nThe year 1941 opened with the stock market in a Minor Rally. A Primary Bear Market \nhad been signaled when prices collapsed in the spring of 1940 and that Bear Market was \n508 Appendix A\nstill in effect. After the May Panic had ended, a Secondary Recovery swing, which lasted \nfor more than five months, had regained more than half of the ground previously lost by \nthe Averages, carrying the Industrials from their closing price of 111.84 on June 10 to 138.12 \non November 9 and the Rails from 22.14 on May 21 to 30.29 on November 14. (During \nthis long Bear Market Secondary, incidentally, volume tended to increase on rallies, which \nencouraged many who did not hold strictly to first principles to believe that this rise was \nthe beginning of a new Bull Trend, illustrating the point we cited under “Volume” in \nChapter 3.) From the November highs, however, the trend turned down again. Then a \nMinor Rally developed, as stated, at the end of the year, reaching its peak on January 10 at \n133.59 in the Industrials and 29.73 in the Rails. From there, prices fell again to 117 .66 and \n26.54, respectively, on February 14.\nThe first severe test\nThe next few months will be particularly interesting for us to trace because they put the \nDow Theory to a real test. Figure A.3 shows the daily ranges and closing prices of the \ntwo Averages and total daily market volume for the seven months from February 1 to \nDOW-JONES INDUSTRIALS\nRAILS\nRAILS\nINDUSTRIALS\n’41 ’42 ’43 ’44’ 45 ’46\n220\n200\n180\n160\n140\n120\n100\n80\n70\n60\n50\n40\n30\n20\nFigure A.1 “Swing” (EN: or Wave) chart showing all the Intermediate and some of the more extensive \nMinor Trends of the Dow–Jones Industrial and Rail Averages, January 1941 to December 1946. \nIndustrial price scale left, Rails right.\n509Appendix A\nAugust 31, 1941. Before we examine it in detail, however, let us first review the situation \non February 14. The Bear Market lows to date had been registered in May–June, 1940. \nThereafter, an extended Intermediate Recovery had advanced the Industrial Average \n26.28 points and the Rail Average 8.15 points. This had been followed by a three-month \ndecline of 20.46 and 3.75 points, respectively, and this decline, incidentally, had consisted \nof three well-defined Minor Waves. In duration, and in extent of price change with \nrespect to the previous swing—46% in the Rails and nearly 78% in the Industrials—this \ndownswing qualified as an Intermediate Trend, and now prices were turning up again. \nDow theorists were on the alert. If both Averages could continue their rise to levels \nabove their high closes of the previous November (138.12 and 30.29), that action would \nconstitute a signal of a new Primary Bull Market, and reinvestment of funds withdrawn \nfrom stocks in May 1940 would be at once in order. Also, it would t", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 236}
{"text": "ified as an Intermediate Trend, and now prices were turning up again. \nDow theorists were on the alert. If both Averages could continue their rise to levels \nabove their high closes of the previous November (138.12 and 30.29), that action would \nconstitute a signal of a new Primary Bull Market, and reinvestment of funds withdrawn \nfrom stocks in May 1940 would be at once in order. Also, it would then be necessary to \ngo back and label the May–June lows of 1940 as the end of a Bear Market, the advance to \nNovember as the first Primary Swing in the new Bull Market, and the decline to February \nas its first Secondary Reaction. Note Rule 12 of our preceding chapter ( EN11: Chapter 3 ) \napplied here; the presumption was it was still a Bear Market until a definite signal to the \ncontrary appeared.\nLet us now turn again to Figure A.3 and see what actually did happen. The Industrials \nrallied for six weeks, reaching 124.65 on April 3. The Rails got up to 29.75 on the same date, \nregistering double the percentage gain of the Industrials, but both Averages were still below \ntheir November highs. Then the Industrials slipped off within two weeks and had broken \ndown below their February low and drifted down to close at 115.30 on May 1. This Average was, \ntherefore, still in an Intermediate Downtrend. The Rails, meanwhile, were staging a different \nsort of performance; they dropped back from their April 3 high for two weeks, but held at 27 .72, \nrallied smartly and then sold off again to 27 .43 on May 31. The picture became at once even more \n130\n128\n126\n124\n122\n120\n116\n118\nINDUSTRIALS\nRAILS\n1941\n31\n30\n29\n28\n27\n26\nFEBRUARY MARCHA PRIL MAYJ UNE JULY AUGUST\n81 52 21 81 52 22 95 12 19 26 31 01 72 43 17 14 21 28 51 21 92 62 91 62 33 0\nSales in\nMillions\n2.0\n1.5\n1.0\n.5Total Vol.\nFigure A.2 Closing price levels of the Dow–Jones Industrial and Rail Averages, February 1 to August \n31, 1941, and total daily market volume. Vertical lines show net daily change from one closing level \nto next.\n510 Appendix A\ninteresting. Here was a Divergence between the two Averages, a failure to confirm; the Rails, \nafter two opportunities, were refusing to confirm the Industrials in the latter’s downtrend.\nFailure to confirm\nWhen prices began to work upward in June, many commentators seized on this “failure to \nconfirm” as a Bullish omen and the wishful thinkers again talked Bull Market. There is an \nunfortunate tendency in the Street to overstress any such divergence, particularly when \nit can be twisted into a favorable sign. The fact is Dow Theory’s refusal of one Average \nto confirm the other can never produce a positive signal of any sort. It has only negative \nconnotations. Divergences sometimes occur at Reversals in the Major Trend—there have \nbeen several instances in market history, in which, perhaps, the most remarkable occurred \nway back in 1901 and 1902, and we shall soon inspect another—but they also occur with \nequal frequency at times when no Major Reversal is developing, and the instance we are \ndiscussing here was one of the latter.\nThe situation at the end of May in 1941 was precisely the same to the Dow theorist, \ninsofar as the Major Trend was concerned, as it had been on February 14. The June–July \nrally topped out in the Rails at 30.88 on August 1, and in the Industrials at 130.06 on July \n28 (compare these figures with their 1940 November highs) and prices then declined at \nan accelerating pace, temporarily culminating in the Pearl Harbor Panic. This took the \nIndustrial Average below its previous Bear Market low (111.84 on June 10, 1940), although the \nRails, again, did not follow. They had, however, by this time, broken below their previous \n(February 14) Intermediate Bottom by a liberal margin.\nThe next period of importance began in April 1942. We can skip any detailed chart of \nthe months between December and April because they posed no Dow Theory problems. \nINDUSTRIALS\nRAILS\n1942\n30\n29\n28\n27\n26\n25\n24\n23\n116\n114\n112\n110\n108\n106\n104\n102\n100\n98\n96\n94\n92 Sales in\nMillions\nTotal Vol.\n1.0\n2.01.5\n.5\nMARCHA PRIL MAYJ UNE JULY AUGUST SEPTEMBERO CTOBER\n71 42 1284 11 18 25 29 16 23 3061 32 02 74 11 18 25 18 15 22 2951 21 92 6310 17 24 31\nFigure A.3 Daily closing price levels of the Dow–Jones Industrial and Rail Averages from March 2 \nto October 31, 1942, and total daily market volume. This period saw the beginning of a 4-year major \nbull market.\n511Appendix A\nAfter a Minor Rally in the Rails in January, prices simply drifted lower and lower, but it \nwas increasingly evident that trading volume did not expand on the dips (Minor Declines). \nLiquidation was drying up; the boardrooms were void of customers; the atmosphere was \ntypical of the last stages of a Bear Market.\nThe daily action of the Averages from March 2 to October 31, 1942 is shown in Figure \nA.4. New lows (since 1940) were registered both in late April, at 23.72 on April 24 in the \nRails and at 92.92 on April 28 in the Industrials. Shortly thereafter, a notable Divergence \ndeveloped, when, after rallying for only seven days, the Railroad Index began to slip off \nwhile the other Average kept right on going up. Trading activity remained at a low ebb \n(there was no sustained volume increase, in fact, until late September). On June 1, the Rails \ndropped to another new low and on the 2nd closed at 23.31. On June 22, it looked as though \nthe Industrials were going to be pulled down again, but only a few days later, the best rally \nin months got started, taking the Industrials to new highs and more than recovering all of \nthe April–May loss in the Rails. Activity also speeded up briefly, with one day registering \na greater turnover than the market had enjoyed in any session since early January. ( EN9: \nNote this warning sign. The ringing of an alarm clock.)\nSigns of Major Turn\nAgain, the Dow theorists were very much on the alert. An advance of Intermediate \nproportions was obviously under way. Until proved otherwise, it had to be labeled a \nSecondary withi", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 237}
{"text": "also speeded up briefly, with one day registering \na greater turnover than the market had enjoyed in any session since early January. ( EN9: \nNote this warning sign. The ringing of an alarm clock.)\nSigns of Major Turn\nAgain, the Dow theorists were very much on the alert. An advance of Intermediate \nproportions was obviously under way. Until proved otherwise, it had to be labeled a \nSecondary within the Bear Market, which was still presumably in effect, but that Major \nINDUSTRIALS\nRAILS 1942–1943\n142\n140\n138\n136\n134\n132\n130\n128\n126\n124\n122\n120\n118\n116\n114\n38\n37\n36\n35\n34\n33\n32\n31\n30\n29\n28\n27\n26\nNOVEMBER DECEMBER JANU ARYM ARCHFEBRUARY APRILM AY JUNE\n71 42 1 2851 21 9 26 29 16 23 30 61 32 02 76 13 20 27 31 01 72 41 81 5 22 29 51 21 92 63\nSales in\nMillions\nTotal Vol.2.0\n1.5\n1.0\n.5\nFigure A.4 Daily closing price levels of the Dow–Jones Industrial and Rail Averages from November 2, \n1942, to June 30, 1943, and total daily market volume.\n512 Appendix A\nDowntrend had by now run for nearly three years—nearly as long as any on record—and \nits last decline had shown no selling pressure whatever, simply a dull drift. This presumed \nSecondary might turn out to be a new Primary; hopes for such a denouement had been \nblighted 12 months earlier under somewhat-similar circumstances, but this time prices \nwere lower and there was a different “feel” to the market. The general news offered little \nencouragement, but the Dow Theory does not concern itself with any news other than the \nmarket itself (which discounts all other kinds of news). In any event, there was nothing to \ndo but wait and see—let the market, in its own time and way, state its own case.\nIn early July, the Industrials started to “mark time”; for 11 weeks, they fluctuated within \na 5-point range, building a typical Dow Line from which they emerged on the upside in \nlate September. The Rails pushed up to a new high for the move at the same time, and by \nNovember 2, both Averages had surpassed their Rally Tops of the preceding January. At \nthis stage, some Dow theorists were willing to announce a Bull Market had been signaled. \nTheir arguments, aside from points of a nontechnical nature or having nothing to do with \nDow Theory, were as follows:\n 1. The conspicuously low level of volume at the April–June Bottom, typical of the end \nof a Bear Swing. (True and cogent.)\n 2. The Rail Average had refused to follow the Industrials into new Major low ground at \nthat time. It had held above its closing level of May 1940. (Also true, but of questionable \nsignificance. More about this later.)\n 3. The Industrials had constructed a Line and gone up out of it. (Again true, but the Line \nwas somewhat short to have, beyond a doubt, major import.)\nINDUSTRIALS\nRAILS\n1943–1944\n146\n144\n142\n140\n138\n136\n134\n132\n130\n37\n36\n35\n34\n33\n32\n30\nJULY AUGUST SEPTEMBER OCTOBER NOVEMBER DECEMBER JANUARY\n31 01 72 43 17 14 21 28 41 11 82 52 91 62 33 06 13 20 27 41 1 18 25 18 15 22 29 5\nSales in\nMillions\n2.0\n1.5\n1.0\n.5\nTotal Vol.\nFigure A.5 Daily closing price levels of the Dow–Jones Industrial and Rail Averages from November \n2, 1942, to June 30, 1943, and total daily market volume. This chart follows and should be compared \nwith Figure A.4. The decline in the Rail Average during November and early December produced the \nfirst test of the Major Trend since the preceding June. When this Index recovered and, on February \n1, 1943, closed above its November 2 high, a Primary Bull Market was thereby signaled according \nto Dow Theory.\n513Appendix A\n 4. The Rail Average had produced successively higher Minor Tops and Bottoms for four \nmonths. (This also was true but did not permit positive differentiation from a Bear \nMarket Secondary.)\nThe more conservative Dow theorists were not yet convinced. They maintained this \nuptrend had yet to undergo the test, bound to occur sooner or later, of an Intermediate \nReaction. They admitted that the picture was most encouraging, but they called attention \nto the fact that, except for Point 1, it was no better than that of November 1940. Let’s \nfollow along through the next five months. Figure A.5 shows the daily market action from \nNovember 1, 1942, to June 30, 1943.\nThe Bull signal\nAfter reaching 29.28 at their close on November 2, the Rails declined in almost a straight \nline for six weeks to 26.03 on December 14. This move indubitably rated as an Intermediate \nin duration and it had “given up” more than half of that Average’s entire advance from \nthe June 2 low point. The Industrial Index, however, held stoutly in another narrow Line \nthroughout November, December, and January. From December 14, the Rails turned up, \nand finally, on February 1, 1943, closed at 29.55, out above their previous Intermediate Top \nof 29.28 recorded the previous November. By then, the Industrials had also moved up into \nnew high ground. This development at last satisfied every strictest requirement of Dow \nTheory; a new Primary Bull Market was in force. Trading volume had also been expanding \non each Minor Advance during the fall and winter months, but its evidence was not needed; \nthe price action alone was conclusive. The Rails had produced the necessary sequence of \nhigher Intermediate Tops and Bottoms. In the Industrials, Lines had served the purposes \nof the theory as substitutes for Intermediate Reactions.\nIt was necessary now to relabel the up-move from April–June to November of 1942 \nas the first Primary Swing in a Bull Market. The decline of the Rails from November 2 to \nDecember 14 was now recognized as the first Secondary within that Major Trend.\nWe may turn back for a moment at this point to comment on the performance of \nthe Rail Index in June 1942. Since it held above its low of May 1940, some commentators \nhave maintained the Bull Market should really have been dated from that former year as \nrepresenting the last “confirmed” lows. This strikes us as rather impractical hair-splitting. \nRegardless of the 1.17 higher level in the Rail Average in June 1942,", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 238}
{"text": "r a moment at this point to comment on the performance of \nthe Rail Index in June 1942. Since it held above its low of May 1940, some commentators \nhave maintained the Bull Market should really have been dated from that former year as \nrepresenting the last “confirmed” lows. This strikes us as rather impractical hair-splitting. \nRegardless of the 1.17 higher level in the Rail Average in June 1942, a genuine Bull Move \ndid not start until that time. We suspect, before many years have passed, Dow theorists \nwill have occasion greatly to regret the importance that has since been assigned to the \nRails’ “failure to confirm” in the spring of 1942. Remember, such a Divergence does not \nand cannot produce a positive signal; at the time of its occurrence, it can serve merely to \nnegate or cast in doubt the implications of the other Average; only subsequent action in the \nopposite direction can establish the existence of a change in trend. If the Rails’ decline in \nMay 1942 had carried them below 22.14, but their subsequent action had followed the course \nit actually did, point for point at a lower level, a Bull Market Signal would nevertheless have \nbeen given at the very same time, not one day later and not one day sooner.\nMoreover, a Divergence does not necessarily imply a move of consequence in the \nopposite direction will ensue. We have already examined one comparable instance (in the \nspring of 1941) that resulted otherwise. Logically, if a failure to confirm such as occurred \nin 1942 is to be taken as an indication of a turn in trend, then its opposite, (confirmation or \nreaffirmation by both Averages) should argue with equal force against a turn in trend. Yet \nthe simple truth is that many more Major Reversals have come when the Averages were in \n514 Appendix A\nagreement than when they were divergent. We have no wish to belabor the point or waste \nthe reader’s time, but we do feel he should be warned against the wishful thinking that \nevery “failure to confirm” seems to inspire when the market is in a Bear Trend.\nTo return to our history, the Averages closed at 125.88 and 29.51, respectively, on the day \nfollowing our conclusive Bull Market Signal in February 1943. Theoretically, that is where an \ninvestor who strictly followed the Dow Theory would have bought his stocks. (Those who \nwere satisfied the Primary Trend was up in November 1942 bought with Averages around \n114.60 and 29.20.) It was reasonable to assume this Bull Market, which as yet showed few of \nthe usual characteristics of the second phase and none whatever of the third phase, would \ncontinue for some time to come. The next four months produced no market developments \nthat required interpretative attention, and we can move on to the events of July. Figure A.6 \ncharts the action from July 1, 1943, to January 31, 1944.\nThe first correction\nAfter closing at 145.82 on July 14, 1943, the Industrial Average drifted off. The Rails pushed \nup to a new high (38.30) 10 days later, but the Industrials refused to join in the rally and \nthen both indexes cracked down sharply for seven sessions. Turnover increased and the \ndecline was the greatest occurring in the Bull Market up to that date. However, everyone \nrealized the market, after several months of quite persistent advance, was “entitled to a \ncorrection.” In neither duration nor extent could this down move be qualified as more than \na Minor Trend. Next ensued three months of desultory fluctuation with little net progress \nin either Average. The Industrials pulled up to 141.75 on September 20 and then drifted \noff again, whereas the Rails struggled back to 35.53 on October 27 . Another quick break \ndeveloped in early November, culminating in a high-volume shakeout that cut the value \nINDUSTRIALS\nRAILS\n1945\n192\n188\n184\n180\n176\n172\n168\n164\n160\n66\n64\n62\n60\n58\n56\n54\n52\n50\nMAY JUNEJ ULYA UGUSTS EPTEMBER OCTOBERN OVEMBER\n51 21 92 62 91 62 33 07 14 21 28 41 11 82 51 81 52 22 96 13 20 27 31 01 72 43 1\nSales in\nMillions\nTotal Vol.2.01.5\n1.0.5\nFigure A.6 Daily closing prices of Dow–Jones Industrial and Rail Averages, and total market volume, \nJuly 1, 1943, to January 31, 1944.\n515Appendix A\nof the Industrials by 3.56 points and the Rails by 1.75 on November 8. Prices rallied a little \nand sold off again, reaching new lows (since early spring) on November 30—Industrials \n129.57 and Rails 31.50.\nThere was no question now that a full-fledged Secondary Reaction had developed. The \nproblem for Dow interpreters was whether there was more involved. If the first drop in July \ncould be construed as an Intermediate Trend in itself, and the August– October action as \nanother Intermediate Swing, then the November break would signal a Bear Market. As a \nmatter of fact, no Dow theorist, so far as we know, gave very serious consideration to any \nsuch interpretation. The July break, as aforesaid, did not rate as an Intermediate in either \nduration or points retraced; the whole move from July to November 1943 had to be regarded \nas all-of-a-piece, all one Secondary Reaction. The real Major Trend test would come on the \nnext advance, whenever that should develop; if that failed to top the July peaks, and prices \nthereafter declined to new lows, a Bear Market would indeed be in effect.\nThe decision was long deferred. Prices began again to move up, but the advance in \nthe Industrials was slow and grudging. The Rails forged ahead more rapidly and pushed \nthrough their July Top on February 17 , 1944, going on to a Minor Peak at 40.48 on March 21. \nThe Industrial Average attained 141 on March 13, but still nearly 5 points below its “signal” \nlevel, faltered and fell back. Here was another striking case of “failure to confirm.” For \nthose who chose to assign grave significance to such developments, it could have only a \nvery Bearish meaning. All it did mean, in fact, was continuation of the Primary Bull Move \nhad not as yet been confirmed. Only if both Averages now declined and closed below \ntheir respective Novem", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 239}
{"text": "s below its “signal” \nlevel, faltered and fell back. Here was another striking case of “failure to confirm.” For \nthose who chose to assign grave significance to such developments, it could have only a \nvery Bearish meaning. All it did mean, in fact, was continuation of the Primary Bull Move \nhad not as yet been confirmed. Only if both Averages now declined and closed below \ntheir respective November 30 Bottoms would the new high registered by the Rails alone \nin February have to be disregarded and a Primary Bear Market announced. In brief, the \nsituation at the end of March was no different, so far as its Major Trend implications were \nconcerned, from what it had been in early January before the Rails pushed through.\nBull Trend reaffirmed\nThe situation remained in doubt (but subject always to that basic presumption of the Dow \nTheory that we named as Rule 12 in the preceding chapter [EN10: Chapter 3]) until June 15, \n1944, when the Industrials finally came through to close at 145.86. It had taken them four \nmonths to confirm the Rails, almost a full year to reaffirm the Primary Uptrend. The effect \nof this “signal” on traders was electric; trading volume increased by 650,000 shares on the \nfollowing day as prices jumped another full point.\nThe following 12 months need no detailed discussion as they produced nothing in \nthe way of market action to give a Dow theorist any concern. Prices drifted off irregularly \nfor nine weeks after mid-July, but their net loss was of minor proportions, and they then \nclimbed with only brief interruptions to 169.08 in the Industrial Index on May 29, 1945, and \n63.06 in the Rail Index on June 26, 1945. We should take a brief look at the period following, \nnot because it illustrates anything new in our study, but because it takes in the surrender \nof Japan and the end of fighting in World War II.\nThe seven months from May 1 to November 30, 1945 are covered in Figure A.7. The \nIndustrials held steady for four weeks while the Rails were making the spurt to their June \n26 Top. On June 28, with nothing in the newspaper headlines to account for such a radical \ntrend change, prices broke sharply and turnover climbed to nearly 3 million shares, the \nhighest day’s total for the Bull Market up to that time. Nevertheless, the Industrial Average \ngave ground reluctantly thereafter, and by June 26, at 160.91 had given up less than 5% of its \ntop price. The Rails shook down rapidly, however. The Hiroshima bomb was dropped on \nAugust 5, and Japan surrendered on the 14th. The Industrials were now rallying up from \n516 Appendix A\ntheir July 26 low, but the Rails could not hold and plunged again, hitting bottom finally \n(for this move) on August 20 at 51.48, for a loss of more than 18% of their June peak value.\nThe Rails falter\nBefore we go on with our examination of the market action here, it is interesting to note up \nto this point the Rail Average had been the “hero” of our story. Starting with its refusal to \ngo down to a new Bear Market low in June of 1942, it was the spearhead of each important \nadvance, had staged the most spectacular rallies, had gained 170% in value as compared \nwith the Industrials’ 82%. In retrospect, the explanation is obvious: the railroads were the \nchief business beneficiaries of the war. They were rolling up profits, paying off indebtedness, \nand reducing their fixed charges at a rate unheard of in this generation (and probably never \nto be seen again). Although the “public’s” eye was on the traditional and better publicized \n“war industries,” the market began, as far back as Pearl Harbor, to shrewdly appraise and \ndiscount this unprecedented harvest for the Rails. But from here on, the picture changes \nand the Rails become the laggards. As we look back now, it is just as obvious that, with \nequal shrewdness, the market began in July of 1945 to discount a change in their fortunes. \nAn illuminating demonstration of the basic assumption (Tenet Number 1) in Dow Theory!\nTurning back to our chart, prices began to push up again with renewed vigor after \nAugust 20. Both Averages had experienced a Secondary Reaction and now Dow theorists \nhad to watch closely to see whether the Primary Uptrend would again be reaffirmed by \ntheir going to new highs. The Industrials “made the grade” when they closed at 169.89 on \nINDUSTRIALS\nRAILS\n1945–1946\n216\n212\n208\n204\n200\n196\n192\n188\n184\n70\n68\n66\n64\n62\n60\nDECEMBER JANUA RY FEBRUARY MARCH APRIL MAY\n81 52 22 95 12 19 26 29 16 23 29 16 23 30 61 32 02 74 11 18 25 1\nSales in\nMillions\nTotal Vol.2.0\n1.5\n1.0\n.5\nFigure A.7 Daily closing price levels of the Dow–Jones Industrial and Rail Averages from May 1 to \nNovember 30, 1945, and total daily market volume. This period, which saw the end of World War \nII, produced only a moderate Secondary Correction in the Primary Bull Market, which had already \nrun for three years from its beginnings in April/June, 1942.\n517Appendix A\nAugust 24, but the Rails had much more ground to recover and were running into offerings \nas they came up in succession to each of the Minor Bottom levels of their June–August \ndowntrend (a phenomenon to which we shall devote some attention later on in the chapter \non Support and Resistance). Not until early November 1945 were they able to confirm the \nsignal of the Industrials by closing above 63.06. At this point, the Averages had, once again, \nannounced that the Primary Bull Market was still in force. It had now lasted for three \nand a half years—longer than most Bull Markets, and “third phase” signs were rapidly \nappearing. The public was buying, the boardrooms were crowded, stock market news was \nmaking the front pages of even small city newspapers, the “cats and dogs” were being \nwhooped up, business was booming.\nWith both Averages in new high ground and the Bull Market reaffirmed, all \nprevious low points could now be disregarded. For example, the 160.91 Bottom of July \n26 in the Industrials and the 51.48 of August 20 in the Rails had no further si", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 240}
{"text": "ms were crowded, stock market news was \nmaking the front pages of even small city newspapers, the “cats and dogs” were being \nwhooped up, business was booming.\nWith both Averages in new high ground and the Bull Market reaffirmed, all \nprevious low points could now be disregarded. For example, the 160.91 Bottom of July \n26 in the Industrials and the 51.48 of August 20 in the Rails had no further significance \nin Dow Theory. This is a point we have not stressed heretofore, but it is important. It \nmight, indeed, be added to our set of rules in the preceding chapter (EN11: Chapter 3) \nwere it not implicit in the basic tenets. Once a Primary Trend has been confirmed or \nreconfirmed, the past is forgotten and everything hinges on future action. At the end \nof 1945, with “third phase” symptoms rife, the action of the market had to be followed \nwith redoubled vigilance. The third phase could last for two more years (as it did in \n1927 to 1929) or be concluded at any moment. Our next chart (Figure A.8 ) carries us \nthrough May 1946.\nThe spring of 1946\nThe market went through a Minor Setback in late December, a development has come to be \nexpected as the normal pattern for that month and is usually attributed to “tax selling”—\nand stormed ahead again in January 1946. Daily volume on January 18 exceeded 3 million \nshares for the first time in more than five years. During the first week of February, prices \n“churned” with little net change. Extreme high closes were registered during this period \nby the Rail Average at 68.23 on February 5, and by the Industrial Average at 206.97 on \nFebruary 2. On February 9, both started to slide off, pulled back sharply from the 13th to \nthe 16th, and then broke in a selling wave that ran to a climax on February 26 with closings \nat 60.53 and 186.02, respectively. The loss in the Industrials was the greatest in points (20.95) \nthey had suffered during the entire Bull Market; in the Rails, it was exceeded only by their \nJuly–August decline of the previous year. It amounted to a little more than 10% in the \nformer and 11% in the latter and gave up a little less than half of their advances from the \n1945 summer lows. The decline was three weeks old on February 26. It was an unqualified \nIntermediate—in Dow Theory a Secondary Reaction presumptively within the still existing \nMajor Uptrend.\nLabor troubles were dogging the steel and motor industries in 1946 from early \nJanuary on, with a coal strike looming. The February break was attributed to those news \ndevelopments, but the ruling cause was more likely the discontinuance of margin trading. \nIn January, the Federal Reserve Board announced after February 1 stocks could be bought \nonly for full 100% cash. The late January up-fling was featured by the “little fellow” seizing \nhis last chance to buy on margin. (Those who participated in this scramble will doubtless \nregret it for a long time yet to come.) Professionals seized the opportunity to unload \ntheir trading commitments, but the “little fellow” was now temporarily out of funds; his \nbrokerage account was quickly “frozen.” Under the circumstances, as we look back, it is \namazing that a more extensive Panic did not then eventuate.\n518 Appendix A\nYet the Dow theorist was not concerned with causes. The Bull Market had been \nreaffirmed by both Averages in early February, canceling all previous “signal” levels. \nBullish Forces were still evidently in effect because the February 26 lows held and prices \nbegan to recover. The Industrials came back quickly and by April 9 had closed in new high \nground at 208.03. The Rails dragged; when the market showed signs of weakening at the \nend of April, the Rail Average was still nearly 5 points below its early February high. Was \nthis another “failure to confirm” to worry about?\nINDUSTRIALS\nRAILS\n1946\n216\n212\n208\n204\n200\n196\n192\n188\n184\n180\n176\n172\n168\n164\n160\n70\n68\n66\n64\n62\n60\n58\n56\n54\n52\n50\n48\n46\n44\nMAY JUNE JULY AUGUST SEPTEMBERO CTOBER\n11 18 25 18 15 22 29 61 3 20 27 31 01 72 43 1 7 14 21 28 5 12 19\nSales in \nMillions\n2.0\n1.5\n1.0\n.5\nTotal Vol.\nFigure A.8 Daily closing price levels of the Dow–Jones Industrial and Rail Averages from December \n1, 1945, to May 31, 1946, and total daily market volume. Noteworthy features of this period included \nthe extremely high volume that prevailed during January and February as compared with lower \nturnover in April and May, and the laggard performance of the Rails when the Industrial Average \npushed up to a new high in April and again at the end of May. At the latter date, the February lows \nwere still the critical downside “signal” levels according to the Dow Theory.\n519Appendix A\nFinal Up-Thrust\nThe late February Bottoms were now the critical points on the downside; if both Averages \nshould decline below the Intermediate Low closes then recorded, before the Rails could \nmake a new high above 68.23 (in which event the Bullish Signal of the Industrials would \nbe canceled), a Bear Market would thereby be signaled. Despite a miner’s strike and an \nimminent rail workers’ strike, the market turned firm again in mid-May and put forth a \nsurprising rally that swept the Industrial Index up to 212.50 on May 29, 1946—a new Bull \nhigh by nearly 6 points. The Rails failed in May by only 0.17 to equal their February high \nclose, slid back a trifle, and then pushed through at last on June 13 to close at 68.31, thereby \nconfirming the Industrials in their announcement that (as of that date) the Primary Trend \nwas still up. The February lows (186.02 and 60.53) now ceased to signify in Dow Theory, \nbut keep those figures in mind because they are involved in an argument that raged among \nDow students for months thereafter.\nThe preceding picture is overlapped by Figure A.9, taking up the market’s action on \nMay 4 and carrying it forward to October 19, 1946. Trading volume, it may be noted, in late \nMay and early June did not come up to the levels of either the late January to early February \nTop or the late Fe", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 241}
{"text": "gures in mind because they are involved in an argument that raged among \nDow students for months thereafter.\nThe preceding picture is overlapped by Figure A.9, taking up the market’s action on \nMay 4 and carrying it forward to October 19, 1946. Trading volume, it may be noted, in late \nMay and early June did not come up to the levels of either the late January to early February \nTop or the late February Bottom; the market appeared to be losing vitality, an ominous, \nalthough by no means, decisive manifestation. Prices began to fall off rapidly immediately \nafter the Rail Confirmation on June 13. The Industrials rallied for two weeks in early July, \nbut the Rails continued to decline; the Industrials broke again on July 15 and the two \nAverages continued their slide until they stood at 195.22 and 60.41 at the close on July 23.\nThere, as it subsequently developed, was the end of that particular Intermediate \nSwing—one in accord with our Rule 12 had to be labeled a Secondary Reaction in a Bull \nMarket until proved otherwise. The market swung up again. It climbed slowly and steadily, \nbut with turnover running well under a million shares, until exactly three weeks later, the \nIndustrials at 204.52 (August 13) had regained a little more than half of their June–July loss \nand the Rails at 63.12 (August 14) a little more than a third of theirs. This advance, therefore, \nhad met the minimum requirements of an Intermediate Trend. If prices could continue to \nrise and eventually push through their May–June Tops, the Major Bull Trend once again \nwould be reaffirmed. Although, if they should turn down and fall below the July 23 closing \nlevels, it would signal a Reversal of the Primary Trend.\nThe Bear Market signal\nThe situation was critical, as evident in the volume chart. Ever since the end of May, \nturnover had tended not only to increase on the declines, but also, and more importantly, \ndried up on the rallies. Compare Figure A.9 with Figures A.7 and A.8 , and you can see \nhow conspicuous this phenomenon had become by mid-August. Prices did turn down, \nwith activity increasing on the breaks, and on August 27 , the closing prices, 191.04 for the \nIndustrials and 58.04 for the Rails, told a sad story. The Averages had spoken: a four-year \nBull Market had ended, and a Bear Market was under way. A Dow investor should have \nsold all his stocks on the following day (at approximately 190 and 58 in terms of the two \nAverages).\nTo clear the record, it was necessary for the Dow theorist now to go back and mark \nthe May 29 and June 13 highs in the Industrials and Rails, respectively, as the end of the \nBull Market. The June–July decline then became the first Primary Swing in the new Bear \nTrend, and the July 23 to August 14 advance became the first Secondary Recovery within \nthe Major Downtrend. A second Primary Swing was now in the process of development.\n520 Appendix A\nYou will have noted in the foregoing, a Bear Market was signaled as soon as both \nAverages penetrated their July 23 lows. Let us return now and take up that argument we \nmentioned on the preceding page. Some students of Dow Theory refused to recognize the \nnew high of June 13 in the Rail Average as a decisive reaffirmation of the Bull Trend. The \nprevious close should be bettered by at least a full point (1.00), many argued, to confirm \nthe signal previously given by the Industrials; the margin of only 0.08 was inconclusive. \nNevertheless, this opinion, if accepted, had logical consequences that later proved \nINDUSTRIALS\nRAILS\n1946\n216\n212\n208\n204\n200\n196\n192\n188\n184\n180\n176\n172\n168\n164\n160\n70\n68\n66\n64\n62\n60\n58\n56\n54\n52\n50\n48\n46\n44\nMAY JUNE JULY AUGUST SEPTEMBERO CTOBER\n11 18 25 18 15 22 29 61 3 20 27 31 01 72 43 1 7 14 21 28 5 12 19\nSales in \nMillions\n2.0\n1.5\n1.0\n.5\nTotal Vol.\nFigure A.9 Daily closing price levels of the Dow–Jones Industrial and Rail Averages from May 4 to \nOctober 19, 1946, and total daily market volume. This chart overlaps Figure A.8. Compare the closing \nprice of the Rail Average on June 13 with its February 5 high close. This June action nullified the \nprevious Dow Theory importance of the February lows. Note significant change in volume pattern \nafter May, especially during the August rally.\n521Appendix A\nembarrassing. For, if the Bull Market had not been reaffirmed in June, then the critical levels \non the downside remained at 186.02 in the Industrials and 60.53 in the Rails, the February \n26 Bottoms. Therefore, a Bear Market could not be “called” until those prices had been \npenetrated downside by both Averages. This view acquired a large following, especially \namong those who were not interested in “hair splitting” theory but wanted “to give the \nmarket every chance in view of the still improving fundamentals.”\nThe market did, of course, proceed to break its February lows, and by that time, the \nPanic (second phase) was on. Obviously, in this case, the orthodox “any-penetration-\nwhatever” school had all the best of it; they had sold out at least 13 points higher up in \nterms of the Industrial Index (at least 6 in the Rails). Six weeks later, on October 9, 1946, this \nsecond Primary Intermediate Swing ended at Industrials 163.12, Rails 44.69, and another \nIntermediate Recovery Move started.\nBefore closing this history of six years of Dow Theory interpretation, we might note the \nJune 13 high in the Rail Average furnished a perfect illustration of the rule stating a trend \ncan change any time after it has been confirmed or reaffirmed, also of the diminishing odds \nin favor of continuance with each successive reaffirmation of the Primary Trend.\n\n523\nAppendix B: Resources\n• Section 1: Important and indispensable sites\n• Section 2: References for further study\n• Section 3: Investment-oriented sites\n• Section 4: The Sharpe Ratio\n• Section 5: Calculating volatility and examples of professional risk analysis\n• Section 6: The essence of fundamental analysis\n• Section 7: Software packages and Internet technical analysis sit", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 242}
{"text": "f the Primary Trend.\n\n523\nAppendix B: Resources\n• Section 1: Important and indispensable sites\n• Section 2: References for further study\n• Section 3: Investment-oriented sites\n• Section 4: The Sharpe Ratio\n• Section 5: Calculating volatility and examples of professional risk analysis\n• Section 6: The essence of fundamental analysis\n• Section 7: Software packages and Internet technical analysis sites\n• Section 8: The Leverage Space Portfolio Model of Ralph Vince\nSection 1: Important and indispensable sites\nContact information for John Magee:\nJohn Magee technical analysis::Delphic options research ltd (jmta::dor)\nE-mail bassetti@edwards-magee.com\nbassetti@att.net\nEdwards-Magee website http://www.www.edwards-magee.com\nSEC Enforcement http://www.enforcement@sec.gov\n(Whenever I receive touts or investment spam, I immediately forward it to this important \nbranch of the SEC. All responsible investors should do the same.)\nVolatilities and options: http://www.optionstrategist.com\nPortfolio hedge computation http://www.cboe.com/portfoliohedge\nhttp://www.cboe.com\nhttp://www.abg-analytics.com\nSoftware reviews and information http://www.traders.com\nSoftware demonstrations and packages http://www.omegaresearch.com\nhttp://www.comstar.com http://www.aiqsystems.com\nhttp://www.tradestation.com http://www.equis.com\nWeb chart analysis site http://www.stockcharts.com\nMorningstar http://www.morningstar.net\nIndustry evaluations http://www.gomez.com\nMutual fund cost calculator http://www.sec.gov/mfcc-int.htm\nInternet analysis http://www.stockcharts.com\n524 Appendix B\nSection 2: References for further study\nOn Volatilities and Options: http://www.optionstrategist.com\n(and futures) http://www.cboe.com\nDOW futures and options http://www.cbot.com\nAMEX iShares (DIA, QQQ, etc.) http://www.amex.com\nOn betas http://www.finance.yahoo.com\nOn risk\nValue at Risk, Phillipe Jorion, New York: John Wiley & Sons, 1996\nAgainst the Gods, Peter Bernstein, New York: John Wiley & Sons, 1996\nRisk Management 101 (software), Zoologic, Inc., 1997 .\nSee also Chapter 42\nOn candlesticks\nJapanese Candlestick Charting Techniques, Steve Nison, New York: NYIF, 1991\nBeyond Candlesticks, Steve Nison, New York: John Wiley & Sons, 1994\nOn futures\nSchwager on Futures, Technical Analysis, Jack Schwager, New York: John Wiley & Sons, 1996 \n(and other titles by Schwager in References).\nOn portfolio management\nThe Journal of Portfolio Management\nRisk Management 101 (software), Zoologic, Inc., 1997\nChapter 42\nSection 5, this appendix\nSection 8, this appendix\nSection 3: Investment-oriented sites\nAARP Investment Program http://www.aarp.scudder.com\nAccutrade http://www.accutrade.com\nADR.com http://www.adr.com\nAmerican Association of Individual Investors http://www.aaii.com\nAmerican Century http://www.americancentury.com\nAmerican Express Financial Services http://www.americanexpress.com/directa\nAmerican Stock Exchange http://www.amex.com\nAmeritrade (has little-advertised free trade site) http://www.tdameritrade.com\nAnnual Report Gallery http://www.reportgallery.com\nBarron’s http://www.barrons.com\nBigCharts http://www.bigcharts.com\nBloomberg Financial http://www.bloomberg.com\nBonds Online http://www.bondsonline.com\n525Appendix B\nBriefing.com http://www.briefing.com\nBrill’s Mutual Funds Interactive http://www.fundsinteractive.com\nBusiness Week http://www.businessweek.com\nCBS MarketWatch http://www.marketwatch.com\nChicago Board of Options Exchange http://www.cboe.com\nCNNFN http://www.cnnfn.com\nDailyStocks http://www.dailystocks.com\nExcite http://www.excite.com\nFederal Deposit Insurance Corporation http://www.fdic.gov\nFederal Trade Commission http://www.ftc.gov\nFidelity Investments http://www.fidelity.com\nFinancial Times http://www.ft.com\nForrester Research http://www.forrester.com\nFundFocus http://www.fundfocus.com\nFund Spot http://www.fundspot.com\nGomez Advisers http://www.gomez.com\nH&R Block http://www.hrblock.com\nHoover’s StockScreener http://www.stockscreener.com\nIPO Central http://www.ipocentral.com\nLombard http://www.lombard.com\nMarketplayer http://www.marketplayer.com\nMarket Technician’s Association http://www.mta.org\nMicrosoft MoneyCentral http://www.moneycentral.com\nMorningstar http://www.morningstar.net\nNational Association of Securities Dealers http://www.nasd.com\nNational Discount Brokers http://www.ndb.com\nNet Investor http://www.netinvestor.com\nNew York Stock Exchange http://www.nyse.com\nOnline Investor http://www.onlineinvestor.com\nPhiladelphia Stock Exchange http://www.phlx.com\nQuick & Reilly http://www.quickwaynet.com\nQuicken http://www.quicken.com\nQuicken Financial Network http://www.qfn.com\nRealty Stocks http://www.realtystocks.com\nReuters http://www.reuters.com\nSchwab, Charles http://www.schwab.com\nSecurities and Exchange Commission http://www.sec.gov\nSecurities and Exchange Commission Enforcement http://enforcement@sec.gov\nSecurities Industry Association http://www.sia.com\nSecurities Investor Protection Corporation http://www.sipc.org\nSmartMoney http://www.smartmoney.com\nSocial Security Online http://www.ssa.gov\nStandard & Poor’s Fund Analyst http://www.micropal.com\nStandard & Poor’s Ratings Services http://www.ratingsdirect.com\nStock Guide http://www.stockguide.com\nStockpoint http://www.stockpoint.com\nSuretrade http://www.suretrade.com\n526 Appendix B\n1040.com http://www.1040.com\nThe Motley Fool http://www.fool.com\nTheStreet.com http://www.thestreet.com\nTechnical Securities Analysis Association of San \nFrancisco\nhttp://www.tsaasf.org\nT. Rowe Price http://www.troweprice.com\nTreasury Direct http://www.publicdebt.treas.gov\nVanguard Brokerage Services http://www.vanguard.com\nWall Street Access http://www.wsaccess.com\nWall Street Journal Interactive Ed http://www.wsj.com\nYahoo! Finance http://www.finance.yahoo.com\nZacks Investment Research http://www.zacks.com\nZD Interactive Investor http://www.zdii.com\na American Express now advertises free trades for some accounts.\nBrokerage houses\nWaterhouse Securities http://www.tdameritrade.com\n800-934-4134", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 243}
{"text": "http://www.vanguard.com\nWall Street Access http://www.wsaccess.com\nWall Street Journal Interactive Ed http://www.wsj.com\nYahoo! Finance http://www.finance.yahoo.com\nZacks Investment Research http://www.zacks.com\nZD Interactive Investor http://www.zdii.com\na American Express now advertises free trades for some accounts.\nBrokerage houses\nWaterhouse Securities http://www.tdameritrade.com\n800-934-4134\nA. B. Watley http://www.abwatley.com\n888-229-2853\nWeb Street Securities http://www.webstreetsecurities.com\n800-932-0438\nJack White http://www.jackwhiteco.com\n800-753-1700\nWitCapital http://www.witcapital.com\n888-494-8227\nNet Investor http://www.netinvestor.com\n800-638-4250\nQuick & Reilly http://www.quickwaynet.com\n800-672-7220\nCharles Schwab http://www.schwab.com\n800-435-4000\nSuretrade http://www.suretrade.com\n401-642-6900\nVanguard Brokerage Services http://www.vanguard.com\n800-992-8327\nWall Street Access http://www.wsaccess.com\n888-925-5782\nEmpire Financial Group, Inc. http://www.lowfees.com\n800-900-8101\nE*TRADE http://www.etrade.com\n800-786-2575\nLombard http://www.lombard.com\nNational Discount Brokers http://www.ndb.com\n800-888-3999\n527Appendix B\nAccutrade http://www.accutrade.com\n800-494-8939\nAmeritrade http://www.tdameritrade.com\n800-326-7507\nSee also http://www.freetrade.com\nDiscover Brokerage http://www.discoverbrokerage.com\n800-688-3462\nDLJ Direct http://www.dljdirect.com\n800-825-5723\nDatek Online http://www.datek.com\nDLJ Direct http://www.dljdirect.com\nDow Jones Markets http://www.djmarkets.com\nDRIP Central http://www.dripcentral.com\nEmpire Financial Group http://www.lowfees.com\nSection 4: The Sharpe Ratio\nAlthough this formula is flawed, it will not hinder the reader to know about it and \nunderstand it. Believing in it would be quite a different matter, however. The Sharpe Ratio \nitself is as follows:\n SR = (E − I)/sd \nwhere\nE is the expected return,\nI is the risk-free interest rate,\nSd is the standard deviation of returns.\nThe effect of this inflexible formula is to stick the trader with a measuring tool \nof little use to the practical trader. It assumes volatility of returns as measured by sd \nequals risk (the common academic problem). In the inflexibility of the sd calculation, \nit fails to measure the most important fact in trading, the maximum drawdown, or, \nthe inevitable fluctuations in gains and losses. Specifically, the greatest expected or \nexperienced loss, the retracement from greatest high to greatest low, and the sequences \nof these experiences.\nSection 5: Calculating volatility\nTo calculate the volatility of a portfolio or of an individual instrument, first find the \ndifference between each return and the average. Then square each difference and add \nthem together. Divide the sum by the number of returns minus one. This result is known \nas the variance. Finally, take the square root of the variance to get the volatility. Combining \nthese steps into a formula (see Diagram B.1):\nStep 1: Calculate the average return.\nStep 2: Calculate the deviation of each return.\nStep 3: Square each period’s deviation.\nStep 4: Add them together.\nStep 5: Divide the sum by the number of periods minus 1.\nStep 6: Take the square root.\n528 Appendix B\nNote this is the formula to use when you have experience with the portfolio. There is quite \na more complex procedure in Modern Portfolio Theory.\nSection 6: The essence of fundamental analysis\nFrom the John Magee Market Letters, December 15, 1984\nby Richard McDermott\nThe Elliott Wave Theory: perspective and comments\nWe had the pleasure of attending the December meeting of the Market Technicians \nAssociation of New York.\nLong-term subscribers will remember the MTANY as the organization that honored \nJohn Magee with its “Man of the Year” award in 1978. The speaker was Robert Prechter, \npublisher of “The Elliott Wave Theorist,” an investment advisory which bases its forecasts \non interpretations of R. N. Elliott’s work on the stock market.\nOf primary interest to SAS subscribers are Prechter’s comments on technical analysis \nitself. The Elliott Wave Theory, it must be remembered, is really no more than a “catalog” \nof stock market price movements, laid one on top of the other, so to speak, until a grand, \nunderlying, and enduring pattern is observed; in short, pure technical analysis. Among \nPrechter’s definitions and observations regarding fundamental analysis are the following:\n 1. “First let’s define ‘technical’ versus ‘fundamental’ data … technic al data is that which \nis generated by the action of the market under study.”\n 2. “The main problem with fundamental analysis is that its indicators are removed from \nthe market itself. The analyst assumes causality between external events and market \nmovements, a concept which is almost certainly false. But, just as important, and \nless recognized, is that fundamental analysis almost always requires a forecast of the \nfundamental data itself before conclusions about the market are drawn. The analyst is \nthen forced to take a second step in coming to a conclusion about how those forecasted \nevents will affect the markets! Technicians only have one step to take, which gives \nthem an edge right off the bat. Their main advantage is that they don’t have to forecast \ntheir indicators.”\n 3. “What’s worse, even the fundamentalists’ second step is probably a process built on \nquicksand…. The most common application of fundamental analysis is estimating \ncompanies’ earnings for both the current year and next year and recommending stocks \non that basis…. And the record on that basis alone is very poor, as Barron’s pointed \nout in a June 4 article, which showed that earnings estimates averaged 18% error in the \nthirty DJIA stocks for any year already completed and 54% error for the year ahead. \nThe weakest link, however, is the assumption that correct earnings estimates are a \nσ=\nµ(R\nn1\n1\n2\n1\n−\n−\n=\n∑ )\ni\nn\nDiagram B.1 Volatility formula. Illustrated is the formula for computing volatility. (1) Calculate the \naverage", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 244}
{"text": "out in a June 4 article, which showed that earnings estimates averaged 18% error in the \nthirty DJIA stocks for any year already completed and 54% error for the year ahead. \nThe weakest link, however, is the assumption that correct earnings estimates are a \nσ=\nµ(R\nn1\n1\n2\n1\n−\n−\n=\n∑ )\ni\nn\nDiagram B.1 Volatility formula. Illustrated is the formula for computing volatility. (1) Calculate the \naverage return; (2) calculate the deviation of each return; (3) square each period’s deviation; (4) add \nthem together; (5) divide the sum by the number of periods minus 1 to get the variance; and (6) take \nthe square root.\n529Appendix B\nbasis for choosing stock market winners. According to a table in the same Barron’s \narticle, a purchase of the ten DJIA stocks with the best earnings estimates would have \nproduced a ten-year cumulative gain of 40.5%, while choosing the ten DJIA with the \nworst earnings estimates would have produced a whopping 142.5% gain.”\nWe enjoyed Prechter’s polished exposition of a technical approach, which differed from \nour own. As for his observations about fundamental analysis, we simply could not agree more.\nKey: portfolio risk report. The Portfolio Risk Analysis screen summarizes delta, profit, \nand several measures of risk for a portfolio of user-specified stocks and options.\nThe screen displays:\nSTOCK SYM = The stock symbol;\nSTOCK POS = The stock position, or number of shares owned;\nDELTAS TOTAL = The sum of the stock deltas and option deltas;\nBETA = The stock beta for each stock (implementation pending);\n$BETA = $The dollar risk due to movement of the general market: $Beta = (Delta × Stock \nPrice) × Beta;\n$DELT = An annualized risk figure based on Position imbalance: $Delta = (Total \nDelta × Stock Price) × Volatility;\nPortfolio Analysis Screens \nDiagrams B.2 and B.3 deal with portfolio risk and profi t \nanalysis. Illustrated are the sophisticated quantita-\ntive portfolio Profi t and Risk reports of Delphic Options \n Research as implemented for Standard & Poor’s trading \nsystems and Prudential Securities to give the reader an \nappreciation of the depth and complexity of professional \nthinking about risk and portfolio analysis. The originals \nof these reports were designed by Blair Hull and Lester \nLoops for their own use in market making.\nPORTFOLIO RISK ANALYSIS (.30 Filename )\nOMS+ .30 PORTFOLIO RISK ANALYSIS 3/24/87 10:55:28\n--STOCK-- ----DELTAS----\nSYM POS OPTION TOTAL PROFIT BETA $BETA $DELTA $GAMMA $THETA $RISK %RISK\nFDX 2800 –3063 –263 16,734 1.60 –32,081 –7017 158,136 –121 18,075 7.3\nGE 3200 –3089 110 12,632 .95 11,374 2993 120,104 –16 13,000 5.3\nHWP –6200 5682 –517 8270 1.20 –45,959 –13,404 –522,208 734 56,617 22.9\nLIT –6700 0 –6700 0 1.40 –56,9834 –122,107 0 0 122,107 49.3\nNSM 3600 –4080 –480 10,411 1.45 –21,076 –7267 150,464 –169 17,436 7.0\nXRX –3600 3991 391 –882 1.05 18,132 4835 186,506 –260 20,232 8.2\n⋅ ⋅ ⋅\n⋅ ⋅ ⋅\n⋅ ⋅ ⋅\n*TOT –6900 –559 –7459 47,165 –63,9444 –141,969 93,000 166 24,7470 100.0\nAV ER AGE VOLATILIT Y: .338\nEQUIVALENT MARKET EQUITY: –419613.40\nPORTFOLIO PROFIT RATIO: .191\nPORTFOLIO PROFIT GAMMA RATIO: 4.815\nDiagram B.2 Risk analysis.\n530 Appendix B\n$GAM = An annualized risk figure based on curvature of the position. A positive \n$Gamma indicates a backspread, and a negative $Gamma indicates a vertical position: \n$Gamma = Total\nGamma × (Stock Price × Volatility);\n$THETA = Theoretical dollar amount a position will gain or lose in one day if the stock \nprice remains unchanged;\n$RISK = The annualized standard deviation of the position based upon a composite of \n$Delta and $Gamma;\n%RISK = Percent of portfolio risk in each position;\nTOT = Totals for each of the above categories;\nA VERAGE VOLATILITY = Average volatility for the stocks;\nEQUIV ALENT MARKET EQUITY = Sum of each of the stock prices multiplied by their \ntotal deltas; PORTFOLIO PROFIT RATIO = Total portfolio profit divided by the total \nportfolio risk; PORTFOLIO PROFIT GAMMA RATIO = Total portfolio profit divided \nby the portfolio $Gamma squared. \nKey: portfolio profit report. The Portfolio Profit Analysis screen summarizes delta, profit, \nand several measures of profit for a portfolio of user-specified stocks and options.\nThe screen displays:\nSTOCK SYM = The stock symbol;\nSTOCK POS = Stock position, or number of shares owned;\nDELTAS OPTION = Total delta of the option position;\nDELTAS TOTAL = Sum of the stock deltas and option deltas;\nM TO M = Mark to market: Total value of stock and options positions based upon \nmarket prices;\nPROFIT TOTAL = Total theoretical profit for each position;\nPROFIT/DAY = Theoretical profit divided by the number of days to expiration;\nPROFIT/RISK = Ratio of theoretical profit to risk;\nPROFIT/DY/RISK = Ratio of theoretical profit per day to risk;\nPORTFOLIO PROFIT ANALYSIS (.31 Filename )\nOMS+.31 PORTFOLIO PROFIT ANALYSIS 3/24/87 10:55:28\n--STOCK— ----DELTAS---- ---------PROFIT--------- $ $ %\nSYM POS OPTION TOTAL M TO M TOTAL /DAY /RISK /DY/RISK THETA RISK RISK\nFDX 2800 –3063 –263 42,3162 16,734 213 .93 4.31 –121 18,075 7.3\nGE 3200 –3089 110 704,006 12,632 107 .97 3.01 .16 13,000 5.3\nHWP –6200 5682 –517 53,787 8270 150 .15 .97 734 56,617 22.9\nLIT –6700 0 –6700 –407,025 0 0 .00 .00 0 122,107 49.3\nNSM 3600 –4080 –480 157,293 10,411 105 .60 2.21 –169 17436 7.0\nXRX –3600 3991 391 –4431 –882 –18 –.04 –.34 –260 20,232 8.2\n⋅ ⋅ ⋅\n⋅ ⋅ ⋅\n⋅ ⋅ ⋅\n*TOT –6900 –559 –7459 926,792 47,165 557 .19 .00 166 247,470 100.0\nAV ER AGE VOLATILIT Y: .338\nEQUIVALENT MARKET EQUITY: –419613.40\nPORTFOLIO PROFIT RATIO: .191\nPORTFOLIO PROFIT GAMMA RATIO: 4.815\nDiagram B.3 Profit analysis.\n531Appendix B\n$THETA = Theoretical dollar amount a position will gain or lose in one day if the stock \nprice remains unchanged;\n$RISK = The annualized standard deviation of the position based upon a composite of \n$Delta and $Gamma;\n%RISK = Percent of portfolio risk in each position;\nTOT = Totals for each of the above categories;\nA VERAGE VOLATILITY = Average volatility for the stocks;\nEQUIV ALENT MARKET EQUITY = Sum of eac", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 245}
{"text": "oretical dollar amount a position will gain or lose in one day if the stock \nprice remains unchanged;\n$RISK = The annualized standard deviation of the position based upon a composite of \n$Delta and $Gamma;\n%RISK = Percent of portfolio risk in each position;\nTOT = Totals for each of the above categories;\nA VERAGE VOLATILITY = Average volatility for the stocks;\nEQUIV ALENT MARKET EQUITY = Sum of each of the stock prices multiplied by their \ntotal deltas;\nPORTFOLIO PROFIT RATIO = Total portfolio profit divided by the total portfolio risk;\nPORTFOLIO PROFIT GAMMA RATIO = Total portfolio profit divided by the portfolio \n$Gamma squared.\nSection 7: Software packages and internet technical analysis sites\nThe first cavemen, fighting over resources, used teeth and claws. The nature of warfare \nwas changed forever when one of the smarter ones picked up a tree branch. Then another \nsmart one discovered the principle of artillery and picked up a rock. Naïve and arrogant \ntraders laughed at Wyckoff’s charts. Market makers on the Pacific Coast Options Exchange \nsniggered at Blair Hull when he started appearing on the floor with printouts. In the days \nof the wooden racquet, squash players hated the arrivistes who appeared with metal and \nthen composite racquets.\nNo longer—the last to adopt the new weapons is a dead man. Charts showed their \npower and so did Hull’s wonky printouts made with the Black Scholes Model. The losers \nfigured out pretty quickly they needed new weapons. With that dissertation on the \nepistemology of warfare, I present some of my favorite weapons in the following software \nand internet sites. No attempt whatsoever is made to be comprehensive or encyclopedic. \nOn the contrary, idiosyncrasy is my operating method and no disfavor is implied to those \nnot included here.\nFor myself, three desktop software packages are powerful and sufficient for all the \nneeds of a technical analyst: AIQ Trading Expert Pro ( http:/ /www.aiqsystems.com), \nMetastock 9.0 (http:/ /www.equis.com), and TradeStation 2000i and later versions (h t t p : //\nwww.tradestation.com). The reader will find examples of charts sprinkled throughout this \nbook, supplementing the beautiful hand-drawn charts of Magee. All these packages have \nthe basic requirements necessary for technical chart analysis, basic charting on readily \navailable data and portfolio. I have said before that all the chart analyst really needs is the \nability to draw lines on a chart … and then pe rhaps to see the chart as a line chart, or a \ncandlestick chart or … and so on and s o on. The analyst is soon seduced by the dazzling \nfeatures, and the analysis is enriched and made more powerful. Even if one says (as I do), \nwhen he looks at an oversold tool, “What do I need that for? I saw it on the bar chart.” The \nanalyst finds himself wanting to know more about % R. If it worked for Larry Williams, \nthere must be something in it.\nAIQ: TRADING EXPERT PRO\nAIQ’s package includes an on-screen control panel and scrolling indicator boxes that \nare color-coded, and this information is synthesized in an indicator barometer. Data \nmanagement is smooth and easy, and the user may use a system module to create and test \nhis own trading ideas. A panoply of reports is available to aid the investor. For the trader, \n532 Appendix B\nreal-time alerts are a feature. A portfolio manager module aids the investor in managing \nnot just the portfolio, but also his positions by making stop management facile. An Expert \nGuru lurks behind the curtain to aid the user in analyzing situations.\nMETASTOCK 9.0\nMetastock 9.0 boasts an impressive array of tools and indicators. “System Experts” pop \nup on demand and can also guide the user through systems tests and explorations. The \nExperts can also suggest buys and sells. A point and figure toolbox is a valuable feature. \nThe ability to create and test trading systems, with exhaustive and critical data analysis, is \na powerful tool. Metastock adapts easily to add-ons, of which Slauson’s Powerstrike (the \nquantitative tool for finding critical Support–Resistance zones) is a good example.\nTradestation 2000i and Tradestation 8\nTradestation 2000i is the standalone version of Tradestation 8. Tradestation 8 is a real-time \nonline package that allows for trading through the Tradestation brokerage affiliate. The \npackage is so powerful that online professional and semiprofessional users probably benefit \nby combining their software arrangement with a brokerage arrangement. 2000i requires \nthe user to maintain his local database, whereas Tradestation 8 always has the data on \ndemand. For the creatively lazy (among them the editor) this is an attractive feature. Systems \nbuilding and testing has always been and remains a powerful feature of Tradestation. With \n“EasyLanguage,” the user may specify virtually any system and then chat about it with the \nTradestation community of traders. This community has contributed to a large database of \ntrading systems and ideas.\nThe Internet: prophet (http://www.thinkorswim.com)\nFor the even lazier and more casual investor, there is http:/ /www.prophet.net (now at \nthinkorswim.com), an internet technical analysis site whose free features will fulfill the \nneeds of the general charting investor. With powerful interactive charts and portfolio \nreporting, the penurious investor will save many pennies at http:/ /www.prophet.net. As \nMark Twain said, a penny saved is a penny earned. Actually, what did Ben Franklin mean \nby a penny saved is capital when put to work? A user community and sharing are other \nattractions. And no local data maintenance is necessary. Among its most valuable features, \nhttp:/ /www.prophet.net occasionally distributes market commentary and analysis by this \neditor. All in all, http:/ /www.prophet.net appears to deserve the continuing awards it has \nreceived from Barron’s and Forbes, as well as Technical Analysis magazine. Prophet charting \nis now available to customers of http:/ /www.tda", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 246}
{"text": "d no local data maintenance is necessary. Among its most valuable features, \nhttp:/ /www.prophet.net occasionally distributes market commentary and analysis by this \neditor. All in all, http:/ /www.prophet.net appears to deserve the continuing awards it has \nreceived from Barron’s and Forbes, as well as Technical Analysis magazine. Prophet charting \nis now available to customers of http:/ /www.tdameritrade.com.\nThe Internet: http://www.stockcharts.com\nOf similar quality, and similarly honored by Forbes and Technical Analysis magazine, h t t p : //\nwww.stockcharts.com has an additional valuable feature: point and figure (P&F) charting. \nI have not remarked on P&F charting here, but it is an important technical method, especially \nfor the patient investor. All the other features are available at http:/ /www.stockcharts.com, \nincluding candlesticks, bar charts, and others. Also, the distinguished analyst John Murphy \nmakes his electronic home there. There is also a “Voyeur” feature that allows the user to \nsee what other traders are doing.\n533Appendix B\nA brief summary\nKnowledge is power. Knowing where to find knowledge is even more powerful. The inquiring \ninvestor can keep himself up to date on these sites through the yearly evaluations in Barron’s \nand Forbes, and the financial press regularly updates its evaluations of Internet resources.\nSection 8: The Leverage Space Portfolio Model\nNo less than John Bollinger called Ralph Vince’s Handbook of Portfolio Mathematics, the most \nimportant work on the subject. Mr. Vince has done the readers of this book, and me, the \nvery great favor of describing his work in a short article I present here verbatim.\nIn 1884, Charles H. Dow began his compilation of what would \nbecome known as the Dow Jones Indexes. Theories pertaining to \nnon-confirmation of these indices, known as “Dow Theory,” would \nbecome the cornerstone of modern Technical Analysis.\nIt is fitting then, with Dow Jones Indexes having embraced the \nconcepts expressed herein with the commercial offerings of The \nDow Jones LSP indexes in 2011, this explanation of Optimal f and \nthe resultant Leverage Space Portfolio Model be included in this the \nfoundational text on modern Technical Analysis.\nLet us consider a case of a simple trade with two possible outcomes. \nIn one of the outcomes, we win 2 units, and in the alternative outcome, \nwe lose 1 unit. We can construct a spectrum ranging between a value \n0, where we risk nothing, and 1, where we risk our entire equity. We \nwill consider this value between 0 and 1 as the fraction (f) of our stake \nat risk, and we will refer to this interchangeably as our leverage. Thus, \non any given trade or over any given period, we are risking some \nfraction of our stake, and thus for any given trade or over any given \nperiod, we have a value, f, assigned to us whether we are aware of \nit or not.\nIf we consider over this hypothetical, simplistic 2-outcome, 2–1 \ntrading situation (similar to if it were the two outcomes of a coin toss) \nwe could plot what we would expect to make on our trading equity \n(expressed as a multiple of our initial equity) over one play at various \nvalues for f as depicted in Diagram B.4.\n1.5\n1.25\n1\n0.75\n0.5\n0.25\n0 .05 1.0\nFraction of Stake (f )\nMultiple\nDiagram B.4 Expected Multiple of Starting Stake in a Single 2:1 Coin Toss.\n534 Appendix B\nWhen there is more than 1 trade or period and what we have left \nto invest in the immediate play or period is a function of what we \nhave made or lost up to this period, the straight line becomes curved, \nand the peak of the curve settles into a fixed point, migrating in from \n1.0 off to the right where a positive expectation trade or period is \ngrowth-maximized over 1 trade or period. Thus, after many trades \nor periods, it settles in to a given location, and for the simplistic case \nof a coin toss that pays 2–1, that peak will settle in at .25 as depicted \nin Diagram B.5.\nThe height of the curve for any given value for f is given by the \nformula for Optimal f, determined as:\nmultiple f t\nW f t\nW\np\nn=+\n\n\n\n\n\n\n\n +\n\n\n\n\n\n\n\n11\n1*|| ** *||\n() (\n…\np p number_of_expected_plays_or_tradesn )\n\n\n\n\n\n\n\n\n\n\n\nThus, for n trades or periods, for a given value of f, we can \ndetermine the multiple made on our stake with simply the outcome \nof each trade or period ( t), probability of that outcome ( p), and the \nworst-case outcome (w), the lowest of all the values for t. We raise the \nresultant product to the power of however many plays we want to \ndetermine our expected growth, obtaining the multiple on our initial \ntradable equity at that many trades or periods.\nThis represents what you would expect to make as a multiple on \nyour starting stake for risking a given fraction, f, of your stake.\nNotice this is not the same as what is known as The Kelly Criterion, \nwhich gives a peak as a “leverage factor,” a value between 0 and \ninfinity representing how much to lever up one’s account, rather than \n12\n11\n10\n9\n8\n7\n6\n5\n4\n3\n2\n1\n95 90 85 80 75 70 65 60 55 50 45 40 35 30 25 20 15 1005\nDiagram B.5 Expected Multiple of Starting Stake after Forty Tosses in a 2:1 Coin Toss.\n535Appendix B\na fraction (a value between 0 and 1) of an account to risk as expressed \nby the Optimal f formula. Under certain conditions the two will give \nan equivalent value for the peak, for example, the leverage factor will \nequal the optimal fraction to risk, as in the 2:1 coin toss example \nherein, but often not, and it can be a perilous mistake to assume \nthat the answer given by The Kelly Criterion is an optimal fraction \nof account equity to risk to be expected growth optimal. The Kelly \nCriterion never yields a peak whose value is the expected growth \noptimal fraction of an account to risk, but rather always yields the \nexpected growth optimal leverage factor. The two can be translated \nbetween one another, but the real benefit of the Optimal f formula is \nit gives us the height to this curve, expressed as an", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 247}
{"text": "n \nof account equity to risk to be expected growth optimal. The Kelly \nCriterion never yields a peak whose value is the expected growth \noptimal fraction of an account to risk, but rather always yields the \nexpected growth optimal leverage factor. The two can be translated \nbetween one another, but the real benefit of the Optimal f formula is \nit gives us the height to this curve, expressed as an expected multiple \nmade (or lost) on our initial equity (which is not provided by the \nKelly Criterion), from which we can derive a field of study.\nFor example, there is a point left of the peak where the curve goes \nfrom concave up to concave down. Given the vertical axis is the \nexpected growth multiple and the horizontal axis is the risk, we can \nstate this point of inflection represents that point where marginal \nincrease in growth is occurring faster than marginal increases in \nrisk, and this flips at the point of inflection.\nConsider the height of the curve at both f\n = .l and f = .4 as \nequivalent yet the latter is risking four times as much! Clearly, there \nis never any reason to be beyond the peak of the curve to the right.\nWe have spoken that you are on this curve, somewhere, whenever \nyou have a position in the markets, whether you acknowledge this or \nnot. Note the point in Figure 2 where f\n = .5, where the multiple = 1.0. \nTo risk any more than this is to see a multiple less than 1.0, and \ntherefore the more one continues to trade at this level, multiplying \nhis initial equity by a number less than 1, the more one insures he \nwill go broke.\nMost importantly, this is a situation created without borrowing \nanything at all—it occurs in a cash account! This is a situation created \nwherein one would have on one unit risked for every 2 units in equity, \na situation that clearly requires no borrowing whatsoever, and yet, \nto continue at that level of “leverage” under these (very favorable) \nconditions, one will go broke with certainty as he continues to trade.\nWhen more than one trade or play occurs simultaneously in various \nmarkets or approaches, the curve displayed in Figure 2 (which is a \ncurve in 2D space since we are looking at one component), manifests \nin N\n + 1 dimensional space for N components traded simultaneously. \nIf we consider a case of trading two of these issues simultaneously, \nof wagering on two 2:1 coin toss games simultaneously, we find \nourselves in an N\n + 1 dimensional manifold (in this case, 2 + 1 = 3 \ndimensional manifold) space as depicted in Diagram B.6.\nThis N + 1 dimensional space is referred to as “Leverage Space,” \nand portfolios derived therefrom as “Leverage Space Portfolios” \n(“LSP” portfolios). LSP-style portfolio construction grants us insights \nunavailable by more conventional portfolio constructs. For example, \nin Figure 3, we find the peak of the curve at the f coordinates for both \n536 Appendix B\ngames at.23, .23. Yet, notice what happens if we are off on only one \naxis; we can be at, say .23, .6, and we find our multiple, the height of \nthe graph at these coordinates, to be less than 1. Thus, even though \nwe are off on only one component in the portfolio (and still not \nborrowing money to assume any positions) we insure we will go \nbroke as we continue to trade. The notion of diversification as one of \nmeliorating risk is clearly challenged in an LSP-style portfolio, and \nthis is not at all evident by more traditional perspectives on portfolio \nconstruction.\nNot only are we ineluctably in leverage space when we put on one \nor more positions in the markets, but we are also very likely moving \nthrough leverage space with changes in our equity and the markets, \npaying the price and reaping the consequences for the various points \nwe traverse through the surface of leverage space.\nThus, various paths can be constructed algorithmically through \nleverage space to achieve different criteria than the conventional \ncriterion of maximizing expected return to expected variance, or \neven that of maximizing expected growth (which would be to reside \nat the peak in the surface). With a path through leverage space in an \nLSP-style portfolio, a path through the surface of expected growth as \na multiple of our starting stake, we are now able to seek solutions to \nany investment criteria.\nf C o in 2\nf C o in 1 .90.80.70.60.50.40.30.20.10.00\n0\n1\n2\n3\n4\n5\n6\n7\n8\n9\n10\nDiagram B.6 Expected Multiple of Starting Stake after Twenty Tosses in Two Simultaneously Played \n2:1 Coin Toss Games.\n537\nAppendix C: Technical Analysis: \nbeyond Edwards & Magee\n• Section 1: A brief general survey of number driven tools\n• Section 2: The creative technician—the work of Richard Arms\n• Section 3: The Point and Figure method by an eminent analyst, Mike Moody\n• Section 4: One of the most famous of technical routines—Bollinger Bands\nSection 1: A brief general survey of number driven tools\nHere is something to contemplate: A listing of technical analysis tools.\nTechnical Overlays\n 1. Bollinger Bands: A chart overlay \nshowing the upper and lower limits of \n“normal” price movements based on \nthe Standard Deviation of prices\n 2. Chandelier Exit: An indicator used to \nset trailing stop-losses for both long \nand short position\n 3. Ichimoku Cloud: A comprehensive \nindicator defining support and \nresistance, identifies trend direction, \ngauges momentum and provides \ntrading signals\n 4. Kaufman’s Adaptive Moving \nAverage (KAMA): A unique moving \naverage that accounts for volatility and \nautomatically adjusts to price behavior\n 5. Keltner Channels: A chart overlay \nshowing upper and lower limits for \nprice movements based on the Average \nTrue Range of prices\n 6. Moving Averages: Chart overlays \nshowing the “average” value over \ntime. Both Simple Moving Averages \n(SMAs) and Exponential Moving \nAverages (EMAs) are explained\n 7. Moving Average Envelopes: A chart \noverlay consisting of a channel formed \nfrom simple moving averages\n 8. Parabolic SAR: A chart overlay \nshowing reversal points below prices \nin a", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 248}
{"text": "ents based on the Average \nTrue Range of prices\n 6. Moving Averages: Chart overlays \nshowing the “average” value over \ntime. Both Simple Moving Averages \n(SMAs) and Exponential Moving \nAverages (EMAs) are explained\n 7. Moving Average Envelopes: A chart \noverlay consisting of a channel formed \nfrom simple moving averages\n 8. Parabolic SAR: A chart overlay \nshowing reversal points below prices \nin an uptrend and above prices in a \ndowntrend\n 9. Pivot Points: A chart overlay showing \nreversal points below prices in \nan uptrend and above prices in a \ndowntrend\n 10. Price Channels: A chart overlay \nshowing a channel made from the \nhighest high and lowest low for a \ngiven period of time\n 11. Volume by Price: A chart overlay \nwith a horizontal histogram showing \n538 Appendix C\nthe amount of activity at various price \nlevels\n 12. Volume-Weighted Average Price \n(VWAP): An intraday indicator based \non total dollar value of all trades for \nthe current day divided by the total \ntrading volume for the current day\n 13. ZigZag: A chart overlay showing \nfiltered price movements greater than \na given percentage\nTechnical Indicators\n 1. Accumulation/Distribution Line: \nCombines price and volume to show \nhow money may be flowing into or out \nof a stock\n 2. Aroon: Uses Aroon Up and Aroon \nDown to determine whether a stock is \ntrending or not\n 3. Aroon Oscillator: Measures the difference \nbetween Aroon Up and Aroon Down\n 4. Average Directional Index (ADX): \nShows whether a stock is trending or \noscillating\n 5. Average True Range (ATR): Measures \na stock’s volatility\n 6. Bandwidth: Shows the percentage \ndifference between the upper and \nlower Bollinger Band\n 7. %B Indicator: Shows the relationship \nbetween price and standard deviation \nBollinger Bands\n 8. Chaikin Money Flow (CMF): \nCombines price and volume to \nshow how money may be flowing \ninto or out of a stock Alternative to \nAccumulation/Distribution Line\n 9. Chaikin Oscillator: Combines price \nand volume to show how money may \nbe flowing into or out of a stock. Based \non Accumulation/Distribution Line\n 10. Chande Trend Meter (CTM): Scores \nthe strength of a stock’s trend, based \non several technical indicators over six \ndifferent timeframes\n 11. Commodity Channel Index (CCI): \nShows a stock’s variation from its \n“typical” price\n 12. Coppock Curve: An oscillator using \nrate-of-change and a weighted moving \naverage to measure momentum\n 13. Correlation Coefficient: Shows the \ndegree of correlation between two \nsecurities over a given timeframe\n 14. DecisionPoint Price Momentum \nOscillator (PMO): An advanced \nmomentum indicator tracking a \nstock’s rate of change\n 15. Detrended Price Oscillator (DPO): \nA price oscillator using a displaced \nmoving average to identify cycles\n 16. Ease of Movement (EMV): An \nindicator comparing volume and price \nto identify significant moves\n 17. Force Index: A simple price-and-\nvolume oscillator\n 18. Mass Index: An indicator identifying \nreversals when the price range widens\n 19. MACD (Moving Average \nConvergence/Divergence Oscillator): \nA momentum oscillator based on the \ndifference between two EMAs\n 20. MACD Histogram: A momentum \noscillator showing the difference \nbetween MACD and its signal line\n 21. Money Flow Index (MFI): A volume-\nweighted version of RSI showing shifts \nis buying and selling pressure\n 22. Negative Volume Index (NVI): A \ncumulative volume-based indicator \nused to identify trend reversals\n 23. On Balance Volume (OBV): Combines \nprice and volume in a very simple way \nto show how money may be flowing \ninto or out of a stock\n 24. Percentage Price Oscillator (PPO): \nA percentage-based version of the \nMACD indicator\n 25. Percentage Volume Oscillator (PVO): \nThe PPO indicator applied to volume \ninstead of price\n 26. Price Relative/Relative Strength: \nTechnical indicator comparing the \nperformance of two stocks to each \nother by dividing their price data\n 27. Pring’s Know Sure Thing (KST): A \nmomentum oscillator from Martin \n539Appendix C\nPring based on the smoothed rate-of-\nchange for four different timeframes\n 28. Pring’s Special K: A momentum \nindicator from Martin Pring \ncombining short-term, intermediate \nand long-term velocity\n 29. Rate of Change (ROC) and \nMomentum: Shows the speed at \nwhich a stock’s price is changing\n 30. Relative Strength Index (RSI): Shows \nhow strongly a stock is moving in its \ncurrent direction\n 31. RRG Relative Strength: Uses RS-Ratio \nto measure relative performance \nand RS-Momentum to measure the \nmomentum of relative performance\n 32. StockCharts Technical Rank (SCTR): \nOur relative ranking system based on \na stock’s technical strength\n 33. Slope: Measures the rise-over-run for \na linear regression\n 34. Standard Deviation (Volatility): \nA statistical measure of a stock’s \nvolatility\n 35. Stochastic Oscillator (Fast, Slow, \nand Full): Shows how a stock’s price \nis doing relative to past movements. \nFast, Slow and Full Stochastics are \nexplained\n 36. StochRSI: Combines Stochastics with \nthe RSI indicator to help you see RSI \nchanges more clearly\n 37. TRIX: A triple-smoothed moving \naverage of price movements\n 38. True Strength Index: An indicator \nmeasuring trend direction and \nidentifying overbought/oversold levels\n 39. Ulcer Index: An indicator designed to \nmeasure market risk or volatility\n 40. Ultimate Oscillator: Combines \nlong-term, mid-term and short-term \nmoving averages into one number\n 41. Vortex Indicator: An indicator \ndesigned to identify the start of a new \ntrend and define the current trend\n 42. Williams %R: Uses Stochastics to \ndetermine overbought and oversold \nlevels\nOutline\nThis is a list of tools and indicators available at stockcharts.com. Most if not all of these \ntools are also available either through software packages (Tradestation, AIQ, Metastock) \nor online (thinkorswim and others). I display the list so newcomers to technical \nanalysis get an idea of the plethora of tools available. Also, I display the list so that \nstudents see the philosopher’s stone n", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 249}
{"text": "ine\nThis is a list of tools and indicators available at stockcharts.com. Most if not all of these \ntools are also available either through software packages (Tradestation, AIQ, Metastock) \nor online (thinkorswim and others). I display the list so newcomers to technical \nanalysis get an idea of the plethora of tools available. Also, I display the list so that \nstudents see the philosopher’s stone nature of building systems to beat the market. To \nbriefly review, the philosopher’s stone is a stone which allows the owner to convert lead \nto gold. In the Middle Ages, it was the subject of much dedicated research. At present, \nto my knowledge, only George Soros has a philosopher’s stone, but it is entirely possible \nfor the dedicated student to find in the list a tool or method which will allow him to \nreap rich rewards.\nDisplaying the list also prompts me to repeat what we have frequently told our graduate \nstudents over the years: You can drive a nail with a screwdriver; so if it works for you it \ndoesn’t matter what it looks like. To this end I will comment on some, but not all, of the \ntools listed here—in some cases revealing tools and systems which, in research, have been \nfiendishly effective.\nMoving averages\nTechnical Analysis of Stock Trends is often the first book investors read when they become \ninterested in the technical approach to the market. This is as it should be and also new \nanalysts need to be informed of the amazingly varied field of technical analysis. Chart \n540 Appendix C\nanalysis is the cornerstone of technical analysis and a required field of knowledge. If the \nanalyst is more statistically oriented or is looking for an algorithmic method he must search \nthrough the numerous alternatives in the technical toolbox.\nThis appendix is intended not to teach the reader the details of operating a moving \naverage or stochastics routine, but to place the various technical tools and systems (or \nmethods) in context and in perspective. The first of these tools is the moving average. \nWe personally can testify to the power of these systems, having reaped outsize profits \nusing moving average systems. Note these profits were gained in roaring bull markets. In \nsideways markets trading a moving average can be the equivalent of producing sausage \nwith a meat grinder. Thus, having confidence in the state of the market is an absolute \nnecessity. The effect of a moving average is to smooth raw price behavior and clarify the \ntrend of the market. The bells and whistles you can hang on a moving average are like a \nChristmas tree. You can use the moving average as input to a signal -–buying when the \nprice penetrates above the MA line. Using the MA line as a stop, selling when prices fall \nbelow the MA line. Or you can construct a filter—buying or selling when prices pierce the \nline by x%. The possible variations are infinite.\nAs is probably obvious, MA systems are in the main trend following systems. As are \nvirtually all Edwards & Magee methods and systems. The reason for attempting to employ \ntrending systems is, without exception, long-term trend following results in larger profits \nthan any other trading method.\nIn general, the market makes something of a shibboleth of two moving averages—the \n50-day and the 200-day. The 50-day is thought by the media and public to be a warning \ncrack in the market and the 200-day penetration is thought to be a bear market phenomenon. \nIn our trading, we watch the 50 and the 200--day but we don’t use them as signals. We are \nusually more concerned with patterns and the character of the market rather than using \nthese moving averages as signals. Rather, we use them as alerts as to what the public is \nthinking and depend on Basing Point analysis for stops.\nMagee’s consideration of moving averages is contained in Chapter 36. It is amusing \nto quote a remark of his upon discovering moving averages: “ …one could derive a sort \nof Automated Trendline that would definitely interpret the change of trend… It seemed \nalmost too good to be true. As a matter of fact, it was too good to be true.”\nPersonally, we have experienced excellent profitability with moving average systems. \nWhile we originally thought this was a sign of genius, with time we realized that the \nmarket was the genius and my company was trading in a roaring bull market—and indeed \nwe were—the monstrous commodity bull markets of the ‘70s—the Russian wheat market, \nthe Hunt silver market…. Almost anything, including bonobo monkeys throwing darts, \nworks in a tidal market.\nNevertheless, a long moving average can keep the investor fully invested for months—\nif not years. In the case of the great Bull Market of 2009–2017 , it took years, as evident by the \nchart with a 200-period simple moving average. (Figure C.1)\nA number of different types of moving averages are used by technicians: simple, \nexponential, triangular, variable, and weighted. The distinguishing difference amongst \nthese methods is the simple method weights all prices equally. Weighted and exponential \nroutines place a higher value on the most recent data, enabling more sensitive and rapid \nreaction. Triangular averages put more weight in the middle of the time period and variable \naverages adjust the weighting according to the volatility of prices.\nDoes this smack of the philosopher’s stone? One thing it should tell the newcomer—and \ngrizzled veteran—is the search for a market beating method is incessant and indefatigable—\nit never ceases.\n541Appendix C\nContemplating an exponential versus a simple moving average the difference is \nprobably not worth the trouble. Trading decisions might be moderately accelerated on \ntrading length systems ( −5–15 days for very short term; 15–23 days for short term; and \n24–50 days for intermediate term; and 100 days and up for long term. With recent thinking \nwe might add super long term—that is 200 days or even longer weekly based systems.)\nThe conventional way to use a moving average system is t", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 250}
{"text": "ly not worth the trouble. Trading decisions might be moderately accelerated on \ntrading length systems ( −5–15 days for very short term; 15–23 days for short term; and \n24–50 days for intermediate term; and 100 days and up for long term. With recent thinking \nwe might add super long term—that is 200 days or even longer weekly based systems.)\nThe conventional way to use a moving average system is to go long when price breaks \nabove the moving average and sell when price falls below the moving average. Probably the \nmost usual modification to these systems is to put a filter on them, for example requiring \nthe penetration of the moving average line by 1 (or x) % to assure validity. (Cf. Chapter \n36, the Pentad system) We think, based on experience, this may be the most effective way \nto employ this tool. Sometimes two moving averages are used. Signals are created by the \ninterplay of the moving average lines, one moving above or below the other. This is a \ncharacteristic of MACD, which will be discussed later.\nFigure C.1 A 200 period moving average on a weekly chart. The investor would never (virtually \nnever) have felt the least anxiety for his position. His confidence in the trend would have been \nbuttressed by the MA line.\n542 Appendix C\nStochastics\nThe first thing to do when studying stochastics is stop trying to figure what “stochastics” \nmeans. Of course, it has a dictionary meaning to be discussed later. Right now, the reader \nshould put aside the question of actual meaning and consider what it means in the discipline \nof technical analysis.\nMarkets have two basic theoretical (and actual) states: trending or mean reverting. If \nthe market is non-trending, swinging back and forth, up and down, traders need tools \nto deal with it. If they want to trade under these conditions they turn to oscillators. The \npurpose of the oscillator is to aid in identifying wave bottoms and wave tops. The stochastic \nalgorithm is one of the more popular of these oscillators.\nStochastics establishes a “window” on the market for the analysis of prices. The default \nvalue for this window is 14 bars, but different practitioners customize the value for their \nown use. The price highs and lows within this window are integral to the analysis. The \nroutine establishes a line (called %K) as the essential benchmark or guide of the analysis. \nA second line is calculated (%D) using a simple moving average of %K. This moving \naverage is quite short (3 periods default value) and thus creates a line of great sensitivity. \nConventionally these lines are displayed on a scale from 1 to 100. Signals are generated by \nvalues of 20 and 80. The routine buys when the low value is 20 and sells upon a high value \nof 80. In short, selling strength and buying weakness. 20 and 80 refer to where the closing \nprice is relative to the window trading range, thus placing price position at 20% or 80% of \nthe range. Other means of generating signals are available, to wit the interaction of the two \nlines, as for example, the %K line falling below or rising above the %D line. (Figure C.2)\nAs with most tools, the technician can modify the routine to suit his whim.\nMACD (Moving Average Convergence/Divergence)\nMACD is a trend following momentum indicator that shows the relationship between \ntwo moving averages of price. It is calculated as the difference between a 26 and a 12-day \nexponential moving average. Gerald Appel, who is reported to be the creator of the routine, \nplaced a 9-day exponential moving average on top of the MACD as a means of identifying \ntrading signals. Generally, a sell signal occurs when MACD falls below the signal line and \na buy signal when it rises above the signal line. Trading also occurs as MACD goes above \nand below zero. (Figure C.3)\nAs one can well imagine with 55 indicators (and counting), there is a tool for every \noccasion. One must always remember the rule of tools: To a man with a hammer everything \nlooks like a nail. Rather than attempting to explicate every tool, I will restrict myself to \nthe obvious, after reminding the reader that careless and uneducated use of any tool can \nseriously endanger his capital.\nSome other chosen indicators to consider: ADX, a tool which shows whether an issue is \ntrending or oscillating. This tool is easily replaced with a ruler and the naked eye. This is the \ncase with many of the indicators; they have been developed by their inventors to attempt to \nremove ambiguity from the market—a desire the experienced chart analyst doesn’t possess. \nThe chart analyst looks at a chart and most of time it is obvious. If not, it becomes obvious \nthe moment a ruler is laid on it. Another tool which does more or less the same is the Aroon \nwhich uses Aroon Up and Aroon Down to determine whether an issue is trending or not. \nOnce again, a question which is painfully obvious at first glance to the chart analyst. We \nshould make clear that some intelligent analyst has used each of these tools to wring a profit \nfrom the market. Accumulation /Distribution Line showing how money flows in and out \n543Appendix C\nof an issue may be useful to some practitioners, as may Volume by price which shows the \namount of activity at various price levels. Pivot points— a relatively simple mechanism \nevidently popular with many traders can at least give the trader unambiguous trading points.\nWhich brings us to a central technical and philosophical point: Almost any system \nis better than no method (or system) at all. The problem for the inexperienced trader—\nor investor—is what system. This book answers that question for most investors and is a \ngood method while the investor refines his own methods. We continue to say the trader \nwho invents a system without thorough knowledge of this book is putting life limb and \ncapital at risk. This statement may be a little less true now than in years past—simply \nbecause so much of this book’s material has leaked via osmosis into general investor \nknowledge—usually", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 251}
{"text": "ion for most investors and is a \ngood method while the investor refines his own methods. We continue to say the trader \nwho invents a system without thorough knowledge of this book is putting life limb and \ncapital at risk. This statement may be a little less true now than in years past—simply \nbecause so much of this book’s material has leaked via osmosis into general investor \nknowledge—usually unconsciously, but often through outright imitation or worse. Not a \npractice which outrages us, though, sometimes amuses us—but no tears. Also, as we have \nbeen in education for many years, we observe the spread of knowledge as something the \nenlightened and educated do as a responsibility to the community and humanity.\nPoint and Figure analysis\nBar chart analysis has so dominated investor usage for so long (partly because of this book) \nthat even many experienced analysts have ignored an interesting and valuable method \nwhich we will explore briefly here. That method is Point and Figure analysis.\nFigure C.2 Stochastic routine on a gold chart. Obviously interpreting the indicator requires some \nexperience and discrimination, but this is true of all number driven indicators.\n544 Appendix C\nFigure C.3 MACD on a gold chart. MACD is a popular tool and deemed effective by many traders. Readers can see why from the chart.\n545Appendix C\nSaid by some to be an invention of Charles Dow, and by others to be created by the \nRussians, PnF charting has shown itself to be surprisingly effective in our experience. \nWhen we examine some of its characteristics we get an idea why. Bar charts represent price \naction (open high low close) with a vertical bar with cross hatches for open and close. The \nx axis represents time, the y, price. PnF ignores time for the most part, though there is a \nnod to it as we will see.\nSeveral basic decisions are made in the construction of the chart. Since the chart is \nmade up of boxes, the size of the box must be determined. The analyst chooses a box \nstyle appropriate to the duration of the chart. Obviously, if one is dealing with years \nof data in the INDU the box must be large—50, 100 points. At shorter durations wave \nanalysis would suggest a good size; and at any rate online routines present reasonably \nsized charts. In general, one might say larger boxes furnish perspective and smaller boxes \nfurnish detail.\nThe other choice the analyst must make is reversal size. The traditional choice here is \na three box reversal. Thus, if the box size is 4 and we are in an x column, 12 points down \nmust occur to change to a column of 0s and three 0s would be drawn in the next column. \nAnd although time is usually ignored, a box is marked with a month indicator as a column \nrolls over to a new month.\nAll these options are subject to change and adjustment by the individual technician. \nWhat is more, there are other varieties of PnF charts—one box reversal, for example, but the \nbasic idea is the same. Using a variety of methods, one may make forecasts from the chart. \nLet me emphasize: Treat this method and any other algorithmic method with caution until \nyou have thoroughly examined it (Figure C.4).\nNext for comparison, a bar (Candlestick) chart shows the traditional picture of this \nperiod (Figure C.5).\nAs the reader can see, PnF charting is a fascinating and valuable method. Many \ninvestors rely on this method alone for their analyses.\nAs with all of the tools surveyed here no attempt is made to give a definitive exploration \nof the tool or to describe the mechanics of its creation. Those details about PnF charts are \nably discharged by the books Point & Figure Charting by Thomas Dorsey and The Definitive \nGuide to Point and Figure by Jeremy du Plessis. Later in this appendix Mike Moody will \ndiscuss the method in a much more sophisticated way.\nSection 2: The creative technician—the work of Richard Arms\nThe Arms Index (TRIN) by Richard Arms\nIn 1967 , when I was still an unknown in Technical Analysis and was working as a \nstockbroker for a major NYSE firm, we moved into new modernized offices. Among the \nimprovements were new quote machines, which actually had a tiny screen to display the \ninformation. Moreover, the data included some fascinating numbers. It was possible to \nsee the number of stocks that were up and the number of stocks that were down at any \ntime, and even a total of the volume traded on the up stocks and a total of the volume \ntraded on the down stocks. Looking at this, I began to wonder if it could serve as an \nindicator, telling us if the ratio of up to downs was the same as the ratio of up volume \nto down volume. If not, deviations from normality might show when the buyers or the \nsellers were more in control. In seconds, the Arms Index, or TRIN, came into being in \nmy mind and then in my research. An article in Barron’s was all that was needed and it \ntook on a life of its own.\n546 Appendix C\nFigure C.4 Here from the edwards-magee.com website is a PnF chart from November 2015 which looks for a target of 2549—this when the S&P \nwas around 2000.\n547Appendix C\nFigure C.5 Here also from the edwards-magee.com website is a chart from November 2015 for comparison with the above PnF chart.\n548 Appendix C\nThe calculation\nWith so many sources, such as newspapers, television stations and every quotation \nservice, providing the calculated index most users will never need to make the calculation \nthemselves. However, in order to appreciate the significance of the index one should be \nfamiliar with its derivation. The Formula is:\n \n()\n() .. ..\nADVANCES/DECLINES\nADVV OL /DECLV OL ArmsIndex=\nAt any time, we can retrieve the numbers showing how many stocks are up for the day, \nhow many stocks are down for the day, the volume on the advancing stocks and the volume \non the declining stocks. Plugging them into the above formula we end up with a single \nnumber, the Arms Index for that instant. The above example* (footnote) has produced a \nsomewhat bearish index. An index of 1.00 is a", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 252}
{"text": "dex=\nAt any time, we can retrieve the numbers showing how many stocks are up for the day, \nhow many stocks are down for the day, the volume on the advancing stocks and the volume \non the declining stocks. Plugging them into the above formula we end up with a single \nnumber, the Arms Index for that instant. The above example* (footnote) has produced a \nsomewhat bearish index. An index of 1.00 is a standoff, indicating both the advancing \nstocks and the declining stock received their fair share of the volume. A value over 1.00 is \nBearish, indicating the declining stocks are receiving more than their share of the volume. \nAn index lower than 1.00 is Bullish since the up stocks are receiving more than their fair \nshare of the volume. Normally, the index will fluctuate closely around 1.00. We have seen \ndays end with an index as low as .19 and other days with an index over 10.00, but these were \nrare occurrences, where the traders were reacting to extremes in euphoria or fear. Normally, \nthe index will be somewhere between .65 and 1.75.\nEXAMPLE THE ARMS INDEX: ADVANCES 1024 DECLINES 2030 ADVANCING \nVOLUME 299,790,000 DECLINING VOLUME 786,830,000 1024/2030 =.504 1024/2030 =.504 \n299790/786830 =.381 .504/.381 = 1.32 .504/.381 = 1.32 (ADVANCES / DECLINES) (ADV . VOL. \n/ DECL. VOL.) (ADV . VOL. / DECL. VOL.) = THE ARMS INDEX (TRIN) EXAMPLE\nThe reasoning\nAt any time, the Arms Index is telling us whether the up stocks are getting their share of \nthe volume or not. If the index is over 1.00 the down stocks are overpowering the up stocks. \n(Remember, under 1.00 for the raw number is good, and over 1.00 is bad. It is counter-intuitive, \nbut it is the way the index was first calculated, and it’s late to try to change it now. If that really \nbothers you, invert the calculation and it will be more intuitive, but you will be out of step with \neveryone else using the index. You will see the index is dealing with comparing two ratios, \nso it is commonplace to have a market that appears to be Bullish because of there being more \nstocks up than down, but is actually under pressure, in that those up stocks are not getting \ntheir share of the volume, and the index is Bearish. Similarly, we can have more stocks down \nthan up, but have a Bullish index, because the up stocks are getting more than their fair share \nof the volume. The Arms Index is measuring the internal dynamics of the market—dynamics \nthat may not be otherwise readily apparent. A Bullish Arms Index in a slumping market may \nbe telling us there is accumulation going on, under the guise of a down market.\nUsing the index\nThe index was originally developed as an intraday timing tool, and it still is valuable in that \nrole. There are two things to look at: the actual reading and the way it is changing during the \nday. The actual level is tending to reflect the current condition; sometimes a Bullish reading \nin a declining market or a Bearish reading in a rising market makes the move suspect. More \noften, the value will be in line with the current market activity, but watch for the big extremes. \n549Appendix C\nNot always, of course, but often, the index will go too far in one direction, and suggest the \nmove is overdone. It is reflecting those times when reason is being abandoned and a blind \npanic or a feeding frenzy is dominating the trading. A very high or a very low index can be a \nsign it is time to be a contrarian. The other intraday use is watching for change, rather than just \nthe actual value of the index. Often the index will change direction before a reversal becomes \napparent in the averages. A Bearish index in a Bearish market that suddenly starts to move \ntoward lower (less Bearish) levels may be a warning the market is about to turn up. The same is \ntrue bullish numbers that start to get higher; suggesting a downturn may be developing. Most \noften, though, the index is now used on a longer-term basis. The most common use is a simple \n10-day moving average of the closing daily numbers. This tends to be a good indicator for \nmarket moves lasting a few weeks. For short-term trading, I like the 5-day moving average. In \norder to get a feel for longer-term trends, I use a 21-day and a 55-day. The big market moves can \nbe recognized by using very big moving averages, such as the 233-day. On each of the following \ncharts, we are looking at simple moving averages of the Arms Index on an inverted scale. The \nred line is the index and the black line is the market. Since the scale has been inverted for the \nindex, the lows on the indicator line tend to coincide with low points in the market. Similarly, \npeaks in the index coincide with the market tops. I have chosen different time intervals on each \nof the charts below since the longer-term moving averages are used for longer-term predictions. \nI have not given any hard-and–fast numerical levels as buy and sell signals because we need to \nlook at the index in the context of the current market. Buy signals in a Bear Market are at more \noversold levels than they are in a Bull Market. Extreme peaks and troughs, compared to what \nhas been seen recently, tell when it is time to become a buyer or a seller. These are only a few \napplications and examples. Not shown are Arms Indices, now available, for NASDAQ and also \nfor a number of foreign markets, in which the index is equally effective. Immense amounts of \nwork, using many different methods, has been done over the years since the index was first \nmade public. Anyone wishing to know more is referred to the various books by Richard W. \nArms, Jr. Figure C.6 illustrates the index and shows Equivolume chart for context.\nFigure C.6 Notice how on the Equivolume chart the breakaway is accentuated by the wide bars. The \ntechnician is constantly in need of accents and alerts like this (cf. also Figure C.7).\n550 Appendix C\nEquivolume charting\nIntroduction\nIn 1971, with the Arms Index a part of Wall Street methodology, I had become more \nfascinated by the role of", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 253}
{"text": "strates the index and shows Equivolume chart for context.\nFigure C.6 Notice how on the Equivolume chart the breakaway is accentuated by the wide bars. The \ntechnician is constantly in need of accents and alerts like this (cf. also Figure C.7).\n550 Appendix C\nEquivolume charting\nIntroduction\nIn 1971, with the Arms Index a part of Wall Street methodology, I had become more \nfascinated by the role of Volume in the marketplace. I had been spending great deal of \ntime studying an early edition of the book you now hold but had also been learning the \nideas of Richard Wyckoff; both placed a great deal of emphasis upon the importance of \nVolume in evaluating stock movements. As I was driving home from work one afternoon, \nI was thinking about stock charts and volume and suddenly realized there might be a better \nway of depicting trading action. What if we could substitute volume for time on our charts? \nWe could depict each day as a rectangle rather than the traditional line on a bar chart. \nThe width of the box would represent the volume for that day. Unbeknownst to me, I was \nreinventing a method suggested decades earlier, but not widely popularized. I decided to \ncall my new approach Equivolume (cf. Figures C.7 and C.11).\nFigure C.7 Once again the wide volume indicating bars alert the technician to an important surge \nin the market.\n551Appendix C\nThe technique\nIn the days before the proliferation of computers, implementing the concept of Equivolume \nwas far from easy. In order to lift the volume from the bottom of the chart and insert it in \nthe posting, a scale for each stock had to be devised based upon its normal trading. That \nscale could change if the stocks went into a phase of much heavier or lighter trading. I will \nnot go into the calculations I used at the beginning, but it seemed to work. I hired a lady to \ndraw dozens of charts for me and proceeded to learn to read what they said; this led to my \nfirst book. Later, each new advancement justified another book. Once people a lot smarter \nthan me figured out how to let a computer do the work, it became a lot easier. Now, one \ncan get Equivolume charts on most major charting services, so there is really no need to \nwonder about the scaling. Suffice it to say, the rectangles on any chart are proportional to \none another in reflecting the volume.\nThe result\nAn Equivolume chart does not in any way change the high and low on each entry, but when \ncombined with the volume it becomes a box, the shape and size of which reflects supply \nand demand for that trading period. All the techniques popularized by the masters who \nfirst published this book are valid when used with Equivolume charts.\nHowever, for example, trendlines tend to be broken earlier if volume becomes \nheavier, and breakouts are more noticeable if volume increases, thereby legitimizing them, \nas are levels of support and resistance. Equivolume uses all the same data, but just gives us \na different picture, which includes all the data in a single entry. Below are two charts: a bar \nchart and an Equivolume chart of the same stock over the same time period. This is three \nmonths of trading in General Electric (Figure C.8).\nThe chart below is posted on a weekly basis (Figure C.9).\nConclusion\nEquivolume represented a far better way of looking at market action because each entry \ntold a more comprehensive story. The shape of the box indicated how easy or hard it was \nfor prices to move while the size of each box showed the interest intensity. It was a method \nthat could be used for any investment product, as long as both price movement and volume \nnumbers were available. It has become a complete methodology and is readily available on \na plethora of data services.\nArms CandleVolume charting\nAfter the introduction and wide adoption of Equivolume, the next logical step was to combine \nthe Equivolume concept with the Japanese method known as Candlesticks. Yet, I was slow \nto do this because one or more of the major charting services had already included a partial \njoining of the two techniques, calling it CandleVolume, but doing it in such a way some of \nthe visual advantages of Equivolume were lost in the process. Yet, if I did the combination of \nthe methods in my way, completely merging the two techniques, I found it could be another \ngreat advance in the way we looked at charts. Clumsily double printing of charts, I was able \nto work on it and found the results to be very helpful, and since the name CandleVolume \nwas already taken, I started calling it Arms CandleVolume. Then, after my first speech on \nthe approach, to the International Federation of Technical Analysts in San Francisco a few \nyears ago, the problem was solved. Within minutes of completing the speech the President \nof Stockcharts.com, who had been in the audience, showed me he had quickly adapted their \nsoftware for the new technique and, with my approval, would immediately include it in their \nservice, which they did. The illustrations in this article are from that source.\n552 Appendix C\nFigure C.8 This is three months of trading in General Electric illustrating two different but \ncomplimentary pictures of the market. By dragging the volume off the bottom margin and including \nit in the price we have made it apparent all days are not equal in importance. Moreover, the concept \nof eliminating time as a market measurement led, in later studies and books, to the development \nof Volume Cyclicality, Ease of Movement and of Volume Adjusted moving averages. It had become \napparent the market is a volume function. If nothing trades, nothing happens; The more trading, \nthe more importance.\n553Appendix C\nThe advantages\nAlthough the open and the close appear on some versions of bar charts, the Equivolume \nmethodology had ignored them. The Candlestick charts did contain the opens and closes; \nin fact, they emphasized them. It led to different and fascinating visual patterns using \nthe ancient methods from their origin given ima", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 254}
{"text": ", nothing happens; The more trading, \nthe more importance.\n553Appendix C\nThe advantages\nAlthough the open and the close appear on some versions of bar charts, the Equivolume \nmethodology had ignored them. The Candlestick charts did contain the opens and closes; \nin fact, they emphasized them. It led to different and fascinating visual patterns using \nthe ancient methods from their origin given imaginative and memorable names. I have, \nin order to distinguish the new methods and to emphasize adding volume changes the \nmeanings very often, tended to use my own nomenclature. The Japanese methods are \nwonderful, but the volume adds a new dimension. As one starts to use this technique it \nbecomes ever more apparent the open and close levels, added to high and low and volume, \nare providing a powerful additional tool.\nThe technique\nAll we have done is to place the Candlestick inside the Equivolume box. However, there \nis a vertical line through the box, the wick, and there are two horizontal lines across the \nbox, the open and the close. Above and below these lines are the legs. If the open is lower \nthan the close the body of the posting with be black and if it is higher the body will be \nred. If color is not available, the body can be filled or unfilled. Below we see a comparison \nof the three techniques: Bar chart, Equivolume chart, and Arms CandleVolume chart. \nThey  are all daily postings of Newmont Mining over the same three-month period \n(Figure C.10).\nTo delve into the interpretation is beyond the scope of this article, but it is clear, I think \nthat each day, each posting, tells us a concise story of supply and demand; of conflicting \npressure of buyers and sellers. Box sizes tell us of overall enthusiasm while box shapes tell \nus how easy or hard it is for price movement to occur. Moreover, the difference between \nthe open and the close tell us whether prices are stalled or moving. Box shape, size, volume \nand Candle body size all present a picture of ease or difficulty of movement.\nFigure C.9 Vividly illustrating the usefulness of the Equivolume chart like signposts on a battlefield: \nLots of fighting here.\n554 Appendix C\nFigure C.10 Notice the increasing analysis of information that occurs from one method to the next \nmoving from conventional bar chart through Equivolume to Candlevolume.\n555Appendix C\nFigure C.11 Notice the increase in information as we move to the newer technique. Candlevolume \ncombines virtues of Equivolume and Candlestick charts.\n556 Appendix C\nPoint & Figure technical analysis by Mike Moody\nLike most technical analysts, my exposure to charts came initially from bar charts. I started \nas a naïve stockbroker, hoping to understand markets to help my clients make money. I \nsoon learned the “account executive” position was—from the faulty point of view of the \nbrokerage firm—primarily a sales job. I quickly learned to use bar charts as a form of self-\ndefense from the firm’s research department. The charts could be used to examine the \nposition of any security the firm’s research department was recommending, in the often \nvain hope the recommendation and the chart were in synch.\nI found the bar charts most commonly in use had a limited perspective, usually only \nabout a year of price data. Soon I was taking an additional charting service that used \nweekly bar charts—including a relative strength line as well.\nMy quest for perspective ended when I was introduced to the Point and Figure chart. \nI think it is an extraordinarily flexible and useful complement to bar charts because of the \nperspective it can supply. Analysts like Richard Wyckoff used both bar charts and Point \nand Figure charts in tandem because of their different features and strengths.\nPoint and Figure charts are now fairly rare, which is unfortunate. Novices often do \nnot understand what they are looking at or how a Point and Figure chart is constructed.\nI’ve included a simple example chart below (Figure C.12).\nThis chart is an example of a traditionally scaled 3-box reversal Point and Figure chart. \nThe chart style was popularized by Abe Cohen of Chartcraft. The price scale is on the left. \n(You can see that price boxes below $20 are smaller than price boxes from $21 to $100. This is \na clever, pre-computer attempt to adjust to a more logarithmic scale.) Columns of Xs denote \nrising prices and columns of Os indicate falling prices. The small numbers embedded in \nthe chart indicate the month a security first printed that price. (1-9 for January through \nSeptember, and A-C for October through December—another elegant early solution to fit \na time identifier in a single-width box.)\nThe perspective is obvious, as this chart covers well over a decade. However, for a \ntechnical analyst used to bar charts, two things stick out. First, there is no time scale; years \nwhere a lot happened are wide because many reversals occurred. Years where the stock \nwas quiet are represented by far fewer columns. Second, it is not immediately obvious how \na 3-box reversal chart is constructed; it’s simple but requires a short explanation.\nA 3-box reversal chart is designed to filter out any price movements less than 3 boxes, \nwhatever that may be on the chart. With a 3-box reversal chart, there will never be a column \nthat consists of less than 3 boxes. The general rule will hold—the minimum column depth \nwill be a function of the reversal value used.\nLet’s pick up the chart in 2012, as it first reversed upward to $34 in September. There is \na simple flow chart logic to plotting a Point and Figure chart.\n 1. If you are rising in a column of Xs, first look to see if a new price high was made. If \nyes, put a new X in the column.\n 2. If no new high was made, check to see if a 3-box reversal down occurred. If yes, put \nin a new column of 3 Os.\n 3. If no new price high was made or no reversal down was made, do nothing.\nIt’s the “do nothing” that is different because time can pass with no adjustment made \nto the chart. The chart", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 255}
{"text": "column of Xs, first look to see if a new price high was made. If \nyes, put a new X in the column.\n 2. If no new high was made, check to see if a 3-box reversal down occurred. If yes, put \nin a new column of 3 Os.\n 3. If no new price high was made or no reversal down was made, do nothing.\nIt’s the “do nothing” that is different because time can pass with no adjustment made \nto the chart. The chart is a record of pure price movement.\nBy November 2012, General Mills had printed $35—without ever reversing down 3 \nboxes or more. In January 2013, the price hit $36. February 2013 was a good month—the \n557Appendix C\nFigure C.12 Years of data for GIS.\n558 Appendix C\nprice hit $37 and continued to $40. $41 was reached in March, and $42 and $43 in April. \nMay 2013 saw the first 3-box reversal, from a peak price of $44 to the minimum reversal \nlevel of $41.\nKey to the value of Point and Figure charts is their flexibility. Many early practitioners \nof Point and Figure used single-box reversal charts calculated with intraday data. This style \nof chart looks more similar to a bar chart, but actually captures volatility particularly well \nbecause of the use of intraday data. With a bar chart, each day might be a single bar, but \nduring a particularly volatile period for the market or for an individual stock, a single-box \nreversal chart can put in many, many columns.\nLike a bar chart, price targets with a Point and Figure chart are usually estimated from \nthe width of the base—and during a particularly volatile period like 1987 or 2008 many, \nmany reversals can occur in a single day! Alan Shaw, formerly the chief market technician \nat Smith Barney, believed that intraday, single-box reversal point & figure charts were the \npremier way to estimate price moves from a base. As a guide to this type of chart, Alan \nalways recommended Alexander Wheelan’s Study Helps in Point and Figure Technique. \nOn more than one occasion, this knowledge allowed Alan to estimate large price moves \nwhen the base on a bar chart was narrow.\nThe computer age has improved Point and Figure charting immeasurably. The computer \nhas no trouble creating true logarithmic charts. Here is the same chart of General Mills, this \ntime using a 2% box and a 3-box reversal. Also shown is the traditional 45-degree trendline, \ndrawn from prominent highs or lows. (Figure C.13)\nPercentage charts are, I think, significantly clearer. There is no reason not to use \nthem now since they can be so easily generated. (All of the charts here are courtesy of \nStockCharts.com.)\nDetail can be added by shrinking the box size; greater perspective can be achieved \nwith a larger box size.\nIt seems simple but changing the box size or reversal value allows the Point and Figure \nchart to be adapted to any time frame, from scalping to swing trading to infinity.\nThe chart below, using a 1% box size with a 3-box reversal shows a clear breakout from \na downtrend that is not visible at the same price on a chart with a larger scale. (Figure C.14)\nMoving averages can also be helpful on Point and Figure charts to help determine \ntrend. The difference with a Point and Figure chart is that the moving average is a moving \naverage of the center point of a certain number of columns.\nThe chart below simply replaces the 45-degree trendline with a 10-column moving \naverage. (Figure C.15)\nTrend is critically important, but as my career developed into money management, it \nbecame important also to measure the power and durability of the trend. The Chartcraft \nservice had, for years, calculated a relative strength ratio (stock price divided by index price), \nadjusted the decimal points to make it chartable, and then plotted it on a traditional 3-box \nreversal chart. At Dorsey Wright, we changed these relative strength charts to percentage \ncharts and gained vast additional perspective.\nThe chart below, of Danaher Corp., is a relative strength chart using a 6% scale with a \n3-box reversal value. The price of Danaher is divided by the price of an S&P 500 ETF and \nplotted on a log scale. Suddenly, it becomes apparent—in broad terms—Danaher has been \noutperforming the market for more than 15 years. (Figure C.16)\nThe final strength of Point and Figure charts is their objectivity. A skilled practitioner \nwith a bar chart can be very effective, but one analyst might discern a continuation pattern \nwhere another sees a different pattern in a larger or smaller time frame. Two analysts \n559Appendix C\nFigure C.13 An alternative view of General Mills.\n560 Appendix C\nlooking at the same Point and Figure chart, on the other hand, will always be in agreement \nabout whether the chart is on a buy signal or a sell signal.\nThe criterion is incredibly simple and unambiguous. If the price exceeds the immediately \nprevious column of Xs, it is on a buy signal. If the price declines below the immediately \nprevious column of Os, it is on a sell signal. On the Danaher relative strength chart, for \nexample, there is a buy signal at 10.88 in October 2000. (It exceeded the previous rising \ncolumn, which topped out at 10.27 .) There is no subsequent sell signal, as no column of Os \never falls below the previous column of Os. A security, by definition, is always on either a \nbuy or sell signal.\nThe objective nature of Point and Figure can be useful in other realms as well. Market \nindicators or diffusion indexes can be plotted on a Point and Figure chart and objectively \ngraded as a buy or sell, for example.\nPerspective, flexibility, and objectivity, then, are the cardinal virtues of the Point and \nFigure charting method. They give a perspective, unlike a bar chart, abstracting pure \nprice and giving deep insight into volatility. They have almost unlimited flexibility to be \nFigure C.14 Clarifying the issue with percentage boxes.\n561Appendix C\nadapted to different scales, time frames, and purposes. Finally, their objectivity can become \na powerful tool in the hands of any analyst.\nFor further investigation, some of", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 256}
{"text": "They give a perspective, unlike a bar chart, abstracting pure \nprice and giving deep insight into volatility. They have almost unlimited flexibility to be \nFigure C.14 Clarifying the issue with percentage boxes.\n561Appendix C\nadapted to different scales, time frames, and purposes. Finally, their objectivity can become \na powerful tool in the hands of any analyst.\nFor further investigation, some of the best-known resources are:\nAlexander Wheelan, Study Helps in Point & Figure Technique\nA.W. Cohen, How to Use the Three-Point Reversal Method of Point & Figure Stock Market \nTrading: A Technical Approach to Stock Market Trading\nThomas J. Dorsey, Point and Figure Charting: The Essential Application for Forecasting and \nTracking Market Prices\nJeremy du Plessis, twenty-first Century Point and Figure: New and Advanced Techniques for \nUsing Point and Figure Charts\nBollinger Bands\nThe creation of John Bollinger, Bollinger Bands is an inventive solution to the question of \nmeasuring and displaying price volatility. Technicians had previously developed channels \nFigure C.15 Overlaying the PnF with a moving average.\n562 Appendix C\nand envelopes which have proved productive for some. Bollinger made the concept \ndynamic, developing a channel whose lines (or bands) are variable depending on volatility.\nBollinger Bands are printed as three lines. The middle line (or band) is a conventional \nmoving average. The upper band is equivalent to the middle band but shifted two standard \ndeviations up. The lower band is similar but shifted two standard deviations down. As \nvolatility varies the bands narrow and widen and technicians look to the position of price \nFigure C.16 Relative strength perspective.\n563Appendix C\nrelative to the lines to orient their trading. Thus, the bands are useful in lending perspective \nas prices oscillate. The routine is quite popular and this mention is meant only as an \nintroduction and should inspire the interested student to take up Bollinger’s publications \nto explore this interesting and valuable tool. Bollinger on Bollinger Bands may be found at \nAmazon. (Figure C.17)\nFigure C.17 The dynamic nature of the bands dramatizes the nature of volatility and can be a \ngreat aid in trading—usually over the short term. Bollinger recommends 20 periods for the moving \naverage.\n\n565\nList of Illustrations and Text Diagrams\nRegarding the illustrations in this book, except for those which are marked as adapted \nfrom other sources, the charts listed as Figures below have been reproduced from the \nauthors’ own “working” charts. As such, they were made up originally for private use \nonly and without a thought to their eventual reproduction, much less their publication. \nThey are not and do not pretend to be works of art, but it is hoped that they will, despite \ntheir “homemade” appearance, serve the purpose of illustrating the various formations, \npatterns, market phenomena, and trading principles discussed in the text. That they do not \nshow the clean line and expert lettering of a professional draftsman’s work is regretted. The \nreader will, we trust, make allowances.\nAs for their selection, it should be stated most emphatically that it was not necessary \nto search through thousands of charts in order to find good examples of all these various \ntechnical formations. Many dozens, even hundreds, were available for practically every \ntype of pattern. Anyone who has learned to recognize them can find for himself plenty \nof good technical pictures in a quick examination of even as small a portfolio as 50 or 100 \ncharts. In other words, the illustrations in this book are in no sense unique. In selecting \nthem, we have tried only to show as much variety as possible and samples from previous \nas well as more recent market history.\nPerhaps it is not necessary, but it is at least in accord with custom, to add that the \ninformation as to specific market prices, volume of transactions, etc., used in preparing our \nillustrations (or cited in the text of this book) has been derived from sources believed to be \nreliable, but is not guaranteed.\n566 List of Illustrations and Text Diagrams\nPart One\nFigure Page\n1.1 UNITED STATES STEEL. Monthly price ranges from January 1929 to December \n1946.\n5\n6.1 HUMANA, INC. Daily, 1988. Head-and-Shoulders Top. 46\n6.2 CHICAGO, MILWAUKEE, ST. PAUL & PACIFIC. The Head- and-Shoulders Top \nFormation which ended its Bull Market in February 1946.\n46\n6.3 WESTINGHOUSE ELECTRIC. The Head-and-Shoulders Top of January through \nFebruary 1946.\n47\n6.4 TELEDYNE, INC. 1984. Large Head-and-Shoulders Top. 48\n6.5 IC INDUSTRIES. 1986. Head-and-Shoulders Top. 49\n6.6 DUPONT. Its Major Top in 1936, with an unusual Pullback. 50\n6.7 CONSOLIDATED EDISON COMPANY of New York. The Head-and-Shoulders \nReversal of 1937.\n50\n6.8 REPUBLIC AVIATION. Its 1946 Bull Market Top. The Head-and-Shoulders \nmeasuring formula.\n51\n6.9 WALT DISNEY PRODUCTIONS. 1986. Head-and-Shoulders Top. 51\n6.10 NEW YORK CENTRAL. Head-and-Shoulders Top in June through July 1945, \nfollowed by a Multiple Head-and-Shoulders Bottom.\n52\n6.11 UNION CARBIDE & CARBON. The Head-and-Shoulders within a Head-and-\nShoulders Top Formation which capped its 1929 Bull Market.\n53\n7.1 LOCKHEED AIRCRAFT. A Head-and-Shoulders Bottom Reversal in December \n1943.\n58\n7.2 DOME MINES. Weekly chart showing the Major Head-and-Shoulders Bottom of \n1942.\n59\n7.3 FEDERAL NATIONAL MORTGAGE ASSOCIATION. 1984. Head-and-Shoulders \nBottom.\n60\n7.4 ILLUSTRATION OF KILROY BOTTOM 60\n7.5 DOW INDUSTRIALS. 2003 Kilroy (H&S) Bottom. 61\n7.6 MCA, INC. 1986. Complex Head-and-Shoulders Top. 62\n7.7 BUDD MANUFACTURING (now The Budd Company). Multiple Head-and-\nShoulders Top of 1946.\n62\n7.8 AMERICAN LOCOMOTIVE. Extended top of Multiple type, 1946. 63\n7.9 DIGITAL EQUIPMENT CORPORATION. 1985. From a Head- and-Shoulders \nTop to Complex Head-and-Shoulders Bottom.\n63\n7.10 ARCHER DANIELS MIDLAND COMPANY. 1984. Complex Head-and-\nShoulders Bottom.\n64\n7.11 GENERAL BRONZE. Multiple type Bottom forme", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 257}
{"text": "7.7 BUDD MANUFACTURING (now The Budd Company). Multiple Head-and-\nShoulders Top of 1946.\n62\n7.8 AMERICAN LOCOMOTIVE. Extended top of Multiple type, 1946. 63\n7.9 DIGITAL EQUIPMENT CORPORATION. 1985. From a Head- and-Shoulders \nTop to Complex Head-and-Shoulders Bottom.\n63\n7.10 ARCHER DANIELS MIDLAND COMPANY. 1984. Complex Head-and-\nShoulders Bottom.\n64\n7.11 GENERAL BRONZE. Multiple type Bottom formed July–September 1945. 64\n7.12 AMDAHL CORPORATION. 1984. Complex Head-and-Shoulders Bottom. 65\n7.13 PUBLIC SERVICE CORP . OF NJ. Weekly chart showing Multiple Bottom pattern \nof 1941 to 1942.\n66\n7.14 NATIONAL SUPPLY. The “two-headed” Top Formation of 1946. 67\n7.15 PHILLIPS PETROLEUM. The 1946 Top — a Multiple Pattern merging into a \nRounding Turn.\n67\n7.16 AMERICAN & FOREIGN POWER 2nd PFD. A. A Rounding Bottom formed in \n1945.\n68\n567List of Illustrations and Text Diagrams\nFigure Page\n7.17 AMERICAN SAFETY RAZOR. Monthly chart. Two Major Bottoms — a Head-\nand-Shoulders in 1932 and “Bowl” in 1942.\n69\n7.18 THE BUDD COMPANY. Monthly chart showing Major Rounding Bottom of \n1942.\n70\n7.19 CERTAINTEED PRODUCTS. Monthly chart. Major Rounding Bottom of 1942. 70\n7.20 J.I. CASE. The Rounding Bottom of 1932 showing a temporary rally out of \npattern.\n71\n7.21 GAMEWELL COMPANY. A “dormant” type of Rounding Bottom in 1944. 72\n7.22 INLAND STEEL. Semi-dormant Rounding Bottom of 1935. 72\n7.23 APPLIED MAGNETIC CORPORATION. 1988. Saucer-like Pattern. 73\n7.24 CRAY RESEARCH. 1987. Gap and Rounding Top. 74\n7.25 NORTHERN INDIANA PUBLIC SERVICE. A magnificent Scalloping tendency. 75\n8.1 HUDSON BAY MINING AND SMELTING. Major Bottom of 1941 to 1942, a \nperfect Symmetrical Triangle. Weekly chart.\n78\n8.2 SEARS, ROEBUCK. Symmetrical Triangle Top of 1946, and subsequent step-\ndown pattern of same form.\n78\n8.3 JOHNS–MANVILLE. Triangular Bottom development of 1941 to 1942. Weekly \nchart.\n79\n8.4 DELAWARE & HUDSON. Weekly chart. Wide-swinging Symmetrical Triangle \nBottom of 1941 to 1942 with Throwback to apex Support.\n80\n8.5 CUBAN–AMERICAN SUGAR. A Rounding Bottom in 1945 which merged into a \nSymmetrical Triangle.\n81\n8.6 NATIONAL GYPSUM. A false move out of the extreme apex of a Symmetrical \nTriangle.\n81\n8.7 NORTH AMERICAN COMPANY. Symmetrical Triangle topping a recovery \nfrom a Panic Low in 1937.\n82\n8.8 VERTIENTES — CAMAGUEY SUGAR of Cuba. Triangular- like development at \n1946 Top.\n83\n8.9 EASTERN AIRLINES. A Symmetrical Triangle in 1947 that did not carry \nthrough.\n83\n8.10 NATIONAL GYPSUM. A typical Symmetrical Triangle leading to continuation \nof the preceding trend in 1944 to 1945. Weekly chart.\n84\n8.11 U.S. INDUSTRIAL CHEMICALS. Triangular Pattern completing an extended \nreaccumulation period.\n84\n8.12 AMERICAN BANKNOTE. The Major Bottom Reversal of 1941 to 1942. 85\n8.13 CELANESE CORPORATION. Ascending Triangle of consolidation type in 1946. 85\n8.14 BRIGGS MANUFACTURING. Weekly chart of 1941 to 1943 showing Triangular \nBottom of ascending type.\n86\n8.15 SEARS, ROEBUCK. The Symmetrical Descending Triangle Top of 1936 and \nsubsequent Intermediate Recovery Bottom of ascending form.\n86\n8.16 SOUTHERN RAILWAY PREFERRED. A perfect Ascending Triangle in 1936. 87\n8.17 ARMOUR & COMPANY. Long Ascending Triangle in 1946 to 1947 in which \ndistribution eventually overcame upward trend.\n88\n8.18 SOCONY–VACUUM OIL. Ascending Triangle forming head of Head-and-\nShoulders Bottom in 1942. Weekly chart.\n89\n8.19 BATH IRON WORKS. Descending Triangle Top of 1946, showing adjustment of \npattern lines for Ex-Dividend Gap.\n90\n568 List of Illustrations and Text Diagrams\nFigure Page\n8.20 REVERE COPPER & BRASS. Large Descending Triangle Top of 1946. 91\n8.21 WESTINGHOUSE ELECTRIC. The Descending Triangle which topped out \n“WX” ahead of the general market.\n92\n8.22 HUDSON MOTOR CAR. Series of Triangles in the 1929–32 Bear Market. Weekly \nchart.\n93\n8.23 AMERICAN ROLLING MILL. The “hybrid” pattern of ascending type which \nformed in 1941 to 1943. Weekly chart.\n94\n8.24 GOODRICH (B.F) COMPANY. The remarkably small but perfect Ascending \nTriangle which reversed its Major Trend in 1942. Weekly chart.\n95\n8.25 EBAY. 2004 Descending Triangle Surprise. 96\n9.1 NASH–KELVINATOR. Rectangular distribution area of 1945 to 1946. 104\n9.2 LIMA LOCOMOTIVE WORKS. Rectangular pattern of “conflict” in 1944 to 1945. 104\n9.3 LOEW’S, INC. Perfect Rectangle of the “pool operation” type, 1936. 105\n9.4 SOCONY–VACUUM OIL. Rectangle Top Formation of 1946. 106\n9.5 YOUNGSTOWN SHEET & TUBE. Major Top of Rectangle formed in 1946. 106\n9.6 EASTERN AIRLINES. Long Consolidation ending in Rectangle in early 1945. 107\n9.7 AMERICAN ZINC, LEAD & SMELTING. The Consolidation Rectangle which \nfollowed a Head-and-Shoulders Top in 1946.\n108\n9.8 SEARS, ROEBUCK. A “hybrid” Major Bottom Formation in 1941 to 1942. 109\n9.9 BELL AIRCRAFT. Ex-dividend drop causing apparent false move out of \nRectangle in 1945.\n109\n9.10 KENNECOTT COPPER. Series of Consolidation Formations in 1937 Bear Trend. 110\n9.11 UNITED AIRCRAFT. The Double Bottom of 1942. Weekly chart. 111\n9.12 INCO COMPANY, LTD. Subsequent to the October crash, developed a large \nHead-and-Shoulders Top.\n111\n9.13 REPUBLIC STEEL. Major Double Top of 1946 with subsidiary patterns. 112\n9.14 AMERICAN AIRLINES. Weekly Chart. Bull Market Top of 1945 to 1946, a form \nof Double Top.\n113\n9.15 CONTAINER CORPORATION. The Major Double Bottom of 1941 to 1943. \nWeekly chart.\n114\n9.16 TRINITY INDUSTRIES. 1985. Triple Bottom. 115\n9.17 PUBLICKER INDUSTRIES. Triple Top of 1946. 116\n9.18 NATIONAL GYPSUM. Triple Bottom of 1941 to 1942. Weekly chart. 117\n10.1 CRANE COMPANY. Broadening Formation of 1945 to 1946, a warning of final \ntop.\n122\n10.2 AIR REDUCTION. The classic Broadening Top of 1929. 123\n10.3 AMERICAN ROLLING MILLS. Small Broadening Top of 1946 at the end of a \ngenerally broadening (and Bearish) Formation.\n124\n10.4 CONSOLIDATED EDISON. Major Broadening Top on weekly chart of 1935 to \n1938.\n124\n10.5 INTERNATIONAL PAPER. Showing a form of “broadening” which is of \ndoubtful tech", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 258}
{"text": "of 1945 to 1946, a warning of final \ntop.\n122\n10.2 AIR REDUCTION. The classic Broadening Top of 1929. 123\n10.3 AMERICAN ROLLING MILLS. Small Broadening Top of 1946 at the end of a \ngenerally broadening (and Bearish) Formation.\n124\n10.4 CONSOLIDATED EDISON. Major Broadening Top on weekly chart of 1935 to \n1938.\n124\n10.5 INTERNATIONAL PAPER. Showing a form of “broadening” which is of \ndoubtful technical significance. Weekly chart, 1945 to 1947.\n125\n10.6 ASSOCIATED DRYGOODS. Right-Angled Broadening Formation with \nhorizontal Top, 1945.\n125\n10.7 PARAMOUNT PICTURES. The 1946 top, a Right-Angled Broadening Pattern \nwith horizontal bottom line.\n126\n569List of Illustrations and Text Diagrams\nFigure Page\n10.8 ALLIED STORES. Flat-topped Broadening Pattern of 1945, and Breakout Gaps. 126\n10.9 U.S. STEEL. The three-month Diamond which formed the 1946 Bull Market Top. 127\n10.10 AMERICAN BOSCH CORPORATION. A Diamond Pattern in 1945 which \nfunctioned as a Consolidation.\n127\n10.11 SHELL UNION OIL. 1946 Major Diamond Top and Descending Triangle. 128\n10.12 DOW INDUSTRIALS. 1999–2000 Diamond. 129\n10.13 HUDSON MOTORS. The 1946 Major Top, a Diamond or Complex \nHead-and-Shoulders.\n130\n10.14 U.S. STEEL. The Wedge as part of a Rounding Top on the August 1937 recovery. 131\n10.15 LOEW’S, INC. Falling Wedge of classic form in 1936; Flag and Rectangle. 132\n10.16 SCHENLEY DISTILLERS. A large Wedge which signaled a Primary Top in 1946. \nWeekly chart.\n133\n10.17 TRANSCONTINENTAL & WESTERN AIRLINES. Major One-Day Reversal and \nlong downtrend. 1945 to 1946.\n134\n10.18 GREYHOUND CORPORATION. A conspicuous One-Day Reversal at the 1946 \nBull high.\n134\n10.19 APPLE. Panic selling and climax in Apple, 1987 Crash. 135\n10.20 NEW YORK CENTRAL. A typical Panic Selling Climax in 1937. 136\n10.21 DOW INDUSTRIALS. 1987 Reagan Crash. 137\n10.22 NATIONAL CASH REGISTER. An example of “One-Week Reversal” in 1941. \nWeekly chart.\n138\n10.23 QUALCOMM. A church spire top in Qualcomm. 139\n10.24 MICROSOFT. A key reversal day in March. 140\n10.25 EBAY. As Ebay broke its trendline and drifted sideways it became a good subject \nfor reversal day trading.\n140\n10.26 EBAY. 2004-5 Astonishing Ebay breaks away on wings of great business. 141\n10.27 LUCENT. Late 20th, early 21st century schizophrenia. 142\n10.28 LUCENT. Fortune telling (or loss of fortune telling) by the chart. 143\n11.1 MARTIN–PARRY. Ideal Flag in rapid advance of 1945. 152\n11.2 NATIONAL GYPSUM. An up Flag and another false move from apex of \nTriangle. 1945.\n153\n11.3 NASH–KELVINATOR. Flag of “Half-Mast” type preceding 1937 Bull Market \nTop.\n154\n11.4 VANADIUM CORPORATION. Rapid sequence of small Consolidation \nFormations in 1936 to 1937.\n155\n11.5 BRIGGS. Bull and Bear Flags and Symmetrical Triangle Top in 1936. Support–\nResistance phenomena.\n156\n11.6 ANACONDA COPPER. Wedge or Pennant, Flag and Runaway Caps in 1936–37. 157\n11.7 PACIFIC TIN. Flag, following and succeeded by Triangles, in 1944. 158\n11.8 MULLINS MANUFACTURING. B. An overlong Flag which worked \nnevertheless. 1936.\n159\n11.9 WYANDOTTE WORSTED. Application of measuring formula to Flag. 1946. 160\n11.10 AMERICAN WOOLEN. Perfect “Half-Mast” Pattern in 1946, with gaps and \nAscending Triangle.\n161\n11.11 MO. 2005 gaps and flags galore. 162\n570 List of Illustrations and Text Diagrams\nFigure Page\n11.12 AMERICAN LOCOMOTIVE. A Flag in 1935 which appeared to fail but finally \ncame through.\n163\n11.13 ANACONDA COPPER. Head-and-Shoulders Consolidations in 1936, and \nmeasuring Flag.\n164\n11.14 AMERICAN & FOREIGN POWER 2D PFD. A. Head-and- Shoulders \nConsolidation Pattern of 1945.\n164\n11.15 MIAMI COPPER. A genuine Scallop uptrend in 1945. 165\n11.16 COMMONWEALTH EDISON. Scalloping trend of an investment stock, 1945. 165\n11.17 INTERNATIONAL TELEPHONE & TELEGRAPH. Saucerlike Consolidation in \n1944.\n166\n11.18 FLINTKOTE. Consolidation Formation — a Symmetrical Triangle — providing \nsignal of Primary Reversal.\n167\n12.1 AMERICAN WATER WORKS & ELECTRIC. Common or Pattern Gaps in a \nRectangle; Runaway Gap and Flag. 1945.\n172\n12.2 BETHLEHEM STEEL. Three types of Breakaway Gap. 1937. 173\n12.3 ZENITH RADIO. Strong Breakaway Gap on weekly chart of 1942 Major Bottom. 174\n12.4 ZENITH RADIO. Monthly chart of 1936 to 1946 for comparison with Figure 124. 175\n12.5 BLAW–KNOX. Gaps following long Rectangle in early 1946, and Major Double \nTop.\n176\n12.6 BALTIMORE & OHIO. The measuring formula applied to a Runaway Gap in \nearly 1937.\n177\n12.7 SOUTHERN PACIFIC. A large Measuring Gap in the Panic Decline of late 1937. 178\n12.8 WILLYS–OVERLAND. Various types of gaps in 1944, and Head-and-Shoulders \nReversal.\n179\n12.9 A.O. SMITH CORPORATION. A technically significant (Runaway) Gap in 1946 \ndecline. Weekly chart.\n180\n12.10 BALTIMORE & OHIO PFD. Small Island in right shoulder of Major Head-and-\nShoulders Top. 1946.\n180\n12.11 LION OIL COMPANY. An Island “shakeout” in a thin stock. 1947. 181\n12.12 BETHLEHEM STEEL. Unusual Island Reversal at the 1937 Bull Top. 182\n12.13 PENNSYLVANIA RAILROAD. Changes in technical lines required by \nex-dividend decline.\n183\n12.14 183\n13.1 JONES & LAUGHLIN. Normal trend action illustrating Support and Resistance. \nWeekly chart, 1944 to 1947.\n191\n13.2 BENDIX AVIATION. Support–Resistance Levels in an Intermediate Uptrend. \n1944 to 1945.\n194\n13.3 NATIONAL DISTILLERS. 1926 to 1947 monthly chart showing Major Support–\nResistance Levels.\n195\n13.4 KRESGE (S.S.) COMPANY. 1936 to 1946 monthly chart showing important \nSupport–Resistance Levels.\n196\n13.5 JEWEL TEA. Major Support–Resistance Levels on 1936 to 1946 monthly chart. 198\n13.6 REMINGTON RAND. Descending Triangle Top and significant failure of \nSupport. Weekly chart, 1945 to 1947.\n199\n13.7 YORK CORPORATION. Measuring Gap and long Rectangle. 1945 to 1946. 200\n13.8 YORK CORPORATION. Sequel to Figure 141. Rectangle Support, false move \nfrom apex of Triangle, and Double Top. 1946.\n201\n571List of Illustrations and Text Diagrams\nFigure Page\n13.9 GOODYEAR TIRE. Four Pullbacks to neckline of Head-and- Shoulders", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 259}
{"text": "e Top and significant failure of \nSupport. Weekly chart, 1945 to 1947.\n199\n13.7 YORK CORPORATION. Measuring Gap and long Rectangle. 1945 to 1946. 200\n13.8 YORK CORPORATION. Sequel to Figure 141. Rectangle Support, false move \nfrom apex of Triangle, and Double Top. 1946.\n201\n571List of Illustrations and Text Diagrams\nFigure Page\n13.9 GOODYEAR TIRE. Four Pullbacks to neckline of Head-and- Shoulders Top. \nWeekly chart, 1945 to 1947.\n203\n13.10 INTERNATIONAL TELEPHONE & TELEGRAPH. Support “field” of \nSymmetrical Triangle. 1945.\n204\n13.11 INTERLAKE IRON. “End run” following a late breakout from Symmetrical \nTriangle. 1944.\n204\n13.12 SOUTHERN RAILWAY. Typical Pullbacks to Head-and- Shoulders Neckline, \nand increase of volume as Support is violated. 1946.\n205\n14.1 ATLANTIC REFINING. Basic Intermediate Trendlines on weekly chart, 1944 to \n1947.\n208\n14.2 ATCHISON, TOPEKA & SANTA FE. Acceleration of Intermediate Uptrend in \n1936. Support Levels.\n209\n14.3 CRANE COMPANY. Short-term trendlines in 1945, and examples of channel \n“failure” and Pullback.\n210\n14.4 COMMERCIAL SOLVENTS. Intermediate Downtrend and Uptrend in 1946. 211\n14.5 PHILLIPS PETROLEUM. An exception to the normal consequences of valid \ntrendline penetration. Weekly chart, 1935 to 1938.\n212\n14.6 PARAMOUNT PICTURES. Double trendlines in accelerated Intermediate \nAdvance. 1945 to 1946.\n213\n14.7 BETHLEHEM STEEL. Trend Channels and Rectangle. 1945. 213\n14.8 PAN AMERICAN AIRWAYS. Descending Triangle Top and long, Double \nDowntrend Channel. 1945 to 1946.\n214\n14.9 SOUTHERN PACIFIC. Intermediate Basic and Return Lines and Flags within \nTrend Channel. 1945.\n214\n14.10 HUDSON MOTORS. Measuring implications of “failure” in Trend Channel. \n1945.\n215\n14.11 CONSOLIDATED VULTEE. Part of a two-year Uptrend Channel. 1945. 215\n14.12 NASH–KELVINATOR. Downtrend Channel in 1946. 216\n14.13 R.H. MACY. Complex Top in 1946 and penetration of Intermediate Up Trendline. \nTentative Fan Lines.\n217\n14.14 ARKANSAS BEST. 1987. Fan and Head-and-Shoulders Bottom. 218\n14.15 BARBER ASPHALT. Application of three-fan principle to Bull Market Reaction. \n1946.\n219\n14.16 DELAWARE & HUDSON. Application of three-fan principle to Bull Market \nReaction. 1944.\n219\n14.17 BACYRUS ERIE. 1984. Excellent Fan Pattern. 220\n15.1 GENERAL MOTORS. Straight-line Bull Trend. Monthly chart, 1938 to 1946. 230\n15.2 HUDSON MOTORS. Up-curving Bull Trend. Monthly chart, 1938 to 1946. 230\n15.3 CURTIS PUBLISHING $7 PFD. Typical decurving Bull Trend of preferred stocks. \nMonthly chart, 1938 to 1946.\n231\n15.4 CURTIS PUBLISHING COMMON. Accelerating Bull Trend of low-priced, \nspeculative common stocks. Monthly chart, 1938 to 1946.\n231\n15.5 COMMONWEALTH EDISON. Straight-line Bull Trend of investment type \nutility. Monthly chart, 1938 to 1946.\n232\n15.6 INTERNATIONAL HYDRO–ELECTRIC. Up-curving Bull Trend of a high \nleverage junior utility stock. Monthly chart, 1938 to 1946.\n232\n572 List of Illustrations and Text Diagrams\nFigure Page\n15.7 HOUSTON OIL. Accelerating trend of a speculative oil stock. Monthly chart, \n1938 to 1946.\n233\n15.8 STANDARD OIL OF OHIO. Straight-line Bull Trend of an investment oil. \nMonthly chart, 1938 to 1946.\n233\n15.9 REPUBLIC STEEL. Typical Bull Trend of steel stocks. Monthly chart, 1938 to \n1946.\n234\n15.10 AMERICAN CAR & FOUNDRY. Up-curving Bull Trend of heavy industry \nissues. Monthly chart, 1938 to 1946.\n234\n15.11 CELOTEX. Accelerating uptrend of a low-priced building supply stock. Monthly \nchart, 1938 to 1946.\n235\n15.12 CLAUDE NEON (Curb Exchange). Strongly up-curved Bull Trend of a low-\npriced, highly speculative issue. Monthly chart, 1938 to 1946.\n235\n15.13 LIGGETT & MYERS TOBACCO B. Straight-line trend characteristic of tobacco \nstocks. Monthly chart, 1938 to 1946.\n236\n15.14 CORN PRODUCTS REFINING COMPANY. Typical Major Uptrend of food \ngroup. Monthly chart, 1938 to 1946.\n236\n15.15 WESTINGHOUSE ELECTRIC. Major Trendlines. Weekly chart, 1935 to 1938. 237\n15.16 THE DOW–JONES INDUSTRIAL AVERAGE. Monthly chart, 1924 through 1937, \nshowing the unique straight downtrend developed by the 1929 to 1932 Bear \nMarket.\n238\n15.17 THE S&P 500. Horrors of the 1987 Crash. 239\n15.18 THE S&P 500. The 1987 Crash viewed from afar. 239\n15.19 THE DOW. Three Bull Market tops. 240\n15.20 THE DOW 1999–2000 The top of the bubble. 241\n16.1 OATS. Tracing “normal” patterns during the 1940s (5th ed.). 246\n16.2 COTTON FUTURES. Familiar technical action in a futures chart (5th ed.). 247\n16.3 GOLD 2005. A great rounding bottom? Foretelling? 248\n16.4 GOLD October 2011. Results of massive rounding bottom. 249\n16.5 SILVER 2005. Another great rounding bottom? 250\n16.6 SILVER MAY 05. Lessons in agility, gaps and run days. 251\n16.7 SILVER October 2011. The bull market foreseen in 2005. 252\n16.8 TBONDS 2005. Applications of charting knowledge. 253\n16.9 Commodity Research Bureau April 2005. Gaps and triangles in futures charts. 254\n16.10 Commodity Research Bureau 2005. Long term view of bull market. 255\n16.11 BONDS. Twenty year Spectacular display of patterns and signals. 255\n16.12 COFFEE September 94. Gaps and flag. Absolute clarity. 256\n16.13 SILVER May 11. A beautiful top. 257\n17.1 SPIEGEL, INC. The Major Top of 1946 and the first part of a Bear Trend. 1946 to \n1947.\n262\n17.2 SPIEGEL, INC. Sequel to Figure 198. Continuation of Bear Trend. 1946 to 1947. 263\n17.3 CBOT DOW INDEX FUTURES AND DIAMONDS. Hedging DIAMONDS with \nindex futures illustrated.\n278\n17.4 CBOT DOW INDEX FUTURES AND OPTIONS ON FUTURES. Using options \nand futures to control portfolio risk.\n282\n573List of Illustrations and Text Diagrams\nPart Two\nFigure Page\n18.1 CUDAHY PACKING. Head-and-Shoulders Reversal at the Major Top in 1928. 294\n18.2 HUDSON MOTORS. Daily chart from January through June 1930, showing large \nDescending Triangle, also Symmetrical Triangle Consolidation during decline.\n295\n18.3 ENRON 2005. The most fundamental lesson. 298\n18.4 IBM. Perhaps those “best and brightest” fundamental analysts were not as \nfeckless as one might think from look", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 260}
{"text": "CUDAHY PACKING. Head-and-Shoulders Reversal at the Major Top in 1928. 294\n18.2 HUDSON MOTORS. Daily chart from January through June 1930, showing large \nDescending Triangle, also Symmetrical Triangle Consolidation during decline.\n295\n18.3 ENRON 2005. The most fundamental lesson. 298\n18.4 IBM. Perhaps those “best and brightest” fundamental analysts were not as \nfeckless as one might think from looking at their 20-year record.\n301\n18.5 XEROX. More benefits of fundamental analysis. 302\n20.1 GOODYEAR TIRE COMMON. Monthly, 1943 to 1947, showing rapid advance of \na somewhat speculative common stock during a Bull Market.\n308\n20.1 GOODYEAR TIRE $5 PFD. Monthly, 1943 to 1947, showing stability of a \nconservative preferred stock of the same company in the same period.\n308\n20.2 S&P . Here the benefits of relaxed long-term investing may be seen. 308\n20.3 SPDR. For illustration, here is a chart of the Amex Index Share, the SPYDR, or \nshare based on the S&P 500.\n309\n20.4 S&P 500 2004-5. The Broadening Top comes home to roost. 309\n22.1 BALTIMORE & OHIO. Weekly, first 6 months of 1945, showing tendency of a \nlow-priced stock to make wide swings in a general market move.\n320\n22.1 UNION PACIFIC. Weekly, first 6 months of 1945, showing tendency of a \nhigh-priced stock of the same group to make small swings.\n320\n23.1 MICROSOFT. A multitude of lessons in Microsoft. 326\n23.2 MICROSOFT. A Monthly perspective. 327\n23.3 MICROSOFT. 2005. The long view after the fall. 328\n23.4 PALM. Fool’s gold. Fool’s gold with naivete writ large on it. 329\n23.5 PALM masquerading as PLMO. A Continuation of the shell game. 329\n23.6 PALM masquerading as PSRC. Which shell is it under? 330\n23.7 3COM. Underwriters cleverly only threw 3% of 3Com-owned Palm stock onto \nthe market at the IPO.\n331\n23.8 ORACLE. Your modern misshapen rectangles in Oracle again, marked by \nrunaway days and gaps.\n332\n23.9 INKTOMI. Scaling the Internet. 333\n23.10 EMULEX. Lessons in high-speed speculation. 334\n23.11 AMAZON. Weekly. Internet dreams of glory. Documenting the great Internet \nbubble. Blow-off and hangover.\n335\n23.12 AMAZON. Daily. Details of the blow-off with some techniques to profit and not \nsuffer.\n335\n23.13 AMAZON. 2005. Rolls on. Biggest river in world. Not of profits. 336\n23.14 CISCO. Exercises in adroit speculation. 337\n23.15 CISCO. Zooming in on Cisco. 338\n23.16 GOOGLE. 2005. More fun than a googly on a sticky wicket. 339\n23.17 GOOGLE 2011. A herd of cash cows. 340\n24.1 CORN PRODUCTS REFINING COMPANY. Weekly, 1945 to 1946. Habits of a \nstock of low sensitivity.\n342\n24.1 SCHENLEY DISTILLERS. Weekly, 1945 to 1946. Habits of a stock of high \nsensitivity.\n342\n574 List of Illustrations and Text Diagrams\nFigure Page\n24.2 CUBAN-AMERICAN SUGAR. Weekly, 1945 to 1946. Habits of low-priced stock \nof fairly low sensitivity.\n343\n24.2 ELECTRIC BOAT. Weekly, 1945 to 1946. Habits of low-priced stock of somewhat \nhigher sensitivity.\n343\n28.1 AMERICAN CABLE & RADIO. Daily, last half of 1945 and beginning of 1946. \nPlacement and change of stop-order levels.\n362\n28.2 BASING POINTS. The most important chart in the book? 366\n28.3 BASING POINTS. Candlestick version. 369\n28.4 APPLE. Illustration of Basing Points in 1987 Reagan Crash. 370\n33.1 SOUTHERN PACIFIC. Daily, 6 months in 1946. Head-and- Shoulders Top, rally, \nand subsequent decline.\n394\n33.2 BRANIFF AIRWAYS. Daily, last half of 1945. Head-and- Shoulders Bottom, \nreactions, Ascending Triangle Consolidation and advancing trend.\n395\n33.3 ASSOCIATED DRY GOODS. Daily, first half of 1946. Rounding Top; also \nBroadening Consolidation.\n396\n33.4 GREYHOUND. Daily, last half of 1945. Rounding Bottom and advance with \nreactions to Support Levels.\n397\n33.5 ALLIED STORES. Daily, last half of 1946. Symmetrical Triangle Consolidation in \ndecline; also small Head-and-Shoulders Continuation Pattern.\n398\n33.6 CONTINENTAL MOTORS. Daily, last half of 1945. Ascending Triangle showing \nPullback to Support Level; also Symmetrical Triangle with reaction to apex.\n399\n33.7 CERTAINTEED PRODUCTS. Daily, 6 months in 1946. Broadening Top, showing \nrally following the breakout, and subsequent decline.\n400\n33.8 REMINGTON RAND. Daily, end of 1944, beginning of 1945. Series of Rectangles \nduring Bull Market Advance, and return moves to Support Levels.\n401\n33.9 PARAMOUNT PICTURES. Weekly, 1941 to 1943. Double Bottom, breakout, and \nreaction to Support before main advance.\n402\n33.10 ASSOCIATED DRY GOODS. Daily, first half of 1945. Right- Angled Broadening \nFormation and ensuing advance.\n403\n33.11 AMERICAN CAN. Daily, end of 1946, beginning of 1947. Diamond Formation at \ntop of Secondary rally.\n404\n33.12 GULF, MOBILE & OHIO. Daily, first 6 months of 1945. Intermediate Bottom and \nWedge.\n405\n33.13 MARTIN–PARRY. Daily, 6 months in 1945. Pennant, showing formation of \nConsolidation Pattern at halfway point in advance.\n406\n33.14 LEHIGH VALLEY RAILROAD. Daily, end of 1945, beginning of 1946. Gaps of \nvarious types.\n407\n33.15 NORTHERN PACIFIC. Daily, 6 months in 1944. Support and Resistance \nphenomena; also showing Symmetrical Triangle and reaction to apex, and small \nRectangle.\n412\n33.16 AMERICAN STEEL FOUNDRIES. Daily, 6 months in 1947. Parallel Trend \nChannels in Primary and Secondary directions.\n413\n36.1 DOW INDUSTRIALS. 150-day moving average. Editor’s choice. 424\n36.2 Freeburg’s PENTAD system. 425\n37.1 U.S. SMELTING, REFINING & MINING. Weekly, 1951 to 1953, showing \nAscending Triangle and Head-and-Shoulders Top.\n428\n575List of Illustrations and Text Diagrams\nFigure Page\n37.2 INSPIRATION CONSOLIDATED COPPER. Downtrend and break through \nMajor Support.\n429\n37.3 GRANITE CITY STEEL. Rectangle and Support–Resistance phenomena in 1956 \nuptrend.\n430\n37.4 MASONITE. 1956 downtrend showing Support–Resistance phenomena. 431\n37.5 DELAWARE, LACKAWANNA & WESTERN. Rectangle and uptrend. 1954 to \n1955.\n432\n37.6 AMERICAN LOCOMOTIVE. Rectangle with false move, and subsequent upside \nbreakout and advance.\n433\n37.7 FANSTEEL METALLURGICAL. Weekly, 1955 to 1956. Sh", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 261}
{"text": "429\n37.3 GRANITE CITY STEEL. Rectangle and Support–Resistance phenomena in 1956 \nuptrend.\n430\n37.4 MASONITE. 1956 downtrend showing Support–Resistance phenomena. 431\n37.5 DELAWARE, LACKAWANNA & WESTERN. Rectangle and uptrend. 1954 to \n1955.\n432\n37.6 AMERICAN LOCOMOTIVE. Rectangle with false move, and subsequent upside \nbreakout and advance.\n433\n37.7 FANSTEEL METALLURGICAL. Weekly, 1955 to 1956. Showing Ascending \nTriangle, reactions to Support, and eventual uptrend.\n434\n37.8 TEXTRON. 1956 to 1957. Descending Triangle, with sharp decline after the \nbreakout.\n435\n37.9(a) LIBBY, McNEILL & LIBBY. Monthly, 1927 to 1930. Showing continuance of \nBullish Trend into 1930.\n436\n37.9(b) CHRYSLER. Monthly, 1927 to 1930. Showing Major Top in 1928 and the collapse \nduring the early months of 1929.\n436\n37.9(c) EAGLE–PICHER LEAD. Monthly, 1927 to 1930. Generally Bearish Major Trend. 436\n37.10(a) WEST INDIES SUGAR. Monthly, 1953 to 1956. Showing continuance of Bullish \nTrend through 1956.\n437\n37.10(b) WESTINGHOUSE ELECTRIC. Monthly, 1953 to 1956. Showing Major Top in \n1955 and the collapse during the early months of 1956.\n437\n37.10(c) S.S. KRESGE. Monthly, 1953 to 1956. Generally Bearish Major Trend. 437\n37.11 NORTHROP AIRCRAFT. 1954 to 1955. Descending Triangle at an important top. 438\n37.12 NORTHROP AIRCRAFT. 1956 to 1957. Ascending Triangle and upside breakout. 439\n37.13 CHICAGO, MILWAUKEE, ST. PAUL & PACIFIC. The magnificent uptrend of \n1954 to 1955 with numerous Support–Resistance and Area Pattern features.\n440\n37.14 WESTINGHOUSE ELECTRIC & MANUFACTURING COMPANY. Downside \ntrend in the early stages of the 1955 to 1956 collapse.\n442\n37.15 OTIS ELEVATOR. 1954 to 1955. Showing a full year of a typical daily chart on \nTEKNIPLAT charting paper. Shows a long Triangle Consolidation, eventually \nfollowed by a continuation of the Major Advance.\n443\n37.16 The DOW–JONES INDUSTRIAL AVERAGE. Daily chart showing the \nBroadening Top established in May to August 1957.\n444\n37.17 The DOW–JONES INDUSTRIAL AVERAGE. Daily chart showing the \nBroadening Top established in 1999–2000.\n445\n37.18 INDUSTRIAL RAYON CORPORATION. Showing Bearish action of a stock \nthrough the entire year 1957. Daily chart.\n446\n37.19 LORILLARD. Showing Bullish action of a stock through the entire year, 1957. \nDaily chart.\n447\n37.20 AVNET ELECTRONICS CORPORATION. May through October 1961, showing \nBearish Trend during a time when the market Averages were strong. Daily \nchart.\n448\n37.21 BURNDY CORPORATION. April to September 1961. Classic Head-and-\nShoulders Top and rallies to neckline. Daily chart.\n449\n37.22 BRUNSWICK CORPORATION. Showing the end of the great Bull Market Move \nin this stock, and the decline which followed. 1960 to 1962. Weekly chart.\n450\n576 List of Illustrations and Text Diagrams\nFigure Page\n37.23 POLAROID. First 6 months of 1962. Long Rectangle followed by a precipitous \ndrop after penetration of Support. Daily chart.\n451\n37.24 COPPER RANGE. First 6 months of 1962. Head-and-Shoulders Top with \ndown-sloping neckline. Daily chart.\n452\n37.25 U.S. SMELTING, REFINING & MINING. April through September, 1962. \nHead-and-Shoulders Bottom, breakout, reaction, and advance. Daily chart.\n453\n37.26 The DOW–JONES INDUSTRIAL AVERAGE. Weekly, July 1961 through June \n1962. The massive Head-and-Shoulders Pattern preceding the 1962 break.\n454\n37.27 ABC VENDING CORPORATION. Daily, April to September 1963. Head-and-\nShoulders Top and Major Downtrend.\n455\n37.28 CERRO CORPORATION. Daily, January to June 1963. Symmetrical Triangle and \nuptrend, showing reaction to “cradle point.”\n456\n37.29 CRUCIBLE STEEL. Daily, March to August 1963. Ascending Triangle, showing \nBreakaway Gap.\n457\n37.30 SUPERIOR OIL. June to November 1962. Showing an important Double Bottom, \nwhich became the base for a Major Advance.\n458\n37.31 GENERAL STEEL INDUSTRIES. Daily, November 1962 to April 1963. Example \nof a Major Uptrend with normal reactions.\n459\n37.32 UNITED ARTISTS. Daily, February to August 1963. A Major Downtrend, \ndemonstrating Resistance Levels during the decline.\n460\n37.33 UTAH–IDAHO SUGAR COMPANY. January to June 1963. Breakout and rapid \nadvance appearing suddenly in a normally dull stock.\n461\n37.34 CONTROL DATA CORPORATION. Daily, February to August 1965. Example of \na Wedge with downside breakout and Major Collapse.\n462\n37.35 U.S. SMELTING, REFINING & MINING. Daily, July to December 1965. Breakout \nfrom dormancy, Major Advance, showing Symmetrical Triangle Consolidation.\n463\n37.36 LIVINGSTON OIL COMPANY. Weekly, January 1965 into January 1966. \nDownside Major Trend, Symmetrical Triangle Bottom, Major Reversal to \nuptrend.\n464\n37.37 PACKARD–BELL ELECTRONICS. Daily, August 1965 to January 1966. Flag \nshowing “Half-Mast” situation, and a large Ascending Triangle with powerful \nbreakout move on the upside.\n465\n37.38 PARKE, DAVIS & COMPANY. Daily, July 1969 to June 1970. This could be \nregarded as a very flat Head-and-Shoulders Top, or as a long Rounding Top.\n466\n37.39 ASTRODATA, INC. Daily, October 1969 through February 1970. A complete \ncollapse; then reopens 20 points lower.\n467\n37.40 ORACLE. Lest one think that the air pocket gap does not still exist, here is an \nexample from the turn of the century (third millennium).\n468\n37.41 PUBLIC SERVICE ELECTRIC & GAS. Monthly, 1969 through 1970. A typical \nelectric and gas utility stock.\n469\n37.42 MEMOREX CORPORATION. Daily, September 1969 through May 1970. Last \n“Bull” fling for Memorex before gapping down with volume in February 1970.\n470\n37.43 FLYING TIGER CORPORATION. Monthly, October, 1969 through 1971. From \nthe 1967 high of 48½, “FLY” started a downtrend that lasted 2 years and took \nthe stock down to 11¼.\n471\n37.44 ACTION INDUSTRIES. Daily, November 1971 to April 1972. A large Ascending \nTriangle formed after an advance of 90%, and followed by a breakout and a \nfurther advance practically duplicating the first one in percentage gain.\n472\n577List of Illustrations and Text Diagrams\nFigure Page\n37.45 DELL COMPUTER. From", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 262}
{"text": "8½, “FLY” started a downtrend that lasted 2 years and took \nthe stock down to 11¼.\n471\n37.44 ACTION INDUSTRIES. Daily, November 1971 to April 1972. A large Ascending \nTriangle formed after an advance of 90%, and followed by a breakout and a \nfurther advance practically duplicating the first one in percentage gain.\n472\n577List of Illustrations and Text Diagrams\nFigure Page\n37.45 DELL COMPUTER. From nothing (a college dorm) to something. 473\n37.46 DELL. Air pockets return. 474\n37.47 INTEL. The heart of the Microsoft computer. Compare MSFT. 474\n37.48 NOKIA. The story of the communications revolution. 475\n37.49 AMD. Intel’s counterpart. 475\n37.50 YAHOO. Internet rocket fuel. 476\n37.51 YAHOO 2005. After the tulipomania. 477\n37.52 APPLE COMPUTER. The revenge of Steve Jobs. 478\n37.53 APPLE 2005. The press’ whipping stock strikes back. 479\n37.54 NDX. A ten year trade using Basing Points. 480\nA.1 Important swings of the DOW–JONES INDUSTRIAL AND RAIL AVERAGES, \n1941 through 1946.\n508\nA.2 The DOW–JONES INDUSTRIAL AND RAIL AVERAGES. Daily closing prices \nand total market volume, February 1 to August 31, 1941.\n509\nA.3 The DOW–JONES INDUSTRIAL AND RAIL AVERAGES. Daily closing prices \nand total market volume, March 2 to October 31, 1942.\n510\nA.4 The DOW–JONES INDUSTRIAL AND RAIL AVERAGES. Daily closing prices \nand total market volume, November 2, 1942, to June 30, 1943.\n511\nA.5 The DOW–JONES INDUSTRIAL AND RAIL AVERAGES. Daily closing prices \nand total market volume, July 1, 1943, to January 31, 1944.\n512\nA.6 The DOW–JONES INDUSTRIAL AND RAIL AVERAGES. Daily closing prices \nand total market volume, May 1 to November 30, 1945.\n514\nA.7 The DOW–JONES INDUSTRIAL AND RAIL AVERAGES. Daily closing prices \nand total market volume, May 1, 1945, to November 30, 1945.\n516\nA.8 The DOW–JONES INDUSTRIAL AND RAIL AVERAGES. Daily closing prices\nand total market volume, December 1, 1945, to May 31, 1946.\n518\nA.9 The DOW–JONES INDUSTRIAL AND RAIL AVERAGES. Daily closing prices \nand total market volume, May 4 to October 19, 1946.\n520\n578 List of Illustrations and Text Diagrams\nText Diagrams\nThe charts listed as Figures all represent actual market history. In contradistinction, the \ndiagrams listed below do not depict real trading history, but have been specially drawn as \nsimplified, hypothetical market situations to facilitate the explanation of certain trading \nprinciples. EN: Certain of these rather than drawings are exhibits of other interest.\nDiagram Page\n3.1 Hypothetical daily chart illustrating the failure of one average to confirm the other \nin making a Dow Theory signal.\n16\n6.1 How a Head-and-Shoulders Top reversal pattern forms. The essential elements. 45\n29.1 Trendline in rising market and parallel to it. (Referred to as Red Trendline and Red \nParallel.)\n374\n29.2 Return line in rising market and parallel to it. (Referred to as Blue Trendline and \nBlue Parallel.)\n374\n29.3 Trendline in declining market and parallel to it. (Referred to as Blue Trendline and \nBlue Parallel.)\n374\n29.4 Return line in declining market and parallel to it. (Referred to as Red Trendline and \nRed Parallel.)\n375\n29.5 Example of trend action, showing decline, reversal, consolidation, advance, top, \nand downside breakout.\n375\n29.6 Diagrams of the principal preliminary buying signals as shown by trend action. 376\n29.6 Diagrams of the principal preliminary signals for short sales as shown by trend \naction.\n377\n38.1 The Evaluative Index. Weekly, 1961, January through December 1961. 483\n38.2 Evaluative Index from Magee Market Letters. 485\nB.1 Formula for Calculating Volatility. 528\nB.2 Risk Analysis. 529\nB.3 Profit Analysis. 530\nTables\n1 The Dow Theory’s 60 Year Record. 43\n1.1 The Dow Theory’s Record to 2005 Longs Only. 45\n1.2 The Dow Theory’s Record to 2005 Longs and Shorts. 48\n579\nAlphabetic Index of Stock Charts\nFigure Stock Name Summary Description of Chart Page\n23.7 3COM. Underwriters cleverly only threw 3% of \n3Com-owned Palm stock onto the market at \nthe IPO.\n331\n12.9 A.O. SMITH \nCORPORATION.\nA technically significant (Runaway) Gap in \n1946 decline. Weekly chart.\n180\n37.27 ABC VENDING \nCORPORATION.\nDaily, April to September 1963. Head-and-\nShoulders Top and Major Downtrend.\n455\n37.44 ACTION INDUSTRIES. Daily, November 1971 to April 1972. A large \nAscending Triangle formed after an advance \nof 90%, and followed by a breakout and a \nfurther advance practically duplicating the \nfirst one in percentage gain.\n472\n10.2 AIR REDUCTION. The classic Broadening Top of 1929. 123\n10.8 ALLIED STORES. Flat-topped Broadening Pattern of 1945, and \nBreakout Gaps.\n126\n33.5 ALLIED STORES. Daily, last half of 1946. Symmetrical Triangle \nConsolidation in decline; also small Head-\nand-Shoulders Continuation Pattern.\n398\n11.11 ALTRIA GROUP (MO). 2005 gaps and flags galore. Chartist’s joy. 162\n23.11 AMAZON. Weekly. Internet dreams of glory. \nDocumenting the great Internet bubble. \nBlow-off and hangover.\n335\n23.12 AMAZON. Daily. Details of the blow-off with some \ntechniques to profit and not suffer.\n335\n23.13 AMAZON. 2005. Rolls on. Biggest river in world. Not of \nprofits.\n336\n37.49 AMD. Intel’s counterpart. 475\n7.12 AMDAHL \nCORPORATION.\nComplex Head-and-Shoulders Bottom, 1984. 65\n11.14 AMERICAN & \nFOREIGN POWER 2D \nPFD.\nA Head-and-Shoulders Consolidation Pattern \nof 1945.\n164\n7.16 AMERICAN & \nFOREIGN POWER 2ND \nPFD.\nA Rounding Bottom formed in 1945. 68\n9.14 AMERICAN AIRLINES. Weekly Chart. Bull Market Top of 1945 to 1946, \na form of Double Top.\n113\n580 Alphabetic Index of Stock Charts\nFigure Stock Name Summary Description of Chart Page\n8.12 AMERICAN BANK \nNOTE.\nThe Major Bottom Reversal of 1941 to 1942. 85\n10.10 AMERICAN BOSCH \nCORPORATION.\nA Diamond Pattern in 1945 which functioned \nas a Consolidation.\n127\n28.1 AMERICAN CABLE & \nRADIO.\nPlacement and change of stop-order levels. 362\n33.11 AMERICAN CAN. Daily, end of 1946, beginning of 1947. \nDiamond Formation at top of Secondary rally.\n404\n15.10 AMERICAN CAR & \nFOUNDRY.\nUp-curving Bull Trend of heavy industry \ni", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 263}
{"text": "r Bottom Reversal of 1941 to 1942. 85\n10.10 AMERICAN BOSCH \nCORPORATION.\nA Diamond Pattern in 1945 which functioned \nas a Consolidation.\n127\n28.1 AMERICAN CABLE & \nRADIO.\nPlacement and change of stop-order levels. 362\n33.11 AMERICAN CAN. Daily, end of 1946, beginning of 1947. \nDiamond Formation at top of Secondary rally.\n404\n15.10 AMERICAN CAR & \nFOUNDRY.\nUp-curving Bull Trend of heavy industry \nissues. Monthly chart, 1938 to 1946.\n234\n7.8 AMERICAN \nLOCOMOTIVE.\nExtended top of Multiple type, 1946. 63\n11.12 AMERICAN \nLOCOMOTIVE.\nA Flag in 1935 which appeared to fail but \nfinally came through.\n163\n37.6 AMERICAN \nLOCOMOTIVE.\nRectangle with false move, and subsequent \nupside breakout and advance.\n433\n8.23 AMERICAN ROLLING \nMILL.\nThe “hybrid” pattern of ascending type which \nformed in 1941 to 1943. Weekly chart.\n94\n10.3 AMERICAN ROLLING \nMILL.\nSmall Broadening Top of 1946 at the end of a \ngenerally broadening (and Bearish) \nFormation.\n124\n7.17 AMERICAN SAFETY \nRAZOR.\nMonthly chart. Two Major Bottoms — a \nHead-and-Shoulders in 1932 and “Bowl” in \n1942.\n69\n33.16 AMERICAN STEEL \nFOUNDRIES.\nDaily, 6 months in 1947. Parallel Trend \nChannels in Primary and Secondary \ndirections.\n413\n12.1 AMERICAN WATER \nWORKS & ELECTRIC.\nCommon or Pattern Gaps in a Rectangle; \nRunaway Gap and Flag. 1945.\n172\n11.10 AMERICAN WOOLEN. Perfect “Half-Mast” Pattern in 1946, with gaps \nand Ascending Triangle.\n161\n9.7 AMERICAN ZINC, \nLEAD & SMELTING.\nThe Consolidation Rectangle which followed a \nHead-and-Shoulders Top in 1946.\n108\n11.13 ANACONDA COPPER. Head-and-Shoulders Consolidations in 1936, \nand measuring Flag.\n164\n11.6 ANACONDA COPPER. Wedge or Pennant, Flag and Runaway Caps in \n1936–37.\n157\n37.52 APPLE. The press’ whipping stock strikes back. 2005. 478\n37.53 APPLE. The revenge of Steve Jobs. 479\n10.19 APPLE. Panic selling and climax in Apple, 1987 Crash. 135\n7.23 APPLIED MAGNETIC \nCORPORATION.\n1988. Saucer-like Pattern. 73\n7.10 ARCHER DANIELS \nMIDLAND COMPANY.\n1984. Complex Head-and-Shoulders Bottom. 64\n14.14 ARKANSAS BEST. Fan and Head-and-Shoulders Bottom. 1987. 218\n8.17 ARMOUR & COMPANY. Long Ascending Triangle in 1946 to 1947 in \nwhich distribution eventually overcame \nupward trend.\n88\n581Alphabetic Index of Stock Charts\nFigure Stock Name Summary Description of Chart Page\n33.3 ASSOCIATED DRY \nGOODS.\nDaily, first half of 1946. Rounding Top; also \nBroadening Consolidation.\n396\n33.10 ASSOCIATED DRY \nGOODS.\nDaily, first half of 1945. Right- Angled \nBroadening Formation and ensuing advance.\n403\n10.6 ASSOCIATED \nDRYGOODS.\nRight-Angled Broadening Formation with \nhorizontal Top, 1945.\n125\n37.39 ASTRODATA, INC. Daily, October 1969 through February 1970. A \ncomplete collapse; then reopens 20 points \nlower.\n467\n14.2 ATCHISON, TOPEKA & \nSANTA FE.\nAcceleration of Intermediate Uptrend in 1936. \nSupport Levels.\n209\n14.1 ATLANTIC REFINING. Basic Intermediate Trendlines on weekly chart, \n1944 to 1947.\n208\n37.20 AVNET ELECTRONICS \nCORPORATION.\nMay through October 1961, showing Bearish \nTrend during a time when the market \nAverages were strong. Daily chart.\n448\n14.17 BACYRUS ERIE. 1984 Excellent Fan Pattern. 220\n12.10 BALTIMORE & OHIO \nPFD.\nSmall Island in right shoulder of Major \nHead-and-Shoulders Top. 1946.\n180\n12.6 BALTIMORE & OHIO. The measuring formula applied to a Runaway \nGap in early 1937.\n177\n22.1 BALTIMORE & OHIO. Weekly, first 6 months of 1945, showing \ntendency of a low-priced stock to make wide \nswings in a general market move.\n320\n14.15 BARBER ASPHALT. Application of three-fan principle to Bull \nMarket Reaction. 1946.\n219\n28.1\n28.2\n28.3\n28.4\nBASING POINTS.\nBASING POINTS, V2\nBASING POINTS, V2\nBASING POINTS, V2\nThe most important chart in the book?\nBasing Points illustrations showing both \nwavelow stops and new high stops\n362\n366\n369\n370\n8.19 BATH IRON WORKS. Descending Triangle Top of 1946, showing \nadjustment of pattern lines for Ex-Dividend \nGap.\n90\n9.9 BELL AIRCRAFT. Ex-dividend drop causing apparent false move \nout of Rectangle in 1945.\n109\n13.2 BENDIX AVIATION. Support–Resistance Levels in an Intermediate \nUptrend. 1944 to 1945.\n194\n12.12 BETHLEHEM STEEL. Unusual Island Reversal at the 1937 Bull Top. 182\n14.7 BETHLEHEM STEEL. Trend Channels and Rectangle. 1945. 213\n12.2 BETHLEHEM STEEL. Three types of Breakaway Gap. 1937. 173\n12.5 BLAW–KNOX. Gaps following long Rectangle in early 1946, \nand Major Double Top.\n176\n33.2 BRANIFF AIRWAYS. Daily, last half of 1945. Head-and- Shoulders \nBottom, reactions, Ascending Triangle \nConsolidation and advancing trend.\n395\n8.14 BRIGGS \nMANUFACTURING.\nWeekly chart of 1941 to 1943 showing \nTriangular Bottom of ascending type.\n86\n582 Alphabetic Index of Stock Charts\nFigure Stock Name Summary Description of Chart Page\n11.5 BRIGGS \nMANUFACTURING.\nBull and Bear Flags and Symmetrical Triangle \nTop in 1936. Support–Resistance phenomena.\n156\n37.22 BRUNSWICK \nCORPORATION.\nShowing the end of the great Bull Market \nMove in this stock, and the decline which \nfollowed. 1960 to 1962. Weekly chart.\n450\n7.18 BUDD COMPANY. Monthly chart showing Major Rounding \nBottom of 1942.\n70\n7.7 BUDD \nMANUFACTURING\n(now The Budd Company). Multiple Head-\nand-Shoulders Top of 1946.\n62\n37.21 BURNDY \nCORPORATION.\nApril to September 1961. Classic Head-and-\nShoulders Top and rallies to neckline. Daily \nchart.\n449\n17.3 CBOT DOW INDEX \nFUTURES AND \nDIAMONDS.\nHedging DIAMONDS with index futures \nillustrated.\n278\n17.4 CBOT DOW INDEX \nFUTURES AND \nOPTIONS ON \nFUTURES.\nUsing options and futures to control portfolio \nrisk.\n282\n8.13 CELANESE \nCORPORATION.\nAscending Triangle of consolidation type in \n1946.\n85\n15.11 CELOTEX. Accelerating uptrend of a low-priced building \nsupply stock. Monthly chart, 1938 to 1946.\n235\n37.28 CERRO \nCORPORATION.\nDaily, January to June 1963. Symmetrical \nTriangle and uptrend, showing reaction to \n“cradle point.”\n456\n33.7 CERTAINTEED \nPRODUCTS.\nDaily, 6 months in 1946. Broadening Top, \nshowing rally following the breakout, and \nsubsequent decline.\n400\n7.19 CERTAINTEED \nPRODUCTS.\nMonthly chart. Maj", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 264}
{"text": "ting uptrend of a low-priced building \nsupply stock. Monthly chart, 1938 to 1946.\n235\n37.28 CERRO \nCORPORATION.\nDaily, January to June 1963. Symmetrical \nTriangle and uptrend, showing reaction to \n“cradle point.”\n456\n33.7 CERTAINTEED \nPRODUCTS.\nDaily, 6 months in 1946. Broadening Top, \nshowing rally following the breakout, and \nsubsequent decline.\n400\n7.19 CERTAINTEED \nPRODUCTS.\nMonthly chart. Major Rounding Bottom of \n1942.\n70\n37.17 CHICAGO, \nMILWAUKEE, ST. PAUL \n& PACIFIC.\nThe magnificent uptrend of 1954 to 1955 with \nnumerous Support–Resistance and Area \nPattern features.\n440\n6.2 CHICAGO, \nMILWAUKEE, ST. PAUL \n& PACIFIC.\nThe Head- and-Shoulders Top Formation \nwhich ended its Bull Market in February \n1946.\n46\n37.9 CHRYSLER. Monthly, 1927 to 1930. Showing Major Top in \n1928 and the collapse during the early \nmonths of 1929.\n436\n23.14 CISCO. Exercises in adroit speculation. 337\n23.15 CISCO. Zooming in on Cisco. 338\n15.12\n16.12\nCLAUDE NEON.\nCOFFEE 1994\n(Curb Exchange). Strongly up-curved Bull \nTrend of a low-priced, highly speculative \nissue. Monthly chart, 1938 to 1946.\nA perfect flag and spike reversal.\n235\n256\n14.4 COMMERCIAL \nSOLVENTS.\nIntermediate Downtrend and Uptrend in 1946. 211\n583Alphabetic Index of Stock Charts\nFigure Stock Name Summary Description of Chart Page\n11.16 COMMONWEALTH \nEDISON.\nScalloping trend of an investment stock, 1945. 165\n15.5 COMMONWEALTH \nEDISON.\nStraight-line Bull Trend of investment type \nutility. Monthly chart, 1938 to 1946.\n232\n6.7 CONSOLIDATED \nEDISON.\nThe Head-and-Shoulders Reversal of 1937. 50\n14.11 CONSOLIDATED \nVULTEE.\nPart of a two-year Uptrend Channel. 1945. 215\n9.15 CONTAINER \nCORPORATION.\nThe Major Double Bottom of 1941 to 1943. \nWeekly chart.\n114\n33.6 CONTINENTAL \nMOTORS.\nDaily, last half of 1945. Ascending Triangle \nshowing Pullback to Support Level; also \nSymmetrical Triangle with reaction to apex.\n399\n37.34 CONTROL DATA \nCORPORATION.\nDaily, February to August 1965. Example of a \nWedge with downside breakout and Major \nCollapse.\n462\n37.24 COPPER RANGE. First 6 months of 1962. Head-and-Shoulders \nTop with down-sloping neckline. Daily chart.\n452\n24.1 CORN PRODUCTS \nREFINING COMPANY.\nWeekly, 1945 to 1946. Habits of a stock of low \nsensitivity.\n342\n15.14 CORN PRODUCTS \nREFINING COMPANY.\nTypical Major Uptrend of food group. Monthly \nchart, 1938 to 1946.\n236\n16.2 COTTON FUTURES. Familiar technical action in a futures chart (5th \ned.).\n247\n10.1 CRANE COMPANY. Broadening Formation of 1945 to 1946, a \nwarning of final top.\n122\n14.3 CRANE COMPANY. Short-term trendlines in 1945, and examples of \nchannel “failure” and Pullback.\n210\n7.24 CRAY RESEARCH. 1987. Gap and Rounding Top. 74\n16.9 CRB INDEX 2005. A futures triangle with breakout. 254\n16.10 CRB INDEX 2005. The long term view, with double bottom. 255\n37.29 CRUCIBLE STEEL. Daily, March to August 1963. Ascending \nTriangle, showing Breakaway Gap.\n457\n8.5 CUBAN-AMERICAN \nSUGAR.\nA Rounding Bottom in 1945 which merged \ninto a Symmetrical Triangle.\n81\n24.2 CUBAN-AMERICAN \nSUGAR.\nWeekly, 1945 to 1946. Habits of low-priced \nstock of fairly low sensitivity.\n343\n18.1 CUDAHY PACKING. Head-and-Shoulders Reversal at the Major Top \nin 1928.\n294\n15.3 CURTIS PUBLISHING $7 \nPFD.\nTypical decurving Bull Trend of preferred \nstocks. Monthly chart, 1938 to 1946.\n231\n15.4 CURTIS PUBLISHING \nCOMMON.\nAccelerating Bull Trend of low-priced, \nspeculative common stocks. Monthly chart, \n1938 to 1946.\n231\n8.4 DELAWARE & \nHUDSON.\nWeekly chart. Wide-swinging Symmetrical \nTriangle Bottom of 1941 to 1942 with \nThrowback to apex Support.\n80\n584 Alphabetic Index of Stock Charts\nFigure Stock Name Summary Description of Chart Page\n14.16 DELAWARE & \nHUDSON.\nApplication of three-fan principle to Bull \nMarket Reaction. 1944.\n219\n37.5 DELAWARE, \nLACKAWANNA & \nWESTERN.\nRectangle and uptrend. 1954 to 1955. 432\n37.45 DELL. From nothing (a college dorm) to something. 473\n37.46 DELL. A weekly look. 474\n7.9 DIGITAL EQUIPMENT \nCORPORATION.\n1985. From a Head- and-Shoulders Top to \nComplex Head-and-Shoulders Bottom.\n63\n7.2 DOME MINES. Weekly chart showing the Major Head-and- \nShoulders Bottom of 1942.\n59\n10.21 DOW-JONES \nINDUSTRIAL \nAVERAGE.\n1987 Reagan Crash. 137\nA.1 DOW–JONES \nINDUSTRIAL AND \nRAIL AVERAGES.\nImportant swings of the 1941 through 1946. 508\nA.3\nFM.1\nDOW–JONES \nINDUSTRIAL AND \nRAIL AVERAGES.\nDOW-JONES \nINDUSTRIAL AND \nRAIL AVERAGES OW\nDaily closing prices and total market volume, \nMarch 2 to October 31, 1942.\nThe historic bull market of 2009–2018.\n510\nv\nA.4 DOW–JONES \nINDUSTRIAL AND \nRAIL AVERAGES.\nDaily closing prices and total market volume, \nNovember 2, 1942, to June 30, 1943.\n511\nA.8 DOW–JONES \nINDUSTRIAL AND \nRAIL AVERAGES.\nDaily closing prices and total market volume, \nDecember 1, 1945 to May 31, 1946.\n518\nA.2 DOW–JONES \nINDUSTRIAL AND \nRAIL AVERAGES.\nDaily closing prices and total market volume, \nFebruary 1 to August 31, 1941.\n509\nA.5 DOW–JONES \nINDUSTRIAL AND \nRAIL AVERAGES.\nDaily closing prices and total market volume, \nJuly 1, 1943, to January 31, 1944.\n512\nA.6 DOW–JONES \nINDUSTRIAL AND \nRAIL AVERAGES.\nDaily closing prices and total market volume, \nMay 1 to November 30, 1945.\n514\nA.7 DOW–JONES \nINDUSTRIAL AND \nRAIL AVERAGES.\nDaily closing prices and total market volume, \nMay 1 to November 30, 1945.\n516\n6.12 DOW–JONES \nINDUSTRIAL \nAVERAGE\n2007–2008 top with large head-and-shoulders 54\n585Alphabetic Index of Stock Charts\nFigure Stock Name Summary Description of Chart Page\n5.2\n5.3\n5.1\nDOW–JONES \nINDUSTRIAL \nAVERAGE.\nDOW–JONES \nINDUSTRIAL \nAVERAGE.\nDOW–JONES \nINDUSTRIAL \nAVERAGE.\nmarked with Dow Theory signals and Magee \nProcedure signals from 1924–34\nmarked with Dow Theory signals and Magee \nProcedure signals from 1900–2011\n2007–2008 top illustrating various analytical \nmethods\n39\n40\n38\n7.5 DOW–JONES \nINDUSTRIAL \nAVERAGE.\nKilroy (H&S) Bottom. 61\n10.12 DOW–JONES \nINDUSTRIAL \nAVERAGE.\n1999–2000 Diamond. 129\n15.16 DOW–JONES \nINDUSTRIAL \nAVERAGE.\nMonthly chart, 1924 through 1937, showing \nthe unique straight downtrend developed by \nthe", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 265}
{"text": "rom 1924–34\nmarked with Dow Theory signals and Magee \nProcedure signals from 1900–2011\n2007–2008 top illustrating various analytical \nmethods\n39\n40\n38\n7.5 DOW–JONES \nINDUSTRIAL \nAVERAGE.\nKilroy (H&S) Bottom. 61\n10.12 DOW–JONES \nINDUSTRIAL \nAVERAGE.\n1999–2000 Diamond. 129\n15.16 DOW–JONES \nINDUSTRIAL \nAVERAGE.\nMonthly chart, 1924 through 1937, showing \nthe unique straight downtrend developed by \nthe 1929 to 1932 Bear Market.\n238\n15.19-20-\n21\nDOW–JONES \nINDUSTRIAL \nAVERAGE.\nThree Bull Market tops. 240\n36.1 DOW–JONES \nINDUSTRIAL \nAVERAGE.\n150day moving average. Editor’s choice. 424\n37.16 DOW–JONES \nINDUSTRIAL \nAVERAGE.\nDaily chart showing the Broadening Top \nestablished in May to August 1957.\n444\n37.17 DOW–JONES \nINDUSTRIAL \nAVERAGE.\nDaily chart showing the Broadening Top \nestablished in 1999–2000.\n445\n37.26 DOW–JONES \nINDUSTRIAL \nAVERAGE.\nWeekly, July 1961 through June 1962. The \nmassive Head-and-Shoulders Pattern \npreceding the 1962 break.\n454\n6.6 DUPONT. Its Major Top in 1936, with an unusual \nPullback.\n50\n37.9 EAGLE–PICHER LEAD. Monthly, 1927 to 1930. Generally Bearish \nMajor Trend.\n436\n8.9 EASTERN AIRLINES. A Symmetrical Triangle in 1947 that did not \ncarry through.\n83\n9.6 EASTERN AIRLINES. Long Consolidation ending in Rectangle in \nearly 1945.\n107\n8.25 EBAY. 2004 Descending Triangle Surprise. 96\n10.25 EBAY. As Ebay broke its trendline and drifted \nsideways it became a good subject for \nreversal day trading.\n140\n586 Alphabetic Index of Stock Charts\nFigure Stock Name Summary Description of Chart Page\n10.26 EBAY. 2004–5 Astonishing Ebay breaks away on \nwings of great business.\n141\n24.2 ELECTRIC BOAT. Weekly, 1945 to 1946. Habits of low-priced \nstock of somewhat higher sensitivity.\n343\n23.10 EMULEX. Lessons in high-speed speculation. 334\n18.3 ENRON. The most fundamental lesson. 2005. 298\n37.7 FANSTEEL \nMETALLURGICAL.\nWeekly, 1955 to 1956. Showing Ascending \nTriangle, reactions to Support, and eventual \nuptrend.\n434\n7.3 FEDERAL NATIONAL \nMORTGAGE \nASSOCIATION.\n1984. Head-and-Shoulders Bottom. 60\n11.18 FLINTKOTE. Consolidation Formation — a Symmetrical \nTriangle — providing signal of Primary \nReversal.\n167\n37.47 FLYING TIGER \nCORPORATION.\nMonthly, October, 1969 through 1971. From the \n1967 high of 481/2, “FLY” started a \ndowntrend that lasted 2 years and took the \nstock down to 111/4.\n471\n7.21 GAMEWELL \nCOMPANY.\nThe Rounding Bottom of 1932 showing a \ntemporary rally out of pattern.\n72\n7.11 GENERAL BRONZE. Multiple type Bottom formed July–September \n1945.\n64\n15.1 GENERAL MOTORS. Straight-line Bull Trend. Monthly chart, 1938 \nto 1946.\n230\n37.31 GENERAL STEEL \nINDUSTRIES.\nDaily, November 1962 to April 1963. Example \nof a Major Uptrend with normal reactions.\n459\n16.3\n16.4\nGOLD 2005.\nGOLD 2011\nA great rounding bottom? Foretelling?\nShowing how the great rounding bottom was \nfulfilled.\n248\n249\n8.24 GOODRICH (B.F) \nCOMPANY.\nThe remarkably small but perfect Ascending \nTriangle which reversed its Major Trend in \n1942. Weekly chart.\n95\n20.1 GOODYEAR TIRE $5 \nPFD.\nMonthly, 1943 to 1947, showing stability of a \nconservative preferred stock of the same \ncompany in the same period.\n308\n20.2 GOODYEAR TIRE \nCOMMON.\nMonthly, 1943 to 1947, showing rapid advance \nof a somewhat speculative common stock \nduring a Bull Market.\n308\n13.9 GOODYEAR TIRE. Four Pullbacks to neckline of Head-and- \nShoulders Top. Weekly chart, 1945 to 1947.\n203\n23.16\n23.17\nGOOGLE.\nGOOGLE.\n2005. More fun than a googly on a sticky \nwicket.\nIllustrating the follow up story in Google\n339-340\n37.3 GRANITE CITY STEEL. Rectangle and Support–Resistance phenomena \nin 1956 uptrend.\n430\n10.18 GREYHOUND. A conspicuous One-Day Reversal at the 1946 \nBull high.\n134\n587Alphabetic Index of Stock Charts\nFigure Stock Name Summary Description of Chart Page\n33.4 GREYHOUND. Daily, last half of 1945. Rounding Bottom and \nadvance with reactions to Support Levels.\n397\n33.12 GULF, MOBILE & OHIO. Daily, first 6 months of 1945. Intermediate \nBottom and Wedge.\n405\n15.7 HOUSTON OIL. Accelerating trend of a speculative oil stock. \nMonthly chart, 1938 to 1946.\n233\n8.1 HUDSON BAY MINING \nAND SMELTING.\nMajor Bottom of 1941 to 1942, a perfect \nSymmetrical Triangle. Weekly chart.\n78\n8.22 HUDSON MOTORS. Series of Triangles in the 1929–32 Bear Market. \nWeekly chart.\n93\n10.13 HUDSON MOTORS. The 1946 Major Top, a Diamond or Complex \nHead-and-Shoulders.\n130\n15.2 HUDSON MOTORS. Up-curving Bull Trend. Monthly chart, 1938 to \n1946.\n230\n18.2 HUDSON MOTORS. Daily chart from January through June 1930, \nshowing large Descending Triangle, also \nSymmetrical Triangle Consolidation during \ndecline.\n295\n14.10 HUDSON MOTORS. Measuring implications of “failure” in Trend \nChannel. 1945.\n215\n6.1 HUMANA, INC. Daily, 1988. Head-and-Shoulders Top. 46\n18.4 IBM. Perhaps those “best and brightest” \nfundamental analysts were not as feckless as \none might think from looking at their 20-year \nrecord.\n301\n6.5 IC INDUSTRIES. 1986. Head-and-Shoulders Top. 49\n7.4 ILLUSTRATION OF \nKILROY BOTTOM\n60\n9.12 INCO COMPANY, LTD. Subsequent to the October crash, developed a \nlarge Head-and-Shoulders Top.\n111\n37.18 INDUSTRIAL RAYON \nCORPORATION.\nShowing Bearish action of a stock through the \nentire year 1957. Daily chart.\n446\n23.9 INKTOMI. Scaling the Internet. 333\n7.22 INLAND STEEL. Semi-dormant Rounding Bottom of 1935. 72\n37.2 INSPIRATION \nCONSOLIDATED \nCOPPER.\nDowntrend and break through Major Support. 429\n37.47 INTEL. The heart of the Microsoft computer. Compare \nMSFT.\n474\n13.11 INTERLAKE IRON. “End run” following a late breakout from \nSymmetrical Triangle. 1944.\n204\n15.6 INTERNATIONAL \nHYDRO-ELECTRIC.\nUp-curving Bull Trend of a high leverage \njunior utility stock. Monthly chart, 1938 to \n1946.\n232\n10.5 INTERNATIONAL \nPAPER.\nShowing a form of “broadening” which is of \ndoubtful technical significance. Weekly chart, \n1945 to 1947.\n125\n588 Alphabetic Index of Stock Charts\nFigure Stock Name Summary Description of Chart Page\n11.17 INTERNATIONAL \nTELEPHONE & \nTELEGRAPH.\nSaucer- like Consolidation in 1944. 166\n13.10 INTE", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 266}
{"text": "nd of a high leverage \njunior utility stock. Monthly chart, 1938 to \n1946.\n232\n10.5 INTERNATIONAL \nPAPER.\nShowing a form of “broadening” which is of \ndoubtful technical significance. Weekly chart, \n1945 to 1947.\n125\n588 Alphabetic Index of Stock Charts\nFigure Stock Name Summary Description of Chart Page\n11.17 INTERNATIONAL \nTELEPHONE & \nTELEGRAPH.\nSaucer- like Consolidation in 1944. 166\n13.10 INTERNATIONAL \nTELEPHONE & \nTELEGRAPH.\nSupport “field” of Symmetrical Triangle. 1945. 204\n7.20 J.I. CASE. The Rounding Bottom of 1932 showing a \ntemporary rally out of pattern.\n71\n13.5 JEWEL TEA. Major Support–Resistance Levels on 1936 to \n1946 monthly chart.\n198\n8.3 JOHNS–MANVILLE. Triangular Bottom development of 1941 to \n1942. Weekly chart.\n79\n13.1 JONES & LAUGHLIN. Normal trend action illustrating Support and \nResistance. Weekly chart, 1944 to 1947.\n191\n9.10 KENNECOTT COPPER. Series of Consolidation Formations in 1937 \nBear Trend.\n110\n13.4 KRESGE (S.S.) \nCOMPANY.\n1936 to 1946 monthly chart showing important \nSupport–Resistance Levels.\n196\n33.14 LEHIGH VALLEY \nRAILROAD.\nDaily, end of 1945, beginning of 1946. Gaps of \nvarious types.\n407\n37.9 LIBBY, McNEILL & \nLIBBY.\nMonthly, 1927 to 1930. Showing continuance of \nBullish Trend into 1930.\n436\n15.13 LIGGETT & MYERS \nTOBACCO B.\nStraight-line trend characteristic of tobacco \nstocks. Monthly chart, 1938 to 1946.\n236\n9.2 LIMA LOCOMOTIVE \nWORKS.\nRectangular pattern of “conflict” in 1944 to \n1945.\n104\n12.11 LION OIL COMPANY. An Island “shakeout” in a thin stock. 1947. 181\n37.36 LIVINGSTON OIL \nCOMPANY.\nWeekly, January 1965 into January 1966. \nDownside Major Trend, Symmetrical Triangle \nBottom, Major Reversal to uptrend.\n464\n7.1 LOCKHEED AIRCRAFT. A Head-and-Shoulders Bottom Reversal in \nDecember 1943.\n58\n9.3 LOEW’S, INC. Perfect Rectangle of the “pool operation” type, \n1936.\n105\n10.15 LOEW’S, INC. Falling Wedge of classic form in 1936; Flag and \nRectangle.\n132\n37.19 LORILLARD. Showing Bullish action of a stock through the \nentire year, 1957. Daily chart.\n447\n10.27 LUCENT. Late 20th, early 21st century schizophrenia. 142\n10.28 LUCENT. What happened after the chart in 104.4 143\n33.13 MARTIN-PARRY. Daily, 6 months in 1945. Pennant, showing \nformation of Consolidation Pattern at \nhalfway point in advance.\n406\n11.1 MARTIN–PARRY. Ideal Flag in rapid advance of 1945. 152\n37.4 MASONITE. Downtrend showing Support–Resistance \nphenomena. 1956.\n431\n7.6 MCA, INC. 1986. Complex Head-and-Shoulders Top 62\n589Alphabetic Index of Stock Charts\nFigure Stock Name Summary Description of Chart Page\n37.42 MEMOREX \nCORPORATION.\nDaily, September 1969 through May 1970. Last \n“Bull” fling for Memorex before gapping \ndown with volume in February 1970.\n470\n11.15 MIAMI COPPER. A genuine Scallop uptrend in 1945. 165\n10.24 MICROSOFT. A key reversal day in March. 140\n23.1 MICROSOFT. A multitude of lessons in Microsoft. 326\n23.2 MICROSOFT. A Monthly perspective. 327\n23.3 MICROSOFT. 2005. The long view after the fall. 328\n11.8 MULLINS \nMANUFACTURING.\nB. An overlong Flag which worked \nnevertheless. 1936.\n159\n9.1 NASH–KELVINATOR. Rectangular distribution area of 1945 to 1946. 104\n14.12\n37.54\nNASH–KELVINATOR.\nNASDAQ 100\nDowntrend Channel in 1946.\nBasing Point Procedure applied to weekly bars\n216\n480\n11.3 NASH–KELVINATOR. Flag of “Half-Mast” type preceding 1937 Bull \nMarket Top.\n154\n10.22 NATIONAL CASH \nREGISTER.\nAn example of “One-Week Reversal” in 1941. \nWeekly chart.\n138\n13.3 NATIONAL \nDISTILLERS.\n1926 to 1947 monthly chart showing Major \nSupport–Resistance Levels.\n195\n8.10 NATIONAL GYPSUM. A typical Symmetrical Triangle leading to \ncontinuation of the preceding trend in 1944 to \n1945. Weekly chart.\n84\n11.2 NATIONAL GYPSUM. An up Flag and another false move from apex \nof Triangle. 1945.\n153\n8.6 NATIONAL GYPSUM. A false move out of the extreme apex of a \nSymmetrical Triangle.\n81\n9.18 NATIONAL GYPSUM. Triple Bottom of 1941 to 1942. Weekly chart. 117\n7.14 NATIONAL SUPPLY. The “two-headed” Top Formation of 1946. 67\n6.10 NEW YORK CENTRAL. Head-and-Shoulders Top in June through July \n1945, followed by a Multiple Head-and-\nShoulders Bottom.\n52\n6.20 NEW YORK CENTRAL. A typical Panic Selling Climax in 1937. 136\n37.48 NOKIA. The story of the communications revolution. 475\n8.7 NORTH AMERICAN \nCOMPANY.\nSymmetrical Triangle topping a recovery from \na Panic Low in 1937.\n82\n7.25 NORTHERN INDIANA \nPUBLIC SERVICE.\nA magnificent Scalloping tendency. 75\n33.15 NORTHERN PACIFIC. Daily, 6 months in 1944. Support and \nResistance phenomena; also showing \nSymmetrical Triangle and reaction to apex, \nand small Rectangle.\n412\n37.11 NORTHROP AIRCRAFT. 1954 to 1955. Descending Triangle at an \nimportant top.\n438\n37.12 NORTHROP AIRCRAFT. 1956 to 1957. Ascending Triangle and upside \nbreakout.\n439\n16.1 OATS.\nTracing “normal” patterns during the 1940s \n(5th ed.).\n246\n590 Alphabetic Index of Stock Charts\nFigure Stock Name Summary Description of Chart Page\n23.8 ORACLE. Your modern misshapen rectangles in Oracle \nagain, marked by runaway days and gaps.\n332\n37.40 ORACLE. Lest one think that the air pocket gap does not \nstill exist, here is an example from the turn of \nthe century (third millennium).\n468\n37.15 OTIS ELEVATOR. Showing a full year of a typical daily chart on \nTEKNIPLAT charting paper. Shows a long \nTriangle Consolidation, eventually followed \nby a continuation of the Major Advance. 1954 \nto 1955.\n443\n11.7 PACIFIC TIN. Flag, following and succeeded by Triangles, in \n1944.\n158\n37.37 PACKARD–BELL \nELECTRONICS.\nDaily, August 1965 to January 1966. Flag \nshowing “Half-Mast” situation, and a large \nAscending Triangle with powerful breakout \nmove on the upside.\n465\n23.5 PALM Masquerading as PLMO. A Continuation of \nthe shell game.\n329\n23.6 PALM Masquerading as PSRC. Which shell is it \nunder?\n330\n23.4 PALM. Fool’s gold. Fool’s gold with naivete writ large \non it.\n329\n14.8 PAN AMERICAN \nAIRWAYS.\nDescending Triangle Top and long, Double \nDowntrend Channel. 1945 to 1946.\n214\n14.6 PARAMOUNT \nPICTURES.\nDouble trendlines in accelera", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 267}
{"text": "reakout \nmove on the upside.\n465\n23.5 PALM Masquerading as PLMO. A Continuation of \nthe shell game.\n329\n23.6 PALM Masquerading as PSRC. Which shell is it \nunder?\n330\n23.4 PALM. Fool’s gold. Fool’s gold with naivete writ large \non it.\n329\n14.8 PAN AMERICAN \nAIRWAYS.\nDescending Triangle Top and long, Double \nDowntrend Channel. 1945 to 1946.\n214\n14.6 PARAMOUNT \nPICTURES.\nDouble trendlines in accelerated Intermediate \nAdvance. 1945 to 1946.\n213\n10.7 PARAMOUNT \nPICTURES.\nThe 1946 top, a Right-Angled Broadening \nPattern with horizontal bottom line.\n126\n33.9 PARAMOUNT \nPICTURES.\nWeekly, 1941 to 1943. Double Bottom, \nbreakout, and reaction to Support before \nmain advance.\n402\n37.38 PARKE, DAVIS & \nCOMPANY.\nDaily, July 1969 to June 1970. This could be \nregarded as a very flat Head-and-Shoulders \nTop, or as a long Rounding Top.\n466\n12.13\n36.2\nPENNSYLVANIA \nRAILROAD.\nPENTAD SYSTEM\nChanges in technical lines required by \nex-dividend decline.\nIllustration of filtered moving average system.\n183\n425\n14.5 PHILLIPS PETROLEUM. An exception to the normal consequences of \nvalid trendline penetration. Weekly chart, \n1935 to 1938.\n212\n7.15 PHILLIPS PETROLEUM. The 1946 Top — a Multiple Pattern merging \ninto a Rounding Turn.\n67\n37.23 POLAROID. First 6 months of 1962. Long Rectangle \nfollowed by a precipitous drop after \npenetration of Support. Daily chart.\n451\n7.13 PUBLIC SERVICE CORP . \nOF NJ.\nWeekly chart showing Multiple Bottom \npattern of 1941 to 1942.\n66\n37.41 PUBLIC SERVICE \nELECTRIC & GAS.\nMonthly, 1969 through 1970. A typical electric \nand gas utility stock.\n469\n591Alphabetic Index of Stock Charts\nFigure Stock Name Summary Description of Chart Page\n9.17 PUBLICKER \nINDUSTRIES.\nTriple Top of 1946. 116\n10.23 QUALCOMM. A church spire top in Qualcomm. 139\n14.13 R.H. MACY. Complex Top in 1946 and penetration of \nIntermediate Up Trendline. Tentative Fan \nLines.\n217\n13.6 REMINGTON RAND. Descending Triangle Top and significant \nfailure of Support. Weekly chart, 1945 to 1947.\n199\n33.8 REMINGTON RAND. Daily, end of 1944, beginning of 1945. Series of \nRectangles during Bull Market Advance, and \nreturn moves to Support Levels.\n401\n6.8 REPUBLIC AVIATION. Its 1946 Bull Market Top. The Head- and-\nShoulders measuring formula.\n51\n9.13 REPUBLIC STEEL. Major Double Top of 1946 with subsidiary \npatterns.\n112\n15.9 REPUBLIC STEEL. Typical Bull Trend of steel stocks. Monthly \nchart, 1938 to 1946.\n234\n8.20 REVERE COPPER & \nBRASS.\nLarge Descending Triangle Top of 1946. 91\n37.10 S.S. KRESGE. Monthly, 1953 to 1956. Generally Bearish \nMajor Trend.\n437\n10.16 SCHENLEY \nDISTILLERS.\nA large Wedge which signaled a Primary Top \nin 1946. Weekly chart.\n133\n24.1 SCHENLEY \nDISTILLERS.\nWeekly, 1945 to 1946. Habits of a stock of high \nsensitivity.\n342\n9.8 SEARS, ROEBUCK. A “hybrid” Major Bottom Formation in 1941 to \n1942.\n109\n8.2 SEARS, ROEBUCK. Symmetrical Triangle Top of 1946, and \nsubsequent step-down pattern of same form.\n78\n8.15 SEARS, ROEBUCK. The Symmetrical Descending Triangle Top of \n1936 and subsequent Intermediate Recovery \nBottom of ascending form.\n86\n10.11 SHELL UNION OIL. 1946 Major Diamond Top and Descending \nTriangle.\n128\n16.4\n16.5\nSILVER 2005.\nSILVER MAY 2005\nAnother great rounding bottom?\nLessons in agility, gaps and run days\n249\n16.5\n16.13\nSILVER 2011\nSILVER 2011\nHow the rounding bottom was resolved\nIllustrating top and stairstops.\n250\n257\n8.18 SOCONY–VACUUM \nOIL.\nAscending Triangle forming head of Head-\nand-Shoulders Bottom in 1942. Weekly chart.\n89\n9.4 SOCONY–VACUUM \nOIL.\nRectangle Top Formation of 1946. 106\n12.7 SOUTHERN PACIFIC. A large Measuring Gap in the Panic Decline of \nlate 1937.\n178\n33.1 SOUTHERN PACIFIC. Daily, 6 months in 1946. Head-and- Shoulders \nTop, rally, and subsequent decline.\n394\n14.9 SOUTHERN PACIFIC. Intermediate Basic and Return Lines and Flags \nwithin Trend Channel. 1945.\n214\n592 Alphabetic Index of Stock Charts\nFigure Stock Name Summary Description of Chart Page\n8.16 SOUTHERN RAILWAY \nPREFERRED.\nA perfect Ascending Triangle in 1936. 87\n13.12 SOUTHERN RAILWAY. Typical Pullbacks to Head-and- Shoulders \nNeckline, and increase of volume as Support \nis violated. 1946.\n205\n20.3 SPDR. SPY For illustration, here is a chart of the Amex \nIndex Share, the SPYDR, or share based on \nthe S&P 500.\n309\n17.1 SPIEGEL, INC. The Major Top of 1946 and the first part of a \nBear Trend. 1946 to 1947.\n262\n17.2 SPIEGEL, INC. Sequel to Figure 198. Continuation of Bear \nTrend. 1946 to 1947.\n263\n15.17 STANDARD & POOR’S \n500 INDEX.\nHorrors of the 1987 Crash. 239\n15.18 STANDARD & POOR’S \n500 INDEX.\nThe 1987 Crash viewed from afar. 239\n20.2 STANDARD & POOR’S \n500 INDEX.\nHere the benefits of relaxed long-term \ninvesting may be seen.\n308\n20.4 STANDARD & POOR’S \n500 INDEX.\nThe Broadening Top comes home to roost. 309\n15.8 STANDARD OIL OF \nOHIO.\nStraight-line Bull Trend of an investment oil. \nMonthly chart, 1938 to 1946.\n233\n37.30 SUPERIOR OIL. June to November 1962. Showing an important \nDouble Bottom, which became the base for a \nMajor Advance.\n458\n6.4 TELEDYNE, INC. 1984. Large Head-and-Shoulders Top. 48\n37.8 TEXTRON. 1956 to 1957. Descending Triangle, with sharp decline after \nthe breakout. 1956 to 1957.\n435\n16.11 TLT Bond reaction to the great Bush bear market 255\n10.17 TRANSCONTINENTAL \n& WESTERN \nAIRLINES.\nMajor One-Day Reversal and long downtrend. \n1945 to 1946.\n134\n9.16 TRINITY INDUSTRIES. 1985. Triple Bottom. 115\n8.11 U.S. INDUSTRIAL \nCHEMICALS.\nTriangular Pattern completing an extended \nreaccumulation period.\n84\n37.1 U.S. SMELTING, \nREFINING & MINING.\nWeekly, 1951 to 1953, showing Ascending \nTriangle and Head-and-Shoulders Top.\n428\n37.25 U.S. SMELTING, \nREFINING & MINING.\nApril through September, 1962. Head-and-\nShoulders Bottom, breakout, reaction, and \nadvance. Daily chart.\n453\n37.35 U.S. SMELTING, \nREFINING & MINING. \nDaily,\nJuly to December 1965. Breakout from \ndormancy, Major Advance, showing \nSymmetrical Triangle Consolidation.\n463\n6.11 UNION CARBIDE & \nCARBON.\nThe Head-and-Shoulders within a Head-and-\nShoulders Top Fo", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 268}
{"text": "37.25 U.S. SMELTING, \nREFINING & MINING.\nApril through September, 1962. Head-and-\nShoulders Bottom, breakout, reaction, and \nadvance. Daily chart.\n453\n37.35 U.S. SMELTING, \nREFINING & MINING. \nDaily,\nJuly to December 1965. Breakout from \ndormancy, Major Advance, showing \nSymmetrical Triangle Consolidation.\n463\n6.11 UNION CARBIDE & \nCARBON.\nThe Head-and-Shoulders within a Head-and-\nShoulders Top Formation which capped its \n1929 Bull Market.\n53\n22.1 UNION PACIFIC. Weekly, first 6 months of 1945, showing \ntendency of a high-priced stock of the same \ngroup to make small swings.\n320\n593Alphabetic Index of Stock Charts\nFigure Stock Name Summary Description of Chart Page\n9.11 UNITED AIRCRAFT. The Double Bottom of 1942. Weekly chart. 111\n37.32 UNITED ARTISTS. Daily, February to August 1963. A Major \nDowntrend, demonstrating Resistance Levels \nduring the decline.\n460\n1.1 UNITED STATES STEEL. Monthly price ranges from January 1929 to \nDecember 1946.\n5\n10.9 UNITED STATES STEEL. The three-month Diamond which formed the \n1946 Bull Market Top.\n127\n10.14 UNITED STATES STEEL. The Wedge as part of a Rounding Top on the \nAugust 1937 recovery.\n131\n37.33 UTAH–IDAHO SUGAR \nCOMPANY.\nJanuary to June 1963. Breakout and rapid \nadvance appearing suddenly in a normally \ndull stock.\n461\n11.4 VANADIUM \nCORPORATION.\nRapid sequence of small Consolidation \nFormations in 1936 to 1937.\n155\n8.8 VERTIENTES — \nCAMAGUEY SUGAR\nof Cuba. Triangular- like development at 1946 \nTop.\n83\n6.9 WALT DISNEY \nPRODUCTIONS.\nHead-and-Shoulders Top. 1986. 51\n37.10 WEST INDIES SUGAR. Monthly, 1953 to 1956. Showing continuance of \nBullish Trend through 1956.\n437\n37.14 WESTINGHOUSE \nELECTRIC.\nDownside trend in the early stages of the 1955 \nto 1956 collapse.\n437\n15.15 WESTINGHOUSE \nELECTRIC.\nMajor Trendlines. Weekly chart, 1935 to 1938. 237\n6.3 WESTINGHOUSE \nELECTRIC.\nThe Head-and-Shoulders Top of January \nthrough February 1946.\n47\n8.21 WESTINGHOUSE \nELECTRIC.\nThe Descending Triangle which topped out \n“WX” ahead of the general market.\n92\n37.10 WESTINGHOUSE \nELECTRIC.\nMonthly, 1953 to 1956. Showing Major Top in \n1955 and the collapse during the early \nmonths of 1956.\n437\n12.8 WILLYS–OVERLAND. Various types of gaps in 1944, and Head-and-\nShoulders Reversal.\n179\n11.9 WYANDOTTE WORSTED. Application of measuring formula to Flag. 1946. 160\n18.5 XEROX. More benefits of fundamental analysis. 302\n37.50 YAHOO. After the tulipomania. 2005. 476\n37.51 YAHOO. Internet rocket fuel. 477\n13.7 YORK CORPORATION. Measuring Gap and long Rectangle. 1945 to 1946. 200\n13.8 YORK CORPORATION. Sequel to Figure 141. Rectangle Support, false \nmove from apex of Triangle, and Double Top. \n1946.\n201\n9.5 YOUNGSTOWN SHEET \n& TUBE.\nMajor Top of Rectangle formed in 1946. 106\n12.3 ZENITH RADIO. Strong Breakaway Gap on weekly chart of \n1942 Major Bottom.\n174\n12.4 ZENITH RADIO. Monthly chart of 1936 to 1946 for comparison \nwith Figure 12.3.\n175\n\n595\nGlossary\nEN: The Glossary is the work of the distinguished editor of the seventh edition, Richard McDermott. \nMinor changes are so noted.\nEN9: Some entries are written by other analysts, whose names are noted.\nAlthough it requires the use of the human brain and some discrimination and judgment, the \ngreat virtue of Magee chart analysis is it allows the practitioner to evaluate how well number-\ndriven indicators function. As, for example, use of a Moving Average to identify the trend works \nwonderfully well in a trending market. If used as a signal generator in a trading market, results will \ncome in whipsaws. Similarly, oscillators often are useful in trading markets but can mislead the \ntrader when the market begins to trend. The reasonably accomplished chart analyst can recognize \nthe state of the market and view the performance of number-driven indicators from a more informed \nperspective. Thus, the reader should keep this in mind while reading about the Average Directional \nMovement Index and suchlike.\nACCUMULATION—The first phase of a Bull Market. The period when farsighted investors \nbegin to buy shares from discouraged or distressed sellers. Financial reports are usually at \ntheir worst and the public is completely disgusted with the stock market. Volume is only \nmoderate but beginning to increase on the rallies.\nACTIVITY—See Volume.\nADX (Average Directional Movement Index)—The ADX is a trend-following indicator \ndevised by Welles Wilder (Wilder Relative Strength Index) and is based on the concept of \ndirectional movement. It is designed to evaluate the trending characteristics of a security. \nThe ADX is frequently used to avoid trendless markets, and signals when a trend reaches \na profitable trading level. In a trendless market, the ADX indicates avoidance.\nDirectional movement is a measure of the net total price movement during a set period \nof time. First, the positive and negative directional movements are determined by summing \nthe daily up and down moves. The values obtained are next normalized by dividing them \nby the “True Range,” the absolute value of the total move for the period; this difference \nbetween normalized values (expressed as a percentage) is the directional movement.\nThe ADX is then obtained from directional movement by the use of exponential average \nand ratios. The ADX is often charted with a second line, the ADXR Indicator. ADXR is a \nsmoothed average of the ADX.\nA rising ADX indicates significant directional movement and the beginning of a good \ntrading period. The declining ADX is shown during a poor period for trend following. \nNormally, an ADX Indicator above 25 signals significant directional movement and good \ntrading.\n596 Glossary\nAPEX—The highest point; the pointed end, tip, of a Triangle.\nARBITRAGE—The simultaneous buying and selling of two different, but closely related, \ninstruments to take advantage of a disparity in their prices in one market or different \nmarkets.\nEN: Those who buy the acquirer and sell the acquired in takeover situations—sometimes called \n“arbs” or arbitrageurs—are ersatz or", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 269}
{"text": "d \ntrading.\n596 Glossary\nAPEX—The highest point; the pointed end, tip, of a Triangle.\nARBITRAGE—The simultaneous buying and selling of two different, but closely related, \ninstruments to take advantage of a disparity in their prices in one market or different \nmarkets.\nEN: Those who buy the acquirer and sell the acquired in takeover situations—sometimes called \n“arbs” or arbitrageurs—are ersatz or faux arbitrageurs; they are really spreaders. Arbitrageur is a \nsolecism used in that sense. It is also a false cognate to the French.\nAREA GAP—See Common Gap.\nAREA PATTERN—When a stock or commodity’s upward or downward momentum has \nbeen temporarily exhausted, the ensuing sideways movement in the price usually traces \nout a design or arrangement of form called an Area Pattern. The shape of some of these \nArea Patterns, or Formations, has predictive value under certain conditions. (See also \nAscending Triangle, Broadening Formations, Descending Triangle, Diamond, Flag, Head-\nand-Shoulders Pattern, Inverted Triangle, Pennant, Rectangle, Right-Angle Triangles, \nSymmetrical Triangles, and Wedges.)\nARITHMETIC SCALE—Price or volume scale where the distance on the vertical axis (i.e., \nspace between horizontal lines) represents equal amounts of dollars or number of shares.\nASCENDING (PARALLEL) TREND CHANNEL—When the tops of the rallies composing \nan advance develop along a line (sometimes called a Return Line), which is also parallel to \nthe basic Up Trendline (i.e., the line that slopes up across the wave bottoms in an advance); \nthe area between the two lines is called an Ascending or Up Channel.\nASCENDING (UP) TRENDLINE—The advancing wave in a stock or commodity is \ncomposed of a series of ripples. When the bottoms of these ripples form on, or very close \nto, an upward-slanting straight line, a basic Ascending or Up Trendline is formed.\nASCENDING TRIANGLE—One of a class of Area Patterns called Right-Angle Triangles. \nThe class is distinguished by the fact that one of the two boundary lines is practically \nhorizontal, whereas the other slants toward it. If the top line is horizontal and the \nlower slants upward to an intersection point to the right, the resulting Area Pattern \nis called Ascending Triangle. The implication is Bullish, with the expectant breakout \nthrough the horizontal line. Measuring Formula: add the broadest part of triangle to the \nbreakout point.\nAT-THE-MONEY—An option, the strike price of which is equal to the market price of the \nunderlying instrument.\nA VERAGES—See Dow–Jones Industrial Averages, Moving Averages, Dow–Jones \nTransportation Averages, and Dow–Jones Utility Averages.\nA VERAGING COST—An investing technique in which the investor buys a stock or \ncommodity at successively lower prices, thereby “averaging down” his average cost of each \n597Glossary\nstock share or commodity contract. Purchases at successively higher prices would “average \nup” the price of stock shares or commodity contracts.\nEN: A very foolish technique for the amateur.\nAXIS—In the graphic sense, an axis is a straight line for measurement or reference. It is also \nthe line, real or imagined, on which a formation is regarded as rotating.\nBALANCED PROGRAM—Proportioning capital, or a certain part of capital, equally \nbetween the long side and the short side of the market.\nBAR CHART—Also called a Line Chart. A graphic representation of prices using a vertical \nbar to connect the highest price in the time period to the lowest price. Opening prices \nare noted with a small horizontal line to the left. Closing prices are shown with a small \nhorizontal line to the right. Bar charts can be constructed for any time period in which \nprices are available. The most common time periods found in bar charts are hourly, daily, \nweekly, and monthly; however, with the growing number of personal computers and the \navailability of “real-time” quotes, it is not unusual for traders to use some period of minutes \nto construct a bar chart.\nBASIC TRENDLINES—See Trendlines.\nBASING POINT—The price level in the chart that determines where a stop-loss point is \nplaced. As technical conditions change, the Basing Point, and stops, can be advanced (in a \nrising market), or lowered (in a falling market). (See Progressive Stops.)\nBASIS POINTS—The measure of yields on bonds and notes. One Basis Point equals 0.01% \nof yield.\nBASKET TRADES—Large transactions made up of a number of various stocks.\nBEAR MARKET—In its simplest form, a Bear Market is a period when prices are primarily \ndeclining, usually for a long period of time. Bear Markets generally consist of three phases. \nThe first phase is distribution, the second is panic, and the third is akin to a washout, \nduring which those investors who have held through the first two phases finally give up \nand liquidate.\nBENT NECKLINE—See Neckline.\nBETA—A measurement of an individual stock’s sensitivity to market swings.\nBETA (COEFFICIENT)—A measure of the market or non-diversifiable risk associated with \nany given security in the market.\nBLOCK TRADES—Large transactions of a particular stock sold as a unit.\nBLOW-OFF—See Climactic Top.\n598 Glossary\nBLUE CHIPS—The nickname given to high-priced companies with good records of \nearnings and price stability; also called gilt-edged securities. Examples include IBM, AT&T, \nGeneral Motors, and General Electric.\nBLUE PARALLEL—A line drawn parallel to the trendline (Blue Trendline) that connects \nat least two highs. The Blue Parallel is started off a low and used to estimate the next low \npoint.\nBLUE TRENDLINE—A straight line connecting two or more Tops together. To avoid \nconfusion, Edwards and Magee use a blue line for Top Trendlines and a red line for Bottom \nTrendlines.\nBOLLINGER BANDS (BB)—An envelope, in the form of two lines, that surrounds the \nprice bars on a chart. Bollinger Bands are plotted two standard deviations away from a \nSimple Moving Average. This is the primary difference between Bollinger Bands and other \nenvelopes. Envelopes are plott", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 270}
{"text": "To avoid \nconfusion, Edwards and Magee use a blue line for Top Trendlines and a red line for Bottom \nTrendlines.\nBOLLINGER BANDS (BB)—An envelope, in the form of two lines, that surrounds the \nprice bars on a chart. Bollinger Bands are plotted two standard deviations away from a \nSimple Moving Average. This is the primary difference between Bollinger Bands and other \nenvelopes. Envelopes are plotted a fixed percentage above and below a Moving Average. As \nstandard deviation is a measure of volatility, Bollinger Bands adjust themselves to differing \nmarket conditions. The bands grow wider during volatile market periods and narrower \nduring less volatile periods.\nBollinger’s premise is to ask the market what it is doing, rather than to tell it what to do. \nHe focused on volatility with the use of standard deviation to set the bandwidth. The bands \nare normally plotted two deviations away from the standard deviation, which is effectively \na 20-day Moving Average Line. The plot is valid if an average acts as a Support Line on \nmarket corrections. If the average is penetrated on corrections, it is too short. Bollinger \nrecommends 10-day Moving Averages for short-term trading, 20-day for intermediate-term \ntrading, and 50-day for long-term trading. Deviations also need to be adjusted: 10 days can \nuse 1.5 deviations, 20 days use 2 deviations, and 50 days use 2.5 deviations. The nature of \nthe time periods does not matter; the bands can be used on monthly, weekly, daily, and \neven intraday figures.\nBollinger Bands do not usually generate buy and sell signals alone. Most often, they \nprovide a framework within which price may be related to other indicators. Bollinger \nrecommends using the bands in relation to other buy and sell signals. However, the bands \ncan be an integral part of the signal. If a price touches an upper band and indicator action \nconfirms it, no sell signal is generated (it is a continuation signal if a buy signal was in \neffect). If a price touches an upper band and an indicator does not confirm (diverges), it is \na sell signal. If a Top Price Chart Formation is formed outside the bands and is followed \nby a second Top inside the bands, a sell signal is generated. The exact opposite is true on \nthe buy side.\nWhen combined with other indicators, such as the Relative Strength Index (RSI), \nthe Bollinger Bands become quite powerful. RSI is an excellent indicator with respect to \noverbought and oversold conditions. Generally, when price touches the upper Bollinger \nBand and RSI is below 70, it is an indication that the trend will continue. Conversely, when \nprice touches the lower Bollinger Band, and RSI is above 30, it is an indication the trend \nshould continue. If a situation occurs in which price touches the upper Bollinger Band and \nRSI is above 70 (possibly approaching 80), it is an indication that the trend may reverse itself \nand move downward. On the other hand, if price touches the lower Bollinger Band and RSI \nis below 30 (possibly approaching 20), the trend may reverse itself and move upward. (See \nalso Multicolincarity, Percent B, Wilder Relative Strength Index.)\n599Glossary\nBOOK V ALUE—The conventional accounting measure of what a stock is worth based on \nthe value of the company’s assets less the company’s debt. Eminently manipulable.\nBOTTOM—See Ascending Triangle, Dormant Bottom, Double Bottom, Head-and-Shoulders \nBottom, Rounding Bottom, and Selling Climax.\nBOUNDARY—The edges of a pattern. BOWL—See Rounding Bottom.\nBRACKETING—A trading range market or a price area that is non-trending.\nBREAKAWAY GAP—The hole or gap in the chart created when a stock or commodity \nbreaks out of an Area Pattern.\nBREAKOUT—When a stock or commodity exits an area pattern.\nBROADENING FORMATION—Sometimes called Inverted Triangles, these are formations \nthat start with narrow fluctuations that widen out between diverging, rather than \nconverging, boundary lines. (See also Broadening Top, Diamond Patterns, Head-and-\nShoulders Pattern, and Right-Angled Broadening Formations.)\nBROADENING TOP—An Area Reversal Pattern that may evolve in any one of three forms, \ncomparable in shape, respectively, to inverted Symmetrical, Ascending, or Descending \nTriangles. Unlike Triangles, the Tops and Bottoms of these patterns do not necessarily \nstop at clearly marked diverging boundary lines. Volume tends to be unusually high and \nirregular throughout pattern construction. No Measuring Formula is available.\nBULL MARKET—A period when prices are primarily rising, normally for an extended \nperiod. Usually, but not always, divisible into three phases. The first phase is accumulation. \nThe second phase is one of fairly steady advance with increasing volume. The third phase \nis marked by considerable activity as the public begins to recognize and attempt to profit \nfrom the rising market.\nCALL OPTION—An option that gives the buyer the right to buy the underlying contract at \na specific price within a certain period, and that obligates the seller to sell the contract for \nthe premium received before expiration of the designated time period.\nCANDLESTICKS—A Japanese graphic representation of price action using the same data \nas bar charts, but that adds color to the candlestick (or data) to indicate the direction of \nprices from the opening (see Nison, Bibliography.)\nCATS AND DOGS—Low-priced stocks of no investment value.\nCHANNEL—If the Tops of the rallies and Bottoms of the reactions develop lines that are \napproximately parallel to one another, the area between these lines is called a Channel. \n(See also Ascending Trend Channel, Descending Trend Channel, and Horizontal Trend \nChannel.)\nCHART—A graphic representation of a stock or commodity in terms of price and/or \nvolume. (See also Bar Chart and Point and Figure Chart.)\n600 Glossary\nCLEAN-OUT DAY—See Selling Climax.\nCLIMACTIC TOP—A sharp advance, accompanied by extraordinary volume, that is, \nmuch larger volume than the normal increase, which signals the final “", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 271}
{"text": "Channel, Descending Trend Channel, and Horizontal Trend \nChannel.)\nCHART—A graphic representation of a stock or commodity in terms of price and/or \nvolume. (See also Bar Chart and Point and Figure Chart.)\n600 Glossary\nCLEAN-OUT DAY—See Selling Climax.\nCLIMACTIC TOP—A sharp advance, accompanied by extraordinary volume, that is, \nmuch larger volume than the normal increase, which signals the final “blow-off” of the \ntrend, followed by either a Reversal, or at least by a period of stagnation, formation of \nConsolidation Pattern, or a Correction.\nCLIMAX DAY—See One-Day Reversal.\nCLIMAX, SELLING—See Selling Climax.\nCLOSING PRICE—The last sale price of the trading session for a stock. In a commodity, it \nrepresents an official price determined from a range of prices deemed to have traded at or \non the close; also called a settlement price.\nCLOSING THE GAP—When a stock or commodity returns to a previous gap and retraces \nthe range of the gap. Also called covering the gap or filling the gap. (See also Gap.)\nCOIL—Another term for a Symmetrical Triangle.\nCOMMISSION—The amount charged by a brokerage house to execute a trade in a stock, \noption, or commodity. In a stock, option, or commodity, a commission is charged for each \npurchase and each sale. In a commodity, a commission is charged only when the original \nentry trade has been closed with an offsetting trade. This is called a round turn commission.\nCOMMON GAP—Also called Area Gap. Any hole or gap in the chart occurring within an \nArea Pattern. The forecasting significance of the Common Gap is nil. (See also Gap.)\nCOMPARATIVE RELATIVE STRENGTH—Compares the price movement of a stock with \nthat of its competitors, industry group, or the whole market.\nCOMPLEX HEAD-AND-SHOULDERS—Also called Multiple Head-and-Shoulders. It is a \nHead-and-Shoulders Pattern with more than one right and left shoulder and/or head. (See \nalso Head-and-Shoulders Pattern.)\nCOMPOSITE A VERAGE—A stock average composed of the 65 stocks that make up the \nDow–Jones Industrial Average and the Dow–Jones Utility Average.\nCOMPOSITE LEVERAGE—In Edwards and Magee, it is a formula for combining the \nprincipal factors affecting a given sum of capital used (i.e., sensitivity, price, and margin) \ninto one index figure.\nCONFIRMATION—In a pattern, it is the point at which a stock or commodity exits an \nArea Pattern in the expected direction by an amount of price and volume sufficient to meet \nminimum pattern requirements for a bona fide breakout. In the Dow Theory, it means both \nthe Industrial Average and the Transportation Average have registered new highs or lows \nduring the same advance or decline. If only one of the Averages establishes a new high (or \nlow) and the other one does not, it would be a non-confirmation, or Divergence. This is also \ntrue of oscillators. To confirm a new high (or low) in a stock or commodity, an oscillator \n601Glossary\nneeds to reach a new high (or low) as well. Failure of the oscillator to confirm a new high \n(or low) is called a Divergence and would be considered an early indication of a potential \nReversal in direction.\nCONGESTION—The sideways trading from which Area Patterns evolve. Not all Congestion \nperiods produce a recognizable pattern, however.\nCONSOLIDATION PATTERN—Also called a Continuation Pattern, it is an Area Pattern \nthat breaks out in the direction of the previous trend. (See also Ascending Triangle, \nDescending Triangle, Flag, Head-and-Shoulders Continuation, Pennant, Rectangle, Scallop, \nand Symmetrical Triangle.)\nCONTINUATION GAP—See Runaway Gap.\nCONTINUATION PATTERN—See Consolidation Pattern.\nCONVERGENT PATTERN (TREND)—Those patterns with upper and lower boundary \nlines that meet, or converge, at some point if extended to the right. (See also Ascending \nTriangle, Descending Triangle, Symmetrical Triangle, Wedges, and Pennants.)\nCORRECTION—A move in a commodity or stock that is opposite to the prevailing trend, \nbut not sufficient to change that trend. Called a rally in a downtrend and a reaction in an \nuptrend. In the Dow Theory, a Correction is a Secondary Trend against the Primary Trend, \nwhich usually lasts from three weeks to three months and retraces from one-third to two-\nthirds of the preceding swing in the Primary Direction.\nCOVERING THE GAP—See Closing the Gap.\nCRADLE—The intersection of the two converging boundary lines of a Symmetrical \nTriangle. (See also Apex.)\nDAILY RANGE—The difference between the high and low price during one trading day.\nDEMAND—Buying interest for a stock at a given price.\nDESCENDING (PARALLEL) TREND CHANNEL—When the Bottoms of the reactions \ncomprising a decline develop along a line (sometimes called a Return Line), which is also \nparallel to the basic down trendlines (i.e., the line which slopes down across the wave tops \nin a decline), the area between the two lines is called a Descending or Down Channel.\nDESCENDING TRENDLINE—The declining wave in a stock or commodity is composed \nof a series of ripples. When the tops of these ripples form on, or very close to, a downward \nslanting straight line, a basic Descending or Down Trendline is formed.\nDESCENDING TRIANGLE—One of a class of Area Patterns called Right-Angle Triangles. \nThe class is distinguished by the fact one of the two boundary lines is practically \nhorizontal, while the other slants toward it. If the bottom line is horizontal and the upper \nslants downward to an intersection point to the right, the resulting Area Pattern is called a \nDescending Triangle. The implication is Bearish, with the expectant breakout through the \n602 Glossary\nflat (horizontal) side. Minimum Measuring Formula: add the broadest part of the Triangle \nto the breakout point.\nDIAMOND—Usually a Reversal Pattern, but it will also be found as a Continuation \nPattern. It could be described as a Complex Head-and-Shoulders Pattern with a V-shaped \n(bent) Neckline, or a Broadening Pattern that, after two or three swings, changes into a \nregular Triangle. The overall shape is a", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 272}
{"text": "ntal) side. Minimum Measuring Formula: add the broadest part of the Triangle \nto the breakout point.\nDIAMOND—Usually a Reversal Pattern, but it will also be found as a Continuation \nPattern. It could be described as a Complex Head-and-Shoulders Pattern with a V-shaped \n(bent) Neckline, or a Broadening Pattern that, after two or three swings, changes into a \nregular Triangle. The overall shape is a four-point Diamond. Since it requires a fairly active \nmarket, it is more often found at Major Tops. Many Complex Head-and-Shoulders Tops \nare borderline Diamond Patterns. The major difference is in the right side of the pattern. It \nshould clearly show two converging lines with diminishing volume as in a Symmetrical \nTriangle. Minimum Measuring Formula: add the greatest width of the pattern to the \nbreakout point.\nDISTRIBUTION—The first phase of a Bear Market, which really begins in the last stage of \na Bull Market. The period when farsighted investors sense that the market has outrun its \nfundamentals and begin to unload their holdings at an increasing pace. Trading volume is \nstill high; however, it tends to diminish on rallies. The public is still active but beginning \nto show signs of caution as hoped-for profits fade away.\nDIVERGENCE—When new highs (or lows) in one indicator are not realized in another \ncomparable indicator. (See also Confirmation.)\nDIVERGENT PATTERN (TREND)—Those patterns with upper and lower boundary lines \nthat meet at some point if extended to the left. (See also Broadening Formation.)\nDIVERSIFICATION—The concept of placing your funds in different industry groups \nand investment vehicles to spread risk. Not to put all your financial eggs in one basket.\nDIVIDENDS—A share of the profits, in cash or stock equivalent, paid to stockholders.\nDORMANT BOTTOM—A variation of a Rounding (Bowl) Bottom, but in an extended, flat-\nbottomed form. It usually appears in “thin” stocks (i.e., those issues with a small number \nof shares outstanding) and characteristically will show lengthy periods during which no \nsales will be registered for days at a time. The chart will appear “fly-specked” due to the \nmissing days. The technical implication is for an upside breakout.\nDOUBLE BOTTOM—Reversal Pattern. A Bottom formed on relatively high volume that is \nfollowed by a rally (of at least 15%), and then a second Bottom (possibly rounded) at the same \nlevel (plus or minus 3%) as the first Bottom on lower volume. A rally back though the apex \nof the intervening rally confirms the Reversal. More than a month should separate the two \nBottoms. Minimum Measuring Formula: take the distance from the lowest bottom to the \napex of the intervening rally and add it to the apex.\nDOUBLE TOP—A high-volume Top is formed, followed by a reaction (of at least 15%) on \ndiminishing activity. Another rally back to the previous high (plus or minus 3%) is made, \nbut on lower volume than the first high. A decline through the low of the reaction confirms \nthe Reversal. The two highs should be more than a month apart. Minimum Measuring \nFormula: add to the breakout point the distance from the highest peak to the low of the \nreaction. Also called an “M” Formation.\n603Glossary\nDOUBLE TRENDLINE—When two relatively close Parallel Trendlines are needed to define \nthe true trend pattern. (See also Trendline.)\nDOW–JONES INDUSTRIAL A VERAGE—Developed by Charles Dow in 1885 to study \nmarket trends. Originally composed of 14 companies (12 railroads and 2 industrials), the \nRails, by 1897 , were separated into their own Average, and 12 industrial companies of the \nday were selected for the Industrial Average. The number was increased to 20 in 1916 and \nto 30 in 1928. The stocks included in this Average have been changed from time to time \nto keep the list up to date or to accommodate a merger. The only original issue still in the \nAverage is General Electric.\nDOW–JONES TRANSPORTATION A VERAGE—Established at the turn of the century with \nthe new Industrial Average, it was originally called the Rail Average and was composed of \n20 railroad companies. With the advent of the airlines industry, the Average was updated \nin 1970 and the name changed to Transportation Average.\nDOW–JONES UTILITY A VERAGE—In 1929, utility companies were dropped from the \nIndustrial Average and a new Utility Average of 20 companies was created. In 1938, the \nnumber of issues was reduced to the present 15.\nDOWNTICK—A securities transaction at a price lower than the preceding transaction.\nDOWNTREND—See Descending Trendline and Trend.\nDRAWDOWN or RETRACEMENT—The ebb, or loss, of a portfolio’s equity from a relative \nhigh to a relative low. Maximum drawdown equals retracement from maximum high point \nto minimum low point.\nEND RUN—When a breakout of a Symmetrical Triangle Pattern reverses its direction \nand trades back through axis Support (if an upside breakout) or Resistance (if a downside \nbreakout), it is termed an end run around the line, or end run for short. The term is sometimes \nused to denote breakout failure in general.\nEQUILIBRIUM MARKET—A price area that represents a balance between demand and \nsupply.\n EXCHANGE-TRADED FUND (ETF)—Funds tracking indexes (e.g., SPY, DIA) or baskets \nof stocks that trade like stocks and do not involve the investor in membership in a mutual \nfund. An ideal way to replace mutual fund investing.\nEX-DIVIDEND—The day when the dividend is subtracted from the price of the stock.\nEX-DIVIDEND GAP—The gap in price caused when the price of a stock is adjusted \ndownward after the dividend payment is deducted.\nEXERCISE—The means by which the holder of an option purchases or sells shares of the \nunderlying security.\nEXHAUSTION GAP—Relatively wide gap in the price of a stock or commodity that occurs \nnear the end of a strong directional move in the price. These gaps are quickly closed, most \n604 Glossary\noften within two to five days, which helps to distinguish them from Runaway Gaps, which \nare not usually covered for a considerable", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 273}
{"text": "he holder of an option purchases or sells shares of the \nunderlying security.\nEXHAUSTION GAP—Relatively wide gap in the price of a stock or commodity that occurs \nnear the end of a strong directional move in the price. These gaps are quickly closed, most \n604 Glossary\noften within two to five days, which helps to distinguish them from Runaway Gaps, which \nare not usually covered for a considerable length of time. An Exhaustion Gap cannot be \nread as a Major Reversal, or even necessarily a Reversal. It signals a halt in the prevailing \ntrend, which is ordinarily followed by some sort of area pattern development.\nEXPIRATION—The last day on which an option can be exercised.\nEXPONENTIAL SMOOTHING—A mathematical method of forecasting that assumes \nfuture price action may be forecast by using a weighted average of past periods; a \nmathematical series in which greater weight is given to more recent price action. A method \nof trend identification.\nFALLING WEDGE—An Area Pattern with two downward-slanting, converging trendlines. \nNormally, it takes more than three weeks to complete, and volume will diminish as prices \nmove toward the apex of the pattern. The anticipated direction of the breakout in a Falling \nWedge is up. Minimum Measuring Formula: a retracement of all the ground lost within \nthe Wedge. (See also Wedge.)\nFALSE BREAKOUT or FALSE SIGNAL—A breakout that is confirmed but quickly reverses \nand eventually leads the stock or commodity to a breakout in the opposite direction. \nIndistinguishable from premature breakout or genuine breakout when it occurs.\nFAN LINES—A set of three secondary trendlines drawn from the same starting high or \nlow that spread out in a Fan shape. In a Primary Uptrend, the fan would be along the tops \nof the Secondary (Intermediate) Reaction. In a Primary Downtrend, the fan would be along \nthe bottoms of the Secondary (Intermediate) Rally. When the third Fan Line is broken, it \nsignals the resumption of the Primary Trend.\n50-DAY MOVING A VERAGE LINE—Is determined by taking the closing price over the \npast 50 trading days and dividing by 50.\nEN: Simple Moving Average for n days consists of summing prices for n days and dividing by n . \nOn\n n + 1 drop the first day and add the new day to the formula, etc.\nFIVE-POINT REVERSAL—See Broadening Pattern.\nFLAG—A Continuation Pattern. A flag is a period of congestion, less than four weeks \nin duration, that forms after a sharp, near-vertical change in price. The upper and lower \nboundary lines of the pattern are parallel, though both may slant up, down, or sideways. \nIn an uptrend, the pattern resembles a Flag flying from a mast, hence the name. Flags are \nalso called Measuring or Half-Mast Patterns because they tend to form at the midpoint of \nthe rally or reaction. Volume tends to diminish during the formation and increase on the \nbreakout. Minimum Measuring Formula: add the distance from the breakout point, which \nstarted the preceding “Mast” rally or reaction, to the breakout point of the Flag.\nFLOATING SUPPLY—The number of shares available for trading at any given time. \nGenerally, the outstanding number of shares less shares closely held and likely to be \nunavailable to the public. Shares of a company held by its employee pension fund, for \nexample, would not generally enter the trading stream and could be subtracted from the \noutstanding shares.\n605Glossary\nFORMATION—See Area Pattern.\nFRONT-MONTH—The first expiration month in a series of months.\nFUNDAMENTALS—Information on a stock pertaining to the business of the company and \nhow it relates to earnings and dividends. In a commodity, it would be information on any \nfactor that would affect supply or demand.\nEN: Also, earnings, profits, profit margins, cash flow, sales, and other statistics sometimes used to \nobfuscate the value of the issue.\nGAP—A hole in the price range that occurs when either (1) the lowest price at which a stock \nor commodity is traded during any time period is higher than the highest price at which \nit was traded on the preceding time period, or (2) the highest price of one time period is \nlower than the lowest price of the preceding time period. When the ranges of the two time \nperiods are plotted, they will not overlap or touch the same horizontal level on the chart—\nthere will be a price gap between them. (See also Common or Area Gap, Ex-Dividend Gap, \nBreakaway Gap, Runaway Gap, Exhaustion Gap, and Island Reversal.)\nGRAPH—See Chart.\nHALF-MAST—See Flag. Edwards said, “The Flag flies at half-mast,” referring to the \ntendency of prices to consolidate halfway through a surging vertical run.\nHEAD-AND-SHOULDERS BOTTOM—Area Pattern that reverses a decline. (See also \nHead-and-Shoulders Pattern.) EN: An upside-down name for an upside-down pattern. (See Kilroy \nBottom.)\nHEAD-AND-SHOULDERS CONSOLIDATION—Area Pattern that continues the previous \ntrend. (See also Head-and-Shoulders Pattern.)\nHEAD-AND-SHOULDERS PATTERN—Although occasionally an Inverted Head-and-\nShoulders Pattern (called a Consolidation Head-and-Shoulders) will form, which is a \nContinuation Pattern, in its normal form, this pattern is one of the more common and \nmore reliable of the Major Reversal Patterns. It consists of the following four elements (a \nHead-and-Shoulders Top will be described for illustration): (1) a rally that ends a more or \nless extensive advance on heavy volume, and that is then followed by a Minor Reaction \non less volume; this is the left shoulder; (2) another high-volume advance that exceeds the \nhigh of the left shoulder, followed by another low-volume reaction that takes prices down \nto near the bottom of the preceding reaction, and below the top of the left shoulder high; \nthis is the head; (3) a third rally, but on decidedly less volume than accompanied either \nof the first two advances, and that fails to exceed the high established on the head; this \nis the right shoulder; and (4) a decline through a line drawn across the proceeding two \nreaction lows (the ne", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 274}
{"text": "s prices down \nto near the bottom of the preceding reaction, and below the top of the left shoulder high; \nthis is the head; (3) a third rally, but on decidedly less volume than accompanied either \nof the first two advances, and that fails to exceed the high established on the head; this \nis the right shoulder; and (4) a decline through a line drawn across the proceeding two \nreaction lows (the neckline), and a close below that line equivalent to 3% of the stock’s \nmarket price. This is the confirmation of the breakout. A Head-and-Shoulders Bottom, \nor any other combination Head-and-Shoulders Pattern, contains the same four elements. \nThe main difference between a Top Formation and a Bottom Formation is in the volume \npatterns. The breakout in a Top can be on low volume. The breakout in a Bottom must show \n606 Glossary\na “conspicuous burst of activity.” Minimum Measuring Formula: add the distance between \nthe head and neckline to the breakout point.\nHEAD-AND-SHOULDERS TOP—Area Pattern that reverses an advance. (See also Head-\nand-Shoulders Pattern.)\nHEA VY VOLUME—The expression “heavy volume,” as used by Edwards and Magee, \nmeans heavy only with respect to the recent volume of sales in the stock you are watching.\nHEDGING—To try to lessen risk by making a counterbalancing investment. In a stock \nportfolio, an example of a hedge would be to buy 100 shares of XYZ stock, and to buy one \nput option of the same stock. The put would help protect against a decline in the stock, but \nit would also limit potential gains on the upside. (See also Natural Hedge.)\nHISTORICAL DATA—A series of past daily, weekly, or monthly market prices.\nHOOK DAY—A trading day in which the open is above/below prior day’s high/low and \nthe close is below /above prior day’s close with narrow range.\nHORIZONTAL CHANNEL—When the Tops of the rallies and Bottoms of the reactions \nform along lines that are horizontal and parallel to one another, the area in between is \ncalled a Horizontal Trend Channel. It may also be called a Rectangle during the early stages \nof formation.\nHORIZONTAL TRENDLINE—A horizontal line drawn across either the Tops or Bottoms \nin a sideways trending market.\nHYBRID HEAD-AND-SHOULDERS—A small Head-and-Shoulders Pattern within a larger \nHead-and-Shoulders Pattern. (See also Head-and-Shoulders Pattern.)\nINDUSTRIAL A VERAGE—See Dow–Jones Industrial Average.\nINSIDE DAY—A day in which the daily price range is totally within the prior day’s daily \nprice range.\nINSIDERS—Individuals who possess fundamental information likely to affect the price of \na stock, but which is unavailable to the public. An example would be an individual who \nknows about a merger before it is announced to the public. Trading by insiders on this type \nof information is illegal.\nINTERMEDIATE TREND—In Edwards and Magee, the term Intermediate or Secondary \nrefers to a trend (or pattern indicating a trend) against the Primary (Major) Trend, which is \nlikely to last from three weeks to three months, and which may retrace one-third to two-\nthirds of the previous Primary Advance or Decline.\nINVERTED BOWL—See Rounding Top.\nINVERTED TRIANGLE—See Right-Angled Broadening Triangle.\n607Glossary\nISLAND REVERSAL—A compact trading range, usually formed after a fast rally or \nreaction, which is separated from the previous move by an Exhaustion Gap, and from the \nmove in the opposite direction that follows by a Breakaway Gap. The result is an Island of \nprices detached by a gap before and after. If the trading range contains only one day, it is \ncalled a One-Day Island Reversal. The two gaps usually occur at approximately the same \nlevel. By itself, the pattern is not of major significance, but it does frequently send prices \nback for a complete retracement of the Minor Move which preceded it.\nKILROY BOTTOM—The editor’s contribution to the nomenclature. A more descriptive \nterm for the undescriptive “Head-and-Shoulders Bottom.”\nLADDERING—A practice some Wall Street underwriters used in the Tulipomania of the \n1990s. Consists of selling initial public offering (IPO) shares for the pre-opening price to \ninsider customers in exchange for their agreement to buy more in the public offering at \nhigher prices. Caused extreme volatility and big run ups in early days of IPOs. An unethical \nform of price manipulation.\nLEVERAGE—Using a smaller amount of capital to control an investment of greater value. \nFor example, exclusive of interest and commission costs, if you buy a stock on 50% margin, \nyou control $1.00 of stock for every $0.50 invested or leverage of 2-to-1.\nLEVERAGE SPACE PORTFOLIO—Ralph Vince uses drawdown as the risk metric for \nportfolios (as does this editor) instead of variance in returns. A sophisticated method for \ndetermining portfolio risk and trade size and optimizing portfolio growth.\nLIMIT MOVE—A change in price that exceeds the limits set by the exchange on which the \nfutures contract is traded.\nLIMIT ORDER—A buy or sell order limited in some way, usually in price. For example, \nif you placed a limit order to buy IBM at 100, the broker would not fill the order unless he \ncould do so at your price or better (i.e., at 100 or lower).\nLIMIT UP , LIMIT DOWN—Commodity exchange restrictions on the maximum upward or \ndownward movements permitted in the price for a commodity during any trading session \nday.\nLINE, DOW THEORY—A Line in the Dow Theory is an Intermediate Sideways Movement \nin one or both of the Averages (Industrial and/or Transportation) in the course of which \nprices fluctuate within a range of 5% (of mean price) or less.\nLOGARITHMIC SCALE—See Semilogarithmic Scale.\nMAJOR TREND—In Edwards and Magee, the term Major (or Primary) refers to a trend \n(or pattern leading to such a trend) that lasts at least one year and shows a rise or decline \nof at least 20%.\nMARGIN—The minimum amount of capital required to buy or sell a stock. The rate, 50% \nof value in 2005, is set by the government. In a commodity, margin is also the minimum, \nusually a", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 275}
{"text": "Semilogarithmic Scale.\nMAJOR TREND—In Edwards and Magee, the term Major (or Primary) refers to a trend \n(or pattern leading to such a trend) that lasts at least one year and shows a rise or decline \nof at least 20%.\nMARGIN—The minimum amount of capital required to buy or sell a stock. The rate, 50% \nof value in 2005, is set by the government. In a commodity, margin is also the minimum, \nusually about 10%, needed to buy or sell a contract. The rate is set by the individual \n608 Glossary\nexchanges. The two differ in cost as well. In a stock, the broker lends the investor the \nbalance of the money due and charges interest for the loan. In a commodity, margin is \ntreated as a good faith payment. The broker does not lend the difference, so no interest \nexpense is incurred.\nMARKET ON CLOSE—An order specification that requires the broker to get the best price \navailable on the close of trading.\nMARKET ORDER—An instruction to buy or sell at the price prevailing when the order \nreaches the floor of the exchange.\nMARKET RECIPROCAL—Normal average range of a stock based on the average range for \na number of years, divided by the current average range. The result is the reciprocal of the \nmarket movement for the period. Wide market activity, for example, would show a small \ndecimal, less than 1. Dull trading would be a larger number.\nMAST—The vertical rally or reaction preceding a Flag or Pennant Formation.\nMcCLELLAN OSCILLATOR—An Index based on New York Stock Exchange net advances \nover declines. It provides a measure of such conditions as overbought/oversold and market \ndirection on a short- to intermediate-term basis. The McClellan Oscillator measures a Bear \nMarket Selling Climax when registering a very negative reading like −150. A sharp buying \npulse in the market is indicated by a very positive reading, well above 100.\nMEASURING FORMULAE—There are certain patterns that do allow the chartist the \nopportunity to project at least an interim target level of the direction of the Primary Trend. \nThe most important of these patterns are found to be Triangles, Rectangles, Head-and-\nShoulders, and Pennants and Flags.\n• Triangles—When a stock breaks out of a Symmetrical Triangle (either up or down), \nthe ensuing move should carry at least as far as the height of the Triangle as measured \nalong its first reaction.\n• Rectangles—The minimum you would expect from a breakout (up or down) out of a \nRectangle Pattern would be the distance equal to the height of the formation.\n• Head-and-Shoulders Tops/Bottoms—The Head-and-Shoulders Pattern has one of \nthe better measuring sticks. In either a Top or Bottom, the interim target, once the \nneckline is penetrated, is the distance from the Top (or Bottom) of the head to the level \nof the neckline directly below (above) the head.\n• Pennants and Flags—The one thing to remember about these Continuation Patterns \nis they “fly at half-mast.” In other words, the leg in equals the leg out.\nMEASURING GAP—See Runaway Gap.\nMEGAPHONES—Megaphones are Broadening Tops. The Broadening Formation may \nevolve in any one of the three forms comparable, respectively, to Inverted Symmetrical, \nInverted Ascending, or Descending Triangles. The symmetrical type, for example, consists \nof a series of price fluctuations across a horizontal axis, with each Minor Top higher and \neach Minor Bottom lower than its predecessor. The pattern may thus be roughly marked \n609Glossary\noff by two diverging lines, the upper sloping up from left to right, the lower sloping down. \nThese Broadening Patterns are characteristically loose and irregular, whereas Symmetrical \nTriangles are regular and compact. The converging boundary lines of Symmetrical Triangles \nare clearly defined, as a rule. Tops and Bottoms within the formation tend to fall within fair \nprecision on these boundary lines. In the Broadening Formation, the rallies and declines \nusually do not all stop at clearly marked boundary lines and are subject to spikes. We could \ncall this a Megaphone Spike because the formation keeps on crowding at the lines to look \nlike a megaphone. It has a tendency to spike down more than up.\nMELON—A handsome rich dividend.\nMINOR TREND—In Edwards and Magee, the term Minor refers to brief fluctuations \n(usually less than six days and rarely longer than three weeks) that, in total, make up the \nIntermediate Trend.\nMOMENTUM INDICATOR—A market indicator utilizing volume statistics for predicting \nthe strength or weakness of a current market and any overbought or oversold conditions \nand to distinguish turning points within the market.\nMOVING A VERAGE—A mathematical technique to smooth data. It is called moving \nbecause the number of elements are fixed, but the time interval advances. Old data must \nbe removed when new data are added, which causes the average to “move along” with the \nprogression of the stock or commodity.\nEN: Simple Moving Average for n days consists of summing prices for n days and dividing by n. On \nn + 1, drop the first day and add the new day to the formula, etc.\nMOVING A VERAGE CONVERGENCE/DIVERGENCE (MACD)—An oscillator derived by \ndividing one Moving Average by another. Basically, it combines three Moving Averages into \ntwo lines. In today’s computer programs, the Moving Averages are usually exponentially \nweighted, thus giving more weight to the more recent data. It is plotted in a chart with a \nhorizontal Equilibrium Line.\nThe Equilibrium Line is important. When the two Moving Averages cross below the \nEquilibrium Line, it means the shorter Exponential Moving Average (EMA) is at a value less \nthan the longer EMA. This is a Bearish signal. When the EMAs are above the Equilibrium \nLine, it means the shorter EMA has a value greater than the longer EMA. This is a Bullish \nsignal.\nThe first line is the difference between a 12-period EMA and a 26-period EMA. The \nsecond line (signal line) is an approximate exponential equivalent of a nine-period Moving \nAverage of the first line. The exponential val", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 276}
{"text": "longer EMA. This is a Bearish signal. When the EMAs are above the Equilibrium \nLine, it means the shorter EMA has a value greater than the longer EMA. This is a Bullish \nsignal.\nThe first line is the difference between a 12-period EMA and a 26-period EMA. The \nsecond line (signal line) is an approximate exponential equivalent of a nine-period Moving \nAverage of the first line. The exponential values being 0.15, 0.075, and 0.20.\nAn MACD can be displayed as a line oscillator or a histogram.\nBuy signals are generated when the faster Moving Average Line crosses the slower \nMoving Average Line from below. Sell signals come from the opposite, when the faster line \ncrosses the slower line from above. Beware of mechanically trading every MACD crossover; \nit can lead to whipsaws and drawdowns with substance. The fact is, narrow trading ranges \ngive many false signals that can be avoided with additional interpretation.\nMOVING A VERAGE CROSSOVERS—The point at which the various Moving Average \nLines pass through or over each other.\n610 Glossary\nMULTICOLINCARITY—The flawed procedure of using the identical data to supply different \ntypes of indicators. The indicators will all confirm each other because they are based on \nthe same data. Combining RSI, Moving Average Convergence/Divergence (MACD), and \nrate of change (where all indicators use the same closing prices and relative time periods) \nshould provide the same signals, but they could easily be incorrect. Multicolincarity can be \navoided by using one indicator based on closing prices, another from volume, and a third \nfrom price ranges. It can also be avoided by using data-generated indicators compared to \nchart patterns. (See also Bollinger Bands, MACD, Wilder Relative Strength Index.)\nMULTIPLE HEAD-AND-SHOULDERS PATTERN—See Complex Head-and-Shoulders.\nNARROW RANGE DAY—A trading day with a narrower price range relative to the \nprevious day’s price range.\nNATURAL and UNNATURAL METHODS or SYSTEMS—Bassetti’s half-humorous \nidentification of “natural methods” of analysis, such as chart analysis, which looks directly \nat market data, as opposed to “unnatural methods,” which place an algorithm between the \ndata and the analysis, such as Moving Averages, oscillators, and so on.\nNATURAL HEDGE—Bassetti’s formulation of a technique recommended by Magee \nwhereby a portfolio is always somewhat long and somewhat short. It is an imperfect hedge \nintended to cushion downside (or upside) risks—for example, long the DIA and short its \nmembers (or their proxies) which are in downtrends.\nNECKLINE—In a Head-and-Shoulders Pattern, it is the line drawn across the two reaction \nlows (in a Top), or two rally highs (in a Bottom), which occur before and after the head. This \nline must be broken by 3% to confirm the Reversal. In a Diamond Pattern, which is similar \nto a Head-and-Shoulders Pattern, the neckline is bent in the shape of a V or inverted V . (See \nalso Diamond and Head-and-Shoulders Pattern.)\nNEGATIVE DIVERGENCE—When two or more Averages, indexes, or indicators fail to \nshow confirming trends.\nNORMAL RANGE FOR PRICE—EN: An analytical tool invented by Magee for measuring the \nvolatility of stocks. Cumbersome in the modern context, but interesting. Described in Appendix A, \nninth edition.\nNUMBER-DRIVEN TECHNICAL ANALYSIS—The use of statistics and algorithms to \nanalyze the market instead of pure chart analysis. Moving Averages and oscillators are \nexamples as are stochastic. There are innumerable indicators of this type. Although having \nmany virtues, it places an algorithm between the price and the analyst.\nODD LOT—A block of stock consisting of fewer than 100 shares.\nON BALANCE VOLUME (OBV)—OBV is a popular Volume Indicator, developed by Joseph \nGranville. Constructing an OBV line is very simple: the total volume for each day is assigned \na positive or negative value depending on whether prices closed higher or lower that day. \nA higher close results in the volume for that day getting a positive value, whereas a lower \nclose results in a negative value. A running total is kept by adding or subtracting each day’s \n611Glossary\nvolume based on the direction of the close. The direction of the OBV line is watched, not \nthe actual volume numbers. Formula:\n• If Today’s Close > Yesterday’s Close, then OBV = Yesterday’s OBV + Today’s Volume\n• If Today’s Close < Yesterday’s Close, then OBV = Yesterday’s OBV − Today’s Volume\n• If Today’s Close = Yesterday’s Close, then OBV = Yesterday’s OBV\nONE-DAY REVERSAL—See Island Reversal.\nOPTION—The right granted to one investor by another to buy (called a call option) or sell \n(called a put option) 100 shares of stock, or one contract of a commodity, at a fixed price \nfor a fixed period of time. The investor granting the right (the seller of the option) is paid a \nnonrefundable premium by the buyer of the option.\nOPTIONS RESEARCH, INC.—Founded by Blair Hull, later of Hull Trading Co. The first \ncompany to computerize the Black–Scholes Model.\nORDER—See Limit Order, Market Order, and Stop Order.\nOSCILLATOR—A form of momentum or rate-of-change indicator usually valued from +1 \nto −1 or from 0% to 100%.\nOVERBOUGHT—Market prices that have risen too steeply and too quickly.\nOVERBOUGHT/OVERSOLD INDICATOR—An indicator that attempts to define when \nprices have moved too far and too quickly in either direction, and thus are liable to a \nreaction.\nOVERSOLD—Market prices that have declined too steeply and too quickly.\nPANIC—The second stage of a Bear Market when buyers thin out and sellers sell at any \nprice. The downward trend of prices suddenly accelerates into an almost vertical drop, \nwhereas volume rises to climactic proportions. (See also Bear Market.)\nPANIC BOTTOM—See Selling Climax.\nPASSIVE INDEXER—Investor who invests in a major index and holds it through up and \ndown waves.\nPATTERN—See Area Pattern.\nPEAK—See Top.\nPENETRATION—The breaking of a pattern boundary line, trendline, or Support and \nResistance Level.\nPENNANT—A Pennant is a", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 277}
{"text": "elerates into an almost vertical drop, \nwhereas volume rises to climactic proportions. (See also Bear Market.)\nPANIC BOTTOM—See Selling Climax.\nPASSIVE INDEXER—Investor who invests in a major index and holds it through up and \ndown waves.\nPATTERN—See Area Pattern.\nPEAK—See Top.\nPENETRATION—The breaking of a pattern boundary line, trendline, or Support and \nResistance Level.\nPENNANT—A Pennant is a Flag with converging, rather than parallel, boundary lines. \n(See also Flag.)\n612 Glossary\nPOINT AND FIGURE CHART—A method of charting believed to have been created by \nCharles Dow. Each day the price moves by a specific amount (the arbitrary box size), an X (if \nup) or O (if down) is placed on a vertical column of squared paper. As long as prices do not \nchange direction by a specified amount (the Reversal), the trend is considered to be in force \nand no new column is made. If a Reversal takes place, another vertical column is started \nimmediately to the right of the first, but in the opposite direction. There is no provision for \ntime on a Point and Figure Chart.\nPREMATURE BREAKOUT—A breakout of an Area Pattern, and then a retreat back into the \npattern. Eventually, the trend will break out again and proceed in the same direction. At \nthe time they occur, false breakouts and premature breakouts are indistinguishable from \neach other or from a genuine breakout.\nPRICE/EARNINGS RATIO—Price of stock divided by earnings (which may or may not be \nreal) to give the P /E ratio. Sometimes an unnatural, or imaginary, number.\nPRIMARY TREND—See Major Trend.\nPROGRAM TRADING—Trades based on signals from various computer programs, usually \nentered directly from the trader’s computer to the market’s computer system.\nEN: Usually indicates large volume transactions on large baskets of stocks by professional traders.\nPROGRESSIVE STOP—A stop order that follows the market up or down. (See also Stop.)\nPROTECTIVE STOP—A stop order used to protect gains or limit losses in an existing \nposition. (See also Stop.)\nPULLBACK—Return of prices to the boundary line of the pattern after a breakout to the \ndownside. Return after an upside breakout is called a Throwback.\nPUT—An option to sell a specified amount of a stock or commodity at an agreed time at \nthe stated exercise price.\nRAIL A VERAGE—See Dow–Jones Transportation Average.\nRALLY—An increase in price that retraces part of the previous price decline.\nRALLY TOPS—A price level that finishes a short-term rally in an ongoing trend.\nRANGE—The difference between the high and low during a specific time period.\nREACTION—A decline in price that retraces part of the previous price advance.\nRECIPROCAL, MARKET—See Market Reciprocal.\nRECOVERY—See Rally.\n613Glossary\nRECTANGLE—A trading area bounded on the Top and the Bottom with horizontal, or near \nhorizontal, lines. A Rectangle can be either a Reversal or Continuation Pattern depending \non the direction of the breakout. Minimum Measuring Formula: add the width (difference \nbetween Top and Bottom) of the Rectangle to the breakout point.\nRED PARALLEL—A line drawn parallel to the trendline (Red Trendline) that connects at \nleast two Bottoms. The Red Parallel (basically a Return Line) is started off a high and used \nto estimate the next high point.\nRED TRENDLINE—A straight line connecting two or more Bottoms together. To avoid \nconfusion, Edwards and Magee use a red line for Bottom Trendlines and a blue line for \nTop Trendlines.\nRELATIVE STRENGTH (RS or RS INDEX)—A stock’s price movement over the past year as \ncompared with a market index (most often the Standard & Poor’s 500 Index). Value below 1 \nmeans the stock shows relative weakness in price movement (underperformed the market); \na value above 1 means the stock shows relative strength over the one-year period. Equation \nfor Relative Strength:\n Current S tock Price/Year-Ago Stock Price\n Current S &P 500/Year-Ago S&P 500\n(See also Wilder Relative Strength Index.)\nRESISTANCE LEVEL—A price level at which a sufficient supply of stock is forthcoming to \nstop, and possibly turn back for a time, an uptrend.\nRETRACEMENT—A price movement in the opposite direction of the previous trend.\nRETURN LINE—See Ascending or Descending Trend Channels.\nREVERSAL GAP—A chart formation where the low of the last day is above the previous \nday’s range with the close above midrange and above the open.\nREVERSAL PATTERN—An Area Pattern that breaks out in a direction opposite to the \nprevious trend. (See also Ascending Triangle, Broadening Formation, Broadening Top, \nDescending Triangle, Diamond, Dormant Bottom, Double Bottom or Top, Head-and-\nShoulders Pattern, Rectangle, Rising or Falling Wedge, Rounding Bottom or Top, Saucer, \nSymmetrical Triangle, and Triple Bottom or Top.)\nRIGHT-ANGLED BROADENING TRIANGLE—Area Pattern with one boundary line \nhorizontal and the other at an angle that, when extended, will converge with the horizontal \nline at some point to the left of the pattern. Similar in shape to Ascending and Descending \nTriangles, except they are inverted and look like Flat-Topped or Bottomed Megaphones. \nRight-Angled Broadening Formations generally carry Bearish implications regardless of \nwhich side is flat. But any decisive breakout (3% or more) through the horizontal boundary \nline has the same forceful significance as does a breakout in an Ascending or Descending \nTriangle.\n614 Glossary\nRIGHT-ANGLE TRIANGLES—See Ascending and Descending Triangles.\nRISING WEDGE—An Area Pattern with two upward-slanting, converging trendlines. \nNormally, it takes more than three weeks to complete and volume will diminish as prices \nmove toward the apex of the pattern. The anticipated direction of the breakout in a Rising \nWedge is down. Minimum Measuring Formula: a retracement of all the ground gained \nwithin the wedge.\nROUND LOT—A block of stock consisting of 100 shares of stock.\nROUND TRIP—The cost of one complete stock or commodity transaction, that is, the entry \ncost and the offset cost combined.\nROUNDING BOTTO", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 278}
{"text": "prices \nmove toward the apex of the pattern. The anticipated direction of the breakout in a Rising \nWedge is down. Minimum Measuring Formula: a retracement of all the ground gained \nwithin the wedge.\nROUND LOT—A block of stock consisting of 100 shares of stock.\nROUND TRIP—The cost of one complete stock or commodity transaction, that is, the entry \ncost and the offset cost combined.\nROUNDING BOTTOM—An Area Pattern that pictures a gradual, progressive, and fairly \nsymmetrical change in the trend from down to up. Both the Price Pattern (along its lows) \nand the Volume Pattern show a concave shape often called a Bowl or Saucer. There is no \nminimum measuring formula associated with this Reversal Pattern.\nROUNDING TOP—An Area Pattern that pictures a gradual, progressive, and fairly \nsymmetrical change in the trend from up to down. The Price Pattern, along its highs, \nshows a convex shape sometimes called an Inverted Bowl. The Volume Pattern is concave \nshaped (a bowl) as trading activity declines into the peak of the Price Pattern and increases \nwhen prices begin to fall. There is no measuring formula associated with this Reversal \nPattern.\nRUNAWAY GAP—A relatively wide gap in prices that occurs in an advance or decline \ngathering momentum. Also called a “Measuring Gap” because it frequently occurs at just \nabout the halfway point between the breakout that started the move and the Reversal Day \nthat calls an end to it. Minimum Measuring Formula: take the distance from the original \nbreakout point to the start of the gap and add it to the other side of the gap.\nRUNNING MARKET—A market wherein prices are moving rapidly in one direction with \nvery few or no price changes in the opposite direction.\nSAUCER—See Rounding Bottom and Scallop.\nSCALLOPS—A series of Rounding Bottom (Saucer) Patterns where the rising end always \ncarries prices a little higher than the preceding Top at the beginning of the pattern. Net \ngains will vary from stock to stock, but there is a strong tendency for it to amount to \n10%–15% of the price. The total reaction, from the left-hand Top of each Saucer to its Bottom, \nis usually in the 20%–30% area. Individual Saucers in a Scallop series are normally five to \nseven weeks long, and rarely less than three weeks. The volume will show a convex or \nBowl Pattern.\nSECONDARY TREND—See Intermediate Trend.\nSECULAR TREND—A major long-lived trend based in solid economic conditions, as \nopposed to cyclic or technical.\n615Glossary\nSELLING CLIMAX—A period of extraordinary volume that comes at the end of a rapid \nand comprehensive decline that exhausts the margin reserves of many speculators or \npatience of investors. Total volume turnover may exceed any single day’s volume during the \nprevious upswing as Panic Selling sweeps through the stock or commodity. Also called a \nClean-Out Day, a Selling Climax reverses the technical conditions of the market. Although \nit is a form of a One-Day Reversal, it can take more than one day to complete.\nSEMILOGARITHMIC SCALE—Price or volume scale in which the distance on the vertical \naxis (i.e., space between horizontal lines) represents equal percentage changes.\nSENSITIVITY—An index used by Edwards and Magee to measure the probable percentage \nmovement (sensitivity) of a stock during a specified percentage move in the stock market \nas a whole.\nEN: More or less equivalent, or with the same intent as beta.\nSHAKEOUT—A corrective move large enough to “shake out” nervous investors before the \nPrimary Trend resumes.\nSHORT INTEREST—The number of shares that have been sold short and not yet repurchased. \nThis information is published monthly by the New York Stock Exchange.\nSHORT SALE—A transaction in which the entry position is to sell a stock or commodity \nfirst and to repurchase it (hopefully at a lower price) at a later date. In the stock market, \nshares you do not own can be sold by borrowing shares from the broker and replacing them \nwhen the offsetting repurchase takes place. In the commodity market, contracts are created \nwhen a buyer and seller get together through a floor broker. As a result, the procedure to \nsell in the commodity market is the same as it is to buy.\nSHOULDER—See Head-and-Shoulders Pattern.\nSMOOTHING—A mathematical approach that removes excess data variability while \nmaintaining a correct appraisal of the underlying trend.\nSPIKE—A sharp rise in price in a single day or two.\nSTOCHASTIC—Random.\nSTOCHASTICS—The Stochastic Oscillator, developed by George Lane, compares a \nsecurity’s price closing level to its price range over a specific period of time. This indicator \nshows, Lane theorized, in an upward-trending market, prices tend to close near their high; \nand during a downward-trending market, prices tend to close near their low. As an upward \ntrend matures, prices tend to close further away from their high; as a downward trend \nmatures, prices tend to close away from their low. The Stochastic Indicator attempts to \ndetermine when prices start to cluster around their low of the day in an uptrending market, \nand cluster around their high in a downtrend. Lane theorizes these conditions indicate a \nTrend Reversal is beginning to occur. The Stochastic Indicator is plotted as two lines, the \n%D Line and %K Line. The %D Line is more important than the %K Line. The Stochastic \nis plotted on a chart with values ranging from 0 to 100. The value can never fall below \n616 Glossary\n0 or above 100. Readings above 80 are considered strong and indicate a price is closing \nnear its high. Readings below 20 are strong and indicate a price is closing near its low. \nOrdinarily, the %K Line will change direction before the %D Line. However, when the %D \nLine changes direction prior to the %K Line, a slow and steady Reversal is often indicated. \nWhen both %K and %D Lines change direction, and the faster %K Line changes direction to \nretest a crossing of the %D Line, though does not cross it, the incident confirms stability of \nthe prior Reversal. A powerf", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 279}
{"text": "low. \nOrdinarily, the %K Line will change direction before the %D Line. However, when the %D \nLine changes direction prior to the %K Line, a slow and steady Reversal is often indicated. \nWhen both %K and %D Lines change direction, and the faster %K Line changes direction to \nretest a crossing of the %D Line, though does not cross it, the incident confirms stability of \nthe prior Reversal. A powerful move is under way when the Indicator reaches its extremes \naround 0 and 100. Following a Pullback in price, if the Indicator retests extremes, a good \nentry point is indicated. Many times, when the %K or %D Lines begin to flatten out, the \naction becomes an indication the trend will reverse during the next trading range.\nSTOCK SPLIT—A procedure used by management to establish a different market price \nfor its shares by changing the common stock structure of the company. Usually a lower price \nis desired and established by canceling the outstanding shares and reissuing a larger number \nof new certificates to current shareholders. The most common ratios are 2-to-1, 3-to-1, and \n3-to-2. Occasionally, a higher price is desired and a reverse split takes place where one new \nshare is issued for some multiple number of old shares.\nSTOP—A contingency order placed above the current market price if it is to buy, or below \nthe current market price if it is to sell. A stop order becomes a market order only when the \nstock or commodity moves up to the price of the buy stop, or down to the price of a sell \nstop. A stop can be used to enter a new position or exit an old position. (See also Protective \nor Progressive Stop.)\nSTOP LOSS—See Protective Stop.\nSUPPLY—Amount of stock available at a given price.\nSUPPLY LINE—See Resistance.\nSUPPORT LEVEL—The price level at which a sufficient amount of demand is forthcoming \nto stop, and possibly turn higher for a time, a downtrend.\nSYMMETRICAL TRIANGLE—Also called a Coil. Can be a Reversal or Continuation \nPattern. A sideways congestion in which each Minor Top fails to attain the height of the \nprevious rally and each Minor Bottom stops above the level of the previous low. The result \nis upper and lower boundary lines that converge, if extended, to a point on the right. The \nupper boundary line must slant down and the lower boundary line must slant up, or it \nwould be a variety of a Wedge. Volume tends to diminish during formation. Minimum \nFormula: add the widest distance within the Triangle to its breakout point.\nTANGENT—See Trendline.\nTAPE READER—One who makes trading decisions by watching the flow of New York \nStock Exchange and American Stock Exchange price and volume data coming across the \nelectronic ticker tape.\nTEKNIPLAT™ PAPER—A specially formatted, two-cycle, semilogarithmic graph paper, \nwith sixth-line vertical accents, used to chart stock or commodity prices. Check h t t p : //\nwww.edwards-magee.com.\n617Glossary\nTEST—A term used to describe the activity of a stock or commodity when it returns to, or \n“tests,” the validity of a previous trendline, or Support or Resistance Level.\nTHIN ISSUE—A stock with a low number of floating shares and is lightly traded.\nTHREE-DAYS-AWAY RULE—An arbitrary time period used by Edwards and Magee in \nmarking suspected Minor Tops or Bottoms.\nTHROWBACK—Return of prices to the boundary line of the pattern after a breakout to the \nupside. Return after a downside breakout is called a Pullback.\nTOP—See Broadening Top, Descending Triangle, Double Top, Head-and-Shoulders Top, \nRounding Top, and Triple Top.\nTREND—The movement of prices in the same general direction, or the tendency or \nproclivity to move in a straight line. (See also Ascending, Descending, and Horizontal \nParallel Trend Channels, Convergent Trend, Divergent Trend, Intermediate Trend, Major \nTrend, and Minor Trend.)\nTREND CHANNEL—A parallel probable price range centered about the most likely price \nline.\nTRENDING MARKET—Price continues to move in a single direction, usually closing \nstrongly for the day.\nTRENDLINE—If we actually apply a ruler to a number of charted price trends, we quickly \ndiscover the line most often really straight in an uptrend trend is a line connecting the \nlower extremes of the Minor Recessions within these lines. In other words, an advancing \nwave in the stock market is composed of a series of ripples, and the bottoms of each of \nthese ripples tend to form on, or very close to, an upward-slanting straight line. The tops \nof the ripples are usually less even; sometimes they also can be defined by a straight line, \nbut more often, they vary slightly in amplitude, and so any line connecting their upper \ntips would be more or less crooked. On a descending price trend, the line most likely to \nbe straight is the one that connects the tops of the Minor Rallies within it, while the Minor \nBottoms may or may not fall along a straight edge. These two lines—the one that slants up \nalong the successive wave bottoms within a broad up-move and the one that slants down \nacross successive wave tops within a broad down-move—are the Basic Trendlines. You \ndraw an Up Trendline by drawing the line on the inner side. You draw a Down Trendline \nby drawing it on the outside. You draw a Sideways Trendline on the bottom.\nTRIANGLE—See Ascending Triangle, Descending Triangle, Right-Angled Broadening \nTriangle, and Symmetrical Triangle.\nTRIPLE BOTTOM—Similar to a flat Head-and-Shoulders Bottom, or Rectangle, the three \nBottoms in a Triple Bottom.\nTRIPLE TOP—An Area Pattern with three Tops widely spaced and with quite deep, and \nusually rounding, reactions between them. Less volume occurs on the second peak than the \n618 Glossary\nfirst peak, and still less on the third peak. Sometimes called a “W” Pattern, particularly if \nthe second peak is below the first and third. The Triple Top is confirmed when the decline \nfrom the third Top penetrates the Bottom of the lowest valley between the three peaks.\n200-DAY MOVING A VERAGE LINE—Determined by taking the closing price over", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 280}
{"text": "lume occurs on the second peak than the \n618 Glossary\nfirst peak, and still less on the third peak. Sometimes called a “W” Pattern, particularly if \nthe second peak is below the first and third. The Triple Top is confirmed when the decline \nfrom the third Top penetrates the Bottom of the lowest valley between the three peaks.\n200-DAY MOVING A VERAGE LINE—Determined by taking the closing price over the \npast 200 trading days and dividing by 200, then repeating the process each succeeding day, \nalways dropping off the earliest day.\nUPTICK—A securities transaction made at a price higher than the preceding transaction.\nUPTREND—See Ascending Trendline and Trend.\nUTILITY A VERAGE—See Dow–Jones Utility Average.\nV /D VOLUME—Is the ratio between the daily up-volume to the daily down-volume. It is a \n50-day ratio determined by dividing the total volume on those days when the stock closed \nup from the prior day by the total volume on days when the stock closed down.\nV ALIDITY OF TRENDLINE PENETRATION—The application of the following three tests \nwhen a trendline is broken to determine whether the break is valid or whether the trendline \nis still basically intact: (1) the extent of the penetration, (2) the volume of trading on the \npenetration, and (3) the trading action after the penetration.\nV ALLEY—The V-shaped price action that occurs between two peaks. (See also Double Top \nand Triple Top.)\nVINCE, RALPH—Author of Handbook of Portfolio Mathematics where optimal f is \ndescribed as a quantitative way to achieve optimal allocation and leverage of a portfolio. \nThe Leverage Space Model achieves optimal bet sizing for maximizing gains while \nminimizing risk.\nVOLATILITY—A measure of a stock’s tendency to move up and down in price, based on \nits daily price history over the latest 12-month period. (See Appendix B, Resources, for the \nformula.)\nVOLUME—The number of shares in stocks or contracts in commodities traded over a \nspecified period of time.\n“W” FORMATION—See Triple Top.\nWEDGE—A chart formation in which the price fluctuations are confined within converging \nstraight (or practically straight) lines.\nWILDER RELATIVE STRENGTH INDICATOR (RSI)—Although relative strength, \ncomparing a security price to a benchmark index price, has been around for some time, this \nindicator was developed by J. Welles Wilder, as explained in his 1978 book, New Concepts \nin Technical Trading.\n619Glossary\nRelative Strength is often used to identify price Tops and Bottoms by keying on specific \nlevels (usually “30” and “70”) on the RSI chart, which is scaled from 0 to 100. The RSI can \nalso be useful to show the following:\n 1. Movement that might not be as readily apparent on the bar chart.\n 2. Failure Swings above 70 or below 30, warning of coming Reversals.\n 3. Support and Resistance Levels appear with greater clarity.\n 4. Divergence between the RSI and price can often be a useful Reversal indicator.\nThe RSI requires a certain amount of lead-up time to operate successfully.\n\n621\nBibliography\nAllen, R.C., How to Use the 4 Day, 9 Day and 18 Day Moving Averages to Earn Larger Profits from \nCommodities, Best Books, Chicago, 1974.\nArms, R.W., Volume Cycles in the Stock Market. Market Timing Through Equivolume Charting, Dow Jones-\nIrwin, Homewood, IL, 1983.\nArms, R.W., Jr., The Arms Index, TRlN, Dow Jones-Irwin, Homewood, IL, 1989.\nBassetti, W.H.C., StairStops, MaoMao Press, San Geronimo, CA, 2009.\nBassetti, W.H.C., Zen Simple Beat the Market with a Ruler, MaoMao Press, San Geronimo, CA, 2009.\nBassetti, W.H.C., Sacred Chickens, the Holy Grail and Dow Theory, MaoMao Press, San Geronimo, CA, 2010.\nBassetti, W.H.C., Ten Trading Lessons, MaoMao Press, San Geronimo, CA, 2010.\nBassetti, W.H.C., Signals, MaoMao Press, San Geronimo, CA, 2011.\nBelveal, L.D., Charting Commodity Market Price Behavior , 2nd ed., Dow Jones-Irwin, Homewood, IL, \n1985.\nBernstein, J., The Handbook of Commodity Cycles. A Window on Time, John Wiley & Sons, New York, 1982.\nBernstein, P ., Against the Gods, John Wiley & Sons, New York, 1996.\nBlumenthal, E., Chart for Profit Point & Figure Trading, Investors Intelligence, Larchmont, NY, 1975.\nBolton, A.H., The Elliott Wave Principle. A Critical Appraisal, Monetary Research, Hamilton, Bermuda, \n1960.\nBressert, W.J., and J.H. Jones, The HAL Blue Book. How to Use Cycles with an Over-Bought/Oversold and \nMomentum Index for More Consistent Profits, HAL Market Cycles, Tucson, AZ, 1984.\nChicago Board of Trade, CBOT Dow Jones Industrial Average and Futures Options, Chicago, 1997 .\nCohen, A.W., How to Use the Three-Point Reversal Method of Point & Figure Stock Market Trading, 8th rev. \ned., Chartcraft, Larchmont, NY, 1982.\nCootner, P .H., Ed., The Random Character of Stock Market Prices, MIT Press, Cambridge, 1964.\nde Villiers, V ., The Point and Figure Method of Anticipating Stock Price Movements. Complete Theory and \nPractice, Windsor Books, Brightwaters, NY, orig. 1933, reprinted in 1975.\nDewey, E.R., and O. Mandino, Cycles, the Mysterious Forces That Trigger Events , Manor Books, \nNew York, 1973.\nDobson, E.D., Understanding Fibonacci Numbers, Trader Press, Greenville, SC, 1984.\nDorsey, T.J., Point & Figure Charting, John Wiley & Sons, New York, 2001.\nDreman, D., Contrarian Investment Strategy, Simon & Schuster, New York, 1974.\nDunn, and Hargitt, Trader’s Notebook. Trading Methods Checked by Computer, Dunn & Hargitt, Lafayette, \nIN, 1970.\nDunn, and Hargitt, Point and Figure Commodity Trading. A Computer Evaluation , Dunn & Hargitt, \nLafayette, IN, 1971.\nDu Plessis, J., The Definitive Guide to Point and Figure, Harriman House Ltd., Hampshire Great Britain, \n2005.\nElliott, R.N., The Major Works of R.N. Elliott, R. Prechter, Ed., New Classics Library, Chappaqua, NY, 1980.\nEmery, W.L., Ed., Commodity Year Book, Commodity Research Bureau, Jersey City, NJ, annually.\nFrost, A.J., and R.R. Prechter, Elliott Wave Principle, Key to Stock Market Profits, New Classics Library, \nChappaqua, NY, 1978.\nGalbraith, J.K., The Great Crash", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 281}
{"text": "d., Hampshire Great Britain, \n2005.\nElliott, R.N., The Major Works of R.N. Elliott, R. Prechter, Ed., New Classics Library, Chappaqua, NY, 1980.\nEmery, W.L., Ed., Commodity Year Book, Commodity Research Bureau, Jersey City, NJ, annually.\nFrost, A.J., and R.R. Prechter, Elliott Wave Principle, Key to Stock Market Profits, New Classics Library, \nChappaqua, NY, 1978.\nGalbraith, J.K., The Great Crash 1929, Houghton Mifflin, Boston, 1961.\n622 Bibliography\nGann, W.D., How to Make Profits in Commodities , rev. ed., Lambert-Gann Publishing, Pomeroy, WA, \norig. 1942, reprinted in 1976.\nGranville, J.E., New Strategy of Daily Stork Market Timing for Maximum Profits, Prentice-Hall, Englewood \nCliffs, NJ, 1976.\nHadady, R.E., Contrary Opinion. How to Use it For Profit in Trading Commodity Futures , Hadady \nPublications, Pasadena, CA, 1983.\nHurst, J.M., The Profit Magic of Transaction Timing, Prentice-Hall, Englewood Cliffs, NJ, 1970.\nJiler, W.L., How Charts Can Help You in the Stock Market, Trendline, New York, 1962.\nJiler, H., Ed., Guide to Commodity Price Forecasting, Commodity Research Bureau, New York, 1971.\nJorion, P ., Value at Risk, John Wiley & Sons, New York, 1996.\nKaufman, P.J., Commodity Trading Systems and Methods, Wiley, New York, 1978.\nKaufman, P.J., Technical Analysis in Commodities, John Wiley & Sons, New York, 1980.\nKirkpatrick, C.D., and J.R. Dahlquist, Technical Analysis, FT Press, Upper Saddle River, NJ, 2007 .\nMacKay, C., Extraordinary Popular Delusions and the Madness of Crowds, Three Rivers Press, New York, \n1980.\nMagee, J., Winning the Mental Game on Wall Street , 2nd ed., W.H.C. Bassetti, Ed., St. Lucie Press, \nBoca Raton, FL, 2000.\nMagee, J., and W.H.C. Bassetti, Introduction to the Magee System of Technical Analysis , St. Lucie Press, \nBoca Raton, FL, 2002.\nMandelbrot, O., “ A MultiFractal Walk Down Wall Street,” Scientific American , February 1999, June \n1999, 280, 70–73.\nMcMillan, L.G., Options as a Strategic Investment, New York Institute of Finance, New York, 1993.\nMurphy, J.J., Technical Analysis of the Futures Markets, New York Institute of Finance, New York, 1986.\nNatenberg, S., Option Volatility and Pricing Strategy, rev. ed., Probus Publishing Company, Chicago, 1994.\nNiederhoffer, V., The Education of a Speculator, John Wiley & Sons, New York, 1997 .\nNison, S., Japanese Candlestick Charting Techniques, New York Institute of Finance, New York, 1991.\nNison, S., Beyond Candlesticks, John Wiley & Sons, New York, 1994.\nO’Neil, W.J., How to Make Money in Stocks, 2nd ed., McGraw-Hill, New York, 1995.\nPatel, C., Technical Trading Systems for Commodities and Stocks, Trading Systems Research, Walnut Creek, \nCA, 1980.\nPring, M., Technical Analysis Explained, 2nd ed., McGraw-Hill, New York, 1985.\nPring, M.J., Technical Analysis Explained, 3rd ed., McGraw-Hill, New York, 1991.\nSchannep, J., Dow Theory for the 21st Century, John Wiley & Sons, New York, 2008.\nSchultz, J.W., The Intelligent Chartist, WRSM Financial Services, New York, 1962.\nSchwager, J.D., A Complete Guide to the Futures Markets. Fundamental Analysis Technical Analysis, Trading \nSpreads and Options, John Wiley & Sons, New York, 1984.\nSchwager, J.D., Market Wizards, HarperBusiness, New York, 1990.\nSchwager, J.D., The New Market Wizards, HarperBusiness, New York, 1992.\nSchwager, J.D., Schwager on Futures, Technical Analysis, John Wiley & Sons, New York, 1996.\nShibayama, Z., Zen Comments on the Mumonkan, Harper and Row, New York, 1974.\nSklarew, A., Techniques of a Professional Commodity Chart Analyst , Commodity Research Bureau, \nNew York, 1980.\nTeweles, R.J., C.V . Harlow, and H.L. Stone, The Commodity Futures Game—Who Wins?—Who Loses?—\nWhy? 2nd ed., McGraw-Hill, New York, 1974.\nVince, R., The Handbook of Portfolio Mathematics, John Wiley & Sons, New York, 2007 .\nVodopich, D.R., Trading for Profit with Precision Timing, Precision Timing, Atlanta, GA, 1984.\nWilder, J.W., New Concepts in Technical Trading Systems, Trend Research, Greensboro, NC, 1978.\nWilliams, L.R., How I Made $1,000,000 Trading Commodities Last Year, 3rd ed., Conceptual Management, \nMonterey, CA, 1979.\nZieg, K.C., Jr., and P .J. Kaufman, Point and Figure Commodity Trading Techniques, Investor’s Intelligence, \nLarchmont, NY, 1975.\nZweig, M., Winning on Wall Street, Warner Books, New York, 1986.\n623\nIndex\nA\nABC Vending Corp., 455, 576, 579\nAbsolute certainty, 275\nAccelerating Downward Trend, 68\nAccumulation, 14, 17, 43, 44, 107, 157, 159, 168, 184, 241, \n245, 265, 327, 538, 542, 595\nPattern, 73, 401\nAction Industries, 472, 576, 579\nActivity, see Volume\nActs of God, 12, 248\nAcute Triangle, 79–80\nAdvisors, 252, 268, 310\nADXR Indicator, 595\nAgricultural commodity, 247–248\nAIQ Trading Expert Pro, 531–532\nAmazon, 27, 335–336, 358, 477, 563, 573, 579\nAMD, 475, 577, 579\nAmerican Locomotive, 63, 163, 433, 566, 570, 575, 580\nAmerican Stock Exchange (AMEX), 271, 309, 311, 312, \n316, 349, 494, 524\n, 616\nApex, 80, 83, 84, 87, 88, 94, 97, 99–100, 122, 128, 142, \n145, 153, 201, 203–205, 209, 398–400, 404, 408, \n412, 423, 440, 443, 596\nApex of Symmetrical Triangle, 414\nAppel, Gerald, 542\nApple Computer Inc (APPL), 135, 366, 478–479, 577\nAppreciated portfolio, protecting profits in, 285 –286\nArbitrage, 344, 596\nArea Gap, see Common Gap\nArea Pattern, 8, 90, 145, 176, 184, 186, 198, 202, 221, 261, \n264, 319, 423, 439, 596, 601, 604, 605, 611–614, \n617–618\nArea Reversal Pattern, 599\nArithmetic paper, 8, 229\nArithmetic scale, 8 , 58, 69, 143, 211–216, 596\nArms CandleVolume charting, 551–553\nArms Index, 545, 548–549\nAroon, 538, 542\nAroon Down, 538, 542\nAroon Oscillator, 538\nAroon Up, 538, 542\nAscending Channel, 596\nAscending Formation, 99\nAscending Pattern, 98 –99\nAscending Trend Channels, 596 , 599, 613\nAscending Trendline, 596, 618\nAscending Triangle, 84 –89, 94–95, 97–98, 114–115, \n122, 135–136, 141, 147, 161, 166, 177–178, 189, \n204, 294, 373–375, 395, 399, 408, 428, 434, \n439–441, 465, 472, 596, 613–614\nAsset allocation, 275, 278, 280–282, 491\nAstrodata Inc. (ADA), 46", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 282}
{"text": "Up, 538, 542\nAscending Channel, 596\nAscending Formation, 99\nAscending Pattern, 98 –99\nAscending Trend Channels, 596 , 599, 613\nAscending Trendline, 596, 618\nAscending Triangle, 84 –89, 94–95, 97–98, 114–115, \n122, 135–136, 141, 147, 161, 166, 177–178, 189, \n204, 294, 373–375, 395, 399, 408, 428, 434, \n439–441, 465, 472, 596, 613–614\nAsset allocation, 275, 278, 280–282, 491\nAstrodata Inc. (ADA), 467, 576, 581\nAt-the-money, 283, 596\nAutomated trendline, 421–425, 540\nAverage(s), 4, 17, 19, 26, 41, 50, 99, 106, 112, 135, 145, \n151, 181, 313, 347, 393–394, 428, 436, 445, 459, \n481, 482, 596, 600\ndiscount, 12\nDow, see Dow averages\ngaps in, 187\ninvestor, 192\nmoving, see Moving averages\nsupport and resistance in, 206\ntrendlines in, 243\nAverage Directional Index (ADX), 538, 542, 595\nAverage True Range (ATR), 358–359, 538\nAveraging Cost, 442, 485, 596–597\nAvnet Electronics Corp., 448, 459, 575, 581\nAxis, 196, 205, 597\nB\nBalanced program, 481–486, 597\nBandwidth, 538, 598\nBar Chart, 31, 266, 304, 531, 532, 545, 550, 552, 554, \n558, 597\nBaruch, Bernard, 265\nBasic Trendlines, see Trendlines\nBasing Points (BP), 31–40, 198, 239, 256, 258, 260, \n299–300, 308, 314, 326, 328, 340, 357–359, \n362–366, 368–370, 404, 414, 480, 504, 506, \n574, 581, 597\nBasket Trades, 389–390, 597\nBearish Move, 391, 451\nBearish Trend, 310, 482\nin Industrial Rayon, 446\nin Lorillard, 447\n624 Index\nBear Market, 13, 15, 225, 242, 264, 293, 299, 386, 413, \n481, 509, 511–512, 597, 602, 611\nsignal, 519–521\nBear Market Bottom in Socony–Vacuum, 89, 109\nBear Market Rallies, 61, 63\nrising wedges in, 144\nBear Market Selling Climax, 608\nBear Raiding, 168\nBent Neckline, see Neckline (NL)\nBent neckline, 138, 444, 597\nBeta, 310, 321, 322, 342–343, 346, 597\ncoefficient, 597\nBitcoin, 326–328\nBlack Scholes model, 266, 273, 531\nBlock Trades, 97–99, 105, 597\nBlow-Off, see Climactic Top\nBlue Chips, 41, 280, 301, 320, 353, 437, 598\nBlue Parallel, 373–374, 378–380, 410, 598\nBlue Trend, 373, 375–379\nBlue Trendline, 373–378, 578, 598\nBollinger Bands (BB), 266, 267, 537, 561–563, 598\nBollinger, John, 533, 561\nBona fide breakout, 600\nBond\nfutures for asset allocation, 280 –282\ntraders and investors, 496\nBook value, 4, 5, 175, 599\nBottom, 599\nKilroy, see Head-and-Shoulders Bottom\nPatterns, 57, 58, 117, 161, 458\nTrendlines, 224, 273, 414\nBou ndar y, 54, 78, 599\nBowl Pattern, see Rounding Bottoms\nBracketing, 599\nBreakaway gaps, 47, 63, 91, 142, 162, 173–174, 177–182, \n186, 202, 254, 258, 410, 412, 417, 423, 470, 599, \n607\nBreaking neckline, 47–49\nBreakout failure, 603\nBreakout Gap, 126, 175, 184\nsignals, \n185\n“Breakout of dormancy,” 73\nBreakouts, 88, 108, 161, 418, 551, 599\ndecisive, 221, 377, 378\ndownside, 95, 99, 398, 408\npremature, 85, 108\npullbacks, 224\nfrom Right-Angle Triangles, 100\nupside, 89, 99, 402, 408\nBroadening Bottoms, 135\nBroadening Formations, 121–122, 599, 608–609\nvolume during, 122–128\nBroadening Pattern, 604\nBroadening Price Formation, 130 –131\nBroadening Price Patterns, 121, 122, 126, 131, 136\nBroadening Tops, 122, 124, 125, 129, 133, 309, 400, 404, \n408, 617\nin Dow–Jones Industrial Average, 444 –445\nOrthodox, see Orthodox Broadening Top\nBroad market, 243\nBroad market background, 264\nBroad Market Trend, 243\nBrokerage firms, 270\nBrokerage houses, 526–527\nBrokers, 145, 146, 268, 269, 313, 347\nBrooker, Brian, \n27\nBrunswick Corporation, 450 , 575, 581\nBullish Market, 321, 460, 481, 483\nBullish Move, 391, 406\nBull Market, 13–19, 23, 70, 226, 241, 264, 293, 299, \n396–397, 481, 492, 493, 514, 518, 595, 599, 602\nin commodities, 260\ndynamic phase of, 157\nPrimar y, see Primary Bull Market\nPublicker, 116\nBull Market Advance, 159, 225, 294\nBull Market Concomitants, 159\nBull Market High, 52\nBull Market Peaks, 114\nBull Market Reaction, 219\nBull Market Top, 53, 86, 240\nof Head-and-Shoulders Form, 50\nSymmetrical Triangle Bottom, 80\nSymmetrical Triangle Reversal, 78\nin U.S. Steel, 127\nin Westinghouse, 96\nof Westinghouse Electric, 47\nBull Market Trend, 237\nof General Motors, 230\nBull Market Trendlines, 229\nBull signal, 513–514\nBull trap, 139, 148, 326, 327, 420, 473\nBull Trend reaffirmation, 515 –516\nBurndy Corporation, 449, 575, \n582\nBuy-and-Hold investor, 26, 27\nBuying at the top, 487\nC\nCall option, 599, 611\nCandlestick charts, 7, 8, 182, 266, 267, 553\nCandlesticks, 551, 599\nCanny investor, 278\nCANSLIM system, 316\nCapital, 489\napplication in practice, 491–494\nto use in trading, 489 –490\nCash, differences with future transactions, 277\nCatastrophic Risk, 503\n“Cats and dogs,” 15, 320, 493, 517, 599\nCaveats, 330–331\nof Moving Averages, 422\nCBOT\n® DJIASM Index futures, 276, 282\nCerro Corporation, 456, 576, 582\nChaff, 270\nChaikin Money Flow (CMF), 538\nChaikin Oscillator, 538\nChandelier Exit, 359, 537\n625Index\nChande Trend Meter (CTM), 538\nChannel, 599\nChart(s), 157, 197, 261, 267, 269, 304, 505, 599, 605\nAscending Triangle, 399\nassociated dry goods winds up, 396\nBroadening Tops, 400, 408\ncandlestick, 7, 8, 182, 266, 267, 553\nComplex or multiple Head-and-Shoulders, 403\ndaily chart in Northern Pacific, 412\ndaily chart of Lehigh Valley R. R, 407\ndecorating graphic charts, 304\nDiamond, 409\nDiamond Pattern in American Can, 404\nDouble Tops and Bottoms, 409\nDow Theory, 393–399\nFlags and Pennants, 410–411\nGaps, 411–413\nGulf, Mobile, and Ohio builds beautiful Wedge, \n405\nHead-and-Shoulders Bottom, 401–403\nHead-and-Shoulders Top, 400–401\nof New York Central, 175\nOne-Day Reversals, 410\nPennant in Martin–Parry, 406\nRectangles, 408 –409\nRectangles in Remington Rand, 401\nRight-Angled Broadening Formations, 409\nRight-Angle Triangles, 408\nrounding Bottom in 1945, 397\nRounding Tops and Bottoms, 403 –406\nSpiegel’s Bear Market, 262\nof stocks, 163\nSupport and Resistance, 414\nSymmetrical Triangle in allied stores, 398\nSymmetrical Triangles, 406 –408\nTrendlines, 414\ntrendlines in American steel foundries, 413\ntypes of scales, 8 –9\nWedges, 409–410\nwide Descending Triangle of, 262\nChart analysis, 304, 539–540\ncomputer for, 304–305\nChart analysts, 259, 266\nCommodity Research Bureau Ind", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 283}
{"text": "Bottoms, 403 –406\nSpiegel’s Bear Market, 262\nof stocks, 163\nSupport and Resistance, 414\nSymmetrical Triangle in allied stores, 398\nSymmetrical Triangles, 406 –408\nTrendlines, 414\ntrendlines in American steel foundries, 413\ntypes of scales, 8 –9\nWedges, 409–410\nwide Descending Triangle of, 262\nChart analysis, 304, 539–540\ncomputer for, 304–305\nChart analysts, 259, 266\nCommodity Research Bureau Index, 254\ntrading futures, 259 –260\nChicago Board of Trade (CBOT\n®), 271\nChicago Board Options Exchange (CBOE), 273, 494\nChicago Mercantile Exchange, 276 –277, 312\nChicago, Milwaukee, St. Paul and Pacific, 440\nChrysler, 436\nClassical technical analysis, 4\nClean-cut Triangle, 82\nClean-Out Day, see Selling Climax\nClimactic Top, 597, 600\nClimax Day, see One-Day Reversal\nClimax, Selling, see Selling Climax\nClose-only charts, 267\nClosing gap, 171–173\nClosing prices, 18, 600\nClosing the gap, 600, 601\nCloud, 269\nCoil, see Symmetrical Triangle\nColby, Robert, 21\nCommission, 600\nCommitments, 417–418\nCommodity, 276\nagricultural, 247–248\nmarket, 615\ntraders, 298\nCommodity Channel Index (CCI), 538\nCommodity charts, technical analysis of\napplication of Edwards and Magee’s methods, \n252–259\nchart analyst trading futures, 259 –260\nrocket scientists, 249 –250\nTurtles, 250–252\n21st-century perspective, 249\nvariety of methods, 259\nCommon Gap, 175–177, 184, 596, 600\nComparative relative strength, 600\nComplete Basing Points Procedure, \n368–370\nComplex Formations, 59\nComplex Head-and-Shoulders Pattern, 59, 403, 600, \n602, 610\nEN, 60\nragged Kilroy Bottom, 61\nstrong movement toward lower interest rates \nevident, 60\nComposite Average, 600\nComposite Leverage, 498, 600\nComposite Leverage Index, 492, 493\nCompound Annual Growth Rates (CAGR), 32\nComputer, 265\nfor charting analysis, 304 –305\ntechnology, 267–268\nComputer software packages, 267\nConant, James Bryant, 289\nConfirmation, 16–19, 600–601\nCongestion, 151, 601\nCongestion Formations, 115, 175–176\nConservative investing, 310–311\nConsolidating, 151\nConsolidation Formation, 110, 151\na, 156\nBull Flag in February and Bear Flag in April 1936\ncompact type of price “Congestion,” 158\nConsolidation Pattern, 167\ndown-sloping, converging price formation, 157\nflag pictures on weekly and monthly charts, \n158–159\nFlags and Pennants, 151–153\nFlag seemed for several weeks, 163\n“Half-Mast” Pattern, 161\nHead-and-Shoulders Consolidations, 160–162, 164\nmeasuring formula, 154 –156\nmodern vs. old-style markets, 168–169\nrectangular Consolidations, 159\nreliability of Flags and Pennants, 156 –157\n626 Index\nConsolidation Formation (Continued)\nscallops, 162–167\nseries of Flag-type Consolidations, 159\nstock make long series of small Consolidation \nPatterns, 155\nConsolidation Head-and-Shoulders, see Head-And-\nShoulders Pattern\nConsolidation Pattern, 79, 94–97, 156, 161, 167, 190, 392, \n600, 601, 604\nConsolidations of Rectangle, 159\nConstruction of index shares and similar \ninstruments, 311–312\nContinuation Formation, see Consolidation \nFormation\nContinuation Gap, see Runaway Gap\nContinuation-of-Trend Pattern, 137\nContinuation Pattern, see Consolidation Pattern\nControl Data Corp (CDA), 462, 576, 583\nControlling risk, 351, 499, 503\nConvergent Pattern (Trend), 601\nCopper Range Co., 452, 576, 583\nCoppock Curve, 538\nCorrection, 601\nCorrective trends, 226 –227\nCorrelation Coefficient, 500, 538\n“Cost of carry,” 276–279\nCosts, 390\nCovering the gap, see Closing the gap\n“Cradle,” 205, 601\n“Cradle point,” 440, 456\nCrossovers, 422–424\nCrucible Steel Co. of America, 457, 576, 583\nCyber trader, 316\nCyclical approach, 3\nD\nDaily Range, 148, 173, 508, 601\nDampened risks, 313\nDanaher Corp., 558\nDay-to-day chart analysis, 196\n“Day traders,” 31, 166, 168, 298, 302\nDay trading, 168, 298\nDecisionPoint Price Momentum Oscillator (PMO), \n538\nDefinite warning, 428\nDegree of fluctuation, 283, 345\nDelaware, Lackawanna And Western, 432\n“Delivery,” 276\nDell, 473–474\nDelphic Options Research, 523 , 529\nDemand, 70, 86, 98, 112, 117, 601\nDemand Line, 98, 104, 176, 202\nDescending Channel, 601\nDescending Trend, 603\nDescending Trend Channel, 374 –375, 599, 601, 613, 619\nDescending Trendline, 601, 603\nDescending Triangle, 92 , 97–99, 122, 136, 175, 294, 408, \n601–602, 613–614, 617\nDetrended Price Oscillator (DPO), 538\nDiagonal Movements, 423\nDiamond, 74, 127, 129, 130, 137–\n139, 602\nPattern, 610\nReversal Formation, 128, 137–138, 409\nDIAMONDS™ (DIA), 271, 274, 299, 312, 317, 323, \n350, 351, 390\nDirectional tendency, 110\nDiscipline, 260, 287, 501, 542\nDissecting Dow Theory, 499\n“Distance away” criteria, 194, 203\nDistribution, 43, 44, 117, 136, 168, 602\nf requency, 500\nLine, 538, 542\nPattern, 90\nplanned, 98\nDistribution period, 15, 17\nDivergence, 4, 99, 212, 510, 511, 513, 600–602\ndefinite, 166\nnegative, 610\nDivergent Pattern, 206, 602\nDivergent Trend, 617\nDivergent Trend Channel, 376, 377, 379\nDiverging boundary lines, 100\nDiversification, 41, 298, 313, 319, 389, 390, 481–486, 602\nDividends, 23, 194, 277, 294, \n297–298, 307, 310–311, 315, \n341, 345, 348, 361, 419, 469, 602\nDonchian system, 251\nDormant Bottom, 72–74, 602\nDouble Bottoms, 113–115, 118, 409, 602\nDouble Top, 103–105, 113–115, 118, 409, 602, 617\nat Primary Trend Reversals, 118\nDouble trendlines, 222 –223, 603\nDow averages, 12\nbasic tenets, 12–14\nmajor trend phases, 14–16\nprinciple of confirmation, 16 –19\ntide, wave, and ripple, 14\nDow Index futures, 277, 287\nDow Industrial Average (DIA), 481\nDow interpretation, 507–508\nDow–Jones Industrial Average (DJIA), 6, 41, 146, 311, \n444–445, 454, 486, 600, 603, 606\nDow–Jones Industrial Index\ndifferences between cash and futures, 277\nDow Index futures, 277\nexercising option, 284\nexploiting market reversals, 285\nfungibility, 276–277\nfutures and options, 275 , 284\ninvestment and hedging strategies, 276\ninvestment uses of Dow Index futures, 279 –282\nmarking-to-market trading, 276\noption premiums, 283\noptions on Dow Index futures, 282 –283\noption spreads in high-or low-volatility markets, \n286–287\nperspective, 287\nportfolio yields improvement,", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 284}
{"text": "ures, 277\nexercising option, 284\nexploiting market reversals, 285\nfungibility, 276–277\nfutures and options, 275 , 284\ninvestment and hedging strategies, 276\ninvestment uses of Dow Index futures, 279 –282\nmarking-to-market trading, 276\noption premiums, 283\noptions on Dow Index futures, 282 –283\noption spreads in high-or low-volatility markets, \n286–287\nperspective, 287\nportfolio yields improvement, 286\n627Index\nprofits in rising markets, 284 –285\nprotecting profits in appreciated portfolio, \n285–286\nsettlement of futures contracts, 276\nstock index futures to control exposure to market, \n277–278\nvolatility, 283–284\nDow–Jones Stock Composite, 12\nDow–Jones Transportation Average, 603, 612\nDow–Jones Utility Average, 600, 603, 618\nDown Channel, see Descending Channel\nDown-slanting boundary line, 79 –80\nDowntick, 603\nDowntrends, 143, 202, 242, 423, 429\nIntermediate, see Intermediate downtrends\nMajor, see Major downtrends\nPrimar y, see Primary downtrends\nDow principles, 16, 17, 23–24\nDow Theory, 3, 11, 18, 21–23, 28–29, 31, 41, 77, 207, 259, \n264, 313, 365, 381, 393–399, 507, 533, 600, 601\nin 20th and 21st centuries, 26 –27\nBear Market signal, 519 –521\nbull signal, 513\n–514\nBull Trend reaffirmation, 515 –516\nclosing price levels of Dow–Jones Industrial and \nRail averages, 509, 510, 511, 512, 514\nfailure to confirm, 510 –511\nfinal up-thrust, 519\nfirst correction, 514–515\nfirst severe test, 508 –510\nfive years of Dow interpretation, 507–508\nintermediate trend investor, 23 –26\nleaving investor in doubt, 23\nRails falter, 516–517\nsigns of major turn, 511–513\nspring of 1946, 517–518\nutilization, 507\nDow Theory Line, 151\nDow Theory replacement with John Magee’s Basing \nPoints Procedure\nDow-Jones Industrials (1924–1934), 39–40\nfractal nature of market, 31\ninteresting charts ever made of Dow-Jones \nIndustrials, 40\ntrades made by Magee Basing Points Procedure, \n33–37\n2008 top in industrials, 38\nDrawdown, 498–499, 603\nDreman, David, 280, 496\nDunn and Hargitt, 251\nE\nEagle-Picher Lead, 436\n“Earnest money,” see Futures “margins”\nEase of Movement (EMV), 538\nEconomic tide, 264\nEdwards and Magee’s methods, 252–258\nstops, 258–259\nElectronic marketplaces, 269\nElectronic portfolio, 270\nElliott Wave Theory, 6, 528–531\nEmotion-driven markets, 266\nEnd Run, 83, 204, 205, 603\nEquilibrium Line, 609\nEquilibrium Market, 603\nEquivolume charting, 550\nresult, \n551–553\ntechnique, 551\nEvaluative Index, 397, 448, 482–483\nEx-Dividend, 90, 173, 175, 361, 443, 603\nEx-dividend gaps, 174, 603\nbreakaway gaps, 177–182\ncommon or area gap, 175–177\ncontinuation or runaway gaps and measuring \nrule, 182–184\nexhaustion gaps, 185–186\ntwo or more runaway gaps, 184–185\nExaggerated leverage, 272\nException, 381\nExchange-traded fund (ETF), 271 , 317, 322, 603\nExchange Traded Notes (ECNs), 268, 321\nExecution of buys, 376–377\nExercise, 283, 325, 603\nexercising option, 284\nprice, 272, 282, 494\nExhaustion Gap, 184, 185–186, 258, 410, 603–604, 607\nExperimental lines, 224\nExpiration, 271, 284, 604\nExponential Moving Average (EMAs), 422, 537, 542, \n609\nExponential Smoothing, 604\n“Extent of decline” criterion, 193\nExtent of penetration, 221\nExtraordinary Risk, 503\nF\nFacebook, 332\nFact chart analysis, 266\nFailure to confirm, 510–511, \n513–514, 515\nFaith, Curtis, 251\nFalling Wedge, 132, 139, 142–143, 410, 604\nFalse Breakout, 604, 612\nFalse moves, 48, 66, 81, 89, 108, 179, 487\nFalse Signal, 66, 88, 129, 149, 266, 479, 604\nFan lines, 217, 218, 220, 227, 309, 604\nFan principle, 226–227\nFansteel Metallurgical, 434 , 448, 585\nFilling the gap, see Closing the gap\nFinal up-thrust, 519\nFinance theory and practice\ndevelopments in, 271\nfutures on indexes, 273 –274\nMPT, 275\noptions, 271–272\noptions on futures and indexes, 274\noptions pricing models and importance, 273\n628 Index\nFinance theory and practice ( Continued)\nquantitative analysis, 272 –273\nwonders and joys of investment technology, 275\nFin de siècle, 139\nFirst correction, 514–515\nFirst severe test, 508 –510\nFive-Point Reversal, see Broadening Pattern\nFlag-type Consolidation, 411\nFlag, 151–159, 258, 410–411, 604\nFlag Consolidation, 157, 179, 392, 465\nFlag of mid-April, 175\nFlat-Topped Broadening Formation, 136–137, 163\nFlat-Topped Broadening Pattern, 151\nFlat-Topped Price Formation, 177\nFloating Supply, 73, 107, 117, 145, 315, 341, 604\nFlying Tiger Corp, 471, 586\nForce Index, 538\nForecasting methods, 11, 176, 421, 604\nFormation, see Area Pattern\nFormula measurement, 154 –156, 160, 164, 596, 608\nFractal nature of market, 31\nDow-Jones Industrials (1924–1934), 39\ninteresting charts ever made of Dow-Jones \nIndustrials, 40\ntrades made by Magee Basing Points Procedure, \n33–37\n2008 top in industrials, 38\nFront-Month, 605\nFundamental analysis, 3, 6, 91, 266, 328, 605\nessence of, 528–531\nFunds tracking indexes, 603\nFungibility, 276–277\nFutures “margins,” 277\nFutures contract, 274, 276–277, 282, 283, 349, 494\nFutures options, 283, 287, 313\nto participate in market movements, 284\nprice of, 283\nFuture transactions, differences between cash and, 277\nG\nGains and losses, percentage, 496\nGalbraith, John Kenneth, 326\nGamblers Anonymous, 302\nGaps, 171, 411–413, 423, 605\nApril–June Rectangle on 1945 chart of “ AW,” 172\nin averages, 187\nclosing gap, 171–173\ndaily chart of Blaw–Knox, 176\nex-dividend gaps, 174–186\nIsland “shakeouts, 181\nIsland in “PA,” 183\nIsland Reversal, 186–187\nmonthly chart of Zenith Radio, 175\nPanic Declines produce large Runaway Gaps, 178\nsmall Island in right shoulder of Head-and-\nShoulders Top, 180\nSMC, 180\nTLT, 183\nGates, Bill, 244\nGeneral Motors, 41, 99, 229, 230, 586, 598\nstraight-line Bull Market Trend, 230\nGeneral Semantics of Wall Street, The, 269\nGeneral Steel Industries, Inc. (GSI), 459, 586\nGilt-edged securities, 598\nGimlet-eyed investor, 270\nGoogle, 321, 331, 339, 340, 343, 389, 586\nGranite City Steel, 430 –\n431, 586\nGraph, see Chart\n“Graphic Stocks,” 437\nGreat Crash, The (1929), 326\nGreenspan, Alan, 248 , 281\nH\n“Hair splitting” theory, 521\n“Half-Mast” patterns, 154, 161, 604, 608\nHandbook of Por", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 285}
{"text": "neral Semantics of Wall Street, The, 269\nGeneral Steel Industries, Inc. (GSI), 459, 586\nGilt-edged securities, 598\nGimlet-eyed investor, 270\nGoogle, 321, 331, 339, 340, 343, 389, 586\nGranite City Steel, 430 –\n431, 586\nGraph, see Chart\n“Graphic Stocks,” 437\nGreat Crash, The (1929), 326\nGreenspan, Alan, 248 , 281\nH\n“Hair splitting” theory, 521\n“Half-Mast” patterns, 154, 161, 604, 608\nHandbook of Portfolio Mathematics (Vince), 618\nHead-and-Shoulders Bottom, 55, 57–59, 61–63, 161, \n336, 395, 401–403, 587, 605, 607, 608\nHead-and-Shoulders Consolidation, 160–162, 164, 605\nHead-and-Shoulders Formation, 48, 88, 373\nHead-and-Shoulders formula, 100, 162\nHead-and-Shoulders Pattern, 47, 137, 241, 392, 414, \n454, 605–606, 608, 610, 615\nHead-and-Shoulders Reversal Pattern, 211\nHead-and-shoulders to Dow Theory, 55\nHead-and-Shoulders Top, 44, 45, 46, 48, 54, 57–59, 63, \n75, 77, 103, 108, 118, 160, 161\n, 180, 198, 202, \n241, 247, 294, 357, 394, 400–401, 449, 454, 455, \n466, 602, 605, 606, 608, 617\nDaily chart of Chicago, 46\nhypothetical daily stock chart, 45\nstarting in March, “HUM,” 46\nvariations in, 49 –52\nHeavy Volume, 355, 356, 363, 398, 402, 435, 605, 606\nHedging, 137, 240, 246, 276, 279, 287, 312, 606\nHedging strategies using CBOT\n® DJIASM futures \ncontract, 276\nHigh-risk stocks\nhope springs eternal, 332 –340\nmanaging tulipomanias and internet frenzies and \nBitcoin, 326–328\nmultitudinous lessons in Microsoft, 326\ntechniques for management of runaway issues, \n328–332\nHigh-volatility markets, option spreads in, 286 –287\nHigher priced stocks, 353\nHistorical Data, 606\nHook Day, 606\nHorizontal Channel, 213, 606\nHorizontal Congestion Pattern, 178, 189\nHorizontal Line Formations, 103 , 207\nHorizontal Movements, 423\nHorizontal pattern boundary, 177\nHorizontal Trendline, 256, 333, \n606\nHull, Blair, 267, 531, 611\nHybrid Head-And-Shoulders, 606\n629Index\nI\nIchimoku Cloud, 537\nI C Industries (ICX), 49\n“Ideal” trend, 197\n“Implied volatility,” 284\nIn-the-money, 283\nIndexes, 7, 19, 243, 261, 271, 310, 312, 314, 341, 343\nfunds tracking, 603\nfutures on, 273 –274\noptions on futures and, 274\nIndex funds, 299, 390\nIndex futures for asset allocation, 280 –282\n“Indexing,” 310–311\nIndex Shares, 302, 310–312, 313, 390, 447\nIndividual stocks, 26, 41, 55, 112, 145, 146, 206, 243, \n342, 447, 454, 484, 493, 495\nIndustrial Average, 11, 12, 13, 16, 18, 20, 23, 393, 444, \n446, 454, 514, 515, 518, 600, 603\nIndustrial Rayon Corporation, 446 , 587\nInflationary and deflationary movements, 481 , 587\nInformation revolution, \n265–266, 268, 270–271\nInitial public offering share (IPO share), 327 –328, 607\nInside Day, 606\nInsiders, 41–42, 168, 322, 327, 606\nInspiration Copper, 429\nIntel, 319, 474, 475, 587\nIntermediate Bottom, 64 , 87, 193, 202, 294, 384, 386, 414\nIntermediate downtrends, 225 –226\nIntermediate Reversals, 59, 200, 206\nIntermediate Support, 197, 198, 226, 384, 385\nIntermediate Support Range, 198\nIntermediate Swing, 13, 507, 508\nIntermediate Tops, 200, 211, 294, 361, 386, 414, 513\nIntermediate Trend, 14, 41, 216, 224, 296, 380, 515, 519, \n590, 606, 614\ninvestor, 23–26\nIntermediate Trendlines, 208 , 226, 229\nIntermediate Uptrend, 194, 212, \n213, 219, 222, 225\nIntermediate Up Trendline (IUT), 52 , 176, 211, 212, 217, \n220–221, 224\nInternet-age markets, 351\nInternet, 265, 268–269, 532\nInternet Age, 269, 351, 393, 494\nInternet frenzies and Bitcoin, 326 –328\nInternet technical analysis sites, 305 , 531–533\nIntraday gaps, 173\nInverted Bowl, see Rounding Top\nInverted Triangles, 100, 121, 135–136\nInvestment\nadvancements in investment technology, 271\nbond and index futures for asset allocation, \n280–282\ndevelopments in finance theory and practice, \n271–275\nfinance theory and practice, 271 –275\nfutures and options on Dow–Jones Industrial \nIndex, 275–287\nincreasing exposure with futures, 280\ninvestment-oriented sites, 524–527\ninvestment/information revolution tools, 265\nportfolio protection, 279 –280\nstrategies using CBOT\n® DJIASM futures contract, \n276\nuses of Dow index futures, 279\nInvestor, 297–298, 332, 351\ncyber, 270\nexperienced, 268\ngimlet-eyed, 270\nlong-term, 310–311\nmodern, 244\nprivate, 312\nsophisticated, 302\niPod, 479\nIsland Congestion, \n186\nIsland Pattern, 147, 186, 187\nIsland Reversal, 182, 186–187, 607, 611\nJ\nJohns-Manville’s Primary Trend Reversal, 79\nJorion, Philippe, 500, 502, 524\nJuly–August Flag, 158–159\nK\nKaufman’s Adaptive Moving Average (KAMA), 537\nKelly Criterion, 534, 535\nKeltner Channels, 537\nKey Reversal Days, 147–149\nKilroy bottom, 57–59, 63, 309, 336, 401, 587, 607\nKovner, Bruce, 357, 365\nKresge (S.S.) Co., 196, 437, 588, 591\nL\nLaddering, 607\nLane, George, 615\nLane theorizes, 615\nLeisurely pattern, 65 –66\nLeverage, 258, 315, 607\nLeverage factor, 534–535\nLeverage Space Model, 351, 504, 618\nLeverage Space Portfolios (LSP), 533–536, 607\nLibby, McNeill And Libby, 436\nLimit Move, 258, 607\nLimit Order, 391, 607, 611\nLimit Up, Limit Down, 607\nLinear Moving Averages, 422\nLine Chart, see Bar Chart\nLine in Dow Theory, 17–18, 607\nLiquidating, 378\n–379\nLivingston Oil Company (LVO), 464, 588\nLogarithmic scale, 211–216, 229, 607\nLong-term charts, 9\nLong-term investment problem, 293\nLong-term investor, 293, 297, 299, 313, 314, 389\nstrategy and tactics for, 297–298\n630 Index\nLong-term investor (Continued)\nstrategy of, 299–300\nviewpoint, 310–311\n“Long side” of market, 41\nLorillard, 447, 588\nLow-volatility markets, option spreads in, 286 –287\nLower-priced stocks, 353\n“Lunatic fringe,” 3\nM\nMacKay, Charles, 325\n“M” Formation, 119, 602\nMagee-type technical analysts, 266\nMagee analyst, 267, 268, 270\nMagee chart analysis, 266 , 270, 595\nMagee Evaluative Index (MEI), 19, 300, 485–486, 491, \n495, 503–504\nMagee methodology, 260\nMagee’s admonitions, 316\nMagee’s Composite Leverage, 499\nMagee’s concept of “sensitivity,” 342\nMagee’s method, 252–259, 343, 497\nMagee’s Sensitivity Index, 342, 354, 497\nMagee’s simple-as-pie method, 32\nMajor Bear Market signal, 393\nMajor Bear Moves, 159\nMajor Bear Trend, 157, 226\nMajor Bull Market, 225\nMajor Bul", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 286}
{"text": "e Evaluative Index (MEI), 19, 300, 485–486, 491, \n495, 503–504\nMagee methodology, 260\nMagee’s admonitions, 316\nMagee’s Composite Leverage, 499\nMagee’s concept of “sensitivity,” 342\nMagee’s method, 252–259, 343, 497\nMagee’s Sensitivity Index, 342, 354, 497\nMagee’s simple-as-pie method, 32\nMajor Bear Market signal, 393\nMajor Bear Moves, 159\nMajor Bear Trend, 157, 226\nMajor Bull Market, 225\nMajor Bull trendlines, 241\nMajor charts, 9\nMajor Double Tops, 114\nMajor Downtrend, 242, 428–429, 439, 511–512, 519, 576, \n579, 592\nMajor Market Turn, 60\nMajor Reversal, 106, 114, 123, 132\n–133, 139, 158, 180, \n491, 510, 513–514, 604–605\nMajor Reversal Formation, 66, 114, 123, 186\nMajor Reversal Patterns, 44, 605\nMajor Signals, 394\nMajor Trend, 17–18, 22, 97, 198–199, 212, 225, 229, 242, \n296, 314, 356, 380–381, 384, 386, 393, 398, \n430, 446, 449, 456, 482, 491, 493, 510, 512, 515, \n607, 612\ngeneral outline of policy for trading in, 380 –381\nof market, 410–411\nMajor Trend Channels, 242–243\nMajor trendlines, 227\naccelerating uptrend of common stock, 231\nBull Market tops, 240\nconservative investment-type utility stock, 232\ndecurving Major Bull Trend of high-grade \npreferred stock, 231\nhigh-grade food issues, 236\nlow-priced building stock, 235\nMajor Bull Trend, 234\nMajor Downtrends, 242\nMajor Trend Channels, 242–243\nprimary Bear Market, 238\nS&P long-term perspective, \n239\nS&P Reagan Crash, 239\nspeculative oil stock, 233\nsteel stocks, 234\nstraight-line uptrends in investment oil, 233\ntobacco stocks, 236\ntrading Averages in 21st century, 244\ntrendlines in averages, 243\nup-curving trend of speculative motors stock, 230\nMajor Turn, 121, 167, 226, 242, 290, 483, 487\nsigns, 511–513\nMargin, 88, 108, 145, 147, 221, 223, 274, 276, 342, 345, \n367, 445, 492, 495, 535, 607–608\ndecisive, 48, 57–58, 118, 128\ntransaction, 346 , 349\nuse, 345–346\nMarket, 3, 6, 11, 19, 27, 31, 42, 77, 82, 104–105, 121, 139, \n143, 147, 192, 207, 256, 259, 264, 270, 274, 280, \n285, 289, 297, 299, 312, 315, 327, 383, 427, 487, \n493, 505, 507\nDow-Jones Industrials (1924–1934), 39\nexploiting market reversals, 285\nfractal nature, 31\nindicator, 609\ninteresting charts ever made of Dow-Jones \nIndustrials, 40\nmarking-to-market, 269 –270\nmarking-to-market trading, 276\ntechnical trading effect on market action, \n419–420\ntrades made by Magee Basing Points Procedure, \n33–37\n2008 top in industrials, 38\nMarket on Close, 608\nMarket Order, 297, 328, 608, 611, 616\nMarket Reciprocal, 497, 608, 612\nMarket Technicians Association, 499\nMarket Technicians Association of New York \n(MTANY), 6\nMasonite, 431, 575, 588\nMass Index, 538\nMast, 152, 217, 392, 411, 604, 608\nmove, 410\nMaximum drawdown, 27, 32, 502, 527, 603\nMaximum retracement, 502\nMcClellan Oscillator, 608\nMcDermott, The Redoubtable Richard, 325 , 528\nMeasuring Formulae, 608\nMeasuring Gap, see Runaway Gap\nMeasuring or Half-Mast Patterns, see Flag\nMeasuring rule, 55, 65, 100, \n154–155, 182–184, 392\nMechanical Dow Theory, 299\nMechanical systems, 250 , 252, 260, 296, 423\nMegaphones, 608, 613\nMelon, 194, 609\nMemorex Corp. (MRX), 470\nMetastock 9.0, 531–532\nMike Moody, 545, 556–561\nMining engineers, 326\n631Index\nMinor Bottom, 88, 91–92, 122–123, 193, 198, 208, 210, \n222, 354, 362–363, 373, 378–379, 386, 403, 413, \n414, 417, 517, 608–609, 616–617\nMinor Bottoms, 123, 208, 222, 361, 363, 373, 386, \n413–414, 617\nBasing Points, 362–365\nBasing Points paradigm, 365 –366\ncomplete Basing Points Procedure, 368 –370\nnarrative of events in chart, 367–368, 371–372\nrepresentative case fully analyzed using wave \nlows and new highs, 370–371\nVariant 2 procedure, 370\nMinor Correction, 209, 363, 386\nMinor Fluctuations, 13, 74, 77, 99, 129–130, 138, 151, \n186, 190\nprocess, 153\nMinor phenomena, 202\nMinor Reaction, 95 –96, 115, 172, 181, 186, 362, 397, 407, \n440, 605\nMinor Reversal, 122–123, 155–156\nMinor Reversal Areas, 157\nMinor Setback, 17, 216, 432, 517\nMinor Swings, 186\nMinor Top, 79–80, 122, 198, 206, 354–355, 361, 363, \n373–374, 378, 385, 414, 439, 444, 513, 616\nBasing Points, 362–365\nBasing Points paradigm, 365 –366\ncomplete Basing Points Procedure, 368 –370\nnarrative of events in chart, 367–368, 371–372\nrepresentative case fully analyzed using wave \nlows and new highs, 370–371\nVariant 2 procedure, 370\nMinor Trend, 13–14, 82, 144, 229, 290, 386, 410, 507, 609\nMinor Wave Pattern, 197\nMinor Waves, 13, 223, 509\nMisconceptions, 198 –200\nModel-driven market, 266, 272\n“Models,” 266–267, 273\nModern-style markets, 168 –169\nModern era development, 271\nModern Portfolio Theory (MPT), 275, 499\nMomentum, 43, 49, 184, 326, 539, 611, 614\nMomentum Indicator, 538, 542, 609\nMoney, 41, 249, 253, 265–266, 270, 272, 283, 299, 332, \n348, 489–490, 608\nmanagement procedures, 503 –504\nmanagement rules, 258\nMoney Flow Index (MFI), 538\nsophisticated risk and, 504\nMonthly chart gaps, 171\nMoving Average, 421, 424, 537, 539, 609, 610\n150-Day Moving Average, 424\n200-Day Moving Average Line, 31, 267, 299, 300, \n317, 422, 423, 484, 618\n50-Day Moving Average Line, 316, 422, 484, 604\ncrossovers and penetrations, 422 –424\nPENTAD Moving Average system from formula \nresearch, 424 –425\nSensitizing Moving Averages, 422\nMoving Average Convergence/Divergence (MACD), \n538, \n542–544, 609, 610\nHistogram, 538\nMoving Average Crossovers, 609\nMoving Average Envelopes, 537\nMoving Average Line, 422–423, 541, 598, 604, \n609, 618\nMulticolincarity, 598, 610\nMultiple Bottoms, 414, 434\nMultiple Formations, 66, 68\nMultiple Head-And-Shoulders Pattern, see Complex \nHead-and-Shoulders Pattern\nMultiple Tops, 364, 403, 409, 414\nMutual funds, 43, 268, 390, 495\nN\nNarrow Range Day, 610\nNASA, 249\nNational Association of Securities Dealers \nAutomated Quotations (NASDAQ), 19, 316\nNASDAQ 100, 312, 480\nNatural Hedge, 485, 610\nNatural mechanical systems, 260\nNatural method, 359, 610\nNDX, 480, 577\nNear progressive stops, 139\nNeckline (NL), 47–49, 57, 597, 610\non multiple head-and-shoulders formations, 61\nNed Davis Research, Inc. (NDR), 424\nNegative divergence, 610\nNegative Volume Index (NVI), 538\nNe", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 287}
{"text": "onal Association of Securities Dealers \nAutomated Quotations (NASDAQ), 19, 316\nNASDAQ 100, 312, 480\nNatural Hedge, 485, 610\nNatural mechanical systems, 260\nNatural method, 359, 610\nNDX, 480, 577\nNear progressive stops, 139\nNeckline (NL), 47–49, 57, 597, 610\non multiple head-and-shoulders formations, 61\nNed Davis Research, Inc. (NDR), 424\nNegative divergence, 610\nNegative Volume Index (NVI), 538\nNelson Freeburg of Formula Research, 424\nNew commitments, 418\nNew Concepts in Technical Trading (Wilder), 618\n“New Haven Investor,” 298\nNew York Stock Exchange (NYSE), 4, 269, 300, 311, \n313, 316, 341\n, 349, 615, 616\nNOKIA (NOK), 475\nNormal Range for Price, 344 , 346, 354, 497, 610\nNormal Uptrend Channel, 141–142\nNorthrop Aircraft, 438 –439\nNumber-driven systems, 259 –260\nNumber-driven technical analysis, 4, 267, 610\nNumber-driven technical analysts, 266\nO\nOdd lots, 351, 610\nOld-style markets, 168–169\nOld-time “plunger,” 168\nOn Balance Volume (OBV), 538, 610–611\nOne-Day Island Reversal, 607\nOne-Day Reversal, 42, 144–145, 410, 600, 615\nOne-Week Reversal, 147, 450, 589\nOperational Risk, 501–504\nOpportunity vs. Security, 308\nOptimal formula, 534, 535\nOptimization, 275\n632 Index\nOptions, 271–272, 611\non Dow index futures, 282–283\nexercising, 284\non futures and indexes, 274\npricing models and importance, 273\nspreads in high-or low-volatility markets, 286 –287\nas strategic investment, 273\ntraders, 272\ntrading, 272\nOptions Research, Inc, 611\nOracle Corporation, 332, 468, 573, 576, 579\nOrder, see Limit Order; Market Order; Stop Order\nOrthodox Broadening Top, 123, 130–135\n“Orthodox” investors, 419\nOscillator, 4, 7, 304, 419, 600, 611\nAroon, see Aroon Oscillator\nChaikin, see Chaikin Oscillator\nOut-and-out boardroom gamblers, 168\nOut-of-the-money, 283\nstrike price, 285\nOverbought, 611\nOversold market, 486, 611\n“Oversold-overbought” indicator, 485, 611\nOvertrading, 351, 493, 496–498\nP\nPacific Coast Options Exchange, 531\nPackard–Bell Electronics Corp (PKB), 465\nPalm Computing, 327\nPanic, 611\ndecline, 145, 157, 159, 171, 178, 192, \n201\nphase, 15, 147, 380\nPanic Bottom, see Selling Climax\nParabolic SAR, 359, 537\nParadigm-setting model, 271\nParadox, 496–498\nParallel Trend Channel, see Descending Trend \nChannel\nParke, Davis and Company (PDC), 466\nPassive Indexer, 611\nPatience, 265\nPattern\nanalysis, 357\nbou ndar y, 203\ngaps, 176, 184\nresistance, 202–205\nPeak, see Top\nPenetration(s), 422–424, 611\nvalidity, 220–222\nPennant(s), 151–154, 410–411, 611\nconsolidations, 157\nand flags, 608\nreliability, 156–157\nPennant Consolidation, 392\nPENTAD Moving Average system from formula \nresearch, 424 –425\n%B Indicator, 538\nPercentage Price Oscillator (PPO), 538\nPercentage Volume Oscillator (PVO), 538\nPerformance measurement, 275\nPersonal body digital assistants (PBDAs), 268\nPhilosopher’s Stone, 249, 265, 275, 539\nPivot Points, 537, 543\nPlain scale, 8\nPlanned distribution, 98\nPoint and figure (P&F), 392, 532, 545\nanalysis, 543\ncharting, 267, 532, 545, 612\ntechnical analysis by Mike Moody, 556 –\n561\nPolaroid Corporation, 451\nPolymath, 31\nPool operations, 105–112\nPortfolio ordinary or operational risk, 502 –503\nPortfolio protection, 279–280\nPortfolio Risk Analysis screen, 529 , 530\nPortfolio Risk Factor (PRF), 502\nPortfolio risk management\ncontrolling risk, 503\nmeasuring maximum drawdown, 502\novertrading, 496 –498\nrisk and money management procedures, 503 –504\nrisk and trend, 499\nrisk of portfolio, 499\nrisk of single stock, 498 –499\nsophisticated risk and money management \nprocedures, 504\nVA R, 499–500\nPortfolio Risk Strategy, 496, 497\nPortfolio valuation, 275\nPortfolio yields improvement, 286\nPragmatic analysts, 275\nPragmatic portfolio analysis, 502\nportfolio extraordinary or catastrophic risk, 503\nportfolio ordinary or operational risk, 502 –503\nportfolio risk over time, 503\nPragmatic portfolio risk measurement, 500\ndetermining risk for portfolio, 501 –502\nrisk of one stock, 500 –501\nPragmatic portfolio theory, 500\nPremature breakouts, 108, 612\nPreparatory buying signals, 375 –376\nPreparatory selling signals, 379\nPrice Congestion Formation, 177\n“Price–earnings ratio” index, 469 , 612\nPrice Relative/Relative Strength, 538\nPrice(s), 196\nchannels, 537\nfluctuation, 261\nof futures option, 283\nline, 423\npattern, 52, 57, 70, 127, 135, 138, 614\nPrimary Bear Market, 238 , 242, 243, 507–\n508\nPrimary Bull Market, 21 , 22, 41, 86, 122, 242\nPrimary Direction, 13 , 355, 363, 380, 381, 383, 385, \n386, 391\nPrimary Downswing, 202 , 242\nPrimary Downtrends, 15\n633Index\nPrimary Market Trend, 26\nPrimary Reversal phenomenon, 118\nPrimary trends, 12 –14, 16\nPring’s Know Sure Thing (KST), 538 –539\nPring’s Special K, 539\nProbable moves of stocks, 341–344\nProfit-taking patterns, 168\nProfit analysis, 530\nProfits in rising markets, 284 –285\nProgram Trading, 311, 612\nProgressive stop, 328, 355–357, 359, 370, 379, 612\nProtective stop(s), 295, 353, 355, 356, 358, 361, 612, 616\nProxy markets, 278\nPsychological grounds, 117\nPsychological handicap, 293\nPublic Service Electric and Gas (PEG), 469\nPullback(s), 110, 202, 205, 224, 612, 617\nPullback Rallies, 58\n“Pure investor,” 294–295\nPut option, 272, 284, 285, 312, 611, 612\nQ\nQID, 350\nQQQ, 244, 271, 312, 313, 490\nQuantitative analysis, 272 –273\nQuantitative analysts, 266\nR\nRail Average, 513, 603\nRails falter, 516–517\nRally, 612\nRally Tops, 612\nRange, 612\nRate of Change (ROC), 539\nReaction, 612\nReciprocal, Market, see Market Reciprocal\nRecover y, see Rally\nRecovery Trends, 202\nRectangle(s), 18, 151, 159, 173, 189, 373, 408–409, 606, \n608, 613\nto Dow Line, 112–113\npatterns, 378\nfrom Right-Angle Triangles, 113\nin Socony–Vacuum, 106\ntops, 103–105\nRectangular Consolidations, 159\nRed Parallel, 373, 378, 379, 613\nRed Trend, 373, 375, 376, 379, 380\nRed Trendline, 373, 376, 377, 613\nRelative Strength, 619\nRelative Strength Index (RSI), 539, 598, 613, 618–619\nRelative Strength Indicator, see Relative Strength \nIndex (RSI)\nReliability of flags and pennants, 156 –157\nRepeated saucers, 162–167\nResistance, 189, 603, 616\nLevel, 155, 1", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 288}
{"text": "6\ntops, 103–105\nRectangular Consolidations, 159\nRed Parallel, 373, 378, 379, 613\nRed Trend, 373, 375, 376, 379, 380\nRed Trendline, 373, 376, 377, 613\nRelative Strength, 619\nRelative Strength Index (RSI), 539, 598, 613, 618–619\nRelative Strength Indicator, see Relative Strength \nIndex (RSI)\nReliability of flags and pennants, 156 –157\nRepeated saucers, 162–167\nResistance, 189, 603, 616\nLevel, 155, 184, 189, 194, 198, 202, 206, 226\n, 246, 613\nLines, 99, 196\nRange, 189, 193, 196, 197\nZones, 192, 194, 197, 200, 206\nResources, 523\nessence of fundamental analysis, 528 –531\nimportant and indispensable sites, 523\ninvestment-oriented sites, 524–527\nleverage space portfolio model, 533 –536\nreferences for further study, 524\nSharpe Ratio, 527\nsoftware packages and internet technical analysis \nsites, 531–533\nvolatility calculation, 527–528\nRetracement, 118, 172, 603, 613\nReturn Line, 223, 225, 596, 601\nReversal\nBroadening Bottoms, 135\nBroadening Formations, 121–122\nThe Diamond, 137–139\nFalling Wedge, 142–143\nKey Reversal Days, 148–149\nOne-Day Reversal, 144–145\nOrthodox Broadening Top, 130–135\nRight-Angled Broadening Formations, 135 –137\nRising Wedges common in Bear Market \nRallies, 144\nRunaway Days, 148\nSelling Climax, 145–147\nshort-term phenomena of potential importance, \n147–148\nSpikes, 147–148\ntypical example, 128 –130\nvolume during broadening formations, 122 –128\nwedge formations, 139–142\nwedges on weekly and monthly charts, 143 –\n144\nReversal Area, 42, 55, 158\nReversal Days, see Key Reversal Days\nReversal Formation, 42, 50, 155, 168, 198\nReversal Gap, 613\nReversal Levels, 190\nReversal Pattern(s), 41, 42, 77, 132–133, 493, 602, 613\nADM turned sharply lower, 64\nbreaking neckline, 47–49\nDescending Triangles, 98 –99\ndistinguishing characteristics, 115 –118\nDormant Bottom variation, 73 –74\nDouble and Triple Tops and Bottoms, 113–115\nDouble Bottoms, 118\nDow Theory, 41\nfine Symmetrical Triangle Reversal Formation, 78\nHead-and-Shoulders Bottoms, 57–59\nHead-and-Shoulders to Dow Theory, 55\nHead-and-Shoulders Top, 44, 45, 46, 63\n“ideal” multiple top made by Budd in (1946), 62\nintermediate bottom of complex class, 64\nJohns-Manville’s Primary Trend Reversal \n(1942), 79\nleisurely pattern, 65 –66\nlong multiple head-and-shoulders top, 63\n634 Index\nReversal Pattern(s) (Continued)\nMCA enjoyed 62excellent advance from \n(1980–1986), 62\nmeasuring implications of Triangles, 100\nmultiple head-and-shoulders patterns, 59 –61\nplanned distribution, 98\npool operations, 105–112\nprice action confirmation, 52–55\nprices break out of Symmetrical Triangle, \n88–90\nRectangles, double and triple tops, 103 –105\nRectangles from Right-Angle Triangles, 113\nrelation of Rectangle to Dow Line, 112–113\nreversal or consolidation, 94 –97\nRight-Angle Triangles, 97–98\nRounding Tops and Bottoms, 66 –70\nRounding Turns affect trading activity, 70 –73\nSears Roebuck made Symmetrical Triangle \nReversal, 78\nslide in Amdahl occupied Bears, 65\nSymmetrical Triangles, 79 –88\ntendency to symmetry, 61\ntime to reverse trend, 42 –44\nTriangles on weekly and monthly charts, 100\nTriangular formations, 100 –101\nTriple Tops and Bottoms, 118–120\ntypical Triangle development, 90 –94\nvariations in head-and-shoulders tops, 49 –52\nvolume, 44–45, 47, 74–75, 99–100\nRhythmic investing, 300 –302\nRhythmic Trading, 485\nRichard Arms work, 545\nArms CandleVolume charting, 551–553\nArms Index, 545 –548\ncalculation, 548\nEquivolume charting, 550 –551\nusing index, 548 –549\nreasoning, 548\nRight-Angled Broadening Formations, 135 –137, \n409\nRight-Angled Broadening Triangle, 606 , 613\nRight-Angle Triangle(s), 97–98, 103, 139, 173, 408, \n596, 601\nchart, 99\nrectangles from, 113\nRipple, 14\nRising Channel, 413\nRising Wedge(s), 139, 141, 143, 614\ncommon in Bear Market Rallies, 144\nRisk\nanalysis, 529\nmanagement, 495–504\nmeasurement, 502–503\nand money management procedures, 503 –504\nsophisticated, 504\n“Risk-free” interest rate, 273\nRocket scientists, 249 –250\nRound-trip costs, 389\nRounding Bottom(s), 66–70, 403–406, 599, 614\nRounding Top(s), 66–70, 403–406, 606, 614, 617\nRounding Turn(s), 66, 68\naffecting trading activity, 70 –73\npicture, 70\nRound lots, 351, 614\nRRG Relative Strength, 539\nRunaway Days, 147, 148\nRunaway Gap, 177, 182–186, 202, 258, 601, 608, 614\nRunaway issues, 327\ntechniques for management of, 328 –332\nRunaway or Continuation Gap, 392\nRunning Market, 614\nS\nSaucer-Like Reaction Pattern, 99\nSaucer Pattern, see Rounding Bottoms\nScales, types of, 8 –9\nScallops, 162–167, 614\nSchadenfreude, 326\nSchannep, Jack, 21, 26\nScholes, Myron, 271\nSchwager, Jack\nSecondary Reaction, 13, 18, 357, 493, 515, 516, 517, 519\nSecondary Recovery swing, 508\nSecondary Trend, see Intermediate Trend\nSecondary trends, 12 , 13, 17\nSecular Trend, 614\n“Self-correction,” 197\nSelling Climax (SC), 138, 145–147, 190, 201, 600, \n611, 615\nSelling Climax Day, 615\nSelling stock short, 379\nSemilogarithmic paper, 8\nSemilogarithmic Scale, 8 , 144, 220, 242, 607, 615\nSensitivity, 341, 342, 346, 354, 422, 495, 600, 615\nSensitivity Index, 322 , 342, 345, 346, 353, 492, 497\nSensitizing Moving Averages, 422\nSettlement\nof futures contracts, 276\nprice, \n276, 600\n“Settlement date,” 276\nShakeout, 89, 145, 181, 221, 264, 505, 615\nSharpe Ratio, 499, 527\nShort-term phenomena of potential importance, \n147–148\nShort-term profits, 297\nShort-term trader, 190, 297, 389, 419\nShorting stocks, 284\nShort Interest, 7, 348, 615\nShort sale(s), 379–380, 400, 409, 615\nShort selling, 145, 346–350, 485\n“Short side” of market, 41\nShoulder, see Head-and-Shoulders Pattern\n“Sideways” chart pattern, 151\nSideways Movements, 423\nSimple Moving Averages (SMAs), 422, 537, 549\nSingle stock risk, 498 –499\nSites, important and indispensable, 523\n“Skullduggery,” 168, 169\n635Index\nSkyrocket, 184, 185, 196, 321, 401, 493\neffect, 71\nrun-up of Willys–Overland, 179\nSlauson, John, 387\nSlope, 539\n“Smart money,” 265\nSmoothing, 615\nSoftware packages, 305, 531–533\n“Special Opening Quotation,” 276\nSpeculative aims, 245\nSpeculative blow-offs, 326\nSpeculative stock, 345, 492", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 289}
{"text": ", 537, 549\nSingle stock risk, 498 –499\nSites, important and indispensable, 523\n“Skullduggery,” 168, 169\n635Index\nSkyrocket, 184, 185, 196, 321, 401, 493\neffect, 71\nrun-up of Willys–Overland, 179\nSlauson, John, 387\nSlope, 539\n“Smart money,” 265\nSmoothing, 615\nSoftware packages, 305, 531–533\n“Special Opening Quotation,” 276\nSpeculative aims, 245\nSpeculative blow-offs, 326\nSpeculative stock, 345, 492\nSpeculator(s), 3, 145, 149, 274, 286, 293, 297–298, 300\nagile, 148\ncom modit y, 246\npsychology, 245\nSpiegel’s Bear Market, 262\nSpike(s), 147–148, 615\nSpring of 1946, 517–518\nSPY, see Standard & Poor’s Depositary Receipts (SPDRs)\nStandard & Poor (S&P), 274, 310–311, 482\nStandard & Poor’s Depositary Receipts (SPDRs), 271, \n274, 299, 317, 323, 351, 390\nStandard Deviation, 539\nStatistical approach, 3\nStatistical driven technical analysts, 266\nStatistics fundamentalists, 4\n“Stepping off” point, 417\nStick to guns, 505 –506\nStochastic(s), 542, 615–616\nStochastic Indicator, 615\nStochastic Oscillator, 539, 615\nStochRSI, 539\nStock(s), 12, 307, 353, 356, 414, 417, 482\nalphabetic index of stock charts, 579 –593\naverages, 483\nchart, 7\nconstruction of index shares and similar \ninstruments, 311–312\nat different times, 427–479\nindex futures to control exposure, 277 –278\ninstruments, 313s\nkinds of stocks long-term investors want, 311\nlong-term investor’s viewpoint, 310–311\nMajor Downtrends, 428 –429, 439\nNDX, 480\nopportunity vs . security, 308\noptions, 494\nprices, 42, 266, 505\nprobable moves, 341–344\nS & P, 308\nS&P 500 in glory and tragedy, 309\nselection of stocks to chart, 315 –323\nSPY. for illustration, 309\ntrends, 218\nStockCharts Technical Rank (SCTR), 539\nStock Exchange vigilance, 168\nStock market(s), 3, 189, 266\nfundamentalist, 3\nto newcomer, 427\nSupport–Resistance Level, 430\nStock Split, 616\nStop, 616\nStop Loss, see Protective Stop\nStop orders, 353, 611\nATR, 358–359\nnatural method using by Turtles, 359\nprogressive stop, 355–357\nSAR, 359\nstop distances, 354\nstop systems and methods, 357–358\nsurvey of stop methods, 358\ntarget stops, 359\nStreet, 3\nStreet firms, 325\n“Strike” price, 282\nSuperior Oil Co (SOC), 458\nSupply, 616\nSupply and demand, 77\nbalance, 245\nequation, 42\nrelation, 175\nSupply Line, see Resistance\nSupport, 189, 603\nsignificance of support failure, 197 –198\nSupport and Resistance, 383 –387, 410, 414\nin averages, 206\nestimating support–resistance potential, 194–196\nexplanation, 191–193\nlevels, 198, 200, 264\nlocating precise levels, 196 –197\nnormal trend development, 190\npattern resistance, 202 –205\npopular misconceptions, 198 –200\npredictions, 189–190\nprinciple, 189\nrepeating historical levels, 200 –202\nround figures, 200\nsignificance of support failure, 197 –198\nt heor y, 202\nvolume on breaks through support, 205 –206\nSupport Level, 151, 189, 192, 198, 206, 210, 364, 383, \n386, 391, 414, 417, 616\nSupport Line, 598\nSupport Range, 189, 192\nSupport–Resistance Level, 266, 430\nSupport–Resistance Theory, 224\n“Swing” power, 307\n, 345\nSymmetrical Triangle, 80 , 600\nSymmetrical Triangles, 79 –88, 103, 121, 151, 168, \n203–205, 406–408, 609, 616\npattern, 603\nprices break out, 88–90\nT\nTactical methods\nmaking new commitments, 418\n636 Index\nTactical methods (Continued)\npresent commitments, 417–418\nquick summation, 417\nTactical problem\nHudson Motors, 295\nlong-term investor, 299\nrhythmic investing, 300 –302\nstrategy and tactics for long-term investor, \n297–298\nstrategy of long-term investor, 299–300\n“Tangents,” 208\nTape Reader, 9, 166, 616\n“Tape watchers,” 163, 166\nTarget stops, 359\nTax, 313\nconsequences, 277\nselling, 517\nTechnical analysis, 4–6, 419, 478, 537\nBollinger Bands, 561–563\nnumber driven tools, 537–545\nPoint & Figure technical analysis by Mike Moody, \n556–561\nRichard Arms work, 545 –553\nand technology, 265–266\nTechnical chart patterns, measuring implications in, \n391–392\nTechnical data, 6, 227, 528\nTechnical indicators, 538 –539\nTechnical Magee analyst and investors, 268\nchaff, 270\ninformation revolution, 270 –271\ninternet, 268–269\nmarking-to-market, 269 –270\nseparating wheat from chaff, 270\nTechnical overlays, 537–538\nTechnical regularity, 313\nTechnical trading effect on market action, 419 –420\n“Teenie,” 272\nTEKNIPLAT\nchart paper, 305, 443, 616\nsemilogarithmic chart sheet, 219 –220\nTenets, \n12–14, 207, 507, 517\nTest(s), 617\nof authority, 216–220\nText diagrams, 565–578\nTextron, 435, 575, 592\n“Theoretical value” of future, 277\nThin Issue, 174, 356, 617\n3COM, 319, 327, 331, 579\n“Three-days-away” rule, 300 , 328, 361, 369, 414, 617\nThrowback(s), 99, 110, 181, 202, 203, 221, 224–225, 612, \n617\nTide, 14\nTime\nrequiring to reverse trend, 42 –44\nscale, 8, 31\nTLT chart, 258\nTop, 611, 617\nBroadening, see Broadening Top\nDouble, see Double Top\nHead-and-Shoulders, see Head-and-Shoulders Top\nRounding, see Rounding Top\nTriple, see Triple Top\nTop of Ascending Triangle, 177\nTop Price Chart Formation, 598\nTop Trendlines, 414, 598, 613\nTotal Capital (TC), 307, 492\n, 498, 502, 503, 504\nTotal Composite Leverage, 297\nTrader(s), 251, 284, 293, 296, 300, 315, 505\nTraders, 358\nTrades, 33–37, 409\nTradestation 2000i, 532\nTradestation 8, 532\nTrading, 4\nact ivit y, 17, 44–45, 80, 91, 122, 163, 185, 221, 316, 441, \n511, 614\narea, 103, 121, 151, 175, 423, 613\naverages in 21st century, 244\ncosts, 390\nopportunities, 42 , 163, 266, 475\nrange, 73, 79, 149, 186, 286, 599, 607, 609, 616\nTransportation Average, 596, 600, 603\nTreasury bonds, 253, 281\nTrend(s), 12, 13, 14, 223, 229, 617\nconsolidation, 151\nranges, 222–223\nand trendline studies, 264\nTrend Channels, 214, 215, 223, 242–243, 356, 392, 617\nin Bethlehem Steel, 213\nParallel Trend Channel, 373 –375, 378\nRising Trend Channel, 225\nTrending Market, 252, 253, 286, 423, 595, 617\nTrendline(s), 207–209, 209–211, 414, 429, 597, 616, 617\nin action, 375\nadditional suggestions, 380\namendment of trendlines, 222\nanalysis, 357\narithmetic vs . logarithmic scale, 211–216\nbuying stock, 375–377\nconsequences of Trendline penetration, 224 –225\ncorrective trends, 226 –227\ncovering short sales, 379–380", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 290}
{"text": "373 –375, 378\nRising Trend Channel, 225\nTrending Market, 252, 253, 286, 423, 595, 617\nTrendline(s), 207–209, 209–211, 414, 429, 597, 616, 617\nin action, 375\nadditional suggestions, 380\namendment of trendlines, 222\nanalysis, 357\narithmetic vs . logarithmic scale, 211–216\nbuying stock, 375–377\nconsequences of Trendline penetration, 224 –225\ncorrective trends, 226 –227\ncovering short sales, 379–380\ndouble trendlines and trend ranges, 222 –223\nexperimental lines, 224\nintermediate downtrends, 225 –226\nliquidating, or selling long position, 378 –379\npolicy for trading in Major Trend, 380 –381\nselling stock short, 379\ntests of authority, 216–220\nvalidity of penetration, 220 –222\nTriangular Price Formations, 103\nTriangular/Triangle(s), 79–80, 423, 608, 617\ndevelopment, 90–94, 98\nformations, 100–101\nmeasuring implications, 100\npatterns, 378\non weekly and monthly charts, 100\nTriple Bottom(s), 113–115, 118–120, 617\n637Index\nTriple Top, 103–105, 113–115, 118–120, 504, 568, 617–618\nTRIX, 539\nTrue Range, 358, 595\nTrue Strength Index, 539\nTulipomania, 61, 308, 325, 331, 332, 339, 577, 593, 607\nmanaging, 326–328\nPALM, 329\nTulips, 241, 325, 329, 331, 339\n“Turbulent period,” 485, 486\nTwain, Mark, 26–27, 304, 365, 532\nTurtle(s), 250–252, 259\nnatural method using by, 359\nsystem, 258–260\nU\nUlcer Index, 539\nUltimate Oscillator, 539\nUnited Artist Corporation (UNA), 460\nUnnatural method, 610\nUp-slanting\nbottom boundary, 92–93\nline, 79–80, 91\nUp Channel, 596\nUptick, 349, 350, 618\nUp trendline, 208, 209, 210, 211, 216–217, 221, 596\n, 617\nUptrends, 14, 104, 153, 158, 208, 212, 219, 225, 233, \n422–423, 429, 432\nU.S. Securities and Exchange Commission (SEC), 105 , \n145, 168, 390\nU.S. Smelting, Refining and Mining Co, 453 , 463\na, 428\nHead-and-Shoulders Top in (1952)\nU.S. Steel, 4, 5, 79, 105, 127, 131, 147, 200, 201, 569\nUtah–Idaho Sugar Co. (UIS), 461, 576, 593\nUtility Average, see Dow–Jones Utility Average\nV\nValidity of Trendline Penetration, 618\nValley, 116, 118, 119, 176, 618\nValue-at-risk procedure (VAR procedure), 499–500\nVariance, 212, 311, 344, 501, 527, 536\nVariant 2 procedure, 368, 370\nVariations in head-and-shoulders tops, 49 –52\nV /D volume, 618\n“Vertical” Panic Declines, 157\n“Vested interest,” 186, 199, 200, 201, 202\nVigor, 95, 144\n, 197, 516\nVince, Ralph, 504, 533, 607, 618\nVolatility, 283–284, 343, 354, 498, 500, 501, 528, 539, 618\ncalculation, 527–528\nVolume-Weighted Average Price (VWAP), 538\nVolume, 44–45, 47, 108, 193, 194, 264, 595, 616, 618\non breaks through support, 205 –206\nduring broadening formations, 122 –128\ncharacteristics same as symmetrical type, 99 –100\nconfirmation, 398, 401, 407, 408, 432, 449\npattern, 46, 47, 57, 59, 63, 64, 67, 74–75, 137, 161, 196, \n207, 216, 605, 614\nby Price, 537–538, 543\nof trading, 67, 193, 197, 221, 618\nVortex Indicator, 539\n“Voyeur” feature, 532\nW\nWall Street investment banks, 325\nWall Street Journal, 11, 12, 243, 312\n“Wash sales,” 107\nWave, 14\nWave analysis methods, 260\nWedge(s), 139, 409–410, 618\nformations, 139–142\non weekly and monthly charts, 143 –144\nWeighted Moving Averages, 422\nWest Indies Sugar, 437, 575, 593\nWestinghouse Electric, 47, 237, 437, 442, 566, 568, 572, \n575, 593\n“W” Formation, see Triple Top\nWide-Ranging Days, see Runaway Days\nWidening Channel effect, 243\nWilder Relative Strength Index (Wilder RSI), 595 , 610, \n618–619\nWieckowicz, R.T., 307\nWilliams, Larry, 420, 531\nWilliams %R, 539\nWorld Equity Benchmarks (WEBs), 312\nWorld War II, end of, 515, 516\n“W” Pattern, see Triple Top\nWright, Charlie, 494\nWyckoff, Richard, 259, 392, 550\nWyckoff’s charts, 531\nY\nYahoo! (YHOO), 330, 476, 477, 526, 577, 593\nZ\nZen, 269\nZigZag, 197, 383, 538\nZone, Resistance, 189, 192–194, 196, 197, 199–200, 202, \n206, 387", "source": "eBooks\\Technical Analysis of Stock Trends 11thed\\original\\Technical Analysis of Stock Trends.pdf", "doc_id": "b9331cc265626ea8e2a09f9c64736ff32d3645a40405859b72219d7db96b43da", "chunk_index": 291}
{"text": "Robert D. Edwards John Magee W.H.C. Bassetti\nRoutledge\nTaylor & Francis Croup\nA PRODUCTIVITY PRESS BOOK\nTechnical Analysis of Stock Trends Eleventh Edition\nTaylor & Francis\nTaylor & Francis Group\nhttp://taylorandfrancis.com\nTechnical Analysis of Stock Trends Eleventh Edition Robert D.\nEdwards John Magee W. H. C. Bassetti\nRoutledge\nTaylor & Francis Group\nA PRODUCTIVITY PRESS BOOK\nRoutledge\nTaylor & Francis Group\n711 Third Avenue, New York, NY 10017\n© 2019 by Taylor & Francis Group, LLC\nProductivity Press is an imprint of Taylor & Francis Group, an Informa\nbusiness No claim to original U.S. Government works\nPrinted on acid-free paper\nInternational Standard Book Number-13: 978-1-138-06941-1 (Hardback)\nThis book contains information obtained from authentic and highly\nregarded sources. Reasonable efforts have been made to publish reliable\ndata and information, but the author and publisher cannot assume\nresponsibility for the validity of all materials or the consequences of their\nuse. The authors and publishers have attempted to trace the copyright\nholders of all material reproduced in this publication and apologize to\ncopyright holders if permission to publish in this form has not been\nobtained. If any copyright material has not been acknowledged please write\nand let us know so we may rectify in any future reprint.\nExcept as permitted under U.S. Copyright Law, no part of this book may be\nreprinted, reproduced, transmitted, or utilized in any form by any electronic,\nmechanical, or other means, now known or hereafter invented, including\nphotocopying, microfilming, and recording, or in any information storage\nor retrieval system, without written permission from the publishers.\nFor permission to photocopy or use material electronically from this work,\nplease access www.copyright.com (http:// www.copyright.com/) or contact\nthe Copyright Clearance Center, Inc. (CCC), 222 Rosewood Drive,\nDanvers, MA 01923, 978-750-8400. CCC is a not-for-profit organization\nthat provides licenses and registration for a variety of users. For\norganizations that have been granted a photocopy license by the CCC, a\nseparate system of payment has been arranged.\nTrademark Notice: Product or corporate names may be trademarks or\nregistered trademarks, and are used only for identification and explanation\nwithout intent to infringe.\nLibrary of Congress Cataloguing-in-Publication Data Names: Edwards,\nRobert D. (Robert Davis), 1893- author. | Magee, John, 1901-author. |\nBassetti, W. H. C., author.\nTitle: Technical analysis of stock trends / Robert D. Edwards, John Magee,\nW.H.C. Bassetti.\nDescription: Eleventh Edition. | New York : CRC Press, [2018] | Revised\nedition of the authors' Technical analysis of stock trends, c2013. | Includes\nbibliographical references and index.\nIdentifiers: LCCN 2018010151 | ISBN 9781138069411 (hardback : alk.\npaper) Subjects: LCSH: Investment analysis. | Stock exchanges--United\nStates. | Securities--United States.\nClassification: LCC HG4521 .E38 2018 | DDC 332.63/20420973--dc23\nLC record available at https://lccn.loc.gov/2018010151\nVisit the Taylor & Francis Web site at http://www.taylorandfrancis.com\nand the Productivity Press site at http://www.ProductivityPress.com\n24800.35\n25810.43 Low 24741.70 Close 25803 10 Volume 3 30\n$ INDU Dow Jones Wuslriai Average inox l2Jifr20i8\n®5tocLCh»rtr com ♦ 108307 («430M) A\n08 Apr Jul\n24000\n23000\n22000\n21000\nFigure 0.1 DOW 25000! What a birthday present for the 11th edition! The\nDow continues to set records since March of 2009, as vividly illustrated by\nthis chart.\nTaylor & Francis\nTaylor & Francis Group\nhttp://taylorandfrancis.com\nContents\nPreface to the tenth edition\nPreface to the ninth edition\nPreface to the eighth edition\nIn memoriam\nPreface to the seventh edition\nPreface to the fifth edition\nPreface to the fourth edition\nPreface to the second edition\nForeword\nThe Dow Theory is not infallible\nReplacing Dow Theory with John Magee's Basing points\nProcedure\nImportant Reversal Patterns\nImportant Reversal Patterns: continued\nImportant Reversal Patterns: the Triangles\nMore important Reversal Patterns\nOther Reversal phenomena\nWedges on weekly and monthly charts\nWhich gaps are significant?\nSupport and Resistance\nTrendlines and Channels\nMajor Downtrends\nA summary and concluding comments\nPerspective\nThe all-important details\nSelection of stocks to chart\nThe probable moves of your stocks\nWhat is a Bottom and what is a Top?\nUse of Support and Resistance\nSymmetrical Triangles\nAutomated trendline: the\nFigure 37.26 Weekly, July 1961 through June 1962. This\nchart shows the Head-and-Shoulders Top Formation in the\nIndustrial Average that preceded the collapse of April, May,\nand June 1962. Normally, especially in the charts of\nindividual stocks, there would tend to be heavier volume on\nthe left shoulder. The price pattern alone is sufficient to mark\nthe pattern as a dangerously toppy situation. During the\nentire period in which this formation took shape, many\nindividual stocks representing important companies were\nshowing Top Reversal symptoms, as might be expected.\nNote, so far as this Head-and-Shoulders Pattern is\nconcerned, the Reversal Signal is not definite until the\nneckline has been penetrated.\nBalanced and diversified\nPortfolio risk management\nAppendix A: The Dow Theory in practice\nAppendix B: Resources\nAppendix C: Technical Analysis beyond Edwards & Magee\n09 10 11 12 13 14 IS It 17\nList of Illustrations and Text Diagrams\nAlphabetic Index of Stock Charts\nGlossary\nBibliography\nIndex\nRange, 189, 193, 196, 197\nContents\nPreface to the eleventh edition\nBeyond Edwards & Magee\nI would be remiss if I did not note the passing of two important figures in\nthe discipline of technical analysis—Richard Arms Jr. and Professor Hank\nPruden of Golden Gate University. Well liked and admired they leave large\ngaps in the community. The article here by Arms is literally his last\ncontribution to the field. Long the central figure in San Francisco, Hank\nPruden, much loved and admired leaves the", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 0}
{"text": "e remiss if I did not note the passing of two important figures in\nthe discipline of technical analysis—Richard Arms Jr. and Professor Hank\nPruden of Golden Gate University. Well liked and admired they leave large\ngaps in the community. The article here by Arms is literally his last\ncontribution to the field. Long the central figure in San Francisco, Hank\nPruden, much loved and admired leaves the entire field with an enormous\ngap. He was my particular friend and mentor. He will be infinitely missed.\nThe reader is advised to read the prefaces to previous editions. They are of a\npiece with the internal text and some practices—of notation and treatment\nmay not make sense otherwise. Those who think gender should be catered\nto will find my previous comments on that issue. Why repeat it here?\nLet me address the central question focused on by this new edition: This\nbook has studiously ignored an entire field of technical analysis—number\ndriven and statistical analysis. This has left previous new readers without\nthe guidance they need if they are uneasy with the qualitative method as\ninvented (or discovered) by Edwards & Magee. That lack is resolved by\nAppendix C. There the new reader will find number-driven material\npresented from the point of view of an Edwards & Magee analyst. There\nalso the reader will find presentations of tools by their creators—a very\nspecial treat, and extremely educational. I venture to say any analyst will\nhave his field of vision broadened by Mike Moody's presentation of Point\nand Figure charting and the tools of Richard Arms, two prominent analysts\nfor whom many of us, especially we chartists, have not given their work the\nstudy it deserves.\nThe list of acknowledgments is as long as a Hollywood awards night. I will\nshorten it by pointing out previously acknowledged colleagues, assistants,\nand supporters in previous prefaces. Generally speaking, it is the usual\nsuspects. Some especially merit additional mention here: Nehemiah Brown\nIII, my much-valued and sometime graduate student helps me keep my\nspreadsheets rational and accurate. My old friend Mark Wainwright (a Tuck\ngraduate) helps me solve technological problems. Part of the pleasure of\npreparing a new edition comes from interacting with these bright and\ncapable people.\nI have not mentioned Ralph Vince (a formidable figure) or Chris Glon,\nRichard Arms, and Mike Moody.\nMy efforts have been made easier by the support of Chip Anderson of\nstockcharts.com, an invaluable resource. I am also indebted to thinkorswim.\nIf I mention them often it is a measure of their importance to my work—\nand not a paid promotion.\nW. H. C. Bassetti San Francisco, California June 15, 2018\nTaylor & Francis\nTaylor & Francis Group\nhttp://taylorandfrancis.com\nPreface to the tenth edition\nA 10th milestone\nSixty-three years. Sixty-three years and Technical Analysis of Stock Trends\nstill towers over the discipline of technical analysis like a mighty redwood.\nAn evergreen sequoia. And now a 10th edition. It is a propitious moment to\nrefresh it for the new millennium, to prune its solecisms and obsolescence,\nand to further develop the sometimes prescient work of its originators.\nWith this premise in mind, I have attempted to make the book shorter,\nsimpler, and more usable in the modern context. I know there are still\nmanual chartists out there. Occasionally they are ecstatic when they find\nthat—as a profit-losing service—I still have TEKNIPLAT™ chart paper in\nmy attic. Like travelers in the desert finding an oasis.\nBut they are the 1%. Everyone else uses software, desktop or internet to do\nhis charting (See note “About Gender” in the Preface to the eighth edition.).\nSo, I have excised the material on manual charting from the new edition.\nBudding manual chartists may always turn to the eighth and ninth editions.\nI have also deleted Magee's chapters on “Composite Leverage” (Chapter 42\nin the seventh edition, Appendix A in the eighth) as they are abstruse and\ncumbersome in the modern context—not to mention being rooted in manual\nchart analysis. I have made every attempt to summarize and replace\nMagee's work, as I believe it has intellectual validity. Primarily this is done\nin the present Chapter 42. I repeat, Magee's thinking and practical work\npredated much modern portfolio management and volatility theory.\nAdditionally, Modern Portfolio Theory has still not caught up to his work\non trend analysis and risk. All this material is available in previous editions.\nI have moved, perhaps, the most difficult chapter in the book, Chapter 4, to\nAppendix A. Edwards' chapter on the minutiae of the operation of Dow\nTheory has stopped more than one reader cold. Now it is available to the\ndetail scholar, and the general reader is relieved of the necessity of slogging\nthrough it.\nMany critics deplored Chapter 16 from the seventh edition, which I\nrelegated to an appendix in the ninth edition. This chapter covered an\nanalysis of futures and derivatives using number-driven analysis. Critics\nsaid it was shallow. More important, it was completely extraneous to the\ntheme of the book, chart analysis, not the exploration of statistical routines\nand indicators, which is a different branch of technical analysis. There are\nnumerous books on the subject, starting with Murphy, Kirkpatrick, and\nKaufman. I have deleted it along with other material in the book that was\nnot compatible with Edwards and Magee's original intent.\nI quote here appropriate remarks from the preface to the eighth edition:\nAbout apparent anachronisms\nCritics with limited understanding of long-term trading success may think\nthat discussions of “what happened in 1929” or “charts of ancient history\nfrom 1946” have no relevance to the markets of the present millennium.\nThey will point out that AT&T no longer exists in that form, that the New\nHaven has long since ceased to exist as a stock, that many charts are records\nof long-buried skeletons. This neglects the value of the charts as metaphor.\nIt ignores their r", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 1}
{"text": "y think\nthat discussions of “what happened in 1929” or “charts of ancient history\nfrom 1946” have no relevance to the markets of the present millennium.\nThey will point out that AT&T no longer exists in that form, that the New\nHaven has long since ceased to exist as a stock, that many charts are records\nof long-buried skeletons. This neglects the value of the charts as metaphor.\nIt ignores their representations of human behavior in the markets which will\nbe replicated tomorrow in some stock named today.com or\nwilltheynevergetit.com. Even more important, it ignores the significance of\nthe past to trading in the present. I cite here material from Jack Schwager's\nilluminating book, The New Wizards of Wall Street. Schwager, in\nconversation with Al Weiss: “Precisely how far back did you go in your\nchart studies?” Answer: “It varied with the individual market and the\navailable charts. In the case of the grain markets, I was able to go back as\nfar as the 1840s.” “Was it really necessary to go back that far?” Answer:\n“Absolutely. One of the keys in long-term chart analysis is realizing that\nmarkets behave differently in different economic cycles. Recognizing these\nrepeating and shifting long-term patterns requires lots of history. Identifying\nwhere you are in an economic cycle—say, an inflationary phase versus a\ndeflationary phase—is critical to interpreting the chart patterns evolving at\nthat time.\nIdentification of original manuscript and revisions\nTrue believers (and skeptics) will find here virtually all of the original\nmaterial written by Edwards and Magee, including their charts and\nobservations on them. Changes and comments introduced by editors since\nthe fifth edition have been rearranged and, when appropriate, have been\nidentified as a revision by that editor.\nMaintaining this policy, where updates to the present technological context\nand market reality were necessary, the present editor has clearly identified\nthem as his own work by beginning such annotations with “EN” for Editor's\nNote. (The eighth edition was the first to use editor's notes. Editor's notes\nfor the ninth edition are identified as EN9, and notes added for the present\nedition are identified as EN10).\nSo, we have here a simpler, shorter, clearer edition of the famous book—\neasier to read, easier to understand, and easier to use. None of the\nconsiderable virtues of the book have been affected. I have attempted to add\nto these virtues with my work on Magee's Basing Points Procedure (see\nChapter 28, 28.1, and 28.2) and portfolio control and risk (see Chapter 42).\nIn spite of my remarks, I have listened to critics of the hand-drawn charts in\nthis book. These charts are the glory of the book and of the discipline of\ntechnical analysis. Their application to modern markets seems ridiculously\nobvious to me—and I am perhaps a dinosaur. So, I have decided to take a\nnumber of examples of the manual charts and post them at\nhttp://www.edwards-magee.com along with the same data charted by\ncomputer so skeptics can compare the two methods. These will be found at\nhttp://www.edwards-magee.com/manualcharts.html.\nThe internet so extends one's capabilities and is so easy to use that it would\nbe irresponsible not to avail oneself. In Figures 9.2 and 9.3, I have printed\ncharts that demand— scream—to be viewed in a larger format. These will\nbe found at http://www.edwards-magee.com/supercharts.html.\nThe reader is urged to read the prefaces to the eighth and ninth editions. I\nhave not repeated here all the editorial conventions detailed in those\nprefaces.\nW. H. C. Bassetti San Francisco, California\nAcknowledgments for the tenth edition\nSo many colleagues and friends contribute to a book like this that one is in\ndanger of getting into the Academy Awards syndrome—endless thank yous\nand acknowledgments until they bring out the hook and pull you off stage.\nSo, I will not thank my parents and aunts and uncles and wife and family,\nalthough they should be and by this mention are thanked.\nMore particularly, acknowledgments are due to my editorial and research\nassistant, Carlos Bassetti.\nMy colleagues at Golden Gate University (GGU) are an invaluable source\nof advice, wisdom, and support, particularly Professor Henry Pruden. It is\nno mystery why he is internationally known and respected—besides being a\nworld authority on Wyckoff. GGU has also furnished me with an unending\nsupply of bright, formidable graduate students who have made major\ncontributions to my work and to my thinking. Nehemiah Brown does his\nbest to keep me semi-organized as to spreadsheets. Matt Mullens and Brian\nBrooker have assisted me with many of the Basing Point studies herein.\nStergios Marinopoulos has stimulated and challenged me in my systems\nwork. All these people are members in the local technical analysis fraternity\nand our much-valued organization, the Technical Securities Analysts\nAssociation of San Francisco.\nMore remote colleagues have also assisted me in many invaluable ways—\nJack Schannep with Dow Theory data, Robert Colby, also with Dow data;\nTim Knight with Prophet data (now part of http://www.thinkorswim,\nhttp://www.tdamertrade.com), Chip Anderson at\nhttp://www.stockcharts.com, and Scott Brown of Metastock for support\nwith charting software.\nI am indebted to Ralph Vince and Nelson Freeburg for material found\nherein that increases the value of this book.\nAnd finally, amigo Frangaise, and fellow chart enthusiast Chris Glon at\nhttp://www. publicharts.com, for his charts, assistance, and friendship. He\nhas supplied some of the most interesting charts in this book.\nTaylor & Francis\nTaylor & Francis Group\nhttp://taylorandfrancis.com\nPreface to the ninth edition\nWarp speed universe. Warp speed financial markets. The eighth edition of\nthis classic book appeared when it seemed the millennium and paradise had\nbeen achieved and that, like Mackay's Tulipomania, the price of stocks\nwould rise forever and men would rush from the world over and pay\nwhatever price was asked for what-was", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 2}
{"text": "aylor & Francis Group\nhttp://taylorandfrancis.com\nPreface to the ninth edition\nWarp speed universe. Warp speed financial markets. The eighth edition of\nthis classic book appeared when it seemed the millennium and paradise had\nbeen achieved and that, like Mackay's Tulipomania, the price of stocks\nwould rise forever and men would rush from the world over and pay\nwhatever price was asked for what-was-its-name.com, internet groceries, or\nihype.com or icon.com or gotcha.com. and, feature this, Dow 36,000. The\nbubble was just in the process of bursting, of course. Before it burst,\nfabulous fortunes were made by roller blader and scooter tycoons and by\nyoung geeks with nothing but chutzpah and a laptop. One of my favorite\nstories is of the young entrepreneur who said, “Why don't I deserve it (the\n$100 million he made in the IPO)? I've devoted three years of my life to this\nproject.” He is now dead.\nNow, many of those people are in prison and the hangover lingers on along\nwith lying, cheating, and stealing on all sides. From Enron to Arthur\nAnderson, billions, if not trillions, fell into a black hole. As all this\ndeveloped, I warned of the impending collapse in the John Magee\nInvestment Letters on the web. There was nothing magical or brilliant about\nseeing what was going on; perspective and perception came from applying\nthe lessons taught in this book by Edwards and Magee. Like Benedict XVI\n(in a different area), I am a humble worker in their vineyard.\nI press on attempting to modernize (where necessary) and extend their\nwork, fit it to the modern situation, and make it even more useful to current\nday traders and investors.\nIn this ongoing labor of love, I have been immeasurably assisted by my\ngraduate students and colleagues at Golden Gate University in San\nFrancisco. In constant interaction with them I have been stimulated to see\nimportant aspects of Edwards and Magee's work and develop and\nemphasize these elements in my teaching and in this new edition.\nSpecifically, both long-term and short-term traders will find important new\nmaterial in this edition. In my graduate seminars, I have seen the power of\nwhat Magee called the “Basing Points Procedure” and so have extended the\ntreatment of this material. My interest in, and respect for, Dow Theory has\nrecently increased as the result of a paper done with Brian Brooker for the\nMarket Technicians Association (“Dissecting Dow Theory”). Material from\nthat paper will be found in this edition. Short-term traders and futures\nspeculators will appreciate extensive new material on commodity trading.\nThese traders have been entirely too influenced by mechanical number-\ndriven systems of recent years and need to restore perspective by mastering\nthe material of this book.\nIt was never the intent of this book to forecast or analyze current markets;\nrather, its purpose was, and is, to learn from history and the past to better\ndeal with the present and the future. Current markets are analyzed (and\nforecast?) at the John Magee website. Nonetheless, the very process of\nkeeping current involves picturing issues and instruments in play. The\nmajor indexes themselves in 2005 are in play, along with gold, silver, and\noil. We don't know how they will pan out, but we can make an analysis with\nthe data we have, for this is the situation the analyst is faced with every day.\nHe doesn't know how it will turn out, but, by following the methods and\nprinciples taught in this book, he can put himself on the right side of the\nprobabilities.\nThis is no idle remark. The power and effectiveness of classical chart\nanalysis can be seen by examining how it performed in the past at critical\ntimes. At the John Magee Technical Analysis website, the following\ncomment was made in January 2000:\nDow: The Dow can expect to find support at 10000 and is buyable, but in\nsmall commitments or portions of a portfolio or additions thereto. We\nexpect to see it in a very large see saw from 9-12000 for some time and\nwould hedge at the high end and increase commitments and lift hedges on\noversold conditions at the low end.\nIn November 2000, the following comment was made:\nNovember 18, 2000\nThere is really only one chart pattern of significance in these markets, and\nthat is the big one, more than 12 months long now, and the pattern is a big\nserpent, whipping back and forth and, as Shakespeare said, signifying\nnothing. Nothing that is but more of the same. How will we know when it\nsignifies something? Well, we won't really know till we know, but we'll let\nyou know when we know. So, we would continue to pick likely shorts and\nemploy short term trading strategies for traders, and hedge at interim tops\nand lift the hedges at bottoms. Based on the chart picture and last week's\nanemic behavior, we would not trade for bounces in the NASDAQ. If\nanything, it is a short, but a risky one.\nThese past letters, dramatically illustrating the effectiveness of the methods\nof this book, may be found online through links at the address specified\nbelow. Your editor, personally, is not a genius for having made these\nanalyses. It is the method which is to credit, and any number of my\ngraduate students can make the same analyses, as can any alert chart\nanalyst.\nThe reader should not skip the prefatory material to the eighth edition. The\nsame practices outlined there have been followed in this edition. Magee\nsaid the reader should not skim through this book and put it on his library\nshelf. Instead, it should be read and reread and constantly referred to and so\nthe reader should, yes, so he should.\nRichard Russell, the dean of Dow Theory Analysts, has reportedly said the\nprice of the Dow and the price of gold will cross in coming years. He has\nalso remarked that the S&P appears to evince a 10-year head-and-shoulders\npattern. Robert Prechter believes we are at the crest of the tidal wave and\nthe tsunami cometh.\nDow 36,000. Dow 3,000. This book contains the best tools to cope with\nwhatever the future holds.\nW. H. C. Bassetti San", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 3}
{"text": "ry Analysts, has reportedly said the\nprice of the Dow and the price of gold will cross in coming years. He has\nalso remarked that the S&P appears to evince a 10-year head-and-shoulders\npattern. Robert Prechter believes we are at the crest of the tidal wave and\nthe tsunami cometh.\nDow 36,000. Dow 3,000. This book contains the best tools to cope with\nwhatever the future holds.\nW. H. C. Bassetti San Francisco, California May 1, 2005\nA special note concerning resources on the Web\nIn the age of instant and easy (and free) access to information on the\ninternet, it would be foolish to ignore the opportunities available to interact\nwith the material of this book. The reader will find free materials that\naugment the book at http://www.edwards-magee. com. For example, when\nthe reader learns in Chapter 28 of the Basing Points Procedure, he will be\nable to go to the website and print out a PDF of material that he can place\nbeside Figure 28.1 for instant and easy cross-reference, instead of having to\nturn pages constantly back and forth from the chart to the keys and\ncommentary or having to bend the book into pretzels at a copy machine. In\ngeneral, wherever references are made in the text to the website, it is for\nthis purpose, to give the reader easy and flexible usage of the material. And,\nlikewise, at this address the reader will find links to past letters that show\nhow the method functioned in real time in real markets.\nA special note about Dow Theory\nSenator Everett Dirkson said one time that trying to get U.S. senators\nherded together and moving in one direction was like trying to transport\nbullfrogs in a wheelbarrow. Trying to synchronize the signals of the various\nDow Theory analysts is a similarly challenging proposition. No Ayatollah\nexists to issue the final fatwa as to whether the signal is valid. Always one\nto abhor a vacuum, I have organized a committee at Golden Gate University\nto evaluate pronouncements of signals and opine as to whether the signals\nare valid. This committee died an unnatural death, unfortunately, for lack of\ndemand as to its expertise.\nAcknowledgments for the ninth edition\nFor professional assistance: Jack Schannep, Robert W. Colby, Curtis Faith,\nGreg Morris, John Murphy, Tim Knight, and Chi Huang.\nFor assistance at Taylor and Francis: Richard O'Hanley, Raymond\nO'Connell, Pat Roberson, Andrea Demby, and Roy Barnhill.\nFor research assistance and manuscript preparation: Brian Brooker and\nGrace Ryan, my fearsomely bright and efficient teaching and research\nassistants. And my inimitable technical assistant, Samuel W. D. Bassetti.\nAt Golden Gate University for ongoing support and assistance: Professor\nHenry Pruden, Barbara Karlin, Janice Carter, Tracy Weed, and Cassandra\nDilosa.\nSpecial appreciation goes to makers of software packages and their\nsupportive executives for software used in the preparation of this and\nprevious editions:\nJohn Slauson Adaptick 1082 East 8175 South Sandy, UT 84094\nhttp://www.adaptick.com\nSteven Hill AIQ Systems P.O. Box 7530 Incline Village, NV 89452 702-\n831-2999 http://www.AIQsystems.com\nAlan McNichol Metastock Equis International, Inc.\n3950 S. 700 East, Suite 100 Salt Lake City, UT 84107 http://www.equis.com\nTaylor & Francis\nTaylor & Francis Group\nhttp://taylorandfrancis.com\nPreface to the eighth edition\nHere is a strange event—a book written in the mid-20th century retains its\nrelevancy and importance to the present day. In fact, Technical Analysis of\nStock Trends remains the definitive book on the subject of analyzing the\nstock market with charts. Knock-offs, look-alikes, and pale imitations have\nproliferated in its wake like seagulls after a productive fishing boat. But the\ntruth is they have added nothing new to the body of knowledge Edwards\nand Magee originally produced and Magee refined up to the fifth edition.\nWhat accounts for this rare occasion of a book's passing to be a classic? To\nbe more, in fact, than a classic, to be the manual or handbook for current\nusage?\nTo answer this question, we must ask another: What are chart formations?\nChart formations identified and analyzed by the authors are graphic\nrepresentations of unchanging human behavior in complex multivariate\nsituations. They are the depiction of multifarious human actions bearing on\na single variable (price). On price, converge a galaxy of influences: fear,\ngreed, desire, cunning, malice, deceit, naivete, earnings estimates, broker\nneed for income, gullibility, professional money managers' need for\nperformance and job security, supply and demand of stocks, monetary\nliquidity and money flow, selfdestructiveness, passivity, trap setting,\nmanipulation, blind arrogance, conspiracy and fraud and double dealing,\nphases of the moon and sun spots, economic cycles and beliefs about them,\npublic mood, and the indomitable human need to be right.\nChart formations are the language of the market, telling us that this stock is\nin its death throes; that stock is on a rocket to the moon; that a life and death\nbattle is being waged in this issue; and in that other, the buyers have\ndefeated the sellers and are breaking away.\nThey are, in short, the inerasable fingerprints of human nature made graphic\nin the greatest struggle in human experience, next to war.\nAs Freud mapped the human psyche, so have Edwards and Magee mapped\nthe human mind and emotions as expressed in the financial markets. Not\nonly did they produce a definitive map, they also produced a methodology\nfor interpreting and profiting from the behavior of men and markets. It is\ndifficult to imagine further progress in this area until the science of artificial\nintelligence, aided by yet unimaginable computer hardware, makes new\nbreakthroughs.\nIf it is definitive, why offer a new edition?\nUnlike Nostradamus and Jules Verne (and many current investment\nadvisors), the authors did not have a crystal ball or a time machine. Magee\ndid not foresee the electronic calculator and made do with a slide rule. And\nwhile he knew of the computer,", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 4}
{"text": "science of artificial\nintelligence, aided by yet unimaginable computer hardware, makes new\nbreakthroughs.\nIf it is definitive, why offer a new edition?\nUnlike Nostradamus and Jules Verne (and many current investment\nadvisors), the authors did not have a crystal ball or a time machine. Magee\ndid not foresee the electronic calculator and made do with a slide rule. And\nwhile he knew of the computer, he did not anticipate that every housewife\nand investor would have 1,000 times the power of a Whirlwind or Univac I\non his (her) desk (cf., “About Gender”). In short, the March of Time. The\nProgress of Science. The Inexorable Advance of Technology.\nAmazingly, the great majority of this book needed no update or\nactualization. Who is to improve on the descriptions of chart formations and\ntheir significance?\nBut insofar as updates are necessary to reflect the changes in technology\nand in the character and composition of the markets, that is another story.\nHuman character may not change, but in the new millennium, there is\nnothing but change in the character and composition of the markets. And\nwhile regulatory forces might not be completely in agreement, the majority\nof these changes have been positive for the investor and the commercial\nuser. Of course, Barings Bank and some others are less than ecstatic with\nthese developments.\nThe most important additions to this book to reflect changes in the times,\ntechnology, and markets\nGenerally speaking, these additions, annotations, and updates are intended\nto inform the general reader of conditions of which he must be aware for\ninvesting success. In most cases, because of the enormous amount of\nmaterial, no attempt is made to be absolutely exhaustive in the treatment of\nthese developments. Rather, the effort is made to put changes and new\nconditions in perspective and furnish the investor with the resources and\nproper guide to pursue subjects at greater length if desired. In fact, an\nappendix has been provided, entitled Resources (EN10: now Appendix B),\nto which the reader may turn when he has mastered the material of the book\nproper.\nThe stubborn individualist may realize investment success with the use of\nthis book alone (and paper, pencil, ruler, and chart paper [cf., Section on\nTEKNIPLAT™ chart paper]).\nTechnology\nIn order to equip this book to serve as a handbook and guide for the markets\nof the new millennium, certain material has been added to the text of the\nfifth and seventh editions. Clearly, the astounding advances in technology\nmust be dealt with and put in the context of the analytical methods and\nmaterial of the original. To achieve success in the new, brave world, an\ninvestor must be aware of and utilize electronic markets, the internet, the\nmicrocomputer, wireless communications, and new exchanges offering\nevery kind of exotica imaginable.\nThe advanced investor should also be aware of and understand some of the\ndevelopments in finance and investment theory and technology—the Black-\nScholes Model, Modern Portfolio Theory, Quantitative Analysis.\nFortunately, all these will not be dealt with here because, in truth, one\nintelligent investor with a piece of chart paper, a pencil, and a quote source\ncan deal with the markets, but that is another story we will explore later in\nthe book. Some of these germane subjects will be discussed sufficiently to\nput them in perspective for the technical analyst, and then guides and\nresources will be pointed out for continued study. My opinion is that the\nmastery of all these subjects is not wholly necessary for effective investing\nat the private level. What need does the general investor have for an\nunderstanding of the Cox-Ross-Rubinstein (CRR) options analysis model to\nrecognize trends? The Edwards-Magee model knows things about the\nmarket the CRR model does not.\nTrading and investment instruments\nThe new universe of available trading and investment instruments must be\ntaken into account. The authors would have been in paradise at the\nprofusion of alternatives. In this future world, they could have traded the\nAverages (one of the most important changes explored in this book); used\nfutures and options as investment and hedging mechanisms; practiced\narbitrage strategies beyond their wildest dreams; and contemplated a candy\nstore full of investment products. The value and utility of these products\nwould have been immeasurably enhanced by their mastery of the charting\nworld of technical analysis. As only one example, one world-prominent\nprofessional trader I know has made significant profits selling calls on\nstocks he correctly analyzed to be in down trends, and vice versa— an\nobvious (or, as they say, no-brainer) to a technician, but not something you\nshould attempt at home without expert advice. Techniques like this\noccasioned the loss of many millions of dollars in the Reagan Crash of\n1987.\nChanges and developments in technical analysis\nHave any new chart patterns (that is to say, changes in human behavior and\ncharacter) emerged since the fifth edition? Not to my knowledge, although\nthere are those who take the same data and draw different pictures from\nthem. How else could you say that you had something new! different!\nbetter!? There are other ways of looking at the data that are interesting,\nsometimes valuable, and often profitable, which goes to prove that many\nare the ways and gateless is the gate to the great Dow. Point and figure\ncharting have been used very effectively by traders I know, and candlestick\ncharting depicts data in interesting ways. Furthermore, since Magee's time,\naided by the computer, technicians have developed innumerable, what I\ncall, number-driven technical analysis tools: (the puzzlingly named)\nstochastics, oscillators, exponential and other moving averages, etc., etc.,\netc. It is not the intent of this book to explore these tools in depth. That will\nbe done in a later volume. These concepts are briefly explored in an\nappendix (Appendix C, 8th edition) supplied by Richard McDermo", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 5}
{"text": "cians have developed innumerable, what I\ncall, number-driven technical analysis tools: (the puzzlingly named)\nstochastics, oscillators, exponential and other moving averages, etc., etc.,\netc. It is not the intent of this book to explore these tools in depth. That will\nbe done in a later volume. These concepts are briefly explored in an\nappendix (Appendix C, 8th edition) supplied by Richard McDermott, editor\nof the seventh edition.\nI have also made additions to the book (see Chapter 18) to give a\nperspective on longterm investing, since Magee specifically addressed the\nsecond part of the book (on tactics) to the speculator. I have substantially\nrewritten Chapters 24 and 42 to reflect current ideas on portfolio\nmanagement and risk management. I have expanded on the idea of\nrhythmic trading—an idea which is implicit in the original. I have expanded\nthe treatment of runaway markets so the internet stocks of the 1990s might\nbe put in perspective (see Chapter 23).\nAnd then, paradigms. Paradigms, as everyone should know by now, are the\nlast refuge of a fundamentalist when all other explanations fail.\nParadigm changes\nWhenever the markets, as they did at the end of the 20th century, depart\nfrom the commonly accepted algorithms for determining what their prices\nought to be, fundamentalists (those analysts and investors who believe they\ncan determine value from such fixed verities as earnings, cash flow, etc.)\nare confronted with new paradigms. Are stock prices (values) to be\ndetermined by dividing price by earnings to establish a reasonable\nprice/earnings (p/e) ratio? Or should sales be used, or cash flow, or the\nphases of the moon, or—in the late 1990s—should losses be multiplied by\nprice to determine the value of the stock? Technicians are not obliged to\nworry about this kind of financial legerdemain. The stock is worth what it\ncan be sold for today in the market.\nThe crystal ball\nInvestors will get smarter and smarter, starting with those who learn what\nthis book has to say. The professionals will stay one step ahead of them\nbecause they are preternaturally cunning and spend all their time figuring\nout how to keep ahead of the public, but the gap will narrow. Software and\nhardware will continue to advance, but not get any smarter. Mechanical\nsystems will work well in some areas, yet not in others. Mechanical systems\nare only as good as the engineer who designs them and the mechanic who\nmaintains them. Buying systems is buying trouble. Everyone should find\nhis own method (usually some variant of the Magee method, in my\nopinion). All good things will end; all bad things will end. The bag of tricks\nwith which the insiders bilk the public will get smaller and smaller. New\nand ingenious procedures will be developed by the insiders. The well of\nhuman naivete is bottomless. For every one educated, a new one will be\nborn in a New York minute. It is deeply disturbing at the turn of the century\nthat the owners of the NASDAQ and the NYSE should be thinking of going\npublic. Could there be any more ominous sign that enormous changes are\nabout to occur?\nVigorous development of the systems, methods, procedures, and philosophy\noutlined in this book is about the only protective shield I know of to guard\nagainst inimical change.\nW. H. C. Bassetti\nSan Geronimo, California January 1, 2001\nAbout the editorial practices in this eighth edition\nNeedless to say, one approaches the revision of a classic work with some\ntrepidation. Every critic and reader has his or her (cf., “About Gender”)\nopinion as to how revision should be done—whether the authors' original\ntext should be invisibly changed as though they had written the book in\n2000 instead of 1948 and were omniscient, or whether errors and\nanachronisms were to be lovingly preserved, or footnoted, or ... etc., etc. (I\nhave preserved Magee's favorite usage of “etc., etc., etc.” against the\nprotestation of generations of English composition teachers because I like\nits evocation of an ever-expanding universe.)\nNotwithstanding every reader having an opinion, I am certain all critics will\nbe delighted with the practices followed in this third millennium edition of\nthe most important book on technical analysis written in the second\nmillennium.\nIntegrity of the original text\nBy and large, the fifth edition has been the source of the authors' original\ntext. Amazingly, almost no stylistic or clarifying emendation has been\nnecessary to that edition. This is a tribute to the clarity, style, and content of\nthe original—one might almost say awesome if the word were not in such\ncurrency on “Saturday Night Live” and the Comedy Central. Considering\nits complex subject was written in the middle of the last century and the\nmarkets were one-tenth of their present complexity, awesome may be the\nappropriate word. No change or update has been necessary to the technical\nobservations and analysis. They are as definitive today as they were in\n1950.\nWhile I have preserved the authors' original intent and text, I have taken the\nliberty of rearranging some of the chapters. Novices wishing to learn\nmanual charting will find the appropriate chapters moved to appendices at\nthe back of the book, along with the chapters on Composite Leverage and\nSensitivity Indexes.\nAbout apparent anachronisms\nCritics with limited understanding of long-term trading success may think\nthat discussions of “what happened in 1929” or “charts of ancient history\nfrom 1946” have no relevance to the markets of the present millennium.\nThey will point out that AT&T no longer exists in that form, that the New\nHaven has long since ceased to exist as a stock, that many charts are records\nof long-buried skeletons. This neglects the value of the charts as metaphor.\nIt ignores their representations of human behavior in the markets which will\nbe replicated tomorrow in some stock named today.com or\nwilltheynevergetit.com. Even more important, it ignores the significance of\nthe past to trading in the present. I cite here material fro", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 6}
{"text": "sed to exist as a stock, that many charts are records\nof long-buried skeletons. This neglects the value of the charts as metaphor.\nIt ignores their representations of human behavior in the markets which will\nbe replicated tomorrow in some stock named today.com or\nwilltheynevergetit.com. Even more important, it ignores the significance of\nthe past to trading in the present. I cite here material from Jack Schwager's\nilluminating book, The New Wizards of Wall Street. Schwager, in\nconversation with Al Weiss: “Precisely how far back did you go in your\nchart studies?” Answer: “It varied with the individual market and the\navailable charts. In the case of the grain markets, I was able to go back as\nfar as the 1840s.” “Was it really necessary to go back that far?” Answer:\n“Absolutely. One of the keys in long-term chart analysis is realizing that\nmarkets behave differently in different economic cycles. Recognizing these\nrepeating and shifting long-term patterns requires lots of history. Identifying\nwhere you are in an economic cycle—say, an inflationary phase versus a\ndeflationary phase—is critical to interpreting the chart patterns evolving at\nthat time.”\nIdentification of original manuscript and revisions\nTrue believers (and skeptics) will find here virtually all of the original\nmaterial written by Edwards and Magee, including their charts and\nobservations on them. Changes and comments introduced by editors since\nthe fifth edition have been rearranged, and, when appropriate, have been\nidentified as a revision by that editor.\nMaintaining this policy, where updates to the present technological context\nand market reality were necessary, the present editor has clearly identified\nthem as his own work by beginning such annotations with “EN” for Editor's\nNote. Figure insertions are identified as “x.1, x.2.”\nAbsolutely necessary revisions\nNot too long ago my youngest son, Pancho, overheard a conversation in\nwhich I referred to a slide rule. “What's a slide rule, Dad?” he asked. Well,\nneedless to say the world has, in general, moved on from the time of\nEdwards and Magee when instead of calculators we had slide rules. Where\ntime has made the text useless, moot, or irrelevant, that problem has\nunobtrusively been corrected.\nWhere the passage of time has made the text obsolete, I have either\nfootnoted the anachronism and/or provided a chapter-ending annotation,\nwhich are marked in the text with “EN.” It is absolutely essential to read the\nannotations; failure to do so will leave the reader stranded in the 20th\ncentury.\nIn some cases, these annotations amount to new chapters—for example,\ntrading directly in the averages was difficult in Magee's time. Nowadays, if\nthere is not a proxy or option or index for some Index or Average or basket\nof stocks, there will be one in less than a New York minute (which, as\neveryone knows, has only 59 seconds). This new reality has resulted in\nmajor additions to this new edition, which are detailed in the Foreword.\nMajor chapter additions necessary to deal with developments in technology\nand finance theory have been clearly identified as this editor's work by\ndesignating them as interpolations, viz., Chapter 18 (with the exception of\nChapter 23, which I have surreptitiously inserted).\nAbsolutely necessary revisions that arose in the 30 minutes since this\neditorial note was written\nIn a number of instances, the book relayed information that, in those days of\nfixed commissions and monopolistic control by the existing exchanges,\nremained valid for long periods of time; for instance, brokerage\ncommissions and trading costs. It is no longer possible to maintain such\ninformation in a printed book because of the rate of change in the financial\nindustry. It must now be filed and updated in real time on the internet.\nConsequently, readers will be able to refer to the internet for this kind of\nephemeral data. The general importance of the ephemera to the subject is\nalways discussed.\nAbout gender\nI quote here from my foreword to the second edition of Magee's General\nSemantics of Wall Street (charmingly renamed according to the current\nfashions, Winning the Mental Game on Wall Street):\nAbout Gender in Grammar\nIch bin ein feminist. How could any modern man, son of a beloved woman,\nhusband of an adored woman, and father of a joyful and delightful daughter\nnot be? I am also a traditionalist and purist in matters of usage, grammar,\nand style. So where does that leave me and my cogenerationalists,\nenlightened literary (sigh) men (and women), with regards to the use of the\nmasculine pronoun when used in the general sense to apply to the neuter\nsituation?\nIn Dictionary of Modern American Usage, Garner notes: “English has a\nnumber of common-sex general words, such as person, anyone, everyone,\nand no one, but it has no common-sex singular personal pronouns. Instead\nwe have he, she, and it. The traditional approach has been to use the\nmasculine pronouns he and him to cover all persons, male and female alike\n... . The inadequacy of the English language in this respect becomes\napparent in many sentences in which the generic masculine pronoun sits\nuneasily.”\nInadequate or not, it is preferable to s/he/it and other bastardizations of the\nEnglish language. (Is it not interesting that “bastard,” in common usage, is\nnever used of a woman, even when she is illegitimate?) As for the\nlegitimacy of the usage of the masculine (actually neuter) pronoun in the\ngeneric, I prefer to lean on Fowler, who says, “There are three makeshifts:\nfirst, as anybody can see for himself or herself; second, as anybody can see\nfor themselves; and third, as anybody can see for himself. No one who can\nhelp it chooses the first; it is correct, and is sometimes necessary, but it is so\nclumsy as to be ridiculous except when explicitness is urgent, and it usually\nsounds like a bit of pedantic humor. The second is the popular solution; it\nsets the literary man's (!) teeth on edge, and he exerts himself to give the\nsame meaning in some", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 7}
{"text": "selves; and third, as anybody can see for himself. No one who can\nhelp it chooses the first; it is correct, and is sometimes necessary, but it is so\nclumsy as to be ridiculous except when explicitness is urgent, and it usually\nsounds like a bit of pedantic humor. The second is the popular solution; it\nsets the literary man's (!) teeth on edge, and he exerts himself to give the\nsame meaning in some entirely different way if he is not prepared to risk the\nthird, which is here recommended. It involves the convention (statutory in\nthe interpretation of documents) that where the matter of sex is not\nconspicuous or important the masculine form shall be allowed to represent a\nperson instead of a man, or say a man (homo) instead of a man (vir).”\nPolitically correct fanatics may rail, but so are my teeth set on edge; thus, I\nhave generally preserved the authors' usage of the masculine for the generic\ncase. This grammatical scourge will pass and be forgotten, and weak-willed\nmyn (by which I intend to indicate men and women) who pander to\ngrammatical terrorists will, in the future, be seen to be stuck with\nmalformed style and sentences no womyn will buy. What would Jane\nAusten have done, after all?\nAbout Gender in Investors\nAs long as we are on the subject of gender, we might as well discuss,\nunscientifically, gender in investors. Within my wide experience as a\ntrading advisor, teacher, and counselor, it strikes me that the women\ninvestors I have known have possessed certain innate advantages over the\nmen. I know there are women gamblers—I have seen some. But I have\nnever seen a woman plunger (shooter, pyramider, pie-eyed gambler) in the\nmarkets, though I have known many men who fit this description. I have\nalso noted among my students and clients that, as a group, women seem to\nhave more patience than men. I refer specifically to the patience that a wise\ninvestor must have to allow the markets to do what they are going to do.\nThese are wholly personal observations. I have made no study of the\nquestion and can't speak to the entire class of women investors— and do not\npersonally know Barbra Streisand (who I understand is a formidable\ninvestor, especially in IPOs). But just as I believe the world would be better\noff if more women ran countries and were police officers, I expect the\nworld of finance will benefit from the steadily increasing number of women\ninvestors and managers.\nA crucial question: sensitivity indexes and betas\nLong before the investment community had formalized the beta measure—\nthe coefficient measuring a stock's volatility relative to the market—Magee\nand Edwards were computing a Sensitivity Index, which, for all practical\npurposes, was the same thing. Readers interested in this aspect of their work\nmay find references in Resources (EN10: now Appendix B), which will\nenable them to obtain betas to plug into the Composite Leverage formula\nwith which Magee intended to determine risk levels. The old appendix on\nSensitivity Indexes has been consigned to Appendix A (8th edition), along\nwith the chapter on Composite Leverage, both originals of which have been\nemended to reflect current practices in finance theory and practice.\nBetwixt and between, 1/8 of a dollar or 12.5 cents\nAs this edition went to press, the financial services industry was once again\nthreatening to implement decimals in stock prices. Pricing in eighths has\nendured long past its time\nbecause it was in the self-interest of the financial industry—it allowed\nbrokers and market makers to enforce larger bid-ask spreads and fatten their\nprofit margins. The importance for this book, and for traders, is what will\nhappen as full decimalization occurs. Often in these pages, Magee will\nrecommend placing a stop 1/8 off the low or high, or placing progressive\nnear stops in eighths. We do not yet know what the psychological interval\nwill be in the new era; it may be 12.5 cents, or more psychologically, 10\ncents, or for gaming purposes, 9 or 11 cents. This remains to be seen. As all\nthe charts in this book are in the old notation, that usage has been preserved\nin this edition.\nThe editorial “I”\nReaders will quickly note the “editorial we” of Edwards and Magee has\nbeen replaced by the first-person voice—or, the “editorial I” or perhaps the\n“professorial I.” Well, there were two authors in Edwards and Magee, and\nthere is only one of me; my text is immediately noticeable as mine, and the\nreader may discriminate quickly. As for the use of “I” as an expression of\nego, the reader is assured that after 40 years in the market, the editor has no\nego left to promote. Perhaps the best way to put the editor's sense of\nimportance in perspective is to quote Dr. Johnson's definition of\nlexicographer from his dictionary. Some people might have thought\nJohnson self-important in creating the first English dictionary; his definition\nof his trade put that right: “Lexicographer: a writer of dictionaries. A\nharmless drudge.” An editor is something like the same.\nAs this book goes to the printer, the publisher, recognizing the importance\nof the work done on this edition, will credit the editor as co-author of the\neighth edition. John Magee would be pleased. We had a cordial master-\nstudent relationship, and nothing pleases a Zen master more than to transfer\nthe dharma to a passionate student.\nAcknowledgments\nIn General:\nJohn Magee, for his ever-patient tutoring.\nBlair Hull, for teaching me the mercurial nature of options.\nBill Dreiss, for teaching me the nature of trading systems.\nArt von Waldburg, respected colleague and discoverer of the Fractal Wave\nAlgorithm. Fischer Black, who should have lived to get the Nobel Prize.\nBill Scott, friend and fellow trader.\nFor specific support and assistance in the preparation of this eighth edition:\nProfessor Henry Pruden, Golden Gate University, San Francisco, for\ninvaluable support and advice.\nMartin Pring; Lawrence Macmillan; Mitch Ackles, Omega Research\nCorporation; Carson Carlisle; Edward Dobson; David Robinson;", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 8}
{"text": "Fischer Black, who should have lived to get the Nobel Prize.\nBill Scott, friend and fellow trader.\nFor specific support and assistance in the preparation of this eighth edition:\nProfessor Henry Pruden, Golden Gate University, San Francisco, for\ninvaluable support and advice.\nMartin Pring; Lawrence Macmillan; Mitch Ackles, Omega Research\nCorporation; Carson Carlisle; Edward Dobson; David Robinson; Shereen\nAsh; Steven W. Poser; Lester Loops, late of Hull Trading Company; Tom\nShanks, Turtle.\nAt St. Lucie Press, the dedication and support of the publisher, Drew\nGierman, and Production Associate, Pat Roberson, have been invaluable, as\nhas been the dedication of Gail Renard, the Production Editor.\nAnd special acknowledgment to my Research Assistant, Don Carlos\nBassetti y Doyle.\nSpecial appreciation goes to makers of software packages used in the\npreparation of this and previous editions:\nAIQ Systems P.O. Box 7530 Incline Village, NV 89452 702-831-2999\nhttp://www.AIQsystems.com\nMetastock Equis International, Inc. 3950 S. 700 East, Suite 100 Salt Lake\nCity, UT 84107 http://www.equis.com\nTradestation Omega Research 14257 SW 119th Avenue Miami, FL 33186\n305-485-7599 http://www.tradestation.com\nTaylor & Francis\nTaylor & Francis Group\nhttp://taylorandfrancis.com\nIn memoriam\nThis book is a memorial for John Magee, who died on June 17, 1987. John\nMagee was considered a seminal pioneer in technical analysis, and his\nresearch with co-author, Robert D. Edwards, clarified and expanded the\nideas of Charles Dow, who laid the foundation for technical analysis in\n1884 by developing the “Averages,” and Richard Schabacker, former editor\nof Forbes in the 1920s, who showed how the signals, which had been\nconsidered important when they appeared in the averages, were applicable\nto stocks themselves. The text, which summarized their findings in 1948,\nwas, of course, Technical Analysis of Stock Trends, now considered the\ndefinitive work on pattern recognition analysis. Throughout his technical\nwork, John Magee emphasized three principles: stock prices tend to move\nin trends; volume goes with the trend; and a trend, once established, tends\nto continue in force.\nA large portion of Technical Analysis of Stock Trends is devoted to the\npatterns which tend to develop when a trend is being reversed: Head and\nShoulders, Tops and Bottoms, “W” patterns, Triangles, Rectangles, etc.—\ncommon patterns to stock market technicians. Rounded Bottoms and\nDrooping Necklines are some of the more esoteric ones.\nJohn urged investors to go with the trend, rather than trying to pick a\nbottom before it was completed, averaging down a declining market. Above\nall, and at all times, he refused to get involved in the game of forecasting\nwhere “the market” was headed, or where the Dow-Jones Industrial\nAverages would be on December 31st of the coming year. Rather, he\npreached care in individual stock selection regardless of which way the\nmarket “appeared” to be headed.\nTo the random walker, who once confronted John with the statement that\nthere was no predictable behavior on Wall Street, John's reply was classic.\nHe said, “You fellows rely too heavily on your computers. The best\ncomputer ever designed is still the human brain. Theoreticians try to\nsimulate stock market behavior, and, failing to do so with any degree of\npredictability, declare that a journey through the stock market is a random\nwalk. Isn't it equally possible that the programs simply aren't sensitive\nenough or the computers strong enough to successfully simulate the thought\nprocess of the human brain?” Then John would walk over to his bin of\ncharts, pull out a favorite, and show it to the random walker. There it was—\nspike up, heavy volume; consolidation, light volume; spike up again, heavy\nvolume. A third time. A fourth time. A beautifully symmetrical chart,\nmoving ahead in a well-defined trend channel, volume moving with price.\n“Do you really believe that these patterns are random?” John would ask,\nalready knowing the answer.\nWe all have a favorite passage or quotation by our favorite author. My\nfavorite quotation of John's appears in the short booklet he wrote especially\nfor subscribers to his Technical Stock Advisory Service: “When you enter\nthe stock market, you are going into a competitive field in which your\nevaluations and opinions will be matched against some of the sharpest and\ntoughest minds in the business. You are in a highly specialized industry in\nwhich there are many different sectors, all of which are under intense study\nby men whose economic survival depends upon their best judgment. You\nwill certainly be exposed to advice, suggestions, offers of help from all\nsides. Unless you are able to develop some market philosophy of your own,\nyou will not be able to tell the good from the bad, the sound from the\nunsound.”\nI doubt if any man alive has helped more investors develop a sound\nphilosophy of investing on Wall Street than John Magee.\nRichard McDermott President, John Magee, Inc.\nSeptember 1991\nPreface to the seventh edition\nMore than 100 years ago, in Springfield, MA, there lived a man named\nCharles H. Dow. He was one of the editors of a great newspaper, the\nSpringfield Republican. When he left Springfield, it was to establish another\ngreat newspaper, the Wall Street Journal.\nCharles Dow also laid the foundation for a new approach to stock market\nproblems.\nIn 1884, he made up an average of the daily closing prices of 11 important\nstocks, nine of which were rails, and recorded the fluctuations of this\naverage.\nHe believed the judgment of the investing public, as reflected in the\nmovements of stock prices, represented an evaluation of the future\nprobabilities affecting the various industries. He saw in his average a tool\nfor predicting business conditions many months ahead. This was true\nbecause those who bought and sold these stocks included people intimately\nacquainted with the industrial situation from every angle. Dow reasoned the\nprice of a security, as determin", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 9}
{"text": "n the\nmovements of stock prices, represented an evaluation of the future\nprobabilities affecting the various industries. He saw in his average a tool\nfor predicting business conditions many months ahead. This was true\nbecause those who bought and sold these stocks included people intimately\nacquainted with the industrial situation from every angle. Dow reasoned the\nprice of a security, as determined by a free competitive market, represented\nthe composite knowledge and appraisal of everyone interested in that\nsecurity—financiers, officers of the company, investors, employees,\ncustomers—everyone, in fact, who might be buying or selling stock.\nDow felt this market evaluation was probably the shrewdest appraisal of\nconditions to come that could be contained, since it integrated all known\nfacts, estimates, surmises, and the hopes and fears of all interested parties.\nIt was William Peter Hamilton who really put these ideas to work. In his\nbook, The Stock Market Barometer, published in 1922, he laid the\ngroundwork for the much-used and much-abused Dow Theory.\nUnfortunately, a great many superficial students of the market never\nunderstood the original premise of the “barometer” and seized on the bare\nbones of the theory as a sort of magic touchstone to fame and easy fortune.\nOthers, discovering the “barometer” was not perfect, set about devising\ncorrections. They tinkered with the rules of classic Dow Theory, trying to\nfind the wonderful formula that would avoid its periodic disappointments\nand failures.\nOf course, what they forgot was the Averages were only averages at best.\nThere is nothing very wrong with the Dow Theory. What is wrong is the\nattempt to find a simple, universal formula—a set of measurements that will\nmake a suit to fit every man, fat, thin, tall, or short.\nDuring the 1920s and 1930s, Richard W. Schabacker reopened the subject\nof technical analysis in a somewhat new direction. Schabacker, who had\nbeen financial editor of Forbes Magazine, set out to find some new answers.\nHe realized whatever significant action appeared in the average must derive\nfrom similar action in some of the stocks making up the average.\nIn his books, Stock Market Theory and Practice, Technical Market Analysis,\nand Stock Market Profits, Schabacker showed how the “signals” that had\nbeen considered important by Dow theorists when they appeared in the\nAverages were also significant and had the same meanings when they\nturned up in the charts of individual stocks.\nOthers, too, had noted these technical patterns, but it was Schabacker who\ncollated, organized, and systematized the technical method. Not only that,\nhe also discovered new technical indications in the charts of stocks;\nindications of a type that would ordinarily be absorbed or smothered in the\naverages, and, hence, not visible or useful to Dow theorists.\nIn the final years of his life, Richard Schabacker was joined by his brother-\nin-law, Robert D. Edwards, who completed Schabacker's last book and\ncarried forward the research of technical analysis.\nEdwards, in turn, was joined in this work in 1942 by John Magee. Magee,\nan alumnus of the Massachusetts Institute of Technology, was well oriented\nto the scientific and technical approach.\nEdwards and Magee retraced the entire road, reexamining the Dow Theory\nand restudying the technical discoveries of Schabacker.\nBasically, the original findings were still good; however, with additional\nhistory and experience, it was possible to correct some details of earlier\nstudies. Also, a number of new applications and methods were brought to\nlight. The entire process of technical evaluation became more scientific.\nIt became possible to state more precisely the premises of technical\nanalysis: that the market represents a most democratic and representative\ncriterion of stock values; that the action of a stock in a free, competitive\nmarket reflects all that is known, believed, surmised, hoped, or feared about\nthat stock; and, therefore, that it synthesizes the attitudes and opinions of\nall. That the price of a stock is the result of buying and selling forces and\nrepresents the “true value” at any given moment. That a Major Trend must\nbe presumed to continue in effect until clear evidence of Reversal is shown.\nAnd, finally, that it is possible to form opinions having a reasonably high\nprobability of confirmation from the market action of a stock as shown in\ndaily, weekly, or monthly charts, or from other technical studies derived\nfrom the market activity of the security.\nIt is important to point out that the ultimate value of a security to the\ninvestor or trader is what he or she ultimately receives from it. That is to\nsay, the price the investor gets when it is sold, or the market price\nobtainable for it at any particular time, adjusted for dividends or capital\ndistribution in either case. If, for example, he or she has bought a stock at\n$25 a share, and it has paid $5 in dividends and is now bid at $35, he or she\nhas realized an accrued benefit of $5 plus $10, or $15 in all. It is the\ncombination of dividends and appreciation of capital that constitutes the\ntotal gain.\nIt seems futile to try to correlate or compare the market value of a stock\nwith the “book value” or with the “value” figured on a basis of capitalized\nearnings or dividends, projected growth, etc. There are too many other\nfactors that may also affect the value, and some of these cannot easily be\nexpressed in simple ratios. For example, a struggle for control of a\ncorporation can as surely increase the value of its securities in the market as\na growth of earnings. Again, a company may lose money for years and pay\nno dividends, yet still be an excellent investment on the basis of its\ndevelopment of potential resources as perceived by those who are buying\nand selling its stock. The market is not evaluating last year's\naccomplishments as such; it is weighing the prospects for the year to come.\nThen, too, in a time of inflation, a majority of stocks may adva", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 10}
{"text": "s. Again, a company may lose money for years and pay\nno dividends, yet still be an excellent investment on the basis of its\ndevelopment of potential resources as perceived by those who are buying\nand selling its stock. The market is not evaluating last year's\naccomplishments as such; it is weighing the prospects for the year to come.\nThen, too, in a time of inflation, a majority of stocks may advance sharply\nin price. This may reflect a depreciation in the purchasing power of dollars\nmore than improvement in business conditions—but it is important,\nnonetheless, in such a case to be “out of dollars” and “into” equities.\nAs a result of their research from 1942 to 1948, Edwards and Magee\ndeveloped new technical methods. They put these methods to practical use\nin actual market operation. Eventually, in 1948, these findings were\npublished in their definitive book, Technical Analysis of Stock Trends.\nThis book, now in its seventh edition, has become the accepted authority in\nthis field. It has been used as a textbook by various schools and colleges\nand is the basic tool of many investors and traders.\nIn 1951, Edwards retired from his work as a stock analyst and John Magee\ncontinued the research, at first, independently, and then from January 1953\nto March 1956 as Chief Technical Analyst with an investment counseling\nfirm.\nMeanwhile, beginning in 1950, Magee started on a new road, which, as it\nturned out, was destined to open up virgin fields of technical market\nresearch.\nUsing the methods of Dow, Hamilton, Schabacker, and Edwards as a base,\nhe initiated a series of studies intended to discover new technical devices.\nThese investigations were long and laborious, and, often, they were\nfruitless. One study required four months of work, involved hundreds of\nsheets of tabulations, many thousands of computations, and proved nothing.\nBut from this type of work, eventually in late 1951, there began to emerge\nsome important new and useful concepts—new bricks to build into the\nstructure of the technical method.\nThe new devices are not revolutionary. They do not vitiate the basic\ntechnical approach. Rather, they are evolutionary and add something to the\nvaluable kit of tools already at hand. The new studies often make it possible\nto interpret and predict difficult situations sooner and more dependably than\nany other method previously used.\nMr. Magee has designated these newest technical devices the Delta Studies.\nThey are basically an extension and refinement of the technical method.\nThere is no magic in the Delta Studies. They do not provide infallible\nformulas for sure profits at all times in every transaction, but they have\nproved eminently successful over a period of years in practical use in actual\nmarket operations, as an auxiliary to the methods outlined in the book,\nTechnical Analysis of Stock Trends.\nThrough his technical work, John Magee emphasized these three principles:\n1. Stock prices tend to move in trends.\n2. Volume goes with the trends.\n3. A trend, once established, tends to continue in force.\nA large portion of the book, Technical Analysis of Stock Trends, is devoted\nto the patterns that tend to develop when a trend is being reversed. Head\nand Shoulders, Tops and Bottoms, “W” Patterns, Triangles, Rectangles, etc.,\nare common patterns to stock market technicians. Rounded Bottoms and\nDrooping Necklines are some of the more esoteric ones.\nMagee urged investors to go with the trend, rather than trying to pick a\nBottom before it was completed or averaging down in a declining stock.\nAbove all, and at all times, he refused to get involved in the game of\nforecasting where “the market” was headed, or where the Dow Jones\nIndustrial Average® would be on December 31st of the coming year.\nRather, he preached care in individual stock selection regardless of which\nway the market “appeared” headed. Finally, his service recommended short\npositions as regularly as it did long positions, based simply on what the\ncharts said.\nRichard McDermott Editor and Reviser Technical Analysis of Stock\nTrends, Seventh Edition January 1997\nTaylor & Francis\nTaylor & Francis Group\nhttp://taylorandfrancis.com\nPreface to the fifth edition\nDuring the 16 printings of the fourth edition of Technical Analysis of Stock\nTrends, very few changes have been made in the original text, mainly\nbecause the lucid presentation of market action by the late Robert D.\nEdwards covered so thoroughly the basic and typical market action of\ncommon stocks. There has seemed no reason, for example, to discard a\nchart picture illustrating some important technical phenomenon merely\nbecause it occurred several or many years ago.\nInstead, over the various printings of the book, pages have been added\nshowing similar examples, or in some cases entirely new types of market\naction taken from recent history; but these demonstrate mainly that the\ninherent nature of a competitive market does not change very much over the\nyears, and that “the same old patterns” of human behavior continue to\nproduce much the same types of market trends and fluctuations.\nThe principal change in this fifth edition, and it is a spectacular\nimprovement, is that practically all of the chart examples drawn to the\nTEKNIPLAT™ scale have been redrawn and new plates of these have been\nsubstituted. In the course of this work, several minor errors of scaling,\ntitling, etc., previously undiscovered, came to light and have been corrected.\nThe difficult work of revision was initiated in our charting room by two\nambitious teenagers, Anne E. Mahoney and Joseph J. Spezeski, who took\non the entire job of preparing the finished drawings and making necessary\ncorrections. This enormous project was undertaken and carried through by\nthese two young people spontaneously. In order to free them entirely from\nother distractions, their regular charting work was taken over for a period of\nmonths by the rest of the chartroom staff, so that a great deal of credit is due\nto the fine efforts of the entire chartro", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 11}
{"text": "reparing the finished drawings and making necessary\ncorrections. This enormous project was undertaken and carried through by\nthese two young people spontaneously. In order to free them entirely from\nother distractions, their regular charting work was taken over for a period of\nmonths by the rest of the chartroom staff, so that a great deal of credit is due\nto the fine efforts of the entire chartroom group.\nJohn Magee December 3, 1966\nxli\nTaylor & Francis\nTaylor & Francis Group\nhttp://taylorandfrancis.com\nPreface to the fourth edition\nIn the several years since publication of the first edition of this work, “the\nstock market goes right on repeating the same old movements in much the\nsame old routine.” Nearly all of the technical phenomena outlined in the\nfirst edition have appeared many times since then, and we see no reason to\nexpect these habits of stocks will change materially in the years ahead,\nbarring revolutionary changes in the economy, such as the abolishment of\nthe free market entirely.\nSince the basic nature of the market has not changed appreciably, it has\nbeen unnecessary to make sweeping alterations in the text of “Part One:\nTechnical Theory.” The previous edition has been very carefully restudied,\nand revisions have been made where they were called for to bring the\nmaterial up to date. In “Part Two: Trading Tactics,” more extensive changes\nwere needed, due to the more specific nature of the material and some\ndifferences in the present margin requirements, trading rules, etc. Also,\nthere have been some improvements in the application of technical methods\nat the tactical level, and these have been incorporated in this section.\nSomewhat less emphasis has been put on the use of stop-loss orders, since\ntheir need is not so great in the case of the experienced trader as it might be\nwith the novice. The principle of always following the Major Trend has\nbeen modified to achieve better protection of capital through balance and\ndiversification. In line with avoiding “all-out” situations, with their\nconsequent dangers, the idea of using an Evaluative Index has been\nintroduced, and this concept has modified somewhat the tactics of following\nthe Major Trend. It also has a bearing on the Composite Leverage or\ndetermination of total risk.\nType for the entire book has been reset in this edition. The illustrative charts\noriginally used have been, in the main, retained, since they demonstrate the\nvarious points very well, but a new chapter includes a number of additional\ncharts taken from the market history of recent years, showing how the same\nphenomena continue to appear again and again.\nThe appendix (Appendix C, 5th edition) on the Sensitivity Indexes has been\ncompletely recomputed and extended to cover a broad list of the more\nimportant issues. The arduous labor of determining these index figures was\nundertaken by Frank J. Curto and Marcella P. Curto. Material help in\nproofreading and revision for this edition was given by Beverly Magee and\nElinor T. Magee.\nJohn Magee January 1, 1957\nTaylor & Francis\nTaylor & Francis Group\nhttp://taylorandfrancis.com\nPreface to the second edition\nIt is, needless to say, gratifying to the authors of this treatise to report that\nnot only has a large first edition been exhausted (although it was originally\nassumed it would suffice for many years), but also, the demand for copies\nhas been increasing at a rather astonishing pace during the past six months\nwithout any “promotion” except word-of-mouth recommendation from one\ninvestor to another.\nIn preparing this new edition, a careful perusal of everything that was\nwritten in the previous printing, checked by the market events of the past 24\nmonths and compared with all of the additional chart data accumulated\nduring that period, resulted in the not unexpected, but nevertheless mildly\nsurprising conclusion that nothing of real consequence needed to be\nchanged or amplified. Hence, only minor revisions of an editorial nature\nhave been made.\nIt would have been interesting to augment our already copious illustrations\nwith a number of charts from current months of market action, but costs of\nengraving and printing have risen to such a distressingly high level that any\nadditions of that sort would, it was found, be prohibitively expensive. Aside\nfrom their novelty, they would add nothing to the book; they would only be\nsubstituted for other charts of precisely the same nature and significance,\nand fully as pertinent to present-day conditions.\nThe stock market, as I wrote in the original Foreword, “goes right on\nrepeating the same old movements in much the same old routine. The\nimportance of a knowledge of these phenomena to the trader and investor\nhas been in no whit diminished.” We see the same forecasting patterns\ndeveloping on the charts today that we have seen over and over again for\nthe past 20 years. Neither the mechanics nor the “human element” of the\nstock market has changed, and there is no reason to think they will.\nRobert D. Edwards May 1, 1951\nxlv\nTaylor & Francis\nTaylor & Francis Group\nhttp://taylorandfrancis.com\nForeword\nThis book has been written for the layman rather than for the Wall Street\nprofessional. But, it assumes the reader is already possessed of at least an\nelementary knowledge of the nature of stocks and bonds, and he has had\nsome dealings with a broker and some familiarity with the financial pages\nof his newspapers. Hence, no attempt is made herein to define common\nstock market terms and procedures. Every effort, however, has been exerted\nto explain, in full, the theories and the terminology of our specific subject,\ntechnical market analysis.\nPart One is based, in large part, on the pioneer researches and writings of\nthe late Richard W. Schabacker. Students of his Technical Analysis and\nStock Market Profits (the latest revision of which is now out of print was\nmade in 1937 by the present writer and Albert L. Kimball) will find in the\npages of this section much that is familiar and, except", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 12}
{"text": "ur specific subject,\ntechnical market analysis.\nPart One is based, in large part, on the pioneer researches and writings of\nthe late Richard W. Schabacker. Students of his Technical Analysis and\nStock Market Profits (the latest revision of which is now out of print was\nmade in 1937 by the present writer and Albert L. Kimball) will find in the\npages of this section much that is familiar and, except for the illustrations,\nonly a little that is really novel. It has been a matter of surprise, in fact, to\nthe authors and other students of market technics that all the new controls\nand regulations of the past several years, the new taxes which have placed a\nheavy handicap on successful investors, the greatly augmented and\nimproved facilities for acquiring dependable information on securities, even\nthe quite radical changes in certain portions of our basic economy, have not\nmuch altered the “pattern” of the stock market.\nCertain of the evidences of pool manipulation that used to appear on the\ncharts are now seldom seen. A few of the price formations that formerly\nwere quite common, now appear rarely or may have lost much of their\npractical utility for the trader; they have been omitted from this text. Others\nhave altered their habits slightly, or their consequences to a degree (but not\ntheir fundamental nature), which has, of course, been noted herein. The\ndistressing thinness of the market at times—one of the undoubted effects of\nregulation—has resulted in a few more “false moves,” more spells of\nuninteresting (and unprofitable) inactivity. But, in the main, the market goes\nright on repeating the same old movements in much the same old routine.\nThe importance of a knowledge of these phenomena to the trader and\ninvestor has been in no whit diminished.\nPart Two, which has to do with the practical application of these market\npatterns and phenomena, with the tactics of trading, is all new. For more\nthan 15 years (his total market experience extends back nearly 30 years),\nJohn Magee has invested and traded exclusively via the technical theory,\nkept thousands of charts, made hundreds of actual trades, tested all sorts of\napplications, audited and analyzed methods, tactics, and results from every\nconceivable angle, depended on his profits for his living. His contribution is\nthat of one who has tried and knows.\nIt may well be added here—and will be often repeated in the following\npages—that the technical guides to trading in stocks are by no means\ninfallible. The more experience one gains in their use, the more alive one\nbecomes to their pitfalls and their failures. There is no such thing as a sure-\nfire method of “beating the market”; the authors have no hesitancy in\nsaying that there never will be. Nevertheless, a knowledge and judicious\napplication of the\nxlvii principles of technical analysis does pay dividends—is more profitable\n(and far safer) for the average investor than any other of the presently\nrecognized and established approaches to the problems of buying and\nselling securities.\nRobert D. Edwards\nJuly 1948\npart one\nTechnical theory\nTaylor & Francis\nTaylor & Francis Group\nhttp://taylorandfrancis.com\nchapter one\nThe technical approach to trading and investing\nFew human activities have been so exhaustively studied during the past\ncentury, from so many angles and by so many different sorts of people, as\nthe buying and selling of corporate securities. The rewards the stock market\nholds out to those who read it right are enormous; the penalties it exacts\nfrom careless, dozing, or “unlucky” investors are calamitous. No wonder it\nhas attracted some of the world's most astute accountants, analysts, and\nresearchers, along with a motley crew of eccentrics, mystics, “hunch\nplayers,” and a multitude of just ordinary hopeful citizens.\nAble brains have sought, and continue constantly to seek, for safe and sure\nmethods of appraising the state and trend of the market, as well as\ndiscovering the right stock to buy and the right time to buy it. This intensive\nresearch has not been fruitless—far from it. There are a great many\nsuccessful investors and speculators (using the word in its true sense, which\nis without opprobrium) who, by one road or another, have acquired the\nnecessary insight into the forces with which they deal and the judgment, the\nforethought, and the all-important self-discipline to deal with them\nprofitably.\nIn the course of years of stock market study, two quite distinct schools of\nthought have arisen, providing two radically different methods of arriving at\nthe answers to the trader's problem of what and when. In the parlance of\n“the Street,” one of these is commonly referred to as the fundamental or\nstatistical, and the other as the technical. (In recent years a third approach,\nthe cyclical, has made rapid progress, and although still beset by a “lunatic\nfringe,” it promises to contribute a great deal to our understanding of\neconomic trends.)\nThe stock market fundamentalist depends on statistics. He examines the\nauditors' reports, the profit-and-loss statements, the quarterly balance\nsheets, the dividend records, and the policies of the companies whose shares\nhe has under observation. He analyzes sales data, managerial ability, plant\ncapacity, and the competition. He turns to bank and treasury reports,\nproduction indexes, price statistics, and crop forecasts, to gauge the state of\nbusiness in general, and reads the daily news carefully to arrive at an\nestimate of future business conditions. Taking all these into account, he\nevaluates his stock; if it is selling currently below his appraisal, he regards\nit as a buy. (EN9: And, no surprise, the buyer's name is Warren Buffet, and\nhe buys the company, not the stock, for although this is an excellent way to\nbuy companies, it is not a very good way to buy stocks.) EN: Read Robert\nPrechter's summation of the fundamental methodology as an amusing\nendnote at the end of this chapter.\nAs a matter of fact, aside from the greenest of newcomers when t", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 13}
{"text": "regards\nit as a buy. (EN9: And, no surprise, the buyer's name is Warren Buffet, and\nhe buys the company, not the stock, for although this is an excellent way to\nbuy companies, it is not a very good way to buy stocks.) EN: Read Robert\nPrechter's summation of the fundamental methodology as an amusing\nendnote at the end of this chapter.\nAs a matter of fact, aside from the greenest of newcomers when they first\ntackle the investment problem, and to whom, in their inexperience, any\nother point of view is not only irrational but incomprehensible, your pure\nfundamentalist is a rare bird. Even those market authorities who pretend to\nscorn charts and “chartists” utterly are not oblivious to the “action”\nchronicled by the ticker tape, and they do not conceal their respect for the\nDow Theory, which, whether they realize it or not, is, in its very essence,\npurely technical.\nDefinition of technical analysis\nThe term “technical,” in its application to the stock market, has come to\nhave a special meaning, quite different from its ordinary dictionary\ndefinition. It refers to the study of the action of the market itself as opposed\nto the study of the goods in which the market deals. Technical Analysis is\nthe science of recording, usually in graphic form, the actual history of\ntrading (price changes, volume of transactions, etc.) in a certain stock or in\n“the Averages” and then deducing from that pictured history the probable\nfuture trend. EN: With the advent of the computer, many schools of\ntechnical analysis have arisen. Number-driven technical analysis (e.g.,\nmoving average studies, oscillators, etc.) attempts to completely objectify\nthe analysis of the markets. The work of Edwards and Magee is the\nembodiment and definition of “classical technical analysis.”\nThe technical student argues thus: it is futile to assign an intrinsic value to a\nstock certificate. One share of U.S. Steel, for example, was worth $261 in\nthe early fall of 1929, but you could buy it for only $22 in June 1932. By\nMarch 1937, it was selling for $126 and just one year later it was selling for\n$38. In May 1946, it had climbed back up to $97, and 10 months later, in\n1947, had dropped below $70, although the company's earnings on this last\ndate were reputed to be nearing an all-time high and interest rates in general\nwere still near an all-time low. The book value of this share of U.S. Steel,\naccording to the corporation's balance sheet, was about $204 in 1929 (end\nof the year), $187 in 1932, $151 in 1937, $117 in 1938, and $142 in 1946.\nThis sort of wide divergence between presumed value and actual price is\nnot the exception—it is the rule. It is going on all the time. The fact is the\nreal value of a share of U.S. Steel common is determined at any given time\nsolely, definitely, and inexorably by supply and demand, which are\naccurately reflected in the transactions consummated on the floor of the\nNew York Stock Exchange (see Figure 1.1).\nOf course, the statistics fundamentalists study play a part in the supply-\ndemand equation—that is freely admitted. But many other factors are\naffecting it as well. The market price reflects not only the differing value\nopinions of many orthodox security appraisers, but also all the hopes and\nfears and guesses and moods, rational and irrational, of hundreds of\npotential buyers and sellers, as well as their needs and their resources—in\ntotal, factors that defy analysis and for which no statistics are obtainable,\nbut that nevertheless are synthesized, weighed, and finally expressed in the\none precise figure at which a buyer and a seller get together and make a\ndeal (through their agents, their respective stock brokers). This is the only\nfigure that counts.\nMoreover, the technician claims, with complete justification, that the bulk\nof the statistics the fundamentalists study are past history, already out of\ndate and sterile because the market is not interested in the past or even in\nthe present. It is constantly looking ahead, attempting to discount future\ndevelopments, weighing and balancing all the estimates and guesses of\nthousands of investors who look into the future from different points of\nview and through glasses of many different hues. In brief, the going price,\nas established by the market itself, comprehends all the fundamental\ninformation the statistical analyst can hope to learn (plus some that is\nperhaps secret from him or known only to a few insiders) and much else\nbesides of equal or even greater importance.\nAll of which, admitting its truth, would be of little significance were it not\nfor the fact, which no one of experience doubts, that prices move in trends\nand trends tend to continue until something happens to change the supply-\ndemand balance. Such changes are usually detectable in the action of the\nmarket. Certain patterns or formations, levels or areas, appear on the charts\nthat have a meaning and that can be interpreted in terms of probable future\nFigure 1.1 Monthly price ranges of U.S. Steel common from January 1929\nto December 1946. Compare the great swings in the market price for this\nstock—from 1929 (extreme high, 261 3/4) to 1932 (extreme low, 21 1/4),\nfrom 1932 to 1937, from 1937 to 1938, from 1942 to 1946—with its book\nvalues for those years as cited on the previous page.\ntrend development. They are not infallible, it must be noted, but the odds\nare definitely in their favor. Time after time, as experience has amply\nproved, they are far more prescient than the best informed and most shrewd\nof statisticians.\nThe technical analyst may go even further in his claims. He may offer to\ninterpret the chart of a stock whose name he does not know, so long as the\nrecord of trading is accurate and covers a long enough term to enable him to\nstudy its market background and habits. He may suggest he could trade with\nprofit in a stock knowing only its ticker symbol, completely ignorant of the\ncompany, the industry, what it manufactures or sells, or how it is\ncapitalized. Needless to say, su", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 14}
{"text": "erpret the chart of a stock whose name he does not know, so long as the\nrecord of trading is accurate and covers a long enough term to enable him to\nstudy its market background and habits. He may suggest he could trade with\nprofit in a stock knowing only its ticker symbol, completely ignorant of the\ncompany, the industry, what it manufactures or sells, or how it is\ncapitalized. Needless to say, such practice is not recommended, but if your\nmarket technician is really experienced at his business, he could, in theory,\ndo exactly what he claims.\nShould the reader, at this point, find the technical approach to trading or\ninvesting, as explained in the foregoing, completely abhorrent, perhaps he\nhad better close the book now, for it is primarily the technical approach, the\nscience of technical analysis, with which the remainder of the book deals.\nEN: The Elliott Wave Theory: perspective and comments from a Magee\ninvestment letter of the 80s. This week, we had the pleasure of attending the\nDecember meeting of the Market Technicians Association of New York\n(MTANY).\nLong-term subscribers will remember the MTANY as the organization that\nhonored John Magee with its Man of the Year award in 1978. The speaker\nwas Robert Prechter, publisher of “The Elliott Wave Theorist,” an\ninvestment advisory that bases its forecasts on interpretations of R. N.\nElliott's work on the stock market.\nOf primary interest to subscribers are Prechter's comments on technical\nanalysis itself. The Elliott Wave Theory, it must be remembered, is really no\nmore than a “catalog” of stock market price movements, laid one on top of\nthe other, so to speak, until a grand, underlying, and enduring pattern is\nobserved; in short, pure technical analysis. Among Prechter's definitions\nand observations regarding fundamental analysis are the following:\n1. First, let's define \"technical\" versus \"fundamental\" data ... technical\ndata is that which is generated by the action of the market under study.\n2. The main problem with fundamental analysis is its indicators are\nremoved from the market itself. The analyst assumes causality between\nexternal events and market movements, a concept which is almost\ncertainly false. But, just as important (and less recognized), is that\nfundamental analysis almost always requires a forecast of the\nfundamental data itself before conclusions about the market are drawn.\nThe analyst is then forced to take a second step in coming to a\nconclusion about how those forecasted events will affect the markets!\nTechnicians only have one step to take, which gives them an edge right\noff the bat. Their main advantage is they don't have to forecast their\nindicators.\n3. What's worse, even the fundamentalists' second step is probably a\nprocess built on quicksand. ... The most common application of\nfundamental analysis is estimating companies' earnings for both the\ncurrent year and next year and recommending stocks on that basis. .\nAnd the record on that basis alone is very poor, as Barron's pointed out\nin a June 4 article, which showed that earnings estimates averaged\n18% error in the 30 Dow Jones Industrial Average (DJIA) stocks for\nany year already completed and 54% error for the year ahead. The\nweakest link, however, is the assumption that correct earnings\nestimates are a basis for choosing stock market winners. According to\na table in the same Barron's article, a purchase of the 10 DJIA stocks\nwith the best earnings estimates would have produced a 10-year\ncumulative gain of 40.5%, while choosing the 10 DJIA with the worst\nearnings estimates would have produced a whopping 142.5% gain.\nWe enjoyed Prechter's polished exposition of a technical approach, which is\ndifferent from our own. As for his observations about fundamental analysis,\nwe simply couldn't agree more.\nchapter two\nCharts\nCharts are the working tools of the technical analyst. They have been\ndeveloped in a multitude of forms and styles to represent graphically almost\nanything that takes place in the market as well as to plot an “index” derived\ntherefrom. They may be monthly charts on which an entire month's trading\nrecord is condensed into a single entry, or they may be weekly, daily,\nhourly, transaction, “point-and-figure,” and candlestick charts. They may be\nconstructed on arithmetic, logarithmic, or square-root scale, or they may be\nprojected as “oscillators.” They may delineate moving averages, proportion\nof trading volume to price movement, average price of most active issues,\nodd-lot transactions, the short interest, and an infinitude of other relations,\nratios, and indexes—all technical in the sense that they are derived, directly\nor indirectly, from what actually has been transacted on the exchanges.\nFortunately, we shall not need to concern ourselves with most of these\ncharts; they are of interest only to the full-time economic analyst. Many of\nthese charts have derived from a completely futile (so far, at least) endeavor\nto discover a “mechanical” index or combination of indexes that will\nalways, automatically, without ever failing or going wrong, give warning of\na change in trend; in our experience, such charts are often confusing and\nsometimes downright deceptive at a most critical juncture. This book,\nhowever, is designed for the layman, the professional who cannot spend all\nof his hours on his investing or trading operations, but to whom these\noperations are, nevertheless, of sufficient importance or interest to warrant\nhis devoting at least a few minutes a day to their study and management.\n(EN9: In retrospect, this is an underestimation of the importance of the\nwork. In the 21st century, the best professionals are acutely aware of the\nimportance of trend analysis and use this work as their textbook.) The\ntheories and methods outlined herein will require only the simplest form of\nstock chart—a record of the price range (open, high/low and close) and\nvolume of shares traded each day. These daily graphs will be supplemented,\nfor certain purposes that wil", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 15}
{"text": "he\nwork. In the 21st century, the best professionals are acutely aware of the\nimportance of trend analysis and use this work as their textbook.) The\ntheories and methods outlined herein will require only the simplest form of\nstock chart—a record of the price range (open, high/low and close) and\nvolume of shares traded each day. These daily graphs will be supplemented,\nfor certain purposes that will be discussed later in this text, by weekly or\nmonthly charts, which for most stocks can be easily generated by almost all\ncommercially available investment software and websites.\nNearly all the illustrations throughout the following chapters are examples\nof such daily charts. They are easy to make and maintain manually,\nrequiring only a supply of graph or cross-section paper (almost any kind\ncan serve), a daily newspaper that gives full and accurate reports on stock\nexchange dealings, a sharp pencil, and a few minutes of time. EN:\nAlternatively, numerous data services are available for use with computer\nsoftware packages, not to mention internet sites (which are mentioned in\nAppendix B, Resources). The use of this technology eliminates the burden of\nmanual chart keeping. If there is a drawback to this technology, it might be\nin the loss of the “feel” the investor gets through manual charting.\nIt is customary in preparing ordinary daily stock charts to let the horizontal\naxis represent time, with the vertical cross-lines (or as some prefer, the\nspaces between them) from left to right, thus standing for successive days.\nThe vertical scale is used for prices, with each horizontal cross-line then\nrepresenting a specific price level. Space is usually provided at the bottom\nof the sheet to plot volume, that is, the number of shares that change hands\neach day. The newspapers publishing complete stock market reports give\nthe day's turnover or volume (exclusive of odd-lot transactions that for our\npresent purpose may be disregarded), the highest and lowest price at which\neach stock sold during the day, the closing price (which is the price at which\nthe last sale effected during the day was made), and usually the opening or\nfirst sale price. On our charts, the daily price range is plotted by drawing a\nvertical line connecting the points representing the high and the low. Then a\nshort horizontal “tick” is added, either crossing the vertical range line or\nextending out to the right from it, at the level of the closing price.\nSometimes all transactions in a stock during a day take place at one and the\nsame price; the high, low, and close are thus all on level and the only mark\non our chart will be the horizontal dash representing the closing figure.\nVolume is depicted by drawing a vertical line up from the baseline of the\nchart.\nThe opening price need not be recorded. (EN10: Candlestick charts require\nthis piece of data.) Experience has shown that it seldom, if ever, has any\nsignificance in estimating future developments, which is all that ordinarily\nshould interest us. The closing price is important, however. It is, in fact, the\nonly price that many casual readers of the financial pages ever look at. It\nrepresents the final evaluation of the stock made by the market during the\nday. The closing price may be registered in the first hour of trading,\nprovided no other sales are subsequently affected, but, it nevertheless\nbecomes the figure upon which a majority of prospective traders base their\nplans for the following day. Hence, its technical significance is evident and\nwill appear in various contexts in later chapters.\nDifferent types of scales\nMany specific suggestions as to the details of charting are deferred for\ndiscussion in Section II of this book, but there is one chart feature that may\nwell be considered here. Until recent years, nearly all stock price charts\nwere kept on the common form of graph paper ruled to what is known as\nplain or arithmetic scale. But more and more chartists have now come to\nuse what is known as semilogarithmic paper, or sometimes as ratio or\npercentage paper. Our experience indicates that the semilogarithmic scale\nhas definite advantages in this work, and most of the charts reproduced in\nthis book employ this scale. The two types of scales may be distinguished at\na glance: on arithmetic paper, equal distances on the vertical scale (i.e.,\nbetween horizontal lines) represent equal amounts in dollars, whereas on\nthe semilogarithmic paper, they represent equal percentage changes. Thus,\non arithmetic paper, the distance between 10 and 20 on the vertical scale is\nexactly the same as that from 20 to 30 and from 30 to 40. On the\nsemilogarithmic scale the difference from 10 to 20, representing an increase\nof 100%, is the same as that from 20 to 40 or from 40 to 80, in each case\nrepresenting another 100% increase.\nPercentage relations, it goes without saying, are important in trading in\nsecurities. The semilogarithmic scale permits direct comparison of high-\nand low-priced stocks and makes it easier to choose the one offering the\ngreater (percentage) profit on the funds to be invested. It facilitates the\nplacing of stop-loss orders. Area patterns appear much the same on either\ntype of paper, but certain trendlines develop more advantageously on the\nratio scale. Almost anyone can quickly become accustomed to making\nentries on semilogarithmic paper. (We recommend its use.) Its advantages,\nhowever, are not so great as to require one to change—one who, because of\nlong familiarity and practice, prefers an arithmetic sheet. Such percentage\ncalculations, as may seem to be required, can be made on another sheet or\nin the head, and the results then can be entered on the arithmetic chart, if a\nrecord is desired.\nSeveral firms specializing in the manufacture of graph paper and other\nengineers' and architects' supplies now offer sheets specifically designed for\nstock charting, on which heavier lines to define the business week mark\neach sixth day on the time scale, and the price scale is subdivid", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 16}
{"text": "other sheet or\nin the head, and the results then can be entered on the arithmetic chart, if a\nrecord is desired.\nSeveral firms specializing in the manufacture of graph paper and other\nengineers' and architects' supplies now offer sheets specifically designed for\nstock charting, on which heavier lines to define the business week mark\neach sixth day on the time scale, and the price scale is subdivided into\neighths to represent the standard fractions of the dollar in which stocks are\ntraded on all U.S. exchanges. (EN9: Eighths went the way of the New\nHaven and now decimals reign.) These sheets are available in various sizes\nand with either arithmetic or logarithmic price and volume scales. EN: This\npaper is only of interest to the manual chartist, as modern software, as\ndetailed in Appendix B, Resources, enables the computer chartist to easily\nswitch between price scales and methods of charting. References to such\npaper are also found there.\nOn weekly charts, each vertical line represents a week's worth of trading.\nThe price range for the week is plotted thereon and usually the total\nvolume, but the closing price may be omitted. The range extends from the\nhighest price at which the stock sold on any day during the week to the\nlowest price at which it sold on any day; these two extremes might, and\nsometimes do, occur on the same day, but the weekly chart makes no\ndistinction as to day. Monthly charts are prepared in the same way but do\nnot, as a rule, record volume. These two charts—often referred to as long-\nterm or major charts—are used chiefly for determining important support\nand resistance levels and for marking long-term trends. Weekly charts—if\nthe reader prefers to keep his own—can be posted easily from the Sunday\nmorning editions of those daily newspapers (e.g., the New York Times or\nBarron's Business and Financial Weekly) that publish a summary of the\nprevious week's transactions.\nIn concluding this chapter on the construction of the charts that we shall\nstudy in succeeding chapters, it can well be said that there is no special\nvirtue, certainly no magic, in the chart itself. It is simply a pictorial record\nof the trading history of the stock or stocks in which we may be interested.\nTo the person possessed of a photographic memory, no chart work is\nnecessary; his mind records all the necessary data—he carries his charts in\nhis head. Many of the expert “tape-readers” who have no use for charts are\ngifted with that rare memory talent that renders reference to graphic records\nunnecessary. But most of us are not so blessed; to use the chart is necessary\nand useful because it lends itself conveniently to the type of analysis that\nindicates future probabilities.\nThere is a saying on Wall Street to the effect that “there is nothing wrong\nwith charts— the trouble is with the chartists,” which is simply another way\nof expressing the truth that it is not the chart but its interpretation that is\nimportant. Chart analysis is neither easy nor foolproof. Yet, it is not at all\nuncommon for some casual investor who has no idea whatever of market\ntechnics to pick up a chart by chance and see in it something he had not\nhitherto suspected, something perhaps that saves him from making an\nunfavorable commitment.\nIf you have never used stock charts, and have never paid much attention to\nthem, you may be surprised at some of the significant things you will detect\nas soon as you begin to study them seriously.\nEN9: Surprise and astonishment are the words used to describe the\nreactions of even professionals when they are fully exposed to a coherent\npresentation of the methods of Edwards and Magee. I have often\ncommented that no understanding of other (number driven statistical)\nmethods of technical analysis is possible without a firm grasp of the\nconcepts and principles of this book.\nSome other comments are worth noting relevant to Edwards' discussion.\nFor manual charting, semilog remains the superior scale. Given the ease of\nchanging scale and time frames on internet sites (e.g., prophet.net,\nthinkorswim.com, tdameritrade.com, and stockcharts.com) and in the\nstandalone software, one may switch from a close-up of a month to a long-\nrange perspective of years. In this process, it is important to maintain\nperspective. Multiyear log charts of large ranges lose graphic importance\nat the top as chart intervals shrink. This distortion must be countered by\nbreaking the time frame into smaller increments. Thus, instead of five years\nof a chart that spans a range of 10-200, we look at five charts of one year\neach as well as the five-year chart.\nIn the modern era, a new graphic representation has gained enormous\npopularity—candlestick charting. In this method, color is added to the chart\nby coloring the body of the candlestick—white for rising prices, black for\nfalling prices (or colors of your choice). Thus, the direction of the trend is\ndramatized. Also, candlestick patterns are said to be of value in recognizing\ntrend reversals and other trend states.\nA host of other charting methods exists: Three Line Break, Renko, Kagi...\nThese may be researched in Nison's book, Beyond Candlesticks. I will not\ntreat these in this book, but I do include them in an appendix on\nexamination of Point and Figure charting.\nchapter three\nThe Dow Theory\nThe Dow Theory is the granddaddy of all technical market studies.\nAlthough it is frequently criticized for being “too late” and occasionally\nderided (particularly in the early stages of a Bear Market) by those who\nrebel against its verdicts, it is known by name to nearly everyone who has\nhad any association with the stock market, and it is respected by most.\nMany who heed it in greater or lesser degrees in determining their\ninvestment policies never realize that it is purely and simply “technical.” It\nis built upon and concerned with nothing but the action of the stock market\n(as expressed in certain averages), deriving nothing from the business\nstatistics on which the fundamentalists dep", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 17}
{"text": "association with the stock market, and it is respected by most.\nMany who heed it in greater or lesser degrees in determining their\ninvestment policies never realize that it is purely and simply “technical.” It\nis built upon and concerned with nothing but the action of the stock market\n(as expressed in certain averages), deriving nothing from the business\nstatistics on which the fundamentalists depend.\nThere is much in the writings of its original promulgator, Charles H. Dow,\nto suggest he did not think of his theory as a device for forecasting the stock\nmarket, or even as a guide for investors, but rather as a barometer of general\nbusiness trends. Dow founded the Dow-Jones Financial News Service and\nis credited with the invention of stock market averages. He outlined the\nbasic principles of the theory, which was later named after him, in editorials\nhe wrote for the Wall Street Journal. Upon his death in 1902, his successor,\nWilliam P. Hamilton, as editor of the Journal, took up Dow's principles and,\nin the course of 27 years of writing on the stock market, organized and\nformulated them into the Dow Theory as we know it today.\nBefore we proceed to an explanation of the theory, it will be necessary to\nexamine the stock averages that it employs. Long before the time of Dow,\nthe fact was familiar to bankers and businessmen that the securities of most\nestablished companies tended to go up or down in price together.\nExceptions—stocks that moved against the general financial tide—were\nrare, nor did they as a rule persevere in that contrary course for more than a\nfew days or weeks at a time. It is true that when a boom was on, the prices\nof some issues rose faster and farther than others, and when the trend was\ntoward depression, some stocks declined rapidly whereas others would put\nup considerable resistance to the forces that were dragging down the\nmarket. The fact remained, however, that most securities tended to swing\ntogether. (They still do and always will.)\nThis fact, as we have said, has long been commonly known and accepted\n(so completely taken for granted that its importance is usually overlooked),\nfor it is important— tremendously important—from many angles in\naddition to those that come within the province of this volume. One of the\nbest reasons for a student of market technics to start with the Dow Theory is\nbecause that theory stresses the general market trend.\nCharles Dow is believed to have been the first to make a thorough effort to\nexpress the general trend (or, more correctly, level) of the securities market\nin terms of the average price of a selected few representative stocks. As\nfinally set up in January of 1897, in the form that has continued to date and\nused by Dow in his studies of market trends, there were two Dow-Jones\nAverages. One was composed solely of the stocks of 20 railroad companies,\nfor the railroads were the dominant corporate enterprises of his day. The\nother, called the Industrial Average, represented all other types of\nbusinesses and was made up, at first, of only 12 issues. This number was\nincreased to 20 in 1916 and to 30 on October 1, 1928.\nThe Dow Averages\nThe stocks included in these two Averages have been changed from time to\ntime to keep the lists up to date and as nearly representative as possible of\ntheir respective groups. Only General Electric, of the present 30 industrial\nstocks, was included in the original Industrial Average, and that was\ndropped at one time (in 1898) and subsequently reinserted. In 1929, all\nstocks of public utility companies were dropped from the Industrial Average\nand a new Utility Average of 20 issues was set up; in 1938, its number was\nreduced to 15. The 20 rail, 30 industrial, and 15 utility stocks are now\naveraged together to make what is known as the Dow-Jones Stock\nComposite. The history of these Averages, the various adjustments that have\nbeen made in them and their method of computation is an interesting story\nin itself, which the reader may want to look up elsewhere. EN: See\nAppendix B, Resources, for references. Note also there is now a\nproliferation of Dow-Jones Averages. For our present purpose, it remains\nonly to add that the Dow Theory pays no attention to the Utility or\nComposite Averages; its interpretations are based on the Rail and Industrial\nAverages only. EN: The Rails are now known as Transportations.\nIn recent years, the values of the Dow-Jones Averages have been computed\nfor the end of each hour of trading as well as the end of the day. EN: Now\ncomputed in real time and available over the internet, these hourly figures\nare published in the Wall Street Journal as well as on all market tickers. In\nfact, presently, the Averages are computed in real time, a necessity for\noptions and futures trading that takes place on them. The Wall Street\nJournal also prints in each issue a summary of the important highs and lows\nof each average by date for the preceding two or three years. Their daily\nclosing prices are reported in many other metropolitan daily newspapers.\nBasic tenets\nTo get back to the Dow Theory, here are its basic tenets:\n1. The Averages discount everything (except “acts of God”): Since\nthey reflect the combined market activities of thousands of investors,\nincluding those possessed of the greatest foresight and the best\ninformation on trends and events, the Averages in their day-to-day\nfluctuations discount everything known, everything foreseeable, and\nevery condition that can affect the supply of or the demand for\ncorporate securities. Even unpredictable natural calamities, when they\nhappen, are quickly appraised and their possible effects discounted.\n2. The Three Trends: The “market,” meaning the price of stocks in\ngeneral, swings in trends, of which the most important are its Major or\nPrimary Trends. These are the extensive up or down movements that\nusually last for a year or more and result in general appreciation or\ndepreciation in value of more than 20%. Movements in the direction of\nthe Prima", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 18}
{"text": "praised and their possible effects discounted.\n2. The Three Trends: The “market,” meaning the price of stocks in\ngeneral, swings in trends, of which the most important are its Major or\nPrimary Trends. These are the extensive up or down movements that\nusually last for a year or more and result in general appreciation or\ndepreciation in value of more than 20%. Movements in the direction of\nthe Primary Trend are interrupted at intervals by Secondary Swings in\nthe opposite direction— reactions or corrections that occur when the\nPrimary Move has temporarily “gotten ahead of itself.” (Both\nSecondary and the intervening segments of the Primary Trend are\nfrequently lumped together as Intermediate Movements—a term we\nshall find useful in subsequent discussions.) Finally, the Secondary\nTrends are composed of Minor Trends or day-to-day fluctuations that\nare unimportant to Dow Theory.\n3. The Primary Trends: These, as aforesaid, are the broad, overall, up\nand down movements that usually (but not invariably) last for more\nthan a year and may run for several years. So long as each successive\nrally (price advance) reaches a higher level than the one before it, and\neach Secondary Reaction stops (i.e., the price trend reverses from\ndown to up) at a higher level than the previous reaction, the Primary\nTrend is up. This is called a Bull Market. Conversely, when each\nIntermediate Decline carries prices to successively lower levels and\neach intervening rally fails to bring them back up to the top level of the\npreceding rally, the Primary Trend is down. This is called a Bear\nMarket. (The terms Bull and Bear are frequently used loosely with\nreference, respectively, to any sort of up or down movements, but we\nshall use them in this book only in connection with the Major or\nPrimary Movements of the market in the Dow sense.) Ordinarily—\ntheoretically, at least—the Primary Trend is the only one of the three\ntrends with which the true long-term investor is concerned. His aim is\nto buy stocks as early as possible in a Bull Market—just as soon as he\ncan be sure that one has started—and then hold them until (and only\nuntil) it becomes evident it has ended and a Bear Market has started.\nHe knows he can safely disregard all the intervening Secondary\nReactions and Minor Fluctuations. The trader, however, may well\nconcern himself also with the Secondary Swings, and it will appear\nlater on in this book that he can do so with profit.\n4. The Secondary Trends: These are the important reactions that\ninterrupt the progress of prices in the Primary Direction. They are the\nIntermediate Declines or corrections that occur during Bull Markets\nand the Intermediate Rallies or recoveries that occur in Bear Markets.\nNormally, they last for three weeks to many months, rarely longer.\nNormally, they retrace from one-third to two-thirds of the gain (or loss,\nas the case may be) in prices registered in the preceding swing in the\nPrimary Direction. Thus, in a Bull Market, prices in terms of the\nIndustrial Average might rise steadily, or with only brief and minor\ninterruptions, for a total gain of 30 points before a Secondary\nCorrection occurred. That correction might then be expected to\nproduce a decline of not less than 10 points and not more than 20\npoints before a new Intermediate Advance in the Primary Bull Trend\ndevelops.\nNote, however, the one-third/two-thirds rule is not an unbreakable law; it is\nsimply a statement of probabilities. Most Secondaries are confined within\nthese limits; many of them stop very close to the halfway mark, retracing\n50% of the preceding Primary Swing. They seldom run less than one-third,\nbut some of them cancel nearly all of it.\nThus, we have two criteria by which to recognize a Secondary Trend. Any\nprice movement contrary in direction to the Primary Trend that lasts for at\nleast three weeks and retraces at least one-third of the preceding net move\nin the Primary Direction (from the end of the preceding Secondary to the\nbeginning of this one, disregarding Minor Fluctuations) is labelled as\nIntermediate Rank, that is, a true Secondary. Despite these criteria,\nhowever, the Secondary Trend is often confusing in its recognition, and its\ncorrect appraisal at the time it develops, and while it is in process poses the\nDow theorist's most difficult problem. We shall have more to say about this\nlater.\n5. The Minor Trends: These are the brief (rarely as long as three\nweeks—usually less than six days) fluctuations that are, so far as the\nDow Theory is concerned, meaningless in themselves, but which, in\ntoto, make up the Intermediate Trends. Usually, but not always, an\nIntermediate Swing, whether a Secondary or the segment of a Primary\nbetween successive Secondaries, is made up of a series of three or\nmore distinguishable Minor Waves. Inferences drawn from these day-\nto-day fluctuations are quite apt to be misleading. The Minor Trend is\nthe only one of the three trends that can be “manipulated” (although it\nis, in fact, doubtful if under present conditions even that can be\npurposely manipulated to any important extent). Primary and\nSecondary Trends cannot be manipulated; it would strain the resources\nof the U.S. Treasury to do so.\nRight here, before we go on to state a sixth Dow tenet, we may well take\ntime out for a few minutes to clarify the concept of the three trends by\ndrawing an analogy between the movements of the stock market and the\nmovements of the sea. The Major (Primary) Trends in stock prices are like\nthe tides. We can compare a Bull Market to an incoming or flood tide that\ncarries the water farther and farther up the beach until finally it reaches\nhigh-water mark and begins to turn; it then follows the receding or ebb tide,\ncomparable to a Bear Market. But all the time, during both ebb and flow of\nthe tide, the waves are rolling in, breaking on the beach, and then receding.\nAlthough the tide is rising, each succeeding wave pushes a little farther up\nonto the shore and, as it recedes, does not carry the water", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 19}
{"text": "beach until finally it reaches\nhigh-water mark and begins to turn; it then follows the receding or ebb tide,\ncomparable to a Bear Market. But all the time, during both ebb and flow of\nthe tide, the waves are rolling in, breaking on the beach, and then receding.\nAlthough the tide is rising, each succeeding wave pushes a little farther up\nonto the shore and, as it recedes, does not carry the water quite so far back\nas did its predecessor. During the tidal ebb, each advancing wave falls a\nlittle short of the mark set by the one before it, and each receding wave\nuncovers a little more of the beach. These waves are the Intermediate\nTrends, Primary or Secondary, depending on whether their movement is\nwith or against the direction of the tide. Meanwhile, the surface of the water\nis constantly agitated by wavelets, ripples, and “cat's-paws” moving with or\nagainst or across the trend of the waves—these are analogous to the\nmarket's Minor Trends, its unimportant day-to-day fluctuations. The tide,\nthe wave, and the ripple represent, respectively, the Primary or Major, the\nSecondary or Intermediate, and the Minor Trends of the market.\nTide, wave, and ripple\nA shore dweller who had no tide table might set about determining the\ndirection of the tide by driving a stake in the beach at the highest point\nreached by an incoming wave. Then, if the next wave pushed the water up\nbeyond his stake, he would know the tide was rising. If he shifted his stake\nwith the peak mark of each wave, a time would come when one wave\nwould stop and start to recede short of his previous mark; then he would\nknow that the tide had turned and had started to ebb. That, in effect (and\nmuch simplified), is what the Dow theorist does in defining the trend of the\nstock market.\nThe comparison with tide, wave, and ripple has been used since the earliest\ndays of the Dow Theory. It is even possible that the movements of the sea\nmay have suggested the elements of the theory to Dow. But the analogy\ncannot be pushed too far. The tides and waves of the stock market are not as\nregular as those of the ocean. Tables can be prepared years in advance to\npredict accurately the time of every ebb and flow of the waters, but no\ntimetables are provided by the Dow Theory for the stock market. We may\nreturn to some points of this comparison later, but we must proceed now to\ntake up the remaining tenets and rules of the Theory.\nMajor trend phases\n1. The Bull Market: Primary Uptrends are usually (but not invariably)\ndivisible into three phases. The first is the phase of accumulation during\nwhich farsighted investors, sensing that business, although now depressed,\nis due to turn up, are willing to pick up all the shares offered by discouraged\nand distressed sellers and to raise their bids gradually as such selling\ndiminishes in volume. Financial reports are still bad— in fact, often at their\nworst—during this phase. The public is completely disgusted with the stock\nmarket—out of it entirely. Activity is only moderate but beginning to\nincrease on the rallies (Minor Advances).\nThe second phase is one of fairly steady advance and increasing activity as\nthe improved tone of business and a rising trend in corporate earnings begin\nto attract attention. It is during this phase that the technical trader normally\nis able to reap his best harvest of profits.\nFinally comes the third phase when the market boils with activity as the\npublic flocks to the boardrooms. All the financial news is good, price\nadvances are spectacular and frequently make the front page of the daily\npapers, and new issues are brought out in increasing numbers. It is during\nthis phase that one of your friends will call up and blithely remark, “Say, I\nsee the market is going up. What's a good buy?”—oblivious to the fact it\nhas been going up for perhaps two years, has already gone up a long way,\nand is now reaching the stage at which it might be more appropriate to ask,\n“What's a good thing to sell?” In the last stage of this phase, with\nspeculation rampant, volume continues to rise, but “air pockets” appear\nwith increasing frequency; the “cats and dogs” (low-priced stocks of no\ninvestment value) are whirled up, but more and more of the top-grade issues\nrefuse to follow.\n2. The Bear Market: Primary Downtrends are also usually (but again, not\ninvariably) characterized by three phases. The first is the distribution period\n(which really starts in the later stages of the preceding Bull Market). During\nthis phase, farsighted investors sense the fact that business earnings have\nreached an abnormal height and unload their holdings at an increasing pace.\nTrading volume is still high, although tending to diminish on rallies, and the\npublic is still active but beginning to show signs of frustration, as hoped-for\nprofits fade away.\nThe second phase is the panic phase. Buyers begin to thin out and sellers\nbecome more urgent; the downward trend of prices suddenly accelerates\ninto an almost vertical drop, whereas volume mounts to climactic\nproportions. After the Panic Phase (which usually runs too far relative to\nthen-existing business conditions), there may be a fairly long Secondary\nRecovery or a sideways movement, and then the third phase begins.\nThis is characterized by discouraged selling on the part of those investors\nwho held on through the Panic or, perhaps, bought during it because stocks\nlooked cheap in comparison with prices that had ruled a few months earlier.\nThe business news now begins to deteriorate. As the third phase proceeds,\nthe downward movement is less rapid, but it is maintained by more and\nmore distress selling from those who have to raise cash for other needs. The\n“cats and dogs” may lose practically all their previous Bull Advance in the\nfirst two phases. Better-grade stocks decline more gradually, as their owners\ncling to them to the last. In consequence, the final stage of a Bear Market is\nfrequently concentrated in such issues. The Bear Market ends when\neverything in the way of po", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 20}
{"text": "e distress selling from those who have to raise cash for other needs. The\n“cats and dogs” may lose practically all their previous Bull Advance in the\nfirst two phases. Better-grade stocks decline more gradually, as their owners\ncling to them to the last. In consequence, the final stage of a Bear Market is\nfrequently concentrated in such issues. The Bear Market ends when\neverything in the way of possible bad news, the worst to be expected, has\nbeen discounted, and it is usually over before all the bad news is “out.”\nThe three Bear Market phases described in the preceding paragraph are not\nthe same as those named by others who have discussed this subject, but the\nwriters of this study feel they represent a more accurate and realistic\ndivision of the Primary down moves of the past 30 years. The reader should\nbe warned, however, that no two Bear Markets are exactly alike, and neither\nare any two Bull Markets. Some may lack one or another of the three\ntypical phases. A few Major Advances have passed from the first to the\nthird stage with only a brief and rapid intervening mark-up. A few short\nBear Markets have developed no marked Panic Phase and others have\nended with it, as in April 1939. No time limits can be set for any phase; the\nthird stage of a Bull Market, for example, the phase of excited speculation\nand great public activity, may last for more than a year or run out in a\nmonth or two. The Panic Phase of a Bear Market is usually exhausted in a\nvery few weeks if not in days, but the 1929 through\n1932 decline was interspersed with at least five Panic Waves of major\nproportions. Nevertheless, the typical characteristics of Primary Trends are\nwell worth keeping in mind. If you know the symptoms that normally\naccompany the last stage of a Bull Market, for example, you are less likely\nto be deluded by its exciting atmosphere.\nPrinciple of confirmation\n1. The two Averages must confirm: This is the most-often questioned and\nthe most difficult to rationalize of all the Dow principles. Yet it has stood\nthe test of time; the fact it has worked is not disputed by any who have\ncarefully examined the records. Those who have disregarded it in practice\nhave, more often than not, had occasion to regret their apostasy. What it\nmeans is that no valid signal of a change in trend can be produced by the\naction of one Average alone. Take, for example, the hypothetical case\nshown in Diagram 3.1. In this, we assume that a Bear Market has been in\neffect for several months and then, starting at a, the Industrial Average rises\n(along with the Rails) in a Secondary Recovery to b. On their next decline,\nhowever, the Industrials\nDiagram 3.1 A hypothetical daily market chart to show how one average\nmay fail to confirm the other's Dow signal. Closing prices, indicated by\nshort horizontal dashes, are connected with vertical lines to make the day-\nto-day trend easier to follow.\nAt this point, the Industrials have “signaled” a change in trend from down\nto up. But note the Rails during this period: their decline from b to c carried\nthem lower than a, and their subsequent advance from c to d has not taken\nthem above b. They have (so far) refused to confirm the Industrials and,\nhence, the Major Trend of the market must be regarded as still down.\nShould the Rails go on to rise eventually above their b, then, and then only,\nwould we have a definite signal of a turn in the tide. Until such a\ndevelopment, however, the chances remain that the Industrials will not be\nable to continue their upward course alone, that they ultimately will be\ndragged down again by the Rails. At best, the direction of the Primary\nTrend is still in doubt.\nThis example illustrates only one of the many ways in which the principle\nof confirmation applies. Note also that at c, it might have been said that the\nIndustrials had thus far not confirmed the Rails in continuing the\nDowntrend, but this had to do only with the continuation or reaffirmation of\nan existing trend. It is not necessary that the two Averages confirm on the\nsame day. Frequently, both will move into new high (or low) ground\ntogether, but there are plenty of cases in which one or the other lags behind\nfor days, weeks, or even a month or two. One must be patient in these\ndoubtful cases and wait until the market declares itself in definite fashion.\n2. “Volume goes with the trend”: Those words, which you may often hear\nspoken with ritual solemnity but little understanding, are the colloquial\nexpression for the general truth that trading activity tends to expand as\nprices move in the direction of the prevailing Primary Trend. Thus, in a Bull\nMarket, volume increases when prices rise and dwindles as prices decline;\nin Bear Markets, turnover increases when prices drop and dries up as they\nrecover. To a lesser degree, this holds for Secondary Trends also, especially\nin the early stages of an extended Secondary Recovery within a Bear\nMarket, when activity may show a tendency to pick up on the Minor Rallies\nand diminish on the Minor Setbacks. But to this rule, again, there are\nexceptions, and useful conclusions can seldom be drawn from the volume\nmanifestations of a few days, much less from a single trading session; it is\nonly the overall and relative volume trend over a period of time that may\nproduce helpful indications. Moreover, in Dow Theory, conclusive signals\nas to the market's trend are produced in the final analysis only by price\nmovement. Volume simply affords collateral evidence that may aid\ninterpretation of otherwise doubtful situations. (We shall have much more\nto say in later chapters about volume in specific relation to other technical\nphenomena.)\n3. “Lines” may substitute for Secondaries: A line in Dow Theory\nparlance is a sideways movement (as it appears on the charts) in one or both\nof the Averages, which lasts for two or three weeks or, sometimes, for as\nmany months, in the course of which prices fluctuate within a range of\napproximately 5% or less (of their mean figure). The fo", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 21}
{"text": "volume in specific relation to other technical\nphenomena.)\n3. “Lines” may substitute for Secondaries: A line in Dow Theory\nparlance is a sideways movement (as it appears on the charts) in one or both\nof the Averages, which lasts for two or three weeks or, sometimes, for as\nmany months, in the course of which prices fluctuate within a range of\napproximately 5% or less (of their mean figure). The formation of a Line\nsignifies that pressure of buying and selling is more or less in balance.\nEventually, of course, either the offerings within that price range are\nexhausted and those who want to buy stocks have to raise their bids to\ninduce owners to sell, or else those who are eager to sell at the Line price\nrange find that buyers have vanished and that, in consequence, they must\ncut their prices to dispose of their shares. Hence, an advance in prices\nthrough the upper limits of an established Line is a Bullish Signal and,\nconversely, a breakdown through its lower limits is a Bearish Signal.\nGenerally speaking, the longer the Line (in duration) and the narrower or\nmore compact its price range, the greater the significance of its ultimate\nbreakout.\nLines occur often enough to make their recognition essential to followers of\nDow's principles. They may develop at important Tops or Bottoms,\nsignaling periods of distribution or of accumulation, respectively, but they\ncome more frequently as interludes of rest or Consolidation in the progress\nof established Major Trends. Under those circumstances, they take the place\nof normal Secondary Waves. A Line may develop in one Average while the\nother is going through a typical Secondary Reaction. A price movement out\nof a Line, either up or down, is usually followed by a more extensive\nadditional move in the same direction than can be counted on to follow the\n“signal” produced when a new wave pushes beyond the limits set by a\npreceding Primary Wave. The direction in which prices will break out of a\nLine cannot be determined in advance of the actual movement. The 5%\nlimit ordinarily assigned to a Line is arbitrarily based on experience; there\nhave been a few slightly wider sideways movements that, by virtue of their\ncompactness and well-defined boundaries, could be construed as true Lines.\n(Later in this book, we shall see that the Dow Line is, in many respects,\nsimilar to the more strictly defined patterns known as rectangles that appear\non the charts of individual stocks.)\n4. Only closing prices used: Dow Theory pays no attention to any extreme\nhighs or lows that may be registered during a day and before the market\ncloses, but takes into account only the closing figures, that is, the average of\nthe day's final sale prices for the component issues. We have discussed the\npsychological importance of the end-of-day prices under the subject of\nchart construction and need not deal with it further here, except to say that\nthis is another Dow rule that has stood the test of time. It works thus:\nsuppose an Intermediate Advance in a Primary Uptrend reaches its peak on\na certain day at 11:00 a.m., at which hour the Industrial Average figures at,\nsay, 152.45, and then falls back to close at 150.70. All that the next advance\nwill have to do to indicate the Primary Trend is still up is register a daily\nclose above 150.70. The previous intraday high of 152.45 does not count.\nConversely, using the same figures for our first advance, if the next\nupswing carries prices to an intraday high at, say, 152.60, but fails to\nregister a closing price above 150.70, the continuation of the Primary Bull\nTrend is still in doubt.\nIn recent years, differences of opinion have arisen among market students\nas to the extent to which an Average should push beyond a previous limit\n(Top or Bottom figure) to signal (or confirm or reaffirm, as the case may\nbe) a market trend. Dow and Hamilton evidently regarded any penetration,\neven as little as 0.01, in closing price as a valid signal, but some modern\ncommentators have required penetration by a full point (1.00). We think the\noriginal view has the best of the argument—that is, that the record shows\nlittle or nothing in practical results to favor any of the proposed\nmodifications. One incident in June 1946, to which we shall refer in the\nfollowing chapter (EN10: Now in Appendix A), shows a decided advantage\nfor the orthodox “any-penetration-whatever” rule.\n5. A trend should be assumed to continue in effect until such time as its\nreversal has been definitely signaled: This Dow Theory tenet is one that,\nperhaps more than any other, has evoked criticism. Yet, when correctly\nunderstood, it, like all the others we have enumerated, stands up under\npractical test. What it states is really a probability. It is a warning against\nchanging one's market position too soon, against “jumping the gun.” It does\nnot imply that one should delay action by one unnecessary minute once a\nsignal of change in trend has appeared. But it expresses the experience that\nthe odds are in favor of the man who waits until he is sure, and against the\nother fellow who buys (or sells) prematurely. These odds cannot be stated in\nmathematical language such as 2-1 or 3-1; as a matter of fact, they are\nconstantly changing. Bull Markets do not climb forever and Bear Markets\nalways reach a Bottom sooner or later. When a new Primary Trend is first\ndefinitely signaled by the action of the two Averages, the odds that it will be\ncontinued, despite any near-term reactions or interruptions, are at their\ngreatest. But as this Primary Trend carries on, the odds in favor of its\nfurther extension grow smaller. Thus, each successive reaffirmation of a\nBull Market (new Intermediate high in one average confirmed by a new\nIntermediate high in the other) carries relatively less weight. The incentive\nto buy, the prospect of selling new purchases at a profit, is smaller after a\nBull Market has been in existence for several months than it was when the\nPrimary Uptrend was first recognized; this 12th Dow ten", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 22}
{"text": "ler. Thus, each successive reaffirmation of a\nBull Market (new Intermediate high in one average confirmed by a new\nIntermediate high in the other) carries relatively less weight. The incentive\nto buy, the prospect of selling new purchases at a profit, is smaller after a\nBull Market has been in existence for several months than it was when the\nPrimary Uptrend was first recognized; this 12th Dow tenet says, “Hold your\nposition pending contrary orders.”\nA corollary to this tenet, which is not so contradictory as it may at first\nseem, is this: a reversal in trend can occur any time after that trend has been\nconfirmed. This can be taken simply as a warning that the Dow Theory\ninvestor must watch the market constantly if he has any commitment in it.\nEN: Modern market importance of Dow Theory and necessity for moving to\na new composite market theory\nDow Theory has much to recommend it. Concepts embodied within Dow\nTheory retain their validity to the present day and retain their importance\nas the foundation thinking for technical analysis. Concepts of waves, major,\nsecondary, and minor movements are absolutely descriptive of the reality of\nthe market. Other constructs within Dow Theory are similarly important—\nthat all information is discounted; that major market movements are like\nthe tide and, as it were, raise all boats; that trends tend to continue. These\nare not just theoretical musings, but observations of reality.\nIn addition to its technical validity, the Dow has now taken on a mythic\ndimension. It has a symbolic function that interacts with its originally\nintended purpose. Dow and Hamilton saw their measurement of the market\nas an economic barometer for the entire economy; its use as a tool for\ninvesting in the market came later.\nIn the opinion of this editor, the Dow Theory is no longer adequate to its\noriginal purpose—or even to its secondary purpose. It is a simple theory\npropounded in a simple time. Expounders of Dow Theory have implicitly\nrecognized the necessity for evolutionary changes to the doctrine with the\naddition of the Rails (now Transportations) and the Utilities ad infinitum.\nThirty stocks may have been sufficient originally to reflect the U.S.\neconomy. No one would deny that simple paradigm must be changed to\nreflect an economic structure geometrically more diverse than that of Dow\nand Hamilton. Entering the twenty-first century, the U.S. and global\neconomy require more sophisticated econometrics than the Dow alone.\nFor that reason, I consider that to fulfill the functions of the old Dow, we\nnow must consider a variety of averages and indexes to measure the state of\nthe market—not to mention the economy, which is another question,\nalthough not altogether another question, but at least another question.\nMagee foreshadowed some instruments of great value to this end in his\nwritings, specifically on the Magee Evaluative Index (Chapter 38), which\nmay be used for the entire market, and not just for one summary index or\naverage. The value and power of this tool are still little used and\nunderstood.\nIn twenty-first-century markets, there are not just broad tides and markets\nflowing in one direction as they might on Magee's Cape Cod. Instead, the\ncurrents, riptide, and crosscurrents are like the economy of the country,\nmoved West. They are now symbolized by the Pacific Ocean roaring in and\nout of San Francisco Bay. Although the Dow is in a secondary Downtrend,\nthe broader Standard & Poor's 500 is going to new highs, and although\nthey are both whipping sideways, the National Association of Securities\nDealers Automated Quotations (NASDAQ) is rocketing into space. For this\nreason, I now believe that only a composite of the three indexes can express\nthe true state of the markets as a whole. And, in addition, to dissect the\nentrails of the market, the Magee Evaluative Index should be run across the\nthree indexes.\nThe Dow Theory required the Rails and Industrial Averages move in\nharmony to signal Bull or Bear Markets. In this century, there is a similar\nneed for harmonic convergence among the averages to indicate to us the\nstate of the markets as a whole.\nWhen all three indexes agree in the direction of their trends, up or down or\nsideways, Bulls may be assumed to be safe in general, and vice versa for\nBears. Failure of the three to be in harmony is a clear sign of mixed\nmarkets and advises one to arrange his bets and portfolio to correspond\nwith economic uncertainty. Capital should flow naturally to the most\nproductive area. What reason is there to ride the Dow down when the\nNASDAQ is raging up? If the investor follows the philosophy of this book,\nhe will never sit passively through an extended Downtrend. At the very\nleast, he will be hedged, if not outright short. (As Edwards and Magee\npreferred and as this editor prefers.)\nEN10: Notes on Edwards' description of Dow Theory\nWe must keep in perspective Edwards' description of Dow Theory. When he\nspeaks of Secondaries of 10 and 20 points, or a Primary of 30 points, we\nshould be reminded that the entire market could be accommodated in the\nbackseat of a Packard. The top in 1929 was approximately 386 and the\nbottom approximately 64; hence, 10, 20, or 30 points constituted important\npercentage moves.\nSimilarly, a primary market move of 20%, although still of importance,\nhardly describes the violence and range of modern markets. From March\n2009 to November 2017, the Dow moved from 6469.95 to 23,602.12—a\nmove of 17,132.17 or 264%.\nchapter four\nThe Dow Theory's defects\nEN10: Figures 2-9 from the ninth edition now appear in Appendix A along\nwith Edwards' detailed account of Dow Theory operations.\nOur readers, we suspect, heaved a deep sigh of relief when they closed the\npreceding chapter (EN10: Chapter 4 in the ninth edition, now Appendix A),\nwhich covered a difficult, tedious, and, at times, confusing subject. Some\nmay even wish at this point that the Dow Theory had never been conceived.\nOthers doubtless spotted one or more of its real or su", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 23}
{"text": "rds' detailed account of Dow Theory operations.\nOur readers, we suspect, heaved a deep sigh of relief when they closed the\npreceding chapter (EN10: Chapter 4 in the ninth edition, now Appendix A),\nwhich covered a difficult, tedious, and, at times, confusing subject. Some\nmay even wish at this point that the Dow Theory had never been conceived.\nOthers doubtless spotted one or more of its real or supposed defects and\nhave questions to ask. Before we proceed to more interesting chart matters,\nwe had better devote a few pages to clearing up these questions.\nFirst, let's take up the charge of “second-guessing,” which is so often flung\nat writers on Dow Theory. It is a charge that will continue to crop up so\nlong as opinions differ among Dow theorists at critical periods (which,\nunfortunately, is often the case). Even the most experienced and careful\nDow analysts find it necessary occasionally to change their interpretations\nwhen a stand first ventured is rendered untenable by some subsequent\naction of the market. They would not attempt to deny it, but, they say, in the\nlong run, surprisingly little is lost by such temporary misinterpretations.\nMany of them publish their comments regularly and can refer you to the\nprinted files of opinions and advice expressed before and during the event,\nas well as after it. Regarding Chapter 4 in the ninth edition (now Appendix\nA), the reader, if he cares to check such records, will find that the\ninterpretations given therein (aside from the remarks made “in retrospect”\nand so labeled) were precisely the interpretations published at the time by\nthe best-established Dow analysts. EN9: Although, in the modern age\nRichard Russell (now deceased) (dowtheoryletters. com) was senior in\nterms of reputation, a host of other Dow theorists (actually trying to round\nthem up is like herding cats) inhabit the scene, among them Jack Schannep\n(thedowtheory.com) and Richard Moroney (dowtheory.com) who must be\ntaken into account when consulting the sacred-chicken bones. Robert W.\nColby (robertwcolby.com) is also currently doing authoritative work in Dow\nTheory. Note that it is the chicken that is sacred, and the bones only\nsecondarily.\nThe Dow Theory is too late\nThe objection that the Dow Theory is too late is more valid. It is sometimes\nexpressed in the rather intemperate statement that “the Dow Theory is a\nsurefire system for depriving the investor of the first third and the last third\nof every Major Move, and sometimes there isn't any middle third!” Or, to\ngive a specific example: A Primary Bull Market started in 1942 with the\nIndustrial Average at 92.92 and ended in 1946 at 212.50, for a total gain of\n119.58 Average points, but the strict Dow theorists could not buy until the\nIndustrials were up to 125.88 and could not sell until prices had already\ndeclined to 191.04; thus, capturing, at best, only about 65 points, or not\nmuch more than half of the total move. This specific statement cannot be\ndisputed, yet the answer to the general objection is to “try to find a man\nwho first bought his stocks at 92.92 (or even within 5 points of that level)\nand stayed 100% long throughout the intervening years, and finally sold out\nat 212.50, or within 5 points thereof.” The reader is welcome to try; he will,\nin fact, find it very difficult to locate even a dozen who did as well as the\nDow Theory.\nA still better answer, because it comprehends all of the hazards of every\nknown kind of Bull and Bear Market to date, is the overall dollars and cents\nrecord of the past 60 years. We are indebted to Richard Durant for\npermission to reprint the following computation of what would, in theory,\nhave resulted if a fund of only $100 could have been invested in the stocks\nof the Dow-Jones Industrial Average on July 12, 1897, when a Primary Bull\nMarket was signaled by the Dow Theory, and those stocks were thereafter\nsold and repurchased when, and only when, the Dow Theory had definitely\nconfirmed a change in the Major Trend (see Table 4.1).\nTable 4.1 The Dow Theory's 60-Year Record\nSignalDate\nDow Jones\nAverage Price\nLoss\n(V)\nChange\n(%)\nCapital\nGain\nAccumulated\nProfit\nBought7/12/189744.61 100\nSold 12/16/189963.84 43.11 143.11\nBought10/20/190059.44\nSold 6/1/190359.59 0.25 0.36 143.47\nBought7/12/190451.37\nSold 4/26/190692.44 79.95 114.7 258.18\nBought4/24/190870.01\nSold 5/3/191084.72 21.01 54.25 312.42\nBought10/10/191081.91\nSold 1/14/191384.96 3.72 11.63 324.05\nBought4/9/191565.02\nSold 8/28/191786.12 32.45 105.16429.22\nBought5/13/191882.16\nSold 2/3/192099.96 21.67 92.99 522.21\nBought2/6/192283.7\nSold 6/20/192390.81 8.49 44.36 566.56\nBought12/7/192393.8\nSold 10/23/1929305.85 226.071,280.811,847.38\nBought5/24/193384.29\nSold 9/7/1937164.39 95.03 1,755.543,602.92\nBought6/23/1938127.41\nSold 3/31/1939136.42 7.07 254.793,857.7\nBought7/17/1939142.58\nSold 5/13/1940137.5 V -3.56 -137.453,720.26\nBought2/1/1943125.88\nSold 8/27/1946191.04 51.76 1,925.745,646\nBought10/2/1950228.94\nSold 4/2/1953280.03 22.32 1,259.956,905.95\nBought1/19/1954288.27\nSold 10/1/1956468.7 62.59 4,322.4811,228.43\nIn brief, an investment of $100 in 1897 would have become $11,228.43 in\n1956 simply by buying the Industrial Average stocks each time the Dow\nTheory announced a Bull Market and holding them until the Dow Theory\nannounced a Bear Market. During this period, the investor would have\nmade 15 purchases and 15 sales, or about one transaction every two years\non average.\nThe record is not perfect. It shows one losing transaction and three\ninstances in which reinvestment would have been made at a higher level\nthan the preceding liquidation. But, at that, it hardly needs defending. Also,\nit takes no account of commissions and transfer taxes, but neither does it\ninclude the dividends the investor would have received during the time he\nheld his stocks; the latter would have added many more dollars to the fund.\nFor the enlightenment of the man who believes in “just buying good stocks\nand putting them away,” compare these results with the best that c", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 24}
{"text": ", it hardly needs defending. Also,\nit takes no account of commissions and transfer taxes, but neither does it\ninclude the dividends the investor would have received during the time he\nheld his stocks; the latter would have added many more dollars to the fund.\nFor the enlightenment of the man who believes in “just buying good stocks\nand putting them away,” compare these results with the best that could have\nbeen done by buying shares only once at the lowest price recorded by the\nIndustrial Average during these entire 60 years and selling them only once\nat the highest: $100 invested at the all-time low, 29.64, on August 10, 1896,\nwould have become only $1,757.93 at the then all-time high, 521.05, 60\nyears later on April 6, 1956. Compare this to the $11,228.43 gained from\nthe Dow Theory program.\nEN: This record of the Dow Theory is updated to end of year 2017 in Table\n4.2. I have left this record as is so that the reader may clearly distinguish\nmy work from that of Edwards.\nThe Dow Theory is not infallible\nThe Dow Theory is not infallible. It depends on interpretation and is subject\nto all the hazards of human interpretive ability. But, again, the record speaks\nfor itself.\nThe Dow Theory frequently leaves the investor in doubt\nThe fact that the Dow Theory frequently leaves the investor in doubt is true\nin one sense, yet not in another. There is never a time when the Dow Theory\ndoes not afford a presumptive answer to the question of the direction of the\nPrimary Trend. That answer will be wrong for a relatively short time at the\nbeginning of each new Major Swing. There will also be times when a good\nDow analyst should say, “The Primary Trend is still presumably up, but it\nhas reached a dangerous stage, and I cannot conscientiously advise you to\nbuy now. It may be too late.”\nFrequently, however, the above objection simply reflects the inability of the\ncritic mentally to accept the fundamental concept that the Averages discount\nall the news and statistics. He doubts the Dow Theory because he cannot\nreconcile its message with his own ideas, derived from other sources, of\nwhat stocks should do. The theory is usually more nearly right.\nThis criticism in other cases reflects nothing but impatience. There may be\nweeks or months (as, e.g., during the formation of a Line) when the Dow\nTheory cannot “talk.” The active trader quite naturally rebels, but patience is\na virtue in the stock market as elsewhere—in fact, essential if serious\nmistakes are to be avoided.\nThe Dow Theory does not help the Intermediate Trend investor\nIt is perfectly true that the Dow Theory does not help the Intermediate Trend\ninvestor, as it gives little or no warning of changes in Intermediate Trend.\nYet, if a fair share of these can be captured, the profit amounts to more than\ncan be derived from the Primary Trend alone. Some traders have worked out\nsupplementary rules on the basis of Dow principles\nSignalDate\nAverage\nPrice\nLoss\n(V)\nPercentage\nChange (%)\nCapital\nGain\nAccumulated\nWealth\n1 Buy 7/12/189744.61 100.00\n2 Sell 12/16/189963.84 43.11 143.11\n3 Buy 10/20/190059.44\n4 Sell 6/1/190359.59 0.25 0.36 143.47\n5 Buy 7/12/190451.37\n6 Sell 4/26/190692.44 79.950 114.70 258.18\n7 Buy 4/24/190870.01\n8 Sell 5/3/191084.72 21.01 54.25 312.42\n9 Buy 10/10/191081.91\n10Sell 1/14/191384.96 3.72 11.63 324.05\n11Buy 4/9/191565.02\n12Sell 8/28/191786.12 32.45 105.16 429.22\n13Buy 5/13/191882.16\n14Sell 2/3/192099.96 21.67 92.99 522.21\n15Buy 2/6/192283.7\n16Sell 6/20/192390.81 8.49 44.36 566.56\n17Buy 12/7/192393.8\n18Sell 10/23/1929305.85 226.07 1280.811,847.38\n19Buy 5/24/193384.29\n20Sell 9/7/1937164.39 95.03 1755.543,602.92\n21Buy 6/23/1938127.41\n22Sell 3/31/1939136.42 7.07 254.79 3,857.70\n23Buy 7/17/1939142.58\n24Sell 5/13/1940137.5 X -3.56 -137.453,720.26\n25Buy 2/1/1943125.88\n26Sell 8/27/1946191.04 51.76 1925.745,646.00\n27Buy 10/2/1950228.94\n28Sell 4/2/1953280.03 22.32 1259.956,905.95\n29Buy 1/19/1954288.27\n30Sell 10/1/1956468.7 62.59 4322.4811,228.43\n31Buy 5/2/1958459.56\n32Sell 3/3/1960612.05 33.18 3725.7914,954.22\n33Buy 2/23/1961654.42\n34Sell 4/26/1962678.68 3.71 554.37 15,508.59\n35Buy 11/9/1962616.13\n36Sell 5/5/1966899.77 46.04 7139.4922,648.08\n37Buy 1/11/1967822.49\n38Sell 10/24/1967888.18 7.99 1808.8424,456.92\n39Buy 10/1/1968942.32\n40Sell 2/25/1969899.8 X -4.51 -1103.5623,353.36\n41Buy 10/27/1969860.28\n42Sell 1/26/1970768.88X -10.62 -2481.1720,872.19\n(Continued)\nTable 4.2 (Continued) The Dow Theory's 121-Year Record\nSignalDate\nAverage\nPrice\nLoss\n(X)\nPercentage\nChange\n(%)\nCapital\nGain\nAccumulated\nWealth\n43Buy 9/28/1970758.97\n44Sell 7/28/1971872.01 14.89 3108.68 23,980.87\n45Buy 2/10/1972921.28\n46Sell 2/23/1973959.89 4.19 1005.02 24,985.88\n47Buy 1/27/1975692.66\n48Sell 10/24/1977802.32 15.83 3955.70 28,941.58\n49Buy 6/6/1978866.51\n50Sell 7/2/1981959.19 10.70 3095.53 32,037.11\n51Buy 10/7/1982965.97\n52Sell 1/25/19841231.89 27.53 8819.43 40,856.54\n53Buy 11/6/19841244.15\n54Sell 10/15/19872355.09 89.29 36482.0777,338.61\n55Buy 2/29/19882071.62\n56Sell 10/13/19892569.26 24.02 18578.11 95,916.72\n57Buy 6/4/19902935.19\n58Sell 8/3/19902809.65X -4.28 -4102.4291,814.30\n59Buy 1/18/19912646.78\n60Sell 10/5/19923179 20.11 18462.21110,276.51\n61Buy 11/25/19923266.22\n62Sell 8/4/19988487.31 159.85 176278.26286,554.76\n63Buy 11/2/19988706.5\n64Sell 9/23/199910318.59 18.52 53058.30339,613.06\n65Buy 11/8/20019587.52\n66Sell 6/25/20029126.8 X -4.81 -16319.81323,293.25\n67Buy 1/6/20038773.57\n68Sell 11/21/200712799.04 45.88 148332.69471,625.94\n69Buy 4/18/200812849.36\n70Sell 9/29/200810365.45X -19.33 -91170.02380,455.93\n71Buy 4/9/20098083.38\n72Sell 6/30/20109774.02 20.92 79572.41460,028.33\n73Buy 9/27/201010812.04\n74Sell 8/2/2011 11866.62 9.75 44870.04504,898.37\n75Buy 12/23/201112294\n76Sell 6/4/201212101.46 -1.57 -7907.36496,991.01\n77Buy 1/18/201313649.7\n78Sell 8/20/201516990.69 24.48 121646.78618,637.78\n79Buy 10/19/201517084.49\n80Sell 1/6/201616906.51 -1.04 -6444.74612,193.04\n81Buy 4/20/201618053.6X\n82Sell 6/24/201617400.75 -3.62 -15926.29596,266.75\n83Buy 9/7/201618526.14\n84Sell 12/29/2017", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 25}
{"text": "/27/201010812.04\n74Sell 8/2/2011 11866.62 9.75 44870.04504,898.37\n75Buy 12/23/201112294\n76Sell 6/4/201212101.46 -1.57 -7907.36496,991.01\n77Buy 1/18/201313649.7\n78Sell 8/20/201516990.69 24.48 121646.78618,637.78\n79Buy 10/19/201517084.49\n80Sell 1/6/201616906.51 -1.04 -6444.74612,193.04\n81Buy 4/20/201618053.6X\n82Sell 6/24/201617400.75 -3.62 -15926.29596,266.75\n83Buy 9/7/201618526.14\n84Sell 12/29/201724719.22 33.43 199325.26795,592.01\nthat they apply to Intermediate Movements, but these have not proved to be\nsatisfactory. The remainder of our book is devoted to a better approach to\nthis problem.\nThe Dow Theory is a mechanical device designed to tell the direction of the\nPrimary Market Trend, which is important because, as said at the beginning\nof this book, most stocks tend to go with the trend. The Dow Theory does\nnot and cannot tell you which individual stocks to buy, aside from those\nstocks that make up the Averages. That, again, is a problem for the\nremainder of this book.\nEN: An old criticism, irrelevant in modern markets.\n“The Dow Theory does not tell you which stocks to buy.” This was true at\nthe time Edwards wrote this, but in modern markets, the investor can buy\nsubstitute instruments that almost perfectly mimic its behavior (DIA). This is\npossible because the investor can trade in surrogates for the Dow Averages\nin present markets (see Chapter 15).\nThe Dow Theory in the 20th and 21st centuries\nAs may be seen in Table 4.2, augmenting Table 4.1, the Dow Theory\ncontinued to provide its user an advantage over the unaware Buy-and-Hold\nInvestor. From its original investment of $100 in 1897, the Dow Theory\ninvestment would have grown to $795,592.01 by December 29, 2017, with\nthe long trade still open. Table 4.2 shows the details, including the post-2000\nbust drawdown. To my mind, this table is a powerful demonstration of the\neffectiveness of methodical technical investing, be it Dow Theory or some\nother robust method—which I will discuss in Chapter 5.\nBy contrast, the buy-and-hold investment of $100, if bought at the low,\n29.64, and sold at the close, December 29, 2017, would have grown to\n$55,411.83.\nI am indebted to Jack Schannep of TheDowTheory.Com\n(http://www.thedowtheory. com) for the data recapitulated here. On\nSchannep's website, a clear exposition of the Dow Theory and its record\nmay be found—much more complete than that which is found here, outside\nof Edwards' magisterial presentation.\nMinor discrepancies are acknowledged within these and others' data, a point\nthat will be raised by purists. This is occasioned by disagreements within the\npriestly circles of those who keep the sacred records. That is, not all theorists\nare in 100% agreement as to the exact date or nature of the signals. (Some\nwill say the reentry date of October 1, 1956 should have been October 7,\n1957, for example.) Meaning some judgment is involved in interpretation of\nthe entrails. The Dow Theory is not a 100% objective algorithm, just as chart\nanalysis is not reducible to an objective algorithm. (I am allowed to jest at\nthe priesthood as I am a minor acolyte in these matters. It would not be\nseemly for the uninitiated to burlesque.)\nIn brief, an investment of $100 in 1897 would have become $795,592.01\nsimply by buying the Industrial Average stocks each time the Dow Theory\nannounced a Bull Market and holding them until the Dow Theory\nannounced a Bear Market, and then selling, with the entire equity reinvested\non each trade.\nThe Technical Investor would have had this amount in pocket marked to\nmarket at the end of 2017, as opposed to the $55,411.83 of his dozing\ncounterpart, or the Trust Department of the Rip Van Winkle Bank of Sleepy\nHollow. And, in addition, he would not have been illiquidified during Bear\nMarkets.\nWhether the Dow Theory retains its validity over the market as a whole,\nthere can be no question that it still calls the turn for its sector of the market,\nwhich as Jack Schannep correctly notes, has five times the capitalization of\nthe NASDAQ (see Table 4.2).\nAs Mark Twain observed, everybody talks about the Dow Theory, but\nnobody does anything about it. Perhaps that is not precisely what Twain\nsaid, but close enough for government work. As further inquiry into the\ninner workings of the Dow Theory, I initiated a series of studies of the\nrecord with Brian Brooker, who holds a master's of science in finance from\nGolden Gate University, and Matt Mullens, and Nehemiah Brown III my\ngraduate students at Golden Gate University. Included here are some of the\nresults of our study, from the book, Sacred Chickens, the Holy Grail and\nDow Theory (Amazon).\nIt seems obvious that the risk characteristics of Dow Theory investing are\nunique, and I will belabor the obvious. The Buy-and-Hold Investor\nmentioned above for comparison with the Dow Theory Investor not only\nrealized less profit over the period of his investment but also experienced\ngreatly expanded risk over the life of the investment. At first blush, all the\nprofits garnered by the reversing investor in Table 4.3 represent risk actually\nexperienced by the Buy-and-Hold Investor—but that is only first blush. A\nlittle deeper thought reveals the true extent of the Buy-and-Hold Investor's\nrisk is measured by maximum drawdowns over any given period of time. It\nis not necessary to theorize about this question; the measurement is\nempirical.\nWhen viewed in perspective, these risks are startling. From the top in 2000\nto the low in 2002, a 39% drawdown occurred. Is this disquieting? A 41%\ndrawdown occurred during the Reagan crash of 1987. A mere bagatelle. The\nHoover drawdown from 1929 to 1932 was 89%. Such things are unlikely to\nhappen again. The big guys would step in and support the market.\nClearly, the way to reduce market risk to zero is to be out of the market. Less\nobviously, or perhaps blatantly, the second most important way to reduce\nrisk is to be right about the trend—or to not be wrong. Moreover, because of\nthe nature of the Dow Theory, much time is spent", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 26}
{"text": "n from 1929 to 1932 was 89%. Such things are unlikely to\nhappen again. The big guys would step in and support the market.\nClearly, the way to reduce market risk to zero is to be out of the market. Less\nobviously, or perhaps blatantly, the second most important way to reduce\nrisk is to be right about the trend—or to not be wrong. Moreover, because of\nthe nature of the Dow Theory, much time is spent on the sidelines by the\nDow investor. This is a natural reduction of risk. In fact, of the total days\nfrom 1897 to 2018, 44,193, the Dow Investor spent 15,492 (or about 35% of\nthe time) days at the beach or at the S&L. But his accumulated profits have\nnot been credited with interest, as this is a “pure” study.\nAs will be readily apparent, Table 4.3 is much richer in data than just the\nduration of investments in the long side of the market. Acting on the maxim\n(my own) that it is unwise to invest on only one side of the market, I have\ncomputed the accumulated profits gained by trading the Dow long and short.\nAfter all, the market goes down as well as up, and for a reversing system a\nliquidation of longs is a signal to go short. If the record on the long side is\nimpressive, showing accumulated profits to 2018 of $795,592.01, how much\nmore impressive is the accumulated profit of $5,757,390.17 garnered from\ntrading both sides of the Dow, long and short?\nThe reader who listens carefully will hear the metamessage. For the great\nmajority of investors, it is the long run that is important. In the right-now\nculture of the internet and computer age and the get-rich-quick mentality,\none wonders whether there are still such investors, outside of the very rich\nand very intelligent. Perhaps there are still a few aging readers of early\neditions of this book, and, not to despair, perhaps some new converts.\nA note of caution is in order here: beware of spreadsheets run amuck. As the\nspreadsheet serenely grinds through a trade it doesn't care how it may be\ncreating a fantasy universe. Likewise, the more transactions the greater the\neventual figure as the compounding effect of reinvesting the total bankroll\non every roll of the dice. This being said, putting the matter into\nmathematical perspective and discounting inflated totals still makes the\nperformance impressive—much more so considering most professional fund\nmanagers can't beat the market.\nTable 4.3 Performance of Dow Theory through 2017: Longs and Shorts\nAccumulated\nTrade#SignalDate PricePL%Profit BullBear\n1 Long7/12/189744.61 100.00\n2 Short12/16/189963.8443.11 143.11 887\n3 Long10/20/190059.446.89 152.97 308\n4 Short6/1/190359.590.25 153.36 954\n5 Long7/12/190451.3713.79174.51 407\n6 Short4/26/190692.4479.95314.04 653\n7 Long4/24/190870.0124.26390.24 729\n8 Short5/3/191084.7221.01472.23 739\n9 Long10/10/191081.913.32 487.89 160\n10 Short1/14/191384.963.72 506.06 827\n11 Long4/9/191565.0223.47624.83 815\n12 Short8/28/191786.1232.45827.60 872\n13 Long5/13/191882.164.60 865.66 258\n14 Short2/3/192099.9621.671,053.20631\n15 Long2/6/192283.7 16.271,224.52 734\n16 Short6/20/192390.818.49 1,328.54499\n17 Long12/7/192393.8 -3.29 1,284.79 170\n18 Short10/23/1929305.85226.074,189.282147\n19 Long5/24/193384.2972.447,224.02 1309\n20 Short9/7/1937164.3995.0314,088.941567\n21 Long6/23/1938127.4122.5017,258.28 289\n22 Short3/31/1939136.427.07 18,478.73281\n23 Long7/17/1939142.58-4.52 17,644.33 108\n24 Short5/13/1940137.5-3.56 17,015.68301\n25 Long2/1/1943125.888.45 18,453.66 994\n26 Short8/27/1946191.0451.7628,005.931303\n27 Long10/2/1950228.94-19.8422,449.90 1497\n28 Short4/2/1953280.0322.3227,459.79913\n29 Long1/19/1954288.27-2.94 26,651.78 292\n30 Short10/1/1956468.762.5943,333.29986\n31 Long5/2/1958459.561.95 44,178.32 578\n32 Short3/3/1960612.0533.1858,837.46671\n33 Long2/23/1961654.42-6.92 54,764.35 586\n34 Short4/26/1962678.683.71 56,794.52198\n35 Long11/9/1962616.139.22 62,028.94 197\n36 Short5/5/1966899.7746.0490,584.421273\n37 Long1/11/1967822.498.59 98,364.60 251\n38 Short10/24/1967888.187.99 106,220.70286\n39 Long10/1/1968942.32-6.10 99,745.90 343\n40 Short2/25/1969899.8-4.51 95,245.10147\n41 Long10/27/1969860.284.39 99,428.35 244\n42 Short1/26/1970768.88-10.6288,864.6391\n(Continued)\nTable 4.3 (Continued) Performance of Dow Theory through 2017: Longs\nand Shorts\nTrade#SignalM/D/Y Price PL%\nAccumulated\nProfit BullBear\n43 Long 9/28/1970758.97 1.29 90,010.00 245\n44 Short 7/28/1971872.01 14.891,03,415.97303\n45 Long 2/10/1972921.28 -5.65 97,572.80 197\n46 Short 2/23/1973959.89 4.19 101,661.99411\n47 Long 1/27/1975692.66 27.84129,964.33 588\n48 Short 10/24/1977802.32 15.83150,539.921084\n49 Long 6/6/1978866.51 -8.00 138,495.90 225\n50 Short 7/2/1981959.19 10.70153,309.11 135\n51 Long 10/7/1982965.97 -0.71 152,225.45 572\n52 Short 1/25/19841231.8927.53194,131.30415\n53 Long 11/6/19841244.15-1.00 192,199.27 462\n54 Short 10/15/19872355.0989.29363,819.94475\n55 Long 2/29/19882071.6212.04407,611.06 362\n56 Short 10/13/19892569.2624.02505,526.50997\n57 Long 6/4/19902935.19-14.24433,526.27 84\n58 Short 8/3/19902809.65-4.28 414,984.06645\n59 Long 1/18/19912646.785.80 439,039.89 234\n60 Short 10/5/19923179 20.11 527,322.9460\n61 Long 11/25/19923266.22-2.74 512,855.15 124\n62 Short 8/4/19988487.31159.851,332,659.972799\n63 Long 11/2/19988706.5 -2.58 1,298,243.21 42\n64 Short 9/23/199910318.5918.521,538,625.09373\n65 Long 11/8/20019587.527.08 1,647,636.37 777\n66 Short 6/25/20029126.8 -4.81 1,568,460.62229\n67 Long 1/6/20038773.573.87 1,629,163.97 195\n68 Short 11/21/200712799.0445.882,376,653.391780\n69 Long 4/18/200812849.36-0.39 2,367,309.47 149\n70 Short 9/29/200810365.45-19.331,909,684.83149\n71 Long 4/9/20098083.3822.022,330,123.36 192\n72 Short 6/30/20109774.0220.922,817,468.97447\n73 Long 9/27/201010812.04-10.622,518,248.26 89\n74 Short 8/2/2011 11866.629.75 2,763,872.05309\n75 Long 12/23/201112294 3.60 2,863,413.76 143\n76 Short 6/4/201212101.46-1.57 2,818,568.99164\n77 Long 1/18/201313649.712.793,179,171.86 228\n78 Short 8/20/201516990.6924.483,957,326.79944\n79 Long 10/19/201517084.490.55 3,979,173.89 60\n80 Short 1/6/201616906.51-1.04", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 27}
{"text": "hort 6/30/20109774.0220.922,817,468.97447\n73 Long 9/27/201010812.04-10.622,518,248.26 89\n74 Short 8/2/2011 11866.629.75 2,763,872.05309\n75 Long 12/23/201112294 3.60 2,863,413.76 143\n76 Short 6/4/201212101.46-1.57 2,818,568.99164\n77 Long 1/18/201313649.712.793,179,171.86 228\n78 Short 8/20/201516990.6924.483,957,326.79944\n79 Long 10/19/201517084.490.55 3,979,173.89 60\n80 Short 1/6/201616906.51-1.04 3,937,720.3079\n81 Long 4/20/201618053.66.78 4,204,890.74 105\n82 Short 6/24/201617400.75-3.62 4,052,834.4765\n83 Long 9/7/201618526.146.47 4,314,950.73 75\n84 MtoMkt12/31/201724719.2233.435,757,390.17480\n85 15417\nTaylor & Francis\nTaylor & Francis Group\nhttp://taylorandfrancis.com\nchapter five\nReplacing Dow Theory with John Magee's Basing points Procedure\nI have humorously compared the interpretation of the market using Dow Theory to the ancient Romanpractice of haruspication—that is, the examination of animal or bird entrails to forecast the future. DowTheory analysts examine the market and venture their expert opinions as to whether Dow Theory saysthe market is a buy, a sell, or a hold. Sometimes it seems as if they might be sitting on a tripod at Delphiand inhaling substances legal in California but forbidden in Washington, D.C. Additionally, from thesame data they often extract different conclusions. (No disrespect of Dow theorists is intended. Some ofmy best friends are Dow analysts.) From this observation came the motivation to look for a better way.That better way is found in Chapter 28 in which Magee outlined (and I have further articulated) a methodthat is eminently adaptable to long-long term investing. We are talking about investments that might lastfor years. One reason the rich get richer is they practice this kind of investing. They correctly assessbusiness conditions and economic circumstances and take deeply entrenched positions that, in secularbull markets, return them profits beyond the hope of swing traders and midterm traders. Perhaps in somecases they even use Dow Theory. Whatever they use, they are not chased from the market, except by truechanges in the major trend.\nInvesting on this time scale has never been easy—except for the well-capitalized mature and patientinvestor. Using Magee's Basing Points Procedure, it is now possible for the general investor to invest onthe Dow Theory (or longer) time scale. To demonstrate the power of this procedure, I undertook anumber of studies. The first and most important of these was a study of the Dow Industrials since 1900using Dow Theory. By studying the Industrials, we have an excellent benchmark in the performance ofDow Theory over that time.\nThe fractal nature of the market\nA fact that all traders know in their bones was enunciated by the polymath, Benoit Mandelbrot, whostated market price behavior is fractal. Fractal literally means self-similar at all scales. In other words, atwo-minute bar chart exhibits the same kind of formations and characteristics as a daily chart, and sodoes a weekly chart. If you were presented a chart and told to determine the time scale, you would beunable to answer from the data alone. When you read about moving average systems in Chapter 36, youwill see—as you probably know already—that a 10-day moving average system trades 10 times as muchas a 200-day moving average system. The closer you are to the market, the more prone you are to be ledastray by noise. This is one reason day traders are so seldom successful—noise and random price activitymake for difficult data to analyze. Important traders of my acquaintance trade on weekly data: in otherwords, they trade using one bar to represent a week of market activity. Not surprisingly, they tradeinfrequently compared with daily bar traders.\nConsidering these facts, I constructed a Basing Points Procedure using weekly bars to test the method.Instead of using “three-days-away” data to determine Basing Points, I used “three-bars-away” data. Itook all the Industrials data and back studied it to see what the performance would have been usingMagee's procedure. The results are impressive; not eye-popping in terms of profits but sufficient.Furthermore, when considering operating characteristics overall, especially in ease of operation, theMagee method wins hands down.\nThe results of using Magee's simple-as-pie method are superior to the results obtained by using thecomplex and often obtuse Dow Theory. Later in this chapter, I will summarize the results of the studyand illustrate the tables.\n• Profits produced by the Magee Procedure are superior to those produced by the Dow Theory:$1,147,486.52 as opposed to $795,592.01.\n• Profits produced by Variant 2 of the Magee Procedure were $2,982,577.83.\n• Compound Annual Growth Rates (CAGR) were also similar: 7.9% (Variant 1) versus 7.87% and 8.37%for Variant 2.\n• Risk profiles were also quite similar: average drawdown for Dow Theory was 13.78% and for theMagee Procedure was 16%. Maximum drawdown was 25.3% for Dow Theory and 30% for the MageeProcedure.\n• Also pertinent to risk, considering long-side trades only, the Dow Theory was out of the market 36% ofthe time and the Magee Procedure 35%. This is a little remarked fact about Dow Theory—and unknownbefore this about Magee's Procedure. This is a radically important fact; it means each procedure is risk-free more than a third of the time. Calculating the out-of-market returns is such a hairy process, it wasnot undertaken.\n• As a result of differences in drawdowns and stop methods, Magee's Procedure is operationally superiorto Dow Theory. Since 1900, the Dow Theory has made 42 trades, the Magee Procedure has made 25.Considering the similarity of risk and profit characteristics, a system that trades less is preferable—lesscost, less slippage, fewer chances to lose market position. This is to say, better control of the vigorish.\nIn short, the Magee Basing Points Procedure represents the best alternative to the Dow Theory for thetrue long-term investor. It can be used on weekly bars", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 28}
{"text": "e Magee Procedure has made 25.Considering the similarity of risk and profit characteristics, a system that trades less is preferable—lesscost, less slippage, fewer chances to lose market position. This is to say, better control of the vigorish.\nIn short, the Magee Basing Points Procedure represents the best alternative to the Dow Theory for thetrue long-term investor. It can be used on weekly bars, in which case its full long-term power isevidenced. It also can be used on daily bars for a more sensitive approach.\nThe Basing Points Procedure may be operated in two ways, which I call Variant 1 and Variant 2. Variant1 sets stops based on wave lows. Variant 2, in addition to wave lows, uses new wave highs (see Chapter28). Table 5.1 denotes trades for the Basing Points Procedure, Variant 1. Table 5.2 denotes trades for theBasing Points Procedure, Variant 2. Keys to trades are shown in Figures 5.2 and 5.3. Readers, andinvestors in general, have every right to be skeptical of academic studies. Every morning, the mailbox isfull of “can't fail” “get-rich-quick” systems being sold by Wall Street hucksters who always showmouthwatering profits. Yet these are always paper studies. By contrast, the Magee Basing PointsProcedure has been in operation in the market for some years, and its effectiveness has beendemonstrated. It exited, and shorted, the market in January 2008 and remained short until March 2009. In2011, the Procedure exited longs and went short in late July before the Greek debt crisis. Letters writtenin real time during these events are in the http://www. edwards-magee.com archives and are available foraudit. Charts made at the time follow here. (See Figures 5.2 and 5.3. Figure 5.1 shows a detailed chart ofthe analysis of the top of the 2007 market and the short that resulted in early 2008.)\nTable 5.1 Trades Made by the Magee Basing Points Procedure, Variant 1\nDate Signal\nWave\nHigh\nWave\nLow\nStop\nPrice\nP/L\nLong%\nAccum\nLng Riskpts Risk%\nDurationDuration\nLongShort\n9/24/1900Long 53.0050.35 143.1\n6/17/1901 78.30 371\n9/30/1901Short 64.0311.0320.81172.8814.2718.22\n11/2/1903 42.20\n7/11/1904Long 52.02 1015\n1/15/1906 103.00\n8/5/1907Short 76.7624.7547.57255.1326.2425.481120\n1/11/1907 53.00\n3/23/1908Long 67.77 231\n9/27/1909 100.50\n1/31/2010Short 91.11 23.3434.43342.979.39 9.34 679\n9/25/1911 72.90\n4/22/1912Long 88.58 812\n9/30/1912 94.20\n12/9/1912Short 85.88-2.70-3.05332.528.32 8.83 231\n12/21/1914 53.20\n3/29/1915Long 60.26 840\n11/13/1916110.13\n8/27/1917Short 84.6524.4040.49467.1425.4823.14882\n12/17/1917 65.90\n8/19/1918Long 84.56 357\n11/3/1919 119.60\n8/9/1920Short 83.72-0.84-0.99462.5035.8830.00721\n8/22/1921 63.90\n10/24/1921 Long 72.10 441\n3/19/1923 105.40\n7/23/1923Short 87.4015.3021.22560.6518.0017.08637\n10/22/1923 85.76\n1/21/1924Long 96.51 182\n9/2/1929 386.10\n10/21/1929Short 319.30222.79230.841854.8666.8017.302100\n7/4/1932 40.60\n4/24/1933Long 70.97 1281\n3/8/1937 195.60\n9/6/1937Short 166.5495.57134.674352.8529.0614.861596\n3/28/1938 97.50\n7/18/1938Long 136.89 315\n9/11/1939 157.80\n5/13/1940Short 135.95-0.94-0.684323.0621.8513.85665\n4/27/1942 92.70\n7/6/1942Long 105.99 784\n5/27/1946 213.4\n9/16/1946Short 172.4366.4462.697033.1740.9719.201533\n6/13/1949 160.6\n10/24/1949 Long 184.27 1134\n4/9/1956 524.4\n9/23/1957Short 468.26283.99154.1217872.7356.1410.712891\n10/21/1957 416.2\nTable 5.1 (Continued) Trades Made by the Magee Basing Points Procedure, Variant 1\nDate SignalWave\nHigh\nWave\nLow\nStop\nPrice\nP/L\nLong\n% Accum\nLng\nRisk ptsRisk% DurationDuration\nLongShort\n6/23/1958Long 465.77 273\n1/4/1960 688.2\n9/26/1960Short 582.64116.8725.0922357.51105.5615.34826\n10/24/1960 564.2\n4/3/1961Long 664.66 189\n11/13/1961741.3\n5/7/1962Short 654.46-10.20-1.5322014.4486.8411.71399\n6/25/1962 524.6\n12/31/1962 Long 640.66\n1/17/1966 1000.6 238\n5/9/1966Short 878.18237.5237.0730176.13122.4212.231225\n10/10/1966 735.7\n10/14/1968 Long 937.71 889\n12/2/1968 994.7\n6/9/1969Short 895.4-42.31-4.5128814.5199.309.98238\n5/25/1970 627.5\n1/11/1971Long 827.40 581\n1/8/1973 1067.2\n5/14/1973Short 871.2543.855.3030341.63195.9518.36854\n12/2/1974 572.1\n12/10/1975 Long 713.58 940\n9/20/1976 1026.3\n5/23/1977Short 904.12190.5426.7038443.24122.1811.90530\n2/27/1978 742.13\n8/14/1978Long 875.60 448\n9/4/1978 907.73\n3/24/1980Short 780.15-95.45-10.9034252.39127.5814.05588\n4/21/1980 759.13\n8/4/1980Long 930.96 133\n3/30/1981 1030.98\n8/3/1981Short 877.8-53.16-5.7132296.66153.1814.86364\n8/9/1982 769.98\n10/4/1982Long 902.82 427\n8/24/1987 2746.7\n10/19/1987 Short 2071.511,168.69129.4574104.67675.1924.581841\n8/24/1987 1616.2\n1/23/1989Long 2234.53\n7/20/1998 9367.94 462\n8/24/1998Short 8141.865,907.33264.37270011.561,226.0813.093500\n7/20/1998 7402.61\n3/8/1999Long 9015.28 196\n1/10/2000 11750.28\n2/21/2000Short 9889.28874.009.69296188.211,861.0015.84350\n10/7/2002 7197.49\n9/1/2003Long 9314.67 1288\n10/8/2007 14198.1\n1/7/2008Short 12503.043,188.3734.23397572.061,695.0611.941589\n3/2/2009 6469.95\nTable 5.1 (Continued) Trades Made by the Magee Basing Points Procedure, Variant 1\nWave Wave Stop P/L Accum Risk Duration Duration\nDate Signal High Low Price Long % Lng pts Risk % Long Short\n5/4/2009 Long 8564.52 484\n12/31/200910428.05\n12/29/2017 Markto 16928.03 24719.22 16154.70 749914.46 188.62 1147486.52 14291.17137.05% 3161\nmarket\n12/29/17\nTable 5.2 Trades Made by the Magee Basing Points Procedure, Variant 2\nDate SignalStopProfit%\nAccumulated\nProfit\nDuration\nLong\nDuration\nShort\n9/25/1900Buy 143.10\n6/18/1901 371\n10/1/1901Sell64.0311.0320.81172.88\n11/3/1903\n7/12/1904Buy52.02 1015\n1/16/1906\n8/6/1907Sell76.7624.7547.57255.13 1120\n1/12/1907\n3/24/1908Buy67.77 231\n9/28/1909\n2/1/1910Sell91.11 23.3434.43342.97 679\n9/26/1911\n4/23/1912Buy88.58 812\n10/1/1912\n12/10/1912Sell85.88-2.70-3.05332.52 231\n12/22/1914\n3/30/1915Buy60.26 840\n11/14/1916\n8/28/1917Sell84.6524.4040.49467.14 882\n12/18/1917\n8/20/1918Buy84.56 357\n11/4/1919\n8/10/1920Sell83.72-0.84-0.99462.50 721\n8/23/1921\n10/25/1921Buy72.10 441\n3/20/1923\n7/24/1923Sell87.4015.3021.22560.65 637\n10/23/1923\n1/22/1924Buy96.51 182\n9/3/1929\n10/22/1929Sell337.92241.412", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 29}
{"text": "9\n9/26/1911\n4/23/1912Buy88.58 812\n10/1/1912\n12/10/1912Sell85.88-2.70-3.05332.52 231\n12/22/1914\n3/30/1915Buy60.26 840\n11/14/1916\n8/28/1917Sell84.6524.4040.49467.14 882\n12/18/1917\n8/20/1918Buy84.56 357\n11/4/1919\n8/10/1920Sell83.72-0.84-0.99462.50 721\n8/23/1921\n10/25/1921Buy72.10 441\n3/20/1923\n7/24/1923Sell87.4015.3021.22560.65 637\n10/23/1923\n1/22/1924Buy96.51 182\n9/3/1929\n10/22/1929Sell337.92241.41250.141963.032100\n7/5/1932\nDate SignalStopProfit%\nAccumulated\nProfit\nDuration\nLong\nDuration\nShort\n4/25/1933Buy70.97 1281\n3/9/1937\n9/7/1937Sell166.5495.57134.674606.691596\n3/29/1938\n7/19/1938Buy136.89 315\n9/12/1939\n5/14/1940Sell135.95-0.94-0.684575.16665\n4/28/1942\n7/7/1942Buy105.99 784\n5/28/1946\n9/17/1946Sell172.4366.4462.697443.311533\n6/14/1949\n10/25/1949Buy184.27 1134\n4/10/1956\n9/24/1957Sell468.26283.99154.1218914.982891\n10/21/1957\n6/24/1958Buy465.77 273\n1/5/1960\n9/27/1960Sell582.64116.8725.0923661.29826\n10/25/1960\n4/4/1961Buy664.66 189\n11/14/1961\n5/8/1962Sell654.46-10.20-1.5323298.21399\n6/26/1962\n1/1/1962Buy640.66\n1/18/1966 238\n5/10/1966Sell878.18237.5237.0731935.851225\n10/11/1966\n10/15/1968Buy937.71 889\n12/3/1968\n6/9/1969Sell895.40-42.31-4.5130494.83238\n5/26/1970\n1/12/1971Buy827.40 581\n1/9/1973\n5/15/1973Sell871.2543.855.3032111.01 854\n12/3/1974\n12/11/1975Buy713.58 940\n9/21/1976\n5/24/1977Sell904.12190.5426.7040685.06530\n2/28/1978\n8/15/1978Buy875.60 448\n9/5/1978\n3/25/1980Sell780.15-95.45-10.9036249.82588\n4/22/1980\nTable 5.2 (Continued) Trades Made by the Magee Basing Points Procedure, Variant 2\nDate SignalStop Profit %\nAccumulated\nProfit\nDuration\nLong\nDuration\nShort\n8/5/1980Buy 930.96 133\n3/31/1981\n8/4/1981Sell 877.80-53.16-5.7134180.04364\n8/10/1982\n10/5/1982Buy 902.82 427\n8/25/1987\n10/20/1987Sell 2458.461555.64172.3193075.781841\n8/25/1987\n1/24/1989Buy 2234.53\n7/21/1998 462\n8/25/1998Sell 8141.865907.33264.37339135.653500\n7/21/1998\n3/9/1999Buy 9015.28 196\n9/21/1999\n9/21/1999Sell 10470.081454.8016.14393862.09196\n1/3/2000\n10/15/2002Buy 8138.30 1120\n10/1/2002\n1/28/2003Sell 7984.95-153.35-1.88386440.54105\n10/8/2006\n3/18/2003Buy 8220.90 49\n5/11/2004Sell 9966.411745.5121.23468491.88420\n2/28/2005Buy 10887.90\n7/30/2007Sell 13110.422222.5220.41564123.97882\n10/1/2007\n3/23/2009Buy 7411.89\n3/2//2009 602\n12/29/2017Mark to24719.2217307.33233.511881396.573262\nMarket\nThis study and the use of Magee's Basing Points Procedure to replace Dow Theory is explained inexquisite detail in the book Sacred Chickens, the Holy Grail and Dow Theory (available athttp://www.amazon.com).\nFigure 5.1 How the 2008 top in the Industrials was managed with Basing Points.\nCertainly, one of the most interesting charts of the last 20 years. Here we can see the stairstops rising ashigher wave lows are made. Moreover, one—or two—of those instances of surprising serendipity occurs.The Basing Point stop is quite close to a stop that would have been calculated from the neckline of thehead-and-shoulders formation. The very long-term trendline from 2003 intersects prices very near theBasing Point calculated stop, calling to mind the “rule of multiple techniques,” which states anyconclusion arrived at by multiple techniques is much more probable than that using only one method.This Basing Points system—or method, or what-have-you— remained short until March 2009.\n116.47\nChapter five: Replacing Dow Theory with John Magee's Basing points Procedure\nFigure 5.2 The Dow-Jones Industrials 1924-1934. This is a period of the chart covered in Figure 5.3.\nFigure 5.3 This is one of the most interesting charts ever made of the Dow-Jones Industrials. It showsevery trade made by Dow Theory since the beginning and also shows trades made by Magee's BasingPoints Procedure.\nTechnical Analysis of Stock Trends\nchapter six\nImportant Reversal Patterns\nIn our discussion of certain deficiencies in the Dow Theory from the point of view of the practical trader, wementioned the fact that it did not tell us what specific stocks to trade in. (EN9: Obviously, no longer aproblem as the investor may buy the DIA and trade the Average like a stock.) A conservative and wealthyinvestor, more interested in safety than maximum profit, can solve this problem by making up acomprehensive and thoroughly diversified list of sound, well-seasoned “blue chip” issues and handing hisbroker an order to buy the lot when the Dow Theory signals a Bull Trend. Some of his selections will dobetter than others; some may “go sour,” but wide diversification will ensure he gets a fair Average result.Better results should be obtained if we can find a way to select for purchase the most favorably situated issuesat any given time and can manage to sell them promptly and switch to others whenever the prospects for thefirst have been fully discounted.\nThere is the possibility, too, of increasing our gains if we can, at times, buy with safety earlier in an uptrendthan the Dow theorist does, and sell before the market has reacted far enough to give a Dow Bear Signal.\nWe mentioned also the fact that the Dow Theory is of little or no assistance in trading on the IntermediateTrends. There is obviously more money to be made if we can get the benefit of each up move without havingto write off some of our profits in each reaction. Or, if we can profit both ways by trading on both the “longside” and “short side” of the market.\nFinally, although all stocks tend to move with “the market” as typified in the Averages, there are, in fact, widevariations in the price paths of individual issues. An average, after all, is just that, a device for expressing inone figure a diversity of other figures. A Primary Bull Market ended in the Dow-Jones Industrial Average onMay 29, 1946, but United Airlines registered its highest price in December 1945; General Motors saw its peakin January 1946; Goodyear in April, DuPont in June, and Schenley in August. Is there a way of capitalizingon these divergences?\nTechnical analysis of the charts of individual stocks definitely answers the first and most important of thesefour problems: the matt", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 30}
{"text": "Dow-Jones Industrial Average onMay 29, 1946, but United Airlines registered its highest price in December 1945; General Motors saw its peakin January 1946; Goodyear in April, DuPont in June, and Schenley in August. Is there a way of capitalizingon these divergences?\nTechnical analysis of the charts of individual stocks definitely answers the first and most important of thesefour problems: the matter of selection. It frequently, but not always, gives us a running start on the DowTheory; it also, in large part, takes care of the question of the Intermediate Trend, although there are certainreservations as to policy and risk in connection with both these points that will be taken up in due course.Finally, careful technical analysis should, in nearly every case, get us out of a stock that “tops out” ahead ofthe Averages long before it has suffered any considerable decline, often in time to transfer funds to otherissues that have yet to complete their advances.\nJust as the Averages constantly discount all known and foreseeable factors affecting the future of securityprices in general, the market action of an individual issue reflects all the factors affecting its individual future.Among these factors, and expressed in its chart, are the general market conditions that influence all stocks toa greater or lesser degree, as well as the particular conditions applying to the particular stock, including theoperations of “insiders.”\nLet us assume right from the start that you, the reader, are not a member of that mysterious inner circle knownto the boardrooms as “the insiders.” Such a group—genuinely entitled to be called insiders, thoroughlyinformed on every fact, figure, and development that might determine the fortunes of a certain corporation—may exist from time to time and may influence the market price of its stock (EN9: and wind up in prison).But it is fairly certain that there are not nearly so many “insiders” as the amateur trader supposes and that theydo not cause one-tenth of the market movements for which the public blames them. It is even more certainthat insiders can be wrong; they would, in fact, be the first to admit it. Frequently, their plans are upset bysome development that they could not foresee or by some blind force that puts to scorn all expert estimates ofvalue. Any success they have, however, can be accomplished only by buying and selling on the floor of theExchange. [EN9: No longer strictly true. Insiders sold stock to their companies in the tulip (dot.com) bubble,which went unreported publicly for up to a year. Still, only an isolated problem.] They can do neither without\naltering the delicate poise of supply and demand that governs prices. Whatever they do is sooner or laterreflected on the charts where you, the “outsider,” can detect it, or at least detect the way in which the supply-demand equation is being affected by insiders' operations, plus all other prevailing market factors. So, you donot need to be an insider to ride with them frequently.\nImportant Reversal Patterns\nStock prices move in trends. Some of those trends are straight, some are curved; some are brief and some arelong-continued; some are irregular or poorly defined and others are amazingly regular or “normal,” producedin a series of action and reaction waves of great uniformity. Sooner or later, these trends change direction;they may reverse (as from up to down), or they may be interrupted by some sort of sideways movement andthen, after a time, proceed again in their former direction.\nIn most cases, when a price trend is in the process of reversal, either from up to down or from down to up, acharacteristic area or pattern takes shape on the chart, which becomes recognizable as a Reversal Formation.Some of these chart pictures are built and completed quickly, whereas others may require several weeks toreach a stage at which one can surely say a Reversal of Trend is definitely indicated. Speaking in broadgeneralities, the greater the Reversal Area—the wider the price fluctuations within it, the longer it takes tobuild, and the more shares transferred during its construction—the more important its implications. Thus,roughly speaking, a big Reversal Formation suggests a big move to follow and a small pattern, a small move.Needless to say, the first and most important task of the technical chart analyst is to learn to know theimportant Reversal Formations and to judge what they may signify in terms of trading opportunities.\nThere is one recognized Reversal Pattern that appears and is completed within a single day's trading, and is, inconsequence, named the “One-Day Reversal.” At times, it has great significance—such as calling a halt, atleast temporarily, to any up or down move—but in its ordinary manifestations, it does not imply much of animmediate move in the opposite direction. It is a useful pattern, and we shall have more to say about it later,but the price formations from which extensive new trends proceed take time to build. One does not bringinstantly to a stop a heavy car moving at 70 miles an hour and, all within the same split second, turn it aroundand get it moving back down the road in the opposite direction at 70 miles an hour.\nTime required to reverse a trend\nWe do not need to lean on a racing automobile analogy to explain why it takes time (and volume and priceaction) to produce an important Trend Reversal. The logic of it is plain enough if we take but a moment toexamine it. We can do so most easily by describing what might have (and, doubtless, many times has)happened in specific terms. Suppose a certain well-informed and well-financed coterie (EN9: A congerie ofmutual funds, for example) decides the shares of a certain company, now selling around 40, are cheap; thatthis company's affairs are progressing so satisfactorily that, before long, it will attract the attention of manyinvestors; and that its stock will be in demand at much higher levels, perhaps at 60 or 65. Our group realizes if", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 31}
{"text": "certain well-informed and well-financed coterie (EN9: A congerie ofmutual funds, for example) decides the shares of a certain company, now selling around 40, are cheap; thatthis company's affairs are progressing so satisfactorily that, before long, it will attract the attention of manyinvestors; and that its stock will be in demand at much higher levels, perhaps at 60 or 65. Our group realizes ifthey manage their market operations skillfully, if nothing unforeseen intervenes to upset their calculations,they can “take” 20 points out of the situation. So they proceed to buy in all offerings, going about thisbusiness as quietly as possible, until they have accumulated their line, which may run to several thousandshares and represent practically all of the current floating supply of the issue. Then they wait. Professionalsbecome suspicious and the rumor circulates that there is “something doing in PDQ,” or other canny bargainhunters discover the company's bright prospects, or chart analysts detect the signs of accumulation in thestock's action. Buyers now find the stock is scarce; there are few offerings on the books, and they have toraise their bids to get it—an advance starts.\nThe up-move gathers momentum as more and more traders are attracted by rising prices. It is helped along bythe good reports (higher earnings, increased dividend, etc.), which our group knew were to be expected.Eventually, prices approach the level at which they had planned to take profits. But this operation, thedistribution of their holdings may require even more patient and skillful handling than did the accumulation.Suppose they have 20,000 shares to unload; they cannot throw all of the shares on the market at once— doing\nso would defeat their own ends immediately and, perhaps, permanently. They must feed their line out little bylittle, trying to avoid attention, feeling their way along and never permitting a surplus of offerings to kill thedemand. If activity in their stock has reached a level of, say, 2000 shares transferred daily, they may be able todispose of 500 shares a day from their holdings without bringing the price down. (They will be competing,sooner or later, with others who have followed their play, bought lower down, and will be ready to take profitsas soon as the advance shows signs of weakening.) So they start to sell when the rising trend appears to haveattained maximum momentum, or as it nears their price objective, but well before it has reached its probablelimit, and they push out their shares as rapidly as buyers will take them.\nBefore long—as a rule, before they have distributed their entire line—a lull in demand will occur. Perhapsprospective buyers sense the increase in supply. A reaction develops. Our group quickly ceases selling,withdraws its offers, and perhaps even buys back a few shares to support prices if they threaten to drop toofar. With supply temporarily held off the market, the decline halts and the advance resumes. Our group lets itproceed this time until it carries prices into new high ground; this reassures other holders and brings in morebuyers. As soon as the pot is once again merrily boiling, distribution is started anew and, if the maneuver hasbeen well directed, completed in perhaps two or three weeks, before the second wave of demand has beenexhausted.\nOur group is now out of its stock with a nice profit; its 20,000 shares have passed into other hands. If theygauged the market correctly and distributed their line at a price about as high as the situation would bear,demand will have been satiated for a long time to come. Prices will probably first drift back to somewherenear the level at which they were supported on the previous dip and then rally feebly on the strength of a littlenew buying from traders who were waiting for just such a minor reaction, meet sales from other traders whofailed to seize the opportunity to take their profits on the preceding volume Top and are now anxious to getout, and then break down into a decline of Intermediate or Major proportions.\nYou can see now why, under one specific set of circumstances, a Top area (a chart pattern of distribution)takes time and volume to complete. Nevertheless, it does not matter whether we have to deal with the highlyorganized operations of a single group of insiders or of an investment syndicate or, as is more often the case,the quite unorganized activities of all the investors variously interested in an issue—the result is pretty muchthe same. Distribution, which is simply Wall Street's way of expressing the process of supply overcomingdemand, takes time and a change in ownership (turnover) of a large number of shares. And it is amazing tosee how these patterns of distribution, which hereafter we shall find it simpler to refer to as “Tops,” tend toassume certain well-defined forms. Most of the same pattern forms appear also as “Bottoms,” in whichmanifestation they signify accumulation instead of distribution.\nThe Head-and-Shoulders Top Formation\nIf you followed closely and were able successfully to visualize how the foregoing example of distributionwould appear on a chart, you saw a Head-and-Shoulders Top Formation. This is one of the more commonand, by all odds, the most reliable of the Major Reversal Patterns. You probably have heard this patternmentioned, as many traders are familiar with its name, but not so many really know it and can distinguish itfrom somewhat similar price developments that do not portend a real Reversal of Trend.\nThe typical or, if you will, the ideal, Head-and-Shoulders Top is illustrated in Diagram 6.1. You can easily seehow this formation got its name. It consists of the following:\nA. A strong rally, climaxing a more or less extensive advance, on which trading volume becomes veryheavy, followed by a Minor Recession on which volume runs considerably lower than it did during thedays of rise and at the Top. This is the “left shoulder.”\nB. Another high-volume advance that reaches a h", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 32}
{"text": "in Diagram 6.1. You can easily seehow this formation got its name. It consists of the following:\nA. A strong rally, climaxing a more or less extensive advance, on which trading volume becomes veryheavy, followed by a Minor Recession on which volume runs considerably lower than it did during thedays of rise and at the Top. This is the “left shoulder.”\nB. Another high-volume advance that reaches a higher level than the top of the left shoulder, and thenanother reaction on less volume that takes prices down to somewhere near the bottom level of the\npreceding recession, somewhat lower perhaps or somewhat higher, but, in any case, below the top of theleft shoulder. This is the “Head.”\nC. A third rally, but this time on decidedly less volume than accompanied the formation of either the leftshoulder or the head, which fails to reach the height of the head before another decline sets in. This is the“right shoulder.”\nD. Finally, decline of prices in this third recession down through a line (the “neckline”) drawn across theBottoms of the reactions between the left shoulder and head, and the head and right shoulder,respectively, and a close below that line by an amount approximately equivalent to 3% of the stock'smarket price. This is the “confirmation” or “breakout.”\nNote that each and every item cited in A, B, C, and D of Diagram 6.1 is essential to a valid Head-and-Shoulders Top Formation. The lack of any one of them casts in doubt the forecasting value of the pattern. Innaming them, we have left the way clear for the many variations that occur (for no two Head-and-Shouldersare exactly alike) and have included only the features that must be present if we are to depend on the patternas signaling an important Reversal of Trend. Let us examine them in greater detail (see Figures 6.1 through6.12).\nVolume is important\nFirst, let us consider the matter of volume. It is always to be watched as a vital part of the total picture. Thechart of trading activity makes a pattern just as does the chart of price\nDiagram 6.1 A hypothetical daily stock chart. Price in the upper part and volume at bottom—drawn to showhow an ideal Head-and-Shoulders Top Reversal Formation would develop. A, B, C, and D refer to essentialfeatures listed on the previous page.\nranges. The two go together and each must conform to the requirements of the case. But note also that volumeis relative. When we speak of high volume, we mean a rate of trading notably greater than has beencustomary in that particular stock during that particular period under examination. The exact number of sharestraded is not important, and it will not ordinarily signify anything for our purposes to compare a daily volumeof, say, 6500 shares in Radio Corporation with 500 in Bohn Aluminum and Brass. The former may be verylow and the latter very high as judged by the proper technical criterion, which is, in each case, the averagerecent activity in the same issue. In the case of a Head-and-Shoulders Top, as mentioned, high volume attendsthe making of the left shoulder; this means that activity on the rise to and at the top of the left shoulder shouldbe greater than on the preceding rally waves in the same issue, followed by a Minor Recession on dwindlingactivity, and then a new advance on high volume. The action thus far does not differ from what we shouldexpect of normal wave development within a continuing uptrend. In these respects, any two typical,successively higher waves in an advance may, as you can see, become the left shoulder and head,respectively, of a Head-and-Shoulders Reversal.\nFigure 6.1 Starting in March, “HUM” formed a broad Head-and-Shoulders Top pattern on the daily chart.August's decline penetrated the neckline by 3%, confirming the Reversal Pattern. The minimum objective forthe Head-and-Shoulders Top would be 18.\nFigure 6.2 Daily chart of Chicago, Milwaukee, St. Paul, & Pacific common from January 1 to June 29, 1946.Head-and-Shoulders that topped this issue's Primary Advance in February was unmistakable, despite thesmall size of shoulders (SS). Note the volume pattern. Measuring implication (see following pages) of thisformation was carried out by April. Rectangular price congestion of March 30 to May 4 is a subject ofChapter 9. “ST” fell to 11 1/2 in October.\n44\n40\n38\n34\n36\n32\n30\nFigure 6.3 Bull market top of Westinghouse Electric in 1946 was the “wide-swinging,” powerful type ofHead-and-Shoulders Pattern (S-H-S). Decline that broke neckline (NL) on February 13 produced a breakawaygap (G) discussed in Chapter 12. Measuring formula (see following pages) called for initial decline to 33. Thepossible Bottom Head-and-Shoulders Pattern (S?-H?-S?) formed in March was never completed (see Chapter7). Note the failure of prices to push up through the neckline of the latter at any time, despite several rallyefforts in late spring while general market Averages were actually reaching new high levels. By the following\nNovember, “WX” had broken on down to 21 1/2. Study in detail the change in volume pattern after the end ofJanuary.\nThe first suggestion a Head-and-Shoulders is really developing may come when the volume record shows thatactivity accompanying the most recent Top was somewhat less than the one preceding it. If this volumedisparity is conspicuous, and if it becomes evident from the way prices are receding that the second andhigher rally has ended, then the chart should be tabbed with a “red” signal and further developments shouldbe scrutinized. But such a preliminary warning does not always appear and should not be taken as conclusivewhen it does. Roughly estimated, about one-third of all confirmed Head-and-Shoulders Formations showmore volume on the left shoulder than on the head, another third show about equal volume, and the final thirdshow greater volume on the head than on the left shoulder.\nAnother warning—or, more often, the first—comes when prices drop in the course of the second reaction(i.e., from the head) below the level of the Top", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 33}
{"text": "hly estimated, about one-third of all confirmed Head-and-Shoulders Formations showmore volume on the left shoulder than on the head, another third show about equal volume, and the final thirdshow greater volume on the head than on the left shoulder.\nAnother warning—or, more often, the first—comes when prices drop in the course of the second reaction(i.e., from the head) below the level of the Top of the left shoulder. Such action, as we shall see later on in ourspecific study of Support and Resistance levels, is significant of weakness in the price structure. So far it isMinor, it may be only temporary, and it is certainly not conclusive. Nevertheless, when this occurs, put adouble red tab on your chart.\nBreaking the neckline\nThe real tip-off appears when activity fails to pick up appreciably on the third rally, the right shoulder. If themarket remains dull as prices recover (at which stage you can draw a tentative “neckline” on your chart) andif, as they approach the approximate level of the left shoulder\nFigure 6.4 A large Head-and-Shoulders Topping Pattern evolved in “TDY” over five months, withDecember's high-volume plunge through the neckline confirming the Trend Reversal. Because this was a veryexpensive stock, you might have considered buying the April 260 puts instead of selling “TDY” sharesoutright. Our measured objective in this issue was 44 points from penetration of the 264 neckline, or 220.\nTop and begin to round over (volume is still relatively small), your Head-and-Shoulders Top is at least 75%completed. Although the specific application of these pattern studies in trading tactics is the province of thesecond part of this book, we note here that many stock traders sell or switch just as soon as they are sure alow-volume right shoulder has been completed, without waiting for the final confirmation named under D asthe breaking of the neckline.\nNevertheless, the Head-and-Shoulders is not complete, and an important Reversal of Trend is notconclusively signaled until the neckline has been penetrated downside by a decisive margin. Until theneckline is broken, a certain percentage of Head-and-Shoulders developments, perhaps 20%, are “saved”—that is, prices do not go lower, but simply flounder listlessly for a period of time in the general range of theright shoulder, then eventually firm up and renew their advance.\nFinally, in rare cases, a Head-and-Shoulders Top is confirmed by a decisive neckline penetration and stillprices do not go down much farther. “False moves” such as this are the most difficult phenomena with whichthe technical analyst has to cope. Fortunately, in the case of the Head-and-Shoulders, they are extremely rare.The odds are so overwhelmingly in favor of the downtrend continuing once a Head-and-Shoulders Formationhas been confirmed, it pays to believe the evidence of the chart no matter how much it may appear to be outof accord with the prevailing news or market psychology.\nOne thing is worth noting about Head-and-Shoulders Formations that fail completion or produce falseconfirmations—that is, such developments almost never occur in the early stages of a Primary Advance. AHead-and-Shoulders Formation that does not work is a warning that even though there is still some life in thesituation, a genuine turn is near. The next time something in the nature of a Reversal Pattern begins to appearon the charts, it is apt to be final.\nFigure 6.5 “ICX” was in a powerful uptrend for more than a decade and gains were spectacular. But theupward momentum began to fade and topping indications were evident. The August peak fulfilled theobjective of the measuring flag formed during 1985. The August gap to new highs was quickly filled,indicating it was an Exhaustion Gap. The reaction back to Support, followed by a slow, relatively low-volumerally to the July high, formed a credible right shoulder. The final week's high-volume plunge through theneckline confirmed the Reversal. The minimum objective for the Head-and-Shoulders Pattern was 19 1/4, thetop of the 1985 Flag. A possible alternative cover point was the Bottom of the Flag at 14 1/4.\nVariations in Head-and-Shoulders Tops\nThere is a tendency, surprising when one thinks of all the vagaries of news and crosscurrents that mayinfluence day-to-day trading, for Head-and-Shoulders Patterns to develop a high degree of symmetry. Theneckline tends to be horizontal and the right shoulder tends to resemble the left in price confirmation(although not, of course, in volume); there is a sort of satisfying balance to the overall picture. But symmetryis not essential to a significant Head-and-Shoulders development. The neckline may slope up (from left toright) or down. The only qualification on an up-sloping neckline is that the Bottom of the recession betweenthe head and right shoulder must form appreciably below the general level of the Top of the left shoulder. It issometimes said that a down-sloping neckline indicates an unusually weak situation. This is so obvious that itis apt to be given even more weight than it deserves. A share of that excessive weakness, it should be noted,will have already been discharged by the time the down-sloping pattern is formed and prices have broken theneckline. The measuring formula, which we shall discuss later, applies to such situations.\nDue to the tendency toward symmetry in shoulder development, some traders, as soon as the neckline hasformed, will draw on their charts a line parallel to the neckline, extending from the top of the left shoulderthrough the head and on to the right. This furnishes a guide as to the approximate height the right shoulderrally should attain and,\n208\n192\n176\n160\n152\n144 Sales 100's\n50\n40\n30\n20\n10\n:: ■ :::\n■::r ■\nb 1 1 .\n::: :::::\nM T\n- •• ’I1 m izn::: .....8• F)T T DC)NTT nn\n1333133t\nJ: ::::: j\n4 S£ ■H S :::: : ::r.\n|(||:::::lllll• •\n4 fl !:!!!! . . ftftift:ft\ntTTTTTTTTTT 1 TV\n'*•T\nuni\nUlf'\n»<1 i!iti\n1 1\n’\ni3.....-I*\nufti nr'it i'HIiiit 11 •.1 i nt id\nI\nB\n;;\nnTr mm\nj ::\nti", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 34}
{"text": "o the approximate height the right shoulderrally should attain and,\n208\n192\n176\n160\n152\n144 Sales 100's\n50\n40\n30\n20\n10\n:: ■ :::\n■::r ■\nb 1 1 .\n::: :::::\nM T\n- •• ’I1 m izn::: .....8• F)T T DC)NTT nn\n1333133t\nJ: ::::: j\n4 S£ ■H S :::: : ::r.\n|(||:::::lllll• •\n4 fl !:!!!! . . ftftift:ft\ntTTTTTTTTTT 1 TV\n'*•T\nuni\nUlf'\n»<1 i!iti\n1 1\n’\ni3.....-I*\nufti nr'it i'HIiiit 11 •.1 i nt id\nI\nB\n;;\nnTr mm\nj ::\ntin\n::::\ni ini: E :IfMl\ntffl\n|| H\ns Hi TT i HHT\n?tHtti: :\n!£!!!!!! :::nnns:ii:mi\ni|fl5I 1936-1\n937\nnr4\n:*n\n;3\n1\n1i\n1\n£11 ! 33~ :\nH*J.33iiii\n1\n- 111IB i\niS r iiiiiil.i\n■■ I ... ■ III\n... lllll■ru...\nS H II nt ■’...\n•4* iiiii- i sim... i\n1\n1 111 II Iiil\nJANUARY\nFEBRUARY MARCH\nOCTOBER NOVEMBER DECEMBER\n3 10 17 24 31 7 14 21 28 5 12 19 26 2 9 16 23 30 6 13 20 27 6 13 20 27\nFigure 6.6 Reversal Formations, which develop in important stocks while the general market is stillapparently in a strong trend, are often difficult to believe, much less act on. But they may be highlysignificant. DuPont topped out in 1936, four months ahead of the Averages. Despite its extended rightshoulder (but note volume), Reversal implications were clear on December 19. The Pullback of January,meeting supply at the old neckline level, and the second try in March were interesting and typical of such ageneral market situation. Compare with Figure 6.11.\n48\n44\n40\n38\n36\n34\n32 Sales 100's\n50\n40\n30\n20\n10\nH\nS\n1937\nAPRIL\nCONSOLIDATED EDISON\nLili udlh kill uBilhihil\nFEBR U A R Y'\" MARCH---:\nIMEUS\nJANUARY\n2 9 16 23 30\nFigure 6.7 Another 1937 Bull Market Top of Head-and-Shoulders Form, with only one quick Pullback(February 10). In this case, volume increased sharply on February 5 with the initial break through the neckline(NL). Measuring formula was satisfied in March. Study this picture in connection with “ED's” long-rangechart (Figure 10.4) in Chapter 10; turn back to it later when you come to the Support-Resistance study inChapter 13.\n20\n19\n18\n17\n16\nSales 100's\n250\n200\n150\n100\n50\nS:\n1946\nS\nMAY\nREPUBLIC AVIATION RA\nFEBRUARY MARCH APRIL\nHEHF\n“ii\nw fllf\np J-if\ni] 1'1Ht]l||g\nH\nFigure 6.8 The six-month-long Head-and-Shoulders Top of Republic Aviation in 1946. Such a patternbecame a possibility to be watched for when prices broke down in May below the level of the February high(first S). Refer to requirement B. Note also how the Head-and-Shoulders Measuring Formula (Chapter 7) isapplied to patterns with up-slanting necklines. Minimum downside requirement here was 12 1/2, reached inNovember. The quick Pullback on July 27 gave a last good selling opportunity.\nFigure 6.9 After a sharp reaction from its 1983 high, which lasted a year and pushed “DIS” back to long-termSupport, the Bulls took over and sent Walt and friends on a trip to the moon. But beginning in April, the\nrocket began to lose power, and it looked like reentry had begun. Since the big-volume days of spring, thisissue etched out a large Head-and-Shoulders Top. High-volume penetration of the neckline by 3% confirmedthe Reversal.\nSales\n100's\n500\n400\n300\n200\n100\n:::::\nSI\nNEW YORK CENTRAL\n1945\nAPRIL\nMAY\nJUNE t . JULY AUGUST SEPTEMBER\n' 7 • 14 21 28 5 12 19 26 2 9 16 23 30 7 14 21 28 4 11 18 25 1 8 15 25 29\nFigure 6.10 New York Central made a Head-and-Shoulders Top in June 1945. Intermediate Up Trendline(IUT) was broken by drop from head on July 5. Minimum measuring implication was carried out at 24 onAugust 18. Reaction ended a few days later at 22 3/4. Prices recovered to projected neckline (see September25), dropped again to 26 7/8 in October, and then pushed up, giving “rebuy” signal (on Fan Line construction)at 30 in the first week of November. Final Bull Market High was made in January at 35 1/2. The period fromAugust 1945 to February 1946 was difficult for technical traders in this stock. Those who sold at 26-27 inJuly 1945 could, however, congratulate themselves in May 1947 when “CN” hit 12.\nconsequently, a selling level. But you will not see very many formations as perfect and symmetrical as ourideal picture, a fact the several actual examples accompanying this chapter amply illustrate. Either shouldermay, in fact, go higher or take more time than the other. Either or both may come up nearly to the level of thehead (but not equal it, or else no Head-and-Shoulders exists) or both may fall considerably short of it. Ifactivity attending the right shoulder is abnormally dull, that shoulder is apt to be low but protracted in time. Ingeneral, there seems to be a balanced relation between the three elements of price pattern, time, and volumethat is practically impossible to express in words or figures, but comes with experience to sense in itsdevelopment. However, there are no laws beyond those stated in our A, B, C, and D of Diagram 6.1; withinthose limits, look for an infinity of minor variations.\nPrice action following confirmation: the measuring formula\nThe final step, the downside penetration of the neckline, may be attended by some increase in activity, but itusually is not at first. If volume remains small for a few days as prices drift lower, a “Pullback” movefrequently ensues that brings quotations up again to the neckline level (rarely through it). Normally, this is the“last gasp”; prices then turn down quickly, as a rule, and break away on a sharply augmented turnover.Whether or not a Pullback Rally will occur after the initial penetration seems often to depend on the conditionof the market in general. If the whole market trend is turning down at the same time as our individual issue,which has just completed its Head-and-Shoulders, there will probably be no Pullback;\n136\n128\n120\n112\n104\n96\n88\n80\n76\n72\n68\n64 Sales 100's\n125\n100\n75\n50\n25\nUNION CARBIDE & CARBON\nUK\n1929\nAUGUST SEPTEMBER OCTOBER\nNOVEMBER DECEMBER\n6 13 20 27 3 10 17 24 31 7 14 21 28 5 12 19 26 2 9 16 23 30 7 1421 28'\nFigure 6.11 The great 1929 Bull Market Top was characterized by many impressive Head-and-ShouldersFormations, of which this is an interesting example. Note the small Head-and-Shoulders Pattern ofSept", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 35}
{"text": "2\n104\n96\n88\n80\n76\n72\n68\n64 Sales 100's\n125\n100\n75\n50\n25\nUNION CARBIDE & CARBON\nUK\n1929\nAUGUST SEPTEMBER OCTOBER\nNOVEMBER DECEMBER\n6 13 20 27 3 10 17 24 31 7 14 21 28 5 12 19 26 2 9 16 23 30 7 1421 28'\nFigure 6.11 The great 1929 Bull Market Top was characterized by many impressive Head-and-ShouldersFormations, of which this is an interesting example. Note the small Head-and-Shoulders Pattern ofSeptember, which became the head of a much larger formation of the same character. The Pullback of\nOctober 9 to the upper neckline afforded a second chance to get out at 128 to those who did not sellimmediately when this first line was decisively penetrated on September 28. The larger pattern “broke” onOctober 19, with a quick pullback on October 22. Less than a month later “UUK” had lost half its peak value.By 1932 it had fallen to 15 1/2. Although such a catastrophic decline as 1929-1932 may never come again, themoral is, nonetheless, plain: never scorn a Head-and-Shoulders Formation. Patterns such as this merge intothe “multiple” types discussed in Chapter 7. Although this example is selected from the 1929 portfolio, theywere not at all uncommon in the mid-20th century. Several modern examples appear in our later pages.\nprices instead will tend to accelerate their decline, with activity increasing as they leave the vicinity of theTop. If, on the other hand, the general market is still firm, then an attempt at a Pullback is likely. Also, theodds seem slightly to favor a Pullback if the neckline has been broken before much of a right shoulderdeveloped, but certainly no sure rules can be laid down. In any event, the Pullback Rally is of practicalinterest chiefly to the trader who wants to sell the stock short, or who has sold it short and has then to decidewhere he should place a stop-loss order.\nNow we come to one of the most interesting features of this basic Reversal Formation— the indication that itgives as to the extent (in points) of the move that is likely to follow the completion of a Head-and-Shoulders.Measure the number of points down vertically\nFigure 6.12 Dow Jones Industrials, Head-and-Shoulders Top 2007-2008; edwards-magee.com identified thismassive Head-and-Shoulders Formation in early 2008, after having already exited the market in January 2008and wrote the following letter. Note \"A low\" and \"B low\"; if this yearlong formation is a massive Top(perhaps a double-headed Head-and-Shoulders) and A low is its lower boundary, then a low of 9680 ispredicted. If B low is the defining point, the predicted low is 10836. Remember Niels Bohr and the difficultyof forecasting? Again, it is not necessary to believe this scenario to know how to bet. The Dow is in a six-month downtrend, the last 21/2 months of which are sideways, with lower highs in the sidetrend. The low of9680 is a probable minimum. Mark Hulbert says Richard Band is predicting a 16000 Dow. Watch out for lowflying eggs (as in getting egg on your face). Then the Dow went to 6469.95 in the great Bush Bear Market.\nTechnical Analysis of Stock Trends\nfrom the Top of the head to the neckline as drawn in Figure 6.4. Then measure the same distance down fromthe neckline at the point at which prices finally penetrated it following the completion of the right shoulder.The price level thus marked is the minimum probable objective of the decline.\nLet us hasten to state one important qualification to the Head-and-Shoulders Measuring Formula. Refer backto our original set of specifications for a Head-and-Shoulders. Under A, we required “strong rally climaxing amore or less extensive advance.” If the up-move preceding the formation of a Reversal Area has been small,the down-move following it may—in fact, probably will—be equally small. In brief, a Reversal Pattern has tohave something to reverse. So, we really have two minimums: one being the extent of the advance precedingthe formation of the Head-and-Shoulders and the other derived from our measuring formula, whichever is thesmaller will apply. The measuring rule is indicated on several of the examples that illustrate this chapter. Youcan see now why a down-sloping neckline indicates a “weaker” situation than an up-sloping neckline, and justhow much weaker, as well as the fact that more than half of the minimum expected weakness has alreadybeen expended in the decline from the top of the head to the penetration of the neckline.\nThe maximum indications are quite another matter, for which no simple rules can be laid down. Factors thatenter into this are the extent of the previous rise, the size, volume, and duration of the Head-and-ShouldersFormation, the general market Primary Trend (very important), and the distance that prices can fall beforethey come to an established Support Zone. Some of these are topics for later discussion.\nRelation of Head-and-Shoulders to Dow Theory\nWithout doubt, some readers have already suspected the Head-and-Shoulders Pattern is, in a sense, just anadaptation of the principles of Dow Theory to the action of an individual stock. So it is. The decline of pricesfrom the head to the neckline, the rally to the right shoulder, and then the ensuing decline that breaks theneckline set up a sequence of lower Tops and Bottoms analogous to those that signal a downtrend in DowTheory. This logical relation of the Head-and-Shoulders to Dow Theory is another reason, in addition to itsbasic importance, frequency, and dependability, why we have placed it first in our study of ReversalFormations. But it also is more definite, gives advance warnings that are relatively easier to detect, and isquicker with its signals in the case of up-sloping necklines. Moreover, it requires no specified minimum timefor any of its component moves, and no confirmation by another stock or Average.\nThere are Head-and-Shoulders Bottoms (EN: An undescriptive term for a bottom formation that I wouldprefer to call the “Kilroy Bottom.” See Figure 7.4.) as well as Tops, with equally important implications. TheBot", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 36}
{"text": "icker with its signals in the case of up-sloping necklines. Moreover, it requires no specified minimum timefor any of its component moves, and no confirmation by another stock or Average.\nThere are Head-and-Shoulders Bottoms (EN: An undescriptive term for a bottom formation that I wouldprefer to call the “Kilroy Bottom.” See Figure 7.4.) as well as Tops, with equally important implications. TheBottom Formations will be taken up in our next chapter.\nTaylor & Francis\nTaylor & Francis Group\nhttp://taylorandfrancis.com\nchapter seven\nImportant Reversal Patterns: continued\nHead-and-Shoulders (EN: or Kilroy) Bottoms\nA formation of the Head-and-Shoulders type may develop at an important Reversal ofTrend from down to up. In that case, it is called a Head-and-Shoulders Bottom, and itsprice pattern (as compared with a Top) is turned upside down, that is, it stands on itshead. EN: The present Editor has always been impatient with the undescriptive natureof the term “Head-and-Shoulders Bottom,” and so he has renamed it the “KilroyBottom.” See Figure 7.4. The volume pattern is somewhat the same (not turned upsidedown) as at a Top but with some important changes in the latter half of the formation,which we shall discuss in detail. We can lay down specifications for it in much thesame words as we used for the Head-and-Shoulders Top. Here they are, with theportions that differ in principle from the Top printed in italics (see Figures 7.1 through7.25):\nA. A decline, climaxing a more or less extensive downtrend, on which tradingvolume increases notably, followed by a Minor Recovery, on which volume runsless than it did during the days of final decline and at the Bottom. This is the “leftshoulder.” EN9: Or left hand.\nB. Another decline that carries prices below the Bottom of the left shoulder, onwhich activity shows some increase (as compared with the preceding recovery)but usually does not equal the rate attained on the left-shoulder decline, followedby another recovery that carries above the Bottom level of the left shoulder and onwhich activity may pick up, or at any rate exceed that on the recovery from the leftshoulder. This is the “head.” EN9: Or nose.\nC. A third decline on decidedly less volume than accompanied the making ofeither the left shoulder or head, which fails to reach the low level of the headbefore another rally starts. This is the “right shoulder.” EN9: Or right hand.\nD. Finally, an advance on which activity increases notably, which pushes upthrough the neckline (EN9: Or fenceline) and closes above by an amountapproximately equivalent to 3% of the stock's market price, with a conspicuousburst of activity attending this penetration. This is the “confirmation” or“breakout.”\nThe essential difference between Top and Bottom Patterns, you can see, lies in theirvolume charts. Activity in Head-and-Shoulders Bottom Formation usually begins toshow uptrend characteristics at the start of the head and always to a detectable degreeon the rally from the head. It is even more marked on the rally from the right shoulder.\nIt must be present on the penetration of the neckline, or else the breakout is not to berelied on as a decisive confirmation.\nAn important basic principle of techniques that is involved here merits furtherdiscussion. Wall Street has an old saying that expresses it: “It takes buying to put stocksup, but they can fall of their own weight.” Thus, we trust, and regard as conclusive, anyprice break (by a decisive margin) down through the neckline of a Head-and-ShouldersTop\n18\n17\n16\n15\n14\n13 Sales 100's\n125\n100\n75\n50\n25\n....\nHr p-\nU\n..\nLOCKHEED\nAIRCRAFT\nLK\nOCTOBER NOVEMBER DECEMBER JANUARY FEBRUARY MARCH '\nI 2 9 16 23 30.6 .13.20-27 4 -11-18 25 1'8 '15 22 29 5 12 19 26: 4 11-18 25\nFigure 7.1 After “rounding over” in October 1943 in the last phase of a long declinefrom 41 in 1940, Lockheed made a conspicuous two-month Head-and-ShouldersBottom. Note especially, on the above chart, the volume on the rally in early Decemberand in the first week of January with reference to points B and D on the precedingpages. “LK” dropped back to 15 again in June 1944, and then ran up quickly to 23 byNovember, finally reaching 45 in January 1946. One advantage of logarithmicallyscaled charts is they expand, and thus call attention to important formations thatdevelop at low price levels, and that would be obscured on an arithmetic scale.\neven though it occurs on a light turnover, but we do not trust a breakout from a Head-and-Shoulders Bottom unless it is definitely attended by high volume. A low-volumebreakout from a Bottom Pattern may only be premature, to be followed after more“work” around the Bottom levels by a genuine advance, or it may be a “false” moveentirely. It pays generally to wait and see. This same distinction in volume developmentapplies to some of the other Reversal Patterns we shall take up later in this chapter.\nOther differences between Top and Bottom Head-and-Shoulders do not involve anynew principles. It can be said that Bottoms are generally longer and flatter, that is, theytake more time in relation to depth of pattern in points than do Tops. This is particularlytrue when they occur at Reversals in the Primary Trend. The overall volume at Bottomstends to be less than at Tops, and the turns tend to be more “rounded.” In theconstruction of a Head-and-Shoulders Top, the activity that goes into the left shoulderusually exceeds that on any preceding rally in the entire uptrend. In a downtrend, on theother hand, there may be Panic Selling in some of the earlier phases of decline, whichruns the volume chart up to a mark higher than any that is subsequently registered inthe final Bottom Formation. None of these differences, however, affects our essentialHead-and-Shoulders specifications.\nThe measuring implications of the Head-and-Shoulders Bottom are the same in allrespects and are applied in the same way as with Tops. Tendency toward symmetry isagain the rule, with variations as to slope of neckli", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 37}
{"text": "rt up to a mark higher than any that is subsequently registered inthe final Bottom Formation. None of these differences, however, affects our essentialHead-and-Shoulders specifications.\nThe measuring implications of the Head-and-Shoulders Bottom are the same in allrespects and are applied in the same way as with Tops. Tendency toward symmetry isagain the rule, with variations as to slope of neckline, relative size of shoulders aboutthe same as in Tops. Reactions to the neckline following the initial breakout from theBottom type appear in about the same frequency and proportions as do the PullbackRallies, which follow the initial breakdown from the Top type.\n19\n18\n17\n16\n15\n14\n13\n12\n11\n10\n9\nSales 100's\n125\n100\n75\n50\n25\nDOME MINES\nDM\nNL\nS\nS\nH\n■ '\n.Ell\nill.I.lit\n-U\n—r\n■ il.nl, .,111 ill III Illi I Hi 111 i III I ill III\n’ A T S ' O ' N ’ D 1 J ’ F ’ M\nFigure 7.2 Weekly charts are particularly useful for detecting Major Bottom Reversalsbecause Bottom Formations characteristically take longer to build than Tops. DomeMines made a typical Head-and-Shoulders base, 13 months' long, at its Primary TrendReversal in 1942. Note the volume pattern. (Volume detail, however, is better studiedon daily charts.) Dome's powerful Head-and-Shoulders Bottom was “high” enough tobe conspicuous on an arithmetic monthly chart. It reached 25 in 1944.\nMultiple Head-and-Shoulders Patterns\nThe Head-and-Shoulders Formations we have examined up to this point have been,despite minor variations, relatively simple and clear-cut, consisting of three well-defined elements. We come now to a group of related patterns that carry much the sametechnical significance but have more elements and are much less clearly defined. Theseare the Multiple Head-and-Shoulders Tops and Bottoms, also known as ComplexFormations. We need not take much of our space to define or lay down specificationsfor them, as they may be described quite sufficiently as Head-and-Shoulders Reversalsin which either the shoulders or the head, or both, has been doubled or proliferated intoseveral distinct waves.\nAlmost any combination is possible, of which only a few can be illustrated in the actualchart examples reproduced in this chapter. Formations of this type appear with fairfrequency at Primary Bottoms and Tops, but more often at Bottoms than at Tops. They\nFigure 7.3 With a strong movement toward lower interest rates evident since June, thetiming of the low in “FNM” is not surprising. Neither is the massive width (fromMarch through October) of its evolving pattern, which closely matches that of the huge,complex Inverse Head-and-Shoulders Bottom in Treasury Bills (December 1984),September 25, 1984. Even the slight timing lag is appropriate.\nFigure 7.4 EN: At the risk of being considered a comic (actually, a satirist), I suggestthat, although the image is comical, the pattern is more descriptive of theincongruously named “Head-and-Shoulders Bottom” than the present terminology.\nLeft hand equals left shoulder, right hand equals right shoulder, nose equals head, andneckline equals fence line, or, as easily, neckline. I am teaching all of my students tothink and use these terms, which makes much more sense than the absurd “upside downHead-and-Shoulders Bottom standing on its head.” One hundred years from now, thiscontribution to the nomenclature will be accepted as totally descriptive andappropriate, and the term “Head-and-Shoulders Bottom” will have disappeared fromthe lexicon.\nA common form consists of two left shoulders of approximately equal size, a singlehead, and then two right shoulders, again, of approximately even size and balancing thetwo on the left. Another is made up of two heads with two or more shoulders on eitherside. Still another form, of which you will usually find several good examples at anyMajor Market Turn, consists of double shoulders on either side of a head, which isitself composed of a small but quite distinguishable Head-and-Shoulders development.\nFigure 7.5 A ragged Kilroy (or, if from the old school, a Head-and-Shoulders) Bottomthat ended the Bear Market (or first phase thereof) of 2001-2002. Some seven and ahalf months in formation it threw a few knuckle balls and curves and looked right up toMarch 2003 as though it were a Bear Market rally. Once the neckline was taken out,there was no arguing with it—it was a real Bottom. It balked at the neckline for acouple of months before becoming a full Bull. Complex economic and political realities\naffected the markets: the terrorist attacks of September 11, 2001, which put paid to thetulipomania of the roaring 1990s and the ill-advised tax cuts of the Bush Jr.administration. Using the formula of cut taxes and increase spending to start a war, themarket was sufficiently stimulated to rally exuberantly. The downtrend line is drawnhere and the reader should have no trouble seeing the break of the long-term downtrendas well as the Kilroy Bottom demanded a shifting of gears from Bear to Bull.\nTendency to symmetry\nWe have mentioned the tendency toward symmetry in the simple Head-and-ShouldersFormation. Patterns of the Multiple or Complex type show an even stronger urgetoward symmetry—so strong, in fact, that it may be counted on in determining tradingpolicy. If there are two shoulders on the left, there are almost always two on the right ofnearly the same size and duration. (One does not know that a Multiple is in the processof formation until its right shoulder becomes evident.) Except in volume, the right-handhalf of the pattern is, in the great majority of cases, an approximate mirror image of theleft.\nNecklines on Multiple Head-and-Shoulders Formations are not always easy to drawbecause the reactions between the shoulders and heads may not stop at levels that allfall on a single line. Up-sloping and down-sloping variants seldom appear in this classof patterns; necklines are almost always very close to the horizontal. Sometimes, it ispossible to estimate by simple inspection where the critical li", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 38}
{"text": "ecklines on Multiple Head-and-Shoulders Formations are not always easy to drawbecause the reactions between the shoulders and heads may not stop at levels that allfall on a single line. Up-sloping and down-sloping variants seldom appear in this classof patterns; necklines are almost always very close to the horizontal. Sometimes, it ispossible to estimate by simple inspection where the critical line really lies. More often,there are two necklines, an inner and an outer, and no price movement of consequenceis to be expected until the outer has been penetrated (which is simply anotherexpression of that tendency toward symmetry referred to above).\nCuriously enough, the “power” of a Multiple Head-and-Shoulders Pattern is more aptto be over rather than underestimated. One might think, in view of the length of timeand\n\nFigure 7.6 “MCA” enjoyed an excellent advance from 1980 to 1986, but the goingbecame increasingly difficult after the turn of the year, when this issue began tochallenge its 1985 high. Although the Bulls did manage to set a new high-water mark inApril, a series of Pullbacks kept this issue well away from any further tests. Indeed, alarge Complex Head-and-Shoulders Top appeared to be unfolding with the MajorNeckline penetrated slightly on the sell-off.\n26\n24\n22\n20\n19\nSales\n100's\n125\n100\n75\n50\n25\nDECEMBER JANUARY FEBRUARY MARCH APRIL MAY\n: 1 8 15 22 29 5 12 19 26 2 9 16 23 2 9 16 23 30 6 13 20 27 4 11 18 25’\nFigure 7.7 An “ideal” Multiple Top made by Budd in 1946, with two heads. Observeaccompanying volume. Prices often break away from Complex Formations morereluctantly than from the simple Head-and-Shoulders type. The late-March rally, whichwent back through the old neckline, was greater than normal in that respect, but thegeneral market Averages were pushing to new highs at this time. Repenetration of aneckline does not, of itself, cancel the implications of a Reversal Formation.\nSales\n100's\n125\n100\n75\n50\n25\nSIL\nRL\nG\nG\nAMERICAN LOCOMOTIVE\nLA\n1946\nAPRIL MAY JUNE\nAUGUST SEPTEMBER\n6 13 20 27 3 10 17 24 31 7 14 21 28\n6 13 20 27 4\nFigure 7.8 The long Multiple Head-and-Shoulders Top made by American Locomotivein 1946 displays very well the sort of volume pattern—irregular but taking on\ndefinitely Bearish character in its latter half—that is normal to this formation. Therounded Bear Market Rally of August (compare price and volume trends) was unable toattain the old neckline and was stopped at a Resistance (RL) created by earlier Bottomlevels (see Chapter 13). G and G mark Breakaway Gaps that were not “covered” (seeChapter 12).\nFigure 7.9 From a Head-and-Shoulders Top in February, Digital plunged sharply lowerinto midJune, retracting roughly two-thirds of the 1983-1985 advance. The summer lowwas the head of a Broad, Complex Head-and-Shoulders (EN: Or Kilroy) Bottom.“DEC,” however, had already enjoyed a high-volume penetration of the neckline andwas, therefore, in a buying position.\nARCHER DANIILS MIDLAND\n300\n32\n30\n20\n15\n28\n26\n24\n800\n81\n82l\n83\n22\n16\n15\nSales a\n100's I\nMARCH APRIL\nMAY\nJUNE\n~ACGU\nT SEPTEMBER\nOCTOBER NOVEMBER DECEMBER\nXD.035\nXD.035 5 % STK.\nXD.035\nFigure 7.10 After testing its 1980 high in mid-1983, “ADM” turned sharply lower,retracing roughly 40% of the 1982-1983 advance by mid-1984. The summer low,however, appeared to be a Bottom. Indeed, if one looked at the volume pattern from\nApril to November and correlated it with price activity, it was not difficult to make agood case for a Complex Head-and-Shoulders Bottom. A neckline through the closesgave us a go signal on a penetration of 20 5/8.\nFigure 7.11 An Intermediate Bottom of the Complex class, abnormal in its lack ofsymmetry but, nonetheless, easy to recognize. Low volume on reactions after the Headwas completed gave the usual (and essential) Bullish Confirmation. The sluggish startof the new trend was a common feature of Multiple Head-and-Shoulder Reversals.\nFigure 7.12 The slide in Amdahl occupied the Bears from March to June before a sharprally gave notice that the Bulls were still alive. After that, a choppy sideways tradingrange evolved with Support near the Pullback lows established earlier in the year.Overall, there was a fine symmetry to this chart, including volume, which indicated theprice action from March to September was actually a Broad Head-and-ShouldersBottom. Entry was on a 3% breakout of the neckline with a minimum objective of 193/4.\namount of trading entering into its construction, that it would signal a move (in reversedirection to the trend preceding it) of greater extent than the simple Head-and-Shoulders. Yet, in its immediate consequences, at least, the Complex showsconsistently less power. Minimum measuring rules for the two types of formations arethe same and are applied in the same manner. The difference between the patternsappears in the price action after the minimum has been reached. The first downswingout of a plain Head-and-Shoulders Top, not counting any early Pullback Rally, willfrequently carry out the minimum measuring implications of that pattern quickly andrun well beyond it. From a Multiple Top, the first downswing is often more leisurely,and very seldom does it exceed the bare minimum—a probability well worthremembering when you are dealing with an Intermediate rather than a Primary Top. Ifthe Complex does develop at a turn in the Primary Trend, prices will eventually gomuch farther; however, even then, there is usually a strong recovery (or reaction, in thecase of a Bottom) from the “minimum rule” level.\nA leisurely pattern\nThe volume attending the construction of Multiple Head-and-Shoulders conforms ingeneral to the “laws” we have previously stated and explained for simple Head-and-Shoulders Reversals. During the earlier stages of Multiple Formation development, thevolume chart may show much irregularity with little recognizable pattern, but in thelatter stages, its correspondence with the Head-and-Shoulders Trend should be plainlyseen.\nThere is something about Multiple Head-a", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 39}
{"text": "ulders conforms ingeneral to the “laws” we have previously stated and explained for simple Head-and-Shoulders Reversals. During the earlier stages of Multiple Formation development, thevolume chart may show much irregularity with little recognizable pattern, but in thelatter stages, its correspondence with the Head-and-Shoulders Trend should be plainlyseen.\nThere is something about Multiple Head-and-Shoulders Patterns that is especiallypleasing to technical chart followers. Due to their symmetrical tendencies, it isfascinating to watch them evolve to completion. Once completed, however, they maytry your patience by their seeming reluctance to “get going” with a new trend. On thataccount, it becomes\n10\nSales\n100's\n1000\n800\n600\n400\n200\nP J\nS\nS\nPUBLIC SERVICE CORP.\nOF N. J.\nA ’ M :\nLi\n■J'A'S'O'N'D'J' I'M\nFigure 7.13 Another variant of the Head-and-Shoulders within a Major ReversalFormation. The smaller Head-and-Shoulders Pattern was easily overlooked on the dailychart. Moreover, although it was six months long, this pattern in itself did notnecessarily imply Primary Reversal. Although, when it pushed \"PJ's\" prices up inOctober through the great supply that had been lodged at 12-13 the previous December,something more than a Secondary Advance could obviously be in prospect. An up-move of consequence was not finally signaled, though, until February 1943 when theupper neckline was penetrated and prices closed at 14. Public Service “threw back” to12 in November 1943 (to the old neckline exactly), but then advanced steadily to 30.Study this again when you take up Support and Resistance in Chapter 13. This chartreiterates the point that, whereas Top Formations are often completed in a relativelyshort time, Major Bottoms usually require many months, and call for a great deal ofpatience. Allowing for the greater time needed, however, most Top Patterns have theircounterparts in Bottom Formations.\neasy at times to jump to the conclusion that they have “blown out,” that is, produced afalse signal. Actually, except in the matter of extent of move, which we have alreadydiscussed, they are fully as reliable as the plain Head and Shoulders. False moves arerelatively rare with both. And in those extraordinary cases when a Complex Formationdoes go wrong, it still stands, like the plain Head-and-Shoulders, as a warning that thefinal Reversal is near.\nRounding Tops and Bottoms\nThe Multiple Formations we have just examined are produced by a sort of extension orproliferation of the ordinary Head-and-Shoulders Pattern. Carry this process still furtherand the Complexes merge into our next class of Reversals, known as Rounding Turns.\n24\n22\n20\n19\n18\n17\n16\n15\n14 Sales 100's 125 100\n75\n50\n25\nL-ii-’-L\n■ ■,\nNATIONAL SUPPLY\nNS\n1946\nUuuilyiil\nAPRIL\n6 13 20 27 4 11 18 25 1 8 15 22 29 6 ' 13 20 27 ' 3 10 17 24 31 7 14 21 28’\nFigure 7.14 Still another form the Complex Reversal may take. This can be describedas a Head-and-Shoulders Pattern with two widely separated heads. Study its volumepattern, noting the breakout on June 20 and the subsequent Pullback. Compare it withBethlehem Steel's Bottom Reversal shown in Chapter 12, Figure 12.12.\n72\n68\n64\n60\n56\nSales 100's\n125\n100\n75\n50\n25\n• il. -fL ..\nS \" 4 T—• $3\n...............\nSUM mt? % ■ $|l\n•■■■-\n1\n. ..\ntttf?:::j: •iiiH SfeSi O T xti::\ngit aS HH 1 ait\n••PHILIPS PETROLEUM I 1946 fig 1 Pl\nMl ■Eft HS I I 1 H\nrni TH In\n[ HI\nnn] .. . H .4i;iL\n.........\niil\n4* I- -1■ |t+\nidlluiUiu\nwuiLin 1 lliitlL mil\nH\nKill\nHFHF\niliiiiliilhiliililillLilIll.lli illillllil jlili\nAPRIL MAY JUNE ’ JULY * AUGUST SEPTEMBER\n■ 6 13 20 27 4 11 18 25’1’8 15’22’29 6 13 20 27 3 10 17 24 31 7 14 21 28\nFigure 7.15 Major Top Reversal Patterns in high-priced investment issues arefrequently long and “flat.” The 1946 Top of Phillips Petroleum could be classified aseither a Multiple Head-and-Shoulders or an irregular Rounding Top. An importanttrendline (see Chapter 14) was broken downside in July.\nIn our first approach to the theory of chart Reversal Patterns, we saw why it takes timeand a considerable volume of trading to swing an established trend in prices from up todown or down to up. In the Head-and-Shoulders type of Reversal, the trend surges,struggles, and attacks again and again before it finally gives up and retreats. During thisstruggle, the balance between the forces of supply and demand fluctuates, often wildly,\nAMERICAN & FOREIGN POWER 2d PFD. A\nFPD Pr\n1945\n26\nSales\n100's\n125\n100\n75\n50\n25\nJULY AUGUST SEPTEMBER OCTOBER NOVEMBER DECEMBE\n7 14 21 28 4 11 18\nFigure 7.16 The war-end reaction of 1945 in American & Foreign Power 2d Preferred,as well as in many other issues, took the form of a Rounding Bottom. Compare theprice and volume trends. By October 4, the implications were plain to see.\nuntil finally the one overcomes the other. In the Multiple Formations, a similar processgoes on but rather less violently and, over a period of time, the progressive change fromone force to the other becomes clearly apparent.\nThe Rounding Turn is a much simpler and more logical manifestation of this technicalphenomenon. It pictures simply and plainly a gradual, progressive, and fairlysymmetrical change in the trend direction, produced by a gradual shift in the balance ofpower between buying and selling.\nIf, for example, the buying has been stronger than the selling for some time past, weknow the result will have been a general upward trend in the price of our stock, asindicated by our pictorial chart record of its trading history. So long as the buyers of thestock remain more anxious, more numerous, more aggressive, and more powerful thanthe sellers, that preceding upward trend will continue. Now, suppose the selling grows alittle stronger while the buying either weakens slightly or remains stationary at itsprevious strength; this slight change in the technical balance will be indicated by aslowing up of the previous advance. As the selling increases in relative power, it willfinally become equal to the buying power, with t", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 40}
{"text": "ul thanthe sellers, that preceding upward trend will continue. Now, suppose the selling grows alittle stronger while the buying either weakens slightly or remains stationary at itsprevious strength; this slight change in the technical balance will be indicated by aslowing up of the previous advance. As the selling increases in relative power, it willfinally become equal to the buying power, with the result of the market level neithermoving up nor down but remaining, for a time, quite stationary (except for Minor andinsignificant fluctuations).\nAssume the new development continues and the selling pressure grows until it is finallystronger than buying power. Now the balance is moving the other way. There are nowmore sellers than buyers, and the result will be a gradual decline in the marketquotations for the stock. If this change in the balance of power is fairly steady andcontinues to its logical conclusion, we can see, even without the aid of a chart, that ourpicture of the price movement for that stock would be one of a long advancing trendslowly beginning to round off, holding in stationary suspense for a time, and thencommencing a retreat, reversing the previous upward movement into a new andAccelerating Downward Trend.\n20\n15\n10\n5\nAMERICAN SAFETY RAZOR ARZ I\nIMSgggiiHi\n........\n1931 ! 1932 1933 11934 .1935 ■'\"1936 0937 0938 0939 0 940 [1941 0942 [1943T1944 ,1945 j 1946.\nFigure 7.17 Monthly chart on an arithmetic scale. American Safety Razor's 1932 MajorBottom was a Head-and-Shoulders and also its 1936 Bull Top. Its 1942 to 1946 Bull\nMarket started from a Rounding Bottom nearly two and a half years long. Monthlychart study pays.\nRounding Bottoms are commonly referred to as Bowl or Saucer Patterns. RoundingTops are sometimes called Inverted Bowls. Despite the logic of their construction,neither type appears as frequently as Head-and-Shoulders Formations. RoundingBottoms occur most often in low-priced stocks, in an extended, flat-bottomed form thatusually takes many months to complete. There was a host of such developments during1942 and 1943 among issues selling under $10.00 a share. (It should be noted here that“Saucer” Bottoms of two or three months' duration also appear frequently, one rightafter another, in the charts of low-priced issues during an extended up-movement. Theircharacteristics and denotations will be discussed in the section “Consolidation.”)\nTops of the Rounding type are rare among stocks in the lower and medium-priceranges, but they are found occasionally in the charts of those high-priced commonstocks that command an AA rating among wealthy investors and do not ordinarilyinterest the general public. They also appear frequently in the charts of high-gradepreferred stocks, quite naturally because the demand for their shares reflects chieflytwo factors—supply of funds seeking conservative investment and interest rates—bothof which tend to change very slowly. The speculative appeal that produces wide-swinging price fluctuations is absent in such issues. The same line of reasoningexplains why Rounding Tops almost never develop\n30\n20\n10\nSales 100's\n200\n100\n1939\nFigure 7.18 Monthly chart of Budd Company. Note that 1942 was the first year toproduce a dull Saucer-Shaped Pattern, a Rounding Bottom of Major import. “BF”climbed from below 3 in 1942 to above 26 in 1946.\nam\n:dH\nigl\nJ\nil /\n1 !l,li„! iie; X\nZu\nBi liihlll,liili;\n30\n20\n10\nSales\n100's\n100\n50\nFigure 7.19 Similar formation in CertainTeed Products, which rose from below 2 in1942 to above 25 in 1946. Study volume, 1940 to 1945. The up-curving type of MajorBull Trend shown on these charts will be discussed in Chapter 15.\nin lower priced, speculative common stocks; Bull Markets in those stocks are toppedoff by excited public buying that pays little or no heed to long-range investmentconsiderations.\nHow Rounding Turns affect trading activity\nWe have not yet mentioned the volume half of the Rounding Turn picture, which isinteresting, as well as meaningful. In the case of Rounding Bottoms, its pattern isusually as clean-cut and decisive as the price pattern. The first step in the gradualconquest of supply by demand, which produces a Rounding Bottom, appears as alessening in selling pressure. Volume, which has been running high, graduallydecreases. Demand is still timid, but the pressure on it is less; so, while prices still\ndecline, the pace is slower and the trend curves more and more to the horizontal. At theBottom, with the two forces technically in balance, relatively few transactions arerecorded. Then demand begins to increase, and as the price curve turns up, tradingbecomes more active. Volume accelerates with the trend until often it reaches a sort ofclimactic peak in a few days of almost “vertical” price movement on the chart.\nIn such formations, the tips of the volume lines at the bottom of the chart, whenconnected, will describe an arc that often roughly parallels the arc formed by the price\n20 27 5\nJ. I. CASE\n1932\nnninniiiiinunnniiiiiinniiinui.nniuiiiii.iiiiii,,iii.li.^iiihiiniTnin.Hiiiiiiiiit\nMARCH APRIL MAY JUNE\n12 1 9 26 ' 2 ■ 9 : 1 6 23 30 7 14r21 :2.8'4 31 '18 25 T 2 '\n12 19 26: 2\nFigure 7.20 A classic example of Rounding Bottom at the Major Trend Reversal of1932. The jump out of line on June 10 and subsequent return to the Saucer Pattern is acommon development in Rounding Bottoms.\n“Bowl” above. These patterns, when they occur after an extensive decline, are ofoutstanding importance, for they nearly always denote a change in Primary Trend andan extensive advance yet to come. That advance, however, seldom carries in a“skyrocket” effect, which completes the entire Major Move in a few weeks. On thecontrary, the uptrend that follows the completion of the pattern itself is apt to be slowand subject to frequent interruptions, tiring out the impatient trader, but yieldingeventually a substantial profit.\nLet us repeat that trading volume should ebb to an extreme low at the Bottom of aBowl Pattern if its implications ar", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 41}
{"text": "kyrocket” effect, which completes the entire Major Move in a few weeks. On thecontrary, the uptrend that follows the completion of the pattern itself is apt to be slowand subject to frequent interruptions, tiring out the impatient trader, but yieldingeventually a substantial profit.\nLet us repeat that trading volume should ebb to an extreme low at the Bottom of aBowl Pattern if its implications are to be trusted. After prices have passed dead center,however, and have begun their first gradual climb with as yet only a slight pickup inactivity, something in the nature of a premature breakout may occur. Without warning,a burst of buying may shoot quotations straight up for a day or two. These incidents areby no means rare, but, almost invariably, prices will quickly drop back again into theirformer channel, and the gradual rounding movement is resumed. There is no particulardanger for the trader in these premature bursts, but if he is tempted to jump in on such a\nsudden showing of strength, he should realize there probably will still be need forpatience. A classic example of this type of premature break is shown in Figure 7.20.\nSee Chapter 16 for some very important 2005 rounding bottoms and their consequencesup to 2011.\n42\n40\n38\n36\n34\n32\n30\n28\n26 Sales 100's\n25\n20\n15\n10\n5\nGAMEWELL GO.\nJANUARY FEBRUARY\nMARCH\nJUNE\n; 8 15 22 29 5 12 19 26 4 11 18 25 1 8 15 22 29 6 13 20 27 3 10 17 24 1\nFigure 7.21 An extreme case of Dormant Bottom. There were many days in the firstfour months during which no shares were traded. A “buy” signal appeared on April 26.Note the volume.\nFigure 7.22 The March 1935 reaction produced many Rounding Bottoms. This oneverges on the dormant type. The gap (G), a Breakaway through a Resistance Level, wasnot closed until late 1937 (see Chapter 12).\n20\n19\n18\n17\n16\n15\n14\n13\n12\n:-:i :t\n1988\nAPPLIED MAGNETICS CORP\nAPM :| C I\nSales\n100's\nJUNE\n1000\n800\n600\n400\n200\nFigure 7.23 In a broad trading range (11—17 1/2) during 1988, \"APM\" turned downfrom Resistance in the summer. The reaction, however, was slow, forming a Saucer-likePattern from July through November on generally Bullish price-volume correlation. Ofparticular note was the fact the low point of the Saucer was above the February low,that is, higher lows were beginning to emerge. The High-Volume Rally through theShort-Term Downtrend Line signaled the start of the next up-leg.\nO1 ... .\nI1RU\nJUNE \"JOEY— AUGUST—SEPTEMBER OCTOBER ' NOVEMBER DECEMBER\n18 25 2 19 16 23 30 6 13 20 27 3 10 17 24 1 8 15 22 29 5 12 19 26 3 10 17 24 31\nThe Dormant Bottom variation\nOne sort of Major Bottom chart picture has been called a Dormant Bottom. Thisvariation relates logically to our Bowl Pattern, being, in effect, an extreme developmentof the \"extended, flat-bottomed form\" to which we have alluded above. It appearscharacteristically in \"thin\" stocks, that is, those in which the total number of shares\noutstanding or, more particularly, the floating supply of shares is very small. In suchissues, a normal day's turnover may be only two or three hundred shares in an activerising market. Finally, weeks and sometimes months will pass during which no saleswill be registered for days at a time, or only an occasional lot at a figure that fluctuateswithin a fractional range, making the chart appear \"flyspecked.\"\nEventually, there may appear a sudden and usually quite inexplicable flurry of activity.Several hundred shares appear on the tape and prices advance sharply. This \"breakoutof dormancy\" can be a premature move, such as we have noted in connection withtypical Rounding Bottoms, to be followed by several more weeks of inactivity, or it canbe the first lift in a sort of step-up process with shorter and shorter intervals betweeneach step, until a consistent uptrend finally develops. In any event, it is a signal that weare dealing with an important Accumulation Pattern.\nWhat has happened to form these Dormant Bottoms is easy to guess. With relativelyfew shares outstanding, and only an occasional lot put up for sale \"at the market,\"investors (perhaps insiders connected with the company) would succeed only inrunning the price up out of reach if they started to bid for the stock. So they simply\"hold a basket under it,\" as the saying goes, quickly picking up anything that is offeredbut never reaching for it,\n\nFigure 7.24 Cray Research, a powerhouse stock for over a decade. Trading at under$1.00 in 1976, it reached 135 3/4 before the late April gap, through the Bottom of aseven-week Diamond, started the decline. However, after the High-Volume Rally inmid-January, “CYR” also managed to form an impressive Rounding Top. The concavevolume pattern, clearly evident after the high-volume decline to Support that followedthe Diamond breakdown, was particularly significant in illuminating this ToppingPattern.\nuntil eventually the tree is shaken clean. Then they may raise their bids a point or so; ifthat seems to bring out a lot of stock for sale, they go back to their waiting tactics.\nVolume pattern at Tops\nThe volume pattern on Rounding Tops is seldom as clearly defined as at Bottoms.Indeed, it is apt to be rather high and irregular throughout the entire rounding-overmovement in prices. Under scrutiny, one can usually see some signs of a change fromBullish to Bearish activity in the Minor Fluctuations after the peak has been passed, butthe volume warnings do not become conspicuous in most cases until the downtrend hasbegun to accelerate toward the vertical.\nWe know of no measuring formula that can be applied to Rounding Turns (except forthe minimum qualifications we mentioned in connection with Head-and-Shoulders, thatis, they cannot be counted on to produce a greater move than the preceding price swingin the opposite direction), but they almost never deceive. Their implications can beroughly estimated from the magnitude of the trends that led to them and the length oftime they take in the rounding-over process. The Rounding Turns that often appear onweekly and monthly", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 42}
{"text": "n connection with Head-and-Shoulders, thatis, they cannot be counted on to produce a greater move than the preceding price swingin the opposite direction), but they almost never deceive. Their implications can beroughly estimated from the magnitude of the trends that led to them and the length oftime they take in the rounding-over process. The Rounding Turns that often appear onweekly and monthly charts, thus, have major import.\nThis leads us to the general consideration of weekly and monthly chart patterns. Thusfar, we have been speaking in detail of only daily chart developments, but all of theformations we have taken up appear, as well, in the much larger swings into whichdaily movements\n30\n28\n26\n24\n22\nNORTHERN INDIANA PUBLIC' SERVICE NI 1984\n14\n13\n11\nSales\n100's\nill\n^ L , P „ AY JUNE . J ULY\n■7 14 21 28 4 11 18 25 3 1017 24 31 7 14 21 28 5 12 19 26 2 9 16 23 30 7 14 21 28 411 18 25 1 8 15 22 29 6 13 XD. 375 XD. 39 XD .39\nFigure 7.25 1984. We love the Scalloping tendency of Northern Indiana PublicService. Although it is obviously not a pattern portending rocket-like advance, thetechnical picture brightens with the high-volume breakout through Resistance at chartend.\nare condensed on weekly and monthly charts, and with identical significance. Thus,volume record may not be quite so easy to read (climactic activity may occur on oneday of a week and the other days run dull, which would not show at all in the week'stotal figure), but it is less critical and may almost be disregarded. Head-and-ShouldersTops are particularly plentiful on monthly charts and should be accorded due respect. Infact, any clearly defined pattern, which is built to completion on a weekly or monthlychart, is proportionately significant (bearing in mind that “a Reversal must havesomething to reverse”).\nTaylor & Francis\nTaylor & Francis Group\nhttp://taylorandfrancis.com\nchapter eight\nImportant Reversal Patterns: the Triangles\nWe come next to an entirely different family of technical patterns, the\nTriangles, a group that has not been as well represented on the charts of the\ndecade of the 1940s as it was during the 1920s and 1930s (EN10: In\nplentiful supply in modern markets of the 2000s). Their scarcity in that\ndecade is regrettable because they are an intriguing lot with excellent profit\npotential. Before we examine them in detail, however, a quick review of the\nbasic theory, which gives meaning and value to technical analysis, may be\nappropriate. That theory can be summarized in the following brief\nstatements (see Figures 8.1 through 8.25).\n1. The market value of a security is determined solely by the\ninteraction of supply and demand.\n2. Supply and demand are governed at any given moment by many\nhundreds of factors, some rational and some irrational. Information,\nopinions, moods, and guesses (shrewd or otherwise) as to the future\ncombine with blind necessities in this equation. No ordinary man can\nhope to grasp and weigh them all, but the market does this\nautomatically.\n3. Disregarding Minor Fluctuations, prices move in trends that persist\nfor an appreciable length of time.\n4. Changes in trend, which represent an important shift in the balance\nbetween supply and demand, however caused, are detectable sooner or\nlater in the action of the market itself.\nBy this time, the fact expressed in the italicized words of the last statement\nmay have begun to raise some misgivings in your mind. The complaint that\nthe Dow Theory is often “late” has already been discussed. The Reversal\nPatterns studied in the two preceding chapters give no certain signal until\nafter the trend has changed, usually “sooner” as compared with Dow\nTheory, but never at the absolute top or bottom price. The man who sells a\nstock as soon as, but not until, a Head-and-Shoulders Top has been\ncompleted on its chart may cash in on no more than half of the total decline\nfrom its extreme high to extreme bottom; this is due to the very terms of our\nmeasuring formula, the first half of the decline can have taken place before\nthe Top Reversal Formation was finally confirmed.\nMake up your mind that there is no help for it. Somebody managed to sell\nhis shares at the very top eighth of a point on the peak of the Head (and\nsome poor devil bought them). The seller was just plain lucky. His exploit\ncan be truly compared with a hole-in-one in golf; even a complete duffer\noccasionally enjoys that thrill. But the more experienced a player, the better\nsatisfied he is to land safely on the green and not too far from the cup. The\nmore experienced an investor, the less concerned he is with getting the last\npoint, or even the last 10 points, out of his market commitments.\nNo one can ever be sure at the time that he is selling at the final high. No\nrules or methods have ever been devised—or ever will be—to ensure\nbuying within fractions of the Bottom or selling within fractions of the Top.\nOf course, a man can make certain of buying a stock at its absolute low\nprovided he is prepared to take at that figure every last\n26\n24\n22\n20\n19\n18\n17 Sales 100's\n50\n40\n30\n20\n10\nHUDSON BAY MINING & SMELTING\nHD\n111\nS O N D '\nr F ’M\ni\nT F ‘ M^A—M: II : A--S 1 O~’~N ; D '\nFigure 8.1 A fine Symmetrical Triangle Reversal Formation on a weekly\nchart. Upper boundary sloping down from February 1942 recovery high at\n21 and lower boundary sloping up from “Pearl Harbor” Bottom at 16 3/8\nconverge to an apex of about 18 5/8. From this Major Bottom Pattern,\n“HD” advanced to 45 in 1946. Note the shrinkage in volume as a pattern\nformed and the increase as the price broke out through the Top in October\n1942. Breakout came not quite three-quarters of the way over from the first\nTop to the apex.\n48\n44\n40\n38 Sales 100's 250 200 150 100\n50\n1946\nSEARS, ROEBUCK\n_ APRIL MAY JUNE JULY AUGUST SEPTEMBER\n6 13 20 27 4 11 18 25 1 8 15 22 29 6 13 20 27 3 10 17 24 31 7 14 21 28’\nFigure 8.2 Sears Roebuck made a Symmetrical Triangle Reversal at its Bull\nMarket Top in 1946, and then it went into another long Triangle that turned", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 43}
{"text": "ame not quite three-quarters of the way over from the first\nTop to the apex.\n48\n44\n40\n38 Sales 100's 250 200 150 100\n50\n1946\nSEARS, ROEBUCK\n_ APRIL MAY JUNE JULY AUGUST SEPTEMBER\n6 13 20 27 4 11 18 25 1 8 15 22 29 6 13 20 27 3 10 17 24 31 7 14 21 28’\nFigure 8.2 Sears Roebuck made a Symmetrical Triangle Reversal at its Bull\nMarket Top in 1946, and then it went into another long Triangle that turned\nout to be a Consolidation rather than Reversal Formation. (Logarithmic\nvolume scaling minimizes volume variations.) Sell signal was given at 44\n1/2 and again at 41. Decline continued to 30 1/2.\n80\n76\n72\n68\n64\n60\n56\n52 Sales 100's\n50\n40\n30\n20\n10\nS' O 'N ' D 1 J ' F ' M ' A 1 M J 'J 'A » S ' O ' N ' D ' J ' F 'M\nFigure 8.3 Johns-Manville's Primary Trend Reversal in 1942 developed out\nof a Symmetrical Triangle that also had some aspects of a Head-and-\nShoulders Pattern with a long right shoulder. Although this is a weekly\nchart, the volume here is worthy of detailed study in connection with the\nprice action. “JM” (old stock) advanced more than 100 points in the next\nfour years.\nshare offered, even to the entire outstanding issue if necessary. It might, in\ntheory, require as much as $3.7 billion to “put a bottom” under U.S. Steel at\n70 (EN9: ca. 1950s) in case you are tempted.\nThe reader, who at this point may think we “protest too much,” will see\nmore excuses for the foregoing remarks when we take up the habits of\nTriangles, for these formations are not always indicative of Trend Reversal.\nOn the contrary, except in certain rather uncommon varieties, they are more\napt to signal what may most conveniently be termed Consolidation,\nterminating an up or down move only temporarily and setting the stage for\nanother strong move in the same direction later on. (Schabacker called such\nchart formations “Continuation Patterns.”) The reason for including\nTriangles in this section of our studies under the general heading of\nReversal Formations is that they do, at times, develop at periods of Major\nTrend change, and those are, by all odds, the periods that are the most\nessential for the investor to recognize.\nSymmetrical Triangles\nThe most common form of a Triangle is composed of a series of price\nfluctuations, each of which is smaller than its predecessor, each Minor Top\nfailing to attain the height of the preceding rally, and each Minor Recession\nstopping above the level of the preceding Bottom. The result is a sort of\ncontracting “Dow Line” on the chart—a sideways price area or trading\nrange whose Top can be more or less accurately defined by a down-slanting\nboundary line and whose Bottom can be similarly bounded by an up-\nslanting line. This type of Triangle is called a Symmetrical Triangle. If we\nwanted to make a more accurate application of the language of geometry,\nwe might better call it an Acute Triangle because it is not at\nFigure 8.4 Logarithmic price scaling on weekly chart emphasizes important\ntechnical developments at low price levels. “DH's” Symmetrical Triangle\nBottom started a Bull Market that reached 57 in 1945. Note the Throwback\nto apex of Triangle, not an uncommon development. The apex itself is a\nstrong Support (see Chapter 13).\nall necessary that its Top and Bottom boundaries be of equal length or, in\nother words, that they make the same angle with the horizontal axis.\nHowever, there is a very strong tendency in these formations to\napproximate the symmetrical form; so, the established name will do well\nenough. This pattern is also sometimes referred to as a “Coil.”\nWhile the process of contraction or coiling, which makes up the price action\nof the Symmetrical Triangle Pattern, is going on, trading activity exhibits a\ndiminishing trend, irregularly perhaps, but nevertheless quite noticeably as\ntime goes on. The converging upper and lower boundary lines of the price\nformation come together somewhere out to the right (the future in the time\nsense) of the chart, at the apex of our Triangle. As prices work their way\nalong in narrower and narrower fluctuations toward the apex, volume ebbs\nto an abnormally low daily turnover and, if we are dealing with a typical\nexample, comes the action that first suggested the name “Coil.” Suddenly\nand without warning, as though a coil spring had been wound tighter and\ntighter and then snapped free, prices break out of their Triangle with a\nnotable pickup in volume, and leap away in a strong move that tends to\napproximate in extent the up or down move that preceded its formation.\nThere is seldom any clue given on the one chart containing the Triangle to\ntell in which direction prices are going to break out of the pattern until that\naction finally occurs. Sometimes you can get a pretty good idea of what is\nlikely to happen by observing what is going on at the same time in the\ncharts of other stocks (which is an important topic for\n28\nCUBAN - AMERICAN SUGAR\n26\n24\n1945\n22\n20\n19\n18 Sales 100's 125 100\n75\n50\n25\nAUGUST\nSEPTEMBER OCTOBER NOVEMBER DECEMBER\"\n7 14 21 28 4 11 18 25 1 8 15 22 29 6 13 20 27'3 10 17 24 1 8 15 22 29 ’\nFigure 8.5 Triangles often form as a part of a larger and more important\npattern of some other type. Here a symmetrical figure constitutes the latter\nhalf of a Rounding Turn. Note the premature breakout on October 17, return\nto pattern, and then final breakaway on November 8.\n24\n22\n20\n19\n18\n17\n16\n15\n14 Sales 100's 125 100\n75\n50\n25\nNATIONAL GYPSUM NG\nRY\nJUNE\n“ FEBRUARY MARCH “ APRIL-----MAY------JUNE--------JULY\ni 3 1017 24 3 4047 24 31 7 44 21 28 5~12 1926- 2 : <462338 7 i 14 >2128’\nFigure 8.6 Prices in this Symmetrical Triangle squeezed way out into the\napex before erupting. Breakout at that stage is unreliable; above is a fair\nsample of the false moves that occur there. Real move was down.\n16\n15\n14\n24\n22\n20\n19\n18\n17\nFigure 8.7 Recovery rallies from “Panic” Bottoms are often capped by\nTriangles, for those are periods in which doubt and indecision are prevalent.\nThe doubt in such cases, however, is usually resolved in favor of renewed\ndecline.", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 44}
{"text": "he\napex before erupting. Breakout at that stage is unreliable; above is a fair\nsample of the false moves that occur there. Real move was down.\n16\n15\n14\n24\n22\n20\n19\n18\n17\nFigure 8.7 Recovery rallies from “Panic” Bottoms are often capped by\nTriangles, for those are periods in which doubt and indecision are prevalent.\nThe doubt in such cases, however, is usually resolved in favor of renewed\ndecline. “Panic” Bottoms seldom hold. This chart shows a typical\nSymmetrical Pattern topping the recovery from the famous Selling Climax\nof October 19, 1937. Note Pullback to apex. later discussion). Often,\nhowever, there is nothing to do but wait until the market makes up its mind\nwhich way to go. And “making up its mind” is just what the market seems\nto be doing when it builds a Triangle; everything about this pattern appears\nto exemplify doubt, vacillation, and stalling until finally a decision is\nreached.\n\nSome cautions about Symmetrical Triangles\nA compact, clean-cut Triangle is a fascinating picture, but it has its tricky\nfeatures. The beginner in technical chart analysis is quite naturally prone to\nlook for Triangles constantly, and will often think he has detected them\nwhen, in fact, something entirely different is in the process of development.\nRemember, it takes 2 points to determine a line. The top boundary line of a\nprice area cannot be drawn until two Minor Trend Tops have been definitely\nestablished, which means prices must have moved up to and then down\naway from both far enough to leave the two peaks standing out clear and\nclean on the chart. A bottom boundary line, by the same token, cannot be\ndrawn until two Minor Trend Bottoms have been definitely established.\nTherefore, before you can conclude that a Symmetrical Triangle is building,\nyou must be able to see four Reversals of Minor Trend. If it comes after an\nadvance in prices, you must first have a Top, next a Bottom, then a second\nTop lower than the first, and finally a second Bottom higher than the first\nBottom (and prices must move up away from the second Bottom before you\ncan be sure it is a Bottom). Then, and only then, can you draw your\nboundary lines and proceed on the assumption you have a Symmetrical\nTriangle.\n26\n24\n22\n20\n19\n18\n17\n16 Sales 100's 125 100\n75\n50\n25\nVERTIENTES - CAMAGUEY SUGAR\n1946\n’ 6 13 20 27 4 11 18 25 18 15 22 29 6 13 20 27 3 10 17 24 31 7 14 21 28\nFigure 8.9 The other side of the story—an imposing Symmetrical Triangle\nwhich failed badly, although for the alert and experienced technician, there\nwere warnings of something amiss in March and April. Eastern Airlines\nbuilt, in late 1946 and early 1947, a formation which, so far as price pattern\nwas concerned, left little to be desired. Prices broke out topside decisively\nin late March. A Throwback in April met normal Support at the upper\nTriangle boundary, but the subsequent advance fell short, weakened, and\nfinally broke down, producing an “end run” around the apex. Warnings\nreferred to were high and irregular volume, particularly on reactions, in\nFebruary and March—not characteristic of valid Triangle development—\nand failure of prices to push up rapidly and vigorously after the April 14\nThrowback.\nFigure 8.8 A Major Symmetrical Triangle Top in which prices squeezed out\ninto the apex and then produced a false move upside (see Figure 8.6).\n“VEC,” as a matter of fact, was a bad actor technically, but this particular\nbreakout would be suspect anyway.\nAPRIL\nEASTERN AIRLINES EAL\n24\n22\n20\n19\n18\n17\n16 Sales 100's\nJ\n'■I\n4\n...A..\nNOVEMBERDECEMBER JANUARY\ni 9 16 23 30 7 14 21 28 4 11 18 25 1\n;EBRUARY MARCH\n8 15 22 1 U 8 15 22 2\nAUGUST SEPTEMBER\n9 16 23 30 6 13 20 27 4\n19\n18\n17\n16\n15\n14\n13\n12\n11\n10\n9 Sales 100's\n50\n40\n30\n20\n10\nFigure 8.10 A weekly chart. The seventh-month Consolidation area of 1944\n—in “NG,” undefinable at first, developed eventually into a typical\nSymmetrical Triangle. Two months after the high-volume breakout in\nJanuary 1945, prices reacted nearly to apex level and then pushed away\nrapidly. Minimum measuring implications of this Triangle were satisfied at\n16.\nFigure 8.11 A small Symmetrical Triangle that tended toward the\n“Ascending” type. Note that the higher volume that developed within this\npattern in early January came on a rally. This sort of action is fairly typical\nof very “thin” stocks.\nAMERICAN BANK NOTE\nABN\nFigure 8.12 An Ascending Triangle 10 months long, which was the start of\na Major Bull Trend, carrying “ABN” to 45. Refusal of prices to react to the\nlower pattern boundary, as here in August 1942, is a frequent development\nin strong formations, a warning of near completion and breakout.\n38\nSales\n100's\n1946\nCELANESE CORPORATION CZ\nJlll.iliiiliilLilnliillil.llil. lllliyihiliiillLliUliii\nJANUARY FEBRUARY^ MARCH ~ APRIL _ MAY JUNE\n6 13 20 27 3 10 17 24 3 10 17 24 31 7 14 21 28’ 5 12 19 26 2 9 16 23 30'\nFigure 8.13 Premature breakouts from Right-Angle Triangles, such as\nappeared in Celanese in March 1946, are temporarily disappointing to the\ntrader who buys on them, but they eventually work out all right. Celanese,\nbefore its 1946 split, was subject to frequent and peculiar shakeouts, as here\non March 9 and 26.\n26\n24\n22\n20\n19\n18\n17\n16\n15\nSales 100's\n50\n40\n30\n20\n10\nBRIGGS MANUFACTURING CO.\nik\nM2 J ' J A sjo'nj d;j’ F ’M\nLife.\nS' O ' N ' D~'~J\nJliUi\nT\"\n1 Hil'L\n1 ]l •n\nj r:**\nFigure 8.14 A steep recovery from a Panic Bottom (the “Pearl Harbor”\nselling) flattened out into a fine Ascending Triangle. Note the horizontal\nSupply Line at 19, above a gradually rising Demand Line. The breakout at\nthe end of September signaled initiation of an advance of some\nconsequence. It turned out to be a Primary Bull Market, which took Briggs\nup to 53.\n112\nSEARS ROEBUCK\n104\n96\n88\n80\n76 Sales 100's 125 150\n25\n50\n25\nOCTOBER NOVEMBER DECEMBER 'JANUARY FEBRUARY\nMARCH\nFigure 8.15 Sears' 1936 Bull Market Top was a Symmetrical Triangle, out\nof which it declined 15 points. An Ascending Triangle then produced an\nIntermediate Recovery to the Supply Zone (see Chapter 13) at the", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 45}
{"text": "quence. It turned out to be a Primary Bull Market, which took Briggs\nup to 53.\n112\nSEARS ROEBUCK\n104\n96\n88\n80\n76 Sales 100's 125 150\n25\n50\n25\nOCTOBER NOVEMBER DECEMBER 'JANUARY FEBRUARY\nMARCH\nFigure 8.15 Sears' 1936 Bull Market Top was a Symmetrical Triangle, out\nof which it declined 15 points. An Ascending Triangle then produced an\nIntermediate Recovery to the Supply Zone (see Chapter 13) at the lower\nside of the top Triangle. Compare this chart with the 1946 Top in Figure\n8.2.\n40\n38\n36\n34\n32\n30\n28\n26\n24\n22\n20 Sales 100's\n50\n40\n30\n20\n10\nSOUTHERN RAILWAY PFD.\nAPRIL MAY JUNE JULY AUGUST\n: 4 :11 18 25 2 9 16 23 30 6 13 20 27 4 11 18 2^ 1 ' 8 15'23 29 '\n1936\nFigure 8.16 An Ascending Triangle at an Intermediate Bottom. This chart\nruns from April through August 1936. Extreme shrinkage in trading volume\nduring this formation indicated a very strong technical situation.\nAnother point to remember—and one that does not conform at all to the\n“Coil” simile— is the farther out into the apex of the Triangle prices push\nwithout bursting its boundaries, the less force or power the pattern seems to\nhave. Instead of building up more pressure, it begins to lose its efficacy\nafter a certain stage. The best moves (up or down) seem to ensue when\nprices break out decisively at a point somewhere between half and three-\nquarters of the horizontal distance from the base (left-hand end) to the apex.\nIf prices continue to move “sideways” in narrower and narrower\nfluctuations from day to day after the three-quarter mark is passed, they are\nquite apt to keep right on to the apex and beyond in a dull drift or ripple that\nleaves the chart analyst completely at sea. The best thing to do in such cases\nis go away and look for something more promising elsewhere in your chart\nbook.\nA third tricky point is that it becomes necessary sometimes to redraw one or\nboth boundaries of a Triangle before it is finally completed (i.e., before\nprices break out and move away from it in a decisive fashion). This can\nhappen, for example, when, after the first two Rally Tops have established a\ndown-slanting upper boundary line, the third rally starting from the lower\nboundary pushes up and through the original Top line by a moderate\n19\n18\n17\n16\n15\n14\n13\n12\n11 Sales 100's\nARMOUR & COMPANY\nMARCH\nAUGUST SEPTEMBEROCTOBER\nNOVEMBER DEC'E.mBeRJANI ARY FEBRUAR\nFigure 8.17 One of the early 1947 disappointments (to the Bulls) was the\nfailure of “AM” to break out topside from the long Ascending Triangle\ndepicted above. Here is a case where supply at 15 finally overwhelmed\ndemand. A pattern such as this indicates a potentially strong underlying\nsituation for the long pull. Ordinarily, the consequence of an Ascending\nTriangle's “failure” of this sort is the development either of an extended\nRectangular base within the general range of the Triangle (in this case, 10 to\n15), or formation of a Double Bottom at or near the earlier low (in this case\nnear 10). However, “AM” dropped lower after several more attempts to\novercome the Major Supply at the 15 level, which was not substantially\npenetrated until 1955.\nmargin and then, without developing a recognizable breakout volume on\nthis move, stops short of surpassing the highest level of the preceding\n(second) pattern Top. When prices subsequently drop back again into\npattern, it is necessary to abandon the original upper boundary line and\ndraw a new one across the highs of the first and third rally tops.\nHow prices break out of a Symmetrical Triangle\nPrices may move out of a Symmetrical Triangle either up or down. There is\nseldom, if ever, as said above, any clue as to direction until the move has\nactually started, that is, until prices have broken out of their triangular “area\nof doubt” in decisive fashion. In a very general way, the precepts laid down\nfor breakouts from Head-and-Shoulders Formations apply here as well. For\nexample, the margin by which prices should close beyond the pattern lines\nis the same, roughly 3%. It is equally essential that an upside break in prices\nbe confirmed by a marked increase in trading volume; lacking volume, do\nnot trust the price achievement. But a downside breakout, again as in the\ncase of the Head-and-Shoulders, does not require confirmation by a pickup\nin activity. As a matter of record, volume does visibly increase in most\ncases, but in a majority of down breaks, it does not do so to any notable\nextent until after prices have fallen below the level of the last preceding\nMinor Bottom within the Triangle, which, as you can see, may be several\npoints lower than the boundary line at the place (date) of the actual\nbreakout.\nThe curious fact is a downside breakout from a Symmetrical Triangle\nattended to right from the start by conspicuously heavy volume is much\nmore apt to be a false signal rather than the start of a genuine downtrend\nthat will be worth following. This is particularly true if the break occurs\nafter prices have worked their way well out into the apex of the Triangle; a\nhigh volume crack then frequently—we might even say usually—develops\ninto\n12\n11\n10\n9\n8\n7\n6 Sales 100's 125 100\n75\n50\n25\nSOCONY-VACUUM OIL\ni\n' J ' A ' S ■ O ' N ' •D'1 T IM\n1\nS : O ' N 1 D ' J ‘M 1 M ’ A r M ; J\nFigure 8.18 The 1942 Bear Market Bottom in Socony-Vacuum was an\nunusual Head-and-Shoulders Formation, with the head consisting of an\nAscending Triangle. Note the increase in volume on the breakout from the\nTriangle in July and again on the break through Head-and-Shoulders\nneckline in October.\na two- or three-day “shakeout,” which quickly reverses itself and is\nfollowed by a genuine move in the up direction.\nAll of the above the reader will have undoubtedly found most\ndisconcerting. Here is a pretty technical pattern, and it cannot always be\ntrusted. Unfortunately, Symmetrical Triangles are subject to false moves to\na far greater extent than the Head-and-Shoulders Formation or any of the\nother formations we have discussed or will discuss later. Unfortunately,\nsome of these false moves can", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 46}
{"text": "p direction.\nAll of the above the reader will have undoubtedly found most\ndisconcerting. Here is a pretty technical pattern, and it cannot always be\ntrusted. Unfortunately, Symmetrical Triangles are subject to false moves to\na far greater extent than the Head-and-Shoulders Formation or any of the\nother formations we have discussed or will discuss later. Unfortunately,\nsome of these false moves cannot be identified as such until after a\ncommitment has been risked (although good trading tactics should prevent\ntheir occasioning much more than a trivial loss). Unfortunately again, even\na typical shakeout, such described in the preceding paragraph, may produce\na double cross, proceeding right on down in a genuine decline. No technical\nchart formation is 100% reliable and, of all our present subject, is the worst\noffender.\nBut most Symmetrical Triangles—lacking an actual statistical count, our\nexperience would suggest more than two-thirds of them—behave\nthemselves properly, produce no false signals that cannot be spotted before\nany damage is done. Upside breakouts on high volume may be premature in\nthe sense that prices return to pattern and do some more “work” there\nbefore the genuine uptrend gets under way, but they seldom are false. We\nshall have a little more to say about false signals in this chapter and more\nlater on that we trust will be helpful in developing the experience a trader\nneeds to defend himself against them.\n125\n100\n75\n50\n25\nSales\n100's\nBATH IRON WORKS\nilk\nJUNE\n: I\nJANUARY FEBRUARY MARCH APRIL MAY \" JUNE\n5 12 19 26 2 9 16 23 2 9 16 23 30 6 13 20 2^ '4 11 18 25 1 8 15 22 29\nFigure 8.19 Due to a dividend of $1.00 went ex on March 14, the lower\nboundary of this Descending Triangle Top in “BIW” had to be dropped 1\npoint from 33 and redrawn at 32. Despite the added leeway thus afforded,\nhowever, the original pattern implications were quickly carried out. Prices\npulled back three times to the new lower boundary line of this Triangle on\nApril 4, April 16, and May 31—unusual, but explained by the existence of a\nstrong general market uptrend during this period. Whenever a stock goes\nex-dividend during the formation of an Area Pattern of any type, the lines\nbounding that pattern should immediately be adjusted to the new value by\nlowering them a distance corresponding to the amount of the dividend.\nA typical Triangle development\nThe several actual chart examples of Symmetrical Triangles that illustrate\nthis chapter will serve, we trust, to give the reader a working acquaintance\nwith their appearance in various manifestations. Yet it may help to clear up\nsome of the more important points if we describe in detail just how a typical\npattern develops step by step. Let us suppose you are watching a stock on\nyour charts that has climbed, with only the normal, brief hesitations and\ninconsequential reactions, from around 20 to 30, 32, 35, and is still moving\nup. (Let's hope you bought it at 20!) Lower down, its turnover ran between\n300 and 600 shares daily, but now, above 30, it has attracted quite a\nfollowing, and daily volume has increased to around 1,000. As it\napproaches 40, activity shoots up to nearly 2,000 shares, the market\n“churns” between 39 and 40, and then prices begin to drop. As they fall\nback, you (especially if you own the stock) watch it with some concern, but\nyou know it is hardly likely that it is going to go straight down again to 20;\nstocks do not act that way. (EN9: Sometimes they do now, in the twenty-first\ncentury.) If the trend of this issue has actually been reversed, it should,\nnevertheless, spend some more time and effort around its top levels and\nmake some sort of a Distribution Pattern.\nREVERE COPPER & BRASS\n1946\n20\n19\n18\nSales 100's 125 100\n75\n50\n25\n....... APR I L .......... M AY \" * J UNE H J ULY AUGUST \"S EPTEMBER\n6 13 20 27 4 11 18 25 1 8 15 22 29 6 13 20 27 3 10 17 24 31 7 14 21 28’\nFigure 8.20 On the basis of “fundamentals,” Revere was an attractive\nholding in 1946, which may account for its reluctance to “give up” when\nthe market generally started downhill in earnest in June of that year. Its\nfluctuations from mid-May to late August constructed a fine, large\nDescending Triangle, in which, however, Bearish Volume Signals had\nalready appeared in late June and on July 23. The breakout came (with a\nwide Breakaway Gap) on August 27. Prices clung to the edge of the pattern\nfor four days and then collapsed. The small formations outlined in April and\nMay are Flags, to be discussed in Chapter 11.\nThe decline continues for 10 days with the turnover also declining quite\nappreciably. By the time prices have worked back to 33, volume is running\nat about 700 shares daily. At 33, it may pick up again for a single day to 800\nor 900 shares, but the reaction stops there, and after a day or two, prices\nbegin to climb again with little change in their turnover rate. In eight or nine\ndays, quotations have gotten back into the upper 30s and activity increases\nand reaches, say, 1,200 shares on the day 39 is reached. Instead of going on\nto 40 or beyond, however, a new reaction sets in and prices drift back to 37.\n(Perhaps you will find this growing picture easier to visualize if you pencil\nits development on a scrap of chart paper.) Now it is evident that a second\nTop has formed at 39; you can now draw a tentative pattern line (there are\nother names for this, as we shall see later) on your chart across the two\nextreme high ranges (not closing prices), which will slant downward from\nleft to right. So far you have only one Bottom point, so you cannot draw\nlines from that, but this second decline brings out even less trading activity\nthan the first. Volume ebbs to 400 shares and the down move halts at 34; the\nprice track “rounds out” and turns up again; trading is very dull, but it\nbegins to pick up as 36 is reached.\nThis action defines a second Minor Bottom and now you can draw a\nBottom “tangent,” an up-slanting line across the extreme low prices\nregistered on the two reactions, th", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 47}
{"text": "ecline brings out even less trading activity\nthan the first. Volume ebbs to 400 shares and the down move halts at 34; the\nprice track “rounds out” and turns up again; trading is very dull, but it\nbegins to pick up as 36 is reached.\nThis action defines a second Minor Bottom and now you can draw a\nBottom “tangent,” an up-slanting line across the extreme low prices\nregistered on the two reactions, the first at 33 and the second at 34. Your\ntwo pattern lines will converge, meeting near the 36H\nFigure 8.21 The 1937 Bull Market Top in Westinghouse was this\nDescending Triangle, which started in January and broke on February 15.\nPrices hung at the lower edge of the Triangle for four days, fell away, and\nthen pulled back to its lower line on March 4 at the time when the general\nmarket Averages were making their final Bull highs.\nlevel about four weeks ahead (i.e., to the right) on your chart. You have a\nSymmetrical Triangle—but you do not know whether prices are going to\nfall out of it eventually or shake off present doubts and push up in a new\nadvance worth following. You can only watch further developments very\nclosely and be prepared to take whatever action is, in due time, indicated.\nThe second rally picks up a little in activity, attains a daily turnover of about\n700 shares, and pushes up to 38 and on for part of a day to 38 3/4. This\nnudges through the previously drawn pattern line by perhaps a quarter of a\npoint (because each swing is shorter in points traveled and, accordingly, in\nduration). But the volume on this Minor Penetration is less than on the\npreceding Top (at 39) and buying again ebbs. As the price range line falls\nback to 37 and 36, draw a new upper tangent across the first Top at 40 and\nthe last Top at 38%. There is the suggestion here in this slight “lift” that the\nbalance may be swinging slightly to the demand side, but do not count on it.\nPinpoint accuracy is not to be expected; Triangles must be allowed some\nleeway.\nOn the third reaction, activity dwindles away to the lowest yet. The up-\nslanting Bottom boundary will be reached at about the 35 level, if prices\ncontinue their present course. It is worth noting now whether they will\ncome all the way down to it this time because if they do not—if their\nrecession is halted half a point or so above it—that action would give some\nsignificance to the previous bulge through the upper boundary. But this\ndoes not happen; the drift continues right on down to 35, and now volume is\nrunning at the rate of only 200 shares daily, less than it ran in the early\nstages of the original advance above 20. This is a critical spot. The price\ntrack flattens out momentarily, turns up feebly, yet keeps hitching\nFigure 8.22 A series of Triangles, Symmetrical and Descending, which\nevolved during the 1929-1932 Bear Market in Hudson Motors. Note that at\nno time during this decline did anything resembling a Major Bottom appear.\nNote also how each Triangle's measuring implications were carried out\nbefore any temporary halt or consequential rally developed. Follow your\ndaily charts for the proper timing of your trading operations but keep an eye\nalways on the long-range pictures that evolve on weekly and monthly\nprojections, so as to maintain your perspective on the Major Trend.\nup, crosses 36%, picks up activity, reaches the (new) upper Triangle\nboundary at 37% and, on the next day, punches through on a turnover of\n1,500 shares to close at 39%. This is a breakout; the doubt is resolved and\n(barring a false move, unlikely at this point) the trend is once again up.\nNote that it was not necessary for prices to surpass the previous high at 40\nto produce this signal—that is one of the interesting things about\nSymmetrical Triangles.\n\nFigure 8.23 The curious, and in its early stages confusing, Major Bottom\nFormation that American Rolling Mills constructed in 1941-1943. The\nrecovery from the “Pearl Harbor Panic” of 1941 ran into a large\nSymmetrical Triangle that broke out on the downside in April 1942. The\nsubsequent decline satisfied the measuring requirements of that Triangle,\nbut it did not carry below the December low. The rally of June and reaction\nof August-September built the whole area out into another and larger\nSymmetrical Triangle, out of which prices broke on the upside in\nSeptember. Then the reaction to the apex of the latter, in December 1942,\nand the following advance built up into a 15-month Ascending Triangle,\nwhich constituted the final Major Bottom for a trend that carried prices up\neventually to 42 in 1946. The low volume on the June and August-\nSeptember reactions, the increase on the October markup, and, even more,\nthe January 1943 rise and breakout in February were unmistakably of Major\nBullish implications. It takes time, remember, to build a foundation for a\nBull Market.\nReversal or Consolidation\nWe started to discuss Symmetrical Triangles as Reversal Patterns, yet our\nexample has turned out to be, instead, a Consolidation Pattern, that is, only\na sort of resting stage in a continued uptrend. Well, three out of four of these\nformations will turn out to be just that; the fourth is the dangerous one (if\nyou own the stock). How would it differ?\nThe example described might have been a Reversal instead of a\nConsolidation Formation any time up to the point of the decisive\nbreakthrough to 39. If it had been a typical Reversal, the first change\nprobably would have appeared shortly after the final rally started up from\nthe third Bottom at 35. That rally would have petered out at about 36%, and\nprices would have started to drift back again. Then, with the activity\nincreasing slightly, the Bottom boundary would be penetrated. As\nquotations dropped to 34, daily volume might mount to 600 or 700 shares.\nAny further decline would constitute a down signal, resulting in a further\npickup in turnover and an acceleration in the price decline as the stop-loss\norders (to be discussed later) spotted under 34 were “touched off.”\nBefore we leave our typical examp", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 48}
{"text": "activity\nincreasing slightly, the Bottom boundary would be penetrated. As\nquotations dropped to 34, daily volume might mount to 600 or 700 shares.\nAny further decline would constitute a down signal, resulting in a further\npickup in turnover and an acceleration in the price decline as the stop-loss\norders (to be discussed later) spotted under 34 were “touched off.”\nBefore we leave our typical example, we might make some mention of the\npost-breakout reactions or Pullbacks that sometimes occur. As in the case of\nthe Head-and-Shoulders\n36\n34\n32\n30\n28\n26\n24\n22\n20\n19\n18\n17\n16\n15\n14\n13\nSales 100's 250 200 150 100\n50\nGOODRICH ( B. F. ) COMPANY\nlull\n-L\nL X\n~F ‘ M 1 AM J\nLU\n'J'A'S'O'N'D'J’F'M\nA\nS O~N—D 1 J\nFigure 8.24 A beautifully compact Ascending Triangle that turned out to be\nthe Major Bear-to-Bull Reversal in Goodrich in 1942. The breakout from\nthis pattern (in April) was not signaled by any extraordinary pickup in\nactivity so far as this weekly record shows (but remember significant\nvolume detail is often hard to see in a weekly plotting). The Triangle's\nmeasuring implications were carried out by the first upswing, which\nreached 18)4 at the end of May. Supply had to be absorbed in the 18 to 21\nrange (refer to this chart when you study Support and Resistance in Chapter\n13), but a Major Up Signal was given in September when prices erupted\nthrough that zone with a conspicuous increase in trading volume.\nFormation, the initial breakout move from a Symmetrical Triangle may halt\nbefore prices are carried very far away from the pattern and be followed by\na Minor Reaction, usually lasting only two or three days, which will carry\nquotations back to the nearest pattern boundary. Thus, in our first example\nin which the break, when it came, took our stock up through the top side to\n39/, the next day might have seen a push on to 40, and then prices might\nhave backed off again in a couple of days of decreased activity to 37% or\n38. The up-move would then normally be resumed with greater vigor.\nDownside breakouts are sometimes followed in much the same manner by\npullbacks to the lower boundary\nebay Inc-(Nasdaq NM) 57.75 0.240 0.417%\n-\nX\nA\n/ T\nr w\n— --4—\n-3 w\nn i\nill 1998-2003 Prophet Financial Systems, Inc. I Terms of use apply.\nVolume (Millions)\ni J . . 1 11\nILJ!\n02 Apr Jul Oct 03 Apr Jul Oct\n63\n57\n51\n45\n42\n39\n36\n33\n30\n27\n24\n125\n100\n75\n50\n25\n0\nFigure 8.25 A real-time chart from prophet.net. The volume blowout in July\n2002 drew attention to eBay and the sloping line was drawn at that time.\nAlthough the lines are sloppy and the pattern is ragged, it looked at the time\nlike a Descending Triangle with all its implications. Nevertheless, when it\nbroke out of the pattern on emphatic volume in October 2003 the\nhandwriting was on the wall. eBay was for real. So, what's for real? It could\nreally make money, not just capture free eyeballs, like its internet brethren\nand sistern. It actually performed a service of economic benefit to many\npeople, unlike the internet fantasy follies. See Figure 10.26 for a longer\nperspective on eBay. Lessons for the attentive: power of trendlines; alarm-\nclock nature of unusual volume; not believing any forecast. Forecast in this\ncase would have been for a downtrend if, as it seemed, the pattern was a\ndescending triangle.\nof the pattern, after which the decline is resumed with an increase in\nvolume. However, these post-breakout reactions occur less often with\nTriangles than they do with Head-and-Shoulders Patterns.\nAnother matter we might take up before going on to study the next\nformation is the rationale of the Symmetrical Triangle. It may help to fix its\ncharacteristics in mind if we try to deduce what sequence of events might\ntypically produce it. Of course, any effort of this sort can result only in a\ngross oversimplification, which will not fit all of the Triangle's various\nmanifestations, but it is an interesting mental speculation—and one not\nwithout benefit to our understanding of the general theory of chart\nformations. Let us turn back again to our typical example. We started with a\nstock that ran up rather steadily from around 20 to 40 and then reacted. It is\nfairly obvious what happened at 40: many investors had substantial paper\nprofits, approaching 100% at that price. (A “round figure” such as 40, 50,\n75, or 100 is apt to become a sort of mental profit objective and, hence,\nbring in increased selling.) Some of them were ready to cash in and did so,\ntemporarily swinging the technical balance from demand to supply; they\nsold less freely, of course, as prices receded. Other would-be investors had\nbeen attracted to the stock, but too late to “get aboard” below 30. Unwilling\nto “chase” it up to 40, they welcomed the reaction and, by the time prices\nhad dropped back to 33, enough of them were ready to buy to swing the\nbalance back again to the demand side of the equation.\nWatching the ensuing rally, however, were the owners of the stock who had\nfailed to grab their profits near 40 on the previous advance and had made up\ntheir minds to be a little less greedy if given a second opportunity. Their\nofferings began to come in above 37, say, and were sufficiently copious at\n39 to stem the advance at that level. Behind the scenes, we can imagine this\nprocess repeated again and again, with new money constantly coming in\nand meeting supply from owners increasingly anxious to cinch their profits.\nEventually, the offerings of the latter are all absorbed, or perhaps\nwithdrawn, and then professionals, as well as hopeful investors, suddenly\ndiscover there is no stock ahead on the books and rush to buy results.\nSince the advance (or decline) that follows the completion of a Symmetrical\nTriangle usually runs to worthwhile trading proportions (we shall discuss\nmeasuring implications later), there would be an evident advantage to the\ntrader who could tell in advance of the breakout which way prices were\ngoing to move. The odds are, as already stated, the new move will proceed\nin the same direc", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 49}
{"text": "buy results.\nSince the advance (or decline) that follows the completion of a Symmetrical\nTriangle usually runs to worthwhile trading proportions (we shall discuss\nmeasuring implications later), there would be an evident advantage to the\ntrader who could tell in advance of the breakout which way prices were\ngoing to move. The odds are, as already stated, the new move will proceed\nin the same direction as the one before the Triangle's formation. These odds\nare greatest, of course, in the early stages of either a Primary Bull or Bear\nMarket with the chances of Reversal increasing as those Major Trends\nmature. Nevertheless, the charts of other stocks often furnish valuable\ncollateral evidence; thus, if at the same time you detect a Symmetrical\nTriangle in the process of formation in “PDQ,” a majority of your charts are\nshowing Saucers or Head-and-Shoulders Bottoms or Ascending Triangles\nor some other pattern of typically Bullish import, it is a fair assumption that\nyour Symmetrical Triangle will break out topside. There are times when\nadvance indications of this sort are strong enough to justify taking a\nposition on it.\nThe Right-Angle Triangles\nWe mentioned Ascending Triangles in the preceding paragraph. The\nAscending and Descending are the Bullish and Bearish manifestations,\nrespectively, of our next class of patterns, the Right-Angle Triangles. In\nmany respects, in most in fact, they perform like their Symmetrical cousins,\nbut with this very gratifying difference: they give advance notice of their\nintentions. Hence, their names, for the supposition always is that prices will\nascend out of the Ascending form and descend from the Descending form.\nThe Symmetrical Triangles, as we have seen, are constructed of a series of\nsuccessively narrower price fluctuations that can be approximately bounded\nacross their Tops by a down-sloping line and across their Bottoms by an up-\nsloping line. Right-Angle Triangles are distinguished by the fact that one of\ntheir boundaries is practically horizontal, whereas the other slants toward it.\nIf the top line is horizontal and the bottom line slopes up to meet it\nsomewhere out to the right of the chart (at the apex), the Triangle is of the\nAscending persuasion. If the bottom line is horizontal and the top line\nslopes down, the Triangle is Descending.\nThese formations are perfectly logical and easy to explain. The Ascending\nTriangle, for instance, pictures in the simplest and most normal form what\nhappens when a growing demand for a certain stock meets a large block of\nshares for sale at a fixed price. If the demand continues, the supply being\ndistributed at that price will eventually be entirely absorbed by new owners\nlooking for still higher levels, and prices will then advance rapidly. A\ntypical Ascending Pattern starts to develop in much the same way as the\n“ideal” Symmetrical Triangle previously described, with an advance in our\ncertain stock from 20 to 40 at which point sufficient supply suddenly\nappears on the market to fill the orders of all buyers and produce a reaction.\nSensing the temporary satiation of demand, some owners may dump their\nholdings on the decline, but offerings are soon exhausted as prices drop\nback to, say, 34, and renewed demand then stimulates a new rally. This runs\ninto supply again at 40, and again, all buyers are accommodated at that\nlevel. The second recession, however, carries quotation down only to 36\nbefore another up-move develops. But the pool or inside group that is\ndistributing at 40 still has some of its holdings left to sell, so it may take\nmore time, another backing away and another attack at the 40 line before\nthe supply there is exhausted and the trend can push along up.\nA planned distribution\nThis type of market action evidences a planned campaign by owners of a\nfairly large quantity of shares to liquidate at a predetermined price. It\ncontains little of the element of doubt that we mentioned as characterizing\nthe Symmetrical Pattern. So long as demand persists, the distributing pool\nknows it can ultimately cash in its entire line at 40 and need not sell for less.\nIt is equally apparent, so long as demand keeps coming in at higher and\nhigher levels that, once the supply at 40 has all been absorbed, the market\nwill advance rapidly and easily. As soon as prices break out above 40, those\nwho took over the supply at that figure will feel their judgment has been\nvindicated and will not be disposed to sell until they, in turn, can register a\ngood profit.\nThe crux of the matter is contained in the two preceding sentences. Demand\nmust continue to come in at higher and higher levels, otherwise, our\nformation will cease to be an Ascending Triangle. Plus, the overhead supply\nmust eventually be absorbed, permitting an upside breakout. If demand\nbegins to falter any time before the Supply Line (horizontal Top boundary)\nhas been broken through, the ensuing reaction may drop prices down “out\nof pattern,” and then the chart technician is faced with the necessity of\nrevising his chart picture. One might think that such a development,\nblasting the earlier promise of the chart, would occur fairly often, but, as a\nmatter of experience, it is surprisingly rare. We say “surprisingly” because it\nis obvious that in many cases of Ascending Triangle development, the\ngroup selling creates its Top boundary or Supply Line must believe that\nlevel to be just about as high as the stock has any right to go. As holders of\na large enough block to influence the market for several weeks, sometimes\nmonths, their judgment is hardly to be scorned. Yet, once it becomes\nevident the lower boundary or Demand Line is slanting up, the odds are\ncertainly somewhere in the neighborhood of 9-1 that the new buyers will\neventually have the best of it.\nOn occasion, the third reaction or fourth reaction within an Ascending\nTriangle Formation will break down through the previously established up-\nslanting Demand Line (lower boundary), but it will be halted at the same\nle", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 50}
{"text": "omes\nevident the lower boundary or Demand Line is slanting up, the odds are\ncertainly somewhere in the neighborhood of 9-1 that the new buyers will\neventually have the best of it.\nOn occasion, the third reaction or fourth reaction within an Ascending\nTriangle Formation will break down through the previously established up-\nslanting Demand Line (lower boundary), but it will be halted at the same\nlevel as the previous reaction. The pattern from there on is apt to develop as\na Rectangle, a formation to be discussed in our next chapter, and should be\ntreated as such. (The tactics of trading on Ascending and Descending\nTriangles, including protection against the rare cases of collapse, will be\ntaken up in Section II.)\nDescending Triangles\nDescending Triangles have a horizontal lower boundary or Demand Line\nand a downsloping upper boundary or Supply Line. It is evident they are\ncreated by reverse market conditions than those of the Ascending Pattern;\nhowever, their implications are equally strong and their failures equally\nrare. Development of a Descending Formation hinges on a campaign by a\ngroup or syndicate (often an investment trust) (EN9: or Mutual Fund or a\ntakeover group) to acquire a large block of shares in a certain company at a\npredetermined price below the market. Their orders are placed and allowed\nto stand until executed at that level. If the successive rallies therefrom,\nwhich their buying generates, are stifled by new supplies of stock for sale at\nlower and lower levels (thus creating the typical Descending picture on the\nchart), orders to buy are eventually all filled and quotations break through\nand on down. The mere breaking of the critical line, which many traders\nhave seen function as a support under the market for a more or less\nextended period, often shakes the confidence of holders who had not\npreviously considered selling. Their offerings now come on the market and\naccelerate the decline.\nVolume characteristics same as the Symmetrical type\nThe volume section of the Right-Angle Triangle's chart requires little\ncomment. It will ordinarily present a picture practically identical with that\naccompanying the development of a Symmetrical Triangle. Activity tends\nto lessen as prices move out toward the apex. In the Ascending Formation,\nthere will usually be a pickup on each rally and an ebb in turnover on each\ndecline within the pattern; in the Descending Formation, the opposite is\ntrue, but sometimes it is not quite so evident. These Minor fluctuations do\nnot affect the overall diminishing trend of volume until the breakout point is\nreached.\nAs to breakouts, practically everything discussed about the Symmetrical\nTriangle will apply as well to the Right-Angle type. Upside breakouts (from\nan Ascending Pattern, of course) are attended by a conspicuous increase in\ntrading volume; if not, they should be treated as suspect. Downside\nbreakouts (from Descending Patterns) may not evince much of a pickup in\nactivity, but turnover usually speeds up the second or third day out of\npattern. Throwback reactions to the pattern's boundary line after a breakout\nare fairly common; their occurrence seems to depend largely on general\nmarket conditions. Thus, if prices break down out of a Descending Triangle\nin an individual stock at a time when the rest of the market is firm, a\nPullback Rally is fairly certain to intervene before any extensive further\ndecline takes place.\nThis chart, and a number that have preceded it, illustrate an important point\nfor the market technician that may well be restated here: When a large\nnumber of individual issues, after an extensive advance, make well-defined\nReversal Patterns of plainly Bearish import, break down out of them, and\nthen succeed only in pulling back no farther than their lower boundaries or\n“Resistance Lines” at a time when the Averages are going on up to new\nhighs, the whole market is in a dangerous condition and a Major Downturn\nis imminent. Divergences of this particular sort between many important\nissues and the Averages seldom develop at Intermediate Turns. The warning\nis particularly pointed when stocks of the caliber of Westinghouse, DuPont,\nGeneral Motors, and others fail to “confirm” new highs in the Averages.\nRefer back to Figures 6.3, 6.6, 6.9, and 8.15, for example, and compare the\n“timing” in those with the trend of the Averages for the same periods. The\nSaucer-Like Reaction Pattern of October to January in the above chart\nanalyzes into a Complex Head-and-Shoulders Consolidation, a formation\nthat will be taken up in Chapter 11.\nIncidentally, “WX” continued on down to 130 in April 1937, made a\nRectangle base there, and recovered to 158 (see above Descending\nTriangle) in August and then fell to 88 in November. Compare this daily\nchart with the monthly chart of “WX” for 1935 to 1938 in Figure 15.15.\nGood, reliable breakouts from Right-Angle Triangles usually occur at about\nthe same stage of pattern completion as they do in Symmetrical Triangles.\nThe earlier the breakout, the less apt it is to be a false move (although false\nmoves from Right-Angle Formations are considerably rarer, it should be\nnoted, than from Symmetrical). In those infrequent cases when prices\n“squeeze” right on out of the apex without producing a definite breakout,\nthe pattern seems to lose much of its power.\nMeasuring implications of Triangles\nIn Chapter 6, we stated a minimum measuring rule to apply to price\nmovements developing from a Head-and-Shoulders Formation, and we can\nlay down a somewhat similar rule for Triangles—one that applies to both\nthe Symmetrical and the Right-Angle species. The method of deriving the\nTriangle formula is not easy to explain in words, but the reader can\nfamiliarize himself with it quickly by studying its application on several of\nthe actual examples that illustrate this chapter. Assuming we are dealing\nwith an up-movement (upside breakout), draw from the Top of the first rally\nthat initiated the pattern (in other words, from its upper le", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 51}
{"text": "Angle species. The method of deriving the\nTriangle formula is not easy to explain in words, but the reader can\nfamiliarize himself with it quickly by studying its application on several of\nthe actual examples that illustrate this chapter. Assuming we are dealing\nwith an up-movement (upside breakout), draw from the Top of the first rally\nthat initiated the pattern (in other words, from its upper left-hand corner) a\nline parallel to the Bottom boundary. This line will slope up away from the\npattern to the right. Prices may be expected to climb until they reach this\nline. Also, as a rule, they will climb, following their breakout from the\npattern, at about the same angle or rate as characterized their trend before\nentering the pattern. This principle permits us to arrive at an approximate\ntime and level for them to attain the measuring line. The same rules apply\n(but measuring down, of course, from the lower left corner) to a descending\nmove.\nAlthough application of the above formula does afford a fair estimate of the\nextent of move to be expected from a Triangle, it is neither as definite nor\nas reliable as the Head-and-Shoulders formula. Do not forget the important\nqualification that the Triangle has somehow lost a part of its potential\nstrength if the breakout is delayed until prices are crowded into the apex.\nTriangles on weekly and monthly charts\nWe have seen in preceding studies how Head-and-Shoulders Formations\nmay appear on the long-range (weekly or monthly) charts and will have\nimportance commensurate with their size. Triangles also may develop on\nweekly charts with their implications usually clear and dependable, but the\ncoarse Triangular Patterns—which can be found on graphs of monthly price\nranges, especially the great, loose convergences that take years to complete\n— had better be dismissed as without useful significance.\nOther Triangular formations\nThere are other patterns of price consolidation or congestion that can be\nbounded by converging lines and might, therefore, be classified as\nTriangles. However, they deviate from the true Triangles of this chapter so\nmarkedly in one or more important respects that they are best treated under\nother headings elsewhere, such as Flags, Pennants, and Wedges. Still\nanother group of chart patterns develops between diverging boundary lines,\non which account they have sometimes been called Inverted Triangles. But\ntheir causes, characteristics, and forecasting implications are so radically\ndifferent that we have chosen to rename them Broadening Formations and\ndiscuss them in a later chapter.\nThe reader may have become dismayed at this point by our frequent\nrecourse to such qualifying adverbs as usually, ordinarily, and the like. It\ncannot be avoided if one wishes to present a true picture of what actually\nhappens. No two chart patterns are ever precisely alike; no two market\ntrends develop in quite the same way. History repeats itself in the stock\nmarket, but never exactly. Nevertheless, the investor who familiarizes\nhimself with the historical pattern, with the normal market action, and\nrefuses to be tempted into a commitment in the belief that “this time will be\ndifferent,” will be far and away ahead of the fellow who looks for the\nexception rather than the rule.\nThe beginner is proverbially lucky. He will find Triangles, Head-and-\nShoulders, or other significant patterns, one after the other, on his charts,\nwatch them develop, and see them carry through with profitable moves\naccording to rule, until the exception comes along—or he will overlook the\nlarger picture while concentrating on some Minor Pattern development—\nand suddenly awake to the fact he is caught in a very bad play. Hence, we\nconstantly emphasize the nonconforming movements. Our words of\nqualification are necessary because technical analysis of market action is\nnot an exact science and never will be.\nTaylor & Francis\nTaylor & Francis Group\nhttp://taylorandfrancis.com\nchapter nine\nMore important Reversal Patterns\nThe Rectangles, Double and Triple Tops\nThe Triangular Price Formations, which we examined in Chapter 8, can be either Reversal or ConsolidationPatterns. In the case of the Right-Angle Triangles, we know as soon as they have attained recognizable form inwhich direction the trend will (or should) proceed. With the Symmetrical Triangles, we have no way of knowingwhether they point up or down until prices finally break away from them, although the odds are, as we have seen,the previous trend will be continued rather than reversed. In this respect, and in many others, our next class oftechnical formations, the Rectangles, resemble the Symmetrical Triangles. There are, in fact, so many points ofsimilarity between them that we can forego any long and detailed discussion. (For illustrations in this chapter, seeFigures 9.1 through 9.18.)\nA Rectangle consists of a series of sideways price fluctuations, a “trading area,” as it is sometimes called, whichcan be bounded both top and bottom by horizontal lines. A glance at any one of the examples that illustrate thesepages will show how it got its name. On rare occasions, you may discover a chart pattern whose upper and lowerboundary lines are parallel but either slightly down-sloping or up-sloping. So long as their departure from thehorizontal is trivial, they may be treated as Rectangles. You will also find, on occasion, patterns whose boundaries,while nearly horizontal, tend somewhat to converge. These may be considered Rectangles or SymmetricalTriangles; it does not matter which because the “prognosis” will be the same in either case.\nIf you will give a quick mental review also to the Head-and-Shoulders, the Complex, and the Rounding types offormations, you will see how, if you disregard the volume part of their charts, any one of these patterns mightmerge or grade into a Rectangle. As a matter of fact, however, you will seldom be left in doubt as to properclassification because the circumstances of trading, the type of buying a", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 52}
{"text": "f you will give a quick mental review also to the Head-and-Shoulders, the Complex, and the Rounding types offormations, you will see how, if you disregard the volume part of their charts, any one of these patterns mightmerge or grade into a Rectangle. As a matter of fact, however, you will seldom be left in doubt as to properclassification because the circumstances of trading, the type of buying and selling, which produce Rectangles aredifferent, which is usually apparent.\nWe characterized the Symmetrical Triangle as a “picture of doubt.” The Rectangle might, with even greaterpropriety, be called a picture of conflict. Of course, any fairly compact price formation represents conflict in thesupply-demand sense. A Head-and-Shoulders Top, for example, portrays a conflict between “strong” sellers and“weak” buyers with the outcome already clearly seen before the combat has ended. But a Rectangle defines acontest between two groups of approximately equal strength—between owners of the stock who wish to dispose oftheir shares at a certain price and others who wish to accumulate the stock at a certain lower figure. They bat theball back and forth (up and down, that is) between them until ultimately, and usually quite suddenly, one team isexhausted (or changes its mind) and the other proceeds to knock the ball out of the lot. Nobody (often, not even thecontestants themselves) can tell who is going to win until one line or the other is decisively broken.\nWe speak of two groups operating in the development of a rectangular trading area because, under present-dayconditions, that is what is usually the fact behind the scenes. This, it should be noted, does not imply“manipulation” in any invidious sense. An investment trust or an estate or, in some cases, an individual heavystockholder has good\n26\n24\n22\n20\nNASH - KELVINATOR\nNK\nSales\n100's\n250\n200\n150\n100\n50\nIlli\nOCTOBER NOVEMBER DECEMBER JANUARY FEBRUARY MARCH\n6 13 20 27 3 10 17 24 1 8 15 22 29 5 12 19 26 2 9 16 23 2 9 16 23 30'\nFigure 9.1 Although its Bottom boundary had a slight tendency to “lift,” the formation that put a Top on Nash-Kelvinator in 1946 was an unmistakable four-month distribution Rectangle. Long and rather loose RectangularPatterns of the type shown here may not evince constantly and noticeably diminishing volume, but note,nevertheless, the general, although irregular, downtrend in volume from mid-October to mid-February.\n56\n52\n48\n44\nLIMA LOCOMOTIVE WORKS\nLMW\nSales\n100's\n50\n40\n30\n20\n10\nOCTOBER NOVEMBER DECEMBER JANUARY FEBRUARY MARCH\n7 14 21 28 4 11 18 25 2 9 16 23 30 6 13 20 27 3 10 17 24 3 10 17 24'31\nFigure 9.2 Consolidation Rectangles in uptrends have been less common in recent years than during the 1920s andearly 1930s. The large price gap (G) in this example is of the “last in pattern” type, which we shall come to inChapter 12. When a gap within a pattern area is followed by breakout from that pattern, as in this case, the gap isinfrequently closed quickly.\nand sufficient reasons for selling at the top price (the “Supply Line” of the Rectangle) with no intent to mislead thepublic. Another investment trust or a group of insiders interested in the company may have equally good and, fromtheir point of view, wise reasons for buying at the bottom price (“Demand Line”). Such are the forces at work inthe market at the start of most Rectangular Chart Patterns, but if the “spread” between top and bottom\n96\n80\n76\n72\n68\n64\n60\n56\n52\n48\n44\nSales 100's 125 100\n75\n50\n25\nJANUARY\nLOEW'S, INC. LW\nFEBRUARY MARCH\nOCTOBER\" NOVEMBER \"DECEMBEi\nI 7 J i/i J oi\"! oe I _ IQ T IO F QZ :\nFigure 9.3 A perfect example of Consolidation Rectangle that formed in Loew's near the end of the 1932-1937Bull Market. In this case, a large block of “inside” stock was distributed at 64 to 65 but taken over around 62 byother investors who had the satisfaction of seeing it go on up to 87 the following August. Note the Throwbackfollowing breakout in January.\nlines is wide enough (say 8%-10% of the market value of the stock), the situation may quickly attract a followingfrom quick-turn scalpers and the professional element. Thus, a syndicate holding a large block of U.S. Steel maydecide to liquidate at 76, whereas another group decides to invest heavily in “Steel” at 69. The price of X willnaturally fluctuate for a time between those two levels. Traders, seeing this, will try to ride the play, buying at 69and selling at 76 (perhaps also selling short at 76 and covering at 69). Their operations will tend to accentuate orextend the Rectangle, although the number of shares involved in such parasitic trading is seldom great enough toaffect the final outcome. As a matter of fact, this type of trading inside a Rectangle can be quite profitable at times,especially if protected by judicious stops (see Section II).\nPool operations\nIn times past, before the U.S. Securities and Exchange Commission (SEC) outlawed the practice, Rectangles werefrequently created by the well-organized operations of a single “pool” or syndicate. Such a pool might undertake toaccumulate a large block of\n13\nSales\n100's\n250\n200\n150\n100\n50\nIII\n::::\n::::\nrKt\nsg\n■ ::h:::::\n::::::: ::: ::::\n•ddfe Sd*Jrs i HE|r\n—:i7WiF14^ ill;: Sr 1 $ giilpil j TtHf H Hr *ii‘*\nBii\nEai££ :x:•hti- 8 $88ihiiuhaamj:iiiidt\n— SOCONY-VACUUMOIL SOV 1946 x glsLlL,\n...........:::::::::::: 7-7:T7:7jt:jLx mint::: ::: q\n1 :::: ::::\n:::: ::::\nIt ill! tttrr i <•••\nU ——\n114\n„ 1\nn|lj|1\n_ i..... JimHIII . ...T\n■41\nHirfjj-\n'' HU TT F’ -J\nmJ \"ill'\nI :i11111U111 ill Bl 1 llill Li Oil11; . ! ih\nAUGUST in I H/i. Hi ’\n6 '13'20 27\n7\nJUNE\nJULY\nFigure 9.4 Here is a Rectangle in Socony-Vacuum, a low-priced stock characterized by fluctuations within anarrow range. After reaching a high of 18 in December 1945, it fell back to 15 and then rallied in mid-1946 asshown above. In late August, prices broke down through an Intermediate Trendline (see Chapter 14) and four dayslater fell out of the Rectangle. This formation, in conjunction with the earlier and higher", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 53}
{"text": "a Rectangle in Socony-Vacuum, a low-priced stock characterized by fluctuations within anarrow range. After reaching a high of 18 in December 1945, it fell back to 15 and then rallied in mid-1946 asshown above. In late August, prices broke down through an Intermediate Trendline (see Chapter 14) and four dayslater fell out of the Rectangle. This formation, in conjunction with the earlier and higher Top, implied lower levelsfor “SOV” for some time to come. See also comment under Figure 9.5.\n1946\n60\nSales\n100's\nYOUNGSTOWN SHEET & TUBE YB\n..\n..\nAPRIL MAY JUNE JULY\n6 13 \"20 27 4 11 18 25 1 8 15 22 29 6 :13 20 27 T3\nAUGUST SEPTEMBER\n10 17 24 31 7 14 21 28\nFigure 9.5 Another long, loose Rectangle of Major Reversal implications, somewhat similar to that pictured inFigure 9.1. Both an Intermediate and Major Up Trendline (to be discussed later) were decisively punctured by“YB” in August, just before its Rectangle broke down. Under Figure 8.21, we discussed one sort of warning of aPrimary Downturn that may be derived from the comparison of individual stock charts with the Averages. Here isanother hint: the better-grade steels and oils (see “SOV,” Figure 9.4) frequently hold up, or make strongerSecondary Recoveries, after the Averages have turned down at Major Tops. The Street sometimes speaks of“distribution under cover of strength in the steels.”\n64\n60\n56\n52\n48\n44\n40 Sales 100's\n50\n40\n30\n20\n10\nT H StHtrHU flpXfflr Hm ;;;;p ttttt\nflIknft imdHH- tr± HFttS! it imt4r nr\nH-F fl i| || :::::: iii •fl01KU\n■•::T Hi:\n. Il laliilwj'jiw■Tihm ::::\n. ■ t tU|t”»+’■14444\n•- i ■ 11*11 ’ i tHt Ttiti\n£ O HHidm tfmtr•• fl :::::::: : : :\n: T tint intiInn ddt flr:::; :::\nFS T fl\n::::\n■ III 1\nJ HF .“iiiuiiii! X M\n.Ht-ntptn*rt • flttt::ffiSr flgGtmiit- Jfffl: L w ffi■ESih\n. Xi. lalfl11111 iX*--1 4 »11 4\n•-fl::: flit\n.......................\ni■ ii11■ ■11\nIIIIIIIIIIIII\n:::::::::::::::::::::::t- + it*::■■!**!:*!:::::::::::: s&\nIlli.\n1 ttflxltliti iiti: i t:::EASTERN AIRLINES EAL\n■ t: «ttx kt< kiji -fl.3\nft\n■i1»* : ffi y\njinisSiS\nIIIIII i JIIIIIIIIII IIIII\n'■<: i IIIIII11mimu lit 11Hiailllllllllllll\nllllllllllltlllllllllllliiimuim44 1945\n'rgSsi\n:gggygffiS'g|\ni;fl H?\n—*\ni- -.; *\nIs i.iHlI i | i|\n■W | |flflflip xufl1n Uifl-fl\nI*\ni; IS\nUMHRI\n*\"* «fl -1\n......\n1 II 11 i 1111\n.\ni • TT\n111\n. ...\ni Hii iliiui Ji 1 hl1III H 1 1\n' 7\n' 5\n3\n26 2 9 16 23 30'\n6 13 20 T7 3 10\nJANUARY . FEBRUARY\nMARCH\nAPRIL\nMAY\nFigure 9.6 The Rectangle in early 1945 in “EAL” was actually the final stage of a nearly two-year Consolidationin the rise, which started around 17 in 1942 and ended above 125 in December 1945. G, G mark gaps (see Chapter12), the first a Breakaway and the second a Measuring Gap, which marked the probable objective of the move as55. When prices reached that level, another Consolidation developed, a Symmetrical Triangle. Neither of thesegaps was “closed” during the following two years.\nstock in a certain company with a view to marking it up and taking profits when some piece of good news, ofwhich they had inside knowledge, eventually became public. To acquire the desired “line,” they would find itnecessary first to shake out shares held by other traders and uninformed investors. They might start their campaignby suddenly selling short a few hundred shares to quench any current demand and start a reaction. Then, on thatreaction to the previously determined accumulation level, they would start to buy, scattering their orders carefullyand avoiding any publicity. Their buying would, sooner or later, engender a rally, but then they would “plant”rumors around the boardrooms to the effect that such-and-such insiders were selling, or that a projected mergerwas being called off, or a dividend would have to be passed, and, if necessary, they would ostentatiously let out afew of their own recently purchased shares to give color to the rumor. The process might be repeated several timeswith the “pool” gradually securing more and more shares on balance until, finally, its intended line is completed orcould not shake out more of the floating supply. Often, what was going on was fairly evident to the alert chartistback in the 1920s even before the operation was concluded, and perfectly evident, of course, as soon as pricesbroke out topside from their Rectangle.\nBut such tactics are no longer permitted. “Wash sales” are strictly condemned; the constant policing of allexchange transactions and prompt investigation by the SEC of any suspicious news or activity in a stockeffectually deters the blatant “pool” manipulations of previous years. This probably is the chief reason whyRectangles are nowhere near so common on the charts of the 1950s as they were in the 1920s. (EN: Not uncommonin the 2000s.)\nSales\n100's\n250\n200\n150\n100\n50\nAMERICAN ZINC, LEAD & SMELTING ZA\nS\nH\n: S\nS\nH\nH\nMARCH\nDECEMBER ' JANUARY FEBRUARY\n......». L1I11L1. .■■■. ...11 ih.^. „ a.^1 U li\nAUGUST SEPTEMBER OCTOBER NOVEMBER\nFigure 9.7 An extraordinary, fine, long Rectangle that developed after “ZA” had broken down out of a Head-and-Shoulders Top in February 1946. A perfect opportunity to sell this stock short was given by its Pullback of July 17-18 after prices had broken out of the Rectangle on the 15th. The Multiple Head-and-Shoulders Bottom that itsubsequently made from September to November produced a recovery to 11, but prices later fell to 6 in early 1947.\nu-T\nJ\n■tgl\nrx\n-t-\nPerhaps we can clear up various details of the Rectangle formation most quickly and easily by comparison withthat most nearly related chart pattern, the Symmetrical Triangle, as follows:\n• Volume—Follows the same rules as in the Triangles, gradually diminishing as the Rectangle lengthens. Anycontrary development, unless it be a momentary news flurry, is suspect.\n• Breakouts—Here also the same rules apply as with Triangles. Review volume requirements, margin ofpenetration, and so on thereunder.\n• False moves—Much less frequent from Rectangles than from Symmetrical Triangles. A clearly definedRectangle is, in fact, a", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 54}
{"text": "in the Triangles, gradually diminishing as the Rectangle lengthens. Anycontrary development, unless it be a momentary news flurry, is suspect.\n• Breakouts—Here also the same rules apply as with Triangles. Review volume requirements, margin ofpenetration, and so on thereunder.\n• False moves—Much less frequent from Rectangles than from Symmetrical Triangles. A clearly definedRectangle is, in fact, almost as reliable as a Head-and-Shoulders, although not as powerful in its implications.\n• Premature breakouts—Slightly more frequent, perhaps, from Rectangles than from Triangles.\n(Note: Both false moves and premature breakouts, in the sense in which we employ these terms, areindistinguishable at the time they occur from genuine breakouts. Following both false and premature breaks, pricesreturn inside the pattern. But, in the case of a false move, the trend ultimately proceeds out of pattern in theopposite direction, while in the case of the premature move, the trend finally breaks out again and proceeds in thesame direction.)\n\nFigure 9.8 In this weekly chart showing Sears Roebuck's 1942 Bear Market Bottom, a Consolidation Rectangle(June to November) forms the right shoulder of a large “unbalanced” Double Head-and-Shoulders Pattern.\n22\n20\n19\n18\n17\n16\nBELL AIRCRAFT\nBLL\n1945\n15\n14\n13 Sales 100's 125 100\n75\n50\n25\n»rt.\n•fern’\nFEBRUARY\nMARCH\nuoULuIllll\nAPRIL\n6 13 20 27 3 10 17 24 3 10 17 24 31 7 14 21 28 5 12 19 26 2 9 16 23 30\nFigure 9.9 After advancing to 16 in January 1945, “BLL” dropped back to 13 and then constructed a 15-weekRectangle. Note that the down gap (G) on April 30 was caused by a $1.00 dividend going off. The revised bottomline of the pattern, drawn $1.00 lower, was not violated.\nFigure 9.10 A brief and very “high” Rectangle formed in September 1937 in the rapid Bear Market Decline of“KN,” followed by a Descending and then a Symmetrical Triangle Consolidation.\n• Pullbacks—Return of prices to the boundary of the pattern, subsequent to its initial penetration (breakout), takesplace more frequently with Rectangles than with Symmetrical Triangles. Our estimate would be that a Pullback orThrowback (the first is the common term for a rally after a downside breakout, and the second for a reactionfollowing an upside breakout) occurs within three days to three weeks in about 40% of all cases.\n• Directional tendency—The Rectangle is more often a Consolidation Formation than a Reversal Formation, theratio being about the same as with Symmetrical Triangles. As Reversal Patterns, Rectangles appear morefrequently at Bottoms (either Major or Intermediate) than at Tops. Long, thin, dull Rectangles are not uncommonat Primary Bottoms, sometimes grading into the type of Flat-Bottomed Saucer or Dormancy described in Chapter7.\n• Measuring implications—A safe minimum measuring formula for the Rectangle is given by its width. Pricesshould go at least as far in points beyond the pattern as the difference in points between the top and bottom lines ofthe pattern itself, though they may go much farther. Generally speaking, the brief, wide-swinging forms, whichappear nearly square in shape on the chart and in which turnover is active, are more dynamic than the longer andnarrower manifestations. Moves out of the latter almost always hesitate or react at the “minimum” point beforecarrying on.\nFigure 9.11 This formation, constructed by United Aircraft in 1942, was not completed and could not be called aDouble Bottom until prices rose above 31 in February 1943. (See following pages.)\nFigure 9.12 INCO quickly recovered from the Reagan Crash of 1987 and by year's end, it was nearly back to its1987 high; the latter was decisively broken in April 1988. The powerful rally continued to carry “N” higher. Butthe August reaction, followed by a poor rally in September, created a large Head-and-Shoulders Top. The earlySeptember decline broke the neckline to confirm the Reversal and the subsequent Throwback, to NecklineResistance, was an excellent selling point.\n52\n48\n44\n40\n38\n36\n34\n32\n30\n28\n26\n24\n22 Sales 100's\nREPUBLIC STEEL\nRS\nG\nAUGUST\nJ’\nJ\n•G—\nt1\n3 H\nIII\nbillIII\nlill IIhl\nJANUARY FEBRUAR^““MARCH APRIL--MAY ” JUNE ’’ JULY\n: 1 8 15 22 29 5 12 19 26 2 9 16 23' 2 9 16 23 30 6 13 20 27 4 11 18 25 P\"8 15 22 29 6T13 20\nFigure 9.13 Owing to the long-time-between-Tops requirement for true Double Top Reversals, these formationscan seldom be seen to advantage on a daily chart, but here is a good 1946 example in Republic Steel. Note the fivemonths and 20% decline between Tops. This chart contains many interesting lesser technical formations also. The“Broadening” Swings (see Chapter 10) in June and July, as the second Top was made, and the rounding rally inAugust were extremely Bearish in their implications.\nRelation of rectangle to Dow Line\nThe resemblance of this individual stock chart formation, which we have discussed under the name of Rectangle,to the Average formation known to Dow theorists as a “Line” has doubtless occurred to you. Obviously, theirrationale and forecasting implications are much the same, but true Rectangles with sharply delimited Top (Supply)and Bottom (Demand) boundaries are truly characteristic only of trading in individual issues. Line formations inthe Averages are seldom rigorously defined, with successive Minor Heights forming quite precisely at a certainhorizontal tangent and successive Bottoms at a similarly precise horizontal level. If you will examine the separatecharts of the issues composing an Average at a time when the Average is “making a Line,” you will surely findsome of them showing an irregular uptrend, others showing an irregular downtrend, still others may be formingTriangles, and a few may be constructing Rectangles, or what not, but it is the algebraic sum of all these more orless divergent pictures that makes up the Average “Line.”\nTo be sure, there is some tendency on the part of active traders to sell (or buy) stocks when a certain Averagereaches a certain figure, regardless of the statu", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 55}
{"text": ", others showing an irregular downtrend, still others may be formingTriangles, and a few may be constructing Rectangles, or what not, but it is the algebraic sum of all these more orless divergent pictures that makes up the Average “Line.”\nTo be sure, there is some tendency on the part of active traders to sell (or buy) stocks when a certain Averagereaches a certain figure, regardless of the status of individual issues involved. An investment counsel willoccasionally advise his clients, for example, to “sell all speculative holdings when the Dow Industrials reach 500”(EN: or 5,000 or 15,000). But trading commitments based solely on general Average levels are so seldom followedconsistently that they have little effect. (EN10: In the modern era, with the availability of index exchange-tradedfunds, this is no longer true.)\n19\n18\n17\n16\n15\n14\n13\n12\n11\n10\n9 Sales 100's\n50\n40\n30\n20\n10\n\nFigure 9.14 Shares of “AMR,” then selling for around 90, were split 5-for-1 in April 1946, resulting in a quickrally to a new high. But the overall aspect of a Double Top with the high made the previous December wasnevertheless apparent and confirmed when prices broke down through the “valley” level on August 28. Popularbuying brought in by “splits” is usually short-lived and only temporarily distorts the broad picture.\nRectangles from Right-Angle Triangles\nIn the preceding chapter, we referred to a type of partial “failure” in the development of a Right-Angle Trianglethat necessitates reclassifying the Triangle as a Rectangle. Now that we have examined the latter pattern in detail,we need say little more about this phenomenon, except to note the odds still appear to be somewhat in favor ofultimate breakout in the direction originally implied by the incipient Triangle. The fact there is this slightpresumption, however, certainly does not warrant disregard of an opposite breakout from the rectangularreconstruction.\nDouble and Triple Tops and Bottoms\nTo some of the old hands in the Street, our relegation of that good old byword, the Double Top, to a Minor Positionin our array of Reversal Formations may seem almost sacrilegious. It is referred to by name perhaps more oftenthan any other chart pattern by traders who possess a smattering of technical “lingo” but little organizedknowledge of technical facts. True Double Tops and Double Bottoms are exceedingly rare; Triple Forms are evenrarer. Additionally, the true patterns (as distinguished from chart pictures that might mistakenly\n22\n20\n19\n18\n17\n16\n15\n14\n13\n12\n11 Sales 100's\n25\n20\n15\n10\n5\nCONTAINER CORPORATION\nCNR\n111\nS’ O ' N ‘ D~*~J 1 F 1 M A 1 M 1 J 1 J A S 1 O~N 1 D~~J F ’ M\nFigure 9.15 The Major Reversal Formation in “CNR” at the start of a Primary Advance that reached 54. Note howan attempt at an Ascending Triangle turned into a Double Bottom.\nbe called such but are really assignable to some one of our other Reversal Formations) can seldom be positivelydetected until prices have gone quite a long way away from them, and can never be foretold or identified as soonas they occur from chart data alone.\nBut we are getting ahead of our story; we should first define what we are talking about. A Double Top is formedwhen a stock advances to a certain level with, usually, high volume at and approaching the Top figure, then retreatswith diminishing activity, then comes up again to the same (or practically the same) top price as before with somepickup in turnover, but not as much as on the first peak, and then finally turns down a second time for a Major orConsequential Intermediate Decline. A Double Bottom is the same picture upside down; the Triple types makethree Tops (or Bottoms) instead of two.\nIt is not difficult to skim through a book of several hundred monthly charts and pick out two or three examples ofMajor Double Tops and, perhaps, one or two Double Bottoms. One will find cases in which stocks made twosuccessive Bull Market Peaks several years apart at almost identical levels. Such phenomena stand out, in distantretrospect, like the proverbial sore thumb, which undoubtedly accounts for the undue awe with which the amateurchartist regards them. He neglects, for the moment, to consider the fact a thousand other issues might have donethe same thing but did not—that some of these even acted, for a time, as though they were going to Double Top,but then went on through and higher.\nIs there any practical utility for the trader or investor in the Double Top concept? Yes, there is, but it will be easierfor us to formulate it if we first consider what is not a Double Top. Refer back for a moment to the AscendingTriangles and the Rectangles previously studied;\n20\n19\n18\n17\nTRINITY INDUSTRIES INC.\n16\n15\n14\n13\n12\n11\nSales\n100's\n500\n400\n300\n200\n100\nMAY\nU\n2330 6 13’2027 4 *11’18’25* 1 * 8’15*22*29’ 6'1____\nX D.125 X D.125\nUfu\n. ±. ;ra\nSB\n3\nDAY\nONE\nREVERSAL.\n10 iiill\nEpTEMBER OCTOBER\nLY AUGUST SE - - - - ----\n3’20*27 3 *10’17*24’31’ 7 *14’21 '28' 5 ’12*19\nFigure 9.16 Although Trinity Industries did not have the well-formed pattern exhibited by our otherrecommendations, we found the high-volume plunge, with the low of the day the third test of the year's low, a verybeguiling technical situation. Basically, it was a Triple Bottom with a One-Day Reversal to get the uptrend started.\nwhen these start to evolve, the majority of the time their first step is the construction of two Tops at an identicallevel with an intervening recession, and with less volume on the second Top than on the first. In the ordinarycourse of events, a third Top will develop there, and ultimately, prices will break through and move on up to stillhigher levels. Thus, we see we must have some rule or criterion to distinguish a true Double Top Reversal Patternfrom the Double Tops that do not imply Reversal when they appear as a part of a Consolidation Area in an uptrend.\nDistinguishing characteristics\nNo absolute and unqualified rule can be laid down to fit all cases involving stocks of different values and marke", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 56}
{"text": "rough and move on up to stillhigher levels. Thus, we see we must have some rule or criterion to distinguish a true Double Top Reversal Patternfrom the Double Tops that do not imply Reversal when they appear as a part of a Consolidation Area in an uptrend.\nDistinguishing characteristics\nNo absolute and unqualified rule can be laid down to fit all cases involving stocks of different values and markethabits, but one relative distinction quickly suggests itself when we study these different kinds of chart formations:if two Tops appear at the same level but quite close together in time and with only a Minor Reaction between them,chances are they are part of a Consolidation Area; or, if a Reversal of Trend is to ensue, there will first be morepattern development—more “work” done—around those top ranges. If, on the other hand, there is a long, dull,deep, and more or less rounding reaction after the initial peak has appeared, and then an evident lack of vitalitywhen prices come up again to the previous high, we can at least be suspicious of a Double Top.\nHow deep is deep, and how long is long? Fair questions, to which, unfortunately, it is impossible to give simple,definite answers, but we can attempt approximations. Thus, if the two Tops are more than a month apart, they arenot likely to belong to the same Consolidation or Congestion Formation. If, in addition, the reaction between thefirst and second high reduces prices by 20% of their top value, the odds swing toward a Double Top\n64\n60\n56\n52\n48\n44\n40\n38 Sales 100's\n50\n40\n30\n20\n10\n! 6 113 120 2 7 4 11 18'25 1 ■ 8 115 22 29 6 43 20:27 3 1047 24 37 7 14'21 28\nFigure 9.17 Publicker made its Bull Market high only a few weeks after it was listed on the “big board.” Then itstarted to build a Descending Triangle but pulled up out of it. The final outcome was a Triple Top, completed inAugust (see Figures 8.17 and 9.15).\ninterpretation. But both of these criteria are arbitrary, and not without exception. There are cases in which the twopeaks have occurred only two or three weeks apart, and others in which the “valley” between them descended onlyabout 15%. Most true Double Tops, however, develop two or three months or more apart. Generally speaking, thetime element is more critical than the depth of the reaction. The greater the time between the two highs, the less theneed of any extensive decline of prices in the interim.\nGiven the conditions we have specified, namely, two Tops at approximately the same level but more than a monthapart on the chart, with somewhat less activity on the second advance than on the first, and a rather dull orirregular and rounding type of recession between them, we can then be suspicious that a Double Top Reversal hasactually evolved. Should a small Head-and-Shoulders or Descending Triangle start to develop at the second Top, asis frequently the case, we can be on guard, to the extent of protecting long commitments at once with a close stopor by switching to something else with a more promising chart picture.\nYet, even all these signs together are not final and conclusive. The situation can still be saved, and often is. Let ustake a look at what is, presumably, going on behind the scenes to create our chart picture up to this point. The firstTop on relatively high volume was a normal incident and tells us little except that here, for the moment, demandmet with sufficient supply to stop the advance and produce a reaction. That supply may have represented onlytraders' profit-taking, in which event the trend is likely to push on up after a brief setback. But, when the reaction\ndrifts off lower and lower until it has given up 15% and more of the stock's peak market value, and flattens outwithout any prompt and\n8\n7\n6\n5\n412\n4\n31\n32 Sales 100's 125 100\n75\n50\n25\n\nFigure 9.18 In the ordinary course of events, at the time this Bottom Pattern developed in “NG,” consisting, as itdid, of fluctuations for 10 long months within a range of only 1 full point, most traders would pay no attention toit. Certainly, it suggested very little opportunity for short-term profits. On an arithmetically scaled chart, thepattern could hardly be seen. Logarithmic price scaling, however, as we have remarked in an earlier chapter, hasthe great advantage of bringing to light the percentage importance of significant market action at very low pricelevels.\nvigorous rebound, it becomes evident that either the demand was pretty well played out on the last advance or theselling represented something more than short-term profit cashing. The questions then are these: did the first highgive evidence of important distribution, and is there much more to meet at the same price range?\nNevertheless, as our chart picture shows, demand did finally come in and absorb enough of the floating supply toturn the trend around. When prices pushed up and began to run into selling again near the level of the first Top,that was to be expected on “psychological” grounds; many quick-turn operators naturally would take profits at theold high (perhaps with the intention of jumping right back in at a still higher price if the old high should beexceeded). Hence, a Minor Hesitation there was quite in order. But selling in sufficient quantity to produce anotherextensive reaction would be quite another matter. We have, by now, established a zone of Supply or Resistance atthe peak levels and a zone of Support or Demand at the Bottom of the valley between. The final and decisivequestion now is this: will the “valley” Support reappear and stop the second decline?\nThe conclusive definition of a Double Top is given by a negative answer to that last question. If prices, on theirrecession from the second peak, drop through the Bottom level of the valley, a Reversal of Trend from up to downis signaled, which is usually a signal of major importance. Fully confirmed Double Tops seldom appear at turns inthe Intermediate Trend; they are characteristically a Primary Reversal phenomenon. Hence, when you ar", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 57}
{"text": "p is given by a negative answer to that last question. If prices, on theirrecession from the second peak, drop through the Bottom level of the valley, a Reversal of Trend from up to downis signaled, which is usually a signal of major importance. Fully confirmed Double Tops seldom appear at turns inthe Intermediate Trend; they are characteristically a Primary Reversal phenomenon. Hence, when you are sure youhave one, do not scorn it. Even though prices may have already receded 20%, the chances are they have very muchfarther to go before they reach bottom.\nAs to measuring implications, the Double Top affords no formula comparable with what we have attributed toHead-and-Shoulders and Triangle Formations, but it is safe to assume the decline will continue at least as farbelow the valley level as the distance from peak to valley. It may not be so in one interrupted slide; on the contrary,considerable time may be required to carry out the full descent in a series of waves. Pullbacks to the “valley” pricerange, following the first breakthrough, are not uncommon. (Take into account the general rule that a ReversalFormation can be expected to produce no more than a retracement of the trend that preceded it.)\nOne more point: we have said the Tops need not form at precisely the same level. Use here the 3% rule we havepreviously laid down as a measuring stick for breakouts. A first Top at 50, for example, and a second at 51 1/2would come within this limit. Curiously enough, the second peak often does exceed the first by a fraction. Theimportant points are (1) that buying cannot push prices up into the clear by a decisive margin, and (2) the Supportbelow is subsequently broken.\nDouble Bottoms\nIn identifying a Double Bottom, we can apply all of the precepts we have formulated for the Double Top Pattern,but upside down. The differences between the two pictures are just what you might expect them to be, having inmind the characteristic differences between Head-and-Shoulders Tops and Bottoms, for example. Thus, the secondBottom is usually conspicuously dull (little trading volume) and is apt to be quite rounded, whereas the second Topin a Double Top is moderately active and nearly as sharp and “spiky” in contour as the first. The rally up from thesecond Bottom shows an increase in turnover, and volume should pick up to a marked degree as the valley level, ormore properly, in this case, the height between the two Bottoms, is surpassed. Double Bottoms appear just about asfrequently as do Double Tops at Primary Trend Reversals, and Double Bottoms also occur sometimes at the end ofIntermediate Corrections in a Major Uptrend.\nIf you are familiar with some of the jargon of the Street, it has probably occurred to you that the second low of aDouble Bottom is an example of the market action so often referred to as a “test.” In a sense, that is just what it is—a test or corroboration of the Support (i.e., demand) that stemmed the first decline at the same level. The successof that test is not proved, however—and this is a point to remember—until prices have demonstrated their abilityto rise on increasing volume above the preceding high (the height of the rally between the two Bottoms). Until\nsuch time, there is always the possibility a second test (third bottom) may be necessary, or even a third, and thatone of these will fail with prices then breaking on down into further decline. This thought leads us to our next typeof Reversal Formation.\nTriple Tops and Bottoms\nLogically, if there are Double Tops, then we might expect that there will also be Triple Tops, which will develop insomewhat similar fashion. The fact is that Reversal Formations, which can only be classed as Triple Tops, dooccur, but they are few and far between. Many patterns evolve at an important turn from up to down in the trendthat contains three Top points, but most fall more readily into the category of Rectangles. For that matter, anyHead-and-Shoulders Formation, particularly if it be rather “flat” with the head not extending much above the levelof the two shoulders, might be called a sort of Triple Top.\nThe true Triple Top (as distinct, that is, from other types of three-peak formations) carries a recognizable familyresemblance to the Double Top. Its Tops are widely spaced and with quite depth and usually rounding reactionsbetween them. Volume is characteristically less on the second advance than on the first, and still less on the third,which often peters out with no appreciable pickup in activity. The three highs need not be spaced quite so far apartas the two that constitute a Double Top, and they need not be equally spaced. Thus, the second Top may occur onlyabout three weeks after the first and the third six weeks or more after the second. Also, the intervening valleysneed not bottom out at exactly the same level; the first may be shallower than the second and vice versa. Also, thethree highs may not come at precisely the same price; our 3% tolerance rule is again useful here. Yet, despite allthese permissible variations, there should be, and generally is, something suspiciously familiar about the overallpicture, something that immediately suggests the possibility of a Triple Top to the experienced chartist.\nThe conclusive test, however, is a decline from the third Top that breaks prices down through the level of the valleyfloor (the lower one, if the two valleys form at different levels). Not until that has occurred can a Triple Top beregarded as confirmed and actually in effect; so long as demand persists at the valley price range, the trend can beturned up again. Only in those cases in which activity is conspicuously lacking on the third peak and then begins toshow Bearish characteristics by accelerating on the ensuing decline is one justified in “jumping the gun.”\nNote this formation qualifies as a Triple Bottom in every detail—spacing between Bottoms, extent in percent ofintervening rallies, volume. Of course, its completion in Octob", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 58}
{"text": "n beturned up again. Only in those cases in which activity is conspicuously lacking on the third peak and then begins toshow Bearish characteristics by accelerating on the ensuing decline is one justified in “jumping the gun.”\nNote this formation qualifies as a Triple Bottom in every detail—spacing between Bottoms, extent in percent ofintervening rallies, volume. Of course, its completion in October 1942 did not necessarily forecast that “NG”would climb to 33, as it ultimately did. But the fact that many other stocks were making sound Major BottomFormations at higher price levels at the same time certainly warranted the conclusion that “NG” was on its way up,and that it was a bargain at 5.\nTriple Bottoms are simply Triple Tops turned upside down, with the same qualifications noted when discussingDouble Bottoms. The third low should always be attended by small volume, and the rise therefrom must show adecided increase in turnover and carry prices decisively above the Tops of the rallies that formed between theBottoms. One is never justified in “jumping the gun” on a presumed Triple Bottom Formation unless nearly everyother chart in the book is in an unmistakably Bullish position. The risk of premature buying is expressed in asaying one sometimes hears in the boardrooms to the effect of “a Triple Bottom is always broken.” This is not atrue saying. Once a Triple Bottom has been established and confirmed by the necessary up-side breakout, itseldomly fails—it almost always produces an advance of distinctly worthwhile proportions. But an uncompleted“possible” Triple Bottom chart picture must be regarded as treacherous. Stick to the breakout rule and you will besafe.\nTriple Tops are sometimes referred to as “W” Patterns because of their occasional resemblance to that capital letteron the chart. There is a sort of hybrid between the Double and Triple Top, in which the middle one of the threeTops does not attain the height of the first and third, and thus, even more strikingly resembles a “W.” For the samereason, Double Tops are sometimes called “M” Formations.\nBecause the elements in Double and Triple patterns are normally spaced well apart in time, they are often easier todetect and appreciate on a weekly chart than on a daily. Monthly graphs disclose numbers of widely spread Doubleand Triple Bottoms but, on the other hand, are too coarse to reveal many good Double and Triple Top Patterns.\nIn our foregoing discussion of the Triple Top, we referred to a sort of intuition that comes with experience andenables a technical analyst to recognize the potentialities for Reversal of a certain chart development, sometimeslong before it has reached a conclusive stage. This is a not uncommon talent, but it is one that is seldom attainedexcept through searching study and long experience (in which the latter usually involves a few expensivemistakes). The reader of this book need not despair of acquiring “chart sense” and without undue cost—if he willconcentrate on his study, watch, check, and double-check every new development on his charts, and “keep score”on himself.\nIt has been said that chart interpretation is not a science but an art. It is not an exact science, to be sure, because ithas no rules to which there are not exceptions. Its finer points defy expression in rule or precept. It requiresjudgment in appraisal of many factors, some of which may seem, at times, to conflict radically with others. But tocall it an art, which implies the need for genius, or at least for a high degree of native talent, is certainly improper.Say, rather, that it demands skill, but a skill that can be acquired by anyone of ordinary intelligence.\nchapter ten\nOther Reversal phenomena\nWe have considered so far eight classes of chart patterns that appear at more or less important Reversals ofdirection in the trend of prices. They are as follows:\n1. The Head-and-Shoulders\n2. Multiple or Complex Head-and-Shoulders\n3. Rounding Turns\n4. Symmetrical Triangles\n5. Right-Angle Triangles\n6. Rectangles\n7. Double and Triple Tops and Bottoms\n8. One-Day Reversal\nOf these, numbers 1, 2, 3, and 7 develop most often at Major Turns, whereas numbers 4, 5, and 6 occurmore frequently at Intermediate Stages. Numbers 1, 2, 3, and 5 give indication before they are completedas to which way the price trend is likely to proceed from them. Numbers 4 and 6 give no such indicationand, as we have seen, are rather more apt to signal Consolidation or Continuation than Reversal. But all ofthem can, and on occasion do, appear at both Major Tops or Bottoms. EN: Number 8 appears typicallyafter uncontrollable moves, up and down.\nWe have yet to take up a few other technical patterns that, because of their limited significance, rarity, ordoubtful utility to long-term traders, have been relegated to the end of our Reversal studies (see Figures10.1 through 10.28).\nThe Broadening Formations\nIn concluding our discussion of Triangles in Chapter 8, we mentioned certain types of price congestion ortrading areas that have sometimes been called “Inverted Triangles” because, starting with very narrowfluctuations, they widen out between diverging rather than converging boundary lines. Herein, we havechosen to classify them instead as Broadening Patterns since, except for that inverted resemblance insuperficial appearance, they are quite different in nature and trend implications.\nIf the Symmetrical Triangle presents a picture of “doubt” awaiting clarification and the Rectangle apicture of controlled “conflict,” the Broadening Formation may be said to suggest a market lackingintelligent sponsorship that is out of control—a situation, usually, in which the “public” is excitedlycommitted and is being whipped around by wild rumors. Note though we say it only suggests such amarket; there are times when it is obvious those are precisely the conditions that create a BroadeningPattern in prices, yet other times when the reasons for it are obscure or undiscoverable. Nevertheless, the", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 59}
{"text": "ent sponsorship that is out of control—a situation, usually, in which the “public” is excitedlycommitted and is being whipped around by wild rumors. Note though we say it only suggests such amarket; there are times when it is obvious those are precisely the conditions that create a BroadeningPattern in prices, yet other times when the reasons for it are obscure or undiscoverable. Nevertheless, thevery fact that chart pictures of this type make their appearance, as a rule, only at the end or in the finalphases of a long Bull Market lends credence to our characterization of them.\n34\nSales 100's\n125\n100\n75\n50\n25\nFigure 10.1 The Symmetrical type of Broadening Formation, which develops most frequently in the laterand more “excited” stages of a Primary Bull Market, is perfectly exemplified in this Crane Companychart. Note that the Broadening Pattern here started to form in December 1945 after a 10% reaction; if ithad formed on Top of a rally, it would have been suspected as a possible Broadening Top. Nevertheless, itcarried the usual Bearish implications. \"CR\" topped out at 49% in June.\n:::::\nH\n1\nif\nMMMWM:::::::::::::iiimiiiiiiiMiaaimiiaai a a a a a aa i a a a a::::::::::::::::::::::::::laaaiiaalaai!\nHE\n::::\n......\nSliBI®\n......1 .H\naaaaaa\n::'1\naaaaaae ■;is\n::::::::::::::::::::::::\n2:2\nIII >::::: :: ■\n“i\" •! : ■\nii-ls\nIf tttti fttft tt tt mil\n: 4,7\n::::::::::\nll’|E ' L\nft:: ftrr:\n1;.. liX\n‘k\nn $\nfl::: ftftl:?::::■:??ftm\naOmSrvnrfeinn\nHiF IhiW? ZHU\n;rH: ::::: :::: :::' Hl? I ::n: ::HFill# :::::tj p “ O IIIH s ’• ■\nfrfCP A MP COMPAMY ( p\niBiliggis1945.\n-1946 Hfnn|rnir\"•ii\niitH\n::::: HU*HiTHH ::::: juftiftft lit::util itg H?r HHi ::H:H:H\njifeHffP iiffi if H Hi: ftmftftftx«ftHmftfti.. :' ■.\n1\n■\nu Illi\nrtf' I-\nllxx 11 imC\n1T .\n1 1 In\nLii..iiliilnlL\ni iii.l,ii.i„,..iiiiiii , 1. L1.1 ,, 11 1 111\nT ; jttn it; : II\n■\nn Il . ;Ji|\nNOVEM\niioii7r?z\nBER DECEMBER JANUARY FEB!\n4 1 8 15 22 29 5 12 19 26 2 » 9\n““MARCH\n■ 9 16 23 3\nHence, after studying the charts for some 20 years and watching what market action has followed theappearance of Broadening Price Patterns, we have come to the conclusion they are definitely Bearish inpurport—that, while further advance in price is not ruled out, the situation is, nevertheless, approaching adangerous stage. New commitments (purchases) should not be made in a stock that produces a chart of\nthis type, and any previous commitments should be switched at once or cashed in at the first goodopportunity.\nThe Broadening Formation may evolve in any one of three forms, comparable, respectively, to invertedSymmetrical, Ascending, or Descending Triangles. The \"Symmetrical\" type, for example, consists of aseries of price fluctuations across a horizontal axis, with each Minor Top higher and each Minor Bottomlower than its predecessor. The pattern may thus be roughly marked off by two diverging lines, the uppersloping up (from left to right) and the lower sloping down. But these Broadening Patterns arecharacteristically loose and irregular, whereas Symmetrical Triangles are normally regular and compact.The converging boundary lines of a Symmetrical Triangle are clearly defined as a rule, and the Tops andBottoms within the formation tend to fall with fair precision on those boundary lines. In a BroadeningFormation, the rallies and declines usually do not all stop at clearly marked boundary lines.\nVolume during Broadening Formations\nAnother distinction between Triangle and Broadening Formation is in the volume chart. The constructionof a true Triangle is attended, as we have seen, by diminishing activity, starting with high volume on thefirst Minor Reversal that initiates the pattern, but growing less and less as prices fluctuate in ever-smallerwaves out toward the apex. Then activity picks up again after prices have broken out of the Triangle,immediately and sharply if the breakout is through the topside. With the Broadening Formation, on theother hand, trading activity usually remains high and irregular throughout its construction. If it developsafter\n240\n224\n208\n176\n160\n152\n144\n136\n128\n120\n112\n104\n80\n76 Sales 100's\n250\n200\n150\n100\n50\nAUGUST SEPTEMBER OCTOBER NOVEMBER DECEMBER\nFigure 10.2 Although this particular Major Reversal Formation appeared on the charts more than 35 yearsago, it is so perfectly developed and on such a large scale that it may well stand as our elementary modelfor an Orthodox Broadening Top. This pattern in Air Reduction is discussed in detail on previous pages.Note also the Symmetrical Triangle Consolidation of July-August, and the examples of Runaway,Breakout, and Exhaustion Gaps (RG, BG, and EG), which will be taken up in Chapter 12.\n192\nT p gg..... f f8W 1 If ii T\nlit::ftfl\n||iB\nW\nn\n1 ?\nrrf\n::\nSBOH\nAft\nIf\nJ\n5aFmbJ ft: lift1 -\ntn:: n:;H •f’**rmtnjn nd::: j fl.tf uill♦••: n*t■: t:\nIp ■if T 1 : ::\nS; S il ffl :::::: j; nn J:J a\n....... H■ —-p\nH w\nifcUHi:I M ft|\njf .:4’ BG: \"' t'S\n. ..\n1 | . T; —•Jfcnft...■■ t tttTttt\n..... rrJ ::::: .1 ::::: :::: IP’ T TT ; ;;\n1 ffii ij 3 3 ft::\n| pH 1 1 MgHH: A n g g mit : it nH: Tfft •Hi:\n~ gin f ::::: mH :g ::t 1 ::::: nn::||H\ntn: Oft:: w ** •ft:iiiii ••• i rft iiin HnnHi\nttin ::1 :n| iiiiiIII n Hg gap liii\n::::in iii.....fit tflinHi|h| fl11“\n« EGiiiiim\nHi ill :st tn I T 11\njnn flit Hiii wife ft JHH tnnIi HiliHtii\n::::: ftti^ ftt ill iHn\niSHSO inn :: Oil nn:::\njft:: ft mimHOf mffi < 4ft r i :::::• lii\n:::::Off m Hi W 1K\n:S\" lg Bigg 1 I tt** ♦tn\nAIR REDUCTIONCO.\nf + tr ll w < ■ i\ngSf:; H flflitiiH Hi\n|||| |\n.....\nffi\nssinn III HggiI : ::fl: fflfl: 4± II I:: $h\nITT flu ii HI H I IiTTl\nill tffi Si .... mniffilffi\n..... Em mtT\n;;... ..... ..... ;« HHO\nIB\nHH:::::\nln«mn\n::. Hl:ffi K\nJlnWH\n:»H ::::\nill!Hi\nEH Em...\n•\n:::::: t 1 in nn tin::Hit\niimhft\nft\n: :::\n••tH \"Hr-- p H' T nt5 • n tj 8 HH I H tin:Ilin:::.:m : !.; UftUih : J H! iHi\ni m: .... n<nffisfi118iiiii\n[ll H i\n. „ .. ..\n1 n 1 fttt II ..\nt\" tt U 1 11 I 1 ...J il\nitiin.iiiliiiii\n1\niiiiixli\nIIIIImil\n1111\n1 1 11 ,h 1 1\nllUULlliILIhLladJill J.1I lllll-lllil111111 1J1111 11 11 1 1", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 60}
{"text": ". ..... ;« HHO\nIB\nHH:::::\nln«mn\n::. Hl:ffi K\nJlnWH\n:»H ::::\nill!Hi\nEH Em...\n•\n:::::: t 1 in nn tin::Hit\niimhft\nft\n: :::\n••tH \"Hr-- p H' T nt5 • n tj 8 HH I H tin:Ilin:::.:m : !.; UftUih : J H! iHi\ni m: .... n<nffisfi118iiiii\n[ll H i\n. „ .. ..\n1 n 1 fttt II ..\nt\" tt U 1 11 I 1 ...J il\nitiin.iiiliiiii\n1\niiiiixli\nIIIIImil\n1111\n1 1 11 ,h 1 1\nllUULlliILIhLladJill J.1I lllll-lllil111111 1J1111 11 11 1 11111Ll\nan advance, as is almost always the case, the first Minor Reversal that starts the pattern will occur on alarge turnover, but so will the second rally in the pattern, and the third, and high\nboth price and volume—is, thus, one of wild and apparently “unintelligent” swings.\nAs can easily be seen, under such circumstances, a true breakout from the area may be difficult, if notimpossible, to detect at the time it eventuates. The volume part of the chart\n1946\nAMERICAN ROLLING MILLS\n28\nSales\n100's\n125\n100\n75\n50\n25\nAPRIL\nMAY\nJUNE\nJULY\nAUGUST\n13 20 27 3 10 17 24 31 7 14 21 28\nFigure 10.3 A small, but perfect, 1946 Broadening Top that formed at the end of a three-month chartpattern, which also had overall Broadening (and, hence, Bearish) aspects. The five critical points ofReversal are numbered on the chart. The “breakout” was registered on August 27. The Pullback Rally thatfollowed immediately was strong, but it still held within normal bounds. Another interesting BroadeningTop of 1946 appears in Figure 33.7.\n50\n45\n40\n35\n30\n25\n20\n4\nCONSOLIDATED EDISON ED\n1935\n1936\n1937\n1938\nFigure 10.4 When they appear as plain and as compact as this example, Broadening Tops on weeklycharts carry very powerful Reversal indications. The Top of the fifth turn in this formation was capped onthe daily chart by a Head and Shoulders, which was pictured in Figure 6.7. The dashed lines on the abovechart are trendlines—to be discussed in Chapter 14.\nkN\n28\n26\n24\n22\n20\n19\n18 Sales 100's\n50\n40\n30\n20\n10\n56\n52\n48\n44\n40\n38\n36 Sales 100's\n50\n40\n30\n20\n10\nFigure 10.5 Broadening tendencies that appear on monthly charts, or very wide spread (with Tops five orsix months apart) like the above on weekly charts, should not be regarded as significant technical\nformations. Reversal points in a true Broadening Top should not be more than two months apart, as inFigure 10.4.\nASSOCIATED DRY GOODS DG\n1945\nJA N UARY FEBRUARY MARCH..............APRIL.............MAY.........* JUNE..........\n■ 6 13 20 27 3 10 17 24 3 10 17 24 31 7 14 21 28 5 12 1926 2~9 16 23 30\nFigure 10.6 Three successive reactions in \"DG\" in February-March 1945 made successively lowerBottoms, but the intervening rallies came up to the same high (about 21%), thus forming a RightAngledBroadening Formation with a horizontal Top (Supply) Line. Penetration of this technically important topline on April 16 was a Bullish signal. The flat-topped type of pattern does not necessarily portray aBearish situation.\n88\n1946\n80\n76\n72\n68\n64\n60\nPARAMOUNT PICTURES\nPX\n56 Sales 100's 125 100\n75\n50\n25\nI...........................mill iiiiini\nJANUARY~FEBRUAR\n5 12 19 26 2 9 16 23\nMARCH\n2 9 16'23 30 6 13 20 27 4 11 18 25 1 8 15 22 29\nFigure 10.7 The 1946 Top in Paramount Pictures, from which it fell to 46 a year later, was a RightAngledBroadening Formation with a horizontal bottom line that was “cracked” the first week of June, but notdecisively broken until June 20. (This stock was later split 2-for-1.)\n48\n44\n40\n38\n36\n34\n32\n30\n28 Sales 100's 125 100\n75\n50\n25\nt p>:z I i i n i: ii i ii\n|t. , i 1 ALLIED S T ORE S L S ,, 11 11 11 1 1......1, 1 11 11 1 ,, 11 1111 11\n::F:: T......::H:SS J:::S:::: :ffi jgffl gff:\n| [F |W g -• * |J-ij1^ H: ♦\n* iitU St: aij-jHii::: str 1\n*: « Unt H:*- iJ ■; nJ ♦ G • *G:\n[H ph ::::: Ilid :jrf 5: : ::::::::\n■ Ap.....■: -■ - - .\n::::: -Im:::: :4 : 1::: 1H:: ::F: :::::::: :::::\n:::§ :H:: h: ::H: | 1 p O PO H H: Sil :HH ::: : § :::: M : OS SI |H SS F::\nEJp'ty^jl ! S | fe~ I::::::-::::::::::::::iFii ::::: ::-:h:\nHf ; ::H; tfet S 011 i hhtl;:h II! ;:|:: Sth1 I? it : ’ i I : ::\nn: nr n n:nr::iiii::::i: 11 :i: i in in in n in:: ::: i i : i i :::::\n........::: : :. . :\ni..i.iiiiiiih...>i.r...ii.l .1 illi.i iiiinillli liliillllliliii ib. Iiiii hi LL bhi |\nJULY AUGUST SEPTEMBER OCTOBER NOVEMBER DECEMBER\n7 1421 28 4 11 18 25 1 8 15 22 29 6 13 20 27 3 10 17 24 18 15 22 29\nFigure 10.8 Another example of the Flat-Topped type of Broadening Price Pattern that appeared near theend of 1945. “LS” went on up to 63 in 1946. Prices broke out of this formation with a Breakout Gap (G)and another Breakout Gap appeared on December 3. G-G marks an “Island.” See Chapter 12 for Gaps.\n76\n72\n68\nSales 100's 250\n200\n150\n100\n50\nU. S. STEEL X\n1946\nAUGUST\n4 11 18 25 1 8 15 22 29 6 13 20 27 3 10 17 24' 31 7 14 21 28\nFigure 10.9 The 1946 Bull Market Top in U.S. Steel was a three-month Diamond that might also beconstrued as a Head-and-Shoulders.\n24\nAMERICAN BOSCH CORP.\n22\n20\n19\n18\n17\n16 Sales 100's\n50\n40\n30\n20\n10\n194-5\nilLyil\nIL.\n’ 7 14 2121 4 11 18 25 1 8 15 22 29 6 13 20 27' 3 10 17 24' 1 8 15 22 29\nFigure 10.10 A Diamond (November) that broke out topside and thus functioned as Consolidation ratherthan Reversal.\nobviously furnishes no clue, while the very looseness and lack of definition of the price pattern preventthe drawing of any line that surely says, “this far and no farther.” (We are referring now to the“Symmetrical” type only of Broadening Formation.) Once prices have run well away, either up or down,from the pattern area, it becomes plain that a breakout has occurred, but by that time, it may be too late torisk a trade on the situation; the move may already have gone too far. What can we do about BroadeningFormations then? Well,\n44\n40\n38\n36\n34\n32\n30\n28\n26\n24 Sales 100's 125 100\n75\n50\n25\nFigure 10.11 Diamond Reversal Formations are often easier to detect on weekly than on daily charts.Trace out the price swings and volume in this May-June 1946 Diamond in Shell. Note also the remarkableDescending Triangle that developed from September 1946 to February 1947, and the March Pullback toits apex, another ideal", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 61}
{"text": "tions then? Well,\n44\n40\n38\n36\n34\n32\n30\n28\n26\n24 Sales 100's 125 100\n75\n50\n25\nFigure 10.11 Diamond Reversal Formations are often easier to detect on weekly than on daily charts.Trace out the price swings and volume in this May-June 1946 Diamond in Shell. Note also the remarkableDescending Triangle that developed from September 1946 to February 1947, and the March Pullback toits apex, another ideal place to sell short.\nwe have already noted 9 times out of 10 they carry Bearish implications. They appear most often at ornear an important topping out of the trend. Hence, it is reasonably safe to assume that prices, when theyfinally break away from the formation, will go down, or if they do go up, will very soon turn around and\ncome back down again. Therein lies one answer to the problem of what to do about a BroadeningFormation.\nIn addition, the price action within the formation, in many cases, furnishes an advance indication ofbreakout direction. If the trend is going to break down from the Broadening Area, the last rally within thearea may fail to rise as high as its predecessor, thus breaking the sequence of ever higher Tops within thepattern. Alternatively, if the trend is going to emerge on the topside, the last reaction within the patternmay fail to depress prices as low as the preceding reaction. These “failures” within the pattern occur, aswe have stated, in a majority of all Broadening Formations. Note that one cannot be sure of such asignificant development (what we have referred to above as a failure, for lack of a better descriptivename) until prices go on and out the other side of the formation or, more precisely, have exceeded the lastpreceding move in that direction by a decisive margin (our 3% rule again).\nA typical example\nNo doubt the foregoing paragraph sounds rather complicated. It will be easier to visualize thedevelopment of a “failure” signal if we cite an example using actual price figures. Easier yet, perhaps, ifthe reader will sketch out our example on a scrap of chart paper. Suppose stock XYZ, after advancingsome 30 points on gradually increasing turnover, runs into heavy selling at 62 and reacts to 58. But thereis still plenty of interest in the issue; it stops\nCreated with TradeStation 2000i by Omega Research© 1999\nFigure 10.12 Technicians in the future will look back with amazement at the Top, which put theexclamation point on the Bull 1990s. The most amazing thing being that what was going on at the timewas recognizable and subject to analysis with a ruler (see Resources). The analysis furthermore indicatedthe party was over (or at least the fat lady was in the process of singing). As Edwards noted, theBroadening Top, which had (and has) implications of its own, morphed into a Diamond, which threw off afalse signal, breaking out on the upside, which developed into another triangular-like pattern (could belooked at as ragged triangular or ascending—only bottom line shown here), which after a head fake brokedown, made a modified V-Bottom and returned to the top of what could be looked at as a monsterrectangle. The top horizontal line, drawn in August 2000, stops the 2001 rally cold and from there it is aslippery slide to the tragedy of September 11, 2001. It was obvious that the investor had no business being\nlong and that trading strategy was in order. Was there any prescience in recognizing the mulish sidewaystrend of the market? None whatsoever. Is all this hindsight? The reader may see for himself by examiningthe record of how this market was analyzed at the time at the edwards-magee.com newsletter archives.\nat 58 and then swings up to a new peak at 63. It “churns” there for a day or two and drops back again, thistime to 56% before it is halted by another burst of buying. Its third rally takes it up to 62, where ithesitates and falls back to 59, but it is then picked up again and carried on to 65. (By this time, aBroadening Formation has become evident on the chart.) At 65, there is a great show of trading, followedby another reaction that drops quotations quickly back to 60. Support appears there momentarily andprices fluctuate for three or four days between 60 and 62 and then fall away again, finally to close at 56,with volume running high all through this phase. A fourth rally starts, but now the traders who bought inat 60 on the preceding downswing are frightened and looking for a chance to “get out even,” and theadvance is stifled at that level. Quotations start to slip and soon are down to 55, below the previous patternBottom. When this occurs, the “failure” of the preceding rally is confirmed—its failure, that is, to riseabove 65 and, thus, carry on the Broadening Movement. The decline below 56, by virtue of that failure,may be regarded as a breakout.\nIf you followed the foregoing example closely, you will have noted there can be (and very often are)Minor Fluctuations inside the pattern that do not affect its outcome. Thus, the rise from 56% to 65 reallyconsisted of three moves, first from 56% to 62, then from 62 back to 59, and, finally, from 59 up to 65.The reaction from 62 had no significance so long\nFigure 10.13 Hudson is another stock that ended its Bull Market in 1946 with a Major Diamond, whichalso could be taken as a Complex Head and Shoulders. This formation was plain on the weekly chart but\nhard to see on the daily. Note how the Diamond gave a sell signal about 2 points higher than the Head-and-Shoulders. The 14%-17% area at the end of the year, when construed as a weak Rectangle, was barelyfulfilled in February 1947.\nas it stopped above 56% and was succeeded by a new rise carrying beyond the previous pattern high,which, in this case, had been 63.\nThe example just detailed is one of the more common types in which the failure occurs on a rally and thebreakout eventuates on the downside. But it could have been converted into the opposite form if the lastdecline had stopped at 60, and then, instead of fluctuating for a few days between 60 and 62", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 62}
{"text": "ucceeded by a new rise carrying beyond the previous pattern high,which, in this case, had been 63.\nThe example just detailed is one of the more common types in which the failure occurs on a rally and thebreakout eventuates on the downside. But it could have been converted into the opposite form if the lastdecline had stopped at 60, and then, instead of fluctuating for a few days between 60 and 62 and breakingdown again, had pushed right back up and past 65. That action would have given us a failure on a declineand an upside breakout. (The odds would be, however, that the final Top was not far away.)\nThe Orthodox Broadening Top\nThere is one particular manifestation—a special case, as the mathematicians might say—of theBroadening Price Formation whose general nature we have discussed in the preceding paragraphs. Thisparticular form appeared at the 1929 Tops of many of the active and popular stocks of that day, but it hasdone so with less frequency at Bull Market highs since 1929, and rarely has done so at high-volume Topspreceding extensive Intermediate Declines, as in 1933 and 1934. It is known to market technicians underthe specific name of Broadening Top, and although it conforms to our general descriptions for allSymmetrical\n120\n112\n104\n96\n88\n80\n76 Sales 100's\n500\n400\n300\n200\n100\n*G\nU. S. STEEL X\ntllHWHHlHtt j 1937\nAPRIL MAY ' JUNE ’ JULY AUGUST SEPTEMBER\n3 10 17 24 1 8 15 22 29 5 12U9 26 3 10 17 24 31 7 ’14 21 28 4 11 18 25\nFigure 10.14 As U.S. Steel approached the Top of its Secondary Recovery in August 1937, its pricefluctuations tended to grow narrower, between upward sloping but converging boundaries, while volumediminished. This pattern—a Wedge—carried a definitely Bearish message. The entire swing from July tothe end of August was essentially a Rounding Top. The three Gs mark Breakaway Gaps (see Chapter 12),the last (September 7) made as prices broke down through a Support Level (see Chapter 13).\nBroadening Price Patterns, it has been so precisely defined, and so often cited in technical writings, thatwe may well take some time to examine it.\nThe Orthodox Broadening Top has three peaks at successively higher levels with two Bottoms betweenthem, with the second Bottom lower than the first. The assumption has been it is completed and in effectas an important Reversal indication just as soon as the reaction from its third peak carries below the levelof its second Bottom.\nPerhaps we can best see what this formation is like if we examine one of the classic patterns thatdeveloped in 1929. Our chart (Figure 10.2) shows the daily market action (price and volume) of AirReduction from July 1 to December 31 of that year. We have numbered from 1 to 5 the significant turningpoints within the Broadening Top that ended that stock's Bull Market in October. A Broadening PricePattern was not detectable until prices had started to move up from the second Minor Low (point 4); bythen 3 had formed above 1 and 4 below 2. New highs at 5 (a and b), followed by the definite downsidebreakout at B (nearly 6% under 4), completed the pattern and, according to the rules, signaled a MajorTrend Reversal. In this case, there can be no doubt as to the importance of the Reversal indication\nbecause, as our chart shows, the price of Air Reduction dropped from above 220 on October 18 to below80 on November 14, just four weeks later, and the final Bottom was not seen until nearly three years laterin 1932.\nThere are some fine points of this classic example that should be noted. First, a new high, that is, a thirdand higher Top, was made at 5a and the subsequent reaction was halted at 195, well above 4, andsucceeded by renewed advance. This looked like one of the advance notices (“failures”) to which we havereferred on a preceding page, portending an upside breakout. But the example before us will serve toemphasize the warning\n72\n68\n1936\n64\nMil\n60\n56\n52\n48\nLOEW'S, INC.\nLW\n44\nSales\n100's\n125\n100\n75\n50\n25\nJULY AUGUST SEPTEMBER OCTOBER NOVEMBER DECEMBER\n4 11 18 25: 1 8 15'22 29 5 12 19 26 3 10 17 24 31 '7 14 21 ' 28 5 12 19 26'\nFigure 10.15 An “ideal” Falling Wedge that developed in Loew's in 1936. Note the volume trend therein,which is irregular but generally diminishing. July produced a small Flag (see Chapter 11), and at the endof the year, “LW” went into a Rectangle out of which prices “skyrocketed” to 75.\nthat we attached thereto—that such an indication is not to be trusted until prices have decisively exceededthe previous Top. At 5b Air Reduction was traded briefly at 223, 2 points, but less than 3% higher than 5a,and the day closed with quotations below 5a. The break on October 24 (to B) took prices more than 3%under the level of 4. Now occurred a development typical of Broadening Tops—a Pullback Rally (to B)retracing about half of the ground lost between the last pattern Top (5b) and the end of the initial breakoutmove (B). Such a recovery (and failure) will be attempted, according to our experience, in at least four outof five Broadening Top Patterns, and it may not fail until it has regained two-thirds of the precedingdecline, although it usually peters out around or even below the halfway mark.\nAs stated, this is a classic example; there were many others at that time. The very fact that so manyevolved at the 1929 peak, which was followed by history's most disastrous losses, probably accounts forthe extremely Bearish implications market technicians have ascribed to the Broadening Top Formation.We regard it now with somewhat less awe; its measuring implications are probably no greater than thoseof a large, high-volume Head-and-Shoulders, but it is a pattern characteristic of the last stages of aPrimary Uptrend.\nThe insistence that the third Top (our number 5), when followed by a decline below the second Bottom(our number 4), completes the Reversal Pattern may be regarded, in the light of experience, as setting toostrict a limitation because Broadening Formations do, on occasion, go on to make a fourth and higher T", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 63}
{"text": "d-and-Shoulders, but it is a pattern characteristic of the last stages of aPrimary Uptrend.\nThe insistence that the third Top (our number 5), when followed by a decline below the second Bottom(our number 4), completes the Reversal Pattern may be regarded, in the light of experience, as setting toostrict a limitation because Broadening Formations do, on occasion, go on to make a fourth and higher Top.Yet this rule may be, and usually is, justified by the fact the overall indications are undeniably Bearishand, hence, one should not wait too long to get out. On the other hand, the requirement for a third Topdoes seem to be justified on the score that Major Reversals are seldom completed until at least three\n96\n88\n80\n76\n72\n68\n64\n60\n56\n52\n48\n44\n40\n38\n36\n34\n32\n30\n28\n26\n24\nSales\n100's\n125\n100\n75\n50\n25\nSCHENLEY DISTILLERS\nFigure 10.16 Wedges seldom appear at Major Trend Reversals, but Schenley's Bull high in 1946 wasmade at the end of an eight-month Rising Wedge, plainly seen on its weekly chart. The dashed line at 60marks a Support Level (see Chapter 13) that served to stem the subsequent decline for nine weeks.\nattempts have been made to push prices on in the direction of the previous trend. This is the reason whypioneer technical students lumped together many formations under the classification “Five-PointReversals.” The Broadening Top is a Five-Point Reversal (our numbers 1-5) and so it is a Head-and-\nShoulders. A Broadening Top might, in fact, be called a Head-and-Shoulders with a high right shoulderand a down-sloping neckline.\n76\n72\n68\n64\n60\n56\n52\n48\n44\n40\n38\n36\n34\n32 Sales 100's\nT' . Til i _ 1\ntill!Jl Jly-ludMuiKlllJ ..\nMARCH\nMAY\nAUGUST\nTRANSCONTINENTAL & WESTERN AIRLINES TWA\nOCTOBER N\nAPRIL\n13 20 2\nJANUARY FEI 12 19 26 2.\n¥\nli -I1,1\nFigure 10.17 There are many interesting and technically significant features in this 12-month daily chartrecord of “TWA.” Note the extraordinary One-Day Reversal, December 3, which marked its Major Top.Although the next four weeks produced a sort of poorly formed Descending Triangle, the Reversal Daywas the only clear-cut and unmistakable signal to sell. When you study Pennants, turn back to this chartfor its November Pennant. Its long Intermediate Down Trendline was tentatively broken in August 1946,without confirming volume (see Chapter 14). Note that at no time during the decline did a “Buy” Patternappear.\n56\n52\n1946\n48\n44\n40\n38\n36 Sales 100's\n125\n100\n75\n50\n25\nGREYHOUND CORP.\nUllulllLillU\nAUGUST\n1 8 15 22 29 6 :13 20 27 3 :10 17 24 :31 7.14 2128\nFigure 10.18 The strong One-Day Reversal that marked Greyhound's 1946 Bull Market high; note theclimax volume. A less conspicuous Reversal Day appeared on August 26. It is suggested the reader goback over all charts in the preceding chapters; he will find many Reversal Days of greater or lesserconsequence. Many gaps (G) were of measuring type (see Chapter 12).\nFigure 10.19 Apple, 1987 Reagan Crash. Does this plunge appear to be out of the blue? Not really.Numerous signs are given: break of major trendline; short-term momentum down before the crash in anenvironment of extreme top psychology; then the crash itself, the Panic Selling exhibiting the typicalpattern of short covering; and then further decline.\nWhy no Broadening Bottoms?\nAll of the other types of Reversal Formations we have studied thus far can occur as either Tops orBottoms; they can develop at the end of a decline to turn the trend up or at the end of an advance to turnthe trend down. But this does not seem to be true of the Broadening Formation. It has been assumed in thepast that Broadening Bottoms must exist, but the writer has never found a good one in his examination ofthe charts of thousands of individual stocks over many years, and only one or two patterns that bore a\nresemblance to it in the charts of the Averages. Apparently, the circumstances that create BroadeningFormations do not exist after a prolonged decline in prices. This would seem to bear out our earliercharacterization of this sort of pattern as suggesting active, excited trading with much public (and, hence,not too well-informed or managed) participation. Such conditions are naturally associated with the finalphases of a Bull Market.\nRight-Angled Broadening Formations\nPrice patterns of the “Inverted Triangle” shape, having a horizontal Top or Bottom boundary, occur aboutas often as the symmetrical type, which is to say, not nearly as often as true Triangles, Rectangles, and soon. In the mid-twentieth century, there were very few of them (EN9: Still scarce in the 2000s). Althoughthe true Right-Angle Triangle with a horizontal top line and up-slanting bottom line is called an AscendingTriangle, just as its counterpart with\n40\n35\n30\n25\nFigure 10.20 The Panic Selling of October 19, 1937, produced a conspicuous Climax Reversal Day innearly all leading stocks, as well as in the Averages. This New York Central chart shows, beside theSelling Climax (SC), its Head-and-Shoulders Recovery Top of July-August and a Consolidation Rectanglethat ended as a Triangle in early October. “CN” made a final Bear Market low the following March at10%. On a logarithmic price scale, its down trendline from August was not broken until June 1938.\na horizontal bottom boundary and a down-slanting top boundary is called a Descending Triangle, wecannot apply these terms to the Inverted or Broadening Forms. Generally speaking, Right-AngledBroadening Formations carry Bearish implications, regardless of which side is horizontal, in nearly thesame degree as the symmetrical manifestations.\nObviously, however, they differ essentially from Symmetrical formations in one respect: a horizontal sideindicates either accumulation or distribution at a fixed price, depending on which side is horizontal.Logically, it follows any decisive break through that horizontal side has immediate forceful significance.Thus, if a Broadening Price Pattern with a flat top boundary develops after a good advance, and if pricesfinally burst up thr", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 64}
{"text": "ially from Symmetrical formations in one respect: a horizontal sideindicates either accumulation or distribution at a fixed price, depending on which side is horizontal.Logically, it follows any decisive break through that horizontal side has immediate forceful significance.Thus, if a Broadening Price Pattern with a flat top boundary develops after a good advance, and if pricesfinally burst up through that top line on high volume and close above it to a conclusive extent (roughly3%), then it is safe to assume the preceding uptrend will be resumed and carried on for a worthwhilemove. This does happen, although it is rare. The odds favor the opposite, that is, the eventual victory ofthe forces of distribution that created the horizontal Top and a breakaway into an extensive decline.\nMoreover, if an advance is to ensue from a Flat-Topped Broadening Formation, chances are the thirdreaction in the formation will be attended by much diminished trading activity\nFigure 10.21 Dow Industrials, 1987 Reagan Crash. Rumors proliferated—ironically, one that Reagan hadAlzheimer's. Proximate cause: professional panic exacerbated by an ill-considered portfolio insurancescheme propagated by academics. Note the authoritative (lower) trendline here (75 days) is broken bymore than 2% (Magee's suggestion) in early September. The broken upper trendline (25 days) would havepulled the ripcord for the more agile trader. Savvy investors were hedging and liquidating throughSeptember, and fund managers panicked in October. According to the Brady Report, Hull Trading Co.bought the bottom on October 20, thus saving American capitalism.\ninstead of the continued high or irregular volume characteristic of Bearish Broadening Movements; eitherit or the fourth reaction will be halted and reversed above the low point of the preceding reaction. Thisturns the formation into a Consolidation Head-and-Shoulders, a Continuation-of-Trend Pattern, which weshall take up in Chapter 11. The message here for the trader owning a stock whose chart begins to developa Broadening Formation of this type is to watch the third reaction. If it carries below the second andvolume does not fall off to a marked degree, sell out on the next rally. (You can always repurchase thesame stock, if you wish, without much “loss of position” should prices finally and, improbably, recoverand push up through the Top.)\nRight-Angled Broadening Formations with horizontal lower boundaries (flat Bottoms) almost alwaysbreak down. Once prices have fallen below the lower boundary line, there is frequently a Pullback Rallyto that line, either in a few days or in two or three weeks, similar to the Pullbacks that so often follow thebreakdown from a Head-and-Shoulders Top.\n(Note that the third or fourth rally in a pattern that starts out as a Flat-Bottomed Broadening Formationmay fail to carry prices as high as its predecessor, in which case a Head-and-Shoulders deal will instill. Inother words, every Head-and-Shoulders begins as a Broadening Formation and the statement of thatrelation takes us logically to our next type of Reversal picture.)\nThe Diamond\nThe Diamond Reversal Formation might be described either as a more or less Complex Head-and-Shoulders with a V-shaped neckline or as a Broadening Formation which, after two or three “swings,”suddenly reverts into a regular Triangle that is nearly always of the Symmetrical form. So far as theaccompanying volume pattern is concerned, the latter is\nNC\nNATIONAL CASH REGISTER\n24\n22\n20\n19\n18\n17\n16\n15\n14\n13\n12\n11 Sales 100's\n50\n40\n30\n20\n10\n!\ni*’-:\n.....\nu\nO-^\"D J~:~F M A ? M 1 J r J A 1 S ; O' N ' D ; J 1 F ' M\nFigure 10.22 The Selling Climax discussed on the preceding pages is typically a one-day phenomenon,and on only one occasion (April 1939) in history has a general market One-Day Reversal signaled thefinal low of a Primary Bear Trend (although many individual stocks evinced a Selling Climax on theircharts in March 1938).\npossibly the better description; its name obviously derives from its pictorial resemblance to theconventional diamond shape.\nAlthough it is fairly conspicuous and easily detected when it appears on the charts, the Diamond is not acommon pattern. Since its development requires fairly active markets, it rarely occurs at BottomReversals. Its “natural habitat” is Major Tops and the High-Volume Tops that precede extensiveIntermediate Reactions. Many Multiple Head-and-Shoulders Formations are borderline Diamond cases;that is, they permit the drawing of slightly bent necklines. The reader is cautioned, however, against tryingtoo hard to make Diamonds out of price patterns of the Head-and-Shoulders type. There is a temptation todo so because a V-shaped neckline may promise to give an earlier (and, hence, more profitable) breakoutsignal than the straight neckline of the Head-and-Shoulders. It is much safer to stick to the latter, however,unless the second half of the formation consists of a series of cleancut, converging Minor Fluctuations,which plainly demands definition by converging boundary lines, and unless activity shows some tendencyto diminish during this period as it would in a Triangle.\nThe Diamond requires little further comment. Our illustrations will suffice to acquaint you with its typicaldetails. It carries a minimum measuring implication that, having studied\nMarch\nSeptember IO ctober November I December\nQUALCOMM (58.7500, 62.0625, 58.0000, 59.8750, ^1.5625)\n. j- 2000\n44^^100000\nFebruaryl\ntpril May\nL|ll|.lllllllllJ.ill lllj.iL II ||. t......iiL.....\nJune July August I\nCreated with Meta Stock www.equis.com\n210\n- 200\n190\n- 180\n170\n160\n- 150\n- 140\n- 130\n- 120 - 110\n100\n- 90\n• 80\n70\n- 60\n- 50\n40\n30\n-10000\n9000\n- 8000\n• 7000\n- 6000\n- 5000\n4000\n- 3000\nFigure 10.23 A church spire top in Qualcomm. The December gap might be mistaken for a buy signal, asmight be the runaway days, but they are actually hand-engraved invitations to leave the party with nearprogressive stops a hair off the day's low. Also valid is t", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 65}
{"text": "200\n190\n- 180\n170\n160\n- 150\n- 140\n- 130\n- 120 - 110\n100\n- 90\n• 80\n70\n- 60\n- 50\n40\n30\n-10000\n9000\n- 8000\n• 7000\n- 6000\n- 5000\n4000\n- 3000\nFigure 10.23 A church spire top in Qualcomm. The December gap might be mistaken for a buy signal, asmight be the runaway days, but they are actually hand-engraved invitations to leave the party with nearprogressive stops a hair off the day's low. Also valid is the exit on the Key Reversal on day two after thegap. How does the trader know this is a blow-off and not a signal to pyramid? By the age, length, state,and slope of the market. When trendlines go vertical, blow-off management must be used. The return tothe base of the first runaway day is notification that it is a Bull trap—the first Bull trap. The second Bulltrap is the breakout of the triangle in March. A wonderful chart filled with fin de siecle and fin demillennium lessons.\nthe Head-and-Shoulders and Triangle formulas, you can probably deduce for yourself. Prices should moveat least as far from the breakout point as the greatest width in points of the pattern from its Top (head) toBottom (V in neckline). This, it must be emphasized, is a minimum rule and subject only to the usualqualification that a Reversal Formation must have something to reverse. Generally, the new trend carriesprices eventually well beyond the minimum measurement.\nWedge Formations\nAll of the chart formations we have discussed up to this point can and do develop at changes in the MajorTrend of prices; a few of them seldomly occur at any other change than a Major Reversal. We have toconsider three patterns that are ordinarily Minor, or, at most, only Intermediate in their trend implications.They are useful, nevertheless, in trading operations. One of them, the Wedge, we have already alluded to(in Chapter 8) as having some resemblance to the Triangles.\nThe Wedge is a chart formation in which the price fluctuations are confined within converging straight (orpractically straight) lines but differs from a Triangle in that both boundary lines either slope up or slopedown. In a Symmetrical Triangle, the Top border slants down, whereas the Bottom border slants up. InRight-Angle Triangles, one boundary slopes either up or down, but the other is horizontal. In a RisingWedge, both boundary lines slant up from left to right, but because the two lines converge, the lower mustproject at a steeper angle than the upper. In a Falling Wedge, the opposite is true.\nMSFT(D)- Da\nilyNASDAQ L= 2\nBull Trap\n7.56+0.35+1.29%\nw\nB =27.55\n1\nA =27.56\nll\nI'D\nO =27.67 Hi= 2773 Lo= 2 .44C =27.56V = 57145012\n44.06 RunawayD\niys\n1 v J Departmentof usticeG ip\nM L\nJISJI V Nr\n1\nIf3530 V RunawayGap\nI L J J L\nExhaustionGap A N ll\nii\nS OND00FMAMJ JA SON\nCreated with TradeStation\nFigure 10.24 Microsoft. A Key Reversal Day in March. Department of Justice breakaway gaps: runawaygaps, exhaustion gaps. Selling Climax. As usual, further lows are achieved. A cornucopia of chartists'\ndelights.\n\nFigure 10.25 eBay. As eBay broke its trendline and drifted sideways, it became a good subject for KeyReversal Day trading. Note several instances.\n8\n26\n24\n22\n20\n18\n16\n14\n12\n10\n32\n30\n28\nFigure 10.26 If you cannot deliver groceries electronically what good is the internet? Meg Whitman (acompetent, well, more than competent, CEO) and eBay found a use for it: the biggest flea market everinvented (and growing every day). Every military commander knows the axiom, Exploit Success! andeBay exploits and exploits and exploits. Is there a fundamental lesson here for the technician? Absolutely.Although the technician should be able to take a nameless chart and trade it competently (CEO of his ownship) no real information or data should be ignored. In this case, the real information—that eBay was an800-pound gorilla (or flea)—fit the chart perfectly. So eBay separated itself from a bunch of nags to runlong and hard. Handicappers know to always keep an eye on winning jockeys: Whitman. Ellison atOracle. Moore at Intel. Gates at Microsoft. Jobs at Apple (and Pixar and NEXT and so on ... and so on ..In2005, what is to be done with eBay? Draw a trendline, raise your stops, and sell it if it reverses.\nSuperficially, one might think because an Ascending Triangle with one horizontal and one up-line is aBullish picture, the Rising Wedge, with both of its pattern lines up, should be even more Bullish. But suchis not the case. Remember, the flat top of an Ascending Triangle signifies a supply of shares beingdistributed at a fixed price; when that supply has been absorbed (and the rising lower boundary lineindicates it will be absorbed), the pressure is off and prices will leap forward. In a Rising Wedge, on theother hand, there is no evident barrier of supply to be vaulted, but rather, a gradual petering out ofinvestment interest. Prices advance, but each new up-wave is feebler than the last. Finally, demand failsentirely and the trend reverses. Thus, a Rising Wedge typifies a situation that is growing progressivelyweaker in the technical sense.\nIt might be said any advance in prices, no matter what shape it may take on the chart, weakens thetechnical status of the market. Prospective buyers are—or, at least, should be—more reluctant to pay highprices than low, and owners are more willing to sell at high prices than at low; in other words, any sort ofrise tends to increase supply and diminish demand. (Although theoretically true, the preceding statementmust be qualified by the fact that rising prices actually attract rather than discourage public buying.) Thedifference between a Rising Wedge and what might be called a normal Uptrend Channel (of which we\nLU (Lucent Tech Inc) 08/26/2006 3:34 PM EDT\nFigure 10.27 Lucent. Late twentieth- and early twenty-first-century schizophrenia. Runaway Days,Breakaway Gaps. Maalox is to be prescribed for the investor. Ecstasy for the trader. Reversal Days andshort-term tactics win the day when the subject is insane. An excellent example of fitting the trader to thestock. Wh", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 66}
{"text": "ed a normal Uptrend Channel (of which we\nLU (Lucent Tech Inc) 08/26/2006 3:34 PM EDT\nFigure 10.27 Lucent. Late twentieth- and early twenty-first-century schizophrenia. Runaway Days,Breakaway Gaps. Maalox is to be prescribed for the investor. Ecstasy for the trader. Reversal Days andshort-term tactics win the day when the subject is insane. An excellent example of fitting the trader to thestock. Why would a rational investor own such a stock?\nshall have more to say later) is the Wedge sets a sort of limit on the advance. Its converging boundarylines focus on a point near where the advance will halt and reaction will set in.\nWe can state most of the essential facts about the Up-Pointed Wedge Formation in a few short sentences.It can develop either as a sort of Topping-Out Pattern on a previously existing uptrend or start to formright at the Bottom of a preceding downtrend. It (the Wedge) normally takes more than three weeks tocomplete; a shorter pattern of this shape is nearly always better classified as a Pennant, which we willdiscuss in the next chapter. Prices almost always fluctuate within the Wedge's confines for at least two-thirds of the distance from the base (beginning of convergence) to the apex; in many cases, they rise clearto the apex, and in some, they actually go a short distance beyond, pushing on out at the Top in a last-gasprally before collapsing. Once prices break out of the Wedge downside, they usually waste little time beforedeclining in earnest. The ensuing drop ordinarily retraces all of the ground gained within the Wedge itself,and sometimes more. Trading volume in a Wedge tends to follow the regular Triangle Pattern, diminishinggradually as prices move up toward the apex of the Wedge.\nThe Falling Wedge\nExcept for the fact it is pointed down, the Falling Wedge appears in all respects like the rising form justdescribed, except the price trend that follows its completion differs in character. When prices break out ofa Rising Wedge, they usually fall away rapidly, but when they\nFigure 10.28 In the caption to Figure 10.27, the editor asked, apparently rhetorically, why a rationalinvestor would own Lucent. The picture here shows what happens when apparently rational investors donot set a stop to protect themselves from irrational volatility. The market knows things investors do notknow, but it will reveal these things to the most basic of investors if he reads the chart. This chart is addedfor the ninth edition to pick up the picture where the eighth left off.\nmove out of a Falling Wedge, they are more apt to drift sideways or in a dull “Saucering-around”movement before they begin to rise. The Rising Wedge may, therefore, call for quick action to secureprofits, whereas with a Falling Wedge, the trader ordinarily can take his time about making hiscommitment for the ensuing rise.\nBoth types of wedges should be well defined on the chart. Unless a trend pattern is quite compact withfrequent fluctuations, nicely bounded by lines that clearly converge to a point, and their up (or down) slantis marked, the Wedge construction must be considered doubtful. You will find borderline cases in whichone of the pattern lines so nearly approaches the horizontal in direction that it resembles a Right-AngleTriangle, and the latter would carry quite different implications for future trend development. It is difficultto lay down any hard and fast rules for distinguishing the two. If one boundary line is nearly horizontal, orif the daily closing prices tend to fall at about the same level, then the formation is more safely construedas a Triangle. The reader need not let this problem worry him unduly, as he will rarely be left in doubt forlong after he has acquired a little experience with charts. One soon gets to recognize the characteristic“symptoms” of the different formations and make correct diagnoses almost instinctively.\nWedges on weekly and monthly charts\nMost true Wedges are too short-lived (seldom longer than three months) to take on a recognizabledefinition on a monthly chart, but they may be spotted occasionally on the weeklies. Longcontinued, gradual downtrends, when plotted on arithmetic scale, sometimes assume the Wedgeform. Thus, an entire Major Bear Decline on any arithmetic monthly chart may appear like a giantFalling Wedge. This is due to the fact that the up and down fluctuations that compose the MajorSwing, while maintaining about the same extent in percentage, tend to shorten in terms of points(dollars) as prices move from higher to lower levels. Such Major chart patterns are not the trueWedges we have discussed herein. When plotted on semilogarithmic scale, these same moveswould normally show a Parallel or even slightly widening, instead of Converging, Channel.\nRising Wedges common in Bear Market Rallies\nAs a final note, we might add that the Rising Wedge is a quite characteristic pattern for Bear MarketRallies. It is so typical, in fact, that frequent appearance of Wedges at a time when, after anextensive decline, there is some question as to whether a new Bull Trend is in the making may betaken as evidence that the Primary Trend is still down. When a Major Bear Swing ends in a Head-and-Shoulders Bottom, the last Rising Wedge will often appear as prices rally from the left shoulderto the neckline and just before they break down to the head (final low). A Rising Wedge on anarithmetically scaled weekly chart is almost invariably a Bear Market phenomenon, expressing thediminishing vigor that is the normal property of any reaction against a prevailing Primary Trend.\nThe One-Day Reversal\nWe referred in Chapter 6 to a price pattern known as the One-Day Reversal. This particulartechnical Reversal indication, when taken alone, can be accorded only temporary or strong MinorTrend significance. True, it may appear at the very peak of a long advance, forming perhaps on thehigh day of the head in a Head-and-Shoulders Pattern, which will be followed by a long decline,but it can hard", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 67}
{"text": "versal\nWe referred in Chapter 6 to a price pattern known as the One-Day Reversal. This particulartechnical Reversal indication, when taken alone, can be accorded only temporary or strong MinorTrend significance. True, it may appear at the very peak of a long advance, forming perhaps on thehigh day of the head in a Head-and-Shoulders Pattern, which will be followed by a long decline,but it can hardly be credited with forecasting that entire decline; all it really signaled was the turn inthe “head” itself. A One-Day Reversal may just as well occur, for example, at the beginning (thefirst peak) of a Symmetrical Triangle which only Consolidates instead of Reversing the previousuptrend. Even so, as you can see, it warns us of at least temporary exhaustion of Bullish forces.\nOn the downside, a One-Day Reversal often appears in magnified and conspicuous form at the endof a Panic Sell-Off, in which case it usually is referred to as a Climax Day or Selling Climax. Thismanifestation of it has special significance, which we shall take up later. First, however, just what isa One-Day Reversal?\nTo begin, it is a day of unusually high volume, exceeding, as a rule, by a notable margin any tradingturnover registered in any one-market session for the past several months. It comes after a fairlylong and steady advance (or a similar decline), on which activity has been increasing gradually.Prices push right ahead from the opening gong as if nothing could stop them. Frequently, even theopening sales are so far beyond the previous day's closing level as to leave a large gap on the chart.(We shall discuss gaps later.) The tape runs late and before the advance (or decline) halts, priceshave been carried as far in an hour or two as three or four days would ordinarily take them. But thehalt does come finally, maybe at the end of the first hour or perhaps not until late in the day. Then\nquotations “churn,” registering only fractional changes to and fro, with the tape still “fast” andoften running late by spurts. Suddenly, the trend reverses and prices move just as rapidly in theopposite direction. The session ends with a final burst of activity that puts the price at the closeright back where it started the day. There has been an enormous amount of activity, and quotationsmay have traversed intraday a range of 2% or 3%, but the net change from the previous day at theend of trading is very small.\nOne-Day Reversals at Tops appear quite often in the charts of individual stocks that are thin(relatively small floating supply of shares), have had an active advance, and have attracted a largepublic following. They rarely develop in the Averages. Selling Climaxes (One-Day Reversals atBottoms), on the other hand, are found conspicuously in the Averages at the end of many abnormalor Panic Declines.\nOne-Day Reversals, as already stated, do not carry Major Trend implications. The nimble in-and-out trader can capitalize on them—maybe pick up several points if he has funds available andjumps in at the right moment. But, as a rule, the new trend (i.e., the trend at the close of the day)does not carry very far right away; prices usually “work” around in the nearby ranges for some timeand build some sort of area pattern before they move away in a swing of Intermediate proportions.The One-Day Reversal, as a phenomenon that occurs frequently within or at the start of morepregnant technical formations, gives an important clue to probable trend developments. In anyevent, it is an urgent warning to watch closely the chart in which it has appeared to see what patternof price action may follow and be prepared for the worthwhile move when it comes.\nThe type of false move or shakeout described in Chapter 8 as occurring at the apex end of aSymmetrical Triangle often takes the form of a One-Day Reversal.\nThe Selling Climax\nIn the “bad old days” when stocks could be bought by putting up as little as 10% of their cost incash and there were no restrictions on short selling, professional operators could (and tradition saysthey often did) organize Bear Raids to shake out weakly margined holdings. By selling short inquantity at a favorable moment when the “public” had gotten itself pretty well extended on the longside, they could break prices down. Brokers then would send out calls for more margin from their“long” accounts, many of whom could not or would not put it up, with the result of their stocksdumped on the market, which in turn produced further declines. The professionals could then stepin, cover their shorts with a profit, and secure a line of long stock for the next advance. Bear Raidsof this sort were effectively checked by the imposition of the Securities and Exchange Commission(SEC) regulations, but margin calls and forced selling will always exist as a market factor so longas stocks can be bought on margin and whenever prices drop extensively following a spree ofpublic buying.\nMost true Selling Climaxes, if not all, have been produced by distress selling such as referred to inthe preceding paragraph. They have come at the end of rapid and comprehensive declines thatexhausted the margin reserves of many speculators and necessitated the dumping of their shares atwhatever the market would bring. This process is progressive—feeding upon itself, so to speak—with each wave of forced sales jeopardizing another lot of margined accounts, until, at last, millionsof shares are tossed overboard, willy-nilly, in a final cleanup. Such is a Selling Climax in which thetotal turnover may exceed any single day's volume during the previous upswing. It is a harvest time\nfor traders who, having avoided the Bullish infection at the top of the market, have funds in reserveto pick up stocks available at panic prices.\nObviously, a cleanout day or Selling Climax radically reverses the technical condition of themarket, for in its process, shares have passed from weak hands into strong hands at very muchlower prices. The ominous weight of potential selling that", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 68}
{"text": "vest time\nfor traders who, having avoided the Bullish infection at the top of the market, have funds in reserveto pick up stocks available at panic prices.\nObviously, a cleanout day or Selling Climax radically reverses the technical condition of themarket, for in its process, shares have passed from weak hands into strong hands at very muchlower prices. The ominous weight of potential selling that has been overhanging the market hasbeen removed. Usually, the Panic has carried quotations (although only temporarily, as a rule) wellbelow even conservative values based on current business conditions.\nA Selling Climax need not be completed, and the Reversal of Trend actually becomes evident,within a single day. We have classified it as a variety of One-Day Reversal, but some of them haveactually spread out over two days, with the decline exhausted and coming to a halt late on the firstday, too near the end of the session to permit much recovery. The next day sees an extensive rallyright from the opening gong, as it is immediately apparent then, if not late on the preceding day,that there are no more distress offerings.\nThe all-time percentage record for Selling Climaxes is held by October 29, 1929. Prices in terms ofthe Dow-Jones Industrial Average opened that day practically at their high, 252.38, which was morethan 8 points below the previous day's closing level. Panic selling flooded the Exchange from thestart; before it was over, the Industrial Average had lost 40.05 points. From that low, 212.33, itrallied in the final two hours to 230.07 for a gain of nearly 18 points and went on up another 28points the following day. This 1929 climax set the alltime record also for daily turnover: 16,410,000shares were traded in those five hours, more than twice as many as in any one day during the entirepreceding Bull Market. But the low level of October 29 was broken a week later, and the bottom ofthat particular early phase of the 1929-1932 Bear Market was not reached until November 13. EN:See comments on the following page on the Reagan Crash of 1987.\nThe Panic of 1937 ended with a classic Selling Climax on October 19, another “Black Tuesday” instock market annals. The Dow Industrials had closed at 125.73 the night before; prices had alreadyfallen without a rally of consequence from a high of 190 in mid-August, and margin accounts werenearly all in a precarious situation. The telephones had worked overtime the preceding day bybrokers demanding additional margin, most of which was not forthcoming. When the Exchangeopened on the 19th, quotations hit the toboggan under a flood of offerings. By 11:30 a.m., with theIndustrial Average around 115, the selling was over and offerings disappeared. An hour later, priceswere jumping a point between sales and the day closed at 126.85, recovering its entire loss. Volumeon that climax was 7,290,000 shares, double that of any day at the top of the preceding BullMarket. An intraday high of 141.22 was reached 10 days later, but the Panic Low was subsequentlybroken on November 20, 1937, and that Bear Market finally ended at 98.95 (Dow-Jones Industrials'closing level) on March 31, 1938.\nEN: No wonder investors have instinctual angst on October 19. In 1987, the Bear returned tocreate another great Panic—on the very same date. From a high of 2746.65 on August 25 the Dowbungeed to a low of 1,616.21 on October 20. The actual full-blown panic took place from October14 (high 2,485.15) to October 20 (low 1,616.21) with October 19 and 20 traversing a range of547.95 points or 25% of the market at that point. Top to bottom, 1130 points were lost, comprisinga retracement of 41%. The more things change the more they stay the same, as Andre Malraux issaid to have remarked. Actually, he said it in French, which is more elegant, and expresses the sameidea: Plus ga change, c'est plus la meme chose. Readers should not assume that similar crashes willnot occur in the future.\nThe foregoing were general market climaxes, a phenomenon that produces (or rather is producedby) simultaneous selling in practically every actively traded individual issue. A Climax Bottom, asa matter of fact, appears in an individual stock chart, as a rule, only as a concomitant of a generalmarket cleanout, although there are cases in which some particular and completely unexpectedpiece of bad news affects one certain company and causes panicky liquidation of its shares alone,terminating with a One-Day Reversal. The Top Reversal Day, on the other hand, is normally amanifestation of an individual stock rather than of the general market average.\nThe two outstanding examples of Selling Climaxes (cited above) and numbers of others that haveappeared at the conclusion of various Panic Sell-offs offered extraordinary opportunities for a quickturn to the trader who was smart (or lucky) enough to get in at the bottom. He could cash in a fewdays later with exceptional profits. Professional operators capitalize on such opportunities. Theproblem is to recognize the climactic nature of the selling in time to seize the chance—and that isnot as easy as it may have sounded in our discussion. Just to emphasize the possibilities of error,there was a 30-point drop, followed by a 30-point recovery, on a turnover of nearly 13 millionshares, on October 24, 1929, but the trader who did not grab his profits within 48 hours never hadanother chance to get out even (in terms of the Averages, that is).\nBut it is not impossible to recognize a Selling Climax, if you have friends in the Street to keep youinformed on the condition of margin accounts and the amount of necessitous selling to be expected.EN: This information is now not difficult to come by. It is easily obtainable in the general financialpress. The climax comes after a decline approaching Panic proportions. The day usually opens witha substantial Downside Gap (opening prices considerably below the previous night's closing);offerings appear too great to be absorbed; prices collapse;", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 69}
{"text": "the amount of necessitous selling to be expected.EN: This information is now not difficult to come by. It is easily obtainable in the general financialpress. The climax comes after a decline approaching Panic proportions. The day usually opens witha substantial Downside Gap (opening prices considerably below the previous night's closing);offerings appear too great to be absorbed; prices collapse; volume is extreme; the market isexceptionally “broad” with nearly every listed stock crowding into the record. Then, some timeafter 11:00 a.m., perhaps not until afternoon, the selling appears to dry up; a few issues continue todecline while others begin to climb. Suddenly prices are jumping, which is the time to act. Buy astock that has been thoroughly depressed but normally has a good following at all times (e.g., U.S.Steel). Do not hang on too long; take a reasonable profit as soon as it is available and sell, in anyevent, whenever the recovery shows signs of bogging down.\nRemember, a One-Day Reversal is not a dependable Major Trend indicator. Selling Climaxes donot normally occur at the final Bottoms of Bear Markets—weak holdings usually have been shakenout long before that stage is reached. Only one Primary Downtrend in all the record has, in fact,ended with the first Panic Phase, that being the five-month Bear Market of 1938-1939 that wasfollowed by an equally short Bull Market.\nOccasionally, a weekly chart will produce a formation that might be called a “One-Week Reversal,”in some such conspicuous fashion as is shown above in “NC.” In this instance, the subsequent riseproves that a Major change in its technical balance occurred in December 1941. Curiously enough,no other obvious Reversal Pattern appeared on the weekly chart at this turn in the Primary Trend of“NC.” (Its daily chart showed an Ascending Triangle.) But this example of a One-Week Reversal isnot shown to give the idea that such phenomena carry important technical indications. On thecontrary, most “Reversal weeks” are followed by very disappointing moves.\nOne remaining Reversal Formation, the Island Pattern, involves the whole subject of Gaps, whichwill be taken up in detail in Chapter 12; thus, we will defer our discussion of the Island Reversaluntil then.\nShort-term phenomena of potential importance\nVery short-term phenomena—of a one-day or a few days' duration—can sometimes be indicative ofnot only short-term direction, but also give hints as to long-term price behavior. Gaps (see Chapter12) and One-Day Reversals (this Chapter) belong to this group. Other short-term patterns of interestinclude Spikes, Key Reversal Days (sometimes merely called Reversal Days), and Runaway Days(sometimes called Wide-Ranging Days).\nSpikes\nOn the day it occurs, a Spike is not immediately identifiable for by definition it protrudes Head-and-Shoulders above days before and after if it is at or near a Top and plunges much below thesurrounding days if it occurs at a Bottom. So after a day that exhibits an unusually wide range, thesubsequent days must be observed to discriminate the day from a Runaway Day. Both are the marksof a far-ranging battle between Bulls and Bears, with the close giving a clue as to whom theeventual winner will be.\nThe importance of the spike is highlighted by the following:\n1. The strength and length of the action that preceded it.\n2. The close of the day, whether up on a Bottom or down on a Top.\n3. Its prominence when compared with the days before and after it.\nAn extremely wide-range day at the end of a long Bull move that closes down after making unusualnew highs might even be construed as a one-day signal. Whether one trades on it or not woulddepend on his particular style and taste and the nature of his trading—long range, scalping, and soon. In fact, the Spike might also be a One-Day Reversal—that pattern in which an opening gapoften is followed by avid buying that collapses and closes below the opening or at the low of theday. Such action might be compared with an army pursuing a seemingly defeated enemy only todiscover the retreat was a ruse, then turning and fleeing the other way in a rout.\nTurn this description on its head and you have a Spike Bottom. It is not infrequent that a Spike willbe followed by significant price movement in the opposite direction. Figure 10.23 illustrates amodern Spike. Figures 1.1 and 7.16 show some spikes on Edwards' and Magee's charts.\nRunaway Days\nA Runaway Day is a day that stands out on the chart as having an unusually long range, oftenopening at the low and closing at the high, or vice versa for Bear runaways. Here the enemy hasretreated precipitously, or treacherously, to draw the Bulls into a trap. The holders and sellerscannot or will not satisfy the eager demand of the buyers and so the price transverses perhaps twoto three times the daily range. Although the agile speculator may jump on this charging train andrealize a nice scalp, it is the following days that reveal the true significance. Nice consolidation andcontinued volume will confirm the day as significant while a tapering of volume and rounding orvolatile pullback will call into question its validity. Although these days may be taken as hair-trigger buy signals (or sell signals, depending) the return of prices to the low of the Runaway Day\nwill probably indicate the day was a false signal and a trade in the opposite direction is shaping up.See Figure 7.20 for runaways complete with gaps.\nOne such example is shown in Figure 10.24 in which a bull trap precipitated by a Runaway Daywith a subsequent collapse foretold the 50% decline in Microsoft stock in 2000.\nKey Reversal Days\nThe Key Reversal Day pattern occurs when one sees a new high in an up-move and then a closebelow the close of the previous day. As a short-term trading signal it has much to recommend it, butlike every other technical pattern, judgment and timing are required to profit from it. In a BullMarket, there will be some if not many such interim highs marked", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 70}
{"text": "e in Microsoft stock in 2000.\nKey Reversal Days\nThe Key Reversal Day pattern occurs when one sees a new high in an up-move and then a closebelow the close of the previous day. As a short-term trading signal it has much to recommend it, butlike every other technical pattern, judgment and timing are required to profit from it. In a BullMarket, there will be some if not many such interim highs marked by Key Reversal Days. On theKey Reversal Day at a major or important Top, the trader shorts the stock on the close with a stop atthe high of the reversal day, or slightly above. He may then exit on the profit side on the occurrenceof a Key Reversal Day in the opposite direction, or on a profit target, or a chart pattern. Ifadventurous, he may use the trade as the first of accumulating a position for an anticipated BearMarket, adding other positions as more significant patterns occur and as support levels are broken.\nThis pattern also is useful in trading range markets, as shown in some internet stocks from 2000,where trading with Key Reversal Days would have allowed the trader to escape unscathed in theminicrash of the NASDAQ in early 2000 (see Figures 10.25 and 10.27 for eBay and Lucent.)\nOf all the Very Short-Term Patterns, Gaps, One-Day Reversals, Key Reversal Days, Spikes, andRunaway Days, it should be noted that the return of prices to the origination of the formation marksthe formation as a false signal and a reason to reverse the trade direction and look for significantprofits.\nClearly, these are the tactics of scalpers and speculators, but it profits the long-term investor toknow and understand them.\nTaylor & Francis\nTaylor & Francis Group\nhttp://taylorandfrancis.com\nchapter eleven\nConsolidation Formations\nAn army, which has pushed forward too rapidly, penetrated far into enemy territory, sufferedcasualties, and outrun its supplies, must halt eventually, perhaps retreat a bit to a more easilydefended position and dig in, bring up replacements, and establish a strong base from which later tolaunch a new attack. In the military parlance with which we have all become more or less familiarthese past few years, that process is known as consolidating one's gains. Although it will not do tooverwork the analogy, there is much in the action of the stock market that may be compared to amilitary campaign. When a stock pushes ahead (up or down) too fast, it reaches a point at which theforces that produced its move are exhausted. Then it either reverses its trend (in a Major orIntermediate sense), reacts to a good Support Level, or Consolidates its position, in some sort of“sideways” chart pattern composed of Minor Fluctuations, until it has caught up with itself, so tospeak, and is ready to go on again. (For illustrations in this chapter, see Figures 11.1 through 11.18.)\nWe already have had occasion to refer to Consolidation Formations in our study of SymmetricalTriangles and Rectangles; exactly how those two chart formations might either reverse the previoustrend or Consolidate it in preparation for its continuation were shown. We noted about three out offour Symmetrical Triangles will turn out to be Consolidations rather than Reversals—andRectangles in about the same proportion. Even a Flat-Topped Broadening Pattern constructed at theTop of an Intermediate Advance may, despite its normally Bearish implications, be converted into aConsolidation or Continuation Formation if its Flat Top is decisively penetrated on the upside.\nA Dow Theory Line in the chart of one of the Averages may be a Consolidation or ReversalFormation, but is rather more likely to be the former than the latter. A Dow Line is, of course, a sortof loose Rectangle. The fact is almost any sort of sideways price pattern, such as is often termed a“Congestion” or trading area, provided trading volume tends to diminish during its construction(and provided it does not show definite broadening tendencies), usually functions as aConsolidation. But most areas of Trend Consolidation are fairly well defined, taking on arecognizable pattern.\nFlags and Pennants\nWe do not need to spend more time here on the Triangles and Rectangles; they have been examinedin both their Reversal and Consolidation manifestations in previous chapters. Our first twoformations, which are characteristic of Consolidation only, are the Flags and Pennants, which arecuriously related in certain aspects to Triangles, Rectangles, and Wedges.\nA Flag looks like a flag on the chart. That is, it does if it appears in an uptrend; the picture isnaturally turned upside down in a downtrend. It might be described as a small, compactparallelogram of price fluctuations, or a tilted Rectangle that slopes back moderately against theprevailing trend. Let us consider the Uptrend Flag first. It usually forms after a rapid and fairlyextensive advance that produces a nearly vertical, or at least quite steep price track on the charts.On such moves, volume normally shows a progressive increase until it reaches a high rate. Thisvolume (since every transaction signifies a sale as well as\n24\n22\n20\n19\n18\n17\n16\n15\n14\n13\n12\n11\nSales 100's 125\n100\n75\n50\n25\n1945\nMARTIN - PARRY\nMAY\nJUNE\nAPRIL\n7 14 21 28 5 12 19 26 2 9 16 23 30 7 14 21 28 4 11 18 25'1 8 15 22 29\nFigure 11.1 This is a typical and practically perfect Flag, constructed May 12 to June 2, 1945, inMartin-Parry. Daily turnover diminished to a low rate as prices settled down for exactly three weeksafter their swift advance from 11 to 16 1/2 but held up away from the lower boundary line duringthe third week, and then burst out topside with high volume in another straight-line push from 15 to21. Study this chart again when you come to the Flag-measuring formula later in this chapter. Thedashes at 12 indicate the upper range of an old Resistance Level (see Chapter 13).\na purchase) is a warning that many holders of the stock are taking profits. Eventually the pressureof profit-taking halts the markup. Prices “churn” without further gain and then r", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 71}
{"text": "in another straight-line push from 15 to21. Study this chart again when you come to the Flag-measuring formula later in this chapter. Thedashes at 12 indicate the upper range of an old Resistance Level (see Chapter 13).\na purchase) is a warning that many holders of the stock are taking profits. Eventually the pressureof profit-taking halts the markup. Prices “churn” without further gain and then react 2 or 3 pointson reduced turnover. A new rally occurs but fails to equal the previous high or attain the previoustop volume. Another reaction carries quotations slightly below the preceding Bottom with further\ndiminution of activity and then follows a series of similar Minor Fluctuations, each of whose Topsand Bottoms are successively a trifle lower than its predecessor, and with volume shrinkingmarkedly and constantly as the pattern develops. On the chart, the initial, steep up-move followedby the compact, sideways, and slightly down-sloping price Congestion Area, which can be roughlybounded, top and bottom, by parallel lines, takes on the appearance of a mast (or halyard) with aflag flying from its peak, hence, the name of the formation.\nSometimes each rally and setback within the Flag takes three or four days, rarely more. In othercases, prices will skip back and forth between the upper and lower Flag boundaries in a single dayor two, in which event the pattern on the chart consists of an almost solid block of price range lines.The wider the pattern (from top to bottom) the longer time,\n24\n22\n20\n19\n18\n17\n16\n15\n14 Sales 100's\nNATIONAL GYPSUM NG\n1945\nJUNE\nIL\nJULY\nAUGUST\n■\n■aBf\nMlffl® • •• It tffit ■ J It li II L i j I ii 'SEPTEMBER OCTOBER NoVEmBi\n------- ----------------\n16 23 30 7 14 21 28 4 11 18 25 1 8 15 22 29 6 13 20 27 3 10 17 24 1 ' 8\nFigure 11.2 Another typical Flag of three weeks' duration, August 30 to September 18. ThisNational Gypsum chart overlaps that in Figure 8.6, showing the false move at the apex of the May-June Symmetrical Triangle. A buy signal was given when prices pushed up through the old apexlevel on August 23 with increased volume. Most interesting is the second Symmetrical Triangle thatformed in October-November, an almost exact replica of the first, but with a downside false moveat its apex. The sharp increase in volume on November 27 left no doubt as to its being aConsolidation rather than Reversal Pattern. “NG” went on up to 33.\nnaturally, it should take for each swing within it to be completed. This process of MinorFluctuations may continue for only five days to a week if the Flag is narrow, or it can go on for aslong as three weeks. Daily turnover by that time usually will have shrunk to a relatively low ebb.Then, suddenly, prices will erupt with a new burst of activity from the end of the Flag and pushstraight up again in another advance that practically duplicates the original “mast” atop which theFlag was constructed.\nWe have spoken of the Flag pattern as being moderately down-slanting, but the very short and“solid” ones will frequently develop horizontally and look like small squares. (On rare occasions, apattern of the Flag type in an uptrend will even slope up a trifle.)\nFlags form on steep down moves in much the same manner and with precisely the sameimplications as they do in uptrends. Down Flags, of course, tend to slope up—that is, they simplyinvert the picture presented by an Up Flag. Trading volume diminishes during their formation andincreases again as prices break down away from them.\nThe Pennant: a pointed Flag\nThe only important difference between a Pennant and a Flag is the former is bounded byconverging boundary lines rather than parallel lines. The normal Pennant, in other words, is a small,compact, sloping Triangle. It slants down when it appears in an uptrend, and it\n24\n22\n20\n19\n18\n17\n16\n15 Sales 100's 250 200 150 100\n50\n2 9 16 23 30 6 13 20 27 6 13 20 27 3 10 17 24 1 8 15 22 29 5 12 19 26\nFigure 11.3 Flags of the “Half-Mast” type appear most often in the later and most active stages of aPrimary Advance. The above example (January) was the last Consolidation Formation before“NK's” 1937 Bull Market Top. Note the Rectangle Reversal Pattern in March and the series of step-down patterns that followed.\nslants up in a downtrend. It forms, as a rule, after a rapid advance (or decline), and trading volumeshrinks notably during its construction. In fact, activity tends to diminish even more rapidly in aPennant than in a Flag (which we naturally would expect on account of the progressively shorterfluctuations that compose it), and it may drop almost to nothing before the Pennant is completedand prices break away from it in a new and rapid move.\nThe Pennant might also be described as a short, compact Wedge, characterized by markeddiminution of activity. When, as is usual, it slants back against the preceding trend, its forecastingimplications are similar to those of the Wedge, in that prices break out of it in a direction oppositeto its slant. But there are rarer Minor variations of the Pennant, comparable with those sometimesfound in the Flag, in which the price area is very short and “solid” and practically horizontal (like aSymmetrical Triangle), or in which the slope is actually slightly in the same direction as thepreceding trend instead of against it. When prices move out of the last-named type, they ordinarilydo so, not in a sudden straight-line breakaway, but rather in an accelerating curve with volumeincreasing gradually instead of abruptly at the break; the whole pattern resembles a curved horn thatruns to a long, slender point. Do not let these variations worry you; there is nothing deceptive abouttheir appearance; their kinship to the more common, normal form is quite apparent.\nThe measuring formula\nThe same approximate measuring formula applies to the Pennant as to the Flag. They are both“Half-Mast” Patterns that ordinarily form after a fairly steady and rapid (steep) price movement. Inapplying the measuring rule, go back to the beginni", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 72}
{"text": "ariations worry you; there is nothing deceptive abouttheir appearance; their kinship to the more common, normal form is quite apparent.\nThe measuring formula\nThe same approximate measuring formula applies to the Pennant as to the Flag. They are both“Half-Mast” Patterns that ordinarily form after a fairly steady and rapid (steep) price movement. Inapplying the measuring rule, go back to the beginning of that immediately preceding move, to thepoint at which it broke away from a previous Consolidation or\n16 Sales 100's 125 100\n75\n50\n25\nJANUARY\nOCTOBER\nin 117I9413\nFEBRUARY MARCH\nOVE M BER DECEMBER\nVANADIUM CORP.\nFigure 11.4 Sometimes a stock will make a long series of small Consolidation Patterns in itsuptrend, one following right on the heels of another as successive groups of traders buy in whileothers take their profits on previous purchases. In this sequence of step-ups in Vanadium, the FlagPattern formed in January 1937 ran a few days over, but the volume breakout of February 4 left nodoubt the trend was still up. A final Top was made at 39 1/2 in March. Note the strong buy signalgiven on December 14. Refer to this record again in connection with Support and Resistancestudies in Chapter 13.\nReversal Formation (or through a significant trendline or Resistance Level, with which laterchapters are concerned), a point recognizable as a rule by a quick spurt in activity, and measurefrom there to the Minor Reversal level at which the Flag or Pennant started to form. Then measurethe same distance from the point at which prices break out of the Flag or Pennant, and in the samedirection. The level thus arrived at is the minimum expectation of this type of ConsolidationPattern. As a matter of fact, advances from Flags\n68\n64\n60\n56\n52\n48\nBRIGGS\n44\n40\nSales\n100's\n250\n200\n150\n100\n50\nJANUARY\"\n1 4 1 n 11\n4 11 18 25\ni.tiiliihtilhiiltttq\n- FEBRUA R\nMARCH\n1 8 15 22 29 7 14 21 28 4 11 18 25 2 9 16 23 30 6\n13 20 27\nFigure 11.5 A Bull Flag in February and a Bear Flag in April 1936, in Briggs. The Top betweenwas a Symmetrical Triangle. April 30 was a Reversal Day. Prices recovered to 64 1/2 in November1936, making there a long-term Major Double Top with this March high. The Support-ResistanceZone at 51-53, indicated by dashed line, was still effective in 1946 (see Chapter 13).\nor Pennants in an uptrend generally go farther (in terms of points or dollars) than the precedingmove, whereas declines may not carry quite so far. Hence, the formula is best applied on asemilogarithmic chart by measuring actual chart distance rather than by counting points. You cancheck this by referring to the examples illustrating this study.\nReliability of Flags and Pennants\nThese pretty little patterns of Consolidation are justly regarded as among the most dependable ofchart formations, both as to directional and measuring indications. They do fail occasionally, butalmost never without giving warning before the pattern itself is completed. All that is necessary toguard against such failures is to strictly apply the tests as to the authenticity of the patternincorporated in their description. These are as follows:\n1. The Consolidation (Flag or Pennant) should occur after a “straight-line” move.\n2. Activity should diminish appreciably and constantly during the pattern's construction andcontinue to decline until prices break away from it.\n3. Prices should break away (in the expected direction) in not more than four weeks. A patternof this type that extends beyond three weeks should be watched with suspicion.\nThe matter of practical trading on these particular formations will be taken up in Section II of thisbook, which is devoted to tactics. Our second test deserves some further\n72\n68\n64\n60\n56\n52\n48\n44\n40\n38\n36 Sales 100's\n500\n400\n300\n200\n100\niittii\nANACONDA COPPER\nOCTOBER\n“N OV E MB\nR DECEMBER\nANUARY \" ' FEBRUARY MARCH '\n: 3 '10' 17\n7 '14'21 '28 1 5 '12 r19 r26 1 2 1 9 116 '23 <30 1 6 113 l20 1 27 1 6 l13 '20'27 1\nFigure 11.6 The down-sloping, Converging Price Formation of November 4 through December 9might be called either a short Wedge or a Pennant. Note the small Flag in October; also RunawayGaps November 4 and February 19, and the Breakout Gap December 10.\ncomment here though. If a pattern begins to develop on the chart—which, so far as the price picturealone is concerned, qualifies as a Flag or Pennant, but during which trading volume remains high orobviously irregular instead of diminishing—then the outcome is more apt to be a quick reactionagainst, rather than continuation of, the previous trend. In other words, such high or irregularactivity formations are characteristically Minor Reversal Areas rather than true Consolidations.Watch the volume half of your chart at all times.\nWhere they may be expected\nFlag and Pennant Consolidations are characteristic of fast moves. Therefore, they show up mostfrequently in the later, dynamic phase of Bull Markets, after the first accumulation and the moreorderly early markup stages have passed. Hence, the appearance of these patterns may be taken as awarning that an advance is approaching its final weeks. The rapid phase of a Major Bear Trend, onthe other hand, is its second stage, often characterized by almost “vertical” Panic Declines. TheFlags and Pennants that develop therein are usually short— completed in a matter of three or fourdays rather than weeks. In the late months of a Bear Market, formations that evolve on the charts inthe Flag or Pennant similitude often will run too long (four weeks or more), begin to show anincrease in volume on the rallies, and be succeeded by only dull and limited reactions.\nFigure 11.7 An example (in June 1944) of the brief and compact type of price “Congestion” thatcan be classed as a Flag. The advance here started at 5 from a 13-month Symmetrical Triangle ofwhich only the last two months appear above. The measuring implication of this tiny Flag was notfulfilled until after prices had undergone a sort of Triangular Consolidation in July.\nIn general, it", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 73}
{"text": "d reactions.\nFigure 11.7 An example (in June 1944) of the brief and compact type of price “Congestion” thatcan be classed as a Flag. The advance here started at 5 from a 13-month Symmetrical Triangle ofwhich only the last two months appear above. The measuring implication of this tiny Flag was notfulfilled until after prices had undergone a sort of Triangular Consolidation in July.\nIn general, it may be said these particular chart patterns are most common (and most dependable) inuptrends. The appearance, after a Major Decline, of price pictures that, at the start, assume thedowntrend Flag or Pennant form must be regarded with caution. Unless such developments holdstrictly to the limitations we have stated above under the heading of “reliability,” do not trade onthem.\nFlag pictures on weekly and monthly charts\nOne of our requisites for a dependable Flag (or Pennant) was it should not take more than fourweeks to complete its pattern and break out in a new move. It stands to reason, therefore, that a true\nFlag cannot show up at all on a monthly chart and barely appears on a weekly chart. You will findprice areas on long-range charts, patterns that have taken 8 or 10 weeks to as many months,sometimes a year or two, in their construction, which assume the shape of a Flag, but do not expectthem to function as Flags. Examined in detail on a daily chart, these same long areas almost alwayswill be found to contain price formations having entirely different significance. Frequently, what isreally a Major Reversal Area following a long, rapid advance will look something like a Flag whenit is condensed on a monthly chart. So, do not trust such pictures on long-range charts; do not takeit for granted that they represent Consolidation for a new rise; find out what the detailed dailyplotting for the same period says.\nThe July-August Flag ran for five weeks—too long to be trusted without additional technicalevidence (see point 3 under “Reliability of Flags and Pennants”). The danger in\n28\n26\n24\n22\n20\n19\n18\n17\n16\n15\n14\n13\n12 Sales 100's\n50\n40\n30\n20\n10\nMULLINS MANUFACTURING B MNS\n1936\nMAY\nAUGUST SEPTEMBER\n1\nFigure 11.8 Another example of the series of Flag-type Consolidations that may form in a rapid,third-phase Bull Market Advance. Mullins went from 15 to above 39 in six months in 1936,dropped back to 31, and then rose again in March 1, 1937, to its previous high, making a MajorDouble Top. (Note that “MNS” was split 2-for-1 in 1937.)\nsuch prolonged formations is either when the breakout finally appears it will fail to follow through,or prices will keep drifting right on down. For the moment—on August 25—it looked as thoughthis Flag had “gone stale,” but when prices rose above the previous high on August 27, with a smartpickup in volume, purchases were obviously safe.\nRectangular Consolidations: an early phase phenomenon\nIn contrast with Flags and Pennants, which are typically last-stage Bull Market Concomitants,Consolidations of the Rectangle class are found more often in the earlier phases of Bull Trendevolution. In Major Bear Moves, Rectangles may develop in the first stage just before a PanicDecline, or in the last stage preceding a strictly limited final sell-off. The latter manifestationpresumably betokens premature accumulation by interests who feel that prices have already gonelow enough to suit their purposes. (They come out all right, if they are able to hold on through theremainder of the Bear Swing and long enough for the next Bull Market to put prices back up againto profitable levels.)\nSales\n100's\n125\n100\n75\n50\n25\nWYANDOTTE WORSTED WYO\nV\nJUNE\n1—_____\nJANUARY FEBRUARY ----- ______ _____\n^22'29 5 112'19^6 2 1 9*16'23 2 1 9 )16l23l30 6 ‘13 l20T2^rTr11 t18l29 1 1 8 1151\nFigure 11.9 The vertical lines marked “M” show how the measuring formula is applied to a FlagPattern. Note the first measurement is taken from the level at which the mast leaves the previous“Congestion” up to the peak of the Flag. This same distance is then measured up from the Flagbreakout. In “WYO,” the formula worked out exactly. Trading commitments should normally have\nbeen cashed in above 36 on this move. They might then have been reinstated when it becameapparent by April 2 that a Rounding Bottom was completed (note volume) for a new advance.\nHead-and-Shoulders Consolidations\nAll our references to the Head-and-Shoulders Formations up to this point (see Chapters 6 and 7)have considered that pattern as typifying a Reversal of Trend, and, in its normal and commonmanifestation, that is most definitely the Head-and-Shoulders function. But, occasionally, priceswill go through a series of fluctuations that construct a sort of inverted Head-and-Shoulders picture,which in turn leads to continuation of the previous trend.\nThere is no danger of confusing such Continuation or Consolidation Formations with regular Head-and-Shoulders Reversals because, as stated, they are inverted or abnormal with respect to thedirection of the price trend before their appearance. In other words, one of the patterns thatdevelops in a rising market will take the form of a Head-and-Shoulders Bottom. Those that appearin decline assume the appearance of a Head-and-Shoulders Top. By the time these price formationsare completed (left shoulder, head, and right shoulder evident), there is no question as to theirimplications. But at the head stage, before the right shoulder is constructed, there may be—usuallyis—considerable doubt as to what really is going on.\nAMERICAN WOOLEN\nWY\n1946\n44 **\n100's\n125 0\n100 1\n75 ■■■■\n50 mi\n25 ii(\nJANUARY-FEBRUARY MARCH APRIL MAY JUNE\n5 12:1926 2' 9 16 23 2 9 16 23 30 6 13 20 27 4 11 18 25 1 : 8 15 22 29-\nFigure 11.10 A 1946 chart that delighted technicians contains a perfect “Half-Mast” Pattern inJanuary, with measuring gaps (G, G) above and below it; a downside Flag in early February (checkmeasurement); a fine Ascending Triangle at the bottom of this reaction with a Throwback in April,giving an ideal “buy spot.”\nThe volume patter", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 74}
{"text": ":1926 2' 9 16 23 2 9 16 23 30 6 13 20 27 4 11 18 25 1 : 8 15 22 29-\nFigure 11.10 A 1946 chart that delighted technicians contains a perfect “Half-Mast” Pattern inJanuary, with measuring gaps (G, G) above and below it; a downside Flag in early February (checkmeasurement); a fine Ascending Triangle at the bottom of this reaction with a Throwback in April,giving an ideal “buy spot.”\nThe volume pattern in Consolidations of this type does not follow the rule for Reversal Head andShoulders. In a downtrend, for example, the Consolidation Formation resembled in its price contoura Head-and-Shoulders Top, but the attendant volume will diminish instead of increase on the leftshoulder and head as well as on the right shoulder. The same holds true for the “Bottom” Patternsthat develop as Consolidation in an advance market; however, Breakouts resemble, in all respects,those arising from Reversal Formations.\nHead-and-Shoulders Consolidations of the Complex or Multiple type seldom appear on the charts.Theoretically, they might and should be as easy for the chart technician to handle as the simpleforms.\nThe formula for determining the probable minimum price move (beyond the neckline) from aHead-and-Shoulders Reversal Formation was discussed in Chapter 6. To anyone familiar with theverities of stock market trends and the endless variety of pictures that the charts can present, it isamazing how accurately that formula works out and how often the first consequential move awayfrom a Head-and-Shoulders Top or Bottom will carry through to the point (or a little beyond)implied by the measurement of the formation. But, the same formula applied to ConsolidationPatterns of the Head-and-Shoulders form does not work out as well. Such patterns are usually quite“flat,” and the ensuing move generally\nMO(D)\nDaily NYSE L = 65.41 +0.42 +0.65% B = 0.00 A = 0.00 O = 65.65 Hi = 65.65 Lo = 65.05 C = 65\n.41 V = 4968500\n69.00\n60.00\n56.00\n52 .51\n52.00\n48.00\n45.00\n42.00\nOND04FMAMJ J A SOND05\n39.00\nF M A M\nCreated with TradeStation\nFigure 11.11 MO. Talk about your technician's delights. Altria Group throws off some pretty gooddelights here: a breakaway gap and run days to the downside, a down flagpole with flag, andpattern gaps. But they are good pattern gaps and really interesting. Then a triangle complete with abreakaway and an up flagpole with flag. The non-technician probably is suffering from nausea atthis point. It is a roller coaster that bodes ill for everyone. Additionally note a completely tradablesituation for the alert short-term technician.\nextends well beyond the measurement implied thereby, although, in some cases, it may not go quiteas far. Consequently, the Head-and-Shoulders formula cannot be applied to Consolidation Areaswith the assurance that it sets up a definite and dependable objective; one has to look, in thesecases, to a variety of other chart indications to appraise the probable proportions of the move tofollow.\nScallops: repeated Saucers\nOur next chart picture differs from the Consolidation Formations previously discussed, in that itdoes not constitute a more or less definite area of Congestion or fluctuation to which one or morecritical boundary lines can be affixed. We could, perhaps, take it up as well in a subsequent chapterunder the general heading of normal trend action. Yet it is a pattern so characteristic of certain typesof stocks and certain types of markets, and so nearly related to the principle of Consolidation forfurther advance, that it may be better treated here.\nWhen a stock for which there is a large number of shares outstanding, and for which there is, at alltimes, a fairly active and “close” market emerges from a long-time Bottom (as exemplified by thepast history of Radio Corporation and Socony-Vacuum), which will often make a long MajorAdvance in a series of “Saucers.” These successive patterns, each of which resembles, in both priceand volume action, the Reversal Formation described in Chapter 7 as a Rounding Bottom, areslightly uptilted, that is, the rising end always carries the price a little higher than the preceding Topat the beginning of the Saucer. The net gain accomplished by each Saucering movement will varyfrom stock to stock, but there seems\n28\n26\n24\n22\n20\n19\n18\n17\n16\n15\n14\nSales 100's\n50\n40\n30\n20\n10\n| Bl::::: H\n■\n;4;\njgEitS:Htgigg• : •\nsjililii\n::::::::::\n■\"\n11II •:::: SUH SB .Eli*• ::::.\n::±AMERICAN LOCOMOTIVEtlj\nLA |:S ftm11 II\nHlHsn::::::::::::::\nHTH\n:::::::::: ::::Z jffi SI\n7 I | ::: TTTTTT ffi\n•|ii It js ;£ .....:::::::::: |BWI\nttllltUII\nftftttftft\n■ .....\niii\n: i\n:Hs 7 ::::::\nif i\no •::::\nffi S:: H L il • BidJt\nill :::••Hl: ta;-:::\n11 ttjft Si\nw : :|?i ::::: • HHr!.. af ir.... Hjpggj\n:\n::\nBg\nii H :: 4::: ..... li\n:::::\nfl :::::ii::: ii:::rnflnSjpxsp\nII gg 1 1Hi fl\nss fl flf1935 S Hr\n| .-r.r •fl .-11.rfcrSttoS 1 i\nr# 1 i lift fl\niflrm ..... nm •fl iftr £ :: Bw\nII\ni liilni i ii li diL\n::::: :\n... (\nBa, tiiiii\n\"jji |||l[ili\" .7.\nio\nUH? I\nflit ’ 1\nJULY AUGUST SEPTEMBER OCTOBER NOVEMBER DECEMBER\n' 6 13’ 2 '27 3 10\n7\nFigure 11.12 A Flag (end of November) that seemed for several weeks to have failed completely.Prices, however, rose quickly to 36 1/4 from their December 23 low, thus finally carrying throughaccording to formula. Note the Flat-Topped Broadening Formation that started the move.\nto be a strong tendency for it to amount to about 10%-15% of the price of the issue. The totalreaction from the left-hand lip of each Saucer to its Bottom level is usually a little greater, from20% to 30%, and the length (duration) of the Saucers is normally five to seven weeks, rarely lessthan three. Thus, the overall advance is slow but steady, in much the same sense as the progress ofthe man who eventually got out of the deep well by climbing three steps for each two that heslipped back.\nThe charts of stocks that take this sort of course show a picture of strikingly similar andsymmetrical Rising Scallops, one succeeding another with little or no pause between. Tradingactivity runs", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 75}
{"text": "han three. Thus, the overall advance is slow but steady, in much the same sense as the progress ofthe man who eventually got out of the deep well by climbing three steps for each two that heslipped back.\nThe charts of stocks that take this sort of course show a picture of strikingly similar andsymmetrical Rising Scallops, one succeeding another with little or no pause between. Tradingactivity runs up to a peak at the latter stage of each Scallop, as the previous high is approached andexceeded, then diminishes into dullness as prices curve down and flatten out at the Bottom of thenext Saucer, picking up again as prices curve up into their next rise.\nThe trading opportunities afforded by stocks of the Saucering habit hardly require extendedcomment (although we shall set down some detailed specifications in Section II of this book). TheBottom level of each Scallop is usually easy to detect by watching price trend and volume, and so isthe topping out at the end. Yet it is curiously a fact that most “tape watchers” handle such stocks inthe wrong way, becoming interested in them and buying when they show activity (“make a newhigh on volume”) and neglecting them entirely when they are in the dull, rounding-out stage oftheir trends.\nSales\n100's\n500\n400\n300\n200\n100\nANACONDA COPPER\n1936\n(ULY\nAUGUST\nSEPTEMBER OCTOBER\n7 14 21 28 5 12 19 26\nFigure 11.13 Typical of the form that Head-and-Shoulders Consolidation Patterns may take, bothas to price pattern and volume, was this development in Anaconda. Measuring formula for the smallFlag in October should be applied from the point of breakout through the Head-and-Shouldersneckline.\nFigure 11.14 A 1945 Head-and-Shoulders Consolidation in which both of the shoulders and thehead took a “Saucer” form. Compare price and volume trends. Prices advanced to 31 1/2 in July,came back again to 25 1/2 in August, and then shot up to 40 in November.\n14\n13\n12\nMIAMI COPPER\n11\n1945\n10\nSales\n100's\n125\n100\n75\n50\n25\nUpiMullxUi IL\nJULY\"\nlllhnl\nAUGUST S\nOCTOBER NOVE'\n23 30 7 14 21 28 4 11 18 25 1 8 15 22 9 6 13 20 27 3 10 17 24 1 8 15\nFigure 11.15 Part of a genuine “Scallop” uptrend, typical except for the short duration andrelatively small decline in the October Saucer. The next Scallop, which started in December,dropped prices back to 12 1/2 in January, and then carried them to 18 1/2 in February. A four-monthSaucer, from February 1945 to June, preceded this chart. Note the position traders found themselvesin if they bought at 9 on the “new high volume” in June.\nCOMMONWEALTH EDISON CWE\n1945\n28 Sales 100's\n125\n100\n75\n50\n25\nHi——\nil l tlLili.itJlil I lltifliliidillil 11 i 1 lililll 11 (Jll 111 lyjlillilllil iilli.ljll\nDECEMBER\nJULY AUGUST SEPTEMBER OCTOBER NOVEMBER ___________\n7 14 21 28 4 11 18 25 1 8 15 22 29 6 13 20 27 3 10 17 24 1 8 15 22 29\nFigure 11.16 Although the Scalloping habit characteristically appears in low-priced issues, it issometimes found in widely held, semi-investment stocks of medium price, such as “CWE.”\n19\n18\n17\n16\n15\n14\n13\n12\n11\nSales\n100's\n250\n200\n150\n100\n50\nINTERNATIONAL TEL. & TEL. IT\n1944\nJANUARY FEBRUARY MARCH\nAPRIL\nMAY\nJUNE\n8 -15 22 29 5 12 19 26 4 11 18 25 1 8 15 22 29 6 13 20 27 3 10 17 24 1\nFigure 11.17 This chart shows the last five months of a broad, 13-month Saucer-like Consolidationin “IT,” which followed its rapid run up from 3 to 16 in late 1943 and early 1944. “IT” is an erraticactor, and its volume is apt to be particularly deceptive in day-to-day movements. Major PricePatterns in it, however, are dependable. This final phase of its long Consolidation (distribution andre-accumulation) first took the form of a Rectangle (with a premature breakout) and then anAscending Triangle. Its 1945-1946 Bull Market Top was a massive Head-and-Shoulders.\nMany boardroom tape watchers scorn charts with unfortunate consequences to their capital in thelong run. Genuinely expert tape readers—those who are able to show fairly consistent profits intheir trades—are really extremely rare. (EN: For “tape readers” substitute “day traders,” 99% ofwhom are unsuccessful.) When you do meet such an individual, you will find that he either, ineffect, “carries charts in his head” or else takes a careful look at the record before he buys on aticker showing activity.\nAs a stock with the Scalloping habit finally works up in price to 15 or so, its pattern tends tobecome less regular; it begins to depart from the smooth, narrow Saucer-like curve of the lowerlevels. Above 20, it is apt to break away entirely from the Scallop sequence and produce, from thereon, more rapid straight-line advances, interspersed with sharp reactions and standard types ofConsolidation Formations, which are characteristic at all times of medium- and high-priced issues.(There are exceptions: some high-priced preferred stocks for which there is always a market, butwhose trends depend almost entirely on the gradual changes in prevailing interest rates and supplyof funds for investment, have a persistent Scallop habit in their Primary Upswings.)\nWe have named rather specific price levels (15 and 20) in the preceding paragraph, but price is notthe sole factor determining the departure of a stock from a Scallop Trend. The only safe assumptionis that, once such a habit is detectable, it will be continued until the chart shows a definitedivergence from it, and such divergence usually takes first the form\n19\n18\n17\n16\n15\n14\n13\n12\n11\n10\n9 Sales 100's\n50\n40\n30\n20\n10\nFigure 11.18 There are times when a Consolidation Pattern gives the only good technical signalthat a Reversal in an issue's Primary Trend has actually taken place. Although cases of a MajorTurn, particularly a Bottom, without some sort of recognizable Reversal Formation on the chart arequite rare, they do occur. This weekly chart of Flintkote illustrates such a phenomenon. A BearMarket low, from which it rose to 47 in 1946, was made at 8 5/8 in December 1941. Withoutdeveloping any important technical foundation on either a daily or weekly chart, its", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 76}
{"text": "place. Although cases of a MajorTurn, particularly a Bottom, without some sort of recognizable Reversal Formation on the chart arequite rare, they do occur. This weekly chart of Flintkote illustrates such a phenomenon. A BearMarket low, from which it rose to 47 in 1946, was made at 8 5/8 in December 1941. Withoutdeveloping any important technical foundation on either a daily or weekly chart, its first upswingtook it to 11 7/8 the following April. From that point, it went into a six-month Symmetrical Triangleand then broke out topside at the three-quarters stage on increased volume. This action, plus the factit immediately thereafter burst up through an old and highly significant Resistance Level at 12, wassufficient to mark it as being in at least a strong Intermediate if not a full Primary Uptrend. Thecombination of technical developments illustrated in this chart—a large Consolidation Patternforming just under a Major Resistance and then a breakout upside from both—is something towatch for when it appears a Reversal from a Bear to Bull Trend is due. Resistance Levels will bediscussed in Chapter 13.\nof a greater-than-wanted advance arising at the end of one of the Saucers. Consequently, if youhave previously taken a position in it at a favorable point (near the Bottom of a Scallop), you willunlikely be hurt when the stock finally alters its action.\nVery low-priced issues may persist in a Scalloping Trend right up to their Major Bull Tops, andeven attempt another Saucer Movement following what turns out to have been the final high, whichattempt then fails to carry out the previous successively higher and higher pattern. Such failures arenot difficult to detect; the change from the previous pattern appears before any appreciable damageis done to a properly assumed commitment.\nModern versus old-style markets\nWe have mentioned in our discussion of Reversal Formations that some of them have appeared lessfrequently in the charts of the 1960s than they did in prior years, and others more frequently. Thesame is true of Consolidation Formations. Patterns of the compact, strictly defined sort such asRectangles and Right-Angle Triangles are less common now. Symmetrical Triangles are apt to besomewhat looser than they were in the 1920s and 1930s—not as clean-cut and conspicuous on thecharts. Typical profit-taking patterns such as Flags and Pennants seem to be as common as ever,whereas “normal” trend pictures, including those formations associated with normal trenddevelopment (such as Head-and-Shoulders, Rounding Turns, and so on), are more common.\nThe reasons for these changes are fairly apparent; Securities and Exchange Commission (SEC)regulations, higher margin requirements, greater public sophistication, and a more conservative—we might better say more pessimistic—approach to the problems of investment and stock tradinggenerally have all played a part in this evolution. SEC and Stock Exchange vigilance have doneaway with the flagrant pool manipulations designed to take advantage of the “lambs” of formeryears. Nowadays, there is even very little of the more “legitimate” sort of syndicate operationplanned to facilitate large-scale accumulation or distribution.\nIt is still possible for “insiders” to hold back for a limited time, or to prematurely releaseannouncements of good or bad portent with regard to the affairs of a particular corporation to servetheir personal strategic purposes. But the stock purchase and sales of officers, directors, andprincipal owners are now too closely watched to allow a great deal of “skullduggery.”(Nevertheless, the average investor had better still be a trifle skeptical as to the probability of anygreat advance in the market following publication of a good report.) Collusion between investmentadvisory services and trading pools has been effectively outlawed. (It is safe to say it never did existas flagrantly, even in the 1920s, as many amateur traders seem to think.) The SEC (with thethorough cooperation of the Stock Exchange) polices the investment counsel profession thoroughly,constantly, and most effectively. No well-established investment counsel can afford to indulge indeceptive or collusive practices even if the desire were there. Most professionals go far beyond themost reasonable needs to safeguard themselves against any contacts that, however innocent oruseful, might be viewed with suspicion.\nThe old-time “plunger” has not disappeared entirely, but high margins and regulations preventing“Bear Raiding” have made present-day stock markets relatively difficult and unprofitable for him.The out-and-out boardroom gamblers (EN: day traders rushing to and fro probably exacerbatesdaily volatility) still come in, although high margins have cramped them too. In recent years, theyhave appeared in numbers only in the final stages of Bull Markets. (EN: Note the day-trading crazethat infected the markets in the late 1990s.) Their operations never did affect the charts muchexcept to augment activity.\nOn the other hand, higher taxes and greater regulation have most certainly not provided safer,closer, or more stable markets for the small investor. Higher margins have not prevented Panic\nCollapses. If anything, markets have been “thinner” on the downside, more vulnerable to rapid anddrastic decline than they were before modern regulation. We still have the very same sort of Bulland Bear Markets, and much the same sort of market trend development as 50 years ago. Thesurprising thing is not that a few types of chart patterns that were, on occasion, produced byunregulated trading are now less common, but rather that the great majority of technical phenomenahave been practically unaffected. The chart student of 1907 would be quite at home with the chartsof 1966. (EN: And with those\nChapter eleven: Consolidation Formations 169 of 2000. That is why so little change has beennecessary to bring Edwards' classic account current to the third millennium. EN9: A note to a note.Pools and", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 77}
{"text": "ow less common, but rather that the great majority of technical phenomenahave been practically unaffected. The chart student of 1907 would be quite at home with the chartsof 1966. (EN: And with those\nChapter eleven: Consolidation Formations 169 of 2000. That is why so little change has beennecessary to bring Edwards' classic account current to the third millennium. EN9: A note to a note.Pools and manipulators disappear and are replaced by some new pernicious form of skullduggery.Specialists and market makers are hauled before the bar of justice for cheating. In the twenty-firstcentury, hedge funds proliferate like rabbits in Australia. For any exacerbation of volatility theycause, they probably make up for in additional market liquidity. The same patterns keep appearingbecause, computers to the contrary notwithstanding, humans are eventually responsible for pullingthe trigger. It does seem that frequently patterns are not so neat as they were “in the old days.”Trendlines, especially horizontal lines, seem to be more “zones” than hard and fast lines and morejudgment might be necessary in interpretation. But everything that Edwards says here might havebeen written in 2005 instead of in the mid-twentieth century.)\nTaylor & Francis\nTaylor & Francis Group\nhttp://taylorandfrancis.com\nchapter twelve\nGaps\nA gap, in the language of the chart technician, represents a price range at which (at the time itoccurred) no shares changed hands. This is a useful concept to keep in mind because it helps toexplain some of their technical consequences, which are illustrated in Figures 12.1 through 12.13.\nGaps on daily charts are produced when the lowest price at which a certain stock is traded on anyone day is higher than the highest price at which it was traded on the preceding day. When theranges of any two such days are plotted, they will not overlap or touch the same horizontal level onthe chart; there will be a price gap between them. For a gap to develop on a weekly chart, it isnecessary for the lowest price recorded at any time in one week be higher than the highest recordedduring any day of the preceding week. This can and does happen, of course, but for obvious reasonsnot as often as daily gaps. Monthly chart gaps are rare in actively traded issues; their occurrence is\nconfined almost entirely to those few instances in which a Panic Decline commences just before theend of a month and continues through the first part of the succeeding month.\nWhich gaps are significant?\nFrom the earliest days of stock charting, gaps attracted attention. These “holes” in theprice trend graph were conspicuous. It was only natural that observers should attachimportance to them and should try to assign some special significance to theiroccurrence. But the result was unfortunate, for there soon accumulated a welter of“rules” for their interpretation, some of which have acquired an almost religious forceand are cited by the superficial chart reader with little understanding as to why theywork when they work (and, as is always the case with any superstition, an utterdisregard of those instances where they do not work). We refer to this situation asunfortunate not so much because the gap “rules” are wrong, but rather because theirblind acceptance has barred the way to a real understanding of a gap's implications andthe establishment of a more logical basis for its uses in trading.\nThe most common superstition is that “a gap must be closed.” Sometimes it is statedmore cautiously in such words as follows: “If a gap is not closed in three days, it willbe closed in three weeks, and if it is not closed in three weeks, it will be closed in threemonths, etc.” There are numerous variations, but they all add up to the belief that a gapmust be closed and the trend is not to be trusted until the gap has been covered. It is thelatter inference that leads to error.\nClosing the gap\nBut first, what is meant by “closing” or “covering” a gap? Suppose a stock in anAdvancing Trend moves up day after day, from 20 to 21, 22, 23, 24, and closes onenight at the top of its range for that day, at 25. The next morning it opens at 26 andkeeps right on moving up from there. This action leaves a 1-point gap, between 25 and26, on the chart. Then suppose the rise continues to 28, halts there and is followed by areaction in the course of which prices\n16\n15\n14\n13\n12\n11\n10\nFigure 12.1 The April-June Rectangle on this 1945 chart of \"AW\" contained a numberof insignificant Pattern Gaps. The two larger gaps marked “G” are of the Continuationor Runaway class. Note that prices closed at or near the top on each day that made agap; neither of these was closed for two years.\nslip to 28, and then halts there and is followed by a reaction in the course of whichprices slip back to 27, 26, and finally to 25. The return move has carried prices backthrough the gap area (25-26); the gap has thereby been covered or closed. In brief, agap is closed when a subsequent price trend comes back and retraces the range of thegap.\nMust a gap be closed before prices move very far away from it? Certainly not. Will itbe closed eventually? Probably, yes. If it is not closed by the next Minor Reaction,there is a chance it will be covered by the next Intermediate Retracement, and if notthen, pretty surely by the next great Major Swing in the opposite trend. But that maybe years later—hardly a matter of interest to the ordinary trader. The investor whobought Chesapeake and Ohio shares at 260 on October 21, 1929, counting on theclosing of the gap which that issue had made on the preceding Friday, 2 points downfrom 266 to 264, had to wait nearly seven years to get out even. Not until it neared theTop of the next Major Bull Market did CO attain an equivalent market value (65, sinceit was split 4-for-1 in 1930). In the meantime, he saw his investment shrink in 1932 toless than a sixth of his purchase price. As a matter of fact, there were hundreds of gaps\nmade in the charts of the 1929-1930 market", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 78}
{"text": "nts downfrom 266 to 264, had to wait nearly seven years to get out even. Not until it neared theTop of the next Major Bull Market did CO attain an equivalent market value (65, sinceit was split 4-for-1 in 1930). In the meantime, he saw his investment shrink in 1932 toless than a sixth of his purchase price. As a matter of fact, there were hundreds of gaps\nmade in the charts of the 1929-1930 markets that never have been covered since then,and many of them, it is safe to say, never will be closed.\nIf you will think the matter over for a moment, you will see that the probabilities wehave stated above for a gap's being closed apply just as well to a stock's returning toany price range at which it has once been traded, gap or no gap.\n120\n112\n104\nSales\n100's\n250\n200\n150\n100\n50\nBETHLEHEM STEEL\nii\nBS\n1937\nGt\nAPRIL MAY JUNE JULY AUGUST SEPTEMBER\n3 10 17 24 1 8 15 22 29 5 12 19 26 3 10 17 24 31 7 14 21 28 4 11 18 25\nFigure 12.2 The large up-gap made on July 5 in this chart was a typical BreakawayGap, occurring as prices broke out of the complex base for the July-August SecondaryRecovery. (Compare this chart with Figure 7.14.) Another type of Breakaway Gap—through a trendline—occurred on August 26. That of September 7 was primarily due to\nthe “ex-dividend,” whereas that of September 18 was still another type of breakaway—through a Support Level. The first gap marked, on April 26, must be classified as aRunaway; it made a sort of an “Island” of the whole April-June complex base.\nAnother point: there are thousands of price gaps made in trading—some of them quitewide—that do not appear at all on the standard daily range charts because they aremade during a single day and not between one day's closing and the next day'sopening. Such intraday gaps are ordinarily overlooked entirely; the gap theorists areoblivious of them, although their significance is often greater than that of manyinterday gaps. Practically every emphatic breakout move from a strictly definedRectangle or Right-Angle Triangle is attended by a gap, but only those few show up onthe charts that occur at the day's opening gong.\nIf we seem to have “protested too much” in the foregoing, it is only because we wantour readers to study this topic with an open mind, free from preconceived notions as toany mystic qualities that gaps may possess. Turning to the other side of the picture,some gaps have technical import. Some gaps are useful to the chart analyst inappraising trend possibilities. Let us see what we can make of them.\n26\n24\n22\n20\n19\n18\n17\n16\n15\n14\n13\n12\n11\n10\n9\n8 Sales 100's 500 400 300 200 100\n\nZENITH RADIO\njG\nS\nrM\nH\nFigure 12.3 A potent Breakaway Gap that showed on Zenith's weekly chart when itbroke out of a Head-and-Shoulders Bottom in early 1942. Note high volume developedbeyond the gap, suggesting it would not be quickly closed. The April reaction stoppedshort of it. In fact, this gap still had not been closed in 1956, more than 14 years later.\nEx-dividend gaps\nFirst, however, we must eliminate from consideration the gaps that do not meananything. An eighth-point gap obviously has no technical significance as it representsonly the minimum permitted change in price. By the same token, a gap of a quarter ofa point or even a half point in a high-priced stock, such as Norfolk & Western (beforethe split), represents only a normal, in fact tight, spread between successive bids. Inbrief, to carry interest for the chart technician, a gap must be wider than the usualchanges in price that occur under normal or prevailing trading conditions. A secondclass of gaps that have no forecasting implications are those formed consistently andhabitually by “thin” issues in\n40\n30\n20\n10\n1936 | 1937 | 1938 | 1939 | 1940 | 1941 | 1942 1943 | 1944 1945 [ 1946\nFigure 12.4 As a matter of interest, this monthly chart of Zenith Radio is reproducedfor comparison with Figure 12.3. The Head-and-Shoulders Bottom is easily seen.\nthe medium- and high-price brackets. You can spot them easily; if your chart of acertain issue shows numerous gaps as a regular thing, then no one of them is apt tomean anything special.\nFinally, gaps that appear on the charts when a stock goes ex-dividend (whether thedividend be in cash, stock, rights, or warrants) possess no trend implications. They areoccasioned not by a change in the Supply-Demand relation that governs the trend, butrather by a sudden and irreversible alteration in the actual book value of the issue.\nAlso of interest in this chart is the Descending Triangle, which started to form inMarch, but it was never completed—a deceptive and discouraging picture until theApril 7 gap was made.\nThe Flag of mid-April “measured” the move from 9 1/2 to 14. The gaps measured thetwo halves of it, on either side of the Flag.\nEliminating the technically meaningless types named above, we are left with the gapsthat occur infrequently (and that are not occasioned by an ex-dividend change in value)\nin issues that are so closely and actively traded as ordinarily to produce “solid” charts.A 1-point gap, for example, in the chart of New York Central would be an unusualevent; it would demand attention and presumably have some forecasting significance.\nSuch gaps, for the purposes of our study, may be divided into four classes: Common orArea Gaps, Breakout Gaps, Continuation or Runaway Gaps, and Exhaustion Gaps.\nThe common or area gap\nThis type of gap gets its name from its tendency to occur within a trading area or PriceCongestion Pattern. All of the Congestion Formations we have studied in the precedingchapters—both Reversal and Consolidation types—are attended by a diminution intrading turnover. The more strictly defined sorts—the Triangles and Rectangles—show\nBLAW - KNOX\n30\n28\n26\n24\nSales 100's\n125\n100\n75\n50\n25\nF EBRUARY .......M ARCH .......APR\n’ 9 16 23 2 9 16 23 30 6 13 2C\n4 11 18\n25\n8 15 22\n29\n13 20\n27\nFigure 12.5 The early 1946 daily chart of Blaw-Knox contained a number ofinteresting technical features. Its spurt from 19 to 25 in December", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 79}
{"text": "tended by a diminution intrading turnover. The more strictly defined sorts—the Triangles and Rectangles—show\nBLAW - KNOX\n30\n28\n26\n24\nSales 100's\n125\n100\n75\n50\n25\nF EBRUARY .......M ARCH .......APR\n’ 9 16 23 2 9 16 23 30 6 13 2C\n4 11 18\n25\n8 15 22\n29\n13 20\n27\nFigure 12.5 The early 1946 daily chart of Blaw-Knox contained a number ofinteresting technical features. Its spurt from 19 to 25 in December 1945 was followedby a nine-week Rectangle Consolidation, the end of which appears in the chart above.Prices erupted from this Rectangle on February 11 with a typical Breakaway Gap. Fourdays later, another gap appeared on even greater volume, and prices closed at the top ofthe day's range. This looked like a Runaway Gap, in which case continuation to 32 wasimplied according to the “rule” stated above. (Note the Rectangle “measurement”called for only 31.) On the following day, however, a One-Day Reversal, from 31 backto 30, appeared and the next session closed the February 15 gap, which now had to berelabeled, tentatively, as an Exhaustion Gap. Prices subsequently dropped back to thesupport of the nine-week Rectangle, rallied grudgingly along an establishedIntermediate Up Trendline, and broke that on April 24 to return again to the 25 support.In May, another advance took “BK” up once more to 30, where it bumped against thepreviously broken trendline. That was its last effort; in late July, the “valley” level at25 was penetrated and a Major Double Top had been completed. To return to theFebruary 15 gap, this is fairly typical of many cases in which it is impossible to saywhether Continuation or Exhaustion is being signaled until two or three days after theday the gap is made.\nthis characteristic most conspicuously. Moreover, activity in these patterns tends to beconcentrated pretty much at or near the top and bottom edges, their Supply andDemand Lines, while the area in between is a sort of “no-man's land.” It is easy to see,therefore, why gaps develop frequently within such areas. You will find numbers ofgood examples of Pattern Gaps in the charts illustrated in Chapters 8 and 9.\nSuch Pattern Gaps are usually closed within a few days, and for obvious reasons,before the Congestion Formation in which they have appeared is completed and pricesbreak away from it, but not always. Sometimes a gap will develop in the last traverseof prices across the pattern area just before a breakout, and in such cases, it is notclosed for a long time, nor is there any reason why it should be.\nThe forecasting significance of Common or Pattern Gaps is practically nil. They havesome use to the technician simply because they help him recognize an Area Pattern—that is, their appearance implies a Congestion Formation is in the process ofconstruction. If, for example, a stock moves up from 10 to 20, drops back to 17, and\nthen returns to 20, making a gap in the course of that rally, it is a fair assumption thatfurther pattern development will take place between approximately 17 and 20. This is aconvenient thing to know and may, on occasion, be turned to profit in short-termtrading policy.\nPattern Gaps are more apt to develop in Consolidation than in Reversal Formations.Thus, the appearance of many gaps within an evolving Rectangle or SymmetricalTriangle\nBALTIMORE & OHIO\nBO\nSales :S ;\n100's °™\n250 KJ\n200 .....I\n150 .......\n100 ......\n50 ......\nS'\nOCTOBER\n.ilJi.ulilu liui.n.dli.nii.ii.i.\n■VEMBER DECEMBE\nFEBRUARY MARCH\n13 110117'24'31'7 ;14-21'281 5 l12'19'2612 1 9 116!23'301 6 113'20 271 6 l13!20'27'\nFigure 12.6 This is a good example of a Runaway Gap that performed according torule. After reacting from 26 1/4 in late 1936, “BO” formed a Head-and-ShouldersBottom (the left shoulder was a Triangle) and broke out of it on February 6, 1937. Asmall Flag formed immediately thereafter, calling for 28. At that level, another Flagdeveloped which signaled 30 1/4 or better. As prices reached this latter goal, however,a gap was made, on March 3, on extraordinary volume. The next two days confirmed\nthis to be a Runaway or Continuation Gap. As such, it implied further advance(measuring from the Head-and-Shoulders neckline) to 37 plus. “BO” made its BullMarket high at 40 1/4 on March 17. The measuring-gap rule should be used forpurposes of “getting out” rather than “getting in.” It does not guarantee a move willcontinue to the implied limit, but it does give assurance the move is near an end whenthe rule has been fulfilled.\nreinforces the normal expectation that the pattern in question will turn out to be aConsolidation rather than a Reversal Area.\nBreakaway gaps\nThe Breakaway type of gap also appears in connection with a Price CongestionFormation, but it develops at the completion of the formation in the breakaway move.Any breakout through a horizontal pattern boundary, such as the Top of an AscendingTriangle, is likely to be attended by a gap. In fact, it is safe to say that most of themare. And, if we consider what goes on in the market to create a Flat-Topped PriceFormation, it is easy to see why Breakaway Gaps should be expected. An AscendingTriangle, for example, is produced by persistent demand for a stock meeting a largesupply of it for sale at a fixed price. Suppose that supply is being distributed at 40.Other holders of the stock, who may have intended originally to liquidate at 40.5 or 41,see quotations come up to 40 time after time, stop there, and turn back. They tend, inconsequence, either to join the crowd selling at 40,\n48\n44\n40\n38\n36\n34\n32\n30\n28\n26\n24\n22\n20\n19\n18\n17 Sales 100's 250 200 150 100\n50\n\nFigure 12.7 Panic Declines often produce large Runaway Gaps. The September 7 gapin this chart, judged by its size, volume, subsequent action, and the fact that it wasmade in “new low ground,” marked it as being of the measuring type. The implied goalwas 26 or below. All other gaps in this chart were obviously of the “common” variety.\nor else to figure that once through 40, prices will go much higher; they may eitherlower or raise th", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 80}
{"text": "duce large Runaway Gaps. The September 7 gapin this chart, judged by its size, volume, subsequent action, and the fact that it wasmade in “new low ground,” marked it as being of the measuring type. The implied goalwas 26 or below. All other gaps in this chart were obviously of the “common” variety.\nor else to figure that once through 40, prices will go much higher; they may eitherlower or raise their selling price. The result is a “vacuum” on the books, a dearth of\nofferings in the price range immediately above the pattern. Hence, when the supply at40 in our Ascending Triangle example is finally all absorbed, the next buyer of thestock finds none offered at 40.125 or 40.25 and he has to bid up a point or more to gethis shares, thus creating a Breakaway Gap.\nAs we remarked earlier in this chapter, gaps of this type actually occur on almost everydecisive breakout from a Horizontal Congestion, although many of them do not showon the charts because they occur during a day and not between one day's close and thefollowing day's opening. Breakaway Gaps also develop at times when prices move outof other types of Reversal or Consolidation Formations; they are not uncommon inconnection\n19\n18\n17\n16\n15\n14\n13\n12\n11\n10\n9\n8\n7 Sales 100's\n500\n400\n300\n200\n100\n1944\nWILLYS - OVERLAND\nWO\nJULY\nAUGUST SEPTEMBER\n8 15 22 29 6 13 20 27' 3 10 17 24 1 8 15 22 29 5 12 19 26 2 9 16 23 30!\nFigure 12.8 The \"skyrocket\" run-up of Willys-Overland in June 1944 was marked by anumber of small gaps. The first two were too small to have much technicalsignificance. The larger gap made June 16 was marked by the \"stickiness\" of prices onthat day as Exhaustion. A small Flag Consolidation ensued. The June 27 gap also actedlike an Exhaustion Gap insofar as price action was concerned, but volume had declinedinstead of climbing to a new peak. On June 28, prices jumped away again, so the June27 gap was marked as another Runaway with an implied objective of 18 1/4 plus,which had already been reached. Note the Head-and-Shoulders Reversal that formedand the subsequent Intermediate Reaction.\nwith Head-and-Shoulders Patterns, for instance, and they even occur on the penetrationof trendlines, which we shall discuss in a subsequent chapter.\nWhat forecasting value can we ascribe to them? First, they serve to call attention to,and emphasize the fact of, a breakout. There can be little doubt that a genuine breakouthas eventuated when prices jump out of a pattern with a conspicuous gap. False movesare seldom attended by gaps. Second, they carry the suggestion that the buying demand(or selling pressure, as the case may be) that produced the gap is stronger than wouldbe indicated by a gapless breakout. Hence, it may be inferred the ensuing move willcarry\n48\n44\n40\n38\n36 Sales 100's\n50\n40\n30\n20\n10\nFigure 12.9 “SMC” is a thin stock whose daily chart is usually “full of holes,” but thislarge gap that appeared on its weekly chart in September 1946 evidently possessedtechnical significance. Treated as a Runaway measuring from the eight-weekCongestion at 68, it called for a downside objective of 44 or below, which was dulyfulfilled.\n40\n38 Sales 100's\n50\n40\n30\n20\n10\nHlttf\nSHL,:::::: III\n1 A. O.SM\n■aHSSHT\n1ITH\n. CO1RPOI>A’I4OI< SMC It-#:\ng..::::\nb 1 rid1: rwmmWas J n\n1\niFmj}gi\n■■::\"I: :iii i i w •u\n:::H 1 :?: ::|i\nS•:$ liu g=:|:\noiw:ffll Bl! :::::i a ::::::::::::::::\n..... HutHui UM. .7 :\nl|» ; ;j •;G M B II\n\"-f ; : \" I TI mj » It\n■p\nSr ' ll 1945-947 M ^IJi 1 J\n1\nSet\nT *|\nIS 1 r\npppp: ss\n4|||+ t - it I »\nTT H fOl\n::::: Ptff•• J:5 mtmt\nSw\nrrrn\n■:•1 J\nHtt;::ii .=\n■rg£gg 11 ihi\nSiiffi, :uiah\niis\n4r......■ :\nL II lillr\nII f jttW\n1\nWith illh s nt H MlTi i i ill\nri tt,II\nN D1 - ■ F' MA 1 M 1\n’ J ' A ■ 1 O N ' D T T ' M 1 A ' M\n1946\nlaaaagi!!\nJANUARY FEBRUARY MARCH APRI\nMAY JUNE\n5 12 19 26 2 9 46 23 2 : 9 16 23 30 6 13 20 27 4 11 18 251 8 15 22 29'\nFigure 12.10 A small Island in the right shoulder of the Head-and-Shoulders Top thatmarked this issue's Major Reversal. The Island served only to emphasize the chart'sBearish implications.\nFigure 12.11 Island “shakeouts” are not uncommon in “thin” stocks. Why they shoulddevelop as they do is hard to explain, but their forecasting implications are obvious.\nprices farther or faster, or both. It does not do to make too much of this point; it is alogical inference and one that has been borne out in the majority of cases, but it has itsexceptions and may prove most disappointing on occasion. Nevertheless, other thingsbeing equal, of two stocks that emerged from Ascending Triangles at the same time,we should choose to buy the one that gapped out over the one that pushed its way outby small fractional steps.\nExcept for the presumption of somewhat greater “steam” behind the move, theBreakaway Gap carries no particular measuring implication, nor any other forecastingsignificance. The next question is this: should we expect a Breakaway Gap to be closedwithin a relatively short time? Or, to put the question in more practical and pragmaticterms: should we defer buying in the expectation that it will be closed before anyworthwhile move develops?\nTo give a fair answer to that question, it is necessary to scrutinize the volume oftransactions before and after the gap. If a great many sales were recorded at the takeofflevel from which prices jumped the gap, but relatively few as prices moved away fromthe far side of the gap, then there is a chance—perhaps about 50-50—that the nextMinor Reaction will carry prices back to the edge of the pattern of origin, thus fillingthe gap. On the other hand, if high volume developed at the far side of the gap, and a\ngreat many transactions took place there as prices moved on away from the gap, thenthe chances are remote that any near-term Throwback will close the gap. In such cases,a Throwback reaction is almost always stopped at the outside of the gap.\n(One is constantly tempted in a work of this sort to employ the words always or neverwithout qualification. Unfortunately, the authors have never bee", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 81}
{"text": "p, and a\ngreat many transactions took place there as prices moved on away from the gap, thenthe chances are remote that any near-term Throwback will close the gap. In such cases,a Throwback reaction is almost always stopped at the outside of the gap.\n(One is constantly tempted in a work of this sort to employ the words always or neverwithout qualification. Unfortunately, the authors have never been able to discover arule of techniques to which the market did not, on rare occasion, produce an exception.It is always necessary to be on guard against such exceptional developments. Many ofthem are caused by general market conditions that counteract the technical trend inindividual issues. Keep an eye on the charts of the “Averages,” as well as the particularissues in which you are interested.)\nWhere Breakaway Gaps develop intraday, the daily chart cannot, of course, indicatehow the day's volume was distributed. In that event, it may be necessary to examinethe\n128\n120\n112\n104\n96\n88\n80\n76\n72\n68\n64\n60\n56\nSales 100's\n250\n200\n150\n100\n50\nFEBRUARY MARCH\nUlilllliimilj\nAPRIL\n2 9 16 23 30 6 13 20 27 6 13 20 27 3 10 17 24 1 8 15 22 29 5 12 19 26\nFigure 12.12 This Island Reversal Pattern at Bethlehem Steel's Major Top in 1937 is a“classic,” yet it was followed by a curious and disturbing abnormality in the strongrally that developed on March 30. Those who sold out on the Island's signal around 95on March 19 or 20 were startled, and, if they had also sold short, justifiably alarmedwhen prices jumped up a week later, not only through the second gap level but wellabove it. But eventually, as can be seen, everything worked out according to theoriginal forecast. This incident will illustrate a general principle: when a clear-cuttechnical pattern of unquestionable significance has been completed on your charts, donot let some apparently contrary development that occurs shortly thereafter lead you toforget or neglect the previous plain signal. Give such situations time to work out.Figure 12.2 shows the sequel to the above chart and, incidentally, another Island.Compare the volume.\nticker tape or ask your broker to refer to the published record of individual transactionsto which most brokerage firms subscribe. (EN: This data may now be easily obtained.See Appendix D, Resources. EN9: Candlestick charts, now much in use, will allow theanalyst to see the intraday breakaway gap.) Lacking any clear-cut volume clue, it issafest to figure that a Breakaway Gap will not be filled until long after the full moveimplied by the pattern of origin (usually a move of Intermediate Extent in the Dowsense) has been carried out.\nContinuation or runaway gaps and the measuring rule\nLess frequent in their appearance than either of the two forms we have discussedabove, gaps of the Continuation or Runaway type are of far greater technicalsignificance because\n44\n40\n38\n36\n34\n32\n30\n28 Sales 100's\n125\n100\n75\n50\n25\n1936\nGE\nGT\nPENN SYL .VANIA RAILROA D\nJULY AUGUST SEPTEMBER- OCTOBER NOVEMBERDECEMBER\n■4 11 18 25' 1 8 15 22 29 5 12 19 26 3 '10 17 24 31 7 14 21 28 5 12 19 26\nFigure 12.13 This looked like an Island in “PA,” but the second gap was actuallyattributable to a $0.50 dividend which went ex on November 20 and, therefore, had tobe discounted technically. Due to this dividend, it was necessary to lower the SupportLine at 40 (see Chapter 13) by half a point. That Support, therefore, was not violated inDecember and prices subsequently advanced to above 50 the following March.\nTlTiSfBres20*YewTreaaryitarfETf HjseieW etedOiftain\n27-t«id7W Open';;;, L«wi2SuL«tiae7IMreuuCIH - IS (*122»>\nCd 9 « 23 St kl I 13 20 27 Dec4 11 IS » 2011\nFigure 12.14 TLT shown here in computer notation produces gaps in profusion. As thereader can see, if one just traded in the direction of the gap many short-term scalpswould be garnered. This chart also lends perspective to the hand drawn charts. A gap isa gap is a gap.\nthey afford a rough indication of the probable extent of the move in which they occur.For that reason they have sometimes been called “Measuring” Gaps.\nBoth the Common or Pattern Gap and the Breakout Gap develop in association withPrice Formations of the Area or Congestion type, the former within the formation andthe latter as prices move out of it. The Runaway Gap, on the other hand, as well as theExhaustion Gap, which we will take up later, is not associated with Area Patterns, butoccurs in the course of rapid, straight-line advances or declines.\nWhen a dynamic move starts from an area of accumulation, the upward trend of priceswill seem often to gather “steam,” to accelerate for a few days, perhaps a week ormore, and then begin to lose momentum as supply increases when the very extent ofthe advance invites more and more profit-taking. Trading volume jumps to a peak on\nthe initial breakout, tapers off somewhat in the middle of the advance, and then leapsup again to a terrific turnover as the move is finally halted. In such moves—and inrapid declines of corresponding character—a wide gap is quite likely to appear at thetime when the Runaway is at its height, when quotations are moving most rapidly andeasily with relation to the volume of transactions. That period comes normally at justabout the halfway point between the breakout that inaugurated the move and theReversal Day or Congestion Pattern that calls an end to it. Hence, a Continuation orRunaway Gap affords an approximate measurement of the move in which it develops.Its inference is that prices will go as much farther beyond the gap as they already havegone between the beginning of the move and the gap, as measured directly (andvertically) on the chart.\nSince there is a tendency for advances to run, in terms of points, beyond the pricelevels arithmetically implied by this rule, and for declines to be more strictly limited,the gap-measuring rule works out particularly well when applied directly onsemilogarithmic scale charts. On arithmetic charts, look for a trifle more on the upsideand a trifle", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 82}
{"text": "as measured directly (andvertically) on the chart.\nSince there is a tendency for advances to run, in terms of points, beyond the pricelevels arithmetically implied by this rule, and for declines to be more strictly limited,the gap-measuring rule works out particularly well when applied directly onsemilogarithmic scale charts. On arithmetic charts, look for a trifle more on the upsideand a trifle less on the downside. (In any event, you will be wise to “bank” onsomething short of the theoretical goal.)\nRunaway Gaps are easy to find and identify in retrospect, but our task is to recognizethem as such at the time they appear; there is no danger of confusing them with Patternor Breakout Gaps. With those aside, any gap that shows up in a fast advance or declineafter prices have moved well away from an Area Formation (or the penetration of animportant trendline or break through a potent Support or Resistance Level, which weshall discuss later) may be a Runaway Gap. What then becomes necessary is todistinguish it from our next type, the Exhaustion Gap. Usually, the price and volumeaction on the day following the gap furnishes the evidence required for a safediagnosis.\nTwo or more runaway gaps\nIt will be much easier to bring out the characteristics distinguishing Runaway andExhaustion Gaps when we take up the latter in detail. Before doing so, we mustmention those cases in which two and, rarely, even three gaps intervene in a fast moveand are evidently all classifiable as of the Continuation or Runaway breed. It does nothappen often and is particularly unlikely to appear in the chart of a fairly large andactive issue, but one of the thinner stocks in the midst of a “skyrocket” move may goskipping along for three or four days, making gaps between each successive pair. Theonly question of practical importance that arises in such cases is this: where should thehalfway measuring point be located? No quick and easy rule can be laid down, butstudious inspection of the chart, especially of the volume trend, will usually afford ananswer. Remember that halfway in these fast moves tends to come at the stage at\nwhich prices are moving most easily and rapidly with respect to the number oftransactions recorded (hence the tendency to gap). If there are two gaps, the halfwaystage may very likely have been reached somewhere between them. Inspect your chartcarefully and try to “average” the picture mentally; look for what appears to be thecenter of “thinness” and use that for your measuring level. But remember also thateach successive gap brings the move inevitably nearer to Exhaustion, so let yourjudgment lean to the conservative side; do not expect too much of the second or thirdgap.\nExhaustion gaps\nThe Breakout Gap signals the start of a move; the Runaway Gap marks its rapidcontinuation at or near its halfway point, and the Exhaustion Gap comes at the end.The first two of these are easily distinguished as to type by their location with respectto the preceding price pattern, but the last is not always immediately distinguishablefrom the second.\nExhaustion Gaps, like Runaway Gaps, are associated with rapid, extensive advances ordeclines. We have described the Runaway type as the sort that occurs in the midst of amove that accelerates to high velocity and then slows down again and finally stops asincreasing Resistance overcomes its momentum. Sometimes, however, “skyrocket”trends evidence no such gradual increase of Resistance as they proceed, showing notendency to lose momentum, but rather continue to speed up until, suddenly, they hit astone wall of supply (or, in cases of a decline, demand) and are brought to an abruptend by a day of terrific trading volume. In such moves, a wide gap may appear at thevery end, that is, between the next to the last and the last day of the move. This gets thename of Exhaustion Gap because the trend seems thereby to have exhausted itself inone final leaping spurt.\nThe best test of whether a gap formed in a rapid, straight-line advance or decline is ofthe Continuation or Exhaustion type comes on the day after the gap (more precisely,the day that makes the gap), although there are frequently other clues in the precedingchart picture. If trading activity mounts to an extraordinary height during the sessionfollowing the gap, and particularly if the previous trend in prices does not appear to becarried along at a pace commensurate with that day's activity, the gap is probably ofthe Exhaustion class. This interpretation is reinforced, in fact, made a virtual certainty,if the day after, the gap develops into a Reversal Day (as described in Chapter 10) withthe closing price registered back near the edge of the gap.\nEvidence that may be derived from the chart anteceding the gap may be enumerated asfollows: If the trend has already carried out the full implications of the price formationor Congestion Area from which it emerged, Exhaustion is more likely than\nContinuation. By the same token, if the reasonable measuring implications of thepattern of origin are still far short of attainment, the gap is probably of theContinuation type. An Exhaustion Gap is seldom the first gap in a runaway move; it isusually preceded by at least one Continuation Gap. Thus, you may ordinarily assume(unless the contrary appears from other and weightier indications) the first gap in arapid advance or decline is a Continuation Gap, but each succeeding gap must beregarded with more and more suspicion, especially if it is wider than its predecessor.\nWe have referred to Exhaustion Gaps as wide gaps. Width is, of necessity, relative inthis study; it is impossible to lay down any exact rules to define wide or narrow. Do notlet this bother you too much. Recognition of what constitutes an unusually wide gapfor the particular stock you have under observation soon comes with a little chartingexperience.\nRunaway Gaps are usually not covered for a considerable length of time, as a rule, notuntil the market stages a swing o", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 83}
{"text": "relative inthis study; it is impossible to lay down any exact rules to define wide or narrow. Do notlet this bother you too much. Recognition of what constitutes an unusually wide gapfor the particular stock you have under observation soon comes with a little chartingexperience.\nRunaway Gaps are usually not covered for a considerable length of time, as a rule, notuntil the market stages a swing of Major or full Intermediate proportions in theopposite direction. But Exhaustion Gaps are quickly closed, most often within two tofive days, a fact that furnishes a final clue to distinguish Exhaustion fromContinuation, if it should still be needed at that stage. This, incidentally, upsets thecommon superstition that all gaps must be closed before the trend can be trusted tocontinue very far. In the case of the Runaway Gap, it is not closed, but the trend movesright along, nevertheless, and often for a surprising distance. In the case of theExhaustion Gap, the closing of it actually contributes to the signal the trend has runout.\nAn Exhaustion Gap, taken by itself, should not be read as a sign of Reversal, or even,necessarily, of Reversal at all. It calls “stop,” but the halt is ordinarily followed bysome sort of area pattern development that may, in turn, lead to either Reversal orContinuation of the move before the gap. In practically every case, however, enough ofa Minor Reaction or delay ensues from the formation of an Exhaustion Gap before anew trend is established to warrant closing out commitments at once. (One can alwaysreenter if it subsequently appears that the previous trend is to be resumed.)\nThe Island Reversal\nWe mentioned (at the end of Chapter 10) a Reversal Pattern, the Island, which was tobe taken up under the general study of gaps. The Island Pattern is not common and it isnot, in itself, of major significance in the sense of denoting a long-term Top or Bottom,but it does, as a rule, send prices back for a complete retracement of the Minor Movethat preceded it.\nAn Island Reversal might be described as a compact trading range separated from themove that led to it (and that was usually fast) by an Exhaustion Gap and from the move\nin the opposite direction that follows it (and that is also equally fast, as a rule) by aBreakaway Gap. The trading range may consist of only a single day, in which event itnormally develops as a One-Day Reversal, or it may be made up of from several daysto a week or so of Minor Fluctuations within a compact price zone. It is characterized,as might be expected, by relatively high volume. The gaps at either end occur atapproximately the same level (they should overlap to some extent) so that the wholearea stands out as an Island on the chart, isolated by the gaps from the rest of the pricepath.\nWe have said an Island does not, of itself, appear as a Major Reversal Formation, butIslands frequently develop within the larger patterns at turning points of Primary orimportant Intermediate consequence, as, for example, in the head of a dynamic Head-and-Shoulders Top. By the same token, they appear occasionally at the extremes of theMinor Swings that compose a Triangle or a Rectangle (in which event, the gaps that setthem off are really better classified as Common or Pattern Gaps).\nThe reasons why Islands can and do develop—in other words, why gaps can and dorepeat at the same price level—will be more apparent when we take up the generalsubject of Support and Resistance in a later chapter. Suffice it to repeat at this pointthat prices can move most rapidly and easily, either up or down, through a range wherelittle or no stock changed hands in the past, where, in other words, previous ownershave no “vested interest.”\nSometimes the second gap—the Breakaway that completes the Island—is closed a fewdays later by a quick Pullback or reaction. More often it is not. Rarely, the first gap—the Exhaustion Gap that starts the Island—is covered in a few days before the secondgap appears, in which event the Island Congestion takes on a sort of V-Shape (if it is aTop), and there is no clear “open water” across the chart horizontally between theIsland and the trends preceding and following it. Yet, in any of these variations, theinterpretation remains the same: the preceding Minor Move should be practicallyretraced.\nAn Island Pattern is not easy to trade on unless it be for a short-term “scalp,” as,obviously, a good share of the retracement already may have been accomplished by thetime the Island is charted and an order to buy or sell on its indications can be executed.If the entering gap is recognized as an Exhaustion Gap, the trader who is interested inthe stock presumably will take action before the second gap forms and before theIsland is in evidence. Perhaps the greatest utility that Islands have for the chart analystis that of calling attention to a situation of putting him on the alert as to itspotentialities.\nGaps in the Averages\nGaps appear also in nearly all Averages but, for obvious reasons, with rather lessfrequency than in the charts of individual issues. Although it is not necessary for all ofthe stocks composing an average to make a gap simultaneously to produce a gap in theAverage figures, a majority of them must. As might therefore be expected, Common orPattern Gaps are particularly rare in Average charts, but Breakaway and Runawaytypes are not uncommon, although they are small as compared with the size of suchgaps in single stocks. Exhaustion Gaps, and, in consequence, Islands, again are rare.The conditions that create an Exhaustion Gap seldom develop in a sufficient number ofindividual issues at any one time to produce a counterpart in the Averages.\nThe technical interpretation of gaps in Averages is, in the main, the same as in singlestocks. The authors have not found that an Average gap possesses any peculiar potencyor significance over and above that attributable to a gap in the chart of any actively andclosely traded single issue.\nThe broader, and henc", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 84}
{"text": "nt number ofindividual issues at any one time to produce a counterpart in the Averages.\nThe technical interpretation of gaps in Averages is, in the main, the same as in singlestocks. The authors have not found that an Average gap possesses any peculiar potencyor significance over and above that attributable to a gap in the chart of any actively andclosely traded single issue.\nThe broader, and hence, most representative market indexes show the fewest andsmallest gaps. EN: On the other hand, the NASDAQ is quite volatile and a good gapproducer.\nIt is suggested the reader review this chapter after he has finished studying theprinciples of Support and Resistance in Chapter 13. (EN9: The truth is there is nothingmore that need be said about gaps, and the truth also is that no modern examples needbe added. But gaps are fun, so see Figure 11.11 and Chapter 16 for modern examples.)\nTaylor & Francis\nTaylor & Francis Group\nhttp://taylorandfrancis.com\nchapter thirteen\nSupport and Resistance\nAs illustrated by Figures 13.1 through 13.12, the phenomena we shall study in this chapter aremarkedly different in kind from those discussed in preceding sections. We shall look at the stockmarket from a new angle and, in so doing, may find it possible to develop some very practicaladditional rules to guide us in selecting stocks for purchase or sale, in estimating their potentialmoves, and in foreseeing where they are likely to “run into trouble.” As a matter of fact, someexperienced traders have built their “systems” almost entirely on the principles of what we callSupport and Resistance, paying no attention to the specific pictorial patterns of price and volumeaction we have been investigating in preceding pages.\nSupport and Resistance phenomena are not, by any means, unrelated to the various patterns andformations previously studied. We have already had occasion to hint at a basic principle of Supportand Resistance in our explanation of gaps, and, as you read on, you will find a number of the otherpatterns of price behavior are explained thereby, or at least become more readily understood.\nThe term Support is commonly used in the Street. In one or more of its connotations, it must befairly familiar to the reader. For example, we may hear such-and-such a crowd is supporting XYZ at50 or is prepared to support the market by buying all stock offered on any 5-point concession. Forthe purposes of this chapter, we may define Support as buying, actual or potential, sufficient involume to halt a downtrend in prices for an appreciable period. Resistance is the antithesis ofSupport; it is selling, actual or potential, sufficient in volume to satisfy all bids and, hence, stopprices from going higher for a time. Support and Resistance, as thus defined, are nearly but not quitesynonymous with demand and supply, respectively.\nA Support Level is a price level at which sufficient demand for a stock appears to hold a downtrendtemporarily at least, and possibly reverse it, that is, start prices moving up again. A Resistance Zone,by the same token, is a price level at which sufficient supply of a stock is forthcoming to stop, andpossibly turn back, its uptrend. There is, theoretically, a certain amount of supply and a certainamount of demand at any given price level. (The relative amount of each will vary according tocircumstances and determine the trend.) But a Support Range represents a concentration of demand,and a Resistance Range represents a concentration of supply.\nAccording to the foregoing definitions, you can see the top boundary of a Horizontal CongestionPattern such as a Rectangle is a Resistance Level, and its bottom edge is a Support Level; the topline of an Ascending Triangle is unmistakably a Resistance Level, and so on. But we are moreinterested now in the reasons why Support or Resistance, as the case may be, can be anticipated toappear at certain price ranges. Within reasonable limits, and with a certain few exceptions to beexamined later, it is quite possible to do this. Expert chart readers are frequently able to make someamazingly accurate predictions as to where an advance will encounter Resistance (supply) or wherea declining trend will meet Support.\nThe basis for such predictions—the elementary data from which Support and Resistance theories arederived—is that turnover in any given issue tends to be concentrated at the several price levels atwhich a large number of shares changed hands in times past. Since any level at which a greatvolume of transactions takes place usually becomes a Reversal point (Major, Intermediate, or Minor)in that stock's trend, it follows naturally that Reversal Levels tend to “repeat.” However, here is theinteresting and the important fact that, curiously enough, many casual chart observers appear never\nto grasp: these critical price levels constantly switch their roles from Support to Resistance and fromResistance to Support. A former Top, once it has been surpassed, becomes a Bottom zone in asubsequent downtrend; and an old Bottom, once it has been penetrated, becomes a Top zone in alater advancing phase.\nNormal trend development\nPerhaps we can make this plainer by citing a typical example of normal trend development. Supposea stock in a Bull Trend moves up from 12 to 24, and there runs into a large volume of selling. Theresult is a reaction that may take the form of a full Intermediate Correction to, say, 18, or a series ofMinor Fluctuations forming a Consolidation Pattern between, say, 24 and 21, the effect being thesame in either case. Following this Correction or Consolidation, a new advance gets under way andcarries the price on up to 30 before running again into supply in sufficient concentration to stifle themove. Now another reaction is evidently due. Again, it may take the form of a sidewaysConsolidation Pattern or an Intermediate Correction. If the latter, where will that corrective setbackbe reversed, or in other words, will it meet Support? The answer is at 24, the", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 85}
{"text": "new advance gets under way andcarries the price on up to 30 before running again into supply in sufficient concentration to stifle themove. Now another reaction is evidently due. Again, it may take the form of a sidewaysConsolidation Pattern or an Intermediate Correction. If the latter, where will that corrective setbackbe reversed, or in other words, will it meet Support? The answer is at 24, the level of the first Top inthe trend. That is the level (below current quotations) where a large turnover had previouslyoccurred. Then it functioned as Resistance, producing a halt or Reversal in the first upswing; now itfunctions as Support, stemming and reversing, at least in a Minor sense, the latest downswing.\nWhy should this be? It will be easier to suggest an answer to that question if we first go on with asimilar example of typical action in a downtrend. This time, suppose our stock makes a Major Topand declines from, say, 70 to 50. There, at 50, a temporary Selling Climax occurs; there is a largeturnover, prices rally, perhaps slip back for a “test” of 50, and then stage a good recovery to 60. At60, buying peters out, the trend rounds over, turns down, and accelerates in renewed decline, whichcarries to a new low at 42. Again, a wave of buying comes in and a second recovery swing getsunder way. We can confidently expect this recovery (from 42) will run into strong Resistance at 50.The price level that functioned as a Support for the first phase of decline, now that it has beenbroken through the downside by the second phase, will reverse its role and function as Resistance tothe second recovery move. The former Bottom level will now become a Top level.\nHere, we may ask again why this should be so, and now we can suggest an answer. In the exampleof downtrend action cited in the preceding paragraph, our stock first dropped to 50, ran intoconsiderable volume there, reversed its trend, and rallied to 60 with activity dwindling on the rise. Alot of shares changed hands at 50, and for every seller there was a buyer. A few of those buyers mayhave been covering short positions and, having done so, had no further interest in the issue. Othershort-term traders and professionals may have purchased simply because they sensed a temporaryBottom in the making and hoped to scalp a few points on the ensuing rally; presumably, they (or atleast some of them) took their profits and were out before prices broke very far on the next decline.But a majority of those who acquired shares at 50, it is safe to say, did so because they thought thestock was cheap at that price, figuring it had gone low enough. Only a few months ago, it was sellingabove 70; surely, it was a bargain at 50 and could be picked up and put away “for the long term.”\nThe explanation\nImagine yourself, for the moment, in the place of those new owners. They see prices turn up, reach55, 58, 60; their judgment appears to have been vindicated. They hang on until the rally peters outand prices start to drift off again, slipping to 57, 55, 52, and finally 50. They are mildly concernedbut still convinced the stock is a bargain at that price. Most likely, there is momentary hesitation in\nthe decline at 50 and then prices break on down. Briefly, there is hope the break is only a shakeout tobe recovered quickly, but that hope vanishes as the downtrend continues. Now our new ownersbegin to worry. Something has gone wrong. When the stock gets down below 45, the former bargaindoes not look so good. “Well, I guess I picked a lemon that time, but I won't take a loss in it. I'll justwait until it gets back up to 50 some day where I can get out even (except for expenses), and thenthey can have it.” (Does this sound familiar, by any chance?)\nWe can skip over the next few swings that “followed the rules” and go on to the change in thepicture, which came with the first notable violation of a Support Level in 1946. Prices had pushed upthe first of February nearly to 54, well out above the Tops around 46, which formed the previousNovember. The late-February reaction should have “caught Support”\nI 1944 I 1945 I 1946 I 1947 !\nFigure 13.1 Why now was so much time spent and \"work\" done during mid-1945 under 33-34? Wecannot see it on this chart, but the previous monthly history shows that the Bottoms of longCongestion Areas were made in this zone in late 1939 and late 1940. These old Bottoms,representing Support, originally, were able to produce some supply (Resistance) five years later.Once prices had worked through that supply, however, they were able to rise quickly to 44, and thentheir subsequent reaction found Support just where you might have expected—at 33-34. Support hadturned to Resistance and then to Support again.\naround 46—but it did not; it crashed on down to the “round figure” 40. This was an ominous(although not necessarily “fatal”) development. Thereafter, a massive Symmetrical Triangle was\nformed and broke downside in September.\nThe first Panic Decline in the Bear Market is no respecter of Support Levels. This one was noexception, although it is noteworthy that prices “bounced” several times from the important old 33-34 zone. By November, the Top Triangle's measurement had been exactly fulfilled. (You should turnback to this record and study it again after you have read further in this chapter.)\nTake the opposite side of the picture—the uptrend process. You, along with many others, boughtXYZ at 12, carried it up to 24, decided that was plenty high for it, and cashed in. Thereupon XYZreacted to 20, and you congratulate yourself on your astuteness. But then, unexpectedly, it turnsaround and rushes up to 30. Now you do not feel as smart knowing that was a better stock than yougave it credit for being. You wish you had it back, yet you will not pay more for it; if it comes backdown to 24, the price at which you sold, you'll “reinstate your position.”\nPerhaps you have never been in either of these situations. Perhaps your own reactions would not, insuch cases,", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 86}
{"text": "ctedly, it turnsaround and rushes up to 30. Now you do not feel as smart knowing that was a better stock than yougave it credit for being. You wish you had it back, yet you will not pay more for it; if it comes backdown to 24, the price at which you sold, you'll “reinstate your position.”\nPerhaps you have never been in either of these situations. Perhaps your own reactions would not, insuch cases, have been the same as those we have indicated. If you have had a fair amount ofexperience in the market—have some knowledge of the psychology of the “average investor”—youknow the pictures described are typical.\nAt this point, you may not be satisfied we have succeeded in giving an adequate explanation for ourbasic principle of Support and Resistance Levels. Remember, however, that the supply and demandbalance in the market is nearly always a delicate thing. Only a moderate oversupply at any one pricewill suffice to stifle an advance; only a little extra demand concentrated at a certain level will stem adecline. Remember, other traders are watching the tape as well and will be quick to sense anychange in the situation and be quick to join the parade whenever a change in trend appears to bedeveloping. Consequently, orders to buy or sell a few hundred shares may induce the transfer ofseveral thousand.\nAnother point worth bearing in mind is that the traders and investors who (because of thepresumption their previous mistakes in either selling or buying prematurely) created Support andResistance Levels are not necessarily ignorant or inexperienced. On the contrary, we must list themamong the wiser and more alert of those who operate in the market. To make one more use of ourprevious theoretical example of typical downtrend action, those who bought at 50 were certainlysmarter than those who bought at the top (70) or on the way down to 50, even though the latter pricewas broken later on. Giving them credit for somewhat superior judgment, it follows that they may beexpected to appraise later developments pretty carefully and display something better than a woodenand stubborn determination to “get out even” when it comes to selling on a Recovery Move. Hence,in a marked Bear Trend “overhanging supply”; that is, stock bought at higher levels by holders nowwaiting for a good chance to unload, will begin to come on the market below the theoreticalResistance Level. Wise owners will be willing to sacrifice a point or so to avoid getting caught in aworse loss.\nBy the same token, “sold-out Bulls,” when a Major Uptrend is under way, may be willing to pay apoint or two more to replace the shares they had previously cashed in too soon. Thus, it ischaracteristic of reactions in well-established (second phase) Bull Markets to drop back only to thevery uppermost limits of a Support Range—and for recoveries in established Bear Markets to reachonly the lowest edges of Resistance Zones, or perhaps even fail of that by an appreciable margin. Weshall have more of this sort of thing to point out later on, but first we must take up two other matters—how to estimate the potential importance of Support and Resistance Zones, and how to moreaccurately locate the centers of axes of such zones.\nEstimating Support-Resistance potential\nTo go back to first principles, the Resistance that an upward move may meet at any given leveldepends on the quantity of stock overhanging there—the number of shares previously bought at thatprice by owners who now would like to get out without loss. Obviously then, volume is our firstcriterion in estimating the power of a Resistance Range. An old Minor Bottom level, at which onlyfour or five hundred shares changed hands, cannot set up much Resistance to a subsequent advance,but a Selling Climax Bottom, where several thousand shares were bought, will provide a lot ofpotential supply after prices have dropped well below it, at some later date, and then attempt to riseup through it again.\nA long Rectangle or a Descending Triangle has a number of Bottoms at the same level. We can get acrude approximation of the amount of Resistance there by summing up the volume of trading on allits Bottoms, but then some discount must be taken for the shares that may have been bought at theBottom of the pattern in its early stages and then sold near the Top before it was completed. In brief,a single, sharp, high-volume Bottom offers somewhat more Resistance than a series of Bottoms withthe same volume spread out in time and with intervening rallies.\nAnother criterion is the extent of the subsequent decline. Or, to put it another way, how far priceswill have to climb before they encounter the old Bottom zone whose Resistance potential we areattempting to appraise. Generally speaking, the greater the distance, the greater the Resistance.Suppose PDQ sells off from 30 to 20, “churns” at that level for several days, rallies to 24, and thendrifts back down to 19. Investors who picked it up at 20 will not be greatly concerned at that stage. Ifa rally now develops from 19, there will be little or no disappointed selling at 20. Should prices dipto 18 before the rally starts, there may be some supply forthcoming at 20, but still not a formidablequantity. From 17, Resistance will become evident. In brief, prices have to break far enough belowthe price at which a trader bought his stock to convince him that he made a bad investment and,hence, that he should sell when he gets a chance to do so without too great a loss.\nIt is impossible to formulate any precise rule or equation to define how far a decline must proceed toset up Resistance above it. However, do not look for much supply to come out of a Bottom level inthe low-middle price ranges (20-35) unless the trend later takes quotations more than 10% under it.This 10% rule cannot be applied to very low-priced issues. A man may buy a stock at 5 and see itdrop to 4 or 3.5 with considerable equanimity despite the fact he stands a loss of 30% at the latterfigure. His “dollar” loss l", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 87}
{"text": "bove it. However, do not look for much supply to come out of a Bottom level inthe low-middle price ranges (20-35) unless the trend later takes quotations more than 10% under it.This 10% rule cannot be applied to very low-priced issues. A man may buy a stock at 5 and see itdrop to 4 or 3.5 with considerable equanimity despite the fact he stands a loss of 30% at the latterfigure. His “dollar” loss looks small, and he still thinks it will be easy for his stock to get back up to6 or 7; so, he is willing to wait.\nAnother factor enters into and reinforces the “extent of decline” criterion. If our PDQ rallies, asbefore, from 20 to 24 and then drops rapidly to 12, not only will many of the old owners at 20 bethoroughly disgusted and glad to get out at that price, given an opportunity, but the new owners at 12also will be pleased to take 20 (66 2/3% profit) and quick to do so if they detect any signs of troublethere. New buyers at 18, needless to say, would not be quite so ready to sell at 20.\nA third criterion for appraising the Resistance potential at an old Bottom level is the length of timethat has elapsed since it was formed and the nature of general market developments in the interim.You will, no doubt, find it reasonable to suppose that an Intermediate Bottom formed in the earlystages of a Bear Market will offer relatively little Resistance after prices have fallen far below it,have taken perhaps the better part of a year\n56\n52\n48\n44\n40\n38\n36\n34 Sales 100's\n50\n40\n30\n20\n10\nFigure 13.2 Support-Resistance Levels in a long Intermediate Uptrend. The reader will need noguidance in applying the principles stated in this chapter to the Bendix weekly chart reproducedabove. Observe that when prices broke down in 1945 through a long trendline, their decline stopped,nevertheless, at the Support set up by the previous November's Top.\nto make a Major base, and then have gradually climbed up to it again four or five years later. Tosome small extent, this is true. A supply only a year or two old is apt to be more effective than onethat is four or five years old, but the latter does not lose all of its potency by any means. In fact, it isoften surprising how effective the Resistance will be at a very old Bottom zone, provided it has notbeen “attacked” in the interim, and provided no changes have been made in the capitalization of thecompany that might obscure, in the mind of the owner, the original cost of his stock. Under the latterheading, we would put split-ups and large stock dividends, or even an unusually generous cash“melon.” We do not mean to imply that an investor is ever actually deceived as to the actual cost ofhis shares, no matter how they may have been split, or what dividend distribution has been made,but his disappointment (and desire to get out even) may be abated.\nIf, however, a Resistance Zone has once been attacked—if prices have come back up to it, hit it, andthen retreated—some of its power has obviously been removed. Some of its overhanging supply hasbeen used up in repelling the first attack. The next advance, therefore, will have less stock to absorbat that level. Here again, the volume chart may be looked to for some approximation of the amountof Resistance consumed. In any event, it is an odds-on assumption that a third attack at a ResistanceLevel will succeed in penetrating it.\nWe have named three criteria—volume, distance away, and time elapsed—to be used in assessingthe amount of Resistance to be expected at any given level. At this point, it must be apparent (andperhaps disappointing) to the reader that his own judgment must play a large role in applying them.This cannot be helped; it is impossible to set up an exact mathematical formula for any of them.\nBut, after all, the problem is not too complicated. The general principles are simple enough and, webelieve, easy to understand. We can look back at the charted history and see where, in the lastpreceding downtrend, a Bottom formed that may produce more or\n30\n25\n20\n15\n10\n5\nFigure 13.3 For Major Support-Resistance Level study, monthly charts are most useful. This onepresents many points of interest. Observe how important levels are formed and how, once formed,they appear again, and reverse their roles. The price scale shows 1947 values with previous yearsadjusted for the splits of 1933 and 1946.\nless Resistance when the current advance reaches back up to its range. We have to estimate howmuch supply resides there, how many shares were bought originally at that price and are still held byowners who may welcome a chance to get out even.\nThe greatest danger in applying judgment to the measuring of these factors lies in underestimatingthe amount of Resistance to be expected. Guard against that effort; it is safer always to overestimateit. You may be Bullishly disposed yourself; you may say, “Those fellows who were hung up there inthis stock must realize that conditions have improved, and they will not be so anxious now to sell.”Don't count on it. Recall, they have been “hung up” for a long time; even if they are mildly Bullishon the market in general, they may be so disappointed with this particular stock that they want toswitch out of it and try something else. (The stubborn and often costly refusal of the averageAmerican investor to “take a loss” operates even against timely switching.)\nEverything we have said in the foregoing paragraphs about estimating potential Resistance appliesas well—but in a reverse direction, of course—to estimating potential Support. The principles areprecisely the same, even though the underlying rationale may be less easy to grasp.\n40\n30\n20\n10 Sales 100's\n800\n400\nFigure 13.4 Particularly noteworthy in this monthly record is the Resistance met in 1939, 1940,1941, and even in 1944, at the Bottom level (just above 26), the three-month Congestion of 1936.Also, the appearance eight years later (!) in 1945 of Resistance at the Bottom level (28) of the High-Volume Top Congestion of 1936-1937.\n50\nIM jff ::::", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 88}
{"text": "be less easy to grasp.\n40\n30\n20\n10 Sales 100's\n800\n400\nFigure 13.4 Particularly noteworthy in this monthly record is the Resistance met in 1939, 1940,1941, and even in 1944, at the Bottom level (just above 26), the three-month Congestion of 1936.Also, the appearance eight years later (!) in 1945 of Resistance at the Bottom level (28) of the High-Volume Top Congestion of 1936-1937.\n50\nIM jff :::: II II\nT Ttfl ±g: tFftCftftI ft ft fffifF IT\nI 1Ff ft 1 gift1 ::::: ■tl\n1 4 4 J £; H w i\n..........r :jKRESG,i\n..... (S.S.)CX).s\nIM\nK ;c\n::\n• w\n■\nITIIT\nW\nft\nffl\nS: I\n■ 1\nr\nrntt\ng tftft\n■ ••ft Bl i ffti\nm\nffl ft-Illin 1 4\nttr\nTT’\nT\n1\nft\nX\nI i ftl\n•ii u ft 1:Ml ::: :\ngH a B 4' tintn 4ftf: i 1 illhggj\nI- *1 ■•: Jt , iji;1\nI §ii F- iftft ft\nft t r grf ::Iffil\n: f \"T 1 t TT tt i 111\n-\nI\n:::\ng\nn\nttfti\n1\n-W\nI\nn +\nft\nffiff\nII\nft ■ F T In Jffl± 1 1 w\nJ. ::: t 1 ;\nu ::: 4g itgii|m\nft\n1 tilt* : ii t iiii\n193619371938 19391940 19411942 1943 1944 1945 | 1946\nPrices were able to “skyrocket” when that Resistance was finally overcome. You will find thatseveral additional Support-Resistance Lines might have been drawn on this chart. Note MajorBottom Formations of 1937-1938 and 1942.\nLocating precise levels\nOur next problem to consider is how, in practical day-to-day chart analysis, we can locate as exactlyas possible the limits of a Support or Resistance Range and, in many cases, the specific price figurerepresenting the core or axis of such a range. In the theoretical examples we have made up so far toillustrate basic principles, we have used even figures, but in actual trading, the levels are seldom sonicely marked. Even the sharp and relatively patternless Bottom of a Recession may consist of aweek of price fluctuations within a narrow range. Perhaps the lowest day of that week's Congestionwill appear on the chart as a One-Day Reversal, or there will be two or three days that “spike” downbelow the general mass. Here again, although no mathematical rule can be laid down, it is easy torelate the price and volume patterns visually, and by simple inspection, arrive at a near estimate ofthe figure at which supply in quantity is likely to be forthcoming. Look particularly at the closinglevels of the days making up the Bottom Congestion and average them mentally; this figure is apt tobe pretty close to the “center of gravity” of the entire Resistance Area.\nSome supply is likely to start coming in as soon as a subsequent advance reaches the bottommostfraction of the Resistance Zone, and more and more will appear as the move pushes up into it.Sometimes, it is possible to predict “to a hair” just how far prices will penetrate a Resistance Rangeby carefully comparing the vigor (volume of trading) on the advance with the volume registered atvarious levels in the original formation of the Resistance. This takes experience, but it is experiencethat you will find quite easy and not at all costly to gain. In most cases, however, it is neithernecessary nor particularly desirable to be so exacting.\nNearly every chart in this book shows some example of Support and Resistance phenomena, and thereader should make it a point when he has finished this chapter to go back over and study them all indetail. The practical application of the rules we have been discussing will be greatly clarified.Equally instructive, if you can manage to obtain such a collection, is a study of the Support andResistance Levels appearing in the monthly charts of all actively traded stocks over a period of 10\nyears or more. EN: Easily generated by most currently available software and on the internet atstockcharts.com and other sites. You will undoubtedly be amazed to see how Tops, Bottoms, andSideways Congestions tend to form at the same approximate levels in successive Major Swings,while prices move freely and rapidly, up or down, through the ranges between such levels. It ishardly necessary to dwell on the practical dollars-and-cents value of such information that may bederived from the chart history.\nThis brings up a matter that we may as well pause to consider here—the kind of charts most usefulfor locating and appraising Support and Resistance Levels. For near-term Minor Moves, the dailychart is naturally the only source of information, and a daily chart record that extends back for a yearor more may, if necessary, be used in the location of levels of Intermediate Trend importance. Thewriters have found, however, that a daily chart does not give the perspective on the long range thatone really needs to determine Major and Intermediate Support and Resistance Zones. It is apt tooveremphasize the potential of a recently set up Minor Support (or Resistance) Zone and obscure theimportance of a true Intermediate Level. For true perspective, a weekly chart, showing volume aswell as price ranges, and covering at least the whole previous Major Bull and Bear cycle, is mostdesirable. Also, very good results can be obtained with a little study and experience from monthlycharts.\nTo return to our study of Support phenomena, we have had several occasions to refer in previouschapters to a “normal” trend. What we have had in mind might perhaps be better called an “ideal”trend because, like so many other so-called normal things, it represents a pattern from which thefacts of experience frequently deviate. In stock trends, nevertheless, this normal or ideal appears as afairly common pattern. If it is an uptrend, it consists of a series of zigzags (EN10: think waves, as inChapter 28), each “zig” carrying prices to a new high and each “zag” taking them back to theapproximate top of the preceding “zig.” To illustrate with figures, up to 10, back to 6, up to 15, backto 10, up to 20, back to 15, up to 26, back to 20, and so on. Such a move is what technicians refer toas “self-correction” and regard as particularly sound and, hence, likely to be continued. You can seeit really represents a reaction to the nearest Minor Support Level following each step forward. If youbecome in", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 89}
{"text": "f the preceding “zig.” To illustrate with figures, up to 10, back to 6, up to 15, backto 10, up to 20, back to 15, up to 26, back to 20, and so on. Such a move is what technicians refer toas “self-correction” and regard as particularly sound and, hence, likely to be continued. You can seeit really represents a reaction to the nearest Minor Support Level following each step forward. If youbecome interested in an issue with such a trend pattern, the normal return to a Support produces agood place to buy.\nSignificance of Support failure\nSooner or later, however, a normal Minor Wave Pattern is bound to be broken up. This generallyoccurs in one of two ways (although there is an infinity of possible variations). In one, prices spurtaway in an advance out of all proportion to the previous succession\nFigure 13.5 A monthly chart of Jewel Tea Company with its Major Support-Resistance Levelsmarked. Note the reversal of roles.\nof up waves. Such a move is seldom followed by a reaction to the Support now left far behind, butrather, by the construction of some sort of Area Pattern—which may be either Consolidation orReversal.\nThe other type of disruption appears when a reaction does not halt and reverse at the level of theprevious Minor Top, but sifts on down through that zone, perhaps to the level of the preceding MinorBottom. This move has “broken its Support,” and any such action carries a distinct warning of achange in trend, a particularly emphatic warning if activity shows a tendency to increase as or afterthe Support is violated. Note we said change in trend rather than Reversal because the puncturing ofa Minor Support Level may signify only a halt for sideways Consolidation, yet it may also foretokenan impending Reversal; either of these is a change.\nIf you will now call to mind the picture of a typical Head-and-Shoulders Top, you will see thedecline from the head constitutes just such a break in Minor Support because it comes down throughthe level of the top of the left shoulder. You will recall this decline is often the first intimation wehave that something in the nature of a Reversal Formation is developing.\nThus, even the violation of a nearby Support Level has a practical meaning in technical chartanalysis. The breaking of a Minor Support should always be regarded as the first step in the Reversalof the Intermediate Trend. (If it turns out to be Consolidation only, there will be an opportunity laterto reenter an abandoned commitment if desired.) By the same token, the breaking of an IntermediateSupport Range is frequently the first sign of a Reversal in the Major Trend. We do not believe it isnecessary to expatiate further on this principle. Recommended trading tactics based thereon arediscussed in Section II of this book; Support and Resistance Levels are particularly useful as BasingPoints for stop-loss orders, which are discussed there.\nPopular misconceptions\nThe reader will understand all we have said here about the breaking of Supports applies as well, butin reverse direction to the penetration of Resistance Levels. One more point may well be mentionedbefore we leave this subject; if you happen to have spent much time in\n44\n40\n38\n36\n34\n32\n30\n28\n26\nSales 100's\n50\n40\nREMINGTON RAND\nRR\n..\nFigure 13.6 When prices broke down out of the large Descending Triangle that formed onRemington Rand's weekly chart in 1946, the decline might have halted, at least temporarily, around37 at the level of the four-week Congestion made in April and should have “caught Support” at 35-36, the level of the February top. Failure of the latter carried Major Trend significance. Note laterResistance at 40 1/2.\nboardrooms, you will have noticed the concepts of Support and Resistance prevalent there aresomewhat different from those outlined in this chapter. For example, if X has advanced to 62,reacted to 57, and then pushed on to 68, many traders will speak of 57 as being the Support Level,presumably because that was the last price at which X was supported in sufficient strength to turn itstrend from down to up. We, as you have seen, would name the vicinity of 62 as the Support Range.The distinction is important to grasp and sometimes extremely important in practical results.\nAdmittedly, it does not come easy to think of a former Top as denoting the level at which a laterBottom should form, or vice versa; it would seem superficially to be much more logical to relate Topto Top and Bottom to Bottom. Moreover, it is perfectly true, to use our X example again, that someof the investors who wanted to buy it at 57 might not have succeeded in getting it before the secondadvance to 68 took it away, and their buy orders might still stand at 57 or might be reentered on anyreturn to that price. Nevertheless, there is certainly no assurance that such is the case; there is no“vested interest” in X at 57 that will “automatically” bring in new buying. On the other hand, wehave seen how there is a sort of vested interest set up at an old Bottom that produces selling(Resistance), and thereby creates a new Top, and at an old Top that produces buying (Support) andthereby creates a new Bottom.\nThe reader is urged to keep this concept well in mind. Any analytical study of the chart records willquickly show it is much easier for prices to push up through a former Top level than through theResistance set up at a previous volume Bottom (and vice versa, of course, with respect to declines).You will find a little selling may come in at a former high, but usually only enough to cause a briefhalt rather than the more or less extensive reactions or Consolidations that develop when the trendcomes up against a real Resistance Zone.\n26\n24\n22\n20\n19\n18\n17\n16 Sales 100's\n125\n100\n75\n50\n25\n:::::::::\nTO II it** ’iff”\" —\nurn «; 4\nfe i\n.....32\nto te\nAt 44\n::::::::::\nis ill\n—\ni IIffl 3..pl klliBhl as jg a A 1\n1\ni\n1 I N ■\n3$ 1 II TOTO... ***♦..... ffif\n4I H ! jmSm I H P 4r4t Hr444+ H .41141114\nIgS ill!1 III llllll!!! III 1 H!’!!*' Hr HUM\n.Hi\n:::: YORK COR", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 90}
{"text": "onsolidations that develop when the trendcomes up against a real Resistance Zone.\n26\n24\n22\n20\n19\n18\n17\n16 Sales 100's\n125\n100\n75\n50\n25\n:::::::::\nTO II it** ’iff”\" —\nurn «; 4\nfe i\n.....32\nto te\nAt 44\n::::::::::\nis ill\n—\ni IIffl 3..pl klliBhl as jg a A 1\n1\ni\n1 I N ■\n3$ 1 II TOTO... ***♦..... ffif\n4I H ! jmSm I H P 4r4t Hr444+ H .41141114\nIgS ill!1 III llllll!!! III 1 H!’!!*' Hr HUM\n.Hi\n:::: YORK CORPORATION YOK rttt aims Bj\nHIII Ul!1HIHHH.\np\nr ttt tttffliHttittt rliHil n\nHHH\nn\nmt.................... rr\nmi.- 1 < 11 < ■ ij ill\n1945 1946 ;; sH4 1\nMn-TOTOII \"\" jgtggHggg sor\n— — kni&int\n1 ii I lili ... ....hp III........ .,1. ......\n1 Illi Jluyll ill ill ..... Lilij\nmil\ni ill li I 1\n3 '10 17 24 1 8 15 22 29 5 12 19 26 2 9 16 23 2 9 16 23 30\n6\nOC\nMARCH\nFigure 13.7 York is a relatively thin stock, which normally makes many small, technicallymeaningless gaps, but its large, high-volume gap of October 8, 1945, demanded attention. It lookedlike a Runaway Gap, and as such implied continuation to 26 1/2 plus, but prices halted their advanceat 24 1/2 and went into a three-month Rectangle. An upside breakout on January 10, 1946, carriedout the minimum measurement of the Rectangle (and October gap); prices then reacted. See sequelin Figure 13.8.\nThe round figures\nThere are certain other levels that may, at times, evidently produce considerable Resistance orSupport without any reference to a previous “vested interest.” We have in mind the “round” figures20, 30, 50, 75, 100, etc. In setting a goal for taking profits when we buy a stock, it is natural for us tothink in terms of such round prices. If a low-priced stock has advanced steadily from around 10, it ispretty certain on this account to meet with profittaking sales at 20, especially if that figure representsa new high for several years. In fact, any time an issue gets out into new all-time high ground, wherethere is nothing in its chart history to indicate otherwise, it is a fairly safe bet that Resistance willappear at the round figures. In old and actively traded stocks, such as U.S. Steel (EN: or IBM andGE), the round figures diminish in importance.\nRepeating historical levels\nIf, once they had been set up, important Support and Resistance Levels always “worked,” we shouldsee Intermediate Tops and Bottoms form at exactly the same ranges year after year in one Bull andBear cycle after another. As a matter of fact, there is a well-marked tendency for this to occur in old-line, actively traded stock. In General Electric, for example, the 22-24, 34-35, 40-42, and 48-50zones were characterized by large turnover (and, consequently, by many Intermediate Reversals oftrend) throughout the 1920s and into the 1950s. In Southern Pacific, there are historical Support andResistance Zones at 21-22, 28-30, 38-40, and 55-56. In U.S. Steel, 42-45, 55-58, 69-72, 78-80, and93-96 are conspicuously marked as Reversal\n26\n24\n22\n20\n19\n18\n17\n16 Sales 100's\n50\n40\n30\n20\n10\nYORK CORPORATION YOK\n___ AUGUST SEPTEMBER, , '22 29 6 [13 5'027 3 l10l17l24 1 31T7 114*21 '28\nr 6 13 20 27 4 11 18 25 1 8 15\nFigure 13.8 The February reaction in Figure 13.7 met momentary Support at 24; prices bounced farenough to close the February 7 gap and then broke down through the Rectangle Top-Line Supporttechnically a distinct warning. Then a Symmetrical Triangle formed, but the breakout came too nearthe apex, produced only a rally to the former high, and then an “end run.” One did not need to waitfor the Double Top signal on August 22 to forecast a decline of more than minor consequence.\nRanges. Additionally, many other stocks might be cited. (EN9: While the particular stocks are deador transmogrified, the principle is alive and well.)\nOver long periods, however, such Support and Resistance Levels do tend to be gradually modified,broadened, or “blurred” as new ones are created. One source of many important new Supply Zonesis a Bear Market Panic. For this is the one type of decline that can be counted on to pay no heedwhatsoever to previous underlying Support Zones. Panics (which, as seen in our earlier study ofPrimary Swings in connection with Dow Theory, typify the second phase of Bear Markets), oncethey get under way, seem to sweep away all potential Support in their calamitous plunges until theyexhaust themselves in a general market Selling Climax for which may or may not come at a levelthat bears a relation to some previously established Support. To use U.S. Steel again as an example,the 1937 Panic Decline took the stock down through its 93-96 range, hesitated briefly at the 78-80level, and then plunged through 69-72 and 55-58 to stop just above 50. In the 1946 Panic, X againbroke swiftly through 78-80 and 69-72 to halt at 66.\nWhen there is a large turnover at a Panic Bottom in any given stock, that level acquires a strong“vested interest” for the future and will usually furnish conspicuous Resistance to a subsequentadvance (after another Bear Market Decline has taken quotations below the Panic Level).\nThis discussion of Panics brings us back to a consideration of Support and Resistance performanceat other stages of the Primary Trend. Bearing in mind the relation of Resistance to volume, it is easyto see why in a long drawn out but otherwise typical Bear Swing in which trading interestdiminishes to a very low ebb as the final low is approached, the next to the last Intermediate Bottommay produce relatively little supply and, consequently, only a small reaction when the new uptrendreaches its level. Add to this the fact that many of the buyers in the last stages of a Major Decline aredeliberate scale-down investors who fully expect prices will go lower and, hence, are not easilyshaken out. The slow progress so often seen in the first part of a new Primary Bull Market is due notso much to overhead Resistance as to lack of impatient public bidding.\nThe Recovery Trends that follow precipitous Bear Market Panics usually exhaust themselves, forobvious reasons, long before they get back up to the las", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 91}
{"text": "own investors who fully expect prices will go lower and, hence, are not easilyshaken out. The slow progress so often seen in the first part of a new Primary Bull Market is due notso much to overhead Resistance as to lack of impatient public bidding.\nThe Recovery Trends that follow precipitous Bear Market Panics usually exhaust themselves, forobvious reasons, long before they get back up to the last Resistance Level left behind in that PrimaryDownswing (which is usually the Bottom of the first Intermediate Decline from the extreme Top ofthe cycle), but they often meet supply at a lower Resistance Zone set up in the preceding BullMarket. Look way back on your charts, therefore, when sizing up the prospective advance in suchsituations.\nA further thought along that line is this: there is no law that requires an advancing trend to keep righton climbing until it reaches a distant overhead Supply Zone. It is true, as a corollary that we havealready mentioned to our Support and Resistance Theory, that prices can and do rise easily through aprice range at which no Bottoms or Congestion Areas have formed in previous downtrends, but ifthe first established Resistance Level is a long way above, the advance may exhaust itself before itgets there. Heavy supply may come in for other reasons at a lower level. Think, then, of a distantResistance Level as a maximum possibility rather than as a certain goal. However, between twostocks whose purchase you are considering, you should select the one, other things being equal, withthe “thinner” track overhead and can rise farther before it encounters a charted Supply Zone.\nPattern Resistance\nWe can revert now to some of the Minor phenomena discussed in connection with Reversal andConsolidation Patterns in earlier chapters. Take gaps, for instance. You will now see why it is easyand, hence, quite in order for a reaction that comes soon after a gap has been made to slip back andclose that gap. There is no “vested interest” whatever in the range through which prices skipped to\nform the gap on the chart. You will also see why such a reaction may stop short and reverse as soonas it has closed the gap, provided there was a high-volume turnover in the price range immediatelypreceding the gap. Such is usually the case with a Breakaway Gap.\nAny gap, for the same reason, is easy to close once a reaction starts prices moving back in thatdirection, if it is not too far away and if there are no intervening Resistance Levels to stop thereaction before it gets there. In the case of a Runaway Gap, however, there is no reason why areaction should halt as soon as it has covered the gap range; on the contrary, it will probablycontinue on through the “thin” price track that preceded the gap.\nPullbacks and Throwbacks—the quick return moves that we noted as developing so often shortlyafter a breakout from a Head-and-Shoulders or other Area Pattern—exemplify the principles ofSupport and Resistance. When prices break down, for example, out of a Descending Triangle, thehorizontal lower boundary of the formation, which was originally a Demand Line, promptly reversesits role and becomes a Resistance Level. Any attempt to put prices back up through it, therefore,after a decisive breakout, is stopped by supply at or near the line. By the same token, the neckline ofa Head-and-Shoulders Top, which was a Demand Line, becomes a Resistance Level after it has beenbroken. The Top or Supply Line of a Rectangle becomes a Support after prices have pushed above iton volume and by a decisive margin.\n76\n72\n68\n64\n60\n56\n52\n48\n44 Sales 100's\n50\n40\n30\n20\n10\nGOODYEAR TIRE\nGT\nid\nN ' D ’ J 'F'M'A'M'J ' J 'A'S'O'N ' D ' I 1~F'1'Mf A M\nFigure 13.9 We first discussed Pullbacks in connection with the Head-and-Shoulders in Chapter 6and refer to them again in this chapter as Support-Resistance phenomena. At least one Pullback tothe neckline (after the breakout) occurs in the great majority of cases. Many Head-and-ShouldersFormations produce two, the first within a few days after the breakout and before prices have gottenvery far away, and the second weeks later, sometimes after the minimum measurement of the Head-and-Shoulders has been fulfilled. Goodyear saw the unusual number of four Pullbacks to its 1946neckline in the first two weeks after the August breakout, another in October, a third in November,and a fourth in February 1947, which met the Double Resistance of the neckline and the downtrendline (see Chapter 14) projected from the 1946 April head and August right shoulder.\nEarlier in this chapter, in our discussion of the three criteria for appraising the amount of Resistanceto be expected at a former Bottom level, we named “distance away” as one of the criteria and statedas a general rule that prices should have gone at least 10% beyond that level in a medium-pricedstock before much Resistance would be set up. This 10%-away rule does not apply in the case of aThrowback to a well-defined area formation when it follows shortly after a breakout. All that isnecessary to establish strong Resistance to such moves at the pattern boundary is a conclusivebreakout.\nThe Symmetrical Triangle has a different sort of Support and Resistance “field.” You will recall thatthe first Reversal point in the formation of a Symmetrical Triangle (a Top, if it forms on a risingtrend, or a Bottom if on a decline) is normally accompanied by high trading volume, but that activitydiminishes rapidly on succeeding fluctuations within its converging boundaries. Consequently, onceprices have broken out of the Triangle and have proceeded well beyond the level of the pattern's firstReversal point, that level, because of the volume of shares traded there, becomes a Support (orResistance) against a subsequent reaction. But, if the breakout move does not carry beyond theTriangle's first Reversal Level by a clear margin, any Throwback will probably bring quotationsback to the extended (sloping) pattern boundary. If the reaction does not occur unt", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 92}
{"text": "the level of the pattern's firstReversal point, that level, because of the volume of shares traded there, becomes a Support (orResistance) against a subsequent reaction. But, if the breakout move does not carry beyond theTriangle's first Reversal Level by a clear margin, any Throwback will probably bring quotationsback to the extended (sloping) pattern boundary. If the reaction does not occur until the trend hasworked out to or beyond the Triangle's apex, then the Throwback usually will not meet Support (or\n30\n1945\n28\n26\n24\n22\n20\n19 Sales 100's\n500\n400\n300\n200\n100\nINTERNATIONAL TEL. & TEL.\nIT\n' 6 13 20 27 3 10 17 24 3 10 17 24 31 7 14 21 28 5 12 19 26 2 9 16 23 30\nFigure 13.10 Several examples of the Support “field” of the Symmetrical Triangle appear in this1945 daily chart of “IT.” Following the belated February 5 breakout from the first Triangle, pricesreturned on the 9th to the level of the mid-January Top, but then suffered a more extensive reaction,which came down on February 26 to the Triangle's apex level. This was a critical juncture. The apexpoint itself is a strong Support (or Resistance), but its level becomes weaker as time passes. In thiscase an “end run” might have been developing. Stop-loss orders should always be entered under anapex level (see Chapter 27). Here the apex held, however, and prices went into another “Coil,”breaking out topside on March 10. Their next reaction was supported, as was to be expected after an\nearly breakout like this, at the Top Pattern Line. The price track from mid-March to the end of Aprilfell into an Ascending Triangle Pattern, the top boundary of which functioned as Support in June butwas broken in July. Refer to Figure 11.17.\nFigure 13.11 In this instance, a belated upside breakout (August 10) from a Symmetrical Trianglefailed quickly and the subsequent reaction, after holding for several days at the apex level, finallybroke down for an “end run.” Thereafter, note the apex level turned into a Resistance againstRecovery Moves.\nResistance) until it has carried back to the level of the apex, which, in brief, represents theconcentration level or axis of the Triangle's Support and Resistance.\nThe intersection of the two converging boundary lines of a Symmetrical Triangle has sometimesbeen called a “cradle.” The axis Support (or Resistance) is strongest near the cradle point and getsweaker as the axis line (apex level) is extended out to the right on the chart (i.e., as time passes).Thus, if a late breakout move fails to carry prices very far from the Triangle area, and the trend thenpeters out, flattens, and begins to react after the cradle point has been passed in terms of time, itsaction, as it reaches the axis line, must be closely watched. (A stop-loss order may be indicatedhere.) Should the axis Support fail to hold, the reaction may plunge through and accelerate in a moreextensive swing, which has aptly been termed an “end run around the line.”\nVolume on breaks through Support\nOn those occasions when prices fail to retreat when they hit a Resistance (or Support) Range, butperhaps after holding there for several days, push on through, there is nearly always a suddenacceleration and a marked pickup in volume. This may be taken as confirmatory evidence of adecisive break and, consequently, an indication the move will carry on. The reasons for this volumeincrease are obscure. Some say, “It takes volume to overcome\n64\n60\n56\n52\nNL\n48\n44\nSOUTHERN RAILWAY\n40\n38\n36\n34 Sales 100's\n125\n100\n75\n50\n25\n' APRIL MAY JUNE JULY AUGUST SEPTEMBER\n; 6 13 20 27 4 11 18 25 1 8 15 22 29 6 13 20 27 3 10 17 24'31 7 14 21 28\nFigure 13.12 Here is a typical case of two Pullbacks to a Head-and-Shoulders neckline, the firstimmediately after the breakout and the second three weeks later. Note the initial breakthrough“bounced” from the early April Top Support and the late July decline met Support at the generalApril-May Congestion Area. However, what this chart particularly illustrates is how volumeincreases when a good Support Range is penetrated. Note the decided pickup on August 27, whenthe April-May area was left behind.\nResistance,” which is true enough, but the volume usually comes after the Resistance has beenpenetrated. Therefore, others say, “The volume is evidence that technicians see what has happenedand are now jumping in.” But that line of thought, in the authors' opinions, also has little tosubstantiate it. (We shall have more to say about the questionable influence of technicians on thetrend later on.) Many of the arguments over volume change versus price change smack of the oldhen-or-egg riddle. In any event, causes for many technical phenomena, such as this one, may be leftto the academicians, provided the practical implications are clear.\nSupport and Resistance in the Averages\nAs has been the case with nearly every other technical phenomenon we have studied, the principlesof Support and Resistance apply, with suitable allowances, to Averages as well as to individual\nstocks. Since an Average reflects the combined charts of the majority of the issues that compose it,but with a minority of them frequently evincing quite divergent patterns, it follows naturally thatSupport and Resistance Zones in the Averages cannot be as sharply and narrowly construed. MinorTops and Bottoms in the Averages, particularly, are less dependable as Resistance Levels. Clearlydefined and important Intermediate Reversals, however, as they nearly always represent Reversals inthe entire market (practically all stocks), will normally produce strong Resistance (or Support, as thecase may be) in the subsequent Average Trend.\nWhen the Averages break down through a Support Level, but simultaneously one or more stockshold firm at or above their corresponding individual Supports, there is a presumption that thoseparticular stocks are in a stronger position than others to participate in the next recovery. The phrase“other things being equal” should be added, however, for there are qualifica", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 93}
{"text": "in the subsequent Average Trend.\nWhen the Averages break down through a Support Level, but simultaneously one or more stockshold firm at or above their corresponding individual Supports, there is a presumption that thoseparticular stocks are in a stronger position than others to participate in the next recovery. The phrase“other things being equal” should be added, however, for there are qualifications to this presumptionthat must be considered. For instance, it may be that the stock that has resisted decline will, for thatvery reason, be less attractive to new buyers than one that broke drastically and is now purchasableat a more “attractive” price.\nMany of the claims made regarding future prospects for stocks that have, by one criterion or another,previously evinced “better-than-Average” or “worse-than-Average” market performance permitargument either way. It is safest to treat all such relative performance indications as only one minorfactor to be appraised in the overall chart picture.\nchapter fourteen\nTrendlines and Channels\nOne of our basic tenets in this system of technical stock chart analysis—\nindeed, a fact that any neophyte can quickly verify for himself by inspection\nof the market records for whatever period he chooses—is that prices move\nin trends. The market, in general, and the many stocks that compose it, do\nnot jump up and down in an altogether random fashion; on the contrary,\nthey show definite organization and pattern in their charted course. (For\nillustrations in this chapter, see Figures 14.1 through 14.17.)\nPrices move in trends. These trends may be either up or down or sideways\n(horizontal). They may be brief or of long duration. They may be classified\nas Major (Primary), Intermediate (Secondary), or Minor, according to the\nrules of Dow Theory, or as Horizontal Line Formations. (The distinction\nbetween a short Intermediate and an extended Minor Trend is often more\ndifficult to make with individual stocks than it is with the Averages, but it is\nnot so important.) Sooner or later, trends change; they may change by\nreversing from up to down or down to up, or they may also change direction\nwithout reversing as from up to sideways and then perhaps to up again, or\nfrom a moderate slope to a steep slope, and vice versa.\nProfits are made by capitalizing on up- or downtrends by following them\nuntil they are reversed. The investor's problem is to recognize a profitable\ntrend at the earliest possible stage of its development and then later to\ndetect, again as quickly as possible, its end and Reversal. The Reversal of\nany important trend is usually characterized, as we have already seen, by\nthe construction of some sort of joint price and volume pattern—in brief, of\na Reversal Formation.\nThe Trendline\nAll of the foregoing statements regarding trends have been expressed or\nimplied in earlier chapters of this text. It is our purpose now to examine\ntrends, as such, more closely, to see how they may be plotted most\neffectively on the charts, and to determine to what extent they can be used\nto reinforce or supplement the technical forecasts derived from our other\nchart formation and Support-Resistance studies—sometimes to furnish even\nearlier forecasts or warnings of change.\nOne of the first discoveries a new student is likely to make when he begins\nto inspect stock charts with a critical eye is that nearly all Minor and most\nIntermediate Trends follow nearly straight lines. A few readers will,\nperhaps, dismiss this as perfectly natural, something to be taken for granted.\nBut the majority become increasingly amazed and excited as they delve\ndeeper. Not only the smaller fluctuations, but also the great Primary Swings\nof several years' duration frequently appear on the charts as though their\ncourses had been plotted with a straight-edge ruler. This phenomenon is, in\ntruth, the most fascinating, impressive, and mysterious all the stock charts\nexhibit.\nIf we actually apply a ruler to a number of charted price trends, we quickly\ndiscover the line that most often is really straight in an uptrend is a line\nconnecting the lower extremes of the Minor Recessions within those trends.\nIn other words, an advancing wave in the\n52\n48\n44\n40\n38\n36\n34\n32\n30\n28\n26 Sales 100's\n: ATLANTIC REFINING AFI\n..........\nIMlltlUb\n1945\n■Ulul\n1946\n1944\n1947\nFigure 14.1 A series of Intermediate Trendlines drawn to illustrate the\n“basic” principle (see “How Trendlines Are Drawn”) on a weekly chart of\nAtlantic Refining, extending from January 1944 through August 1947.\nObserve that each up trendline required two distinct Bottom points to\ndetermine it, and each down trendline, two Tops. In some cases, the two\ndetermining points were formed only a few weeks apart, as in August and\nSeptember 1945. The Bottom points that fixed the early 1946 up trendline,\non the other hand, were months apart—February and June. Note that only\nfinal Trendlines are shown here. Many other experimental lines might have\nbeen drawn on this chart originally, including several uptrends whose\nIntermediate authority was questionable because they were “too steep”—as\nin early 1944, late 1945, and early 1946. There are also some interesting\nexamples of Pullbacks (after trendline penetration) that are discussed later\nin this chapter. Note July 1944, April 1945, September 1945, and May\n1947.\nstock market is composed of a series of ripples and the Bottoms of each of\nthese ripples tend to form on, or very close to, an upward-slanting straight\nline. The Tops of the ripples are usually less even; sometimes they also can\nbe defined by a straight line, but more often, they vary slightly in\namplitude, and so any line connecting their upper tips would be more or\nless crooked.\nOn a Descending Price Trend, the line most likely to be straight is the one\nthat connects the Tops of the Minor Rallies within it, while the Minor\nBottoms may or may not fall along a straight edge.\nThese two lines—the one that slants up along the successive wave Bottoms\nwithin a broad up-m", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 94}
{"text": ", they vary slightly in\namplitude, and so any line connecting their upper tips would be more or\nless crooked.\nOn a Descending Price Trend, the line most likely to be straight is the one\nthat connects the Tops of the Minor Rallies within it, while the Minor\nBottoms may or may not fall along a straight edge.\nThese two lines—the one that slants up along the successive wave Bottoms\nwithin a broad up-move and the one that slants down across successive\nwave Tops within a broad down-move—are the basic trendlines.\nIt is unfortunate that a more distinctive name for them has never been\ndevised than the threadbare word “line,” which has so many other uses and\nconnotations. A few analysts have called them “tangents,” a term that has\nthe advantage of novelty, but, because it is a distinct perversion of the true\nmeaning of the word tangent, confuses many readers even more. Perhaps\ntangent will eventually become established in this new sense. We shall be\nsatisfied herein with the overworked “line,” and will give it some\ndistinctiveness in its present context by joining it to trend in the one word\n“trendline.”\nFigure 14.2 This 1935-1936 daily chart of Atchison illustrates how the\nlatter part of a long, strong Intermediate Advance may accelerate away from\nits trendline. Notice the action in late January and early February. Prices\ndropped back to 66 in April 1936 after this Up Trendline was broken at the\nend of March. Note also at the point at which the December 1935 reaction\nmet Support, the trendline coincided with a Triangle apex level. Such\n“coincidences” appear frequently in technical studies.\nTrendlines, you may have heard it said, “are made to be broken,” but that is\none of those exasperatingly sententious remarks that fails to clarify\nanything. Of course they are broken; they are all always broken, ultimately,\nand some very shortly after they are set up. The problem is to decide which\nbreaks (i.e., penetrations by a price movement) are of important technical\nsignificance and which are of no practical consequence, requiring possibly\nonly a Minor Correction in the drawing of the original trendline. There are\nno 100% certain quick answers to this problem; the significance of some\npenetrations cannot be determined as soon as they appear, but rather must\nawait confirmatory indications from other chart developments. In a great\nmajority of instances, however, an important break—one that requires a\nprompt review and possibly a revision of trading policy—is easy to\nrecognize.\nHow Trendlines are drawn\nFirst, how are trendlines drawn? A straight line is mathematically\ndetermined by any two points along it. To draw a trendline, therefore, we\nrequire two determining points— two established Top Reversal points to fix\na Down Trendline and two established Bottom Reversal points to fix an Up\nTrendline. The principle here is the same as the one we laid down in our\nspecifications for drawing Triangle boundary lines in Chapter 8. The fact is\nthat boundary lines of Triangles and Rectangles, as well as necklines of\nHead-and-Shoulders Formations, are simply special types of trendlines.\nSuppose we start with a Major Bottom point and describe how a series of\nUp Trendlines might develop therefrom. To make this first illustration\nsimple, let us assume the Bear\n36\n34\nCRANE COMPANY\n32\n30\n28\n26 Sales 100's\n125\n100\n75\n50\n25\nJANUARY FEBRUARY MARCH ApRIL MAY JUNE\n■ 6 M3 20 27 3 10 17 24 3 10 17 24 31 7 14 21 28 5 12 19 26 2 9 16 23 30\nFigure 14.3 Trendlines that defined the short-term swings in Crane\nCompany in 1945. Note three Bottoms formed on the first up-line and the\nthird rally (late February) in this advance failed to reach a line drawn across\nthe earlier Tops parallel to the Basic Trendline. A failure of this sort\nfrequently precedes a break in the trend. The same thing happened at the\nend of the second uptrend in late May. “Failures” and the use of parallel or\n“Return” Lines will be discussed later in this chapter. The downtrend in\nMarch assumed a Wedge form. Observe how the April 6 reaction met\nSupport at its previously penetrated Top line. In June, a rally met Resistance\nat the previously broken Up Trendline. Such Pullbacks are common. The\nsmall Complex Head-and-Shoulders in June was never completed because\nprices did not break down out of it by the required margin.\nMarket Bottom in our stock consisted of a Rectangle area between 6.5 and\n8, and the last move in this formation arose from the 6.5 level, broke\nthrough the pattern's Top at 8, and proceeded to 9. From 9, prices reacted to\n8 and then headed back up again. As soon as this last rally had gone far\nenough to leave the dip to 8 showing in the clear as a Minor Bottom, we\ncould draw our first Up Trendline because we then had two Bottom points,\nthe second (8) higher than the first (6.5), to fix its slope. This would be a\nMinor Up Trendline. We would rule it in lightly on our chart in pencil and\nextend it on up and ahead for, perhaps, a week or more. (It will help you to\nvisualize our example if you sketch it on a scrap of chart paper.) To\nproceed, suppose prices push up to 10, then move sideways for a few days,\nor dip slightly, until they have approached and touched, once more, our\nextended Minor Trendline. Then they start to move up in a third advance,\nbut they run into supply again without making much progress, quickly\nmake a fourth contact with the trendline, hesitate, and then break down\nthrough it. If prices now close clearly below the line and if there has been\nsome pickup in trading volume evident on the penetration, we may\nconclude our first Minor Trend is completed, plus our stock either will build\nsome sort of Consolidation Pattern before it stages another advance or it\nwill suffer a more extensive “Correction” than any of the brief dips it\nregistered during its first Minor Upswing.\nThe whole Minor Uptrend we have described as an example in the\nforegoing paragraphs might well have run its course in two weeks; our first\ntrendline would then have been very st", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 95}
{"text": "plus our stock either will build\nsome sort of Consolidation Pattern before it stages another advance or it\nwill suffer a more extensive “Correction” than any of the brief dips it\nregistered during its first Minor Upswing.\nThe whole Minor Uptrend we have described as an example in the\nforegoing paragraphs might well have run its course in two weeks; our first\ntrendline would then have been very steep—too steep, obviously, to hold\nfor any very long period of time. Now, let us assume a series of downward\nfluctuations produces the more extensive correction that we have foreseen\nas one probability following the trendline break that carries prices back to\nthe Support Level set up at the Top of the original Rectangle, that is, at 8.\n(From our previous Support-Resistance studies, we would recognize this as\na prime “buy spot.”) Assuming\n32\n30\n28\n26\n24\n22\n20 Sales 100's 250 200 150 100\n50\nCOMMERCIAL SOLVENTS\nCV\n1946\nMAY\n‘JANUARY- ,\n' 5 12 19 26 2 9 16 23 2 9 16 23 30 6 13 20 27 4 11 18 25 1\nJUNE\n8 15 22 29\nFigure 14.4 Intermediate Downtrend and Uptrend in Commercial Solvents\nin 1946. Note the increased volume on the March 30 penetration of the\nbasic Down Trendline (and, at the same time, a breakout from a small\nHead-and-Shoulders Bottom). The drop through the lower parallel at the\nend of February had no technical significance. The Up Trendline from the\nMarch low was broken on June 14, simultaneously with a breakout from a\nDescending Triangle, which, as it turned out, was the final Bull Market Top.\nthat subsequent developments pursue a normal course, prices should not\nlinger long at 8, but should start promptly on a new series of advancing\nfluctuations. As soon as this becomes evident and the new Bottom at 8 is\n“in the clear,” we can rule in a new trendline across the original base point\nat 6.5 and the new point at 8. This should be, and probably is, an\nIntermediate Up Trendline that will not be penetrated for several weeks,\nmaybe for several months, until the Intermediate Advance tops out.\nSubsequently, if that Intermediate Top takes the form of a Head-and-\nShoulders Reversal Pattern, our Intermediate Up Trendline may be broken\nby the recession from the top of the head to the neckline. As a rule,\nhowever, the final advance in a strong Intermediate Move accelerates far\nenough away from the extended trendline to leave room (to the right on the\nchart) for considerable pattern construction before the line is again touched\nand penetrated. Hence, the actual puncturing of the trendline is more apt to\noccur either on the decline from the right shoulder to the neckline, or at\nabout the same time as prices break down through the neckline to complete\nthe Head-and-Shoulders signal. It is surprising to see how often the two\nlines, neckline and trendline, are broken simultaneously. In other instances,\nand there are many of them also, in which the trendline is the first to be\npunctured, perhaps shortly after prices turn down from the right shoulder,\nwe do not have to wait for a neckline break but can take action at once.\nHere is one type of trendline indication that produces a working signal a\nlittle earlier, and often at a much more favorable price level, than is given\nby the completion of a Reversal Formation.\nArithmetic versus logarithmic scale\nBy this time, the more mathematically inclined among our readers must\nhave begun to ponder the difference between trendlines projected on the\nordinary or arithmetic scale\n20\n19\n18\n17 Sales 100's\n- —\nii iln i n>\nPHILLIPS PETROLEUM P\n1935\n1936\n1937\n1938\nFigure 14.5 Valid trendline penetration and its normal consequences—\nReaction or Consolidation—is illustrated on nearly every chart in this\nchapter and on many others throughout the book. This weekly chart of\nPhillips Petroleum is reproduced here to show an outstanding exception.\nThe Intermediate Up Trendline projected from “P's” September 1936 low\nup across its early October and late-November Bottoms was penetrated\ndownside decisively the third week of May 1937. Moreover, a Multiple\nHead-and-Shoulders Top Reversal Pattern had been forming since February,\nwith a critical neckline at 52. And the then-current Bull Market had already\nrun for four years; “P” had come all the way up from 2! Cover up the chart\nfrom July 1, 1937, and you will agree there was plenty of reason for any\ntechnician to sell at once without waiting for the 52 neckline to be broken.\nBut this, as we have said, was one of the exceptions that occurs to all\ntechnical patterns and rules. “P” turned right around and shot up to 64\nbefore it was finished. Nevertheless, developments such as this carry a\nvaluable warning. They very seldomly appear unless the Major Trend has\nalmost run out; any further rise is dangerous to follow. and on the\nlogarithmic or ratio scale. A series of points that fall on a perfectly straight,\nup-sloping line on arithmetic chart paper will, when transferred to a\nsemilogarithmic sheet, produce a curved line that rises sharply at first and\nthen gradually rounds over. Points that fall on a straight line on a\nsemilogarithmic sheet will produce an accelerating curve on an arithmetic\nsheet, a line that slants up more and more steeply the farther it is projected.\nAs a matter of fact, this variance is of little or no importance in defining\nMinor Trends, as they seldom run far enough for the dissimilar\ncharacteristics of the two types of scales to become effective. The same\nholds true for average Intermediate Moves of normal slope. However, when\nit comes to very long and strong Intermediates, the divergence may become\nmarked and may make a considerable difference in the time and level of\nultimate trendline penetration. Therein lies one of the strongest reasons for\nusing semi-logarithmic paper in charting stocks for technical analysis. Let\nus postpone further discussion of this point until we take up Major Trends\nand go on now with the Intermediate Lines that are much the same on either\ntype of scale, concentrating on Intermediate Uptrends. (In", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 96}
{"text": "e difference in the time and level of\nultimate trendline penetration. Therein lies one of the strongest reasons for\nusing semi-logarithmic paper in charting stocks for technical analysis. Let\nus postpone further discussion of this point until we take up Major Trends\nand go on now with the Intermediate Lines that are much the same on either\ntype of scale, concentrating on Intermediate Uptrends. (Intermediate\nMoves, rather than Minor, are emphasized for the obvious reason Minors\nare of little practical importance in either trading or investing.)\n40 Sales 100s\n125\n100\n75\n50\n25\nPX\nPARAMOUNT PICTURES\n1945-1946\nJllll llllfllll\n—MARCH\nBiu_____\nOCTOBER NOVEMBER DECEMBER JANUARY FEBRUARY ....._____\n6 13 20 27 3 10 17 24 1 8 15 22 29 5 12 19 26 2V9 16 23 2 9 16 23 30\nFigure 14.6 Double Trendlines (see next section) usually are not evident\nuntil after a trend has run for several months. In Paramount's accelerated\nphase of Intermediate Uptrend, which began in October 1945, the double\nnature of the basic trendline was not detectable until January 1946. The\ninner (upper) line was broken again in April, but the outer (lower) line was\nnot decisively penetrated downside until May, at the Bull Market Top.\n96\n88\n80\n76 Sales 100's\n125\n100\n75\n50\n25\nFigure 14.7 Trend Channels in Bethlehem Steel in 1945. Prices burst out of\nthe 92-98 Horizontal Channel (Rectangle) on the upside in January 1946\nand went on to 114. A short-term trader might have sold around 94-96 in\nearly November (because of the uptrend break) and rebought at 99 in\nJanuary on the Rectangle breakout. (See discussion of Channels.)\n14\nSales 100's\n500\n400\n300\n200\n100\nMARCH\n’JUNE\nS\nPN\nAPRIL\nM11M \"DECEMBER •\n24 1-8 15 22 29\nJANUAR^FEBRUAR^\n5 12 19 26 2 9 16 23\nAUGUST SEPTEMBER ’\n10 17 24 31 7 14 21 28 5 ’\nFigure 14.8 A 10-month downtrend, extraordinarily long and straight,\nwhich was nicely defined by Double Basic Trendlines above the Price\nChannel and also by a double set of Return Lines below it. The Major Top\nstarted with a strong One-Day Reversal on December 3, 1945 and worked\nout into a Descending Triangle that broke February 19, 1946. The\nSymmetrical Triangle beginning to appear in September 1946 also broke\nout downside.\n1 7 14 21 28 5 12 19 26 2 9 16 23 30 7 • 14 21 28 4 11 18 25 18 15 22 29\nFigure 14.9 Well-marked Intermediate Basic Trendline and Return Lines in\nSouthern Pacific, 1945. Note the Flags within Trend Channels—an up Flag\nin June and a down Flag in August. The Uptrend Channel, which began\nAugust 22, ran until February 1946.\n34\n32\n30\n28\n26 Sales\n\n26\n24\n22\n20\n19\n18\nFigure 14.10 Note the extent by which prices failed to come down to their\nReturn Line in late November measured the distance by which they\nadvanced through and above the Basic Down Trendline in early December.\nThis rule is stated in the discussion of Trend Channels.\nSales\nFigure 14.11 Six months of an Uptrend Channel that actually started to\nform in December 1943. It was broken downside in August 1945.\nTo go back to first principles, granting that price advances trend up in more\nor less straight lines, it follows that finding and drawing the lines that\naccurately define those trends, they will serve two purposes:\n1. When the trendline is broken (i.e., when prices drop down through it\nin decisive fashion), it signals the advance has run out. It calls time for\nthe intermediate-term trader to sell out that issue and to look for\nreinvestment opportunities elsewhere.\n2. When a small Top Reversal Pattern forms on the chart of an issue\nwell up and away from that issue's Intermediate Up Trendline, so that\nthere apparently is room for\n24\n22\n20\n19\n18\n17\n16 Sales 100's 125 100\n75\n50\n25\nNASH - KELVINATOR\nNK\n1946 g\nJULY\nAUGUST SEPTEMBER\nApRIL MAY, , , JUNE , ,\n6 13 20 27 4 11 18 25 1 8 15 22 29\" 6 13 20 27 3 10 17 24' 317 14 21 28\nFigure 14.12 The downtrend that started in June 1946 in Nash-Kelvinator,\nsignaled by the break of both its Intermediate and Major Up Trendlines\n(MUT) on July 15, made a nice channel until September. An Intermediate\nDown Trendline, drawn across the June 17 and July 1 highs, held for the\nAugust rally. The Return Line, drawn parallel to it across the June 20 low,\nheld in late July but remained intact for only a few days at the end of\nAugust. The August rally in both price and volume pattern showed Bear\nMarket characteristics. Compare this chart with Figure 8.25 and you will\nsee that a Major Double Top was signaled on July 23.\nthe downside implications of the Reversal Formations to be carried out\nbefore the trendline is violated, then the intermediate-trend trader may well\ndecide to ignore the small Reversal Pattern. He can hold on so long as the\ntrendline holds.\nThe advantages of the first-named trendline function are obvious. Those of\nthe second, although less obvious to the inexperienced, are equally\nimportant to the investor who has learned it is an expensive practice to\nswitch out of every holding as soon as it shows evidence of a Minor\nSetback, provided the chance of further Intermediate Advance still exists.\nTo accomplish these purposes it is necessary, as we have said, to find and\ndraw the line that accurately defines the Intermediate Trend, and then to\nrecognize when that line has been broken in decisive fashion. Our earlier\nquick review of how a trendline is constructed did not attempt to cover\nthese points thoroughly.\nTests of authority\nThe following are some of the tests that may be applied to judge the\ntechnical validity, or authority, of an Up Trendline:\n1. The greater the number of Bottoms that have developed at (or very near)\na trendline in the course of a series of Minor Up Waves, the greater the\nimportance of that line in the technical sense. With each successive “test,”\nthe significance of the line is increased.\nFigure 14.13 The decline that took Macy down through an Intermediate Up\nTrendline (IUT) in June 1946 turned out to be also the drop from the head\nof a “Flat-Shouldered” Head-and-Shoulders Top, which was, in turn, part of\na larger Complex", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 97}
{"text": "series of Minor Up Waves, the greater the\nimportance of that line in the technical sense. With each successive “test,”\nthe significance of the line is increased.\nFigure 14.13 The decline that took Macy down through an Intermediate Up\nTrendline (IUT) in June 1946 turned out to be also the drop from the head\nof a “Flat-Shouldered” Head-and-Shoulders Top, which was, in turn, part of\na larger Complex. The upper neckline was broken June 19 and the lower on\nJuly 16. Note Pullbacks to each. F1, F2, and F3 are tentative Fan Lines.\nPrices were finally able to clear F3 in December, but by that time, a Primary\nBear Market had been signaled, so the Fan Rule no longer applied. Fans call\nthe turn only on Secondary (Corrective) Moves.\nA first and tentative Up Trendline can be drawn as soon as two Bottoms\nhave formed, the second higher than the first, but if prices move back to\nthat line a third time, make a third Bottom there, and start a renewed\nadvance, then the validity of that line as a true definition of the trend has\nbeen confirmed by the action of the market. Should a fourth Bottom later\nform on it, and prices move up away from it again, its value as a trend\ncriterion is very considerably enhanced.\n2. The length of the line, that is, the longer it has held without being\npenetrated downside by prices, the greater its technical significance. This\nprinciple, however, requires some qualification. If your trendline is drawn\nfrom two original Bottoms that are very close together in time—say, less\nthan a week apart—it is subject to error; it may be too steep or (more often)\ntoo flat. If the latter, prices may move away from it and stay high above it\nfor a long time; they may then turn down and have declined well along in\nan Intermediate Correction before the trendline thus drawn is reached. But\nif the trendline has been drawn from Bottoms that are far enough apart to\nhave developed as independent wave components of the trend you are\ntrying to define, with a good rally and “open water” between them, then it is\nmore apt to be the true trendline. Greater weight should be given to the\nnumber of Bottoms that have formed on a trendline (Test 1) than to its\nlength alone (Test 2).\n3. The angle of the trendline (to the horizontal) is also, to some degree,\na criterion of its validity as a true delimiter of Intermediate Trend. A\nvery steep line can easily be broken by a brief sideways Consolidation\nmove—as, for example, by a compact Flag forming on an advance of\nthe “mast” type—only to have prices shoot up again in another\nextensive advance. Such steep lines are of little forecasting value to the\ntechnician. The flatter, more nearly horizontal the trendline, the more\nimportant it is technically and, in consequence, the greater the\nsignificance of any downside break through it.\nARKANSAS BEST\n34\n30\n32\n25\n20\n15\n28\n10\n26\n85\nI—\n>80'81',82:83 84\n8687\n24 -\n22\n20\n19\n18\n17\n16\n15\n14\n13\n12\n11\nSales 100's\nJANUARY Fl\nARKANSAS BEST'\nF1 tati\nEBRUARY MARC\n11412128 7 1141211\nAUGUST\n7 114'21128 4\nXD.09\nXD.09\nFigure 14.14 “ABZ” dropped sharply following its late January high,\ncapping off a nearly uninterrupted two-year rally. But despite the rapidity\nand severity of the Pullback, it was, in fact, a picture-perfect reaction,\nwhich stopped just above excellent long-term Support at the 1983 high after\nretracing almost exactly 50% from its January peak. Not only is the reaction\na classic, but so, too, is the Fan Line development, which, when coupled\nwith the recently completed Head-and-Shoulders Bottom, suggests “ABZ”\nhas reversed its short-term downtrend.\nBut “steep,” as applied to stock trends, is a relative term and one that we\ndefies exact definition. Experience, which can only be gained by studying\nmany charts and by actually building and working with them over a period\nof many months, brings an almost intuitive ability to distinguish between a\ntrendline that is “too steep to hold” and one whose angle of rise is\nreasonable and should be maintained until such time as the trend is actually\nreversed from Intermediate Up to Intermediate Down. Trend slopes will\nvary from stock to stock according to their characteristic market habits.\nThey will vary also according to the stages of the Primary Cycle—tending\nto become somewhat steeper in its later phases. The more chart history you\nhave on any particular issue in which you are interested, the better able you\nwill be to judge its present trend. (The foregoing statement, we might\nremark, applies to the interpretation of most other technical patterns and\nphenomena as well as to trendlines.)\n38\n36\n34\n32\n30 Sales 100's 125 100\n75\n50\n25\n56\n52\n48\n44\n40\n38\n36 Sales 100's\n50\n40\n30\n20\n10\nFigure 14.15 A valid application of the Three-Fan Principle. Note prices\nafter they pushed up through F1 in March fell back to it but did not\nrepenetrate it. When F2 was broken in late March, prices came back to it at\nthe end of April but did not go below it. F3 was surmounted in May. This\nwas a Bull Market Reaction; \"AS\" made its final Top above 64 in August.\nThe March-May pattern might be called a weak Double Bottom.\nDELAWARE & HUDSON DH\nJULY ' AUGUST SEPTEMBER ’OCTOBER NOVEMBER DECEMBER\n8 15 22 29 5 12 19 26 2 9 16 23 30 7 14 21 28^4 11 18 25 29 16 23 30\nFigure 14.16 Try the Three-Fan Principle on this chart of the late 1944 Bull\nMarket Reaction out of a Symmetrical Triangle in \"DH.\" F1 should be\ndrawn from the August 30 high down across the September 12 closing. F2\nis already marked on the chart but not labeled. F3 would extend from\nAugust 30 across the Rally Top of November 9. It was surmounted on\nincreased volume November 21. The mid-September to November price\npattern looked at first like a Descending Triangle, but volume began to rise\nin October.\nOne clue to relative steepness is afforded to those who employ the\nTEKNIPLAT semilogarithmic chart sheet, which has been used for most of\nthe illustrations in this book. When projected on this scale, Intermediate\nUptrends on the daily charts, in the great majority", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 98}
{"text": "vember 21. The mid-September to November price\npattern looked at first like a Descending Triangle, but volume began to rise\nin October.\nOne clue to relative steepness is afforded to those who employ the\nTEKNIPLAT semilogarithmic chart sheet, which has been used for most of\nthe illustrations in this book. When projected on this scale, Intermediate\nUptrends on the daily charts, in the great majority of issues selling in the 10\nto 50 range, rise at an angle of approximately 30 degrees to the horizontal.\nSome will be a trifle flatter, some a trifle steeper, but it is surprising to see\n30\n28\n26\n24\n22\nBUCYRUS ERIE CO.\n1984\n20\n19\n18\n17\n16\n15\n14\n13\n12\nF.\n11\nSales ~\n100's\n1000\n800\n600\n400\n200\nM ARCH APRIL MAY IUNE IUL Y AUGUST SEPTEMBER O CTOBER\nN OVEMBER DECEMBER ~\n17 24 31 7 14 21 28 5 12 19 26 2 9 16 23 301 7 14 21 28 4 11 18 25 1 8 15\n22 29 6 13 20 27 3 <10 17 24 1 8 15 22 29\nXD. 11 XD. 11\nFigure 14.17 In a downtrend throughout the first half, “BY” gave back a\nlarge part of its 1983 rally by mid-summer. Nevertheless, the 1982 low held\nthe Bears in check, and over the following several months, this issue etched\nout an excellent Fan Pattern. Fan Line 1 gave way in mid-September on a\nhigh-volume penetration. The advance quickly lost its momentum, but old\nResistance-new Support contained the Pullback perfectly, setting the stage\nfor a rally through Fan Line 2. This occurred in mid-November on good\nvolume. Following a five-week correction, “BY” charged through Fan Line\n3 on the best volume of the three breakouts.\nhow often the trendline falls very close to the 30-degree slope in stocks of\naverage volatility and activity. Thin, highly speculative issues and heavy\ninvestment stocks offer exceptions, the former usually steeper and the latter\nflatter. The semilogarithmic scale has the virtue of reducing all movements,\nregardless of price level, to a ratio or percentage basis. On a straight\narithmetic scale, the trendline will ordinarily be steeper on a stock trading in\nthe\nOn weekly charts employing the same price scale, the angle of Intermediate\nAdvance will be much steeper than on the daily plotting. Different scaling\nwill produce different angles. It is pure happenstance that TEKNIPLAT\nsheets tend to produce the 30-degree ascending line.\nUnfortunately, TEKNIPLAT paper is no longer produced but a comparable\nanalysis is\nValidity of penetration\nWe have these three criteria, then, for appraising the authority or accuracy\nof an Intermediate Up Trendline: (1) the number of times it has been\n“tested” or contacted without breaking,\n(2) its length or duration, and (3) its angle of ascent. Given a trendline that,\nby the application of one or more of these criteria (preferably by at least\ntwo of them), appears to be a reasonably accurate delimiter of the trend, our\nnext problem is to determine when it has been finally and definitely broken.\nAgain, we can set up three tests or criteria, two of which are practically\nidentical with the rules laid down in earlier chapters for determining\ndecisive breakouts from Reversal or Consolidation Formations. The first is\nextent of penetration. To be decisive, prices must not only push through the\nline but also close beyond it by a margin equal to about 3% of the stock's\nprice. This does not need to be accomplished in a single day, although it\noften is. The 3% penetration may come as a result of two or three days of\ngradual decline.\nThe second is volume of trading. We saw how activity should always be\nexpected to rise notably on a genuine upside breakout from an Area Pattern\nbut need not increase to confirm a downside break. We have seen how, in\nmany cases, volume does not show much increase on the first day of a\ndown-break from Descending Triangles, for example, but usually it picks\nup rapidly as the decline proceeds. In our present discussion, we are dealing\nwith Up Trendlines, and their penetration is, therefore, analogous to a\ndownside breakout. We should expect the same rules to apply, and in\ngeneral, they do. Given a close beyond the line by a price margin of 3%, it\nis not necessary for volume to have expanded much at that point to confirm\nthe validity of the penetration.\nThe fact is, however, that the breaking of an Intermediate Up Trendline,\nmuch more often than not, is attended by some visible intensification of\ntrading activity. To that extent, then, an increase in volume may be regarded\nas confirmation of a decisive penetration. It is a particularly useful adjunct\nin borderline cases. If, for example, prices start to decline from a point\nsomewhat above the trendline, move down through it on conspicuously\nexpanding turnover, and close beyond it, say, only 2% of the price but at or\nnear the bottom of the day's range, then our 3% margin rule has not been\nsatisfied, but the lesser margin plus the volume action may be construed as\ndecisive.\nBeware, however, and do not be stampeded into a hasty commitment by the\nshakeout move that cracks down through a trendline with a great flurry of\nactivity—perhaps several minutes of late tape—and then turns up again to\nclose the day back above the trend or at least very close to it. This may very\nwell be—in fact, usually is—a false move so far as that particular moment\nis concerned. But watch the next few days' performance very closely; the\ntechnical situation is evidently critical, or else a shakeout could not have\nbeen easily staged.\nThe third test is also one that applies particularly to breaks that are\nborderline so far as margin of penetration is concerned. Suppose a stock\nthat is quoted in the neighborhood of 40 declines through a well-established\nIntermediate Up Trendline and closes 1 or 1 1/4 points below it—a margin\nthat is only slightly less than our specified 3%—without much, if any,\nenlargement in trading volume. Suppose it fluctuates there for a day or two\nin a dull and narrow market and then starts to rally; if there is no pickup in\nactivity on this recovery move—if prices simply edge up feebly to the\nunderside of the", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 99}
{"text": "ll-established\nIntermediate Up Trendline and closes 1 or 1 1/4 points below it—a margin\nthat is only slightly less than our specified 3%—without much, if any,\nenlargement in trading volume. Suppose it fluctuates there for a day or two\nin a dull and narrow market and then starts to rally; if there is no pickup in\nactivity on this recovery move—if prices simply edge up feebly to the\nunderside of the trendline and tend to “round over” there without being able\nto close clearly above it—then the situation is indeed critical, and the\nslightest sign of renewed selling pressure may be taken as a signal that the\nuptrend has been decisively broken.\nSuch a return move as we have described in the preceding paragraph is\nknown as a Throwback or Pullback. We previously described analogous\ndevelopments that follow breakouts from Head-and-Shoulders and other\npatterns, and we will have more to say about them in connection with\ntrendlines later on.\nThe three tests we have been discussing, which help to establish the validity\nof a trendline penetration, cannot, unfortunately, be applied inflexibly and\nwithout a modicum of judgment. The majority of Intermediate Trendlines\ncan hardly be said to possess the precision of pattern boundary lines, and\neven in the latter, some leeway must be allowed. There are exceptions, as\nwe have taken occasion to remark several times before, to every technical\nrule of price action, but judgment in the establishing of significant\ntrendlines and in interpreting their penetrations does come with experience.\nAmendment of Trendlines\nWhen a trendline is broken by a margin less than decisive, and prices\nsubsequently rally back up through it again, doubt naturally arises as to the\ncontinued authority of the original line. Should it be discarded, revised, or\nallowed to stand as is?\nHere again, judgment and experience must be called into play, but a few\ngeneral principles are helpful in deciding. If the original trendlines\ndepended on only 2 points, that is, on the first two Bottoms across which it\nwas projected and the indecisive penetration occurred when prices returned\nto it for the third time, then the line had better be redrawn across the\noriginal first and the new third Bottoms. (Of course, you will not do this\nuntil prices have moved up from the third Bottom point and it has become\nclearly established as a Minor Bottom.) Or, you may find in such cases that\na new line drawn across the second and third Bottoms works better; if the\nfirst Bottom was a Reversal Day with its closing level well above the low of\nits range, you may find this new line, when extended back, strikes just\nabout at that closing level.\nIf, on the other hand, the original trendline has been “tested” one or more\ntimes after it was drawn—if, that is, a third and perhaps a fourth Bottom\nhave formed on it without penetrating it and have thus “confirmed” it—then\nthe subsequent indecisive penetration may be disregarded and the original\nline considered to be still in effect.\nAn intraday break through an established trendline that, however, does not\nresult in prices closing beyond the line may be disregarded and the line left\nas is. In fact, as has already been suggested, the closing prices frequently\nmake a better trendline than the extreme intraday lows of successive\nBottoms, which is most apt to be true with “thin” stocks subject to erratic\nswings. A bit of experimenting with different lines often pays. A thin,\ntransparent ruler is especially useful for trendline study.\nThere is another type of price action that may require redrawing a trendline.\nSometimes, after a line has been projected up across the first two Minor\nBottoms in an advancing trend, a third Minor Bottom will form, not on that\nline, but well above it. In such cases, let the original line stand, but draw in\na new one across the second and third Bottom points, and watch\ndevelopments. If the rally from the third Bottom peters out quickly, and the\nnew trendline, as a consequence, is soon broken, then the original trendline\nis probably the correct one. But, if the third Bottom turns out to be a\n“strong” one, and the new line stands up well for several weeks (and if it\nwas not, patently, too steep to begin with), then the old line may be\nabandoned and the new one regarded as the better trend definer.\nDouble Trendlines and trend ranges\nIn the course of your “cutting and trying” in an effort to fit a good line to an\nIntermediate Uptrend, you may find that two parallel lines, perhaps a point\nor so apart in a stock selling in the 30s, will define the true trend pattern\nmuch better than any single line that can be drawn. Sharp Bottoms and\nshakeout thrusts in such cases will often fall along the outer or lower line,\nwhile the duller, more rounded reactions will stop at or near the upper or\ninner line. Or the two lines will mark off a range somewhere within which\nsuccessive Minor Down Waves tend to halt and reverse.\nSuch Double Trendlines are really plentiful, although most chart technicians\nseem to be quite unaware of them. It pays to develop an eye for them—to\nwatch constantly for trends to which they can be applied. They will clear up\nmany situations in which attempts to find a single critical line lead only to\nfrustration and to your finally giving up in disgust.\nTrends that you find are best defined by Double Trendlines (or by a very\nBroad Trendline, if you prefer) cannot be regarded as having ended until the\nouter, lower line has been decisively penetrated. In that connection, note\nwhat we said at the beginning of this topic: sharp, shakeout Bottoms tend to\nfall on the outer line. The recoveries from such Bottoms are usually just as\nsharp, and prices, therefore, rally back above the upper, inner line quickly.\nWarning of an impending break in the trend is given when prices come\ndown to the outer line steadily, rather than by the quick “shake” type of\nreaction, and then have difficulty rallying back through the inner line.\nWatch such developments closely. A break", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 100}
{"text": "outer line. The recoveries from such Bottoms are usually just as\nsharp, and prices, therefore, rally back above the upper, inner line quickly.\nWarning of an impending break in the trend is given when prices come\ndown to the outer line steadily, rather than by the quick “shake” type of\nreaction, and then have difficulty rallying back through the inner line.\nWatch such developments closely. A break down may not follow; the\nsituation may still be “saved,” but the chances are that the trend is near its\nend.\nTrend Channels\nAt the start of this trend study, we applied the term Basic Trendline to the\nline that slopes up across the Wave Bottoms in an advance and to the line\nthat slopes down across the Wave Tops in a decline. Furthermore, we noted\nthe opposite Reversal Points, that is, the wave crests in an advance and the\nwave troughs in a decline, were, as a rule, less clearly delimited. That is one\nof the reasons why all of our discussion up to this point has been devoted to\nBasic Trendlines. Another reason is that the technician's most urgent task is\nto determine when a trend has run out, and for that purpose, the Basic Line\nis all important.\nIn a fair share of normal trends, however, the Minor Waves are sufficiently\nregular to be defined at their other extremes by another line. That is, the\nTops of the rallies composing an Intermediate Advance sometimes develop\nalong a line that is approximately parallel to the Basic Trendline projected\nalong their Bottoms. This parallel might be called the Return Line because\nit marks the zone where reactions (return moves against the prevailing\ntrend) originate. The area between Basic Trendline and Return Line is the\nTrend Channel.\nNicely defined Trend Channels appear most often in actively traded stocks\nof large outstanding issue—least often in the less popular and the relatively\nthin equities that receive only sporadic attention from investors. The value\nof the Trend Channel concept for the technical trader would hardly seem to\nrequire extended comment here; its tactical utilization is discussed in the\nsecond half of this book.\nIts greatest utility, however, is not what usually appeals to the beginner\nwhen he first makes its acquaintance, namely, the determination of good\nprofit-taking levels. Experienced technicians find it more helpful in a\nnegative sense. Thus, once a Trend Channel appears to have become well\nestablished, any failure of a rally to reach the Return Line (top parallel of\nthe channel in an Intermediate Advance) is taken as a sign of deterioration\nin the trend. Furthermore, the margin by which a rally fails to reach the\nReturn Line (before turning down) frequently equals the margin by which\nthe Basic Trendline is penetrated by the ensuing decline before a halt or\nThrowback in the latter occurs.\nBy the same token, given an established Trend Channel, when a reaction\nfrom the Return Line fails to carry prices all the way back to the Basic\nTrendline but bottoms out somewhere above it, the advance from that\nBottom will usually push up out of the channel on the top side (through the\nReturn Line) by a margin approximately equal to the margin by which the\nreaction failed to reach the bottom of the channel (Basic Trendline).\nExperimental Lines\nYour experienced technician, in fact, is constantly drawing trendlines of all\nsorts—Minor, Intermediate, and Major—on his charts. He will first very\nlightly pencil them in wherever he can find an excuse to draw one. Many\nwill quickly prove to be of no significance; those he may erase. Others will\n“stand out,” showing evidence of technical authority, which he will make\nheavier or color, as suggested later on. He will be constantly on the watch\nfor Double Trendlines and will draw tentative Return Lines to mark off\npossible channels at every opportunity. As soon as he has what appears to\nbe a Basic Up Trendline, for example projected from two Bottoms, he will\ngo back to the Top of the rally between those two Bottoms and draw from\nthat parallel to the Bottom Trendline. If the next rally comes up to that\nparallel, stops there and turns down, he has a probable Return Line and\nchannel established.\nThis practice of drawing in and experimenting with every trendline, which\nthe price action permits or suggests, is earnestly recommended to the reader\nof this book, particularly if the technical approach is new to him. It is the\nquickest way—in fact, the only way— of acquiring the experience we have\nstressed as essential to recognition, judgment, and utilization of trendline\nimplications in trading.\nPerhaps we should add here one “don't” for the beginner. You will have\nnoted we have not mentioned a line projected from a Bottom to a Top, or\nvice versa. Trendlines are always drawn across two or more Bottoms, or\ntwo or more Tops. They should never be drawn to cross through the price\ntrack. (Prices may cross their extensions later, but this should not have\nhappened at the time the lines are first drawn.) If you did not know better,\nyou might, for example, put in a line from the Top of the left shoulder to the\nTop of the right shoulder of a Head-and-Shoulders Formation, thus cutting\nthrough the head, but such a line would have no technical validity.\nConsequences of Trendline penetration: Throwbacks\nAt the beginning of this chapter, we mentioned the probable consequences\nof a breakdown through an Intermediate Up Trendline. To repeat, if an\nIntermediate Up Trendline has been constructed, has qualified as\ntechnically significant by the tests previously discussed, and has then been\ndecisively broken, the inference is the uptrend is finished. And the\nconsequences to be expected are either a full Intermediate Recession or a\nperiod of Consolidation (usually becoming a recognizable Area Formation).\nTechnical indications of other sorts may be seen on the chart, which will\nsuggest which of these two consequences is the more likely. In either event,\nthe Intermediate Trend trader will certainly look twice before attempting to\nfind furthe", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 101}
{"text": "hed. And the\nconsequences to be expected are either a full Intermediate Recession or a\nperiod of Consolidation (usually becoming a recognizable Area Formation).\nTechnical indications of other sorts may be seen on the chart, which will\nsuggest which of these two consequences is the more likely. In either event,\nthe Intermediate Trend trader will certainly look twice before attempting to\nfind further profit in that particular situation at that time.\nA more immediate but less important probable consequence of trendline\npenetration has also been mentioned—the “Pullback.” Pullbacks that follow\nbreakouts from Reversal and Consolidation Formations have been\ndescribed in our earlier studies of those price patterns. It is easy to\nunderstand why a rally that develops after prices break out through the\nlower boundary of a Rectangle, for example, will be stopped when it gets\nback to that boundary by the Resistance (supply) now residing there.\nSupport-Resistance Theory enables us to rationalize most of the Throwback\nmoves that occur after prices have broken out of other types of Reversal or\nConsolidation Areas. The Pullbacks that follow trendline penetrations\ncannot be thus rationalized; yet they occur much more frequently, and they\nappear to be stopped much more exactly at the old trendline level than is the\ncase with Area Formations. Why should prices, after they have thrust down\nthrough a rising trendline, perhaps for several points, turn back up and\nascend to or very near the old trendline, stop there, and then go off in\nrenewed decline? The Top of that Pullback Rally may be 2 or 3 points\nabove the original penetration level, because the trendline is sloping up all\nthe time; nevertheless, there it stops, falters, and gives up. No one knows\nwhy supply should overcome demand or why Resistance should be so\nplainly evident at that particular point whose level is determined by two\nvariants—the slope of the line and the time it is reached.\nYou cannot reasonably expect a Pullback Rally to climb all the way back to\na trendline that is ascending at a very steep angle, which may mean the\nattainment of a new high price for the entire Intermediate Uptrend; yet even\nthat happens in more than just a few cases. What can be counted on in the\ngreat majority of typical Up Trendlines (those that slant up at a normal or\nfairly flat angle) is that after the line has been broken, a Pullback Rally will\ndevelop, either in a few days or in the usual Minor Wave tempo and will\ncarry prices back up to the projected trendline.\nThrowbacks do not occur, it should be noted, when prices erupt through a\nReturn Line, that is, break out of the top side of an Uptrend Channel. Or,\nmore correctly stated, the Return Line does not function as a Support\nagainst a Throwback after prices have gone through it. An unusually strong\nupswing in a Rising Trend Channel may carry beyond the top of the\nChannel as defined by its Return Line, but the next reaction may go right\nback down through it without evidencing any hesitation at its level.\nThe Throwback is one of the mysteries in trendline price action to which we\nalluded at the outset. The technical analyst who studies trends and\ntrendlines over any considerable period will discover many other even more\nmysterious phenomena that cannot find space in this treatise, as no way has\nyet been found to put them to practical use in trading and investing. They\nare extraordinarily interesting in retrospect, but they are not subject to\nforecast.\nIntermediate Downtrends\nIn all of the foregoing discussion of trends and trendlines, we have\nconcentrated on uptrends; we have, in fact, had in mind specifically\nIntermediate Advances in the direction of the Primary Trend, that is, within\na Major Bull Market. Those particular trends are most apt to develop\n“normally” and are most amenable to trendline definition. Intermediate\nDown Moves in a Major Bear Market may well be taken up next. Before\ndiscussing the respects in which they differ from Primary Advances, recall\nthat the Basic Trendline on a down-move is the line projected across the\nTops of the rallies within it. The Trend Channel will be to the left of that\ntrendline and below it on the chart. The Return Line (if any) will define the\nBottom of the channel.\nIntermediate (Bear Market) Downtrends are far less regular and uniform in\ntheir development than Bull Market Advances. Their angles of decline are\ncharacteristically steeper, and this is particularly true, of course, of the\nPanic Moves typical of the second phase of a Bear Market, as in our\ndiscussion of Major Trends in Chapter 3. Moreover, prices have a tendency\nto drop away from any trendline drawn across the first two Rally Tops; in\nother words, to curve down or accelerate as the move proceeds. This shows\nplainly on an arithmetically scaled chart and even more conspicuously on a\nsemilogarithmic sheet.\nThe practical results of this down-curving tendency are not so important,\ninsofar as it delays the penetration of the original trendline and, hence, the\ngiving of a signal of trend change. The fact is prices tend to thrash around\nfor some time, making a base at the Bottom of one of these precipitous\ndeclines. In so doing, they work out sideways on the chart and the trend\nfrequently does not turn up visibly until after the trendline has finally been\nreached and broken through on the upside after all. Thus, there is\njustification for drawing down trendlines and keeping them in view even\nthough they may seem, for some time, simply to travel off into space with\nno apparent relevance to the actual trend of prices.\nIt naturally follows from the above that Return Lines on most Bear Market\nDeclines have little practical utility; they are, more often than not, very\nquickly broken downside. Good channels are hard to find.\nHowever, and this is of considerable practical importance, the very last\nIntermediate Downswing in a Major Bear Market is the last Primary Move\nthat leads to the final, longterm Bottom, which is us", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 102}
{"text": "aturally follows from the above that Return Lines on most Bear Market\nDeclines have little practical utility; they are, more often than not, very\nquickly broken downside. Good channels are hard to find.\nHowever, and this is of considerable practical importance, the very last\nIntermediate Downswing in a Major Bear Market is the last Primary Move\nthat leads to the final, longterm Bottom, which is usually cleaner, more\nregular, and less precipitous—in other words, it is a more nearly normal\ntrend of the sort we expect to find in most Intermediate Advances in a Bull\nMarket (except that it slants down instead of up). This interesting habit is,\nas we said, of practical importance. Knowing it, we have an additional and\nvery useful clue to the end of a Bear Market.\nWhen, after a Major Bear Trend has proceeded for some time and distance,\nand has experienced at least one Panic Sell-Off, it then goes off in another\nbut less active and more orderly decline, and this decline develops and\nfollows a good trendline. Watch it closely though. If this Intermediate holds\nto its steady and not-too-steep downward course—if its trendline is\ncontacted several times by Minor Rallies or it produces a fairly consistent\nchannel and prices do not “fall out of bed” down through its parallel Return\nLine, then the eventual upside penetration of this trendline may well signal\na Major Turn, that is, the inception of a new Bull Market.\nCorrective trends: the Fan Principle\nIn this study of Intermediate Trendlines, we have left to be taken up last the\nsubject of Secondary or Corrective Trends. These are the Intermediate\nDeclines that interrupt the Primary Advances in a Bull Market, and the\nIntermediate Recoveries that alternate with Primary Declines in Bear\nMarkets.\nIntermediate Reactions against the Major Direction of the market take a\nvariety of forms. Sometimes, as we have seen in our earlier study of chart\npatterns, they run out into Consolidation Formations—Triangles,\nRectangles, and so on—in which the net price reaction is of minor\nconsequence, but time is consumed in backing and filling before the\nPrimary Trend can be resumed. In such cases, there is no basis for drawing\nan Intermediate Trendline, nor is one needed for any practical purpose.\nAt the other extreme, so to speak, we find Corrective Swings that develop\nas a more or less orderly straight-line return of moderate slope to the nearest\ngood Intermediate Support or Resistance Level, retracing perhaps a third to\na half of the preceding Primary Swing. These reactions produce good\ntrendlines, as a rule, and the eventual penetration of their trendlines is a\ngood technical signal of Reversal. Intermediate Corrections clearly of this\ntype are relatively rare.\nA third form taken by Intermediate Corrections is nearly as common as the\nfirst named above (Consolidation Pattern) and much more common on the\ncharts than the second. In a Bull Market, it starts with a sharp reaction that\nproceeds for several days—perhaps for as much as two weeks—producing\na steep Minor Trendline. This line is broken upside by a quick Minor Rally,\nafter which prices slide off again in a duller and less precipitate trend. A\nsecond Minor Trendline may now be drawn from the original high point\nacross the Top of the upthrust that broke the first trend. This second\ntrendline is broken by another partial recovery thrust, and a third and still\nduller and flatter sell-off ensues. A third trendline can now be drawn from\nthe original high across the Top of the second upthrust. The whole move, by\nthis time, has taken roughly and irregularly a “Saucering-out” form. The\nthree trendlines drawn from the original Reversal points from which the\nCorrective Decline started, each at a flatter angle than its predecessor, are\nknown as Fan Lines. The rule is when the third Fan Line is broken upside,\nthe low of the Intermediate Correction has been seen.\nThere are exceptions to this rule—as there are to every so-called rule of\ntechnical chart analysis. Rarely, a correction of this type will go on to make\nanother dip to a new low for the whole corrective move before prices really\nstart to round up again. But the Three-Fan Principle works in the great\nmajority of cases. Moreover, it offers the trader an opportunity to take a\nposition at a point at which he can logically employ a very near stop order\nand, thus, limit his loss to a controlled amount if the rule does not work out.\nIt is interesting to note that prices consistently throw back in these\nmovements to the preceding Fan Line after each upthrust. The new Primary\nSwing, once the low has been passed, usually starts slowly and carries out\nfor a time the Saucer picture.\nThe Three-Fan Rule works just as well in calling the turn on Intermediate\nRecoveries in a Bear Market, the majority of which take the rounding form\nthat is adapted to its use. Note, however, that the Fan Principle is normally\napplied only to corrective moves, that is, to determine the end of\nIntermediate Reactions in a Bull Market and the end of Intermediate\nRecoveries in a Bear Market.\nMajor Trendlines will be outlined in the following chapter, but before we\nleave this study of Intermediate Trends, it will be well to state again that the\npractical application of trendlines in actual trading requires experience and\nthe good judgment to be attained only therefrom. Some technical analysts\ndepend largely on trendline studies, few attempt to use trendlines almost\nexclusively, but the majority have found they are best employed as an\nadjunct to other technical data.\nTechnical analysis of a stock chart is something like putting together a\njigsaw puzzle. There are many items to be considered, among them volume,\npattern, and the measurements derived therefrom, Support and Resistance\nLevels, trendlines, and general market prospects—and all fit into place to\nget the complete picture.\nTaylor & Francis\nTaylor & Francis Group\nhttp://taylorandfrancis.com\nchapter fifteen\nMajor Trendlines\nIn the preceding chapter on In", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 103}
{"text": "ike putting together a\njigsaw puzzle. There are many items to be considered, among them volume,\npattern, and the measurements derived therefrom, Support and Resistance\nLevels, trendlines, and general market prospects—and all fit into place to\nget the complete picture.\nTaylor & Francis\nTaylor & Francis Group\nhttp://taylorandfrancis.com\nchapter fifteen\nMajor Trendlines\nIn the preceding chapter on Intermediate Trendlines, mention was made of\nthe distinctive effects produced by arithmetic and semilogarithmic plotting,\nbut it was noted that these differences were unimportant in connection with\nMinor Trends or Intermediate Trends of average duration. When we come\nto Major Trends, however, we find the difference does become important.\nMajor Trendlines are illustrated by Figures 15.1 through 15.20.\nIf you will examine a large collection of arithmetically scaled monthly\ncharts covering 10 years or more of market history, you will quickly see\nthat Bull Trends, in the great majority of actively traded, more or less\nspeculative common stocks, tend to accelerate. They start slowly and push\nup at a steeper and steeper angle as they approach a Major Top. This up-\ncurving path takes them farther and farther away from any straight trendline\ndrawn from two Bottom points in the first, slow-moving stage of advance.\nAs a consequence, they top out and have gone down a long way in a\nrecession that may be of Major consequence before their straight trendline\nis again touched.\nMany of the stocks that show such typical accelerating curves in their\nadvance (Major) Trends on arithmetic paper produce straight trends on a\nlogarithmic scale. As a consequence, their logarithmic Major Trendlines are\nbroken more quickly, and usually at a higher price level, when at last their\ntrends do top out and turn down. In the case of such stocks, then, the\nlogarithmic scale gives a better trend signal.\nBut there are other stocks—mostly of the more substantial investment or\nsemiinvestment type—that tend to advance in straight arithmetic trends.\nConsolidated Edison, General Motors, and Libbey-Owens-Ford Glass are\nexamples. (The trends of these on a logarithmic scale show a decelerating\ncurve.) Still a third class, made up largely of highgrade preferred stocks,\nproduces a rounding over or decelerating Bull Trendline even on the\narithmetic scale. And, finally, there are a number of issues whose normal\nBull Market Trendlines fall somewhere between our first two types—that is,\nthey curve up away from a straight path on the arithmetic scale, but curve\nover to the right (breaking through a straight line) on the logarithmic scale.\n(EN: Fortunately, in this age of computers and easily processed data, there\nis analytical software that allows the analyst to instantaneously switch\nbetween the scales. Desktop packages are available[(see Appendix B,\nResources] and a number of internet sites have these capabilities.)\nAll of which, the reader, at this point, no doubt finds most discouraging.\nSome stocks do this and some stocks do that, but what help is there for us in\nsuch a mix-up? The answer lies in studying the history of each issue in\nwhich you may be interested. Most stocks do not change their habits and\ntheir technical characteristics much from one Bull and Bear cycle to the\nnext. An issue, like General Motors, that produces a straight-line Bull Trend\non an arithmetic chart in one Primary Upswing is likely to repeat that\nperformance in the next. EN10: GM after the fall will, we suspect, retain its\nprevious habits, but that remains to be seen.\nAs a matter of interest, stocks do sometimes change over a long period of\nyears. Companies that were regarded as extremely speculative when their\nshares were first listed\n60\n40\n20 Sales 100's 4000 2000\nFigure 15.1 The straight-line Bull Market Trend of General Motors on an\narithmetic monthly chart: 1941 low, 28 5/8; 1946 high, 80 3/8.\nFigure 15.2 The up-curving trend of a speculative motors stock, Hudson\nMotors. Compare this with “GM”: 1941 low, 2 5/8; 1946 high, 34.\nFigure 15.3 Typical decurving Major Bull Trend of a high-grade preferred\nstock. This is Curtis Publishing $7.00 Preferred: 1942 low, 12; 1945 high,\n154.\n30\n20\n10\nSales\n100's\n1200\n1000\nFigure 15.4 The accelerating uptrend of the common stock of the same\npublishing company: 1942 low, 3/8; 1946 high, 26.\nFigure 15.5 A conservative investment-type utility stock makes a straight-\nline Major Bull Trend. This is Commonwealth Edison: 1942 low, 17 3/8;\n1946 high, 36 1/8. Leverage is an important factor in trends.\n15\n10\n5\nFigure 15.6 The up-curving trend of a low-priced “junior” utility,\nInternational Hydro-Electric: 1942 low, 1/4; 1946 high, 15 1/2.\nSales 100's 400 200\nFigure 15.7 A speculative oil stock, Houston Oil: 1942 low, 2 1/4; 1946\nhigh, 30. Compare this picture with “SOH” in Figure 5.8.\nFigure 15.8 Straight-line uptrends in an investment oil, Standard Oil of\nOhio: 1942 low, 10 1/8; 1946 high, 30. Note: trendline unbroken until 1948.\n\nFigure 15.9 Steel stocks have the speculative or accelerating type of\nPrimary Uptrend, Republic Steel: 1942 low, 13 3/8; 1946 high, 40 7/8.\nFigure 15.10 The normal Major Bull Trend of heavy industrial issues is up-\ncurving, American Car & Foundry: 1942 low, 20; 1946 high, 72 3/8.\n40\n80\n60\nFigure 15.11 A low-priced building stock, Celotex Corporation: 1942 low,\n6 1/8; 1946 high, 38 1/8.\nFigure 15.12 A highly speculative, low-priced issue, traded on the Curb\nExchange, Claude Neon Lights: 1942 low, 1/8; 1946 high, 9.\nFigure 15.13 The tobacco stocks follow the investment type of trend. This\nis Liggett & Myers: 1942 low, 50 1/2; 1946 high, 103 1/2. Note the Double\nTrendline.\n70\n60\n50\n40\nSales\n100's\n400\n200\nFigure 15.14 High-grade food issues (Corn Products Refining) resemble\nthe tobaccos: 1940 low, 40 1/4; 1946 high, 75 3/4.\n192\n176\n160\n152\n144\n136\n128\n120\n112\n104\n96\n88\n80\n76\n72\n68\n64\n60\n56\n52\n48\n44\nSales\n100's\n1935\n1936\n1937\n1938\nFigure 15.15 In the process of “pulling back” to a very steep Up Trendline,\nprices may e", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 104}
{"text": "/2; 1946 high, 103 1/2. Note the Double\nTrendline.\n70\n60\n50\n40\nSales\n100's\n400\n200\nFigure 15.14 High-grade food issues (Corn Products Refining) resemble\nthe tobaccos: 1940 low, 40 1/4; 1946 high, 75 3/4.\n192\n176\n160\n152\n144\n136\n128\n120\n112\n104\n96\n88\n80\n76\n72\n68\n64\n60\n56\n52\n48\n44\nSales\n100's\n1935\n1936\n1937\n1938\nFigure 15.15 In the process of “pulling back” to a very steep Up Trendline,\nprices may easily go to a new high. Note the Pullback of August 1936 in\nthis weekly chart of Westinghouse Electric. The second, less steep line\nturned out to be the true Major Bull Trend. Note that the February-April\nprice pattern in 1936 could not be considered a true Double Top Reversal of\nPrimary import because the recession between the two highs was only about\n10% of the Top's value (around 122). Figure 8.21 shows on a daily chart the\nfinal Top Reversal Formation that “WX” made in 1937.\nmay attain an increasingly important and stable position in the general\neconomy, with the result that, eventually, their stock acquires a solid\ninvestment rating. Their Bull Market Trends will then gradually change\nfrom an up-curve to a straight line and, finally, to a decelerating curve.\nOther old, established corporations may lose position and rating, as well as\nshift from the investment type of trendline to the speculative. But, it is true\nin general, that Major Patterns do repeat.\nIf you are keeping your own set of manual monthly charts, you can choose\nwhichever scale you please. But most technical chart followers prefer to\nbuy their long-range pictures readymade, thereby getting a much more\nextensive history of many more issues than they could hope to chart\nthemselves. Since the only comprehensive portfolios of monthly charts that\nare available at reasonable cost are arithmetically scaled, you will possibly\nhave to make these serve all purposes. (EN: No longer necessary because of\nthe availability of good software and internet chart sites. See Appendix B,\nResources.) You will find with a little experimentation that an architect's\nFrench curve can be used to plot good Major Uptrend Lines on many of the\nissues whose normal Bull Trends accelerate away from a straight line.\n400\n360\n320\n280\n240\n200\n160\n120\n\nDOW - JONES INDUSTRIAL AVERAGE ranmnnninnmnsjwssss\n::::::::::::::\nFigure 15.16 The 1929-1932 Primary Bear Market was the only one in all\nstock market records that produced a Straight-Line Major Downtrend. Trace\nalso the Support and Resistance Levels throughout this 14-year history of\nthe Dow Industrials. Each rally in the great Bear Move stopped at or near a\nprevious Bottom level. Each decline stopped near the level of a Congestion\nin the 1924-1929 Bull Market. See also the level of 1937 Top. (Source:\nChart courtesy of Market Research, Inc., at http:// wwwbarchart.com.)\nFigure 15.17 S&P Reagan Crash. As can be clearly seen, this crash sent\nnumerous signals, starting with the breaking of a Major Trendline by more\nthan 2% in late August. Once this occurs extreme caution and watchfulness\nmust be exercised. The darker and darker complexion of things is brought\nout by the “smart selling,” which shows many “downthrust days\" toward\nthe end (October 10-20). The April trendline breaks (by more than 2%)\nwould have ejected the trend trader also to be put back long in June.\nObservance of the 2%-3% trendline-break rule or use of Basing Points and\nprogressive stops (see Chapters 27 and 28) would have avoided much\nneedless grief.\nFigure 15.18 S&P Long-Term Perspective. Viewed from afar it seems an\nexercise in futility to attempt to “time the market.” One must keep in\nperspective the crashes in market prices are timed to coincide with personal\nand business needs for short-term liquidity, or cash. One must also\nremember the market behavior from 1965-1982, as well as the table of Dow\nTheory Performance from Chapter 4 (Table 4.2).\n\nFigure 15.19 Three Bull Market Tops, 1929, 1987, 1998. Notice here that\nin each case the crash occurred after the nearest important trendline had\nbeen decisively broken—usually trendlines of approximately three months\nby 2% or more, and sometimes accompanied by reversal formations. All\nhistoric tops will show evidence of attempts to resume the trend after a\nbreak of this kind. Belief dies hard. Nonetheless, hedging or exiting on\nthese trend breaks proves to be the best strategy over and over again.\nFigure 15.20 The Bull 1990s top in the S&P gave much clearer readings\nthan the Dow top, with the broken trendlines being paramount. But while\nthe Dow flirted with the emotions of Bulls who wanted to believe in the\nDow 36,000, the S&P broke its trendlines and went south for the winter, a\npotentially very long winter. This might have started off as a rounding top\nand then became a complex-complex top, and you can even see traces of a\nHead-and-Shoulders top in it. It is the editor's opinion we may never see\nsuch unruly tops again in this generation. The pent-up greed, lust, and\nnaivete as even the bootblacks (they still have those don't they?) rushed to\nget the latest tulip bulbs. Tulips are like century plants; they only bloom\nonce each hundred years. A little old lady with a ruler could have saved her\nportfolio here. All it takes is not believing the hype (Dow 36,000 indeed!)\nand making an unemotional analysis and honoring the stops.\nThe tests for the technical significance of a Major Trendline are\nsubstantially the same as those specified for Intermediate Lines in the\npreceding chapter. A little more leeway must be allowed on penetrations—\nagain, a matter of judgment—but you are dealing with coarse data and long\nswings here, and what you want from your monthly charts, primarily, is\nperspective on the broad picture.\nOne more point regarding the construction of Major Bull Trendlines: the\nbest lines—the most useful—are drawn, as a rule, not from the absolute low\nof the preceding Bear Market but starting from the next Intermediate\nBottom. The accumulation area at the beginning of a Bull Market is usually\nlong and drawn", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 105}
{"text": "e, and what you want from your monthly charts, primarily, is\nperspective on the broad picture.\nOne more point regarding the construction of Major Bull Trendlines: the\nbest lines—the most useful—are drawn, as a rule, not from the absolute low\nof the preceding Bear Market but starting from the next Intermediate\nBottom. The accumulation area at the beginning of a Bull Market is usually\nlong and drawn out in time and relatively flat. The first trendline that can be\ndrawn from the extreme low point may, therefore, be too nearly horizontal\nto express the genuine Bull Trend that starts with the markup phase. The\nseveral charts showing Major Trendlines that illustrate this chapter will\ndemonstrate this point (EN: Especially Figure 15.14). It applies as well to\nmany Intermediate Moves that start from Area Formations. Take the Head-\nand-Shoulders Pattern, for example: the true Intermediate Trendline usually\nstarts from the right shoulder rather than from the head.\nMajor Downtrends\nFrom the technical analyst's point of view, it is regrettable that few Bear Markets haveproduced Major Trendlines of any practical significance on the charts of individualstocks. A notable exception was the long Bear Market of 1929-1932, which producedmagnificently straight trendlines on the arithmetic plotting of a host of issues (as wellas in the Averages, to which we shall refer later). But it is almost impossible to findother instances in which a Bear Trendline having any forecasting value can be drawnon either arithmetic or semilogarithmic scale.\nThe normal Major Bear Market Trend is not only steeper than the normal Bull Trend(because Bear Markets last, on the average, only about half as long as Bull Markets),but it is also accelerating or down-curving in its course. This feature is accentuatedand, hence, particularly difficult to project effectively on the semilogarithmic scale.\nThe technician cannot expect to obtain much in the net of it, help from his MajorTrendlines in determining the change from a Primary Downswing to a PrimaryUpswing. This should not be taken, however, as advice to not draw trendlines on aMajor Down Move, or to disregard entirely any trendlines that may develop withsome appearance of authority. If you do not expect too much of them, they may,nevertheless, afford some useful clue as to the way in which conditions are tending tochange.\nThe student of stock market action who is not altogether concerned with dollars andcents results from his researches will find Bear Market Trendlines a fascinating fieldof inquiry. They do some strange things even though they fail in the practical functionof calling the actual Major Turn and go shooting off into space, they sometimesproduce curious reactions (or, at least, appear to produce what would be otherwiseinexplicable market action) when the real price trend catches up with them months oryears later. But such effects, interesting as they may be, are, in our present state ofknowledge, uncertain and unpredictable. (EN: This fact may persist into the mists ofthe future and be thought of like Fermat's Last Theorem. Our present state ofknowledge in the twenty-first century is no further advanced than it was in Magee'stime.)\nWe must dismiss this rather unfruitful topic with the reminder that one clue to the endof a Primary Bear Market is afforded by the Intermediate Trendline of its final phase,which we cited in the preceding chapter.\nMajor Trend Channels\nAnother difficulty is met when trying to draw Return Lines and construct channels forMajor Trends on an arithmetic chart. Owing to the marked tendency for prices tofluctuate in ever-wider swings (both Intermediate and Minor) as they work upward ina Primary Bull Market, their channel grows progressively broader. The Return Linedoes not run parallel to the Basic Trendline (assuming there is a good Basic Trendlineto begin with) but diverges from it. Occasionally, a stock produces a clear-cut MajorChannel Pattern, but the majority do not.\nA large Rectangle base was made on this weekly chart in April, May, and June 1937,but observe the poor volume that accompanied the breakout and rise from thatformation—an extremely Bearish indication for the Major Trend. The “measurement”of the Rectangle was carried out by August, but that was all.\nAs is usually the case, it was impossible to draw a Major Down Trendline that hadany forecasting value on this chart. The beautiful straight trendlines that appeared inthe 1929-1932 Primary Bear Market led many chart students to expect similardevelopments in every Bear Market, but the fact is that 1929-1932 was unique in thatrespect.\nSemilogarithmic scaling will correct, in many cases, for the Widening Channel effectin Bull Trends, but then we run into the opposite tendency in Primary Bear Markets,and for that, neither type of scaling will compensate.\nTrendlines in the Averages\nPractically everything stated in the preceding chapter regarding IntermediateTrendline development in individual stocks applies, as well, to the various Averages.The broad Averages or Indexes, in fact, produce more regular trends and, inconsequence, more exactly applicable trendlines. This may be partly due to the factmost Averages are composed of active, well-publicized, and widely owned issueswhose market action individually is “normal” in the technical sense. Another reason isthe process of averaging smooths out the vagaries of component stocks, and the resultmore truly reflects the deep and relatively steady economic trends and tides.\nIn any event, it is a fact that such averages as the Dow-Jones Rails, Industrials, and65-Stock Composite, The New York Times 50, and Standard & Poor's Average of 90stocks (the last two named being probably the most scientifically composed to typifythe entire broad market) do propagate excellent trendlines on their charts. (EN: As thereader will note, most of these indices are obsolete. In the modern age, the S&P 500probably best fulfills this function.)\nThe very accuracy of thei", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 106}
{"text": "and65-Stock Composite, The New York Times 50, and Standard & Poor's Average of 90stocks (the last two named being probably the most scientifically composed to typifythe entire broad market) do propagate excellent trendlines on their charts. (EN: As thereader will note, most of these indices are obsolete. In the modern age, the S&P 500probably best fulfills this function.)\nThe very accuracy of their trends, particularly their Intermediate Moves, permits us toconstrue their trendlines more tightly. Less leeway need be allowed for doubtfulpenetrations. Thus, although we ask for a 3% penetration in the case of an individualstock of medium range, 2% is ample in the Averages to give a dependable breaksignal.\nExperienced traders know it pays to heed the Broad Market Trend. It is still easier toswim with the tide than against it.\nEN: Trendlines in the Averages and Trading in the Averages\nNumerous averages and indexes have come online since the fifth edition, includingthe S&P 100, S&P 500, Russell 2000, and so on. It would be an exercise in dailyjournalism to attempt to list all the indexes now available, as new ones spring up likeweeds after the spring rain. This is because the invention of a widely adopted indexcan be very lucrative for its creator S&P and Dow-Jones collect licensing fees fromthe “use” of their indexes by the exchanges. The constant addition of new tradinginstruments requires that current lists be kept in Resources, and the reader may alsoconsult the Wall Street Journal, Barron's, and the Investor's Business Daily whereprices of indexes and averages are reported. Online brokerages and financial newssites also offer up-to-the-minute lists and quotes on virtually all trading instruments.A list and links to these sites may also be found in Appendix B, Resources, and athttp://www.edwards-magee.com.\nAs of the turn of the century, the most important of these indexes joining the Dow areprobably the S&P 500, the S&P 100, and the NASDAQ. In fact, these are probablysufficient for economic analysis and forecasting purposes, and certainly good tradingvehicles by means of surrogate instruments, options, and futures. Some would includethe Russell 2000 in this list. These indexes and averages have been created to fillneeds not addressed adequately by the Dow-Jones Averages.\nWith this proliferation of measures of the market and various parts of it, a differentquestion arises questioning the value of the Dow alone in indicating the BroadMarket Trend. Limited research has been done on this question; however, my opinionis the Broad Market Trend must now be determined by examining the DowIndustrials, the S&P 500, and the NASDAQ Composite.\nTrading the Averages in the 21st century\nAs pointed out in other new chapters and notes in the eighth edition, the ability totrade the Averages instead of individual stocks is a powerful choice offered bymodern markets. The index ETFs offer ideal vehicles for investing: The DIA, SPY,\nQQQ and IWM give the modern investor unparalleled flexibility and convenience.Magee was of the opinion that the Averages offered technical smoothness oftenlacking in individual issues. This would seem to be true intuitively. After all, just as amoving average smooths data, the average of a basket of stocks should dampen pricevolatility. Of course, as Mandelbrot pointed out, in a 10-sigma market stormeverything sinks.\nIllustrated in this chapter are several detailed cases following Magee's suggestion ofAverage trading. I attempt to demonstrate here two perspectives: one, the horror ofthe immediate, what the crash and panic look like as they occur; and two, what thecrash and panic look like in retrospect. We all live in the present, except for the greatbillionaires who can afford to doze through horrific Bear Markets. Bill Gates' networth varied by $16 billion or $17 billion in early 2000. This would put the ordinaryinvestor out of business.\nSo the ordinary investor, you and I, have to respect the great yawning Bear Market.We must step to the sidelines and let the bear eat the foolish virgins, to borrow aBiblical metaphor.\nYou will remember Magee opined that a trendline break of 2% was sufficient to causeliquidation of longs when analyzing the Averages. In the accompanying figures, thishypothesis is examined.\nEN9: In respect to the breaking of trendlines (by 2% or 3%), I should note thebreaking of a trendline is as much a warning as a signal to act. The break, instead ofa change of trend to the reverse, may indicate a change of trend to the sideways—intoa reversal or continuation pattern.\nchapter sixteen\nTechnical analysis of commodity charts (EN9: Following the practice of allowing thereader to discriminate between the work of Edwards and Magee and that of the editor,a section on commodity trading, Chapter 16, has been added to the ninth edition. Seesame.)\nA little thought suggests the variously interesting and significant patterns we haveexamined in the foregoing chapters on stock charts should logically appear as well inthe charts of any other equities and commodities that are freely, constantly, andactively bought and sold on organized public exchanges. In general, this is true. Theprice trends of anything for which market value is determined solely (or for allpractical purposes within very wide limits) by the free interplay of supply anddemand will, when graphically projected, show the same pictorial phenomena of riseand fall, accumulation and distribution, congestion, consolidation, and reversal that\nwe have seen in stock market trends. Speculative aims and speculators' psychologyare the same whether the goods dealt in are corporate shares or contracts for the futuredelivery of cotton bales. (For illustrations in this chapter, see Figures 16.1 through16.13.)\nIt should be possible in theory, therefore, to apply our principles of technical analysisto any of the active commodity futures (wheat, corn, oats, cotton, cocoa, hides, eggs,etc.) for which accurate daily price and volume da", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 107}
{"text": "same whether the goods dealt in are corporate shares or contracts for the futuredelivery of cotton bales. (For illustrations in this chapter, see Figures 16.1 through16.13.)\nIt should be possible in theory, therefore, to apply our principles of technical analysisto any of the active commodity futures (wheat, corn, oats, cotton, cocoa, hides, eggs,etc.) for which accurate daily price and volume data are published. It should be, thatis, if proper allowance is made for the intrinsic differences between commodityfutures contracts and stocks and bonds.\nIn previous editions of this book (EN9: up to the eighth), traders who cast longingeyes on the big, quick profits apparently available in wheat, for example, werewarned that commodity charts were “of very little help,” as of 1947.\nIt was pointed out that successful technical analysis of commodity futures charts hadbeen possible up to about 1941 or 1942, but the domination of these marketsthereafter by government regulations, loans, and purchases completely subject to thechanging (and often conflicting) policies and acts of the several governmentalagencies concerned with grains and other commodities had seriously distorted thenormal evaluative machinery of the market. At that time, radical reversals of trendcould and did happen overnight without any warning so far as the action of the marketcould show. The ordinary and orderly fluctuations in supply-demand balance, whichcreate significant definite patterns for the technician to read, did not exist. Yet, whilefortunes were made (and lost) in wheat, corn, and cotton futures during the World WarII period, it is safe to say they were not made from the charts.\nDuring the past five or six years, however, the application of technical methods tocommodity trading has been reexamined. Under 1956 conditions, it appears thatcharts can be a most valuable tool for the commodity trader. The effects of presentgovernment regulation have apparently resulted in “more orderly” markets withoutdestroying their evaluative function. Allowing for the various essential differencesbetween commodities and stocks, the basic technical methods can be applied.\n104\n96\n88\n80\n76\n72\n68\n64\n60 Sales 100's\nSEPTEMBER OATS\nChicag<\nsir\n1118'25 11 8 15'22T 8 15'22295112119263 W17124W7r142r28''5Ti219l26t 2 1 9\nFigure 16.1 Oats, for obvious reasons, traced more “normal” patterns than Wheatduring the 1940s. This chart contains an H & S bottom, a Symmetrical Triangle thatmerged into the Ascending form, a gap through a former top level, and an interestingtrendline. The Island shake-out through the trendline was an extremely deceptivedevelopment.\nIt may be in order here to discuss briefly some of the intrinsic differences betweencommodity futures and stocks referred to above and to some of the special traits ofcommodity charts. First, the most important difference is the contracts for futuredelivery, which are the stock-in-trade of the commodity exchange, have a limited life.For example, the October cotton contract for any given year has a trading life of about18 months. It comes “on the board” as a “new issue,” is traded with volumeincreasing more or less steadily during that period, and then vanishes. Theoretically, itis a distinct and separate commodity from all other cotton deliveries. Practically, itseldom gets far out of line with such other deliveries as are being bought and soldduring the same period, or with the “cash” price of the physical cotton in warehouses.Nevertheless, it has this special quality of a limited independent life, as a consequenceof which long-term Support and Resistance Levels have no meaning whatever.(EN10: This absolute may not be absolute. Evaluate the longterm charts for yourissue to see whether influence is evident.)\nSecond, a very large share of the transactions in commodity futures—as much as 80%certainly in normal times—represents commercial hedging rather than speculation.(EN10: Less true in the twenty-first century.) It is, in fact, entered in to obviate riskand to avoid speculation. Hence, even near-term Support and Resistance Levels haverelatively less potency than with stocks. Also, because hedging is to a considerabledegree subject to seasonal factors, there are definite seasonal influences on the\ncommodity price trends that the commodity speculator must keep in mind, even ifonly to weigh the meaning of their apparent absence at any given period.\nA third difference is in the matter of volume. The interpretation of volume withrespect to trading in stocks is relatively simple, but it is greatly complicated incommodities by the fact that there is, in theory, no limit to the number of contracts fora certain future delivery that may be sold in advance of the delivery date. In the caseof any given stock, the number\nFigure 16.2 In contrast with the grains, the technical action of the Cotton futuresmarkets has been fairly consistent with normal supply-demand functioning ever since\nprices rose well above government support levels. In this daily chart of the 1947October delivery (New York Cotton Exchange), the reader will find a variety offamiliar technical formations, including critical trendlines, a Head-and-Shoulders topthat was never completed (no breakout), and Support-Resistance phenomena muchthe same as appear in stock charts. Double trendlines are not at all unusual in Cottoncharts.\nof shares outstanding is always known. As this is written (1956), there are in thehands of stockholders 13,700,203 common shares of Consolidated Edison, and thatquantity has not varied for many years nor is it likely to change for several years tocome. Every transaction\nIn the case of commodity future contracts—say, September wheat—trading beginslong before anyone knows how many bushels of wheat will exist to be delivered thatcoming September, and the open interest at some time during the life of the contractmay exceed the potential supply many times over, and all quite legitimately. (EN9: Asalways, volume data is a supplem", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 108}
{"text": "several years tocome. Every transaction\nIn the case of commodity future contracts—say, September wheat—trading beginslong before anyone knows how many bushels of wheat will exist to be delivered thatcoming September, and the open interest at some time during the life of the contractmay exceed the potential supply many times over, and all quite legitimately. (EN9: Asalways, volume data is a supplementary indicator to price. No one makes a profit onit.)\nOne more important difference may be mentioned. Certain kinds of news—aboutweather, drought, floods, and so on that affect the growing crop, if we are dealingwith an agricultural commodity—can change the trend of the futures marketimmediately\n\n1997 1998 1999 2000 2001 2002 2003 2004\nCreated with TradeStation\nFigure 16.3 A Rounding Bottom in Gold 1997-2004. “These patterns, when theyoccur after an extensive decline, are of outstanding importance, for they nearlyalways denote a change in Primary Trend and an extensive advance yet to come. Thatadvance, however, seldom carries in a ‘skyrocket' effect, which completes the entireMajor Move in a few weeks. On the contrary, the uptrend that follows the completionof the pattern itself is apt to be slow and subject to frequent interruptions, tiring outthe impatient trader, but yielding eventually a substantial profit.” So said RobertEdwards in remarking on Rounding Bottoms in stock charts. As may be seen here,this Rounding Bottom consists of a downtrend, a false signal off the Double Bottom(upon which a pretty penny might have been made by the agile trader), and ahandsome uptrend—and it all looks like a huge Rounding Bottom.\nand drastically and are not foreseeable given the present stage of our weatherknowledge. Analogous developments in the stock market are extremely rare. (EN:Except for acts of God and Alan Greenspan [and Ben Bernanke]).\nIt is not the purpose of this book to explain the operation of commodity futuresmarkets, nor to offer instruction to those who wish to trade therein. This brief chapteris included only as a starter for readers who may want to pursue the study further.They should be advised that successful speculation in commodities requires far morespecialized knowledge and demands more constant daily and hourly attention. Theordinary individual can hope to attain a fair degree of success in investing insecurities by devoting only his spare moments to his charts, but he might better shuncommodity speculation entirely unless he is prepared to make a career of it.\n(EN: The editor has been, during his checkered career, a registered commoditytrading advisor. At the beginning of that career, I discussed these subjects with Mageeand received essentially the above comments, which are here reproduced from thefifth edition. Subsequently, I observed among my associates and partners, and on myown, that futures are eminently tradable with the adaptation of techniques andmethods described in this book. It is also true, as Magee says, that futures trading isso different in tempo, leverage, and character that the novice risks life, limb, andcapital in entering the area unescorted. Resource references are essential reading, butthe beginner is urged to educate himself before beginning trading with extensive studyand paper trading.)\nFigure 16.4 Gold, October 2011. The momentous earth-shaking power of a massiverounding bottom is vividly dramatized by the gold chart since 2005, as well as thepower of chart analysis to anticipate it. Regrettably, the editor did not compute theprice target implications of the pattern in the ninth edition in 2005. That computationwas made at the http://www.edwards-magee.com website at the time. There it wascomputed as follows (and the reader can do it for himself): depth of pattern, 248.20plus neckline 507.40, target 755.60. In fact, the possibility was entertained that theentire formation from 1980 to 2008 might be a Rounding Bottom. In which case, thedepth was 700.70, added to the neckline of 959 and resulted, actually achieve, in atarget of 1,660. Remember Edwards said these were probable minimummeasurements.\nTechnical analysis of commodity charts, part 2: a 21st-century perspective\nIn the search for the Philosopher's Stone, more sweat and money have been put intothe area of commodities and futures than were ever expended in the securities arena.There is a simple reason for this—great fortunes are made and lost with much greaterrapidity in the futures area than in securities. Of all the great dramatic moments instock market history, few are so memorable as the great Hunt silver market, or Sorosfacing off against the Bank of England, or of gold soaring to $1,000 an ounce(deferred contracts). And the saga continues in 2005: $50 oil? $60? $70? $100? Andthe effects, economic and psychological! In dimly lit garrets and brightly lit computerrooms thousands of researchers concoct systems to trade these markets—corn,soybeans, silver, copper ...\nRocket scientists\nAt times, individual traders and groups of traders have plundered (harvested?) thesemarkets for fairy tale profits. I know whereof I speak, having been a principal inCalifornia's first licensed commodity trading advisor that was founded by the NASArocket scientist R. T. Wieckowicz. During the 1970s, as the stock markets groundfutilely around the 1,000 level on the Dow, the futures markets returned yearly gainsin the 100% range. Consistently. For years. Those were the years of the Californiasystems traders and the beginning of computerized trading. From the primeval slimeof NASA, rocket scientists emerged to create a renaissance in market technology. Atthe time it seemed clear that science and genius had at last conquered the markets andthat clients would come buzzing from the world over like bees to a honey\n@SI.P(D) - Weekly COMEX L = 7.035 +0.077 +1.11% B = 0.000 A = 0.000 O =6.985 Hi = 7.085 Lo = 6.980 C = 7.045 V = 145\nN\n1998 1999 2000 2001 2002 2003 2004 2005\nCreated with TradeStation\nFigure 16.5 A Rounding Bottom", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 109}
{"text": "ce in market technology. Atthe time it seemed clear that science and genius had at last conquered the markets andthat clients would come buzzing from the world over like bees to a honey\n@SI.P(D) - Weekly COMEX L = 7.035 +0.077 +1.11% B = 0.000 A = 0.000 O =6.985 Hi = 7.085 Lo = 6.980 C = 7.045 V = 145\nN\n1998 1999 2000 2001 2002 2003 2004 2005\nCreated with TradeStation\nFigure 16.5 A Rounding Bottom in Silver, 1998-2005. The apparent RoundingBottom in silver, combined with the same pattern in gold, would seem to cast a pallover the economic situation for some time to come in 2005. This coincides with theapparent long-term patterns setting up in the securities markets. If the best that can behoped for in securities is a 1965-1982 kind of widely whipping market, commoditiesmay react as they did in the 1970s—with tidal wave markets. These markets can betraded by the well-capitalized chart analyst who is well seasoned. Tyros will losemoney learning the game whatever markets they trade. Their chances will beimmeasurably improved by applying the techniques taught in this book. In addition tothe technical pattern pictured here, there is every reason to suspect that a largefundamental shortage of silver bullion exists and will worsen. Ted Butler, athttp://www.doomgloom.com, is a long-term silver analyst (and associate of the editor)who anticipates a new silver blow-off is coming. One wonders what Nelson andBunker Hunt are doing at present. A very cautious investor (like Warren Buffet who isreported to have invested $1 billion in silver bullion) may defeat futures silvervolatility by buying the bullion.\npot and that the rivers of profits would last forever. They did last for some time, andthen the markets changed. Mechanical systems that cut through the markets like areaper in a wheat field in Bull Markets grind up capital like sausage in sidewaysmarkets. Science and genius were revealed as the happy combination of man,moment, system, and market.\nTurtles?\nDuring the 1980s from the sea came crawling the Turtles. Progeny of the proteantrading wizard, Richard Dennis, the Turtles again harvested outsize profits from themarkets, reportedly running in the 80% yearly range. The so-called Turtles got theirname from a comment that Dennis is reported to have made that traders were madenot born, and he was going to raise traders like turtles. Additional reading about theTurtles is available in Jack Schwager's fascinating books, including Market Wizardsand others. Schwager's books are required reading for aspiring futures traders.Additionally, the trading manual of the Turtles will be found online athttp://www.originalturtles.org. This workbook, written by\nS\nK05(D)-\nn\nDailyCOM4EXL = 6.900-0.CC3-0.04%B =6.92\nC A=6.93\n5 O =6.9CCHi =\n6.9C5Lo\n=6.9CCC\n=6.9CCV\n/=6\nA'\n1\n1 A\n’8.CCC\n. \"7 cnn\n0 s\nA\nA\n7.500\n, nc\\c\\c\\\nA\n11\nc V\n1I\n7.000\n3H9CH\n< cnn\n( 1\n1\n. -1\nY\nT 1/ 0.500\n. 6 000\nh r\nA M J J A S O N D 05 F M A M\nCreated with TradeStation\nFigure 16.6 Silver, May 2005. Although the long-term silver outlook may be Bullish,the short term will be very volatile, especially for the thinly capitalized trader. Thenshort-term tactics must be adopted. The Island Top here at 1 is a gentle invitation tothe trader to take his profits and be gone. Even to short, with a stop just above thehigh. The run day after 1 adds a note of urgency to the invitation. The gap ispunishment for the hard of hearing and a bonus for the quick-witted (everybody whosurvives in futures is either quick witted or extremely well financed). The stop movesdown to the top of the gap day, then to the top of the next gap day, and for the veryapt profits are taken on the next run day down, on the principle of sell weakness, buyweakness. The tight trendline at 2 crossed by the heavy run day is a buy signal with\nthe stop moving to the bottom of the gap at 3, where it is taken out a few days later bythe long-range day down. The run day at 4 is a short signal with the stop being at theday's high. Is it necessary to say short-term futures trading can be quite rapid? Thereis always bullion or associated stock plays.\nCurtis Faith, an original Turtle, contains virtually all of the elements necessary in atrader's systems and procedures manual. The manual was prepared according to thetraining Dennis gave his Turtles. Serious traders do not operate without some suchdocument. Certainly all of the serious traders I have known (a considerable number)have had fully developed manuals like the Turtle workbook. I cite the Turtleworkbook rather than others in my possession because it is publicly available athttp://www.originalturtles.org (as well as in the 9th edition of this book) and becauseit is beautifully articulated.\nIn the late 1990s, the Turtles were made into turtle soup in the futures markets as themajority of systems traders wound up as hamburger meat. Is there a moral? Yes. Themarkets giveth and the markets taketh away. Science and genius are again revealed tobe the happy combination of man, method, moment, and market.\nThe Turtle system is basically an adaptation of Richard Donchian's channel breakoutsystem. In the Donchian system, the trader goes long when the 20-day high is brokenand sells and goes short when the 20-day low is broken. In the 1970s, Dunn andHargitt evaluated a number of mechanical trading systems and found that Donchian'ssystem was superior to the others evaluated at that time. Will Donchian's system stillwork? Yes,\n\nFigure 16.7 Silver, October 2011. Here is what happened in silver after the ninthedition was published. Could there be any greater vindication of the value of chartslooking at the issue six years later? Just as in the case of gold, the analysis allowedthe analyst to anticipate a monster Bull Market. On http://www.edwards-magee.com,the authors wrote letters all during this time pointing out the silver Bull. Measuringthe entire formation, the depth is 33.96, added to the neckline of 37.5 equals 71.46.This seems quite fanciful to us, but that is t", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 110}
{"text": "value of chartslooking at the issue six years later? Just as in the case of gold, the analysis allowedthe analyst to anticipate a monster Bull Market. On http://www.edwards-magee.com,the authors wrote letters all during this time pointing out the silver Bull. Measuringthe entire formation, the depth is 33.96, added to the neckline of 37.5 equals 71.46.This seems quite fanciful to us, but that is the measurement.\nin broadly trending markets. Will the Turtle system still work? Yes, in broadlytrending markets. Plus, like virtually all mechanical systems, they do not knowwhether they are in a broadly trending market or not. They are blind—all they see areones and zeros. The addition to these systems of prudently applied chart analysis willimmeasurably improve their performance and risk characteristics.\nThe application of Edwards and Magee's methods to 21st-century futuresmarkets\nDuring my career as a commodity trading advisor, I have known a number ofsuccessful traders and advisors who used what I would describe as Magee-type chartanalysis to make their trades. Often, other elements were input into their decision-making process, but manual charting was a key factor in their operations. Some ofthese traders used simple trendline analysis with price or volume filters and someused a combination of trendlines and support and resistance. All were trend followers.\nHaving looked at the futures markets with some attention over the past several years,it seems to me there is no reason why chart analysis should not work as well now infutures as it has always worked in stocks. Essentially, the questions raised bysecurities trading are the same as those presented by futures trading in the analysis ofa chart. Is there a trend? Where are support and resistance? Is there a breakout? Arethere waves and wavelets? How do you enter and how do you exit?\nThe great bug-a-boo of securities traders coming to the futures trading is the speed ofthe game. Like college football players stepping up to the NFL, there is a brutallearning curve and rookies are the most likely to get killed. I am not going to makeany effort here to present a primer for new futures traders, but rather, I will look atsome futures charts at the end of this chapter to show the journeyman that chartanalysis can be used\nFigure 16.8 Treasury Bonds. The double-pump triple-nod head fake is a specialty offutures markets. The fear and greed factor are multiplied by 10, like the leverage. Buthere in September 2004 Bonds, we can see how simple chart analysis can serve thetrader. The downtrend from March (1) is completely manageable with a simpletrendline and trend analysis. The end of the downtrend in May is marked by twostrong run days. At any rate, the stop would have been at May 1, using a Basing Pointkind of analysis. If we were going to trade it long, this would have been traded for ascalp (because we do not know whether or not there is a bottom). The break of thetrendline at 2 is an engraved invitation to get long and the trendline at 3 keeps us longuntil broken by the signal day at the end of July. This would put us short again,whereas a two-day trade as the signal day on the trendline at 4 puts us long again.Obviously, we are using very tight, short trendlines and long-range days (or run days)as signals. The use of the run day as a signal, combined with other indicators, iscommon in my experience among traders.\nas a decision-making method in these dramatic markets. Again, chart analysis has theweakness (or strength) of being a qualitative process. It will not make decisions forthe average trader, as a mechanical system will.\nOn the other hand, a breakout is a breakout. A gap is a gap, leaving aside the questionof limit move gaps for the moment. A trend is a trend. And here is the great advantage\nthat a firm grasp of charting methods can give the practitioner. It can give him theperspective to recognize the essential nature of the market at hand and choose to waitor to enter. Mechanical methods not having the qualitative discrimination of anexperienced chartist will blindly take every trade until they are out of money. Theexperienced chart analyst can sit back and say, this market has not yet made a bottomand the time to begin trading it long has not yet come. Or, he can recognize theessential differences between a trading and a trending market and adjust his tacticsaccordingly. As Magee noted in Chapter 16:\nUnder what might be called normal market conditions, those chart patterns whichreflect trend changes in most simple and logical fashion work just as well withcommodities as with stocks. Among these we would list Head-and-Shouldersformations, Rounding Tops\n\n306\n303\n300\n297\n294\n291\n288\n285\n282\n279\n276\n273\n270\nIsi 1998-2004 Prophet Financial Systems, Inc. I Terms of use apply.\nFigure 16.9 Commodity Research Bureau Index, April 2005 Futures. Just asTriangles often work in securities, they often work in futures. Breakaway gap, secondbreakaway gap, runaway gap, second runaway gap—this is the formation before thesecond runaway gap is somewhat quizzical—it might be considered a flag, but it hasthe same effect, and depending on the trader's operating methods, the stop would bejust under the gap/run day anyway. It will not take much study for the reader to seethe principles of chart analysis used in this entire book are validated here. The maindifference is in the setting of stops, and in fact, the same stop methods may be used ifthe trader is sufficiently well financed.\nand Bottoms, and basic trendlines. Trendlines, in fact, are somewhat better definedand more useful in commodities than in stocks. Other types of chart formations whichare associated with stocks with short-term trading or with group distribution andaccumulation, such as the Triangles, Rectangles, Flags, etc., appear less frequently incommodities and are far less reliable as to either direction or extent of the ensuingmove. Support and Resistance Levels, as we have already noted, are less", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 111}
{"text": "useful in commodities than in stocks. Other types of chart formations whichare associated with stocks with short-term trading or with group distribution andaccumulation, such as the Triangles, Rectangles, Flags, etc., appear less frequently incommodities and are far less reliable as to either direction or extent of the ensuingmove. Support and Resistance Levels, as we have already noted, are less potent in\ncommodities than in stocks; sometimes they seem to work to perfection, but just asoften they don't. For similar reasons, gaps have relatively less technical significance.\nThese words remain true today, as do virtually all the principles enunciated in thisbook by Edwards and Magee and myself. In fact, if most futures charts were given toan\nFigure 16.10 Commodity Research Bureau (CRB), long-term view. It does not takemuch analysis of this 10-year CRB chart to see a huge Double Bottom and to considerits implications. If China and India are going to compete with us for natural resources,we could see an entirely new economic paradigm, if the reader will excuse the term.Clearly, there is a Bull market in commodities. In Chapter 42, Pragmatic PortfolioManagement, it is suggested that capital should flow to markets that are moving,rather than remaining committed to markets that are mired in mulish trends.Furthermore, it is suggested in that chapter that a good natural hedge is to go long onthe uptrend of an index and short the components of it that are in downtrends. TheCRB is somewhat thin but might lend itself to this strategy.\nFigure 16.11 The 20-year bonds as expressed in the TLT; ETF Bonds displayclassical signals of absolute clarity.\nFigure 16.12 September, 1994. Coffee was so easy in retrospect that it should beengraved on a brass plate. The long is taken on the breakout of the horizontaltrendline. The position is never in any danger, as there is no down-wave ofsignificance until May when stops are advanced to stay 5% under lows (Basing\nPoints). The May down-wave allows a Basing Point stop to be established. Thebreakaway gap is a windfall profit. The flag tells us that more is coming—as it doeswith another gap and run days—until the spike reversal, which is a clear signal to beout on the close. A gap up on the open, an exploration up, and a close down—anabsolutely clear message of reversal from the market.\n256 Technical Analysis of Stock Trends\nFigure 16.13 The May 11 top in silver. In the first quarter of 2011, silver took off in aroaring uptrend. Any surprise here, after looking at the Bounding Bottom? As seen inthe chart, it came near to going parabolic. The top notice came on April 25—interestingly on a reversal bar. Reading the Candlestick, the market gapped wide onthe opening and took a long excursion down to close the opening gap. Then bargainhunters thought they were getting a good price on silver and drove the price back up,so it did not close on the lows. The next day, it gapped down on the open andbasically wandered down all day long—the party was over. The signs were subtle.\nChapter sixteen: Technical analysis of commodity charts 257\nanalyst, without issue identification and dates would not be identifiable as commoditycharts. When limit moves appear, the difference slaps one in the face. On this point Imight differ from Magee slightly as regards to gaps. Obviously, limit move gaps havebreathtaking significance. All in all, it seems to me gaps often say the same thing tofutures analysts as they do to stock analysts.\nAnother mathematical reason might be adduced for the practicality of using simplechart analysis to trade futures. That is the tautological nature of the method. A trend isa trend, and a trendline is a trendline. If you enter a suspected trend (setting a\nprotective stop at a technically analyzed place) and follow the trend using BasingPoints or observing the trendline and exiting on a break and reversal there will be nodifference from doing the same with a stock. Well, some difference. Due to theleverage, you will be required to be hyperaware of risk. In futures, the penalty forholding a position through “a normal reaction” can be extremely harsh. That is whystops are so important.\nThe TLT chart from late 2008 is a spectacular display of patterns and signals. Thispattern has appeared many times before and will appear again in the future.\nPrices break out of a sideways pattern on a strong gap. The gap is across the trendline,which is what makes the signal significant. Every gap is not a signal. In this case, thegap is extra significant because there is a power bar on the gap day—it should bebought. This is called a breakaway gap. Prices continue to progress, and a few dayslater another gap occurs. This is a runaway gap and is another signal.\nShortly thereafter, prices drift sideways for a few days. This is a flag. Flags are vividmessages to traders. Robert Edwards described how they are used. He said, “The flagflies at half-mast,” meaning after a rocket-like advance and this formation, pricesshould advance on at least as far as they had come.\nPower bars (signals) exit from the flag, and then another gap occurs. This is theexhaustion gap. This is a message to exit longs and to short the issue. The messagecould not have been clearer.\nThe skilled trader, first of all, catches the original signal—the power bar exiting fromthe sideways pattern. He then pyramids on the subsequent signals. Exiting from theflag, a good trader should have a boatload of this issue, and at the top, selling after theexhaustion gap, he should have made at least a small killing.\nStops\nSome traders set their stops using money management rules rather than technicallyidentified points. I believe it is always better to find the technical point using a BasingPoint, or support and resistance. To me it makes better sense to adjust position size tocontrol risk as I describe in Chapter 26. The use of money management stops hasbeen very successful for many traders. If some logical and disciplined method o", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 112}
{"text": "heir stops using money management rules rather than technicallyidentified points. I believe it is always better to find the technical point using a BasingPoint, or support and resistance. To me it makes better sense to adjust position size tocontrol risk as I describe in Chapter 26. The use of money management stops hasbeen very successful for many traders. If some logical and disciplined method ofsetting and observing stops is not installed, the trader is assured of failure.\nA money management stop is, simply enough, a stop calculated by deciding to risk2% (or 3% or 4% or x%) of capital on a trade. For example, William O'Neil says thatwhen a stock trader enters a position, he should set a stop 8% under his entry price.\nThis is a little crude, and not strictly speaking, a money management stop, but it isbetter than no risk calculation at all. In a stricter sense, if we said we wanted to limitthe risk of the trade to 3% of capital, we would use the 8% rule to set the stop and theScott Procedure in Chapter 26 to determine the number of shares or contracts. TheTurtle system contains similar procedures. Numerous studies have proven the size ofthe risk per trade—1%, 2%, 3%—is directly correlated to equity volatility.\nThe 25th looked like a reversal day. The gap down on the 26th could have beenconsidered the closing of an exhaustion gap—not apparent here because the tails(shadows) of the candlesticks obscure the complete price behavior.\n(EN10: In the 10th edition, a new section on stops in Chapter 27 examines a numberof stop methods.)\nA variety of methods\nAs noted above, a competent chart analyst may, in my opinion (and in Magee'sopinion), perform profitably in the futures markets. There are other questions, ofcourse, namely of character, temperament, intelligence, judgment, and so on. Let usleave those questions to Dr. Elder and confine ourselves to the method question. Chartanalysts proved their abilities in the futures markets long before computers existed. Infact, long before in the case of Japanese rice traders, enlightening their efforts withcandlesticks in the eighteenth century.\nIn the 1970s, I saw point and figure chartists enjoy great success at Dean Witter andMerrill Lynch and other major firms in futures. I have seen least squares curve fitters,moving average calculators, and abstruse statistical analysts all enjoy profitableoutings in commodities. Not to speak of the Turtles who, using naturalistic high-lowsystems, harvested good profits in the markets. As the saying goes, gateless is the gateand many are the ways to the great Dow. Although I have enjoyed great successmyself using mechanical number-driven systems over the years, I have become moreand more attracted to “natural” systems. Chart analysis is essentially natural, as is theTurtle system. The Dow Theory is a natural system in which no mathematicalalgorithm comes between the analyst and the data. The essential, more, quintessential,weakness of all number-driven systems is their blindness. They do not have the abilityto discriminate between the forest and the trees. The experienced human chartist cansee (and hear) the changing rhythms of the market and respond to them, responding tofactors too subtle (and even subconscious) to program. Nevertheless, even naturalsystems, like the Turtle systems, can fall into this trap. When the markets learn a lotof capital is waiting just above the 20-day high, they will set a trap for it. For“markets” you may read “they.” If you apply the knowledge of this book to suchsituations, you may avoid the trap.\nEverything you need to know as a chart analyst trading futures\n“Jack be nimble, Jack be quick, Jack jump over the Candlestick.” Yes, it is true, as theleverage is 10 times greater and the speed is 10 times faster. I have illustrated inFigure 16.9 the combination of a very tight trendline with a run day, which it seems tome is a good current (twenty-first century) combination. Otherwise, the same qualitiesthat make a good securities trader make a good futures trader once the great leap toleveraged quick-fire markets is made. If you have been successful trading stocks, youwill probably be successful trading futures, and you probably should practice onstocks while studying futures. A sobering fact I often recount to my graduate studentsis that Richard Wyckoff worked in the securities business for eight years beforemaking his first investment; he studied the markets an additional six years beforetrading.\nThe Magee methodology will serve as a valuable cornerstone of your futuresoperations and you must never cease studying. Mechanical systems have theirattractions, especially when seasoned with experienced chart analysis. No methodwill survive unless practiced with diligence, persistence, judgment, and patience.Time and again you will hear famous traders say discipline is the secret of theirsuccess. What they mean by discipline is their ability to measure and contain the risk,set a stop based on technical or money management procedures, and then honor thestop. The most important lesson the futures trader has to learn from Edwards andMagee is the ability to see the character of the market, trading or trending, and then toadjust his tactics accordingly.\nIn the next great Bull Market in commodities, which is inevitable, these methods andsystems derived from them will once again reap windfall profits.\nI have attempted in the ninth edition of this classic book to show the book'susefulness to the intelligent futures trader. Simple classical chart analysis alone can besuccessful in the futures markets in the hands of an experienced competent analyst.Natural mechanical systems such as the Turtle system have been effective and will beagain, perhaps with some tweaking (such as imposing a chart analysis superstructure).Wave analysis methods such as the Basing Points Procedure of Chapter 28 can beused. Even number-driven systems, such as moving averages, can be successful,especially if combined with chart", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 113}
{"text": "hands of an experienced competent analyst.Natural mechanical systems such as the Turtle system have been effective and will beagain, perhaps with some tweaking (such as imposing a chart analysis superstructure).Wave analysis methods such as the Basing Points Procedure of Chapter 28 can beused. Even number-driven systems, such as moving averages, can be successful,especially if combined with chart analysis.\nchapter seventeen\nA summary and concluding comments\nWe began our study of technical stock chart analysis in Chapter 1 with a\ndiscussion of the philosophy underlying the technical approach to the\nproblems of trading and investing. We could ask the reader to turn back\nnow and review those few pages to recapture a perspective on the subject\nthat must have been dimmed by the many pages of more or less arduous\nreading that have intervened. (For illustrations in this chapter, see Figures\n17.1 through 17.4.)\nIt is easy, in a detailed study of the many and fascinating phenomena that\nstock charts exhibit, to lose sight of the fact they are only the rather\nimperfect instruments by which we hope to gauge the relative strength of\nsupply and demand, which, in turn, exclusively determines what way, how\nfast, and how far a stock will go.\nRemember, in this work, it does not matter what creates the supply and the\ndemand. The fact of their existence and the balance between them are all\nthat count. No man, no organization (and we mean this verbatim et\nliteratim) can hope to know and accurately appraise the infinity of factual\ndata, mass moods, individual necessities, hopes, fears, estimates, and\nguesses that, with the subtle alterations ever proceeding in the general\neconomic framework, combine to generate supply and demand.\nNevertheless, the summation of all these factors is reflected virtually\ninstantaneously in the market.\nThe technical analyst's task is to interpret the action of the market itself—to\nread the flux in supply and demand mirrored therein. For this task, charts\nare the most satisfactory tools thus far devised. Lest you become enrapt,\nhowever, with the mechanics of the chart— the minutiae of daily\nfluctuations—ask yourself constantly, “What does this action really mean in\nterms of supply and demand?”\nJudgment, perspective, and a constant reversion to first principles is\nrequired. A chart, as we have said and should never forget, is not a perfect\ntool nor a robot; it does not give all the answers quickly, easily, or\npositively, in terms anyone can read and translate at once into certain profit.\nWe have examined and tested exhaustively many technical theories,\nsystems, indexes, and devices that have not been discussed in this book\n(chiefly because they tend to shortcircuit judgment) to see the impossible by\na purely mechanical approach to what is far from a purely mechanical\nproblem. The methods of chart analysis that have been presented are those\nthat have proved most useful because they are relatively simple and easily\nrationalized since they stick closely to first principles. Additionally, they are\nof a nature that does not lead us to expect too much of them and they\nsupplement each other and work well together.\nLet us review these methods briefly. They fall roughly into four categories:\n1. The Area Patterns or formations of price fluctuation that, with their\nconcomitant volume, indicate an important change in the supply-demand\nbalance. They can signify Consolidation, a recuperation or gathering of\nstrength for renewed drive in the same direction as the trend that preceded\nthem. Or they can indicate Reversal, the playing out of the force formerly\nprevailing, and the victory of the opposing force, resulting in a new drive in\nthe reverse direction. In either case, they may be described as periods\nduring which energy is brewed or pressure is built up to propel prices in\nFigure 17.1 Spiegel's Bear Market started in April 1946 from a\nSymmetrical Triangle that changed into a Descending Triangle. Note the\nPullback in June and two Flags. This history is carried on in Figure 17.2,\nwhich overlaps Figure 17.1; this chart shows the move that ensued from the\nwide Descending Triangle of early 1947, culminating in a Reversal Day on\nMay 19. Note various Minor and Intermediate Resistance Levels.\nTechnical Analysis of Stock Trends\nFigure 17.2 Overlapping Figure 17.1, this chart shows the move that\nensued from the wide Descending Triangle of early 1947, culminating in a\nReversal Day on May 19. Note various Minor and Intermediate Resistance\nLevels.\nChapter seventeen: A summan/ and concluding comments\na move (up or down) that can be turned to profit. Some of them provide an\nindication as to how far their pressure will push prices. These chart\nformations, together with volume, furnish the technician with most of his\n“get-in” and many of his “get-out” signals.\nVolume, which has not been discussed in this book as a feature apart from\nprice action, and which cannot, in fact, be utilized as a technical guide by\nitself, deserves some further comment. Remember it is relative that it tends\nnaturally to run higher near the top of a Bull Market than near the bottom of\na Bear Market. Volume “follows the trend,” meaning it increases on rallies\nand decreases on reactions in an overall uptrend, and vice versa. But use\nthis rule judiciously; do not place too much dependence on the showing of a\nfew days and bear in mind that even in a Bear Market (except during Panic\nMoves), there is always a slight tendency for activity to pick up on rises.\n(“Prices can fall of their own weight, but it takes buying to put them up” as\nEdwards said.)\nA notable increase in activity, as compared with previous days or weeks,\nmay signify either the beginning (breakout) or the end (climax) of a move,\ntemporary or final. (More rarely, it may signify a “shakeout.”) Its meaning,\nin any given case, can be determined by its relation to the price pattern.\n2. Trend and trendline studies supplement Area Patterns as a means of\ndetermining the general dire", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 114}
{"text": ")\nA notable increase in activity, as compared with previous days or weeks,\nmay signify either the beginning (breakout) or the end (climax) of a move,\ntemporary or final. (More rarely, it may signify a “shakeout.”) Its meaning,\nin any given case, can be determined by its relation to the price pattern.\n2. Trend and trendline studies supplement Area Patterns as a means of\ndetermining the general direction in which prices are moving and of\ndetecting changes in direction. Although lacking the nice definition of Area\nFormations, they may frequently be used for “get-in” and “get-out”\npurposes in short-term trading, as well as provide a defense against\npremature relinquishment of profitable long-term positions.\n3. Support and Resistance Levels are created by the previous trading and\ninvestment commitments of others. They may indicate where it should pay\nto take a position, but their more important technical function is to show\nwhere a move is likely to slow down or end, and at what level it should\nencounter a sudden and important increase in supply or demand.\nBefore entering a trade, look both to the pattern of origin for an indication\nof the power behind the move and to the history of Support-Resistance for\nan indication as to whether it can proceed without difficulty for a profitable\ndistance. SupportResistance studies are especially useful in providing\n“cash-in” or “switch” signals.\n4. Broad market background, including the Dow Theory, should not be\nscorned. This time-tested device designates the (presumed) prevailing\nMajor Trend of the market. Its signals are “late,” but with all its faults (like\nthe greatly augmented following it has acquired in recent years resulting in\na considerable artificial stimulation of activity at certain periods), it is still\nan invaluable adjunct to the technical trader's toolkit.\nThe general characteristics of the various stages in the stock market's great\nPrimary Bull and Bear cycles, which were discussed in our Dow Theory\nchapters, should never be lost to view. This brings us back to the idea of\nperspective, which we emphasized as essential to successful technical\nanalysis at the beginning of our summary. The stock that does not, to some\ndegree, follow the Major Trend of the market as a whole is an extraordinary\nexception. More money has been lost by buying perfectly good stocks in the\nlater and most exciting phases of a Bull Market, and then selling them,\nperhaps from necessity, in the discouraging conditions prevailing in a Bear\nMarket, than from all other causes combined.\nHence, keep your perspective on the broad market picture. The basic\neconomic tide is one of the most important elements in the supply-demand\nequation for each individual stock. It may pay to buck “the public,” but it\ndoes not ever pay to buck the real underlying trend.\nMajor Bull and Bear Markets have recurred in fairly regular patterns\nthroughout all recorded economic history, and there is no reason to suppose\nthey will not continue to recur for as long as our present system exists. It is\nwell to keep in mind that caution is in order whenever stock prices are at\nhistorically high levels and that purchases will usually work out well\neventually when they are at historically low levels.\nIf you make known your interest in your charts, you will be told the chart\nanalyst (like the Dow theorist) is always late—buying after prices have\nalready started up (maybe not until long after the “smart money” has\ncompleted its accumulation) and sells after the trend has unmistakably\nturned down. Partly true, as you have no doubt already discovered for\nyourself. The secret of success lies not in buying at the very lowest possible\nprice and selling at the absolute top, but rather in the avoidance of large\nlosses. (Small losses you will have to take, and as quickly as possible as\nwarranted by the situation.)\nOne of the most successful “operators” Wall Street has ever seen, Bernard\nBaruch, a multimillionaire and a nationally respected citizen today, is\nreputed to have said never in his entire career had he succeeded in buying\nwithin 5 points of the bottom or selling within 5 points of the top! (EN: For\nperspective, the 5 points mentioned constituted roughly 10% of the market\nat that time.)\nBefore we leave this treatise on theory and proceed to the more practical\nmatters of application and market tactics that are the province of Section II\nof this book, the reader will, we hope, forgive one more admonition. There\nis nothing in the science of technical analysis that requires one always to\nhave a position in the market. There is nothing that dictates something must\nhappen every day. There are periods—sometimes long months—when the\nconservative trader's best policy is to stay out entirely. What is more there is\nnothing in technical analysis to compel the market to go ahead and\ncomplete (in a few days) a move the charts have foretold; it will take its\nown good time. Patience is as much a virtue in stock trading as in any other\nhuman activity.\nTechnical analysis and technology in the 21st century: the\ncomputer and the internet: tools of the investment/information\nrevolution\nThe purpose of this section is to put computer and information technology\ninto proper context and perspective for chart-oriented technical analysts.\nIn John Magee's time, in his office in Springfield, Massachusetts, there was\na chart room—a room filled with all-age chartists from teenagers to senior\ncitizens. These people spent all their time keeping charts and assisting\nMagee in interpretation. These were wonderful and intelligent people who\ndeveloped marvelous insights into the stocks they charted as well as created\nthe manual charts that adorn this book.\nToday, that room and all those technicians have been replaced by a beige\n(sometimes lime) box that sits crowded on our desktops and that is often\nworshipped as a fount of insight and wisdom: “Computer, analyze my\nstocks.”\nUnfortunately, the computer does not have the discrimination and pattern", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 115}
{"text": "arvelous insights into the stocks they charted as well as created\nthe manual charts that adorn this book.\nToday, that room and all those technicians have been replaced by a beige\n(sometimes lime) box that sits crowded on our desktops and that is often\nworshipped as a fount of insight and wisdom: “Computer, analyze my\nstocks.”\nUnfortunately, the computer does not have the discrimination and pattern\nrecognition ability of the people in that chart room. Undeterred by this\nweakness in computer technology, traders and investors have poured\nincalculable money and effort into computer-aided research, attempting to\ndiscover the keys to market success. More money has been spent in this\neffort than was ever put into the search for the philosopher's stone. Much of\nit was wasted, but it has not all been spent in vain. In some areas, it has\nbeen quite productive. But no fail-safe algorithm, in spite of all this effort,\nhas been found for investment success, and certainly not for stock trading.\nThe research has demonstrated that even the algorithm of “buy low, sell\nhigh” has fatal flaws in it.\nTo fully understand the importance of the computer, the reader should\nappreciate some basic differences in participants' approach to the markets,\nor, we might say, schools of analysts and investors. We will not bother with\nfundamental analysts here, as they are of a different religious persuasion.\nChart analysts, or Magee-type technical analysts, pretty much confine their\nanalysis of the market to the interpretation of bar charts. (This does not\nmean their minds must be closed to other inputs. On the contrary—anything\nthat works.) Another chart analyst school uses point and figure charts, and\nanother candlestick charts. Another breed of technical analysts takes basic\nmarket data, price and volume, and uses them as the input to statistical\nroutines that calculate everything from moving averages to mystically\ndesignated indicators like %R or Bollinger Bands (see Glossary); they are\nknown as statistical or number-driven technical analysts. All these analysts\nattempt to invest or trade stocks and other financial instruments (not\nincluding options) using some form of what is called technical analysis—\nthat is, they all take hard data that people cannot lie about, misrepresent,\nand manipulate, (unlike the data inputted to fundamental analysis like\nearnings, cash flow, sales, etc.) as input to their analysis.\nUsing number-driven or statistical technical analysis, these latter schools\nattempt, just as chart analysts do, to predict market trends and trading\nopportunities. This can be more than a little difficult because the stock and\nbond markets are behavioral markets driven by human emotion, perhaps the\nmost important of many variables influencing price. Plus, human emotion\nand behavior dictates manic and depressive elements, which have not yet\nbeen quantified. Yet, some chart analysts believe they can recognize it when\nthey see it on the charts.\nIn another area, the computer has yielded much more dramatic and\nprofitable results, but that is in a model-driven market, namely the options\nmarkets. Quantitative analysts, those who investigate and trade the options\nmarkets, are a breed apart from technical analysts. In an interesting irony,\nemotion-driven markets, the stock markets, are used as the basis for\nderivatives, or options, whose price is determined largely by the operation\nof algorithms called “models;” for example, the Black Scholes model.\nQuantitative analysts believe, as does this editor, the options markets can be\nsuccessfully gamed through quantitative analysis. Results of skilled\npractitioners indicate this belief is accurate.\nAlas, life is not so simple for the simple stock trader. Stock prices having\nnothing to do with mathematics, except for being expressed as natural\nnumbers, are not susceptible to easy prediction as to their future direction.\nNot even with Magee chart analysis or any other form of analysis—\ntechnical, fundamental, or psychic. (From a theoretical point of view, each\ntrade made on the basis of a chart analysis should be looked at as an\nexperiment made to confirm a probability. The experiment is ended quickly\nif the trend does not develop.) The fact chart analysis is not mechanizable is\nimportant. It is one reason chart analysis continues to be effective in the\nhands of a skilled practitioner. Not being susceptible to mechanization,\ncounterstrategies cannot be brought against it, except in situations whose\nmeaning is obvious to everyone, for instance, a large important Support or\nResistance Level or a glaringly obvious chart formation. These days\neveryone looks at charts to trade even if they do not believe in their use. In\nthese obvious cases, some market participants will attempt to push prices\nthrough these levels to profit from volatility and confusion. Indeed, human\nnature has not changed much since Jay Gould and Big Jim Fisk.\nWhen these manipulations of price occur, they create false signals—Bull\nand Bear traps. Interestingly, the failure of these signals may constitute a\nreliable signal in itself—but in the direction opposite to the original signal.\nThe importance of computer technology\nOf what use and importance then is this marvelous tool—the most\ninteresting tool man (homo) has acquired since papyrus? (Numerous\ncomputer software packages available are capable of executing the\nfunctions described in the following discussion.) If the computer cannot\ndefinitively identify profitable opportunities, what good is it?\nProbably the most important function the computer has for the Magee\nanalyst is the automation of rote detail work. Data can be gathered by\ndownloading from database servers. Charts can be called up in an instant.\nPortfolio accounting, maintenance, and tax preparation can be disposed of\nwith one hand while drinking coffee with the other. All in all, this might\nmake it sound as though the computer is a great tool, but with a pretty dull\nedge. Not strictly true. There is at l", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 116}
{"text": "s the automation of rote detail work. Data can be gathered by\ndownloading from database servers. Charts can be called up in an instant.\nPortfolio accounting, maintenance, and tax preparation can be disposed of\nwith one hand while drinking coffee with the other. All in all, this might\nmake it sound as though the computer is a great tool, but with a pretty dull\nedge. Not strictly true. There is at least one great leap forward for Magee\nanalysts with this tool, leaving aside the rote drudgery it saves. This great\nadvantage is portfolio analysis. In Appendix B, Resources, a complex\nportfolio analysis of the kind used by professional traders (Blair Hull and\nOptions Research Inc.) is illustrated. Even simpler portfolios of the average\ninvestor can benefit from the facilities afforded by most portfolio programs,\neither on the net or in commercial software packages (locations and\nsoftware identified in Appendix B, Resources).\nAnother advantage is the ability to see basic data displayed in many\ndifferent forms: point and figure charts, candlestick charts, close-only charts\n—these are prepared in the flick of an eyelash and may indeed contribute to\nunderstanding the particular situation under the magnifying glass. The\neffortless quantification of some aspects of analysis may be useful—volume\nstudies, for instance, and given the popularity of moving averages, seeing\nthe 50- and 200-day moving averages can be interesting. These moving\naverages are considered significant by many market participants—even\nfundamental analysts. The analysis of any of these should be considered in\nrelation to the current state of the market as understood by the careful chart\nanalyst.\nBut what about (the strangely named) stochastics, Bollinger Bands, %R,\nMACD, Moving Averages (plain vanilla, exponential, crossover, etc.),\nprice/volume divergence, RSI (plain vanilla and Wilder), VP Trend, TCI,\nOBV, Upper/Lower Trading Bands, ESA Trading Bands, and AcmDis?\nWell, there is a certain whiff of alchemy to some of them, and some have\nsome usefulness sometimes. What is more, all systems work beautifully at\nleast twice in their lives: in research and in huge monumental Bull Markets.\nThese number-driven indicators are also the times when trading genius is\nmost likely to be discovered. (EN9: It is also true, as I have said, that you\ncan drive a nail with a screwdriver. And the inventor of a tool may be\nfabulously successful with it while its adopters lose their assets.)\nIt is also possible the excess of technical information created by these\nindicators may be like the excess of fundamental information—another\nshell to hide the pea under, another magician's trick to keep the investor\nfrom seeing what is truly important, and what is necessary and sufficient to\nknow to trade well. Perhaps the investor would be better off with a\nbehavioral model because the markets are behavioral. Number-driven\ntechnical analysis can do many things, some like Dr. Johnson's dog, which\nwalked on its hind legs, but they cannot put the market in perspective—only\nthe human mind can do that. Number-driven models after all do not\nconsider skirt lengths, moon cycles, sun spots, the length of the economic\ncycle, or the Bullish or Bearish state of the market (if Bear Markets still\nexist) (EN9: A wry ironical comment written before the market crash of the\n2000s.) In the end, the human brain is still the only organ capable of\nsynthesizing all this quantitative and qualitative information and assessing\nthose elements that cannot be reduced to ones and zeros. The educated mind\nis still the best discriminator of patterns and their contexts.\nSummary 1\nThe computer is a tool, a powerful tool, but a tool nonetheless. It is not an\nintelligent problem solver or decision maker. We use a mechanical ditch\ndigger to dig a ditch, but not to figure out where the ditch should be.\nThe multitude of indicators and systems should be viewed with a skeptical\neye and evaluated within the context of informed chart analysis. Sometimes\nan indicator or technique will work for one user or its inventor but strangely\nmislead the chart analyst who tries to use it—or buys it, even based on a\nverified track record.\nTherefore, the experienced investor keeps his methods and analysis simple\nuntil he has definitive knowledge of any technique, method, or indicator he\nwould like to add to his repertoire. Most of all, he depends on his own\nobservations and experience to evaluate his and others' trading techniques.\nOther technological developments of importance to the technical\nMagee analyst and all investors\nThe computer is not the only technological development of interest to the\ntechnical investor. A number of information revolution technologies need to\nbe put in perspective. These are, in broad categories, the internet and all its\nfacilities, developments in electronic markets, and advances in finance and\ninvestment theory and practice. This last is treated in the final section of this\nchapter.\nOwing to the enormous body of material on these subjects, no attempt will\nbe made to explore these subjects exhaustively, but the general investor will\nbe given the information he needs to know to put these subjects in their\nproper perspective. Resources will point the analyst to avenues for further\ninvestigation if the need is felt.\nFirst of all, are there any technological developments of whatever sort that\nhave made charting obsolete? No. Are there any developments that have\nmade trading a guaranteed success? No. The only sure thing is some\nhuckster will claim to have a sure thing. Those who believe such claims are\nthe victims of their own naivete.\nThe Internet: the eighth wonder of the modern world (EN9: Appendix B,\nResources, for the ninth edition has been enormously expanded and is of\nparamount importance to modern investors.)\nThe internet has been called the most complex project ever built by man,\nwhich is probably true. Complex, sprawling, and idiosyncratic, it has\nsomething for everyone, especially the", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 117}
{"text": "the victims of their own naivete.\nThe Internet: the eighth wonder of the modern world (EN9: Appendix B,\nResources, for the ninth edition has been enormously expanded and is of\nparamount importance to modern investors.)\nThe internet has been called the most complex project ever built by man,\nwhich is probably true. Complex, sprawling, and idiosyncratic, it has\nsomething for everyone, especially the investor. Every form of investment\ncreature known to man has set up a site on the internet and waits like the\nhungry arachnid for the casual surfer: brokers and advisors—technical and\nfundamental; newspapers, news magazines, newsgroups, and touts; mutual\nfunds, mutual fund advisories, critics and evaluators of all the above;\ndatabase vendors, chat rooms, electronic marketplaces and exchanges, and\nExchange Traded Notes (ECNs)—the only unfilled niche that seems to exist\nis investment pornography. Perhaps naked options will be able to satisfy\nthis need.\nThis is a bewildering array of resources. How does one sort them out? The\nimplications of all this for the electronic or cyber investor may be further\nexpanded to indicate the services and facilities available: quotes and data;\nportfolio management and accounting; online interactive charting;\nautomatic alerts to PBDAs (personal body digital assistants or gizmos\ncarried on the body, for example, cell phones and handheld computers, and\nso on); analysis and advice; electronic boardrooms; and electronic\nexchanges where trading takes place without intermediaries. Appendix B,\nResources, supplies the specifics on these categories while this chapter\nsupplies perspective. It is one thing to contemplate this cornucopia of\nfacilities and another thing to appreciate the importance and priority of its\nelements. What good are real-time quotes if you are only interested in\nreviewing your portfolio once a week, except for special occasions? What\ngood are satellite alerts and virtual reality glasses to a long-term investor? It\nis easy for the investor with no philosophy or method to be drawn into the\nmaelstrom of electronic wonders and stagger out of it a little wiser and\nmuch poorer.\nObserve then the goods and services of all of this are of importance to the\nlevelheaded investor with his feet on the ground and his head out of the\nclouds (or Cloud). This, hopefully not, abstract investor, the object of our\nattention here, needs what? He needs data, charts, and a connection to a\ntrading place. Data are available at the click of a mouse. A chart occupies\nthe screen in another click. Another click and a trade is placed. In the\nInternet Age, it would be tautological to attempt to describe this process in\nprose when live demonstrations are as close as the desktop computer and an\ninternet connection. A demonstration of this rather simple process (easy to\nsay when one does it without thinking) may be seen at locations linked in\nAppendix B, Resources. The trade will be made, of necessity, through a\nbroker of some sort, perhaps an electronic broker or even a non-virtual\nbroker who communicates via telephone. This will occur shortly, if not\nalready, an electronic pit where one matches wits with a computer instead\nof a market maker or specialist.\nHow long brokers will be necessary is a question that is up in the air in the\nnew century. (The broker who earns his keep will always be with us, and\nwelcome, too.) Electronic marketplaces where investors meet without the\nnecessity of a broker or specialist are already proliferating (see Appendix B,\nResources) and will continue to gain the advantage for the investor over the\ntrading pit, which is one of the last remaining edges the professionals hold\nover off-floor traders. Suffice it to say, their initial phases will undoubtedly\nbe periods of dislocation, risk, and opportunity as their glitches are ironed\nout.\nPlacing electronic orders, whether to an electronic exchange or to the New\nYork Stock Exchange, has certain inherent advantages over oral orders. No\none can quarrel about a trade registered electronically as opposed to orally\nwhere the potential for disagreement exists. In addition, the trader has only\nhandled the data once—rather than making an analysis, calling a broker,\nrecording the trade, and passing it to the portfolio. If he just hits the trade\nbutton and the transaction is routed through his software package, no one\nwill have any doubt as to where an error might lie. The manual method\npresents an opportunity for error at each step. Rest assured, errors occur and\ncan be disastrous to trading.\nThe efficiency and ease of the process with a computer have much to\nrecommend it— automation of trade processing, elimination of confusion\nand ambiguities, audit tracks, automation of portfolio maintenance, and,\nperhaps most important of all, automatic mark-to-market of the portfolio\n(the practice of valuing a portfolio at its present market value whether\ntrades are open or closed).\nMarking-to-market\nThis book might have been entitled Zen and the Art of Technical Analysis if\nthat title were not so hackneyed and threadbare. It conveys, nonetheless, the\nmessage of Zen in the art of archery, that of direct attachment to reality and\nthe importance of the present moment. In his seminal book The General\nSemantics of Wall Street (now Winning the Mental Game on Wall Street),\nJohn Magee inveighed at some length against the very human tendency to\nkeep two sets of books in the head—one recording profits, open and closed,\nand another recording losses, but only closed losses. Open losses were not\nlosses until booked. Having an electronic portfolio accountant that refuses\nto participate in such self-deception has much to recommend it. If the\nportfolio is always marked to the market when the computer communicates\nwith the data vendor, or the trade broker, it is difficult not to see red ink, and\nto see the equity of the account reflects all trades, open and closed.\nSeparating the wheat from the chaff\nIt requires a gimlet-eyed investor to pick his", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 118}
{"text": "untant that refuses\nto participate in such self-deception has much to recommend it. If the\nportfolio is always marked to the market when the computer communicates\nwith the data vendor, or the trade broker, it is difficult not to see red ink, and\nto see the equity of the account reflects all trades, open and closed.\nSeparating the wheat from the chaff\nIt requires a gimlet-eyed investor to pick his way through the minefield of\ntemptations in electronic investing and number-driven technical analysis.\nPlaying with the toys, seeing what the pundits have to say, and fiddling with\n“research” can subtly replace profitable trading as the activity. Actually,\nalmost all the research the Magee analyst must do is addressed in this book.\nChaff\nChat rooms, touts, news, predictions, punditry, brokerage house buy, sell,\nhold, strong hold, weak buy, strong buy, and any other species of brokerage\nhouse recommendation should be taken at face value. Remember, brokerage\nfirms survive by selling securities and make their money in general on\nactivity. Actually, much of their money is made servicing their institutional\nclients and distributing their clients' shares to their retail clientele—a blatant\nconflict of interest that blew up in their faces in the early 2000s, resulting in\nmany fines and some jail terms (plus ga change ... ). In the surging Clinton-\nGore Bull Markets of the 1990s, all of these worked. In a serious Bear\nMarket, none of them will work. (EN9: A serious Bear Market started in\nearnest in 2000 and was correctly identified with Magee chart analysis as\nmay be seen from the John Magee Letters at the http://www.edwards-\nmagee.com.)\nSummary 2\nNever in the history of the markets have so many facilities for private\ninvestors been available. The computer is necessary to take advantage of\nthose facilities.\nData may be acquired automatically via internet or dial-up sites at little or\nno cost. A (as they say) plethora of websites offer cyber investors\neverything from portfolio accounting to alerts sent to their personal body-\ncarried devices (cell phones, pagers, handheld PDAs, and so on). Some of\nthese even offer real-time data, which is a way for the unsophisticated\ntrader to go broke in real time. Many of these sites offer every kind of\nanalysis from respectable technical analysis (usually too complicated) to\nextraterrestrial channeling.\nInternet chat rooms will provide real-time touting and numerous rumors to\nsend the lemmings and impressionable scurrying hither and yon. But, one\nexpects, not the readers of this book.\nOf more importance, the information revolution and the computer will:\n1. Relieve the analyst of manual drudgery, accelerate all the steps of\nanalysis: data gathering, chart preparation, portfolio accounting, and\nanalysis and tax preparation.\n2. Give the analyst virtually effortless portfolio accounting and mark-\nto-market prices—a valuable device to have to keep the investor from\nmixing his cash and accrual accounting, as Magee says.\n3. Enable processing of a hitherto unimaginable degree. An unlimited\nnumber of stocks may be analyzed. Choosing those to trade with a\ncomputer will be dealt with in Chapter 21, Selection of Stocks to\nChart.\n4. Allow the investor to trade on ECNs or in electronic marketplaces\nwhere there are no pit traders or locals to fiddle with prices.\nAdvancements in investment technology, part 1: developments in\nfinance theory and practice\nNumerous pernicious and useless inventions, services, and products litter\nthe internet and the financial industry marketplace; but modern finance\ntheory and technology are important and must be taken into consideration\nby the general investor. This chapter will explore the minimum the\nmoderately advanced investor needs to know about advances in theory and\npractice. And it will point the reader to further resources if he desires to\ncontinue more advanced study.\nInstruments of limited (or non) availability during the time of Edwards and\nMagee included exchange traded options on stocks, futures on averages and\nindexes, options on futures and indexes, and securitized indexes and\naverages, as a partial list of only the most important instruments.\nUndoubtedly, one of the most important developments of the modern era is\nthe creation of trading instruments that allow the investor to trade and\nhedge the major indexes. Of these, the instruments created by the Chicago\nBoard of Trade (CBOT®) are of singular importance. These are the CBOT®\nDJIASM Futures and the CBOT® DJIASM Futures Options, which are\ndiscussed in greater detail at the end of this chapter. (EN9: Not so singular,\nperhaps. Probably of greater importance to readers of this book are the\nAMEX iShares, particularly DIA, SPY, and QQQ, which are instruments\n(ETFs) that offer the investor direct participation in the major indexes as\nthough they were stocks.)\nGeneral developments of great importance in finance theory and practice\nare found in the following sections.\nOptions\nFrom the pivotal moment in 1973 when Fischer Black (friend and college\nclassmate) and his partner, Myron Scholes, published their—excuse the\nusage—paradigm-setting Model, the options and derivatives markets have\ngrown from negligible to trillions of dollars a year. The investor who is not\ninformed about options is playing with half a deck. The subject, however, is\nbeyond the scope of this book, which hopes only to offer some perspective\non the subject and guides to the further study necessary for most traders and\nmany investors.\nSomething in the neighborhood of 30% or more of options expire\nworthless. This is probably the most important fact to know about options.\n(There is a rule of thumb about options called the 60-30-10 rule: 60% are\nclosed out before expiration, 30% are “long at expiration,” meaning they\nare worthless, and 10% are exercised.) Another fact to know about options\noccurred in the Reagan Crash of 1987; the money puts bought at $0.625 on\nOctober 16 were worth hundreds of dollars on October 19—if you could", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 119}
{"text": "mportant fact to know about options.\n(There is a rule of thumb about options called the 60-30-10 rule: 60% are\nclosed out before expiration, 30% are “long at expiration,” meaning they\nare worthless, and 10% are exercised.) Another fact to know about options\noccurred in the Reagan Crash of 1987; the money puts bought at $0.625 on\nOctober 16 were worth hundreds of dollars on October 19—if you could get\nthe broker to pick up the telephone and trade them. (The editor had a client\nat Options Research, Inc. during that time who lost $57 million in three\ndays and almost brought down a major Chicago bank; he had sold too many\nnaked puts.)\nThe most sophisticated and skilled traders in the world make their livings\n(quite sumptuous livings, thank you) trading options. Educated estimates\nhave been made that as many as 90% of retail options traders lose money.\nThat combined with the fact that by far it is the general public that buys\n(rather than sells) options should suggest some syllogistic reasoning to the\nreader.\nWith these facts firmly fixed in mind, let us put options in their proper\nperspective for the general investor. Options have a number of useful\nfunctions, such as offering the trader powerful leverage. With an option, he\ncan control much more stock than by the direct purchase of stock—his\ncapital stretches much further. So options are an ideal speculative\ninstrument (Exaggerated leverage is almost always a characteristic of\nspeculative instruments.), but they can also be used in a most conservative\nway—as an insurance policy. For example, a position on the long security\nside may be hedged by the purchase of a put on the option side. (This is not\na specific recommendation to do this. Every specific situation should be\nevaluated by the prudent investor with professional assistance as to its\nmonetary consequences.)\nThe experienced investor may also use options to increase yield on his\nportfolio of securities. He may write covered calls or naked puts on a stock\nto acquire it at a lower cost (e.g., he sells out of the money put options. This\nis a way of being long the stock; if the stock comes back to the exercise\nprice, he acquires the stock. If not, he pockets the premium.)\nThere are numerous tactics of this sort that may be played with options.\nPlayed because, for the general investor, the options game can be\ndisastrous, as professionals are not playing. They are seriously practicing\nskills the amateur can never hope to master. Many floor traders, indeed,\nwould qualify as idiot savants—they can compute the “fair value” of\noptions in their heads and make money on price anomalies of 1/16, or, as\nthey call it, a “teenie.” For perspective, the reader may contemplate a\nconversation the editor had with one of the most important options traders\nin the world who remarked casually that his fortune was built on teenies.\nThe reader may imagine at some length what would be necessary for the\ngeneral investor to make a profit on anomalies of 1/16. (EN10: The advent\nof digital pricing has given market makers and specialists even more\nflexibility to beat the investor by shaving spreads, theoretically, to $0.01.)\nThis does not mean the general investor should never touch options; it just\nmeans he should be thoroughly prepared before he goes down to play that\ngame. In options trading, traders speak of bull spreads, bear spreads, and\nalligator spreads. The alligator spread is an options strategy that eats the\ncustomer's capital in toto.\nAmong these strategies is covered call writing. This strategy is touted as\nbeing an income producer on a stock portfolio. There is no purpose in\nwriting a call on a stock in which the investor is long—unless that stock is\nstuck in a clear congestion phase that is not due to expire before the option\nexpires. Besides, if the stock is in a downtrend, it should be liquidated, but\nto write a call on a stock in a clear uptrend is to make oneself beloved of the\nbroker, whose good humor improves markedly with account activity and\ncommission income. The outcome of a covered call on an ascending stock\nis that the writer (you, dear reader) has the stock called at the exercise price,\nlosing his position and future appreciation, not to mention costs. The\nincome is actually small consolation, a sort of booby prize—a way of\ncutting your profits while increasing your costs. Nevertheless, covered\nwrites are justified and profitable in some cases.\nQuantitative analysis\nThe investor should be aware of another area of computer and investment\ntechnology that has yielded much more dramatic and profitable results, but\nthat is in a model-driven market—namely, the options markets. Quantitative\nanalysts, those who investigate and trade the options markets, are a breed\napart from technical analysts. In an interesting irony, behavioral markets,\nthe stock markets, are used as the basis for derivatives, or options whose\nprice is determined largely by the operation of algorithms called “models.”\nThe original model that created the modern world of options trading was\nthe Black-Scholes options analysis model, which assumed the “fair value”\nof an option could be determined by entering five parameters into the\nformula: the strike price of the option, the price of the stock, the “risk-free”\ninterest rate, the time to expiration, and the volatility of the stock.\nThe eventual universal acceptance of this model resulted in the derivatives\nindustry we have today. To list all the forms of derivatives available for\ntrading today would be to expand this book by many pages, and it is not the\npurpose of this book anyway. The purpose of this paragraph is to sternly\nwarn general investors who are thinking of “beating the derivatives\nmarkets” to undergo rigorous training first. The alternative could be\nextremely expensive.\nAt first, the traders who saw the importance of this model and used it to\nprice options virtually skinned older options traders and the public, who\ntraded pretty much by the seat of the pants or the stre", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 120}
{"text": "rpose of this paragraph is to sternly\nwarn general investors who are thinking of “beating the derivatives\nmarkets” to undergo rigorous training first. The alternative could be\nextremely expensive.\nAt first, the traders who saw the importance of this model and used it to\nprice options virtually skinned older options traders and the public, who\ntraded pretty much by the seat of the pants or the strength of their\nconvictions, meaning human emotion. But professional losers learn fast and\nnow all competent options traders use some sort of model or anti-model, or\nanti-antimodel to trade. True to form, options sellers, who are largely\nprofessionals, take most of the public's (the buyers) money. This is the way\nof the world.\nOptions pricing models and their importance\nAfter the introduction of the Black-Scholes model, numerous other models\nfollowed, among them the Cox-Ross-Rubinstein, the Black Futures, and\nothers. For the general investor, the message is this: he must be acquainted\nwith these models and what their functions are if he intends to use options.\nRecall, the model computes the “fair value” of the option. One way\nprofessionals make money off amateurs is by selling overpriced options and\nbuying underpriced options to create a relatively lower risk spread (for\nthemselves). Not knowing what these values are for the private investor is\nlike not knowing where the present price is for a stock; it is a piece of\nignorance for which the professional will charge him a premium to be\neducated about. Unfortunately, many private options traders never get\neducated, in spite of paying tuition over and over again. But ignorance is\nnot bliss—it is expensive.\nTechnology and knowledge works its way from innovators and creative\ngeniuses through the ranks of professionals and sooner or later is\ndisseminated to the general public. By that time, the innovators have\ndeveloped new technology. Nonetheless, even assuming that professionals\nhave superior tools and technology, the general investor must thoroughly\neducate himself before using options. As it is not the province of this book\nto dissect options trading, though the reader may find references in\nAppendix B, Resources.\nHere it would not be untoward to mention one of the better books on\noptions as a starting point for the moderately advanced and motivated\ntrader. Lawrence McMillan's Options as a Strategic Investment is necessary\nreading. In addition, the newcomer may contact the Chicago Board Options\nExchange (the CBOE) at http://www.cboe.com, which has tutorial software.\nFutures on indexes\nFutures, like options, offer the speculator intense leverage—the ability to\ncontrol a comparatively large position with much less capital than the\npurchase of the underlying commodity or index. Futures salesmen are fond\nof pointing out the fact that, if you are margined at 5% or 10% of the\ncontract value, a similar move in the price of the index will double your\nmoney. They are often not so conscientious about pointing out a similar\nmove against your position will wipe out your margin (actually earnest\nmoney). Unlike (long) options, a mishap in the market can result in more\nthan the loss of margin; it can become a deficit account and debts to the\nbroker—in other words, losses of more than 100%. For this, among other\nreasons, it is wise not to plunge into futures without considerable\npreparation. This preparation might well begin, for the adroit investor, with\nthe reading of Schwager's Technical Analysis, Schwager on Futures,\ncurrently one of the better books on the subject.\nLet us say that, instead of using futures to speculate, we want to use them as\na hedge for our portfolio of Dow-Jones DIAMONDS (DIA) or portfolio of\nDow-Jones stocks. Now we are purchasing insurance, rather than\nspeculating. As an oversimplified example, the investor might see the\nfailure of the DJIA to break through a top as the beginning of a congestion\nzone (a consolidation or reversal pattern). He could then hedge his position\nby shorting the Dow-Jones futures. Now he is both long and short—long\nthe cash, short the futures. He would place a stop on the futures above his\npurchase price to close the trade if the market continued rising. If the\nmarket fell, he would maintain the futures position until he calculated that\nthe reaction had passed its worst point, or until it were definitely analyzed\nto have reversed. He would then take his profits on the futures position\n(taxable), but his cash position would be intact, and presumably, the greater\ncapital gains on those positions would be safe from taxation, and also safe\nfrom the costs, slippage, and difficulties of reestablishing the stock position.\nOptions on futures and indexes\nConservative as well as speculative use may be made of options. For\nexample, the investor might, after a vigorous spike upwards, feel the\nStandard & Poor's (S&P) 500, or the SPYs which he is long, were\noverbought. He might then buy an index put on the S&P as a hedge against\nthe expected decline. If it occurs, he collects his profit on the option and his\ncash position in the S&P is undisturbed. If the index continues to climb, he\nloses the option premium—an insurance policy he took out to protect his\nstock portfolio.\nNote: The tactics described here are for the reader's conceptual education.\nBefore executing tactics of this kind, or any other unfamiliar procedure, the\ninvestor should thoroughly inform himself and rehearse the procedure,\ntesting outcomes through paper trading before committing real capital. He\nmust, in short, figure out how you lose. A number of websites offer facilities\nof this kind, and the investor may also build on his own computer a research\nor paper-trading portfolio segregated from his actual transactions.\nThe trader might also choose to buy an option on a future. At the CBOT®,\nthe trader can trade both options and futures on the DJIA. These can be\nused as the above examples for speculating or hedging, except in this case,\nthe successful option buyer m", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 121}
{"text": "ties\nof this kind, and the investor may also build on his own computer a research\nor paper-trading portfolio segregated from his actual transactions.\nThe trader might also choose to buy an option on a future. At the CBOT®,\nthe trader can trade both options and futures on the DJIA. These can be\nused as the above examples for speculating or hedging, except in this case,\nthe successful option buyer might wind up owning a futures contract instead\nof the cash position. This could be disconcerting to one not accustomed to\nthe futures market, especially if large price anomalies between futures and\ncash occurred, as happened in 1987 and 1989 when futures prices went to\nhuge discounts to cash. A primary reason for employing the futures would\nbe for leverage and the reason for using the options on futures would be the\nanalysis that uncertainty was in store and the wish to only risk the amount\nof the options premium.\nObviously, a speculator can choose to forget the stock or futures part of the\nportfolio and trade only options. Before taking such a step, the trader should\npass a postgraduate course. The proportion of successful amateur option\ntraders to successful professional traders is extremely skewed. In fact, one\nmight say all successful options traders are professionals.\nModern Portfolio Theory\nModern Portfolio Theory (MPT) is a procedure and process whereby a\nportfolio manager may classify and analyze the components of his portfolio\nin such a way as to, hopefully, be aware of and control risk and return. It\nattempts to quantify the relationship between risk and return. Rather than\nanalyzing only the individual instruments within a portfolio, MPT attempts\nto determine the statistical relationships among the members of the\nportfolio and their relationships to the market.\nThe processes involved in MPT analysis are as follows (1) portfolio\nvaluation, or describing the portfolio in terms of expected risk and expected\nreturn; (2) asset allocation, determining how capital is to be allocated\namong the classes of instruments (bonds, stocks, and so on); (3)\noptimization, or finding the trade-offs between risk and return in selecting\nthe components of the portfolio; and (4) performance measurement, or the\ndivision of each stock's risk into systemic and security-related classes.\nHow important is this for the general investor? Not very and there is a large\nquestion among pragmatic analysts, such as the editor, as to its pragmatic\nusefulness for professionals, although they cling to it as to a life ring in a\nshipwreck. Mandelbrot observed in articles (“A Multifractal Walk Down\nWall Street”) and letters in the Scientific American (February 1999 and June\n1999) that MPT discards about 5% of statistical experience as if it did not\nexist (although it [the experience] does). He also observed the ignored\nexperience includes 10-sigma market storms that are blamed for portfolio\nfailures as though it were the fault of the data instead of the fault of the\nprocess.\nThe wonders and joys of investment technology\nAre there any other innovations in finance and investment theory of which\nthe general investor should be aware? (See Chapter 42 for discussion of\nValue at Risk and Pragmatic Portfolio Theory.) Well, it never hurts to know\neverything, and the very best professionals not only are aware of\neverything, but also are in the constant process of finding new wrinkles and\nglitches and anomalies. Though, as Magee would ask, what is necessary and\nsufficient to know (see Winning the Mental Game on Wall Street)? Absolute\ncertainty is the hallmark of religious extremists and the naive, who do not\nknow what they do not know. So I will remark that probably this book\ncontains either what is necessary and sufficient for the investor to know\nabout these matters or guides the reader to further study.\nNot to mention, nota bene, any number of little old ladies with a chart, a\npencil, a ruler, and previous editions of this book have beaten the pants off\nprofessional stock pickers with supercomputers and MPT and Nobel\nLaureates and who knows what other resources. I personally know\ninvestment groups that have thrown enormous resources into the\ndevelopment of real-time systems that, in research, were 100% successful\nin beating the market. The only real glitch was the systems required so\nmuch computer power they could not be run quickly enough in real time to\nactually trade in the markets. Philosopher's stone redux.\nAdvancements in investment technology, part 2: futures and\noptions on futures on the Dow-Jones Industrial Index at the\nCBOT\n(EN9: The general investor must be aware that the methods and techniques\ndescribed in this chapter are for advanced practitioners. Careless use of the\ndescribed instruments can be extremely damaging to a portfolio.)\nInvestment and hedging strategies using the CBOT® DJIASM futures\ncontract\nA futures contract is the obligation to buy or sell a specific commodity on\nor by some specified date in the future. For example, if one went long corn\nfutures, he would be obligated to accept delivery of corn on the delivery\ndate, unless he sold the contract before the settlement date. Shorting the\ncontract would obligate the seller to deliver corn unless he offset (by\nrepurchase) the contract. The “commodity” in our present case is the basket\nof stocks represented by the DJIA futures index. All futures contracts\nspecify the date by which the transaction must conclude, known as the\n“settlement date,” and how the transaction will be implemented, known as\n“delivery.” The DJIA futures contract price closely tracks the price of the\nDow-Jones Industrials as computed from stock market values.\nThe value of the future is found by multiplying the index price of the\nfutures contract by $10.00. For example, if the futures index price is 10,000,\nthe value of the contract is 10,000 x $10.00 = $100,000. So the buyer or\nseller of the futures contract is trading approximately $100,000 worth of\nstocks at that Dow futures level. The value", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 122}
{"text": "Dow-Jones Industrials as computed from stock market values.\nThe value of the future is found by multiplying the index price of the\nfutures contract by $10.00. For example, if the futures index price is 10,000,\nthe value of the contract is 10,000 x $10.00 = $100,000. So the buyer or\nseller of the futures contract is trading approximately $100,000 worth of\nstocks at that Dow futures level. The value may be higher or lower owing to\nseveral factors, for example, cost of carry, which will be discussed below.\nSettlement of futures contracts\nAll futures contracts must be “settled.” Some futures are settled by delivery,\nthe famous nightmare of finding 5,000 bushels of soybeans delivered on\nyour front lawn. Dow Index futures “settle” (are delivered) in cash. The\nshort does not dump a basket of Dow stocks on the yard of the long. Thus,\non the settlement date of the contract, the settlement price is $10.00 times a\nfigure called the “Special Opening Quotation,” a value calculated from the\nopening prices of the member stocks of the Dow Future following the last\nday of trading in the futures contract. This value is compared with the price\npaid for the contract when the trade initiated. For example, if the Dow\nFuture is 10,000 at expiration, a long who bought the contract at 9,000\nreceives $10,000 ($10.00 x 1000) from the short.\nMarking-to-market\nThis $10,000, however, is paid daily over the life of the contract, rather than\nin one payment upon expiration of the contract. It is paid as successive\ndaily “margin” payments. These payments are not really margin but are in\neffect “earnest money” or a performance bond. The practice of squaring up\naccounts at the end of every day's trading is called “marking-to-market.”\nThese daily payments are determined based on the difference between the\nprevious day's settlement price and the contract settlement price at the close\nof trading each day.\nAs a practical example, if the settlement price of June Dow Index futures\nincreases from 9,800 to 9,840 from May 17 to May 18, the short pays $400\n($10.00 x 40) and the long's account is credited $400. If the futures\nsettlement price decreases 10 points the following day, the long pays $100\nto the short's account—and so on each day until expiration of the contract,\nwhen the futures price and the index price achieve parity.\nAt any time, the trader can close his position by offsetting the contract, that\nis, by selling to close an open long, or buying to close an open short. At the\nexpiration date, open contracts are settled in cash at the final settlement\nprice.\nFungibility\nOne of the great contributions of the great established exchanges like the\nCBOT® and the Chicago Mercantile Exchange is their institutionalization\nof contract terms and relationships is known as “fungibility.” Any one\nfutures contract for corn, or an index, or any other commodity is\nsubstitutable for another of the same commodity. Similarly, the Exchange\nhas negated counterparty risk by placing a Clearing Corporation between all\nparties to trades. Thus, even if the other party to a trade went broke, the\nClearing Corporation would assume his liability and, using the mechanism\nof daily settlement, whereby losers pay winners daily, the danger of major\ndefault is avoided.\nFutures “margins” (or “earnest money”) are deposited with the broker on\nopening a trade. The leverage obtainable is quite extreme for a stock trader.\nThe initial margin is usually 3%-5% of the total value of the contract. Each\nday thereafter, margins vary according to the process described above of\nmarking-to-market.\nAs the reader can see, the purchase or sale of a Dow Future is the\nequivalent of a fairly large portfolio transaction, with the understanding it is\na transaction that will be closed in the future, unlike a stock purchase,\nwhich may be held indefinitely.\nDifferences between cash and futures\nThe main two differences between the cash and the futures transactions are\nas follows:\n1. In cash, the value of the portfolio must be paid up front or financed\nin a stock margin account.\n2. The owner of the cash portfolio receives cash dividends.\nThese are not the only differences. The leverage employed in the futures\ntransaction is a two-edged sword. If the trader has no reserves, a minor\nmove in the index wipes him out. Such a minor move would be barely\nnoticed by the owner of a cash portfolio.\nDow Index futures\nThe price of the future and the price of the index are closely linked. Any\nprice anomaly is quickly corrected by arbitragers. On any significant price\ndifference, arbitragers will buy the underpriced and sell the overpriced,\nbringing the relationship back in line. Their prices are not exactly the same\nbecause the futures contract value must reflect the costs of short-term\nfinancing of stocks and the dividends paid by index stocks until futures\nexpiration, known as the “cost of carry.” The “theoretical value” of the\nfuture should equal the price of the index plus the carrying cost, what is\ncalled the “fair” or “theoretical” value.\nUsing stock index futures to control exposure to the market\nThe owner of a cash portfolio in the Dow, or of DIAMONDS, can control\nhis exposure, his risk, by using futures to hedge. If, for example, he is\npessimistic about the market, or more to the point, a lot of uptrend lines\nhave been broken and the technical situation seems to be deteriorating, he\ncan sell a futures contract equivalent to his portfolio and be flat the market.\nReaders will immediately recognize the advantages of this strategy. Tax\nconsequences on the cash portfolio are avoided, as are the other negative\nconsequences of trading— slippage, errors, and so on. Long-term positions\nare better left alone. By flattening his position, the investor has now insured\nthe future value of his portfolio, and the capital involved is now earning the\nmoney market rate of return.\nWhat happens if the forecast market decline occurs? The portfolio is\nprotected from loss and the capital earns the market rate of re", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 123}
{"text": "ative\nconsequences of trading— slippage, errors, and so on. Long-term positions\nare better left alone. By flattening his position, the investor has now insured\nthe future value of his portfolio, and the capital involved is now earning the\nmoney market rate of return.\nWhat happens if the forecast market decline occurs? The portfolio is\nprotected from loss and the capital earns the market rate of return; however,\nthe investor should monitor his hedge closely, lifting it when he calculates\nthe correction has run its course. Taxes will then be due on the profits on the\nhedge.\nIn monitoring the hedge, the possibility the market rises instead of falls\nmust be considered. In planning the hedge in the first place, the investor\nmust plan for this eventuality and determine at which point he will lift the\nhedge on the losing side. At worst, the investor has surrendered portfolio\nappreciation. Not considering cash flow implications.\nIt is worth emphasizing, in fact strongly emphasizing, that these techniques\nrequire knowledge, expertise, and study. Careless use of techniques of this\nnature can bloody the amateur investor. Hence, it is probably best to have a\nprofessional guide for the first several of these expeditions and to execute\nfirst a number of paper transactions.\nThe canny investor can increase his exposure to the market and the risk to\nhis capital by buying index futures. But the canny investor must be careful\nnot to turn into a burned speculator. Futures trading, because of the extreme\nleverage, is an area for dedicated and experienced speculators.\nA Dow futures transaction costs less than if you had to buy or sell a whole\nbasket of stocks. Professional fund managers—as well as other\nprofessionals—regularly use futures for asset allocation and reallocation. In\nall likelihood, they are not using the extreme leverage afforded by futures.\nIn other words, if they have a $1 million cash portfolio, they do not buy $10\nmillion worth of futures. It is not the leverage in which they are interested,\nbut rather it is the extreme convenience and agility offered by doing short-\nterm allocations in futures. The ability to almost instantaneously move in\nand out of the market without disturbing the underlying portfolio is a\npowerful feature of these “proxy markets.”\nFigure 17.3 Diamonds and Futures. The 2% plus break at the arrow of an\n11-month trendline is an unmistakable invitation to hedge the DIAMONDS\nby shorting the futures. Profits on the short would have offset losses in the\nDIAMONDS. This convenient drill would have preserved liquidity,\npostponed capital gains taxes, and avoided loss of equity. Notice the return\nto the trendline after the break. More of the foolish virgin syndrome?\nInvestment uses of Dow Index futures\nThe following examples describe the basic mechanics of using Dow futures\ncontracts. These can be used to adjust equity exposure in anticipation of\nvolatile market cycles and to rebalance portfolios among different asset\nclasses. The futures also may be used for other purposes not illustrated here.\nThe following examples are not intended to be absolutely precise, but only\nto illustrate the mechanics involved. For the sake of simplicity, mark-to-\nmarket payments and cost of carry have been eliminated from the examples.\nSituation 1: Portfolio protection\nYou are a long-term Magee-type investor and you have old and profitable\npositions with which you are satisfied. Yet, you have seen the broadening\ntop of the Dow Jones (ca. 2000) and it is almost October, so you would not\nbe surprised to see a little bloodshed. You have $400,000 in the Dow and\n$100,000 in money market instruments. You decide to reverse this ratio, but\nyou do not want to liquidate the Dow portfolio, as there is no sign of a\nconfirmed downtrend, only that of consolidation. You sell $300,000 of\nindex futures, leaving yourself with a $100,000 kicker in case you are\nwrong about the market's declining. At the time, the market is 10,000 and\nthe futures are 10,500, meaning the cost of carry is approximately 0.5%\n(10,500/10,000 - 1).\nYou sell three futures contracts [$300,000/($10 x 10,000)]. You now have\nreversed your position and are long $100,000 Dow stocks and long\n$400,000 money market equivalents.\nValidating your technical analysis, the market has begun to swing in broad\nundulations and, at the expiration of the futures, the Dow is at 10,000. On\nyour stocks, you have a return of -0.5%, and the money market position has\na rate of return of 0.5%.\nWhat would have been the situation had you not hedged?\nStock Portfolio $400,000 x 0.95$380,000\nMoney Market + 100,000 x 1.005$100,500\nTotal $480,500\nHow the futures position affects the portfolio:\nShort three futures 3 x $10.00 x (10,000-9,500)+$15,000\nTotal $495,000\nValue of portfolio with reallocation of assets in cash market:\nStocks $100,000 x 0.95 $95,000\nMoney market + $400,000 x 1.005$402,000\nTotal $497,000\nBy hedging in the futures market, you now have the equivalent of a\n$100,000 investment in Dow futures stocks and a $400,000 investment in\nthe money market instrument. The stock market decline now affects only\n$100,000 of your stock portfolio rather than $400,000; in addition, you earn\na money market rate of return of 0.5% on the $300,000 difference.\nWithout the futures transaction, the portfolio is worth $480,500. The\n$15,000 profit on the short futures position offsets the loss on the $300,000\nof the portfolio that was moved out of equities by the short futures position.\nIn brief, by selling futures, you are able to protect $300,000 of your initial\nportfolio value from a stock price decline, nearly breaking even, an\nachievement given these market conditions. Had you been more confident\nof the market decline, you might have completely neutralized the equity\nrisk on the portfolio by selling more futures contracts. This would have\nconverted the entire stock position to a $400,000 investment in the money\nmarket. The amount of protection you should obtain depends on your\nassessme", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 124}
{"text": "decline, nearly breaking even, an\nachievement given these market conditions. Had you been more confident\nof the market decline, you might have completely neutralized the equity\nrisk on the portfolio by selling more futures contracts. This would have\nconverted the entire stock position to a $400,000 investment in the money\nmarket. The amount of protection you should obtain depends on your\nassessment of the market and your tolerance for risk.\nSituation 2: Increasing exposure with futures\nNow let us look at the other side of the coin. The market has come off its\nhighs in a predictable and controlled secondary reaction and your technical\nanalysis is that the Bull Market will continue. At 10,000, it appears headed\nfor 11,000, and you want to increase your commitment. Your portfolio is as\npreviously described, split 80/20 between Dow stocks and money markets.\nIt is time to go whole hog, you decide. You are acutely aware of the market\nmaxim (bulls make money and bears make money and hogs wind up\nslaughtered), but there is also a market maxim that no market maxim is true\n100% of the time, which is also true of this maxim.\nRather than liquidate your money market holdings, you buy one futures\ncontract, which puts you long another $100,000 of stocks. The rate of return\non the money markets in your portfolio is 0.5%. To get a $500,000 exposure\nin blue chips, you buy the following number of contracts: $100,000/($10 x\n10,000) = 1 contract.\nResults: Your technical analysis of the direction of the market is correct,\nand the Dow future rises to 11,000 at the September expiration, or by 10%.\nValue of portfolio with passive management:\nStocks $400,000 x 1.10$440,000\nMoney market+$100,000 x 1.005$100,500\nTotal $540,500\nValue of portfolio with futures position:\nLong DJIA futures 1 x $10.00 x (11,000 - 10,000)$10,000\nTotal $550,500\nValue of portfolio with reallocation of assets in cash market:\nStocks $500,000 x 1.10$550,000\nMoney market $0\nTotal $550,000\nIn buying Dow Index futures, you are able to “equitize” $100,000 of your\nmoney market investment, effectively increasing your return from the\nmoney market rate of 0.5%-10%. If you had not bought futures, the total\nvalue of your portfolio at the September expiration would have been\n$540,500 instead of $550,500. Not only do you have a $10,000 extra gain in\nyour portfolio, but also you have taken advantage of the market's continuing\nupward climb without having to adjust your portfolio.\nSituation 3: Using bond and index futures for asset allocation\nSpeculation in bonds can be quite profitable, notwithstanding David\nDreman's assertion that long-term investments in bonds are net losers.\n(EN9: An oversimplification of a sophisticated thesis by an important\nfigure.) Subsequently, it is not unusual for an investor to have both bonds\nand stocks in his portfolio. In this event, the portfolio can be managed with\nfacility by using both Index futures and Treasury bond futures.\nMany investors consider it prudent to reallocate their capital commitments\nbased on inflation rates, interest rates, and the reported expression on Alan\nGreenspan's (or Bernanke's) face before congressional testimony.\nAn efficient and inexpensive way to reallocate assets between stocks and\nbonds is to put on spreads of Treasury bond futures and Dow Index futures.\nAnalysis of recent long- and medium-term trends in the market, however,\nhas led you to consider increasing your equity portfolio and decreasing your\nbond portfolio. You have $200,000 invested in Dow stocks and $200,000\ninvested in Treasury bonds. You would like to take advantage of the\nsustained market rally by increasing your equities exposure to 75% and\ndecreasing your bond holdings to 25%.\nAs for tactics, you can reallocate both sides of your portfolio—buying\n$100,000 of stocks and selling $100,000 of bonds—with the sale of\nTreasury bond futures and the purchase of Dow Index futures.\nThe Treasury bonds in your portfolio have a market price of 103-20. The\nprice of September Treasury bond futures is 102-20 per $100 of face value,\nand $100,000 of face value must be delivered against each contract. The\nvalue of the Dow futures is 10,000, and the price of the Dow Index futures\ncontract is 10,000 (ignoring the cost of carry).\nThe number of T-bond futures to sell is: short T-bond futures: $100,000/\n(102 - 20 x $1,000) = 1 (number of futures is rounded to the nearest whole\nnumber). The number of stock index futures to buy is as follows: long stock\nindex futures: $100,000/ ($10.00 x 10,000) = 1 (number of futures is\nrounded to the nearest whole number).\nResults: at the September futures expiration, the value of the Dow future is\n11,000, a rate of return of 10%, and the market value of the bonds is 101-\n08, a rate of return of -1%.\nPortfolio value with no market action taken:\nStocks $200,000 x 1.10$220,000\nMoney market$200,000 x 0.99$198,000\nTotal $418,000\nValue of futures positions:\nLong Dow futures$10 x 1 x (11,000 - 10,000)$10,000\nShort bond futures+$1000 x 1 x (102-20 - 101-08)$1375\nTotal $11,375\nGrand total $429,375\nValue of portfolio had transaction been done in cash market:\nStocks$300,000 x 1.10$330,000\nBonds+$100,000 x 0.99$99,000\nTotal $429,000\nBy this simple maneuver, you have quickly and easily changed your market\nposture to add an additional $100,000 exposure to stocks and subtract\n$100,000 exposure to bonds.\nFigure 17.4 Dow-Jones Futures and Options. A put purchased at the arrow\non the break would have protected patiently won gains over the previous 11\nmonths. The increase in the value of the put can be seen as futures track\ndeclining Dow cash. A theoretical drill, but theoretical drills precede actual\ntactics in the market.\nHaving correctly analyzed market trends, your action results in an increase\nin portfolio value from $418,000 to $429,375. You could have\naccomplished the same result by buying and selling bonds and stocks, but\nnot without tax consequences and the attendant transaction headaches. The\nuse of futures to accomplish yo", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 125}
{"text": "h. A theoretical drill, but theoretical drills precede actual\ntactics in the market.\nHaving correctly analyzed market trends, your action results in an increase\nin portfolio value from $418,000 to $429,375. You could have\naccomplished the same result by buying and selling bonds and stocks, but\nnot without tax consequences and the attendant transaction headaches. The\nuse of futures to accomplish your goals allowed you to implement your\nPerspective\nAlthough there can be no argument about the importance of CBOT®\nDJIASM Index futures— they are markets of enormous usefulness and\nimportance—there can also be no doubt the futures novice should\nthoroughly prepare himself before venturing into these pits. In such a highly\nleveraged environment, mistakes will be punished much more severely than\nan error in the stock market. By the same token, ignorance of this vital tool\nis the mark of an investor who is not serious about his portfolio, or who is\nless intense in his investment goals. “They” (the infamous “they”) use all\nthe weapons at their disposal; so should “we.”\nOptions on Dow Index futures\nThe buyer of this instrument has the choice, or the right, to assume a\nposition. It is his option to do so—unlike a futures contract in which he has\nan obligation once entered. There are two kinds of options: calls (the right\nto buy the underlying instrument) and puts (the right to sell). Also, options\ncan be bought (long) or sold (short) like futures contracts.\nA long call option on Dow Index futures gives the buyer the right to buy\none futures contract at a specified price which is called the “exercise” or\n“strike” price. A long put option on Dow Index futures gives the buyer the\nright to sell one futures contract at the strike price. For example, a call at a\nstrike price of 10,000 entitles the buyer to be long one futures contract at a\nprice of 10,000 when he exercises the option. A put at the same strike price\nentitles the buyer to be short one futures contract at 10,000. The strike\nprices of Dow Index futures options are listed in increments of 100 index\npoints, giving the trader the flexibility to express his opinions about upward\nor downward movement of the market.\nThe seller, or writer, of a call or put is short the option. Effectively selling a\ncall makes the writer short the market, just as selling a put makes the writer\nlong the market. As in a futures contract, the seller is obligated to fulfill the\nterms of the option if the buyer exercises. If you are short a call, and the\nlong exercises, you become short one futures contract at 10,000. If you are\nshort one put and the long exercises, you become long one futures contract\nat 10,000.\nBuyers of options enjoy fixed risk. They can lose no more than the premium\nthey pay to go long an option. On the other hand, sellers of options have\npotentially unlimited risk. Catastrophic moves in the markets often\nbankrupt imprudent option sellers.\nOption premiums\nThe purchase price of the option is called the option premium. The option\npremium is quoted in points, each point being worth $100. The premium for\na Dow Index option is paid by the buyer at initiation of the transaction.\nThe underlying instrument for one CBOT® futures option is one CBOT®\nDJIASM futures contract; so the option contract and the futures contract are\nessentially different expressions of the same instrument, and both are based\non the Dow-Jones Index.\nOptions premiums consist of two elements: intrinsic value and time value.\nThe difference between the futures price and strike price is the intrinsic\nvalue of the option. If the futures price is greater than the strike price of a\ncall, the call is said to be “in-the-money.” In fact, you can be long the\nfutures contract at less than its current price. For example, if the futures\nprice is 10,020 and the strike price is 10,000, the call is in-the-money and\nimmediate exercise of the call pays $10.00 times the difference between the\nfutures and strike price, or $10 x 20 = $200. If the futures price is less than\nthe strike price, the call is “out-of-the-money.” If the two are equal, the call\nis “at-the-money.” A put is in-the-money if the futures price is less than the\nstrike price and out-of-the-money if the futures price is greater than the\nstrike price. It is at-the-money when these two prices are equal.\nSince a Dow Index futures option can be exercised at any date until\nexpiration, and exercise results in a cash payment equal to the intrinsic\nvalue, the value of the option must be at least as great as its intrinsic value.\nThe difference between the option price and the intrinsic value represents\nthe time value of the option. The time value reflects the possibility that\nexercise will become more profitable if the futures price moves farther\naway from the strike price. Generally, the more time until expiration, the\ngreater the time value of the option because the likelihood of the option\nbecoming profitable to exercise is greater. At expiration, the time value is\nzero and the option price equals the intrinsic value.\nVolatility\nThe degree of fluctuation in the price of the underlying futures contract is\nknown as “volatility” (see Appendix B, Resources, for the formula). The\ngreater the volatility of the futures, the higher the option premium. The\nprice of a futures option is a function of the futures price, the strike price,\nthe time left to expiration, the money market rate, and the volatility of the\nfutures price. Of these variables, volatility is the only one that cannot be\nobserved directly. Considering all the other variables are known, however, it\nis possible to infer from option prices an estimate of how the market is\ngauging volatility. This estimate is called the “implied volatility” of the\noption. It measures the market's average expectation of what the volatility\nof the underlying futures return will be until the expiration of the option.\nImplied volatility is usually expressed in annualized terms. The significance\nand use of implied volat", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 126}
{"text": "ossible to infer from option prices an estimate of how the market is\ngauging volatility. This estimate is called the “implied volatility” of the\noption. It measures the market's average expectation of what the volatility\nof the underlying futures return will be until the expiration of the option.\nImplied volatility is usually expressed in annualized terms. The significance\nand use of implied volatility is potentially complex and confusing for the\ngeneral investor, professionals having a decided edge in this area. Their\nedge can be removed by serious study.\nExercising the option\nAt expiration, the rules of optimal exercise are clear. The call owner should\nexercise the option if the strike price is less than the underlying futures\nprice. The value of the exercised call is the difference between the futures\nprice and the strike price. Conversely, the put owner should exercise the\noption if the strike price is greater than the futures price. The value of the\nexercised put is the difference between the strike price and the futures price.\nTo illustrate, if the price of the expiring futures contract is 7,600, a call\nstruck at 7,500 should be exercised, but a put at the same or lower strike\nprice should not. The value of the exercised call is $1,000. The value of the\nunexercised put is $0.00. If the price of the expiring futures contract is\n7,500, a 7,600 put should be exercised but not a call at 7,600 or a higher\nstrike. The value of the exercised put is $1,000 and that of the unexercised\ncall is $0.00.\nThe profit on long options is the difference between the expiration value\nand the option premium. The profit on short options is the expiration value\nplus the option premium. The expiration values and profits on call and put\noptions can often be an important tool in an investment strategy. Their\npayoff patterns and risk parameters make options quite different from\nfutures. Their versatility makes them good instruments to adjust a portfolio\nto changing expectations about stock market conditions. Moreover, these\nexpectations can range from general to specific predictions about the future\ndirection and volatility of stock prices. Effectively, there is an option\nstrategy suited to virtually every set of market conditions.\nUsing futures options to participate in market movements\nTraders must often react to rapid and surprising events in the market. The\ntransaction costs and price impact of buying or selling a portfolio's stocks\non short notice inhibit many investors from reacting to short-term market\ndevelopments. Shorting stocks is an even less palatable option for average\ninvestors because of the margin and risks involved and semantical\nprejudices.\nThe flexibility that options provide can allow one to take advantage of the\nprofits from market cycles quickly and conveniently. A long call option on\nDow Index futures profits at all levels above its strike price. A long put\noption similarly profits at all levels below its strike price. Let us examine\nboth strategies.\nProfits in rising markets\nIn August, the Dow Index is 10,000 and the Dow Index September future is\n10,050. You expect the current Bull Market to continue, and you would like\nto take advantage of the trend without tying up too much capital and also\nundertake only limited risk.\nYou buy a September call option on Dow Index futures. These options will\nexpire simultaneously with September futures, and the futures price will be\nthe same as the cash index at expiration.\nYour analysis is bullish, so the 10,500 call (out-of-the-money strike price) is\na reasonable alternative at a quoted premium of 10.10. You pay $1,010 for\nthe call ($100 x 10.10).\nThe payoff: at the September expiration, the value of the Dow Future is\n10,610. Now, your call is in-the-money, and you exercise it and garner the\nexercise value less the premium, or $90.00 = $10.00 x (10,610 - 10,500) -\n$100 x (10.10) = $1,100 - $1,010. If the Dow future stays at or below\n10,500, you let the call expire worthless and simply lose the premium. This\nis the maximum possible loss on the call. If the Dow future increases by\n101 points above the strike price, you break even.\nInstead of buying the call option, the trader could have invested $100,500\ndirectly in the Dow stocks. Given a value of the Dow future of 10,110 in\nSeptember, he would have had a gain of $3,030. If he had invested directly\nin the stocks, however, an unexpected market decline would have led to a\nloss.\nExploiting market reversals\nThe trader expects a reversal of the Bull Market now at 7,800 and would\nlike some downside protection.\nHe buys a put with a strike price of 7,700 (out-of-the-money). The put\npremium is 9.80, for a total cost of $980 = $100 x 9.80. If the Index\ndecreases to 7,600, with a corresponding decrease in the futures contract in\nSeptember, the put is worth $1,000. The maximum loss is the premium cost,\nwhich is lost if the Dow future is above 7,700 at expiration. The trader\nbreaks even if the Dow future decreases by 98 points below the strike price.\nUsing puts to protect profits in an appreciated portfolio\nDuring a sustained Bull Market, investors often search for ways to protect\ntheir paper profits from a possible market break. Even when fundamental\neconomic factors tend to support a continued market upside, investors have\nto guard against unpredictable “technical market corrections” and market\nover-reactions to news.\nSelling stocks to reduce downside risk is costly in fees and taxes and\nsacrifices potential price gains. What is desirable in a sideways market\nenvironment is an instrument that protects the value of a portfolio against a\nmarket drop but does not constrain upside participation. This is precisely\nwhat put options are designed to do.\nSituation 1\nThe market is in an uptrend in August, which is when the market lives with\nthe anxiety the Federal Reserve will tighten short-term interest rates further\nin the coming months. The trader has $78,000 invested in the Dow\nportfolio, and the Dow Future is at 7,", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 127}
{"text": "ortfolio against a\nmarket drop but does not constrain upside participation. This is precisely\nwhat put options are designed to do.\nSituation 1\nThe market is in an uptrend in August, which is when the market lives with\nthe anxiety the Federal Reserve will tighten short-term interest rates further\nin the coming months. The trader has $78,000 invested in the Dow\nportfolio, and the Dow Future is at 7,800.\nTo hedge his portfolio, he purchases a put option on September futures\nagainst a possible market downturn. He buys a 7,600 put at a premium of\n6.60, cost $100 x 6.60 = $660.\nBuying the put places a floor on the value of the portfolio at the strike price.\nBuying a put with a strike price of 7600 effectively locks in the value of the\nportfolio at $76,000. Above its strike price, a put is not exercised and the\nportfolio value is unconstrained. If the trader is wrong, and the market goes\nup, he loses the premium paid for the put. Depending on which strike price\nhe chooses, he increases or decreases downside risk. He breaks even when\nthe Dow future reaches a value of 7,534 = 7,600 - 66, the strike price less\nthe put premium. At this level, the unprotected and put-protected portfolios\nare equally profitable.\nThe similarity to life insurance is striking. If you do not die, the premium is\nwasted. But if you do...\nImproving portfolio yields\nSituation 2\nAll markets, as the reader is perhaps aware, are not trending. Days, weeks,\nmonths, sometimes years can pass while the markets grind up and down in\nwhat are euphemistically known as trading range markets. When the astute\ntechnician identifies one of these market doldrums and judges that it will\ncontinue, he can reap other returns on his portfolio by selling puts and calls\non Dow Index futures.\nFor example, when the Dow Index is 10,000 and the trader calculates it will\nnot break out for the next month above 10,200, he sells calls at a strike price\nof 10,200. The quoted premium of the 10,200 call is, say, 10.10; selling a\n10,200 call generates $1010 income.\nThe trader pockets the entire premium as a profit if the index remains below\n10,200 at the September expiration. The downside of this trade is that the\ntrader gives up price appreciation above 10,200. Above 10,200, the\ncombined value of the portfolio and short call premium is $101,010. The\nbreak-even point is 10,301, where the Dow Future is equal to the sum of the\nstrike price and call premium. Above this point the covered call portfolio\nbecomes less profitable than the original portfolio. Since the short call is\ncovered by the portfolio, this strategy is not exposed to the risk represented\nby a naked call. The main risk is the trader giving up the profit potential\nabove the strike price of the call. As is obvious to the technician, this is a\nbad strategy in trending markets. Only in clearly range-bound markets\nwould an enlightened trader want to write covered calls. The call premium\ncollected is some compensation for this risk, but cold comfort when the\ntrader has misanalyzed the market. The best strike price of the call depends\non the probabilities you have assigned to future increases and behavior of\nthe Dow.\nUsing option spreads in high- or low-volatility markets\nLong and short stock positions reflect definite market opinions or analyses.\nThe market will go up or the market will go down and the moderately\ncompetent technician should be right about this more often than the\nunwashed general public. In markets of coiling volatility (i.e., lower than\naverage volatility and declining), it is sometimes possible to exploit\nuncertainty by putting on a long straddle. The long straddle combines a long\nput and a long call at the same strike price. This spread generates a return\nover two ranges of market values: values below the strike price of the put\nand values above the strike price of the call. It is a profitable strategy given\nsufficient volatility; the editor's company used such a strategy immediately\nbefore the crash of 1987 for managed accounts and collected\ndisproportionate profits on a very low-risk position. Experienced\nspeculators and traders generally sell high-volatility markets and try to\nbackspread (go long) in chosen less-volatile markets, expecting volatility to\nreturn to the mean. Sometimes they do this by writing a short straddle, a\nposition with a short put and a short call at the same strike price.\nSituation 3\nIn August, a technical analysis predicts that volatility will increase, and the\nmarket is in a coiling process. The direction of prices is uncertain but\npotentially explosive. The trader buys a straddle of a long put at 7,800 and a\nlong call at 7,800. The quoted call premium is 18.90 and the quoted put\npremium is 13.90. The total cost of the straddle is $3280 = $100 x 32.80.\nThis is the maximum loss if the Dow Future stalls at 7,800.\nThe straddle makes a profit when the Dow Future moves enough to recover\nthe cost of the straddle, either below 7,472 = 7,800 - 328 or above 8,128 =\n7,800 + 328. The potential upside profit is unlimited. The maximum profit\non the downside is $10.00 x (7,800 - 328), or $74,720, if the Dow future\ngoes to zero (somewhat unlikely, but one never knows what Chicken Little\nthe investor will do if he thinks the sky is falling).\nSituation 4\nIn August, the investor calculates options are overvalued and volatility will\nbe lower than implied volatility. He expects a dormant market to continue\nthrough the end of the summer. He decides to sell the September put and\ncall at 7,800, collecting $3,280. The return on this short straddle will turn\nnegative if the Dow future in September goes below 7,472 or above 8,128.\nThe maximum loss on the downside is $10.00 x (7,800 - 328), or $74,720,\nand the loss on the upside is unlimited. The investor, however, perceives the\nrisk as limited because he believes the Dow future will neither increase nor\ndecrease to these levels within the next month when the options expire. In\nthese cases, the trader must also consider catastrophic r", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 128}
{"text": "ptember goes below 7,472 or above 8,128.\nThe maximum loss on the downside is $10.00 x (7,800 - 328), or $74,720,\nand the loss on the upside is unlimited. The investor, however, perceives the\nrisk as limited because he believes the Dow future will neither increase nor\ndecrease to these levels within the next month when the options expire. In\nthese cases, the trader must also consider catastrophic risk—as, for\nexample, the editor's client who was short puts in the crash of 1987 and lost\n$57 million.\nPerspective\n(EN9: Once again, do not practice the methods and techniques described in\nthis chapter without complete confidence in their use. A course in futures\nand options is recommended, or professional consultation.)\nI like to tell these stories so prospective options traders and general\ninvestors are made dramatically aware of the potential dangers, as well as\nthe potential profits. As stated elsewhere in this book, the novice should\nwork to achieve competence and experience before attempting advanced\ntricks in futures and options. On the other hand, the investment use of these\ninstruments for prudent hedging and insurance is recommended to the\ninvestor willing to do his homework, acquire competence, and grow in\ninvestment skills.\nDow Index futures and futures options present new techniques of portfolio\nprotection and profit-making for the general investor. Numerous strategies\ncan be practiced by the moderately competent investor using these\ninstruments. Keep in mind always that all the methods of analytical\ninvesting espoused in this book are the base discipline—that is, knowledge\nof the instruments and their use, prudent trade management, stop-loss\ndiscipline, and close attention to the dynamics of the situation. Above all,\nthe existence of these instruments allows the most conservative of investors\ninsurance and hedging techniques not previously available.\nIn summation, knowledge of the DJIA futures and options on futures is\nabsolutely essential for the competent technical investor and trader.\nRecommended further study\nIn view of the importance of this chapter, noted here are references to\nadvanced material, which are also found in Appendix B, Resources.\nThe CBOE has a website explaining the math behind hedging. To hedge a\nportfolio of $500,000 tracking the S&P 500, you need four puts. The\naddress for the calculation of the hedging ratio is available at\nhttp://www.cboe.com/portfoliohedge.\nFor further study, see the following:\n• Options as a Strategic Investment by Lawrence Macmillan,\nhttp://www.optionstrategist. com\n• Chicago Board Options Exchange, http://www.cboe.com\n• Chicago Board of Trade, 312-435-3558 or 800-THE-CBOT; 312-341-\n3168 (fax); http:// www.cbot.com\npart two\nTrading tactics\nMidword\nAs a kind of foreword to Section II of this book, we might mention a\ncommentary, “On Understanding Science: An Historical Approach,” by\nJames Bryant Conant, president emeritus of Harvard.\nDr. Conant points out that, in school, we learn science is a systematic\ncollection of facts that are classified in orderly array, broken down,\nanalyzed, examined, synthesized, and pondered; and then lo! a Great\nPrinciple emerges—pat, perfect, and ready for use in industry, medicine, or\nwhat-have-you.\nHe further points out that all of this is a mistaken point of view held by\nmost laymen. Discovery takes form little by little, shrouded in questioning,\nand only gradually assumes the substance of a clear, precise, well-supported\ntheory. The neat tabulation of basic data, forming a series of proofs and\nchecks, does not come at the start but much later. In fact, it may be the work\nof other men entirely, men who, being furnished with the conclusions, are\nthen able to construct a complete, integrated body of evidence. Theories of\nmarket action are not conceived in a flash of inspiration; they are built, step\nby step, out of the experience of traders and students, to explain the typical\nphenomena that appear over and over again through the years.\nIn market operations, the practical trader is not concerned with theory as\nsuch. The neophyte's question, “What is the method?” probably means,\nactually, “What can I buy to make a lot of money easily and quickly?” If\nsuch a trader reads this book, he may feel there is “something in it.” He may\nfeel “It's worth a try” (a statement, incidentally, that reflects little credit on\nhis own previous tries). He may also start out quite optimistically, without\nany understanding of theory or any experience in these methods, and\nwithout any basis for real confidence in the method.\nIn such cases, the chances are great he will not immediately enjoy the easy\nsuccess he hopes for. His very inexperience in a new approach will result in\nmistakes and failures. Yet, even with the most careful application of these\nmethods, in correctly entered commitments, he may encounter a series of\ndifficult market moves that may give him a succession of losses.\nWhereupon, having no solid confidence in what he is doing, he may sigh,\nput the book back on the shelf, and say, “Just as I thought. It's no damn\ngood.”\nNow, if you were about to go into farming for the first time, you might be\ntold (and it would be true) the shade tobacco business offers spectacular\nprofits. But you would not expect to gain these profits without investing\ncapital, without studying how shade tobacco is grown and in what kinds of\nsoils and what localities, nor without some experience with the crop.\nFurthermore, you would need confidence—faith in the opportunity and also\nin the methods you were using. If your first season's crop were blighted\n(and these things do happen), you would naturally be disappointed. If it\nshould happen that your second year's crop were destroyed by a hailstorm,\nyou would be hurt and understandably despondent. Moreover, if your third\nseason's crop were to be a total loss because of drought, you would\nprobably be very gloomy indeed (and who could blame you?). But you\nwould not say, “There's nothing to it. It's no d", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 129}
{"text": "d these things do happen), you would naturally be disappointed. If it\nshould happen that your second year's crop were destroyed by a hailstorm,\nyou would be hurt and understandably despondent. Moreover, if your third\nseason's crop were to be a total loss because of drought, you would\nprobably be very gloomy indeed (and who could blame you?). But you\nwould not say, “There's nothing to it. It's no damn good.”\nYou would know (if you had studied the industry and the approved\ncultivation methods) that you were right, regardless of any combination of\nunfavorable circumstances, and you would know the ultimate rewards\nwould justify your continuation, no matter how hard the road, rather than\nturn to some easier but less potentially profitable crop.\nSo it is with technical methods in the stock market; anyone may encounter\nbad seasons. The Major Turns inevitably will produce a succession of losses\nto Minor Trend operators using the methods suggested in this book. There\nwill also be times when a man who has no understanding of basic theory\nwill be tempted to give up the method entirely and look for a “system” that\nwill fit into the pattern of recent market action nicely, so he can say, “If I\nhad only averaged my trades ... . If I had followed the Dream Book ... . If I\nhad taken Charlie's tip on XYZ ... . If I had done it this way or that way, I\nwould have come out with a neat profit.”\nIt would be better, and safer, to understand at the start that no method ever\ndevised will unfailingly protect you against a loss, or sometimes even a\npainful succession of losses. You should realize what we are looking for is\nthe probability inherent in any situation. Likewise, just as you would be\njustified in expecting to draw a white bean from a bag which you knew\ncontained 700 white beans and 300 black beans (even though you had just\ndrawn out 10 black beans in succession!), so too you are justified in\ncontinuing to follow the methods that, over long periods, seem most surely\nand most frequently to coincide with the mechanism of the market.\nThus, this book should not be given a quick “once-over” and adopted\nstraightaway as a sure and easy road to riches. It should be read over and\nover, a number of times, and it should be consulted as a reference work.\nFurthermore, and most importantly, you will need the experience of your\nown successes and failures so you will know what you are doing is the only\nlogical thing you can do under a given set of circumstances. In such a frame\nof mind, you will have your portion of successes and your failures, which\nyou can take in stride, as part of the business, will not ruin either your\npocketbook or your morale.\nIn short, the problem stated and analyzed through this whole volume is not\nso much a matter of “systems” as it is a matter of philosophy. The end result\nof your work in technical analysis is a deep understanding of what is going\non in the competitive free auction, what is the mechanism of this auction,\nand what is the meaning of it all. Be mindful this philosophy does not grow\non trees; it does not spring full-bodied from the sea foam either. It comes\ngradually from experience and from sincere, intelligent, hard work.\nSection II of this book, which follows, is concerned with tactics. Up to this\npoint, we have been studying the technical formations and their\nconsequences. We should have a good general understanding of what is\nlikely to happen after certain manifestations on the charts. Knowing that,\nhowever, we will still need a more definite set of guides as to when and\nhow it is best to execute this or that sale.\nThese chapters are based on one man's experience and his analysis of\nthousands of specific cases. It takes up questions of method, of detail, and\nof application, and should provide you with a workable basis for your actual\nmarket operations. As time goes on, you will very likely adopt refinements\nof your own or modify some of the suggested methods according to your\nown experience. However, the authors feel the suggestions made here will\nenable you to use technical analysis in an intelligent and orderly way that\nshould help to protect you from losses and increase your profits.\nJohn Magee\nTaylor & Francis\nTaylor & Francis Group\nhttp://taylorandfrancis.com\nchapter eighteen\nThe tactical problem\n(EN: In this chapter, Magee addresses the question of tactics for the\n“speculator” who follows short and medium-term trends. The later sections\nof the chapter address the question of strategy and tactics for the long-term\ninvestor and provide a discussion of the term “speculator.”)\nIt is possible (as many traders have discovered) to lose money in a Bull\nMarket—and, likewise, to lose money trading short in a Bear Market. You\nmay be perfectly correct in judging the Major Trend; your long-term\nstrategy, let us say, may be 100% right. Except, without tactics, without the\nability to shape the details of the campaign on the field, it is not possible to\nput your knowledge to work to your best advantage.\nThere are several reasons why traders, especially inexperienced traders, so\noften do so poorly. At the time of buying a stock, if it should go up, they\nhave no objectives and no idea of what policy to use in deciding when to\nsell and take a profit. If it should go down, they have no way of deciding\nwhen to sell and take a loss. Result: they often lose their profits; and their\nlosses, instead of being nipped off quickly, run heavily against them. Also,\nthere is this psychological handicap: the moment a stock is bought (or sold\nshort), commissions and costs are charged against the transaction. The\ntrader knows the moment he closes the trade there will be another set of\ncharges. Also, since he is not likely to catch the extreme top of a rally or the\nextreme bottom of a reaction, he is bound, in most cases, to see the stock\nrunning perhaps several points against him after he has made his\ncommitment. Even on a perfectly sound, wise trade, he may see a 10% or\nmore paper loss before the expec", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 130}
{"text": "he\ntrader knows the moment he closes the trade there will be another set of\ncharges. Also, since he is not likely to catch the extreme top of a rally or the\nextreme bottom of a reaction, he is bound, in most cases, to see the stock\nrunning perhaps several points against him after he has made his\ncommitment. Even on a perfectly sound, wise trade, he may see a 10% or\nmore paper loss before the expected favorable move gets under way (see\nFigure 18.1). Obviously, if he weakens and runs for cover without sufficient\nreason before the stock has made the profitable move he looked for, he is\ntaking an unnecessary loss and forfeiting entirely his chance to register a\ngain.\nThe long-term investor who buys in near the bottom and remains in the\nmarket to a point near the top, to later liquidate and remain in cash or bonds\nuntil (perhaps several years later) there is another opportunity to buy in at\nthe bottom, does not face the continual problem of when to buy and when to\nsell. This assumes one can tell precisely when such a bottom has been\nreached and when the trend has reached its ultimate top (and those are very\nbroad assumptions indeed). The long-term investment problem for large\ngains over the Major Trends is by no means as simple as it sounds when\nyou say, “Buy them when they're low, and sell them near the top.” However,\nsuch large gains have been made over the long pull, and they are very\nimpressive. (EN: Note the record of the Dow Theory in Chapters 4 and 5.)\nThis section of the book is concerned more particularly with the speculative\npurchase and sale of securities.\nThere are some basic differences between the “investment” point of view\nand the “speculative.” It is a good thing to know these differences and make\nsure you know exactly where you stand (see Figure 18.2). Either viewpoint\nis tenable and workable, but you can create serious problems for yourself,\nand sustain heavy losses, if you confuse them.\nOne difference is a speculator deals with stocks as such. A stock, to be sure,\nrepresents ownership in a company, but the stock is not the same thing as\nthe company. The securities\n76\n72\n68\n64\n60 Sales 100's 125 100\n75\n50\n25\nCUX\nCUDAHY PACKING\nJULY AUGUST SEPTEMBER OCTOBER NOVEMBER DECEMBER\nI 7 114 I 211 28> 4 i 111181 251 1 1 8 115122 ■ 29 I 6 113 120 127 1 3\n110117 >241 1 * 8 11^ 22 • 29 •\nFigure 18.1 It is possible to lose money owning stocks in a Bull Market.\nNotice this Major Top Formation did not occur in 1929, but in the summer\nof 1928. For more than a year after this, a majority of stocks and the\nAverages continued the Bull Market Advance. But Cudahy declined\nsteadily, reaching a price below 50 well before the 1929 Panic, and\ncontinued in its Bearish course for more than four years, ultimately selling\nat 20. Except for the somewhat unusual volume on the head on August 21,\nthis is a typical Head-and-Shoulders Pattern with a perfect Pullback Rally in\nmid-November. It underscores what we have mentioned before—a Head-\nand-Shoulders Top in a stock, even when other stocks look strong, cannot\nsafely be disregarded.\nThe Head-and-Shoulders Pattern, either in its simple form or with multiple\nheads or shoulders, is likely to occur at Major and Intermediate Tops, and in\nreverse position at Major and Intermediate Bottoms. It has the same general\ncharacteristics as volume, duration, and breakout as the Rectangles and the\nAscending and Descending Triangles. In conservative stocks, it tends to\nresemble the Rounding Turns.\nof a strong company are often weak, and sometimes the securities of a very\nweak concern are exceedingly strong. It is important to realize the company\nand the stock are not precisely identical. The technical method is concerned\nonly with the value of the stock as perceived by those who buy, sell, or own\nit.\nA second difference is in the matter of dividends. The “pure investor,” who,\nby the way, is a very rare person, is supposed to consider only the “income”\nor potential income from stocks—the return on his investment in cash\ndividends. (EN: This rara avis is largely extinct now.) Nevertheless, there\nare many cases of stocks that have maintained a steady dividend while\nlosing as much as 75% or more of their capital value. There are other cases\nin which stocks have made huge capital gains while paying only nominal\ndividends or none at all. If the dividend rate were as important as some\ninvestors consider it, the only research tool one would need would be a\ncalculator to determine the percentage yields of the various issues; hence,\ntheir “value,” which, on this basis, stocks paying no dividends would have\nno value at all.\nFrom the technical standpoint, “income,” as separate from capital gains and\nlosses, ceases to have any meaning. The amount realized in the sale of a\nstock, less the price paid and plus total dividends received, is the total gain.\nWhether the gain is made entirely in capital increase, entirely in dividends,\nor in some combination of these, makes no difference. In the case of short\nsales, the short seller must pay the dividends. Although, here again, this is\nsimply one factor to be lumped with the capital gain or loss in determining\nthe net result of the transaction.\nFigure 18.2 What would you have done with Hudson Motors? The great\nPanic Move of October-November 1929 carried the Dow-Jones Industrial\nAverage down from its September all-time high of 386.10 to a November\nlow of 198.69. A rally, bringing the Average back to 294.07 in April 1930,\nrecovered 95 points, or 51% of the ground lost, a perfectly normal\ncorrection.\nSuppose you had bought HT after the decline from its 1929 high of 93 1/2,\nsay at 56, in the belief that the 37-point drop had brought it into a “bargain”\nrange. On your daily chart, you would have seen the pattern shown above\n(which you will now recognize as a Descending Triangle) taking shape in\nthe early months of 1930. Would you have had a protective stop at 51?\nWould you have sold at the market the day after HT broke and closed below\n54? Or would y", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 131}
{"text": "9 high of 93 1/2,\nsay at 56, in the belief that the 37-point drop had brought it into a “bargain”\nrange. On your daily chart, you would have seen the pattern shown above\n(which you will now recognize as a Descending Triangle) taking shape in\nthe early months of 1930. Would you have had a protective stop at 51?\nWould you have sold at the market the day after HT broke and closed below\n54? Or would you have hoped for a rally, perhaps even bought more\n“bargains” at 50, at 48, at 40? Would you still have been holding onto your\n“good long-term investment” when HT reached 25 1/2 in June? Would you\nstill have been holding HT when it reached its ultimate 1932 bottom at less\nthan 3 (see Figure 8.22)? (EN: See Figure 18.4 for a recapitulation of the\nlesson from the 2000s.)\nThere is a third source of confusion; very often, the “pure investor” will\ninsist he has no loss in the stock he paid $30.00 for, which is now selling at\n$22.00, because he has not sold it. Usually he will tell you he has\nconfidence in the company and he will hold the stock until it recovers.\nSometimes he will state emphatically that he never takes losses.\nHow such an investor would justify his position if he had bought\nStudebaker at more than $40.00 in 1953 and still held Studebaker Packard\nat around $5.00 in 1956 (EN: Or Osborne at $25.00 and $0.00 in the 1980s\nor Visacalc at similar prices in the same decade. EN9: Or Enron and\nWorldCom in the 2000s. Or Bear Stearns, or Lehman, or ... ) is hard to say;\nhowever, for him, the loss does not exist until it becomes a “realized” loss.\nActually, his faith the stock will eventually be worth what he paid for it may\nbe no more than a speculative hope—and a forlorn one at that.\nFurthermore, one may question whether his reasoning is always consistent.\nFor example, suppose another stock this investor had bought at $30.00 was\nnow selling at $45.00. Would he tell you he did not consider a profit or loss\nuntil the stock was sold? Or would he be tempted to speak of the “profit” he\nhad in this purchase?\nIt is all right to consider gains or losses either on the basis of “realized” or\ncompleted transactions, or on the basis of the market values “accrued” at a\nparticular time? Yet, it is not being honest with yourself to use one method\nto conceal your mistakes and the other method to accentuate your\nsuccesses. The confusion of these concepts is responsible for many\nfinancial tragedies. (EN: One might almost say, in the modern context, such\nconfusion amounts to willful or neurotic behavior. Given the easy\navailability of portfolio software that marks-to-market positions, avoidance\nof this knowledge can only be regarded as self-defeating.)\nAs a trader using technical methods, you will probably find the most\nrealistic view is to consider your gains and losses “as accrued.” In other\nwords, your gain or loss at a given time will be measured with reference to\nthe closing pricing of the stock on that day.\nRecapitulating, it is important (1) to avoid regarding a stock and the\ncompany it represents as identical or equivalent; (2) to avoid the conscious\nor unconscious attribution of “value” to a stock on the basis of dividend\nyield, without regard to market prices; and (3) to avoid confusing “realized”\nand “accrued” gains or losses.\nThe technical trader is not committed to a buy-and-hold policy. There are\ntimes when it is clearly advantageous to retain a position for many months\nor for years, but there are also times when it will pay to get out of a stock,\neither with a profit or with a loss. The successful technician will never, for\nemotional causes, remain in a situation that, on the evidence at hand, is no\nlonger tenable.\nAn experienced trader using technical methods can take advantage of the\nshorter Intermediate Trends, and it can be shown that the possible net gains\nare larger than the entire net gains on the Major Trend, even after allowing\nfor the greater costs in commissions and allowing for the greater income tax\nliability on short-term operations.\nIt should be understood that any such additional profits are not easily won.\nThey can be obtained only by continual alertness and adherence to\nsystematic tactical methods. For the market, regarded as a gambling\nmachine, compares very poorly with stud poker or roulette, and it is not\npossible to “beat the market” by the application of any simple mathematical\nsystem. If you doubt this, it would be best to stop at this point and make a\ncareful study of any such “system” that may appeal to you, checking it\nagainst a long record of actual market moves. Ask yourself whether you\nhave ever known anyone who followed such a system alone, as a guide to\nmarket operations, and was successful. (EN: After Magee wrote this, many\nsuccessful traders, aided by computer technology and advances in finance\ntheory, have created algorithmic systems that have been successful in the\nfinancial markets. However, the markets usually become aware of the\nsuccess of these systems and develop counterstrategies to defeat them. So\nthere is a tendency for the performance of mechanical systems to\ndegenerate or totally fail over time. It is the happy combination of the\nsystem with markets hospitable to it that makes mechanical systems\nsuccessful over defined periods of time.)\nThe practice of technical analysis, on the other hand, is not a mathematical\nprocess, although it does involve mathematics. It is intended to search out\nthe significance of market moves in the light of past experience in similar\ncases, by means of charts, with a full recognition of the fact that the market\nis a sensitive mechanism by which all of the opinions of all interested\npersons are reduced by a competitive democratic auction to a single figure,\nrepresenting the price of the security at any particular moment. The various\nformations and patterns we have studied are not meaningless or arbitrary.\nThey signify changes in real values, the expectations, hopes, fears,\ndevelopments in the industry, and all other factors th", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 132}
{"text": "sm by which all of the opinions of all interested\npersons are reduced by a competitive democratic auction to a single figure,\nrepresenting the price of the security at any particular moment. The various\nformations and patterns we have studied are not meaningless or arbitrary.\nThey signify changes in real values, the expectations, hopes, fears,\ndevelopments in the industry, and all other factors that are known to\nanyone. It is not necessary to know, in each case, what particular hopes,\nfears, or developments are represented by a certain pattern. It is important\nto recognize the pattern and understand what results may be expected to\nemerge from it.\nThe short-term profits are, you might say, payment for service in the\n“smoothing out” of inequalities of trends, and for providing liquidity in the\nmarket. As compared with the long-term investor, you will be quicker to\nmake commitments and quicker to take either profits or (if necessary)\nlosses. You will not concern yourself with maintaining “position” in a\nmarket on any particular stocks (although, as you will see, we will try to\nmaintain a certain “total Composite Leverage” [or risk and profit exposure]\naccording to the state of the market, which accomplishes the same result).\nYou will have smaller gains on each transaction than the long-term investor,\nbut you will have the advantage of being able to frequently step aside and\nreview the entire situation before making a new commitment.\nMost particularly, you will be protected against Panic Markets. There are\ntimes (and 1929 was by no means the only time) (EN: 1987 and 1989 also\ncome to mind. EN9: Add 20012002, if you please: May 2, 2001, Dow\n11,350; September 17, 2001, 8,062; March 18, 2002, 10,673; and July 22,\n2002, 7,532), when the long-term investor stands to see a large part of his\nslowly accumulated gains wiped out in a few days. The short-term trader, in\nsuch catastrophes, will be taken out by his stop-loss orders, or his market\norders, with only moderate losses, and will still have his capital largely\nintact to use in the new trend as it develops. (EN: The best technical\nanalysts' opinion in “modern times” is that even long-term investors should\nnot grin and bear a Bear Market. This is a necessity only for bank trust\ndepartments and believers in Burton Malkiel.)\nFinally, before we get on with the subject of tactics, the operations we are\nspeaking of are those of the small and midsize trader. The methods\nsuggested here, either for getting into a market or getting out of it, will\napply to the purchase or sale of odd lots, 100 shares, 200 shares, and\nsometimes up to lots of thousands of shares or more of a stock, depending\non the activity and the market for the particular issue. The same methods\nwould not work for the trader who was dealing in 10,000-share blocks\n(except in the largest issues) because, in such cases, his own purchases or\nsales would seriously affect the price of the stock. Such large-scale\noperations are in a special field governed by the same basic trends and\nstrategy, but that requires a different type of market tactics (see Figure\n18.3). (EN: Or, put another way, as Magee said to me one time, a mouse\ncan go where an elephant cannot.)\nStrategy and tactics for the long-term investor— What's a\nspeculator? What's an investor?\nIn the years since Magee wrote the original Chapter 18, some different\nconnotations have attached themselves to the terms “speculator” and\n“investor.” A great cultural shift has also occurred. The days when the New\nHaven (New York, New Haven, and Hartford Railroad) was a beacon of\nrespectability (and lent luster to its investor) and paid “good dividends” are\ngone forever; as is the New Haven. In fact, after the turn of the century,\ncorporations saw a change in investor sentiment about dividends. Investors\nwanted capital appreciation\nFigure 18.3 If an investor only learned one thing from this book, it would\nbe that one thing might be the salvation of his portfolio or his retirement\nplan (if all his assets in the investment plan were shares of Enron). Instead,\nthe employees of Enron made a major mistake in not having a diversified\nretirement portfolio—they had all their eggs in one basket, their income and\nsavings came from one source. But diversification is not even the crucial\nlesson here; the lesson is get out of the stock when it reverses. The corollary\nof that lesson is never buy a stock in a downtrend. However, the more\nimportant lesson is never buy a stock when it is in a swan dive. So obvious\nyou say, but not so obvious at the time for portfolio managers for the\nUniversity of Miami who continued to accumulate Enron stock even as it\nneared earth at 100 miles an hour. Of course, they had a sophisticated (?)\ncompany; the Motley Fools had a death grip on the stock all the way to the\nbottom.\nand cared less for dividends. In fact, it has lately been considered the mark\nof a “growth stock” not to pay dividends. Evidently, the days of the New\nHaven are gone forever, when an “investor” was one who bought, held, and\ncollected dividends, and “speculators” were slightly suspect men like\nMagee who played the medium-term trends and bought “unchic,\nspeculative” stocks. It all has a sepia tone to it. Yesterday's Magee\nspeculator might be called a medium-term investor today.\nAlthough the term “speculator” could still be applied to anyone who\n“trades” the market, today that old-time speculator and his kind would more\nlikely be called traders than speculators. Commodity traders who have no\nbusiness interest in the contracts they exchange are always referred to as\nspeculators, as opposed to commercials, who are hedgers and users of the\ncommodities they trade. Now “day traders” might be considered the\nequivalent of the old-time speculators—except that day trading veers\ndangerously close to gambling. And only the passive, in the opinion of this\neditor, never trade at all and sit on their holdings during Bear Markets.\nOn the spectrum of investors, from investor to gam", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 133}
{"text": "ors, as opposed to commercials, who are hedgers and users of the\ncommodities they trade. Now “day traders” might be considered the\nequivalent of the old-time speculators—except that day trading veers\ndangerously close to gambling. And only the passive, in the opinion of this\neditor, never trade at all and sit on their holdings during Bear Markets.\nOn the spectrum of investors, from investor to gambler, the old “New\nHaven Investor” who “wants his dividends” is pretty rare these days, and,\nagain, may be one of those trust departments that does not want to get sued\nand so stays out of stocks that go up. After all, prudent men do not “trade in\nvolatile stocks” but “invest in safe issues, like bonds,” which only lose\nabout 1.5%-2.0% of their purchasing value per year but preserve the\nillusion of having “preserved principal.”\nOne definition of the long-term investor\nLet us take as a long-term investor now one who expects to at least track\nmarket returns, for it has been demonstrated over a relatively long period of\ntime that this can be done by passive indexing. At the turn of the century, as\nthis is written, it would seem neither longterm, medium-term, nor short-\nterm investors think about the risks involved in matching the market\nbecause, entering the third millennium, it has been so many years since we\nhave had a really vicious Bear Market. Dow 36,000? This is a passing\nphase. As each Bull Market reaches higher and higher, the odds are lower\nand lower that it will continue— historic Bull Markets of the 1990s\nnotwithstanding.\nWhat then are the strategy and tactics for the long-term investor to achieve\na goal of matching the market? (EN9: Is it necessary to remind the reader of\nChapter 4 and the Dow Theory?)\nLet us remark immediately that the tactics Magee described for the\nspeculator—or trader if you will—are not at all in conflict with the short-\nterm tactics used occasionally by the long-term investor. As buying or\nselling time approaches the stops of the long-term investor, that investor\nbecomes a trader who can and should adopt the trader's tactics. Sooner or\nlater, the focus even narrows to real time at the moment of trade execution.\nInterestingly, the charting techniques we have described here work on tick-\nby-tick data in real time also. Hence, if the trader wants to enter into the\nreal-time environment, he can attempt to time his trade right down to the\nreal-time chart formations. Only the really active and skilled long-term\ninvestor will be concerned with squeezing the last half point or points out of\nhis position. This illustration of the time focus is addressed to any investor\nor trader or speculator to demonstrate the fractal nature of both price data\nand the applicability of Magee-type technical analysis to it.\nThe strategy of the long-term investor\nThe strategy of the long-term investor is to catch the long trends—to\nparticipate in trades that lasts months and years. However, this strategy does\nnot intend to be sucked into long Bear Markets. Rather, portfolios are\nliquidated or hedged when Bear Market signals are received. As has been\npreviously seen in examples of the performance of (more or less)\nmechanical Dow Theory (see Chapter 4), this kind of performance can be\nquite satisfactory—better indeed than buy-and-hold strategies that have\ncome much into vogue because of the Clinton-Gore Bull Markets of the\n1990s.\nIf the goal is to beat not only the markets but also the mutual funds (only\n20% of which outperform the market over the long term anyway—and\nsometimes none of them make money), then passive indexing is the most\nlikely strategy. This may be done in a number of ways—index funds,\nbuying the basket, buying the futures, and so on. Nevertheless, the most\nattractive method might be the use of the Standard & Poor's Depositary\nReceipts (SPDRs; SPY) and DIAMONDS™ (DIA) and the like. The tactics\nmay be calibrated to the risk tolerance and character of the investor. He\nmight hedge or sell on Dow Theory signals, or on breaks of the 200-day\nmoving average, or on breaks of the long-term or intermediate trendlines\nwith a filter (Magee recommended 2%, and this might be calibrated to the\ncharacter of the markets and increased to 3% or a factor relevant to actual\nmarket volatility). Basing Points (see Chapter 28) is also a powerful\nmethod. Instruments we have previously discussed— SPDRs,\nDIAMONDS, index futures, and options—can be used to execute these\ntactics.\nSuffice it to say that every strategy must provide for the plan gone wrong,\nin other words, the dreaded Bear Market. Bear Markets would not be so\nfearsome if the average investor did not insist on seeing only the long side\nof the market. Long-term strategies go out the window quickly when blood\nruns on the floor of the New York Stock Exchange. The well-prepared\ntechnical investor has a plan that provides for the liquidation of positions\ngone bad and presumably the discipline to execute it.\nThis involves the regular recomputation of stops as markets go in the\nplanned direction, and ruthless liquidation of losers that do not perform.\nOne may think of a portfolio as a fruit tree. Weak branches must be pruned\nto improve the yield. Stop computation is treated in a number of places in\nthis book (see Chapters 27 and 28). For the investor trading long term, this\nmay be, as an example only and not as a recommendation, the breaking of\nthe 200-day moving average or the breaking of a long-term trendline. The\n200-day moving average is widely believed to be the long-term trend\nindicator, for which believing will sometimes make it come true. (EN9: Let\nme emphasize here that “200” is a parameter and an example. Personal\nresearch may fit a better parameter to the actual market.)\nIn reality, more than just the 200-day moving average or a manually drawn\ntrendline should be looked at. The chart patterns comprising the portfolio\nshould be considered also, as well as charts of major indexes and averages.\nAlso, consider the condition of the averages and", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 134}
{"text": "e emphasize here that “200” is a parameter and an example. Personal\nresearch may fit a better parameter to the actual market.)\nIn reality, more than just the 200-day moving average or a manually drawn\ntrendline should be looked at. The chart patterns comprising the portfolio\nshould be considered also, as well as charts of major indexes and averages.\nAlso, consider the condition of the averages and their components—their\ntechnical state—whether they are topping, consolidating, or trending as\nindicated by their charts.\nMoreover, it would be impossible not to mention Magee's Basing Points\nProcedure (see Chapter 28). Possibly the most powerful trailing stop\nmethod in existence.\nRhythmic investing\nIn addition, if Chapter 31 on “Not All in One Basket” is weighed seriously,\none might be rolling a portfolio from long to short gradually in natural\nrhythm with the markets and in harmony with the Magee Evaluative Index\ndescribed there. That is the preferred strategy of the authors and editor of\nthis book.\nThese things all depend on the goals, temperament, and character of the\ninvestor. If he is going to spend full time on the markets, he is probably not\na long-term investor. Such men eat well and sleep soundly at night. The\ntrader is lean and hungry—not necessarily for money, but for activity. It\nbehooves one to know his type as a trader or investor. Knowing one's type\nor character is best established before finding it out in the markets, as the\nmarkets can be an expensive place to search for self-knowledge.\nThere is no inherent conflict in holding long-term positions and also\nattempting to profit from intermediate trends, depending on the amount of\ncapital in hand and how much time, energy, and capital the investor wants\nto put into trading. A long-term strategy can be implemented with a\nmodicum of time and energy, as follows: pay attention to the major indexes\nand averages and buy on breakouts, at the bottoms of consolidations and on\npullbacks; sell or hedge on the breaking of trendlines, calculated on Basing\nPoints (see Chapter 28) and the penetration of support zones.\nThe long-term investor will accept greater swings against his position than\nthe intermediate-term trader or speculator. As an example with the method\nof using Basing Points in Chapter 28, the speculator is using a three-days-\naway rule, whereas a long-term investor might be using a three-week\nBasing Point or some such analogy. Plus, if interested, when he suspects or\nanalyzes a long Bull Market is approaching a climax, he might adopt the\nthree-days rule also, or even begin following his stock with a daily stop just\nunder the market. Beware though, as professionals look for stops just under\nthe close of the previous day in situations such as these.\nIt would be wise not to confuse long-term investing with “buy and hold,” or\nas it was expressed in one investment fad in the 1970s, “one-decision\ninvesting.” As an example of this misguided thinking, in 1972, the “best and\nbrightest” investment analysts (fundamental) on the Street picked a\nportfolio of stocks for the generation, or 20 years. The companies would be\ndifficult to argue with as the creme de la creme of American business. After\nall, who could kvetch at Avon, Eastman Kodak, IBM, Polaroid (unless he\nhappened to look at Figure 37.27), Sears Roebuck, and Xerox? Even today,\nif you did not have a close eye on the market, you would immediately\nrespond, “blue chips.” Consider the following table showing the stocks and\nthe results achieved over the long term.\nPrice Price Percent\nStock 4/14/7212/31/92Change\nAvon Products61.00 27.69 (54.6)%\nEastman Kodak42.47 32.26 (24.0)%\nIBM 39.50 25.19 (36.2)%\nPolaroid 65.75 31.13 (52.7)%\nSears Roebuck21.67 17.13 (21.0)%\nXerox 47.37 26.42 (44.2)%\nIn 2017, the vagaries of unsupervised portfolios is again seen: Avon 2.50;\nKodak 7.75; IBM 141; Polaroid unlisted; Sears 7.21; Xerox 32.64. Beware\nof pundits and mindless investing.\nCharts (Figures 18.4 and 18.5) showing activity for IBM and Xerox appear\non the following pages.\nFigure 18.4 The questionable—even bizarre—results of “one-decision\ninvesting” (i.e., buy and hold) are amply illustrated by this chart. First of\nall, the “best and brightest” recommended IBM at a decade high to see it\ndecline by more than 50%. It subsequently recovered to double from their\noriginal recommendation. Ah, sweet justification! Only, unfortunately, at\nthe end of 20 years to see it rest approximately 40% beneath the\nrecommendation. The analytical lines give some hint of how a technician\nmight have traded the issue. I like to say that there are bulls, bears, and\nostriches, and anyone who followed this one-decision investment proves\nmy case.\nFigure 18.5 Like IBM in the previous figure, Xerox was recommended at a\nplace at which it should have been sold instead of bought. The comments\nthere might apply to the chart here. The foolishness of “buy and hold” or\n“one-decision investing” is amply illustrated by observing the long-term\nswings of the stock and thus of the investor's equity. Technical analysis is\nintended to be an antidote to such foolishness.\nSummary\nThe long-term investor attempts to catch major market moves—those\nlasting hundreds, if not thousands, of Dow points and stay in trades for\nmany months if not years.\nWithin this time frame, he expects to take secondary trends against his\nposition. Depending on his temperament and inclination, he may attempt to\nhedge his portfolio upon recognizing secondary market moves against his\nprimary direction.\nHis preference for stocks and portfolio will be for market leaders, for\nbaskets that reproduce the major indexes (or Index Shares) as the ballast for\nhis portfolio, and he may choose some speculative stocks to add spice to his\nportfolio.\nIn spite of his penchant for long-lasting trades he will not tolerate weak,\nlosing, or underperforming stocks. They are the shortest of his trades. He\nwill cut losses and let profits run, the truest of the market maxims and the\nleast understood b", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 135}
{"text": "reproduce the major indexes (or Index Shares) as the ballast for\nhis portfolio, and he may choose some speculative stocks to add spice to his\nportfolio.\nIn spite of his penchant for long-lasting trades he will not tolerate weak,\nlosing, or underperforming stocks. They are the shortest of his trades. He\nwill cut losses and let profits run, the truest of the market maxims and the\nleast understood by unsuccessful investors. The other maxim least\nunderstood by investors is “buy strength, sell weakness.”\nTruly sophisticated investors attempt to participate in Bear Market trends\nalso. This is the greatest difference between professional and general\ninvestors—professionals have no bias against the short side.\nFor the convenience of day traders, the URL of Gamblers Anonymous is\nnoted: http:// www.gamblersanonymous.org.\nchapter nineteen\nThe all-important details\nIn this chapter and the one following, we take up a number of elementary\nsuggestions intended largely for the benefit of those who have never kept\ncharts before. Much of this will seem obvious and repetitive to the\nadvanced student, although even he may find some thoughts that will\nsimplify his work. The beginner should read these chapters carefully and\nuse them for later reference.\nThe details of how and when you keep the charts will not guarantee you\nprofits, but if you fail to work out these details in such a way as to make\nyour work easy, as part of a regular systematic routine, you cannot expect to\nkeep up your charts properly or make any profits.\nCharting and analyzing your charts is not a difficult process, nor will it take\ntoo much of your time if you have determined a reasonable number of\ncharts and have arranged for doing the work regularly, meaning every day\nwithout fail.\nYou will need a source of data—the day's market prices and volume. If you\nlive in a big city, your evening paper will carry the complete list, and you\ncan plan to set aside a certain period before dinner, or after dinner, or during\nthe evening. If you cannot allot such a period and keep it sacred against all\nother social or business obligations, then plan to do the charting in the\nmorning. The key is to set a definite time and let nothing interfere, ever, or\nyou are lost. (EN: This process is radically simplified by automated\ncomputer downloading procedures and access to data sources and internet\nsites, but the principle is the same.)\nYou should have a suitable place to work and keep your charts. If it is at\nhome, in the dining room or living room, other members of the family\nshould understand that what you are doing is important. You should be able\nto shut the door and work without interruption. The light should be bright\nand as free from shadows as possible. (It makes a big difference, especially\nif you are keeping a large number of charts.) The ordinary desk lamp throws\na reflected glare directly across the paper and into the eyes. It can be a\nstrain if you are doing much of this close work. Better to have an overhead\nlight, placed just a few inches in front of your head and a convenient\ndistance above; and if this light can be a fluorescent fixture using two 40-\nwatt lamps, you will get almost perfect shadowless lighting. These\nsuggestions apply in case you are not working by daylight.\nAdditionally, have plenty of room. A big desk top or a dining room table\nwith a large clear space for chart books, extra sheets, pencils, scratch paper,\nruler, calculator, computer equipment, and anything else you need. If your\nworking surface is fairly low, say 28 or 29 inches from the floor, it will be\nless tiring than the usual 30-inch desk height.\nWhether you are working in ink or in pencil, pick out the writing tool that is\neasiest for you to use. If you are using pencils, try several different makes\nand degrees of hardness. Find one that is hard enough not to smudge too\neasily, and yet is not so hard you have to bear down to make a clean black\nmark. The wrong kind of pencil can tire you and irritate you more than you\nrealize. Also, have plenty of pencils, a dozen at least, well-sharpened, so as\nsoon as one becomes a trifle dull and you are not getting a clean, fine line,\nyou can simply lay it aside and continue at once with another freshly-\nsharpened pencil.\nKeep your charts in loose leaf books with big enough rings to make turning\nthe pages easy. Do not overcrowd the books; get new books if a volume is\ntoo crowded. Finished charts may be kept in file folders. The only ones that\nneed to be in the books are the current sheets and the sheets for the\nimmediately preceding period. If possible, use a seven-ring binder. Pages\nare easily torn loose from two- and three-ring binders, but seven rings will\nhold the pages safely and you will seldom have one tear out.\nThe charts you keep will become increasingly valuable to you as the chart\nhistory builds up. The old chart sheets will be very helpful to you for\nreference. Provide a file or space where they can be indexed and kept in\nchronological order, and also have file folders for brokers' slips, dividend\nnotices, corporate reports, clippings and articles, notes on your own\nmethods, and analyses and special studies of the work you are doing.\nIn this connection you will, of course, keep a simple but complete record of\neach purchase, sale, dividend, and so on, on stocks you have bought or sold.\nThis record will make your work much easier when the time comes to\nfigure out income taxes. It will also give you all the statistical information\nyou need to judge the results of your trading operations.\n(EN: At the beginning of my investment career, and often in the middle of it,\nI thought the above was cracker-barrel wisdom. The longer I last the more I\nthink that homespun wisdom might be the best kind to have in investing—\nsomewhat like Mark Twain, who was astounded at how much his father\nincreased in wisdom the older Twain himself got.\nWe may restate the modest homilies above: Be serious. Be methodical. Be\ndisciplined. Be businesslike.", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 136}
{"text": "er, and often in the middle of it,\nI thought the above was cracker-barrel wisdom. The longer I last the more I\nthink that homespun wisdom might be the best kind to have in investing—\nsomewhat like Mark Twain, who was astounded at how much his father\nincreased in wisdom the older Twain himself got.\nWe may restate the modest homilies above: Be serious. Be methodical. Be\ndisciplined. Be businesslike. Anyone who succeeds in investing without\nthese qualities is the recipient of blind luck and will be fortunate not to fall\ninto a hole before his career is over.\nThese thoughts occur when one is wondering how Magee would have\nviewed the advent of the microcomputer and its impact on technical\nanalysis and investing. Might he have said, “What hath this tool wrought?!\nWonders and abominations!!”\nGiven the possibilities for complicating analysis and operations when\nconfronted with all the bells and whistles of the average computer software\npackage, the investor must maintain perspective. What, then, are the all-\nimportant details in practicing technical analysis with the aid of a\ncomputer?)\nThe simplest and most direct way to use\na computer for charting analysis\nIn reality, the computer can be used as a simple tool to do a simple job.\nThere is nothing inherently complicated about keeping a chart on a\ncomputer. All computer software packages enable bar charting and many, if\nnot most, enable many other kinds of charting, from candlesticks to\noscillator charting. The process, in almost all commercially available\npackages, is so simple that explaining it here would be superfluous (see\nAppendix B, Resources, for demonstrations), except to generally say it\nconsists of retrieving data, updating the program's price database, and\nclicking an icon to run a chart. The software packages themselves explain\ntheir features better than can be done here. What is important here is to\ngive perspective. Even simpler when the whole process takes place on the\ninternet, as at http://www.stockcharts.com or http://www.bigcharts.com, or\nhttp://www. tradestation.com.\nIn this respect, charting can be done with quite expensive programs and\nalso on publicly available free programs or freeware. Charting can also be\ndone with interactive charting programs on many internet sites. The basic\nbar chart can be enhanced with an unending number of technical studies—\nmoving averages, oscillators, and so on. Therein lies the danger. Chart\nanalysis in itself is a qualitative process. Decorating graphic charts with\nnumber-driven information and studies can lead the general investor astray\n—and into confusion and indecision.\nThus, the first preference of this analyst is to keep the process as simple as\npossible. Get the data, draw a chart, analyze the patterns, consider the\nvolume, and draw the appropriate analytical lines—this can usually be\ndone by the program on the screen. Often a better graphic picture may be\nobtained by printing the chart and hand-drawing the analytical lines. This\nbrings to the fore one of the main problems of almost all the software\npackages—screen graphics are poor and, at least to old chartists,\ndisorienting. They are especially befuddling to analysts who are\naccustomed to working on TEKNIPLAT™ chart paper. With passing\neditions of Resources, this problem will be dealt with. (EN9: In the\nintervening years since the eighth edition, two things have occurred: the\neditor adjusted to modern technology and the technology achieved a level\nof excellence acceptable to a carping analyst. Internet technical analysis\nsites such as http://www.stockcharts.com and http://www.thinkorswim.com\nimproved to be surprisingly valuable resources at unbelievably low prices—\neven free.)\nThe question of graphic representation of the facts is worth noting as a\npersistent one. To a certain extent, the individual analyst will solve this\nconundrum by adapting his eye and mind to a graphic environment, using\none graphic method consistently and seeing how it relates to the facts in the\nmarket. John Magee-oriented solutions to this problem will be available on\nthe website http:// www.edwards-magee.com.\nIn Appendix B, Resources, the reader may see some examples of simple and\ninexpensive software packages and internet sites that are quite adequate to\nthe required tasks of charting technical analysis, as well as more complex\nnumber-driven analysis.\nSummary\nThe computer is an invaluable tool for analysis. Use of it will enable the\nfollowing:\n• Data may be acquired automatically via internet or dial-up sites at\nlittle or no cost. Some of these even offer real-time data, which is a\nway for the unsophisticated trader to go broke in real time, but which\nthe general investor may desire on the day of executing a trade. Many\nof these sites offer every kind of analysis from respectable technical\nanalysis (usually too complicated) to extraterrestrial channeling.\n• A computer package and internet portfolio sites will give the analyst\nvirtually effortless portfolio accounting and mark-to-market prices—a\nvaluable device to have to keep the investor from mixing his cash and\naccrual accounting, as Magee says.\n• The computer will enable processing of a hitherto unimaginable\ndegree. An unlimited number of stocks may be analyzed. Choosing\nthose to trade with a computer will be dealt with in Chapters 20 and\n21.\n• Appendix B, Resources, contains information on software packages\nthat the reader may try and purchase at quite reasonable prices. In all\nlikelihood, the least expensive of these will be adequate to the needs of\nmost general investors. In addition, I present a brief discussion of\ninternet sites and resources.\nTaylor & Francis\nTaylor & Francis Group\nhttp://taylorandfrancis.com\nchapter twenty\nThe kind of stocks we want: the speculator's\nviewpoint\nThe specifications of the kind of stock we want to chart are fairly simple\nand few. We want a stock that will enable us to make a profit through\ntrading operations, meaning a stock whose price will move over a wide\nenough", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 137}
{"text": "ussion of\ninternet sites and resources.\nTaylor & Francis\nTaylor & Francis Group\nhttp://taylorandfrancis.com\nchapter twenty\nThe kind of stocks we want: the speculator's\nviewpoint\nThe specifications of the kind of stock we want to chart are fairly simple\nand few. We want a stock that will enable us to make a profit through\ntrading operations, meaning a stock whose price will move over a wide\nenough range to make trading worthwhile. There are those who are\nconcerned mainly with safety of principal and the assurance of income from\na stock. For them, there are (EN9: or were) stocks that afford a considerable\ndegree of stability. You may (and probably will) want to keep a substantial\npart of your total capital in stocks of this type. They move in a narrow price\nrange; are extremely resistant to downside breaks in the market; are also\n(and necessarily) unresponsive to fast upside moves in the market as a\nwhole, and are highly desirable for the conservative investor. They are not,\nhowever, the most suitable issues for trading operations, because their\nswings are small, and commissions would tend to diminish the narrow\ntrading profits that could be taken. Also, they do not make the sharp, clear\nchart patterns of the more speculative issues, but move in rounding,\nsluggish undulations. (EN9: These remarks reflect a bygone time. The\ndescribed stocks by and large went the way of the Dodo. When T can\ndisappear from the market as a factor, there is no place to hide, except in\nbonds, which, when stagnant, only lose real value at the rate of inflation\nand loss of purchasing power of the dollar. Even bonds should be subject to\nfrequent reevaluation using the tools described in this book.) (For\nillustrations in this chapter, see Figures 20.1 through 20.4.)\nTo amplify this comment and explain a bit about what underlies what we\nare doing, let us assume a certain company has two issues of stock, a\npreferred and a common. We will assume the concern has a certain steady\nminimum profit it has earned for years, sufficient to pay the preferred\ndividend, the continuance of these dividends seems practically assured. The\ndividends on the preferred are fixed at, let us say, 6%. Now the common\nstock gets all that is left. In one year, there may be $0.50 a share for the\ncommon stockholders. The next year, there may be $2.00 a share or four\ntimes as much. In a case like this, if there are no other factors, you would\nexpect the preferred stock to sell at a fairly steady price without much\nchange, whereas the common stock is subject to a “leverage” and might\nshoot up to four times its former value. The more speculative issues\nrepresent either a business that is, by its nature, uncertain as to net profit\nfrom year to year, where the volume of business or the profit margin\nfluctuates widely, or one in which the majority of the “sure” net profit has\nbeen sheared off for the benefit of senior obligations. There are also other\nfactors that affect the speculative swing of a stock, and, as a result, one\nissue may be very sensitive and another extremely conservative, and\nbetween them there would be all shades and degrees of sensitivity or risk. It\nis enough here to note briefly the nature of the business itself does not\nalways account for the habits of the stock because the other factors may be\nvery important. Most stocks have a fairly well-defined “swing” power,\nwhich can usually be determined by past performance of\n76\n72\n68\n64\n--------------------------------1--------------------------------\n_ GOODYEAR TIJ\nCOMMON\nRE ”ti\n60\n56\n52\n48\n44\n40\n36\n32\n28\nJ1L\nJ\nJi1 1 I\npnpr\n1\nir\nI\n1943 1944 194519461947\n120\n112\n104\n96\n88\n80\n---------------------------------1--------------------------\n-------\n“GOODYEAR T 1 ST PREFERR]\nIRE\nRD\nII ill\nl.lll, ■■•I,,...\"1 ...........nil.I\n.Hl1'\nr\n1943 1944 1945 1946 1947\nFigure 20.1 Opportunity vs. Security. Here (at left) is Goodyear Common,\nrepresenting the residual interest in all profits after senior obligations have\nbeen met, compared (at right) with the Goodyear $5.00 Preferred, which\ncarries a high degree of assurance that the $5.00 dividend will be met, but\nno promise of further participation in profits. Monthly range of each stock\nfor the same 54-month period is shown on a ratio scale. As the Common\nmakes an advance of more than 300%, the Preferred advances about 25%,\nleveling off at a point that represents the maximum price investors are\nwilling to pay for the sure $5.00 dividend.\n88\n89\n90\n99\n00\n92\n93\n97\n500\n400\n300\n1500\n1400\n1300\n1200\n1100\n1000\n900\n800\n700\n600\nSPX LAST-Monthly-—\n94\nFigure 20.2 S&P. Here the benefits of relaxed long-term investing may be\nseen, buttressed, of course, by the longest and handsomest Bull Market in\nAmerican history in the Clinton-Gore years. At the end of this record, the\neffects of public enthusiasm (or as Chairman Greenspan of the Fed said,\n“irrational exuberance” vide tulipomania) can be seen in the wide\nundisciplined swings (best seen in Figure 20.3). The dotted line represents\n150-day (approximately) Moving Average. Just using the Moving Average\nas a signal (or the Basing Points Procedure) would have beaten the market\nand 99% (the 99%) of other investors.\nII'.\nZj\nI\nI’\n2000000\n1600000\n1200000\n8000000\n4000000\n'5/19986/19r987/i99887i998,9/1998’'\n2/19993/199\n>4/1999 5/1999 6/1999 7/1999 8/1999 9/1999 10/1999 11/1999 12/199\n'10/1998'11/1998 12/1998 99\n129.999\n).999\n114.999\n• 104.999\n.. 9 4.999\n■ • • 109.999\nSPY LAST-Daily J ; ;\nCreated with TiadeStation www.Tai i +-■\nT\ni\ni.....\nFigure 20.3 SPY. For illustration, here is a chart of the AMEX Index Share,\nthe SPY, or ETF based on the S&P 500. After the crash of 1998 (the Asian\nEconomic Flu crash), the fan lines tell a story, as does the last phase of the\nchart where the market whips in what appears a Broadening Top. (EN9:\nNote this Broadening Top was identified in 1999-2000 before the crash as\ndocumented in the http://www. edwards-magee.com archives. See Figure\n20.4.)\nFigure 20.4 The S&P 500 in all its glory and tragedy. An", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 138}
{"text": "e S&P 500. After the crash of 1998 (the Asian\nEconomic Flu crash), the fan lines tell a story, as does the last phase of the\nchart where the market whips in what appears a Broadening Top. (EN9:\nNote this Broadening Top was identified in 1999-2000 before the crash as\ndocumented in the http://www. edwards-magee.com archives. See Figure\n20.4.)\nFigure 20.4 The S&P 500 in all its glory and tragedy. An especially good\nportrait by Holbein, the younger. The Broadening Top pointed out in Figure\n20.3 in 2000 foretold the decline of the S&P to below 790—not quite 50%\nbut close enough to catch the eye. Particularly fine lessons here, besides the\nBroadening Top lesson. All of them screaming for action. The broken\ntrendline at A, the broken trendline at B, the broken “neckline” or\nhorizontal line at C. Notice the close correspondence of the break at B and\nC. The next lesson is not to buy downtrends until a clear bottom is made in\na major bear market. Clearly no bottom is made until the Kilroy Bottom at\n1-2-3. Even then, the least risky trade for the long-term investor is when the\nKilroy Fenceline (Neckline) is broken at D. All of this was knowable at the\ntime.\nhow a stock will behave in the future as to the extent of its swing. (EN9: Or\nwe might say, short-term volatility and long-term range.)\nIncidentally, for short-term trading (EN9: amusing in the modern context;\nby short-term trading Magee means trading of trends of shorter length than\nDow Waves), we are thinking about the habits of the stock that are only\npartly determined by the business it represents. Purchase of stock in one\ncompany that has a somewhat uncertain or fluctuating profit record may be\nmore conservative than purchase of a highly leveraged stock of another\ncompany whose basic business is steadier and more conservative. We will\ntake up the matter of determining these risk constants a little later.\nOne should also understand the short sale of a stock does not imply any\nfeeling that the country is going to the dogs or even that the concern\nrepresented is going to the dogs. Such a sale merely indicates your belief\nthe stock may be temporarily overpriced; that earnings or dividends may\nhave been abnormal in recent years and are likely to be reduced; or that for\none reason or another, the stock of the company may be worth a bit less\nthan it has been worth.\nFor technical trading, we want a fairly speculative stock, one that will make\nsizable swings up in a Bullish Trend and down in a Bearish Trend. The very\nfactors that tend to make a stock safe and desirable to the investor may\nmake it entirely unsuitable for trading. Also, with certain reservations that\nwill be taken up later on, the more speculative the stock the better it is for\nour purposes.\n(EN: Entering the third millennium (since we Anglo-Saxons started\ncounting—the fourth or fifth by other measures), the distinctions between\n“speculative” stocks and every other kind of stock has grown increasingly\nblurry. Rather than apply a perhaps pejorative (in the minds of some\nreaders) term like “speculative” to otherwise-innocent stocks, we would do\nbetter to describe stocks as wide ranging or narrow ranging, as volatile or\nnonvolatile. Stocks may then be evaluated one against another by their\nbetas and historical volatilities, statistical data easy to obtain. “Betas” and\n“volatilities” are dealt with in Chapters 24 and 42.)\nIn line with this more current thinking, there is another question for readers\nof this book—the choice of trading (or investment) instruments for the long-\nterm investor.\nThe kind of stocks we want: the long-term investor's viewpoint\nChanging opinions about conservative investing\nVirtually no one invests like the conservative investor described above in\nChapter 20— except perhaps trust departments of antediluvian banks. There\nmay be some investors still out there who are so risk averse they still follow\nthe method described. Bank trust departments may be still doing it; they\nused to do it so the trust beneficiaries could not sue them. This is the reason\ntrust departments exist, to give legal cover (the so-called prudent man rule)\nto trustees in case of suit by beneficiaries. Most enlightened trust\ndepartments and trustees now probably follow indexing or other more\nproductive strategies to cater to new understandings of the prudent man\nrule.\n“Indexing” refers to the practice of constructing a portfolio to replicate or\nclosely reproduce the behavior of a widely followed index such as the\nStandard & Poor's (S&P) 500 or the Dow-Jones Industrials. These\nportfolios never track the Indexes exactly because the advisors and funds\nwho manage them take management fees and expenses. These fees are\ngenerally less than fees and expenses on actively managed funds, but in fact\nare not necessary for the private investor to pay because even the tyro\ninvestor can now use “Index Shares” (e.g., DIAMONDS™ [DIA], S&P\nDepositary Receipts [SPDR; SPY, QQQ,] and so on) or other proxy\ninstruments to do what the funds and professionals do. Essentially what\nindexing does is track the Averages, a strategy that was impossible or\ndifficult (expensive) when Magee examined it, as in Chapter 15. (EN9: In\nthe opinion of this editor, hiring a management company to run an indexing\nstrategy is a waste of capital. Much better for the investor to invest directly\nin ETFs and to exit the market when uptrends end and reverse. This is a\nmuch better strategy than “passive indexing,” which cleverly manages to\ncapture both losses and profits in the Averages.)\nThe kinds of stocks long-term investors want:\nthe long-term investor's viewpoint\nPerhaps one of the most important actualizations of recent editions is to\nbring current this book's treatment of the Averages, noting that it is now\npossible to trade the Averages in stock-like instruments. This fact deserves\nto be marked as a vitally important development in modern markets. This\nchapter will confine itself to describing facilities for trading and investing in\nthe Ave", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 139}
{"text": "'s viewpoint\nPerhaps one of the most important actualizations of recent editions is to\nbring current this book's treatment of the Averages, noting that it is now\npossible to trade the Averages in stock-like instruments. This fact deserves\nto be marked as a vitally important development in modern markets. This\nchapter will confine itself to describing facilities for trading and investing in\nthe Averages and Indexes.\nIn 1993, the American Stock Exchange (AMEX) introduced trading in\nSPDRs™, an Exchange-traded unit investment trust based on the S&P 500\nComposite Stock Price Index. The AMEX calls these securities Index\nShares™, a name they also use for other similar instruments. As noted\nabove, large investors and funds have long traded “baskets” of stocks\nrepresenting the S&P 500, obviously an activity requiring large capital. In\nfact, a certain class of investment managers and funds have practiced\n“passive investing” meaning indexing, primarily for large clients. The\npurchase and liquidation of these and other “baskets” is one form of\n“program trading.”\nRecognizing the utility of this investment practice, the AMEX created the\nSPDR as a proxy instrument to allow the smaller investor to practice the\nsame strategy. The effectiveness of this product introduction may be\nmeasured by public participation in the trading of the SPDR (SPY). By\n2000, almost $15 billion was invested in SPDRs with more than\n100,000,000 shares outstanding. These units allow the investor to buy or\nsell the entire portfolio or basket of the S&P 500 stocks just as he would an\nindividual stock, but the capital required to do so is radically reduced.\nIn 1998, the AMEX introduced DIA, Index Shares on the Dow-Jones\nIndustrial Average™ (DJIA), which is analogous in every way to the\nSPDRs. Thus, an investor may “buy the DJIA.” So in current financial\nmarkets, it is possible to “buy the market,” unlike those conditions under\nwhich Edwards and Magee operated.\nConstruction of the Index Shares and similar instruments\nThe AMEX unit investment trusts are constructed to replicate the\ncomposition of their base instrument. The SPDR, for example, is an\ninstrument that represents one-tenth of the full value of a basket of the S&P\nstocks and trades on the AMEX, just like a stock (SPY). Other\ncharacteristics of stocks are also reproduced such as long life (the SPDR\nTrust lasts into the twenty-second century) and quarterly dividends (cash\npaid on the SPDRs reproducing dividends accumulated on the stocks of the\nS&P 500). Even dividend reinvestment is possible, and the units may be\ntraded on the AMEX during regular trading hours. Under normal\nconditions, there should be little variance in the price of the SPY relative to\nthe S&P 500. (In 2008, the AMEX merged with the New York Stock\nExchange. Trading and instruments remain as described.)\nThese elements, as discussed for SPDRs, are common to all the Index\nShares— DIAMONDS, World Equity Benchmarks (WEBs), and others.\nThere are, of course, some expenses and costs to using the Index Shares—a\nsmall price to pay for the use of the instrument and generally less than the\ncosts of a fund. Index Shares are also much more flexible for the\nindependent investor. Among other advantages, the private investor can\ncontrol the tax consequences of his investment, which is not possible in\nfunds.\nOther Exchanges have created similar security instruments or derivatives or\nfutures to replicate or track the well-known averages and indexes. Among\nthese are tracking shares or index shares or futures (let us call them\n“instruments”) on other indexes (Russell, Nikkei, and so on) or options on\nthe futures or indexes until there is a bewildering array of instruments\navailable for trading, investing, and hedging. Among the more important\nexchanges and instruments traded are the Chicago Board of Trade (futures\nand options on futures on the Dow); the Chicago Mercantile Exchange\n(futures on the S&P, Nikkei 225, Mini S&P 500, S&P Midcap 400, Russell\n2000, and NASDAQ 100); and the Chicago Board Options Exchange (S&P\n100 and 500 options). This, by no means, is an exhaustive list. All the\nfutures and options that matter will be found listed in the Wall Street\nJournal under Futures Prices or Futures Options Prices.\nThis book does not deal in comprehensive detail with futures and options,\nbut it is worth mentioning these exchanges and their futures and options\nproducts because of the facility they offer the investor and trader for\nhedging portfolios in Index Shares and Average trading, not to mention\nopportunities for speculating.\nBriefly, hedging is the practice of being neutral in the market. That is, one\nmight be long the DIAMONDS and buy a put option on the DJIA at the\nChicago Board of Trade, meaning that advances in the DJIA would result in\nprofits in the DIAMONDS, and a loss of premium in the put. Conversely, a\ndecline in the Dow would result in profits in the put and losses in the\nDIAMONDS. As this area is not the province of this book, this is a highly\nsimplified description of a hedge. Nevertheless, the reader should see and\nunderstand that hedging can be an important strategy. Hedging can take the\nplace of liquidation of a portfolio when the analyst recognizes a change of\ntrend or unstable conditions but does not wish to incur taxes or wishes to\ndefer them.\nAn outline of instruments available for trading and investing\nIt would be herculean to attempt to list the entire panoply of averages,\nindexes, futures, and options available for trading—herculean due to the\nfact new trading instruments are constantly in creation and due to the fact,\nnow operating at internet speed, we may expect the rate of change to\naccelerate. In addition to those listed above, there are WEBS (meaning that\nexposure to world markets may be arranged).\nIn all, approximately 30 or more Index Share units or instruments were\navailable for trading on the AMEX at the turn of the century, in addition to\nDIAMONDS and SPDRs. Similar instruments exist on the Phila", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 140}
{"text": "act,\nnow operating at internet speed, we may expect the rate of change to\naccelerate. In addition to those listed above, there are WEBS (meaning that\nexposure to world markets may be arranged).\nIn all, approximately 30 or more Index Share units or instruments were\navailable for trading on the AMEX at the turn of the century, in addition to\nDIAMONDS and SPDRs. Similar instruments exist on the Philadelphia and\nin Chicago, and others are being created daily. To reduce the confusion, the\ngeneral investor will probably find the major indices of the most\nimportance. The more instruments one deals with the more complicated the\nstrategy and tactics become. Therefore, the Dow, the S&P 500, and the\nNASDAQ composite (DIA, SPY, QQQ) are probably sufficient for the\npurposes of the gentleman (or lady) investor. The Mid-Caps, the Nikkei,\nand others begin to come into play when the trader begins to try to catch\nsector rotation, fads, short-term cycles, and so on.\nThe importance of these instruments: diversification, dampened\nrisks, tax, and technical regularity\nIt would be difficult to underestimate the importance of these new trading\ninstruments. First of all, they afford the private investor what was\npreviously reserved for the large capital trader—the ultimate in market\ndiversification. The S&P 500 represents stocks comprising 69% of the value\nof stocks on the New York Stock Exchange. Buying it is buying the\nAmerican economy. The 30 Dow Industrial stocks represent the most\nimportant symbol in the American economy—and perhaps in the world.\nInvestors are well advised to pay attention to both Averages if they would\nfare well in the markets (Note the plural: markets). These two Averages\nnow have the influence or clout that once the Dow alone had to express the\nstate of the markets and stocks in general.\nBuying the SPY or DIA then represents the immediate acquisition of a\ndiversified portfolio. And buying the NASDAQ or QQQ gives one\nimmediate exposure to the more speculative and volatile sector of the\nAmerican economy. Given the long-term bullish bias of the averages and\nthe American economy, it is difficult to argue with this as both strategy and\ntactics for the long-term investor. This does not mean positions should be\ntaken blindly without thought or not monitored. On the contrary, recall if\nyou will the record of the Dow Theory; even for the long-term investor,\nbear markets should not be allowed to destroy liquidity and equity value.\nThese questions are discussed at greater length in Chapter 18.\nAlthough we believe these instruments are good vehicles, it is wise to\nremember Magee's frequent admonition (less important now than when\nspoken) that it is a market of stocks, not a stock market. Meaning when the\ntide is flowing down with the Dow and S&P, prudence and care must be\nused in taking long positions in stocks that are in doubt as to direction.\nAdditionally, it is worth noting investments in these instruments will be less\nprofitable than an astutely chosen individual stock. For example,\nQualcomm appreciated approximately 240% (temporarily) in 1999-2000\ncompared with about 24% in the S&P over the same period. Those who\nbought Qualcomm at its top and sold it at the bottom of its reaction lost\nabout 75% or about $148 a share. Traders in Qualcomm tended to obsess\nand pay hyper attention to the stock, whereas investors in the SPY reviewed\nit once a week or less or told their computers or their brokers to give them a\ncall if it broke the trendline or entered stops. Then they slept at night and\nhad eupeptic digestion.\nOther advantages accrue to the trading of the SPDRs. Ownership of a fund\ncan result in tax liabilities as managers adjust portfolios to reflect changing\nmembership in the fund or withdrawals in capital by irate stockholders.\nSince Index Shares last into the twenty-second century, the long-term\ninvestor has no need to realize gains and pay taxes. Bear markets may be\ndealt with by hedging with other instruments—futures, options, or proxy\nbaskets of stock, or individual stocks, and accepting the tax consequences\nof these trades.\nJohn Magee aptly observed before the direct trading of the Averages was\npossible that the Dow-Jones Industrials were very regular and dependable\nfrom the technical point of view. This observation is annotated at some\nlength in comments on Dow Theory in Chapter 36. Therefore, the investor\nin the Index Shares may have a smoother time technically than a trader of\nan individual stock.\nSummary\nThe long-term investor and mid-term speculator attempt to capture long\nsecular (as well as cyclical) trends in the markets. They shun frequent\ntrading and capital-eroding transactions. They recognize that risk fluctuates\nwith time and trend, and they know that frequent turnover benefits mainly\nthe broker.\nThe strategy of the long-term investor may be to match the market by using\nfunds or SPDRs or baskets, but he does not like to participate in Bear\ntrends. He hedges or liquidates his positions on major trend shifts. In fact,\nhe may even short the indexes if his analysis indicates major bear markets.\nIf he desires to outperform the market (which will happen automatically if\nhe follows the methods of this work), he finds some individual speculative\nstocks to trade in addition to his foundation portfolio. Depending on his risk\ntolerance, he may always be somewhat hedged. When long the indexes, he\nfinds some stocks in downtrends to short. When he is short the indexes, he\nfinds some strong stocks to hold long. There is no excuse for a moderately\nskilled and reasonably capitalized investor to lose money over the long term\nin the market.\nAs a reminder, Chapters 5 and 28 describe powerful methods for the long-\nterm investor using Magee's Basing Points Procedure.\nchapter twenty-one\nSelection of stocks to chart\nThe trader who operates on the “fundamental” basis, making his\ncommitments on his analysis of earnings, dividends, corporate\nmanagement, prospects for the industry, and so on, will usually", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 141}
{"text": "ney over the long term\nin the market.\nAs a reminder, Chapters 5 and 28 describe powerful methods for the long-\nterm investor using Magee's Basing Points Procedure.\nchapter twenty-one\nSelection of stocks to chart\nThe trader who operates on the “fundamental” basis, making his\ncommitments on his analysis of earnings, dividends, corporate\nmanagement, prospects for the industry, and so on, will usually (of\nnecessity) confine himself to a few stocks or a single group of stocks in the\nsame field.\nTo the contrary, the technical trader, using daily charts, should have a large\nportfolio of issues. Since he is primarily interested in the technical chart\npatterns, he will not try to make an exhaustive study of the background of\neach company. In fact, the characteristics of the stocks themselves, as they\nact in the market, are more important to him than what these companies\nmake or what they are earning. This is because, although the stocks\nrepresent ownership in the company, the capital structure, “leverage,” and\nfloating supply of the stock may (and very often does) mean fluctuations in\nthe stock price that are not directly in proportion to changes in the affairs of\nthe business.\nYou will also find many cases in which the stock of a well-regarded, well-\nmanaged, long-established concern, whose latest earnings report shows\nincreased profits, and with a long record of dividends paid, would not be a\ngood buy at the market price. It may be overpriced and due for a serious\ndepreciation. You will find other cases in which a stock, which apparently\nrepresents no great promise of either earnings or dividends, suddenly starts\na series of spectacular moves upward, and is indicated clearly as a buy. Of\ncourse, the answer, in each case, is the records available apply to the past,\nnot the future; and very often, chart action will indicate the inside\nknowledge of those who are in possession of facts the public has not yet\nreceived.\nTo change our example to something more easily visualized, let's assume\nthere are two houses for sale. One is a fine, well-built, modern home in an\nattractive part of town at, say, $200,000—and the other property, a\nsomewhat shabby six-family tenement in a less attractive section, at the\nsame price of $200,000. There is no question which is the “better” house,\nbut in a case like this, the market for well-built single homes at this price\nmay be poor, whereas the demand for apartments may be good. The six-\nfamily house may be the better investment.\nThen again, we have the question of what is conservative and what is highly\nspeculative. It is not always enough to judge from the type of business of\nthe company itself. You may have a highly conservative concern, carrying\non a stable volume of business, with a long record of successful operation.\nYet, if there are bonds, debentures, preferred stocks, and other senior\nobligations, the common stock may be subject to wide fluctuations. Also, if\nthe issue is small, or if a large part of it is closely held, you will have a\n“leverage” effect that results in wide swings in the stock.\nTherefore, in choosing your stock to chart, you will want to consider the\nkind of stock and its character and habits in the market, rather than the\nbusiness of the concern it represents. We will come back to this point and\nshow you how you can shape up a list that will give you the kind of stocks\nyou want for trading.\nMeanwhile, the question “How many charts?” has been left hanging. One\nanswer to this is that the more stocks you chart, the more good\nopportunities you will have. Many stocks, even of active issues, will go\nthrough long periods when, indeed, there is nothing much to tell. In a period\nof stability, the chart simply indicates it is a period of stability, and the only\npossible trading activity would be purchases and sales at the Bottoms and\nTops of its undulations. The charts are more informative when a change in\nthe situation occurs; they will signal a change of trend as soon as (and\nusually before) the news of the changed conditions has come out. If you\nhave enough charts, you will always have some stocks making decisive and\nclear-cut moves either up or down, at any time.\nYou should, therefore, keep as many charts as you can. Do not bite off more\nthan you can chew, however. A man with only 15 minutes to half an hour a\nday for this work might have to confine himself to 20 or 30 charts. It would\nbe much better if he could have 100. If he is in a position to give a major\npart of his time to the work, he could very well run as many as 300 charts. A\nmost important word of caution is indicated here: Do not start anything you\ncannot finish. It is better to have too few at the beginning than too many.\nThen, if you find you can add others, you will be in a better position, from\nyour experience, to pick out the ones you want to include. However, if you\nstart with too many charts or begin to run behind with your analyses, you\nwill not be getting the best use from your portfolio and it would be better to\ncut down at once. (EN: Magee's admonitions are still in effect for the\nmanual chartist. The modern computer-equipped investor has a different\nproblem. He can chart every issue in the market every day. The question\nbecomes how many can he effectively study and analyze? There is even a\ncomputer answer to this question. Namely, the cyber trader can program\nthe computer to report stocks on an exception basis. For example,\n“Computer, show me all the stocks which are above their 50-day moving\naverage and which have unusual volume.”)\nFrom what we have already been over, you know it is possible to chart\nanything that is sold in identical units in a free competitive market. This\nincludes all kinds of commodities, bonds, debentures, when-issued\ncontracts, and so on, as well as stocks. You may have some special interest\nthat will call for charting something outside the field of stocks—well and\ngood.\nIn general, however, you will want to chart active, listed stocks of well-\nesta", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 142}
{"text": "is possible to chart\nanything that is sold in identical units in a free competitive market. This\nincludes all kinds of commodities, bonds, debentures, when-issued\ncontracts, and so on, as well as stocks. You may have some special interest\nthat will call for charting something outside the field of stocks—well and\ngood.\nIn general, however, you will want to chart active, listed stocks of well-\nestablished corporations. There is no reason an unlisted stock cannot be\ncharted, but ordinarily, the only figures you can obtain on it are the bid and\noffer prices. On these stocks, you do not have a published statement of the\nvolume of sales each day or any record of prices at which sales actually\ntook place, and those are essential to the charting of daily technical action.\nTherefore, you will usually be charting stocks listed on some exchange.\nThis is also an advantage because concerns listed on the larger exchanges\nare required to meet certain conditions, publish certain information, and\ncomply with definite rules and practices.\nIn this book, most of the examples have been taken from stocks listed on\nthe New York Stock Exchange (NYSE). There are thousands of issues\ntraded on the NYSE, and these stocks represent every type of security, from\nthe most conservative to the most speculative, from the cheapest to the most\nexpensive, and they include every principal type of industry and business.\nThere is no reason, however, that stocks should not be chosen from the\nAmerican Stock Exchange, the NASDAQ, or from any other exchange in\nthis country, or for that matter, in some other country. (EN: So far as the\nchart action is concerned, the patterns and their meanings will be the\nsame).\n(EN9: In general the stocks to watch, or chart, will tend to leap out of the\nhaystack of stocks. For stock pickers Investor's Business Daily is in the\nconstant process of sifting the markets for nuggets with its CANSLIM\nsystem. (Not a recommendation to use that system, only a recommendation\nto examine every tool that might be of use.) Stocks that appear suddenly on\nthe most active lists of http://www.stockcharts.com might bear examination\nby the chart analyst. These include optionable stocks that suddenly show a\nradical change in implied volatility,; stocks that pop up with suspicious\nChapter twenty-one: Selection of stocks to chart 317\nvolume spikes compared with average volume, and those with internet and\nsoftware packages one might construct a filter to be informed by the\ncomputer of stocks breaking their 14-, 44-, 150-, and 200-day moving\naverages: 14 because some professionals think the public thinks in this time\nframe; 44 because some think funds think in 44-day time frames. The others\nbecause everyone thinks they are important.\nIn reality, if the investor aim is to beat the market, he may choose just to\nconfine his activities to the ETFs that represent the indices—DIAMONDS™\n(DIA), Standard & Poor's Depository Receipts (SPY), and QQQ. ETFs are\ninherently less risky than any individual stock.)\nTaylor & Francis\nTaylor & Francis Group\nhttp://taylorandfrancis.com\nchapter twenty-two\nSelection of stocks to chart: continued\nIn choosing your stocks, you will probably look for the greatest diversity in\nthe kind of industry. As you are not specializing in the detailed study of a\nsingle group, you will try to get stocks from as many different groups as\npossible. You will want to include mines and oils, rails and chemicals,\nliquors and amusements, airlines, utilities, techs, internets, biotechs, ad\ninfinitum. The reason for this is simply that, very often, many stocks in a\nparticular industrial group will show the same or similar patterns, as the\nentire industry is affected by certain Major conditions. You will often find,\nfor instance, when Allis-Chalmers (EN: or Dell) makes a Triangle or other\nArea Pattern, followed by a sharp upward move, Deere (EN: or Compaq),\nMinneapolis-Moline, Harvester, and Case will make similar Triangles, or\npossibly Rectangles or some other Consolidation Pattern, followed by a\nsimilar upward move. When Schenley is moving in a long downtrend, you\nwill very likely find that Distillers—Seagram's, National Distillers,\nPublicker, and American Distilling—are also moving in a long downtrend.\n(EN: Metaphorical names, like the names of Greek gods or Ulysses and\nLeopold Bloom. The present-day reader may read Intel, Fairchild, and\nNational Semiconductor or 3COM. The idea is the same.) (For an\nillustration in this chapter, see Figure 22.1.)\nTherefore, unless you plan to keep enough charts to include several stocks\nof each important group, it is best to pick your stocks to make up as widely\ndiversified a list as possible. In this way, during times when certain groups\nare moving indecisively, or are inactive, you will have some representation\nin other groups that may be active. (Do not infer from this that all stocks of\na group move together at all times. Individual concerns will frequently\nmove according to special influences that bear on a single company. Where\nthe Major influence is some industry-wide condition, the group will move\nmore or less as a unit.)\nWe, therefore, choose stocks representing a wide variety of groups or basic\nindustries. Nevertheless, suppose we are limited as to the number of charts\nand we must choose one stock from a group; which stock to choose? For\ninstance, we must choose one stock from the transportation group (EN: or\nBiotech, or internets.) As a matter of fact, you would probably want more\nthan one because this particular group is so important and so large, but for\nthe moment, let us choose just one. (EN9: Or, even better, why not one of\nthe indexes—for example, an ETF—for the desired group. An example of\nbetting on all the horses rather than trying to pick the winner, and there is\nno conflict between making both bets.)\nShould it be a high-priced stock or a low-priced stock? Let us examine that\npoint first. If you examine the past records of stocks, you will generally find\nthe lower p", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 143}
{"text": "ust one. (EN9: Or, even better, why not one of\nthe indexes—for example, an ETF—for the desired group. An example of\nbetting on all the horses rather than trying to pick the winner, and there is\nno conflict between making both bets.)\nShould it be a high-priced stock or a low-priced stock? Let us examine that\npoint first. If you examine the past records of stocks, you will generally find\nthe lower priced issues make much larger percentage moves than the higher\npriced stocks. It is not unusual for a stock selling around 5 to make a rise of\n100%, moving up to 10 sometimes within a few weeks. On the other hand,\nyou do not find 100% moves in days or weeks among the stocks selling at\n100 or 200. The same industry-wide move that carries your $5.00 stock\nfrom 5 to 10 might carry your $100 stock from 100 to 140. Obviously, if\nyou had put $1,000 into outright purchase of the stock at 5, the move would\nhave increased the value of your stock 100% or $1,000. In the other case, if\nyou had put the same amount into a stock at 100,\n136\n128\n120\n112\n104\n96\n88\n80\nFigure 22.1 Low-priced stocks move faster than high-priced stocks. Here\nare weekly charts of two rail stocks, charted on ratio scale over the same\nsix-month period. Baltimore and Ohio during this time advanced from 12\n3/8 to 28 7/8, a gain of 16 1/2 points, while Union Pacific moved up from\n109 to 137, a gain of 28 points. The advance in “UP,” however, compared\nwith its price, is much less than the advance in “BO.” A thousand dollars\nused for outright purchase of “UP” would show you a capital increase of\n25%. On the other hand, if you had put a thousand dollars into outright\npurchase of “BO,” your increase would have been 133%, or more than five\ntimes as much.\nBear in mind low-priced stocks not only go up much faster, but also come\ndown much faster than high-priced stocks. When you own a low-priced\nstock, you cannot safely “put it away in the box and forget it.” For security\nand stability, you would do better to buy a few shares of a high-priced, gilt-\nedge security. For trading purposes, you will want to strike a compromise\nbetween the rather sluggish “blue chips” and the extremely erratic “cats and\ndogs” in the lowest price bracket.\nthe move to 140 (although many more points) would have increased your\ncapital to only $1,400. The gain in the lower priced stock would be about\ntwo and one-half times as great.\nThe authors have worked out and tabulated the percentage moves of large\ngroups of stocks over long periods of time (see Appendix A, ninth edition)\nand have set up a table that shows the relative average sensitivity of stocks\nat different price levels. This table pertains only to the price level of stocks;\nthus, the same stock that today sells at 5 and makes wide percentage swings\nwill not swing so widely when it has moved up to a price level of 20-30.\n(EN10: These concepts replaced by beta and volatility.)\nSeveral questions may come to your mind at this point. Do not the costs of\ntrading low-priced stocks relative to high-priced issues have to be taken into\naccount? (EN: Yes, they do. Given the extreme changeability in these costs\nin the internet economy, calculation of those costs here would be\ntantamount to wasting trees. This cost question may be researched quickly\nand easily given the availability of search engines such as Google and\naccess to the internet.)\nIn selecting the price level of the stocks you prefer to trade in, you cannot\nset too arbitrary a limit because there are other factors to consider and you\nmay have to make some compromises on one score to get what you want in\nsome other direction. Stocks from 20 to 30 are in a good trading price\nrange. Very often, you will find stocks in the 10-20 range that are so\ninteresting you will want to chart and trade in them. You will find good\nsituations in stocks selling at 30-40. Furthermore, you will understand, of\ncourse, the stocks that are now selling at 10 may be selling next year at 40,\nor vice versa. Considering you cannot be changing your portfolio of charts\nall the time, you must not be too “choosy” in picking the price range of\nyour stocks. You would not ordinarily pick out a stock that was selling far\nabove the price range of most stocks of its group, say at 150, when several\nothers in the same industry were selling at 15, 28, or 37. For the high-priced\nstock, as we have said, is likely to be sluggish as a trading medium. On the\nother hand, you would not take the very lowest priced issues of the group,\nselling at, say, 4 or 2 when others were in the 10-30 bracket. You would not\nonly be faced with erratic and tricky chart action, and much higher\npercentage costs for commissions, but also you might not be able to operate\non margin at all. There are, from time to time, limitations on the amount of\nmargin on stocks at all levels. In the lower priced issues, these limits are\noften more stringent. Plus, in the lowest priced stocks, you are sometimes\nnot permitted to trade on margin. (EN: As these requirements are subject to\nthe vagaries of the Federal Reserve Board, the investor must inform himself\nat his personal broker or ECN. For quite some years, the general margin\nrequirement has been 50%. The Fed came in for some sharp criticism for\nnot dampening speculation in the fin de siecle bubble by raising margin\nrates to 100%, and its lack of action exacerbated the blow off of 2000. A\nchange in margin rates should get the immediate attention of the technical\nanalyst. Something will be up.)\nOrdinarily, you will get the greatest effective leverage at some point in the\n20s, considering all these factors, and your trading can run down through\nthe teens and up through the 40s. Above 40 and below 10, you will have to\nhave strong reasons for trading, which might be, of course, ample capital. It\nwould therefore be best for the moderately financed investor to choose a\nmajority of his stocks from the middle price range (10-40), plus only those\nspecial situations you are particularly interested in wa", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 144}
{"text": "ors, and your trading can run down through\nthe teens and up through the 40s. Above 40 and below 10, you will have to\nhave strong reasons for trading, which might be, of course, ample capital. It\nwould therefore be best for the moderately financed investor to choose a\nmajority of his stocks from the middle price range (10-40), plus only those\nspecial situations you are particularly interested in watching among the very\nlow and very high brackets.\nIf, however, you will go back to the long-time past record of any group of\nstocks, you will find that even among stocks moving at nearly the same\nprice levels today, there are widely different behavior patterns. You will find\nsome stocks respond to a severe market setback by reacting, let us say, 20%\n—that is, if they were selling at 30, they would move down to around 24.\nOthers will respond to the same setback in the general market by a reaction\nof 50%—that is, if they were selling at 30, they would end up at around 15.\nAdditionally, if you examine the records, the same stocks that make these\nrelatively different reactions in one setback will make about the same\nmoves, relative to each other, in other setbacks. Furthermore, the same ones\nthat make only moderate corrections on declines will make only moderate\nadvances on rises. The ones that go down sharply on setbacks will also\nskyrocket in a Bullish Market. This has nothing to do with the phenomenon\nwe discussed earlier, by which we saw that cheap stocks move faster than\nexpensive stocks. This is due to the habits of particular stocks, and these\nhabits seem to be quite stable over periods of many years.\nWe will find, for instance, volatile and speculative issues that make larger\npercentage swings than most other stocks at their price level. On the other\nhand, we will find a stock, selling for much less, that has smaller percentage\nswings than most stocks at its price level. This fact may be obscured, as the\ncomparatively low-priced stock may actually make larger swings than the\nhigher priced. It is only when we have taken the price level into account\nthat we can see the individual habit of the stock. Knowing this, we can\nproject that habit to other price levels.\nWe are not too interested, as we have said before, in stocks that do not\nordinarily make substantial moves. We are very much interested in those\nthat make the wider moves. We can compute the basic swing power of a\nstock, which we call the Sensitivity Index, and will outline the method for\ndoing this in Appendix A, ninth edition. (EN: The procedure Magee speaks\nof here, of computing a “Sensitivity Index,” may be regarded as the\nhistorical predecessor of what are now called “betas.” The beta of a stock\ncompares its relative volatility with that of the market as a whole, so if the\nbeta of the market is 1.00 and the beta of the stock in question is 1.50, a\nmove of 1.00 in the market will probably be matched by a move of 1.50 in\nthe higher beta stock. The formula for beta will be found in Appendix B,\nResources, and calculated betas at finance.yahoo.com.)\nTherefore, you will have eliminated from your list stocks at the wrong price\nlevel and stocks without enough swing power (for you want to chart only\nthose stocks in which you can trade profitably). Of the ones left, you will\neliminate others and find that some stocks, which make wide price moves\nand apparently offer large opportunities for profit, may be very “thin.” The\ncharts will be spotty, filled with gaps, days of “no sale,” and moves of\nseveral points on only a few hundred shares of business. These stocks are\nthin because of a small issue, because of ownership of a large block of\nshares by some corporation or by insiders, or for other reasons. They are\ndifficult to trade in because they are hard to buy and hard to sell; you stand\nto lose heavily on the “spread” between bid and offer. It might be hard to\nliquidate even 500 shares without driving the price down badly, to your\nloss, and sometimes you will see changes of 1 or 2 full points between sales\nof single hundreds. These you will want to eliminate, and if you do not\nknow the habits before you choose your portfolio, you will probably find it\nworthwhile to drop any stocks that prove too thin, substituting new and\nmore dependable choices.\nAfter you have culled the list from all these angles you will find you have\nleft a choice of a number of stocks, all of them selling in a price range that\nis attractive, all of them sufficiently active and responsive to market trends,\nand all of them available in sufficient supply to provide a good trading\nmedium. The final choice of any one (or several) of these stocks is then a\nmatter of personal preference.\nAfter you pick out your stocks from one group, study the other groups—the\nmotors group, the amusements, the computers (EN: the internets) and so\nforth, until you have finally made up your selection of stocks to follow. Try\nto get as complete and balanced a representation of groups as the number of\nyour charts will allow. (EN: In this context, the process described here is\nmade infinitely simpler by available software and by the proliferation of\ngroup indexes, ETFs, and indicators. In fact, if the investor desires, rather\nthan trading an individual stock in an industry group, he may often choose\nto trade the average or index itself and cushion his risks. This will almost\nnever be as profitable as a well-chosen individual issue but will always be\nbetter than a badly chosen individual issue. And ETFs never go broke (so\nfar).)\nIn this connection, if you are not planning to represent all groups, there are\nsome groups more likely to provide good trading stocks than others. Foods\nand tobaccos, for example, are generally less responsive to market swings\nthan the rails, liquors, and airlines, which are very responsive. Do not worry\ntoo much, however, about exactly which stocks to choose for even if you\ntook the first 50 or 100 stocks in the listed issues, you would have among\nthem at least 25 good tradi", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 145}
{"text": "ome groups more likely to provide good trading stocks than others. Foods\nand tobaccos, for example, are generally less responsive to market swings\nthan the rails, liquors, and airlines, which are very responsive. Do not worry\ntoo much, however, about exactly which stocks to choose for even if you\ntook the first 50 or 100 stocks in the listed issues, you would have among\nthem at least 25 good trading stocks. You can start with almost any list, and,\nas time goes on, you will drop some and add others, improving your\nportfolio and tailoring it to your own needs.\n(EN: As additional commentary here it is worth noting that “techs,”\n“biotechs” (or whatever the mania of the moment is—probably space hotels\nand intergalactic travel in this millennium) will present areas of risk and\nreward sufficient to excite the seventeenth-century tulip trader. The centered\ninvestor and trader will consider vogues and manias as he chooses his\nactive portfolio and choose to participate (or not) depending on his appetite\nfor risk and excitement. Or, as the popular maxim has it, one man's\nchampagne is another man's poison. This question is pursued in greater\ndetail in Chapter 23.)\nBy way of further simplification, the investor may choose to follow only one\nor two issues— Standard & Poor's Depositary Receipts (SPY) or\nDIAMONDS™ (DIA). If it were not only bought, but also sold or hedged,\nthe market would be outperformed. This would be a simple investor's life\nindeed.\nTaylor & Francis\nTaylor & Francis Group\nhttp://taylorandfrancis.com\nchapter twenty-three\nChoosing and managing high-risk stocks: tulip\nstocks, Internet sector, and speculative frenzies\nNothing could more vividly illustrate the timeless nature of chart patterns\nand situations than the internet stocks that bloomed at the turn of the\ncentury. These stocks repeated that eternal pattern—the Tulipomania, the\nGold Rush, the can't-fail-opportunity-to-get-rich-quick. (For illustrations in\nthis chapter, see Figures 23.1 through 23.17.)\nIt is almost impossible to resist comparing the speculative frenzy that took\nplace in the internet and technology issues to the famous seventeenth-\ncentury mania that Holland experienced in the famous Tulipomania. In\nMacKay's undying classic account (Extraordinary Popular Delusions and\nthe Madness of Crowds), the trading of tulip bulbs replaced sober\ncommerce and business as the occupation of the country, and enormous\nfortunes were made trading the tubers. Blocks of real estate, breweries,\nassets of real and large value were traded for one tulip bulb. MacKay\nproduced my favorite paragraph in the literature of finance: “A golden bait\nhung temptingly out before the people, and one after the other, they rushed\nto tulip-marts, like flies around a honey pot. Every one imagined that the\npassion for tulips would last forever, and that the wealthy from every part of\nthe world would send to Holland, and pay whatever prices were asked for\nthem.”\nThat mania ended in ruin. A better long-term prospect may be in store for\nthe internet, as there is a basis of technology and economic substance to the\nsector. You could not, after all, use your tulip to check the market for prices.\nIn fact, there were those, admittedly a small number, who struck it rich in\nthe California Gold Rush of 1849. It is an ill wind, etc.\nAs an exercise in rueful perspective, the seventh edition of this book\nremarked, in the words of Richard McDermott,\nCompanies like Lotus or Microsoft went public and grew into business\ngiants in a short period of time... A significant theme stock for the 1990s has\nbeen Internet stocks. Names like America Online, CompuServe, and\nNetscape have provided important products and services that allow\nindividuals to “surf the net” for information around the world.\nYoung students of the market will search in vain for Lotus, CompuServe,\nand Netscape in the lists of stock symbols. The giant Lotus was swallowed\nby IBM, in part because Microsoft, a ruthless competitor, disemboweled it.\nCompuServe and Netscape disappeared into the belly of a larger fish, AOL,\nwith some of the same factors involved. Later Microsoft got its\ncomeuppance—halving in value as the U.S. Justice Department brought\nsuccessful antitrust action against it.\nThere are those who fault the great Wall Street investment banks for having\nbrought half-baked potatoes (or unblooming tulips) to market. The Street\nfirms, cashing in on the mania, were willing to sell the public every\nimmature profitless idea and company named\n\nFigure 23.1 Multitudinous lessons in Microsoft. However, short-lived joy.\nThe top rounds over, price makes another attempt, and then the momentum\nis clearly, if puzzlingly, down. The cancellation of the runaway day in\nJanuary definitely marked this move as a bull trap, and the short-term\ntrendline from October would also have taken the trader out of the trap. Use\nof the Basing Points technique (see Chapter 28) would also have allowed\nescape from the trap. Failed signals, as this one, often are excellent signals\nfor a trade in the other direction.\n“dot.com Inc.” that venture capitalists floated on a sea of seed money.\nMining engineers will recognize the phenomenon of “salting the mine.” It\nwas the finest moment for the great old firms of the Street since the\ninvestment trusts of the 1920s. The reader is most recommended to look\ninto The Great Crash, 1929 by John Kenneth Galbraith to compare the\nStreet firms' behavior from one mania to the next. It will be found most\nedifying. At the pinnacle of great manias, no one can be trusted.\nManaging tulipomanias and Internet frenzies and.. .Bitcoin\nIn a time of excess, the centered investor maintains his composure and\nfocus. Probably easier said than done. Nonetheless, many investors and\ntraders profited from the internet boom or were not severely damaged.\nMany managers and traders watched with envy from the sidelines, and with\nschadenfreude when the bubble burst.\nFor technical analysts speculating and trading according to the principle", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 146}
{"text": "coin\nIn a time of excess, the centered investor maintains his composure and\nfocus. Probably easier said than done. Nonetheless, many investors and\ntraders profited from the internet boom or were not severely damaged.\nMany managers and traders watched with envy from the sidelines, and with\nschadenfreude when the bubble burst.\nFor technical analysts speculating and trading according to the principles of\nthis book, important opportunities arise in speculative frenzies and buying\npanics—namely, important profits may be made by remaining calm and\nmethodical while the uninformed and naive cause speculative blow-offs,\nwhich have some things in common with the ends of great bull trends in\nsubstantive issues.\nThe question becomes that of realizing some of the profits to be made in\nthese exciting times. Of course, the first thing to do is not get excited. These\nmanias come and go— sometimes they are called biotechs, sometimes\ncomputers, sometimes internets, and probably, at some point, human\ngenome miracle drugs or Martian real estate. It should be emphasized these\nprofits are made on both sides, long and short. The crowd will only\nFigure 23.2 MSFT monthly. It is easy to lose perspective when looking at a\ndaily chart of a bull trap in which one has lost a leg. A monthly long-term\nlook at Microsoft can help restore perspective. Unfortunately, the Dow-\nJones Company was looking at this chart, not the nearby, when they added\nMicrosoft to the Dow 30 in 2000. Expert timing? At the time, the John\nMagee Newsletter observed it was a negative indicator of a major top in the\nIndustrials.\nthink of the riches to be made long. Professionals and skilled technicians,\nprofessional or not, will take the profits on the short side.\nHere is the most important concept in trading these runaway issues: all of\nthe techniques and methods described in this book remain valid for dealing\nwith these kinds of stocks. In addition, here are some other points that\nshould be taken into consideration. The best way to control risk in the\nBitcoin market is by trading a position so small (like a roulette bet) that a\n100% loss will cause no distress or discomfort. The sector in question, tech-\ntech, web-tech, biotech, internet, space travel, whatever, will be a market\nunto itself, and special technical factors will apply to it. The phases of\nmarket lives, accumulation, attraction, markup, mania, and blow-off will\noccur in compressed time spans—much shorter than the cyclical life of an\nissue with fundamental data to attach it to reality (see Figure 23.4 of Palm\nComputing).\nBy the time the IPO occurs, the insiders are already prepared to begin the\ndistribution phase. For example, when Palm Computing was spun off from\n3Com in 2000, only 3% of the shares were sold—creating an artificial\nscarcity and propelling it to absurd heights—Palm attained an instant\nmarket value greater than that of 3Com, which owned most of its stock.\n(EN9: We have, since The Fall, learned of “laddering.” To let their inside\nclients in on the IPO, some of the underwriters required the clients to buy\nmore of the stock in the open market after the IPO at higher prices. A clever\nway to throw gasoline on a raging bonfire. Whether Palm was laddered or\nnot is not known.)\nFigure 23.3 The editor learns a lesson. Never leave a chart unanalyzed,\neven if the implications are obvious. Also, never be afraid to belabor the\nobvious. Obviously, this figure should have had a longterm trendline drawn\non it. No monumental bull market should be ignored. Why give the market\nits money back? It should have been obvious from this figure that the\nMicrosoft party was over and not just the fat lady but the entire chorus was\nbeating on anvils. Plus, the protective line must be drawn. Here the broken\nline at A is the most important and saves a bit of capital rather than waiting\nfor the plaintive signal at C. Given the robust Bull Market in Microsoft, the\nlong-term investor might have been justified in waiting until the C trendline\nwas broken. A matter of investing style and philosophy. There appears to be\nsome long-term support at 18. The five-year sideways market appears to be\nresolving itself into a macro triangle that might break out one way or the\nother in 2005. This is a case in which an investor might make a fundamental\nanalysis to guide his position (always confirming with the chart analysis).\nMicrosoft is beset with howling wolves on all sides. Linux, Unix, sales of\nonly one copy of Windows in China, hackers playing hob with security\nholes in its software. Can it rise again? Only the chart knows for sure, and it\nis silent at this recording. In 2011, MSFT was in an 11-year sidewave.\nThese issues must be traded with the utmost care and attention. For\nexample, it is the height of foolishness to enter a market order to buy on the\nissue of the IPO. An issue going public at 12 might trade on the opening at\n50 in these frenzies—a sign to the savvy technician the sheep are headed for\nthe shearing shed.\nCertain factors must be kept in mind. Some IPOs collapse shortly after\ngoing public. Others rocket off before distribution is complete. So stops\nmust be carefully computed. Once it is clear the rocket is taking off, as\nindicated by price and volume, some discreet pyramiding might be possible\nfor the experienced and skilled speculator.\nDetailed techniques for management of the runaway issues\nThe technique described in Chapter 28 for tight progressive stops is\ncertainly one way of dealing with these stocks. There, the method for\nfinding Basing Points and raising stops based on the three-days-away rule is\ndetailed. Also, especially in the case of these rocket stocks, the practice of\nraising stops based on new percentage highs should be\n170 -\n160 -\nPALM\nCreated with MetaStock www.equis.com\n150 -\n140 -\n130 -\n120 -\n110 -\n20 -\n10 -\n35000 -\n30000 -\n25000 -\n20000 -\n15000 :\n10000 -\n5000 -\nX10\n40 •\n30 •\nApril\nMay\nJune\nJuly\nAugust\nJ. 4 11\nSeptember\nFigure 23.4 PALM. Fool's gold. Fool's gold with naivete writ", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 147}
{"text": "etailed. Also, especially in the case of these rocket stocks, the practice of\nraising stops based on new percentage highs should be\n170 -\n160 -\nPALM\nCreated with MetaStock www.equis.com\n150 -\n140 -\n130 -\n120 -\n110 -\n20 -\n10 -\n35000 -\n30000 -\n25000 -\n20000 -\n15000 :\n10000 -\n5000 -\nX10\n40 •\n30 •\nApril\nMay\nJune\nJuly\nAugust\nJ. 4 11\nSeptember\nFigure 23.4 PALM. Fool's gold. Fool's gold with naivete writ large on it.\nHere is a spike reversal day on the initial day of trading. The accumulation,\nmarkup, and most of the distribution occurred behind closed doors before\nthis trick was perpetrated. After the matanza, the continuation takes on\nFigure 23.5 Dealers palmed all the missing capital in PALM? Somebody\nmade the money disappear up a shirtsleeve. What makes you think the deck\nwas stacked? Or that the initial public offering (IPO) was laddered? Maybe\nit was just fools chasing tulips. Those investors (gamblers) playing the shell\ngame with PALM found themselves playing with six shells instead of three\nas like an insidious amoeba PALM divided into two tulips, PLMO and\nPSRC. Keep your eye on the magician closely. For the analyst, all the\nsmoke and mirrors could not hide the fact gravity took PALM in all its\nmanifestations down. The downtrend lines are broken in 2003 and 2004 and\na respectable Kilroy Bottom is made. Nevertheless, the implications of the\nbottom may have already been carried out. A continuing story for\nspeculators or astute (very astute) investors who know something\nfundamental and have very long-term vision.\nFigure 23.6 PSRC in its amoeba-like glory. The failure of what might have\nbeen a rounding bottom, especially with the breakdown gap in October and\nthe failure to rally back to the neckline left no doubt as to the fate of PALM\nby any other symbol. Broken trendlines are also indicative. Remember that\nany large pattern can be broken down into smaller patterns susceptible to\nshort trendline analysis, as in this case. Sooner or later a palm-size\ncomputer, PDA, widget device is going to be the wave of the future. (EN10:\nA visionary prediction of the iPhone.) The canny investor will not mistake\nthe company for the stock and will also not venture capital until there is a\nbetter chart story.\nimplemented. Since these are “game” situations, and irrational, one may\nemploy tactics he might not ordinarily use with his serious capital—some\nlight pyramiding and some scaling out of the position based on continuous\nnew highs. Additionally, in the blow-off phase when close monitoring is\nnecessary, one might want to exit on a long reversal day, or on a key\nreversal pattern, and then go to the beach; or, if from Texas, one might want\nto short the issue.\nEssentially, I view these stocks as interesting aberrations in the early part of\ntheir lives. So I would not look for long-term investment-type trades. Take\nthe money and run. In all likelihood, these stocks will explode like\nfireworks and then expire. There will be the companies like Microsoft and\n—it remains to be seen—Yahoo!. After the fireworks show, the patient\ntechnician may return to the scene of the crime to see whether there are any\nburning embers. Once they have blown off, crashed, and made reasonable\nbottoms, then one begins to look for investment possibilities, which there\ndefinitely will be. There is too much potential in the technology of the\ninternet—and biotech and the human genome—for some phoenix not to rise\nfrom the ashes.\nIn the beginning it behooves the trader to regard them as speculative\ninstruments of exceptional risk and opportunity.\nSeveral caveats are in order:\n• The prudent speculator does not commit too much of his capital to such\nenterprises. Probably no more than 5%-10%.\n3com Corporation-(Nasdaq NM) 3.71 0.10 2.77%\nApr Jul Oct 97 Apr Jul Oct 98 Apr Jul Oct99 Apr Jul Oct 00 AprJul Oct 01\nApr Jul Oct\n24\n22\n20\n18\n16\n14\n12\n10\n2\n540\n480\n420\n360\n300\n240\n180\n120\n60\n0\nFigure 23.7 COMS. Underwriters cleverly doled out only 3% of 3Com-\nowned Palm stock onto the market at the IPO. Palm wound up “worth”\nmore than 3Com for a short time. Here the lesson of tulipomania is vivid.\nThe contrast in before and after volume. The necessity of analysis to deal\nwith tulips in bloom. The fatal lesson of heeding (or not heeding) gaps\nacross horizontal trendlines. Impossible to manage for the buy-and-hold\ninvestor.\n• When selling them short, one should not be early. A definite top should be\nseen because there might be a second stage of the rocket.\n• Emotional involvement with tulips and internet stocks—or stocks of any\nkind actually—can lead to a broken heart. In the charts, note the success in\na number of cases of trading the key reversal day.\n(EN9: Reviewing charts from the apocalypse is a sobering experience. So\nmany rash and mad adventures. So much capital sucked into the black hole\nof underwriters and 21-year-old huckster CEO wallets. Better than the\nSouth Seas Bubble. And, as definite proof that man is directly descended\nfrom geese and sees no farther ahead than the next feeding bowl, the ghost\nof the mania oozes from the closet in 2005, reborn as Google mania. Man\n(or goose if you will) never learns. That is why he is so much fun to watch.)\nGoogle—what a creature is man! What a game is the market! Google, a\nwonderful company, and a great concept goes public in 2004 after world-\nclass hype (world class? intergalactic class!). Floated as a red herring at\n135, it eventually goes IPO at 85 in an innovative public offering. Then the\nfun starts. Future readers of this book may observe the markup made as of\nthe date of this writing (November 2004) and judge whether the method\nworked. A company on roller blades, impossible to dislike as a company.\nRemember, unless you are Warren Buffet, you are buying the stock, not the\ncompany.\n45\n39\n36\n33\n30\n27\n24\n21\n18\n15\n12\nFigure 23.8 ORCL. True to the character of stocks during the Tulipomania,\nOracle was difficult to handle without careful analysis. Stock splits\npreceded a number of the sell-offs (note gaps p", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 148}
{"text": "e whether the method\nworked. A company on roller blades, impossible to dislike as a company.\nRemember, unless you are Warren Buffet, you are buying the stock, not the\ncompany.\n45\n39\n36\n33\n30\n27\n24\n21\n18\n15\n12\nFigure 23.8 ORCL. True to the character of stocks during the Tulipomania,\nOracle was difficult to handle without careful analysis. Stock splits\npreceded a number of the sell-offs (note gaps post splits). Bullish gaps are\nalso frequent here, and the tulip top is obvious, and was at the time. An\nexcellent trading vehicle though a wreck for the casual investor.\nHope springs eternal and there is one born every second\nOne might have thought the age of the tulip was over as we moved into the\nsecond decade of the new millennium—but what naivete! Not over at all.\nInvestors rushed into the LinkedIn and Groupon IPOs and stood quivering\non the sideline begging for Facebook to go public. But Facebook, the\nultimate practitioner of chutzpah, satisfied itself by feeding on the venture\ncapital community, demanding ever higher valuations from venture\ncapitalists desperate to own a sliver of the deal at whatever cost. The public\nwill have to wait to be shorn. But have faith, it will be. Remember Palm.\nYou can buy these things, but you have to remain glued to the screen and\nthe ride will be rough. Unless you have your professional speculator's\nlicense and have lost money on these deals before, watch the snake pit from\nthe sidelines—and do not buy any snake oil.\n260\n220\n180\n160\n140\n120\n100\n80\n60\n40\n20\n2\nFigure 23.9 INKT. The pleasures and delights (and disappointments) of\ninternet stocks. The last trendline, in conjunction with the second horizontal\ntrendline, clearly marks the end of the party (AND WILL FOR ANY\nSTOCK WHATSOEVER). The break of the long-term trendline is the last\nexit signal, as if the previous signals were not clear enough. Is it not\nobvious that this issue was (and is) manageable with technical analysis?\nFigure 23.10 EMULEX (ELX). The message of 2000, a severe drubbing,\nand precipitous at that, would have been lost on the non-technician. Those\nwho continued to ride the roller coaster relearned a lesson some technicians\nknow—stocks often repeat the same behavior (or misbehavior). The lesson\nof monster breakaway gaps (or air gaps) may have needed relearning also.\nOh well, after such a gap the damage is done, the unenlightened investor\nsays, only to see the damage continue down to 10 (from 110!). These are\nsignals of such magnitude that disaster awaits the trader who denies its\nsignificance. The air gap here nicely complements those of Figures 12.9 and\n37.43.\n10\n120\n100\n80\n60\n50\n40\n30\n20\n1\n120\n100\n80\n60\n40\n20\n0\nFigure 23.11 Amazon weekly. Amazing Amazon dances in the internet\nfollies. The breathtaking plunges are the direct result of the breathtaking\nspeculative excess. See the daily chart (Figure 23.12) for a closer look at the\ndetails of the blow-off.\nAMZN (Amazon.com, Inc.)\nFigure 23.12 Amazon daily. In cases of speculative blow-off, trendlines are\nof little use. A dozing trader (presumably it was obvious this was not an\ninvestment issue) would have been mauled in the plunge. An alert trader,\nknowing that in blow-offs the procedure is to sell strength, might have\navoided it. Other techniques include recognition of the second exhaustion\ngap and exit. Also, a trader using the techniques described in Chapter 28,\nsetting progressively tight stops, might have avoided the fall.\nFigure 23.13 The wild frontier of the internet and of the gunslinger\nspeculators (gamblers?). Amazon bucks on. Give us a slug of rotgut\nwhiskey and get out the ruler. A clear top for the rational analyst with clear\nbroken trendlines and broken horizontal lines and then a clear Bear Market\nwith a clear bottom resembling a Kilroy Bottom and then a clear breakout\nand another Bull Market and then another downtrend. Talk about your\nfearless bull riders down at the rodeo. But this Bull-Bear is ridable with a\nlittle technical analysis. Without technical analysis it is like being the target\nin a shooting gallery—a sitting duck.\nFigure 23.14 CISCO (CSCO). Although the first long-term trendline\nbeautifully intercepts the downtrend in progress at a gap (a coincidence of\nindicators that occurs too often to be a coincidence), the trendlines drawn\nlater are of such strength that even the novice analyst should know how to\nexit. In fact, one of my students, an employee of Cisco, did just that, saving\nhimself thousands of paper dollars in this very case.\nCreated with TradeStation 2000i by Omega Research '.s'-1999\nFigure 23.15 Is there any way the trader (investors keep away) could avoid\nstepping off this cliff? Extreme paranoia is one way. Another way is by\nbeing acutely conscious of the pattern of behavior manifested by Cisco in\nFigure 23.14.\nFigure 23.16 You thought all the tulips and Bulls had been exhausted in the\nTulipomania in 2000? Silly you. There is an inexhaustible supply. All you\nneed is a company and a story and an underwriter to peddle it. Sometimes\nthere are even earnings. Sometimes the earnings are even real. Sometimes\nthe earnings are skating uphill on roller blades. Then sometimes the\ncharacters are so appealing that you are almost willing to buy the IPO at\nface value, but not if you are a cynic, as are all technical analysts. Google\nwas rumored at $200 or more on the IPO. The editor offered to sell all of it\nat that price and throw in the Brooklyn Bridge for free. This offer (well,\nthere may have been other factors also) knocked the IPO down to $85 (still\nan errant speculation), but only insane, not unreasonable. The\noversubscription in an innovative offering revealed that the tulip virus was\nnot dead, but very much alive and infecting not just the same old suspects,\nbut many new ones. We love a horse race, and this is a great one. Notice the\nobvious defensive lines and support and resistance. How long Google can\ndefy gravity (a galactic price-earnings ratio) remains to be seen. Prudent\ngamblers will have a stop ide", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 149}
{"text": "bscription in an innovative offering revealed that the tulip virus was\nnot dead, but very much alive and infecting not just the same old suspects,\nbut many new ones. We love a horse race, and this is a great one. Notice the\nobvious defensive lines and support and resistance. How long Google can\ndefy gravity (a galactic price-earnings ratio) remains to be seen. Prudent\ngamblers will have a stop identified. On this chart, for the long-term\ngambler, it might be in the 182 area. For the more agile gambler, it might be\nfailure of the support around 204, or closing of the breakaway gap there. No\nopprobrium is attached to the term gambler. In fact, bolder investors\n(competent readers of this book) should take a flyer from time to time with\nabout 5% of their capital. This is the flyer that should have been taken. The\nbreakaway gaps in October and April, operating against disbelief, were\nsignals of enormous technical strength. And Google went to 475! The\nlesson here, which must be learned and relearned and ... ad infinitum ... is\nthis: trust the chart. Ignore the story. In 2008, GOOG went to 700, halved in\nthe Bush Bear Market, recovered to 600, and entered a two-year sidewave.\nFigure 23.17 Google, 2011. Google turned out to be the real thing and had\na herd of cash cows that produced and produced and produced. Mother's\nmilk? Or America's love affair with advertising? Whatever, the reader can\nsee the simple-minded management of the issue with trendlines. Using\ntrendlines would have avoided bungee-like equity, which is never pleasant.\nBasing Points might have been used the same way with the same effect.\nGOOG has essentially been in a large sidewave (very large) since 2010. The\nexit from this sidewave should have dramatic consequences—up or down.\nchapter twenty-four\nThe probable moves of your stocks\nAt first glance, all stocks appear to move helter-skelter without rhyme or\nreason, all over the lot. All stocks go up at times, and all go down at times\n—and not always at the same time. We already have seen in these rises and\nfalls stocks do follow trends, make various typical patterns, and behave in a\nnot completely disorderly manner. (For illustrations in this chapter, see\nFigures 24.1 and 24.2.)\nIt is also true that each stock has its own habits and characteristics, which\nare more or less stable from year to year. Certain stocks normally respond\nto a Bullish Phase of the market with a very large upsurge, whereas others,\nperhaps in the same price class, will make only moderate moves. You will\nfind that the same stocks that make wide upward swings are also the ones\nthat make large declines in Bear Markets, whereas the ones that make less\nspectacular up-moves are more resistant to downside breaks in the market.\nThere are stocks that ordinarily move many, many times faster than others.\nWe do not know, for example, whether a year from now Glenn Martin (EN:\nread, Microsoft, eBay) will be moving up or down, but we do know, and it\nis one of the most dependable things we know, whichever way it is going, it\nwill be covering ground much faster than American Telephone and\nTelegraph. (EN9: Even T accelerated into hyperspace after its unfortunate\ndivestment of local Bells. And, unlike the leopard, completely changed its\nspots.) These differences of habit, of course, are due to the size of issue,\nfloating supply, nature of business, and leverage in the capital structure,\nmatters we have touched on briefly before. As a matter of fact, we are not\nespecially concerned with why the differences exist. We are interested\nmainly in what the differences are, and how we can determine them.\nThis is important: stocks that habitually move in a narrow range, although\nexcellent for investment purposes in cases in which stability and income\n(dividends) are the chief desiderata, are not good trading stocks. A fairly\nhigh degree of sensitivity (EN: volatility), with wide percentage moves, is\nnecessary to make possible profitable commitments that will cover costs\nand leave a net gain. To be in a position to make a profit, you should see the\nprobability of at least a 15% move in your stock.\nHow then are you going to tell which stocks are most sensitive and\npotentially most profitable?\nBy examining the record of a certain stock for a number of years back, and\ncomparing the percentage moves it has made with the percentage moves of\nthe market as a whole, you can obtain a fair picture of that stock's habits.\nYou will not be able to say, at any particular moment, “This stock is now\ngoing to move up 25%,” but you can say, with a good deal of confidence,\n“If the market as a whole makes an advance of 10%, this stock will\nprobably advance about 25%.” Or, conversely, “If the market goes down\n10%, this stock will very likely go down at least 25%.” (EN10: The concept\nof beta.)\nMany methods have been used for measuring and checking these\npercentage-move habits, differing only in detail. (EN10: With the ready\navailability of desktop and internet software, the investor may call up a\ntwo- or five-year chart and see the potential range of the stock at hand.)\nIndexes on several hundred important stocks listed on the New York Stock\nExchange have been computed by the authors and are presented in\nAppendix A, ninth edition.\n44\n\n46\n40\n36\n32\n28\n72\n68\n64\n60\n56\n52\nFigure 24.1 Some stocks move faster than others. We have already noticed\nthat low-priced stocks have much larger percentage moves than high-priced\nissues. Yet, even between two stocks that may, at a particular time, be\nselling at the same price, there are enormous differences in their habits.\nFurthermore, these habits change very little from year to year.\nHere we have a weekly chart of Corn Products Refining Company (left),\ncovering an 18-month period in the years 1945 and 1946. We also have a\nchart of Schenley Distillers (right) for the same period. The average price\nbetween the high and low on these charts is about 64 1/2, the same for both\nstocks.\nHowever, during this period, we see “CFG” moving b", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 150}
{"text": "ese habits change very little from year to year.\nHere we have a weekly chart of Corn Products Refining Company (left),\ncovering an 18-month period in the years 1945 and 1946. We also have a\nchart of Schenley Distillers (right) for the same period. The average price\nbetween the high and low on these charts is about 64 1/2, the same for both\nstocks.\nHowever, during this period, we see “CFG” moving between a low of 58\n1/2 and a high of 71, a range of 12 1/2 points, while at the same time, “SH”\nhas moved between 28 1/2 and 100, a range of 71 1/2. A thousand dollars\nput into an outright purchase of “CFG” at its extreme low would have\ngrown to $1,210 at its extreme high, whereas the same amount used for\noutright purchase of “SH” at its low would have grown to $3,510. Your gain\nof $2,510 in “SH” would be more than 10 times the gain of $210 in “CFG,”\nand this without using margin.\nIt is not likely you would actually purchase either stock at the extreme low,\nnor sell at the extreme high. The point we are bringing out here is there are\nenormous differences in the swing habits of stocks.\n(EN10: Magee's concept of “sensitivity” appears to combine some aspects\nof our modern concept of beta and modern computation of volatility. The\nreplacement for Magee's Sensitivity Index is readily available at\nfinance.yahoo.com and http://www.abg-analytics.com as well as any\nnumber of other sites findable by Google.)\nIndividual stocks have their characteristic habits, as do some entire\nindustries. In general, the food stocks, of which “CFG” is one, are stable\nand slow-moving. On the other hand, liquor stocks make wide moves on\nany general advance or decline of the market. At this time “CFG” had a\nSensitivity Index (EN9: or beta equivalent) of 0.58, whereas Schenley's was\n2.05.\n(EN: Current-day betas or volatilities may be compared with these and/or\nsubstituted for them in other computations suggested in this book, for\nexample, in Composite Leverage formulas. The reader\nCUBAN - AMERICANSUGAR CSU\n36\n34\n32\n30\n28\nX MJI\n24 Pftirww\nr •\n22\n20 4. UL J L I d\n1\n18\n164 --------------r\n141945 1946\n4\nllliiil\n\"TO\nFigure 24.2 Another example of the difference in swings between stocks. In\nthis case also, the stocks show the same average price between the high and\nlow of the period, and both stocks are plotted for the same 18 months in\n1945 and 1946. Although in a lower price range and even though the\ndisparity in their Sensitivity Indexes is less, there is a considerable\ndifference in their actions. Cuban-American Sugar (left), a food stock,\nshows a range of 76% from its low of 16 1/2 to its high of 29, whereas\nElectric Boat (right), a shipbuilding concern, advances more than 140%.\nmay read in the following text “beta” for “Sensitivity Index” and avoid the\nannoyance of excessive notation by the editor.)\nThe Indexes are relative. They show stocks with a high Sensitivity Index\n(EN: beta) will move much faster in either Bull Markets or Bear Markets\nthan stocks with low Indexes, and about how much faster, relative to the\nother stocks.\n(EN: As is obvious to the experienced reader, and new to the inexperienced,\nMagee's method predates the modern compilation of betas and volatilities.\nBeta measures the systematic risk of a stock, or for those who are not into\nfinancial industry jargon, the sensitivity of a stock to the market. Volatility\nmeasures the dispersion of returns in the stock itself. Thus, if the market\nmoves 1 point, a stock with beta of 1.5 will move 1.5 points. A stock with a\nbeta of 0.5 will move 0.5 points, approximately or more or less. Not\nsurprisingly, high beta stocks are volatile. For readers who like to roll their\nown, I offer here the formula for computing the beta of a stock, which is\nsomewhat more sophisticated than Magee's method:\n((N)(Sum of XY)) - ((Sum of X)(Sum of Y))\nwhere\nN = the number of observations,\nX = rate of return for the S&P 500 Index,\nY = rate of return for stock or fund.\nThe general investor may not be avidly interested in this calculation,\nespecially when the beta is readily available at Value Line and\nfinance.yahoo.com and is published regularly by Merrill Lynch. Betas litter\nthe internet, found by searching Google; seekingalpha.com has lists; and\nfinance.yahoo. com displays the stock beta in “Key Statistics” for each\nstock covered.\nOf equal or greater importance is the individual risk of a stock that\nprofessionals like to determine by computing its volatility. Somewhat akin to\nMagee's “normal range for price,” volatility measures the variability of a\nstock's returns (price movement). The general investor should be informed\nthe study of volatility is an extremely sophisticated subject, and\nprofessionals expend enormous resources dealing with the question.\nNumerous methods are used to derive volatilities, but these mainly come\ninto play in options arbitrage and professional trading on exchange floors.\nFor the private investor, it is sufficient to know of the dangers of this arcane\narea. Before venturing into “volatility plays,” the newcomer should take a\npostgraduate course. For the general investor who wants to know enough\nto calculate his own volatilities (not recommended or necessary), I note the\nformula here:\nTo calculate volatility, first find the difference between each return and the\naverage. Then square each difference and add them together. Divide the\nsum by the number of returns minus one. This result is known as the\nvariance. Finally, take the square root of the variance to get the volatility.\nCombining these steps into a formula:\n^(Ri -|i)2\n• Step 1: Calculate the average return.\n• Step 2: Calculate the deviation of each return.\n• Step 3: Square each period's deviation.\n• Step 4: Add them together.\n• Step 5: Divide the sum by the number of periods - 1. This is the\nvariance.\n• Step 6: Take the square root.\nThe less punctilious (or more practical) investor may find volatilities at ht\ntp://www . optionstrategist.com, ht tp: // www .cboe.com, and\nfinance.yahoo.com, as well as other locati", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 151}
{"text": "lculate the deviation of each return.\n• Step 3: Square each period's deviation.\n• Step 4: Add them together.\n• Step 5: Divide the sum by the number of periods - 1. This is the\nvariance.\n• Step 6: Take the square root.\nThe less punctilious (or more practical) investor may find volatilities at ht\ntp://www . optionstrategist.com, ht tp: // www .cboe.com, and\nfinance.yahoo.com, as well as other locations that can be located by\nsearching on Google.)\nchapter twenty-five\nTwo touchy questions\nThis chapter is directed largely to the new trader, to the investor who has\nfollowed other analytical methods, and to the investor type who is now, for\nthe first time, taking up the technical trading of stocks for the shorter term.\nThe use of margin\nThe first question here is the use of margin. There are many people who,\nknowing of the disastrous margin calls of 1929 and the staggering way\nlosses can be multiplied against one in a margined account during a sharp\nbreak in the market, take the attitude that the use of margin is intrinsically\nbad, dangerous, foolish, and unsound. They will tell you they are willing to\nrisk their own money, but they never speculate on borrowed funds. They\nwill tell you that by buying securities outright, they are safe against any\nkind of break in the market.\nThere is something to this line of argument, although very often you will\nfind the arguer has not really thought the case through all the way. If he had,\nhe might realize that, in buying outright stocks that are sensitive or highly\nleveraged, he is accomplishing almost exactly the same thing as someone\nelse who buys more conservative stocks on a margin basis. Very often,\ndespite his feeling that outright purchase is more conservative than margin\nbuying, he is a speculator at heart. He is not really interested in dividends\nand a stable investment. Rather, he is looking for “something with\nappreciation opportunity.” Considering he is not facing the issue squarely,\nhe may fall into expensive errors.\nTo be thoroughly consistent here, a man who shuns the risks inherent in\nmargin trading should shun the risks of leverage and volatility. He should\navoid risk, forget “opportunity for appreciation,” and confine himself to\nsound, income-producing stocks of a sort that will not fluctuate widely.\nIf we are looking for stability, we do not want excessive fluctuation and\nthere are securities that provide stability. In this work, however, we are\nlooking for “swing power.” We want the highest degree of fluctuation we\ncan handle safely. We can secure this by buying outright a stock that is\nnormally subject to fairly broad swings—that is, a stock with a high\nSensitivity Index (EN: beta). We can get the same effect by trading in a\nstock of more conservative habits but increasing the Composite Leverage\n(EN: or simply leverage) by using margin. (The method of computing and\ncomparing Composite Leverages in various situations is covered in\nAppendix A, ninth edition and may be studied in Chapter 42.)\nLet us assume, for example, we will buy 100 shares of a rather speculative\nstock, which we will call UVW, on an outright basis. It has a Sensitivity\nIndex of 1.50, and now sells (let us say) at 20. At the same time, we buy a\nsomewhat less speculative stock, XYZ, also selling at 20; but in this case,\nwe buy on 70% margin, putting up only three-quarters of the value of the\nstock. In a general advance affecting both of these stocks, the probabilities\nwould favor a somewhat greater percentage move in UVW than in XYZ. If\nsuch a general rise should bring UVW to 30, we might expect XYZ to rise\nto a lesser degree, say to 28. Now the advance of 10 points on the $2,000\ninvested in outright purchase of UVW will represent a gain of $1,000 or\n50%. The advance of XYZ to 28 on the $1,400 invested at 70% margin will\nmean a gain of $800 or 57%. In other words, we have, by the use of margin,\nincreased the effective leverage of XYZ; we have made it, in fact, slightly\nmore speculative than UVW.\nThe effect of margin use is simply to accentuate or increase the sensitivity\nof a situation. It is a mechanism for assuming more risks and, therefore,\nmore opportunities for faster gains. Assuming you are willing to assume\nrisk (as you must be if you intend to make speculative commitments), it is\nsimply a matter of knowing approximately what risks you are taking and\nwhether you can afford to take them. The danger in margin lies in cases in\nwhich the customer grossly overextends himself, taking on a risk far\nbeyond his ability to protect himself. This will not happen if he sets a\nreasonable limit to his total leverage (EN: put another way, his portfolio\nrisk).\nThe margin transaction is simply a matter of buying (or selling short) more\nstock than you have money to pay for in full. The purchase of a home on a\nmortgage is essentially a margin transaction. The financing of business\noperations, using borrowed money for part of the capital, is the same. The\nbuying of anything for which the purchaser puts up part of the capital and\nborrows the rest, using the value of the purchased property as security for\nthe loan, is exactly similar to the trading of stocks on margin. In each case,\nany change in the value of the property will cause a larger net change in the\nvalue of the margin capital. Thus, if a man buys a home for $100,000,\npaying $50,000 cash, and later sells it for $150,000 (an increase of 50% in\nthe value of his property), he will benefit to the extent of $50,000 profit, or\n100% on his invested capital.\nThe question of margin calls, being “wiped out” on margin transactions,\nwill seldom, if ever, come up if you protect yourself properly by\nmaintaining stops at all times or by closing out the transaction when it has\nviolated certain predetermined danger points. Needless to say, if you have\nallowed a trade to go so bad it reaches the minimum margin maintenance\nrange, the best thing is to take your loss and forget it; not try to meet the\nmargin call. Yet again—this need not ever happe", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 152}
{"text": "f ever, come up if you protect yourself properly by\nmaintaining stops at all times or by closing out the transaction when it has\nviolated certain predetermined danger points. Needless to say, if you have\nallowed a trade to go so bad it reaches the minimum margin maintenance\nrange, the best thing is to take your loss and forget it; not try to meet the\nmargin call. Yet again—this need not ever happen.\nAs we will see in discussions of sensitivity and leverage, stop levels, and so\non, there are certain limits that can be fairly well defined, beyond which\nyou cannot safely venture. If you could buy stock on a 10% margin, as you\ncould at one time, you might have visions of highballing $1,000 up to $1\nmillion in one Bull Market; that is not a reasonable hope and it is not safe to\nrisk your capital on a 10% margin because, in many cases, your perfectly\nlogical purchase would sag enough to wipe you out entirely before going\nahead to the normal advance you expected. (EN: In a nutshell, the risk of\ntrading commodities and futures.) In judging how much margin you can or\nshould use within the limits of margin trading laid down by law, you must\ntake into account the method of trading you are using, the amount of\nadverse fluctuation you must expect in the normal operation of your\nmethod, and the nature of the stock you are dealing with, that is, its\nSensitivity Index and Normal Range-for-Price (EN: at the risk of being\nrepetitive, beta and volatility), at the time you make the original\ncommitment.\nShort selling\nThe other touchy question is that of short sales. A majority of traders avoid\nthe short side of the market. Six out of seven investors you meet, who have\nbought or sold stocks, will tell you they would never sell a stock short under\nany conditions, at any time. In fact, short selling is limited, very largely, to\nskilled professionals. (EN: The private investor, because of his fears and\nprejudices, voluntarily grants this “edge” or advantage to professionals.\nMagee dealt with this subject at length in Winning the Mental Game on\nWall Street, which I wholeheartedly recommend to the reader. EN9: The\nwidespread proliferation of hedge funds in the new century attests to the\nfrustration of professional managers with mutual fund rules requiring them\nto maintain only long positions. Even with this development, short selling\nby the general investor remains a limited technique—to the disadvantage of\nthe nonprofessional.)\nNow, if you have studied long-term charts (weekly and monthly), and the\ndaily charts in this book, you will recognize several facts about the action of\nmarkets. Most stocks go up most of the time. There are almost always more\nadvances than declines in the list of the most active stocks published each\nday. Stocks, in general, advance about two-thirds of the time, and go down\nonly about one-third of the time. (EN9: Probably a truth over the long term,\nbut in the modern context, ample short opportunities exist.)\nFurthermore, most of the news releases, rumors, and comments in the press\nrelated to stocks and corporate affairs have to do with the brighter side of\nindustry. It is only natural that executives, public relations people, and the\nreporters themselves should be interested in forward-looking developments,\nnew processes, expansion of facilities, increased earnings, and the like, and\nthat such items should prove more newsworthy than less optimistic reports.\nThese various factors may explain why “the public” is always Bullish. The\npublic is always hoping and expecting stocks to go up all the time. If stocks\nare rising and in a Bullish Phase, the public expects them to still go higher.\nIf stocks have declined sharply, the public will argue they are now better\nbuys than before and must surely go up soon. It is up, up, UP, always up, in\nthe mind of the public.\nYet, examination of the long-term charts covering the action of the\nAverages over many years will show you that, through these long periods,\nthe levels rise and fall about the same amount. This being the case, it must\nfollow that stocks come down as far as they go up and because they go up\nabout two-thirds of the time, they must come down much faster than they\ngo up. This you will find is true. The angles of decline in the Averages and\nalso in individual stocks are usually steeper in Bear Market Moves than the\nadvances are in Bull Market Moves. A corollary to that is that profits can be\nmade faster on the downside of the market than on the upside.\nSuch profits are made by selling short. It is important if you are a trader to\nunderstand the meaning of a short sale. When you sell a stock short, you\nborrow that stock from someone who owns it, and then you turn around and\nsell it to someone else, agreeing with the original owner to replace his\nshares at some unspecified time in the future. All of the details of this\ntransaction is handled by your broker. Shares of most stocks of large\noutstanding issue are available for loan at all times in the hands of brokers,\nand your broker has access to them. The mechanics of this borrowing and\nsale are interesting; you may wish to get from your broker the whole story\nof how these operations are carried out. For all practical purposes, however,\nall you need to do is tell your broker what you wish to sell and leave the rest\nto him.\nHe will advise you if, by any chance, the stock you have selected for short\nsale is not available for loan. Another practical point, although of minor\nconsequence, is that a slight additional tax is assessed against short sales.\n(EN: In that gains on short sales are not eligible for long-term capital gains\ntax.)\nIt is important also, if you are a trader, to accept opportunities to sell short\nas readily as you go long stock. Unfortunately, there are psychological\nbarriers to short selling. There are, for example, the unintelligent and\nentirely irrelevant slogans about “selling America short.” There is the\nfeeling on the part of many who are poorly informed that short selling i", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 153}
{"text": "long-term capital gains\ntax.)\nIt is important also, if you are a trader, to accept opportunities to sell short\nas readily as you go long stock. Unfortunately, there are psychological\nbarriers to short selling. There are, for example, the unintelligent and\nentirely irrelevant slogans about “selling America short.” There is the\nfeeling on the part of many who are poorly informed that short selling is the\nsomewhat unethical trick of the manipulator. Others have the impression\nthat, in selling short, one is hoping to profit by the misfortunes of others at\ntimes of disaster and Panic. It is not the purpose of this book to persuade\nanyone to sell stocks short, any more than it is our purpose to advise anyone\nwho should not to speculate on the long side of the market. Nevertheless, so\nmany questions are constantly raised, even by fairly sophisticated investors,\nabout the ethics, as well as the practical procedure of short selling, that we\nmay perhaps be pardoned for saying a few more words in its defense.\nAll of the popular ideas about short selling mentioned in the preceding\nparagraph may be branded as so much nonsense. There is nothing more\nreprehensible about selling short than buying long. Each is a speculation in\nrelative values. The truth is money is a commodity, just as much as a share\nof stock. There is no moral or practical difference between borrowing\nmoney to buy stock because you believe the latter will go up in value in\nterms of the former and borrowing stock to “buy” money because you\nbelieve the latter is going to go up in value in terms of the former. In each\ncase, you are obligated eventually to repay the loan whether it be money or\nstock. In each case, you are taking a risk on the basis of your considered\nforecast as to the future trend of relative values.\nThere are, in fact, many common business practices that are more or less\nanalogous to selling stocks short. For example, every time the publisher of a\nmagazine accepts cash in advance for a subscription, he is making\nsomething like a short sale. His ultimate profit or loss will depend on what\nthe magazines he will eventually supply have cost him by the time the\nsubscription runs out.\nWhen you sell stocks short, you (or rather your broker) receive the proceeds\nof the sale at once but you are obligated to turn back an equal number of the\nsame shares at some future date to the man from whom the stock\ncertificates were borrowed. (EN: One of the advantages or edges that\nprofessionals enjoy over private investors is the credit of short sales to their\naccounts and the payment of interest thereon. Although the proceeds are\ncredited to the private investor, no interest is generally paid on it, unless the\ninvestor has influence with the broker. A favorable situation is created,\nhowever, if a short sale of $100,000 were made on, say, 50% margin, a\ncredit of $150,000 would be made to his account, and no interest would be\ncharged. Any dividends the trader paid on the transaction would be\nexpensable.) Consequently, sooner or later, you have to go into the market\nagain and buy those shares. When you buy them, you (or rather your\nbroker) return the shares to the original lender, thus discharging your\nobligation. If the cost of your purchase was less than the proceeds of the\nearlier sale, the difference is your profit. If it costs you more to buy in the\nshares—or as it is termed, cover your short—the difference represents a\nloss. You do not enter into a short-side transaction unless you expect the\nprice of the stock to go down; hence, showing you a profit.\nOne of the little-appreciated results of a large volume of short selling is\nactually to strengthen the market. Every short seller is a potential buyer.\nMost short sellers are glad to cover and take their profits on a relatively\nMinor Decline. Consequently, if there is a big short interest at any given\ntime in a particular issue, it means there are many people waiting to buy\nthat stock when it goes down. This situation tends to “cushion” bad breaks.\nSome astute operators will actually buy a stock when they learn there is a\nvery large short interest in it, meaning a great many shares of it have been\nsold short and not yet covered, because they realize competition among the\nshort sellers to buy the stock whenever it has a small decline may result in a\nvery fast and profitable Short-Covering Rally. Any stock is stronger,\ntechnically, if there is a good-size short interest in it.\nThere is one further objection raised against short selling. It will be pointed\nout when you buy stock that your loss, if worse comes to worst, can be no\nmore than the total amount you paid for it. In the case of a short sale, the\nprice of your stock could, theoretically, rise against you to $50.00, $100,\n$1,000, $10,000 a share; in other words, it could rise without limit. This\nargument sounds much more alarming than it really is. Certainly there is no\noccasion to lose sleep over it. Stocks do not go up without limit all of a\nsudden. It is just\nas easy to set a stop on the loss you are willing to take on a short-side\ntransaction as it is on a long purchase. Such situations as the famous 1901\ncorner in Northern Pacific are not likely ever to occur again under present\nregulations. (EN: The famous “short squeeze.” Short squeezes still occur\nbut are extremely rare in big liquid issues. A famous short squeeze occurred\nin the silver markets of the 1980s when the Hunt brothers trapped Exchange\nmembers and almost bankrupted them. The members, being in control,\nretaliated by quintupling margin requirements and bankrupted the Hunts.)\nThe authors realize nothing said, and probably no amount of cold-blooded\nanalysis on the part of the reader himself, will remove entirely the\ntrepidation that most nonprofessional traders experience when they sell\nshort. The mental hazards will always be slightly greater than in buying\nlong. Nevertheless, from every practical angle, a short sale is exactly the\nsame thing (although in a reverse dire", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 154}
{"text": "he authors realize nothing said, and probably no amount of cold-blooded\nanalysis on the part of the reader himself, will remove entirely the\ntrepidation that most nonprofessional traders experience when they sell\nshort. The mental hazards will always be slightly greater than in buying\nlong. Nevertheless, from every practical angle, a short sale is exactly the\nsame thing (although in a reverse direction) as a long purchase, with no\ngreater risk, with actually somewhat greater chance of quick profit, and\ndiffering only in details of execution.\nA commitment in commodity futures contracts, whether long or short,\nalthough quite different in theory, has some similarities to a short sale of\nstock. In making a contract, no actual sale takes place, and no loan of either\ncash or the commodity is involved. Such a contract is simply a binding\nlegal agreement to accept delivery or to deliver a certain commodity at a\ncertain price at a certain time. In this respect, it is different from a short sale\nof stock. It is also different in that it must be closed out on or before a\ndefinite date. Although, the purchase or sale of a commodity contract is\nsimilar to a stock short sale in that (1) it is necessarily a margin transaction,\nand (2) it creates an “open” or incomplete transaction that eventually must\nbe liquidated.\nA short sale of stock must always and necessarily be a margin transaction.\nThus, if you buy 100 shares of stock outright at 20, it can sink to 15 and you\ncannot be called for more margin. You have lost $500, but the stock is still\nyours. If you sell, you get back $1,500, disregarding commissions. On the\nother hand, if you sell a stock short at 20, putting up a margin of 100%, and\nthe stock rises to 25, you will also have lost $500. The broker, under certain\nconditions, such as the 100% margin requirements in effect at one time,\nmight call on you for $500 additional margin. Or, if the transaction were to\nbe closed out at that point, you would receive back $1,500 less\ncommissions, the same as in the long transaction. In the case of this short\nsale, had the price dropped to 15, your profit would have been $500.\nOn short-term moves, the effect of short selling is exactly the same as the\nbuying of long stock, but in the opposite direction. You simply apply the\nsame methods here in reverse, during a Bear Market, that you would use in\na Bull Market. As we have already seen, the various technical indications\nthat point to upward moves in a Bullish Phase have their counterparts in\ndownside signals during a Bearish Phase.\nExecution of short sales cannot be made at any time and at any price you\nwish. A short sale must be made in a rising market. You are not permitted to\nsell a stock short on the New York Stock Exchange during a market break\nwhen each regular sale is at a lower price than the one before it (EN9: the\nuptick rule). However, this need not bother you much because, ordinarily,\nyou would make such a sale on the rally as it reached your price, and this\nwould naturally fill the requirement of a rising market. Your broker can give\nyou, in detail, the special rules and regulations that apply to short sales. It\nwill pay for you to study these so you can place your orders correctly when\nthe proper time comes to make such sales. (EN9: At the AMEX, short sales\non ETFs and some HOLDRS are exempt from the uptick rule as are futures\ncontracts on the futures exchanges. EN10: In 2007, the uptick rule was\nremoved in an ill-considered bow by the Securities and Exchange\nCommission to large speculative interests. The reader may judge for himself\nwhether subsequent markets have been more volatile on the downside. It is\nour observation that the loss of this rule results in accelerating slides in fast\ndownside markets. Since 2009, there has been wide debate about\nreinstatement of the uptick rule, so far to no avail.\nIn the current context, short selling has been institutionalized. The public\nmay buy ETFs, which take the short side of almost any instrument, as, for\ninstance, QID for the Qs is a short bet, as is DOG for the DIAMONDS™\n(DIA). There are even leveraged [two times, three times] ETFs [long and\nshort].)\nchapter twenty-six\nRound lots or odd lots?\n(EN: Or, put another way, size?)\nOne of the minor tactical questions bound to plague you is whether to trade\nin round lots of 100 shares or odd lots (less than 100 shares in active\nstocks).\n(EN: In Internet-age markets, this question has virtually lost its relevancy.\nIn Magee's time, there was a distinct disadvantage to trading odd lots, and\none traded odd lots only if hampered by limited capital. Now that an\ninvestor can achieve full diversification in an odd lot position by buying\nodd lots of Standard & Poor's Depositary Receipts (SPYs) and\nDIAMONDs™ (DIA), there seems little point in discussing it. There is, of\ncourse, always the question of broker commission—if the broker has a fixed\ncommission rate, regardless of the size of the trade, then the small investor\ngets nicked. It would seem this follows the old adage that the rich get richer.\nNevertheless, now the small investor can strike back by finding a broker\nwho does not charge commissions. At first I thought commission-free\nbrokers were making up their profit on volume; in fact, there are other ways\nto make a profit on trades than charging a commission—for example,\ndirecting the execution of the orders to a trader who needs “order flow.”\nIn the Internet age, the question of what size a trade or investment should\nbe is different from the question that confronted traders of, as it were,\nancient times. Now, it is not so much a matter of cost disadvantage in\ntrading odd lots as it is a much deeper question—that of risk and portfolio\nmanagement. So how does the aware investor determine the size of any\nindividual trade?\nI am indebted to a longtime friend, colleague, broker, and fellow trader,\nWilliam Scott, for articulating the common-sense procedure here for\ncalculating trade size and controlling risk.\nFirst,", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 155}
{"text": "t so much a matter of cost disadvantage in\ntrading odd lots as it is a much deeper question—that of risk and portfolio\nmanagement. So how does the aware investor determine the size of any\nindividual trade?\nI am indebted to a longtime friend, colleague, broker, and fellow trader,\nWilliam Scott, for articulating the common-sense procedure here for\ncalculating trade size and controlling risk.\nFirst, we determine the percentage of our capital we want to risk on any\ngiven trade. Among many professional traders of our acquaintance, this\nfigure is often 2% or 3%. For the sake of illustration, using round numbers,\nif we have $100,000 capital this means we will be risking $3,000 on a trade.\nLet us say we are going to buy a $20.00 stock and defend our position with\na stop-loss order $5.00 away. Our formula for computing position size is as\nfollows:\n3,000/5 = n number of shares (600 shares)\nIf we were going to accept a $10.00 risk, our trade size would be 3,000/10\n= 300 shares. Thus, we adjust our trade size to fit our risk parameters.\nThis is a simple, practical, and elegant way to implement risk control at the\nindividual trade level.\nTrade size is, without doubt, one of the most crucial factors in success for\nthe general investor. Ignorance, or denial, of its importance is a major\nreason for the failure of many traders. In short, overtrading. Other\nperspectives on risk and trade size are found in Chapter 42 and in Appendix\nB, where the Leverage Space Model is explained.)\nTaylor & Francis\nTaylor & Francis Group\nhttp://taylorandfrancis.com\nchapter twenty-seven\nStop orders\nWe are going to take up two kinds of stop orders, or, rather, two entirely\ndifferent uses of the mechanism of stop orders.\nFirst, let us look at the protective stop order. At best, it is not a happy\nsubject. Stop orders of this type are like fire extinguishers; the occasions\nwhen they are put into operation are not times of rejoicing. Stop orders are\nused for emergency rescue when things get so bad there seems no\nreasonable hope for a situation.\nWherever you set your protective stop, it is likely to be touched off at what\nseems to be the worst possible moment. You will set it at a safe distance\nunder a certain bottom; the stock will break through, catch your stop, and\nthen proceed to build a new bottom at this level for the next rise, or to rally\nat once and make new highs. No matter, you had your reasons for setting\nthe stop. The stock did not act the way it should have. The situation is not\nworking out according to Hoyle and certainly not the way you hoped it\nwould. Better to be out of it, even at a loss, rather than face a period of\nuncertainty and worry. If the stock has started to act badly, you cannot tell\nhow much worse it is going to behave. If you fail to set a stop, you may go\non day after day hoping for a rally that never comes while your stock sinks\nlower and lower until, eventually, you find (as millions have found) that\nwhat started to be a small reaction, and an annoying but trivial loss, has\nturned out to be a ruinous catastrophe. Stop orders cannot always be placed;\nin certain cases in active stocks, the exchanges may even restrict the use of\nstop orders.\nThe question is where and when to set the stop, realizing there is no perfect\nand absolutely satisfactory rule. If the stop is too close, you will take\nunnecessary losses; you will lose your holdings of stocks that eventually\nforge ahead and complete the profitable rise you hoped for. If stops are too\nwide (too far away), you will take larger losses than necessary in those\ncases in which your stock definitely has broken out of pattern.\nNow, it will be obvious, as the setting of stop orders depends on the price of\nthe stock and its habits. You would not place your stop level at the same\npercentage distance under a Bottom in a conservative, high-priced stock\nwhen it is selling at 80 that you would to protect a speculative issue at a\ntime when it is selling at 8.\nThe higher priced stocks, as we have already seen, make smaller percentage\nmoves. Conversely, the lower-priced stocks make wider percentage moves.\nTherefore, the lower-priced stocks should have more leeway for their\ngyrations. We will need a wider stop for them than we will for the less\nvolatile “blue chips.”\nSimilarly, we can take our Sensitivity Indexes (EN: betas in considering a\nstock relative to the market, and volatilities for absolute measure of one\nstock against another) to give us a picture of the individual habits of the\nstock. Although two stocks may be selling at the same price at a given\nmoment, you would expect a high-beta, high-volatility stock to make wider\nswings than a low-beta, low-volatility stock; therefore, you will set your\nstops wider on the higher volatility stock.\nWe must take these factors into account and work out some sort of simple\nrule of thumb to follow. Let us arbitrarily assume an imaginary stock of\n“average” habits and a price of 25 and further assume we will be satisfied,\nin this particular case, with stop protection 5% below the last established\nMinor Bottom.\nFor a stock of the same sensitivity selling at 5, we would need about half\nagain as much stop leeway (on a percentage basis). That is, the stop would\nbe placed 7.5% below the last Bottom (EN9: significant low).\n(EN10: Here Magee gave an account of how, using his Sensitivity Index and\nhis normal range for price, he computed stop positions. The process is too\nconvoluted for modern investors—and unnecessary because Magee boiled\nthe procedure down to a table I have modernized below. The Procedure is\nintact in the eighth and ninth editions for the scholarly (or obsessed)\ninvestor or academic.)\nFor most ordinary purposes, a simplified table of stop distances will be\nsufficient. Table 27.1 gives you the approximate stop distance you would\nget by the method outlined above, for stocks in various price classifications\nand of various degrees of sensitivity (volatility).\n(EN10: Magee originally constructed this table based on h", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 156}
{"text": "th editions for the scholarly (or obsessed)\ninvestor or academic.)\nFor most ordinary purposes, a simplified table of stop distances will be\nsufficient. Table 27.1 gives you the approximate stop distance you would\nget by the method outlined above, for stocks in various price classifications\nand of various degrees of sensitivity (volatility).\n(EN10: Magee originally constructed this table based on his Sensitivity\nIndex. The informed reader may consider an alternative to Magee's\nSensitivity Index, which I have conjectured here for the modern context—\nthat is, basing the stop distance on volatility, which would present a\ndynamic method of adjustment.)\nThe stop level should be marked on your chart as a horizontal line as soon\nas an actual or theoretical transaction has been entered into, and it should be\nmaintained until the transaction is closed, or until progressive stops (which\nwe will explain in a moment) have been started to close it out. In the case of\npurchases, the stop level ordinarily will be at the indicated distance below\nthe last previous Minor Bottom. In the case of short sales, it ordinarily\nwould be at the indicated distance above the last Minor Top.\nTo determine the position of this stop level, simply figure what the\npercentage distance would amount to at the price of the stock. If you are\ndealing with a stock selling at 30 and the stop distance comes out 10%, then\nallow 3 points under your last Minor Bottom.\nIn no case would we ever set a protective stop level at less than a 5%\ninterval, even for the most conservative, high-priced stocks.\nThese questions remain: What constitutes a Minor Bottom? What makes an\nestablished Minor Top? How do we know how to choose the Basing Point\n(EN9: see Chapter 28) from which to measure off our stop level interval?\nThe constitution of a Bottom or a Top (EN10: wave high, wave low) will be\ntaken up in the next chapter. For the present, let us accept the proposition\nwe will determine the correct Basing Point and will always, always set our\nstop level at the moment we make the commitment.\nTable 27.1 Table of stop distances (expressed in percent of the price of the\nstock)\nPrice Conservative\nsensitivity\nMedian\nsensitivity\nSpeculative\nsensitivity\nVolatility\nunder 0.40\nVolatility\n0.41-0.79\nVolatility\nover 0.79\nOver\n100 5% 5% 5%\n40-1005% 5% 6%\n20-40 5% 5% 8%\n10-20 5% 6% 10%\n5-10 5%a 7% 12%\nUnder 55%a 10% 15%\na Ordinarily, stocks in these price ranges would not be in the conservative\ngroup.\nIt is understood protective stops under long stock are never moved down,\nnor are protective stops over shorts ever moved up. As soon as the stock has\nmoved in the right direction far enough to establish a new Basing Point, the\nstop level is moved up (on longs) or down (on shorts), using the same rules\nfor determining the new stop level as were used in fixing the original level.\nThe progressive stop\nThere is another use of a stop that is properly considered here. This is the\nprogressive stop, which is used to close out a stock that has made a\nprofitable move, or in some cases, where a stock has given a danger signal\nbefore either completing a profitable move or violating a previous Minor\nBottom.\nYou will find on many moves, the stock will progress in the primary\ndirection for several days and then may develop exceptional volume. Often,\nthis occurs just as the stock reaches an important trendline or pattern border\nor Resistance Area. This heavy volume means one of two things: usually,\nthat the Minor Move has come to an end, being this is the top of the rise for\nthe moment; occasionally, the volume may signal the start of a breakaway\nmove that may run up several (and perhaps many) points, almost vertically.\n(The reverse situation may develop on downside moves.)\nIf, noticing the heavy volume following a good rise, and assuming this day\nmarks the end of the move, you sell the stock at the market or at a limit, you\nare going to be dreadfully disappointed if this should be one of those rare\ncases in which the stock opens the next day on an upside gap and continues\n3, 5, or 20 points up in the following days. On the other hand, experience\nwill have shown you it will not pay to expect that sort of move very often.\nYou will know that, 9 times out of 10, you will be better off out of the\nstock.\nAfter such a day when volume is exceptionally high (provided this is not\nthe first day of breakout into new high ground beyond the last previous\nMinor Top), cancel your protective stop and set a stop order, for the day\nonly, just 1/8 (0.125) point under the closing price. For example, you have\nbought a stock at 21; it goes up on moderate volume, smashes through the\nold Minor Top one day at 23 on very heavy volume, the next day continues\nto 23 3/4 on moderate volume, the third day advances on moderate volume\nto 24 1/4, and, finally, the fourth day makes a rise to 25 on much heavier\nvolume than it has shown on any day of the rise except the day it broke\nthrough 23. The morning after this close at 25, you will notice the volume\nsignal. You will cancel your protective stop, which may be at 18, and you\nwill place a stop order, for the day only, to sell on stop at 24 7/8. In most\ncases, this will mean your stock will be stopped out on the first sale of the\nday. Plus, you may get a slightly lower price than you would get with a\nstraight market order. On the other hand, after a day of high volume\nactivity, you are not likely to be left in a thin market; there should be bids\nenough, near the top, to get you out at or near your stop price.\nMeanwhile, you are protected against losing the stock if there should be a\ncontinued move in the right direction. Suppose the opening the morning\nafter you set your stop at 24 7/8 should be a gap at 25 1/4, and that prices\nthen move up further, closing at 26. (On “runaway” moves of this sort, the\nclosing for the day during the move is likely to be at the top.) You will then\nset your stop, again for a single day only, at 25 7/8. If the stock then opens\nat 26 3/8", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 157}
{"text": "ould be a\ncontinued move in the right direction. Suppose the opening the morning\nafter you set your stop at 24 7/8 should be a gap at 25 1/4, and that prices\nthen move up further, closing at 26. (On “runaway” moves of this sort, the\nclosing for the day during the move is likely to be at the top.) You will then\nset your stop, again for a single day only, at 25 7/8. If the stock then opens\nat 26 3/8 and moves up to 28, you will set another day stop at 27 7/8,\nwhich, let us assume, is caught at the opening the following day at 27 5/8.\nIn this example, you risked only 1/8 point on the first day, and eventually\nnetted an extra gain of 2 5/8 points. This, it should be pointed out, is all net\ngain because your commissions are approximately the same in either case.\nA progressive stop of this sort can be indicated on the chart by any mark\nyou choose to use—for example, a band of short diagonal lines. When a\nstock moves for several days in a runaway move, you may repeat this mark\neach day, indicating a tight stop 1/8 point under the close for each\nsuccessive day, until finally, one of these stops is caught. In the case of\nshort sales, a buy stop is used in precisely the same way as the selling stop,\nby following the stock down on a sharp runaway dive.\nThis use of tight progressive stop orders is indicated wherever a stock has\nreached its reasonable objective on high volume, or where it has exceeded\nits objective and is moving out of the Trend Channel in free air, so to speak,\nand in some cases, where the stock has failed to reach its objective.\nIf your stock, for instance, is rising in a Trend Channel, and, about halfway\nbetween the lower and upper trendlines, suddenly develops great volume,\nthen a progressive tight stop will protect you against the threatened failure\nof the move. Extreme volume in such a case, before there has been a\nbreakout to a new high above the last Minor High, is definitely a warning\nand a threat. This would be especially true if there were also a gap or a One-\nDay Reversal at this point.\nThe one day on which a tight stop would not be applied after heavy volume\nhad appeared would be the day the stock made a new high, running entirely\nthrough the previous Minor Top and closing above it. This action generally\nmeans the move is not yet completed. Should the move continue higher and\nagain show heavy volume, even if it is the very next day, we would then\nprotect with a progressive stop.\nIn this chapter, as throughout the book, the expression “heavy volume”\nmeans heavy only with respect to the recent volume of sale in the stock you\nare watching. A thousand shares may be significantly heavy volume in\nsome thin issues, whereas 10,000 shares would be no more than a normal\nturnover in more actively traded stocks. The volume chart itself will show,\nby a market peak, when a day of abnormally heavy volume occurs.\nIt should be understood the progressive stops we have been discussing are\nintended to take short-term gains, or to close out an exceptionally profitable\nrunaway move terminating in an Intermediate Climax. Although the\nextreme conditions that call for this type of operation are by no means rare,\nthey are not the usual, everyday action of the market. In the case of ordinary\nMinor Tops, even when they are fairly apparent on the basis of Trend\nChannels, volume peak, and other indications, many traders and investors\nwill prefer to wait out the expected reaction rather than pay additional\ncommissions and lose a position that is still presumably in a favorable\nMajor Trend.\nIn short, the progressive stop is a device that may be very useful on\noccasion, but it is intended to cope with a special and somewhat unusual\nmove.\nThe protective stops, on the other hand, offer the average trader, the man\nwho is not able to spend his entire time studying the market, or who has not\nhad long experience, a device by which he can limit his possible loss. He\nwill be protected from his own reluctance to close out the bad holding, and\nhe will avoid the ruinous condition of becoming frozen into a hopeless\nsituation. Since he will be taken out automatically, regardless of whether he\nhas an ultimate gain or loss, he will have the capital to use in better-looking\nissues and will not have to worry about the prospects of recovery in his\nstock after it has gone many points against him.\nIf one has sufficient knowledge and sufficient determination to get out as\nsoon as the trend has shown convincing evidence on a turn, there is less\nneed for the stop orders. (EN: This editor believes that only the proven\ntrader-investor should trade without a stop in the market. The reader may\ndetermine whether he meets this criterion by examining his portfolio to see\nwhether he has ever let a loss run or allowed a significant profit to slip\naway. If so he, or she, or they, or it, is not proven.) It is possible for such a\nperson to operate successfully without them; and there are some advantages\nin doing this because a stop order will occasionally be caught by a false\nmove or an extended dull reaction. There are also advantages in not using\nstop orders for the experienced technician who is looking toward a possible\nlong-term gain and who is willing to wait out a Secondary Reaction. Yet it\nis a thousand times better for the person who is not sure of his methods to\nbe stopped out early, than to be left holding a stock bought at, say 60, when\nit has declined to 29—or to 5!\nStop systems and methods\nThe two most important concepts in investing and trading are trends and\nstops. Being right, the trend immeasurably diminishes risk and increases\nour probability of profit. However, without skillful setting of stops, all our\nwork and study can easily result in nothing as the markets dodge and\nweave, deceive, and throw off false signals. If our analysis has not resulted\nin skillful stop setting, we will be no better off than that unfortunate fellow\nwho is acting on a tip from his brother-in-law—or his bootblack.\nConsequently, let us first at", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 158}
{"text": "our probability of profit. However, without skillful setting of stops, all our\nwork and study can easily result in nothing as the markets dodge and\nweave, deceive, and throw off false signals. If our analysis has not resulted\nin skillful stop setting, we will be no better off than that unfortunate fellow\nwho is acting on a tip from his brother-in-law—or his bootblack.\nConsequently, let us first attack this question from the viewpoint of the\ntrend-following investor and deal with trading stops thereafter. In Magee's\nsystems for the trend follower, there are two basic stop methods. One is\nbased on trendlines (sloped and horizontal), and the other is rooted in\nBasing Points. Chart patterns interact with these two methods. This entire\nbook treats the former at length in too many chapters to mention here. The\nsecond, Basing Points, is discussed exhaustively in Chapter 28.\nThe breaking of trendlines is always significant. Magee tested the validity\nof the break by requiring that prices penetrate the line by 2%-3%. This may\nnot be perfect, but it serves for the majority of situations. The longer the\ntrendline the more important the break, as illustrated in the market breaks of\n2008 and 2011 (a trendline of more than 700 days). The downwaves\n(crashes?) resulting from these trendline breaks were recognized and\ncommented on at the time at http://www/edwards-magee.com. Figure 5.1\nillustrates the serendipitous convergence of all three methods combining to\nexit longs and short the market in 2008. Trendline analysis, pattern analysis,\nand Basing Points analysis by their very nature are complementary and lead\nto similar conclusions, as, for example, in August 2011 when the long-term\ntrendline from March 2009 was broken, a Head-and-Shoulders Top was\nidentified, and the Basing Point stops were taken out.\nTherefore, we have three ways of setting stops in extended trends—\ntrendlines, patterns, and Basing Points. Are there other stop methods for\ntrend following? Indeed. A multitude. A plethora. A cornucopia. An excess.\nFirst, let us remark on the crucial question of stop setting in trends.\nStops set too close to the market result in the trader losing his position. The\nstop must be set to give the market room to move against his position, thus\n(crocodile tears) apparently surrendering precious profits. As the market\nadvances in waves (truism)—wave up, wave down—stops must be, as in\nthe Basing Points Procedure, set sufficiently below wave-low points to\navoid being exercised. In an interview in Market Wizards, Jack Schwager\nasked a major trader, Bruce Kovner, where he set his stops. “Where they're\nhard to get to,” replied Kovner.\nThis is the principle at work in Basing Point stops. Knowing that locals and\nmarket mischief-makers probe for stops at wave lows and support zones,\nthe stop is set with a filter, thus some distance below the wave low (or wave\nhigh). This stop is hard to access.\nThe same thing is true if using a moving average. Magee used a 2% or 3%\nstop for trendlines and a stop of this type is probably good for a moving\naverage, too. At the same time, if volatility and excitement are running\nhigh, the trader must adjust the size of his filter. In a rising market tracked\nwith a moving average, the trailing stop would be moving every day the\ndotted line moved up. Naturally, with a filter that might be enlarged if\nmarket volatility became excessive.\nA brief survey of stop methods\nHere we are going to deal primarily in exit stops. (EN: My book Signals\n[available on Amazon's Kindle platform] analyzes at length methods for\nentering trades and trends.) Many traders use stops to enter positions, but\nthat is not our interest at this moment. We want to know how to protect our\ninitial entry and how to advance our stops so as to lock in our profits when\nthe trade has gone our direction. The initial stop may be set as with Basing\nPoints (as described in Chapter 28), or it may be set above or below a\nSupport-Resistance zone, or as a percentage (William O'Neil says a stop\nshould be set 8% below the entry), or even as a percentage of capital—for\nexample, 2% risk per trade—a $2,000 stop ($100,000 capital) is a common\nmoney management system.\nIf the market moves against our trade, the protective stop limits the loss. If\nthe market moves with us and begins to accumulate profits for us, we have\na different, and happy, problem. It is only a matter of time until the market\nthrows us a downwave to test our mettle—or to dislodge us altogether. We\nare trend followers, so we buy strength and sell weakness, but our\nantagonists are contrarians—they do the opposite. Thus, after a reasonable\nupwave, contrarians will be taking profits and driving prices down. Swing\ntraders will be doing the same thing. We want to stick to the trend until it\nchanges, even taking these “corrective” waves against our position. Basing\nPoint stops will do this, and the inevitable result is fluctuation in equity.\nLong experience has shown that fleeing from downwaves and exiting\ninvariably results in smaller long-range profits. Accepting downwaves and\nfluctuations in profit leads to greater long-range profits. Look at the tables\nof Dow and Basing Points performance. It is not unusual to see downwaves\nof 10%-30% without a change of trend occurring. We have seen how we\ncan stop these trends with trend analysis and Basing Points analysis—and\nthere are other philosophies and other methods.\nSome other stop methods\nAverage True Range\nAverage True Range (ATR) is an interesting concept and tool. It is a\nmeasure of volatility, in actuality, and tracking it gives us some interesting\ninformation. True Range is defined as the largest of the following:\nToday's high minus today's low.\nToday's high minus yesterday's close.\nToday's low minus yesterday's close.\nATR is the average of True Range over some defined period. Twenty days is\na not uncommon parameter, as is 14. Five days is very sensitive, which has\nadvantages and disadvantages.\nATR may be used to set stops. For e", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 159}
{"text": "nteresting\ninformation. True Range is defined as the largest of the following:\nToday's high minus today's low.\nToday's high minus yesterday's close.\nToday's low minus yesterday's close.\nATR is the average of True Range over some defined period. Twenty days is\na not uncommon parameter, as is 14. Five days is very sensitive, which has\nadvantages and disadvantages.\nATR may be used to set stops. For example, we might set our initial\nprotective stop 2 (or x) ATRs below our entry. We might set our trailing\nprofit protection stop in the same way: x ATRs below the recent high—or\nthe low of the recent high.\nStops set this close are typical of trading situations. There is at least one\npractitioner of my knowledge (Eric Crittenden,\nhttp://www.blackstarfunds.com) who judges if prices take out the stop 10\nATRs below the most recent high, the trend has changed. This is sometimes\ncalled a Chandelier Exit. This kind of concept can be examined using\ntrendlines and reversal formations. ATR is a natural way of measuring\nmarket volatility and it rhythmically adjusts to market behavior. This makes\na system more flexible than fixed percentages or fixed dollar amounts. An\ninteresting paper on Crittenden's method is found at http://www.\ntrendfollowing.com/whitepaper/Does_trendfollowing_work_on_stocks.pdf.\nFeature this, relevant to my point, that the market must be given room to\nwork: Crittenden found that a 10-ATR filter averaged a space of 27%. So\nwhat we have here is an inherent stop system that posits a 27% reversal to\nindicate a change of trend.\nParabolic stop and reverse\nWelles Wilder's (1978) parabolic stop and reverse (SAR) technique uses an\n“acceleration factor.” Consequently, the stop rises parabolically, which has\nits strengths and weaknesses as the reader can imagine. Chuck LeBeau has\nconjectured a Modified Parabolic Exit, which tweaks the acceleration factor\nat http://lcchong.files.wordpress.com/2011/05/precise-exits-entries-\nmanual.pdf. This presentation includes other interesting comments on stop\nmethods.\nTarget stops\nI am not a great proponent of target stops, but many traders analyze a\nformation or market situation and compute a possible target and exit the\nmarket when their target is reached. Other target criteria may be used—a\ndollar or point amount, or as in Bill Scott's method, five days down causes\nliquidation of half the position, six days the other half.\nSimilar to the target method, the trailing stop is raised when x% of profits\nare achieved and raised again as prices advance. An old Japanese saying has\nit as follows: “Sell half at 8 new prices, half again at 10 new prices, and the\nrest at 12 new prices.”\nOf a similar nature, some traders will close the trade when an extreme move\noccurs in their direction.\nA natural method used by the Turtles\nThe Turtles used the breakdown from a 10-day channel to exit their long\ntrades. This can be modified to as little as three days, in which case the\ntrader would set a very tight stop based on the three-day low if a market\nwere running away. Such a situation might also be managed with Magee's\ntight progressive stops—raising the stop each day to just under the low of\nthe day to be in effect for the next day.\nIn the end, as the reader can see, there are as many stop methods as there\nare traders. For our purposes, the more natural and less algorithmic the\nmethod, the better—so it comes back down to trendlines, formations, and\nBasing Points, which can be tweaked to the individual taste.\nIf there is a truism about the markets it is this: a trader without stops will\nsoon be a trader without capital.\nTaylor & Francis\nTaylor & Francis Group\nhttp://taylorandfrancis.com\nchapter twenty-eight\nWhat is a Bottom and what is a Top?\n(EN9: In this extremely important chapter, I have left intact Magee's usage\nof “Tops and Bottoms.” It will be less potentially confusing for the reader\nto think of “highs and lows” as that terminology is commonly used in the\nbusiness in the modern era. Also, thinking in terms of highs and lows is an\nimportant concept in itself. Thus, for a Bull trend, higher highs, higher\nlows. When this pattern is broken in an important way, the trader should be\nalert for a trend change. Also, as the use of eighths is of the essence in\nFigure 28.1, I have left the discussion in eighths, although the reader knows\ndecimals are now used in the markets.)\nIn this chapter, we are not talking about what makes a Major Top or Bottom\nor what makes an Intermediate Top or Bottom. We are speaking of the\nMinor Tops and Bottoms that give us important hooks on which to hang our\ntechnical operations. Stop-order levels, trendlines, objectives, and Supports\nand Resistances are determined by these Minor Tops and Bottoms. They are\nof prime importance to us as traders. (For illustrations in this chapter, see\nFigures 28.1 through 28.4.)\nUsually, these Minor Tops and Bottoms are well marked and perfectly clear,\nthough often they are not. Sometimes, it is not possible to say definitely that\nthis or that place is or is not a Top or Bottom, but it is possible to set certain\nstandards and practical working rules that will help us in making these\npoints, and these rules will not fail us too often.\nA good rule for setting stop levels is to consider a Bottom has been made\nwhen the stock has moved “three days away” from the day marking the\nsuspected low of the Bottom. If a stock reacts for some days and finally\nmakes a low at 24, with a high for that day at 25, then we will not have an\nestablished Bottom until we have had three days in which the stock sells at\nno lower than 25 1/8. The entire price range for three full days must be\nentirely above the top price for the day making the low. This is the three-\ndays-away rule, and it would apply in reverse in declining markets, in\nwhich the range for three days must be entirely below the entire range of\nthe day making the high.\nThis gives a rule for setting an original stop order. It also gives a rule for\nchanging the stop order. As soon as", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 160}
{"text": "rice range for three full days must be\nentirely above the top price for the day making the low. This is the three-\ndays-away rule, and it would apply in reverse in declining markets, in\nwhich the range for three days must be entirely below the entire range of\nthe day making the high.\nThis gives a rule for setting an original stop order. It also gives a rule for\nchanging the stop order. As soon as the stock has moved three days away\nfrom a new Bottom, we move the stop order to a position below that\nBottom. (We have already explained in Chapter 27 how we determine the\ndistance this stop level should be below the Bottom.)\nProtective stops for long stocks can move only up. A stop level, once\nestablished, is never to be moved down except when the stock goes ex-\ndividend or ex-rights; then, the stop may be dropped the amount of the\ndividend or rights. Similarly, protective stops for short sales are to be\nmoved only down and may not be raised. (In the case of ex-dividends and\nex-rights, the short-sale stop would be dropped the amount of the dividend\nor rights.)\nThere are certain situations in which it is difficult to determine Bottoms and\nTops; where, indeed, it seems as though a Consolidation or Correction had\nbeen made without any significant move in the Secondary Direction. In\nsuch cases (as contrasted to the obvious situation in which the stock moves\nup or down in series of well-marked steps and reactions, like a staircase),\nyou will need all your judgment and experience to determine the point at\nwhich the Minor Basing Points actually occur.\n17\n16\n15\n14\nJULY AUGUST SEPTEMBER OCTOBER NOVEMBER DECEMBER\n7 14 21 28 4 11 18 25 1'8 15 22 29 6 13 20 29 3 :10 17:24' 1 8 15 22 29 5 ’\nFigure 28.1 Advance of a protective stop order in a long commitment. The\ndaily chart of American Cable and Radio in the summer of 1945 made a\nRounded Bottom, part of a long period of Consolidation following the\nadvance that ended in July 1944. A breakout on heavy volume occurred\nSeptember 12, and purchases were then possible on any Minor Reactions.\n13\n12\n11\n10\nSales\n100's\n250\n200\n150\n100\n50\n\nThe first protective stop would immediately be placed 6% below the\nprevious Minor Bottom of August 21, using Table 27.1 in Chapter 27. This\nwould put the stop level at 9 7/8. On September 19 and 20, we would have\ntwo days of market action entirely “away” from the September 17 Minor\nBottom, and, on September 28, a third day. We would then move the stop\nup to 6% under the September 17 Bottom, or to 10 5/8. The next move\nwould come after the new high closing of October 11, which is more than\n3% higher than the October 1 Minor Peak. The stop would now be placed at\n11 7/8. On November 2, a new high close was registered more than 3% over\nthe October 15 Minor Peak; the stop would be raised to 12 3/4. On\nNovember 15, another high closing topped by more than 3% the Minor\nPeak made on November 7. The stop would be moved up again, this time to\n13 1/2. November 29 made the third day the entire range was “three days\naway” from the November 26 Bottom, and the stop was upped to 13 3/4.\nThe closing on December 5 gave us a 3% advance over the November 17\nhigh, and again we moved the stop, raising it to 14 7/8. Finally, on January\n3, 1946, this stop was caught as shown on the chart. In a Bear Market,\nprotective stops would be moved down in exactly the same manner to\nprotect a short sale. (EN9: A number of inconsistencies exist in this figure\nand caption that are clarified later in the text.)\nBasing Points\nLet us call the levels that determine where stops should be placed Basing\nPoints. In a Bull Market Move, we will consider the Bottom of each Minor\nReaction as a Basing Point, from which we will figure our stop-order level\nas soon as the stock has moved up to “three days away.” We will also use\neach Minor Top as a Basing Point in a Bull Move. In a Bear Market, we\nwill consider the Tops of each rally and also each Minor Bottom as Basing\nPoints for the protective stops in the same way.\nWhere a stock makes a substantial move in the Primary Direction, say a\nmove of 15% or more, and then moves back at least 40% of the distance\ncovered from the previous Basing Point to the end of the Primary Move,\nthat surely gives us a Basing Point as soon as the stock again starts off in\nthe Primary Direction. If the stock reacts less than 40%, however, perhaps\neven marks time at the same level for a week or more, that should also be\nconsidered a Basing Point as soon as the move in the Primary Direction is\ncontinued (provided the volume indications are right).\nThe daily volume, as we have seen, is like the trained nurse's clinical\nthermometer; it tells a great deal about what is happening in a stock, more\nthan the superficial symptoms of price alone. There are three times at which\nyou may look for exceptionally heavy volume: (1) on the day of breakout\nfrom a pattern or a period of inaction, especially if the breakout is on the\nupside; (2) on the day on which the stock goes into new ground in the\nPrimary or Intermediate Direction, that is, goes above the last Minor Top in\na Bull Market or below the last Minor Bottom in a Bear Market; and (3) on\nthe day on which the Minor Move is completed or nearly completed, that is,\nthe new Minor Top in a Bull Market and the Minor Bottom in a Bear\nMarket. To this we might add that extra heavy volume on any other day\nduring a move in the Primary Direction is likely to indicate the move is at\nan end and will not complete the hoped-for advance or decline.\nNow, after a Minor Top has occurred, the stock now being in new high\nground, and the Top having been made on very heavy volume, we may look\nfor the corrective move. Ordinarily, that would be a decline of several days,\na week, sometimes longer. Occasionally, the correction, as we said a few\nparagraphs back, will take the form of a horizontal hesitation lasting a week\nor more without any particular corrective move in the downward direction.\nWhere there is a downward correction, it is likely", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 161}
{"text": "ng been made on very heavy volume, we may look\nfor the corrective move. Ordinarily, that would be a decline of several days,\na week, sometimes longer. Occasionally, the correction, as we said a few\nparagraphs back, will take the form of a horizontal hesitation lasting a week\nor more without any particular corrective move in the downward direction.\nWhere there is a downward correction, it is likely to come down to or near\nthe Top of the last previous Minor High (support). Also, and often at the\nsame time, the corrective move will carry down to the Basic Trendline\ndrawn through two or more previous Minor Bottoms; or to the “parallel”; or\nto a trendline drawn through the last two or more previous Minor Tops. If\nthe corrective move is horizontal, it is likely to run out until it meets one of\nthese lines.\nIn any case, the thing to watch for is the decline of volume. If the trading\nshrinks, perhaps irregularly, but on the whole, steadily, for some days after a\nnew Top has been made, during which time the stock either reacts or, at any\nrate, makes no progress in the Primary Direction, then you are justified in\nconsidering this as a Minor Correction. If the stock now continues the\nPrimary Move and gets to a point that is “three days away,” you can\nconsider the Bottom (i.e., the point you draw your trendline through, not\nnecessarily the extreme low point in the case of horizontal moves) as a new\nBasing Point.\nWhere a stock is starting what appears to be a new move or a breakout from\na period of vacillating moves, it is sometimes hard to say precisely what\npoint should be considered the Bottom. There may be several small and\nindecisive moves on low volume preceding the real breakout. In such a\ncase, we would consider the appearance of high volume as the breakout\nsignal and set our Basing Point at the low point immediately preceding this\nsignal. There usually will be such a point on one of the low-volume days in\nthe three or four days just before the breakout.\nAll that has been said about Basing Points in a Bull Market would also be\ntrue, in reverse, in a Bear Market, except that heavy volume does not\nalways accompany a downside breakout.\nNow comes the difficult and distressing situation in which the stock, having\nmade a long runaway move (let us assume it is an upward move), starts out\nto make a Flag; is bought after a sufficient correction of 40% with a decline\nof volume; and then continues to go down steadily, without any rallies and\nwithout any clear volume indications. This is an unusual situation, but it\ndoes happen on both the upside and the downside, from time to time. In the\ncase we have just mentioned, we would look for Support Levels\n(Consolidation Patterns, Multiple Tops, and so on) formed on the way down\nin the previous trend and lying below the level at which we purchased the\nstock. We would use these supports as Basing Points rather than hold a stop\nunder the extreme Bottom of the vertical move.\nIn many cases of this type, you will not be able to find adequate Basing\nPoints. Therefore, it seems unwise to try to get in on corrections after long\nrunaway moves except in the following cases: (1) the stock has risen well\nabove good Support that can serve as a Basing Point, or (2) the stock is\ncompletely above all prices for several years and is moving “in the clear.”\n(And the reverse: in Bear Markets, the stock should have fallen below a\nstrong Resistance Area or must be in new low ground for the past several\nmonths before you consider a short sale.) In any case of this sort in which\nyou are thinking of a trade in a stock that appears to be making a\nConsolidation after a fast, long, vertical move, you must have pronounced\nand conspicuous drying up of volume throughout the formation of the Flag\nor Pennant Correction.\nThere is one more word of caution needed here regarding trading in an\nIntermediate Trend. A series of moves in a trend will often take place in\nvery regular form. There may be a good trendline, and the reactions may be\nabout 40%-50% and may come back to the previous Minor Tops. The\nvolume on the Corrections may shrink with increasing volume on the new\nTops. It is easy to start trading on such a “staircase” in the expectation the\nmoves will continue to be regular and consistent, but trends do not go on\nforever. Any Minor Top may be the last. The importance of finding your\nBasing Points is to enable you to get out, at best, on any closing violation of\none of these points, and at worst, on your protective stop order. The volume\nmay again come to your aid in this question of when to stop trading on a\ntrend. Although you look for high volume on the Tops, you will be\nexceedingly suspicious of volume that is much higher than on any of the\npreceding Minor Tops (or Bottoms in a Bear Market). The final, or the next-\nto-final, “blow-off” of a trend usually will show more volume than any of\nthe Minor blow-offs along the way. When you see such climactic volume,\nyou should prepare to retire into your shell and wait for a full Correction of\nthe entire series of moves making up your Intermediate Trend. Later, weeks\nlater, or perhaps months later, you may find the stock has corrected 40% or\nmore of the whole Intermediate Move and is resting quietly with very little\nactivity. Then is the time to watch it for new opportunities and a new trend\nin the Primary Direction.\n(EN9: In a book composed of nothing but important chapters, this Chapter\n28 might not get the emphasis it deserves from the unwary reader. In fact,\nthe procedure outlined here is of absolutely basic importance in analyzing\nand trading trends. I have added to this chapter material that has been of\ngreat importance to my trading and to the trading of my students.)\nBasing Points: a case analyzed\nThe longer one thinks about the chart so casually tossed off in Figure 28.1,\nthe more he realizes it embodies a profound and natural understanding of\ntrends and the market. Consider—wave up, wave recedes, wave up, wave\nrecedes, and so on. As l", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 162}
{"text": "ds. I have added to this chapter material that has been of\ngreat importance to my trading and to the trading of my students.)\nBasing Points: a case analyzed\nThe longer one thinks about the chart so casually tossed off in Figure 28.1,\nthe more he realizes it embodies a profound and natural understanding of\ntrends and the market. Consider—wave up, wave recedes, wave up, wave\nrecedes, and so on. As long as the trader or investor is not chased from his\nposition by the corrective wave, he will, under normal circumstances, ride\nthe trend to its natural end. Nevertheless, locals and hedge funds and those\nwho profit from volatility know the previous low is where investors and\ntraders set their stops. So in the ordinary flow of trading, if they see an\nopportunity to take out an important low, they will do it—if possible.\nIndeed, it is sometimes possible and the low sometimes falls from the\nnatural flow of trading.\nBruce Kovner, on being interviewed by Jack Schwager (Market Wizards),\nwas asked where he set his stops. “Where they're hard to get to,” he said. A\ntwice told tale for its importance a stop set on a Basing Point with a\nprudently calculated filter is hard to get to unless the market has truly\nreversed direction. In fact, what is a long-term moving average but a\nlagging stop with a filter built in?\nBasing Points are merely the marking of highs and lows in full realization\nthat a pattern of higher highs and higher lows is a Bull trend, and when that\npattern changes to one of lower highs and lower lows the trend is changing\nor has changed. This is the principle behind Dow Theory, and it is the\nprinciple behind trading trends of lesser duration than Dow trends.\nMoreover, as is quickly realized, a pattern of lower highs and lower lows\nmeans inevitably the trendline has been broken.\nAs for Figure 28.1, Mark Twain had some cogent comments on it. He said\nanyone trying to make sense of it would go crazy, and anyone trying to\njustify the prices with the chart would be shot. Figure 28.1 preserves\nunexplainable conundrums and conflicts carefully preserved since the\nearliest editions. The reader is urged to take it as a concept rather than using\nit as a lesson (See Figure 28.2). Let me codify the rules implicitly presented\nin the figure:\n• A high is made, being recognized by no higher prices occurring for the\nmoment.\n• Prices recede and a low is made. This low is found by watching each day\nafter the previous high until no lower prices are made. As prices begin to\nrise again, we note each day on which prices are completely outside the\nrange of our low day candidate.\n• When three such days are observed (three days away) before a new low is\nmade, we mark the candidate day as a Basing Point and raise our stop to 6%\n(or x%) under the low of the Basing Point day (see Chapter 27).\n• If a new high is 3% greater than the previous high, a new Basing Point is\nfound at the low of the new high day.\nThe Basing Points paradigm\nBy no means will every issue be amenable to this kind of analysis.\nHowever, the method is so paradigmatic, it is worth examining at greater\nlength. Similar to virtually every other method of classical chart analysis, it\nmust be used with caution and good, thoughtful judgment. Sometimes some\nstocks will seem to work as smooth as silicon lubricant, while other issues\nwill appear to be useless. Even on recalcitrant issues, however, the\nprinciples underlying the method will be of use, if not the actual method\nitself. With this in mind, Figure 28.2 is presented; the careful reader will see\nthe chart in this example uses only bottoms or lows in stop setting and does\nnot advance stops on the making of new highs as in Figure 28.1. This is\ndone for instructional purposes and to keep the example simple for the\ngeneral investor. More advanced traders will want to study and perhaps\nutilize the new high techniques in Figure 28.1.\nFigure 28.2 actually serves more than one instructional purpose. It\nillustrates a pictureperfect case of the use of Basing Points, as well as a\ncomplete analysis of a Bull Market from entry to exit with keys marking\nevents in the life of the market. Thus, the observation of Basing Points, the\nsetting of the stops, the tracking of potentially false turns are all noted. The\nchart is accompanied by the keys. Originally the marked and keyed chart\nwas used in graduate seminars at Golden Gate University for instructional\npurposes. Shortly, it became obvious that marking the chart in this manner\nwas extremely useful in trading. Thus, it is suggested to the reader as a way\nof making his charts more communicative and more useful.\nKey to Figure 28.2 analysis\n1. A rounding bottom, or perhaps a scallop.\n2. Resistance or breakout line.\n3. Wake-up call on volume.\n4. Run day, big volume. Breakout through line 2. Sure entry signal.\n5. First Basing Point (BP). Notice prior volume fall-off in\nconsolidation and surge on run day. A stop was entered before this BP\nusing the low of the formation before the entry.\n6. BP.\n7. A weak BP (because of shallowness of retracement).\n8. BP.\n9. Test of BP at 8.\n10. A trendline drawn after point 9.\n11. BP.\n12. BP candidate that fails the three-day-away rule.\n13. BP.\n14. A potential BP, but not a very good one because a new high has not\nbeen made from 13.\n15. A Support-Resistance line.\n16. A test of 16 BP.\n17. BP.\n18. A Resistance-Support line.\n\nFigure 28.2 Apple Computer, Bull Market of 1987. A near-perfect\nexample of the use of Basing Points for trading of a reasonably regular\nand smooth Bull Market. Only wave-low Basing Points are illustrated.\n19. Flag that becomes BP.\n20. Trendline, but too steep to last.\n21. Trendline.\n22. BP.\n23. Trendline.\n24. BP.\n25. BP.\n26. Horizontal trendline.\n27. BP at 26.75 (stop 25.41). Stopped out at 25.41.\nA narrative of the events in the chart\n1-3. Had we been asleep, the event at number 3 should have awakened us; a\nvolume day like this should catch our attention. We begin paying attention\nto the stock and note the pattern that has", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 163}
{"text": "0. Trendline, but too steep to last.\n21. Trendline.\n22. BP.\n23. Trendline.\n24. BP.\n25. BP.\n26. Horizontal trendline.\n27. BP at 26.75 (stop 25.41). Stopped out at 25.41.\nA narrative of the events in the chart\n1-3. Had we been asleep, the event at number 3 should have awakened us; a\nvolume day like this should catch our attention. We begin paying attention\nto the stock and note the pattern that has been developing—the rounding\nbottom, or scallop.\n4. At number 4 we see a run day on heavy volume. A good signal for\nentry with the breaking of the horizontal line at number 2. When we\nenter, we set our stop 5% under the recent low. After entering on\nstrength, there is every possibility that some profit-taking will occur as\nwell as probing by locals to chase out arrivistes.\n5. We watch with interest for the first reaction. Each day we observe as\na candidate for a possible Basing Point. This occurs at 5, and we now\nbegin to count “days away” from the Basing Point—days whose range\nis entirely outside the range of the candidate day and occur before a\nlower low is made. When the Basing Point at 5 is confirmed, we raise\nour stop to 5% under the low of 5.\n6. A higher high is made after 5 with a subsequent reaction to 6, which\nproves to be another Basing Point. Therefore, we raise our stop to 5%\nunder 6.\n7. Prices continue to climb and another Basing Point is made at 7. The\nprocedure is becoming clear: find a Basing Point and establish a stop a\nprudent distance under it. If a new Basing Point is made, raise the stop.\nWatch with interest the reactions against the trend. Either they allow\nyou to establish a new higher Basing Point, or they end your trade.\n8-10. We find a new Basing Point at 9, raise our stop and draw the trendline\nat 10. At 9 we have a lower low than 8, but our “filter,” our 5% padding,\nkeeps our position intact. We do not lower our stops using 9 as a new\nBasing Point. One of the inviolable rules is stops are never lowered. The\nfilter is important because traders try to take out nearby lows and\nexacerbate volatility. It is called the running of the sheep.\n11. At 11 we find a new, if tenuous, Basing Point. An advance with a\nthin higher high.\n12. At 12 we have a candidate for a Basing Point that fails the three-\nday-away rule.\n13. At 13 we find the Basing Point that is good and raise our stop.\n14. At 14 we are confronted with a marginal situation. It is a potential\nBasing Point, but a marginal one because a higher high was not made\nafter 13.\n15. At 15 we are able to draw a line defining resistance—a line that\nwill become a support line.\n16. At 16 we have a new Basing Point that would have tested a point at\n14.\n17-21. At 17 we find a new Basing Point, and at 18, we can identify a\nresistance line. The spurt across this line is both gratifying and a warning\nbecause it becomes a flagpole from which the flag at 19 flies. Flags and\nflagpoles are messages the market has heated up and now wants close\nwatching. A flag can serve as a Basing Point, so we move our stop again,\nfully aware the end may be approaching. The trendline at 20 is further\nconfirmation of this environment because of its steepness, but we see two\ngood anchor points in 16 and 17 and draw trendline 21—a better line to\ndefend.\n22, 23. A good reaction finally occurs at 22, giving a strong Basing\nPoint and good rationale for raising the stop. Notice the interesting fact\nthat points 22 and 24 have come back to rest on the trendline we drew\nat 10.\n24. As the tempo has increased and the volatility 24 furnishes us\nanother valid Basing Point.\n25, 26. Even 25 is a valid point, and we can now see the clear support\nline at 26.\n27. When this line is pierced at 27 upon extraordinary volume, and in the\nprocess takes out our Basing Point stop from 25, it is clearly time to exit the\ntrain. The Basing Points concept is even more thoroughly explored in the\nbook entitled, StairStops, which is available on the John Magee Technical\nAnalysis website at http://www.edwards-magee.com and on\nhttp://www.amazon.com, including Kindle edition.\nThe complete Basing Points Procedure: taking into consideration the\nsetting of Basing Points on both wave lows and new highs As previously\ndiscussed by Magee, the Basing Points Procedure may set Basing Points on\nboth wave lows and on new highs. We find the wave-low Basing Point by\nthe three-days-away rule; we find the new high Basing Point, by marking\nwave highs and subsequent new highs so when price exceeds by 3% the old\nwave high, or recent high, whether or not an intervening wave low has\noccurred, we may set the new Basing Point at the low of the new high day.\nIf a new high were made subsequent to this new high, we would reset the\nBasing Point again if we were using this variant of the procedure, which I\ncall Variant 2.\nOnce again, the one-armed economist rules. On the one hand, raising the\nstops like this on new highs may easily result in being ejected from the\nposition by a price dip; then you watch the train leaving the station on the\nway to incredible new highs amid much teeth gnashing and irritation.\n(Incidentally, if emotional distress occurs in this or other like situations it is\na message to you are too emotionally attached to the market. Complete\nmarket maturity is not achieved until such situations can be viewed with\nrelative equanimity so the event is viewed with detached interest and a plan\nto set things right.)\nOn the other hand, after having accumulated large paper profits, the issue\ncollapses and snatches back from you a third (or more) of your hard-earned\nprofits. (If you had only advanced stops based on new highs!) Remember,\nthe problem with Dow Theory (and trend following) is you give up the first\nthird of the move and the last third of the move and sometimes there is not a\nmiddle third, as conventional market wisdom has it.\nWhat essentially occurs when using Variant 2 of the procedure is as follows:\nwhen blow-off or runaway conditions occur, the procedure changes from\nselling weakness to selling stren", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 164}
{"text": "hs!) Remember,\nthe problem with Dow Theory (and trend following) is you give up the first\nthird of the move and the last third of the move and sometimes there is not a\nmiddle third, as conventional market wisdom has it.\nWhat essentially occurs when using Variant 2 of the procedure is as follows:\nwhen blow-off or runaway conditions occur, the procedure changes from\nselling weakness to selling strength. I believe very strongly in the variation\nof tactics, generally. Also, I am intimately familiar with the pitfalls of\nvarying tactics, but I like the procedure in general and also think knowing\nwhen to use it and when not to use it can require a great deal of experience\nand emotional coolness in potentially high-stress conditions. If the entire\n(Variant 2) procedure is executed and also combined with a scale-in/scale-\nout plan, the user may succeed in shooting the moon.\nThe phlegmatic Marc Antony (who sleeps well of night and is sleek and\nwell fed) follows the conservative wave-low method (Variant 1) and\nprobably wins in the long run. The Variant 1 procedure is simpler and\nnaturally expands to accommodate the high-volatility market that ejects the\ntrader attempting to escape the inevitable collapse before going on to new\ncompletely unexpected heights.\nAs it goes, damned if you do, damned if you don't, unless you are charmed\nor kissed by the market fairy—or lucky.\nThe complete Basing Points procedure\n1. A wave high is made, recognized by no higher prices coming for the\nmoment. If this high is 3% (Magee's number, but could be a parameter)\nhigher than the previous wave high (or the recent high in a run or blow\noff), the Basing Point is raised to the low of the new high day.\nObviously, this comes into effect for the next trading day.\n2. Prices recede and a low is made. This low is found by watching each\nday after the previous high until no lower prices are made (a potential\nwave low or Basing Points candidate). As prices begin to rise again,\nwe note each day on which prices are completely out of the range of\n(away from) our low-day candidate, or a “day away.”\n3. When three such days are observed (the three-days-away rule)\nbefore a new low is made, we mark the candidate day as a Basing\nPoint and raise our stop to 6% (or x% as this is a parameter) under the\nlow of the Basing Point day. Obviously, the new stop is established the\nday after the three days away have occurred.\n4. If a new high is made without an intervening wave low Basing\nPoint, the process starts over from the new high.\n5. If the new high is 3% (or x%) higher than the previous high\n(whether made from a wave low or wave high), or from surging prices\ncontinually making new highs, a new Basing Point is found at the low\nof the new high day. Thus, a price move that went from 10 to 10.3 to\n10.61 to 10.93 would create new Basing Points at the low of each new\nhigh day.\n11\n14\n13.5\n13\n12.5\n12\n11.5\nFigure 28.3 Basing Points candlestick version. This chart is a\ncandlestick version of Figure 28.2. It illustrates the complete\nprocedure, showing establishment of Basing Points made by wave\nlows and by higher highs. This is a blow up of the period in the chart\nduring which higher high conditions exist. As might be obvious, the\nhigher high rules begin to come into play late in the life of a trend, in\nthe runaway and blow-off stages.\n10.5\n10\nFigure 28.4 Apple Variant 2 of the Basing Points Procedure. This chart\nshows the trend from beginning to end as in Figure 28.2, with the\naddition of dotted lines to show where stops fell when computed from\nhigher highs. The previous candlestick chart is used for the close-up\nanalysis. This chart puts into broad perspective the relative level of\nstops using the Variant 2 method. As can be seen, setting stops from\nnew higher highs results in stops closer to the market prices. This can\nbe good or bad, depending on what the market does to you.\nTwo charts giving a long-view perspective on\nthe complete (Variant 2) procedure\nThere is another method Magee advocated for surging and blow-off\nmarkets. He called this alternative method “progressive stops,” which is\nexplained in the ninth edition. Strictly speaking, although there is a\nvariation in tactics involved in using new highs for stop calculation, this\nmethod is a twist on selling on strength. Variant 2 is still lagging stops\nbehind prices. A pure strength selling method would attempt to time exit on\na blow-off day, or a key reversal day or a one-day reversal, or even on a\nstrong long running day up. This is perhaps a little easier to visualize on the\ndownside. A panic selling day (which tends to finish at the lows) would\nprovoke an exit on the close.\nThe representative case fully analyzed using wave lows and new\nhighs\nThe case will not be unfamiliar to readers, and its use will fully highlight\nthe differences found in the procedure. The same materials will be used,\nand the differences will be boldfaced in the text.\n1. A rounding bottom, or perhaps a scallop.\n2. Resistance or breakout line.\n3. Wake-up call on volume.\n4. Run day, big volume; breakout through line 2; sure entry signal.\n5. First Basing Point (BP). Notice prior volume fall-off in\nconsolidation, and surge on run day.\n6. BP.\n7. A weak BP (because of shallow retracement).\n8. BP.\n9. Test of BP at 8.\n10. A trendline drawn after point 9.\n11. BP.\n12. BP candidate that fails the three-day-away rule.\n13. BP.\n14. A potential BP but not a very good one because new high has not\nbeen made from 13.\n15. A Support-Resistance line.\n16. BP.\n16A. New High: 10.35.\n17. BP.\n17A. New Higher High 10.81; Low BP 9.89 (+3% 11.13); Stop 9.30.\n17B. New Higher High 11.16; Low BP 10.58 (+3% 11.49); Stop 10.49.\n17C. New Higher High 11.62; Low BP 11.22 (+3% 11.96); Stop 10.55.\n18. A Resistance-Support line.\n19. Flag that becomes BP. High 11.62.\n19A. New Higher High 12.55; Low BP 11.91 (+3% 12.93); Stop 11.19.\n20. Trendline, but too steep to last.\n21. Trendline.\n22. BP.\n23. Trendline.\n24. BP.\n24A. New Higher High 12.93; Low BP 12.43 (+3% 13.", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 165}
{"text": "17B. New Higher High 11.16; Low BP 10.58 (+3% 11.49); Stop 10.49.\n17C. New Higher High 11.62; Low BP 11.22 (+3% 11.96); Stop 10.55.\n18. A Resistance-Support line.\n19. Flag that becomes BP. High 11.62.\n19A. New Higher High 12.55; Low BP 11.91 (+3% 12.93); Stop 11.19.\n20. Trendline, but too steep to last.\n21. Trendline.\n22. BP.\n23. Trendline.\n24. BP.\n24A. New Higher High 12.93; Low BP 12.43 (+3% 13.34); Stop 11.68.\n24B. New Higher High 13.41; Low BP 13.07 (+3% 13.81); Stop 12.29.\n25. BP.\n25A. New Higher High 13.82; Low BP 13.36 (+3% 14.23); Stop 12.56.\n25B. Stopped out at 12.56.\n26. Horizontal trendline.\n27. BP at 25 (stop 11.80); Stopped out at 11.80.\nA narrative of the events in the chart\n1-3. Had we been asleep, the event at number 3 should have awakened us; a\nvolume day like this (Cf. chart 28.2) should catch the attention. We begin\npaying attention to the stock and note the pattern that has been developing\n—the rounding bottom, or scallop.\n4. At number 4 we see a run day on heavy volume. A good signal for\nentry with the breaking of the horizontal line at 2. When we enter, we\nset our stop 6% under the recent low. After entering on strength, there\nis every possibility that some profittaking will occur as well as probing\nby locals to chase out arrivistes.\n5. We watch with interest for the first reaction. Each day we observe as\na candidate for a possible Basing Point. This occurs at 5 and we now\nbegin to count “days away” from the Basing Point, that is, days whose\nrange is entirely outside the range of the candidate day, and that occur\nbefore a lower low is made. When the Basing Point at 5 is confirmed,\nwe raise our stop to 6% under 5.\n6. A higher high is made after 5 with a subsequent reaction to 6, which\nproves to be another Basing Point, so we raise our stop to 6% under 6.\n7. Prices continue to climb and another Basing Point is made at 7. The\nprocedure is becoming clear: find a Basing Point and establish a stop a\nprudent distance under it. If a new Basing Point is made, raise the stop.\nWatch with interest the reactions against the trend. Either they allow\nyou to establish a new higher Basing Point, or they end your trade.\n8-10. We find a new Basing Point at 8, raise our stop, and draw the\ntrendline at 10. At 9 we have a lower low than 8, but our “filter,” our 6%\npadding, keeps our position intact. We do not lower our stops using 9 as a\nnew Basing Point. One of the inviolable rules is that stops are never\nlowered. The filter is important, because traders try to take out nearby lows\nand exacerbate volatility. It is called the running of the lambs.\n11. At 11 we find a new, if tenuous, Basing Point. An advance with a\nthin higher high.\n12. At 12 we have a candidate for a Basing Point that fails the three-\nday-away rule.\n13. At 13 we find the Basing Point that is good and raise our stop.\n14. At 14 we are confronted with a marginal situation. It is potential\nBasing Point, but a marginal one because a higher high was not made\nafter 13.\n15. At 15 we are able to draw a line defining resistance—a line that\nwill become a support line.\n16. At 16 we get a Basing Point.\n16A. New High: 10.35 (a benchmark).\n17. At 17 we find a new Basing Point and at 18 we can identify a\nresistance line. The spurt across this line is both gratifying and a\nwarning because it becomes a flagpole from which the flag at 19 flies.\nFlags and flagpoles are messages that the market has heated up and\nnow wants close watching. A flag can serve as a Basing Point, so we\nmove our stop again, fully aware the end may be approaching. The\ntrendline at 20 is further confirmation of this environment due to its\nsteepness. However, we see two good trendline anchor points in 16\nand 17 and draw trendline 21—a better line to defend.\n17A. New Higher High 10.81; Low BP 9.89 (+3% 11.13).\n17B. New Higher High 11.16; Low BP 10.58 (+3% 11.49).\n17C. New Higher High 11.62; Low BP 11.22 (+3% 11.96).\n18. Support-resistance line.\n19. Flag that becomes BP. High 11.62.\n19A. New Higher High 12.55; Low BP 11.91 (+3% 12.93); Stop 11.19.\n22-24. A good reaction finally occurs at 22 giving a strong Basing Point and\ngood rationale for raising the stop. Notice the interesting fact that points 22\nand 24 have come back to rest on the trendline we drew at 10. As the tempo\nhas increased, and the volatility, 24 furnishes us another valid Basing Point.\n24A. New Higher High 12.93; Low BP 12.43 (+3% 13.34); Stop 11.68.\n24B. New Higher High 13.41; Low BP 13.07 (+3% 13.81); Stop 12.29.\n25. Even 25 is a valid point and we can now see the clear support line\nat 26.\n25A. New Higher High 13.82; Low BP 13.36 (+3% 14.23); Stop 12.56.\n25B. Stopped out at 12.56.\n26. Support-resistance line.\n27. When this line is pierced at 27 upon extraordinary volume, and in\nthe process takes out our Basing Point stop from 25, it is clearly time\nto exit the train.\nchapter twenty-nine\nTrendlines in action\nFrom what has already been said in Section I of this book, you will be\nfamiliar with the characteristic single-line trends of stocks and the\nnumerous exceptions and deviations that come into the picture from time to\ntime. We know stocks often move in parallel trends, sometimes for months,\noccasionally even for years. We also know they may, and do, break out of\ntrend or change the direction of their trends without notice.\nMost of the pattern formations we have studied can be considered as\nmanifestations of trend action, or Continuations or Reversals of a trend.\nThus, a Symmetrical Triangle is simply the meeting of two trends. During\nthe formation of the Triangle, the stock is following both trends in a\nnarrowing pattern until, finally, the dominant trend asserts itself. An\nAscending Triangle is following an upward trend but has encountered a\nResistance Level at the Top. A Head-and-Shoulders Formation shows the\nend of an upward trend and the beginning of a downward trend. A\nRectangle is a Parallel Trend Channel running in a horizontal direction, and\nso on.\nWe can project a Parallel Trend and, in the", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 166}
{"text": "owing pattern until, finally, the dominant trend asserts itself. An\nAscending Triangle is following an upward trend but has encountered a\nResistance Level at the Top. A Head-and-Shoulders Formation shows the\nend of an upward trend and the beginning of a downward trend. A\nRectangle is a Parallel Trend Channel running in a horizontal direction, and\nso on.\nWe can project a Parallel Trend and, in the case of stocks continuing to\nmove in that trend, we can buy and sell at almost the precise points of\ncontact with the trendline. Unfortunately, long and perfect straight-line\ntrends of this sort are the exception rather than the rule. For actual trading\npurposes, we will project our trends more or less continuously on the basis\nof the most recently established data.\nFrom the standpoint of tactics, let us consider the trends as they are\nindicated by the successive Minor Tops and Minor Bottoms. For illustration\nof this, and as a guide to what we are leading up to, we will consider\nsimplified, ideal situations (see the examples in Diagrams 29.1 through\n29.6).\nTo avoid confusion, mark the top trendline in blue pencil and the bottom\ntrendline in red pencil. We will refer to the upper trendline as the Blue\nTrend, and the lower trendline as the Red Trend. From time to time, we will\nalso want to draw a line parallel to a Blue Trend across the Bottom of the\ntrend so as to include a segment of the Trend Channel between two Tops\nwithin parallel lines. This we will call the Blue Parallel, and we will mark it\nwith a dotted or broken blue line. Conversely, we may wish to draw a\nparallel to the Red Trend so as to include the segment of the Trend Channel\nbetween two Bottoms, and this dotted red line we will call the Red Parallel.\nOrdinarily, a Top (wave high) will be formed after a Bottom (wave low) and\na Bottom after a Top; thus, we will expect to draw, alternately, a Blue\nTrendline and a Red Trendline with these lines being drawn as soon as the\nnew Top or Bottom is established. (In some cases, a light pencil line may be\ndrawn to indicate suspected Tops or Bottoms, until developments confirm\ntheir validity.)\nWe have already taken up the important and rather difficult question of\ndetermining the Minor Tops and Bottoms. Very often, these points will be\nclear and obvious. Sometimes they will be obscure, and you will be able to\ndraw trendlines with confidence, in such cases, only after considerable\nexperience covering many types of actions. The most difficult times to\ndetermine Minor Trends are during Reversals, especially in cases in which\nthese are of\nDiagram 29.1 Here is a rising trend showing the Basic Trendline across two\nBottoms, which we call the Red Trendline, and its parallel (indicated by a\nbroken line) through the Top of the intervening peak. The parallel suggests\nthe approximate objective of the next move if the stock continues in trend.\nDiagram 29.2 The same rising trend with the Return Line, which we call\nthe Blue Trendline, drawn through two Tops. The broken line represents its\nparallel through the intervening Bottom. This Blue Parallel is useful in\ndetermining a buying point, especially in trends of rapidly changing form\nwhen the stock may not react to its Basic Trendline.\nDiagram 29.3 This is a declining trend showing the Basic Trendline across\ntwo Tops, which we call the Blue Trendline, and its parallel (indicated by a\nbroken line) through the Bottom of the intervening decline. The parallel\nsuggests the approximate objective of the next move if the stock continues\nin trend.\nthe rounded and irregular types. In these cases (of Reversal), however, we\nwill not depend much on the trendlines to determine buying and selling\npoints.\nAs long as a stock persists in a Parallel Trend Channel, it is perfectly clear\nto buy near the Bottom of the channel and sell near the Top. From the\ngeometry of the situation (see examples), you will see at a glance it is not\nlikely to be profitable to sell short in an\n\nDiagram 29.4 The same declining trend with the Return Line, which we\ncall the Red Trendline, drawn through two Bottoms. The broken line\nrepresents its parallel through the intervening Top. This Red Parallel is\nuseful in determining a point at which to make short sales, especially in\ntrends of rapidly changing form when the stock may not rally to its Basic\nTrendline.\nDiagram 29.5 Simplified diagram of a stock chart showing trend action.\nBasic Trendlines are marked with heavy lines; Return Lines are marked\nlightly.\nupward-moving trend (because the reactions are necessarily smaller than\nthe advances), or to buy stock in a downward-moving trend.\nTherefore, a trend must show it is presumably an uptrend before you are\njustified in buying stock. Plus, you must have what is presumably a\ndowntrend to justify a short sale.\nYou will notice from the simplified examples shown here that pattern\nformations indicate trends. The breaking of a Rectangle on the upside\nresults in an upward slope of the Blue Trend. The move up out of an\nAscending Triangle confirms the rising Red Trend and creates a rising Blue\nTrend. The downside breaking of a Head-and-Shoulders neckline confirms\na descending Blue Trend and sets up a descending Red Trend, and so on.\nFrom studies of these patterns and various trend actions, we arrive at a\ncompact set of trading rules based on these Red and Blue trendlines. These\nrules are summarized below.\nBuying stock, “going long”\n• Preparatory buying signals (indicating a buying opportunity may be in\nthe making). Penetration of Blue Trend to a new high closing (in most\ncases). The simple breaking of a descending Blue Trendline, in cases in\nwhich no other pattern or indication is present, is not sufficiently conclusive\nevidence of Reversal to justify commitments.\nb\n\ng\nh\nDiagram 29.6 Preparatory buying signals shown by trend action.\na. Penetration of an ascending Blue Trendline.\nb. Penetration of a horizontal Blue Trendline.\nc. The penetration of a descending Blue Trendline without other\ntechnical indications is n", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 167}
{"text": "endline, in cases in\nwhich no other pattern or indication is present, is not sufficiently conclusive\nevidence of Reversal to justify commitments.\nb\n\ng\nh\nDiagram 29.6 Preparatory buying signals shown by trend action.\na. Penetration of an ascending Blue Trendline.\nb. Penetration of a horizontal Blue Trendline.\nc. The penetration of a descending Blue Trendline without other\ntechnical indications is not conclusive evidence of a change in trend\nand does not justify long commitments.\nd. Contact with the Blue Trendline of an Ascending Parallel Trend\nPattern.\ne. Contact with the Blue Trendline of an Ascending Divergent Trend\nPattern.\nf. In this case, contact with the Blue Trendline does not suggest a buy\non the next reaction, because the trend appears to be converging; a\npossible Wedge in the making, with Bearish implications.\ng. Contact with the Blue Trendline of a Rectangle at its fifth point of\nReversal.\nh. Contact with the Blue Trendline of an Ascending Triangle.\ni. Penetration on volume of descending Blue Trendline when Red\nTrendline is ascending (Symmetrical Triangle).\n• Contact with the ascending Blue Trend if the Red Trend is also ascending,\nprovided the trends do not converge (Parallel or Divergent Trend Channel).\n• Contact with the horizontal Blue Trend if the Red Trend is also horizontal\nor ascending (Rectangle, Ascending Triangle).\n• Penetration of the descending Blue Trend on volume if the Red Trend is\nascending (Symmetrical Triangle).\n• Execution of buys (after preparatory buying signal).\n• In case the previous Blue Trend has been ascending, draw the Blue\nParallel and buy at or near this line.\n\nDiagram 29.6 (Continued) Preparatory signals for short sales shown by\ntrend action.\nj. Penetration of a descending Red Trendline.\nk. Penetration of a horizontal Red Trendline.\nl. The penetration of an ascending Red Trendline without other\ntechnical indications is not conclusive evidence of a change in trend\nand does not justify short commitments.\nm. Line of a Descending Parallel Trend Channel.\nn. Contact with the Red Trendline of a Descending Divergent Trend\nPattern.\no. In this case, contact with the Red Trendline does not suggest a short\nsale on the next rally, because the trend appears to be converging; a\npossible Wedge in the making, with Bullish implications.\np. Contact with the Red Trendline of a Rectangle at its fifth point of\nReversal.\nq. Contact with the Red Trendline of a Descending Triangle.\nr. Penetration of ascending Red Trendline (with or without volume)\nwhen Blue Trendline is descending (Symmetrical Triangle).\nIn descending trends, the Red Trendline is a return Line, and short sales will\nbe made on rallies to a line parallel to the new Red Trendline established at\nthe Bottom of the signal move and drawn through the intervening peak.\nNote in the case of decisive breakouts from patterns such as Rectangles and\nTriangles, a short sale might also be made on the basis of a computed\n40%-50% correction of the breakout move, or on a return to Resistance.\n• In case the previous Blue Trend has been horizontal or descending (that is\nto say, emerging from Rectangles, Triangles, and various Reversal\nPatterns), buy on a reaction of 40%-45% of the distance from the last\nprevious Minor Bottom to the extreme Top of the most recent move.\nLiquidating, or selling a long position\nImmediately on execution of the buy order, determine the stop level (see\nChapter 27, Stop Orders) and place your protective stop. Penetration of this\nstop level will automatically close out your transaction. The stop level may\nbe moved up according to the “three-days-away” rule but may never be\nmoved down (except to adjust for ex-dividend or ex-rights). If the stock\ncloses below a previous Minor Bottom (thus setting up a descending Red\nTrend), sell on tight (EN: or hair-trigger) progressive stops.\nAt the start, the stock declines in a Parallel Trend Channel. The Blue\nTrendline is basic here. A short sale on a rally to the Red Parallel at point A\nwill find its objective on the Blue Parallel at B. Another short sale on the\nRed Parallel at C would be followed by failure to reach the objective.\nChances are good, however, that increased volume would develop at the\nDouble Bottom and give warning to get out of short commitments. The\nupside penetration of the basic Blue Trendline at E, alone, is not sufficient\nreason to reverse position and go long. Trendlines set up during formation\nof the Rectangle would be marked in the regular way, but they are indicated\nhere by broken lines to emphasize the pattern. Another short sale, if tried on\nthe sixth point of contact with the Rectangle at F, would be stopped out on\nthe breakout.\nThe trend is now rising, although we cannot yet draw a Basic (Red)\nTrendline. The first buy would be made on a 40%-50% correction of the\nbreakout move from the Rectangle, or on a return to the Top (Support) level\nat H.\nA trendline would be drawn to the first Bottom established in the Triangle.\nThis is not shown, as it would ultimately be replaced by the line shown\nthrough the outermost point in the Triangle. We have indicated by broken\nlines the trendlines set up during the formation of the pattern.\nThe objective of the breakout move from the Triangle would be the Red\nParallel to our now rising Basic Trendline; this objective is reached at J. A\nReturn Line (Blue) would be drawn from the first Reversal Top of the\nTriangle at G through the Top of the breakout move at J, and the parallel to\nthis through point I would indicate about where to make the next purchase.\nAs a matter of fact, the stock does not actually get back to that point; in\npractice, the purchase would probably be made at K on the basis of a\n40%-50% correction, or on a reaction to the Support Level G.\nThe subsequent upward move would not carry through to the Red Parallel\nmarked W; however, the alarm would probably be sounded clearly by a day\nof heavy volume, a One-Day Reversal, or a gap. Since the trend is now\nobviously convergent, no further purchas", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 168}
{"text": "o that point; in\npractice, the purchase would probably be made at K on the basis of a\n40%-50% correction, or on a reaction to the Support Level G.\nThe subsequent upward move would not carry through to the Red Parallel\nmarked W; however, the alarm would probably be sounded clearly by a day\nof heavy volume, a One-Day Reversal, or a gap. Since the trend is now\nobviously convergent, no further purchases would be considered. The next\nmove fails to make such headway and falls far short of the objective set by\nthe Red Parallel marked Y. Soon after, the Wedge breaks out downside.\nIf the stock advances on moderate volume and then develops unusually high\nvolume on any day during the advance before either the Blue Trend is\nbroken (with a close above that trendline) or before the stock has made a\nnew high closing over the last Minor Top, close out the transaction on tight\nprogressive stops.\nIf the stock develops high volume on the day on which it either tops and\ncloses above the Blue Trend or makes a new high closing over the previous\nMinor Top, hold it. If heavy volume again occurs on the following day or\nany subsequent day, however, sell on tight progressive stops.\nIn rising trends, the Blue Trendline is a Return Line, and purchases will be\nmade on reactions to a line parallel to the new Blue Trendline established at\nthe Top of the signal move and drawn through the intervening Bottom. Note\nin the case of decisive breakouts from patterns such as Rectangles and\nTriangles, a purchase may also be made on the basis of a computed\n40%-50% correction of the breakout move, or on a return to Support.\nYou will find in many cases the heavy volume signal will develop\n(sometimes with also a One-Day Reversal or an Exhaustion Gap) on or near\nthe Red Parallel; watch especially for this volume indication as a sign of a\ngood profit-taking point. If the volume signal does not show up, your\nselling objective is this Red Parallel, at a limit or on tight progressive stops.\nIn case there is no such volume signal at the top of the move and the move\ndoes not reach the Blue Trend or make a new high, you are very likely\nrunning into a Triangle situation. In that case, you will have to wait for a\nbreakout one way or another. Meanwhile, maintain your stop protection\nunderneath.\nSelling stock short\n• Preparatory selling signals (indicating an opportunity for short sales may\nbe in the making).\n• Penetration of Red Trend to a new low closing (in most cases). The simple\nbreaking of an ascending Red Trendline where no other pattern or\nindication is present is not sufficiently conclusive evidence of Reversal to\njustify commitments.\n• Contact with descending Red Trend if Blue Trend is also descending,\nprovided the trends do not converge (Parallel or Divergent Trend Channel).\n• Contact with horizontal Red Trend if Blue Trend is also horizontal or\ndescending (Rectangle, Descending Triangle).\n• Penetration of ascending Red Trend (with or without volume increase) if\nBlue Trend is descending (Symmetrical Triangle).\n• Execution of short sales (after preparatory selling signal).\n• In case the previous Red Trend has been descending, draw the Red\nParallel and sell at or near this line.\n• In case the previous Red Trend has been horizontal or ascending (that is to\nsay, emerging from Rectangles, Triangles, and various Reversal Patterns),\nsell on a rally of 40%-45% of the distance from the last previous Minor Top\nto the extreme Bottom of the most recent move.\nCovering short sales\nImmediately on execution of the short sale, determine the stop level (see\nChapter 27, Stop Orders) and place your protective stop. Penetration of this\nstop level will automatically close out your transaction. The stop level may\nbe moved down according to the three-days-away rule, but it may never be\nmoved up.\nIf the stock closes above a previous Minor Top (thus setting up an\nascending Blue Trend), buy to cover on tight progressive stops.\nIf the stock declines on moderate volume and then develops unusually high\nvolume on any day during the decline before either the Red Trend is broken\n(with a close below that trendline), or before the stock has made a new low\nclosing under the last Minor Bottom, close out the transaction on tight\nprogressive stops.\nIf the stock develops high volume on the day on which it either breaks and\ncloses below the Red Trend or makes a new low closing under the previous\nMinor Bottom, hold it short. If heavy volume again occurs on the following\nday or any subsequent day, however, buy to cover on tight progressive\nstops.\nYou will find in many cases the heavy volume signal will develop\n(sometimes with also a One-Day Reversal or an Exhaustion Gap) on or near\nthe Blue Parallel; watch especially for this volume indication as a sign of a\ngood profit-taking point. If the volume signal does not show up, your\nbuying objective is the Blue Parallel, at a limit or on tight progressive stops.\nIn case there is no such volume signal at the bottom of the move and the\nmove does not reach the Red Trend or make a new low, you are very likely\nrunning into a Triangle situation. In that case, you will have to wait for a\nbreakout one way or another, meanwhile maintaining your stop protection\noverhead.\nAdditional suggestions\nWhen a level is reached that appears to be either a Minor Bottom on a\nreaction or a Minor Top on a rally, and when the stock continues to stall and\nremain at this point, moving in a very narrow range for three weeks or more\nwithout giving any signal either by way of price change or volume action as\nto its next move, it is wise to assume this congestion is definitely a key area\nand should be considered a Minor Top or Bottom; protective stops should\nbe adjusted to it as a Basing Point, instead of the previously established Top\nor Bottom, as against the possibility that the move out of this area, when it\ncomes, may be in the wrong direction.\nAfter a series of moves in a trend, with each move in the Primary Direction\nmarked by heavier volume than the retre", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 169}
{"text": "nitely a key area\nand should be considered a Minor Top or Bottom; protective stops should\nbe adjusted to it as a Basing Point, instead of the previously established Top\nor Bottom, as against the possibility that the move out of this area, when it\ncomes, may be in the wrong direction.\nAfter a series of moves in a trend, with each move in the Primary Direction\nmarked by heavier volume than the retreats or Corrective Moves against the\ntrend, you are likely to have a move in the Primary Direction, which is\nmarked by extraordinary volume (much larger volume than the normal\nincrease for a Primary Move). On such a move, after taking your profits on\nprevious commitments, you would ordinarily begin to plan the next\ncommitment on the Correction. In this particular case, noting the extreme\nvolume, you would cancel any immediate plans for further commitments in\nthe Primary Direction.\nThe reason for this is such climactic volume normally indicates the final\n“blow-off” of the Intermediate Trend, to be followed either by a Reversal,\nor at least by a period of stagnation, or by formation of Consolidation\nPatterns, or by Intermediate Correction. In such a case, it is not safe to make\nany further commitments on this trend pending further developments and\nthe positive reassertion of the trend.\nIf you examine daily charts of various stocks, covering long and important\ntrends, you will find the series of Minor Moves making up the Intermediate\nTrend is likely to culminate in a Minor Move marked by tremendous\nvolume. This is truer of Tops than Bottoms, although at the end of the Panic\nPhase of a Bear Market, we very often see climactic volume. The climax\nindicates, on the other hand, the sale of large amounts of stock by strong\ninvestors to weak traders, near the top; on the other hand, the liquidation of\nholdings by weak traders occurs near the bottom, into the hands of strong\ninvestors who will hold them for the next Major Move.\nOne of the most common errors, and easiest to fall into, is to mistake a\nClimactic Top or Bottom for a normal confirmation or preparatory signal\nfor a new commitment in line with the preceding trend.\nIt is similar in nature to the error often made by novices in the market of\nbuying on the Minor Tops (becoming dazzled with the rapid price advance\nand the great volume of activity). However, in the case of these final “blow-\noff” moves, the volume is greater and the adverse portent far more serious.\nGeneral outline of policy for trading in the Major Trend\nA. Always trade in the direction of the Major or Primary Dow Trend\n(EN: see the editor's comments in Chapter 3) as it is indicated at the\ntime.\nB. If the two component Averages of the Dow Theory (Industrials and\nRails; EN9: Transportations) are not in agreement, trade in the\ndirection of the last established Primary Trend but only in the\ncomponent that is still following that trend.\nC. Examine charts of group Averages covering groups of businesses in\nthe same or related lines; trade in the Primary Direction when the trend\nof the group corresponds.\nD. Trade in any particular stock when its own individual chart\nindicates a trend in the same direction as the Primary Trend, and when\nthe technical picture has indicated a probable move in that direction.\nMake all new commitments on the reactions or rallies following the\nsignaling move in the Primary direction, except in the case of Primary\nReversals from Bull Market to Bear Market, when short sales may be made\nat the market immediately following the Reversal.\nException: after an extended move or a series of moves in the Primary\nDirection, when signs of exhaustion and Reversal appear in individual\ncharts, commitments in the opposite direction may be made with objectives\nlimited to a correction of the preceding Intermediate Move in the Primary\nDirection.\n(EN9: Now the reader's head is spinning and the color blind are completely\nconfused. As this book is unfortunately printed in black and white, the\nreader without colored pencils will be at sea. This is what I recommend:\ntake out your colored pencils and color the lines yourself. The principles\narticulated here by Magee are of great value to a trader and are worth\nstudying.)\nTaylor & Francis\nTaylor & Francis Group\nhttp://taylorandfrancis.com\nchapter thirty\nUse of Support and Resistance\nWe know that after many breakouts from well-defined Reversal and Consolidation Patterns, we get ashort countermove back to the edge of the pattern and the checking of this move at that point is anexample of Support or Resistance, as the case may be. Also, we should be familiar by now with thetendency of stocks to move up or down in a series of zigzag steps (EN10: i.e., waves and wavelets). If themove is upward, the reaction after each advance tends to stop at the level of the preceding peak. If themove is downward, the rally after each decline tends to stop at the level of the preceding bottom. This isagain a matter of Support and Resistance and provides the basis for buying on reactions or selling onrallies. It has also been pointed out Intermediate Secondary Moves will frequently stop at or close to theprevious Intermediate Top or Bottom.\nIt is necessary to evaluate the importance of these phenomena of Support and Resistance and apply themin market practice, for they are among the most important tools we have. Unfortunately, it is not easy toreduce this particular subject to a neat formula or body of rules. (EN9: And the effort will be made. Seeendnote of this chapter for an interesting effort to do just that.) Here you will depend very largely onexperience and observation. You will have to be alert in spotting the levels at which Resistance or Supportis likely to be encountered, and some judgment is needed in balancing the various factors that will affectthe situation.\nFor example, there is a stock that has broken up out of a well-defined Rectangle of considerable duration.Should the heavy volume of the breakout move give way to a dull reaction, you will look", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 170}
{"text": "tion. You will have to be alert in spotting the levels at which Resistance or Supportis likely to be encountered, and some judgment is needed in balancing the various factors that will affectthe situation.\nFor example, there is a stock that has broken up out of a well-defined Rectangle of considerable duration.Should the heavy volume of the breakout move give way to a dull reaction, you will look for anopportunity to buy this stock at a point a little above the top level of the Rectangle. It will probably notpenetrate very far below that level and, indeed, will often fail to react all the way to the Support. If thestock should then advance to a new high, and once more decline on low volume, you may look foranother buying point at about the level of the peak reached on the original breakout. Another advancemay be followed by reaction to the second peak, and this process may be repeated a number of times,each reaction carrying back to the level of the preceding high.\nNow we all know this sort of thing does not continue indefinitely. When the stock first breaks out,moving from, say, 15 to 19, we may buy rather confidently on the reaction to 17, if that is the SupportLevel. If we did not buy on this move, we may buy with considerable assurance on the reaction toSupport after the next advance. This advance might have carried the price to 21 and our buying pointwould be at the previous peak of 19. As the stock moves up to 25, 30, 40, it must be clear we areapproaching a real Top; although we cannot say where that Top will be reached, we can be sure it isbecoming increasingly tempting to long-time holders of this stock to sell and take their substantial gains.The series of steps is bound to come to an end. To be sure, the Major course of the stock and of themarket may continue up for months or years, but after a series of sharp rises, we may reasonably expect aReversal and a rather substantial Intermediate Decline before the upward move is continued.\nTherefore, we must regard each successive step of advance with increasing suspicion; after a stock hasmade three such moves in the Primary Direction, it is time to look for an Intermediate Correction or atleast for an important period of Consolidation. Thus, we have the rough shape of a rule. Buy on thereaction to Support after the first breakout; buy on the reaction to the first Minor Peak after the nextmove, but do not buy on the reaction to the second Minor Peak.\nLet us say, then, we have been successful in two short-term moves, buying on the reaction to Support andselling on the climax after a new Top has been made. Nevertheless, we have decided not to attempt a thirdsuch trade. What, then, may we expect next? We may see a period of Consolidation, we may see thebeginning of an Intermediate Decline, or we may see the stock actually go right on moving up. No matter—we will wait for the Intermediate Reaction. We will wait until the stock makes a very substantial\ndecline, and this may take many weeks. Then, if the Major Trend has not reversed itself, we will againlook for a buying opportunity at (or somewhat above) the Intermediate Support, which will usually be thetop level of the advance preceding the one just completed, for this is the level from which the nextPrimary Advance is likely to proceed and is a good buying point.\nWe find the same situation in Bear Markets. A breakout is likely to be followed by one, two, three, ormore steps of decline, with intervening rallies to Minor Resistance. Sooner or later (and we would counton no more than three such steps in a series), we will get a turn and an Intermediate Recovery. We willthen wait for this rally, which may itself be made up of several Minor steps, to reach or approach closelythe preceding Intermediate Bottom, at which point we may look for substantial Resistance. Here is theplace again to put out shorts.\nQuestions will come to your mind. One of them, and one of the most important: how do we decide whenan expected Support or Resistance has failed us, and at what point do we then abandon our position?\nIt will be clear this question can be a very painful one. Let us suppose you have seen a stock rise to 25and have placed an order to buy it at 23 1/2 on the basis of expected Support at 23, the level of a previousMinor Peak. The order is executed during a dull reaction. The next day, the stock slips down to 22 1/2, onperhaps only two or three sales. The next day, it continues down to 21 1/2, still on low volume. Plus,during the next week, it goes down steadily, without much volume, nearly every sale being at a lowerprice, as though no new bids were being received, and as though no substantial number of bids werestanding on the book at any point. A decline of this sort can eventually assume the magnitude of anIntermediate Reaction. The move may carry down to 15 before it turns. Obviously, this was not what youexpected, and you should be out of the stock.\nThe painful part of these drifting moves is you do not want to sell your stock (which you bought at 231/2) on just a slight move down, say to 22 3/4, because the probability is strong it will shoot up at anymoment to new high levels. Yet, at some point during a continued decline, you must decide, “This hasgone through the Support; I should sell and take a small loss now, rather than risk a more serious loss.”The most painful part of all is, sometimes, the moment you have sold and taken your loss, the stock willcome to life and complete what would have been an extremely profitable move.\nYou might just as well prepare yourself for this sort of disappointment, for it will happen to you. To avoidnights of pacing the floor and days of worry, you should decide, at the time you make the originalcommitment, just how much leeway you are prepared to give the stock. Then you will not be tempted toput off a decision from day to day if things are not going the way you hoped.\nIn the case of purchases or short sales made against Minor Peaks or Bottoms, as the", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 171}
{"text": "ent, for it will happen to you. To avoidnights of pacing the floor and days of worry, you should decide, at the time you make the originalcommitment, just how much leeway you are prepared to give the stock. Then you will not be tempted toput off a decision from day to day if things are not going the way you hoped.\nIn the case of purchases or short sales made against Minor Peaks or Bottoms, as the case may be, youmight set up the following rule. Measuring from the extreme high of the previous (Supporting) MinorTop, or the extreme low of the previous (resisting) Minor Bottom, set a stop using the method we haveoutlined in Chapter 27. (EN9: See also Chapter 28 and consider the risk limitation procedures in Chapter42.) This often would be the intraday high or low, not necessarily the closing price. Penetration to thatextent should be presumptive evidence that your expected Support or Resistance is not going to function.\nWhere you are buying against Major or Intermediate Support, or selling short against Major orIntermediate Resistance, you can allow a little more leeway for penetration. In such cases, examine theSupport or Resistance Area, and estimate visually its core or axis; in other words, try to gauge the “centerof gravity” of this area, the point is most nearly the mean price of sales occurring there, taking intoaccount the volume, because the important thing is to determine the approximate price level at which agreat many shares changed hands. Having determined this point, set your stop beyond it, according to themethods specified in Chapter 27.\nUp to this point we have concerned ourselves (reversing the usual order) with how to get out of situationsthat have gone bad. We have said nothing about where, precisely, to get in, nor where, precisely, to takeprofits.\nIn the matter of getting in, that is, making the original commitment, you might feel there is a conflictbetween acting on Support or Resistance and acting on either trendline action or a computed reaction of40% to 50% after a previous move. At times, these conflicts might arise and it is not possible to state anyexact rule that will reconcile these three different trading indications. In a great number of cases,however, you will be delighted to observe a reaction of about 45% will bring your stock to the trendlineand will also bring it near to the Support or Resistance Level. After a move to a new Minor Top, a stockmay be expected to react (1) about 40% to 50% of that move, (2) to the Basic Trendline, and (3) to theprevious supporting Minor Top. Your purchase, then, will be based on a consideration of all three factors.If you have bought “early,” on the basis of one factor alone, you may expect the stock to react a bitfurther without spoiling the triple indications to the extent of catching your stop. It would be best to makeyour purchases on the basis of whichever factor indicates the smallest reaction and to place your stopbeyond the greatest reaction indicated by any of the three. Ordinarily, there will not be too muchdifference between these three factors. As usual, the method applies in reverse to short sales.\nIn cases in which you are buying after an Intermediate Decline or selling after an Intermediate Rally, youwill lean somewhat more heavily on Support and Resistance than on either a computed percentage for theSecondary Move or a trendline. You will examine the history of the stock, preferably on weekly ormonthly charts first, to see its Major Trend, to locate important Support or Resistance Areas, and toestimate roughly the extent of the Corrective Move, the termination of which you are trying to gauge. Youwill then check these data in the more detailed picture you can get from your daily charts. As theIntermediate Corrective Move approaches within 4% or 5% of the Support or Resistance Level, you maycome to a day of extremely heavy volume, and this day may also be a One-Day Reversal. If so, yourcommitment should be made at once and protected by a stop. Otherwise, you may make yourcommitment whenever the chart begins to hesitate or flatten out, or, lacking other indications, when it hascome to within 3% of the Support or Resistance.\nIn this case, your problem in taking profits is a bit more difficult than in the case of Minor Moves. Youare expecting a Reversal of the Intermediate Corrective Move and the establishment of a newIntermediate Trend in the Primary Direction. You are at a point at which the course of the market isuncertain. You must realize prices may stay at the Support (or Resistance) Level, forming a Line orRectangle, and finally penetrate that level, establishing Reversal of the Major Trend. However, they maybe stopped and turned at the Support or Resistance Level, only to make a small move away and thenreturn for another, and possibly successful, attempt at penetration. Then again (and this is what you hope),a continuation of the Major Trend may develop with a sharp move on increased volume in the favorabledirection, to be followed by a Minor Corrective Move and another thrust in the Primary direction—perhaps a new series of Minor Moves carrying the entire Primary Trend into new ground.\nTaking these cases one by one, if the stock remains at the Support or Resistance Level for many days orseveral weeks and then penetrates that level, closing at a price that is clearly through it, get out at once. Ifthe stock makes a small move in the right direction and returns to the Support or Resistance, prepare toget out if there is a definite penetration. If, however, the move is in the right direction, watch for volumeindications, and prepare to set tight stops to take your profits as soon as heavy volume appears (except ona day of breakout). Once such a signal has appeared, you are then justified in continuing to make newcommitments on the following Minor Correction, and the one following that, for you are again moving inthe Major Trend.\nOne other situation should be mentioned; up to this point, we have assumed al", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 172}
{"text": "cations, and prepare to set tight stops to take your profits as soon as heavy volume appears (except ona day of breakout). Once such a signal has appeared, you are then justified in continuing to make newcommitments on the following Minor Correction, and the one following that, for you are again moving inthe Major Trend.\nOne other situation should be mentioned; up to this point, we have assumed all of your commitmentshave been made to take advantage of a move in the direction of the Major Trend. Let us suppose a move\nthat has carried a stock up to new high levels in a series of Minor steps proceeds to form and then breaksout of a Reversal Pattern. We must now look for a Secondary Move of Intermediate extent. We may sellshort on the rally to the Minor Resistance, and, if the move continues down, we may make a second andeven (more cautiously) a third commitment against successive Minor Bottoms. In this case, we will belooking for the decline to end somewhere in the vicinity of the last previous Intermediate Top, which isnow a Support Level. Similarly, following a recognized Reversal Pattern and upward breakout on volumeduring a Bear Market, we may expect an Intermediate Rally that can be used for trading up to theprevious Intermediate Bottom where strong Resistance is likely to show up. A skillful trader can turnthese Secondary Moves into profits during periods when it is not possible to trade along the indicatedPrimary Trend; however, it should be remembered, ordinarily, such moves cannot be expected to go as faras will those in the Primary Direction.\nWe might close this chapter by reminding you again that, although Support and Resistance action in theMinor Trend is shown clearly in daily charts, the Intermediate and Major Supports and Resistances aremost easily recognized on weekly or monthly charts.\n(EN9: It seems to this editor that Magee's discussion here of the use of Support and Resistance is reallymost pertinent to position building and pyramiding. Alternatively, the method applies to an issue that hasjust caught the analyst's attention, and he has missed the breakout, which is usually obvious (at least inhindsight). I feel strongly that the serious trader should not miss the original breakout. Chasing movingtrains is never a healthy activity. Does this appear an impossible occupation, to watch thousands ofstocks? Impossible for your average analyst, but not for your average computer. For example, thecomputer may be programmed to alert you when a stock is gapping on volume or trading at volumes thatare suspiciously large. And given the plethora of services and user groups, the trader stands a goodchance of spotting an issue to put on his watch list before it takes off.\nInvestors should, in theory, never miss a breakout, because they should be watching a much more limitedgroup of issues. In my opinion, these are primarily indexes and iShares. An investor's portfolio mightinclude a few well-chosen individual issues, but these would be of obvious visibility to the individual, forexample, biotechs for an investor with some knowledge of the area, or Internets for an engineer, and soon.\nThe unending effort to remove ambiguity from market interpretation extends to identifying areas ofSupport and Resistance. Metastock (http://www.metastock.com), an excellent software package, has anumber of value-added packages. One of the more interesting of these, Powerstrike™ by John Slauson ofAdaptick, Inc. (http://www.adaptick.com) attempts to mathematically define Support and Resistancezones. Slauson's package is interesting, and the reasoning and observation behind it are interesting aswell. Market analysis is rooted in one thing: the intelligent observation of the operation of the market.Dow watched the markets for years and came to the understanding of waves that led to Dow Theory.Schabacker and Edwards, equipped with these observations and comments, collated and observed moredata and recognized the persistent patterns that occurred over and over in the markets, and added Mageefor his practical engineer's approach to solving the tactical and strategic questions. In the 1980s, one ofmy friends, a Chicago market maker in the options pit, noticed that there was a 90-second delay on datacoming out of the futures pits to the options pit. He set up a “human ticker” with a direct phoneconnection to his pit and enjoyed a 90-second advantage over other market makers until the glitch wasnoticed and corrected.\nSlauson (among others) noticed that important trading and Support and Resistance in optionable stockstended to cluster around important option strike price levels. In fact, these levels influence stock pricesand may be said to determine where “important” buying and selling occur. Obviously, Support andResistance Levels are set by concentrated face-offs between buyers and sellers. A battleground metaphoris appropriate: since the time of the Greeks, battles have occurred time and again in the same physical\nlocations. The reason is obvious. You need physical space to deploy an army. So commanders will beattracted to the plain or open ground for face-offs and to the high ground for defensive purposes. Optionstrike prices have the same attractiveness for traders that a good battleground has for a militarycommander. A good place to test the enemy.\nPowerstrike™ analyzes the instrument price and volume around the nearby option strike prices anddetermines whether Support or Resistance is stronger. All in all, this is a clever application of number-driven analysis to the Support and Resistance question. The chart analyst may supplement his analysiswith a routine like this.)\nTaylor & Francis\nTaylor & Francis Group\nhttp://taylorandfrancis.com\nchapter thirty-one\nNot all in one basket\n(EN: As diversification for the general investor is nowadays infinitely easier, an important endnotefollows Magee's text.)\nDiversification is important because technical patterns do not always carry out their original promise. Ifall yo", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 173}
{"text": "t may supplement his analysiswith a routine like this.)\nTaylor & Francis\nTaylor & Francis Group\nhttp://taylorandfrancis.com\nchapter thirty-one\nNot all in one basket\n(EN: As diversification for the general investor is nowadays infinitely easier, an important endnotefollows Magee's text.)\nDiversification is important because technical patterns do not always carry out their original promise. Ifall your capital is tied up in one stock, or in a few stocks of the same group or line of business, you maybe hurt by a false move affecting only your holdings, even though the rest of the market may continue tohold firm or even to move farther along the Primary Trend. By diversifying, you are protected by the lawof averages against all of your holdings going the wrong way, except in the case of some Reversalaffecting the entire market or a large segment of it.\nIntelligent diversification calls for study of the costs of buying and selling stocks, especially in smallquantities. You might wish to have a portfolio of stocks representing the entire Dow-Jones Averages, or aselection that includes at least one stock of every major group. However, if your capital is limited, thismight mean buying only a half-dozen shares of each stock, and the minimum commission charges wouldmake this an expensive operation, entirely too costly for short-term trading. The short-term trader mustalways think of these costs. They are more important to him than to the long-term investor who mayintend to hold the same stock for many months or years. To you as a trader, a quarter point or a half pointmay amount to serious proportions when it is multiplied through a number of transactions.\nYour broker can give you a schedule showing commission and tax costs, and in case there are anyimportant changes in the rates, which you should study to see what effect they will have on your costs oftrading in stocks at various prices. (EN: You may also evaluate these charges at http://www.gomez.comand by checking websites of http://www.scottrade.com, http:// www.etrade.com, and\nhttp://www.tdameritrade.com. Google is, as ever, an important price-checking resource, and Barron'spublishes a yearly edition evaluating brokerage houses. In general, this editor believes the investor whodoes it the “old-fashioned way,” that is, by phone and human broker, operates at a disadvantage unlessthe broker's value added can be quantified and proven.)\nYou will find your round-trip costs are a higher percentage of the capital invested in low-priced stocksthan in high-priced stocks. Also, the percentage costs will be higher on a smaller number of shares thanon a round lot and increasing as the number of shares decreases. Additionally, the percentage costs rise asthe total amount of capital used is less.\nIf your capital is, say $1,000 or $2,000, you might do well to divide it into units of about $500 each andconfine your trading to odd lots of stocks selling at 40 or higher. With larger capital, you could use largertrading units and extend the range of trading into somewhat lower priced stock. In any case, it isimportant to diversify your holdings. By dividing your capital and using it in such a way as to avoidunnecessary penalties in high costs, you will have greater protection against freak moves and suddenchanges that might affect a single stock very seriously.\nOn the other hand, if you have sufficient capital to secure plenty of diversification (8 or 10 stocks shouldbe a maximum for an active trading account), you can increase the size of the trading units. The wholequestion here is as to the minimum amounts to be invested in a single commitment and, if these amountswere doubled or tripled, it would not increase costs, but would, in many cases, reduce them.\nEN: diversification and costs\nIn this original chapter, Magee discussed the necessity for considering costs while striving fordiversification. In present-day markets, diversification may be achieved through the use of Standard &Poor's Depository Receipts (SPDRs; SPY) and DIAMONDS™ (DIA) and similar instruments (ETFs) atcomparatively reasonable costs. Index funds and mutual funds also represent diversification and costcontrol for the general investor. Mutual funds will not control costs and expenses as efficiently as theIndex Shares and ETFs. This is because mutual funds create costs that the Index Shares do not:management fees and expenses, slippage, the spread, turnover, and taxes resulting from realized gains.These costs may be avoided by the careful independent investor.\nAn internationally prominent trader has told me, on more than one occasion, his considerable tradingfortune amounts to what brokers and specialists would have made off of him if he had been a member ofthe general public instead of a member of the Exchanges. The most important weapons in his quiver wereseats in Chicago, New York, and San Francisco.\nThe message is extremely clear. The general investor must control his costs. The more frequently hetrades, the greater his chances of having his capital ground to hamburger meat by brokers, specialists,floor traders, market makers, tax authorities, Exchanges, etc., etc., because there is undoubtedly anotherparty out there taking a chunk as the capital changes hands. The phone company maybe.\nTrading costs are the last item brokerage firms want to focus on (see the book Where Are the Customers'Yachts?). For years, the Street firms and Exchanges controlled commission costs, keeping them high, butentering the Internet age a different ethos rules—cutthroat (and cut fees) competition, reluctantly broughtto the old-line exchanges and brokers by upstart competitors, and not suppressed by the Securities andExchange Commission (SEC) and the Commodities Futures Trading Commission.\nIt would be misleading to attempt to analyze costs in this book because of the mercurial nature of costfigures as firms compete in the Internet age.\nThe SEC runs a mutual fund calculator for computing costs of mutual funds. Mutual", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 174}
{"text": "old-line exchanges and brokers by upstart competitors, and not suppressed by the Securities andExchange Commission (SEC) and the Commodities Futures Trading Commission.\nIt would be misleading to attempt to analyze costs in this book because of the mercurial nature of costfigures as firms compete in the Internet age.\nThe SEC runs a mutual fund calculator for computing costs of mutual funds. Mutual funds are amongthose that manage somehow to not be overly punctilious in estimating (read, disclosing) their costs toinvestors. Another good resource for researching mutual funds is http://www.morningstar. com.\nBut let me emphasize once again that iShares and ETFs have really made mutual funds obsolete if theinvestor uses the simple procedures outlined in this book.\nchapter thirty-two\nMeasuring implications in technical chart patterns\nIf you show one of your charts to a friend and tell him it looks Bullish, he will reply immediately, “Howfar do you think it will go?” This is an automatic response; you can count on it.\nThe question is a good one. How far is this expected move likely to go? You do not know, nor doesanyone. Very often you can say, with a fair degree of assurance, “This stock, which has just made such-and-such an advance, is likely to react to around such-and-such a price.” That you can estimate fairlyclosely 7 or 8 times out of 10, by referring to the Basic Trendline, the parallel projection of the toptrendline, or the Support Level.\nThese rules work out fairly well as applied to reactions in the Bull Trend, and similarly, we can estimaterallies in a Bear Trend. Not so with the move in the direction of the trend itself. A Bullish Move may, andoften does, overrun the upper trendline by running up as far again as the move to the trendline. A BearishMove may exceed the downtrend, dropping apparently without limit. (That is one reason we haveprotective stops—to prevent disaster in case the trend suddenly reverses itself.) Additionally, it is why weprefer the use of nearby progressive stops as a method of taking profits, rather than using limit ordersplaced at a trendline, Resistance Level, or at some other definite point. Very often, to be sure, a stock willcheck its advance at one of these indicated points, but the cases in which a move carries beyond itsobjectives are fairly common, and in such cases, no one can make even a reasonable guess as to whatlimit the stock will reach on the move.\nThis follows because the move itself is an unreasonable one. It is an example of public participation, thesurge of uncontrolled speculation (and, very often, it is the final surge of that particular trend).\nIn exactly the same way, and often more violently, the uncontrolled falling out of trend in a downwardmove is an example of Panic, and being completely beyond reason, it follows no rule and knows nopredetermined limits.\nThere are, however, certain patterns and certain situations in which we can make some estimate of theprobable extent of a move in the Primary Direction—usually an estimate of its minimum extent. In thesecases, we have a guide to help us in making the decision as to whether the situation offers enoughpotential gain to be worth the risks involved. Also, the indicated measurement gives us at least a hint ofabout where we might reasonably begin to look for the volume that will indicate the Top.\nFor example, a decisive breakout from a Symmetrical Triangle is likely to carry at least as far as theheight of the Triangle measured along its first reaction. This is a conservative measurement. The movemay go much farther. In fact, the trend implications of the Triangle would suggest a continuation equal tothe move preceding the Triangle and leading into it, for if the trend continues valid, the move should runup to the upper limit of the channel. In the case of a Reversal, we would also use the height of the firstreaction as a minimum measure. With Right-Angle Triangles, we also can take the long side (formed bythe first reaction) as a rough measure of the minimum expected move.\nWhat is more, with Rectangles the minimum we may reasonably expect after a breakout is a distanceequal to the height of the Rectangle. The Head-and-Shoulders Pattern carries a good measuring stick. Theheight of the formation from the extreme Top of the head down to the point directly beneath where theneckline crosses represents the minimum probable move from the neckline down. Again, this is a matterof Trend Channels, and most emphatically, this is only a minimum move. Some Head-and-ShouldersPatterns, representing an implied move of no more than 3 or 4 points, have marked the start of a declineeventually running to hundreds of points.\nThe rather unusual breakout that takes the form of an almost vertical “mast” running up (or down) manypoints before arriving at a stopping point, where some Consolidation Pattern is made, carries with it amost explicit measuring rule, and one that works out with amazing accuracy. The Flag or PennantConsolidation will occur at the halfway point—“the Flag flies at half-mast.” The speculation moveleading up to the Flag very likely will be duplicated by another rise, at least equal to the first, in the nearfuture. Following this rise, there may be another Consolidation and other rises, or there may not. Aftertwo surges of this sort, it is best to stand back and let someone else carry the ball. If you keep enoughcharts, and for a long enough time, you will see many perfect examples of this beautiful formation. Youwill also see some imperfect examples and some failures. And because the move is so spectacularlyprofitable when it works out, you will be tempted to buy on every Consolidation Pattern formed after asharp rise. It would be best to wait until the example is clear—a nearly vertical, almost unbelievable rise,followed by several days of congestion with practically no volume. If the congestion continues or sags offfor more than about three weeks, sell the stock; it is probably not the", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 175}
{"text": "pectacularlyprofitable when it works out, you will be tempted to buy on every Consolidation Pattern formed after asharp rise. It would be best to wait until the example is clear—a nearly vertical, almost unbelievable rise,followed by several days of congestion with practically no volume. If the congestion continues or sags offfor more than about three weeks, sell the stock; it is probably not the real thing.\nNeedless to say, this same pattern appears in reverse in downtrends and can be traded on accordingly.\nThe questions relating to the measuring attributes of gaps have been reviewed in detail in Chapter 12. Theonly type of gap that carries substantial implications as to the extent of the move to follow is theRunaway or Continuation Gap. The appearance of such a gap during a rapid price move is likely to markapproximately the halfway point; two or more such gaps can be weighed, in connection with volume andtotal extent of the move, to estimate the probable midpoint of the move and thus to predict a probableultimate objective.\nMeasuring properties have been ascribed to other patterns and occasionally work out according to plan. Ingeneral, the best measuring devices are your trendlines, Support-and-Resistance Levels, and the all-important signals of increased volume.\nOther tools exist for measuring moves. Arthur Sklarew (see Bibliography) describes the-rule-of-seven,which I have often found effective. In addition, Wyckoff used PnF charts to measure moves and I haveseen some impressive analyses produced by Professor Hank Pruden using PnF charts.\n(EN9: I have always been extremely chary of measuring moves. If the measurement does not lead thetrader to indulge in expectations that distract him from the crucial nature of the moment at hand, it mightbe quite all right. So, as an off-hand casual tool, it might serve some use. Always better to observe closelywhat the situation is when the price arrives at the measured point. Decisions should always be made inthe here and now, and not in the “I measured it then.”)\nchapter thirty-three\nTactical review of chart action\nThe Dow Theory\n(EN: In this chapter, multiple references are made to the tight stop - 1/8 point which decimalizes to .125.Readers should read this as decimal.13 to.25, depending on the habits of the issue. Issues greater than adollar are quoted at two decimal places. Penny stocks can go to 4 decimal places.)\nThe record shows an investor who had bought a representative group of stocks on every Major BullMarket signal according to the Dow Theory, as outlined in Chapters 3 through 5, and sold all his stockson every Major Bear Market signal, since the start of the Dow Averages, would have come out very wellindeed over the years. (EN: see tables in Chapter 4.) Although this tabulation does not take short salesinto account (EN9: now taken into account in the ninth edition), it would be perfectly consistent to add arepresentative group of stocks might be sold short on every Major Bear Market signal and covered at thenext Bull Market signal. Additionally, if the figures for such short sales, based on the level of theIndustrial Average, were included, the total profits on these theoretical transactions, both long and short,would be enormous. (EN9: Buy and Hold to 2018: $55,411.83. Dow Theory, long only: $795,592.01.Dow Theory, long and short: $5,757,390.17.) (For illustrations in this chapter, see Figures 33.1 through33.16.)\nWe believe this record carries some weighty implications that have a bearing on the operations of everytrader and investor. We will comment on these shortly, but before doing so, it should be pointed out thatfew, if any, investors have actually followed the long-time Dow signals, buying or selling 100% on everyMajor signal.\nIn the first place, to do so would require a long market lifetime and would presuppose the investor hadaccepted the Dow Theory in its classic form in toto from the start and he had never wavered, never alteredthe definitions nor his method of trading, and never withdrew any of his capital during the entire period.\nIn the second place, we would have to assume our ideal investor had an extraordinary degree of courageto stand firm in periods during which the Major Trend appeared to be making dangerous threats againsthis position and an extraordinary degree of patience to wait out the many months of stagnation when thetrend seemed to be getting nowhere at all.\nFinally, we would have to make the assumption the group of stocks actually bought or sold reallyrepresented a fair cross-section of the Averages in that they would make about the same moves as theAverage itself. As a matter of fact, if the group were well diversified, the chances are good its movesmight approximate those of the Averages.\nHowever, it is taking a lot for granted to suppose an investor could meet all of these conditions over aperiod of years, which he would have to do to operate strictly as a “Dow Theory” trader. It is not seriouslysuggested anyone try to follow any such plan literally. (EN: Well, in retrospect, why not? Given, in theInternet age, the availability of trading instruments and markets [DIAMOND™—DIA, Standard &Poor's Depositary Receipts—SPY] it might not\nFigure 33.1 Head-and-Shoulders Top. The Bull Market that carried Southern Pacific from 8 to 70 in theyears 1941 through 1946 culminated in June 1946 with this formation. Notice the heavy volume on theleft shoulder, lower volume on the head, and small volume on the right shoulder. The breakout signal,which was decisive on July 15, served notice on holders of long commitments to sell at the market thenext day (at about 63) instead of waiting for the protective stop, which would have been set at 61, to becaught. Volume eventually developed at the Bottom of the breakout move at about 58 1/2, which move,incidentally, carried out the minimum measure of the Head-and-Shoulders prediction.\nFrom this point, however, a weak rally on low volume started and continued up for four weeks. T", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 176}
{"text": "at the market thenext day (at about 63) instead of waiting for the protective stop, which would have been set at 61, to becaught. Volume eventually developed at the Bottom of the breakout move at about 58 1/2, which move,incidentally, carried out the minimum measure of the Head-and-Shoulders prediction.\nFrom this point, however, a weak rally on low volume started and continued up for four weeks. Theweakness of this picture would justify a short sale on a rally of 40% to 50% of the move from the leftshoulder to the bottom or on a return to the neckline, say, at 63. The rally actually extended to theneckline at 64, broke away on a gap with volume, and continued down in a move that led, in the nextthree months, to prices below 40, and later even lower.\nAn extraordinary feature of Head-and-Shoulders Tops is the frequency with which a comparatively smallformation, such as the one shown here, will herald a Major Move, changing the course of the stock formonths or even years to come. Not all patterns of this type will lead to such big moves as this, but noHead-and-Shoulders should be regarded lightly, ever.\nbe such a bad idea. The implementation of such a plan in Magee's time would have been extremelycumbersome and expensive, but it is eminently practicable in modern markets.)\nThe important implications of which we spoke are these: if the record of the Averages shows on theseMajor Signals it is possible to take substantial theoretical profits over the long term, and if the Averagesare composed of the prices of individual stocks, then the probabilities favor buying or selling a majorityof stocks in line with the Major Trend of the Averages. The evidence shows Major Trends normallycontinue for months or years. The line of “most probable gain,” therefore, is the line of the Major Trend.\nOn this basis, we would be on safe ground to say when a trend of sufficient importance gives a MajorSignal, the Averages are under way and there will be a greater likelihood of finding profitable situationsamong individual stocks moving in that trend than among those moving in the reverse trend.\nFigure 33.2 Head-and-Shoulders (or Kilroy) Bottom in Braniff Airways, 1945. Strictly speaking, aContinuation Head-and-Shoulders after a Secondary Correction in the Bull Market. A Major Bottom,reversing a long Bear Market, would normally take much longer to form.\nHere we see heavy volume on the left shoulder, somewhat less on the head, and very little on the rightshoulder, with a sharp increase, as required, on the breakout move of September 21. The breakout wasfollowed by a Throwback to the neckline on diminishing volume, providing a good opportunity forpurchases at 23. The upward move was resumed, and again there was a reaction to the neckline Support.A second reaction of this sort is not unusual. The closing at 22 3/4 on October 19, below the previousMinor Bottom, and on increased volume, was mildly disturbing. But in view of the strength of the patternand breakout, we would not have sold the stock, and the protective stop at 21 7/8 was not eventhreatened. On October 25, the advance was resumed with a Breakaway Gap and continued up to 29 1/2,where the move was signed off with a One-Day Reversal and Exhaustion Gap.\nNotice on reaching 29 1/2, “BNF” went into a Consolidation Pattern for more than three weeks, makingan Ascending Triangle, before leaping to 37 1/2. Notice also (we might as well get all we can out of theseexamples) the Ascending Triangle takes shape at approximately the halfway point of the whole advance.We are already familiar with this tendency of stocks in fast moves to form “halfway” patterns.\nIt is suggested you read this preceding paragraph again, carefully. It means we do not try to sell stocks “atthe Top” in a Bull Market. We do not try to “pick up bargains at the Bottom” in a Bear Market. We do notdeliberately buck the kind of trend that history shows is likely to continue for an undetermined andpossibly long time.\nWhat we have said here is stated with a little different emphasis than in previous editions of this book.You will notice we have not said you will never sell a stock short during a Major Bull Market or buy astock in a Bear Market. There will be, and often are, cases of stocks moving against the Major Trend and,on the basis of their individual technical behavior, may justify a commitment against the trend of theAverages.\nASSOCIATED DRY GOODS DG\n•••••••••••\n44 Sales 100's\n50\n40\n30\n20\n10\nJANUARY FEBRUARY MARCH APRIL\n5 12 19 26 2 9 16 23 2 9 16'23 30'6 13 20 :\n13'20 27 4\nMAY\n11 18 25 1\n8 15 22\nFigure 33.3 Associated Dry Goods winds up its Bull Market Trend with a Rounding Top. This is a dailychart for the first six months of 1946.\nThe advance in “DG” from 4 to above 72 in just 3 1/2 years, when seen on monthly charts, is a smooth,accelerating curve that emerged from a long Bottom Formation that had lasted five years from 1938through 1942.\nAs we enter the final six months leading up to the ultimate peak, note first the action during January andFebruary. “DG” had just completed a fast run-up in the last quarter of 1945 and was about due for aConsolidation or a Secondary Correction. On reaching 48, it turned back to 45, advanced to 50 1/2, to 51,and finally to 52, and then reacted to 44 at the end of February. Had the move on January 22 gone a littlelower and closed below the January 3 low, followed by an even lower closing on February 26, we wouldhave had to consider this January-February pattern a completed Broadening Top, a definite Reversalsignal. However, the pattern was not perfect, and, therefore, not valid, but the erratic price action showsincipient weakness.\nIt is not unusual in these last stages, when public participation is running high, for the climactic advancesto be spectacular and fast; that is what we see here. A five-point Breakaway Gap occurred on March 25,followed by an advance that petered off at 63 1/2 reacted, and then ran up to more than 68.\nFrom here on the move advanced sl", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 177}
{"text": "ot valid, but the erratic price action showsincipient weakness.\nIt is not unusual in these last stages, when public participation is running high, for the climactic advancesto be spectacular and fast; that is what we see here. A five-point Breakaway Gap occurred on March 25,followed by an advance that petered off at 63 1/2 reacted, and then ran up to more than 68.\nFrom here on the move advanced slowly with suggestions of a Convergent Trend and a succession of“heads” and “shoulders,” and volume dropped off as the Top was reached. The drop on June 4 to belowthe May 7 Minor Bottom on increased volume would complete the Rounding Top and call for immediatesale if we were still long; and the penetration of the “neckline” on June 18 was a conclusive break.\nWe feel such trades should be made cautiously and with a full realization the majority of stocks aremoving in a contrary manner. Such trades might be made, for example, in particular cases as indicated bythe charts of the stocks involved, as partial hedges to reduce overall risk. For example, if a Bull Markethad persisted for several years and was still presumably in effect, but certain stocks had broken badly andshowed individual weakness, a trader might continue to hold three-quarters of his capital in good longpositions but might make a limited number of short sales in the weaker stocks. If, then, the\n34\n32\n30\n28\n26\n24\n22 Sales 100's 125 100\n75\n50\n25\n\nFigure 33.4 Greyhound: a Rounding Bottom in 1945. A Continuation Pattern after the May run-up tomore than 29 and reaction to Support at 24, the 1944 high.\nIn July, volume ran fairly high on downside days, drying up as we entered August. August 10 showed aspurt of volume on the upside, and then more dullness.\nThe various small moves through August and September would not give us any basis for tradingoperations. The move to a new high in the pattern on August 31 suggested an upturn, and again onSeptember 19-20, we see another little push up to the 26 level—still not conclusive, however.\nThe move that got under way in the week ending October 13 is more definite. This decisive move withgood volume carries right out of the “Bowl” in an almost vertical ascent; not a big move, but a clearindication of the probable trend. We would look for a point to buy “G” on a correction of 40-50% of theentire move up from the Bottom, or on a return to near the Support Level around 26. The purchase wouldprobably be made around 26 1/2. Notice the drying up of volume on this reaction.\nThe advance from here to 30, marking an entirely new Bull Market high, came almost immediately. OnNovember 3, with very heavy volume for a Saturday, “G” closed at 30; since this volume was not on theday of breakout, we would have closed out the transaction on a tight stop at 29 7/8 on Monday (unless wehad elected to wait out the next Minor Reaction for a further advance).\nTwo weeks later, on the basis of the reaction to good Support, we would have bought “G” again at about29 (you cannot figure on getting the extreme low price on any reaction). The following advance carriedup to 34 1/4 in two days. At that point, profits could have been taken or the stock held for the longer term.“G,” it might be noted, continued up eventually to 54.\nBull Market continued, he might eventually have to close out the shorts for losses, which could beregarded as the reasonable cost of “insurance.” On the other hand, if the general weakness became greaterand eventually reversed the Major Trend, then the short sales would cushion the depreciation of the longsup to the time of the Reversal signal. (EN9: An extremely wise observation the present editor hasdeveloped at greater length in the theory of “natural hedging.” Given the complexity of modern markets,profits may be made on both sides of the hedge, and this should be the objective.)\nBy using an Evaluative Index (see Chapter 38) instead of, or in addition to, the Averages, it is possible tosay, “The market appears to be about 60% Bullish,” or “55% Bullish,” instead of merely Bullish orBearish. This takes account of the fact that some markets are more\n52\n48\n44\n40\n38\n36\n34\n32 Sales 100's 125 100\n75\n50\n25\nFigure 33.5 Symmetrical Triangle in Allied Stores, a Consolidation in the 1946 decline. Notice heavyvolume as “LS” crashed to the first Reversal point of the pattern on September 10, and the drying up ofvolume during the successive swings of the Triangle. In Point-and-Figure charts, this type of pattern isknown as a Pendulum Swing because it does seem to come to rest like a pendulum. Often, volume willpick up somewhat at each Reversal point, but a valid Triangle must show some overall decrease ofvolume.\nIf, by some unhappy chance, you were then long “LS,” you should have had your protective stop at 331/8, 8% below the Bottom reached at 36. However, the move down out of the Triangle on Friday andSaturday, October 4 and 5, although on slight volume, was a true breakout (remember that downsidebreakouts do not require volume confirmation), and you would have been justified in selling your longcommitment at the market on Monday. You would have received about 38 1/2. To justify a short sale,however, the breakout would have had to close at least 3% outside the Triangle. The return to the borderof the pattern at 40 was interesting, and you will notice volume increased characteristically as the declinereally got under way on October 9 and 10.\nNo question about the validity of this breakout. Short sales were in order on a return to the border of theTriangle, or a 40-50% Correction of the breakout move, say, at 38 1/2 to 39. The rally carried to the apexof the Triangle and then broke away fast for the decline to 33, where, on October 30, a Selling Climaxand One-Day Reversal occurred—a signal to take profits.\nNotice the small Head-and-Shoulders in August. This was a Continuation Pattern marking the top of therally before the September-November crack-up.\nBullish or more Bearish than others, and it enables the investor to", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 178}
{"text": "e rally carried to the apexof the Triangle and then broke away fast for the decline to 33, where, on October 30, a Selling Climaxand One-Day Reversal occurred—a signal to take profits.\nNotice the small Head-and-Shoulders in August. This was a Continuation Pattern marking the top of therally before the September-November crack-up.\nBullish or more Bearish than others, and it enables the investor to “roll with the punch” instead of havingto take an all-out position one way or the other. (EN9: I have called this “Rhythmic Trading.”)\nIt should be noted, however, while he may take such a partial position against the (presumed) MajorTrend, he will continue to use the bulk of his capital in situations that accord with the main trend. He willnever risk the larger part of his assets in opposition to the trend, and he will make any countermoves witha clear understanding they are of the nature of insurance and serve this purpose even though theyultimately may be closed out as small losses.\nSummarizing all these implications of the Dow Theory: do not make a majority of your commitmentsagainst the Major Trend. During periods of potential Reversal, gradually reduce your long holdings, andmake short sales to a limited amount in weak stocks; but do not attempt to anticipate either a Major Topor Major Bottom in the Averages by making an all-out commitment counter to the main trend.\n19\n18\n17\n16\n15\n14\n13\n12\n\n11\nFigure 33.6 An Ascending Triangle. “CMR,” after emerging from the doldrums in 1943, forged up toabout 12 early in 1945. The first eight months of the year on a monthly chart showed an AscendingTriangle with Top at 12 1/4. On daily charts, however, we see the more detailed aspects of this largepattern. For instance, the final reaction of the whole (monthly) formation in August became here aSymmetrical Triangle. The breakout from this pattern carried out the minimum measuring requirements,bringing the price again to the 12 1/4 Top, from which point there was a reaction that was stopped cold at11, the apex of the Triangle. A purchase on the reaction after the powerful breakout from the Triangle, sayaround 11 1/2, would have been closed out on progressive stops, starting September 28 when “CMR”reached 14, the sale being consummated October 2 at 14 1/2, a highly profitable move.\nProfit-taking of this sort would largely explain the stopping of the rise and the formation of aConsolidation Pattern that turned out to be the Ascending Triangle with Top at 16 1/4, lasting eightweeks. Notice the November 7 volume when price went through the 16 1/4 level, but failed to closeoutside the pattern, and the volume on November 30 when a clean, decisive breakout move closed at 17.This move ran to 20, and purchases would have been made at 18 or less on the reaction. The next wavetook “CMR” to its ultimate Bull Market Top at 24 in January. On the ratio scale, the Top of the AscendingTriangle was exactly halfway between the September Bottom at 11, and the extreme high of 24. This typeof halfway consolidation is typical of Flags and Pennants, and this is a very similar case.\nHead-and-Shoulders Top\nA. If you are long a stock, should a breakout down through the neckline occur, with a closing at least 3%below the neckline, next morning place a stop 1/8 point below the last close. Continue to place such“tight stops” if not caught the first day, 1/8 point under each day's close until one is caught.\nB. Short sales may be made after a breakout, on a recovery of 40% of the distance from the top of theright shoulder to the bottom of the breakout move, or on a recovery to a line drawn down across the topof the head and right shoulder, or on a Pullback to\n26\n24\n22\n20\n19\n18\n17\n\nFigure 33.7 A Broadening Top. This somewhat rare but beautiful and highly dependable formationdeveloped as CertainTeed made its Bull Market Peak in 1946. A quick glance at the volume scale in thisdaily chart shows the high volume on the final stages of the advance, the dullness during the developmentof the Top Pattern, and the increased volume after the breakout.\nAs we all know by now (or go back to Chapter 10 and review the specifications), a Broadening Top is aFive-Point Reversal, differing from the Head-and-Shoulders, Triangles, Rectangles, and so on, in thateach Reversal must be at a new high or low for the pattern. It is, if you wish, a sort of reversed Trianglewith its apex to the left, the swings becoming continually wider.\nIn the second week of May, “CT” (the symbol has since been changed to “CRT”) made a new BullMarket high at 25 1/4 (marked “1”). The reaction carried back to Support at the previous Minor Peak(point “2”) and the following week, “CT” advanced to another new high at 3, closing 1/8 point above theprevious Top.\nAnother week had brought “CT” down to point “4” with a closing at 22 1/2, three-quarters of a pointbelow point “2.” This, in itself, is not sufficient reason for making short commitments. Three weeks later,“CT” closed at 25 5/8, another new high, at point “5.” Finally, the stock dropped to 21 1/2 on July 23, andat this point (marked “B”), the pattern was completed. Notice the tendency of volume to rise at eachReversal point of the pattern.\nLong holdings would be sold at the market the day after the breakout, but short sellers should wait for acorrection of 40-50% of the move from point \"5\" to point \"B.\" If shorts were put out at 23, we would notworry if the stock advanced for a time, as it did, without making a new high. The downside move in \"CT\"went quickly to 15 1/2, and within 12 months to 11 1/2.\n26\n22\n24\nFigure 33.8 Rectangles in Remington Rand. This is part of a long Bull Market rise that carried “RR”from under 10 to above 50 in the period from 1942 to 1946. The last three years of this advance werealmost continuous, as seen on monthly charts, without any extensive reactions. When we put the chart ona daily basis, such as this section covering the end of 1944 and the early months of 1945, right in themiddle of the advance, we s", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 179}
{"text": "ton Rand. This is part of a long Bull Market rise that carried “RR”from under 10 to above 50 in the period from 1942 to 1946. The last three years of this advance werealmost continuous, as seen on monthly charts, without any extensive reactions. When we put the chart ona daily basis, such as this section covering the end of 1944 and the early months of 1945, right in themiddle of the advance, we see that the rise was not actually continuous but rather was built up of steps inan ascending “staircase” of Accumulation Patterns. Each sharp advance on increased volume is followedby a period of dullness and slight recession.\nA picture of this type suggests the methodical campaign of buyers who intended to purchase large blocksof the stock for large long-term advances without creating a “skyrocket” market by their own buyingoperations. Presumably, each advance was checked by the temporary distribution of part of the stock heldby such buyers, and accumulation restarted on reactions.\nIn October and November, there is a well-marked Rectangle between 20 3/4 and 22. A purchase couldhave been made at or near the bottom limit, say at 21, on the fifth Reversal on November 14. The moveout of pattern in the week of December 2 did not carry 3% out of pattern, but about two weeks later, amove got under way that qualified as a valid breakout, with volume confirmation as required on upsidemoves. Notice the volume increase and One-Day Reversal on December 20 as this move neared its Top.Purchases would have been made at about 22 1/2 on the basis of a normal correction, and you would have\nexpected Support at the 22 level. This Support was respected, but the move did not advance beyond 233/4 (made this same Top three times in a period of two weeks) and returned again to 22 1/4.\nThere was no question about the breakout on January 25. Extent and volume were decisive. Notice thegap and One-Day Reversal on the following day as this Minor Move reached its end.\nIn mid-March, as you will see, “RR” plunged down from its high of 27, but the decline was stopped in itstracks at the top level of the January Rectangle, a good Support shelf. Never again during the Bull Marketdid “RR” even threaten this level because it moved up in April and continued its long march to the 1946Top.\nthe neckline, whichever point is reached first. If the breakout move continues down another day, or forseveral days, the 40% recovery would be based on the entire move from the top of the right shoulder tothe lowest point reached.\nHead-and-Shoulders Bottom\n(EN: The editor, long distressed by the paradox of the term “Head-and-Shoulders Bottom,” proposes thisformation be renamed in technician's nomenclature to “the Kilroy Bottom” [see Figure 7.4.])\nA. If you are short a stock, should a breakout on increased volume occur, penetrating the neckline andclosing at least 3% above it, place a stop next morning to cover at 1/8 point higher than the close. If sucha stop is not caught, continue each day to place a stop 1/8 point higher than the previous day's close untilone is caught.\nB. New purchases may be made after a breakout, on a reaction of 40% of the distance from the bottom ofthe right shoulder to the top of the breakout move (which reaction must be on decreasing volume), or on areaction to a line drawn across the bottom of the head and the right shoulder, or on a Throwback to theneckline, whichever is reached first. As in the case of the Top Formation, this 40% reaction is figured onthe entire distance of the breakout move if it should continue up for several days.\n22\n20\n19\n18\n17\n16\n15\n14\n13\n12 Sales 100's\n50\n40\n30\n20\n10\nFigure 33.9 A Double Bottom in Paramount Pictures. Double Tops and Double Bottoms are not ascommon as many traders like to think. They require considerable time to develop and must conform tospecifications as to price range and time, and also (on upside breakouts from Double Bottoms) as tovolume. They are easier to spot on weekly charts than on dailies.\nThis is a weekly chart of “PX” from September 1941 through March 1943. A Bottom was made onclimactic volume at 11 3/4 during the “Pearl Harbor Panic” Move. Then came a rise lasting eight weeksthat brought “PX” back to 15 5/8—a rise, incidentally, on feeble volume, strongly suggesting thepossibility of another crack-up to even lower levels. This rise, you will notice, was a considerable one,amounting to 35% of the price at the December low.\nThe downward move, however, which lasted to mid-April, was on low volume and ended precisely at theDecember low of 11 3/4. (Note: it is not necessary moves of this sort end at exactly the same level; thesecond Bottom could have been a bit higher or lower without spoiling the pattern.)\nThe second week in July shows the first sign of a possible Reversal when the price advanced on increasedvolume, but it did not close above 15 5/8 and, therefore, was not a breakout. Two weeks later, on heavyvolume, “PX” had moved up to 16 1/2, closing the week at 16. This is a true breakout and purchaseswould have been in order on reactions from this point on.\nThe move continued up for three years to an ultimate Top at 85.\nFigure 33.10 A Right-Angled Broadening Formation in Associated Dry Goods. A beautiful example of abreakout through Multiple Tops, followed by an important move. This is, however, a pattern that is morefun to observe in retrospect than to follow as an active trader. The stock had moved up from an importantBottom around 4, established in 1938, 1940, and 1942. At the time of this chart in 1945, “DG” wasstarting the accelerating climb that eventually ended with the 1946 Rounding Top at more than 70 (seeFigure 33.3).\nIf you had been holding the stock, you would have been watching for a substantial corrective move afterthe advance from 12 to 20. In late February and the first week of March, “DG” went into a new BullMarket high-ground, reacted to Support around 19 to 19 1/2, and then advanced again in the week ofMarch 17, failing in this move to make a new h", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 180}
{"text": "he 1946 Rounding Top at more than 70 (seeFigure 33.3).\nIf you had been holding the stock, you would have been watching for a substantial corrective move afterthe advance from 12 to 20. In late February and the first week of March, “DG” went into a new BullMarket high-ground, reacted to Support around 19 to 19 1/2, and then advanced again in the week ofMarch 17, failing in this move to make a new high. Ten days later, “DG” had reacted to 18 1/2, closingbelow the previous Minor Bottom. An inexperienced observer, at this point, might have commented“Double Top” and planned to sell “DG” at once or even to make a short sale. The pattern, however, wasnot large enough in duration or extent of price movement to qualify as a Double Top, nor did it conformto any other recognizable pattern of Reversal. Nor was the volume as high as one would expect on animportant Top.\nThe rally in early April carried through to a decisive breakout of more than 3% in the move that reached22 7/8 on April 18. This move was a near penetration of the middle Top and confirmed the uptrend. If youstill held your long stock, you would not rest easier, and in any case, you would have looked for a chanceto buy on a reaction after the breakout. If you had tried to buy at the 21 1/2 Support Level, you wouldhave been left behind, but if you had put your order in a little higher, say at 22, you would have had a niceprofit on the advance to 25 7/8, where you would have sold on a tight stop at 25 3/4.\nComplex or multiple Head-and-Shoulders\nThe same tactical suggestions apply to these as to the simple Head-and-Shoulders. Definitions and specialfeatures of these formations are covered in Chapter 7.\nRounding Tops and Bottoms\nIt is difficult to set precise rules for trading on these gradual changes of trend. In the case of RoundingTops, if one is long the stock, the general appearance of a Rounding Formation, extending over a periodof several weeks, leveling off from the rise and then turning down, very likely with a tapering off ofvolume nearing the top of the rise and a pick-up of volume as the turn starts down, would suggest gettingout of the stock at the market as soon as the picture looks more or less definite. A short sale of a RoundingTop could be very profitable; but no exact rule could be stated except, in the absence of fixed BasingPoints, one would want to be very certain the formation was unmistakably a Rounding Top. It would needto be well formed and following a long rise and extending over a period of some weeks in its formation. Itwould also need to be protected with a stop above the Top of the curve, as explained in the chapter onstops.\n104\n96\n88\nSales\n100's\n50\n40\n30\n20\n10\n::::::..................................»>•••••«!• — ::::::::::....■T? MOM\nAMERICANCANA C ! II j 1946-1947tiffFffl\n91 H H w:- ■8 111\n:::J\nn r|l| iffltS\niniiini\n11 ii iiin\n.......Il\nJ }•-\n■+wII\n,iLji\n:fl\n+ ■ ffff tit w fl•• J t: •|Aff+\n1-. ifflll1 ttt**+ff: ■ ff1#r ::: iist\"}+■■th: iff!\nmi ;;f Q X1 I limt3‘+ TT1 ::cff: H::xff • iiilfiEi a\nI ■ in II ,11 ........T\nii 1111 nnAlldjLiuIi i 1luliiiuu\n........1\niLiiliimill'\n:\nFEBRUARY\nMARCH\nAPRIL\nMAY\nDECEMBER JANUARY\n7 14 21 28 4 11 18 25 1 8 15 22 1 8 15 22 29 5 12 19 26 3 : 10 17 24 31\nFigure 33.11 A Diamond Pattern in American Can. The daily chart covers the period from December 3,1946, through May 1947, inclusive. For background on this situation, keep in mind that “AC” made itsBull Market Peak in October 1945 when it reached 112. The tendency of high-grade, high-priced stocksto top out early at the end of a Bull Market has already been noted. The first decline carried nearly to 90and was followed by a rally to 106. The stock then dropped to below 80 and a second rally brought us tothe situation we see here.\nYou will notice at once the moves have a gradual “rounding” appearance, due to the fact, at this price,conservative stocks do not make large percentage moves. If charted on a scale having larger verticalintervals, the patterns would look very much like those in more speculative stocks.\nThe first part of the pattern is similar to a Broadening Top. The first Minor Peak at 96 is followed by areaction to 92. The second peak carries even higher, to 98; and the reaction this time goes down to 91 1/4.A third rally takes “AC” to 99. So far, we have the five Reversal points of a Broadening Top, needingonly a close below 91 1/4 to confirm the Bearish indications. The next decline fails to break out of thepattern, however, and for several weeks, we have a narrowing picture like a Symmetrical Triangle.\nEventually, the stock makes a clean breakout to 89, which is the signal to get out of longs and to considershort sales on the next rally. As a matter of fact, the three-week rally that started never made an upsidepenetration of the Resistance Level at 94, the level of the apex of the converging lines bounding the latterpart of the Diamond.\nAmerican Can did not make a spectacular move down from this point, which is not surprising consideringthe markdown that had already taken place in “AC,” the habits and price of the stock, and the generalcondition of the market. It did not, however, again rise to the level shown here and, in fact, retreated tothe 80 level.\nTo review the nature of the Diamond—it is not a common pattern. It is somewhat like a Complex Head-and-Shoulders with a bent neckline. It resembles, at the start, a Broadening Top, and its latter phasenarrows like a Symmetrical Triangle.\n30\n28\n26\n24\n22\n20\n19\n18\n17\n16\n15 Sales 100's 250 200 150 100\n50\nGULF MOBILE & OHIO RR.\nFEBRUARY\nillli.ill.lili.-i\nMARCH\n741 . n\nAPRIL\nMAY\n: 6 13 20 27 3 10 17 24 3 10 17 24 31 7 14 21 28 5 42 19 26 2 9 16 23 30\nFigure 33.12 Gulf, Mobile, and Ohio builds a beautiful Wedge, as shown on this daily chart for the firsthalf of 1945. This was the move that terminated the spectacular rise of “GFO,” its final Bull Market Top.\nImmediately after the downside breakdown from the Wedge, “GFO” came down to 18 3/4, and from thisIntermediate low,", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 181}
{"text": "AY\n: 6 13 20 27 3 10 17 24 3 10 17 24 31 7 14 21 28 5 42 19 26 2 9 16 23 30\nFigure 33.12 Gulf, Mobile, and Ohio builds a beautiful Wedge, as shown on this daily chart for the firsthalf of 1945. This was the move that terminated the spectacular rise of “GFO,” its final Bull Market Top.\nImmediately after the downside breakdown from the Wedge, “GFO” came down to 18 3/4, and from thisIntermediate low, which was reached in August, rallied into a long Rectangle between 23 3/4 and 26 3/4from which it eventually broke down in a series of crashes that found it, in May 1947, selling for 6 1/8!\nIt is rather hard, with a formation of this sort, to say at what precise point the convergence of the trends isestablished. The breakout move late in April was normal; the stock was a buy on the next reaction. Thefollowing advance in May, which reached 23 1/2, did not carry out a Parallel Trend Channel, and we sawa tendency to converge as prices retreated on the reaction. The next three advances all repeated andconfirmed the Wedge picture, and at the top, we see a sort of “bunching up” as prices make little or noheadway. The chances are at 11 an alert trader would have taken profits on long commitments after thehigh volume appeared at the top of the Minor Move ending June 4 and 5. In any case, he would havemaintained a protective stop at all times to take him out if and when a downside breakout occurred.\nYou would not be likely to be short a stock on a Rounding Bottom. The long and gradual roundingappearance with dull volume, followed by a sudden revival on greatly increased volume, would be signalenough to cover if you should find yourself in this uncomfortable position. Purchases would be justifiedin a stock whose chart showed a Rounded Bottom or Saucer, after the first spasm of activity following along, dull period of dormancy. You would buy, according to the rules we have given for purchases onreactions, not on the breakout, but on the reaction following it, which would almost surely come.\n24\n22\n20\n19\n18\n17\n16\n15\n14\n13\n12\n11\nSales 100's 125 100\n75\n50\n25\nI it it H\ntint titpp\" wHTg.LL.J\n»::i\nIII II\nII* It li**1 m n\nHi it ill (1\n......\nIlli II\n■ IH 1 .\nIlli II ......:::::: 1 fi\n:::: K :: ftJJ. / ■\n: fils L\n1945 r Si /flflT::: : : :: : ::: : :\n.. ■ i ■lllllt IIIIII\n::::::\n:::::\nIIIIIIMIIIIII III\n>11111111.........\niiiiiiiniiiittmi\nH\n1\ni\nA ’ : : :ffft ft;• U P ■yiijfl L\n1jfl | :: : j ki ill\nfl . 1 U L I I I ••J =•: I H.L ;h 1 tif\n:::::: f ||r m—iaet? : j;| 1 • |;;L |....1.1.:\ntt;• T r ffi II ••XHu:.:: : : :r • •t h : .::::• H: : fl t■:\nh.1 1: it:i:GjLU i Hit It:: K : :|H| : III! |H !\n:... . ph 1 Haitisfli\n:: /\nHi II Hl H.fl A ' A '\ntin :::: :\n1 1\n; 1\n1\nWi IE?:::::\nEE El?\nJi :\n•1Iffii;li I if [■\nI flP S.-J • alltt Ifrili rm\nf\n■\nnut\nfl.;jf; if-£ ■[ fl|| ■ Hl MAPTTXT-PAPPY MPT £Hil ’ iL -ill\nfl f fl■fl|H MMMA AlxTIX N X.AXxXxl ..\ni L1T HIT . .ft Jtt ff fff Iffffj I..:::: .\n1 tt TT TT :±:: SH I i ■ ■■\n1it 4 1\n■ ■ y nil ■ flihi 1 1 iflfl.|n\n■ • l•\nII11\nX\nu :: :\n.....I .1.. flfl I ^fl: : : :\n;; •:::::•\nm H HH fl-fl t flHI fi H \" E\n1 1 t Hit... .r :: T -\nMM ™ . 1: ’: E ‘: 1:: ' L:\nIf\nM!\nit’ ■ i\nHI 5 * :: :::::::\n1 1 Mill......: 1\nIlill .uJl uLi uliJlulljiMiunkuUi-uhaxI.\nAPRIL _ MAY IUNE JULY AUGUST SEPTEMBER\n7 14 21 28 5 12 19 26 2 9 16 23 30 7 14 21 28 4 11 18 25 1 8 15 22 29\nFigure 33.13 A Pennant in Martin-Parry. This type of pattern is fairly common in fast-moving markets.The extraordinary point about Flags and Pennants (and sometimes other Consolidation Patterns in fastmoves) is their tendency to form almost exactly halfway between Bottom and Top.\nJust before this move, “MRT” had built a Rectangle between 10 and 12 lasting seven months, whichfollowed the 1944 rise from around 4 to 12. The May breakout on heavy volume carried “MRT” right tothe top of the Pennant without any adequate reaction. Note the increase of volume at the top of that rise.For three weeks prices drifted off with a drying up of volume that is clearly shown in the chart. Thepattern did not correct the entire first phase but found Support at the Minor Peak at 14 1/2.\nSuddenly, on high volume, the move was resumed and this time went right up to 24 3/4. The chances aretraders who were still long their original stock or who had bought in around 15 on the Pennant wouldhave sold after the high volume of June 6 when “MRT” reached 19 7/8.\nSymmetrical Triangles\nA. If you already have a position in the stock. During the formation of\na Symmetrical Triangle, you may be unable to make any change in\nyour holdings. Let us say you have bought the stock on a reaction after\na Bullish Move. The next upsurge fails to make a new high and gives\nno sufficient volume signal to cause you to sell out. The next reaction\nfails to carry below the previous one. You are “locked” into the\nTriangle, and you cannot safely sell, because the Triangle that has\nformed may eventually break out in the original direction and show\nyou a good profit (in fact, the odds favor that it will break out in that\ndirection). In case of a breakout move (which must be on increased\nvolume on the upside), you can close it out for a profit (according to\nthe rules for trading we have already given) and immediately mark it\nas a rebuy on the next reaction. If the breakout is down (whether or not\non increased volume), with a closing outside the Triangle, you should\nprotect yourself with a tight (1/8 point) stop the next day and continue\nto set such tight progressive stops under each day's close until it is\nsold.\nIf you are short the stock, the same rules would apply in reverse, except the\nbreakout in the right direction (down) would require no volume\nconfirmation while the adverse breakout (up) would need such increased\nvolume.\nFigure 33.14 This daily chart of Lehigh Valley R.R. through late 1945 and\nearly 1946 shows a variety of gaps. At this particular time, “LV” was\ncompleting a Secondary Corrective Move before making one more (and as\nit turned out, final) effort to exceed the 1945 Top just above 17.", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 182}
{"text": "direction (down) would require no volume\nconfirmation while the adverse breakout (up) would need such increased\nvolume.\nFigure 33.14 This daily chart of Lehigh Valley R.R. through late 1945 and\nearly 1946 shows a variety of gaps. At this particular time, “LV” was\ncompleting a Secondary Corrective Move before making one more (and as\nit turned out, final) effort to exceed the 1945 Top just above 17. This long-\nterm situation could be used for a discussion of Double Tops because the\nBottom of the intervening move was violated in the summer of 1946 and\nthe stock continued a downward course to below the 5 level.\nNot all gaps are significant, as displayed in the first gap on October 3, when\nthe stock was moving in a narrow range on low volume. The gap on\nSaturday, November 3, however, is important because the Saturday volume\n(when doubled) is high. The move failed to qualify by a 3% new high\nclosing as a true breakout, but the implications of the move were Bullish\nand might well have justified purchases on Minor Reactions. The low-\nvolume gaps on these reactions were of no particular interest.\nIt is not until the third week of January that we see another gap that looks\nlike a real breakaway. On January 14, with high volume, “LV” moved up\nand out in a rush that took it to 15 7/8 on January 16, closing at 15 1/2. The\nsecond appearance of volume here would have suggested application of\nprogressive stops, and long trades would have been closed out at 15 3/8.\nNew purchases could have been made on the reaction at 14 1/2. A second\nadvance accompanied by a Breakaway Gap developed on January 23. If we\nconsider the second gap (of January 24) a Runaway or Measuring Gap, we\nwould estimate the probable top of this move at around 17 3/4. When a\nthird gap appeared on January 28 with a One-Day Reversal and climactic\nvolume, it would be clear this move was about finished and progressive\nstops would be used to clear out longs at 16 3/4.\nNote the attempt to rally after the sharp drop and the One-Day Island\nformed by two gaps as “LV” fails to hold at the 15 level.\nB. If you do not have a position in the stock. Stay away from any\nstocks making Symmetrical Triangles until a clear and definite\nbreakout close has been made. After such a breakout, if on the upside,\nbuy on the next reaction if the Major Trend is up; on the downside, sell\nshort on the next rally if the Major Trend is down. Rules for making\nsuch commitments have already been given.\nNote: Avoid breakouts from Symmetrical Triangles of the type that have\ncontinued to narrow until the breakout point comes far out toward the apex.\nThe most reliable breakouts occur about two-thirds along the Triangle.\nRight-Angle Triangles\nThe same rules would apply to Right-Angle Triangles as to Symmetrical\nTriangles (see Chapter 8, Important reversal patterns: the triangles). Early\nbreakouts are more dependable here, as in the case of Symmetrical\nTriangles. Volume confirmation is more important on upside breakouts from\nAscending Triangles and is not strictly required on downside breakouts\nfrom Descending Triangles. Commitments already made are retained until\nthe breakout and then closed out in the same way as any transaction that\nshows a gain.\nAs the Ascending and Descending Triangles carry a directional forecasting\nimplication that the Symmetrical Triangles do not have, it is possible to\nmake new commitments on reactions within an Ascending Triangle or\nrallies within a Descending one. Since the flat horizontal side of one of\nthese Triangles represents a supply or demand area of unknown magnitude,\nand because such a Triangle can be (and sometimes is) turned back before\nthe horizontal line has been decisively penetrated, it might be better policy\nto note such formations in the making and wait until the decisive breakout\nbefore making the new commitment.\nBroadening Tops\nPresumably, you would not be long a Broadening Top. The early Reversals\nin the pattern would have taken you out of the stock, if you follow the\ntactical rules based on trendlines, as previously outlined, long before\ncompletion of the pattern. Neither would you be tempted to buy into such a\npattern because the trend indications would be clearly against a move.\nOn the other hand, a Broadening Top, after its completion, offers excellent\nopportunities for a short sale. After downside penetration and a close below\nthe fourth point of Reversal in the pattern, you are justified in selling short\non a rally of about 40% of the distance covered from the extreme top (fifth\npoint of Reversal) and the lowest point reached on the breakout move. The\nstop would be placed at the proper distance above the fifth Reversal, that is,\nthe extreme top of the pattern.\nRectangles\nA. If you already have a commitment in the stock. The early moves of a\nRectangle may provide no volume signals to permit you to get out. There\nwill be no “breakout” moves during the formation of a Rectangle that will\nallow you to take a profit. However, as soon as the character of the\nRectangle is well established (which requires at least four Reversals to set\nup a clear Top and Bottom), you may trade on the Tops and Bottoms— that\nis, sell at or near the Top, or buy at or near the bottom. For, as in the case of\nSymmetrical Triangles, there is a definite presumption in such formations\nthat they are more likely to lead to continuous moves than to Reversals, this\nwould mean you would probably pass up your first opportunity to get out\n(on the fifth Reversal) and would indeed probably decide to “ride along” in\nthe expectation of a continuation of the original move, which will be in the\n“right” direction for your commitment. In the case of a breakout in the right\ndirection, you would dispose of your commitment according to the rules for\ntrading already stated. If in the wrong direction, use the tight (1/8 point)\nprogressive stops, the same as with the Triangles.\nB. If you are not committed in the stock. Trades can be made within the\nRectangle on the fifth and subsequ", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 183}
{"text": "ll be in the\n“right” direction for your commitment. In the case of a breakout in the right\ndirection, you would dispose of your commitment according to the rules for\ntrading already stated. If in the wrong direction, use the tight (1/8 point)\nprogressive stops, the same as with the Triangles.\nB. If you are not committed in the stock. Trades can be made within the\nRectangle on the fifth and subsequent Reversals. Due to the slight\nprobability, the move will eventually continue in the same direction as the\npreceding move leading up or down to the Rectangle; thus, it might be best\nto wait until the sixth Reversal for new commitments, which would set your\ninterests in the same direction as a continuation. Also, short sales can be\nmade after any downside breakout close from a Rectangle or purchases\nafter an upside breakout close with increased volume. Both the short sales\nand the long purchases would be made on the Corrective Move following\nthe breakout.\nDouble Tops and Bottoms\nDouble and Multiple Tops or Bottoms are not valid unless they conform to\nthe requirements for such formations. Chapter 9 on these patterns should be\nread carefully in this context.\nA. If you are long a stock. On penetration and close at a price lower than the\nextreme Bottom of the pattern between the Multiple Tops, dispose of the\nstock on tight (1/8 point) progressive stops.\nB. If you are short a stock. On penetration of the highest point of the\nInverted Bowl or rise between the Bottoms, with a close above that point,\nclose out the short sale on tight stops.\nC. If you are not committed in the stock. Consider a penetration and\nclose beyond the limit of the correction between the Tops (or Bottoms)\nas a signal of Reversal and make new commitments on rallies or\nreactions.\nRight-Angled Broadening Formations\nThe handling of these on breakouts through the horizontal side would be\nsimilar to what has been said about Multiple Tops and Bottoms, and Right-\nAngle Triangles.\nThe Diamond\nIf you are sure what you have is a valid Diamond Pattern, the rules for\ntrading will be the same as those we have already covered in connection\nwith breakouts from Symmetrical Triangles. As in the case of such\nTriangles, new commitments should wait for a definite breakout.\nCommitments already in force would have to remain until such a breakout\nhad occurred, either declaring a Reversal or indicating a probable\ncontinuation of the original trend.\nWedges\nThere is no need to set forth detailed rules for policy within a Wedge and\nduring its formation because the general principles taken up in connection\nwith trendlines and Support and Resistance would take you out of such a\nsituation at the first opportunity after the convergent nature of the pattern\nbecame clear. At the very worst, your stops (which we hope you maintain\nfaithfully in all situations) will take you out before the consequences\nbecome serious.\nRegarding new purchases (from a Falling Wedge breakout) or short sales\n(from a Rising Wedge), the same volume characteristics would be expected:\nnotably increased volume on an upside breakout from a Falling Wedge and\nless pronounced volume action on the first stages of breakout from a Rising\nWedge. New commitments, in line with the implications of the breakout,\nmay be placed on rallies or reactions after a clear breakout closing occurs,\ncarrying beyond the trendlines forming the Wedge.\nOne-Day Reversals\nOne-Day Reversals are not technical patterns suitable for trading in the\nsame sense as the important Reversal and Consolidation pictures we have\nexamined. They are mainly useful as a gauge in helping to find the precise\nTop or Bottom of a Minor Move to protect profits on commitments\npreviously made. The One-Day Reversal, the Exhaustion Gap, and the day\nof exceptionally heavy volume following several days of movement in a\nMinor Trend are strong indications that the move may have run out. Any of\nthese three signals is worth watching for; any two of them together carry\nmore weight than one alone; and the appearance of all three carries very\nstrong implications of a Minor (EN: or even a Major) Top or Bottom.\nRegarding trading on movements signaled by One-Day Reversals, this type\nof trading would lie almost in the field of gambling, or at least trading for\nquick, small profits on short moves. It would not be the same kind of\ntrading at all that we have been studying in the greater part of this book.\nThe indications and some suggestions for trading on those one-day moves\nare covered in their discussion in Chapter 10.\nFlags and Pennants\nIn many cases, the total decline from a Flag in an uptrend will bring the\nprice back to a point at which the stock may be bought according to our\nregular trading tactics, namely, the decline may carry down to the Basic\n(Red) Trendline, to the Blue Parallel, or make a 40% to 50% correction of\nthe rising “mast” preceding the Flag. If the “mast” move is the first such\nmove out of a level or only moderately rising trend, and if the Major Trend\nof the market is Bullish, we would be justified in buying at the first\nopportunity, which would be on the Blue Parallel. In such a case we would\nexpect, and ordinarily get, some further reaction, but it is important to get in\nearly because sometimes the reaction is very brief and does not meet either\nof the other requirements for the correction. It is most important in a\nsituation like this that the volume drop off sharply. Volume must decrease\nand remain slight; any increase of volume during the formation of the Flag\nshould be reviewed as casting suspicion on the entire pattern, except the\nincreasing volume that characteristically attends the start of the breakout\ndrive. This drive is usually so virile that we would be safe in placing a tight\n(1/8 point) stop under the close of any day during formation of a Flag or\nPennant that showed notably increased volume. Hence, if the volume\nindicated failure of the pattern, we would be taken out at once; but if the\nbreakout was under way, we would pro", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 184}
{"text": "g volume that characteristically attends the start of the breakout\ndrive. This drive is usually so virile that we would be safe in placing a tight\n(1/8 point) stop under the close of any day during formation of a Flag or\nPennant that showed notably increased volume. Hence, if the volume\nindicated failure of the pattern, we would be taken out at once; but if the\nbreakout was under way, we would probably be left in because the stock\nwould ordinarily move up then without a reaction, very often making a\nBreakaway Gap.\nIn downward movements, when the Major Trend of the market is Bearish,\nthe same suggestions would apply, with one difference. The final high day\nof the Flag type of rally may be on high volume and also may show the\nExhaustion Gap or One-Day Reversal. If a short sale has been made into\nsuch a day showing high volume, gap, or One-Day Reversal, a stop order\nplaced above the peak of the Flag will protect you should the advance be\nresumed unexpectedly.\nIn either the up-moving or down-moving manifestations of this type of\naction, there may be Flags having horizontal Tops and Bottoms, which are\nRectangles. If the drying-up of volume and other aspects of the picture,\nincluding the sharp upward or downward move preceding it, suggest a Flag-\ntype Consolidation, you would be justified in making a commitment on the\nsixth Reversal point, or for that matter, at almost any point in the pattern\n(because you cannot expect this pattern to continue very long).\nFlags and Pennants continuing too long (more than three weeks) are open to\nquestion. Stops should then be set at the usual computed distance above or\nbelow their extreme Tops or Bottoms (as the case may be). The fairly\nfrequent appearance of Flag-like Formations that eventually fail is\nunfortunate because it is particularly hard to give up hoping with this kind\nof pattern, and it is necessary to set the three-week time limit to prevent the\nstock from drifting all the way back to previously established stop levels.\nOn the other hand, breakout moves from these patterns, when completed\nnormally, are among the fastest and most profitable forms of market action.\nThe question remains what to do in the case of stocks you may be holding\nas they go into Flag or Pennant Formation. Obviously, they should be held\nif you are long and the move leading to the Flag is up; or short positions\nshould be retained if the move is down. This would not happen ordinarily,\nhowever, if you had followed the trading rules strictly. In most cases, your\nsignals calling for tight (1/8 point) progressive stops would have appeared\nduring the formation of the “mast.” You would have been taken out of the\npicture somewhere along the way, possibly at the extreme top of the mast\n(although ordinarily, you could not count on being so fortunate).\nIf no signal should appear and you still are holding a position as the Flag\nstarts to make its appearance, by all means hold your position. The odds\nfavor a continuation of the original move.\nNow, if you have been holding the stock long (in a Bull Market) and have\nseen it break out and start leaping to new highs, say from 20 to 32, and you\nhave been stopped out at 30, and then you see the price advance, halt, and\nduring the next several days retreat, with the rather high previous volume\ndrying up to practically nothing (it must be a drastic drying-up, and no\nmistake about it), then you are justified in buying right back in again, even\nat a higher price than you received only a few days before.\nGaps\nIf you are long a stock that is in a well-marked pattern formation, or in an\narea of dull movement within fairly narrow limits, and the stock suddenly\nbreaks out on the upside with high volume and a gap, that is a Bullish\nindication. You will hold the stock until signs of exhaustion appear as the\nrise continues, or reappearance of high volume, or another gap or One-Day\nReversal. Then, particularly if two or all three of these indications show up\nat the same time, you can protect your commitment with tight progressive\nstops. You will have to consider whether a second gap should be considered\nan exhaustion gap or a continuation gap, depending on the volume and the\nspeed of the rise, as discussed in the chapters on gaps and their measuring\nimplications.\n19\n18\n16\n15\n14\n17\nFigure 33.15 This daily chart in Northern Pacific, covering six months\nduring 1944, shows several examples of Support and Resistance. The entire\nchart covers only part of the series of Consolidations that took place in 1943\nand 1944 preceding the 1945-1946 advance that carried beyond 38.\nSupport and Resistance phenomena appear on many, in fact, on most of the\ncharts in this book, and you will find them on the charts you set up for\nyourself. There is nothing unique or even unusual about the Support-\nResistance action in “NP.”\nStarting at the left in April, after the downside move on volume to 14 1/4,\nnotice the recovery to 15 5/8 where the move stops at the Resistance Level\nof the preceding two weeks. After the formation of the Symmetrical\nTriangle, there is a breakaway move with a gap that runs right on up to\nabove 17, where a small Rectangle is built during the next three weeks. The\nstock ultimately breaks down from this pattern on considerable volume. It is\ndoubtful whether one would want to trade on this as a normal reaction after\nthe breakout from the Triangle because of the downside volume and the\nimplications of the Rectangle.\nNote, however, how the reaction stops cold at the 15 line, the apex level of\nthe Triangle, and then moves right on up. Rather surprisingly, there is only a\nthree-day hesitation at the Bottom of the Rectangle, but a little setback\noccurs at the Top of that pattern.\nThe July Top might be classed as a Head-and-Shoulders or Complex or\nRounding Top; in fact, it is almost a Rectangle, and after the downside\nbreakout, prices hesitate at the level of the Top of the May Rectangle,\ncontinue down, find temporary Support again at the April Support Shelf\naround 16, a", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 185}
{"text": "e-day hesitation at the Bottom of the Rectangle, but a little setback\noccurs at the Top of that pattern.\nThe July Top might be classed as a Head-and-Shoulders or Complex or\nRounding Top; in fact, it is almost a Rectangle, and after the downside\nbreakout, prices hesitate at the level of the Top of the May Rectangle,\ncontinue down, find temporary Support again at the April Support Shelf\naround 16, and ultimately wind up a bit under 15. Although “NP” actually\ndid penetrate and close slightly below the apex of the Triangle, the violation\nwas barely 3%, and it is interesting to note this September Bottom was the\nlowest point reached. From here, the stock started its climb to the 38 level,\nwhich was reached in December 1945.\nOrdinarily, after a Breakaway Gap, regardless of whether you sell on the\nnext Minor Top, you would consider the move Bullish and would prepare to\nmake a purchase on the next reaction.\nNow if you are long a stock and during the course of a sharp rise it develops\na gap after several days of the move, you must make your decision as to\nwhether or not it is a Continuation (Runaway) Gap. If so, you would\nprepare to hold the stock for a further rise approximately equal to the rise\nup to the gap. You would watch the approach to the ultimate objective\nindicated very closely; on the appearance then of Reversal signals, you\ncould protect your holding with tight stops.\nIf you are satisfied a gap following a good rise is actually an Exhaustion\nGap, then you should protect your stock with a tight progressive stop at\nonce.\nIn Bear Markets, you would apply these same rules in reverse to your short\nsales, remembering a downside breakaway is not necessarily accompanied\nby the high volume you expect on an upside breakaway.\nWhere you are long or short a stock that is moving in a Pattern Formation\nand the stock then makes a Breakaway Gap in the adverse direction, the\ncommitment should be closed out immediately at the market, or on tight\nprogressive stops.\n38\n36\n34\n30\n28\n26\n32\n\nFigure 33.16 Trendlines in American Steel Foundries. This daily chart\nshows the tendency of trendlines to develop along straight channels. We\nhave already pointed out that these channels are frequently easier to see in\nretrospect than during their formation, that stocks move in perfect channels\nonly occasionally, and that all channels come to an end, frequently without\nwarning. In this case, the long trend channel does give a warning of\nReversal.\nIn 1946, “FJ” had declined from 48 to a Support Level of 30. From here it\nrallied for three months in a Trend Channel that brought us to the February\nTop at 37. The next decline broke the previous trend, and volume developed\nat the bottom of this break. If you will follow the entire chart, you will\nnotice volume nearly always shows an increase at the points of Reversal,\nwhich are also usually points of contact with the Trend Channel. Notice also\nthe way the Corrective Rallies tend to stop at or near the previous Minor\nBottoms in the downward trend, and how reactions tend to stop at the\nprevious Minor Tops in the upward trend.\nTrading on this situation would have been profitable. The Secondary\nIntermediate Rally up to February approached the Resistance Level marked\nby a 1946 Bottom around 40, and a correction of the drop from 48 to 30\nwould indicate short sales around 37 (which objective was just barely\nreached). Such sales, if made, would have been covered after the first drop\n(week of March 1) around 33 1/4. New shorts at 34 1/2 would have been\nclosed in the week of March 15 at about 31 1/2. Shorts made on the rally of\nthe March 22 week around 33 would be covered in the week of April 19 at\n30. If shorted again, the same week at 31, the sale would have been covered\nafter the Climactic Bottom in the week of May 24. The combination, here,\nof great volume and a One-Day Reversal would have warned against further\nshorts.\nThe Rising Channel, being a Secondary, presumably of limited extent,\nwould not offer any great inducement to long-side trading in the absence of\nother good reasons.\nSupport and Resistance\nWhen you are long a stock, you do not want to see it violate any Minor\nBottoms previously made. Neither do you want to see it violate any of the\npreceding Minor Tops that it has surpassed. Therefore, your stop orders will\nbe placed at a computed distance, as explained in Chapter 27 on stop orders,\nusing both the Minor Bottoms and the Minor Tops as Basing Points.\nNormally, the Minor Bottom most recently formed will be at the\napproximate level of the preceding Minor Top, so that these Basing Points\noften will coincide. Ordinarily, therefore, in a rising trend, we look to the\nmost recently formed Minor Bottom. When the stock has, for three days,\nmade a price range that is entirely above the entire range of the day marking\nthis Bottom, you may move up your stop protection to a place indicated by\nthis new Basing Point.\nThe same procedure will apply in Bear Markets; the “three-days-away” rule\nbeing used to confirm Basing Points established by Minor Peaks and also\nby the preceding Minor Bottoms. Ordinarily, it will be sufficient to use the\nMinor Peaks as Basing Points.\nIntermediate Tops and Bottoms are used in determining the probable\nobjectives of Intermediate Moves because previous Tops constitute Support\nunder Intermediate Reactions, and previous Bottoms indicate Resistance\nover Intermediate Rallies.\nMultiple Tops are Support Levels. Multiple Bottoms are Resistance Levels.\nThe neckline of a Head-and-Shoulders Pattern is a Support or Resistance\nLevel, as the case may be. The apex of a Symmetrical Triangle is a strong\nSupport and Resistance point that may show its effect again on a subsequent\nmove. Any congestion or area at a certain price level or within narrow price\nlimits may provide Support or Resistance when a stock moves again to that\nprice or range.\nTrendlines\nWe have already gone into the methods of following trends in stocks, and\nthe use of the Top and Bottom Trendlines (Basic an", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 186}
{"text": "l Triangle is a strong\nSupport and Resistance point that may show its effect again on a subsequent\nmove. Any congestion or area at a certain price level or within narrow price\nlimits may provide Support or Resistance when a stock moves again to that\nprice or range.\nTrendlines\nWe have already gone into the methods of following trends in stocks, and\nthe use of the Top and Bottom Trendlines (Basic and Return Lines) as\nindicators of Bullish and Bearish opportunities, and as price determinants\nfor executing purchases or short sales.\nThere remains the tactical problem of the stock in which you are\ncommitted, which is acting badly, but which has neither broken out of a\nrecognized pattern nor violated an established Minor Peak. This is not a\ncommon situation, but it can present a very difficult problem when it does\ncome up. Let us say the Major Trend is Bullish, and a certain stock that has\nbeen moving up irregularly in a Parallel Trend Channel confirms its uptrend\nby a long, more or less continuous advance and calls for repurchase on the\nnext reaction. You buy on the reaction, and the stock continues down;\nnamely, the reaction continues with prices sagging for days and weeks,\nwithout any rallies, Consolidations, or Corrections that are sufficiently well-\ndefined to serve as Basing Points for stop orders.\nIn the absence of clear indications during the reaction, and also during the\npreceding large upward move, your stop would be placed at a computed\ndistance below the top of the preceding rise. Plus, if the reaction continues\ndown until that level is reached, you will have sustained an abnormally\nlarge loss.\nIn a case like this, you should examine the trendlines making up the long\nadvance in the Trend Channel. The points of contact with the Basic\nTrendline can serve as a fair emergency substitute for Minor Bottoms. Your\nstop level, therefore (in the absence of more definite Basing Points), should\nbe placed at the computed distance below the last point at which the stock\nmade contact with the bottom trendline and moved decisively up away from\nit. If a penetration and close below this point occurs without catching the\nstop, sell on tight progressive stops. (EN: The editor feels that such\nsituations should occur only in positionbuilding or pyramiding cases. Every\neffort should be made to join trends on breakout or origination, whatever\nthe source. There is no excuse for “chasing stocks” in the modern\nenvironment in which literally monitoring all stocks and instructing the\nsystem to alert one to the conditions attending breakouts is possible with a\ncomputer. EN9: On the other hand, human frailty being what it is, we will\nall find ourselves chasing a train at some time or other.)\nThe reverse of this rule would apply to the same type of situation in a Bear\nMarket, where stops for short sales would be placed at the computed\ndistance above the point at which the stock made contact with and fell away\nfrom the upper trendline.\nThe changes of angularity and direction in Intermediate trendlines are\nhelpful in showing the gradual turning of a Major Trend.\nTaylor & Francis\nTaylor & Francis Group\nhttp://taylorandfrancis.com\nchapter thirty-four\nA quick summation of tactical methods\nThere are three types of tactical operations: (1) getting into new\ncommitments; (2) getting out of commitments that have moved as expected\nand show a profit; and (3) getting out of commitments that have not moved\nas expected, whether the transaction shows a profit or a loss.\nThe principles of taking profits based on trends, Resistance and Support\nLevels, measuring implications of patterns, and most especially, on the\ndaily technical and volume action of the stock, already have been covered.\nThese profit-taking operations seldom present very difficult problems\nbecause the picture has developed normally and in the way you hoped and\nexpected it would. The “stepping off” point is usually easy to determine.\nThe more difficult problems arise in making new commitments correctly,\nand in the very important defensive operations of getting out of losing\ncommitments with the least possible loss.\nIt should be emphasized that a stock ceasing to act in a Bullish manner\nshould, therefore, be sold and is not necessarily a short sale on the next\nrally. In other words, the signal that shows weakness or failure of a move in\none trend is not always a signal to make new commitments on the opposite\nside of the market. More often than not, in fact, it is nothing of the kind.\nWe know certain moves, such as adverse breakouts from Symmetrical\nTriangles or Rectangles, advise us simultaneously to get out of\ncommitments in what is now clearly the “wrong” direction and to make\nnew commitments in the “right” direction. The simple failure of a trendline,\nhowever, where the stock merely penetrates an old Minor Bottom without\ncompleting a Head-and-Shoulders or other Reversal Pattern, although\nreason enough to get out of commitments that are showing losses, is not\nsufficiently conclusive by itself to justify reversing policy and making new\ncommitments in the opposite direction. Therefore we separate the two types\nof signals as follows:\nGet out of present commitments\n• On adverse breakout from Head-and-Shoulders Formation.\n• On adverse breakout from Symmetrical Triangle.\n• On adverse breakout from Rectangle.\n• On establishment of new Minor low or new Minor high in adverse\ndirection.\n• On adverse breakout from Diamond.\n• On adverse breakout from Wedge.\n• On One-Day Reversal if marked by heavy volume or a gap.\n• On adverse breakout from Flag or Pennant.\n• On clear penetration of any Resistance or Support Level in the adverse\ndirection.\n• On an adverse Breakaway Gap.\n• On the appearance of an Island after a move in the favorable direction.\n• On penetration of basic trendline in the absence of pattern or other\nfavorable criteria.\nNote: It is understood all breakouts must close in the breakout area. A\nclosing 3% beyond the Support, trend, or pattern is sufficient to give the", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 187}
{"text": "ny Resistance or Support Level in the adverse\ndirection.\n• On an adverse Breakaway Gap.\n• On the appearance of an Island after a move in the favorable direction.\n• On penetration of basic trendline in the absence of pattern or other\nfavorable criteria.\nNote: It is understood all breakouts must close in the breakout area. A\nclosing 3% beyond the Support, trend, or pattern is sufficient to give the\ndanger signal. All takeouts are performed by the use of 1/8-point\nprogressive stops.\nMake new commitments\n• In line with the Major Dow Trend, or to a limited extent in countertrend,\nmoves as insurance to reduce overall risk.\n• On breakout from Head-and-Shoulders Pattern.\n• On breakout from Symmetrical Triangle, provided it is not working into\nthe final third of its length toward the apex.\n• On breakout from Right-Angle Triangle.\n• On breakout from Rectangle, or (possibly) on points of contact, beginning\nwith the sixth Reversal.\n• On breakout from a Broadening Top.\n• On breakout from Double or Multiple Top or Bottom. (Namely breakout\nthrough the Bottom of the valley between Tops, or upside penetration of the\n“dome” between Bottoms.)\n• On breakout from Wedge, or (possibly) commitments within the Wedge in\nthe last third of its length as it approaches its apex.\n• On Flags and Pennants, after sufficient Secondary or Corrective Move by\nthe pattern, or (possibly) within the pattern, provided volume and all other\nindications tend strongly to confirm the pattern.\n• On clear penetration of a well-defined Support or Resistance Area.\n• On Breakaway Gap (possibly).\n• After formation of an important and well-defined Island following a\nconsiderable move.\n• On contact with, or penetration of, the “favorable” trendline if both\ntrendlines are moving in the Major Trend direction. (Blue Top Trendline in\na Bull Market, Red Bottom Trendline in a Bear Market.) Note: Breakouts\nand penetrations must show a closing in the breakout area and must\nconform to volume requirements. Breakout closings should conform to the\n3% rule.\nNew commitments (marked “possibly”) may be made in certain cases\nwithin some patterns: Rectangles, Wedges, Flags, and Pennants.\nExceptional care should be used in such cases.\nIt is extremely difficult to catch Breakaway Gaps; we would not\nrecommend this as a general practice. (EN: This is not so difficult as it was\nin Magee's time thanks to modern communications, computers, and access\nto the internet.)\nAll commitments, except those just noted, are made on the next following\nreaction or rally, to rules previously stated.\nAll commitments are protected by stops from the moment they are made.\nStops are moved, as conditions justify moving them, but always in the\nfavorable direction, never in the adverse direction.\nchapter thirty-five\nEffect of technical trading on market action\nThe question often is asked whether the very fact that traders are studying\nmethods and patterns tends to create those very patterns and trends—in\nother words, whether the technical method sets up, to some extent, an\nartificial market in which the market action is merely the reflection of chart\naction instead of the reverse.\nThis does not seem to be true. The charts we make today seem to follow the\nold patterns; the presumption is very strong that markets have followed\nthese patterns long before there were any technicians to chart them. The\ndifferences mentioned briefly in Section I, due to changed margin\nrequirements, restraining of manipulative practices, and so on, seem to have\nchanged these habits, if at all, only in degree and not in their fundamental\nnature.\nThe market is big, too big for any person, corporation, or combine to\ncontrol as a speculative unit. (EN9: And even beyond big in the twenty-first\ncentury. Gargantuan.) Its operation is extremely free and extremely\ndemocratic in the sense it represents the integration of the hopes and fears\nof many kinds of buyers and sellers. Not all are shortterm traders; there are\ninvestors, industrialists, employees of corporations, those who buy to keep,\nthose who buy to sell years later—all grades and types of buyers and\nsellers.\nWhat is more, not all short-term traders are technicians by any manner of\nmeans. There are those who trade on fundamentals for the short term, and\nthose who rely on tips, hunches, on reading the stars, or on personal\nknowledge of the company. They are all part of the competitive market and\nall use methods different from yours—and sometimes they will be right and\nyou will be wrong.\nThe technician using the various tools of technical analysis, Dow Theory,\nPoint-and-Figure charts, oscillators, scale order systems, and monthly,\nweekly, and daily charts is in the minority. The cold attempt to analyze a\nsituation on the basis of the market record alone does not appeal to many\npeople. Technical analysis leaves out the warmth and human interest of the\nboardroom, the trading room, the fascinating rumors of fat extra dividends\nto come, the whispered information on new patents, and the thrilling study\nof the quarterly earnings reports. (EN9: Unless I am mistaken the only\nappearance of irony in Magee's work.)\nIt is the influence of all these rumors, facts, and statistics that causes people\nto buy and sell their stocks. It is their actions that build the familiar chart\npatterns. You are not interested in why they are doing what they are doing.\nSo far as your trading is concerned, you are interested only in the results of\ntheir actions.\nThe habits and evaluative methods of people are deeply ingrained. The\nsame kinds of events produce the same kinds of emotional responses,\nhence, the same kinds of market action. These characteristic approaches are\nextremely durable. It is not quite true that “you can't change human nature,”\nbut it is true it is very difficult to change the perceptive habits of a lifetime.\nConsidering the “orthodox” investors greatly outnumber the technicians, we\nmay confidently assume technical trading will have little or no effect on the\ntypical behavior", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 188}
{"text": "the same kinds of market action. These characteristic approaches are\nextremely durable. It is not quite true that “you can't change human nature,”\nbut it is true it is very difficult to change the perceptive habits of a lifetime.\nConsidering the “orthodox” investors greatly outnumber the technicians, we\nmay confidently assume technical trading will have little or no effect on the\ntypical behavior of free markets.\n(EN: This statement by Magee is still true in principle and it should be\nnoted in modern markets professional investors attempt to learn (or\nperhaps it is “the mysterious and anomalous market”) what makes systems\nand other investors successful. They then take action to frustrate those\nmethods, which are inimical to their self-interest. For example, locals and\nprofessionals will search for stops above a congestion zone in an attempt to\ncause the market to break away. This might be in an attempt to create a\ntrend or it might be in an attempt to create a Bull trap.\nThe proliferation of systems trend traders in the futures markets has, some\nof those traders feel, created conditions hostile to systems traders as a\ngroup. The moral of the story is the trader-investor must be ever alert for\nthe false move and the changing rhythm of the markets.\nNo one has been able to quantify chart analysis or to disguise his own\nactivities from the x-ray of the charts. Nor has anyone changed human\nnature to eliminate treachery and perfidy and truculent defense of self-\ninterest.)\n(EN9: And—dramatic drum roll—in 2005, Smith-Barney fires its entire\ntechnical analysis staff. What to make of this is left to the imagination of the\nreader. Some commentators attribute it to the Bearish outlook of the\ntechnical staff as opposed to the need of the firm to sell long positions to its\ncustomers. In my view, an unintended validation of the craft. When you\nhave to shoot the messenger, it says something about the state of the market,\nas well as something about the industry.\nAlso, in conversation at a meeting of the Technical Securities Analysts\nAssociation of San Francisco (http://www.tsaasf.org), Larry Williams said,\n“I hate technical analysis.” I am reasonably certain the “technical\nanalysis” referred to is number-driven analysis.)\nchapter thirty-six\nAutomated trendline: the\nMoving Average\nIn 1941, we were still filled with starry-eyed ignorance and felt if only we worked hard enough and lookedshrewdly enough, we would discover the sure, unbeatable formula or system that would solve all our problems inthe stock market, and all we would have to do for the rest of life was apply the magic and telegraph our brokerperiodically from Nassau, or Tahiti, or Switzerland, or wherever we happened to be enjoying life at the time.\nWe have learned (we hope) quite a bit since then. We have learned most particularly a number of things not to doand by not repeating the same errors over and over, we have been able to improve our performance substantially.We have also learned (to date) (EN: still true in the twenty-first century) there are no sure, unbeatable formulas orsystems in the market, even the most useful and generally dependable forecasting methods must be regarded asstatements of probability only, subject to revision and vulnerable to failure at all times.\nOne of the useful tools, and one of the first many students of market action adopt, is the trendline. Whether a stockis moving generally up or down or sideways, there seems to be a tendency for the Major Trend to persist. It is trueevery trend is broken sooner or later, and the fact that it has been broken is often significant. But given a well-established trend, the probabilities certainly appear to favor its continuance rather than its Reversal.\nAs with all other market studies, however, there are times and conditions in which the simple trendline actionseems “not quite good enough.” One feels there should be some mechanical or mathematical way of determiningthe trend that might avoid some of the perplexities of choosing the right point through which to draw a trendline. Itwas back in 1941 when we delightedly made the discovery (although many others had made it before) that byaveraging the data for a stated number of days, weeks, or months, one could derive a sort of Automated Trendlinethat would definitely interpret the changes of trend over the past 30 days, or 200 days, or 12 months, or whateverperiod was chosen. It seemed almost too good to be true. As a matter of fact, it was too good to be true.\nThe Moving Average is a fascinating tool and has real value in showing the trend of an irregular series of figures(like a fluctuating market) more clearly. It also has value in the fact it can be used to cancel out the effect of anyregular cyclical variation, such as a normal seasonal range of temperatures, to get a better picture of the truesecular trend.\nThe trouble with a Moving Average (which we discovered long since but keep bumping into from time to time) isit cannot entirely escape from its past. The smoother the curve (longer cycle) one has, the more “inhibited” it is inresponding to recent important changes of trend. Plus, there is a very bad fault of Moving Averages in that “the tailtends to wag the dog”; the figures back to the first date of the current tabulation, perhaps six months ago, or a yearago, if they are large, may unduly affect the present average, and may conceal or mask some important feature bydistorting the curve. We feel the Moving Averages trendlines are useful, but they should be understood and usedwith discretion and with a full perception of their limitations.\nAfter going through some of the caveats of Moving Averages, let us give you some of the ways to construct them.Moving Averages can be classified as Simple Moving Averages, Weighted or Exponential Moving Averages, andLinear Moving Averages. We have found over the years, and prefer, the simple methods that work just as well andsometimes better than the more complicated Moving Averages,", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 189}
{"text": "limitations.\nAfter going through some of the caveats of Moving Averages, let us give you some of the ways to construct them.Moving Averages can be classified as Simple Moving Averages, Weighted or Exponential Moving Averages, andLinear Moving Averages. We have found over the years, and prefer, the simple methods that work just as well andsometimes better than the more complicated Moving Averages, while the others are more useful when usingcomputers.\nFor this reason, we will concentrate on Simple Moving Averages. The most common are the 50-day and the 200-day Moving Averages. If you want to increase the sensitivity of a Moving Average, shorten the Moving Average byusing 10 or 20 days. Another way is to increase the lead time by starting on the third day for the 10-day MovingAverage, or on the 20th day for a 50-day Moving Average, and so on.\nTo construct a Simple Moving Average, whether it is 5 days, 10 days, 50 days, or 200 days, add the price of 5 daysand divide by 5, or the 10 days and divide by 10, or the 50 days and divide by 50, or 200 days and divide by 200. Asimple way of doing the five-day Moving Average, instead of adding all five prices each time, is to drop day one\nand add day six. A similar method can be used in calculating the 50-day Moving Average or the 200-day MovingAverage. Instead of adding the 50-day Moving Average each time, just drop the first day of the previous averageand add the 51st day. The same with the 200-day Moving Average; drop the first day of the previous 200 and addthe 201st day. Another way of calculating the 200-day Moving Average is to take one day of the week of 30 weeks,such as Wednesday or Thursday, add them, and divide by 30. This will give you the same Moving Averages as youwould have doing 200. Another way to put it is, on the second day, take the total, add the new day's price, andsubtract the oldest day's price from your 5-day, 10-day, 50-day, or 200-day Moving Average, whichever way youare doing it. Repeat the process on a daily basis and divide by the representative day—for the 5 day, you woulddivide by 5; for the 10 day, you would divide by 10; for the 50 day, divide by 50; and for the 200 day, you woulddivide by 200.\nSensitizing Moving Averages\nThe shorter the time period, the greater the sensitivity you will develop in your Moving Average. The 5-dayMoving Average will be much more sensitive than a 10-day. The problem with short-term Moving Averages is youcan have a greater number of false moves. Shorter Moving Averages are more suitable for commodities. Oncommodities, we would even advise using a 30-hour, a three-day, and a six-day Moving Average.\nIt is often better to use two Moving Averages, one of shorter duration and one of longer duration. In addition, youcan use channels, a Moving Average of lows and a Moving Average of highs. (EN10: In the markets of the 2000s,the most watched Moving Averages are the 50-day and the 200-day. In fact, these two have gained almost iconicstatus.)\nCrossovers and penetrations\nAs a general rule, consider the crossing of two lines (EN10: as 50 and 200) by the price line as a sell or buy signalin the direction of the crossover or penetration.\n1. Uptrends—Long positions are retained as long as the price trend remains above the Moving Average Line.\na. When the price line intersects or penetrates the Moving Average Line on the upside, it activates a buysignal.\nb. When the price line goes above the 200-day Moving Average, but falls sharply toward it withoutpenetration, it is a possible buy signal. Additionally, conditions at the time must be closely observed.\nc. When the price line falls below the Moving Average Line while the line is still rising, it could be a buysignal.\nd. When the price line spikes down too fast and far below a declining Moving Average Line, a short-termrebound toward the line may be expected: a possible whipsaw trap.\n2. Downtrends—Short positions are held as long as the price trend remains below the Moving Average. Whenthe price trend reaches a bottom and turns upward, a penetration of the Moving Average is a possible buysignal.\na. When the price line moves above the average line while the average line is still falling, it is a sell signal.\nb. When the stock price line moves below the average line and rises toward it, but fails to penetrate andbreaks down again, it is a possible sell signal.\nc. If the price line rises too fast above the rising average line, a short-term reaction may be expected: could bea whipsaw.\nd. Occasionally, penetration of the Moving Average Line will occur in close conjunction with the penetrationof a trendline, and then according to its direction, it is a buy or sell signal.\n3. Horizontal, Diagonal, or Sideways Movements—If the fluctuations are broad in comparison to the lengthof the Moving Averages being used, the price trend will fluctuate back and forth as the Moving Average, trueto its character or purpose, moves horizontally. The trader must be alert to the need to change tactics.\n4. Gaps—Moving Averages, depending on their length, may have a tendency to be penetrated in proximity toa Breakaway Gap, particularly at the beginning of a Major Phase of an Intermediate cycle, and also in suchcases in which Breakaway Gaps occur at the beginning of correction phases.\nArea Patterns can be a pitfall for the Moving Averages. Normally, the Moving Average oscillates through thecenter of these areas, producing buy and sell signals in rapid succession. In Area Patterns, the Moving Average is aheadache to the trader because he never knows which penetration is the one preceding either the renewal of thetrend or the Confirmation of a Reversal.\nWhen trading areas develop in the form of Triangles—Descending, Declining, or Symmetrical—the MovingAverage will trend through the center of the Triangle. The technician has some small advantage in judging whichof the series of penetrations of a Moving Average is the important one. When the Triangle reaches its apex and thestock breaks ou", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 190}
{"text": "the renewal of thetrend or the Confirmation of a Reversal.\nWhen trading areas develop in the form of Triangles—Descending, Declining, or Symmetrical—the MovingAverage will trend through the center of the Triangle. The technician has some small advantage in judging whichof the series of penetrations of a Moving Average is the important one. When the Triangle reaches its apex and thestock breaks out in one direction or another and penetrates the Moving Average, the penetration is likely to be themost important one during the sideways movement of the Triangle's development. Penetrations occur many timesin close conjunction with the penetration of a trendline.\nAs a price derivative product, the Moving Average can be a trend indicator by the way it fits a trendline.Nevertheless, it should be considered an adjunctive tool to everything else you have learned in relation to technicalanalysis.\n(EN10: Magee had, and I have, an instinctive aversion to mechanical systems. We want to see and feel the analysisand the moment and consider the context and the subtle variables. A mechanical system of any type—and aMoving Average system is not bad in broadly trending markets—is blind. It will throw your capital in front of anon-rushing train and merrily hum along while the\nFigure 36.1 150-day Moving Average (dotted line). Up to the 1980s (the period during which Ronald Reagantripled the national debt) trading the 150-day Moving Average (buying on an up crossover and selling on a downcrossover) gave a trader somewhat the same advantage that trading the Dow Theory afforded. In the 1980s, thesystem stopped working. Here in 1929 it would have been a lifesaver, as can be seen. Not illustrated here is whatthe Moving Average does in a Dow Line, or rectangle or congestion pattern. If taking signals on crossovers onecould find his capital ground to hamburger meat.\nmarket is eating your lunch. I have called these “unnatural” systems—they interpose an algorithm between thetrader and the facts. This reduces decision-making stress but can go badly awry in some types of markets.)\nA 150-day Moving Average is charted in Figure 36.1.\nThe PENTAD Moving Average system from Formula Research\nOne of the solid and prestigious technical research firms in the country is Ned Davis Research, Inc. (NDR). NelsonFreeburg of Formula Research has taken one of NDR's systems and tweaked it to yield what may be an effectivelong-range approach to the market. It is presented here because Magee was interested in Moving Average systems,as well as investors who are graphically challenged, meaning they can relate to numbers but not to pictures.\nFreeburg took an NDR Moving Average system and a 20-week Moving Average, added a filter, and produced asystem that reportedly has an 80% profitability on signals and generated returns in the 15% range going back to1942. Since 1980, returns averaged 19%. We all know (or the reader can quickly demonstrate to himself with asoftware package) that a Moving Average tends to create whipsaws in a sideways market. As the market movessideways, the Moving Average moves through the pattern creating buy and sell\n490-i S&P 600 and 20-Week MA: / r490\n485 -iS&P 500 Close Unfiltered Signals / v 4 485\n480 -i\n475-;\n470 -i\n\\rA\n/ k‘ A*\nI »\n1 \\ A / •\n/ vA K / •\n■480\n■475\n■470\n465 -\n460\n455 -\n• • . •\n\\ ./X 4 A J\nX \\ A*/ \\ —. J • *\nF Vt \\ / *\n*• • •* V\\ /\n■465\n•460\n-455\n450- ■450\n445 ■ t = Buy, S&P 500 Crosses Above 20-Wk MA■445\n440 + = Sell, S&P 500 Crosses Below 20-Wk MA■440\n490\"t Buy, S&P 500 Crosses 1% Above 20-Wk MA\nFiltered Signals . /\n■490\n485* Sell, S&P 500 Crosses 1% Below 20-Wk MA ■485\n480- ■480\n475 -475\n470- 20-Wk MA+1% [ V\\ j y -470\n465 • r 465\n460-i 7\\ I* j-460\n455 r\n450- 20-Wk MA-1% 1\n-455\n- 450\n445 -i j-445\n440- ■-440\n1 1 ' 1\n(Nov| Dec | 94 [Feb |Mar|Apr |May| Jun | Ju. ’Aug | Sep (Oct ]Nov| Dec ] 95 | Feb ] Mar\nFigure 36.2 Looking at the top chart, we can see the deleterious effects of using a Moving Average system in asideways market. Of course, at the end in January 1995, the system gets ready to cash in big time. You will nevermiss a big market with a Moving Average system—if you have any capital left after the whipsaws. Yet when a 1%filter is added, the number of trades is dramatically reduced and the accuracy improved. Something systems tradersnever think of is a qualitative filter—looking at the context when price crosses the average. What is the volumeand what is the price action? Also, the trader can experiment with different-size filters and filtering conditions.\nsignals as price oscillates about it. In a common-sense move, Freeburg added a filter to the system thatimmeasurably improved it. Readers should be aware we include this method because experience tells us this kindof system can be effective, but we have not validated the research. Also, any system including the 1990s isguaranteed to have good, if not spectacular, results. Diagrams illustrating the idea are shown in Figure 36.2.\nTaylor & Francis\nTaylor & Francis Group\nhttp://taylorandfrancis.com\nchapter thirty-seven\nThe same old patterns\nTo the newcomer, the market appears filled with wonders and mysteries as the landscape of Mars will appear to thefirst space travelers to land there. There are strange rumblings, apparently unexplainable upheavals, weird growths.An unknown stock will suddenly emerge from a morass of debt and deficit and proceed to soar to great heights. Anold and trusted issue will paradoxically sag and droop, although apparently rooted in the soil of economic stability.All will seem peaceful and secure, and, suddenly, the ground opens up and swallows values in a sensational marketbreak. (For illustrations in this chapter, see Figures 37.1 through 37.54.)\nSuch a newcomer, perhaps not realizing what appears unusual and alarming is only the normal fluctuation andadjustment that goes on continually in the market according to the changing evaluations of millions of investors,will feel frightened, insecure, and indecisive. He may scur", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 191}
{"text": "p and swallows values in a sensational marketbreak. (For illustrations in this chapter, see Figures 37.1 through 37.54.)\nSuch a newcomer, perhaps not realizing what appears unusual and alarming is only the normal fluctuation andadjustment that goes on continually in the market according to the changing evaluations of millions of investors,will feel frightened, insecure, and indecisive. He may scurry from boardroom to boardroom, personally or on thetelephone, scan the financial pages, talk with friends, accumulate a mass of conflicting information, and end upshutting his eyes and making a blind stab in the hope he may come up with the right answer.\nSome never, even after years of contact with the market, achieve a tranquil and assured approach.\nHowever, it is possible to learn something about the basic nature of stock trends. It is possible to know, withinreasonable limits, about what might be expected in certain situations. It is also possible to find ways of coping withthese situations, including the exceptional cases that persist in doing the unexpected. To repeat: it is possible todeal successfully with the unexpected and with what cannot be precisely predicted.\nTo put it another way, it is possible to be wrong part of the time and still to be successful on the balance. To dothis, it is only necessary to have a background of experience sufficient to know what will usually happen underparticular conditions, about how often the unexpected will occur, and how to deal with the unexpected when itdoes happen. These are the same general problems that would confront the space traveler, the chemist, thephysician, or almost anyone else in his daily affairs.\nThere are men who have observed the market long enough and carefully enough to discover there are not quite somany unexpected events as the newcomer might be led to believe.\nThe charts in this book are, in the main, the same as those used for examples in the first edition in 1947. Some ofthem show situations from 1928 and 1929, others from the 1930s and 1940s. (EN: And still others from the 1980s,1990s, and 2000s.) The reader can hardly overlook the similarities that occur in various stocks at different timesduring corresponding phases of their trends or turning points.\nWe have said that these same patterns, trends, and Support/Resistance phenomena repeat themselves over and overagain, and that they may be observed by anyone in his own current charts for any period of time, in any normallyactive stocks, and on any exchange or market.\nBy way of demonstration, there were included in this chapter of the fifth edition a number of typical technicalexamples, similar to those already discussed, but taken from\nFigure 37.1 A 1952 Major Head-and-Shoulders Top in U.S. Smelting, Refining and Mining. This stock had movedup from a bottom at 33 in 1950 to the peak at nearly 88 shown here. The decline carried down to 37. This chartshows the typical high volume on the left shoulder. The volume at the head is a little higher than in the “ideal”pattern. Light volume on the right shoulder is a definite warning. Notice the Pullback Rally to the neckline in thelast week of August. Also, the Secondary Recovery in November and December. There also appears, at the left sideof this chart in 1951, a beautiful example of an Ascending Triangle, indicating the resumption of the previousinterrupted advance.\nthe period 1947-1966. (EN: The eighth edition includes examples taken up through the turn of the millennium.) Itwould be possible to include ten times the number of good examples, for almost every situation that has beenpreviously illustrated has appeared again and again in recent years.\nNot all the same\nAlthough a majority of stocks will participate in a big market trend, they will not all move at the same time or tothe same degree. Some will move quite independently and contrary to the Averages. There was a “boom” in the1920s and there was a Panic in October 1929, but these are inadequate statements, half-truths if you will, and canbe very misleading if they are swallowed whole. A technician, following the individual behavior of stocks, wouldhave been able, through a balanced and diversified portfolio, to protect himself against irreparable loss.\nThe facts are that of 676 stocks we have studied through the period 1924-1935, only 184 made a Bull Market Topin August-September-October 1929 and suffered Major Declines in October and November of that year. Therewere 262 stocks actually in Major Downtrends before the year 1929. Another 181 stocks made their Bull MarketTops in the first nine months of the year and were already moving down before the end of the summer. Five stocksdid not start their decline until after 1929 and 44 stocks continued to make new highs after 1929. In Figures 37.9through 37.11, there are three stocks showing very different trends during the years 1927-1930.\nFigure 37.2 Downtrends seldom show the perfect and regular trendlines we often see in uptrends, but in spite ofthe irregular, ragged rallies and spotty volume action, the basic principles are about the same as for advances.Notice in this six-month period, Inspiration Copper had no rally that carried above the Top of a preceding rally. Awell-marked downtrend of this sort must be presumed to continue until there is a marked change in the pattern andvolume action. Notice the volume on the day “IC” broke the historically important 52 level, and subsequent action.\n\nFigure 37.3 Part of the Major Advance in Granite City Steel. Here we see the familiar phenomenon of Support andResistance in almost every move through the period shown.\nThe August-September Rectangle held for six weeks between the top limit of 47, which was reached on threeoccasions, and the bottom at 44. Like most Rectangles, it was marked by heavy volume at the start on July 19, andgradually declining volume as the pattern progressed. The breakout move on August 29 was on enormous volume.\nAfter this breakout, there was a typical Flag-l", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 192}
{"text": "through the period shown.\nThe August-September Rectangle held for six weeks between the top limit of 47, which was reached on threeoccasions, and the bottom at 44. Like most Rectangles, it was marked by heavy volume at the start on July 19, andgradually declining volume as the pattern progressed. The breakout move on August 29 was on enormous volume.\nAfter this breakout, there was a typical Flag-like reaction on sharply diminished volume, and although this movepenetrated the top border of the Rectangle, the penetration was not decisive or significant, and the lower borderwas never violated. Now, see how volume appears on October 15 as the old high is reached, and again at the top ofthe move on November 14. The decline returns to the level of the September high on a low-volume reaction. It isinteresting how, on five occasions in this chart, the 52 level served as a Support or Resistance point: twice asResistance on the way up, and three times after the new October high, as Support.\nOn the next rise, we see almost the same type of advance. In this case, the Support-Resistance Level is about 57.Notice the approach to the critical level, the backing away, the aggressive move into new high ground (in mid-December), and the recession to the Support at 57.\nAdvances of this sort seem to represent the ebb and flow of the Minor Moves during a Major Trend when there areno great “news developments” to change the normal progress of the trend. Where there are frequent and importantchanges in the market or in news affecting the industry, we may see long Consolidations or Secondary Reactions,but the Major Trend is durable. We must not assume a Major Reversal prematurely.\n48\n44\n40\n38\n36\n34\n32\n30\n28 Sales 100's 125 100\n75\n50\n25\nJULY AUGUST SEPTEMBER OCTOBER NOVEMBER DECEMBER\nTT ■ ■ ■ 1!! ; : TH ;48 i fH\n••■•Itill!\n:::::\ntainlllll\n::::::\n::::: 7\n:w\nB Tim .. ■ ■ ■f tt\n3\n::\nr*\n::Hill\ni m\nw\nnrn O\nmi i T jji t tr 1 ffffff H\n' *tTirt .f;:: : Iff \"•ffi\n• \nt \n■\n.... y ::\n111\nif\nyHt\n®i°\nW Q\niND 50inr.r;lND4%STOCKtarn*\n.....i\nSEE\nHWuul\n*’J1 ::\n11\nllllllllll\n!!iljiijiiii.i\n: :• i::::\n: :::\n: :::iiniiii\ni:\n1:\nmi mi\n■ inIIIXI4 EEEE\nWE H H\n:::\n1 1\n1 1\n• ■\n5 E\n:\nE\nmin\n......\n••MM\nEEEEEE\n::: j\nS:\n: :\nEEE::\n::::: ::: : SI? ii|*H\n•\n::::::: 5\n::::: wl- w 4ltn - H-l mi■Ffll: \nHn5?fl HHi\n:::: |\n.H::-'\nr Ift :,;g| I s ii :I4iIn :1i wiffi :::: ::m\n& Hr SS J im i ::::\nml B r :nn JlHiiii t t \ni k KA\nASON\n..... < HTE\nM\nvINC\n:: 4\nL956\nHl\n►int \n: ::\n, ,■\n•«•■<\ni ii\n.......\n:■ ■a\n1 T r 1 II 1 1 1 1mil III11111111111\n.\nhi I L i kill1 JillLI LUJ111LklinkUlLuiiiiiiiii\nFigure 37.4 During the same period that Granite City Steel was making the series of steps upward, as shown inFigure 37.3, Masonite was doing almost the same thing in reverse.\nTo have continued to hope for a change in trend with a stock that was acting as “MNC” did through the latter partof 1956 would have required an unusual amount of optimism or innocence about the habits of stocks. Actually,there would be good reason for optimism if the stock had been sold short early in the trend.\nThis is almost a perfect counterpart to the “GRC” chart. We have not only a series of declines with rallies that failto establish even Minor highs above the previous Tops, but we are also able to draw a trendline with a number ofpoints of contact on the way down, which is somewhat unusual in a downtrending situation. Notice the tendency ofthe rallies to stop short at the level of previous bottoms in a series of Support-Resistance Levels. We see suchaction at 44, at 41, at 38, and at 36.\nWe would certainly not consider the breaking of the trendline on the upside in late December as evidence of aReversal. Such a break after a trend of this sort probably means no more than a Secondary Recovery. To be ofgreater significance, it would certainly call for some volume showing, which was utterly lacking here, and beforewe would consider the stock again strong enough to buy, there would have to be some sort of Reversal Pattern. Afaltering rally back to around 40 would, in fact, suggest the advisability of further short sales.\nDELAWARE, LACKAWANNA AND WESTERN\n11\nSales\n100's\n125\n100\n75\n50\n25\nSEPTEMBER OCTOBER\nNOVEMBER DECEMBER\nJANUARY FEBRUARY\nFigure 37.5 Very often you will hear the question, “But how can you tell whether a technical formation or abreakout is valid?” In many cases, and in a great majority of upside patterns, the volume gives such a decisiveanswer that all doubts are removed. Not always is the volume confirmation as clear as in this chart of Delaware,\nLackawanna and Western, but this is typical of a good many breakouts in uptrends. You will see the volume wasgenerally light during the Rectangle, in which we see five plainly marked Tops and Bottoms.\nOn Thursday, November 4, the volume increased sharply as the price moved up to the top of the Rectangle andclosed at that point. The following day, Friday, we see good volume again with a close beyond the top border.From this point on, the move is obviously upward.\nThere was no indication of Reversal at any time after the breakout. A Top was reached in March at 25 1/2.\nThis was an especially vigorous move as it came out of the Rectangle. Normally, we would look for MinorSetbacks such as the series of reactions in “GRC,” Figure 37.3. If these had occurred, it would in no way haveweakened the Bullish Pattern.\n22\n20\n19\n18\n17\n16\n15\n14\n13\n12\n11 Sales 100's\n250\n200\n150\n100\n50\nFigure 37.6 The situation, somewhat similar to “DL” in Figure 37.5, presents a little complication. The problemwould have been whether to sell or continue to hold “LA” after the late October break down through the Bottom ofthe Rectangle. There was no important volume on this drift move, and on only one day did the price close barely3% below the bottom of the pattern. A holder of the stock might well have sold it, might even have executed ashort sale.\nSuppose now, you had actually sold the stock short; observe the volume and the price action on Thursday,November 4, and Friday, No", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 193}
{"text": "tober break down through the Bottom ofthe Rectangle. There was no important volume on this drift move, and on only one day did the price close barely3% below the bottom of the pattern. A holder of the stock might well have sold it, might even have executed ashort sale.\nSuppose now, you had actually sold the stock short; observe the volume and the price action on Thursday,November 4, and Friday, November 5. Notice the volume and the price on the following Monday and Tuesday as itreacted slightly. Then see the quick pick up in volume as the price advanced on Wednesday, the week and a half ofdull Consolidation, and the larger volume on the move up on Friday. Surely by the middle of the first week ofDecember, if not before, you would have seen the danger signals and closed out your short.\nSuch a turnabout does not need to be a tragedy nor even a discouragement. Some easily discouraged traders wouldbe so concerned about the small loss realized on their unsuccessful short sale they would not be ready to seize theopportunity to reverse position and buy the stock after the strong up signals. This move carried to 26 3/4 in March1955.\n52\n48\n44\n40\n38\n36\n34\n32\n30\n28\n26\n24\n22\nSales\n100's\n250\n200\n150\n100\n50\nsi 1 ftftt ::::: :iff BBintFii liil iff\n■ ■ II § : :: ••••iff ii ttft t ft f fttftft ni 1 ii ittHtiftftgftfftt: 11 :: ::Hh H•\nW- T A MCTTCTA/FTTA T T T TDAZTr’A T LNTTft Lt fit f 11 ft ft tftft tftt .. .iff\nFAN S TEEL M META ALLURGI AL F 1NLff:: JfffffftfffS .. ..lift\n:: !!!!! IIlllll\nII Illi*\n...... :::::\nI\n: :: :\n|: i i\nn;::::innnnin\ng: -tffffOff 5:it\nIff ' *1\nII Kit* IIllltl iiiiiiiiiinliniliiiiii 1:1: I' i 111 tffiigLA g:::::}ggggtg{g•\nii mu IInut II lllll■I lllll iiinn\nIM.11\nlinn\niiitn■ffl\n1\n........\nu tt U 1I ::\n;:::::\n...... tttjSt lilt ft ft 1ft' T ft ■ ■ ftIt t B:\nII.....Illi\nH MH MM m :nu\nI::::::::::::::::::::: 'Hii\nJR\n1R\nIRHIM:::Illi : :: : ft :\n0 nd:::::\nH-n;-:\n-- - -\nS 4 H ♦tmt;\n::::::::::: H::| Ii ::::! : ••1 im lu:: u\nj:. mi\nHI\nis\n::::\n:::L\n-■*\n11- -\n•\n■\n1\nft ft : ::ft : 4; u.: Ji ii * j\n1 4ft\n.■::\nI g! Hi ii ' ■ '|i|H iiilliiljft i’HiiiS&i4; iiSShtti\nll L W R::: si ii ii;:::::::: :::: Hffg\niggae\nIff Iffi\n;; •; j !\nJ\n■K\nfS\n•r :: B-fr-n ttmW\n;; 1\nsmHSffls .....\n::: ■........\n■ iiiiitPw 4$inniii mfrffl It lllll 1L1 nt 11+41 IUL1+11+ 4h iB•••••4-4\n::::::::\n1 <(l 1 III\n1 III 1 III\n:|i\n:::::\n3mfftfeIffiff\n1955 - 19561 III 1 III1 III 1 III iittt HHHfftflffft* ft I* tttft ftrr tftftftp t\nfttftffttfftfttft\nft fttftft tt tftfttuti •tftft\nIII 1\nIII 1\nIII 1\nIII 1\nIII 1\nIII 1\nIII 1\n■ 1 1 1\nmill::::::\n■■■IIImin 1Illi\nmin\n:: ::\n::\nm 11\nIff\n: :::::U\nL H ftift.ttft, L\n4ft ft + ■ ttt ■ ■ftftt iftft jffiW +\n:: | :\n'■■■:\nIII 1\nIII 1\nIII 1\nIII I\nIMtt nt i tttft ft*ititii t\n1 w ffl :\n4- ITT . .. ........ ffjggslSmi :::::\nT s r 1 1 if\niimini\nlilllll[ TJ IBS i■'liii\nu\nII\nHI\nlilllll\nmffi\nIt\n.111\nF ' M ‘ A ’ M ' J ’A ' S 1 O ' N ‘ D 1 J 1 F 1 M 1 “A“'TM-' J L\nFigure 37.7 Bottoms normally take longer to complete than Tops. That is one reason we have this chart of Fansteelon a weekly basis, so that a year and a half of the action can be shown. The pattern shown at the left is aConsolidation formed after a rise from the 1953-1954 Multiple Bottoms around 21. The top of the AscendingTriangle corresponds roughly with the April 1953 peak.\nAt the time this Triangle started, in early 1955, it was not possible to identify it as such—particularly since theFebruary high ran a little higher than the horizontal Tops that eventually formed. However, during the sevenmonths preceding the first breakout move, it became increasingly clear each rally to the neighborhood of 32 1/2was followed by a reaction on low volume, and these reactions were forming a series of Rising Bottoms.\nIn the first week of September we see a clean penetration upside, and from here on, the advances and declines fitinto the typical pattern of a Major Advance. Notice the Breakaway Gap in November and the low volumethroughout the December-January-February reaction.\n14 Sales 100's\n125\n100\n75\n50\n25\n:::::|| || $ BHHH2ma::::: .....\n:;:!: ::::: ::::::::: ■| W Esffi i\nkii ...» TnttHft+1 +i+ 4+ :HH Hr r*4 0 •\n■>]\nHIH\nInjS: O*Htt ii 1:tin* Lrt*14■ B ; iV P-\n—\nilS\n— :::::\nI ■ •(III: :s::\n. MillI\nrr4 ftft ■ 30 Libi > n ill HPtill n it! !:::::::::::::ai:::s\nB jtt H?ra ffl •ran “4* H>:1*II Mir '\n:n ™ iilB T p nt\nS' Soli innb Si ■ iiiiii\n::::::::::::: s#;1HHi s HH: m iiiiii\nli\n:HTr\nW SI rfeiS\n:-l i\nit« f\n:: ':': :\nuwO ijrsf*ffiH£T iSi: T\nX:::::::::!:::: fflgggmgsxiiiulHRx stiff Hl £ |Pl\nT ::::::iniinn4ftt ini s n t|fn\nSi ...syas\n:: : ii :::::u i ::::::::::::::::::\n®£fe aa :::::xHttI T :\niil IO TEXTRONTXT ||i 1956-1957 1\n: if\n::::::::::::::::: w i :::::fttr :\nT F K R lira ama S H F ffe:\nI......ORI ni .11\nII 1 \"\nJ iiulLlliiilLlilJiLill111 jl lift Llilt1111 11 Hill111\nT\n2 1\nAUGUST SEPTEMBER OCTOBER NOVEMBER DECEMBER JANUARY\n11 18 25 1 8 15 ’22 ’2^ 6 13 20 27' 3 10-17 24 1 '8 15 22 29 5 ' 12 19\nFigure 37.8 Here, in a daily chart, we see once again the dramatic sequel to a Descending Triangle. Here is thetypical series of declining Tops on rather low volume with retreats between the rallies to a horizontal line.\nNotice the important Support here was violated with heavy volume on Friday, January 25. Although the degree ofpenetration was not great, in view of the generally Bearish reaction to this point we would sell at once. ADescending Triangle has Bearish implications even before the breakout. There was no substantial Pullback afterthe breakout. Since it is not possible to count on such a recovery after a break through Support, it is safest to selllong holdings immediately or to place a very near stop on them as soon as a close outside pattern occurs (in thiscase, outside the pattern as adjusted for ex-dividend).\nNotice the pickup of volume as the price drops into a tailspin at the end of January. Heavy volume is notnecessarily a feature of important downside moves, but it may, and often does, accompany them, and when it does,it simply underscores the significance of the", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 194}
{"text": "place a very near stop on them as soon as a close outside pattern occurs (in thiscase, outside the pattern as adjusted for ex-dividend).\nNotice the pickup of volume as the price drops into a tailspin at the end of January. Heavy volume is notnecessarily a feature of important downside moves, but it may, and often does, accompany them, and when it does,it simply underscores the significance of the move.\nQuestion: does Textron look like a “bargain” to you at the end of January on this chart? Would you be tempted tobuy this stock because “it can't go down any more,” or because it is “due for a rally,” or because it is “sellingbelow its true value”?\nSuppose “TXT” did have a technical rally, which seems quite likely after the move shown. How far would youlook for it to go? Would you expect it to penetrate the 20 level in the near future? Would you call this a BullishSituation at the end of January 1957?\nLIBBY, McNEILL\nAND LIBBY\n1927 1928 1929 1930\n\nFigure 37.9 (a) Libby, McNeill and Libby showed no serious effects at the time of the October 1929 panic, andwent on to new highs in March and April 1930. (b) Chrysler, one of the great market leaders, made its Bull MarketTop in 1928, more than a year before the Panic, and had already lost 60% of its value before October 1929. (c)Eagle-Picher Lead never enjoyed any Bull Market at all. Aside from an unimpressive rally in 1928, it was in adowntrend all the way.\nThe examples given are not rare exceptions; there are many others involving important stocks that did not followthe pattern set by the Averages. This variety of behavior is typical of the market. It is to be seen today. They are not“all the same,” and each stock must be studied individually. In Figure 37.10, there are a few examples showingdisparate action during the years 1953-1956. There are hundreds of others that would illustrate the point equallywell.\n(a)\n50\n40\n30\n20\n750\n500\n250\nSales\n100's\n\nFigure 37.10 (a) West Indies Sugar broke out of its “Scalloping” Pattern in late 1956 to make its own Bull Marketat a time when action in the Averages was apathetic and generally weak. (b) Although the Averages continued tomake new highs through the spring of 1956, Westinghouse Electric made its top and went into a Major Declinemore than a year earlier. (c) Here is a companion piece to Eagle-Picher's chart of more than 25 years ago, shownabove it. Kresge, like a number of other “blue chips,” did not participate in the Bull Market Moves of 1953-1956.\nThese six charts were adapted from “Graphic Stocks” (F.W. Stephens, New York). The 1927-1930 charts are froma Special Edition covering nearly 700 stocks through the period 1924-1935. The 1953-1956 charts are from a lateredition of “Graphic Stocks.”\n38\n36\n34\n32\n30\n28\n26\n24\n22\n20\n19\n18 Sales 100's\n250\n200\n150\n100\n50\nNORTHROP AIRCRAFT\nNOC\nDECEMBER\n' 4 ;11 18 25\nJ ANUARY FEB R UARY MAR CH\n4 41 18 2^ 1 8 45 22 2^ 5 12 19 26 5 12 19 26 2 9 16 23 30 7 14 21 28 ’\nFigure 37.11 A beautiful Top Formation in Northrop Aircraft, 1954-1955. The move, which ended here at 39 3/4 inJanuary 1955, emerged from a Bottom in 1953 at 6 1/4.\nThe Descending Triangle is marked by rather unusual volume at the peaks of rallies in February and March.Otherwise it is typical of this sort of Reversal Pattern. As so frequently happens, there was a Pullback effort afterthe March 14 breakout, but this rally lasted only two days.\nYou will notice the volume on the breakout and throughout the downside move was not so spectacularly heavy, notnearly as heavy, in fact, as on the Minor Rallies within the Triangle. As pointed out previously, however, we do notneed or expect so much volume on a decline as we look for in an advance.\nVolume did not develop until the end of the first stage of the decline. It is quite usual for heavy volume to show upat the end of a Minor Move whether on the upside or the downside.\nNotice the Flag formed on the subsequent rally in mid-April. The measuring implications of this Flag wereapproximately carried out a month later.\nDuring the following year and a half, “NOC” never reached 31 again.\n20\n19\n18\n28\n26\n22\n24\nFigure 37.12 Bearing in mind the 1954-1955 chart of Northrop in Figure 37.11, we now turn to the action in thissame stock in the latter part of 1956 and the beginning of 1957. The question is whether the Major Downtrend isstill in effect or whether an important upturn has taken place.\nAs usual, it is the volume that must be watched and studied. Notice the Minor Peak on August 14, then the veryheavy volume on August 24. See how the activity dries up during September but resumes briskly as a new MinorTop is established in October. Observe the drying-up of volume on declines and the activity on rallies to the 25 1/2level, which, by the middle of December, has become the horizontal Top of an Ascending Triangle.\nThere was no question about the validity of the breakout move on December 10, and the subsequent reaction in thenext two weeks confirmed this by the lack of activity on the decline. Again, in early February, we see volume pickup notably as a new high is registered.\nAt the time this is written (EN: 1957), it is not possible to say whether or not “NOC” will continue this upwardcourse and eventually smash the “31 barrier.” We feel there will be no doubt in the reader's mind at the beginning\nof February, Northrop was presumably moving in an uptrend and must be presumed to be in that trend until adefinite change in its market action has taken place. It seems quite probable if “NOC” should advance to the 30-31level, there is likely to be a period of Consolidation with the formation of an Area Pattern before a successfuladvance above 31 is accomplished.\nAs a sidelight on this chart, it might be mentioned that during the period of advance shown above, many aircraftstocks were moving lower.\n38\n36\n34\n32\n30\n28\n26\n24\n22\n20\n19\n18\n17\n16\n15\n14\n13\n12\n11 Sales 100's\n’EMBER OCTOBER.\nAPRIL\nAUGUST S\nCHICAGO, MILWAUKIE, ST PAUL AND PACIFIC ST\nJOVEMBER DECEMBER JANUARY FEBRUARY MA", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 195}
{"text": "formation of an Area Pattern before a successfuladvance above 31 is accomplished.\nAs a sidelight on this chart, it might be mentioned that during the period of advance shown above, many aircraftstocks were moving lower.\n38\n36\n34\n32\n30\n28\n26\n24\n22\n20\n19\n18\n17\n16\n15\n14\n13\n12\n11 Sales 100's\n’EMBER OCTOBER.\nAPRIL\nAUGUST S\nCHICAGO, MILWAUKIE, ST PAUL AND PACIFIC ST\nJOVEMBER DECEMBER JANUARY FEBRUARY MARCH\nB.;\n100\n50\nFigure 37.13 The 1954-1955 advance in Chicago, Milwaukee, St. Paul and Pacific is an object lesson in BullMarket techniques. Where would such a trend (of which there are many similar cases) leave the man who sells just“because he has a good profit,” say at 15, or who feels “17 is too high a price”?\nHere is a chart worth considerable study because it exemplifies a great many features of the “ideal” uptrend. In thisfull year of advance, there is no point at which even a tyro technician could find reasonable cause for anxiety orjustification for selling the stock. What is more, we should not overlook the tax advantages of long-term gains.\nIn August and September, we have a perfect example of the Symmetrical Triangle as a Consolidation. The volumeis typically heavy at the start of the pattern and shrinks to almost nothing as it progresses. The breakout volume isdecisive. The reaction after the breakout, also on lower volume, as it should be, runs right back to the apex, the“cradle point” that is nearly always a strong Support on such a reaction.\nNow follow the action from here; the two days of higher volume in the early November rally represent thepenetration of the previous Minor Top, and the end of the rally, respectively. The reaction comes back to theprevious top.\nThe December rally is marked by heavier volume when the November top is exceeded, and again, to a lesserdegree, at the end of the move. Once more there is a reaction, this time to the November top.\nA fast move near the end of December repeats the same price and volume action, and it is followed by a typicallow-volume reaction to the early December top. (This is becoming monotonous, but it is important. You are seeinghere a long-term demonstration of Bullish technical action.)\nNext, we have the January breakout. How far would you expect its Minor Reaction to go? Would you be surprisedif it found Support at the level of the three little Tops formed early in the month at 17 1/2?\nThe following advance drives through the 20 level, and, in a series of small fluctuations, forms an AscendingTriangle. By the end of February, another new high has been established. Can you estimate where to look forsupport on the reaction?\nFigure 37.13 (Continued) Now we see the formation of the second Ascending Triangle (notice the relatively lowvolume), which is broken on the upside in a burst of trading activity toward the end of April. The next reactioncomes back to the support of the former Tops as you would expect. Once again, an Ascending Triangle is formed,and you will see how the volume dries up throughout this pattern, coming to life emphatically on the breakout onWednesday, June 8.\nMany students, on first seeing this chart, remark, “Well, the trend wasn't broken until Tuesday, June 21.” Actually,no break occurred on that day. The stock simply went ex-dividend $1.50, which, as you will see if you adjust theprice by that amount, merely brings it back to the Support at the top level of the April-May Ascending Triangle.\nIt is inconceivable that any such regular series of Bullish Patterns could appear throughout a full year of trading ina stock “by accident.” This is part of the normal mechanism of the market, representing the judgments, opinions,fears, hopes, and trading tactics of thousands of traders and investors. It should be added, however, that it is notoften that one sees such a long and “perfect” Major Advance as this. Normally, there are interruptions, distortions,or Secondary Reactions from time to time.\n80\n76\n72\n68\n64\n60\n56\n52\n48\n44 Sales 100's\n250\n200\n150\n100\n50\nWESTINGHOUSE ELECTRIC AND MANUFACTURING CO.\n1955\nFEBRUARY MARCH i . ApR1^ , , MAY . , JUNE JULY. ,\n5 12 19 26 5 12 19 26 2 9 16'23 30 7 14 21 28 4 11 18 25 29 16 23 30'\nFigure 37.14 Does it require second sight to perceive this is a Bearish stock? If you were keeping a chart onWestinghouse Electric and Manufacturing, wouldn't you have recognized, long before the end of the period shownabove, that the trend was down, not up?\nIt is one of the great delusions of the market that the stock we own must be “good.” As prices decline, the price-dividend ratio, based on past history, will improve. Additionally, the priceearnings ratio likewise will lookcontinually better. Investors will begin to speak of “averaging their cost” by putting more money into a tumblingstock (instead of looking for something going their way). They will talk endlessly about improved outlook, newproducts, and a forward-looking management; they will prove to you it is selling “below its true value,” whateverthat may mean. They will bend every effort to establish what is going on before their eyes is not true; that the veryweak-looking stock is actually strong; that the American public is making a great mistake and is misjudging thisstock; that the tape is wrong because they must be right.\nNevertheless, values in the market are determined democratically and, by and large, probably represent the bestcomposite appraisal you can find. A move like this is not meaningless, and it is not possible today to attribute it tothe machinations of a few manipulators. In the chart, we are seeing the reflection of a collective evaluation thatcannot be lightly disregarded. Westinghouse reached 50 7/8 in November 1956.\no\no\no\no\no\no\no\nChapter thirty-seven: The same old patterns\nFigure 37.15 A typical stock chart on TEKNIPLAT™ charting paper. Allowing for ex-dividends, \"OT\" neversignificantly violated the apex of the Triangle. The advance ultimately added 60% to the value of the stock. Thischart, in its long, mostly sideways mov", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 196}
{"text": "uation thatcannot be lightly disregarded. Westinghouse reached 50 7/8 in November 1956.\no\no\no\no\no\no\no\nChapter thirty-seven: The same old patterns\nFigure 37.15 A typical stock chart on TEKNIPLAT™ charting paper. Allowing for ex-dividends, \"OT\" neversignificantly violated the apex of the Triangle. The advance ultimately added 60% to the value of the stock. Thischart, in its long, mostly sideways movement, is a good example of the importance of making allowance for theex-dividend drop in the price. During the first five months shown, we see an almost perfect Symmetrical Triangle.The first critical point would be on the slight breakdown in the middle of May. The lower border of the Trianglewas violated just a trifle, even if we had allowed for the 62 1/2(2 March dividend. If one had sold the stock here,who could blame him? No great or immediate harm would have been done. However, an experienced technicianmight have taken into account the insignificant volume at this point and waited a bit, with a stop at, say, 60. (Seethe somewhatsimilar situation in the chart of \"LA,\" Figure 37.6.) If \"OT\" had been held, the volume pickup on therally would have shown the trend had not yet reversed itself. The second critical point came in late September andearly October, at the time of President Eisenhower's illness. However, if we allow for the two dividends that wentex in July and October, the break did not violate the May Bottom. Furthermore, it was on relatively light volume.If the stock was still held, there was no valid reason for selling on this decline. From here on, breaking upwardsharply from the October-November Island, \"OT\" resumed the Major Advance interrupted by this long period ofConsolidation, and advanced to the equivalent of over 100 (adjusted for two-for-one split) in 1956.\n550\n540\n530\n520\n500\n490\n480\n470\n460\n450\n440\n430\n420\n510\nFigure 37.16 The Broadening Top in the Dow-Jones Industrial Average that formed in May, June, July, and August1957. Although Broadening Tops have appeared many times in individual stocks, and, as a rule, have carried outtheir Bearish implications, such a chart pattern has never before been completed in the Industrial Average. In 1929,on two occasions, there were patterns that began to show Broadening tendencies, but because these wereinterrupted by continuation moves, about all one can say of them is they may have indicated a growing technicalweakness in the market.\nThe 1957 situation, on the other hand, was very definite and was fully completed. During the early stages of thepattern, several of our friends wrote, calling attention to the possible Broadening Top, among them Charles E.Carden of Fort Worth, TX, who has handled Dow Theory comment and analysis for the Fort Worth Star Telegram.The chart shown in Figure 37.16 is adapted from one of Mr. Carden's charts and is reproduced with his permission.\nThe first significant point after the February 12 Bottom was the Minor Peak of Tuesday May 21, marked (1). TheMinor Decline from this point on Tuesday, May 28 (2), was quite normal, as was the renewed advance to Monday,June 17 (3).\nThe first sign of a broadening tendency was when the Average closed on Monday, June 24 (4), below the May 28bottom. However, this by itself did not indicate a Reversal. The advance was resumed, and surmounted the May 21and June 17 Minor Tops, reaching a high closing figure of 520.77 on Friday, July 12 (5). The Broadening picturewas now quite evident, and the completion of a Broadening Top required only a close below the June 24 Bottom.\nOn Tuesday, August 6, the Industrial Average closed decisively below the June 24 Bottom, signaling thecompletion of the Broadening Top. This was an indication of Major weakness, a warning not to be taken lightly.\nThe Broadening Top, as we have pointed out previously, is an indication of a wildly gyrating market, a marketwithout leadership or definite trend. The presumption is that heavy distribution is going on under cover of therallies and the breakout move is seldom a false one.\nFigure 37.16 (Continued) Since we are dealing with an Average rather than a single stock, we would consider anyclosing below point (4) after the peak at (5), regardless of how slight the margin might be, would constitute a validbreakout, because Averages are less sensitive than individual stocks, and it is customary to consider even slightpenetrations at signal points (as in Dow Theory) as perfectly satisfactory. You will notice also that, although itwould be possible to draw the Broadening Top through the extreme ranges of the price, as we have done with thewide-dashed line, we have used the closing prices as marked by the narrow-dashed line. This, too, is in line withDow Theory practice, where only closing prices are considered.\nThe implication of the pattern here was Bearish for the “market-as-a-whole.” As might be expected, a majority ofstocks showed weak patterns of trends at this time. As always, however, it was necessary to examine each stockseparately on its merits, because, as we will show in the following pages, not all stocks behaved alike even in thisextremely weak market situation. Compare the broadening top from 1999 to 2000 (Figure 37.17).\nFigure 37.17 The Broadening Top in the Dow in 1999-2000. If repetition is the heart of pedagogy, the reader maydie of heart disease with looking at the Dow Broadening Top, especially if he was long at the time and eitherdisregarded the signs or was not educated as to their significance. The lesson is always the same: bad news is on\nthe way. The numerous technical aspects of this historic market top are discussed at length in other views of theDow taken at this time. Remember, this time it is different. The market paradigm has changed, and so on and soon. ... Those who listen to fools will be fooled.\nFigure 37.18 1957 Bearish Trend in Industrial Rayon. At no time did this stock show significant strength.\nAverages do not tell the whole story. Each stock has to be considered on its own", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 197}
{"text": "rket top are discussed at length in other views of theDow taken at this time. Remember, this time it is different. The market paradigm has changed, and so on and soon. ... Those who listen to fools will be fooled.\nFigure 37.18 1957 Bearish Trend in Industrial Rayon. At no time did this stock show significant strength.\nAverages do not tell the whole story. Each stock has to be considered on its own merits. Long before the formationof the 1957 Broadening Top in the Industrial Average, Industrial Rayon was moving down in a Major Decline. Youwill find many cases in which it is difficult to \"see\" what a stock is doing or to determine its Major Trend, but insuch a situation as this (and this is not a rare case), it is perfectly obvious that the trend is down. Although therewere a number of Minor Rallies and Consolidations during the decline, the entire pattern was so obviously part andparcel of the same big decline that no one who was even slightly familiar with typical stock behavior would havebeen tempted to buy the stock, even to cover shorts.\nOn Monday, July 29, there was a sharp downward break with a gap on climactic volume. This would havesuggested the probability of a Minor Bottom, and for three and a half weeks, the stock did stabilize at around 24.But even during this Consolidation, the continuing weakness showed up on the small Descending Triangle that wasformed, and ultimately on Wednesday, August 21, the price broke sharply to continue the Major Decline.\n446 Technical Analysis of Stock Trends\nFigure 37.19 1957 Bullish Trend in Lorillard. Although most stocks declined in 1957, there were a number ofstrong issues like this one that appeared to be totally unaffected by the general pessimism.\nAverages do not tell the whole story. It will come as a shock to many readers, who rightly regard the latter half of1957 as a Major Bear Market, to see Lorillard making a typical Bull Market Advance. Lorillard moved up from15L to 34 during the year—and reached 54J during the first three months of 1958. It is hard to believe this chartand the Industrial Rayon chart we just looked at cover the same period, the year 1957.\nThe majority of stocks did suffer severe depreciation, but there were a good many issues, like Lorillard, whichenjoyed a generally Bullish Trend all year. Among the important stocks that moved up consistently in 1957 wereAmerican Chicle, Anchor Hocking Glass, Colgate-Palmolive, General Foods, General Cigar, Grand Union,National Biscuit, Parke Davis, Penick and Ford, Plough, Inc., Proctor and Gamble, Ruberoid, Vick Chemical,Winn-Dixie Stores, and Zenith Radio.\nWhatever theories we may have as to the condition of the \"market-as-a-whole,\" we must always realize we arebuying and selling individual stocks. (EN: Unless we are trading Index Shares.) We may get a picture of extremeBullishness or extreme Bearishness in the \"general market,\" but if this picture conflicts with the clear evidence in aparticular stock, we must recognize it is the stock, not the Average, with which we have to deal. We cannot assumea stock \"must\" follow the Average. Often, it is possible to obtain greater stability and safety by buying a few strongstocks in a Bear Market or by selling short a few weak stocks in a Bull Market, than by attempting to maximizeprofits with an \"all-out\" position one way or the other.\nChapter thirty-seven: The same old patterns 447\n448\nTechnical Analysis of Stock Trends\n68\n64\n60\n56\n52\n48\n44\n40\n38\n36\n34\n32\n30\n28\n26\n24\n22\nFigure 37.20 During the latter nine months of 1961, some well-known market Averages continued to show newall-time highs. However, the Evaluative Index (see Chapter 38), in this period did not indicate any such overallstrength; many stocks were in almost continuous decline for the nine months. These included such important issuesas Air Reduction, Allied Chemical, Allis-Chalmers, Aluminum, Ltd., Fansteel Metallurgical, Flintkote, HeydenNewport Chemical, Sperry Rand, Texas Instruments, Trans World Airlines, Universal Match, and many others. Atsuch times, it is best to choose stocks selectively and maintain adequate liquid reserves.\n40\n38\n36\n34\n32\n30\n28\n26\n24\nSales 100's\n50\n40\n30\n20\n10\nHOTigttfg o -\nl■l■■ll■■l■ mill millIII laiiaiuiiilamiiiiiaiHi r^Jrtrr:l*illrffilti i i rmOWtr5\niiatuiiiii laaiimaaaitai\n:s:::ss: isaniHsiss\n• •1...... nil; mil. 11 44-\nU 1 11»i ■ fi- • ■ -tit-• ‘\n8BH\nn(HlifIBiHIf? ifi BiWiSnt r.;i. nni tupfh IL\n•jtiMM\n:::::::\n: ::: ::::::\nB y-\ng.g h* 1\n1 iiii i\nlOii\nHfflgl§3\nQr\nIffl BU■RND'\ns?s\nf C ORPORAT\n11\n4()\\ E >DC H\nisy ,1J 4 | ||\n•\n• ■ ■\n: :: : ::\n!••••ss 5\n::\nw\ni: 4:4\n: ::: :: \" :¥’s?:S#1 i..HI. 1H?US ri IB4 H 444U T\nj\n.m iii\nII\ni ii\n■WfMW i ■■\n•\nMl .■\n: :: 1}\nTT I TT 4\n•:::::: H\nu\n<.\n••it\n:: :::: ::\n■ ■y o\n:::::::::\nii\nSI IMi H i i imp J ffit J\nI-::::::::::::::::::::::::::mi ■ ■ ■■” ■■•••■•a rti\n1961\n' TT T ''11 P+ff'ff-Tw 111 ...... :4t 4 tf\nIII w io 7TT T H :1Wi±L . ti,\nIHlii.11 :::::! S S□ m’ 'tg rirl mt II : :\n4: I IIIffi 4 i S -HU\niHffl ::::::: T I ttTT...........\n:jh:,‘Ut |' |H|h{-: t J..... jffl\n• i \" i : III; ill 1 1 titutffi i# Hi:\n■..... 1......J mj • . W 1.111ii\n1- nnn irnnmn\nn.\n1 1 11.1Lini\nrr\n. :ii .iili 1: im . A.11\nZZUZZ-------------------------0\niuiiiliii^iiiii,uiiiiiuuiiiiuuuu.uuiaiii»iiiii^iiuniiiuuiiiiiiiiuiu^ui»'ui»uiijuuiuiuiiuiiiiuiiiiuiiiu^iu.imii\nAPRIL MAY JUNE JULY AUGUST\n125 1 I 8 15 22 29 6 43 20 47 3 40 47 24 1 . 8 15 22 ■ 25 5 '12-19 25 2 '9 46?\nFigure 37.21 A familiar Top Pattern. From the end of 1957 to the spring of 1961, Burndy Corporation moved frombelow 10 to 37 in a generally Bullish Trend. The advance accelerated sharply on the postelection rally of late 1960and early 1961. However, with Burndy, as with many other stocks, the rally ended in the early months of 1961.Here, we have not only a perfect example of the Head-and-Shoulders Top in the price action, but we also have thetypical volume confirmation. The early April rally was on heavy volume. The rally in the last week of April was onsomewhat-disappointing volume", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 198}
{"text": "the postelection rally of late 1960and early 1961. However, with Burndy, as with many other stocks, the rally ended in the early months of 1961.Here, we have not only a perfect example of the Head-and-Shoulders Top in the price action, but we also have thetypical volume confirmation. The early April rally was on heavy volume. The rally in the last week of April was onsomewhat-disappointing volume, although a new high was made at that time. We have a definite increase ofvolume on the retreat from this peak, and practically no enthusiasm in the final rally of the first week of June. Thebreakdown on Monday, June 19, accompanied by heavier volume and a definite gap in the price track, confirmedthe Top Formation. Although Burndy held around the 30 level for a time, and after a further drop recovered to 31,the Major Trend had definitely been reversed. By June 1962, Burndy was selling at 11 3/4.\nFigure 37.22 Weekly chart of Brunswick Corporation showing the final stages of the long Bull Market in \"BC,\"the Climactic Top in March 1961, the distributive phase through December 1961, and the ultimate breakdown.\nFor five years, from 1956 into early 1961, Brunswick advanced in a great Bull Market surge. During this period,the stock was split four times. In the first week of March 1961, terminating the postelection rally, \"BC\" made anew high on extraordinary volume, but closed the week nearly at the bottom of the weekly range. The One-WeekReversal might well have served as a warning to the market trader.\nAssuming, however, the owner of shares in Brunswick was not a trader and was interested in the stock from along-term point of view, he might have held the stock through the breakdown from the Symmetrical Triangle\nformed in March and early April. He might have continued to keep his shares through the summer and fall of 1961and the rally of September and October. If so, and if he had been watching the action of the stock, he would realizethe 50-52 level was a critical area. A break through this previous Bottom would represent a serious failure ofSupport and, certainly, the decisive violation of the 50 level in the first week of January 1962 (with heavy volume)could be recognized as a very dangerous Reversal Signal, calling for immediate sale of the stock regardless ofcapital gains tax or anything else. Although this move preceded the general collapse of the market by severalmonths, it was a clear technical indication of extreme weakness and extreme danger in Brunswick, regardless ofthe action of other stocks at that time. If an investor had noted the break but decided to \"wait for a rally\" to sell hisstock, he would have had no chance to get out. Brunswick never recovered, never rallied, and by October 1962 itwas selling at 17.\nTechnical Analysis of Stock Trends\n240\n224\n208\n192\n160\n152\n144\n136\n128\n120\n112\n104\nSales 100's 1100 1000 900 800 700 600 500 400 300 200 100\n:::::\n::: :::: i 4.....—\n22 :::: ipjmmHtm:4 •:::: :\nm\n::i ::::\n:::: SgwM r St I J\nftmm26663££\njl 0\nE\nH : ffl\n3t 4..»<tr H 1962\n11 H s rr.:rS3?0 Br 1FW !\nEr *II!3 ft -HjiJjUE H frant!? b mt'Hl m\nJ\n31\non w\nw\nTT•-k\nlijl\nIlliII\nI |Lnm\nHR ::::::::::........\nIIIMIIKII 1\nmt tfflHfflrr HTTfffltt \"4H Httt t\nHim | • tiITT milm mH::::: ttu .211 1\n::::::::::::::::::::::::::::::::::::: ■ ■;;; 1 S 1HH ■■\n::::::::::::\nsi&Hiinmiff 3 iii:l g\nm2tiitimff iiii..\nIS a :mr l>±[EHr m\n............ mt rrm timnmmt T/ii\nrtttttxi. 1 Hriti |i mt\n4mm?\nQu\nSf mfr •tiintitr iM\n1 : R :: 1\n3 s gH|:: sii ■ H 1 ii\n:::::- T : gig— E3 1 ...J6T: -\n1 P OL\nARC\nmns?\n)ID\nC\nnmf\nOR\n.....\nPC\n::\n)i\nHCATIOIN PR\nEED\nw\ntmti r!\nHig\nmm\nit t it it:::::.....\n...\" WtIraira t\n• i ::::tmgII\ni\ntte.....i:;; - ■\n111).ill <111 ■\"T llll 1 IIIm\n1 11 tt I\nttii\nuw\n.... ii i.il. 61.. .1\n**t-T • • • 1\n......f'f\nml\n.. . ... w ±..111k 1\nIll 1 iinn\njjll. ulIllillll11.1lilk..in Hill Mui■ nilinnlulililill. .Ilillli.l.III\n3\nJANUARY FEBRUARY\nFigure 37.23 A beautiful example of a Rectangle in Polaroid. Notice the low-volume fluctuations between(approximately) 178 and 202. On Thursday, May 10, on the highest volume of that year to date, Polaroid brokeSupport and plunged to 168. This was a clearly Bearish Move. It would have been fatal to “hold for a rally,” forthere was no rally. It can be very expensive to hold onto a stock wishfully when the situation has changed radically,no matter how good it may have looked previously. Note this break came more than two weeks before the “near-panic” of May 28. By that time, “PRD” had dropped 50 points and was headed for still lower levels.\n17\n16\n15\n14\n13\n26\n24\n22\n20\n19\n18\nFigure 37.24 At a time when a majority of stocks were already showing signs of serious weakness, early in 1962,Copper Range was making vigorous new highs. Actually, the move did not get far; it never substantially brokeabove the 1961 Top.\nThe evidence of weakness in “CPX” did not become apparent until, after the relatively weak April rally, the stockbroke through 19 on Monday, April 30, and closed at 17. This was the completion of a well-marked Head-and-Shoulders Top. In this case, there were three days of rally before the downward move really got under way, but itmight have been dangerous to count on a rally after the clearly Bearish signal.\nIncidentally, this Top Formation was completed well before the precipitous drop of May and June.\n40\n26\n24\n22\n38\n36\n34\n32\n30\n28\nSales\nFigure 37.25 Like practically all stocks, “UV” went into a tailspin in the spring of 1962. After the “bad day,” May28, it continued to slide throughout the month of June. At this point, there started what could be considered nomore than a technical rally in a Bear Market. This rally stopped at 29 and was followed by a dull decline lastingabout two weeks.\nThe next move, in the second week of August, was marked by considerable volume, and although there was noobvious, clear-cut pattern, it seemed significant that the 29 level, briefly touched on May 23, May 28, and July 12,was penetrated on August 6.\nWhether to regard this August 6 closing as a", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 199}
{"text": "ally in a Bear Market. This rally stopped at 29 and was followed by a dull decline lastingabout two weeks.\nThe next move, in the second week of August, was marked by considerable volume, and although there was noobvious, clear-cut pattern, it seemed significant that the 29 level, briefly touched on May 23, May 28, and July 12,was penetrated on August 6.\nWhether to regard this August 6 closing as an immediate buy signal, or to wait for the completion of the breakoutmove and look for an opportunity to buy on a reaction, would be a problem. In this case, it would have paid towait. Notice the late August reaction came back to the 29 level, where it found Support, and then continued itsupward move.\nConsidering the weakness of most stocks in this period, the action of “UV” is remarkable. The important thing torecognize is individual stocks do not necessarily follow “the main trend” of the Averages.\n\nFigure 37.26 Weekly, July 1961 through June 1962. This chart shows the Head-and-Shoulders Top Formation inthe Industrial Average that preceded the collapse of April, May, and June 1962. Normally, especially in the chartsof individual stocks, there would tend to be heavier volume on the left shoulder. The price pattern alone issufficient to mark the pattern as a dangerously toppy situation. During the entire period in which this formationtook shape, many individual stocks representing important companies were showing Top Reversal symptoms, asmight be expected. Note, so far as this Head-and-Shoulders Pattern is concerned, the Reversal Signal is notdefinite until the neckline has been penetrated.\n\nFigure 37.27 Daily, April through September 1961. Here is a rather confusing and complicated chart, but one thatcontains several points of interest worth a bit of analysis. Notice the beautiful little Head-and-Shoulders Top inApril and May, especially the volume weakness on the final rally before the downside breakout. Notice also thisstock was split two-for-one in June, but such a split does not materially affect the technical action of the stock,except because there are now two shares of stock (at half the market value) for each share of old stock, there maybe some increase in the average number of shares traded per day. Notice also that once the downtrend wasestablished, the rallies (especially the mid-July rally) do not penetrate the trendline drawn through the April andMay peaks. This trend continued down for more than a year after this, reaching a low of 11 1/4 in October 1962.\nFigure 37.28 Daily, January through June 1963. Here is a good example of a Symmetrical Triangle as aContinuation Pattern. Triangles of this (Symmetrical) type may mark Consolidations in a Major Trend, or they mayconstitute a Reversal Formation. The characteristics in either case are an active move to the first turning point ofthe Triangle, and then, generally diminishing volume as the price fluctuates in a narrowing pattern. During thisperiod, it could be said the stock was in both an uptrend, marked by the lower boundary of the formation, and adowntrend, indicated by the upper boundary. Notice the increase of volume on the breakout, which, in this case,was on the upside. Also, notice the reaction to the “cradle point” defined by the intersection of the two boundarytrends of the Triangle. The advance of the stock from April to June measures just a little more than the height ofthe open side of the Triangle. The attainment of this “objective” does not necessarily mean the termination of theMajor Trend, however, and by August 1963, Cerro had reached 33 1/4.\nM CRUCIBLE STEEL CO. OF AME\nm i\n11\n111 11111\ni iii ii Ji! III I Illi\n1 ' ■ 1 1 1\n11\nH::::::::: ::::::::::::::::::::::::::::::::::::\n:::: ::::::::::::::::: an\n- A- 1 >• ^iHiiiii i iii iiiiiai ii iiii iiiieiiiii 1 uiati nai 1\nnBaMaiiaaBtiiBiaBtittaaiBioaaia aaa aaaaanvaaa laaaaaaaaaaaaai 11 it*'itiaatatiaatinataiittaaai(aaaa«*taaa aaaaataaaaaai; *« n laaaiaaam\n(UlUllill...... I 1 (It ............... «( 1 ............\n.......................... • 1 11a ........... mm 11 » itnat ai aia •\niisnaiiaai.....liiiiituiii t i tia temnaaa ta aaiaaa 11 » aami 11 tn i\nw—ac~*\"ii’\"**jaa—nrrnwr • t x:n:N: ::wa\niiitmlatiniaai n mitiiimi ttu it iiiiuh it tairii i iimiii at at i\nanna«iaaHiMiiiiiaii>iitaaa«i •laM'ittiiMiNHi, taaaaaaiaaattaait at\n1 h ■: 1 in: 1n»w 1 mr; ji 1• t m n umiNNii u nti u HNNNNN*iK±;uNN imKint•i\"ihi nnnn:m<im nnhmu•••••tau#. i aamaiai at i\n:::..........................:::::::::::::::: ::!:::::::: :\naa •••••• aa • aa a aaa aaaaaa aaaaa aa • aaaaaaaa aaaaaa a •• aaa aa aaaaa • • •••••■ •< • •• • •••••••••••••••»•aaaa aaaaaaaaaaaaaaaaaaataaaaaaa aaaaa ....... •• • •• ................................. ......\n• • • • ••• ft • aa • ••• ••••••••••«•• •• • •••• aaa a ••• •••••••• aaaaa ::::::: ::::: :::::::::: ::::: :::::: : :u r:: mm :::::\n•• •• ••• •• • •• • •••««• ••••• •••••• • > •• •••* • •••••\n■ >■■■ aaa a......a aaa aaaaaa ( ■ ■ ■■ a a in 1 >1 aaa a aaaaa\n........Si : —:S\n111 11111111111 min min 11111111 i iiuiiiim\nurn 111111111111 mu 11111 H 111 mil i iminim\n1111111111 ni mi mu mu mu i imnnii\nmu 111111111 in mu mu mm u iiuiiiin\nIIIII 1 ru 1111111 mu 1 min 1111 gu miimiiii\n1111 mi\nMARCH APRIL. , ’.MAY/ . JUNE JULY . AUGUST\n1 9 16 23 37'6 13 20 27 4\"11’18 25’ 1 1 8 ’15 22 47 6 43 20 27 3 ' 10 1724 31\nFigure 37.29 XA. Daily, March through August 1963. Here is a good example of an Ascending Triangle, in whichthe rallies advance repeatedly to a given level; the reactions find Support at gradually higher points. Such a patternnormally indicates a potentially Bullish situation in the making, just as the reverse (Descending Triangle) implies aBearish tendency. Notice the higher volume on the various peaks near 22, and the very high volume on thebreakout move in August. If any further evidence of the strength of this move was needed, the Breakaway Gap atthe opening, Monday, August 12, would supply it. After a breakout of this sort, it would be quite normal for thestock to suffer some", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 200}
{"text": "g, just as the reverse (Descending Triangle) implies aBearish tendency. Notice the higher volume on the various peaks near 22, and the very high volume on thebreakout move in August. If any further evidence of the strength of this move was needed, the Breakaway Gap atthe opening, Monday, August 12, would supply it. After a breakout of this sort, it would be quite normal for thestock to suffer some profit-taking reaction, usually on light volume, and such a reaction might run back to 22 oreven a little below this without altering the essentially Bullish nature of this picture.\n1408\n1280\n1216\n1152\n1088\n1024\n960\n896\n832\n768\n704\nSales\n100's\n5\n4\n3\n2\n1\nJUNE JULY AUGUST SIPIIMBI^ OCTOBER NOVEMBER\n' 2 ' 9 '16 23 30 7 '14 21 28 4 ■11 18 25 1 8 15 22 29 6 13 20 27 3 1017 24\nFigure 37.30 SOC. Daily, June through November 1962. Before commenting on the November breakout here, weshould call attention to the fact “SOC” was one of the stocks that held up fairly well during the Cuban crisis inOctober 1961 and did not make a new low under the June bottoms. This chart picture is an excellent example of aDouble Bottom. It is not necessary for the two Bottoms to be at exactly the same level if they are reasonably close.The important thing is the stock has found Support once, has rallied, then declined again, and has found Support atnearly the same point. The Bottoms should be some distance apart; there should be at least six weeks betweenthem, preferably more. Also, the rally between them should be definite and should amount to at least a 15% gain atits peak. The formation does not acquire significance as a Major Bottom Pattern until the level of the top of therally is penetrated on substantial volume. This penetration took place on Tuesday, November 13, and from thattime continued in a Major Bullish Trend, reaching 1559 in May 1963, an advance of more than 500 points from theclose on the day of breakout.\nDouble Tops have an opposite significance; they are similar to the Double Bottoms, but they consist of two tops atapproximately the same level, separated by some weeks or months, and with a decline between them, which mustbe penetrated to validate the Top Formation.\n64\n60\n56\n52\n48\n44\n40\n38\n36\n34\n32\n30 Sales 100's\n50\n40\n30\n20\n10\n\nFigure 37.31 Daily, November 1962 to April 1963. To the average person unfamiliar with the usual behavior ofstocks in the market, the price fluctuations appear meaningless and entirely fortuitous. If they are aware of generaltrends lasting months or years, they are often inclined to consider only the trend of “the Averages,” and are notconscious of the fact many stocks may be making large advances at the very same time that others are slidinglower and lower. It is not always possible to lay a straight-edge ruler along the trend and show \\ it makes a perfectstraight line (although this does sometimes happen); however, as in the case of General Steel Industries, there is noquestion the advance is fairly consistent over a long period of time, barring the relatively unimportant reactions,Consolidations, and so on, along the way. You will notice, too, the two-for-one split in early March did notmaterially affect the upward trend except to show somewhat more volume, as might be expected with a greaternumber of (new) shares. For a contrasting (downside) trend, see the chart of Avnet Electronics, Figure 37.20.\n32\n30\n28\n26\n24\n22\n20\n19 Sales 100's 250 200 150 100\n50\nFigure 37.32 Daily, February to August 1963. This is an interesting study of Support and Resistance phenomena.Incidentally, it is also an example of a Bearish Stock (and not the only one by any means) in what was generallyconsidered a Bullish Market, during the spring and summer of 1963. We would point out several rallies to 31 inMarch and April, and the breakdown in early May. In May and June, the stock rallied, but it stalled at about the\nlevel of the March low. Then there was another drop, and in the rally, this time came back to the late April low. Thenext drop, in July, was followed by a little rally to the June Bottom at 25. This is fairly typical Support-Resistancebehavior. The price level that has been a Support tends to become a Resistance once the Support has beensubstantially broken. Vice versa, as regards overhead Resistance; after it has been broken, it tends to serve as aSupport level.\n19\n18\n17\n16\n15\n14\n13\n12\n11\n10\n9 Sales 100's 125 100\n75\n50\n25\nFigure 37.33 January through June 1963. Sometimes a move happens all of a sudden and does not result in acontinuing long trend. In this case, it is not possible to say whether the long-term trend will be up or not. Thepurpose of showing this chart is to point up the remarkable action that can follow a break through an importantSupport or Resistance Level. You will notice that the entire period from mid-January to Tuesday, May 14, can beregarded as a Rectangle on the chart with Bottoms at about 10 1/8 or 10 1/4, and Tops at about 11 3/4. Notice theincrease of activity on the several rallies during the formation. The move, which was a “situational” thing insugars, affected all sugars in May, and turned out to be somewhat of a flash in the pan. Nevertheless, it was aspectacular one, and a trader with courage and acuity might have picked up this stock as a speculation after theclose of Tuesday, May 14. The next five trading days advanced the price from Wednesday's opening at 12 to theTuesday, May 21, close at 17 1/2, an advance of 46%. This is a type of market trading we would not recommendgenerally; it calls for courage, experience, and the willingness to take a number of small losses to secure onesubstantial gain. However, the in-and-out trader who observed the action on May 21 and noticed the One-DayReversal with abnormal volume and a gap could have secured maximum quick profits either by selling his stock atthe opening of the next day or by placing a stoploss order just under the close, say, at 17 3/8.\n64\n60\n56\n52\n48\n44\n40\n38\n36\n34\n32\n30\n28\n26\n24\n22\nSales 100's 500 400 300 2", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 201}
{"text": "to secure onesubstantial gain. However, the in-and-out trader who observed the action on May 21 and noticed the One-DayReversal with abnormal volume and a gap could have secured maximum quick profits either by selling his stock atthe opening of the next day or by placing a stoploss order just under the close, say, at 17 3/8.\n64\n60\n56\n52\n48\n44\n40\n38\n36\n34\n32\n30\n28\n26\n24\n22\nSales 100's 500 400 300 200 100\nii( ii urn\nIii 11 mu\nCONTROL DATA CORP’ CDA\n::::::::::::::\nFEBRUARY MARCH APRIL MAY JUNE . JULY\n' 13 20 27 6 :13 20 27 3 10 17 24 1'8 15 22 29 5 12 19 26 3 10 17 24 31' 7 7\nFigure 37.34 There are some warning signs in “CDA” in the Minor Breakdowns of late March and early May.What seems especially significant, however, is the nature of the recovery move in May and early June 1965. Thetwo convergent boundaries of the Recovery Trend form an up-sloping Wedge, which has rather definite Bearishimplications. If the Wedge had been pointed down, it would strongly suggest the possibility of a decisive upwardbreakout. Notice on the two days during which the highest prices were attained during this Wedge Pattern, thestock closed near the Bottom of the day's range. The subsequent history here, the collapse on heavy volume, showsclearly how dramatic a break from this not-too-common formation can be.\n256\n240\n224\n208\n192\n176\n160\n152\n144\n136\n128\n120\n112\n104\n96\n88\nSales 100's 500 400 300 200 100\n:::\niii\n:::\n::::\nHS-::::\n::::::\n::::::::::::\n:::::::\n:: :::\n:: :::::::::::::::\n::::::::\n::::::::\n::::::\n:::::\nnils\n::::::::\n11 II\n1\n:: ::\n:: :::\n:: Is\n: :::::0\nss\nII w tmti ::m\n;60\nlit :::::::::\n:::::::::Hi:\nF it.;-!Hti?ni\n♦ m\nIi w1 ::ii: I ttmfII si •56 :: ::::\n■\np«I\n<:■\n!!! a\nffii\n1\n: : n Mtt n\n3tH J\nii\n::::\n•\n■U.S. SMELTING, REFINING ANDa 52 ‘B :*++\n4I NINIG CO . U V\nIHirTTT 148-i 1 III\nlllll\n■ mi 111:: ::::HU\n1 mil ■iii> ' H T\nIIIIIIII\nMUM ftn | tth :ti: i TTl\n1 III\n11111111\nII1 ::::::multiin.....St-- 41\ntlliu TTTTT4 SDT IT\nffMtf tffr TtTTTT nr\nf ff ff 111111 Uf:jj\nI IT i: i i :::::::::B :« SI -40. fill\n1965\nItltt H I:;:;:::S0t HH\n4 ::::::: •Hu itr.ri?\n:• HHE: ::: 4'\n4:::: iiiiiiii S :::::::u :::EHH\nIi\nBttt:1\n-- ■HiHu\n1! |L MII\n134\n#\nEld ii k\n1: a\nIS\ng ; ■:: ::\ng Im tgg4 •4» :: ::\nr: >28: lip\nill\n:: ::\nIt H\nH BL\n■ ftltl\n••\n■■• 4\n■■■•II\n......\n::::::\n■■•••I\nMMMi\n::::::\nih . ::: :\nr:::\n••\n?:1\ni ni\n;!?■■-I\nII\n::\nii\n• l*U :: ••••*\na\n“it\nIiMM\n::::::\nmi iiMR\n■ ilijl\nRail\nm *\n■■■■■■■\n:::::::\n11 ■ ■ 1■ 1 ...\n::::\ninin 1114 • •\n■ 22-\n1\ni\nITT 22\ni 11 11\n41\nI\n4 i\n4 i 1\n1 1 U11\n: d t\nJULY AUGUST SEPTEMBER OCTOBER NOVEMBER DECEMBER\n10 17 24 31 7 14 21 28 4 11 28 25 2 9 :16 23 30 6 13 20 27’4 11-18 25’\n■3\nFigure 37.35 Here is a chart that shows several interesting technical features. In July, August, and most ofSeptember, “W” was in a period of dormancy. The breakout of September 27 was followed by a week of inactionand then a strong continuation of the move on big volume. Notice the October-November Consolidation, whichtook the form of a large Symmetrical Triangle. If we draw the upper boundary of this Triangle, and the lower, wesee the breakout signaling a continuation of the move, on Wednesday, December 1, was decisive both in price andvolume action. At no time during the advance from 28 1/2 to more than 62 was there any indication of potentialweakness.\n16\n15\n14\n13\n12\n11\n10\n9\n8\n7\n6\nSales\n100's\n500\n400\n300\n200\n100\n2|g Hi:r itlri ::u: :::|ii!iiiiiiiiiii!ito«i\nSnb~ilwSHwtttt* ........::::: ::::\n•HHHir\n:::::\ngm\n:::::\n::::\n1\n::::: ::::: i: .\n.......\n:::u Hie fix\n5\n1 sL sail\nin\nIS! l|ti~ Bfi glffi aliift«...■fwf 1 ttttmittTtttt\nxttts {flftfe 4l|f\n''*****■***'''4tT*»* mil 1141k4 •t..» r m *m it tit.TtFtr irIt\nI 4 miS HIH S 3f: :&t E\nt Iff\nInf ftfft 1 :: |Si :: :O;H wBwW ±g;;£t\nnrrttm :: ::: [rlr j-’r-f-:::\n’SSrrSTiPtffl:::::::zilllllitffitll r ?ntl Iff! 4 ft\nttnirt i:nr J\nlllJll ttM 1min in i mtnin t min tn imm mu\n.......\nT nt IT\nilg\n1\nH+ttH\n::::: : :\nTffff\n.....\nmin in i ......ill I mill IM •I j\nII1*IIIIIIIIIIIIIIIIIIIIII II l> IIII IIiimuiiiiiwiffS :::::ffi\n::::: 03\nfsxssi ■’■ '1 ::::::::\n::::::::::::::xs 4 ! :::::: ::::::::::::fiH m*\n,n;:;:;r: ;;;;;;;■•;;;•••■ tts text\nig:t:::■ 8§Ss ■ •■'iiili:::: . :::: :::tin: ts4yalHini itsH nk ms xst IftS\ntrft ks; I Xtr 1 mftIk: mH\n: :::s tttt:m7 ' I f(Igig •• II ftm ::::: :s\nit tt siitiUft:41U4W tff nfn: nff:ftr: xitttth ji\nip ::::::::: :: ::::::: tffff :t|. . ..\nTTA7'TXT/~,CrTV'\\XT<ATT r,f\\AJDAXTVT A\nll LIVINGSTON OIL COMPAN Y LVO ::::\nwH •\"fmrtnt — : ::r —*-*rHr\nIEf|FT ::I: IHB o nn;;\n: 1::iff f O f HgHrS st Iff ii\n:::::::: ■ ■' : ti*if if H OI|...... Fff\ni: ■ ■#1 ■\n: • 1 i:: t ’' * *' nil\n'll ft f:: '::::: | :L ii .ii\nT E L- I III II\n1 M' A 1 M r~J --T 1 S 1 o 1 N 1 b 1 .\nFigure 37.36 The weekly chart of Livingston Oil from January 1965 into January 1966 is a good example of aMajor Bottom. Just how weak the stock was during the early months of 1965 can be judged by the clear DownsideGap during the month of May. Also, you will notice the volume on this whole headlong collapse was rather heavy.From July to the middle of October, however, the trading activity “dried up,” and the stock fluctuated in narrowerand narrower swings, forming a Symmetrical Triangle. The pickup of volume on the October breakout wasspectacular, and an observant investor would have had a “second chance” to buy on the reaction in the first weekof November when the stock drifted back to the top of the Triangle.\n\nFigure 37.37 Here is a beautiful picture of technical market action in Packard-Bell Electronics from August 1965into January 1966. The first point of interest is the Flag Consolidation in September and October, a classic example(“The Flag flies at half-mast”) and on the resumption of the up-move, the stock did duplicate the earlier move, anda bit more. (Compare with the 1945 chart of Martin-Parry, Figure 33.13.) Notice the nearly flat Tops and the risingBottoms from October to January, with generally declining volume (Ascending Triangle), and the magnificentbreakout move in the second week of January 1966. In", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 202}
{"text": "ssic example(“The Flag flies at half-mast”) and on the resumption of the up-move, the stock did duplicate the earlier move, anda bit more. (Compare with the 1945 chart of Martin-Parry, Figure 33.13.) Notice the nearly flat Tops and the risingBottoms from October to January, with generally declining volume (Ascending Triangle), and the magnificentbreakout move in the second week of January 1966. In this case, we can see no evidence calling for selling thestock all the way from September into January.\n1969 197\nN OVEMBER . D ECEMBER J ANUARY\nPARKE, DAVIS AND COMPANY PDC\nAUGUST\n9 1 6 23 '\nj^.UBiJluLIIL.lJlLUllJlIinUliJ\nSEPTEMBER OCTOBER\n. 6 1 3 20 27 4 11 18 25\n1 iLi.mUxh\nMARCH'\n14 2.1 2.8\nuLLuJu\nAPRIL\n1118 2\nFigure 37.38 This could be regarded as a very flat Head-and-Shoulders Top or as a long Rounding Top. Thebreakdown through 66 was a warning, and certainly the sharp break below 60 in February was a definitely Bearishsignal.\nASTRODATA INC.\nADA\n125 . ..\n100 '\n75\n50\n25\nOCTOBER NOVEMBER DECEMBER JANUARY FEBRUARY\n4 11118 25 1 8 15 22 29 6 13 20 27 I 3 10 17 24 31 7 14 21 28 >\nFigure 37.39 A complete collapse in one day, Astrodata in January 1970. Not the sort of action you see every day,or even every month, but it is “normal” in the sense it is a phenomenon we have seen many times in the past andundoubtedly will be seen many times in years to come. When it does happen, it should be heeded—it meanstrouble. “ADA” was doing well in what appeared to be a typical and perfectly healthy uptrend. After a one-daysuspension on January 15, it reopened many points lower and never recovered. Trading was halted in lateSeptember. Some readers may remember other downside moves of this nature in the past. In Mack Trucks, in FifthAvenue Coach, and some may even recall, many years ago, a break like this in American Woolen. Such a break isdue to some sudden development or change in company affairs, but it is not necessary “to know the reasons”: thechart speaks for itself. As Lady Macbeth put it (in another connection), “Stand not upon the order of your going,but go at once.” There was a good example of this type of a “Gap Move” in Villager Industries on April 30, 1971,when the stock dropped 42%, from 7 3/8 to 4 1/4 in one day. Such moves as we are discussing here are nearlyalways on the downside; we do not often see comparable upside gap moves. After this type of break, althoughthere may be brief rallies, the stock nearly always resumes the downtrend, and in many cases, is delisted from theExchange. Anyone caught holding such a stock should not feel he had made a mistake in buying it, nor should helook for evidence of weakness before the big breakdown, for ordinarily, there is none, however, he should get outimmediately to avoid further loss. By way of reassurance, it can be repeated though this kind of collapse is a ratherrare occurrence.\n\nFigure 37.40 Oracle Corporation. Lest one think the air pocket gap does not still exist, here is an example from theturn of the century (third millennium). These gaps, caused by disappointing earnings, were so prevalent at the endof the century at the top of that Bull Market that one could short vulnerable stocks before earnings reports withlittle upside risk and often collect nice scalps like this one.\nEARN.\nDIV.\n. SHARE S\nPUBLIC SERVICE ELECTRIC AND G A S PE G\nTHOUSANDS OF\n, 1\nElLJ\nFigure 37.41 A typical electric and gas utility stock. There are a great many stocks in this group, serving variousmunicipalities or regions. They tend to show similar market behavior because they are basically similar in nature.\nThere is a relation between the earnings of a company and the dividends paid, and the market price of the shares.Neither earnings nor dividends alone, however, are sufficient to constitute a complete determination of “value”because there are many other factors that can affect the “value” considered from different angles, such asdependability of earnings, future prospects, taxability, research and development investment by the company, andso forth.\nThe electric and gas companies, enjoying a regulated monopoly position in most communities, have a sure andsteady income. They are also in a definite “growth” situation because of the constantly increasing demands forpower by users. Most utilities will show a record and pattern of trading over a period of years very similar to thatof “PEG.” You will notice reported earnings have been larger each year from 1959 through 1970. Also, thedividend rate has been increased each year except in 1970, when it was unchanged from the year before. Anyonebasing his estimate of “value” on a simple index such as “price-earnings ratio” would conclude the stock was 2 1/2times as good a buy in 1970 as it had been in early 1965.\nObviously, there is more to it; the big funds and other large holders of stock are not giving up “bargains” of thatsort lightly and for no reason. The depressed chart is undoubtedly reflecting the whole thorny outlook facing theutility industry, including costly new facilities, anti-pollution devices, and other problems including deregulation.\n176\n160\n152\n144\n136\n128\n120\n112\n104\n48 Sales 100's 2000 1600 1200\n800\n400\nJANUARY\nAUGUST\n[ARCH APRIL MAY\nMEMOREX CORP. MRX\nSEPTEMBER OCTOBER NOVEMBER DECEMB\nFEBRUARY\nFigure 37.42 Although 1969 was Bearish for most stocks, “MRX” was enjoying the final fling of a dramatic four-year advance. Notice the Island-like Top in November, December, and January, and the low volume all throughthis period. The Breakaway Gap in early February speaks for itself. See also Figure 37.39.\n44\n40\n38\n36\n34\n32\n30\n28\n26\n24\n22\n20\n19\n18\n17\n16\n15\n14\n13\n12\n11\n250\n200\n150\n100\n50\nFLY\nFLYING TIGER CORP\n1969, 1970, 1971\nTTi\nI\n• • • • •'\nM T A T M ^L J A T S J P T N J-. D J J J F\nFigure 37.43 From a 1967 high of 48 1/2, “FLY” started a downtrend that lasted two years and took the stockdown to 11 1/4; but during the spring and summer of 1970, the stock found bottom, made a Head-and-ShouldersReversal, and took off in a", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 203}
{"text": "26\n24\n22\n20\n19\n18\n17\n16\n15\n14\n13\n12\n11\n250\n200\n150\n100\n50\nFLY\nFLYING TIGER CORP\n1969, 1970, 1971\nTTi\nI\n• • • • •'\nM T A T M ^L J A T S J P T N J-. D J J J F\nFigure 37.43 From a 1967 high of 48 1/2, “FLY” started a downtrend that lasted two years and took the stockdown to 11 1/4; but during the spring and summer of 1970, the stock found bottom, made a Head-and-ShouldersReversal, and took off in a skyrocket move that, by February 1971, had recovered nearly all of the two-year drop.\n44\n42\n40\n38\n36\n34\n32\n30\n28\n26\n24\n22\n20\n19\n18\n17\n16\n15\n14\n13\n12\n11\nSales 100's\n250\n200\n150\n100\n50\nHtt::: 8\" SSO1I\n...........1............fit \" i i T' T H m ■ IILilt SOS Sim®\n-H T ■*frIftt ttt+ WStTTTT :>\n[Et *H*\n....... ........... ::::: •lllflltltllllnmiiiiiiiii\n::::::::::::::\n••lll•■\nmimi\nin H T i i iHtti n r r t H*Hin iff i i HHtr it f f f rHHJI .... .11. fU :::::mHJ fit:: S IS® ‘Mft’\n:fi{ 44:444rrr :: IIS 4 4Hfin ft:'\nTn \" ” <■■■■w\n—.. .........\nM ff\nWlff\nS H\nU.K.Ham !<■■>!minmill\n:::\nII111111'Illi\nIII imu> mi\nM MU . . 1 NI\nli tMBMMJfeH\nIIIIII\nIII\nIII\nII<\nPi 10 HH iii;\n: • H H.::Mali 5 ttin J : t \"glffl\n'Plpf nhifr?\n■•••::■\nHili;\n::::\niii\n\\\\ Eii’iiili :HHi ! f*rSIffi\nH ACTION IND, INC.ACX\ntiS :: ||: ||\ntf H ♦ tin: :::::\n■■■••••■••••••••••••••••••:: ::: :: i in 1 ii®\n::::::: mmm «:\n•• •::: :::::: 1\n♦♦W44tt»l..!.. 444 nni:::: O nnn::: tint ill w 1 OJBB\n: : :::: :■ •: :: | 3H:i HiiHiii 5: iiiiiiii: i ::::::::::: ::::::: :\n1971-197\nTTt 2H4iitt2\nEBII1\n2 I\n::::::\n:: ’ t!T H -\n: :::::\nII |\n:::::: ::::::: :::: p Hitt :: ; f= ts?H iff m: Hs:itsn\nUH 1.1 it SE l:i h w ::: T 10 i W Hft:::;:\n'\"TTT'T'T’tT t • T f* +♦Ufl ' ' S O: : W\n.... M.M «••• al »\n;; . : J : | :T:**iftin::4|::\nT Bi Hi\nfc:.\n4 Pl\n9uKi\ni>mu ■ii\n)■Ml1IIMl\nIUUU-Swl Hi:\n8\n::EpHp:::H::t£ttmp HIT\nHTT:: ::: IB\n■■ft rt tt” i T T ' T ' HTT' HH !'*■\nKIIIII .\nMU -ft' ttttt ft\n• •• *• — • • •• .......Ju i; HmfflffJ .< tttt Iff t '■TTTTTTt ft 4f • - \nf Jftf t J 1 HO1 .. . | .... M i ffi m :S:[$S£ ft ft\n|...... — ft 1 Hi TH iITTTIT lilll lf|l| 1\n|gH :• :::: :::::: :::::: n:::: :::::::\nH 3-1. 1 liffi HU p. t. ixc ::::: ::::::::::::::::::: :: ::::::::::: Jinn\n: : : :: :: : ::: :: : :::::: 22222\n: : ::: :::::: ::: 32 23 31332\n::::\n:::::::::::\n:::::::\n..... y-niit\n: : : :: :: : ::: :: : :\n: ?: ::: : H: ::: ;Hm:\n• ■ ■ ..............\n•• ■ ...... .... ......\n•• iii\n—U-...........\ngi H ?\nMill 8 ilKI 1\n11\ntllll::: 1 il\n::: :: ::::::\niii iiiiiiiiill :i iiiHi\n: :: : : ::::: : :: :: ::::: : :: : ::::::\n::::\n::::::\n1\n2\n1\n»aaaa\n: iiiiii\n||ljl|ii|ll|ll|||||i||\nfit • • U t i fitfi iui: w Hi\nl•l■l•■•l■ll•■l\n• a ■ 11 a ■ a■ 1 mai aaiaaa ■ a a ■aa aai\nlilil\n:: : : : : : ::::\nill ill\n1»T**t4m\n• II\nURN\n• ■■•■in\nt 11 mu\n1 ii aim\n• II\n•■nun mu\nHlllll.....I\n•■*■!■■•!*!'*\nSii-'giatffi W’4 . ..«, • ti muii::: tHHf \nIf f ■ ■ f■■■ ttf Htf Htt-I TT H TT TTT\nTT - tttt- tt* 'TTT 111111 • • 11 mil 1U1U\n:::: :.4 <44\n:: :::::::\n& 11 atut\n■......HUIllllllllllll •II■■■■•1 III: :::::\n=111\n♦tp—mt: 1\n:::: : 1\n1-1Ifff fl\n•lllllllllll............\nIttlttitttltl I:::::: 1\nbill OH ::::\n. . xC\n•: 1\n- -co- fff fft MUI-\n: iin nr ' ' T 1.....1TT ! T \" nun '\n.....its.........s.......1.1.....1.\nsit 1 ■\n. ... u.\nI 1.....i n .........n.... 1,\niili i 1 ii ilili^il\nNOVEMBER DECEMBER JANUARY FEBRUARY MARCH . APML\n23 30 6 13 20 27 4 11 18 25 1 8 15 22 29 5 12 19 26 4 11 18 25 1 8 15\nFigure 37.44 Here is a familiar pattern you have seen many times before in the pages of this book or in your owncharts—a large Ascending Triangle in the daily chart of Action Industries, formed in December of 1971 andJanuary of 1972. Notice the typical breakout and reaction moves and the continued uptrend into April of 1972.\nFigure 37.45 Two things are remarkable here: (1) the amazing story of a business emerging from a college dormroom—a computer business, of course—and (2) the regular occurrence of air pockets, which will be seen better onthe next chart. Not a stock for those who dislike carnival rides and surprises. One should fit his portfolio to hisdigestion. Dell broke its long-term trendline, which the reader may easily draw here with a ruler, and after setting abull trap, went to 20, displaying several major warning downside gaps (see next chart). The out-of-proportionvolume at the chart end is a forewarning.\nFigure 37.46 DELL. The breakaway or air pocket gap continues to astound, so frequently choosing to occur athorizontal lines. An exceptionally alert trader might have avoided the air pocket, observing the broken trendlines.\nThe average technician would have got out and shorted the breakaway gap. Seen one tulip, seen them all.\nFigure 37.47 The benefits of the “Wintel” partnership are reflected in Intel's chart. The trader might have been inand out of Intel several times based on tightening trendlines, whereas the long-term investor would have patientlywaited out the—call it a “rectangular wedge”—that never was violated on the downside. The steeper the trendlinethe more likely—even the more certainly—it will be broken.\nFigure 37.48 NOKIA (NOK). Not enough is made of the marking of zones of Support and Resistance (highs andlows) with horizontal trendlines. These benchmarks help the technician to mark the running of the tide, just likeDow's stakes on the beach. Notice how the high of 1999 influences the high of 2004. The breaking of horizontallines here after the breaking of the steepest trendline once again tells the tale for the technician.\nFigure 37.49 AMD. Reflecting the vagaries of the semiconductor business, including the felicity (or infelicity) ofbeing a competitor of Intel, AMD shows trading opportunities both up and down. Here the intermediate-termtrader would respond to the vigorous breaking of short-term downtrend lines to get long.\nJulOct 97 Apr Jul Oct 98 Apr Jul Oct 99 Apr Jul Oct 00 Apr JulOct 01 Apr\nFigure 37.50 Yahoo! (YHOO). A superb trendline that should have kept the technician long until April of 2000—and then got him out, especially when combined with the top horizontal trendline. The extravagant volume at the\nv", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 204}
{"text": "ntermediate-termtrader would respond to the vigorous breaking of short-term downtrend lines to get long.\nJulOct 97 Apr Jul Oct 98 Apr Jul Oct 99 Apr Jul Oct 00 Apr JulOct 01 Apr\nFigure 37.50 Yahoo! (YHOO). A superb trendline that should have kept the technician long until April of 2000—and then got him out, especially when combined with the top horizontal trendline. The extravagant volume at the\nvery top is the exclamation point on the warning.\nFigure 37.51 Any resemblance between this chart and Amazon (see Figure 23.13) is not strictly coincidental.Readers will remember Magee's principle that birds of a feather flock together. Internet goony birds certainly do—or did. Yahoo! looks in this guise somewhat stronger than Amazon, but then selling books and mortar is a harderrow to hoe than selling electronic images (best business in the world). Again, such an attractive fundamental story.Gooks (or geeks) on skates helping revolutionize the wild frontier—we love these stories, but not enough to stopdrawing lines on the chart and selling them when they violate our lines. Even love must obey the rule of the ruler.\nFigure 37.52 Apple (APPL). Apple is a remarkable delight because it illustrates vividly one of the centralprinciples of technical analysis: ignore (or take with a cellar of salt) the news. Any time the media swarms on acompany, be skeptical. If we believed the media, Apple would have more lives than a cat, considering how manytimes the media has written it off as dead. It is also a chartist's delight as illustrated in my Basing Point studies(Chapter 28), and here, by trendlines (horizontal and sloped) and a large fan. Readers years from now will want toobserve how the trendlines here forecast Apple's future. Figure 37.53 vividly illustrates the technical signal thatkicked off Apple's run, complete with Triangle and run day, and wake up volume. We constantly deprecated thepress disrespect of Apple—hounds of the press are appropriate—and they paid the price for their disrespect asApple went to 425 in 2011. It is satisfying to see the know-nothings of the financial press exposed for how littlethey know.\nFigure 37.53 The file of press clippings predicting the death of Apple weighs as much as the daily output of theAugean Stables, and it is worth as much. One wonders why the press likes to beat on Apple so, especially when thewizard was up to his never-ending tricks; the wizard (Steve Jobs) had millions of fanatics ready to support his nexttrick. Although the Beatles are mad at Jobs and Apple, Apple is now a music company as well as a computercompany. The smooth-as-silicon lubricant iPod made music to investor's ears and Apple took off on another run.The start of the latest trick is pictured here. The volume in April is the wake-up call. Of course, what is thatvolume? A shakeout. The breakout across the Descending Triangle line after the false signal (Remember? Thosefalse signals are often followed by valid signals), the volume, and the surging run days—all good grist for theanalyst's mill. Furthermore, the surge across the downtrend line on big volume should be recognized as animportant technical pattern regardless of what proceeds it.\n\nFigure 37.54 $NDX, THE NASDAQ 100. Following the Basing Points Procedure in Chapter 28, an almostcompletely objective procedure may be devised for the very long-term investor to replace or augment Dow Theory.In this chart, the Basing Points Procedure is applied to weekly bars. Thus, instead of three days away, we look forthree bars away. The result is a trade that lasts around 10 years! The method gets long in 1991 at the arrow, holdsthe trade until about 2001, and reverses. Observes the bottom of 2002 and reverses again and is long into the BullMarkets of 2006. Arrows show the signals; numbers mark the Basing Points, and Stops, which would be about 5%under the Basing Points, are not illustrated.\nchapter thirty-eight\nBalanced and diversified\nThe average investor wants a clear-cut, simple, easy answer to his question,\n“What do you think of the market?” To him, it must be at all times either a\nBull Market or a Bear Market. If, in answer to his insistent demand, you\nreply with the question, “What particular stocks are you interested in?” he\nwill avoid that issue and say, “Oh, I mean in general.” (For illustrations in\nthis chapter see Diagrams 38.1 and 38.2.)\nIf you will examine the pages of any magazine or newspaper carrying a\ngreat deal of financial advertising, you will find many advisers and advisory\nservices make a great point of giving unhedged opinions as to the future\ncourse of the market, and these opinions are most frequently couched in\nterms of what the market as a whole is going to do.\nNow, there is just enough truth in the common belief that they all move\ntogether to make this an exceedingly dangerous assumption. It is true, for\nexample, we can set up definitions of what we feel constitutes a Bull\nMarket or a Bear Market, such as the Dow Theory, and if a given set of\nconditions meets the rules we have laid down (i.e., our definitions), then we\ncan say accurately, “according to my premises this is now a Bull Market”\n(or a Bear Market, as the case may be). It is also true that over the years, if\nwe had treated the Dow Industrial Average (DIA) as if it were a stock and\nhad theoretically bought it and sold it according to classic Dow Theory, we\nwould have done very well. (EN: As is vividly illustrated in Chapter 4,\nwhere buying and selling by the Theory netted one $795,592.01 as opposed\nto $55,411.83 [as of December 29, 201]) through buying and holding. Of\ncourse, now it is the same as a stock [ETF], DIA.)\nIt is also true in the great inflationary and deflationary movements, which\nreflect the changes in the relative values of dollars to equities, there is a\ntendency for the majority of stocks to move with the tide. Furthermore, it is\ntrue in the day-to-day movement of stock prices that most stocks move up\nor move down together.\nWe should never lose si", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 205}
{"text": "urse, now it is the same as a stock [ETF], DIA.)\nIt is also true in the great inflationary and deflationary movements, which\nreflect the changes in the relative values of dollars to equities, there is a\ntendency for the majority of stocks to move with the tide. Furthermore, it is\ntrue in the day-to-day movement of stock prices that most stocks move up\nor move down together.\nWe should never lose sight of the fact the Averages themselves are\nabstractions, not railroads, manufacturing companies, airlines, and so on. If\nthe Averages move, it is because the individual stocks making up the\nAverages have moved; although, it is true during a time when the Averages\nare advancing, a majority of stocks are also advancing, it is not quite\npossible to reverse this and make it absolute by saying because the\nAverages are advancing, therefore, all stocks must advance. If we carried\nthis to its logical conclusion, we would arrive at the point (that some have\narrived at) at which the fact that a stock has not advanced, but rather has\ndeclined in a Bull Market, is considered sufficient reason to make the stock\nattractive for purchase on the basis it must catch up with the others.\nIf we examine the facts, namely, the long-term records of what stocks have\nactually done, we find there are periods when most stocks go up in value\nand other times when most of them go down. We find, sometimes, laggard\nstocks eventually will join the procession in an upward trend.\nHowever, this does not always happen and it can be extremely\nuncomfortable to have bought stocks in a presumably Bullish Market\nbecause they are behind the market or they are all going to go up, and then\nwait for months as we watch other stocks climbing to new highs, whereas\nour own securities continue to languish or decline further.\nFrom what you already know of the market, you will surely agree it is not a\nwise policy to put all your capital into buying stocks in what is clearly a\nBear Market in the Averages and in most stocks. You will agree, too, it is\nnot a safe thing to sell stocks short to the limit of your resources in a\nskyrocketing Bull Market.\nIf you have to be 100% on one side or the other, it is much better to go with\nthe trend. In that way, you will be in line with the probabilities as shown by\na majority of stocks and by the Averages.\nNevertheless, you should realize going with the trend is not always as easy\nas it sounds. We can set up definitions, as we have, of what constitutes the\nMajor Trend. Then the question is whether you have the patience and the\ncourage to maintain a position in line with these definitions through months\nof uncertainty and possible adverse moves. During turning periods, it is\noften hard to make the decision whether to buy or sell.\nMost especially, there is the difficulty of knowing what to buy or what to\nsell and when. The simple patterns and signals of the Averages do not tell\nthe whole story. There is a certain usefulness in regarding the market as a\nwhole in studying Dow Theory, just so long as we keep in mind the\nAverages we are studying are generalities (high-order abstractions) and the\nrules for determining their trend apply to these generalities and not\nnecessarily to each and every stock listed on the Stock Exchange.\nIn many cases, for example, a group of stocks will top out and start an\nimportant Bearish Trend, whereas other groups of stocks are continuing to\nmake new highs. This occurred in 1946, when we saw a large number of\nstocks topping out in January and February, and others continuing strong\nuntil the end of May.\nWe think of 1929 as the year the market made its great peak and crashed in\nOctober to start the series of breaks that continued into 1932. There is some\ntruth in this, but it is not the whole truth. There were some important stocks\nthat made their highs long before the 1929 Top. Chrysler, for example,\nmade its high in October 1928, and had dropped from 140 to 60 before the\nPanic of 1929. There were stocks that never enjoyed a Bull Market at all in\nthe whole period from 1924 to 1929. By actual count of nearly 700 listed\nstocks, 262 issues made their Bull Market highs before 1929, and 181\ntopped in 1929, but before August of that year. There were several stocks\nthat did not have their first downside break until after 1929. Forty-four\nstocks went into new Bull Market high ground after 1929 and before mid-\n1932. Only 184 of the 676 stocks studied made their Bull Market highs in\nAugust, September, or October of 1929 and crashed in October and\nNovember.\nIn other words, only 27% of the stocks acted the way everybody knows all\nstocks acted. (EN: As the Dow and S&P 500 made all-time highs in 1999\nand were near those highs in 2000, the same condition held true again.\nMany stocks had topped and were in long downtrends. EN9: And as stocks\ncrashed after the top of March 2000, Dow stocks held up well compared\nwith NASDAQ stocks and Standard & Poor's (S&P) 500, which saw\ndeclines of around 50% [see Figure 20.3].)\nIt is all right to accept the general trend as a useful device, as long as we\nknow it is a device only, and not a picture of the detailed reality. We have to\nface the problem that continually confronts every student of the market:\nhow to protect ourselves from uncertainties in interpretation of the\nAverages, and how to protect ourselves against stocks that are not moving\nwith the majority. The problem can be met, first of all, by not taking an\nunreasonable amount of risk at any time (see Chapter 41).\nIt can also be met by using an Evaluative Index instead of switching from\nall-out Bullish to all-out Bearish. By this we mean using an indicator that\nwill show not merely whether it is a Bull Market or a Bear Market, but how\nBullish or how Bearish it seems to be at a given time.\n\n10\n20\nDiagram 38.1 The Evaluative Index shows the percentage of stocks that\nappear in Bullish or Bearish Major Trends. In 1961, this Index conflicted\nwith “stock Averages,” suggesting a possible Major Turn.\n\n30\n40\n50\n60\n70", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 206}
{"text": "arish. By this we mean using an indicator that\nwill show not merely whether it is a Bull Market or a Bear Market, but how\nBullish or how Bearish it seems to be at a given time.\n\n10\n20\nDiagram 38.1 The Evaluative Index shows the percentage of stocks that\nappear in Bullish or Bearish Major Trends. In 1961, this Index conflicted\nwith “stock Averages,” suggesting a possible Major Turn.\n\n30\n40\n50\n60\n70\n80\n90\nAt first glance, this may seem not too different a conception from that of the\nclassic Dow Theory; the same technical methods apply. Also, during a\nstrongly Bullish Market, an Evaluative Index will also indicate\napproximately the degree of strength. As the market begins to develop weak\nspots, as did the market in 1928 and 1929, the degree of Bullishness will\ngradually decline.\nBefore considering the use of this Index, let us outline what it is and how it\nmay be constructed. You will understand it is not a precise tool; it gives\nonly an approximate picture of the state of the market; it gives no positive\nsignals; and, in the final analysis, it is a reflection of the judgment and\nopinion of the person who is maintaining it.\nSuppose you are keeping daily charts of 100 stocks; at the end of each\nweek, you can mark these along the bottom of the chart with a small plus or\nminus, indicating your opinion as to whether each particular stock is\nmoving in a Bullish Major Trend or is Bearish. In some cases, you will find\nit hard to make a decision. This is not too important, however, because\nthese cases will not be numerous, and in the majority of stocks, you\nnormally will be able to mark them plus or minus on the basis of their\nobvious action. If you now total the plus stocks and also the minus stocks,\nincluding those in which you have had to make a tentative decision, you\nwill have two figures totaling the number of your charts. If 75 of these are\nplus, you can say the market looks 75% Bullish to you. If next week the\npercentage is higher, say 80%, it indicates a stronger or more Bullish\ncondition. If it is lower, say 70%, it shows that, on balance, fewer of your\nstocks look strong; hence, the market is presumably weaker.\n(EN10: A quick way to construct an Index of this sort is to run Moving\nAverage studies on the market, examining how many stocks are above their\n50-day Moving Average, how many above and below their 200-day Moving\nAverage, and so on. Obviously, you can also do it as Magee did, by\nexamining each chart of the Dow to see whether it looks strong or not.)\nAs we have said before, if the Averages are making new highs, you will\nexpect (and find) the Evaluative Index will range well above 50%. In an\nobvious Bear Market, the Index will stand considerably lower than 50%.\nHowever, notice we do not speak, here, of signals. There is no point at\nwhich we need to say, “Sell everything.” Neither is there a point at which\nwe can say, “Buy now,” in an all-out sense. The Index will float and adjust\nitself continually to the shifting conditions.\nIt must be clear that a market in which only 53% of a large group of\nrepresentative stocks are moving Bullishly is not as strong as one in which\n80% of these stocks are acting Bullish.\nTherefore, you would be justified in making larger commitments on the\nlong side in this second case.\nYou would still have the problem of selection of the individual stocks to\nbuy, but you would be justified in making larger total commitments or in\nassuming total greater risk (see again Chapter 41), than in a market that was\nbarely qualifying as a Bull Market.\nBy bringing the total of one's investment program in line with this Index, it\nis possible to roll with the punches, and one would almost automatically be\nwithdrawn from a deteriorating market before things became too dangerous.\nFurthermore, this would be accomplished without the need for torturing\ndecisions as to whether to sell now or wait a while.\nThere is a further extension of this method. If an investor were to follow the\nEvaluative Index only by increasing or decreasing his long commitments\nwith the rise and fall of the Index, he might be better off than if he had only\nthe two alternatives of complete optimism or complete pessimism. In this\ncase, he would still be pointed always in one direction and would stand to\nlose to some degree on his long commitments if the market did eventually\nreverse and go into a Panic Move.\nThe extension of the method is to proportion capital, or a certain portion of\ncapital, between the long side and the short side of the market. Assuming\nyour interpretation of your own charts is reasonably correct in a majority of\ncases, you can, at any particular time, select several stronger-than-average\nstocks, and similarly, several weaker-than-average issues.\nWith the Index standing in the vicinity of 50% (as it did for a number of\nmonths in mid-1956), you can then select several strong stocks to buy, and\nseveral candidates for short sale, making commitments that will\napproximately balance your total risk. In the case of an upward surge that\nsweeps all before it, you will accrue losses on the short sales and eventually\nmay have to reverse your classification of them from minus to plus, closing\nthem out for a loss. In such a case, the gains on your good long positions\nwill more than offset the loss, assuming your choices were well made, and\nthe loss realized can be absorbed as insurance, namely, the price you have\npaid to be in a protected position.\nOn the other hand, should the market collapse suddenly (as it did, for\nexample, at the time of President Eisenhower's illness in 1955) (EN: and as\nit did on rumors of Reagan's incompetence in October 1987, and the Asian\nFlu of 1998, and so on and so on), the accrual of loss in the long positions\nwill be offset by accrual of gains in the short positions. If the decline should\ncontinue to a point calling for sale of the long stock, the losses here could\nbe considered the price of the insurance protection to the shorts provided by\nthe longs. (EN: In the tradi", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 207}
{"text": "s of Reagan's incompetence in October 1987, and the Asian\nFlu of 1998, and so on and so on), the accrual of loss in the long positions\nwill be offset by accrual of gains in the short positions. If the decline should\ncontinue to a point calling for sale of the long stock, the losses here could\nbe considered the price of the insurance protection to the shorts provided by\nthe longs. (EN: In the tradition of the Texas Hedge, I take a somewhat\ndifferent view of shorts. Although they would be viewed in Pragmatic\nPortfolio Theory as reducing risk, I like to view shorts as another profit\nopportunity with the added benefit of reducing total risk. Being short a\nstock in a confirmed Uptrend is simply feckless, and vice versa.)\nIt is also quite possible, in a more normal market, for both the long\npositions and the short positions to show gains. What we are proposing is a\nsystematic and continuous arbitrage or hedge. As the Evaluative Index\nadvances, the proportion of short positions would gradually be reduced, and\nthe long positions increased. As the Index declines, the reverse would\nhappen. (EN9: I have suggested the method outlined here be called a\n“Natural Hedge,” and the implementation of the hedge be called\n“Rhythmic Trading.” A Natural Hedge of the Dow would consist of a long\ncommitment to, for example, the DIA in a Bull Market and short positions\nin Bear stocks within the Dow. Or, even better, short positions in stocks\npositively correlated to the weak Dow stocks. This last because even weak\nmembers of the Dow will tend to be cushioned by the large holdings of\npassive indexers.)\nThis method is essentially conservative. Those who have always feared the\nshort sale as a purely speculative gamble might well reexamine short selling\nfrom the standpoint of using the short sale as a regular part of their\ninvestment program as counterbalance to the long holdings.\nThe result to be looked for in this conservative balanced and diversified\nprogram is primarily protection of capital. By its very nature, it eliminates\nthe possibility of plunging for spectacular profits, but it also provides the\nmechanism by which the technical method can stand on its merits, largely\nindependent of the changes and chances of the market. It makes it possible\nto eliminate a large part of the anxiety and uncertainty so many traders and\ninvestors carry every day and often late into the night.\n(EN: Many modern readers are probably unaware that John Magee wrote a\nweekly advisory letter for four decades. These wise and practical letters\ncomprise the John Magee Market Letter\nDiagram 38.2 From Collected Market Letters, September 28, 1985. Magee\nEvaluative Index computed on the Dow-Jones Industrials illustrating the\nuse of the Index to identify Tops and Bottoms in the market. A sort of\n“oversold-overbought” indicator.\nArchive. From this Archive, I append here the letter of September 28, 1985,\nrelative to the Magee Evaluative Index (MEI). It speaks very strongly for\nitself.)\nSeptember 28, 1985: an oversold market\nThis week, the MEI fell to 9% Strong, its deepest penetration into the\noversold quadrant this year. Not since June of 1984 has this index been\nlower (see Diagram 38.1). Shortly after its June low of 8% Strong, the MEI\nheaded steadily higher, giving an Aggressive Buy signal throughout late\nJune and July.\nThe June 1984 MEI low of 8% Strong, together with the 8% level reached\non February 25, 1984, constituted a Double Bottom oversold reading for\nthis index. It corresponded to the 1,079 Bottom recorded by the Dow-Jones\nIndustrial Average (DJIA) on June 18, 1984, after which that Index\nadvanced steadily to its recent July peak of 1,372.\nFor more than 20 years, all major stock market Bottoms have corresponded\nwith extremely low MEI readings. During the “turbulent period” when the\nstock market oscillated violently but showed no gain at all, MEI readings of\n5% Strong or less corresponded with all Major DJIA Bottoms until the June\n1982 low of 9% Strong, which immediately preceded the stock market's\nupward explosion.\nThat slightly higher than “5% Strong or less” Bottom was an important clue\nthat a reinvigorated stock market was at hand; the straight-line DJIA\nadvance from 770 to nearly 1,300 ended a 17-year “do-nothing” period for\nstock prices and ushered in the “renewed upswing” period shown on the\nchart.\nIn this context, the “8% Strong Bottom” of June 1984, and the current MEI\nreading of 9% Strong, take on added meaning. If, in fact, we are in a period\nof Renewed (or major secular) Upswing, stock market Bottoms will tend to\nbe less severe and Tops more extremely overbought than would otherwise\nbe the case. Both the June 1982 DJIA low and that of June 1984 fit this\nmodel. Because secular stock market waves tend to last for many years,\neven decades, the likelihood is that the current MEI reading of 9% Strong\nwill also define a Major DJIA low.\nchapter thirty-nine\nTrial and error\nYou will not expect to turn in a perfect record from the start. You may\nindeed do poorly, which is one of the reasons we have suggested using only\na safe amount of your capital, allowing enough leeway so if you should\nmisread and misdirect your campaigns, or if you should encounter an\nIntermediate Setback in the trend of a Major Turn, you will be able to get\nback on course, undismayed, and richer in experience.\nYour records of actual transactions (and notes on theoretical transactions)\nwill help you. As time goes on, you will discover new trading refinements.\nTry these methods against your previous chart records. See whether your\nimprovements work out consistently to your advantage. In that way, you\ncan test new details of method without risking actual capital until you have\nchecked the operation thoroughly.\nIn one actual case, a trader who had shown a rather poor record of\nperformance through a fast-moving Bear Phase of the market, rechecked 30\nof his actual trades made during that period in light of new methods he had\nsubsequently developed. Where the original", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 208}
{"text": "r advantage. In that way, you\ncan test new details of method without risking actual capital until you have\nchecked the operation thoroughly.\nIn one actual case, a trader who had shown a rather poor record of\nperformance through a fast-moving Bear Phase of the market, rechecked 30\nof his actual trades made during that period in light of new methods he had\nsubsequently developed. Where the original record showed a loss at the rate\nof about 40% per year on the capital for the time it was tied up, the changes\nhe introduced, applied to the same situations, would have resulted in a\nprofit at the annual rate of 156%. Such a result, although not conclusive,\nwould strongly suggest trying out the new method in all similar situations in\nthe future, and if the performance continued to show this advantage, to\nadopt it as a permanent policy. It is only by continual checking and testing\nthat you can learn to pick up more of the profitable opportunities and\nprotect yourself better against the unexpected Reversals.\nIf you follow the suggestions of this book, those already given, and those in\nthe following chapters, you will proceed slowly and cautiously, not risking\nall your capital on a single move in a single stock; subsequently, errors and\nplain bad luck, when they hurt you, will not hurt you too seriously. You will\nbe prepared for false moves, wrong interpretations, and complete Reversals\nof expected developments.\nIf you have worked thoughtfully and serenely, without permitting your\nemotions to rule your judgment, the law of averages will bring you\ncontinually greater success. You are not gambling blindly in this work; you\nare intelligently using past experience as a guide— and it is a dependable\nguide. Your operations are part of the competitive workings of a free\nmarket; your purchases and sales are part of the process of interpreting the\ntrend, checking runaway inflation and crashes, and determining the value of\nthe American industrial plant.\nThe market will continue to go up and down in the future as it has in the\npast. Your technical knowledge will save you from “buying at the Top” in\nthe final Climactic Blowoff, and it will save you from selling everything in\na fit of depression and disgust when the Bottom is being established. In\nyour studies of past market action, you have a strong shield against the\nsudden thrusts that surprise and often defeat the novice trader.\n(EN9: I have often told my students if their knowledge of this material does\nnothing more than keep them from making stupid mistakes like buying a\nTop or buying a downtrend or buying before a Bottom has completed\nforming, then their time will have been well spent. The elimination of\namateur blunders such as these can immeasurably improve investment\nperformance.)\nTaylor & Francis\nTaylor & Francis Group\nhttp://taylorandfrancis.com\nchapter forty\nHow much capital to use in trading\nUp to this point, we have been talking mostly in terms of points and\npercentages. Little has been said about dollars. From here on we are going\nto turn the spotlight on the questions revolving around money, capital, and\nthe dollars you will actually be using in your operations; just as an\nunderstanding of the technical signals and patterns alone will not guarantee\nyour profits without a tactical method of applications, so too your tactics\nalone will not ensure you profits until you have tailored your method to fit\nyour pocketbook, and until you have a systematic control of your trading in\nterms of dollars and cents.\nAt the start of your charting operations, you will be using no capital. You\nwill be making no trades either actual or theoretical. Any commitment you\nmight make during the first four or five weeks on a new chart would be no\nmore than gambling on a hunch. It will take about two months of thankless\ncharting before you have any clear picture of how any of your stocks are\nacting technically. From then on, your chart history will become more\nvaluable each week. Your first trades probably will be theoretical ones. You\nwill want to get the feel of the charts and learn to apply the methods you\nhave studied. Eventually, you will want to make an actual transaction.\n(EN: The prudence of this approach can hardly be disputed. Just as markets\nhave changed, stock market mentality and awareness have changed. The\nmere existence of this book and of the general atmosphere enable the\nmodern investor to progress more rapidly than the old pencil-and-paper\nand slide-rule chap. The availability of computers and databases and\ntutorial tools, not to mention online and offline courses in the subject, are\nunparalleled resources.)\nThen the question will come up, “How much of my capital shall I use for\ntrading purposes?” (EN: In a certain sense, this question begs the question.\nIt presupposes the reader has capital. If the reader does not have capital\nbut is gambling with the milk money or the mortgage payment, his failure is\nvirtually assured. Do not speculate with money whose loss will occasion\nyou more than passing discomfort.)\nThe amount will depend on your circumstances and how much of your time\nand effort you plan to put into stock trading, as well as your experience in\nthe market. If you have been buying and selling stocks for a number of\nyears, you will naturally continue along the same lines, simply applying the\nnew techniques to your operations.\nOn the other hand, if stock trading is entirely a new field for you, or if it is\nonly a minor hobby or sideline, it would pay to make haste slowly. Some\nwriters have pointed out it usually takes about two years to gain enough\npractical experience to operate safely in the market; during the two-year\napprenticeship period, many traders come in, gradually lose their capital,\nand retire permanently from the field, leaving their money behind them.\nTherefore, no matter how confident you may be or how anxious to get in\nand start pitching, it would be safest to do most of your experimenting on\nthe theoretical basis and to use only a s", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 209}
{"text": "l experience to operate safely in the market; during the two-year\napprenticeship period, many traders come in, gradually lose their capital,\nand retire permanently from the field, leaving their money behind them.\nTherefore, no matter how confident you may be or how anxious to get in\nand start pitching, it would be safest to do most of your experimenting on\nthe theoretical basis and to use only a small amount of your actual capital,\nso that after, say, two years, if you have shown some actual profits,\nconsistently and regularly, even though small, you will be much better\nprepared to use more of your capital wisely and safely. Conversely, if\nduring that time you have made repeated mistakes and have registered\nmany unnecessary losses, you will be able to correct your methods and\ncontinue on a sounder basis, without having lost your main capital reserve.\nIn no case do you want to risk everything you can scrape together on the\ntheory that here is the quick way to make easy money. That simply is not\ntrue and the chances are overwhelmingly against you if you go ahead under\nany such plan.\nIt is better to figure out how much you can spare, how much you could\nafford to spend for experience, considering the amount you start with is in\nthe same category as money you might use for taking a special course of\ninstruction, or for improving property you hope to sell. Or, to take another\nexample, it would be similar to the salary you might lose in accepting a\nlower paid position in a new kind of work that eventually should be worth\nmore than your present job.\nIn other words, you will not depend, from the start, on any returns from the\ncapital you use in trading. You will plan your own budget outside of these\nfunds, even if that calls for trimming your budget to make that possible.\nThen you can go ahead and follow your trading method free from any\npressure to take unnecessary risks, free from the need to sell stock\nprematurely to meet obligations, and free from heckling fears and worries.\nYou can start operations with as little as $500. (EN: This is especially true\nin the Internet age. Free commissions in many sites and the availability of\nlow-cost diversified trading instruments like index ETFs [(the SPY (S&P\n500), DIA (Dow Jones Industrials), and QQQ (NASDAQ 100)] offer the\nsmall investor more opportunity than ever before in financial market\nhistory.) Better to have $1,000 or several thousand, but it makes little\ndifference, so long as you have worked out what you can afford to use\nduring the apprenticeship period, and as long as you are sure you will have\ncapital to continue your operation as you develop ability. The important\nthing at the start is not how many dollars you can make, but what\npercentage of increase per year you can average with the capital you are\nusing.\nIf you approach the serious business of trading in this frame of mind, you\nwill not be afraid to take losses when it is necessary (and there are times\nwhen that is the only wise course to adopt). You will not be straining to\nmake an unreasonable or impossible profit (with the usual disastrous\nresults). Additionally, you will be able calmly to build your trading policy\nin the sure conviction the market will still be there next year, that\nopportunities will still be waiting for you, and that the basic procedures you\nare developing are more valuable than any “lucky break” you might pull out\nof thin air or a boardroom rumor.\nchapter forty-one\nApplication of capital in practice\n(EN: Today we would refer to this as “asset allocation,” about which many\nlearned books and articles have been written (see Appendix B, Resources).\nThe modest suggestions in this chapter are, like Magee, very pragmatic and\nsimple—and quite possibly more effective for the general investor than\nthose complicated procedures spun out by supercomputers for complicated\nStreet portfolios.)\nLet us now restate a number of ideas we have already investigated and on\nwhich (let's hope) we are thoroughly agreed.\n1. Major Trends ordinarily run for long periods of time, covering a\ntremendous number of points in total advance or decline—15733.05,\n2009 to 2017.\n2. Almost unbelievable profits could be made by one who could buy\nstocks at the extreme Bottom of a Bear Market and sell at the extreme\nTop of the following Bull Market; or sell short at the extreme peak of a\nBull Market and cover at the extreme Bottom of the following Bear\nMarket.\n3. It is not possible to accomplish either of these desirable results.\n4. It is possible to avoid becoming trapped in purchases made at or\nnear the extreme Bull Market Top so that losses become dangerous or\nruinous in a Major Reversal. It is also possible, of course, to avoid\nsuch losses through ill-advised short sales near the extreme Bottom of\na Bear Market.\n5. It is possible to make profits by trading in line with the Major Trend,\nand in some cases, by trading on the Intermediate Corrections to the\nMajor Trend, or, occasionally, on the individual behavior of a stock\nmoving contrary to the Major Trend.\n6. The greatest and most dependable profits may be made along the\nMajor Trend during the principal period of advance (or decline, in the\ncase of short sales), but not during the earliest phases when the\nmovement first gets under way or during the rounding off or Reversal\nphenomena near the end of the movement.\nTherefore, to get the greatest benefits from following the Major Trends, one\nwould want to have a relatively small equity in the market at the very start\nof the move and very little at or near the termination of the move, but a very\nsubstantial interest during the mid-portion when the advance or decline was\nmaking the greatest headway.\nThe writers have felt it should be possible to express this relation between\nthe amount of capital tied up and the state of the Major Trend in a neat and\ndefinite equation. Yet, inasmuch as the idea of a Major Trend is, itself, a\nmatter of definition, and because the trend is an abstraction from the\nindividual move", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 210}
{"text": "during the mid-portion when the advance or decline was\nmaking the greatest headway.\nThe writers have felt it should be possible to express this relation between\nthe amount of capital tied up and the state of the Major Trend in a neat and\ndefinite equation. Yet, inasmuch as the idea of a Major Trend is, itself, a\nmatter of definition, and because the trend is an abstraction from the\nindividual movements of many stocks, it does not seem possible to arrive at\nany such easy solution to the problem of how much capital to use at a given\ntime.\nNor is it necessary to have a definite and exact answer. As we have already\nstated, it is possible to set up an Evaluative Index that will give an\napproximate answer good enough for all practical purposes so far as\nweighing the “strength” of the trend at a particular time. (EN: To clarify and\nmake more explicit the concept here, I would point out the Asset Allocation\nimplications of the Magee Evaluative Index. If the analyst's evaluation of\nthe market indicated 30% of stocks were Bullish, 30% Bearish, and 40%\nneutral, he might so commit his capital—30% long, 30% short, and 40%\ncash. This would also assume his assessment of risk also indicated the risks\nof the long and short positions were balanced, or approximately equal since\ninfinite precision is achievable only by the writers of academic treatises\nworking with perfect hindsight.)\nThere are, however, some other questions. Most important is the question of\nhow much total “risk” you are assuming because some stocks are very\nconservative and others are very speculative, it is not enough to determine\nwhat part of your capital should be applied in a market trend. The\nproportion of your total capital used is not necessarily the whole measure of\nyour participation. The price level of a stock will affect its habits (low-\npriced stocks make bigger percentage moves than high-priced stocks). The\namount of margin you are using will have an effect on the degree of risk.\nThere is some substance to this plan (otherwise we would not be taking the\ntime to discuss it here at all), but there is a serious question whether the\ndecision as to the amount of capital to be used at any specified time can\never be reduced to a simple mathematical operation. (EN: Still true\nalthough there are those who attempt it.)\nLet us suppose you are convinced this is a Bull Market, in a phase of such\npotency that you would be justified in using 80% of your capital. However,\nyou will immediately realize, from what has been said in earlier chapters, if\nthis money is put into a high-priced (EN: and low-beta) stock, it will not\ngive you as much likelihood of either profit (if you are right) or loss (if you\nare wrong), as it would if put into a lower priced (EN: and high-beta) stock.\nIn the same way, your money put into a stock having a low Sensitivity\nIndex, that is, a conservative stock like a Utility stock, will not give you as\nmuch likelihood for either profit or loss as a stock of a high Sensitivity\nIndex (EN: volatility), namely, a speculative stock such as an internet issue.\nThese factors, quite as much as the amount of actual dollars, affect your\nstatus, and are factors in answering the question, “Am I out on a limb and,\nif so, how far out?”\nTo make this perfectly clear, we could take 80% of our capital, say $8,000\nout of $10,000, and put this amount into the market by purchasing a\nconservative preferred stock, outright. A great rise in the general market\nmight bring us an increase in value of a few points, perhaps 4% or 5%.\nConversely, a great decline might depress the issue by about the same\namount. An example of going to the other extreme might be to purchase\n$8,000 worth of options on a low-priced, extremely speculative stock, in\nwhich the probable result within 90 days would be either a profit of several\nhundred percent, or a total loss of $8,000.\nObviously, we could vary our status during the progress of the market either\nby increasing or decreasing the amount of the total commitment, or by\nchanging the nature of the account, switching part of the total into more or\nless speculative stocks, higher or lower priced stocks, and also by varying\nthe amount of margin used.\nIn Appendix A, ninth edition, and Chapter 42, we will show how the\nprincipal factors affecting a given sum of capital used (sensitivity, price,\nand margin) can be combined into one figure, which we are going to call\nthe Composite Leverage Index. (EN: Once again, Magee demonstrates a\npractical vision and intuitive understanding both of the markets and of the\nbasic character of investing far ahead of investment theory and\nunderstanding of his time. What we have in this concept is nothing less than\nthe original glimmerings of VAR, or Value at Risk. The concepts and\npractices of VAR are succinctly summarized in Chapter 42. Composite\nLeverage is a complex subject and based on manual charting. For that\nreason, it has been left in the ninth edition, where the truly dedicated\nscholar may study it at leisure.)\nIt is perfectly true you must vary your Composite Leverage (EN: risk\nexposure) to take advantage of the fast-moving central portions of important\nmoves, using a lower Composite Leverage at the beginning of such moves\nand during the tapering-off or turning periods near the end.\nIt is one thing to express the Composite Leverage accurately, however,\nanother thing to write a formula for applying specific degrees of leverage at\nparticular times. The method suggested at the very beginning of this chapter\nhas some value but owing to the Secondary Reactions and the difficulty of\ndetermining Major Trends in individual stocks, it is not possible to make\nthis into the neat, pat rule we are looking for.\nIt must be a matter of experience, or intuition based on experience. You will\nnot permit your Composite Leverage factor (i.e., your Portfolio Risk Factor;\nsee Chapter 42, Portfolio Risk Management) to run out to a dangerous point\non the limb. Neither will you allow it to become so low du", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 211}
{"text": "Major Trends in individual stocks, it is not possible to make\nthis into the neat, pat rule we are looking for.\nIt must be a matter of experience, or intuition based on experience. You will\nnot permit your Composite Leverage factor (i.e., your Portfolio Risk Factor;\nsee Chapter 42, Portfolio Risk Management) to run out to a dangerous point\non the limb. Neither will you allow it to become so low during times of\ngood market opportunity that you are not getting full benefits from the\nmove.\nWe can keep the general shape of a Major Swing in our minds as we\nconsider this. Bull Markets normally rise through a series of irregular\nadvances and declines, starting with a moderate upward trend, and\ngradually accelerating as the market approaches its ultimate top. Bear\nMarkets are likely to move fastest at the start and to taper off gradually\ntoward the end. Bear Markets are steeper than Bull Markets. These\nconsiderations will help us to judge the times when the market will offer the\nbest opportunities, the times when our Composite Leverage should be\nincreased.\nThere are other factors, even harder to pin down in simple figures. We\nwould, at times, make switches of our holdings for reasons indirectly\nrelated to the factors making up the Composite Leverage Index of the\nstocks. We know, for example, high-grade issues, the active market leaders,\nand perhaps some stocks of a more conservative nature will tend to start\ntheir moves in a Bull Market fairly early and to continue their advance at a\nfairly steady pace. Eventually, they will reach their tops and make a\nReversal Pattern. They will decline from this point, probably at a steeper\naverage angle than the ascent. Low-priced and low-grade issues, on the\nother hand, tend to be slow in getting started, will remain dormant during\nthe early phases of a Bull Market, and will then suddenly and spectacularly\nskyrocket in a series of moves that brings them to their ultimate Top. This\nTop, however, is likely to be reached at a later point (perhaps months later)\nthan the point at which many of the more conservative stocks topped out.\nThe speculative group will then drop very fast and will return to the dead\nlevels of inaction before the conservative group has finished its more\nleisurely Major Decline.\nThis means you will do well to concentrate your Bull Market trading in the\nearly stages, in the higher grade stocks, and in the later stages, in the lower\ngrade stocks. In a Bear Market, you would perhaps be able to make short\nsales unsuccessfully in high-grade stocks even while some of the “cats and\ndogs” were still completing their final run-up; however, you would be\nwatching for the opportunity to cover those shorts and go short the low-\ngrade stocks as soon as their Reversal was signaled.\nAppendix A, ninth edition, will go into the Composite Leverage Index. It\nshould be a useful gauge for you in your market operations, and a\nprotection against overtrading. Except, do not expect to use it mechanically\nas an index against the market to answer all your questions involving the\nnature and size of your commitments. For in gauging the condition of the\nMajor Trend at any time, your personal experience and judgment must be\nthe final arbiters.\nPut and call options\nOptions of various sorts have a long history in commercial markets. Nearly\n2,000 years ago, the merchants who operated in the Mediterranean region\nused “to arrive” at agreements that amounted to option contracts, as\ninsurance to reduce the risks of storm and piracy. Modern commodity\nfutures contracts resemble stock options in their dual nature of serving\neither as trading media or as insurance devices. Options are also widely\nused in real estate transactions and in various other applications.\nFor many years, stock options were traded only on the basis of individual\nagreement between a buyer or a writer, and an opposite number, directly or\nthrough a broker or dealer. The customer and the writer were free to decide\nwhat stock (any stock) would be optioned, at what exercise or striking\nprice, for what period of time, and at what premium.\nIn 1973, a new method of handling option contracts was inaugurated by the\nChicago Board Options Exchange and later the American Stock Exchange,\nand then to other Exchanges across the country in which call options on a\nselected list of actively traded stocks are offered with standard expiration\ndates (like commodity contracts) and at definite exercise prices, the\npremium depending on the bids and offers of buyers and writers. An\nexcellent guide to this rapidly expanding market is (EN) Options as a\nStrategic Investment by Lawrence G. McMillan.\n(EN: In the Internet age, options and derivatives markets have attained an\nastounding economic importance. One amusing way of measuring this\nimportance is by listing some of the great debacles that have occurred to\nmajor traders of derivatives. Bank Negara, Malaysia's central bank, lost $5\nbillion in 1992-1993 through bad bets on exchange rates. Showa Shell\nSekiyu, Japan, lost $1.58 billion in 1993; Metallgesellschaft, Germany, lost\n$1.34 billion in the same period. Barings Bank lost $1.33 billion on stock\nindex futures. From 1987-1995, known losses like this totaled $16.7 billion.\nAs Magee would say, etc., etc., which is appropriate considering in 2012 JP\nMorgan Chase lost 2 to 5 billion trading derivatives. Of course, compared\nwith the estimated total market in 1995 of $25 trillion, this is a mere\nbagatelle. Perhaps this is sufficient to warn the general investor that the\nfield is strewn with financial mines even for the sophisticated.\nEN9: If the investor considers stocks a complex or difficult area [although\nit is hoped this book will make it less so for him] options are exponentially\nmore difficult. Professionals beat amateurs at that game so thoroughly and\nso often as to consider it easy money. So, the general investor should be\nsternly warned that much training and study should be undertaken before\nbecoming fodder for the pros.\nEN9: Trad", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 212}
{"text": "vestor considers stocks a complex or difficult area [although\nit is hoped this book will make it less so for him] options are exponentially\nmore difficult. Professionals beat amateurs at that game so thoroughly and\nso often as to consider it easy money. So, the general investor should be\nsternly warned that much training and study should be undertaken before\nbecoming fodder for the pros.\nEN9: Tradestation, the superlatively fine trading system and brokerage\noperation, distributed at one time an intelligent little book by Charlie\nWright, Trading for a Living, which among its other fine points offered a\nplan for the ongoing allocation of capital to trading.)\nchapter forty-two\nPortfolio risk management\nAs we suggested in the preceding chapter, there is some relation between\nthe state or stage of a Major Market and its potentialities for profit. There\nare many mechanical plans and systems for coping with the problem, but\nwe do not believe it can be fully solved by mechanical means alone. We\nmentioned one plan by which the commitments were governed according to\nthe consensus of trends in an entire portfolio of charts. (EN: The Magee\nEvaluative Index, or MEI.) There are other plans dependent on pyramiding\nthe commitment as the trend proceeds, and still others based on averaging\ncosts by increasing the commitment working against the trend, namely, by\nbuying on a scale-down at progressively lower levels in a Bear Market and\nselling on a scale-up in Bull Markets. (EN9: Invitations to disaster, the first,\nand demanding adroit skill, the second. Avoid such methods unless you are\nan expert position trader.)\nNone of the plans, taken by themselves, are adequate to answer the\nquestions of when to buy and when to sell. The primary purpose of this\nbook is to study the technical phenomena of individual stocks. If we can\nlearn from the charts at what points to buy and under what conditions to\nsell, we have acquired the basic machinery for successful trading. On the\nother hand, if buying and selling at points that more often than not result in\nnet losses, then it makes no difference how you divide up your capital or\napply it in the market, for it will be bound to shrink until, eventually, it has\nall disappeared. (EN: An investor who finds himself in this situation should\nset a benchmark. He should decide if he loses 50% of his capital he will\nquit trading and put his money in index or mutual funds or in the hands of\nan advisor. Generally speaking, an advisor is preferable to a mutual fund,\nyet both are preferable to an investor with two left feet. They can certainly\ndo no worse than a consistently losing performer. EN10: On second\nthought, from the vantage point of 2011, maybe they can.)\nThe first problem, then, is to learn to use the technical tools, patterns,\ntrends, Supports, Resistances, and so on. Then we can consider how much\nmoney we will risk and in what way.\nWe have already grasped it makes a difference, sometimes a great\ndifference, how we apply our capital. The various factors of price level,\nsensitivity, and margin enter into the concept we are going to call the\nPortfolio Risk. Meanwhile, we have said enough so you will understand\nwhat we are driving at if we use the term in connection with your market\ncommitments.\nYou realize, of course, you do not want to be so conservative to rule out\npractically all opportunities for making gains. If you decide never to oppose\nthe Primary Trend, you will have to be inactive during long Secondary\nTrends and may be left waiting, sometimes for weeks on end, for a\ncontinuation of the Primary Move. Naturally, you will pass up all weak\nsignals and convergent trends and shun new commitments after very active\nblow-offs or Panic Climaxes. You could, no doubt, carry your refinement of\ncaution so far that your percentage of success, instead of being a mere 60%,\n70%, or 80%, might approach 90%; you might actually be right 95% of the\ntime in your decisions, but this extreme conservatism would also mean you\nwould trade only in the very finest possible situations, when every factor\nwas clean-cut and favorable. You would not have such opportunities very\noften. The result might be a profit, but too small a profit to justify all the\nwork and study you would be\nputting into your charts, for you can obtain nominally respectable returns on\nyour capital without very much study and without much risk, and you must\nexpect a much higher rate of return if your efforts are to be worthwhile.\n(EN: These “nominally respectable returns” are obtained by investing in T\nBonds and similar instruments. Bond traders and investors traditionally\nconsider these investments “risk free,” which is another form of the denial\nof reality. In reality, as David Dreman has demonstrated (Contrarian\nInvestment Strategy, Simon & Schuster), bonds are a kind of deteriorating\nasset because of the unarrestable depreciation in the commodity-\ndenominated value of currency.)\nTo put your charts to work, you have to avail yourself of the higher\nleveraged stocks that carry more opportunity for gain, hence, more risk of\nloss. You have to accept, deliberately, a greater risk than the man who is\ncontent to buy a “safe” security, put it in the box, and forget it.\nBy maintaining your Portfolio Risk at or near some constant level that your\nexperience and judgment tells you is safe for the particular state of the\nmarket, you will be protected against overcaution and irrational exuberance.\nMore important, if you maintain this risk posture in your operations, you\nwill be protected against unconsciously overtrading. This is a fault more\ncommon than extreme caution and can be a dangerous enemy even when\nyour percentage of theoretical trading gains is high. When you select a\ndefinite Portfolio Risk Strategy and adhere to it in your trading\ncommitments, changing it as necessary to meet changed conditions, you\nwill be forced to restrain your enthusiasm within safe limits, and you will\nbe continually aware of the risks you are taking.", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 213}
{"text": "common than extreme caution and can be a dangerous enemy even when\nyour percentage of theoretical trading gains is high. When you select a\ndefinite Portfolio Risk Strategy and adhere to it in your trading\ncommitments, changing it as necessary to meet changed conditions, you\nwill be forced to restrain your enthusiasm within safe limits, and you will\nbe continually aware of the risks you are taking.\nOvertrading: a paradox\nA series of identical percentage gains and losses on your capital does not\ngive you a series of equal gains and losses in dollars and cents. This is a\nserious problem, worth understanding, for a trader who is greatly\noverextended is intensifying this problem (which exists in any case, but\nwhich does not need to cause him too much worry if he has planned his\nprogram).\nYou can understand the paradoxical statement that percentage gains and\nlosses are not equal if you take the extreme case, first, of a man, who, in\nevery business venture he enters, risks his entire capital with the\nexpectation of either a 100% gain or a 100% loss. If this first venture is a\nloss, he loses 100%. He is finished, because he cannot gain by making\n100% on nothing. However, if the first venture is successful and he then\nuses his entire capital, including the new profits, again on the same terms,\nand the second venture is a failure, he will be wiped out completely. No\nmatter how many successes he may have, he stands to lose everything on\nhis first failure.\nIn a lesser degree, this is the situation in which we speak; you would not\nrisk all of your capital on the basis of doubling your money or losing all.\nThough, suppose you were extended, continually, to a point at which you\nwere taking the risk of a 40% net loss on each transaction, with the hope of\na 40% net gain. Should you start with $1,000 and have a succession of 10\nlosses, you would wind up with about $6.00. Now suppose the very next 10\ntransactions were all successful. You would finally come out, after 10 losses\nand 10 gains, each of 40%, with capital of less than $100. It would not be\nnecessary either that these 10 losses and 10 gains come in the order given.\nYou might have the 10 gains first, or three gains, four losses, seven gains,\nand then six losses. The result would be the same. After 10 gains and losses,\nin any order, you would have lost more than 90% of your capital.\nOn the other hand, if you risked your entire capital each time on 20\nventures, in 10 of which you took an 8% net gain and in 10 an 8% net loss,\nyour $1,000 after the 10 gains and losses would be reduced only to $937.\nYou would still have about 94% of your original capital. Therefore, in this\ncase (and 8% is a fair average figure for short-term transactions resulting in\na loss, in fact, a rather liberal figure according to extensive tabulations of\nactual transactions), you would have a handicap due to this paradox of only\nabout one-third of 1% on each trade.\nNow it is conceivable that 10 successive trades might go wrong, although\nthat would be an unusual condition. There was one period of 10 months\nbetween the actual turn of the market and the Dow Signal for a Reversal of\nthe Primary Trend. True, the resulting new trend, once established, ran far\nand long, and it would have made up all losses and produced fine profits;\nhowever, during the 10 hard months, allowing the fair average time of 30\ndays per transaction, it is possible that 10 successive wrong-way trades\nmight have been stopped out for losses, reducing the original $1,000 to\n$434.\nThe important thing is that the next 10 successful trades would have\nbrought this $434 back to $937; in other words, you could have righted the\nboat and sailed right on if you were working on the 8% basis, whereas if\nyou had been following the 40% basis we gave previously as an example,\nyou would have been sunk without a trace, a victim of overtrading.\nTherefore, by maintaining a sane Portfolio Risk Strategy and letting the law\nof averages work for you and with you, you will be on solid mathematical\nground. Your technical studies will have every opportunity to make you a\nprofit. Otherwise, you can, simply by unwise overextension of your trading,\nprevent even the best technical analysis from producing a net profit.\nEN: John Magee could easily be called the father of modern investment\ntheory but modern investment theory is so unenlightened as to technical\nanalysis that academics largely have not recognized his contributions—and\nmany probably have not read his work. If they had, he would be recognized\nas having identified what theorists now call systematic risk, and what is\nnow called the beta (Greek letter 3) with his concept of the Sensitivity Index.\nSimilarly, his work on Composite Leverage precedes (and may be more\npractical than) modern Portfolio Risk analysis, if cumbersome in the\nmodern context.\nSystematic risk, simply put, is market risk in aggregate; beta relates the\nindividual instrument risk to the market. Thus, Magee's Sensitivity Index did\nwhat beta calculations do—relate instrument behavior to market behavior.\nA stock with a beta of 1 will move up or down 1 point for each 1 point of\nmarket move. A 1.5 will move 1.5 for each 1 point of market move, and a\n0.5 will move 0.5 for each 1 point of market move. This number tells us\nimmediately which stocks are more volatile and sensitive to aggregate\nmarket behavior.\nComposite Leverage was Magee's method of determining how much risk the\ninvestor was assuming in a stock or portfolio.\nThe formula was (is) as follows:\nCL = SNT\n15.5 x C\nwhere S = the Sensitivity Index, N = Normal Range-for-Price (an attempt to\nquantify volatility), T = Total Paid, C = Capital dedicated to this\ncommitment, 15.5 a constant Magee called a Market Reciprocal, a sort of\nproxy for market volatility. The same formula, using sums, was used for\nPortfolio Composite Leverage. The number that falls out of this formula\nquantifies risk for Magee and uses concepts that are extremely modern.\nIn his original exposition of", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 214}
{"text": "(an attempt to\nquantify volatility), T = Total Paid, C = Capital dedicated to this\ncommitment, 15.5 a constant Magee called a Market Reciprocal, a sort of\nproxy for market volatility. The same formula, using sums, was used for\nPortfolio Composite Leverage. The number that falls out of this formula\nquantifies risk for Magee and uses concepts that are extremely modern.\nIn his original exposition of Composite Leverage in this chapter, Magee\nmade use of some cumbersome manual chart procedures and tables that I\nhave relegated to Appendix A in the eighth and ninth editions, and deleted\nin this edition. There is nothing invalid about them, even now, I feel, but\nthere might be simpler and more convenient ways for the present-day trader\nto assess his leverage, risk, and profit exposure. One of these is certainly\nutilizing Value at Risk (VAR) technology. However, there might be simpler\nmore pragmatic (and even more effective) ways of extracting this\ninformation from our trading portfolios. In short, Pragmatic Portfolio\nTheory and practice, which we will explore shortly.\nVolatility, for example, tells us something about the risk of a stock insofar as\nthe dispersion of returns. Portfolio volatility gives us a way of measuring\nthe riskiness of a group of stocks. In researching our systems and methods,\nwe should be able to get some handle on “drawdown,” or the average and\nlargest negative swings against our equity in an account. Simple\nconclusions follow: if we are willing to accept larger risks, we pick a\nportfolio of volatile stocks—a portfolio of Internet (or whatever the current\nfrenzy is) stocks rather than a portfolio of utility stocks.\nIt is indispensable to maintain a regular periodic review of portfolio\nstatistics to assure oneself that excessive risks are not being undertaken\nheedlessly. These important numbers include the following:\n• Original risk per trade\n• Actual realized loss\n• Average (and ranges) loss and profit per trade and their relationship\n(average profit divided by average loss)\n• Number of winning and losing trades and their ratio\n• Time in winning and losing trades (long-time trades combined with\noversize losses is an ominous sign)\n• Equity swings: average drawdown, maximum drawdown\n• Costs and expenses, summation, and per trade\n• Daily risk, yearly risk, and catastrophic risk, as computed by Pragmatic\nPortfolio Theory (as discussed below)\nRisk of a single stock\nThe beginning of conventional, or academic, analysis of risk is the\nexamination of volatility.\nThe formula for calculating the volatility of a stock (or downloading it) was\ndiscussed in Chapter 24. As a theoretical exercise, the formula and the\ntheory make certain assumptions that are not necessarily of interest to the\npragmatic practitioner. One of the assumptions is the holder chooses to\naccept the inherent volatility of the stock at hand. Except the point of\ntechnical analysis is to limit the risk accepted while attempting to realize\nprofit opportunities. Thus, the volatility of a stock, its (academic) risk, is\n0.30% or 30%, but when we trade it, we put a stop loss on it and only risk a\nmove of (say arbitrarily) 5%-8% against our position (where the 5%-8%\nsums to 2%-3%, or x% of total capital.) Thus, our method of risk control is\nbasically more dynamic than the theory. Nonetheless, volatility will give us\na measure of the stocks that make interesting trading vehicles.\nIt is perfectly possible to take our own experience with a stock or our\nsystem's experience with a stock and calculate its volatility to ourselves,\nusing the method described in Chapter 24. If the dispersion of its returns (in\nour trading) was greater than our appetite, we could then eliminate it from\nour watch list. To my knowledge, the literature does not mention this\nmethod for customizing our analysis of risk. Use of a customizing procedure\nlike this would give us an idea of the reliability of our methods in a\nparticular case. Stocks that did not behave would be banished to the\nportfolios of mutual fund managers.\nWe subscribe to a much more pragmatic and practical concept of risk. Risk\nis, to us, drawdown, or the probability of loss. Volatility qua risk is static\nand non-descriptive of the “risks” we take in trading and investing. We will\nchoose a volatile stock or instrument because that is where the profit\nopportunity is—in movement. Less risk-oriented investors will choose utility\nstocks. As some carnival goers choose the Ferris wheel and others the\nroller coaster. The probability of an exciting ride will be in the volatile\ninstruments. Our skills as traders give us the confidence to manage the\nprobabilities of the more “dangerous” instrument.\nBy measuring the drawdowns, we empirically measure the risks of trading.\nRisk of a portfolio\nIf you have sufficient experience with a portfolio, you can calculate its\nvolatility the same way you calculate the volatility of a stock using the\nmethod in Chapter 24. Note Modern Portfolio Theory (MPT) has a complex\nprocedure for computing portfolio volatility. (The value of MPT may be\ncomputed by examining MPT portfolios after a market collapse.) You may\nalso dramatize the volatility of your portfolio by preparing a frequency\ndistribution. The dispersion of the returns would certainly highlight\ncharacteristics of your trading system or style.\nAcademicians and investment managers use a measure called the Sharpe\nRatio to compare the performance of two systems or competing money\nmanagers. It is discussed in Appendix B, Resources, and has deficiencies in\nanalyzing Portfolio Risk. I will address this question later in this chapter\nafter looking at some of the ways professionals treat risk.\nThe reader may judge for himself in the use of Composite Leverage as\npresented in Appendix A of the ninth Edition by Magee, or he may consider\nthe following brief presentation of modern portfolio management and risk\nanalysis. The purpose of Magee's Composite Leverage is to measure and\ncontrol risk and profit exposure in a more o", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 215}
{"text": "s chapter\nafter looking at some of the ways professionals treat risk.\nThe reader may judge for himself in the use of Composite Leverage as\npresented in Appendix A of the ninth Edition by Magee, or he may consider\nthe following brief presentation of modern portfolio management and risk\nanalysis. The purpose of Magee's Composite Leverage is to measure and\ncontrol risk and profit exposure in a more or less quantitative manner.\nPresent-day portfolio managers might use VAR technology or do this as\nfollows. The editor offers this exposition only for perspective. His own\npreferred method, Pragmatic Portfolio Theory, follows thereafter.\nEN9: Risk and trend\nRisk of a portfolio and risk of a stock are affected by being the right way in\nthe trend. It seems intuitive and it is observable that losses (thus risk)\nexpand in an Enron case in which the trader remains long while the stock\ndies. The converse is also true; Risk is diminished to a portfolio and a stock\nwhen it is with the trend. In a paper submitted to the Market Technicians\nAssociation (http://www.mta.org), “Dissecting Dow Theory,” Bassetti and\nBrooker argue (with some success in the opinion of this editor) that risk can\nbe proved to diminish in the Industrials when the portfolio (of Industrials) is\nwith the trend as identified by Dow Theory. This paper is available at the\nMagee website, http://www.edwardsmagee. com. The paper was\nsubsequently expanded into the book, Sacred Chickens, the Holy Grail and\nDow Theory.\nValue-at-Risk procedure\n(EN: VAR is a method of assessing and controlling risk. Particularly, VAR\nmeasures the worst expected loss over a given time interval under normal\nmarket conditions at a given confidence level. This rather complex\nstatistical process is in use in numerous banks, American and European\nregulators in Basel and at the Federal Reserve have largely accepted it as\nan acceptable risk control procedure. The hole in the procedure is in the\nwords “normal market conditions.” The procedure is based in MPT. As\nMandelbrot has remarked, MPT ignores 5% of market data, treating market\ncollapse as if it did not exist. VAR and MPT both ignore trend risk, as\nthough it does not exist.\nAs a brief description of the VAR procedure, I offer the following: returns of\nthe individual securities are determined and, from these, returns of the\nportfolio are calculated. This is done based on some time period for which\nthe portfolio is held. Thus, from day to day the returns, or changes in value,\nof the portfolio will vary—some positive and some negative. Taking a\ntotality of returns, an average return will be determined. A frequency\ndistribution of returns may be constructed. The width of this frequency\ndistribution measures the riskiness of the portfolio. Thus, a portfolio with a\nminimum return of 1% and a maximum return of 8% is inherently less risky\n(according to investment theory) than one with returns varying from -1% to\n20%. Although a frequency distribution is illustrative, it does not give us a\ncommon measure for two different portfolios. That is done by determining\nthe volatility of the portfolio.)\nVolatility measures the deviation of returns from the mean, known as the\nstandard deviation and is indicated by the Greek letter sigma (o). (EN: The\nhigher the volatility of a portfolio the greater its risk, according to the\nacademic theory. This would seem to be intuitive, in that a commodity\nportfolio might range from -30% to 100% returns because of leverage,\nwhereas a bond portfolio would vary only by the market price of the bonds\nand would return face value at maturity. In calculating bond risks,\nmanagers ignore the deterioration of money—but that is a little secret\namong us pragmatic analysts and we need not bother academicians and\nbond traders with that information, as they would not want to know it\nanyway.\nAs pointed out, portfolio volatility can be easily obtained if we have\nsufficient experience with the portfolio. If we have to calculate the volatility,\nthe procedure gets quite complicated and the entire procedure for\ndetermining our VAR requires some statistical sophistication as well as a\ngamut of data. We must weigh the components of our portfolio, determine\ntheir correlations, compute correlation coefficients, and on and on. As\nMandelbrot notes in Scientific American, at the end of all this, we would\nstill be wondering what to do in the Perfect Storm. A crystal-clear\nprocedure for computing VAR is presented in Philippe Jorion's excellent\nbook Value at Risk.\nPragmatic Portfolio Theory (and practice)\nPerhaps, rather than giving ourselves headaches trying to remember\ncollege statistics, we should look for something simpler and more\npragmatic—something just as serviceable for the general investor:\nPragmatic Portfolio Theory. The academic world, and the world of rarefied\nWall Street, strives madly to quantify everything in the world except the\nrisks and liabilities that they themselves create for their customers.\nLet us seek simpler methods to quantify the risks of individual stocks and\nthe portfolios they reside in, knowing all the time that absolute precision is\nimpossible (namely, professional portfolio managers' performance in the\nGreat Panics—1929,1957,1987,1989,2008-2009; Long-Term Capital\nManagement, which almost brought down the world financial system in\n1998; and Leland O'Brien Rubinstein Portfolio Insurance, which\ncontributed significantly to the Reagan Crash in 1987).\nPragmatic portfolio risk measurement\nDetermining the risk of one stock\nThe theoretical risk of a stock is commonly agreed to be its volatility, which\nis determined as detailed in Chapter 24. Subsequently, we might say the\ntheoretical risk of our stock, Microsoft, for example, equals on 100 shares,\nour position, at the market price of 120 and annualized volatility of 0.44:\nTheoretical Risk = Volatility x Position x Price\nV x Po x Pr = T$Risk\n.44 x 100 x 120 = $5,200\nwhere\nT$Risk = Theoretical Risk (dollar)\nV = Volatility\nPo = Position (number of shares)", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 216}
{"text": "ined as detailed in Chapter 24. Subsequently, we might say the\ntheoretical risk of our stock, Microsoft, for example, equals on 100 shares,\nour position, at the market price of 120 and annualized volatility of 0.44:\nTheoretical Risk = Volatility x Position x Price\nV x Po x Pr = T$Risk\n.44 x 100 x 120 = $5,200\nwhere\nT$Risk = Theoretical Risk (dollar)\nV = Volatility\nPo = Position (number of shares)\nPr = Price\nTheoretically speaking, the annual risk for Microsoft should be Volatility x\nPrice or (in 2000) 0.44 x 120 or $52.00. In fact, those non-chart analysts\nwho bought Microsoft at 120 (there were some), and who did not have the\ntechnician's ability to set a stop and discipline to stick to it, saw a risk of\n50% from its top of 120 in February 2000 to its (presumed) bottom of 60 in\nJune 2000.\nThere is another measurement that might be more meaningful to us,\nOperational Risk. Operational Risk refers to the specific instance of the\nparticular trade. For example, we have taken an initial position in\nMicrosoft of 100 shares. Our analysis has identified a stop point at which\nwe put our stop, which is 5% away from the market price. Our Operational\nRisk is as follows:\nOperational Risk = Market Price — Stop Price x Position\n(MP — S) x Po = O$Risk\n(120 — 114) x 100 = 600\nwhere\nO$Risk = Operational Risk (dollar)\nMP = Market Price\nPo = Position\nS = Stop Price\nDetermining the risk for a portfolio\nComputing the theoretical risk for a portfolio is quite a complex process. It\ninvolves, in essence, finding the volatility for the portfolio as a whole, and\nmultiplying the portfolio market value by the portfolio volatility. This does\nnot sound so complex, but volatility is not determined by simply adding\ntogether volatilities of individual securities. Rather, correlations between\ninstrument returns must be computed, and variance and covariance of\nsecurities must be determined as steps along the way. This by no means\npresumes to be a complete description of the process, further study of which\nmay be guided by entries in Appendix B, Resources.\nThe theoretical risk for a portfolio is, for a simple case, as follows:\nVolatility x Market Value\nTP$Risk = MV x V\nwhere\nTP$Risk = Portfolio Theoretical Risk (dollar)\nMV = Market Value\nV = Volatility\nUnder normal market conditions, the Operational Risk of a simple\nPortfolio, PO$Risk, may be calculated by first taking the sum of the\nOperational Risk figures, O$Risk, for each stock held long. Then the sum of\nO$Risk for short positions is subtracted from the first figure.\nPO$Risk = (sum of O$Risk longs) - (sum of O$Risk shorts)\nIn the situation of perfect negative correlation, the two factors would be\nsummed.\nMeasuring maximum drawdown (maximum retracement)\nIn the designing and testing of a system, or in actual trading experience, we\ncare little about standard deviations and cold statistics. What bothers us is\nthe flow of blood—the worst run of “luck” or experience we have. What is\nthe greatest sustained loss we suffer before our system or trading method\nrights itself, stanches the flow of blood, and begins to accumulate profits\nagain? Constructing a wave chart is one way to look at this experience.\nMeasuring from the top of the wave to the bottom gives us our maximum\ndrawdown, and an idea of what amount of capital we need and how much\nreserves to maintain. It also gives us a vivid depiction of our results. A chart\nwith many tsunamis (in the wrong direction) probably means we need to\nmodify our methods—unless we genuinely enjoy riding roller coasters (with\nthe full understanding that dreadful accidents do sometimes happen on\nthrill rides). If constructing a system without actual market experience, one\nshould multiply maximum drawdown by 3 or 4 to get a reasonable amount\nof capital with which to back the system.\nPragmatic portfolio analysis: measuring the risk\nIn analyzing a portfolio, we must first know what is important to measure.\nTo be able to control risk, we must be able to measure it. Theoreticians\nidentify risk with volatility. There are some real-life problems with this\nconcept, but we will use it for the moment anyway. In a portfolio, we want\nto be able to separate our various types and weights of risk. In terms of\nvolatility, bonds are obviously less volatile than stocks, and unleveraged\ncommitments are less volatile than, say, futures. Similarly, if the portfolio is\nnot risk balanced, that is, if one issue represents a large proportion of the\nwhole, then it represents a larger portion of the risk. But, if a portfolio\nconsisted of only the Standard & Poor's 500, that would obviously be a\ndifferent case, because a commitment like this would be by definition\ndiversified. Thus, we must know what is important to measure (see Philippe\nJorion's Value at Risk. In addition, there is a piece of tutorial software\ncalled Risk Management 101, Zoologic Corp., which is excellent in\npresenting these concepts).\nIn operational or pragmatic terms, a trader wants to know what his\noperational risk is, rather than his theoretical risk, and does not consider\nupside equity volatility a negative. A trader may choose to measure risk by\nthe pragmatic method outlined here. In doing so, he will want to know for\nhis Portfolio Ordinary or Normal Risk, POR, his Risk Over Time, PRT, and\nhis Extraordinary or Catastrophic Risk, PCR.\nPortfolio Ordinary or Operational Risk\n“Ordinary” and “Operational” may be used interchangeably when\ndiscussing daily risk. First consider we want to measure our risk today. Our\nOrdinary Risk today is easily computed by taking the stop price from the\nmarket price on each position and summing the differences, as above.\nDividing this figure by the allocated capital (Total Capital, TC) will give us\na Portfolio Risk Factor (PRF), which is the risk factor the trader is willing\nto assume for one day.\nPOR = sum of differences\nPRF = PO$Risk/TC\nPortfolio risk over time\nThe Daily Operational Risk number can be annualized to give us a number\nfor risk over time—or it can be compute", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 217}
{"text": "on and summing the differences, as above.\nDividing this figure by the allocated capital (Total Capital, TC) will give us\na Portfolio Risk Factor (PRF), which is the risk factor the trader is willing\nto assume for one day.\nPOR = sum of differences\nPRF = PO$Risk/TC\nPortfolio risk over time\nThe Daily Operational Risk number can be annualized to give us a number\nfor risk over time—or it can be computed for a week or a month, and so on.\nOr, this factor may be collected from operations. It may be collected by\ntaking each day's Ordinary Risk, summing and dividing for the desired time\nperiod (and plotted). It also may be computed by taking the average return\nand the variances therefrom and calculating the standard deviation. This is\nRisk Over Time. Annualized risk, for example:\nDR x (square root 365) where DR = Daily Risk\nPortfolio extraordinary or catastrophic risk\nExtraordinary Risk is the risk of market collapse or panic on any given day.\nThe way to look at this risk is, first of all, to assume normal behavior of the\nmarkets, or your everyday panic. In this case, if all of one's positions\ncratered, one would take his worst-case, one-day loss and be out of the\nmarket. To extend this analysis, assume the market makes a two, then four,\nthen six standard deviation move. What will be the effect on your position in\nthis event, when stops will not be honored by specialists and market makers\nand the market will be stampeding like spooked cattle for the exits? That is,\nmeltdown. This is Extraordinary or Catastrophic Risk. If you have no capital\nreserve you are out of business.\nControlling the Risk\nThe most danger in these meltdown events is in the greatest leverage—so\nthe greatest risk is in short options—and usually short puts. You will\nremember my story of my customer at Options Research Inc. who lost $57\nmillion during the Reagan Crash of 1987; he was short puts. Some market\nmakers have been destroyed by shorting calls, but the case is rare and\nspecifically results in the case of takeovers and unwise concentration of\ncommitments in one issue only.\nThe least risk lies in being hedged. To oversimplify, long the stock, long the\nput. The profit of one makes up for the loss on the other. Also, if one were\nlong some stocks and short others, that also is a kind of hedge. Or long the\nDow and short futures on the Dow, or some of its components.\nNow, let us be pragmatic; if during the management of our portfolios we\nconsistently measured the market with the MEI and balanced our portfolio\naccordingly, we will be at less risk, both from the Ordinary and the\nExtraordinary viewpoint. In fact, we may profit from an event that\ndisemploys many professional money managers.\nIf you have been religiously raising your stops, following the market with\nprogressive stops, and in fact raising them on the basis of new highs as\ndescribed in Chapter 28 (the three-days-away rule), it is quite possible that\nwhile the market is storming, you will be sailing to Byzantium in your\ncustomer yacht.\nSummary of Risk and Money Management Procedures\nThe procedures described above are easily reducible to simple formulas,\neven for the math phobic. Trade size is the basic unit for controlling risk.\nRegardless of volatility, 500 shares of anything is riskier than 100 shares.\nTo determine trade size, take the difference between the entry price and the\nstop price, giving Dollar Risk 1 ($R1). Take the Risk Control Factor, the\npercentage of total capital to be ventured on the trade, and multiply times\nTotal Capital—for example, 3% times TC of $100,000, giving Risk-per-\nTrade. Divide Risk-per-Trade by Dollar Risk 1 to determine Trade Size.\nEP - SP = $R1\nRCF x TC = RpT\nRpT/$R1 = TS\nwhere\nTS = Trade Size EP = Entry Price SP = Stop Price\n$R1 = Dollar Risk 1 RCF = Risk Control Factor\nTC = Total Capital RpT = Risk-per Trade\nMeasure daily Operational Risk as described above. Divide Operational\nRisk by Total Capital to determine Portfolio Operational Risk Factor. If this\nfactor is too high, look for hedges or positions to eliminate, starting with\nthose that are underwater.\nRecompute stops frequently (daily for a trader), raising them according to\nthe Basing Points Procedure, Support and Resistance, or Trendlines.\nAdditionally, a money management stop may be employed, where the trader\nsays, for instance, no more than 8% from the market price will be risked\nand this 8% must represent no more than x% of total capital. Money\nmanagement stops, it should be noted, are inherently less dynamic than\ntechnically placed stops.\nAs the markets proceed inevitably through their phases, track their internal\ncomposition with the MEI, and as positions are naturally terminated, put on\nnew positions in accord with the general long and short strength readings\nof the MEI. Remember that exceptionally high MEI readings coincide with\nbroad market tops, and exceptionally low MEI readings coincide with broad\nmarket bottoms.\nProfessional risk managers compute daily the Extraordinary Risk potential\nin the markets using the procedure described in this chapter to constrain\ntraders under their authority from overexposure. In fact, panics and crashes\nrarely occur out of the blue. There is almost always a pre-panic phase the\ntruly alert trader can identify, especially with the aid of a computer; these\nare marked by insider and professional selling that creates increasing\nvolume with Reversal Days occurring in many stocks and Gaps and\nRunaway down days. Almost always, these conditions will be preceded by\nmany top formations among key stocks—Double and Triple Tops and\nHeads-and-Shoulders and V-Tops.\nEternal vigilance is the cost of freedom. It is also the cost of investing\nsuccess.\nInfinitely more sophisticated risk and money management\nprocedures—Ralph Vince and optimal f\nUndoubtedly, one of the most sophisticated analysts now practicing is\nRalph Vince, author of The Handbook of Portfolio Mathematics and\nprogenitor of the Leverage Space Model. He defines risk as we do, as\ndrawdown, not as", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 218}
{"text": "s.\nEternal vigilance is the cost of freedom. It is also the cost of investing\nsuccess.\nInfinitely more sophisticated risk and money management\nprocedures—Ralph Vince and optimal f\nUndoubtedly, one of the most sophisticated analysts now practicing is\nRalph Vince, author of The Handbook of Portfolio Mathematics and\nprogenitor of the Leverage Space Model. He defines risk as we do, as\ndrawdown, not as the variance of returns. His procedure for determining\ntrade size is extremely sophisticated—more so than the procedures I have\noutlined here. Although I feel these procedures meet the needs of the\ngeneral investor, Vince's procedure is must reading for the more\nsophisticated investor and trader. He has described the Leverage Space\nModel in a short article found in Section 8 of Appendix B, Resources.\nchapter forty-three\nStick to your guns\nIt has often been pointed out that any of several different plans of operation,\nif followed consistently over a period of years, would have produced\nconsistently a net gain on market operations. The methods we have\ndiscussed in this book (representing the technical approach) are a case in\npoint.\nThe fact is, however, that many traders, not having set up a basic strategy\nand having no sound philosophy of what the market is doing and why, are at\nthe mercy of every Panic, boom, rumor, tip, in fact, of every wind that\nblows. Since the market, by its very nature, is a meeting place of conflicting\nand competing forces, they are constantly torn by worry, uncertainty, and\ndoubt. As a result, they often drop their good holdings for a loss on a\nsudden dip or shakeout; they can be scared out of their short commitments\nby a wave of optimistic news; they spend their days picking up gossip,\npassing on rumors, trying to confirm their beliefs or alleviate their fears;\nand they spend their nights weighing and balancing, checking, and\nquestioning, in a welter of bright hopes and dark fears.\nFurthermore, a trader of this type is in continual danger of getting caught in\na situation that might be truly ruinous. Since he has no fixed guides or\ndanger points to tell him when a commitment has gone bad and it is time to\nget out with a small loss, he is prone to let stocks run entirely past the red\nlight, hoping the adverse move will soon be over, and there will be a\n“chance to get out even,” a chance that often never comes. What is more,\neven should stocks be moving in the right direction and showing him a\nprofit, he is not in a much happier position because he has no guide as to the\npoint at which to take these profits. The result is he is likely to get out too\nsoon and lose most of his possible gain or overstay the market and lose part\nor all of the expected profits.\nIf you have followed the preceding chapters carefully, you will have\nrealized none of the technical formations and signals is certain and\nunfailing. The chart action of a stock discounts and records all presently\nknown information about that stock (which includes all matters of dividends\ndeclared or expected, split-ups, and mergers that are known to be planned,\npolitical angles as they affect the market, world affairs, management,\nearning records, and so on). The chart does not and cannot forecast\nunforeseeable events, matters that are completely unknown to anybody. In a\nmajority of cases, the charts are dependable. If you are not satisfied this is\ntrue, you should study further, or else plan not to use charts at all.\nOn the other hand, if you are satisfied the charts are, for you, the most\ndependable indication of the probable future course of stock prices, then\nyou should follow explicitly the signals given on your charts, either\naccording to the rules we suggest here or according to such other rules and\nmodifications as your experience dictates. Nevertheless, while you are\nfollowing any set of rules and policies, follow them to the letter. It is the\nonly way they can help you.\nIf you do this, you will have certain large advantages, right at the start: (1)\nyou will never be caught in a situation in which a single stock commitment\ncan wipe out your entire capital and ruin you; (2) you will not find yourself\nfrozen in a market that has turned against you badly, with a large\naccumulated loss and your capital tied up, so that you cannot use it in the\nreversed trend to make new and potentially profitable commitments; and (3)\nyou can make your decisions calmly, knowing exactly what you will be\nlooking for as a signal to take profits, and knowing also that your losses, at\nthe very worst, will be limited to a certain definite amount.\nAll of this means you will have peace of mind. You will take losses and you\nwill make gains. In neither case will you have to take your notebooks home\nand lie awake worrying. You will have made certain decisions. If\ndevelopments prove you were right, you will, at the proper point, take your\nprofit. And if it turns out that you were wrong, then you can take your\ncomparatively small loss, and start looking for a better situation, with your\ncapital still largely intact, liquid, and available.\nYour job, as a speculator, is to provide liquidity in the market and to\ncounteract the irrational excesses of market-in-motion. Part of that job is to\nkeep yourself free to become liquid whenever it is necessary to reverse your\nposition. It is part of your job to keep yourself free from irrational and\nexcessive emotional actions. If you do this intelligently and consistently,\nyou will be performing a useful and necessary service to the general\neconomic welfare, and you will find the market offers as good or better\nreturns for your efforts as any other line of endeavor.\n(EN9: With the ninth edition, I expect the reader will have some powerful\nnew guns to stick to: new lessons in Basing Points that show what a\npowerful procedure it can be; new analyses of Dow Theory that refresh and\nreinforce the validity and persuasiveness not just of the Theory, but also of\nlong-term investing as such. EN10: And a host of new s", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 219}
{"text": "rns for your efforts as any other line of endeavor.\n(EN9: With the ninth edition, I expect the reader will have some powerful\nnew guns to stick to: new lessons in Basing Points that show what a\npowerful procedure it can be; new analyses of Dow Theory that refresh and\nreinforce the validity and persuasiveness not just of the Theory, but also of\nlong-term investing as such. EN10: And a host of new stop systems to work\nwith. Good trading and stick to all your guns!)\nAppendix A: The Dow Theory in practice\nEN10: This appendix appears as Chapter 4 in the ninth edition.\nEN9: The casual and careless reader will shake his head at this chapter and ask why on earth theeditor has not excised it from the book. The editor has not deleted the chapter because, like old-fashioned cod liver oil, it is good medicine. It will appeal mainly to the serious student of not justDow Theory but also of long-term investing. If the reader has absolutely no interest in DowTheory or long-term investing, he may skip over this chapter and return to it in his old age, whenhe is wiser.\nAt this point, the reader, if he has little previous knowledge of the stock market, may be sufferinga mild attack of mental indigestion. The Dow Theory is a pretty big dose to swallow at onesitting. We departed deliberately in the foregoing chapter from the order in which its principlesare usually stated in an effort to make it a little easier to follow and understand. Actually, not allof the 12 tenets we named are of equal import. The essential rules are contained in 2, 3, 4, 5, 8,10, and 11. Number 1 is, of course, the basic assumption, the philosophical justification for theserules. The other points (6, 7, 9, and 12) furnish “background material,” as the news reportersmight put it, which aid in interpretation. Theoretically, one should, by strict adherence to theessential rules alone, accomplish just as much as he could with the added collateral evidence. (Forillustrations in this appendix, see Figures A.1 through A.9.)\nHowever, the utilization of Dow Theory is, after all, a matter of interpretation. You may memorizeits principles verbatim and yet be confounded when you attempt to apply them to an actual marketsituation. We can better organize our knowledge of the theory and acquire some understanding ofits interpretation by following through a few years of market action and seeing how it looked atthe time through the eyes of a Dow theorist. For this purpose, we may well take the period fromlate 1941 to the beginning of 1947 because this covers the end of one Bear Market, an entire longBull Market, and part of another Bear Market, and includes examples of most of the marketphenomena with which the Dow Theory has to deal.\nFive years of Dow interpretation\nFigure A.2 is a condensed chart of the course of the two Dow-Jones Averages from January 1,1941, to December 31, 1946, on which most of the Minor Trends have been disregarded but allthe recognized Intermediate Swings (Primary and Secondary) have been indicated. Certainportions of this history will be supplemented by complete daily charts in connection with ourdetailed discussion that follows.\nThe year 1941 opened with the stock market in a Minor Rally. A Primary Bear Market had beensignaled when prices collapsed in the spring of 1940 and that Bear Market was\nFigure A.1 “Swing” (EN: or Wave) chart showing all the Intermediate and some of the moreextensive\nMinor Trends of the Dow-Jones Industrial and Rail Averages, January 1941 to December 1946.Industrial price scale left, Rails right.\nstill in effect. After the May Panic had ended, a Secondary Recovery swing, which lasted for morethan five months, had regained more than half of the ground previously lost by the Averages,carrying the Industrials from their closing price of 111.84 on June 10 to 138.12 on November 9and the Rails from 22.14 on May 21 to 30.29 on November 14. (During this long Bear MarketSecondary, incidentally, volume tended to increase on rallies, which encouraged many who didnot hold strictly to first principles to believe that this rise was the beginning of a new Bull Trend,illustrating the point we cited under “Volume” in Chapter 3.) From the November highs, however,the trend turned down again. Then a Minor Rally developed, as stated, at the end of the year,reaching its peak on January 10 at 133.59 in the Industrials and 29.73 in the Rails. From there,prices fell again to 117.66 and 26.54, respectively, on February 14.\nThe first severe test\nThe next few months will be particularly interesting for us to trace because they put the DowTheory to a real test. Figure A.3 shows the daily ranges and closing prices of the two Averagesand total daily market volume for the seven months from February 1 to\n130\n128\n126\n124\n122\n120\n118\n116\nH\n-IS\ni\n* Jmm$ Bl •mi\nMmp: ft ml\n|I\nNDUSTRIALS®\n(Hi\niffn Wi -\n: Pi.i\n........\n“V\n1 /\nmHII •|m ■ iri?\n■\npi Mf 1,A » l ■Hrm£ -m■:is iii i\nVr~!H\nIIm:t\n1941\n/ HI\nr ■sg-j pi ig\nR flY lifeA;\n1\nRAILS\n:P*f lll» j; HH H\nw1\nA, rflJ\n1\nf* J Kit lOy' h\n*»\ntin* lift::t L t*ii,r~J :\n•Hi\nl§|l g\n!L-\nitIIPH n\nHffl lilt; i Si $ ffi\nK\nTH Hill TTTTIlli ' n 'i |I —\nn\n1 .\nLiIII\nllyi jilili lilll 1II II11\n31\n30\n29\n28\n27\n26\nFEBRUARY MARCH-------APRIL-------MAY---- JUNE JULY' AUGUST “\n845 22'1 8 151122 29 5 121926'3'1017'2431 7 14\"21'28 5'12'19 ' 26 2 9 16 23 \"30'\nFigureA.2 Closing price levels of the Dow-Jones Industrial and Rail Averages, February 1 toAugust 31, 1941, and total daily market volume. Vertical lines show net daily change from oneclosing level to next.\nAugust 31, 1941. Before we examine it in detail, however, let us first review the situation onFebruary 14. The Bear Market lows to date had been registered in May-June, 1940. Thereafter, anextended Intermediate Recovery had advanced the Industrial Average 26.28 points and the RailAverage 8.15 points. This had been followed by a three-month decline of 20.46 and 3.75 points,respectively, and this decline, incidentally, had consisted of three well-defined Minor Waves.", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 220}
{"text": "t review the situation onFebruary 14. The Bear Market lows to date had been registered in May-June, 1940. Thereafter, anextended Intermediate Recovery had advanced the Industrial Average 26.28 points and the RailAverage 8.15 points. This had been followed by a three-month decline of 20.46 and 3.75 points,respectively, and this decline, incidentally, had consisted of three well-defined Minor Waves. Induration, and in extent of price change with respect to the previous swing—46% in the Rails andnearly 78% in the Industrials—this downswing qualified as an Intermediate Trend, and nowprices were turning up again. Dow theorists were on the alert. If both Averages could continuetheir rise to levels above their high closes of the previous November (138.12 and 30.29), thataction would constitute a signal of a new Primary Bull Market, and reinvestment of fundswithdrawn from stocks in May 1940 would be at once in order. Also, it would then be necessaryto go back and label the May-June lows of 1940 as the end of a Bear Market, the advance toNovember as the first Primary Swing in the new Bull Market, and the decline to February as itsfirst Secondary Reaction. Note Rule 12 of our preceding chapter (EN11: Chapter 3) applied here;the presumption was it was still a Bear Market until a definite signal to the contrary appeared.\nLet us now turn again to Figure A.3 and see what actually did happen. The Industrials rallied forsix weeks, reaching 124.65 on April 3. The Rails got up to 29.75 on the same date, registeringdouble the percentage gain of the Industrials, but both Averages were still below their November\nhighs. Then the Industrials slipped off within two weeks and had broken down below theirFebruary low and drifted down to close at 115.30 on May 1. This Average was, therefore, still inan Intermediate Downtrend. The Rails, meanwhile, were staging a different sort of performance;they dropped back from their April 3 high for two weeks, but held at 27.72, rallied smartly andthen sold off again to 27.43 on May 31. The picture became at once even more\n116\n114\n112\n110\n108\n106\n104\n102\n100\n98\n96\n94\n92\nINDUSTRIALS\n1942\nRAILS\nOCTOBER\n30\n29\n28\n27\n26\n25\n24\n23\n; MBER T ■\nAPRIL\ni 1 i\nAUGUST----SEPT\n;■ \"r /r i rr':”1 - I\nMARCH\nr'„ i i i\nFigure A.3 Daily closing price levels of the Dow-Jones Industrial and Rail Averages from March2 to October 31, 1942, and total daily market volume. This period saw the beginning of a 4-yearmajor bull market.\ninteresting. Here was a Divergence between the two Averages, a failure to confirm; the Rails,after two opportunities, were refusing to confirm the Industrials in the latter's downtrend.\nFailure to confirm\nWhen prices began to work upward in June, many commentators seized on this “failure toconfirm” as a Bullish omen and the wishful thinkers again talked Bull Market. There is anunfortunate tendency in the Street to overstress any such divergence, particularly when it can betwisted into a favorable sign. The fact is Dow Theory's refusal of one Average to confirm theother can never produce a positive signal of any sort. It has only negative connotations.Divergences sometimes occur at Reversals in the Major Trend—there have been several instancesin market history, in which, perhaps, the most remarkable occurred way back in 1901 and 1902,and we shall soon inspect another—but they also occur with equal frequency at times when noMajor Reversal is developing, and the instance we are discussing here was one of the latter.\nThe situation at the end of May in 1941 was precisely the same to the Dow theorist, insofar as theMajor Trend was concerned, as it had been on February 14. The June-July rally topped out in theRails at 30.88 on August 1, and in the Industrials at 130.06 on July 28 (compare these figures withtheir 1940 November highs) and prices then declined at an accelerating pace, temporarilyculminating in the Pearl Harbor Panic. This took the Industrial Average below its previous BearMarket low (111.84 on June 10, 1940), although the Rails, again, did not follow. They had,however, by this time, broken below their previous (February 14) Intermediate Bottom by aliberal margin.\nThe next period of importance began in April 1942. We can skip any detailed chart of the monthsbetween December and April because they posed no Dow Theory problems.\nFigure A.4 Daily closing price levels of the Dow-Jones Industrial and Rail Averages fromNovember 2, 1942, to June 30, 1943, and total daily market volume.\nAfter a Minor Rally in the Rails in January, prices simply drifted lower and lower, but it wasincreasingly evident that trading volume did not expand on the dips (Minor Declines). Liquidationwas drying up; the boardrooms were void of customers; the atmosphere was typical of the laststages of a Bear Market.\nThe daily action of the Averages from March 2 to October 31, 1942 is shown in Figure A.4. Newlows (since 1940) were registered both in late April, at 23.72 on April 24 in the Rails and at 92.92on April 28 in the Industrials. Shortly thereafter, a notable Divergence developed, when, afterrallying for only seven days, the Railroad Index began to slip off while the other Average keptright on going up. Trading activity remained at a low ebb (there was no sustained volumeincrease, in fact, until late September). On June 1, the Rails dropped to another new low and onthe 2nd closed at 23.31. On June 22, it looked as though the Industrials were going to be pulleddown again, but only a few days later, the best rally in months got started, taking the Industrials tonew highs and more than recovering all of the April-May loss in the Rails. Activity also speededup briefly, with one day registering a greater turnover than the market had enjoyed in any sessionsince early January. (EN9: Note this warning sign. The ringing of an alarm clock.)\nSigns of Major Turn\nAgain, the Dow theorists were very much on the alert. An advance of Intermediate proportionswas obviously under way. Until proved otherwise, it had to be l", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 221}
{"text": "May loss in the Rails. Activity also speededup briefly, with one day registering a greater turnover than the market had enjoyed in any sessionsince early January. (EN9: Note this warning sign. The ringing of an alarm clock.)\nSigns of Major Turn\nAgain, the Dow theorists were very much on the alert. An advance of Intermediate proportionswas obviously under way. Until proved otherwise, it had to be labeled a Secondary within theBear Market, which was still presumably in effect, but that Major Downtrend had by now run fornearly three years—nearly as long as any on record—and its last decline had shown no sellingpressure whatever, simply a dull drift. This presumed Secondary might turn out to be a newPrimary; hopes for such a denouement had been blighted 12 months earlier under somewhat-similar circumstances, but this time prices were lower and there was a different “feel” to themarket. The general news offered little encouragement, but the Dow Theory does not concernitself with any news other than the market itself (which discounts all other kinds of news). In anyevent, there was nothing to do but wait and see—let the market, in its own time and way, state itsown case.\nIn early July, the Industrials started to “mark time”; for 11 weeks, they fluctuated within a 5-pointrange, building a typical Dow Line from which they emerged on the upside in late September.The Rails pushed up to a new high for the move at the same time, and by November 2, bothAverages had surpassed their Rally Tops of the preceding January. At this stage, some Dowtheorists were willing to announce a Bull Market had been signaled. Their arguments, aside frompoints of a nontechnical nature or having nothing to do with Dow Theory, were as follows:\n1. The conspicuously low level of volume at the April-June Bottom, typical of the end of aBear Swing. (True and cogent.)\n2. The Rail Average had refused to follow the Industrials into new Major low ground at thattime. It had held above its closing level of May 1940. (Also true, but of questionablesignificance. More about this later.)\n3. The Industrials had constructed a Line and gone up out of it. (Again true, but the Line wassomewhat short to have, beyond a doubt, major import.)\n\n37\n36\n35\n34\n33\n32\n30\nFigure A.5 Daily closing price levels of the Dow-Jones Industrial and Rail Averages fromNovember 2, 1942, to June 30, 1943, and total daily market volume. This chart follows andshould be compared with Figure A.4. The decline in the Rail Average during November andearly December produced the first test of the Major Trend since the preceding June. Whenthis Index recovered and, on February 1, 1943, closed above its November 2 high, a PrimaryBull Market was thereby signaled according to Dow Theory.\n4. The Rail Average had produced successively higher Minor Tops and Bottoms for fourmonths. (This also was true but did not permit positive differentiation from a Bear MarketSecondary.)\nThe more conservative Dow theorists were not yet convinced. They maintained this uptrend hadyet to undergo the test, bound to occur sooner or later, of an Intermediate Reaction. They admittedthat the picture was most encouraging, but they called attention to the fact that, except for Point 1,it was no better than that of November 1940. Let's follow along through the next five months.Figure A.5 shows the daily market action from November 1, 1942, to June 30, 1943.\nThe Bull signal\nAfter reaching 29.28 at their close on November 2, the Rails declined in almost a straight line forsix weeks to 26.03 on December 14. This move indubitably rated as an Intermediate in durationand it had “given up” more than half of that Average's entire advance from the June 2 low point.The Industrial Index, however, held stoutly in another narrow Line throughout November,December, and January. From December 14, the Rails turned up, and finally, on February 1, 1943,closed at 29.55, out above their previous Intermediate Top of 29.28 recorded the previousNovember. By then, the Industrials had also moved up into new high ground. This development atlast satisfied every strictest requirement of Dow Theory; a new Primary Bull Market was in force.Trading volume had also been expanding on each Minor Advance during the fall and wintermonths, but its evidence was not needed; the price action alone was conclusive. The Rails hadproduced the necessary sequence of higher Intermediate Tops and Bottoms. In the Industrials,Lines had served the purposes of the theory as substitutes for Intermediate Reactions.\nIt was necessary now to relabel the up-move from April-June to November of 1942 as the firstPrimary Swing in a Bull Market. The decline of the Rails from November 2 to December 14 wasnow recognized as the first Secondary within that Major Trend.\nWe may turn back for a moment at this point to comment on the performance of the Rail Index inJune 1942. Since it held above its low of May 1940, some commentators have maintained theBull Market should really have been dated from that former year as representing the last“confirmed” lows. This strikes us as rather impractical hair-splitting. Regardless of the 1.17higher level in the Rail Average in June 1942, a genuine Bull Move did not start until that time.We suspect, before many years have passed, Dow theorists will have occasion greatly to regret theimportance that has since been assigned to the Rails' “failure to confirm” in the spring of 1942.Remember, such a Divergence does not and cannot produce a positive signal; at the time of itsoccurrence, it can serve merely to negate or cast in doubt the implications of the other Average;only subsequent action in the opposite direction can establish the existence of a change in trend. Ifthe Rails' decline in May 1942 had carried them below 22.14, but their subsequent action hadfollowed the course it actually did, point for point at a lower level, a Bull Market Signal wouldnevertheless have been given at the very same time, not one day later and not one day sooner.", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 222}
{"text": "e other Average;only subsequent action in the opposite direction can establish the existence of a change in trend. Ifthe Rails' decline in May 1942 had carried them below 22.14, but their subsequent action hadfollowed the course it actually did, point for point at a lower level, a Bull Market Signal wouldnevertheless have been given at the very same time, not one day later and not one day sooner.\nMoreover, a Divergence does not necessarily imply a move of consequence in the oppositedirection will ensue. We have already examined one comparable instance (in the spring of 1941)that resulted otherwise. Logically, if a failure to confirm such as occurred in 1942 is to be taken asan indication of a turn in trend, then its opposite, (confirmation or reaffirmation by both Averages)should argue with equal force against a turn in trend. Yet the simple truth is that many more MajorReversals have come when the Averages were in\n66\n64\n62\n60\n58\n56\n54\n52\n50\nFigureA.6 Daily closing prices of Dow-Jones Industrial and Rail Averages, and total marketvolume, July 1, 1943, to January 31, 1944.\nagreement than when they were divergent. We have no wish to belabor the point or waste thereader's time, but we do feel he should be warned against the wishful thinking that every “failureto confirm” seems to inspire when the market is in a Bear Trend.\nTo return to our history, the Averages closed at 125.88 and 29.51, respectively, on the dayfollowing our conclusive Bull Market Signal in February 1943. Theoretically, that is where aninvestor who strictly followed the Dow Theory would have bought his stocks. (Those who weresatisfied the Primary Trend was up in November 1942 bought with Averages around 114.60 and29.20.) It was reasonable to assume this Bull Market, which as yet showed few of the usualcharacteristics of the second phase and none whatever of the third phase, would continue for sometime to come. The next four months produced no market developments that required interpretativeattention, and we can move on to the events of July. Figure A.6 charts the action from July 1,1943, to January 31, 1944.\nThe first correction\nAfter closing at 145.82 on July 14, 1943, the Industrial Average drifted off. The Rails pushed upto a new high (38.30) 10 days later, but the Industrials refused to join in the rally and then bothindexes cracked down sharply for seven sessions. Turnover increased and the decline was thegreatest occurring in the Bull Market up to that date. However, everyone realized the market, afterseveral months of quite persistent advance, was “entitled to a correction.” In neither duration norextent could this down move be qualified as more than a Minor Trend. Next ensued three monthsof desultory fluctuation with little net progress in either Average. The Industrials pulled up to141.75 on September 20 and then drifted off again, whereas the Rails struggled back to 35.53 onOctober 27. Another quick break developed in early November, culminating in a high-volumeshakeout that cut the value of the Industrials by 3.56 points and the Rails by 1.75 on November 8.Prices rallied a little and sold off again, reaching new lows (since early spring) on November 30—Industrials 129.57 and Rails 31.50.\nThere was no question now that a full-fledged Secondary Reaction had developed. The problemfor Dow interpreters was whether there was more involved. If the first drop in July could beconstrued as an Intermediate Trend in itself, and the August- October action as anotherIntermediate Swing, then the November break would signal a Bear Market. As a matter of fact, noDow theorist, so far as we know, gave very serious consideration to any such interpretation. The\nJuly break, as aforesaid, did not rate as an Intermediate in either duration or points retraced; thewhole move from July to November 1943 had to be regarded as all-of-a-piece, all one SecondaryReaction. The real Major Trend test would come on the next advance, whenever that shoulddevelop; if that failed to top the July peaks, and prices thereafter declined to new lows, a BearMarket would indeed be in effect.\nThe decision was long deferred. Prices began again to move up, but the advance in the Industrialswas slow and grudging. The Rails forged ahead more rapidly and pushed through their July Topon February 17, 1944, going on to a Minor Peak at 40.48 on March 21. The Industrial Averageattained 141 on March 13, but still nearly 5 points below its “signal” level, faltered and fell back.Here was another striking case of “failure to confirm.” For those who chose to assign gravesignificance to such developments, it could have only a very Bearish meaning. All it did mean, infact, was continuation of the Primary Bull Move had not as yet been confirmed. Only if bothAverages now declined and closed below their respective November 30 Bottoms would the newhigh registered by the Rails alone in February have to be disregarded and a Primary Bear Marketannounced. In brief, the situation at the end of March was no different, so far as its Major Trendimplications were concerned, from what it had been in early January before the Rails pushedthrough.\nBull Trend reaffirmed\nThe situation remained in doubt (but subject always to that basic presumption of the Dow Theorythat we named as Rule 12 in the preceding chapter [EN10: Chapter 3]) until June 15, 1944, whenthe Industrials finally came through to close at 145.86. It had taken them four months to confirmthe Rails, almost a full year to reaffirm the Primary Uptrend. The effect of this “signal” on traderswas electric; trading volume increased by 650,000 shares on the following day as prices jumpedanother full point.\nThe following 12 months need no detailed discussion as they produced nothing in the way ofmarket action to give a Dow theorist any concern. Prices drifted off irregularly for nine weeksafter mid-July, but their net loss was of minor proportions, and they then climbed with only briefinterruptions to 169.08 in the Industrial Index on May 2", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 223}
{"text": "res on the following day as prices jumpedanother full point.\nThe following 12 months need no detailed discussion as they produced nothing in the way ofmarket action to give a Dow theorist any concern. Prices drifted off irregularly for nine weeksafter mid-July, but their net loss was of minor proportions, and they then climbed with only briefinterruptions to 169.08 in the Industrial Index on May 29, 1945, and 63.06 in the Rail Index onJune 26, 1945. We should take a brief look at the period following, not because it illustratesanything new in our study, but because it takes in the surrender of Japan and the end of fighting inWorld War II.\nThe seven months from May 1 to November 30, 1945 are covered in Figure A.7. The Industrialsheld steady for four weeks while the Rails were making the spurt to their June 26 Top. On June28, with nothing in the newspaper headlines to account for such a radical trend change, pricesbroke sharply and turnover climbed to nearly 3 million shares, the highest day's total for the BullMarket up to that time. Nevertheless, the Industrial Average gave ground reluctantly thereafter,and by June 26, at 160.91 had given up less than 5% of its top price. The Rails shook downrapidly, however. The Hiroshima bomb was dropped on August 5, and Japan surrendered on the14th. The Industrials were now rallying up from\n216\n212\n208\n204\n200\n196\n192\n188\n184\n2.0\n1.5\n1.0\n.5\n70\n68\n66\n64\n62\n60\nFigure A.7 Daily closing price levels of the Dow-Jones Industrial and Rail Averages from May 1to November 30, 1945, and total daily market volume. This period, which saw the end of WorldWar II, produced only a moderate Secondary Correction in the Primary Bull Market, which hadalready run for three years from its beginnings in April/June, 1942.\nINDUSTRIALS\nRAILS\nMARCH\nFEBRUARY\niigii -\nJANUARY\nIn I 1 n T 6\nAPRIL\n1 £ I i Q I on\nMAY\nl\"l I 1 O I QK 111\nDECEMBER\nI o I i K Inn I on I\ntheir July 26 low, but the Rails could not hold and plunged again, hitting bottom finally (for thismove) on August 20 at 51.48, for a loss of more than 18% of their June peak value.\nThe Rails falter\nBefore we go on with our examination of the market action here, it is interesting to note up to thispoint the Rail Average had been the “hero” of our story. Starting with its refusal to go down to anew Bear Market low in June of 1942, it was the spearhead of each important advance, had stagedthe most spectacular rallies, had gained 170% in value as compared with the Industrials' 82%. Inretrospect, the explanation is obvious: the railroads were the chief business beneficiaries of thewar. They were rolling up profits, paying off indebtedness, and reducing their fixed charges at arate unheard of in this generation (and probably never to be seen again). Although the “public's”eye was on the traditional and better publicized “war industries,” the market began, as far back asPearl Harbor, to shrewdly appraise and discount this unprecedented harvest for the Rails. Butfrom here on, the picture changes and the Rails become the laggards. As we look back now, it isjust as obvious that, with equal shrewdness, the market began in July of 1945 to discount achange in their fortunes. An illuminating demonstration of the basic assumption (Tenet Number 1)in Dow Theory!\nTurning back to our chart, prices began to push up again with renewed vigor after August 20.Both Averages had experienced a Secondary Reaction and now Dow theorists had to watchclosely to see whether the Primary Uptrend would again be reaffirmed by their going to newhighs. The Industrials “made the grade” when they closed at 169.89 on August 24, but the Railshad much more ground to recover and were running into offerings as they came up in successionto each of the Minor Bottom levels of their June-August downtrend (a phenomenon to which weshall devote some attention later on in the chapter on Support and Resistance). Not until earlyNovember 1945 were they able to confirm the signal of the Industrials by closing above 63.06. Atthis point, the Averages had, once again, announced that the Primary Bull Market was still inforce. It had now lasted for three and a half years—longer than most Bull Markets, and “thirdphase” signs were rapidly appearing. The public was buying, the boardrooms were crowded,stock market news was making the front pages of even small city newspapers, the “cats and dogs”were being whooped up, business was booming.\nWith both Averages in new high ground and the Bull Market reaffirmed, all previous low pointscould now be disregarded. For example, the 160.91 Bottom of July 26 in the Industrials and the51.48 of August 20 in the Rails had no further significance in Dow Theory. This is a point wehave not stressed heretofore, but it is important. It might, indeed, be added to our set of rules in\nthe preceding chapter (EN11: Chapter 3) were it not implicit in the basic tenets. Once a PrimaryTrend has been confirmed or reconfirmed, the past is forgotten and everything hinges on futureaction. At the end of 1945, with “third phase” symptoms rife, the action of the market had to befollowed with redoubled vigilance. The third phase could last for two more years (as it did in1927 to 1929) or be concluded at any moment. Our next chart (Figure A.8) carries us throughMay 1946.\nThe spring of 1946\nThe market went through a Minor Setback in late December, a development has come to beexpected as the normal pattern for that month and is usually attributed to “tax selling”— andstormed ahead again in January 1946. Daily volume on January 18 exceeded 3 million shares forthe first time in more than five years. During the first week of February, prices “churned” withlittle net change. Extreme high closes were registered during this period by the Rail Average at68.23 on February 5, and by the Industrial Average at 206.97 on February 2. On February 9, bothstarted to slide off, pulled back sharply from the 13th to the 16th, and then broke in a selling wavethat ran to a climax on February 26 with", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 224}
{"text": "five years. During the first week of February, prices “churned” withlittle net change. Extreme high closes were registered during this period by the Rail Average at68.23 on February 5, and by the Industrial Average at 206.97 on February 2. On February 9, bothstarted to slide off, pulled back sharply from the 13th to the 16th, and then broke in a selling wavethat ran to a climax on February 26 with closings at 60.53 and 186.02, respectively. The loss inthe Industrials was the greatest in points (20.95) they had suffered during the entire Bull Market;in the Rails, it was exceeded only by their July-August decline of the previous year. It amountedto a little more than 10% in the former and 11% in the latter and gave up a little less than half oftheir advances from the 1945 summer lows. The decline was three weeks old on February 26. Itwas an unqualified Intermediate—in Dow Theory a Secondary Reaction presumptively within thestill existing Major Uptrend.\nLabor troubles were dogging the steel and motor industries in 1946 from early January on, with acoal strike looming. The February break was attributed to those news developments, but theruling cause was more likely the discontinuance of margin trading. In January, the FederalReserve Board announced after February 1 stocks could be bought only for full 100% cash. Thelate January up-fling was featured by the “little fellow” seizing his last chance to buy on margin.(Those who participated in this scramble will doubtless regret it for a long time yet to come.)Professionals seized the opportunity to unload their trading commitments, but the “little fellow”was now temporarily out of funds; his brokerage account was quickly “frozen.” Under thecircumstances, as we look back, it is amazing that a more extensive Panic did not then eventuate.\n216\n212\n208\n204\n200\n196\n192\n188\n184\n180\n176\n172\n168\n164\n160\nRAILS\nINDUSTRIALS\n' AUGUST SEPTEMBER OCTOBER’-\n1 1 3 1 2 90 2 97 2 3 2 10 2 1 7 2 9A 2 31 L 7 2 1A ^Tl2 9 32 3 219 IQ\nFinal Up-Thrust\nThe late February Bottoms were now the critical points on the downside; if both Averages shoulddecline below the Intermediate Low closes then recorded, before the Rails could make a new highabove 68.23 (in which event the Bullish Signal of the Industrials would be canceled), a BearMarket would thereby be signaled. Despite a miner's strike and an imminent rail workers' strike,the market turned firm again in mid-May and put forth a surprising rally that swept the IndustrialIndex up to 212.50 on May 29, 1946—a new Bull high by nearly 6 points. The Rails failed inMay by only 0.17 to equal their February high close, slid back a trifle, and then pushed through atlast on June 13 to close at 68.31, thereby confirming the Industrials in their announcement that (asof that date) the Primary Trend was still up. The February lows (186.02 and 60.53) now ceased tosignify in Dow Theory, but keep those figures in mind because they are involved in an argumentthat raged among Dow students for months thereafter.\nThe preceding picture is overlapped by Figure A.9, taking up the market's action on May 4 andcarrying it forward to October 19, 1946. Trading volume, it may be noted, in late May and earlyJune did not come up to the levels of either the late January to early February Top or the lateFebruary Bottom; the market appeared to be losing vitality, an ominous, although by no means,decisive manifestation. Prices began to fall off rapidly immediately after the Rail Confirmation onJune 13. The Industrials rallied for two weeks in early July, but the Rails continued to decline; theIndustrials broke again on July 15 and the two Averages continued their slide until they stood at195.22 and 60.41 at the close on July 23.\nThere, as it subsequently developed, was the end of that particular Intermediate Swing—one inaccord with our Rule 12 had to be labeled a Secondary Reaction in a Bull Market until provedotherwise. The market swung up again. It climbed slowly and steadily, but with turnover runningwell under a million shares, until exactly three weeks later, the Industrials at 204.52 (August 13)had regained a little more than half of their June-July loss and the Rails at 63.12 (August 14) alittle more than a third of theirs. This advance, therefore, had met the minimum requirements ofan Intermediate Trend. If prices could continue to rise and eventually push through their May-June Tops, the Major Bull Trend once again would be reaffirmed. Although, if they should turndown and fall below the July 23 closing levels, it would signal a Reversal of the Primary Trend.\nThe Bear Market signal\nThe situation was critical, as evident in the volume chart. Ever since the end of May, turnover hadtended not only to increase on the declines, but also, and more importantly, dried up on the rallies.Compare Figure A.9 with Figures A.7 and A.8, and you can see how conspicuous thisphenomenon had become by mid-August. Prices did turn down, with activity increasing on thebreaks, and on August 27, the closing prices, 191.04 for the Industrials and 58.04 for the Rails,told a sad story. The Averages had spoken: a four-year Bull Market had ended, and a Bear Marketwas under way. A Dow investor should have sold all his stocks on the following day (atapproximately 190 and 58 in terms of the two Averages).\nTo clear the record, it was necessary for the Dow theorist now to go back and mark the May 29and June 13 highs in the Industrials and Rails, respectively, as the end of the Bull Market. TheJune-July decline then became the first Primary Swing in the new Bear Trend, and the July 23 toAugust 14 advance became the first Secondary Recovery within the Major Downtrend. A secondPrimary Swing was now in the process of development.\n216\n212\n208\n204\n200\n196\n192\n188\n184\n180\n176\n172\n168\n164\n160\n2.0\n21..05\n1.0\n.5\nRAILS\nINDUSTRIALS\n' AUGUST SEPTEMBER OCTOBER’-\n1 1 3 1 90 1 97 1 3 1 10 1 1 7 1 9A 1 31 L 7 1 1A ^Tl1 9 31 3 119 IQ\nFigure A.9 Daily closing price levels of the Dow-Jones Industrial and", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 225}
{"text": "14 advance became the first Secondary Recovery within the Major Downtrend. A secondPrimary Swing was now in the process of development.\n216\n212\n208\n204\n200\n196\n192\n188\n184\n180\n176\n172\n168\n164\n160\n2.0\n21..05\n1.0\n.5\nRAILS\nINDUSTRIALS\n' AUGUST SEPTEMBER OCTOBER’-\n1 1 3 1 90 1 97 1 3 1 10 1 1 7 1 9A 1 31 L 7 1 1A ^Tl1 9 31 3 119 IQ\nFigure A.9 Daily closing price levels of the Dow-Jones Industrial and Rail Averages from May 4to October 19, 1946, and total daily market volume. This chart overlaps Figure A.8. Compare theclosing price of the Rail Average on June 13 with its February 5 high close. This June actionnullified the previous Dow Theory importance of the February lows. Note significant change involume pattern after May, especially during the August rally.\nYou will have noted in the foregoing, a Bear Market was signaled as soon as both Averagespenetrated their July 23 lows. Let us return now and take up that argument we mentioned on thepreceding page. Some students of Dow Theory refused to recognize the new high of June 13 inthe Rail Average as a decisive reaffirmation of the Bull Trend. The previous close should bebettered by at least a full point (1.00), many argued, to confirm the signal previously given by theIndustrials; the margin of only 0.08 was inconclusive. Nevertheless, this opinion, if accepted, hadlogical consequences that later proved embarrassing. For, if the Bull Market had not beenreaffirmed in June, then the critical levels on the downside remained at 186.02 in the Industrialsand 60.53 in the Rails, the February 26 Bottoms. Therefore, a Bear Market could not be “called”until those prices had been penetrated downside by both Averages. This view acquired a largefollowing, especially among those who were not interested in “hair splitting” theory but wanted“to give the market every chance in view of the still improving fundamentals.”\nThe market did, of course, proceed to break its February lows, and by that time, the Panic (secondphase) was on. Obviously, in this case, the orthodox “any-penetration-whatever” school had allthe best of it; they had sold out at least 13 points higher up in terms of the Industrial Index (atleast 6 in the Rails). Six weeks later, on October 9, 1946, this second Primary Intermediate Swingended at Industrials 163.12, Rails 44.69, and another Intermediate Recovery Move started.\nBefore closing this history of six years of Dow Theory interpretation, we might note the June 13high in the Rail Average furnished a perfect illustration of the rule stating a trend can change anytime after it has been confirmed or reaffirmed, also of the diminishing odds in favor ofcontinuance with each successive reaffirmation of the Primary Trend.\nTaylor & Francis\nTaylor & Francis Group\nhttp://taylorandfrancis.com\n1\n2.0\n21..05\n1.0\n.5\nFigureA.8 Daily closing price levels of the Dow-Jones Industrial and Rail Averages fromDecember\n2\n1945, to May 31, 1946, and total daily market volume. Noteworthy features of this periodincluded the extremely high volume that prevailed during January and February as compared withlower turnover in April and May, and the laggard performance of the Rails when the IndustrialAverage pushed up to a new high in April and again at the end of May. At the latter date, theFebruary lows were still the critical downside “signal” levels according to the Dow Theory.\nYet the Dow theorist was not concerned with causes. The Bull Market had been reaffirmed byboth Averages in early February, canceling all previous “signal” levels. Bullish Forces were stillevidently in effect because the February 26 lows held and prices began to recover. The Industrialscame back quickly and by April 9 had closed in new high ground at 208.03. The Rails dragged;when the market showed signs of weakening at the end of April, the Rail Average was still nearly5 points below its early February high. Was this another “failure to confirm” to worry about?\nAppendix B: Resources\n• Section 1: Important and indispensable sites\n• Section 2: References for further study\n• Section 3: Investment-oriented sites\n• Section 4: The Sharpe Ratio\n• Section 5: Calculating volatility and examples of professional risk analysis\n• Section 6: The essence of fundamental analysis\n• Section 7: Software packages and Internet technical analysis sites\n• Section 8: The Leverage Space Portfolio Model of Ralph Vince\nSection 1: Important and indispensable sites\nContact information for John Magee:\nJohn Magee technical analysis::Delphic options research ltd (jmta::dor)\nE-mail bassetti@edwards-magee.com\nbassetti@att.net\nEdwards-Magee website\nSEC Enforcement\nhttp://www.www.edwards-magee.com\nhttp://www.enforcement@sec.gov\n(Whenever I receive touts or investment spam, I immediately forward it to this important branch ofthe SEC. All responsible investors should do the same.)\nVolatilities and options:http://www.optionstrategist.com\nPortfolio hedge computationhttp://www.cboe.com/portfoliohedge http://www.cboe.comhttp://www.abg-analytics.com\nSoftware reviews andinformation\nSoftware demonstrations andpackages\nhttp://www.traders.com http://www.omegaresearch.comhttp://www.comstar.com http://www.aiqsystems.comhttp://www.tradestation.com http://www.equis.com\nWeb chart analysis site\nMorningstar\nIndustry evaluations Mutualfund cost calculator Internetanalysis\nhttp://www.stockcharts.com http://www.morningstar.nethttp://www.gomez.com http://www.sec.gov/mfcc-int.htmhttp://www.stockcharts.com\nSection 2: References for further study\nOn Volatilities and Options:http://www.optionstrategist.com\n(and futures) http://www.cboe.com\nDOW futures and optionshttp://www.cbot.com\nAMEX iShares (DIA, QQQ, etc.)http://www.amex.com\nOn betas http://www.finance.yahoo.com\nOn risk\nValue at Risk, Phillipe Jorion, New York: John Wiley & Sons, 1996 Against the Gods, Peter Bernstein,New York: John Wiley & Sons, 1996 Risk Management 101 (software), Zoologic, Inc., 1997.\nSee also Chapter 42\nOn candlesticks\nJapanese Candlestick Charting Techniques, Steve Nison, New Yo", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 226}
{"text": "http://www.cbot.com\nAMEX iShares (DIA, QQQ, etc.)http://www.amex.com\nOn betas http://www.finance.yahoo.com\nOn risk\nValue at Risk, Phillipe Jorion, New York: John Wiley & Sons, 1996 Against the Gods, Peter Bernstein,New York: John Wiley & Sons, 1996 Risk Management 101 (software), Zoologic, Inc., 1997.\nSee also Chapter 42\nOn candlesticks\nJapanese Candlestick Charting Techniques, Steve Nison, New York: NYIF, 1991 Beyond Candlesticks,Steve Nison, New York: John Wiley & Sons, 1994\nOn futures\nSchwager on Futures, Technical Analysis, Jack Schwager, New York: John Wiley & Sons, 1996 (andother titles by Schwager in References).\nOn portfolio management\nThe Journal of Portfolio Management\nRisk Management 101 (software), Zoologic, Inc., 1997\nChapter 42\nSection 5, this appendix\nSection 8, this appendix\nSection 3: Investment-oriented sites\nAARP Investment Program\nAccutrade\nADR.com\nAmerican Association of Individual Investors\nAmerican Century\nAmerican Express Financial Services\nAmerican Stock Exchange\nAmeritrade (has little-advertised free trade site)\nAnnual Report Gallery\nBarron's\nBigCharts\nBloomberg Financial\nBonds Online\nhttp://www.aarp.scudder.com http://www.accutrade.com http://www.adr.com http://www.aaii.comhttp://www.americancentury.com http://www.americanexpress.com/directa http://www.amex.comhttp://www.tdameritrade.com http://www.reportgallery.com http://www.barrons.comhttp://www.bigcharts.com http://www.bloomberg.com http://www.bondsonline.com\nBriefing.com\nBrill's Mutual Funds Interactive\nBusiness Week\nCBS MarketWatch\nChicago Board of Options Exchange\nCNNFN\nDailyStocks\nExcite\nFederal Deposit Insurance Corporation\nFederal Trade Commission\nFidelity Investments\nFinancial Times\nForrester Research\nFundFocus\nFund Spot\nGomez Advisers\nH&R Block\nHoover's StockScreener\nIPO Central\nLombard\nMarketplayer\nMarket Technician's Association\nMicrosoft MoneyCentral\nMorningstar\nNational Association of Securities Dealers National Discount Brokers\nNet Investor\nNew York Stock Exchange\nOnline Investor\nPhiladelphia Stock Exchange\nQuick & Reilly\nQuicken\nQuicken Financial Network\nRealty Stocks\nReuters\nSchwab, Charles\nSecurities and Exchange Commission\nSecurities and Exchange Commission Enforcement\nSecurities Industry Association\nSecurities Investor Protection Corporation SmartMoney\nSocial Security Online\nStandard & Poor's Fund Analyst\nStandard & Poor's Ratings Services\nStock Guide\nStockpoint\nSuretrade\nhttp://www.briefing.com http://www.fundsinteractive.com http://www.businessweek.comhttp://www.marketwatch.com http://www.cboe.com http://www.cnnfn.com http://www.dailystocks.comhttp://www.excite.com http://www.fdic.gov http://www.ftc.gov http://www.fidelity.comhttp://www.ft.com http://www.forrester.com http://www.fundfocus.com http://www.fundspot.comhttp://www.gomez.com http://www.hrblock.com http://www.stockscreener.comhttp://www.ipocentral.com http://www.lombard.com http://www.marketplayer.com http://www.mta.orghttp://www.moneycentral.com http://www.morningstar.net http://www.nasd.com http://www.ndb.comhttp://www.netinvestor.com http://www.nyse.com http://www.onlineinvestor.com http://www.phlx.comhttp://www.quickwaynet.com http://www.quicken.com http://www.qfn.com http://www.realtystocks.comhttp://www.reuters.com http://www.schwab.com http://www.sec.gov http://enforcement@sec.govhttp://www.sia.com http://www.sipc.org http://www.smartmoney.com http://www.ssa.govhttp://www.micropal.com http://www.ratingsdirect.com http://www.stockguide.comhttp://www.stockpoint.com http://www.suretrade.com\n1040.com http://www.1040.com\nThe Motley Fool http://www.fool.com\nTheStreet.com http://www.thestreet.com\nTechnical Securities Analysis Association of San\nFrancisco http://www.tsaasf.org\nT. Rowe Price http://www.troweprice.com\nTreasury Direct http://www.publicdebt.treas.gov\nVanguard Brokerage Serviceshttp://www.vanguard.com\nWall Street Access http://www.wsaccess.com\nWall Street Journal Interactive Edhttp://www.wsj.com\nYahoo! Finance http://www.finance.yahoo.com\nZacks Investment Researchhttp://www.zacks.com\nZD Interactive Investor http://www.zdii.com\na American Express now advertises free trades for some accounts.\nBrokerage houses\nWaterhouse Securitieshttp://www.tdameritrade.com\n800-934-4134\nA. B. Watley http://www.abwatley.com\n888-229-2853\nWeb Street Securitieshttp://www.webstreetsecurities.com\n800-932-0438\nJack White http://www.jackwhiteco.com\n800-753-1700\nWitCapital http://www.witcapital.com\n888-494-8227\nNet Investor http://www.netinvestor.com\n800-638-4250\nQuick & Reilly http://www.quickwaynet.com\n800-672-7220\nCharles Schwab http://www.schwab.com\n800-435-4000\nSuretrade http://www.suretrade.com\n401-642-6900\nVanguard Brokerage Serviceshttp://www.vanguard.com\n800-992-8327\nWall Street Access http://www.wsaccess.com\n888-925-5782\nEmpire Financial Group, Inc.http://www.lowfees.com\n800-900-8101\nE*TRADE http://www.etrade.com\n800-786-2575\nLombard http://www.lombard.com\nNational Discount Brokershttp://www.ndb.com\n800-888-3999\nAccutrade\nAmeritrade\nSee also\nDiscover Brokerage\nDLJ Direct\nDatek Online\nDLJ Direct\nDow Jones Markets\nDRIP Central\nEmpire Financial Group\nhttp://www.accutrade.com\n800-494-8939\nhttp://www.tdameritrade.com\n800-326-7507\nhttp://www.freetrade.com http://www.discoverbrokerage.com 800-688-3462 http://www.dljdirect.com\n800-825-5723\nhttp://www.datek.com\nhttp://www.dljdirect.com http://www.djmarkets.com http://www.dripcentral.com http://www.lowfees.com\nSection 4: The Sharpe Ratio\nAlthough this formula is flawed, it will not hinder the reader to know about it and understand it. Believingin it would be quite a different matter, however. The Sharpe Ratio itself is as follows:\nSR = (E - I)/sd\nwhere\nE is the expected return, I is the risk-free interest rate, Sd is the standard deviation of returns.\nThe effect of this inflexible formula is to stick the trader with a measuring tool of little use to the practicaltrader. It assumes volatility of returns as measured by sd equals risk (the common academic problem). Inthe inflexibility of the sd ca", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 227}
{"text": "e Ratio itself is as follows:\nSR = (E - I)/sd\nwhere\nE is the expected return, I is the risk-free interest rate, Sd is the standard deviation of returns.\nThe effect of this inflexible formula is to stick the trader with a measuring tool of little use to the practicaltrader. It assumes volatility of returns as measured by sd equals risk (the common academic problem). Inthe inflexibility of the sd calculation, it fails to measure the most important fact in trading, the maximumdrawdown, or, the inevitable fluctuations in gains and losses. Specifically, the greatest expected orexperienced loss, the retracement from greatest high to greatest low, and the sequences of theseexperiences.\nSection 5: Calculating volatility\nTo calculate the volatility of a portfolio or of an individual instrument, first find the difference betweeneach return and the average. Then square each difference and add them together. Divide the sum by the\nnumber of returns minus one. This result is known as the variance. Finally, take the square root of thevariance to get the volatility. Combining these steps into a formula (see Diagram B.1):\nStep 1: Calculate the average return.\nStep 2: Calculate the deviation of each return.\nStep 3: Square each period's deviation.\nStep 4: Add them together.\nStep 5: Divide the sum by the number of periods minus 1.\nStep 6: Take the square root.\na =\n£ (Ri - M )2\ni=1\nn-1\nDiagram B.1 Volatility formula. Illustrated is the formula for computing volatility. (1) Calculate theaverage return; (2) calculate the deviation of each return; (3) square each period's deviation; (4) add themtogether; (5) divide the sum by the number of periods minus 1 to get the variance; and (6) take the squareroot.\nNote this is the formula to use when you have experience with the portfolio. There is quite a morecomplex procedure in Modern Portfolio Theory.\nSection 6: The essence of fundamental analysis\nFrom the John Magee Market Letters, December 15, 1984\nby Richard McDermott\nThe Elliott Wave Theory: perspective and comments\nWe had the pleasure of attending the December meeting of the Market Technicians Association of NewYork.\nLong-term subscribers will remember the MTANY as the organization that honored John Magee with its“Man of the Year” award in 1978. The speaker was Robert Prechter, publisher of “The Elliott WaveTheorist,” an investment advisory which bases its forecasts on interpretations of R. N. Elliott's work onthe stock market.\nOf primary interest to SAS subscribers are Prechter's comments on technical analysis itself. The ElliottWave Theory, it must be remembered, is really no more than a “catalog” of stock market price\nmovements, laid one on top of the other, so to speak, until a grand, underlying, and enduring pattern isobserved; in short, pure technical analysis. Among Prechter's definitions and observations regardingfundamental analysis are the following:\n1. “First let's define ‘technical' versus ‘fundamental' data .. technical data is that which is generatedby the action of the market under study.”\n2. “The main problem with fundamental analysis is that its indicators are removed from the marketitself. The analyst assumes causality between external events and market movements, a conceptwhich is almost certainly false. But, just as important, and less recognized, is that fundamentalanalysis almost always requires a forecast of the fundamental data itself before conclusions about themarket are drawn. The analyst is then forced to take a second step in coming to a conclusion abouthow those forecasted events will affect the markets! Technicians only have one step to take, whichgives them an edge right off the bat. Their main advantage is that they don't have to forecast theirindicators.”\n3. “What's worse, even the fundamentalists' second step is probably a process built on quicksand....The most common application of fundamental analysis is estimating companies' earnings for boththe current year and next year and recommending stocks on that basis.. And the record on that basisalone is very poor, as Barron's pointed out in a June 4 article, which showed that earnings estimatesaveraged 18% error in the thirty DJIA stocks for any year already completed and 54% error for theyear ahead. The weakest link, however, is the assumption that correct earnings estimates are a basisfor choosing stock market winners. According to a table in the same Barron's article, a purchase ofthe ten DJIA stocks with the best earnings estimates would have produced a ten-year cumulative gainof 40.5%, while choosing the ten DJIA with the worst earnings estimates would have produced awhopping 142.5% gain.”\nWe enjoyed Prechter's polished exposition of a technical approach, which differed from our own. As forhis observations about fundamental analysis, we simply could not agree more.\nKey: portfolio risk report. The Portfolio Risk Analysis screen summarizes delta, profit, and severalmeasures of risk for a portfolio of user-specified stocks and options.\nThe screen displays:\nSTOCK SYM = The stock symbol;\nSTOCK POS = The stock position, or number of shares owned;\nDELTAS TOTAL = The sum of the stock deltas and option deltas;\nBETA = The stock beta for each stock (implementation pending);\n$BETA = $The dollar risk due to movement of the general market: $Beta = (Delta x Stock Price) x Beta;\n$DELT = An annualized risk figure based on Position imbalance: $Delta = (Total Delta x Stock Price) xVolatility;\nPortfolio Analysis Screens\nDiagrams B.2 and B.3 deal with portfolio risk and profit analysis. Illustrated are the sophisticatedquantitative portfolio Profit and Risk reports of Delphic Options Research as implemented forStandard & Poor's trading systems and Prudential Securities to give the reader an appreciation of\nthe depth and complexity of professional thinking about risk and portfolio analysis. The originals ofthese reports were designed by Blair Hull and Lester Loops for their own use in market making.\nPORTFOLIO RISK ANALYSIS (.30 Filename)\n*TOT -690", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 228}
{"text": "isk reports of Delphic Options Research as implemented forStandard & Poor's trading systems and Prudential Securities to give the reader an appreciation of\nthe depth and complexity of professional thinking about risk and portfolio analysis. The originals ofthese reports were designed by Blair Hull and Lester Loops for their own use in market making.\nPORTFOLIO RISK ANALYSIS (.30 Filename)\n*TOT -6900\n-559 -7459 47,165\n-63,9444 -141,969 93,000\n166 24,7470 100.0\nOMS+ .30 PORTFOLIO RISK ANALYSIS 3/24/87 10:55:28\n--STOCK-- ----DELTAS\nSYMPOSOPTIONTOTALPROFITBETA$BETA $DELTA $GAMMA$THETA$RISK%RISK\nFDX2800-3063-26316,7341.60-32,081-7017158,136-121 18,0757.3\nGE3200-3089110 12,632.95 11,3742993120,104-16 13,0005.3\nHWP-62005682 -51782701.20-45,959-13,404-522,208734 56,61722.9\nLIT-67000 -67000 1.40-56,9834-122,1070 0 122,10749.3\nNSM3600-4080-48010,411 1.45-21,076-7267150,464-169 17,4367.0\nXRX-36003991 391 -882 1.0518,1324835186,506-260 20,2328.2\nAVERAGE VOLATILITY: .338\nEQUIVALENT MARKET EQUITY: -419613.40\nPORTFOLIO PROFIT RATIO: .191\nPORTFOLIO PROFIT GAMMA RATIO: 4.815\nDiagram B.2 Risk analysis.\n$GAM = An annualized risk figure based on curvature of the position. A positive $Gamma indicates abackspread, and a negative $Gamma indicates a vertical position: $Gamma = Total\nGamma x (Stock Price x Volatility);\n$THETA = Theoretical dollar amount a position will gain or lose in one day if the stock price remainsunchanged;\n$RISK = The annualized standard deviation of the position based upon a composite of $Delta and$Gamma;\n%RISK = Percent of portfolio risk in each position;\nTOT = Totals for each of the above categories;\nAVERAGE VOLATILITY = Average volatility for the stocks;\nEQUIVALENT MARKET EQUITY = Sum of each of the stock prices multiplied by their total deltas;PORTFOLIO PROFIT RATIO = Total portfolio profit divided by the total portfolio risk; PORTFOLIOPROFIT GAMMA RATIO = Total portfolio profit divided by the portfolio $Gamma squared.\nKey: portfolio profit report. The Portfolio Profit Analysis screen summarizes delta, profit, and severalmeasures of profit for a portfolio of user-specified stocks and options.\nThe screen displays:\nSTOCK SYM = The stock symbol;\nSTOCK POS = Stock position, or number of shares owned;\nDELTAS OPTION = Total delta of the option position;\nDELTAS TOTAL = Sum of the stock deltas and option deltas;\nM TO M = Mark to market: Total value of stock and options positions based upon market prices;\nPROFIT TOTAL = Total theoretical profit for each position;\nPROFIT/DAY = Theoretical profit divided by the number of days to expiration; PROFIT/RISK = Ratio oftheoretical profit to risk;\nPROFIT/DY/RISK = Ratio of theoretical profit per day to risk;\nPORTFOLIO PROFIT ANALYSIS (.31 Filename )\nOMS+.31 PORTFOLIO PROFIT ANALYSIS 3/24/87 10:55:28\n--STOCK— ----DELTAS ---------PROFIT--------- $ $ %\nSYMPOSOPTIONTOTALM TO MTOTAL/DAY/RISK/DY/RISKTHETARISKRISK\nFDX2800-3063-26342,316216,734213.93 4.31 -12118,0757.3\nGE 3200-3089110 704,00612,632107.97 3.01 .16 13,0005.3\nHWP-62005682 -51753,7878270150.15 .97 734 56,61722.9\nLIT-67000 -6700-407,0250 0 .00 .00 0 122,10749.3\nNSM3600-4080-480157,29310,411 105.60 2.21 -169174367.0\nXRX-36003991 391 -4431-882-18-.04-.34 -26020,2328.2\n*TOT-6900-559 -7459926,79247,165557.19 .00 166 247,470100.0\nAVERAGE VOLATILITY: .338\nEQUIVALENT MARKET EQUITY: -419613.40\nPORTFOLIO PROFIT RATIO: .191\nPORTFOLIO PROFIT GAMMA RATIO: 4.815\nDiagram B.3 Profit analysis.\n$THETA = Theoretical dollar amount a position will gain or lose in one day if the stock price remainsunchanged;\n$RISK = The annualized standard deviation of the position based upon a composite of $Delta and$Gamma;\n%RISK = Percent of portfolio risk in each position;\nTOT = Totals for each of the above categories;\nAVERAGE VOLATILITY = Average volatility for the stocks;\nEQUIVALENT MARKET EQUITY = Sum of each of the stock prices multiplied by their total deltas;\nPORTFOLIO PROFIT RATIO = Total portfolio profit divided by the total portfolio risk;\nPORTFOLIO PROFIT GAMMA RATIO = Total portfolio profit divided by the portfolio $Gammasquared.\nSection 7: Software packages and internet technical analysis sites\nThe first cavemen, fighting over resources, used teeth and claws. The nature of warfare was changedforever when one of the smarter ones picked up a tree branch. Then another smart one discovered theprinciple of artillery and picked up a rock. Naive and arrogant traders laughed at Wyckoff's charts. Marketmakers on the Pacific Coast Options Exchange sniggered at Blair Hull when he started appearing on thefloor with printouts. In the days of the wooden racquet, squash players hated the arrivistes who appearedwith metal and then composite racquets.\nNo longer—the last to adopt the new weapons is a dead man. Charts showed their power and so did Hull'swonky printouts made with the Black Scholes Model. The losers figured out pretty quickly they needednew weapons. With that dissertation on the epistemology of warfare, I present some of my favoriteweapons in the following software and internet sites. No attempt whatsoever is made to be comprehensiveor encyclopedic. On the contrary, idiosyncrasy is my operating method and no disfavor is implied to thosenot included here.\nFor myself, three desktop software packages are powerful and sufficient for all the needs of a technicalanalyst: AIQ Trading Expert Pro (http://www.aiqsystems.com), Metastock 9.0 (http://www.equis.com),and TradeStation 2000i and later versions (http:// www.tradestation.com). The reader will find examplesof charts sprinkled throughout this book, supplementing the beautiful hand-drawn charts of Magee. Allthese packages have the basic requirements necessary for technical chart analysis, basic charting onreadily available data and portfolio. I have said before that all the chart analyst really needs is the abilityto draw lines on a chart ... and then perhaps to see the chart as a line chart, or a candlestick chart or ... andso on and so on. The analyst is soon seduced by the dazzl", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 229}
{"text": "harts of Magee. Allthese packages have the basic requirements necessary for technical chart analysis, basic charting onreadily available data and portfolio. I have said before that all the chart analyst really needs is the abilityto draw lines on a chart ... and then perhaps to see the chart as a line chart, or a candlestick chart or ... andso on and so on. The analyst is soon seduced by the dazzling features, and the analysis is enriched andmade more powerful. Even if one says (as I do), when he looks at an oversold tool, “What do I need thatfor? I saw it on the bar chart.” The analyst finds himself wanting to know more about %R. If it worked forLarry Williams, there must be something in it.\nAIQ: TRADING EXPERT PRO\nAIQ's package includes an on-screen control panel and scrolling indicator boxes that are color-coded, andthis information is synthesized in an indicator barometer. Data management is smooth and easy, and theuser may use a system module to create and test his own trading ideas. A panoply of reports is available toaid the investor. For the trader, real-time alerts are a feature. A portfolio manager module aids the investorin managing not just the portfolio, but also his positions by making stop management facile. An ExpertGuru lurks behind the curtain to aid the user in analyzing situations.\nMETASTOCK 9.0\nMetastock 9.0 boasts an impressive array of tools and indicators. “System Experts” pop up on demandand can also guide the user through systems tests and explorations. The Experts can also suggest buys andsells. A point and figure toolbox is a valuable feature. The ability to create and test trading systems, withexhaustive and critical data analysis, is a powerful tool. Metastock adapts easily to add-ons, of whichSlauson's Powerstrike (the quantitative tool for finding critical Support-Resistance zones) is a goodexample.\nTradestation 2000i and Tradestation 8\nTradestation 2000i is the standalone version of Tradestation 8. Tradestation 8 is a real-time onlinepackage that allows for trading through the Tradestation brokerage affiliate. The package is so powerfulthat online professional and semiprofessional users probably benefit by combining their softwarearrangement with a brokerage arrangement. 2000i requires the user to maintain his local database,whereas Tradestation 8 always has the data on demand. For the creatively lazy (among them the editor)this is an attractive feature. Systems building and testing has always been and remains a powerful featureof Tradestation. With “EasyLanguage,” the user may specify virtually any system and then chat about itwith the Tradestation community of traders. This community has contributed to a large database oftrading systems and ideas.\nThe Internet: prophet (http://www.thinkorswim.com)\nFor the even lazier and more casual investor, there is http://www.prophet.net (now at thinkorswim.com),an internet technical analysis site whose free features will fulfill the needs of the general charting investor.\nWith powerful interactive charts and portfolio reporting, the penurious investor will save many pennies athttp://www.prophet.net. As Mark Twain said, a penny saved is a penny earned. Actually, what did BenFranklin mean by a penny saved is capital when put to work? A user community and sharing are otherattractions. And no local data maintenance is necessary. Among its most valuable features,http://www.prophet.net occasionally distributes market commentary and analysis by this editor. All in all,http://www.prophet.net appears to deserve the continuing awards it has received from Barron's andForbes, as well as Technical Analysis magazine. Prophet charting is now available to customers ofhttp://www.tdameritrade.com.\nThe Internet: http://www.stockcharts.com\nOf similar quality, and similarly honored by Forbes and Technical Analysis magazine, http://www.stockcharts.com has an additional valuable feature: point and figure (P&F) charting. I have notremarked on P&F charting here, but it is an important technical method, especially for the patientinvestor. All the other features are available at http://www.stockcharts.com, including candlesticks, barcharts, and others. Also, the distinguished analyst John Murphy makes his electronic home there. There isalso a “Voyeur” feature that allows the user to see what other traders are doing.\nA brief summary\nKnowledge is power. Knowing where to find knowledge is even more powerful. The inquiring investorcan keep himself up to date on these sites through the yearly evaluations in Barron's and Forbes, and thefinancial press regularly updates its evaluations of Internet resources.\nSection 8: The Leverage Space Portfolio Model\nNo less than John Bollinger called Ralph Vince's Handbook of Portfolio Mathematics, the most importantwork on the subject. Mr. Vince has done the readers of this book, and me, the very great favor ofdescribing his work in a short article I present here verbatim.\nIn 1884, Charles H. Dow began his compilation of what would become known as the Dow Jones Indexes.Theories pertaining to non-confirmation of these indices, known as “Dow Theory,” would become thecornerstone of modern Technical Analysis.\nIt is fitting then, with Dow Jones Indexes having embraced the concepts expressed herein with thecommercial offerings of The Dow Jones LSP indexes in 2011, this explanation of Optimal f and theresultant Leverage Space Portfolio Model be included in this the foundational text on modern TechnicalAnalysis.\nLet us consider a case of a simple trade with two possible outcomes. In one of the outcomes, we win 2units, and in the alternative outcome, we lose 1 unit. We can construct a spectrum ranging between avalue 0, where we risk nothing, and 1, where we risk our entire equity. We will consider this valuebetween 0 and 1 as the fraction (f) of our stake at risk, and we will refer to this interchangeably as ourleverage. Thus, on any given trade or over any given period, we are risking some fraction of our stake,and thu", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 230}
{"text": "he alternative outcome, we lose 1 unit. We can construct a spectrum ranging between avalue 0, where we risk nothing, and 1, where we risk our entire equity. We will consider this valuebetween 0 and 1 as the fraction (f) of our stake at risk, and we will refer to this interchangeably as ourleverage. Thus, on any given trade or over any given period, we are risking some fraction of our stake,and thus for any given trade or over any given period, we have a value, f, assigned to us whether we areaware of it or not.\nIf we consider over this hypothetical, simplistic 2-outcome, 2-1 trading situation (similar to if it were thetwo outcomes of a coin toss) we could plot what we would expect to make on our trading equity(expressed as a multiple of our initial equity) over one play at various values for f as depicted in DiagramB.4.\nDiagram B.4 Expected Multiple of Starting Stake in a Single 2:1 Coin Toss.\nDiagram B.5 Expected Multiple of Starting Stake after Forty Tosses in a 2:1 Coin Toss.\nWhen there is more than 1 trade or period and what we have left to invest in the immediate play or periodis a function of what we have made or lost up to this period, the straight line becomes curved, and thepeak of the curve settles into a fixed point, migrating in from 1.0 off to the right where a positiveexpectation trade or period is growth-maximized over 1 trade or period. Thus, after many trades orperiods, it settles in to a given location, and for the simplistic case of a coin toss that pays 2-1, that peakwill settle in at .25 as depicted in Diagram B.5.\nThe height of the curve for any given value for f is given by the formula for Optimal f, determined as:\nt1\nmultiple = 1 + f *| py |\n'( P)\n* *\n\\( Pn )'\nnumber_of_expected_plays_or_trades\nThus, for n trades or periods, for a given value of f, we can determine the multiple made on our stake withsimply the outcome of each trade or period (t), probability of that outcome (p), and the worst-caseoutcome (w), the lowest of all the values for t. We raise the resultant product to the power of howevermany plays we want to determine our expected growth, obtaining the multiple on our initial tradableequity at that many trades or periods.\nThis represents what you would expect to make as a multiple on your starting stake for risking a givenfraction, f, of your stake.\nNotice this is not the same as what is known as The Kelly Criterion, which gives a peak as a “leveragefactor,” a value between 0 and infinity representing how much to lever up one's account, rather than\na fraction (a value between 0 and 1) of an account to risk as expressed by the Optimal f formula. Undercertain conditions the two will give an equivalent value for the peak, for example, the leverage factor willequal the optimal fraction to risk, as in the 2:1 coin toss example herein, but often not, and it can be aperilous mistake to assume that the answer given by The Kelly Criterion is an optimal fraction of accountequity to risk to be expected growth optimal. The Kelly Criterion never yields a peak whose value is theexpected growth optimal fraction of an account to risk, but rather always yields the expected growthoptimal leverage factor. The two can be translated between one another, but the real benefit of theOptimal f formula is it gives us the height to this curve, expressed as an expected multiple made (or lost)on our initial equity (which is not provided by the Kelly Criterion), from which we can derive a field ofstudy.\nFor example, there is a point left of the peak where the curve goes from concave up to concave down.Given the vertical axis is the expected growth multiple and the horizontal axis is the risk, we can state thispoint of inflection represents that point where marginal increase in growth is occurring faster thanmarginal increases in risk, and this flips at the point of inflection.\nConsider the height of the curve at both f = .l and f = .4 as equivalent yet the latter is risking four times asmuch! Clearly, there is never any reason to be beyond the peak of the curve to the right.\nWe have spoken that you are on this curve, somewhere, whenever you have a position in the markets,whether you acknowledge this or not. Note the point in Figure 2 where f = .5, where the multiple = 1.0. Torisk any more than this is to see a multiple less than 1.0, and therefore the more one continues to trade atthis level, multiplying his initial equity by a number less than 1, the more one insures he will go broke.\nMost importantly, this is a situation created without borrowing anything at all—it occurs in a cashaccount! This is a situation created wherein one would have on one unit risked for every 2 units in equity,a situation that clearly requires no borrowing whatsoever, and yet, to continue at that level of “leverage”under these (very favorable) conditions, one will go broke with certainty as he continues to trade.\nWhen more than one trade or play occurs simultaneously in various markets or approaches, the curvedisplayed in Figure 2 (which is a curve in 2D space since we are looking at one component), manifests inN + 1 dimensional space for N components traded simultaneously. If we consider a case of trading two ofthese issues simultaneously, of wagering on two 2:1 coin toss games simultaneously, we find ourselves inan N + 1 dimensional manifold (in this case, 2 + 1 = 3 dimensional manifold) space as depicted inDiagram B.6.\nThis N + 1 dimensional space is referred to as “Leverage Space,” and portfolios derived therefrom as“Leverage Space Portfolios” (“LSP” portfolios). LSP-style portfolio construction grants us insights\nunavailable by more conventional portfolio constructs. For example, in Figure 3, we find the peak of thecurve at the f coordinates for both\nf C o in 2\n.50\nf C o in 1\nDiagram B.6 Expected Multiple of Starting Stake after Twenty Tosses in Two Simultaneously Played 2:1Coin Toss Games.\ngames at.23, .23. Yet, notice what happens if we are off on only one axis; we can be at, say .23, .6, and wefin", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 231}
{"text": "ights\nunavailable by more conventional portfolio constructs. For example, in Figure 3, we find the peak of thecurve at the f coordinates for both\nf C o in 2\n.50\nf C o in 1\nDiagram B.6 Expected Multiple of Starting Stake after Twenty Tosses in Two Simultaneously Played 2:1Coin Toss Games.\ngames at.23, .23. Yet, notice what happens if we are off on only one axis; we can be at, say .23, .6, and wefind our multiple, the height of the graph at these coordinates, to be less than 1. Thus, even though we areoff on only one component in the portfolio (and still not borrowing money to assume any positions) weinsure we will go broke as we continue to trade. The notion of diversification as one of meliorating risk isclearly challenged in an LSP-style portfolio, and this is not at all evident by more traditional perspectiveson portfolio construction.\nNot only are we ineluctably in leverage space when we put on one or more positions in the markets, butwe are also very likely moving through leverage space with changes in our equity and the markets, payingthe price and reaping the consequences for the various points we traverse through the surface of leveragespace.\nThus, various paths can be constructed algorithmically through leverage space to achieve different criteriathan the conventional criterion of maximizing expected return to expected variance, or even that ofmaximizing expected growth (which would be to reside at the peak in the surface). With a path throughleverage space in an LSP-style portfolio, a path through the surface of expected growth as a multiple ofour starting stake, we are now able to seek solutions to any investment criteria.\nAppendix C: Technical Analysis beyond Edwards& Magee\n• Section 1: A brief general survey of number driven tools\n• Section 2: The creative technician—the work of Richard Arms\n• Section 3: The Point and Figure method by an eminent analyst, Mike Moody\n• Section 4: One of the most famous of technical routines—Bollinger Bands\nSection 1: A brief general survey of number driven tools\nHere is something to contemplate: A listing of technical analysis tools.\nTechnical Overlays\n1. Bollinger Bands: A chart overlay showing the upper and lower limits of “normal” price movementsbased on the Standard Deviation of prices 2. Chandelier Exit: An indicator used to set trailing stop-lossesfor both long and short position 3. Ichimoku Cloud: A comprehensive indicator defining support andresistance, identifies trend direction, gauges momentum and provides trading signals\n4. Kaufman's Adaptive Moving Average (KAMA): A unique moving average that accounts forvolatility and automatically adjusts to price behavior\n5. Keltner Channels: A chart overlay showing upper and lower limits for price movements based on theAverage True Range of prices 6. Moving Averages: Chart overlays showing the “average” value overtime. Both Simple Moving Averages (SMAs) and Exponential Moving Averages (EMAs) are explained 7.Moving Average Envelopes: A chart overlay consisting of a channel formed from simple movingaverages 8. Parabolic SAR: A chart overlay showing reversal points below prices in an uptrend andabove prices in a downtrend 9. Pivot Points: A chart overlay showing reversal points below prices in anuptrend and above prices in a downtrend 10. Price Channels: A chart overlay showing a channel madefrom the highest high and lowest low for a given period of time 11. Volume by Price: A chart overlaywith a horizontal histogram showing the amount of activity at various price levels\n12. Volume-Weighted Average Price (VWAP): An intraday indicator based on total dollar value ofall trades for the current day divided by the total trading volume for the current day\n13. ZigZag: A chart overlay showing filtered price movements greater than a given percentage\nTechnical Indicators\n1. Accumulation/Distribution Line: Combines price and volume to show how money may beflowing into or out of a stock\n2. Aroon: Uses Aroon Up and Aroon Down to determine whether a stock is trending or not\n3. Aroon Oscillator: Measures the difference between Aroon Up and Aroon Down 4. AverageDirectional Index (ADX): Shows whether a stock is trending or oscillating\n5. Average True Range (ATR): Measures a stock's volatility\n6. Bandwidth: Shows the percentage difference between the upper and lower Bollinger Band\n7. %B Indicator: Shows the relationship between price and standard deviation Bollinger Bands 8.Chaikin Money Flow (CMF): Combines price and volume to show how money may be flowing into orout of a stock Alternative to Accumulation/Distribution Line 9. Chaikin Oscillator: Combines price andvolume to show how money may be flowing into or out of a stock. Based on Accumulation/DistributionLine 10. Chande Trend Meter (CTM): Scores the strength of a stock's trend, based on several technicalindicators over six different timeframes 11. Commodity Channel Index (CCI): Shows a stock's variationfrom its “typical” price 12. Coppock Curve: An oscillator using rate-of-change and a weighted movingaverage to measure momentum 13. Correlation Coefficient: Shows the degree of correlation betweentwo securities over a given timeframe\n14. DecisionPoint Price Momentum Oscillator (PMO): An advanced momentum indicator trackinga stock's rate of change\n15. Detrended Price Oscillator (DPO): A price oscillator using a displaced moving average toidentify cycles\n16. Ease of Movement (EMV): An indicator comparing volume and price to identify significantmoves\n17. Force Index: A simple price-and-volume oscillator\n18. Mass Index: An indicator identifying reversals when the price range widens 19. MACD (MovingAverage Convergence/Divergence Oscillator): A momentum oscillator based on the difference betweentwo EMAs 20. MACD Histogram: A momentum oscillator showing the difference between MACD andits signal line 21. Money Flow Index (MFI): A volume-weighted version of RSI showing shifts is buyingand selling pressure 22. Negative Volume Index (NVI): A cumulative volume-based indicat", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 232}
{"text": "e widens 19. MACD (MovingAverage Convergence/Divergence Oscillator): A momentum oscillator based on the difference betweentwo EMAs 20. MACD Histogram: A momentum oscillator showing the difference between MACD andits signal line 21. Money Flow Index (MFI): A volume-weighted version of RSI showing shifts is buyingand selling pressure 22. Negative Volume Index (NVI): A cumulative volume-based indicator used toidentify trend reversals 23. On Balance Volume (OBV): Combines price and volume in a very simpleway to show how money may be flowing into or out of a stock\n24. Percentage Price Oscillator (PPO): A percentage-based version of the MACD indicator\n25. Percentage Volume Oscillator (PVO): The PPO indicator applied to volume instead of price\n26. Price Relative/Relative Strength: Technical indicator comparing the performance of two stocksto each other by dividing their price data\n27. Pring's Know Sure Thing (KST): A momentum oscillator from Martin\nPring based on the smoothed rate-of-change for four different timeframes 28. Pring's Special K: Amomentum indicator from Martin Pring combining short-term, intermediate and long-term velocity 29.Rate of Change (ROC) and Momentum: Shows the speed at which a stock's price is changing 30.Relative Strength Index (RSI): Shows how strongly a stock is moving in its current direction 31. RRGRelative Strength: Uses RS-Ratio to measure relative performance and RS-Momentum to measure themomentum of relative performance\n32. StockCharts Technical Rank (SCTR): Our relative ranking system based on a stock's technicalstrength\n33. Slope: Measures the rise-over-run for a linear regression\n34. Standard Deviation (Volatility): A statistical measure of a stock's volatility\n35. Stochastic Oscillator (Fast, Slow, and Full): Shows how a stock's price is doing relative to pastmovements. Fast, Slow and Full Stochastics are explained\n36. StochRSI: Combines Stochastics with the RSI indicator to help you see RSI changes moreclearly\n37. TRIX: A triple-smoothed moving average of price movements\n38. True Strength Index: An indicator measuring trend direction and identifying overbought/oversoldlevels 39. Ulcer Index: An indicator designed to measure market risk or volatility 40. UltimateOscillator: Combines long-term, mid-term and short-term moving averages into one number 41. VortexIndicator: An indicator designed to identify the start of a new trend and define the current trend 42.Williams %R: Uses Stochastics to determine overbought and oversold levels Outline\nThis is a list of tools and indicators available at stockcharts.com. Most if not all of these tools are alsoavailable either through software packages (Tradestation, AIQ, Metastock) or online (thinkorswim andothers). I display the list so newcomers to technical analysis get an idea of the plethora of tools available.Also, I display the list so that students see the philosopher's stone nature of building systems to beat themarket. To briefly review, the philosopher's stone is a stone which allows the owner to convert lead togold. In the Middle Ages, it was the subject of much dedicated research. At present, to my knowledge,only George Soros has a philosopher's stone, but it is entirely possible for the dedicated student to find inthe list a tool or method which will allow him to reap rich rewards.\nDisplaying the list also prompts me to repeat what we have frequently told our graduate students over theyears: You can drive a nail with a screwdriver; so if it works for you it doesn't matter what it looks like. Tothis end I will comment on some, but not all, of the tools listed here—in some cases revealing tools andsystems which, in research, have been fiendishly effective.\nMoving averages\nTechnical Analysis of Stock Trends is often the first book investors read when they become interested inthe technical approach to the market. This is as it should be and also new analysts need to be informed ofthe amazingly varied field of technical analysis. Chart analysis is the cornerstone of technical analysis anda required field of knowledge. If the analyst is more statistically oriented or is looking for an algorithmicmethod he must search through the numerous alternatives in the technical toolbox.\nThis appendix is intended not to teach the reader the details of operating a moving average or stochasticsroutine, but to place the various technical tools and systems (or methods) in context and in perspective.The first of these tools is the moving average. We personally can testify to the power of these systems,having reaped outsize profits using moving average systems. Note these profits were gained in roaring bullmarkets. In sideways markets trading a moving average can be the equivalent of producing sausage with ameat grinder. Thus, having confidence in the state of the market is an absolute necessity. The effect of amoving average is to smooth raw price behavior and clarify the trend of the market. The bells and whistlesyou can hang on a moving average are like a Christmas tree. You can use the moving average as input to asignal —buying when the price penetrates above the MA line. Using the MA line as a stop, selling whenprices fall below the MA line. Or you can construct a filter—buying or selling when prices pierce the lineby x%. The possible variations are infinite.\nAs is probably obvious, MA systems are in the main trend following systems. As are virtually all Edwards& Magee methods and systems. The reason for attempting to employ trending systems is, withoutexception, long-term trend following results in larger profits than any other trading method.\nIn general, the market makes something of a shibboleth of two moving averages—the 50-day and the 200-day. The 50-day is thought by the media and public to be a warning crack in the market and the 200-daypenetration is thought to be a bear market phenomenon. In our trading, we watch the 50 and the 200--daybut we don't use them as signals. We are usually more concerned with patterns and th", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 233}
{"text": "g method.\nIn general, the market makes something of a shibboleth of two moving averages—the 50-day and the 200-day. The 50-day is thought by the media and public to be a warning crack in the market and the 200-daypenetration is thought to be a bear market phenomenon. In our trading, we watch the 50 and the 200--daybut we don't use them as signals. We are usually more concerned with patterns and the character of themarket rather than using these moving averages as signals. Rather, we use them as alerts as to what thepublic is thinking and depend on Basing Point analysis for stops.\nMagee's consideration of moving averages is contained in Chapter 36. It is amusing to quote a remark ofhis upon discovering moving averages: \"...one could derive a sort of Automated Trendline that woulddefinitely interpret the change of trend. It seemed almost too good to be true. As a matter of fact, it was toogood to be true.”\nPersonally, we have experienced excellent profitability with moving average systems. While we originallythought this was a sign of genius, with time we realized that the market was the genius and my companywas trading in a roaring bull market—and indeed we were—the monstrous commodity bull markets of the‘70s—the Russian wheat market, the Hunt silver market.. Almost anything, including bonobo monkeysthrowing darts, works in a tidal market.\nNevertheless, a long moving average can keep the investor fully invested for months— if not years. In thecase of the great Bull Market of 2009-2017, it took years, as evident by the chart with a 200-period simplemoving average. (Figure C.1) A number of different types of moving averages are used by technicians:simple, exponential, triangular, variable, and weighted. The distinguishing difference amongst thesemethods is the simple method weights all prices equally. Weighted and exponential routines place a highervalue on the most recent data, enabling more sensitive and rapid reaction. Triangular averages put moreweight in the middle of the time period and variable averages adjust the weighting according to thevolatility of prices.\nDoes this smack of the philosopher's stone? One thing it should tell the newcomer—and grizzled veteran—is the search for a market beating method is incessant and indefatigable— it never ceases.\nFigure C.1 A 200 period moving average on a weekly chart. The investor would never (virtually never)have felt the least anxiety for his position. His confidence in the trend would have been buttressed by theMA line.\nContemplating an exponential versus a simple moving average the difference is probably not worth thetrouble. Trading decisions might be moderately accelerated on trading length systems (-5-15 days for veryshort term; 15-23 days for short term; and 24-50 days for intermediate term; and 100 days and up for longterm. With recent thinking we might add super long term—that is 200 days or even longer weekly basedsystems.) The conventional way to use a moving average system is to go long when price breaks above themoving average and sell when price falls below the moving average. Probably the most usual modificationto these systems is to put a filter on them, for example requiring the penetration of the moving average lineby 1 (or x) % to assure validity. (Cf. Chapter 36, the Pentad system) We think, based on experience, thismay be the most effective way to employ this tool. Sometimes two moving averages are used. Signals arecreated by the interplay of the moving average lines, one moving above or below the other. This is acharacteristic of MACD, which will be discussed later.\nStochastics\nThe first thing to do when studying stochastics is stop trying to figure what “stochastics” means. Ofcourse, it has a dictionary meaning to be discussed later. Right now, the reader should put aside thequestion of actual meaning and consider what it means in the discipline of technical analysis.\nMarkets have two basic theoretical (and actual) states: trending or mean reverting. If the market is non-trending, swinging back and forth, up and down, traders need tools to deal with it. If they want to tradeunder these conditions they turn to oscillators. The purpose of the oscillator is to aid in identifying wavebottoms and wave tops. The stochastic algorithm is one of the more popular of these oscillators.\nStochastics establishes a “window” on the market for the analysis of prices. The default value for thiswindow is 14 bars, but different practitioners customize the value for their own use. The price highs andlows within this window are integral to the analysis. The routine establishes a line (called %K) as theessential benchmark or guide of the analysis. A second line is calculated (%D) using a simple movingaverage of %K. This moving average is quite short (3 periods default value) and thus creates a line ofgreat sensitivity. Conventionally these lines are displayed on a scale from 1 to 100. Signals are generatedby values of 20 and 80. The routine buys when the low value is 20 and sells upon a high value of 80. Inshort, selling strength and buying weakness. 20 and 80 refer to where the closing price is relative to thewindow trading range, thus placing price position at 20% or 80% of the range. Other means of generatingsignals are available, to wit the interaction of the two lines, as for example, the %K line falling below orrising above the %D line. (Figure C.2)\nAs with most tools, the technician can modify the routine to suit his whim.\nMACD (Moving Average Convergence/Divergence)\nMACD is a trend following momentum indicator that shows the relationship between two movingaverages of price. It is calculated as the difference between a 26 and a 12-day exponential moving average.Gerald Appel, who is reported to be the creator of the routine, placed a 9-day exponential moving averageon top of the MACD as a means of identifying trading signals. Generally, a sell signal occurs whenMACD falls below the signal line and a buy signal when it rises above the si", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 234}
{"text": "een two movingaverages of price. It is calculated as the difference between a 26 and a 12-day exponential moving average.Gerald Appel, who is reported to be the creator of the routine, placed a 9-day exponential moving averageon top of the MACD as a means of identifying trading signals. Generally, a sell signal occurs whenMACD falls below the signal line and a buy signal when it rises above the signal line. Trading also occursas MACD goes above and below zero. (Figure C.3) As one can well imagine with 55 indicators (andcounting), there is a tool for every occasion. One must always remember the rule of tools: To a man with ahammer everything looks like a nail. Rather than attempting to explicate every tool, I will restrict myselfto the obvious, after reminding the reader that careless and uneducated use of any tool can seriouslyendanger his capital.\nSome other chosen indicators to consider: ADX, a tool which shows whether an issue is trending oroscillating. This tool is easily replaced with a ruler and the naked eye. This is the case with many of theindicators; they have been developed by their inventors to attempt to remove ambiguity from the market—a desire the experienced chart analyst doesn't possess. The chart analyst looks at a chart and most of time itis obvious. If not, it becomes obvious the moment a ruler is laid on it. Another tool which does more orless the same is the Aroon which uses Aroon Up and Aroon Down to determine whether an issue istrending or not. Once again, a question which is painfully obvious at first glance to the chart analyst. Weshould make clear that some intelligent analyst has used each of these tools to wring a profit from the\nmarket. Accumulation /Distribution Line showing how money flows in and out\nFigure C.2 Stochastic routine on a gold chart. Obviously interpreting the indicator requires someexperience and discrimination, but this is true of all number driven indicators.\nof an issue may be useful to some practitioners, as may Volume by price which shows the amount ofactivity at various price levels. Pivot points—a relatively simple mechanism evidently popular with manytraders can at least give the trader unambiguous trading points.\nWhich brings us to a central technical and philosophical point: Almost any system is better than nomethod (or system) at all. The problem for the inexperienced trader— or investor—is what system. Thisbook answers that question for most investors and is a good method while the investor refines his ownmethods. We continue to say the trader who invents a system without thorough knowledge of this book isputting life limb and capital at risk. This statement may be a little less true now than in years past—simplybecause so much of this book's material has leaked via osmosis into general investor knowledge—usuallyunconsciously, but often through outright imitation or worse. Not a practice which outrages us, though,sometimes amuses us—but no tears. Also, as we have been in education for many years, we observe thespread of knowledge as something the enlightened and educated do as a responsibility to the communityand humanity.\nPoint and Figure analysis\nBar chart analysis has so dominated investor usage for so long (partly because of this book) that evenmany experienced analysts have ignored an interesting and valuable method which we will explore brieflyhere. That method is Point and Figure analysis.\n$SPX S3P 500 Large Cap Index INOX\n© StockCharts com\nFigure C.3 MACD on a gold chart. MACD is a popular tool and deemed effective by many traders.Readers can see why from the chart.\n544 Appendix C\nSaid by some to be an invention of Charles Dow, and by others to be created by the Russians, PnF chartinghas shown itself to be surprisingly effective in our experience. When we examine some of itscharacteristics we get an idea why. Bar charts represent price action (open high low close) with a verticalbar with cross hatches for open and close. The x axis represents time, the y, price. PnF ignores time for themost part, though there is a nod to it as we will see.\nSeveral basic decisions are made in the construction of the chart. Since the chart is made up of boxes, thesize of the box must be determined. The analyst chooses a box style appropriate to the duration of thechart. Obviously, if one is dealing with years of data in the INDU the box must be large—50, 100 points.At shorter durations wave analysis would suggest a good size; and at any rate online routines presentreasonably sized charts. In general, one might say larger boxes furnish perspective and smaller boxesfurnish detail.\nThe other choice the analyst must make is reversal size. The traditional choice here is a three box reversal.Thus, if the box size is 4 and we are in an x column, 12 points down must occur to change to a column of0s and three 0s would be drawn in the next column. And although time is usually ignored, a box is markedwith a month indicator as a column rolls over to a new month.\nAll these options are subject to change and adjustment by the individual technician. What is more, thereare other varieties of PnF charts—one box reversal, for example, but the basic idea is the same. Using a\nvariety of methods, one may make forecasts from the chart. Let me emphasize: Treat this method and anyother algorithmic method with caution until you have thoroughly examined it (Figure C.4).\nNext for comparison, a bar (Candlestick) chart shows the traditional picture of this period (Figure C.5).\nAs the reader can see, PnF charting is a fascinating and valuable method. Many investors rely on thismethod alone for their analyses.\nAs with all of the tools surveyed here no attempt is made to give a definitive exploration of the tool or todescribe the mechanics of its creation. Those details about PnF charts are ably discharged by the booksPoint & Figure Charting by Thomas Dorsey and The Definitive Guide to Point and Figure by Jeremy duPlessis. Later in this appendix Mike Moody will discuss the", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 235}
{"text": "thod alone for their analyses.\nAs with all of the tools surveyed here no attempt is made to give a definitive exploration of the tool or todescribe the mechanics of its creation. Those details about PnF charts are ably discharged by the booksPoint & Figure Charting by Thomas Dorsey and The Definitive Guide to Point and Figure by Jeremy duPlessis. Later in this appendix Mike Moody will discuss the method in a much more sophisticated way.\nSection 2: The creative technician—the work of Richard Arms\nThe Arms Index (TRIN) by Richard Arms\nIn 1967, when I was still an unknown in Technical Analysis and was working as a stockbroker for a majorNYSE firm, we moved into new modernized offices. Among the improvements were new quote machines,which actually had a tiny screen to display the information. Moreover, the data included some fascinatingnumbers. It was possible to see the number of stocks that were up and the number of stocks that weredown at any time, and even a total of the volume traded on the up stocks and a total of the volume tradedon the down stocks. Looking at this, I began to wonder if it could serve as an indicator, telling us if theratio of up to downs was the same as the ratio of up volume to down volume. If not, deviations fromnormality might show when the buyers or the sellers were more in control. In seconds, the Arms Index, orTRIN, came into being in my mind and then in my research. An article in Barron's was all that was neededand it took on a life of its own.\nSSPX S«P 500 Large Cap Index NDX\n02-Nov-2015.16:00 ET. da4y, 0 2.08076, H 2,106 20. L 2.080.76. C 2.104 05. Chg *24 69 (1 19%) P&FPattern Long Tai Up on 28-Oct-2015\nTrad ton al scaling 3 box reversal\nBuksh Price Objective (Tentative) 2549 0\n(<) StockChirtrcom\nn\nI\n2140.00\n2140.00\n2130.00 X X 2130.00\n2120.00 X X Xo X Xo 2120.00\n2110.00 X X X XoXoXoX XoXoX 2110.00\n2100.00 X3Xo XoXoXoXoXoXoXoX8X\\ X B <<2104.05\n2090.00X XOXo XoXo5oX6XoXoXoXoXoXo X 2090.00\n2080.00Xo XoXoX Xo o oXo/ o oXoXoXoXo X 2080.00\n2070.00Xo XoXoX4X o / oXo o oXo X 2070.00\n2060.00c XoX X XoXoXOX oX o o X 2060.00\n2050.00° X1Xo Xo XoXo O 7 o X 2050.00\n2040.00P XoXo Xo Xo o X _2040.00\n2030.00\n2020.00\n2010.00\n2030.00\n2020.00\n2010.00\n1990.00 °X oooo o X Xo X 1990.00\n1980.00 ° o X9 X Xo X 1980.00\n1970.00 o XOX XoXo X 1970.00\n1960.00 o XOXoXoXo X 1960.00\n1950.00 o XOXoXoXoX X 1950.00\n1940.00 oX XOXoXo oXoX 1940.00\n1930.00 oXoXOXoX oXoA 1930.00\n1920.00 oXoXoXo oXoX 1920.00\n1910.00 oXoXo o oX 1910.00\n1900.00 oXoX / oX 1900.00\n1890.00 oXoX oX 1890.00\n1880.00 oXo/ O/ 1880.00\n1870.00 o / 1870.00\n1860.00 1860.00\nFigure C.4 Here from the edwards-magee.com website is a PnF chart from November 2015 which looksfor a target of 2549—this when the S&P was around 2000.\n$ S P X S&P 500 Large Cap Index INDX ® StockCharts.com\nAppendix C 547\nThe calculation\nWith so many sources, such as newspapers, television stations and every quotation service, providing thecalculated index most users will never need to make the calculation themselves. However, in order toappreciate the significance of the index one should be familiar with its derivation. The Formula is:(ADVANCES/DECLINES)\n2---------------------- = ArmsIndex\n(ADV.VOL./DECL.VOL.)\nAt any time, we can retrieve the numbers showing how many stocks are up for the day, how many stocksare down for the day, the volume on the advancing stocks and the volume on the declining stocks.Plugging them into the above formula we end up with a single number, the Arms Index for that instant.The above example* (footnote) has produced a somewhat bearish index. An index of 1.00 is a standoff,indicating both the advancing stocks and the declining stock received their fair share of the volume. Avalue over 1.00 is Bearish, indicating the declining stocks are receiving more than their share of thevolume. An index lower than 1.00 is Bullish since the up stocks are receiving more than their fair share ofthe volume. Normally, the index will fluctuate closely around 1.00. We have seen days end with an indexas low as .19 and other days with an index over 10.00, but these were rare occurrences, where the traderswere reacting to extremes in euphoria or fear. Normally, the index will be somewhere between .65 and1.75.\nEXAMPLE THE ARMS INDEX: ADVANCES 1024 DECLINES 2030 ADVANCING VOLUME 299,790,000DECLINING VOLUME 786,830,000 1024/2030 =.504 1024/2030 =.504 299790/786830 =.381 .504/.381\n= 1.32 .504/.381 = 1.32 (ADVANCES / DECLINES) (ADV. VOL. / DECL. VOL.) (ADV. VOL. / DECL.VOL.) = THE ARMS INDEX (TRIN) EXAMPLE\nThe reasoning\nAt any time, the Arms Index is telling us whether the up stocks are getting their share of the volume ornot. If the index is over 1.00 the down stocks are overpowering the up stocks. (Remember, under 1.00 forthe raw number is good, and over 1.00 is bad. It is counter-intuitive, but it is the way the index was firstcalculated, and it's late to try to change it now. If that really bothers you, invert the calculation and it willbe more intuitive, but you will be out of step with everyone else using the index. You will see the index isdealing with comparing two ratios, so it is commonplace to have a market that appears to be Bullishbecause of there being more stocks up than down, but is actually under pressure, in that those up stocksare not getting their share of the volume, and the index is Bearish. Similarly, we can have more stocksdown than up, but have a Bullish index, because the up stocks are getting more than their fair share of thevolume. The Arms Index is measuring the internal dynamics of the market—dynamics that may not beotherwise readily apparent. A Bullish Arms Index in a slumping market may be telling us there isaccumulation going on, under the guise of a down market.\nUsing the index\nThe index was originally developed as an intraday timing tool, and it still is valuable in that role. There aretwo things to look at: the actual reading and the way it is changing during the day. The actual level istending to reflect the current conditi", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 236}
{"text": "rent. A Bullish Arms Index in a slumping market may be telling us there isaccumulation going on, under the guise of a down market.\nUsing the index\nThe index was originally developed as an intraday timing tool, and it still is valuable in that role. There aretwo things to look at: the actual reading and the way it is changing during the day. The actual level istending to reflect the current condition; sometimes a Bullish reading in a declining market or a Bearishreading in a rising market makes the move suspect. More often, the value will be in line with the currentmarket activity, but watch for the big extremes. Not always, of course, but often, the index will go too farin one direction, and suggest the move is overdone. It is reflecting those times when reason is beingabandoned and a blind panic or a feeding frenzy is dominating the trading. A very high or a very low indexcan be a sign it is time to be a contrarian. The other intraday use is watching for change, rather than justthe actual value of the index. Often the index will change direction before a reversal becomes apparent inthe averages. A Bearish index in a Bearish market that suddenly starts to move toward lower (less Bearish)levels may be a warning the market is about to turn up. The same is true bullish numbers that start to gethigher; suggesting a downturn may be developing. Most often, though, the index is now used on a longer-term basis. The most common use is a simple 10-day moving average of the closing daily numbers. Thistends to be a good indicator for market moves lasting a few weeks. For short-term trading, I like the 5-daymoving average. In order to get a feel for longer-term trends, I use a 21-day and a 55-day. The big marketmoves can be recognized by using very big moving averages, such as the 233-day. On each of thefollowing charts, we are looking at simple moving averages of the Arms Index on an inverted scale. Thered line is the index and the black line is the market. Since the scale has been inverted for the index, thelows on the indicator line tend to coincide with low points in the market. Similarly, peaks in the indexcoincide with the market tops. I have chosen different time intervals on each of the charts below since thelonger-term moving averages are used for longer-term predictions. I have not given any hard-and-fastnumerical levels as buy and sell signals because we need to look at the index in the context of the currentmarket. Buy signals in a Bear Market are at more oversold levels than they are in a Bull Market. Extremepeaks and troughs, compared to what has been seen recently, tell when it is time to become a buyer or aseller. These are only a few applications and examples. Not shown are Arms Indices, now available, forNASDAQ and also for a number of foreign markets, in which the index is equally effective. Immenseamounts of work, using many different methods, has been done over the years since the index was firstmade public. Anyone wishing to know more is referred to the various books by Richard W. Arms, Jr.Figure C.6 illustrates the index and shows Equivolume chart for context.\nFigure C.6 Notice how on the Equivolume chart the breakaway is accentuated by the wide bars. Thetechnician is constantly in need of accents and alerts like this (cf. also Figure C.7).\nEquivolume charting\nIntroduction\nIn 1971, with the Arms Index a part of Wall Street methodology, I had become more fascinated by the roleof Volume in the marketplace. I had been spending great deal of time studying an early edition of the bookyou now hold but had also been learning the ideas of Richard Wyckoff; both placed a great deal ofemphasis upon the importance of Volume in evaluating stock movements. As I was driving home fromwork one afternoon, I was thinking about stock charts and volume and suddenly realized there might be abetter way of depicting trading action. What if we could substitute volume for time on our charts? Wecould depict each day as a rectangle rather than the traditional line on a bar chart. The width of the boxwould represent the volume for that day. Unbeknownst to me, I was reinventing a method suggesteddecades earlier, but not widely popularized. I decided to call my new approach Equivolume (cf. FiguresC.7 and C.11).\nFigure C.7 Once again the wide volume indicating bars alert the technician to an important surge in themarket.\nThe technique\nIn the days before the proliferation of computers, implementing the concept of Equivolume was far fromeasy. In order to lift the volume from the bottom of the chart and insert it in the posting, a scale for eachstock had to be devised based upon its normal trading. That scale could change if the stocks went into aphase of much heavier or lighter trading. I will not go into the calculations I used at the beginning, but itseemed to work. I hired a lady to draw dozens of charts for me and proceeded to learn to read what theysaid; this led to my first book. Later, each new advancement justified another book. Once people a lotsmarter than me figured out how to let a computer do the work, it became a lot easier. Now, one can getEquivolume charts on most major charting services, so there is really no need to wonder about the scaling.Suffice it to say, the rectangles on any chart are proportional to one another in reflecting the volume.\nThe result\nAn Equivolume chart does not in any way change the high and low on each entry, but when combinedwith the volume it becomes a box, the shape and size of which reflects supply and demand for that tradingperiod. All the techniques popularized by the masters who first published this book are valid when usedwith Equivolume charts.\nHowever, for example, trendlines tend to be broken earlier if volume becomes heavier, and breakouts aremore noticeable if volume increases, thereby legitimizing them, as are levels of support and resistance.Equivolume uses all the same data, but just gives us a different picture, which includes all the data in asingle ent", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 237}
{"text": "ers who first published this book are valid when usedwith Equivolume charts.\nHowever, for example, trendlines tend to be broken earlier if volume becomes heavier, and breakouts aremore noticeable if volume increases, thereby legitimizing them, as are levels of support and resistance.Equivolume uses all the same data, but just gives us a different picture, which includes all the data in asingle entry. Below are two charts: a bar chart and an Equivolume chart of the same stock over the sametime period. This is three months of trading in General Electric (Figure C.8).\nThe chart below is posted on a weekly basis (Figure C.9).\nConclusion\nEquivolume represented a far better way of looking at market action because each entry told a morecomprehensive story. The shape of the box indicated how easy or hard it was for prices to move while thesize of each box showed the interest intensity. It was a method that could be used for any investmentproduct, as long as both price movement and volume numbers were available. It has become a completemethodology and is readily available on a plethora of data services.\nArms CandleVolume charting\nAfter the introduction and wide adoption of Equivolume, the next logical step was to combine theEquivolume concept with the Japanese method known as Candlesticks. Yet, I was slow to do this becauseone or more of the major charting services had already included a partial joining of the two techniques,calling it CandleVolume, but doing it in such a way some of the visual advantages of Equivolume werelost in the process. Yet, if I did the combination of the methods in my way, completely merging the twotechniques, I found it could be another great advance in the way we looked at charts. Clumsily doubleprinting of charts, I was able to work on it and found the results to be very helpful, and since the nameCandleVolume was already taken, I started calling it Arms CandleVolume. Then, after my first speech onthe approach, to the International Federation of Technical Analysts in San Francisco a few years ago, theproblem was solved. Within minutes of completing the speech the President of Stockcharts.com, who hadbeen in the audience, showed me he had quickly adapted their software for the new technique and, withmy approval, would immediately include it in their service, which they did. The illustrations in this articleare from that source.\n200\n180\n214\n210\n8 10 12 17 Od\n14 15 17 21 27 28 1 5 7 11 14 18 20 22 28 2\nOec 201\nGE General Eiectnc Co. NYSE ‘Bats •StoclCtarfsrom SJin-20181:27pm Open 1880 High 18 88 Low18.51 Last 1840 Volume 48 1U Chg »0 02 (•013%) •\n¥« (Dally) 18.56\n104\n175\n200M\n100M\n20 2011\nM GE (Oaily) 18.57\n•hiiunu\nGE General Electric Co. hyse ♦ bats 5.J1O-2018 128pm\n8\nA Volume 48,359,892\n300M\nOltockClurtKom g <003 (*0.19%) -\n243\n240\n235\n23.0\n225\n22.0\n213\n210\n205\n20.0\ny l.<J-\n•\nlov1 13\nn\nIlliInlll\n■r\nFigure C.8 This is three months of trading in General Electric illustrating two different but complimentarypictures of the market. By dragging the volume off the bottom margin and including it in the price wehave made it apparent all days are not equal in importance. Moreover, the concept of eliminating time as amarket measurement led, in later studies and books, to the development of Volume Cyclicality, Ease ofMovement and of Volume Adjusted moving averages. It had become apparent the market is a volumefunction. If nothing trades, nothing happens; The more trading, the more importance.\nFigure C.9 Vividly illustrating the usefulness of the Equivolume chart like signposts on a battlefield: Lotsof fighting here.\nThe advantages\nAlthough the open and the close appear on some versions of bar charts, the Equivolume methodology hadignored them. The Candlestick charts did contain the opens and closes; in fact, they emphasized them. Itled to different and fascinating visual patterns using the ancient methods from their origin given\nimaginative and memorable names. I have, in order to distinguish the new methods and to emphasizeadding volume changes the meanings very often, tended to use my own nomenclature. The Japanesemethods are wonderful, but the volume adds a new dimension. As one starts to use this technique itbecomes ever more apparent the open and close levels, added to high and low and volume, are providing apowerful additional tool.\nThe technique\nAll we have done is to place the Candlestick inside the Equivolume box. However, there is a vertical linethrough the box, the wick, and there are two horizontal lines across the box, the open and the close. Aboveand below these lines are the legs. If the open is lower than the close the body of the posting with be blackand if it is higher the body will be red. If color is not available, the body can be filled or unfilled. Belowwe see a comparison of the three techniques: Bar chart, Equivolume chart, and Arms CandleVolume chart.They are all daily postings of Newmont Mining over the same three-month period (Figure C.10).\nTo delve into the interpretation is beyond the scope of this article, but it is clear, I think that each day, eachposting, tells us a concise story of supply and demand; of conflicting pressure of buyers and sellers. Boxsizes tell us of overall enthusiasm while box shapes tell us how easy or hard it is for price movement tooccur. Moreover, the difference between the open and the close tell us whether prices are stalled ormoving. Box shape, size, volume and Candle body size all present a picture of ease or difficulty ofmovement.\n8 12 17 10 23 25 20 30 1 Oct Hoi\nNEM Nowmont Mong Corp. NYSE •itocKharticom 5-Jan-2018 Open 38 18 High 38 43 low 3802Close 38 40 Volume 2 0M Chg •0.14(t037*)>\n38.75 aa M\nW1V 3800\n37.75\n37 60\n37 26 37 00 3076\n36 60 36 26 3600\n3575\n36 60\n35 25\n0 10 23 XNov e 13 20 27 Dec 11 10 20 2010\nNEM Mrmg Corp NYSE\n5-J aft-2018\nM NEM (Daily) 38.40\n• $to< kChart i com Open 38 18 High 38 43 Low 3802 Close 38 40 Volume 2 OM Chg *0 14 («O37M) -\nNEM Newmort MnngCorp NYSE\n5 Jan-2016\nMNEM Daily) 38.40\n• StocKKarttc", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 238}
{"text": "igh 38 43 low 3802Close 38 40 Volume 2 0M Chg •0.14(t037*)>\n38.75 aa M\nW1V 3800\n37.75\n37 60\n37 26 37 00 3076\n36 60 36 26 3600\n3575\n36 60\n35 25\n0 10 23 XNov e 13 20 27 Dec 11 10 20 2010\nNEM Mrmg Corp NYSE\n5-J aft-2018\nM NEM (Daily) 38.40\n• $to< kChart i com Open 38 18 High 38 43 Low 3802 Close 38 40 Volume 2 OM Chg *0 14 («O37M) -\nNEM Newmort MnngCorp NYSE\n5 Jan-2016\nMNEM Daily) 38.40\n• StocKKarttcora Open 38 18 High 38 43 Low 38 02 Close 38 40 Volume 2 0M Chg «0 14 (*037M) -\n370\n370\n365\n360\n355\nVNEM (Oatlv) 38.40\nI W I\nn, .\ntt]\nLI, d\n3500\n3475\n3450\n3425\nFigure C.10 Notice the increasing analysis of information that occurs from one method to the nextmoving from conventional bar chart through Equivolume to Candlevolume.\nFigure C.11 Notice the increase in information as we move to the newer technique. Candlevolumecombines virtues of Equivolume and Candlestick charts.\nPoint & Figure technical analysis by Mike Moody\nLike most technical analysts, my exposure to charts came initially from bar charts. I started as a naivestockbroker, hoping to understand markets to help my clients make money. I soon learned the “accountexecutive” position was—from the faulty point of view of the brokerage firm—primarily a sales job. I\nquickly learned to use bar charts as a form of selfdefense from the firm's research department. The chartscould be used to examine the position of any security the firm's research department was recommending,in the often vain hope the recommendation and the chart were in synch.\nI found the bar charts most commonly in use had a limited perspective, usually only about a year of pricedata. Soon I was taking an additional charting service that used weekly bar charts—including a relativestrength line as well.\nMy quest for perspective ended when I was introduced to the Point and Figure chart. I think it is anextraordinarily flexible and useful complement to bar charts because of the perspective it can supply.Analysts like Richard Wyckoff used both bar charts and Point and Figure charts in tandem because of theirdifferent features and strengths.\nPoint and Figure charts are now fairly rare, which is unfortunate. Novices often do not understand whatthey are looking at or how a Point and Figure chart is constructed.\nI've included a simple example chart below (Figure C.12).\nThis chart is an example of a traditionally scaled 3-box reversal Point and Figure chart. The chart stylewas popularized by Abe Cohen of Chartcraft. The price scale is on the left. (You can see that price boxesbelow $20 are smaller than price boxes from $21 to $100. This is a clever, pre-computer attempt to adjustto a more logarithmic scale.) Columns of Xs denote rising prices and columns of Os indicate fallingprices. The small numbers embedded in the chart indicate the month a security first printed that price. (1-9for January through September, and A-C for October through December—another elegant early solution tofit a time identifier in a single-width box.) The perspective is obvious, as this chart covers well over adecade. However, for a technical analyst used to bar charts, two things stick out. First, there is no timescale; years where a lot happened are wide because many reversals occurred. Years where the stock wasquiet are represented by far fewer columns. Second, it is not immediately obvious how a 3-box reversalchart is constructed; it's simple but requires a short explanation.\nA 3-box reversal chart is designed to filter out any price movements less than 3 boxes, whatever that maybe on the chart. With a 3-box reversal chart, there will never be a column that consists of less than 3 boxes.The general rule will hold—the minimum column depth will be a function of the reversal value used.\nLet's pick up the chart in 2012, as it first reversed upward to $34 in September. There is a simple flowchart logic to plotting a Point and Figure chart.\n1. If you are rising in a column of Xs, first look to see if a new price high was made. If yes, put a newX in the column.\n2. If no new high was made, check to see if a 3-box reversal down occurred. If yes, put in a newcolumn of 3 Os.\n3. If no new price high was made or no reversal down was made, do nothing.\nIt's the “do nothing” that is different because time can pass with no adjustment made to the chart. Thechart is a record of pure price movement.\nBy November 2012, General Mills had printed $35—without ever reversing down 3 boxes or more. InJanuary 2013, the price hit $36. February 2013 was a good month—the\nScaling: Traditional [Reversal: 3]\n(c) StockCharts.com\nxoxix 7OXOX XOXO2\nOXOXOX OSO9OX\n1 SAX AX 7 A\nX2X040C9\nX9 XO XO\nXO\nXO\nXO X xox\n4 xoxoxo XOXO5A2O XO5O XO\n3\n> OX OXOX AXoxox 5XO6OXOX\n3OXO\nI OX\nX COX\n5 7 BOX 4OXOX s xoxox XOX X9XO XOX2XA\n45XOAO3 XO79 O 30\nX\nSOX BA\n70X09\n05\nOX °n4\nO\nJ.\n14 15 IS\n3 7X0\nXOA\n1400 OB 3\n13 50 ~O 13.00 _\n03 04 05 OS 10 11 II 13\nTTTT\n4SXO t XO9\n5 . C1X XOX\n902 3X\n4 OX OX 30\nFigure C.12 Years of data for GIS.\nprice hit $37 and continued to $40. $41 was reached in March, and $42 and $43 in April. May 2013 sawthe first 3-box reversal, from a peak price of $44 to the minimum reversal level of $41.\nKey to the value of Point and Figure charts is their flexibility. Many early practitioners of Point and Figureused single-box reversal charts calculated with intraday data. This style of chart looks more similar to abar chart, but actually captures volatility particularly well because of the use of intraday data. With a barchart, each day might be a single bar, but during a particularly volatile period for the market or for anindividual stock, a single-box reversal chart can put in many, many columns.\nLike a bar chart, price targets with a Point and Figure chart are usually estimated from the width of thebase—and during a particularly volatile period like 1987 or 2008 many, many reversals can occur in asingle day! Alan Shaw, formerly the chief market technician at Smith Barney, believed that intraday,single-box reversal point & figure charts were the premier", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 239}
{"text": "chart can put in many, many columns.\nLike a bar chart, price targets with a Point and Figure chart are usually estimated from the width of thebase—and during a particularly volatile period like 1987 or 2008 many, many reversals can occur in asingle day! Alan Shaw, formerly the chief market technician at Smith Barney, believed that intraday,single-box reversal point & figure charts were the premier way to estimate price moves from a base. As aguide to this type of chart, Alan always recommended Alexander Wheelan's Study Helps in Point andFigure Technique. On more than one occasion, this knowledge allowed Alan to estimate large price moveswhen the base on a bar chart was narrow.\nThe computer age has improved Point and Figure charting immeasurably. The computer has no troublecreating true logarithmic charts. Here is the same chart of General Mills, this time using a 2% box and a 3-box reversal. Also shown is the traditional 45-degree trendline, drawn from prominent highs or lows.(Figure C.13) Percentage charts are, I think, significantly clearer. There is no reason not to use them nowsince they can be so easily generated. (All of the charts here are courtesy of StockCharts.com.) Detail canbe added by shrinking the box size; greater perspective can be achieved with a larger box size.\nIt seems simple but changing the box size or reversal value allows the Point and Figure chart to be adaptedto any time frame, from scalping to swing trading to infinity.\nThe chart below, using a 1% box size with a 3-box reversal shows a clear breakout from a downtrend thatis not visible at the same price on a chart with a larger scale. (Figure C.14)\nMoving averages can also be helpful on Point and Figure charts to help determine trend. The differencewith a Point and Figure chart is that the moving average is a moving average of the center point of acertain number of columns.\nThe chart below simply replaces the 45-degree trendline with a 10-column moving average. (Figure C.15)Trend is critically important, but as my career developed into money management, it became importantalso to measure the power and durability of the trend. The Chartcraft service had, for years, calculated arelative strength ratio (stock price divided by index price), adjusted the decimal points to make itchartable, and then plotted it on a traditional 3-box reversal chart. At Dorsey Wright, we changed theserelative strength charts to percentage charts and gained vast additional perspective.\nThe chart below, of Danaher Corp., is a relative strength chart using a 6% scale with a 3-box reversalvalue. The price of Danaher is divided by the price of an S&P 500 ETF and plotted on a log scale.Suddenly, it becomes apparent—in broad terms—Danaher has been outperforming the market for morethan 15 years. (Figure C.16) The final strength of Point and Figure charts is their objectivity. A skilledpractitioner with a bar chart can be very effective, but one analyst might discern a continuation pattern\nwhere another sees a different pattern in a larger or smaller time frame. Two analysts Scaling: Percentage(Reversal: 3, Box Size:2.0%]\n(c) StockChartscom\n69 87 69 87\n68 50 7 68 50\n6715 X 9 6715\n65 84 XO 65 84\n64 55 xo 64.55\n63 38 xo 63 38\n63 04 6OX 63 04\n60 83 4 xoxo 60 83\n59 63 XOX A 3O X <<60 18\n58 46 xo 50 ox X X 58 46\n57 33 7 0 0X0X0 c 57 32\n56 19 X 4XO6OXX 56 19\n55 09 7 X 5 O OXOX55 09\n54 01 XOXIX O8OX54 01\n52 95 7OXOX OX 52 95\n51 91 XOXO 2 9X 51 91\n50 89 X XOXO OX 50 89\n49 90 1 2XOX 5 49 90\n48 92 Xco 3OX 48 92\n47 96 57 80ox 47 96\n47 03 40X ox 47 03\n46 10 5 xox ox 46 10\n45 19 XOB39X ox 45 19\n44 31 xox CXA 0 44 31\n43 44 X7 oxox 43 44\n43 59 45XOAOX 43 59\n41 75 xox 93 41 75\n40 93 XOX 40 93\n40 13 86 40 13\n39 34 X 39 34\n38 57 X 38 57\n37 82 X 37 82\n3707 7 37 07\n36 35 1 36 35\n35 63 c 35 63\n34 94 34 94\n34 25 1 p 34 25\n33 58 c 77 33 58\n32 92 A OX 33 93\n33 38 XXOX 33 38\n31 64 56 907 31 64\n31 03 Xox6 31 03\n30 41 X 4ox 30.41\n39 83 604X xox 39 83\n39 33 5098Xox8X 39 33\n38 66 30X01030 28 66\n28 10 1OX0 0 28 10\n27.55 X7X 27 55\n2701 cox 2701\n26 48 9 8 26 48\n25 96XX X 25 96\n25 45X8XO A 25 45\n24 95 ’xox ox X 24 95\n24 46 OXOXOXOX\\X 24 46\n23 98 OXOoxoxo X 23 98\n23 51 OOXOXO9 23 51\n23 05 ' 0 cox X 23 05\n23.60 OX3 ‘22 60\n33 15 /01 OX ‘22 15\n31 73 0 0 7 ‘21 72\n31 39 0 X 21 29\n30 88 0 6 ‘20 88\n20 47 oxX 20 47\n20 07 ~ OXO5 ‘20 07\n19 67 ~ 3X04 19 67\n19 39 OX OX 19 29\n18 91 ~ OOX 18 91\n18 54 OX 18 54\n1817 \" ox/ 18 17\n17 82 ’ 0/ 17 82\n1747 ‘ 17 47\n09 10 11 12 13 14 IS It 17\nFigure C.13 An alternative view of General Mills.\n70 15\n69 45\n68.77\n68 09\nScaling: Percentage [Reversal: 3, Box Sized.0%) (c) StockCharts com\nXOXO CX OX OX\nO OXOXO OXOXO 7X0X0 O 0 90\nOX OXO\nXX OX ox ox\nO9OXOXOXOX3 \\ 0 o/o 0 oxox \\ / oxoxox \\\n/ O OXOXO \\\n/ 4X0X0 X \\\noxoxox xo \\ 5XOXOXO 8OX OXO6OXOXOXO\nOXO2 X 0 ox ox\nOX OX/ 0X0/ ox/ 0/ /\n/\nxoxox\nX 2 XO! O\nX \\\n7 8X\\ XOX 9 XOXO XO O X X X X X X X XXX\nX\nXOX XOX\nxo\nOX X X X / OXAXOX9X / oxoxoxox / oxo o ox/ 0 o/\n4 OX OX XOXO6 XOXO X XOX XOXO5 XOXO 30\n70 15\n69 45\n68 77\n68 09\n6741\n66.74\n66 08\n65 43\n64 78\n64.14\n63 50\n62 88\n62 25\n61 64\n61 03\n60 42\n<<60 18\n59 23\n58 65\n58 06\n5749\n56 92\n56 36\n55 80\n55 25\n54 70\n5416\n53 62\n53 09\n52 57\n52 04\n51 53\n51 02\n50 51\n50 01\n'49 52\n16\n17\nFigure C.14 Clarifying the issue with percentage boxes.\nlooking at the same Point and Figure chart, on the other hand, will always be in agreement about whether thechart is on a buy signal or a sell signal.\nThe criterion is incredibly simple and unambiguous. If the price exceeds the immediately previous column ofXs, it is on a buy signal. If the price declines below the immediately previous column of Os, it is on a sellsignal. On the Danaher relative strength chart, for example, there is a buy signal at 10.88 in October 2000. (Itexceeded the previous rising column, which topped out at 10.27.) There is no subsequent sell signal, as nocolumn of Os ever falls below the previous column of Os. A security, by definition, is always on either a buyor sell signal.\nThe objective nature of Point and Figure can be use", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 240}
{"text": "a sellsignal. On the Danaher relative strength chart, for example, there is a buy signal at 10.88 in October 2000. (Itexceeded the previous rising column, which topped out at 10.27.) There is no subsequent sell signal, as nocolumn of Os ever falls below the previous column of Os. A security, by definition, is always on either a buyor sell signal.\nThe objective nature of Point and Figure can be useful in other realms as well. Market indicators or diffusionindexes can be plotted on a Point and Figure chart and objectively graded as a buy or sell, for example.\nPerspective, flexibility, and objectivity, then, are the cardinal virtues of the Point and Figure charting method.They give a perspective, unlike a bar chart, abstracting pure price and giving deep insight into volatility. Theyhave almost unlimited flexibility to be\nScaling: Percentage [Reversal: 3, Box Size:1.0%)\n(c) StockChartscom\n70 15 ~r 70.15\n69 45 X 69 45\n68 77 76X 68 77\n68 09 xox 68 09\n67.41 xoxo 67.41\n66 74 xo 2 66.74\n66 08 X 2 66.08\n65 43 X 2 65 43\n64 78 X 2 64.78\n64 14 X 2 64.14\n63 50 X 2 63.50\n62 88 X 2 62 88\n62 25 X 2 62 25\n61 64 XXX X 61 64\n61 03 xox ox 2X0 xo11 61 03\n60 42 4 ox ox4XOX xoxc I X 60 42\n59 82 xoxo6 OXOX ex ox X <<6018\n59 23 xoxoJ 2 BOX OX OX OX? X 59 23\n58 65 x xoX 2 00 0 7XOX X 58 65\n58 06 XOXO5 7XOXOX XX 58 06\n5749 xoxo O 0X0X0 cox 5749\n56 92 30 4X0X0 xox 56 92\n56 36 X oxoxox xox 56 36\n55 80 X _L_ 5XOXOXOS xo 55 80\n55 25CX X X “T OXO 6OXOXOX X 55 25\n54 70 9xoxoX1 X 0 000X0X0 X 54 70\n5416 OX OX OXO/ 0X0X0 XX 54 16\n53 62OXO 7xoxo xox 53 62\n53 09 OX0 ox ox 0 090 xox 53 09\n52 57 0 ox ox 00 xo 52 57\n52 04 ' oxo oxX X 52 04\n5! 53 ox OXAXOXBX 51 53\n51 02 0 oxoxoxox 51 02\n50 51 0X00 ox 50 51\n50 01 0 0 50 01\n49 52 - 49 52\nFigure C.15 Overlaying the PnF with a moving average.\nadapted to different scales, time frames, and purposes. Finally, their objectivity can become a powerful tool inthe hands of any analyst.\nFor further investigation, some of the best-known resources are: Alexander Wheelan, Study Helps in Point &Figure Technique A.W. Cohen, How to Use the Three-Point Reversal Method of Point & Figure Stock MarketTrading: A Technical Approach to Stock Market Trading Thomas J. Dorsey, Point and Figure Charting: TheEssential Application for Forecasting and Tracking Market Prices Jeremy du Plessis, twenty-first CenturyPoint and Figure: New and Advanced Techniques for Using Point and Figure Charts Bollinger Bands\nThe creation of John Bollinger, Bollinger Bands is an inventive solution to the question of measuring anddisplaying price volatility. Technicians had previously developed channels DHR:SPY DsnjhefCo<p7SWS6P'OOETF NYSE\n27-Oec-ai 7.16 00 El. <W 0 34 8S3. K 3$ 067. L 34 71$. C: 34 J39. Chg; .0 On (021%)\nSeeing Peicertege (Reretul 3. Box See 6 0%)\n(<) JtocKhertixom\nFigure C.16 Relative strength perspective.\nand envelopes which have proved productive for some. Bollinger made the concept dynamic, developing achannel whose lines (or bands) are variable depending on volatility.\nBollinger Bands are printed as three lines. The middle line (or band) is a conventional moving average. Theupper band is equivalent to the middle band but shifted two standard deviations up. The lower band is similarbut shifted two standard deviations down. As volatility varies the bands narrow and widen and technicianslook to the position of price\nM|1»U (hit) 25803.19 -seeo2J)2e»24-M»w-aKia jINDU to* ndtstul Avenge INOX 12J»2018\nOltockChartscon\nOpen 255331 Low 2t»K X Close 2S803 /6 Volume 3770M dig *22S.4 (•««*)«\n21250\n22250\n22000\n21750\n21500\n21000\n20750\n20500\n20260\n20000\n10’50\n25260\n2050\n2300\n6^8291\n2400\n23’50\n23500\n23260\n23000\n22750\n22500\nFigure C.17 The dynamic nature of the bands dramatizes the nature of volatility and can be a great aid intrading—usually over the short term. Bollinger recommends 20 periods for the moving average.\nrelative to the lines to orient their trading. Thus, the bands are useful in lending perspective as prices oscillate.The routine is quite popular and this mention is meant only as an introduction and should inspire theinterested student to take up Bollinger's publications to explore this interesting and valuable tool. Bollinger onBollinger Bands may be found at Amazon. (Figure C.17)\nTaylor & Francis\nTaylor & Francis Group\nhttp://taylorandfrancis.com\nList of Illustrations and Text\nDiagrams\nRegarding the illustrations in this book, except for those which are marked\nas adapted from other sources, the charts listed as Figures below have been\nreproduced from the authors' own “working” charts. As such, they were\nmade up originally for private use only and without a thought to their\neventual reproduction, much less their publication. They are not and do not\npretend to be works of art, but it is hoped that they will, despite their\n“homemade” appearance, serve the purpose of illustrating the various\nformations, patterns, market phenomena, and trading principles discussed in\nthe text. That they do not show the clean line and expert lettering of a\nprofessional draftsman's work is regretted. The reader will, we trust, make\nallowances.\nAs for their selection, it should be stated most emphatically that it was not\nnecessary to search through thousands of charts in order to find good\nexamples of all these various technical formations. Many dozens, even\nhundreds, were available for practically every type of pattern. Anyone who\nhas learned to recognize them can find for himself plenty of good technical\npictures in a quick examination of even as small a portfolio as 50 or 100\ncharts. In other words, the illustrations in this book are in no sense unique.\nIn selecting them, we have tried only to show as much variety as possible\nand samples from previous as well as more recent market history.\nPerhaps it is not necessary, but it is at least in accord with custom, to add\nthat the information as to specific market prices, volume of transactions,\netc., used in preparing our illustrations (or cited in the text of this book) has\nbeen derive", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 241}
{"text": "sense unique.\nIn selecting them, we have tried only to show as much variety as possible\nand samples from previous as well as more recent market history.\nPerhaps it is not necessary, but it is at least in accord with custom, to add\nthat the information as to specific market prices, volume of transactions,\netc., used in preparing our illustrations (or cited in the text of this book) has\nbeen derived from sources believed to be reliable, but is not guaranteed.\nPart One\nFigure Page\n1945.\nShoulders Bottom in 1942. Weekly chart.\n8.19 BATH IRON WORKS. Descending Triangle Top of 1946,\nshowing adjustment of 90 pattern lines for Ex-Dividend Gap.\nwith horizontal bottom line.\nfrom apex of Triangle, and Double Top. 1946.\nleverage junior utility stock. Monthly chart, 1938 to 1946.\nand futures to control portfolio risk.\nPart Two\nFigure Page\nsensitivity.\n24.2 CUBAN-AMERICAN SUGAR. Weekly, 1945 to 1946. Habits of\nlow-priced stock 343 of fairly low sensitivity.\n24.2 ELECTRIC BOAT. Weekly, 1945 to 1946. Habits of low-priced\nstock of somewhat 343\nhigher sensitivity.\nAscending Triangle and Head-and-Shoulders Top.\nDaily chart.\n37.20 AVNET ELECTRONICS CORPORATION. May through\nOctober 1961, showing 448\nBearish Trend during a time when the market Averages were strong. Daily\nchart.\n37.21 BURNDY CORPORATION. April to September 1961. Classic\nHead-and- 449\nShoulders Top and rallies to neckline. Daily chart.\n37.22 BRUNSWICK CORPORATION. Showing the end of the great\nBull Market Move 450\nin this stock, and the decline which followed. 1960 to 1962. Weekly chart.\n37.23POLAROID. First 6 months of 1962. Long Rectangle followed\nby a precipitous drop after penetration of Support. Daily chart.451\n37.24COPPER RANGE. First 6 months of 1962. Head-and-\nShoulders Top with down-sloping neckline. Daily chart.452\n37.25\nU.S. SMELTING, REFINING & MINING. April through\nSeptember, 1962. Head-and-Shoulders Bottom, breakout,\nreaction, and advance. Daily chart.\n453\n37.26\nThe DOW-JONES INDUSTRIAL AVERAGE. Weekly, July\n1961 through June 1962. The massive Head-and-Shoulders\nPattern preceding the 1962 break.\n454\n37.27ABC VENDING CORPORATION. Daily, April to September\n1963. Head-and-Shoulders Top and Major Downtrend. 455\n37.28\nCERRO CORPORATION. Daily, January to June 1963.\nSymmetrical Triangle and uptrend, showing reaction to “cradle\npoint.”\n456\n37.29CRUCIBLE STEEL. Daily, March to August 1963. Ascending\nTriangle, showing Breakaway Gap. 457\n37.30\nSUPERIOR OIL. June to November 1962. Showing an\nimportant Double Bottom, which became the base for a Major\nAdvance.\n458\n37.31GENERAL STEEL INDUSTRIES. Daily, November 1962 to\nApril 1963. Example of a Major Uptrend with normal reactions.459\n37.32\nUNITED ARTISTS. Daily, February to August 1963. A Major\nDowntrend, demonstrating Resistance Levels during the\ndecline.\n460\n37.33\nUTAH-IDAHO SUGAR COMPANY. January to June 1963.\nBreakout and rapid advance appearing suddenly in a normally\ndull stock.\n461\n37.34\nCONTROL DATA CORPORATION. Daily, February to August\n1965. Example of a Wedge with downside breakout and Major\nCollapse.\n462\n37.35\nU.S. SMELTING, REFINING & MINING. Daily, July to\nDecember 1965. Breakout from dormancy, Major Advance,\nshowing Symmetrical Triangle Consolidation.\n463\n37.36\nLIVINGSTON OIL COMPANY. Weekly, January 1965 into\nJanuary 1966. Downside Major Trend, Symmetrical Triangle\nBottom, Major Reversal to uptrend.\n464\n37.37\nPACKARD-BELL ELECTRONICS. Daily, August 1965 to\nJanuary 1966. Flag showing “Half-Mast” situation, and a large\nAscending Triangle with powerful breakout move on the\nupside.\n465\n37.38\nPARKE, DAVIS & COMPANY. Daily, July 1969 to June 1970.\nThis could be regarded as a very flat Head-and-Shoulders Top,\nor as a long Rounding Top.\n466\n37.39ASTRODATA, INC. Daily, October 1969 through February\n1970. A complete collapse; then reopens 20 points lower. 467\n37.40\nORACLE. Lest one think that the air pocket gap does not still\nexist, here is an example from the turn of the century (third\nmillennium).\n468\n37.41PUBLIC SERVICE ELECTRIC & GAS. Monthly, 1969\nthrough 1970. A typical electric and gas utility stock.469\n37.42\nMEMOREX CORPORATION. Daily, September 1969 through\nMay 1970. Last “Bull” fling for Memorex before gapping down\nwith volume in February 1970.\n470\n37.43FLYING TIGER CORPORATION. Monthly, October, 1969\nthrough 1971. From the 1967 high of 48%, \"FLY\" started a\n471\ndowntrend that lasted 2 years and took the stock down to 11%.\n37.44\nACTION INDUSTRIES. Daily, November 1971 to April 1972.\nA large Ascending Triangle formed after an advance of 90%,\nand followed by a breakout and a further advance practically\nduplicating the first one in percentage gain.\n472\nFigure Page\n37.45DELL COMPUTER. From nothing (a college dorm) to\nsomething. 473\n37.46DELL. Air pockets return. 474\n37.47INTEL. The heart of the Microsoft computer. Compare MSFT. 474\n37.48NOKIA. The story of the communications revolution.475\n37.49AMD. Intel's counterpart. 475\n37.50YAHOO. Internet rocket fuel. 476\n37.51YAHOO 2005. After the tulipomania. 477\n37.52APPLE COMPUTER. The revenge of Steve Jobs. 478\n37.53APPLE 2005. The press' whipping stock strikes back.479\n37.54NDX. A ten year trade using Basing Points. 480\nA.1 Important swings of the DOW-JONES INDUSTRIAL AND\nRAIL AVERAGES, 1941 through 1946. 508\nA.2\nThe DOW-JONES INDUSTRIAL AND RAIL AVERAGES.\nDaily closing prices and total market volume, February 1 to\nAugust 31, 1941.\n509\nA.3\nThe DOW-JONES INDUSTRIAL AND RAIL AVERAGES.\nDaily closing prices and total market volume, March 2 to\nOctober 31, 1942.\n510\nA.4\nThe DOW-JONES INDUSTRIAL AND RAIL AVERAGES.\nDaily closing prices and total market volume, November 2,\n1942, to June 30, 1943.\n511\nA.5\nThe DOW-JONES INDUSTRIAL AND RAIL AVERAGES.\nDaily closing prices and total market volume, July 1, 1943, to\nJanuary 31, 1944.\n512\nA.6\nThe DOW-JONES INDUSTRIAL AND RAIL AVERAGES.\nDaily closing prices and total market volume, May 1 to\nNovember 30, 1945.\n514\nA.7\nThe DOW-JONES INDUSTRIAL AND RAIL AVERAGES.\nDaily closing prices and total market volume, Ma", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 242}
{"text": "ume, November 2,\n1942, to June 30, 1943.\n511\nA.5\nThe DOW-JONES INDUSTRIAL AND RAIL AVERAGES.\nDaily closing prices and total market volume, July 1, 1943, to\nJanuary 31, 1944.\n512\nA.6\nThe DOW-JONES INDUSTRIAL AND RAIL AVERAGES.\nDaily closing prices and total market volume, May 1 to\nNovember 30, 1945.\n514\nA.7\nThe DOW-JONES INDUSTRIAL AND RAIL AVERAGES.\nDaily closing prices and total market volume, May 1, 1945, to\nNovember 30, 1945.\n516\nA.8\nThe DOW-JONES INDUSTRIAL AND RAIL AVERAGES.\nDaily closing prices and total market volume, December 1,\n1945, to May 31, 1946.\n518\nA.9\nThe DOW-JONES INDUSTRIAL AND RAIL AVERAGES.\nDaily closing prices and total market volume, May 4 to\nOctober 19, 1946.\n520\nText Diagrams\nThe charts listed as Figures all represent actual market history. In\ncontradistinction, the diagrams listed below do not depict real trading\nhistory, but have been specially drawn as simplified, hypothetical market\nsituations to facilitate the explanation of certain trading principles. EN:\nCertain of these rather than drawings are exhibits of other interest.\nDiagram Page\nAlphabetic Index of Stock Charts\nFigureStock Name Summary Description of ChartPage\n23.7 3COM.\nUnderwriters cleverly only threw 3% of\n3Com-owned Palm stock onto the\nmarket at the IPO.\n331\n12.9 A.O. SMITH\nCORPORATION.\nA technically significant (Runaway)\nGap in 1946 decline. Weekly chart.\n180\n37.27ABC VENDING\nCORPORATION.\nDaily, April to September 1963. Head-\nand-Shoulders Top and Major\nDowntrend.\n455\n37.44ACTION\nINDUSTRIES.\nDaily, November 1971 to April 1972. A\nlarge Ascending Triangle formed after\nan advance of 90%, and followed by a\nbreakout and a further advance\npractically duplicating the first one in\npercentage gain.\n472\n10.2 AIR REDUCTION.The classic Broadening Top of 1929. 123\n10.8 ALLIED STORES.Flat-topped Broadening Pattern of 1945,\nand Breakout Gaps. 126\n33.5 ALLIED STORES.\nDaily, last half of 1946. Symmetrical\nTriangle Consolidation in decline; also\nsmall Head-and-Shoulders Continuation\nPattern.\n398\n11.11 ALTRIA GROUP\n(MO).\n2005 gaps and flags galore. Chartist's\njoy. 162\n23.11 AMAZON.\nWeekly. Internet dreams of glory.\nDocumenting the great Internet bubble.\nBlow-off and hangover.\n335\n23.12AMAZON. Daily. Details of the blow-off with some\ntechniques to profit and not suffer. 335\n23.13AMAZON. 2005. Rolls on. Biggest river in world.\nNot of profits. 336\n37.49AMD. Intel's counterpart. 475\n7.12\nAMDAHL\nCORPORATION.\nComplex Head-and-Shoulders Bottom,\n1984. 65\n11.14\nAMERICAN &\nFOREIGN\nPOWER 2D PFD.\nA Head-and-Shoulders Consolidation\nPattern of 1945. 164\n7.16\nAMERICAN &\nFOREIGN\nPOWER 2ND\nPFD.\nA Rounding Bottom formed in 1945.68\n9.14 AMERICAN\nAIRLINES.\nWeekly Chart. Bull Market Top of 1945\nto 1946, a form of Double Top. 113\nStock Name\nAMERICAN BANK NOTE.\nAMERICAN BOSCH CORPORATION.\nAMERICAN CABLE & RADIO.\nAMERICAN CAN.\nAMERICAN CAR &\nFOUNDRY.\nAMERICAN\nLOCOMOTIVE.\nAMERICAN\nLOCOMOTIVE.\nAMERICAN\nLOCOMOTIVE.\nAMERICAN ROLLING MILL.\nAMERICAN ROLLING MILL.\nAMERICAN SAFETY RAZOR.\nAMERICAN STEEL FOUNDRIES.\nAMERICAN WATER WORKS & ELECTRIC.\nAMERICAN WOOLEN.\nAMERICAN ZINC, LEAD & SMELTING.\nANACONDA COPPER.\nANACONDA COPPER.\nAPPLE.\nAPPLE.\nAPPLE.\nAPPLIED MAGNETIC CORPORATION.\nARCHER DANIELS MIDLAND COMPANY.\nARKANSAS BEST. ARMOUR & COMPANY.\nSummary Description of Chart Page\nRunaway Gap and Flag. 1945.\nPerfect “Half-Mast” Pattern in 1946, with gaps 161 and Ascending\nTriangle.\nThe Consolidation Rectangle which followed a 108 Head-and-Shoulders\nTop in 1946.\nwhich distribution eventually overcame upward trend.\nFigureStock Name Summary Description of ChartPage\n33.3 ASSOCIATED DRY\nGOODS.\nDaily, first half of 1946.\nRounding Top; also Broadening\nConsolidation.\n396\n33.10ASSOCIATED DRY\nGOODS.\nDaily, first half of 1945. Right-\nAngled Broadening Formation\nand ensuing advance.\n403\n10.6 ASSOCIATED\nDRYGOODS.\nRight-Angled Broadening\nFormation with horizontal Top,\n1945.\n125\n37.39ASTRODATA, INC.\nDaily, October 1969 through\nFebruary 1970. A complete\ncollapse; then reopens 20 points\nlower.\n467\n14.2 ATCHISON, TOPEKA &\nSANTA FE.\nAcceleration of Intermediate\nUptrend in 1936. Support Levels.209\n14.1 ATLANTIC REFINING.Basic Intermediate Trendlines on\nweekly chart, 1944 to 1947.208\n37.20AVNET ELECTRONICS\nCORPORATION.\nMay through October 1961,\nshowing Bearish Trend during a\ntime when the market Averages\nwere strong. Daily chart.\n448\n14.17BACYRUS ERIE. 1984Excellent Fan Pattern. 220\n12.10BALTIMORE & OHIO\nPFD.\nSmall Island in right shoulder of\nMajor Head-and-Shoulders Top.\n1946.\n180\n12.6 BALTIMORE & OHIO.The measuring formula applied to\na Runaway Gap in early 1937.177\n22.1 BALTIMORE & OHIO.\nWeekly, first 6 months of 1945,\nshowing tendency of a low-priced\nstock to make wide swings in a\ngeneral market move.\n320\n14.15BARBER ASPHALT. Application of three-fan principle\nto Bull Market Reaction. 1946.219\n28.1 BASING POINTS. The most important chart in the\nbook? 362\n28.2 BASING POINTS, V2\nBasing Points illustrations\nshowing both 366\n28.3 BASING POINTS, V2\nwavelow stops and new high\nstops 369\n28.4 BASING POINTS, V2 370\n8.19 BATH IRON WORKS.\nDescending Triangle Top of 1946,\nshowing adjustment of pattern\nlines for Ex-Dividend Gap.\n90\n9.9 BELL AIRCRAFT.\nEx-dividend drop causing\napparent false move out of\nRectangle in 1945.\n109\n13.2 BENDIX AVIATION.\nSupport-Resistance Levels in an\nIntermediate Uptrend. 1944 to\n1945.\n194\n12.12BETHLEHEM STEEL.Unusual Island Reversal at the\n1937 Bull Top. 182\n14.7 BETHLEHEM STEEL.Trend Channels and Rectangle.\n1945. 213\n12.2 BETHLEHEM STEEL.Three types of Breakaway Gap.\n1937. 173\n12.5 BLAW-KNOX. Gaps following long Rectangle in\nearly 1946, and Major Double\n176\nTop.\n33.2 BRANIFF AIRWAYS.\nDaily, last half of 1945. Head-\nand- Shoulders Bottom, reactions,\nAscending Triangle\nConsolidation and advancing\ntrend.\n395\n8.14 BRIGGS\nMANUFACTURING.\nWeekly chart of 1941 to 1943\nshowing Triangular Bottom of\nascending type.\n86\nFigureStock Name\nSummary Description of\nChart Page\n11.5 BRIGGS\nMANUFACTURING.\nBull and Bear Flags and\nSymmetrical Triangle\nTop in 1936. Support-\nResi", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 243}
{"text": "33.2 BRANIFF AIRWAYS.\nDaily, last half of 1945. Head-\nand- Shoulders Bottom, reactions,\nAscending Triangle\nConsolidation and advancing\ntrend.\n395\n8.14 BRIGGS\nMANUFACTURING.\nWeekly chart of 1941 to 1943\nshowing Triangular Bottom of\nascending type.\n86\nFigureStock Name\nSummary Description of\nChart Page\n11.5 BRIGGS\nMANUFACTURING.\nBull and Bear Flags and\nSymmetrical Triangle\nTop in 1936. Support-\nResistance phenomena.\n156\n37.22BRUNSWICK\nCORPORATION.\nShowing the end of the great\nBull Market Move in this\nstock, and the decline which\nfollowed. 1960 to 1962.\nWeekly chart.\n450\n7.18 BUDD COMPANY. Monthly chart showing Major\nRounding Bottom of 1942.70\n7.7 BUDD\nMANUFACTURING\n(now The Budd Company).\nMultiple Head-and-Shoulders\nTop of 1946.\n62\n37.21\nBURNDY\nCORPORATION.\nApril to September 1961.\nClassic Head-and-Shoulders\nTop and rallies to neckline.\nDaily chart.\n449\n17.3\nCBOT DOW INDEX\nFUTURES AND\nDIAMONDS.\nHedging DIAMONDS with\nindex futures illustrated.278\n17.4\nCBOT DOW INDEX\nFUTURES AND OPTIONS\nON FUTURES.\nUsing options and futures to\ncontrol portfolio risk. 282\n8.13\nCELANESE\nCORPORATION.\nAscending Triangle of\nconsolidation type in 1946.85\n15.11 CELOTEX.\nAccelerating uptrend of a low-\npriced building supply stock.\nMonthly chart, 1938 to 1946.\n235\n37.28\nCERRO\nCORPORATION.\nDaily, January to June 1963.\nSymmetrical Triangle and\nuptrend, showing reaction to\n“cradle point.”\n456\n33.7 CERTAINTEED\nPRODUCTS.\nDaily, 6 months in 1946.\nBroadening Top, showing rally\nfollowing the breakout, and\nsubsequent decline.\n400\n7.19 CERTAINTEED\nPRODUCTS.\nMonthly chart. Major\nRounding Bottom of 1942.70\n37.17CHICAGO, MILWAUKEE,\nST. PAUL & PACIFIC.\nThe magnificent uptrend of\n1954 to 1955 with numerous\nSupport-Resistance and Area\nPattern features.\n440\n6.2 CHICAGO, MILWAUKEE,\nST. PAUL & PACIFIC.\nThe Head- and-Shoulders Top\nFormation which ended its\nBull Market in February 1946.\n46\n37.9 CHRYSLER.\nMonthly, 1927 to 1930.\nShowing Major Top in 1928\nand the collapse during the\nearly months of 1929.\n436\n23.14CISCO. Exercises in adroit\nspeculation. 337\n23.15CISCO. Zooming in on Cisco. 338\n15.12CLAUDE NEON. (Curb Exchange). Strongly up-\ncurved Bull Trend of a low-\n235\npriced, highly speculative\nissue. Monthly chart, 1938 to\n1946.\n16.12COFFEE 1994 A perfect flag and spike\nreversal. 256\n14.4 COMMERCIAL\nIntermediate Downtrend and\nUptrend in 1946. 211\nSOLVENTS.\nFigureStock Name Summary Description of ChartPage\n11.16\nCOMMONWEALTH\nEDISON.\nScalloping trend of an investment\nstock, 1945. 165\n15.5 COMMONWEALTH\nEDISON.\nStraight-line Bull Trend of\ninvestment type utility. Monthly\nchart, 1938 to 1946.\n232\n6.7\nCONSOLIDATED\nEDISON.\nThe Head-and-Shoulders Reversal\nof 1937. 50\n14.11\nCONSOLIDATED\nVULTEE.\nPart of a two-year Uptrend\nChannel. 1945. 215\n9.15\nCONTAINER\nCORPORATION.\nThe Major Double Bottom of 1941\nto 1943. Weekly chart. 114\n33.6\nCONTINENTAL\nMOTORS.\nDaily, last half of 1945. Ascending\nTriangle showing Pullback to\nSupport Level; also Symmetrical\nTriangle with reaction to apex.\n399\n37.34CONTROL DATA\nCORPORATION.\nDaily, February to August 1965.\nExample of a Wedge with\ndownside breakout and Major\nCollapse.\n462\n37.24COPPER RANGE.\nFirst 6 months of 1962. Head-and-\nShoulders Top with down-sloping\nneckline. Daily chart.\n452\n24.1\nCORN PRODUCTS\nREFINING COMPANY.\nWeekly, 1945 to 1946. Habits of a\nstock of low sensitivity. 342\n15.14CORN PRODUCTS\nREFINING COMPANY.\nTypical Major Uptrend of food\ngroup. Monthly chart, 1938 to\n1946.\n236\n16.2 COTTON FUTURES.Familiar technical action in a\nfutures chart (5th ed.). 247\n10.1 CRANE COMPANY.\ned.).\nBroadening Formation of 1945 to\n1946, a warning of final top.\n122\n14.3 CRANE COMPANY.\nShort-term trendlines in 1945, and\nexamples of channel “failure” and\nPullback.\n210\n7.24 CRAY RESEARCH.1987. Gap and Rounding Top. 74\n16.9 CRB INDEX 2005.A futures triangle with breakout.254\n16.10CRB INDEX 2005.The long term view, with double\nbottom. 255\n37.29CRUCIBLE STEEL.\nDaily, March to August 1963.\nAscending Triangle, showing\nBreakaway Gap.\n457\n8.5 CUBAN-AMERICAN\nSUGAR.\nA Rounding Bottom in 1945 which\nmerged into a Symmetrical\nTriangle.\n81\n24.2 CUBAN-AMERICAN\nSUGAR.\nWeekly, 1945 to 1946. Habits of\nlow-priced stock of fairly low\nsensitivity.\n343\n18.1 CUDAHY PACKING.Head-and-Shoulders Reversal at\nthe Major Top in 1928. 294\n15.3 CURTIS PUBLISHING\n$7 PFD.\nTypical decurving Bull Trend of\npreferred stocks. Monthly chart,\n1938 to 1946.\n231\n15.4 CURTIS PUBLISHING\nCOMMON.\nAccelerating Bull Trend of low-\npriced, speculative common stocks.\nMonthly chart, 1938 to 1946.\n231\n8.4\nDELAWARE &\nHUDSON.\nWeekly chart. Wide-swinging\nSymmetrical Triangle Bottom of\n1941 to 1942 with Throwback to\napex Support.\n80\nFigureStock Name Summary Description of ChartPage\n14.16DELAWARE &\nHUDSON.\nApplication of three-fan\nprinciple to Bull Market\nReaction. 1944.\n219\n37.5\nDELAWARE,\nLACKAWANNA &\nWESTERN.\nRectangle and uptrend. 1954 to\n1955. 432\n37.45DELL. From nothing (a college dorm) to\nsomething. 473\n37.46DELL. A weekly look. 474\n7.9 DIGITAL EQUIPMENT\nCORPORATION.\n1985. From a Head- and-\nShoulders Top to Complex Head-\nand-Shoulders Bottom.\n63\n7.2 DOME MINES.\nWeekly chart showing the Major\nHead-and-Shoulders Bottom of\n1942.\n59\n10.21\nDOW-JONES\nINDUSTRIAL\nAVERAGE.\n1987 Reagan Crash. 137\nA.1\nDOW-JONES\nINDUSTRIAL AND\nRAIL AVERAGES.\nImportant swings of the 1941\nthrough 1946. 508\nA.3\nDOW-JONES\nINDUSTRIAL AND\nRAIL AVERAGES.\nDaily closing prices and total\nmarket volume, March 2 to\nOctober 31, 1942.\n510\nFM.1\nDOW-JONES\nINDUSTRIAL AND\nRAIL AVERAGES OW\nThe historic bull market of 2009-\n2018. v\nA.4\nDOW-JONES\nINDUSTRIAL AND\nRAIL AVERAGES.\nDaily closing prices and total\nmarket volume, November 2,\n1942, to June 30, 1943.\n511\nA.8\nDOW-JONES\nINDUSTRIAL AND\nRAIL AVERAGES.\nDaily closing prices and total\nmarket volume, December 1,\n1945 to May 31, 1946.\n518\nA.2\nDOW-JONES\nINDUSTRIAL AND\nRAIL AVERAGES.\nDaily closing prices and total\nmarket volume, February 1 to\nAugust 31, 1941.\n509\nA.5\nDOW-JONES\nINDUSTRIAL AND\nRAIL AVERAGES.\nDaily closing prices and total\nmarket volume, July 1, 1943, to\nJanuary 31,", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 244}
{"text": "1942, to June 30, 1943.\n511\nA.8\nDOW-JONES\nINDUSTRIAL AND\nRAIL AVERAGES.\nDaily closing prices and total\nmarket volume, December 1,\n1945 to May 31, 1946.\n518\nA.2\nDOW-JONES\nINDUSTRIAL AND\nRAIL AVERAGES.\nDaily closing prices and total\nmarket volume, February 1 to\nAugust 31, 1941.\n509\nA.5\nDOW-JONES\nINDUSTRIAL AND\nRAIL AVERAGES.\nDaily closing prices and total\nmarket volume, July 1, 1943, to\nJanuary 31, 1944.\n512\nA.6\nDOW-JONES\nINDUSTRIAL AND\nRAIL AVERAGES.\nDaily closing prices and total\nmarket volume, May 1 to\nNovember 30, 1945.\n514\nA.7\nDOW-JONES\nINDUSTRIAL AND\nRAIL AVERAGES.\nDaily closing prices and total\nmarket volume, May 1 to\nNovember 30, 1945.\n516\n6.12\nDOW-JONES\nINDUSTRIAL\nAVERAGE\n2007-2008 top with large head-\nand-shoulders 54\nFigure Stock Name\n5.2 DOW-JONES\nINDUSTRIAL AVERAGE.\n5.3 DOW-JONES\nINDUSTRIAL AVERAGE.\n5.1 DOW-JONES\nINDUSTRIAL AVERAGE.\n7.5 DOW-JONES\nINDUSTRIAL AVERAGE.\n10.12 DOW-JONES\nINDUSTRIAL AVERAGE.\n15.16 DOW-JONES\nINDUSTRIAL AVERAGE.\nSummary Description of Chart Page marked with Dow Theory signals\nand Magee 39 Procedure signals from 1924-34\nmarked with Dow Theory signals and Magee 40 Procedure signals from\n1900-2011\nthe unique straight downtrend developed by the 1929 to 1932 Bear Market.\n15.19-20- DOW-JONES\n21 INDUSTRIAL\nAVERAGE.\n36.1 DOW-JONES\nINDUSTRIAL AVERAGE.\n37.16 DOW-JONES\nINDUSTRIAL AVERAGE.\n37.17 DOW-JONES\nINDUSTRIAL AVERAGE.\n37.26 DOW-JONES\nINDUSTRIAL AVERAGE.\n6.6 DUPONT.\nThree Bull Market tops.\n150day moving average. Editor's choice.\n37.9 EAGLE-PICHER LEAD.\n8.9 EASTERN AIRLINES.\n9.6 EASTERN AIRLINES.\n8.25 EBAY.\n10.25 EBAY.\nDaily chart showing the Broadening Top established in May to August\n1957.\nDaily chart showing the Broadening Top established in 1999-2000.\nWeekly, July 1961 through June 1962. The massive Head-and-Shoulders\nPattern preceding the 1962 break.\nIts Major Top in 1936, with an unusual Pullback.\nMonthly, 1927 to 1930. Generally Bearish Major Trend.\nA Symmetrical Triangle in 1947 that did not carry through.\nLong Consolidation ending in Rectangle in early 1945.\n2004 Descending Triangle Surprise.\nAs Ebay broke its trendline and drifted sideways it became a good subject\nfor reversal day trading.\n240\n424\n444\n445\n454\n50\n436\n83\n107\n96\n140\nFigureStock Name Summary Description of ChartPage\n10.26EBAY. 2004-5 Astonishing Ebay breaks\naway on wings of great business.141\n24.2 ELECTRIC BOAT.\nWeekly, 1945 to 1946. Habits of\nlow-priced stock of somewhat\nhigher sensitivity.\n343\n23.10EMULEX. Lessons in high-speed\nspeculation. 334\n18.3 ENRON. The most fundamental lesson.\n2005. 298\n37.7 FANSTEEL\nMETALLURGICAL.\nWeekly, 1955 to 1956. Showing\nAscending Triangle, reactions to\nSupport, and eventual uptrend.\n434\n7.3\nFEDERAL NATIONAL\nMORTGAGE\nASSOCIATION.\n1984. Head-and-Shoulders\nBottom. 60\n11.18 FLINTKOTE. Consolidation Formation — a\nSymmetrical Triangle —\n167\nproviding signal of Primary\nReversal.\n37.47\nFLYING TIGER\nCORPORATION.\nMonthly, October, 1969 through\n1971. From the 1967 high of\n481/2, “FLY” started a\ndowntrend that lasted 2 years\nand took the stock down to\n111/4.\n471\n7.21 GAMEWELL\nCOMPANY.\nThe Rounding Bottom of 1932\nshowing a temporary rally out of\npattern.\n72\n7.11 GENERAL BRONZE. Multiple type Bottom formed\nJuly-September 1945. 64\n15.1 GENERAL MOTORS. Straight-line Bull Trend.\nMonthly chart, 1938 to 1946.230\n37.31GENERAL STEEL\nINDUSTRIES.\nDaily, November 1962 to April\n1963. Example of a Major\nUptrend with normal reactions.\n459\n16.3 GOLD 2005.\nA great rounding bottom?\nForetelling? 248\n16.4 GOLD 2011 Showing how the great rounding\nbottom was fulfilled. 249\n8.24\nGOODRICH (B.F)\nCOMPANY.\nThe remarkably small but perfect\nAscending Triangle which\nreversed its Major Trend in 1942.\nWeekly chart.\n95\n20.1 GOODYEAR TIRE $5\nPFD.\nMonthly, 1943 to 1947, showing\nstability of a conservative\npreferred stock of the same\ncompany in the same period.\n308\n20.2 GOODYEAR TIRE\nCOMMON.\nMonthly, 1943 to 1947, showing\nrapid advance of a somewhat\nspeculative common stock\nduring a Bull Market.\n308\n13.9 GOODYEAR TIRE.\nFour Pullbacks to neckline of\nHead-and-Shoulders Top.\nWeekly chart, 1945 to 1947.\n203\n23.16GOOGLE. 2005. More fun than a googly on\na sticky wicket.\n339-\n340\n23.17GOOGLE. Illustrating the follow up story in\nGoogle\n37.3 GRANITE CITY STEEL.\nRectangle and Support-\nResistance phenomena in 1956\nuptrend.\n430\n10.18GREYHOUND. A conspicuous One-Day\nReversal at the 1946 134\nBull high.\nFigureStock Name Summary Description of ChartPage\n33.4 GREYHOUND.\nDaily, last half of 1945. Rounding\nBottom and advance with reactions\nto Support Levels.\n397\n33.12GULF, MOBILE &\nOHIO.\nDaily, first 6 months of 1945.\nIntermediate Bottom and Wedge. 405\n15.7 HOUSTON OIL.\nAccelerating trend of a speculative\noil stock.\nMonthly chart, 1938 to 1946.\n233\n8.1\nHUDSON BAY\nMINING AND\nSMELTING.\nMajor Bottom of 1941 to 1942, a\nperfect Symmetrical Triangle.\nWeekly chart.\n78\n8.22 HUDSON MOTORS. Series of Triangles in the 1929-32\nBear Market. Weekly chart. 93\n10.13HUDSON MOTORS. The 1946 Major Top, a Diamond or\nComplex Head-and-Shoulders.130\n15.2 HUDSON MOTORS. Up-curving Bull Trend. Monthly\nchart, 1938 to 1946. 230\n18.2 HUDSON MOTORS.\nDaily chart from January through\nJune 1930, showing large\nDescending Triangle, also\nSymmetrical Triangle\nConsolidation during decline.\n295\n14.10HUDSON MOTORS. Measuring implications of “failure”\nin Trend Channel. 1945. 215\n6.1 HUMANA, INC. Daily, 1988. Head-and-Shoulders\nTop. 46\n18.4 IBM.\nPerhaps those “best and brightest”\nfundamental analysts were not as\nfeckless as one might think from\nlooking at their 20-year record.\n301\n6.5 IC INDUSTRIES.\n1986. Head-and-Shoulders Top. 49\n7.4\nILLUSTRATION OF\nKILROY BOTTOM 60\n9.12 INCO COMPANY,\nLTD.\nSubsequent to the October crash,\ndeveloped a large Head-and-\nShoulders Top.\n111\n37.18INDUSTRIAL RAYON\nCORPORATION.\nShowing Bearish action of a stock\nthrough the entire year 1957. Daily\nchart.\n446\n23.9 INKTOMI. Scaling the Internet. 333\n7.22 INLAND STEEL. Semi-dormant Rounding Bottom of\n1935. 72\n37.2\nINSPIRATION\nCONSOLIDATED\nCOPPER.\nDowntrend and break through\nMajor Suppo", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 245}
{"text": "60\n9.12 INCO COMPANY,\nLTD.\nSubsequent to the October crash,\ndeveloped a large Head-and-\nShoulders Top.\n111\n37.18INDUSTRIAL RAYON\nCORPORATION.\nShowing Bearish action of a stock\nthrough the entire year 1957. Daily\nchart.\n446\n23.9 INKTOMI. Scaling the Internet. 333\n7.22 INLAND STEEL. Semi-dormant Rounding Bottom of\n1935. 72\n37.2\nINSPIRATION\nCONSOLIDATED\nCOPPER.\nDowntrend and break through\nMajor Support. 429\n37.47INTEL. The heart of the Microsoft\ncomputer. Compare MSFT. 474\n13.11 INTERLAKE IRON.“End run” following a late breakout\nfrom Symmetrical Triangle. 1944.204\n15.6 INTERNATIONAL\nHYDRO-ELECTRIC.\nUp-curving Bull Trend of a high\nleverage junior utility stock.\nMonthly chart, 1938 to 1946.\n232\n10.5\nINTERNATIONAL\nPAPER.\nShowing a form of “broadening”\nwhich is of doubtful technical\nsignificance. Weekly chart, 1945 to\n1947.\n125\nStock Name Summary Description of ChartPage\nINTERNATIONAL\nTELEPHONE &\nTELEGRAPH.\nSaucer- like Consolidation in 1944.166\nINTERNATIONAL\nTELEPHONE &\nTELEGRAPH.\nSupport “field” of Symmetrical\nTriangle. 1945. 204\nJ.I. CASE.\nThe Rounding Bottom of 1932\nshowing a temporary rally out of\npattern.\n71\nJEWEL TEA. Major Support-Resistance Levels on\n1936 to 1946 monthly chart. 198\nJOHNS-MANVILLE.Triangular Bottom development of\n1941 to 1942. Weekly chart. 79\nJONES & LAUGHLIN.\nNormal trend action illustrating\nSupport and Resistance. Weekly chart,\n1944 to 1947.\n191\nKENNECOTT COPPER. Series of Consolidation Formations in\n1937 Bear Trend. 110\nKRESGE (S.S.)\n1936 to 1946 monthly chart showing\nimportant 196\nCOMPANY. Support-Resistance Levels.\nLEHIGH VALLEY\nDaily, end of 1945, beginning of 1946.\nGaps of 407\nRAILROAD. various types.\nLIBBY, McNEILL &\nMonthly, 1927 to 1930. Showing\ncontinuance of 436\nLIBBY. Bullish Trend into 1930.\nLIGGETT & MYERS\nStraight-line trend characteristic of\ntobacco 236\nTOBACCO B. stocks. Monthly chart, 1938 to 1946.\nLIMA LOCOMOTIVE\nRectangular pattern of “conflict” in\n1944 to 104\nWORKS. 1945.\nLION OIL COMPANY.\nAn Island “shakeout” in a thin stock.\n1947. 181\nLIVINGSTON OIL\nWeekly, January 1965 into January\n1966. 464\nCOMPANY.\nDownside Major Trend, Symmetrical\nTriangle Bottom, Major Reversal to\nuptrend.\nLOCKHEED AIRCRAFT. A Head-and-Shoulders Bottom\nReversal in December 1943. 58\nLOEW'S, INC. Perfect Rectangle of the “pool\noperation” type, 1936. 105\nLOEW'S, INC. Falling Wedge of classic form in 1936;\nFlag and Rectangle. 132\nLORILLARD.\nShowing Bullish action of a stock\nthrough the entire year, 1957. Daily\nchart.\n447\nLUCENT. Late 20th, early 21st century\nschizophrenia. 142\nLUCENT. What happened after the chart in 104.4143\nMARTIN-PARRY.\nDaily, 6 months in 1945. Pennant,\nshowing formation of Consolidation\nPattern at halfway point in advance.\n406\nMARTIN-PARRY. Ideal Flag in rapid advance of 1945.152\nMASONITE. Downtrend showing Support-\nResistance phenomena. 1956. 431\nMCA, INC. 1986. Complex Head-and-Shoulders\nTop 62\nFigureStock Name Summary Description of ChartPage\n37.42\nMEMOREX\nCORPORATION.\nDaily, September 1969 through\nMay 1970. Last “Bull” fling for\nMemorex before gapping down\nwith volume in February 1970.\n470\n11.15 MIAMI COPPER. A genuine Scallop uptrend in\n1945. 165\n10.24MICROSOFT. A key reversal day in March.140\n23.1 MICROSOFT.\nA multitude of lessons in\nMicrosoft. 326\n23.2 MICROSOFT. A Monthly perspective. 327\n23.3 MICROSOFT. 2005. The long view after the fall.328\n11.8\nMULLINS\nMANUFACTURING.\nB. An overlong Flag which\nworked nevertheless. 1936.159\n9.1 NASH-KELVINATOR.\nRectangular distribution area of\n1945 to 1946. 104\n14.12NASH-KELVINATOR. Downtrend Channel in 1946.216\n37.54NASDAQ 100\nBasing Point Procedure applied to\nweekly bars 480\n11.3 NASH-KELVINATOR. Flag of “Half-Mast” type\npreceding 1937 Bull Market Top. 154\n10.22NATIONAL CASH\nREGISTER.\nAn example of “One-Week\nReversal” in 1941. Weekly chart.138\n13.3 NATIONAL\nDISTILLERS.\n1926 to 1947 monthly chart\nshowing Major Support-\nResistance Levels.\n195\n8.10 NATIONAL GYPSUM.\nA typical Symmetrical Triangle\nleading to continuation of the\npreceding trend in 1944 to 1945.\nWeekly chart.\n84\n11.2 NATIONAL GYPSUM.\nAn up Flag and another false\nmove from apex of Triangle.\n1945.\n153\n8.6 NATIONAL GYPSUM.A false move out of the extreme\napex of a Symmetrical Triangle. 81\n9.18 NATIONAL GYPSUM.Triple Bottom of 1941 to 1942.\nWeekly chart. 117\n7.14 NATIONAL SUPPLY.\nThe “two-headed” Top Formation\nof 1946. 67\n6.10 NEW YORK\nCENTRAL.\nHead-and-Shoulders Top in June\nthrough July 1945, followed by a\nMultiple Head-and-Shoulders\nBottom.\n52\n6.20\nNEW YORK\nCENTRAL.\nA typical Panic Selling Climax in\n1937. 136\n37.48NOKIA.\nThe story of the communications\nrevolution. 475\n8.7 NORTH AMERICAN\nCOMPANY.\nSymmetrical Triangle topping a\nrecovery from a Panic Low in\n1937.\n82\n7.25 NORTHERN INDIANA\nPUBLIC SERVICE.\nA magnificent Scalloping\ntendency. 75\n33.15NORTHERN PACIFIC.\nDaily, 6 months in 1944. Support\nand Resistance phenomena; also\nshowing Symmetrical Triangle\nand reaction to apex, and small\nRectangle.\n412\n37.11 NORTHROP\nAIRCRAFT.\n1954 to 1955. Descending\nTriangle at an important top.438\n37.12NORTHROP\nAIRCRAFT.\n1956 to 1957. Ascending Triangle\nand upside breakout. 439\n16.1 OATS. Tracing “normal” patterns during\nthe 1940s (5th ed.). 246\nFigureStock Name Summary Description of ChartPage\n23.8 ORACLE.\nYour modern misshapen rectangles in\nOracle again, marked by runaway days\nand gaps.\n332\n37.40ORACLE.\nLest one think that the air pocket gap\ndoes not still exist, here is an example\nfrom the turn of the century (third\nmillennium).\n468\n37.15OTIS ELEVATOR.\nShowing a full year of a typical daily\nchart on TEKNIPLAT charting paper.\nShows a long Triangle Consolidation,\neventually followed by a continuation\nof the Major Advance. 1954 to 1955.\n443\n11.7 PACIFIC TIN. Flag, following and succeeded by\nTriangles, in 1944. 158\n37.37\nPACKARD-BELL\nELECTRONICS.\nDaily, August 1965 to January 1966.\nFlag showing “Half-Mast” situation,\nand a large Ascending Triangle with\npowerful breakout move on the upside.\n465\n23.5 PALM Masquerading as PLMO. A\nContinuation of the shell game.329\n23.6 PALM Masq", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 246}
{"text": "d by a continuation\nof the Major Advance. 1954 to 1955.\n443\n11.7 PACIFIC TIN. Flag, following and succeeded by\nTriangles, in 1944. 158\n37.37\nPACKARD-BELL\nELECTRONICS.\nDaily, August 1965 to January 1966.\nFlag showing “Half-Mast” situation,\nand a large Ascending Triangle with\npowerful breakout move on the upside.\n465\n23.5 PALM Masquerading as PLMO. A\nContinuation of the shell game.329\n23.6 PALM Masquerading as PSRC. Which shell is\nit under? 330\n23.4 PALM. Fool's gold. Fool's gold with naivete\nwrit large on it. 329\n14.8 PAN AMERICAN\nAIRWAYS.\nDescending Triangle Top and long,\nDouble Downtrend Channel. 1945 to\n1946.\n214\n14.6\nPARAMOUNT\nPICTURES.\nDouble trendlines in accelerated\nIntermediate Advance. 1945 to 1946.213\n10.7 PARAMOUNT\nPICTURES.\nThe 1946 top, a Right-Angled\nBroadening Pattern with horizontal\nbottom line.\n126\n33.9 PARAMOUNT\nPICTURES.\nWeekly, 1941 to 1943. Double Bottom,\nbreakout, and reaction to Support\nbefore main advance.\n402\n37.38PARKE, DAVIS &\nCOMPANY.\nDaily, July 1969 to June 1970. This\ncould be regarded as a very flat Head-\nand-Shoulders Top, or as a long\nRounding Top.\n466\n12.13\nPENNSYLVANIA\nRAILROAD.\nChanges in technical lines required by\nex-dividend decline. 183\n36.2 PENTAD SYSTEMIllustration of filtered moving average\nsystem. 425\n14.5 PHILLIPS\nPETROLEUM.\nAn exception to the normal\nconsequences of valid trendline\npenetration. Weekly chart, 1935 to\n1938.\n212\n7.15 PHILLIPS\nPETROLEUM.\nThe 1946 Top — a Multiple Pattern\nmerging into a Rounding Turn. 67\n37.23POLAROID.\nFirst 6 months of 1962. Long Rectangle\nfollowed by a precipitous drop after\npenetration of Support. Daily chart.\n451\n7.13\nPUBLIC SERVICE\nCORP.\nOF NJ.\nWeekly chart showing Multiple Bottom\npattern of 1941 to 1942. 66\n37.41\nPUBLIC SERVICE\nELECTRIC &\nGAS.\nMonthly, 1969 through 1970. A typical\nelectric and gas utility stock. 469\nFigureStock Name Summary Description of ChartPage\n9.17 PUBLICKER\nINDUSTRIES.Triple Top of 1946. 116\n10.23QUALCOMM.A church spire top in Qualcomm.139\n14.13R.H. MACY.\nComplex Top in 1946 and penetration of\nIntermediate Up Trendline. Tentative\nFan Lines.\n217\n13.6 REMINGTON\nRAND.\nDescending Triangle Top and significant\nfailure of Support. Weekly chart, 1945 to\n1947.\n199\n33.8 REMINGTON\nRAND.\nDaily, end of 1944, beginning of 1945.\nSeries of Rectangles during Bull Market\nAdvance, and return moves to Support\nLevels.\n401\n6.8 REPUBLIC\nAVIATION.\nIts 1946 Bull Market Top. The Head-\nand-Shoulders measuring formula.51\n9.13 REPUBLIC\nSTEEL.\nMajor Double Top of 1946 with\nsubsidiary patterns. 112\n15.9 REPUBLIC\nSTEEL.\nTypical Bull Trend of steel stocks.\nMonthly chart, 1938 to 1946. 234\n8.20\nREVERE\nCOPPER &\nBRASS.\nLarge Descending Triangle Top of 1946.91\n37.10S.S. KRESGE.Monthly, 1953 to 1956. Generally\nBearish Major Trend. 437\n10.16SCHENLEY\nDISTILLERS.\nA large Wedge which signaled a Primary\nTop in 1946. Weekly chart. 133\n24.1 SCHENLEY\nDISTILLERS.\nWeekly, 1945 to 1946. Habits of a stock\nof high sensitivity. 342\n9.8 SEARS,\nROEBUCK.\nA “hybrid” Major Bottom Formation in\n1941 to 1942. 109\n8.2 SEARS,\nROEBUCK.\nSymmetrical Triangle Top of 1946, and\nsubsequent step-down pattern of same\nform.\n78\n8.15 SEARS,\nROEBUCK.\nThe Symmetrical Descending Triangle\nTop of 1936 and subsequent\nIntermediate Recovery Bottom of\nascending form.\n86\n10.11 SHELL UNION\nOIL.\n1946 Major Diamond Top and\nDescending Triangle. 128\n16.4 SILVER 2005. Another great rounding bottom?249\n16.5\nSILVER MAY\n2005 Lessons in agility, gaps and run days\n16.5 SILVER 2011 How the rounding bottom was resolved250\n16.13SILVER 2011 Illustrating top and stairstops. 257\n8.18\nSOCONY-\nVACUUM\nOIL.\nAscending Triangle forming head of\nHead-and-Shoulders Bottom in 1942.\nWeekly chart.\n89\n9.4\nSOCONY-\nVACUUM\nOIL.\nRectangle Top Formation of 1946.106\n12.7 SOUTHERN\nPACIFIC.\nA large Measuring Gap in the Panic\nDecline of late 1937. 178\n33.1 SOUTHERN\nPACIFIC.\nDaily, 6 months in 1946. Head-and-\nShoulders Top, rally, and subsequent\n394\ndecline.\n14.9 SOUTHERN\nPACIFIC.\nIntermediate Basic and Return Lines and\nFlags 214\nwithin Trend Channel. 1945.\nFigureStock Name\nSummary Description of\nChart Page\n8.16 SOUTHERN RAILWAY\nPREFERRED.\nA perfect Ascending Triangle\nin 1936. 87\n13.12SOUTHERN RAILWAY.\nTypical Pullbacks to Head-\nand- Shoulders Neckline, and\nincrease of volume as Support\nis violated. 1946.\n205\n20.3 SPDR. SPY\nFor illustration, here is a chart\nof the Amex Index Share, the\nSPYDR, or share based on the\nS&P 500.\n309\n17.1 SPIEGEL, INC.\nThe Major Top of 1946 and\nthe first part of a Bear Trend.\n1946 to 1947.\n262\n17.2 SPIEGEL, INC. Sequel to Figure 198.\nContinuation of Bear Trend.\n263\n1946 to 1947.\n15.17\nSTANDARD & POOR'S\n500 INDEX. Horrors of the 1987 Crash.239\n15.18\nSTANDARD & POOR'S\n500 INDEX.\nThe 1987 Crash viewed from\nafar. 239\n20.2 STANDARD & POOR'S\n500 INDEX.\nHere the benefits of relaxed\nlong-term investing may be\nseen.\n308\n20.4\nSTANDARD & POOR'S\n500 INDEX.\nThe Broadening Top comes\nhome to roost. 309\n15.8\nSTANDARD OIL OF OHIO.\nStraight-line Bull Trend of an\ninvestment oil. Monthly chart,\n1938 to 1946.\n233\n37.30SUPERIOR OIL.\nJune to November 1962.\nShowing an important Double\nBottom, which became the\nbase for a Major Advance.\n458\n6.4 TELEDYNE, INC.\n1984. Large Head-and-\nShoulders Top. 48\n37.8 TEXTRON. 1956 to 1957.\nDescending Triangle, with\nsharp decline after the\nbreakout. 1956 to 1957.\n435\n16.11 TLT\nBond reaction to the great\nBush bear market 255\n10.17\nTRANSCONTINENTAL\n& WESTERN AIRLINES.\nMajor One-Day Reversal and\nlong downtrend. 1945 to 1946.134\n9.16 TRINITY INDUSTRIES.1985. Triple Bottom. 115\n8.11 U.S. INDUSTRIAL\nCHEMICALS.\nTriangular Pattern completing\nan extended reaccumulation\nperiod.\n84\n37.1 U.S. SMELTING,\nREFINING & MINING.\nWeekly, 1951 to 1953,\nshowing Ascending Triangle\nand Head-and-Shoulders Top.\n428\n37.25U.S. SMELTING,\nREFINING & MINING.\nApril through September,\n1962. Head-and-Shoulders\nBottom, breakout, reaction,\nand advance. Daily chart.\n453\n37.35U.S. SMELTING,\nREFINING & MINING.\nDaily,\nJuly to December 1965.\nBreakout from dormancy,\nMajor Advance, showing\nSymmetrical Triangle\nCons", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 247}
{"text": ". SMELTING,\nREFINING & MINING.\nWeekly, 1951 to 1953,\nshowing Ascending Triangle\nand Head-and-Shoulders Top.\n428\n37.25U.S. SMELTING,\nREFINING & MINING.\nApril through September,\n1962. Head-and-Shoulders\nBottom, breakout, reaction,\nand advance. Daily chart.\n453\n37.35U.S. SMELTING,\nREFINING & MINING.\nDaily,\nJuly to December 1965.\nBreakout from dormancy,\nMajor Advance, showing\nSymmetrical Triangle\nConsolidation.\n463\n6.11\nUNION CARBIDE &\nCARBON.\nThe Head-and-Shoulders\nwithin a Head-and-Shoulders\nTop Formation which capped\nits 1929 Bull Market.\n53\n22.1 UNION PACIFIC.\nWeekly, first 6 months of\n1945, showing tendency of a\nhigh-priced stock of the same\ngroup to make small swings.\n320\nFigureStock Name Summary Description of ChartPage\n9.11 UNITED AIRCRAFT.\nThe Double Bottom of 1942. Weekly\nchart. 111\n37.32UNITED ARTISTS.\nDaily, February to August 1963. A\nMajor Downtrend, demonstrating\nResistance Levels during the\ndecline.\n460\n1.1 UNITED STATES\nSTEEL.\nMonthly price ranges from January\n1929 to December 1946. 5\n10.9 UNITED STATES\nSTEEL.\nThe three-month Diamond which\nformed the 1946 Bull Market Top. 127\n10.14UNITED STATES\nSTEEL.\nThe Wedge as part of a Rounding\nTop on the August 1937 recovery. 131\n37.33\nUTAH-IDAHO\nSUGAR\nCOMPANY.\nJanuary to June 1963. Breakout and\nrapid advance appearing suddenly in\na normally dull stock.\n461\n11.4 VANADIUM\nCORPORATION.\nRapid sequence of small\nConsolidation Formations in 1936 to\n1937.\n155\n8.8\nVERTIENTES —\nCAMAGUEY\nSUGAR\nof Cuba. Triangular- like\ndevelopment at 1946 Top. 83\n6.9 WALT DISNEY\nPRODUCTIONS.Head-and-Shoulders Top. 1986. 51\n37.10WEST INDIES\nSUGAR.\nMonthly, 1953 to 1956. Showing\ncontinuance of Bullish Trend\nthrough 1956.\n437\n37.14\nWESTINGHOUSE\nELECTRIC.\nDownside trend in the early stages of\nthe 1955 to 1956 collapse. 437\n15.15\nWESTINGHOUSE\nELECTRIC.\nMajor Trendlines. Weekly chart,\n1935 to 1938. 237\n6.3\nWESTINGHOUSE\nELECTRIC.\nThe Head-and-Shoulders Top of\nJanuary through February 1946.47\n8.21 WESTINGHOUSE\nELECTRIC.\nThe Descending Triangle which\ntopped out “WX” ahead of the\ngeneral market.\n92\n37.10WESTINGHOUSE\nELECTRIC.\nMonthly, 1953 to 1956. Showing\nMajor Top in 1955 and the collapse\nduring the early months of 1956.\n437\n12.8 WILLYS-\nOVERLAND.\nVarious types of gaps in 1944, and\nHead-and-Shoulders Reversal.179\n11.9 WYANDOTTE\nWORSTED.\nApplication of measuring formula to\nFlag. 1946. 160\n18.5 XEROX. More benefits of fundamental\nanalysis. 302\n37.50YAHOO. After the tulipomania. 2005.476\n37.51YAHOO. Internet rocket fuel. 477\n13.7\nYORK\nCORPORATION.\nMeasuring Gap and long Rectangle.\n1945 to 1946. 200\n13.8 YORK\nCORPORATION.\nSequel to Figure 141. Rectangle\nSupport, false move from apex of\nTriangle, and Double Top. 1946.\n201\n9.5\nYOUNGSTOWN\nSHEET\n& TUBE.\nMajor Top of Rectangle formed in\n1946. 106\n12.3 ZENITH RADIO.Strong Breakaway Gap on weekly\nchart of 1942 Major Bottom.174\n12.4 ZENITH RADIO.Monthly chart of 1936 to 1946 for\ncomparison with Figure 12.3.175\n\nTaylor & Francis\nTaylor & Francis Group\nhttp://taylorandfrancis.com\nGlossary\nEN: The Glossary is the work of the distinguished editor of the seventh\nedition, Richard McDermott. Minor changes are so noted.\nEN9: Some entries are written by other analysts, whose names are noted.\nAlthough it requires the use of the human brain and some discrimination\nand judgment, the great virtue of Magee chart analysis is it allows the\npractitioner to evaluate how well number-driven indicators function. As, for\nexample, use of a Moving Average to identify the trend works wonderfully\nwell in a trending market. If used as a signal generator in a trading market,\nresults will come in whipsaws. Similarly, oscillators often are useful in\ntrading markets but can mislead the trader when the market begins to trend.\nThe reasonably accomplished chart analyst can recognize the state of the\nmarket and view the performance of number-driven indicators from a more\ninformed perspective. Thus, the reader should keep this in mind while\nreading about the Average Directional Movement Index and suchlike.\nACCUMULATION—The first phase of a Bull Market. The period when\nfarsighted investors begin to buy shares from discouraged or distressed\nsellers. Financial reports are usually at their worst and the public is\ncompletely disgusted with the stock market. Volume is only moderate but\nbeginning to increase on the rallies.\nACTIVITY—See Volume.\nADX (Average Directional Movement Index)—The ADX is a trend-\nfollowing indicator devised by Welles Wilder (Wilder Relative Strength\nIndex) and is based on the concept of directional movement. It is designed\nto evaluate the trending characteristics of a security. The ADX is frequently\nused to avoid trendless markets, and signals when a trend reaches a\nprofitable trading level. In a trendless market, the ADX indicates avoidance.\nDirectional movement is a measure of the net total price movement during a\nset period of time. First, the positive and negative directional movements\nare determined by summing the daily up and down moves. The values\nobtained are next normalized by dividing them by the “True Range,” the\nabsolute value of the total move for the period; this difference between\nnormalized values (expressed as a percentage) is the directional movement.\nThe ADX is then obtained from directional movement by the use of\nexponential average and ratios. The ADX is often charted with a second\nline, the ADXR Indicator. ADXR is a smoothed average of the ADX.\nA rising ADX indicates significant directional movement and the beginning\nof a good trading period. The declining ADX is shown during a poor period\nfor trend following. Normally, an ADX Indicator above 25 signals\nsignificant directional movement and good trading.\nAPEX—The highest point; the pointed end, tip, of a Triangle.\nARBITRAGE—The simultaneous buying and selling of two different, but\nclosely related, instruments to take advantage of a disparity in their prices in\none market or different markets.\nEN: Those who buy the acquirer and sell the acquired in takeover situations\n—sometimes c", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 248}
{"text": "above 25 signals\nsignificant directional movement and good trading.\nAPEX—The highest point; the pointed end, tip, of a Triangle.\nARBITRAGE—The simultaneous buying and selling of two different, but\nclosely related, instruments to take advantage of a disparity in their prices in\none market or different markets.\nEN: Those who buy the acquirer and sell the acquired in takeover situations\n—sometimes called “arbs” or arbitrageurs—are ersatz or faux\narbitrageurs; they are really spreaders. Arbitrageur is a solecism used in\nthat sense. It is also a false cognate to the French.\nAREA GAP—See Common Gap.\nAREA PATTERN—When a stock or commodity's upward or downward\nmomentum has been temporarily exhausted, the ensuing sideways\nmovement in the price usually traces out a design or arrangement of form\ncalled an Area Pattern. The shape of some of these Area Patterns, or\nFormations, has predictive value under certain conditions. (See also\nAscending Triangle, Broadening Formations, Descending Triangle,\nDiamond, Flag, Head-and-Shoulders Pattern, Inverted Triangle, Pennant,\nRectangle, Right-Angle Triangles, Symmetrical Triangles, and Wedges.)\nARITHMETIC SCALE—Price or volume scale where the distance on the\nvertical axis (i.e., space between horizontal lines) represents equal amounts\nof dollars or number of shares.\nASCENDING (PARALLEL) TREND CHANNEL—When the tops of the\nrallies composing an advance develop along a line (sometimes called a\nReturn Line), which is also parallel to the basic Up Trendline (i.e., the line\nthat slopes up across the wave bottoms in an advance); the area between the\ntwo lines is called an Ascending or Up Channel.\nASCENDING (UP) TRENDLINE—The advancing wave in a stock or\ncommodity is composed of a series of ripples. When the bottoms of these\nripples form on, or very close to, an upward-slanting straight line, a basic\nAscending or Up Trendline is formed.\nASCENDING TRIANGLE—One of a class of Area Patterns called Right-\nAngle Triangles. The class is distinguished by the fact that one of the two\nboundary lines is practically horizontal, whereas the other slants toward it.\nIf the top line is horizontal and the lower slants upward to an intersection\npoint to the right, the resulting Area Pattern is called Ascending Triangle.\nThe implication is Bullish, with the expectant breakout through the\nhorizontal line. Measuring Formula: add the broadest part of triangle to the\nbreakout point.\nAT-THE-MONEY—An option, the strike price of which is equal to the\nmarket price of the underlying instrument.\nAVERAGES—See Dow-Jones Industrial Averages, Moving Averages,\nDow-Jones Transportation Averages, and Dow-Jones Utility Averages.\nAVERAGING COST—An investing technique in which the investor buys a\nstock or commodity at successively lower prices, thereby “averaging down”\nhis average cost of each\nstock share or commodity contract. Purchases at successively higher prices\nwould “average up” the price of stock shares or commodity contracts.\nEN: A very foolish technique for the amateur.\nAXIS—In the graphic sense, an axis is a straight line for measurement or\nreference. It is also the line, real or imagined, on which a formation is\nregarded as rotating.\nBALANCED PROGRAM—Proportioning capital, or a certain part of\ncapital, equally between the long side and the short side of the market.\nBAR CHART—Also called a Line Chart. A graphic representation of prices\nusing a vertical bar to connect the highest price in the time period to the\nlowest price. Opening prices are noted with a small horizontal line to the\nleft. Closing prices are shown with a small horizontal line to the right. Bar\ncharts can be constructed for any time period in which prices are available.\nThe most common time periods found in bar charts are hourly, daily,\nweekly, and monthly; however, with the growing number of personal\ncomputers and the availability of “real-time” quotes, it is not unusual for\ntraders to use some period of minutes to construct a bar chart.\nBASIC TRENDLINES—See Trendlines.\nBASING POINT—The price level in the chart that determines where a\nstop-loss point is placed. As technical conditions change, the Basing Point,\nand stops, can be advanced (in a rising market), or lowered (in a falling\nmarket). (See Progressive Stops.)\nBASIS POINTS—The measure of yields on bonds and notes. One Basis\nPoint equals 0.01% of yield.\nBASKET TRADES—Large transactions made up of a number of various\nstocks.\nBEAR MARKET—In its simplest form, a Bear Market is a period when\nprices are primarily declining, usually for a long period of time. Bear\nMarkets generally consist of three phases. The first phase is distribution, the\nsecond is panic, and the third is akin to a washout, during which those\ninvestors who have held through the first two phases finally give up and\nliquidate.\nBENT NECKLINE—See Neckline.\nBETA—A measurement of an individual stock's sensitivity to market\nswings.\nBETA (COEFFICIENT)—A measure of the market or non-diversifiable risk\nassociated with any given security in the market.\nBLOCK TRADES—Large transactions of a particular stock sold as a unit.\nBLOW-OFF—See Climactic Top.\nBLUE CHIPS—The nickname given to high-priced companies with good\nrecords of earnings and price stability; also called gilt-edged securities.\nExamples include IBM, AT&T, General Motors, and General Electric.\nBLUE PARALLEL—A line drawn parallel to the trendline (Blue Trendline)\nthat connects at least two highs. The Blue Parallel is started off a low and\nused to estimate the next low point.\nBLUE TRENDLINE—A straight line connecting two or more Tops\ntogether. To avoid confusion, Edwards and Magee use a blue line for Top\nTrendlines and a red line for Bottom Trendlines.\nBOLLINGER BANDS (BB)—An envelope, in the form of two lines, that\nsurrounds the price bars on a chart. Bollinger Bands are plotted two\nstandard deviations away from a Simple Moving Average. This is the\nprimary difference between Bollinger Bands and other envelopes.\nEnvelopes are plotted a fixed percentage above and be", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 249}
{"text": "nd Magee use a blue line for Top\nTrendlines and a red line for Bottom Trendlines.\nBOLLINGER BANDS (BB)—An envelope, in the form of two lines, that\nsurrounds the price bars on a chart. Bollinger Bands are plotted two\nstandard deviations away from a Simple Moving Average. This is the\nprimary difference between Bollinger Bands and other envelopes.\nEnvelopes are plotted a fixed percentage above and below a Moving\nAverage. As standard deviation is a measure of volatility, Bollinger Bands\nadjust themselves to differing market conditions. The bands grow wider\nduring volatile market periods and narrower during less volatile periods.\nBollinger's premise is to ask the market what it is doing, rather than to tell it\nwhat to do. He focused on volatility with the use of standard deviation to set\nthe bandwidth. The bands are normally plotted two deviations away from\nthe standard deviation, which is effectively a 20-day Moving Average Line.\nThe plot is valid if an average acts as a Support Line on market corrections.\nIf the average is penetrated on corrections, it is too short. Bollinger\nrecommends 10-day Moving Averages for short-term trading, 20-day for\nintermediate-term trading, and 50-day for long-term trading. Deviations\nalso need to be adjusted: 10 days can use 1.5 deviations, 20 days use 2\ndeviations, and 50 days use 2.5 deviations. The nature of the time periods\ndoes not matter; the bands can be used on monthly, weekly, daily, and even\nintraday figures.\nBollinger Bands do not usually generate buy and sell signals alone. Most\noften, they provide a framework within which price may be related to other\nindicators. Bollinger recommends using the bands in relation to other buy\nand sell signals. However, the bands can be an integral part of the signal. If\na price touches an upper band and indicator action confirms it, no sell signal\nis generated (it is a continuation signal if a buy signal was in effect). If a\nprice touches an upper band and an indicator does not confirm (diverges), it\nis a sell signal. If a Top Price Chart Formation is formed outside the bands\nand is followed by a second Top inside the bands, a sell signal is generated.\nThe exact opposite is true on the buy side.\nWhen combined with other indicators, such as the Relative Strength Index\n(RSI), the Bollinger Bands become quite powerful. RSI is an excellent\nindicator with respect to overbought and oversold conditions. Generally,\nwhen price touches the upper Bollinger Band and RSI is below 70, it is an\nindication that the trend will continue. Conversely, when price touches the\nlower Bollinger Band, and RSI is above 30, it is an indication the trend\nshould continue. If a situation occurs in which price touches the upper\nBollinger Band and RSI is above 70 (possibly approaching 80), it is an\nindication that the trend may reverse itself and move downward. On the\nother hand, if price touches the lower Bollinger Band and RSI is below 30\n(possibly approaching 20), the trend may reverse itself and move upward.\n(See also Multicolincarity, Percent B, Wilder Relative Strength Index.)\nBOOK VALUE—The conventional accounting measure of what a stock is\nworth based on the value of the company's assets less the company's debt.\nEminently manipulable.\nBOTTOM—See Ascending Triangle, Dormant Bottom, Double Bottom,\nHead-and-Shoulders Bottom, Rounding Bottom, and Selling Climax.\nBOUNDARY—The edges of a pattern. BOWL—See Rounding Bottom.\nBRACKETING—A trading range market or a price area that is non-\ntrending.\nBREAKAWAY GAP—The hole or gap in the chart created when a stock or\ncommodity breaks out of an Area Pattern.\nBREAKOUT—When a stock or commodity exits an area pattern.\nBROADENING FORMATION—Sometimes called Inverted Triangles,\nthese are formations that start with narrow fluctuations that widen out\nbetween diverging, rather than converging, boundary lines. (See also\nBroadening Top, Diamond Patterns, Head-and-Shoulders Pattern, and\nRight-Angled Broadening Formations.)\nBROADENING TOP—An Area Reversal Pattern that may evolve in any\none of three forms, comparable in shape, respectively, to inverted\nSymmetrical, Ascending, or Descending Triangles. Unlike Triangles, the\nTops and Bottoms of these patterns do not necessarily stop at clearly\nmarked diverging boundary lines. Volume tends to be unusually high and\nirregular throughout pattern construction. No Measuring Formula is\navailable.\nBULL MARKET—A period when prices are primarily rising, normally for\nan extended period. Usually, but not always, divisible into three phases. The\nfirst phase is accumulation. The second phase is one of fairly steady\nadvance with increasing volume. The third phase is marked by considerable\nactivity as the public begins to recognize and attempt to profit from the\nrising market.\nCALL OPTION—An option that gives the buyer the right to buy the\nunderlying contract at a specific price within a certain period, and that\nobligates the seller to sell the contract for the premium received before\nexpiration of the designated time period.\nCANDLESTICKS—A Japanese graphic representation of price action\nusing the same data as bar charts, but that adds color to the candlestick (or\ndata) to indicate the direction of prices from the opening (see Nison,\nBibliography.)\nCATS AND DOGS—Low-priced stocks of no investment value.\nCHANNEL—If the Tops of the rallies and Bottoms of the reactions develop\nlines that are approximately parallel to one another, the area between these\nlines is called a Channel. (See also Ascending Trend Channel, Descending\nTrend Channel, and Horizontal Trend Channel.)\nCHART—A graphic representation of a stock or commodity in terms of\nprice and/or volume. (See also Bar Chart and Point and Figure Chart.)\nCLEAN-OUT DAY—See Selling Climax.\nCLIMACTIC TOP—A sharp advance, accompanied by extraordinary\nvolume, that is, much larger volume than the normal increase, which signals\nthe final “blow-off” of the trend, followed by either a Reversal, or at least\nby a period of stagnation, formation of Cons", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 250}
{"text": "n of a stock or commodity in terms of\nprice and/or volume. (See also Bar Chart and Point and Figure Chart.)\nCLEAN-OUT DAY—See Selling Climax.\nCLIMACTIC TOP—A sharp advance, accompanied by extraordinary\nvolume, that is, much larger volume than the normal increase, which signals\nthe final “blow-off” of the trend, followed by either a Reversal, or at least\nby a period of stagnation, formation of Consolidation Pattern, or a\nCorrection.\nCLIMAX DAY—See One-Day Reversal.\nCLIMAX, SELLING—See Selling Climax.\nCLOSING PRICE—The last sale price of the trading session for a stock. In\na commodity, it represents an official price determined from a range of\nprices deemed to have traded at or on the close; also called a settlement\nprice.\nCLOSING THE GAP—When a stock or commodity returns to a previous\ngap and retraces the range of the gap. Also called covering the gap or filling\nthe gap. (See also Gap.)\nCOIL—Another term for a Symmetrical Triangle.\nCOMMISSION—The amount charged by a brokerage house to execute a\ntrade in a stock, option, or commodity. In a stock, option, or commodity, a\ncommission is charged for each purchase and each sale. In a commodity, a\ncommission is charged only when the original entry trade has been closed\nwith an offsetting trade. This is called a round turn commission.\nCOMMON GAP—Also called Area Gap. Any hole or gap in the chart\noccurring within an Area Pattern. The forecasting significance of the\nCommon Gap is nil. (See also Gap.)\nCOMPARATIVE RELATIVE STRENGTH—Compares the price\nmovement of a stock with that of its competitors, industry group, or the\nwhole market.\nCOMPLEX HEAD-AND-SHOULDERS—Also called Multiple Head-and-\nShoulders. It is a Head-and-Shoulders Pattern with more than one right and\nleft shoulder and/or head. (See also Head-and-Shoulders Pattern.)\nCOMPOSITE AVERAGE—A stock average composed of the 65 stocks that\nmake up the Dow-Jones Industrial Average and the Dow-Jones Utility\nAverage.\nCOMPOSITE LEVERAGE—In Edwards and Magee, it is a formula for\ncombining the principal factors affecting a given sum of capital used (i.e.,\nsensitivity, price, and margin) into one index figure.\nCONFIRMATION—In a pattern, it is the point at which a stock or\ncommodity exits an Area Pattern in the expected direction by an amount of\nprice and volume sufficient to meet minimum pattern requirements for a\nbona fide breakout. In the Dow Theory, it means both the Industrial Average\nand the Transportation Average have registered new highs or lows during\nthe same advance or decline. If only one of the Averages establishes a new\nhigh (or low) and the other one does not, it would be a non-confirmation, or\nDivergence. This is also true of oscillators. To confirm a new high (or low)\nin a stock or commodity, an oscillator needs to reach a new high (or low) as\nwell. Failure of the oscillator to confirm a new high (or low) is called a\nDivergence and would be considered an early indication of a potential\nReversal in direction.\nCONGESTION—The sideways trading from which Area Patterns evolve.\nNot all Congestion periods produce a recognizable pattern, however.\nCONSOLIDATION PATTERN—Also called a Continuation Pattern, it is\nan Area Pattern that breaks out in the direction of the previous trend. (See\nalso Ascending Triangle, Descending Triangle, Flag, Head-and-Shoulders\nContinuation, Pennant, Rectangle, Scallop, and Symmetrical Triangle.)\nCONTINUATION GAP—See Runaway Gap.\nCONTINUATION PATTERN—See Consolidation Pattern.\nCONVERGENT PATTERN (TREND)—Those patterns with upper and\nlower boundary lines that meet, or converge, at some point if extended to\nthe right. (See also Ascending Triangle, Descending Triangle, Symmetrical\nTriangle, Wedges, and Pennants.)\nCORRECTION—A move in a commodity or stock that is opposite to the\nprevailing trend, but not sufficient to change that trend. Called a rally in a\ndowntrend and a reaction in an uptrend. In the Dow Theory, a Correction is\na Secondary Trend against the Primary Trend, which usually lasts from\nthree weeks to three months and retraces from one-third to two-thirds of the\npreceding swing in the Primary Direction.\nCOVERING THE GAP—See Closing the Gap.\nCRADLE—The intersection of the two converging boundary lines of a\nSymmetrical Triangle. (See also Apex.)\nDAILY RANGE—The difference between the high and low price during\none trading day.\nDEMAND—Buying interest for a stock at a given price.\nDESCENDING (PARALLEL) TREND CHANNEL—When the Bottoms of\nthe reactions comprising a decline develop along a line (sometimes called a\nReturn Line), which is also parallel to the basic down trendlines (i.e., the\nline which slopes down across the wave tops in a decline), the area between\nthe two lines is called a Descending or Down Channel.\nDESCENDING TRENDLINE—The declining wave in a stock or\ncommodity is composed of a series of ripples. When the tops of these\nripples form on, or very close to, a downward slanting straight line, a basic\nDescending or Down Trendline is formed.\nDESCENDING TRIANGLE—One of a class of Area Patterns called Right-\nAngle Triangles. The class is distinguished by the fact one of the two\nboundary lines is practically horizontal, while the other slants toward it. If\nthe bottom line is horizontal and the upper slants downward to an\nintersection point to the right, the resulting Area Pattern is called a\nDescending Triangle. The implication is Bearish, with the expectant\nbreakout through the flat (horizontal) side. Minimum Measuring Formula:\nadd the broadest part of the Triangle to the breakout point.\nDIAMOND—Usually a Reversal Pattern, but it will also be found as a\nContinuation Pattern. It could be described as a Complex Head-and-\nShoulders Pattern with a V-shaped (bent) Neckline, or a Broadening Pattern\nthat, after two or three swings, changes into a regular Triangle. The overall\nshape is a four-point Diamond. Since it requires a fairly active market, it is\nmore often found at Major Tops. Many Complex Head-and-Shoulders Tops\nare borderline Diamond Patterns. The major di", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 251}
{"text": "Pattern. It could be described as a Complex Head-and-\nShoulders Pattern with a V-shaped (bent) Neckline, or a Broadening Pattern\nthat, after two or three swings, changes into a regular Triangle. The overall\nshape is a four-point Diamond. Since it requires a fairly active market, it is\nmore often found at Major Tops. Many Complex Head-and-Shoulders Tops\nare borderline Diamond Patterns. The major difference is in the right side of\nthe pattern. It should clearly show two converging lines with diminishing\nvolume as in a Symmetrical Triangle. Minimum Measuring Formula: add\nthe greatest width of the pattern to the breakout point.\nDISTRIBUTION—The first phase of a Bear Market, which really begins in\nthe last stage of a Bull Market. The period when farsighted investors sense\nthat the market has outrun its fundamentals and begin to unload their\nholdings at an increasing pace. Trading volume is still high; however, it\ntends to diminish on rallies. The public is still active but beginning to show\nsigns of caution as hoped-for profits fade away.\nDIVERGENCE—When new highs (or lows) in one indicator are not\nrealized in another comparable indicator. (See also Confirmation.)\nDIVERGENT PATTERN (TREND)—Those patterns with upper and lower\nboundary lines that meet at some point if extended to the left. (See also\nBroadening Formation.)\nDIVERSIFICATION—The concept of placing your funds in different\nindustry groups and investment vehicles to spread risk. Not to put all your\nfinancial eggs in one basket.\nDIVIDENDS—A share of the profits, in cash or stock equivalent, paid to\nstockholders.\nDORMANT BOTTOM—A variation of a Rounding (Bowl) Bottom, but in\nan extended, flat-bottomed form. It usually appears in “thin” stocks (i.e.,\nthose issues with a small number of shares outstanding) and\ncharacteristically will show lengthy periods during which no sales will be\nregistered for days at a time. The chart will appear “fly-specked” due to the\nmissing days. The technical implication is for an upside breakout.\nDOUBLE BOTTOM—Reversal Pattern. A Bottom formed on relatively\nhigh volume that is followed by a rally (of at least 15%), and then a second\nBottom (possibly rounded) at the same level (plus or minus 3%) as the first\nBottom on lower volume. A rally back though the apex of the intervening\nrally confirms the Reversal. More than a month should separate the two\nBottoms. Minimum Measuring Formula: take the distance from the lowest\nbottom to the apex of the intervening rally and add it to the apex.\nDOUBLE TOP—A high-volume Top is formed, followed by a reaction (of\nat least 15%) on diminishing activity. Another rally back to the previous\nhigh (plus or minus 3%) is made, but on lower volume than the first high. A\ndecline through the low of the reaction confirms the Reversal. The two\nhighs should be more than a month apart. Minimum Measuring Formula:\nadd to the breakout point the distance from the highest peak to the low of\nthe reaction. Also called an “M” Formation.\nDOUBLE TRENDLINE—When two relatively close Parallel Trendlines\nare needed to define the true trend pattern. (See also Trendline.)\nDOW-JONES INDUSTRIAL AVERAGE—Developed by Charles Dow in\n1885 to study market trends. Originally composed of 14 companies (12\nrailroads and 2 industrials), the Rails, by 1897, were separated into their\nown Average, and 12 industrial companies of the day were selected for the\nIndustrial Average. The number was increased to 20 in 1916 and to 30 in\n1928. The stocks included in this Average have been changed from time to\ntime to keep the list up to date or to accommodate a merger. The only\noriginal issue still in the Average is General Electric.\nDOW-JONES TRANSPORTATION AVERAGE—Established at the turn of\nthe century with the new Industrial Average, it was originally called the Rail\nAverage and was composed of 20 railroad companies. With the advent of\nthe airlines industry, the Average was updated in 1970 and the name\nchanged to Transportation Average.\nDOW-JONES UTILITY AVERAGE—In 1929, utility companies were\ndropped from the Industrial Average and a new Utility Average of 20\ncompanies was created. In 1938, the number of issues was reduced to the\npresent 15.\nDOWNTICK—A securities transaction at a price lower than the preceding\ntransaction.\nDOWNTREND—See Descending Trendline and Trend.\nDRAWDOWN or RETRACEMENT—The ebb, or loss, of a portfolio's\nequity from a relative high to a relative low. Maximum drawdown equals\nretracement from maximum high point to minimum low point.\nEND RUN—When a breakout of a Symmetrical Triangle Pattern reverses\nits direction and trades back through axis Support (if an upside breakout) or\nResistance (if a downside breakout), it is termed an end run around the line,\nor end run for short. The term is sometimes used to denote breakout failure\nin general.\nEQUILIBRIUM MARKET—A price area that represents a balance\nbetween demand and supply.\nEXCHANGE-TRADED FUND (ETF)—Funds tracking indexes (e.g., SPY,\nDIA) or baskets of stocks that trade like stocks and do not involve the\ninvestor in membership in a mutual fund. An ideal way to replace mutual\nfund investing.\nEX-DIVIDEND—The day when the dividend is subtracted from the price\nof the stock.\nEX-DIVIDEND GAP—The gap in price caused when the price of a stock is\nadjusted downward after the dividend payment is deducted.\nEXERCISE—The means by which the holder of an option purchases or\nsells shares of the underlying security.\nEXHAUSTION GAP—Relatively wide gap in the price of a stock or\ncommodity that occurs near the end of a strong directional move in the\nprice. These gaps are quickly closed, most often within two to five days,\nwhich helps to distinguish them from Runaway Gaps, which are not usually\ncovered for a considerable length of time. An Exhaustion Gap cannot be\nread as a Major Reversal, or even necessarily a Reversal. It signals a halt in\nthe prevailing trend, which is ordinarily followed by some sort of area\npattern development.\nEXPIRATION—The last day on which an option can", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 252}
{"text": "most often within two to five days,\nwhich helps to distinguish them from Runaway Gaps, which are not usually\ncovered for a considerable length of time. An Exhaustion Gap cannot be\nread as a Major Reversal, or even necessarily a Reversal. It signals a halt in\nthe prevailing trend, which is ordinarily followed by some sort of area\npattern development.\nEXPIRATION—The last day on which an option can be exercised.\nEXPONENTIAL SMOOTHING—A mathematical method of forecasting\nthat assumes future price action may be forecast by using a weighted\naverage of past periods; a mathematical series in which greater weight is\ngiven to more recent price action. A method of trend identification.\nFALLING WEDGE—An Area Pattern with two downward-slanting,\nconverging trendlines. Normally, it takes more than three weeks to\ncomplete, and volume will diminish as prices move toward the apex of the\npattern. The anticipated direction of the breakout in a Falling Wedge is up.\nMinimum Measuring Formula: a retracement of all the ground lost within\nthe Wedge. (See also Wedge.)\nFALSE BREAKOUT or FALSE SIGNAL—A breakout that is confirmed\nbut quickly reverses and eventually leads the stock or commodity to a\nbreakout in the opposite direction. Indistinguishable from premature\nbreakout or genuine breakout when it occurs.\nFAN LINES—A set of three secondary trendlines drawn from the same\nstarting high or low that spread out in a Fan shape. In a Primary Uptrend,\nthe fan would be along the tops of the Secondary (Intermediate) Reaction.\nIn a Primary Downtrend, the fan would be along the bottoms of the\nSecondary (Intermediate) Rally. When the third Fan Line is broken, it\nsignals the resumption of the Primary Trend.\n50-DAY MOVING AVERAGE LINE—Is determined by taking the closing\nprice over the past 50 trading days and dividing by 50.\nEN: Simple Moving Average for n days consists of summing prices for n\ndays and dividing by n. On n + 1 drop the first day and add the new day to\nthe formula, etc.\nFIVE-POINT REVERSAL—See Broadening Pattern.\nFLAG—A Continuation Pattern. A flag is a period of congestion, less than\nfour weeks in duration, that forms after a sharp, near-vertical change in\nprice. The upper and lower boundary lines of the pattern are parallel, though\nboth may slant up, down, or sideways. In an uptrend, the pattern resembles\na Flag flying from a mast, hence the name. Flags are also called Measuring\nor Half-Mast Patterns because they tend to form at the midpoint of the rally\nor reaction. Volume tends to diminish during the formation and increase on\nthe breakout. Minimum Measuring Formula: add the distance from the\nbreakout point, which started the preceding “Mast” rally or reaction, to the\nbreakout point of the Flag.\nFLOATING SUPPLY—The number of shares available for trading at any\ngiven time. Generally, the outstanding number of shares less shares closely\nheld and likely to be unavailable to the public. Shares of a company held by\nits employee pension fund, for example, would not generally enter the\ntrading stream and could be subtracted from the outstanding shares.\nFORMATION—See Area Pattern.\nFRONT-MONTH—The first expiration month in a series of months.\nFUNDAMENTALS—Information on a stock pertaining to the business of\nthe company and how it relates to earnings and dividends. In a commodity,\nit would be information on any factor that would affect supply or demand.\nEN: Also, earnings, profits, profit margins, cash flow, sales, and other\nstatistics sometimes used to obfuscate the value of the issue.\nGAP—A hole in the price range that occurs when either (1) the lowest price\nat which a stock or commodity is traded during any time period is higher\nthan the highest price at which it was traded on the preceding time period,\nor (2) the highest price of one time period is lower than the lowest price of\nthe preceding time period. When the ranges of the two time periods are\nplotted, they will not overlap or touch the same horizontal level on the chart\n— there will be a price gap between them. (See also Common or Area Gap,\nEx-Dividend Gap, Breakaway Gap, Runaway Gap, Exhaustion Gap, and\nIsland Reversal.)\nGRAPH—See Chart.\nHALF-MAST—See Flag. Edwards said, “The Flag flies at half-mast,”\nreferring to the tendency of prices to consolidate halfway through a surging\nvertical run.\nHEAD-AND-SHOULDERS BOTTOM—Area Pattern that reverses a\ndecline. (See also Head-and-Shoulders Pattern.) EN: An upside-down name\nfor an upside-down pattern. (See Kilroy Bottom.)\nHEAD-AND-SHOULDERS CONSOLIDATION—Area Pattern that\ncontinues the previous trend. (See also Head-and-Shoulders Pattern.)\nHEAD-AND-SHOULDERS PATTERN—Although occasionally an\nInverted Head-and-Shoulders Pattern (called a Consolidation Head-and-\nShoulders) will form, which is a Continuation Pattern, in its normal form,\nthis pattern is one of the more common and more reliable of the Major\nReversal Patterns. It consists of the following four elements (a Head-and-\nShoulders Top will be described for illustration): (1) a rally that ends a more\nor less extensive advance on heavy volume, and that is then followed by a\nMinor Reaction on less volume; this is the left shoulder; (2) another high-\nvolume advance that exceeds the high of the left shoulder, followed by\nanother low-volume reaction that takes prices down to near the bottom of\nthe preceding reaction, and below the top of the left shoulder high; this is\nthe head; (3) a third rally, but on decidedly less volume than accompanied\neither of the first two advances, and that fails to exceed the high established\non the head; this is the right shoulder; and (4) a decline through a line\ndrawn across the proceeding two reaction lows (the neckline), and a close\nbelow that line equivalent to 3% of the stock's market price. This is the\nconfirmation of the breakout. A Head-and-Shoulders Bottom, or any other\ncombination Head-and-Shoulders Pattern, contains the same four elements.\nThe main difference between a Top Formation and a Bottom Formation is\nin the volume pat", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 253}
{"text": "line through a line\ndrawn across the proceeding two reaction lows (the neckline), and a close\nbelow that line equivalent to 3% of the stock's market price. This is the\nconfirmation of the breakout. A Head-and-Shoulders Bottom, or any other\ncombination Head-and-Shoulders Pattern, contains the same four elements.\nThe main difference between a Top Formation and a Bottom Formation is\nin the volume patterns. The breakout in a Top can be on low volume. The\nbreakout in a Bottom must show a “conspicuous burst of activity.”\nMinimum Measuring Formula: add the distance between the head and\nneckline to the breakout point.\nHEAD-AND-SHOULDERS TOP—Area Pattern that reverses an advance.\n(See also Head-and-Shoulders Pattern.)\nHEAVY VOLUME—The expression “heavy volume,” as used by Edwards\nand Magee, means heavy only with respect to the recent volume of sales in\nthe stock you are watching.\nHEDGING—To try to lessen risk by making a counterbalancing\ninvestment. In a stock portfolio, an example of a hedge would be to buy 100\nshares of XYZ stock, and to buy one put option of the same stock. The put\nwould help protect against a decline in the stock, but it would also limit\npotential gains on the upside. (See also Natural Hedge.)\nHISTORICAL DATA—A series of past daily, weekly, or monthly market\nprices.\nHOOK DAY—A trading day in which the open is above/below prior day's\nhigh/low and the close is below/above prior day's close with narrow range.\nHORIZONTAL CHANNEL—When the Tops of the rallies and Bottoms of\nthe reactions form along lines that are horizontal and parallel to one another,\nthe area in between is called a Horizontal Trend Channel. It may also be\ncalled a Rectangle during the early stages of formation.\nHORIZONTAL TRENDLINE—A horizontal line drawn across either the\nTops or Bottoms in a sideways trending market.\nHYBRID HEAD-AND-SHOULDERS—A small Head-and-Shoulders\nPattern within a larger Head-and-Shoulders Pattern. (See also Head-and-\nShoulders Pattern.)\nINDUSTRIAL AVERAGE—See Dow-Jones Industrial Average.\nINSIDE DAY—A day in which the daily price range is totally within the\nprior day's daily price range.\nINSIDERS—Individuals who possess fundamental information likely to\naffect the price of a stock, but which is unavailable to the public. An\nexample would be an individual who knows about a merger before it is\nannounced to the public. Trading by insiders on this type of information is\nillegal.\nINTERMEDIATE TREND—In Edwards and Magee, the term Intermediate\nor Secondary refers to a trend (or pattern indicating a trend) against the\nPrimary (Major) Trend, which is likely to last from three weeks to three\nmonths, and which may retrace one-third to two-thirds of the previous\nPrimary Advance or Decline.\nINVERTED BOWL—See Rounding Top.\nINVERTED TRIANGLE—See Right-Angled Broadening Triangle.\nISLAND REVERSAL—A compact trading range, usually formed after a\nfast rally or reaction, which is separated from the previous move by an\nExhaustion Gap, and from the move in the opposite direction that follows\nby a Breakaway Gap. The result is an Island of prices detached by a gap\nbefore and after. If the trading range contains only one day, it is called a\nOne-Day Island Reversal. The two gaps usually occur at approximately the\nsame level. By itself, the pattern is not of major significance, but it does\nfrequently send prices back for a complete retracement of the Minor Move\nwhich preceded it.\nKILROY BOTTOM—The editor's contribution to the nomenclature. A\nmore descriptive term for the undescriptive “Head-and-Shoulders Bottom.”\nLADDERING—A practice some Wall Street underwriters used in the\nTulipomania of the 1990s. Consists of selling initial public offering (IPO)\nshares for the pre-opening price to insider customers in exchange for their\nagreement to buy more in the public offering at higher prices. Caused\nextreme volatility and big run ups in early days of IPOs. An unethical form\nof price manipulation.\nLEVERAGE—Using a smaller amount of capital to control an investment\nof greater value. For example, exclusive of interest and commission costs, if\nyou buy a stock on 50% margin, you control $1.00 of stock for every $0.50\ninvested or leverage of 2-to-1.\nLEVERAGE SPACE PORTFOLIO—Ralph Vince uses drawdown as the\nrisk metric for portfolios (as does this editor) instead of variance in returns.\nA sophisticated method for determining portfolio risk and trade size and\noptimizing portfolio growth.\nLIMIT MOVE—A change in price that exceeds the limits set by the\nexchange on which the futures contract is traded.\nLIMIT ORDER—A buy or sell order limited in some way, usually in price.\nFor example, if you placed a limit order to buy IBM at 100, the broker\nwould not fill the order unless he could do so at your price or better (i.e., at\n100 or lower).\nLIMIT UP, LIMIT DOWN—Commodity exchange restrictions on the\nmaximum upward or downward movements permitted in the price for a\ncommodity during any trading session day.\nLINE, DOW THEORY—A Line in the Dow Theory is an Intermediate\nSideways Movement in one or both of the Averages (Industrial and/or\nTransportation) in the course of which prices fluctuate within a range of 5%\n(of mean price) or less.\nLOGARITHMIC SCALE—See Semilogarithmic Scale.\nMAJOR TREND—In Edwards and Magee, the term Major (or Primary)\nrefers to a trend (or pattern leading to such a trend) that lasts at least one\nyear and shows a rise or decline of at least 20%.\nMARGIN—The minimum amount of capital required to buy or sell a stock.\nThe rate, 50% of value in 2005, is set by the government. In a commodity,\nmargin is also the minimum, usually about 10%, needed to buy or sell a\ncontract. The rate is set by the individual exchanges. The two differ in cost\nas well. In a stock, the broker lends the investor the balance of the money\ndue and charges interest for the loan. In a commodity, margin is treated as a\ngood faith payment. The broker does not lend the difference, so no interest\nexpense is incurred.\nMARKET ON CLOSE—An order specification tha", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 254}
{"text": "10%, needed to buy or sell a\ncontract. The rate is set by the individual exchanges. The two differ in cost\nas well. In a stock, the broker lends the investor the balance of the money\ndue and charges interest for the loan. In a commodity, margin is treated as a\ngood faith payment. The broker does not lend the difference, so no interest\nexpense is incurred.\nMARKET ON CLOSE—An order specification that requires the broker to\nget the best price available on the close of trading.\nMARKET ORDER—An instruction to buy or sell at the price prevailing\nwhen the order reaches the floor of the exchange.\nMARKET RECIPROCAL—Normal average range of a stock based on the\naverage range for a number of years, divided by the current average range.\nThe result is the reciprocal of the market movement for the period. Wide\nmarket activity, for example, would show a small decimal, less than 1. Dull\ntrading would be a larger number.\nMAST—The vertical rally or reaction preceding a Flag or Pennant\nFormation.\nMcCLELLAN OSCILLATOR—An Index based on New York Stock\nExchange net advances over declines. It provides a measure of such\nconditions as overbought/oversold and market direction on a short- to\nintermediate-term basis. The McClellan Oscillator measures a Bear Market\nSelling Climax when registering a very negative reading like -150. A sharp\nbuying pulse in the market is indicated by a very positive reading, well\nabove 100.\nMEASURING FORMULAE—There are certain patterns that do allow the\nchartist the opportunity to project at least an interim target level of the\ndirection of the Primary Trend. The most important of these patterns are\nfound to be Triangles, Rectangles, Head-and-Shoulders, and Pennants and\nFlags.\n• Triangles—When a stock breaks out of a Symmetrical Triangle (either up\nor down), the ensuing move should carry at least as far as the height of the\nTriangle as measured along its first reaction.\n• Rectangles—The minimum you would expect from a breakout (up or\ndown) out of a Rectangle Pattern would be the distance equal to the height\nof the formation.\n• Head-and-Shoulders Tops/Bottoms—The Head-and-Shoulders Pattern has\none of the better measuring sticks. In either a Top or Bottom, the interim\ntarget, once the neckline is penetrated, is the distance from the Top (or\nBottom) of the head to the level of the neckline directly below (above) the\nhead.\n• Pennants and Flags—The one thing to remember about these Continuation\nPatterns is they “fly at half-mast.” In other words, the leg in equals the leg\nout.\nMEASURING GAP—See Runaway Gap.\nMEGAPHONES—Megaphones are Broadening Tops. The Broadening\nFormation may evolve in any one of the three forms comparable,\nrespectively, to Inverted Symmetrical, Inverted Ascending, or Descending\nTriangles. The symmetrical type, for example, consists of a series of price\nfluctuations across a horizontal axis, with each Minor Top higher and each\nMinor Bottom lower than its predecessor. The pattern may thus be roughly\nmarked off by two diverging lines, the upper sloping up from left to right,\nthe lower sloping down. These Broadening Patterns are characteristically\nloose and irregular, whereas Symmetrical Triangles are regular and\ncompact. The converging boundary lines of Symmetrical Triangles are\nclearly defined, as a rule. Tops and Bottoms within the formation tend to\nfall within fair precision on these boundary lines. In the Broadening\nFormation, the rallies and declines usually do not all stop at clearly marked\nboundary lines and are subject to spikes. We could call this a Megaphone\nSpike because the formation keeps on crowding at the lines to look like a\nmegaphone. It has a tendency to spike down more than up.\nMELON—A handsome rich dividend.\nMINOR TREND—In Edwards and Magee, the term Minor refers to brief\nfluctuations (usually less than six days and rarely longer than three weeks)\nthat, in total, make up the Intermediate Trend.\nMOMENTUM INDICATOR—A market indicator utilizing volume\nstatistics for predicting the strength or weakness of a current market and\nany overbought or oversold conditions and to distinguish turning points\nwithin the market.\nMOVING AVERAGE—A mathematical technique to smooth data. It is\ncalled moving because the number of elements are fixed, but the time\ninterval advances. Old data must be removed when new data are added,\nwhich causes the average to “move along” with the progression of the stock\nor commodity.\nEN: Simple Moving Average for n days consists of summing prices for n\ndays and dividing by n. On n + 1, drop the first day and add the new day to\nthe formula, etc.\nMOVING AVERAGE CONVERGENCE/DIVERGENCE (MACD)—An\noscillator derived by dividing one Moving Average by another. Basically, it\ncombines three Moving Averages into two lines. In today's computer\nprograms, the Moving Averages are usually exponentially weighted, thus\ngiving more weight to the more recent data. It is plotted in a chart with a\nhorizontal Equilibrium Line.\nThe Equilibrium Line is important. When the two Moving Averages cross\nbelow the Equilibrium Line, it means the shorter Exponential Moving\nAverage (EMA) is at a value less than the longer EMA. This is a Bearish\nsignal. When the EMAs are above the Equilibrium Line, it means the\nshorter EMA has a value greater than the longer EMA. This is a Bullish\nsignal.\nThe first line is the difference between a 12-period EMA and a 26-period\nEMA. The second line (signal line) is an approximate exponential\nequivalent of a nine-period Moving Average of the first line. The\nexponential values being 0.15, 0.075, and 0.20.\nAn MACD can be displayed as a line oscillator or a histogram.\nBuy signals are generated when the faster Moving Average Line crosses the\nslower Moving Average Line from below. Sell signals come from the\nopposite, when the faster line crosses the slower line from above. Beware of\nmechanically trading every MACD crossover; it can lead to whipsaws and\ndrawdowns with substance. The fact is, narrow trading ranges give many\nfalse signals that can be avoid", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 255}
{"text": "istogram.\nBuy signals are generated when the faster Moving Average Line crosses the\nslower Moving Average Line from below. Sell signals come from the\nopposite, when the faster line crosses the slower line from above. Beware of\nmechanically trading every MACD crossover; it can lead to whipsaws and\ndrawdowns with substance. The fact is, narrow trading ranges give many\nfalse signals that can be avoided with additional interpretation.\nMOVING AVERAGE CROSSOVERS—The point at which the various\nMoving Average Lines pass through or over each other.\nMULTICOLINCARITY—The flawed procedure of using the identical data\nto supply different types of indicators. The indicators will all confirm each\nother because they are based on the same data. Combining RSI, Moving\nAverage Convergence/Divergence (MACD), and rate of change (where all\nindicators use the same closing prices and relative time periods) should\nprovide the same signals, but they could easily be incorrect.\nMulticolincarity can be avoided by using one indicator based on closing\nprices, another from volume, and a third from price ranges. It can also be\navoided by using data-generated indicators compared to chart patterns. (See\nalso Bollinger Bands, MACD, Wilder Relative Strength Index.)\nMULTIPLE HEAD-AND-SHOULDERS PATTERN—See Complex Head-\nand-Shoulders.\nNARROW RANGE DAY—A trading day with a narrower price range\nrelative to the previous day's price range.\nNATURAL and UNNATURAL METHODS or SYSTEMS—Bassetti's half-\nhumorous identification of “natural methods” of analysis, such as chart\nanalysis, which looks directly at market data, as opposed to “unnatural\nmethods,” which place an algorithm between the data and the analysis, such\nas Moving Averages, oscillators, and so on.\nNATURAL HEDGE—Bassetti's formulation of a technique recommended\nby Magee whereby a portfolio is always somewhat long and somewhat\nshort. It is an imperfect hedge intended to cushion downside (or upside)\nrisks—for example, long the DIA and short its members (or their proxies)\nwhich are in downtrends.\nNECKLINE—In a Head-and-Shoulders Pattern, it is the line drawn across\nthe two reaction lows (in a Top), or two rally highs (in a Bottom), which\noccur before and after the head. This line must be broken by 3% to confirm\nthe Reversal. In a Diamond Pattern, which is similar to a Head-and-\nShoulders Pattern, the neckline is bent in the shape of a V or inverted V.\n(See also Diamond and Head-and-Shoulders Pattern.)\nNEGATIVE DIVERGENCE—When two or more Averages, indexes, or\nindicators fail to show confirming trends.\nNORMAL RANGE FOR PRICE—EN: An analytical tool invented by\nMagee for measuring the volatility of stocks. Cumbersome in the modern\ncontext, but interesting. Described in Appendix A, ninth edition.\nNUMBER-DRIVEN TECHNICAL ANALYSIS—The use of statistics and\nalgorithms to analyze the market instead of pure chart analysis. Moving\nAverages and oscillators are examples as are stochastic. There are\ninnumerable indicators of this type. Although having many virtues, it places\nan algorithm between the price and the analyst.\nODD LOT—A block of stock consisting of fewer than 100 shares.\nON BALANCE VOLUME (OBV)—OBV is a popular Volume Indicator,\ndeveloped by Joseph Granville. Constructing an OBV line is very simple:\nthe total volume for each day is assigned a positive or negative value\ndepending on whether prices closed higher or lower that day. A higher close\nresults in the volume for that day getting a positive value, whereas a lower\nclose results in a negative value. A running total is kept by adding or\nsubtracting each day's volume based on the direction of the close. The\ndirection of the OBV line is watched, not the actual volume numbers.\nFormula:\n• If Today's Close > Yesterday's Close, then OBV = Yesterday's OBV +\nToday's Volume\n• If Today's Close < Yesterday's Close, then OBV = Yesterday's OBV -\nToday's Volume\n• If Today's Close = Yesterday's Close, then OBV = Yesterday's OBV\nONE-DAY REVERSAL—See Island Reversal.\nOPTION—The right granted to one investor by another to buy (called a call\noption) or sell (called a put option) 100 shares of stock, or one contract of a\ncommodity, at a fixed price for a fixed period of time. The investor granting\nthe right (the seller of the option) is paid a nonrefundable premium by the\nbuyer of the option.\nOPTIONS RESEARCH, INC.—Founded by Blair Hull, later of Hull\nTrading Co. The first company to computerize the Black-Scholes Model.\nORDER—See Limit Order, Market Order, and Stop Order.\nOSCILLATOR—A form of momentum or rate-of-change indicator usually\nvalued from +1 to -1 or from 0% to 100%.\nOVERBOUGHT—Market prices that have risen too steeply and too\nquickly.\nOVERBOUGHT/OVERSOLD INDICATOR—An indicator that attempts\nto define when prices have moved too far and too quickly in either\ndirection, and thus are liable to a reaction.\nOVERSOLD—Market prices that have declined too steeply and too\nquickly.\nPANIC—The second stage of a Bear Market when buyers thin out and\nsellers sell at any price. The downward trend of prices suddenly accelerates\ninto an almost vertical drop, whereas volume rises to climactic proportions.\n(See also Bear Market.)\nPANIC BOTTOM—See Selling Climax.\nPASSIVE INDEXER—Investor who invests in a major index and holds it\nthrough up and down waves.\nPATTERN—See Area Pattern.\nPEAK—See Top.\nPENETRATION—The breaking of a pattern boundary line, trendline, or\nSupport and Resistance Level.\nPENNANT—A Pennant is a Flag with converging, rather than parallel,\nboundary lines. (See also Flag.)\nPOINT AND FIGURE CHART—A method of charting believed to have\nbeen created by Charles Dow. Each day the price moves by a specific\namount (the arbitrary box size), an X (if up) or O (if down) is placed on a\nvertical column of squared paper. As long as prices do not change direction\nby a specified amount (the Reversal), the trend is considered to be in force\nand no new column is made. If a Reversal takes place, another vertical\ncolumn is started immediately to the right of the", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 256}
{"text": "harles Dow. Each day the price moves by a specific\namount (the arbitrary box size), an X (if up) or O (if down) is placed on a\nvertical column of squared paper. As long as prices do not change direction\nby a specified amount (the Reversal), the trend is considered to be in force\nand no new column is made. If a Reversal takes place, another vertical\ncolumn is started immediately to the right of the first, but in the opposite\ndirection. There is no provision for time on a Point and Figure Chart.\nPREMATURE BREAKOUT—A breakout of an Area Pattern, and then a\nretreat back into the pattern. Eventually, the trend will break out again and\nproceed in the same direction. At the time they occur, false breakouts and\npremature breakouts are indistinguishable from each other or from a\ngenuine breakout.\nPRICE/EARNINGS RATIO—Price of stock divided by earnings (which\nmay or may not be real) to give the P/E ratio. Sometimes an unnatural, or\nimaginary, number.\nPRIMARY TREND—See Major Trend.\nPROGRAM TRADING—Trades based on signals from various computer\nprograms, usually entered directly from the trader's computer to the\nmarket's computer system.\nEN: Usually indicates large volume transactions on large baskets of stocks\nby professional traders.\nPROGRESSIVE STOP—A stop order that follows the market up or down.\n(See also Stop.)\nPROTECTIVE STOP—A stop order used to protect gains or limit losses in\nan existing position. (See also Stop.)\nPULLBACK—Return of prices to the boundary line of the pattern after a\nbreakout to the downside. Return after an upside breakout is called a\nThrowback.\nPUT—An option to sell a specified amount of a stock or commodity at an\nagreed time at the stated exercise price.\nRAIL AVERAGE—See Dow-Jones Transportation Average.\nRALLY—An increase in price that retraces part of the previous price\ndecline.\nRALLY TOPS—A price level that finishes a short-term rally in an ongoing\ntrend.\nRANGE—The difference between the high and low during a specific time\nperiod.\nREACTION—A decline in price that retraces part of the previous price\nadvance.\nRECIPROCAL, MARKET—See Market Reciprocal.\nRECOVERY—See Rally.\nRECTANGLE—A trading area bounded on the Top and the Bottom with\nhorizontal, or near horizontal, lines. A Rectangle can be either a Reversal or\nContinuation Pattern depending on the direction of the breakout. Minimum\nMeasuring Formula: add the width (difference between Top and Bottom) of\nthe Rectangle to the breakout point.\nRED PARALLEL—A line drawn parallel to the trendline (Red Trendline)\nthat connects at least two Bottoms. The Red Parallel (basically a Return\nLine) is started off a high and used to estimate the next high point.\nRED TRENDLINE—A straight line connecting two or more Bottoms\ntogether. To avoid confusion, Edwards and Magee use a red line for Bottom\nTrendlines and a blue line for Top Trendlines.\nRELATIVE STRENGTH (RS or RS INDEX)—A stock's price movement\nover the past year as compared with a market index (most often the\nStandard & Poor's 500 Index). Value below 1 means the stock shows\nrelative weakness in price movement (underperformed the market); a value\nabove 1 means the stock shows relative strength over the one-year period.\nEquation for Relative Strength:\nCurrent Stock Price/Year-Ago Stock Price\nCurrent S&P 500/Year-Ago S&P 500\n(See also Wilder Relative Strength Index.)\nRESISTANCE LEVEL—A price level at which a sufficient supply of stock\nis forthcoming to stop, and possibly turn back for a time, an uptrend.\nRETRACEMENT—A price movement in the opposite direction of the\nprevious trend.\nRETURN LINE—See Ascending or Descending Trend Channels.\nREVERSAL GAP—A chart formation where the low of the last day is\nabove the previous day's range with the close above midrange and above\nthe open.\nREVERSAL PATTERN—An Area Pattern that breaks out in a direction\nopposite to the previous trend. (See also Ascending Triangle, Broadening\nFormation, Broadening Top, Descending Triangle, Diamond, Dormant\nBottom, Double Bottom or Top, Head-and-Shoulders Pattern, Rectangle,\nRising or Falling Wedge, Rounding Bottom or Top, Saucer, Symmetrical\nTriangle, and Triple Bottom or Top.)\nRIGHT-ANGLED BROADENING TRIANGLE—Area Pattern with one\nboundary line horizontal and the other at an angle that, when extended, will\nconverge with the horizontal line at some point to the left of the pattern.\nSimilar in shape to Ascending and Descending Triangles, except they are\ninverted and look like Flat-Topped or Bottomed Megaphones. Right-Angled\nBroadening Formations generally carry Bearish implications regardless of\nwhich side is flat. But any decisive breakout (3% or more) through the\nhorizontal boundary line has the same forceful significance as does a\nbreakout in an Ascending or Descending Triangle.\nRIGHT-ANGLE TRIANGLES—See Ascending and Descending Triangles.\nRISING WEDGE—An Area Pattern with two upward-slanting, converging\ntrendlines. Normally, it takes more than three weeks to complete and\nvolume will diminish as prices move toward the apex of the pattern. The\nanticipated direction of the breakout in a Rising Wedge is down. Minimum\nMeasuring Formula: a retracement of all the ground gained within the\nwedge.\nROUND LOT—A block of stock consisting of 100 shares of stock.\nROUND TRIP—The cost of one complete stock or commodity transaction,\nthat is, the entry cost and the offset cost combined.\nROUNDING BOTTOM—An Area Pattern that pictures a gradual,\nprogressive, and fairly symmetrical change in the trend from down to up.\nBoth the Price Pattern (along its lows) and the Volume Pattern show a\nconcave shape often called a Bowl or Saucer. There is no minimum\nmeasuring formula associated with this Reversal Pattern.\nROUNDING TOP—An Area Pattern that pictures a gradual, progressive,\nand fairly symmetrical change in the trend from up to down. The Price\nPattern, along its highs, shows a convex shape sometimes called an Inverted\nBowl. The Volume Pattern is concave shaped (a bowl) as trading activity\ndeclines into the peak of the Price Pattern and in", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 257}
{"text": "minimum\nmeasuring formula associated with this Reversal Pattern.\nROUNDING TOP—An Area Pattern that pictures a gradual, progressive,\nand fairly symmetrical change in the trend from up to down. The Price\nPattern, along its highs, shows a convex shape sometimes called an Inverted\nBowl. The Volume Pattern is concave shaped (a bowl) as trading activity\ndeclines into the peak of the Price Pattern and increases when prices begin\nto fall. There is no measuring formula associated with this Reversal Pattern.\nRUNAWAY GAP—A relatively wide gap in prices that occurs in an\nadvance or decline gathering momentum. Also called a “Measuring Gap”\nbecause it frequently occurs at just about the halfway point between the\nbreakout that started the move and the Reversal Day that calls an end to it.\nMinimum Measuring Formula: take the distance from the original breakout\npoint to the start of the gap and add it to the other side of the gap.\nRUNNING MARKET—A market wherein prices are moving rapidly in one\ndirection with very few or no price changes in the opposite direction.\nSAUCER—See Rounding Bottom and Scallop.\nSCALLOPS—A series of Rounding Bottom (Saucer) Patterns where the\nrising end always carries prices a little higher than the preceding Top at the\nbeginning of the pattern. Net gains will vary from stock to stock, but there\nis a strong tendency for it to amount to 10%-15% of the price. The total\nreaction, from the left-hand Top of each Saucer to its Bottom, is usually in\nthe 20%-30% area. Individual Saucers in a Scallop series are normally five\nto seven weeks long, and rarely less than three weeks. The volume will\nshow a convex or Bowl Pattern.\nSECONDARY TREND—See Intermediate Trend.\nSECULAR TREND—A major long-lived trend based in solid economic\nconditions, as opposed to cyclic or technical.\nSELLING CLIMAX—A period of extraordinary volume that comes at the\nend of a rapid and comprehensive decline that exhausts the margin reserves\nof many speculators or patience of investors. Total volume turnover may\nexceed any single day's volume during the previous upswing as Panic\nSelling sweeps through the stock or commodity. Also called a Clean-Out\nDay, a Selling Climax reverses the technical conditions of the market.\nAlthough it is a form of a One-Day Reversal, it can take more than one day\nto complete.\nSEMILOGARITHMIC SCALE—Price or volume scale in which the\ndistance on the vertical axis (i.e., space between horizontal lines) represents\nequal percentage changes.\nSENSITIVITY—An index used by Edwards and Magee to measure the\nprobable percentage movement (sensitivity) of a stock during a specified\npercentage move in the stock market as a whole.\nEN: More or less equivalent, or with the same intent as beta.\nSHAKEOUT—A corrective move large enough to “shake out” nervous\ninvestors before the Primary Trend resumes.\nSHORT INTEREST—The number of shares that have been sold short and\nnot yet repurchased. This information is published monthly by the New\nYork Stock Exchange.\nSHORT SALE—A transaction in which the entry position is to sell a stock\nor commodity first and to repurchase it (hopefully at a lower price) at a later\ndate. In the stock market, shares you do not own can be sold by borrowing\nshares from the broker and replacing them when the offsetting repurchase\ntakes place. In the commodity market, contracts are created when a buyer\nand seller get together through a floor broker. As a result, the procedure to\nsell in the commodity market is the same as it is to buy.\nSHOULDER—See Head-and-Shoulders Pattern.\nSMOOTHING—A mathematical approach that removes excess data\nvariability while maintaining a correct appraisal of the underlying trend.\nSPIKE—A sharp rise in price in a single day or two.\nSTOCHASTIC—Random.\nSTOCHASTICS—The Stochastic Oscillator, developed by George Lane,\ncompares a security's price closing level to its price range over a specific\nperiod of time. This indicator shows, Lane theorized, in an upward-trending\nmarket, prices tend to close near their high; and during a downward-\ntrending market, prices tend to close near their low. As an upward trend\nmatures, prices tend to close further away from their high; as a downward\ntrend matures, prices tend to close away from their low. The Stochastic\nIndicator attempts to determine when prices start to cluster around their low\nof the day in an uptrending market, and cluster around their high in a\ndowntrend. Lane theorizes these conditions indicate a Trend Reversal is\nbeginning to occur. The Stochastic Indicator is plotted as two lines, the %D\nLine and %K Line. The %D Line is more important than the %K Line. The\nStochastic is plotted on a chart with values ranging from 0 to 100. The\nvalue can never fall below 0 or above 100. Readings above 80 are\nconsidered strong and indicate a price is closing near its high. Readings\nbelow 20 are strong and indicate a price is closing near its low. Ordinarily,\nthe %K Line will change direction before the %D Line. However, when the\n%D Line changes direction prior to the %K Line, a slow and steady\nReversal is often indicated. When both %K and %D Lines change direction,\nand the faster %K Line changes direction to retest a crossing of the %D\nLine, though does not cross it, the incident confirms stability of the prior\nReversal. A powerful move is under way when the Indicator reaches its\nextremes around 0 and 100. Following a Pullback in price, if the Indicator\nretests extremes, a good entry point is indicated. Many times, when the %K\nor %D Lines begin to flatten out, the action becomes an indication the trend\nwill reverse during the next trading range.\nSTOCK SPLIT—A procedure used by management to establish a different\nmarket price for its shares by changing the common stock structure of the\ncompany. Usually a lower price is desired and established by canceling the\noutstanding shares and reissuing a larger number of new certificates to\ncurrent shareholders. The most common ratios are 2-to-1, 3-to-1, and 3-to-\n2. Occasionally, a higher price i", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 258}
{"text": "e.\nSTOCK SPLIT—A procedure used by management to establish a different\nmarket price for its shares by changing the common stock structure of the\ncompany. Usually a lower price is desired and established by canceling the\noutstanding shares and reissuing a larger number of new certificates to\ncurrent shareholders. The most common ratios are 2-to-1, 3-to-1, and 3-to-\n2. Occasionally, a higher price is desired and a reverse split takes place\nwhere one new share is issued for some multiple number of old shares.\nSTOP—A contingency order placed above the current market price if it is to\nbuy, or below the current market price if it is to sell. A stop order becomes a\nmarket order only when the stock or commodity moves up to the price of\nthe buy stop, or down to the price of a sell stop. A stop can be used to enter\na new position or exit an old position. (See also Protective or Progressive\nStop.)\nSTOP LOSS—See Protective Stop.\nSUPPLY—Amount of stock available at a given price.\nSUPPLY LINE—See Resistance.\nSUPPORT LEVEL—The price level at which a sufficient amount of\ndemand is forthcoming to stop, and possibly turn higher for a time, a\ndowntrend.\nSYMMETRICAL TRIANGLE—Also called a Coil. Can be a Reversal or\nContinuation Pattern. A sideways congestion in which each Minor Top fails\nto attain the height of the previous rally and each Minor Bottom stops above\nthe level of the previous low. The result is upper and lower boundary lines\nthat converge, if extended, to a point on the right. The upper boundary line\nmust slant down and the lower boundary line must slant up, or it would be a\nvariety of a Wedge. Volume tends to diminish during formation. Minimum\nFormula: add the widest distance within the Triangle to its breakout point.\nTANGENT—See Trendline.\nTAPE READER—One who makes trading decisions by watching the flow\nof New York Stock Exchange and American Stock Exchange price and\nvolume data coming across the electronic ticker tape.\nTEKNIPLAT™ PAPER—A specially formatted, two-cycle,\nsemilogarithmic graph paper, with sixth-line vertical accents, used to chart\nstock or commodity prices. Check http:// www.edwards-magee.com.\nTEST—A term used to describe the activity of a stock or commodity when\nit returns to, or “tests,” the validity of a previous trendline, or Support or\nResistance Level.\nTHIN ISSUE—A stock with a low number of floating shares and is lightly\ntraded.\nTHREE-DAYS-AWAY RULE—An arbitrary time period used by Edwards\nand Magee in marking suspected Minor Tops or Bottoms.\nTHROWBACK—Return of prices to the boundary line of the pattern after a\nbreakout to the upside. Return after a downside breakout is called a\nPullback.\nTOP—See Broadening Top, Descending Triangle, Double Top, Head-and-\nShoulders Top, Rounding Top, and Triple Top.\nTREND—The movement of prices in the same general direction, or the\ntendency or proclivity to move in a straight line. (See also Ascending,\nDescending, and Horizontal Parallel Trend Channels, Convergent Trend,\nDivergent Trend, Intermediate Trend, Major Trend, and Minor Trend.)\nTREND CHANNEL—A parallel probable price range centered about the\nmost likely price line.\nTRENDING MARKET—Price continues to move in a single direction,\nusually closing strongly for the day.\nTRENDLINE—If we actually apply a ruler to a number of charted price\ntrends, we quickly discover the line most often really straight in an uptrend\ntrend is a line connecting the lower extremes of the Minor Recessions\nwithin these lines. In other words, an advancing wave in the stock market is\ncomposed of a series of ripples, and the bottoms of each of these ripples\ntend to form on, or very close to, an upward-slanting straight line. The tops\nof the ripples are usually less even; sometimes they also can be defined by a\nstraight line, but more often, they vary slightly in amplitude, and so any line\nconnecting their upper tips would be more or less crooked. On a descending\nprice trend, the line most likely to be straight is the one that connects the\ntops of the Minor Rallies within it, while the Minor Bottoms may or may\nnot fall along a straight edge. These two lines—the one that slants up along\nthe successive wave bottoms within a broad up-move and the one that slants\ndown across successive wave tops within a broad down-move—are the\nBasic Trendlines. You draw an Up Trendline by drawing the line on the\ninner side. You draw a Down Trendline by drawing it on the outside. You\ndraw a Sideways Trendline on the bottom.\nTRIANGLE—See Ascending Triangle, Descending Triangle, Right-Angled\nBroadening Triangle, and Symmetrical Triangle.\nTRIPLE BOTTOM—Similar to a flat Head-and-Shoulders Bottom, or\nRectangle, the three Bottoms in a Triple Bottom.\nTRIPLE TOP—An Area Pattern with three Tops widely spaced and with\nquite deep, and usually rounding, reactions between them. Less volume\noccurs on the second peak than the first peak, and still less on the third\npeak. Sometimes called a “W” Pattern, particularly if the second peak is\nbelow the first and third. The Triple Top is confirmed when the decline\nfrom the third Top penetrates the Bottom of the lowest valley between the\nthree peaks.\n200-DAY MOVING AVERAGE LINE—Determined by taking the closing\nprice over the past 200 trading days and dividing by 200, then repeating the\nprocess each succeeding day, always dropping off the earliest day.\nUPTICK—A securities transaction made at a price higher than the\npreceding transaction.\nUPTREND—See Ascending Trendline and Trend.\nUTILITY AVERAGE—See Dow-Jones Utility Average.\nV/D VOLUME—Is the ratio between the daily up-volume to the daily\ndown-volume. It is a 50-day ratio determined by dividing the total volume\non those days when the stock closed up from the prior day by the total\nvolume on days when the stock closed down.\nVALIDITY OF TRENDLINE PENETRATION—The application of the\nfollowing three tests when a trendline is broken to determine whether the\nbreak is valid or whether the trendline is still basically intact: (1) the extent\nof the penetration, (2", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 259}
{"text": "-day ratio determined by dividing the total volume\non those days when the stock closed up from the prior day by the total\nvolume on days when the stock closed down.\nVALIDITY OF TRENDLINE PENETRATION—The application of the\nfollowing three tests when a trendline is broken to determine whether the\nbreak is valid or whether the trendline is still basically intact: (1) the extent\nof the penetration, (2) the volume of trading on the penetration, and (3) the\ntrading action after the penetration.\nVALLEY—The V-shaped price action that occurs between two peaks. (See\nalso Double Top and Triple Top.)\nVINCE, RALPH—Author of Handbook of Portfolio Mathematics where\noptimal f is described as a quantitative way to achieve optimal allocation\nand leverage of a portfolio. The Leverage Space Model achieves optimal\nbet sizing for maximizing gains while minimizing risk.\nVOLATILITY—A measure of a stock's tendency to move up and down in\nprice, based on its daily price history over the latest 12-month period. (See\nAppendix B, Resources, for the formula.)\nVOLUME—The number of shares in stocks or contracts in commodities\ntraded over a specified period of time.\n“W” FORMATION—See Triple Top.\nWEDGE—A chart formation in which the price fluctuations are confined\nwithin converging straight (or practically straight) lines.\nWILDER RELATIVE STRENGTH INDICATOR (RSI)—Although relative\nstrength, comparing a security price to a benchmark index price, has been\naround for some time, this indicator was developed by J. Welles Wilder, as\nexplained in his 1978 book, New Concepts in Technical Trading.\nRelative Strength is often used to identify price Tops and Bottoms by\nkeying on specific levels (usually “30” and “70”) on the RSI chart, which is\nscaled from 0 to 100. The RSI can also be useful to show the following:\n1. Movement that might not be as readily apparent on the bar chart.\n2. Failure Swings above 70 or below 30, warning of coming Reversals.\n3. Support and Resistance Levels appear with greater clarity.\n4. Divergence between the RSI and price can often be a useful\nReversal indicator.\nThe RSI requires a certain amount of lead-up time to operate successfully.\nTaylor & Francis\nTaylor & Francis Group\nhttp://taylorandfrancis.com\nBibliography\nAllen, R.C., How to Use the 4 Day, 9 Day and 18 Day Moving Averages to\nEarn Larger Profits from Commodities, Best Books, Chicago, 1974.\nArms, R.W., Volume Cycles in the Stock Market. Market Timing Through\nEquivolume Charting, Dow Jones-Irwin, Homewood, IL, 1983.\nArms, R.W., Jr., The Arms Index, TRlN, Dow Jones-Irwin, Homewood, IL,\n1989.\nBassetti, W.H.C., StairStops, MaoMao Press, San Geronimo, CA, 2009.\nBassetti, W.H.C., Zen Simple Beat the Market with a Ruler, MaoMao Press,\nSan Geronimo, CA, 2009.\nBassetti, W.H.C., Sacred Chickens, the Holy Grail and Dow Theory,\nMaoMao Press, San Geronimo, CA, 2010. Bassetti, W.H.C., Ten Trading\nLessons, MaoMao Press, San Geronimo, CA, 2010.\nBassetti, W.H.C., Signals, MaoMao Press, San Geronimo, CA, 2011.\nBelveal, L.D., Charting Commodity Market Price Behavior, 2nd ed., Dow\nJones-Irwin, Homewood, IL, 1985.\nBernstein, J., The Handbook of Commodity Cycles. A Window on Time,\nJohn Wiley & Sons, New York, 1982. Bernstein, P., Against the Gods, John\nWiley & Sons, New York, 1996.\nBlumenthal, E., Chart for Profit Point & Figure Trading, Investors\nIntelligence, Larchmont, NY, 1975.\nBolton, A.H., The Elliott Wave Principle. A Critical Appraisal, Monetary\nResearch, Hamilton, Bermuda, 1960.\nBressert, W.J., and J.H. Jones, The HAL Blue Book. How to Use Cycles with\nan Over-Bought/Oversold and Momentum Index for More Consistent\nProfits, HAL Market Cycles, Tucson, AZ, 1984.\nChicago Board of Trade, CBOT Dow Jones Industrial Average and Futures\nOptions, Chicago, 1997.\nCohen, A.W., How to Use the Three-Point Reversal Method of Point &\nFigure Stock Market Trading, 8th rev. ed., Chartcraft, Larchmont, NY,\n1982.\nCootner, P.H., Ed., The Random Character of Stock Market Prices, MIT\nPress, Cambridge, 1964.\nde Villiers, V., The Point and Figure Method of Anticipating Stock Price\nMovements. Complete Theory and Practice, Windsor Books, Brightwaters,\nNY, orig. 1933, reprinted in 1975.\nDewey, E.R., and O. Mandino, Cycles, the Mysterious Forces That Trigger\nEvents, Manor Books, New York, 1973.\nDobson, E.D., Understanding Fibonacci Numbers, Trader Press,\nGreenville, SC, 1984.\nDorsey, T.J., Point & Figure Charting, John Wiley & Sons, New York,\n2001.\nDreman, D., Contrarian Investment Strategy, Simon & Schuster, New York,\n1974.\nDunn, and Hargitt, Trader's Notebook. Trading Methods Checked by\nComputer, Dunn & Hargitt, Lafayette, IN, 1970.\nDunn, and Hargitt, Point and Figure Commodity Trading. A Computer\nEvaluation, Dunn & Hargitt, Lafayette, IN, 1971.\nDu Plessis, J., The Definitive Guide to Point and Figure, Harriman House\nLtd., Hampshire Great Britain, 2005.\nElliott, R.N., The Major Works of R.N. Elliott, R. Prechter, Ed., New\nClassics Library, Chappaqua, NY, 1980. Emery, W.L., Ed., Commodity Year\nBook, Commodity Research Bureau, Jersey City, NJ, annually.\nFrost, A.J., and R.R. Prechter, Elliott Wave Principle, Key to Stock Market\nProfits, New Classics Library, Chappaqua, NY, 1978.\nGalbraith, J.K., The Great Crash 1929, Houghton Mifflin, Boston, 1961.\nGann, W.D., How to Make Profits in Commodities, rev. ed., Lambert-Gann\nPublishing, Pomeroy, WA, orig. 1942, reprinted in 1976.\nGranville, J.E., New Strategy of Daily Stork Market Timing for Maximum\nProfits, Prentice-Hall, Englewood Cliffs, NJ, 1976.\nHadady, R.E., Contrary Opinion. How to Use it For Profit in Trading\nCommodity Futures, Hadady Publications, Pasadena, CA, 1983.\nHurst, J.M., The Profit Magic of Transaction Timing, Prentice-Hall,\nEnglewood Cliffs, NJ, 1970.\nJiler, W.L., How Charts Can Help You in the Stock Market, Trendline, New\nYork, 1962.\nJiler, H., Ed., Guide to Commodity Price Forecasting, Commodity Research\nBureau, New York, 1971. Jorion, P., Value at Risk, John Wiley & Sons, New\nYork, 1996.\nKaufman, P.J., Commodity Trading System", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 260}
{"text": "Pasadena, CA, 1983.\nHurst, J.M., The Profit Magic of Transaction Timing, Prentice-Hall,\nEnglewood Cliffs, NJ, 1970.\nJiler, W.L., How Charts Can Help You in the Stock Market, Trendline, New\nYork, 1962.\nJiler, H., Ed., Guide to Commodity Price Forecasting, Commodity Research\nBureau, New York, 1971. Jorion, P., Value at Risk, John Wiley & Sons, New\nYork, 1996.\nKaufman, P.J., Commodity Trading Systems and Methods, Wiley, New\nYork, 1978.\nKaufman, P.J., Technical Analysis in Commodities, John Wiley & Sons,\nNew York, 1980. Kirkpatrick, C.D., and J.R. Dahlquist, Technical Analysis,\nFT Press, Upper Saddle River, NJ, 2007. MacKay, C., Extraordinary\nPopular Delusions and the Madness of Crowds, Three Rivers Press, New\nYork, 1980.\nMagee, J., Winning the Mental Game on Wall Street, 2nd ed., W.H.C.\nBassetti, Ed., St. Lucie Press, Boca Raton, FL, 2000.\nMagee, J., and W.H.C. Bassetti, Introduction to the Magee System of\nTechnical Analysis, St. Lucie Press, Boca Raton, FL, 2002.\nMandelbrot, O., “A MultiFractal Walk Down Wall Street,” Scientific\nAmerican, February 1999, June 1999, 280, 70-73.\nMcMillan, L.G., Options as a Strategic Investment, New York Institute of\nFinance, New York, 1993.\nMurphy, J.J., Technical Analysis of the Futures Markets, New York Institute\nof Finance, New York, 1986. Natenberg, S., Option Volatility and Pricing\nStrategy, rev. ed., Probus Publishing Company, Chicago, 1994.\nNiederhoffer, V., The Education of a Speculator, John Wiley & Sons, New\nYork, 1997.\nNison, S., Japanese Candlestick Charting Techniques, New York Institute\nof Finance, New York, 1991. Nison, S., Beyond Candlesticks, John Wiley &\nSons, New York, 1994.\nO'Neil, W.J., How to Make Money in Stocks, 2nd ed., McGraw-Hill, New\nYork, 1995.\nPatel, C., Technical Trading Systems for Commodities and Stocks, Trading\nSystems Research, Walnut Creek, CA, 1980.\nPring, M., Technical Analysis Explained, 2nd ed., McGraw-Hill, New York,\n1985.\nPring, M.J., Technical Analysis Explained, 3rd ed., McGraw-Hill, New\nYork, 1991. Schannep, J., Dow Theory for the 21st Century, John Wiley &\nSons, New York, 2008.\nSchultz, J.W., The Intelligent Chartist, WRSM Financial Services, New\nYork, 1962.\nSchwager, J.D., A Complete Guide to the Futures Markets. Fundamental\nAnalysis Technical Analysis, Trading Spreads and Options, John Wiley &\nSons, New York, 1984.\nSchwager, J.D., Market Wizards, HarperBusiness, New York, 1990.\nSchwager, J.D., The New Market Wizards, HarperBusiness, New York,\n1992.\nSchwager, J.D., Schwager on Futures, Technical Analysis, John Wiley &\nSons, New York, 1996. Shibayama, Z., Zen Comments on the Mumonkan,\nHarper and Row, New York, 1974.\nSklarew, A., Techniques of a Professional Commodity Chart Analyst,\nCommodity Research Bureau, New York, 1980.\nTeweles, R.J., C.V. Harlow, and H.L. Stone, The Commodity Futures Game\n—Who Wins?—Who Loses?— Why? 2nd ed., McGraw-Hill, New York,\n1974.\nVince, R., The Handbook of Portfolio Mathematics, John Wiley & Sons,\nNew York, 2007.\nVodopich, D.R., Trading for Profit with Precision Timing, Precision Timing,\nAtlanta, GA, 1984. Wilder, J.W., New Concepts in Technical Trading\nSystems, Trend Research, Greensboro, NC, 1978.\nWilliams, L.R., How I Made $1,000,000 Trading Commodities Last Year,\n3rd ed., Conceptual Management, Monterey, CA, 1979.\nZieg, K.C., Jr., and P.J. Kaufman, Point and Figure Commodity Trading\nTechniques, Investor's Intelligence, Larchmont, NY, 1975.\nZweig, M., Winning on Wall Street, Warner Books, New York, 1986.\nIndex\nA\nABC Vending Corp., 455, 576, 579\nAbsolute certainty, 275\nAccelerating Downward Trend, 68\nAccumulation, 14, 17, 43, 44, 107, 157, 159, 168, 184, 241, 245, 265, 32,\n538, 542, 595\nPattern, 73, 401\nAction Industries, 472, 576, 579\nActivity, see Volume\nActs of God, 12, 248\nAcute Triangle, 79-80\nAdvisors, 252, 268, 310\nADXR Indicator, 595\nAgricultural commodity, 247-248\nAIQ Trading Expert Pro, 531-532\nAmazon, 2 , 335-336, 358, 47 , 563, 573, 579\nAMD, 475, 57 , 579\nAmerican Locomotive, 63, 163, 433, 566, 570, 575, 580\nAmerican Stock Exchange (AMEX), 271, 309, 311, 312, 316, 349, 494,\n524, 616\nApex, 80, 83, 84, 8 , 88, 94, 9 , 99-100, 122, 128, 142,\n145, 153, 201, 203-205, 209, 398-400, 404, 408, 412, 423, 440, 443, 596\nApex of Symmetrical Triangle, 414\nAppel, Gerald, 542\nApple Computer Inc (APPL), 135, 366, 478-479, 577 Appreciated portfolio,\nprotecting profits in, 285-286 Arbitrage, 344, 596\nArea Gap, see Common Gap\nArea Pattern, 8, 90, 145, 176, 184, 186, 198, 202, 221, 261, 264, 319, 423,\n439, 596, 601, 604, 605, 611-614, 617-618\nArea Reversal Pattern, 599\nArithmetic paper, 8, 229\nArithmetic scale, 8, 58, 69, 143, 211-216, 596\nArms CandleVolume charting, 551-553\nArms Index, 545, 548-549\nAroon, 538, 542\nAroon Down, 538, 542\nAroon Oscillator, 538\nAroon Up, 538, 542\nAscending Channel, 596\nAscending Formation, 99\nAscending Pattern, 98-99\nAscending Trend Channels, 596, 599, 613\nAscending Trendline, 596, 618\nAscending Triangle, 84-89, 94-95, 97-98, 114-115,\n122, 135-136, 141, 147, 161, 166, 177-178, 189, 204, 294, 373-375, 395,\n399, 408, 428, 434, 439-441, 465, 472, 596, 613-614\nAsset allocation, 275, 278, 280-282, 491\nAstrodata Inc. (ADA), 46, 576, 581\nAt-the-money, 283, 596\nAutomated trendline, 421-425, 540\nAverage(s), 4, 17, 19, 26, 41, 50, 99, 106, 112, 135, 145, 151, 181, 313, 34 ,\n393-394, 428, 436, 445, 459, 481, 482, 596, 600\ndiscount, 12\nDow, see Dow averages\ngaps in, 187\ninvestor, 192 moving, see Moving averages support and resistance in, 206\ntrendlines in, 243\nAverage Directional Index (ADX), 538, 542, 595 Average True Range\n(ATR), 358-359, 538\nAveraging Cost, 442, 485, 596-597\nAvnet Electronics Corp., 448, 459, 575, 581\nAxis, 196, 205, 597\nB\nBalanced program, 481-486, 597\nBandwidth, 538, 598\nBar Chart, 31, 266, 304, 531, 532, 545, 550, 552, 554, 558, 597\nBaruch, Bernard, 265\nBasic Trendlines, see Trendlines\nBasing Points (BP), 31-40, 198, 239, 256, 258, 260, 299-300, 308, 314,\n326, 328, 340, 357-359, 362-366, 368-370, 404, 414, 480, 504, 506, 574,\n581, 597\nBasket Trades,", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 261}
{"text": "vnet Electronics Corp., 448, 459, 575, 581\nAxis, 196, 205, 597\nB\nBalanced program, 481-486, 597\nBandwidth, 538, 598\nBar Chart, 31, 266, 304, 531, 532, 545, 550, 552, 554, 558, 597\nBaruch, Bernard, 265\nBasic Trendlines, see Trendlines\nBasing Points (BP), 31-40, 198, 239, 256, 258, 260, 299-300, 308, 314,\n326, 328, 340, 357-359, 362-366, 368-370, 404, 414, 480, 504, 506, 574,\n581, 597\nBasket Trades, 389-390, 597\nBearish Move, 391, 451\nBearish Trend, 310, 482\nin Industrial Rayon, 446\nin Lorillard, 447\nBear Market, 13, 15, 225, 242, 264, 293, 299, 386, 413,\n481, 509, 511-512, 597,602, 611\nsignal, 519-521\nBear Market Bottom in Socony-Vacuum, 89, 109\nBear Market Rallies, 61, 63\nrising wedges in, 144\nBear Market Selling Climax, 608\nBear Raiding, 168\nBent Neckline, see Neckline (NL)\nBent neckline, 138, 444, 597\nBeta, 310, 321, 322, 342-343, 346, 597\ncoefficient, 597\nBitcoin, 326-328\nBlack Scholes model, 266, 273, 531\nBlock Trades, 97-99, 105, 597\nBlow-Off, see Climactic Top\nBlue Chips, 41, 280, 301, 320, 353, 43 , 598\nBlue Parallel, 373-374, 378-380, 410, 598\nBlue Trend, 373, 375-379\nBlue Trendline, 373-378, 578, 598\nBollinger Bands (BB), 266, 267, 53 , 561-563, 598\nBollinger, John, 533, 561\nBona fide breakout, 600\nBond\nfutures for asset allocation, 280-282\ntraders and investors, 496\nBook value, 4, 5, 175, 599\nBottom, 599\nKilroy, see Head-and-Shoulders Bottom\nPatterns, 5 , 58, 117, 161, 458\nTrendlines, 224, 273, 414\nBoundary, 54, 78, 599\nBowl Pattern, see Rounding Bottoms\nBracketing, 599\nBreakaway gaps, 4 , 63, 91, 142, 162, 173-174, 177-182, 186, 202, 254,\n258, 410, 412, 417, 423, 470, 599, 607\nBreaking neckline, 47-49\nBreakout failure, 603\nBreakout Gap, 126, 175, 184\nsignals, 185\n“Breakout of dormancy,” 73\nBreakouts, 88, 108, 161, 418, 551, 599 decisive, 221, 37 , 378 downside,\n95, 99, 398, 408 premature, 85, 108 pullbacks, 224 from Right-Angle\nTriangles, 100 upside, 89, 99, 402, 408\nBroadening Bottoms, 135\nBroadening Formations, 121-122, 599, 608-609 volume during, 122-128\nBroadening Pattern, 604\nBroadening Price Formation, 130-131\nBroadening Price Patterns, 121, 122, 126, 131, 136\nBroadening Tops, 122, 124, 125, 129, 133, 309, 400, 404, 408, 617\nin Dow-Jones Industrial Average, 444-445\nOrthodox, see Orthodox Broadening Top\nBroad market, 243\nBroad market background, 264\nBroad Market Trend, 243\nBrokerage firms, 270\nBrokerage houses, 526-527\nBrokers, 145, 146, 268, 269, 313, 347\nBrooker, Brian, 27\nBrunswick Corporation, 450, 575, 581\nBullish Market, 321, 460, 481, 483\nBullish Move, 391, 406\nBull Market, 13-19, 23, 70, 226, 241, 264, 293, 299, 396-39 , 481, 492, 493,\n514, 518, 595, 599, 602 in commodities, 260 dynamic phase of, 157\nPrimary, see Primary Bull Market\nPublicker, 116\nBull Market Advance, 159, 225, 294\nBull Market Concomitants, 159\nBull Market High, 52\nBull Market Peaks, 114\nBull Market Reaction, 219\nBull Market Top, 53, 86, 240\nof Head-and-Shoulders Form, 50\nSymmetrical Triangle Bottom, 80\nSymmetrical Triangle Reversal, 78\nin U.S. Steel, 127\nin Westinghouse, 96\nof Westinghouse Electric, 47\nBull Market Trend, 237\nof General Motors, 230\nBull Market Trendlines, 229\nBull signal, 513-514\nBull trap, 139, 148, 326, 32 , 420, 473\nBull Trend reaffirmation, 515-516\nBurndy Corporation, 449, 575, 582\nBuy-and-Hold investor, 26, 27\nBuying at the top, 487\nC\nCall option, 599, 611\nCandlestick charts, , 8, 182, 266, 267, 553 Candlesticks, 551, 599\nCanny investor, 278\nCANSLIM system, 316\nCapital, 489 application in practice, 491-494 to use in trading, 489-490\nCash, differences with future transactions, 277 Catastrophic Risk, 503\n“Cats and dogs,” 15, 320, 493, 517, 599\nCaveats, 330-331\nof Moving Averages, 422\nCBOT® DJIASM Index futures, 276, 282\nCerro Corporation, 456, 576, 582\nChaff, 270\nChaikin Money Flow (CMF), 538\nChaikin Oscillator, 538\nChandelier Exit, 359, 537\nChande Trend Meter (CTM), 538 Channel, 599\nChart(s), 15, 19, 261, 267, 269, 304, 505, 599, 605 Ascending Triangle, 399\nassociated dry goods winds up, 396 Broadening Tops, 400, 408 candlestick,\n, 8, 182, 266, 26, 553 Complex or multiple Head-and-Shoulders, 403 daily\nchart in Northern Pacific, 412 daily chart of Lehigh Valley R. R, 407\ndecorating graphic charts, 304 Diamond, 409\nDiamond Pattern in American Can, 404 Double Tops and Bottoms, 409\nDow Theory, 393-399\nFlags and Pennants, 410-411\nGaps, 411-413\nGulf, Mobile, and Ohio builds beautiful Wedge, 405\nHead-and-Shoulders Bottom, 401-403 Head-and-Shoulders Top, 400-401 of\nNew York Central, 175\nOne-Day Reversals, 410\nPennant in Martin-Parry, 406 Rectangles, 408-409\nRectangles in Remington Rand, 401 Right-Angled Broadening Formations,\n409 Right-Angle Triangles, 408 rounding Bottom in 1945, 397\nRounding Tops and Bottoms, 403-406 Spiegel's Bear Market, 262 of stocks,\n163\nSupport and Resistance, 414 Symmetrical Triangle in allied stores, 398\nSymmetrical Triangles, 406-408 Trendlines, 414\ntrendlines in American steel foundries, 413 types of scales, 8-9\nWedges, 409-410\nwide Descending Triangle of, 262\nChart analysis, 304, 539-540 computer for, 304-305\nChart analysts, 259, 266 Commodity Research Bureau Index, 254 trading\nfutures, 259-260\nChicago Board of Trade (CBOT®), 271\nChicago Board Options Exchange (CBOE), 273, 494\nChicago Mercantile Exchange, 276-27 , 312\nChicago, Milwaukee, St. Paul and Pacific, 440 Chrysler, 436\nClassical technical analysis, 4 Clean-cut Triangle, 82\nClean-Out Day, see Selling Climax\nClimactic Top, 59 , 600\nClimax Day, see One-Day Reversal\nClimax, Selling, see Selling Climax Close-only charts, 267\nClosing gap, 171-173\nClosing prices, 18, 600\nClosing the gap, 600, 601\nCloud, 269\nCoil, see Symmetrical Triangle\nColby, Robert, 21\nCommission, 600 Commitments, 417-418\nCommodity, 276\nagricultural, 247-248\nmarket, 615\ntraders, 298\nCommodity Channel Index (CCI), 538\nCommodity charts, technical analysis of application of Edwards and\nMagee's methods, 252-259\nchart analyst trading futures, 259-260 rocket scientists, 249-250\nTurtles, 250-252\n21st-century perspective, 249\nvariety of method", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 262}
{"text": "see Symmetrical Triangle\nColby, Robert, 21\nCommission, 600 Commitments, 417-418\nCommodity, 276\nagricultural, 247-248\nmarket, 615\ntraders, 298\nCommodity Channel Index (CCI), 538\nCommodity charts, technical analysis of application of Edwards and\nMagee's methods, 252-259\nchart analyst trading futures, 259-260 rocket scientists, 249-250\nTurtles, 250-252\n21st-century perspective, 249\nvariety of methods, 259\nCommon Gap, 175-17, 184, 596, 600\nComparative relative strength, 600\nComplete Basing Points Procedure, 368-370 Complex Formations, 59\nComplex Head-and-Shoulders Pattern, 59, 403, 600, 602, 610\nEN, 60\nragged Kilroy Bottom, 61 strong movement toward lower interest rates\nevident, 60\nComposite Average, 600\nComposite Leverage, 498, 600\nComposite Leverage Index, 492, 493\nCompound Annual Growth Rates (CAGR), 32\nComputer, 265\nfor charting analysis, 304-305 technology, 267-268\nComputer software packages, 267\nConant, James Bryant, 289\nConfirmation, 16-19, 600-601\nCongestion, 151, 601\nCongestion Formations, 115, 175-176\nConservative investing, 310-311\nConsolidating, 151\nConsolidation Formation, 110, 151\na, 156\nBull Flag in February and Bear Flag in April 1936 compact type of price\n“Congestion,” 158 Consolidation Pattern, 167 down-sloping, converging\nprice formation, 157 flag pictures on weekly and monthly charts, 158-159\nFlags and Pennants, 151-153\nFlag seemed for several weeks, 163\n“Half-Mast” Pattern, 161\nHead-and-Shoulders Consolidations, 160-162, 164 measuring formula, 154-\n156 modern vs. old-style markets, 168-169 rectangular Consolidations, 159\nreliability of Flags and Pennants, 156-157\nConsolidation Formation (Continued)\nscallops, 162-167\nseries of Flag-type Consolidations, 159 stock make long series of small\nConsolidation Patterns, 155\nConsolidation Head-and-Shoulders, see Head-And-Shoulders Pattern\nConsolidation Pattern, 79, 94-9 , 156, 161, 167, 190, 392, 600, 601, 604\nConsolidations of Rectangle, 159\nConstruction of index shares and similar instruments, 311-312\nContinuation Formation, see Consolidation Formation\nContinuation Gap, see Runaway Gap Continuation-of-Trend Pattern, 137\nContinuation Pattern, see Consolidation Pattern Control Data Corp (CDA),\n462, 576, 583\nControlling risk, 351, 499, 503\nConvergent Pattern (Trend), 601\nCopper Range Co., 452, 576, 583\nCoppock Curve, 538\nCorrection, 601\nCorrective trends, 226-227\nCorrelation Coefficient, 500, 538\n“Cost of carry,” 276-279\nCosts, 390\nCovering the gap, see Closing the gap\n“Cradle,” 205, 601\n“Cradle point,” 440, 456\nCrossovers, 422-424\nCrucible Steel Co. of America, 45 , 576, 583\nCyber trader, 316\nCyclical approach, 3\nD\nDaily Range, 148, 173, 508, 601\nDampened risks, 313\nDanaher Corp., 558\nDay-to-day chart analysis, 196\n“Day traders,” 31, 166, 168, 298, 302\nDay trading, 168, 298\nDecisionPoint Price Momentum Oscillator (PMO),\n538\nDefinite warning, 428\nDegree of fluctuation, 283, 345\nDelaware, Lackawanna And Western, 432 “Delivery,” 276\nDell, 473-474\nDelphic Options Research, 523, 529\nDemand, 70, 86, 98, 112, 117, 601\nDemand Line, 98, 104, 176, 202\nDescending Channel, 601\nDescending Trend, 603\nDescending Trend Channel, 374-375, 599, 601, 613, 619 Descending\nTrendline, 601, 603\nDescending Triangle, 92, 97-99, 122, 136, 175, 294, 408,\n601-602, 613-614, 617\nDetrended Price Oscillator (DPO), 538 Diagonal Movements, 423\nDiamond, 74, 12 , 129, 130, 137-139, 602\nPattern, 610\nReversal Formation, 128, 137-138, 409 DIAMONDS™ (DIA), 271, 274,\n299, 312, 317, 323, 350, 351, 390 Directional tendency, 110 Discipline,\n260, 28 , 501, 542 Dissecting Dow Theory, 499 “Distance away” criteria,\n194, 203 Distribution, 43, 44, 117, 136, 168, 602 frequency, 500 Line, 538,\n542 Pattern, 90 planned, 98\nDistribution period, 15, 17 Divergence, 4, 99, 212, 510, 511, 513, 600-602\ndefinite, 166\nnegative, 610 Divergent Pattern, 206, 602 Divergent Trend, 617 Divergent\nTrend Channel, 376, 377, 379 Diverging boundary lines, 100\nDiversification, 41, 298, 313, 319, 389, 390, 481-486, 602 Dividends, 23,\n194, 27 , 294, 297-298, 30 , 310-311, 315, 341, 345, 348, 361, 419, 469,\n602 Donchian system, 251 Dormant Bottom, 72-74, 602\nDouble Bottoms, 113-115, 118, 409, 602 Double Top, 103-105, 113-115,\n118, 409, 602, 617\nat Primary Trend Reversals, 118 Double trendlines, 222-223, 603 Dow\naverages, 12\nbasic tenets, 12-14 major trend phases, 14-16 principle of confirmation, 16-\n19 tide, wave, and ripple, 14 Dow Index futures, 27 , 287 Dow Industrial\nAverage (DIA), 481 Dow interpretation, 507-508 Dow-Jones Industrial\nAverage (DJIA), 6, 41, 146, 311,\n444-445, 454, 486, 600, 603, 606 Dow-Jones Industrial Index differences\nbetween cash and futures, 277 Dow Index futures, 277 exercising option,\n284 exploiting market reversals, 285 fungibility, 276-277 futures and\noptions, 275, 284 investment and hedging strategies, 276 investment uses of\nDow Index futures, 279-282 marking-to-market trading, 276 option\npremiums, 283 options on Dow Index futures, 282-283 option spreads in\nhigh-or low-volatility markets, 286-287\nperspective, 287\nportfolio yields improvement, 286 profits in rising markets, 284-285\nprotecting profits in appreciated portfolio, 285-286\nsettlement of futures contracts, 276 stock index futures to control exposure\nto market, 277-278\nvolatility, 283-284 Dow-Jones Stock Composite, 12 Dow-Jones\nTransportation Average, 603, 612 Dow-Jones Utility Average, 600, 603, 618\nDown Channel, see Descending Channel Down-slanting boundary line, 79-\n80 Downtick, 603 Downtrends, 143, 202, 242, 423, 429\nIntermediate, see Intermediate downtrends Major, see Major downtrends\nPrimary, see Primary downtrends\nDow principles, 16, 17, 23-24\nDow Theory, 3, 11, 18, 21-23, 28-29, 31, 41, 7, 207, 259,\n264, 313, 365, 381, 393-399, 50 , 533, 600, 601 in 20th and 21st centuries,\n26-27 Bear Market signal, 519-521 bull signal, 513-514\nBull Trend reaffirmation, 515-516 closing price levels of Dow-Jones\nIndustrial and Rail averages, 509, 510, 511, 512, 514 failure to confirm,\n510-511 final up-thrust, 519 first correction,", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 263}
{"text": "ciples, 16, 17, 23-24\nDow Theory, 3, 11, 18, 21-23, 28-29, 31, 41, 7, 207, 259,\n264, 313, 365, 381, 393-399, 50 , 533, 600, 601 in 20th and 21st centuries,\n26-27 Bear Market signal, 519-521 bull signal, 513-514\nBull Trend reaffirmation, 515-516 closing price levels of Dow-Jones\nIndustrial and Rail averages, 509, 510, 511, 512, 514 failure to confirm,\n510-511 final up-thrust, 519 first correction, 514-515 first severe test, 508-\n510 five years of Dow interpretation, 507-508 intermediate trend investor,\n23-26 leaving investor in doubt, 23 Rails falter, 516-517 signs of major\nturn, 511-513 spring of 1946, 517-518 utilization, 507 Dow Theory Line,\n151 Dow Theory replacement with John Magee's Basing Points Procedure\nDow-Jones Industrials (1924-1934), 39-40 fractal nature of market, 31\ninteresting charts ever made of Dow-Jones Industrials, 40 trades made by\nMagee Basing Points Procedure,\n33-37\n2008 top in industrials, 38 Drawdown, 498-499, 603 Dreman, David, 280,\n496 Dunn and Hargitt, 251\nE\nEagle-Picher Lead, 436 “Earnest money,” see Futures “margins” Ease of\nMovement (EMV), 538 Economic tide, 264\nEdwards and Magee's methods, 252-258 stops, 258-259\nElectronic marketplaces, 269\nElectronic portfolio, 270\nElliott Wave Theory, 6, 528-531\nEmotion-driven markets, 266\nEnd Run, 83, 204, 205, 603\nEquilibrium Line, 609\nEquilibrium Market, 603\nEquivolume charting, 550\nresult, 551-553\ntechnique, 551\nEvaluative Index, 39 , 448, 482-483\nEx-Dividend, 90, 173, 175, 361, 443, 603\nEx-dividend gaps, 174, 603\nbreakaway gaps, 177-182 common or area gap, 175-177 continuation or\nrunaway gaps and measuring rule, 182-184\nexhaustion gaps, 185-186 two or more runaway gaps, 184-185\nExaggerated leverage, 272\nException, 381\nExchange-traded fund (ETF), 271, 317, 322, 603\nExchange Traded Notes (ECNs), 268, 321\nExecution of buys, 376-377\nExercise, 283, 325, 603 exercising option, 284 price, 272, 282, 494\nExhaustion Gap, 184, 185-186, 258, 410, 603-604, 607 Experimental lines,\n224\nExpiration, 271, 284, 604\nExponential Moving Average (EMAs), 422, 53 , 542, 609\nExponential Smoothing, 604 “Extent of decline” criterion, 193 Extent of\npenetration, 221\nExtraordinary Risk, 503\nF\nFacebook, 332\nFact chart analysis, 266\nFailure to confirm, 510-511, 513-514, 515\nFaith, Curtis, 251\nFalling Wedge, 132, 139, 142-143, 410, 604\nFalse Breakout, 604, 612\nFalse moves, 48, 66, 81, 89, 108, 179, 487\nFalse Signal, 66, 88, 129, 149, 266, 479, 604\nFan lines, 217, 218, 220, 22, 309, 604\nFan principle, 226-227\nFansteel Metallurgical, 434, 448, 585\nFilling the gap, see Closing the gap\nFinal up-thrust, 519\nFinance theory and practice developments in, 271 futures on indexes, 273-\n274\nMPT, 275\noptions, 271-272 options on futures and indexes, 274 options pricing\nmodels and importance, 273\nFinance theory and practice (Continued) quantitative analysis, 272-273\nwonders and joys of investment technology, 275\nFin de siecle, 139\nFirst correction, 514-515 First severe test, 508-510\nFive-Point Reversal, see Broadening Pattern Flag-type Consolidation, 411\nFlag, 151-159, 258, 410-411, 604 Flag Consolidation, 15 , 179, 392, 465\nFlag of mid-April, 175 Flat-Topped Broadening Formation, 136-137, 163\nFlat-Topped Broadening Pattern, 151 Flat-Topped Price Formation, 177\nFloating Supply, 73, 107, 117, 145, 315, 341, 604 Flying Tiger Corp, 471,\n586\nForce Index, 538 Forecasting methods, 11, 176, 421, 604 Formation, see\nArea Pattern\nFormula measurement, 154-156, 160, 164, 596, 608 Fractal nature of\nmarket, 31\nDow-Jones Industrials (1924-1934), 39 interesting charts ever made of\nDow-Jones Industrials, 40\ntrades made by Magee Basing Points Procedure, 33-37\n2008 top in industrials, 38\nFront-Month, 605\nFundamental analysis, 3, 6, 91, 266, 328, 605\nessence of, 528-531 Funds tracking indexes, 603 Fungibility, 276-277\nFutures “margins,” 277 Futures contract, 274, 276-27 , 282, 283, 349, 494\nFutures options, 283, 28 , 313\nto participate in market movements, 284 price of, 283\nFuture transactions, differences between cash and, 277\nG\nGains and losses, percentage, 496 Galbraith, John Kenneth, 326 Gamblers\nAnonymous, 302 Gaps, 171, 411-413, 423, 605\nApril-June Rectangle on 1945 chart of “AW,” 172 in averages, 187 closing\ngap, 171-173 daily chart of Blaw-Knox, 176 ex-dividend gaps, 174-186\nIsland “shakeouts, 181 Island in “PA,” 183 Island Reversal, 186-187\nmonthly chart of Zenith Radio, 175\nPanic Declines produce large Runaway Gaps, 178 small Island in right\nshoulder of Head-and-\nShoulders Top, 180\nSMC, 180\nTLT, 183\nGates, Bill, 244\nGeneral Motors, 41, 99, 229, 230, 586, 598 straight-line Bull Market Trend,\n230\nGeneral Semantics of Wall Street, The, 269\nGeneral Steel Industries, Inc. (GSI), 459, 586 Gilt-edged securities, 598\nGimlet-eyed investor, 270\nGoogle, 321, 331, 339, 340, 343, 389, 586\nGranite City Steel, 430-431, 586\nGraph, see Chart\n“Graphic Stocks,” 437\nGreat Crash, The (1929), 326\nGreenspan, Alan, 248, 281\nH\n“Hair splitting” theory, 521\n“Half-Mast” patterns, 154, 161, 604, 608\nHandbook of Portfolio Mathematics (Vince), 618 Head-and-Shoulders\nBottom, 55, 57-59, 61-63, 161, 336, 395, 401-403, 58 , 605, 60 , 608\nHead-and-Shoulders Consolidation, 160-162, 164, 605 Head-and-Shoulders\nFormation, 48, 88, 373\nHead-and-Shoulders formula, 100, 162 Head-and-Shoulders Pattern, 4 , 13 ,\n241, 392, 414,\n454, 605-606, 608, 610, 615\nHead-and-Shoulders Reversal Pattern, 211 Head-and-shoulders to Dow\nTheory, 55 Head-and-Shoulders Top, 44, 45, 46, 48, 54, 57-59, 63, 75, 7 ,\n103, 108, 118, 160, 161, 180, 198, 202, 241, 24 , 294, 35 , 394, 400-401,\n449, 454, 455, 466, 602, 605, 606, 608, 617\nDaily chart of Chicago, 46 hypothetical daily stock chart, 45 starting in\nMarch, “HUM,” 46 variations in, 49-52\nHeavy Volume, 355, 356, 363, 398, 402, 435, 605, 606 Hedging, 137, 240,\n246, 276, 279, 28 , 312, 606 Hedging strategies using CBOT® DJIASM\nfutures contract, 276\nHigh-risk stocks\nhope springs eternal, 332-340\nmanaging tulipomanias and internet frenzies and Bitcoin, 326-328\nmultitudinous lessons in Microsof", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 264}
{"text": "cago, 46 hypothetical daily stock chart, 45 starting in\nMarch, “HUM,” 46 variations in, 49-52\nHeavy Volume, 355, 356, 363, 398, 402, 435, 605, 606 Hedging, 137, 240,\n246, 276, 279, 28 , 312, 606 Hedging strategies using CBOT® DJIASM\nfutures contract, 276\nHigh-risk stocks\nhope springs eternal, 332-340\nmanaging tulipomanias and internet frenzies and Bitcoin, 326-328\nmultitudinous lessons in Microsoft, 326 techniques for management of\nrunaway issues, 328-332\nHigh-volatility markets, option spreads in, 286-287 Higher priced stocks,\n353\nHistorical Data, 606\nHook Day, 606\nHorizontal Channel, 213, 606\nHorizontal Congestion Pattern, 178, 189\nHorizontal Line Formations, 103, 207\nHorizontal Movements, 423\nHorizontal pattern boundary, 177\nHorizontal Trendline, 256, 333, 606\nHull, Blair, 26 , 531, 611\nHybrid Head-And-Shoulders, 606\nI\nIchimoku Cloud, 537\nI C Industries (ICX), 49\n“Ideal” trend, 197\n“Implied volatility,” 284\nIn-the-money, 283\nIndexes, , 19, 243, 261, 271, 310, 312, 314, 341, 343 funds tracking, 603\nfutures on, 273-274\noptions on futures and, 274\nIndex funds, 299, 390\nIndex futures for asset allocation, 280-282\n“Indexing,” 310-311\nIndex Shares, 302, 310-312, 313, 390, 447\nIndividual stocks, 26, 41, 55, 112, 145, 146, 206, 243, 342, 44 , 454, 484,\n493, 495\nIndustrial Average, 11, 12, 13, 16, 18, 20, 23, 393, 444, 446, 454, 514, 515,\n518, 600, 603\nIndustrial Rayon Corporation, 446, 587\nInflationary and deflationary movements, 481, 587\nInformation revolution, 265-266, 268, 270-271\nInitial public offering share (IPO share), 327-328, 607\nInside Day, 606\nInsiders, 41-42, 168, 322, 32 , 606\nInspiration Copper, 429\nIntel, 319, 474, 475, 587\nIntermediate Bottom, 64, 8 , 193, 202, 294, 384, 386, 414\nIntermediate downtrends, 225-226\nIntermediate Reversals, 59, 200, 206\nIntermediate Support, 197, 198, 226, 384, 385\nIntermediate Support Range, 198\nIntermediate Swing, 13, 50 , 508\nIntermediate Tops, 200, 211, 294, 361, 386, 414, 513\nIntermediate Trend, 14, 41, 216, 224, 296, 380, 515, 519, 590, 606, 614\ninvestor, 23-26\nIntermediate Trendlines, 208, 226, 229\nIntermediate Uptrend, 194, 212, 213, 219, 222, 225\nIntermediate Up Trendline (IUT), 52, 176, 211, 212, 21 , 220-221, 224\nInternet-age markets, 351\nInternet, 265, 268-269, 532\nInternet Age, 269, 351, 393, 494\nInternet frenzies and Bitcoin, 326-328\nInternet technical analysis sites, 305, 531-533\nIntraday gaps, 173\nInverted Bowl, see Rounding Top\nInverted Triangles, 100, 121, 135-136\nInvestment advancements in investment technology, 271 bond and index\nfutures for asset allocation, 280-282\ndevelopments in finance theory and practice, 271-275\nfinance theory and practice, 271-275 futures and options on Dow-Jones\nIndustrial Index, 275-287\nincreasing exposure with futures, 280 investment-oriented sites, 524-527\ninvestment/information revolution tools, 265 portfolio protection, 279-280\nstrategies using CBOT® DJIASM futures contract, 276\nuses of Dow index futures, 279\nInvestor, 297-298, 332, 351 cyber, 270 experienced, 268 gimlet-eyed, 270\nlong-term, 310-311 modern, 244 private, 312 sophisticated, 302 iPod, 479\nIsland Congestion, 186 Island Pattern, 147, 186, 187\nIsland Reversal, 182, 186-187, 60 , 611\nJ\nJohns-Manville's Primary Trend Reversal, 79 Jorion, Philippe, 500, 502,\n524\nJuly-August Flag, 158-159\nK\nKaufman's Adaptive Moving Average (KAMA), 537 Kelly Criterion, 534,\n535\nKeltner Channels, 537\nKey Reversal Days, 147-149\nKilroy bottom, 57-59, 63, 309, 336, 401, 58 , 607 Kovner, Bruce, 35 , 365\nKresge (S.S.) Co., 196, 43 , 588, 591\nL\nLaddering, 607\nLane, George, 615 Lane theorizes, 615 Leisurely pattern, 65-66 Leverage,\n258, 315, 607 Leverage factor, 534-535\nLeverage Space Model, 351, 504, 618\nLeverage Space Portfolios (LSP), 533-536, 607 Libby, McNeill And Libby,\n436\nLimit Move, 258, 607\nLimit Order, 391, 60 , 611 Limit Up, Limit Down, 607\nLinear Moving Averages, 422 Line Chart, see Bar Chart Line in Dow\nTheory, 17-18, 607\nLiquidating, 378-379\nLivingston Oil Company (LVO), 464, 588 Logarithmic scale, 211-216, 229,\n607\nLong-term charts, 9\nLong-term investment problem, 293\nLong-term investor, 293, 29 , 299, 313, 314, 389 strategy and tactics for,\n297-298\nLong-term investor (Continued)\nstrategy of, 299-300\nviewpoint, 310-311\n“Long side” of market, 41\nLorillard, 44 , 588\nLow-volatility markets, option spreads in, 286-287 Lower-priced stocks,\n353\n“Lunatic fringe,” 3\nM\nMacKay, Charles, 325\n“M” Formation, 119, 602\nMagee-type technical analysts, 266\nMagee analyst, 267, 268, 270\nMagee chart analysis, 266, 270, 595\nMagee Evaluative Index (MEI), 19, 300, 485-486, 491,\n495, 503-504\nMagee methodology, 260\nMagee's admonitions, 316\nMagee's Composite Leverage, 499\nMagee's concept of “sensitivity,” 342\nMagee's method, 252-259, 343, 497\nMagee's Sensitivity Index, 342, 354, 497\nMagee's simple-as-pie method, 32\nMajor Bear Market signal, 393\nMajor Bear Moves, 159\nMajor Bear Trend, 15 , 226\nMajor Bull Market, 225\nMajor Bull trendlines, 241\nMajor charts, 9\nMajor Double Tops, 114\nMajor Downtrend, 242, 428-429, 439, 511-512, 519, 576,\n579, 592\nMajor Market Turn, 60\nMajor Reversal, 106, 114, 123, 132-133, 139, 158, 180,\n491, 510, 513-514, 604-605\nMajor Reversal Formation, 66, 114, 123, 186\nMajor Reversal Patterns, 44, 605\nMajor Signals, 394\nMajor Trend, 17-18, 22, 9 , 198-199, 212, 225, 229, 242,\n296, 314, 356, 380-381, 384, 386, 393, 398,\n430, 446, 449, 456, 482, 491, 493, 510, 512, 515, 60 , 612\ngeneral outline of policy for trading in, 380-381 of market, 410-411\nMajor Trend Channels, 242-243\nMajor trendlines, 227\naccelerating uptrend of common stock, 231\nBull Market tops, 240 conservative investment-type utility stock, 232\ndecurving Major Bull Trend of high-grade preferred stock, 231\nhigh-grade food issues, 236\nlow-priced building stock, 235\nMajor Bull Trend, 234\nMajor Downtrends, 242\nMajor Trend Channels, 242-243\nprimary Bear Market, 238\nS&P long-term perspective, 239\nS&P Reagan Crash, 239 speculative oil stock, 233 steel stocks, 234 straight-\nline uptrends in investment oil", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 265}
{"text": "ative investment-type utility stock, 232\ndecurving Major Bull Trend of high-grade preferred stock, 231\nhigh-grade food issues, 236\nlow-priced building stock, 235\nMajor Bull Trend, 234\nMajor Downtrends, 242\nMajor Trend Channels, 242-243\nprimary Bear Market, 238\nS&P long-term perspective, 239\nS&P Reagan Crash, 239 speculative oil stock, 233 steel stocks, 234 straight-\nline uptrends in investment oil, 233 tobacco stocks, 236 trading Averages in\n21st century, 244 trendlines in averages, 243 up-curving trend of\nspeculative motors stock, 230 Major Turn, 121, 167, 226, 242, 290, 483,\n487 signs, 511-513\nMargin, 88, 108, 145, 147, 221, 223, 274, 276, 342, 345,\n367, 445, 492, 495, 535, 607-608 decisive, 48, 57-58, 118, 128 transaction,\n346, 349 use, 345-346\nMarket, 3, 6, 11, 19, 2, 31, 42, 7, 82, 104-105, 121, 139,\n143, 147, 192, 20 , 256, 259, 264, 270, 274, 280, 285, 289, 29, 299, 312,\n315, 32, 383, 42, 48, 493, 505, 507\nDow-Jones Industrials (1924-1934), 39 exploiting market reversals, 285\nfractal nature, 31 indicator, 609\ninteresting charts ever made of Dow-Jones\nIndustrials, 40 marking-to-market, 269-270 marking-to-market trading, 276\ntechnical trading effect on market action, 419-420\ntrades made by Magee Basing Points Procedure,\n33-37\n2008 top in industrials, 38\nMarket on Close, 608\nMarket Order, 29 , 328, 608, 611, 616\nMarket Reciprocal, 49 , 608, 612\nMarket Technicians Association, 499\nMarket Technicians Association of New York\n(MTANY), 6\nMasonite, 431, 575, 588\nMass Index, 538\nMast, 152, 217, 392, 411, 604, 608\nmove, 410\nMaximum drawdown, 2 , 32, 502, 52 , 603\nMaximum retracement, 502\nMcClellan Oscillator, 608\nMcDermott, The Redoubtable Richard, 325, 528 Measuring Formulae, 608\nMeasuring Gap, see Runaway Gap\nMeasuring or Half-Mast Patterns, see Flag\nMeasuring rule, 55, 65, 100, 154-155, 182-184, 392 Mechanical Dow\nTheory, 299\nMechanical systems, 250, 252, 260, 296, 423 Megaphones, 608, 613\nMelon, 194, 609\nMemorex Corp. (MRX), 470\nMetastock 9.0, 531-532\nMike Moody, 545, 556-561\nMining engineers, 326\nMinor Bottom, 88, 91-92, 122-123, 193, 198, 208, 210, 222, 354, 362-363,\n373, 378-379, 386, 403, 413, 414, 41 , 517, 608-609, 616-617\nMinor Bottoms, 123, 208, 222, 361, 363, 373, 386, 413-414, 617\nBasing Points, 362-365\nBasing Points paradigm, 365-366 complete Basing Points Procedure, 368-\n370 narrative of events in chart, 367-368, 371-372 representative case fully\nanalyzed using wave lows and new highs, 370-371\nVariant 2 procedure, 370\nMinor Correction, 209, 363, 386\nMinor Fluctuations, 13, 74, 7 , 99, 129-130, 138, 151, 186, 190\nprocess, 153\nMinor phenomena, 202\nMinor Reaction, 95-96, 115, 172, 181, 186, 362, 39 , 40 , 440, 605\nMinor Reversal, 122-123, 155-156\nMinor Reversal Areas, 157\nMinor Setback, 17, 216, 432, 517\nMinor Swings, 186\nMinor Top, 79-80, 122, 198, 206, 354-355, 361, 363, 373-374, 378, 385,\n414, 439, 444, 513, 616\nBasing Points, 362-365\nBasing Points paradigm, 365-366 complete Basing Points Procedure, 368-\n370 narrative of events in chart, 367-368, 371-372 representative case fully\nanalyzed using wave lows and new highs, 370-371\nVariant 2 procedure, 370\nMinor Trend, 13-14, 82, 144, 229, 290, 386, 410, 50 , 609 Minor Wave\nPattern, 197\nMinor Waves, 13, 223, 509\nMisconceptions, 198-200 Model-driven market, 266, 272 “Models,” 266-26\n, 273\nModern-style markets, 168-169\nModern era development, 271\nModern Portfolio Theory (MPT), 275, 499 Momentum, 43, 49, 184, 326,\n539, 611, 614 Momentum Indicator, 538, 542, 609\nMoney, 41, 249, 253, 265-266, 270, 272, 283, 299, 332, 348, 489-490, 608\nmanagement procedures, 503-504 management rules, 258\nMoney Flow Index (MFI), 538\nsophisticated risk and, 504\nMonthly chart gaps, 171\nMoving Average, 421, 424, 53 , 539, 609, 610\n150-Day Moving Average, 424\n200-Day Moving Average Line, 31, 267, 299, 300,\n31 , 422, 423, 484, 618\n50-Day Moving Average Line, 316, 422, 484, 604 crossovers and\npenetrations, 422-424\nPENTAD Moving Average system from formula research, 424-425\nSensitizing Moving Averages, 422\nMoving Average Convergence/Divergence (MACD),\n538, 542-544, 609, 610 Histogram, 538\nMoving Average Crossovers, 609 Moving Average Envelopes, 537\nMoving Average Line, 422-423, 541, 598, 604,\n609, 618 Multicolincarity, 598, 610 Multiple Bottoms, 414, 434 Multiple\nFormations, 66, 68\nMultiple Head-And-Shoulders Pattern, see Complex Head-and-Shoulders\nPattern\nMultiple Tops, 364, 403, 409, 414 Mutual funds, 43, 268, 390, 495\nN\nNarrow Range Day, 610\nNASA, 249\nNational Association of Securities Dealers\nAutomated Quotations (NASDAQ), 19, 316 NASDAQ 100, 312, 480\nNatural Hedge, 485, 610\nNatural mechanical systems, 260\nNatural method, 359, 610 NDX, 480, 577\nNear progressive stops, 139\nNeckline (NL), 47-49, 57, 59, 610\non multiple head-and-shoulders formations, 61 Ned Davis Research, Inc.\n(NDR), 424 Negative divergence, 610 Negative Volume Index (NVI), 538\nNelson Freeburg of Formula Research, 424 New commitments, 418\nNew Concepts in Technical Trading (Wilder), 618 “New Haven Investor,”\n298\nNew York Stock Exchange (NYSE), 4, 269, 300, 311,\n313, 316, 341, 349, 615, 616\nNOKIA (NOK), 475\nNormal Range for Price, 344, 346, 354, 49 , 610 Normal Uptrend Channel,\n141-142 Northrop Aircraft, 438-439\nNumber-driven systems, 259-260 Number-driven technical analysis, 4, 26 ,\n610\nNumber-driven technical analysts, 266\nO\nOdd lots, 351, 610 Old-style markets, 168-169\nOld-time “plunger,” 168\nOn Balance Volume (OBV), 538, 610-611 One-Day Island Reversal, 607\nOne-Day Reversal, 42, 144-145, 410, 600, 615 One-Week Reversal, 147,\n450, 589 Operational Risk, 501-504 Opportunity vs. Security, 308 Optimal\nformula, 534, 535 Optimization, 275\nOptions, 271-272, 611\non Dow index futures, 282-283 exercising, 284\non futures and indexes, 274 pricing models and importance, 273 spreads in\nhigh-or low-volatility markets, 286-287 as strategic investment, 273 traders,\n272\ntrading, 272\nOptions Research, Inc, 611 Oracle Corporation, 332, 468, 573, 576, 579\nOrder, see Limit Order; Market Order; Stop Order Orthodox", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 266}
{"text": "ormula, 534, 535 Optimization, 275\nOptions, 271-272, 611\non Dow index futures, 282-283 exercising, 284\non futures and indexes, 274 pricing models and importance, 273 spreads in\nhigh-or low-volatility markets, 286-287 as strategic investment, 273 traders,\n272\ntrading, 272\nOptions Research, Inc, 611 Oracle Corporation, 332, 468, 573, 576, 579\nOrder, see Limit Order; Market Order; Stop Order Orthodox Broadening\nTop, 123, 130-135 “Orthodox” investors, 419\nOscillator, 4, , 304, 419, 600, 611 Aroon, see Aroon Oscillator\nChaikin, see Chaikin Oscillator\nOut-and-out boardroom gamblers, 168 Out-of-the-money, 283 strike price,\n285\nOverbought, 611 Oversold market, 486, 611 “Oversold-overbought”\nindicator, 485, 611 Overtrading, 351, 493, 496-498\nP\nPacific Coast Options Exchange, 531 Packard-Bell Electronics Corp (PKB),\n465\nPalm Computing, 327 Panic, 611\ndecline, 145, 157, 159, 171, 178, 192, 201 phase, 15, 147, 380\nPanic Bottom, see Selling Climax Parabolic SAR, 359, 537\nParadigm-setting model, 271 Paradox, 496-498\nParallel Trend Channel, see Descending Trend Channel\nParke, Davis and Company (PDC), 466 Passive Indexer, 611\nPatience, 265 Pattern\nanalysis, 357 boundary, 203 gaps, 176, 184 resistance, 202-205\nPeak, see Top\nPenetration(s), 422-424, 611 validity, 220-222\nPennant(s), 151-154, 410-411, 611 consolidations, 157 and flags, 608\nreliability, 156-157\nPennant Consolidation, 392 PENTAD Moving Average system from\nformula research, 424-425\n%B Indicator, 538\nPercentage Price Oscillator (PPO), 538\nPercentage Volume Oscillator (PVO), 538 Performance measurement, 275\nPersonal body digital assistants (PBDAs), 268 Philosopher's Stone, 249,\n265, 275, 539\nPivot Points, 53 , 543\nPlain scale, 8\nPlanned distribution, 98\nPoint and figure (P&F), 392, 532, 545\nanalysis, 543\ncharting, 26 , 532, 545, 612\ntechnical analysis by Mike Moody, 556-561 Polaroid Corporation, 451\nPolymath, 31\nPool operations, 105-112\nPortfolio ordinary or operational risk, 502-503 Portfolio protection, 279-\n280\nPortfolio Risk Analysis screen, 529, 530\nPortfolio Risk Factor (PRF), 502\nPortfolio risk management\ncontrolling risk, 503\nmeasuring maximum drawdown, 502 overtrading, 496-498\nrisk and money management procedures, 503-504\nrisk and trend, 499\nrisk of portfolio, 499\nrisk of single stock, 498-499\nsophisticated risk and money management procedures, 504\nVAR, 499-500\nPortfolio Risk Strategy, 496, 497\nPortfolio valuation, 275\nPortfolio yields improvement, 286\nPragmatic analysts, 275\nPragmatic portfolio analysis, 502\nportfolio extraordinary or catastrophic risk, 503 portfolio ordinary or\noperational risk, 502-503 portfolio risk over time, 503\nPragmatic portfolio risk measurement, 500\ndetermining risk for portfolio, 501-502\nrisk of one stock, 500-501\nPragmatic portfolio theory, 500 Premature breakouts, 108, 612 Preparatory\nbuying signals, 375-376 Preparatory selling signals, 379 Price Congestion\nFormation, 177 “Price-earnings ratio” index, 469, 612 Price\nRelative/Relative Strength, 538 Price(s), 196\nchannels, 537\nfluctuation, 261\nof futures option, 283\nline, 423\npattern, 52, 5 , 70, 12 , 135, 138, 614\nPrimary Bear Market, 238, 242, 243, 507-508 Primary Bull Market, 21, 22,\n41, 86, 122, 242\nPrimary Direction, 13, 355, 363, 380, 381, 383, 385, 386, 391\nPrimary Downswing, 202, 242\nPrimary Downtrends, 15\nPrimary Market Trend, 26\nPrimary Reversal phenomenon, 118\nPrimary trends, 12-14, 16\nPring's Know Sure Thing (KST), 538-539\nPring's Special K, 539\nProbable moves of stocks, 341-344\nProfit-taking patterns, 168\nProfit analysis, 530\nProfits in rising markets, 284-285\nProgram Trading, 311, 612\nProgressive stop, 328, 355-357, 359, 370, 379, 612\nProtective stop(s), 295, 353, 355, 356, 358, 361, 612, 616\nProxy markets, 278\nPsychological grounds, 117\nPsychological handicap, 293\nPublic Service Electric and Gas (PEG), 469\nPullback(s), 110, 202, 205, 224, 612, 617\nPullback Rallies, 58\n“Pure investor,” 294-295\nPut option, 272, 284, 285, 312, 611, 612\nQ\nQID, 350\nQQQ, 244, 271, 312, 313, 490\nQuantitative analysis, 272-273\nQuantitative analysts, 266\nR\nRail Average, 513, 603\nRails falter, 516-517\nRally, 612\nRally Tops, 612\nRange, 612\nRate of Change (ROC), 539\nReaction, 612\nReciprocal, Market, see Market Reciprocal\nRecovery, see Rally\nRecovery Trends, 202\nRectangle(s), 18, 151, 159, 173, 189, 373, 408-409, 606, 608, 613\nto Dow Line, 112-113\npatterns, 378\nfrom Right-Angle Triangles, 113\nin Socony-Vacuum, 106\ntops, 103-105\nRectangular Consolidations, 159\nRed Parallel, 373, 378, 379, 613\nRed Trend, 373, 375, 376, 379, 380\nRed Trendline, 373, 376, 37 , 613\nRelative Strength, 619\nRelative Strength Index (RSI), 539, 598, 613, 618-619\nRelative Strength Indicator, see Relative Strength Index (RSI)\nReliability of flags and pennants, 156-157\nRepeated saucers, 162-167\nResistance, 189, 603, 616\nLevel, 155, 184, 189, 194, 198, 202, 206, 226, 246, 613\nLines, 99, 196\nRange, 189, 193, 196, 197\nZones, 192, 194, 19 , 200, 206\nResources, 523\nessence of fundamental analysis, 528-531 important and indispensable sites,\n523 investment-oriented sites, 524-527 leverage space portfolio model,\n533-536 references for further study, 524 Sharpe Ratio, 527\nsoftware packages and internet technical analysis sites, 531-533\nvolatility calculation, 527-528 Retracement, 118, 172, 603, 613 Return\nLine, 223, 225, 596, 601 Reversal\nBroadening Bottoms, 135\nBroadening Formations, 121-122\nThe Diamond, 137-139 Falling Wedge, 142-143\nKey Reversal Days, 148-149 One-Day Reversal, 144-145 Orthodox\nBroadening Top, 130-135 Right-Angled Broadening Formations, 135-137\nRising Wedges common in Bear Market\nRallies, 144\nRunaway Days, 148 Selling Climax, 145-147 short-term phenomena of\npotential importance, 147-148\nSpikes, 147-148\ntypical example, 128-130\nvolume during broadening formations, 122-128 wedge formations, 139-142\nwedges on weekly and monthly charts, 143-144 Reversal Area, 42, 55, 158\nReversal Days, see Key Reversal Days Reversal Formation, 42, 50, 155,\n168, 198\nReversal Gap, 613\nReversal Levels, 190\nReversal P", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 267}
{"text": "Days, 148 Selling Climax, 145-147 short-term phenomena of\npotential importance, 147-148\nSpikes, 147-148\ntypical example, 128-130\nvolume during broadening formations, 122-128 wedge formations, 139-142\nwedges on weekly and monthly charts, 143-144 Reversal Area, 42, 55, 158\nReversal Days, see Key Reversal Days Reversal Formation, 42, 50, 155,\n168, 198\nReversal Gap, 613\nReversal Levels, 190\nReversal Pattern(s), 41, 42, 7 , 132-133, 493, 602, 613 ADM turned sharply\nlower, 64 breaking neckline, 47-49 Descending Triangles, 98-99\ndistinguishing characteristics, 115-118 Dormant Bottom variation, 73-74\nDouble and Triple Tops and Bottoms, 113-115 Double Bottoms, 118 Dow\nTheory, 41\nfine Symmetrical Triangle Reversal Formation, 78 Head-and-Shoulders\nBottoms, 57-59 Head-and-Shoulders to Dow Theory, 55 Head-and-\nShoulders Top, 44, 45, 46, 63 “ideal” multiple top made by Budd in (1946),\n62 intermediate bottom of complex class, 64 Johns-Manville's Primary\nTrend Reversal (1942), 79\nleisurely pattern, 65-66\nlong multiple head-and-shoulders top, 63\nReversal Pattern(s) (Continued)\nMCA enjoyed 62excellent advance from (1980-1986), 62\nmeasuring implications of Triangles, 100 multiple head-and-shoulders\npatterns, 59-61 planned distribution, 98 pool operations, 105-112 price\naction confirmation, 52-55 prices break out of Symmetrical Triangle,\n88-90\nRectangles, double and triple tops, 103-105 Rectangles from Right-Angle\nTriangles, 113 relation of Rectangle to Dow Line, 112-113 reversal or\nconsolidation, 94-97 Right-Angle Triangles, 97-98 Rounding Tops and\nBottoms, 66-70 Rounding Turns affect trading activity, 70-73 Sears\nRoebuck made Symmetrical Triangle Reversal, 78\nslide in Amdahl occupied Bears, 65 Symmetrical Triangles, 79-88 tendency\nto symmetry, 61 time to reverse trend, 42-44 Triangles on weekly and\nmonthly charts, 100 Triangular formations, 100-101 Triple Tops and\nBottoms, 118-120 typical Triangle development, 90-94 variations in head-\nand-shoulders tops, 49-52 volume, 44-45, 4 , 74-75, 99-100\nRhythmic investing, 300-302\nRhythmic Trading, 485\nRichard Arms work, 545\nArms CandleVolume charting, 551-553\nArms Index, 545-548 calculation, 548\nEquivolume charting, 550-551 using index, 548-549 reasoning, 548\nRight-Angled Broadening Formations, 135-137, 409\nRight-Angled Broadening Triangle, 606, 613\nRight-Angle Triangle(s), 97-98, 103, 139, 173, 408, 596, 601\nchart, 99\nrectangles from, 113\nRipple, 14\nRising Channel, 413\nRising Wedge(s), 139, 141, 143, 614\ncommon in Bear Market Rallies, 144\nRisk\nanalysis, 529 management, 495-504 measurement, 502-503 and money\nmanagement procedures, 503-504 sophisticated, 504\n“Risk-free” interest rate, 273\nRocket scientists, 249-250\nRound-trip costs, 389\nRounding Bottom(s), 66-70, 403-406, 599, 614\nRounding Top(s), 66-70, 403-406, 606, 614, 617\nRounding Turn(s), 66, 68\naffecting trading activity, 70-73 picture, 70\nRound lots, 351, 614\nRRG Relative Strength, 539\nRunaway Days, 147, 148\nRunaway Gap, 17 , 182-186, 202, 258, 601, 608, 614\nRunaway issues, 327 techniques for management of, 328-332\nRunaway or Continuation Gap, 392 Running Market, 614\nS\nSaucer-Like Reaction Pattern, 99 Saucer Pattern, see Rounding Bottoms\nScales, types of, 8-9\nScallops, 162-167, 614\nSchadenfreude, 326 Schannep, Jack, 21, 26 Scholes, Myron, 271 Schwager,\nJack\nSecondary Reaction, 13, 18, 35 , 493, 515, 516, 517, 519 Secondary\nRecovery swing, 508\nSecondary Trend, see Intermediate Trend Secondary trends, 12, 13, 17\nSecular Trend, 614 “Self-correction,” 197\nSelling Climax (SC), 138, 145-147, 190, 201, 600, 611, 615\nSelling Climax Day, 615\nSelling stock short, 379 Semilogarithmic paper, 8\nSemilogarithmic Scale, 8, 144, 220, 242, 60 , 615 Sensitivity, 341, 342,\n346, 354, 422, 495, 600, 615 Sensitivity Index, 322, 342, 345, 346, 353,\n492, 497 Sensitizing Moving Averages, 422\nSettlement\nof futures contracts, 276\nprice, 276, 600\n“Settlement date,” 276\nShakeout, 89, 145, 181, 221, 264, 505, 615\nSharpe Ratio, 499, 527\nShort-term phenomena of potential importance,\n147-148\nShort-term profits, 297\nShort-term trader, 190, 29 , 389, 419 Shorting stocks, 284\nShort Interest, , 348, 615\nShort sale(s), 379-380, 400, 409, 615\nShort selling, 145, 346-350, 485 “Short side” of market, 41\nShoulder, see Head-and-Shoulders Pattern “Sideways” chart pattern, 151\nSideways Movements, 423\nSimple Moving Averages (SMAs), 422, 537, 549 Single stock risk, 498-499\nSites, important and indispensable, 523 “Skullduggery,” 168, 169\nSkyrocket, 184, 185, 196, 321, 401, 493 effect, 71\nrun-up of Willys-Overland, 179\nSlauson, John, 387\nSlope, 539\n“Smart money,” 265\nSmoothing, 615\nSoftware packages, 305, 531-533 “Special Opening Quotation,” 276\nSpeculative aims, 245\nSpeculative blow-offs, 326\nSpeculative stock, 345, 492\nSpeculator(s), 3, 145, 149, 274, 286, 293, 297-298, 300 agile, 148\ncommodity, 246\npsychology, 245\nSpiegel's Bear Market, 262 Spike(s), 147-148, 615 Spring of 1946, 517-518\nSPY, see Standard & Poor's Depositary Receipts (SPDRs) Standard & Poor\n(S&P), 274, 310-311, 482\nStandard & Poor's Depositary Receipts (SPDRs), 271, 274, 299, 317, 323,\n351, 390\nStandard Deviation, 539\nStatistical approach, 3\nStatistical driven technical analysts, 266\nStatistics fundamentalists, 4 “Stepping off” point, 417\nStick to guns, 505-506 Stochastic(s), 542, 615-616\nStochastic Indicator, 615\nStochastic Oscillator, 539, 615\nStochRSI, 539\nStock(s), 12, 30 , 353, 356, 414, 41 , 482 alphabetic index of stock charts,\n579-593 averages, 483 chart, 7\nconstruction of index shares and similar instruments, 311-312\nat different times, 427-479 index futures to control exposure, 277-278\ninstruments, 313s\nkinds of stocks long-term investors want, 311 long-term investor's\nviewpoint, 310-311 Major Downtrends, 428-429, 439\nNDX, 480 opportunity vs. security, 308 options, 494 prices, 42, 266, 505\nprobable moves, 341-344\nS&P, 308\nS&P 500 in glory and tragedy, 309 selection of stocks to chart, 315-323\nSPY. for illustration, 309 trends, 218\nStockCharts Technical Rank (SCTR), 539\nStock Ex", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 268}
{"text": "instruments, 313s\nkinds of stocks long-term investors want, 311 long-term investor's\nviewpoint, 310-311 Major Downtrends, 428-429, 439\nNDX, 480 opportunity vs. security, 308 options, 494 prices, 42, 266, 505\nprobable moves, 341-344\nS&P, 308\nS&P 500 in glory and tragedy, 309 selection of stocks to chart, 315-323\nSPY. for illustration, 309 trends, 218\nStockCharts Technical Rank (SCTR), 539\nStock Exchange vigilance, 168\nStock market(s), 3, 189, 266 fundamentalist, 3 to newcomer, 427 Support-\nResistance Level, 430\nStock Split, 616\nStop, 616\nStop Loss, see Protective Stop\nStop orders, 353, 611\nATR, 358-359 natural method using by Turtles, 359 progressive stop, 355-\n357\nSAR, 359\nstop distances, 354 stop systems and methods, 357-358 survey of stop\nmethods, 358 target stops, 359\nStreet, 3\nStreet firms, 325 “Strike” price, 282\nSuperior Oil Co (SOC), 458 Supply, 616\nSupply and demand, 77 balance, 245 equation, 42 relation, 175\nSupply Line, see Resistance\nSupport, 189, 603 significance of support failure, 197-198\nSupport and Resistance, 383-38 , 410, 414 in averages, 206 estimating\nsupport-resistance potential, 194-196 explanation, 191-193 levels, 198, 200,\n264 locating precise levels, 196-197 normal trend development, 190 pattern\nresistance, 202-205 popular misconceptions, 198-200 predictions, 189-190\nprinciple, 189 repeating historical levels, 200-202 round figures, 200\nsignificance of support failure, 197-198 theory, 202 volume on breaks\nthrough support, 205-206\nSupport Level, 151, 189, 192, 198, 206, 210, 364, 383, 386, 391, 414, 41 ,\n616\nSupport Line, 598\nSupport Range, 189, 192 Support-Resistance Level, 266, 430 Support-\nResistance Theory, 224 “Swing” power, 30 , 345\nSymmetrical Triangle, 80, 600 Symmetrical Triangles, 79-88, 103, 121,\n151, 168,\n203-205, 406-408, 609, 616 pattern, 603 prices break out, 88-90\nT\nTactical methods making new commitments, 418\nTactical methods (Continued)\npresent commitments, 417-418 quick summation, 417\nTactical problem\nHudson Motors, 295\nlong-term investor, 299 rhythmic investing, 300-302\nstrategy and tactics for long-term investor, 297-298\nstrategy of long-term investor, 299-300 “Tangents,” 208\nTape Reader, 9, 166, 616 “Tape watchers,” 163, 166 Target stops, 359\nTax, 313\nconsequences, 277\nselling, 517\nTechnical analysis, 4-6, 419, 478, 537\nBollinger Bands, 561-563\nnumber driven tools, 537-545\nPoint & Figure technical analysis by Mike Moody, 556-561\nRichard Arms work, 545-553 and technology, 265-266\nTechnical chart patterns, measuring implications in, 391-392\nTechnical data, 6, 22 , 528\nTechnical indicators, 538-539\nTechnical Magee analyst and investors, 268\nchaff, 270\ninformation revolution, 270-271 internet, 268-269\nmarking-to-market, 269-270 separating wheat from chaff, 270\nTechnical overlays, 537-538 Technical regularity, 313\nTechnical trading effect on market action, 419-420 “Teenie,” 272\nTEKNIPLAT\nchart paper, 305, 443, 616 semilogarithmic chart sheet, 219-220\nTenets, 12-14, 20 , 50 , 517 Test(s), 617\nof authority, 216-220\nText diagrams, 565-578 Textron, 435, 575, 592 “Theoretical value” of\nfuture, 277 Thin Issue, 174, 356, 617 3COM, 319, 32 , 331, 579\n“Three-days-away” rule, 300, 328, 361, 369, 414, 617 Throwback(s), 99,\n110, 181, 202, 203, 221, 224-225, 612, 617\nTide, 14 Time\nrequiring to reverse trend, 42-44\nscale, 8, 31\nTLT chart, 258\nTop, 611, 617\nBroadening, see Broadening Top\nDouble, see Double Top\nHead-and-Shoulders, see Head-and-Shoulders Top Rounding, see Rounding\nTop\nTriple, see Triple Top\nTop of Ascending Triangle, 177 Top Price Chart Formation, 598 Top\nTrendlines, 414, 598, 613 Total Capital (TC), 30 , 492, 498, 502, 503, 504\nTotal Composite Leverage, 297 Trader(s), 251, 284, 293, 296, 300, 315, 505\nTraders, 358 Trades, 33-3 , 409 Tradestation 2000i, 532 Tradestation 8, 532\nTrading, 4\nactivity, 17, 44-45, 80, 91, 122, 163, 185, 221, 316, 441, 511, 614\narea, 103, 121, 151, 175, 423, 613 averages in 21st century, 244 costs, 390\nopportunities, 42, 163, 266, 475 range, 73, 79, 149, 186, 286, 599, 60 , 609,\n616 Transportation Average, 596, 600, 603 Treasury bonds, 253, 281\nTrend(s), 12, 13, 14, 223, 229, 617\nconsolidation, 151\nranges, 222-223\nand trendline studies, 264\nTrend Channels, 214, 215, 223, 242-243, 356, 392, 617\nin Bethlehem Steel, 213\nParallel Trend Channel, 373-375, 378\nRising Trend Channel, 225\nTrending Market, 252, 253, 286, 423, 595, 617 Trendline(s), 207-209, 209-\n211, 414, 429, 59 , 616, 617 in action, 375 additional suggestions, 380\namendment of trendlines, 222 analysis, 357 arithmetic vs. logarithmic scale,\n211-216 buying stock, 375-377 consequences of Trendline penetration, 224-\n225 corrective trends, 226-227 covering short sales, 379-380 double\ntrendlines and trend ranges, 222-223 experimental lines, 224 intermediate\ndowntrends, 225-226 liquidating, or selling long position, 378-379 policy\nfor trading in Major Trend, 380-381 selling stock short, 379 tests of\nauthority, 216-220 validity of penetration, 220-222 Triangular Price\nFormations, 103 Triangular/Triangle(s), 79-80, 423, 608, 617 development,\n90-94, 98 formations, 100-101 measuring implications, 100 patterns, 378 on\nweekly and monthly charts, 100 Triple Bottom(s), 113-115, 118-120, 617\nTriple Top, 103-105, 113-115, 118-120, 504, 568, 617-618 TRIX, 539\nTrue Range, 358, 595\nTrue Strength Index, 539\nTulipomania, 61, 308, 325, 331, 332, 339, 57 , 593, 607 managing, 326-328\nPALM, 329\nTulips, 241, 325, 329, 331, 339\n“Turbulent period,” 485, 486\nTwain, Mark, 26-2 , 304, 365, 532\nTurtle(s), 250-252, 259\nnatural method using by, 359\nsystem, 258-260\nU\nUlcer Index, 539\nUltimate Oscillator, 539\nUnited Artist Corporation (UNA), 460\nUnnatural method, 610\nUp-slanting\nbottom boundary, 92-93\nline, 79-80, 91\nUp Channel, 596\nUptick, 349, 350, 618\nUp trendline, 208, 209, 210, 211, 216-217, 221, 596, 617 Uptrends, 14, 104,\n153, 158, 208, 212, 219, 225, 233, 422-423, 429, 432\nU.S. Securities and Exchange Commission (SEC), 105, 145, 168, 390\nU.S. Smelting, Refining and Mining Co, 453, 463\na, 42", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 269}
{"text": "539\nUnited Artist Corporation (UNA), 460\nUnnatural method, 610\nUp-slanting\nbottom boundary, 92-93\nline, 79-80, 91\nUp Channel, 596\nUptick, 349, 350, 618\nUp trendline, 208, 209, 210, 211, 216-217, 221, 596, 617 Uptrends, 14, 104,\n153, 158, 208, 212, 219, 225, 233, 422-423, 429, 432\nU.S. Securities and Exchange Commission (SEC), 105, 145, 168, 390\nU.S. Smelting, Refining and Mining Co, 453, 463\na, 428\nHead-and-Shoulders Top in (1952)\nU.S. Steel, 4, 5, 79, 105, 12, 131, 147, 200, 201, 569\nUtah-Idaho Sugar Co. (UIS), 461, 576, 593\nUtility Average, see Dow-Jones Utility Average\nV\nValidity of Trendline Penetration, 618\nValley, 116, 118, 119, 176, 618\nValue-at-risk procedure (VAR procedure), 499-500\nVariance, 212, 311, 344, 501, 527, 536\nVariant 2 procedure, 368, 370\nVariations in head-and-shoulders tops, 49-52\nV/D volume, 618\n“Vertical” Panic Declines, 157\n“Vested interest,” 186, 199, 200, 201, 202\nVigor, 95, 144, 197, 516\nVince, Ralph, 504, 533, 60 , 618\nVolatility, 283-284, 343, 354, 498, 500, 501, 528, 539, 618 calculation, 527-\n528\nVolume-Weighted Average Price (VWAP), 538\nVolume, 44-45, 4 , 108, 193, 194, 264, 595, 616, 618 on breaks through\nsupport, 205-206 during broadening formations, 122-128 characteristics\nsame as symmetrical type, 99-100 confirmation, 398, 401, 40 , 408, 432,\n449 pattern, 46, 4 , 5 , 59, 63, 64, 6 , 74-75, 13 , 161, 196, 20 , 216, 605,\n614 by Price, 537-538, 543 of trading, 67, 193, 197, 221, 618\nVortex Indicator, 539\n“Voyeur” feature, 532\nW\nWall Street investment banks, 325 Wall Street Journal, 11, 12, 243, 312\n“Wash sales,” 107\nWave, 14\nWave analysis methods, 260\nWedge(s), 139, 409-410, 618 formations, 139-142 on weekly and monthly\ncharts, 143-144\nWeighted Moving Averages, 422\nWest Indies Sugar, 43 , 575, 593\nWestinghouse Electric, 4 , 237, 437, 442, 566, 568, 572, 575, 593\n“W” Formation, see Triple Top\nWide-Ranging Days, see Runaway Days Widening Channel effect, 243\nWilder Relative Strength Index (Wilder RSI), 595, 610, 618-619\nWieckowicz, R.T., 307 Williams, Larry, 420, 531\nWilliams %R, 539\nWorld Equity Benchmarks (WEBs), 312\nWorld War II, end of, 515, 516 “W” Pattern, see Triple Top Wright, Charlie,\n494\nWyckoff, Richard, 259, 392, 550\nWyckoff's charts, 531\nY\nYahoo! (YHOO), 330, 476, 47, 526, 577, 593\nZ\nZen, 269\nZigZag, 197, 383, 538 Zone, Resistance, 189, 192-194, 196, 197, 199-200,\n202, 206, 387\n©Taylor & Francis Group\nan informa business\nTaylor & Francis eBooks\nwww.taylorfrancis.com\nA single destination for eBooks from Taylor & Francis with increased\nfunctionality and an improved user experience to meet the needs of our\ncustomers.\n90,000+ eBooks of award-winning academic content in Humanities, Social\nScience, Science, Technology, Engineering, and Medical written by a global\nnetwork of editors and authors.\nTAYLOR & FRANCIS EBOOKS OFFERS:\nREQUEST A FREE TRIAL\nsupport@taylorfrancis.com\n3 Routledge „oC CRC Press\nTaylor & Francis Croup Taylor & Francis Croup", "source": "eBooks\\Technical Analysis of Stock Trends, Eleventh Edition-CRC Press (2018).pdf", "doc_id": "0858b77a47bb22143624fdb822ee49f709afc6bd15590447be326cb91e8ea535", "chunk_index": 270}
{"text": "BEST\nLOSER\nWINS\nBEST\nLOSER\nWINS\nWhy Normal Thinking Never\nWins the Trading Game\nTom Hougaard\n\nHARRIMAN HOUSE LTD\n3 Viceroy Court\nBedford Road\nPetersfield\nHampshire\nGU32 3LJ\nGREAT BRITAIN\nTel: +44 (0)1730 233870\nEmail: enquiries@harriman-house.com\nWebsite: harriman.house\nFirst published in 2022.\nCopyright © Tom Hougaard\nThe right of Tom Hougaard to be identified as the Author has been asserted in accordance with the\nCopyright, Design and Patents Act 1988.\nPaperback ISBN: 978-0-85719-822-8\neBook ISBN: 978-0-85719-823-5\nBritish Library Cataloguing in Publication Data\nA CIP catalogue record for this book can be obtained from the British Library.\nAll rights reserved; no part of this publication may be reproduced, stored in a retrieval system, or\ntransmitted in any form or by any means, electronic, mechanical, photocopying, recording, or\notherwise without the prior written permission of the Publisher. This book may not be lent, resold,\nhired out or otherwise disposed of by way of trade in any form of binding or cover other than that in\nwhich it is published without the prior written consent of the Publisher.\nWhilst every effort has been made to ensure that information in this book is accurate, no liability can\nbe accepted for any loss incurred in any way whatsoever by any person relying solely on the\ninformation contained herein.\nNo responsibility for loss occasioned to any person or corporate body acting or refraining to act as a\nresult of reading material in this book can be accepted by the Publisher, by the Author, or by the\nemployers of the Author.\nThe Publisher does not have any control over or any responsibility for any Author’s or third-party\nwebsites referred to in or on this book.\n\nTo the girl at the Bloomberg terminal\nCONTENTS\nDear Markets\nPreface\nIntroduction\nLiar’s Poker\nThe Trading Floor\nEveryone Is a Chart Expert\nThe Curse of Patterns\nFighting My Humanness\nDisgust\nThe Drifter Mind\nTrading Through a Slump\nEmbracing Failure\nBest Loser Wins\nThe Ideal Mindset\nAbout the Author\nDEAR MARKETS\nFROM THE MOMENT I first came across you, I have been fascinated by you. I\nprobably even fell in love with you. I was too young to know what that\nmeant, no more than ten years old. You were featured in a national\nnewspaper – a competition of sorts.\nI was too young to play with you, so I observed. Time was not on my side. I\nwas born a few decades too soon to participate in trading like it is possible\ntoday. I had to go and live my early life and you went about yours.\nWhen you went through the devastating bear market of 1973, I was just\nlearning to walk. When you roared with anger during the crash of 1987, I\nwas just finishing school. When you took the first steps towards the epic\n1990s bull market I was almost ready. But not quite there yet.\nSo, you sent me a message that would change my life, and I took you up on\nthe invitation, leaving everything behind me to pursue you. I studied you at\nuniversity, two degrees in fact. I toiled for hours and hours, trying to\nunderstand you through the eyes of the conventional economic thinkers,\nthrough the eyes of Nobel Prize recipients, and through the eyes of well-\nmeaning journalists and experts.\nI wish you could have told me back then not to bother. You are not an\nequation to be solved. You are far more complex than a model could ever\ncapture. Over and over, you prove yourself to be the elusive mistress that no\none every truly understands. You are everywhere and you are nowhere.\nUniversal laws do not apply to you.\nMy love for you was deep. You gave me so much joy. I gave you my all.\nYou were there when I woke up, and you were there when I went to sleep.\nYou have elevated me when I was fluid, rewarded me beyond my wildest\ndreams when I was flexible. You have punished me when I was rigid and\nstubborn, taking all your gifts back – with interest.\nAnd boy did I pursue you. I pursued you like a lovestruck teenager. I\napproached you from all angles, from Fibonacci ratios to Keltner Channels,\nto Bollinger Bands, to Trident strategies, as well as mythical vibrations of\nGann and Murry Math.\nI developed models of the tide swell in the Hudson River to see if you\nresponded to that. I printed out thousands and thousands of charts, applying\nlines and circles, trying to find a way to dance with you so that my feet\ndidn’t get stamped on so much.\nI had sore toes, my love. Sometimes my toes were so sore that I had to go to\nthe beach and just throw stones in the water for hours on end, angry that\nyou didn’t want to do the tango with me.\nYou gave me sleepless nights. You gave me tears in my eyes, anger in my\nbody, hurt in my soul, and yet I couldn’t let you go. I knew there was more\nto it, and I knew I had to keep looking.\nI gave you everything because you made me feel alive. You gave me a\npurpose. You gave me challenges so hard even a drill sergeant would have\nto give you a nod of respect. And I will always love you for it. You kept me\non my toes, like a parent wanting only the best for their child.\nBut you made the lessons obscure. You designed it to look easy. But it was\nnever easy. You made everyone believe that you could be danced with\nthrough models, through equations, through indicators, through\nconventional thinking and through logic. But often there is little logic to\nyou. And I struggled to dance with you for years, until one day by chance\nyou told me your secret. You told me to stop trying to understand you. You\ntold me to understand myself.\nI stopped trading. I took the time to understand myself, and I came back.\nAnd when I returned to the dance floor, you welcomed me with open arms,\nsmiled, and said, “Welcome back, I see you get it now. Did you bring the\nband-aids?”\nAnd I did. Best loser wins.\nPREFACE\nHOW YOU FEEL about failure will to a very large degree define your growth and\nyour life trajectory, in virtually every aspect of your life.\nYou may want to close this book and think about that for a while. It is quite\nfrightening how deep that sentence is.\nWhat 99% of tra", "source": "eBooks\\Tom Hougaard - Best Loser Wins.pdf", "doc_id": "db0d74ee3eb2ba5542f0943f7b8e994e1f3211b7a93aee04b5bfd56525c663f3", "chunk_index": 0}
{"text": "arms,\nsmiled, and said, “Welcome back, I see you get it now. Did you bring the\nband-aids?”\nAnd I did. Best loser wins.\nPREFACE\nHOW YOU FEEL about failure will to a very large degree define your growth and\nyour life trajectory, in virtually every aspect of your life.\nYou may want to close this book and think about that for a while. It is quite\nfrightening how deep that sentence is.\nWhat 99% of traders do not realise is that they are looking for answers in\nthe wrong places. Knowledge of technicals, fundamentals, indicators, ratios,\npatterns and trend lines… well, everyone knows about them – and everyone\nloses, except the 1%.\nWhat do the 1% do that the 99% is not doing?\nWhat am I doing, enabling me to have the success in trading that I have,\nwhich the others are not doing?\nThe answer is as simple as it is complex. I am an outstanding loser.\nThe best loser wins.\nI have conditioned my mind to lose without anxiety, without loss of mental\nequilibrium, without emotional attachment, and without fostering feelings\nof resentment or desire to get even.\nIt is because of how my mind works that I am able to trade in the way that I\ndo. My knowledge of technical analysis is average at best. My knowledge\nof myself is what sets me apart.\nThe true measure of your growth as a human being is not what you know,\nbut rather what you do with what you know.\nI wrote this book to describe how I transformed myself into the trader I am\ntoday, and how I was able to bridge the gap between what I knew I was\ncapable of, and what I actually achieved.\nINTRODUCTION\nMY NAME IS Tom Hougaard. I am 52 years old. Thirty years ago, I left my\nnative Denmark. I wanted to trade the financial markets and I wanted to do\nit in London.\nI had an idea of what I needed to do to become a trader. I got a BSc in\nEconomics and MSc in Money, Banking and Finance. I thought I had\neverything I needed to become a trader: the right kind of education; a good\nwork ethic; and passion for the markets.\nI was wrong.\nOn paper, I was qualified to navigate the financial markets. In reality,\neducational qualifications mean little in the dog-eat-dog world of trading.\nThis book describes the journey I went through to get to where I am today.\nWhere am I today?\nAs I type this, I have not had a losing day in 39 trading days. I run a\nTelegram trading channel, where my followers witnessed me make\n£325,000 in the last month alone – in real time, with real-time entries,\nmoney management, position sizing, and ultimately the exit of the position.\nNo time delays. No lag. All done before their eyes – time stamped.\nThis book dispels the myths of what it takes to be a home trader, or any\ntrader for that matter. It has been a journey that saw me initially pursue the\npath that everyone else takes – a lot of books about a lot of indicators,\npatterns and ratios – before finally realising that the real answer to the\nelusive quest for trading profits was right inside of me all along. It truly was\nthe last place I ever thought of looking.\nA PROMISING BEGINNING\nAfter completing my university degrees, I started working for JPMorgan\nChase. It wasn’t a trading job, but it was close enough. Then in 2000 I\nbecame a home trader for a year and a half. It only lasted 18 months\nbecause I ran out of money.\nI had befriended the staff at the broker I traded with. They hired me as a\nfinancial analyst. I say analyst, but I was a glorified media whore. My\nmandate was to get the brokerage seen on TV and my credentials were an\nunderstanding of technical analysis.\nI started that job in the summer of 2001. My first customer-facing\nexperience was when the CEO brought me to Royal Ascot – a significant\nevent in the social calendar of the rich and famous. It is a horse racing\nevent, mixed with champagne, funny-looking hats and big cigars.\nOnly the best and most lucrative clients were invited to this VIP event. On\nboard the executive coach taking the prestigious clients to Ascot, I was\nintroduced as the new financial analyst. “Ask him anything,” declared the\nCEO.\nOne client asked me what I thought of Marconi. Marconi was a member of\nthe FTSE 100. It had seen better days. It had declined from 1,200 pence to\n450 pence over the preceding 12 months.\n“Do you think Marconi is cheap?” asked a pharmacist from Luton.\nI didn’t know it at the time, but my answer – and a similar one on TV a few\nmonths later – would eventually get me fired from my job. Even if I had\nknown, I would not have changed my answer:\nMarconi is garbage, gentlemen. Why are you chasing stocks that have\nfallen in price? The stock market is not like a supermarket, where it\nmakes sense to buy toilet paper when there is a sale on.\nSure, it makes sense to buy toilet paper at a 50% discount, but it makes\nno sense to buy a stock that has fallen more than 50%. Concepts like\n‘cheap’ and ‘expensive’ may work in the world of Saturday grocery\nshopping, but not in the financial markets.\nMy answer hung in the air like a morbid joke at a funeral. I had barely\nfinished my verdict before I noticed the death stare from my boss. All these\nclients were long Marconi and they would go on to lose fortunes. Later that\nyear I was on CNBC and I was asked to do a chart analysis of Marconi.\nBy that point Marconi had fallen to 32 pence – from 1,200 pence. And still\npeople were buying it. I suggested that on the basis of the chart pattern,\nMarconi would go to zero.\nA few newspaper outlets picked up on the story and a few days later I was\ncalled to the offices of Sporting Index. The CEO wanted to ask me if it was\npossible to get these Marconi comments deleted from “that internet”.\nMarconi went to zero and I was asked to find another job. Fortunately, City\nIndex hired me the same day I left Financial Spreads. I spent seven years on\nthe trading floor at City Index. In 2009 I was made redundant and I have\nbeen a private trader ever since.\nI have spent the last 12 years of my life perfecting my craft. I am what\nbrokers call a high-stake trader. The average stake size amongst reta", "source": "eBooks\\Tom Hougaard - Best Loser Wins.pdf", "doc_id": "db0d74ee3eb2ba5542f0943f7b8e994e1f3211b7a93aee04b5bfd56525c663f3", "chunk_index": 1}
{"text": "rconi went to zero and I was asked to find another job. Fortunately, City\nIndex hired me the same day I left Financial Spreads. I spent seven years on\nthe trading floor at City Index. In 2009 I was made redundant and I have\nbeen a private trader ever since.\nI have spent the last 12 years of my life perfecting my craft. I am what\nbrokers call a high-stake trader. The average stake size amongst retail\ntraders is about £10 per point risk. I risk anywhere from £100 per point to\n£3,500 per point.\nOn volatile days I have traded in excess of £250 million in notional value. I\nonce made a little more than £17,000 in less than seven seconds. One time I\nlost £29,000 in eight seconds.\nThat kind of stake size sharpens the senses. Yes, it is a great life when it\ngoes well, but a very challenging one when adversity sets in.\nThis book describes my journey from an unemployed financial broker in\nFebruary 2009 to the high-stake trader that I am today. But it is not a\nconventional trading book.\nJUST ANOTHER TRADING BOOK?\nThe world does not need more trading books. So, I decided not to write one.\nI know enough about technical analysis to write a few books. I also know\nthat technical analysis does not make you a rich trader. It doesn’t even make\nyou a good trader.\nI had no ambitions of wanting to write a book, but one day, while I was\nwatching a documentary on YouTube, an advert appeared on my monitor. I\nrecognised the face immediately.\nIt was a guy who once attended a few speeches I gave on technical analysis,\nwhile I was working as a trader at City Index in London. Now he appeared\nin an advert, promising to reveal the secrets to the financial markets through\nhis courses.\nThe advert proudly declared that if you wanted to learn to trade like a pro,\nthen this course was what you needed.\nAs it happened, a friend of mine had attended the course. It took place over\na weekend in some plush offices in London. The place was packed and the\nhopefuls hung on every word of this self-proclaimed guru as he took them\nthrough one chart after another.\nThere was no critical thinking present. No one questioned his claims.\nEveryone left that office building on Sunday night thinking they would\nmake a small fortune by the coming Friday.\nI saw the course notes. It was hundreds of pages of regurgitated material\nfrom a standard textbook on technical analysis. There was no original\nthought behind it. There were no new contributions to the field of technical\nanalysis.\nAnyone with half an afternoon at their disposal could find the same material\nfree of charge on the internet. More importantly, my friend told me, the\nguru never missed an opportunity over the weekend to pitch additional\nproducts such as personal mentoring and the advanced course.\nTHOSE WHO CAN, DO\nThere is a saying that those who can, do. And those who can’t, teach.\nI don’t agree with that. There are many people who “can” and who also\n“do”. One is not exclusive of the other. Many great “do’ers” see it as part of\ntheir life mission to pass on knowledge to those around them. When I\nworked at City Index, I might not have been an oracle of technical analysis,\nbut I certainly knew more than most of our clients. For that reason I gave\ntechnical analysis lessons most evenings to our clients and the many white\nlabel clients that City Index had, such as Barclays Bank, Hargreaves\nLansdown and TD Waterhouse.\nI truly enjoy passing on knowledge and I did the best I could with the\nknowledge I had. However, what I didn’t realise back then was that\ntechnical analysis is rather pointless unless it is combined with behavioural\nresponse training.\nMy main beef with the many gurus teaching outrageously expensive\nweekend courses is their outcome focus. They are driving their agenda by\nthe use of external stimuli, such as portraying themselves in a helicopter or\non a private jet, and they portray trading as an easy profession to master, or\none where there is a secret to be learned, and once in possession of this\ncoveted secret you become your own ATM. Rarely if EVER will these\ngurus risk their reputation by disclosing their trades in real time. It is always\nafter the fact. We never hear about their losing trades. This gives the illusion\nthat losing is a mere inconvenience you experience from time to time when\ntrading.\nIt is only when you sit down in front of the screen on Monday morning,\nafter your overpriced weekend course on trading, and the market is moving\nin front of you, and you don’t have the after the fact chart in front of you,\nthat you realise this game is not as easy as the guru told you during the\nweekend course.\nI have written a book that is an antidote to all the rubbish that is being\npeddled in the trading arena by charlatans who are 99% marketing and 1%\ntrading. They preach their message to unsuspecting people – who sadly\nbelieve them – with neither the teacher nor the student realising that they\nonly got 10% of the story.\nMore importantly, I have written a book which is all about the aspect of\ntrading they never teach you, and how to get to the top of the trading\npyramid.\nWhile writing this book, I saw an advert for a technical analysis course in\nmy home country, Denmark. Only the year before, the person running the\ncourse had lost 35% of their trading capital on a copy trader account for\ntheir followers, before closing the account.\nThat is the problem with technical analysis. It is very easy to learn, but it\nshould not be touted as the path to untold riches in the financial markets.\nThe gurus appear on adverts suggesting that all you need to make money\nfrom the market is to learn technical analysis.\nI wish it was that easy, but it isn’t.\nIF NOT TECHNICAL ANALYSIS, THEN\nWHAT?\nThere is a law in Europe that states that brokers offering trading services to\nretail clients must disclose what percentage of their clients lose money.\nI looked up the major players in the industry. According to their websites,\naround 80% of their clients lose money.\nI called one broker to ask how this n", "source": "eBooks\\Tom Hougaard - Best Loser Wins.pdf", "doc_id": "db0d74ee3eb2ba5542f0943f7b8e994e1f3211b7a93aee04b5bfd56525c663f3", "chunk_index": 2}
{"text": "hnical analysis.\nI wish it was that easy, but it isn’t.\nIF NOT TECHNICAL ANALYSIS, THEN\nWHAT?\nThere is a law in Europe that states that brokers offering trading services to\nretail clients must disclose what percentage of their clients lose money.\nI looked up the major players in the industry. According to their websites,\naround 80% of their clients lose money.\nI called one broker to ask how this number was calculated. The number is\nadjusted quarterly. The broker compares the account balances of its clients\nfrom the prior quarter and simply takes the percentage of accounts that have\na lower balance than three months earlier.\nIf the answer to the trading quest was to study technical analysis, then you\nwould not have default rates of 80%. Incidentally, the guru who gave a\nweekend course to my friend happens to also own a brokerage that he refers\nall his attendees to. I looked up its default rate.\nMore than 80%!\nSo, either his clients are just awful traders, or he is an awful teacher.\nI will come to the rescue of both camps and state that to become a profitable\ntrader, you need much more than just technical analysis under your belt.\nThat is why I wrote this book – to describe the path I have taken to get\nwhere I am today. Over the last 20 years I have read many books on\ntechnical analysis and trading techniques. I personally find most of them\nboring and pointless.\nAll I see in these trading books is one perfect chart example after another. It\ncreates an illusion in the mind of the reader. They absorb these conceited\ntales, written by traders who espouse the same material as everyone else –\nmaterial that bears little resemblance to the real trading world. It leaves the\nreader blindsided to the reality of the trading arena.\nOf course, there are exceptions. There are some good books written on\ntechniques and strategies, but most of them are garbage because the author\nsuffers under the illusion that he or she should only show perfect trading\nexamples.\nThey perpetuate the illusion that trading is an easy endeavour. I think it is\nfair to say that with a failure rate around 80%, there is absolutely nothing\neasy about trading.\nI dare say that if technical analysis as a subject was comparable to\nsomething like dentistry, the vocation would be terminated on account of\nthe 80% failure rate. You don’t have a 80% failure rate amongst dentists.\nTHE MILLION VIEWS YOUTUBE\nTALK\nI was invited by one of the biggest brokers in the world to give a talk about\nthe life of a home trader. They filmed the event, which lasted a few hours. I\ngave the speech a provocative title:\nNormal Does Not Make Money\nThe broker emailed me last year to say that my video had received five\ntimes more views than their second-best video, and that it had now\nsurpassed one million views on YouTube.\nThis gave me the confidence to push ahead with the book project, because I\ncould see that my message resonated with an audience that wanted to move\nbeyond the conventional teachings in trading.\nAlthough this is not a book about trading techniques, I am not arguing that\nyou can do without technical analysis, or some form of analysis. There must\nbe some rhyme or reason to your entries and exits, and your stop-loss\nplacement.\nHowever, I am also arguing that techniques alone will not make you rich.\nAnalysis alone will not get you to where you want to be. I imagine you\nwant trading to give you a meaningful side income or perhaps even be your\nmain income.\nI am arguing that a normal human being, displaying normal thinking\npatterns and traits, will never stand a chance of making money trading. In\nother words, normal won’t cut it.\nOne of the best books ever written on trading is Reminiscences of a Stock\nOperator. There is not a single mention of trading techniques in that book.\nLet’s face it, we can all learn to walk a tightrope suspended one foot off the\nground. However, can you walk across that same tightrope when it is\nsuspended 100 feet off the ground?\nIn the same vein, we can all trade bravely and aggressively when we are\ntrading one lot, but can you trade with absolute clarity and emotional\ndetachment when you are trading a 10-lot or a 100-lot?\nI can’t guarantee you will trade 100-lots, but I will describe the process that\ngot me to trade that kind of size.\nI am leaving no stone unturned. I have described every facet of life as a\ntrader, from the mundaneness to the excitement, and I have described the\nexact steps I take every day, week, month and year, to ensure that I am up to\nthe job.\nAnd let me immediately make an important declaration: I am not going to\nsugar-coat my message. It is an insanely difficult profession, one that is\nbeyond the apparent mental abilities of almost everybody, yet at the same\ntime a profession that will reward you with wealth beyond your\nimagination, once you understand how this game really should be played.\nThis book describes how to play the game of trading.\nNow you know the end destination. If you don’t like the sound of it, now is\na good time to put down the book and go to the YouTube and TikTok videos\nand watch the Ferrari-driving 20-year-old trading coaches tell you how it is\nall done.\nIf, however, you want lasting change – not only in your trading, but in how\nyou live your life – then stay with me. Your transformation into a consistent\ntrader will permeate other parts of your life. It will give you a deep\nunderstanding of who you are and what you can do to better yourself. The\nend result is not just more money on your trading account, but a more\nharmonious and exciting life journey.\nLIAR’S POKER\nMY JOURNEY AS a trader started when I came across a book called Liar’s Poker.\nI was home from school with flu and my dad brought me some books from\nthe library. Liar’s Poker was one of them.\nIt is a period piece, written by Michael Lewis, the man behind the book The\nBig Short, which was made into a Hollywood blockbuster.\nIn Liar’s Poker, Lewis describes life as a bond trader during the excesses of\nthe 1980s. In his own wo", "source": "eBooks\\Tom Hougaard - Best Loser Wins.pdf", "doc_id": "db0d74ee3eb2ba5542f0943f7b8e994e1f3211b7a93aee04b5bfd56525c663f3", "chunk_index": 3}
{"text": "arted when I came across a book called Liar’s Poker.\nI was home from school with flu and my dad brought me some books from\nthe library. Liar’s Poker was one of them.\nIt is a period piece, written by Michael Lewis, the man behind the book The\nBig Short, which was made into a Hollywood blockbuster.\nIn Liar’s Poker, Lewis describes life as a bond trader during the excesses of\nthe 1980s. In his own words it was meant to serve as a warning to future\ngenerations about the gluttony of the finance industry, as well as a warning\nto young people wanting to work in the financial industry.\nI think it had the opposite effect. I suspect thousands of young men and\nwomen like me read the book and thought to themselves that Wall Street\nwas the place to be.\nThe book describes a young man travelling from America to Britain to\nstudy at a London university and subsequently being hired to work for an\nAmerican investment bank. It describes what it was like to work on a\ntrading floor and observe some of the big traders there.\nI was hooked, and I knew trading would be my vocation. I have since read\nmany other trading books that are perhaps more specific about trading than\nLiar’s Poker, but as a starter book, I could not have asked for anything\nbetter.\nMy life changed after reading that book. It was a wake-up call. I went from\nbeing a skateboard-loving football fanatic, to being a focused and driven\nindividual. I had found my calling.\nI started applying to university degree courses around Europe. I already had\na job at a pension fund as an office trainee. After reading the book, I knew\nthat would not be my end destination.\nI got accepted to a university in Britain for the following year, but I had a\nproblem. There was no funding. I had to pay my own way. I worked all\nhours, day and night. During the day I would work at the pension fund, then\nin the evening I would skate five miles to an amusement park to work there\nuntil 1 am.\nI absorbed as much information as I could from the Danish finance pages. I\nwould read English books to improve my language skills.\nMy family was less than supportive. On the big day of departure, I had to\nmake my own way to the airport. They eventually came around and shared\nmy trials and tribulations throughout the years. My sister once told me she\nchewed her nails the first time she saw me on TV. She was so nervous I\nwould freeze on air.\nMY FIRST BIG TRADE\nThere is a saying in the financial markets that perfectly sums up my first\nbrush with speculation. Don’t confuse talent with luck. I was blind to the\nways of the financial markets, but I got incredibly lucky.\nIt was September 1992. I had just been accepted to my university. I had\nworked hard to earn enough money to finance the tuition fees and living\nexpenses for three years, although I was a little short. I figured I would\nwork through the holidays to make up for the shortfall.\nAs I was packing up my home and preparing myself to journey to the\nUnited Kingdom for my first year as a university student, there was a\nproverbial hurricane blowing through the currency markets.\nThe UK was a member of the European Exchange Rate Mechanism (ERM).\nThis was a system introduced by the European Economic Community to\nreduce exchange rate variability and achieve monetary stability in Europe.\nThe UK joined the ERM in 1990, but by 1992 the UK was in a recession.\nThe Bank of England found it more and more difficult to honour their\ncommitment to maintain the British pound within a tight band against other\ncurrencies in Europe. Speculators were actively betting against the pound,\nthinking that it was heavily overvalued.\nAs I was walking to my local bank in Denmark with my savings, looking to\nexchange my Danish kroner for British pounds, a major drama was\nunfolding in the financial markets. It was called Black Wednesday.\nOn 16 September 1992 the British government was forced to withdraw the\npound from the ERM after a failed attempt to keep the pound above the\nlower currency exchange limit mandated by the ERM.\nI found the following information about Black Wednesday on Wikipedia. It\nsets the tone well for what I was about to experience, and what caused a\nmassive windfall for a 22-year-old aspiring trader:\nSoros’ Quantum Fund began a massive sell-off of pounds on Tuesday,\n15 September 1992. The Exchange Rate Mechanism stated that the\nBank of England was required to accept any offers to sell pounds.\nHowever, the Bank of England only accepted orders during the trading\nday. When the markets opened in London the next morning, the Bank\nof England began their attempt to prop up their currency as per the\ndecision made by Norman Lamont and Robin Leigh-Pemberton, the\nthen Chancellor of the Exchequer and Governor of the Bank of\nEngland respectively.\nThey began buying orders to the amount of 300 million pounds twice\nbefore 8:30 am to little effect. The Bank of England’s intervention was\nineffective because Soros’ Quantum Fund was dumping pounds far\nfaster. The Bank of England continued to buy, and Quantum continued\nto sell until Lamont told Prime Minister John Major that their pound\npurchasing was failing to produce results.\nAt 10:30 am on 16 September, the British government announced a\nrise in the base interest rate from an already high 10%, to 12% to tempt\nspeculators to buy pounds. Despite this and a promise later the same\nday to raise base rates again to 15%, dealers kept selling pounds,\nconvinced that the government would not stick with its promise.\nBy 7:00 that evening, Norman Lamont, then Chancellor, announced\nBritain would leave the ERM and rates would remain at the new level\nof 12%; however, on the next day the interest rate was back on 10%.\nThis was of course all unbeknownst to me, yet it had a material impact on\nmy studies. Had I walked down to the bank just a few days earlier I would\nhave had to pay close to 12 Danish kroner for one pound. By sheer luck I\nwalked straight into, and benefited from, one of the biggest modern-day\ncurrency crashes, and I was able", "source": "eBooks\\Tom Hougaard - Best Loser Wins.pdf", "doc_id": "db0d74ee3eb2ba5542f0943f7b8e994e1f3211b7a93aee04b5bfd56525c663f3", "chunk_index": 4}
{"text": "level\nof 12%; however, on the next day the interest rate was back on 10%.\nThis was of course all unbeknownst to me, yet it had a material impact on\nmy studies. Had I walked down to the bank just a few days earlier I would\nhave had to pay close to 12 Danish kroner for one pound. By sheer luck I\nwalked straight into, and benefited from, one of the biggest modern-day\ncurrency crashes, and I was able to convert my Danish kroner at an\nexchange rate of about 9 kroner to the pound.\nI made an extra £4,000 from my savings. My annual budget with tuition and\nlodging was £2,500. ‘Uncle George’ made my university education debt\nfree.\nAlthough the day was called Black Wednesday, many historians argue it\nwas a Golden Wednesday, because the cheaper pound attracted investment.\nIt set the stage for an economic growth spurt in the United Kingdom.\nTHE PRICE OF A HOTDOG IN PARIS\nI wasn’t the only one who made a life-changing amount of money that day.\nGeorge Soros made a billion dollars. It cemented his name as one of the\ngreatest speculators of all time.\nAnd he wasn’t the only one who had noticed stark value differences\nbetween the European currencies before that fatal day in September 1992.\nAnother trader had too. Actually he wasn’t a trader at all. He owned a\nprinting company in East London. We shall call him the Englishman.\nWhen I started working in the City of London, I heard the story of a client\nwho had been holidaying in France. During a visit to Paris, he found\nhimself buying a hotdog at a corner stand, down by the Eiffel Tower.\nWhen it came to pay for the goods, the price for the hotdog was so shocking\nto our Englishman that he was thinking the hotdog stand owner was trying\nto cheat him.\nHe was assured that this was the prevailing price for a hotdog in Paris. He\ndecided to buy another hotdog somewhere else, just to make sure he had not\nbeen cheated the first time around. The outcome was the same.\nOur Englishman was laying the foundation for one of the greatest single-\nman bets in the history of the retail trading industry. He walked into a\nsupermarket in Paris and started making a note of the prices for food, drink\nand other household items.\nBack in London our Englishman compared the French prices to the prices\nfor the same goods in his local supermarket, and he concluded that the\nFrench franc was hugely overvalued. He called his financial trading house,\nand spoke to a young broker, who was later to become my boss.\nMy boss loved to tell the story of how his client managed to turn a £5,000\naccount deposit into an £8m (that is eight million pounds!) profit. He\nrelentlessly pursued the idea that the French franc was hopelessly\novervalued, and he profited hugely from it.\nThe reason for sharing this anecdote is not merely to tell you a good story,\nbut also to prepare you for what this book is all about. You see, this might\nhave been a great story, had it not been for the fact that the client later went\non to lose all of that money, and then some.\nIsn’t successful trading all about making the money and holding on to it as\nwell?\nWhat 99% of people do not realise is that when you win, there are things\nhappening in your brain chemistry, which – if left unnoticed and unchecked\n– will have a detrimental effect on your decision making.\nECONOMIC THEORY AND\nECONOMIC HISTORY\nStudying at university taught me what there was to learn about economic\ntheory. It taught me how the financial markets were put together and how\ncurrent economic theory tried to make sense of the world around us.\nHowever, it didn’t teach me how to trade. It didn’t teach me how\nmomentum, psychology and sentiment have a major influence on the\nfinancial markets. My degree course did little to prepare me for the real\nworld. I thought that taking a master’s degree would change that, and while\nit was a little more industry relevant, I still felt the market was a big\nmystery to me.\nThe idea that you can test variables within an economic system by holding\nother components constant didn’t sit well with me. I am not sure I was\nconsciously mindful of it then, but I saw the world differently.\nI didn’t think that the markets were efficient. I had a strong belief that the\nmarkets were anything but rational. The markets are driven by humans, and\nif there is something humans are not, it is rational or logical when exposed\nto stress.\nRICH MAN’S PANIC\nI enjoyed studying economic history more than I enjoyed studying\neconomic models. One of the pivotal moments came when studying the rich\nman’s panic of 1903 and the panic of 1907. Bernard Baruch, a famed Wall\nStreet speculator, made a substantial amount of money by correctly\nanticipating the consequences of a failed corner of a railroad stock.\nA corner is when a group of people or a syndicate inflates the price of a\nstock in order to create a buzz, thus trying to entice more gullible investors\nto join the bandwagon, and then offloads the stock to the latecomers. Today\nit would be called a pump and dump. Just think GameStop!\nWhat made an impression on me was how Bernard Baruch anticipated the\nsequence of events. He started to sell short a broad range of popular stocks\nbecause he reasoned that the syndicate would have to raise money to keep\ntheir ill-fated corner alive. He was right. The general market declined\nrapidly. The Dow Jones Index fell 49% in a few months, and Baruch\nprofited from it.\nFrom then onwards I found it difficult to study economic models. I found\nthem rigid and too theoretical in concept. I felt they made fallible\nassumptions. They argued that humans always act rationally.\nBut mankind most certainly does not always act rationally. As I write this\npage, I am looking at my quote monitor. The Dow Jones is called down 500\npoints. The DAX Index is already down 250 points. “Why is that?” I hear\nyou ask. It is because there is a serious virus called coronavirus spreading\nthrough the world. Some 80 people have died already.\nThe market is not so concerned about the 80 people. The market is\nconcerned it is", "source": "eBooks\\Tom Hougaard - Best Loser Wins.pdf", "doc_id": "db0d74ee3eb2ba5542f0943f7b8e994e1f3211b7a93aee04b5bfd56525c663f3", "chunk_index": 5}
{"text": "not always act rationally. As I write this\npage, I am looking at my quote monitor. The Dow Jones is called down 500\npoints. The DAX Index is already down 250 points. “Why is that?” I hear\nyou ask. It is because there is a serious virus called coronavirus spreading\nthrough the world. Some 80 people have died already.\nThe market is not so concerned about the 80 people. The market is\nconcerned it is going to get worse. The markets are ALL about perception,\nsprinkled with economic reality. I don’t understand the fundamentals behind\na virus, and I don’t need to.\nMy job is NOT to understand the implications of a virus. My job is to\nunderstand the players in the market and what they are feeling. They are\nscared, and I have spotted their fear. So of course I am short. I am not short\nthe market because I think a virus is going to wreak havoc on the global\neconomy. I am short because I think they think something terrible is about\nto happen.\nWhatever happens, my job is to read the sentiment and to keep my own\nemotions in check.\nThat is essentially what I am going to teach you in this book. I am aligned\nwith reason when it comes to explaining bull markets and bear markets. The\nhealth of the underlying economy will drive a market up or down. However,\nas a day trader I need to have a mental flexibility that is never described or\naccounted for in economic theory.\nI also need to know “when to hold, and when to fold,” as Kenny Rodgers\nsings in ‘The Gambler’. Am I a gambler? If I say yes, you might think there\nis no difference between me and the guy who visits a casino for a bit of\nexcitement.\nWhat if I were to tell you that I make more money than the average\nprofessional football player, and I do so not because I am gifted with special\nabilities to read the markets, but because I have learned to control my\nemotions?\nI am not an unemotional sociopath. I feel. I love. I cry. I ache. I mourn. I\nlaugh. I smile. You can be a nice guy and still finish on top. But you do\nneed to learn to think differently than the 99% does, when you are trading.\nWe will get to that soon enough.\nJPMORGAN CHASE\nAfter my graduation I interviewed for many graduate jobs within the\nbanking and finance industry. I didn’t get my dream job, working as a\ntrainee trader, but I did get a good job working for Chase Manhattan Bank,\nlater called JPMorgan Chase.\nIt was an invaluable experience. I arrived with a bagful of enthusiasm.\nWorking for an American investment bank was probably the best thing that\ncould have happened to me.\nI was able to channel my enthusiasm for the financial markets into my\nwork. I worked with portfolio analysis and performance benchmarking,\nwhich meant I was able to observe the financial markets unfold before my\neyes every single day.\nI happened to sit right next to a Bloomberg terminal. I loved that machine. I\nwould often sneak into the office building on Saturdays and Sundays to\ndevour analysis and trading stories, and download data.\nThe great thing about working for an American bank is that there is a very\ndifferent work ethic to typical European companies. This may have changed\nin the last 20 years, but when I was working at JPMorgan we were literally\nallowed to work as many hours of overtime as we wanted.\nI worked for JPM for close to three years, and in those three years I never\nhad a month where I didn’t do at least 40 hours’ overtime. You got used to\nworking long hours with focus because the job required forensic attention to\ndetail.\nBy the time I left the bank, I was a hardened and seasoned workaholic. I\ndon’t say that with pride, but I don’t think there is any point in hiding the\nfact that the reason for my success was not due to immense intelligence, but\nrather my work ethic. I just worked longer hours than the others. I made the\nsacrifice for what I wanted.\nMy attitude reminds me of the ethos of Navy Seals, the American special\nforces unit: anything in life worth doing is worth overdoing. Moderation is\nfor cowards.\nMy dream finally did come true, when I walked onto a trading floor for the\nfirst time.\nTHE TRADING FLOOR\nWALKING ONTO A trading floor is a special experience. I vividly remember being\ninterviewed for a trading job after my university graduation. This took place\non the trading floor of Handelsbanken, the Scandinavian bank, and the guy\nwho interviewed me was the head of trading.\nI could tell that he was intensely focused on something else, and I was an\ninconvenient distraction. I have been in that situation many times in my\ntrading life. Having a big position on in the market and then having to deal\nwith the trivialities of the world outside of trading can be a peculiar\nexperience.\nBoxing Day 2018 is a great example. I was trading the biggest one-day rally\nin the history of the Dow Jones Index, while eating Christmas pudding. I\nhad to hide my mobile phones under the dinner table so as not to offend my\nhost, and I had to fake numerous trips to the toilet so I could watch the chart\non one phone and the broker platform on another.\nI arrived at the trading floor of Financial Spreads with a very different\nattitude to most of my colleagues. As I know many of them will read this\nbook, I owe it to them to explain that I am not accusing them of being lazy.\nI had lots to learn, including the fact that when the markets are quiet, there\nreally isn’t much for brokers to do.\nWhat I found was that people would sit around and read the newspapers or\ncomic books. If the phone didn’t ring, you could hardly force a broker to do\nanything. I think this was the biggest culture shock I experienced – the\ncontrast between a normal office job and a trading floor.\nWorking on a trading floor is intimidating at first. As the months go by, you\nbecome immune to the money changing hands. It is all just numbers on a\nscreen. I once walked in at 6 am to find that a Russian client was on a\nmargin call for $10m. I quickly calculated that it would take me 133 years\non my current salary to make $10m. By 7 am he had wired the funds over", "source": "eBooks\\Tom Hougaard - Best Loser Wins.pdf", "doc_id": "db0d74ee3eb2ba5542f0943f7b8e994e1f3211b7a93aee04b5bfd56525c663f3", "chunk_index": 6}
{"text": "l office job and a trading floor.\nWorking on a trading floor is intimidating at first. As the months go by, you\nbecome immune to the money changing hands. It is all just numbers on a\nscreen. I once walked in at 6 am to find that a Russian client was on a\nmargin call for $10m. I quickly calculated that it would take me 133 years\non my current salary to make $10m. By 7 am he had wired the funds over.\nThis was a private trader. I was in awe. Inspired.\nThere is a unique atmosphere present on a trading floor. When it is busy, it\nis nothing short of a gigantic melting pot of human emotions. I once saw a\ncolleague of mine kick his PC so hard – repeatedly – that IT engineers had\nto come and replace it.\nIt is hard to fathom that the financial markets are a complex mechanism if\nyou just look at what is happening on a trading floor. It reminds you more\nof a local market stall on a busy Saturday morning in any given town\nanywhere in the world, where one stall owner is trying to out-voice the\nnext.\nWhen you witness the raw, uncensored emotions that unfold before your\neyes on the trading floor, it is difficult to see how that fits into a finely tuned\nglobal economic environment that makes up the very fabric of our modern\nsociety and civilisation.\nImpulse buying, panic selling, holding on to losses, refusing to admit\ndefeat, greed, stupidity, stubbornness, despair, tears, abject depression,\nexhilaration and excitement are all on display here, and all in quick\nsuccession of each other.\nI worked for Financial Spreads for a year, and was then asked to leave. The\nsame day I was headhunted to City Index, which was owned by ICAP – the\nbiggest US government bond broker in the world.\nCity Index had about 25,000 clients, of which 3,000 were active most days.\nThese clients would trade currencies, commodities, stock indices, individual\nstocks, options, bonds and anything in between. I must have witnessed tens\nof millions of trades in my career, executed by thousands of people. Very\nfew, if any, of them stood out, and if they stood out it was for all the wrong\nreasons. For every success story, I can tell you ten horror stories.\nNO MEMORY OF THE GREAT\nTRADERS\nI recently spoke to a friend of mine, who is the CEO of a trading company\nin London. I asked him if there were traders who had stood out during his\n30 years working on trading floors. He said that over the years he had\nwitnessed many bizarre things, but in terms of good traders, he had seen\nvery few.\nHere is a man who has spent his entire adult life on trading floors, yet he is\nincapable of remembering people who did well. We are talking about a\npercentage of successful traders so infinitesimally small that it makes you\nwonder why anyone would want to trade in the first place, or if anyone\ncould ever get good at this profession. The conversation with him went as\nfollows.\nTom: You have worked in the contract for difference (CFD) industry for 30 years. You must\nhave seen some good traders along the way. Can you tell me about them?\nCEO: I wish I could. I have seen many people make a lot of money, but very few managed to\nkeep the money. I started in the industry at a time when CFD trading was not a mainstream\ntool. It was mostly very wealthy people or people who worked in the industry that had CFD\naccounts. These clients back then often traded as part of an old boys’ club kind of network. It\nmeant they mostly traded specific shares and some commodities. Back then trading was\nnowhere near as prolific as it is today.\nTom: Were they good traders?\nCEO: No, I would not say they were. We had clients who were well-known personalities in\nthe City, and their personal trading was often atrocious, even though they were hedge fund\ntraders or fund managers. It was almost as if they lost their discipline when trading their own\nmoney. I am certain they would not be allowed to trade for their clients in the manner they\ntraded for themselves.\nToday we have far more smaller traders, but the pattern is remarkably similar between a small\ntrader and a large trader. Almost all clients have more winning trades than losing trades. As\nsuch you could argue that they are good traders.\nHowever, they tend to lose more, much more, on their losing trades than they win on their\nwinning trades. The ratio is that for every pound they win, they lose about £1.66.\nTom: How does a CFD broker make money out of that?\nCEO: Well, believe it or not, we want our clients to win. I have a network of contacts in the\nCFD industry. I regularly meet with CEOs of competing companies. Although we are\ncompetitors, and we would do anything to outmanoeuvre a competitor, we do have one shared\nwish. We wish our clients would trade better.\nWe try our best to help them. We give them every tool under the sun. We give them favourable\nspreads, and we give them news services. We give them sophisticated charting packages. We\ngive them data. We give them analytical tools to measure their performance.\nIn short, we do absolutely everything we can to ensure they have all the tools they need to\nmake money. And then we let them trade. The problem is that most smaller accounts tend to\nlose within a short space of time.\nTrust me when I say I wish it was different. I don’t know what more we as brokers can do for\nour clients. We prefer clients to make money because there is clear evidence that those who\ntrade and win, carry on trading. That is better for business.\nThe truth of the matter is that you can clearly see the difference between a consistently\nprofitable trader and a normal trader. Their approach is very different.\nTom: How can you tell whether someone knows what they are doing?\nCEO: There are a multitude of parameters that we may look at. If I have to narrow it down to\nthe five most important factors, it would be these:\n1. Account size.\n2. Trade frequency.\n3. Ratio of time spent holding winning trades versus losing trades.\n4. Adding to winning or adding to losing trades.\n5. Trading with a stop-loss.\nSomeone who opens an accoun", "source": "eBooks\\Tom Hougaard - Best Loser Wins.pdf", "doc_id": "db0d74ee3eb2ba5542f0943f7b8e994e1f3211b7a93aee04b5bfd56525c663f3", "chunk_index": 7}
{"text": "l whether someone knows what they are doing?\nCEO: There are a multitude of parameters that we may look at. If I have to narrow it down to\nthe five most important factors, it would be these:\n1. Account size.\n2. Trade frequency.\n3. Ratio of time spent holding winning trades versus losing trades.\n4. Adding to winning or adding to losing trades.\n5. Trading with a stop-loss.\nSomeone who opens an account with anything less than £100 will, with a very high degree of\ncertainty, lose that money, sadly. Someone who trades everything and anything, i.e.,\novertrading, will eventually lose their money.\nAnyone who is unable to hold on to their winners, but holds on to their losing trades, will\neventually lose their money.\nAnyone who adds to their winning trades will catch our attention (positively), but anyone\nadding to their losing trades will, with near certainty, lose their account deposit at some point.\nAnyone trading without a stop-loss will follow that path too. We sadly see it all the time.\nAs you can see, as brokers we do everything we can to help people make money, but people\nare people, which means they will find a way to self-sabotage.\nCONDITIONS 20 YEARS AGO\nI keep an eye on all brokers, to make sure I trade with the best and cheapest.\nWhy would I pay 1.5 in spread if I can pay 1 in spread? That is simple\neconomics. I run a business, and I want to spend as little on transaction\ncosts as possible.\nOne of my favourite instruments to trade is the German DAX Index. Today\nwhen I trade, I pay a 0.9 point spread in the DAX.\nHowever, when I started trading some 20 years ago, the spread intraday in\nthe DAX was 6 to 8 points. I remember vividly trading the Dow intraday.\nYou had to pay an 8-point spread in the Dow for the intraday product.\nIf you wanted to trade the quarterly contract the spread was 16 points. This\nwas at a time when the Dow was trading around 10,000. Today I am trading\nthe Dow with a 1-point spread and the Dow is now trading around 35,000.\nYou are much better off trading in 2020 than you were trading in 1999. It\nwas much harder to make money trading back then. The market has to\nmove significantly less in your favour before you are at breakeven now,\ncompared to 1999.\nAnother major advantage that people who start trading today have is the\ntools available from the brokers. Look at virtually any trading platform\ntoday, and you will see the length brokers go to in order to help you make\nmoney.\nYou have access to hundreds of technical studies. You have access to instant\nnews flow. You have the option to be trained through online material and\nwebinars. You have access to Level 2 data for stocks all over the world.\nYou have decent bid-ask spreads. If an institutional trader from 30 years ago\nsaw the tools that you are trading with today, he or she would be green with\nenvy.\nYou have at your disposal every single conceivable analytical tool available\nfrom the vast resource pool of technical indicators. You have Bollinger\nBands, you have Keltner Channels, you have moving averages. You have\ntools that I have never even heard of or used myself.\nSuffice it to say, every broker in the world has spared no expense in their\neffort to provide you with every opportunity to make as much money as you\npossibly can out of the markets.\nBut it matters nothing. Most people will fail. The failure rate is\nastronomical in the trading industry. No one is immune to statistics.\nNORMAL IS A LOSER\nThere is something inherently wrong with the approach of people who are\ntrading. We have to assume that most people in society are normal, well-\nadjusted human beings. Their pattern of behaviour, while leaving room for\npersonality, is most likely very similar.\nFrom cradle to grave, from morning to night, from one year to the next, the\naverage person is engaged in a remarkably similar pattern: pattern of\nthought, pattern of action, pattern of hopes and dreams, fears and\ninsecurities. We call that person normal.\nIf normal is the familiar pattern, and if normal is opening an account with a\nCFD broker and proceeding to lose the money (sooner or later), then normal\nis simply a representative of everyone else. Everyone who is normal will\nend up losing.\nIs that a push too far? Let us look at the evidence. Let us take a look at the\nnorm for a typical CFD trader in the retail trading space.\nEven though your broker makes all the tools under the sun available to you,\nno one is immune to the statistics of the financial markets. Unless you have\ngone through some sort of structured training, or you have been schooled by\nsomeone who is walking the path you yourself want to walk, or you give\nthis endeavour some serious thought, you will most likely fail in the\nfinancial markets.\nLook at any broker website in the European Union, and you will see the\nfailure rate. Brokers are obliged by law to post this on the front page of\ntheir website. Here are some of the biggest and most well-known CFD\nbrokers in the world, and their failure rates:\nBROKER FAILURE RATE\nIG Markets 75%\nMarkets.com 89%\nCMC Markets 75%\nSaxo Bank 74%\nFX PRO 77%\nRates correct as of 7 November 2019.\nI know you like to think you are different. However, in the eyes of the\nfinancial markets, you are statistically like everyone else.\nYou can look at the top ten brokers of the world and the statistics do not\nchange. You can look at CMC Markets, you can look at IG Markets, you\ncan look at Gain Capital, or you can look at any one of the top tier or\nsecond tier CFD brokers. No one will have a failure rate less than 70%.\nNORMAL IS NOT GOOD ENOUGH\nTools do not make you a top trader. Techniques do not make you a top\ntrader. If you want to be a good trader, if you want to achieve the level of\nsuccess that you know is possible, you immediately need to stop thinking\nthat the path to riches in trading has anything to do with the tools or\ntechniques you are using.\nYes, of course you need a strategy. Yes, you need a plan. Yes, you need to\nunderstand the markets. So, what is this book all about,", "source": "eBooks\\Tom Hougaard - Best Loser Wins.pdf", "doc_id": "db0d74ee3eb2ba5542f0943f7b8e994e1f3211b7a93aee04b5bfd56525c663f3", "chunk_index": 8}
{"text": "not make you a top\ntrader. If you want to be a good trader, if you want to achieve the level of\nsuccess that you know is possible, you immediately need to stop thinking\nthat the path to riches in trading has anything to do with the tools or\ntechniques you are using.\nYes, of course you need a strategy. Yes, you need a plan. Yes, you need to\nunderstand the markets. So, what is this book all about, if it is not about\ntools and strategies?\nWell, let me address that question from a different perspective. Let me\naddress it from the perspective of the people who work in the industry as\nbrokers and sales traders and as marketing people.\nDo they trade?\nI would say it is likely they do not. Yet, traders are taking advice, guidance\nand training from them; they being guided by people who are no better at\ntrading than they are.\nIt reminds me of Fred Schwed’s book, Where Are the Customers’ Yachts?,\nin which he says that Wall Street is the only place in the world where people\nwho arrive to work by train and bus give advice to people who arrive by\nlimousine and helicopter (slightly paraphrased for a more modern touch).\nTraders are being guided by people who can’t trade!\nWRONG FOCUS\nWhen you go to trading shows, read trading magazines or look at the online\neducation materials on broker websites, 100% of the focus is on what I call\nHow To:\n•How do I scalp?\n•How do I swing trade?\n•How do I day trade?\n•How do I trend follow?\n•How do I trade the foreign exchange (FX) market?\n•How do I use Ichimoku charts?\n•How do I trade with moving average convergence divergence\n(MACD) or stochastics?\nThis is perfectly normal. The trade shows and magazines are geared\ntowards providing the solutions that most people believe they need in order\nto make money in the financial markets. The brokers are following the same\npath. They provide the information that they think traders need and that\ntraders think they need.\nNewcomers to the industry of trading are often guided by the very people\nwho are likely to set them off on the wrong path. They are led to believe\nthat it is all about technique and strategy – no one is preparing them for the\nfact that it isn’t strategy that will set them apart from other traders.\nIt is how traders think about their strategy – and their ability to follow the\nstrategy – that will set them apart.\nDo you not wonder if this is the right path for you? Do you not wonder\nabout the futility of dedicating all your resources to one pursuit, when\nvirtually everyone who walked that path before you has failed?\nYou should. You really should ask yourself what makes you different to the\n90% of traders that do not make money. If you are normal – as in you do\nwhat everyone else is doing – then you won’t make it.\nNORMAL WON’T CUT IT\nThe organisers of one of these trade shows invited me to give a talk. This\nshow was in London, and I was told I could talk about whatever I wanted. I\ndecided to give a talk about the disastrous failure rate in the trading\nindustry.\nMy argument is that if 90% of all CFD accounts lose money, the problem is\na human problem. I feel I am making a reasonable assumption when I say\nthat everyone opening a CFD account is a normal person with a normal way\nof thinking. There must be something inherently wrong in the way normal\npeople think and act that makes trading so unsuccessful for them.\nIT SHOULD BE EASIER THAN EVER\nTO MAKE MONEY TRADING\nI mentioned previously how small today’s bid-ask spreads are compared to\n20 years ago. Therefore, it should be easier than ever for traders to make\nmoney. However, it isn’t.\nPeople are still struggling to make money trading. My main premise of this\nbook is to get to the bottom of this conundrum. The approach I have taken\nis centred around the following facts:\n1. It has never been easier to trade. The IT infrastructure is superb for\ntraders.\n2. The spreads have never been lower.\n3. The margins have never been more favourable.\n4. The tools have never been so readily available.\n5. The brokers have never done as much for their clients as they do\nnow.\n6. The stock indices have never been higher, meaning there is\nvolatility.\nTo reiterate, I assume that people who open trading accounts are normal,\nwell-adjusted human beings – without using this as a slight or an insult –\nwho are perfectly capable of functioning within society.\nThe questions I want to ask, and answer, are these: what does normal\nbehaviour look like? How can I avoid being normal when I trade? If we\nassume that 80–90% of people trading are normal people, I want to avoid\nacting like they do.\nARE YOU NORMAL?\nMy argument, provocative as it is, asks an essential question: are you\nthinking like everyone else is thinking and approaching trading like\neveryone else is approaching trading?\nIf so, you will have a problem.\nIf you think like everyone else, is it so strange that you get the results that\neveryone else gets?\nLet us take a look at what normal behaviour is.\nNormal behaviour is to engage in a never-ending cycle of education,\nlooking for the next new edge. I knew from the moment I read Liar’s Poker\nthat I wanted to be a trader, but I never had any formal training in how a\ngood trader behaves. Why should I? I was always told that a good trader\nbuys low and sells high. But every time I bought low, it always went lower\nand lower. So what kind of advice was that?\nAnd yet this is the advice we listen to when we start. This is the benchmark,\nand if this is the benchmark, then it is a miracle that it is only 90% that are\nlosing. It should be 100%, because buying low and selling high is a sure\nrecipe for ruin.\nPeople will attend weekend courses hoping to learn secrets. People will\nstudy and learn to use tools such as candlestick analysis, stochastics,\nRelative Strength Index (RSI), MACD and moving averages. The list goes\non and on. All of this is normal behaviour in a nutshell.\nEVEN THE BIBLE IS WRONG\nEven the bible of technical analysis doesn’t do much to help a person on\ntheir way, once the initial learning curve", "source": "eBooks\\Tom Hougaard - Best Loser Wins.pdf", "doc_id": "db0d74ee3eb2ba5542f0943f7b8e994e1f3211b7a93aee04b5bfd56525c663f3", "chunk_index": 9}
{"text": "attend weekend courses hoping to learn secrets. People will\nstudy and learn to use tools such as candlestick analysis, stochastics,\nRelative Strength Index (RSI), MACD and moving averages. The list goes\non and on. All of this is normal behaviour in a nutshell.\nEVEN THE BIBLE IS WRONG\nEven the bible of technical analysis doesn’t do much to help a person on\ntheir way, once the initial learning curve is over.\nThe bible of technical analysis was authored by Robert D. Edwards and\nJohn Magee. The book is called Technical Analysis of Stock Trends, and it\nhas sold millions of copies since its first printing in 1948.\nWhat most readers don’t realise, however, is that Edwards and Magee were\nnot the real creators of modern technical analysis. Rather, it was a little-\nknown technical analyst named Richard W. Schabacker.\nA brilliant market technician, Schabacker codified almost everything there\nwas to know about technical analysis up to his time – which included such\npioneering work as the Dow theory of Charles Dow.\nBetween 1930 and 1937, Schabacker taught several courses to serious Wall\nStreet traders and investors. Unfortunately, he died in 1938 when he was\nnot even 40 years old.\nShortly before his death, Schabacker gave a mimeographed copy of his\nlessons to his brother-in-law, Robert D. Edwards, who rewrote\nSchabacker’s lessons with the help of his collaborator, John F. Magee, an\nMIT-trained engineer.\nAs a result, it was not Schabacker who received credit for the original\ncompilation of technical analysis, but Edwards and Magee, whose work\nbecame a perennial bestseller.\nLet me be clear: reading a book like Technical Analysis of Stock Trends is a\nmust, but please don’t think that it will make you a professional, profitable\ntrader, any more than reading a manual on tennis will enable you to\ncompete with Rafa Nadal.\nI see newcomers make classic mistakes after reading books on technical\nanalysis. They will study indicators such as RSI and stochastics, and they\nwill excitedly declare that a market is ‘overbought’ or ‘oversold’.\nWhat they don’t realise is that ‘overbought’ is an emotional expression for a\npsychological conceptualisation of ‘expensive’. The people reading a\nstochastics chart are led to believe – through a mathematical manipulation\nof data – that the market is now expensive, and it should be shorted.\nThe same can be said for ‘oversold’. It is another way for the mind to tell\nyou that the market is cheap, and that there is value associated with it.\nI’ll give you an example. Yesterday was a particularly bearish day in the\nDow Jones Index and the German DAX 40 Index. I was short all day and I\nhad one of my better days, all verified and documented on my Telegram\nchannel. It was 1 October 2019.\nTowards the end of the day, when the Dow Index was falling even lower, a\nstudent of mine contacted me and asked me a very alarming question. The\nconversation was in Danish, and I have translated it here.\n“Tom, have you seen the stochastics indicator? It is deeply in ‘oversold’\nterritory. Do you think it is a good idea to buy now, ahead of the close?”\nI reply: “Hmm, I am short… maybe you should ask someone else.”\nHe goes on to express his absolute shock that I am short, and a little later he\ngoes on to state that he has bought the Dow at 25,590.\nOf course, when there is a buyer, there is a seller. However, I am not\nconvinced that buying the Dow Jones Index ten minutes before the close, on\na day where it has fallen 400 points, is a good idea.\nIt reminds me of the kind of thinking I would have done 20 years ago. Not\ntoday though. If I buy the Dow on a weak day, just before the close, it is to\nclose a short position. I value my sleep too much to carry a position\novernight.\nI said to him: “You had all day to find a short entry. What are you hoping to\nachieve by being a buyer now? Are you thinking that because it has fallen\n400 points, now it is cheap, and maybe just before the close, you may see\nsome buying of these cheap stocks?”\nI used to think like that too. That was when I was not profitable.\nThe Dow didn’t rally into the close. There was no bounce. I am sure my\nstudent didn’t lose a lot. It wasn’t so much his wallet I was concerned about\n– it was his way of thinking.\nThat is what this book is about. It is about making you think the right way\nabout the market. That is where the 80–90% of losing traders tend to go\nwrong.\nCLOSE THE SCHOOL\nIf trading was a school, it would be closed. No school or university could\nfunction if 90% of its students failed their exams.\nWe are all pretty much normal people. We fit in and function well within\nthe fabric of modern society. If every person engaged in trading is a normal\nhuman being – and I assume they are, meaning they are well-functioning,\nintelligent, considerate, hard-working – then why is there a 90% failure rate\nin our industry?\nThat doesn’t make any sense at all. Usually when people work hard at\nsomething they will succeed, or they will see some degree of success. That\ndoesn’t appear to be the case with trading. Other professions do not have a\n90% failure rate.\nIf you go to the dentist, and you are told there is a 90% chance he will not\nbe able to fix your teeth, you are out of there like a shot. Yet, those are the\nodds that face a private trader. But it doesn’t have to be like that.\nAs traders, we tend to engage in a never-ending, predictable cycle. We trade\nwell for a while. We are happy. Our discipline weakens. We lose money. We\nstrengthen our resolve, and we get more education. We do well for a while.\nWe lose money. We stop – sometimes for a while, sometimes permanently.\nSound familiar?\nThe sad part about this cycle is that everybody has good spells in trading.\nEverybody has periods when they make money. Everybody has their\nmoments. I am sure you have too.\nSo what happens? What happens is that 99% of people do not know how to\nlose. The emotions they experience when they lose cause them to act in a\nmanner which is not in their own best interest.\nEmotions are", "source": "eBooks\\Tom Hougaard - Best Loser Wins.pdf", "doc_id": "db0d74ee3eb2ba5542f0943f7b8e994e1f3211b7a93aee04b5bfd56525c663f3", "chunk_index": 10}
{"text": "ently.\nSound familiar?\nThe sad part about this cycle is that everybody has good spells in trading.\nEverybody has periods when they make money. Everybody has their\nmoments. I am sure you have too.\nSo what happens? What happens is that 99% of people do not know how to\nlose. The emotions they experience when they lose cause them to act in a\nmanner which is not in their own best interest.\nEmotions are response driven. Say you hear a funny joke, and you laugh out\nloud. That is an emotion. When you hear the joke the next time, you don’t\nlaugh. Your mind has become habituated to the joke.\nWhen you fall in love with a beautiful man or woman you experience\nstrong emotions, and your inner life is in beautiful turmoil. When you see\nthat person, you just want to express your love for him or her, and be united\nwith them, gaze into their eyes.\nAs time goes by, your loving turmoil is replaced with a sense of calm. You\nlove being around them, but the feelings of passion are less pronounced\nthan they were in the beginning. You have become habituated to the other\nperson.\nA free solo climber, climbing intimidating rock surfaces without ropes, is\nfaced with severe consequences if they lose their grip. They acclimatise\ntheir minds through years of practice, so that their amygdala – the\nemotional response centre of the mind – is not firing on all cylinders when\nthey are climbing. They are calm.\nAn elite solider is scared to death the first time he is in a combat situation.\nThat is why his first combat situation will be a simulation. And the next\none. And the next one. And little by little, his fear is trained out of him,\nthrough the use of repetition, breathing awareness and habituation.\nFor every hour you spend on technical analysis, you must set aside at least\n25% of that time for what I call internal analysis. You need to know what\nyour weaknesses are. You need to know what your strengths are. You need\nto know what you are good at, and you need to know what you are not good\nat.\nIf you don’t spend time trying to improve these things, how will you get\nbetter? Very few people, if any, will engage in that level of introspection in\norder to gain the results they want. If making money trading is your goal,\nand 99% of people lose, and 99% of people think analysis and strategies are\nthe key to trading profits, you can be 100% sure that strategies and analysis\nare not the key to trading profits.\n43 MILLION TRADES ANALYSED\nThere is a piece of research that makes for very interesting reading. It was\nthe brainchild of an analyst called David Rodriguez, and it is brilliant.\nRodriguez worked for a major FX broker, and he attempted to find out why\nthere was such a high failure rate amongst its clients trading currencies. The\nbroker had some 25,000 people who traded FX daily.\nRodriguez investigated all the trades executed over a 15-month period. The\nnumber of trades was truly staggering. The 25,000 people executed close to\n43 million trades. From a statistical point of view, that created a statistically\nsignificant and immensely interesting sample space to investigate.\nSpecifically, Rodriguez and his colleagues looked at the number of winning\ntrades. I would like to give you an opportunity now to think about how\nmany trades were winning trades and how many trades were losing trades.\nYou can represent it as a percentage of the overall 43 million trades.\nIf you feel it has any influence on the answer you want to give, I can tell\nyou that most of the trades were executed in Euro Dollar, Sterling Dollar,\nDollar Swiss and Dollar Yen.\nHowever, the vast majority of the trades were executed in Euro Dollar,\nwhere the spread is very tight. Unfortunately, that doesn’t seem to make\nmuch of a difference to the outcome.\n62% of all the trades by the broker’s clients ended in a profit. That is a little\nmore than six out of ten trades. That’s a good hit rate. A trader with a hit\nrate of six out of ten should be able to make money from trading.\nOf course, it does depend greatly on how much he wins when he wins and\nhow much he loses when he loses. Therein lies the problem for the 25,000\npeople.\nThey were very successful in terms of hit rate. Yet when you look at how\nmuch they made on average per trade and how much they lost on average\nper trade, you soon realise that they had a major problem. When they won,\nthey made about 43 pips. When they lost, they lost about 78 pips.\nThere’s nothing wrong with having a system where you lose more on your\nlosing trades than you win on your winning trades. However, it does require\nthat you have a sufficiently high hit rate in order to absorb the losing trades.\nA colleague of mine, a professional trader from South Africa who trades at\na hedge fund, has a hit rate of about 25%. I tell his story in greater detail\nlater in the book, but let me explain the term hit rate in the context of his\nhedge fund.\nWhen his hedge fund loses on a trade, they lose 1X. When they win, they\nwin as high as 25X. It stands to reason that my friend is immensely\nprofitable even though he doesn’t have a convincing hit rate, at least not\nfrom a traditional perspective.\nWhat I find particularly interesting is how much bad advice there is in the\ntrading industry. You will often hear traders talk about risk-to-reward ratio,\nwhich in itself is fairly innocent, unless the trader takes it literally and\napplies it on a trade-by-trade basis.\nWhen I call out trades in my live TraderTom Telegram group, I will always\nannounce a stop-loss. Always! However, I often get asked if I have a target\nin mind. The answer is quite often a little sarcastic: “No, my crystal ball is\nout for repairs,” or if I am particularly grumpy and tired, I will be rude and\nsay, “Sorry amigo, but do I look like a fortune teller to you?”\nYes, I know – that isn’t very polite. I’m sorry. Ignoring my blatant inability\nto be polite when I am faced with the same question for the 450th time,\nthere is a deeper meaning to me not calling targets on my trades. It has a lot\nto do wit", "source": "eBooks\\Tom Hougaard - Best Loser Wins.pdf", "doc_id": "db0d74ee3eb2ba5542f0943f7b8e994e1f3211b7a93aee04b5bfd56525c663f3", "chunk_index": 11}
{"text": "y crystal ball is\nout for repairs,” or if I am particularly grumpy and tired, I will be rude and\nsay, “Sorry amigo, but do I look like a fortune teller to you?”\nYes, I know – that isn’t very polite. I’m sorry. Ignoring my blatant inability\nto be polite when I am faced with the same question for the 450th time,\nthere is a deeper meaning to me not calling targets on my trades. It has a lot\nto do with risk versus reward.\nRISK VERSUS REWARD\nI personally find the whole risk-to-reward concept enormously flawed, but\nsince I am the only one who ever talks about it, I accept that I am probably\nwrong. Still, hear me out.\nHow on earth do I know what my reward will be? I literally do not know.\nEven if I pretended to know – say, by using a measured move calculation or\na Fibonacci extension – I know myself well enough to know that I will have\nadded to my trade along the way. When it got to my target, I would not\nclose it, because that is my philosophy.\nI would kick myself if I closed a trade at my target, and then it went even\nfurther. I would rather give away some of my open profits than miss out on\npotentially even more profits.\nNow I am probably making a big fuss out of nothing, but targets are not for\nme. I want to see what the market will give me. I am prepared to accept that\nthis may mean I will give away some of my open profits. I have lost count\nof the number of times I have had a 100-point winner in the Dow, which\nthen turned into a zero.\nA week before writing this (all documented of course) I had one such\nwinner, which turned into a big fat zero. Some less-than-happy traders\nconfronted me in my live trading room as to why I had not taken my profits.\nIt is difficult to explain, but it is all to do with pain.\nIt gives me much less pain to kiss a 100-point winner goodbye than it does\nto take my 100 points, only to see the market moving even more in my\nfavour.\nIt is because of this philosophy that I am at times able to make 400–500-\npoint gains, as I did today. It is one or the other. I don’t think you can have\nthe best of both worlds!\nINTERVIEW WITH CNN\nIn an interview with CNN some years ago, I was asked about the traits of\nwinning traders. In this very candid interview, I highlighted a few points\nthat I felt differentiated the winning traders from the losing traders. It was\nbased upon my experiences from observing millions of trades by retail\ntraders, while I was on the brokerage trading floor. Here are the main\ndifferences I identified:\n1. TRYING TO FIND THE LOW\nWhen the market is trending lower, whether intraday or over a longer time\nframe, there seems to be a tendency for retail traders to attempt to find the\nlow of the move.\nWhether that is out of a desire to buy cheap, or because they use ineffective\ntools, I simply don’t know. What I do know is that this trait is immensely\ndamaging to anyone’s trading account.\nWinning traders seem to be much more trusting of the prevailing trend. This\nattitude adjustment may seem trivial, but it literally makes the difference\nbetween the winning trader and the losing trader.\nOver time the losing trader will repeat his distrust in the prevailing trend\nand will take positions against it. He will do so because from an emotional\nstandpoint it appears as if he is buying a market that is cheap or selling\nshort a market that is expensive.\nThis is emotionally satisfying, like buying toilet paper at a 50% discount\nfrom the local supermarket, but the financial markets are not supermarkets.\nThere is no ‘cheap’. There is no ‘expensive’. There is just the prevailing\nprice.\nThe winning trader, however, is not emotionally attached to an idea of\n‘cheap’ or ‘expensive’. He is focused on this moment right now, and in this\nmoment right now the market is trending, and he trusts this trend and can\nunemotionally join this trend without internal discomfort.\n2. TRYING TO FIND THE HIGH\nThe opposite also holds true. When the market is trending higher, traders\ntend to want to find a place to sell short. Although it must be said that\npeople are generally better at jumping on board a market that has already\nrisen than they are at jumping on board with a short position in a market\nthat has already fallen significantly.\nIf the market has moved higher by a significant amount, especially in the\nvery short term, retail traders tend to want to fade the rising prices, i.e., they\nlook to establish short positions. Again, this is probably the result of a\ndistorted view of things being cheap and things being expensive.\n3. THINKING EVERY SMALL COUNTER-MOVE AGAINST\nA TREND IS THE START OF A NEW TREND\nI have sat on a trading floor through the darkest days of the financial\nmarkets. For example, 15 September 2008, when Lehman Brothers was\ndeclared bankrupt, the Dow Jones Index fell 4.5%.\nThroughout that trading day, there were two attempts to rally. Both failed. It\nwas tragic to see how many clients tried to buy the low of the day, only to\nsee the Dow move lower and lower.\nWhenever there was a single green candle on the 5-minute chart that day,\nwe saw the buy order flow into our position monitors on the trading floor. It\nseemed as if the clients were possessed by the notion that a low was near,\nand that they had to be the one buying it.\nThe low didn’t come that day. Nor the next day.\nThis is a common trait amongst traders. They think that every single little\ncounter reaction against the trend is the beginning of a new trend. More\nfortunes have been lost trying to catch the lows in a falling market than in\nall wars put together (okay, this is an unsubstantiated statement made for\nemphasis, but please don’t attempt to catch lows).\nIt seems obvious to me that newcomers and probably also some seasoned\ntraders – profitable or unprofitable – believe that successful trading is all\nabout charts.\nThis belief is a detriment to their accounts, because no one ever took the\ntime to tell them otherwise. No one told them, or thought to tell them, or\nknew enough to tell them, that actually focusing all your time", "source": "eBooks\\Tom Hougaard - Best Loser Wins.pdf", "doc_id": "db0d74ee3eb2ba5542f0943f7b8e994e1f3211b7a93aee04b5bfd56525c663f3", "chunk_index": 12}
{"text": "t attempt to catch lows).\nIt seems obvious to me that newcomers and probably also some seasoned\ntraders – profitable or unprofitable – believe that successful trading is all\nabout charts.\nThis belief is a detriment to their accounts, because no one ever took the\ntime to tell them otherwise. No one told them, or thought to tell them, or\nknew enough to tell them, that actually focusing all your time on your\ncharts is a mistaken strategy. We’ll look at this further in the next chapter.\nEVERYONE IS A CHART EXPERT\nI ONCE DECLARED IN an article that you can learn the basics of technical analysis\nover a weekend. I may have exaggerated a little – but only a little.\nI know without an inkling of doubt that a chart expert does not equate to a\ntrading expert. I have seen so many of my trading friends build impressive\nlibraries of technical indicators and acquire knowledge about both known\nand obscure technical indicators. But it didn’t translate into making more\nmoney. When it comes to charts, less can be more.\nCharts can be as simple or as complicated as you want. There seems to be a\ntendency amongst traders to make charting more complicated than it really\nneeds to be. I have seen many new traders plaster their charts with so many\ntools that they can barely see the price chart itself.\nIt surprises many people, especially newcomers, when they see my chart\nscreens. There is not a single indicator on them. Not a single one. I might be\nold fashioned, but I don’t need these extra tools.\nMy job as a trader is to find low-risk trading setups. My approach to trading\nis not centred around any other tool than price itself. All indicators – more\nor less – are built from time and price. Therefore, the indicator is a\ndistortion of the reality I am seeing right in front of me.\nThe markets can be range bound, or the markets can trend. Some indicators\nwork well in ranging markets. These usually perform terribly in trending\nmarkets. Other indicators work well in trending markets, but are dreadful to\nuse in range-bound markets.\nAs a famous trader friend of mine, Tepid2, once said on the now-defunct\ntrader feed Avid Trader: “Indicators – they all work some of the time, but\nnone of them work all of the time.”\nI think that many of the 90% of people that lose money trading may very\nwell have excellent chart reading abilities. They can read charts very well,\nand they understand patterns too.\nHowever, I happen to think there is much more to trading than knowing a\nhead and shoulder formation, a bar chart pattern or a Fibonacci ratio.\nI have seen outstanding traders juggle millions of pounds worth of stock\nindex futures contracts using nothing but a simple ten-minute chart. In fact,\nI do that myself every single trading day.\nI truly believe that what separates the 1% from the 99% is how they think\nwhen they are in a trade, how they handle their emotions when they trade.\nThat is not to say that there is no merit to learning the craft of chart reading.\nI know from my own experience that chart reading is an absolute must for\nmy decision making, but that is only a small part of the whole trading\npicture.\nThe proliferation of gurus selling trading courses is evidence there is a\ndemand to learn the art and craft of trading. I suspect the ‘shortcut’ of a\nweekend course is a much more appealing proposition than spending that\ntime reading books.\nIf a guru holding a weekend course on trading claims that you will be\nqualified to trade “like the millionaire professionals” by the Sunday night,\nthen the unsuspecting will select that option. It is perfectly natural to expect\na human being to drift down the path of least resistance.\nLearning any new skill takes time. So when you see an advert saying “learn\na new language in 30 days”, you might not believe it consciously, but\nsubconsciously you want to believe it, because people love shortcuts.\nSimilarly, a diet book that promises you will lose 5kg in a year is unlikely\nto sell as well as one promising you will lose 5kg in two weeks.\nMy philosophy to life is different from so many other people’s. This is the\nreason I have what so many people dream of. I will choose the path of most\nresistance, because I know I need to stay clear of the opinion of the 99%.\nIf you think I am conceited, then you are thoroughly mistaken. I have no\ninflated view of myself. Quite the contrary. I decide carefully what I want,\nand then I work towards it. This book reflects that ethos.\nYou truly can be a master trader. You truly can live in the house you desire,\nwith the cars you desire in the drive. BUT you must believe me when I say\nthat in order to get what you want, you need to think like the 1%. In fact,\nyou don’t even need to think like the 1%. You just need to not think like the\n99%.\nThe following trade is a good example of how mindset trumps technical\nanalysis any day of the week. In this example I short the German DAX 30\nIndex.\nI get stopped out for a loss. I kick myself, because my stop-loss gets\nexceeded by a point or so, only to reverse back in my favour. My stop was\ntoo tight. Rather than lose my composure, I dismiss it.\nLet me pause for a second. Do you know why some athletes let out a shout\nof frustration when they are not performing well? I thought about it for a\nwhile, after I saw Serena Williams shout when she lost an important point\nin a Wimbledon tennis final.\nI think they let out a cry because it is a way to reset the mind, to come back\ninto balance and get into the zone again. The act of letting out a cry helps\nthem get rid of the frustration and find their inner peace and balance again.\nI re-enter a short position at 14,479.80. The screenshot below is from the\ntime of the trade.\n    AmountOpen PriceCurrent PriceOpen P/L\nGermany 30Sell 200\n12479.812478.5\n€ 260.00\nWall Street 30Sell 200 27044 27046 −$500.00\nThe chart at the time of the trade looks as shown in Figure 1.\nFigure 1\nSource: eSignal (esignal.com)\nThe DAX had gapped up. Did you know that only 48% of all gaps get filled\non the same trad", "source": "eBooks\\Tom Hougaard - Best Loser Wins.pdf", "doc_id": "db0d74ee3eb2ba5542f0943f7b8e994e1f3211b7a93aee04b5bfd56525c663f3", "chunk_index": 13}
{"text": "hort position at 14,479.80. The screenshot below is from the\ntime of the trade.\n    AmountOpen PriceCurrent PriceOpen P/L\nGermany 30Sell 200\n12479.812478.5\n€ 260.00\nWall Street 30Sell 200 27044 27046 −$500.00\nThe chart at the time of the trade looks as shown in Figure 1.\nFigure 1\nSource: eSignal (esignal.com)\nThe DAX had gapped up. Did you know that only 48% of all gaps get filled\non the same trading day?\nBy the third trading day after the gap, 76% of gaps were filled. Why am I\ntelling you this? Don’t believe trading books stating that all gaps get filled.\nThey do not!\nI short the DAX because the second bar on the chart is an inside bar – from\nthe first ten-minute bar at the open. The third bar closes below the lowest\npoint of the inside bar. Now I have a sell signal, because the first bar’s high\nis at the same price as a prior high – a double top. I have a stop-loss in\nplace. I have done my job as a trader. I have identified a low-risk entry\npoint, and I have placed my stop-loss.\nAt this point in time, I am at the mercy of the markets. Maybe this will be a\ngreat trade. Maybe it won’t. Who knows? No one knows. Before I carry on,\nI would like to ask YOU a question. It is a question for you to ponder upon.\nSay you believe in the whole risk-to-reward argument, and you decide that\nyou have a 40-point profit target. You decide upon a 40-point profit target\nbecause you risked 20 points. So, you argue that risk-to-reward is 2:1, two\nunits of profit for one unit of risk, which sounds good.\nIt all sounds great, and there is virtually no textbook on trading that would\nargue against it. But I am arguing against it. I want to ask you some simple\nquestions.\nIf you make 40 points on this short position, and the market continues in\nyour favour, how will you feel? How will you feel if a few hours later you\nsee the market down a further 100 points from your exit?\nI think the risk-to-reward concept has been designed by an academic who\ndoes not understand risk and the mind’s association with risk. I think this\nacademic has created a method to keep his mind at peace, in order to avoid\npain.\nFifty minutes later the DAX is filling the gap. This is shown in Figure 2.\nThe position is in profit.\nFigure 2\n\nSource: eSignal (esignal.com)\nA colleague of mine has followed my trade. The chart is looking good for\nus. We are in a conversation about the trade. It goes like this:\nFriend: I am tempted to take my profit. Do you have a target for this trade?\nTom: Amigo, I don’t trade with targets. Let’s see what the market will give us. Stop-loss is at\nbreakeven. We can’t lose.\nFriend: Yes, I know. But yesterday was a poor day of trading. I lost 150 points. I read the\nmarket poorly. I had an idea, and the idea didn’t work out. Either way, I lost 150 points. If I\nclose my DAX position right now, I can make up for the lost trade this morning, and I can\nrecover a lot of the points lost yesterday.\nWhat do you think?\nTom: I think you are trading yesterday’s experience. You haven’t wiped the mind-slate clean.\nYou are not present. You are focused on the past. You are trying to get back to an emotional\nequilibrium. You are in a state of imbalance because you are unable to shake the loss from\nyesterday. As a result, you are not judging the trade on its own merit, but on the merit of a past\ntrade. You are not seeing the world as it is. You are seeing it as you are.\nI understand it is a soothing thought to close the trade. However, we are not trading to break\neven. We are trading to make money.\nCan you appreciate that trading is a mind game? It is a game of nerves. My\nfriend was understandably shaken from his loss yesterday. He carried the\nloss over to the next day. It affected his decision making.\nBack in 2007 I was invited to the Wimbledon tennis final. My friend was a\nbig name in the media industry, and none other than Ralph Lauren had\ninvited her to the tennis final – with a guest. So, there I was in the VIP tent,\nand I got to sit next to Luke Donald, who at the time was one of the best\ngolfers in the world.\nHe is a softly spoken man, and very polite. We got talking about Tiger\nWoods, and I asked him a pretty to-the-point question about competing with\nTiger.\n“Is Tiger Woods a better golfer than you?”\nI found his answer so incredibly insightful that I never forgot it. He said:\nI don’t think Tiger is a better golfer than me, if you measure it in how\nwell we putt, or how far we hit the ball, but Tiger Woods does have an\namazing ability to forget his mistakes and move on.\nFor example, we can be on the 15th and both make a bad putt. By the\ntime we get to tee up on the 16th, it is as if Tiger has wiped his mind of\nwhatever happened on the 15th, and he is totally in the moment.\nI, on the other hand, will still deal with the mistake I made on the 15th,\nand it will affect my performance on the 16th.\nThat is a truly insightful perspective of what really separates the very best\nin a chosen field. It is the mind, and what it processes at any given moment\nin time. Is it working with you or against you?\nCOGNITIVE DISSONANCE\nMy friend is having a ping-pong dialogue in his head, arguing for and\nagainst taking profits. I am no stranger to that conversation. I may have\nmany years of trading experience, but I still have those thoughts in my\nhead. I am just mindful of them when they arrive. When they do, I focus on\nthe chart and what it is telling me. I don’t look at the profit and loss (P&L).\nWhat my friend is experiencing is known as cognitive dissonance. In the\nfield of psychology, cognitive dissonance is the mental discomfort –\npsychological stress – experienced by an individual who simultaneously\nholds two contradictory beliefs or ideas in their head.\nThis discomfort is triggered by a situation in which a person’s belief clashes\nwith new evidence contradicting that belief. When confronted with facts\nthat contradict beliefs, ideals, and values, people will try to find a way to\nresolve the contradiction to reduce their discomfort.\nThe best way for", "source": "eBooks\\Tom Hougaard - Best Loser Wins.pdf", "doc_id": "db0d74ee3eb2ba5542f0943f7b8e994e1f3211b7a93aee04b5bfd56525c663f3", "chunk_index": 14}
{"text": "rienced by an individual who simultaneously\nholds two contradictory beliefs or ideas in their head.\nThis discomfort is triggered by a situation in which a person’s belief clashes\nwith new evidence contradicting that belief. When confronted with facts\nthat contradict beliefs, ideals, and values, people will try to find a way to\nresolve the contradiction to reduce their discomfort.\nThe best way for your rational mind to resolve the discomfort of a\nprofitable position is to close it. The best way for the rational mind to\nresolve the discomfort of a losing position is to let it run.\nIn his 1957 book, A Theory of Cognitive Dissonance, author Leon Festinger\nproposed that human beings strive for internal psychological consistency to\nfunction mentally in the real world. He says that a person who experiences\ninternal inconsistency tends to become psychologically uncomfortable and\nis motivated to reduce the cognitive dissonance.\nOne way to achieve the goal of reducing the discomfort is by making\nchanges to justify the stressful behaviour, either by adding new\nunsubstantiated or irrelevant information to the cognition, or by avoiding\ncircumstances and contradictory information likely to increase the\nmagnitude of the cognitive dissonance.\nIn my friend’s case, he is conflicted. He is associating pain with the\nperformance of yesterday. He has an opportunity to eradicate the pain by\nclosing his profitable position right now. The way he justifies this reasoning\nis by ignoring the information the market is giving him about his position.\nThe market participants agree that the market should be sold short, but\ninstead of acknowledging this, he is ignoring it.\nFrom a logical point of view, this all makes sense. From an emotional point\nof view, this is an inconsistent approach to trading. Our trades from\nyesterday have no bearing on the markets today.\nIt is a new day. It is a new set of circumstances. Yet to most people’s minds,\nthe two trading days are connected. To our minds we are continuing today\nwhat we did yesterday. “Why wouldn’t we be?” we tell ourselves.\nAre you telling me that you can ‘reset’ your emotions every morning? Are\nyou telling me that you can go to bed at night after a blazing row with your\nloved ones, and wake up reset and emotionally in equilibrium?\nI doubt it; at least, not without a conscious effort. It is for this reason that I\nwarm up ahead of the trading day by going through a process. We cover that\nlater in the book. It is, after all, what the book is about. It is a recipe book\nfor methods to avoid the pitfalls that the 90% experience.\nNow, what is the source of my friend’s turmoil? It is fear. Pure and simple.\nHe is afraid he will lose what he has made on paper. He is desperate to get\nback to an emotional state where he is at peace. He is no longer trading the\ncharts. He is no longer trading the markets. He is trading his own mental\nwellbeing.\nFEAR\nMy friend is fearful. He is afraid that the money he lost yesterday will not\nbe offset by the good trade he has going now. He is afraid that the profits he\nis currently experiencing will diminish, or in the worst case disappear.\nHe acknowledges that he can’t lose on the trade. The stop-loss is now at\nbreakeven. Unfortunately, that gives him little comfort.\nI once saw a quote that made me smile: everything you ever wanted lives\non the other side of fear. Yet fear is a necessity in our lives. The human\nbrain is a product of millions of years of evolution, and we are hardwired\nwith instincts that helped our ancestors to survive. We need fear to ensure\nsurvival in certain situations, but many of the fears that we carry are not\nappropriate for our trading.\nOur minds have a primary function, which is to protect us against pain. If\nyou introduce big drastic changes in your life, you are likely going to come\nface to face with that pain. A clever way to build staying power during\nchange is to introduce that change slowly.\nSay you set yourself the ambitious target of running a marathon. You\nachieve this goal by building up your body and mind for the task. Trading\nbig size is exactly the same process. You need to give your mind time to\nlearn to handle the mental anguish that comes from losing when the stakes\nare bigger.\nThere is no point in comparing yourself with others. Sure, take inspiration\nfrom others; but know this is a personal journey, and your job is to achieve\nan equilibrium mindset, no matter what size you are trading.\nPHILIPPE PETIT\nI saw a documentary about Philippe Petit a long time ago. Petit was a\nFrench artist who strapped a wire between the two World Trade Center\nbuildings and then walked across it – several times.\nWhat struck me about the incredible feat was the preparation.\nIt took Philippe some seven years of physical and mental training to\naccomplish the feat. Did you think he just set off and hoped for the best?\nNo. In fact his original training height was quite modest compared to the\naltitudes he would eventually reach.\nPhilippe Petit is a fascinating character; he is someone who has had to deal\nwith fear at a level beyond that which the rest of us have. I have learned a\nlot about fear and identifying my own shortcomings by studying his\napproach to his craft.\nVISUALISATION\n“Before my high-wire walk across the Seine to the second story of the\nEiffel Tower, the seven-hundred-yard-long inclined cable looked so steep,\nthe shadow of fear so real, I worried. Had there been an error in rigging\ncalculations?”\nHow does Petit overcome these doubts?\nWith a simple visualisation exercise.\n“On the spot I vanquished my anxiety by imagining the best outcome: my\nvictorious last step above a cheering crowd of 250,000.”\nAdded to this, Petit exaggerates his fears. Rather than try to muscle through\nor outwit fear, he suggests taming it by building it up so that when you are\nfinally faced with your fear, you will be disappointed by how mundane the\nthreat really is:\nA clever tool in the arsenal to destroy fear: if a nightmare taps you on\nthe shou", "source": "eBooks\\Tom Hougaard - Best Loser Wins.pdf", "doc_id": "db0d74ee3eb2ba5542f0943f7b8e994e1f3211b7a93aee04b5bfd56525c663f3", "chunk_index": 15}
{"text": "st outcome: my\nvictorious last step above a cheering crowd of 250,000.”\nAdded to this, Petit exaggerates his fears. Rather than try to muscle through\nor outwit fear, he suggests taming it by building it up so that when you are\nfinally faced with your fear, you will be disappointed by how mundane the\nthreat really is:\nA clever tool in the arsenal to destroy fear: if a nightmare taps you on\nthe shoulder, do not turn around immediately expecting to be scared.\nPause and expect more, exaggerate.\nBe ready to be very afraid, to scream in terror. The more delirious your\nexpectation, the safer you will be when you see that reality is much\nless horrifying than what you had envisioned. Now turn around. See?\nIt was not that bad – and you’re already smiling.\nHe goes on to say that he has fears like everyone else. In particular, he talks\nabout his dislike of spiders:\nOn the ground I profess to know no fear, but I lie. I will confess, with\nself-mockery, to arachnophobia and cynophobia [fear of dogs].\nBecause I see fear as an absence of knowledge, it would be simple for\nme to conquer such silly terrors.\n“I am too busy these days,” I’ll say, “but when I decide it’s time to get\nrid of my aversion to animals with too many legs (or not enough legs\n—snakes are not my friends, either), I know exactly how to proceed.”\nI will read science reports, watch documentaries, visit the zoo. I will\ninterview spider-wranglers (is there such a profession?) to discover\nhow these creatures evolved, how they hunt, mate, sleep, and, most\nimportantly, what frightens the hairy, scary beast. Then, like James\nBond, I won’t have any problem having a tarantula dance on my\nforearm.\nPetit’s walk remains one of the most fabled – and stunning – acts of public\nart ever. He says there was no why behind the act. To quote his own words:\nTo me, it is really simple. Life should be lived on the edge of life. You\nhave to exercise rebellion, to refuse to tape yourself to rules, to refuse\nyour own success, to refuse to repeat yourself, to see every day, every\nyear, every idea as a true challenge, and then you are going to live your\nlife on a tightrope.\nTHE EGO, AND WONDERFUL\nFAILURE\nI am not a fan of clichés. They display a lack of original thought. I am quite\ncynical towards those who peddle clichés. It doesn’t sit well with me to hear\npeople say that I should run my profits and cut my losses. Yes, but how do I\ndeal with the fear of running my profits?\nIt doesn’t sit well with me when a female friend tells me she is in an\nabusive relationship, and another friend chirps in and dismissively states\nthat the solution is to “just leave the bastard.” It is a platitude. It is factually\ntrue, but it is nonsense, nevertheless.\nWhen a solution is obvious, the problem is rarely the only problem. You\nmight as well tell an alcoholic to just stop drinking. There is a reason he is\ndrinking, and there is a reason he is struggling to stop.\nDoes failure exist? I come from a home where you rarely received praise\nfor your achievements. They were expected. The failures, on the other hand,\nwere pointed out – and not in a constructive manner.\nI had to retrain my mind to stop being afraid of making mistakes. I used to\nhave a favourite saying as a child: “It is not my fault”. Today the buck stops\nwith me every time. It is always my fault. I am good at making mistakes, so\nthat I can learn from them.\nFailure is a friend in life – if you tell your mind that it is okay to fail. I\nparticipate in a radio programme about trading and investments. The focal\npoint of the show is the competition between two other traders and me.\nThe competition is always fierce, and every week we are questioned about\nthe content of our portfolios. My trading style is quite black and white. If I\nthink the market is headed lower, I will buy some put options or some bear\ncertificates, and vice-versa if I am bullish.\nI learned a long time ago that the best way to shut down a journalist is to be\n100% honest. So, when the radio host baits me by saying “Uhm Tom, you\ngot that one wrong, huh?”, the worst thing I can do is to start defending\nmyself. If I start making excuses or argue a defensive stance, I simply pour\npetrol on that fire.\nIt is such a great metaphor for life. Own up to your errors and be done with\nit. So, when the radio host is trying to engage in a line of questioning aimed\nat getting me to defend myself, I always double down in the opposite\ndirection by saying something like, “Oh my lord, I don’t think I could have\nbeen more wrong, even if I tried,” or “Oh boy, even a five-year-old could\nhave done better than me.”\nTRADING MIND UPSIDE-DOWN\nFrom my research into the behaviour of our clients during my years at City\nIndex, I concluded that the overwhelming majority had an unhealthy mental\nthought pattern. They would feel fear at times where there was no reason to\nbe fearful. This would manifest during times in which their positions were\nmaking money.\nHowever I manipulate the argument, it is still a fear of losing. In this case it\nis the fear of losing the profits accrued on paper.\nWhen the clients were in losing positions, they would be reluctant to realise\nthe loss. It was as if they had the attitude that as long as the position was\nopen, it might still come good. As I see it, they opted to replace fear with\nhope. They hoped the losing position would come back to breakeven.\nGoing back to the DAX example, my friend hung on to the trade. I did my\nbest to guide him through the pain. He moved his stop-loss down. It meant\nhe had some profits to show for it, if the market moved back up again.\nIn my experience if you can guide a person through a successful trade,\nwhere he or she holds on to the trade, you will begin to create the right kind\nof neuro-associations. The trader will experience the thrill of holding on to\na trade. They will experience the joy of locking in more and more profits.\nMy friend was over the moon with the development of the chart. However,\nit was quite clear that he was consta", "source": "eBooks\\Tom Hougaard - Best Loser Wins.pdf", "doc_id": "db0d74ee3eb2ba5542f0943f7b8e994e1f3211b7a93aee04b5bfd56525c663f3", "chunk_index": 16}
{"text": "ence if you can guide a person through a successful trade,\nwhere he or she holds on to the trade, you will begin to create the right kind\nof neuro-associations. The trader will experience the thrill of holding on to\na trade. They will experience the joy of locking in more and more profits.\nMy friend was over the moon with the development of the chart. However,\nit was quite clear that he was constantly looking for reasons to take profit.\nThe thought of leaving money on the table did not sit well with him at all.\nTo his credit he held on to the trade, spurred on by my conviction that the\nmarket showed nothing but weakness. We were soon rewarded by a sudden\nliquidity vacuum. I try not to get excited when the market is giving me a\nwindfall. However, at times even I will have to fist pump the air, even\nthough I am alone in my office.\nThe whole trade sequence is displayed in the time-stamped records in my\nTelegram channel under 1 October 2019. See Figure 3.\nFigure 3\nSource: eSignal (esignal.com)\nELON MUSK\nI am not a fan of Tesla. This is due to the fact I shorted it and lost big. Yes, I\nknow. What a silly argument, considering Teslas are seemingly good cars.\nI am a fan of Elon Musk, however. We are bound to make mistakes in life,\nbut mistakes are like fuel for the rocket of improvement. Talking of rockets,\nhow do you think people like Elon Musk handle failure?\nHe is trying to accomplish incredible, life-changing things – things like the\nelectrification of automobiles and the colonisation of space – and he does it\nwhile the whole world is watching.\nFor him the possibility of failure is ever present. Not only that, but when he\nfails it becomes spectacular headline news. Yet Musk just keeps on going\nand going, doing things that are extremely risky but also extremely\nimportant.\nHow does he handle his fear of failure? Does he even fear failure at all, or is\nhe somehow hardwired with resilience again this form of anxiety?\nApparently not. Musk has publicly stated he feels fear quite strongly. So\nhow does he keep going despite this terror?\nThere are two main elements to Musk’s ability to overcome his fears. The\nfirst is an overwhelming passion for his projects. He admits that SpaceX\nwas an insane venture, but he had a compelling reason for pushing ahead:\nI had concluded that if something didn’t happen to improve rocket\ntechnology, we’d be stuck on earth forever. People sometimes think\ntechnology just automatically gets better every year but actually it\ndoesn’t. It only gets better if smart people work like crazy to make it\nbetter.\nBy itself, technology, if people don’t work at it, actually will decline.\nLook at, say, ancient Egypt, where they were able to build these\nincredible pyramids and then they basically forgot how to build\npyramids… There are many such examples in history... entropy is not\non your side.\nElon Musk was not prepared to sit idly by and watch history repeat itself.\nThe second element is what Musk calls fatalism. Just focusing on why\nyou’re taking a scary risk isn’t always enough to overcome hesitation. It\nwasn’t for Musk:\nSomething that can be helpful is fatalism, to some degree. If you just\naccept the probabilities, then that diminishes fear. When starting\nSpaceX, I thought the odds of success were less than ten percent and I\njust accepted that actually probably I would just lose everything. But\nthat maybe we would make some progress.\nHe is not the only one to use this approach. Visualising the worst-case\nscenario can make us appreciate objectively what we are trying to achieve.\nFacing our fears removes their power over us.\nHave I digressed too far from the trading journey ahead?\nI don’t think so. I draw inspiration from many sources, both in and outside\nof the trading world: Kobe Bryant, Rafa Nadal, Cristiano Ronaldo, Sergio\nRamos and Charlie Munger, to name a few.\nVery different people, yet all obsessed with the journey, the enrichment of\ntheir lives and the perfection of their craft. Studying their approach to their\nwork suggests they found the thing they would love to do even if they\ndidn’t get paid for it. I am sure they are businessmen too, and I am sure they\nkeep an eye on the dollars coming in. However, it feels like they perform\ntheir craft for the love of it.\nDO YOU WANT IT BAD?\nHow bad do you want it? Is this journey for you? I don’t know. Only you\ncan answer that. Permit me to ask you a question: what is the alternative?\nYou are reading these pages because you want to trade well. Perhaps you\nhave been in my live trading room, and you have seen what my trading\nphilosophy is doing for me. You want to learn more. I applaud that.\nPerhaps it is time to acknowledge trading for what it is? It is a great way to\nexpose all your flaws. It is a great way to highlight your strengths. Through\nmy trading and my research, I have uncovered weaknesses in my character.\nFor me, the side benefit of earning a living from trading the financial\nmarkets is the character traits it instils in me. I am more patient than ever. I\nam much more focused and disciplined than I was before.\nFailure is one of our greatest learning tools.\nTIMES OF DOUBT\nDo you really want to trade profitably? I have had to answer that a few\ntimes in my career. I have had to make some sacrifices along the way. I\nhave been called out once by a coach who felt my effort was insincere.\nI recently found myself having dinner with a friend. I have known him for\n15 years. I met him when I gave a speech somewhere in the North of\nEngland. My friend had asked if he could consult with me while I was in\nManchester to give a talk about trading, and naturally I agreed.\nAs we ate, he became very animated. At one point he knocked over a glass\nof water while expressing his frustration with his trading. It was difficult to\nreally pinpoint what the problem was in his trading, because he never made\nany specific reference to a problem.\nIt was clear to me that he really was in distress and wanted help, but I was\nunable to figure out in what capac", "source": "eBooks\\Tom Hougaard - Best Loser Wins.pdf", "doc_id": "db0d74ee3eb2ba5542f0943f7b8e994e1f3211b7a93aee04b5bfd56525c663f3", "chunk_index": 17}
{"text": "and naturally I agreed.\nAs we ate, he became very animated. At one point he knocked over a glass\nof water while expressing his frustration with his trading. It was difficult to\nreally pinpoint what the problem was in his trading, because he never made\nany specific reference to a problem.\nIt was clear to me that he really was in distress and wanted help, but I was\nunable to figure out in what capacity my help should come. So, I offered\nhim help in the one area that I felt was appropriate. I offered to go over his\ntrading statements. As I see it, that is the only way I can really help\nsomeone. It is a lot of work, but at least I am getting a sense of who he is as\na trader.\nAs we said our goodbyes, he told me he would send over his statements. I\nconfirmed, and said I would look forward to hearing from him. As I write\nthis, he has not emailed me. He has not written to me on message apps.\nSilence. Not a word.\nIf I am offered help in an area where I desperately want to excel, and the\nhelp comes from a friend who is an expert in the area, I will respond as\nsoon as I can, if not immediately. As of some four to five days later, I\nhaven’t heard a peep.\nHow badly do you think he wants this? How desperate do you think he is? I\nquestion how much he really wants this. I have observed this pattern on\nseveral occasions. The student claims to be really keen, but in reality it is\nmere words.\nIt reminds me of a conversation that the famous trader Ed Seykota had with\nanother brilliant trader and friend. The friend told Ed that he intended to\ncoach a losing trader into a winning trader by teaching him some important\npointers that were missing from his trading.\nEd Seykota paused for a second, and then said that the friend would fail to\nteach the student anything. He said that a losing trader is not going to wish\nto transform himself. That is the sort of thing that only winning traders do.\nWe can all ask for guidance from someone who is better than us. As the\nsaying goes, you only get better by playing a better opponent. I have guided\nmany that were already well on their way to trading with confidence. I\nmerely refined and suggested.\nWhether I will hear from my friend or not remains unknown. What is\nknown is that many people open trading accounts in the hope of making\nmoney. Their effort is disproportional to their expectations, and their results\nare aligned with their effort. They simply don’t work hard enough.\nBefore I move on to the next topic, I want to warn you: I am a trader who\nuses charts, but that doesn’t mean that I believe charts are responsible for\nmy profitable trading. I once read that technical analysts are afraid of\nheights. That is another way of saying that they are unable to let their\nwinners run, because they keep seeing overhead resistance.\nI have called the next chapter ‘The Curse of Patterns’, because I believe\nfully that as much as patterns help us, they also make our trading lives\ndifficult. In the search for patterns, we see things that are simply not there.\nTHE CURSE OF PATTERNS\nIF YOU STRIP away the time and price axis of a chart, you will likely be unable to\ndifferentiate between a five-minute chart and an hourly chart.\nIn a sense, that is good news. It means we can perfect our craft and then\nfind a time frame that suits our trading temper. The trader with the ability to\nfocus for long stretches of time will find the one-minute chart and the five-\nminute chart provide ample opportunity to make money.\nThe trader with time constraints will probably favour a longer time frame\nsuch as the hourly chart or the four-hour chart. It means he or she doesn’t\nhave to check the chart so frequently.\nCharts are far superior to fundamental analysis when it comes to entry\npoints and exit points, and I can use the same tools, irrespective of what\ntime frame I am trading on.\nAm I opposed to fundamental macroanalysis? I would be a fool if I\ndismissed the fundamentals. The two should not be in opposing camps.\nThey should walk hand in hand, as they complement each other and make\nup for each other’s flaws.\nNow, I would not go so far as to say that chart analysis is the Holy Grail.\nYes, I have made a lot of money from trading charts, but it was not my\nability to read a chart that made me a wealthy trader.\nI don’t believe that there is a Holy Grail when it comes to trading, and I\ncertainly don’t believe that chart analysis is the Holy Grail.\nPATTERNICITY\nApophenia is a Latin word that, translated into English, means patternicity.\nThis is a behaviour centred around seeing things that aren’t there; the\ntendency to perceive meaningful patterns and connections amongst\nunrelated events. Patternicity is often a harmless diversion. However, it can\nbe used to support a belief that is otherwise lacking in evidence, like a\nconspiracy theory.\nOur minds tend to seek out the information that confirms the bias that we\nhave already decided upon. Therefore, to be completely objective in chart\nanalysis is virtually impossible.\nMy early mentor Bryce Gilmore once commented on this fact. He said to\nme, “Tom, you only see in the markets and on charts what you have trained\nyour eyes to see.”\nAnother perspective of such wisdom was expressed by Anaïs Nin. She said,\n“We don’t see things as they are, we see them as we are.”\n“What is the relevance to trading?” I hear you say. I had a friend a long time\nago who had made a lot of money trading. Nick was a great trader, right up\nuntil 2004.\nHe started reading and believing some writers and contributors on Zero\nHedge and he turned bearish on the stock market. He kept shorting. But the\nmarket kept going up. He just could not accept that there was no more\ndownside after the bear market of 2000–2003. He didn’t see the market as it\nwas. He saw it as he was. He was negative. He had read that the bear\nmarket would continue. He stopped trading what he saw, and he let his\nopinion cloud his objectivity.\nNick no longer trades.\nI didn’t want to write a book on charts. There are so many books on\nte", "source": "eBooks\\Tom Hougaard - Best Loser Wins.pdf", "doc_id": "db0d74ee3eb2ba5542f0943f7b8e994e1f3211b7a93aee04b5bfd56525c663f3", "chunk_index": 18}
{"text": "pt going up. He just could not accept that there was no more\ndownside after the bear market of 2000–2003. He didn’t see the market as it\nwas. He saw it as he was. He was negative. He had read that the bear\nmarket would continue. He stopped trading what he saw, and he let his\nopinion cloud his objectivity.\nNick no longer trades.\nI didn’t want to write a book on charts. There are so many books on\ntechnical analysis, written by people who I doubt trade full time. I think\nthey tell themselves that because they have a trading account and because\nthey trade from time to time, they are qualified to write books on trading.\nAlthough I trade full time, I really don’t think I could add anything new to\nthe world of charting. Charting didn’t make me money. Indicators never\nmade me money. Ratios and bands never filled my bank account.\nAs I am about to post some charts, I want to point out to you that it is to\nprove a point, rather than to educate you on the merits of technical analysis.\nTHE TREND LINE FANATICAL\nIn the early stages of our chart journey, we come across trend lines. Trend\nlines are easy to use, and they give the appearance of a great trading\nstrategy, especially when we do it after the fact.\nFigure 4 shows a naked chart. The diligent chartist begins to draw trend\nlines. He or she has the full overview of the day.\nFigure 4\nSource: eSignal (esignal.com)\nRemember, the brain will have as its prime objective – I repeat, PRIME\nOBJECTIVE – to avoid you experiencing pain. A losing trade equals pain.\nSo, the brain sends a signal to the eyes to ignore the setups that do not\nwork. This selection bias creates a distorted image of the validity of trend\nlines.\nYou can replace trend lines with any other analytical tool from your\ncharting package, and the bias will remain in place: Fibonacci, Bollinger\nBands, Keltner Channels, etc.\nYour eyes will only see what they want to see. At best they may see the\nlosing trades, but they glance over them, diminishing their significance.\nThe result is predictable. The researcher will end up with a chart that looks\nlike the one in Figure 5. It has a lot of trend line setups that all result in\ngreat trades.\nFigure 5\nSource: eSignal (esignal.com)\nThere are no losing trades. Every single trade results in meaningful profits.\nSuch is the power of our subconscious.\nCynical traders (people like me) will notice things other traders miss – not\nbecause others don’t have the ability to see them, but because they don’t\nwant to. See Figure 6.\nFigure 6\nSource: eSignal (esignal.com)\nIf you are in a research position, and you draw enough of these trend lines\nafter the fact, you’re most likely going to conclude that trend lines are\nnothing short of a fantastic tool, perhaps the Holy Grail.\nThere is nothing wrong with trend lines, but they will not make you rich.\nWhat will make you rich is how you think when you trade. If you think like\neveryone else, then your results will be like everyone else’s.\nDon’t you want to make money? Don’t you want to separate yourself from\nthe herd? Then realise that trading profitably has nothing to do with the\ninstrument you use.\nIn order to prove to you how pointless it is to research tools, I would like to\nintroduce you to two of the world’s most esteemed traders, Larry Pesavento\nand Larry Williams.\nLARRY PESAVENTO VERSUS LARRY\nWILLIAMS\nThe two Larrys are both in their senior years. They are both Americans, and\nincidentally they are friends. Both of them have enjoyed trading careers\nspanning decades. Both of them have made their living from trading.\nLarry Pesavento is famous for his use of patterns and Fibonacci ratios.\nLarry Williams is famous for his pattern recognition setups. Both have\nwritten several books on their chosen tools.\nIn a workshop I organised back in 2005, Larry Williams – who was one of\nthe speakers – showed statistics from the S&P 500 Index, which depicted\nall the major retracements on an hourly chart spanning a decade.\nAs you can imagine, there was virtually every single conceivable\npercentage retracement on display. What did not stand out, though, was\n61.8% or 38.2% – the two prominent Fibonacci ratios. Sure, they were\nthere, but they were surrounded by masses of other percentages.\nYes, it turns out the magical growth sequence of Fibonacci does not, after\nall, rule the market. So how come it works for Larry Pesavento? The answer\nis simple: it doesn’t have to work all the time to make it a profitable\nstrategy.\nIn Oslo, Norway, in 2016 I gave a talk on Fibonacci ratios. For the talk I\nhad researched all occurrences in which the German DAX Index retraced\n78.6% – the square root of 0.618 – and I proved that although the 78.6%\nretracement had a hit rate of 20%, it could still be a useful strategy. You had\nto risk very little and go for big pay-outs for it to work.\nS&P 500 & FIBONACCI\nThe S&P 500 enjoyed an 11% rally during the summer months of 2021. The\nindex rallied from 4,050 to 4,550. Along the way, as you can see on the next\nchart, there were three significant retracements. The role of the Fibonacci\nsequence is to enable us to buy into retracements at favourable retracement\nratios, such as 38.2% retracement, 61.8% retracement, or even 78.6%\nretracement. See Figure 7.\nFigure 7\nSource: eSignal (esignal.com)\nWhat I am going to show you now is a simple demonstration of the power\nof hype and selection bias. See Figure 8.\nFigure 8\nSource: eSignal (esignal.com)\nFibonacci ratios are one of the best-known tools in the trading arena. There\nis not a single one of these three major retracements in the S&P 500 Index\nthat is identified by either 38.2%, 61,8% or even 78.6% ratios.\nIn fact, two ratios seem to come up more frequently: 43% retracement and\n74% retracement. I put that down to randomness. Yes, such is the power of\nour belief system.\nWe want to believe there is a magical growth sequence to the way the\nfinancial markets expand and contract. We want to believe that there is a\nuniversal order to the markets, dictated by a higher deity who c", "source": "eBooks\\Tom Hougaard - Best Loser Wins.pdf", "doc_id": "db0d74ee3eb2ba5542f0943f7b8e994e1f3211b7a93aee04b5bfd56525c663f3", "chunk_index": 19}
{"text": "1,8% or even 78.6% ratios.\nIn fact, two ratios seem to come up more frequently: 43% retracement and\n74% retracement. I put that down to randomness. Yes, such is the power of\nour belief system.\nWe want to believe there is a magical growth sequence to the way the\nfinancial markets expand and contract. We want to believe that there is a\nuniversal order to the markets, dictated by a higher deity who created the\nuniverse using the mathematical sequence of what we know as Fibonacci.\nAnd it works just often enough to keep the believers believing. This is the\ndanger of charts. When we research, we are looking for something to get us\nin on the long side, so we never miss a rally; or we look for something to\nmake us sell short, so we never miss a short sell. We enter with a bias.\nThis is apophenia in play. Beware!\nDIVORCE RATES IN SPAIN\nThe definition of ignorance is a lack of knowledge or information. You can\nbe a smart individual but be ignorant in some areas. For example, I am\nrather ignorant when it comes to, say, soulmates and flat Earth theory. You\ncould argue that I am ignorant because I am not interested, or I don’t\nbelieve in it.\nFair point. Specifically, on the point of finding your soulmate – the one-\nand-only whom you will spend eternity with, the person who is perfect for\nyou in every shape or form – well, I don’t believe they are real.\nYou see, as ignorant as I am in the ways of love, I can read statistics, and on\nthat basis, I am supposed to conclude that soulmates have better chances of\nfinding each other in certain countries? I don’t think so!\nFor example, there are certainly not many self-confessed soulmates in Spain\nor Luxembourg. Did you know that there is a 65% divorce rate in Spain and\nan 87% divorce rate in Luxembourg?\nThere’s only a 42% divorce rate in the UK. Does that mean that you have a\nhigher chance of finding your soulmate if you live on the British Isles than\nin Spain?\nPlenty of people believe that the sun’s heavenly position relative to\nrandomly defined stellar constellations at the time of my birth somehow\naffects my personality.\nThere are also people who believe that the markets are an equation to be\nsolved, a code to be cracked. All of those people are delusional, or to put it\nmore politely, they are ignorant.\nTHE FRAUD OF THE CANDLESTICK\nGURU\nIn order to avoid a lawsuit, I have blanked out the name of the central\ncharacter in the following story. When candlestick charts became a hot topic\nin the 1990s, one person – who had been instrumental in the propagation of\ntheir use – was sitting in a restaurant somewhere in the world with another\nhigh-profile trader and me.\nThe central character had at the time published books on the use of\ncandlestick charts. As we sat in the restaurant, I asked him if he believed\nthat some of these patterns had to be identified by different names, when\nthey were practically identical.\nFor example, I argued, the Harami pattern and the Harami Cross pattern are\nto all intents and purposes identical, except the Harami Cross pattern has no\nbody, while the Harami pattern has one. However, they are both inside bar\npatterns.\nIt seemed to me like a deliberate attempt to inflate the number of patterns,\nfor purely commercial reasons rather than for legitimate trading reasons.\nMany of the patterns are near identical but have different names.\nI asked him if he had a favourite pattern he used, or a selection of preferred\npatterns he stuck to, and if so, what time frame he traded them on.\nHe answered that he wasn’t trading the patterns. Not only that, but he also\nconceded that he didn’t trade at all.\nI don’t know how you feel about that, but it doesn’t sit very well with me. I\nimmediately cut all ties with the gentleman. I felt as if his only mission was\nto invent as many patterns as he possibly could, in order to fill pages in\nbooks and courses, and create alerts on his trading software.\nAm I arguing that candlestick charts are worthless? No. I just don’t believe\nthat there is statistical relevance to all the patterns.\nI am not alone. A handful of academic research articles suggest the same.\nHere is the conclusion from one such article, ‘A Statistical Analysis of the\nPredictive Power of Japanese Candlesticks’, written by Mohamed\nJamaloodeen, Adrian Heinz and Lissa Pollacia, and published in the\nJournal of International & Interdisciplinary Business Research in June\n2018:\nJapanese Candlesticks is a technique for plotting past price action of a\nspecific underlying such as a stock, index or commodity using open,\nhigh, low and close prices. These candlesticks create patterns believed\nto forecast future price movement. Although the candles’ popularity\nhas increased rapidly over the last decade, there is still little statistical\nevidence about their effectiveness over a large number of occurrences.\nIn this work, we analyze the predictive power of the Shooting Star and\nHammer patterns using over six decades of historical data of the S&P\n500 Index. In our studies, we found out that historically these patterns\nhave offered little forecasting reliability when using closing prices.\nIn another work by Piyapas Tharavanij, Vasan Siraprapasiri and Kittichai\nRajchamaha, the researchers conclude the following:\nThis article investigates the profitability of candlestick patterns. The\nholding periods are one, three, five, and ten days. This study tests the\npredictive power of bullish and bearish candlestick reversal patterns\nboth without technical filtering and with technical filtering (stochastics\n[%D], Relative Strength Index [RSI], Money Flow Index [MFI]) by\napplying the skewness adjusted t test and the binomial test.\nThe statistical analysis finds little use of both bullish and bearish\ncandlestick reversal patterns since the mean returns of most patterns\nare not statistically different from zero.\nEven the ones with statistically significant returns do have high risks in\nterms of standard deviations. The binomial test results also indicate\nthat candlestick patterns ca", "source": "eBooks\\Tom Hougaard - Best Loser Wins.pdf", "doc_id": "db0d74ee3eb2ba5542f0943f7b8e994e1f3211b7a93aee04b5bfd56525c663f3", "chunk_index": 20}
{"text": "ness adjusted t test and the binomial test.\nThe statistical analysis finds little use of both bullish and bearish\ncandlestick reversal patterns since the mean returns of most patterns\nare not statistically different from zero.\nEven the ones with statistically significant returns do have high risks in\nterms of standard deviations. The binomial test results also indicate\nthat candlestick patterns cannot reliably predict market directions. In\naddition, this article finds that filtering by %D, RSI, or MFI generally\ndoes not increase profitability nor prediction accuracy of candlestick\npatterns.\nTRADERS BEWARE\nBrokers and educators have put the cart before the horse. They make us\nthink that learning as many patterns as we possibly can will increase our\nchances of trading success. This is simply not true. The more patterns we\nknow, the more we are inclined to talk ourselves out of good positions.\nThere is nothing wrong with technical analysis and patterns, and candle\nformation and indicators and ratios and bands. Yes, I don’t believe in many\nof them, because they are subjective and don’t hold up under real scrutiny.\nBut then again, trading is so subjective anyway that we don’t need to be\nright very much to make a good living from trading.\nAN OLD FOX TELLS\nMy friend Trevor Neil ran a hedge fund that had a 25% hit rate on their\ntrades. I want to tell you his story here to give you some deeper insight into\nhow some of the best professional traders work and think. I hope you will\nfind it illuminating.\nIt should also serve as a reminder that there are many ways to make money\nin the market. Your job is not to follow someone, but to find a way that you\nlike, that resonates with you and who you are and what you like to do.\nThe story starts with me asking Trevor a question. I knew that he had been\nassociated with Tom DeMark and his Sequential indicator. Tom DeMark is\nsomething of a legend within the technical analysis world.\nI happen to have met DeMark myself at a Bloomberg lunch many years\nago. He seemed like a nice guy, although I had very little to ask him, as I\nwas unfamiliar with his work. You see, his work was only available to those\nwho had a Bloomberg terminal.\nThe Bloomberg terminal at that time was some $25,000 a year. Today,\nthough, Tom DeMark’s work is available on many trading platforms, in\ncase you are interested.\nI asked Trevor about the Sequential indicator, and his eyes lit up. He told\nme a story about how he and his friend had decided that there was an edge\nto be gained from trading the Sequential indicator on a very short-term time\nframe.\nThey moved to South Africa and started trading South African shares on a\none-minute chart. I have never heard of a professional outfit, with\nsignificant funds under management, trade on such a short time frame.\nHowever, that is not what impressed me most about the story. What\nimpressed me most was how they managed to make money on what other\ntraders would consider an abysmal hit rate.\nMost people believe that you have to deploy a trading strategy that has a hit\nrate better than 50%. Trevor told me that their results varied. There were\ntimes when they were hot, and there were times when they were not.\nWhen they were hot, the hit rate would push 40%. When they were not, the\nhit rate was down in the mid-20s.\nOverall, though, they had in their hands a tool that generated about 25–30\nwinning trades out of every 100 trades placed. They were wildly successful.\nThey traded the fund for a handful of years, then they returned the capital to\nthe investors. They had made their money, and as neither of them were\nspring chickens, they decided enough was enough. It was time to go home\nand spend quality time with their families. Had they been younger, they\nprobably would have continued.\nNow I don’t know about you, but I like the story. It reaffirms the idea that I\nhave about trading. How you think when you trade is much more important\nthan whether your strategy has a hit rate in the 50s or in the 70s or in the\n90s.\nWhile the story is not conclusive evidence that anyone can make money\ntrading, as long as they have the proper money management rules and the\nrequired patience, it is a brilliant anecdote of two traders being able to make\nmoney even though – from a conventional point of view – their strategy on\npaper should not have generated a profit.\nSo, what was the secret?\nWell, the answer is simple. Although they lost 75 out of 100 trades, those 25\nwinning trades more than surpassed in profits what the 75 trades generated\nin losses. Trevor told me that they expected to make 25 times in profit what\nthe risk was. He also told me that when they executed a trade, they expected\nit to work immediately. So, I grilled him a little bit on that point.\n“What do you mean you expected it to work immediately?” I said. He said\nhe meant exactly that: when they executed a trade, they expected the trade\nto begin to work immediately. If they had bought at 50, they would not\nwant it to go to 48. If it went to 48, they would stop themselves out.\nIt meant they had plenty of small losses. Their back-testing had shown that\nif the strategy was to be traded correctly, it would work immediately. If it\ndidn’t work immediately, the strategy called for the position to be closed.\nBELIEVE AND ACT\nWhen you can act and perform without any fear of consequences and\nrepercussions, you are trading from an ideal state. When you consider how\nmany people lose money overall in trading, you logically have to conclude\nthat achieving this state is not an easy undertaking. It would be foolish to\nthink that this state of mind comes easily or even naturally. It doesn’t.\nI once sat and traded for a few months with a guy from Germany. He\npossessed an almost superhuman ability to do nothing. His patience was\nunrivalled. While we traded together I made it a sport to be as patient as he\nwas.\nIt was fun and, dare I say, somewhat painful. I missed many a good trade,\nbut the ones I took outweighed all the others.\nYou mus", "source": "eBooks\\Tom Hougaard - Best Loser Wins.pdf", "doc_id": "db0d74ee3eb2ba5542f0943f7b8e994e1f3211b7a93aee04b5bfd56525c663f3", "chunk_index": 21}
{"text": "f mind comes easily or even naturally. It doesn’t.\nI once sat and traded for a few months with a guy from Germany. He\npossessed an almost superhuman ability to do nothing. His patience was\nunrivalled. While we traded together I made it a sport to be as patient as he\nwas.\nIt was fun and, dare I say, somewhat painful. I missed many a good trade,\nbut the ones I took outweighed all the others.\nYou must be patient with yourself. You must be able to let your knowledge\nsettle and mature within you. If you trade small size now, but you want to\ntrade bigger size in the future, then that journey will most likely be anything\nbut linear.\nIt will be a journey of progress and setbacks. It will be a journey of progress\nand status quo. I can guarantee you that. You have to grow into the trader\nyou dream of becoming.\nYou must be patient with your trade entries. You must be patient with\nyourself. If you can bring those two qualities to the table, then the rest will\nsolve itself in time. You will grow your trade size at a pace where your\nmind will not be alarmed or fearful.\nI discuss this in much greater detail towards the end of the book. Otherwise,\nI am just like the well-meaning friend who says to my alcoholic friend,\n“Well, just stop drinking.”\nSure, if only it were that easy. Likewise, me saying to you “Just have more\npatience” is about as helpful as a hog roast at a vegan convention.\nOne macro trader I deeply admire is Greg Coffey, an outstanding London\nhedge fund trader. In a piece in a newspaper one client described him as\n“humble and arrogant in equal measures – the perfect trader”.\nThe piece went on to describe that Coffey had an absolute conviction on his\ntrades, to the point of being arrogant, but he was equally quick to be humble\nwhen the trades didn’t work out well.\nRemember this saying:\nIt is not what you know that kills you. It is what you think you know, but\nwhich just isn’t so, that kills you.\nTHE NATURE OF THE GAME\nThe game never changes, and it never will. Algorithms won’t change the\ngame. Laws won’t change the game. Because this is an inner game, and you\nneed to spend time – maybe not as much time as you do on charts, but a\nhuge amount of time – contemplating what human qualities you are\nbringing to the game of trading.\nMoving in the right direction comes from knowledge of yourself and an\nunderstanding of the markets. The game never changes. The players change,\nof course. We all grow old and die, and we are replaced with fresh blood.\nSadly, people don’t change, unless they make an out-of-the-ordinary effort\nto do so.\nWe have a reptile mind, which is not fond of change. “Hey, if it ain’t broke,\nwhy do you want to fix it?” Well, because it is broken. I am not making\nmoney how I know I can, so I want to change that. If that means I have to\nlearn to live under a different paradigm, and have a different perspective on\nfear and hope, so be it.\nTHE ROLE OF CHARTS\nYou can’t create a master painting with just one colour. You don’t create a\nMichelin-star meal with just one ingredient. And you most certainly do not\ncreate a viable business as a trader by only focusing on charts.\nThe role of the chart is to give you a visual representation of the thoughts of\nother market participants. It enables me to be much more specific in my\nentry and exit criteria than, say, a fundamental trader.\nHowever, it is easy to get seduced by the randomness of charts. Over time,\nthough, it is not your chart reading skills that will decide the number of\nzeros on your trading account.\nControlling your mind is no easy task. Your reflex mind will jump to\nconclusions before your conscious, reflective mind has had a moment to\nreally consider your response.\nThe sole purpose of this book is to provide you with the right tools to\nprogram your mind to be a trader – a profitable one.\nOur minds are feeble creatures, if left unchecked. Whenever I give a talk\nabout the role of psychology in trading, I always show people the logo of\nFederal Express, and then I ask them: “Where is the arrow?”\nIn case you didn’t know already, take a look at the FedEx logo – there is an\narrow hidden between the ‘E’ and the ‘x’.\nThe coordination between the eyes and the mind is fascinating. The eyes\ncan see one thing, while the reactive impulse mind tells us that we are\nseeing something else.\nIt is only through observance and training that we become mindful of our\ntendency to believe what we immediately think we see.\nConsider the following image. Which square on this chequerboard is darker,\nA or B?\nYou might be surprised to learn that both squares are exactly the same shade\nof grey, though it is very likely that your mind told you that square A is\ndarker. Published by MIT professor Edward H. Adelson in 1995, this optical\nillusion perfectly demonstrates how the mind can misinterpret information\npassed to it by the eyes.\nAnother example you may have encountered before is a little harder to\ndemonstrate in this book, but I will explain how it played out in the speech I\ngave – which gave me the impetus to write this book. It is a mind-flexibility\nexercise.\nI showed the audience a simple image: a red square. I asked them to call out\nthe colour of the image. “Red!” they shouted in unison.\nSimple enough, right? I then removed the red square and revealed a yellow\none. Same result: “Yellow!”\nI swapped in a green square. “Green!” they cried.\nRed. Yellow. Green. So far, so good.\nThe audience didn’t even need to think about it; that is how dominant the\nautomatic response system is.\nThen we moved onto the trickier bit. I showed the audience an image of the\nword red written in blue ink, and asked what colour that image was.\nA lot of them called out “Red!”\nI showed them yellow written in red ink. Some called out “Red!” but I heard\nfar more shouts of “Yellow!”\nWe repeated this process with a series of colour names written in ink of a\ndifferent colour. Over time, the audience responses became more\nconsistently accurate. Through a humorous exercise I established that our", "source": "eBooks\\Tom Hougaard - Best Loser Wins.pdf", "doc_id": "db0d74ee3eb2ba5542f0943f7b8e994e1f3211b7a93aee04b5bfd56525c663f3", "chunk_index": 22}
{"text": "n blue ink, and asked what colour that image was.\nA lot of them called out “Red!”\nI showed them yellow written in red ink. Some called out “Red!” but I heard\nfar more shouts of “Yellow!”\nWe repeated this process with a series of colour names written in ink of a\ndifferent colour. Over time, the audience responses became more\nconsistently accurate. Through a humorous exercise I established that our\neyes and minds do not necessarily work in a coordinated manner. Our brain,\nseeing the word red, wants us to say “red” – even when the answer to the\nquestion is “blue”. It is as if we consciously need to stop the brain from\njumping to conclusions.\nThis is an important trait in trading, because we often see things that are\nliterally not there.\nCharts do not work as well in real time as after the fact. Unfortunately, you\nhave to believe and act.\nIf you struggle with that after a few failed trades, then that is your brain\ntrying to protect you against pain. You will begin to second guess your\nsignals, and you will sabotage your own best interests. I have been there. I\nhave done it. And I have the cure.\nGOOD TRADING GOES AGAINST\nHUMAN NATURE\nWhen I make speeches about trading, in person or on YouTube, I often talk\nabout the concepts of value and price. What is something worth?\nI think my old car is worth £10,000. The car dealer feels it is worth £8,000.\nWho do you think is going to win that argument, if I am keen to sell?\nWhat something is worth is an emotional, biased statement. Price, on the\nother hand, is where buyers and sellers meet. It doesn’t make much sense to\nsay that something is worth more.\nYou can anticipate that something will be worth more or less in the future. I\nmean, that is the essence of the mechanics of my job. Psychology aside, I\nbuy in the hope that whatever I buy will rise in price.\nHeraclitus, the pre-Socratic Greek philosopher, said: “No man ever steps in\nthe same river twice, for it’s not the same river and he’s not the same man.”\nThat is important to bear in mind as a speculator, because the market\nchanges constantly.\nMankind has an ambivalent attitude to change. We want change, because\notherwise our lives become mundane and boring; but if the change is thrust\nupon us, rather than driven by motivation and enthusiasm, then we tend to\nresent it.\nThe first time I became aware of the importance of mindset in trading was\nupon reading a book about the trading life of an anonymous trader called\nPhantom of the Pit. It is a free book. You can find it with my own notes on\nwww.tradertom.com – in the resource section.\nIn the book the mystery trader argues that behaviour modification is the\nsingle most important concept in trading. The ability to change one’s mind\nwithout causing a mental disequilibrium is the single most important ability\nfor a trader.\nRunning a live Telegram trading channel means I am constantly asked\nquestions – the majority of them from inexperienced traders. One persistent\nquestion I get asked is: “Why are you trading against the trend?”\nWhen I get asked such a question, I smile, because it is both a naïve and\ninnocent question. It is naïve because any trader can be accused of trading\nagainst the trend.\nIt simply depends on the time frame you are looking at. If you are a five-\nminute candle trader, you don’t care that the trend on the weekly chart is\ndown. You care about the trend of the five-minute chart.\nAnother reason why it is naïve is because the whole construct of technical\nanalysis is fraught with contradictions.\nThink about it.\nYou are asked to follow the trend; but what happens when you sell a double\ntop? You are betting against the trend. The same can be argued for a double\nbottom. You are buying a market that is moving down.\nTHIRTY YEARS OF DATA\nI am a day trader. My speciality is stock indices such as the Dow Jones\nIndex. I looked at the statistics of closing prices in the index over the last 30\nyears. That equates to roughly 7,500 trading days. I wanted to know how\noften the Dow Index closed higher for the day and how often it closed\nlower for the day compared to the previous day’s closing price.\nI had an idea that, since the Dow Index over the last 30 years had risen from\n3,300 to nearly 36,000, you could expect more positive closing prices than\nnegative closing prices. I was wrong in that assumption.\nOver the last 30 years only 50.4% of all closing prices were higher than the\nprevious day’s closing price. This means the distribution of plus days and\nminus days in the Dow Index is evenly distributed.\nThe ramifications of this statistic is that day traders like me can’t rely too\nmuch on the trend on the higher time frame, because virtually anything can\nhappen down on the five-minute chart.\nThe challenge traders face can be summed up very easily, in a Heraclitus-\nstyle explanation. When we shop for a pint of milk, we know that milk is a\nuniform product. It doesn’t matter where on God’s green earth you shop for\na pint of milk. Milk is milk.\nHence, if milk costs twice as much in one supermarket as opposed to\nanother supermarket, you can again rightly conclude that a pint of milk is\nexpensive in one supermarket, and it is cheap in the other supermarket.\nHowever, a share, or a currency, or a share index, is like a river. It is in\nconstant transformation. The transformation is the result of the interaction\nof traders and investors.\nTheir action is the result of their opinions about the future. You may agree\nwith their opinions, or you may disagree; but to say that the majority are\nwrong is counterproductive to efficient money-making in the markets.\nThere are many part-time traders who are incredibly successful in their\nother careers but struggle when it comes to trading. What we have to do to\nsucceed in the world of trading is significantly different to what we have to\ndo to succeed in the world outside of it.\nFor example, if you go into a supermarket to buy dinner, and you see that\nthere is a special offer on chicken, you will be inclined to take advantage", "source": "eBooks\\Tom Hougaard - Best Loser Wins.pdf", "doc_id": "db0d74ee3eb2ba5542f0943f7b8e994e1f3211b7a93aee04b5bfd56525c663f3", "chunk_index": 23}
{"text": "rt-time traders who are incredibly successful in their\nother careers but struggle when it comes to trading. What we have to do to\nsucceed in the world of trading is significantly different to what we have to\ndo to succeed in the world outside of it.\nFor example, if you go into a supermarket to buy dinner, and you see that\nthere is a special offer on chicken, you will be inclined to take advantage of\nthis offer. If chicken is offered at half price, then you might be thinking that\nthis is a great price, and you will want to buy some supply for the freezer.\nOur human nature is such that we love a bargain. We love to seek out good\noffers and take advantage of them. It fills us with a sense of joy to know we\nhave bought something which is cheap.\nJust yesterday I went shopping and there was an aisle with discounted\nitems. Everything was half price or less. I bought soap and washing liquid\nand detergent for the next 12 months.\nAs I filled the trolley, I laughed to myself, mostly because I knew that I\nwould go on to write a chapter about this very behaviour. It felt great to\nsave 70% on stuff I knew I would buy anyway at some point during the\nyear.\nLet’s face it, we can save a lot of money if we shop contrary to the trend.\nIf at all possible, I tend to buy my winter jackets when there is a heatwave\noutside. That is when the shops want to get rid of these items, to make\nspace for the summer clothes.\nConversely, I love to buy my summer clothing when there is six feet of\nsnow outside. I know it is not normal to do that, and maybe that is why I\nlike doing it. I love a bargain. I don’t think I am alone in loving to buy\ncheap.\nAs I said earlier, the world of trading is diametrically opposed to the world\noutside trading. The traits I display as a human being outside my world of\ntrading don’t serve me well in the world of trading. This is not just me I am\ntalking about. This is people in general.\nOur minds struggle to separate the world of trading from the world of\ngeneral consumer behaviour. Let’s look at the differences.\nSUPERMARKET BARGAIN\nWhen I see something in the supermarket that is cheaper than it was before,\nor that gives me a discount for buying more than one item, I am attracted to\nbuying it. My action is driven by a subconscious drive towards pleasure.\nMy action is that of a rational consumer who will seek out the cheapest\nproducts. The supermarket knows this, and they will tailor their offering to\nmaximise my spending.\nMy behaviour is driven towards maximising my pleasure – within my\nbudget constraint. When I do so, it gives me a sensation of well-being.\nFINANCIAL MARKET BARGAIN\nWhen I see the FTSE Index falling in price during the day, my mind\nassociates falling prices with value and becoming cheap.\nIf I act on the impulse, one of two things will happen:\n1. My feeling of value is confirmed. The market begins to rise.\n2. My feeling of value is not confirmed. The market continues to fall.\nMy argument is perhaps provocative, but no matter what happens next, I\nwill end up losing – even if I win on the trade.\nIf I buy with no good reason other than my mind sending me an impulse to\nsay the market is cheap, I will lose if the market continues lower. And why\nwould the market not continue lower? That is the premise of technical\nanalysis. Trends persist. The market suffers from inertia, meaning that\nwhatever it is doing now, the odds are above 50% it will continue to do.\nIf I buy, and the market begins to rise, I will eventually lose anyway,\nbecause I have now taught my mind that it is okay to stick my hand out and\ncatch the proverbial falling knife.\nI have created a pattern in my mind that associates buying falling asset\nprices with pleasure, because I had success with it at some point.\nAs a side note: when I began taking trading very seriously, I would review\nmy trades when the day was over. I would print out the chart and plot my\ntrades onto it. I realised that some eight out of ten trades were impulse\ntrades. I began to become much more conscious of my trades. As I\nproceeded down that path, I became more and more profitable. The fewer\nimpulse trades I had, the more money I made, and the more satisfaction I\nderived from my job.\nSELF-ANALYSIS\nThrough analysis of my trading behaviour – meticulously logging my trades\non a chart after the trading day was over – I came to the realisation that I\nwas a prolific value trader. I would repeatedly short rising markets. I would\nrepeatedly buy falling markets.\nIt helps me to remind myself daily that when I am buying, someone else is\nshorting or getting out of a long position. A significant factor to my trading\nsuccess, going from being a losing trader to a winning trader, was the\nrealisation that there are no bargains in the financial markets.\nSUPERMARKET SUBSTITUTES\nWhen I am shopping for something in the supermarket, and I discover a\nproduct has gone up in price, or a product that used to be on offer is no\nlonger on offer, my mind will associate this with pain. My mind will direct\nme towards a substitute. This is perfectly rational human behaviour.\nMy sister and I laugh about this phenomenon. She lives in Germany and\nfrequently travels with the airline EasyJet from Berlin. She puts it so\neloquently, when she says, “I will get up in the middle of the night for a 5\nam flight, if it means I can save myself €25.”\nI think many of us can recognise this trait.\nFINANCIAL MARKET SUBSTITUTES\nIf something has gone up in price in the financial markets, then it means\nthere is demand for it. It may seem expensive, but it merely reflects the\nequilibrium point between buyers and sellers.\nI struggled with this for years. I argued it was expensive, and this faulty\nview was compounded by the technical indicators I was using.\nIndicators like stochastics would suggest a market was overbought or\noversold. Those are other words for cheap and expensive. It is for this\nreason I am no longer trading with any kind of technical indicators. My\ncharts are 100% naked.\nThe perverseness of", "source": "eBooks\\Tom Hougaard - Best Loser Wins.pdf", "doc_id": "db0d74ee3eb2ba5542f0943f7b8e994e1f3211b7a93aee04b5bfd56525c663f3", "chunk_index": 24}
{"text": "ellers.\nI struggled with this for years. I argued it was expensive, and this faulty\nview was compounded by the technical indicators I was using.\nIndicators like stochastics would suggest a market was overbought or\noversold. Those are other words for cheap and expensive. It is for this\nreason I am no longer trading with any kind of technical indicators. My\ncharts are 100% naked.\nThe perverseness of the financial markets is that it generally makes sense to\nbuy something because it is more expensive today than it was yesterday.\nDEALING WITH ADVERSITY\nWhen I experience difficult situations in my life, I will be patient and work\non resolving them. Through my work and my resolve, I hope I will be able\nto solve the problem. I may even use force on the issue or use my authority\nto solve the problem.\nNo amount of hard work, resolve or prayer will turn a bad trading position\ninto a good position. Either the market agrees with you or it doesn’t. It\ndoesn’t matter how rich you are; how big and powerful you are. If the\nmarket disagrees, it disagrees.\nThe market can only hurt you if you let it hurt you. The market will rally.\nThe market will fall. Whether you are on board or not, making money or\nnot, is inconsequential to the market. It knows nothing about you.\nWhen you make money, you make money because you are aligned with the\nmarket. The market itself is nothing more than the combined force of all the\nmarket players. They, like you, are looking to make money from trading.\nUnfortunately, we can’t all make money. I came to realise, after years of\nsuffering, that I had to change my relationship – not with the market, but\nwith how I reacted to what the market did.\nMuch of that process was undoing my life values and beliefs when it came\nto the trading world. In the normal world, when I don’t get my will, I will\nwork hard at convincing the other party to see things my way. I am very\npersuasive, and I usually get things how I want them.\nWhile that may be a trait that helped me in the real world, it is a trait that\nwas detrimental to my trading performance. The market doesn’t care about\nyour position. It doesn’t care if you are long or short or on the side lines.\nThe market has no feelings about you or your position.\nThe essence of my argument is that many of the traits we display as\nperfectly normal people don’t serve us well in the world of trading.\nI think all the successful traders I know have gone through a transformation\nprocess. Some were gradual. Others talk about a specific situation which\nacted as a catapult to success.\nSome became so disgusted with themselves, they decided that they were\ngoing to either follow the rules or quit trading altogether.\nTHE INNOCENCE OF OBJECTIVE\nOBSERVATION\nA very good friend of mine, Dr David Paul, describes his own\ntransformation in the following story.\nI have a PhD in mechanical engineering. I have worked for De Beers. I invented a mining drill\nwhich made me a fortune. I have had my own mining company. So, it is fair to say that I came\ninto the markets with a lot of confidence, and a lot of money at my disposal.\nI started investing money in the 1980s. It was easy to make money in the stock market then.\nAll you had to do was buy shares and then sit and wait. While I waited, I started doing\nprogramming on the early computers. I eventually created my own share selection software. It\nwas incredibly sophisticated software for its time.\nOn this particular day in question the software called for the market to rise very strongly. So,\nat the open of trading I phoned my broker and placed a very large buy order.\nAnd sure enough, the market did what my software had said it would do. It started moving\nhigher. I was naturally happy that the analysis was correct and that I was making money. I held\non because the software predicted the rise would continue, only much more strongly.\nA short while later, however, the market began to drop. I was naturally a little surprised but\nknew that it must be just a temporary aberration and a good chance to buy a little more before\nthe market really took off. So, I did. I bought some more. And yet the market continued to\ndrop. And drop. And drop.\nI began to get a little worried, so I phoned my broker and all my trading friends to see if there\nwas any reason for this deviation. They too were at a loss to explain why the market was\ndown. Their analysis had suggested the market would rally strongly. All the newsletters\nsuggested that we were in the middle of a major wave three in Elliott Wave Analysis terms,\nand everything pointed to higher prices.\nI felt somewhat better having spoken to my friends and my broker about the situation, and I\nwas sure that this was just an aberration, so I decided to buy a little bit more at these cheaper\nprice levels. The market bounced for a while, and I felt pretty good about having bought some\nmore at what I thought would be the lows of the day.\nThe market then began to head lower again, and I began to get really concerned, even a little\nscared. It was quite a big position I had accumulated.\nJust then my wife walked into my office to ask what I wanted for dinner that night. She must\nhave sensed that I was distracted or in discomfort, and she walked over to my desk and looked\nat the trading screen. “Is anything the matter, dear?” she asked. She can be so sweet.\n“No, my love, just working. My software says this market should go up.” I pointed at the\nscreen. “The software has never been wrong, and I have spoken to the brokers and to my\nfriends, and they all say that this market should be going up, but it is going down.”\nShe looked at the screen with the market and said, “Is this the market you are trading in?”\n“Yes,” I said. “I really don’t understand why it keeps moving lower. I am sure it will move up\nvery soon.”\n“But it is not moving up right now, is it?” she said.\nI got a little impatient with her, and I said, “No dear, but what you don’t understand is that the\nsoftware and the Elliott Wave Count are in agreement", "source": "eBooks\\Tom Hougaard - Best Loser Wins.pdf", "doc_id": "db0d74ee3eb2ba5542f0943f7b8e994e1f3211b7a93aee04b5bfd56525c663f3", "chunk_index": 25}
{"text": "looked at the screen with the market and said, “Is this the market you are trading in?”\n“Yes,” I said. “I really don’t understand why it keeps moving lower. I am sure it will move up\nvery soon.”\n“But it is not moving up right now, is it?” she said.\nI got a little impatient with her, and I said, “No dear, but what you don’t understand is that the\nsoftware and the Elliott Wave Count are in agreement, and the market absolutely has to go\nup.”\n“Oh well, you are right, I don’t know anything about this software or the Elliott thing, but it\njust doesn’t seem to be going up right now, does it?”\nI distinctly remember taking a deep breath. I said to the woman I love but who had now begun\nto irritate me, “No dear, but just as soon as this passes, it will start to go up. It absolutely has\nto. I think this is just an AB=CD formation. The software says so. The broker says so. My\ntrading friends say so. The Elliott Count says so. There is no way that all these people and my\nsoftware could be wrong.”\n“Ok, I am sorry, you are right; I don’t understand your software or the Elliott thing or what the\nbroker is talking about. All I see is that this market right now is going down, isn’t it?”\nI stopped staring at the screen for a second, and I looked up at my wife. “Could you please\nrepeat what you just said?”\nShe looked at me puzzled, and said, “Well, I am just saying that right now, right at this\nmoment, right here right now, this market is moving down, isn’t it?”\nAnd then it hit me like a thunderbolt. I wasn’t trading the market. I was trading my opinion. I\nbegan to laugh, because I felt for the first time that I knew what had to be done to make money\nin the market. I understood that the very thing I was trying to avoid was the very thing that was\nkilling me right now. I was trying to avoid losing trades at all cost, and now I was in a trade\nthat was losing me – only because I refused to listen to what the market was trying to tell me.\nI realised in that moment that I had to learn to lose in order to win. It was as simple as that. I\nwasn’t trading the market. I was reinforcing my ego through the market.\nI picked up the phone, called my broker and sold out all my long positions. Furthermore, I sold\na large number of contracts short as well. And sure enough, the market continued – down and\ndown and down.\nMy trading life changed that day. I no longer paid so much attention to expert theories, and I\nstopped guessing where the market was going. I started trading the markets. It was a\nrevelation. I started making lots of money. I realised that some of the stuff I had read was\noutright wrong and detrimental to my trading.\nFor example, we have all read the axiom of ‘buy low and sell high’. I changed that to ‘sell low\nand cover lower’ and ‘buy high and sell higher’.\nSURRENDER\nWhen I asked David to sum up his experience, he said to me:\nLook at your own life. You love to surf. You wait for the waves, and\nyou paddle into their energy flow, and you ride the wave. How is that\nany different to what we do as traders?\nWhen you are out there, sitting outside the impact zone, waiting to\npaddle in, you don’t paddle when there are no waves. You are patient.\nWhen the right size wave builds ups, you get ready. You are one with\nthe sea. You roll with its flow. You surrender.\nTo succeed in the markets, we must surrender. Every single individual on\nplanet Earth has a great deal of time, money and value tied up in what we\nknow, and it is unthinkable to even consider surrendering all this perceived\nknowledge.\nThe purpose of my trading and your trading is not to be proven right and\nbolster our egos. Our job is to make money. If that means we come to the\nmarket with an opinion, and we are proven right, so be it.\nIf it means we have to change our opinion because the market dictates it, so\nbe it. A more spiritual person than I would perhaps express this as “empty\nyour mind and let the market guide you”.\nTHERE IS A LOT LESS TO TRADING\nTHAN MEETS THE EYE\nThe fact is that our complicated human minds have a great deal of trouble\nprocessing information that is simple. Unless it is complex to the tenth\ndegree, our minds tend to pass it over. We think that something simple can’t\nbe profitable.\nWhat is your aim? The simple answer should be to make money. In the past\nI was so preoccupied with what should happen. But to make money we\nmust be focused on what is happening right here, right now.\nWhen I started writing this book, I wanted to keep it practical. I had no\ninterest in trying to pass myself off as a trader therapist or a psychologist,\nbecause I am not. I wanted it to show the true nature of what trading is,\nwritten by someone who has skin in the game, and who has both scars and\nmedals to show for it.\nIf the last few pages have been a little too theoretical for your liking, I\nwould like to describe a real-life case study – one that was captured on\nvideo (my way of telling you that this is an authentic story) by Round the\nClock Trader in July 2019.\nI want to explain what I mean by going into the market with an open mind\nand an empty cup. I bought an index after a double bottom. Everything\nlooked pretty good. I was long from 12,808 and I had bought again at\n12,818. Then it happened: the index plummeted. My five-minute chart\nshowed three major lows (I call these get out bars, when I am trading\nagainst their direction, or add to bars, when I am on the right side of them).\nI was wrong being long.\nI got out of my long position and reversed my position to short, relatively\nearly on in the downward spiral of the index. There were some 500 traders\nattending the event, and what pleased me most about the outcomes was not\nthat I lost on my first trade, or that I won my money back soon after. What\npleased me most was that I did not stubbornly hold on to a losing trade, and\nthat I had the mental freedom to move from being long the market to now\nbeing short the market.\nWhen I started trading, there was no chance in hell I would have done what\nI did there. I", "source": "eBooks\\Tom Hougaard - Best Loser Wins.pdf", "doc_id": "db0d74ee3eb2ba5542f0943f7b8e994e1f3211b7a93aee04b5bfd56525c663f3", "chunk_index": 26}
{"text": "he event, and what pleased me most about the outcomes was not\nthat I lost on my first trade, or that I won my money back soon after. What\npleased me most was that I did not stubbornly hold on to a losing trade, and\nthat I had the mental freedom to move from being long the market to now\nbeing short the market.\nWhen I started trading, there was no chance in hell I would have done what\nI did there. I would have held on and held on to that losing position. “I\nknow I am right,” I would have said; except I wasn’t, and I wasn’t making\nmoney.\nThe most critical point came when my new short position showed a profit\nwhich was equal to what I had lost on the long position. My mind\ndesperately wanted me to bring balance to its emotions. What better way to\ndo that than to offset the loss from the first trade? Well, in the words of my\ngreatest trading hero, Charlie DiFrancesca, “Good trading means\ncombatting the emotions that make us human.” Let’s take a look at how we\ncan do that.\nFIGHTING MY HUMANNESS\nWHAT IS NORMAL behaviour amongst retail traders? We know that 80–90% of all\nretail traders engage in the same self-destructive behavioural pattern.\nWe know that some 90% of traders do not make money consistently trading\nCFDs or spread betting or in futures markets. It is probably also fair to\nassume that those 80–90% of traders are intelligent, ambitious, self-\nmotivated human beings, who like to create their own luck and forge their\nown way in life.\nI have never met anyone who started trading because they thought it was\nthe same as playing the lottery. Virtually every person I have ever met who\nwas interested in trading and who wanted to learn more about trading has\nbeen a self-starter, entrepreneur, or student at an institution of further\neducation.\nTherefore, it’s a fallacy to say trading attracts the wrong kind of people. It\nattracts the right kind of people. It attracts those who have a chance of\nsucceeding at it.\nI think it attracts the kind of people who are not fooled by the get-rich-quick\nschemes. I doubt many traders buy lottery tickets, purely on account of the\nodds being rubbish, and traders understanding that all too well.\nNevertheless, something is wrong.\nSomething is wrong when 90% of people fail. In the following table I have\nidentified a handful of behavioural patterns that I think are detrimental to\ntraders. The most frequently observed behaviour is the inability to take a\nloss.\nWhat is the reason for not taking a loss? I argue there is one reason we tell\nourselves, and then there is another, real reason. The real reason is always\nthe same.\nAction Conscious Reason Subconscious Reason\n1.I am letting my loss runI am hoping Avoid pain\n2.I am letting my loss runIndicator/Fib/etc., says soAvoid pain\n3.I am taking my profits You can’t go broke taking a\nprofit\nAvoid pain\n4.I am winning, so I am\nreducing my stake\nI want to take it easy nowAvoid pain\n5.I am losing, so I am increasing\nmy stake\nI am trying to get back to\nwhere I was\nGet rid of pain\n6.I made my points for today, so\nI stop\nI am afraid to lose what I madeAvoid pain\n7.I am trading without real\nconviction\nI am bored/scared of missing\nout\nAvoid pain of boredom or pain of\nmissing out\nHope features high on the list of reasons. As the saying goes, hope dies last.\nOur minds seem ill equipped to engage in risk management. Our minds\nhave one primary objective: to protect us against perceived or real pain.\nDuring the process of running an open position that is producing a loss, our\nsubconscious mind is telling our conscious mind to keep the position open.\nIt will mask this message as well as it can, in order to protect the ego, which\nis more fragile than the state of your trading account.\nIf this sounds too airy-fairy, on account of the use of words like ego and\nsubconscious, let’s explore the same argument using a different language.\nAVOIDING PAIN\nAs long as a losing position is open, there is hope that the position will turn\npositive. The moment you close the position, and you crystallise the loss,\nthe pain of the loss becomes real.\nI accept there are many permutations to the situation of handling a losing\ntrade. Some will argue that the very act of closing a losing trade is the point\nwhen you can stop agonising over the open loss and open yourself up to\nother trade options. I personally agree with this argument. When I have a\nlosing position and I no longer believe in it, the worst I can do to myself\nand my psyche is to begin to hope. I don’t feel free in my thinking and in\nmy market perspective when an open losing position is beaming at me on\nmy open position monitor. When I close the position, I feel free again, and I\nam opening myself up to taking in market information from an\nopportunistic frame of mind.\nHowever, my primary argument is that the reason we are hoping has little to\ndo with hope itself and everything to do with avoiding pain.\nHow many times did I see clients sit on losing positions for ages? I saw\nthem deposit more money every time their losing position received a\nmargin call. A margin call is when the broker demands more money to keep\nyour position open. They just didn’t want to take the loss.\nTo compound my confusion, how many times did I see the position come\ngood again, and the client close the position as soon as it did? I saw it\nfrequently. They didn’t hold on to the position because they believed in the\nposition. They held on to the position because they could not stand being\nwrong.\nThe moment they were relieved of their pain of the losing position, they got\nout – for nothing. They were so relieved to have avoided the pain of being\nwrong that they completely ignored the fact that the market was now\nactually agreeing with them.\nThey weren’t trading the financial market. They were trading their\nemotions, responding to how they felt. When they felt relief that the\nposition had come good again, they now associated a tremendous amount of\npain with the thought of having to relive this anxiety once more.\nAs a result of thi", "source": "eBooks\\Tom Hougaard - Best Loser Wins.pdf", "doc_id": "db0d74ee3eb2ba5542f0943f7b8e994e1f3211b7a93aee04b5bfd56525c663f3", "chunk_index": 27}
{"text": "of being\nwrong that they completely ignored the fact that the market was now\nactually agreeing with them.\nThey weren’t trading the financial market. They were trading their\nemotions, responding to how they felt. When they felt relief that the\nposition had come good again, they now associated a tremendous amount of\npain with the thought of having to relive this anxiety once more.\nAs a result of this association, they closed the position. They felt relieved at\nthe thought of not having to go through this anxiety again.\nIf you are taking your profits early under the excuse that ‘you can’t go\nbroke taking a profit’, you are reacting to your mind warning you against\nfuture pain.\nIf you are on a winning streak, and you reduce your stake size, you are\nessentially anticipating the pain of losing some of your gains. You are now\nrationalising your way to avoid the pain, even though nothing painful has\nactually happened.\nI want to reiterate the last paragraph. If you are in doubt whether you are\ntrading from an opportunistic frame of mind or a fear-based frame of mind,\nthen answer this simple question: when you are winning, are you increasing\nyour trading size or decreasing your trading size?\nYou see, the vast majority of traders will decrease their trading size when\nthings are going well, because they are afraid their winning streak will\neventually run out. The flip side to that coin is that they might even increase\ntheir trading size during a trading slump, so they can win back the lost\nmoney.\nAs Greg De Riba, an S&P 500 pit trader of superior quality, said in the\nmovie Floored: “99% still don’t get it – when they win, they start betting\nless. Bet more!”\nPerceived pain or real pain matters not to the subconscious. It will be\ntreated with the same response and the same emotions.\nWhen the pain is real, i.e., real pain has manifested itself in body and mind\nbecause of a trading loss, there is no end to the lengths our ego will go to in\nits efforts to make the money back. This is the primary driver behind the\nargument of ‘when wrong, double up’.\nDuring a losing streak we tell ourselves that we are ever so close to winning\nagain, so the natural conclusion must be to double up in order to regain\nwhat has been lost.\nThe real (subconscious) reason for doubling up on a losing trade is to\nattempt to get rid of the pain. Now we are not trying to avoid pain; we are\ndealing with existing pain, and we are trying to get back to that state of\nequilibrium where we were pain free.\nACT WITHOUT FEAR\nYou learn a lot from observing millions of trades. If you want to stand a\ngenuine chance of making money as a trader from the financial markets, I\nbelieve with every string of DNA within me, with every fibre in my body,\nthat you need to change the way you think about fear and pain and hope.\nWilliam Blake said that “He who desires, but acts not, breeds pestilence”. I\nhave worked tirelessly towards being able to act without fear and hesitation.\nThe true measure of your growth as a human being is not what you know,\nbut rather what you do with the things you know.\nWhat do I mean by that?\nHave you ever seen a chart pattern, and your first impulse was to buy or sell\nshort, but then – without warning – the very next thought was one of fear?\nIt was a thought you had no control over. It just exploded into the forefront\nof your mind.\nI have experienced that at times in my career. When it happens, I know I\nneed to reset somehow. Maybe I need to meditate. Maybe I need to sleep.\nMaybe I need to eat or go for a walk. I know that something is blocking me,\nand I need to resolve it.\nMy free creative mind instructed me to do something, but my fear instinct\nimmediately cautioned me not to follow through, because I might lose.\nIt doesn’t really matter whether you were right not to trade, or whether the\nposition would have lost you money or made you money. Those are\nafterthoughts (rationalisations or justifications). We can file those under\nanecdotal evidence, or evidence that has no merit. We all have an uncle who\nsmoked until he was 90 with no negative effects – anecdotal evidence – but\nthat does not justify the argument for smoking.\nIf my free mind argues for a position, and my fear mind argues about the\nconsequences of failing on that trade, then I am essentially arguing with\nmyself. The posh term for this phenomenon is cognitive dissonance.\nMy trades need to flow from a point of freedom of expression. Trades\nconducted from a perspective of fear or greed will not lead to good decision\nmaking.\nMy advice: stop trading and start contemplating. What is going on? When I\nexperience cognitive dissonance, it is for one or both of the following\nreasons:\n1. I have trading fatigue (or physical fatigue – ever heard the saying\n‘fatigue makes cowards of us all’?).\n2. I haven’t done my preparation well enough.\nHOW DOES SHE DANCE?\nHave you ever seen a market that was in freefall, and you were reluctant to\nsell short because you were afraid you might lose? My basic aim with this\nbook is not to rid you of these fears. Fear will always be part of our lives.\nMy aim is to make you understand why you feel that fear and how to\nprocess it, so you can take the trade.\nI accept that I am a human ruled by emotions. I understand that I can’t\nescape emotions, and nor should I try to escape them. Rather I want to help\nyou understand your fear, why it is there, and how to become friends with\nit.\nEarlier in the book I wrote about Philippe Petit, the man who walked across\na wire suspended between the Twin Towers. He is afraid of spiders. Yes, it\nsounds silly, doesn’t it? His approach to dealing with fear is worth\nrepeating.\nHe would do everything in his power to understand the nature of his fear of\nspiders. He would study spiders. He would learn everything there was to\nknow about spiders. Through his study he would come to appreciate the\nnature of his fear.\nHow does that translate into the world of trading? Let’s take a practical\nexample. I am trading the FTSE 100 Index.", "source": "eBooks\\Tom Hougaard - Best Loser Wins.pdf", "doc_id": "db0d74ee3eb2ba5542f0943f7b8e994e1f3211b7a93aee04b5bfd56525c663f3", "chunk_index": 28}
{"text": "roach to dealing with fear is worth\nrepeating.\nHe would do everything in his power to understand the nature of his fear of\nspiders. He would study spiders. He would learn everything there was to\nknow about spiders. Through his study he would come to appreciate the\nnature of his fear.\nHow does that translate into the world of trading? Let’s take a practical\nexample. I am trading the FTSE 100 Index. My stake size is around £300 a\npoint for a starter position. Now I have to find the best entry points and the\nbest exit points.\nBut what do I do if I am afraid? What do I do if I am scared to place my\ntrades because I am not sure what the market is capable of doing?\nThe greater understanding you have of your opponent, the better you are\nable to understand what she is doing. I use the word opponent here, but\nreally, the market, she is my friend. I want to dance with her. But I am\nafraid of making a fool of myself. So, I study her moves.\nI haven’t seen other traders do what I do, so I argue this is a novel way of\nanalysing the markets. Whether it is a new approach or not doesn’t matter.\nWhat matters is that I get a sense of what my dancing partner is capable of\ndoing. What can I expect from her price behaviour? Is it erratic? Is it\nsmooth?\nObserve the chart in Figure 9.\nFigure 9\nSource: eSignal (esignal.com)\nWe are all chart experts after the fact. However, studying past pricing\nbehaviour gives me a strong indication of what I can expect for the trading\nday. You may see a market that initially rallies, makes a double top, and\nthen declines.\nLet me show you the chart in Figure 9 from another vantage point – see\nFigure 10.\nFigure 10\nSource: eSignal (esignal.com)\nAs part of my quest to trade without fear, I break down the chart into its\nsmallest components. I see the first wave up is 24 points. I see the\nretracement is 9 points down. I see an attempt to make new highs, but it\nonly rallies 6 points. I see a deeper retracement of 12 points. I see an 8-\npoint rally, a 3-point retracement and another 11-point rally.\nThe retracements lower are between 9 and 12 points, with the exception\nof one move of 17 points. You may argue that this is great (said with\nsarcasm), if you had known about it before the trading session started. Well,\nyou did. Let me show you the day before, in Figure 11.\nFigure 11\nSource: eSignal (esignal.com)\nThe retracements lower are between 7 and 12 points, with the exception\nof one move that was 14 points.\nMy approach to a non-fearful trading style is a combination of emotional\ndiscipline, mental warm-up, and knowledge of what the market can do.\nWhile these two trading days are different in outcome, their behaviour is\nnot altogether different.\nI would go into the trading day armed with the following knowledge:\n1. Deep retracements and outright moves tend to be around 10 points.\n2. Small retracements against a strong trend are around 3–7 points.\nKnowing this, combined with an understanding of basic price patterns, I can\ndevelop an entry strategy aimed at risking as little as possible. For example,\non the previous chart, after the market has pushed higher for a move of +11,\nI wait to buy a retracement. I know that most retracements are around 7 to\n12 points, with the last three of them being 8, 7 and 10.\nSo now I am looking to buy. Say I buy at the point where the market has\nretraced −7 points; I may be fearful that the market will move against me.\nMy knowledge of the immediate past suggests that the market is unlikely to\nmove more than −12 points in a retracement. I therefore place my stop-loss\nat an appropriate distance away, based on the past behaviour.\nThe discipline to wait for the right entry, combined with the knowledge of\npast price behaviour, will set you apart from the majority of traders. They\nare unlikely to have done the same level of preparation.\nThrough your preparation (and I admit, I speak for myself now), you are\nworking through the issues your fear mind can throw at you. Your fear mind\nmight say “What if I lose?” If it does, the answer is that if the market moves\nbeyond −12 points your position is probably wrong, and your stop-loss will\nhandle your exit.\nWhen I lend a helping hand to struggling traders via my Telegram channel,\nthe first thing I ask them is do they write down their trades? By that I don’t\nmean write the particular trade entry on a piece of paper. I mean, do they\nplot their trade entries on a chart once the trading day is over?\nI have included a couple of examples from my own trading diary to serve as\na visual reference guide. See Figures 12 and 13. I use these to warm up in\nthe morning ahead of the trading day. I have selected random files from my\nold trading days, and I will relive those moments, both the terrible ones – to\nget me fired up on how not to trade today – as well at the good ones for\ninspiration.\nFigure 12\nFigure 13\nBy observing my past behaviour, I am able to reinforce my good points\nwhile being mindful of my weak points. I will observe the disastrous\nconsequences of my hasty trading decisions and my impulses. I will\nobserve trades where I didn’t let my profits run. I will in essence torment\nmyself by looking at my bad trades because I know this will act as a\npositive catalyst.\nIncidentally, I am not the only one who works like that. I read that Michael\nJordan and Cristiano Ronaldo thrive on negative talk about them and their\nperformance. They take that on board, and it acts as fuel to propel them to\ngreater achievements. Unfortunately, no one writes about Tom Hougaard\nand his trading, so I recreate the situation by putting myself through my\npast bad trades.\nNOT ALONE\nThe disastrous, impulsive patterns I saw most frequently on the trading\nfloor fell into two categories:\n1. Clients executed a long position in markets that they thought looked\ncheap. More often than not they bought into established downtrends.\n2. Clients executed a short position in markets that they felt had rallied\nby too much. To them it looked as if the market couldn’t m", "source": "eBooks\\Tom Hougaard - Best Loser Wins.pdf", "doc_id": "db0d74ee3eb2ba5542f0943f7b8e994e1f3211b7a93aee04b5bfd56525c663f3", "chunk_index": 29}
{"text": "bad trades.\nNOT ALONE\nThe disastrous, impulsive patterns I saw most frequently on the trading\nfloor fell into two categories:\n1. Clients executed a long position in markets that they thought looked\ncheap. More often than not they bought into established downtrends.\n2. Clients executed a short position in markets that they felt had rallied\nby too much. To them it looked as if the market couldn’t move any\nhigher.\nI don’t blame you if you think I am making this up. Surely, traders can’t be\nengaged in this kind of behaviour in an enlightened era like the one we live\nin, where information flows so freely?\nTo prove my point, I went to the IG Client Sentiment Report from 26\nOctober 2021. IG Markets is a broker that has been around for some time.\nTheir client base is global, and as such their sentiment report represents the\ntrade positions of a large segment of the retail trading community.\nBefore I show you the sentiment report for stock indices, I want to tell you\nthat as I type this, on the day of the sentiment report, stock indices all over\nthe world made fresh new all-time highs. The FTSE 100 Index in the UK\ntraded at levels not seen for years. In the US the Dow Index traded at levels\nnever seen before.\nSo, you would imagine that if my observations were inaccurate, the bias on\nthe sentiment report would call for people being bullish the market.\nYou would be wrong. Sadly, I was right about traders’ behaviour. 71.39% of\nall Dow Index positions were short positions – on a day when the Dow\nmade fresh new all-time highs. Things were not much better for the DAX\nIndex or the FTSE Index.\nSymbol Net-Long (%)Net-Short (%)\nGermany 30\n37.04 62.96\nFTSE 100\n30.60 69.40\nUS 500\n39.85 60.15\nWall Street\n28.61 71.39\nThis is why the 90% lose. We don’t see the market for what it is. We see it\nas we are. A chart is only as illuminating as our ability to keep out\npreconceived ideas of the direction of the market.\nWe are not losing money over time because we don’t know enough about\ntechnical analysis or the markets as a whole. We lose money because we\nrefuse to accept what is right in front of us.\nMy basic premise is that people:\n1. think the wrong way before they get into a trade, and\n2. think the wrong way when they are in a trade.\nIt reminds me of the late Mark Douglas, a phenomenal light in the trading\nindustry and an inspiration to thousands of people, when he said that good\ntraders “think differently from everyone else” at the start of his book\nTrading in the Zone.\nI have coined my own phrase. I argue that people are fearful when they\nshould be hopeful, and they are hopeful when they should be fearful. I\nwould like to illustrate that by use of an example.\nImagine you have bought German DAX Index at 15,510 and the market is\nnow trading up at 15,525. Instead of thinking that the market may be on a\ntear – and may go on to offer you many more points – you begin to fear that\nthe points you have already earned will be taken away from you.\nHence my saying: you should be hopeful in a situation like this, but instead\nyou are fearful. You are afraid that the points will be taken away from you.\nYou are not thinking about how many points this position may end up\nmaking you. Your focus is on fear rather than opportunity.\nThe opposite holds true when you are in a losing position. You are now\nhoping that the market will turn around. Your sole objective is to get rid of\nyour pain, and instead of being afraid that you’re going to lose even more,\nyou now hope that you can reach a position in which you will lose less.\nEvery tick in your favour is celebrated. Every tick against you is ignored.\nIf you want to trade well, you need to turn this on its head. You need to\nteach your brain to be hopeful (about profits) when it is wrongly fearful\n(about losing the profits). You need to teach your brain to be fearful (about\nlosses) when it is mistakenly hopeful (about the position turning positive).\nIt starts with being mindful of this behaviour. Perhaps a conversation with a\nstudent of mine can further clarify what I am talking about.\nCONVERSATION WITH A STUDENT\nIn the following conversation, my student and I are discussing a long\nposition I have running in Sterling Dollar.\nStudent: It feels like gambling.\nTom: Please explain.\nStudent: Well, I have 40 pips in profit, but you will not let me take the profit.\nTom: I won’t stop you from taking the profit, but if you ask for my opinion, you should let the\nposition run. You might want to consider the following scenarios, and then ask yourself how\nyou would feel in each case:\n1. Run position and you get stopped out for nothing.\n2. Run position and it explodes higher.\n3. Close position and it explodes higher.\n4. Close position and it reverses.\nStudent: I think it is best to close the position and secure the profits, rather than risk that the\nmarket will take the profits away from me.\nTom: How would you then feel if the market exploded higher – in your favour?\nStudent: I would be disappointed, but I could always jump back in again.\nTom: If you jumped back in, you would have to pay commission again or at least the spread,\nand you would have missed the explosive move. The only way you would profit from the\nexplosive move is if you were already in the move.\nStudent: Yes, but at least I would be playing for momentum to continue.\nTom: That is true, but you are already in a position where the momentum is on your side.\nStudent: I guess I just don’t want to see my profits disappear.\nAnd there you have it – in a nutshell. People are hopeful when they are\nlosing money. They are fearful when they are making money. I believe this\nis how the 90% think. It is the reason why – in a study of 25,000 traders –\nthey won more often than they lost, but they lost 66% more on their average\nloss than they gained on their average win.\nWhen the trader is confronted with a loss, they hope it will turn around. The\noperative word here is hope. When they are confronted with a profitable\nposition, they are afraid the profi", "source": "eBooks\\Tom Hougaard - Best Loser Wins.pdf", "doc_id": "db0d74ee3eb2ba5542f0943f7b8e994e1f3211b7a93aee04b5bfd56525c663f3", "chunk_index": 30}
{"text": "ey. I believe this\nis how the 90% think. It is the reason why – in a study of 25,000 traders –\nthey won more often than they lost, but they lost 66% more on their average\nloss than they gained on their average win.\nWhen the trader is confronted with a loss, they hope it will turn around. The\noperative word here is hope. When they are confronted with a profitable\nposition, they are afraid the profit will disappear. The operative word in this\nscenario is fear.\nMy student naïvely thought he could jump back in again, but he would\nundoubtedly have had to do so at a worse price than the exit price of his\nprofitable position.\nSo, the trader holds onto the position until a point at which the pain finally\nbecomes too much, then closes the position. Unfortunately, this threshold\ntends to be further down the road than the threshold of hope.\nThis is what you need to focus on.\nThis is what you need to work on constantly to change your pattern. I will\nnot state whether it will be easy to do or difficult to do. It just is. There is no\npoint in going any further in speculation if you can’t get yourself to do what\nyou must do, even though it feels uncomfortable.\nYou must be aware that in trading we tend to chase hope a lot further down\nthe road of misery than we are prepared to follow the road of opportunity. It\nis just the way we are put together. You must be aware of this and have a\nplan for combatting your natural behaviour.\nHowever, I must warn you. Your mind is like a muscle. This is not a one-off\nquick fix any more than doing 100 push-ups once will make you look like\nCaptain America for the rest of your life.\nAtrophy is not just something that happens to bodies. It also affects our\nminds. You need to strengthen that mind of yours through repetition. I\npresent my own training regime at the end of the book, although I am\nactually describing it piece by piece as we move through the book.\nTHE NOT-SO-NORMAL BEHAVIOUR\nWhat is not-so-normal behaviour? Well, firstly, I am all too aware of the\nshortcomings most people display when they are trading: running a loss,\ncutting short the profitable positions, over-trading, trading for excitement\nand entertainment.\nBut this is already known to most – if not all – people, so the not-so-normal\nbehaviour goes somewhat beyond that. It is very rare that we ask ourselves\nwhy we do what we do. Why do I trade when I do? Why do I take profits\nwhen I do?\nI think it’s time to bring in the words of a relatively unknown trader (but\none who was hugely respected by his peers). He was a pit trader at the\nChicago Board of Trade (CBOT), and his name was Charlie DiFrancesca,\nalso known as ‘Charlie D’.\nMY HERO\nCharlie DiFrancesca arrived at the floor of the CBOT with a dream and a\nsmall account. He had a background in competitive college football –\nAmerican style – but otherwise there was nothing about this guy that would\nindicate he would go on to become the biggest trader in the US Treasury\nbond pit in Chicago.\nHe had a rough start. He barely traded in the first six months on the floor.\nHe just stood there and observed. Then one afternoon something clicked,\nand he traded up a storm for two hours, making himself $5,000. From then\nonwards there was no stopping Charlie D. He became a legend in the\ntrading pit until his untimely death.\nIn William D. Falloon’s biography of Charlie D., the great trader says:\nThe time you know you’ve become a good trader is that first day you\nwere able to win by holding and adding to a winning position. There\nare many people here (in the trading pit) that have traded for a long\ntime, and who have never added to a winner.\nAdding to winning trades is an absolute key trait of the successful trader. It\nreinforces correct behaviour. It serves as an antidote to the temptation of\nwanting to take profit. When I am in a profitable position, I have trained my\nmind to ask, “How can I make my position bigger?” rather than dwelling on\nthe idea of taking profits.\nCharlie D. goes on to talk about his own mentor, Everett Klipp, who taught\nhim about correct trading:\nUnfortunately, it’s only human nature to want to cut your winning\ntrades. Say I am long at 6, and the market goes 7 bid, our mind\ninstantly thinks get me out with a profit. That’s human nature. It is also\nhuman nature to ride the losses. I am stuck. I won’t close. I will wait.\nADDING EPIPHANY\nIn 2007 I met a person who was going to radically change my way of\ntrading. It all came about by chance. I had come back from a lunch break\nand a colleague of mine returned from a meeting with an educational\ncompany. This educational company taught technical analysis and they\nwere pitching their products to my colleague, who happened to be the head\nof marketing.\nWhat you need to know about my colleague is that he was the most\nobnoxious East End London guy you could possibly imagine. He was brash,\nobnoxious (I know, I said that twice), and arrogant, and no one could tell\nhim anything he didn’t already know.\nYet somehow this educational company had gotten his attention. He spoke\nglowingly about a gentleman called Dr David Paul, who had taken him\nthrough some basic technical analysis.\nHe showed me the technical analysis, and it was basic. Yet there was\nsomething about the course material, which I had been given a copy of, that\ntold me that I needed to engage in a conversation with this gentleman.\nIt turned out that Dr David Paul had a two-day trading course coming up in\nJohannesburg. So a few days later I booked myself onto a flight. It was one\nof the only times I have ever participated in formal training on the topic of\ntechnical analysis.\nI have mentioned him before, but I’ll describe him a little more now. There\nis something incredibly humble about Dr David Paul, despite everything he\nhas accomplished. He has a PhD in mechanical engineering. He used his\nimmense abilities to invent a drill for miners in South Africa. This was no\nordinary drill. It was the kind that sucks gas out of the ground as it drills,\nand thus saves l", "source": "eBooks\\Tom Hougaard - Best Loser Wins.pdf", "doc_id": "db0d74ee3eb2ba5542f0943f7b8e994e1f3211b7a93aee04b5bfd56525c663f3", "chunk_index": 31}
{"text": "nalysis.\nI have mentioned him before, but I’ll describe him a little more now. There\nis something incredibly humble about Dr David Paul, despite everything he\nhas accomplished. He has a PhD in mechanical engineering. He used his\nimmense abilities to invent a drill for miners in South Africa. This was no\nordinary drill. It was the kind that sucks gas out of the ground as it drills,\nand thus saves lives by more or less eradicating the occurrence of\nexplosions.\nDavid Paul spent much of his time investing and trading. He made himself\na wealthy man. On the second day of the course David said something that\nwould change my perspective on trading.\nHe said something along the lines of this: “When you are in a winning\nposition, instead of thinking where to get out, why don’t you think about\nwhere to get in more?”\nHe basically told me to turn everything upside down. Most traders with a\nprofit will begin to contemplate where to take half the profit. Next, they will\nbegin to contemplate where to take the next half of the profit.\nDavid argued that this was what the 90% would do. He didn’t use those\nexact words, but he did argue that if you want to make money trading, you\nneed to do that which the majority finds difficult to do. The first time you\ntry it, you may fall flat on your face. That is to be expected, but the next\ntime it might be a little easier, and the next time a little easier again.\nDO WHAT IS HARD\nDavid was essentially arguing that when you are in a winning position you\nshould put pressure on your position. The argument for doing so was\nsomething he himself had observed when the market really began to trend.\nI have tried to put a different spin on his words. When you want what you\nwant more than you fear what you want, you will have it. You want profits\nin your trading. You probably have a good instinct about trading. You\nprobably also realise by now that it is your thinking that causes your\nproblems, rather than your knowledge about the financial markets.\nIf the 90% of traders are engaged with taking half profits and letting the\nother half run, maybe the right thing to do is to double up on your position,\nor perhaps conservatively add a little to the position, when everyone else is\ntaking half the profits. At least this is what I read between the lines, as I sat\nin that hotel conference room in Johannesburg.\nWhen the workshop was over I walked across the street and locked myself\ninto my hotel room. I sat down and waited. The Dow Index was trending. I\nwaited for a retracement. Then I waited for a five-minute bar to close above\nthe high of the prior five-minute bar.\nThen I bought. Ten minutes later I added to my first position. Twenty\nminutes later I closed at a double top. It was the most satisfying trading\nmoment in my life. A whole new world had opened up to me.\nDepending on your experience level, you may or may not be able to answer\nthis question: why is it easier to add to a losing position than a winning\nposition? I have wondered about that myself many times.\nYou decide that you want to buy the DAX at 12,325. The market then\nmoves down to 12,315 and you are tempted to add to the position.\nWhy?\nWhy is it easier to add to a losing position than to a winning position?\nWell, for starters, you would have loved to have bought at 12,315 rather\nthan 12,325 because you would have gotten a better entry price. Therefore,\nbuying again at 12,315 makes sense from an economics point of view. That\nis plain simple logic.\nThere is a chance that you have a stop-loss in mind, and there is a chance\nthat you have a target in mind. Now you have an opportunity to have the\nsame stop-loss as before, but you have 10 points less risk, and you have\nmore profit potential.\nYou have also created a better average price, so the market has to move\nfewer points in your favour before you are at breakeven.\nSimple and logical – something our minds love.\nHowever, you will now also have added to your position exposure, and the\nmarket has told you that you are wrong, at least right now. It was easy to do\nthe wrong thing because we attach a value to the market. When the market\ngives an opportunity to increase the value of our trade, it will seem\ncompelling to us.\nSo why is it difficult to add to a winning trade?\nIf I bought at 12,325, and the market is moving in my favour, I am relieved.\nNow other emotions will enter the consciousness. There will be greed. You\nwant to make more. There will be fear. You want to protect what you have\nmade.\nWhen the market reaches 12,345, you will be thinking that if you buy more\nnow, you have increased your average price to 12,335. It means that the\nmarket will only have to move 10 points against you before your position\nwill be at breakeven, rather than in profit.\nThe key point here is: what is your mind dwelling on?\nWhen we add to a losing position, we decide to dwell on the potential for\nbigger profits. We decide not to dwell on the fact that the market is telling\nus we are wrong. We decide not to dwell on the fact we have just doubled\nour risk.\nWhen we add to a winning position, we decide to dwell on the fact that the\nmarket may take our profits away, because we have now decreased our\naverage price. We decide not to dwell on the fact that the market is\ncorroborating with us.\nPut simply, the market disagrees with us, but we have faith that the market\nis wrong, and we add to a losing position; or the market agrees with us by\nshowing a profit, but we doubt the market is right, so we don’t add to our\nwinning position.\nIt doesn’t quite make sense, does it? And yet, this is what the majority of\ntraders are doing all the time. Adding to a winning position can be\nuncomfortable to begin with. No one is saying you have to double up on\nyour trading size the first time you add to a winning position. You could add\njust a little bit.\nADDING STRATEGIES\nThere are two ways you can add to your winning trades. You can use a\nsame-size principle, by which you keep adding the same size. Say you buy\nten lots to", "source": "eBooks\\Tom Hougaard - Best Loser Wins.pdf", "doc_id": "db0d74ee3eb2ba5542f0943f7b8e994e1f3211b7a93aee04b5bfd56525c663f3", "chunk_index": 32}
{"text": "are doing all the time. Adding to a winning position can be\nuncomfortable to begin with. No one is saying you have to double up on\nyour trading size the first time you add to a winning position. You could add\njust a little bit.\nADDING STRATEGIES\nThere are two ways you can add to your winning trades. You can use a\nsame-size principle, by which you keep adding the same size. Say you buy\nten lots to begin with, and then you add ten more lots at a higher price, and\nso on.\nThat is a risky way of trading. Instead you could use a second principle, by\nwhich your first position is the biggest position, and subsequent positions\nare smaller. So your first position might be ten lots, but the subsequent\npositions might be five lots.\nWhen I trade, I pretty much always use the same-size principle, but I urge\nyou to use the second principle until you are comfortable with adding to\nwinning trades.\nBUILDING NEW PATHWAYS\nThe purpose of adding to winning trades is at its heart an attempt to fight\nyour normal human behaviour. In the beginning it is not about adding to\nyour profitability. That will come later. The purpose is to stop you from\ntaking half profits.\nBy adding to the winning trade, by thinking, “How can I make more when I\nam right?” rather than thinking, “Where should I take profit?” you are\nbuilding a new way of thinking about trading.\nDo you remember what Mark Douglas said in the opening lines of Trading\nin the Zone? In trading, consistent winners “think differently from everyone\nelse”. When you start to think, “Where can I add to my winning trades?”\nyou are beginning to think differently. From then onwards, it becomes a\nmatter of habit. You have built a new neurological pathway in your mind, or\nat least taken meaningful steps in the right direction.\nCONTROLLING RISK\nHow do you control risk when you add to winning trades? This is a question\nI am often asked. The answer is the same whether you are adding to a\nwinning or a losing trade: you place a stop-loss.\nSome who receive this answer will say, “But if I get stopped out on an add-\non on a profitable trade, then I will have lost profits from the original trade\nas well.”\nYes, that is true; but isn’t it better to get stopped out of a trade where you\nhave some profits to cushion your loss, rather than having added to a losing\ntrade, where you are now feeling the full force of the loss? At least when\nyou add to a winning trade, the market is currently agreeing with you.\nI have just bought the Dow at 26,629. My stop-loss is 26,590. The Dow has\nalready rallied from a base of 26,569, so I might be a little late to the party,\nbut that doesn’t bother me.\nMany a good trade has been missed by those arriving too late to the party.\nAs long as I have a stop-loss in place, I am fine to join a momentum move,\neven one that has been moving for a while.\nThe Dow prints 26,649, and I buy once more. I am adding to my winning\nposition. Now my stop-loss on the first position I bought has been moved to\nreflect the fact that I have taken on more risk. My first stop-loss is now at\n26,629. The stop-loss on my second position is also 26,629.\nAt this point, two things can happen. Ideally, the market will carry on\nmoving higher, and every point move is now making me twice as much as\nif I had only one position.\nThe less appealing alternative is that the market moves against me, and I\nwill get stopped out of the first position at breakeven, and I will lose 20\npoints on the second position.\nThere is no magic to it. It is a philosophy, and it is born out of a desire to\nnot be normal. The normal thing to do is to close half your position and let\nthe other half run.\nWhy would you do that? Why would you have the market agree with you,\nbut you only ride it with half a stake?\nThat is what the 90% are doing, and I don’t want to do what the 90% are\ndoing, no matter how logical it may seem. They are wrong over time, and I\nwant to be right over time!\nIt is such a crucial point I am attempting to get across to you, right here and\nright now. I don’t know what is going to happen over the course of one\ntrade. Anything can happen. However, I do know what will happen –\nstatistically speaking – over the course of 100 trades.\nOver the course of one trade, you may win, or you may lose. Over the\ncourse of one coin flip, you may get a head or you may get a tail, and you\nmay get five tails in a row, but you will still end up – statistically speaking –\nwith a 50/50 outcome when you throw the coin 100 times.\nThe same applies to trades. You may be on a hot run, and have nothing but\nwinning trades on your screen, but over time it will even itself out.\nTherefore, it is vitally important you don’t think too much about the\noutcome of one trade, but rather the outcome of 100 trades.\nThe outcome of one trade is random. The outcome of 100 trades is\npredictable. It is for this reason that our behaviour needs to be the same for\nevery trade we execute, whether we like it or not. By applying the same\ncorrect behaviour to every trade, we are virtually guaranteed to be\nprofitable.\nWhat is the correct behaviour? Well, why don’t we observe what everyone\nelse is doing, and then do the opposite of what they are doing?\nThe basic premise is that the majority of people who trade end up losing\nmoney. That is our starting point. Now we observe what those people do. I\nhave been doing that for ten years. Here is what I observed:\n1. THEY DON’T ADD TO WINNERS\nThey don’t add to winning trades. So, to be profitable, add to winning\ntrades, whether you add a little or you double up. Start slowly, add a little.\n2. THEY DON’T USE A STOP-LOSS\nThey don’t like to use a stop-loss, because that would crystallise the pain of\nthe loss. As long as the position is open, there is hope. So, to be profitable\nover time, use a stop-loss. Use a stop-loss on your first position and on\nsubsequent positions.\n3. THEY ADD TO LOSING TRADES\nWe all love a bargain at the local supermarket, don’t we? And by all means,\ncontinue to shop for bargains at the loc", "source": "eBooks\\Tom Hougaard - Best Loser Wins.pdf", "doc_id": "db0d74ee3eb2ba5542f0943f7b8e994e1f3211b7a93aee04b5bfd56525c663f3", "chunk_index": 33}
{"text": "They don’t like to use a stop-loss, because that would crystallise the pain of\nthe loss. As long as the position is open, there is hope. So, to be profitable\nover time, use a stop-loss. Use a stop-loss on your first position and on\nsubsequent positions.\n3. THEY ADD TO LOSING TRADES\nWe all love a bargain at the local supermarket, don’t we? And by all means,\ncontinue to shop for bargains at the local supermarket; but do not do it in\nthe financial markets by buying more, just because you can buy it at a\ncheaper price than the first time you bought it.\nWhile you may get lucky from time to time, this is one of the main traits of\nlosing traders. Remember, we are focused on establishing the behaviour that\nwill ensure we will be profitable over time.\n4. THEY TAKE HALF PROFITS\nThis one is going to be tough to argue, so bear with me. I know so many\ntraders – even people who have traded for decades longer than I have – who\nadvocate taking half profits. Their thinking goes along this pathway:\nI will risk 20 points.\nI will take half profits at 20 points and move stop-loss on the other half\nto breakeven.\nI will take the other half profit at 40 points.\nIt sounds so compelling. You close half the position, so if the market turns\naround, at least you will have made 20 points on half the position. I can\nunderstand the thinking behind it.\nThe problem I have with this strategy is that it never gives you the home-\nrun trades that you need to sustain yourself in this business. You will never\nbe on board the big moves because you have always limited yourself.\nI have two fundamental arguments against taking half profits:\n1. The market agrees with you. Let it ride.\n2. Since I don’t believe in the risk-to-reward argument, because no\nhuman being can know in advance what their reward will be without\nlimiting themselves, I don’t believe that taking half profits is the right\nway to trade.\nRISK TO REWARD\nDid I just say that I don’t believe in the whole risk-to-reward argument?\nYes, that is correct. I do not. I believe in defining my risk. I don’t believe in\ndefining my reward.\nWhen I am about to execute a trade, there is only one variable I have\nmeaningful control over: how much money/points/pips will I risk on this\ntrade?\nAnything else is pure guess work. How much I will make will depend on\nthe market. It will not depend on me, unless I put a limit on my profits. A\nvery wise old trader once told me that losers spend their time thinking how\nmuch they will make, while winners spend their time thinking about how\nmuch they will lose.\nThe only variable I am in control of, as a point-and-click trader (as opposed\nto one who uses an algorithm), is how much I can lose on a trade.\nObserving hundreds of millions of trades over a decade, executed by an\narmy of well-meaning traders doing their best to make a profit, I have come\nto the conclusion that setting a limit on your profits is not the way forward.\nIf I buy the FTSE 100 Index at 7,240 with a stop-loss at 7,235, and a take-\nprofit target at 7,250, I am sure I will be happy if the FTSE goes to 7,250\nand reverses back down again. However, how will I feel if the FTSE moves\nto 7,260, or 7,270, or higher?\nOf course, there are exceptions to this rule. I may genuinely want to get out\nat 7,250 because I feel there is overhead resistance at this area. It may even\nbe an area where I would want to sell short the market. I may also put in a\ntake-profit order at 7,250 because I may not be able to follow the market as\nclosely on this particular trade.\nBut generally, I do not work with targets because a target will limit my\nprofit, particularly on days where the market is in a runaway mode. With\nthis in mind, I would like to show you an example of a decision I made, and\nhow it ended up costing me dearly.\nHOW NOT TO DO IT\nThe DAX gapped up, as shown in Figure 14. I know from statistics that\n48% of all gaps get filled on the same day they occur. Considering that 90%\nof daily highs and lows occur in the first hour and a half of the trading day,\nI felt reasonably good about shorting the DAX on the low bar, indicated by\nthe arrow. The stop-loss was close to the high of the day. The risk was 35\nDAX points.\nFigure 14\nSource: eSignal (esignal.com)\nAs shown in Figure 15, instead of continuing lower, the DAX Index\nconsolidates and moves higher, and it eventually takes out my stop-loss. I\nam now at −35 points.\nFigure 15\nSource: eSignal (esignal.com)\nThe previous pattern does suggest higher prices to come. Yes, it looks like a\ndouble top sell; but on a gap up day, the odds are higher of continuation\nthan of a reversal. Remember the saying, “In bull markets, resistance is\noften broken, and in bear markets support rarely holds.” Well, you can\nreplace bull markets with bull trends, and bear markets with bear trends.\nIn Figure 16, I execute a long position on the close of the bar, as it closes\nabove my stop-loss. It is in reality a stop and reverse situation. I am stopped\nout of my short position, and as a result of it, I am going long.\nFigure 16\nSource: eSignal (esignal.com)\nThe market moves into a consolidation, and eventually breaks higher. I add\nto my long position, as show in Figure 17. So far everything looks okay.\nFigure 17\nSource: eSignal (esignal.com)\nThen I make a mistake. I am at this point able to close the position with a\nprofit that exceeds the loss I made earlier.\nDo you see what I am doing wrong now? I am not trading the chart. I am\ntrading my account. I am trading my state of mind. I am trying to get rid of\nthe pain from my previous trade. You can see this in Figure 18.\nFigure 18\nSource: eSignal (esignal.com)\nMuch to my disappointment, I admit I close my long position for no other\nreason than being able to offset the prior loss. I talk myself out of the\nposition rather than just moving my stop-loss higher. It is not until my\nreview of my trading day that I really come to realise what I have done.\nFor now the market is not entirely in disagreement with me. For the next\ntwo hours the mark", "source": "eBooks\\Tom Hougaard - Best Loser Wins.pdf", "doc_id": "db0d74ee3eb2ba5542f0943f7b8e994e1f3211b7a93aee04b5bfd56525c663f3", "chunk_index": 34}
{"text": "l (esignal.com)\nMuch to my disappointment, I admit I close my long position for no other\nreason than being able to offset the prior loss. I talk myself out of the\nposition rather than just moving my stop-loss higher. It is not until my\nreview of my trading day that I really come to realise what I have done.\nFor now the market is not entirely in disagreement with me. For the next\ntwo hours the market trades sideways. The longer a market moves from a\ntrending market into a sideways market, the less the prior trend matters. At\nleast that is what I tell myself.\nThen as the US markets opens the DAX Index moves higher, and I am not\non board. You may not yet see the subtle point I am making here, so let me\npoint it out to you.\nI do not belong to the brigade of traders who believe that “you can’t go\nbroke taking a profit.” I do think you can go broke taking a profit, if it\nmeans you never have really big profit days because you are unable to let\nprofits run.\nSimple as that!\nFigure 19 shows what happened after my exit. While I don’t insist on\nperfect trading, I review my trades religiously to pick up on errors creeping\ninto the inner workings of my trading mind. Am I maintaining my\ndiscipline? Am I adding to winners? Am I impulsive?\nFigure 19\nSource: eSignal (esignal.com)\nYou may look at the chart and think I did okay. I look at the chart and I\nwonder why I got out. The pain of having missed out on the rally towards\nthe end of the day was greater than the pleasure from making back what I\nhad lost earlier in the day.\nPRESSING WINNERS\nAdding to winners is habitual for me. I have new and experienced traders\nfollowing me on YouTube and Telegram exclaiming they want to know how\nI do it.\nOne simple way of doing it is to look over the prior trading days, and come\nup with a number of points at which you will want to add to your position.\nFor example, you may look at Euro Dollar and conclude you want to add to\nyour position at every 10-pip interval.\nI went about my approach in a different manner. I think it is best illustrated\nthrough the use of a theoretical explanation.\nI want to trade the FTSE 100 Index, and I am looking for an approach to\nadding to my winning trades. How do I go about doing that?\nSTEP 1\nI need to establish what the historical volatility is in this index. I use a\nmeasure called Average True Range (ATR). When using it I carefully\ndifferentiate between periods in which I don’t want to trade the product, and\nthose in which I do want to trade the product.\nFor example, the volatility of the FTSE Index on a five-minute chart during\nthe night could be around 4 points, while the volatility on a five-minute\nchart at the open at 8 am GMT is around 14 points. That is a significant\ndifference.\nSay for the sake of argument that I have established that the volatility is\nequal to 10 pips/10 points where I day trade the FTSE Index on the time\nframe I prefer to trade.\nWe call that value N.\nN = 10\nMy stop-loss is 2 × N.\nSTEP 2\nEstablish how much money you want to risk on a trade. This is a percentage\nfunction of your account value. Say you have £10,000 in your trading\naccount, and you decide you want to risk 2% of the account.\nHence 2% of £10,000 = £200.\nSTEP 3\nNow I establish my trading size unit, which is essentially how big my\ntrading size is.\nIf N = 10\nRisk = 2N\nMonetary Risk = £200\nThen my trading size unit will be £200 / 20 = £10\nSTEP 4\nI can then argue that I want to add to my position at every ½N. I think this\nis where your own research should come into play. However, for the sake of\nthe argument, I will take you through an example, based on the numbers\nabove.\nEXAMPLE\nI buy the FTSE Index at 7,500.\nMy stop is 20 points.\nMy risk is £10 per point.\nMy add-on is at every ½N. This means I add at every 5-point increment.\nThe FTSE Index now trades at 7,505. I buy one more unit, meaning I am\nnow buying £10 a point at 7,505.\nI now have two open positions:\nLong 7,500 with stop-loss at 7,480.\nLong at 7,505 with stop-loss at 7,485.\nAs you can quickly gather, this will cause a bigger loss than anticipated if I\ndo not move my stop-loss up on the first position.\nBefore I enter the second position, I have already planned to move my stop-\nloss up by ½N. I will move the stop-loss up on the first position by 5 points.\nThis means that the stop-losses on the first and second positions are\nidentical. My total risk is now 35 points.\nAs I hope you can see, this way of trading can quickly materialise a larger\nloss than perhaps you had wanted it to. It is for this reason I urge you to\nconsider variations of this method, such as adding with smaller stake size\non the second, third and fourth positions.\nYou may ask, “Why add at all?”\nBecause by adding, I am actively combatting the brain’s proclivity to\nscaling down risk. Our brains want to take profit. I am doing the opposite. I\nam adding to my position.\nREAL-LIFE EXAMPLE\nThe following chart shows the Dow Jones Index on a trend day. I define a\ntrend day as a day when the market opens at the high or the low of the day,\nand closes at the low or the high of the day.\nThe problem with trend days is that you won’t know it was a trend day until\nthe day is over. So, you have to make an assumption, based around what\nyou see on the chart, about whether you think it is a trend day.\nI have researched the price action behaviour of the Dow Jones Index over\n18 years. I have identified a handful of first hour patterns, which I believe\nare precursors for trend days. One of those patterns is a gap down after a\ngap up day, where the gap down is not filled within the first hour.\nFigure 20 shows a positive Thursday. The trade I want to show you took\nplace on the Friday. Friday is notorious for producing lasting trends, often\nleading to trend days, especially on Fridays at the beginning or end of the\nmonth.\nFigure 20\nSource: eSignal (esignal.com)\nI have also included a screenshot of my trading monitor.\nWall Street 3,000.0\n25419.625135.9\nkr851,150.00\n \n500.0\n25458\n25135.9\nkr161,500.00\n \n700.0\n254", "source": "eBooks\\Tom Hougaard - Best Loser Wins.pdf", "doc_id": "db0d74ee3eb2ba5542f0943f7b8e994e1f3211b7a93aee04b5bfd56525c663f3", "chunk_index": 35}
{"text": "tive Thursday. The trade I want to show you took\nplace on the Friday. Friday is notorious for producing lasting trends, often\nleading to trend days, especially on Fridays at the beginning or end of the\nmonth.\nFigure 20\nSource: eSignal (esignal.com)\nI have also included a screenshot of my trading monitor.\nWall Street 3,000.0\n25419.625135.9\nkr851,150.00\n \n500.0\n25458\n25135.9\nkr161,500.00\n \n700.0\n25455\n25135.9\nkr224,000.00\n \n350.0\n25469\n25135.9\nkr116,725.00\n \n450.0\n25455\n25135.9\nkr143,775.00\n \n200.0\n25441\n25135.9\nkr61,100.00\n \n300.0\n25329\n25135.9\nkr58,050.00\n \n250.0\n25356\n25135.9\nkr55,250.00\n \n125.0\n25258\n25135.9\nkr15,312.50\n \n125.0\n25259\n25135.9\nkr15,437.50\nThe top line shows my overall exposure. It states I am short 3,000 in Wall\nStreet. My average entry is 25,419.6. The current price is 25,135.9. The\n3,000 means I am short 3,000 Danish kroner per point, which equates to\nabout 500 US dollars per point movement in the Dow.\nSo, for every point the Dow Index drops, I make 3000 kroner, and vice\nversa. For every point it rallies, I lose 3000 kroner. At the time of the screen\nshot I am in profit by 851,000 kroner.\nBelow my total exposure, you see each of the entries, which add up to\n3,000.\nIf you look at the previous chart, you will see the numbers 1, 2, and 3.\nThose are points where I am adding to my position.\nAt Point 1 on the chart, I start selling short. I scale into my short position\nover five entries. Those are the first five entries you see below my total\nexposure.\nAt Point 2, I add more short positions. I do so because the market is weak,\nand I am certain a trend day is developing. I add about 25% more to my\nshort position at Point 2. At Point 3, I add about 10% more to my short\nposition\nAs the market moves lower, I add to my positions, as I have been trained to\ndo. I move my stop-loss down as well. What you are unable to see on the\nchart is that initially the market moved against me.\nWhat I am doing here is critical to your understanding of fear. I have been\nunder water on my position, and now I am finally making money. My brain\nhas had to endure pain during the loss period, and I am now being sent\nsignals from my mind to relieve my brain of the pain it felt during the\nlosing period (15 minutes earlier).\nI counteract this pain by actively doing the very thing that causes me pain. I\nam embracing the discomfort by compounding it. This is required if I am to\nactively engage in behaviour that is the opposite of the 90%’s. You will\nnotice that my add-on is not a big position. Yet, it serves to reinforce the\nright kind of behaviour.\nThe Dow falls strongly. I am in the safe zone now. My core position cannot\nbe threatened. My stops are placed at breakeven. However, I am still\nprepared to let this trade turn into an insignificant trade (small profit trade)\nin the hope that it will turn into a significant trade.\nYou must find your own level of risk temperance. Once I was asked “If you\nkeep adding to your trades, when do you take profits?” That is a great\nquestion. I use the charts to take profits. If I double bottom on a chart, and I\nam short, then I might be tempted to take profit.\nAlternatively – and this is a really good trick – I will place my stop-loss\nwhere I would want to get into the market, but in the other direction. For\nexample, in this case, if I am short the Dow Jones Index I might place my\nstop-loss at the price level where I would turn into a buyer of the index.\nAlthough I am 100 points in profit, I am by no means relaxing. I am adding\nto my position again and again, in smaller increments, in order to reinforce\nthe right behaviour.\nThe trade had the potential to turn into a spectacular trade. It didn’t. The\nDow bounced strongly (before falling again), and although I made a profit,\nit was not the amount you see on the screenshot.\nThat is very important for me to get across to you, because I think it is\nimportant that you establish some criteria for how much of your paper\nprofits you are prepared to give away in order to capture the really big days.\nThere are days when I come to work, and I just want to capture 20–30\npoints, and then be done. Not every day has hundreds of points available in\nit.\nThen there are days when the market starts out very strongly or very\nweakly, and you think to yourself, “This could be a really big day.”\nI have a philosophy to trading that means I am prepared to sacrifice profits\nin order to discover how big the profit can get. If you don’t have that\nphilosophy, you will never discover how big the profit can get.\nIf you always think of potential targets, using technical analysis, you are\nmost likely just talking your way out of a good trade. You might be using\ntechnical measures to time your exit, but I don’t subscribe to this method.\nThere is a reason for that. When the market is trending, and I am on board\nthe trend with a position, I hope that the market will close that night at its\nstrongest/weakest for the day.\nIt happens on at least 20% of all trading days in stock indices. Yes, I have\nhad plenty of disappointments, but I have had sufficient stellar days to make\nit part of my philosophy.\nDAX INDEX – TRADING EXAMPLE\nLet me show you another example of a trade where I added to my positions.\nHowever, this time I will show you what I saw at the time of the trade. See\nFigure 21.\nFigure 21\nSource: eSignal (esignal.com)\nI am not on board the first push down. I look at the rebound for an\nopportunity to short the DAX Index. On the next image you can see my\ninitial position entries highlighted in box 1.\n\nDAX finally caves in and resumes its downtrend, as shown in Figure 22.\nYou can see my subsequent short entries in box 2. There are a couple of\nthings I would like you to see here:\nFigure 22\nSource: eSignal (esignal.com)\n1. I am not afraid to sell short something that has already fallen in\nprice. This is consistent with what the majority of people do not want\nto do.\n2. I scale into the position in this example, and I add aggressively to\nmy short position once my", "source": "eBooks\\Tom Hougaard - Best Loser Wins.pdf", "doc_id": "db0d74ee3eb2ba5542f0943f7b8e994e1f3211b7a93aee04b5bfd56525c663f3", "chunk_index": 36}
{"text": "e 22.\nYou can see my subsequent short entries in box 2. There are a couple of\nthings I would like you to see here:\nFigure 22\nSource: eSignal (esignal.com)\n1. I am not afraid to sell short something that has already fallen in\nprice. This is consistent with what the majority of people do not want\nto do.\n2. I scale into the position in this example, and I add aggressively to\nmy short position once my position is in profit.\nI urge you to contemplate how you can introduce the element of adding to\nwinners into your trading. I am not interested in rewriting your trading plan.\nI am not interested in turning you into a copy of me. I am interested in\ntrying to make you understand the value of pain in trading, as a barometer\nfor adding to positions.\nIf it is uncomfortable, then it is probably the right thing to do.\nI will repeat something I mentioned earlier. I think you should give serious\ncontemplation to the question of why people in general find it easier to add\nto a losing trade than a winning trade.\nI don’t ever want to be accused of glorifying trading. It is a risky\nproposition. Twenty years ago most brokers in Europe didn’t have what we\ntoday know as negative balance protection. Today, it is a legal requirement.\nIt means that you can’t lose more money than is available on your trading\naccount.\nYou can still lose a lot more than you anticipate, especially if you add to\npositions, like I do.\nAs you become better at trading, you will want to trade bigger and bigger\nsize, and the market on a big position doesn’t have to change direction by a\nlot before you give away a big portion of your open profits.\nIf you want proof of that, here it is. This was a perfectly good-looking DAX\nposition which turned from being very profitable to showing a significant\nloss. It starts well with a short position at 11,288. I then add to the position\nas the DAX Index falls. Then the market reverses, and I add a little more at\nthe old top.\nAt the point of the screenshot I am short 4,500 kroner per point, and I am\nlosing 25 points. I close the position shortly after for a loss.\n4,500.0\n11289.411314.0\nkr−110,5100.00\n300.011288.311314.0\nkr−7,710.00\n350.011286.811314.0\nkr−9,520.00\n400.011285.211314.0\nkr−11,520.00\n500.011285.011314.0\nkr−14,500.00\n500.011279.011314.0\nkr−17,500.00\n500.011274.811314.0\nkr−19,600.00\n450.011295.211314.0\nkr−8,460.00\n500.011293.211314.0\nkr−10,400.00\n500.011292.711314.0\nkr−10,650.00\n500.011312.711314.0\nkr650.00\nUNCOMFORTABLE\nThere are no shortcuts in the trading industry, any more than there are\nshortcuts in, say, professional sports. I expect to get uncomfortable during\nthe trading. At times it feels like the minutes last for hours. My impatience\nto do something is raging within me. I am battling my own emotions more\nthan I am battling the markets.\nFinally, when I am in a position, my mind has something to occupy itself\nwith. Be careful what you ask for! Maybe the position is showing a loss, so\nnow I am battling my subconscious mind, which wants the position to run a\nlittle longer.\nMy conscious mind has a stop-loss, but my subconscious mind wants to me\nto remove it. It doesn’t want to lose.\nIt could be the position is going well. Now my subconscious wants me to\ntake my profits. It loves the gratification of a good profit. So, I am battling\nit whether I am winning or losing on my trades.\nThe key to victory starts with being mindful of the existence of two brains.\nThe ability to anticipate your enemy’s next move is crucial. The\nsubconscious brain is a rather simple beast. It just wants to avoid pain.\nFor the subconscious brain there are two pains in trading. There is the pain\nof seeing a profit. When it sees a profit, it wants you to close it because then\nit doesn’t have to deal with the pain of seeing the profit disappear. Then\nthere is the pain of loss. When the subconscious brain sees a loss, it wants\nyou to hold on to the position a little longer and a little longer. Otherwise, it\nwill have to deal with taking the loss. As long as the position is open, there\nis always hope.\nIn a nutshell, what separates the 10% of winners from the 90% of losers is\nwhich brain they are listening to. It took me many years to realise this. I\ndeveloped a system for my mind, a training program that enabled me to\nwithstand the influences of the emotional subconscious brain on my trading\ndecisions.\nDuring the Round the Clock Trader event referred to previously, a guest\nasked me if I wasn’t afraid that the market would turn back up the moment I\nwent short.\nWho do you think was really asking that question? It was the part of his\nmind controlled by fear. Of course, the market might very well turn around.\nI would lie if I said that had never happened. It probably happens five times\nout of ten. So, the real question to be asked is this:\nwhat would cause you more pain?\n1. You sell short and the market reverses back up.\n2. You do nothing and the market reverses back up.\n3. You sell short and the market continues lower.\n4. You do nothing and the market continues lower.\nOPTION 1\nI sell short and the darn market moves against me again. It is annoying, but\nthe stop-loss will take care of my exit. At least I can say that I followed my\nplan.\nOPTION 2\nI do nothing and the market moves back up. I might be happy, but I have\njust trained my mind not to follow the plan, and I was rewarded for it.\nI was rewarded by not selling short, which would have lost me money, and\nmy mind is now congratulating me for my excellent chart reading skills, but\nfor all the wrong reasons.\nOPTION 3\nI sell short, like I am supposed to, and the market follows through to the\ndownside. Instead of clapping my small paws in joy, I am proactive, and I\nadd to my winning trade. I am doing absolutely everything I am meant to\ndo.\nOPTION 4\nI decide not to follow the plan of shorting, and the market moves\naggressively lower. I would have made all the lost money back from the\nfirst trade, but I do not.\nI can’t speak for you, but I will tell you how I feel about it. It c", "source": "eBooks\\Tom Hougaard - Best Loser Wins.pdf", "doc_id": "db0d74ee3eb2ba5542f0943f7b8e994e1f3211b7a93aee04b5bfd56525c663f3", "chunk_index": 37}
{"text": "h to the\ndownside. Instead of clapping my small paws in joy, I am proactive, and I\nadd to my winning trade. I am doing absolutely everything I am meant to\ndo.\nOPTION 4\nI decide not to follow the plan of shorting, and the market moves\naggressively lower. I would have made all the lost money back from the\nfirst trade, but I do not.\nI can’t speak for you, but I will tell you how I feel about it. It causes me\nmore emotional pain to miss a move because I didn’t follow through on my\nplan than when I followed through with my plan.\nWHAT IS TOO FAR?\nAnother question that came in after the short trade was this: “Were you not\nconcerned that the market had already moved too far? Do you not think you\nhad already missed the boat?”\nThe person who asked this question is most likely the same person who\nwould not buy the DAX because it had already rallied 1% on the day.\nThis is the supermarket analogy all over. We seek out bargains, but we\navoid buying items that have risen in price.\nIt is a mental illusion. You can’t say the DAX is too expensive just because\nit has rallied 1% on the day. We do not want to buy something that is\nalready going up. We would rather wait until it comes down again to buy it,\nbecause then it is cheaper.\nSimilarly, we do not want to sell short something that is already going\ndown. We want to wait for it to rise again and sell it when it is higher (more\nexpensive) because it gives us better value.\nIn principle, I don’t disagree with these statements, but here is the flaw: that\nis what everyone else wants to do, and the majority tend to be wrong.\nCorrection: they don’t tend to be wrong; they are wrong. Sure, they are\nright 60% of the time, but when they are wrong they are really wrong. How\ndo you know where the top or the bottom is? I have seen a lot of trading\nsystems, but none of them had an acceptable success ratio of predicting tops\nor bottoms.\nThis is why I say that you should buy strength and you should sell\nweakness. Buy high, sell higher; sell low, buy back lower. Will I miss the\nabsolute turning points? Yes, I will. Top pickers and bottom pickers soon\nbecome cotton pickers.\nWhen I am distressed about profits disappearing, I remind myself of the\nstory of a US super trader whose reputation for doing the right thing under\npressure is legendary. His name is Paul Tudor Jones.\nHe was once watching the market and, as it had been rising all morning, he\nhad been buying steadily. He was long several hundred contracts showing a\ngood profit.\nSuddenly the market jolted lower for no apparent reason. Without blinking,\nhe sold out all his long positions, and as the market continued to fall, he\nstarted to sell short the market too. One of his colleagues who didn’t know\nhe had commenced shorting the market commented on the fall and said this\nwas a good chance to start buying.\nThe conversation, edited for expletives, went on as follows:\n“Are you mad?” said Paul.\n“What do you mean?” said the colleague.\n“You must be mad. The market has just broken 100 points in 15 minutes,\nand you are looking to buy it?”\n“Well, what would you do?”\n“Let’s put it this way, I am certainly not looking to buy it here.”\n“Well, would you sell them short here?”\n“Of course I would!”\n“But they have come down so far.”\n“Exactly, that’s the point.”\n“Right,” said the colleague. “Well just how far would the market have to\nfall before you started to buy it?”\n“As long as it is going down, why would I buy it?”\n“Because it’s so cheap, it’s an absolute bargain. It’s 100 points cheaper than\nit was 15 minutes ago.”\n“Forget cheap. Forget expensive. It’s just numbers on a page.”\n“But I don’t understand. If it kept going down, where would you try and\nbuy it?”\n“If it kept going down, I’d want to be selling it, not buying it. If it kept\ngoing down, I would sell it down to zero.”\n“And if it was going up?”\nIf it kept going up, I’d buy it to infinity.”\nI absolutely love this story. Having seen Paul Tudor Jones trade, you sense\nhis energy, his intensity and determination, and his utter conviction in\nwhatever he does. He doesn’t just say, “Sell short.” He shouts, “Sell short!”\nstamps his feet and swings his hands.\nI admire his mental agility – flowing from being convinced on the long side\nto turning the position to the short side. Sadly, this is one trait that is hard to\nacquire. I know some traders with decades of trading experience who are\nunable to flip the switch and go from being long to being short.\nFINDING A LOW\nTrying to find the low in a stock can be a costly affair. We all make\nmistakes, but how costly is the mistake going to be? I remember very\nvividly watching a CNBC show called Mad Money, during the financial\ncrisis in 2008.\nOn the show Jim Cramer received an email from a viewer asking about the\nhealth of Bear Stearns. Now I am sure that if Mr Cramer had an opportunity\nto go back in time he would most certainly amend what he said in that\nbroadcast.\nHe basically shouted at the screen, saying that Bear Stearns was fine. But a\nfew days later Bear Stearns was gone, done and dusted, never to be seen\nagain.\nYou may recall my first brush with meeting clients back in 2001. I gave\nthem the not-so-welcome advice to get the hell out of their Marconi shares.\nWould you believe it if I told you that history repeated itself in 2007?\nIt is easy to be swayed by a supermarket mentality when we are trading. As\nI mentioned previously in the book, when we go into a supermarket, we are\ndrawn towards the special offers. When I look at my shopping basket from\nthis weekend, I see things that I wouldn’t normally buy.\nOf course, I would need these things at some point or another. We all need\ntoilet paper. We all need dishwasher tablets, and we all need hand soap. The\nreason why they were in my shopping basket this week was because they\nwere on offer. Who can resist a 50% discount?\nBut a 50% discount in a supermarket is not the same thing as a 50%\ndiscount in the financial markets. Many clients of City Index, the broker I\nworked at for more than eight year", "source": "eBooks\\Tom Hougaard - Best Loser Wins.pdf", "doc_id": "db0d74ee3eb2ba5542f0943f7b8e994e1f3211b7a93aee04b5bfd56525c663f3", "chunk_index": 38}
{"text": "point or another. We all need\ntoilet paper. We all need dishwasher tablets, and we all need hand soap. The\nreason why they were in my shopping basket this week was because they\nwere on offer. Who can resist a 50% discount?\nBut a 50% discount in a supermarket is not the same thing as a 50%\ndiscount in the financial markets. Many clients of City Index, the broker I\nworked at for more than eight years, came face to face with this reality\nduring the financial crisis from 2007 to 2009.\nIn 2006, after having done very little for years, a stock called Northern\nRock went on a tear. It rallied 50% in months. There was no real interest\nfrom City Index clients in the stock during the rally phase.\nHowever, when it began to slide back down again afterwards, the interest\nrose. It was as if Northern Rock had the same effect on investors that half-\nprice toilet paper has on shoppers in a supermarket.\nNorthern Rock became quite a lively traded stock. The more Northern Rock\nfell in price, the more people got interested in the stock. At one point I\nreceived a phone call on a Saturday morning at home. At this point\nNorthern Rock had slipped from 1200 pence down to around 500 pence.\nThe person on the other end of the phone was a stranger to me. He had\npicked up my business card at one of the talks I had given on technical\nanalysis. He apologised for calling me so early on a Saturday morning, but\nhe and his friend had decided to invest in Northern Rock. They had decided\nto get the opinion of a professional, just to double check whether it was a\ngood idea.\nApart from being rather annoyed at being woken up at 7 am on a Saturday\nby a stranger, I was also annoyed with the question. At this point Northern\nRock was in freefall. I roughly said the following to the stranger:\nLook, I don’t know what is going on with Northern Rock, but there is\nsomething horribly wrong. Although the general market is declining\ntoo, Northern Rock is declining much more.\nWhat I am afraid of is that there is something amiss that we don’t\nknow about, and it has yet to be known to the market. It feels as if\nsomeone somewhere knows something is horribly wrong, and they are\nselling out while they can.\nI told him that I had many clients who had said exactly what he was saying\nnow, but about Marconi five years earlier. Fortunes were lost by clients who\nkept buying Marconi, even though it was falling and falling, because they\nengaged in bargain hunting. It had been horrible to see the losses our most\nvaluable clients endured simply because they did not want to admit they\nwere on the wrong side of a bad share.\nI said to him: “From a trader’s perspective, you are engaging in a very\ndangerous activity. If you buy Northern Rock now, it will be very difficult\nfor you to have a meaningful stop-loss. You are essentially trying to catch\nthe falling knife. You talk as if Northern Rock is the only bank in the world\nworth investing in.\n“You talk about Northern Rock as if it couldn’t go bust. You talk about it as\nif the fact that it is 200 years old means that things couldn’t get worse\nbefore they get better. You even said it yourself: Northern Rock is too big to\nfail. It means you are already to some extent aware of the danger here.” I\nasked him if he remembered Barings Bank. He did.\n“There is a second reason why I don’t think it’s a good idea you buy\nNorthern Rock,” I continued. “Let’s say you are fortunate enough to witness\na turnaround in the fortunes of Northern Rock. You will have trained your\nmind to think that it is perfectly okay to buy into things that are falling. This\nworks perfectly in a supermarket. Toilet paper has a practical use. Soap has\na practical use, so when you are provided with an opportunity to purchase\nthese items at a 50% discount, you should do it.\n“However, to believe that the financial markets offer discounts akin to what\nyou’re seeing in a supermarket is ludicrous. The financial markets are not a\nsupermarket with special offers.”\nEventually Northern Rock went bust. The British government had to\nguarantee customers’ savings. That didn’t stop panic scenes as people\nqueued up to get their money out.\nTHINKING RIGHT\nAs you read this anecdote, you might think it could never happen to you.\nPerhaps you are right. I am not going to suggest otherwise, but I would like\nto ask you a simple question.\nImagine you have two investments, Investment A and Investment B. Each\ninvestment had equal starting value of $100,000.\nInvestment A is doing well. It is up 50%.\nInvestment B on the other hand is not performing. It is down 50%.\nYou are now in a situation where you need $50,000. What do you do?\n1. Close a third of Investment A to raise $50,000?\n2. Close investment B to raise $50,000?\nWhen I asked this question to a group of investors at a conference in\nCopenhagen recently, the overwhelming majority opted for option 1. They\nwould close enough of investment A to raise the $50,000.\nWhy do you think that is? Why do you think people close the investment\nthat is doing well?\nMy theory is it all boils doing to how people react to taking a loss. Are they\nable to take a loss and move on? Or are they so averse to taking a loss\nbecause as long as the position is open, there is hope it will come good\nagain?\nOf course, it is impossible to say exactly how you would react in this\nsituation, but I don’t have to rely on fictitious examples to get an answer. If\nyou recall the chapter where I spoke about the 43 million trades executed by\n25,000 traders, you will remember that those traders lost more on their\nlosing trades than they won on their winning trades.\nEmotionally, a loss is clearly felt much harder than a win. Otherwise, there\nwould be no reason for this anomaly. Human beings postpone making\ndecisions that will cause pain. It is the reason why we let losing trades run.\nWe want the instant gratification, but we want to delay the pain. Hope dies\nlast. As long as the losing position is open, there is hope.\nTHE JUNKIE AND THE CEO\nI use an analogy to illustrate", "source": "eBooks\\Tom Hougaard - Best Loser Wins.pdf", "doc_id": "db0d74ee3eb2ba5542f0943f7b8e994e1f3211b7a93aee04b5bfd56525c663f3", "chunk_index": 39}
{"text": "a loss is clearly felt much harder than a win. Otherwise, there\nwould be no reason for this anomaly. Human beings postpone making\ndecisions that will cause pain. It is the reason why we let losing trades run.\nWe want the instant gratification, but we want to delay the pain. Hope dies\nlast. As long as the losing position is open, there is hope.\nTHE JUNKIE AND THE CEO\nI use an analogy to illustrate the concept I have just explained: it is akin to\nfiring the CEO of a successful Fortune 500 company and betting your\nmoney on the junkie turning his life around.\nCrude? Yes. The junkie might turn his life around, but I think the odds of\nthe CEO continuing his successful run are higher than those of the junkie\nturning a corner for the better.\nThat is why I am arguing that trading is so much more than technical\nanalysis. That is why I am arguing that we need to learn to handle losses a\nlot better than the general population does, because they handle them very\npoorly, and as a result they are generally unable to make money from\nspeculation.\nCONTROL YOUR MIND – CONTROL\nYOUR FUTURE\nI am not a masochist. Nothing could be further from the truth. If I do tend to\ndwell on pain, it is more a reflection of pain’s role in the context of trading\nprofitably. What I’m attempting to do is a difficult endeavour. I’m trying to\nexplain why 90% of all people fail in achieving their hopes and dreams\nwhen it comes to trading.\nWhen so many people commit the same mistakes over and over, there must\nbe a deeper meaning that has yet to be uncovered. Naturally I’m hoping that\nby now you will have a much greater understanding of what it is that is\ngoing wrong.\nMy own motto is: control your mind – control your future. Doing so\nrequires constant vigilance. You have to own your life. If you don’t own it,\nyou are not the boss. You have to take full responsibility for everything that\nyou do.\nYou must be the master of your own kingdom. You can’t walk through life\nwith your eyes half shut. You have to walk through life with your eyes fully\nopen. You have to know what you are getting into – be prepared. You have\nto take possession of your life.\nThis is a thought process you have to constantly reaffirm. Our minds tend to\ndrift. There are so many distractions in life, so much superficial noise that\ndoesn’t bring substance but that our brains are attracted to nonetheless. The\nbrain would rather look at Facebook and YouTube than sit in quiet\ncontemplation.\nThe drifter brain needs to be controlled through daily vigilance, whether it\nbe through a mantra or meditation or whatever you decide suits you best. As\na famous doctor once said when asked what exercise is best for us humans:\n“It’s the one you do”. It doesn’t matter whether you meditate or write a\ndiary or do whatever other practice you choose to centre yourself, so long\nas you do it.\nThere needs to be a regular time in your day where you remind yourself of\nyour purpose, of who you are. The world is full of temptations that distort a\nhealthy self image. The temptations take us away from who we are by\ntelling us that who we are is not enough.\nBut you are enough.\nBeing a good trader really has little to do with tools and charts. It has a lot\nto do with fighting our humanness. If you really want to trade the markets\nusing leverage, engaging in high-octane speculation, you have to learn to\ndesensitise your normal emotional response mechanism to fear, greed and\nother delightful human reactions. You have to fight your humanness.\nDISGUST\nMANY YEARS AGO, when I was just a young man, I had a girlfriend. She was my\nfirst real girlfriend, and I was her first real boyfriend. We were young, and\nwe were very much in love.\nMy girlfriend was a little round bodily, which I found very attractive. She,\nhowever, did not like her body image, so she began to diet. She had dieted\nbefore, but had always failed to sustain a weight loss plan. Now she was in\nlove, and her motivation shifted into another gear. The weight loss became\nquite dramatic, and it led me and her family down a path that pains me to\nwrite about.\nAnorexia is a serious psychiatric disorder, but (and forgive me for using a\ntragic story to illustrate a point about behavioural change) it is an\ninteresting motivational phenomenon.\nWe are hardwired to eat. We need no training to eat. Yet somehow this\nhardwired pattern is overridden by a social motivation: the desire not to be\noverweight. This force, this motivation, is so strong in patients with an\neating disorder that it proves to be impervious to both medical and\npsychological treatment.\nWhat is the basis for this powerful motivation? It isn’t chanting, and it isn’t\npositive self-talk. As I understand it, my girlfriend was motivated by love,\nbut more importantly by disgust. She was disgusted by anything that looked\nand felt fat and overweight. This force was so strong it could disrupt her\nhardwired pattern of eating food.\nAs humans we are driven forward by forces. Those forces can be born out\nof a desire to move away from something, or they can be born out of a\ndesire to move towards something. I happen to be a person who is primarily\nmotivated to move away from something.\nI grew up in a wealthy part of Denmark, and I attended a school for the\nwell-to-do. Then my parents divorced, and I went from living in a big house\nwith an enormous garden to living in a one-bedroom flat, where my father\nwould sleep on a pull-out sofa bed in the living room.\nI was a young boy at a time when all my school friends wore Levi’s denims\nand Lacoste shirts. There was no money for that in my life, and it created a\nsense of inferiority in me.\nAs soon as I was old enough, I started taking afterschool jobs in order to\nearn money. What did I spend it on? You guessed it. Brand clothes.\nI also became a prolific hoarder of money, a saver, if you like. I took great\npride in depositing my wage cheques in the bank and seeing my account\nbalance grow. I moved away from poverty.\nIn my belief system and in my experience, away-o", "source": "eBooks\\Tom Hougaard - Best Loser Wins.pdf", "doc_id": "db0d74ee3eb2ba5542f0943f7b8e994e1f3211b7a93aee04b5bfd56525c663f3", "chunk_index": 40}
{"text": "f inferiority in me.\nAs soon as I was old enough, I started taking afterschool jobs in order to\nearn money. What did I spend it on? You guessed it. Brand clothes.\nI also became a prolific hoarder of money, a saver, if you like. I took great\npride in depositing my wage cheques in the bank and seeing my account\nbalance grow. I moved away from poverty.\nIn my belief system and in my experience, away-oriented goal setting is a\nmuch stronger motivational force than towards-oriented, but I accept that\nthis is an individual preference. You can test for yourself where your\npreference lies, using a simplistic scenario. What would compel you to lose\nweight more: a picture of you in perfect shape or a picture of you where you\nare obese?\nI asked my circle of friends what they would prefer, and all agreed that they\nwould find the obese picture a stronger motivator than the perfect picture,\nalthough a few did comment that they would probably still like to have\nboth. Fair point.\nI believe that disgust is a much stronger emotion than joy or happiness. We\nall have reasons to be happy every day, but we tend to forget that. However,\ndisgust is not something we are likely to forget.\nYou won’t forget the rotten milk you drank by mistake, nor will you forget\nthe client of yours who had such repugnant breath that you nearly threw up.\nEd Seykota once said that everybody gets what they want from the markets.\nWhen I read that, I dismissed it. I wanted to win, but I wasn’t winning, so I\nclearly wasn’t getting what I wanted. End of story.\nIt annoyed me that he had said that. The thought of never being able to trade\nprofitably consumed me. I had spent so much time studying, researching,\ntesting, formulating plans, calculating ratios that I really didn’t know what\nmore I could do.\nIf you look around in your life, you are likely to be able to find examples of\ndramatic changes induced by disgust. What gets a person to finally commit\nto a goal is reaching the point of disgust. I got disgusted with my trading\nover a long period of time. The pattern was always the same:\n1. Trade like a wizard.\n2. Become over-confident.\n3. Blow up the account.\nI became so sick of it. Positive intentions, sticky notes with mantras on my\ntrading monitor, and self-help exercises don’t possess nearly the\nmotivational force of physical disgust with oneself.\nIf disgust can turn eating into a behaviour to be avoided, and if disgust can\nturn an alcoholic’s drinking into a thing of the past, then disgust can also\nturn you into the trader you would be proud of looking at in the mirror.\nI am sorry if I have shocked you. Those of you who know me well will\nprobably be taken back by my extreme steps to ensure my pattern of\nbehaviour in the trading arena is exemplary.\nI am not going back to the rollercoaster ride I was on in my early trading\ndays. I was so disgusted with the amount of money I lost. It was\nembarrassing.\nWe are most apt to change a pattern once we become truly disgusted by it.\nWould you continue to do business with someone who violated your trust\nand stole money from you? No, you’d become so disgusted with such a\ndishonest character that you would cut all ties with them.\nWell, that person is you when your own patterns violate your contract with\nyourself and cause you to lose money consistently. Once you become truly\ndisgusted with your own patterns, you’ll shun them altogether.\nA trader is losing and continues to lose because he doesn’t want to change.\nChange is hard work. I began plotting my trades on the chart when the day\nwas over. I put a marker where my entry was and where my exit was. It was\nhorrible. It was like incriminating yourself over and over. I was disgusted\nwith my recklessness.\nI had to face up to the fact that I was actually an awful trader. I was like the\nguy who could recite the entire technical analysis syllabus for the Master\nTechnician exam, but I could not stop myself from\n1. Overtrading out of boredom.\n2. Overtrading out of anger and a desire to get revenge.\n3. Impatient trading – jumping the gun.\n4. Trading against the trend – trying to catch the low of the day.\n5. Fearful trading – by cutting my winners short out of fear the profit\nwould disappear.\n6. Constantly averaging in lower and lower – i.e., adding to losing\ntrades.\nALCOHOL\nWhen you are a successful trader, you make good money. My friend and\ntrader mentor Larry Pesavento instilled in me the passion for passing on.\nLarry himself is an inspiring trader, but his passion for helping others is\nequally admirable.\nOne project I support is to help people dealing with alcohol issues. I do so\nby offering anyone who sincerely desires to quit drinking a book that helped\nme truly understand the nature of the addiction trap.\nI developed a drinking problem in the aftermath of a painful breakup. I\ndrank to forget. I was in love. I was a fool. She left me. I started drinking.\nThe problem was that I didn’t seem to be able to stop myself from drinking.\nThis carried on for many months. I could not stop myself from drinking, so\nI sought out help. I remember vividly standing up at an Alcoholics\nAnonymous (AA) meeting saying, “My name is Tom Hougaard. I am an\nalcoholic.”\nIt was horrible, but at the same time it was relieving. I felt like a fraud. I felt\nthere was inconsistency in my life. I was outwardly a success. I had two\ncars. One was a luxury SUV, the other an Audi R8. I lived in a nice part of\ntown, overlooking the sea. What did I have to be unhappy about? Well, for\none, I had no control over myself and my drinking.\nStanding at an AA meeting is like being stripped naked for the whole world\nto see. They see your fat ass, your tiny willy, your saggy boobs, your\ncellulite, your scars, your spots, your pimples, your swellings, your bald\nhead and whatever bodily imperfections you can imagine. It is absolutely\neverything you don’t want, and you have a hall full of eyes watching you.\nBut by the end of the exercise you realise the truth. You break yourself\ndown so that you can survi", "source": "eBooks\\Tom Hougaard - Best Loser Wins.pdf", "doc_id": "db0d74ee3eb2ba5542f0943f7b8e994e1f3211b7a93aee04b5bfd56525c663f3", "chunk_index": 41}
{"text": "e world\nto see. They see your fat ass, your tiny willy, your saggy boobs, your\ncellulite, your scars, your spots, your pimples, your swellings, your bald\nhead and whatever bodily imperfections you can imagine. It is absolutely\neverything you don’t want, and you have a hall full of eyes watching you.\nBut by the end of the exercise you realise the truth. You break yourself\ndown so that you can survive, so that you can be reborn as the person that\nyou really want to be. A fresh start. Vanity thrown on the rubbish pile. Clean\ncanvas. Here I am. This is me.\nThe walls are ready to be decorated however you want. Exactly the same\nmodel is used to train elite soldiers. They are pushed beyond their breaking\npoint. Then they are put back together again, stronger, wiser and with an\nunshakable faith in their own strength, their own abilities and their\ndetermination to get a job done – no matter what.\nNo one in their right mind enjoys exposing themselves like this. It is why\nwe get defensive. It is why we fight our corner. Our identity is being\nquestioned. Call it ego, call it identity, call it what you want, but no one\nlikes having their intelligence questioned. It is a lot less painful to continue\ndown the known path than to stop, evaluate, and turn around.\nThere is only a slight, nagging pain when you choose to continue down the\nknown path, and you can soothe your inner pain by reminding yourself that\nyou are not alone. There is power in numbers, even when everyone is\nwrong. But you soon find yourself being disgusted by your own lack of\nprogress, your own inability to stop the behaviour that is troubling you.\nAttending AA meetings was rock bottom for me. I evaluated. I got honest\nwith myself. The pain was relentless because everything was new, and I felt\nnaked, very alone and exposed.\nAnd yet, that is power! There is power in being honest. There is power in\nstanding up and saying to the world and yourself: “This is who I am, and I\ndon’t like it! In fact I hate it. I am embarrassed by it, but it is what it is. It is\na clean slate. It is a fresh start. It is like a forest fire. It clears the debris.\nNew growth can start.”\nI have not touched alcohol for six years and I know I never will. It wasn’t\nthe AA that finally helped me; it was healthy living advocate Jason Vale. I\nhave never met the man, but I want to thank him for setting my life on a\ngood path. I am certain that no one has bought more copies of his book\nabout alcohol dependency than I have. I send them to people all over the\nworld.\nJason describes better than anyone the trap of alcohol. Reading his book\nhelped me understand the nature of addiction on an entirely different level,\nand I found it easy to stop drinking from day one!\nYou may ask what this has to do with trading. Rightly so. The answer is\nsimple: if you have some trading experience, and it is not turning out to be\nhow you want it to be, you have a choice. You can carry on, thinking that\nthings will change. I can tell you they won’t, but you will probably not\nlisten to me.\nOr you can take my advice. You did after all make it all the way to this\nsection of the book, so maybe there is room for improvement. You can strip\nyourself naked (metaphorically speaking), and get honest with yourself.\nYou can stop trading, and start reviewing. You can begin to understand what\nit is you are consistently doing that causes you not to make money trading.\nTake yourself apart, clean up the process, take on board my guidance for the\nmental side of trading, put yourself back together again, fund a small\naccount and start with an entirely fresh mindset and approach.\nTHE DRIFTER MIND\nHOW OUR MINDS work is fascinating. The brain can be our best friend or our\nworst enemy. When I give talks in public, my own life mantra is written on\nvirtually every PowerPoint page of any presentation I give.\nControl your mind – control your future.\nYou have to want to do what you do. You can live a life that is authentic to\nyour soul, or you can live the life you think people want you to live.\nYou can be authentic and own your life and take responsibility for\neverything you do. If you don’t take ownership of your life, you are not the\nboss. You have to take full responsibility for everything that you do.\nWhy would you live life any other way?\nWhy be subservient? You must be the master of your own kingdom. But\nbrace yourself. You will be forced to make many difficult decisions, and\nyou cannot count on your mind to back you up if your determination\nwanders a little.\nYou can’t just walk through your life with your eyes half open. You have to\nknow where you are going. You have to take possession of your life. It\nwould be nice if you could rely on your friends and family, but when it\ncomes to your life’s journey, you are on your own. It is your responsibility.\nPart of that journey, including your trading journey, is to discover your\nweaknesses. You have to know where your mind lets you down. For the\nvast majority of people in the world, this will include their mind’s tendency\nto wander.\nYou see, all of us know what to do. All of us have the knowledge to do what\nneeds to be done, but the path from knowledge to action, where we\nimplement our knowledge, is elusive for many people in many areas of their\nlives.\nYour mind will drift. This is unfortunate but perfectly natural. The solution\nis trivial, and it is powerful. You have to constantly reaffirm your purpose.\nWhether you meditate or talk to yourself while you brush your teeth in the\nmorning, there needs to be some period in your day when you remember\nyour purpose. There must be a time to remind yourself where you want to\ngo, what you want to do.\nOne thing I can’t always rely on is my ability to act in my own best self-\ninterest. My mind needs constant guidance and direction. I don’t know why\nthat is, but it is. I suspect the majority of the population of the planet is put\ntogether like I am. They just haven’t realised it yet, so they drift through\nlife, rather than taking charg", "source": "eBooks\\Tom Hougaard - Best Loser Wins.pdf", "doc_id": "db0d74ee3eb2ba5542f0943f7b8e994e1f3211b7a93aee04b5bfd56525c663f3", "chunk_index": 42}
{"text": "to remind yourself where you want to\ngo, what you want to do.\nOne thing I can’t always rely on is my ability to act in my own best self-\ninterest. My mind needs constant guidance and direction. I don’t know why\nthat is, but it is. I suspect the majority of the population of the planet is put\ntogether like I am. They just haven’t realised it yet, so they drift through\nlife, rather than taking charge. This doesn’t mean they can’t be financially\nsuccessful, but wouldn’t it be nice to be both financially and spiritually\nfulfilled? Your job after all is that thing that you do the most, outside of\nsleeping.\nI am a professional trader. I cannot afford to go into the trading ring without\nbeing 100% mentally prepared. My profession is a mind game like nothing\nelse. If I want to win, I have to focus on what is important now. So Ed\nSeykota was right, much to my chagrin. I did get what I deserved, because I\nwas only good at one part of the game. I was good at the technical part.\nI don’t like this metaphor, but being good at the technical part of trading is\nlike being good at putting together a sniper rifle; what good does that do\nyou when you go into combat and you don’t know how to handle yourself?\nI actively take control of my inner world. I have to give myself enough\nconfidence to reassure myself that I have enough to go out and kick ass in\nthe markets every day.\nTo make that challenge even more real, I post my trades for the world to\nsee. I have never consciously thought about why I do that, until someone\nrecently asked me. I realised that I do it because it keeps me accountable. It\nkeeps me focused.\nI have been as lost as they come. I tell you that not to inspire you to get lost,\nnor to evoke sympathy, nor to tell a tale of rags-to-riches, but to make sure\nyou understand that exposing your weaknesses will be a good thing.\nYour mind is a tool. If you let it delude you into thinking all is well, you\nwill not get the success you want in trading or in life.\nLosing and failing might be a knock to the ego, but it is rocket fuel for\ngrowth. It sounds like I am trying to write a self-help manual for\nprocrastination, a bestselling inspirational book. But I am describing\nhonesty. When you are honest with yourself, in the company of yourself, or\non a podium in front of 40 alcoholics, or whatever the setting may be, you\njust took a step that 99% of the population don’t ever contemplate taking.\nYou already started the journey to winning.\nSo, the journey starts with technical knowledge acquisition and continues\nindefinitely with the constant evolution of both the technical and mental\ntraining.\nTechnical training is part of my day-to-day job, but the mental part needs\nmore dedicated focus, otherwise it gets lost in the noise of the outside\nworld. I need dedicated time to give that brain of mine a workout.\nI want to show you one of the mental warmup images that I go through\nbefore the trading day starts. It gives me the visual evidence I need to act in\na manner that is aligned with what I am trying to achieve.\nThis example happened a while ago, but it could happen any day of the\nweek if I don’t mentally prepare myself. Figure 23 tells the tale in all its\nglory.\nFigure 23\nI short a double top off the open. I am so certain that my research is right.\nThe market will fall.\nI don’t have a problem with the first short position. I have a problem with\nthe four subsequent ones. I could even forgive myself for the last one,\nbecause at least I am shorting weakness. This is unstructured and\nundisciplined trading. I don’t care how certain I am of something\nhappening. If it isn’t happening, don’t pursue it as if it is. Showing you is so\nembarrassing!\nThis is part of my preparation. It has been the most useful tool to build\nmental stamina and discipline. It reminds me of everything that is weak in\nme. It reminds me of how my mind, if left unchecked and untrained, will go\non a rampage to seek excitement and gratification.\nOne of the best ways to increase profits is to use goalsetting and\nvisualisations to align the conscious and subconscious with making profits.\nI use fear to achieve my goals. I imagine trading a size which even in my\nmind makes me uncomfortable.\nI sit quietly in my bed or in my office. The world is quiet, and if it isn’t, I\nstick a pair of earplugs in my ears. I imagine I am trading, and the market is\nmoving against me. I see myself cut the loss.\nI imagine I bought the XYZ, and I see it going my way. I feel the brain\nsending me signals to close the position to crystallise the profit. I see myself\ndoing nothing, as I continue to watch the profit increase and decrease.\nI see a big profit turn into a small profit. I smile and accept it, and I move\non, telling myself it is okay. I place my brain under as much stress as I can\nwith imagined scenarios. I am long and the market is going my way, and a\nsudden news story breaks the market.\nI observe my fear shooting through the roof as my P&L turns into a\nbloodbath. I see myself closing the positions and going in the opposite\ndirection. I see myself not getting unhinged just because the market is\nmoving against me.\nI cannot guarantee that this approach will work for everyone. Perhaps you\nthink it is brilliant, or at least could be useful after a few personal tweaks. It\nworks for me because I learn visually. I get the message when I see it\nvisually. If you tell me not to trade against the trend, it will not mean any\nmore to me than when a cat meows. But show me a chart with my trades\nplotted on, with me trading against the trend (better yet, show me\nrepeatedly), and I get the message.\nThis is my therapy. This is like seeing a psychologist every morning. I get\nfired up. The therapist expands my mind and my horizon. The goal is to\nremind myself of what behaviour I want to enact. It is about making\nchanges and keeping the changes.\nSo what makes me think this will work for you? Behaviour is patterned.\nHow we think, feel, and act has a pattern to it, and that patterning is w", "source": "eBooks\\Tom Hougaard - Best Loser Wins.pdf", "doc_id": "db0d74ee3eb2ba5542f0943f7b8e994e1f3211b7a93aee04b5bfd56525c663f3", "chunk_index": 43}
{"text": "essage.\nThis is my therapy. This is like seeing a psychologist every morning. I get\nfired up. The therapist expands my mind and my horizon. The goal is to\nremind myself of what behaviour I want to enact. It is about making\nchanges and keeping the changes.\nSo what makes me think this will work for you? Behaviour is patterned.\nHow we think, feel, and act has a pattern to it, and that patterning is what\nmakes us who we are. The sum total of our patterns is our personality.\nSometimes our patterns interfere with our goals and dreams in life. They\nprevent us from being who we want to be or accomplishing what we want\nto accomplish. We are sometimes our own worst enemy, and we seemingly\ncan’t stop ourselves when we are in the moment.\nA person can know very well that they have anger issues, and yet be unable\nto prevent themself from lashing out. Another might have eating issues, and\nyet can’t exercise the needed restraint in the moment of eating.\nA trader is fighting the trend all day and his account is suffering, but he\ncan’t stop himself. He is simply incapable of turning his position and trade\nin the direction of the trend. Only afterwards is he disgusted with himself.\nThe purpose of my warm-up is not to take away everything that is bad in\nour lives in one swift move. The purpose is not to guarantee I won’t mess\nup. The purpose is to focus on what I want to achieve or become, while\nbeing mindful of the things that will most certainly sabotage my goals.\nThe wonderful part is that I am almost certainly guaranteed success if I\navoid the failures. I was guaranteed success with my weight goal if I could\ncut out all the Coca-Cola I drank. I just had to be mindful of that, and the\npounds began to come off. I didn’t have to do anything else.\nI don’t have to be certain that my trade is going to work out. I just have to\nbe aware that my mind wants to do things that are not in my own best\ninterest. So, I don’t add to my losing trades. That in itself means I just need\nto be mindful of the one variable I can control.\nMy action in the morning is about changing the patterns that do not serve\nme. This started by observing another very successful trader and asking\nmyself what was holding me back from becoming him.\nMy technical abilities were just as good as his. I don’t think he was\nfinancially much better off than I was, but he was seemingly fearless. How\ncould I become fearless in trading? Did I even want to be fearless?\nI came to the conclusion that the trader I wanted to become was patient but\naggressive when the time was right. It was like Federer playing in the\nWimbledon final in 2007: he was patient until just the right moment, and\nthen played with focused aggression.\nAfter that it was a question of reminding myself of that goal every day, and\nseveral times a day if necessary. That is how habits are built: through\nrepetition.\nAs I grow wiser to the ways of life, I realise that there is a lot of truth to\nJohn Lennon’s words, “Life is what happens to you while you’re busy\nmaking other plans.” We become so engaged in our day-to-day life, with\nresponsibilities at work and home, that the big picture of our lives stays in\nthe background.\nDay after day, year after year we busy ourselves with work and routines,\nonly to realise later in life that opportunities have passed us by. So, the first\nquestion to address in a change process is: “What do you want to change?”\nOr, stated otherwise: “How would you like your life to be different?”\nMy answer? I want to dedicate time to trading well, to combat my natural\ninclinations that stand between me and successful trading. I want to prepare\nmy mind every morning through a series of meditations and visual\nexercises.\nTo achieve this I will train my mind to act calmly through visualising\nmyself in difficult situations. I will focus on my breath. I will calmly put\nmyself through stressful situations to ensure I would react how I want to\nreact if the circumstances were real.\nMaking changes entails far more than simply engaging in positive thinking\nor getting positive images in your head. I didn’t want positive images. I\nwanted a portrait of the dire hell I would reside in if I didn’t change. This\nmay seem like a negative state of being, but it really isn’t. It is immensely\npositive, albeit a rather tense way of getting what you want.\nAs the saying goes: “The end justifies the means.” I have turned\nconventional thinking on its head. I do so because I know what compels me\nmore. Roses don’t compel me. Thorns compel me to action.\nConsider the market itself. It is not so unlike us in its behaviour (because\nwe are the market). It climbs the wall of worry, but it slides down the slope\nof hope. It might be a Wall Street saying, but it says a whole lot more about\nhumans than it says about the markets. All I have done is used fear and\ndisgust as my protagonist – my major motivator.\nGETTING BACK IN THE GAME\nI was surfing in a town outside Biarritz, France, in 1996. I was literally in\nover my head. The waves were twice as big as anything I had ever handled\nbefore. I tried to drop in a few times, but the waves were too fast, and the\nlip was so steep.\nFinally, I got myself positioned for a wave, but I was too far into the impact\nzone, and instead of gliding into the energy path of the wave, it literally\nknocked me out. I just remember everything going black. Luckily for me\nsomeone spotted me and pulled me out of the water. Eight lives left.\nI was back in the water that afternoon. I was too stupid and ignorant to\nconsider what had happened. Ignorance is bliss. It is only now that I can\nappreciate my behaviour. Sure, you took a hit, but you are okay. Do you\nwant to sit on the beach and mope all day or do you want to get back in the\ngame?\nHere’s an example illustrating the importance of getting back in the game.\nI am writing this the day after a particularly challenging and volatile trading\nsession. It was one of those days that will stick in your my mind for reasons\nthat will shortly become a", "source": "eBooks\\Tom Hougaard - Best Loser Wins.pdf", "doc_id": "db0d74ee3eb2ba5542f0943f7b8e994e1f3211b7a93aee04b5bfd56525c663f3", "chunk_index": 44}
{"text": "behaviour. Sure, you took a hit, but you are okay. Do you\nwant to sit on the beach and mope all day or do you want to get back in the\ngame?\nHere’s an example illustrating the importance of getting back in the game.\nI am writing this the day after a particularly challenging and volatile trading\nsession. It was one of those days that will stick in your my mind for reasons\nthat will shortly become apparent.\nOver the last week oil has dictated the mood of the stock indices. Naturally,\nI expected to see the same behaviour on Friday. The Dow started off with a\n200-point rally at the open.\nHowever, 30 minutes into the trading session, it seemed to lose momentum.\nOil on the other hand was in full-blown panic. I started shorting Dow,\nexpecting it to follow oil.\nIn Figure 24, Dow is on the left, and oil is on the right. Both are five-minute\ncharts, and both show the entirety of the trading session from about noon\nuntil late evening.\nFigure 24\nI expected the Dow to follow oil, and it did, but not for long. It seemed to\npause, as if it suddenly had a mind of its own. By mid-afternoon oil had\ndropped almost $2 – more than 5% – in little over an hour. The Dow,\nhowever, wasn’t moving lower with it. It held. I took my Dow short\nposition off with a loss, and I reversed to long.\nAs soon as I had done that, the Dow dropped 50 points, and oil dropped\neven lower. I began to wonder if I had simply been too quick to reverse my\nposition, and I decided to close my long position. By now I was convinced\nthe Dow had merely delayed its inevitable fall. I went short again. In\nhindsight that turned out to be near the low of the day (after the open).\nJust 15 minutes later the Dow made new highs for the day. I closed my\nshort position and scratched my head. I had gone short at the first low and I\nhad closed at the second high. I had gone long at the second high, and I had\nclosed at the second low. I had gone short at the second low, and I had just\nstopped myself out at the new highs for the day.\nI took a moment to reflect. Was I trading with a plan? Was I betting on a\nrelationship between oil and the Dow Index that might not be there\nanymore?\nJust then my best trader friend called, and we spoke briefly. I said to him,\n“What does it mean when the Dow makes new highs on a Friday evening,\neven though oil is plummeting?”\nSaying it out loud helped me to get some perspective. It was the last day of\nthe month, which often brings aggressive buying or selling in the market.\nRemember it was also a Friday, which has a tendency to bring about trend\ndays. I started buying, reluctantly. The market went higher. I bought some\nmore, careful to move the stop-loss up as the markets moved higher. I kept\nan eye on oil. It was recovering nicely.\nWith 60 minutes to go (and no dinner), the Dow made a new high for the\nday; and I know from my statistics that you should not short a market that\nmakes new highs for the day in the final hour.\nBy then I began to add more to my position. I was now betting on a classic\ntrend day finish. On those days the market closes right at the high tick of\nthe day.\nIt would have been easy to throw in the towel after the three failed attempts\nto get on board a move in the market. The effect would have been the same\nas stopping the game of throwing coins just because you have had three of a\nkind in a row.\nI hear about people who stop trading because they have three losing trades\nin a row. That is a flawed approach if you understand the markets. If you\nare ill, or you are weighed down by emotional circumstances, then you stop\ntrading. If you are otherwise able, you don’t stop trading just because you\nhave lost three times in a row.\nAs I type this, I look back at my trading before the Friday. I had lost on\nevery other day that week. It is rare, but I had four losing days in a row. I\ndon’t even remember when that last happened.\nIn the movie Floored, the trader Greg Riba puts it so elegantly, albeit in his\nown way:\nI swear to god that 99% still don’t get it. When they are winning, they\nstart betting less. Bet more. I mean, if there is one roll that you can\nmake a hundred thousand dollars on, let it ride. If you roll three sixes\nin a row, let it ride. Let the winners ride.\nGreg Riba should know. He was said to be one of the best S&P 500 futures\npit traders ever. Why do people bet less when they are winning and bet\nmore when they are losing?\nFear.\nTRADING THROUGH A SLUMP\nI HAVE A FRIEND who was suicidal because of the losses he sustained. He called\nme to say that he was standing at a railroad bridge. I don’t think it was his\nintention to end his life. I think he needed someone to talk to.\nSome would argue that a chapter of this nature does not belong in a trading\nbook. I think people who have lost significant amounts of money will find it\nreassuring that the focus isn’t one-sided.\nEither way, while I have plenty of positive memories from my trading\ncareer, I also have memories that can only be described as dark.\nI had a friend called Adam. I no longer know of his whereabouts. He owes\nme £20,000 – money I doubt I will ever see. Adam was a brilliant trader.\nAbsolutely brilliant. Until it all unravelled for him.\nAdam and his brother worked on the factory floor for their father’s thriving\nbusiness. During the 1990s Adam became interested in trading. Over the\nensuing years he developed a system for trading stock indices using a 30-\nminute chart. He told me it was inspired in part by George Taylor’s book\nThe Taylor Trading Technique.\nIt was a simple but very effective strategy. It required Adam to check the\ncharts every 30 minutes, and if the parameters were right he would execute\na trade. Otherwise he would leave it alone until the next 30-minute period\nwas up, at which point he would check the charts again.\nAdam became so adept at trading the 30-minute chart that he soon made\nmuch more money trading than he did managing his father’s factory. He\ndecided to sell his share of the factory to his brother and focus all his energy\no", "source": "eBooks\\Tom Hougaard - Best Loser Wins.pdf", "doc_id": "db0d74ee3eb2ba5542f0943f7b8e994e1f3211b7a93aee04b5bfd56525c663f3", "chunk_index": 45}
{"text": "if the parameters were right he would execute\na trade. Otherwise he would leave it alone until the next 30-minute period\nwas up, at which point he would check the charts again.\nAdam became so adept at trading the 30-minute chart that he soon made\nmuch more money trading than he did managing his father’s factory. He\ndecided to sell his share of the factory to his brother and focus all his energy\non trading. Adam did well. Really well.\nI traded with Adam on many occasions in my house or online. He possessed\na supernatural patience. I have personally never seen a person stare at a\nscreen from the open of the US market to the close of the US market and\nnot trade once. Yet that was the norm for Adam if there was no signal.\nAmazing patience.\nI believe that Adam’s patience and pattern-reading ability made him the\nsupertrader that he was. He lived the life of the supertrader too. He ordered\na custom-built house. He travelled first class to exotic holiday destinations\nwith his loving wife and children.\nHowever, all supertraders will go through bumpy terrain at some point or\nanother. It is not a question of if it will happen – because it will – but a\nquestion of how badly it will affect them when it inevitably does.\nFor Adam the bumpy road caused him to lose everything. His trading\naccount, his wife and his house. I stepped in when Adam was living on the\nstreets in Manchester, suicidal and penniless. I did what I could – but Adam\ndidn’t want my help, and I lost contact with him.\nIt started with a bad loss, and it escalated into a complete blow-out. Adam\nhad seen a pattern on a Friday night, and he had gone maximum short the\nmarket. At the close he was well in the money, and he decided to keep the\nposition over the weekend.\nUnfortunately for Adam, this was the weekend when the American special\nforces finally captured Saddam Hussein. The financial markets cheered at\nthe good news. I guess naïvely they thought that the Middle East powder\nkeg would settle down once Saddam had been captured. That Sunday night\nthe American markets opened limit up!\nLimit up is a situation where the market is unable to move any higher until\nthe stock market opens at 9.30 am in New York. Adam was short, but he\nwas unable to close his short position because when the market is limit up\nyou can’t buy, which is what you need to do to close a short position.\nAdam was awake when the phone call came. It was his futures broker.\nAdam was informed of his options: deposit more money on the account or\nrisk being closed out once the future market came out of limit up. Adam\ndidn’t have any available capital. It was a long night and a long day until\nthe market finally opened at 2.30 am (Adam lived in the UK).\nThe market opened and stocks soared. The broker liquidated his position\nbecause he was in breach of the margin requirement. The account had stood\nat close to £750,000. Now there was only £400,000 on the account.\nYou may say that £400,000 is also a decent pot of money to trade with, but\nsomething short circuited in his mind. He saw the market soar that day, and\nhe saw his position being liquidated. Unfortunately, he also saw how the\nmarket came all the way back to his entry point.\nYou see, once the good news had been digested by the market, there was a\nfeeling that this probably wasn’t such great news after all. The Dow Index\ncame all the way back, giving up all the gains for the day.\nAdam felt the broker had cheated him. He felt as if he had been forced to\nliquidate. He felt that the broker had acted too hastily. He tried to complain,\nbut his claim was rejected.\nHe then tried to make up for the lost money through trading, but his head\nwasn’t right. He began to second guess his system and double up on trades.\nThen his builder demanded payment for his house. Adam had paid a\ndeposit, but now he couldn’t make full and final payment. He lost the\ndeposit and the house.\nAdam was unable to stop his own downfall. So was his family. He began a\npattern of lying and withholding information for his own gain. The last time\nI heard from Adam was when he cheated me out of a fair sum of money,\nonly to disappear. I haven’t seen him since.\nSadly, this is not an isolated story. I have had to cut short a business trip\nwhile working in the London because my boss called me back to the office.\nThere was a client in our reception crying his eyes out because he had lost\n£750,000 trading forex. He was afraid to go home and tell his wife about it.\nHe begged my boss to lend him money so that he could trade again and\nhopefully make the money back.\nYou may think that this individual lacks the moral fortitude to trade. You\nmay even think less of him because of his apparent lack of dignity. What if I\nwere to tell you that he was a renowned surgeon in a prestigious private\nLondon clinic?\nEducation means very little in this industry. It doesn’t matter where you\nwent to school or what your day job is. If you don’t know how to handle a\nlosing trade, and then a winning trade, you will not go very far in this arena.\nIt is for this reason that I tell people to spend less time on technical analysis\nand more time on self-analysis.\nSuccessful trading can mean just making a good living. I got a message\nfrom a close friend of mine. He trades full time. He has been doing it for 15\nyears and, unlike so many other hopefuls, managed to make a success of it.\nHe has made himself a good living over the years.\nI don’t know many traders who like to talk about what they earn from their\ntrading. When I spoke to my friend about it, he told me he had made about\nthe same as if he had a well-paid managerial job in the City. However, he\nhad no commute, and he had time to be there for his children when they\ncame home from school.\nTo me, my friend is an example of a person who made trading work for\nhim. He had not made himself rich in the process, but he had paid the bills,\nput food on the table for his family, taken them on holidays, and bought a\nnice family car.\nThere seems to be an inclinat", "source": "eBooks\\Tom Hougaard - Best Loser Wins.pdf", "doc_id": "db0d74ee3eb2ba5542f0943f7b8e994e1f3211b7a93aee04b5bfd56525c663f3", "chunk_index": 46}
{"text": "anagerial job in the City. However, he\nhad no commute, and he had time to be there for his children when they\ncame home from school.\nTo me, my friend is an example of a person who made trading work for\nhim. He had not made himself rich in the process, but he had paid the bills,\nput food on the table for his family, taken them on holidays, and bought a\nnice family car.\nThere seems to be an inclination to describe trading as the venue for making\nuntold riches. Yes, the potential is always there, but with bigger reward\ncomes bigger risk. You can’t catch big fish in shallow waters.\nHowever, my friend was tiring from the long hours, and he called me to\ntalk. He asked me if I had ever had enough of the endless hours of watching\nthe screens.\nI immediately responded, “No, and if you feel like that, you have to stop\ntrading and take a break from it all.” We spoke for a while that night on the\nphone.\nHe told me that now that the kids were older, they wanted to hang out with\nfriends rather than their old dad. His wife worked full time too. It meant he\nwas often alone in the house from early morning until later afternoon, and it\nbegan to bother him.\nI helped him get a few job interviews and he secured himself a job as a\nbroker in London, on account of his in-depth understanding of the markets\nand his ability to understand what clients are going through in their trading.\nA fairly innocent story, I am sure you would argue; so why am I telling you\nabout my friend? Well, I am telling you the story for several reasons.\nThe first reason is that trading can be a very lonely business. It has never\nbothered me, but I have the deepest of sympathy for those who feel lonely\nwhile trading. I am not sociable, don’t drink or smoke, can’t stand watching\na football match (that excludes me from a lot of male social activities) and\nprefer my own company; but even I like to pick up the phone from time to\ntime and just shoot the breeze with a friend.\nWhen I worked in the City, I would at times stick my head into my boss’s\noffice, who always had a minute to say hi and catch up on life. If you one\nday decide to make a go of trading full time, you may experience a twinge\nof sadness that you no longer have the odd chat with a work colleague.\nI recommend that you take a week or two’s holiday and try full-time trading\nbefore you hand in your notice to your boss and begin your full-time online\ntrading job. It will give you a taster of what your day will look like.\nThe second reason I told you the story about my friend is to make sure you\nrealise that a pause from trading is not the end of trading. The markets will\nalways be there.\nMy friend will no doubt be back to trading full-time one day. In the\nmeantime, he is enjoying a new life where he is helping others achieve what\nthey want from trading.\nThe third reason I am telling you this story is because I would love to see\nyou succeed, but I think it is important you understand that trading may not\noffer you the rainbow you had hoped for. But does it have to?\nCould it not just offer you a good income, where you are working on your\nown terms and perhaps doing something that you find immensely\ninteresting? Does it have to result in owning a beachfront property in\nBarbados?\nSure, if you get there, I am happy for you, and you should be proud of\nyourself. However, if you don’t get there, but you still manage to pay your\nbills and put money aside for the sweet things in life as if you were the\nrecipient of a monthly pay cheque, then to me you have done what the 99%\nof the population do not dare to do.\nThey dare not take a chance on their dreams. If you can make a living from\nit, be it a decent living or a great living, then you really are something out\nof the ordinary.\nAnd trust me when I say that once you understand trading better, you will\nalso come to understand what makes you work optimally in the trading\narena, and that is when being a trader gets really fun.\nEight months ago, I went through a tough time. It happened during the\nmonth of May. I started strongly, and then the wheels started falling off. I\nwas up some £200,000 on the month, and it started to unravel.\nIt started with a loss of £33,000. Often when I have a bad day, I will come\nroaring back the day after, but I didn’t. I lost another £9,000 the day after.\nThen came the weekend – not a moment too soon.\nMonday started where Friday had left off, in spite of all my preparation and\nintrospection over the weekend. I lost another £38,000. Before the week\nwas over, I had lost more than 50% of the gains for the month.\nMore disturbingly, I felt completely lost. I had no idea why I was losing. I\nwasn’t tired. I was sleeping well. I had no emotional issues that occupied\nmy focus. I was just not performing.\nI have endured hard times before. Progress has at times been slow. Setbacks\nhave been frequent. Setbacks are always lurking. My goal is to stay in the\ngame until I don’t want to spend all my waking mental energy on the\nmarkets.\nAs you can perhaps gather, this is a deeply personal journey for me. It is\noften a mentally draining journey, where I feel I am not making any\nprogress. What made it worse for me was that a really good friend of mine –\nalso a trader, and probably the best private trader the world has never heard\nof – was having a great run.\nWe have always been brutally honest with each other. I think therein lies the\nstrength of our friendship. I will tell him point blank, “I am jealous of you. I\nfeel bad that I am jealous of you, because you are my closest friend, and I\nwould give you my last dollar, but right now I am shooting blanks. I am\nhaemorrhaging money.”\nI told him I had a huge position on. It was literally the biggest position I\nhave ever carried. Each point was worth £4,000. That equates to 400 FTSE\nfutures contracts. I was so certain the FTSE would fall.\nI have seen the pattern so many times: big fall off the open – two to three\nbars of five-minute duration of rebound – and then new lows.\nBut it didn’t. Not th", "source": "eBooks\\Tom Hougaard - Best Loser Wins.pdf", "doc_id": "db0d74ee3eb2ba5542f0943f7b8e994e1f3211b7a93aee04b5bfd56525c663f3", "chunk_index": 47}
{"text": "blanks. I am\nhaemorrhaging money.”\nI told him I had a huge position on. It was literally the biggest position I\nhave ever carried. Each point was worth £4,000. That equates to 400 FTSE\nfutures contracts. I was so certain the FTSE would fall.\nI have seen the pattern so many times: big fall off the open – two to three\nbars of five-minute duration of rebound – and then new lows.\nBut it didn’t. Not that day. It rallied. And he was long. I was short. It was\nimmensely painful. It took me to a place I didn’t want to visit. A place of\nenvy, resentment and despair.\n“You know Tom, you are lucky.” My thoughts were interrupted by my\ngirlfriend. It was as if she knew what I was thinking. “Not everyone has\nsomeone who is better than them, and who they stay up at night wondering\nhow to beat. Not everyone is Mozart versus Salieri. You should be happy.\nSo you lost. But what have you gained? Don’t you know that he feels the\nsame as you do? He desperately wants to beat you – for no other reason that\nyou bring out the best in each other.”\nShe carried on: “You know, my old professor Peele, I told you about him…\nbrilliant man. Do you know what made him brilliant? His colleague –\nProfessor Kyle – they were best friends and neither of them would ever\nacknowledge that they were insanely jealous of each other, yet they were\nthe two most brilliant minds anyone could wish to learn from. You should\nreally count your blessings that you have someone who you so badly want\nto beat. It is really not a curse. It is a blessing. What do you think would\nhappen if your idols stopped trading?”\nIf they stopped, I thought, who would I beat then? I always loved beating\nmy old high score, and I did today, in size; but she was right. I am not just\ntrading to make money; I am trading to push myself into those places where\nI am not comfortable.\nI was once in a restaurant in Porto Cristo, having dinner with my son. I\nhappened to look over my shoulder and I saw Rafa Nadal having a late\nmeal with his friends. It was great to witness a world-famous tennis star just\nshooting the breeze with his old friends.\nA few days later we visited his tennis academy. Rafa was training. It was\nhot as Hell that day. He trained like his life depended on it. He was out\nthere pouring his heart out – in the blazing heat – just to get better.\nWhy do you think he was doing that? It is for the same reason that someone\nlike Matthew McConaughey – during his Oscar acceptance speech in 2014\n– said, “There are three things that I need each day: one, I need something\nto look up to; two, I need something to look forward to; three, I need\nsomething to chase.”\nI am writing this because I think being open about what drives us is healthy.\nThere will come a point in your career as a financial trader where you will\ngo through a slump. When it happens, it might serve you well to step back\nand think deeply about why you are so drawn to this game.\nAnd when it happens, I hope you will turn to these pages. I hope they will\nremind you why you are doing what you are doing.\nWhat my slump taught me was to slow down. If you do not slow down and\nlet the knowledge mature, then you will take a huge loss, which will dent\nyour confidence.\nNot every trade is the World Cup final. Not every trading session is the final\nexam of the final year, the culmination of four years of relentless studies.\nEveryone has setbacks. Kobe. Rafa. Federer. You. Me.\nAnd – all slumps end.\nSlumps are inevitable. You are bearish and the market goes up. You are\nbullish, the market goes down. It happens to us all. Every one of us.\nIs there a key to escaping a slump? No.\nWhy should I throw old, worn clichés at you? Why should I tell you to stay\ncalm and work your way through it? Why don’t I just tell you that it is\nhorrible to go through, but it will end – if you persist?\nI wrote this chapter over several weeks. When I started it, I was not in a\nslump. Then the slump arrived, and I described it. As I type these words, I\nhave had a fantastic trading morning. Am I out of the slump? Who knows? I\ndo not know what I am doing differently to what I did when the slump set\nin.\nI am simply following the process I always follow. I am a process-oriented\ntrader. The markets determine the outcome. I have little control over that. I\nhave faith. I believe that my process will carry me through the highs and the\nlows of trading.\nEMBRACING FAILURE\nTHE LATE MARK Douglas argued that successful trading is a question of\naccepting risk and thinking differently.\nThe Market Wizard trader Ed Seykota put it another way. “A losing trader\ncan do little to transform himself into a winning trader. A losing trader is not\ngoing to want to transform himself. That’s the kind of thing winning traders\ndo.”\nWhen I read that passage the first time, I was not mature enough to\nunderstand its importance. When I started trading for myself, I began to\nappreciate its depth and wisdom.\nAs I began trading bigger and bigger size, I realised that my journey from a\nlow-stakes trader to a high-stakes trader was not the result of evolution.\nSure, I got better the more I traded, but remember this: Practice does not\nmake perfect. It merely makes it permanent. Only through a dedicated\napproach to practice, with a specific attention to finding your mistakes, will\nyou improve. Otherwise you just are just cementing your unprofitable\nbehaviour.\nBECOMING A DIFFERENT PERSON\nBeing anxious and fearful is a reflection of an unknown situation. Through\nexposure – over and over – our minds come to accept the new reality and\nthrough that exposure become accustomed to it.\nYou think there is a hack that will all of a sudden take you from trading £10\na point to £100 a point? You think there is some book you can read, or some\ncourse you can take, or a pill you can ingest that will take you from being\nan average-stake trader to a high-stake trader?\nWell, not quite. But there are certainly ways you can accelerate your\nprogress. It is a question of priority. I am not some hardcore monk with", "source": "eBooks\\Tom Hougaard - Best Loser Wins.pdf", "doc_id": "db0d74ee3eb2ba5542f0943f7b8e994e1f3211b7a93aee04b5bfd56525c663f3", "chunk_index": 48}
{"text": "hack that will all of a sudden take you from trading £10\na point to £100 a point? You think there is some book you can read, or some\ncourse you can take, or a pill you can ingest that will take you from being\nan average-stake trader to a high-stake trader?\nWell, not quite. But there are certainly ways you can accelerate your\nprogress. It is a question of priority. I am not some hardcore monk with no\nlife and a never-ending commitment to pushing myself into those cold, dark\ncorners where I dance with uncertainty until my emotions are stunted and I\nessentially become a psychopath with no fear.\nBut I am committed. I want to explore my weaknesses. I am reasonably\nattuned to my mind and body, and I know that left to my own devices I can\nquickly spiral into self-destructive behaviour.\nI had a painful breakup with a loved one, and I turned to food and alcohol.\nSure, I think we all do things like that. Even Bridget Jones (I love movies)\nate her way through a tub of ice cream in one sitting when she was dumped\nby the love of her life.\nBut you move on. You get off the sofa. You turn off the TV and throw the\nice cream bucket in the bin, and you say, “Okay, so I made a mistake. I will\nown it.”\nHow you feel about failure will to a very large degree define your growth\nand the trajectory of virtually every aspect of your life. You may want to\nclose the book and think about that for a while. It is quite frightening how\ndeep that sentence is.\nA significant part of your success as a trader is correlated to your\nrelationship with failing. If you see failure as the endgame, then you won’t\nmake it as a trader. I have colleagues who will stop trading if they have\nthree losing trades in a row. What kind of attitude is that? You think Kobe\nBryant – the absolute superman of basketball – had that attitude? You think\nduring a game he would make three misses and then ask the coach to be\nreplaced by someone else?\nKOBE BRYANT – THE BIGGEST\nFAILURE\nWhile we are on the topic of Kobe Bryant, I want to tell you a story about\nhim, which I read in a paper – sadly after Kobe passed away in a tragic\naccident.\nAfter the accident, most obituaries focused on Bryant’s amazing\nachievements and trophies won, but Andy Bull from the Guardian wrote\nabout Kobe Bryant from a different vantage point.\nThe headline of the article sums it up well: “Bryant’s success story began\nwith working to conquer the fear of failure.”\nIt seems Kobe Bryant intuitively knew that, in order to be a great player, he\nneeded to conquer his fear of failing. The article goes on to tell the story of\na game in May 1997. It was Kobe’s first season for the LA Lakers, his\nrookie season. He made four crucial errors inside five minutes, which some\nsay cost his team the game.\nThat night, the story goes, Bryant stayed up shooting hoops privately and\nalone. He was still at it when the sun came up. I know this feels a little\nsugar-sweet; it has a David versus Goliath feel to it. But there is more to\nthis than meets the eye.\nOn the surface, it reads that Kobe Bryant was beaten in that game and he\nfollowed it with a punishing all-night session. To me the story tells of a man\nwho night-after-night confronted his fear of failure by repeatedly trying. He\nbecame used to sometimes failing temporarily, and yet he kept at it.\nBull concludes by saying, “He missed more shots than any other player in\nhistory. Bryant was willing to encounter failure in every game he played.”\nIt is not the first story I have read about an all-American great, someone\nwho confronted the fear of being wrong, in order to be proven right. Babe\nRuth, the American baseball player, held home run records for decades. At\nthe same time, he went by the nickname King of Strikeouts. If the term itself\ndoesn’t give it away, let me explain: a home run is great; a strikeout is the\nvery opposite.\nI found the story resonated with traders all over the world who seek out\nsystems and strategies aimed at eliminating losing trades.\nAs I write this on a quiet trading day on 1 June 2020, I look over my trading\nstatistics for the month of May. I made a total of 1,513 points. Yet out of the\n137 trades I executed, I lost on 66 of them, won on 53 of them, and broke\neven on 18 of them (where stop-loss was moved to entry point).\nIf I gauged my success according to some of the hyped-up system sellers on\nthe internet who promise a 95% (or better) hit rate on trades, I am an abject\nfailure. I mean, I was less than 50/50 in May.\nYet, somehow, I still managed to make a decent return for the month. How\ndo you explain that? The answer is found in the erroneous belief that the\nmore winning trades you have, the better a trader you are. That is plainly\nand simply wrong.\nOne of the popular clichés in the trading world is that you can’t go broke\ntaking a profit. Oh, hell yes you can. If you are unable to let your profits\nrun, you will never make money trading. While basketball and trading\ndiffer on this point, if I were afraid to lose, I would never have had a\nprofitable month.\nSTATISTICS DO NOT MAKE SENSE\nWe know that 90% of traders lose. We also know from the FX trading\nsample of 25,000 traders that most trading accounts have more winning\ntrades than losing trades. This does not make sense. How can we reconcile\nthose two facts?\nThe answer is found if you read between the lines of the story of Kobe\nBryant. If you are in a losing position, you are essentially wrong. However,\nunlike a shot in a basketball game, where you immediately know when you\nare right or wrong, in trading there is always the hope that the trade will\ncome back in your favour.\nHope is what keeps people in trades long after they should have closed\nthem. As the saying goes, hope dies last. So true, and so detrimental to\ntraders. How do I deal with hope and fear in my trading?\nI tend to only feel hope when I am in a trade. I hope my position will come\ngood. I hope the market will move in my favour.\nFear, however, is felt in more situations. I can feel fear when I am in a trade.", "source": "eBooks\\Tom Hougaard - Best Loser Wins.pdf", "doc_id": "db0d74ee3eb2ba5542f0943f7b8e994e1f3211b7a93aee04b5bfd56525c663f3", "chunk_index": 49}
{"text": "s what keeps people in trades long after they should have closed\nthem. As the saying goes, hope dies last. So true, and so detrimental to\ntraders. How do I deal with hope and fear in my trading?\nI tend to only feel hope when I am in a trade. I hope my position will come\ngood. I hope the market will move in my favour.\nFear, however, is felt in more situations. I can feel fear when I am in a trade.\nBut I can also feel fear when I am not in a trade. That is a subtle but\nimportant distinction between hope and fear.\nHope tends to be reserved for the activity of being in the trade, while fear\nmanifests itself both when I am in a trade and when I am not in a trade. I\ncan be fearful that the market will move ahead without me, or I can be\nafraid that I have closed my position too soon – which could also rightly be\nclassified as regret.\nWhile I intend to write in much more depth about my trading regime at the\nend of the book, I will describe my approach briefly now.\nI deal with fear when I am in a trade by having an exit strategy. I have a\nstop-loss, which defines the size of my loss. I have accepted this loss before\nI started the trading day. It is part of my trading plan.\nI will have mentally prepared in the morning, ahead of the trading day. I\nwill have sat quietly, contemplating what I am about to do. I will have\nsubjected my mind to images of me losing. I will have calmed my mind,\nwhen it experienced these imagined losses, so as to negotiate away any\nfeelings of anxiety and regret, as well as desires to get revenge and get\neven.\nI will have dealt with hope by accepting that my stop-loss will define my\nexit. Maybe I will win. Maybe I will not win. Before the trading day started\nI will have gone through mental exercises that saw me enter the market,\nobserve the market move against me, negotiate with my fear brain and the\nimpulse urges it sent to my conscious awareness.\nBy the start of the trading day I will already have seen myself win and lose,\nadd to positions, and patiently wait for the right setup. By the time the bell\nrings, opening the market for trading, I am mentally warmed up. I am ready\nto fail without losing my composure.\nMY COMPETITIVE SON\nI have a fascination with reading about the lives of high-performance\nsoldiers. I love reading about the trials and tribulations of the SAS and\nNavy Seals. My son shares this interest. In particular, we are fascinated with\nthe free-diving part of the training.\nOne of the obstacles that these elite warriors have to pass is the 50-metre\nunderwater free-dive. Do you think there is a shortcut to diving 50 metres\nunder water?\nTake it from someone who has swum 46 metres under water, there is no\nshortcut. I practised and practised while on holiday with my son. There\nhappened to a 50-metre swimming pool in the complex we were staying at.\nBeing the competitive spirits that both my son and I are, he set out first on\nour initial attempt. He made it a little less than halfway. Now I had a goal,\nand I made it almost to the halfway line. I beat him by an inch or two.\nWe spoke about how we could get better, and we agreed that we needed to\nfocus more on our preparation before the swim. So next we sat on the edge\nof the pool, and we focused on filling our lungs with oxygen and\noxygenating our bodies.\nGradually we got better and better. Then we realised that if we swam less\nfrantically while underwater, we would expend less oxygen. Our focus\nshifted to staying calm and taking rhythmic strokes.\nBy the end of the seven-day holiday, I came within a few strokes of 50\nmetres. My son was a metre or two behind me. Passing this test is one of\nthe major stumbling blocks for aspiring Navy Seals. I am not saying that\nmy son or I are Navy Seal material, but I am saying that there is no way you\nare going to swim 50 metres under water without relentless practice.\nWe worked on it. Then we evaluated our process. We didn’t actually focus\non the outcome at all. We just did everything we could to make the process\nas efficient as possible. Does that remind you of something? If you have a\ngoal that you want to make X amount of money a day, or a certain amount\nof pips or points, you might be sabotaging your chances of making a lot of\nmoney. You are outcome-oriented. You would benefit immensely from\nshifting your focus to being process orientated.\nBEST LOSER WINS\nTHE TIME HAS come to get more specific. We can skirt around the issue forever,\nor we can decide to get our hands dirty and get down to the business of\ncreating a finely tuned trading mind.\nWhat you become in life is dependent on the decisions you make and how\nyou react to decisions made on your behalf.\nAt Stanford University, Steve Jobs, standing at the podium in front of the\nclass of 2005, gave the new graduates their commencement speech – advice\non how to live life. It went something like this:\nRemembering that you’re going to die is the best way I know to avoid\nthe trap of thinking you have something to lose. You are already naked.\nThere is no reason not to follow your heart.\nFew can walk the walk when money is on the line. The main contributor to\nnot having the life you want is fear. Most play this game called life safely\nwithin the boundaries they set while growing up, boundaries built by\navoiding pain and anxiety.\nI am often asked if I know the secret to becoming a good trader. I think\nmany novices believe that I know some really good trading setups. They’re\nnot entirely wrong; yes, I know some great setups, but they still only work –\nat best – about 70% of the time. I am still wrong 30 times out of 100.\nI am not where I am in the trading world because of my IQ. I’ll tell you that\nimmediately. I am here because of my relationship with pain. Our brains\nhate the idea of losing something that is valuable to us. The brain will\nabandon all rational thought and make some really poor decisions trying to\navoid losing something that has value.\nI am a profitable trader. Is that because I possess superior charting abilities?\nNo. Of c", "source": "eBooks\\Tom Hougaard - Best Loser Wins.pdf", "doc_id": "db0d74ee3eb2ba5542f0943f7b8e994e1f3211b7a93aee04b5bfd56525c663f3", "chunk_index": 50}
{"text": "trading world because of my IQ. I’ll tell you that\nimmediately. I am here because of my relationship with pain. Our brains\nhate the idea of losing something that is valuable to us. The brain will\nabandon all rational thought and make some really poor decisions trying to\navoid losing something that has value.\nI am a profitable trader. Is that because I possess superior charting abilities?\nNo. Of course not. There are many brilliant chartists who can’t trade.\nIs it because I have a superior system? No, there are many great systems but\nmost will still only have a 60% strike rate.\nIs it because I have friends in high places that feed me insider information?\nNo. Did you not read my book? I am socially reclusive, and I certainly do\nnot have friends in high places.\nI have no secrets. I have no special abilities, with the possible exception of\none. Do you want to know why I am so good at trading?\nI am exceptionally good at losing. When speculating in financial markets,\nthe best loser wins. Don’t underestimate these four words.\nThough it may go against the conditioning that life and the modern world\nhave programmed you with, success in financial market speculation is not\nabout being the best, coming first, or winning.\nInstead, it’s about losing. Your relationship with fear and adversity will to a\nvery high degree define your life.\nAnd that’s why I win. I win because I’m really good at losing. In trading,\nunlike life, it’s the best loser that wins. Do you think a dentist, or a doctor\nwould be in business if they had a 60% win rate? Of course not. But a trader\ncan thrive and prosper on that kind of success rate – as long as they are\nprepared for it. Most are not.\nMANY ARE CALLED…\nTrading attracts many people who shouldn’t be traders. They are led to\nbelieve that trading is easy. Maybe a broker is tempting them; I’m sure\nyou’ve seen the broker advertisements where a calm, confident actor\nknowingly pressing buttons in front of a bedazzling array of screens, then\nwalks away victorious with a confident smirk.\nIf you look at the trading industry, we are led to believe it is all about the\ntools. Hang on – do you think I can play tennis like Roger Federer just\nbecause I have a Wilson Pro tennis racket?\nIt’s an illusion. How do I know? Because, for years, I was an insider\nworking at one of the largest financial market brokers in London.\nWhy do so many people lose? Statistically speaking, it should be\nimpossible for so many people to lose. If the market is random – and most\nof the time, market movement is indeed random – why do 90% of clients\nconsistently lose a 50:50 bet?\nThe answer is as simple as it is complex. It isn’t the market-beating them.\nThey are beating themselves. I wasn’t always a successful trader either. To\nbecome successful, I had to break down the barrier that separates the many\nfrom the few, in a business where there is no instruction manual, and where\nthe lesson comes after the test.\nIt didn’t take me long as a broker to notice our clients’ trading behaviour.\nAs a group, traders are predictable. Or, more accurately, their outcome is\npredictable, because everyone is doing the same thing.\nI watched thousands of traders execute millions of trades. Their behaviour\nbecame predictable, almost as if they were connected together in one hive\nmind. Week after week, month after month, year in, year out, when they\nwere making a loss they hoped the market would give them back their\nlosses, yet when they were making a profit they feared the market would\ntake it away.\nThey were fearful when they should have been hopeful. They were hopeful\nwhen, in fact, they should have been fearful.\nThese human experiences helped make me the trader I am today. Watching\nthem struggle, I realised they were searching in the wrong place.\nThe answer they were so desperate to find is not found in the external. It’s\nnot found in the software, or in any of the tools. Instead, I realised, the\nanswer is to be found inside the self.\nTUNING MY MIND\nIn the silence of the early morning, I’m in my office, preparing for the day’s\ntrading. It is a minimalistic office. Depending on where I am, there are\neither two or four screens. That is it. There are no special monitors or water-\ncooled PCs.\nMy secret ingredient is a couple of files on my hard drive. There is my\nPowerPoint presentation on one screen. There is a Microsoft Word\ndocument on another.\nThe PowerPoint file is my cue. At game time, before I begin to trade, it’s\ntime to become someone else. In the movie Gladiator, why does Maximus\nDecimus Meridius rub dirt on his hands before combat?\nIt’s a ritual.\nHe must immunise himself before battle, to feel nothing, to become an\ninstrument of death, indestructible, so that he can survive another day.\nRubbing dirt on his hands is his ritual of leaving his old self behind. Every\nday from 5 am until 9 pm, even late into the night, I am battling myself.\nTrading is a battle of the self.\nThe PowerPoint file contains old trades, mistakes, triumphs, inspirations,\nand warnings visually arranged to prepare me for the day ahead.\nI need to become something else; otherwise, I will not make money. This is\nwhy trading looks simple when looked at from the outside, but it’s not easy\nbecause trading successfully goes counter to virtually every piece of DNA\nstored in your body.\nIn the 1960s, neuroscientist Paul MacLean proposed the human brain has\nevolved with three areas of function: the reptile brain, the limbic brain, and\nthe neocortex.\nSo, who’s really in charge when you are trading?\nIt’s your reptile brain, your base self, that’s really in charge. When you are\nstartled, and you react, perhaps you detect a wobble in your stomach, a\nvibration in the lower back – that’s your reptile mind preparing you for\nsurvival, triggering a fight-or-flight response.\nWill you run, or will you fight? Your subconscious reptile mind has only\none function, and that is to protect you. It does this whether you want it to\nor not.\nAnd this is a problem, because to be successf", "source": "eBooks\\Tom Hougaard - Best Loser Wins.pdf", "doc_id": "db0d74ee3eb2ba5542f0943f7b8e994e1f3211b7a93aee04b5bfd56525c663f3", "chunk_index": 51}
{"text": "e\nstartled, and you react, perhaps you detect a wobble in your stomach, a\nvibration in the lower back – that’s your reptile mind preparing you for\nsurvival, triggering a fight-or-flight response.\nWill you run, or will you fight? Your subconscious reptile mind has only\none function, and that is to protect you. It does this whether you want it to\nor not.\nAnd this is a problem, because to be successful as a trader you need to be\nvery good at losing. This means constant conflict with your built-in\nsubconscious protection system.\nA system that protected you from death as a caveman guarantees you’ll not\nsurvive as a trader – unless you can learn to overcome it. And overcoming it\nbegins with accepting pain.\nOne exercise I use in the morning is closing my eyes and playing out a\nscenario. I imagine I lose a large amount of money. I will often use an\namount that has some significance to me, such as the cost of my last car, or\nthe cost of my son’s college tuition, or the size of a memorable loss.\nSay for the sake of the argument that I have opted to meditate on losing\n£78,000. I will see myself losing the amount. I will let it sit there – in my\nconsciousness. I will let it take hold. I will imagine what I will not be able\nto buy because of the loss. I will make it as emotionally vivid as I can.\nNow I will turn the table. I will now imagine that I am winning the same\namount. I will imagine that I am winning the £78,000. What will happen is\nthat my emotional response system will not allow me to feel a reciprocal\nsense of joy to the misery I felt earlier.\nNeurobiology has shown we experience a financial loss 250% more\nintensely than an equivalent financial gain. After going through this\nexercise of feeling pain and then not feeling pleasure, I then swap back to\nfeeling the loss again.\nThe purpose of the exercise is to align my feelings of gain and loss. In truth,\nI don’t really want to feel anything – I have found that if I get overly happy\nabout a win, I tend to get overly sad about a loss. I don’t want that.\nI am not a dentist who has a win rate of 99.99%. I am a bloody trader, who\nhas to live with being wrong around 50% of the time. It is exhausting to feel\njoy and pain many times a day. I prefer not to feel anything at all, rather\nthan going through that emotional roller coaster.\nI win. Move on.\nI lose. Move on.\nBy adopting this attitude and by warming up my subconscious mind, I am\nable to flow in and out of winning and losing trades, day in and day out,\nwithout it affecting my strategy.\nPain is inevitable to some degree in life. Someone lets you down, you feel\npain. Someone hurts you emotionally or physically, you feel pain.\nIn life, outside of trading, one way to deal with the pain is to talk to\nsomeone. As the saying goes, a problem shared is a problem halved.\nWhy a painful experience feels less potent after we have shared it with a\nfriend I don’t know. Maybe the act of verbalising the disappointment puts\nthe problem into a healthier perspective.\nEither way, you feel better, and the pain subsides.\nBut when I’m trading, while the majority look to run away and rid\nthemselves of pain, I do the opposite. I run towards it. I embrace it. I don’t\nwant to share my pain. I want to hold on to it. I need it.\nWhether you are new to trading and speculation, or you have years of\nexperience, you should give this question some serious thought:\nIf you want to be a success in a field where 90% or more fail, how do you\nthink you should approach this task?\nTrading looks easy on the outside, but in reality it’s much more challenging\nthan people expect – because we are hardwired to do the opposite of what\nwe should be doing. This is why 90 out of every 100 people end up losing.\nThe road to consistency, success, and enlightenment in trading begins in the\nlast place you’d ever think to look. Inside yourself.\nTHE KEY\nSo, here it is. What follows is the key that will unlock the door to your\nsuccess, the key to breaking down the barrier between the life you want and\nthe life you are leading now.\nIf you want to succeed in an endeavour where 90% are failing, you have\ntwo choices. You can study the large 90% losing group and do the opposite\nof what they do, or you can replicate what the 10% do.\nIf you are not as successful as you want to be, sooner or later you need to\nchange your behaviour. It doesn’t matter if you’ve been trading\nunsuccessfully for three months or 30 years, you are much closer to success\nthan you realise.\nThe 90% fail because they interpret the pain messages received\nautomatically from our reptile brain without any modification.\nYou need to learn to recode your brain’s messages when pain comes\nknocking. Instead of reacting and running away, a small group of consistent\ntraders, the 10%, hold fast and run towards the danger – not away from it.\nThe 10% succeed because they have learned to flip the switch.\nFLIP THE SWITCH\nThis will feel very uncomfortable, but it is a discomfort you must accept\nand embrace if you want to succeed in the game of financial speculation. It\nis the reason why trading looks simple but is not easy.\nThe paradox of trading is this: by doing what the 90% cannot do, you will\nbecome successful. In other words, I expect to be uncomfortable. I expect\nmy trading to cause me anxiety. I am waiting for it.\nI can sum it up in a few sentences:\n1. I assume I am wrong – until proven otherwise.\n2. I expect to be uncomfortable.\n3. I add when I am right.\n4. I never add when I am wrong.\nASSUME YOU ARE WRONG\nRemember, I’ve watched thousands of traders execute millions of trades,\nand I noticed when most traders enter into a position they assume they are\nright. In a business where 90% of people fail, your recoding process begins\nby flipping that switch.\nI will assume that I will quickly have to get rid of a losing trade. My\nconfidence in this action is not centred around my ability to select the right\nsetup. That is what the 90% will do.\nInstead, my confidence is centred around trusting I will get rid of", "source": "eBooks\\Tom Hougaard - Best Loser Wins.pdf", "doc_id": "db0d74ee3eb2ba5542f0943f7b8e994e1f3211b7a93aee04b5bfd56525c663f3", "chunk_index": 52}
{"text": "enter into a position they assume they are\nright. In a business where 90% of people fail, your recoding process begins\nby flipping that switch.\nI will assume that I will quickly have to get rid of a losing trade. My\nconfidence in this action is not centred around my ability to select the right\nsetup. That is what the 90% will do.\nInstead, my confidence is centred around trusting I will get rid of a trade\nthat is not performing. I trust myself to know that if this trade does not work\nout, there will be another one coming shortly.\nDo you see how I have flipped the switch on my thinking? I am thinking\ndifferently to the 90%. I will assume I am wrong until the market proves me\nright.\nFlip the switch!\nWhen the 90% of traders execute trades, they experience emotions, which\noriginate from their pain centre. Now it’s only a question of time before\ntheir emotionally driven pain threshold centre sends them a false signal,\ncausing them to lose. It is a never-ending rollercoaster ride of\ndisappointment, lost money and pain.\nWhen I trade, I assume I am wrong. I enter a trade, and the trade moves in\nmy favour. I am trading my account size or the available profit – I am\ntrading the market because I understand the size of my profit is irrelevant to\nthe market.\nI know my P&L has no influence on the market. I know that my brain’s\nautomatic pain receptor will kick in causing an inbuilt safety reflex to\nregister pain.\nI am subject to the same built-in automatic pain receptor as everyone else,\nbut the difference lies in how I handle the pain. Instead of giving in to it,\ninstead of being ruled by my emotional responses, I have flipped the switch.\nI have trained myself to expect the pain.\nI am aware of the pain. It is there. It is real, but I accept it. I have\nencountered it in training over and over. It no longer acts as a debilitating\nforce in my life. I have trained the fear of out my decision making.\nEXPECT TO BE UNCOMFORTABLE\nHow can you have a good time while you are uncomfortable? Logic will\nsay it is not possible. Well, for starters, I think all humans come alive when\nwe strive. We toil in the garden, we work out, we study for an exam. I think\nit is perfectly possible to be uncomfortable while enjoying a challenging\nprocess. As a trading position grows in profit, instead of giving into the fear\nit will be taken away from me, I flip the switch, using my mental warm-up,\nmy training exercises and visualisation of trend days where the market just\ngoes higher and higher all day.\nI flip the switch in my mind from negative mental imagery to positive\nmental imagery. I see myself riding this monster momentum wave. I see\nmyself being at the forefront of every tick higher.\nThe 90% will focus on what they want to avoid. I focus on what I want to\nachieve. The 90% give in to their fears. I expect my fears to come in\nabundance, and I have a plan for counteracting them. I see a different\nimage.\nAnd when I am losing?\nWell, I already expected to lose anyway, so the market disagreeing with my\ntrade will not be associated with pain or fear. I expected it. I have accepted\nmy loss already.\nI don’t entertain the idea of compounding my mistake by adding to my\nlosing position. I have trained that trait out of my mind. It doesn’t even\nenter my mind anymore. My mind knows I want to be big when I am right,\nand I want to be small when I am wrong.\nEmotions kill trading accounts. It isn’t the lack of knowledge that’s\nstopping you from winning big. It’s the way you handle yourself when you\nare in a trade.\nI spent a decade observing traders lose money. They were intelligent people\nwho often had great hit ratios, but they couldn’t lose well.\nAfter reading this far, if you remember only one thing, remember this: in\ntrading, unlike life, the best loser wins.\nTHE IDEAL MINDSET\nTHERE IS AN ideal way to think as a trader. There is an ideal mindset – one that\nis flexible to the extreme. It does not care about winning. It does not care\nabout losing. It is a carefree state of mind, but it still acts in your best\ninterest.\nThe ideal trading mindset has no fear. If you are alarmed by this statement,\nthen pause for a second. The ideal mindset may have no fear, but the ideal\nmindset is still acting in your best interest. The ideal mindset might be\nfearless, but it is not reckless.\nFear plays a significant role in explaining why people lose the game of\ntrading. This fear can manifest itself in several ways. It can be the fear of\nnot being in the market and missing a good move. It can be the fear of\nstaying in the market for too long and seeing the open profits disappear.\nCan you acquire an ideal mindset? Yes. Without a doubt. You may have to\ngrow into it. You may have to begin a period of significant introspection\nand get to know thyself. I will discuss how to get to know yourself as a\ntrader shortly.\nThe ideal trader mindset does exist, and you can train yourself towards this\nstate of thinking and believing. When you arrive at this state, it means you\nare able to perceive information from the markets without feeling\nthreatened or fearful.\nDoes it mean you will never lose? No. You will have losing trades just like\neveryone else. However, the ideal trading mindset is as at peace with losing\ntrades, as it is with winning trades. Neither will impact your ability to\nunemotionally and dispassionately perceive market information in a non-\nthreatening frame of mind. Your emotional state will stay in balance.\nEvery trader has experienced periods of being in the zone, of being balmed\nby the soothing feeling of the ideal mindset. It often happens when certain\ncircumstances are present. For me personally, I experience that sense of\ncalm whenever I am trading while on holiday.\nOne story stands out. I was on holiday for 14 days, and I traded every day\nfrom my holiday home. I was totally at peace, trading only when the market\nreally spoke to me. Otherwise, I was at the pool relaxing in the sun.\nWhen I returned to the trading floor, my boss came out and said, “So", "source": "eBooks\\Tom Hougaard - Best Loser Wins.pdf", "doc_id": "db0d74ee3eb2ba5542f0943f7b8e994e1f3211b7a93aee04b5bfd56525c663f3", "chunk_index": 53}
{"text": "stances are present. For me personally, I experience that sense of\ncalm whenever I am trading while on holiday.\nOne story stands out. I was on holiday for 14 days, and I traded every day\nfrom my holiday home. I was totally at peace, trading only when the market\nreally spoke to me. Otherwise, I was at the pool relaxing in the sun.\nWhen I returned to the trading floor, my boss came out and said, “Someone\nis on fire!” and clapped. Fourteen days later I had given away all my\nholiday profits. I remember the story so vividly because it happened to be\none of the catalysts that led me to seek a deeper understanding of myself as\na trader.\nHARD-CODED DNA\nThe ideal mindset does exist, but few traders have it consistently. When we\ndo not operate from a frame of mind of the ideal mindset, we are afraid of\nsomething. This fear is a manifestation of a lack of trust. We do not trust\nourselves to do what we have to do without hesitation, without reservation\nor internal conflict or argument.\nOur mind is the problem. Our mind’s core objective is to keep us alive and\navoid pain. We are automatically wired to think in a way that keeps us alive.\nThis thought pattern is hard-coded into our DNA. It might keep us alive, but\nit makes trading difficult.\nThe very thing that keeps us alive is the very thing that makes trading an\nincredibly difficult proposition, until you have learned how to counter your\nhard-coding.\nThe issues we face largely fall into two categories:\n1. We associate this moment with another moment, whether we are\nconscious of it or not.\n2. We have a mind wired to avoid pain.\nWe have learned to associate in order to benefit from experiences.\nAssociation (connecting past moments with the present moment) and pain\navoidance do not go hand in hand with trading.\nWhy do I say this? Why do I say that association and pain avoidance are\ndetrimental to profitable trading? I say so because in trading each moment\nis unique, and anything can happen. Trading is the equivalent of a coin-flip\ngame. Since the win ratio of many professional traders – including myself –\nis not far from 50/50, the coin-flip analogy is even more appropriate than\nyou might think.\nIf you play a game of heads and tails, you are probably not too concerned\nabout the outcome. Over time it will play itself out quite predictably. You\nwill win 50%. You will lose 50%. If you developed a system where you lost\na unit on your losses, and you made 1.5 units on your wins, you have\nyourself a good business.\nTrading is just like that in many respects. You don’t judge your system on\nthe merit of one trade. You judge it over many trades. We do so because\neven a game of heads and tails will show an uneven distribution, even if the\noutcome over 100 flips is 50/50. As my friend David Paul once said, “There\nis randomness in the outcome of one, but there is order in the outcome of\n100.” He was talking about the coin-flip scenario.\nI once flipped a coin 100 times, and I wrote down the result on a piece of\npaper. I witnessed 15 heads in a row. At one point I stopped and looked at\nthe coin, as if to see whether there were obvious flaws to it. There weren’t.\nIf you had 15 losing trades in a row, I imagine your mental state would\nsuffer. If you had 15 winning trades in a row, you may feel invincible.\nThe market will do what the market will do. It doesn’t care about you or\nyour position. It doesn’t care if you are in the market or on the side-lines. If\nyou have 15 winners in a row, it doesn’t care. If you have 15 losers in a row,\nit doesn’t care.\nYou can’t make the argument that just because you have lost on a trade you\nare now closer to winning. By doing so, you are doing exactly what we\nneed to learn not to do. Every moment is unique. Just because you had 15\nheads in a row does not mean the odds of a head are less on the 16th throw.\nThey are still 50/50.\nWhy? Because there is complete randomness in the outcome of one. That is\nanother way of saying that every moment is unique. However, over time the\nlaw of averages will come into play, and over 100 throws, you will\nexperience 50 heads and 50 tails.\nHowever, while you may understand this academically, and even logically,\nthere is a good chance you will not understand this emotionally, especially\nif you just had 15 winners or 15 losers in a row. Therein lies the difference\nbetween the trained mind and the untrained mind. I will steadily guide you\ntowards the trained mind, so that you do not succumb to fear.\nPERCEIVING INFORMATION\nInformation on its own has no power over us. It is our belief system and the\nenergy we give to the information that decide its potency. If you receive an\nemail from an unknown person saying, “You are a dead man,” the chances\nare your emotional reaction will be very different than if you received an\nemail saying, “Du er en død mand.”\nThe message is the same. One is in English, the other Danish. On its own,\nthe sentence is merely a construct of letters put together. Once it is decoded\nby the brain, it is assigned an emotional charge. The sentence is\nmeaningless. It is how we interpret the sentence that causes the emotional\nresponse.\nSo, imagine a mindset where you can perceive the market information\npurely from an opportunistic point of view. You are not threatened by the\ninformation. You are not thinking, “Oh God, why am I not in this move?”\nYou are not thinking, “Why am I in this move?” You merely observe and\ndecide from a frame of mind that sees opportunities. It does not see threats.\nThe market moves up and down in ticks all day. They form patterns, which\nwe trade on. These ticks up and down are just ticks. If you have a position\non, however, these ticks take on a life and meaning of their own. They\nvalidate you, or they diminish you. That is not how you want to trade. That\nis not an ideal mindset.\nFOCUS AND ATTRACT\nWhat we focus on is what we attract. I believe in that, so it is true for me.\nThe fear we experience causes us to focus on the object of our fear so that\nwe end up creating th", "source": "eBooks\\Tom Hougaard - Best Loser Wins.pdf", "doc_id": "db0d74ee3eb2ba5542f0943f7b8e994e1f3211b7a93aee04b5bfd56525c663f3", "chunk_index": 54}
{"text": "just ticks. If you have a position\non, however, these ticks take on a life and meaning of their own. They\nvalidate you, or they diminish you. That is not how you want to trade. That\nis not an ideal mindset.\nFOCUS AND ATTRACT\nWhat we focus on is what we attract. I believe in that, so it is true for me.\nThe fear we experience causes us to focus on the object of our fear so that\nwe end up creating the very experience we’re trying to avoid.\nI want to give you a simple example of the mind seeking information as a\nresult of what your focus is on. You bought yourself a new car. It is a yellow\nVolkswagen Beetle. As you drive your new car, you begin to notice other\nVolkswagen Beetles. You never did that before. Your mind has opened a\nfilter, allowing information about Beetles into your consciousness.\nWhat we focus on is what we attract. The trader who has a position on in\nthe market will focus on the price movements (the ticks) that move in his or\nher favour because they relieve pain and give pleasure. Movements against\nthe position create pain.\nYou might be thinking I am stating the obvious. You are right. My point\nwas not to state the obvious, but to point out that this state of mind is not\nopen to other possibilities. The more fear we experience, the less\ninformation the mind will focus on. It will narrow its focus. It will stop you\nfrom perceiving alternative options.\nI run a live trading channel, where I trade in real time. When I trade\npublicly, one type of scenario I am most proud of is that in which I accept I\nhave misread the market, and I change my position. For example, I may\nhave pushed the short side on the Dow Jones Index, and the market is\nmoving against me. I accept I am wrong. I close my position. I open a trade\nin the opposite direction.\nIt requires a tremendous amount of self-belief to do this when you are\ntrading big size. What helps me in situations of this type is to recite a\nmantra I have created: “Focus on the process. Focus on what you can\ncontrol.” I have developed a belief system that allows me to encourage this\nkind of flexibility.\nThis kind of mindset is possible for you too. When I set out, I wanted to\ncreate a mindset that allowed me to perceive information without fear. That\nis the ideal mindset. It takes time to create it, but your rewards are directly\ncorrelated to your effort. Don’t expect a eureka moment. Expect to get\nbetter and better gradually.\nBELIEFS\nOur beliefs determine how we react to information. We were born with a\nclean slate, and our beliefs are taught and adopted. We were taught what to\nthink. We also had experiences that shaped our beliefs.\nI will get personal for a second. I felt my mother and father abandoned me\nat a young age. They divorced and I became the object of their fighting. I\nsee now how that shaped my beliefs, which in turn influenced my choices\nin life and the decisions I made. The moment I was old enough to take\ncharge of my own destiny, I saved up as much money as I could so that I\ncould say goodbye to that toxic environment and leave my home country.\nHow does this relate to trading? Trading gives us unlimited potential to\nexpress ourselves. We can open a trading account, and away we go. You are\nyour own boss. There are no rules. There are no limits. Do what you want.\nYou are no longer influenced or guided by your parents. The world is your\noyster. You have total freedom to do what you want to do, when you want\nto do it.\nWe tend not to want to operate under rules. After all, much of our young\nadulthood is spent rebelling against parents giving us rules. Trading is a\nrule-free environment. Unfortunately, the result is quite astounding. Traders\nhave free will, and 90% of them will have a belief system that leads them to\nfailure.\nIn order to prosper in trading, we need a combination of being able to\noperate under trading rules while not feeling we are being held back,\nbecause ultimately, we want to experience total freedom. Essentially, what\nit boils down to is creating a mindset that always acts in your own best\ninterest. It is a mindset that allows you to see opportunities. It knows your\nweaknesses and what to be mindful of. It allows you to receive information\nwithout being threatened by the information.\nYou can operate from a carefree state of mind. I have created a blueprint for\na carefree trading mind. I have changed my beliefs about trading. That is\nthe message at the heart of this book – to change how we think, especially\nhow we think about losing. It is to explain my mindset and teach you the\nmindset.\nThe old way of thinking is still there. It will always be there. It is part of\nyour personality. But the old belief has no charge anymore. It is faded,\ndiffused. Just because you have said goodbye to an old belief does not mean\nit isn’t still in your memory.\nI will give you a childish example. We used to believe in Santa Claus. We\nused to believe if we were good, he would come and visit us to leave us\npresents. Does it bother you that he is not real? Of course not. You have\ndiffused the emotional charge of being deceived. Your life is no worse off. I\nhave the same sentiment about my old trading beliefs. I am not missing out.\nI am thriving on a new mindset. I used to think I couldn’t live without a\ncigarette after a meal. Now I can’t imagine a life where I stick a cigarette in\nmy mouth. I eat every day, and I never have an urge to smoke. Once I could\nnot imagine a life without a smoke. Now I can’t believe I was ever hooked\non it. It took me a little more than a week to re-program my mind. The same\nwill happen to you as you apply my blueprint for the ideal trading mindset.\nMy biggest belief I had to overcome in trading was the associations I made\nwhen I was confronted with losses. I had to learn how to disassociate losses\nfrom feelings of failure or feelings of wanting to extract revenge on the\nmarket to create a state of mental equilibrium. Achieving that was a\nmomentous leap for my trading performance.\nTHE BOOK OF TRUTHS\nI want", "source": "eBooks\\Tom Hougaard - Best Loser Wins.pdf", "doc_id": "db0d74ee3eb2ba5542f0943f7b8e994e1f3211b7a93aee04b5bfd56525c663f3", "chunk_index": 55}
{"text": "rint for the ideal trading mindset.\nMy biggest belief I had to overcome in trading was the associations I made\nwhen I was confronted with losses. I had to learn how to disassociate losses\nfrom feelings of failure or feelings of wanting to extract revenge on the\nmarket to create a state of mental equilibrium. Achieving that was a\nmomentous leap for my trading performance.\nTHE BOOK OF TRUTHS\nI want to move the narrative towards the practical element of creating the\nright mindset. You can only dance around the fire for so long. Let’s get\ndown to brass tacks. Let’s get specific.\nI once saw a sign that said, “The best views come after the hardest climbs.”\nProverbs have a way of simplifying complex messages, but they are hit-\nand-run in their nature. They don’t tell you how to do it.\nHow do I climb the mountain? Telling us to “Just Do It” might be well\nintentioned, but falls disastrously short of a meaningful description of how\nto climb the damn mountain. In a similar vein, to be told to just “run your\nprofits” and “cut your losses” falls disastrously short of providing a\nmeaningful guide to achieving these noble trading goals.\nWhen I started trading, I had the right credentials. On paper I was\nacademically destined to do well. Emotionally, though, I was like everyone\nelse. I was not making money. I should say I wasn’t making meaningful\nmoney. I lost more on bad days than I made on good days. Granted I had\nmore good days than bad days, but the bad days would set me back\nsignificantly, to the point where I might as well go and get a job. It would\nhave paid better than my trading did.\nI didn’t question what I brought to the game beyond chart preparation. I\nshowed up. I traded. I studied charts. That was it. I thought that was all\nthere was to it. If it didn’t go well, then I had to do more of it.\nHowever, I never looked inwards. Then something happened. I read the\nresearch (described earlier in the book) on the 25,000 traders executing 43\nmillion trades, and I thought to myself, I am just like them. They all\nbelieved they would be profitable. Practically none of them were.\nIt prompted me to start thinking about trading holistically. I had been\nobsessed with techniques. I had a belief that more is better when it came to\ntechnical analysis. Yet, I was not seeing the results I wanted.\nIt got me thinking about thinking and about what I believed. More\nimportantly, I began to wonder if what I considered to be my beliefs were\nactually helping me to become a better trader. So far, they had not.\nYour beliefs create your world. How you see the world is a result of what\nyou believe in. Some beliefs are easy to identify. I believe we should look\nafter the environment, so I make sure I recycle. That is an example of a\nbelief. That was an easy example. How are your beliefs shaping your\ntrading performance? Are you even aware of what your trading beliefs are?\nYour trading performance is a function of your belief system, and only by\ndissecting your trading performance are you able to uncover what your\nbelief system is. There is an easy way to discover your trading beliefs.\nAlthough I say it is easy, it is also hard work.\nA friend of mine wanted to improve his surfing, so he hired a friend to\nvideo him for a few hours during a surf session. He watched himself surf\nand he was able to identify his issues. He needed to strengthen his core\nmuscles and he needed to trust his wave selection rather than being half\ncommitted, as he often was on many waves.\nIn a similar way, I decided I needed to relive my trades to truly figure out\nwhat my problem was. So, I downloaded my trading results into an Excel\nspreadsheet and went to work. I meticulously went through the trades. I\nsplit my trades up into many different categories, with many of them\nappearing in more than one category.\nThere were trades I held for days. There were trades I held for seconds.\nThere were trades I executed in the mornings. There were trades I executed\nin the afternoons and evenings.\nI recommend you read my assessment of my own trading, and you repeat it\non your own trading. It is a vital step in understanding who you are and\nhow you interact with the markets. Once you have done that, you will create\nwhat I call the Book of Truths.\nAbove all, be honest with yourself, as I was. If you are not honest with\nyourself, you will not be rewarded with consistency in trading. The courage\nto be honest with yourself is its own reward.\nHere goes:\n1. I had periods where my win rate exceeded 85%.\n2. My average profitable trade was less than my average losing trade.\n3. I was a winning trader, but my big losses were seriously denting my\noverall P&L.\n4. I traded well in the first half of the day.\n5. I traded well in the first three to four days of the week.\n6. I often gave away much of my profit from the morning session\nwhen I traded in the afternoon.\n7. I often gave away much of my weekly profit on Fridays.\n8. I would do very well on range-bound days.\n9. I would almost always miss trend days, and I would often fight\nthem.\n10. My biggest losses came from fighting trending moves.\nThe breakdown of my performance was incredibly cathartic. I took great\npleasure in reviewing my own mistakes, because it felt like I was actually\nmeaningfully moving towards a better version of myself.\nI took a very time-consuming decision to put all of my trades on the\nrelevant charts. I created a PowerPoint containing every trade to give me\nvisual imagery of my performance. This is the Book of Truths.\nI will argue that this process stood out as the single most beneficial practical\nexercise in enhancing my performance. I was, and I am, confronted daily\nwith all my flaws, and I have a visual representation of those flaws. It\nseems as if the act of portraying a loss in a visual representation is a much\nmore powerful tool for change than merely writing “Don’t trade without a\nstop-loss” on a Post-It Note and taping it to your screen.\nI use the PowerPoint file to warm up every morning before tradin", "source": "eBooks\\Tom Hougaard - Best Loser Wins.pdf", "doc_id": "db0d74ee3eb2ba5542f0943f7b8e994e1f3211b7a93aee04b5bfd56525c663f3", "chunk_index": 56}
{"text": "ng my performance. I was, and I am, confronted daily\nwith all my flaws, and I have a visual representation of those flaws. It\nseems as if the act of portraying a loss in a visual representation is a much\nmore powerful tool for change than merely writing “Don’t trade without a\nstop-loss” on a Post-It Note and taping it to your screen.\nI use the PowerPoint file to warm up every morning before trading begins. I\nam reminded of the things I am good at and the things that tend to be my\ndownfall. It has become an integral part of my process, to ensure I am\nacting in my own best self-interest.\nWhen I started the process of visually recalling my old trades, my old hurts,\nmy old successes, I felt an empowering surge to replicate what I was good\nat and avoid what I was bad it. I immediately began to trade differently. I\nimmediately saw measurable improvements in my trading. The results were\nimmediate, even if I had to get used to the new way of thinking. I made\nmore money.\nI became much more trusting of the markets. I trusted that I would be given\nan opportunity to make money every day. As odd as it sounds, I began to\ntrade less, and I started to make more money. Sure, I wasn’t perfect from\nday one. I am not perfect today either. In fact, one of my beliefs is don’t\ninsist on perfection in trading.\nOne truth I came face to face with was less is more. There was a clear\nrelationship between the time of the day and my profitability. I was\nnowhere near as profitable in the afternoons as I was in the mornings.\nWould I make more money if I just traded mornings? The statistics said yes.\nMy heart said no. I wanted to trade, and I felt (or rather my belief dictated) I\nhad to trade in the afternoons. How else could I call myself a trader if I only\ntraded part time? It was a process of trial and error.\nThis was the immediate benefit from the Book of Truths, but I didn’t stop\nthere. I began to seriously question my motivation for trading. I argue that\nin a business like trading, where 90% fail to make a positive return on their\ntrading account, the only way to separate yourself from the masses is to\nacknowledge that your mind is either your best friend or your worst enemy.\nIf you don’t prepare your mind ahead of the game, and you experience\nadversity during the game, your mind will most likely work against your\nprime objective. Your prime objective is not to make money. Your prime\nobjective is to follow the strategy you have developed. More importantly,\nyour prime objective is to follow the process you have designed for\nyourself. If you follow the process, the outcome will take care of itself.\nI don’t set goals. I just focus on my process. I am a process-oriented trader.\nI don’t think being overtly goal oriented will help you achieve your goals.\nOf course, the goal is to win. But a mind subjected to adversity is a mind in\nstress. A stressed mind needs structure and process. Otherwise, it will\nsuccumb to feelings of fear, revenge and desperation, and the decisions it\nmakes will originate from these feelings. Who wants to make decisions\nabout the wellbeing of their financial health based on fear or stress?\nThe mind needs guidance. I read about an American football coach who,\nduring the half-time break, gave specialised talks designed to re-awaken the\nimagination of the players on his team. One time his team had taken a\nbeating in the first half of the game. During the break in the locker room the\ncoach put on a special video he had prepared. It showed some of the\ngreatest comebacks in football history.\nThe purpose of the video was to give the players a path out of their stressed\nstate. It gave them mental imagery of what was possible. Coupled with the\nright kind of motivation, encouraging the players to focus on the process,\nstaying present in the moment, waiting for the right opportunity and trusting\nthe process, their minds had gone from being stressed to being prepared.\nI want to remind you that the first part of my trading life was spent on a\ntrading floor, observing traders – thousands of them – go about their daily\nlives. I am adamant in my claim that those who were behind at half-time\nhad no mental tools to help themselves, and as a result tended to dig the\nhole they were in deeper and deeper, as the day wore on.\nLEAVING THE OLD SELF\nRemember how Maximus ritualistically rubs dirt on his hands before\ncombat in the movie Gladiator? How, through this symbol of mental\npreparation, he was leaving his old self behind? Well, I too have to leave\nmy old self behind. I too have to become someone else for the day. Charlie\nDi Francesca, the legendary bond trader in the pits in Chicago, said that\ngood trading goes against normal human instinct. To succeed you have to\nget used to being uncomfortable.\nTrading is a battle of the self. Every morning I have to shed my skin and\nbecome someone else. The Book of Truths is key to my transformation. It\narouses a desire to do better than the old pattern of behaviour. I am certain\nthat had I not taken the steps to focus on my mental game and confront\nmyself daily with my old behaviour, I would not be where I am today.\nI argue this to be the case based on my observations of diaries. One of the\ncatalysts for my trading transformation came from tidying up my old office\ncabinets. I found old trading diaries in which I had meticulously described\nmy trading day. As I read through the diaries, which spanned a decade, I\nsaw how desperate I was to make trading work for me.\nI saw how day after day I promised myself not to add to losing trades – how\nI promised myself not to trade well from Monday to Thursday and then lose\nit all on Friday – how I promised myself I would stick to one setup, and so\non.\nAs I read page after page of trials and tribulations (but mostly trials), I\nrealised that the Tom whose words I was reading was in real pain, but he\nwas not transforming. He was repeating the same mistakes day after day.\nHe might have been increasingly technically competent, as his studies took", "source": "eBooks\\Tom Hougaard - Best Loser Wins.pdf", "doc_id": "db0d74ee3eb2ba5542f0943f7b8e994e1f3211b7a93aee04b5bfd56525c663f3", "chunk_index": 57}
{"text": "Thursday and then lose\nit all on Friday – how I promised myself I would stick to one setup, and so\non.\nAs I read page after page of trials and tribulations (but mostly trials), I\nrealised that the Tom whose words I was reading was in real pain, but he\nwas not transforming. He was repeating the same mistakes day after day.\nHe might have been increasingly technically competent, as his studies took\nhim deeper and deeper into expert territory of technical analysis, but he kept\nmaking the same mistakes when his mind became stressed.\nAs I have said before, it was not an epiphany. My change came slowly. It\nwas a gradual realisation that all my chart studies didn’t move me\nmeaningfully towards the goals I wanted to accomplish. Rather, they merely\ndistracted me from the real problem, which was my behaviour when things\ndid not go to plan. Instead of focusing on the process and having tools to\nget me to operate from a stress-free mind, I succumbed to foolish trading,\nintending to make back the lost ground. My mind desperately wanted to get\nrid of the pain of having lost money, and its solution was to chase every\nmovement in the market recklessly. And all I did was dig the hole deeper\nand deeper.\nThe Book of Truths will give you up-close, face-to-face time with your own\nshortcomings. It made me realise what my faults were. I also started\nplotting my good trades. I felt it was necessary not just to remind myself of\nthe behaviour I wanted to avoid. I should also remind myself of the\nbehaviour I wanted to strive towards.\nThe charts I use to prepare for each trading day, to warm up, are my old\ntrades plotted on a chart. That way I can emotionally relive the trades and\nreinforce the behaviour that is good for me and remind myself what my\nweak points are.\nAN EXAMPLE\nFriday 4 March 2022 was an extremely volatile trading day. A colleague\npointed out to me that Brent Oil was soaring. I looked at the chart, shown in\nFigure 25, and I thought, “Wow, it really is.”\nFigure 25\nI bought the first retracement on this ten-minute chart. Now there is nothing\nwrong with this entry. I am trading with trend, but as I look back at the\ntrade, I acknowledge that at that precise moment in time I was not trading\nfrom an emotionally stable point of view. I was eager to get on board a\nmove, based purely on the opinion of another trader.\nSo, I just bought it without much thought to it. And I had no stop loss in\nmind. I just put an arbitrary stop loss, for safety. See Figure 26.\nFigure 26\nThis is the power of the Book of Truths. I want to remind myself of things\nlike that. I want to remind myself, in the morning, before the trading starts,\nthat Tom Hougaard trades best when he is calm and is not caught up in an\nemotional whirlpool of excitement and a brain awash with adrenaline and\ndopamine.\nI looked at my trading monitor and saw my position losing me money. I\nreminded myself that, although I got caught up in the emotions of another\ntrader (one that I respect), I am not him. I am me. I closed the trade, and\nthen I waited. I had made an impulsive trade – an emotional trade without a\nreal plan or a real setup. I wasn’t annoyed so much with the losing trade as\nmuch as I was annoyed with suddenly being impulsive and acting without\ntruly thinking. I could have spent 30 seconds thinking it through and the\noutcome would have been very different.\nI calmed myself down, and I thoroughly analysed the chart, and I decided\nupon a better entry point. I used my process – the tools that work for me.\nAnd then this pattern in Figure 27 showed up. It was late in the day, and I\nwas prepared for a restful evening after a long trading week. I bought Brent,\nand I held it.\nFigure 27\nThe setup is simply a Harmonic Retracement. The first retracement and the\nsecond retracement are identical. It gives razor-sharp entries, where it is\neasy to control your risk.\nI want to remind myself of the things I do well. I want to remind myself of\nthe things I can be prone to when I am not calm. I want to do that ahead of\nthe open. I accept that I will never be perfect. I will at times still make\nstupid Brent Oil trades on a Friday afternoon because a friend of mine is\ntelling me of his success; but I like to think that like a missile I will self-\ncoordinate as new data becomes apparent, and I like to think that my mental\npreparation makes my mistakes short lived.\nTRUST\nMy review of my trades revealed that I didn’t trust myself or the markets.\nProfitable trading requires trust. If you don’t believe it can happen, you\nshould not even start. If you don’t trust, then you will not make money.\nTherefore, before you start trading again, you have to work on your beliefs\nabout yourself and the markets.\nAs I see it, trust falls into two categories.\nTRUST YOURSELF\nYou have to trust that you already have all the tools you need to make a\nliving from trading. Yes, you need to acquire a certain competence level in\nthe field of technical analysis (or whatever edge you use to make trading\ndecisions).\nI continue to study technical analysis, and I do so to improve my\nunderstanding of the ever-changing nature of the markets I trade, but it is\nnot technical analysis that will make me money. It is trusting that I already\nhave all the skills I need to make money consistently.\nThe reason why I was not more successful in my early trading was not\nbecause I didn’t know enough about technical analysis. It was because I\nthought the only thing I needed was technical analysis. However, that was,\nand is, simply not true.\nI had not focused my time and attention on matters outside of technical\nanalysis. My focus was not on the right things. My technical savvy was not\nmatched by an emotional maturity, because I had not spent time working on\nthat side of my game.\nYou need to trust that you already have all that you need. Otherwise, you\nwill not bridge the gap between what you know you can achieve and what\nyou are achieving. You need to believe. The belief comes from doing. I will\naddress that in a moment", "source": "eBooks\\Tom Hougaard - Best Loser Wins.pdf", "doc_id": "db0d74ee3eb2ba5542f0943f7b8e994e1f3211b7a93aee04b5bfd56525c663f3", "chunk_index": 58}
{"text": "us was not on the right things. My technical savvy was not\nmatched by an emotional maturity, because I had not spent time working on\nthat side of my game.\nYou need to trust that you already have all that you need. Otherwise, you\nwill not bridge the gap between what you know you can achieve and what\nyou are achieving. You need to believe. The belief comes from doing. I will\naddress that in a moment.\nTRUST MARKETS\nThe second trust consideration is the trust in the markets. When I go to\nwork in the morning, it would be great if the perfect setup manifested itself\nbefore my eyes right at the opening bell. However, it rarely does.\nI use a five-minute and a ten-minute chart as my primary trading time\nframe. A typical trading session runs over ten hours for me. That means I\nwill be confronted with a total of 120 candles/bars of five-minute duration.\nAs a result of my review of my trading performance, I came to a realisation.\nI didn’t trust the market would give me the opportunities I needed to make\nmoney. It was a debilitating belief.\nI set out to prove that I was wrong in that belief by reviewing ten years’\nworth of intra-day data from the handful of products that I traded most\nfrequently. Now I wasn’t just studying for the sake of identifying patterns. I\nstudied to prove that the technical analysis setups that served me well\nwould repeat every day.\nI arrived at a new set of beliefs. I came to believe I can trust the market to\ngive me an opportunity to make money every day. I came to trust the fact\nthat at least two or three of those five-minute candles would produce a great\ntrade entry.\nI came to trust that the market would give me a perfect entry point, such as\na double top in a higher time frame downtrend or a continuation signal. In\nconclusion, I shaped a new belief around the evidence that I laid bare\nthrough my research. I came to accept that I can produce a good living from\ntrading, from waiting for those ideal setups.\nBut those ideal setups don’t necessarily materialise when I want them to, in\nthe time frame I have at my disposal to trade. I need something else beyond\ntrust.\nTrust is a vital part of the journey to making the markets your playground,\nbut it is not the only component. I needed to work on another part of my\nbehaviour. I would often tire before the afternoon trading session. I would\noften tire as the week progressed. This led to poor decisions, which can be\ndirectly attributed to boredom and impatience.\nPATIENCE\nI realised that my patience was my weakness. However, there is more than\none kind of patience. For example, a mother teaching her young child to\nread may experience a sense of impatience, but the mother will remind\nherself that eventually all children learn how to read.\nThe impatience that a parent may experience is mitigated by the perceived\ntime horizon to reach the end goal. We know our children will learn basic\nreading skills, as long as we persist. We simply have to maintain our\npatience as our little ones inch their way towards the desired skill.\nYou can’t argue that patience is a quality directly transferable from\nparenting to trading. As a parent you can tell yourself you will patiently\nwork towards your child being able to read. However, you can’t say that\nyou will patiently wait for the market to hit your desired entry point,\nbecause it might not hit your desired entry point.\nAs a result, you will experience emotions that a parent doesn’t. You will\nexperience a fear that the market will move without you. You will be fearful\nthat the market will not give you an opportunity to jump on board. Without\nthe right kind of conditioning, you will act upon these fear impulses.\nHad I not gone through all the data I had, I would not have been so assured\nin my decision to wait for the right setup. I accept my process is thorough,\nbut with that preparation comes significant financial reward.\nWithout a doubt, one of the greatest flaws I saw traders exhibit during my\ndecade on a London trading floor was the idea that it is too late to join the\ntrend. It was a common occurrence during trend days to witness clients\ncontinuously try to find the low of the day.\nOn those days our clients lost the most. If the market was rallying, they\nwould either do nothing, or they would try to find a place to sell short. If the\nmarket was falling, they would do nothing; but more likely they would try\nto find the low of the day and buy.\nConsidering the action was so common across such a large group of\nindividuals, I conclude that there is an inherent trading flaw in our thinking\nwhich makes us want to go against the trend. I have previously mentioned\nthis supermarket mentality, which compels us to seek value.\nAnother reason this behaviour is commonplace is because of the prolific use\nof chart indicators that display what is technically known as overbought and\noversold price levels. The use of overbought and oversold indicators has a\nterrible track record in trending markets.\nTo my mind patience is a skillset that can make the difference between\nbeing an abject failure or a wizard. I used the word skillset because I believe\nthat patience can be developed.\nI developed my patience in trading using two methods. Both are practical in\nnature, but they are very different in their application. One is a proactive\nexercise. One is a reflective exercise.\nEXPANDING MY FIELD OF\nINFORMATION\nThe proactive exercise evolved around the concept of expanding the field of\ninformation. I print out the charts of my favourite markets every night,\nwhile the trading session is still fresh in my mind. For example, I will print\nout the DAX Index chart and the FTSE Index chart on both a five-minute\nchart and a ten-minute chart.\nThe reason I am printing out two time frames is because of perspective. I\nfound that my use of the five-minute chart prompted overtrading. By\nconsidering the ten-minute chart I am forcing myself to slow down my\ndecision making. This act of slowing down my time perspective also\nstrengthens my pat", "source": "eBooks\\Tom Hougaard - Best Loser Wins.pdf", "doc_id": "db0d74ee3eb2ba5542f0943f7b8e994e1f3211b7a93aee04b5bfd56525c663f3", "chunk_index": 59}
{"text": "nt\nout the DAX Index chart and the FTSE Index chart on both a five-minute\nchart and a ten-minute chart.\nThe reason I am printing out two time frames is because of perspective. I\nfound that my use of the five-minute chart prompted overtrading. By\nconsidering the ten-minute chart I am forcing myself to slow down my\ndecision making. This act of slowing down my time perspective also\nstrengthens my patience. I see things on a ten-minute chart that give me a\ngreater clarity than if I had seen them on a five-minute chart alone.\nPatience, however, is not a quality that is easy to come by. I am a man in\nmy 50s. Over my lifespan the world has pandered to the impatient. When I\nwas a child, if my family ran out of milk on a Sunday afternoon I would\nhave to wait until Monday morning before I could purchase another bottle.\nEverything was shut on a Sunday.\nForgive me if I sound like a relic. I am really not. I love technological\nadvances. So many wonderful things flow from our advancement of living,\nbut the flipside of the coin is that we as a species have also become\nimpatient.\nThat is important to remember when you set out on a trading journey. Not\nlong ago, I read about a gentleman called Navinder Sarao, a trader who\nbecame synonymous with the infamous 2010 flash crash. In the book Flash\nCrash, by Liam Vaughan, it becomes apparent that some of the primary\nskills that Navinder possessed were focus and patience. According to the\nbook, Navinder Sarao would hide himself away from the other traders he\nworked with, so as not to be disturbed. He needed quiet around him to\nexercise focus and patience.\nThe exercise of printing out the specific charts every day instils in me faith\nthat every day the market will give me an opportunity to make good trades.\nThe exercise is also an opportunity for me to discover new behaviour in the\nmarket and continuously train my mind and eyes to spot patterns. I happen\nto believe that you only see things you have trained your eyes to see.\nIMAGERY AND BREATHING\nThe second exercise is hard to begin with. Some call this exercise\nmeditation. Some call it visual imagery. I don’t have a name for it, but I\nknow what I want to achieve. I want to calm down my mind. Depending on\nthe mood I am in, I will use one of the following tools to keep my mind\ntrained for the task of being a high-stake day trader.\nI sit quietly in a comfortable position, and I observe my breath. I breathe in\nfor seven seconds, and I breathe out for 11. I repeat. I will do as much or as\nlittle as I need to feel calm coming over me. Sometimes it takes five\nminutes. Sometimes it takes 15 minutes.\nThe purpose of the exercise is simply to calm my mind. Through the use of\nbreathing exercises I have been able to increase my attention span\nsignificantly. I was hesitant at first. I was even hesitant to write about it. It\nhas that taste of a new-age fad. The reality is that calming your mind\nthrough breathwork is used extensively by high-performance athletes. I read\nextensively on the topic of meditation amongst Formula 1 drivers. It was\nboth a surprise and a relief that ultra-competitive sportsmen and women,\npeople I admire and am inspired by, are turning their sight inwards to\nimprove their edge.\nI have to be upfront with you. I have no formal training in meditation or\nimagery. I simply trust and let myself be guided by what enters my head.\nMy mental imagery is designed to place myself in physically dangerous\nsituations. I may be face to face with an alligator. I may climb a steep rock\nface. I may surf a monstrous swell. The exercise is simple. I want to elevate\nmy pulse through imagery. Then I want to consciously focus on my breath\nand simply accept the situation for what it is. The aim is to confront the\nimagery and remain calm.\nOnce I am calm, I see myself trading the absolute biggest stake size I am\nallowed by my broker. I see the market move against me, and I visualise my\nP&L go deeply into negative. I feel my pulse elevate, and I focus on\ncalming it down. I repeat this process over and over.\nI see myself riding a trend higher and higher. I see my P&L grow larger and\nlarger. I am waiting for my mind to tell me to take profit. Then I stop the\ntape and flip the switch. I calm my mind down, and I see myself looking at\nmy P&L dispassionately. I calm my breath until I am able to simply observe\nmy profit grow larger and larger as I trend with the market, higher and\nhigher. The goal is simply to be, to be an unemotional observer of the\nmarket. The goal is to act without fear, without hope, without anything but\nan objective assessment of the price action.\nASK FOR HELP\nI believe that beliefs shape our lives. I believe not all my beliefs are\nbeneficial to the life I want to live. I accept they are there, and as my self-\nknowledge evolves I address them to the best of my ability. I have come up\nwith this back-to-front idea of how to address my beliefs.\nIt evolves around the old saying, “I will believe it when I see it.” How about\nturning it on its head to say, “I will see it when I believe it”? This argues\nthat you must believe before you can see. Many of our beliefs have been\npart of our construct since our formative years. They are not going to go\naway without a fight. Of course you might decide not to fight them, but to\naccept them.\nI call this process Ask for Help. I sit with a blank piece of paper, and I pose\na question. It could be, “Why am I afraid to join a down-trend after it\nalready started?” I write down everything that appears in my mind. I sit\nwith my eyes closed and I observe my thoughts. I do not censor myself. I\njust sit and ask and listen and write down.\nI may write for 10–20 minutes. What often appears on paper are thoughts\nstraight out of the psych ward. It scares me at times how brutally to the\npoint and honest the answers can be. It can be quite horrifying to read the\nthings the subconscious mind brings up. I don’t judge. I accept.\nWhen I am working with my beliefs, fighting those beliefs will not work. I\nt", "source": "eBooks\\Tom Hougaard - Best Loser Wins.pdf", "doc_id": "db0d74ee3eb2ba5542f0943f7b8e994e1f3211b7a93aee04b5bfd56525c663f3", "chunk_index": 60}
{"text": "t and ask and listen and write down.\nI may write for 10–20 minutes. What often appears on paper are thoughts\nstraight out of the psych ward. It scares me at times how brutally to the\npoint and honest the answers can be. It can be quite horrifying to read the\nthings the subconscious mind brings up. I don’t judge. I accept.\nWhen I am working with my beliefs, fighting those beliefs will not work. I\nthink giving negative energy to a belief will only cause it to fight for its life.\nThe only thing that works is complete acceptance. I accept what is there. I\nunderstand it. It allows me to retire it. I diffuse it. If I approach it from a\nperspective of “I hate this belief”, it will enforce and entrench itself.\nSay I have a belief about trading that suggests I need to make my money\nquickly. I need to get in on the move first thing in the morning. If I want to\ndiffuse this belief, because I have strong evidence to suggest it is\ndestructive to my trading account, I will ask for help. I will accept the\nbelief. I will diffuse its negative energy, and I will replace it with positive\nenergy. I will reinforce a new belief such as “I will wait for the first ten-\nminute bar to complete before I make a decision to trade”.\nUnfortunately, beliefs do not have the power to dismantle themselves. All\nbeliefs demand expression. Desire and willingness to ask questions from a\nsincere space, with a sincere mindset, will give you answers.\nWhen I use the Ask for Help process, I know it is complete when I can distil\nmy question into a short one-sentence answer. Then I know I have\ncondensed the exercise into its lowest common denominator, and I have\ndiffused whatever belief I had that didn’t serve me. The old memory will\nalways be there, but the context has changed from negative to positive.\nIt is important for me to remind you that money is a by-product of the ideal\ntrading mindset. You are creating a process that will guarantee an optimal\nmindset for your trading life. The essence of good trading lies squarely in\nhow we think and perceive information about the markets. It has everything\nto do with how we think and how we live our lives.\nToday I spoke to a friend of mine. We had not spoken in a while. I consider\nhim a very close friend, and it was a joy to reconnect. As he spoke, I\nlistened intently. You have two ears and one mouth. Use them in that\nproportion. He was talking animatedly about his trading and how well it\nwas going. In between the stream of sentences, I picked up on a sentence\nthat spoke volumes: “I am still working on increasing my trading size.”\nI thought long and hard about that sentence, knowing I was going to write\nthis final chapter today. My friend first spoke to me about increasing his\ntrading size back in 2015. Today it is 2022. He has spent seven years talking\nabout increasing his trading size. What does that tell you about his desire to\nincrease his trading size? Do you think there might be a misalignment\nbetween what he says he wants, and what he is actually doing to get what\nhe wants?\nI often tell my children this. Do what you have to do, so that you can do\nwhat you want to do. I tell them to make up their minds what they want but\nthink very long and hard about it first. If you say you want something, and\nthen you do nothing about it, then you can be damn certain there is a\nmisalignment between your conscious and your subconscious. When I am\nfaced with a situation like that, I use the Ask for Help exercise, and I always\nget a brutally honest answer. The most common answer I get is: “Actually\nyou say want it, but you don’t!”\nThe idea of deciding what you want can undo a lifetime of negative energy\nsurrounding your beliefs and your belief system. The power of making up\nyour mind will remove all negative energy surrounding a belief system. I\nhave come to accept that many people do not want to do that. We fall in\nlove with our drama. We cling on to our drama because it validates us and\ngives us attention.\nWhen I am out of sorts, angry, frustrated, I ask questions and work my way\nbackwards. I work my way to the source of the problem. Anger is often a\nself-defence mechanism. If I am angry, I need to know what the underlying\nbelief for the anger is. So, I ask.\nI am often told I am very disciplined. This is not true. The word itself is an\noxymoron. Discipline implies the use of force and will. My action flows\nfrom a love of what I do. I don’t have to apply will to do what I do. Those\nwho are self-disciplined don’t think of themselves as self-disciplined. They\nare just expressing themselves in harmony with their own dreams and goals\nand desires.\nWhen you watch spiritual movies like The Secret and listen to self-help\ntapes, you get this sense that the universe is a menu, and you can help\nyourself to whatever you want. I find that to be one of the most distressing\naspects of the self-help industry, be it neurolinguistic programming or Law\nof Attraction or whatever name the latest fad goes by.\nI have stood in an auditorium and listened to motivational speakers make\ntheir audience shout out whatever grievances are holding them back, and\nthen push the audience towards their private island retreat for untold sums. I\nnever believed in it. I don’t believe anyone ever achieved anything\nspectacular without putting in a massive amount of effort. I know I put in\nthe effort. I know that everything I do on a daily basis is the result of grit\nand determination. I am not talented. I am hard working. I am not gifted. I\nam determined. I am not lucky. I am persistent.\nTWENTY TRADES\nMy friend Dr David Paul gave me an exercise, which at its heart is designed\nto strengthen the process of your trading. It is as simple as it is difficult.\nYour job is to execute 20 trades, as the signals appear.\nOne by one, you take every trade signal as it comes. The purpose of the\nexercise is not actually to make money. You will probably break even, and\nthat is fine. The purpose of the exercise is to smoke out your internal\nconflicts and y", "source": "eBooks\\Tom Hougaard - Best Loser Wins.pdf", "doc_id": "db0d74ee3eb2ba5542f0943f7b8e994e1f3211b7a93aee04b5bfd56525c663f3", "chunk_index": 61}
{"text": "which at its heart is designed\nto strengthen the process of your trading. It is as simple as it is difficult.\nYour job is to execute 20 trades, as the signals appear.\nOne by one, you take every trade signal as it comes. The purpose of the\nexercise is not actually to make money. You will probably break even, and\nthat is fine. The purpose of the exercise is to smoke out your internal\nconflicts and your unresolved emotions.\nIt has at its core the idea that if you can execute 20 trades without any kind\nof conflict, you are trading from a carefree and fearless frame of mind. This\nmeans you are trading from the perspective that:\n1. Anything can happen – and you are emotionally detached from the\noutcome.\n2. Every moment is unique – and you are no longer drawing\nassociations between this moment and another moment. You are pain\nfree.\n3. There is a random distribution of wins and losses – you accept the\noutcome as if it were a coin-flip exercise.\n4. You don’t have to know what will happen next to make money – so\nyou trust the process, and you focus on controlling the only variable\nyou truly can control, which is how much you want to risk on this\ntrade.\nThe purpose of the exercise is to add energy to your beliefs. Until you can\ndo that without conflict and unresolved thoughts and conflicting energy\nissues, the negative charge will not dissipate.\nHow do you know when you are successful? When you can trade without\nany conflicting or competing thoughts. The results are not important during\nthe exercise. This a process exercise. You may have to repeat the 20 trades\nover and over until you come to a point where you find that you are firing\noff trades without fear, without hesitation, without connecting this moment\nwith a past moment, and you accept the outcome dispassionately. When you\narrive there, you really have arrived!\nDISASSOCIATION\nA friend called. She had put up a post on a social media outlet, and her post\nwas very ill received. She endured a torrent of abuse for what was a well-\nintentioned post. She called me for help. I read her post and the slew of\nabusive comments. To me, however, they were just words. They were\nwords without energy.\nI dispassionately read the posts, and then I explained to her what to do. As\ntraders we need to work towards being as dispassionate about our trading as\nI was about her social media post. The more we work on this, the better we\nwill trade. Some will argue against me. Remember, I am writing this from\nthe perspective of what works for me.\nHow do you do trade dispassionately? How do you disassociate yourself\nfrom feeling anything when you are trading? Well, that is what my exercises\ntake care of. If you want to be able to receive information from the market,\nwithout feeling threatened, it will not happen by itself. I believe working on\nwhat you think and how you respond and evaluate your responses will\nimprove your trading in measures you would struggle to appreciate right\nnow.\nI once sped down the autobahn doing 186 miles an hour. Yes, it was\nreckless. Whilst doing it, I wasn’t wondering if there was milk in the fridge\nor if I had remembered to floss my teeth this morning. I was in the moment.\nFocused. That is what I want to bring to my trading every day.\nEvery moment is unique. That does not mean we have to act like a formless\nblob with no memory of the past. There will always be some degree of\ncorrespondence. However, just because I was rejected by a girl the first time\nI invited her for a dance does not mean I will be rejected the next time. But\nmy mind might think so, so I may have an argument with my conscious\nthinking and my subconscious beliefs.\nMy rational mind might say, “The next girl will say yes to a dance.” My\nsubconscious mind, unbeknownst to me, might say, “No way amigo, give\nup, she will never dance with you.” If you have a moment of doubt before\nventuring over to ask the lucky lady, you know you are not aligned. When I\nexperience this in my trading, I will Ask for Help, or I will use imagery to\nresolve whatever is going on in my head.\nMIND LOOP\nMy training involves accepting pain and making it part of my existence\nthrough habit and repetition, so that my degree of pain tolerance is\nexpanded. I also have to train my mind about expectations, and how to deal\nwith unrealised expectations.\nThis requires a tenacious effort, through journalling, mental imagery, and\nasking for help. You may quite rightly ask, “Does it work?” I think it does.\nIt has revolutionised my trading. As I type these words, in March 2022, I\nhave not had a losing day since September 2021. That is nearly seven\nmonths without a single losing day.\nI don’t think this should be celebrated. I am not writing this to show off in\nany shape or form. The intention is to inspire you to take the mental side of\ntrading almost as seriously as the technical side. If I were to describe the\nbeliefs that are the foundation for my trading, they would resemble a\nflowchart, one where the entire mindset ecosystem forms a loop.\nMy trust (in the markets and in myself) supports my patience. My patience\n(that a setup will materialise) feeds my confidence. My confidence (that I\nwill win) dictates my inner dialogue. My inner dialogue (what I tell myself\nwhile I am trading) supports my process-oriented mindset. The process\nenables me to stay focused in this moment. I support this loop with my\nmental exercises. They feed, nourish and sustain the loop.\nI am a process-oriented trader. I do not believe in goal setting. There are no\nPost-It Notes on my monitor reminding me how much I want to make today\nor this month or year. I have no monetary goals or pip/point goals. I will\ntake what the market will give me. I never trade with targets.\nBy being utterly focused on the process as opposed to being outcome\noriented, I ensure that I am staying present. When you are present, you\ndon’t connect past moments with this moment or future moments. You are\nright here, right now.\nBeing present is what some would call mindfulnes", "source": "eBooks\\Tom Hougaard - Best Loser Wins.pdf", "doc_id": "db0d74ee3eb2ba5542f0943f7b8e994e1f3211b7a93aee04b5bfd56525c663f3", "chunk_index": 62}
{"text": "r. I have no monetary goals or pip/point goals. I will\ntake what the market will give me. I never trade with targets.\nBy being utterly focused on the process as opposed to being outcome\noriented, I ensure that I am staying present. When you are present, you\ndon’t connect past moments with this moment or future moments. You are\nright here, right now.\nBeing present is what some would call mindfulness. I call it focus. I call it\nconcentration. I call it knowing what I want. I want to win. That is my\noverriding motive for trading – to win. I want to win, but I don’t mind\nlosing.\nHowever, I know that if I forget all about winning, and I focus on the\nprocess, I will win. It is an idiosyncratic conundrum that for a long time I\njust could not believe and give into. How can I win if I am not focused on\nthe goal at all times?\nIt took me almost a decade to figure out that process is everything. Don’t\nfocus on the goal. Sure, know what the goal is, but focus on the process.\nTrust the process. I built my trading life around this mind loop. How does\nthe loop look?\nI trust. The research underpins the trust. The trust supports the patience. The\npatience is underpinned by the mental exercises, and it nourishes my\nconfidence. My internal dialogue is driven by a process-oriented mindset,\nfuelled by my confidence. I focus on what I can control – my mindset, my\nrisk approach – and I let the market do what it wants to do. Whatever it\ndoes, does not fuel the fearful side of my mind. That has been trained away.\nI am not afraid of the market. The only thing I am afraid of is that I do\nsomething stupid in the market. As I trust myself, this does not happen.\nI trust that I have the skills to make money, and I trust that the market will\ngive me opportunities to make money. This trust has been nurtured and\nstrengthened by my intense study of market charts for the time period I\ndesire to trade. The trust is further strengthened by continuous dedication to\nmy vocational skillset.\nMy patience flows from my trust in the market and in myself. I have built\nan emotional connection between trust and patience. I trust the setups will\ncome, if I am patient. If I am patient, I will win. Winning means more than\nanything else to me. If I am not patient, I will not win. I will do anything to\nwin. Therefore, the trust overrides any emotional impatience that may arise\nin my mind, because I trust that if I miss this signal, there will be another\none coming.\nMy confidence comes from continuously working on my game. I don’t\nlearn technical analysis once. I learn all the time. Some markets move.\nSome markets are dead. Some markets require larger stops. Some require\nyou to trade with orders because they move so fast. The markets are forever\nchanging, and I change with them.\nMy inner dialogue stems from the trust and the patience and the confidence.\nOf course, yours truly has bad trading days. I just don’t let it bother me. I\nam grounded in this moment. I focus on the process. That is all I can do. I\ncan’t dictate to the market what it must do. I must be like water, and flow. I\nmust flow with the market. I don’t fight the market. I flow with the market.\n“Just flow,” I tell myself.\nThis is what lies behind the process. I never expect to be comfortable when\nI am trading. If I am comfortable, I know I am not pushing the boundaries\nof what I am capable of. I know that to get the best out of myself I need to\nbe a little uncomfortable. I will give you an example.\nI sold short the Dow Index in my Telegram channel (timestamped for\nauthenticity and verification). I have marked my entry point in Figure 28.\nInitially, the market moves against me. Then it turns and trends lower. As it\ntrends lower, I am mindful of my mind saying, “Take profit.” That voice\nused to be much louder. Now I am so focused on the process that the voice\nis no longer heard. I focus on the process, not on the outcome.\nFigure 28\nHowever, at one point I have 200 points in profit and the market sits at an\nold low. I have to accept that there is a real possibility the market will\nrebound from there, and much of my 200-point profit will disappear. That is\nbeing uncomfortable. I accept it and decide to let the position ride.\nDo you know why I let it ride? Because I know myself well enough to\naccept that if I took profit, and the market then continued lower, I would\nfeel awful. The pain of seeing a market giving you even more profit when\nyou are not on board is much greater than the pain of seeing some of your\npaper profit disappear – to me at least!\nThis time it worked. Tomorrow it might not work. I have to trust the process\nwill sustain me over the long run and be less concerned about the outcome\nof a single event. Remember, there is complete randomness in the outcome\nof one event, but over hundreds of observations there is no randomness.\nA trading life is not defined by what we do every now and then, but by what\nwe do over and over. You will never be able to trade without having losing\ntrades. The whole purpose for giving this book the title it has, Best Loser\nWins, is to illustrate this point right from the beginning. The one who is best\nable to lose will win the game of trading.\nThe survey of 25,000 traders executing 43 million FX trades over a 15-\nmonth period illustrates this point perfectly. Overall, they had more winning\ntrades than losing trades. Out of those 43 million trades, up to 61% of them\nwere winners, depending on what currency pair they traded.\nWhat does that tell you?\nIt tells you that those 25,000 traders have a good grasp on the markets and\nwhere to place their trades. It tells you that if they were somehow able to\noperate with a 1:1 risk-to-reward ratio, they would win 61 out of 100 and\nlose 39 out of 100. That is a winning formula. That creates a net positive\ntrade flow of 22. That is a business model that has an integral foundation.\nThe problem is that the survey shows that when they win, they win on\naverage 43 pips. When they lose, they lose on average 83 pi", "source": "eBooks\\Tom Hougaard - Best Loser Wins.pdf", "doc_id": "db0d74ee3eb2ba5542f0943f7b8e994e1f3211b7a93aee04b5bfd56525c663f3", "chunk_index": 63}
{"text": "It tells you that if they were somehow able to\noperate with a 1:1 risk-to-reward ratio, they would win 61 out of 100 and\nlose 39 out of 100. That is a winning formula. That creates a net positive\ntrade flow of 22. That is a business model that has an integral foundation.\nThe problem is that the survey shows that when they win, they win on\naverage 43 pips. When they lose, they lose on average 83 pips. In other\nwords, they lose twice as much (almost) on their losing trade than they\nmake on their winning trades.\nLet’s say 100 trades are executed.\n61 winners at 43 pips = 2,623 pips\n39 losers at 83 pips = 3,237 pips\nWhat does that tell you?\nIt tells you that they are good at picking winners, but when they are faced\nwith a losing trade, they don’t have the mental discipline to cut the loss.\nWhat does that tell you?\nIt tells you that they need to work on their mental game so that they are\nbetter equipped to handle losses. Their minds are most likely wired to\nassociate pain with taking a loss. The mind has at its core a mandate to\nprotect you against pain – physical as well as mental pain, perceived pain\nand real pain.\nFINAL WORDS\nYour path to becoming a profitable trader lies not in better understanding\nthe markets, but in better understanding your mind. Your mind and how you\noperate it will dictate the level of success you have as a trader.\nI am going to go out on a limb and tell you something about you. People\nreading this book could have fallen into one of two categories, but I doubt\nit. I doubt that new traders, who have never traded before, will ever\ngravitate towards a book like mine.\nThey are more likely to buy books that have titles like Mastering Trading or\nTrade Your Way to Financial Independence. This kind of book will be 300\npages of technical analysis and most likely not contain a single mention of\nlosing trades. It will contain page after page of perfect chart examples.\nThis book, I speculate, will be read by the people who previously bought\nthe sort of book mentioned above, but have come to the realisation that the\ngap between where they are now and where they know they can be can only\nbe bridged by a better mindset.\nThe advantage I have in writing this book is that I don’t have to establish\nmy credentials. I have a four-year public track record, timestamped and\nreadily available for anyone to read. I post my broker trades in Excel format\non my website and in my Telegram channel daily. There are plenty of bad\ntrades in that track record, I assure you, but somehow I still manage to\nmake money overall, and quite significantly so.\nTherefore, the focus now needs to be on the actual steps I have taken – and\nstill take – to ensure I stay at the top of my game. That is where you are\nheaded now.\nI want to finish the book on a note which is important to me. I have\ndescribed a process that works for me. It is based around my particular\nbeliefs. Those beliefs are the result of my particular life circumstances.\nI believe that beliefs are defined by one’s own desires and needs. As a result\nof my desire to be a profitable trader, and my need to create financial\nstability in my life, I have acquired beliefs that are consistent with this goal.\nThat said, I accept that my way is not the only way. I don’t describe the\nway. I describe my way. Whatever you decide is right for you is right for\nyou. Trust it.\nI periodically suffer from verbal diarrhoea on the mental aspect of trading. I\npost my musings on both www.BestLoserWins.com as well as on my\nwebsite www.TraderTom.com\nHave a wonderful journey.\nWith love.\nTom Hougaard\nABOUT THE AUTHOR\nTOM HOUGAARD studied economics and finance at two universities in the United\nKingdom, and then went on to work for JPMorgan Chase before spending\nthe next ten years in the City of London as a chief market strategist for a\nCFD broker. He has given thousands of TV and radio interviews on the\nstate of the market and has educated tens of thousands of clients on trading\nstrategies. Since 2009 he has traded for himself.\nTom has self-published several works on trading psychology, price action\nand product knowledge.\nYou can follow Tom’s trading via Telegram and YouTube. You can view his\ntrading results at www.tradertom.com\nTable of Contents\nCover\nTitle\nCopyright\nDedication\nContents\nDear Markets\nPreface\nIntroduction\nLiar’s Poker\nThe Trading Floor\nEveryone Is a Chart Expert\nThe Curse of Patterns\nFighting My Humanness\nDisgust\nThe Drifter Mind\nTrading Through a Slump\nEmbracing Failure\nBest Loser Wins\nThe Ideal Mindset\nAbout the Author", "source": "eBooks\\Tom Hougaard - Best Loser Wins.pdf", "doc_id": "db0d74ee3eb2ba5542f0943f7b8e994e1f3211b7a93aee04b5bfd56525c663f3", "chunk_index": 64}
{"text": "Contents Foreword\nPreface\nAcknowledgments\nPart I: The Basics of Option Greeks\nChapter 1: The Basics\nContractual Rights and Obligations\nETFs, Indexes, and HOLDRs\nStrategies and At-Expiration Diagrams\nChapter 2: Greek Philosophy\nPrice vs. Value: How Traders Use Option-Pricing Models\nDelta\nGamma\nTheta\nVega\nRho\nWhere to Find Option Greeks\nCaveats with Regard to Online Greeks\nThinking Greek\nNotes\nChapter 3: Understanding Volatility\nHistorical Volatility\nImplied Volatility\nExpected Volatility\nImplied Volatility and Direction\nCalculating Volatility Data\nVolatility Skew\nNote\nChapter 4: Option-Specific Risk and Opportunity\nLong ATM Call\nLong OTM Call\nLong ITM Call\nLong ATM Put\nFinding the Right Risk\nIt’s All About Volatility\nOptions and the Fair Game\nNote\nChapter 5: An Introduction to Volatility-Selling\nStrategies\nProfit Potential\nChapter 6: Put-Call Parity and Synthetics\nPut-Call Parity Essentials\nAmerican-Exercise Options\nSynthetic Stock\nSynthetic Stock Strategies\nTheoretical Value and the Interest Rate\nA Call Is a Put\nNote\nChapter 7: Rho\nRho and Interest Rates\nRho and Time\nConsidering Rho When Planning Trades\nTrading Rho\nNotes\nChapter 8: Dividends and Option Pricing\nDividend Basics\nDividends and Option Pricing\nDividends and Early Exercise\nInputting Dividend Data into the Pricing Model\nPart II: Spreads\nChapter 9: Vertical Spreads\nVertical Spreads\nVerticals and Volatility\nThe Interrelations of Credit Spreads and Debit Spreads\nBuilding a Box\nVerticals and Beyond\nNote\nChapter 10: Wing Spreads\nCondors and Butterflies\nTaking Flight\nKeys to Success\nGreeks and Wing Spreads\nDirectional Butterflies\nConstructing Trades to Maximize Profit\nThe Retail Trader versus the Pro\nNotes\nChapter 11: Calendar and Diagonal Spreads\nCalendar Spreads\nTrading Volatility Term Structure\nDiagonals\nThe Strength of the Calendar\nNote\nPart III: Volatility\nChapter 12: Delta-Neutral Trading\nDirection Neutral versus Direction Indifferent\nDelta Neutral\nTrading Implied Volatility\nConclusions\nChapter 13: Delta-Neutral Trading\nGamma Scalping\nArt and Science\nGamma, Theta, and Volatility\nGamma Hedging\nSmileys and Frowns\nChapter 14: Studying Volatility Charts\nNine Volatility Chart Patterns\nNote\nPart IV: Advanced Option Trading\nChapter 15: Straddles and Strangles\nLong Straddle\nShort Straddle\nSynthetic Straddles\nLong Strangle\nShort Strangle\nNote\nChapter 16: Ratio Spreads and Complex Spreads\nRatio Spreads\nHow Market Makers Manage Delta-Neutral Positions\nTrading Skew\nWhen Delta Neutral Isn’t Direction Indifferent\nManaging Multiple-Class Risk\nChapter 17: Putting the Greeks into Action\nTrading Option Greeks\nChoosing between Strategies\nManaging Trades\nThe HAPI: The Hope and Pray Index\nAdjusting\nAbout the Author\nIndex\nSince 1996, Bloomberg Press has published books for financial\nprofessionals on investing, economics, and policy affecting investors. Titles\nare written by leading practitioners and authorities, and have been translated\ninto more than 20 languages.\nThe Bloomberg Financial Series provides both core reference knowledge\nand actionable information for financial professionals. The books are\nwritten by experts familiar with the work flows, challenges, and demands of\ninvestment professionals who trade the markets, manage money, and\nanalyze investments in their capacity of growing and protecting wealth,\nhedging risk, and generating revenue.\nFor a list of available titles, please visit our web site at\nwww.wiley.com/go/bloombergpress .\n\nCopyright © 2012 by Dan Passarelli. All rights reserved.\nPublished by John Wiley & Sons, Inc., Hoboken, New Jersey.\nFirst edition was published in 2008 by Bloomberg Press.\nPublished simultaneously in Canada.\nNo part of this publication may be reproduced, stored in a retrieval system,\nor transmitted in any form or by any means, electronic, mechanical,\nphotocopying, recording, scanning, or otherwise, except as permitted under\nSection 107 or 108 of the 1976 United States Copyright Act, without either\nthe prior written permission of the Publisher, or authorization through\npayment of the appropriate per-copy fee to the Copyright Clearance Center,\nInc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978)\n646-8600, or on the Web at www.copyright.com . Requests to the Publisher\nfor permission should be addressed to the Permissions Department, John\nWiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011,\nfax (201) 748-6008, or online at www.wiley.com/go/permissions .\nLimit of Liability/Disclaimer of Warranty: While the publisher and author\nhave used their best efforts in preparing this book, they make no\nrepresentations or warranties with respect to the accuracy or completeness\nof the contents of this book and specifically disclaim any implied warranties\nof merchantability or fitness for a particular purpose. No warranty may be\ncreated or extended by sales representatives or written sales materials. The\nadvice and strategies contained herein may not be suitable for your\nsituation. You should consult with a professional where appropriate. Neither\nthe publisher nor author shall be liable for any loss of profit or any other\ncommercial damages, including but not limited to special, incidental,\nconsequential, or other damages.\nLong-Term AnticiPation Securities® (LEAPS) is a registered trademark of\nthe Chicago Board Options Exchange.\nStandard & Poor’s 500® (S&P 500) and Standard & Poor’s Depository\nReceipts™ (SPDRs) are registered trademarks of the McGraw-Hill\nCompanies, Inc.\nPower Shares QQQ™ is a registered trademark of Invesco PowerShares\nCapital Management LLC.\nNASDAQ-100 Index® is a registered trademark of The NASDAQ Stock\nMarket, Inc.\nFor general information on our other products and services or for technical\nsupport, please contact our Customer Care Department within the United\nStates at (800) 762-2974, outside the United States at (317) 572-3993 or fax\n(317) 572-4002.\nWiley also publishes its books in a variety of electronic formats. Some\ncontent that appears in print may not be available", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 0}
{"text": "ark of The NASDAQ Stock\nMarket, Inc.\nFor general information on our other products and services or for technical\nsupport, please contact our Customer Care Department within the United\nStates at (800) 762-2974, outside the United States at (317) 572-3993 or fax\n(317) 572-4002.\nWiley also publishes its books in a variety of electronic formats. Some\ncontent that appears in print may not be available in electronic books. For\nmore information about Wiley products, visit our web site at\nwww.wiley.com .\nLibrary of Congress Cataloging-in-Publication Data :\nPassarelli, Dan, 1971-\nTrading options Greeks : how time, volatility, and other pricing factors\ndrive profits / Dan Passarelli. – 2nd ed.\np. cm. – (Bloomberg financial series)\nIncludes index.\nISBN 978-1-118-13316-3 (cloth); ISBN 978-1-118-22512-7 (ebk); ISBN\n978-1-118-26322-8 (ebk); ISBN 978-1-118-23861-5 (ebk)\n1. Options (Finance) 2. Stock options. 3. Derivative securities. I. Title.\nHG6024.A3P36 2012\n332.64′53—dc23\n2012019462\n\nThis book is dedicated to Kathleen, Sam, and Isabel. I wouldn’t trade them\nfor all the money in the world .\nDisclaimer\nThis book is intended to be educational in nature, both theoretically and\npractically. It is meant to generally explore the factors that influence option\nprices so that the reader may gain an understanding of how options work in\nthe real world. This book does not prescribe a specific trading system or\nmethod. This book makes no guarantees.\nAny strategies discussed, including examples using actual securities and\nprice data, are strictly for illustrative and educational purposes only and are\nnot to be construed as an endorsement, recommendation, or solicitation to\nbuy or sell securities. Examples may or may not be based on factual or\nhistorical data.\nIn order to simplify the computations, examples may not include\ncommissions, fees, margin, interest, taxes, or other transaction costs.\nCommissions and other costs will impact the outcome of all stock and\noptions transactions and must be considered prior to entering into any\ntransactions. Investors should consult their tax adviser about potential tax\nconsequences. Past performance is not a guarantee of future results.\nOptions involve risks and are not suitable for everyone. While much of\nthis book focuses on the risks involved in option trading, there are market\nsituations and scenarios that involve unique risks that are not discussed.\nPrior to buying or selling an option, a person should read Characteristics\nand Risks of Standardized Options (ODD) . Copies of the ODD are\navailable from your broker, by calling 1-888-OPTIONS, or from The\nOptions Clearing Corporation, One North Wacker Drive, Chicago, Illinois\n60606.\nForeword\nThe past several years have brought about a resurgence in market volatility\nand options volume unlike anything that has been seen since the close of the\ntwentieth century. As markets have become more interdependent,\ninterrelated, and international, the U.S. listed option markets have solidified\ntheir place as the most liquid and transparent venue for risk management\nand hedging activities of the world’s largest economy. Technology,\ncompetition, innovation, and reliability have become the hallmarks of the\nindustry, and our customer base has benefited tremendously from this\nongoing evolution.\nHowever, these advances can be properly tapped only when the users of\nthe product continue to expand their knowledge of the options product and\nits unique features. Education has always been the driver of growth in our\nbusiness, and it will be the steward of the next generation of options traders.\nDan Passarelli’s new and updated book Trading Option Greeks is a\nnecessity for customers and traders alike to ensure that they possess the\nknowledge to succeed and attain their objectives in the high-speed, highly\ntechnical arena that the options market has become.\nThe retail trader of the past has given way to a new retail trader of the\npresent—one with an increased level of technology, support, capital\ntreatment, and product selection. The impact of the staggering growth in\nsuch products as the CBOE Holdings’ VIX options and futures, and the\nliterally dozens of other products tied to it, have made the volatility asset\nclass a new, unique, and permanent pillar of today’s option markets.\nDan’s updated book continues his mission of supporting, preparing, and\nreinforcing the trader’s understanding of pricing, volatility, market\nterminology, and strategy, in a way that few other books have been able.\nUsing a perspective forged from years as an options market maker,\nprofessional trader, and customer, Dan has once again provided a resource\nfor those who wish to know best how the option markets behave today, and\nhow they are likely to continue to behave in the future. It is important to\nunderstand not only what happens in the options space, but also why it\nhappens. This book is intended to provide those answers. I wish you all the\nbest in your trading!\nWilliam J. Brodsky\nChairman and CEO Chicago Board Options Exchange\nPreface\nI’ve always been fascinated by trading. When I was young, I’d see traders\non television, in their brightly colored jackets, shouting on the seemingly\nchaotic trading floor, and I’d marvel at them. What a wonderful job that\nmust be! These traders seemed to me to be very different from the rest of\nus. It’s all so very esoteric.\nIt is easy to assume that professional traders have closely kept secrets to\ntheir ways of trading—something that secures success in trading for them,\nbut is out of reach for everyone else. In fact, nothing could be further from\nthe truth. If there are any “secrets” of professional traders, this book will\nexpose them.\nTrue enough, in years past there have been some barriers to entry to\ntrading success that did indeed make it difficult for nonprofessionals to\nsucceed. For example, commissions, bid-ask spreads, margin requirements,\nand information flow all favored the professional trader. Now, these barriers\nare gone. Competi", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 1}
{"text": "e truth. If there are any “secrets” of professional traders, this book will\nexpose them.\nTrue enough, in years past there have been some barriers to entry to\ntrading success that did indeed make it difficult for nonprofessionals to\nsucceed. For example, commissions, bid-ask spreads, margin requirements,\nand information flow all favored the professional trader. Now, these barriers\nare gone. Competition among brokers and exchanges—as well as the\nubiquity of information as propagated on the Internet—has torn down those\nwalls. The only barrier left between the Average Joe and the options pro is\nthat of knowledge. Those who have it will succeed; those who do not will\nfail.\nTo be sure, the knowledge held by successful traders is not that of what\nwill happen in the future; it is the knowledge of how to manage the\nuncertainty. No matter what our instincts tell us, we do not know what will\nhappen in the future with regard to the market. As Socrates put it, “The only\ntrue wisdom is in knowing you know nothing.” The masters of option\ntrading are masters of managing the risk associated with what they don’t\nknow—the risk of uncertainty.\nAs an instructor, I’ve talked to many traders who were new to options\nwho told me, “I made a trade based on what I thought was going to happen.\nI was right, but my position lost money!” Choosing the right strategy makes\nall the difference when it comes to mastery of risk management and\nultimate trading success. Knowing which option strategy is the right\nstrategy for a given situation comes with knowledge and experience.\nAll option strategies are differentiated by their unique risk characteristics.\nSome are more sensitive to directional movement of the underlying asset\nthan others; some are more affected by time passing than others. The exact\nexposure positions have to these market influences determines the success\nof individual trades and, indeed, the long-term success of the trader who\nknows how to exploit these risk characteristics. These option-value\nsensitivities can be controlled when a trader understands the option greeks.\nOption greeks are metrics used to measure an option’s sensitivity to\ninfluences on its price. This book will provide the reader with an\nunderstanding of these metrics, to help the reader truly master the risk of\nuncertainty associated with option trading.\nSuccessful traders strive to create option positions with risk-reward\nprofiles that benefit them the most in a given situation. A trader’s objectives\nwill dictate the right strategy for the right situation. Traders can tailor a\nposition to fit a specific forecast with respect to the time horizon; the degree\nof bullishness, bearishness, neutrality, or volatility in the underlying stock;\nand the desired amount of leverage. Furthermore, they can exploit\nopportunities unique to options. They can trade option greeks. This opens\nthe door to many new opportunities.\nA New Direction\nTraders, both professional and retail, need ways to act on their forecasts\nwithout the constraints of convention. “Get long, or do nothing” is no\nlonger a viable business model for people active in the market. “Up is good;\ndown is bad” is burned into traders’ minds from the beginning of their\nmarket education. This concept has its place in the world of investing, but\nbecoming an active trader in the option market requires thinking in a new\ndirection.\nMarket makers and other expert option traders look at the market\ndifferently from other traders. One fundamental difference is that these\ntraders trade all four directions: up, down, sideways, and volatile.\nTrading Strategies\nBuying stock is a trading strategy that most people understand. In practical\nterms, traders who buy stock are generally not concerned with the literal\nownership stake in a corporation, just the opportunity to profit if the stock\nrises. Although it’s important for traders to understand that the price of a\nstock is largely tied to the success or failure of the corporation, it’s essential\nto keep in mind exactly what the objective tends to be for trading a stock: to\nprofit from changes in its price. A bullish position can also be taken in the\noptions market. The most basic example is buying a call.\nA bearish position can be taken by trading stock or options, as well. If\ntraders expect the value of a stock they own to fall, they will sell the stock.\nThis eliminates the risk of losses from the stock’s falling. If the traders do\nnot own the stock that they think will decline, they can take a more active\nstance and short it. The short-seller borrows the stock from a party that\nowns it and then sells the borrowed shares to another party. The goal of\nselling stock short is to later repurchase the shares at a lower price before\nreturning the stock to its owner. It is simply reversing the order of “buy\nlow/sell high.” The risk is that the stock rises and shares have to be bought\nat a higher price than that at which they were sold. Although shorting stock\ncan lead to profits when the market cooperates, in the options market, there\nare alternative ways to profit from falling prices. The most basic example is\nbuying a put.\nA trader can use options to take a bullish or bearish position, given a\ndirectional forecast. Sideways, nontrending stocks and their antithesis,\nvolatile stocks, can be traded as well. In the later market conditions, profit\nor loss can be independent of whether the stock rises or falls. Opportunity\nin option trading is not necessarily black and white—not necessarily up and\ndown. Option trading is nonlinear. Consequently, more opportunities can be\nexploited by trading options than by trading stock.\nOption traders must consider the time period in question, the volatility\nexpected during this period, interest rates, and dividends. Along with the\nstock price, these factors make up the dynamic components of an option’s\nvalue. These individual factors can be isolated, measured, and exploited.\nIncremental changes in any of these elements as measured by opti", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 2}
{"text": "y trading options than by trading stock.\nOption traders must consider the time period in question, the volatility\nexpected during this period, interest rates, and dividends. Along with the\nstock price, these factors make up the dynamic components of an option’s\nvalue. These individual factors can be isolated, measured, and exploited.\nIncremental changes in any of these elements as measured by option greeks\nprovide opportunity for option traders. Because of these other influences,\ndirection is not the only tradable element of a forecast. Time, volatility,\ninterest rates—these can all be traded using option greeks. These factors\nand more will all be discussed at great length throughout this book.\nThis Second Edition of Trading\nOption Greeks\nThis book addresses the complex price behavior of options by discussing\noption greeks from both a theoretical and a practical standpoint. There is\nsome tactical discussion throughout, although the objective of this book is\nto provide education to the reader. This book is meant to be less a how-to\nmanual than a how-come tutorial.\nThis informative guide will give the retail trader a look inside the mind of\na professional trader. It will help the professional trader better understand\nthe essential concepts of his craft. Even the novice trader will be able to\napply these concepts to basic options strategies. Comprehensive knowledge\nof the greeks can help traders to avoid common pitfalls and increase profit\npotential.\nMuch of this book is broken down into a discussion of individual\nstrategies. Although the nuances of each specific strategy are not relevant,\npresenting the material this way allows for a discussion of very specific\nsituations in which greeks come into play. Many of the concepts discussed\nin a section on one option strategy can be applied to other option strategies.\nAs in the first edition of Trading Option Greeks , Chapter 1 discusses\nbasic option concepts and definitions. It was written to be a review of the\nbasics for the intermediate to advanced trader. For newcomers, it’s essential\nto understand these concepts before moving forward.\nA detailed explanation of option greeks begins in Chapter 2. Be sure to\nleave a bookmark in this chapter, as you will flip to it several times while\nreading the rest of the book and while studying the market thereafter.\nChapter 3 introduces volatility. The same bookmark advice can be applied\nhere, as well. Chapters 4 and 5 explore the minds of option traders. What\nare the risks they look out for? What are the opportunities they seek? These\nchapters also discuss direction-neutral and direction-indifferent trading. The\nremaining chapters take the reader from concept to application, discussing\nthe strategies for nonlinear trading and the tactical considerations of a\nsuccessful options trader.\nNew material in this edition includes updated examples, with more\ncurrent price information throughout many of the chapters. More detailed\ndiscussions are also included to give the reader a deeper understanding of\nimportant topics. For example, Chapter 8 has a more elaborate explanation\nof the effect of dividends on option prices. Chapter 17 of this edition has\nnew material on strategy selection, position management, and adjusting, not\nfeatured in the first edition of the book.\nAcknowledgments\nA book like Trading Option Greeks is truly a collaboration of the efforts of\nmany people. In my years as a trader, I had many teachers in the School of\nHard Knocks. I have had the support of friends and family during the trials\nand tribulations throughout my trading career, as well as during the time\nspent writing this book, both the first edition and now this second edition.\nSurely, there are hundreds of people whose influences contributed to the\ncreation of this book, but there are a few in particular to whom I’d like to\ngive special thanks.\nI’d like to give a very special thanks to my mentor and friend from the\nCBOE’s Options Institute, Jim Bittman. Without his help this book would\nnot have been written. Thanks to Marty Kearney and Joe Troccolo for\nlooking over the manuscript. Their input was invaluable. Thanks to Debra\nPeters for her help during my career at the Options Institute. Thanks to\nSteve Fossett and Bob Kirkland for believing in me. Thanks to the staff at\nBloomberg Press, especially Stephen Isaacs and Kevin Commins. Thanks to\nmy friends at the Chicago Board Options Exchange, the Options Industry\nCouncil, and the CME group. Thanks to John Kmiecik for his diligent\ncontent editing. Thanks to those who contribute to sharing option ideas on\nmy website, markettaker.com . Thanks to my wife, Kathleen, who has been\nmore patient and supportive than anyone could reasonably ask for. And\nthanks, especially, to my students and those of you reading this book.\nPART I\nThe Basics of Option Greeks\nCHAPTER 1\nThe Basics\nTo understand how options work, one needs first to understand what an\noption is. An option is a contract that gives its owner the right to buy or the\nright to sell a fixed quantity of an underlying security at a specific price\nwithin a certain time constraint. There are two types of options: calls and\nputs. A call gives the owner of the option the right to buy the underlying\nsecurity. A put gives the owner of the option the right to sell the underlying\nsecurity. As in any transaction, there are two parties to an option contract—\na buyer and a seller.\nContractual Rights and Obligations\nThe option buyer is the party who owns the right inherent in the contract.\nThe buyer is referred to as having a long position and may also be called the\nholder, or owner, of the option. The right doesn’t last forever. At some point\nthe option will expire. At expiration, the owner may exercise the right or, if\nthe option has no value to the holder, let it expire without exercising it. But\nhe need not hold the option until expiration. Options are transferable—they\ncan be traded intraday in much the same way as stock is traded. Because it’s\nuncertain", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 3}
{"text": "older, or owner, of the option. The right doesn’t last forever. At some point\nthe option will expire. At expiration, the owner may exercise the right or, if\nthe option has no value to the holder, let it expire without exercising it. But\nhe need not hold the option until expiration. Options are transferable—they\ncan be traded intraday in much the same way as stock is traded. Because it’s\nuncertain what the underlying stock price of the option will be at expiration,\nmuch of the time this right has value before it expires. The uncertainty of\nstock prices, after all, is the raison d’être of the option market.\nA long position in an option contract, however, is fundamentally different\nfrom a long position in a stock. Owning corporate stock affords the\nshareholder ownership rights, which may include the right to vote in\ncorporate affairs and the right to receive dividends. Owning an option\nrepresents strictly the right either to buy the stock or to sell it, depending on\nwhether it’s a call or a put. Option holders do not receive dividends that\nwould be paid to the shareholders of the underlying stock, nor do they have\nvoting rights. The corporation has no knowledge of the parties to the option\ncontract. The contract is created by the buyer and seller of the option and\nmade available by being listed on an exchange.\nThe party to the contract who is referred to as the option seller, also called\nthe option writer, has a short position in the option. Instead of having a right\nto take a position in the underlying stock, as the buyer does, the seller\nincurs an obligation to potentially either buy or sell the stock. When a trader\nwho is long an option exercises, a trader with a short position gets assigned\n. Assignment means the trader with the short option position is called on to\nfulfill the obligation that was established when the contract was sold.\nShorting an option is fundamentally different from shorting a stock.\nCorporations have a quantifiable number of outstanding shares available for\ntrading, which must be borrowed to create a short position, but establishing\na short position in an option does not require borrowing; the contract is\nsimply created. The strategy of shorting stock is implemented statistically\nfar less frequently than simply buying stock, but that is not at all the case\nwith options. For every open long-option contract, there is an open short-\noption contract—they are equally common.\nOpening and Closing\nTraders’ option orders are either opening or closing transactions. When\ntraders with no position in a particular option buy the option, they buy to\nopen. If, in the future, the traders wish to eliminate the position by selling\nthe option they own, the traders enter a sell to close order—they are closing\nthe position. Likewise, if traders with no position in a particular option want\nto sell an option, thereby creating a short position, the traders execute a sell-\nto-open transaction. When the traders cover the short position by buying\nback the option, the traders enter a buy-to-close order.\nOpen Interest and Volume\nTraders use many types of market data to make trading decisions. Two\nitems that are often studied but sometimes misunderstood are volume and\nopen interest. Volume, as the name implies, is the total number of contracts\ntraded during a time period. Often, volume is stated on a one-day basis, but\ncould be stated per week, month, year, or otherwise. Once a new period\n(day) begins, volume begins again at zero. Open interest is the number of\ncontracts that have been created and remain outstanding. Open interest is a\nrunning total.\nWhen an option is first listed, there are no open contracts. If Trader A\nopens a long position in a newly listed option by buying a one-lot, or one\ncontract, from Trader B, who by selling is also opening a position, a\ncontract is created. One contract traded, so the volume is one. Since both\nparties opened a position and one contract was created, the open interest in\nthis particular option is one contract as well. If, later that day, Trader B\ncloses his short position by buying one contract from Trader C, who had no\nposition to start with, the volume is now two contracts for that day, but open\ninterest is still one. Only one contract exists; it was traded twice. If the next\nday, Trader C buys her contract back from Trader A, that day’s volume is\none and the open interest is now zero.\nThe Options Clearing Corporation\nRemember when Wimpy would tell Popeye, “I’ll gladly pay you Tuesday\nfor a hamburger today.” Did Popeye ever get paid for those burgers? In a\ncontract, it’s very important for each party to hold up his end of the bargain\n—especially when there is money at stake. How does a trader know the\nparty on the other side of an option contract will in fact do that? That’s\nwhere the Options Clearing Corporation (OCC) comes into play.\nThe OCC ultimately guarantees every options trade. In 2010, that was\nalmost 3.9 billion listed-options contracts. The OCC accomplishes this\nthrough many clearing members. Here’s how it works: When Trader X buys\nan option through a broker, the broker submits the trade information to its\nclearing firm. The trader on the other side of this transaction, Trader Y, who\nis probably a market maker, submits the trade to his clearing firm. The two\nclearing firms (one representing Trader X’s buy, the other representing\nTrader Y’s sell) each submit the trade information to the OCC, which\n“matches up” the trade.\nIf Trader Y buys back the option to close the position, how does that\naffect Trader X if he wants to exercise it? It doesn’t. The OCC, acting as an\nintermediary, assigns one of its clearing members with a customer that is\nshort the option in question to deliver the stock to Trader X’s clearing firm,\nwhich in turn delivers the stock to Trader X. The clearing member then\nassigns one of its customers who is short the option. The clearing member\nwill assign the trader either randomly or first in, first out. Effectively, the\nOCC", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 4}
{"text": "OCC, acting as an\nintermediary, assigns one of its clearing members with a customer that is\nshort the option in question to deliver the stock to Trader X’s clearing firm,\nwhich in turn delivers the stock to Trader X. The clearing member then\nassigns one of its customers who is short the option. The clearing member\nwill assign the trader either randomly or first in, first out. Effectively, the\nOCC is the ultimate counterparty to both the exercise and the assignment.\nStandardized Contracts\nExchange-listed options contracts are standardized, meaning the terms of\nthe contract, or the contract specifications, conform to a customary\nstructure. Standardization makes the terms of the contracts intuitive to the\nexperienced user.\nTo understand the contract specifications in a typical equity option,\nconsider an example:\nBuy 1 IBM December 170 call at 5.00\nQuantity\nIn this example, one contract is being purchased. More could have been\npurchased, but not less—options cannot be traded in fractional units.\nOption Series, Option Class, and Contract Size\nAll calls or puts of the same class, the same expiration month, and the same\nstrike price are called an option series . For example, the IBM December\n170 calls are a series. Options series are displayed in an option chain on an\nonline broker’s user interface. An option chain is a full or partial list of the\noptions that are listed on an underlying.\nOption class means a group of options that represent the same underlying.\nHere, the option class is denoted by the symbol IBM—the contract\nrepresents rights on International Business Machines Corp. (IBM) shares.\nBuying one contract usually gives the holder the right to buy or to sell 100\nshares of the underlying stock. This number is referred to as contract size .\nThough this is usually the case, there are times when the contract size is\nsomething other than 100 shares of a stock. This situation may occur after\ncertain types of stock splits, spin-offs, or stock dividends, for example. In\nthe minority of cases in which the one contract represents rights on\nsomething besides 100 shares, there may be more than one class of options\nlisted on a stock.\nA fairly unusual example was presented by the Ford Motor Company\noptions in the summer of 2000. In June 2000, Ford spun off Visteon\nCorporation. Then, in August 2000, Ford offered shareholders a choice of\nconverting their shares into (a) new shares of Ford plus $20 cash per share,\n(b) new Ford stock plus fractional shares with an aggregate value of $20, or\n(c) new Ford stock plus a combination of more new Ford stock and cash.\nThere were three classes of options listed on Ford after both of these\nchanges: F represented 100 shares of the new Ford stock; XFO represented\n100 shares of Ford plus $20 per share ($2,000) plus cash in lieu of $1.24;\nand FOD represented 100 shares of new Ford, 13 shares of Visteon, and\n$2,001.24.\nSometimes these changes can get complicated. If there is ever a question\nas to what the underlying is for an option class, the authority is the OCC. A\nlot of time, money, and stress can be saved by calling the OCC at 888-\nOPTIONS and clarifying the matter.\nExpiration Month\nOptions expire on the Saturday following the third Friday of the stated\nmonth, which in this case is December. The final trading day for an option\nis commonly the day before expiration—here, the third Friday of\nDecember. There are usually at least four months listed for trading on an\noption class. There may be a total of six months if Long-Term Equity\nAnticiPation Securities® or LEAPS® are listed on the class. LEAPS can have\none year to about two-and-a-half years until expiration. Some underlyings\nhave one-week options called WeeklysSM listed on them.\nStrike Price\nThe price at which the option holder owns the right to buy or to sell the\nunderlying is called the strike price, or exercise price. In this example, the\nholder owns the right to buy the stock at $170 per share. There is method to\nthe madness regarding how strike prices are listed. Strike prices are\ngenerally listed in $1, $2.50, $5, or $10 increments, depending on the value\nof the strikes and the liquidity of the options.\nThe relationship of the strike price to the stock price is important in\npricing options. For calls, if the stock price is above the strike price, the call\nis in-the-money (ITM). If the stock and the strike prices are close, the call is\nat-the-money (ATM). If the stock price is below the strike price the call is\nout-of-the-money (OTM). This relationship is just the opposite for puts. If\nthe stock price is below the strike price, the put is in-the-money. If the stock\nprice and the strike price are about the same, the put is at-the-money. And,\nif the stock price is above the put strike, it is out-of-the-money.\nOption Type\nThere are two types of options: calls and puts. Calls give the holder the\nright to buy the underlying and the writer the obligation to sell the\nunderlying. Puts give the holder the right to sell the underlying and the\nwriter the obligation to buy the underlying.\nPremium\nThe price of an option is called its premium. The premium of this option is\n$5. Like stock prices, option premiums are stated in dollars and cents per\nshare. Since the option represents 100 shares of IBM, the buyer of this\noption will pay $500 when the transaction occurs. Certain types of spreads\nmay be quoted in fractions of a penny.\nAn option’s premium is made up of two parts: intrinsic value and time\nvalue. Intrinsic value is the amount by which the option is in-the-money.\nFor example, if IBM stock were trading at 171.30, this 170-strike call\nwould be in-the-money by 1.30. It has 1.30 of intrinsic value. The\nremaining 3.70 of its $5 premium would be time value.\nOptions that are out-of-the-money have no intrinsic value. Their values\nconsist only of time premium. Sometimes options have no time value left.\nOptions that consist of only intrinsic value are trading at what traders call\nparity . Time value is sometimes called pre", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 5}
{"text": "-strike call\nwould be in-the-money by 1.30. It has 1.30 of intrinsic value. The\nremaining 3.70 of its $5 premium would be time value.\nOptions that are out-of-the-money have no intrinsic value. Their values\nconsist only of time premium. Sometimes options have no time value left.\nOptions that consist of only intrinsic value are trading at what traders call\nparity . Time value is sometimes called premium over parity .\nExercise Style\nOne contract specification that is not specifically shown here is the exercise\nstyle. There are two main exercise styles: American and European.\nAmerican-exercise options can be exercised, and therefore assigned,\nanytime after the contract is entered into until either the trader closes the\nposition or it expires. European-exercise options can be exercised and\nassigned only at expiration. Exchange-listed equity options are all\nAmerican-exercise style. Other kinds of options are commonly European\nexercise. Whether an option is American or European has nothing to with\nthe country in which it’s listed.\nETFs, Indexes, and HOLDRs\nSo far, we’ve focused on equity options—options on individual stocks. But\ninvestors have other choices for trading securities options. Options on\nbaskets of stocks can be traded, too. This can be accomplished using\noptions on exchange-traded funds (ETFs), index options, or options on\nholding company depositary receipts (HOLDRs).\nETF Options\nExchange-traded funds are vehicles that represent ownership in a fund or\ninvestment trust. This fund is made up of a basket of an underlying index’s\nsecurities—usually equities. The contract specifications of ETF options are\nsimilar to those of equity options. Let’s look at an example.\nOne actively traded optionable ETF is the Standard & Poor’s Depositary\nReceipts (SPDRs or Spiders). Spider shares and options trade under the\nsymbol SPY. Exercising one SPY call gives the exerciser a long position of\n100 shares of Spiders at the strike price of the option. Expiration for ETF\noptions typically falls on the same day as for equity options—the Saturday\nfollowing the third Friday of the month. The last trading day is the Friday\nbefore. ETF options are American exercise. Traders of ETFs should be\naware of the relationship between the price of the ETF shares and the value\nof the underlying index. For example, the stated value of the Spiders is\nabout one tenth the stated value of the S&P 500. The PowerShares QQQ\nETF, representing the Nasdaq 100, is about one fortieth the stated value of\nthe Nasdaq 100.\nIndex Options\nTrading options on the Spiders ETF is a convenient way to trade the\nStandard & Poor’s (S&P) 500. But it’s not the only way. There are other\noption contracts listed on the S&P 500. The SPX is one of the major ones.\nThe SPX is an index option contract. There are some very important\ndifferences between ETF options like SPY and index options like SPX.\nThe first difference is the underlying. The underlying for ETF options is\n100 shares of the ETF. The underlying for index options is the numerical\nvalue of the index. So if the S&P 500 is at 1303.50, the underlying for SPX\noptions is 1303.50. When an SPX call option is exercised, instead of getting\n100 shares of something, the exerciser gets the ITM cash value of the\noption times $100. Again, with SPX at 1303.50, if a 1300 call is exercised,\nthe exerciser gets $350—that’s 1303.50 minus 1300, times $100. This is\ncalled cash settlement .\nMany index options are European, which means no early exercise. At\nexpiration, any long ITM options in a trader’s inventory result in an account\ncredit; any short ITMs result in a debit of the ITM value times $100. The\nsettlement process for determining whether a European-style index option is\nin-the-money at expiration is a little different, too. Often, these indexes are\na.m. settled. A.m.-settled index options will have actual expiration on the\nconventional Saturday following the third Friday of the month. But the final\ntrading day is the Thursday before the expiration day. The final settlement\nvalue of the index is determined by the opening prices of the components of\nthe index on Friday morning.\nHOLDR Options\nLike ETFs, holding company depositary receipts also represent ownership\nin a basket of stocks. The main difference is that investors owning\nHOLDRs retain the ownership rights of the individual stocks in the fund,\nsuch as the right to vote shares and the right to receive dividends. Options\non HOLDRs, for all intents and purposes, function much like options on\nETFs.\nStrategies and At-Expiration\nDiagrams\nOne of the great strengths of options is that there are so many different\nways to use them. There are simple, straightforward strategies like buying a\ncall. And there are complex spreads with creative names like jelly roll, guts,\nand iron butterfly. A spread is a strategy that involves combining an option\nwith one or more other options or stock. Each component of the spread is\nreferred to as a leg. Each spread has its own unique risk and reward\ncharacteristics that make it appropriate for certain market outlooks.\nThroughout this book, many different spreads will be discussed in depth.\nFor now, it’s important to understand that all spreads are made up of a\ncombination of four basic option positions: buy call, sell call, buy put, and\nsell put. Understanding complex option strategies requires understanding\nthese basic positions and their common, practical uses. When learning\noptions, it’s helpful to see what the option’s payout is if it is held until\nexpiration.\nBuy Call\nWhy buy the right to buy the stock when you can simply buy the stock? All\noption strategies have trade-offs, and the long call is no different. Whether\nthe stock or the call is preferable depends greatly on the trader’s forecast\nand motivations.\nConsider a long call example:\nBuy 1 INTC June 22.50 call at 0.85.\nIn this example, a trader is bullish on Intel (INTC). He believes Intel will\nrise at least 20 percent, from $22.25 per share to around $27 by June\nexpir", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 6}
{"text": "tock? All\noption strategies have trade-offs, and the long call is no different. Whether\nthe stock or the call is preferable depends greatly on the trader’s forecast\nand motivations.\nConsider a long call example:\nBuy 1 INTC June 22.50 call at 0.85.\nIn this example, a trader is bullish on Intel (INTC). He believes Intel will\nrise at least 20 percent, from $22.25 per share to around $27 by June\nexpiration, about two months from now. He is concerned, however, about\ndownside risk and wants to limit his exposure. Instead of buying 100 shares\nof Intel at $22.25—a total investment of $2,225—the trader buys 1 INTC\nJune 22.50 call at 0.85, for a total of $85.\nThe trader is paying 0.85 for the right to buy 100 shares of Intel at $22.50\nper share. If Intel is trading below the strike price of $22.50 at expiration,\nthe call will expire and the total premium of 0.85 will be lost. Why? The\ntrader will not exercise the right to buy the stock at a $22.50 if he can buy it\ncheaper in the market. Therefore, if Intel is below $22.50 at expiration, this\ncall will expire with no value.\nHowever, if the stock is trading above the strike price at expiration, the\ncall can be exercised, in which case the trader may purchase the stock\nbelow its trading price. Here, the call has value to the trader. The higher the\nstock, the more the call is worth. For the trade to be profitable, at expiration\nthe stock must be trading above the trader’s break-even price. The break-\neven price for a long call is the strike price plus the premium paid—in this\nexample, $23.35 per share. The point here is that if the call is exercised, the\neffective purchase price of the stock upon exercise is $23.35. The stock is\nliterally bought at the strike price, which is $22.50, but the premium of 0.85\nthat the trader has paid must be taken into account. Exhibit 1.1 illustrates\nthis example.\nEXHIBIT 1.1 Long Intel call.\nExhibit 1.1 is an at-expiration diagram for the Intel 22.50 call. It shows\nthe profit and loss, or P&(L), of the option if it is held until expiration. The\nX-axis represents the prices at which INTC could be trading at expiration.\nThe Y-axis represents the associated profit or loss on the position. The at-\nexpiration diagram of any long call position will always have this same\nhockey-stick shape, regardless of the stock or strike. There is always a limit\nof loss, represented by the horizontal line, which in this case is drawn at\n−0.85. And there is always a line extending upward and to the right, which\nrepresents effectively a long stock position stemming from the strike.\nThe trade-offs between a long stock position and a long call position are\nshown in Exhibit 1.2 .\nEXHIBIT 1.2 Long Intel call vs. long Intel stock.\nThe thin dotted line represents owning 100 shares of Intel at $22.25.\nProfits are unlimited, but the risk is substantial—the stock can go to zero.\nHerein lies the trade-off. The long call has unlimited profit potential with\nlimited risk. Whenever an option is purchased, the most that can be lost is\nthe premium paid for the option. But the benefit of reduced risk comes at a\ncost. If the stock is above the strike at expiration, the call will always\nunderperform the stock by the amount of the premium.\nBecause of this trade-off, conservative traders will sometimes buy a call\nrather than the associated stock and sometimes buy the stock rather than the\ncall. Buying a call can be considered more conservative when the volatility\nof the stock is expected to rise. Traders are willing to risk a comparatively\nsmall premium when a large price decline is feared possible. Instead, in an\ninterest-bearing vehicle, they harbor the capital that would otherwise have\nbeen used to purchase the stock. The cost of this protection is acceptable to\nthe trader if high-enough price advances are anticipated. In terms of\npercentage, much higher returns and losses are possible with the long call.\nIf the stock is trading at $27 at expiration, as the trader in this example\nexpected, the trader reaps a 429 percent profit on the $0.85 investment\n([$27 − 23.35] / $0.85). If Intel is below the strike price at expiration, the\ntrader loses 100 percent.\nThis makes call buying an excellent speculative alternative. Those willing\nto accept bigger risk can further increase returns by purchasing more calls.\nIn this example, around 26 Intel calls—representing the rights on 2,600\nshares—can be purchased at 85 cents for the cost of 100 shares at $22.25.\nThis is the kind of leverage that allows for either a lower cash outlay than\nbuying the stock—reducing risk—or the same cash outlay as buying the\nstock but with much greater exposure—creating risk in pursuit of higher\nreturns.\nSell Call\nSelling a call creates the obligation to sell the stock at the strike price. Why\nis a trader willing to accept this obligation? The answer is option premium.\nIf the position is held until expiration without getting assigned, the entire\npremium represents a profit for the trader. If assignment occurs, the trader\nwill be obliged to sell stock at the strike price. If the trader does not have a\nlong position in the underlying stock (a naked call), a short stock position\nwill be created. Otherwise, if stock is owned (a covered call), that stock is\nsold. Whether the trader has a profit or a loss depends on the movement of\nthe stock price and how the short call position was constructed.\nConsider a naked call example:\nSell 1 TGT October 50 call at 1.45\nIn this example, Target Corporation (TGT) is trading at $49.42. A trader,\nSam, believes Target will continue to be trading below $50 by October\nexpiration, about two months from now. Sam sells 1 Target two-month 50\ncall at 1.45, opening a short position in that series. Exhibit 1.3 will help\nexplain the expected payout of this naked call position if it is held until\nexpiration.\nEXHIBIT 1.3 Naked Target call.\nIf TGT is trading below the exercise price of 50, the call will expire\nworthless. Sam keeps the 1.45 premium, and the obligation to sell the", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 7}
{"text": "ion, about two months from now. Sam sells 1 Target two-month 50\ncall at 1.45, opening a short position in that series. Exhibit 1.3 will help\nexplain the expected payout of this naked call position if it is held until\nexpiration.\nEXHIBIT 1.3 Naked Target call.\nIf TGT is trading below the exercise price of 50, the call will expire\nworthless. Sam keeps the 1.45 premium, and the obligation to sell the stock\nceases to exist. If Target is trading above the strike price, the call will be in-\nthe-money. The higher the stock is above the strike price, the more intrinsic\nvalue the call will have. As a seller, Sam wants the call to have little or no\nintrinsic value at expiration. If the stock is below the break-even price at\nexpiration, Sam will still have a profit. Here, the break-even price is $51.45\n—the strike price plus the call premium. Above the break-even, Sam has a\nloss. Since stock prices can rise to infinity (although, for the record, I have\nnever seen this happen), the naked call position has unlimited risk of loss.\nBecause a short stock position may be created, a naked call position must\nbe done in a margin account. For retail traders, many brokerage firms\nrequire different levels of approval for different types of option strategies.\nBecause the naked call position has unlimited risk, establishing it will\ngenerally require the highest level of approval—and a high margin\nrequirement.\nAnother tactical consideration is what Sam’s objective was when he\nentered the trade. His goal was to profit from the stock’s being below $50\nduring this two-month period—not to short the stock. Because equity\noptions are American exercise and can be exercised/assigned any time from\nthe moment the call is sold until expiration, a short stock position cannot\nalways be avoided. If assigned, the short stock position will extend Sam’s\nperiod of risk—because stock doesn’t expire. Here, he will pay one\ncommission shorting the stock when assignment occurs and one more when\nhe buys back the unwanted position. Many traders choose to close the naked\ncall position before expiration rather than risk assignment.\nIt is important to understand the fundamental difference between buying\ncalls and selling calls. Buying a call option offers limited risk and unlimited\nreward. Selling a naked call option, however, has limited reward—the call\npremium—and unlimited risk. This naked call position is not so much\nbearish as not bullish . If Sam thought the stock was going to zero, he\nwould have chosen a different strategy.\nNow consider a covered call example:\nBuy 100 shares TGT at $49.42\nSell 1 TGT October 50 call at 1.45\nUnlimited and risk are two words that don’t sit well together with many\ntraders. For that reason, traders often prefer to sell calls as part of a spread.\nBut since spreads are strategies that involve multiple components, they have\ndifferent risk characteristics from an outright option. Perhaps the most\ncommonly used call-selling spread strategy is the covered call (sometimes\ncalled a covered write or a buy-write ). While selling a call naked is a way\nto take advantage of a “not bullish” forecast, the covered call achieves a\ndifferent set of objectives.\nAfter studying Target Corporation, another trader, Isabel, has a neutral to\nslightly bullish forecast. With Target at $49.42, she believes the stock will\nbe range-bound between $47 and $51.50 over the next two months, ending\nwith October expiration. Isabel buys 100 shares of Target at $49.42 and\nsells 1 TGT October 50 call at 1.45. The implications for the covered-call\nstrategy are twofold: Isabel must be content to own the stock at current\nlevels, and—since she sold the right to buy the stock at $50, that is, a 50\ncall, to another party—she must be willing to sell the stock if the price rises\nto or through $50 per share. Exhibit 1.4 shows how this covered call\nperforms if it is held until the call expires.\nEXHIBIT 1.4 Target covered call.\nThe solid kinked line represents the covered call position, and the thin,\nstraight dotted line represents owning the stock outright. At the expiration\nof the call option, if Target is trading below $50 per share—the strike price\n—the call expires and Isabel is left with a long position of 100 shares plus\n$1.45 per share of expired-option premium. Below the strike, the buy-write\nalways outperforms simply owning the stock by the amount of the\npremium. The call premium provides limited downside protection; the stock\nIsabel owns can decline $1.45 in value to $47.97 before the trade is a loser.\nIn the unlikely event the stock collapses and becomes worthless, this\nlimited downside protection is not so comforting. Ultimately, Isabel has\n$47.97 per share at risk.\nThe trade-off comes if Target is above $50 at expiration. Here, assignment\nwill likely occur, in which case the stock will be sold. The call can be\nassigned before expiration, too, causing the stock to be called away early.\nBecause the covered call involves this obligation to sell the sock at the\nstrike price, upside potential is limited. In this case, Isabel’s profit potential\nis $2.03. The stock can rise from $49.42 to $50—a $0.58 profit—plus $1.45\nof option premium.\nIsabel does not want the stock to decline too much. Below $47.97, the\ntrade is a loser. If the stock rises too much, the stock is sold prematurely and\nupside opportunity is lost. Limited reward and unlimited risk. (Technically,\nthe risk is not unlimited—the stock can only go to zero. But if the stock\ndrops from $49.42 to zero in a short time, the risk will certainly feel\nunlimited.) The covered call strategy is for a neutral to moderately bullish\noutlook.\nSell Put\nSelling a put has many similarities to the covered call strategy. We’ll\ndiscuss the two positions and highlight the likenesses. Chapter 6 will detail\nthe nuts and bolts of why these similarities exist.\nConsider an example of selling a put:\nSell 1 BA January 65 put at 1.20\nIn this example, trader Sam is neutral to moderately bullish on Boeing (BA)\nbetween n", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 8}
{"text": "l to moderately bullish\noutlook.\nSell Put\nSelling a put has many similarities to the covered call strategy. We’ll\ndiscuss the two positions and highlight the likenesses. Chapter 6 will detail\nthe nuts and bolts of why these similarities exist.\nConsider an example of selling a put:\nSell 1 BA January 65 put at 1.20\nIn this example, trader Sam is neutral to moderately bullish on Boeing (BA)\nbetween now and January expiration. He is not bullish enough to buy BA at\nthe current market price of $69.77 per share. But if the shares dropped\nbelow $65, he’d gladly scoop some up. Sam sells 1 BA January 65 put at\n1.20. The at-expiration diagram in Exhibit 1.5 shows the P&(L) of this trade\nif it is held until expiration.\nEXHIBIT 1.5 Boeing short put.\nAt the expiration of this option, if Boeing is above $65, the put expires\nand Sam retains the premium of $1.20. The obligation to buy stock expires\nwith the option. Below the strike, put owners will be inclined to exercise\ntheir option to sell the stock at $65. Therefore, those short the put, as Sam is\nin this example, can expect assignment. The break-even price for the\nposition is $63.80. That is the strike price minus the option premium. If\nassigned, this is the effective purchase price of the stock. The obligation to\nbuy at $65 is fulfilled, but the $1.20 premium collected makes the purchase\neffectively $63.80. Here, again, there is limited profit opportunity ($1.20 if\nthe stock is above the strike price) and seemingly unlimited risk (the risk of\npotential stock ownership at $63.80) if Boeing is below the strike price.\nWhy would a trader short a put and willingly assume this substantial risk\nwith comparatively limited reward? There are a number of motivations that\nmay warrant the short put strategy. In this example, Sam had the twin goals\nof profiting from a neutral to moderately bullish outlook on Boeing and\nbuying it if it traded below $65. The short put helps him achieve both\nobjectives.\nMuch like the covered call, if the stock is above the strike at expiration,\nthis trader reaches his maximum profit potential—in this case 1.20. And if\nthe price of Boeing is below the strike at expiration, Sam has ownership of\nthe stock from assignment. Here, a strike price that is lower than the current\nstock level is used. The stock needs to decline in order for Sam to get\nassigned and become long the stock. With this strategy, he was able to\nestablish a target price at which he would buy the stock. Why not use a limit\norder? If the put is assigned, the effective purchase price is $63.80 even if\nthe stock price is above this price. If the put is not assigned, the premium is\nkept.\nA consideration every trader must make before entering the short put\nposition is how the purchase of the stock will be financed in the event the\nput is assigned. Traders hoping to acquire the stock will often hold enough\ncash in their trading account to secure the purchase of the stock. This is\ncalled a cash-secured put . In this example, Sam would hold $6,380 in his\naccount in addition to the $120 of option premium received. This affords\nhim enough free capital to fund the $6,500 purchase of stock the short put\ndictates. More speculative traders may be willing to buy the stock on\nmargin, in which case the trader will likely need around 50 percent of the\nstock’s value.\nSome traders sell puts without the intent of ever owning the stock. They\nhope to profit from a low-volatility environment. Just as the short call is a\nnot-bullish stance on the underlying, the short put is a not-bearish play. As\nlong as the underlying is above the strike price at expiration, the option\npremium is all profit. The trader must actively manage the position for fear\nof being assigned. Buying the put back to close the position eliminates the\nrisk of assignment.\nBuy Put\nBuying a put gives the holder the right to sell stock at the strike price. Of\ncourse, puts can be a part of a host of different spreads, but this chapter\ndiscusses the two most basic and common put-buying strategies: the long\nput and the protective put. The long put is a way to speculate on a bearish\nmove in the underlying security, and the protective put is a way to protect a\nlong position in the underlying security.\nConsider a long put example:\nBuy 1 SPY May 139 put at 2.30\nIn this example, the Spiders have had a good run up to $140.35. Trader\nIsabel is looking for a 10 percent correction in SPY between now and the\nend of May, about three months away. She buys 1 SPY May 139 put at 2.30.\nThis put gives her the right to sell 100 shares of SPY at $139 per share.\nExhibit 1.6 shows Isabel’s P&(L) if the put is held until expiration.\nEXHIBIT 1.6 SPY long put.\nIf SPY is above the strike price of 139 at expiration, the put will expire\nand the entire premium of 2.30 will be lost. If SPY is below the strike price\nat expiration, the put will have value. It can be exercised, creating a short\nposition in the Spiders at an effective price of $136.70 per share. This price\nis found by subtracting the premium paid, 2.30, from the strike price, 139.\nThis is the point at which the position breaks even. If SPY is below $136.70\nat expiration, Isabel has a profit. Profits will increase on a tick-for-tick\nbasis, with downward movements in SPY down to zero. The long put has\nlimited risk and substantial reward potential.\nAn alternative for Isabel is to short the ETF at the current price of\n$140.35. But a short position in the underlying may not be as attractive to\nher as a long put. The margin requirements for short stock are significantly\nhigher than for a long put. Put buyers must post only the premium of the put\n—that is the most that can be lost, after all.\nThe margin requirement for short stock reflects unlimited loss potential.\nMargin requirements aside, risk is a very real consideration for a trader\ndeciding between shorting stock and buying a put. If the trader expects high\nvolatility, he or she may be more inclined to limit upside risk while\nleveraging downside", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 9}
{"text": "must post only the premium of the put\n—that is the most that can be lost, after all.\nThe margin requirement for short stock reflects unlimited loss potential.\nMargin requirements aside, risk is a very real consideration for a trader\ndeciding between shorting stock and buying a put. If the trader expects high\nvolatility, he or she may be more inclined to limit upside risk while\nleveraging downside profit potential by buying a put. In general, traders buy\noptions when they expect volatility to increase and sell them when they\nexpect volatility to decrease. This will be a common theme throughout this\nbook.\nConsider a protective put example:\nThis is an example of a situation in which volatility is expected to\nincrease.\nOwn 100 shares SPY at 140.35\nBuy 1 SPY May139 put at 2.30\nAlthough Isabel bought a put because she was bearish on the Spiders, a\ndifferent trader, Kathleen, may buy a put for a different reason—she’s\nbullish but concerned about increasing volatility. In this example, Kathleen\nhas owned 100 shares of Spiders for some time. SPY is currently at\n$140.35. She is bullish on the market but has concerns about volatility over\nthe next two or three months. She wants to protect her investment. Kathleen\nbuys 1 SPY May 139 put at 2.30. (If Kathleen bought the shares of SPY and\nthe put at the same time, as a spread, the position would be called a married\nput.)\nKathleen is buying the right to sell the shares she owns at $139.\nEffectively, it is an insurance policy on this asset. Exhibit 1.7 shows the risk\nprofile of this new position.\nEXHIBIT 1.7 SPY protective put.\nThe solid kinked line is the protective put (put and stock), and the thin\ndotted line is the outright position in SPY alone, without the put. The most\nKathleen stands to lose with the protective put is $3.65 per share. SPY can\ndecline from $140.35 to $139, creating a loss of $1.35, plus the $2.30\npremium spent on the put. If the stock does not fall and the insuring put\nhence does not come into play, the cost of the put must be recouped to\njustify its expense. The break-even point is $142.65.\nThis position implies that Kathleen is still bullish on the Spiders. When\ntraders believe a stock or ETF is going to decline, they sell the shares.\nInstead, Kathleen sacrifices 1.6 percent of her investment up front by\npurchasing the put for $2.30. She defers the sale of SPY until the period of\nperceived risk ends. Her motivation is not to sell the ETF; it is to hedge\nvolatility.\nOnce the anticipated volatility is no longer a concern, Kathleen has a\nchoice to make. She can let the option run its course, holding it to\nexpiration, at which point it will either expire or be exercised; or she can\nsell the option before expiration. If the option is out-of-the-money, it may\nhave residual time value prior to expiration that can be recouped. If it is in-\nthe-money, it will have intrinsic value and maybe time value as well. In this\nsituation, Kathleen can look at this spread as two trades—one that has\ndeclined in price, the SPY shares, and one that has risen in price, the put.\nLosses on the ETF shares are to some degree offset by gains on the put.\nMeasuring Incremental Changes in\nFactors Affecting Option Prices\nAt-expiration diagrams are very helpful in learning how a particular option\nstrategy works. They show what the option’s price will ultimately be at\nvarious prices of the underlying. There is, however, a caveat when using at-\nexpiration diagrams. According to the Options Industry Council, most\noptions are closed before they reach expiration. Traders not planning to\nhold an option until it expires need to have a way to develop reasonable\nexpectations as to what the option’s price will be given changes that can\noccur in factors affecting the option’s price. The tool option traders use to\naid them in this process is option greeks.\nCHAPTER 2\nGreek Philosophy\nMy wife, Kathleen, is not an options trader. Au contraire. However, she,\nlike just about everyone, uses them from time to time—though without\nreally thinking about it. She was on eBay the other day bidding on a pair of\nshoes. The bid was $45 with three days left to go. She was concerned about\nthe price rising too much and missing the chance to buy them at what she\nthought was a good price. She noticed, though, that someone else was\nselling the same shoes with a buy-it-now price of $49—a good-enough\nprice in her opinion. Kathleen was effectively afforded a call option. She\nhad the opportunity to buy the shoes at (the strike price of) $49, a right she\ncould exercise until the offer expired.\nThe biggest difference between the option in the eBay scenario and the\nsort of options discussed in this book is transferability. Actual options are\ntradable—they can be bought and sold. And it is the contract itself that has\nvalue—there is one more iteration of pricing.\nFor example, imagine the $49 opportunity was a coupon or certificate that\nguaranteed the price of $49, which could be passed along from one person\nto another. And there was the chance that the $49-price guarantee could\nrepresent a discount on the price paid for the shoes—maybe a big discount\n—should the price of the shoes rise in the eBay auction. The certificate\nguaranteeing the $49 would have value. Anyone planning to buy the shoes\nwould want the safety of knowing they were guaranteed not to pay more\nthan $49 for the shoes. In fact, some people would even consider paying to\nbuy the certificate itself if they thought the price of the shoes might rise\nsignificantly.\nPrice vs. Value: How Traders Use\nOption-Pricing Models\nLike in the common-life example just discussed, the right to buy or sell an\nunderlying security—that is, an option—can have value, too. The specific\nvalue of an option is determined by supply and demand. There are several\nvariables in an option contract, however, that can influence a trader’s\nwillingness to demand (desire to buy) or supply (desire to sell) an option at\na given price. For example, a trader would rather own—that i", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 10}
{"text": "just discussed, the right to buy or sell an\nunderlying security—that is, an option—can have value, too. The specific\nvalue of an option is determined by supply and demand. There are several\nvariables in an option contract, however, that can influence a trader’s\nwillingness to demand (desire to buy) or supply (desire to sell) an option at\na given price. For example, a trader would rather own—that is, there would\nbe higher demand for—an option that has more time until expiration than a\nshorter-dated option, all else held constant. And a trader would rather own a\ncall with a lower strike than a higher strike, all else kept constant, because it\nwould give the right to buy at a lower price.\nSeveral elements contribute to the value of an option. It took academics\nmany years to figure out exactly what those elements are. Fischer Black and\nMyron Scholes together pioneered research in this area at the University of\nChicago. Ultimately, their work led to a Nobel Prize for Myron Scholes.\nFischer Black died before he could be honored.\nIn 1973, Black and Scholes published a paper called “The Pricing of\nOptions and Corporate Liabilities” in the Journal of Political Economy ,\nthat introduced the Black-Scholes option-pricing model to the world. The\nBlack-Scholes model values European call options on non-dividend-paying\nstocks. Here, for the first time, was a widely accepted model illustrating\nwhat goes into the pricing of an option. Option prices were no longer wild\nguesswork. They could now be rationalized. Soon, additional models and\nalterations to the Black-Scholes model were developed for options on\nindexes, dividend-paying stocks, bonds, commodities, and other optionable\ninstruments. All the option-pricing models commonly in use today have\nslightly different means but achieve the same end: the option’s theoretical\nvalue. For American-exercise equity options, six inputs are entered into any\noption-pricing model to generate a theoretical value: stock price, strike\nprice, time until expiration, interest rate, dividends, and volatility.\nTheoretical value—what a concept! A trader plugs six numbers into a\npricing model, and it tells him what the option is worth, right? Well, in\npractical terms, that’s not exactly how it works. An option is worth what the\nmarket bears. Economists call this price discovery. The price of an option is\ndetermined by the forces of supply and demand working in a free and open\nmarket. Herein lies an important concept for option traders: the difference\nbetween price and value.\nPrice can be observed rather easily from any source that offers option\nquotes (web sites, your broker, quote vendors, and so on). Value is\ncalculated by a pricing model. But, in practice, the theoretical value is really\nnot an output at all. It is already known: the market determines it. The trader\nrectifies price and value by setting the theoretical value to fall between the\nbid and the offer of the option by adjusting the inputs to the model.\nProfessional traders often refer to the theoretical value as the fair value of\nthe option.\nAt this point, please note the absence of the mathematical formula for the\nBlack-Scholes model (or any other pricing model, for that matter).\nAlthough the foundation of trading option greeks is mathematical, this book\nwill keep the math to a minimum—which is still quite a bit. The focus of\nthis book is on practical applications, not academic theory. It’s about\nlearning to drive the car, not mastering its engineering.\nThe trader has an equation with six inputs equaling one known output.\nWhat good is this equation? An option-pricing model helps a trader\nunderstand how market forces affect the value of an option. Five of the six\ninputs are dynamic; the only constant is the strike price of the option in\nquestion. If the price of the option changes, it’s because one or more of the\nfive variable inputs has changed. These variables are independent of each\nother, but they can change in harmony, having either a cumulative or net\neffect on the option’s value. An option trader needs to be concerned with the\nrelationship of these variables (price, time, volatility, interest). This\nmultidimensional view of asset pricing is unique to option traders.\nDelta\nThe five figures commonly used by option traders are represented by Greek\nletters: delta, gamma, theta, vega, rho. The figures are referred to as option\ngreeks. Vega, of course, is not an actual letter of the greek alphabet, but in\nthe options vernacular, it is considered one of the greeks.\nThe greeks are a derivation of an option-pricing model, and each Greek\nletter represents a specific sensitivity to influences on the option’s value. To\nunderstand concepts represented by these five figures, we’ll start with delta,\nwhich is defined in four ways:\n1. The rate of change of an option value relative to a change in the\nunderlying stock price.\n2. The derivative of the graph of an option value in relation to the stock\nprice.\n3. The equivalent of underlying shares represented by an option\nposition.\n4. The estimate of the likelihood of an option expiring in-the-money. 1\nDefinition 1 : Delta (Δ) is the rate of change of an option’s value relative\nto a change in the price of the underlying security. A trader who is bullish\non a particular stock may choose to buy a call instead of buying the\nunderlying security. If the price of the stock rises by $1, the trader would\nexpect to profit on the call—but by how much? To answer that question, the\ntrader must consider the delta of the option.\nDelta is stated as a percentage. If an option has a 50 delta, its price will\nchange by 50 percent of the change of the underlying stock price. Delta is\ngenerally written as either a whole number, without the percent sign, or as a\ndecimal. So if an option has a 50 percent delta, this will be indicated as\n0.50, or 50. For the most part, we’ll use the former convention in our\ndiscussion.\nCall values increase when the underlying stock price increases and vice\nversa. Because", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 11}
{"text": "ll\nchange by 50 percent of the change of the underlying stock price. Delta is\ngenerally written as either a whole number, without the percent sign, or as a\ndecimal. So if an option has a 50 percent delta, this will be indicated as\n0.50, or 50. For the most part, we’ll use the former convention in our\ndiscussion.\nCall values increase when the underlying stock price increases and vice\nversa. Because calls have this positive correlation with the underlying, they\nhave positive deltas. Here is a simplified example of the effect of delta on\nan option:\nConsider a $60 stock with a call option that has a 0.50 delta and is trading\nfor 3.00. Considering only the delta, if the stock price increases by $1, the\ntheoretical value of the call will rise by 0.50. That’s 50 percent of the stock\nprice change. The new call value will be 3.50. If the stock price decreases\nby $1, the 0.50 delta will cause the call to decrease in value by 0.50, from\n3.00 to 2.50.\nPuts have a negative correlation to the underlying. That is, put values\ndecrease when the stock price rises and vice versa. Puts, therefore, have\nnegative deltas. Here is a simplified example of the delta effect on a −0.40-\ndelta put:\nAs the stock rises from $60 to $61, the delta of −0.40 causes the put value\nto go from $2.25 to $1.85. The put decreases by 40 percent of the stock\nprice increase. If the stock price instead declined by $1, the put value would\nincrease by $0.40, to $2.65.\nUnfortunately, real life is a bit more complicated than the simplified\nexamples of delta used here. In reality, the value of both the call and the put\nwill likely be higher with the stock at $61 than was shown in these\nexamples. We’ll expand on this concept later when we tackle the topic of\ngamma.\nDefinition 2 : Delta can also be described another way. Exhibit 2.1 shows\nthe value of a call option with three months to expiration at a variable stock\nprice. As the stock price rises, the call is worth more; as the stock price\ndeclines, the call value moves toward zero. Mathematically, for any given\npoint on the graph, the derivative will show the rate of change of the option\nprice. The delta is the first derivative of the graph of the option price\nrelative to the stock price .\nEXHIBIT 2.1 Call value compared with stock price.\nDefinition 3 : In terms of absolute value (meaning that plus and minus\nsigns are ignored), the delta of an option is between 1.00 and 0. Its price can\nchange in tandem with the stock, as with a 1.00 delta; or it cannot change at\nall as the stock moves, as with a 0 delta; or anything in between. By\ndefinition, stock has a 1.00 delta—it is the underlying security. A $1 rise in\nthe stock yields a $100 profit on a round lot of 100 shares. A call with a\n0.60 delta rises by $0.60 with a $1 increase in the stock. The owner of a call\nrepresenting rights on 100 shares earns $60 for a $1 increase in the\nunderlying. It’s as if the call owner in this example is long 60 shares of the\nunderlying stock. Delta is the option’s equivalent of a position in the\nunderlying shares .\nA trader who buys five 0.43-delta calls has a position that is effectively\nlong 215 shares—that’s 5 contracts × 0.43 deltas × 100 shares. In option\nlingo, the trader is long 215 deltas. Likewise, if the trader were short five\n0.43-delta calls, the trader would be short 215 deltas.\nThe same principles apply to puts. Being long 10 0.59-delta puts makes\nthe trader short a total of 590 deltas, a position that profits or loses like\nbeing short 590 shares of the underlying stock. Conversely, if the trader\nwere short 10 0.59-delta puts, the trader would theoretically make $590 if\nthe stock were to rise $1 and lose $590 if the stock fell by $1—just like\nbeing long 590 shares.\nDefinition 4 : The final definition of delta is considered the trader’s\ndefinition. It’s mathematically imprecise but is used nonetheless as a\ngeneral rule of thumb by option traders. A trader would say the delta is a\nstatistical approximation of the likelihood of the option expiring in-the-\nmoney . An option with a 0.75 delta would have a 75 percent chance of\nbeing in-the-money at expiration under this definition. An option with a\n0.20 delta would be thought of having a 20 percent chance of expiring in-\nthe-money.\nDynamic Inputs\nOption deltas are not constants. They are calculated from the dynamic\ninputs of the pricing model—stock price, time to expiration, volatility, and\nso on. When these variables change, the changes affect the delta. These\nchanges can be mathematically quantified—they are systematic.\nUnderstanding these patterns and other quirks as to how delta behaves can\nhelp traders use this tool more effectively. Let’s discuss a few observations\nabout the characteristics of delta.\nFirst, call and put deltas are closely related. Exhibit 2.2 is a partial option\nchain of 70-day calls and puts in Rambus Incorporated (RMBS). The stock\nwas trading at $21.30 when this table was created. In Exhibit 2.2 , the 20\ncalls have a 0.66 delta.\nEXHIBIT 2.2 RMBS Option chain with deltas.\nNotice the deltas of the put-call pairs in this exhibit. As a general rule, the\nabsolute value of the call delta plus the absolute value of the put delta add\nup to close to 1.00. The reason for this has to do with a mathematical\nrelationship called put-call parity, which is briefly discussed later in this\nchapter and described in detail in Chapter 6. But with equity options, the\nput-call pair doesn’t always add up to exactly 1.00.\nSometimes the difference is simply due to rounding. But sometimes there\nare other reasons. For example, the 30-strike calls and puts in Exhibit 2.2\nhave deltas of 0.14 and −0.89, respectively. The absolute values of the\ndeltas add up to 1.03. Because of the possibility of early exercise of\nAmerican options, the put delta is a bit higher than the call delta would\nimply. When puts have a greater chance of early exercise, they begin to act\nmore like short stock and consequently will have a greater delta. Often,\ndividend-paying stocks", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 12}
{"text": "xhibit 2.2\nhave deltas of 0.14 and −0.89, respectively. The absolute values of the\ndeltas add up to 1.03. Because of the possibility of early exercise of\nAmerican options, the put delta is a bit higher than the call delta would\nimply. When puts have a greater chance of early exercise, they begin to act\nmore like short stock and consequently will have a greater delta. Often,\ndividend-paying stocks will have higher deltas on some in-the-money calls\nthan the put in the pair would imply. As the ex-dividend date—the date the\nstock begins trading without the dividend—approaches, an in-the-money\ncall can become more apt to be exercised, because traders will want to own\nstock to capture the dividend. Here, the call begins to act more like long\nstock, leading to a higher delta.\nMoneyness and Delta\nThe next observation is the effect of moneyness on the option’s delta.\nMoneyness describes the degree to which the option is in- or out-of-the-\nmoney. As a general rule, options that are in-the-money (ITM) have deltas\ngreater than 0.50. Options that are out-of-the-money (OTM) have deltas\nless than 0.50. Finally, options that are at-the-money (ATM) have deltas that\nare about 0.50. The more in-the-money the option is, the closer to 1.00 the\ndelta is. The more out-of-the-money, the closer the delta is to 0.\nBut ATM options are usually not exactly 0.50. For ATMs, both the call\nand the put deltas are generally systematically a value other than 0.50.\nTypically, the call has a higher delta than 0.50 and the put has a lower\nabsolute value than 0.50. Incidentally, the call’s theoretical value is\ngenerally greater than the put’s when the options are right at-the-money as\nwell. One reason for this disparity between exactly at-the-money calls and\nputs is the interest rate. The more time until expiration, the more effect the\ninterest rate will have, and, therefore, the higher the call’s theoretical and\ndelta will be relative to the put.\nEffect of Time on Delta\nIn a close contest, the last few minutes of a football game are often the most\nexciting—not because the players run faster or knock heads harder but\nbecause one strategic element of the game becomes more and more\nimportant: time. The team that’s in the lead wants the game clock to run\ndown with no interruption to solidify its position. The team that’s losing\nuses its precious time-outs strategically. The more playing time left, the less\ncertain defeat is for the losing team.\nAlthough mathematically imprecise, the trader’s definition can help us\ngain insight into how time affects option deltas. The more time left until an\noption’s expiration, the less certain it is whether the option will be ITM or\nOTM at expiration. The deltas of both the ITM and the OTM options reflect\nthat uncertainty. The more time left in the life of the option, the closer the\ndeltas tend to gravitate to 0.50. A 0.50 delta represents the greatest level of\nuncertainty—a coin toss. Exhibit 2.3 shows the deltas of a hypothetical\nequity call with a strike price of 50 at various stock prices with different\ntimes until expiration. All other parameters are held constant.\nEXHIBIT 2.3 Estimated delta of 50-strike call—impact of time.\n\nAs shown in Exhibit 2.3 , the more time until expiration, the closer ITMs\nand OTMs move to 0.50. At expiration, of course, the option is either a 100\ndelta or a 0 delta; it’s either stock or not.\nEffect of Volatility on Delta\nThe level of volatility affects option deltas as well. We’ll discuss volatility\nin more detail in future chapters, but it’s important to address it here as it\nrelates to the concept of delta. Exhibit 2.4 shows how changing the\nvolatility percentage (explained further in Chapter 3), as opposed to the\ntime to expiration, affects option deltas. In this table, the delta of a call with\n91 days until expiration is studied.\nEXHIBIT 2.4 Estimated delta of 50-strike call—impact of volatility.\nNotice the effect that volatility has on the deltas of this option with the\nunderlying stock at various prices. In this table, at a low volatility with the\ncall deep in- or out-of-the-money, the delta is very large or very small,\nrespectively. At 10 percent volatility with the stock at $58 a share, the delta\nis 1.00. At that same volatility level with the stock at $42 a share, the delta\nis 0.\nBut at higher volatility levels, the deltas change. With the stock at $58, a\n45 percent volatility gives the 50-strike call a 0.79 delta—much smaller\nthan it was at the low volatility level. With the stock at $42, a 45-percent\nvolatility returns a 0.30 delta for the call. Generally speaking, ITM option\ndeltas are smaller given a higher volatility assumption, and OTM option\ndeltas are bigger with a higher volatility.\nEffect of Stock Price on Delta\nAn option that is $5 in-the-money on a $20 stock will have a higher delta\nthan an option that is $5 in-the-money on a $200 stock. Proportionately, the\nformer is more in-the-money. Comparing two options that are in-the-money\nby the same percentage yields similar results.\nAs the stock price changes because the strike price remains stable, the\noption’s delta will change. This phenomenon is measured by the option’s\ngamma.\nGamma\nThe strike price is the only constant in the pricing model. When the stock\nprice moves relative to this constant, the option in question becomes more\nin-the-money or out-of-the-money. This means the delta changes. This\nisolated change is measured by the option’s gamma, sometimes called\ncurvature .\nGamma (Γ) is the rate of change of an option’s delta given a change in\nthe price of the underlying security . Gamma is conventionally stated in\nterms of deltas per dollar move. The simplified examples above under\nDefinition 1 of delta, used to describe the effect of delta, had one important\npiece of the puzzle missing: gamma. As the stock price moved higher in\nthose examples, the delta would not remain constant. It would change due\nto the effect of gamma. The following example shows how the delta would\nchange given a 0.04 g", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 13}
{"text": "ally stated in\nterms of deltas per dollar move. The simplified examples above under\nDefinition 1 of delta, used to describe the effect of delta, had one important\npiece of the puzzle missing: gamma. As the stock price moved higher in\nthose examples, the delta would not remain constant. It would change due\nto the effect of gamma. The following example shows how the delta would\nchange given a 0.04 gamma attributed to the call option.\nThe call in this example starts as a 0.50-delta option. When the stock\nprice increases by $1, the delta increases by the amount of the gamma. In\nthis example, delta increases from 0.50 to 0.54, adding 0.04 deltas. As the\nstock price continues to rise, the delta continues to move higher. At $62, the\ncall’s delta is 0.58.\nThis increase in delta will affect the value of the call. When the stock\nprice first begins to rise from $60, the option value is increasing at a rate of\n50 percent—the call’s delta at that stock price. But by the time the stock is\nat $61, the option value is increasing at a rate of 54 percent of the stock\nprice. To estimate the theoretical value of the call at $61, we must first\nestimate the average change in the delta between $60 and $61. The average\ndelta between $60 and $61 is roughly 0.52. It’s difficult to calculate the\naverage delta exactly because gamma is not constant; this is discussed in\nmore detail later in the chapter. A more realistic example of call values in\nrelation to the stock price would be as follows:\nEach $1 increase in the stock shows an increase in the call value about\nequal to the average delta value between the two stock prices. If the stock\nwere to decline, the delta would get smaller at a decreasing rate.\nAs the stock price declines from $60 to $59, the option delta decreases\nfrom 0.50 to 0.46. There is an average delta of about 0.48 between the two\nstock prices. At $59 the new theoretical value of the call is 2.52. The\ngamma continues to affect the option’s delta and thereby its theoretical\nvalue as the stock continues its decline to $58 and beyond.\nPuts work the same way, but because they have a negative delta, when\nthere is a positive stock-price movement the gamma makes the put delta\nless negative, moving closer to 0. The following example clarifies this.\nAs the stock price rises, this put moves more and more out-of-the-money.\nIts theoretical value is decreasing by the rate of the changing delta. At $60,\nthe delta is −0.40. As the stock rises to $61, the delta changes to −0.36. The\naverage delta during that move is about −0.38, which is reflected in the\nchange in the value of the put.\nIf the stock price declines and the put moves more toward being in-the-\nmoney, the delta becomes more negative—that is, the put acts more like a\nshort stock position.\nHere, the put value rises by the average delta value between each\nincremental change in the stock price.\nThese examples illustrate the effect of gamma on an option without\ndiscussing the impact on the trader’s position. When traders buy options,\nthey acquire positive gamma. Since gamma causes options to gain value at\na faster rate and lose value at a slower rate, (positive) gamma helps the\noption buyer. A trader buying one call or put in these examples would have\n+0.04 gamma. Buying 10 of these options would give the trader a +0.4\ngamma.\nWhen traders sell options, gamma works against them. When options lose\nvalue, they move toward zero at a slower rate. When the underlying moves\nadversely, gamma speeds up losses. Selling options yields a negative\ngamma position. A trader selling one of the above calls or puts would have\n−0.04 gamma per option.\nThe effect of gamma is less significant for small moves in the underlying\nthan it is for bigger moves. On proportionately large moves, the delta can\nchange quite a bit, making a big difference in the position’s P&(L). In\nExhibit 2.1 , the left side of the diagram showed the call price not\nincreasing at all with advances in the stock—a 0 delta. The right side\nshowed the option advancing in price 1-to-1 with the stock—a 1.00 delta.\nBetween the two extremes, the delta changes. From this diagram another\ndefinition for gamma can be inferred: gamma is the second derivative of the\ngraph of the option price relative to the stock price. Put another way,\ngamma is the first derivative of a graph of the delta relative to the stock\nprice. Exhibit 2.5 illustrates the delta of a call relative to the stock price.\nEXHIBIT 2.5 Call delta compared with stock price.\nNot only does the delta change, but it changes at a changing rate. Gamma\nis not constant. Moneyness, time to expiration, and volatility each have an\neffect on the gamma of an option.\nDynamic Gamma\nWhen options are far in-the-money or out-of-the-money, they are either\n1.00 delta or 0 delta. At the extremes, small changes in the stock price will\nnot cause the delta to change much. When an option is at-the-money, it’s a\ndifferent story. Its delta can change very quickly.\nITM and OTM options have a low gamma.\nATM options have a relatively high gamma.\nExhibit 2.6 is an example of how moneyness translates into gamma on\nQQQ calls.\nEXHIBIT 2.6 Gamma of QQQ calls with QQQ at $44.\nWith QQQ at $44, 92 days until expiration, and a constant volatility input\nof 19 percent, the 36- and 54-strike calls are far enough in- and out-of-the-\nmoney, respectively, that if the Qs move a small amount in either direction\nfrom the current price of $44, the movement won’t change their deltas\nmuch at all. The chances of their money status changing between now and\nexpiration would not be significantly different statistically given a small\nstock price change. They have the smallest gammas in the table.\nThe highest gammas shown here are around the ATM strike prices. (Note\nthat because of factors not yet discussed, the strike that is exactly at-the-\nmoney may not have the highest gamma. The highest gamma is likely to\noccur at a slightly higher strike price.) Exhibit 2.7 shows a graph of the\ncorresponding numbers in Exhi", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 14}
{"text": "given a small\nstock price change. They have the smallest gammas in the table.\nThe highest gammas shown here are around the ATM strike prices. (Note\nthat because of factors not yet discussed, the strike that is exactly at-the-\nmoney may not have the highest gamma. The highest gamma is likely to\noccur at a slightly higher strike price.) Exhibit 2.7 shows a graph of the\ncorresponding numbers in Exhibit 2.6 .\nEXHIBIT 2.7 Option gamma.\nA decrease in the time to expiration solidifies the likelihood of ITMs or\nOTMs remaining as such. But an ATM option’s moneyness at expiration\nremains to the very end uncertain. As expiration draws nearer, the gamma\ndecreases for ITMs and OTMs and increases for the ATM strikes. Exhibit\n2.8 shows the same 92-day QQQ calls plotted against 7-day QQQ calls.\nEXHIBIT 2.8 Gamma as time passes.\n\nAt seven days until expiration, there is less time for price action in the\nstock to change the expected moneyness at expiration of ITMs or OTMs.\nATM options, however, continue to be in play. Here, the ATM gamma is\napproaching 0.35. But the strikes below 41 and above 48 have 0 gamma.\nSimilarly-priced securities that tend to experience bigger price swings\nmay have strikes $3 away-from-the-money with seven-day gammas greater\nthan zero. The volatility of the underlying will affect gamma, too. Exhibit\n2.9 shows the same 19 percent volatility QQQ calls in contrast with a graph\nof the gamma if the volatility is doubled.\nEXHIBIT 2.9 Gamma as volatility changes.\nRaising the volatility assumption flattens the curve, causing ITM and\nOTM to have higher gamma while lowering the gamma for ATMs.\nShort-term ATM options with low volatility have the highest gamma.\nLower gamma is found in ATMs when volatility is higher and it is lower for\nITMs and OTMs and in longer-dated options.\nTheta\nOption prices can be broken down into two parts: intrinsic value and time\nvalue. Intrinsic value is easily measurable. It is simply the ITM part of the\npremium. Time value, or extrinsic value, is what’s left over—the premium\npaid over parity for the option. All else held constant, the more time left in\nthe life of the option, the more valuable it is—there is more time for the\nstock to move. And as the useful life of an option decreases, so does its time\nvalue.\nThe decline in the value of an option because of the passage of time is\ncalled time decay, or erosion. Incremental measurements of time decay are\nrepresented by the Greek letter theta (θ). Theta is the rate of change in an\noption’s price given a unit change in the time to expiration . What exactly is\nthe unit involved here? That depends.\nSome providers of option greeks will display thetas that represent one\nday’s worth of time decay. Some will show thetas representing seven days\nof decay. In the case of a one-day theta, the figure may be based on a seven-\nday week or on a week counting only trading days. The most common and,\narguably, most useful display of this figure is the one-day theta based on the\nseven-day week. There are, after all, seven days in a week, each day of\nwhich can see an occurrence with the potential to cause a revaluation in the\nstock price (that is, news can come out on Saturday or Sunday). The one-\nday theta based on a seven-day week will be used throughout this book.\nTaking the Day Out\nWhen the number of days to expiration used in the pricing model declines\nfrom, say, 32 days to 31 days, the price of the option decreases by the\namount of the theta, all else held constant. But when is the day “taken out”?\nIt is intuitive to think that after the market closes, the model is changed to\nreflect the passing of one day’s time. But, in fact, this change is logically\nanticipated and may be priced in early.\nIn the earlier part of the week, option prices can often be observed getting\ncheaper relative to the stock price sometime in the middle of the day. This is\nbecause traders will commonly take the day out of their model during\ntrading hours after the underlying stabilizes following the morning\nbusiness. On Fridays and sometimes Thursdays, traders will take all or part\nof the weekend out. Commonly, by Friday afternoon, traders will be using\nMonday’s days to value their options.\nWhen option prices are seen getting cheaper on, say, a Friday, how can\none tell whether this is the effect of the market taking the weekend out or a\nchange in some other input, such as volatility? To some degree, it doesn’t\nmatter. Remember, the model is used to reflect what the market is doing,\nnot the other way around. In many cases, it’s logical to presume that small\ndevaluations in option prices intraday can be attributed to the routine of the\nmarket taking the day out.\nFriend or Foe?\nTheta can be a good thing or a bad thing, depending on the position. Theta\nhurts long option positions; whereas it helps short option positions. Take an\n80-strike call with a theoretical value of 3.16 on a stock at $82 a share. The\n32-day 80 call has a theta of 0.03. If a trader owned one of these calls, the\ntrader’s position would theoretically lose 0.03, or $0.03, as the time until\nexpiration change from 32 to 31 days. This trader has a negative theta\nposition. A trader short one of these calls would have an overnight\ntheoretical profit of $0.03 attributed to theta. This trader would have a\npositive theta.\nTheta affects put traders as well. Using all the same modeling inputs, the\n32-day 80-strike put would have a theta of 0.02. A put holder would\ntheoretically lose $0.02 a day, and a put writer would theoretically make\n$0.02. Long options carry with them negative theta; short options carry\npositive theta.\nA higher theta for the call than for the put of the same strike price is\ncommon when an interest rate greater than zero is used in the pricing\nmodel. As will be discussed in greater detail in the section on rho, interest\ncauses the time value of the call to be higher than that of the corresponding\nput. At expiration, there is no time value left in either option. Because the\ncall begin", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 15}
{"text": "itive theta.\nA higher theta for the call than for the put of the same strike price is\ncommon when an interest rate greater than zero is used in the pricing\nmodel. As will be discussed in greater detail in the section on rho, interest\ncauses the time value of the call to be higher than that of the corresponding\nput. At expiration, there is no time value left in either option. Because the\ncall begins with more time value, its premium must decline at a faster rate\nthan that of the put. Most modeling software will attribute the disparate\nrates of decline in value all to theta, whereas some modeling interfaces will\nmake clear the distinction between the effect of time decay and the effect of\ninterest on the put-call pair.\nThe Effect of Moneyness and Stock Price\non Theta\nTheta is not a constant. As variables influencing option values change, theta\ncan change, too. One such variable is the option’s moneyness. Exhibit 2.10\nshows theoretical values (theos), time values, and thetas for 3-month\noptions on Adobe (ADBE). In this example, Adobe is trading at $31.30 a\nshare with three months until expiration. The more ITM a call or a put gets,\nthe higher its theoretical value. But when studying an option’s time decay,\none needs to be concerned only with the option’s time value, because\nintrinsic value is not subject to time decay.\nEXHIBIT 2.10 Adobe theos and thetas (Adobe at $31.30).\nThe ATM options shown here have higher time value than ITM or OTM\noptions. Hence, they have more time premium to lose in the same three-\nmonth period. ATM options have the highest rate of decay, which is\nreflected in higher thetas. As the stock price changes, the theta value will\nchange to reflect its change in moneyness.\nIf this were a higher-priced stock, say, 10 times the stock price used in\nthis example, with all other inputs held constant, the option values, and\ntherefore the thetas, would be higher. If this were a stock trading at $313,\nthe 325-strike call would have a theoretical value of 16.39 and a one-day\ntheta of 0.189, given inputs used otherwise identical to those in the Adobe\nexample.\nThe Effects of Volatility and Time on\nTheta\nStock price is not the only factor that affects theta values. Volatility and\ntime to expiration come into play here as well. The volatility input to the\npricing model has a direct relationship to option values. The higher the\nvolatility, the higher the value of the option. Higher-valued options decay at\na faster rate than lower-valued options—they have to; their time values will\nboth be zero at expiration. All else held constant, the higher the volatility\nassumption, the higher the theta.\nThe days to expiration have a direct relationship to option values as well.\nAs the number of days to expiration decreases, the rate at which an option\ndecays may change, depending on the relationship of the stock price to the\nstrike price. ATM options tend to decay at a nonlinear rate—that is, they\nlose value faster as expiration approaches—whereas the time values of ITM\nand OTM options decay at a steadier rate.\nConsider a hypothetical stock trading at $70 a share. Exhibit 2.11 shows\nhow the theoretical values of the 75-strike call and the 70-strike call decline\nwith the passage of time, holding all other parameters constant.\nEXHIBIT 2.11 Rate of decay: ATM vs. OTM.\n\nThe OTM 75-strike call has a fairly steady rate of time decay over this\n26-week period. The ATM 70-strike call, however, begins to lose its value\nat an increasing rate as expiration draws nearer. The acceleration of\npremium erosion continues until the option expires. Exhibit 2.12 shows the\nthetas for this ATM call during the last 10 days before expiration.\nEXHIBIT 2.12 Theta as expiration approaches.\nDays to Exp .ATM Theta\n10 0.075\n9 0.079\n8 0.084\n7 0.089\n6 0.096\n5 0.106\n4 0.118\n3 0.137\n2 0.171\n1 0.443\nIncidentally, in this example, when there is one day to expiration, the\ntheoretical value of this call is about 0.44. The final day before expiration\nultimately sees the entire time premium erode.\nVega\nOver the past decade or so, computers have revolutionized option trading.\nOptions traded through an online broker are filled faster than you can say,\n“Oops! I meant to click on puts.” Now trading is facilitated almost entirely\nonline by professional and retail traders alike. Market and trading\ninformation is disseminated worldwide in subseconds, making markets all\nthe more efficient. And the tools now available to the common retail trader\nare very powerful as well. Many online brokers and other web sites offer\nhigh-powered tools like screeners, which allow traders to sift through\nthousands of options to find those that fit certain parameters.\nUsing a screener to find ATM calls on same-priced stocks—say, stocks\ntrading at $40 a share—can yield a result worth talking about here. One $40\nstock can have a 40-strike call trading at around 0.50, while a different $40\nstock can have a 40 call with the same time to expiration trading at more\nlike 2.00. Why? The model doesn’t know the name of the company, what\nindustry it’s in, or what its price-to-earnings ratio is. It is a mathematical\nequation with six inputs. If five of the inputs—the stock price, strike price,\ntime to expiration, interest rate, and dividends—are identical for two\ndifferent options but they’re trading at different prices, the difference must\nbe the sixth variable, which is volatility.\nImplied Volatility (IV) and Vega\nThe volatility component of option values is called implied volatility (IV).\n(For more on implied volatility and how it relates to vega, see Chapter 3.)\nIV is a percentage, although in practice the percent sign is often omitted.\nThis is the value entered into a pricing model, in conjunction with the other\nvariables, that returns the option’s theoretical value. The higher the\nvolatility input, the higher the theoretical value, holding all other variables\nconstant. The IV level can change and often does—sometimes dramatically.\nWhen IV rises or falls, option prices rise", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 16}
{"text": "although in practice the percent sign is often omitted.\nThis is the value entered into a pricing model, in conjunction with the other\nvariables, that returns the option’s theoretical value. The higher the\nvolatility input, the higher the theoretical value, holding all other variables\nconstant. The IV level can change and often does—sometimes dramatically.\nWhen IV rises or falls, option prices rise and fall in line with it. But by how\nmuch?\nThe relationship between changes in IV and changes in an option’s value\nis measured by the option’s vega. Vega is the rate of change of an option’s\ntheoretical value relative to a change in implied volatility . Specifically, if\nthe IV rises or declines by one percentage point, the theoretical value of the\noption rises or declines by the amount of the option’s vega, respectively.\nFor example, if a call with a theoretical value of 1.82 has a vega of 0.06 and\nIV rises one percentage point from, say, 17 percent to 18 percent, the new\ntheoretical value of the call will be 1.88—it would rise by 0.06, the amount\nof the vega. If, conversely, the IV declines 1 percentage point, from 17\npercent to 16 percent, the call value will drop to 1.76—that is, it would\ndecline by the vega.\nA put with the same expiration month and the same strike on the same\nunderlying will have the same vega value as its corresponding call. In this\nexample, raising or lowering IV by one percentage point would cause the\ncorresponding put value to rise or decline by $0.06, just like the call.\nAn increase in IV and the consequent increase in option value helps the\nP&(L) of long option positions and hurts short option positions. Buying a\ncall or a put establishes a long vega position. For short options, the opposite\nis true. Rising IV adversely affects P&(L), whereas falling IV helps.\nShorting a call or put establishes a short vega position.\nThe Effect of Moneyness on Vega\nLike the other greeks, vega is a snapshot that is a function of multiple facets\nof determinants influencing option value. The stock price’s relationship to\nthe strike price is a major determining factor of an option’s vega. IV affects\nonly the time value portion of an option. Because ATM options have the\ngreatest amount of time value, they will naturally have higher vegas. ITM\nand OTM options have lower vega values than those of the ATM options.\nExhibit 2.13 shows an example of 186-day options on AT&T Inc. (T),\ntheir time value, and the corresponding vegas.\nEXHIBIT 2.13 AT&T theos and vegas (T at $30, 186 days to Expry, 20%\nIV).\nNote that the 30-strike calls and puts have the highest time values. This\nstrike boasts the highest vega value, at 0.085. The lower the time premium,\nthe lower the vega—therefore, the less incremental IV changes affect the\noption. Since higher-priced stocks have higher time premium (in absolute\nterms, not necessarily in percentage terms) they will have higher vega.\nIncidentally, if this were a $300 stock instead of a $30 stock, the 186-day\nATMs would have a 0.850 vega, if all other model inputs remain the same.\nThe Effect of Implied Volatility on Vega\nThe distribution of vega values among the strike prices shown in Exhibit\n2.13 holds for a specific IV level. The vegas in Exhibit 2.13 were calculated\nusing a 20 percent IV. If a different IV were used in the calculation, the\nrelationship of the vegas to one another might change. Exhibit 2.14 shows\nwhat the vegas would be at different IV levels.\nEXHIBIT 2.14 Vega and IV.\nNote in Exhibit 2.14 that at all three IV levels, the ATM strike maintains a\nsimilar vega value. But the vegas of the ITM and OTM options can be\nsignificantly different. Lower IV inputs tend to cause ITM and OTM vegas\nto decline. Higher IV inputs tend to cause vegas to increase for ITMs and\nOTMs.\nThe Effect of Time on Vega\nAs time passes, there is less time premium in the option that can be affected\nby changes in IV. Consequently, vega gets smaller as expiration approaches.\nExhibit 2.15 shows the decreasing vega of a 50-strike call on a $50 stock\nwith a 25 percent IV as time to expiration decreases. Notice that as the\nvalue of this ATM option decreases at its nonlinear rate of decay, the vega\ndecreases in a similar fashion.\nEXHIBIT 2.15 The effect of time on vega.\n\nRho\nOne of my early jobs in the options business was clerking on the floor of\nthe Chicago Board of Trade in what was called the bond room. On one of\nmy first days on the job, the trader I worked for asked me what his position\nwas in a certain strike. I told him he was long 200 calls and long 300 puts.\n“I’m long 500 puts?” he asked. “No,” I corrected, “you’re long 200 calls\nand 300 puts.” At this point, he looked at me like I was from another planet\nand said, “That’s 500. A put is a call; a call is a put.” That lesson was the\nbeginning of my journey into truly understanding options.\nPut-Call Parity\nPut and call values are mathematically bound together by an equation\nreferred to as put-call parity. In its basic form, put-call parity states:\nwhere\nc = call value,\nPV(x) = present value of the strike price,\np = put value, and\ns = stock price.\nThe put-call parity assumes that options are not exercised before\nexpiration (that is, that they are European style). This version of the put-call\nparity is for European options on non-dividend-paying stocks. Put-call\nparity can be modified to reflect the values of options on stocks that pay\ndividends. In practice, equity-option traders look at the equation in a\nslightly different way:\nTraders serious about learning to trade options must know put-call parity\nbackward and forward. Why? First, by algebraically rearranging this\nequation, it can be inferred that synthetically equivalent positions can be\nestablished by simply adding stock to an option. Again, a put is a call; a call\nis a put.\nand\nFor example, a long call is synthetically equal to a long stock position\nplus a long put on the same strike, once interest and dividends are figured\nin. A synthetic long stock position is created by buyi", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 17}
{"text": "braically rearranging this\nequation, it can be inferred that synthetically equivalent positions can be\nestablished by simply adding stock to an option. Again, a put is a call; a call\nis a put.\nand\nFor example, a long call is synthetically equal to a long stock position\nplus a long put on the same strike, once interest and dividends are figured\nin. A synthetic long stock position is created by buying a call and selling a\nput of the same month and strike. Understanding synthetic relationships is\nintrinsic to understanding options. A more comprehensive discussion of\nsynthetic relationships and tactical considerations for creating synthetic\npositions is offered in Chapter 6.\nPut-call parity also aids in valuing options. If put-call parity shows a\ndifference in the value of the call versus the value of the put with the same\nstrike, there may be an arbitrage opportunity. That translates as “riskless\nprofit.” Buying the call and selling it synthetically (short put and short\nstock) could allow a profit to be locked in if the prices are disparate.\nArbitrageurs tend to hold synthetic put and call prices pretty close together.\nGenerally, only professional traders can capture these types of profit\nopportunities, by trading big enough positions to make very small profits (a\npenny or less per contract sometimes) matter. Retail traders may be able to\ntake advantage of a disparity in put and call values to some extent, however,\nby buying or selling the synthetic as a substitute for the actual option if the\nposition can be established at a better price synthetically.\nAnother reason that a working knowledge of put-call parity is essential is\nthat it helps attain a better understanding of how changes in the interest rate\naffect option values. The greek rho measures this change. Rho is the rate of\nchange in an option’s value relative to a change in the interest rate.\nAlthough some modeling programs may display this number differently,\nmost display a rho for the call and a rho for the put, both illustrating the\nsensitivity to a one-percentage-point change in the interest rate. When the\ninterest rate rises by one percentage point, the value of the call increases by\nthe amount of its rho and the put decreases by the amount of its rho.\nLikewise, when the interest rate decrease by one percentage point, the value\nof the call decreases by its rho and the put increases by its rho. For example,\na call with a rho of 0.12 will increase $0.12 in value if the interest rate used\nin the model is increased by one percentage point. Of course, interest rates\nusually don’t rise or fall one percentage point in one day. More commonly,\nrates will have incremental changes of 25 basis points. That means a call\nwith a 0.12 rho will theoretically gain $0.03 given an increase of 0.25\npercentage points.\nMathematically, this change in option value as a product of a change in\nthe interest rate makes sense when looking at the formula for put-call parity.\nand\n\nBut the change makes sense intuitively, too, when a call is considered as a\ncheaper substitute for owning the stock. For example, compare a $100 stock\nwith a three-month 60-strike call on that same stock. Being so far ITM,\nthere would likely be no time value in the call. If the call can be purchased\nat parity, which alternative would be a superior investment, the call for $40\nor the stock for $100? Certainly, the call would be. It costs less than half as\nmuch as the stock but has the same reward potential; and the $60 not spent\non the stock can be invested in an interest-bearing account. This interest\nadvantage adds value to the call. Raising the interest rate increases this\nvalue, and lowering it decreases the interest component of the value of the\ncall.\nA similar concept holds for puts. Professional traders often get a short-\nstock rebate on proceeds from a short-stock sale. This is simply interest\nearned on the capital received when the stock is shorted. Is it better to pay\ninterest on the price of a put for a position that gives short exposure or to\nreceive interest on the credit from shorting the stock? There is an interest\ndisadvantage to owning the put. Therefore, a rise in interest rates devalues\nputs.\nThis interest effect becomes evident when comparing ATM call and put\nprices. For example, with interest at 5 percent, three-month options on an\n$80 stock that pays a $0.25 dividend before option expiration might look\nsomething like this:\nThe ATM call is higher in theoretical value than the ATM put by $0.75.\nThat amount can be justified using put-call parity:\n(Here, simple interest of $1 is calculated as 80 × 0.05 × [90 / 360] = 1.)\nChanges in market conditions are kept in line by the put-call parity. For\nexample, if the price of the call rises because of an increase in IV, the price\nof the put will rise in step. If the interest rate rises by a quarter of a\npercentage point, from 5 percent to 5.25 percent, the interest calculated for\nthree months on the 80-strike will increase from $1 to $1.05, causing the\ndifference between the call and put price to widen. Another variable that\naffects the amount of interest and therefore option prices is the time until\nexpiration.\nThe Effect of Time on Rho\nThe more time until expiration, the greater the effect interest rate changes\nwill have on options. In the previous example, a 25-basis-point change in\nthe interest rate on the 80-strike based on a three-month period caused a\nchange of 0.05 to the interest component of put-call parity. That is, 80 ×\n0.0025 × (90/360) = 0.05. If a longer period were used in the example—say,\none year—the effect would be more profound; it will be $0.20: 80 × 0.0025\n× (360/360) = 0.20. This concept is evident when the rhos of options with\ndifferent times to expiration are studied.\nExhibit 2.16 shows the rhos of ATM Procter & Gamble Co. (PG) calls\nwith various expiration months. The 750-day Long-Term Equity\nAnticiPation Securities (LEAPS) have a rho of 0.858. As the number of\ndays until expiration decreases, rho", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 18}
{"text": "be more profound; it will be $0.20: 80 × 0.0025\n× (360/360) = 0.20. This concept is evident when the rhos of options with\ndifferent times to expiration are studied.\nExhibit 2.16 shows the rhos of ATM Procter & Gamble Co. (PG) calls\nwith various expiration months. The 750-day Long-Term Equity\nAnticiPation Securities (LEAPS) have a rho of 0.858. As the number of\ndays until expiration decreases, rho decreases. The 22-day calls have a rho\nof only 0.015. Rho is usually a fairly insignificant factor in the value of\nshort-term options, but it can come into play much more with long-term\noption strategies involving LEAPS.\nEXHIBIT 2.16 The effect of time on rho (Procter & Gamble @ $64.34)\n\nWhy the Numbers Don’t Don’t Always\nAdd Up\nThere will be many times when studying the rho of options in an option\nchain will reveal seemingly counterintuitive results. To be sure, the numbers\ndon’t always add up to what appears logical. One reason for this is\nrounding. Another is that traders are more likely to use simple interest in\ncalculating value, whereas the model uses compound interest. Hard-to-\nborrow stocks and stocks involved in mergers and acquisitions may have\nput-call parities that don’t work out right. But another, more common and\nmore significant fly in the ointment is early exercise.\nSince the interest input in put-call parity is a function of the strike price, it\nis reasonable to expect that the higher the strike price, the greater the effect\nof interest on option prices will be. For European options, this is true to a\nlarge extent, in terms of aggregate impact of interest on the call and put pair.\nStrikes below the price where the stock is trading have a higher rho\nassociated with the call relative to the put, whereas strikes above the stock\nprice have a higher rho associated with the put relative to the call.\nEssentially, the more in-the-money an option is, the higher its rho. But with\nEuropean options, observing the aggregate of the absolute values of the call\nand put rhos would show a higher combined rho the higher the strike.\nWith American options, the put can be exercised early. A trader will\nexercise a put before expiration if the alternative—being short stock and\nreceiving a short stock rebate—is a wiser choice based on the price of the\nput. Professional traders may own stock as a hedge against a put. They may\nexercise deep ITM puts (1.00-delta puts) to avoid paying interest on capital\ncharges related to the stock. The potential for early exercise is factored into\nmodels that price American options. Here, when puts get deeper in-the-\nmoney—that is, more apt to be exercised—the rho decreases. When the\nstrike price is very high relative to the stock price—meaning the put is very\ndeep ITM—and there is little or no time value left to the call or the put, the\naggregate put-call rho can be zero. Rho is discussed in greater detail in\nChapter 7.\nTHE GREEKS DEFINED\nDelta (Δ) is:\n1. The rate of change in an option’s value relative to a change in the underlying asset\nprice.\n2. The derivative of the graph of an option’s value in relation to the underlying asset\nprice.\n3. The equivalent of underlying asset represented by an option position.\n4. The estimate of the likelihood of an option’s expiring in-the-money.\nGamma (Γ) is the rate of change in an option’s delta given a change in the price of the\nunderlying asset.\nTheta (θ) is the rate of change in an option’s value given a unit change in the time to\nexpiration.\nVega is the rate of change in an option’s value relative to a change in implied volatility.\nRho (ρ) is the rate of change in an option’s value relative to a change in the interest rate.\nWhere to Find Option Greeks\nThere are many sources from which to obtain greeks. The Internet is an\nexcellent resource. Googling “option greeks” will display links to over four\nmillion web pages, many of which have real-time greeks or an option\ncalculator. An option calculator is a simple interface that accepts the input\nof the six variables to the model and yields a theoretical value and the\ngreeks for a single option.\nSome web sites devoted to option education, such as\nMarketTaker.com/option_modeling , have free calculators that can be used\nfor modeling positions and using the greeks.\nIn practice, many of the option-trading platforms commonly in use have\nsophisticated analytics that involve greeks. Most options-friendly online\nbrokers provide trading platforms that enable traders to conduct\ncomprehensive manipulations of the greeks. For example, traders can look\nat the greeks for their positions up or down one, two, or three standard\ndeviations. Or they can see what happens to their position greeks if IV or\ntime changes. With many trading platforms, position greeks are updated in\nreal time with changes in the stock price—an invaluable feature for active\ntraders.\nCaveats with Regard to Online\nGreeks\nOften, online greeks are one click away, requiring little effort on the part of\nthe trader. Having greeks calculated automatically online is a quick and\nconvenient way to eyeball greeks for an option. But there is one major\nproblem with online greeks: reliability.\nFor active option traders, greeks are essential. There is no point in using\nthese figures if their accuracy cannot be assured. Experienced traders can\noften spot these inaccuracies a proverbial mile away.\nWhen looking at greeks from an online source that does not require you\nto enter parameters into a model (as would be the case with professional\noption-trading platforms), special attention needs to be paid to the\nrelationship of the option’s theoretical values to the bid and offer. One must\nbe cautious if the theoretical value of the option lies outside the bid-ask\nspread. This scenario can exist for brief periods of time, but arbitrageurs\ntend to prevent this from occurring routinely. If several options in a chain\nall have theoretical values below the bid or above the offer, there is\nprobably a problem with one or more of the inputs used in the model.\nR", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 19}
{"text": "o the bid and offer. One must\nbe cautious if the theoretical value of the option lies outside the bid-ask\nspread. This scenario can exist for brief periods of time, but arbitrageurs\ntend to prevent this from occurring routinely. If several options in a chain\nall have theoretical values below the bid or above the offer, there is\nprobably a problem with one or more of the inputs used in the model.\nRemember, an option-pricing model is just that: a model. It reflects what is\noccurring in the market. It doesn’t tell where an option should be trading.\nThe complex changes that occur intraday in the market—taking the day\nor weekend out, changes in stock price, volatility, and the interest rate—are\nnot always kept current. The user of the model must keep close watch. It’s\nnot reasonable to expect the computer to do the thinking for you.\nAutomatically calculated greeks can be used as a starting point. But before\nusing these figures in the decision-making process, the trader may have to\noverride the parameters that were used in the online calculation to make the\ntheos line up with market prices. Professional traders will ignore online\ngreeks altogether. They will use the greeks that are products of the inputs\nthey entered in their trading software. It comes down to this: if you want\nsomething done right, do it yourself.\nThinking Greek\nThe challenge of trading option greeks is to adapt to thinking in terms of\ndelta, gamma, theta, vega, and rho. One should develop a feel for how\ngreeks react to changing market conditions. Greeks need to be monitored as\nclosely as and in some cases more closely than the option’s price itself. This\ngreek philosophy forms the foundation of option trading for active traders.\nIt offers a logical way to monitor positions and provides a medium in and of\nitself to trade.\nNotes\n1 . Please note that definition 4 is not necessarily mathematically accurate.\nThis “trader’s definition” is included in the text because many option\ntraders use delta as a quick rule of thumb for estimating probability\nwithout regard to the mathematical shortcomings of doing so.\n2 . Note that the interest input in the equation is the interest, in dollars and\ncents, on the strike. Technically, this would be calculated as compounded\ninterest, but in practice many traders use simple interest as a quick and\nconvenient way to do the calculation.\nCHAPTER 3\nUnderstanding Volatility\nMost option strategies involve trading volatility in one way or another. It’s\neasy to think of trading in terms of direction. But trading volatility?\nVolatility is an abstract concept; it’s a different animal than the linear\ntrading paradigm used by most conventional market players. As an option\ntrader, it is essential to understand and master volatility.\nMany traders trade without a solid understanding of volatility and its\neffect on option prices. These traders are often unhappily surprised when\nvolatility moves against them. They mistake the adverse option price\nmovements that result from volatility for getting ripped off by the market\nmakers or some other market voodoo. Or worse, they surrender to the fact\nthat they simply don’t understand why sometimes these unexpected price\nmovements occur in options. They accept that that’s just the way it is.\nPart of what gets in the way of a ready understanding of volatility is\ncontext. The term volatility can have a few different meanings in the\noptions business. There are three different uses of the word volatility that an\noption trader must be concerned with: historical volatility, implied\nvolatility, and expected volatility.\nHistorical Volatility\nImagine there are two stocks: Stock A and Stock B. Both are trading at\naround $100 a share. Over the past month, a typical end-of-day net change\nin the price of Stock A has been up or down $5 to $7. During that same\nperiod, a typical daily move in Stock B has been something more like up or\ndown $1 or $2. Stock A has tended to move more than Stock B as a\npercentage of its price, without regard to direction. Therefore, Stock A is\nmore volatile—in the common usage of the word—than Stock B. In the\noptions vernacular, Stock A has a higher historical volatility than Stock B.\nHistorical volatility (HV) is the annualized standard deviation of daily\nreturns. Also called realized volatility, statistical volatility , or stock\nvolatility , HV is a measure of how volatile the price movement of a\nsecurity has been during a certain period of time. But exactly how much\nhigher is Stock A’s HV than Stock B’s?\nIn order to objectively compare the volatilities of two stocks, historical\nvolatility must be quantified. HV relates this volatility information in an\nobjective numerical form. The volatility of a stock is expressed in terms of\nstandard deviation.\nStandard Deviation\nAlthough knowing the mathematical formula behind standard deviation is\nnot entirely necessary, understanding the concept is essential. Standard\ndeviation, sometimes represented by the Greek letter sigma (σ), is a\nmathematical calculation that measures the dispersion of data from a mean\nvalue. In this case, the mean is the average stock price over a certain period\nof time. The farther from the mean the dispersion of occurrences (data) was\nduring the period, the greater the standard deviation.\nOccurrences, in this context, are usually the closing prices of the stock.\nSome utilizers of volatility data may use other inputs (a weighted average\nof high, low, and closing prices, for example) in calculating standard\ndeviation. Close-to-close price data are the most commonly used.\nThe number of occurrences, a function of the time period, used in\ncalculating standard deviation may vary. Many online purveyors of this data\nuse the closing prices from the last 30 consecutive trading days to calculate\nHV. Weekends and holidays are not factored into the equation since there is\nno trading, and therefore no volatility, when the market isn’t open. After\neach day, the oldest price is taken out of the calculation", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 20}
{"text": "unction of the time period, used in\ncalculating standard deviation may vary. Many online purveyors of this data\nuse the closing prices from the last 30 consecutive trading days to calculate\nHV. Weekends and holidays are not factored into the equation since there is\nno trading, and therefore no volatility, when the market isn’t open. After\neach day, the oldest price is taken out of the calculation and replaced by the\nmost recent closing price. Using a shorter or longer period can yield\ndifferent results and can be useful in studying a stock’s volatility.\nKnowing the number of days used in the calculation is crucial to\nunderstanding what the output represents. For example, if the last 5 trading\ndays were extremely volatile, but the 25 days prior to that were\ncomparatively calm, the 5-day standard deviation would be higher than the\n30-day standard deviation.\nStandard deviation is stated as a percentage move in the price of the asset.\nIf a $100 stock has a standard deviation of 15 percent, a one-standard-\ndeviation move in the stock would be either $85 or $115—a 15 percent\nmove in either direction. Standard deviation is used for comparison\npurposes. A stock with a standard deviation of 15 percent has experienced\nbigger moves—has been more volatile—during the relevant time period\nthan a stock with a standard deviation of 6 percent.\nWhen the frequency of occurrences are graphed, the result is known as a\ndistribution curve. There are many different shapes that a distribution curve\ncan take, depending on the nature of the data being observed. In general,\noption-pricing models assume that stock prices adhere to a lognormal\ndistribution.\nThe shape of the distribution curve for stock prices has long been the\ntopic of discussion among traders and academics alike. Regardless of what\nthe true shape of the curve is, the concept of standard deviation applies just\nthe same. For the purpose of illustrating standard deviation, a normal\ndistribution is used here.\nWhen the graph of data adheres to a normal distribution, the result is a\nsymmetrical bell-shaped curve. Standard deviation can be shown on the bell\ncurve to either side of the mean. Exhibit 3.1 represents a typical bell curve\nwith standard deviation.\nEXHIBIT 3.1 Standard deviation.\nLarge moves in a security are typically less frequent than small ones.\nEvents that cause big changes in the price of a stock, like a company’s\nbeing acquired by another or discovering its chief financial officer cooking\nthe books, are not a daily occurrence. Comparatively smaller price\nfluctuations that reflect less extreme changes in the value of the corporation\nare more typically seen day to day. Statistically, the most probable outcome\nfor a price change is found around the midpoint of the curve. What\nconstitutes a large move or a small move, however, is unique to each\nindividual security. For example, a two percent move in an index like the\nStandard & Poor’s (S&P) 500 may be considered a big one-day move,\nwhile a two percent move in a particularly active tech stock may be a daily\noccurrence. Standard deviation offers a statistical explanation of what\nconstitutes a typical move.\nIn Exhibit 3.1 , the lines to either side of the mean represent one standard\ndeviation. About 68 percent of all occurrences will take place between up\none standard deviation and down one standard deviation. Two- and three-\nstandard-deviation values could be shown on the curve as well. About 95\npercent of data occur between up and down two standard deviations and\nabout 99.7 percent between up and down three standard deviations. One\nstandard deviation is the relevant figure in determining historical volatility.\nStandard Deviation and Historical\nVolatility\nWhen standard deviation is used in the context of historical volatility, it is\nannualized to state what the one-year volatility would be. Historical\nvolatility is the annualized standard deviation of daily returns. This means\nthat if a stock is trading at $100 a share and its historical volatility is 10\npercent, then about 68 percent of the occurrences (closing prices) are\nexpected to fall between $90 and $110 during a one-year period (based on\nrecent past performance).\nSimply put, historical volatility shows how volatile a stock has been\nbased on price movements that have occurred in the past. Although option\ntraders may study HV to make informed decisions as to the value of options\ntraded on a stock, it is not a direct function of option prices. For this, we\nmust look to implied volatility.\nImplied Volatility\nVolatility is one of the six inputs of an option-pricing model. Some of the\nother inputs—strike price, stock price, the number of days until expiration,\nand the current interest rate—are easily observable. Past dividend policy\nallows an educated guess as to what the dividend input should be. But\nwhere can volatility be found?\nAs discussed in Chapter 2, the output of the pricing model—the option’s\ntheoretical value—in practice is not necessarily an output at all. When\noption traders use the pricing model, they commonly substitute the actual\nprice at which the option is trading for the theoretical value. A value in the\nmiddle of the bid-ask spread is often used. The pricing model can be\nconsidered to be a complex algebra equation in which any variable can be\nsolved for. If the theoretical value is known—which it is—it along with the\nfive known inputs can be combined to solve for the unknown volatility.\nImplied volatility (IV) is the volatility input in a pricing model that, in\nconjunction with the other inputs, returns the theoretical value of an option\nmatching the market price.\nFor a specific stock price, a given implied volatility will yield a unique\noption value. Take a stock trading at $44.22 that has the 60-day 45-strike\ncall at a theoretical value of $1.10 with an 18 percent implied volatility\nlevel. If the stock price remains constant, but IV rises to 19 percent, the\nvalue of the call will rise by its vega, which in this case is ab", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 21}
{"text": "option\nmatching the market price.\nFor a specific stock price, a given implied volatility will yield a unique\noption value. Take a stock trading at $44.22 that has the 60-day 45-strike\ncall at a theoretical value of $1.10 with an 18 percent implied volatility\nlevel. If the stock price remains constant, but IV rises to 19 percent, the\nvalue of the call will rise by its vega, which in this case is about 0.07. The\nnew value of the call will be $1.17. Raising IV another point, to 20 percent,\nraises the theoretical value by another $0.07, to $1.24. The question is:\nWhat would cause implied volatility to change?\nSupply and Demand: Not Just a Good\nIdea, It’s the Law!\nOptions are an excellent vehicle for speculation. However, the existence of\nthe options market is better justified by the primary economic purpose of\noptions: as a risk management tool. Hedgers use options to protect their\nassets from adverse price movements, and when the perception of risk\nincreases, so does demand for this protection. In this context, risk means\nvolatility—the potential for larger moves to the upside and downside. The\nrelative prices of options are driven higher by increased demand for\nprotective options when the market anticipates greater volatility. And option\nprices are driven lower by greater supply—that is, selling of options—when\nthe market expects lower volatility. Like those of all assets, option prices\nare subject to the law of supply and demand.\nWhen volatility is expected to rise, demand for options is not limited to\nhedgers. Speculative traders would arguably be more inclined to buy a call\nthan to buy the stock if they are bullish but expect future volatility to be\nhigh. Calls require a lower cash outlay. If the stock moves adversely, there\nis less capital at risk, but still similar profit potential.\nWhen volatility is expected to be low, hedging investors are less inclined\nto pay for protection. They are more likely to sell back the options they may\nhave bought previously to recoup some of the expense. Options are a\ndecaying asset. Investors are more likely to write calls against stagnant\nstocks to generate income in anticipated low-volatility environments.\nSpeculative traders will implement option-selling strategies, such as short\nstrangles or iron condors, in an attempt to capitalize on stocks they believe\nwon’t move much. The rising supply of options puts downward pressure on\noption prices.\nMany traders sum up IV in two words: fear and greed . When option\nprices rise and fall, not because of changes in the stock price, time to\nexpiration, interest rates, or dividends, but because of pure supply and\ndemand, it is implied volatility that is the varying factor. There are many\ncontributing factors to traders’ willingness to demand or supply options.\nAnticipation of events such as earnings reports, Federal Reserve\nannouncements, or the release of other news particular to an individual\nstock can cause anxiety, or fear, in traders and consequently increase\ndemand for options that causes IV to rise. IV can fall when there is\ncomplacency in the market or when the anticipated news has been\nannounced and anxiety wanes. “Buy the rumor, sell the news” is often\nreflected in option implied volatility. When there is little fear of market\nmovement, traders use options to squeeze out more profits—greed.\nArbitrageurs, such as market makers who trade delta neutral—a strategy\nthat will be discussed further in Chapters 12 and 13—must be relentlessly\nconscious of implied volatility. When immediate directional risk is\neliminated from a position, IV becomes the traded commodity. Arbitrageurs\nwho focus their efforts on trading volatility (colloquially called vol traders )\ntend to think about bids and offers in terms of IV. In the mind of a vol\ntrader, option prices are translated into volatility levels. A trader may look at\na particular option and say it is 30 bid at 31 offer. These values do not\nrepresent the prices of the options but rather the corresponding implied\nvolatilities. The meaning behind the trader’s remark is that the market is\nwilling to buy implied volatility at 30 percent and sell it at 31 percent. The\nactual prices of the options themselves are much less relevant to this type of\ntrader.\nShould HV and IV Be the Same?\nMost option positions have exposure to volatility in two ways. First, the\nprofitability of the position is usually somewhat dependent on movement\n(or lack of movement) of the underlying security. This is exposure to HV.\nSecond, profitability can be affected by changes in supply and demand for\nthe options. This is exposure to IV. In general, a long option position\nbenefits when volatility—both historical and implied—increases. A short\noption position benefits when volatility—historical and implied—decreases.\nThat said, buying options is buying volatility and selling options is selling\nvolatility.\nThe Relationship of HV and IV\nIt’s intuitive that there should exist a direct relationship between the HV and\nIV. Empirically, this is often the case. Supply and demand for options, based\non the market’s expectations for a security’s volatility, determines IV.\nIt is easy to see why IV and HV often act in tandem. But, although HV\nand IV are related, they are not identical. There are times when IV and HV\nmove in opposite directions. This is not so illogical, if one considers the key\ndifference between the two: HV is calculated from past stock price\nmovements; it is what has happened. IV is ultimately derived from the\nmarket’s expectation for future volatility.\nIf a stock typically has an HV of 30 percent and nothing is expected to\nchange, it can be reasonable to expect that in the future the stock will\ncontinue to trade at a 30 percent HV. By that logic, assuming that nothing is\nexpected to change, IV should be fairly close to HV. Market conditions do\nchange, however. These changes are often regular and predictable. Earnings\nreports are released once a quarter in many stocks, Federal Open Market\nCommittee", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 22}
{"text": "ing is expected to\nchange, it can be reasonable to expect that in the future the stock will\ncontinue to trade at a 30 percent HV. By that logic, assuming that nothing is\nexpected to change, IV should be fairly close to HV. Market conditions do\nchange, however. These changes are often regular and predictable. Earnings\nreports are released once a quarter in many stocks, Federal Open Market\nCommittee meetings happen regularly, and dates of other special\nannouncements are often disclosed to the public in advance. Although the\noutcome of these events cannot be predicted, when they will occur often\ncan be. It is around these widely anticipated events that HV-IV divergences\noften occur.\nHV-IV Divergence\nAn HV-IV divergence occurs when HV declines and IV rises or vice versa.\nThe classic example is often observed before a company’s quarterly\nearnings announcement, especially when there is lack of consensus among\nanalysts’ estimates. This scenario often causes HV to remain constant or\ndecline while IV rises. The reason? When there is a great deal of\nuncertainty as to what the quarterly earnings will be, investors are reluctant\nto buy or sell the stock until the number is released. When this happens, the\nstock price movement (volatility) consolidates, causing the calculated HV\nto decline. IV, however, can rise as traders scramble to buy up options—\nbidding up their prices. When the news is out, the feared (or hoped for)\nmove in the stock takes place (or doesn’t), and HV and IV tend to converge\nagain.\nExpected Volatility\nWhether trading options or stocks, simple or complex strategies, traders\nmust consider volatility. For basic buy-and-hold investors, taking a potential\ninvestment’s volatility into account is innate behavior. Do I buy\nconservative (nonvolatile) stocks or more aggressive (volatile) stocks?\nTaking into account volatility, based not just on a gut feeling but on hard\nnumbers, can lead to better, more objective trading decisions.\nExpected Stock Volatility\nOption traders must have an even greater focus on volatility, as it plays a\nmuch bigger role in their profitability—or lack thereof. Because options can\ncreate highly leveraged positions, small moves can yield big profits or\nlosses. Option traders must monitor the likelihood of movement in the\nunderlying closely. Estimating what historical volatility (standard deviation)\nwill be in the future can help traders quantify the probability of movement\nbeyond a certain price point. This leads to better decisions about whether to\nenter a trade, when to adjust a position, and when to exit.\nThere is no way of knowing for certain what the future holds. But option\ndata provide traders with tools to develop expectations for future stock\nvolatility. IV is sometimes interpreted as the market’s estimate of the future\nvolatility of the underlying security. That makes it a ready-made estimation\ntool, but there are two caveats to bear in mind when using IV to estimate\nfuture stock volatility.\nThe first is that the market can be wrong. The market can wrongly price\nstocks. This mispricing can lead to a correction (up or down) in the prices\nof those stocks, which can lead to additional volatility, which may not be\npriced in to the options. Although there are traders and academics believe\nthat the option market is fairly efficient in pricing volatility, there is a room\nfor error. There is the possibility that the option market can be wrong.\nAnother caveat is that volatility is an annualized figure—the annualized\nstandard deviation. Unless the IV of a LEAPS option that has exactly one\nyear until expiration is substituted for the expected volatility of the\nunderlying stock over exactly one year, IV is an incongruent estimation for\nthe future stock volatility. In practice, the IV of an option must be adjusted\nto represent the period of time desired.\nThere is a common technique for deannualizing IV used by professional\ntraders and retail traders alike. 1 The first step in this process to deannualize\nIV is to turn it into a one-day figure as opposed to one-year figure. This is\naccomplished by dividing IV by the square root of the number of trading\ndays in a year. The number many traders use to approximate the number of\ntrading days per year is 256, because its square root is a round number: 16.\nThe formula is\nFor example, a $100 stock that has an at-the-money (ATM) call trading at\na 32 percent volatility implies that there is about a 68 percent chance that\nthe underlying stock will be between $68 and $132 in one year’s time—\nthat’s $100 ± ($100 × 0.32). The estimation for the market’s expectation for\nthe volatility of the stock for one day in terms of standard deviation as a\npercentage of the price of the underlying is computed as follows:\nIn one day’s time, based on an IV of 32 percent, there is a 68 percent\nchance of the stock’s being within 2 percent of the stock price—that’s\nbetween $98 and $102.\nThere may be times when it is helpful for traders to have a volatility\nestimation for a period of time longer than one day—a week or a month, for\nexample. This can be accomplished by multiplying the one-day volatility by\nthe square root of the number of trading days in the relevant period. The\nequation is as follows:\nIf the period in question is one month and there are 22 business days\nremaining in that month, the same $100 stock with the ATM call trading at a\n32 percent implied volatility would have a one-month volatility of 9.38\npercent.\nBased on this calculation for one month, it can be estimated that there is a\n68 percent chance of the stock’s closing between $90.62 and $109.38 based\non an IV of 32 percent.\nExpected Implied Volatility\nAlthough there is a great deal of science that can be applied to calculating\nexpected actual volatility, developing expectations for implied volatility is\nmore of an art. This element of an option’s price provides more risk and\nmore opportunity. There are many traders who make their living distilling\ndirection out of their positions", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 23}
{"text": "109.38 based\non an IV of 32 percent.\nExpected Implied Volatility\nAlthough there is a great deal of science that can be applied to calculating\nexpected actual volatility, developing expectations for implied volatility is\nmore of an art. This element of an option’s price provides more risk and\nmore opportunity. There are many traders who make their living distilling\ndirection out of their positions and trading implied volatility. To be\nsuccessful, a trader must forecast IV.\nConceptually, trading IV is much like trading anything else. A trader who\nthinks a stock is going to rise will buy the stock. A trader who thinks IV is\ngoing to rise will buy options. Directional stock traders, however, have\nmany more analysis tools available to them than do vol traders. Stock\ntraders have both technical analysis (TA) and fundamental analysis at their\ndisposal.\nTechnical Analysis\nThere are scores, perhaps hundreds, of technical tools for analyzing stocks,\nbut there are not many that are available for analyzing IV. Technical\nanalysis is the study of market data, such as past prices or volume, which is\nmanipulated in such a way that it better illustrates market activity. TA\nstudies are usually represented graphically on a chart.\nDeveloping TA tools for IV is more of a challenge than it is for stocks.\nOne reason is that there is simply a lot more data to manage—for each\nstock, there may be hundreds of options listed on it. The only practical way\nof analyzing options from a TA standpoint is to use implied volatility. IV is\nmore useful than raw historical option prices themselves. Information for\nboth IV and HV is available in the form of volatility charts, or vol charts.\n(Vol charts are discussed in detail in Chapter 14.) Volatility charts are\nessential for analyzing options because they give more complete\ninformation.\nTo get a clear picture of what is going on with the price of an option (the\ngoal of technical analysis for any asset), just observing the option price does\nnot supply enough information for a trader to work with. It’s incomplete.\nFor example, if a call rises in value, why did it rise? What greek contributed\nto its value increase? Was it delta because the underlying stock rose? Or\nwas it vega because volatility rose? How did time decay factor in? Using a\nvolatility chart in conjunction with a conventional stock chart (and being\naware of time decay) tells the whole, complete, story.\nAnother reason historical option prices are not used in TA is the option\nbid-ask spread. For most stocks, the difference between the bid and the ask\nis equal to a very small percentage of the stock’s price. Because options are\nhighly leveraged instruments, their bid-ask width can equal a much higher\npercentage of the price.\nIf a trader uses the last trade to graph an option’s price, it could look as if\na very large percentage move has occurred when in fact it has not. For\nexample, if the option trades a small contract size on the bid (0.80), then on\nthe offer (0.90) it would appear that the option rose 12.5 percent in value.\nThis large percentage move is nothing more than market noise. Using\nvolatility data based off the midpoint-of-the-market theoretical value\neliminates such noise.\nFundamental Analysis\nFundamental analysis can have an important role in developing\nexpectations for IV. Fundamental analysis is the study of economic factors\nthat affect the value of an asset in order to determine what it is worth. With\nstocks, fundamental analysis may include studying income statements,\nbalance sheets, and earnings reports. When the asset being studied is IV,\nthere are fewer hard facts available. This is where the art of analyzing\nvolatility comes into play.\nEssentially, the goal is to understand the psychology of the market in\nrelation to supply and demand for options. Where is the fear? Where is the\ncomplacency? When are news events anticipated? How important are they?\nUltimately, the question becomes: what is the potential for movement in the\nunderlying? The greater the chance of stock movement, the more likely it is\nthat IV will rise. When unexpected news is announced, IV can rise quickly.\nThe determination of the fundamental relevance of surprise announcements\nmust be made quickly.\nUnfortunately, these questions are subjective in nature. They require the\ntrader to apply intuition and experience on a case-by-case basis. But there\nare a few observations to be made that can help a trader make better-\neducated decisions about IV.\nReversion to the Mean\nThe IVs of the options on many stocks and indexes tend to trade in a range\nunique to those option classes. This is referred to as the mean—or average\n—volatility level. Some securities will have smaller mean IV ranges than\nothers. The range being observed should be established for a period long\nenough to confirm that it is a typical IV for the security, not just a\ntemporary anomaly. Traders should study IV over the most recent 6-month\nperiod. When IV has changed significantly during that period, a 12-month\nstudy may be necessary. Deviations from this range, either above or below\nthe established mean range, will occur from time to time. When following a\nbreakout from the established range, it is common for IV to revert back to\nits normal range. This is commonly called reversion to the mean among\nvolatility watchers.\nThe challenge is recognizing when things change and when they stay the\nsame. If the fundamentals of the stock change in such a way as to give the\noptions market reason to believe the stock will now be more or less volatile\non an ongoing basis than it typically has been in the recent past, the IV may\nnot revert to the mean. Instead, a new mean volatility level may be\nestablished.\nWhen considering the likelihood of whether IV will revert to recent levels\nafter it has deviated or find a new range, the time horizon and changes in\nthe marketplace must be taken into account. For example, between 1998\nand 2003 the mean volatility level of the SPX was around 20 percen", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 24}
{"text": "n in the recent past, the IV may\nnot revert to the mean. Instead, a new mean volatility level may be\nestablished.\nWhen considering the likelihood of whether IV will revert to recent levels\nafter it has deviated or find a new range, the time horizon and changes in\nthe marketplace must be taken into account. For example, between 1998\nand 2003 the mean volatility level of the SPX was around 20 percent to 30\npercent. By the latter half of 2006, the mean IV was in the range of 10\npercent to 13 percent. The difference was that between 1998 and 2003 was\nthe buildup of “the tech bubble,” as it was called by the financial media.\nMarket volatility ultimately leveled off in 2003.\nIn a later era, between the fall of 2010 and late summer of 2011 SPX\nimplied volatility settled in to trade mostly between 12 and 20 percent. But\nin August 2011, as the European debt crisis heated up, a new, more volatile\nrange between 24 and 40 percent reigned for some time.\nNo trader can accurately predict future IV any more than one can predict\nthe future price of a stock. However, with IV there are often recurring\npatterns that traders can observe, like the ebb and flow of IV often\nassociated with earnings or other regularly scheduled events. But be aware\nthat the IV’s rising before the last 15 earnings reports doesn’t mean it will\nthis time.\nCBOE Volatility Index\n®\nOften traders look to the implied volatility of the market as a whole for\nguidance on the IV of individual stocks. Traders use the Chicago Board\nOptions Exchange (CBOE) Volatility Index® , or VIX® , as an indicator of\noverall market volatility.\nWhen people talk about the market, they are talking about a broad-based\nindex covering many stocks on many diverse industries. Usually, they are\nreferring to the S&P 500. Just as the IV of a stock may offer insight about\ninvestors’ feelings about that stock’s future volatility, the volatility of\noptions on the S&P 500—SPX options—may tell something about the\nexpected volatility of the market as a whole.\nVIX is an index published by the Chicago Board Options Exchange that\nmeasures the IV of a hypothetical 30-day option on the SPX. A 30-day\noption on the SPX only truly exists once a month—30 days before\nexpiration. CBOE computes a hypothetical 30-day option by means of a\nweighted average of the two nearest-term months.\nWhen the S&P 500 rises or falls, it is common to see individual stocks\nrise and fall in sympathy with the index. Most stocks have some degree of\nmarket risk. When there is a perception of higher risk in the market as a\nwhole, there can consequently be a perception of higher risk in individual\nstocks. The rise or fall of the IV of SPX can translate into the IV of\nindividual stocks rising or falling.\nImplied Volatility and Direction\nWho’s afraid of falling stock prices? Logically, declining stocks cause\nconcern for investors in general. There is confirmation of that statement in\nthe options market. Just look at IV. With most stocks and indexes, there is\nan inverse relationship between IV and the underlying price. Exhibit 3.2\nshows the SPX plotted against its 30-day IV, or the VIX.\nEXHIBIT 3.2 SPX vs. 30-day IV (VIX).\nThe heavier line is the SPX, and the lighter line is the VIX. Note that as\nthe price of SPX rises, the VIX tends to decline and vice versa. When the\nmarket declines, the demand for options tends to increase. Investors hedge\nby buying puts. Traders speculate on momentum by buying puts and\nspeculate on a turnaround by buying calls. When the market moves higher,\ninvestors tend to sell their protection back and write covered calls or cash-\nsecured puts. Option speculators initiate option-selling strategies. There is\nless fear when the market is rallying.\nThis inverse relationship of IV to the price of the underlying is not unique\nto the SPX; it applies to most individual stocks as well. When a stock\nmoves lower, the market usually bids up IV, and when the stock rises, the\nmarket tends to offer IV creating downward pressure.\nCalculating Volatility Data\nAccurate data are essential for calculating volatility. Many of the volatility\ndata that are readily available are useful, but unfortunately, some are not.\nHV is a value that is easily calculated from publicly accessible past closing\nprices of a stock. It’s rather straightforward. Traders can access HV from\nmany sources. Retail traders often have access to HV from their brokerage\nfirm. Trading firms or clearinghouses often provide professional traders\nwith HV data. There are some excellent online resources for HV as well.\nHV is a calculation with little subjectivity—the numbers add up how they\nadd up. IV, however, can be a bit more ambiguous. It can be calculated\ndifferent ways to achieve different desired outcomes; it is user-centric. Most\nof the time, traders consider the theoretical value to be between the bid and\nthe ask prices. On occasion, however, a trader will calculate IV for the bid,\nthe ask, the last trade price, or, sometimes, another value altogether. There\nmay be a valid reason for any of these different methods for calculating IV.\nFor example, if a trader is long volatility and aspires to reduce his position,\ncalculating the IV for the bid shows him what IV level can be sold to\nliquidate his position.\nFirms, online data providers, and most options-friendly brokers offer IV\ndata. Past IV data is usually displayed graphically in what is known as a\nvolatility chart or vol chart. Current IV is often displayed along with other\ndata right in the option chain. One note of caution: when the current IV is\ndisplayed, however, it should always be scrutinized carefully. Was the bid\nused in calculating this figure? What about the ask? How long ago was this\ncalculation made? There are many questions that determine the accuracy of\na current IV, and rarely are there any answers to support the number.\nTraders should trust only IV data they knowingly generated themselves\nusing a pricing model.\nVolatility Skew\nThere are many platforms (software or Web-ba", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 25}
{"text": "ized carefully. Was the bid\nused in calculating this figure? What about the ask? How long ago was this\ncalculation made? There are many questions that determine the accuracy of\na current IV, and rarely are there any answers to support the number.\nTraders should trust only IV data they knowingly generated themselves\nusing a pricing model.\nVolatility Skew\nThere are many platforms (software or Web-based) that enable traders to\nsolve for volatility values of multiple options within the same option class.\nValues of options of the same class are interrelated. Many of the model\nparameters are shared among the different series within the same class. But\nIV can be different for different options within the same class. This is\nreferred to as the volatility skew . There are two types of volatility skew:\nterm structure of volatility and vertical skew.\nTerm Structure of Volatility\nTerm structure of volatility—also called monthly skew or horizontal skew\n—is the relationship among the IVs of options in the same class with the\nsame strike but with different expiration months. IV, again, is often\ninterpreted as the market’s estimate of future volatility. It is reasonable to\nassume that the market will expect some months to be more volatile than\nothers. Because of this, different expiration cycles can trade at different IVs.\nFor example, if a company involved in a major product-liability lawsuit is\nexpecting a verdict on the case to be announced in two months, the one-\nmonth IV may be low, as the stock is not expected to move much until the\nsuit is resolved. The two-month volatility may be much higher, however,\nreflecting the expectations of a big move in the stock up or down,\ndepending on the outcome.\nThe term structure of volatility also varies with the normal ebb and flow\nof volatility within the business cycle. In periods of declining volatility, it is\ncommon for the month with the least amount of time until expiration, also\nknown as the front month, to trade at a lower volatility than the back\nmonths, or months with more time until expiration. Conversely, when\nvolatility is rising, the front month tends to have a higher IV than the back\nmonths.\nExhibit 3.3 shows historical option prices and their corresponding IVs for\n32.5-strike calls on General Motors (GM) during a period of low volatility.\nEXHIBIT 3.3 GM term structure of volatility.\nIn this example, no major news is expected to be released on GM, and\noverall market volatility is relatively low. The February 32.5 call has the\nlowest IV, at 32 percent. Each consecutive month has a higher IV than the\nprevious month. A graduated increasing or decreasing IV for each\nconsecutive expiration cycle is typical of the term structure of volatility.\nUnder normal circumstances, the front month is the most sensitive to\nchanges in IV. There are two reasons for this. First, front-month options are\ntypically the most actively traded. There is more buying and selling\npressure. Their IV is subject to more activity. Second, vegas are smaller for\noptions with fewer days until expiration. This means that for the same\nmonetary change in an option’s value, the IV needs to move more for short-\nterm options.\nExhibit 3.4 shows the same GM options and their corresponding vegas.\nEXHIBIT 3.4 GM vegas.\nIf the value of the September 32.5 calls increases by $0.10, IV must rise\nby 1 percentage point. If the February 32.5 calls increase by $0.10, IV must\nrise 3 percentage points. As expiration approaches, the vega gets even\nsmaller. With seven days until expiration, the vega would be about 0.014.\nThis means IV would have to change about 7 points to change the call value\n$0.10.\nVertical Skew\nThe second type of skew found in option IV is vertical skew, or strike skew.\nVertical skew is the disparity in IV among the strike prices within the same\nmonth for an option class. The options on most stocks and indexes\nexperience vertical skew. As a general rule, the IV of downside options—\ncalls and puts with strike prices lower than the at-the-money (ATM) strike\n—trade at higher IVs than the ATM IV. The IV of upside options—calls and\nputs with strike prices higher than the ATM strike—typically trade at lower\nIVs than the ATM IV.\nThe downside is often simply referred to as puts and the upside as calls.\nThe rationale for this lingo is that OTM options (puts on the downside and\ncalls on the upside) are usually more actively traded than the ITM options.\nBy put-call parity, a put can be synthetically created from a call, and a call\ncan be synthetically created from a put simply by adding the appropriate\nlong or short stock position.\nExhibit 3.5 shows the vertical skew for 86-day options on Citigroup Inc.\n(C) on a typical day, with IVs rounded to the nearest tenth.\nEXHIBIT 3.5 Citigroup vertical skew.\nNotice the IV of the puts (downside options) is higher than that of the\ncalls (upside options), with the 31 strike’s volatility more than 10 points\nhigher than that of the 38 strike. Also, the difference in IV per unit change\nin the strike price is higher for the downside options than it is for the upside\nones. The difference between the IV of the 31 strike is 2 full points higher\nthan the 32 strike, which is 1.8 points higher than the 33 strike. But the 36\nstrike’s IV is only 1.1 points higher than the 37 strike, which is also just 1.1\npoints higher than the 38 strike.\nThis incremental difference in the IV per strike is often referred to as the\nslope. The puts of most underlyings tend to have a greater slope to their\nskew than the calls. Many models allow values to be entered for the upside\nslope and the downside slope that mathematically increase or decrease IVs\nof each strike incrementally. Some traders believe the slope should be a\nstraight line, while others believe it should be an exponentially sloped line.\nIf the IVs were graphed, the shape of the skew would vary among asset\nclasses. This is sometimes referred to as the volatility smile or sneer,\ndepending on the shape of the IV skew. Although", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 26}
{"text": "nside slope that mathematically increase or decrease IVs\nof each strike incrementally. Some traders believe the slope should be a\nstraight line, while others believe it should be an exponentially sloped line.\nIf the IVs were graphed, the shape of the skew would vary among asset\nclasses. This is sometimes referred to as the volatility smile or sneer,\ndepending on the shape of the IV skew. Although Exhibit 3.5 is a typical\nparadigm for the slope for stock options, bond options and other commodity\noptions would have differently shaped skews. For example, grain options\ncommonly have calls with higher IVs than the put IVs.\nVolatility skew is dependent on supply and demand. Greater demand for\ndownside protection may cause the overall IV to rise, but it can cause the\nIV of puts to rise more relative to the calls or vice versa. There are many\ntraders who make their living trading volatility skew.\nNote\n1 . This technique provides only an estimation of future volatility.\nCHAPTER 4\nOption-Specific Risk and Opportunity\nNew endeavors can be intimidating. The first day at a new job or new\nschool is a challenge. Option trading is no different. When traders first\nventure into the world of options, they tend to start with what they know—\ntrading direction. Buying stocks is at the heart of the comfort zone for many\ntraders. Buying a call as a substitute for buying a stock is a logical\nprogression. And for the most part, call buying is a pretty straightforward\nway to take a bullish position in a stock. But it’s not just a bullish position.\nThe greeks come into play with the long call, providing both risk and\nopportunity.\nLong ATM Call\nKim is a trader who is bullish on the Walt Disney Company (DIS) over the\nshort term. The time horizon of her forecast is three weeks. Instead of\nbuying 100 shares of Disney at $35.10 per share, Kim decides to buy one\nDisney March 35 call at $1.10. In this example, March options have 44\ndays until expiration. How can Kim profit from this position? How can she\nlose?\nExhibit 4.1 shows the profit and loss (P&(L)) for the call at different time\nperiods. The top line is when the trade is executed; the middle, dotted line is\nafter three weeks have passed; and the bottom, darker line is at expiration.\nKim wants Disney to rise in price, which is evident by looking at the graph\nfor any of the three time horizons. She would anticipate a loss if the stock\nprice declines. These expectations are related to the position’s delta, but that\nis not the only risk exposure Kim has. As indicated by the three different\nlines in Exhibit 4.1 , the call loses value over time. This is called theta risk .\nShe has other risk exposure as well. Exhibit 4.2 lists the greeks for the DIS\nMarch 35 call.\nEXHIBIT 4.1 P&(L) of Disney 35 call.\nEXHIBIT 4.2 Greeks for 35 Disney call.\nDelta 0.57\nGamma0.166\nTheta −0.013\nVega 0.048\nRho 0.023\nKim’s immediate directional exposure is quantified by the delta, which is\n0.57. Delta is immediate directional exposure because it’s subject to change\nby the amount of the gamma. The positive gamma of this position helps\nKim by increasing the delta as Disney rises and decreasing it as it falls.\nKim, however, has time working against her—theta. At this point, she\ntheoretically loses $0.013 per day. Since her call is close to being at-the-\nmoney, she would anticipate her theta becoming more negative as\nexpiration approaches if Disney’s share price remains unchanged. She also\nhas positive vega exposure. A one-percentage-point increase in implied\nvolatility (IV) earns Kim just under $0.05. A one-point decrease costs her\nabout $0.05. With so few days until expiration, the 35-strike call has very\nlittle rho exposure. A full one-percentage-point change in the interest rate\nchanges her call’s value by only $0.023.\nDelta\nSome of Kim’s risks warrant more concern than others. With this position,\ndelta is of the greatest concern, followed by theta. Kim expects the call to\nrise in value and accepts the risk of decline. Delta exposure was her main\nrationale for establishing the position. She expects to hold it for about three\nweeks. Kim is willing to accept the trade-off of delta exposure for theta,\nwhich will cost her three weeks of erosion of option premium. If the\nanticipated delta move happens sooner than expected, Kim will have less\ndecay. Exhibit 4.3 shows the value of her 35 call at various stock prices\nover time. The left column is the price of Disney. The top row is the number\nof days until expiration.\nEXHIBIT 4.3 Disney 35 call price–time matrix–value.\nThe effect of delta is evident as the stock rises or falls. When the position\nis established (44 days until expiration), the change in the option price if the\nstock were to move from $35 to $36 is 0.62 (1.66 − 1.04). Between stock\nprices of $36 and $37, the option gains 0.78 (2.44 −1.66). If the stock were\nto decline in value from $35 to $34, the option loses 0.47 (1.04 − 0.57). The\noption gains value at a faster rate as the stock rises and loses value at a\nslower rate as the stock falls. This is the effect of gamma.\nGamma\nWith this type of position, gamma is an important but secondary\nconsideration. Gamma is most helpful to Kim in developing expectations of\nwhat the delta will be as the stock price rises or falls. Exhibit 4.4 shows the\ndelta at various stock prices over time.\nEXHIBIT 4.4 Disney call price–time matrix–delta.\nKim pays attention to gamma only to gauge her delta. Why is this\nimportant to her? In this trade, Kim is focused on direction. Knowing how\nmuch her call will rise or fall in step with the stock is her main concern.\nNotice that her delta tends to get bigger as the stock rises and smaller as the\nstock falls. As time passes, the delta gravitates toward 1.00 or 0, depending\non whether the call is in-the-money (ITM) or out-of-the-money (OTM).\nTheta\nOption buying is a veritable race against the clock. With each passing day,\nthe option loses theoretical value. Refer back to Exhibit 4.3 . When three\nweeks pass and the time t", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 27}
{"text": "at her delta tends to get bigger as the stock rises and smaller as the\nstock falls. As time passes, the delta gravitates toward 1.00 or 0, depending\non whether the call is in-the-money (ITM) or out-of-the-money (OTM).\nTheta\nOption buying is a veritable race against the clock. With each passing day,\nthe option loses theoretical value. Refer back to Exhibit 4.3 . When three\nweeks pass and the time to expiration decreases from 44 days to 23, what\nhappens to the call value? If the stock price stays around its original level,\ntheta will be responsible for a loss of about 30 percent of the premium. If\nDisney is at $35 with 23 days to expiration, the call will be worth $0.73.\nWith a big enough move in either direction, however, theta matters much\nless.\nWith 23 days to expiration and Disney at $39, there is only 0.12 of time\nvalue—the premium paid over parity for the option. At that point, it is\nalmost all delta exposure. Similarly, if the Disney stock price falls after\nthree weeks to $33, the call will have only 0.10 of time value. Time decay is\nthe least of Kim’s concerns if the stock makes a big move.\nVega\nAfter delta and theta, vega is the next most influential contributor to Kim’s\nprofit or peril. With Disney at $35.10, the 1.10 premium for the 35-strike\ncall represents $1 of time value—all of which is vulnerable to changes in\nIV. The option’s 1.10 value returns an IV of about 19 percent, given the\nfollowing inputs:\nStock: $35.10\nStrike: 35\nDays to expiration: 44\nInterest: 5.25 percent\nNo dividend paid during this period\nConsequently, the vega is 0.048. What does the 0.048 vega tell Kim?\nGiven the preceding inputs, for each point the IV rises or falls, the option’s\nvalue gains or loses about $0.05.\nSome of the inputs, however, will change. Kim anticipates that Disney\nwill rise in price. She may be right or wrong. Either way, it is unlikely that\nthe stock will remain exactly at $35.10 to option expiration. The only\ncertainty is that time will pass.\nBoth price and time will change Kim’s vega exposure. Exhibit 4.5 shows\nthe changing vega of the 35 call as time and the underlying price change.\nEXHIBIT 4.5 Disney 35 call price–time matrix–vega.\nWhen comparing Exhibit 4.5 to Exhibit 4.3 , it’s easy to see that as the\ntime value of the option declines, so does Kim’s exposure to vega. As time\npasses, vega gets smaller. And as the call becomes more in- or out-of-the-\nmoney, vega gets smaller. Since she plans to hold the position for around\nthree weeks, she is not concerned about small fluctuations in IV in the\ninterim.\nIf indeed the rise in price that Kim anticipates comes to pass, vega\nbecomes even less of a concern. With 23 days to expiration and DIS at $37,\nthe call value is 2.21. The vega is $0.018. If IV decreases as the stock price\nrises—a common occurrence—the adverse effect of vega will be minimal.\nEven if IV declines by 5 points, to a historically low IV for DIS, the call\nloses less than $0.10. That’s less than 5 percent of the new value of the\noption.\nIf dividend policy changes or the interest rate changes, the value of Kim’s\ncall will be affected as well. Dividends are often fairly predictable.\nHowever, a large unexpected dividend payment can have a significant\nadverse impact on the value of the call. For example, if a surprise $3\ndividend were announced, owning the stock would become greatly\npreferable to owning the call. This preference would be reflected in the call\npremium. This is a scenario that an experienced trader like Kim will realize\nis a possibility, although not a probability. Although she knows it can\nhappen, she will not plan for such an event unless she believes it is likely to\nhappen. Possible reasons for such a belief could be rumors or the\ncompany’s historically paying an irregular dividend.\nRho\nFor all intents and purposes, rho is of no concern to Kim. In recent years,\ninterest rate changes have not been a major issue for option traders. In the\nAlan Greenspan years of Federal Reserve leadership, changes in the interest\nrate were usually announced at the regularly scheduled Federal Open\nMarket Committee (FOMC) meetings, with but a few exceptions. Ben\nBernanke, likewise, changed interest rates fairly predictably, when he made\nany rate changes at all. In these more stable periods, if there is no FOMC\nmeeting scheduled during the life of the call, it’s unlikely that rates will\nchange. Even if they do, the rho with 44 days to expiration is only 0.023.\nThis means that if rates change by a whole percentage point—which is four\ntimes the most common incremental change—the call value will change by\na little more than $0.02. In this case, this is an acceptable risk. With 23 days\nto expiration, the ATM 35 call has a rho of only 0.011.\nTweaking Greeks\nWith this position, some risks are of greater concern than others. Kim may\nwant more exposure to some greeks and less to others. What if she is\nconcerned that her forecasted price increase will take longer than three\nweeks? She may want less exposure to theta. What if she is particularly\nconcerned about a decline in IV? She may want to decrease her vega.\nConversely, she may believe IV will rise and therefore want to increase her\nvega.\nKim has many ways at her disposal to customize her greeks. All of her\nalternatives come with trade-offs. She can buy more calls, increasing her\ngreek positions in exact proportion. She can buy or sell stock or options\nagainst her call, creating a spread. The simplest way to alter her exposure to\noption greeks is to choose a different call to buy. Instead of buying the ATM\ncall, Kim can buy a call with a different relationship to the current stock\nprice.\nLong OTM Call\nKim can reduce her exposure to theta and vega by buying an OTM call. The\ntrade-off here is that she also reduces her immediate delta exposure.\nDepending on how much Kim believes Disney will rally, this may or may\nnot be a viable trade-off. Imagine that instead of buying one Disney March\n35 call, Kim buys one Disney March 37.50 call, for 0.20", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 28}
{"text": "t relationship to the current stock\nprice.\nLong OTM Call\nKim can reduce her exposure to theta and vega by buying an OTM call. The\ntrade-off here is that she also reduces her immediate delta exposure.\nDepending on how much Kim believes Disney will rally, this may or may\nnot be a viable trade-off. Imagine that instead of buying one Disney March\n35 call, Kim buys one Disney March 37.50 call, for 0.20.\nThere are a few observations to be made about this alternative position.\nFirst, the net premium, and therefore overall risk, is much lower, 0.20\ninstead of 1.10. From an expiration standpoint, the breakeven at expiration\nis $37.70 (the strike price plus the call premium). Since Kim plans on\nexiting the position after about three weeks, the exact break-even point at\nthe expiration of the contract is irrelevant. But the concept is the same: the\nstock needs to rise significantly. Exhibit 4.6 shows how Kim’s concerns\ntranslate into greeks.\nEXHIBIT 4.6 Greeks for Disney 35 and 37.50 calls.\n35 Call37.50 Call\nDelta 0.57 0.185\nGamma0.1660.119\nTheta −0.013−0.007\nVega 0.0480.032\nRho 0.0230.007\nThis table compares the ATM call with the OTM call. Kim can reduce her\ntheta to half that of the ATM call position by purchasing an OTM. This is\ncertainly a favorable difference. Her vega is lower with the 37.50 call, too.\nThis may or may not be a favorable difference. That depends on Kim’s\nopinion of IV.\nOn the surface, the disparity in delta appears to be a highly unfavorable\ntrade-off. The delta of the 37.50 call is less than one third of the delta of the\n35 call, and the whole motive for entering into this trade is to trade\ndirection! Although this strategy is very delta oriented, its core is more\nfocused on gamma and theta.\nThe gamma of the 37.50 call is about 72 percent that of the 35 call. But\nthe theta of the 37.50 call is about half that of the 35 call. Kim is improving\nher gamma/theta relationship by buying the OTM, but with the call being so\nfar out-of-the-money and so inexpensive, the theta needs to be taken with a\ngrain of salt. It is ultimately gamma that will make or break this delta play.\nThe price of the option is 0.20—a rather low premium. In order for the\ncall to gain in value, delta has to go to work with help from gamma. At this\npoint, the delta is small, only 0.185. If Kim’s forecast is correct and there is\na big move upward, gamma will cause the delta to increase, and therefore\nalso the premium to increase exponentially. The call’s sensitivity to gamma,\nhowever, is dynamic.\nExhibit 4.7 shows how the gamma of the 37.50 call changes as the stock\nprice moves over time. At any point in time, gamma is highest when the call\nis ATM. However, so is theta. Kim wants to reap as much benefit from\ngamma as possible while minimizing her exposure to theta. Ideally, she\nwants Disney to rally through the strike price—through the high gamma\nand back to the low theta. After three weeks pass, with 23 days until\nexpiration, if Disney is at $37 a share, the gamma almost doubles, to 0.237.\nWhen the call is ATM, the delta increases at its fastest rate. As Disney rises\nabove the strike, the gamma figures in the table begin to decline.\nEXHIBIT 4.7 Disney 37.50 call price–time matrix–gamma.\n\nGamma helps as the stock price declines, too. Exhibit 4.8 shows the effect\nof time and gamma on the delta of the 37.50 call.\nEXHIBIT 4.8 Disney 37.50 call price–time matrix–delta.\nThe effect of gamma is readily observable, as the delta at any point in\ntime is always higher at higher stock prices and lower at lower stock prices.\nKim benefits greatly when the delta grows from its initial level of 0.185 to\nabove 0.50—above the point of being at-the-money. If the stock moves\nlower, gamma helps take away the pain of the price decline by decreasing\nthe delta.\nWhile delta, gamma, and theta occupy Kim’s thoughts, it is ultimately\ndollars and cents that matter. She needs to translate her study of the greeks\ninto cold, hard cash. Exhibit 4.9 shows the theoretical values of the 37.50\ncall.\nEXHIBIT 4.9 Disney 37.50 call price–time matrix–value.\nThe sooner the price rise occurs, the better. It means less time for theta to\neat away profits. If Kim must hold the position for the entire three weeks,\nshe needs a good pop in the stock to make it worth her while. At a $37 share\nprice, the call is worth about 0.50, assuming all other market influences\nremain constant. That’s about a 150 percent profit. At $38, Exhibit 4.9\nreveals the call value to be 1.04. That’s a 420 percent profit.\nOn one hand, it’s hard for a trader like Kim not to get excited about the\nprospect of making 420 percent on an 8 percent move in a stock. On the\nother hand, Kim has to put things in perspective. When the position is\nestablished, the call has a 0.185 delta. By the trader’s definition of delta,\nthat means the call is estimated to have about an 18.5 percent chance of\nexpiring in-the-money. More than four out of five times, this position will\nbe trading below the strike at expiration.\nAlthough Kim is not likely to hold the position until expiration, this\nobservation tells her something: she’s starting in the hole. She is more likely\nto lose than to win. She needs to be compensated well for her risk on the\nwinners to make up for the more prevalent losers.\nBuying OTM calls can be considered more speculative than buying ITM\nor ATM calls. Unlike what the at-expiration diagrams would lead one to\nbelieve, OTM calls are not simply about direction. There’s a bit more to it.\nThey are really about gamma, time, and the magnitude of the stock’s move\n(volatility). Long OTM calls require a big move in the right direction for\ngamma to do its job.\nLong ITM Call\nKim also has the alternative to buy an ITM call. Instead of the 35 or 37.50\ncall, she can buy the 32.50. The 32.50 call shares some of the advantages\nthe 37.50 call has over the 35 call, but its overall greek characteristics make\nit a very different trade from the two previous alternatives. Exhibit 4.10\nshows a comparison of the gr", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 29}
{"text": "move in the right direction for\ngamma to do its job.\nLong ITM Call\nKim also has the alternative to buy an ITM call. Instead of the 35 or 37.50\ncall, she can buy the 32.50. The 32.50 call shares some of the advantages\nthe 37.50 call has over the 35 call, but its overall greek characteristics make\nit a very different trade from the two previous alternatives. Exhibit 4.10\nshows a comparison of the greeks of the three different calls.\nEXHIBIT 4.10 Greeks for Disney 32.50, 35, and 37.50 calls.\nLike the 37.50 call, the 32.50 has a lower gamma, theta, and vega than the\nATM 35-strike call. Because the call is ITM, it has a higher delta: 0.862. In\nthis example, Kim can buy the 32.50 call for 3. That’s 0.40 over parity (3 −\n[35.10 − 32.50] = 0.40). There is not much time value, but more than the\n37.50 call has. Thus, theta is of some concern. Ultimately, the ITMs have\n0.40 of time value to lose compared with the 0.20 of the OTM calls. Vega is\nalso of some concern, but not as much as in the other alternatives because\nthe vega of the 32.50 is lower than the 35s or the 37.50s. Gamma doesn’t\nhelp much as the stock rallies—it will get smaller as the stock price rises.\nGamma will, however, slow losses somewhat if the stock declines by\ndecreasing delta at an increasing rate.\nIn this case, the greek of greatest consequence is delta—it is a more\npurely directional play than the other alternatives discussed. Exhibit 4.11\nshows the matrix of the delta of the 32.50 call.\nEXHIBIT 4.11 Disney 32.50 call price–time matrix–delta.\nBecause the call starts in-the-money and has a relatively low gamma, the\ndelta remains high even if Disney declines significantly. Gamma doesn’t\nreally kick in until the stock retreats enough to bring the call closer to being\nat-the-money. At that point, the position will have suffered a big loss, and\nthe higher gamma is of little comfort.\nKim’s motivation for selecting the ITM call above the ATM and OTM\ncalls would be increased delta exposure. The 0.86 delta makes direction the\nmost important concern right out of the gate. Exhibit 4.12 shows the\ntheoretical values of the 32.50 call.\nEXHIBIT 4.12 Disney 32.50 call price–time matrix–value.\nSmall directional moves contribute to significant leveraged gains or\nlosses. From share price $35 to $36, the call gains 0.90—from 2.91 to 3.81\n—about a 30 percent gain. However, from $35 to $34, the call loses 0.80, or\n27 percent. With only 0.40 of time value, the nondirectional greeks (theta,\ngamma, and vega) are a secondary consideration.\nIf this were a deeper ITM call, the delta would start out even higher,\ncloser to 1.00, and the other relevant greeks would be closer to zero. The\ndeeper ITM a call, the more it acts like the stock and the less its option\ncharacteristics (greeks) come into play.\nLong ATM Put\nThe beauty of the free market is that two people can study all the available\ninformation on the same stock and come up with completely different\noutlooks. First of all, this provides for entertaining television on the\nbusiness-news channels when the network juxtaposes an outspoken bullish\nanalyst with an equally unreserved bearish analyst. But differing opinions\nalso make for a robust marketplace. Differing opinions are the oil that\ngreases the machine that is price discovery. From a market standpoint, it’s\nwhat makes the world go round.\nIt is possible that there is another trader, Mick, in the market studying\nDisney, who arrives at the conclusion that the stock is overpriced. Mick\nbelieves the stock will decline in price over the next three weeks. He\ndecides to buy one Disney March 35 put at 0.80. In this example, March has\n44 days to expiration.\nMick initiates this long put position to gain downside exposure, but along\nwith his bearish position comes option-specific risk and opportunity. Mick\nis buying the same month and strike option as Kim did in the first example\nof this chapter: the March 35 strike. Despite the different directional bias,\nMick’s position and Kim’s position share many similarities. Exhibit 4.13\noffers a comparison of the greeks of the Disney March 35 call and the\nDisney March 35 put.\nEXHIBIT 4.13 Greeks for Disney 35 call and 35 put.\nCall Put\nDelta 0.57 −0.444\nGamma0.1660.174\nTheta −0.013−0.009\nVega 0.0480.048\nRho 0.023−0.015\nThe first comparison to note is the contrasting deltas. The put delta is\nnegative, in contrast to the call delta. The absolute value of the put delta is\nclose to 1.00 minus the call delta. The put is just slightly OTM, so its delta\nis just under 0.50, while that of the call is just over 0.50. The disparate, yet\nrelated deltas represent the main difference between these two trades.\nThe difference between the gamma of the 35 put and that of the\ncorresponding call is fairly negligible: 0.174 versus 0.166, respectively. The\ngamma of this ATM put will enter into the equation in much the same way\nas the gamma of the ATM call. The put’s negative delta will become more\nnegative as the stock declines, drawing closer to −1.00. It will get less\nnegative as the stock price rises, drawing closer to zero. Gamma is\nimportant here, because it helps the delta. Delta, however, still remains the\nmost important greek. Exhibit 4.14 illustrates how the 35 put delta changes\nas time and price change.\nEXHIBIT 4.14 Disney 35 put price–time matrix–delta.\nSince this put is ATM, it starts out with a big enough delta to offer the\ndirectional exposure Mick desires. The delta can change, but gamma\nensures that it always changes in Mick’s favor. Exhibit 4.15 shows how the\nvalue of the 35 put changes with the stock price.\nEXHIBIT 4.15 Disney 35 put price–time matrix–value.\nOver time, a decline of only 10 percent in the stock yields high\npercentage returns. This is due to the leveraged directional nature of this\ntrade—delta.\nWhile the other greeks are not of primary concern, they must be\nmonitored. At the onset, the 0.80 premium is all time value and, therefore\nsubject to the influences of time decay and volatility. This is where trading", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 30}
{"text": "put price–time matrix–value.\nOver time, a decline of only 10 percent in the stock yields high\npercentage returns. This is due to the leveraged directional nature of this\ntrade—delta.\nWhile the other greeks are not of primary concern, they must be\nmonitored. At the onset, the 0.80 premium is all time value and, therefore\nsubject to the influences of time decay and volatility. This is where trading\ngreeks comes into play.\nConventional trading wisdom says, “Cut your losses early, and let your\nprofits run.” When trading a stock, that advice is intellectually easy to\nunderstand, although psychologically difficult to follow. Buyers of options,\nespecially ATM options, must follow this advice from the standpoint of\ntheta. Options are decaying assets. The time premium will be zero at\nexpiration. ATMs decay at an increasing nonlinear rate. Exiting a long\nposition before getting too close to expiration can cut losses caused by an\nincreasing theta. When to cut those losses, however, will differ from trade\nto trade, situation to situation, and person to person.\nWhen buying options, accepting some loss of premium due to time decay\nshould be part of the trader’s plan. It comes with the territory. In this\nexample, Mick is willing to accept about three weeks of erosion. Mick\nneeds to think about what his put will be worth, not just if the underlying\nrises or falls but also if it doesn’t move at all. At the time the position is\nestablished, the theta is 0.009, just under a penny. If Disney share price is\nunchanged when three weeks pass, his theta will be higher. Exhibit 4.16\nshows how thetas and theoretical values change over time if DIS stock\nremains at $35.10.\nEXHIBIT 4.16 Disney 35 put—thetas and theoretical values.\nMick needs to be concerned not only about what the theta is now but what\nit will be when he plans on exiting the position. His plan is to exit the trade\nin about three weeks, at which point the put theta will be −0.013. If he\namortizes his theta over this three-week period, he theoretically loses an\naverage of about 0.01 a day during this time if nothing else changes. The\naverage daily theta is calculated here by subtracting the value of the put at\n23 days to expiration from its value when the trade was established to find\nthe loss of premium attributed to time decay, then dividing by the number\nof days until expiration.\nSince the theta doesn’t change much over the first three weeks, Mick can\neyeball the theta rather easily. As expiration approaches and theta begins to\ngrow more quickly, he’ll need to do the math.\nAt nine days to expiration, the theoretical value of Mick’s put is about\n0.35, assuming all other variables are held constant. By that time, he will\nhave lost 0.45 (0.80 − 0.35) due to erosion over the 35-day period he held\nthe position if the stock hasn’t moved. Mick’s average daily theta during\nthat period is about 0.0129 (0.45 ÷ 35). The more time he holds the trade,\nthe greater a concern is theta. Mick must weigh his assessment of the\nlikelihood of the option’s gaining value from delta against the risk of\nerosion. If he holds the trade for 35 days, he must make 0.0129 on average\nper day from delta to offset theta losses. If the forecast is not realized within\nthe expected time frame or if the forecast changes, Mick needs to act fast to\ncurtail average daily theta losses.\nFinding the Right Risk\nMick could lower the theta of his position by selecting a put with a greater\nnumber of days to expiration. This alternative has its own set of trade-offs:\nlower gamma and higher vega than the 44-day put. He could also select an\nITM put or an OTM put. Like Kim’s call alternatives, the OTM put would\nhave less exposure to time decay, lower vega, lower gamma, and a lower\ndelta. It would have a lower premium, too. It would require a bigger price\ndecline than the ATM put and would be more speculative.\nThe ITM put would also have lower theta, vega, and gamma, but it would\nhave a higher delta. It would take on more of the functionality of a short\nstock position in much the same way that Kim’s ITM call alternative did for\na long stock position. In its very essence, however, an option trade, ITM or\notherwise, is still fundamentally different than a stock trade.\nStock has a 1.00 delta. The delta of a stock never changes, so it has zero\ngamma. Stock is not subject to time decay and has no volatility component\nto its pricing. Even though ITM options have deltas that approach 1.00 and\nother greeks that are relatively low, they have two important differences\nfrom an equity. The first is that the greeks of options are dynamic. The\nsecond is the built-in leverage feature of options.\nThe relationship of an option’s strike price to the stock price can change\nconstantly. Options that are ITM now may be OTM tomorrow and vice\nversa. Greeks that are not in play at the moment may be later. Even if there\nis no time value in the option now because it is so far away-from-the-\nmoney, there is the potential for time premium to become a component of\nthe option’s price if the stock moves closer to the strike price. Gamma,\ntheta, and vega always have the potential to come into play.\nSince options are leveraged by nature, small moves in the stock can\nprovide big profits or big losses. Options can also curtail big losses if used\nfor hedging. Long option positions can reap triple-digit percentage gains\nquickly with a favorable move in the underlying. Even though 100 percent\nof the premium can be lost just as easily, one option contract will have far\nless nominal exposure than a similar position in the stock.\nIt’s All About Volatility\nWhat are Kim and Mick really trading? Volatility. The motivation for\nbuying an option as opposed to buying or shorting the stock is volatility. To\nsome degree, these options have exposure to both flavors of volatility—\nimplied volatility and historical volatility (HV). The positions in each of the\nexamples have positive vega. Their values are influenced, in part, by IV.\nOver time, IV begins", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 31}
{"text": "ility\nWhat are Kim and Mick really trading? Volatility. The motivation for\nbuying an option as opposed to buying or shorting the stock is volatility. To\nsome degree, these options have exposure to both flavors of volatility—\nimplied volatility and historical volatility (HV). The positions in each of the\nexamples have positive vega. Their values are influenced, in part, by IV.\nOver time, IV begins to lose its significance if the option is no longer close\nto being at-the-money.\nThe main objective of each of these trades is to profit from the volatility\nof the stock’s price movement, called future stock volatility or future\nrealized volatility. The strategies discussed in this chapter are contingent on\nvolatility being one directional. The bigger the move in the trader’s\nforecasted direction the better. Volatility in the form of an adverse\ndirectional move results in a decline in premium. The gamma in these long\noption positions makes volatility in the right direction more beneficial and\nvolatility in the wrong direction less costly.\nThis phenomenon is hardly unique to the long call and the long put.\nAlthough some basic strategies, such as the ones studied in this chapter,\ndepend on a particular direction, many don’t. Except for interest rate\nstrategies and perhaps some arbitrage strategies, all option trades are\nvolatility trades in one way or another. In general, option strategies can be\ndivided into two groups: volatility-buying strategies and volatility-selling\nstrategies. The following is a breakdown of common option strategies into\ncategories of volatility-buying strategies and volatility-selling strategies:\nVolatility-Selling Strategies Volatility-Buying Strategies\nShort Call, Short Put, Covered Call, Covered Put,\nBull Call Spread, Bear Call Spread, Bull Put\nSpread, Bear Put Spread, Short Straddle, Short\nStrangle, Guts, Ratio Call Spread, Calendar,\nButterfly, Iron Butterfly, Broken-Wing Butterfly,\nCondor, Iron Condor, Diagonals, Double Diagonals,\nRisk Reversals/Collars.\nLong Call, Long Put, Bull Call Spread, Bear\nCall Spread, Bull Put Spread, Bear Put Spread,\nLong Straddle, Long Strangle, Guts, Back\nSpread, Calendar, Butterfly, Iron Butterfly,\nBroken-Wing Butterfly, Condor, Iron Condor,\nDiagonals, Double Diagonals, Risk\nReversals/Collars.\nLong option strategies appear in the volatility-buying group because they\nhave positive gamma and positive vega. Short option strategies appear in\nthe volatility-selling group because of negative gamma and vega. There are\nsome strategies that appear in both groups—for example, the\nbutterfly/condor family, which is typically associated with income\ngeneration. These particular volatility strategies are commonly instituted as\nvolatility-selling strategies. However, depending on whether the position is\nbought or sold and where the stock price is in relation to the strike prices,\nthe position could fall into either group. Some strategies, like the vertical\nspread family—bull and bear call and put spreads—and risk reversal/collar\nspreads naturally fall into either category, depending on where the stock is\nin relation to the strikes. The calendar spread family is unique in that it can\nhave characteristics of each group at the same time.\nDirection Neutral, Direction Biased, and\nDirection Indifferent\nAs typically traded, volatility-selling option strategies are direction neutral.\nThis means that the position has the greatest results if the underlying price\nremains in a range—that is, neutral. Although some option-selling strategies\n—for example, a naked put—may have a positive or negative delta in the\nshort term, profit potential is decidedly limited. This means that if traders\nare expecting a big move, they are typically better off with option-buying\nstrategies.\nOption-buying strategies can be either direction biased or direction\nindifferent. Direction-biased strategies have been shown throughout this\nchapter. They are delta trades. Direction-indifferent strategies are those that\nbenefit from increased volatility in the underlying but where the direction of\nthe move is irrelevant to the profitability of the trade. Movement in either\ndirection creates a winner.\nAre You a Buyer or a Seller?\nThe question is: which is better, selling volatility or buying volatility? I\nhave attended option seminars with instructors (many of whom I regard\nwith great respect) teaching that volatility-selling strategies, or income-\ngenerating strategies, are superior to buying options. I also know option\ngurus that tout the superiority of buying options. The answer to the question\nof which is better is simple: it’s all a matter of personal preference.\nWhen I began trading on the floor of Chicago Board Options Exchange\n(CBOE) in the 1990s, I quickly became aware of a dichotomy among my\nmarket-making peers. Those making markets on the floor of the exchange at\nthat time were divided into two groups: teenie buyers and teenie sellers.\nTeenie Buyers\nBefore options traded in decimals (dollars and cents) like they do today, the\nlowest price increment in which an option could be traded was one\nsixteenth of a dollar—a teenie . Teenie buyers were market makers who\nwould buy back OTM options at one sixteenth to eliminate short positions.\nThey would sometimes even initiate long OTM option positions at a teenie,\ntoo. The focus of the teenie-buyer school of thought was the fact that long\noptions have unlimited reward, while short options have unlimited risk. An\noption purchased so far OTM that it was offered at one sixteenth is unlikely\nto end up profitable, but it’s an inexpensive lottery ticket. At worst, the\ntrader can only lose a teenie. Teenie buyers felt being short OTM options\nthat could be closed by paying a sixteenth was an unreasonable risk.\nTeenie Sellers\nTeenie sellers, however, focused on the fact that options offered at one\nsixteenth were far enough OTM that they were very likely to expire\nworthless. This appears to be free money, unless the unexpected occurs, in\nwhich case potentia", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 32}
{"text": "st, the\ntrader can only lose a teenie. Teenie buyers felt being short OTM options\nthat could be closed by paying a sixteenth was an unreasonable risk.\nTeenie Sellers\nTeenie sellers, however, focused on the fact that options offered at one\nsixteenth were far enough OTM that they were very likely to expire\nworthless. This appears to be free money, unless the unexpected occurs, in\nwhich case potential losses can be unlimited. Teenie sellers would routinely\nsave themselves $6.25 (one sixteenth of a dollar per contract representing\n100 shares) by selling their long OTMs at a teenie to close the position.\nThey sometimes would even initiate short OTM contracts at one sixteenth.\nThese long-option or short-option biases hold for other types of strategies\nas well. Volatility-selling positions, such as the iron condor, can be\nconstructed to have limited risk. The paradigm for these strategies is they\ntend to produce winners more often than not. But when the position loses,\nthe trader loses more than he would stand to profit if the trade worked out\nfavorably.\nHerein lies the issue of preference. Long-option traders would rather trade\nBabe Ruth–style. For years, Babe Ruth was the record holder for the most\nhome runs. At the same time, he was also the record holder for the most\nstrikeouts. The born fighters that are option buyers accept the fact that they\nwill have more strikeouts, possibly many more strikeouts, than winning\ntrades. But the strategy dictates that the profit on one winner more than\nmakes up for the string of small losers.\nShort-option traders, conversely, like to have everything cool and\ncopacetic. They like the warm and fuzzy feeling they get from the fact that\nmonth after month they tend to generate winners. The occasional loser that\nnullifies a few months of profits is all part of the game.\nOptions and the Fair Game\nThere may be a statistical advantage to buying stock as opposed to shorting\nstock, because the market has historically had a positive annualized return\nover the long run. A statistical advantage to being either an option buyer or\nan option seller, however, should not exist in the long run, because the\noption market prices IV. Assuming an overall efficient market for pricing\nvolatility into options, there should be no statistical advantage to\nsystematically buying or selling options. 1\nConsider a game consisting of one six-sided die. Each time a one, two, or\nthree is rolled, the house pays the player $1. Each time a four, five, or six is\nrolled, the house pays zero. What is the most a player would be willing to\npay to play this game? If the player paid nothing, the house would be at a\ntremendous disadvantage, paying $1 50 percent of the time and nothing the\nother 50 percent of the time. This would not be a fair game from the house’s\nperspective, as it would collect no money. If the player paid $1, the player\nwould get his dollar back when one, two, or three came up. Otherwise, he\nwould lose his dollar. This is not a fair game from the player’s perspective.\nThe chances of winning this game are 3 out of 6, or 50–50. If this game\nwere played thousands of times, one would expect to receive $1 half the\ntime and receive nothing the other half of the time. The average return per\nroll one would expect to receive would be $0.50, that’s ($1 × 50 percent +\n$0 × 50 percent). This becomes a fair game with an entrance fee of $0.50.\nNow imagine a similar game in which a six-sided die is rolled. This time\nif a one is rolled, the house pays $1. If any other number is rolled, the house\npays nothing. What is a fair price to play this game? The same logic and the\nsame math apply. There is a \n percent chance of a one coming up and the\nplayer receiving $1. And there is a \n percent chance of each of the other\nfive numbers being rolled and the player receiving nothing. Mathematically,\nthis translates to: \n percent \n percent). Fair value for a\nchance to play this game is about $0.1667 per roll.\nThe fair game concept applies to option prices as well. The price of the\ngame, or in this case the price of the option, is determined by the market in\nthe form of IV. The odds are based on the market’s expectations of future\nvolatility. If buying options offered a superior payout based on the odds of\nsuccess, the market would put upward pressure on prices until this arbitrage\nopportunity ceased to exist. It’s the same for selling volatility. If selling\nwere a fundamentally better strategy, the market would depress option\nprices until selling options no longer produced a way to beat the odds. The\noptions market will always equalize imbalances.\nNote\n1 . This is not to say that unique individual opportunities do not exist for\noverpriced or underpriced options, only that options are not overpriced or\nunderpriced in general. Thus, neither an option-selling nor option-buying\nmethodology should provide an advantage.\nCHAPTER 5\nAn Introduction to Volatility-Selling Strategies\nAlong with death and taxes, there is one other fact of life we can all count\non: the time value of all options ultimately going to zero. What an alluring\nconcept! In a business where expected profits can be thwarted by an\nunexpected turn of events, this is one certainty traders can count on. Like all\ncertainties in the financial world, there is a way to profit from this fact, but\nit’s not as easy as it sounds. Alas, the potential for profit only exists when\nthere is risk of loss.\nIn order to profit from eroding option premiums, traders must implement\noption-selling strategies, also known as volatility-selling strategies. These\nstrategies have their own set of inherent risks. Selling volatility means\nhaving negative vega—the risk of implied volatility rising. It also means\nhaving negative gamma—the risk of the underlying being too volatile. This\nis the nature of selling volatility. The option-selling trader does not want the\nunderlying stock to move—that is, the trader wants the stock to be less\nvolatile. That is the risk.\nProfit Potential\nProf", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 33}
{"text": "n set of inherent risks. Selling volatility means\nhaving negative vega—the risk of implied volatility rising. It also means\nhaving negative gamma—the risk of the underlying being too volatile. This\nis the nature of selling volatility. The option-selling trader does not want the\nunderlying stock to move—that is, the trader wants the stock to be less\nvolatile. That is the risk.\nProfit Potential\nProfit for the volatility seller is realized in a roundabout sort of way. The\nreward for low volatility is achieved through time decay. These strategies\nhave positive theta. Just as the volatility-buying strategies covered in\nChapter 4 had time working against them, volatility-selling strategies have\ntime working in their favor. The trader is effectively paid to assume the risk\nof movement.\nGamma-Theta Relationship\nThere exists a trade-off between gamma and theta. Long options have\npositive gamma and negative theta. Short options have negative gamma and\npositive theta. Positions with greater gamma, whether positive or negative,\ntend to have greater theta values, negative or positive. Likewise, lower\nabsolute values for gamma tend to go hand in hand with lower absolute\nvalues for theta. The gamma-theta relationship is the most important\nconsideration with many types of strategies. Gamma-theta is often the\nmeasurement with the greatest influence on the bottom line.\nGreeks and Income Generation\nWith volatility-selling strategies (sometimes called income-generating\nstrategies), greeks are often overlooked. Traders simply dismiss greeks as\nunimportant to this kind of trade. There is some logic behind this reasoning.\nTime decay provides the profit opportunity. In order to let all of time\npremium erode, the position must be held until expiration. Interim changes\nin implied volatility are irrelevant if the position is held to term. The\ngamma-theta loses some significance if the position is held until expiration,\ntoo. The position has either passed the break-even point on the at-expiration\ndiagram, or it has not. Incremental daily time decay–related gains are not\nthe ultimate goal. The trader is looking for all the time premium, not\nportions of it.\nSo why do greeks matter to volatility sellers? Greeks allow traders to be\nflexible. Consider short-term-momentum stock traders. The traders buy a\nstock because they believe it will rise over the next month. After one week,\nif unexpected bearish news is announced causing the stock to break through\nits support lines, the traders have a decision to make. Short-term speculative\ntraders very often choose to cut their losses and exit the position early rather\nthan risk a larger loss hoping for a recovery.\nVolatility-selling option traders are often faced with the same dilemma. If\nthe underlying stays in line with the traders’ forecast, there is little to worry\nabout. But if the environment changes, the traders have to react. Knowing\nthe greeks for a position can help traders make better decisions if they plan\nto close the position before expiration.\nNaked Call\nA naked call is when a trader shorts a call without having stock or other\noptions to cover or protect it. Since the call is uncovered, it is one of the\nriskier trades a trader can make. Recall the at-expiration diagram for the\nnaked call from Chapter 1, Exhibit 1.3 : Naked TGT Call. Theoretically,\nthere is limited reward and unlimited risk. Yet there are times when\nexperienced traders will justify making such a trade. When a stock has been\ntrading in a range and is expected to continue doing so, traders may wait\nuntil it is near the top of the channel, where there is resistance, and then\nshort a call.\nFor example, a trader, Brendan, has been studying a chart of Johnson &\nJohnson (JNJ). Brendan notices that for a few months the stock has trading\nbeen in a channel between $60 and $65. As he observes Johnson & Johnson\nbeginning to approach the resistance level of $65 again, he considers selling\na call to speculate on the stock not rising above $65. Before selling the call,\nBrendan consults other technical analysis tools, like ADX/DMI, to confirm\nthat there is no trend present. ADX/DMI is used by some traders as a filter\nto determine the strength of a trend and whether the stock is overbought or\noversold. In this case, the indicator shows no strong trend present. Brendan\nthen performs due diligence. He studies the news. He looks for anything\nspecific that could cause the stock to rally. Is the stock a takeover target?\nBrendan finds nothing. He then does earnings research to find out when\nthey will be announced, which is not for almost two more months.\nNext, Brendan pulls up an option chain on his computer. He finds that\nwith the stock trading around $64 per share, the market for the November\n65 call (expiring in four weeks) is 0.66 bid at 0.68 offer. Brendan considers\nwhen Johnson & Johnson’s earnings report falls. Although recent earnings\nhave seldom been a major concern for Johnson & Johnson, he certainly\nwants to sell an option expiring before the next earnings report. The\nNovember fits the mold. Brendan sells ten of the November 65 calls at the\nbid price of 0.66.\nBrendan has a rather straightforward goal. He hopes to see Johnson &\nJohnson shares remain below $65 between now and expiration. If he is\nright, he stands to make $660. If he is wrong? Exhibit 5.1 shows how\nBrendan’s calls hold up if they are held until expiration.\nEXHIBIT 5.1 Naked Johnson & Johnson call at expiration.\nConsidering the risk/reward of this trade, Brendan is rightfully concerned\nabout a big upward move. If the stock begins to rally, he must be prepared\nto act fast. Brendan must have an idea in advance of what his pain threshold\nis. In other words, at what price will he buy back his calls and take a loss if\nJohnson & Johnson moves adversely?\nHe decides he will buy all 10 of his calls back at 1.10 per contract if the\ntrade goes against him. (1.10 is an arbitrary price used for illustrative\npurposes. The actual price will vary, based on the si", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 34}
{"text": "ared\nto act fast. Brendan must have an idea in advance of what his pain threshold\nis. In other words, at what price will he buy back his calls and take a loss if\nJohnson & Johnson moves adversely?\nHe decides he will buy all 10 of his calls back at 1.10 per contract if the\ntrade goes against him. (1.10 is an arbitrary price used for illustrative\npurposes. The actual price will vary, based on the situation and the risk\ntolerance of the trader. More on when to take profits and losses is discussed\nin future chapters.) He may choose to enter a good-till-canceled (GTC)\nstop-loss order to buy back his calls. Or he may choose to monitor the stock\nand enter the order when he sees the calls offered at 1.10—a mental stop\norder. What Brendan needs to know is: How far can the stock price advance\nbefore the calls are at 1.10?\nBrendan needs to examine the greeks of this trade to help answer this\nquestion. Exhibit 5.2 shows the hypothetical greeks for the position in this\nexample.\nEXHIBIT 5.2 Greeks for short Johnson & Johnson 65 call (per contract).\nDelta −0.34\nGamma−0.15\nTheta 0.02\nVega −0.07\nThe short call has a negative delta. It also has negative gamma and vega,\nbut it has positive time decay (theta). As Johnson & Johnson ticks higher,\nthe delta increases the nominal value of the call. Although this is not a\ndirectional trade per se, delta is a crucial element. It will have a big impact\non Brendan’s expectations as to how high the stock can rise before he must\ntake his loss.\nFirst, Brendan considers how much the option price can move before he\ncovers. The market now is 0.66 bid at 0.68 offer. To buy back his calls at\n1.10, they must be offered at 1.10. The difference between the offer now\nand the offer price at which Brendan will cover is 0.42 (that’s 1.10 − 0.68).\nBrendan can use delta to convert the change in the ask prices into a stock\nprice change. To do so, Brendan divides the change in the option price by\nthe delta.\nThe −0.34 delta indicates that if JNJ rises $1.24, the calls should be\noffered at 1.10.\nBrendan takes note that the bid-ask spreads are typically 0.01 to 0.03\nwide in near-term Johnson & Johnson options trading under 1.00. This is\nnot necessarily the case in other option classes. Less liquid names have\nwider spreads. If the spreads were wider, Brendan would have more\nslippage. Slippage is the difference between the assumed trade price and the\nactual price of the fill as a product of the bid-ask spread. It’s the difference\nbetween theory and reality. If the bid-ask spread had a typical width of, say,\n0.70, the market would be something more like 0.40 bid at 1.10 offer. In\nthis case, if the stock moved even a few cents higher, Brendan could not\nbuy his calls back at his targeted exit price of 1.10. The tighter markets\nprovide lower transaction costs in the form of lower slippage. Therefore,\nthere is more leeway if the stock moves adversely when there are tighter\nbid-ask option spreads.\nBut just looking at delta only tells a part of the story. In reality, the delta\ndoes not remain constant during the price rise in Johnson & Johnson but\ninstead becomes more negative. Initially, the delta is −0.34 and the gamma\nis −0.15. After a rise in the stock price, the delta will be more negative by\nthe amount of the gamma. To account for the entire effect of direction,\nBrendan needs to take both delta and gamma into account. He needs to\nestimate the average delta based on gamma during the stock price move.\nThe formula for the change in stock price is\nTaking into account the effect of gamma as well as delta, Johnson &\nJohnson needs to rise only $1.01, in order for Brendan’s calls to be offered\nat his stop-loss price of 1.10.\nWhile having a predefined price point to cover in the event the underlying\nrises is important, sometimes traders need to think on their feet. If material\nnews is announced that changes the fundamental outlook for the stock,\nBrendan will have to adjust his plan. If the news leads Brendan to become\nbullish on the stock, he should exit the trade at once, taking a small loss\nnow instead of the bigger loss he would expect later. If the trader is\nuncertain as to whether to hold or close the position, the Would I Do It\nNow? rule is a useful rule of thumb.\nWould I Do It Now? Rule\nTo follow this rule, ask yourself, “If I did not already have this position,\nwould I do it now? Would I establish the position at the current market\nprices, given the current market scenario?” If the answer is no, then the\nsolution is simple: Exit the trade.\nFor example, if after one week material news is released and Johnson &\nJohnson is trading higher, at $64.50 per share, and the November 65 call is\ntrading at 0.75, Brendan must ask himself, based on the price of the stock\nand all known information, “If I were not already short the calls, would I\nshort them now at the current price of 0.75, with the stock trading at\n$64.50?”\nBrendan’s opinion of the stock is paramount in this decision. If, for\nexample, based on the news that was announced he is now bullish, he\nwould likely not want to sell the calls at 0.75—he only gets $0.09 more in\noption premium and the stock is 0.50 closer to the strike. If, however, he is\nnot bullish, there is more to consider.\nTheta can be of great use in decision making in this situation. As the\nnumber of days until expiration decreases and the stock approaches $65\n(making the option more at-the-money), Brendan’s theta grows more\npositive. Exhibit 5.3 shows the theta of this trade as the underlying rises\nover time.\nEXHIBIT 5.3 Theta of Johnson & Johnson.\nWhen the position is first established, positive theta comforts Brendan by\nshowing that with each passing day he gets a little closer to his goal—to\nhave the 65 calls expire out-of-the-money (OTM) and reap a profit of the\nentire 66-cent premium. Theta becomes truly useful if the position begins to\nmove against him. As Johnson & Johnson rises, the trade gets more\nprecarious. His negative delta increases. His negative gamma increases.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 35}
{"text": "ed, positive theta comforts Brendan by\nshowing that with each passing day he gets a little closer to his goal—to\nhave the 65 calls expire out-of-the-money (OTM) and reap a profit of the\nentire 66-cent premium. Theta becomes truly useful if the position begins to\nmove against him. As Johnson & Johnson rises, the trade gets more\nprecarious. His negative delta increases. His negative gamma increases. His\ngoal becomes more out of reach. In conjunction with delta and gamma,\ntheta helps Brendan decide whether the risk is worth the reward.\nIn the new scenario, with the stock at $64.50, Brendan would collect $18\na day (1.80 × 10 contracts). Is the risk of loss in the short run worth earning\n$18 a day? With Johnson & Johnson at $64.50, would Brendan now short\n10 calls at 0.75 to collect $18 a day, knowing that each day may bring a\ncontinued move higher in the stock? The answer to this question depends on\nBrendan’s assessment of the risk of the underlying continuing its ascent. As\ntime passes, if the stock remains closer to the strike, the daily theta rises,\nproviding more reward. Brendan must consider that as theta—the reward—\nrises, so does gamma: a risk factor.\nA small but noteworthy risk is that implied volatility could rise. The\nnegative vega of this position would, then, adversely affect the profitability\nof this trade. It will make Brendan’s 1.10 cover-point approach faster\nbecause it makes the option more expensive. Vega is likely to be of less\nconsequence because it would ultimately take the stock’s rising though the\nstrike price for the trade to be a loser at expiration.\nShort Naked Puts\nAnother trader, Stacie, has also been studying Johnson & Johnson. Stacie\nbelieves Johnson & Johnson is on its way to test the $65 resistance level yet\nagain. She believes it may even break through $65 this time, based on\nstrong fundamentals. Stacie decides to sell naked puts. A naked put is a\nshort put that is not sold in conjunction with stock or another option.\nWith the stock around $64, the market for the November 65 put is 1.75\nbid at 1.80. Stacie likes the fact that the 65 puts are slightly in-the-money\n(ITM) and thus have a higher delta. If her price rise comes sooner than\nexpected, the high delta may allow her to take a profit early. Stacie sells 10\nputs at 1.75.\nIn the best-case scenario, Stacie retains the entire 1.75. For that to happen,\nshe will need to hold this position until expiration and the stock will have to\nrise to be trading above the 65 strike. Logically, Stacie will want to do an\nat-expiration analysis. Exhibit 5.4 shows Stacie’s naked put trade if she\nholds it until expiration.\nEXHIBIT 5.4 Naked Johnson & Johnson put at expiration.\nWhile harvesting the entire premium as a profit sounds attractive, if\nStacie can take the bulk of her profit early, she’ll be happy to close the\nposition and eliminate her risk—nobody ever went broke taking a profit.\nFurthermore, she realizes that her outlook may be wrong: Johnson &\nJohnson may decline. She may have to close the position early—maybe for\na profit, maybe for a loss. Stacie also needs to study her greeks. Exhibit 5.5\nshows the greeks for this trade.\nEXHIBIT 5.5 Greeks for short Johnson & Johnson 65 put (per contract).\nDelta 0.65\nGamma−0.15\nTheta 0.02\nVega −0.07\nThe first item to note is the delta. This position has a directional bias. This\nbias can work for or against her. With a positive 0.65 delta per contract, this\nposition has a directional sensitivity equivalent to being long around 650\nshares of the stock. That’s the delta × 100 shares × 10 contracts.\nStacie’s trade is not just a bullish version of Brendan’s. Partly because of\nthe size of the delta, it’s different—specific directional bias aside. First, she\nwill handle her trade differently if it is profitable.\nFor example, if over the next week or so Johnson & Johnson rises $1,\npositive delta and negative gamma will have a net favorable effect on\nStacie’s profitability. Theta is small in comparison and won’t have too much\nof an effect. Delta/gamma will account for a decrease in the put’s\ntheoretical value of about $0.73. That’s the estimated average delta times\nthe stock move, or [0.65 + (–0.15/2)] × 1.00.\nStacie’s actual profit would likely be less than 0.73 because of the bid-ask\nspread. Stacie must account for the fact that the bid-ask is 0.05 wide (1.75–\n1.80). Because Stacie would buy to close this position, she should consider\nthe 0.73 price change relative to the 1.80 offer, not the 1.75 trade price—\nthat is, she factors in a nickel of slippage. Thus, she calculates, that the puts\nwill be offered at 1.07 (that’s 1.80 − 0.73) when the stock is at $65. That is\na gain of $0.68.\nIn this scenario, Stacie should consider the Would I Do It Now? rule to\nguide her decision as to whether to take her profit early or hold the position\nuntil expiration. Is she happy being short ten 65 puts at 1.07 with Johnson\n& Johnson at $65? The premium is lower now. The anticipated move has\nalready occurred, and she still has 28 days left in the option that could allow\nfor the move to reverse itself. If she didn’t have the trade on now, would she\nsell ten 65 puts at 1.07 with Johnson & Johnson at $65? Based on her\noriginal intention, unless she believes strongly now that a breakout through\n$65 with follow-through momentum is about to take place, she will likely\ntake the money and run.\nStacie also must handle this trade differently from Brendan in the event\nthat the trade is a loser. Her trade has a higher delta. An adverse move in the\nunderlying would affect Stacie’s trade more than it would Brendan’s. If\nJohnson & Johnson declines, she must be conscious in advance of where\nshe will cover.\nStacie considers both how much she is willing to lose and what potential\nstock-price action will cause her to change her forecast. She consults a\nstock chart of Johnson & Johnson. In this example, we’ll assume there is\nsome resistance developing around $64 in the short term. If this resistance\nlevel holds, the trade", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 36}
{"text": "son & Johnson declines, she must be conscious in advance of where\nshe will cover.\nStacie considers both how much she is willing to lose and what potential\nstock-price action will cause her to change her forecast. She consults a\nstock chart of Johnson & Johnson. In this example, we’ll assume there is\nsome resistance developing around $64 in the short term. If this resistance\nlevel holds, the trade becomes less attractive. The at-expiration breakeven is\n$63.25, so the trade can still be a winner if Johnson & Johnson retreats. But\nStacie is looking for the stock to approach $65. She will no longer like the\nrisk/reward of this trade if it looks like that price rise won’t occur. She\nmakes the decision that if Johnson & Johnson bounces off the $64 level\nover the next couple weeks, she will exit the position for fear that her\noutlook is wrong. If Johnson & Johnson drifts above $64, however, she will\nride the trade out.\nIn this example, Stacie is willing to lose 1.00 per contract. Without taking\ninto account theta or vega, that 1.00 loss in the option should occur at a\nstock price of about $63.28. Theta is somewhat relevant here. It helps\nStacie’s potential for profit as time passes. As time passes and as the stock\nrises, so will theta, helping her even more. If the stock moves lower (against\nher) theta helps ease the pain somewhat, but the further in-the-money the\nput, the lower the theta.\nVega can be important here for two reasons: first, because of how implied\nvolatility tends to change with market direction, and second, because it can\nbe read as an indication of the market’s expectations.\nThe Double Whammy\nWith the stock around $64, there is a negative vega of about seven cents. As\nthe stock moves lower, away from the strike, the vega gets a bit smaller.\nHowever, the market conditions that would lead to a decline in the price of\nJohnson & Johnson would likely cause implied volatility (IV) to rise. If the\nstock drops, Stacie would have two things working against her—delta and\nvega—a double whammy. Stacie needs to watch her vega. Exhibit 5.6\nshows the vega of Stacie’s put as it changes with time and direction.\nEXHIBIT 5.6 Johnson & Johnson 65 put vega.\nIf after one week passes Johnson & Johnson gaps lower to, say, $63.00 a\nshare, the vega will be 0.043 per contract. If IV subsequently rises 5 points\nas a result of the stock falling, vega will make Stacie’s puts theoretically\nworth 21.5 cents more per contract. She will lose $215 on vega (that’s 0.043\nvega × 5 volatility points × 10 contracts) plus the adverse delta/gamma\nmove.\nA gap opening will cause her to miss the opportunity to stop herself out at\nher target price entirely. Even if the stock drifts lower, her targeted stop-loss\nprice will likely come sooner than expected, as the option price will likely\nincrease both by delta/gamma and vega resulting from rising volatility. This\ncan cause her to have to cover sooner, which leaves less room for error.\nWith this trade, increases in IV due to market direction can make it feel as if\nthe delta is greater than it actually is as the market declines. Conversely, IV\nsoftening makes it feel as if the delta is smaller than it is as the market rises.\nThe second reason IV has importance for this trade (as for most other\nstrategies) is that it can give some indication of how much the market thinks\nthe stock can move. If IV is higher than normal, the market perceives there\nto be more risk than usual of future volatility. The question remains: Is the\nhigher premium worth the risk?\nThe answer to this question is subjective. Part of the answer is based on\nStacie’s assessment of future volatility. Is the market right? The other part is\nbased on Stacie’s risk tolerance. Is she willing to endure the greater price\nswings associated with the potentially higher volatility? This can mean\ngetting whipsawed, which is exiting a position after reaching a stop-loss\npoint only to see the market reverse itself. The would-be profitable trade is\nclosed for a loss. Higher volatility can also mean a higher likelihood of\ngetting assigned and acquiring an unwanted long stock position.\nCash-Secured Puts\nThere are some situations where higher implied volatility may be a\nbeneficial trade-off. What if Stacie’s motivation for shorting puts was\ndifferent? What if she would like to own the stock, just not at the current\nmarket price? Stacie can sell ten 65 puts at 1.75 and deposit $63,250 in her\ntrading account to secure the purchase of 1,000 shares of Johnson &\nJohnson if she gets assigned. The $63,250 is the $65 per share she will pay\nfor the stock if she gets assigned, minus the 1.75 premium she received for\nthe put × $100 × 10 contracts. Because the cash required to potentially\npurchase the stock is secured by cash sitting ready in the account, this is\ncalled a cash-secured put.\nHer effective purchase price if assigned is $63.25—the same as her\nbreakeven at expiration. The idea with this trade is that if Johnson &\nJohnson is anywhere under $65 per share at expiration, she will buy the\nstock effectively at $63.25. If assigned, the time premium of the put allows\nher to buy the stock at a discount compared with where it is priced when the\ntrade is established, $64. The higher the time premium—or the higher the\nimplied volatility—the bigger the discount.\nThis discount, however, is contingent on the stock not moving too much.\nIf it is above $65 at expiration she won’t get assigned and therefore can\nonly profit a maximum of 1.75 per contract. If the stock is below $63.25 at\nexpiration, the time premium no longer represents a discount, in fact, the\ntrade becomes a loser. In a way, Stacie is still selling volatility.\nCovered Call\nThe problem with selling a naked call is that it has unlimited exposure to\nupside risk. Because of this, many traders simply avoid trading naked calls.\nA more common, and some would argue safer, method of selling calls is to\nsell them covered.\nA covered call is when calls are sold and stock is purchased on a sha", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 37}
{"text": "the\ntrade becomes a loser. In a way, Stacie is still selling volatility.\nCovered Call\nThe problem with selling a naked call is that it has unlimited exposure to\nupside risk. Because of this, many traders simply avoid trading naked calls.\nA more common, and some would argue safer, method of selling calls is to\nsell them covered.\nA covered call is when calls are sold and stock is purchased on a share-\nfor-share basis to cover the unlimited upside risk of the call. For each call\nthat is sold, 100 shares of the underlying security are bought. Because of the\naddition of stock to this strategy, covered calls are traded with a different\nmotivation than naked calls.\nThere are clearly many similarities between these two strategies. The\nmain goal for both is to harvest the premium of the call. The theta for the\ncall is the same with or without the stock component. The gamma and vega\nfor the two strategies are the same as well. The only difference is the stock.\nWhen stock is added to an option position, the net delta of the position is\nthe only thing affected. Stock has a delta of one, and all its other greeks are\nzero.\nThe pivotal point for both positions is the strike price. That’s the point the\ntrader wants the stock to be above or below at expiration. With the naked\ncall, the maximum payout is reaped if the stock is below the strike at\nexpiration, and there is unlimited risk above the strike. With the covered\ncall, the maximum payout is reaped if the stock is above the strike at\nexpiration. If the stock is below the strike at expiration, the risk is\nsubstantial—the stock can potentially go to zero.\nPutting It on\nThere are a few important considerations with the covered call, both when\nputting on, or entering, the position and when taking off, or exiting, the\ntrade. The risk/reward implications of implied volatility are important in the\ntrade-planning process. Do I want to get paid more to assume more\npotential risk? More speculative traders like the higher premiums. More\nconservative (investment-oriented) covered-call sellers like the low implied\nrisk of low-IV calls. Ultimately, a main focus of a covered call is the option\npremium. How fast can it go to zero without the movement hurting me? To\ndetermine this, the trader must study both theta and delta.\nThe first step in the process is determining which month and strike call to\nsell. In this example, Harley-Davidson Motor Company (HOG) is trading at\nabout $69 per share. A trader, Bill, is neutral to slightly bullish on Harley-\nDavidson over the next three months. Exhibit 5.7 shows a selection of\navailable call options for Harley-Davidson with corresponding deltas and\nthetas.\nEXHIBIT 5.7 Harley-Davidson calls.\nIn this example, the May 70 calls have 85 days until expiration and are\n2.80 bid. If Harley-Davidson remained at $69 until May expiration, the 2.80\npremium would represent a 4 percent profit over this 85-day period (2.80 ÷\n69). That’s an annualized return of about 17 percent ([0.04 / 85)] × 365).\nBill considers his alternatives. He can sell the April (57-day) 70 calls at\n2.20 or the March (22-day) 70 calls at 0.85. Since there is a different\nnumber of days until expiration, Bill needs to compare the trades on an\napples-to-apples basis. For this, he will look at theta and implied volatility.\nPresumably, the March call has a theta advantage over the longer-term\nchoices. The March 70 has a theta of 0.032, while the April 70’s theta is\n0.026 and the May 70’s is 0.022. Based on his assessment of theta, Bill\nwould have the inclination to sell the March. If he wants exposure for 90\ndays, when the March 70 call expires, he can roll into the April 70 call and\nthen the May 70 call (more on this in subsequent chapters). This way Bill\ncan continue to capitalize on the nonlinear rate of decay through May.\nNext, Bill studies the IV term structure for the Harley-Davidson ATMs\nand finds the March has about a 19.2 percent IV, the April has a 23.3\npercent IV, and the May has a 23 percent IV. March is the cheapest option\nby IV standards. This is not necessarily a favorable quality for a short\ncandidate. Bill must weigh his assessment of all relevant information and\nthen decide which trade is best. With this type of a strategy, the benefits of\nthe higher theta can outweigh the disadvantages of selling the lower IV. In\nthis case, Bill may actually like selling the lower IV. He may infer that the\nmarket believes Harley-Davidson will be less volatile during this period.\nSo far, Bill has been focusing his efforts on the 70 strike calls. If he trades\nthe March 70 covered call, he will have a net delta of 0.588 per contract.\nThat’s the negative 0.412 delta from shorting the call plus the 1.00 delta of\nthe stock. His indifference point if the trade is held until expiration is\n$70.85. The indifference point is the point at which Bill would be\nindifferent as to whether he held only the stock or the covered call. This is\nfigured by adding the strike price of $70 to the 0.85 premium. This is the\neffective sale price of the stock if the call is assigned. If Bill wants more\npotential for upside profit, he could sell a higher strike. He would have to\nsell the April or May 75, since the March 75s are a zero bid. This would\ngive him a higher indifference point, and the upside profits would\nmaterialize quickly if HOG moved higher, since the covered-call deltas\nwould be higher with the 75 calls. The April 75 covered-call net delta is\n0.796 per contract (the stock delta of 1.00 minus the 0.204 delta of the call).\nThe May 75 covered-call delta is 0.751.\nBut Bill is neutral to only slightly bullish. In this case, he’d rather have\nthe higher premium—high theta is more desirable than high delta in this\nsituation. Bill buys 1,000 shares of Harley-Davidson at $69 and sells 10\nHarley-Davidson March 70 calls at 0.85.\nBill also needs to plan his exit. To exit, he must study two things: an at-\nexpiration diagram and his greeks. Exhibit 5.8 shows the P&(L) at\nexpiration of the Harley-Dav", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 38}
{"text": "htly bullish. In this case, he’d rather have\nthe higher premium—high theta is more desirable than high delta in this\nsituation. Bill buys 1,000 shares of Harley-Davidson at $69 and sells 10\nHarley-Davidson March 70 calls at 0.85.\nBill also needs to plan his exit. To exit, he must study two things: an at-\nexpiration diagram and his greeks. Exhibit 5.8 shows the P&(L) at\nexpiration of the Harley-Davidson March 70 covered call. Exhibit 5.9\nshows the greeks.\nEXHIBIT 5.8 Harley-Davidson covered call.\nEXHIBIT 5.9 Greeks for Harley-Davidson covered call (per contract).\nDelta 0.591\nGamma−0.121\nTheta 0.032\nVega −0.066\nTaking It Off\nIf the trade works out perfectly for Bill, 22 days from now Harley-Davidson\nwill be trading right at $70. He’d profit on both delta and theta. If the trade\nisn’t exactly perfect, but still good, Harley-Davidson will be anywhere\nabove $68.15 in 22 days. It’s the prospect that the trade may not be so good\nat March expiration that occupies Bill’s thoughts, but a trader has to hope\nfor the best and plan for the worst.\nIf it starts to trend, Bill needs to react. The consequences to the stock’s\ntrending to the upside are not quite so dire, although he might be somewhat\nfrustrated with any lost opportunity above the indifference point. It’s the\ndownside risk that Bill will more vehemently guard against.\nFirst, the same IV/vega considerations exist as they did in the previous\nexamples. In the event the trade is closed early, IV/vega may help or hinder\nprofitability. A rise in implied volatility will likely accompany a decline in\nthe stock price. This can bring Bill to his stop-loss sooner. Delta versus\ntheta however, is the major consideration. He will plan his exit price in\nadvance and cover when the planned exit price is reached.\nThere are more moving parts with the covered call than a naked option. If\nBill wants to close the position early, he can leg out, meaning close only\none leg of the trade (the call or the stock) at a time. If he legs out of the\ntrade, he’s likely to close the call first. The motivation for exiting a trade\nearly is to reduce risk. A naked call is hardly less risky than a covered call.\nAnother tactic Bill can use, and in this case will plan to use, is rolling the\ncall. When the March 70s expire, if Harley-Davidson is still in the same\nrange and his outlook is still the same, he will sell April calls to continue\nthe position. After the April options expire, he’ll plan to sell the Mays.\nWith this in mind, Bill may consider rolling into the Aprils before March\nexpiration. If it is close to expiration and Harley-Davidson is trading lower,\ntheta and delta will both have devalued the calls. At the point when options\nare close to expiration and far enough OTM to be offered close to zero, say\n0.05, the greeks and the pricing model become irrelevant. Bill must\nconsider in absolute terms if it is worth waiting until expiration to make\n0.05. If there is a lot of time until expiration, the answer is likely to be no.\nThis is when Bill will be apt to roll into the Aprils. He’ll buy the March 70s\nfor a nickel, a dime, or maybe 0.15 and at the same time sell the Aprils at\nthe bid. This assumes he wants to continue to carry the position. If the roll\nis entered as a single order, it is called a calendar spread or a time spread.\nCovered Put\nThe last position in the family of basic volatility-selling strategies is the\ncovered put, sometimes referred to as selling puts and stock. In a covered\nput, a trader sells both puts and stock on a one-to-one basis. The term\ncovered put is a bit of a misnomer, as the strategy changes from limited risk\nto unlimited risk when short stock is added to the short put. A naked put can\nproduce only losses until the stock goes to zero—still a substantial loss.\nAdding short stock means that above the strike gains on the put are limited,\nwhile losses on the stock are unlimited. The covered put functions very\nmuch like a naked call. In fact, they are synthetically equal. This concept\nwill be addressed further in the next chapter.\nLet’s looks at another trader, Libby. Libby is an active trader who trades\nseveral positions at once. Libby believes the overall market is in a range\nand will continue as such over the next few weeks. She currently holds a\nshort stock position of 1,000 shares in Harley-Davidson. She is becoming\nmore neutral on the stock and would consider buying in her short if the\nmarket dipped. She may consider entering into a covered-put position.\nThere is one caveat: Libby is leaving for a cruise in two weeks and does not\nwant to carry any positions while she is away. She decides she will sell the\ncovered put and actively manage the trade until her vacation. Libby will sell\n10 Harley-Davidson March (22-day) 70 puts at 1.85 against her short 1,000\nshares of Harley-Davidson, which is trading at $69 per share.\nShe knows that her maximum profit if the stock declines and assignment\noccurs will be $850. That’s 0.85 × $100 × 10 contracts. Win or lose, she\nwill close the position in two weeks when there are only eight days until\nexpiration. To trade this covered put she needs to watch her greeks.\nExhibit 5.10 shows the greeks for the Harley-Davidson 70-strike covered\nput.\nEXHIBIT 5.10 Greeks for Harley-Davidson covered put (per contract).\nDelta −0.419\nGamma−0.106\nTheta 0.031\nVega −0.066\nLibby is really focusing on theta. It is currently about $0.03 per day but\nwill increase if the put stays close-to-the-money. In two weeks, the time\npremium will have decayed significantly. A move downward will help, too,\nas the −0.419 delta indicates. Exhibit 5.11 displays an array of theoretical\nvalues of the put at eight days until expiration as the stock price changes.\nEXHIBIT 5.11 HOG 70 put values at 8 days to expiry.\nAs long as Harley-Davidson stays below the strike price, Libby can look\nat her put from a premium-over-parity standpoint. Below the strike, the\nintrinsic value of the put doesn’t matter too much, because losses on\nintrinsic value are offse", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 39}
{"text": "isplays an array of theoretical\nvalues of the put at eight days until expiration as the stock price changes.\nEXHIBIT 5.11 HOG 70 put values at 8 days to expiry.\nAs long as Harley-Davidson stays below the strike price, Libby can look\nat her put from a premium-over-parity standpoint. Below the strike, the\nintrinsic value of the put doesn’t matter too much, because losses on\nintrinsic value are offset by gains on the stock. For Libby, all that really\nmatters is the time value. She sold the puts at 0.85 over parity. If Harley-\nDavidson is trading at $68 with eight days to go, she can buy her puts back\nfor 0.12 over parity. That’s a 73-cent profit, or $730 on her 10 contracts.\nThis doesn’t account for any changes in the time value that may occur as a\nresult of vega, but vega will be small with Harley-Davidson at $68 and\neight days to go. At this point, she would likely close down the whole\nposition—buying the puts and buying the stock—to take a profit on a\nposition that worked out just about exactly as planned.\nHer risk, though, is to the upside. A big rally in the stock can cause big\nlosses. From a theoretical standpoint, losses are potentially unlimited with\nthis type of trade. If the stock is above the strike, she needs to have a mental\nstop order in mind and execute the closing order with discipline.\nCurious Similarities\nThese basic volatility-selling strategies are fairly simple in nature. If the\ntrader believes a stock will not rise above a certain price, the most\nstraightforward way to trade the forecast is to sell a call. Likewise, if the\ntrader believes the stock will not go below a certain price he can sell a put.\nThe covered call and covered put are also ways to generate income on long\nor short stock positions that have these same price thresholds. In fact, the\ncovered call and covered put have some curious similarities to the naked\nput and naked call. The similarities between the two pairs of positions are\nno coincidence. The following chapter sheds light on these similarities.\nCHAPTER 6\nPut-Call Parity and Synthetics\nIn order to understand more complex spread strategies involving two or\nmore options, it is essential to understand the arbitrage relationship of the\nput-call pair. Puts and calls of the same month and strike on the same\nunderlying have prices that are defined in a mathematical relationship. They\nalso have distinctly related vegas, gammas, thetas, and deltas. This chapter\nwill show how the metrics of these options are interrelated. It will also\nexplore synthetics and the idea that by adding stock to a position, a trader\nmay trade with indifference either a call or a put to the same effect.\nPut-Call Parity Essentials\nBefore the creation of the Black-Scholes model, option pricing was hardly\nan exact science. Traders had only a few mathematical tools available to\ncompare the relative prices of options. One such tool, put-call parity, stems\nfrom the fact that puts and calls on the same class sharing the same month\nand strike can have the same functionality when stock is introduced.\nFor example, traders wanting to own a stock with limited risk can buy a\nmarried put: long stock and a long put on a share-for-share basis. The\ntraders have infinite profit potential, and the risk of the position is limited\nbelow the strike price of the option. Conceptually, long calls have the same\nrisk/reward profile—unlimited profit potential and limited risk below the\nstrike. Exhibit 6.1 is an overview of the at-expiration diagrams of a married\nput and a long call.\nEXHIBIT 6.1 Long call vs. long stock + long put (married put).\nMarried puts and long calls sharing the same month and strike on the\nsame security have at-expiration diagrams with the same shape. They have\nthe same volatility value and should trade around the same implied\nvolatility (IV). Strategically, these two positions provide the same service to\na trader, but depending on margin requirements, the married put may\nrequire more capital to establish, because the trader must buy not just the\noption but also the stock.\nThe stock component of the married put could be purchased on margin.\nBuying stock on margin is borrowing capital to finance a stock purchase.\nThis means the trader has to pay interest on these borrowed funds. Even if\nthe stock is purchased without borrowing, there is opportunity cost\nassociated with the cash used to pay for the stock. The capital is tied up. If\nthe trader wants to use funds to buy another asset, he will have to borrow\nmoney, which will incur an interest obligation. Furthermore, if the trader\ndoesn’t invest capital in the stock, the capital will rest in an interest-bearing\naccount. The trader forgoes that interest when he buys a stock. However the\ntrader finances the purchase, there is an interest cost associated with the\ntransaction.\nBoth of these positions, the long call and the married put, give a trader\nexposure to stock price advances above the strike price. The important\ndifference between the two trades is the value of the stock below the strike\nprice—the part of the trade that is not at risk in either the long call or the\nmarried put. On this portion of the invested capital, the trader pays interest\nwith the married put (whether actually or in the form of opportunity cost).\nThis interest component is a pricing consideration that adds cost to the\nmarried put and not the long call.\nSo if the married put is a more expensive endeavor than the long call\nbecause of the interest paid on the investment portion that is below the\nstrike, why would anyone buy a married put? Wouldn’t traders instead buy\nthe less expensive—less capital intensive—long call? Given the additional\ninterest expense, they would rather buy the call. This relates to the concept\nof arbitrage. Given two effectively identical choices, rational traders will\nchoose to buy the less expensive alternative. The market as a whole would\nbuy the calls, creating demand which would cause upward price pressure on\nthe call. The price of the call w", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 40}
{"text": "xpensive—less capital intensive—long call? Given the additional\ninterest expense, they would rather buy the call. This relates to the concept\nof arbitrage. Given two effectively identical choices, rational traders will\nchoose to buy the less expensive alternative. The market as a whole would\nbuy the calls, creating demand which would cause upward price pressure on\nthe call. The price of the call would rise until its interest advantage over the\nmarried put was gone. In a robust market with many savvy traders,\narbitrage opportunities don’t exist for very long.\nIt is possible to mathematically state the equilibrium point toward which\nthe market forces the prices of call and put options by use of the put-call\nparity. As shown in Chapter 2, the put-call parity states\n\nwhere c is the call premium, PV(x) is the present value of the strike\nprice, p is the put premium and s is the stock price.\nAnother, less academic and more trader-friendly way of stating this\nequation is\nwhere Interest is calculated as\nInterest = Strike × Interest Rate ×(Days to Expiration/365) 1\nThe two versions of the put-call parity stated here hold true for European\noptions on non-dividend-paying stocks.\nDividends\nAnother difference between call and married-put values is dividends. A call\noption does not extend to its owner the right to receive a dividend payment.\nTraders, however, who are long a put and long stock are entitled to a\ndividend if it is the corporation’s policy to distribute dividends to its\nshareholders.\nAn adjustment must be made to the put-call parity to account for the\npossibility of a dividend payment. The equation must be adjusted to account\nfor the absence of dividends paid to call holders. For a dividend-paying\nstock, the put-call parity states\nThe interest advantage and dividend disadvantage of owning a call is\nremoved from the market by arbitrageurs. Ultimately, that is what is\nexpressed in the put-call parity. It’s a way to measure the point at which the\narbitrage opportunity ceases to exist. When interest and dividends are\nfactored in, a long call is an equal position to a long put paired with long\nstock. In options nomenclature, a long put with long stock is a synthetic\nlong call. Algebraically rearranging the above equation:\nThe interest and dividend variables in this equation are often referred to\nas the basis. From this equation, other synthetic relationships can be\nalgebraically derived, like the synthetic long put.\nA synthetic long put is created by buying a call and selling (short) stock.\nThe at-expiration diagrams in Exhibit 6.2 show identical payouts for these\ntwo trades.\nEXHIBIT 6.2 Long put vs. long call + short stock.\nThe concept of synthetics can become more approachable when studied\nfrom the perspective of delta as well. Take the 50-strike put and call listed\non a $50 stock. A general rule of thumb in the put-call pair is that the call\ndelta plus the put delta equals 1.00 when the signs are ignored. If the 50 put\nin this example has a −0.45 delta, the 50 call will have a 0.55 delta. By\ncombining the long call (0.55 delta) with short stock (–1.00 delta), we get a\nsynthetic long put with a −0.45 delta, just like the actual put. The\ndirectional risk is the same for the synthetic put and the actual put.\nA synthetic short put can be created by selling a call of the same month\nand strike and buying stock on a share-for-share basis (i.e., a covered call).\nThis is indicated mathematically by multiplying both sides of the put-call\nparity equation by −1:\nThe at-expiration diagrams, shown in Exhibit 6.3 , are again conceptually\nthe same.\nEXHIBIT 6.3 Short put vs. short call + long stock.\nA short (negative) put is equal to a short (negative) call plus long stock,\nafter the basis adjustment. Consider that if the put is sold instead of buying\nstock and selling a call, the interest that would otherwise be paid on the cost\nof the stock up to the strike price is a savings to the put seller. To balance\nthe equation, the interest benefit of the short put must be added to the call\nside (or subtracted from the put side). It is the same with dividends. The\ndividend benefit of owning the stock must be subtracted from the call side\nto make it equal to the short put side (or added to the put side to make it\nequal the call side).\nThe same delta concept applies here. The short 50-strike put in our\nexample would have a 0.45 delta. The short call would have a −0.55 delta.\nBuying one hundred shares along with selling the call gives the synthetic\nshort put a net delta of 0.45 (–0.55 + 1.00).\nSimilarly, a synthetic short call can be created by selling a put and selling\n(short) one hundred shares of stock. Exhibit 6.4 shows a conceptual\noverview of these two positions at expiration.\nEXHIBIT 6.4 Short call vs. short put + short stock.\nPut-call parity can be manipulated as shown here to illustrate the\ncomposition of the synthetic short call.\nMost professional traders earn a short stock rebate on the proceeds they\nreceive when they short stock—an advantage to the short-put–short-stock\nside of the equation. Additionally, short-stock sellers must pay dividends on\nthe shares they are short—a liability to the married-put seller. To make all\nthings equal, one subtracts interest and adds dividends to the put side of the\nequation.\nComparing Synthetic Calls and Puts\nThe common thread among the synthetic positions explained above is that,\nfor a put-call pair, long options have synthetic equivalents involving long\noptions, and short options have synthetic equivalents involving short\noptions. After accounting for the basis, the four basic synthetic option\npositions are:\nBecause a call or put position is interchangeable with its synthetic\nposition, an efficient market will ensure that the implied volatility is closely\nrelated for both. For example, if a long call has an IV of 25 percent, the\ncorresponding put should have an IV of about 25 percent, because the long\nput can easily be converted to a synthetic long call and vice versa.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 41}
{"text": "synthetic option\npositions are:\nBecause a call or put position is interchangeable with its synthetic\nposition, an efficient market will ensure that the implied volatility is closely\nrelated for both. For example, if a long call has an IV of 25 percent, the\ncorresponding put should have an IV of about 25 percent, because the long\nput can easily be converted to a synthetic long call and vice versa. The\ngreeks will be similar for synthetically identical positions, too. The long\noptions and their synthetic equivalents will have positive gamma and vega\nwith negative theta. The short options and their synthetics will have\nnegative gamma and vega with positive theta.\nAmerican-Exercise Options\nPut-call parity was designed for European-style options. The early exercise\npossibility of American-style options gums up the works a bit. Because a\ncall (put) and a synthetic call (put) are functionally the same, it is logical to\nassume that the implied volatility and the greeks for both will be exactly the\nsame. This is not necessarily true with American-style options. However,\nput-call parity may still be useful with American options when the\nlimitations of the equation are understood. With at-the-money American-\nexercise options, the differences in the greeks for a put-call pair are subtle.\nExhibit 6.5 is a comparison of the greeks for the 50-strike call and the 50-\nstrike put with the underlying at $50 and 66 days until expiration.\nEXHIBIT 6.5 Greeks for a 50-strike put-call pair on a $50 stock.\nCall Put\nDelta 0.5540.457\nGamma0.0750.078\nTheta 0.0200.013\nVega 0.0840.084\nThe examples used earlier in this chapter in describing the deltas of\nsynthetics were predicated on the rule of thumb that the absolute values of\ncall and put deltas add up to 1.00. To be a bit more realistic, consider that\nbecause of American exercise, the absolute delta values of put-call pairs\ndon’t always add up to 1.00. In fact, Exhibit 6.5 shows that the call has\ncloser to a 0.554 delta. The put struck at the same price then has a 0.457\ndelta. By selling 100 shares against the long call, we can create a combined-\nposition delta (call delta plus stock delta) that is very close to the put’s\ndelta. The delta of this synthetic put is −0.446 (0.554 − 1.00). The delta of a\nput will always be similar to the delta of its corresponding synthetic put.\nThis is also true with call–synthetic-call deltas. This relationship\nmathematically is\n\nThis holds true whether the options are in-, at-, or out-of-the-money. For\nexample, with a stock at $54, the 50-put would have a −0.205 delta and the\ncall would have a 0.799 delta. Selling 100 shares against the call to create\nthe synthetic put yields a net delta of −0.201.\nIf long or short stock is added to a call or put to create a synthetic, delta\nwill be the only greek affected. With that in mind, note the other greeks\ndisplayed in Exhibit 6.5 —especially theta. Proportionally, the biggest\ndifference in the table is in theta. The disparity is due in part to interest.\nWhen the effects of the interest component outweigh the effects of the\ndividend, the time value of the call can be higher than the time value of the\nput. Because the call must lose more premium than the put by expiration,\nthe theta of the call must be higher than the theta of the put.\nAmerican exercise can also cause the option prices in put-call parity to\nnot add up. Deep in-the-money (ITM) puts can trade at parity while the\ncorresponding call still has time value. The put-call equation can be\nunbalanced. The same applies to calls on dividend-paying stocks as the\ndividend date approaches. When the date is imminent, calls can trade close\nto parity while the puts still have time value. The role of dividends will be\ndiscussed further in Chapter 8.\nSynthetic Stock\nNot only can synthetic calls and puts be derived by manipulation of put-call\nparity, but synthetic positions for the other security in the equation—stock\n—can be derived, as well. By isolating stock on one side of the equation,\nthe formula becomes\nAfter accounting for interest and dividends, buying a call and selling a put\nof the same strike and time to expiration creates the equivalent of a long\nstock position. This is called a synthetic stock position, or a combo. After\naccounting for the basis, the equation looks conceptually like this:\nThis is easy to appreciate when put-call parity is written out as it is here.\nIt begins to make even more sense when considering at-expiration diagrams\nand the greeks.\nExhibit 6.6 illustrates a long stock position compared with a long call\ncombined with a short put position.\nEXHIBIT 6.6 Long stock vs. long call + short put.\nA quick glance at these two strategies demonstrates that they are the\nsame, but think about why. Consider the synthetic stock position if both\noptions are held until expiration. The long call gives the trader the right to\nbuy the stock at the strike price. The short put gives the trader the obligation\nto buy the stock at the same strike price. It doesn’t matter what the strike\nprice is. As long as the strike is the same for the call and the put, the trader\nwill have a long position in the underlying at the shared strike at expiration\nwhen exercise or assignment occurs.\nThe options in this example are 50-strike options. At expiration, the trader\ncan exercise the call to buy the underlying at $50 if the stock is above the\nstrike. If the underlying is below the strike at expiration, he’ll get assigned\non the put and buy the stock at $50. If the stock is bought, whether by\nexercise or assignment, the effective price of the potential stock purchase,\nhowever, is not necessarily $50.\nFor example, if the trader bought one 50-strike call at 3.50 and sold one\n50-strike put at 1.50, he will effectively purchase the underlying at $52\nupon exercise or assignment. Why? The trader paid a net of $2 to get a long\nposition in the stock synthetically (3.50 of call premium debited minus 1.50\nof put premium credited). Whether the call or the put is", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 42}
{"text": "urchase,\nhowever, is not necessarily $50.\nFor example, if the trader bought one 50-strike call at 3.50 and sold one\n50-strike put at 1.50, he will effectively purchase the underlying at $52\nupon exercise or assignment. Why? The trader paid a net of $2 to get a long\nposition in the stock synthetically (3.50 of call premium debited minus 1.50\nof put premium credited). Whether the call or the put is ITM, the effective\npurchase price of the stock will always be the strike price plus or minus the\ncost of establishing the synthetic, in this case, $52.\nThe question that begs to be asked is: would the trader rather buy the\nstock or pay $2 to have the same market exposure as long stock?\nArbitrageurs in the market (with the help of the put-call parity) ensure that\nneither position—long stock or synthetic long stock—is better than the\nother.\nFor example, assume a stock is trading at $51.54. With 71 days until\nexpiration, 26.35 IV, a 5 percent interest rate, and no dividends, the 50-\nstrike call is theoretically worth 3.50, and the 50-strike put is theoretically\nworth 1.50. Exhibit 6.7 charts the synthetic stock versus the actual stock\nwhen there are 71 days until expiration.\nEXHIBIT 6.7 Long stock and synthetic long stock with 71 days to\nexpiration.\nLooking at this exhibit, it appears that being long the actual stock\noutperforms being long the stock synthetically. If the stock is purchased at\n$51.54, it need only rise a penny higher to profit (in the theoretical world\nwhere traders do not pay commissions on transactions). If the synthetic is\npurchased for $2, the stock needs to rise $0.46 to break even—an apparent\ndisadvantage. This figure, however, does not include interest.\nThe synthetic stock offers the same risk/reward as actually being long the\nstock. There is a benefit, from the perspective of interest, to paying only $2\nfor this exposure rather than $51.54. The interest benefit here is about\n$0.486. We can find this number by calculating the interest as we did earlier\nin the chapter. Interest, again, is computed as the strike price times the\ninterest rate times the number of days to expiration divided by the number\nof days in a year. The formula is as follows:\nInputting the numbers from this example:\nThe $0.486 of interest is about equal to the $0.46 disparity between the\ndiagrams of the stock and the synthetic stock with 71 days until expiration.\nThe difference is due mainly to rounding and the early-exercise potential of\nthe American put. In mathematical terms\nThe synthetic long stock is approximately equal to the long stock position\nwhen considering the effect of interest. The two lines in Exhibit 6.7 —\nrepresenting stock and synthetic stock—would converge with each passing\nday as the calculated interest decreases.\nThis equation works as well for a synthetic short stock position; reversing\nthe signs reveals the synthetic for short stock.\nOr, in this case,\nShorting stock at $51.54 is about equal to selling the 50 call and buying\nthe 50 put for a $2 credit based on the interest of 0.486 computed on the 50\nstrike. Again, the $0.016 disparity between the calculated interest and the\nactual difference between the synthetic value and the stock price is a\nfunction of rounding and early exercise. More on this in the “Conversions\nand Reversals” section.\nSynthetic Stock Strategies\nUltimately, when we roll up our sleeves and get down to the nitty-gritty,\noptions trading is less about having another alternative for trading the\ndirection of the underlying than it is about trading the greeks. Different\nstrategies allow traders to exploit different facets of option pricing. Some\nstrategies allow traders to trade volatility. Some focus mainly on theta.\nMany of the strategies discussed in this section present ways for a trader to\ndistill risk down mostly to interest rate exposure.\nConversions and Reversals\nWhen calls and puts are combined to create synthetic stock, the main\ndifferences are the interest rate and dividends. This is important because the\nrisks associated with interest and dividends can be isolated, and ultimately\ntraded, when synthetic stock is combined with the underlying. There are\ntwo ways to combine synthetic stock with its underlying security: a\nconversion and a reversal.\nConversion\nA conversion is a three-legged position in which a trader is long stock, short\na call, and long a put. The options share the same month and strike price.\nBy most metrics, this is a very flat position. A trader with a conversion is\nlong the stock and, at the same time, synthetically short the same stock.\nConsider this from the perspective of delta. In a conversion, the trader is\nlong 1.00 deltas (the long stock) and short very close to 1.00 deltas (the\nsynthetic short stock). Conversions have net flat deltas.\nThe following is a simple example of a typical conversion and the\ncorresponding deltas of each component.\nShort one 35-strike call:−0.63 delta\nLong one 35-strike put:−0.37 delta\nLong 100 shares: 1.00 delta\n0.00 delta\nThe short call contributes a negative delta to the position, in this case,\n−0.63. The long put also contributes a negative delta, −0.37. The combined\ndelta of the synthetic stock is −1.00 in this example, which is like being\nshort 100 shares of stock. When the third leg of the spread is added, the\nlong 100 shares, it counterbalances the synthetic. The total delta for the\nconversion is zero.\nMost of the conversion’s other greeks are pretty flat as well. Gamma,\ntheta, and vega are similar for the call and the put in the conversion,\nbecause they have the same expiration month and strike price. Because the\ntrader is selling one option and buying another—a call and a put,\nrespectively—with the same month and strike, the greeks come very close\nto offsetting each other. For all intents and purposes, the trader is out of the\nprimary risks of the position as measured by greeks when a position is\nconverted. Let’s look at a more detailed example.\nA trader executes the following trade (for the purposes o", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 43}
{"text": "he\ntrader is selling one option and buying another—a call and a put,\nrespectively—with the same month and strike, the greeks come very close\nto offsetting each other. For all intents and purposes, the trader is out of the\nprimary risks of the position as measured by greeks when a position is\nconverted. Let’s look at a more detailed example.\nA trader executes the following trade (for the purposes of this example,\nwe assume the stock pays no dividend and the trade is executed at fair\nvalue):\nSell one 71-day 50 call at 3.50\nBuy one 71-day 50 put at 1.50\nBuy 100 shares at $51.54\nThe trader buys the stock at $51.54 and synthetically sells the stock at\n$52. The synthetic price is computed as −3.50 + 1.50 − 50. Therefore, the\nstock is sold synthetically at $0.46 over the actual stock price.\nExhibit 6.8 shows the analytics for the conversion.\nEXHIBIT 6.8 Conversion greeks.\nThis position has very subtle sensitivity to the greeks. The net delta for\nthe spread has a very slightly negative bias. The bias is so small it is\nnegligible to most traders, except professionals trading very large positions.\nWhy does this negative delta bias exist? Mathematically, the synthetic’s\ndelta can be higher with American options than with their European\ncounterparts because of the possibility of early exercise of the put. This\nanomaly becomes more tangible when we consider the unique directional\nrisk associated with this trade.\nIn this example, the stock is synthetically sold at $0.46 over the price at\nwhich the stock is bought. If the stock declines significantly in value before\nexpiration, the put will, at some point, trade at parity while the call loses all\nits time value. In this scenario, the value of the synthetic stock will be short\nat effectively the same price as the actual stock price. For example, if the\nstock declines to $35 per share then the numbers are as follows:\nor\nWith American options, a put this far in-the-money with less than 71 days\nuntil expiry will be all intrinsic value. Interest, in this case, will not factor\ninto the put’s value, because the put can be exercised. By exercising the put,\nboth the long stock leg and the long put leg can be closed for even money,\nleaving only the theoretically worthless call. The stock-synthetic spread is\nsold at 0.46 and essentially bought at zero when the put is exercised. If the\nput is exercised before expiration, the profit potential is 0.46 minus the\ninterest calculated between the trade date and the day the put is exercised.\nIf, however, the conversion is held until expiration, the $0.46 is negated by\nthe $0.486 of interest incurred from holding long stock over the entire 71-\nday period, hence the trader’s desire to see the stock decline before\nexpiration, and thus the negative bias toward delta.\nThis is, incidentally, why the synthetic price (0.46 over the stock price)\ndoes not exactly equal the calculated value of the interest (0.486). The\ntrader can exercise the put early if the stock declines and capitalize on the\ndisparity between the interest calculated when the conversion was traded\nand the actual interest calculation given the shorter time frame. The model\nvalues the synthetic at a little less than the interest value would indicate—in\nthis case $0.46 instead of $0.486.\nThe gamma of this trade is fairly negligible. The theta is slightly positive.\nRho is the figure that deserves the most attention. Rho is the change in an\noption’s price given a change in the interest rate.\nThe −0.090 rho of the conversion indicates that if the interest rate rises\none percentage point, the position as a whole loses $0.09. Why? The\nfinancing of the position gets more expensive as the interest rate rises. The\ntrader would have to pay more in interest to carry the long stock. In this\nexample, if interest rises by one percentage point, the synthetic stock, which\nhad an effective short price of $0.46 over the price of the long stock before\nthe interest rate increase, will be $0.55 over the price of the long stock\nafterward. If, however, the interest rate declines by one percentage point,\nthe trader profits $0.09, as the synthetic is repriced by the market to $0.37\nover the stock price. The lower the interest rate, the less expensive it is to\nfinance the long stock. This is proven mathematically by put-call parity.\nNegative rho indicates a bearish position on the interest rate; the trader\nwants it to go lower. Positive rho is a bullish interest rate position.\nBut a one-percentage-point change in the interest rate in one day is a big\nand uncommon change. The question is: is rho relevant? That depends on\nthe type of position and the type of trader. A 0.090 rho would lead to a\n0.0225 profit-and-loss (P&(L)) change per one lot conversion on a 25-basis-\npoint, or quarter percent, change. That’s just $2.25 per spread. This\nincremental profit or loss, however, can be relevant to professional traders\nlike market makers. They trade very large positions with the aspiration of\nmaking small incremental profits on each trade. A market maker with a\n5,000-lot conversion would stand to make or lose $11,250, given a quarter-\npercentage-point change in interest rate and a 0.090 rho.\nThe Mind of a Market Maker\nMarket makers are among the only traders who can trade conversions and\nreversals profitably, because of the size of their trades and the fact that they\ncan buy the bid and sell the offer. Market makers often attempt to leg into\nand out of conversions (and reversals). Given the conversion in this\nexample, a market maker may set out to sell calls and in turn buy stock to\nhedge the call’s delta risk (this will be covered in Chapters 12 and 17), then\nbuy puts and the rest of the stock to create a balanced conversion: one call\nto one put to one hundred shares. The trader may try to put on the\nconversion in the previous example for a total of $0.50 over the price of the\nlong stock instead of the $0.46 it’s worth. He would then try to leg out of\nthe trade for less, say $0.45 over the stock,", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 44}
{"text": "risk (this will be covered in Chapters 12 and 17), then\nbuy puts and the rest of the stock to create a balanced conversion: one call\nto one put to one hundred shares. The trader may try to put on the\nconversion in the previous example for a total of $0.50 over the price of the\nlong stock instead of the $0.46 it’s worth. He would then try to leg out of\nthe trade for less, say $0.45 over the stock, with the goal of locking in a\n$0.05 profit per spread on the whole trade.\nReversal\nA reversal, or reverse conversion, is simply the opposite of the conversion:\nbuy call, sell put, and sell (short) stock. A reversal can be executed to close\na conversion, or it can be an opening transaction. Using the same stock and\noptions as in the previous example, a trader could establish a reversal as\nfollows:\nBuy one 71-day 50 call at 3.50\nSell one 71-day 50 put at 1.50\nSell 100 shares at 51.54\nThe trader establishes a short position in the stock at $51.54 and a long\nsynthetic stock position effectively at $52.00. He buys the stock\nsynthetically at $0.46 over the stock price, again assuming the trade can be\nexecuted at fair value. With the reversal, the trader has a bullish position on\ninterest rates, which is indicated by a positive rho.\nIn this example, the rho for this position is 0.090. If interest rates rise one\npercentage point, the synthetic stock (which the trader is long) gains nine\ncents in value relative to the stock. The short stock rebate on the short stock\nleg earns more interest at a higher interest rate. If rates fall one percentage\npoint, the synthetic long stock loses $0.09. The trader earns less interest\nbeing short stock given a lower interest rate.\nWith the reversal, the fact that the put can be exercised early is a risk.\nSince the trader is short the put and short stock, he hopes not to get\nassigned. If he does, he misses out on the interest he planned on collecting\nwhen he put on the reversal for $0.46 over.\nPin Risk\nConversions and reversals are relatively low-risk trades. Rho and early\nexercise are relevant to market makers and other arbitrageurs, but they are\namong the lowest-risk positions they are likely to trade. There is one\nindirect risk of conversions and reversals that can be of great concern to\nmarket makers around expiration: pin risk. Pin risk is the risk of not\nknowing for certain whether an option will be assigned. To understand this\nconcept, let’s revisit the mind of a market maker.\nRecall that market makers have two primary functions:\n1. Buy the bid or sell the offer.\n2. Manage risk.\nWhen institutional or retail traders send option orders to an exchange\n(through a broker), market makers are usually the ones with whom they\ntrade. Customers sell the bid; the market makers buy the bid. Customers\nbuy the offer; the market makers sell the offer. The first and arguably easier\nfunction of market makers is accomplished whenever a marketable order is\nsent to the exchange.\nManaging risk can get a bit hairy. For example, once the market makers\nbuy April 40 calls, their first instinct is to hedge by selling stock to become\ndelta neutral. Market makers are almost always delta neutral, which\nmitigates the direction risk. The next step is to mitigate theta, gamma, and\nvega risk by selling options. The ideal options to sell are the same calls that\nwere bought—that is, get out of the trade. The next best thing is to sell the\nApril 40 puts and sell more stock. In this case, the market makers have\nestablished a reversal and thereby have very little risk. If they can lock in\nthe reversal for a small profit, they have done their job.\nWhat happens if the market makers still have the reversal in inventory at\nexpiration? If the stock is above the strike price—40, in this case—the puts\nexpire, the market makers exercise the calls, and the short stock is\nconsequently eliminated. The market makers are left with no position,\nwhich is good. They’re delta neutral. If the stock is below 40, the calls\nexpire, the puts get assigned, and the short stock is consequently eliminated.\nAgain, no position. But what if the stock is exactly at $40? Should the calls\nbe exercised? Will the puts get assigned? If the puts are assigned, the\ntraders are left with no short stock and should let the calls expire without\nexercising so as not to have a long delta position after expiration. If the puts\nare not assigned, they should exercise the calls to get delta flat. It’s also\npossible that only some of the puts will be assigned.\nBecause they don’t know how many, if any, of the puts will be assigned,\nthe market makers have pin risk. To avoid pin risk, market makers try to\neliminate their position if they have conversions or reversals close to\nexpiration.\nBoxes and Jelly Rolls\nThere are two other uses of synthetic stock positions that form conventional\nstrategies: boxes and rolls.\nBoxes\nWhen long synthetic stock is combined with short synthetic stock on the\nsame underlying within the same expiration cycle but with a different strike\nprice, the resulting position is known as a box. With a box, a trader is\nsynthetically both long and short the stock. The two positions, for all intents\nand purposes, offset each other directionally. The risk of stock-price\nmovement is almost entirely avoided. A study of the greeks shows that the\ndelta is close to zero. Gamma, theta, vega, and rho are also negligible.\nHere’s an example of a 60–70 box for April options:\nShort 1 April 60 call\nLong 1 April 60 put\nLong 1 April 70 call\nShort 1 April 70 put\nIn this example, the trader is synthetically short the 60-strike and, at the\nsame time, synthetically long the 70-strike. Exhibit 6.9 shows the greeks.\nEXHIBIT 6.9 Box greeks.\nAside from the risks associated with early exercise implications, this\nposition is just about totally flat. The near-1.00 delta on the long synthetic\nstock struck at 60 is offset by the near-negative-1.00 delta of the short\nsynthetic struck at 70. The tiny gammas and thetas of both combos are\nbrought closer to zero when th", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 45}
{"text": "y long the 70-strike. Exhibit 6.9 shows the greeks.\nEXHIBIT 6.9 Box greeks.\nAside from the risks associated with early exercise implications, this\nposition is just about totally flat. The near-1.00 delta on the long synthetic\nstock struck at 60 is offset by the near-negative-1.00 delta of the short\nsynthetic struck at 70. The tiny gammas and thetas of both combos are\nbrought closer to zero when they are spread against each another. Vega is\nzero. And the bullish interest rate sensitivity of the long combo is nearly all\noffset by the bearish interest sensitivity of the short combo. The stock can\nmove, time can pass, volatility and interest can change, and there will be\nvery little effect on the trader’s P&(L). The question is: Why would\nsomeone trade a box?\nMarket makers accumulate positions in the process of buying bids and\nselling offers. But they want to eliminate risk. Ideally, they try to be flat the\nstrike —meaning have an equal number of calls and puts at each strike\nprice, whether through a conversion or a reversal. Often, they have a\nconversion at one strike and a reversal at another. The stock positions for\nthese cancel each other out and the trader is left with only the four option\nlegs—that is, a box. They can eliminate pin risk on both strikes by trading\nthe box as a single trade to close all four legs. Another reason for trading a\nbox has to do with capital.\nBorrowing and Lending Money\nThe first thing to consider is how this spread is priced. Let’s look at another\nexample of a box, the October 50–60 box.\nLong 1 October 60 call\nShort 1 October 60 put\nShort 1 October 70 call\nLong 1 October 70 put\nA trader with this position is synthetically long the stock at $60 and short\nthe stock at $70. That sounds like $10 in the bank. The question is: How\nmuch would a trader be willing to pay for the right to $10? And for how\nmuch would someone be willing to sell it? At face value, the obvious\nanswer is that the equilibrium point is at $10, but there is one variable that\nmust be factored in: time.\nIn this example, assume that the October call has 90 days until expiration\nand the interest rate is 6 percent. A rational trader would not pay $10 today\nfor the right to have $10 90 days from now. That would effectively be like\nloaning the $10 for 90 days and not receiving interest—A losing\nproposition! The trader on the other side of this box would be happy to\nenter into the spread for $10. He would have interest-free use of $10 for 90\ndays. That’s free money! Certainly, there is interest associated with the cost\nof carrying the $10. In this case, the interest would be $0.15.\nThis $0.15 is discounted from the price of the $10 box. In fact, the\ncombined net value of the options composing the box should be about 9.85\n—with differences due mainly to rounding and the early exercise possibility\nfor American options.\nA trader buying this box—that is, buying the more ITM call and more\nITM put—would expect to pay $0.15 below the difference between the\nstrike prices. Fair value for this trade is $9.85. The seller of this box—the\ntrader selling the meatier options and buying the cheaper ones—would\nconcede up to $0.15 on the credit.\nJelly Rolls\nA jelly roll, or simply a roll, is also a spread with four legs and a\ncombination of two synthetic stock trades. In a box, the difference between\nthe synthetics is the strike price; in a roll, it’s the contract month. Here’s an\nexample:\nLong 1 April 50 call\nShort 1 April 50 put\nShort 1 May 50 call\nLong 1 May 50 put\nThe options in this spread all share the same strike price, but they involve\ntwo different months—April and May. In this example, the trader is long\nsynthetic stock in April and short synthetic stock in May. Like the\nconversion, reversal, and box, this is a mostly flat position. Delta, gamma,\ntheta, vega, and even rho have only small effects on a jelly roll, but like the\nothers, this spread serves a purpose.\nA trader with a conversion or reversal can roll the option legs of the\nposition into a month with a later expiration. For example, a trader with an\nApril 50 conversion in his inventory (short the 50 call, long the 50 put, long\nstock) can avoid pin risk as April expiration approaches by trading the roll\nfrom the above example. The long April 50 call and short April 50 put\ncancel out the current option portion of the conversion leaving only the\nstock. Selling the May 50 calls and buying the May 50 puts reestablishes\nthe conversion a month farther out.\nAnother reason for trading a roll has to do with interest. The roll in this\nexample has positive exposure to rho in April and negative exposure to rho\nin May. Based on a trader’s expectations of future changes in interest rates,\na position can be constructed to exploit opportunities in interest.\nTheoretical Value and the Interest\nRate\nThe main focus of the positions discussed in this chapter is fluctuations in\nthe interest rate. But which interest rate? That of 30-year bonds? That of 10-\nor 5-year notes? Overnight rates? The federal funds rate? In the theoretical\nworld, the answer to this question is not really that important. Professors\nsimply point to the riskless rate and continue with their lessons. But when\nputting strategies like these into practice, choosing the right rate makes a\nbig difference. To answer the question of which interest rate, we must\nconsider exactly what the rates represent from the standpoint of an\neconomist. Therefore, we must understand how an economist makes\narguments—by making assumptions.\nTake the story of the priest, the physicist, and the economist stranded on a\ndesert island with nothing to eat except a can of beans. The problem is, the\ncan is sealed. In order to survive, they must figure out how to open the can.\nThe priest decides he will pray for the can to be opened by means of a\nmiracle. He prays for hours, but, alas, the can remains sealed tight. The\nphysicist devises a complex system of wheels and pulleys to pop the top off\nthe can. This crude machine unfortunately f", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 46}
{"text": "nothing to eat except a can of beans. The problem is, the\ncan is sealed. In order to survive, they must figure out how to open the can.\nThe priest decides he will pray for the can to be opened by means of a\nmiracle. He prays for hours, but, alas, the can remains sealed tight. The\nphysicist devises a complex system of wheels and pulleys to pop the top off\nthe can. This crude machine unfortunately fails as well. After watching the\nlack of success of his fellow strandees, the economist announces that he has\nthe solution: “Assume we have a can opener.”\nIn the spirit of economists’ logic, let’s imagine for a moment a theoretical\neconomic microcosm in which a trader has two trading accounts at the same\nfirm. The assumptions here are that a trader can borrow 100 percent of a\nstock’s value to finance the purchase of the security and that there are no\nlegal, moral, or other limitations on trading. In one account the trader is\nlong 100 shares, fully leveraged. In the other, the trader is short 100 shares\nof the same stock, in which case the trader earns a short-stock rebate.\nIn the long run, what is the net result of this trade? Most likely, this trade\nis a losing proposition for the trader, because the interest rate at which the\ntrader borrows capital is likely to be higher than the interest rate earned on\nthe short-stock proceeds. In this example, interest is the main consideration.\nBut interest matters in the real world, too. Professional traders earn\ninterest on proceeds from short stock and pay interest on funds borrowed.\nInterest rates may vary slightly from firm to firm and trader to trader.\nInterest rates are personal. The interest rate a trader should use when pricing\noptions is specific to his or her situation.\nA trader with no position in a particular stock who is interested in trading\na conversion should consider that he will be buying the stock. This implies\nborrowing funds to open the long stock position. The trader should price his\noptions according to the rate he will pay to borrow funds. Conversely, a\ntrader trading a reversal should consider the fact that he is shorting the stock\nand will receive interest at the rate of the short-stock rebate. This trader\nshould price his options at the short-stock rate.\nA Call Is a Put\nThe idea that “a put is a call, a call is a put” is an important one, indeed. It\nlays the foundation for more advanced spreading strategies. The concepts in\nthis chapter in one way or another enter into every spread strategy that will\nbe discussed in this book from here on out.\nNote\n1 . Note, for simplicity, simple interest is used in the computation.\nCHAPTER 7\nRho\nInterest is one of the six inputs of an option-pricing model for American\noptions. Although interest rates can remain constant for long periods, when\ninterest rates do change, call and put values can be positively or negatively\naffected. Some options are more sensitive to changes in the interest rate\nthan others. To the unaware trader, interest-rate changes can lead to\nunexpected profits or losses. But interest rates don’t have to be a wild-card\nrisk. They’re one that experienced traders watch closely to avoid\nunnecessary risk and increase profitability. To monitor the effect of changes\nin the interest rate, it is important to understand the quiet greek—rho.\nRho and Interest Rates\nRho is a measurement of the sensitivity of an option’s value to a change in\nthe interest rate. To understand how and why the interest rate is important to\nthe value of an option, recall the formula for put-call parity stated in\nChapter 6.\nCall + Strike − Interest = Put + Stock 1\nFrom this formula, it’s clear that as the interest rate rises, put prices must\nfall and call prices must rise to keep put-call parity balanced. With a little\nalgebra, the equation can be restated to better illustrate this concept:\nand\nIf interest rates fall,\nand\nRho helps quantify this relationship. Calls have positive rho, and puts\nhave negative rho. For example, a call with a rho of +0.08 will gain $0.08\nwith each one-percentage-point rise in interest rates and fall $0.08 with\neach one-percentage-point fall in interest rates. A put with a rho of −0.08\nwill lose $0.08 with each one-point rise and gain $0.08 in value with a one-\npoint fall.\nThe effect of changes in the interest variable of put-call parity on call and\nput values is contingent on three factors: the strike price, the interest rate,\nand the number of days until expiration.\nInterest = Strike×Interest Rate×(Days to Expiration/365) 2\nInterest, for our purposes, is a function of the strike price. The higher the\nstrike price, the greater the interest and, consequently the more changes in\nthe interest rate will affect the option. The higher the interest rate is, the\nhigher the interest variable will be. Likewise, the more time to expiration,\nthe greater the effect of interest. Rho measures an option’s sensitivity to the\nend results of these three influences.\nTo understand how changes in interest affect option prices, consider a\ntypical at-the-money (ATM) conversion on a non-dividend-paying stock.\nShort 1 May 50 call at 1.92\nLong 1 May 50 put at 1.63\nLong 100 shares at $50\nWith 43 days until expiration at a 5 percent interest rate, the interest on\nthe 50 strike will be about $0.29. Put-call parity ensures that this $0.29\nshows up in option prices. After rearranging the equation, we get\nIn this example, both options are exactly ATM. There is no intrinsic value.\nTherefore, the difference between the extrinsic values of the call and the put\nmust equal interest. If one option were in-the-money (ITM), the intrinsic\nvalue on the left side of the equation would be offset by the Stock − Strike\non the right side. Still, it would be the difference in the time value of the\ncall and put that equals the interest variable.\nThis is shown by the fact that the synthetic stock portion of the\nconversion is short at $50.29 (call − put + strike). This is $0.29 above the\nstock price. The synthetic stock equals the Sto", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 47}
{"text": "rinsic\nvalue on the left side of the equation would be offset by the Stock − Strike\non the right side. Still, it would be the difference in the time value of the\ncall and put that equals the interest variable.\nThis is shown by the fact that the synthetic stock portion of the\nconversion is short at $50.29 (call − put + strike). This is $0.29 above the\nstock price. The synthetic stock equals the Stock + Interest, or\nCertainly, if the interest rate were higher, the interest on the synthetic\nstock would be a higher number. At a 6 percent interest rate, the effective\nshort price of the synthetic stock would be about $50.35. The call would be\nvalued at about 1.95, and the put would be 1.60—a net of $0.35.\nA one-percentage-point rise in the interest rate causes the synthetic stock\nposition to be revalued by $0.06—a $0.03 gain in the call value and a $0.03\ndecline in the put. Therefore, by definition, the call has a +0.03 rho and the\nput has a −0.03 rho.\nRho and Time\nThe time component of interest has a big impact on the magnitude of an\noption’s rho, because the greater the number of days until expiration, the\ngreater the interest. Long-term options will be more sensitive to changes in\nthe interest rate and, therefore, have a higher rho.\nTake a stock trading at about $120 per share. The July, October, and\nJanuary ATM calls have the following rhos with the interest rate at 5.5\npercent.\nOption Rho\nJuly (38-day) 120 calls+0.068\nOctober (130-day) 120 calls+0.226\nJanuary (221-day) 120 calls+0.385\nIf interest rates rise 25 basis points, or a quarter of a percentage point, the\nJuly calls with only 38 days until expiration will gain very little: only\n$0.017 (0.068 × 0.25). The October 120 calls with 130 days until expiration\ngain more: $0.057 (0.226 × 0.25). The January calls that have 221 days\nuntil they expire make $0.096 theoretically (0.385 × 0.25). If all else is held\nconstant, the more time to expiration, the higher the option’s rho, and\ntherefore, the more interest will affect the option’s value.\nConsidering Rho When Planning\nTrades\nJust having an opinion on a stock is only half the battle in options trading.\nChoosing the best way to trade a forecast can make all the difference to the\nsuccess of a trade. Options give traders choices. And one of the choices a\ntrader has is the month in which to trade. When trading LEAPS—Long-\nTerm Equity AnticiPation Securities—delta, gamma, theta, and vega are\nimportant, as always, but rho is also a valuable part of the strategy.\nLEAPS\nOptions buyers have time working against them. With each passing day,\ntheta erodes the value of their assets. Buying a long-term option, or a\nLEAPS, helps combat erosion because long-term options can decay at a\nslower rate. In environments where there is interest rate uncertainty,\nhowever, LEAPS traders have to think about more than the rate of decay.\nConsider two traders: Jason and Susanne. Both are bullish on XYZ Corp.\n(XYZ), which is trading at $59.95 per share. Jason decides to buy a May 60\ncall at 1.60, and Susanne buys a LEAPS 60 call at 7.60. In this example,\nMay options have 44 days until expiration, and the LEAPS have 639 days.\nBoth of these trades are bullish, but the traders most likely had slightly\ndifferent ideas about time, volatility, and interest rates when they decided\nwhich option to buy. Exhibit 7.1 compares XYZ short-term at-the-money\ncalls with XYZ LEAPS ATM calls.\nEXHIBIT 7.1 XYZ short-term call vs. LEAPS call.\nTo begin with, it appears that Susanne was allowing quite a bit of time for\nher forecast to be realized—almost two years. Jason, however, was looking\nfor short-term price appreciation. Concerns about time decay may have\nbeen a motivation for Susanne to choose a long-term option—her theta of\n0.01 is half Jason’s, which is 0.02. With only 44 days until expiration, the\ntheta of Jason’s May call will begin to rise sharply as expiration draws near.\nBut the trade-off of lower time decay is lower gamma. At the current\nstock price, Susanne has a higher delta. If the XYZ stock price rises $2, the\ngamma of the May call will cause Jason’s delta to creep higher than\nSusanne’s. At $62, the delta for the May 60s would be about 0.78, whereas\nthe LEAPS 60 call delta is about 0.77. This disparity continues as XYZ\nmoves higher.\nPerhaps Susanne had implied volatility (IV) on her mind as well as time\ndecay. These long-term ATM LEAPS options have vegas more than three\ntimes the corresponding May’s. If IV for both the May and the LEAPS is at\na yearly low, LEAPS might be a better buy. A one- or two-point rise in\nvolatility if IV reverts to its normal level will benefit the LEAPS call much\nmore than the May.\nTheta, delta, gamma, and vega are typical considerations with most\ntrades. Because this option is long term, in addition to these typical\nconsiderations, Susanne needs to take a good hard look at rho. The LEAPS\nrho is significantly higher than that of its short-term counterpart. A one-\npercentage-point change in the interest rate will change Susanne’s P&(L) by\n$0.64—that’s about 8.5 percent of the value of her option—and she has\nnearly two years of exposure to interest rate fluctuations. Certainly, when\nthe Federal Reserve Board has great concerns about growth or inflation,\nrates can rise or fall by more than one percentage point in one year’s time.\nIt is important to understand that, like the other greeks, rho is a snapshot\nat a particular price, volatility level, interest rate, and moment in time. If\ninterest rates were to fall by one percentage point today, it would cause\nSusanne’s call to decline in value by $0.64. If that rate drop occurred over\nthe life of the option, it would have a much smaller effect. Why? Rate\nchanges closer to expiration have less of an effect on option values.\nAssume that on the trade date, when the LEAPS has 639 days until\nexpiration, interest rates fall by 25 basis points. The effect will be a decline\nin the value of the call of 0.16—one-fourth of the 0.638 rho. If the next rate\ncut occurs si", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 48}
{"text": "e drop occurred over\nthe life of the option, it would have a much smaller effect. Why? Rate\nchanges closer to expiration have less of an effect on option values.\nAssume that on the trade date, when the LEAPS has 639 days until\nexpiration, interest rates fall by 25 basis points. The effect will be a decline\nin the value of the call of 0.16—one-fourth of the 0.638 rho. If the next rate\ncut occurs six months later, the rho of the LEAPS will be smaller, because it\nwill have less time until expiration. In this case, after six months, the rho\nwill be only 0.46. Another 25-basis-point drop will hurt the call by $0.115.\nAfter another six months, the option will have a 0.26 rho. Another quarter-\npoint cut costs Susanne only $0.065. Any subsequent rate cuts in ensuing\nmonths will have almost no effect on the now short-term option value.\nPricing in Interest Rate Moves\nIn the same way that volatility can get priced in to an option’s value, so can\nthe interest rate. When interest rates are expected to rise or fall, those\nexpectations can be reflected in the prices of options. Say current interest\nrates are at 8 percent, but the Fed has announced that the economy is\ngrowing at too fast of a pace and that it may raise interest rates at the next\nFederal Open Market Committee meeting. Analysts expect more rate hikes\nto follow. The options with expiration dates falling after the date of the\nexpected rate hikes will have higher interest rates priced in. In this situation,\nthe higher interest rates in the longer-dated options will be evident when\nentering parameters into the model.\nTake options on Already Been Chewed Bubblegum Corp. (ABC). A\ntrader, Kyle, enters parameters into the model for ABC options and notices\nthat the prices don’t line up. To get the theoretical values of the ATM calls\nfor all the expiration months to sit in the middle of the actual market values,\nKyle may have to tinker with the interest rate inputs.\nAssume the following markets for the ATM 70-strike calls in ABC\noptions:\nCalls Puts\nAug 70 calls1.75–1.851.30–1.40\nSep 70 calls2.65–2.751.75–1.85\nDec 70 calls4.70–4.902.35–2.45\nMar 70 calls6.50–6.702.65–2.75\nABC is at $70 a share, has a 20 percent IV in all months, and pays no\ndividend. August expiration is one month away.\nEntering the known inputs for strike price, stock price, time to expiration,\nvolatility, and dividend and using an 8 percent interest rate yields the\nfollowing theoretical values for ABC options:\nThe theoretical values, in bold type, are those that don’t line up in the\nmiddle of the call and put markets. These values are wrong. The call\ntheoretical values are too low, and the put theoretical values are too high.\nThey are the product of an interest rate that is too low being applied to the\nmodel. To generate values that are indicative of market prices, Kyle must\nchange the interest input to the pricing model to reflect the market’s\nexpectations of future interest rate changes.\nUsing new values for the interest rate yields the following new values:\nAfter recalculating, the theoretical values line up in the middle of the call\nand put markets. Using higher interest rates for the longer expirations raises\nthe call values and lowers the put values for these months. These interest\nrates were inferred from, or backed out of, the option-market prices by use\nof the option-pricing model. In practice, it may take some trial and error to\nfind the correct interest values to use.\nIn times of interest rate uncertainty, rho can be an important factor in\ndetermining which strategy to select. When rates are generally expected to\ncontinue to rise or fall over time, they are normally priced in to the options,\nas shown in the previous example. When there is no consensus among\nanalysts and traders, the rates that are priced in may change as economic\ndata are made available. This can cause a revision of option values. In long-\nterm options that have higher rhos, this is a bona fide risk. Short-term\noptions are a safer play in this environment. But as all traders know, risk\nalso implies opportunity.\nTrading Rho\nWhile it’s possible to trade rho, most traders forgo this niche for more\ndynamic strategies with greater profitability. The effects of rho are often\novershadowed by the more profound effects of the other greeks. The\nopportunity to profit from rho is outweighed by other risks. For most\ntraders, rho is hardly ever even looked at.\nBecause LEAPS have higher rho values than corresponding short-term\noptions, it makes sense that these instruments would be appropriate for\ninterest-rate plays. But even with LEAPS, rho exposure usually pales in\ncomparison with that of delta, theta, and vega.\nIt is not uncommon for the rho of a long-term option to be 5 to 8 percent\nof the option’s value. For example, Exhibit 7.2 shows a two-year LEAPS on\na $70 stock with the following pricing-model inputs and outputs:\nEXHIBIT 7.2 Long 70-strike LEAPS call.\nThe rho is +0.793, or about 5.8 percent of the call value. That means a 25-\nbasis-point rise in rates contributes to only a 20-cent profit on the call.\nThat’s only about 1.5 percent of the call’s value. On one hand, 1.5 percent is\nnot a very big profit on a trade. On the other hand, if there are more rate\nrises at following Fed meetings, the trader can expect further gains on rho.\nEven if the trader is compelled to wait until the next Fed meeting to make\nanother $0.20—or less, as rho will get smaller as time passes—from a\nsecond 25-basis-point rate increase, other influences will diminish rho’s\nsignificance. If over the six-week period between Fed meetings, the\nunderlying declines by just $0.60, the $0.40 that the trader hoped to make\non rho is wiped out by delta loss. With the share price $0.60 lower, the\n0.760 delta costs the trade about $0.46. Furthermore, the passing of six\nweeks (42 days) will lead to a loss of about $0.55 from time decay because\nof the −0.013 theta. There is also the risk from the fat vegas associated with\nLEAPS. A 1.5 percent drop in impl", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 49}
{"text": "ng declines by just $0.60, the $0.40 that the trader hoped to make\non rho is wiped out by delta loss. With the share price $0.60 lower, the\n0.760 delta costs the trade about $0.46. Furthermore, the passing of six\nweeks (42 days) will lead to a loss of about $0.55 from time decay because\nof the −0.013 theta. There is also the risk from the fat vegas associated with\nLEAPS. A 1.5 percent drop in implied volatility completely negates any\nhopes of rho profits.\nAside from the possibility that delta, theta, and vega may get in the way\nof profits, the bid-ask spread with these long-term options tends to be wider\nthan with their short-term counterparts. If the bid-ask spread is more than\n$0.40 wide, which is often the case with LEAPS, rho profits are canceled\nout by this cost of doing business. Buying the offer and selling the bid\nnegative scalps away potential profits.\nWith LEAPS, rho is always a concern. It will contribute to prosperity or\nperil and needs to be part of the trade plan from forecast to implementation.\nBuying or selling a LEAPS call or put, however, is not a practical way to\nspeculate on interest rates.\nTo take a position on interest rates in the options market, risk needs to be\ndistilled down to rho. The other greeks need to be spread off. This is\naccomplished only through the conversions, reversals, and jelly rolls\ndescribed in Chapter 6. However, the bid-ask can still be a hurdle to trading\nthese strategies for non–market makers. Generally, rho is a greek that for\nmost traders is important to understand but not practical to trade.\nNotes\n1 . Please note, for simplification, dividends are not included.\n2 . Note, for simplicity, simple interest is used in the calculation.\nCHAPTER 8\nDividends and Option Pricing\nMuch of this book studies how to break down and trade certain components\nof option prices. This chapter examines the role of dividends in the pricing\nstructure. There is no greek symbol that measures an option’s sensitivity to\nchanges in the dividend. And in most cases, dividends are not “traded” by\nmeans of options in the same way that volatility, interest, and other option\nprice influences are. Dividends do, though, affect option prices, and\ntherefore a trader’s P&(L), so they deserve attention.\nThere are some instances where dividends provide ample opportunity to\nthe option trader, and there some instances where a change in dividend\npolicy can have desirable, or undesirable, effects on the bottom line.\nDespite the fact that dividends do not technically involve greeks, they need\nto be monitored in much the same way as do delta, gamma, theta, vega, and\nrho.\nDividend Basics\nLet’s start at the beginning. When a company decides to pay a dividend,\nthere are four important dates the trader must be aware of:\n1. Declaration date\n2. Ex-dividend date\n3. Record date\n4. Payable date\nThe first date chronologically is the declaration date. This date is when\nthe company formally declares the dividend. It’s when the company lets its\nshareholders know when and in what amount it will pay the dividend.\nActive traders, however, may buy and sell the same stock over and over\nagain. How does the corporation know exactly who collects the dividend\nwhen it is opening up its coffers?\nDividends are paid to shareholders of record who are on the company’s\nbooks as owning the stock at the opening of business on another important\ndate: the record date. Anyone long the stock at this moment is entitled to the\ndividend. Anyone with a short stock position on the opening bell on the\nrecord date is required to make payment in the amount of the dividend.\nBecause the process of stock settlement takes time, the important date is\nactually not the record date. For all intents and purposes, the key date is two\ndays before the record date. This is called the ex-dividend date, or the ex-\ndate.\nTraders who have earned a dividend by holding a stock in their account\non the morning of the ex-date have one more important date they need to\nknow—the date they get paid. The date that the dividend is actually paid is\ncalled the payable date. The payable date can be a few weeks after the ex-\ndate.\nLet’s walk through an example. ABC Corporation announces on March\n21 (the declaration date) that it will pay a 25-cent dividend to shareholders\nof record on April 3 (the record date), payable on April 23 (the payable\ndate). This means market participants wishing to receive the dividend must\nown the stock on the open on April 1 (the ex-date). In practice, they must\nbuy the stock before the closing bell rings on March 31 in order to have it\nfor the open the next day.\nThis presents a potential quandary. If a trader only needs to have the stock\non the open on the ex-date, why not buy the stock just before the close on\nthe day before the ex-date, in this case March 31, and sell it the next\nmorning after the open? Could this be an opportunity for riskless profit?\nUnfortunately, no. There are a couple of problems with that strategy. First,\nas far as the riskless part is concerned, stock prices can and often do change\novernight. Yesterday’s close and today’s open can sometimes be\nsignificantly different. When they are, it is referred to as a gap open.\nWhenever a stock is held (long or short), there is risk. The second problem\nwith this strategy to earn riskless profit is with the profit part. On the ex-\ndate, the opening stock price reflects the dividend. Say ABC is trading at\n$50 at the close on March 31. If the market for the stock opens unchanged\nthe next morning—that is, a zero net change on the day on—ABC will be\ntrading at $49.75 ($50 minus the $0.25 dividend). Alas, the quest for\nriskless profit continues.\nDividends and Option Pricing\nThe preceding discussion demonstrated how dividends affect stock traders.\nThere’s one problem: we’re option traders! Option holders or writers do not\nreceive or pay dividends, but that doesn’t mean dividends aren’t relevant to\nthe pricing of these securities. Observe the behavior of a conversion or a\nreve", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 50}
{"text": "$0.25 dividend). Alas, the quest for\nriskless profit continues.\nDividends and Option Pricing\nThe preceding discussion demonstrated how dividends affect stock traders.\nThere’s one problem: we’re option traders! Option holders or writers do not\nreceive or pay dividends, but that doesn’t mean dividends aren’t relevant to\nthe pricing of these securities. Observe the behavior of a conversion or a\nreversal before and after an ex-dividend date. Assuming the stock opens\nunchanged on the ex-date, the relationship of the price of the synthetic stock\nto the actual stock price will change. Let’s look at an example to explore\nwhy.\nAt the close on the day before the ex-date of a stock paying a $0.25\ndividend, a trader has an at-the-money (ATM) conversion. The stock is\ntrading right at $50 per share. The 50 puts are worth 2.34, and the 50 calls\nare worth 2.48. Before the ex-date, the trader is\nLong 100 shares at $50\nLong one 50 put at 2.34\nShort one 50 call at 2.48\nHere, the trader is long the stock at $50 and short stock synthetically at\n$50.14—50 + (2.48 − 2.34). The trader is synthetically short $0.14 over the\nprice at which he is long the stock.\nAssume that the next morning the stock opens unchanged. Since this is\nthe ex-date, that means the stock opens at $49.75—$0.25 lower than the\nprevious day’s close. The theoretical values of the options will change very\nlittle. The options will be something like 2.32 for the put and 2.46 for the\ncall.\nAfter the ex-date, the trader is\nLong 100 shares at $49.75\nLong one 50 put at 2.32\nShort one 50 call at 2.46\nEach option is two cents lower. Why? The change in the option prices is\ndue to theta. In this case, it’s $0.02 for each option. The synthetic stock is\nstill short from an effective price of $50.14. With the stock at $49.75, the\nsynthetic short price is now $0.39 over the stock. Incidentally, $0.39 is\n$0.25 more than the $0.14 difference before the ex-date.\nDid the trader who held the conversion overnight from before the ex-date\nto after it make or lose money? Neither. Before the ex-date, he had an asset\nworth $50 per share (the stock) and he shorted the asset synthetically at\n$50.14. After the ex-date, he still has assets totaling $50 per share—the\nstock at $49.75 plus the 0.25 dividend—and he is still synthetically short\nthe stock at $50.14. Before the ex-date, the $0.14 difference between the\nsynthetic and the stock is interest minus the dividend. After the ex-date, the\n$0.39 difference is all interest.\nDividends and Early Exercise\nAs the ex-date approaches, in-the-money (ITM) calls on equity options can\noften be found trading at parity, regardless of the dividend amount and\nregardless of how far off expiration is. This seems counterintuitive. What\nabout interest? What about dividends? Normally, these come into play in\noption valuation.\nBut option models designed for American options take the possibility of\nearly exercise into account. It is possible to exercise American-style calls\nand exchange them for the underlying stock. This would give traders, now\nstockholders, the right to the dividend—a right for which they would not be\neligible as call holders. Because of the impending dividend, the call\nbecomes an exercise just before the ex-date. For this reason, the call can\ntrade for parity before the ex-date.\nLet’s look at an example of a reversal on a $70 stock that pays a $0.40\ndividend. The options in this reversal have 24 days until expiration, which\nmakes the interest on the 60 strike roughly $0.20, given a 5 percent interest\nrate. The day before the ex-date, a trader has the following position at the\nstated prices:\nShort 100 shares at $70\nLong one 60 call at 10.00\nShort one 60 put at 0.05\nTo understand how American calls work just before the ex-date, it is\nhelpful first to consider what happens if the trader holds the position until\nthe ex-date. Making the assumption that the stock is unchanged on the ex-\ndividend date, it will open at $69.60, lower by the amount of the dividend—\nin this case, $0.40. The put, being so far out-of-the-money (OTM) as to\nhave a negligible delta, will remain unchanged. But what about the call?\nWith no dividend left in the stock, the put call-parity states\nIn this case,\n\nBefore the ex-date, the model valued the call at parity. Now it values the\nsame call at $0.25 over parity (9.85 − [69.60 − 60]). Another way to look at\nthis is that the time value of the call is now made up of the interest plus the\nput premium. Either way, that’s a gain of $0.25 on the call. That sounds\ngood, but because the trader is short stock, if he hasn’t exercised, he will\nowe the $0.40 dividend—a net loss of $0.15. The new position will be\nShort 100 shares at $69.60\nOwe $0.40 dividend\nLong one 60 call at 9.85\nShort one 60 put at 0.05\nAt the end of the trading day before the ex-date, this trader must exercise\nthe call to capture the dividend. By doing so, he closes two legs of the trade\n—the call and the stock. The $10 call premium is forfeited, the stock that is\nshort at $70 is bought at $60 (from the call exercise) for a $10 profit. The\ntransaction leads to neither a profit nor a loss. The purpose of exercising is\nto avoid the $0.15 loss ($0.25 gain in call time value minus the $0.40 loss in\ndividends owed).\nThe other way the trader could achieve the same ends is to sell the long\ncall and buy in the short stock. This is tactically undesirable because the\ntrader may have to sell the bid in the call and buy the offer in the stock.\nFurthermore, when legging a trade in this manner, there is the risk of\nslippage. If the call is sold first, the stock can move before the trader has a\nchance to buy it at the necessary price. It is generally better and less risky to\nexercise the call rather than leg out of the trade.\nIn this transaction, the trader begins with a fairly flat position (short\nstock/long synthetic stock) and ends with a short put that is significantly\nout-of-the-money. For all intents and purposes, exercising the call in this\ntrade is like sy", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 51}
{"text": "before the trader has a\nchance to buy it at the necessary price. It is generally better and less risky to\nexercise the call rather than leg out of the trade.\nIn this transaction, the trader begins with a fairly flat position (short\nstock/long synthetic stock) and ends with a short put that is significantly\nout-of-the-money. For all intents and purposes, exercising the call in this\ntrade is like synthetically selling the put. But at what price? In this case, it’s\n$0.15. This again is the cost benefit of saving $0.40 by avoiding the\ndividend obligation versus the $0.25 gain in call time value. Exercising the\ncall is effectively like selling the put at 0.15 in this example. If the dividend\nis lower or the interest is higher, it may not be worth it to the trader to\nexercise the call to capture the dividend. How do traders know if their calls\nshould be exercised?\nThe traders must do the math before each ex-dividend date in option\nclasses they trade. The traders have to determine if the benefit from\nexercising—or the price at which the synthetic put is essentially being sold\n—is more or less than the price at which they can sell the put. The math\nused here is adopted from put-call parity:\nThis shows the case where the traders can effectively synthetically sell the\nput (by exercising) for more than the current put value. Tactically, it’s\nappropriate to use the bid price for the put in this calculation since that is\nthe price at which the put can be sold.\nIn this case, the traders would be inclined to not exercise. It would be\ntheoretically more beneficial to sell the put if the trader is so inclined.\nHere, the traders, from a valuation perspective, are indifferent as to whether\nor not to exercise. The question then is simply: do they want to sell the put\nat this price?\nProfessionals and big retail traders who are long (ITM) calls—whether as\npart of a reversal, part of another type of spread, or because they are long\nthe calls outright—must do this math the day before each ex-dividend date\nto maximize profits and minimize losses. Not exercising, or forgetting to\nexercise, can be a costly mistake. Traders who are short ITM dividend-\npaying calls, however, can reap the benefits of those sleeping on the job. It\nworks both ways.\nTraders who are long stock and short calls at parity before the ex-date\nmay stand to benefit if some of the calls do not get assigned. Any shares of\nlong stock remaining on the ex-date will result in the traders receiving\ndividends. If the dividends that will be received are greater in value than the\ninterest that will subsequently be paid on the long stock, the traders may\nstand reap an arbitrage profit because of long call holders’ forgetting to\nexercise.\nDividend Plays\nThe day before an ex-dividend date in a stock, option volume can be\nunusually high. Tens of thousands of contracts sometimes trade in names\nthat usually have average daily volumes of only a couple thousand. This\nspike in volume often has nothing to do with the market’s opinion on\ndirection after the dividend. The heavy trading has to do with the\nrevaluation of the relationship of exercisable options to the underlying\nexpected to occur on the ex-dividend date.\nTraders that are long ITM calls and short ITM calls at another strike just\nbefore an ex-dividend date have a potential liability and a potential benefit.\nThe potential liability is that they can forget to exercise. This is a liability\nover which the traders have complete control. The potential benefit is that\nsome of the short calls may not get assigned. If traders on the other side of\nthe short calls (the longs) forget to exercise, the traders that are short the\ncall make out by not having to pay the dividend on short stock.\nProfessionals and big retail traders who have very low transaction costs\nwill sometimes trade ITM call spreads during the afternoon before an ex-\ndividend date. This consists of buying one call and selling another call with\na different strike price. Both calls in the dividend-play strategy are ITM and\nhave corresponding puts with little or no value (to be sure, the put value is\nless than the dividend minus the interest). The traders trade the spreads,\nfairly indifferent as to whether they buy or sell the spreads, in hope of\nskating—or not getting assigned—on some of their short calls. The more\nthey don’t get assigned the better.\nThis usually occurs in options that have high open interest, meaning there\nare a lot of outstanding contracts already. The more contracts in existence,\nthe better the possibility of someone forgetting to exercise. The greatest\nvolume also tends to occur in the front month.\nStrange Deltas\nBecause American calls become an exercise possibility when the ex-date is\nimminent, the deltas can sometimes look odd. When the calls are trading at\nparity, they have a 1.00 delta. They are a substitute for the stock. They, in\nfact, will be stock if and when they are exercised just before the ex-date.\nBut if the puts still have some residual time value, they may also have a\nsmall delta, of 0.05 or perhaps more.\nIn this unique scenario, the delta of the synthetic can be greater than\n+1.00 or less than −1.00. It is not uncommon to see the absolute values of\nthe call and put deltas add up to 1.07 or 1.08. When the dividend comes out\nof the options model on the ex-date, synthetics go back to normal. The delta\nof the synthetic again approaches 1.00. Because of the out-of-whack deltas,\ndelta-neutral traders need to take extra caution in their analytics when ex-\ndates are near. A little common sense should override what the computer\nspits out.\nInputting Dividend Data into the\nPricing Model\nOften dividend payments are regular and predictable. With many\ncompanies, the dividend remains constant quarter after quarter. Some\ncorporations have a track record of incrementally increasing their dividends\nevery year. Some companies pay dividends in a very irregular fashion, by\npaying special dividends that are often announced as a surprise", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 52}
{"text": "s out.\nInputting Dividend Data into the\nPricing Model\nOften dividend payments are regular and predictable. With many\ncompanies, the dividend remains constant quarter after quarter. Some\ncorporations have a track record of incrementally increasing their dividends\nevery year. Some companies pay dividends in a very irregular fashion, by\npaying special dividends that are often announced as a surprise to investors.\nIn a truly capitalist society, there are no restrictions and no rules on when,\nwhether, or how corporations pay dividends to their shareholders.\nUnpredictability of dividends, though, can create problems in options\nvaluation.\nWhen a company has a constant, reasonably predictable dividend, there is\nnot a lot of guesswork. Take Exelon Corp. (EXC). From November 2008 to\nthe time of this writing, Exelon has paid a regular quarterly dividend of\n$0.525. During that period, a trader has needed simply to enter 0.525 into\nthe pricing calculator for all expected future dividends to generate the\ntheoretical value. Based on recent past performance, the trader could feel\nconfident that the computed analytics were reasonably accurate. If the\ntrader believed the company would continue its current dividend policy,\nthere would be little options-related dividend risk—unless things changed.\nWhen there is uncertainty about when future dividends will be paid in\nwhat amounts, the level of dividend-related risk begins to increase. The\nmore uncertainty, the more risk. Let’s examine an interesting case study:\nGeneral Electric (GE).\nFor a long time, GE was a company that has had a history of increasing\nits dividends at fairly regular intervals. In fact, there was more than a 30-\nyear stretch in which GE increased its dividend every year. During most of\nthe first decade of the 2000s, increases in GE’s dividend payments were\naround one to six cents and tended to occur toward the end of December,\nafter December expiration. The dividends were paid four times per year but\nnot exactly quarterly. For several years, the ex-dates were in February, June,\nSeptember, and December. Option traders trading GE options had a pretty\neasy time estimating their future dividend streams, and consequently\nevaded valuation problems that could result from using wrong dividend\ndata. Traders would simply adjust the dividend data in the model to match\ntheir expectations for predictably increasing future dividends in order to\nachieve an accurate theoretical value. Let’s look back at GE to see how a\ntrader might have done this.\nThe following shows dividend-history data for GE.\nEx-DateDividend*\n12/27/02$0.19\n02/26/03$0.19\n06/26/03$0.19\n09/25/03$0.19\n12/29/03$0.20\n02/26/04$0.20\n06/24/04$0.20\n09/23/04$0.20\n12/22/04$0.22\n02/24/05$0.22\n06/23/05$0.22\n09/22/05$0.22\n12/22/05$0.25\n02/23/06$0.25\n06/22/06$0.25\n09/21/06$0.25\n12/21/06$0.28\n02/22/07$0.28\n06/21/07$0.28\n* These data are taken from the following Web page on GE’s web site:\nwww.ge.com/investors/stock_info/dividend_history.html .\nAt the end of 2006, GE raised its dividend from $0.25 to $0.28. A trader\ntrading GE options at the beginning of 2007 would have logically\nanticipated the next increase to occur again in the following December\nunless there was reason to believe otherwise. Options expiring before this\nanticipated next dividend increase would have the $0.28 dividend priced\ninto their values. Options expiring after December 2007 would have a\nhigher dividend priced into them—possibly an additional three cents to 0.31\n(which indeed it was). Calls would be adversely affected by this increase,\nand puts would be favorably affected. A typical trader would have\nanticipated those changes. The dividend data a trader pricing GE options\nwould have entered into the model in January 2007 would have looked\nsomething like this.\nEx-DateDividend*\n02/22/07$0.28\n06/21/07$0.28\n09/20/07$0.28\n12/20/07$0.31\n02/21/08$0.31\n06/19/08$0.31\n09/18/08$0.31\n* These data are taken from the following Web page on GE’s web site:\nwww.ge.com/investors/stock_info/dividend_history.html .\nThe trader would have entered the anticipated future dividend amount in\nconjunction with the anticipated ex-dividend date. This trader projection\ngoes out to February 2008, which would aid in valuing options expiring in\n2007 as well as the 2008 LEAPS. Because the declaration dates had yet to\noccur, one could not know with certainty when the dividends would be\nannounced or in what amount. Certainly, there would be some estimation\ninvolved for both the dates and the amount. But traders would probably get\nit pretty close—close enough.\nThen, something particularly interesting happened. Instead of raising the\ndividend going into December 2008 as would be a normal pattern, GE kept\nit the same. As shown, the 12/24/08 ex-dated dividend remained $0.31.\nEx-DateDividend*\n02/22/07$0.28\n06/21/07$0.28\n09/20/07$0.28\n12/20/07$0.31\n02/21/08$0.31\n06/19/08$0.31\n09/18/08$0.31\n12/24/08$0.31\n* These data are taken from the following Web page on GE’s web site:\nwww.ge.com/investors/stock_info/dividend_history.html .\nThe dividend stayed at $0.31 until the June 2009 dividend, which held\nanother jolt for traders pricing options. Around this time, GE’s stock price\nhad taken a beating. It fell from around $42 a share in the fall of 2007\nultimately to about $6 in March 2009. GE had its first dividend cut in more\nthan three decades. The dividend with the ex-date of 06/18/09 was $0.10.\n12/24/08$0.31\n02/19/09$0.31\n06/18/09$0.10\n09/17/09$0.10\n12/23/09$0.10\n02/25/10$0.10\n06/17/10$0.10\n09/16/10$0.12\n12/22/10$0.14\n02/24/11$0.14\n06/16/11$0.15\n09/15/11$0.15\nThough the company gave warnings in advance, the drastic dividend\nchange had a significant impact on option prices. Call prices were helped by\nthe dividend cut (or anticipated dividend cut) and put prices were hurt.\nThe break in the pattern didn’t stop there. The dividend policy remained\n$0.10 for five quarters until it rose to $0.12 in September 2010, then to\n$0.14 in December 2010, then to $0.15 in June 2011. These irregula", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 53}
{"text": "ngs in advance, the drastic dividend\nchange had a significant impact on option prices. Call prices were helped by\nthe dividend cut (or anticipated dividend cut) and put prices were hurt.\nThe break in the pattern didn’t stop there. The dividend policy remained\n$0.10 for five quarters until it rose to $0.12 in September 2010, then to\n$0.14 in December 2010, then to $0.15 in June 2011. These irregular\nchanges in the historically predictable dividend policy made it tougher for\ntraders to attain accurate valuations. If the incremental changes were bigger,\nthe problem would have been even greater.\nGood and Bad Dates with Models\nUsing an incorrect date for the ex-date in option pricing can lead to\nunfavorable results. If the ex-dividend date is not known because it has yet\nto be declared, it must be estimated and adjusted as need be after it is\nformally announced. Traders note past dividend history and estimate the\nexpected dividend stream accordingly. Once the dividend is declared, the\nex-date is known and can be entered properly into the pricing model. Not\nexecuting due diligence to find correct known ex-dates can lead to trouble.\nUsing a bad date in the model can yield dubious theoretical values that can\nbe misleading or worse—especially around the expiration.\nSay a call is trading at 2.30 the day before the ex-date of a $0.25\ndividend, which happens to be thirty days before expiration. The next day,\nof course, the stock may have moved higher or lower. Assume for\nillustrative purposes, to compare apples to apples as it were, that the stock is\ntrading at the same price—in this case, $76.\nIf the trader is using the correct date in the model, the option value will\nadjust to take into account the effect of the dividend expiring, or reaching\nits ex-date, when the number of days to expiration left changes from 30 to\n29. The call trading postdividend will be worth more relative to the same\nstock price. If the dividend date the trader is using in the model is wrong,\nsay one day later than it should be, the dividend will still be an input of the\ntheoretical value. The calculated value will be too low. It will be wrong.\nExhibit 8.1 compares the values of a 30-day call on the ex-date given the\nright and the wrong dividend.\nEXHIBIT 8.1 Comparison of 30-day call values\nAt the same stock price of $76 per share, the call is worth $0.13 more\nafter the dividend is taken out of the valuation. Barring any changes in\nimplied volatility (IV) or the interest rate, the market prices of the options\nshould reflect this change. A trader using an ex-date in the model that is\nfarther in the future than the actual ex-date will still have the dividend as\npart of the generated theoretical value. With the ex-date just one day later,\nthe call would be worth 2.27. The difference in option value is due to the\neffect of theta—in this case, $0.03.\nWith a bad date, the value of 2.27 would likely be significantly below\nmarket price, causing the market value of the option to look more expensive\nthan it actually is. If the trader did not know the date was wrong, he would\nneed to raise IV to make the theoretical value match the market. This option\nhas a vega of 0.08, which translates into a difference of about two IV points\nfor the theoretical values 2.43 and 2.27. The trader would perceive the call\nto be trading at an IV two points higher than the market indicates.\nDividend Size\nIt’s not just the date but also the size of the dividend that matters. When\ncompanies change the amount of the dividend, options prices follow in step.\nIn 2004, when Microsoft (MSFT) paid a special dividend of $3 per share,\nthere were unexpected winners and losers in the Microsoft options. Traders\nwho were long calls or short puts were adversely affected by this change in\ndividend policy. Traders with short calls or long puts benefited. With long-\nterm options, even less anomalous changes in the size of the dividend can\nhave dramatic effects on options values.\nLet’s study an example of how an unexpected rise in the quarterly\ndividend of a stock affects a long call position. Extremely Yellow Zebra\nCorp. (XYZ) has been paying a quarterly dividend of $0.10. After a steady\nrise in stock price to $61 per share, XYZ declares a dividend payment of\n$0.50. It is expected that the company will continue to pay $0.50 per\nquarter. A trader, James, owns the 528-day 60-strike calls, which were\ntrading at 9.80 before the dividend increase was announced.\nExhibit 8.2 compares the values of the long-term call using a $0.10\nquarterly dividend and using a $0.50 quarterly dividend.\nEXHIBIT 8.2 Effect of change in quarterly dividend on call value.\nThis $0.40 dividend increase will have a big effect on James’s calls. With\n528 days until expiration, there will be six dividends involved. Because\nJames is long the calls, he loses 1.52 per option. If, however, he were short\nthe calls, 1.52 would be his profit on each option.\nPut traders are affected as well. Another trader, Marty, is long the 60-\nstrike XYZ puts. Before the dividend announcement, Marty was running his\nvalues with a $0.10 dividend, giving his puts a value of 5.42. Exhibit 8.3\ncompares the values of the puts with a $0.10 quarterly dividend and with a\n$0.50 quarterly dividend.\nEXHIBIT 8.3 Effect of change in quarterly dividend on put value.\nWhen the dividend increase is announced, Marty will benefit. His puts\nwill rise because of the higher dividend by $0.66 (all other parameters held\nconstant). His long-term puts with six quarters of future expected dividends\nwill benefit more than short-term XYZ puts of the same strike would. Of\ncourse, if he were short the puts, he would lose this amount.\nThe dividend inputs to a pricing model are best guesses until the dates\nand amounts are announced by the company. How does one find dividend\ninformation? Regularly monitoring the news and press releases on the\ncompanies one trades is a good way to stay up to date on dividend\ninformation, as well as other company news. Dividend announ", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 54}
{"text": "Of\ncourse, if he were short the puts, he would lose this amount.\nThe dividend inputs to a pricing model are best guesses until the dates\nand amounts are announced by the company. How does one find dividend\ninformation? Regularly monitoring the news and press releases on the\ncompanies one trades is a good way to stay up to date on dividend\ninformation, as well as other company news. Dividend announcements are\nwidely disseminated by the major news services. Most companies also have\nan investor-relations phone number and section on their web sites where\ndividend information can be found.\nPART II\nSpreads\nCHAPTER 9\nVertical Spreads\nRisk—it is the focal point around which all trading revolves. It may seem as\nif profit should be occupying this seat, as most important to trading options,\nbut without risk, there would be no profit! As traders, we must always look\nfor ways to mitigate, eliminate, preempt, and simply avoid as much risk as\npossible in our pursuit of success without diluting opportunity. Risk must be\ncontrolled. Trading vertical spreads takes us one step further in this quest.\nThe basic strategies discussed in Chapters 4 and 5 have strengths when\ncompared with pure linear trading in the equity markets. But they have\nweaknesses, too. Consider the covered call, one of the most popular option\nstrategies.\nA covered call is best used as an augmentation to an investment plan. It\ncan be used to generate income on an investment holding, as an entrance\nstrategy into a stock, or as an exit strategy out of a stock. But from a trading\nperspective, one can often find better ways to trade such a forecast.\nIf the forecast on a stock is neutral to moderately bullish, accepting the\nrisk of stock ownership is often unwise. There is always the chance that the\nstock could collapse. In many cases, this is an unreasonable risk to assume.\nTo some extent, we can make the same case for the long call, short put,\nnaked call, and the like. In certain scenarios, each of these basic strategies is\naccompanied with unwanted risks that serve no beneficial purpose to the\ntrader but can potentially cause harm. In many situations, a vertical spread\nis a better alternative to these basic spreads. Vertical spreads allow a trader\nto limit potential directional risk, limit theta and vega risk, free up margin,\nand generally manage capital more efficiently.\nVertical Spreads\nVertical spreads involve buying one option and selling another. Both are on\nthe same underlying and expire the same month, and both are either calls or\nputs. The difference is in the strike prices of the two options. One is higher\nthan the other, hence the name vertical spread . There are four vertical\nspreads: bull call spread, bear call spread, bear put spread, and bull put\nspread. These four spreads can be sliced and diced into categories a number\nof ways: call spreads and put spreads, bull spreads and bear spreads, debit\nspreads and credit spreads. There is overlap among the four verticals in how\nand when they are used. The end of this chapter will discuss how the\nspreads are interrelated.\nBull Call Spread\nA bull call spread is a long call combined with a short call that has a higher\nstrike price. Both calls are on the same underlying and share the same\nexpiration month. Because the purchased call has a lower strike price, it\ncosts more than the call being sold. Establishing the trade results in a debit\nto the trader’s account. Because of this debit, it’s called a debit spread.\nBelow is an example of a bull call spread on Apple Inc. (AAPL):\nIn this example, Apple is trading around $391. With 40 days until\nFebruary expiration, the trader buys the 395–405 call spread for a net debit\nof $4.40, or $440 in actual cash. Or one could simply say the trader paid\n$4.40 for the 395–405 call.\nConsider the possible outcomes if the spread is held until expiration.\nExhibit 9.1 shows an at-expiration diagram of the bull call spread.\nEXHIBIT 9.1 AAPL bull call spread.\nBefore discussing the greeks, consider the bull call spread from an at-\nexpiration perspective. Unlike the long call, which has two possible\noutcomes at expiration—above or below the strike—this spread has three\npossibilities: below both strikes, between the strikes, or above both strikes.\nIn this example, if Apple is below $395 at expiration, both calls expire\nworthless. The rights and obligations of the options are gone, as is the cash\nspent on the trade. In this case, the entire debit of $4.40 is lost.\nIf Apple is between the strikes at expiration, the 405-strike call expires\nworthless. The trader is long stock at an effective price of $399.40. This is\nthe $395-strike price at which the stock would be purchased if the call is\nexercised, plus the $4.40 premium spent on the spread. The break-even\nprice of the trade is $399.40. If Apple is above $399.40 at expiration, the\ntrade is profitable; below $399.40, it is a loser. The aptly named bull call\nspread requires the stock to rise to reach its profit potential. But unlike an\noutright long call, profits are capped with the spread.\nIf Apple is above $405 at expiration, both calls are in-the-money (ITM).\nIf the 395-strike calls are exercised, the trader buys 100 shares of Apple at\n$395 and these shares, in turn, would be sold at $405 when the 405-strike\ncalls are assigned, for a $10 gain per share. Subtract from that $10 the $4.40\ndebit spent on the trade and the net profit is $5.60 per share.\nThere are some other differences between the 395–405 call spread and the\noutright purchase of the 395 call. The absolute risk is lower. To buy the\n395-strike call costs 14.60, versus 4.40 for the spread—a big difference.\nBecause the debit is lower, the margin for the spread is lower at most\noption-friendly brokers, as well.\nIf we dig a little deeper, we find some other differences between the bull\ncall spread and the outright call. Long options are haunted by the specter of\ntime. Because the spread involves both a long and a short option, the time-\ndecay risk is lower", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 55}
{"text": ", versus 4.40 for the spread—a big difference.\nBecause the debit is lower, the margin for the spread is lower at most\noption-friendly brokers, as well.\nIf we dig a little deeper, we find some other differences between the bull\ncall spread and the outright call. Long options are haunted by the specter of\ntime. Because the spread involves both a long and a short option, the time-\ndecay risk is lower than that associated with owning an option outright.\nImplied volatility (IV) risk is lower, too. Exhibit 9.2 compares the greeks of\nthe long 395 call with those of the 395–405 call spread.\nEXHIBIT 9.2 Apple call versus bull call spread (Apple @ $391).\n395 Call395–405 Call\nDelta 0.484 0.100\nGamma0.00970.0001\nTheta −0.208−0.014\nVega 0.513 0.020\nThe positive deltas indicate that both positions are bullish, but the outright\ncall has a higher delta. Some of the 395 call’s directional sensitivity is lost\nwhen the 405 call is sold to make a spread. The negative delta of the 405\ncall somewhat offsets the positive delta of the 395 call. The spread delta is\nonly about 20 percent of the outright call’s delta. But for a trader wanting to\nfocus on trading direction, the smaller delta can be a small sacrifice for the\nbenefit of significantly reduced theta and vega. Theta spread’s risk is about\n7 percent that of the outright. The spread’s vega risk is also less than 4\npercent that of the outright 395 call. With the bull call spread, a trader can\nspread off much of the exposure to the unwanted risks and maintain a\ndisproportionately higher greeks in the wanted exposure (delta).\nThese relationships change as the underlying moves higher. Remember,\nat-the-money (ATM) options have the greatest sensitivity to theta and vega.\nWith Apple sitting at around the long strike, gamma and vega have their\ngreatest positive value, and theta has its most negative value. Exhibit 9.3\nshows the spread greeks given other underlying prices.\nEXHIBIT 9.3 AAPL 395–405 bull call spread.\nAs the stock moves higher toward the 405 strike, the 395 call begins to\nmove away from being at-the-money, and the 405 call moves toward being\nat-the-money. The at-the-money is the dominant strike when it comes to the\ncharacteristics of the spread greeks. Note the greeks position when the\nunderlying is directly between the two strike prices: The long call has\nceased to be the dominant influence on these metrics. Both calls influence\nthe analytics pretty evenly. The time-decay risk has been entirely spread off.\nThe volatility risk is mostly spread off. Gamma remains a minimal concern.\nWhen the greeks of the two calls balance each other, the result is a\ndirectional play.\nAs AAPL continues to move closer to the 405-strike, it becomes the at-\nthe-money option, with the dominant greeks. The gamma, theta, and vega\nof the 405 call outweigh those of the ITM 395 call. Vega is more negative.\nPositive theta now benefits the trade. The net gamma of the spread has\nturned negative. Because of the negative gamma, the delta has become\nsmaller than it was when the stock was at $400. This means that the benefit\nof subsequent upward moves in the stock begins to wane. Recall that there\nis a maximum profit threshold with a vertical spread. As the stock rises\nbeyond $405, negative gamma makes the delta smaller and time decay\nbecomes less beneficial. But at this point, the delta has done its work for the\ntrader who bought this spread when the stock was trading around $395. The\naverage delta on a move in the stock from $395 to $405 is about 0.10 in this\ncase.\nWhen the stock is at the 405 strike, the characteristics of the trade are\nmuch different than they are when the stock is at the 395 strike. Instead of\nneeding movement upward in the direction of the delta to combat the time\ndecay of the long calls, the position can now sit tight at the short strike and\nreap the benefits of option decay. The key with this spread, and with all\nvertical spreads, is that the stock needs to move in the direction of the delta\nto the short strike.\nStrengths and Limitations\nThere are many instances when a bull call spread is superior to other bullish\nstrategies, such as a long call, and there are times when it isn’t. Traders\nmust consider both price and time.\nA bull call spread will always be cheaper than the outright call purchase.\nThat’s because the cost of the long-call portion of the spread is partially\noffset by the premium of the higher-strike short call. Spending less for the\nsame exposure is always a better choice, but the exposure of the vertical is\nnot exactly the same as that of the long call. The most obvious trade-off is\nthe fact that profit is limited. For smaller moves—up to the price of the\nshort strike—vertical spreads tend to be better trades than outright call\npurchases. Beyond the strike? Not so much.\nBut time is a trade-off, too. There have been countless times that I have\ntalked with new traders who bought a call because they thought the stock\nwas going up. They were right and still lost money. As the adage goes,\ntiming is everything. The more time that passes, the more advantageous the\nlower-theta vertical spread becomes. When held until expiration, a vertical\nspread can be a better trade than an outright call in terms of percentage\nprofit.\nIn the previous example, when Apple is at $391 with 40 days until\nexpiration, the 395 call is worth 14.60 and the spread is worth 4.40. If\nApple were to rise to be trading at $405 at expiration, the call rises to be\nworth 10, for a loss of 4.60 on the 14.60 debit paid. The spread also is worth\n10. It yields a gain of about 127 percent on the initial $4.40 per share debit.\nBut look at this same trade if the move occurs before expiration. If Apple\nrallies to $405 after only a couple weeks, the outcome is much different.\nWith four weeks still left until expiration, the 395 call is worth 19.85 with\nthe underlying at $405. That’s a 36 percent gain on the 14.60. The spread is\nworth 5.70. That’s a 30 percent gain. The vertical spread must be he", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 56}
{"text": "tial $4.40 per share debit.\nBut look at this same trade if the move occurs before expiration. If Apple\nrallies to $405 after only a couple weeks, the outcome is much different.\nWith four weeks still left until expiration, the 395 call is worth 19.85 with\nthe underlying at $405. That’s a 36 percent gain on the 14.60. The spread is\nworth 5.70. That’s a 30 percent gain. The vertical spread must be held until\nexpiration to reap the full benefits, which it accomplishes through erosion\nof the short option.\nThe long-call-only play (with a significantly larger negative theta) is\npunished severely by time passing. The long call benefits more from a\nquick move in the underlying. And of course, if the stock were to rise to a\nprice greater than $405, in a short amount of time—the best of both worlds\nfor the outright call—the outright long 395 call would be emphatically\nsuperior to the spread.\nBear Call Spread\nThe next type of vertical spread is called a bear call spread . A bear call\nspread is a short call combined with a long call that has a higher strike\nprice. Both calls are on the same underlying and share the same expiration\nmonth. In this case, the call being sold is the option of higher value. This\ncall spread results in a net credit when the trade is put on and, therefore, is\ncalled a credit spread.\nThe bull call spread and the bear call spread are two sides of the same\ncoin. The difference is that with the bull call spread, one is buying the call\nspread, and with the bear call spread, one is selling the call spread. An\nexample of a bear call spread can be shown using the same trade used\nearlier.\nHere we are selling one AAPL February (40-day) 395 call at 14.60 and\nbuying the 405 call at 10.20. We are selling the 395–405 call at $4.40 per\nshare, or $440.\nExhibit 9.4 is an at-expiration diagram of the trade.\nEXHIBIT 9.4 Apple bear call spread.\nThe same three at-expiration outcomes are possible here as with the bull\ncall spread: the stock can be above both strikes, between both strikes, or\nbelow both strikes. If the stock is below both strikes at expiration, both calls\nwill expire worthless. The rights and obligations cease to exist. In this case,\nthe entire credit of $440 is profit.\nIf AAPL is between the two strike prices at expiration, the 395-strike call\nwill be in-the-money. The short call will get assigned and result in a short\nstock position at expiration. The break-even price falls at $399.40—the\nshort strike plus the $4.40 net premium. This is the price at which the stock\nwill effectively be sold if assignment occurs.\nIf Apple is above both strikes at expiration, it means both calls are in-the-\nmoney. Stock is sold at $395 because of assignment and bought back at\n$405 through exercise. This leads to a loss of $10 per share on the negative\nscalp. Factoring in the $4.40-per-share credit makes the net loss only $5.60\nper share with AAPL above $405 at February expiration.\nJust as the at-expiration diagram is the same but reversed, the greeks for\nthis call spread will be similar to those in the bull call spread example\nexcept for the positive and negative signs. See Exhibit 9.5 .\nEXHIBIT 9.5 Apple 395–405 bear call spread.\nA credit spread is commonly traded as an income-generating strategy. The\nidea is simple: sell the option closer-to-the-money and buy the more out-of-\nthe-money (OTM) option—that is, sell volatility—and profit from\nnonmovement (above a certain point). In this example, with Apple at $391,\na neutral to slightly bearish trader would think about selling this spread at\n4.40 in hopes that the stock will remain below $395 until expiration. The\nbest-case scenario is that the stock is below $395 at expiration and both\noptions expire, resulting in a $4.40-per-share profit.\nThe strategy profits as long as Apple is under its break-even price,\n$399.40, at expiration. But this is not so much a bearish strategy as it is a\nnonbullish strategy. The maximum gain with a credit spread is the premium\nreceived, in this case $4.40 per share. Traders who thought AAPL was\ngoing to decline sharply would short it or buy a put. If they thought it would\nrise sharply, they’d use another strategy.\nFrom a greek perspective, when the trade is executed it’s very close to its\nhighest theta price point—the 395 short strike price. This position\ntheoretically collects $0.90 a day with Apple at around $395. As time\npasses, that theta rises. The key is that the stock remains at around $395\nuntil the short option is just about worthless. The name of the game is sit\nand wait.\nAlthough the delta is negative, traders trading this spread to generate\nincome want the spread to expire worthless so they can pocket the $4.40 per\nshare. If Apple declines, profits will be made on delta, and theta profits will\nbe foregone later. All that matters is the break-even point. Essentially, the\nidea is to sell a naked call with a maximum potential loss. Sell the 395s and\nbuy the 405s for protection.\nIf the underlying decreases enough in the short term and significant\nprofits from delta materialize, it is logical to consider closing the spread\nearly. But it often makes more sense to close part of the spread. Consider\nthat the 405-strike call is farther out-of-the-money and will lose its value\nbefore the 395 call.\nSay that after two weeks a big downward move occurs. Apple is trading at\n$325 a share; the 405s are 0.05 bid at 0.10, and the 395s are 0.50 bid at\n0.55. At this point, the lion’s share of the profits can be taken early. A trader\ncan do so by closing only the 395 calls. Closing the 395s to eliminate the\nrisk of negative delta and gamma makes sense. But does it make sense to\nclose the 405s for 0.05? Usually not. Recouping this residual value\naccomplishes little. It makes more sense to leave them in your position in\ncase the stock rebounds. If the stock proves it can move down $70; it can\ncertainly move up $70. Because the majority of the profits were taken on\nthe 395 calls, holding on to the 405s is like getting paid to own ca", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 57}
{"text": "ma makes sense. But does it make sense to\nclose the 405s for 0.05? Usually not. Recouping this residual value\naccomplishes little. It makes more sense to leave them in your position in\ncase the stock rebounds. If the stock proves it can move down $70; it can\ncertainly move up $70. Because the majority of the profits were taken on\nthe 395 calls, holding on to the 405s is like getting paid to own calls. In\nscenarios where a big move occurs and most of the profits can be taken\nearly, it’s often best to hold the long calls, just in case. It’s a win-win\nsituation.\nCredit and Debit Spread Similarities\nThe credit call spread and the debit call spread appear to be exactly opposite\nin every respect. Many novice traders perceive credit spreads to be\nfundamentally different from debit spreads. That is not necessarily so.\nCloser study reveals that these two are not so different after all.\nWhat if Apple’s stock price was higher when the trade was put on? What\nif the stock was at $405? First, the spread would have had more value. The\n395 and 405 calls would both be worth more. A trader could have sold the\nspread for a $5.65-per-share credit. The at-expiration diagram would look\nalmost the same. See Exhibit 9.6 .\nEXHIBIT 9.6 Apple bear call spread initiated with Apple at $405.\nBecause the net premium is much higher in this example, the maximum\ngain is more—it is $5.65 per share. The breakeven is $400.65. The price\npoints on the at-expiration diagram, however, have nothing to do with the\ngreeks. The analytics from Exhibit 9.5 are the same either way.\nThe motivation for a trader selling this call spread, which has both\noptions in-the-money, is different from that for the typical income\ngenerator. When the spread is sold in this context, the trader is buying\nvolatility. Long gamma, long vega, negative theta. The trader here has a\ntrade more like the one in the bull call spread example—except that instead\nof needing a rally, the trader needs a rout. The only difference is that the\nbull call spread has a bullish delta, and the bear call spread has a bearish\ndelta.\nBear Put Spread\nThere is another way to take a bearish stance with vertical spreads: the bear\nput spread. A bear put spread is a long put plus a short put that has a lower\nstrike price. Both puts are on the same underlying and share the same\nexpiration month. This spread, however, is a debit spread because the more\nexpensive option is being purchased.\nImagine that a stock has had a good run-up in price. The chart shows a\nsteady march higher over the past couple of months. A study of technical\nanalysis, though, shows that the run-up may be pausing for breath. An\noscillator, such as slow stochastics, in combination with the relative\nstrength index (RSI), indicates that the stock is overbought. At the same\ntime, the average directional movement index (ADX) confirms that the\nuptrend is slowing.\nFor traders looking for a small pullback, a bear put spread can be an\nexcellent strategy. The goal is to see the stock drift down to the short strike.\nSo, like the other members of the vertical spread family, strike selection is\nimportant.\nLet’s look at an example of ExxonMobil (XOM). After the stock has\nrallied over a two-month period to $80.55, a trader believes there will be a\nshort-term temporary pullback to $75. Instead of buying the June 80 puts\nfor 1.75, the trader can buy the 75–80 put spread of the same month for\n1.30 because the 75 put can be sold for 0.45. 1\nIn this example, the June put has 40 days until expiration. Exhibit 9.7\nillustrates the payout at expiration.\nEXHIBIT 9.7 ExxonMobil bear put spread.\nIf the trader is wrong and ExxonMobil is still above 80 at expiry, both\nputs expire and the 1.30 premium is lost. If ExxonMobil is between the two\nstrikes, the 80 puts are ITM, resulting in an exercise, and the 75 puts are\nOTM and expire. The net effect is short stock at an effective price of\n$78.70. The effective sale price is found by taking the price at which the\nshort stock is established when the puts are exercised—$80—minus the net\n1.30 paid for the spread. This is the spread’s breakeven at expiration.\nIf the trader is right and ExxonMobil is below both strikes at expiration,\nboth puts are ITM, and the result is a 3.70 profit and no position. Why a\n3.70 profit? The 80 puts are exercised, making the trader short at $80, and\nthe 75 puts are assigned, so the short is bought back at $75 for a positive\nstock scalp of $5. Including the 1.30 debit for the spread in the profit and\nloss (P&(L)), the net profit is $3.70 per share when the stock is below both\nstrikes at expiration.\nThis is a bearish trade. But is the bear put spread necessarily a better trade\nthan buying an outright ATM put? No. The at-expiration diagram makes this\nclear. Profits are limited to $3.70 per share. This is an important difference.\nBut because in this particular example, the trader expects the stock to\nretrace only to around $75, the benefits of lower cost and lower theta and\nvega risk can be well worth the trade-off of limited profit. The trader’s\nobjectives are met more efficiently by buying the spread. The goal is to\nprofit from the delta move down from $80 to $75. Exhibit 9.8 shows the\ndifferences between the greeks of the outright put and the spread when the\ntrade is put on with ExxonMobil at $80.55.\nEXHIBIT 9.8 ExxonMobil put vs. bear put spread (ExxonMobil @\n$80.55).\n80 Put75–80 Put\nDelta −0.445−0.300\nGamma+0.080+0.041\nTheta −0.018−0.006\nVega +0.110+0.046\nAs in the call-spread examples discussed previously, the spread delta is\nsmaller than the outright put’s. It appears ironic that the spread with the\nsmaller delta is a better trade in this situation, considering that the intent is\nto profit from direction. But it is the relative differences in the greeks\nbesides delta that make the spread worthwhile given the trader’s goal.\nGamma, theta, and vega are proportionately much smaller than the delta in\nthe spread than in the outright put. While the spread’s delta is two thi", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 58}
{"text": "that the spread with the\nsmaller delta is a better trade in this situation, considering that the intent is\nto profit from direction. But it is the relative differences in the greeks\nbesides delta that make the spread worthwhile given the trader’s goal.\nGamma, theta, and vega are proportionately much smaller than the delta in\nthe spread than in the outright put. While the spread’s delta is two thirds\nthat of the put, its gamma is half, its theta one third, and its vega around 42\npercent of the put’s.\nRetracements such as the one called for by the trader in this example can\nhappen fast, sometimes over the course of a week or two. It’s not\nnecessarily bad if this move occurs quickly. If ExxonMobil drops by $5\nright away, the short delta will make the position profitable. Exhibit 9.9\nshows how the spread position changes as the stock declines from $80 to\n$75.\nEXHIBIT 9.9 75–80 bear put spread as ExxonMobil declines.\n\nThe delta of this trade remains negative throughout the stock’s descent to\n$75. Assuming the $5 drop occurs in one day, a delta averaging around\n−0.36 means about a 1.80 profit, or $180 per spread, for the $5 move (0.36\ntimes $5 times 100). This is still a far cry from the spread’s $3.70 potential\nprofit. Although the stock is at $75, the maximum profit potential has yet to\nbe reached, and it won’t be until expiration. How does the rest of the profit\nmaterialize? Time decay.\nThe price the trader wants the stock to reach is $75, but the assumption\nhere is that the move happens very fast. The trade went from being a long-\nvolatility play—long gamma and vega—to a short-vol play: short gamma\nand vega. The trader wanted movement when the stock was at $80 and\nwants no movement when the stock is at $75. When the trade changes\ncharacteristics by moving from one strike to another, the trader has to\nreconsider the stock’s outlook. The question is: if I didn’t have this position\non, would I want it now?\nThe trader has a choice to make: take the $180 profit—which represents a\n138 percent profit on the 1.30 debit—or wait for theta to do its thing. The\ntrader looking for a retracement would likely be inclined to take a profit on\nthe trade. Nobody ever went broke taking a profit. But if the trader thinks\nthe stock will sit tight for the remaining time until expiration, he will be\nhappy with this income-generating position.\nAlthough the trade in the last, overly simplistic example did not reap its\nfull at-expiration potential, it was by no means a bad trade. Holding the\nspread until expiration is not likely to be part of a trader’s plan. Buying the\n80 put outright may be a better play if the trader is expecting a fast move. It\nwould have a bigger delta than the spread. Debit and credit spreads can be\nused as either income generators or as delta plays. When they’re used as\ndelta plays, however, time must be factored in.\nBull Put Spread\nThe last of the four vertical spreads is a bull put spread. A bull put spread is\na short put with one strike and a long put with a lower strike. Both puts are\non the same underlying and in the same expiration cycle. A bull put spread\nis a credit spread because the more expensive option is being sold, resulting\nin a net credit when the position is established. Using the same options as in\nthe bear put example:\nWith ExxonMobil at $80.55, the June 80 puts are sold for 1.75 and the\nJune 75 puts are bought at 0.45. The trade is done for a credit of 1.30.\nExhibit 9.10 shows the payout of this spread if it is held until expiration.\nEXHIBIT 9.10 ExxonMobil bull put spread.\nThe sale of this spread generates a 1.30 net credit, which is represented by\nthe maximum profit to the right of the 80 strike. With ExxonMobil above\n$80 per share at expiration, both options expire OTM and the premium is\nall profit. Between the two strike prices, the 80 put expires in the money. If\nthe ITM put is still held at expiration, it will be assigned. Upon assignment,\nthe put becomes long stock, profiting with each tick higher up to $80, or\nlosing with each tick lower to $75. If the 80 put is assigned, the effective\nprice of the long stock will be $78.70. The assignment will “hit your sheets”\nas a buy at $80, but the 1.30 credit lowers the effective net cost to $78.70.\nIf the stock is below $75 at option expiration, both puts will be ITM. This\nis the worst case scenario, because the higher-struck put was sold. At\nexpiration, the 80 puts would be assigned, the 75 puts exercised. That’s a\nnegative scalp of $5 on the resulting stock. The initial credit lessens the pain\nby 1.30. The maximum possible loss with ExxonMobil below both strikes\nat expiration is $3.70 per spread.\nThe spread in this example is the flip side of the bear put spread of the\nprevious example. Instead of buying the spread, as with the bear put, the\nspread in this case is sold.\nExhibit 9.11 shows the analytics for the bull put spread.\nEXHIBIT 9.11 Greeks for ExxonMobil 75–80 bull put spread.\nInstead of having a short delta, as with the bear spread, the bull spread is\nlong delta. There is negative theta with positive gamma and vega as XOM\napproaches the long strike—the 75s, in this case. There is also positive theta\nwith negative gamma and vega around the short strike—the 80s.\nExhibit 9.11 shows the characteristics that define the vertical spread. If\none didn’t know which particular options were being traded here, this could\nalmost be a table of greeks for either a 75–80 bull put spread or a 75–80\nbull call spread.\nLike the other three verticals, this spread can be a delta play or a theta\nplay. A bullish trader may sell the spread if both puts are in-the-money.\nImagine that XOM is trading at around $75. The spread will have a positive\n0.364 delta, positive gamma, and negative theta. The spread as a whole is a\ndecaying asset. It needs the underlying to rally to combat time decay.\nA bullish trader may also sell this spread if XOM is between the two\nstrikes. In this case, with XOM at, say, $77, the delta is +0.388, and all\nother gree", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 59}
{"text": "puts are in-the-money.\nImagine that XOM is trading at around $75. The spread will have a positive\n0.364 delta, positive gamma, and negative theta. The spread as a whole is a\ndecaying asset. It needs the underlying to rally to combat time decay.\nA bullish trader may also sell this spread if XOM is between the two\nstrikes. In this case, with XOM at, say, $77, the delta is +0.388, and all\nother greeks are negligible. At this particular price point in the underlying,\nthe trader has almost pure leveraged delta exposure. But this trade would be\npositioned for only a small move, not much above $80. A speculator\nwanting to trade direction for a small move while eliminating theta and\nvega risks achieves her objectives very well with a vertical spread.\nA bullish-to-neutral trader would be inclined to sell this spread if\nExxonMobil were around $80 or higher. Day by day, the 1.30 premium\nwould start to come in. With 40 days until expiration, theta would be small,\nonly 0.004. But if the stock remained at $80, this ATM put would begin\ndecaying faster and faster. The objective of trading this spread for a neutral\ntrader is selling future realized volatility—selling gamma to earn theta. A\ntrader can also trade a vertical spread to profit from IV.\nVerticals and Volatility\nThe IV component of a vertical spread, although small compared with that\nof an outright call or put, is still important—especially for large traders with\nlow margin and low commissions who can capitalize on small price\nchanges efficiently. Whether it’s a call spread or a put spread, a credit\nspread or a debit spread, if the underlying is at the short option’s strike, the\nspread will have a net negative vega. If the underlying is at the long\noption’s strike, the spread will have positive vega. Because of this\ncharacteristic, there are three possible volatility plays with vertical spreads:\nspeculating on IV changes when the underlying remains constant, profiting\nfrom IV changes resulting from movement of the underlying, and special\nvolatility situations.\nVertical spreads offer a limited-risk way to speculate on volatility changes\nwhen the underlying remains fairly constant. But when the intent of a\nvertical spread is to benefit from vega, one must always consider the delta\n—it’s the bigger risk. Chapter 13 discusses ways to manage this risk by\nhedging with stock, a strategy called delta-neutral trading.\nNon-delta-neutral traders may speculate on vol with vertical spreads by\nassuming some delta risk. Traders whose forecast is vega bearish will sell\nthe option with the strike closest to where the underlying is trading—that is,\nthe ATM option—and buy an OTM strike. Traders would lean with their\ndirectional bias by choosing either a call spread or a put spread. As risk\nmanagers, the traders balance the volatility stance being taken against the\nadditional risk of delta. Again, in this scenario, delta can hurt much more\nthan help.\nIn the ExxonMobil bull put spread example, the trader would sell the 80-\nstrike put if ExxonMobil were around $80 a share. In this case, if the stock\ndidn’t move as time passed, theta would benefit from historical volatility\nbeing’s low—that is, from little stock movement. At first, the benefit would\nbe only 0.004 per day, speeding up as expiration nears. And if implied\nvolatility decreased, the trader would profit 0.04 for every 1 percent decline\nin IV. Small directional moves upward help a little. But in the long run,\nthose profits are leveled off by the fact that theta gets smaller as the stock\nmoves higher above $80—more profit on direction, less on time.\nFor the delta player, bull call spreads and bull put spreads have a potential\nadded benefit that stems from the fact that IV tends to decrease as stocks\nrise and increase when stocks fall. This offers additional opportunity to the\nbull spread player. With the bull call spread or the bull put spread, the trader\ngains on positive delta with a rally. Once the underlying comes close to the\nshort option’s strike, vega is negative. If IV declines, as might be\nanticipated, there is a further benefit of vega profits on top of delta profits.\nIf the underlying declines, the trader loses on delta. But the pain can\npotentially be slightly lessened by vega profits. Vega will get positive as the\nunderlying approaches the long strike, which will benefit from the firming\nof IV that often occurs when the stock drops. But this dual benefit is paid\nfor in the volatility skew. In most stocks or indexes, the lower strikes—the\nones being bought in a bull spread—have higher IVs than the higher strikes,\nwhich are being sold.\nThen there are special market situations in which vertical spreads that\nbenefit from volatility changes can be traded. Traders can trade vertical\nspreads to strategically position themselves for an expected volatility\nchange. One example of such a situation is when a stock is rumored to be a\ntakeover target. A natural instinct is to consider buying calls as an\ninexpensive speculation on a jump in price if the takeover is announced.\nUnfortunately, the IV of the call is often already bid up by others with the\nsame idea who were quicker on the draw. Buying a call spread consisting of\na long ITM call and a short OTM call can eliminate immediate vega risk\nand still provide wanted directional exposure.\nCertainly, with this type of trade, the trader risks being wrong in terms of\ndirection, time, and volatility. If and when a takeover bid is announced, it\nwill likely be for a specific price. In this event, the stock price is unlikely to\nrise above the announced takeover price until either the deal is\nconsummated or a second suitor steps in and offers a higher price to buy the\ncompany. If the takeover is a “cash deal,” meaning the acquiring company\nis tendering cash to buy the shares, the stock will usually sit in a very tight\nrange below the takeover price for a long time. In this event, implied\nvolatility will often drop to very low levels. Being short an ATM call when\nth", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 60}
{"text": "l either the deal is\nconsummated or a second suitor steps in and offers a higher price to buy the\ncompany. If the takeover is a “cash deal,” meaning the acquiring company\nis tendering cash to buy the shares, the stock will usually sit in a very tight\nrange below the takeover price for a long time. In this event, implied\nvolatility will often drop to very low levels. Being short an ATM call when\nthe stock rallies will let the trader profit from collapsing IV through\nnegative vega.\nSay XYZ stock, trading at $52 a share, is a rumored takeover target at\n$60. When the rumors are first announced, the stock will likely rise, to say\n$55, with IV rising as well. Buying the 50–60 call spread will give a trader\na positive delta and a negligible vega. If the rumors are realized and a cash\ntakeover deal is announced at $60, the trade gains on delta, and the spread\nwill now have negative vega. The negative vega at the 60 strike gains on\nimplied volatility declining, and the stock will sit close to $60, producing\nthe benefits of positive theta. Win, win, win.\nThe Interrelations of Credit\nSpreads and Debit Spreads\nMany traders I know specialize in certain niches. Sometimes this is because\nthey find something they know well and are really good at. Sometimes it’s\nbecause they have become comfortable and don’t have the desire to try\nanything new. I’ve seen this strategy specialization sometimes with traders\ntrading credit spreads and debit spreads. I’ve had serial credit spread traders\ntell me credit spreads are the best trades in the world, much better than debit\nspreads. Habitual debit spread traders have likewise said their chosen\nspread is the best. But credit spreads and debit spreads are not so different.\nIn fact, one could argue that they are really the same thing.\nConventionally, credit-spread traders have the goal of generating income.\nThe short option is usually ATM or OTM. The long option is more OTM.\nThe traders profit from nonmovement via time decay. Debit-spread traders\nconventionally are delta-bet traders. They buy the ATM or just out-of-the-\nmoney option and look for movement away from or through the long strike\nto the short strike. The common themes between the two are that the\nunderlying needs to end up around the short strike price and that time has to\npass to get the most out of either spread.\nWith either spread, movement in the underlying may be required,\ndepending on the relationship of the underlying price to the strike prices of\nthe options. And certainly, with a credit spread or debit spread, if the\nunderlying is at the short strike, that option will have the most premium.\nFor the trade to reach the maximum profit, it will need to decay.\nFor many retail traders, debit spreads and credit spreads begin to look\neven more similar when margin is considered. Margin requirements can\nvary from firm to firm, but verticals in retail accounts at option-friendly\nbrokerage firms are usually margined in such a way that the maximum loss\nis required to be deposited to hold the position (this assumes Regulation T\nmargining). For all intents and purposes, this can turn the trader’s cash\nposition from a credit into a debit. From a cash perspective, all vertical\nspreads are spreads that require a debit under these margin requirements.\nProfessional traders and retail traders who are subject to portfolio margining\nare subject to more liberal margin rules.\nAlthough margin is an important concern, what we really care about as\ntraders is risk versus reward. A credit call spread and a debit put spread on\nthe same underlying, with the same expiration month, sharing the same\nstrike prices will also share the same theoretical risk profile. This is because\ncall and put prices are bound together by put-call parity.\nBuilding a Box\nTwo traders, Sam and Isabel, share a joint account. They have each been\nstudying Johnson & Johnson (JNJ), which is trading at around $63.35 per\nshare. Sam and Isabel, however, cannot agree on direction. Sam thinks\nJohnson & Johnson will rise over the next five weeks, and Isabel believes it\nwill decline during that period.\nSam decides to buy the January 62.50 −65 call spread (January has 38\ndays until expiration in this example). Sam can buy this spread for 1.28. His\nmaximum risk is 1.28. This loss occurs if Johnson & Johnson is below\n$62.50 at expiration, leaving both calls OTM. His maximum gain is 1.22,\nrealized if Johnson & Johnson is above $65 (65–62.50–1.28). With Johnson\n& Johnson at $63.35, Sam’s delta is long 0.29 and his other greeks are\nabout flat.\nIsabel decides to buy the January 62.50–65 put spread for a debit of 1.22.\nIsabel’s biggest potential loss is 1.22, incurred if Johnson & Johnson is\nabove $65 a share at expiration, leaving both puts OTM. Her maximum\npossible profit is 1.28, realized if the stock is below $62.50 at option\nexpiration. With Johnson & Johnson at $63.35, Isabel has a delta that is\nshort around 0.27 and is nearly flat gamma, theta, and vega.\nCollectively, if both Sam and Isabel hold their trades until expiration, it’s\na zero-sum game. With Johnson & Johnson below $62.50, Sam loses his\ninvestment of 1.28, but Isabel profits. She cancels out Sam’s loss by making\n1.28. Above $65, Sam makes 1.22 while Isabel loses the same amount,\ncanceling out Sam’s gains. Between the two strikes, Sam has gains on his\n62.50 call and Isabel has gains on her 65 put. The gains on the two options\nwill total 2.50, the combined total spent on the spreads—another draw.\nEXHIBIT 9.12 Sam’s long call spread in Johnson & Johnson.\n62.50–65 Call Spread\nDelta +0.290\nGamma+0.001\nTheta −0.004\nVega +0.006\nEXHIBIT 9.13 Isabel’s long put spread in Johnson & Johnson.\n62.50–65 Put Spread\nDelta −0.273\nGamma−0.001\nTheta +0.005\nVega −0.006\nThese two spreads were bought for a combined total of 2.50. The\ncollective position, composed of the four legs of these two spreads, forms a\nnew strategy altogether.\nThe two traders together have created a box. This box, which is empty of\nboth profit and loss, is", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 61}
{"text": "+0.006\nEXHIBIT 9.13 Isabel’s long put spread in Johnson & Johnson.\n62.50–65 Put Spread\nDelta −0.273\nGamma−0.001\nTheta +0.005\nVega −0.006\nThese two spreads were bought for a combined total of 2.50. The\ncollective position, composed of the four legs of these two spreads, forms a\nnew strategy altogether.\nThe two traders together have created a box. This box, which is empty of\nboth profit and loss, is represented by greeks that almost entirely offset each\nother. Sam’s positive delta of 0.29 is mostly offset by Isabel’s −0.273 delta.\nGamma, theta, and vega will mostly offset each other, too.\nChapter 6 described a box as long synthetic stock combined with short\nsynthetic stock having a different strike price but the same expiration\nmonth. It can also be defined, however, as two vertical spreads: a bull (bear)\ncall spread plus a bear (bull) put spread with the same strike prices and\nexpiration month.\nThe value of a box equals the present value of the distance between the\ntwo strike prices (American-option models will also account for early\nexercise potential in the box’s value). This 2.50 box, with 38 days until\nexpiration at a 1 percent interest rate, has less than a penny of interest\naffecting its value. Boxes with more time until expiration will have a higher\ninterest rate component. If there was one year until expiration, the\ncombined value of the two verticals would equal 2.475. This is simply the\ndistance between the strikes minus interest (2.50–[2.50 × 0.01]).\nCredit spreads are often made up of OTM options. Traders betting against\na stock rising through a certain price tend to sell OTM call spreads. For a\nstock at $50 per share, they might sell the 55 calls and buy the 60 calls. But\nbecause of the synthetic relationship that verticals have with one another,\nthe traders could buy an ITM put spread for the same exposure, after\naccounting for interest. The traders could buy the 60 puts and sell the 55\nputs. An ITM call (put) spread is synthetically equal to an OTM put (call)\nspread.\nVerticals and Beyond\nTraders who want to take full advantage of all that options have to offer can\ndo so strategically by trading spreads. Vertical spreads truncate directional\nrisk compared with strategies like the covered call or single-legged option\ntrades. They also reduce option-specific risk, as indicated by their lower\ngamma, theta, and vega. But lowering risk both in absolute terms and in the\ngreeks has a trade-off compared with buying options: limited profit\npotential. This trade-off can be beneficial, depending on the trader’s\nforecast. Debit spreads and credit spreads can be traded interchangeably to\nachieve the same goals. When a long (short) call spread is combined with a\nlong (short) put spread, the product is a box. Chapter 10 describes other\nways vertical spreads can be combined to form positions that achieve\ndifferent trading objectives.\nNote\n1 . Note that it is customary when discussing the purchase or sale of\nspreads to state the lower strike first, regardless of which is being bought\nor sold. In this case, the trader is buying the 75–80 put spread.\nCHAPTER 10\nWing Spreads\nCondors and Butterflies\nThe “wing spread” family is a set of option strategies that is very popular,\nparticularly among experienced traders. These strategies make it possible\nfor speculators to accomplish something they could not possibly do by just\ntrading stocks: They provide a means to profit from a truly neutral market\nin a security. Stocks that don’t move one iota can earn profits month after\nmonth for income-generating traders who trade these strategies.\nThese types of spreads have a lot of moving parts and can be intimidating\nto newcomers. At their heart, though, they are rather straightforward break-\neven analysis trades that require little complex math to maintain. A simple\nat-expiration diagram reveals in black and white the range in which the\nunderlying stock must remain in order to have a profitable position.\nHowever, applying the greeks and some of the mathematics discussed in\nprevious chapters can help a trader understand these strategies on a deeper\nlevel and maximize the chance of success. This chapter will discuss condors\nand butterflies and how to put them into action most effectively.\nTaking Flight\nThere are four primary wing spreads: the condor, the iron condor, the\nbutterfly, and the iron butterfly. Each of these spreads involves trading\nmultiple options with three or four strikes prices. We can take these spreads\nat face value, we can consider each option as an individual component of\nthe spread, or we can view the spreads as being made up of two vertical\nspreads.\nCondor\nA condor is a four-legged option strategy that enables a trader to capitalize\non volatility—increased or decreased. Traders can trade long or short iron\ncondors.\nLong Condor\nLong one call (put) with strike A; short one call (put) with a higher strike,\nB; short one call (put) at strike C, which is higher than B; and long one call\n(put) at strike D, which is higher than C. The distance between strike price\nA and B is equal to the distance between strike C and strike D. The options\nare all on the same security, in the same expiration cycle, and either all calls\nor all puts.\nLong Condor Example\nBuy 1 XYZ November 70 call (A)\nSell 1 XYZ November 75 call (B)\nSell 1 XYZ November 90 call (C)\nBuy 1 XYZ November 95 call (D)\nShort Condor\nShort one call (put) with strike A; long one call (put) with a higher strike, B;\nlong one call (put) with a strike, C, that is higher than B; and short one call\n(put) with a strike, D, that is higher than C. The options must be on the\nsame security, in the same expiration cycle, and either all calls or all puts.\nThe differences in strike price between the vertical spread of strike prices A\nand B and the strike prices of the vertical spread of strikes C and D are\nequal.\nShort Condor Example\nSell 1 XYZ November 70 call (A)\nBuy 1 XYZ November 75 call (B)\nBuy 1 XYZ November 90 call (C)\nSell 1 XYZ November 95 call (D)", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 62}
{"text": "must be on the\nsame security, in the same expiration cycle, and either all calls or all puts.\nThe differences in strike price between the vertical spread of strike prices A\nand B and the strike prices of the vertical spread of strikes C and D are\nequal.\nShort Condor Example\nSell 1 XYZ November 70 call (A)\nBuy 1 XYZ November 75 call (B)\nBuy 1 XYZ November 90 call (C)\nSell 1 XYZ November 95 call (D)\nIron Condor\nAn iron condor is similar to a condor, but with a mix of both calls and puts.\nEssentially, the condor and iron condor are synthetically the same.\nShort Iron Condor\nLong one put with strike A; short one put with a higher strike, B; short one\ncall with an even higher strike, C; and long one call with a still higher\nstrike, D. The options are on the same security and in the same expiration\ncycle. The put credit spread has the same distance between the strike prices\nas the call credit spread.\nShort Iron Condor Example\nBuy 1 XYZ November 70 put (A)\nSell 1 XYZ November 75 put (B)\nSell 1 XYZ November 90 call (C)\nBuy 1 XYZ November 95 call (D)\nLong Iron Condor\nShort one put with strike A; long one put with a higher strike, B; long one\ncall with an even higher strike, C; and short one call with a still higher\nstrike, D. The options are on the same security and in the same expiration\ncycle. The put debit spread (strikes A and B) has the same distance between\nthe strike prices as the call debit spread (strikes C and D).\nLong Iron Condor Example\nSell 1 XYZ November 70 put (A)\nBuy 1 XYZ November 75 put (B)\nBuy 1 XYZ November 90 call (C)\nSell 1 XYZ November 95 call (D)\nButterflies\nButterflies are wing spreads similar to condors, but there are only three\nstrikes involved in the trade—not four.\nLong Butterfly\nLong one call (put) with strike A; short two calls (puts) with a higher strike,\nB; and long one call (put) with an even higher strike, C. The options are on\nthe same security, in the same expiration cycle, and are either all calls or all\nputs. The difference in price between strikes A and B equals that between\nstrikes B and C.\nLong Butterfly Example\nBuy 1 XYZ December 50 call (A)\nSell 2 XYZ December 60 call (B)\nBuy 1 XYZ December 70 call (C)\nShort Butterfly\nShort one call (put) with strike A; long two calls (puts) with a higher strike,\nB; and short one call (put) with an even higher strike, C. The options are on\nthe same security, in the same expiration cycle, and are either all calls or all\nputs. The vertical spread made up of the options with strike A and strike B\nhas the same distance between the strike prices of the vertical spread made\nup of the options with strike B and strike C.\nShort Butterfly Example\nSell 1 XYZ December 50 call\nBuy 2 XYZ December 60 call\nSell 1 XYZ December 70 call\nIron Butterflies\nMuch like the relationship of the condor to the iron condor, a butterfly has\nits synthetic equal as well: the iron butterfly.\nShort Iron Butterfly\nLong one put with strike A; short one put with a higher strike, B; short one\ncall with strike B; long one call with a strike higher than B, C. The options\nare on the same security and in the same expiration cycle. The distances\nbetween the strikes of the put spread and between the strikes of the call\nspread are equal.\nShort Iron Butterfly Example\nBuy 1 XYZ December 50 put (A)\nSell 1 XYZ December 60 put (B)\nSell 1 XYZ December 60 call (B)\nBuy 1 XYZ December 70 call (C)\nLong Iron Butterfly\nShort one put with strike A; long one put with a higher strike, B; long one\ncall with strike B; short one call with a strike higher than B, C. The options\nare on the same security and in the same expiration cycle. The distances\nbetween the strikes of the put spread and between the strikes of the call\nspread are equal. The put debit spread has the same distance between the\nstrike prices as the call debit spread.\nLong Iron Butterfly Example\nSell 1 XYZ December 50 put\nBuy 1 XYZ December 60 put\nBuy 1 XYZ December 60 call\nSell 1 XYZ December 70 call\nThese spreads were defined in terms of both long and short for each\nstrategy. Whether the spread is classified as long or short depends on\nwhether it was established at a credit or a debit. Debit condors or butterflies\nare considered long spreads. And credit condors or butterflies are\nconsidered short spreads.\nThe words long and short mean little, though in terms of the spread as a\nwhole. The important thing is which strikes have long options and which\nhave short options. A call debit spread is synthetically equal to a put credit\nspread on the same security, with the same expiration month and strike\nprices. That means a long condor is synthetically equal to a short iron\ncondor, and a long butterfly is synthetically equal to a short iron butterfly,\nwhen the same strikes are used. Whichever position is constructed, the best-\ncase scenario is to have debit spreads expire with both options in-the-money\n(ITM) and credit spreads expire with both options out-of-the-money\n(OTM).\nMany retail traders prefer trading these spreads for the purpose of\ngenerating income. In this case, a trader would sell the guts, or middle\nstrikes, and buy the wings, or outer strikes. When a trader is short the guts,\nlow realized volatility is usually the objective. For long butterflies and short\niron butterflies, the stock needs to be right at the middle strike for the\nmaximum payout. For long condors and short iron condors, the stock needs\nto be between the short strikes at expiration for maximum payout. In both\ninstances, the wings are bought to limit potential losses of the otherwise\nnaked options.\nLong Butterfly Example\nA trader, Kathleen, has been studying United Parcel Service (UPS), which\nis trading at around $70.65. She believes UPS will trade sideways until July\nexpiration. Kathleen buys the July 65–70–75 butterfly for 2.00. She\nexecutes the following legs:\nKathleen looks at her trade as two vertical spreads, the 65–70 bull (debit)\ncall spread and the 70–75 bear (credit) call spread. Intuitively, she would\nwant UPS to be at or above $70 at exp", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 63}
{"text": "g United Parcel Service (UPS), which\nis trading at around $70.65. She believes UPS will trade sideways until July\nexpiration. Kathleen buys the July 65–70–75 butterfly for 2.00. She\nexecutes the following legs:\nKathleen looks at her trade as two vertical spreads, the 65–70 bull (debit)\ncall spread and the 70–75 bear (credit) call spread. Intuitively, she would\nwant UPS to be at or above $70 at expiration for her bull call spread to have\nmaximum value. But she has the seemingly conflicting goal of also wanting\nUPS to be at or below $70 to get the most from her 70–75 bear call spread.\nThe ideal price for the stock to be trading at expiration in this example is\nright at $70 per share—the best of both worlds. The at-expiration diagram,\nExhibit 10.1 , shows the profit or loss of all possible outcomes at expiration.\nEXHIBIT 10.1 UPS 65–70–75 butterfly.\nIf the price of UPS shares declines below $65 at expiration, all these calls\nwill expire. The entire 2.00 spent on the trade will be lost. If UPS is above\n$65 at expiration, the 65 call will be ITM and will be exercised. The call\nwill profit like a long position in 100 shares of the underlying. The\nmaximum profit is reached if UPS is at $70 at expiration. Kathleen makes a\n5.00 profit from $65 to $70 on her 65 calls. But because she paid 2.00\ninitially for the spread, her net profit at $70 is just 3.00. If UPS is above $70\na share at expiration in this example, the two 70 calls will be assigned. The\nassignment of one call will offset the long stock acquired by the 65 calls\nbeing exercised. Assignment of the other call will create a short position in\nthe underlying. That short position loses as UPS moves higher up to $75 a\nshare, eating away at the 3.00 profit. If UPS is above $75 at expiration, the\n75 call can be exercised to buy back the short stock position that resulted\nfrom the 70’s being assigned. The loss on the short stock between $70 and\n$75 will cost Kathleen 5.00, stripping her of her 3.00 profit and giving her a\nnet loss of 2.00 to boot. End result? Above $75 at expiration, she has no\nposition in the underlying and loses 2.00.\nA butterfly is a break-even analysis trade . This name refers to the idea\nthat the most important considerations in this strategy are the breakeven\npoints. The at-expiration diagram, Exhibit 10.2 , shows the break-even\nprices for this trade.\nEXHIBIT 10.2 UPS 65–70–75 butterfly breakevens.\nIf the position is held until expiration and UPS is between $65 and $70 at\nthat time, the 65 calls are exercised, resulting in long stock. The effective\npurchase price of that stock is $67. That’s the strike price plus the cost of\nthe spread; that’s the lower break-even price. The other break-even is at\n$73. The net short position of 100 shares resulting from assignment of the\n70 call loses more as the stock rises between $70 and $75. The entire 3.00\nprofit realized at the $70 share price is eroded when the stock reaches $73.\nAbove $73, the trade produces a loss.\nKathleen’s trading objective is to profit from UPS trading between $67\nand $73 at expiration. The best-case scenario is that it declines only slightly\nfrom its price of $70.65 when the trade is established, to $70 per share.\nAlternatives\nKathleen had other alternative positions she could have traded to meet her\ngoals. An iron butterfly with the same strike prices would have shown about\nthe same risk/reward picture, because the two positions are synthetically\nequivalent. But there may, in some cases, be a slight advantage to trading\nthe iron butterfly over the long butterfly. The iron butterfly uses OTM put\noptions instead of ITM calls, meaning the bid-ask spreads may be tighter.\nThis means giving up less edge to the liquidity providers.\nShe could have also bought a condor or sold an iron condor. With condor-\nfamily spreads, there is a lower maximum profit potential but a wider range\nin which that maximum payout takes place. For example, Kathleen could\nhave executed the following legs to establish an iron condor:\nEssentially, Kathleen would be selling two credit spreads: the July 60–65\nput spread for 0.30 and the July 75–80 call spread for 0.35. Exhibit 10.3\nshows the payout at expiration of the UPS July 60–65–75–80 iron condor.\nEXHIBIT 10.3 UPS 60–65–75–80 iron condor.\nAlthough the forecast and trading objectives may be similar to those for\nthe butterfly, the payout diagram reveals some important differences. First,\nthe maximum loss is significantly higher with a condor or iron condor. In\nthis case, the maximum loss is 4.35. This unfortunate situation would occur\nif UPS were to drop to below $60 or rise above $80 by expiration. Below\n$60, the call spread expires, netting 0.35. But the put spread is ITM.\nKathleen would lose a net of 4.70 on the put spread. The gain on the call\nspread combined with the loss on the put spread makes the trade a loser of\n4.35 if the stock is below $60 at expiration. Above $80, the put spread is\nworthless, earning 0.30, but the call spread is a loser by 4.65. The gain on\nthe put spread plus the loss on the call spread is a net loser of 4.35. Between\n$65 and $75, all options expire and the 0.65 credit is all profit.\nSo far, this looks like a pretty lousy alternative to the butterfly. You can\nlose 4.35 but only make 0.65! Could there be any good reason for making\nthis trade? Maybe. The difference is wiggle room. The breakevens are 2.65\nwider in each direction with the iron condor. Exhibit 10.4 shows these\nprices on the graph.\nEXHIBIT 10.4 UPS 60–65–75–80 iron condor breakevens.\nThe lower threshold for profit occurs at $64.35 and the upper at $75.65.\nWith condor/iron condors, there can be a greater chance of producing a\nwinning trade because the range is wider than that of the butterfly. This\nbenefit, however, has a trade-off of lower potential profit. There is always a\nparallel relationship of risk and reward. When risk increases so does\nreward, and vice versa. This way of thinking should now be ingrained in\nyour DNA. The risk of failure is les", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 64}
{"text": "th condor/iron condors, there can be a greater chance of producing a\nwinning trade because the range is wider than that of the butterfly. This\nbenefit, however, has a trade-off of lower potential profit. There is always a\nparallel relationship of risk and reward. When risk increases so does\nreward, and vice versa. This way of thinking should now be ingrained in\nyour DNA. The risk of failure is less, so the payout is less. Because the\nodds of winning are higher, a trader will accept lower payouts on the trade.\nKeys to Success\nNo matter which trade is more suitable to Kathleen’s risk tolerance, the\noverall concept is the same: profit from little directional movement. Before\nKathleen found a stock on which to trade her spread, she will have sifted\nthrough myriad stocks to find those that she expects to trade in a range. She\nhas a few tools in her trading toolbox to help her find good butterfly and\ncondor candidates.\nFirst, Kathleen can use technical analysis as a guide. This is a rather\nstraightforward litmus test: does the stock chart show a trending, volatile\nstock or a flat, nonvolatile stock? For the condor, a quick glance at the past\nfew months will reveal whether the stock traded between $65 and $75. If it\ndid, it might be a good iron condor candidate. Although this very simplistic\napproach is often enough for many traders, those who like lots of graphs\nand numbers can use their favorite analyses to confirm that the stock is\ntrading in a range. Drawing trendlines can help traders to visualize the\nchannel in which a stock has been trading. Knowing support and resistance\nis also beneficial. The average directional movement index (ADX) or\nmoving average converging/diverging (MACD) indicator can help to show\nif there is a trend present. If there is, the stock may not be a good candidate.\nSecond, Kathleen can use fundamentals. Kathleen wants stocks with\nnothing on their agendas. She wants to avoid stocks that have pending\nevents that could cause their share price to move too much. Events to avoid\nare earnings releases and other major announcements that could have an\nimpact on the stock price. For example, a drug stock that has been trading\nin a range because it is awaiting Food and Drug Administration (FDA)\napproval, which is expected to occur over the next month, is not a good\ncandidate for this sort of trade.\nThe last thing to consider is whether the numbers make sense. Kathleen’s\niron condor risks 4.35 to make 0.65. Whether this sounds like a good trade\ndepends on Kathleen’s risk tolerance and the general environment of UPS,\nthe industry, and the market as a whole. In some environments, the\n0.65/4.35 payout-to-risk ratio makes a lot of sense. For other people, other\nstocks, and other environments, it doesn’t.\nGreeks and Wing Spreads\nMuch of this chapter has been spent on how wing spreads perform if held\nuntil expiration, and little has been said of option greeks and their role in\nwing spreads. Greeks do come into play with butterflies and condors but not\nnecessarily the same way they do with other types of option trades.\nThe vegas on these types of spreads are smaller than they are on many\nother types of strategies. For a typical nonprofessional trader, it’s hard to\ntrade implied volatility with condors or butterflies. The collective\ncommissions on the four legs, as well as margin and capital considerations,\nput these out of reach for active trading. Professional traders and retail\ntraders subject to portfolio margining are better equipped for volatility\ntrading with these spreads.\nThe true strength of wing spreads, however, is in looking at them as\nbreak-even analysis trades much like vertical spreads. The trade is a winner\nif it is on the correct side of the break-even price. Wing spreads, however,\nare a combination of two vertical spreads, so there are two break-even\nprices. One of the verticals is guaranteed to be a winner. The stock can be\neither higher or lower at expiration—not both. In some cases, both verticals\ncan be winners.\nConsider an iron condor. Instead of reaping one premium from selling one\nOTM call credit spread, iron condor sellers double dip by additionally\nselling an OTM put credit spread. They collect a double credit, but only one\nof the credit spreads can be a loser at expiration. The trader, however, does\nhave to worry about both directions independently.\nThere are two ways for greeks and volatility analysis to help traders trade\nwing spreads. One of them involves using delta and theta as tools to trade a\ndirectional spread. The other uses implied volatility in strike selection\ndecisions.\nDirectional Butterflies\nTrading a butterfly can be an excellent way to establish a low-cost,\nrelatively low-risk directional trade when a trader has a specific price target\nin mind. For example, a trader, Ross, has been studying Walgreen Co.\n(WAG) and believes it will rise from its current level of $33.50 to $36 per\nshare over the next month. Ross buys a butterfly consisting of all OTM\nJanuary calls with 31 days until expiration.\nHe executes the following legs:\nAs a directional trade alternative, Ross could have bought just the January\n35 call for 1.15. As a cheaper alternative, he could have also bought the 35–\n36 bull call spread for 0.35. In fact, Ross actually does buy the 35–36\nspread, but he also sells the January 36–37 call spread at 0.25 to reduce the\ncost of the bull call spread, investing only a dime. The benefit of lower cost,\nhowever, comes with trade-offs. Exhibit 10.5 compares the bull call spread\nwith a bullish butterfly.\nEXHIBIT 10.5 Bull call spread vs. bull butterfly (Walgreen Co. at $33.50).\n\nThe butterfly has lower nominal risk—only 0.10 compared with 0.35 for\nthe call spread. The maximum reward is higher in nominal terms, too—0.90\nversus 0.65. The trade-off is what is given up. With both strategies, the goal\nis to have Walgreen Co. at $36 around expiration. But the bull call spread\nhas more room for error to the upside. If the stock trades a lot higher than", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 65}
{"text": "Walgreen Co. at $33.50).\n\nThe butterfly has lower nominal risk—only 0.10 compared with 0.35 for\nthe call spread. The maximum reward is higher in nominal terms, too—0.90\nversus 0.65. The trade-off is what is given up. With both strategies, the goal\nis to have Walgreen Co. at $36 around expiration. But the bull call spread\nhas more room for error to the upside. If the stock trades a lot higher than\nexpected, the butterfly can end up being a losing trade.\nGiven Ross’s expectations in this example, this might be a risk he is\nwilling to take. He doesn’t expect Walgreen Co. to close right at $36 on the\nexpiration date. It could happen, but it’s unlikely. However, he’d have to be\nwildly wrong to have the trade be a loser on the upside. It would be a much\nlarger move than expected for the stock to rise significantly above $36. If\nRoss strongly believes Walgreen Co. can be around $36 at expiration, the\ncost benefit of 0.10 vs. 0.35 may offset the upside risk above $37. As a\ngeneral rule, directional butterflies work well in trending, low-volatility\nstocks.\nWhen Ross monitors his butterfly, he will want to see the greeks for this\nposition as well. Exhibit 10.6 shows the trade’s analytics with Walgreen Co.\nat $33.50.\nEXHIBIT 10.6 Walgreen Co. 35–36–37 butterfly greeks (stock at $33.50,\n31 days to expiration).\nDelta +0.008\nGamma−0.004\nTheta +0.001\nVega −0.001\nWhen the trade is first put on, the delta is small—only +0.008. Gamma is\nslightly negative and theta is very slightly positive. This is important\ninformation if Walgreen Co.’s ascent happens sooner than Ross planned.\nThe trade will show just a small profit if the stock jumps to $36 per share\nright away. Ross’s theoretical gain will be almost unnoticeable. At $36 per\nshare, the position will have its highest theta, which will increase as\nexpiration approaches. Ross will have to wait for time to pass to see the\ntrade reach its full potential.\nThis example shows the interrelation between delta and theta. We know\nfrom an at-expiration analysis that if Walgreen Co. moves from $33.50 to\n$36, the butterfly’s profit will be 0.90 (the spread of $1 minus the 0.10\ninitial debit). If we distribute the 0.90 profit over the 2.50 move from\n$33.50 to $36, the butterfly gains about 0.36 per dollar move in Walgreen\nCo. (0.90/(36 − 33.50). This implies a delta of about 0.36.\nBut the delta, with 31 days until expiration and Walgreen Co. at $33.50, is\nonly 0.008, and because of negative gamma this delta will get even smaller\nas Walgreen Co. rises. Butterflies, like the vertical spreads of which they are\ncomposed, can profit from direction but are never purely directional trades.\nTime is always a factor. It is theta, working in tandem with delta, that\ncontributes to profit or peril.\nA bearish butterfly can be constructed as well. One would execute the\ntrade with all OTM puts or all ITM calls. The concept is the same: sell the\nguts at the strike at which the stock is expected to be trading at expiration,\nand buy the wings for protection.\nConstructing Trades to Maximize\nProfit\nMany traders who focus on trading iron condors trade exchange-traded\nfunds (ETFs) or indexes. Why? Diversification. Because indexes are made\nup of many stocks, they usually don’t have big gaps caused by surprise\nearnings announcements, takeovers, or other company-specific events. But\nit’s not just selecting the right underlying to trade that is the challenge. A\ntrader also needs to pick the right strike prices. Finding the right strike\nprices to trade can be something of an art, although science can help, as\nwell.\nThree Looks at the Condor\nStrike selection is essential for a successful condor. If strikes are too close\ntogether or two far apart, the trade can become much less attractive.\nStrikes Too Close\nThe QQQs are options on the ETFs that track the Nasdaq 100 (QQQ). They\nhave strikes in $1 increments, giving traders a lot to choose from. With\nQQQ trading at around $55.95, consider the 54–55–57–58 iron condor. In\nthis example, with 31 days until expiration, the following legs can be\nexecuted:\nIn this trade, the maximum profit is 0.63. The maximum risk is 0.37. This\nisn’t a bad profit-to-loss ratio. The break-even price on the downside is\n$54.37 and on the upside is $57.63. That’s a $3.26 range—a tight space for\na mover like the QQQ to occupy in a month. The ETF can drop about only\n2.8 percent or rise 3 percent before the trade becomes a loser. No one needs\nany fancy math to show that this is likely a losing proposition in the long\nrun. While choosing closer strikes can lead to higher premiums, the range\ncan be so constricting that it asphyxiates the possibility of profit.\nStrikes Too Far\nStrikes too far apart can make for impractical trades as well. Exhibit 10.7\nshows an options chain for the Dow Jones Industrial Average Index (DJX).\nThese prices are from around 2007 when implied volatility (IV) was\nhistorically low, making the OTM options fairly low priced. In this\nexample, DJX is around $135.20 and there are 51 days until expiration.\nEXHIBIT 10.7 Options chain for DJIA.\nIf the goal is to choose strikes that are far enough apart to be unlikely to\ncome into play, a trader might be tempted to trade the 120–123–142–145\niron condor. With this wingspan, there is certainly a good chance of staying\nbetween those strikes—you could drive a proverbial truck through that\nrange.\nThis would be a great trade if it weren’t for the prices one would have to\naccept to put it on. First, the 120 puts are offered at 0.25 and the 123 puts\nare 0.25 bid. This means that the put spread would be sold at zero! The\nmaximum risk is 3.00, and the maximum gain is zero. Not a really good\nrisk/reward. The 142–145 call spread isn’t much better: it can be sold for a\ndime.\nAt the time, again a low-volatility period, many traders probably felt it\nwas unlikely that the DJX will rise 5 percent in a 51-day period. Some\ntraders may have considered trading a similarly priced iron condor (though\nof course they’d have to require some s", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 66}
{"text": "is 3.00, and the maximum gain is zero. Not a really good\nrisk/reward. The 142–145 call spread isn’t much better: it can be sold for a\ndime.\nAt the time, again a low-volatility period, many traders probably felt it\nwas unlikely that the DJX will rise 5 percent in a 51-day period. Some\ntraders may have considered trading a similarly priced iron condor (though\nof course they’d have to require some small credit for the risk). A little over\na year later the DJX was trading around 50 percent lower. Traders must\nalways be vigilant of the possibility of volatility, even unexpected volatility\nand structure their risk/reward accordingly. Most traders would say the\nrisk/reward of this trade isn’t worth it. Strikes too far apart have a greater\nchance of success, but the payoff just isn’t there.\nStrikes with High Probabilities of Success\nSo how does a trader find the happy medium of strikes close enough\ntogether to provide rich premiums but far enough apart to have a good\nchance of success? Certainly, there is something to be said for looking at\nthe prices at which a trade can be done and having a subjective feel for\nwhether the underlying is likely to move outside the range of the break-\neven prices. A little math, however, can help quantify this likelihood and aid\nin the decision-making process.\nRecall that IV is read by many traders to be the market’s consensus\nestimate of future realized volatility in terms of annualized standard\ndeviation. While that is a mouthful to say—or in this case, rather, an eyeful\nto read—when broken down it is not quite as intimidating as it sounds.\nConsider a simplified example in which an underlying security is trading at\n$100 a share and the implied volatility of the at-the-money (ATM) options\nis 10 percent. That means, from a statistical perspective, that if the expected\nreturn for the stock is unchanged, the one-year standard deviations are at\n$90 and $110. 1 In this case, there is about a 68 percent chance of the stock\ntrading between $90 and $110 one year from now. IV then is useful\ninformation to a trader who wants to quantify the chances of an iron\ncondor’s expiring profitable, but there are a few adjustments that need to be\nmade.\nFirst, because with an iron condor the idea is to profit from net short\noption premium, it usually makes more sense to sell shorter-term options to\nprofit from higher rates of time decay. This entails trading condors\ncomposed of one- or two-month options. The IV needs to be deannualized\nand converted to represent the standard deviation of the underlying at\nexpiration.\nThe first step is to compute the one-day standard deviation. This is found\nby dividing the implied volatility by the square root of the number of\ntrading days in a year, then multiplying by the square root of the number of\ntrading days until expiration. The result is the standard deviation (σ) at the\ntime of expiration stated as a percent. Next, multiply that percentage by the\nprice of the underlying to get the standard deviation in absolute terms.\nThe formula 2 for calculating the shorter-term standard deviation is as\nfollows:\nThis value will be added to or subtracted from the price of the underlying\nto get the price points at which the approximate standard deviations fall.\nConsider an example using options on the Standard & Poor’s 500 Index\n(SPX). With 50 days until expiration, the SPX is at 1241 and the implied\nvolatility is 23.2 percent. To find strike prices that are one standard\ndeviation away from the current index price, we need to enter the values\ninto the equation. We first need to know how many actual trading days are\nin the 50-day period. There are 35 business days during this particular 50-\nday period (there is one holiday and seven weekend days). We now have all\nthe data we need to calculate which strikes to sell.\nThe lower standard deviation is 1134.55 (1241 − 106.45) and the upper is\n1347.45 (1241 + 106.45). This means there would be about a 68 percent\nchance of SPX ending up between 1134.55 and 1347.45 at expiration. In\nthis example, to have about a two-thirds chance of success, one would sell\nthe 1135 puts and the 1350 calls as part of the iron condor.\nBeing Selective\nThere is about a two-thirds chance of the underlying staying between the\nupper and lower standard deviation points and about a one-third chance it\nwon’t. Reasonably good odds. But the maximum loss of an iron condor will\nbe more than the maximum profit potential. In fact, the max-profit-to-max-\nloss ratio is usually less than 1 to 3. For every $1 that can be made, often $4\nor $5 will be at risk.\nThe pricing model determines fair value of an option based on the implied\nvolatility set by the market. Again, many traders consider IV to be the\nmarket’s consensus estimate of future realized volatility. Assuming the\nmarket is generally right and options are efficiently priced, in the long run,\nfuture stock volatility should be about the same as the implied volatility\nfrom options prices. That means that if all of your options trades are\nexecuted at fair value, you are likely to break even in the long run. The\ncaveat is that whether the options market is efficient or not, retail or\ninstitutional traders cannot generally execute trades at fair value. They have\nto sell the bid (sell below theoretical value) and buy the offer (buy above\ntheoretical value). This gives the trade a statistical disadvantage, called\ngiving up the edge, from an expected return perspective.\nEven though you are more likely to win than to lose with each individual\ntrade when strikes are sold at the one-standard-deviation point, the edge\ngiven up to the market in conjunction with the higher price tag on losers\nmakes the trade a statistical loser in the long run. While this means for\ncertain that the non-market-making trader is at a constant disadvantage,\ntrading condors and butterflies is no different from any other strategy.\nGiving up the edge is the plight of retail and institutional traders. To profit\nin the long run, a tra", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 67}
{"text": "dge\ngiven up to the market in conjunction with the higher price tag on losers\nmakes the trade a statistical loser in the long run. While this means for\ncertain that the non-market-making trader is at a constant disadvantage,\ntrading condors and butterflies is no different from any other strategy.\nGiving up the edge is the plight of retail and institutional traders. To profit\nin the long run, a trader needs to beat the market, which requires careful\nplanning, selectivity, and risk management.\nSavvy traders trade iron condors with strikes one standard deviation away\nfrom the current stock price only when they think there is more than a two-\nthirds chance of market neutrality. In other words, if you think the market\nwill be less volatile than the prices in the options market imply, sell the iron\ncondor or trade another such premium-selling strategy. As discussed above,\nthis opinion should reflect sound judgment based on some combination of\ntechnical analysis, fundamental analysis, volatility analysis, feel, and\nsubjectivity.\nA Safe Landing for an Iron Condor\nAlthough traders can’t control what the market does, they can control how\nthey react to the market. Assume a trader has done due diligence in studying\na stock and feels it is a qualified candidate for a neutral strategy. With the\nstock at $90, a 16.5 percent implied volatility, and 41 days until expiration,\nthe standard deviation is about 5. The trader sells the following iron condor:\nWith the stock at $90, directly between the two short strikes, the trade is\ndirection neutral. The maximum profit is equal to the total premium taken\nin, which in this case is $800. The maximum loss is $4,200. There is about\na two-thirds chance of retaining the $800 at expiration.\nAfter one week, the overall market begins trending higher on unexpected\nbullish economic news. This stock follows suit and is now trading at $93,\nand concern is mounting that the rally will continue. The value of the spread\nnow is about 1.10 per contract (we ignore slippage from trading on the bid-\nask spreads of the four legs of the spread). This means the trade has lost\n$300 because it would cost $1,100 to buy back what the trader sold for a\ntotal of $800.\nOne strategy for managing this trade looking forward is inaction. The\nphilosophy is that sometimes these trades just don’t work out and you take\nyour lumps. The philosophy is that the winners should outweigh the losers\nover the long term. For some of the more talented and successful traders\nwith a proven track record, this may be a viable strategy, but there are more\nactive options as well. A trader can either close the spread or adjust it.\nThe two sets of data that must be considered in this decision are the prices\nof the individual options and the greeks for the trade. Exhibit 10.8 shows\nthe new data with the stock at $93.\nEXHIBIT 10.8 Greeks for iron condor with stock at $93.\nThe trade is no longer neutral, as it was when the underlying was at $90.\nIt now has a delta of −2.54, which is like being short 254 shares of the\nunderlying. Although the more time that passes the better—as indicated by\nthe +0.230 theta—delta is of the utmost concern. The trader has now found\nhimself short a market that he thinks may rally.\nClosing the entire position is one alternative. To be sure, if you don’t have\nan opinion on the underlying, you shouldn’t have a position. It’s like\nmaking a bet on a sporting event when you don’t really know who you\nthink will win. The spread can also be dismantled piecemeal. First, the 85\nputs are valued at $0.07 each. Buying these back is a no-brainer. In the\nevent the stock does retrace, why have the positive delta of that leg working\nagainst you when you can eliminate the risk inexpensively now?\nThe 80 puts are worthless, offered at 0.05, presumably. There is no point\nin trying to sell these. If the market does turn around, they may benefit,\nresulting in an unexpected profit.\nThe 80 and 85 puts are the least of his worries, though. The concern is a\ncontinuing rally. Clearly, the greater risk is in the 95–100 call spread.\nClosing the call spread for a loss eliminates the possibility of future losses\nand may be a wise choice, especially if there is great uncertainty. Taking a\nsmall loss now of only around $300 is a better trade than risking a total loss\nof $4,200 when you think there is a strong chance of that total loss\noccurring.\nBut if the trader is not merely concerned that the stock will rally but truly\nbelieves that there is a good chance it will, the most logical action is to\nposition himself for that expected move. Although there are many ways to\naccomplish this, the simplest way is to buy to close the 95 calls to eliminate\nthe position at that strike. This eliminates the short delta from the 95 calls,\nleading to a now-positive delta for the position as a whole. The new\nposition after adjusting by buying the 85 puts and the 95 calls is shown in\nExhibit 10.9 .\nEXHIBIT 10.9 Iron condor adjusted to strangle.\nThe result is a long strangle: a long call and a long put of the same month\nwith two different strikes. Strangles will be discussed in subsequent\nchapters. The 80 puts are far enough out-of-the-money to be fairly\nirrelevant. Effectively, the position is long ten 100-strike calls. This serves\nthe purpose of changing the negative 2.54 delta into a positive 0.96 delta.\nThe trader now has a bullish position in the stock that he thinks will rally—\na much smarter position, given that forecast.\nThe Retail Trader versus the Pro\nIron condors are very popular trades among retail traders. These days one\ncan hardly go to a cocktail party and mention the word options without\nhearing someone tell a story about an iron condor on which he’s made a\nbundle of money trading. Strangely, no one ever tells stories about trades in\nwhich he has lost a bundle of money.\nTwo of the strengths of this strategy that attract retail traders are its\nlimited risk and high probability of success. Another draw of this type of\nstrategy is", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 68}
{"text": "a cocktail party and mention the word options without\nhearing someone tell a story about an iron condor on which he’s made a\nbundle of money trading. Strangely, no one ever tells stories about trades in\nwhich he has lost a bundle of money.\nTwo of the strengths of this strategy that attract retail traders are its\nlimited risk and high probability of success. Another draw of this type of\nstrategy is that the iron condor and the other wing spreads offer something\ntruly unique to the retail trader: a way to profit from stocks that don’t move.\nIn the stock-trading world, the only thing that can be traded is direction—\nthat is, delta. The iron condor is an approachable way for a nonprofessional\nto dabble in nonlinear trading. The iron condor does a good job in\neliminating delta—unless, of course, the stock moves and gamma kicks in.\nIt is efficient in helping income-generating retail traders accomplish their\ngoals. And when a loss occurs, although it can be bigger than the potential\nprofits, it is finite.\nBut professional option traders, who have access to lots of capital and\nhave very low commissions and margin requirements, tend to focus their\nefforts in other directions: they tend to trade volatility. Although iron\ncondors are well equipped for profiting from theta when the stock\ncooperates, it is also possible to trade implied volatility with this strategy.\nThe examples of iron condors, condors, iron butterflies, and butterflies\npresented in this chapter so far have for the most part been from the\nperspective of the neutral trader: selling the guts and buying the wings. A\ntrader focusing on vega in any of these strategies may do just the opposite\n—buy the guts and sell the wings—depending on whether the trader is\nbullish or bearish on volatility.\nSay a trader, Joe, had a bullish outlook on volatility in Salesforce.com\n(CRM). Joe could sell the following condor 100 times.\nIn this example, February is 59 days from expiration. Exhibit 10.10 shows\nthe analytics for this trade with CRM at $104.32.\nEXHIBIT 10.10 Salesforce.com condor ( Salesforce.com at $104.32).\nAs expected with the underlying centered between the two middle strikes,\ndelta and gamma are about flat. As Salesforce.com moves higher or lower,\nthough, gamma and, consequently, delta will change. As the stock moves\ncloser to either of the long strikes, gamma will become more positive,\ncausing the delta to change favorably for Joe. Theta, however, is working\nagainst him with Salesforce.com at $104.32, costing $150 a day. In this\ninstance, movement is good. Joe benefits from increased realized volatility.\nThe best-case scenario would be if Salesforce.com moves through either of\nthe long strikes to, or through, either of the short strikes.\nThe prime objective in this example, though, is to profit from a rise in IV.\nThe position has a positive vega. The position makes or loses $400 with\nevery point change in implied volatility. Because of the proportion of theta\nrisk to vega risk, this should be a short-term play.\nIf Joe were looking for a small rise in IV, say five points, the move would\nhave to happen within 13 calendar days, given the vega and theta figures.\nThe vega gain on a rise of five vol points would be $2,000, and the theta\nloss over 13 calendar days would be $1,950. If there were stock movement\nassociated with the IV increase, that delta/gamma gain would offset some of\nthe havoc that theta wreaked on the option premiums. However, if Joe\ntraded a strategy like a condor as a vol play, he would likely expect a bigger\nvolatility move than the five points discussed here as well as expecting\nincreased realized volatility.\nA condor bullish vol play works when you expect something to change a\nstock’s price action in the short term. Examples would be rumors of a new\nproduct’s being unveiled, a product recall, a management change, or some\nother shake-up that leads to greater uncertainty about the company’s future\n—good or bad. The goal is to profit from a rise in IV, so the trade needs to\nbe put on before the announcement occurs. The motto in option-volatility\ntrading is “Buy the rumor; sell the news.” Usually, by the time the news is\nout, the increase in IV is already priced into option premiums. As\nuncertainty decreases, IV decreases as well.\nNotes\n1 . It is important to note that in the real world, interest and expectations\nfor future stock-price movement come into play. For simplicity’s sake,\nthey’ve been excluded here.\n2 . This is an approximate formula for estimating standard deviation.\nAlthough it is mathematically only an approximation, it is the convention\nused by many option traders. It is a traders’ short cut.\nCHAPTER 11\nCalendar and Diagonal Spreads\nOption selling is a niche that attracts many retail and professional traders\nbecause it’s possible to profit from the passage of time. Calendar and\ndiagonal spreads are practical strategies to limit risk while profiting from\ntime. But these spreads are unique in many ways. In order to be successful\nwith them, it is important to understand their subtle qualities.\nCalendar Spreads\nDefinition : A calendar spread, sometimes called a time spread or a\nhorizontal spread , is an option strategy that involves buying one option and\nselling another option with the same strike price but with a different\nexpiration date.\nAt-expiration diagrams do a calendar-spread trader little good. Why? At\nthe expiration of the short-dated option, the trader is left with another option\nthat may have time value. To estimate what the position will be worth when\nthe short-term option expires, the value of the long-term option must be\nanalyzed using the greeks. This is true of the variants of the calendar—\ndouble calendars, diagonals, and double diagonals—as well. This chapter\nwill show how to analyze strategies that involve options with different\nexpirations and discuss how and when to use them.\nBuying the Calendar\nThe calendar spread and all its variations are commonly associated with\nincome-generating spreads.", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 69}
{"text": "option must be\nanalyzed using the greeks. This is true of the variants of the calendar—\ndouble calendars, diagonals, and double diagonals—as well. This chapter\nwill show how to analyze strategies that involve options with different\nexpirations and discuss how and when to use them.\nBuying the Calendar\nThe calendar spread and all its variations are commonly associated with\nincome-generating spreads. Using calendar spreads as income generators is\npopular among retail and professional traders alike. The process involves\nbuying a longer-term at-the-money option and selling a shorter-term at-the-\nmoney (ATM) option. The options must be either both calls or both puts.\nBecause this transaction results in a net debit—the longer-term option being\npurchased has a higher premium than the shorter-term option being sold—\nthis is referred to as buying the calendar.\nThe main intent of buying a calendar spread for income is to profit from\nthe positive net theta of the position. Because the shorter-term ATM option\ndecays at a faster rate than the longer-term ATM option, the net theta is\npositive. As for most income spreads, the ideal outcome occurs when the\nunderlying is at the short strike (in this case, shared strike) when the\nshorter-term option expires. At this strike price, the long option has its\nhighest value, while the short option expires without the trader’s getting\nassigned. As long as the underlying remains close to the strike price, the\nvalue of the spread rises as time passes, because the short option decreases\nin value faster than the long option.\nFor example, a trader, Richard, watches Bed Bath & Beyond Inc. (BBBY)\non a regular basis. Richard believes that Bed Bath & Beyond will trade in a\nrange around $57.50 a share (where it is trading now) over the next month.\nRichard buys the January–February 57.50 call calendar for 0.80. Assuming\nJanuary has 25 days until expiration and February has 53 days, Richard will\nexecute the following trade:\nRichard’s best-case scenario occurs when the January calls expire at\nexpiration and the February calls retain much of their value.\nIf Richard created an at-expiration P&(L) diagram for his position, he’d\nhave trouble because of the staggered expiration months. A general\nrepresentation would look something like Exhibit 11.1 .\nEXHIBIT 11.1 Bed Bath & Beyond January–February 57.50 calendar.\nThe only point on the diagram that is drawn with definitive accuracy is\nthe maximum loss to the downside at expiration of the January call. The\nmaximum loss if Bed Bath & Beyond falls low enough is 0.80—the debit\npaid for the spread. If Bed Bath & Beyond is below $57.50 at January\nexpiration, the January 57.50 call expires worthless, and the February 57.50\ncall may or may not have residual value. If Bed Bath & Beyond declines\nenough, the February 57.50 call can lose all of its value, even with residual\ntime until expiration. If the stock falls enough, the entire 0.80 debit would\nbe a loss.\nIf Bed Bath & Beyond is above $57.50 at January expiration, the January\n57.50 call will be trading at parity. It will be a negative-100-delta option,\nimitating short stock. If Bed Bath & Beyond is trading high enough, the\nFebruary 57.50 call will become a positive-100-delta option trading at\nparity plus the interest calculated on the strike. The February deep-in-the-\nmoney option would imitate long stock. At a 2 percent interest rate, interest\non the 57.50 strike is about 0.17. Therefore, Richard would essentially have\na short stock position from $57.50 from the January 57.50 call and would\nbe essentially long stock from $57.50 plus 0.28 from the February call. The\nmaximum loss to the upside is about 0.63 (0.80 − 0.17).\nThe maximum loss if Bed Bath & Beyond is trading over $57.50 at\nexpiration is only an estimate that assumes there is no time value and that\ninterest and dividends remain constant. Ultimately, the maximum loss will\nbe 0.80, the premium paid, if there is no time value or carry considerations.\nThe maximum profit is gained if Bed Bath & Beyond is at $57.50 at\nexpiration. At this price, the February 57.50 call is worth the most it can be\nworth without having the January 57.50 call assigned and creating negative\ndeltas to the upside. But how much precisely is the maximum profit?\nRichard would have to know what the February 57.50 call would be worth\nwith Bed Bath & Beyond stock trading at $57.50 at February expiration\nbefore he can know the maximum profit potential. Although Richard can’t\nknow for sure at what price the calls will be trading, he can use a pricing\nmodel to estimate the call’s value. Exhibit 11.2 shows analytics at January\nexpiration.\nEXHIBIT 11.2 Bed Bath & Beyond January–February 57.50 call calendar\ngreeks at January expiration.\nWith an unchanged implied volatility of 23 percent, an interest rate of two\npercent, and no dividend payable before February expiration, the February\n57.50 calls would be valued at 1.53 at January expiration. In this best-case\nscenario, therefore, the spread would go from 0.80, where Richard\npurchased it, to 1.53, for a gain of 91 percent. At January expiration, with\nBed Bath & Beyond at $57.50, the January call would expire; thus, the\nspread is composed of just the February 57.50 call.\nLet’s now go back in time and see how Richard figured this trade. Exhibit\n11.3 shows the position when the trade is established.\nEXHIBIT 11.3 Bed Bath & Beyond January–February 57.50 call calendar.\nA small and steady rise in the stock price with enough time to collect\ntheta is the recipe for success in this trade. As time passes, delta will flatten\nout if Bed Bath & Beyond is still right at-the-money. The delta of the\nJanuary call that Richard is short will move closer to exactly −0.50. The\nFebruary call delta moves toward exactly +0.50.\nGamma and theta will both rise if Bed Bath & Beyond stays around the\nstrike. As expiration approaches, there is greater risk if there is movement\nand greater reward if there is not.\nVega is positive because the long-term", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 70}
{"text": "h & Beyond is still right at-the-money. The delta of the\nJanuary call that Richard is short will move closer to exactly −0.50. The\nFebruary call delta moves toward exactly +0.50.\nGamma and theta will both rise if Bed Bath & Beyond stays around the\nstrike. As expiration approaches, there is greater risk if there is movement\nand greater reward if there is not.\nVega is positive because the long-term option with the higher vega is the\nlong leg of the spread. When trading calendars for income, implied\nvolatility (IV) must be considered as a possible threat. Because it is\nRichard’s objective to profit from Bed Bath & Beyond being at $57.50 at\nexpiration, he will try to avoid vega risk by checking that the implied\nvolatility of the February call is in the lower third of the 12-month range.\nHe will also determine if there are any impending events that could cause\nIV to change. The less likely IV is to drop, the better.\nIf there is an increase in IV, that may benefit the profitability of the trade.\nBut a rise in IV is not really a desired outcome for two reasons. First, a rise\nin IV is often more pronounced in the front month than in the months\nfarther out. If this happens, Richard can lose more on the short call than he\nmakes on the long call. Second, a rise in IV can indicate anxiety and\ntherefore a greater possibility for movement in the underlying stock.\nRichard doesn’t want IV to rock the boat. “Buy low, stay low” is his credo.\nRho is positive also. A rise in interest rates benefits the position because\nthe long-term call is helped by the rise more than the short call is hurt. With\nonly a one-month difference between the two options, rho is very small.\nOverall, rho is inconsequential to this trade.\nThere is something curious to note about this trade: the gamma and the\nvega. Calendar spreads are the one type of trade where gamma can be\nnegative while vega is positive, and vice versa. While it appears—at least\non the surface—that Richard wants higher IV, he certainly wants low\nrealized volatility.\nBed Bath & Beyond January–February 57.50 Put\nCalendar\nRichard’s position would be similar if he traded the January–February 57.50\nput calendar rather than the call calendar. Exhibit 11.4 shows the put\ncalendar.\nEXHIBIT 11.4 Bed Bath & Beyond January–February 57.50 put calendar.\nThe premium paid for the put spread is 0.75. A huge move in either\ndirection means a loss. It is about the same gamma/theta trade as the 57.50\ncall calendar. At expiration, with Bed Bath & Beyond at $57.50 and IV\nunchanged, the value of the February put would be 1.45—a 93 percent gain.\nThe position is almost exactly the same as the call calendar. The biggest\ndifference is that the rho is negative, but that is immaterial to the trade. As\nwith the call spread, being short the front-month option means negative\ngamma and positive theta; being long the back month means positive vega.\nManaging an Income-Generating\nCalendar\nLet’s say that instead of trading a one-lot calendar, Richard trades it 20\ntimes. His trade in this case is\nHis total cash outlay is $1,600 ($80 times 20). The greeks for this trade,\nlisted in Exhibit 11.5 , are also 20 times the size of those in Exhibit 11.3 .\nEXHIBIT 11.5 20-Lot Bed Bath & Beyond January–February 57.50 call\ncalendar.\nNote that Richard has a +0.18 delta. This means he’s long the equivalent\nof about 18 shares of stock—still pretty flat. A gamma of −0.72 means that\nif Bed Bath & Beyond moves $1 higher, his delta will be starting to get\nshort; and if it moves $1 lower he will be longer, long 90 deltas.\nRichard can use the greeks to get a feel for how much the stock can move\nbefore negative gamma causes a loss. If Bed Bath & Beyond starts trending\nin either direction, Richard may need to react. His plan is to cover his deltas\nto continue the position.\nSay that after one week Bed Bath & Beyond has dropped $1 to $56.50.\nRichard will have collected seven days of theta, which will have increased\nslightly from $18 per day to $20 per day. His average theta during that time\nis about $19, so Richard’s profit attributed to theta is about $133.\nWith a big-enough move in either direction, Richard’s delta will start\nworking against him. Since he started with a delta of +0.18 on this 20-lot\nspread and a gamma of −0.72, one might think that his delta would increase\nto 0.90 with Bed Bath & Beyond a dollar lower (18 − [−0.072 × 1.00]). But\nbecause a week has passed, his delta would actually get somewhat more\npositive. The shorter-term call’s delta will get smaller (closer to zero) at a\nfaster rate compared to the longer-term call because it has less time to\nexpiration. Thus, the positive delta of the long-term option begins to\noutweigh the negative delta of the short-term option as time passes.\nIn this scenario, Richard would have almost broken even because what\nwould be lost on stock price movement, is made up for by theta gains.\nRichard can sell about 100 shares of Bed Bath & Beyond to eliminate his\nimmediate directional risk and stem further delta losses. The good news is\nthat if Bed Bath & Beyond declines more after this hedge, the profit from\nthe short stock offsets losses from the long delta. The bad news is that if\nBBBY rebounds, losses from the short stock offset gains from the long\ndelta.\nAfter Richard’s hedge trade is executed, his delta would be zero. His\nother greeks remain unchanged. The idea is that if Bed Bath & Beyond\nstays at its new price level of $56.50, he reaps the benefits of theta\nincreasing with time from $18 per day. Richard is accepting the new price\nlevel and any profits or losses that have occurred so far. He simply adjusts\nhis directional exposure to a zero delta.\nRolling and Earning a “Free” Call\nMany traders who trade income-generating strategies are conservative.\nThey are happy to sell low IV for the benefits afforded by low realized\nvolatility. This is the problem-avoidance philosophy of trading. Due to risk\naversion, it’s common to trade calendar spreads by buying the two-month\nopti", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 71}
{"text": "ed so far. He simply adjusts\nhis directional exposure to a zero delta.\nRolling and Earning a “Free” Call\nMany traders who trade income-generating strategies are conservative.\nThey are happy to sell low IV for the benefits afforded by low realized\nvolatility. This is the problem-avoidance philosophy of trading. Due to risk\naversion, it’s common to trade calendar spreads by buying the two-month\noption and selling the one-month option. This can allow traders to avoid\nbuying the calendar in earnings months, and it also means a shorter time\nhorizon, signifying less time for something unwanted to happen.\nBut there’s another school of thought among time-spread traders. There\nare some traders who prefer to buy a longer-term option—six months to a\nyear—while selling a one-month option. Why? Because month after month,\nthe trader can roll the short option to the next month. This is a simple tactic\nthat is used by market makers and other professional traders as well as\nsavvy retail traders. Here’s how it works.\nXYZ stock is trading at $60 per share. A trader has a neutral outlook over\nthe next six months and decides to buy a calendar. Assuming that July has\n29 days until expiration and December has 180, the trader will take the\nfollowing position:\nThe initial debit here is 2.55. The goal is basically the same as for any\ntime spread: collect theta without negative gamma spoiling the party. There\nis another goal in these trades as well: to roll the spread.\nAt the end of month one, if the best-case scenario occurs and XYZ is\nsitting at $60 at July expiration, the July 60 call expires. The December 60\ncall will then be worth 3.60, assuming all else is held constant. The positive\ntheta of the short July call gives full benefits as the option goes from 1.45 to\nzero. The lower negative theta of the December call doesn’t bite into profits\nquite as much as the theta of a short-term call would.\nThe profit after month one is 1.05. Profit is derived from the December\ncall, worth 3.60 at July expiry, minus the 2.55 initial spread debit. This\nworks out to about a 41 percent return. The profit is hardly as good as it\nwould have been if a short-term, less expensive August 60 call were the\nlong leg of this spread.\nRolling the Spread\nThe July–December spread is different from short-term spreads, however.\nWhen the Julys expire, the August options will have 29 days until\nexpiration. If volatility is still the same, XYZ is still at $60, and the trader’s\nforecast is still neutral, the 29-day August 60 calls can be sold for 1.45. The\ntrader can either wait until the Monday after July expiration and then sell\nthe August 60s, or when the Julys are offered at 0.05 or 0.10, he can buy the\nJulys and sell the Augusts as a spread. In either case, it is called rolling the\nspread. When the August expires, he can sell the Septembers, and so on.\nThe goal is to get a credit month after month. At some point, the\naggregate credit from the call sales each month is greater than the price\ninitially paid for the long leg of the spread, thus eliminating the original net\ndebit. Exhibit 11.6 shows how the monthly credits from selling the one-\nmonth calls aggregate over time.\nEXHIBIT 11.6 A “free” call.\nAfter July has expired, 1.45 of premium is earned. After August\nexpiration, the aggregate increases to 2.90. When the September calls,\nwhich have 36 days until expiration, are sold, another 1.60 is added to the\ntotal premium collected. Over three months—assuming the stock price,\nvolatility, and the other inputs don’t change—this trader collects a total of\n4.50. That’s 0.50 more than the price originally paid for the December 60\ncall leg of the spread.\nAt this point, he effectively owns the December call for free. Of course,\nthis call isn’t really free; it’s earned. It’s paid for with risk and maybe a few\nsleepless nights. At this point, even if the stock and, consequently, the\nDecember call go to zero, the position is still a profitable trade because of\nthe continued month-to-month rolling. This is now a no-lose situation.\nWhen the long call of the spread has been paid for by rolling, there are\nthree choices moving forward: sell it, hold it, or continue writing calls\nagainst it. If the trader’s opinion calls for the stock to decline, it’s logical to\nsell the December call and take the residual value as profit. In this case,\nover three months the trade will have produced 4.50 in premium from the\nsale of three consecutive one-month calls, which is more than the initial\npurchase price of the December call. At September expiration, the premium\nthat will be received for selling the December call is all profit, plus 0.50,\nwhich is the aggregate premium minus the initial cost of the December call.\nIf the outlook is for the underlying to rise, it makes sense to hold the call.\nAny appreciation in the value of the call resulting from delta gains as the\nunderlying moves higher is good—$0.50 plus whatever the call can be sold\nfor.\nIf the forecast is for XYZ to remain neutral, it’s logical to continue selling\nthe one-month call. Because the December call has been financed by the\naggregate short call premiums already, additional premiums earned by\nwriting calls are profit with “free” protection. As long as the short is closed\nat its expiration, the risk of loss is eliminated.\nThis is the general nature of rolling calls in a calendar spread. It’s a\nbeautiful plan when it works! The problem is that it is incredibly unlikely\nthat the stock will stay right at $60 per share for five months. It’s almost\ninevitable that it will move at some point. It’s like a game of Russian\nroulette. At some point it’s going to be a losing proposition—you just don’t\nknow when. The benefit of rolling is that if the trade works out for a few\nmonths in a row, the long call is paid for and the risk of loss is covered by\naggregate profits.\nIf we step outside this best-case theoretical world and consider what is\nreally happening on a day-to-day basis, we can gain insight on how to\nmanag", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 72}
{"text": "an\nroulette. At some point it’s going to be a losing proposition—you just don’t\nknow when. The benefit of rolling is that if the trade works out for a few\nmonths in a row, the long call is paid for and the risk of loss is covered by\naggregate profits.\nIf we step outside this best-case theoretical world and consider what is\nreally happening on a day-to-day basis, we can gain insight on how to\nmanage this type of trade when things go wrong. Effectively, a long\ncalendar is a typical gamma/theta trade. Negative gamma hurts. Positive\ntheta helps.\nIf we knew which way the stock was going, we would simply buy or sell\nstock to adjust to get long or short deltas. But, unfortunately, we don’t. Our\nonly tool is to hedge by buying or selling stock as mentioned above to\nflatten out when gamma causes the position delta to get more positive or\nnegative. 1 The bottom line is that if the effect of gamma creates unwanted\nlong deltas but the theta/gamma is still a desirable position, selling stock\nflattens out the delta. If the effect of gamma creates unwanted short deltas,\nbuying stock flattens out the delta.\nTrading Volatility Term Structure\nThere are other reasons for trading calendar spreads besides generating\nincome from theta. If there is skew in the term structure of volatility, which\nwas discussed in Chapter 3, a calendar spread is a way to trade volatility.\nThe tactic is to buy the “cheap” month and sell the “expensive” month.\nSelling the Front, Buying the Back\nIf for a particular stock, the February ATM calls are trading at 50 volatility\nand the May ATM calls are trading at 35 volatility, a vol-calendar trader\nwould buy the Mays and sell the Februarys. Sounds simple, right? The devil\nis in the details. We’ll look at an example and then discuss some common\npitfalls with vol-trading calendars.\nGeorge has been studying the implied volatility of a $164.15 stock.\nGeorge notices that front-month volatility has been higher than that of the\nother months for a couple of weeks. There is nothing in the news to indicate\nimmediate risk of extraordinary movement occurring in this example.\nGeorge sees that he can sell the 22-day July 165 calls at a 45 percent IV\nand buy the 85-day September 165 calls at a 38 percent IV. George would\nlike to buy the calendar spread, because he believes the July ATM volatility\nwill drop down to around 38, where the September is trading. If he puts on\nthis trade, he will establish the following position:\nWhat are George’s risks? Because he would be selling the short-term\nATM option, negative gamma could be a problem. The greeks for this trade,\nshown in Exhibit 11.7 , confirm this. The negative gamma means each\ndollar of stock price movement causes an adverse change of about 0.09 to\ndelta. The spread’s delta becomes shorter when the stock rises and longer\nwhen the stock falls. Because the position’s delta is long 0.369 from the\nstart, some price appreciation may be welcomed in the short term. The stock\nadvance will yield profits but at a diminishing rate, as negative gamma\nreduces the delta.\nEXHIBIT 11.7 10-lot July–September 165 call calendar.\nBut just looking at the net position greeks doesn’t tell the whole story. It\nis important to appreciate the fact that long calendar spreads such as this\nhave long vegas. In this case, the vega is +1.522. But what does this number\nreally mean? This vega figure means that if IV rises or falls in both the July\nand the September calls by the same amount, the spread makes or loses\n$152 per vol point.\nGeorge’s plan, however, is to see the July’s volatility decline to converge\nwith the September’s. He hopes the volatilities of the two months will move\nindependently of each other. To better gauge his risk, he needs to look at the\nvega of each option. With the stock at $164.15 the vegas are as follows:\nIf George is right and July volatility declines 8 points, from 46 to 38, he\nwill make $1,283 ($1.604 × 100 × 8).\nThere are a couple of things that can go awry. First, instead of the\nvolatilities converging, they can diverge further. Implied volatility is a slave\nto the whims of the market. If the July IV continues to rise while the\nSeptember IV stays the same, George loses $160 per vol point.\nThe second thing that can go wrong is the September IV declining along\nwith the July IV. This can lead George into trouble, too. It depends the\nextent to which the September volatility declines. In this example, the vega\nof the September leg is about twice that of the July leg. That means that if\nthe July volatility loses eight points while the September volatility declines\nfour points, profits from the July calls will be negated by losses from the\nSeptember calls. If the September volatility falls even more, the trade is a\nloser.\nIV is a common cause of time-spread failure for market makers. When i\nin the front month rises, the volatility of the back-months sometimes does\nas well. When this happens, it’s often because market makers who sold\nfront-month options to retail or institutional buyers buy the back-month\noptions to hedge their short-gamma risk. If the market maker buys enough\nback-month options, he or she will accumulate positive vega. But when the\nmarket sells the front-month volatility back to the market makers, the back\nmonths drop, too, because market makers no longer need the back months\nfor a hedge.\nTraders should study historical implied volatility to avoid this pitfall. As\nis always the case with long vega strategies, there is a risk of a decline in\nIV. Buying long-term options with implied volatility in the lower third of\nthe 12-month IV range helps improve the chances of success, since the\nvolatility being bought is historically cheap.\nThis can be tricky, however. If a trader looks back on a chart of IV for an\noption class and sees that over the past six months it has ranged between 20\nand 30 but nine months ago it spiked up to, say, 55, there must be a reason.\nThis solitary spike could be just an anomaly. To eliminate the noise from\nvolatility", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 73}
{"text": "ove the chances of success, since the\nvolatility being bought is historically cheap.\nThis can be tricky, however. If a trader looks back on a chart of IV for an\noption class and sees that over the past six months it has ranged between 20\nand 30 but nine months ago it spiked up to, say, 55, there must be a reason.\nThis solitary spike could be just an anomaly. To eliminate the noise from\nvolatility charts, it helps to filter the data. News stories from that time\nperiod and historical stock charts will usually tell the story of why volatility\nspiked. Often, it is a one-time event that led to the spike. Is it reasonable to\ninclude this unique situation when trying to get a feel for the typical range\nof implied volatility? Usually not. This is a judgment call that needs to be\nmade on a case-by-case basis. The ultimate objective of this exercise is to\ndetermine: “Is volatility cheap or expensive?”\nBuying the Front, Selling the Back\nAll trading is based on the principle of “buy low, sell high”—even volatility\ntrading. With time spreads, we can do both at once, but we are not limited\nto selling the front and buying the back. When short-term options are\ntrading at a lower IV than long-term ones, there may be an opportunity to\nsell the calendar. If the IV of the front month is 17 and the back-month IV is\n25, for example, it could be a wise trade to buy the front and sell the back.\nBut selling time spreads in this manner comes with its own unique set of\nrisks.\nFirst, a short calendar’s greeks are the opposite of those of a long\ncalendar. This trade has negative theta with positive gamma. A sideways\nmarket hurts this position as negative theta does its damage. Each day of\ncarrying the position is paid for with time decay.\nThe short calendar is also a short-vega trade. At face value, this implies\nthat a drop in IV leads to profit and that the higher the IV sold in the back\nmonth, the better. As with buying a calendar, there are some caveats to this\nlogic.\nIf there is an across-the-board decline in IV, the net short vega will lead to\na profit. But an across-the-board drop in volatility, in this case, is probably\nnot a realistic expectation. The front month tends to be more sensitive to\nvolatility. It is a common occurrence for the front month to be “cheap”\nwhile the back month is “expensive.”\nThe volatilities of the different months can move independently, as they\ncan when one buys a time spread. There are a couple of scenarios that might\nlead to the back-month volatility’s being higher than the front month. One is\nhigh complacency in the short term. When the market collectively sells\noptions in expectation of lackluster trading, it generally prefers to sell the\nshort-term options. Why? Higher theta. Because the trade has less time until\nexpiration, the trade has a shorter period of risk. Because of this, selling\npressure can push down IV in the front-month options more than in the\nback. Again, the front month is more sensitive to changes in implied\nvolatility.\nBecause volatility has peaks and troughs, this can be a smart time to sell a\ncalendar. The focus here is in seeing the “cheap” front month rise back up\nto normal levels, not so much in seeing the “expensive” back month fall.\nThis trade is certainly not without risk. If the market doesn’t move, the\nnegative theta of the short calendar leads to a slow, painful death for\ncalendar sellers.\nAnother scenario in which the back-month volatility can trade higher than\nthe front is when the market expects higher movement after the expiration\nof the short-term option but before the expiration of the long-term option.\nSituations such as the expectation of the resolution of a lawsuit, a product\nannouncement, or some other one-time event down the road are\nopportunities for the market to expect such movement. This strategy\nfocuses on the back-month vol coming back down to normal levels, not on\nthe front-month vol rising. This can be a more speculative situation for a\nvolatility trade, and more can go wrong.\nThe biggest volatility risk in selling a time spread is that what goes up can\ncontinue to go up. The volatility disparity here is created by hedgers and\nspeculators favoring long-term options, hence pushing up the volatility, in\nanticipation of a big future stock move. As the likely date of the anticipated\nevent draws near, more buyers can be attracted to the market, driving up IV\neven further. Realized volatility can remain low as investors and traders lie\nin wait. This scenario is doubly dangerous when volatility rises and the\nstock doesn’t move. A trader can lose on negative theta and lose on negative\nvega.\nA Directional Approach\nCalendar spreads are often purchased when the outlook for the underlying is\nneutral. Sell the short-term ATM option; buy the long-term ATM option;\ncollect theta. But with negative gamma, these trades are never really\nneutral. The delta is constantly changing, becoming more positive or\nnegative. It’s like a rubber band: at times being stretched in either direction\nbut always demanding a pull back to the strike. When the strike price being\ntraded is not ATM, calendar spreads can be strategically traded as\ndirectional plays.\nBuying a calendar, whether using calls or puts, where the strike price is\nabove the current stock price is a bullish strategy. With calls, the positive\ndelta of the long-term out-of-the-money (OTM) call will be greater than the\nnegative delta of the short-term OTM call. For puts, the positive delta of the\nshort-term in-the-money (ITM) put will be greater than the negative delta of\nthe long-term ITM put.\nJust the opposite applies if the strike price is below the current stock\nprice. The negative delta of the short-term ITM call is greater than the\npositive delta of the long-term ITM call. The negative delta of the long-term\nOTM put is greater than the positive delta of the short-term OTM put.\nWhen the position starts out with either a positive or negative delta,\nmovement in the direction of the delta is necessar", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 74}
{"text": "te applies if the strike price is below the current stock\nprice. The negative delta of the short-term ITM call is greater than the\npositive delta of the long-term ITM call. The negative delta of the long-term\nOTM put is greater than the positive delta of the short-term OTM put.\nWhen the position starts out with either a positive or negative delta,\nmovement in the direction of the delta is necessary for the trade to be\nprofitable. Negative gamma is also an important strategic consideration.\nStock-price movement is needed, but not too much.\nBuying calendar spreads is like playing outfield in a baseball game. To\ncatch a fly ball, an outfielder must focus on both distance and timing. He\nmust gauge how far the ball will be hit and how long it will take to get\nthere. With calendars, the distance is the strike price—that’s where the stock\nneeds to be—and the time is the expiration day of the short month’s option:\nthat’s when it needs to be at the target price.\nFor example, with Wal-Mart (WMT) at $48.50, a trader, Pete, is looking\nfor a rise to about $50 over the next five or six weeks. Pete buys the\nAugust–September call calendar. In this example, August has 39 days until\nexpiration and September has 74 days.\nExactly what does 50 cents buy Pete? The stock price sitting below the\nstrike price means a net positive delta. This long time spread also has\npositive theta and vega. Gamma is negative. Exhibit 11.8 shows the\nspecifics.\nEXHIBIT 11.8 10-lot Wal-Mart August–September 50 call calendar.\nThe delta of this trade, while positive, is relatively small with 39 days left\nuntil August expiration. It’s not rational to expect a quick profit if the stock\nadvances faster than expected. But ultimately, a rise in stock price is the\ngoal. In this example, Wal-Mart needs to rise to $50, and timing is\neverything. It needs to be at that price in 39 days. In the interim, a move too\nbig and too fast in either direction hurts the trade because of negative\ngamma. Starting with Wal-Mart at $48.50, delta/gamma problems are worse\nto the downside. Exhibit 11.9 shows the effects of stock price on delta,\ngamma, and theta.\nEXHIBIT 11.9 Stock price movement and greeks.\nIf Wal-Mart moves lower, the delta gets more positive, racking up losses\nat a higher rate. To add to Pete’s woes, theta becomes less of a benefit as the\nstock drifts lower. At $47 a share, theta is about flat. With Wal-Mart trading\neven lower than $47, the positive theta of the August call is overshadowed\nby the negative theta of the September. Theta can become negative, causing\nthe position to lose value as time passes.\nA big move to the upside doesn’t help either. If Wal-Mart rises just a bit,\nthe −0.323 gamma only lessens the benefit of the 0.563 delta. But above\n$50, negative gamma begins to cause the delta to become increasingly\nnegative. Theta begins to wither away at higher stock prices as well.\nThe place to be is right at $50. The delta is flat and theta is highest. As\nlong as Wal-Mart finds its way up to this price by the third Friday of\nAugust, life is good for Pete.\nThe In-or-Out Crowd\nPete could just as well have traded the Aug–Sep 50 put calendar in this\nsituation. If he’d been bearish, he could have traded either the Aug–Sep 45\ncall spread or the Aug–Sep 45 put spread. Whether bullish or bearish, as\nmentioned earlier, the call calendar and the put calendar both function about\nthe same. When deciding which to use, the important consideration is that\none of them will be in-the-money and the other will be OTM. Whether you\nhave an ITM spread or an OTM spread has potential implications for the\nsuccess of the trade.\nThe bid-ask spreads tend to be wider for higher-delta, ITM options.\nBecause of this, it can be more expensive to enter into an ITM calendar.\nWhy? Trading options with wider markets requires conceding more edge.\nTake the following options series:\nBy buying the May 50 calls at 3.20, a trader gives up 0.10 of theoretical\nedge (3.20 is 0.10 higher than the theoretical value). Buying the put at 1.00\nmeans buying only 0.05 over theoretical.\nBecause a calendar is a two-legged spread, the double edge given up by\ntrading the wider markets of two in-the-money options can make the out-of-\nthe-money spread a more attractive trade. The issue of wider markets is\ncompounded when rolling the spread. Giving up a nickel or a dime each\nmonth can add up, especially on nominally low-priced spreads. It can cut\ninto a high percentage of profits.\nEarly assignment can complicate ITM calendars made up of American\noptions, as dividends and interest can come into play. The short leg of the\nspread could get assigned before the expiration date as traders exercise calls\nto capture the dividend. Short ITM puts may get assigned early because of\ninterest.\nAlthough assignment is an undesirable outcome for most calendar spread\ntraders, getting assigned on the short leg of the calendar spread may not\nnecessarily create a significantly different trade. If a long put calendar, for\nexample, has a short front-month put that is so deep in-the-money that it is\nlikely to get assigned, it is trading close to a 100 delta. It is effectively a\nlong stock position already. After assignment, when a long stock position is\ncreated, the resulting position is long stock with a deep ITM long put—a\nfairly delta-flat position.\nDouble Calendars\nDefinition : A double calendar spread is the execution of two calendar\nspreads that have the same months in common but have two different strike\nprices.\nExample\nSell 1 XYZ February 70 call\nBuy 1 XYZ March 70 call\nSell 1 XYZ February 75 call\nBuy 1 XYZ March 75 call\nDouble calendars can be traded for many reasons. They can be vega\nplays. If there is a volatility-time skew, a double calendar is a way to take a\nposition without concentrating delta or gamma/theta risk at a single strike.\nThis spread can also be a gamma/theta play. In that case, there are two\nstrikes, so there are two potential focal points to gravitate to (in the case of\na long double calenda", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 75}
{"text": "ll\nDouble calendars can be traded for many reasons. They can be vega\nplays. If there is a volatility-time skew, a double calendar is a way to take a\nposition without concentrating delta or gamma/theta risk at a single strike.\nThis spread can also be a gamma/theta play. In that case, there are two\nstrikes, so there are two potential focal points to gravitate to (in the case of\na long double calendar) or avoid (in the case of a short double calendar).\nSelling the two back-month strikes and buying the front-month strikes\nleads to negative theta and positive gamma. The positive gamma creates\nfavorable deltas when the underlying moves. Positive or negative deltas can\nbe covered by trading the underlying stock. With positive gamma, profits\ncan be racked up by buying the underlying to cover short deltas and\nsubsequently selling the underlying to cover long deltas.\nBuying the two back-month strikes and selling the front-month strikes\ncreates negative gamma and positive theta, just as in a conventional\ncalendar. But the underlying stock has two target price points to shoot for at\nexpiration to achieve the maximum payout.\nOften double calendars are traded as IV plays. Many times when they are\ntraded as IV plays, traders trade the lower-strike spread as a put calendar\nand the higher-strike spread a call calendar. In that case, the spread is\nsometimes referred to as a strangle swap . Strangles are discussed in\nChapter 15.\nTwo Courses of Action\nAlthough there may be many motivations for trading a double calendar,\nthere are only two courses of action: buy it or sell it. While, for example,\nthe trader’s goal may be to capture theta, buying a double calendar comes\nwith the baggage of the other greeks. Fully understanding the\ninterrelationship of the greeks is essential to success. Option traders must\ntake a holistic view of their positions.\nLet’s look at an example of buying a double calendar. In this example,\nMinnesota Mining & Manufacturing (MMM) has been trading in a range\nbetween about $85 and $97 per share. The current price of Minnesota\nMining & Manufacturing is $87.90. Economic data indicate no specific\nreasons to anticipate that Minnesota Mining & Manufacturing will deviate\nfrom its recent range over the next month—that is, there is nothing in the\nnews, no earnings anticipated, and the overall market is stable. August IV is\nhigher than October IV by one volatility point, and October implied\nvolatility is in line with 30-day historical volatility. There are 38 days until\nAugust expiration, and 101 days until October expiration.\nThe Aug–Oct 85–90 double calendar can be traded at the following\nprices:\nMuch like a traditional calendar spread, the price points cannot be\ndefinitively plotted on a P&(L) diagram. What is known for certain is that at\nAugust expiration, the maximum loss is $3,200. While it’s comforting to\nknow that there is limited loss, losing the entire premium that was paid for\nthe spread is an outcome most traders would like to avoid. We also know\nthe maximum gains occur at the strike prices; but not exactly what the\nmaximum profit can be. Exhibit 11.10 provides an alternative picture of the\nposition that is useful in managing the trade on a day-to-day basis.\nEXHIBIT 11.10 10-lot Minnesota Mining & Manufacturing Aug–Oct 85–\n90 double call calendar.\nThese numbers are a good representation of the position’s risk. Knowing\nthat long calendars and long double calendars have maximum losses at the\nexpiration of the short-term option equal to the net premiums paid, the max\nloss in this example is 3.20. Break-even prices are not relevant to this\nposition because they cannot be determined with any certainty. What is\nimportant is to get a feel for how much movement can hurt the position.\nTo make $19 a day in theta, a −0.468 gamma must be accepted. In the\nlong run, $1 of movement is irrelevant. In fact, some movement is favorable\nbecause the ideal point for MMM to be at, at August expiration is either $85\nor $90. So while small moves are acceptable, big moves are of concern. The\nnegative gamma is an illustration of this warning.\nThe other risk besides direction is vega. A positive 1.471 vega means the\ncalendar makes or loses about $147 with each one-point across-the-board\nchange in implied volatility. Implied volatility is a risk in all calendar\ntrades. Volatility was one of the criteria studied when considering this trade.\nRecall that the August IV was one point higher than the October and that\nthe October IV was in line with the 30-day historical volatility at inception\nof the trade.\nConsidering the volatility data is part of the due diligence when\nconsidering a calendar or a double calendar. First, the (slightly) more\nexpensive options (August) are being sold, and the cheaper ones are being\nbought (October). A study of the company reveals no news to lead one to\nbelieve that Minnesota Mining & Manufacturing should move at a higher\nrealized volatility than it currently is in this example. Therefore, the front\nmonth’s higher IV is not a red flag. Because the volatility of the October\noption (the month being purchased) is in line with the historical volatility,\nthe trader could feel that he is paying a reasonable price for this volatility.\nIn the end, the trade is evaluated on the underlying stock, realized\nvolatility, and IV. The trade should be executed only after weighing all the\navailable data. Trading is both cerebral and statistical in nature. It’s about\ngaining a statistically better chance of success by making rational decisions.\nDiagonals\nDefinition : A diagonal spread is an option strategy that involves buying one\noption and selling another option with a different strike price and with a\ndifferent expiration date. Diagonals are another strategy in the time spread\nfamily.\nDiagonals enable a trader to exploit opportunities similar to those\nexploited by a calendar spread, but because the options in a diagonal spread\nhave two different strike prices, the trade is more focused on delta. The\nn", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 76}
{"text": "involves buying one\noption and selling another option with a different strike price and with a\ndifferent expiration date. Diagonals are another strategy in the time spread\nfamily.\nDiagonals enable a trader to exploit opportunities similar to those\nexploited by a calendar spread, but because the options in a diagonal spread\nhave two different strike prices, the trade is more focused on delta. The\nname diagonal comes from the fact that the spread is a combination of a\nhorizontal spread (two different months) and a vertical spread (two different\nstrikes).\nSay it’s 22 days until January expiration and 50 days until February\nexpiration. Apple Inc. (AAPL) is trading at $405.10. Apple has been in an\nuptrend heading toward the peak of its six-month range, which is around\n$420. A trader, John, believes that it will continue to rise and hit $420 again\nby February expiration. Historical volatility is 28 percent. The February 400\ncalls are offered at a 32 implied volatility and the January 420 calls are bid\non a 29 implied volatility. John executes the following diagonal:\nExhibit 11.11 shows the analytics for this trade.\nEXHIBIT 11.11 Apple January–February 400–420 call diagonal.\n\nFrom the presented data, is this a good trade? The answer to this question\nis contingent on whether the position John is taking is congruent with his\nview of direction and volatility and what the market tells him about these\nelements.\nJohn is bullish up to August expiration, and the stock in this example is in\nan uptrend. Any rationale for bullishness may come from technical or\nfundamental analysis, but techniques for picking direction, for the most\npart, are beyond the scope of this book. Buying the lower strike in the\nFebruary option gives this trade a more positive delta than a straight\ncalendar spread would have. The trader’s delta is 0.255, or the equivalent of\nabout 25.5 shares of Apple. This reflects the trader’s directional view.\nThe volatility is not as easy to decipher. A specific volatility forecast was\nnot stated above, but there are a few relevant bits of information that should\nbe considered, whether or not the trader has a specific view on future\nvolatility. First, the historical volatility is 28 percent. That’s lower than\neither the January or the February calls. That’s not ideal. In a perfect world,\nit’s better to buy below historical and sell above. To that point, the February\noption that John is buying has a higher volatility than the January he is\nselling. Not so good either. Are these volatility observations deal breakers?\nA Good Ex-Skews\nIt’s important to take skew into consideration. Because the January calls\nhave a higher strike price than the February calls, it’s logical for them to\ntrade at a lower implied volatility. Is this enough to justify the possibility of\nselling the lower volatility? Consider first that there is some margin for\nerror. The bid-ask spreads of each of the options has a volatility disparity. In\nthis case, both the January and February calls are 10 cents wide. That means\nwith a January vega of 0.34 the bid-ask is about 0.29 vol points wide. The\nFebruarys have a 0.57 vega. They are about 0.18 vol points wide. That\naccounts for some of the disparity. Natural vertical skew accounts for the\nrest of the difference, which is acceptable as long as the skew is not\nabnormally pronounced.\nAs for other volatility considerations, this diagonal has the rather\nunorthodox juxtaposition of positive vega and negative gamma seen with\nother time spreads. The trader is looking for a move upward, but not a big\none. As the stock rises and Apple moves closer to the 420 strike, the\npositive delta will shrink and the negative gamma will increase. In order to\ncontinue to enjoy profits as the stock rises, John may have to buy shares of\nApple to keep his positive delta. The risk here is that if he buys stock and\nApple retraces, he may end up negative scalping stock. In other words, he\nmay sell it back at a lower price than he bought it. Using stock to adjust the\ndelta in a negative-gamma play can be risky business. Gamma scalping is\naddressed further in Chapter 13.\nMaking the Most of Your Options\nThe trader from the previous example had a time-spread alternative to the\ndiagonal: John could have simply bought a traditional time spread at the\n420 strike. Recall that calendars reap the maximum reward when they are at\nthe shared strike price at expiration of the short-term option. Why would he\nchoose one over the other?\nThe diagonal in that example uses a lower-strike call in the February than\na straight 420 calendar spread and therefore has a higher delta, but it costs\nmore. Gamma, theta, and vega may be slightly lower with the in-the-money\ncall, depending on how far from the strike price the ITM call is and how\nmuch time until expiration it has. These, however, are less relevant\ndifferences.\nThe delta of the February 400 call is about 0.57. The February 420 call,\nhowever, has only a 0.39 delta. The 0.18 delta difference between the calls\nmeans the position delta of the time spread will be only about 0.07 instead\nof about 0.25 of the diagonal—a big difference. But the trade-off for lower\ndelta is that the February 420 call can be bought for 12.15. That means a\nlower debit paid—that means less at risk. Conversely, though there is\ngreater risk with the diagonal, the bigger delta provides a bigger payoff if\nthe trader is right.\nDouble Diagonals\nA double diagonal spread is the simultaneous trading of two diagonal\nspreads: one call spread and one put spread. The distance between the\nstrikes is the same in both diagonals, and both have the same two expiration\nmonths. Usually, the two long-term options are more out-of-the-money than\nthe two shorter-term options. For example\nBuy 1 XYZ May 70 put\nSell 1 XYZ March 75 put\nSell 1 XYZ March 85 call\nBuy 1 XYZ May 90 call\nLike many option strategies, the double diagonal can be looked at from a\nnumber of angles. Certainly, this is a trade composed of two diagonal\nspreads—th", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 77}
{"text": "and both have the same two expiration\nmonths. Usually, the two long-term options are more out-of-the-money than\nthe two shorter-term options. For example\nBuy 1 XYZ May 70 put\nSell 1 XYZ March 75 put\nSell 1 XYZ March 85 call\nBuy 1 XYZ May 90 call\nLike many option strategies, the double diagonal can be looked at from a\nnumber of angles. Certainly, this is a trade composed of two diagonal\nspreads—the March–May 70–75 put and the March–May 85–90 call. It is\nalso two strangles—buying the May 70–90 strangle and selling the March\n75–85 strangle. One insightful way to look at this spread is as an iron\ncondor in which the guts are March options and the wings are May options.\nTrading a double diagonal like this one, rather than a typically positioned\niron condor, can offer a few advantages. The first advantage, of course, is\ntheta. Selling short-term options and buying long-term options helps the\ntrader reap higher rates of decay. Theta is the raison d’être of the iron\ncondor. A second advantage is rolling. If the underlying asset stays in a\nrange for a long period of time, the short strangle can be rolled month after\nmonth. There may, in some cases, also be volatility-term-structure\ndiscrepancies on which to capitalize.\nA trader, Paul, is studying JPMorgan (JPM). The current stock price is\n$49.85. In this example, JPMorgan has been trading in a pretty tight range\nover the past few months. Paul believes it will continue to do so over the\nnext month. Paul considers the following trade:\n\nPaul considers volatility. In this example, the JPMorgan ATM call, the\nAugust 50 (which is not shown here), is trading at 22.9 percent implied\nvolatility. This is in line with the 20-day historical volatility, which is 23\npercent. The August IV appears to be reasonably in line with the September\nvolatility, after accounting for vertical skew. The IV of the August 52.50\ncalls is 1.5 points above that of the September 55 calls and the August 47.50\nput IV is 1.6 points below the September 45 put IV. It appears that neither\nmonth’s volatility is cheap or expensive.\nExhibit 11.12 shows the trade’s greeks.\nEXHIBIT 11.12 10-lot JPMorgan August–September 45–47.50–52.50–55\ndouble diagonal.\nThe analytics of this trade are similar to those of an iron condor.\nImmediate directional risk is almost nonexistent, as indicated by the delta.\nBut gamma and theta are high, even higher than they would be if this were\na straight September iron condor, although not as high as if this were an\nAugust iron condor.\nVega is positive. Surely, if this were an August or a September iron\ncondor, vega would be negative. In this example, Paul is indifferent as to\nwhether vega is positive or negative because IV is fairly priced in terms of\nhistorical volatility and term structure. In fact, to play it close to the vest,\nPaul probably wants the smallest vega possible, in case of an IV move.\nWhy take on the risk?\nThe motivation for Paul’s double diagonal was purely theta. The\nvolatilities were all in line. And this one-month spread can’t be rolled. If\nPaul were interested in rolling, he could have purchased longer-term\noptions. But if he is anticipating a sideways market for only the next month\nand feels that volatility could pick up after that, the one-month play is the\nway to go. After August expiration, Paul will have three choices: sell his\nSeptembers, hold them, or turn them into a traditional iron condor by\nselling the September 47.50s and 52.50s. This depends on whether he is\nindifferent, expects high volatility, or expects low volatility.\nThe Strength of the Calendar\nSpreads in the calendar-spread family allow traders to take their trading to a\nhigher level of sophistication. More basic strategies, like vertical spreads\nand wing spreads, provide a practical means for taking positions in\ndirection, realized volatility, and to some extent implied volatility. But\nbecause calendar-family spreads involve two expiration months, traders can\ntake positions in the same market variables as with these more basic\nstrategies and also in the volatility spread between different expiration\nmonths. Calendar-family spreads are veritable volatility spreads. This is a\npowerful tool for option traders to have at their disposal.\nNote\n1 . Advanced hedging techniques are discussed in subsequent chapters.\nPART III\nVolatility\nCHAPTER 12\nDelta-Neutral Trading\nTrading Implied Volatility\nMany of the strategies covered so far have been option-selling strategies.\nSome had a directional bias; some did not. Most of the strategies did have a\nprimary focus on realized volatility—especially selling it. These short\nvolatility strategies require time. The reward of low stock volatility is theta.\nIn general, most of the strategies previously covered were theta trades in\nwhich negative gamma was an unpleasant inconvenience to be dealt with.\nMoving forward, much of the remainder of this book will involve more\nin-depth discussions of trading both realized and implied volatility (IV),\nwith a focus on the harmonious, and sometimes disharmonious, relationship\nbetween the two types. Much attention will be given to how IV trades in the\noption market, describing situations in which volatility moves are likely to\noccur and how to trade them.\nDirection Neutral versus Direction\nIndifferent\nIn the world of nonlinear trading, there are two possible nondirectional\nviews of the underlying asset: direction neutral and direction indifferent.\nDirection neutral means the trader believes the stock will not trend either\nhigher or lower. The trader is neutral in his or her assessment of the future\ndirection of the asset. Short iron condors, long time spreads, and out-of-the-\nmoney (OTM) credit spreads are examples of direction-neutral strategies.\nThese strategies generally have deltas close to zero. Because of negative\ngamma, movement is the bane of the direction-neutral trade.\nDirection indifferent means the trader may desire movement in the\nunderlying but is indifferent as to whether that movement is up o", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 78}
{"text": "asset. Short iron condors, long time spreads, and out-of-the-\nmoney (OTM) credit spreads are examples of direction-neutral strategies.\nThese strategies generally have deltas close to zero. Because of negative\ngamma, movement is the bane of the direction-neutral trade.\nDirection indifferent means the trader may desire movement in the\nunderlying but is indifferent as to whether that movement is up or down.\nSome direction-indifferent trades are almost completely insulated from\ndirectional movement, with a focus on interest or dividends instead.\nExamples of these types of trades are conversions, reversals, and boxes,\nwhich are described in Chapter 6, as well as dividend plays, which are\ndescribed in Chapter 8.\nOther direction-indifferent strategies are long option strategies that have\npositive gamma. In these trades, the focus is on movement, but the direction\nof that movement is irrelevant. These are plays that are bullish on realized\nvolatility. Yet other direction-indifferent strategies are volatility plays from\nthe perspective of IV. These are trades in which the trader’s intent is to take\na bullish or bearish position in IV.\nDelta Neutral\nTo be truly direction neutral or direction indifferent means to have a delta\nequal to zero. In other words, there are no immediate gains if the underlying\nmoves incrementally higher or lower. This zero-delta method of trading is\ncalled delta-neutral trading .\nA delta-neutral position can be created from any option position simply\nby trading stock to flatten out the delta. A very basic example of a delta-\nneutral trade is a long at-the-money (ATM) call with short stock.\nConsider a trade in which we buy 20 ATM calls that have a 50 delta and\nsell stock on a delta-neutral ratio.\nBuy 20 50-delta calls (long 1,000 deltas)\nShort 1,000 shares (short 1,000 deltas)\nIn this position, we are long 1,000 deltas from the calls (20 × 50) and\nshort 1,000 deltas from the short sale of stock. The net delta of the position\nis zero. Therefore, the immediate directional exposure has been eliminated\nfrom the trade. But intuitively, there are other opportunities for profit or loss\nwith this trade.\nThe addition of short stock to the calls will affect only the delta, not the\nother greeks. The long calls have positive gamma, negative theta, and\npositive vega. Exhibit 12.1 is a simplified representation of the greeks for\nthis trade.\nEXHIBIT 12.1 20-lot delta-neutral long call.\nWith delta not an immediate concern, the focus here is on gamma, theta,\nand vega. The +1.15 vega indicates that each one-point change in IV makes\nor loses $115 for this trade. Yet there is more to the volatility story. Each\nday that passes costs the trader $50 in time decay. Holding the position for\nan extended period of time can produce a loser even if IV rises. Gamma is\npotentially connected to the success of this trade, too. If the underlying\nmoves in either direction, profit from deltas created by positive gamma may\noffset the losses from theta. In fact, a big enough move in either direction\ncan produce a profitable trade, regardless of what happens to IV.\nImagine, for a moment, that this trade is held until expiration. If the stock\nis below the strike price at this point, the calls expire. The resulting position\nis short 1,000 shares of stock. If the stock is above the strike price at\nexpiration, the calls can be exercised, creating 2,000 shares of long stock.\nBecause the trade is already short 1,000 shares, the resulting net position is\nlong 1,000 shares (2,000 − 1,000). Clearly, the more the underlying stock\nmoves in either direction the greater the profit potential. The underlying has\nto move far enough above or below the strike price to allow the beneficial\ngains from buying or selling stock to cover the option premium lost from\ntime decay. If the trade is held until expiration, the underlying needs to\nmove far enough to cover the entire premium spent on the calls.\nThe solid lines forming a V in Exhibit 12.2 conceptually illustrate the\nprofit or loss for this delta-neutral long call at expiration.\nEXHIBIT 12.2 Profit-and-loss diagram for delta-neutral long-call trade.\nBecause of gamma, some deltas will be created by movement of the\nunderlying before expiration. Gamma may lead to this being a profitable\ntrade in the short term, depending on time and what happens with IV. The\ndotted line illustrates the profit or loss of this trade at the point in time when\nthe trade is established. Because the options may still have time value at\nthis point—depending on how far from the strike price the stock is trading\n—the value of the position, as a whole, is higher than it will be if the calls\nare trading at parity at expiration. Regardless, the plan is for the stock to\nmake a move in either direction. The bigger the move and the faster it\nhappens, the better.\nWhy Trade Delta Neutral?\nA few years ago, I was teaching a class on option trading. Before the\nseminar began, I was talking with one of the students in attendance. I asked\nhim what he hoped to learn in the class. He said that he was really\ninterested in learning how to trade delta neutral. When I asked him why he\nwas interested in that specific area of trading, he replied, “I hear that’s\nwhere all the big money is made!”\nThis observation, right or wrong, probably stems from the fact that in the\npast most of the trading in this esoteric discipline has been executed by\nprofessional traders. There are two primary reasons why the pros have\ndominated this strategy: high commissions and high margin requirements\nfor retail traders. Recently, these two reasons have all but evaporated.\nFirst, the ultracompetitive world of online brokers has driven\ncommissions for retail traders down to, in some cases, what some market\nmakers pay. Second, the oppressive margin requirements that retail option\ntraders were subjected to until 2007 have given way to portfolio margining.\nPortfolio Margining\nCustomer portfolio margining is a method of calculating customer margin\nin which", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 79}
{"text": "t evaporated.\nFirst, the ultracompetitive world of online brokers has driven\ncommissions for retail traders down to, in some cases, what some market\nmakers pay. Second, the oppressive margin requirements that retail option\ntraders were subjected to until 2007 have given way to portfolio margining.\nPortfolio Margining\nCustomer portfolio margining is a method of calculating customer margin\nin which the margin requirement is based on the “up and down risk” of the\nportfolio. Before the advent of portfolio margining, retail traders were\nsubject to strategy-based margining, also called Reg. T margining, which in\nmany cases required a significantly higher amount of capital to carry a\nposition than portfolio margining does.\nWith portfolio margining, highly correlated securities can be offset\nagainst each other for purposes of calculating margin. For example, SPX\noptions and SPY options—both option classes based on the Standard &\nPoor’s 500 Index—can be considered together in the margin calculation. A\nbearish position in one and a bullish position in the other may partially\noffset the overall risk of the portfolio and therefore can help to reduce the\noverall margin requirement.\nWith portfolio margining, many strategies are margined in such a way\nthat, from the point of view of this author, they are subject to a much more\nlogical means of risk assessment. Strategy-based margining required traders\nof some strategies, like a protective put, to deposit significantly more\ncapital than one could possibly lose by holding the position. The old rules\nrequire a minimum margin of 50 percent of the stock’s value and up to 100\npercent of the put premium. A portfolio-margined protective put may\nrequire only a fraction of what it would with strategy-based margining.\nEven though Reg. T margining is antiquated and sometimes unreasonable,\nmany traders must still abide by these constraints. Not all traders meet the\neligibility requirements to qualify for portfolio-based margining. There is a\nminimum account balance for retail traders to be eligible for this treatment.\nA broker may also require other criteria to be met for the trader to benefit\nfrom this special margining. Ultimately, portfolio margining allows retail\ntraders to be margined similarly to professional traders.\nThere are some traders, both professional and otherwise, who indeed have\nmade “big money,” as the student in my class said, trading delta neutral.\nBut, to be sure, there are successful and unsuccessful traders in many areas\nof trading. The real motivation for trading delta neutral is to take a position\nin volatility, both implied and realized.\nTrading Implied Volatility\nWith a typical option, the sensitivity of delta overshadows that of vega. To\ntry and profit from a rise or fall in IV, one has to trade delta neutral to\neliminate immediate directional sensitivity. There are many strategies that\ncan be traded as delta-neutral IV strategies simply by adding stock.\nThroughout this chapter, I will continue using a single option leg with\nstock, since it provides a simple yet practical example. It’s important to note\nthat delta-neutral trading does not refer to a specific strategy; it refers to the\nfact that the trader is indifferent to direction. Direction isn’t being traded,\nvolatility is.\nVolatility trading is fundamentally different from other types of trading.\nWhile stocks can rise to infinity or decline to zero, volatility can’t. Implied\nvolatility, in some situations, can rise to lofty levels of 100, 200, or even\nhigher. But in the long-run, these high levels are not sustainable for most\nstocks. Furthermore, an IV of zero means that the options have no extrinsic\nvalue at all. Now that we have established that the thresholds of volatility\nare not as high as infinity and not as low as zero, where exactly are they?\nThe limits to how high or low IV can go are not lines in the sand. They are\nmore like tides that ebb and flow, but normally come up only so far onto the\nbeach.\nThe volatility of an individual stock tends to trade within a range that can\nbe unique to that particular stock. This can be observed by studying a chart\nof recent volatility. When IV deviates from the range, it is typical for it to\nreturn to the range. This is called reversion to the mean , which was\ndiscussed in Chapter 3. IV can get stretched in either direction like a rubber\nband but then tends to snap back to its original shape.\nThere are many examples of situations where reversion to the mean enters\ninto trading. In some, volatility temporarily dips below the typical range,\nand in some, it rises beyond the recent range. One of the most common\nexamples is the rush and the crush.\nThe Rush and the Crush\nIn this situation, volatility rises before and falls after a widely anticipated\nnews announcement, of earnings, for instance, or of a Food and Drug\nAdministration (FDA) approval. In this situation, option buyers rush in and\nbid up IV. The more uncertainty—the more demand for insurance—the\nhigher vol rises. When the event finally occurs and the move takes place or\ndoesn’t, volatility gets crushed. The crush occurs when volatility falls very\nsharply—sometimes 10 points, 20 points, or more—in minutes. Traders\nwith large vega positions appreciate the appropriateness of the term crush\nall too well. Volatility traders also affectionately refer to this sudden drop in\nIV by saying that volatility has gotten “whacked.”\nIn order to have a feel for whether implied volatility is high or low for a\nparticular stock, you need to know where it’s been. It’s helpful to have an\nidea of where realized volatility is and has been, too. To be sure, one\nanalysis cannot be entirely separate from the other. Studying both implied\nand realized volatility and how they relate is essential to seeing the big\npicture.\nThe Inertia of Volatility\nSir Isaac Newton said that an object in motion tends to stay in motion\nunless acted upon by another force. Volatility acts much the same way.\nMost stocks tend to trade w", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 80}
{"text": "atility is and has been, too. To be sure, one\nanalysis cannot be entirely separate from the other. Studying both implied\nand realized volatility and how they relate is essential to seeing the big\npicture.\nThe Inertia of Volatility\nSir Isaac Newton said that an object in motion tends to stay in motion\nunless acted upon by another force. Volatility acts much the same way.\nMost stocks tend to trade with a certain measurable amount of daily price\nfluctuations. This can be observed by looking at the stock’s realized\nvolatility. If there is no outside force—some pivotal event that\nfundamentally changes how the stock is likely to behave—one would\nexpect the stock to continue trading with the same level of daily price\nmovement. This means IV (the market’s expectation of future stock\nvolatility) should be the same as realized volatility (the calculated past stock\nvolatility).\nBut just as in physics, it seems there is always some friction affecting the\ncourse of what is in motion. Corporate earnings, Federal Reserve Board\nreports, apathy, lulls in the market, armed conflicts, holidays, rumors, and\ntakeovers, among other market happenings all provide a catalyst for\nvolatility changes. Divergences of realized and implied volatility, then, are\ncommonplace. These divergences can create tradable conditions, some of\nwhich are more easily exploited than others.\nTo find these opportunities, a trader must conduct a study of volatility.\nVolatility charts can help a trader visualize the big picture. This historical\ninformation offers a comparison of what is happening now in volatility with\nwhat has happened in the past. The following examples use a volatility\nchart to show how two different traders might have traded the rush and\ncrush of an earnings report.\nVolatility Selling\nSusie Seller, a volatility trader, studies semiconductor stocks. Exhibit 12.3\nshows the volatilities of a $50 chip stock. The circled area shows what\nhappened before and after second-quarter earnings were reported in July.\nThe black line is the IV, and the gray is the 30-day historical.\nEXHIBIT 12.3 Chip stock volatility before and after earnings reports.\nSource : Chart courtesy of iVolatility.com\nIn mid-July, Susie did some digging to learn that earnings were to be\nannounced on July 24, after the close. She was careful to observe the classic\nrush and crush that occurred to varying degrees around the last three\nearnings announcements, in October, January, and April. In each case, IV\nfirmed up before earnings only to get crushed after the report. In mid-to-late\nJuly, she watched as IV climbed to the mid-30s (the rush) just before\nearnings. As the stock lay in wait for the report, trading came to a\nproverbial screeching halt, sending realized volatility lower, to about 13\npercent. Susie waited for the end of the day just before the report to make\nher move. Before the closing bell, the stock was at $50. Susie sold 20 one-\nmonth 50-strike calls at 2.10 (a 35 volatility) and bought 1,100 shares of the\nunderlying stock at $50 to become delta neutral.\nExhibit 12.4 shows Susie’s position.\nEXHIBIT 12.4 Delta-neutral short ATM call, long stock position.\nHer delta was just about flat. The delta for the 50 calls was 0.54 per\ncontract. Selling a 20-lot creates 10.80 short deltas for her overall position.\nAfter buying 1,100 shares, she was left long 0.20 deltas, about the\nequivalence of being long 20 shares. Where did her risk lie? Her biggest\nconcern was negative gamma. Without even seeing a chart of the stock’s\nprice, we can see from the volatility chart that this stock can have big\nmoves on earnings. In October, earnings caused a more than 10-point jump\nin realized volatility, to its highest level during the year shown. Whether the\nstock rose or fell is irrelevant. Either event means risk for a premium seller.\nThe positive theta looks good on the surface, but in fact, theta provided\nSusie with no significant benefit. Her plan was “in and out and nobody gets\nhurt.” She got into the trade right before the earnings announcement and out\nas soon as implied volatility dropped off. Ideally, she’d like to hold these\ntypes of trades for less than a day. The true prize is vega.\nSusie was looking for about a 10-point drop in IV, which this option class\nhad following the October and January earnings reports. April had a big\ndrop in IV, as well, of about eight or nine points. Ultimately, what Susie is\nlooking for is reversion to the mean.\nShe gauges the normal level of volatility by observing where it is before\nand after the surges caused by earnings. From early November to mid- to\nlate- December, the stock’s IV bounced around the 25 percent level. In the\nmonth of February, the IV was around 25. After the drop-off following\nApril earnings and through much of May, the IV was closer to 20 percent.\nIn June, IV was just above 25. Susie surmised from this chart that when no\nearnings event is pending, this stock’s options typically trade at about a 25\npercent IV. Therefore, anticipating a 10-point decline from 35 was\nreasonable, given the information available. If Susie gets it right, she stands\nto make $1,150 from vega (10 points × 1.15 vegas × 100).\nAs we can see from the right side of the volatility chart in Exhibit 12.3 ,\nSusie did get it right. IV collapsed the next morning by just more than ten\npoints. But she didn’t make $1,150; she made less. Why? Realized volatility\n(gamma). The jump in realized volatility shown on the graph is a function\nof the fact that the stock rallied $2 the day after earnings. Negative gamma\ncontributed to negative deltas in the face of a rallying market. This negative\ndelta affected some of Susie’s potential vega profits.\nSo what was Susie’s profit? On this trade she made $800. The next\nmorning at the open, she bought back the 50-strike calls at 2.80 (25 IV) and\nsold the stock at $52. To compute her actual profit, she compared the prices\nof the spread when entering the trade with the prices of the spread when\nexiting. Exhibit 12.5 sh", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 81}
{"text": "lying market. This negative\ndelta affected some of Susie’s potential vega profits.\nSo what was Susie’s profit? On this trade she made $800. The next\nmorning at the open, she bought back the 50-strike calls at 2.80 (25 IV) and\nsold the stock at $52. To compute her actual profit, she compared the prices\nof the spread when entering the trade with the prices of the spread when\nexiting. Exhibit 12.5 shows the breakdown of the trade.\nEXHIBIT 12.5 Profit breakdown of delta-neutral trade.\nAfter closing the trade, Susie knew for sure what she made or lost. But\nthere are many times when a trader will hold a delta-neutral position for an\nextended period of time. If Susie hadn’t closed her trade, she would have\nlooked at her marks to see her P&(L) at that point in time. Marks are the\nprices at which the securities are trading in the actual market, either in real\ntime or at end of day. With most online brokers’ trading platforms or\noptions-trading software, real-time prices are updated dynamically and\nalways at their fingertips. The profit or loss is, then, calculated\nautomatically by comparing the actual prices of the opening transaction\nwith the current marks.\nWhat Susie will want to know is why she made $800. Why not more?\nWhy not less, for that matter? When trading delta neutral, especially with\nmore complex trades involving multiple legs, a manual computation of each\nleg of the spread can be tedious. And to be sure, just looking at the profit or\nloss on each leg doesn’t provide an explanation.\nSusie can see where her profits or losses came from by considering the\nprofit or loss for each influence contributing to the option’s value. Exhibit\n12.6 shows the breakdown.\nEXHIBIT 12.6 Profit breakdown by greek.\nDelta\nSusie started out long 0.20 deltas. A $2 rise in the stock price yielded a $40\nprofit attributable to that initial delta.\nGamma\nAs the stock rose, the negative delta of the position increased as a result of\nnegative gamma. The delta of the stock remained the same, but the negative\ndelta of the 50 call grew by the amount of the gamma. Deriving an exact\nP&(L) attributable to gamma is difficult because gamma is a dynamic\nmetric: as the stock price changes, so can the gamma. This calculation\nassumes that gamma remains constant. Therefore, the gamma calculation\nhere provides only an estimate.\nThe initial position gamma of −1.6 means the delta decreases by 3.2 with\na $2 rise in the stock (–1.60 times the $2 rise in the stock price). Susie, then,\nwould multiply −3.2 by $2 to find the loss on −3.2 deltas over a $2 rise. But\nshe wasn’t short 3.2 deltas for the whole $2. She started out with zero deltas\nattributable to gamma and ended up being 3.2 shorter from gamma over that\n$2 move. Therefore, if she assumes her negative delta from gamma grew\nsteadily from 0 to −3.2, she can estimate her average delta loss over that\nmove by dividing by 2.\nTheta\nSusie held this trade one day. Her total theta contributed 0.75 or $75 to her\nposition.\nVega\nVega is where Susie made her money on this trade. She was able to buy her\ncall back 10 IV points lower. The initial position vega was −1.15.\nMultiplying −1.15 by the negative 10-point crush of volatility yields a vega\nprofit of $1,150.\nConclusions\nStudying her position’s P&(L) by observing what happened in her greeks\nprovides Susie with an alternate—and in some ways, better—method to\nevaluate her trade. The focus of this delta-neutral trade is less on the price at\nwhich Susie can buy the calls back to close the position than on the\nvolatility level at which she can buy them back, weighed against the P&(L)\nfrom her other risks. Analyzing her position this way gives her much more\ninformation than just comparing opening and closing prices. Not only does\nshe get a good estimate of how much she made or lost, but she can\nunderstand why as well.\nThe Imprecision of Estimation\nIt is important to notice that the P&(L) found by adding up the P&(L)’s\nfrom the greeks is slightly different from the actual P&(L). There are a\ncouple of reasons for this. First, the change in delta resulting from gamma is\nonly an estimate, because gamma changes as the stock price changes. For\nsmall moves in the underlying, the gamma change is less significant, but for\nlarger moves, the rate of change of the gamma can be bigger, and it can be\nnonlinear. For example, as an option moves from being at-the-money\n(ATM) to being out-of-the-money (OTM), its gamma decreases. But as the\noption becomes more OTM, its gamma decreases at a slower rate.\nAnother reason that the P&(L) from the greeks is different from the actual\nP&(L) is that the greeks are derived from the option-pricing model and are\ntherefore theoretical values and do not include slippage.\nFurthermore, the volatility input in this example is rounded a bit for\nsimplicity. For example, a volatility of 25 actually yielded a theoretical\nvalue of 2.796, while the call was bought at 2.80. Because some options\ntrade at minimum price increments of a nickel, and none trade in fractions\nof a penny, IV is often rounded.\nCaveat Venditor\nReversion to the mean holds the promise of profit in this trade, but Susie\nalso knows that this strategy does not come without risks of loss. The mean\nto which volatility is expected to revert is not a constant. This benchmark\ncan and does change. In this example, if the company had an unexpectedly\nterrible quarter, the stock could plunge sharply. In some cases, this would\ncause IV to find a new, higher level at which to reside. If that had happened\nhere, the trade could have been a big loser. Gamma and vega could both\nhave wreaked havoc. In trading, there is no sure thing, no matter what the\nchart looks like. Remember, every ship on the bottom of the ocean has a\nchart!\nVolatility Buying\nThis same earnings event could have been played entirely differently. A\ndifferent trader, Bobby Buyer, studied the same volatility chart as Susie. It\nis shown again here as Exhibit 12.7 . Bobby also thought there would be a\nrush and crush of I", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 82}
{"text": "voc. In trading, there is no sure thing, no matter what the\nchart looks like. Remember, every ship on the bottom of the ocean has a\nchart!\nVolatility Buying\nThis same earnings event could have been played entirely differently. A\ndifferent trader, Bobby Buyer, studied the same volatility chart as Susie. It\nis shown again here as Exhibit 12.7 . Bobby also thought there would be a\nrush and crush of IV, but he decided to take a different approach.\nEXHIBIT 12.7 Chip stock volatility before and after earnings reports.\nSource : Chart courtesy of iVolatility.com\nAbout an hour before the close of business on July 21, just three days\nbefore earnings announcements, Bobby saw that he could buy volatility at\n30 percent. In Bobby’s opinion, volatility seemed cheap with earnings so\nclose. He believed that IV could rise at least five points over the next three\ndays. Note that we have the benefit of 20/20 hindsight in the example.\nNear the end of the trading day, the stock was at $49.70. Bobby bought 20\n33-day 50-strike calls at 1.75 (30 volatility) and sold short 1,000 shares of\nthe underlying stock at $49.70 to become delta neutral. Exhibit 12.8 shows\nBobby’s position.\nEXHIBIT 12.8 Delta-neutral long call, short stock position.\nWith the stock at $49.70, the calls had +0.51 delta per contract, or +10.2\nfor the 20-lot. The short sale of 1,000 shares got Bobby as close to delta-\nneutral as possible without trading an odd lot in the stock. The net position\ndelta was +0.20, or about the equivalent of being long 20 shares of stock.\nBobby’s objective in this case is to profit from an increase in implied\nvolatility leading up to earnings.\nWhile Susie was looking for reversion to the mean, Bobby hoped for a\nfurther divergence. For Bobby, positive gamma looked like a good thing on\nthe surface. However, his plan was to close the position just before earnings\nwere released—before the vol crush and before the potential stock-price\nmove. With realized volatility already starting to drop off at the time the\ntrade was put on, gamma offered little promise of gain.\nAs fate would have it, IV did indeed increase. At the end of the day before\nthe July earnings report, IV was trading at 35 percent. Bobby closed his\ntrade by selling his 20-lot of the 50 calls at 2.10 and buying his 1,000 shares\nof stock back at $50. Exhibit 12.9 shows the P&(L) for each leg of the\nspread.\nEXHIBIT 12.9 Profit breakdown.\n\nThe calls earned Bobby a total of $700, while the stock lost $300. Of\ncourse, with this type of trade, it is not relevant which leg was a winner and\nwhich a loser. All that matters is the bottom line. The net P&(L) on the trade\nwas a gain of $400. The gain in this case was mostly a product of IV’s\nrising. Exhibit 12.10 shows the P&(L) per greek.\nEXHIBIT 12.10 Profit breakdown by greek.\nDelta\nThe position began long 0.20 deltas. The 0.30-point rise earned Bobby a\n0.06 point gain in delta per contract.\nGamma\nBobby had an initial gamma of +1.8. We will use 1.8 for estimating the P&\n(L) in this example, assuming gamma remained constant. A 0.30 rise in the\nstock price multiplied by the 1.8 gamma means that with the stock at $50,\nBobby was long an additional 0.54 deltas. We can estimate that over the\ncourse of the 0.30 rise in the stock price, Bobby was long an average of\n0.27 (0.54 ÷ 2). His P&(L) due to gamma, therefore, is a gain of about 0.08\n(0.27 × 0.30).\nTheta\nBobby held this trade for three days. His total theta cost him 1.92 or $192.\nVega\nThe biggest contribution to Bobby’s profit on this trade was made by the\nspike in IV. He bought 30 volatility and sold 35 volatility. His 1.20 position\nvega earned him 6.00, or $600.\nConclusions\nThe $422 profit is not exact, but the greeks provide a good estimate of the\nhows and the whys behind it. Whether they are used for forecasting profits\nor for doing a postmortem evaluation of a trade, consulting the greeks offers\ninformation unavailable by just looking at the transaction prices.\nBy thinking about all these individual pricing components, a trader can\nmake better decisions. For example, about two weeks earlier, Bobby could\nhave bought an IV level closer to 26 percent. Being conscious of his theta,\nhowever, he decided to wait. The $64-a-day theta would have cost him\n$896 over 14 days. That’s much more that the $480 he could have made by\nbuying volatility four points lower with his 1.20 vega.\nRisks of the Trade\nLike Susie’s trade, Bobby’s play was not without risk. Certainly theta was a\nconcern, but in addition to that was the possibility that IV might not have\nplayed out as he planned. First, IV might not have risen enough to cover\nthree days’ worth of theta. It needed to rise, in this case, about 1.6 volatility\npoints for the 1.20 vega to cover the 1.92 theta loss. It might even have\ndropped. An earlier-than-expected announcement that the earnings numbers\nwere right on target could have spoiled Bobby’s trade. Or the market simply\nmight not have reacted as expected; volatility might not have risen at all, or\nmight have fallen. Remember, IV is a function of the market. It does not\nalways react as one thinks it should.\nCHAPTER 13\nDelta-Neutral Trading\nTrading Realized Volatility\nSo far, we’ve discussed many option strategies in which realized volatility\nis an important component of the trade. And while the management of these\npositions has been the focus of much of the discussion, the ultimate gain or\nloss for many of these strategies has been from movement in a single\ndirection. For example, with a long call, the higher the stock rallies the\nbetter.\nBut increases or decreases in realized volatility do not necessarily have an\nexclusive relationship with direction. Recall that realized volatility is the\nannualized standard deviation of daily price movements. Take two similarly\npriced stocks that have had a net price change of zero over a one-month\nperiod. Stock A had small daily price changes during that period, rising\n$0.10 one day and falling $0.10 the next. Stock B went up or down by", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 83}
{"text": "ility do not necessarily have an\nexclusive relationship with direction. Recall that realized volatility is the\nannualized standard deviation of daily price movements. Take two similarly\npriced stocks that have had a net price change of zero over a one-month\nperiod. Stock A had small daily price changes during that period, rising\n$0.10 one day and falling $0.10 the next. Stock B went up or down by $5\neach day for a month. In this rather extreme example, Stock B was much\nmore volatile than Stock A, regardless of the fact that the net price change\nfor the period for both stocks was zero.\nA stock’s volatility—either high or low volatility—can be capitalized on\nby trading options delta neutral. Simply put, traders buy options delta\nneutral when they believe a stock will have more movement and sell\noptions delta neutral when they believe a stock will move less.\nDelta-neutral option sellers profit from low volatility through theta. Every\nday that passes in which the loss from delta/gamma movement is less than\nthe gain from theta is a winning day. Traders can adjust their deltas by\nhedging. Delta-neutral option buyers exploit volatility opportunities through\na trading technique called gamma scalping.\nGamma Scalping\nIntraday trading is seldom entirely in one direction. A stock may close\nhigher or lower, even sharply higher or lower, on the day, but during the day\nthere is usually not a steady incremental rise or fall in the stock price. A\ntypical intraday stock chart has peaks and troughs all day long. Delta-\nneutral traders who have gamma don’t remain delta neutral as the\nunderlying price changes, which inevitably it will. Delta-neutral trading is\nkind of a misnomer.\nIn fact, it is gamma trading in which delta-neutral traders engage. For\nlong-gamma traders, the position delta gets more positive as the underlying\nmoves higher and more negative as the underlying moves lower. An upward\nmove in the underlying increases positive deltas, resulting in exponentially\nincreasing profits. But if the underlying price begins to retrace downward,\nthe gain from deltas can be erased as quickly as it was racked up.\nTo lock in delta gains, a trader can adjust the position to delta neutral\nagain by selling short stock to cover long deltas. If the stock price declines\nafter this adjustment, losses are curtailed thanks to the short stock. In fact,\nthe delta will become negative as the underlying price falls, leading to\ngrowing profits. To lock in profits again, the trader buys stock to cover\nshort deltas to once again become delta neutral.\nThe net effect is a stock scalp. Positive gamma causes the delta-neutral\ntrader to sell stock when the price rises and buy when the stock falls. This\nadds up to a true, realized profit. So positive gamma is a money-making\nmachine, right? Not so fast. As in any business, the profits must be great\nenough to cover expenses. Theta is the daily cost of running this gamma-\nscalping business.\nFor example, a trader, Harry, notices that the intraday price swings in a\nparticular stock have been increasing. He takes a bullish position in realized\nvolatility by buying 20 off the 40-strike calls, which have a 50 delta, and\nselling stock on a delta-neutral ratio.\nBuy 20 40-strike calls (50 delta) (long 1,000 deltas)\nShort 1,000 shares at $40 (short 1,000 deltas)\nThe immediate delta of this trade is flat, but as the stock moves up or\ndown, that will change, presenting gamma-scalping opportunities. Gamma\nscalping is the objective here. The position greeks in Exhibit 13.1 show the\nrelationship of the two forces involved in this trade: gamma and theta.\nEXHIBIT 13.1 Greeks for 20-lot delta-neutral long call.\nThe relationship of gamma to theta in this sort of trade is paramount to its\nsuccess. Gamma-scalping plays are not buy-and-hold strategies. This is\nactive trading. These spreads need to be monitored intraday to take\nadvantage of small moves in the underlying security. Harry will sell stock\nwhen the underlying rises and buy it when the underlying falls, taking a\nprofit with each stock trade. The goal for each day that passes is to profit\nenough from positive gamma to cover the day’s theta. But that’s not always\nas easy as it sounds. Let’s study what happens the first seven days after this\nhypothetical trade is executed. For the purposes of this example, we assume\nthat gamma remains constant and that the trader is content trading odd lots\nof stock.\nDay One\nThe first day proves to be fairly volatile. The stock rallies from $40 to $42\nearly in the day. This creates a positive position delta of 5.60, or the\nequivalent of being long about 560 shares. At $42, Harry covers the\nposition delta by selling 560 shares of the underlying stock to become delta\nneutral again.\nLater in the day, the market reverses, and the stock drops back down to\n$40 a share. At this point, the position is short 5.60 deltas. Harry again\nadjusts the position, buying 560 shares to get flat. The stock then closes\nright at $40.\nThe net result of these two stock transactions is a gain of $1,070. How?\nThe gamma scalp minus the theta, as shown below.\nThe volatility of day one led to it being a profitable day. Harry scalped 560\nshares for a $2 profit, resulting from volatility in the stock. If the stock\nhadn’t moved as much, the delta would have been smaller, and the dollar\namount scalped would have been smaller, leading to an exponentially\nsmaller profit. If there had been more volatility, profits would have been\nexponentially larger. It would have led to a bigger bite being taken out of\nthe market.\nDay Two\nThe next day, the market is a bit quieter. There is a $0.40 drop in the price\nof the stock, at which point the position delta is short 1.12. Harry buys 112\nshares at $39.60 to get delta neutral.\nFollowing Harry’s purchase, the stock slowly drifts back up and is trading\nat $40 near the close. Harry decides to cover his deltas and sell 112 shares\nat $40. It is common to cover all deltas at the end of the day to get back to\nbeing delta", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 84}
{"text": "ieter. There is a $0.40 drop in the price\nof the stock, at which point the position delta is short 1.12. Harry buys 112\nshares at $39.60 to get delta neutral.\nFollowing Harry’s purchase, the stock slowly drifts back up and is trading\nat $40 near the close. Harry decides to cover his deltas and sell 112 shares\nat $40. It is common to cover all deltas at the end of the day to get back to\nbeing delta neutral. Remember, the goal of gamma scalping is to trade\nvolatility, not direction. Starting the next trading day with a delta, either\npositive or negative, means an often unwanted directional bias and\nunwanted directional risk. Tidying up deltas at the end of the day to get\nneutral is called going home flat.\nToday was not a banner day. Harry did not quite have the opportunity to\ncover the decay.\n\nDay Three\nOn this day, the market trends. First, the stock rises $0.50, at which point\nHarry sells 140 shares of stock at $40.50 to lock in gains from his delta and\nto get flat. However, the market continues to rally. At $41 a share, Harry is\nlong another 1.40 deltas and so sells another 140 shares. The rally\ncontinues, and at $41.50 he sells another 140 shares to cover the delta.\nFinally, at the end of the day, the stock closes at $42 a share. Harry sells a\nfinal 140 shares to get flat.\nThere was not any literal scalping of stock today. It was all selling.\nNonetheless, gamma trading led to a profitable day.\nAs the stock rose from $40 to $40.50, 140 deltas were created from\npositive gamma. Because the delta was zero at $40 and 140 at $40.50, the\nestimated average delta is found by dividing 140 in half. This estimated\naverage delta multiplied by the $0.50 gain on the stock equals a $35 profit.\nThe delta was zero after the adjustment made at $40.50, when 140 shares\nwere sold. When the stock reached $41, another $35 was reaped from the\naverage delta of 70 over the $0.50 move. This process was repeated every\ntime the stock rose $0.50 and the delta was covered.\nDay Four\nDay four offers a pleasant surprise for Harry. That morning, the stock opens\n$4 lower. He promptly covers his short delta of 11.2 by buying 1,120 shares\nof the stock at $38 a share. The stock barely moves the rest of the day and\ncloses at $38.\nAn exponentially larger profit was made because there was $4 worth of\ngains on the growing delta when the stock gapped open. The whole position\ndelta was covered $4 lower, so both the delta and the dollar amount gained\non that delta had a chance to grow. Again, Harry can estimate the average\ndelta over the $4 move to be half of 11.20. Multiplying that by the $4 stock\nadvance gives him his gamma profit of $2,240. After accounting for theta,\nthe net profit is $2,190.\nDays Five and Six\nDays five and six are the weekend; the market is closed.\n\nDay Seven\nThis is a quiet day after the volatility of the past week. Today, the stock\nslowly drifts up $0.25 by the end of the day. Harry sells 70 shares of stock\nat $38.25 to cover long deltas.\nThis day was a loser for Harry, as profits from gamma were not enough to\ncover his theta.\nArt and Science\nAlthough this was a very simplified example, it was typical of how a\nprofitable week of gamma scalping plays out. This stock had a pretty\nvolatile week, and overall the week was a winner: there were four losing\ndays and three winners. The number of losing days includes the weekends.\nWeekends and holidays are big hurdles for long-gamma traders because of\nthe theta loss. The biggest contribution to this being a winning week was\nmade by the gap open on day four. Part of the reason was the sheer\nmagnitude of the move, and part was the fact that the deltas weren’t covered\ntoo soon, as they had been on day three.\nIn a perfect world, a long-gamma trader will always buy the low of the\nday and sell the high of the day when covering deltas. This, unfortunately,\nseldom happens. Long-gamma traders are very often wrong when trading\nstock to cover deltas.\nBeing wrong can be okay on occasion. In fact, it can even be rewarding.\nDay three was profitable despite the fact that 140 shares were sold at\n$40.50, $41, and $41.50. The stock closed at $42; the first three stock trades\nwere losers. Harry sold stock at a lower price than the close. But the\nposition still made money because of his positive gamma. To be sure, Harry\nwould like to have sold all 560 shares at $42 at the end of the day. The day’s\nprofits would have been significantly higher.\nThe problem is that no one knows where the stock will move next. On\nday three, if the stock had topped out at $40.50 and Harry did not sell stock\nbecause he thought it would continue higher, he would have missed an\nopportunity. Gamma scalping is not an exact science. The art is to pick\nspots that capture the biggest moves possible without missing opportunities.\nThere are many methods traders have used to decide where to cover\ndeltas when gamma scalping: the daily standard deviation, a fixed\npercentage of the stock price, a fixed nominal value, covering at a certain\ntime of day, “market feel.” No system appears to be absolutely better than\nanother. This is where it gets personal. Finding what works for you, and\nwhat works for the individual stocks you trade, is the art of this science.\nGamma, Theta, and Volatility\nClearly, more volatile stocks are more profitable for gamma scalping, right?\nWell . . . maybe. Recall that the higher the implied volatility, the lower the\ngamma and the higher the theta of at-the-money (ATM) options. In many\ncases, the more volatile a stock, the higher the implied volatility (IV). That\nmeans that a volatile stock might have to move more for a trader to scalp\nenough stock to cover the higher theta.\nLet’s look at the gamma-theta relationship from another perspective. In\nthis example, for 0.50 of theta, Harry could buy 2.80 gamma. This\nrelationship is based on an assumed 25 percent implied volatility. If IV were\n50 percent, theta for this 20 lot would be higher, and the gamma would be\nlower. At a volatility of 50, Harry could", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 85}
{"text": "e more for a trader to scalp\nenough stock to cover the higher theta.\nLet’s look at the gamma-theta relationship from another perspective. In\nthis example, for 0.50 of theta, Harry could buy 2.80 gamma. This\nrelationship is based on an assumed 25 percent implied volatility. If IV were\n50 percent, theta for this 20 lot would be higher, and the gamma would be\nlower. At a volatility of 50, Harry could buy 1.40 gammas for 0.90 of theta.\nThe gamma is more expensive from a theta perspective, but if the stock’s\nstatistical volatility is significantly higher, it may be worth it.\nGamma Hedging\nKnowing that the gamma and theta figures of Exhibit 13.1 are derived from\na 25 percent volatility assumption offers a benchmark with which to gauge\nthe potential profitability of gamma trading the options. If the stock’s\nstandard deviation is below 25 percent, it will be difficult to make money\nbeing long gamma. If it is above 25 percent, the play becomes easier to\ntrade. There is more scalping opportunity, there are more opportunities for\nbig moves, and there are more likely to be gaps in either direction. The 25\npercent volatility input not only determines the option’s theoretical value\nbut also helps determine the ratio of gamma to theta.\nA 25 percent or higher realized volatility in this case does not guarantee\nthe trade’s success or failure, however. Much of the success of the trade has\nto do with how well the trader scalps stock. Covering deltas too soon leads\nto reduced profitability. Covering too late can lead to missed opportunities.\nTrading stock well is also important to gamma sellers with the opposite\ntrade: sell calls and buy stock delta neutral. In this example, a trader will\nsell 20 ATM calls and buy stock on a delta-neutral ratio.\nThis is a bearish position in realized volatility. It is the opposite of the\ntrade in the last example. Consider again that 25 percent IV is the\nbenchmark by which to gauge potential profitability. Here, if the stock’s\nvolatility is below 25, the chances of having a profitable trade are increased.\nAbove 25 is a bit more challenging.\nIn this simplified example, a different trader, Mary, plays the role of\ngamma seller. Over the same seven-day period as before, instead of buying\ncalls, Mary sold a 20 lot. Exhibit 13.2 shows the analytics for the trade. For\nthe purposes of this example, we assume that gamma remains constant and\nthe trader is content trading odd lots of stock.\nEXHIBIT 13.2 Greeks for 20-lot delta-neutral short call.\n\nDay One\nThis was one of the volatile days. The stock rallied from $40 to $42 early in\nthe day and had fallen back down to $40 by the end of the day. Big moves\nlike this are hard to trade as a short-gamma trader. As the stock rose to $42,\nthe negative delta would have been increasing. That means losses were\nadding up at an increasing rate. The only way to have stopped the\nhemorrhaging of money as the stock continued to rise would have been to\nbuy stock. Of course, if Mary buys stock and the stock then declines, she\nhas a loser.\nLet’s assume the best-case scenario. When the stock reached $42 and she\nhad a −560 delta, Mary correctly felt the market was overbought and would\nretrace. Sometimes, the best trades are the ones you don’t make. On this\nday, Mary traded no stock. When the stock reached $40 a share at the end of\nthe day, she was back to being delta neutral. Theta makes her a winner\ntoday.\nBecause of the way Mary handled her trade, the volatility of day one was\nnot necessarily an impediment to it being profitable. Again, the assumption\nis that Mary made the right call not to negative scalp the stock. Mary could\nhave decided to hedge her negative gamma when the stock reach $42 and\nthe position delta was at −$560 by buying stock and then selling it at $40.\nThere are a number of techniques for hedging deltas resulting from\nnegative gamma. The objective of hedging deltas is to avoid losses from the\nstock trending in one direction and creating increasingly adverse deltas but\nnot to overtrade stock and negative scalp.\nDay Two\nRecall that this day had a small dip and then recovered to close again at\n$40. It is more reasonable to assume that on this day there was no negative\nscalping. A $0.40 decline is a more typical move in a stock and nothing to\nbe afraid of. The 112 delta created by negative gamma when the stock fell\nwouldn’t be perceived as a major concern by most traders in most\nsituations. It is reasonable to assume Mary would take no action. Today,\nagain, was a winner thanks to theta.\n\nDay Three\nDay three saw the stock price trending. It slowly drifted up $2. There would\nhave been some judgment calls throughout this day. Again, delta-neutral\ntrades are for active traders. Prepare to watch the market much of the day if\nimplementing this kind of strategy.\nWhen the stock was at $41 a share, Mary decided to guard against further\nadvances in stock price and hedged her delta. At that point, the position\nwould have had a −2.80 delta. She bought 280 shares at $41.\nAs the day progressed, the market proved Mary to be right. The stock rose\nto $42 giving the position a delta of −2.80 again. She covered her deltas at\nthe end of the day by buying another 280 shares.\nCovering the negative deltas to get flat at $41 proved to be a smart move\ntoday. It curtailed an exponentially growing delta and let Mary take a\nsmaller loss at $41 and get a fresh start. While the day was a loser, it would\nhave been $280 worse if she had not purchased stock at $41 before the run-\nup to $42. This is evidenced by the fact that she made a $280 profit on the\n280 shares of stock bought at $41, since the stock closed at $42.\nDay Four\nDay four offered a rather unpleasant surprise. This was the day that the\nstock gapped open $4 lower. This is the kind of day short-gamma traders\ndread. There is, of course, no right way to react to this situation. The stock\ncan recover, heading higher; it can continue lower; or it can have a dead-cat\nbounce, remaining where it is after the fall.\nSta", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 86}
{"text": "at $41, since the stock closed at $42.\nDay Four\nDay four offered a rather unpleasant surprise. This was the day that the\nstock gapped open $4 lower. This is the kind of day short-gamma traders\ndread. There is, of course, no right way to react to this situation. The stock\ncan recover, heading higher; it can continue lower; or it can have a dead-cat\nbounce, remaining where it is after the fall.\nStaring at a quite contrary delta of 11.20, Mary was forced to take action\nby selling stock. But how much stock was the responsible amount to sell for\na pure short-gamma trader not interested in trading direction? Selling 1,120\nshares would bring the position back to being delta neutral, but the only\nway the trade would stay delta neutral would be if the stock stayed right\nwhere it was.\nHedging is always a difficult call for short-gamma traders. Long-gamma\ntraders are taking a profit on deltas with every stock trade that covers their\ndeltas. Short-gamma traders are always taking a loss on delta. In this case,\nMary decided to cover half her deltas by selling 560 shares. The other 560\ndeltas represent a loss, too; it’s just not locked in.\nHere, Mary made the conscious decision not to go home flat. On the one\nhand, she was accepting the risk of the stock continuing its decline. On the\nother hand, if she had covered the whole delta, she would have been\naccepting the risk of the stock moving in either direction. Mary felt the\nstock would regain some of its losses. She decided to lead the stock a little,\ngoing into the weekend with a positive delta bias.\nDays Five and Six\nDays five and six are the weekend.\n\nDay Seven\nThis was the quiet day of the week, and a welcome respite. On this day, the\nstock rose just $0.25. The rise in price helped a bit. Mary was still long 560\ndeltas from Friday. Negative gamma took only a small bite out of her profit.\nThe P&(L) can be broken down into the profit attributable to the starting\ndelta of the trade, the estimated loss from gamma, and the gain from theta.\nMary ends these seven days of trading worse off than she started. What\nwent wrong? The bottom line is that she sold volatility on an asset that\nproved to be volatile. A $4 drop in price of a $42 dollar stock was a big\nmove. This stock certainly moved at more than 25 percent volatility. Day\nfour alone made this trade a losing proposition.\nCould Mary have done anything better? Yes. In a perfect world, she\nwould not have covered her negative deltas on day 3 by buying 280 shares\nat $41 and another 280 at $42. Had she not, this wouldn’t have been such a\nbad week. With the stock ending at $38.25, she lost $1,050 on the 280\nshares she bought at $42 ($3.75 times 280) and lost $770 on the 280 shares\nbought at $41 ($2.75 times 280). Then again, if the stock had continued\nhigher, rising beyond $42, those would have been good buys.\nMary can’t beat herself up too much for protecting herself in a way that\nmade sense at the time. The stock’s $2 rally is more to blame than the fact\nthat she hedged her deltas. That’s the risk of selling volatility: the stock may\nprove to be volatile. If the stock had not made such a move, she wouldn’t\nhave faced the dilemma of whether or not to hedge.\nConclusions\nThe same stock during the same week was used in both examples. These\ntwo traders started out with equal and opposite positions. They might as\nwell have made the trade with each other. And although in this case the vol\nbuyer (Harry) had a pretty good week and the vol seller (Mary) had a not-\nso-good week, it’s important to notice that the dollar value of the vol\nbuyer’s profit was not the same as the dollar value of the vol seller’s loss.\nWhy? Because each trader hedged his or her position differently. Option\ntrading is not a zero-sum game.\nOption-selling delta-neutral strategies work well in low-volatility\nenvironments. Small moves are acceptable. It’s the big moves that can blow\nyou out of the water.\nLike long-gamma traders, short-gamma traders have many techniques for\ncovering deltas when the stock moves. It is common to cover partial deltas,\nas Mary did on day four of the last example. Conversely, if a stock is\nexpected to continue along its trajectory up or down, traders will sometimes\noverhedge by buying more deltas (stock) than they are short or selling more\nthan they are long, in anticipation of continued price rises. Daily standard\ndeviation derived from implied volatility is a common measure used by\nshort-gamma players to calculate price points at which to enter hedges.\nMarket feel and other indicators are also used by experienced traders when\ndeciding when and how to hedge. Each trader must find what works best for\nhim or her.\nSmileys and Frowns\nThe trade examples in this chapter have all involved just two components:\ncalls and stock. We will explore delta-neutral strategies in other chapters\nthat involve more moving parts. Regardless of the specific makeup of the\nposition, the P&(L) of each individual leg is not of concern. It is the\nprofitability of the position as a whole that matters. For example, after a\nvolatile move in a stock occurs, a positive-gamma trader like Harry doesn’t\ncare whether the calls or the stock made the profit on the move. The trader\nwould monitor the net delta that was produced—positive or negative—and\ncover accordingly. The process is the same for a negative-gamma trader. In\neither case, it is gamma and delta that need to be monitored closely.\nGamma can make or break a trade. P&(L) diagrams are helpful tools that\noffer a visual representation of the effect of gamma on a position. Many\noption-trading software applications offer P&(L) graphing applications to\nstudy the payoff of a position with the days to expiration as an adjustable\nvariable to study the same trade over time.\nP&(L) diagrams for these delta-neutral positions before the options’\nexpiration generally take one of two shapes: a smiley or a frown. The shape\nof the graph depends on whether the position gamma is positive or negative.\nExhibit 13.3", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 87}
{"text": "ications offer P&(L) graphing applications to\nstudy the payoff of a position with the days to expiration as an adjustable\nvariable to study the same trade over time.\nP&(L) diagrams for these delta-neutral positions before the options’\nexpiration generally take one of two shapes: a smiley or a frown. The shape\nof the graph depends on whether the position gamma is positive or negative.\nExhibit 13.3 shows a typical positive-gamma trade.\nEXHIBIT 13.3 P&(L) diagram for a positive-gamma delta-neutral\nposition/l.\nThis diagram is representative of the P&L of a delta-neutral positive-\ngamma trade calculated using the prices at which the trade was executed.\nWith this type of trade, it is intuitive that when the stock price rises or falls,\nprofits increase because of favorably changing deltas. This is represented by\nthe graph’s smiley-face shape. The corners of the graph rise higher as the\nunderlying moves away from the center of the graph.\nThe graph is a two-dimensional snapshot showing that the higher or lower\nthe underlying moves, the greater the profit. But there are other dimensions\nthat are not shown here, such as time and IV. Exhibit 13.4 shows the effects\nof time on a typical long-gamma trade.\nEXHIBIT 13.4 The effect of time on P&(L).\nAs time passes, the reduction in profit is reflected by the center point of\nthe graph dipping farther into negative territory. That is the effect of time\ndecay. The long options will have lost value at that future date with the\nstock still at the same price (all other factors held constant). Still, a move in\neither direction can lead to a profitable position. Ultimately, at expiration,\nthe payoff takes on a rigid kinked shape.\nIn the delta-neutral long call examples used in this chapter the position\nbecomes net long stock if the calls are in-the-money at expiration or net\nshort stock if they are out-of-the-money and only the short stock remains.\nVolatility, as well, would move the payoff line vertically. As IV increases,\nthe options become worth more at each stock price, and as IV falls, they are\nworth less, assuming all other factors are held constant.\nA delta-neutral short-gamma play would have a P&(L) diagram quite the\nopposite of the smiley-faced long-gamma graph. Exhibit 13.5 shows what is\ncalled the short-gamma frown.\nEXHIBIT 13.5 Short-gamma frown.\nAt first glance, this doesn’t look like a very good proposition. The highest\npoint on the graph coincides with a profit of zero, and it only gets worse as\nthe price of the underlying rises or falls. This is enough to make any trader\nfrown. But again, this snapshot does not show time or volatility. Exhibit\n13.6 shows the payout diagram as time passes.\nEXHIBIT 13.6 The effect of time on the short-gamma frown.\n\nA decrease in value of the options from time decay causes an increase in\nprofitability. This profit potential pinnacles at the center (strike) price at\nexpiration. Rising IV will cause a decline in profitability at each stock price\npoint. Declining IV will raise the payout on the Y axis as profitability\nincreases at each price point.\nSmileys and frowns are a mere graphical representation of the technique\ndiscussed in this chapter: buying and selling realized volatility. These P&\n(L) diagrams are limited, because they show the payout only of stock-price\nmovement. The profitability of direction-indifferent and direction-neutral\ntrading is also influenced by time and implied volatility. These actively\ntraded strategies are best evaluated on a gamma-theta basis. Long-gamma\ntraders strive each day to scalp enough to cover the day’s theta, while short-\ngamma traders hope to keep the loss due to adverse movement in the\nunderlying lower than the daily profit from theta.\nThe strategies in this chapter are the same ones traded in Chapter 12. The\nonly difference is the philosophy. Ultimately, both types of volatility are\nbeing traded using these and other option strategies. Implied and realized\nvolatility go hand in hand.\nCHAPTER 14\nStudying Volatility Charts\nImplied and realized volatility are both important to option traders. But\nequally important is to understand how the two interact. This relationship is\nbest studied by means of a volatility chart. Volatility charts are invaluable\ntools for volatility traders (and all option traders for that matter) in many\nways.\nFirst, volatility charts show where implied volatility (IV) is now\ncompared with where it’s been in the past. This helps a trader gauge\nwhether IV is relatively high or relatively low. Vol charts do the same for\nrealized volatility. The realized volatility line on the chart answers three\nquestions:\nHave the past 30 days been more or less volatile for the stock than\nusual?\nWhat is a typical range for the stock’s volatility?\nHow much volatility did the underlying historically experience in the\npast around specific recurring events?\nWhen IV lines and realized volatility lines are plotted on the same chart,\nthe divergences and convergences of the two spell out the whole volatility\nstory for those who know how to read it.\nNine Volatility Chart Patterns\nEach individual stock and the options listed on it have their own unique\nrealized and implied volatility characteristics. If we studied the vol charts of\n1,000 stocks, we’d likely see around 1,000 different volatility patterns. The\nnumber of permutations of the relationship of realized to implied volatility\nis nearly infinite, but for the sake of discussion, we will categorize volatility\ncharts into nine general patterns. 1\n1. Realized Volatility Rises, Implied\nVolatility Rises\nThe first volatility chart pattern is that in which both IV and realized\nvolatility rise. In general, this kind of volatility chart can line up three ways:\nimplied can rise more than realized volatility; realized can rise more than\nimplied; or they can both rise by about the same amount. The chart below\nshows implied volatility rising at a faster rate than realized vol. The general\ntheme in this case is that the stock’s price movement h", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 88}
{"text": "at in which both IV and realized\nvolatility rise. In general, this kind of volatility chart can line up three ways:\nimplied can rise more than realized volatility; realized can rise more than\nimplied; or they can both rise by about the same amount. The chart below\nshows implied volatility rising at a faster rate than realized vol. The general\ntheme in this case is that the stock’s price movement has been getting more\nvolatile, and the option prices imply even higher volatility in the future.\nThis specific type of volatility chart pattern is commonly seen in active\nstocks with a lot of news. Stocks du jour, like some Internet stocks during\nthe tech bubble of the late 1990s, story stocks like Apple (AAPL) around\nthe release of the iPhone in 2007, have rising volatilities, with the IV\noutpacing the realized volatility. Sometimes individual stocks and even\nbroad market indexes and exchange-traded funds (ETFs) see this pattern,\nwhen the market is declining rapidly, like in the summer of 2011.\nA delta-neutral long-volatility position bought at the beginning of May,\naccording to Exhibit 14.1 , would likely have produced a winner. IV took\noff, and there were sure to be plenty of opportunities to profit from gamma\nwith realized volatility gaining strength through June and July.\nEXHIBIT 14.1 Realized volatility rises, implied volatility rises.\nSource : Chart courtesy of iVolatility.com\nLooking at the right side of the chart, in late July, with IV at around 50\npercent and realized vol at around 35 percent, and without the benefit of\nknowing what the future will bring, it’s harder to make a call on how to\ntrade the volatility. The IV signals that the market is pricing a higher future\nlevel of stock volatility into the options. If the market is right, gamma will\nbe good to have. But is the price right? If realized volatility does indeed\ncatch up to implied volatility—that is, if the lines converge at 50 or realized\nvolatility rises above IV—a trader will have a good shot at covering theta.\nIf it doesn’t, gamma will be very expensive in terms of theta, meaning it\nwill be hard to cover the daily theta by scalping gamma intraday.\nThe question is: why is IV so much higher than realized? If important\nnews is expected to be released in the near future, it may be perfectly\nreasonable for the IV to be higher, even significantly higher, than the\nstock’s realized volatility. One big move in the stock can produce a nice\nprofit, as long as theta doesn’t have time to work its mischief. But if there is\nno news in the pipeline, there may be some irrational exuberance—in the\nwords of ex-Fed chairman Alan Greenspan—of option buyers rushing to\nacquire gamma that is overvalued in terms of theta.\nIn fact, a lack of expectation of news could indicate a potential bearish\nvolatility play: sell volatility with the intent of profiting from daily theta\nand a decline in IV. This type of play, however, is not for the fainthearted.\nNo one can predict the future. But one thing you can be sure of with this\ntrade: you’re in for a wild ride. The lines on this chart scream volatility.\nThis means that negative-gamma traders had better be good and had better\nbe right!\nIn this situation, hedgers and speculators in the market are buying option\nvolatility of 50 percent, while the stock is moving at 35 percent volatility.\nTraders putting on a delta-neutral volatility-selling strategy are taking the\nstance that this stock will not continue increasing in volatility as indicated\nby option prices; specifically, it will move at less than 50 percent volatility\n—hopefully a lot less. They are taking the stance that the market’s\nexpectations are wrong.\nInstead of realized and implied volatility both trending higher, sometimes\nthere is a sharp jump in one or the other. When this happens, it could be an\nindication of a specific event that has occurred (realized volatility) or news\nsuddenly released of an expected event yet to come (implied volatility). A\nsharp temporary increase in IV is called a spike, because of its pointy shape\non the chart. A one-day surge in realized volatility, on the other hand, is not\nso much a volatility spike as it is a realized volatility mesa. Realized\nvolatility mesas are shown in Exhibit 14.2 .\nEXHIBIT 14.2 Volatility mesas.\nSource : Chart courtesy of iVolatility.com\nThe patterns formed by the gray line in the circled areas of the chart\nshown below are the result of typical one-day surges in realized volatility.\nHere, the 30-day realized volatility rose by nearly 20 percentage points,\nfrom about 20 percent to about 40 percent, in one day. It remained around\nthe 40 percent level for 30 days and then declined 20 points just as fast as it\nrose.\nWas this entire 30-day period unusually volatile? Not necessarily.\nRealized volatility is calculated by looking at price movements within a\ncertain time frame, in this case, thirty business days. That means that a\nreally big move on one day will remain in the calculation for the entire\ntime. Thirty days after the unusually big move, the calculation for realized\nvolatility will no longer contain that one-day price jump. Realized volatility\ncan then drop significantly.\n2. Realized Volatility Rises, Implied\nVolatility Remains Constant\nThis chart pattern can develop from a few different market conditions. One\nscenario is a one-time unanticipated move in the underlying that is not\nexpected to affect future volatility. Once the news is priced into the stock,\nthere is no point in hedgers’ buying options for protection or speculators’\nbuying options for a leveraged bet. What has happened has happened.\nThere are other conditions that can cause this type of pattern to\nmaterialize. In Exhibit 14.3 , the IV was trading around 25 for several\nmonths, while the realized volatility was lagging. With hindsight, it makes\nperfect sense that something had to give—either IV needed to fall to meet\nrealized, or realized would rise to meet market expectations. Here, indeed,\nthe latter materialized as real", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 89}
{"text": "ned.\nThere are other conditions that can cause this type of pattern to\nmaterialize. In Exhibit 14.3 , the IV was trading around 25 for several\nmonths, while the realized volatility was lagging. With hindsight, it makes\nperfect sense that something had to give—either IV needed to fall to meet\nrealized, or realized would rise to meet market expectations. Here, indeed,\nthe latter materialized as realized volatility had a steady rise to and through\nthe 25 level in May. Implied, however remained constant.\nEXHIBIT 14.3 Realized volatility rises, implied volatility remains\nconstant.\nSource : Chart courtesy of iVolatility.com\nTraders who were long volatility going into the May realized-vol rise\nprobably reaped some gamma benefits. But those who got in “too early,”\nbuying in January or February, would have suffered too great of theta losses\nbefore gaining any significant profits from gamma. Time decay (theta) can\ninflict a slow, painful death on an option buyer. By studying this chart in\nhindsight, it is clear that options were priced too high for a gamma scalper\nto have a fighting chance of covering the daily theta before the rise in May.\nThis wasn’t necessarily an easy vol-selling trade before the May realized-\nvol rise, either, depending on the trader’s timing. In early February, realized\ndid in fact rise above implied, making the short volatility trade much less\nattractive.\nTraders who sold volatility just before the increase in realized volatility in\nMay likely ended up losing on gamma and not enough theta profits to make\nup for it. There was no volatility crush like what is often seen following a\none-day move leading to sharply higher realized volatility. IV simply\nremained pretty steady throughout the month of May and well into June.\n3. Realized Volatility Rises, Implied\nVolatility Falls\nThis chart pattern can manifest itself in different ways. In this scenario, the\nstock is becoming more volatile, and options are becoming cheaper. This\nmay seem an unusual occurrence, but as we can see in Exhibit 14.4 ,\nvolatility sometimes plays out this way. This chart shows two different\nexamples of realized vol rising while IV falls.\nEXHIBIT 14.4 Realized volatility rises, implied volatility falls.\nSource : Chart courtesy of iVolatility.com\nThe first example, toward the left-hand side of the chart, shows realized\nvolatility trending higher while IV is trending lower. Although\nfundamentals can often provide logical reasons for these volatility changes,\nsometimes they just can’t. Both implied and realized volatility are\nultimately a function of the market. There is a normal oscillation to both of\nthese figures. When there is no reason to be found for a volatility change, it\nmight be an opportunity. The potential inefficiency of volatility pricing in\nthe options market sometimes creates divergences such as this one that vol\ntraders scour the market in search of.\nIn this first example, after at least three months of IV’s trading marginally\nhigher than realized volatility, the two lines converge and then cross. The\npoint at which these lines meet is an indication that IV may be beginning to\nget cheap.\nFirst, it’s a potentially beneficial opportunity to buy a lower volatility than\nthat at which the stock is actually moving. The gamma/theta ratio would be\nfavorable to gamma scalpers in this case, because the lower cost of options\ncompared with stock fluctuations could lead to gamma profits. Second, with\nIV at 35 at the first crossover on this chart, IV is dipping down into the\nlower part of its four-month range. One can make the case that it is getting\ncheaper from a historical IV standpoint. There is arguably an edge from the\nperspective of IV to realized volatility and IV to historical IV. This is an\nexample of buying value in the context of volatility.\nFurthermore, if the actual stock volatility is rising, it’s reasonable to\nbelieve that IV may rise, too. In hindsight we see that this did indeed occur\nin Exhibit 14.4 , despite the fact that realized volatility declined.\nThe example circled on the right-hand side of the chart shows IV\ndeclining sharply while realized volatility rises sharply. This is an example\nof the typical volatility crush as a result of an earnings report. This would\nprobably have been a good trade for long volatility traders—even those\nbuying at the top. A trader buying options delta neutral the day before\nearnings are announced in this example would likely lose about 10 points of\nvega but would have a good chance to more than make up for that loss on\npositive gamma. Realized volatility nearly doubled, from around 28 percent\nto about 53 percent, in a single day.\n4. Realized Volatility Remains Constant,\nImplied Volatility Rises\nExhibit 14.5 shows that the stock is moving at about the same volatility\nfrom the beginning of June to the end of July. But during that time, option\npremiums are rising to higher levels. This is an atypical chart pattern. If this\nwas a period leading up to an anticipated event, like earnings, one would\nanticipate realized volatility falling as the market entered a wait-and-see\nmode. But, instead, statistical volatility stays the same. This chart pattern\nmay indicate a potential volatility-selling opportunity. If there is no news or\nreason for IV to have risen, it may simply be high tide in the normal ebb\nand flow of volatility.\nEXHIBIT 14.5 Realized volatility remains constant, implied volatility\nrises.\nSource : Chart courtesy of iVolatility.com\nIn this example, the historical volatility oscillates between 20 and 24 for\nnearly two months (the beginning of June through the end of July) as IV\nrises from 24 to over 30. The stock price is less volatile than option prices\nindicate. If there is no news to be dug up on the stock to lead one to believe\nthere is a valid reason for the IV’s trading at such a level, this could be an\nopportunity to sell IV 5 to 10 points higher than the stock volatility. The\ngoal here is to profit from theta or falling vega or both while not", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 90}
{"text": "e end of July) as IV\nrises from 24 to over 30. The stock price is less volatile than option prices\nindicate. If there is no news to be dug up on the stock to lead one to believe\nthere is a valid reason for the IV’s trading at such a level, this could be an\nopportunity to sell IV 5 to 10 points higher than the stock volatility. The\ngoal here is to profit from theta or falling vega or both while not losing\nmuch on negative gamma. As time passes, if the stock continues to move at\n20 to 23 vol, one would expect IV to fall and converge with realized\nvolatility.\n5. Realized Volatility Remains Constant,\nImplied Volatility Remains Constant\nThis volatility chart pattern shown in Exhibit 14.6 is typical of a boring,\nrun-of-the-mill stock with nothing happening in the news. But in this case,\nno news might be good news.\nEXHIBIT 14.6 Realized volatility remains constant, implied volatility\nremains constant.\nSource : Chart courtesy of iVolatility.com\nAgain, the gray is realized volatility and the black line is IV.\nIt’s common for IV to trade slightly above or below realized volatility for\nextended periods of time in certain assets. In this example, the IV has traded\nin the high teens from late January to late July. During that same time,\nrealized volatility has been in the low teens.\nThis is a prime environment for option sellers. From a gamma/theta\nstandpoint, the odds favor short-volatility traders. The gamma/theta ratio\nprovides an edge, setting the stage for theta profits to outweigh negative-\ngamma scalping. Selling calls and buying stock delta neutral would be a\ntrade to look at in this situation. But even more basic strategies, such as\ntime spreads and iron condors, are appropriate to consider.\nThis vol-chart pattern, however, is no guarantee of success. When the\nstock oscillates, delta-neutral traders can negative scalp stock if they are not\ncareful by buying high to cover short deltas and then selling low to cover\nlong deltas. Time-spread and iron condor trades can fail if volatility\nincreases and the increase results from the stock trending in one direction.\nThe advantage of buying IV lower than realized, or selling it above, is\nstatistical in nature. Traders should use a chart of the stock price in\nconjunction with the volatility chart to get a more complete picture of the\nstock’s price action. This also helps traders make more informed decisions\nabout when to hedge.\n6. Realized Volatility Remains Constant,\nImplied Volatility Falls\nExhibit 14.7 shows two classic implied-realized convergences. From mid-\nSeptember to early November, realized volatility stayed between 22 and 25.\nIn mid-October the implied was around 33. Within the span of a few days,\nthe implied vol collapsed to converge with the realized at about 22.\nEXHIBIT 14.7 Realized volatility remains constant, implied volatility falls.\nSource : Chart courtesy of iVolatility.com\nThere can be many catalysts for such a drop in IV, but there is truly only\none reason: arbitrage. Although it is common for a small difference between\nimplied and realized volatility—1 to 3 points—to exist even for extended\nperiods, bigger disparities, like the 7- to 10-point difference here cannot\nexist for that long without good reason.\nIf, for example, IV always trades significantly above the realized\nvolatility of a particular underlying, all rational market participants will sell\noptions because they have a gamma/theta edge. This, in turn, forces options\nprices lower until volatility prices come into line and the arbitrage\nopportunity no longer exists.\nIn Exhibit 14.7 , from mid-March to mid-May a similar convergence took\nplace but over a longer period of time. These situations are often the result\nof a slow capitulation of market makers who are long volatility. The traders\ngive up on the idea that they will be able to scalp enough gamma to cover\ntheta and consequently lower their offers to advertise their lower prices.\n7. Realized Volatility Falls, Implied\nVolatility Rises\nThis setup shown in Exhibit 14.8 should now be etched into the souls of\nanyone who has been reading up to this point. It is, of course, the picture of\nthe classic IV rush that is often seen in stocks around earnings time. The\nmore uncertain the earnings, the more pronounced this divergence can be.\nEXHIBIT 14.8 Realized volatility falls, implied volatility rises.\nSource : Chart courtesy of iVolatility.com\nAnother classic vol divergence in which IV rises and realized vol falls\noccurs in a drug or biotech company when a Food and Drug Administration\n(FDA) decision on one of the company’s new drugs is imminent. This is\nespecially true of smaller firms without big portfolios of drugs. These\ndivergences can produce a huge implied–realized disparity of, in some\ncases, literally hundreds of volatility points leading up to the\nannouncement.\nAlthough rising IV accompanied by falling realized volatility can be one\nof the most predictable patterns in trading, it is ironically one of the most\ndifficult to trade. When the anticipated news breaks, the stock can and often\nwill make a big directional move, and in that case, IV can and likely will\nget crushed. Vega and gamma work against each other in these situations, as\nIV and realized volatility converge. Vol traders will likely gain on one vol\nand lose on the other, but it’s very difficult to predict which will have a\nmore profound effect. Many traders simply avoid trading earnings events\naltogether in favor of less erratic opportunities. For most traders, there are\neasier ways to make money.\n8. Realized Volatility Falls, Implied\nVolatility Remains Constant\nThis volatility shift can be marked by a volatility convergence, divergence,\nor crossover. Exhibit 14.9 shows the realized volatility falling from around\n30 percent to about 23 percent while IV hovers around 25. The crossover\nhere occurs around the middle of February.\nEXHIBIT 14.9 Realized volatility falls, implied volatility remains constant.\nSource : Chart courtesy of iVolatility.com\nThe relative", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 91}
{"text": "is volatility shift can be marked by a volatility convergence, divergence,\nor crossover. Exhibit 14.9 shows the realized volatility falling from around\n30 percent to about 23 percent while IV hovers around 25. The crossover\nhere occurs around the middle of February.\nEXHIBIT 14.9 Realized volatility falls, implied volatility remains constant.\nSource : Chart courtesy of iVolatility.com\nThe relative size of this volatility change makes the interpretation of the\nchart difficult. The last half of September saw around a 15 percent decline\nin realized volatility. The middle of October saw a one-day jump in realized\nof about 15 points. Historical volatility has had several dynamic moves that\nwere larger and more abrupt than the seven-point decline over this six-week\nperiod. This smaller move in realized volatility is not necessarily an\nindication of a volatility event. It could reflect some complacency in the\nmarket. It could indicate a slow period with less trading, or it could simply\nbe a natural contraction in the ebb and flow of volatility causing the\ncalculation of recent stock-price fluctuations to wane.\nWhat is important in this interpretation is how the options market is\nreacting to the change in the volatility of the stock—where the rubber hits\nthe road. The market’s apparent assessment of future volatility is unchanged\nduring this period. When IV rises or falls, vol traders must look to the\nunderlying stock for a reason. The options market reacts to stock volatility,\nnot the other way around.\nFinding fundamental or technical reasons for surges in volatility is easier\nthan finding specific reasons for a decline in volatility. When volatility falls,\nit is usually the result of a lack of news, leading to less price action. In this\nexample, probably nothing happened in the market. Consequently, the stock\nvolatility drifted lower. But it fell below the lowest IV level seen for the six-\nmonth period leading up to the crossover. It was probably hard to take a\nconfident stance in volatility immediately following the crossover. It is\ndifficult to justify selling volatility when the implied is so cheap compared\nwith its historic levels. And it can be hard to justify buying volatility when\nthe options are priced above the stock volatility.\nThe two-week period before the realized line moved beneath the implied\nline deserves closer study. With the IV four or five points lower than the\nrealized volatility in late January, traders may have been tempted to buy\nvolatility. In hindsight, this trade might have been profitable, but there was\nsurely no guarantee of this. Success would have been greatly contingent on\nhow the traders managed their deltas, and how well they adapted as realized\nvolatility fell.\nDuring the first half of this period, the stock volatility remained above\nimplied. For an experienced delta-neutral trader, scalping gamma was likely\neasy money. With the oscillations in stock price, the biggest gamma-\nscalping risk would have been to cover too soon and miss out on\nopportunities to take bigger profits.\nUsing the one-day standard deviation based on IV (described in Chapter\n3) might have produced early covering for long-gamma traders. Why?\nBecause in late January, the standard deviation derived from IV was lower\nthan the actual standard deviation of the stock being traded. In the latter half\nof the period being studied, the end of February on this chart, using the one-\nday standard deviation based on IV would have produced scalping that was\ntoo late. This would have led to many missed opportunities.\nTraders entering hedges at regular nominal intervals—every $0.50, for\nexample—would probably have needed to decrease the interval as volatility\nebbed. For instance, if in late January they were entering orders every\n$0.50, by late February they might have had to trade every $0.40.\n9. Realized Volatility Falls, Implied\nVolatility Falls\nThis final volatility-chart permutation incorporates a fall of both realized\nand IV. The chart in Exhibit 14.10 clearly represents the slow culmination\nof a highly volatile period. This setup often coincides with news of some\nscary event’s being resolved—a law suit settled, unpopular upper\nmanagement leaving, rumors found to be false, a happy ending to political\nissues domestically or abroad, for example. After a sharp sell-off in IV,\nfrom 75 to 55, in late October, marking the end of a period of great\nuncertainty, the stock volatility began a steady decline, from the low 50s to\nbelow 25. IV fell as well, although it remained a bit higher for several\nmonths.\nEXHIBIT 14.10 Realized volatility falls, implied volatility falls.\nSource : Chart courtesy of iVolatility.com\nIn some situations where an extended period of extreme volatility appears\nto be coming to an end, there can be some predictability in how IV will\nreact. To be sure, no one knows what the future holds, but when volatility\nstarts to wane because a specific issue that was causing gyrations in the\nstock price is resolved, it is common, and intuitive, for IV to fall with the\nstock volatility. This is another type of example of reversion to the mean.\nThere is a potential problem if the high-volatility period lasted for an\nextended period of time. Sometimes, it’s hard to get a feel for what the\nmean volatility should be. Or sometimes, because of the event, the stock is\nfundamentally different—in the case of a spin-off, merger, or other\ncorporate action, for example. When it is difficult or impossible to look\nback at a stock’s performance over the previous 6 to 12 months and\nappraise what the normal volatility should be, one can look to the volatility\nof other stocks in the same industry for some guidance.\nStocks that are substitutable for one another typically trade at similar\nvolatilities. From a realized volatility perspective, this is rather intuitive.\nWhen one stock within an industry rises or falls, others within the same\nindustry tend to follow. They trade similarly and therefore experience\nsimilar vol", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 92}
{"text": "be, one can look to the volatility\nof other stocks in the same industry for some guidance.\nStocks that are substitutable for one another typically trade at similar\nvolatilities. From a realized volatility perspective, this is rather intuitive.\nWhen one stock within an industry rises or falls, others within the same\nindustry tend to follow. They trade similarly and therefore experience\nsimilar volatility patterns. If the stock volatility among names within one\nindustry tends to be similar, it follows that the IV should be, too.\nRegardless which of the nine patterns discussed here show up, or how the\nvolatilities line up, there is one overriding observation that’s representative\nof all volatility charts: vol charts are simply graphical representations of\nrealized and implied volatility that help traders better understand the two\nvolatilities’ interaction. But the divergences and convergences in the\nexamples in this chapter have profound meaning to the volatility trader.\nCombined with a comparison of current and past volatility (both realized\nand implied), they give traders insight into how cheap or expensive options\nare.\nNote\n1 . The following examples use charts supplied by iVolatility.com . The\ngray line is the 30-day realized volatility, and the black line is the implied\nvolatility.\nPART IV\nAdvanced Option Trading\nCHAPTER 15\nStraddles and Strangles\nStraddles and strangles are the quintessential volatility strategies. They are\nthe purest ways to buy and sell realized and implied volatility. This chapter\ndiscusses straddles and strangles, how they work, when to use them, what to\nlook out for, and the differences between the two.\nLong Straddle\nDefinition : Buying one call and one put in the same option class, in the\nsame expiration cycle, and with the same strike price.\nLinearly, the long straddle is the best of both worlds—long a call and a\nput. If the stock rises, the call enjoys the unlimited potential for profit while\nthe put’s losses are decidedly limited. If the stock falls, the put’s profit\npotential is bound only by the stock’s falling to zero, while the call’s\npotential loss is finite. Directionally, this can be a win-win situation—as\nlong as the stock moves enough for one option’s profit to cover the loss on\nthe other. The risk, however, is that this may not happen. Holding two long\noptions means a big penalty can be paid for stagnant stocks.\nThe Basic Long Straddle\nThe long straddle is an option strategy to use when a trader is looking for a\nbig move in a stock but is uncertain which direction it will move.\nTechnically, the Commodity Channel Index (CCI), Bollinger bands, or\npennants are some examples of indicators which might signal the possibility\nof a breakout. Or fundamental data might call for a revaluation of the stock\nbased on an impending catalyst. In either case, a long straddle, is a way for\ntraders to position themselves for the expected move, without regard to\ndirection. In this example, we’ll study a hypothetical $70 stock poised for a\nbreakout. We’ll buy the one-month 70 straddle for 4.25.\nExhibit 15.1 shows the payout of the straddle at expiration.\nEXHIBIT 15.1 At-expiration diagram for a long straddle.\nAt expiration, with the stock at $70, neither the call nor the put is in-the-\nmoney. The straddle expires worthless, leaving a loss of 4.25 in its wake\nfrom erosion. If, however, the stock is above or below $70, either the call or\nthe put will have at least some value. The farther the stock price moves\nfrom the strike price in either direction, the higher the net value of the\noptions.\nAbove $70, the call has value. If the underlying is at $74.25 at expiration,\nthe put will expire worthless, but the call will be worth 4.25—the price\ninitially paid for the straddle. Above this break-even price, the trade is a\nwinner, and the higher, the better. Below $70, the put has value. If the\nunderlying is at $65.75 at expiration, the call expires, and the put is worth\n4.25. Below this breakeven, the straddle is a winner, and the lower, the\nbetter.\nWhy It Works\nIn this basic example, if the underlying is beyond either of the break-even\npoints at expiration, the trade is a winner. The key to understanding this is\nthe fact that at expiration, the loss on one option is limited—it can only fall\nto zero—but the profit potential on the other can be unlimited.\nIn practice, most active traders will not hold a straddle until expiration.\nEven if the trade is not held to term, however, movement is still beneficial\n—in fact, it is more beneficial, because time decay will not have depleted\nall the extrinsic value of the options. Movement benefits the long straddle\nbecause of positive gamma. But movement is a race against the clock—a\nrace against theta. Theta is the cost of trading the long straddle. Only pay it\nfor as long as necessary. When the stock’s volatility appears poised to ebb,\nexit the trade.\nExhibit 15.2 shows the P&(L) of the straddle both at expiration and at the\ntime the trade was made.\nEXHIBIT 15.2 Long straddle P&(L) at initiation and expiration.\nBecause this is a short-term at-the-money (ATM) straddle, we will\nassume for simplicity that it has a delta of zero. 1 When the trade is\nconsummated, movement can only help, as indicated by the dotted line on\nthe exhibit. This is the classic graphic representation of positive gamma—\nthe smiley face. When the stock moves higher, the call gains value at an\nincreasing rate while the put loses value at a decreasing rate. When the\nstock moves lower, the put gains at an increasing rate while the call loses at\na decreasing rate. This is positive gamma.\nThis still may not be an entirely fair representation of how profits are\nearned. The underlying is not required to move continuously in one\ndirection for traders to reap gamma profits. As described in Chapter 13,\ntraders can scalp gamma by buying and selling stock to offset long or short\ndeltas created by movement in the underlying. When traders scalp gamma,\nthey lock in profits as the stock", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 93}
{"text": "mma.\nThis still may not be an entirely fair representation of how profits are\nearned. The underlying is not required to move continuously in one\ndirection for traders to reap gamma profits. As described in Chapter 13,\ntraders can scalp gamma by buying and selling stock to offset long or short\ndeltas created by movement in the underlying. When traders scalp gamma,\nthey lock in profits as the stock price oscillates.\nThe potential for gamma scalping is an important motivation for straddle\nbuyers. Gamma scalping a straddle gives traders the chance to profit from a\nstock that has dynamic price swings. It should be second nature to volatility\ntraders to understand that theta is the trade-off of gamma scalping.\nThe Big V\nGamma and theta are not alone in the straddle buyer’s thoughts. Vega is a\nmajor consideration for a straddle buyer, as well. In a straddle, there are two\nlong options of the same strike, which means double the vega risk of a\nsingle-leg trade at that strike. With no short options in this spread, the\nimplied-volatility exposure is concentrated. For example, if the call has a\nvega of 0.05, the put’s vega at that same strike will also be about 0.05. This\nmeans that buying one straddle gives the trader exposure of around 10 cents\nper implied volatility (IV) point. If IV rises by one point, the trader makes\n$10 per one-lot straddle, $20 for two points, and so on. If IV falls one point,\nthe trader loses $10 per straddle, $20 for two points, and so on. Traders who\nwant maximum positive exposure to volatility find it in long straddles.\nThis strategy is a prime example of the marriage of implied and realized\nvolatility. Traders who buy straddles because they are bullish on realized\nvolatility will also have bullish positions in implied volatility—like it or\nnot. With this in mind, traders must take care to buy gamma via a straddle\nthat it is not too expensive in terms of the implied volatility. A winning\ngamma trade can quickly become a loser because of implied volatility.\nLikewise, traders buying straddles to speculate on an increase in implied\nvolatility must take the theta risk of the trade very seriously. Time can eat\naway all a trade’s vega profits and more. Realized and implied exposure go\nhand in hand.\nThe relationship between gamma and vega depends on, among other\nthings, the time to expiration. Traders have some control over the amount of\ngamma relative to the amount of vega by choosing which expiration month\nto trade. The shorter the time until expiration, the higher the gammas and\nthe lower the vegas of ATM options. Gamma traders may be better served\nby buying short-term contracts that coincide with the period of perceived\nhigh stock volatility.\nIf the intent of the straddle is to profit from vega, the choice of the month\nto trade depends on which month’s volatility is perceived to be too high or\ntoo low. If, for example, the front-month IV looks low compared with\nhistorical IV, current and historical realized volatility, and the expected\nfuture volatility, but the back months’ IVs are higher and more in line with\nthese other metrics, there would be no point in buying the back-month\noptions. In this case, traders would need to buy the month that they think is\ncheap.\nTrading the Long Straddle\nOption trading is all about optimizing the statistical chances of success. A\nlong-straddle trade makes the most sense if traders think they can make\nmoney on both implied volatility and gamma. Many traders make the\nmistake of buying a straddle just before earnings are announced because\nthey anticipate a big move in the stock. Of course, stock-price action is only\nhalf the story. The option premium can be extraordinarily expensive just\nbefore earnings, because the stock move is priced into the options. This is\nbuying after the rush and before the crush. Although some traders are\nsuccessful specializing in trading earnings, this is a hard way to make\nmoney.\nIdeally, the best time to buy volatility is before the move is priced in—\nthat is, before everyone else does. This is conceptually the same as buying a\nstock in anticipation of bullish news. Once news comes out, the stock\nrallies, and it is often too late to participate in profits. The goal is to get in at\nthe beginning of the trend, not the end—the same goal as in trading\nvolatility.\nAs in analyzing a stock, fundamental and technical tools exist for\nanalyzing volatility—namely, news and volatility charts. For fundamentals,\nbuy the rumor, sell the news applies to the rush and crush of implied\nvolatility. Previous chapters discussed fundamental events that affect\nvolatility; be prepared to act fast when volatility-changing situations present\nthemselves. With charts, the elementary concept of buy low, sell high is\nobvious, yet profound. Review Chapter 14 for guidance on reading\nvolatility charts.\nWith all trading, getting in is easy. It’s managing the position, deciding\nwhen to hedge and when to get out that is the tricky part. This is especially\ntrue with the long straddle. Straddles are intended to be actively managed.\nInstead of waiting for a big linear move to evolve over time, traders can\ntake profits intermittently through gamma scalping. Furthermore, they hold\nthe trade only as long as gamma scalping appears to be a promising\nopportunity.\nLegging Out\nThere are many ways to exiting a straddle. In the right circumstances,\nlegging out is the preferred method. Instead of buying and selling stock to\nlock in profits and maintain delta neutrality, traders can reduce their\npositions by selling off some of the calls or puts that are part of the straddle.\nIn this technique, when the underlying rises, traders sell as many calls as\nneeded to reduce the delta to zero. As the underlying falls, they sell enough\nputs to reduce their position to zero delta. As the stock oscillates, they\nwhittle away at the position with each hedging transaction. This serves the\ndual purpose of taking profits and reducing risk.\nA trader, Susan, has been studying Acme", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 94}
{"text": "dle.\nIn this technique, when the underlying rises, traders sell as many calls as\nneeded to reduce the delta to zero. As the underlying falls, they sell enough\nputs to reduce their position to zero delta. As the stock oscillates, they\nwhittle away at the position with each hedging transaction. This serves the\ndual purpose of taking profits and reducing risk.\nA trader, Susan, has been studying Acme Brokerage Co. (ABC). Susan\nhas noticed that brokerage stocks have been fairly volatile in recent past.\nExhibit 15.3 shows an analysis of Acme’s volatility over the past 30 days.\nEXHIBIT 15.3 Acme Brokerage Co. volatility.\nStock Price Realized VolatilityFront-Month Implied Volatility\n30-day high $78.6630-day high 47%30-day high 55%\n30-day low $66.9430-day low 36%30-day low 34%\nCurrent px $74.80Current vol 36%Current vol 36%\nDuring this period, Acme stock ranged more than $11 in price. In this\nexample, Acme’s volatility is a function of interest rate concerns and other\nmacroeconomic issues affecting the brokerage industry as a whole. As the\nstock price begins to level off in the latter half of the 30-day period, realized\nvolatility begins to ebb. The front month’s IV recedes toward recent lows as\nwell. At this point, both realized and implied volatility converge at 36\npercent. Although volatility is at its low for the past month, it is still\nrelatively high for a brokerage stock under normal market conditions.\nSusan does not believe that the volatility plaguing this stock is over. She\nbelieves that an upcoming scheduled Federal Reserve Board announcement\nwill lead to more volatility. She perceives this to be a volatility-buying\nopportunity. Effectively, she wants to buy volatility on the dip. Susan pays\n5.75 for 20 July 75-strike straddles.\nExhibit 15.4 shows the analytics of this trade with four weeks until\nexpiration.\nEXHIBIT 15.4 Analytics for long 20 Acme Brokerage Co. 75-strike\nstraddles.\nAs with any trade, the risk is that the trader is wrong. The risk here is\nindicated by the −2.07 theta and the +3.35 vega. Susan has to scalp an\naverage of at least $207 a day just to break even against the time decay. And\nif IV continues to ebb down to a lower, more historically normal, level, she\nneeds to scalp even more to make up for vega losses.\nEffectively, Susan wants both realized and implied volatility to rise. She\npaid 36 volatility for the straddle. She wants to be able to sell the options at\na higher vol than 36. In the interim, she needs to cover her decay just to\nbreak even. But in this case, she thinks the stock will be volatile enough to\ncover decay and then some. If Acme moves at a volatility greater than 36,\nher chances of scalping profitably are more favorable than if it moves at\nless than 36 vol. The following is one possible scenario of what might have\nhappened over two weeks after the trade was made.\nWeek One\nDuring the first week, the stock’s volatility tapered off a bit more, but\nimplied volatility stayed firm. After some oscillation, the realized volatility\nended the week at 34 percent while IV remained at 36 percent. Susan was\nable to scalp stock reasonably well, although she still didn’t cover her seven\ndays of theta. Her stock buys and sells netted a gain of $1,100. By the end\nof week one, the straddle was 5.10 bid. If she had sold the straddle at the\nmarket, she would have ended up losing $200.\nSusan decided to hold her position. Toward the end of week two, there\nwould be the Federal Open Market Committee (FOMC) meeting.\nWeek Two\nThe beginning of the week saw IV rise as the event drew near. By the close\non Tuesday, implied volatility for the straddle was 40 percent. But realized\nvolatility continued its decline, which meant Susan was not able to scalp to\ncover the theta of Saturday, Sunday, Monday, and Tuesday. But, the straddle\nwas now 5.20 bid, 0.10 higher than it had been on previous Friday. The\nrising IV made up for most of the theta loss. At this point, Susan could have\nsold her straddle to scratch her trade. She would have lost $1,100 on the\nstraddle [(5.20 − 5.75) × 20] but made $1,100 by scalping gamma in the\nfirst week. Susan decided to wait and see what the Fed chairman had to say.\nBy week’s end, the trade had proved to be profitable. After the FOMC\nmeeting, the stock shot up more than $4 and just as quickly fell. It\ncontinued to bounce around a bit for the rest of the week. Susan was able to\nlock in $5,200 from stock scalps. After much gyration over this two-week\nperiod, the price of Acme stock incidentally returned to around the same\nprice it had been at when Susan bought her straddle: $74.50. As might have\nbeen expected after the announcement, implied volatility softened. By\nFriday, IV had fallen to 30. Realized volatility was sharply higher as a result\nof the big moves during the week that were factored into the 30-day\ncalculation.\nWith seven more days of decay and a lower implied volatility, the straddle\nwas 3.50 bid at midafternoon on Friday. Susan sold her 20-lot to close the\nposition. Her profit for week two was $2,000.\nWhat went into Susan’s decision to close her position? Susan had two\nobjectives: to profit from a rise in implied volatility and to profit from a rise\nin realized volatility. The rise in IV did indeed occur, but not immediately.\nBy Tuesday of the second week, vega profits were overshadowed by theta\nlosses.\nGamma was the saving grace with this trade. The bulk of the gain\noccurred in week two when the Fed announcement was made. Once that\nevent passed, the prospects for covering theta looked less attractive. They\nwere further dimmed by the sharp drop in implied volatility from 40 to 30.\nIn this hypothetical scenario, the trade ended up profitable. This is not\nalways the case. Here the profit was chiefly produced by one or two high-\nvolatility days. Had the stock not been unusually volatile during this time,\nthe trade would have been a certain loser. Even though implied volatility\nhad risen four points by Tuesday of the second week, the trade did not", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 95}
{"text": "lied volatility from 40 to 30.\nIn this hypothetical scenario, the trade ended up profitable. This is not\nalways the case. Here the profit was chiefly produced by one or two high-\nvolatility days. Had the stock not been unusually volatile during this time,\nthe trade would have been a certain loser. Even though implied volatility\nhad risen four points by Tuesday of the second week, the trade did not yield\na profit. The time decay of holding two options can make long straddles a\ntough strategy to trade.\nShort Straddle\nDefinition : Selling one call and one put in the same option class, in the\nsame expiration cycle, and with the same strike price.\nJust as buying a straddle is a pure way to buy volatility, selling a straddle\nis a way to short it. When a trader’s forecast calls for lower implied and\nrealized volatility, a straddle generates the highest returns of all volatility-\nselling strategies. Of course, with high reward necessarily comes high risk.\nA short straddle is one of the riskiest positions to trade.\nLet’s look at a one-month 70-strike straddle sold at 4.25.\nThe risk is easily represented graphically by means of a P&(L) diagram.\nExhibit 15.5 shows the risk and reward of this short straddle.\nEXHIBIT 15.5 Short straddle P&(L) at initiation and expiration.\nIf the straddle is held until expiration and the underlying is trading below\nthe strike price, the short put is in-the-money (ITM). The lower the stock,\nthe greater the loss on the +1.00 delta from the put. The trade as a whole\nwill be a loser if the underlying is below the lower of the two break-even\npoints—in this case $65.75. This point is found by subtracting the premium\nreceived from the strike. Before expiration, negative gamma adversely\naffects profits as the underlying falls. The lower the underlying is trading\nbelow the strike price, the greater the drain on P&(L) due to the positive\ndelta of the short put.\nIt is the same proposition if the underlying is above $70 at expiration. But\nin this case, it is the short call that would be in-the-money. The higher the\nunderlying price, the more the −1.00 delta adversely impacts P&(L). If at\nexpiration the underlying is above the higher breakeven, which in this case\nis $74.25 (the strike plus the premium), the trade is a loser. The higher the\nunderlying, the worse off the trade. Before expiration, negative gamma\ncreates negative deltas as the underlying climbs above the strike, eating\naway at the potential profit, which is the net premium received.\nThe best-case scenario is that the underlying is right at $70 at the closing\nbell on expiration Friday. In this situation, neither option is ITM, meaning\nthat the 4.25 premium is all profit. In reaping the maximum profit, both\ntime and price play roles. If the position is closed before expiration, implied\nvolatility enters into the picture as well.\nIt’s important to note that just because neither option is ITM if the\nunderlying is right at $70 at expiration, it doesn’t mean with certainty that\nneither option will be assigned. Sometimes options that are ATM or even\nout-of-the-money (OTM) get assigned. This can lead to a pleasant or\nunpleasant surprise the Monday morning following expiration. The risk of\nnot knowing whether or not you will be assigned—that is, whether or not\nyou have a position in the underlying security—is a risk to be avoided. It is\nthe goal of every trader to remove unnecessary risk from the equation.\nBuying the call and the put for 0.05 or 0.10 to close the position is a small\nprice to pay when one considers the possibility of waking up Monday\nmorning to find a loss of hundreds of dollars per contract because a position\nyou didn’t even know you owned had moved against you. Most traders\navoid this risk, referred to as pin risk, by closing short options before\nexpiration.\nThe Risks with Short Straddles\nLooking at an at-expiration diagram or even analyzing the gamma/theta\nrelationship of a short straddle may sometimes lead to a false sense of\ncomfort. Sometimes it looks as if short straddles need a pretty big move to\nlose a lot of money. So why are they definitely among the riskiest strategies\nto trade? That is a matter of perspective.\nOption trading is about risk management. Dealing with a proverbial train\nwreck every once in a while is part of the game. But the big disasters can\nend one’s trading career in an instant. Because of its potential—albeit\nsometimes small potential—for a colossal blowup, the short straddle is,\nindeed, one of the riskiest positions one can trade. That said, it has a place\nin the arsenal of option strategies for speculative traders.\nTrading the Short Straddle\nA short straddle is a trade for highly speculative traders who think a security\nwill trade within a defined range and that implied volatility is too high.\nWhile a long straddle needs to be actively traded, a short straddle needs to\nbe actively monitored to guard against negative gamma. As adverse deltas\nget bigger because of stock price movement, traders have to be on alert,\nready to neutralize directional risk by offsetting the delta with stock or by\nlegging out of the options. To be sure, with a short straddle, every stock\ntrade locks in a loss with the intent of stemming future losses. The ideal\nsituation is that the straddle is held until expiration and expires with the\nunderlying right at $70 with no negative-gamma scalping.\nShort-straddle traders must take a longer-term view of their positions than\nlong-straddle traders. Often with short straddles, it is ultimately time that\nprovides the payout. While long straddle traders would be inclined to watch\ngamma and theta very closely to see how much movement is required to\ncover each day’s erosion, short straddlers are more inclined to focus on the\nat-expiration diagram so as not to lose sight of the end game.\nThere are some situations that are exceptions to this long-term focus. For\nexample, when implied volatility gets to be extremely high for a particular\noption class relative to both the", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 96}
{"text": "watch\ngamma and theta very closely to see how much movement is required to\ncover each day’s erosion, short straddlers are more inclined to focus on the\nat-expiration diagram so as not to lose sight of the end game.\nThere are some situations that are exceptions to this long-term focus. For\nexample, when implied volatility gets to be extremely high for a particular\noption class relative to both the underlying stock’s volatility and the\nhistorical implied volatility, one may want to sell a straddle to profit from a\nfall in IV. This can lead to leveraged short-term profits if implied volatility\ndoes, indeed, decline.\nBecause of the fact that there are two short options involved, these\nstraddles administer a concentrated dose of negative vega. For those willing\nto bet big on a decline in implied volatility, a short straddle is an eager\ncroupier. These trades are delta neutral and double the vega of a single-leg\ntrade. But they’re double the gamma, too. As with the long straddle,\nrealized and implied volatility levels are both important to watch.\nShort-Straddle Example\nFor this example, a trader, John, has been watching Federal XYZ Corp.\n(XYZ) for a year. During the 12 months that John has followed XYZ, its\nfront-month implied volatility has typically traded at around 20 percent, and\nits realized volatility has fluctuated between 15 and 20 percent. The past 30\ndays, however, have been a bit more volatile. Exhibit 15.6 shows XYZ’s\nrecent volatility.\nEXHIBIT 15.6 XYZ volatility.\nStock Price Realized VolatilityFront-Month Implied Volatility\n30-day high $111.7130-day high 26%30-day high 30%\n30-day low $102.0530-day low 21%30-day low 24%\nCurrent px $104.75Current vol 22%Current vol 26%\nThe stock volatility has begun to ease, trading now at a 22 volatility\ncompared with the 30-day high of 26, but still not down to the usual 15-to-\n20 range. The stock, in this scenario, has traded in a channel. It currently\nlies in the lower half of its recent range. Although the current front-month\nimplied volatility is in the lower half of its 30-day range, it’s historically\nhigh compared with the 20 percent level that John has been used to seeing,\nand it’s still four points above the realized volatility. John believes that the\nconditions that led to the recent surge in volatility are no longer present. His\nforecast is for the stock volatility to continue to ease and for implied\nvolatility to continue its downtrend as well and revert to its long-term mean\nover the next week or two. John sells 10 September 105 straddles at 5.40.\nExhibit 15.7 shows the greeks for this trade.\nEXHIBIT 15.7 Greeks for short XYZ straddle.\n\nThe goal here is for implied volatility to fall to around 20. If it does, John\nmakes $1,254 (6 vol points × 2.09 vega). He also thinks theta gains will\noutpace gamma losses. The following is a two-week examination of one\npossible outcome for John’s trade.\nWeek One\nThe first week in this example was a profitable one, but it came with\nchallenges. John paid for his winnings with a few sleepless nights. On the\nMonday following his entry into the trade, the stock rose to $106. While\nJohn collected a weekend’s worth of time decay, the $1.25 jump in stock\nprice ate into some of those profits and naturally made him uneasy about\nthe future.\nAt this point, John was sitting on a profit, but his position delta began to\ngrow negative, to around −1.22 [(–1.18 × 1.25) + 0.26]. For a $104.75\nstock, a move of $1.25—or just over 1 percent—is not out of the ordinary,\nbut it put John on his guard. He decided to wait and see what happened\nbefore hedging.\nThe following day, the rally continued. The stock was at $107.30 by\nnoon. His delta was around −3. In the face of an increasingly negative delta,\nJohn weighed his alternatives: He could buy back some of his calls to offset\nhis delta, which would have the added benefit of reducing his gamma as\nwell. He could buy stock to flatten out. Lastly, he could simply do nothing\nand wait. John felt the stock was overbought and might retrace. He also still\nbelieved volatility would fall. He decided to be patient and enter a stop\norder to buy all of his deltas at $107.50 in case the stock continued trending\nup. The XYZ shares closed at $107.45 that day.\nThis time inaction proved to be the best action. The stock did retrace.\nWeek one ended with Federal XYZ back down around $105.50. The IV of\nthe straddle was at 23. The straddle finished up week one offered at $4.10.\nWeek Two\nThe future was looking bright at the start of week two until Wednesday.\nWednesday morning saw XYZ gap open to $109. When you have a short\nstraddle, a $3.50 gap move in the underlying tends to instantly give you a\nsinking feeling in the pit of your stomach. But the damage was truly not that\nbad. The offer in the straddle was 4.75, so the position was still a winner if\nJohn bought it back at this point.\nGamma/delta hurt. Theta helped. A characteristic that enters into this\ntrade is volatility’s changing as a result of movement in the stock price.\nDespite the fact that the stock gapped $3.50 higher, implied volatility fell by\n1 percent, to 22. This volatility reaction to the underlying’s rise in price is\nvery common in many equity and index options. John decided to close the\ntrade. Nobody ever went broke taking a profit.\nThe trade in this example was profitable. Of course, this will not always\nbe the case. Sometimes short straddles will be losers—sometimes big ones.\nBig moves and rising implied volatility can be perilous to short straddles\nand their writers. If the XYZ stock in the previous example had gapped up\nto $115—which is not an unreasonable possibility—John’s trade would\nhave been ugly.\nSynthetic Straddles\nStraddles are the pet strategy of certain professional traders who specialize\nin trading volatility. In fact, in the mind of many of these traders, a straddle\nis all there is. Any single-legged trade can be turned into a straddle\nsynthetically simply by adding stock.\nChapter 6 discussed put-call parity and sho", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 97}
{"text": "s not an unreasonable possibility—John’s trade would\nhave been ugly.\nSynthetic Straddles\nStraddles are the pet strategy of certain professional traders who specialize\nin trading volatility. In fact, in the mind of many of these traders, a straddle\nis all there is. Any single-legged trade can be turned into a straddle\nsynthetically simply by adding stock.\nChapter 6 discussed put-call parity and showed that, for all intents and\npurposes, a put is a call and a call is a put. For the most part, the greeks of\nthe options in the put-call pair are essentially the same. The delta is the only\nreal difference. And, of course, that can be easily corrected. As a matter of\nperspective, one can make the case that buying two calls is essentially the\nsame as buying a call and a put, once stock enters into the equation.\nTake a non-dividend-paying stock trading at $40 a share. With 60 days\nuntil expiration, a 25 volatility, and a 4 percent interest rate, the greeks of\nthe 40-strike calls and puts of the straddle are as follows:\nEssentially, the same position can be created by buying one leg of the\nspread synthetically. For example, in addition to buying one 40 call, another\n40 call can be purchased along with shorting 100 shares of stock to create a\n40 put synthetically.\n\nCombined, the long call and the synthetic long put (long call plus short\nstock) creates a synthetic straddle. A long synthetic straddle could have\nsimilarly been constructed with a long put and a long synthetic call (long\nput plus long stock). Furthermore, a short synthetic straddle could be\ncreated by selling an option with its synthetic pair.\nNotice the similarities between the greeks of the two positions. The\nsynthetic straddle functions about the same as a conventional straddle.\nBecause the delta and gamma are nearly the same, the up-and-down risk is\nnearly the same. Time and volatility likewise affect the two trades about the\nsame. The only real difference is that the synthetic straddle might require a\nbit more cash up front, because it requires buying or shorting the stock. In\npractice, straddles will typically be traded in accounts with retail portfolio\nmargining or professional margin requirements (which can be similar to\nretail portfolio margining). So the cost of the long stock or margin for short\nstock is comparatively small.\nLong Strangle\nDefinition : Buying one call and one put in the same option class, in the\nsame expiration cycle, but with different strike prices. Typical long\nstrangles involve an OTM call and an OTM put. A strangle in which an\nITM call and an ITM put are purchased is called a long guts strangle.\nA long strangle is similar to a long straddle in many ways. They both\nrequire buying a call and a put on the same class in the same expiration\nmonth. They are both buying volatility. There are, however, some functional\ndifferences. These differences stem from the fact that the options have\ndifferent strike prices.\nBecause there is distance between the strike prices, from an at-expiration\nperspective, the underlying must move more for the trade to show a profit.\nExhibit 15.8 illustrates the payout of options as part of a long strangle on\na $70 stock. The graph is much like that of Exhibit 15.1 , which shows the\npayout of a long straddle. But the net cost here is only 1.00, compared with\n4.25 for the straddle with the same time and volatility inputs. The cost is\nlower because this trade consists of OTM options instead of ATM options.\nThe breakdown is as follows:\n\nEXHIBIT 15.8 Long strangle at-expiration diagram.\nThe underlying has a bit farther to go by expiration for the trade to have\nvalue. If the underlying is above $75 at expiration, the call is ITM and has\nvalue. If the underlying is below $65 at expiration, the put is ITM and has\nvalue. If the underlying is between the two strike prices at expiration both\noptions expire and the 1.00 premium is lost.\nAn important difference between a straddle and a strangle is that if a\nstrangle is held until expiration, its break-even points are farther apart than\nthose of a comparable straddle. The 70-strike straddle in Exhibit 15.1 had a\nlower breakeven of $65.75 and an upper break-even of $74.25. The\ncomparable strangle in this example has break-even prices of $64 and $76.\nBut what if the strangle is not held until expiration? Then the trade’s\ngreeks must be analyzed. Intuitively, two OTM options (or ITM ones, for\nthat matter) will have lower gamma, theta, and vega than two comparable\nATM options. This has a two-handed implication when comparing straddles\nand strangles.\nOn the one hand, from a realized volatility perspective, lower gamma\nmeans the underlying must move more than it would have to for a straddle\nto produce the same dollar gain per spread, even intraday. But on the other\nhand, lower theta means the underlying doesn’t have to move as much to\ncover decay. A lower nominal profit but a higher percentage profit is\ngenerally reaped by strangles as compared with straddles.\nA long strangle composed of two OTM options will also give positive\nexposure to implied volatility but, again, not as much as an ATM straddle\nwould. Positive vega really kicks in when the underlying is close to one of\nthe strike prices. This is important when anticipating changes in the stock\nprice and in IV.\nSay a trader expects implied volatility to rise as a result of higher stock\nvolatility. As the stock rises or falls, the strangle will move toward the price\npoint that offers the highest vega (the strike). With a straddle, the stock will\nbe moving away from the point with the highest vega. If the stock doesn’t\nmove as anticipated, the lower theta and vega of the strangle compared with\nthe ATM straddle have a less adverse effect on P&L.\nLong-Strangle Example\nLet’s return to Susan, who earlier in this chapter bought a straddle on Acme\nBrokerage Co. (ABC). Acme currently trades at $74.80 a share with current\nrealized volatility at 36 percent. The stock’s volatility range for the past\nmonth was bet", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 98}
{"text": "doesn’t\nmove as anticipated, the lower theta and vega of the strangle compared with\nthe ATM straddle have a less adverse effect on P&L.\nLong-Strangle Example\nLet’s return to Susan, who earlier in this chapter bought a straddle on Acme\nBrokerage Co. (ABC). Acme currently trades at $74.80 a share with current\nrealized volatility at 36 percent. The stock’s volatility range for the past\nmonth was between 36 and 47. The implied volatility of the four-week\noptions is 36 percent. The range over the past month for the IV of the front\nmonth has been between 34 and 55.\nAs in the long-straddle example earlier in this chapter, there is a great deal\nof uncertainty in brokerage stocks revolving around interest rates, credit-\ndefault problems, and other economic issues. An FOMC meeting is\nexpected in about one week’s time about whose possible actions analysts’\nestimates vary greatly, from a cut of 50 basis points to no cut at all. Add a\npending earnings release to the docket, and Susan thinks Acme may move\nquite a bit.\nIn this case, however, instead of buying the 75-strike straddle, Susan pays\n2.35 for 20 one-month 70–80 strangles. Exhibit 15.9 compares the greeks of\nthe long ATM straddle with those of the long strangle.\nEXHIBIT 15.9 Long straddle versus long strangle.\nThe cost of the strangle, at 2.35, is about 40 percent of the cost of the\nstraddle. Of course, with two long options in each trade, both have positive\ngamma and vega and negative theta, but the exposure to each metric is less\nwith the strangle. Assuming the same stock-price action, a strangle would\nenjoy profits from movement and losses from lack of movement that were\nsimilar to those of a straddle—just nominally less extreme.\nFor example, if Acme stock rallies $5, from $74.80 to $79.80, the gamma\nof the 75 straddle will grow the delta favorably, generating a gain of 1.50,\nor about 25 percent. The 70–80 strangle will make 1.15 from the curvature\nof the delta–almost a 50 percent gain.\nWith the straddle and especially the strangle, there is one more detail to\nfactor in when considering potential P&L: IV changes due to stock price\nmovement. IV is likely to fall as the stock rallies and rise as the stock\ndeclines. The profits of both the long straddle and the long strangle would\nlikely be adversely affected by IV changes as the stock rose toward $79.80.\nAnd because the stock would be moving away from the straddle strike and\ntoward one of the strangle strikes, the vegas would tend to become more\nsimilar for the two trades. The straddle in this example would have a vega\nof 2.66, while the strangle’s vega would be 2.67 with the underlying at\n$79.80 per share.\nShort Strangle\nDefinition : Selling one call and one put in the same option class, in the\nsame expiration cycle, but with different strike prices. Typically, an OTM\ncall and an OTM put are sold. A strangle in which an ITM call and an ITM\nput are sold is called a short guts strangle.\nA short strangle is a volatility-selling strategy, like the short straddle. But\nwith the short strangle, the strikes are farther apart, leaving more room for\nerror. With these types of strategies, movement is the enemy. Wiggle room\nis the important difference between the short-strangle and short-straddle\nstrategies. Of course, the trade-off for a higher chance of success is lower\noption premium.\nExhibit 15.10 shows the at-expiration diagram of a short strangle sold at\n1.00, using the same options as in the diagram for the long strangle.\nEXHIBIT 15.10 Short strangle at-expiration diagram.\nNote that if the underlying is between the two strike prices, the maximum\ngain of 1.00 is harvested. With the stock below $65 at expiration, the short\nput is ITM, with a +1.00 delta. If the stock price is below the lower\nbreakeven of $64 (the put strike minus the premium), the trade is a loser.\nThe lower the stock, the bigger the loss. If the underlying is above $75, the\nshort call is ITM, with a −1.00 delta. If the stock is above the upper\nbreakeven of $76 (the call strike plus the premium), the trade is a loser. The\nhigher the stock, the bigger the loss.\nIntuitively, the signs of the greeks of this strangle should be similar to\nthose of a short straddle—negative gamma and vega, positive theta. That\nmeans that increased realized volatility hurts. Rising IV hurts. And time\nheals all wounds—unless, of course, the wounds caused by gamma are\ngreater than the net premium received.\nThis brings us to an important philosophical perspective that emphasizes\nthe differences between long straddles and strangles and their short\ncounterparts. Losses from rising vega are temporary; the time value of all\noptions will be zero at expiration. But gamma losses can be permanent and\nprofound. These short strategies have limited profit potential and unlimited\nloss potential. Although short-term profits (or losses) can result from IV\nchanges, the real goal here is to capture theta.\nShort-Strangle Example\nLet’s revisit John, a Federal XYZ (XYZ) trader. XYZ is at $104.75 in this\nexample, with an implied volatility of 26 percent and a stock volatility of\n22. Both implied and realized volatility are higher than has been typical\nduring the past twelve months. John wants to sell volatility. In this example,\nhe believes the stock price will remain in a fairly tight range, causing\nrealized volatility to revert to its normal level, in this case between 15 and\n20 percent.\nHe does everything possible to ensure success. This includes scanning the\nnews headlines on XYZ and its financials for a reason not to sell volatility.\nPlaying devil’s advocate with oneself can uncover unforeseen yet valid\nreasons to avoid making bad trades. John also notes the recent price range,\nwhich has been between $111.71 and $102.05 over the past month. Once\nJohn commits to an outlook on the stock, he wants to set himself up for\nmaximum gain if he’s right and, for that matter, to maximize his chances of\nbeing right. In this case, he decides to sell a strangle to give himself as\nmuch m", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 99}
{"text": "ver unforeseen yet valid\nreasons to avoid making bad trades. John also notes the recent price range,\nwhich has been between $111.71 and $102.05 over the past month. Once\nJohn commits to an outlook on the stock, he wants to set himself up for\nmaximum gain if he’s right and, for that matter, to maximize his chances of\nbeing right. In this case, he decides to sell a strangle to give himself as\nmuch margin for error as possible. He sells 10 three-week 100–110\nstrangles at 1.80.\nExhibit 15.11 compares the greeks of this strangle with those of the 105\nstraddle.\nEXHIBIT 15.11 Short straddle vs. short strangle.\nAs expected, the strangle’s greeks are comparable to the straddle’s but of\nless magnitude. If John’s intention were to capture a drop in IV, he’d be\nbetter off selling the bigger vega of the straddle. Here, though, he wants to\nsee the premium at zero at expiration, so the strangle serves his purposes\nbetter. What he is most concerned about are the breakevens—in this case,\n98.20 and 111.8. The straddle has closer break-even points, of $99.60 and\n$110.40.\nDespite the fact that in this case, John is not really trading the greeks or\nIV per se, they still play an important role in his trade. First, he can use\ntheta to plan the best strangle to trade. In this case, he sells the three-week\nstrangle because it has the highest theta of the available months. The second\nmonth strangle has a −0.71 theta, and the third month has a −0.58 theta.\nWith strangles, because the options are OTM, this disparity in theta among\nthe tradable months may not always be the case. But for this trade, if he is\nstill bearish on realized volatility after expiration, John can sell the next\nmonth when these options expire.\nCertainly, he will monitor his risk by watching delta and gamma. These\nare his best measures of directional exposure. He will consider implied\nvolatility in the decision-making process, too. An implied volatility\nsignificantly higher than the realized volatility can be a red flag that the\nmarket expects something to happen, but there’s a bigger payoff if there is\nno significant volatility. An IV significantly lower than the realized can\nindicate the risk of selling options too cheaply: the premium received is not\nhigh enough, based on how much the stock has been moving. Ideally, the\nIV should be above the realized volatility by between 2 and 20 percent,\nperhaps more for highly speculative traders.\nLimiting Risk\nThe trouble with short straddles and strangles is that every once in a while\nthe stock unexpectedly reacts violently, moving by three or more standard\ndeviations. This occurs when there is a takeover, an extreme political event,\na legal action, or some other extraordinary incident. These events can be\nguarded against by buying farther OTM options for protection. Essentially,\ninstead of selling a straddle or a strangle, one sells an iron butterfly or iron\ncondor. Then, when disaster strikes, it’s not a complete catastrophe.\nHow Cheap Is Too Cheap?\nAt some point, the absolute premium simply is not worth the risk of the\ntrade. For example, it would be unwise to sell a two-month 45–55 strangle\nfor 0.10 no matter what the realized volatility was. With the knowledge that\nthere is always a chance for a big move, it’s hard to justify risking dollars to\nmake a dime.\nNote\n1 . This depends on interest, dividends, and time to expiration. The delta\nwill likely not be exactly zero.\nCHAPTER 16\nRatio Spreads and Complex Spreads\nThe purpose of spreading is to reduce risk. Buying one contract and selling\nanother can reduce some or all of a trade’s risks, as measured by the greeks,\ncompared with simply holding an outright option. But creative traders have\nthe ability to exercise great control over their greeks risk. They can\npractically eliminate risk in some greeks, while retaining risks in just the\ndesired greeks. To do so, traders may have to use more complex, and less\nconventional spreads. These spreads often involve buying or selling options\nin quantities other than one-to-one ratios.\nRatio Spreads\nThe simplest versions of these strategies used by retail traders, institutional\ntraders, proprietary traders, and others are referred to as ratio spreads . In\nratio spreads, options are bought and sold in quantities based on a ratio. For\nexample, a 1:3 spread is when one option is bought (or sold) and three are\nsold (or bought)—a ratio of one to three. This kind of ratio spread would be\ncalled a “one-by-three.”\nHowever, some option positions can get a lot more complicated. Market\nmakers and other professional traders manage a complex inventory of long\nand short options. These types of strategies go way beyond simple at-\nexpiration diagrams. This chapter will discuss the two most common types\nof ratio spreads—backspreads and ratio vertical spreads—and also the\ndelta-neutral position management of market makers and other professional\ntraders.\nBackspreads\nDefinition : An option strategy consisting of more long options than short\noptions having the same expiration month. Typically, the trader is long calls\n(or puts) in one series of options and short a fewer number of calls (or puts)\nin another series with the same expiration month in the same option class.\nSome traders, such as market makers, refer generically to any delta-neutral\nlong-gamma position as a backspread.\nShades of Gray\nIn its simplest form, trading a backspread is trading a one-by-two call or put\nspread and holding it until expiration in hopes that the underlying stock’s\nprice will make a big move, particularly in the more favorable direction.\nBut holding a backspread to expiration as described has its challenges. Let’s\nlook at a hypothetical example of a backspread held to term and its at-\nexpiration diagram.\nWith the stock at $71 and one month until March expiration:\nIn this example, there is a credit of 3.20 from the sale of the 70 call and a\ndebit of 1.10 for each of the two 75 calls. This yields a total net credit of\n1.00 (3.20 − 1.10 − 1.10). Let’s co", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 100}
{"text": "ead to expiration as described has its challenges. Let’s\nlook at a hypothetical example of a backspread held to term and its at-\nexpiration diagram.\nWith the stock at $71 and one month until March expiration:\nIn this example, there is a credit of 3.20 from the sale of the 70 call and a\ndebit of 1.10 for each of the two 75 calls. This yields a total net credit of\n1.00 (3.20 − 1.10 − 1.10). Let’s consider how this trade performs if it is held\nuntil expiration.\nIf the stock falls below $70 at expiration, all the calls expire and the 1.00\ncredit is all profit. If the stock is between $70 and $75 at expiration, the 70\ncall is in-the-money (ITM) and the −1.00 delta starts racking up losses\nabove the breakeven of $71 (the strike plus the credit). At $75 a share this\ntrade suffers its maximum potential loss of $4. If the stock is above $75 at\nexpiration, the 75 calls are ITM. The net delta of +1.00, resulting from the\n+2.00 deltas of the 75 calls along with the −1.00 delta of the 70 call, makes\nmoney as the stock rises. To the upside, the trade is profitable once the\nstock is at a high enough price for the gain on the two 75 calls to make up\nfor the loss on the 70 call. In this case, the breakeven is $79 (the $4\nmaximum potential loss plus the strike price of 75).\nWhile it’s good to understand this at-expiration view of this trade, this\ndiagram is a bit misleading. What does the trader of this spread want to\nhave happen? If the trader is bearish, he could find a better way to trade his\nview than this, which limits his gains to 1.00—he could buy a put. If the\ntrader believes the stock will make a volatile move in either direction, the\nbackspread offers a decidedly limited opportunity to the downside. A\nstraddle or strangle might be a better choice. And if the trader is bullish, he\nwould have to be very bullish for this trade to make sense. The underlying\nneeds to rise above $79 just to break even. If instead he just bought 2 of the\n75 calls for 1.10, the maximum risk would be 2.20 instead of 4, the\nbreakeven would be $77.20 instead of $79, and profits at expiration would\nrack up twice as fast above the breakeven, since the trader is net long two\ncalls instead of one. Why would a trader ever choose to trade a backspread?\nEXHIBIT 16.1 Backspread at expiration.\nThe backspread is a complex spread that can be fully appreciated only\nwhen one has a thorough knowledge of options. Instead of waiting patiently\nuntil expiration, an experienced backspreader is more likely to gamma scalp\nintermittent opportunities. This requires trading a large enough position to\nmake scalping worthwhile. It also requires appropriate margining (either\nprofessional-level margin requirements or retail portfolio margining). For\nexample, this 1:2 contract backspread has a delta of −0.02 and a gamma of\n+0.05. Fewer than 10 deltas could be scalped if the stock moves up and\ndown by one point. It becomes a more practical trade as the position size\nincreases. Of course, more practical doesn’t necessarily guarantee it will be\nmore profitable. The market must cooperate!\nBackspread Example\nLet’s say a 20:40 contract backspread is traded. (Note : In trader lingo this is\nstill called a one-by-two; it is just traded 20 times.) The spread price is still\n1.00 credit per contract; in this case, that’s $2,000. But with this type of\ntrade, the spread price is not the best measure of risk or reward, as it is with\nsome other kinds of spreads. Risk and reward are best measured by delta,\ngamma, theta, and vega. Exhibit 16.2 shows this trade’s greeks.\nEXHIBIT 16.2 Greeks for 20:40 backspread with the underlying at $71.\nBackspreads are volatility plays. This spread has a +1.07 vega with the\nstock at $71. It is, therefore, a bullish implied volatility (IV) play. The IV of\nthe long calls, the 75s, is 30 percent, and that of the 70s is 32 percent. Much\nas with any other volatility trade, traders would compare current implied\nvolatility with realized volatility and the implied volatility of recent past\nand consider any catalysts that might affect stock volatility. The objective is\nto buy an IV that is lower than the expected future stock volatility, based on\nall available data. The focus of traders of this backspread is not the dollar\ncredit earned. They are more interested in buying a 30 volatility—that’s the\nfocus.\nBut the 75 calls’ IV is not the only volatility figure to consider. The short\noptions, the 70s, have implied volatility of 32 percent. Because of their\nlower strike, the IV is naturally higher for the 70 calls. This is vertical skew\nand is described in Chapter 3. The phenomenon of lower strikes in the same\noption class and with the same expiration month having higher IV is very\ncommon, although it is not always the case.\nBackspreads usually involve trading vertical skew. In this spread, traders\nare buying a 30 volatility and selling a 32 volatility. In trading the skew, the\ntraders are capturing two volatility points of what some traders would call\nedge by buying the lower volatility and selling the higher.\nBased on the greeks in Exhibit 16.2 , the goal of this trade appears fairly\nstraightforward: to profit from gamma scalping and rising IV. But, sadly,\nwhat appears to be straightforward is not. Exhibit 16.3 shows the greeks of\nthis trade at various underlying stock prices.\nEXHIBIT 16.3 70–75 backspread greeks at various stock prices.\nNotice how the greeks change with the stock price. As the stock price\nmoves lower through the short strike, the 70 strike calls become the more\nrelevant options, outweighing the influence of the 75s. Gamma and vega\nbecome negative, and theta becomes positive. If the stock price falls low\nenough, this backspread becomes a very different position than it was with\nthe stock price at $71. Instead of profiting from higher implied and realized\nvolatility, the spread needs a lower level of both to profit.\nThis has important implications. First, gamma traders must approach the\nbackspread a little differently than they", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 101}
{"text": "ome negative, and theta becomes positive. If the stock price falls low\nenough, this backspread becomes a very different position than it was with\nthe stock price at $71. Instead of profiting from higher implied and realized\nvolatility, the spread needs a lower level of both to profit.\nThis has important implications. First, gamma traders must approach the\nbackspread a little differently than they would most spreads. The\nbackspread traders must keep in mind the dynamic greeks of the position.\nWith a trade like a long straddle, in which there are no short options, traders\nscalping gamma simply buy to cover short deltas as the stock falls and sell\nto cover long deltas as the stock rises. The only risks are that the stock may\nnot move enough to cover theta or that the traders may cover deltas too\nsoon to maximize profits.\nWith the backspread, the changing gamma adds one more element of risk.\nIn this example, buying stock to flatten out delta as the stock falls can\nsometimes be a premature move. Traders who buy stock may end up with\nmore long deltas than they bargained for if the stock falls into negative-\ngamma territory.\nExhibit 16.3 shows that with the stock at $68, the delta for this trade is\n−2.50. If the traders buy 250 shares at $68, they will be delta neutral. If the\nstock subsequently falls to $62 a share, instead of being short 1.46 deltas, as\nthe figure indicates, they will be long 1.04 because of the 250 shares they\nbought. These long deltas start to hurt as the stock continues lower.\nBackspreaders must therefore anticipate stock movements to avoid\noverhedging. The traders in this example may decide to lean short if the\nstock shows signs of weakness.\nLeaning short means that if the delta is −2.50 at $68 a share, the traders\nmay decide to underhedge by buying just 100 or 200 shares. If the stock\ncontinues to fall and negative gamma kicks in, this gives the traders some\ncushion to the downside. The short delta of the position moves closer to\nbeing flat as the stock falls. Because there is a long strike and a short strike\nin this delta-neutral position, trading ratio spreads is like trading a long and\na short volatility position at the same time. Trading backspreads is not an\nexact science. The stock has just as good a chance of rising as it does of\nfalling, and if it does rise and the traders have underhedged at $68, they will\nnot participate in all the gains they would have if they had fully hedged by\nbuying 250 shares of stock. If trading were easy, everyone would do it!\nBackspreaders must also be conscious of the volatility of each leg of the\nspread. There is an inherent advantage in this example to buying the lower\nvolatility of the 75 calls and selling the higher volatility of the 70 calls. But\nthere is also implied risk. Equity prices and IV tend to have an inverse\nrelationship. When stock prices fall—especially if the drop happens quickly\n—IV will often rise. When stock prices rise, IV often falls.\nIn this backspread example, as the stock price falls to or through the short\nstrike, vega becomes negative in the face of a potentially rising IV. As the\nstock price rises into positive vega turf, there is the risk of IV’s declining. A\ndynamic volatility forecast should be part of a backspread-trading plan. One\nof the volatility questions traders face in this example is whether the two-\npoint volatility skew between the two strike prices is enough to compensate\nfor the potential adverse vega move as the stock price changes.\nPut backspreads have the opposite skew/volatility issues. Buying two\nlower-strike puts against one higher-strike put means the skew is the other\ndirection—buying the higher IV and selling the lower. The put backspread\nwould have long gamma/vega to the downside and short gamma/vega to the\nupside. But if the vega firms up as the stock falls into positive-vega\nterritory, it would be in the trader’s favor. As the stock rises, leading to\nnegative vega, there is the potential for vega profits if IV indeed falls. There\nare a lot of things to consider when trading a backspread. A good trader\nneeds to think about them all before putting on the trade.\nRatio Vertical Spreads\nDefinition : An option strategy consisting of more short options than long\noptions having the same expiration month. Typically, the trader is short calls\n(or puts) in one series of options and long a fewer number of calls (or puts)\nin another series in the same expiration month on the same option class.\nA ratio vertical spread, like a backspread, involves options struck at two\ndifferent prices—one long strike and one short. That means that it is a\nvolatility strategy that may be long or short gamma or vega depending on\nwhere the underlying price is at the time. The ratio vertical spread is\neffectively the opposite of a backspread. Let’s study a ratio vertical using\nthe same options as those used in the backspread example.\nWith the stock at $71 and one month until March expiration:\nIn this case, we are buying one ITM call and selling two OTM calls. The\nrelationship of the stock price to the strike price is not relevant to whether\nthis spread is considered a ratio vertical spread. Certainly, all these options\ncould be ITM or OTM at the time the trade is initiated. It is also not\nimportant whether the trade is done for a debit or a credit. If the stock price,\ntime to expiration, volatility, or number of contracts in the ratio were\ndifferent, this could just as easily been a credit ratio vertical.\nExhibit 16.4 illustrates the payout of this strategy if both legs of the 1:2\ncontract are still open at expiration.\nEXHIBIT 16.4 Short ratio spread at expiration.\nThis strategy is a mirror image of the backspread discussed previously in\nthis chapter. With limited risk to the downside, the maximum loss to the\ntrade is the initial debit of 1 if the stock is below $70 at expiration and all\nthe calls expire. There is a maximum profit potential of 4 if the stock is at\nthe short strike at expiration. There is unlimited", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 102}
{"text": "HIBIT 16.4 Short ratio spread at expiration.\nThis strategy is a mirror image of the backspread discussed previously in\nthis chapter. With limited risk to the downside, the maximum loss to the\ntrade is the initial debit of 1 if the stock is below $70 at expiration and all\nthe calls expire. There is a maximum profit potential of 4 if the stock is at\nthe short strike at expiration. There is unlimited loss potential, since a short\nnet delta is created on the upside, as one short 75 call is covered by the long\n70 call, and one is naked. The breakevens are at $71 and $79.\nLow Volatility\nWith the stock at $71, gamma and vega are both negative. Just as the\nbackspread was a long volatility play at this underlying price, this ratio\nvertical is a short-vol play here. As in trading a short straddle, the name of\nthe game is low volatility—meaning both implied and realized.\nThis strategy may require some gamma hedging. But as with other short\nvolatility delta-neutral trades, the fewer the negative scalps, the greater the\npotential profit. Delta covering should be implemented in situations where\nit looks as if the stock will trend deep into negative-gamma territory.\nMurphy’s Law of trading dictates that delta covering will likely be wrong at\nleast as often as it is right.\nRatio Vertical Example\nLet’s examine a trade of 20 contracts by 40 contracts. Exhibit 16.5 shows\nthe greeks for this ratio vertical.\nEXHIBIT 16.5 Short ratio vertical spread greeks.\nBefore we get down to the nitty-gritty of the mechanics and management\nof this trade—the how—let’s first look at the motivations for putting the\ntrade on—the why. For the cost of 1.00 per spread, this trader gets a\nleveraged position if the stock rises moderately. The profits max out with\nthe stock at the short-strike target price—$75—at expiration.\nAnother possible profit engine is IV. Because of negative vega, there is\nthe chance of taking a quick profit if IV falls in the interim. But short-term\nlosses are possible, too. IV can rise, or negative gamma can hurt the trader.\nUltimately, having naked calls makes this trade not very bullish. A big\nmove north can really hurt.\nBasically, this is a delta-neutral-type short-volatility play that wins the\nmost if the stock is at $75 at expiration. One would think about making this\ntrade if the mechanics fit the forecast. If this trader were a more bullish than\nindicated by the profit and loss diagram, a more-balanced bull call spread\nwould be a better strategy, eliminating the unlimited upside risk. If upside\nrisk were acceptable, this trader could get more aggressive by trading the\nspread one-by-three. That would result in a credit of 0.05 per spread. There\nwould then be no ultimate risk below $70 but rather a 0.05 gain. With\ndouble the naked calls, however, there would be double punishment if the\nstock rallied strongly beyond the upside breakeven.\nUltimately, mastering options is not about mastering specific strategies.\nIt’s about having a thorough enough understanding of the instrument to be\nflexible enough to tailor a position around a forecast. It’s about minimizing\nthe unwanted risks and optimizing exposure to the intended risks. Still,\nthere always exists a trade-off in that where there is the potential for profit,\nthere is the possibility of loss—you can always be wrong.\nRecalling the at-expiration diagram and examining the greeks, the best-\ncase scenario is intuitive: the stock at $75 at expiration. The biggest theta\nwould be right at that strike. But that strike price is also the center of the\nbiggest negative gamma. It is important to guard against upward movement\ninto negative delta territory, as well as movement lower where the position\nhas a slightly positive delta. Exhibit 16.6 shows what happens to the greeks\nof this trade as the stock price moves.\nEXHIBIT 16.6 Ratio vertical spread at various prices for the underlying.\nAs the stock begins to rise from $71 a share, negative deltas grow fast in\nthe short term. Careful trend monitoring is necessary to guard against a\nrally. The key, however, is not in knowing what will happen but in skillfully\nhedging against the unknown. The talented option trader is a disciplined\nrisk manager, not a clairvoyant.\nOne of the risks that the trader willingly accepted when placing this trade\nwas short gamma. But when the stock moves and deltas are created,\ndecisions have to be made. Did the catalyst(s)—if any—that contributed to\nthe rise in stock price change the outlook for volatility? If not, the decision\nis simply whether or not to hedge by buying stock. However, if it appears\nthat volatility is on the rise, it is not just a delta decision. A trader may\nconsider buying some of the short options back to reduce volatility\nexposure.\nIn this example, if the stock rises and it’s feared that volatility may\nincrease, a good choice may be to buy back some of the short 75-strike\ncalls. This has the advantage of reducing delta (buy enough deltas to flatten\nout) and reducing gamma and vega. Of course, the downside to this strategy\nis that in purchasing the calls, a loss is likely to be locked in. Unless a lot of\ntime has passed or implied volatility has dropped sharply, the calls will\nprobably be bought at a higher price than they were sold.\nIf the stock makes a violent move upward, a loss will be incurred.\nWhether this loss is locked in by closing all or part of the position, the\naccount will still be down in value. The decision to buy the calls back at a\nloss is based on looking forward. Nothing good can come of looking back.\nHow Market Makers Manage\nDelta-Neutral Positions\nWhile market makers are not position traders per se, they are expert\nposition managers. For the most part, market makers make their living by\nbuying the bid and selling the offer. In general, they don’t act; they react.\nMost of their trades are initiated by taking the other side of what other\npeople want to do and then managing the risk of the positions they\naccumulate.\nThe business of a market maker is mu", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 103}
{"text": "ket makers are not position traders per se, they are expert\nposition managers. For the most part, market makers make their living by\nbuying the bid and selling the offer. In general, they don’t act; they react.\nMost of their trades are initiated by taking the other side of what other\npeople want to do and then managing the risk of the positions they\naccumulate.\nThe business of a market maker is much like that of a casino. A casino\ntakes the other side of people’s bets and, in the long run, has a statistical\n(theoretical) edge. For market makers, because theoretical value resides in\nthe middle of the bid and the ask, these accommodating trades lead to a\ntheoretical profit—that is, the market maker buys below theoretical value\nand sells above. Actual profit—cold, hard cash you can take to the bank—\nis, however, dependent on sound management of the positions that are\naccumulated.\nMy career as a market maker was on the floor of the Chicago Board\nOptions Exchange (CBOE) from 1998 to 2005. Because, over all, the trades\nI made had a theoretical edge, I hoped to trade as many contracts as\npossible on my markets without getting too long or too short in any option\nseries or any of my greeks.\nAs a result of reacting to order flow, market makers can accumulate a\nlarge number of open option series for each class they trade, resulting in a\nsingle position. For example, Exhibit 16.7 shows a position I had in Ford\nMotor Co. (F) options as a market maker.\nEXHIBIT 16.7 Market-maker position in Ford Motor Co. options.\n\nWith all the open strikes, this position is seemingly complex. There is not\na specific name for this type of “spread.” The position was accumulated\nover a long period of time by initiating trades via other traders selling\noptions to me at prices I wanted to buy them—my bid—and buying options\nfrom me at prices I wanted to sell them—my offer. Upon making an option\ntrade, I needed to hedge directional risk immediately. I usually did so by\noffsetting my option trades by taking the opposite delta position in the stock\n—especially on big-delta trades. Through this process of providing liquidity\nto the market, I built up option-centric risk.\nTo manage this risk I needed to watch my other greeks. To be sure, trying\nto draw a P&L diagram of this position would be a fruitless endeavor.\nExhibit 16.8 shows the risk of this trade in its most distilled form.\nEXHIBIT 16.8 Analytics for market-maker position in Ford Motor Co.\n(stock at $15.72).\nDelta +1,075\nGamma−10,191\nTheta +1,708\nVega +7,171\nRho −33,137\nThe +1,075 delta shows comparatively small directional risk relative to\nthe −10,191 gamma. Much of the daily task of position management would\nbe to carefully guard against movement by delta hedging when necessary to\nearn the $1,708 per day theta.\nMuch of the negative gamma/positive theta comes from the combined\n1,006 short January 15 calls and puts. (Note that because this position is\ntraded delta neutral, the net long or short options at each strike is what\nmatters, not whether the options are calls or puts. Remember that in delta-\nneutral trading, a put is a call, and a call is a put.) The positive vega stems\nfrom the fact that the position is long 1,927 January 2003 20-strike options.\nAlthough this position has a lot going on, it can be broken down many\nways. Having long LEAPS options and short front-month options gives this\nposition the feel of a time spread. One way to think of where most of the\ngamma risk is coming from is to bear in mind that the 15 strike is\nsynthetically short 503 straddles (1,006 options ÷ two). But this position\noverall is not like a straddle. There are more strikes involved—a lot more.\nThere is more short gamma to the downside if the price of Ford falls toward\n$12.50. To the upside, the 17.50 strike is long a combined total of 439\noptions. Looking at just the 15 and 17.50 strikes, we can see something that\nlooks more like a ratio spread: 1,006:439. If the stock were at $17.50, the\ngamma would be around +5,000.\nWith the stock at $15.72, there is realized volatility risk of F rallying, but\nwith gamma changing from negative to positive as the stock rallies, the risk\nof movement decreases quickly. The 20 strike is short 871 options which\nbrings the position back to negative-gamma territory. Having alternating\nlong and short strikes, sometimes called a butterflied position, is a handy\nway for market makers to reduce risk. A position is perfectly butterflied if it\nhas alternating long and short strikes with the same number of contracts.\nThrough Your Longs to Your Shorts\nWith market-maker-type positions consisting of many strikes, the greatest\nprofit is gained if the underlying security moves through the longs to the\nshorts. This provides kind of a win-win scenario for greeks traders. In this\nsituation, traders get the benefit of long gamma as the stock moves higher\nor lower through the long strike. They also reap the benefits of theta when\nthe stock sits at the short strike.\nTrading Flat\nMost market makers like to trade flat—that is, profit from the bid-ask\nspread and strive to lower exposure to direction, time, volatility, and interest\nas much as possible. But market makers are at the mercy of customer\norders, or paper, as it’s known in the industry. If someone sells, say, the\nMarch 75 calls to a market maker at the bid, the best-case scenario is that\nmoments later someone else buys the same number of the same calls—the\nMarch 75s, in this case—from that same market maker at the offer. This is\nlocking in a profit.\nUnfortunately, this scenario seldom plays out this way. In my seven years\nas a market maker, I can count on one hand the number of times the option\ngods smiled upon me in such a way as to allow me to immediately scalp an\noption. Sometimes, the same option will not trade again for a week or\nlonger. Very low-volume options trade “by appointment only.” A market\nmaker trading illiquid options may hold the position until it expires, having\nno chance to get out at a reasonable", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 104}
{"text": "a market maker, I can count on one hand the number of times the option\ngods smiled upon me in such a way as to allow me to immediately scalp an\noption. Sometimes, the same option will not trade again for a week or\nlonger. Very low-volume options trade “by appointment only.” A market\nmaker trading illiquid options may hold the position until it expires, having\nno chance to get out at a reasonable price, often taking a loss on the trade.\nMore typically, if a market maker buys an option, he must sell a different\noption to lessen the overall position risk. The skills these traders master are\nto lower bids and offers on options when they are long gamma and/or vega\nand to raise bids and offers on options when they are short gamma and/or\nvega. This raising and lowering of markets is done to manage risk.\nEffectively, this is your standard high school economics supply-and-\ndemand curves in living color. When the market demands (buys) all the\noptions that are supplied (offered) at a certain price, the price rises. When\nthe market supplies (sells) all the options demanded (bid) at a price level,\nthe price falls. The catalyst of supply and demand is the market maker and\nhis risk tolerance. But instead of the supply and demand for individual\noptions, it is supply and demand for gamma, theta, and vega. This is trading\noption greeks.\nHedging the Risk\nDelta is the easiest risk for floor traders to eliminate quickly. It becomes\nsecond nature for veteran floor traders to immediately hedge nearly every\ntrade with the underlying. Remember, these liquidity providers are in the\nbusiness of buying option bids and selling option offers, not speculating on\ndirection.\nThe next hurdle is to trade out of the option-centric risk. This means that\nif the market maker is long gamma, he needs to sell options; if he’s short\ngamma, he needs to buy some. Same with theta and vega. Market makers\nmove their bids and offers to avoid being saddled with too much gamma,\ntheta, and vega risk. Experienced floor traders are good at managing option\nrisk by not biting off more than they can chew. They strive to never buy or\nsell more options than they can spread off by selling or buying other\noptions. This breed of trader specializes in trading the spread and managing\nrisk, not in predicting the future. They’re market makers, not market takers.\nTrading Skew\nThere are some trading strategies for which market makers have a natural\npropensity that stems from their daily activity of maintaining their\npositions. While money managers who manage equity funds get to know\nthe fundamentals of the stocks they trade very well, options market makers\nknow the volatility of the option classes they trade. When they adjust their\nmarkets in reacting to order flow, it’s, mechanically, implied volatility that\nthey are raising or lowering to change theoretical values. They watch this\nfigure very carefully and trade its subtle changes.\nA characteristic of options that many market makers and some other\nactive professional traders observe and trade is the volatility skew. Savvy\ntraders watch the implied volatility of the strikes above the at-the-money\n(ATM)—referred to as calls , for simplicity—compared with the strikes\nbelow the ATM, referred to as puts . In most stocks, there typically exists a\n“normal” volatility skew inherent to options on that stock. When this skew\ngets out of line, there may be an opportunity.\nSay for a particular option class, the call that is 10 percent OTM typically\ntrades about four volatility points lower than the put that is 10 percent\nOTM. For example, for a $50 stock, the 55 calls are trading at a 21 IV and\nthe 45 puts are trading at a 25 volatility. If the 45 puts become bid higher,\nsay, nine points above where the calls are offered—for instance, the puts are\nbid at 32 volatility bid while the calls are offered at 23 vol—a trader can\nspeculate on the skew reverting back to its normal relationship by selling\nthe puts, buying the calls, and hedging the delta by selling the right amount\nof stock.\nThis position—long a call, short a put with a different strike, and short\nstock on a delta-neutral ratio—is called a risk reversal. The motive for risk\nreversals is to capture vega as the skew realigns itself. But there are many\nrisk factors that require careful attention.\nFirst, as in other positions consisting of both long and short strikes, the\ngamma, theta, and vega of the position will vary from positive to negative\ndepending on the price of the underlying. Risk-reversal traders must be\nprepared to trade long gamma (and battle time decay) when the stock rallies\ncloser to the long-call strike and trade short gamma (and assume the risk of\npossible increased realized volatility) when the stock moves closer to the\nshort-put strike.\nAs for vega, being short implied volatility on the downside and long on\nthe upside is inherently a potentially bad position whichever way the stock\nmoves. Why? As equities decline in price, the implied volatility of their\noptions tends to rise. But the downside is where the risk reversal has its\nshort vega. Furthermore, as equities rally, their IV tends to fall. That means\nthe long vega of the upside hurts as well.\nWhen Delta Neutral Isn’t Direction\nIndifferent\nMany dynamic-volatility option positions, such as the risk reversal, have\nvega risk from potential IV changes resulting from the stock’s moving. This\nis indirectly a directional risk. While having a delta-neutral position hedges\nagainst the rather straightforward directional risk of the position delta, this\nhidden risk of stock movement is left unhedged. In some circumstances, a\ndelta-lean can help abate some of the vega risk of stock-price movement.\nSay an option position has fairly flat greeks at the current stock price. Say\nthat given the way this particular position is set up, if the stock rises, the\nposition is still fairly flat, but if the stock falls, short lower-strike options\nwill lead to negative gamma and vega. One way to partially hedge th", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 105}
{"text": "ome circumstances, a\ndelta-lean can help abate some of the vega risk of stock-price movement.\nSay an option position has fairly flat greeks at the current stock price. Say\nthat given the way this particular position is set up, if the stock rises, the\nposition is still fairly flat, but if the stock falls, short lower-strike options\nwill lead to negative gamma and vega. One way to partially hedge this\nposition is to lean short deltas—that is, instead of maintaining a totally flat\ndelta, have a slightly short delta. That way, if the stock falls, the trade\nprofits some on the short stock to partially offset some of the anticipated\nvega losses. The trade-off of this hedge is that if the stock rises, the trade\nloses on the short delta.\nDelta leans are more of an art than a science and should be used as a\nhedge only by experienced vol traders. They should be one part of a well-\norchestrated plan to trade the delta, gamma, theta, and vega of a position.\nAnd, to be sure, a delta lean should be entered into a model for simulation\npurposes before executing the trade to study the up-and-down risk of the\nposition. If the lean reduces the overall risk of the position, it should be\nimplemented. But if it creates a situation where there is an anticipated loss\nif the stock moves in either direction and there is little hope of profiting\nfrom the other greeks, the lean is not the answer—closing the position is.\nManaging Multiple-Class Risk\nMost traders hold option positions in more than one option class. As an\naside, I recommend doing so, capital and experience permitting. In my\nexperience, having positions in multiple classes psychologically allows for\na certain level of detachment from each individual position. Most traders\ncan make better decisions if they don’t have all their eggs in one basket.\nBut holding a portfolio of option positions requires one more layer of risk\nmanagement. The trader is concerned about the delta, gamma, theta, vega,\nand rho not only of each individual option class but also of the portfolio as a\nwhole. The trader’s portfolio is actually one big position with a lot of\nmoving parts. To keep it running like a well-oiled machine requires\nmonitoring and maintaining each part to make sure they are working\ntogether. To have the individual trades work in harmony with one another, it\nis important to keep a well-balanced series of strategies.\nOption trading requires diversification, just like conventional linear stock\ntrading or investing. Diversification of the option portfolio is easily\nmeasured by studying the portfolio greeks. By looking at the net greeks of\nthe portfolio, the trader can get some idea of exposure to overall risk in\nterms of delta, gamma, theta, vega, and rho.\nCHAPTER 17\nPutting the Greeks into Action\nThis book was intended to arm the reader with the knowledge of the greeks\nneeded to make better trading decisions. As the preface stated, this book is\nnot so much a how-to guide as a how-come tutorial. It is step one in a three-\nstep learning process:\nStep One: Study . First, aspiring option traders must learn as much as\npossible from books such as this one and from other sources, such as\narticles, both in print and online, and from classes both in person and\nonline. After completing this book, the reader should have a solid base\nof knowledge of the greeks.\nStep Two: Paper Trade . A truly deep understanding requires practice,\npractice, and more practice! Fortunately, much of this practice can be\ndone without having real money on the line. Paper trading—or\nsimulated trading—in which one trades real markets but with fake\nmoney is step two in the learning process. I highly recommend paper\ntrading to kick the tires on various types of strategies and to see how\nthey might work differently in reality than you thought they would in\ntheory.\nStep Three: Showtime ! Even the most comprehensive academic study\nor windfall success with paper profits doesn’t give one a true feel for\nhow options work in the real world. There are some lessons that must\nbe learned from the black and the blue. When there’s real money on the\nline, you will trade differently—at least in the beginning. It’s human\nnature to be cautious with wealth. This is not a bad thing. But emotions\nshould not override sound judgment. Start small—one or two lots per\ntrade—until you can make rational decisions based on what you have\nlearned, keeping emotions in check.\nThis simple three-step process can take years of diligent work to get it\nright. But relax. Getting rich quick is truly a poor motivation for trading\noptions. Option trading is a beautiful thing! It’s about winning. It’s about\nbeating the market. It’s about being smart. Don’t get me wrong—wealth can\nbe a nice by-product. I’ve seen many people who have made a lot of money\ntrading options, but it takes hard work. For every successful option trader\nI’ve met, I’ve met many more who weren’t willing to put in the effort, who\nbrashly thought this is easy, and failed miserably.\nTrading Option Greeks\nTraders must take into account all their collective knowledge and\nexperience with each and every trade. Now that you’re armed with\nknowledge of the greeks, use it! The greeks come in handy in many ways.\nChoosing between Strategies\nA very important use of the greeks is found in selecting the best strategy for\na given situation. Consider a simple bullish thesis on a stock. There are\nplenty of bullish option strategies. But given a bullish forecast, which\noption strategy should a trader choose? The answer is specific to each\nunique opportunity. Trading is situational.\nExample 1\nImagine a trader, Arlo, is studying the following chart of Agilent\nTechnologies Inc. (A). See Exhibit 17.1 .\nEXHIBIT 17.1 Agilent Technologies Inc. daily candles.\nSource : Chart courtesy of Livevol® Pro ( www.livevol.com )\nThe stock has been in an uptrend for six weeks or so. Close-to-close\nvolatility hasn’t increased much. But intraday volatility has increased\ngreatly as indicated by the larger candles", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 106}
{"text": "a trader, Arlo, is studying the following chart of Agilent\nTechnologies Inc. (A). See Exhibit 17.1 .\nEXHIBIT 17.1 Agilent Technologies Inc. daily candles.\nSource : Chart courtesy of Livevol® Pro ( www.livevol.com )\nThe stock has been in an uptrend for six weeks or so. Close-to-close\nvolatility hasn’t increased much. But intraday volatility has increased\ngreatly as indicated by the larger candles over the past 10 or so trading\nsessions. Earnings is coming up in a week in this example, however implied\nvolatility has not risen much. It is still “cheap” relative to historical\nvolatility and past implied volatility. Arlo is bullish. But how does he play\nit? He needs to use what he knows about the greeks to guide his decision.\nArlo doesn’t want to hold the trade through earnings, so it will be a short-\nterm trade. Thus, theta is not much of a concern. The low-priced volatility\nguides his strategy selection in terms of vega. Arlo certainly wouldn’t want\na short-vega trade. Not with the prospect of implied volatility potential\nrising going into earnings. In fact, he’d actually want a big positive vega\nposition. That rules out a naked/cash-secured put, put credit spread and the\nlikes.\nHe can probably rule out vertical spreads all together. He doesn’t need to\nspread off theta. He doesn’t want to spread off vega. Positive gamma is\nattractive for this sort of trade. He wouldn’t want to spread that off either.\nPlus, the inherent time component of spreads won’t work well here. As\ndiscussed in Chapter 9, the bulk of vertical spreads profits (or losses) take\ntime to come to fruition. The deltas of a call spread are smaller than an\noutright call. Profits would come from both delta and theta, if the stock rises\nto the short strike and positive theta kicks in.\nThe best way for Arlo to play this opportunity is by buying a call. It gives\nhim all the greeks attributes he wants (comparatively big positive delta,\ngamma and vega) and the detriment (negative theta) is not a major issue.\nHe’d then select among in-the-money (ITM), at-the-money (ATM), and\nout-of-the-money (OTM) calls and the various available expiration cycles.\nIn this case, because positive gamma is attractive and theta is not an issue,\nhe’d lean toward a front month (in this case, three week) option. The front\nmonth also benefits him in terms of vega. Though the vegas are smaller for\nshort-term options, if there is a rise in implied volatility leading up to\nearnings, the front month will likely rise much more than the rest. Thus, the\ntrader has a possibility for profits from vega.\nExample 2\nA trader, Luke, is studying the following chart for United States Steel Corp.\n(X). See Exhibit 17.2 .\nEXHIBIT 17.2 United States Steel Corp. daily candles.\nSource : Chart courtesy of Livevol® Pro ( www.livevol.com )\nThis stock is in a steady uptrend, which Luke thinks will continue.\nEarnings are out and there are no other expected volatility events on the\nhorizon. Luke thinks that over the next few weeks, United States Steel can\ngo from its current price of around $31 a share to about $34. Volatility is\nmidpriced in this example—not cheap, not expensive.\nThis scenario is different than the previous one. Luke plans to potentially\nhold this trade for a few weeks. So, for Luke, theta is an important concern.\nHe cares somewhat about volatility, too. He doesn’t necessarily want to be\nlong it in case it falls; he doesn’t want to be short it in case it rises. He’d\nlike to spread it off; the lower the vega, the better (positive or negative).\nLuke really just wants delta play that he can hold for a few weeks without\nall the other greeks getting in the way.\nFor this trade, Luke would likely want to trade a debit call spread with the\nlong call somewhat ITM and the short call at the $34 strike. This way, Luke\ncan start off with nearly no theta or vega. He’ll retain some delta, which\nwill enable the spread to profit if United States Steel rises and as it\napproaches the 34 strike, positive theta will kick in.\nThis spread is superior to a pure long call because of its optimized greeks.\nIt’s superior to an OTM bull put spread in its vega position and will likely\nproduce a higher profit with the strikes structured as such too, as it would\nhave a bigger delta.\nIntegrating greeks into the process of selecting an option strategy must\ncome natural to a trader. For any given scenario, there is one position that\nbest exploits the opportunity. In any option position, traders need to find the\noptimal greeks position.\nManaging Trades\nOnce the trade is on, the greeks come in handy for trade management. The\nmost important rule of trading is Know Thy Risk . Knowing your risk means\nknowing the influences that expose your position to profit or peril in both\nabsolute and incremental terms. At-expiration diagrams reveal, in no\nuncertain terms, what the bottom-line risk points are when the option\nexpires. These tools are especially helpful with simple short-option\nstrategies and some long-option strategies. Then traders need the greeks.\nAfter all, that’s what greeks are: measurements of option risk. The greeks\ngive insight into a trade’s exposure to the other pricing factors. Traders must\nknow the greeks of every trade they make. And they must always know the\nnet-portfolio greeks at all times. These pricing factors ultimately determine\nthe success or failure of each trade, each portfolio, and eventually each\ntrader.\nFurthermore, always—and I do mean always—traders must know their up\nand down risk, that is, the directional risk of the market moving up or down\ncertain benchmark intervals. By definition, moves of three standard\ndeviations or more are very infrequent. But they happen. In this business\nanything can happen. Take the “flash crash of 2010 in which the Dow Jones\nIndustrial Average plunged more than 1,000 points in “a flash.” In my\ntrading career, I’ve seen some surprises. Traders have to plan for the worst.\nIt’s not too hard to tell your significant other, “Sorry I’m late, but I hit\nun", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 107}
{"text": "moves of three standard\ndeviations or more are very infrequent. But they happen. In this business\nanything can happen. Take the “flash crash of 2010 in which the Dow Jones\nIndustrial Average plunged more than 1,000 points in “a flash.” In my\ntrading career, I’ve seen some surprises. Traders have to plan for the worst.\nIt’s not too hard to tell your significant other, “Sorry I’m late, but I hit\nunexpected traffic. I just couldn’t plan for it.” But to say, “Sorry, I lost our\nlife savings, and the kids’ college fund, and our house because the market\nmade an unexpected move. I couldn’t plan for it,” won’t go over so well.\nThe fact is, you can plan for it. And as an option trader, you have to. The\nbottom line is, expect the unexpected because the unexpected will\nsometimes happen. Traders must use the greeks and up and down risk,\ninstead of relying on other common indicators, such as the HAPI.\nThe HAPI: The Hope and Pray\nIndex\nSo you bought a call spread. At the opening bell the next morning, you find\nthat the market for the underlying has moved lower—a lot lower. You have\na loss on your hands. What do you do? Keep a positive attitude? Wear your\nlucky shirt? Pray to the options gods? When traders finds themselves\nhoping and praying—I swear I’ll never do that again if I can just get out of\nthis position!—it is probably time for them to take their losses and move on\nto the next trade. The Hope and Pray Index is a contraindicator. Typically,\nthe higher it is, the worse the trade.\nThere are two numbers a trader can control: the entry price and the exit\nprice. All of the other flashing green and red numbers on the screen are out\nof the trader’s control. Savvy traders observe what the market does and\nmake decisions on whether and when to enter a position and when to exit.\nTraders who think about their positions in terms of probability make better\ndecisions at both of these critical moments.\nIn entering a trade, traders must consider their forecast, their assessment\nof the statistical likelihood of success, the potential payout and loss, and\ntheir own tolerance for risk. Having considered these criteria helps the\ntraders stay the course and avoid knee-jerk reactions when the market\nmoves in the wrong direction. Trading is easy when positions make money.\nIt is how traders deal with adverse positions that separates good traders\nfrom bad.\nGood traders are good at losing money. They take losses quickly and let\nprofits run. Accepting, before entering the trade, the statistical nature of\ntrading can help traders trade their positions with less emotion. It then\nbecomes a matter of competent management of those positions based on\ntheir knowledge of the factors affecting option values: the greeks. Learning\nto think in terms of probability is among the most difficult challenges for a\nnew options trader.\nChapter 5 discussed my Would I Do It Now? Rule, in which a trader asks\nhimself: if I didn’t currently have this position, would I put it on now at\ncurrent market prices? This rule is a handy technique to help traders filter\nout the noise in their heads that clouds judgment and to help them to make\nrational decisions on whether to hold a position, close it out or adjust it.\nAdjusting\nSometimes the position a trader starts off with is not the position he or she\nshould have at present. Sometimes positions need to be changed, or\nadjusted, to reflect current market conditions. Adjusting is very important to\noption traders. To be good at adjusting, traders need to use the greeks.\nImagine a trader makes the following trade in Halliburton Company\n(HAL) when the stock is trading $36.85.\nSell 10 February 35–36–38–39 iron condors at 0.45\nFebruary has 10 days until expiration in this example. The greeks for this\ntrade are as follows:\nDelta: −6.80\nGamma: −119.20\nTheta: +21.90\nVega: −12.82\nThe trader has a neutral outlook, which can be inferred by the near-flat\ndelta. But what if the underlying stock begins to rise? Gamma starts kicking\nin. The trader can end up with a short-biased delta that loses exponentially\nif the stock continues to climb. If Halliburton rises (or falls for that matter)\nthe trader needs to recalibrate his outlook. Surely, if the trader becomes\nbullish based on recent market activity, he’d want to close the trade. If the\ntrader is bearish, he’d probably let the negative delta go in hopes of making\nback what was lost from negative gamma. But what if the trader is still\nneutral?\nA neutral trader needs a position that has greeks which reflect that\noutlook. The trader would want to get delta back towards zero. Further,\ndepending on how much the stock rises, theta could start to lose its benefit.\nIf Halliburton approaches one of the long strikes, theta could move toward\nzero, negating the benefit of this sort of trade all together. If after the stock\nrises, the trader is still neutral at the new underlying price level, he’d likely\nadjust to get delta and theta back to desired territory.\nA common adjustment in this scenario is to roll the call-credit-spread legs\nof the iron condor up to higher strikes. The trader would buy ten 38 calls\nand sell ten 39 calls to close the credit spread. Then the trader would buy 10\nof the 39 calls as sell 10 of the 40 calls to establish an adjusted position that\nis short a 10 lot of the February 35–36–39–40 iron condor.\nThis, of course, is just one possible adjustment a trader can make. But the\ncommon theme among all adjustments is that the trader’s greeks must\nreflect the trader’s outlook. The position greeks best describe what the\nposition is—that is, how it profits or loses. When the market changes it\naffects the dynamic greeks of a position. If the market changes enough to\nmake a trader’s position greeks no longer represent his outlook, the trader\nmust adjust the position (adjust the greeks) to put it back in line with\nexpectations.\nIn option trading there are an infinite number of uses for the greeks. From\nfinding trades, to planning execution, to managing and adjusting th", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 108}
{"text": "e market changes it\naffects the dynamic greeks of a position. If the market changes enough to\nmake a trader’s position greeks no longer represent his outlook, the trader\nmust adjust the position (adjust the greeks) to put it back in line with\nexpectations.\nIn option trading there are an infinite number of uses for the greeks. From\nfinding trades, to planning execution, to managing and adjusting them, to\nplanning exits; the greeks are truly a trader’s best resource. They help\ntraders see potential and actual position risk. They help traders project\npotential and actual trade profitability too. Without the greeks, a trader is at\na disadvantage in every aspect of option trading. Use the greeks on each\nand every trade, and exploit trades to their greatest potential.\nI wish you good luck !\nFor me, trading option greeks has been a labor of love through the good\ntrades and the bad. To succeed in the long run at greeks trading—or any\nendeavor, for that matter—requires enjoying the process. Trading option\ngreeks can be both challenging and rewarding. And remember, although\noption trading is highly statistical and intellectual in nature, a little luck\nnever hurt! That said, good luck trading!\nAbout the Author Dan Passarelli is an\nauthor, trader, and former member of the\nChicago Board Options Exchange (CBOE)\nand CME Group. Dan has written two books\non options trading—Trading Option Greeks\nand The Market Taker’s Edge . He is also the\nfounder and CEO of Market Taker\nMentoring, a leading options education firm\nthat provides personalized, one-on-one\nmentoring for option traders and online\nclasses. The company web site is\nwww.markettaker.com .\nDan began his trading career on the floor of the CBOE as an equity\noptions market maker. He also traded agricultural options and futures on the\nfloor of the Chicago Board of Trade (now part of CME Group).\nIn 2005, Dan joined CBOE’s Options Institute and began teaching both\nbasic and advanced trading concepts to retail traders, brokers, institutional\ntraders, financial planners and advisers, money managers, and market\nmakers. In addition to his work with the CBOE, he has taught options\nstrategies at the Options Industry Council (OIC), the International\nSecurities Exchange (ISE), CME Group, the Philadelphia Stock Exchange,\nand many leading options-based brokerage firms. Dan has been seen on\nFOX Business News and other business television programs. Dan also\ncontributes to financial publications such as TheStreet.com , SFO.com , and\nthe CBOE blog.\nDan can be reached at his web site, MarketTaker.com , or by e-mail:\ndan@markettaker.com . He can be followed on Twitter at\ntwitter.com/Dan_Passarelli .\nIndex American-exercise options\nArbitrageurs\nAt-the-money (ATM) Backspreads\nBear call spread Bear put spread Bernanke, Ben\nBlack, Fischer Black-Scholes option-pricing model Boxes\nbuilding\nBull call spread strengths and limitations Bull put spread Butterflies\nlong\nalternatives example\nshort\niron\nlong\nshort\nBuy-to-close order Calendar spreads buying\n“free” call, rolling and earning rolling the spread\nincome-generating, managing strength of\ntrading volatility term structure buying the front, selling the back\ndirectional approach double calendars ITM or OTM\nselling the front, buying the back\nCalls\nbuying\ncovered\nentering\nexiting\nlong ATM\ndelta\ngamma\nrho\ntheta\ntweaking greeks vega\nlong ITM\nlong OTM\nselling\nCash settlement Chicago Board Options Exchange (CBOE) Volatility\nIndex®\nCondors\niron\nlong\nshort\nlong\nshort\nstrikes\nsafe landing selectiveness too close\ntoo far\nwith high probability of success\nContractual rights and obligations open interest and volume opening and\nclosing Options Clearing Corporation (OCC) standardized contracts\nexercise style expiration month option series, option class, and contract size\noption type\npremium\nquantity\nstrike price\nCredit call spread Debit call spread Delta\ndynamic inputs effect of stock price on effect of time on effect of\nvolatility on moneyness and Delta-neutral trading art and science\ndirection neutral vs. direction indifferent gamma, theta, and volatility\ngamma scalping implied volatility, trading selling\nportfolio margining realized volatility, trading reasons for\nsmileys and frowns Diagonal spreads double\nDividends\nbasics\nand early exercise dividend plays strange deltas\nand option pricing pricing model, inputting data into dates, good and bad\ndividend size\nEstimation, imprecision of European-exercise options Exchange-traded\nfund (ETF) options Exercise style Expected volatility CBOE Volatility\nIndex®\nimplied\nstock\nExpiration month Ford Motor Company Fundamental analysis Gamma\ndynamic\nscalping\nGreeks\nadjusting\ndefined\ndelta\ndynamic inputs effect of stock price on effect of time on effect of\nvolatility on moneyness and\ngamma\ndynamic\nHAPI: Hope and Pray Index managing trades online, caveats with regard\nto price vs. value rho\ncounterintuitive results effect of time on put-call parity\nstrategies, choosing between theta\neffect of moneyness and stock price on effects of volatility and time\non positive or negative taking the day out\ntrading\nvega\neffect of implied volatility on effect of moneyness on effect of time\non implied volatility (IV) and\nwhere to find Greenspan, Alan HOLDR options\nImplied volatility (IV) trading\nselling\nand vega\nIn-the-money (ITM) Index options\nInterest, open Interest rate moves, pricing in Intrinsic value Jelly rolls\nLong-Term Equity AnticiPation Securities® (LEAPS®) Open interest\nOption, definition of Option class\nOption prices, measuring incremental changes in factors affecting Option\nseries\nOptions Clearing Corporation (OCC) Out-of-the-money (OTM) Parity,\ndefinition of Pin risk\nborrowing and lending money boxes\njelly rolls\nPremium\nPrice discovery Price vs. value Pricing model, inputting data into dates,\ngood and bad dividend size “The Pricing of Options and Corporate\nLiabilities” (Black & Scholes) Put-call parity American exercise options\nessentials\ndividends\nsynthetic calls and puts, comparing\nsynthetic stock strategies", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 109}
{"text": "-of-the-money (OTM) Parity,\ndefinition of Pin risk\nborrowing and lending money boxes\njelly rolls\nPremium\nPrice discovery Price vs. value Pricing model, inputting data into dates,\ngood and bad dividend size “The Pricing of Options and Corporate\nLiabilities” (Black & Scholes) Put-call parity American exercise options\nessentials\ndividends\nsynthetic calls and puts, comparing\nsynthetic stock strategies\ntheoretical value and interest rate Puts\nbuying\ncash-secured long ATM\nmarried\nselling\nRatio spreads and complex spreads delta-neutral positions, management\nby market makers through longs to shorts risk, hedging trading flat\nmultiple-class risk ratio spreads backspreads\nvertical\nskew, trading Realized volatility trading\nReversion to the mean Rho\ncounterintuitive results effect of time on and interest rates in planning\ntrades interest rate moves, pricing in LEAPS\nput-call parity and time\ntrading\nRisk and opportunity, option-specific finding the right risk long ATM call\ndelta\ngamma\nrho\ntheta\ntweaking greeks vega\nlong ATM put long ITM call long OTM call options and the fair game\nvolatility\nbuying and selling direction neutral, direction biased, and direction\nindifferent\nScholes, Myron Sell-to-open transaction Skew\nterm structure trading\nvertical\nSpreads\ncalendar\nbuying\n“free” call, rolling and earning income-generating, managing\nstrength of\ntrading volatility term structure\ndiagonal\ndouble\nratio and complex delta-neutral positions, management by market makers\nmultiple-class risk ratio\nskew, trading\nvertical\nbear call\nbear put\nbox, building bull call\nbull put\ncredit and debit, interrelations of credit and debit, similarities in and\nvolatility\nwing\nbutterflies\ncondors\ngreeks and\nkeys to success retail trader vs. pro trades, constructing to maximize\nprofit\nStandard deviation and historical volatility Standard & Poor’s Depositary\nReceipts (SPDRs or Spiders) Straddles\nlong\nbasic\ntrading\nshort\nrisks with\ntrading\nsynthetic\nStrangles\nlong\nexample\nshort\npremium\nrisk, limiting\nStrategies and At-Expiration Diagrams buy call\nbuy put\nfactors affecting option prices, measuring incremental changes in sell call\nsell put\nStrike price\nSupply and demand Synthetic stock strategies\nconversion\nmarket makers pin risk\nreversal\nTechnical analysis Teenie buyers\nTeenie sellers Theta\neffect of moneyness and stock price on effects of volatility and time on\npositive or negative risk\ntaking the day out Time value\nTrading strategies Value\nVega\neffect of implied volatility on effect of moneyness on effect of time on\nimplied volatility (IV) and Vertical spreads bear call\nbear put\nbox, building bull call\nbull put\ncredit and debit interrelations of similarities in\nand volatility Volatility\nbuying and selling teenie buyers teenie sellers\ncalculating data direction neutral, direction biased, and direction\nindifferent expected\nCBOE Volatility Index®\nimplied\nstock\nhistorical (HV) standard deviation\nimplied (IV) and direction HV-IV divergence inertia\nrelationship of HV and IV\nselling\nsupply and demand\nrealized\ntrading\nskew\nterm structure vertical\nvertical spreads and Volatility charts, studying patterns\nimplied and realized volatility rise realized volatility falls, implied\nvolatility falls realized volatility falls, implied volatility remains\nconstant realized volatility falls, implied volatility rises realized\nvolatility remains constant, implied volatility falls realized volatility\nremains constant, implied volatility remains constant realized\nvolatility remains constant, implied volatility rises realized volatility\nrises, implied volatility falls realized volatility rises, implied\nvolatility remains constant\nVolatility-selling strategies profit potential covered call covered put\ngamma-theta relationship greeks and income generation naked\ncall\nshort naked puts similarities Would I Do It Now? Rule\nVolume\nWeeklysSM\nWing spreads\nbutterflies\ndirectional\nlong\nshort\niron\ncondors\niron\nlong\nshort\ngreeks and\nkeys to success retail trader vs. pro trades, constructing to maximize\nprofit Would I Do It Now? Rule", "source": "eBooks\\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf", "doc_id": "9c955a4100b025a276418a0107d50dde5016e41431640dc5a3498bb1b5f494b5", "chunk_index": 110}